ECO 301: TOPIC 1: CONSUMER

THEORY
TOPIC 1: THEORY OF CONSUMER BEHAVIOUR
• Preference Theory
• Utility Theory
• Demand Theory
• The Theory of Revealed Preference
Readings:
Nicholson et al ch 3; Varian ch2 – ch5

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 INTRODUCTION: CONSUMER THEORY
• The consumer theory is developed in stages:
I. Preference theory
II. Utility theory
III. Demand theory
IV. Theory of revealed preferences

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 1.1 PREFERENCE THEORY
1.1.1 Preference Theory :
• The preference theory is a theory where the consumer
expresses her preference for a commodity bundle over another.
• This theory is regarded as the “most primitive concept” in the
modern theory of a consumer.
• It is so called primitive because the consumer need not
mention/specify/answer why she prefers the said commodity
bundle instead of the other commodity bundles available in a
consumption set.
NB:
• We will denote the consumption set by using X; and the
consumption bundles are denoted by : , ….. .
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 1.1.2 Description of Preference Notations:
• Suppose that we have two commodity bundles; & in a consumption set X.
a) We use the notation “ > ”to mean ‘strictly preferred to’; i.e. > implies that
is strictly preferred to commodity bundle .
b) If a consumer can not state her preference between two commodity
bundles, we say that the consumer is ‘indifferent’ between the two
commodity bundles. We use the notation “ ” to denote the indifference
notation. i.e. If neither > nor > then it implies that implying that the
consumer is indifferent between the two commodity bundles.
c) A ‘weak preference’ notation is denoted as, “. This notation combines the
strictly preferred to notation to the indifferent notation. i.e. means that is
at least as good as commodity bundle .
NB:
The above mentioned preference notations are used “ to order” the set of
commodity bundles that a consumer has to choose from. These preferences must
therefore, satisfy certain standard properties which are:
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1.1.3 Properties of Consumer Preferences
• The properties of consumer preferences are:
a) Complete: Meaning that for all possible bundles, the consumer
must be able to ‘rank’ her preferences. i.e. For all & in X ; either >
or > Thus, this property says that the two commodity bundles can
be ‘compared’.
b) Transitive: implying that for all in X; If > a> ; then it must be the
case that > . This property is necessary when discussing preference
maximization. In this property, the consumer is ‘consistent’ in his
choice of commodity bundles.
c) Reflexive: This implies that a commodity bundle is as good
as itself. i.e. For all in X; > . This property is ‘trivial.’ It is not that
important. It is there theoretically for learners to know it but
practically it is insignificant.
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 1.1.4 BUDGET CONSTRAINT
• Here we describe the constraint consumers face when making their preferences.
• The consumer cannot spend more than her available income. This means that
consumers are restricted by their budget in their choices of consumption bundles.
• It is assumed that consumers choose to consume the consumption bundle that is
‘optimal’. That is, the consumption bundle that exhausts all the consumers’
income.
• Therefore, a consumer is said to be endowed with income, Y, such that her wealth
will be divided over the commodities she prefers.
• Her budget constraint is expressed algebraically as follows:
+ + +……….

• NB:
The budget constraint is expressed as a function of prices of the commodities () and the
income (Y). i.e. B(P,Y) where: = the price of good ; = 1,2,…..n commodity bundles; Y =
income.

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 1.1.5 Rationality of a Consumer
• The rationality of a consumer is defined with
respect to how she ranks the commodity bundles
given her income.
• A rational consumer will always spend her income
over the ‘most preferred’ consumption bundle. i.e.
That bundle that exhausts all her income (optimal
bundle).
• The optimal bundle is attained where the budget
line & the indifference curve meet with tangency.
See diagram on the next slide.
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Diagram showing a Rational Consumer

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• The optimal point for a rational consumer is
attained where and meet with tangency. The
consumer is exhausting all her income.
• and it does not exhaust all the consumer’s
income.
• and it is unattainable. The consumer at will be
living beyond her means.

