THE CONSUMER:

Lectures 5 - 8
 Quantities  Functions
xi consumption of good i U utility function
x = (x1, x2 , …, xn ) consumption vector C cost (expenditure) function
X consumption set Hi compensated demand for good i
Ri resource stock of good i Di ordinary demand for good i
R = (R1,R2 ,…,Rn) resource endowment V indirect utility function

 Prices and income  Other

pi price of good i λ Lagrange multiplier (min cost)
p = (p1, p2 , …, pn) price vector µ Lagrange multiplier (max utility)
y money income υ utility level
The budget constraint
A typical budget constraint
x2
Slope determined by price ratio
“Distance out” of budget line
fixed by income or resources

Two important cases determined by

1. amount of money income y
2. vector of resources R
p
– __1
p2
 Text: Section 4.2
x1
The budget constraint and prices: two cases
x2  Case 1: fixed nominal income
•  Swing the boundary to change p1
 Case 2: fixed “resources” R
 Swing the boundary to change p1

 Case 1:
n

•
y/p1
Σ pi xi ≤ y
i=1
x1
x2

 Case 2:
n n
Σ pi xi ≤ Σ pi Ri
i=1 i=1
R

x1
Conceptual problems
 Can we follow an analogy with the firm?
• inputs – stuff you buy
• constraint – one of the specs of the budget constraint
• output?
 Objective of the consumer
• utility?
• subjective wellbeing?
 Happiness?
• can we measure happiness? use it to rank situations / states / societies?
Bond & Lang (JPE 2019) “The Sad Truth about Happiness Scales”

• do people make choices so as to max happiness?

Benjamin, et al. (AER 2012) “What Do You Think Would Make You Happier? What Do You Think You Would Choose?

 How can we make progress in studying consumer behaviour?

Revealed Preference
x2  Market prices determine a person's budget constraint
 Suppose the person chooses bundle x
 Use this to introduce Revealed Preference

 x′
x

x1

Axiom of Rational Choice  Essential if observations are to

have meaning
Consumer always makes a
choice and selects the most  Text: Section 4.3
preferred bundle that is available
Weak Axiom of Revealed Preference
 Weak Axiom of Revealed Preference (WARP):
• If 𝐱𝐱 ⊳ 𝐱𝐱𝐱 then 𝐱𝐱′ ⋫ 𝐱𝐱

 Fundamental principle with a straightforward implication:

 Suppose that x is chosen when prices are p

• If x' is also affordable at p then ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 ≥ ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖′

 Now suppose x' is chosen at prices p'

• WARP means that x cannot be affordable at p': ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖′ 𝑥𝑥𝑖𝑖 > ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖′ 𝑥𝑥𝑖𝑖′
WARP in action
x2  Take the original situation
 Now let the prices change…
WARP rules out points like x° as possible solutions

• x° Clearly WARP induces a kind of

negative substitution effect
 x′ But could we extend this idea…?

 x
x1
Trying to extend WARP
x2 Take basic idea of revealed preference
Invoke revealed preference again
Invoke revealed preference yet again
Draw the “envelope”

 x''

Is this an “indifference curve”…?

 x' No. WARP does not rule out

cycles of preference
 You need an extra axiom to
 x progress further on this
x1
The axiomatic approach
 ≽: basic weak-preference relation  x ≽ x': "x at least as good as x'"
• from ≽ derive indifference relation ~  x ~ x' : x ≽ x' and x' ≽ x
• also, strict preference relation ≻  x ≻ x' : x ≽ x' and not x' ≽ x

 ≽ made operational through a set of

axioms:
 For every x, x'∈X either x ≽ x' is true,
1. completeness or x‘ ≽ x is true, or both are true
2. transitivity  If x ≽ x' and x‘ ≽ x" then x ≽ x"

3. continuity  For all x∈X the not-better-than-x set

and the not-worse-than-x set are
4. greed closed in X
5. (strict) quasiconcavity
 Text: Section 4.4
6. smoothness
The utility function
 Representation Theorem:
• given completeness, transitivity, continuity
• preference ordering ≽ can be represented by a continuous utility function
 In other words there exists some function U such that
• x ≽ x' implies U(x) ≥ U(x')
• and vice versa
 U is purely ordinal
• defined up to a monotonic transformation
 For example we could replace U(•) by any of the following
• log( U(•) )
• √( U(•) )
• φ( U(•) ) where φ is increasing
 All these transformed functions have the same shaped contours
 Utility function and indifference curves
 Draw function U
 Take a slice at given utility level
 Project down to get contours
 Draw U* = φ(U)
 Again take a slice…
 Project down to get same contours

