x2

a
sod
of 10
tion
mp
U = 25
su 5
Con U=
12.5
1

1 2.5 5 U
x1 = 1
Consumption of
hotdogs
Intuitively what we have done in the graph is equate the tradeoff from prices to the
tradeoff in utility.

I.e., (p2/p1) = (MU2/MU1)

Where p2 is the price of good 2 and p1 is the price of good 1. Where MU2 is the
marginal utility of consuming good 2 and MU1 is the marginal utility of consuming good
1.

(p2/p1) = (MU2/MU1) can be rewritten as:

(MU2 / p2) = (MU1 / p1)

This says that you are normalizing the change in utility by the price of the good and then
equating it to the normalized marginal utility of the other good. Another way to look at this
is to say that the marginal utility derived from the last dollar spent for each good is equal.

What happens if one side is greater than the other?

There are many things that can change consumer equilibrium. The major two items
that we will examine that can change consumer equilibrium, ceteris paribus (Note:
Ceteris paribus means that we hold everything else fixed):

 Income

 Price of each good

 Change in Equilibrium example

Dr. Hurley’s budget constraint:

M = p1*x1 + p2*x2 ⇒ 10 = 1*x1 + 1*x2

Where x1 is the quantity of soda consumed

Where x2 is the quantity of chips consumed

 To find the maximum utility we can make the following argument:

We know that are maximum utility point must lie on the budget line assuming all the
consumption goods are desirable and we are non-satiated, i.e., utility is always
increasing. This being the case we can examine the points on the budget line to see
which provides the highest utility. Once we have found the maximum utility on the budget
curve, we can hold our utility fixed and draw the utility function.

Income and Substitution Effects

The total effect of a price change is the summation of the substitution and income effect. The
substitution and income effect can work in opposite direction of each other. The income
effect defines whether the good is an inferior good or a normal good.

 An inferior good can be defined as a good whose consumption has a negative

correlation with the income effect.
A good can be classified as an inferior good if the consumption for it has a negative
correlation with income. i.e., when income increases, you consume less of the good and
when income decreases you consume more.

A good can be both a normal good and an inferior good. It all depends on where you are
on the level of consumption of the good and your income. Suppose you have $10 to use
for buying food each week. You might try living off spaghetti because you cannot afford
steak. What happens when your income doubles, you might find yourself eating more
spaghetti and still no steak? What happens if you have $100 to spend, you might begin
to eat less spaghetti and start consuming steak?

 of a budget constraint and utility function, we can derive a person’s demand schedule
or curve. When we derived demand, we only change the price of the good we were
investigating and the change in the quantity demanded for the good. Prices of the other
good(s) and income were held fixed. Any other variable that might affect the utility
function were held fixed also.

 Income (M)

 Prices of other goods (pj)

 Tastes and preferences

This can either show up as a variable in the demand function or it can change the
function altogether.

Other items Affecting Demand

 Composition of the Population

 Attitudes toward Nutrition and Health

 Food Safety

 Lifestyles
  Technological Forces

 Advertising

Consumer Surplus

Consumer surplus is a measure of the difference between the amount of money a

person was willing to pay to buy a quantity of good and the actual price they paid. This
measure is used as a tool in policy analysis. Consumer surplus is represented
graphically as the area underneath the demand curve above the price paid for the goods.

∂Z/∂x2 = fx2 – λ p’ = 0
∂Z/∂ λ = Y0 – px1 –px2 = 0
Fx1 = λ p
Fx2 = λ p’
Fx1/fx2 = p/p’

Constrained profit maximization

Fx1x1>0
Fx1x1fx2x2-(fx1x2)>0

Constrained cost minimization

F1=p1- λ f1
F11= - λ f11
F2=p2- λ f2
F22= - λ f22
F12 = - λ f12
F21 =- λ f21

1) The Law of equi-marginal utility is of great practical importance. The application of

the principle of substitution extends over almost every field of economic enquiry.

2) Every consumer consciously or unconsciously trying to get the maximum satisfaction

from his limited resources acts upon this principle of substitution. Same is the case
with the producer.

3) In the field of exchange and in theory of distribution too, this law plays a vital role. In
short, despite its limitation, the law of maximum satisfaction is meaningful general
statement of how consumers behave.

4) In addition to its application to consumption, it applies equally to the theory of

production and theory of distribution. In the theory of production, it is applied on the
substitution of various factors of production to the point where marginal return from
all the factors are equal.

