Review of
Consumer Theory
Christopher Makler
Stanford University Department of Economics
Econ 50: Lecture 15
What's On The Test?
- Budget line / budget set
- Utility maximization
- Demand curve
- Price offer curve
- Income offer curve
- Hicks decomposition
- Cost minimization
Graphs / Representations
- Complements
- Substitutes
- Normal Goods
- Inferior Goods
- Income Effect
- Substitution Effect
- Compensating Variation
- Equivalent Variation
Concepts
- Utility-maximizing bundle given a budget constraint
- Marshallian demand function
- Cost-minimizing bundle given a utility constraint
- Hicksian demand function
Derivations
You should be able to perform this kind of analysis for any utility function,
including ones you haven't seen before (or seen before in this context).
What's On The Test?
- Budget line / budget set
- Utility maximization
Graphs / Representations
Concepts
- Utility-maximizing bundle given a budget constraint
Derivations
You should be able to perform this kind of analysis for any utility function,
including ones you haven't seen before (or seen before in this context).
m=money income
m = \text{money income}
p1=price of good 1
p_1 = \text{price of good 1}
p2=price of good 2
p_2 = \text{price of good 2}
horizontal intercept=p1m
\text{horizontal intercept} = \frac{m}{p_1}
vertical intercept=p2m
\text{vertical intercept} = \frac{m}{p_2}
slope of budget line=−p2p1
\text{slope of budget line} = -\frac{p_1}{p_2}
Gravitational Pull Argument
move to the right along the budget line
move to the left along the budget line
MRS>p2p1
MRS > {p_1 \over p_2}
MRS<p2p1
MRS < {p_1 \over p_2}
IF...
THEN...
The consumer's preferences are "well behaved"
-- smooth, strictly convex, and strictly monotonic
MRS=0 along the horizontal axis (x2=0)
The budget line is a simple straight line
The optimal consumption bundle will be characterized by two equations:
MRS=p2p1
MRS = \frac{p_1}{p_2}
p1x1+p2x2=m
p_1x_1 + p_2x_2 = m
More generally: the optimal bundle may be found using the Lagrange method
MRS→∞ along the vertical axis (x1→0)
How do you tell if a preferences are "well behaved"?
Strictly monotonic
Strictly convex
Smooth
MU1>0 and MU2>0 for any x1,x2
∂x1∂MRS≤0 and ∂x2∂MRS≥0, with at least one strict
MRS has no "jumps" (not defined piecewise)
Continuous
Utility function has no "jumps" (not defined piecewise)
(i.e., indifference curves get flatter as you move down and to the right)
The Tangency Condition
What happens when the price of a good increases or decreases?
The Tangency Condition when Lagrange sometimes works
What happens when income decreases?
What's On The Test?
- Budget line / budget set
- Utility maximization
- Demand curve
- Price offer curve
- Income offer curve
- Hicks decomposition
- Cost minimization
Graphs / Representations
- Complements
- Substitutes
- Normal Goods
- Inferior Goods
- Income Effect
- Substitution Effect
- Compensating Variation
- Equivalent Variation
Concepts
- Utility-maximizing bundle given a budget constraint
- Marshallian demand function
- Cost-minimizing bundle given a utility constraint
- Hicksian demand function
Derivations
You should be able to perform this kind of analysis for any utility function,
including ones you haven't seen before (or seen before in this context).
✅
✅
✅
What's On The Test?
- Budget line / budget set
- Utility maximization
- Demand curve
Graphs / Representations
Concepts
- Utility-maximizing bundle given a budget constraint
- Marshallian demand function
Derivations
You should be able to perform this kind of analysis for any utility function,
including ones you haven't seen before (or seen before in this context).
✅
✅
✅
Specific Prices & Income
General Prices & Income
Constraint: 2x1+x2=12
\text{Constraint: }2 x_1 + x_2 = 12
Constraint: p1x1+p2x2=m
\text{Constraint: }p_1x_1 + p_2x_2 = m
Objective function: x121x221
\text{Objective function: } x_1^{1 \over 2}x_2^{1 \over 2}
MRS(x1,x2)=x1x2
MRS(x_1,x_2) = {x_2 \over x_1}
x1∗=3
x_1^* = 3
x1∗(p1,p2,m)=2p1m
x_1^*(p_1,p_2,m) = {m \over 2p_1}
x2∗=2x1∗=6
x_2^* = 2x_1^* = 6
x2∗(p1,p2,m)=2p2m
x_2^*(p_1,p_2,m) = {m \over 2p_2}
OPTIMAL BUNDLE
DEMAND FUNCTIONS
(optimization)
(comparative statics)
What's On The Test?
- Budget line / budget set
- Utility maximization
- Demand curve
- Price offer curve
- Income offer curve
- Hicks decomposition
- Cost minimization
Graphs / Representations
- Complements
- Substitutes
- Normal Goods
- Inferior Goods
- Income Effect
- Substitution Effect
- Compensating Variation
- Equivalent Variation
Concepts
- Utility-maximizing bundle given a budget constraint
- Marshallian demand function
- Cost-minimizing bundle given a utility constraint
- Hicksian demand function
Derivations
You should be able to perform this kind of analysis for any utility function,
including ones you haven't seen before (or seen before in this context).
