Chapter 3 Demand Theory

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The Budget Constraint

Attainable

consumption bundles are bundles that the consumer can afford to buy. Attainable consumption bundles satisfy the following inequality known as the budget constraint.

p1x1 + p2x2 M
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Figure 3.1 Attainable consumption bundles

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Opportunity Cost, Real Income and Relative Prices

Rewriting the budget constraint by solving for X2 gives: x2 = M/p2 (p1/p2)x1 M/p2 is real income P1/P2 is the relative price

Where:

The relative price shows that the opportunity cost of good 1 is P1/P2 units of good 2. P1/P2 is the absolute value of the slope of the budget line.
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Endowments Rather Than Money

Sometimes an endowment of goods is assumed rather than cash. Sally owns apples x10 and eggs x20. Her budget constraint is:

p1x1 + p2x2 p1x10 + p2x20 Solving for x2: x2 = (p1x10 + p2x20)/p2 (p1/p2)/x1
As before, the budget constraint depends upon relative prices and real income (the endowment).
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Figure 3.2 The budget line with endowments

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The Choice Problem

The

non-satiation assumption implies that utility maximizing consumption lies on the budget line. The consumer choice problem is:
maximize U(x1, x2) by choice of x1 & x2 subject to constraint p1x1 + p2x2 = M

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Figure 3.3 Nonsatiation and the utilitymaximizing consumption bundle

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Demand Functions
X1* = D1(p1,p2, M) X2* = D2(p1,p2, M) These equations simply say that the choice of X1* and X2* depend upon the prices of all items in the consumption bundle and the budget devoted to that bundle.
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Graphic Analysis of Utility Maximization

Assume

indifference curves are smooth and strictly convex. Interior solution is where quantities of both goods are positive. Corner solution is one where the quantity of one good is positive and the quantity of the other is zero.
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Interior Solution

1.

2.

An interior solution is described by: P1x1* + P2x2* M, the optimal bundle lies on the budget line. MRS(X1*, X2*) P1/P2 , the slope of the indifference curve equals the slope of the budget line at the optimal bundle.

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Figure 3.4 The utility-maximizing consumption bundle

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Figure 3.5 Essential goods

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Corner Solutions
A

corner solutions graphically lies not in the interior between the two axis, but at a corner where the budget line intersects one of the two axes. For example, if at the point where the budget line intersects the X2 axis, the budget line is steeper than the indifference curve, only good 2 will be purchased.
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Figure 3.6 Inessential goods

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Excise Tax Versus Lump-Sum Tax

Given

a choice between a lump sum tax and an excise tax that raises the same revenue, the consumer will choose the lump sum tax (see Figure 3.7).

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Figure 3.7 Excise versus lump-sum taxes

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Figure 3.8 Cash transfer versus in-kind transfers

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Figure 3.9 Optimal consumption with endowments

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Figure 3.10 Normal and inferior goods

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Figure 3.11 Engel curves

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Figure 3.12 The consumption response to a

change in the price of another good

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Consumption Response to a Change in Price

The

price-consumption path connects the utility maximizing bundles that arise from a change in the price of p1 or p2. Note that when p1 changes, M and p2 are assumed to be constant. Likewise if p2 were to change, M and p1 are assumed to be constant.
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Figure 3.13 The price-consumption path and the demand function

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Elasticity
Elasticity

is a measure of responsiveness of the quantity demanded for one good to a change in one of the exogenous variables: price or income. Arc elasticity measures discrete changes in x1 when there is a discrete change in p1,p2 or M).
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Elasticity
By

allowing changes in the exogenous variables to approach zero gives marginal or point elasticity. Price elasticity of demand for a good is the elasticity of quantity consumed per capita with respect to the price of the good.

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Price Elasticity Formula

E11 (x1 / p1)( p1 / x1)

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Income Elasticity
The

income elasticity of demand is the elasticity of quantity consumed per capita with respect to income per capita.

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Income Elasticity Formula

E1m (x1 / M )( M / x1)

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Cross Price Elasticity

The

cross price elasticity of demand for good 1 with respect to the price of good 2, is the elasticity of per capita consumption of good 1 with respect to p2.

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Cross Price Elasticity Formula

E1m (x1 / p 2)( p 2 / x1)

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