Consumer Theory: ECO201 - Intermediate Microeconomics

Consumer Theory
ECO201 - Intermediate Microeconomics
Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 1 / 85

Objectives
Describe a parsimonious model of consumer behavior: chooses the bun-

dle that he prefers among those he can afford.
Consumer preferences / Utility function.
Budget constraint.
Constrained optimization.
How do price/revenue variations affect the consumer’s choice?
Which are the properties of the demand function?

Consumer preferences
Outline
1 Consumer preferences

Consumer preferences Definitions - Notations
Some definitions and notations
Goods
We define by L the total number of goods, each good being indexed by
g = 1, . . . , L. For simplicity, we focus on L = 2.
A good can be identified by its physical characteristics but also by the
date, the location, etc.
Consumption bundle
x = (x1 , x2 , . . . , xL ) ∈ RL+ .
Consumption set
X ⊂ RL+ is the subset of possible bundles (there may be physical con-
straints that limit availabilty for some goods).
We assume for simplicity in most cases that X = R2+ .

More definitions and notations

Prices
Good g is sold at price pg ≥ 0.
We denote by p = (p1 , p2 , . . . , pL ) ∈ RL+ , the price vector.
For simplicity, we assume that all prices are positive, that is, p ∈ RL++ ,
i.e., pg > 0 for any g .
Budget constraint
Let R be the consumer’s budget measured in the same unit than the
prices.
The consumer is budget-constrained, in the sense that he can
only select bundles that he can afford:
p1 x1 + p2 x2 + . . . + pL xL ≤ R.

Budget constraint
x2
p1x1 + p2x2 =R
Budget Set Bp,R
x1

Even more definitions and notations
Budget set
The budget set consists of all the bundles that are affordable at the given
prices and income, that is, Bp,R = {x ∈ X |p.x ≤ R} .
In the case L = 2, p.x = R is often called the budget line. The budget
line’s slope is −p1 /p2 (i.e., in absolute value, it is the relative price of
good 1 - relative to the price of good 2).
The consumer choice problem is thus to select her preferred bundle

within her budget set, i.e., the “best” affordable bundle.
It remains to model consumer preferences over the consumption set.

Consumer preferences Preferences
Preference relations
Preference relations
Consumer preferences are defined as an order relation over the con-
sumption set X .
x y means that the consumer weakly-prefers bundle x to bundle y .
The consumer is indifferent between the two bundles, x ∼ y , when x y
and y x.
x is strictly preferred to y when x y and y x.
Properties (Axioms) of preference relations

1 Complete: ∀x, y ∈ X , x y and/or y x.
2 Transitive: ∀x, y , z ∈ X , if x y and y z, then x z.
3 Continuous: ∀y ∈ X , {x|x y } and {x|y x} are closed-sets.

Consumer preferences Preferences
Some (useful) properties of preference relations
Weakly monotonic:
∀x, y ∈ X , x y (i.e., ∀l, xl > yl ) =⇒ x y .
Example 1: x = (1, 1) and y = (0, 0) then x y so that x y

Example 2: x = (1, 1) and y = (1, 0) then x 6 y so that we do not know
whether x y
Strongly monotonic:
∀x, y ∈ X , x ≥ y (i.e., ∀l, xl ≥ yl ) and x 6= y =⇒ x y .
(Local) Non-satiation:
∀x ∈ X , ∀ε > 0, ∃y ∈ X such that kx − y k < ε and y x.

Consumer preferences Indifference curves
Indifference curves
An indifference curve including bundle x is the set of bundles for

which the consumer is just indifferent to bundle x.
Indifference curve ≈ contour line (maps).
Indifference curve that includes bundle x ∈ X : {y ∈ X |y ∼ x}.
We will use indifference curves as a benchmark for satisfaction degree.

Weakly monotonic preferences

Weakly monotonic preferences ⇒ Indifference curves are weakly
decreasing.
x2
x1
Some (useful) properties of preference relations
Convex:
∀x, y , z ∈ X , if x z and y z, then ∀λ ∈ [0, 1] , λx +(1−λ)y z.
Strictly convex:
∀x 6= y , z ∈ X , if x z and y z, then ∀λ ∈]0, 1[, λx+(1−λ)y z.
Having convex preferences usually means having a preference for diver-

sity.
As should become clear later, strict convexity is a very helpful

property of preference relations.

