LECTURE 2

Consumer Theory

17/20 August, 2021

 Part 1
CONSUMER CHOICE: UTILITY MAXIMIZATION

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 Where are we?
• Preference
• Budget constraint
• Consumer’s optimal choice
– On the budget line
– On the highest indifference curve
• The optimal choice is the point of tangency
– Tangency condition + budget line
– Or the Lagrangian method
• Optimal basket is not always a point of tangency

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 What is the optimal basket?
• Suppose the consumer has utility function
U(F, C) = FC +10F

• Price of food is 1, price of clothing is 2, consumer’s income is

10
• The utility maximization problem is
max FC +10F
F,C

s.t. F + 2C = 10

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 What is the optimal basket? Cont’
• Solving it, we get the two equations
C +10 1
=
F 2
F + 2C = 10

• The solution is F=15, C=-2.5

• Is it the optimal basket?

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 Rewriting the Utility Maximization Problem
• In fact, there should be two more constraints to any utility
maximization problem
– The consumption of each good cannot be negative
• The true utility maximization problem (problem A) is
max FC +10F
F,C

F + 2C = 10
s.t. F ≥ 0
C≥0
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 What is the difference?
• What is the difference between problem A and the following
problem (problem B)?
max FC +10F
F,C

s.t. F + 2C = 10
• If the solution to B satisfies F>=0 and C>=0
– It is also the solution to A
• If the solution to B does not satisfy F>=0 or C>=0
– It is not the solution to A

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 The Intuitive Way
• Solve problem B and check
– Whether the solution to B indeed satisfies F>=0 and C>=0
• If yes, we are done
– Solution to problem B is also the solution to problem A
• Unfortunately in our example the solution to B is F=15, C=-2.5
– Violates C>=0

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 The Intuitive Way Cont’
• This means the constraint C>=0 must bind
– I.e., it holds with equality, C=0
– As C=-2.5 is not possible, C=0 is the best/closest we can get
• Thus the solution to A is F=10, C=0
• When there are inequality constraints, the constraints may or
may not bind
– In this example, the constraint C>=0 binds while the constraint F>=0
does not bind

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 How do we know F=10, C=0 is optimal?
• At this basket, consumer spends all the money on food
• Comparing the per dollar marginal utilities at this point
MU F C +10 MUC F 10
= = 10 > = = =5
PF PF PC PC 2

• If possible, consumer wants to buy more F and less C to

increase utility
• But consumption of C is already 0

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 The Scenario in Graph
C

U1 U2 U3

J
I
0 F
10 H

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 Corner Solution
• At optimal basket, it is not always true that both (all) goods are
consumed
• Corner solution is an optimal basket at which the consumption
of at least one good is 0
– Optimal basket either on the horizontal or vertical axis
• An optimal basket in which both goods are consumed is an
interior solution
• At corner solutions
– Indifference curve may not be tangent to the budget line

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 The Formal Way
• If we want to solve it formally, we can rewrite problem A as
max FC +10F
F,C,a,b

F + 2C = 10
s.t. F − a 2 = 0
C − b2 = 0
• The solution to this problem is F=10, C=0
• But in most cases we do not need to use the formal method

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 Application: Back-To-School Vouchers
• NTUC offers back-to-school education vouchers to low-income
families
– $125 voucher per school child to be spent on school-related goods
• Similar program
– US food stamps
• What is the effect of the voucher on
– Consumer’s choice
– Consumer’s utility

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 Impact of Voucher on Consumer 1
Others(y)
y is called a composite good as it is
the composite of all other goods
I B
Py C is the new optimal basket with
y2 C voucher
y1
A

0 School(x)
x1125 x2 I I +125
Px Px Px

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 Impact of Voucher on Consumer 2
Others(y)
B is the new optimal basket
with voucher
I
Py
B
y1
A

0 School(x)
x1 125 I I +125
Px Px Px

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 How about a cash subsidy of $125?
Others(y)
Consumer 1: C is still the new optimal
basket with cash
I B
Py
y2 C
y1
A

0 School(x)
x1125 x2 I I +125
Px Px Px

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 Cash Gives Consumer 2 Higher Utility!
Others(y)
Consumer 2: D is the new
y2 D optimal basket with cash
I
Py
B
y1
A

0 School(x)
x1 x2 125 I I +125
Px Px Px

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 Why not just use cash?
• The lump sum principle
– Cash subsidy gives consumers higher or the same utility compared to
subsidizing specific goods
– Income tax leaves consumers with higher or the same utility
compared to tax on specific goods
• Why not use cash instead of the back-to-school vouchers?

