BRAC University, ESS; Fall 2011, THN ECO 203: Consumer Theory II Extensions The main topics to be covered

d in this set of lecture notes include: (i) demand curves and their properties; (ii) income and substitution eects and the Slutsky equation; (iii) income elasticities and types of goods; (iv) welfare measures; and (v) cross-price elasticites.

Demand Curves: Theoretically, the rst order conditions from the constrained utility maximization problem can be solved to obtain closed-form solutions or the demand functions for each good. These optimal quantities are the consumers quantity demanded of the various goods, x , x , ..., x , and in a two n 1 2 good world, the demand curves are given by: x = x (px , py , I) y = y (px , py , I) (1) (2)

In equations (1) and (2), x is the quantity demanded of good x, y is the quantity demanded of good y, px is the price of good x, py is the price of good y, and I is the income of the consumer. The above two demand functions are the equations of demand curves that we have studied in principles classes. If we assume specic forms for the utility function we will have a closed form solution for the demand curves in equation (1) and (2). For example, if we assume a Cobb-Douglas utility function of the form U = xa y 1a , the resultant demand equations will be as follows: x = aI px (1 a)I py

(3)

y =

(4)

Properties of Demand Curves: (i) the demand for each good depends only on its own price and income; (ii) the demand curves are negatively sloped (conforms to the law of demand, we can check that xx < 0 and yy < 0); (iii) the demand curves are homogeneous of degree zero in all p p prices and income; and (iv) a and (1 a) are the income shares spent on x and y respectively. Deriving the Demand Curves Graphically: The above demand curves can also derived graphically from the fact that the consumer chooses to buy dierent quantities of good x at dierent levels of px . As the price of good x decreases the budget line rotates further and further away from the origin and we can trace dierent combinations of optimal quantities of goods x and y. A line that connects all the optimal bundles of goods x 1

and y as price of only good x changes is known as the price consumption curve. These dierent quantities of good x can be plotted against the dierent prices of good x to obtain the negatively sloped demand curve for good x. Change in Income and Type of Goods: We know that changes in the consumers income (while prices of both goods remain the same) shift the demand curve for a good. But how does it happen? Consider there is an increase in income and we know as a result the budget line will shift outward or to the right. When the budget line shifts to the right we will have a new optimal bundle of goods at the same level of prices as before. This shift in demand will continue if there is another subsequent increase in income and the demand curve for both goods will continue to shift to the right. An income consumption curve traces all such optimal consumption bundles as the consumers income changes. And an Engel curve shows the relationship between quantity demanded of an individual good and income, holding prices constant. For normal goods, Engel curve is positively sloped. Normal vs. Inferior Good: Relationship between changes in income and changes in consumption also denes two types of goods: (i) If x () i > 0, I x () i < 0, I the good is a normal good; and

(ii) if

the good is an inferior good

Another way of determining the type of goods is to calculate income elasticity values. Income elasticities are generally used as a summary measure for the shapes of income consumption curves and Engel curves. Recall that income elasticity is the percentage change in quantity demanded of a good due to a given percentage change in income. The formula for income elasticity of good x is given by:
y

x x I I

x I I x

(5)

Range of values for income elasticities denes the various types of goods. A good with negative income elasticity, i.e., y < 0, is known as an inferior good. Inferior goods are ones for which your demand falls as your income increase, e.g., junk/fast food, potatoes, etc. Most other goods have positive income elasticities, i.e., y > 0, these goods are known as normal goods. Normal goods are ones for which your demand increases as your income increases, e.g., cars, wines, etc. Normal goods can also be distinguished into two further types: (i) necessities goods which have income elasticity values between 0 and 1 and inclusive, that is 0 y 1, e.g., beer, cigarettes, rice; and (ii) luxuries goods which have income elasticity values strictly greater than 1, that is y > 1, e.g., the 2009 BMW 335xi Coupe.

 Keep in mind that the above denitions of all the goods are relevant for a representative rational consumer whose underlying preferences always follow economic theory. Also, a good that is luxury for on individual could be a necessity for another individual depending on their relative perception of things and a host of other subjective factors. Change in Prices and the Slutsky Equation: Remember we are still in the world with two goods (x and y). Price of good x is given by px and price of good y is given by py . Now, consider a decrease in the price of good x (that is px has fallen) and the total eect consists of two smaller eects: Substitution eect: If utility is held constant, the consumer will now substitute more of good x with the cheaper good y. Substitution eect is always negative we will always buy more of the less expensive product, good x in this case. Income eect: With a decrease in px consumers real income (that is purchasing power) has increased, so he or she will buy more of at least one good. Income eect can be both positive and negative depending on whether we have a normal good or an inferior good. The Slutsky equation is a mathematical equation that shows the decomposition of the total eect of a price change into the above two eects. The Slutsky equation is given by: Total eect x px = Substitution eect x px + Income eect x x I (6)

where px is the price of x, and I is income. Graphically, we will look at eects of price changes for normal, inferior, and gien good. Compensated and Uncompensated Demand Curves: The demand curves that we have encountered so far are known as uncompensated or Marshallian demand curves; this curve shows the total price eect (the left side of equation (6)). Uncompensated demand curves, on the other hand, shows only the substitution eect of a price change, that is the term on the right side of (6). Mathematically, compensated demand curves are given by: x = xc (px , py , U ) Consumer Welfare: Economists and policy makers have always been and will always be interested to know how to compare changes in welfare across a broad group of consumers, such as how has a community of consumers been aected (better or worse o) as a result of a given government action or regulation. Recall from previous chapters that the one of the most important building block of consumer theory is the utility function. But individual utility functions are not observable in the market and it is not possible to compare utility values (such as utils of satisfaction) acrossconsumers. As a result we will introduce and discuss the following three measures of calculating changes in consumer welfare (all of which will show changes in consumers welfare measured in dollars): 3 (7)

 Consumer surplus Compensating variation Equivalent variation As long as we can somehow estimate a demand curve for the particular good in question we can calculate the above measures of surplus. But keep in mind that by saying a demand curve can be estimated we are implicitly assuming that: Consumers preferences are well behaved and follows all the assumptions we talked about in Chapter 3. When preferences are well behaved they can be translated to a well dened utility function. The indierence curves ensure that we can solve the constrained utility maximization problem and solve for the above demand curve for the product. Welfare Measures: Welfare or surplus is the additional amount of satisfaction or benet a consumer obtains from consuming (a unit of) a good over and above the cost of purchasing that (unit of the) good. In other words, if you are buying a unit of a good at a price which is lower than the benet you derive from that unit you are better o buying the unit of the good. Your true willingness-to-pay (referred to as WTP) is more than the actual price you pay in the market. Consider a situation where a consumer (Joe) is at his equilibrium the tangency between his indierence curve and the budget constraint. Now consider an increase only in the price of x, price increases from p0 to p1 , while py has remained unchanged. x x Consumer surplus is a dollar measure of the sum of the per unit surpluses from zero unit of the good to the number of units bought at the market equilibrium price. An individuals consumer surplus is measured by the area under the inverse demand curve and above the market price from zero units to the number of units the consumer buys. CS =
p1 x p0 x

x(px , py , I)dpx

(8)

Compensating variation is the amount of money that is needed to fully compensate for Joes loss in utility arising from the price increase. In other words, this is amount of money needed to keep Joe xed at his previous indierence curve: CV =
p1 x p0 x

dE =

p1 x p0 x

xc (px , py , U0 )dpx

(8a)

CV = E(p1 , py , U0 ) E(p0 , py , U0 ) x x

(8b)

Both these measures are calculating how better or worse o Joe is after the price increase. The important dierence between the two is that compensating variation is calculated at the original utility level and equivalent variation is calculated at the new utility level. Compensating and equivalent variations will be explained graphically. 4

Cross-Price Eects: In this class, we will focus on net substitutes and complements. Goods xi and xj will be net substitutes if: xi > 0, pj where U is held constant (9)

and, net complements if: xi < 0, pj where U is held constant (10)

where utility held xed means that we are only looking at the substitution eect of price changes. Exercises: 1. Assume the following utility function: U (x, y) = x0.3 y 0.7 (a) Derive the uncompensated demand functions for x and y and use them to compute the indirect utility function and the expenditure function. (b) Check the degree of homogeneity for each of the demand function computed in (a). (c) Use the expenditure function calculated in (a), together with the Shephards lemma, to compute the compensated demand function for good x. (d) Use the results from (c), together with the uncompensated demand function for good x, to show that the Slutsky equation holds for this case. 2. Assume the following utility function: U (x, y) = xy + y (a) Derive the uncompensated demand functions for x and y. And, describe how the two demand curves are shifted by changes in I or the price of the other good. (b) Check the degree of homogeneity for each of the demand function computed in (a). (c) Calculate the expenditure function for x and y. (d) Use the results from (c) to compute the compensated demand functions for x and y. Describe how the compensated demand functions for x and y are shifted by changes in income or by changes in the price of the other good.