Weakly convex preferences

Weakly convex preferences ⇒ Indifference curves are weakly convex.
x2
x1

Strictly convex preferences

Strictly convex preferences ⇒ Indifference curves are strictly convex.
x2
x1

Non convex preferences
x2
x1

Indifference curves do not intersect
Indifferences curves cannot intersect
Assume preferences are transitive and monotonic.
Reductio ad absurdum
Assume that (at least) two indifference curves, say C1 and C2 intersect and
denote by x one of the intersection points: by definition x ∈ C1 and x ∈ C2 .
Now consider bundle y such that y ∈ C1 but y ∈ / C2 , and bundle z such
that z ∈ C2 and z ∈/ C1 with z ≥ y (i.e. ∀l, zl ≥ yl ) and z 6= y .
Monotonicity implies that z y . But since x ∼ y and x ∼ z, transivity
imposes to have y ∼ z.

Consumer preferences Utility function
Utility function
Consumer (optimal) choice: given her income and prices, choos-

ing her preferred bundle within her budget set; that is: the “best
affordable bundle.”
In theory, it suffices to know the consumer’s preference relations (i.e.,
the full set of indifference curves) to derive consumer choice. Not really
practical ...
Next objective: find an alternative way to represent preferences that
allows us to identify a standard constrained optimization problem:
Choosing the preferred bundle ⇐⇒ identifying the “highest” indifference
curve in the budget set
As for contour lines on maps, it suffices to label indifference curves (i.e.,
attribute a value to each indifference curve).
“The” utility function.

Utility function
Utility function
A function u : X → R is a utility function representing the preference
relation if and only if:
∀x, y ∈ X , u (x) > u (y ) ⇐⇒ x y .
There does not always exist a utility function representing .

Example: the preference order is not transitive.
If a utility function representing exists, it is not unique.

If u represents , then any strictly increasing transformation of u
is also a utility function representing .
Utility is an ordinal concept.

Existence
Existence
If the preference relation is complete, transitive and continuous over
X , then there exists a (continuous) utility function u defined over X repre-
senting this preference relation.
Proof’s intuition when X = RL+ and is monotonic:
For any a ∈ R+ , consider the bundle a = (a, a, . . . , a) and the indiffer-

ence curve that includes a, that is, CIa = {x|x ∼ a}.
Given that the preference relation is monotonic and continuous , for
any x ∈ RL+ , there exists a unique a such that x ∈ CIa .
Set u (x) = a: u is a (continuous) function representing .

Properties of utility functions
An ordinal concept
u(x) = 4u(y ) does not mean√that the consumer values x four times
more than y . (Function v = u represents the same preferences, yet
v (x) = 2v (y )!).
It is impossible to compare utility levels between individuals. If u and
v respectively represent the preferences of consumers A and B, it is
possible to have v (y ) < u(x) < 2v (y ). Yet v and 2v represent the same
preferences.
If preferences are (strictly) convex, then u is (strictly) quasi-concave,

that is: ∀u, {x ∈ X |u(x) ≥ u} is a (strictly) convex set.

Consumer preferences Marginal rate of substitution
Marginal rate of substitution

Consider a preference relation that can be represented by the utility
function u : X → R.
Question: Suppose that the consumption of good 2 reduces from
x2 to x2 − dx2 . How does one need to modify the consumption
of good 1 (increasing it from x1 to x1 + dx1 ), to maintain the
consumer on the same indifference curve?
Following the variations −dx2 and dx1 , the change in utility is:
∂u ∂u
du = − dx1 + dx2 .
∂x1 ∂x2
We thus have:
∂u
dx2 ∂x1
du = 0 ⇐⇒ = ∂u
.
dx1 ∂x2


The marginal rate of substitution of good i to good j is equal to the
ratio of marginal utilities, that is:
∂u
∂xi
MRSi→j = ∂u
.
∂xj
The marginal rate of substitution does not depend on the choice of the
utility function but only on the preference relation. To see this, consider
the function v (x) = f (u(x)) where f : R → R is strictly increasing and
continuous :
∂v
∂xi f 0 (u(x)) ∂x
∂u
i
∂u
∂xi
∂v
= = .
f 0 (u(x)) ∂u ∂u
∂xj ∂xj ∂xj

Properties of the MRS
MRSi→j MRSj→i = 1
In general, the MRS depends on the initial quantities.

When preferences are strictly convex, MRSi→j is lower when the quan-
tity of good i is higher, i.e., MRSi→j is a decreasing function of xi .
When L = 2, MRS1→2 is equal to the (absolute value of the)

slope of the indifference curve. .

Consumer preferences Usual utility functions
Strictly convex preferences - Cobb-Douglas
Qi=L ai
u(x) = i=1 xi , with ai > 0, ∀i = 1, . . . , L.
Pi=L
We often assume that i=1 ai = 1.
Pi=L
Possible monotonic transformation: v (x) = ln (u(x)) = i=1 ai ln (xi ).
In this case:
ai xj
MRSi→j = .
aj xi
MRSi→j is a (strictly) decreasing function of xi and (strictly) increasing

function of xj .
For any xj > 0, when xi → 0, MRSi→j → ∞.
For any xj > 0, when xi → ∞, MRSi→j → 0.

