BUYING AND SELLING: CONSUMER

WITH ENDOWMENT BUNDLE

• We now consider the case of a consumer who has preferences satisfying all the assumptions and is endowed, not with a
given money income, but with fixed amounts of commodities which she can consume or sell on the market in order to
finance purchases of other commodities.
• The feasible set is defined by the nonnegativity requirements on consumption and by the constraint that the market value of
the bundle consumed cannot exceed the market value of the consumer’s initial endowments. Her budget constraint is
therefore
 BUDGET LINE FOR TWO GOOD C ASE:

• The budget line will pass trough the point 𝑥ҧ =( 𝑥ҧ1 , 𝑥ҧ2 ).
𝑝
• The slope of the -𝑝1
2

• The market value of the endowment 𝑤 = σ𝑛𝑖=1 𝑝𝑖 𝑥ҧ𝑖 will increase or decrease as the price of a commodity increases or
decreases.
• Since the consumer is always able to consume her initial endowment vector 𝑥ҧ =( 𝑥ҧ1 , 𝑥ҧ2 ), a change in a single price will cause
the budget line to rotate through 𝑥ҧ =( 𝑥ҧ1 , 𝑥ҧ2 ), rather than through an intercept on one of the axes.
• An equal proportionate change in all prices leaves the budget line unaffected, though the nominal value of the endowments
varies in the same proportion. The budget line must still pass through 𝑥,ҧ and its slope will be unaffected by such price changes
and hence its position is unchanged. Only change in relative prices or in the initial endowments will alter the consumer’s feasible
set and therefore the consumer’s demand or supply of a commodity. Her demand functions will again be homogeneous of degree
zero in prices. 𝑥2
• 𝑥ҧ =( 𝑥ҧ1 , 𝑥ҧ2 ).
𝑝 𝑝
𝑝
Slope=-(𝑝1)* 𝑝
Slope=-𝑝1 Where (𝑝1)∗ > 𝑝1
2 2 2
2

𝑥1
 CONSUME R ’S E QUI L I BR IUM • .
Offer curve is the
Here 𝑥 ∗ is the initial equilibrium point locus of optimal
bundles traced out
as p1/p2 varies
with 𝑥ҧ fixed
Offer curve

Net buyer of
first good

Increases in 𝑝1 relative to 𝑝2 will make the budget line

rotate clockwise about 𝑥ҧ and
𝑝
the optimal bundle will vary as 𝑝1 changes
2

Net Demand Curve

 UTILITY MAXIMIZATION WITH
EXPENDITURE MINIMSATION
ENDOWMENT (PRIMAL PROBLEM)
PROBLEM (DUAL PROBLEM)
• Max u (x) • Min px-p𝑥=p(x-
ҧ 𝑥)=p
ҧ 𝑥ො
• s.t. : p · x ≤ p𝑥ҧ Assuming consumers spends his • Subject to u(x)≥ 𝑢ത
entire income we consider this constraint as
• The Lagrangian is given by:
equality.
• L = p𝑥ҧ + λ (ത
𝑢− u (x)) Differentiating with respect to 𝑥𝑖
• The Lagrangian is given by:
• The First order conditions are
• L = u (x) + λ (p𝑥ҧ − px). Differentiating with
respect to 𝑥𝑖 • 𝑝𝑖 = 𝜆𝑢𝑖 i=1, 2, ………………n
• The First order conditions are • Solving we get
• 𝑢𝑖 = 𝜆𝑝𝑖 i=1, 2, ………………n ത σ𝑛𝑖=1 𝑝𝑖 (ℎ 𝒑, 𝑢ത − 𝑥ҧ𝑖 )
• 𝑒 ∗ (𝒑, 𝑢)=
• σ𝑛𝑖=1 𝑝𝑖 𝑥𝑖 = σ𝑛𝑖=1 𝑝𝑖 𝑥ҧ𝑖
• The solution to this problem
• 𝑥𝑖∗ = 𝑥𝑖 (𝒑, 𝒙
ഥ)
• And net demand:
ഥ)-𝑥ҧ𝑖
• 𝑥ො𝑖 = 𝑥𝑖 (𝒑, 𝒙
 CONSUMER AS A LABOUR SUPPLIER
• The consumer’s utility function depends on the bundle of goods consumed (x) and the amount of non-work time or
leisure (L).
• 𝑢 = 𝑢 𝑥, 𝐿
• Since more leisure is assumed to be preferred to less, the marginal utility of leisure 𝑢𝐿 is positive. The consumer is constrained
in two ways. First she cannot spend more than her income M
• σ𝑛𝑖=1 𝑝𝑖 𝑥𝑖 ≤ 𝑤𝑧 + 𝑚 = 𝑀 here z is the labour time sold in the ,market at the wage rate w and m is the non-labour income. Due to
non satiation assumption the constraint is satisfied as equality.
• Second, the consumer in any given period of length T is constrained by her ‘time budget’ 𝑇 = 𝑧 + 𝐿.
• σ𝑛𝑖=1 𝑝𝑖 𝑥𝑖 = 𝑤 𝑇 − 𝐿 + 𝑚
• Consider a simplified case where consumer consumes only a composite commodity y. Thus, the above problem becomes
• max 𝑢 = 𝑢 𝑦, 𝐿
• 𝑝𝑦 = 𝑤 𝑇 − 𝐿 + 𝑚
• Replacing y in the utility function gives the first order condition as
𝑢𝐿 𝑤
• = implying slope of the indifference curve equal to slope of the budget line
𝑢𝑦 𝑝
 ALTERNATIVE APPROACH