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 Part 2
REVEALED PREFERENCE

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 What is revealed preference?
• What we have been doing so far
– Given preference (indifference curves/utility functions)
– Given budget constraint
– We can find consumer’s optimal choice
• Can we go the other way round?
– Given budget constraint
– Given consumer’s optimal choice
– Can we get any information on preference?
• Revealed preference is the analysis that enable us to infer
preference based on observed prices and choices

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 Strictly Preferred vs. Weakly Preferred
• A is strictly preferred to B
AB
• A is weakly preferred to B if
– Either
AB
– Or
A≈B
– We use
A≥B
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 From Choice to Preference
• Suppose we observe the budget constraint of a consumer
• We also know the optimal basket chosen given the budget
constraint
• But we do not know his preference
– We know his preference satisfies the four assumptions
– We also know his preference does not change with prices or income
• Our goal
– To infer preference – how he ranks different baskets

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 A vs. Other Points on the Budget Line
y
20
Since A is optimal, no other point on the
budget line is strictly preferred to A

10 A Can we conclude that A is strictly

preferred to any other basket on the
B budget line?
C

0 x
5 10

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 A vs. Other Points on the Budget Line Cont’
y
20
Depending on the consumer’s preference,
A may not be the only optimal basket

10 A A is revealed to be weakly preferred to

any other basket on the budget line
B
C

0 x
5 10

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 A vs. Other Points below the Budget Line
y
20 CB
A≥C
⇒AB

10 A is revealed to be strictly preferred to

A
any other basket in the budget set (but
not on the budget line)
C

B
0 x
5 10

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 Another Way to Understand Revealed Preference
• Suppose basket A=(xA, yA) is the optimal basket given prices Px,
Py, and income I
– Basket A must be on the budget line
Px x A + Py yA = I
• No other affordable basket is strictly preferred to A
• Therefore, if basket B=(xB, yB) is strictly preferred to basket A, it
must be that
Px x B + Py yB > Px x A + Py yA = I

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 Another Way to Understand Revealed Preference
Cont’
• Similarly, if basket C=(xC, yC) is indifferent to basket A, it must
be that
Px xC + Py yC ≥ Px x A + Py yA = I

• To summarize
– If A is the optimal basket given the budget constraint
– Any basket that is strictly preferred to A cannot be affordable
– Any basket that is indifferent to A cannot cost less than A

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 Part 3
DEMAND FUNCTION AND INDIRECT UTILITY
FUNCTION

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 Consumer Theory Roadmap
• Consumer choice
– Utility maximization problem
– Expenditure minimization problem
• Demand
– Demand function and indirect utility function
– Compensated demand function and expenditure function
• Revealed preference
• Slutsky equation
• Consumer welfare

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 From Optimal Baskets to Individual Demand Curve
• Assume the consumer chooses food and clothing
• Suppose the price of food changes
– The price of clothing and income are fixed
• Consumer’s optimal consumption of food will change
• Consumer’s individual demand curve for food is the optimal
consumption level of food as a function of the price of food

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 Demand Curve for Food
C

A C Price-consumption curve
B
PF = 10
PF = 30 PF = 20
F
20 28 50
PF
30
20 Demand curve for food
10
D
F
20 28 50
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 Demand Curve
• What is demand curve?
– Optimal (utility maximizing) quantity of a good the consumer is
willing to buy as a function of its price
– Holding income and other prices fixed
• Law of demand
– Demand curve is downward sloping
– Higher price, lower quantity demanded

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 Example: Deriving Individual Demand Curve
• Suppose the consumer has utility function
U(F, C) = FC

• Suppose price of clothing is 2, income is 10

• What is the demand curve for food?
• The consumer solves
max FC
F,C

s.t. PF F + 2C = 10

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 What if income changes?
C Suppose prices are fixed
C
A B

