Part I

Consumer Behavior

1
Introduction

Consider the following situation. You are an economist for Company A that sells
smartphones and tablets. The company is deciding whether they should increase
the price of tablets or smartphones. As a resident economist, you are asked to
analyze which price should the company increase and by how much? How would
you solve such a problem?
Let us further assume that the tablets (think of Apple iPad) are mostly bought
by college students and smartphones are meant for business executive (think of
iPhone 12 phones). If the price of tablets increase how do you think the revenue
of the company would be affected? How about the price of smartphones? What
information would you need to make such comparisons? What would be the optimal
pricing policy in this case?
Consider another situation. Now you are advising the federal government on
whether to impose a tax on gas. However, you do not know how much gas each
individual customer is buying but you have the price of gas and GDP data from past
years. How would you determine how much tax to impose? How would compare a
tax on gas to an increase in income tax that generates the same revenue?
In the following chapters in this section, we would try to answer these questions.
To answer the first question we need information about demand for smartphones
and tablets by the consumer and also we need to know how the demand changes
with price.
To answer these questions we will assume the agent or the consumer here is ra-
tional in the sense he chooses the best possible alternative for himself. For example,
if he wants to buy a smartphone he would not buy a tablet when both goods are
available to him. This implies the consumer will choose alternatives optimally given
what he likes and what is available to him. To understand what is available to the
consumer we need to know how much money(resources) the consumer has and what
is the price of the commodity. We will discuss the solution to these questions in the
first four chapters.
Answering the second question is harder because we have fewer data points
available to us. This would imply we need to build models that can deal with the
real-life scenario where the economist has to design policies with only price and
demand/choice data from previous periods. We will discuss these questions in the
5 chapter.
Finally, in the last chapter, we would discuss the effects of changing prices and
other factors in the economy to the demand.

3
4
Chapter 1

Budget Set

1.1 Choice Sets

We define the choice set as the set X that consists of all conceivable choices that
a decision-maker (DM) or economic agent (agent in short) has in a given economic
situation. Depending on the economic model this abstract set X can take any form.
E.g., in a voting context, the choice set may refer to the possible policy positions
available to the voters. Another example would be total time available to you in a
given day for studying and playing video games.
Few other examples include total money you can spend or save, total time
available to work or study, list of possible colleges you can attend and so on. Even
though theoretically we consider X to be set of all conceivable choices, in practice
it might be difficult to measure what an agent actually considers as her choice set.
Analyzing what a DM pays attention to in a choice set is a more difficult problem.
So, for this course we will assume our DM can observe and considers all the choices
available to him.

1.2 Budget Constraint

The most standard choice set X in economics is called the budget set, which is
defined over n commodities. All these commodities are perfectly divisible and non-
negative and hence the budget set will live in Rn+ .
We will consider only two types of goods in the economy, namely good 1 and good
1
2. We will denote a commodity bundle by (x1 , x2 ), where x1 denotes the amount
of good 1 and x2 denotes the amount of good 2. Note that the consumption bundle
is written as an ordered pair such that the first term denotes the good 1 and the
second term good 2. Thus a bundle (2, 3) is not same as a bundle (3, 2). We will
use this ordered pair notation repeatedly in our course.
Suppose the total income of the consumer is given by m > 0 with which he can
buy either good 1 or good 2. The price vector is given by p~ ≡ (p1 , p2 ) >> 0 where
x̃ >> 0 implies all component in the vector x̃ are strictly positive.
1
Even though in reality we never consume only two goods you can think of good 1 as the good
you want to purchase and good 2 as the amount of money left that can be used to purchase other
commodities.

5
6 CHAPTER 1. BUDGET SET

With the strictly positive income m and strictly positive prices p~ we define the
budget constraint or the budget set of the DM as follows:

p 1 x1 + p 2 x 2 ≤ m (BC)

Any commodity bundle that satisfies equation BC is called a feasible bundle. The
boundary of the budget set is called the budget line and is given by,

p 1 x1 + p 2 x2 = m

If a consumer chooses a bundle on the budget line then he uses his entire income
m on the two goods. One nice property of the budget set thus defined is that for a
given set of prices and income it is a convex set, i.e., all convex combination of any
two elements of the set remain in the set. However, if price changes for different
levels of goods it will not remain so. In the next few sections we will explore cases
where the price of one or both goods change exogenously in the market.

Figure 1.1: Budget Constraint and Budget Line

1.3 Shifts in Budget Line

First, let us rewrite the budget constraint to obtain the slope and the intercept,
m p1
x2 = − x1 .
p2 p2
So the slope of the function is − pp12 , the ratio of the prices of good 1 and good 2
respectively. If both prices are positive then the slope is negative which means if
the agent wants to buy more of good 1 he would buy less of good 2. Thus the slope
of the budget line is measuring the opportunity cost of consuming good 1. Think
of a scenario where one of the prices is negative. What happens to the slope there?
Note that the intercept of the budget line on x2 axis is pm2 which is the maximum
amount of x2 that he can buy with income m and price p2 . Similarly the budget
line intersects the x1 axis at pm1 , i.e., at the maximum level of x1 the consumer can
buy with income m and price p1 for good 1.
1.3. SHIFTS IN BUDGET LINE 7

We have taken the price and income as given, they are called the parameters of
the model. We are interested to know how the choice of the consumer will change
when the parameters of the model are changed. To do so, we first ask the question,
what happens to the budget set when we change the parameters of the model.

Figure 1.2: Shift in budget line after m increases

If income m increases, then the slope of the line does not change but both the x1
and x2 intercept would change. If m increases then both pm1 and pm2 increases, because
now the agent can buy more of both goods with the additional income.(Refer fig
1.2)

Figure 1.3: Panel a: shift in budget line after p1 decreases, Panel b: shift in budget
line after p2 decreases

If the price of good 1 changes, then the slope of the line changes and the x1
intercept changes as well. If p1 decreases, then the slope becomes less negative or
the budget line becomes flatter. In terms of x1 intercept, since income is fixed and
p1 has gone down, pm1 increases, i.e., the agent can buy more amount of good 1 when
8 CHAPTER 1. BUDGET SET

Figure 1.4: Lump sum tax

he spends his entire income on good 1. Similarly if p2 decreases the budget line will
become steeper and the intercept pm2 will increase. (Refer fig 1.3)

1.4 Tax Policies

We all have encountered while buying things from a store, government tax policies
can affect the price of a commodity. We will consider three types of taxes, lump
sum tax, value tax or ad valorem tax, and quantity tax. The lump sum tax does
not change the prices of the goods but rather the income. It requires the consumer
to pay a certain amount T irrespective of his choice of goods. If T is the amount
of lump sum tax, then the new budget line would be

p1 x1 + p2 x2 = m − T.

The diagram below (refer 1.4) illustrates, For value-added tax (also known as ad
valorem tax), the tax rate applies to the value of good, namely it becomes (1 + τ ) p1 .
So in both cases, the slope of the budget line changes. An example of a value-added
tax is sales tax. The budget constraint, in this case, is given by

(1 + τ ) p1 x1 + p2 x2 = m

The diagram below (refer 1.5) illustrates the change in budget set. In the case of
quantity taxes, if the tax rate on good 1 is τ , then the new price would be p1 + τ .
The budget constraint is given by,

(p1 + τ )x1 + p2 x2 = m
1.4. TAX POLICIES 9

Figure 1.5: Ad valorem tax

Think about how a quantity tax will change the budget set. Beside taxes we can
also consider subsidies as well, where the effective price is reduced, so the signs in
front of the tax rate term would be negative but the analysis would remain the
same.

Also, the government can have rationing policies that restrict the consumer to
buy only up to k units, in which case at x1 = k the budget line becomes verti-
cal.(Refer fig 1.8)

Figure 1.6: Rationing

10 CHAPTER 1. BUDGET SET

Thought Exercise
Another important government policy is food stamp or food subsidy program which
runs in many countries. Under this program, the government gives f units of food
stamps to people to buy food. The stamps can only be used to buy food and nothing
else and for purchasing food the stamps are as good as money. If x1 denotes the
consumption of food by an agent then he can buy m+f p1
units of x1 but when he
m
spends all his income on good 2 he can only consume p2 units of good 2. Even
when he spends all his income on good 2, he can use his food stamps and get pf1 .
Draw a budget line where m = $200, f = $40 and the prices are p1 = $5 and
p2 = $10 respectively.

1.5 Numerical Examples

1.5.1 Shipping cost

Let us consider the following example with shipping cost. Suppose the price of
good 1 and good 2 are p1 = $5 and p2 = $10 respectively. The total income of the
consumer is $200. However, there is a fixed shipping cost of c = $30 levied only
on good 1, i.e., whenever the consumer purchases a positive amount of good 1 she
needs to pay $30 for shipping cost.
To draw the budget line we will break down the problem into two cases, namely,
case 1, when x1 = 0 and case 2, when x1 > 0. In the former case the maximum
amount of x2 the consumer can buy is x2 = 200/10 = 20. In the later case, the
consumer needs to pay $30 for shipping cost. So the maximum amount of x1 the
consumer can buy is (200 − 30)/5 = 34. For this case the slope of the budget line
will be −5/10 = −1/2. Combining these two cases we get the following budget
constraint,

Figure 1.7: Budget line with shipping cost for x1

1.5. NUMERICAL EXAMPLES 11

1.5.2 Bulk Discount

Supermarkets often offer a price scheme where the first few units of a product are
sold at a higher price but for bulk quantities, you can get a discount. The following
is an example of a bulk discount for which we will draw the budget line.
Let the income be m = $200 and p2 = $10 for all levels of quantities. For good
1 there is a bulk discount and the price scheme is as follows:
(
20 for x1 ∈ [0, 6]
p1 =
10 for x1 > 6

For the case where x1 ∈ [0, 6] the slope of the budget line is −2 and if the
consumer buys only good 2 he can afford x2 = 20. At x1 = 6 the consumer has
already spent $120 on good 1. Hence the maximum amount of good 2 he can afford
is x2 = (200 − 120)/10 = 8 and the maximum amount of additional good 1 he can
afford (above the first six units bought at $10 per unit) is 80/10 = 8. The slope
of the budget line for this case is −1, which is flatter than the initial slope. This
generates the following budget line.

Figure 1.8: Budget line with bulk discount

Algebraically, for 0 ≤ x1 ≤ 6 the budget set is given by the inequality

10x2 ≤ 200 − 20x1

x2 ≤ 20 − 2x1

and for 6 < x1 ≤ 14 the budget set is given by,

10x2 ≤ 200 − 120 − 10(x1 − 6)

x2 ≤ 14 − x1

The budget line is piece-wise linear since for different values of x1 the slope
changes. As we will see in later chapters this will complicate the optimization
problem for this consumer.
12 CHAPTER 1. BUDGET SET
Chapter 2

Preferences and Choices

The goal of neoclassical consumer theory is to predict choices from a budget set.
For that, we need a method of selection by the DM from the budget set which
would be general across all prices and income. To begin with, we will construct the
theory of choices over simple arbitrary choice set X and then we will extend the
theory to budget sets. We will start with pairwise comparisons for objects in X
and then extend it to global choice over the entire set X. The goal of the theory
is formalize the idea that if a consumer chooses an element x ∈ X then x must be
the subjectively best choice for him.

2.1 Preference Relation

To make pairwise comparisons let us first define a binary relation over X. A binary
relationship on X identifies all pairs of x, y ∈ X that satisfies a well-defined criterion.
For example if X = R then the criterion > defines a binary relation on X. In a
political economy context for any issue, a (e.g., climate change) “being to the left
of” defines a binary relation over all candidates.
In this chapter we are interested in the binary relationship called “ at least
as good as”. For any two elements x, y ∈ X, x  y implies the DM likes x at
least as much as y. This relationship is called weak preference. We can generate
two other binary relationships from weak preference, namely strict preference and
indifference. For two elements x, y ∈ X we denote x  y, i.e., x is strictly preferred
to y if x % y but ¬y % x (¬ reads negation). For two elements x, y ∈ X x is
indifferent between x and y, i.e., x ∼ y if x % y and y % x.
Our goal is to predict the choice from the entire set X. So we need to extend the
pairwise comparison to global choice from X. This requires imposing assumptions
on % to make it rich enough and logically coherent. The following two assumptions
are necessary for a theory of choice from X.
Completeness: A preference relation % on X is complete if for any two ele-
ments x, y ∈ X either x  y or y  x is valid. In other words, any two elements
are comparable.
Transitivity: A preference relation % on X is transitive if for any three elements
x, y, z ∈ X if x  y and y  z then x  z. In words, if the first element is preferred
to second and the second element to the third then the first element is also preferred
to third (Can you think of a relationship where this is not true?).

13
14 CHAPTER 2. PREFERENCES AND CHOICES

A Complete and Transitive (CT ) relation % is called a preference order over

X. Completeness makes the binary relationship rich, since any two elements can
be compared and transitivity makes it logically consistent. Given CT on %, let us
investigate the implications on  and ∼ separately.

Thought Exercise
Show that the following property of a preference order follows from Completeness.
Reflexive: Any bundle x ∈ X is at least as good as itself.

Claim 1:  is transitive
Let x  y and y  z. To prove  is transitive we need to show x  z, i.e., x % z
and ¬z % x. Since x  y, we know x % y and ¬y % x, similarly y % z and ¬z % y.
By transitivity of % x % z. If  is not transitive and z % x then by transitivity of
% z % y since x % y. This contradicts our assumption y  z. Hence, proved.

Claim 2:  is not complete

Consider the following example, X = {x, y}, where x % y and y % x. This is a
well-defined preference order (why?) where x and y is not comparable by .

Thought Exercise
Show that ∼ is transitive but not complete.

2.2 Preference to Choice

The goal of the choice theory is to show given a choice set X and preference order
defined over X the DM would choose maximally. Formally, for choice set X the set
of maximal elements, C(X) ⊂ X is defined as follows:

C(X) = {x ∈ X|x % y, ∀y ∈ X}

The chosen set C(X) can contain more than one element and the theory is silent
about how to chose uniquely in that case.
The assumptions on % ensure that C(X) 6= ∅, i.e., C(X) has at least one
element. We will consider examples with two-element and three-element choice set
to illustrate this. Let us consider the choice X = {x, y, }. Given CT there are three
possibilities. First, x % y only, second x % y and y % x and third, y % x only. In
the first case, we have x  y so x will be chosen. In the second case x ∼ y so either
x or y can be chosen. In the third case, y  x so y is chosen. Thus the assumptions
guarantee choice of at least one element from a two-element choice set.
Now consider a three-element budget set X = {x, y, z}. If we have x % y, y % z,
and x % z then the preference is complete and transitive. From % we get x  y,
y  z and x  z, which implies the theory suggest to choose x. Similarly for the
same X if we have x % y, y % x, x % z, and y % z, we get x ∼ y  z, so the theory
is to choose x or y. This preference is also complete and transitive (How?).
Now consider the same three-element choice set X with only y % x, then the
preference is not complete, since we don’t know anything about z. Thus the theory
2.3. INDIFFERENCE CURVE 15

cannot predict choice for this preference. Similarly, if x % y, y % z, and z % x then

the preference is not transitive and the theory cannot say anything about choice.
Claim: For any finite set X, a complete and transitive binary relation always
has a maximal element.
Proof: Let us start with any arbitrary element x ∈ X. If x % x0 for all x0 ∈ X,
i.e., x is preferred to or indifferent to all other elements in X, then x is the maximal
element.
If not, then by completeness there exists y ∈ X such that y % x. By transitivity
for all z ∈ X such that x % z we get y % z as well. If y % y 0 for all y 0 inX then y is
maximal.
If y is not maximal then by completeness there is an element t ∈ X such that
t % y. Iterate the steps until all elements are exhausted. Since X is finite and there
are no cycles by transitivity, the iterative process will terminate in finite steps.
Hence we will find an element x such that x % y for all y ∈ X.

2.3 Indifference Curve

Using similar logic from the previous section we can show that the CT preference
over a finite set X can be written as a sequence of strict preference and indifference
only. This allows us to divide the choice set X into subsets of indifference I1 , I2 , . . .
such that for all x, y ∈ Ik , x ∼ y and x ∈ Ik and y ∈ Ik+1 , x  y. We can do this by
picking any element x ∈ X and comparing it with other elements y ∈ X. If x ∼ y
then both belong to Ij , if x  y then y ∈ Ij+1 and x ∈ Ij . By CT we can complete
the comparisons between any pair of objects in X.
Similar to the finite case, a preference order % over the choice set X = RN
+ can
also be partitioned into indifference sets according to  and ∼. Consider any two
points x, y ∈ X. One of the following relation must be true: x  y, y  x, or x ∼ y.
Each set of points in x, y ∈ X such that x ∼ y belongs to the same indifference set.
And each pair of point x, y ∈ X such that x  y belong to two different indifference
sets. Transitivity ensures that two indifferent sets doesn’t intersect.

Math Aside
The transitivity assumption implies that two indifference sets can not intersect. We
will prove this by contradiction. Assume an element x ∈ X = RN + belongs to two
difference indifference sets I1 and I2 . Let y ∈ I1 and z ∈ I2 such that either y  z
or z  y, i.e., I1 6= I2 . Since x ∈ I1 , we have x ∼ y or x % y and y % x. But x ∈ I2
as well so x ∼ z or x % z and z % x. By transitivity y % z and z % y or y ∼ z,
leading to a contraction.

For any point x ∈ Rn+ we can define the weakly preferred set as the set of all
y ∈ RN N
+ such that y % x. A weakly preferred set of any point x ∈ X = R+ consists
of several indifference sets. In particular, the boundary of the weakly preferred set,
i.e., the set of all points y ∼ x is called the indifference curve (IC). Transitivity
implies that two ICs cannot intersect. The figure below (refer figure 2.1) illustrates,
16 CHAPTER 2. PREFERENCES AND CHOICES

Figure 2.1: Violating Transitivity: Intersecting ICs

The two regularity conditions below ensure that the indifference curve is well-
behaved, i.e., downward sloping and convex (bowed in).
Strict Monotonicity: A preference relation % is strictly monotone if for any
two elements x̃, ỹ ∈ X = RN + , x̃ > ỹ implies x  y. Where x̃ > ỹ implies xi ≥ yi
for all 1 ≤ i ≤ N and there exists at least one j such that xj > yj , that is x̃ is
at least as high as ỹ component-wise and strictly higher in at least one dimension.
This assumption says more is better, i,e., all goods are good and not bad.
Strict monotonicity implies if we go to the north-east of a bundle x̃ ∈ X = RN +
we get bundles that are strictly preferred, which implies the IC can not be upward
sloping, or thick or increasing in south-west direction. Let us show in the following
diagrams. For all three cases we can find two bundles x̃ and ỹ such that y1 > x1
and y2 > x2 . Then by strict monotonicity (y1 , y2 )  (x1 , x2 ) so they cannot belong
to the same IC.

(a) Thick IC (b) Upward-sloping IC (c) S-W improvement

Figure 2.2: Violation of Monotonicity

Convexity: The preference relation % is convex if the weakly preferred set for
any bundle is convex, that is all convex combination of any two points in the weakly
preferred set belong to the set itself. Consider two elements x and y such that y ∼ x,
then any convex combination with a weight λ ∈ [0, 1], namely λx+(1−λ)y % x ∼ y.
If the convex combination λx + (1 − λ)y  x ∼ y then the preference relation is
strictly convex. Convexity implies that the average bundle is more preferred to the
extreme bundles.
2.3. INDIFFERENCE CURVE 17

Under convexity the slope of the IC will be decreasing in x1 . This implies as

the consumer gets more of good 1 he is willing to give up a lesser amount of good
2 to get one extra unit of good 1. In other words, this also means that the agent
does not want to go to the extreme and rather prefers an average bundle.

Figure 2.3: Convexity of Preference

2.3.1 Examples:
Perfect Substitutes: Suppose you need to choose between two alternatives to go
to the city museum, one is a red bus and another is a blue bus. The two buses
take exactly the same route and are equally comfortable. This is an example of
perfect substitutes since you would be happy to substitute one with the other. The
diagram below shows the shape of the IC for a perfect substitute.
Perfect Complements: The polar opposite case of perfect substitute would
be perfect complements. An example would be left and right pair of shoes. Unless
you have both of them you can not use the pair. So one extra left shoe is as good
as no extra shoes at all. The L-shaped IC for perfect complements reflects this
complementarity.

Figure 2.4: Panel a: Perfect Substitutes Panel b: Perfect Complements

Non-monotone preference: Below is an example preference relation when

monotonicity fails. In the diagram (x1 , x2 ) denotes the point of satiation, which
18 CHAPTER 2. PREFERENCES AND CHOICES

means this bundle is weakly preferred to all other bundles. The ICs away from the
satiation point are less preferred. Note that, here the IC is not always downward
sloping.

Figure 2.5: Satiation

Non-convex preference: Below is an example of a preference that is not

convex. The IC is concave in this case. This implies the consumer prefers extreme
bundles over average bundles.

Figure 2.6: Non-convex preference

Bad and Neutral: Two interesting examples of non-standard preferences are

bad and neutral. A commodity is bad if more of that commodity is less preferred.
A good example would be pollution. To go to the city museum you need to take the
bus (blue or red). Though you may enjoy the visit to the museum, the pollution
is a ”bad” commodity for you. A commodity is neutral if the agent is indifferent
to any amount of that commodity. For example, if you can not read Latin, then
2.3. INDIFFERENCE CURVE 19

more and more books in Latin would not be preferred by you and hence would be
a neutral commodity. The diagram below illustrates.

Figure 2.7: Panel a: x1 is bad Panel b: x2 is neutral

Lexicographic Preference: Another exciting example is that of lexicographic

preference. Lexicon means dictionary, the preference relation works a similar way
you would read a dictionary. Suppose you are looking for the word ”stable” in the
dictionary, then you would start with the first word ”s”. Once you are at ”s”, then
you will search for the second word ”t” and so on.
Similarly, under a lexicographic preference, you first start with good 1, then if
two bundles has same amount of good 1 we look at good 2. For any two bundles
(x1 , x2 ) and (y1 , y2 ) then (x1 , x2 ) % (y1 , y2 ) if x1 > y1 or if x1 = y1 and x2 ≥ y2 .
(Think about how you would draw an IC for a lexicographic preference! )
20 CHAPTER 2. PREFERENCES AND CHOICES
Chapter 3

Demand

In this chapter, we will graphically explore optimal choice from a standard budget
set. Throughout the chapter we will assume the choice set with two goods only,
namely, X ∈ R2+ . Recall, in the two good case the standard budget set is given by

(x1 , x2 ) ∈ R2+ |p1 x1 + p2 x2 ≤ m



and the budget line given by

p1 x1 + p2 x2 = m.

We will assume the two regularity conditions, namely, strict monotonicity and con-
vexity, defined in the last chapter. No other assumptions are made on the particular
form of the indifference curve, which implies any such curve will be consistent with
the standard choice theory.
Given the preference of the agent and the budget constraint he is facing, we want
to know what the agent would actually choose from his budget set. The implicit
assumption in the standard choice theory is that the agent is rational, which in this
context means that he would choose his most preferred alternative that is feasible
in his budget set. We call this the choice problem for the consumer. In this chapter
we will solve the choice problem graphically.

Math Aside
Existence of Unique Maximal Element: If a consumer faces a convex budget
set X over which he tries to maximize a CT, strictly monotone and strictly convex
preference relation then the maximal element is unique. To prove that, let us
suppose the maximal element is not unique. Then there exists x, y ∈ X such that
both x, y ∈ C(X), where C(X) denotes the set of maximal elements.
Since the budget set X is convex, any convex combination of x and y also belongs
to X. Consider a convex combination of x, y, namely, λx+(1−λ)y where λ ∈ (0, 1).
By strict convexity we get λx + (1 − λ)y  x ∼ y and from convexity of budget set
we get λx + (1 − λ)y ∈ X. This violates the assumption that x, y ∈ C(X). Since we
have shown already that for a CT and continuous preference the maximal element
must exists, it has to be unique.

21
22 CHAPTER 3. DEMAND

3.1 Choice problem: Graphical Representation

Suppose the budget line is given by the red line in fig 3.1 and the blue lines represent
ICs. If the agent is on IC3 , then the agent is choosing a commodity bundle that is
not feasible under the budget constraint. If the agent is on IC1 , then not choosing
maximally since by going to the dashed line he will obtain a more preferred bundle.
Furthermore, from the dashed line going to NE leads to choosing more preferred
bundles. He can continue this process until he reaches the point x∗ , where he is at
the highest possible IC curve given his budget constraint.

Figure 3.1: Solving Consumer’s Problem

Note that, when the agent is choosing optimally, i.e., at point x∗ the IC is
tangent to the budget constraint. If the IC is not tangent to the budget line and
intersects the budget line then we can find another IC in the NE direction which
gives higher utility but still remains feasible. Thus the condition for the optimal
solution is that the slope of the IC should be equal to the slope of the budget line,
i.e., the budget line and IC are tangent at the optimal bundle.
The optimal bundle chosen from a budget set thus depends on prices and income,
hence it is written as (x̂1 (p1 , p2 , m), x̂2 (p1 , p2 , m)), that is a function of price vector
and income. These functions are called demand function in economics since they
determine the quantity of a good demand for a set of given prices and income.

3.2 Comparative Statics

In economics, we are always interested in the question of comparative statics. We
build models where the agent chooses optimally so that we can predict how the agent
would behave if we change the environment. The parameters of an optimization
problem are an integral part of the environment. When solving the agent’s problem
we take the parameters as given and once we have the optimal solution we want to
know how the optimal decision changes when the parameters of the model change?
This analysis is called comparative statics in economics.
In the first half of this chapter we have analyzed the optimal choice of the DM
given a set of prices p~ > 0 and income m > 0. In the rest of the chapter we will
change these parameters, price and income one at a time, also called ceteris paribus
or cet par and analyze the impact on optimal choice.
3.2. COMPARATIVE STATICS 23

3.2.1 Change in Income

We are interested in analyzing the change in the optimal decision when income
changes. In the previous section we have already derived the optimal choice of the
agent, x̂1 (p1 , p2 , m) and x̂∗2 (p1 , p2 , m). For this entire section, we will consider the
impact of changing various parameters on the optimal choice of good 1 but the
analysis for good 2 would be identical. The question we are interested to answer
here is how does the optimal choice for good 1 changes when income m changes.
We assume that the prices of good 1 and 2 are fixed at p̄1 and p̄2 resp.
Graphically, we can see the effect of change in demand when income changes
with a shift of the budget line. So we find the optimal points, namely the point
of tangency between the IC and budget line as m changes. If we join the optimal
choices for each budget line, the curve we generate is known as income offer curve
(IOC) or income expansion path. This curve is drawn in our usual x1 − x2 plane
where the change of money income can be difficult to see.
Instead, if we are only interested in the relation between x̂1 and m, we can use
a diagram that plots x1 on x-axis and m on the y−axis. If we draw the relationship
x̂1 (p̄1 , p̄2 , m) for each m in this graph, the resulting curve is called the Engel curve.
The diagram below illustrates.

Figure 3.2: Panel a: Income Offer Curve, Panel b: Engel Curve

We would call a good normal if an increase in income increases the demand for
it. A good would be called an inferior good if an increase in income decreases the
demand for the good. Also, a normal is called a luxury if increase in income cause
more than proportionate increase in demand. This is just a convenient classification
scheme. Note that this classification is defined locally, for a given level of income
an increase in income can reduce demand but at a different level of income it can
increase demand as well. The following diagram shows the classification scheme
for good x1 . If the black line is the original budget line then the different regions
denote where the new optimal bundle will be after an increase in income.
The income effect for a luxury good and inferior good is illustrated below:
24 CHAPTER 3. DEMAND

Figure 3.3: Categorization of x1 by income effect

Figure 3.4: Panel a: Luxury good, Panel b: Inferior good

3.2.2 Change in Price

Suppose, now we change the price of good 1, p1 keeping everything else in the model
constant. We want to know how does the optimal choice for good 1 changes due to
that. Let us assume the price of 2 and income are fixed at p̄2 and m̄ resp.
Graphically changing the price of good 1 is equivalent to changing the slope
of the budget line. If p1 falls the budget line becomes flatter and if p1 increases
the budget line gets steeper. If we plot the curve that joins the optimal choice for
each budget line as the price of good 1 changes we generate the price offer curve.
Similar to the IOC, the offer curve lies in x1 − x2 plane , where the magnitude of
price change is difficult to observe.
To interpret the price change better we can plot the different values of p1 and
3.2. COMPARATIVE STATICS 25

optimal choice of good 1, x̂1 (p1 , p̄2 , m̄) on a price quantity (of good 1) diagram.
This would generate the demand curve for good 1. This is the usual demand curve
we are all familiar with. The diagram below illustrates.

Figure 3.5: Panel a: Price Offer Curve, Panel b: Demand Curve

Based on price effect we can divide goods into two categories, Giffen good and
ordinary good . If the demand for a good increase with an increase in price it is
called a Giffen good, otherwise an ordinary good. This is also a local classification
scheme.

3.2.3 Slutsky Equation

The effect of change in price encompasses two different effects. Note that when the
price of good 1 decreases the budget line rotates around the x2 −axis. As a result,
two things would happen, as the price of good 1 goes down the slope of the budget
line decreases and more bundles become affordable.
We want to decompose the change in demand due to these two effects, namely
the change in the price ratio or the slope of the budget line and change in the budget
set due to change in real income. The first effect of the price of change is called
the substitution effect as the price ratio determines at which rate agents would
be substitution one commodity against another and the second effect is called the
income effect as it measures the effect of change in real income or the purchasing
power.
Suppose the price of good 1 decreases from p1 to q1 . Let x̂1 (p1 , p̄2 , m̄) denote the
original bundle the agent was choosing and x̂1 (q1 , p̄2 , m̄) denote the chosen bundle
at the new price. The change is demand is given by

Price Effect = x̂(p1 , p̄2 , m̄) − x̂(q1 , p̄2 , m̄)

Our goal is to decompose it to analyze the effect of change in purchasing power

versus change in price ratio. To do so, we define a new hypothetical budget line,
where the price ratio is changed to the new price, namely, q1 /barp2 but the real
income or purchasing power remains the same. This means on the hypothetical
budget line we would change the money income m such that the consumer can just
afford the older bundle (nothing more or less), thus his real income would remain
26 CHAPTER 3. DEMAND

the same. Since the price of good 2 does not change let m0 be the income that keeps
the old bundle just affordable. Then

m0 = q1 x̂1 (p1 , p̄2 , m̄) + p̄2 x̂2 (p1 , p̄2 , m̄)

< p1 x̂1 (p1 , p̄2 , m̄) + p̄2 x̂2 (p1 , p̄2 , m̄) = m̄.

The substitution effect is the change in the optimal choice of x1 as the price
ratio changes, keeping the real income same. This is capture by the movement of
the optimal choice from the original budget line to the hypothetical budget line.
The income effect on the other hand is the change in the optimal choice of x1 as the
real income changes. This would be captured by the movement of optimal choice
from the hypothetical to the new budget line. The diagram below illustrates,

Figure 3.6: Slutsky Decomposition

In the diagram above the price p1 decreases from the red line to the black line.
The black dashed line represents the adjust budget line with money income m0 .
Let xold
1 and xnew
1 are the two optimum consumption levels of good 1 for the red
and black budget line resp. The movement from red line to the dashed black line
denotes the substitution effect and the movement from the black dashed line to
solid black line denotes income effect. Combining together, the movement from the
red line to the black line would give the total price effect.
Substitution effect always increases the demand when price decreases. It is easy
to prove it geometrically. Suppose not. Suppose after a drop in price of good 1
the DM chooses lower amount of x1 then as you can see in the diagram below, the
optimal choice will be on a lower IC. Since old choice is affordable at income m0
this cannot be optimal for the DM. In general the substitution effect ∆S has the
3.2. COMPARATIVE STATICS 27

opposite sign of that of the price change ∆p. In other words the substitution effect
∆S /∆p ≤ 0.

Figure 3.7: ∆s < 0 after price drop

Even though the substitution effect is always negative the income effect can be
negative or positive. The earlier diagram denotes the case where the substitution
effect and income effect due to the decrease in the price of good 1 go in the same
direction but that may not always be the case. In the diagram below we show the
other case where the two effects go in the opposite direction. This happens when
good 1 is an inferior good.

Figure 3.8: Slutsky Decomposition for Inferior Good

This way the income effect component links the classification due to price change
28 CHAPTER 3. DEMAND

and due to income change. The sign of the income effect depends on whether a good
is normal or inferior. For normal goods, the income effect raises the optimal choice
of x1 as price decreases. But for inferior goods, as price decreases the real income
increases and the optimal choice for x1 decreases (as shown in 3.8).
The sign of the substitution effects leads to a well-known result in economics,
namely Fundamental theorem of consumption theory, or more commonly law of
demand. The theorem says, if the consumption of a good increase with the increase
in income then the consumption would decrease with the increase in own price. It
is apparent from the Slutsky decomposition.

3.2.4 Change in Cross Price

The last parameter we need to consider is p2 , which is also known as the cross price.
We will analyze what happens to the demand of good 1, x̂1 as the price of good 2,
p1 changes? We can classify goods in two ways based on cross price effect. If the
demand for good 1 increases with an increase in p2 then we call these two goods
substitutes of each other. If the demand of x1 falls with an increase in p2 , the two
goods are complements.
We can also write the Slutsky equation for the cross price effect as well. Suppose,
the price of good 2 only changes, while m̄ and p̄1 remains same. The new price vector
is (p̄1 , q2 ). So x̄1 (p̄1 , p2 , m̄) denotes the old consumption bundle and x̄1 (p̄1 , q2 , m̄)
denotes the new consumption bundle. The Slutsky equation for change in price of
good 2 is given by,
∆ ∆s ∆m
= − x2
∆p ∆p ∆m
|{z}2 |{z}2 | {z }
Cross PE (SE) (IE)

The SE for cross price is always positive (how will you show that?) and for a normal
good the IE is always positive. If the SE > IE then the P E > 0, which means the
two goods are substitutes and if SE < IE, the P E < 0, the two goods are then
complements.

3.3 Examples
We will consider two extreme examples, perfect substitutes, perfect complements.
The diagrams below illustrate:

Perfect Substitutes

Slutsky decomposition can be different for different level of price change. The
diagram below illustrates. In the first case, since the change in price is sufficiently
the DM buys only x1 before and after the price change and IE = P E. In the second
case, however, at the old prices the DM was not buying any positive amount of x1
and a substantial change in prices imply that he is only buying x1 after the price
change, hence SE = P E.
3.3. EXAMPLES 29

Figure 3.9: Slutsky Decomposition for Perfect Substitutes

Perfect Complements
For perfect complements the DM needs to buy both goods in the same ratio irre-
spective of prices. Thus there is no room for substitution which leads to IE = P E.

Figure 3.10: Slutsky Decomposition: Perfect Complements

30 CHAPTER 3. DEMAND
Chapter 4

Utility

In the last chapter, we have defined preference relation over commodity bundles and
have used IC for a graphical representation. But, for most of the practical purposes,
we will need an algebraic representation of the preference, namely we want to write
a function involving the two goods that will tell us between two commodity bundles
which one is preferred. Such a function is called utility function.

4.1 Utility Function

A preference relation % has a utility function representation if there exists a function
u : X → R such that for any x, y ∈ X
x % y ⇔ u(x) ≥ u(y).
Note that, the implication goes both ways. This implies finding the maximal ele-
ment over X according to the preference relation % is equivalent to maximize the
utility function over X.
The actual value of u(x) is irrelevant as long as the ranking of elements is
preserved. This means there will be more than one utility function that can describe
the same preference relation. For example if u(x) represents some preference relation
% then so does u(x)+5, because if u(x) ≥ u(y) then u(x)+5 ≥ u(y)+5. In general,
this is true for any increasing function of u(x).
An increasing function f (.) is called a positive monotonic transformation of u (x)
if f is an increasing function of u (x), i.e., if f 0 u (x) > 0. So, when u(x) represents
some preference relation %, then all positive monotonic transformation of u (x1 , x2 )
would represent the preference relation %.
For example, consider the following two utility functions u, v : R2+ → R, where
x̃ > 0, and
1/3 2/3
u(x1 , x2 ) = x1 x2 v(x1 , x2 ) = ln x1 + 2 ln x2
For the monotonic transformation function f (t) = 3 ln t we can show f (u(x1 , x2 )) =
v(x1 , x2 ). Note that, f 0 (t) = 3t > 0 for all t > 0. Thus the two utility functions
represent the same preference ordering.
On the other hand the following two utility functions do not represent the same
preference order,
u(x1 , x2 ) = x1 x22 v(x1 , x2 ) = x1 + 2x2

31
32 CHAPTER 4. UTILITY

Consider, two vectors (y1 , y2 ) = (2, 2) and (z1 , z2 ) = (5, 1) then

u(y1 , y2 ) = 8 > 5 = u(z1 , z2 )

v(y1 , y2 ) = 6 < 7 = v(z1 , z2 ).

Hence, they cannot represent the same preference relation.

Furthermore, the if and only if equivalence between the preference and utility
means solving for the maximal element for a preference order % is equivalent to
maximizing an utility function u : X → R that represents %. More specifically, we
can rewrite the chosen set C(X) from X as follows:

C(X) = {x ∈ X|u(x) ≥ u(y); ∀y ∈ X} .

This is true because if x is a maximal element for % over X then x % y for all
y ∈ X, but the equivalence implies u(x) ≥ u(y) for all y ∈ X, thus x will also be
maximal according to the utility function. On the other hand if u(x) ≥ u(y) for all
y ∈ X, that is x is the maximal element according to the utility function u(.) then
x % y for all y ∈ X. Thus x is also a maximal element according to the preference
order %.
However, if the implication was one-sided then maximizing preference would not
be same as maximizing the utility function. Suppose,

x % y ⇒ u(x) ≥ u(y)

then consider the example where X = {x, y} with x % y and define u(x) = c
for some constant c for both x, y ∈ X. The optimal choice for % is x but since
u(x) = u(y) = c, maximizing utility would be lead to choice of x or y.

Math Aside
Existence of Utility Function
The necessary condition for the existence of utility representation for any preference
relationship % is completeness and transitivity. However, completeness and transi-
tivity is not sufficient for the existence of a utility representation. An example is a
lexicographic preference on R2+ does not have a utility representation even though
it satisfies completeness and transitivity.
Furthermore, if the utility function is continuous then the utility function is con-
tinuous as well. Continuity, as defined below guarantees the existence of the utility
function.
Continuity: A preference relation is continuous if the weakly preferred set of any
bundle is closed. In other words, if we consider a converging sequence of commodity
bundles namely, x1 , x2 · · · → x such that all of these bundles are preferred to y then
their limit is also preferred to y, i.e., x % y. This technical assumption ensures that
a maximal element exists for the choice set X ∈ R+ n.
4.2. MARGINAL UTILITY AND MRS 33

Math Aside: Contd.

Claim 3: Completeness is necessary for utility representation Consider

a preference relationship % that is not complete. Then there exists x, y ∈ X such
that ¬x % y and ¬y % y. However, if a utility representation exists then either
u(x) ≥ u(y) or u(y) ≥ u(x) since ≥ is a complete binary relationship on R. This
contradicts that u(x) represents %.

Claim 4: Transitivity is necessary for utility representation Consider a

preference relationship % that is not transitive. Then there exists x, y, z ∈ X such
that x % y, y % z and z % x. If % admits a utility representation then u(x) ≥ u(y)
and u(y) ≥ u(z) and by transitivity of ≥ on R we get u(x) ≥ u(z). This contradicts
that u(x) represents %.

4.2 Marginal Utility and MRS

Now that we have two ways of representing the preference, one graphically using
an IC and other algebraically using a utility function, we can ask how do these two
representations relate to each other. Note that, if two bundles are on an IC then
the consumer is indifferent between them. In the language of the utility function,
this would mean the two bundles would generate the same utility. Thus we can
write an IC in terms of,

u (x1 , x2 ) = ū, (IC)

where ū denotes the amount of utility the consumer gets from the commodity
bundle. Then instead of writing in terms of commodity bundle, we can denote the
ICs in terms of ū they generate.
Now that we have written ICs in terms of the utility function, we can represent
the slope of the utility function algebraically. First consider how utility changes
when the amount of one good changes, this can found by looking at the partial
derivative of the utility function. The amount of change in utility due to change in
one good is called the marginal utility (MU) of that good,

∂u
M U1 = (MU)
∂x1

Now going back to the IC, if we take a total derivative of both sides of equation
IC, we get
∂u ∂u
dx1 + dx2 = 0
∂x1 ∂x2
by rearranging we get,

∂u
dx2 M U1
M RS = = − ∂x
∂u
1
=− . (4.1)
dx1 ∂x2
M U2
34 CHAPTER 4. UTILITY

4.3 Choice Problem: Solving Analytically

In this section we will maximize the utility function to obtain the maximal element.
However, this would be a constrained optimization problem since the chosen element
need to be within the budget set.Let us define the constrained optimization problem
for the agent as follows:
max u (x1 , x2 )
{x1 ,x2 }

subject to p1 x1 + p2 x2 = m
As in the previous chapter we will assume that the preference is strictly monotone
and convex. Strict monotonicity of % implies is u(.) represents % then for any two
vectors x̃, ỹ ∈ X ⊂ RN+ , if x̃ > ỹ then u(x̃) > u(ỹ). This implies for a standard
budget set the optimal choice will lie on the budget line, since otherwise a movement
in NE direction will increase utility.
The convexity of % implies that slope of IC decreases with an increase in x1 .
Optimal choice given an utility function will be obtained by equating the slope of
the IC and the budget line, as in the graphical method. This implies,
p1
M RS} = − (4.2)
| {z p
slope of IC |{z}2
slope of budget line

rewriting MRS in terms of marginal utilities we get,

M U1 p1
= (4.3)
M U2 p2

The slope of the IC gives the ratio of the marginal benefit of good 1 against good 2
and the slope of the budget line gives the opportunity cost of good 1 against good 2.
Equation 4.3 says the marginal cost has to be equal to the marginal benefit which
is the fundamental condition for optimization.
However 4.3 is one equation in two variables x̂1 and x̂2 , the two optimal levels of
goods. To solve for then we need the budget lines that ensures two equations in two
unknowns. Solving them simultaneously gives us the solution of the constrained
optimization problem.The solution of the problem would be a function of the pa-
rameters, so we can write them as x̂1 (p1 , p2 , m) and x̂2 (p1 , p2 , m). The function
x̂1 (p1 , p2 , m) is called the Marshallian demand function for good 1 and similarly
x̂2 (p1 , p2 , m) is called the Marshallian demand function for good 2.
In the following two subsections we show two different methods of solving the
optimization problem in the two goods case that leads to the same solution.

Substitution Method
For this method we eliminate the constraint and substitute x2 by a function of x1 in
the objective function. Then we can solve the unconstrained optimization problem
for only x̂1 and recover x̂2 using the predefined substitution relationship. To do so
we rewrite the budget equation as follows:
m p1
x2 = − x1 . (4.4)
p2 p2
4.3. CHOICE PROBLEM: SOLVING ANALYTICALLY 35

If equation 4.4 is satisfied then budget constraint is satisfied. We substitute this

expression of x2 into the objective function. This reduces our problem to solving
 
m p1
max u x1 , − x1 . (4.5)
x1 p2 p2
This is an unconstrained maximization problem in one variable x1 . To solve the
maximization problem we need to take first order derivative with respect to x1 and
set it to zero. This is known as the First Order Condition or FOC or necessary
condition.
At the value of x1 where FOC is satisfied we then need to take the second-order
derivative and check that it is negative. This is known as Second Order Condition
(SOC) or sufficiency condition. Refer to the last subsection of this section for a
discussion on SOC or sufficiency.
For our optimization problem the FOC would be
p1
u1 − u2 = 0 (FOC)
p2
u1 p1
−M RS =
=
u2 p2
Note that this is the same condition as derived using graphical method. Similarly
if we combine the equation F OC with the budget constraint we get x̂1 (p1 , p2 , m)
and x̂2 (p1 , p2 , m).
Once we have solved for the values of x1 and x2 that maximizes the utility of the
agent we can use this values to obtain the value of the maximized utility in terms of
the parameters of the model. If we put the values of x̂1 (p1 , p2 , m) and x̂2 (p1 , p2 , m)
in the utility function we get,

U (p1 , p2 , m) = u (x̂1 (p1 , p2 , m) , x̂2 (p1 , p2 , m)) .

The function U (p1 , p2 , m) is called the indirect utility function, since this is the
utility function in terms of money.