Strictly convex preferences - Cobb-Douglas
x2
x1

Non-differentiable preferences - Leontieff
u(x) = min {a1 x1 , a2 x2 , . . . , aL xL }, with ai > 0, ∀i = 1, . . . , L.
The utility is not always differentiable.

For instance when L = 2, u(x) = min {a1 x1 , a2 x2 }.
If a1 x1 > a2 x2 , then u(x) = a2 x2 , thus MRS1→2 = 0
If a1 x1 < a2 x2 , then u(x) = a1 x1 , thus MRS1→2 = ∞
These goods are often called perfect complements, in the sense that
they “have to” be used in fixed proportion (one unit of good 1 with aa21
units of good 2).

Non-differentiable preferences - Leontieff
x2
a1x1=a2x2
x1

Constant MRS - Perfect Substitutes
Pi=L
u(x) = i=1 ai xi , with ai > 0, ∀i = 1, . . . , L.
ai
In this case, the MRS are constant and MRSi→j = aj for any xi and
any xj .
These goods are often called perfect substitutes, although some only
use this terminology when MRS = 1 (i.e., ai = aj for any i 6= j ∈
{1, . . . , L}.).
Example: good offered in three different formats / packages, say 1 - liter
bottles, 2-liter bottles and packs of six 1-liter bottles.
One could then simply write: u(x) = x1 + 2x2 + 6x3 .

Constant MRS - Perfect Substitutes
x2
MRS1→2 = -slope = a1/a2
x1

Pi=L 2
u(x) = i=1 ai xi , with ai > 0, ∀i = 1, . . . , L.
We then have:
ai xi
MRSi→j = .
aj xj
MRSi→j is a strictly increasing function of xi and a strictly decreasing

function of xj .
For any xj > 0, when xi → 0, MRSi→j → 0.
Example to keep in mind ... see soon !

x2
x1

Other (frequently used) examples
Quasi-linear preferences, i.e., utility functions that take the following

form: u (x1 , x2 , . . . , xL ) = x1 + v (x2 , . . . , xL ) .
Constant-elasticity of substitution (or CES) functions

σ
P σ−1 σ−1
i=L
u (x1 , x2 , . . . , xL ) = i=1 ai xi
σ
Extreme cases correspond to perfect complements (Leontieff, σ = 0)

and perfect substitutes (σ = ∞).
The limit case σ = 1 corresponds to the Cobb-Douglas utility function.
Lexicographic preferences (assume L = 2 to simplify)

x y ⇔ x1 > y1 or (x1 = y1 and x2 > y2 ).
Such preferences are not continuous, and there does not exist any utility
function representing these preferences.

Lexicographic preferences: Proof

cannot be represented by some utility function.
· Suppose by contradiction that there is some u that represents .
· For any x1 ∈ R, (x1 , 1) (x1 , 0) and thus u(x1 , 1) > u(x1 , 0) since u
represents
· For any interval (a, b), there is a rational number r ∈ (a, b). So there is
some rational number r (x1 ) such that u(x1 , 1) > r (x1 ) > u(x1 , 0). Let
r : R → R be the function that assigns to each x1 , the rational number
r (x1 ) as previously described.
· Claim: r (·) is a injective function (one-to-one). Take x1 6= x10 and assume

that x1 > x10 . Then r (x1 ) |{z}
> u(x1 , 0) |{z}> u(x10 , 1) |{z}
> r (x10 ).
def (x1 ,0)(x10 ,1) def
Thus r (·) is injective from the real numbers to the rational numbers,
contradiction!
Choice and demand
Outline
2 Choice and demand
3 Revenue and substitution effects
4 Applications

Choice and demand Choice
Consumer optimization problem
Consumer optimization problem

Given observed prices for goods i = 1, . . . , L, select the “best afford-
able” bundle, that is:
x (p, R) ∈ arg maxx∈Bp,R u(x).
The objective function is continuous.

When prices are all strictly positive, the budget set is a bounded and
closed subset of RL (i.e., compact set).
The maximization problem has therefore at least one solution
x(p, R).

Choice and demand (Walrasian) Demand
Some properties of the optimal solution
“The” solution x(p, R) is called the Walrasian demand function (or

correspondence if the solution is not unique).
Budget constraint is binding

If preferences are monotonic, any solution satisfies p.x(p, R) = R.
Absence of money illusion

The Walrasian demand function x(p, R) is homogeneous of degre 0,
that is,
∀λ > 0, x(λ.p, λR) = x(p, R).

