Question

Problem 1 What is the condition on consumer utility that is met when consumers maximize utility (hint: it is a formula). Describe the behavior of the consumer that this formula represents (what are they doing and why is it an optimum). 

Problem 2 What is the goal of the firm? What is the condition that is met when firms achieve this goal? Describe in words why this condition leads to an optimum for the firm.

Answer 1

Ans. Utility is maximized where,

Marginal Rate of Substitution = Price ratio of the two goods

Marginal rate of substitution is an indicator of how the consumer values his consumption i.e. how many units of 1 good, the consumer is willing to give up for an additional unit of the orher good. So, MRS measures the consumer's perceived value of the good. The price ratio of the two goods indicate how many times one good costs the other. So, it indicated the market's valuation of the good. Thus, utility is maximized where the market's valuation of the good equals the consumer's perceived valuation of that good i.e. MRS = Price of Good 1 / Price of good 2

Ans. Firm's goal is to maximize profits. So, the profit maximizing condition is,

Marginal Revenue = Marginal Cost

So, marginal revenue is the addition revenue from an incremental unit sold and marginal cost is additional cost from an additional unit produced. Thus, the firm will be able to maximize profits when MR = MC because at this point marginal profits become zero and hence, they are maximized.