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Optimization, Revealed Preference, and Deriving Individual Demand

1. The document discusses corner solutions in consumer optimization problems that occur when the optimal quantity of a good is zero. It provides an example where the consumer's optimal choice is a corner solution with x=0 and y=2. 2. It then discusses revealed preference, using budget constraints and observed consumer choices to determine preferences. It provides an example where two choices contradict each other and are thus not rational. 3. Finally, it derives individual demand curves and Engel curves for goods x and y using a utility function and budget constraint. It characterizes the goods as substitutes and discusses how demand changes with income.

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40 views9 pages

Optimization, Revealed Preference, and Deriving Individual Demand

1. The document discusses corner solutions in consumer optimization problems that occur when the optimal quantity of a good is zero. It provides an example where the consumer's optimal choice is a corner solution with x=0 and y=2. 2. It then discusses revealed preference, using budget constraints and observed consumer choices to determine preferences. It provides an example where two choices contradict each other and are thus not rational. 3. Finally, it derives individual demand curves and Engel curves for goods x and y using a utility function and budget constraint. It characterizes the goods as substitutes and discusses how demand changes with income.

Uploaded by

dijojnay
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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1

1 Corner Solution of Optimization

Lecture 6

Optimization, Revealed Preference, and Deriving


Individual Demand

Outline
1. Chap 3: Corner Solution of Optimization
2. Chap 3: Revealed Preference
3. Chap 4: Deriving Individual Demand, Engle Curve
1 Corner Solution of Optimization
When we have an interior solution,

Px Ux
=
Py Uy

must be satisfied. However, sometimes a consumer gets highest utility level


when x = 0 or y = 0. If that’s the case, we have corner solutions, and

=
as shown in Figure 1.
In Figure 1, because people cannot consume negative amounts of goods
(bundle A), their best choice is to consume bundle B, so the quantity of y
consumed is zero. Conditions for corner solutions:
•
=
wheny = 0.

•
=
whenx = 0.

Example (An example of consumer’s problem). The parameters are

Px = 1,
2
Py = 1,
1 Corner Solution of Optimization
3
Figure 1: Corner Solution to Consumer’s Problem.
2 Revealed Preference

I = 2.
The utility function is
U(x,y) = x + 2√y.
The budget constraint is x + y = 2.
According to the condition for an interior solution:
Px Ux = . Py U y
=⇒
1 1
1 = √1y .
=⇒
y = 1 =⇒ x = 1.

If the price y changes to 1:


Py = 1,
then the solution is y = 4 =⇒ x = −3 < 0,

which is impossible.
Then we have the corner solution:

x = 0,y = 2.

x = 0 since consumer wants to consume as little as possible.

2 Revealed Preference
In the former chapters, we discussed how to decide optimal consumption from
utility function and budget constraint:

Utility Function
=⇒ Optimal Consumption

Budget Constraint

And now we discuss how to know consumer’s preference from budget


constraint and consumption:

Budget Constraint
=⇒ Preference
4
Consumption
Deriving Individual Demand, Engle Curve 5
3

Figure 2: A Contradiction of Preference. A and B are the Choices.

Example (Revealed preference). In Figure 2, two budget constraint lines


intersect. Assume one person’s choices are A and B respectively. Then we have

A C,

B D. And Figure 2
obviously shows that

C≻ B,

D ≻ A.

Thus,
A C ≻ B D ≻ A,

which is a contradiction, which means utility does not optimized and the choice
is not rational.

3 Deriving Individual Demand, Engle Curve


Use the following utility function again:

U(x,y) = x + 2√y,
Deriving Individual Demand, Engle Curve 6
with a budget constraint:
Pxx + Pyy = I.
3

When
Px 2
I ,
Py
we have an interior solution. MRS = Px/Py. Thus,

I Px
x=− ,
Px Py

Px 2
y= .
Py
When
Px 2
I ,
Py
we have a corner solution.
x = 0,
I
y= .
Py
• Figure 3 shows a demand function of y and Py as an example. (Assume that
I, x and Px are held constant.)

• Engle Curve describes the relation between quantity and income. Figure 4
shows the relation between x and income, and Figure 5 shows that
between y and income.

Normal good. Quantity demanded of good increases with income.


Inferior good. Quantity demanded of good decreases with income.

Substitutes. Increase in price of one leads to an increase in quantity


demanded of the other.
Complements. Increase in price of one leads to an decrease in quantity
demanded of the other.
Deriving Individual Demand, Engle Curve 7
For this problem,

and y are neither substitutes nor complements, and x is a


normal good.

are substitutes, and y is a normal good.


3
Deriving Individual Demand, Engle Curve 8
Figure 3: Demand Function for Goods ‘y’.
3

10

5
x

1 2
Px /Py

0
0 1 2 3 4 5 6 7 8 9 10
I

Figure 4: The Relation between Income and Quantity Demanded of ‘x’. Engle
curve of x.

10

5
y

1
2
Px /Py

0
0 1 2 3 4 5 6 7 8 9 10
I
Deriving Individual Demand, Engle Curve 9
Figure 5: The Relation between Income and Quantity Demanded of ‘y’. Engle
curve of y.

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