U U*
υ υ

0 x2 x2
0
 The greed axiom
Pick any consumption bundle in X
(a) Greed implies that these bundles are preferred to x'
Gives a clear “North-East” direction of preference
(b) What can happen if consumers are not greedy

x2 (a) x2 (b)

 Bliss!

x' 

x1 x1
Conventionally shaped indifference curves
Slope well-defined everywhere

x2 Pick two points on the same

indifference curve
Draw the line joining them
 Any interior point must line on a
A
higher indifference curve

 ICs are smooth

 ICs strictly concaved-contoured
 C
 I.e. strictly quasiconcave

B
(-) Slope is the Marginal
Rate of Substitution
x1 U1(x) .
—— .

U2 (x) .
Other types of IC: Three cases
x2
A 1: Strictly quasiconcave, but not smooth
2: Smooth but not quasiconcave
Case 1 3: Smooth and quasiconcave, but not strictly
quasiconcave
 C

B

x1
x2 x2

Case 2 Case 3
A

 C

B

14
The primal problem
 The consumer aims to maximise utility…
x2
 Subject to budget constraint (green set)
 Defines the primal problem
 x*: Solution to primal problem

max U(x) subject to

 x* n
Σ pi xi ≤ y
i=1

There's another way of

looking at this
x1
The dual problem
 Alternatively the consumer
z2x2
q could aim to minimise cost…

υ  Subject to utility constraint

 Defines the dual problem
 x*: Solution to the problem
 Cost minimisation by the firm

minimise
n

 Σ pixi
x*
z* i=1

subject to U(x) ≥ υ

z1 But where have we seen

x1 the dual problem before?
 Text: Section 4.5
A lesson from the firm
 Compare cost-minimisation for the firm…
…and for the consumer

z2 q x2 υ  The difference is
only in notation

 So their solution
functions and
response functions
must be the same
 
z* x*

z1 x1

 Text: Section 4.5.1

Cost-minimisation: strictly quasiconcave U
 Minimise ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 + 𝜆𝜆 𝜐𝜐 − 𝑈𝑈 𝐱𝐱
 Get 𝑛𝑛 + 1 First-Order Conditions
 Build Lagrangian from objective
function and budget constraint
 Differentiate w.r.t. x1, …, xn , λ
and set equal to 0

𝜆𝜆∗ 𝑈𝑈1 𝐱𝐱 ∗ = 𝑝𝑝1 𝜐𝜐 = 𝑈𝑈 𝐱𝐱 ∗

𝜆𝜆∗ 𝑈𝑈2 𝐱𝐱 ∗ = 𝑝𝑝2  * denotes C-min values
⋯
𝜆𝜆∗ 𝑈𝑈𝑛𝑛 𝐱𝐱 ∗ = 𝑝𝑝𝑛𝑛
 Implication of the FOCs
𝑈𝑈𝑖𝑖 𝐱𝐱 ∗ 𝑝𝑝𝑖𝑖
=  “implicit” price = market price
𝑈𝑈𝑗𝑗 𝐱𝐱 ∗ 𝑝𝑝𝑗𝑗
MRS = price ratio
The solution
 Get C-minimising value for each good and Lagrange multiplier
• 𝑥𝑥𝑖𝑖∗ = 𝐻𝐻𝑖𝑖 (p, 𝜐𝜐), 𝑖𝑖 = 1, … , 𝑛𝑛; 𝜆𝜆∗ = 𝜆𝜆∗ (p, 𝜐𝜐)
 Consumer’s cost function is defined as 𝐶𝐶 𝐩𝐩, 𝜐𝜐 ≔ min Σ𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖
𝑈𝑈 𝐱𝐱 ≥𝜐𝜐

