Professor Jay Bhattacharya Spring 2001

Substitutes and Complements

Demand III • We will now examine the effect of a change
in the price of another good on demand.
• Last lecture we covered:
• Define x1 and x2 as “Gross Substitutes” if an
– Substitution and Income Effects
increase in the price of x2 leads to an
– Slutsky Equation increase in the demand for x1.
– Giffen Goods dx1
– Price Elasticity of Demand > 0 ⇒ Gross Substitutes
dp2

Spring 2001 Econ 11--Lecture 7 1 Spring 2001 Econ 11--Lecture 7 2

Substitutes and Complements Substitutes and Complements

• Define x1 and x2 as “Gross Complements” if Gross Substitutes Gross Complements
x2 x2
an increase in the price of x2 leads to an
decrease in the demand for x1. dx1 dx1
>0 <0
dp2 dp2
dx1
<0⇒ “Gross complements”
dp2

x1 x1
Spring 2001 Econ 11--Lecture 7 3 Spring 2001 Econ 11--Lecture 7 4

Cross-Price Elasticity of Demand

Hicksian Demand Functions
dx p
ε12 = 1 2
dp2 x1 • Recall “Marshallian” Demand Functions

ε 12 > 0 ⇒ – x1 = f ( p1 , p 2 , I ) hold income constant

Gross Substitutes
• “Hicksian” or “Utility Constant” or
ε 12 < 0 ⇒ Gross Complements “Compensated” Demand Function
– Hicksian demand functions hold utility constant
Why estimate elasticities rather than just the
derivatives?—Elasticities are unitless. x1 = h ( p1 , p 2 , U )

Spring 2001 Econ 11--Lecture 7 5 Spring 2001 Econ 11--Lecture 7 6

Econ 11--Lecture 7 1
Professor Jay Bhattacharya Spring 2001

Hicksian vs. Marshallian

Hicksian Demand
Demand
x2 p1 p1 p1
Hicksian demand Hicksian demand
curves are steeper curves are flatter
for normal goods for inferior goods
Decreasing p1

DHicksian
DMarshallian
DHicksian DMarshallian
x1 x1 x1 x1
Spring 2001 Econ 11--Lecture 7 7 Spring 2001 Econ 11--Lecture 7 8

Hicksian Demand Functions Law of Demand

• Recall Slutsky Equation • Hicksian Demand Curves must slope down.
– Why? The substitution effect is negative.
dx1 dx dx
= − 1 x10 x2
dp1 dp1 Compensated
dI
• Hicksian (or Compensated or Utility constant
demand functions) yield the amount of good x1
purchased at prices p1 and p2 when income is just
high enough to get utility level u0.

(
x1 = h p1 , p 2 , u 0 ) x1
Spring 2001 Econ 11--Lecture 7 9 Spring 2001 Econ 11--Lecture 7 10

Calculating Hicksian Demand Calculating Hicksian Demand (II)

• For Hicksian demand, utility is held constant. • Suppose U0=U(x1, x2) is a utility function at
• The trick to calculating Hicksian demand is to use a given utility level U0
expenditure minimization subject to a constant
• Prices are p1 and p2.
level of utility, rather than utility maximization
subject to a constant level of income. • Total expenditures are p1x1 + p2x2
• Expenditure minimization is known as the “dual” • The expenditure minimization problem is:
problem to utility maximization. min p x + p x
x1 , x2 1 1 2 2

s.t. U ( x1 , x2 ) = U 0
Spring 2001 Econ 11--Lecture 7 11 Spring 2001 Econ 11--Lecture 7 12

Econ 11--Lecture 7 2
Professor Jay Bhattacharya Spring 2001

Net Complements and Net Substitutes

Calculating Hicksian Demand (III) • Assume 3 goods, x1, x2, and x3
• Define x1 and x2 as “net substitutes” if an
• We can set up the Lagrangian objective: increase in the price of good 2 leads to an
max L = p x + p x − λ (U ( x , x ) − U ) increase in the compensated demand for
x1 , x2 1 1 2 2 1 2 0
good 1.
• The solution to this problem will be two dx1
Hicksian demand functions: > 0 ⇒ net substitutes
dp2
x1 = h1 ( p1 , p2 ,U 0 )
* compensated

x2* = h2 ( p1 , p2 , U 0 )
Spring 2001 Econ 11--Lecture 7 13 Spring 2001 Econ 11--Lecture 7 14

