Consumer Theory

Indifference curves of valid utility functions

- Consumption bundles or indifference curves further to the top right preferred

- Every consumption bundle lies on some indifference curve – completeness
- In general indifference curves:
- Slope downwards as more is better
- Can’t be thick – as more is better
- Can’t cross, since preferences satisfy transitivity
- Completeness – the assumption that an individual can state which of 2 options is preferred
- Transitivity – if A is preferred to B and B to C then A is preferred to C

Marginal Rate of Substitution (MRS)

- The rate a consumer is willing to substitute one good for another along an indifference curve
−M U x
- Slope of the indifference curve: ie the differential of the x over the differential of y
MU y
- Negative as downward sloping
MUx
- MRS is the positive
MU y
- Usually the slope becomes gentler as x increases. When very little x you are willing to give up
far more of y.
- When 2 goods are perfect substitutes then indifference curve is straight line
- When perfect complements we have L shaped curves, need equal of both
- In between we have downward sloping curves with diminishing MRS

Budget constraint

- Once we have our model of preferences we now need to know the set of goods the
consumer can afford. Budget constraint
- Consumers are usually price takers and therefore this will be a straight line
- (if consumer buys different units at different prices this wouldn’t be straight eg quantity
discounts)

Utility maximisation

- Choose the point where the highest indifference curve is tangent to the budget constraint
line
- Where M is the total budget
- At the point they meet the gradients
−Px
equal so -MRS =
Py
Px
- So MRS =
Py

-
- we use the Langragian multiplier to show and solve this
 - L = U(x,y) + λ(M-Pxx -Pyy)
- We now do + λ and then the budget minus the prices (same as other way round)
Using the Lagrange multiplier to solve a condition
subject to a constraint. We find the first
derivatives in terms of x and y.

Dividing the x derivative by the y derivative we

see that the MRS (gradient of the indifference
curve) equals the gradient of the budget
constraint as we showed graphically above.

- Then find the ratio of y to x, and then using the derivative of the constraint find the solutions

- This is the case for diminishing marginal returns

- For perfect substitutes the optimal is either a corner or if the line is on the budget line
- For perfect complements the optimal is where the corner of the L hits the budget line
- If the MRS curve isn’t convex then wed need a second order derivative to show that this is
actually the maximum

Demand Curves

- Quantities chosen depend on preferences and budget

- As income increases:
- Normal goods: as income increases people buy more of these goods
- Some may increase more rapidly – necessities less so as even with lower income you buy
engels law – eg as income increases fraction spent on food decreases
- Inferior goods: as income increases amount purchased decreases
- Income – consumption curve traces the path of optimal bundles as income varies (engel
curve)
- Price changes: if one good becomes cheaper this has 2 effects
- Substitution effect: will buy more of the cheaper good
- Income effect: will be able to afford a larger bundle overall as relatively more well off, can
reach a higher utility level
- The budget constraint slope will be flatter (if x has become cheaper)
- To understand how much of the change is due to substitution effect and how much is due to
income effect we draw a hypothetical budget constraint with the new prices but along the
original indifference curve. The movement along the same indifference curve shows the
substitution effect. The change from there to the real new budget constraint is the income
effect

-
- Red dotted line is the hypothetical budget line at the new prices. B would be the bundle
purely due to change in prices, if income did not improve at all as a result
- From B to C is purely income effect

Price elasticity of Demand

- The percentage change in quantity demanded, divided by the corresponding percentage
change in price
- For a usual demand curve this will be negative, so we just display the number without the
negative sign
- The larger the elasticity, the more sensitive the product is to a change in price. Ie the lower
the elasticity the less sensitive the quantity is to a change in price.
- With a linear demand curve, elasticity is high at high prices as change in price is a smaller
percentage of the overall price whereas the percent of quantity change is larger as the
overall quantity is less
- Whereas at a lower price the change in quantity is less as there is a larger overall quantity,
whereas the percentage change in price is larger relative to the overall cheaper price.
- To calculate elasticity we calculate the slope of the demand curve and then plug in a specific
price to get the elasticity at that point
 -

