Jim Whitney | Economics 250 |
Situation:
Goal: maximize U = U(X,Y)
Constraint: I = PxX + PyY
Key relationships:
(1) Tangency Condition (T.C.):
MUx/MUy = (dU/dX)/(dU/dY) = Px/Py
(2) Budget Constraint: I
= Px X + Py Y
Steps:
Step 1: take partial derivatives of U to get the
tangency condition:
MUx/MUy = Px/Py
Step 2: rearrange the tangency condition to express
Y in terms of X, Px, and Py
Step 3: plug the expression for Y into the budget
constraint to solve for X in terms of I, Px, and Py.
Step 4: plug the solution for X into the formula
for Y derived in Step 2 to solve for Y in terms of Px, Py, and I.
Step 5: check your answers.
Is the tangency condition
met?
Is all income spent?
Example:
I = entertainment budget; X=video rentals; Y=CDs
U = X2/3 Y1/3
I = $120
Px = $2, Py = $10
X = ______
Y = ______
Depict the optimum in the diagram to the right.