✅
✅
✅
✅
✅
What's On The Test?
- Budget line / budget set
- Utility maximization
- Demand curve
- Price offer curve
- Income offer curve
Graphs / Representations
- Complements
- Substitutes
- Normal Goods
- Inferior Goods
Concepts
- Utility-maximizing bundle given a budget constraint
- Marshallian demand function
Derivations
You should be able to perform this kind of analysis for any utility function,
including ones you haven't seen before (or seen before in this context).
✅
✅
✅
✅
✅
Remember what you learned about demand and demand curves in Econ 1 / high school:
- The demand curve shows the quantity demanded of a good at different prices
- A change in the price of a good results in a movement along its demand curve
- A change in income or the price of other goods results in a shift of the demand curve
-
- If two goods are substitutes, an increase in the price of one will increase the demand for the other (shift the demand curve to the right).
- If two goods are complements, an increase in the price of one will decrease the demand for the other (shift the demand curve to the left).
- If a good is a normal good, an increase in income will increase demand for the good
- If a good is an inferior good, an increase in income will decrease demand the good
x_1^*(p_1,p_2,m)\ \
Three Relationships
...its own price changes?
Movement along the demand curve
...the price of another good changes?
Complements
Substitutes
Independent Goods
How does the quantity demanded of a good change when...
...income changes?
Normal goods
Inferior goods
Giffen goods
(possible) shift of the demand curve
x_1^*(p_1,p_2,m)\ \
Three Relationships
...its own price changes?
Movement along the demand curve
How does the quantity demanded of a good change when...
The demand curve for a good
shows the quantity demanded of that good
as a function of its own price
holding all other factors constant
(ceteris paribus)
The price offer curve shows how the optimal bundle changes in good 1-good 2 space as the price of one good changes.
x1
x_1
x1
x_1
x2
x_2
p1
p_1
DEMAND CURVE FOR GOOD 1
BLp1=2
BL_{p_1 = 2}
BLp1=3
BL_{p_1 = 3}
BLp1=4
BL_{p_1 = 4}
2
2
3
3
4
4
"Good 1 - Good 2 Space"
"Quantity-Price Space for Good 1"
BL
BL
PRICE OFFER CURVE
x_1^*(p_1,p_2,m)\ \
Three Relationships
...the price of another good changes?
How does the quantity demanded of a good change when...
Substitutes
Complements
When the price of one good goes up, demand for the other increases.
When the price of one good goes up, demand for the other decreases.
Independent
Demand not related
x1
x_1
x2
x_2
x1
x_1
x2
x_2
Complements: p2↑⇒x1∗↓
What happens to the quantity of good 1 demanded when the price of good 2 increases?
Substitutes: p2↑⇒x1∗↑
COMPLEMENTS:
UPWARD-SLOPING
PRICE OFFER CURVE
SUBSTITUTES:
DOWNWARD-SLOPING
PRICE OFFER CURVE
x_1^*(p_1,p_2,m)\ \
Three Relationships
How does the quantity demanded of a good change when...
...income changes?
Normal Goods
Inferior Goods
When your income goes up,
demand for the good increases.
When your income goes up,
demand for the good decreases.
The income offer curve shows how the optimal bundle changes in good 1-good 2 space as income changes.
x1
x_1
x2
x_2
x1
x_1
x2
x_2
Good 1 normal: m↑⇒x1∗↑
What happens to the quantity of good 1 demanded when the income increases?
Good 1 inferior: m↑⇒x1∗↓
BOTH NORMAL GOODS:
UPWARD-SLOPING
INCOME OFFER CURVE
ONE GOOD INFERIOR:
DOWNWARD-SLOPING
PRICE OFFER CURVE
CES Utility
={∞0 if x1<x2 if x1>x2
= \begin{cases}\infty & \text{ if } x_1 < x_2 \\ 0 & \text{ if } x_1 > x_2 \end{cases}
−∞
-\infty
1
1
0
0
MRS=(x1x2)∞
MRS = \left(x_2 \over x_1\right)^\infty
MRS=x1x2
MRS = {x_2 \over x_1}
MRS=1
MRS = 1
r
r
u(x1,x2)=min{x1,x2}
u(x_1,x_2) = \min\{x_1,x_2\}
u(x1,x2)=x1x2
u(x_1,x_2) = x_1x_2
u(x1,x2)=x1+x2
u(x_1,x_2) = x_1 + x_2
PERFECT
SUBSTITUTES
PERFECT
COMPLEMENTS
INDEPENDENT
PERFECT
SUBSTITUTES
u(x1,x2)=(x1r+x2r)r1
u(x_1,x_2) = (x_1^r+x_2^r)^{1 \over r}
Constant Elasticity of Substitution (CES) Utility
MRS=(x1x2)1−r
MRS = \left(x_2 \over x_1\right)^{1-r}
- A change in the price of a good results in a movement along its demand curve
- A change in income or the price of other goods results in a shift of the demand curve
What's On The Test?