∆Q P ∆Q
- where will just be the coefficient of the p value and p/q is the p value we are
∆P Q ∆P
given and the q that comes out from using that p
- At high price levels demand is more elastic – a fall in price causes increases in demand more
than proportionally.
- At low prices demand is more inelastic, a fall in price has little impact

Cross price elasticity of demand

- Effect on the quantity demanded of good i when the price of good j increases.
- If the demand of i rises when the price of j increases this is a positive cross price elasticity
and if the demand for i falls when the price of j rises this is negative cross price elasticity
- If goods are substitutes then they will have a positive cross price elasticity. As one becomes
more expensive the demand for the substitute increases
- If goods are complements then they will have negative cross price demand. As one becomes
more expensive we will also demand less of the other.
- It’s the percentage change in quantity demanded of i divided by the corresponding
percentage change in the price of good j

∆ Q px ∆Q
At a point, this will be where is the coefficient of the price which is changing Px and
∆ Px Q ∆ Px
px/Q is the given price of the good changing price over the quantity for that specific price

Income Elasticity

- income elasticity of demand- the percentage change in quantity demanded of a good,

divided by the corresponding percentage change in income.
- The income elasticity of demand of a good measures how far the demand curve shifts
horizontally when incomes change. Ie the change in quantity demanded at every given price.
- The income elasticity is larger the more it shifts.
- If the demand curve moves to the left that means as income rises demand falls at every
given price meaning a negative income elasticity of demand

- When elasticity exceeds 1 the good is a luxury good, necessities like food have a lower
elasticity

Compensated demand curve

- The standard demand curve (Marshallian) we vary the price of the good x, but hold constant
prices of any other goods and also income level. Of course as the price of x changes so the
optimal amount changes, the utility level changes also. Known as the uncompensated
demand curve
- Compensated (Hicksian) demand curve, we keep the price of other goods constant and keep
utility constant, allowing income to change
- if the price of x, say, falls (so that the new optimal bundle of the consumer would be
associated with a higher level of utility if income is left unchanged), we take away enough
income to leave the consumer at the original level of utility. It is clear that this process
eliminates the income effect and simply captures the substitution effect.
- For a normal good, the uncompensated demand curve is more elastic than the
compensated. As for normal good, income effect adds to substitution effect. The
compensated demand curve removes the income effect of a price change, hence responds
less to a price change.
- For an inferior good the uncompensated demand curve is less elastic than the compensated.
As for an inferior good, income effect goes against substitution effect. The compensated
demand curve removes the income effect of a price change, hence responds more to a price
change.
- Compensated demand curve always slopes downwards – substitution effect, more expensive
less of it

Effect of a price change

- When we decomposed the price effect into income and substitution we created a
hypothetical point which was the budget constraint at the new prices, but compensated to
return to the original utility. (ignore income effect). Shows substitution effect
Compensating variation.

If the price of x went down. So we went from A to C

The hypothetical budget constraint line in red, uses

the new prices but shows how much we could lower
the income to maintain the same utility level.

The difference in income is the compensating

variation

-
- Alternatively we could use the old prices, but have an income change equivalent to the
change in utility.
 Equivalent variation

This shows how much extra income we

would need to have the same new utility
(as with the cheaper price) but at the
original price.

-
- First way shows new prices but at old income, second shows old prices at new income.
Either way rules out income change

-
- Here is a way to understand the difference between the 2.
- Compensating variation: how much the difference in income is needed to maintain the same
utility as the original
- Equivalent variation: how different the income could be to maintain the new utility level but
at the original prices.
- Because we are dealing with a price increase of a normal good, the CV>EV
- If we had a price decrease or an inferior good then this would be the opposite

Maths: finding the demand curves from the utility curve.

- So we have the utility function and we have the budget constraint.

