Prerequisites

Prerequisites

Almost
Almostessential
essential
Consumer:
Consumer:Optimisation
Optimisation
Useful,
Useful,but
butoptional
optional
Firm: Optimisation
Firm: Optimisation

HOUSEHOLD DEMAND
AND SUPPLY
MICROECONOMICS
Principles and Analysis
Frank Cowell

April 2018 Frank Cowell: Household Demand & Supply 1

 Working out consumer responses
 The analysis of consumer optimisation gives us some
powerful tools:
• The primal problem of the consumer is what we are really
interested in
• Related dual problem can help us understand it
• The analogy with the firm helps solve the dual
 Use earlier work to map out the consumer's responses
• to changes in prices
• to changes in income

April 2018 Frank Cowell: Household Demand & Supply 2

 Overview
Household
Demand & Supply

Response
functions
The basics of the
consumer demand Slutsky
system equation

Supply of
factors

Examples

April 2018 Frank Cowell: Household Demand & Supply 3

 Solving the max-utility problem
 The primal problem and its solution
n
Lagrangean for the max U problem
max U(x) + m[y – S pi xi ]
i=1

U1(x*) = mp1
ü  The n + 1 first-order conditions,
U2(x*) = mp2
… … …
ý assuming all goods purchased
þ
n n(x ) = mpn
U *

S pixi* = y
i=1

 Solve this set of equations:

x1* = D1(p, y)
x2 = D (p, y)
* 2
ü Gives a set of demand functions, one
for each good: functions of prices and

… … …
ý incomes

xnn* = Dn(p, y) þ A restriction on the n equations. Follows

from the budget constraint
S pi Di(p, y) = y
i=1

April 2018 Frank Cowell: Household Demand & Supply 4

 The response function
 The response function for the primal Should be treated as just one
problem is demand for good i: of a set of n equations
xi* = Di(p,y)
 The system of equations must have Reason? Follows immediately
an “adding-up” property: from the budget constraint: left-
n hand side is total expenditure
Spi Di(p, y) = y
i=1

 Each equation in the system must be  Reason? Again follows from

homogeneous of degree 0 in prices and the budget constraint
income. For any t > 0:
xi* = Di(p, y )= Di(tp, ty)

To make more progress we need to exploit the relationship

between primal and dual approaches again
April 2018 Frank Cowell: Household Demand & Supply 5
 How you would use this in practice
 Consumer surveys
• data on expenditure for each household
• over a number of categories of goods
• perhaps income, hours worked as well
 Market data are available on prices
 Given some assumptions about the structure of preferences
• estimate household demand functions for commodities
• from this recover information about utility functions

April 2018 Frank Cowell: Household Demand & Supply 6

 Overview
Household
Demand & Supply

Response
functions
A fundamental
decomposition of Slutsky
the effects of a equation
price change
Supply of
factors

Examples

April 2018 Frank Cowell: Household Demand & Supply 7

 Consumer’s demand responses
 What’s the effect of a budget change on demand?
 Depends on the type of budget constraint
• Fixed income?
• Income endogenously determined?
 And on the type of budget change
• Income alone?
• Price in primal type problem?
• Price in dual type problem?
 So let’s tackle the question in stages
 Begin with a type 1 (exogenous income) budget constraint

April 2018 Frank Cowell: Household Demand & Supply 8

 Effect of a change in income
 Take the basic equilibrium
x2  Suppose income rises
The effect of the income increase

 Demand for each good does not

fall if it is “normal”

 x**
 But could the opposite happen?

x*

x1

April 2018 Frank Cowell: Household Demand & Supply 9

 An “inferior” good
 Take same market data, but
x2 different preferences
 Again suppose income rises
The effect of the income increase

 Demand for good 1 rises,

but…
 Demand for “inferior” good 2
falls a little

 Can you think of any goods

like this?

x*  x** How might it depend on the
categorisation of goods?

x1

April 2018 Frank Cowell: Household Demand & Supply 10

 A glimpse ahead…
 We can use the idea of an “income effect” in many applications
 Basic to an understanding of the effects of prices on the
consumer
 Because a price cut makes a person better off, as would an
income increase

April 2018 Frank Cowell: Household Demand & Supply 11

 Effect of a change in price
 Again take the basic equilibrium
x2
 Allow price of good 1 to fall
The effect of the price fall
The “journey” from x* to x**
broken into two parts

income
incomesubstitution
substitution
effect
effect effect
effect

° x**


x*

x1

April 2018 Frank Cowell: Household Demand & Supply 12

 And now let’s look at it in maths
 We want to take both primal and dual aspects of the problem…
 …and work out the relationship between the response
functions…
 … using properties of the solution functions
 (Yes, it’s time for Shephard’s lemma again…)

April 2018 Frank Cowell: Household Demand & Supply 13

 A fundamental decomposition
compensated
compensated ordinary
ordinary
demand
demand demand
demand

 Take the two methods of writing xi*:  Remember: they are two ways of
Hi(p,u) = Di(p,y) representing the same thing
 Use cost function to substitute for y: Gives us an implicit relation in
Hi(p,u) = Di(p, C(p,u)) prices and utility