 The cost function has same properties as for the firm

 Shephard's Lemma gives demand as a function of p and 𝜐𝜐:
𝐻𝐻 𝑖𝑖 (p, 𝜐𝜐) = 𝐶𝐶𝑖𝑖 (p, 𝜐𝜐)
• “conditional demand” or “compensated demand”
 Properties of 𝐶𝐶 give behaviour of response functions 𝐻𝐻 𝑖𝑖 :
• downward-sloping with respect to its own price
𝑗𝑗
• symmetry of 𝐻𝐻𝑗𝑗𝑖𝑖 and 𝐻𝐻𝑖𝑖
 “Short-run” results can be used to model side constraints
Example • Constraint is 𝜐𝜐 ≤ 𝑥𝑥10.25 𝑥𝑥20.75

• IC (as before) does not touch either axis

x2
• Constraint set for given 𝜐𝜐
• Cost minimisation must have interior solution
• Lagrangian for cost minimisation:
𝑝𝑝1 𝑥𝑥1 + 𝑝𝑝2 𝑥𝑥2 + 𝜆𝜆 q − 𝑥𝑥10.25 𝑥𝑥20.75
• FOCs for min: 𝑝𝑝1 − 0.25𝜆𝜆𝑥𝑥1−0.75 𝑥𝑥20.75 = 0,
𝑝𝑝2 − 0.75𝜆𝜆𝑥𝑥10.25 𝑥𝑥2−0.25 = 0,
𝜐𝜐 = 𝑥𝑥10.25 𝑥𝑥20.75
• FOCs characterise optimum 𝐱𝐱 ∗


x*

x1
Comparing firm and consumer
 Cost-minimisation by the firm…
 …and expenditure-minimisation by the consumer
 …are effectively identical problems
 So the solution and response functions are the same:

Firm Consumer
m n
 Problem: min Σ wizi + λ[q – φ (z)] min Σ pixi + λ[υ – U(x)]
z i=1 x i=1

 Solution: C(w, q) C(p, υ)

 Response: zi* = Hi(w, q) xi* = Hi(p, υ)

 The Primal and the Dual
𝑛𝑛
 In both cases the ps are given and you
𝑈𝑈 𝐱𝐱 + 𝜇𝜇 𝑦𝑦 − � 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖
choose the xs. 𝑖𝑖=1
 But constraint in the primal becomes
objective in the dual 𝑛𝑛

 and vice versa � 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 + 𝜆𝜆 𝜐𝜐 − 𝑈𝑈 𝐱𝐱

𝑖𝑖=1

x2 x2 υ  Two aspects of the

same problem

 So we can link up
their solution functions
and response functions

 x* 
 Text: Section 4.5.2,
x*
pp 87-89

x1 x1
Utility maximisation
 Maximise 𝑈𝑈 𝐱𝐱 + 𝜇𝜇 𝑦𝑦 − ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖  Build Lagrangian from objective
function and budget constraint
 Differentiate w.r.t. x1, …, xn , µ
and set equal to 0
 Get 𝑛𝑛 + 1 First-Order Conditions
𝑛𝑛
𝑈𝑈1 𝐱𝐱 ∗ = 𝜇𝜇∗ 𝑝𝑝1
𝑈𝑈2 𝐱𝐱 ∗ = 𝜇𝜇∗ 𝑝𝑝2 𝑦𝑦 = � 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖∗  * denotes U-max values
⋯ 𝑖𝑖=1
𝑈𝑈𝑛𝑛 𝐱𝐱 ∗ = 𝜇𝜇∗ 𝑝𝑝𝑛𝑛
 Implication of the FOCs
𝑈𝑈𝑖𝑖 𝐱𝐱 ∗ 𝑝𝑝𝑖𝑖
=  “implicit” price = market price
𝑈𝑈𝑗𝑗 𝐱𝐱 ∗ 𝑝𝑝𝑗𝑗
MRS = price ratio
Properties of the solution (1)

 Get U-maximising value for each good

• 𝑥𝑥𝑖𝑖∗ = 𝐷𝐷 𝑖𝑖 (p, 𝑦𝑦), 𝑖𝑖 = 1, … , 𝑛𝑛
• where 𝐷𝐷 𝑖𝑖 ( � , � ) is the ordinary demand function for good i

 The 𝐷𝐷 𝑖𝑖 collectively have an “adding-up” property:

• ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖 𝐷𝐷𝑖𝑖 𝐩𝐩, 𝑦𝑦 = 𝑦𝑦
 Each 𝐷𝐷 𝑖𝑖 is homogeneous of deg 0 in 𝐩𝐩, 𝑦𝑦
• for any t > 0:
• 𝑥𝑥𝑖𝑖∗ = 𝐷𝐷𝑖𝑖 𝐩𝐩, 𝑦𝑦 = 𝐷𝐷 𝑖𝑖 𝑡𝑡𝐩𝐩, 𝑡𝑡𝑡𝑡

 Text: Section 4.5.2, pp 90-92

Properties of the solution (2)
 In addition get U-maximising value for Lagrange multiplier
• 𝜇𝜇∗ = 𝜇𝜇∗ (p, 𝑦𝑦)
 And the expression for maximised utility
• the indirect utility function is defined as
• 𝑉𝑉 𝐩𝐩, 𝑦𝑦 ≔ max 𝑈𝑈 𝐱𝐱
Σ𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 ≤𝑦𝑦

 The solution functions give two views of the same optimum:

• primal: 𝜐𝜐 = V(p, y)
• dual: y = C(p, 𝜐𝜐)
 The two solutions combined give 𝜐𝜐 = V(p, C(p, 𝜐𝜐))
• differentiate with respect to 𝑝𝑝𝑖𝑖 : 0 = 𝑉𝑉𝑖𝑖 (p, 𝑦𝑦)+𝑉𝑉𝑦𝑦 (p, 𝑦𝑦)𝐶𝐶𝑖𝑖 (p, 𝜐𝜐)
• from Shephard’s Lemma we have 𝐶𝐶𝑖𝑖 (p, 𝜐𝜐)=𝑥𝑥𝑖𝑖∗ and so we get
𝑉𝑉 (p, 𝑦𝑦)
• Roy’s identity: − 𝑖𝑖 = 𝑥𝑥𝑖𝑖∗
𝑉𝑉𝑦𝑦 (p, 𝑦𝑦)
Exogenous income

 Take the equilibrium at x*

x2
 Suppose income y rises
 New equilibrium at x**

 Demand for each good does not

fall if it is “normal”

• x**
 But could the opposite happen?
•
x*

x1
An “inferior” good
 Same original budget, different preferences
x2  Again suppose income rises
Equilibrium shifts from x** to x**

 Demand for good 1 rises, but…

 Demand for “inferior” good 2 falls

 Can you think of any goods like this?

 Could it depend on the
categorisation of goods?
•
x* • x**

x1
Effect of a change in price
 Again take the original equilibrium
x2
 Allow price of good 1 to fall
 Big blue arrow: the effect of the price fall
 Small blue arrows: “journey” from x* to x**
broken into two parts

° x**
•
•
x*

x1
A fundamental decomposition
 Take the two ways of writing demand:
𝑥𝑥𝑖𝑖∗ = 𝐻𝐻𝑖𝑖 p, 𝜐𝜐 = 𝐷𝐷 𝑖𝑖 p, 𝑦𝑦
𝐻𝐻 𝑖𝑖 p, 𝜐𝜐 = 𝐷𝐷 𝑖𝑖 p, 𝐶𝐶 p, 𝜐𝜐
 Differentiate with respect to pj:
𝐻𝐻𝑗𝑗𝑖𝑖 p, 𝜐𝜐 = 𝐷𝐷𝑗𝑗𝑖𝑖 p, 𝑦𝑦 + 𝐷𝐷𝑦𝑦𝑖𝑖 p, 𝑦𝑦 𝐶𝐶𝑗𝑗 p, 𝜐𝜐
= 𝐷𝐷𝑗𝑗𝑖𝑖 p, 𝑦𝑦 + 𝐷𝐷𝑦𝑦𝑖𝑖 p, 𝑦𝑦 𝑥𝑥𝑗𝑗∗
 Rearrange to get:
𝐷𝐷𝑗𝑗𝑖𝑖 p, 𝑦𝑦 = 𝐻𝐻𝑗𝑗𝑖𝑖 p, 𝜐𝜐 − 𝑥𝑥𝑗𝑗∗ 𝐷𝐷𝑦𝑦𝑖𝑖 p, 𝑦𝑦
 Substitution effect: “When the
price of jelly falls and I’m kept on
the same utility level, I prefer to
switch from ice cream for dessert”
 Two representations of same thing
 Implicit relation in prices and utility
 Uses (1) y = C(p,υ) (2) function-of-
a-function rule and (3) Shephard’s
Lemma
 This is the Slutsky equation
 Income effect: “I'm better off if the
price of jelly falls; so I buy more
normal goods, such as ice cream”
The size of the effect depends on
how much jelly I am buying
The Slutsky equation: own-price
 Set j = i to get the effect of the price of  Important special case
ice-cream on the demand for ice-cream