- Eg u= x0.5y0.5 and p1x+p2y =M
∂ ux Px
- So we find the MRS so this = solve and reorganise to make y the subject
∂ uy Py
y p1 p1
- So here we end up with = so y=x
x p2 p2
- Plug this into the budget constraint and make x the subject this is the demand curve for x
 M M
- So x = doing the same but other way round to get the demand curve for y =
2 p1 2 p2
M
- Now plug these into the utility function to get that u* (p1,p2,M) =
2 √ p1 p 2
Welfare Measures

- Change in consumer surplus – calculate the differences between consumer surplus at the
original price and the new price
- But because of presence of income effect this may not be accurate. Rather we have:
- Compensating Variation (CV) CV is the amount of money that must be given to a consumer
to offset the harm from a price increase, i.e. to keep the consumer on the original
indifference curve before the price increase.
- Equivalent Variation (EV) EV is the amount of money that must be taken away from a
consumer to cause as much harm as the price increase. In this case, we keep the price at its
original level (before the rise) but take away income to keep the consumer on the
indifference curve reached after the price rise.

- So using the functions we just did the maths with. Suppose the original prices are (1,1) and
the income is 100
- Then price of x increases to 2
M M
- At initial prices u* = at new price its
2 2 √2
M +CV M
- CV is the extra income that restores the original utility at the new prices so =
2 √2 2
- So solving we get CV = M(√ 2-1) using M = 100 CV is 41.42
- EV is the change in income which at the original prices will leave us on the same utility as
M M −EV
after the price change so =
2 √2 2
( √ 2−1)M
- Solving we get EV = using M = 100 this gives 29.29
√2
- Since this is a price rise and a normal good EV<CV
- For a price rise in a normal good EV<∆CS<CV
- For a price rise in an inferior good CV<∆CS<EV

Linking to substitution and income effect

- Suppose x becomes cheaper, so we have a new optimal bundle

- Substitution effect: along the same utility as original prices, what is the change in x
demanded due to the price drop, so set the utility function whilst using the new price equal
to the original utility level, and find the amount of x given from that. The difference between
this and the original x is the substitution effect.
- We find the original demand, and the new demand. The difference is the total effect.
- Example
- First set MRS = px/py. Then use this to find y in terms of x. plug this into the budget
constraint (px+py=M) to find the demand functions for x and y respectively.
- Use these to find change in demand (total change due to both substitution and income
effect) this change in demand is sum of sub effect and income effect.
- To find sub effect we now find the utility function in terms of x (subbing in y in terms of x)
- Use OG price and then the given demand X (which we found) to find OG utility. Sub effect
will replace P with new price but equate to the same utility. Change in X is sub effect.
- To find income effect: we take the actual new demand from demand function, and subtract
from it the substitution demand level.
- So we have the diff between the OG demand and the theoretical demand is sub effect, and
the diff between the theoretical demand and the actual new demand is income effect.
-

-
-

- As we have overall change 3.5 so compensated demand we find to be 6. So 4.5 to 6 is the

substitution effect. The change at the same utility. This is 1.5. The remaining 2 is the income
effect. Moving from one utility to another.

-
 -
- For CV set the OG utility function (where we use the demand functions in the utility
function) equal to the new one where we add a CV to ensure they are the same at the new
price level. Here the new price is lower so we must remove the CV to get back to equal
utility

