Managerial Economics

Topic 1
Individual Choices and Decisions

Substitutes and compliments,

Derivation of individual demand

Sumit Sarkar, XLRI Jamshedpur

HRM - Term I – 2021
Session 6
 Definitions - Substitutes and complements
• X and Y are gross substitutes if the demand of Y
increases with a rise in the price of X.
• X and Y must be substitutes in consumption.

• X and Y are gross complements if the demand of Y

decreases with a rise in the price of X.

Sumit Sarkar, XLRI

 X and Y are gross substitutes

y1 E1 E0
y0

x1 x0 x

Sumit Sarkar, XLRI

 X and Y are gross complements

y
X and Y may be substitutes in
consumption, and still, they
may be gross complements if
the income effect is stronger
than the substitution effect.

y0 E0
y 1
E1

x
x
1
x0

Sumit Sarkar, XLRI

 Substitutes and complements – Substitution and
income effects

• X and Y are gross substitutes if

• The magnitude of substitution effect is more than that of
income effect.

• X and Y are gross complements if

• The magnitude of income effect is more than that of
substitution effect.
• If X and Y are unrelated in consumption or complements in
consumption, the entire price effect is due to income effect.

Sumit Sarkar, XLRI

 X and Y are gross substitutes

y Price effect: E0 to E1
Sub. Effect: E0 to Es
Income effect: Es to E1

Magnitude of substitution
Es effect on Y (ys – y0) is
yS
y1 E1 E0 larger than the magnitude
y0 of income effect (ys – y1)

x1 xS x0 x

Sumit Sarkar, XLRI

 X and Y are gross complements

Magnitude of income effect

on Y (ys – y1) is larger than
the magnitude of
substitution effect (ys – y0).
Es
ys
y0 E0
y 1
E1

x
x
1
x0
xs
Sumit Sarkar, XLRI
 Individual Demand Function
• In the 2-goods world, consumers’ equilibrium depends on
three parameters: px, py and M. It is intuitive that the demand
of a good for an individual is a function of these three
variables.
• x = Dx (px, py, M)
• px is the endogenous variable and py and M are exogenous
variables.
• In the general N-goods model, consumers’ equilibrium
depends on N prices p1, p2 , , , pn and M. The consumer’s
demand for good i is:
• xi = Di (p1, p2 , , pi, , , , pn, M)

Sumit Sarkar, XLRI

 Consumer’s equilibrium to consumer’s demand

y
Equation B1: x. px1 + y.py = M

Equation B2: x. px2 + y.py = M p x 2 > px 1

Equation B3: x. px3 + y.py = M p x 3 > px 2

B3 B2 B1
x3 x2 x1 x
px
Given the axioms of consumers’
px 3 behavior, the relation between
px 2 quantity demanded for a good
px 1 and its price is bound to be
inverse.

x3 x2 x1 x
Sumit Sarkar, XLRI
 Derivation of the individual demand function
from basic consumer behavior
• Consumer’s Optimization Problem
Max: U = U(x, y)
s.t. M = pxx + pyy
• Lagrangian:

L = U(x, y) +  (M - pxx - pyy)

• Maximize L (partially) with respect to x, y and .

• Use the first order conditions to solve for x and y.

• You get x = Dx (px, py, M) and y = Dy (px, py, M).

An example:
The utility function of a consumer is given by, U = xy(1 - ),
where 0 <  < 1. Find the consumer’s demand functions for x
and y.

Sumit Sarkar, XLRI

Finding demand function - example
  
1. U = x  y1- .
 > 0, and > 0
 In equilibrium,
 => =>
 Budget eq: x + y = M
 => x = M or, x = M /

Sumit Sarkar, XLRI

 Change in quantity demanded for a change in price
of the product (other factors remaining constant)

px

px1

px0

x
x1 x0

Sumit Sarkar, XLRI

 Shift of the demand curve – change in demand

For all prices demand increases (or decreases) due to

change(s) in exogenous factor(s)

px

px 0

x0 x1 x

Sumit Sarkar, XLRI

 Shift of the demand curve – change in price of
substitutes
If the price of a substitute product reduces, consumer’s
demand falls even when product price remain unchanged.

px

px0

x1 x0 x

Sumit Sarkar, XLRI

 Shift of the demand curve – change in price of
complements
If the price of a complementary product rises, consumer’s
demand falls even when product price remain unchanged.

px

px 0

x1 x0 x

Sumit Sarkar, XLRI

 Problem 8 – Set 1
A consumer’s utility function is given by U = x + 2y. Draw the
consumer’s indifference map. What is her marginal rate of
substitution? Suppose her income is 30. Draw her demand curve
for x when the price of y is 6. Also draw her demand curve for y
when the price of x is 3.

Sumit Sarkar, XLRI

 Solution to Problem 8 – Set 1

U = x + 2y MRS = -1/2
y
Budget 30 = px x+ 6y, Slope = - px / 6

BL is steeper than IC if px > 3. x = 0 in eq. DD of x = 0

BL is flatter than IC if px < 3. x = 30/px in eq.

5 DD of x = 30/px
 BL has same slope as IC if p = 3.
x
In eq, x can be anything between 0 and 10.
DD for x

x
30/px 10 30/px

Sumit Sarkar, XLRI

 Demand function for x when py = 6

px

x
10

Derive the demand function for y

Sumit Sarkar, XLRI
Reading
• Besanko & Braeutigam. Ch. 5 (Section 5.1 to 5.4)
• Problems 5.1, 5.3, 5.6-5.9, 5.11, 5.12, 5.17-5.19
(excluding parts in consumers’ surplus).

Sumit Sarkar, XLRI