Lagrangian Multiplier method

This is a more general methodology to solve a constrained optimization problem.
In this method, we first write an auxiliary function called Lagrangian that combines
the objective function with the constraint. An objective function is a function we are
trying to maximize. In our case the objective function is the utility function. The
constraint is the budget constraint in our case. The Lagrangian function involves a
new variable called the Lagrangian multiplier which is denoted by λ. This method
then solves the unconstrained optimization problem for the auxiliary Lagrangian
function with respect to x1 , x2 and the Lagrangian multiplier λ.
In case of the consumer problem the Lagrangian function is given by,

max L (x1 , x2 , λ) = max u (x1 , x2 ) + λ [m − p1 x1 − p2 x2 ]

x1 ,x2 ,λ x1 ,x2 ,λ

If we take the FOC with respect to x1 , x2 and λ we get

∂L (x1 , x2 , λ)
= u1 − λp1 = 0 (4.6)
∂x1
36 CHAPTER 4. UTILITY

∂L (x1 , x2 , λ)
= u2 − λp2 = 0 (4.7)
∂x2
∂L (x1 , x2 , λ)
= m − p 1 x1 − p 2 x2 = 0 (4.8)
∂λ
We can rewrite equations 4.6 and 4.7 as

u1 = λp1 (4.9)

u2 = λp2 . (4.10)
Dividing equation 4.9 by 4.10 we get,
u1 p1
−M RS = =
u2 p2
Which is again same as before. If we combine this equation with 4.8, which is the
budget constraint, we can solve for the demand functions of x̂1 and x̂2 .
One of the main reason behind using the Lagrangian multiplier method is that
the Lagrangian multiplier has an economic interpretation. One can show that

∂L (x1 , x2 , λ) ∂U (p1 , p2 , m)
= = λ.
∂m ∂m
This implies λ is the amount of increase in the indirect utility if we increase
the income by the unit. In other words, this shows the opportunity cost of the
constrained and that is why it is called the shadow price of the constraint. If we
can relax the constraint by one unit we would get λ extra units of utility, thus λ
tells us how costly it is to have the constraint.
Finally combining all the methods together we can see that all methods lead
to the same conclusion namely, −M RS = price ratio. Each method has it’s own
advantage and disadvantage and depending on the context we may use one or the
other.

4.3.1 Sufficiency Condition

In the last two subsections, we only considered the FOC (First Order Condition)
for maximization. Here, we will show first, if the utility function is concave then
considering only the FOC is sufficient for maximization, and second, a concave
utility function represents a convex preference, so the IC is bowed in with an unique
solution for concave utility function.

Concave Function and SOC

If f : [0, X̄] → R be a concave function that we want to maximize over the interval
[0, X̄] then there are three possibilities:

1. The optimization problem admits an interior solution, i.e., x∗ 6= 0 or x∗ 6= X̄.

Then the FOC, f 0 (x) = 0 is a sufficient condition for maximizing f (x).

2. x∗ = 0 only if f 0 (0) ≤ 0

3. x∗ = X̄ only if f 0 (X̄) ≥ 0.
4.3. CHOICE PROBLEM: SOLVING ANALYTICALLY 37

Thus maximizing a concave either lead to a corner solution where x̂1 = 0 or x̂2 = 0
or the FOC is the sufficient condition for maximization.

The following two diagrams show the maximum element x̂ for a one dimensional
function f (x) defined over [0, B]. The diagram below shows the corner solutions,
The diagram below illustrates the interior solution,

Figure 4.1: Corner solution: concave function

One example of boundary solution in the standard two good case is that of
linear utility function u(x1 , x2 ) = ax1 + bx2 . The optimal solution for this linear
function given a standard budget line usually lies at the corner. The diagram below
illustrates.

Figure 4.2: Interior solution: concave function

38 CHAPTER 4. UTILITY

Figure 4.3: Linear Utility function: corner solution

In the above diagram the parallel blue lines represents the IC function and the
red line is the budget line. Since the budget line is flatter, i.e., the Marginal Cost
(MC) for consuming 1 additional unit of x1 is lower than the slope of IC, i.e.,
Marginal Benefit (MB) from consuming 1 additional unit of x1 , the consumer will
optimally choose to consume the corner, where x̂2 = 0.

Convex Preference and Concave Utility function For convex choice set X
and concave utility function the preference relationship is convex. To show that we
consider x, y ∈ X and λ ∈ [0, 1] such that

u(λx + (1 − λ)y) ≥ λu(x) + (1 − λ)u(y);

where u(.) represents the preference relationship % and x ∼ y. Since u(.) represents
%, this implies u(x) = u(y). Going back to the concavity condition of utility function
we get,

u(λx + (1 − λ)y) ≥ λu(x) + (1 − λ)u(y)

u(λx + (1 − λ)y) ≥ λu(x) + (1 − λ)u(x) = u(x)
λx + (1 − λ)y % x ∼ y.

Hence, % is a convex preference.

Math Aside
However, concavity of utility function is not necessary for convexity of preferences.
Instead convexity of preference is equivalent to quasi-concave utility function. The
quasi-concave function u : X → R is defined as follows:

u(λx + (1 − λ)y) ≥ min u(x), u(y) λ ∈ [0, 1]

If % is convex then for any x, y ∈ X such that x ∼ y then λx + (1 − λ)y % x ∼ y.

If u(.) represents % then u(λx + (1 − λ)y) ≥ u(x) = u(y) = min u(x), u(y), making
u(.) quasi-concave. The converse is also true. Think how you can prove that.
Even though concavity of utility function is stronger than necessary it simplifies
the optimization problem and hence for the rest of the section, we will assume
that the utility function is concave, unless otherwise stated. Note that for concave
4.3. CHOICE PROBLEM: SOLVING ANALYTICALLY 39

utility function the IC are bowed in, which gives us an unique maximal element in
the two-good case.
The problem with non-convex preference or non-concave utility is described in
the diagram below. In the diagram below at point, x̂1 the agent is on IC1 . Even
though the FOC is satisfied at x̂1 , as the MRS equals to the price ratio the SOC
fails here. If the agent moves to x̂2 , he is at a higher level of utility on IC2 and
at x̂2 also the budget constraint is satisfied. Thus x̂1 can not be the optimal or
utility-maximizing bundle.

Figure 4.4: Consumer problem for Non-convex Preference

4.3.2 Comparative Statics

Now that we have derived the demand functions algebraically we can redo all the
comparative statics exercises. In this section, we will investigate how the DM’s
optimal choice would change if we change the prices, p~ or income m.
Let us first consider the effect of changing income (m) on choice of good 1
x̂1 (p1 , p2 , m). Analytically this would be given by the partial derivative of the
demand function with respect to m, namely, ∆x̂1 (p∆m 1 ,p2 ,m)
.
A related concept that captures the effect of change in income on demand func-
tion is the income elasticity of demand, which is defined as follows,

% change in demand m ∆x̂1 (p1 , p2 , m)

η1 = income elasticity = =
% change in income x̂1 ∆m
i.e., the rate of change of demand with respect to change in income. For a small
change in the parameter we can use partial derivatives in place of ∆ 1
Similar to the the graphical representation, we can also use the same classi-
fication based on the income effect by using range of values of income elasticity.
If the derivative ∆x̂1 (p∆m 1 ,p2 ,m)
≥ 0 or the elasticity is positive, i.e., the agent would
increase his consumption of good 1 when income increases we call good 1 a normal
good. If ∆x̂1 (p∆m
1 ,p2 ,m)
< 0 or the elasticity is negative it would be an inferior good.
Furthermore, if income elasticity is greater than 1, i.e., the agent wants to consume
proportionately more of x1 as income increases we say good 1 is a luxury good. If
the income elasticity is less than or equal to 1, then we call it a necessary good. If
1 ∂y
Remember the derivative ∂x is the limit of the ratio of changes of the two variables when
∂y ∂y
∆x → 0, i.e., lim∆x→0 ∂x = ∂x .
40 CHAPTER 4. UTILITY

good 1 is a luxury good then the income offer curve bends towards x-axis, i.e., good
1.
Note that, if we plug the optimal choice in the budget line we get,

p1 x̂1 (p1 , p2 , m) + p2 x̂2 (p1 , p2 , m) = m.

Differentiating both sides by m we get,

∂ x̂1 (p1 , p2 , m) ∂ x̂2 (p1 , p2 , m)
p1 + p2 =1
∂m ∂m
Multiplying and dividing the first and second element with x̂i /m for i = 1, 2 resp.
we get,
p1 x̂1 m∂ x̂1 (p1 , p2 , m) p2 x̂2 m∂ x̂2 (p1 , p2 , m)
+ =1
m x̂1 ∂m m x̂2 ∂m
| {z } | {z }
η1 η2

Thus the weighted average of income elasticity adds up to 1, where the weights are
given by expenditure share, pm i x̂i
for i = 1, 2.
Next consider the impact of change is p1 on the optimal choice of x̂1 . Similar
to the analysis before this change is summarized by ∆x̂1 (p∆p1 ,p1 2 ,m) . The own price
elasticity, mostly written as price elasticity is defined in a similar manner as,
% change in demand p1 ∆x̂1 (p1 , p2 , m)
1 = price elasticity = = .
% change in own price x̂1 ∆p1
Continuing with the classification scheme if the price elasticity is positive, i.e,
as the price of good 1 decreases the agent would optimally choose to consume less
of good 1, we will define it as a Giffen good. Otherwise, we call it a ordinary good.
If we consider the effect of change in p2 on x1 we can capture it by ∆x)
∆p2
1
and the
corresponding cross price elasticity is given by,
% change in demand of good 1 p2 ∆x̂1 (p1 , p2 , m)
12 = cross price elasticity = = .
% change in price of good 2 x̂1 ∆p2
Similar to the graphical analysis, if the cross-price elasticity is positive, i.e., as the
price of good 2 increases demand for good 1 increases then the goods are called sub-
stitutes. If the cross-price elasticity is negative, i.e., consumption of good 1 increases
when the price of good 2 increases then the two goods are called complements. Note
that the earlier examples of perfect complements and perfect substitutes are special
cases of this complement and substitute goods.
We can also revisit the Slutsky Decomposition. As before, suppose price of good
1 reduces from p1 to q1 and p2 , m remains the same. Then the hypothetical income
that keeps the original bundle just affordable would be

m0 = q1 x̂1 (p1 , p̄2 , m̄) + p̄2 x̂2 (p1 , p̄2 , m̄)