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 1.2 UTILITY THEORY
1.2.1 Utility Theory:
• This theory is developed from the preference relation
with respect to the commodity bundle satisfaction.
• From the indifference relation “ ” , we prescribe a
mapping for all the indifference classes. This mapping
is given a name, “Utility function” and it is denoted as
follows:
)
• This is the utility derived from the consumption of
good .
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• The utility function is defined in relation to the
preference notations as follows:
Preference relation Utility reation
then )=)
then ) )
then ) )

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 1.2.2 How to Measure Utility
• There are two notions on how to measure utility:
a) Cardinal utility: This is used in classical economics to imply the
intensity of utility as specified by the utility function. This
intensity is specified in cardinal numbers.
Example: Meat might have yielded a consumer say, 10 utiles;
and potatoes yielded 5 utiles. Hence, the meat gave twice the
satisfaction of one potatoe.
• Thus, the measurement of anything in cardinal units such as;
temperature, in terms of specific numbers that can be verified, is
referred to as a ‘cardinal measure’.
i.e. temperature is measured in degrees centigrade () or farrenite
() . The height of Mona flats is measured in metres (M).
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b) Ordinal utility:
• This is a mechanism for “ranking” commodity bundles in
the commodity space.
• To compare items with another, and to rank them according
to the level of satisfaction that one derives form them, is
called a comparison on an ordinal scale.
Example: I would rather have a glass of juice than a glass of
coca cola; and I would prefer juice compared to fanta orange.
NB:
• Here we are not assigning cardinal numbers but we are
making comparisons that are consistent.
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1.2.3 PROPERTIES OF UTILITY FUNCTIONS

• The properties of utility functions are:

a) Nonsatiation
b) Strict Convexity
c) Differentiability

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a) Nonsatiation:
• This property states that the consumer experiences no satisfaction so long as her
income still permits/allows her to consume more.
• Nonsatiation guarantees that all bundles in the preferred subset exhausts all the
income for the consumer.
• That is, the prefferred/optimal consumption bundles are represented by points on,
and not below the budget line.
• Any bundle that does not exhaust the consumer’s income is considered ‘inferior’ in
terms of preference ordering, when compared to the bundle that uses up all the
income.
• Nonsatiation implies that the consumer is not expected to be operating inside the
budget set( shaded triangle); but she must be moving towards the budget line. The
consumer will continue to pick/choose higher indifference curves until no space is
left between the budget line and the budget set.
• In short, nonsatiation implies that the budget set and the indifference curve will
meet with strict equality. This is shown in the following diagram:

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Diagram Showing Nonsatiation

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• Nonsatiation is attained only at point D in the
diagram.
• We also note that Nonsatiation supports
consumer rationality 100%.

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b) Strict Convexity:
• This property imposes strong restrictions on
the shape/form of the consumer’s
indifference surfaces. It emphasizes that
indifference curves must be strictly convex to
the origin and are rounded in shape.
• The property does not consider indifference
curves that are concave or that have flat
segments
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Diagram showing the strict convexity of
utility functions

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c) Differentiability:
• This property states that the utility function ), is
differentiable for all strictly positive consumption bundles.
• The property guarantees that so long as > 0, for all i, then
the derivative exists.
• The derivative tells us by how much utility is increased
when the consumption of the commodity is increased at
the rate of one unit per time period.
• This notion is known as the ‘marginal utility’ of the
commodity, denoted as : )=

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 1.2.4 COMMODITY SUBSTITUTION IN
CONSUMER THEORY
• Commodity substitution is defined as the
maximum rate at which the consumption of
say, good j will be reduced when the
consumption of good i is increased by one
unit.
• It is mostly referred to as the ‘Slope of the
indifference curve’
• Graphically, the slope of the indifference curve
is shown in the following diagram.
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 Diagram showing the commodity
substitution/ slope of indifference curve

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• The slope of the indifference curve is calculated as follows:
= slope of the indifference curve
• The marginal rate of substitution of the two commodities is simply
the negative of the slope of the indifference curve.
• The slope of the indifference curve indicates the rate at which the
consumption of commodity y is reduced when the consumption of
commodity x is increased, while holding the level of utility constant.
NB: That since the amount by which the consumer is willing to reduce
the consumption of commodity y when the consumption of commodity
x is increased by one unit is ‘negative’ ; then that is why a negatively
sloped indifference curve gives rise to a ‘POSITIVE’ marginal rate of
substitution.