I = 350
Income-consumption curve
I = 100 I = 200
F
20 25 45
I
350
Engel Curve
200
100

F
20 25 45
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 Engel Curve
• Engel curve of a good is the curve that shows the relationship
between income and optimal consumption
– Holding other factors fixed
• If the good is normal
– Engel curve is upward sloping
• If the good is inferior
– Engel curve is downward sloping

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 Demand Function
• Quantity demanded depends on
– Price of the good
– Income
– Prices of other goods
• Can we write down a general formula?
– Quantity demanded as a function of all parameters (income and all prices)
– I.e., F(PF , PC , I ), C(PF , PC , I )
• Demand function for a good is quantity demanded as a function of
income and all prices
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 Example: Demand Function
• Using the same utility function U(F,C)=FC
• The consumer solves
max FC
F,C

s.t. PF F + PC C = I
• We get
PF C
=
PC F
PF F + PC C = I
• Demand functions are
I I
F= , C=
2PF 2PC
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 Cobb-Douglas Utility Function
y
U(x, y) = Ax α y β , A > 0, α > 0, β > 0

MU x = Aα x α −1 y β
MU y = Aβ x α y β −1

MU x Aα x α −1 y β α y
MRSx,y = = α β −1
=
MU y Aβ x y βx

0 x

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 Demand Function for Cobb-Douglas Utility Function
• The consumer solves
max Axα y β
x,y

s.t. Px x + Py y = I

• The tangency condition is

α y Px
=
β x Py
• Tangency condition can be written as
β
Py y = Px x
α
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 Demand Functions with Cobb-Douglas Utility
Function Cont’
• The budget line is
Px x + Py y = I

• Demand functions for x and y are

α I β I
x= × , y= ×
α + β Px α + β Py

• For Cobb-Douglas utility functions

– Demand for one good does not depend on the price of the other
good
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 Indirect Utility Function
• Demand function tells us how consumption of a good changes with
prices and income
• How about consumer’s utility?
– When prices or income change, optimal consumption will change
– Maximum utility will change
• Maximum utility depends indirectly on prices and income
• Indirect utility function is maximum utility as a function of prices
and income
V (Px , Py , I ) = U(x(Px , Py , I ), y(Px , Py , I ))

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 Example: Indirect Utility Function
• Suppose a consumer solves the following problem
max FC
F,C

s.t. PF F + PC C = I

• The demand functions are

I I
F= , C=
2PF 2PC
• The indirect utility function is
I I I2
V (PF , PC , I ) = U( , )=
2PF 2PC 4PF PC

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 Re-examine the Lagrange Multiplier
• If we were to solve the problem using Lagrangian, the multiplier would
be
MU F MUC
λ= =
PF PC
• Using the example from the previous page
MU F C I
λ= = =
PF PF 2PF PC

• Differentiating the indirect utility function w.r.t. income, we also get

∂V (PF , PC , I ) I
=
∂I 2PF PC

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 Envelope Theorem
• Suppose we solve the following problem
max f (x, y, a)
x,y

s.t. g(x, y, a) = 0
– where a is a parameter
• The Lagrangian is
Λ(x, y, λ, a) = f (x, y, a) + λ g(x, y, a)

• The solution is
x * (a), y* (a), λ * (a)

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 Envelope Theorem Cont’
• If we plug the optimal values back into the objective function, we get
f * (a)
• The envelope theorem states that
df * (a) ∂Λ
= x=x* ,y=y* , λ =λ *
da ∂a
– When the parameter changes, the rate of change in the maximal value of the
objective function can be found by partially differentiating the Lagrangian
function w.r.t. the parameter and evaluating the derivative at the optimal point

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 Proof by Envelope Theorem
• The general utility maximization problem is
max U(x, y)
x,y

s.t. Px x + Py y = I
• The Lagrangian is
Λ = U(x, y) + λ (I − Px x − Py y)
• The solution to this problem gives rise to the demand functions, the
multiplier, and the indirect utility function
x * (Px , Py , I ), y* (Px , Py , I ), λ * (Px , Py , I ), V (Px , Py , I )