• Suppose we represent the problem as max 𝑢 = 𝑢 𝑦, 𝐿 = 𝑢 𝑦, (𝑇 − 𝑧) = v(y, z)

• 𝑆𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝑝𝑦 = 𝑤𝑧 + 𝑚
𝜕𝑣
• Here 𝜕𝑧 = 𝑣𝑧 < 0 that is more work gives disutility to individual, and 𝑣𝑦 > 0 as before. The First order condition gives

The marginal rate of substitution between consumption and labour supply

must be equal to the real wage w/p. This condition and the budget constraint
yield the Marshallian consumption demand and labour supply functions y(w, p,
m), z(w, p, m) respectively
. y

The consumer can initially purchase m/p of

𝑝𝑦 = 𝑤𝑧 + 𝑚 the composite consumption good without
supplying any labour and (m+ wT)/p=F/p if
she has no leisure. The budget constraint
or wage line in (z, y) space has slope w/p
Total time=T and at the initial optimum the indifference
curve is tangent to the budget constraint.

L*=T-z*
z
Z*
 WAGE INCREASE AND LABOUR SUPPLY
As the wage increases in the wage line pivots about m/p and
becomes steeper and the optimal position changes from A to B
and then to C as the wage increases from w1 to w2 and then to
w3. In part (b) the labour supply curve shows the amount of
labour supplied at the different wage rates, with points a, b and
c on the supply curve S corresponding to the optimal positions
A, B and C in part (a). The locus of optimal points in part (a)
generates the supply curve in part (b).
There is a backward bending supply curve with increases in w
increasing the supply of labour at low wage rates but decreasing
it at high wage rates. Since decreases in labour supplied imply
increases in leisure demanded and w is the opportunity cost of
leisure, this apparently perverse response at high wage rates is
analogous to a Giffen consumption good where an increase in
price leads to an increase in demand.
 SUBSTITUTION EFFECT AND INCOME EFFECT OF WAGE CHANGE

• Suppose after increase in wage from 𝑤1 𝑡𝑜 𝑤2 the optimal bundle shifts from A to
B.

• The wage line is then shifted downward parallel with itself until it is tangent to the
initial indifference curve 𝐼1 at D. The substitution effect AD shows the change due
solely to the variation in w with utility held constant. DB is the income effect,
showing the change due to the rise in utility with w held constant. Substitution effect
of a wage rise is always to increase the supply of labour.The wage line becomes
steeper, and since the slope of I1 rises as z rises, the point of tangency D between
the wage line with slope 𝑤2 and 𝐼1 must be to the right of A.

• No such restriction can be placed on the income effect. B may be to the right or to
the left of D. If B is to the left of D then z falls as income rises

• with constant w, or equivalently L rises as income rises, so that leisure is a normal

good. Notice that if the supply of labour declines as w rises B would have to be to
the left of A. Since A is always to the left of D the supply of labour would then have
to fall (L rise) as income rises with constant w. Hence leisure being a normal good is
a necessary, but not sufficient, condition for a backward bending, negatively sloped
supply curve of labour.