5) The government can also use this analysis for evaluation of its different economic
prices.
∂z/∂x1=3x2-3 λ

∂z/∂x2 =3x1-5 λ

∂z/∂ λ =100-3x1-5x2=0

3x2-3 λ=0

Λ=x2

3x1=5 λ=5x2

X1=5/3x2

100-5x2-5x2=0

X2=10

Find input demand and total cost when w = $10, r = $10 and Q = 20.
In order to produce 20 units of output, the firm must choose a point on the isoquant labeled
as
Q = 20. As is clear in the diagram, point (L = 10, K = 0) is on the lowest isocost curve. Thus,
the
Firm’s input demand is L∗ = 10, K∗ = 0. This will cost
C = wL + rK = $10 × 10 + $10 × 0 = $100
Find input demand and total cost when w = $30, r = $10 and Q = 20.

Suppose that production function is given as

Q = F (K, L) = √K√L
Then, marginal product of capital and labor would be
MPk = ∂f/∂k=1/2k-1/2l1/2
MP 1/2 -1/2
L = ∂f/∂L= 1/2K L
Input prices are given as w=$ 10 & r=$ 20
At cost minimizing pt. We have
MPL/MPk=w/r
K/L=1/2
Therefore, cost minimizing input demand (demand for labor and capital) requires
L = 2K
Substituting this into production function yields
Q = F (K, L) == √2K
To produce √50 units of output, we must have

√50 = √2K

K=5

Thus, L = 2K = 10. Then, total cost is

C = wL + rK = $10 × 10 + $20 × 5 = $200

Cost-minimizing input demand tells us that at cost minimizing point we need to hire twice as
many labors as capital.

Noah and Naomi face weekly inverse demand function P(Q) = 200-Q for their garden
benches
Weekly cost function is C (Q)=Q2
Suppose they produce in batches of 10
To maximize profit, they need to find the production level with the greatest difference
between revenue and cost

Π = R −C = P ×Q −C
Π = ( 200 −Q ) ×Q −Q 2
Π = 200 Q −Q 2 −Q 2 = 200 Q − 2Q 2
Π = 2(100 Q −Q 2 ) = 2(50 2 −50 2 +100 Q −Q 2 )
Π = 2(50 2 −[50 2 −100 Q +Q 2 ])
Π = 2(50 2 −[50 2 −2 ×50 ×Q +Q 2 ])
Π = 2(50 2 −[50 −Q ]2 )

Note that [50 – Q]2 is always a positive number. Therefore, to maximize profit one must
minimize [50 – Q]2. Therefore, to maximize profit, Noah and Naomi must produce Q = 50
units. This is their profit-maximizing output.
When Q = 50, π = 2 × 502 = 5000. This is the biggest profit Noah and Naomi can achieve.

If the firm intends to maximize the profit, then we require dπ/dQ = 0 and (d 2 π)/(dQ2 ) < 0

Where, π = 12Q – 0?4Q2 - ?06Q2 – 5

dπ/(dQ2 ) = [8 – 2Q] = 0 i.e., Q = 4

(d2 π)/(dQ2 ) = - 2

Thus, for this profit-maximizing firm

If the firm to maximize revenue subject to no constraint, then to locate the size of the
optimum decision variable Q, the decision rules required are

dR/dQ = 0 and (d^2 π)/(dQ^2 ) < 0

Where R=PQ
= 12Q – 0.4Q2
dR/dQ = [12 – 0?8] = 0 i.e. Q = 15

(d2 π)/(dQ2 ) = - 0?8

In this unconstrained sales maximization case,

Finally suppose that that firm’s objective function is to maximize sales subject to the profit
constraint,

π > 10 Setting π = 10,

We have
10 = 8Q – Q2 – 5,
i.e,
Q2 – 8Q + 15 = 0

Let the revenue fn be R =8x1+5x2 & product transformation curve be C = λ(2x12+3x22). Find
the condition for profit maximization
We have R=8x1+5x2
C = λ(2x12+3x22)
Now the profit can be defined as
P=8x1+ 5x2- λ(2x12+3x22)
∂p/∂x1=8-4 λx1=0
∂p/∂x2=5-6 λx2=0
8=4 λx1
5=6 λx2
Dividing 8/4x1=5/6x2
Fx1x1=4
Fx1x1fx2x2-(fx1x2)2=4*6-0=24>0

Conclusion

. Py / Px = MUy / MUx MU1/p1=MU2/p2