𝐷𝐷𝑖𝑖𝑖𝑖 p, 𝑦𝑦 = 𝐻𝐻𝑖𝑖𝑖𝑖 p, 𝜐𝜐 − 𝑥𝑥𝑖𝑖∗ 𝐷𝐷𝑦𝑦𝑖𝑖 p, 𝑦𝑦

 Hii (own-price substitution effect) must  Follows from the results on
be negative the firm

 Dyi is non-negative for normal goods  Price increase means less

disposable income
 So the income effect of a price rise must
be non-positive for normal goods

 Theorem: if the demand for i does not

decrease when y rises, then it must
decrease when pi rises
Price fall: normal good
p1
 Initial equilibrium at x*1
ordinary
 first red arrow: price fall, substitution effect
demand curve
compensated  second red arrow: income effect, normal good
D1(p,y) (Hicksian)  both red arrows: total effect, normal good
demand curve
H1(p,υ)

For normal good income effect

must be positive or zero
price

(for an inferior good, income

fall

effect would be negative)

x*1 x**
1
x1
Consumer equilibrium and the offer curve
x2  Budget constraint, endogenous y
 Consumer's equilibrium at x*
 Price rises of good 1 yield x**,x***
 Connect points on the path

 x***  Equilibrium: same FOCs as before

 This purple path is the offer curve
 x**  Red arrow: amount of good 1 that
household supplies to the market

 x*  Text: Section 5.3

 R
x1
Household supply
 Flip horizontally , to make
supply clearer
 Rescale the vertical axis to
measure price of good 1
 Plot p1 against x1
x2 p1

 This path is the

 x***
household’s supply curve
 x** of good 1

 x*  The curve “bends back”

on itself
supply of
 R supply of good 1
Why?
good 1
Decomposition – another look
 Demand for good i: 𝑥𝑥𝑖𝑖∗ = 𝐷𝐷 𝑖𝑖 (p, 𝑦𝑦) Function of prices and income
 Substitute in for y: 𝑥𝑥𝑖𝑖∗ = 𝐷𝐷 𝑖𝑖 (p, Σ𝑗𝑗 𝑝𝑝𝑗𝑗 𝑅𝑅𝑗𝑗 ) Income now depends on prices
 Differentiate with respect to pj : The indirect effect uses
d𝑥𝑥𝑖𝑖∗ function-of-a-function rule again
= 𝐷𝐷𝑗𝑗𝑖𝑖 p, 𝑦𝑦 + 𝐷𝐷𝑦𝑦𝑖𝑖 p, 𝑦𝑦 Rj
d𝑝𝑝𝑗𝑗
 Now take the Slutsky relation: Just the same as on earlier slide
𝐷𝐷𝑗𝑗𝑖𝑖 p, 𝑦𝑦 = 𝐻𝐻𝑗𝑗𝑖𝑖 p, 𝜐𝜐 − 𝑥𝑥𝑗𝑗∗ 𝐷𝐷𝑦𝑦𝑖𝑖 p, 𝑦𝑦
 Use this to substitute for 𝐷𝐷𝑗𝑗𝑖𝑖 : The modified Slutsky equation
d𝑥𝑥𝑖𝑖∗
= 𝐻𝐻𝑗𝑗𝑖𝑖 p, 𝜐𝜐 + Rj − 𝑥𝑥𝑗𝑗∗ 𝐷𝐷𝑦𝑦𝑖𝑖 p, 𝑦𝑦
d𝑝𝑝𝑗𝑗

 Substitution effect same as before

 Income effect, 2nd term same as before
 Income effect, 1st term is very important:
• negative if the person is a net demander
• positive if the person is a net supplier
Application: savings
x2
 Resource endowment is non-
interest income profile
 Slope of budget constraint
increases with interest rate, r
 Consumer's equilibrium
 Its interpretation

 x1,x2 are consumption “today”

and “tomorrow”
 Determines time-profile of
consumption
 What happens to saving
 x* when interest rate changes?

