MG207

Managerial Economics
Michaelmas Term

Lecture 3
Catherine Thomas

c.m.thomas@lse.ac.uk
 Today

• Choice and Demand for special

cases of utility functions.
• Slutsky equation.
• Buying and selling, including
endowment effects.
 Computing Ordinary Demands.
A Cobb-Douglas Example

• So we have discovered that the most preferred affordable

bundle for a consumer with Cobb-Douglas preferences

is
 Income Changes
Fix p1 and p2. How does the value of x1*(p1,p2,m) change as
m changes, holding both p1 and p2 constant?

y’ < y’’ < y’’’Let m’ < m’’ < m’’’.

x2’’’
x2’’
x2 ’

x1’’’
x1 ’
x1’’
 Income Changes
y
Engel
curve;
good 2
Fixed p1 and p2. y’’’
m’’’
y’’
m’’
y’ < y’’ < y’’’
y’
m’
Income
offer curve x2 ’ x2’’’ x2 *
y x2’’
x2’’’
y’’’
m’’’
x2’’ Engel
y’’
m’’ curve;
x2 ’ good 1
y’
m’

x1 ’ x1’’’ x1’ x1’’’ x1 *

x1’’
x1’’
 Income Changes and Cobb-Douglas
Preferences
For the Cobb-Douglas case, the ordinary demand equations
are:
am bm
x =
*
1 ;x 2 =
*
.
( a + b ) p1 (a + b) p2
Rearranged to isolate m, these are:

( a + b) p1 *
m= x1 Engel curve for good 1
a
( a + b) p2 *
m= x2
b Engel curve for good 2
 Income Changes and Cobb-Douglas
Preferences
m
( a + b ) p1 *
m= x1 Engel curve for good 1
a

x1 *
m
(a + b) p2 *
m= x2
b
Engel curve for good 2

x2 *
 Income Effects
• A good for which quantity demanded rises with
income is called normal.
• Therefore a normal good’s Engel curve is
positively sloped.

• A good for which quantity demanded falls as

income increases is called income inferior.
• Therefore an income inferior good’s Engel curve
is negatively sloped.
 Recap of where we had got to…

• A consumer with well-behaved preferences and a limited

budget will, out of all the feasible bundles in her budget
set, prefer the bundle at which her MRS between
commodities in the bundle is equal to the (negative of)
the relative prices.

• But, what if there is no tangency point? Or the MRS is

undefined? Or, the tangency point is not the highest-
utility IC set in the budget set?

• In these cases, our economic intuition about her

decision-making can still get us quite far…
The Perfect Substitutes Case: Corner Solutions
For example, U(x1,x2)= x1 + x2
x2
MRS = -1

x1
The Perfect Substitutes Case: Corner Solutions

x2
MRS = -1

BC Slope = -p1/p2 with p1 > p2.

x1
The Perfect Substitutes Case: Corner Solutions

x2
MRS = -1
m
x2* =
p2

BC Slope = -p1/p2 with p1 > p2.

x1* = 0
x1
The Perfect Substitutes Case: Corner Solutions

x2
MRS = -1

BC Slope = -p1/p2 with p1 < p2.

x2* = 0
m x1
x =
*
1
p1
The Perfect Substitutes Case: Corner Solutions

• So when U(x1,x2) = x1 + x2, the most

preferred affordable bundle is (x1*,x2*)
where
æ m ö if p < p
( x , x ) = ç ,0 ÷
*
1
*
2 çp
1
÷
2
è 1 ø
• and
æ mö
( x , x ) = çç 0,
*
1
*
2
÷÷ if p1 > p2.
è p2 ø
The Perfect Substitutes Case: Corner Solutions

x2 All the bundles in the constraint are

m equally the most preferred
p2
affordable bundles when p1 = p2.

m
x1
p1
The Non-Convex Preferences Case: Corner Solutions

x2 B
et
te
r

x1
The Non-Convex Preferences Case: Corner Solutions

x2

The most preferred

affordable bundle

x1
The Perfect Complements Case: Kinked Solutions

x2 U(x1,x2) = min{ax1,x2}

MRS = - ¥
MRS is undefined
x2 = ax1
MRS = 0

x1
The Perfect Complements Case: Kinked
Solutions

x2 U(x1,x2) = min{ax1,x2}

Which is the most

preferred affordable bundle?