- Budget line / budget set
- Utility maximization
- Demand curve
- Price offer curve
- Income offer curve
- Hicks decomposition
- Cost minimization
Graphs / Representations
- Complements
- Substitutes
- Normal Goods
- Inferior Goods
- Income Effect
- Substitution Effect
- Compensating Variation
- Equivalent Variation
Concepts
- Utility-maximizing bundle given a budget constraint
- Marshallian demand function
- Cost-minimizing bundle given a utility constraint
- Hicksian demand function
Derivations
You should be able to perform this kind of analysis for any utility function,
including ones you haven't seen before (or seen before in this context).
✅
✅
✅
✅
✅
✅
✅
✅
✅
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Two Effects
Substitution Effect
Effect of change in relative prices, holding utility constant.
Effect of change in real income,
holding relative prices constant.
Income Effect
Decomposition Bundle
Suppose that, after a price change,
we compensated the consumer
just enough to afford some bundle
that would give the same utility
as they had before the price change?
The Hicks decomposition bundle
is the lowest-cost bundle
that satisfies this condition.
Approach
TOTAL EFFECT
A
A
C
C
B
B
INITIAL BUNDLE
FINAL BUNDLE
DECOMPOSITION BUNDLE
SUBSTITUTION EFFECT
INCOME EFFECT
Utility Maximization
Cost Minimization
max u(x1,x2)
\max \ u(x_1,x_2)
min p1x1+p2x2
\min \ p_1x_1 + p_2x_2
s.t. p1x1+p2x2=m
\text{s.t. }p_1x_1 + p_2x_2 = m
s.t. u(x1,x2)=U
\text{s.t. }u(x_1,x_2) = U
Solution functions:
"Ordinary" Demand functions
x1∗(p1,p2,m)
x_1^*(p_1,p_2,m)
x2∗(p1,p2,m)
x_2^*(p_1,p_2,m)
Solution functions:
"Compensated" Demand functions
x1c(p1,p2,U)
x_1^c(p_1,p_2,U)
x2c(p1,p2,U)
x_2^c(p_1,p_2,U)
Hicks Decomposition Bundle
Suppose the price of good 1 increases from p1 to p1′.
The price of good 2 (p2) and income (m) remain unchanged.
Initial Bundle (A):
Solves
utility maximization
problem
Final Bundle (C):
Solves
utility maximization
problem
max u(x1,x2)
\max \ u(x_1,x_2)
min p1′x1+p2x2
\min \ p_1^\prime x_1 + p_2x_2
s.t. p1x1+p2x2=m
\text{s.t. }p_1x_1 + p_2x_2 = m
s.t. u(x1,x2)=U(A)
\text{s.t. }u(x_1,x_2) = U(A)
Decomposition Bundle (B):
Solves
cost minimization
problem
max u(x1,x2)
\max \ u(x_1,x_2)
s.t. p1′x1+p2x2=m
\text{s.t. }p_1^\prime x_1 + p_2x_2 = m
Complements and Substitutes (one last time)
Complements
Substitutes
When the price of good 1 goes up...
Net effect: buy less of both goods
Net effect: buy less good 1 and more good 2
Substitution effect: buy less of good 1 and more of good 2
Income effect (if both goods normal): buy less of both goods
Substitution effect dominates
Income effect dominates
Compensating and Equivalent Variation
Compensating Variation
Equivalent
Variation
When the price of a good changes...
How much would your income need to change for you to be able to afford the initial utility at the new prices?
How much would your income need to change for you to be able to afford the new utility at the initial prices?
How to Calculate CV and EV
Compensating Variation
Equivalent Variation
How much would your income need to change for you to be able to afford the initial utility at the new prices?
How much would your income need to change for you to be able to afford the new utility at the initial prices?
- Find lowest-cost way to achieve initial utility at the new prices (Hicks Decomposition bundle); this is at the intersection of U1 and IOC2
- Evaluate the cost of that bundle at the new prices
- Compare that cost to your actual income
- Find lowest-cost way to achieve new utility at the initial prices (this is actually the Hicks Decomposition bundle for the reverse price change); at the intersection of U2 and IOC1
- Evaluate the cost of that bundle at the initial prices
- Compare that cost to your actual income
General Things To Think About
- Read each question carefully. Answer that question.
(A highlighter is a good idea!) - Watch out for corner solutions or other weirdness.
- Clearly (but succinctly) write down your process!
You can get lots of points even if you make a math error,
but only if we know what you were trying to do. - People who "run out of time" generally spend too long
in a rabbit hole, or write far too much in their answers.
Get something down for each question before tackling algebra!
Good luck!
Review of Consumer Theory Christopher Makler Stanford University Department of Economics Econ 50: Lecture 15
Econ 50 | Lecture 15
By Chris Makler
Econ 50 | Lecture 15
Review of Consumer Theory
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