1 Utility Function, Deriving MRS 1

Lecture 5

Deriving MRS from Utility Function, Budget

Constraints, and Interior Solution of
Optimization

Outline
1. Chap 3: Utility Function, Deriving MRS
2. Chap 3: Budget Constraint
3. Chap 3: Optimization: Interior Solution
1 Utility Function, Deriving MRS
Examples of utility:
Example (Perfect substitutes).

U(x,y) = ax + by.

Example (Perfect complements).

U(x,y) = min{ax,by}.

Example (Cobb-Douglas Function).

Example (One good is bad).

U(x,y) = −ax + by.

An important thing is to derive MRS.

= = Slope of Indifference Curve|.

1 Utility Function, Deriving MRS 2

10

7
U(x,y)=ax+by=Const
6

y
4

0
0 2 4 6 8 10
x

Figure 1: Utility Function of Perfect Substitutes

10

5
y

U(x,y)=min{ax,by}=Const
4

0
0 2 4 6 8 10
x

Figure 2: Utility Function of Perfect Complements

1 Utility Function, Deriving MRS 3

10

y
U(x,y)=Axayb =Const
4

0
0 2 4 6 8 10
x

Figure 3: Cobb-Douglas Utility Function

10

5
y

U(x,y)=−ax+by=Const
4

0
0 2 4 6 8 10
x

Figure 4: Utility Function of the Situation That One Good Is Bad

 4
2 Budget Constraint

Because utility is constant along the indifference curve,

u = (x,y(x)) = C,=⇒

∂u ∂u dy
+ = 0,=⇒
∂x ∂y dx
dy ∂u

− dx = ∂u∂x .
∂y

Thus,
∂u

MRS = ∂u∂x .
∂y Example
(Sample utility function).
u(x,y) = xy 2 .
Two ways to derive MRS:
• Along the indifference curve

xy 2 = C.

c
y=
.
x
Thus,
dy √c y
MRSd = −dx = 2x3/2 = 2x .
• Using the conclusion above

=
.

2 Budget Constraint
The problem is about how much goods a person can buy with limited income.
Assume: no saving, with income I, only spend money on goods x and y with
the price Px and Py.
Thus the budget constraint is
 5
Px · x + Py · y I.

Suppose Px = 2, Py = 1, I = 8, then
2x + y 8.
The slope of budget line is

=
Bundles below the line are affordable. Budget
line can shift:
2 Budget Constraint

10

6
y

4 2x+y≤8

0
0 2 4 6 8 10
x

Figure 5: Budget Constraint

3 Optimization: Interior Solution 6
10

6 2x+y≤8

y
5

4 2x+y≤6
3

0
0 2 4 6 8 10
x

Figure 6: Budget Line Shifts Because of Change in Income

10

6 2x+y≤8

5
y

4 x+y≤4
3

0
0 2 4 6 8 10
x

Figure 7: Budget Line Rotates Because of Change in Price

• Change in Income Assume I′ = 6, then 2x+y = 6. The budget line shifts right
which means more income makes the affordable region larger.

• Change in Price Assume = 2, then 2x + 2y = 8. The budget line changes

which means lower price makes the affordable region larger.

3 Optimization: Interior Solution

Now the consumer’s problem is: how to be as happy as possible with limited
income. We can simplify the problem into language of mathematics:
 7
+
max U(x,y)subject to
0 x,y
0

Since the preference has non-satiation property, only (x,y) on the budget line can
be the solution. Therefore, we can simplify the inequality to an equality:

xPx + yPy = I.

First, consider the case where the solution is interior, that is, x > 0 and y > 0.
Example solutions:

• Method 1
3 Optimization: Interior Solution 8

10

y
4 U(x,y)=Const

2 Pxx+Pyy=I

0
2 4 6 8 10
x

Figure 8: Interior Solution to Consumer’s Problem

From Figure 8, the utility function reaches its maximum when the
indifferent curve and constraint line are tangent, namely:

=
– If
,

then one should consume more y, less x.

– If
,

then one should consume more x, less

y. Intuition behind = :
is the market price of x in terms of y, and MRS is the price of x in
terms of y valued by the individual. If Px/Py > MRS, x is relatively
expensive for the individual, and hence he should consume more y.
On the other hand, if Px/Py < MRS, x is relatively cheap for the
individual, and hence he should consume more x.
• Method 2: Use Lagrange Multipliers

L(x,y,λ) = u(x,y) − λ(xPx + yPy − I).

3 Optimization: Interior Solution 9

In order to maximize u, the following first order conditions must be

satisfied:

∂L ux
=0= = λ,
∂x ⇒ Px
∂L uy
=0= = λ,
∂y ⇒ Py
∂L

∂λ = 0 =⇒ xPx + yPy − I = 0.

Thus we have
=

• Method 3

Since xPx + yPy + I = 0,

=
Then the problem can be written as

=
At the maximum, the following first order condition must be satisfied:

∂y Px ux + uy( )=
ux + uy(− ) = 0.
∂x Py
=⇒
Px ux =
.
Py uy