Lecture 15

Choice with Endowments of

Goods
A. Banerji
Endowments of Goods
• In the utility maximization problem, where does income 𝑚 come from?
• Wage income from supplying labor from my time endowment
• Income from ownership of endowments of assets

• Extend the consumer model with exogenous 𝑚 to think about:

• How much labor time should I supply?

• How much should I save and invest in assets to get income later?
• Model equilibrium in the economy as a whole: where I demand goods as a
consumer but also work as a producer
11/17/2023 A. Banerji: Microeconomics
2-good world
• I have coconut trees (good 1) and an apple orchard (good 2) and my
endowment is 𝑤 , 𝑤 units: this is how many of these fruits drop from the
trees.
• Market prices are 𝑝 , 𝑝 . I can sell my endowment, get income 𝑚 𝑝 𝑤
𝑝 𝑤 , and buy amounts of these goods to consume.
• I choose amounts 𝑥 , 𝑥 to consume to maximize my monotone utility
• 𝑢 𝑥 , 𝑥 subject to 𝑝 𝑥 𝑝 𝑥 𝑝 𝑤 𝑝 𝑤
• Now, the Marshallian demand functions are 𝑥 ∗ 𝑝 , 𝑝 , 𝑤 , 𝑤 , 𝑗 1,2.
• This will be the same as 𝑥 ∗ 𝑝 , 𝑝 , 𝑚 , 𝑤𝑖𝑡ℎ 𝑚 𝑝 𝑤 𝑝 𝑤 .

11/17/2023 A. Banerji: Microeconomics

2-good endowment
• It may be more reasonable to rewrite 𝑝 𝑥 𝑝 𝑥 𝑝 𝑤 𝑝 𝑤 as
• 𝑝 𝜉 𝑝 𝜉 0, 𝑤ℎ𝑒𝑟𝑒 𝜉 ≡ 𝑥 𝑤 , 𝑗 1,2, is the excess demand for
good 𝑗. If 𝜉 0, I consume 𝑥 from my endowment, and sell 𝑤 𝑥 on the
market; if it is positive, I buy an excess of 𝑥 𝑤 of good 𝑗 over and above my
endowment 𝑤 from the market.
• This form of the budget constraint also says that the total market value of my
excess demands is zero.

11/17/2023 A. Banerji: Microeconomics

2-good endowment
• Since 𝑤 , 𝑤 generates income 𝑚 ∑ 𝑝 𝑤 and with this amount of
income, you can buy 𝑤 , 𝑤 , this point is on the budget line; and the slope is
.
• Clearly, utility will typically not be maxed at this endowment point; so I will
trade some of one of my endowments and buy more of the other good.

11/17/2023 A. Banerji: Microeconomics

Slutsky Equation
• .

11/17/2023 A. Banerji: Microeconomics

Slutsky Equation
• .

11/17/2023 A. Banerji: Microeconomics

Slutsky Equation
• .

11/17/2023 A. Banerji: Microeconomics

Slutsky Equation
• .

11/17/2023 A. Banerji: Microeconomics

Slutsky equation
• We have:
, , ∗ ∗ , ,
∗
• Δ𝑥 Δp
• Dividing by Δ𝑝 and taking limits we get
∗ , , ∗ ∗ , ,
•
• In the diagram, it was the higher income from the higher value of 𝑤 that is
leading to the move to higher utility, when the price of good 1 increases: in the
exogenous income 𝑚 model that we were using earlier, this effect would be
absent.

11/17/2023 A. Banerji: Microeconomics

Example
• Maximize 𝑢 𝑥 , 𝑥 𝑥 𝑥 subject to 𝑝 𝑥 𝑝 𝑥 𝑝 𝑤 𝑝 𝑤
• From our knowledge of Cobb-Douglas utility, and setting 𝑝 𝑤 𝑝 𝑤 𝑚
• We have
• 𝑥∗
• So, in the endowment model, even in the Cobb-Douglas case, the demand for
good 𝑗 depends on the price of good 𝑖 as well: because there is an effect on
income/wealth through the endowment.

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• A person has 𝑇 units of time to divide up between leisure 𝑥 and labor 𝐿.
• He/she gets a wage 𝑤 per unit of of labor supplied: so wage income equals
𝑤𝐿 𝑤 𝑇 𝑥 .
• She also has some exogenous, other income 𝑚.
• So, working for 𝐿 hours gives total income = 𝑤 𝑇 𝑥 𝑚, where 𝑥 is the
amount of leisure that is then consumed.
• Consuming leisure gives positive utility; working does not give any direct
utility.
• The person can also buy another good, good 2, at price 𝑝 1 (just a
normalization of this price; note that the `price’ of leisure = w).