Choice and demand (Walrasian) Demand
Uniqueness
Unique solution
If preferences are strictly convex, x(p, R) is uniquely defined for any
vector of (strictly positive) prices p and any income R.
Proof.
Suppose that there are x, x 0 ∈ x(p, R) with x 6= x 0 . We then have p.x ≤ R
and p.x 0 ≤ R. Thus, for any λ ∈ (0, 1) , p.(λx + (1 − λ)x 0 ) ≤ R . More-
over, u(x) = u(x 0 ). Strict convexity of preferences therefore implies that,
for any λ ∈ (0, 1), u(λx + (1 − λ)x 0 ) > u(x) = u(x 0 ). A contradiction.

Choice and demand Differentiable case
Solution when u is differentiable

The consumer’s optimization program writes as:
max u(x) s.t. : p.x ≤ R.
x≥0
The utility function being (at least weakly) monotonic, the budget
constraint must be binding. The program thus rewrites as:
L−1
!
R X pi
max u x1 , . . . , xL−1 , − xi .
x≥0 pL pL
i=1
If it is interior, that is, xi > 0 for any i, the solution is given is charac-
terized by the L − 1 first-order conditions (+ the budget constraint):
∂u
∂u pi ∂u ∂xi pi
− =0 ⇐⇒ ∂u
= .
∂xi pj ∂xj ∂xj
pj
|{z}
=MRSi→j

Solution when u is differentiable
When the optimum is interior (all quantities are strictly positive), it is

characterized by:
pl
∀l, k : MRSl→k = and p.x = R.
pk
An interior optimum is thus such that the budget constraint binds
and marginal rates of substitution are equal to relative prices.
When L = 2, this amounts to looking for the point where the budget
constraint and the indifference curve are tangent.

Interior optimum
x2
p1x1 + p2x2 = R
MRS1→2 = p1/p2
x2(p1,p2,R)
x1(p1,p2,R) x1

Corner solutions
Consider the case L = 2. We can then write the consumer’s optimal
program as:
R p1
max u x1 , − x1 .
0≤x1 ≤ pR p2 p2
1
1 The optimum solution is x1 = 0 and x2 = pR2 when the derivative (with

respect to x1 ) at x1 = 0 is negative, i.e., when:

∂u
∂u p1 ∂u ∂x1 R p1
− ≤ 0 ⇔ ∂u
= MRS1→2 0, ≤
∂x1 p2 ∂x2 0, R ∂x R
p2 p2
p2 2 0, p
2
2 The optimum solution is x1 = pR1 and x2 = 0 when the derivative (with

respect to x1 ) at x1 = pR1 is negative, i.e., when:

∂u
∂u p1 ∂u ∂x1 R p1
− ≥ 0 ⇔ ∂u
= MRS 1→2 , 0 ≥
∂x1 p2 ∂x2 R ,0 p1 p2

∂x
R
p1 2
p1 ,0
3 In all other cases, the optimal is interior.

Choice and demand Some usual examples
Cobb-Douglas utility function
Pl=L
u(x) = l=1 al ln xl
The interior solution is characterized by:
l=L
pi X
∀i, j = 1, . . . , L : MRSi→j = and pl xl = R
pj l=1
This yields:
l=L
ai xj pi aj X
= ⇔ pj xj = pi xi and pl xl = R.
aj xi pj ai l=1
Therefore:
 
X aj al R
1 +  pi xi = R ⇔ ∀l = 1, . . . , L : xl (p, R) = Pj=L .
a
j6=i i a p
j=1 j i

Cobb-Douglas utility function
x2
p1x1 + p2x2 = R
MRS1→2 = p1/p2
x2(p1,p2,R)
x1(p1,p2,R) x1

Perfect complements
u(x) = min {a1 x1 , a2 x2 , . . . , aL xL }
The utility function is not differentiable everywhere, we thus have to use our “intuition” (or a
graph when L = 2) to find the optimal solution. Indeed, the optimum solution satisfies
a1 x1 = a2 x2 = . . . = aL xL .

If that is not the case, define the set I = i0 |ai0 xi0 = maxi ai xi . For any i ∈ I , let reduce the
ε
quantity xi to xi − a and use the corresponding income to buy additional quantities of all the
i
goods j ∈ J = j0 |aj0 xj0 = minj aj xj . This is always feasible and strictly increases the consumer’s
utility.
The optimal choice (i.e., demand function) is thus:
R
∀l = 1, . . . , L : xl (p, R) = Pj=L pj
al j=1 aj
When L = 2, this simplifies to:
a2 R a1 R
x1 (p1 , p2 , R) = and x2 (p1 , p2 , R) = .
a2 p1 + a1 p2 a2 p1 + a1 p2