 R
x1
Application: labour supply
x2
 Endowment: total time & non-labour
income
 Slope of budget constraint is wage rate
 Consumer's equilibrium

 x1,x2 are leisure and consumption

 Determines labour supply

 Will people work harder if their wage

rate goes up?
 x*
 R
x1
 Two views of the problem
 Primal: Max utility subject to
the budget constraint
 Dual: Min cost subject to a
utility constraint
 What effect on max-utility of
V(p, y) C(p,υ) an increase in budget?
 What effect on min-cost of
x2 x2 an increase in target utility?

∆C
∆V

 x* 
x*

x1 x1

37
Marginal changes
 W get the value of marginal changes just by re-using results on solutions

 The solution function for the primal: 𝑉𝑉 𝐩𝐩, 𝑦𝑦 = 𝑈𝑈 𝐱𝐱 ∗ +𝜇𝜇∗ 𝑦𝑦 − � 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖∗
𝑖𝑖
 Differentiate with respect to y and rearrange:
𝑉𝑉𝑦𝑦 𝐩𝐩, 𝑦𝑦 = ∑𝑖𝑖 𝑈𝑈𝑖𝑖 𝐱𝐱 ∗ 𝐷𝐷𝑦𝑦𝑖𝑖 𝐩𝐩, 𝑦𝑦 + 𝜇𝜇∗ − ∑𝑖𝑖 𝜇𝜇∗ 𝑝𝑝𝑖𝑖 𝐷𝐷𝑦𝑦𝑖𝑖 𝐩𝐩, 𝑦𝑦
𝑉𝑉𝑦𝑦 𝐩𝐩, 𝑦𝑦 = 𝜇𝜇∗

 The solution function for the dual: 𝐶𝐶 𝐩𝐩, 𝜐𝜐 = ∑𝑖𝑖 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖∗ +𝜆𝜆∗ 𝜐𝜐 − 𝑈𝑈 𝐱𝐱 ∗
 Differentiate with respect to υ and rearrange:
𝐶𝐶𝜐𝜐 𝐩𝐩, 𝜐𝜐 = ∑𝑖𝑖 𝑝𝑝𝑖𝑖 𝐻𝐻𝜐𝜐𝑖𝑖 𝐩𝐩, 𝜐𝜐 + 𝜆𝜆∗ − ∑𝑖𝑖 𝜆𝜆∗ 𝑈𝑈𝑖𝑖 𝐱𝐱 ∗ 𝐻𝐻𝜐𝜐𝑖𝑖 𝐩𝐩, 𝜐𝜐
𝐶𝐶𝜐𝜐 𝐩𝐩, 𝜐𝜐 = 𝜆𝜆∗

1
 We also find 𝜆𝜆∗ =
𝜇𝜇 ∗
 But what about non-marginal changes?
How to value a price change
 Price of good 1 changes
• p: original price vector
• p': vector after price change
 This causes utility to change
• υ = V(p, y)  original utility level at prices p

• υ' = V(p', y)  new utility level at prices p'

 Value this utility change in money terms:

• what change in income would bring a person
back to the starting point?
 Define the Compensating Variation:
 original utility level restored
• υ = V(p', y – CV) at new prices p'
 Amount CV is just sufficient to undo
effect of going from p to p'  Text: Section 4.6
Story 1: the compensating variation

 A fall in price of good 1

x2
 Reference point is original utility level υ
υ  Red line: CV measured in terms of good 2

x**
•
•
x*

x1
How to value a price change (again)
 Price of good 1 changes
• p: original price vector
• p': vector after price change
 This causes utility to change
 original utility level at prices p
• υ = V(p, y)
• υ' = V(p', y)  new utility level at prices p'

 Value this utility change in money terms:

• what income change would have been needed
to bring the person to the new utility level?
 Define the Equivalent Variation:
 new utility level reached at
• υ' = V(p, y + EV) original prices p