< p1 x̂1 (p1 , p̄2 , m̄) + p̄2 x̂2 (p1 , p̄2 , m̄) = m̄

Then the overall change in real income is given by

∆m = x̂1 (q1 , p̄2 , m̄)(q1 − p1 ) < 0

4.3. CHOICE PROBLEM: SOLVING ANALYTICALLY 41

Let x̃(q1 , p̄2 , m0 ) denote the chosen bundle with the new price ratio but same real
income. Then we can rewrite the impact of price change (Price Effect) as follows:
x̂1 (q1 , p̄2 , m)−x̂1 (p1 , p̄2 , m̄) = [x̂1 (q1 , p̄2 , m0 ) − x̂1 (p1 , p̄2 , m̄)] + [x̂1 (q1 , p̄2 , m) − x̂1 (q1 , p̄2 , m0 )]
| {z } | {z }
∆S ≡substitution effect ∆m ≡income effect

which can be equivalently written as

∆ = ∆ s + ∆m .
This equation is known as Slutsky equation though actually this is an identity, since
we have just subtracted and added the same term on the RHS. Also, the substitution
effect is called the Slutsky substitution effect. We often write it in terms of rate of
change, for which we divide both sides of the Slutsky equation by ∆p1 = (q1 − p1 )
and get,
∆ ∆s ∆m
= +
∆p1 ∆p1 ∆p1
0
plugging back the value of ∆m = m − m̄ = x̂1 (p1 , p̄2 , m̄)∆p1 we get
∆ ∆s ∆m
= + x̂1 (p1 , p̄2 , m̄) .
∆p1 ∆p1 ∆m
Note that, the real income and price changes in opposite direction, so we sometimes
write the the equation with a negative sign in front of income effect as follows,
∆ ∆s ∆m
= − x̂1 (p1 , p̄2 , m̄)
∆p1 ∆p1 −∆m
This takes care of the negative relationship and hence we can easily identify for
normal good the income effect would be positive and for inferior good the income
effect would be negative.This version of Slutsky equation makes it easier to compare
the signs of different elements of the RHS.

4.3.3 Examples:
Let us first revisit our examples from the earlier chapter an then using the algebraic
structure of the utility function, we will consider a few more interesting examples.

Cobb-Douglas Utility function:

One of the most widely used utility function is Cobb-Douglas function. For X = R2+
the utility function is written as
u (x1 , x2 ) = α log (x1 ) + (1 − α) log (x2 ) ..
One common monotonic transformation is given by
v (x1 , x2 ) = xa1 xb2
which is useful for many application. Think about how will you show the two utility
functions represent the same preferences. More generally for X = RN + the utility
function is given by,
N
X
u(x̃) = αn ln xn αn ≥ 0.
n
42 CHAPTER 4. UTILITY

Cobb-Douglas utility function belongs to a class of utility function which is

called homothetic preference. This type of utility function are parallel to any ray
going through the origin.

Math Aside
Homothetic Preference: A preference relation is such that when (x1 , x2 ) ∼
(y1 , y2 ) then for all t > 0 we get (tx1 , tx2 ) ∼ (ty1 , ty2 ), then we call the preference
relation  is homothetic. The utility function also has the same property namely,

u (tx1 , tx2 ) = tu (x1 , x2 )

This property of a function is called the homogeneity of degree one in mathematics.

The degree refers to the degree of the term t in the RHS. For homothetic preferences,
if we draw an arrow through the origin, then all the the ICs would shift in parallel
with respect to any such arrow.

Math Aside: contd.

Figure 4.5: Homothetic utility function

Since ICs shift parallely along a ray through the origin if there is a change in income
only the optimal choice will remain on the same ray, i.e., the income elasticity is
constant for homothetic preferences.

Next we will show the two methods of constrained optimization for a general two-
good Cobb-Douglas utility function.

Substitution method In case of the substitution method we get,

m p1
x2 = − x1 . (4.11)
p2 p2

thus the unconstrained problem we need to solve is given by,

 
m p1
max α ln x1 + (1 − α) ln − x1
x1 p2 p2
4.3. CHOICE PROBLEM: SOLVING ANALYTICALLY 43

The FOC is given by,

α (1 − α)p1
−   =0
x1 p m − p 1 x
2 p2 p2 1

rearranging,  
m p1
αp2 − x1 = (1 − α)p1 x1
p2 p2
cross-multiplying we get,

αm = (αp1 + (1 − α)p1 ) x1

rearranging and plugging back for x2 we get

m m
x̂1 = α and x̂2 = (1 − α) .
p1 p2
One interesting feature of the demand function is that the ratio of expenditure
on two goods namely, px12xp12 = (1−α)
α
, i.e., a constant. This implies no matter what
happens to price or income the share of expenditure on two goods would not change.

Lagrangian Multiplier method For the Cobb-Douglas utility function the La-
grangian function is given by,

L (x1 , x2 , λ) = α ln x1 + (1 − α) ln x2 + λ (m − p1 x1 − p2 x2 )

The FOCs are given by

1
α = λp1 (FOC1)
x1
1
(1 − α) = λp2 (FOC2)
x2
m − p 1 x1 − p 2 x2 = 0 (FOC3)
Dividing FOC1 by FOC2 we get,
αx2 p1
=
(1 − α)x1 p2
so we can write,
(1 − α)p1
x2 = x1
αp2
Combining with FOC 3 we get,
(1 − α)p1
p 1 x1 + x1 =m
a
Hence, we can get
m m
x̂1 = α and x̂2 = (1 − α)
p1 p2
Substituting back the value of x̂1 and x̂2 in we get,
α 1
λ∗ = =
p1 xˆ1 m
44 CHAPTER 4. UTILITY

If we also plug the values of x̂1 and x̂2 in the utility function, we get the following
indirect utility function:

αm (1 − α)m
U (p1 , p2 , m) = α ln + (1 − α) ln (4.12)
p1 p2

If we differentiate equation 4.12 with respect to m we get,

∂U (p1 , p2 , m) α (1 − α) 1
= + = = λ∗ . (4.13)
∂m m m m

This shows that the Lagrangian multiplier is indeed the shadow price of relaxing
the constraint.
Note that, the Cobb-Douglas utility function is concave since,

N
X
u(x̃) = αn ln xn
n=1

is a sum of N concave functions. Thus we do not need to check for the sufficiency
condition.
Given the demand function for good 1 for the Cobb-Douglas utility function,
namely,
m
x̂1 = α
p1

the income elasticity is given by,

m ∂x1
η1 = = 1.
x1 ∂m

The price elasticity is given by,

p1 ∂x1
1 = = −1
x1 ∂p1

and the cross price elasticity is given by,

p2 ∂x1
12 = = 0.
x1 ∂p2

The same result holds true for demand for good 2 as well. This generates an
interesting feature in the Slutsky decomposition diagram. If the price of good 1
changes the new bundle would be on the same horizontal line as the old bundle and
if the price of good 2 changes the new bundle would be on the same vertical line as
the old bundle. So for the cross price the SE and the IE cancels out.
4.3. CHOICE PROBLEM: SOLVING ANALYTICALLY 45

Figure 4.6: Slutsky Decomposition: Cobb-Douglas utility function

Note that all the elasticities are constant for Cobb-Douglas utility function.
Cobb-Douglas utility function belongs to a class of utility function known as Con-
stant Elasticity of Substitution (CES) utility function. The name is derived from
the fact the price elasticities are constant for these type of utility function. We can
write the general two-good CES utility function as

u(x1 , x2 ) = (αxr1 + (1 − α)xr2 )1/r , α ∈ [0, 1], r ≥ 1

Quasi-linear preference:

Another widely-used utility function in economics is the quasi-linear utility func-

tion. Consider a commodity bundle where the first element is the good we are
interested in and the second element refers to the money left after consuming the
first commodity. The second good is often called the composite good as it includes
all other goods that the agent can consume. A quasi-linear preference in good 2 is
very useful to describe such a preference relation and is denoted by,

u (x1 , x2 ) = v (x1 ) + x2

where v (x) can be any concave function of x1 . Note that the function is linear in
x2 , the composite good but not in good 1. That is why this is called a quasi-linear
preference. An interesting feature about the IC for the quasi-linear good is that
they are vertical shifts on each other.
46 CHAPTER 4. UTILITY

Figure 4.7: Quasi-linear utility function

Since v(x1 ) is concave the quasi-linear utility function is also concave. This
implies for the quasi-linear utility the sufficiency condition is also satisfied.

Perfect Substitutes:
For the perfect substitutes case we showed that the IC is a downward sloping line,
thus the utility function can be written as
u (x1 , x2 ) = ax1 + bx2 ,
where − ab denotes the slope of the IC which is also the MRS between the two
goods. Let us consider an example where ū = 5 and a = 1, b = 5. Then the agent
would be indifferent between 5 units of good 1 and 1 unit of good 2. Thus the
MRS denotes the rate at which the agent is willing to trade good 1 for good 2. For
perfect substitutes, the MRS remains constant. Given the MRS − ab if the price
ratio is such that pp12 < ab then the consumer will only consume x1 and no x2 and if
p1
p2
> ab then he will consume only x2 , thus the demand function for good 1 is given
by,
m p1 a
 p1 if p2 < b

x̂1 (p1 , p2 , m) = [0, pm1 ] if pp21 = ab
0 if pp21 > ab



The income elasticity of the demand function is given by

(
m ∂x1 1 if pp12 < ab
income elasticity = =
x1 ∂m 0 otherwise

The price elasticity depends on the level of change in price of good 1. We will only
consider one case, pp21 < ab where the agent is consuming only good 1. If the price
p01 a
change for good 1 is such that p2
< b
then

p1 ∂x1
price elasticity = = −1
x1 ∂p1
4.3. CHOICE PROBLEM: SOLVING ANALYTICALLY 47

p0
but if the change in price of good 1 is such that p12 > ab , then the consumption of
good 1 goes to zero as the consumer only starts to consume good 2. We can do
similar exercise for price of good 2.

Perfect Complements:
The perfect complements case is the polar opposite of perfect substitutes. In case of
perfect complements the agent would consume the two goods together. For example
suppose our consumer only takes one cup of coffee with two spoons of sugar. That
means he only consumes (1C, 2S) at any time. More sugar without coffee is not
valuable for him. More coffee without sugar is also not valuable to him. Thus we
can write the utility function as

u (x1 , x2 ) = min {ax1 , bx2 } .

The IC would have a kink at a point where ax1 = bx2 . (Think about the slope of
the line that joins the kinks for different IC and the origin!) The reason we get the
L-shaped IC is the following; if ax1 > bx2 , then u(x1 , x2 ) = bx2 which implies in
the region where ax1 > bx2 the IC is given by bx2 = ū, which is a horizontal line
at x2 = ū/b. For the region where ax1 < bx2 we have u(x1 , x2 ) = ax1 and the IC
would be given ax1 = ū, which is a vertical lien at x1 = ū/a. The vertical and the
horizontal line forms the two hands on the L-shaped IC. Note that, the optimal
bundle will always be on the kink (think about what happens if that is not the
case), we can get the consumption bundle at the intersection between the budget
line and kink. This implies the demand function for good 1 is given by,
m
x(p1 , p2 , m) =
p1 + p2
Then the income elasticity is given by,
m ∂x1
income elasticity = =1
x1 ∂m
and the price elasticity is given by,
p1 ∂x1 p1
price elasticity = =−
x1 ∂p1 p1 + p2
and the cross price elasticity is given by,
p2 ∂x1 p2
cross price elasticity = =− .
x1 ∂p2 p1 + p2
48 CHAPTER 4. UTILITY
Chapter 5

Revealed Preference

In the previous chapters, we have followed two approaches to solve for the optimal
choice problem of the decision maker. In the first one, we have taken the preference
as the primitive and then derived the choice of the agent by combining the prefer-
ence with the budget constraint. In the second approach, we have defined utility
functions that represents a preference and found the optimal choice using standard
calculus technique.
In this entire analysis, our main assumption was agents are rational, they are
maximizing their gains subject to the constraint they face. But how can we be sure
whether that is true? If we could somehow know the preference of an agent then
we could test whether they are maximizing or not. But the concept of preference
is in the mind of the consumer and it is impossible to know for an economist. We
can try to test different assumptions we have made on this preference relation, but
that can also be computationally difficult. For example, suppose you have a choice

set with 50 elements, in order to check for completeness, we need to test all 50 2
pairs to test that. For a standard budget set this implies checking infinite pairs of
elements which is impossible. Thus it is impossible to operationalize the theory of
choice using preference relationship.
Note that, the only thing we observe about the consumers is their final choice,
i.e., how much of each good the agents are choosing given the prices. Thus any
theory of testable implication will only rely on the observable choice data. In this
chapter, we will build a framework that just takes the choice data as given and
generates a theory of optimal choice based on some assumptions on the choice data.
A choice data refers to the data set consisting of the tuple of price, income and
chosen bundles. For example, suppose X = RiN and there are J price, income pairs
are available then the choice data is given

(p̃j , mj , x̃j )|1 ≤ j ≤ J



where each x̄j and p̄j are N −dimensional vectors and all prices and income are
strictly positive.
Our goal is to find conditions under which the choice data represents a maximiza-
tion over a standard monotonic utility function. Before we impose any condition
on the choice data, to ensure monotonicity it must be the case that at the chosen
bundle x̃j at price p̃j we get
p̃j .x̃j = mj .

49
50 CHAPTER 5. REVEALED PREFERENCE

To form a theory of choice we need two conditions on the data set. First, what
conditions will be implied by the standard utility representation and second what
conditions will violate the standard utility representation. In the rest of the chapter
we will impose conditions to build the ”if and only if” relationship between choice
data and the standard utility representation. This means if x̃j is chosen at price,
income pair (p̃j , mj ) then we want to find conditions under which x̃j is the optimal
choice from the following budget set

B j = z̃ ∈ RN j j

+ |p̃ .z̃ ≤ m .

All the elements z̃ is the budget set B j are affordable when x̃j is chosen. Using
this notion of affordability let us define a new binary relationship namely, revealed
preferred to on our choice data. For a given price p̃j if bundle x̃j when income level
is mj then we say x̃j isrevealed preferred to bundle z̃ if z̃ is strictly affordable at p̃j
and mj ,

p̃j .z̃ < mj .

For a standard utility representation we need if x̃RP z̃ then u(x̃) > u(z̃).
Consider the choice data set with J = 2, p̃1 = (1, 2), x̃1 = (3, 1), m1 = 5 and
p̃2 = (2, 1), x̃2 = (1, 3), m2 = 5. At p̃1 , x̃2 is not affordable since

p̃1 .x̃2 = 1 + 6 = 7 > 5 = m1

and similarly x̃1 is not affordable at p̃2 so none of them are revealed preferred to
the other.
Contrast this with the example of a choice set where p̃1 = (1, 2), x̃1 = (1, 3), m1 =
7 and p̃2 = (2, 1), x̃2 = (3, 1), m2 = 7. Here, at price p̃1 the bundle x̃2 is affordable,

p̃1 .x̃2 = 3 + 2 = 5 < 7 = m1 ,

and vice versa. So x̃1 is revealed preferred to x̃2 and vice versa.
In the second example, it is clear that a consumer with a monotone utility
function is not choosing optimally. Inspired by this example we introduce the first
axioms of this chapter.

5.1 Weak Axiom of Revealed Preference(WARP):

Choice data set {p̃j , m̄j , x̃j )|1 ≤ j ≤ J} satisfies WARP if there does not exist j, k ∈
{1, . . . J} such that x̃j is revealed preferred to x̃k and x̃k is revealed preferred to x̃j .
5.2. STRONG AXIOM OF REVEALED PREFERENCE(SARP) 51

Figure 5.1: Left: WARP satisfied , Right: WARP violated

The left panel denotes a case where W ARP is not violated as in the case with
the first example and the second diagram shows the case where W ARP is violated
similar to example 2.
Now consider the third example :

p̃1 = (2, 2, 1), m̄1 = 5, x̃1 = (0, 2, 1);

p̃2 = (1, 2, 2), m̄2 = 5, x̃2 = (1, 0, 2);
p̃3 = (2, 1, 2), m̄3 = 5, x̃3 = (2, 1, 0);

In this example x̃1 RP x̃2 x̃2 RP x̃3 and x̃3 RP x̃1 ,i.e., it generates a cycle of re-
vealed preferred relationship even though WARP is satisfied. Hence, we need to
strengthen our assumption to rule out circularity of choices. Otherwise, according
to a standard utility function we will get

u(x̃1 ) > u(x̃2 ) > u(x̃3 ) > u(x̃1 )

5.2 Strong Axiom of Revealed Preference(SARP)

To strengthen WARP we now define a new binary relationship as follows: x̃j is indi-
rectly revealed preferred to x̃k if there exists a string of revealed preferred relations
of length above 1 starting with x̃j and ending with x̃k .
Data set {p̃j , x̃j , mj |1 ≤ j ≤ J} satisfies SARP if there does not exist 1 ≤ j, k ≤
J such that x̃j is either directly or indirectly revealed preferred to x̃k and x̃k is
either directly or indirectly revealed preferred to x̃j . The example below illustrates:
We check SARP using total cost matrix as follows:

x1 x2 x3
p1 5∗ → 4↓ 6
p2 ↑6 5∗ → 4↓
p3 ↑4 ←6 ← 5∗

Table 5.1: Example of payoff matrix/state

Start with a bundle on the diagonal. If there exists another bundle with a lower
expenditure in the same row then that bundle is affordable at the row price. For
52 CHAPTER 5. REVEALED PREFERENCE

this bundle go vertically to the diagonal element and repeat. If a cycle exists then
SARP is violated. No cycle would imply SARP is satisfied.
WARP is a necessary condition for the existence of a continuous and monotone
utility function. SARP is stronger since it implies the sufficiency. If SARP is
satisfied for a finite number of commodity bundles then a continuous, monotone and
concave(convex IC) utility function exists. Thus the existence of utility function is
equivalent to checking SARP on finitely many commodity bundles which is much
easier than recovering the preferences from the consumer’s mind. This theory thus
has a strong influence on empirical approach that tries to recover the consumer
demand function based on choice data.
Note, this again leads to the famous Fundamental Theorem of Consumption
Theory more commonly known as Law of Demand in economics. To recall, the
theorem says that if the demand for a good increases when income increases then
demand decreases for an increase in price. We will explore this further in the
problem set.