Question:
a) Johnny consumes peanuts (x1) and a composite good (x2). His utility function is U = x1x2. His marginal utilities are MU1 = x2 and MU2 = x1. Johnny's budget is $20 and the price of the composite good is $1. Derive Johnny's demand function for peanuts.
b) Ambrose consumes peanuts (x1) and a composite good (x2).He has a utility functionU = 4 x1 + x2. This means his MU1 = 2/√x1 and his MU2 = 1 . The price of the composite good is p2 = 1. His budget is $20 per month. Derive Ambrose's demand function for peanuts. How does it compare with Johnny's demand curve for peanuts?
Solution:
a) U = x1x2
MRS = MU1/MU2 = x2/x1
Now, MRS = P1/P2 = P/1 = x2/x1 => x2 = 2Px1 {taking P1 = P}
Putting this value in budget equation:
Px1 + x2 = 20
- Px1 + 2Px1 = 30
- Px1 = 10
- x1 = 10/P
- x2 = 20
b) U = 4 Öx1 + x2.
MRS = MU1/ MU2 = (2/Öx1)/1 = 2/Öx1
Now, MRS = P1/P2 = P/1 = 2/Öx1
- Öx1=2/P
- x1 = 4/P2
Therefore, Ambrose's demand for peanuts does not depend upon his income, while Johnny's demand for peanuts does depend upon his income.