 Amount EV is just sufficient to mimic

effect of going from p to p'
Story 2: the equivalent variation
 Price fall as before
x2
υ'  Reference point is the new utility level υ'
 Red line: EV measured in terms of good 2

x**
•
•
x*

x1
Welfare changes as cost changes
 Compensating Variation as –∆(cost):  (–) change in cost of hitting utility
level υ. If positive we have a
CV(p→p') = C(p, υ) – C(p', υ) welfare increase

 Equivalent Variation as –∆(cost):  (–) change in cost of hitting

utility level υ'. If positive we
EV(p→p') = C(p, υ') – C(p', υ') have a welfare increase

 Using these definitions we also have  Looking at welfare change in

the reverse direction, starting
CV(p'→p) = C(p', υ') – C(p, υ') at p' and moving to p

= – EV(p→p')
Application
 An index to measure changes in cost of living
 What's the change in cost of
𝐶𝐶 𝐩𝐩′ ,𝜐𝜐
 If we use a CV-based index: 𝐼𝐼CV = hitting the base utility level υ?
𝐶𝐶 𝐩𝐩,𝜐𝜐
1. but why base utility level rather than final?
2. what if utility fn is not homothetic?

 A convenient approximation – the Laspeyres price  What's the change in cost of

Σ𝑖𝑖 𝑝𝑝𝑖𝑖′ 𝑥𝑥𝑖𝑖 buying the base consumption
index: 𝐼𝐼L = bundle x?
Σ𝑖𝑖 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖
 The basis for the Consumer
 But 𝐼𝐼L does not take account of consumer Price Index and many others
substitution when prices change
 So, a potential overestimate?
• if x is cost-min bundle when prices are p: Σ𝑖𝑖 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 = 𝐶𝐶 𝐩𝐩, 𝜐𝜐
• if p → p', x may no longer be cost-min bundle: Σ𝑖𝑖 𝑝𝑝𝑖𝑖′ 𝑥𝑥𝑖𝑖 ≥ 𝐶𝐶 𝐩𝐩′ , 𝜐𝜐
• therefore 𝐼𝐼L ≥ 𝐼𝐼CV

.
Welfare change and consumer demand
 Measure impact on welfare of p→p' by cost-diff:
𝐶𝐶 𝐩𝐩, 𝜐𝜐 ∗ − 𝐶𝐶 𝐩𝐩′, 𝜐𝜐 ∗ where 𝜐𝜐 ∗ is reference utility level ( 𝜐𝜐 or 𝜐𝜐 ′ )

 Let price of good 1 change from 𝑝𝑝1 to 𝑝𝑝1′ , other prices unchanged
𝑝𝑝1 𝜕𝜕𝐶𝐶 𝐩𝐩,𝜐𝜐∗
 Then the cost diff is: ∫𝑝𝑝′ 𝜕𝜕𝑝𝑝 d𝑝𝑝1
1 1
𝑝𝑝1
 Further rewrite as: ∫𝑝𝑝′ 𝐻𝐻1 𝐩𝐩, 𝜐𝜐 ∗ d𝑝𝑝1
1

 Welfare change is an area under the compensated demand curve

Compensated demand and CV
p1  The initial equilibrium
 price fall: (welfare increase)
compensated (Hicksian)
demand curve  shaded area: value of price fall,
relative to original utility level

H1(p, υ)

The CV provides an exact

welfare measure
Compensating Based on reference point υ
price
fall

Variation

x*1
x1
Compensated demand and EV

p1 compensated  As before but use new utility

level as a reference point
(Hicksian)  price fall: (welfare increase)
demand curve
 Shaded area: value of price fall,
relative to new utility level

H1(p, υ′)
The EV provides another exact
welfare measure
 Based on reference point υ′

Equivalent
price
fall

Variation

x**
1
x1
Ordinary demand and CS
 Initial equilibrium at x1*
p1 ordinary (Marshallian)  price fall: (welfare increase)
demand curve
 Yellow area: an alternative
method of valuing the price fall?

D1(p, y)
CS provides an approximate
welfare measure

Consumer's
price
fall

surplus

x*1 x**
1
x1
 The benefits of a price fall: three stories
p1

D1(p, y)

H1(p,υ) Summary of the three approaches.

H1(p,υ ′) Illustrated for normal goods

For normal goods: CV ≤ CS ≤ EV

price

For inferior goods: CV > CS > EV

fall

x1* x1**
x1