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1.2.5 THE LAW OF DIMINISHING MARGINAL
RATE OF SUBSTITUTION (MRS)
• The strict convexity property can be re-interpreted using the
MRS concept.
• The strict convexity assumption implies that indifference
curves are convex to the origin , hence the rate of change of
the marginal rate of substitution of one commodity for
another commodity() with respect to a change in the
consumption of commodity x (holding utility constant is
strictly negative.
<0
• Because of the above notation, the property of strict convexity
is sometimes called the assumption of , ‘DIMINISHING
MARGINAL RATE OF SUBSTITUTION’.
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 1.2.6 UTILITY MAXIMIZATION
(LINK)
• The problem of consumer choice can be represented as
the problem of maximizing the utility function subject to
the a budget constraint using the lagrangian method.
NB:
That a solution to the maximization problem gives rise to an
‘ordinary or marshallian demand function’ and a solution to
the minimization problem gives rise to a ‘ compensated or
hicksian demand function’.

• Thus, the utility maximization links the utility theory to the

demand theory.
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 1.3 DEMAND THEORY
1.3.1. THE DEMAND THEORY:
• The demand theory starts with solving the constrained
optimization of the utility function subject to the budget
constraint.
• The maximization problem is generally expressed as follows:
Utility Maximization Problem:
Maximize
Subject to

Where, , and

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Formulate the Lagrangian Function:
• The second step in trying to derive the demand
function is to formulate the Lagrangian
function as follows:
)

• Opening the brackets for the budget constraint

yields:
)

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First Order Necessary Conditions (FONCs):
(equate them to zero) as follows:

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NOTE:
• That solving the FONCs for a maximization problem
we get the Ordinary/Marshalian Demand function
which is expressed as follows: for all i=1,2,…n.

• That solving the FONCs for a minimization problem

we get the Compensated/Hicksian Demand
function which is expressed as follows: for all i=1,2,
…n.

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NUMERICAL EXAMPLE 1: Maximization Case
Consider a given utility function and a budget
constraint defined as : Y
Question:
Derive the ordinary/marshalian demand functions.

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Solution:
Utility Maximization Problem:
Maximize
Subject to Y
0
Formulate the Lagrangian Function:
) open up the brackets of the budget constraint and get:

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First Order Necessary Conditions (FONCs): (equate them
to zero) as follows:

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• Divide equation (1) by (2) and get:

• Make either the subject and get:

Or

• Substitute equation (4) into (3) and get:

Ordinary demand function for commodity1………………………………….……………………..(5)

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• To solve for insert (5) into (4) and get:

ordinary demand function for commodity 2.

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 1.3.1.1. PROPERTIES OF THE ORDINARY
DEMAND FUNCTION
1. The ordinary demand function is single valued in
price(P) and income(Y). (This means that price & income
are constants).
2. The ordinary demand function is homogeneous of
degree zero in price (P) and Income (Y). This means that if
we multiply the price (P) and income(Y) by a scalar, say k,
the FONCs will not change.
3. The ordinary demand function is non-decreasing in
income (Y).
4. The ordinary demand function is non-increasing in
price (P).
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NUMERICAL EXAMPLE 2: Minimization Case
Consider a given utility function and a budget
constraint defined as : Y
Question:
Derive the compensated/hicksian demand functions.