x2 = ax1

x1
The Perfect Complements Case: Kinked
Solutions

x2 U(x1,x2) = min{ax1,x2}

The most preferred

affordable bundle

x2 = ax1

x1
The Perfect Complements Case: Kinked
Solutions

x2 U(x1,x2) = min{ax1,x2}
(a) p1x1* + p2x2* = m
(b) x2* = ax1*

x2 = ax1
x2*

x1* x1
 The Perfect Complements Case: Kinked
Solutions
(a)p1x1* + p2x2* = m; (b) x2* = ax1*.
Substitution from (b) for x2* in (a) gives
p1x1* + p2ax1* = m, which gives
* m * am
x =
1 ; x =
2 .
p1 + ap2 p1 + ap2

A bundle of one unit of commodity 1 and a

units of commodity 2 costs p1 + ap2; so
m/(p1 + ap2) such bundles are affordable.
 The Perfect Complements Case:
Kinked Solutions

x2 U(x1,x2) = min{ax1,x2}

x2 = ax1
am
x2* =
p1 + ap2

m
x1* =
p1 + ap2
x1
 Own-Price Changes
• What does a p1 price-offer curve look like for a
perfect complements utility function?
• For U(x1, x2) = min{x1, x2}, the ordinary demand
functions for commodities 1 and 2 are
x1*(p1, p2, m) = x2 *(p1, p2, m)= m / (p1 + p2)
• So with p2 and m fixed, higher p1 causes smaller
x1* and smaller x2 *.
• As p1 approaches 0, x1*= x2* approaches (m / p2).
• As p1 approaches infinity, x1 *= x2* approaches 0.
 Own-Price Changes
Fixed p2 and m. p1
x2
p1 = p1’
m/p2
p1’
m
x =
*
2
p1 '+ p2 m x1*
x1* =
p1 '+ p2

m
x1* =
p '1 + p2 x1
 Own-Price Changes
p1 Ordinary
Fixed p2 and m. p1’’’ demand curve
x2 for commodity 1 is
m
x1* = .
p1 + p2
m/p2 p1’’

p1’
m
x =
*
2
p1 + p2 m x1*
p2

m
x1* =
p1 + p2
x1
 Own-Price Changes
• What does a p1 price-offer curve look like for a perfect
substitutes utility function?
• Let U(x1, x2)= x1 + x2
• Then the ordinary demand functions for commodities 1
and 2 are:
ì0,if p1 > p2
x1 ( p1 , p2 , m) = í
*

îm / p1,if p1 < p2

ì0,if p1 < p2
x ( p1 , p2 , m) = í
*
2
îm / p2 ,if p1 > p2 .
 Own-Price Changes
p1
Fixed p2 and m.
x2

Budget constraint
p1 = p1’ < p2 p1’

x1* =
m
p1 '
x1*

x*2 = 0
m
x1* =
p1 ' x1
 Own-Price Changes
p1
Fixed p2 and m.
x2
p1 = p1’’ = p2

p1’

x1*

x1
 Own-Price Changes
Fixed p2 and m. p1
x2 p1 = p1’’ = p2
p2 = p1’’
x1* = 0
m
x2* = p1’
p2
ì
ï !##"##
$ x1*
ï
í x =0
* 0 £ x1* £
m
p2
ï 2

ïî
x1* =
m
p1 ' '
=
m
p2
x1
 Own-Price Changes
p1 Ordinary demand
Fixed p2 and m. p1’’’ curve for commodity 1

x2 m
x1* =
p1
p2 = p1’’

m p1’
p2

p1 price-offer
!##"##
$ x1*
curve m
0 £ x1* £
p2

x1
 Effects of a Price Change
• What happens when a commodity’s price
decreases?
– Substitution effect: the commodity is now relatively
cheap, so consumers substitute it for now relatively
more expensive other commodities.
– Income effect: the consumer’s budget of $m can
purchase more than before, as if the consumer’s
income rose, with consequent income effects on
quantities demanded.
• Slutsky discovered that changes to demand
from a price change are the sum of a pure
substitution effect and an income effect.
 Real Income Changes
• Slutsky asserted that if, at the new prices,
– less income is needed to buy the original bundle
then “real income” is increased.
– more income is needed to buy the original bundle
then “real income” is decreased.
• Slutsky also isolated the change in demand
due to the change in relative prices only by
asking “What is the change in demand when
the consumer’s income is adjusted so that, at
the new prices, she can only just buy the
original bundle?”
 Pure Substitution Effect
x2

x2 ’

x1 ’ x1
 Pure Substitution Effect Only
x2

x2 ’

x1 ’ x1
 Pure Substitution Effect Only
x2

x2 ’

x1 ’ x1
 Pure Substitution Effect Only
x2
Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
(x1’,x2’) ® (x1’’, x2’’) is the
x2 ’ pure substitution effect.

x2’’

x1 ’ x1’’ x1
 And Now The Income Effect
x2

x2 ’ (x1’’’,x2’’’)

x2’’

x1 ’ x1’’ x1
 And Now The Income Effect
x2
The income effect is
(x1’’, x2’’) ® (x1’’’, x2’’’).

x2 ’ (x1’’’,x2’’’)

x2’’

x1 ’ x1’’ x1
 The Overall Change in Demand
x2 The change to demand due to
lower p1 is the sum of the
income and substitution effects,
(x1’,x2’) ® (x1’’’,x2’’’).
x2 ’ (x1’’’,x2’’’)

x2’’

x1 ’ x1’’ x1
 Slutsky Effects for Normal Goods
• Most goods are normal (i.e. demand increases with
income).
• The substitution and income effects reinforce each other
when a normal good’s own price changes.
• (In the previous example, we can see the arrows for
good 1 both point in the same way in response to a
lower price of good 1. Good 1 is, therefore, normal. And,
so is Good 2 here.)
• Since both the substitution and income effects increase
demand when own-price falls, a normal good’s ordinary
demand curve slopes down.
• The Law of Downward-Sloping Demand therefore
always applies to normal goods.
 Slutsky Effects for Income-Inferior Goods
• Some goods are income inferior, i.e. demand is reduced
by higher income.
• The substitution and income effects oppose each other
when an income-inferior good’s own price changes.
• In rare cases of extreme income-inferiority, the income
effect may be larger in size than the substitution effect,
causing quantity demanded to fall as own-price falls.
• Such goods are Giffen goods.
• Slutsky’s decomposition of the effect of a price change
into a pure substitution effect and an income effect thus
explains why the Law of Downward-Sloping Demand is
violated for extremely income-inferior goods.
Slutsky Effects for Income-Inferior Goods
x2

x2 ’

x1 ’ x1
Slutsky Effects for Income-Inferior Goods
x2

x2 ’

x2’’

x1 ’ x1’’ x1
Slutsky Effects for Income-Inferior Goods
The pure substitution effect is as for a normal good. But, the
x2 income effect is in the opposite direction. Good 1 is income-
inferior because an increase to income causes demand to fall.

(x1’’’,x2’’’)
x2 ’

x2’’

x1 ’ x1’’ x1
Slutsky Effects for Income-Inferior Goods
x2 The overall changes to demand are
the sums of the substitution and income effects.

(x1’’’,x2’’’)
x2 ’

x2’’

x1 ’ x1’’ x1
 Slutsky Effects for Giffen Goods
x2
A decrease in p1 causes quantity
demanded of good 1 to fall.

x2’’’

x2 ’

x1’’’ x1 ’ x1
 Slutsky Effects for Giffen Goods
x2
A decrease in p1 causes quantity
demanded of good 1 to fall.

x2’’’

x2 ’

x2’’

x1’’’ x1 ’ x1’’ x1
Substitution effect
Income effect
 Summary, using algebra
• The change in demand due to a change in that good’s price
can be decomposed into two parts:
• Δx1 = x1 (p1’, m) – x1(p1,m) = Δx1S + Δx1N
= [x1(p1’, m’) – x1(p1,m)] + [x1(p1’,m) – x1 (p1’, m’)]
• This equation is called the Slutsky Identity.
• This identity gives us the Law of Demand: If demand for a
good increases when income increases, then the demand for
that good must increase when its price decreases.
• Notes: x1 is also (usually) a function of p2, but since this is
held constant in this exercise, we have dropped it from the
identity.
• Could also think of the Slutsky Identity in terms of rates of
change (see text book Chapter 8).
 Buying and Selling

• Trade involves exchange: when something is

bought something else must be sold.
• What will be bought? What will be sold?
• Who will be a buyer? Who will be a seller?
• And how are incomes generated?
• How does the value of income depend upon
commodity prices?
• How can we put all this together to explain better
how price changes affect demands?
 Endowments
• The list of resource units a consumer starts off
with is his endowment.
• A consumer’s endowment will be denoted by the
vector ω (omega).
• For example, ω = (ω1, ω2) = (10, 2) states that
the consumer is endowed with 10 units of good
1 and 2 units of good 2.
• Q: What is the value of the endowment?
• Q: For which consumption bundles can it be
exchanged?
• Answers depends on prices of goods 1 and 2.
 Endowments
• Say p1=2 and p2=3 so the value of the endowment
(ω1, ω2) = (10, 2) is:
p1ω1 + p2ω 2 = 2 ×10 + 3× 2 = 26
• Q: For which consumption bundles may the endowment
be exchanged?
• A: For any bundle costing no more than the
endowment’s value.
• So, given p1 and p2, the budget constraint for a
consumer with an endowment (ω1, ω2) is
p1 x1 + p2 x2 = p1ω1 + p2ω 2 .
• The budget set is:

{( x , x ) p x + p x
1 2 1 1 2 2 £ p1w1 + p2w2 , x1 ³ 0,x2 ³ 0}.
 Budget Constraints Revisited

x2

p1x1 + p 2x 2 = p1w 1 + p 2w 2

w2 Budget set:
{( x1 , x 2 ) p1 x1 + p 2x 2 £ p1w 1 + p2w 2 ,
x1 ³ 0, x 2 ³ 0}

w1 x1
 Budget Constraints Revisited

The endowment point is always on

x2
the budget constraint.

p1x1 + p 2x 2 = p1w 1 + p 2w 2
So price changes pivot the constraint
about the endowment point.
w2

p'1x1 + p'2x 2 = p'1w 1 + p'2w 2

w1 x1
 Budget Constraints Revisited
• The constraint
p1x1 + p 2x 2 = p1w 1 + p 2w 2
can be rearranged to give:
p1 ( x1 - w 1 ) + p 2 ( x 2 - w 2 ) = 0 .
• That is, the sum of the values of a consumer’s net
demands is zero.
• Suppose a consumer’s endowment is:
(ω1, ω2) = (10,2), and p1 = 2, p2 = 3. Then the
constraint is:
p1x1 + p 2x 2 = p1w 1 + p 2w 2 = 26.
 Net Demands
• If the consumer demands (x1*, x2*) = (7,4), then three
units of good 1 are exchanged for two units of good
2.

• Net demands are

x1*- ω1 = 7-10 = – 3 and
x2*- ω2 = 4 - 2 = + 2.

• We are moving along the budget set, with the same

purchasing power, given the prices:
p1 ( x1 - w1 ) + p2 ( x2 - w2 ) = 2 ´ (-3) + 3 ´ (2)= 0.
• The purchase of two extra units of good 2 at $3 each
is funded by giving up three units of good 1 at $2
each.
 Net Demands

x2 p1 ( x 1 - w 1 ) + p 2 ( x 2 - w 2 ) = 0

At prices (p1,p2) the consumer sells

x2 * units of good 1 to acquire more units of
good 2.

w2

x1 * w 1 x1
 Net Demands
' ' ' '
x2
p1x1 + p 2x 2 = p1w 1 + p 2w 2
At prices (p1’,p2’) the consumer sells
units of good 2 to acquire more of
good 1.

w2
x2 *

w1 x1 * x1
 Net Demands

x2
p"1x1 + p"2x 2 = p"1w 1 + p"2w 2
At prices (p1”, p2”) the consumer
consumes her endowment; net
demands are all zero.
x2*=w2

x1*=w1 x1
 Net Demands

x2 p1 ( x 1 - w 1 ) + p 2 ( x 2 - w 2 ) = 0
Price-offer curve contains all the utility-
maximizing gross demands for which the
endowment can be exchanged.

w2

w1 x1
 Net Demands

x2 p1 ( x 1 - w 1 ) + p 2 ( x 2 - w 2 ) = 0
Price-offer curve

Sell good 1, buy good 2

w2

w1 x1
 Net Demands

x2 p1 ( x 1 - w 1 ) + p 2 ( x 2 - w 2 ) = 0
Price-offer curve

Buy good 1, sell good 2

w2

w1 x1
 Slutsky Equation Revisited
• Slutsky: changes to demands caused by a price
change are the sum of:
– a pure substitution effect, and
– an income effect.
• This assumed that income m did not change as
prices changed. But
m = p1w1 + p2w2
does change with price. How does this modify
Slutsky’s equation?
• There will be an additional income effect, called the
endowment income effect.
• Slutsky’s decomposition will thus have three
components: a pure substitution effect; an ordinary
income effect; an endowment income effect.
 Next week

• Slutsky Equation with Endowments

• Intertemporal Choice
 Recap of Today

• We looked at ordinary demand for unusual

consumer preferences.
• Substitution and Income effects following a
change in price: The Slutsky Identity.
• Normal goods; Inferior goods; Giffen goods.
• Buying and Selling.
• Endogenizing income; concept of Endowments.