Net Substitutes Net Complements

Increase in p2 Í • Define x1 and x2 as “net complements” if an
Increase in x1
increase in the price of good 2 leads to an
slope = −
p1 decrease in the compensated demand for
p2
good 1.

dx1
slope = −
p1 <0⇒ Net complements
p2′ dp2 compensated

Spring 2001 Econ 11--Lecture 7 15 Spring 2001 Econ 11--Lecture 7 16

Compensated Price and Income

Net Complements
Elasticities Of Demand
• Fact: All goods can’t be net complements.
dx1 I
ηI =
dI x1 p2 dx1
ε1s =
x1 dp2
Can’t draw this in a two p2 dx1 compensated
dimensional graph! ε12s =
x1 dp2 compensated

Spring 2001 Econ 11--Lecture 7 17 Spring 2001 Econ 11--Lecture 7 18

Econ 11--Lecture 7 3
Professor Jay Bhattacharya Spring 2001

Slutsky Equation
p1 dx1 dx1 p1 I
• The Slutsky Equation can also be written in = + x1 ⋅
x1 dp1 dI x1 I
terms of elasticities.
p1 dx1 p1 x1 I dx
dx1 dx1 dx1 = + ⋅
= + x1 x1 dp1 I x1 dI
dp1 compensate d
dp1 dI
ε 1s = ε 1 + S x η I
p1  dx1 dx1 
1
p1 dx1
=  + x1  Income
x1  dp1 dI 
Compensated price = Price elasticity + Share of * elasticity
x1 dp1 compensate d
elasticity of demand expenditure

Spring 2001 Econ 11--Lecture 7 19 Spring 2001 Econ 11--Lecture 7 20

The Consumer Price Index (CPI)
• What is the CPI?
• The CPI is an index which tells us how much it
would cost in current prices to buy a fixed bundle of
goods. Currently, we use a 1982-1984=100 base for
the CPI. This means we use the average bundle
purchased in the 1982 to 1984 period as a
“representative bundle of goods.”
– In Aug 1997, the CPI was 160.8. This means that it now
costs 1.608 times more to purchase “a representative
bundle” than it did in the 1982-1984 period.
• The inflation rate is the rate of change in the CPI
– In Aug 1996 the CPI was 157.3. Thus, the inflation rate
over this period was 2.23%
Issues
• Is the CPI a “true” cost-of-living index?
• If the CPI rose by 10% from 1986 to 1987 and
your income rose by the same 10%, are you worse
off, better off, or just as well off?
• Does the CPI overstate the “true” inflation rate?
• A few years, ago, Alan Greenspan, the Fed Chairman, stated
that the CPI overstates the “true” inflation rate by roughly .5 to
1.5%
• The Boskin Commission found that the CPI overstated
inflation by 1.1%. What do they mean?

Spring 2001 Econ 11--Lecture 7 21 Spring 2001 Econ 11--Lecture 7 22

A. Income needs to increase by π

0 0
Suppose I purchase x1 , x2 ( ) ( 0 0
in year 0 at prices p1 , p2 ) x2
I0
with income I0
p10

Budget constraint: x10 p10 + x20 p 20 = Ι I0

p20 (1 + π )
Suppose that both prices increase by the inflation rate π
p = p (1 + π )
1
1
0
1 p = p (1 + π )
1
2
0
2

Q. By how much will income have to increase in order to keep

me at my original level of utility?

I0 I0
x1
p10 (1 + π ) p10
Spring 2001 Econ 11--Lecture 7 23 Spring 2001 Econ 11--Lecture 7 24

Econ 11--Lecture 7 4
Professor Jay Bhattacharya Spring 2001

Now suppose that only the price of good 1 increases by 2π

p11 = p10 (1 + 2π ) p12 = p20 If the CPI is a good indicator of changes in

welfare resulting from changes in prices, then
restoring my ability to purchase the original
Furthermore, suppose I spend exactly ½ of my income on consumption bundle should leave me no better
good 1 in year 0. Thus off than before the price change. However, the
graph demonstrates that I will be better off.
I0 Thus CPI overestimates the “true cost of
p10 x10 = living”.
2
The increase in “CPI” is just the increase in the cost of
purchasing ( x10 , x20 )

( p (1 + 2π )x
0
1
0
1 ) ( )
+ p 20 x 20 − p10 x10 + p 20 x 20 = 2π p10 x10 = π I 0

Spring 2001 Econ 11--Lecture 7 25 Spring 2001 Econ 11--Lecture 7 26

Econ 11--Lecture 7 5