Labour Supply

- An individual can work up to 24 hours a day and receive a wage w

- The time spent not working is leisure time, and each hour spent in leisure time has an
opportunity cost w
- Leisure is a normal good.
- If wage w becomes higher, we have the substitution effect, as the cost of an extra hour of
leisure is higher, so people work more
- But also there is an income effect – the more wealth people have the more they want to
spend on leisure, meaning a tendency to work less
- We have the budget constraint. Which is the straight line, where the intercepts are when
you work 24 hours in a day, and the x intercept when you work 0 hours. Gradient is -w
- We then have utility curves. The maximising point is when the gradient of the constraint w
equals the MRS of leisure hours for consumption
- Suppose Z = hours worked N = leisure hours M = income and M = independent income
(inheritance)
- We want to maximise the utility of u(M,N)
- Z = 24 – N and M = wZ + M
- So budget constraint is M = w(24-N)+ M
- At the optimum the slope of the indifference curve equals the slope of the budget constraint
MU n
- So =w
MU m
- How does the optimal choice of labour respond to a change in w? We can analyse this using
income and substitution effects. In this case, a change in w, also changes income directly (as
you can see from the budget constraint), so the exercise is a little different compared to that
under standard goods.
- Suppose w rises.
- Income effect: The rise in w raises income at current levels of labour and leisure. Assuming
leisure is a normal good (this should be your default assumption), this raises the demand for
leisure.
- Substitution effect: The rise in w makes leisure relatively more expensive, causing the agent
to substitute away from leisure. This reduces demand for leisure.
- The two effects go in opposite directions, therefore the direction of the total effect is
unclear. In most cases, the substitution effect dominates, giving us an upward-sloping labour
supply function. However, it is possible, especially at high levels of income (i.e. when wage
levels are high), that the income effect might dominate. In that case we would get a
backward-bending labour supply curve which initially slopes upward but then turns back and
has a negative slope.
- Below shows the 2 possible outcomes for the labour supply curve

Saving and borrowing – Intertemporal choice

- Suppose we have income over 2 years. So in year 0 income is Y0 and in 1 its Y1
- Can save or consume. Whatever is saved has an interest rate r
- So consumption in year 0 is C0 and in year 1 C1
- We want to find the optimal amount of consumption in each year. U(C0,C1)
Y1
- Suppose we consume all income in year 0 then C0 would equal Y0 + and C1 = 0
1+ r
- If we consumed all income in year 1 then C0 = 0 and C1 = Y0(1+r) + Y1
- So the budget constraint is C1 = (Y0 – C0)(1+r) +Y1
- Ie the consumption of Y1 is on the y axis and Y0 on the x. C1 will equal any earnings from Y0
which weren’t spent, times the interest, plus earnings from Y1

-
- This is then like a classic optimisation case with 2 goods, C0 and C1. The price of C0 is 1 and
1
the price of C1 is ie any spending done in C1 is ‘cheaper’
1+ r
- The optimal point will satisfy the MRS = gradient of budget line
MU C 0
- So =(1+ r)
MU C 1
- If the optimal bundle is C0 = Y0 and C1 = Y1 then the consumer isn’t a borrower or a saver
- If C0 > Y0 and C1 <Y1 then this consumer is a borrower, borrowing in year 0 and therefore
spending less in year 1
- If C0 < Y0 and C1 >Y1 then this consumer is a saver, saving from year 0 to spend in year 1
- A change in interest rates will change the intertemporal bundle:
- A raise in interest shifts up the budget line (would be more to spend in Y 1)
- For a borrower: Y0<C0
- Substitution effect: higher interest rates means immediate consumption more costly, will
therefore move towards saving more, lower C0
- Income effect: higher interest rate means that borrowed money worth is less as Y 1 incomes
will be discounted more heavily, so overall income worth less, so should spend less lower C 0
- Both affects in the same direction so direction of change unambiguous, higher interest rates
mean less borrowing
- For a saver: Y0>C0
- Substitution effect: higher interest rates mean that spending now is more costly (higher
interest rates on saved money) should save more
- Income effect: higher interest rate raises overall income and therefore consumption
(including in Y0) increases, so C0 increases
- Ambiguous as to which way the total effect on saving goes.

As the interest rate increases the budget constrain

will pivot around the endowment point (point of
how much money earned each year)

With higher interest rates the Y intercept is higher

Consumers with an optimal point above the

endowment point are savers

Consumers with an optimal point below the

endowment point are borrowers

Suppose we start with dotted line and we are a

borrower. If interest rates fall line pivots to the
-
solid line, so a borrower will still be able to have
his ideal bundle of borrowing. However if it was
the other way round and we started on the solid
and interest rates rise, he wont be able to afford
the bundle he had on the solid line (as it is outside
the dotted line) but will be able to reach higher
levels of output if he saves that he couldn’t before,
so may be tempted to save