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• The person’s utility function is 𝑢 𝑥 , 𝑥 𝑥 𝑥 which he/she wishes to
maximize subject to the budget constraint 𝑥 𝑤 𝑇 𝑥 𝑚
• Let us rewrite the budget constraint as
• 𝑤𝑥 𝑥 𝑤𝑇 𝑚 ; as if the person is selling all her time endowment and
then buying back 𝑥 units at 𝑤 per unit.
• Writing this in this expenditure equals income form, we can straightaway
write down the U max without cranking through a substitution or a Lagrangian.
• 𝑥∗ , 𝑥∗
• Cobb Douglas demands are total income divided by own price, times
exponent share from utility function

11/17/2023 A. Banerji: Microeconomics

Labor Supply: effect of change in wage rate
• Effect on leisure:
∗
•
• For the Cobb-Douglas, higher wage increases labor supply, decreases leisure.
• If you write down a Slutsky equation, you find that the higher price of leisure
reduces leisure (substitution effect), but the higher wage implies a higher
endowment income effect which tends to increase leisure: but the substitution
effect dominates.
∗
• : in the no endowment model, the wage would be just a price of
leisure, and with Cobb-Douglas utility, the demand for good 2 would depend
only on its own price 𝑝 . But here, the wage increase has an endowment
income effect on 𝑥 ∗ .
11/17/2023 A. Banerji: Microeconomics
Labor Supply
• The way we solved this problem, we ignored a constraint: Namely, that leisure
𝑥 can at most equal 𝑇.
• We assumed this constraint, 𝑥 𝑇, would hold with ‘<‘ at the U max.
• Stated in full, the problem is to find 𝑥 , 𝑥 to
• Maximize 𝑢 𝑥 , 𝑥 𝑥 𝑥
• Subject to 0 𝑥 𝑇, 𝑥 0, 𝑥 𝑤 𝑇 𝑥 𝑚
• Or, making a substitution,
• Choose 𝑥 ∈ 0, 𝑇 to Maximize 𝑥 𝑤 𝑇 𝑥 𝑚 .
• We gave the solution for the interior max.

11/17/2023 A. Banerji: Microeconomics

Labor supply curve
• .

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• .

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• .

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• .

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• .

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• .

11/17/2023 A. Banerji: Microeconomics

Labor Supply
• .

11/17/2023 A. Banerji: Microeconomics

Intertemporal Consumption: 2-period (Fisher) model
• Let’s say there is only 1 good, a consumption good, available to consume in
each period 𝑡 1,2.

11/17/2023 A. Banerji: Microeconomics

2-period model
• .

11/17/2023 A. Banerji: Microeconomics

2-period model
• .

11/17/2023 A. Banerji: Microeconomics

2-period model
• .

11/17/2023 A. Banerji: Microeconomics

2-period model
• .

11/17/2023 A. Banerji: Microeconomics

2-period model
• .

11/17/2023 A. Banerji: Microeconomics

2-period model: Present Value
• .

11/17/2023 A. Banerji: Microeconomics

Present Value
• .

11/17/2023 A. Banerji: Microeconomics

Present Value
• Typically, if I invest a sum of money for a longer duration, I can get a higher
rate of interest. We will come to this when we discuss yield curves, and how to
calculate interest rates for different durations if we look at bonds floated by RBI
or in general floated by the Treasuries of countries that have no risk of default.
• We now go back to the 2-period utility maximization model.
• .

11/17/2023 A. Banerji: Microeconomics

2-period model
• So I solve:

11/17/2023 A. Banerji: Microeconomics

2-period model
• .We have

11/17/2023 A. Banerji: Microeconomics

On the U max tangency
• .

11/17/2023 A. Banerji: Microeconomics

Consumption Smoothing
• .

11/17/2023 A. Banerji: Microeconomics

Consumption smoothing
• .

11/17/2023 A. Banerji: Microeconomics

Savers
• .

11/17/2023 A. Banerji: Microeconomics

Borrowers
• .

11/17/2023 A. Banerji: Microeconomics

 U max example
• .

11/17/2023 A. Banerji: Microeconomics

U max example
• .

11/17/2023 A. Banerji: Microeconomics

U Max example
• .

11/17/2023 A. Banerji: Microeconomics

More patience
• .

11/17/2023 A. Banerji: Microeconomics

Inflation
• .

11/17/2023 A. Banerji: Microeconomics

Inflation
• .

11/17/2023 A. Banerji: Microeconomics

Real interest rate
• .

11/17/2023 A. Banerji: Microeconomics