[Math] Economics, numeraire, utility, demand, marginal rate of substitution

economicsutility

I typed my question in Microsoft Word and printscreen it instead of typing it, this is because I don't know how to type mathematical questions here, sorry for the inconvenience caused.

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Best Answer

It is a method to maximize/minimize a function with constraints. I demonstrate the method with your exercise.

$\mathcal L=f(x_1,x_2)+\lambda (m-g(x_1,x_2))$

$f(x_1,x_2)$ is the function, which has to be maximized/minimized, in your case maximized.

$m-g(x_1,x_2)$ has to be zero. You have the budget restriction $m=p_1x_1+x_2$.

Now we can put all on the LHS: $m-p_1x_1+x_2=0$. The LHS can be insert into the brackets of the lagrange function, because it is equal to zero.

$\lambda$ ist the lagrange multiplier. For the moment you handle it like a ordinary variable.

$\mathcal L=x_1^{1/3}+x_2^{1/3}+\lambda (m-p_1x_1+x_2) $

Building the partial dervatives and set them equal to zero:


$\frac{\partial \mathcal L}{\partial x_1 }=\frac{1}{3}x_1^{-2/3}-\lambda p_1=0$

$\Rightarrow \frac{1}{3}x_1^{-2/3}=\lambda p_1 \quad (1)$


$\frac{\partial \mathcal L}{\partial x_2}=\frac{1}{3}x_2^{-2/3}-\lambda =0$

$\Rightarrow\frac{1}{3}x_2^{-2/3}=\lambda \quad (2)$


$\frac{\partial \mathcal L}{\partial \lambda}=m-p_1x_1+x_2=0\quad (3)$


Now you can divide (1) by (2):

$\frac{x_2^{2/3}}{x_1^{2/3}}=p_1$ The lambdas are cancelling out.

$x_2=p_1^{3/2}\cdot x_1 \quad (4)$

Now you can insert the expression for $x_2$ in (3)

$m-p_1x_1+p_1^{3/2}\cdot x_1=0$

Factoring out $x_1$

$m-x_1(p_1+p_1^{3/2})=0$

Now solve for $x_1$ and you will get the demand of good 1.

When you have the demand for good 1, you can use (4) to get the demand for good 2.

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