Perfect complements
x2
a1x1=a2x2
x2(p1,p2,R)
p1x1 + p2x2 = R
x1(p1,p2,R) x1

Perfect substitutes
Pl=L
u(x) = l=1 al xl
ai
In this case, MRS are constant: MRSi→j = aj
. Except in special cases, it is impossible to have
equality between the MRS and the relative price (or price ratio) for all pairs of goods.
Let’s use our intuition once more! Good i and j are perfect substitutes in the sense that, whatever
its current bundle, the consumer is always willing to exchange aj units of good i by ai of good
j. Thsu, if the relative price of good i, i.e., ppi , differs from aai , the consumer is always better
j j
pi ai
off consuming only one of the two goods. In particular, if pj
< aj
, it must be the case that
xj (p, R) = 0.
One alternative way to understand this result, is to “normalize” the goods to make them directly
comparable: for any l = 1, . . . , L, define yl = al xl and set the price of this “new good i” to be
equal to p̃l = pal . The consumer’s preferences over the new goods can be represented by the
l
utility function ũ(y ) = l=L
P
l=1 yl . In this case, one can easily understand why the consumer only
buys the cheapest good(s).
n o
Define I = i|p̃i = minl p̃l ⇔ pai = minl pal . We then have: xl (p, R) = 0 for any l ∈ / I and
P i l
i∈I pi xi = R.

Perfect substitutes
x2
x2(p1,p2,R)
MRS1→2 = a1/a2 < p1/p2
p1x1 + p2x2 = R
x1(p1,p2,R)=0 x1

Perfect substitutes
x2
MRS1→2 = a1/a2 = p1/p2
p1x1 + p2x2 = R
x1

Perfect substitutes
x2
x2(p1,p2,R)
MRS1→2 = a1/a2 < p1/p2
p1x1 + p2x2 = R
x1(p1,p2,R)=0 x1

Lexicographic preferences (L = 2)
x y ⇔ x1 > y1 or (x1 = y1 and x2 > y2 ).
There does not exist a utility function representing those preferences.
It is thus impossible to write down a simple constrained optimization

problem. Yet, the optimal choice is easily derived. If all prices are
strictly positive, the consumer always wants to spend all of her income
to buy good 1. The optimal solution is thus given by:
R
x1 (p, R) = and x2 (p, R) = 0.
p1

Revenue and substitution effects
Outline
2 Choice and demand
4 Applications

Revenue and substitution effects
Simplifying assumptions
We now maintain the following assumptions:
Preferences are continuous, strictly monotonic and strictly con-

vex (so that the Walrasian demand is uniquely defined).
We further assume that the Walrasian demand function is differ-

entiable. (A sufficient condition is to ensure that the utility u is twice
continuously differentiable, i.e., C 2 .)

Revenue and substitution effects Demand reaction to income variations
Demand reaction to income variations

Income-elasticity of demand
∂xg
Percentage change in quantity demanded
εgR (p, R) = ∂R
xg (p,R)
=
Percentage change in income
R
Typology of goods:
Inferior good (at (p, R)): εgR (p, R) ≤ 0
Normal good (at (p, R)): εgR (p, R) ≥ 0
Luxury good (at (p, R)): εgR (p, R) > 1
Priority good (at (p, R)): εgR (p, R) ∈ [0, 1]
Budget coefficient for good g :
pg xg (p, R) ∂θg
θg (p, R) = , ≥ 0 ⇐⇒ εR ≥ 1
R ∂R

Some values of income-elasticities
Luxury goods (εR > 1) Priority goods (εR < 1)

Foreign Vacation 2.10 Fruits and Vegetables 0.61
Domestic Vacation 1.70 Gasoline 0.48
Vacation Home 1.20 Electricity 0.23
Healthcare 1.18 Rice -0.44
Housing 1.00 Public Transit -0.75
Source: Acemoglu, Laibson and List (2020), Pearson Education.

Engel curve
Engel curve describes how household expenditure on a particular good

varies with household income: it represents demand for a particular
good xg (p, R) as a function of income R (for fixed prices).
The income-consumption curve (or income expansion path) is the

locus of points showing bundles (demand) x(p, R) (for fixed prices) as
income varies.