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Solution:
Minimization Problem:
Minimize Y

Subject to
0
Formulate the Lagrangian Function:
)
open up the brackets of the utility function and get:
.
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First Order Necessary Conditions (FONCs): (equate them
to zero) as follows:

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• Divide equation (1) by (2) and get:

• Make either the subject and get:

Or

• Substitute equation (4) into (3) and solve for and get:
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 multiply both sides by and get:
simplify and get:
divide both sides by and get:
simplify and get:
solve for and get:
solve for and get:
or a compensated/hicksian demand function
for good
2…………………………………………………………........(5)
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• Substitute equation into (3) and solve for and get:

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 multiply both sides by and get:
simplify and get:
divide both sides by and get:
simplify and get:
solve for and get:
solve for and get:
or a compensated/hicksian demand function for good
1…………………………………………………………........(6)

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 1.3.1.2 .PROPERTIES OF THE
COMPENSATED/HICKSIAN DEMAND FUNCTION
1. The hicksian demand function is homogeneous of
degree zero in price (P).
2. The hicksian demand function is non-decreasing in
price (P).
3. The hicksian demand function is continuous in price ,
(P) for all P>0.

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 1.4. DUALITY IN CONSUMER THEORY
• Duality in consumer theory explains the concepts of an “indirect utility
function” and the “expenditure function”.

1.4.1. THE INDIRECT UTILITY FUNCTION:

• It is defined as the maximum utility as a function of price, P and a fixed

level of income, Y.
• It is denoted as U(P,Y).
• The indirect utility function reflects that utility levels depend indirectly
on price,P, and income, Y.
• The indirect utility function is attained by substituting the ordinary
demand functions into the given utility function. This is shown in the
following numerical example:
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NUMERICAL EXAMPLE : Indirect Utility Function
• Let us use the previous numerical examples where the given utility function is and the
budget constraint is Y.
• We solved the lagrangian function and obtained the ordinary demand functions which
are: & .

Question:
• Using the above mentioned information, calculate the indirect utility function.
Solution:
• The indirect utility function is attained by substituting the ordinary demand
functions into the given utility function:
substitute the ordinary demand functions into the given utility function and get:

simplify and get:

or is the indirect utility function. QED.
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 1.4.1.1. PROPERTIES OF THE INDIRECT
UTILITY FUNCTION
1. The indirect utility function is continous for all positive
values of price(P) and income(Y). This means that price &
income are positive constants, (P>0 & Y>0).
2. The indirect utility function is homogeneous of degree
zero in price (P) and Income (Y). This means that if we
multiply the price (P) and income(Y) by a positive scalar, say
t, the function will not change. That is, .
3. The indirect utility function is non-decreasing in income
(Y).
4. The indirect utility function is non-increasing in price (P).
5. The indirect utility function is quasiconvex in price.
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1.4.2. THE EXPENDITURE FUNCTION:
• It is defined as the minimum level of expenditure a consumer
requires in order to achieve a given level of utility.
• The expenditure function is a minimum-value function expressed as
follows: e(P,U).
• The expenditure function is attained by substituting the
compensated/hicksian demand functions into the budget constraint.
This is shown in the following numerical example:

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NUMERICAL EXAMPLE : Expenditure Function
• Let us use the previous numerical examples where the given utility function is and the budget
constraint is Y.
• We solved the lagrangian function and obtained the compensated demand functions which are:
&

Question:
• Using the above mentioned information, calculate the expenditure function.
Solution:
• The expenditure function is attained by substituting the compensated/hicksian demand functions
into the budget constraint.
Y substitute the compensated demand functions into the budget constraint function and get:
Y
e(P,U)
e(P,U) simplify and get:
simplify and get:
Expenditure function. QED.

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 1.4.2.1. PROPERTIES OF THE EXPENDITURE
FUNCTION
1. The expenditure function is homogeneous of degree
one in price (P).
2. The expenditure function is non-decreasing in price
(P).
3. The expenditure function is continuous in price ,(P) for
all P>0.
4. The expenditure function is concave in price, P.

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 1.4.3. ROY’S THEOREM
• The Roy’s theorem states if the indirect utility
function U(P,Y) is differentiable, then the
ordinary/marshalian demand function can be
obtained back using the following :
for all i= 1,2,3…n
• The Roy’s formular says that, you can differentiate
the indirect utility with respect to the price,P and
divide that by the derivative of the indirect utility
function with respect to income, Y.

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NUMERICAL EXAMPLE : Application of the Roy’s Theorem:
• In the previous examples, we found an indirect utility function :
or

.
Question:
Using the Roy’s Theorem find the ordinary demand functions for the first
commodity.

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Solution:
for commodity 1.
.

.
] simplify and get:
which is simplified as :
which is the ordinary demand function we obtained using the lagrangian method. QED.

Homework:
Use the Roy’s theorem to get back the ordinary demand function for the second
commodity.

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 1.4.4. HOTELLING’S/SHEPARD LEMMA
THEOREM
• The Hotelling’s theorem states if the expenditure
function e(P,U) is differentiable, then the
compensated/hicksian demand function can be
obtained back using the following :
where i= 1,2,3,…n
• The Hotelling’s formular says that, you can
differentiate the expenditure function with
respect to the price,P and obtain the commodity.

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NUMERICAL EXAMPLE : Application of the Hotelling’s / Shepard Lemma
Theorem:
• In the previous examples, we found an expenditure function :

Question:
Using the Hottelling’s theorem find the compensated demand functions for the
first commodity.

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Solution:

for commodity 1.

which is the compensated demand function we obtained using the lagrangian method. QED.

Homework:
Use the Hottelling’s theorem to get back the compensated demand function for the second
commodity.

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 1.5. THE THEORY OF REVEALED
PREFERENCES
1.5.1: INTRODUCTION:
• The revealed preference theory was developed
by an American economist named Paul
Anthony Samuelson in 1938.
• The theory states that consumer behavior, if
their income and prices are held constant, is
the best indicator of the consumer preferences.
The revealed preference theory works on the
assumption that consumers are rational.
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• For a long time, consumer behaviour, most notably consumer choice, had been
understood through the concept of utility.
• In economics refers to how much satisfaction or pleasure consumers get from the
purchase of a product, service or event.
• However, utility is incredibly difficult to quantify in indisputable terms, and by the 20th
century, economists were complaining about the pervasive reliance on utility.
• Replacement theories were considered, but all of them were criticized, until the
establishment of Samuelson’s Revealed Preference Theory.
• Samuelson’s revealed preference theory posited that consumer behaviour was not based
on utility, but on observable behaviour ( price-quantity data) that relied on a small
number of relatively uncontested assumptions.
• The revealed preference theory asserts that the best way to measure consumer
preferences is to observe their purchasing behaviour.
• The basic approach of the theory of revealed preferences is founded on the notion that
the consumption bundle that is chosen by the consumer, given a set of prices reveals a
consumer’s preference for that bundle over all other alternative consumption bundles
which could have been chosen but were not.

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 1.5.2.THREE AXIOMS OF THE REVEALED
PREFERENCE THEORY
• Economists have identified three primary
axioms of the theory of revealed preferences:
the weak, strong and generalized axioms.
1. The Weak Axiom of Revealed Preference (WARP):
• This axiom states that given incomes and prices, if one
product or service is purchased instead of another,
then as consumers, we will always make the same
choice.
• This means that as consumers, we will buy what we
prefer and our choices are consistent.
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2. The Strong Axiom of Revealed Preference (SARP) :
• This axiom states that in a world where there are more
than two goods we need to chose from (i.e. ). If is
revealed preferred to, which is revealed preferred to ;
Then must never be revealed preferred to .
• This axiom ensures that revealed preferences are
transitive.

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3. The Generalized Axiom of Revealed Preference (GARP)
• This axiom covers the case where, for a given level of
income and prices, we can get the same level benefit
from more than one consumption bundle.
• In other words, this particular axiom, accounts for when
there is no unique bundle that maximizes utility.
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MOTIVATION
Philipians 4: 13 “I can do all things through Christ who gives me strength”

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