 Differentiate with respect to pj :  Uses y = C(p,u) and function-of-a-

Hji(p,u) = Dji(p,y) + Dyi(p,y)Cj(p,u) function rule again

 Simplify : Using cost function and Shephard’s

Hji(p,u) = Dji(p,y) + Dyi(p,y) Hj(p,u) Lemma
 From the comp. demand function
= Dji(p,y) + Dyi(p,y) xj*
 And so we get:
 This is the Slutsky equation
Dji(p,y) = Hji(p,u) – xj*Dyi(p,y)

April 2018 Frank Cowell: Household Demand & Supply 14

* detail on slide can only be seen if you run the slideshow

The Slutsky equation

Dji(p,y) = Hji(p,u) – xj* Dyi(p,y)
 Gives fundamental breakdown
of effects of a price change

 Income effect: “I'm better off if

the price of jelly falls; I’m worse
off if the price of jelly rises. The
size of the effect depends on
how much jelly I am buying…
 x**  …if the price change makes me
better off then I buy more normal
 x* goods, such as ice cream”

 Substitution effect: “When the

price of jelly falls and I’m kept on
the same utility level, I prefer to
switch from ice cream for dessert”
April 2018 Frank Cowell: Household Demand & Supply 15
 Slutsky: Points to watch
 Income effects for some goods may have “wrong” sign
• for inferior goods…
• …get opposite effect to that on previous slide
 For n > 2 the substitution effect for some pairs of goods could
be positive
• net substitutes
• apples and bananas?
 While that for others could be negative
• net complements
• gin and tonic?
 Neat result is available if we look at special case where j = i

April 2018 Frank Cowell: Household Demand & Supply 16

 The Slutsky equation: own-price
 Set j = i to get the effect of the price of  Important special case
ice-cream on the demand for ice-cream
Dii(p,y) = Hii(p,u) – xi* Dyi(p,y)
 Own-price substitution effect must be  Follows from the results on
negative the firm

 This is non-negative for normal goods  Price increase means less

disposable income
 So the income effect of a price rise must
be non-positive for normal goods

 Theorem: if the demand for i does not

decrease when y rises, then it must
decrease when pi rises
April 2018 Frank Cowell: Household Demand & Supply 17
 Price fall: normal good
p1  The initial equilibrium
ordinary
 price fall: substitution effect
demand curve
compensated  total effect: normal good

D1(p,y) (Hicksian)  income effect: normal good

demand curve
H1(p,u)
initial
initial price
price
level
level
For normal good income effect
must be positive or zero
price
fall

x*1 x1**
x1

April 2018 Frank Cowell: Household Demand & Supply 18

 Price fall: inferior good
p1  The initial equilibrium

ordinary  price fall: substitution effect

demand curve  total effect: inferior good
 income effect: inferior good

compensated
initial demand curve
Note relative slopes of
initial price
price
level
level these curves in inferior-
good case
For inferior good income
price

effect must be negative

fall

x*1 x1** x1

April 2018 Frank Cowell: Household Demand & Supply 19

 Features of demand functions
 Homogeneous of degree zero
 Satisfy the “adding-up” constraint
 Symmetric substitution effects
 Negative own-price substitution effects
 Income effects could be positive or negative:
• in fact they are nearly always a pain

April 2018 Frank Cowell: Household Demand & Supply 20

 Overview
Household
Demand & Supply

Response
functions
Extending the
Slutsky analysis Slutsky
equation

Supply of
factors

Examples

April 2018 Frank Cowell: Household Demand & Supply 21

 Consumer demand: alternative approach
 Now for an alternative way of modelling consumer responses
 Take a type-2 budget constraint
• endogenous income
• determined by value of resources you own
 Analyse the effect of price changes
• will get usual income and substitution effect
• but an additional effect
• arises from the impact of price on the valuation of income

April 2018 Frank Cowell: Household Demand & Supply 22

 Consumer equilibrium: another view
x2  Type 2 budget constraint:
fixed resource endowment
Budget constraint with
endogenous income
 Consumer's equilibrium
Its interpretation

nn nn
{x: Spii xii  S pii Rii }
i=1
i=1 i=1
i=1
 Equilibrium is familiar:
so
so as
as to
to same FOCs as before
buy
buy more
more  x*
good
good 22
consumer
consumer sells
sells
some
some of good 11
of good
 R
x1

April 2018 Frank Cowell: Household Demand & Supply 23

 Two useful concepts
 From the analysis of the endogenous-income case
derive two other tools:
1. The offer curve:
• Path of equilibrium bundles mapped out by prices
• Depends on “pivot point” - the endowment vector R
2. The household’s supply curve:
• The “mirror image” of household demand
• Again the role of R is crucial

April 2018 Frank Cowell: Household Demand & Supply 24

 The offer curve
x2
 Take the consumer's equilibrium
 Let the price of good 1 rise
 Let the price of good 1 rise a bit
more
 Draw the locus of points

 x***
 This path is the offer curve
 x**
 Amount of good 1 that household
supplies to the market
 x*

 R
x1

April 2018 Frank Cowell: Household Demand & Supply 25

 Household supply
 Flip horizontally, to make
supply clearer
 Rescale the vertical axis to
measure price of good 1
 Plot p1 against x1
x2 p1

 This path is the

 x***
household’s supply curve
 x** of good 1

 x*  Note that the curve

“bends back” on itself
supply of supply of
 R good 1 good 1 Why?