Income-consumption curve
x2
Income-consumption curve
x1

Revenue and substitution effects Demand reaction to price variations
Demand reaction to price variations

The Walrasian demand for good g may increase or decrease when
the price of good g increases. There is no Walrasian law of demand.
∂xg
Ordinary good (at (p, R)): ∂pg < 0.
∂xg
Giffen good (at (p, R)): ∂pg > 0.
Own-price elasticity of demand xg (p, R):
∂xg
Percentage change in quantity demanded ofg ∂pg
εgg (p, R) = = − x (p,R) .
Percentage change in price of g g
pg
Substitutes and complements

Cross-price elasticity of demand xg (p, R) (for any h 6= g ):
∂xg
Percentage change in quantity demanded ofg ∂ph
εgh (p, R) = = xg (p,R)
.
Percentage change in price of h
ph
Substitutes at (p, R): εgh (p, R) ≥ 0

Complements at (p, R): εgh (p, R) ≤ 0
Revenue and substitution effects Demand reaction to price variations
Some values of own-price elasticities
Own-price Elasticities
Olive Oil 1.92
Peanut Butter 1.73
Ketchup 1.36
Wine 1.00
Laundry detergent 0.81
Shampoo 0.79
Cigarettes 0.40
Source: Acemoglu, Laibson and List (2020), Pearson .
The higher the elasticity, the more elastic the demand for the good.
Example: Shampoo is inelastic, Olive oil is elastic
Cross-price elasticities: Meat and Fish: 1.6 (substitutes) whereas Food
and Entertainment : -0.7 (Complements)

Revenue and substitution effects Substitution and revenue effects
Effects of a variation in price pk
The effect of an increase (decrease) in the price of good h on the

demand for good g can be decomposed in two parts:
A substitution effect which corresponds to the effect of a change in
the price of good h relative to the price of good g keeping utility
constant. The increase (decrease) in ph leads to a decrease (increase)
or the relative price of good g : the consumer should thus be inclined to
consume more (less) good g relative to good h.
A revenue (or income) effect which correspond to the effect of lower

(higher) purchasing power due to the increase (decrease) of ph . An
increase (decrease) in price indeed reduces (increases) the budget set.

Global effect of an increase in p1

x2
R/p2
x1
R/p’1 R/p1

Substitution effect
x2
R/p2
Substitution Effect
x1
R/p’1 R/p1

Revenue (or Income) effect

x2
R/p2
Revenue Effect
x1
R/p’1 R/p1

Substitution and revenue effects

x2
R/p2
Substitution Effect
Revenue Effect
x1
R/p’1 R/p1

Indirect utility function
Indirect utility = utility for the optimal choice
v (p, R) = u(x(p, R))
The indirect utility function v (p, R) is:

Homogeneous of degree 0 in p and R.
Strictly increasing in R and weakly decreasing in pl for any l.
Continuous in p and R.
Dependent on the choice of the utility function representing the

consumer’s preferences.

Hicksian demand and expenditure function
Objective: for given prices, select the cheapest bundle that yields
a utility at least equal to u.
We restrict our attention to strictly positive prices (p 0) and to
u > u(0).

Hicksian demand: h(p, u) ∈ arg min{x∈X |u(x)≥u} p.x
Expenditure function: e(p, u) = min{x∈X |u(x)≥u} p.x

h2
u(x) = u
h2(p1,p2,,u))
h1(p1,p2,u) h1

Relationships between the two problems
1 x(p, R) = h(p, v (p, R))

2 e(p, v (p, R)) = R
3 h(p, u) = x(p, e(p, u))

4 v (p, e(p, u)) = u
The Hicksian demand is also called compensated demand. When prices
increase, Walrasian demands are affected and the indirect utility decreases. To maintain the
same level of utility (as in the initial situation) for the consumer, he must be compensated
(i.e., her income needs to be increased). But, in turn, this change in income modifies the
consumer demand (this is taken into account in the Hicksian or compensated demand).

Difference between Walrasian and Hicksian Demand
Walrasian Demand x(p, R) describes how consumption varies with

prices and income
Obtained by maximizing utility subject to the budget constraint
x(p, R) = arg max u(x)

p.x≤R
Hicksian Demand h(p, u) describes how consumption varies with

prices and utility
Obtained by minimizing expenditure subject to the utility constraint
h(p, u) = arg min p.x

u(x)≥u
Hicksian demand is useful to describe substitution effect

Law of demand
We usually call “law of compensated demand” the fact that the de-
mand for a good diminishes when the price of that good increases.
But there is no such law of demand for the Walrasian demand (e.g.,
Giffen goods).
(Hicksian) Law of compensated demand

The Hicksian demand for good l is a decreasing function of the price
pl .