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 Proof by Envelope Theorem Cont’
• By the envelope theorem,
∂V (Px , Py , I ) ∂Λ
= x=x* ,y=y* , λ =λ *
∂I ∂I
– The derivative of the indirect utility function w.r.t. income is the
derivative of the Lagrangian function w.r.t. income when x, y, and the
multiplier are held at the optimal level
• Thus
∂V (Px , Py , I ) ∂Λ
= * *
x=x ,y=y , λ =λ * = λ * (Px , Py , I )
∂I ∂I

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 Part 4
INCOME AND SUBSTITUTION EFFECTS (WARM-
UP FOR SLUTSKY EQUATION)

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 What happens to the consumption of food when
food becomes cheaper?
C

C1 A
C2 B

0 F
F1 F2

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 Why does the consumer buy more food?
• Change in relative price
– Food becomes cheaper relative to clothing
• Budget line becomes flatter
– Consumer buys more food and less clothing
• Change in purchasing power
– Consumer is effectively richer
• New budget line is “higher”
– Consumer buys more food

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 Decomposing the Change in Budget Line
C
Step 1: Lower the price of food but
hold purchasing power constant

Step 2: Increase purchasing power

without changing the price of food

0 F

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 From A to C
C
Holding purchasing power constant =
holding utility constant

From A to C, price of food is lower, income

C1 A B is lower, but utility remains the same
C2 C
C3

0 F
F1 F3 F2

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 Substitution Effect
• Substitution effect is the change in consumption of one good
associated with a change in its price, holding the level of utility
and other prices constant
• Substitution effect for food is F3-F1
– Let the price of food drop, and take away some income from the
consumer so that the consumer is exactly as well off as before
– The consumption of food increases from F1 to F3

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 From C to B
C

C1 A
C2 B
C
C3

0 F
F1 F3 F2

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 Income Effect
• Income effect is the change in consumption of a good
associated with a change in purchasing power, holding all
prices constant
• Income effect for food is F2-F3
– Keep the prices fixed, and give back the consumer the income we
took away
– The consumptions of food increases from F3 to F2

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 Decomposing the Effect of Price Change
C
Effect of price change
=substitution effect + income effect

C1 A
C2 B
C
C3

0 F
Income effect
Substitution effect
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 Direction of Substitution Effect in Graph
C
Is F3 always bigger than F1?
Price of food is PF

C1 A
Price of food
C decreases to PF’
C3

0 F
F1 F3

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 Direction of Substitution Effect
• If price of food decreases, substitution effect is always non-
negative
• Suppose from A (F1, C1) to C (F3, C3), the price of F dropped
from PF to PF’
• Since the consumer is indifferent between A and C, by revealed
preference, we have
PF F3 + PC C3 ≥ PF F1 + PC C1
PF ' F1 + PC C1 ≥ PF ' F3 + PC C3

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 Direction of Substitution Effect Cont’
• Rearranging,
PF (F3 − F1 ) + PC (C3 − C1 ) ≥ 0
PF '(F1 − F3 ) + PC (C1 − C3 ) ≥ 0
• Adding up the two equations,
(PF − PF ')(F3 − F1 ) ≥ 0
• Since
PF > PF '
• We have
F3 ≥ F1
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 Direction of Income Effect
• If food is normal
– Income effect and substitution effect have the same sign
– Why?
• What if food is inferior?
– Income effect and substitution effect have opposite signs

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 Income Effect for an Inferior Good
C
Substitution effect: F3-F1>0
Income effect: F2-F3<0
Total effect: F2-F1>0
C2
B
C1 A

C
C3

0 F
F1 F2 F3

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 What if income effect dominates substitution
effect?
C
Substitution effect: F3-F1>0
Income effect: F2-F3<0
B Total effect: F2-F1<0
C2

C1
A
C
C3

0 F
F2 F1 F3

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 Giffen Good
• A good is a Giffen good if
– As price decreases, quantity demanded for the good drops
– As price increases, quantity demanded for the good goes up
– Holding other factors fixed
• Law of demand revisited
– Is demand curve always downward sloping?
– Not for Giffen good!
– Demand curve is upward sloping for Giffen good

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