April 2018 Frank Cowell: Household Demand & Supply 26

 Decomposition – another look
 Take ordinary demand for good i:  Function of prices and income
xi* = Di(p,y)
 Substitute in for y :  Income itself now depends on
xi* = Di(p, Sj pjRj) direct
direct effect
ppjj on
effect of
of prices
on demand
demand
 Differentiate with respect to pj :  The indirect effect uses function-
dxi* dy of-a-function rule again
— = Dji(p, y) + Dyi(p, y) —
dpj dpj indirect
indirect effect
effect of
of ppjjon
on
demand
demand viavia the
the impact
impact
on
on income
income
= Dji(p, y) + Dyi(p, y) Rj
 Now recall the Slutsky relation:  Just the same as on earlier slide
Dji(p,y) = Hji(p,u) – xj* Dyi(p,y)
 Use this to substitute for Dji:  This is the modified Slutsky
dxi* equation
— = Hji(p,u) + [Rj – xj*] Dyi(p,y)
dpj
April 2018 Frank Cowell: Household Demand & Supply 27
* detail on slide can only be seen if you run the slideshow

The modified Slutsky equation:

dxi*
── = Hji(p, u ) + [Rj – xj*] Dyi(p,y)
dpj

 Substitution effect has same interpretation as before

 Two terms to consider when interpreting the income effect
 The second term is just the same as before
 The first term makes all the difference:
• negative if the person is a net demander
• positive if the person is a net supplier

April 2018 Frank Cowell: Household Demand & Supply 28

 Overview
Household
Demand & Supply

Response
functions
Labour supply,
savings… Slutsky
equation

Supply of
factors

Examples

April 2018 Frank Cowell: Household Demand & Supply 29

 Some examples
 Many important economic issues fit this type of model :
• Subsistence farming
• Saving
• Labour supply
 It's important to identify the components of the model
• How are the goods to be interpreted?
• How are prices to be interpreted?
• What fixes the resource endowment?
 To see how key questions can be addressed
• How does the agent respond to a price change?
• Does this depend on the type of resource endowment?

April 2018 Frank Cowell: Household Demand & Supply 30

 Subsistence agriculture
x2  Resource endowment
includes a lot of rice
 Slope of budget constraint
increases with price of rice
 Consumer's equilibrium

 x1,x2 are “rice” and “other goods”

 Will the supply of rice to export
rise with the world price…?

 x*

supply
supply  R
x1

April 2018 Frank Cowell: Household Demand & Supply 31

 The savings problem
x2  Resource endowment is non-
interest income profile
 Slope of budget constraint
increases with interest rate, r
 Consumer's equilibrium
 Its interpretation

 x1,x2 are consumption “today”

and “tomorrow”
 Determines time-profile of
consumption
 What happens to saving
 x* when the interest rate
changes…?

saving
saving  R 1+
1+ rr
x1

April 2018 Frank Cowell: Household Demand & Supply 32

 Labour supply
x2  Endowment: total time & non-labour
income
 Slope of budget constraint is wage rate
 Consumer's equilibrium

 x1,x2 are leisure and consumption

 Determines labour supply

 Will people work harder if their wage

rate goes up?
 x* wage
wage
rate
rate
labour
labour
 R
supply
supply non-labour
non-labour income
income
x1

April 2018 Frank Cowell: Household Demand & Supply 33

 Modified Slutsky: labour supply
 Take the modified Slutsky:  The general form. We are going
dxi*
to make a further simplifying
— = Hii(p,u) + [Ri – xi*] Diy(p,y) assumption
dpi
 Let ℓ:=[Ri – xi*] be the supply of labour  Suppose good i is labour time;
and s the share of earnings in total then Ri – xi is the labour you sell
income y, Then we get: in the market (leisure time not
consumed);
. pi is the wage rate
dxi*

— = Hii(p,u) + ℓ Diy(p,y)
dpi
 Rearranging :  Divide by labour supply; multiply
.
pi dxi* pi y by (-) wage rate
– — — = – — H i(p,u) – s — Diy(p,y)
i
ℓ dpi ℓ ℓ
 Write as elasticities of labour supply:  The Modified Slutsky equation in
etotal = esubst + s eincome a simple form

April 2018 Frank Cowell: Household Demand & Supply 34

 Summary
 How it all fits together:

 Compensated (H) and ordinary (D) demand functions can be

hooked together.
 Slutsky equation breaks down effect of price i on demand for j
 Endogenous income introduces a new twist when prices change

April 2018 Frank Cowell: Household Demand & Supply 35

 What next?
 The welfare of the consumer
 How to aggregate consumer behaviour in the market

April 2018 Frank Cowell: Household Demand & Supply 36