Law of Compensated demand: Proof

Consider the case L = 2 and suppose that prices increase from (p1 , p2 ) to
(p10 , p2 ).
By definition, h minimizes the expenditure of the consumer, that is h(p, u)
minimizes the expenditure at price p for each price p. Therefore,
p1 h1 (p, u) + p2 h2 (p, u) ≤ p1 h1 p 0 , u + p2 h2 p 0 , u

| {z } | {z }
expenditure at h(p,u) at price p expenditure at h(p 0 ,u) at price p
p10 h1 p 0 , u + p2 h2 p 0 , u ≤ p10 h1 (p, u) + p2 h2 (p, u)

| {z } | {z }
expenditure at h(p 0 ,u) at price p’ expenditure at h(p,u) at price p’
and therefore
0 ≤ p10 − p1 . h1 (p, u) − h1 p 0 , u

which leads to
h1 p 0 , u ≤ h1 (p, u)


How to compute substitution and revenue effects?
The change in price from p to p 0 (to simplify let us assume that only
the price of good k changes, from pk to pk0 ) induces a change in the
Walrasian demand from x(p, R) (generating an indirect utility equal
to u = v (p, R)) to x(p 0 , R).
The substitution effect corresponds to the change in demand
from x(p, R) to h(p 0 , u).
Since x(p, R) = h(p, u), the price increase necessarily leads to a decreas-
ing in consumption of good k (Hicksian law of demand).
For good l 6= k, the sign of the substitution effect depends on whether
goods l and k are substitutes or complements.
The revenue effects corresponds to the change in demand from

h(p 0 , u) to x(p 0 , R) = h(p 0 , u 0 ).
Moreover h(p 0 , u) = x(p 0 , e(p 0 , u)) with e(p 0 , u) > R.
The revenue effect is negative for all normal goods.
Revenue and substitution effects Compensating and equivalent variations
Quantifying the effects of variations of prices
How can we evaluate in monetary terms, the effects of a change in

prices (for instance following the introduction of consumption taxes on
some goods)?
The introduction of consumption taxes leading to a price increase from

p to p 0 reduces the consumer’s utility.
By how much should we increase the consumer’s income to en-
sure that her utility remains constant?
The income should be increased from R to R 0 . The difference R 0 − R is
called the compensating variation (CV).
To what loss of revenue is the change in utility equivalent?

The loss of utility would have been the same (than with taxes) if the
income had been reduced from R to R 00 . The difference R − R 00 is called
the equivalent variation (EV).

Quantifying the effects of variations of prices
Compensating and equivalent variations

Compensating variation: v (p 0 , R + CV ) = v (p, R)
Equivalent variation: v (p 0 , R) = v (p, R − EV )
Alternative definitions (with u = v (p, R) and u 0 = v (p 0 , R)):
CV = e(p 0 , u) − e(p, u) and EV = e(p 0 , u 0 ) − e(p, u 0 )

Compensating variation
x2
R/p2
CV / p2
x1
R/p’1 R/p1

Equivalent variation
x2
R/p2
EV / p2
x1
R/p’1 R/p1

Applications
Outline
2 Choice and demand
4 Applications

Applications Labor supply
Labor - Leisure trade-off

A consumer has H hours available that can be divided between
work (labor supply, T hours) and leisure (L hours). We must
thus have L + T = H .
We denote by w the hourly wage and by p the price of the consumption

good (quantity denoted by C ). The household may also earn a non-
salarial income R.
The budget constraint thus writes as:
pC ≤ wT + R ⇔ pC + wL ≤ wH + R.
Alternative interpretation: working H yields a maximal (salarial) rev-

enue wH. Choosing to spend an hour as leisure is equivalent to not
working an hour and thus giving up the opportunity to generate an
income equal to w . The price of leisure is therefore equal to the op-
portunity cost, that is, to the hourly wage w .
The household chooses its optimal bundle, that is, its level of consump-
tion C and leisure time L so as to maximize its utility u(C , L) subject
to the budget constraint. The corresponding constrained optimization
program thus writes as:
max u(C , L) s.t. pC + wL ≤ wH + R.
When preferences are strictly convex and the solution is interiror, the
optimal bundle is characterized by:
∂u
∂L w
∂u
= and pC + wL = wH + R.
∂C
p

(R+wH)/p
R/p
Labor Supply
L
H


Effect of a non-salarial shock on labor supply
(R+wH)/p
Non-salarial
income shock
R/p
Change in labor supply

= Pure income effect
L
H


Effect of a wage increase on labor supply
(R+wH)/p (Real) Wage

decrease
Lowering the (real) wage has an
ambiguous effect on labor supply =
sum of a substitution and income
effect
R/p
L
H

Applications Consumption and savings
Consumption - Savings trade-off

2 periods, T = 1 and T = 2.
At time T = 1, the consumer allocates her (first-period) income R1
between consumption (C1 ) (composite good with price p1 ) and savings
(S = R1 − p1 C1 ).
At time T = 2, the consumer simply consumes all of her second period
income R2 plus the revenues generated through savings. In the sec-
ond period, we thus have p2 C2 = R2 + (1 + i)S , where i is the (net)
interest rate earned on savings.
At T = 1, the budget constraint thus writes as:
1 p2 1
R1 − p1 C1 = (p2 c2 − R2 ) ⇔ p1 C1 + C2 = R1 + R2 .
1+i 1+i 1+i
The inter-temporal budget constraint is simply the equality be-

tween the net present value of consumption and the net present
value of income.
In general we assume that p1 = 1 and p2 = (1 + a)p1 where a is simply

the inflation rate.
The consumer’s constrained optimization program thus writes as:

1+a 1
max u (C1 , C2 ) s.t. C1 + C2 = R1 + R2
(C1 ,C2 ) 1+i 1+i
When the preferences are strictly convex and the solution is interior,
the optimal bundle is characterized by:
∂u
∂C1 1+i 1+a 1
∂u
= and C1 + C2 = R1 + R2 .
∂C2
1+a 1+i 1+i

C2
R2/(1+a)
Savings
R1 R1 +R2/(1+i)
C1


Effect of a decrease in interest rate on savings
C2
The effect of a decrease in interest rate

on savings is ambiguous: it is the
combination of the revenue effect (two
effects actually) and a substitution effect
R2/(1+a)
Impact on savings
R1 R1 +R2/(1+i)
C1

Consumer Theory: ECO201 - Intermediate Microeconomics

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Consumer Theory

ECO201 - Intermediate Microeconomics

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 1 / 85

Describe a parsimonious model of consumer behavior: chooses the bun-

How do price/revenue variations affect the consumer’s choice?

Which are the properties of the demand function?

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 2 / 85

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 3 / 85

Some definitions and notations

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 4 / 85

More definitions and notations

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 5 / 85

Budget Set Bp,R

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 6 / 85

Even more definitions and notations

The consumer choice problem is thus to select her preferred bundle

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 7 / 85

Properties (Axioms) of preference relations

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 8 / 85

Some (useful) properties of preference relations

∀x, y ∈ X , x  y (i.e., ∀l, xl > yl ) =⇒ x  y .

Example 1: x = (1, 1) and y = (0, 0) then x  y so that x  y

∀x, y ∈ X , x ≥ y (i.e., ∀l, xl ≥ yl ) and x 6= y =⇒ x  y .

∀x ∈ X , ∀ε > 0, ∃y ∈ X such that kx − y k < ε and y  x.

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 9 / 85

An indifference curve including bundle x is the set of bundles for

Indifference curve ≈ contour line (maps).

Indifference curve that includes bundle x ∈ X : {y ∈ X |y ∼ x}.

We will use indifference curves as a benchmark for satisfaction degree.

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 10 / 85

Weakly monotonic preferences

Some (useful) properties of preference relations

∀x, y , z ∈ X , if x  z and y  z, then ∀λ ∈ [0, 1] , λx +(1−λ)y  z.

∀x 6= y , z ∈ X , if x  z and y  z, then ∀λ ∈]0, 1[, λx+(1−λ)y  z.

Having convex preferences usually means having a preference for diver-

As should become clear later, strict convexity is a very helpful

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 12 / 85

Weakly convex preferences

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 13 / 85

Strictly convex preferences

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 14 / 85

Non convex preferences

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 15 / 85

Indifference curves do not intersect

Indifferences curves cannot intersect

Assume preferences are transitive and monotonic.

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 16 / 85

Consumer (optimal) choice: given her income and prices, choos-

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 17 / 85

∀x, y ∈ X , u (x) > u (y ) ⇐⇒ x  y .

There does not always exist a utility function representing .

If a utility function representing  exists, it is not unique.

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 18 / 85

Proof’s intuition when X = RL+ and  is monotonic:

For any a ∈ R+ , consider the bundle a = (a, a, . . . , a) and the indiffer-

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 19 / 85

Properties of utility functions

If preferences are (strictly) convex, then u is (strictly) quasi-concave,

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 20 / 85

Marginal rate of substitution

Matı́as Núñez (CREST & CNRS) Consumer Theory X - Bach.2 - ECO201 21 / 85

Marginal rate of substitution

Marginal rate of substitution

∀x, y ∈ X , x y (i.e., ∀l, xl > yl ) =⇒ x y .

Example 1: x = (1, 1) and y = (0, 0) then x y so that x y

∀x, y ∈ X , x ≥ y (i.e., ∀l, xl ≥ yl ) and x 6= y =⇒ x y .

∀x ∈ X , ∀ε > 0, ∃y ∈ X such that kx − y k < ε and y x.

∀x, y , z ∈ X , if x z and y z, then ∀λ ∈ [0, 1] , λx +(1−λ)y z.

∀x 6= y , z ∈ X , if x z and y z, then ∀λ ∈]0, 1[, λx+(1−λ)y z.

∀x, y ∈ X , u (x) > u (y ) ⇐⇒ x y .

There does not always exist a utility function representing .

If a utility function representing exists, it is not unique.

Proof’s intuition when X = RL+ and is monotonic: