Consumers’

Equilibrium
 The consumption decision
◎ Given the assumptions about utility and consumer’s feasible set, the consumer’s problem of
choosing the :most preferred bundle from those available can be formally stated as:

◎ We can derive the conditions which the solution to this problem must satisfy by a diagrammatic
analysis of the two-good case.
◎ The principal behavioral postulate is that a decision-maker chooses its most preferred alternative
from those available to it.
◎ The available choices constitute the choice set.
◎ How is the most preferred bundle in the choice set located/found?
◎ All commodities are assumed to have positive ◎
marginal utility so that bundles on higher
indifference curves are preferred to those on lower
indifference curves. This assumption also means
that the consumer will spend all his income since he
cannot be maximizing u if he can buy more of some
good with positive marginal utility. The consumer
will therefore choose a bundle on his budget line B.
◎ In the figure there is a tangency solution where the
optimal bundle x* is such that the highest attainable
indifference curve 𝐼1 is tangent to the budget line
and the consumer consumes some of both goods.
◎ The slope of the indifference curve is equal to the
slope of the budget line at the optimum:
◎

3
The negative of the slope of the indifference curve ◎ If the consumer spent an extra unit of
is the marginal rate of substitution 𝑀𝑅𝑆21 ; and the money on 𝑥1 he would be able to buy
1
negative of the slope of the budget line is the ratio units of 𝑥1 .
𝑝1
of the prices. Hence the consumer’s equilibrium
condition can be written as ◎ If consumption of 𝑥1 increases by ∆𝑥1 , the
utility of consumer will increase by 𝑢1 ∆𝑥1 .
◎ Thus, for an increase in spending of one
extra unit of money on 𝑥1 , the utility will go
𝑢
up by 1 , at the margin.
𝑝1

The consumer is in equilibrium (choosing an ◎ Similarly for an unit extra spending on 𝑥2 ,

𝑢
optimal bundle) when the rate at which he can utility will increase by 2 .
𝑝2
substitute one good for another on the market is
equal to the rate at which he is just content to ◎ At the margin a consumer equates his
substitute one good for another. marginal benefit from spending one extra
unit of money on 𝑥1 to 𝑥2 .
𝑢1 𝑢2
◎ Thus we get =
𝑝1 𝑝2

◎ Here 𝑢𝑀 is the marginal utility of income

that measures rate of change in utility for
one unit increase in income. 4
 Corner Point Solution

◎ Only one commodity is consumed in equilibrium: ◎

where the optimal bundle x* does not contain positive
amounts of all
◎ goods, as in Figure where no 𝑥2 is purchased. In this case
the indifference curve at x* is steeper than the budget line,
i.e. has a smaller slope (remembering that the indifference
curve and the budget line are negatively sloped).

◎ Also, in case of perfect substitute the commodity with

lowest price will be consumed. 5
Consumers’ Optimisation Problem

◎ Since due to non satiation assumption, we know consumers spend all their income, the
budget constraint will satisfy as equality 𝑝𝑖 𝑥𝑖 = 𝑀. Assuming utility functions and
feasible set are following all standard assumptions, hence consumers consumer a
positive quantity of all goods. Thus the non negativity constraints on consumption levels
are non binding, that is 𝑥𝑖 > 0.
The Lagrange function:

The first order conditions to the interior solutions are: Eliminating 𝜆

6
◎ Alternatively, the terms can be arranged as

◎ The value of the Lagrange multiplier λ is the rate at which the objective
function increases as the constraint parameter increases. In this case the
objective function is the utility function and the constraint parameter is the
individual’s money income so that λ is the rate at which utility increases as
money income increases.
◎
The Lagrange multiplier can be interpreted as the
marginal utility of money income, since, a we argued
above, ui /pi is the rate
at which utility increases as more money is spent on
good i.
7
 Second order condition of utility maximization: (n commodities and one constraint)

◎ A sufficient condition for a unique solution to an

unconstrained maximization is that the objective
function is strictly concave.
◎ For a constrained optimization problem sufficiency
condition for a unique solution requires that objective
function should be strictly quasi concave subject to
convex constraint set.

8
◎ In this case the unconstrained Lagrange function is maximized with respect to n+1 variables.
Concavity of L requires:
𝜕 𝐿2 𝜕2 𝐿 𝜕2 𝐿
⋯⋯⋯
𝜕𝜆2 𝜕𝜆𝜕𝑥1 𝜕𝜆𝜕𝑥𝑛
𝜕2 𝐿 𝜕2 𝐿 𝜕2 𝐿
◎ 𝜕𝑥1 𝜕𝜆 𝜕𝑥1 2
⋯⋯⋯
𝜕𝑥1 𝜕𝑥𝑛
⋮ ⋮ ⋯⋯ ⋮
𝜕2 𝐿 𝜕2 𝐿 𝜕2 𝐿
𝜕𝑥𝑛 𝜕𝜆 𝜕𝑥𝑛 𝜕𝑥1
⋯⋯ 𝜕𝑥𝑛 2
◎ The sufficiency condition of L to be concave or the maximum
of u(x) subject to the constraint set is found if the bordered
principal minors H1+j should have sign (-1)1+j j=1,2 n-1
such that Hn= H
9
 The two commodity case with one constraints

◎ The second order condition becomes

0  p1  p2
◎ H2 =  p1 L11 L12  0
 p2 L21 L22
2 p1 p2 L12  p12 L22  p22 L11  0
L12  L21 L ij  uij

◎ Reducing the condition will yield the following result:

◎ 2𝑢1𝑢2𝑢12 − 𝑢12 𝑢22 − 𝑢22𝑢11 >0
 Implication of the condition:

◎ The slope of the indifference curve is:

◎ 𝑑𝑥2
𝑑𝑥1
=−
𝑢1
𝑢2

◎ The convexity implies that as we reduce 𝑥2 and increase 𝑥1 indifference curves will become flatter implying
actual slope is higher. That is
◎ 𝑑𝑥2
𝑑𝑥1 𝑥 ′ ,𝑥 ′
>
𝑑𝑥2
𝑑𝑥1 𝑥 ′′ ,𝑥 ′′
where 𝑥1′ > 𝑥1′′ 𝑎𝑛𝑑 𝑥2′ < 𝑥2′′ . Since actual slope is rising, rate of change of slope must
1 2 1 2
be positive.
𝜕𝑢1 𝜕𝑢1 𝑑𝑥2 𝜕𝑢2 𝜕𝑢2 𝑑𝑥2
𝑢2 + −𝑢1 +
𝑑 2 𝑥2 𝜕𝑥1 𝜕𝑥2 𝑑𝑥1 𝜕𝑥1 𝜕𝑥2 𝑑𝑥1
◎ Taking total differentiation yields
𝑑𝑥12
=−
𝑢22

𝑑 2 𝑥2 𝑢12 𝑢22 +𝑢22 𝑢11 −2𝑢1 𝑢2 𝑢12

◎ Reducing the terms we get
𝑑𝑥12
= −
𝑢23
> 0 where 𝑢12 = 𝑢21

◎ This implies as we move along a negatively sloped indifference curve, with increasing the level of 𝑥1 and
reducing the level of 𝑥2 the rate of change in the slope increases and the indifference curves become flatter.
Which leads to convex to origin indifference curves along which marginal rate of substitution (𝑀𝑅𝑆21 ) falls.
◎ Thus second order condition actually implies that utility function is quasi concave.
Law of Diminishing MRS and Law of diminishing Marginal Utility:

◎ The law of diminishing marginal rate of substitution (DMRS) implies that indifference curves are
convex to origin or
𝑑 2 𝑥2 𝑢12 𝑢22 +𝑢22 𝑢11 −2𝑢1 𝑢2 𝑢12
◎ = − > 0 implying 2𝑢1 𝑢2 𝑢12 − 𝑢12 𝑢22 − 𝑢22 𝑢11 >0
𝑑𝑥12 𝑢23

◎ Law of diminishing marginal utility (DMU) implies that 𝑢11 and 𝑢22 are negative. Does
diminishing marginal utility leads to diminishing marginal rate of substitution? No, because even
if 𝑢𝑖𝑖 < 0, the sign of 𝑢𝑖𝑗 may be negative to make 2𝑢1 𝑢2 𝑢12 − 𝑢12 𝑢22 − 𝑢22 𝑢11 <0. Thus DMU does
not imply DMRS.
◎ Cardinal utility theory assumes that total utility is additively separable and utility derived form
each commodity is independent follows law of diminishing marginal utility. During the 19th
century and for much of the 20th century, many prominent scholars, including Jeremy Bentham
(1748–1832), thought that utility functions should provide cardinal information about preferences.
According to this view, people are “pleasure machines”—they use consumption goods as inputs
to produce utility as an output. Bentham and others argued that the aim of public policy should be
to maximize the total utility generated through economic activity.
◎ 𝐔 = 𝑵𝒊=𝟏 𝒖𝒊 (𝒙𝒊) , In this case as 𝒖𝒊𝒋=0, the DMU leads to DMRS.
12
◎
 ◎ Perfect complements:

Choice under non-convex preferences

Suppose 𝑢 = min 𝑥1 , 𝑥2 At the optimum 𝑥1 = 𝑥2 = 𝑥

13
Discrete good

◎ Suppose that good 1 is a discrete good that is

available only in integer units, while good 2 is
money to be spent on everything else. If the
consumer chooses 1, 2, 3, · · · units of good 1, she
will implicitly choose the consumption bundles
(1,m−p1), (2,m−2p1), (3,m−3p1), and so on.
◎ We can simply compare the utility of each of these
bundles to see which has the highest utility.
◎ As usual, the optimal bundle is the one on the
highest indifference “curve.” If the price of good 1 is
very high, then the consumer will choose zero units
◎ of consumption; as the price decreases the
consumer will find it optimal to consume 1 unit of
the good. Typically, as the price decreases further
the consumer will choose to consume more units of
good 1.

14
 Comparative Static Analysis

◎ The First order conditions for consumer's optimization problem :

◎ Solving these n+1 first order conditions we get Marshallian demand function for commodities as a function
of prices and money income and preference pattern of the consumer:

◎ Properties: First, provided that p, M are finite and positive, the optimization problem must have a solution,
since the requirements of the Existence Theorem are satisfied.
◎ Second, the differentiability of the indifference curves and the linearity of the budget constraint imply that
the optimal bundle will vary continuously in response to changes in prices and income, and that the demand
functions are differentiable.

15
 Third, the conditions of the Uniqueness
Theorem are satisfied and so the demand relationships are functions rather than
correspondences: a unique bundle is chosen at each (p, M) combination.

Finally, Marshallian demand curves are homogenous of degree zero in prices and income.
In general, a function is called homogeneous of degree k in a variables X, if 𝐹(𝜆𝑥1 , 𝜆𝑥2 ) = 𝜆𝑘 𝐹(𝑥1 , 𝑥2 )
if the particular case where 𝐹(𝜆𝑥1 , 𝜆𝑥2 ) = 𝐹(𝑥1 , 𝑥2 ).
is just the case where k = 0 so this is homogeneity of degree zero.
That is 𝐷𝑖 𝜆𝑝1 , 𝜆𝑝2 … … … . . 𝜆𝑝𝑛 , 𝜆𝑀 = 𝐷𝑖 (𝑝1 , 𝑝2 … … … . . 𝑝𝑛 , 𝑀)

The intuitive logic:

If all the prices and money income are increased by same proportion, the budget line of the consumer will
remain same. It will not have any shift or change in slope.
Since the feasible set of the consumer is not changing, the demand for commodities will remain same.
Thus, 𝐷𝑖 𝜆𝑝1 , 𝜆𝑝2 … … … . . 𝜆𝑝𝑛 , 𝜆𝑀 = 𝐷𝑖 (𝑝1 , 𝑝2 … … … . . 𝑝𝑛 , 𝑀)

16
Effect of Change in Income

◎ Suppose 𝐵1 in initial budget line where x* is chosen by the consumer.

◎ An increase in M, with 𝑝1 , 𝑝2 constant, will shift the budget line outward parallel with itself, say to 𝐵2
where 𝑥 ′ is chosen. A further increase in income will shift the budget line further to 𝐵3 where 𝑥 ′′ is
chosen
Normal Good: if an increase in money income, with prices
constant raises the demand for a commodity, we call it a
𝜕𝐷
normal good. For a normal good 𝜕𝑀𝑖>0. Hence income
𝜕𝐷𝑖 𝑀
elasticity is also positive. . >0.
𝜕𝑀 𝐷𝑖
Inferior Good:if an increase in money income, with prices
constant decreases the demand for a commodity, we call it an
𝜕𝐷
inferior good. For an inferior good 𝜕𝑀𝑖 <0. Hence income
𝜕𝐷𝑖 𝑀
elasticity is also negative. . <0.
𝜕𝑀 𝐷𝑖
The income consumption curve is the set of optimal points
traced out as income varies in this way, with prices constant.

17
 Income Effect
For movement from x* to 𝑥 ′ to 𝑥 ′′ , both goods are normal.
If we consider movement from x* to 𝑥 + , commodity 1 is normal but
commodity 2 in inferior.
If we move from x* to 𝑥 0 , commodity 2 is normal but commodity 1 in
inferior.
All goods cannot be inferior. If the consumer reduces demand for all
goods when income rises he will be behaving inconsistently.
To show this, let x* be the bundle chosen with an initial money income of 𝑀1
and x′ the bundle chosen when money income rises to 𝑀2 . If x≪x* i.e. if the
demand for all goods is reduced, then x′ must cost less than x* since prices
are held constant. x′ was therefore available when x* was chosen. But when ◎
x′ was chosen x* was still attainable (since money income had increased).
The consumer therefore preferred x* over x′ with a money income of 𝑀1 and
x′ over x* with money income 𝑀2 >𝑀1 . He is therefore inconsistent: his ICC1
behaviour violates the transitivity assumption and our model would have to be
rejected.

18
Engel curve

◎ For each level of income, M, there will ◎

be some optimal choice for each of the
goods. Let us focus on good 1 and
consider the optimal choice at each set
of prices and income, 𝐷1 (𝑝1 , 𝑝2 , 𝑀)
◎ This is simply the demand function for
good 1. If we hold the prices of goods 1
and 2 fixed and look at how demand
changes as we change income, we
generate a curve known as the Engel
curve. The Engel curve is a graph of the
demand for one of the goods as a
function of income, with all prices being
held constant. For

19
Engel curve for perfect substitute: Income consumption curve (ICC) will be either
horizontal axis or along vertical axis depending on the prices.

◎ If 𝑝1 < 𝑝2 the demand

for good 1 is
x1 = M/p1 in this case,
The Engel curve
will be a straight line with
a slope of p1,

20
Perfect complement goods where both goods are mixed at 1:1 ratio.

We have seen that the demand for good 1 is

x1 = m/(p1 + p2), so the Engel curve is a straight line with a
slope of (p1 + p2) as shown in the figure.

21
 Cobb-Douglas Preferences

◎ For the case of Cobb-Douglas preferences it is easier to look at the algebraic form of the demand functions to see what the graphs
will look like. If
◎ 𝑈 = 𝑥1𝛼 𝑥21−𝛼
◎ 𝑥1 =
𝛼𝑀
𝑝1

◎ For a fixed value of 𝑝1 , this is a linear function of M. Thus, doubling M will double demand, tripling M will triple demand, and so on.
◎ In fact, multiplying M by any positive number t will just multiply demand by the same amount.

22
 Quasilinear Preferences

◎ 𝑢 𝑥1 , 𝑥2 = 𝑣 𝑥1 + 𝑥2
◎ If preferences are quasilinear, we sometimes say that there is a “zero income effect” for good 1.
Thus the Engel curve for good 1 is a vertical line—as you change income, the demand for good 1
remains constant.

𝑥1

23
 Effects of a Price Change
 What happens when a commodity’s price
decreases?
– Substitution effect: the commodity is relatively cheaper, so
consumers substitute it for now relatively more than expensive other
commodities, while holding his real income constant
– Income effect: the consumer’s budget of M can purchase more than
before, as if the consumer’s income rose, with consequent income
effects on quantities demanded.
 The income effect, which is the change resulting solely from the change in real
 income, with relative prices held constant; and
 The own substitution effect, which results solely from the change in p1 with real
 income held constant.
Effects of a Price Change

Consumer’s budget is Rs. M.

x2
M Original choice
p2

x1
Effects of a Price Change

Consumer’s budget is M.
x2
Lower price for commodity 1
M pivots the constraint outwards.
p2

x1
 Effects of a Price Change

Consumer’s budget is Rs.M.

x2
Lower price for commodity 1
M pivots the constraint outwards.
p2
Now only M’ are needed to buy the
M'
original bundle at the new prices,
p2
as if the consumer’s income has
increased by Rs.M – Rs.M’.
Constant
Purchasing
power budget
line
x1
 Effects of a Price Change

◎ Changes to quantities demanded due to this ‘extra’ income

are the income effect of the price change.
 Effects of a Price Change
◎ Slutsky discovered that changes to demand from a price
change are always the sum of a pure substitution effect
and an income effect.
Real Income Changes

◎ Slutsky asserted that if, at the new prices,

○ less income is needed to buy the original bundle
then “real income” is increased
○ more income is needed to buy the original bundle
then “real income” is decreased
Real Income Changes

x2

Original budget constraint and choice

x1
Real Income Changes

x2

Original budget constraint and choice

New budget constraint

x1
Real Income Changes

x2

Original budget constraint and choice

New budget constraint; real
income has risen

x1
Real Income Changes

x2

Original budget constraint and choice

x1
Real Income Changes

x2

Original budget constraint and choice

New budget constraint

x1
Real Income Changes

x2

Original budget constraint and choice

New budget constraint; real
income has fallen

x1
Pure Substitution Effect

◎ Slutsky isolated the change in demand due only to the

change in relative prices by asking “What is the change
in demand when the consumer’s income is adjusted so
that, at the new prices, she can only just buy the original
bundle?”
Pure Substitution Effect Only (Slutsky Concept)
x2

x 2’

x 1’ x1
Pure Substitution Effect Only (Slutsky Concept)
x2

x 2’

x 1’ x1
 Pure Substitution Effect Only (Slutsky Concept)
x2

x 2’
Constant
Purchasing
power budget
line

x 1’ x1
Pure Substitution Effect Only (Slutsky Concept)
x2

Hypothetical
equilibrium on
Constant
x 2’ Purchasing
power budget
line
x2’’

x 1’ x1’’ x1
Pure Slutsky Substitution Effect Only
x2

x 2’

x2’’

x 1’ x1’’ x1
Pure Substitution Effect Only (Slutsky Concept)
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
x 2’

x2’’

x 1’ x1’’ x1
Pure Substitution Effect using Slutsky constant Purchasing power budget line Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
(x1’,x2’)  (x1’’,x2’’) is the
x 2’
pure substitution effect.
x2’’

x 1’ x1’’ x1
And Now The Income Effect
x2

x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
And Now The Income Effect
x2 The income effect is
(x1’’,x2’’)  (x1’’’,x2’’’).

x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
The Overall Change in Demand (Slutsky Concept)
x2 The change to demand due to
lower p1 is the sum of the
income and substitution effects,
(x1’,x2’)  (x1’’’,x2’’’).
x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
 Price effect using Hicksian compensated budget line
x2

x 2’
Hypothetical
budget line that
allows
consumer to
enjoy initial
level of utility

x 1’ x1
Pure Substitution Effect Only (Hicksian Concept)
x2 Hypothetical
equilibrium on
budget line that
allows
consumer to
enjoy initial
x 2’ utility level

x2’’

x 1’ x1’’ x1
Pure Hicksian Substitution Effect Only
x2

x 2’

x 2’

x 1’ x1’’ x1
Pure Substitution Effect Only (Hicksian Concept)
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
x 2’

x2’’

x 1’ x1’’ x1
Pure Substitution Effect using Hicksian constant utility budget line Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
(x1’,x2’)  (x1’’,x2’’) is the
x 2’
pure substitution effect.

x2’’

x 1’ x1’’ x1
And Now The Income Effect
x2

x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
And Now The Income Effect
x2 The income effect is
(x1’’,x2’’)  (x1’’’,x2’’’).

x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
The Overall Change in Demand ( Hicksian Concept)
x2 The change to demand due to
lower p1 is the sum of the
income and substitution effects,
(x1’,x2’)  (x1’’’,x2’’’).
x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
 Slutsky’s Effects for Normal Goods= Substitution effect+Income effect

◎ Most goods are normal (i.e. demand increases with

income).
◎ The substitution and income effects reinforce each
other when a normal good’s own price changes.
Slutsky’s Effects for Normal Goods

x2 Good 1 is normal because

higher income increases
demand

x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Normal Goods

x2 Good 1 is normal because

higher income increases
demand, so the income
and substitution
x 2’ (x1’’’,x2’’’)effects reinforce
each other.
x2’’

x 1’ x1’’ x1
 Slutsky’s Effects for Normal Goods

◎ Since both the substitution and income effects increase

demand when own-price falls, a normal good’s ordinary
demand curve slopes down.
◎ The Law of Downward-Sloping Demand therefore
always applies to normal goods.
 Slutsky’s Effects for Income-Inferior Goods

◎ Some goods are income-inferior (i.e. demand is

reduced by higher income).
◎ The substitution and income effects oppose each other
when an income-inferior good’s own price changes.
Slutsky’s Effects for Income-Inferior Goods

x2

x 2’

x 1’ x1
Slutsky’s Effects for Income-Inferior Goods

x2

x 2’

x 1’ x1
Slutsky’s Effects for Income-Inferior Goods

x2

Slutsky
compensated
constant purchasing
x 2’ power

x 1’ x1
Slutsky’s Effects for Income-Inferior Goods

x2

x 2’

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior Goods

x2
The pure substitution effect is as for
a normal good. But, ….

x 2’

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior Goods

x2 The pure substitution effect is as for a

normal good. But, the income effect is
in the opposite direction.
(x1’’’,x2’’’)
x 2’

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior Goods

x2 The pure substitution effect is as for a

normal good. But, the income effect is
in the opposite direction. Good 1 is
(x1’’’,x2’’’) income-inferior
x 2’ because an
increase to income
x2’’ causes demand to
fall.

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior Goods

x2
The overall changes to demand are
the sums of the substitution and
(x ’’’,x ’’’) income effects.
1 2
x 2’

x2’’

x 1’ x1’’ x1
Giffen Goods

◎ In rare cases of extreme income-inferiority, the income

effect may be larger in size than the substitution effect,
causing quantity demanded to fall as own-price
decreases.
◎ Such goods are Giffen goods.
Slutsky’s Effects for Giffen Goods

x2 A decrease in p1 causes
quantity demanded of
good 1 to fall.

x 2’

x1’ x1
Slutsky’s Effects for Giffen Goods

x2 A decrease in p1 causes
quantity demanded of
good 1 to fall.
x2’’’

x 2’

x1’’’x1’ x1
Slutsky’s Effects for Giffen Goods

x2 A decrease in p1 causes
quantity demanded of
good 1 to fall.
x2’’’

x 2’

x2’’
x1’’’x1’ x1’’ x1
Substitution effect
Income effect
Slutsky’s Effects for Giffen Goods

◎ Slutsky’s decomposition of the effect of a price change

into a pure substitution effect and an income effect thus
explains why the Law of Downward-Sloping Demand is
violated for extremely income-inferior goods.
Slutsky Equation

◎ Slutsky equation with Hicksian compensated price

change:

◎ Slutsky equation with Slutsky compendated price

change:
𝜕𝑞𝑖 𝜕𝑞𝑖 ∗ 𝜕𝑞𝑖
◎ = − 𝑞𝑖
𝜕𝑝𝑖 𝜕𝑝𝑖 𝐶𝑃 𝜕𝑚
 The Price Consumption Curve and the Demand Curve

◎ Suppose that we let the price of good 1 change while we hold 𝑝2

and income fixed. Geometrically this involves pivoting the budget
◎
line. We can think of connecting together the optimal points to
construct the price offer curve as illustrated in Figure.
◎ Again, holding the price of good 2 and money income fixed, and for
each different value of 𝑝1 plot the optimal level of consumption of
good 1. The result is the demand curve depicted in Figure. The
demand curve is a plot of the demand function, x1(p1, p2, m), 𝑝1
holding p2 and m fixed at some predetermined values.
◎ Ordinarily, when the price of a good increases, the demand for that
good will decrease. Thus the price and quantity of a good will move
in opposite directions, which means that the demand curve will
typically have a negative slope.

𝑥1
 Perfect Substitutes

◎ The offer curve and demand

curve for perfect substitutes—
the red and blue pencils
example—are illustrated in
Figure. The demand for good
1 is zero when p1 > p2, any
amount on the budget line
when p1 = p2, and m/p1 when
p1 < p2. The offer curve traces
out these possibilities.
◎ In order to find the demand
curve, we fix the price of good
2 at some price 𝑝2∗ and graph
the demand for good 1 versus
the price of good 1 to get
◎ the shape depicted in Figure.

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 Perfect Complements
◎
◎ The case of perfect
complements—the right and
left shoes example—is
◎ depicted in Figure . We know
that whatever the prices are, a
consumer will demand the
same amount of goods 1 and
2. Thus his offer curve will be
a diagonal line as depicted in
Figure

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Demand Curves

◎ The individual’s demand curve for a good shows how

desired or planned purchases of it vary as its price
varies, other prices and income being held constant.
◎ A distinction can be drawn between constant real and
constant money income and there are also two possible
definitions of constant real income.

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 The Marshallian constant money income demand curve
DD shows the effect of
◎ changes in p1 with M (and p2) held constant. It plots the
information contained in the price consumption curve. For
example, a fall in p1 from p″1 to p′1 with M constant
causes the consumer to shift from bundle x* to x′ and his
demand for x1 to rise from x*1 to x′1 .

The constant purchasing power demand curve gg

corresponds to the CP curve. The fall
in p1 from p″1 to p′1 with purchasing power constant
causes the consumer to shift from x* to x″ and his demand
to increase from x*1 to x″1 .
The Hicksian constant utility demand curve hh is derived
from the indifference curve I1. The fall in p1 with utility
constant at its initial level u(x*) causes the consumer to
shift from x* to x+, and his demand to increase from x*1 to
x+1

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