Lecture 5

Theory of the Consumer

(Essential, Luxury and Giffen Goods,)
 Essential and Luxury

• Impact of income effect and substitution effect

• For goods and services that a consumer cannot substitute easily,
a sizeable price change may have a significant income effect.
• Eg, when gasoline prices jumps dramatically in the United
States, consumers may reduce their driving somewhat, but are
unable to find a substitute for the essential needs served by
driving their cars.
• As a result, consumers experience a dramatic drop in wealth
available for other goods and services and consume generally
less of all of those to compensate for the greater expenditure on
gasoline.
 Giffen Goods

• Impact of income effect and substitution effect

• Normally, price increases result in less consumption of the
associated good or service, whereas price decreases results in
more consumption.
• This typical pattern is usually supported by both the
substitution effect and the income effect.
• An interesting exception is the case of Giffen goods, which is a
situation where consumption of a good or service may
increase in response to a price increase or decrease in
response to a price decrease
• This anomaly is explained by a strong income effect.
. Class Exercise: { Give Example of a giffen good}
 Robert Giffen

• An economist named Robert Giffen discovered that

Irish consumers increased the use of potatoes in their
diet during the Irish Potato Famine of the 1840s, even
though the price of potatoes rose dramatically.
• Basically, because potatoes were a staple of the Irish
diet, when the potato price increased, the wealth
available to purchase other food items diminished
and Irish consumers wanted to purchase more
potatoes to compensate for the diminished purchases
of other food items.
 Theory of the Consumer
Standard Economic Model Revisited

 General Assumptions
 • Consumer, buyers (or economic agents as
they are sometimes referred to) are rational.
 • More is preferred to less.
 • Buyers seek to maximize their utility.
 • Consumers act in self-interest and do not
consider the utility of others.
 Consumers face a constraint of their income
 Consumer Theory

• The aim of this lecture is to revisit and explain a

fundamental problem in economics,
• the derivation of a consumer’s demand function, in a very
simple way.
• The lecture is organized as follows:
• Conceptual review of assumptions in demand theory
• Description of the Utility Maximization Problem (UMP)
• Derivation of the Expenditure Minimization Problem
• Then students should be able to deduce the relationship
between both problems
 Assumptions

• The consumer theory assumes that the consumer is rational. This implies that his
preferences satisfy the following properties:
1) They are complete; that is, given any set of possible bundles of goods, the
consumer is always capable of deciding which one is preferable to the others and
then ranking them in terms of preference.
2) They are reflexive; it means that any bundle is at least as good as itself. In
algebra, the reflexive property of equality states that a number is always equal
to itself. Reflexive property of equality states that if a is a number, then a = a
3) They are transitive; meaning that if a bundle A is preferred to a bundle B, and
this bundle B is preferable to a third bundle C, then it is implied that the first
bundle A will be preferred to the bundle C.
 Assumptions 1-4 cont

4) They are continuous; there are no big jumps in the ranking of

alternatives, where a function is continuous there is at least one
maximum and one minimum. In other words, it must have at least
two extreme values. In mathematics, a continuous function is
a function that does not have any abrupt changes in value, known as
discontinuities. More precisely, sufficiently small changes in the input
of a continuous function result in arbitrarily small changes in its
output. If not continuous, a function is said to be discontinuous.
• The fulfillment of these properties ensures that consumer’s
preferences are consistent and can be represented by an utility
function, U(.) such that if bundle A is preferred to bundle B then 
U(A)>U(B)
 Indifference Curves
• The locus of all bundles that give a certain level of utility to
the consumer constitutes an indifference curve (or level
curve),
• which is the usual way of representing preferences.
• Nevertheless, in spite of these four properties, there is still
the possibility of having “special cases” such as the
existence of perfect substitutes or perfect complements,
among others, which lead to special shapes for the
indifference curves.
• For avoiding these cases, two additional properties are
assumed:
 Additional Properties

5) Preferences are monotonic, or “more is preferred to

less”; this implies that, given any set of two bundles,
if one of them contains at least as much of all goods
and more of one good than the other, then the first
bundle will be preferred to the second.
6) Preferences are convex; that is, any combination of
two equally preferable bundles will be more
desirable than these bundles.
• These five properties confer a special shape to level
curves: they are downward slopping and convex.
 Utility Maximization Problem

• This section develops the Utility Maximization Problem (UMP) for the simplest
case of only two goods.
• The model can easily be generalized to N goods
• Assume that there are two goods, x1 and x2 whose prices are p1 and p2
respectively.
• The consumer has a fixed amount of income, m for spending on consumption,
and his preferences are represented by a generic utility function U(x1,x2) with 
U1>0, U2>0,
• The consumer’s aim is to obtain the maximum possible utility but he is
constrained by his level of income.
• He cannot spend more than m, thus he faces a budget constraint: p1x1 + p2x2 = m
• NB Strictly, the constraint is p1x1 + p2x2 ≤ m, but the monotonicity assumption
ensures that he will spend all his income.
 Formal Representation
• Formally, the problem can be formulated as follows:
• Max U﴾x1,x2﴿ subject to P1X1 + P2X2 = m
• And it can be solved by the Lagrange Multipliers method:
• Max L = U(x1,x2) + λ( m- p1x1 - p2x2)
• {x1,x2 , λ}
• Lagrange multipliers are used in multivariable calculus to find
maxima and minima of a function subject to constraints (like "find
the highest elevation along the given path" or "minimize the cost
of materials for a box enclosing a given volume").
• In this case the constraint is the budget or wealth of the consumer
 First Order Conditions
• First Order Condition for a function of one variable to attain its maximum
value at some point, the. derivative at that point must be zero
• Therefore the first order conditions (FOC) are:
• L1= U1 - λP1 = 0
• L2 = U2 – λP2 = 0
• L λ = m- p1x1 - p2x2 =0
• Note that, conditions (1) and (2) = .

• That is, the marginal rate of substitution (MRS) must be equal to the
relation of prices,
• and it means that the indifference curve must be tangent to the budget
constraint.
 Second Order Conditions
• For instance, profit maximization arises when
the derivative of the profit function with respect to
an input is zero.
• This property is known as a first-order condition
A second characteristic of a maximum is that
the second derivative is negative (or no npositive).
This property is known as the second-order condition
• The second order conditions (SOC) are:
•  |Hu | =>0
 Second-order condition (SOC)

• Maximum: As you move up a curve from the

left, leading to a maximum, the curve gets
increasingly flatter, i.e. the slope gets smaller
and smaller.
• This means that f'' < 0.
• For example, if f' goes from 6 to 2,
it means that f'' < 0
 Demonstration of SOC
• It can be demonstrated that the SOC imply that indifference curves are
convex.
• The reciprocal is true only for the case of two goods.
• The solutions to the FOC are xM1, xM 2 , λM.
• They depend on prices and income, thus they can be written as xM1( p1, p2, m),
xM2( p2, p1, m), λM( m,p2, p1).
• The functions xM1 and xM 2, ˂ are the Marshallian Demand Functions.
• They represent the amount of goods  x1 and x2 that the consumer is willing to
purchase given their prices, income and tastes.
• In microeconomics, a consumer's Marshallian demand function (named after
Alfred Marshall) specifies what the consumer would buy in each price and
income or wealth situation, assuming it perfectly solves the utility
maximization problem.
 Indirect Utility Function
• Another concept that emerges from the UMP is
the Indirect Utility Function, and it can be obtained by
replacing the Marshallian demands into the utility
function.
• By definition, it also is a function of prices and income,
• then it can be written as U*( p1, p2, m) ≡ U(xM1( p1, p2,
m), xM2( p2, p1, m),
• Intuitively, it represents the maximum utility that the
consumer can achieve for any given values of p1,p2,m.
 Envelop Theorem
• Note that, because of the Envelop Theorem, it
must be the case that = λM( m,p2, p1).
• It implies that the Lagrange multiplier can be
thought as the marginal utility of income.
• That is, it represents the rate of change of the
maximum utility that is derived from an
infinitesimal rise in income.
 Expenditure Minimization Problem

• The Expenditure Minimization Problem (EPM) is the dual

problem of the UMP and it can be thought as follows.
Consider a consumer who gets utility through the
consumption of the two goods. In this case, there is no
restriction on the income to be spent, but the consumer
must be on a certain level curve,U0.
• Given this constraint, his objective is to reach this
indifference curve with the minimum possible expenditure.
• Therefore, the problem is:
• Min G = p1x1 + p2x2 subject to U﴾x1,x2) =U0
 Lagrange Multipliers method
• Again, this constrained optimization can be solved by
the Lagrange Multipliers method:
• Min  L = p1x1 + p2x2 +ᶙ﴾ U0- U﴾x1,x2)﴿
• {x1,x2, ᶙ}
• In mathematical optimization, the method of Lagrange
multipliers is a strategy for finding the local maxima
and minima of a function subject to equality constraints
(i.e., subject to the condition that one or more
equations have to be satisfied exactly by the chosen
values of the variables).
 Lagrange Multipliers method
• The increase in the production at the point of
maximization with respect to the increase in the value of
the inputs equals to the Lagrange multiplier,
• i.e., the value of λ∗ represents the rate of change of the
optimum value of f as the value of the inputs increases,
• Maximization of a function with a constraint is common
in economic situations.
• considers the problem in consumer theory of
maximization of the utility function with a fixed amount
of wealth to spend on the commodities.
 First Order Condition
• The FOC of this program are:
• L1= p1 - ᶙU1 =0
• L2= p2 - ᶙU1 =0
• Lᶙ = U0- U﴾x1,x2)
 FOC
• For a function of one variable to attain its
maximum value at some point, the. derivative
at that point must be zero.
• The necessary condition for a relative
extremum (maximum or minimum) is that the
first-order derivative be zero, i.e. f'(x) = 0.
 Second Order Condition
• And the SOC are:
 |HE | ˂0
• Note that conditions (5) and (6) imply the same
tangency condition than the UMP: =.
 Hicksian Demand Functions
• In this program, it means that the expenditure function must be
tangent to the indifference curve U0. Solving equations (5) and (7) gives
the optimal levels of xH1, xH2 , H.
• The demand functions xH1 and xH2 are the Hicksian (or Compensated)
Demand Functions.
• In microeconomics, a consumer's Hicksian demand correspondence is
the demand of a consumer over a bundle of goods that minimizes
their expenditure while delivering a fixed level of utility.
• If the correspondence is actually a function, it is referred to as
the Hicksian demand function, or compensated demand function.
• Note that these demands depend on prices and the utility level,
therefore they are denoted by xH1 (p1,p2,U0), xH2 (p1,p2,U0), ᶙH(p1,p2,U0).
 Indirect Expenditure Function
• The function resulting from replacing the Hicksian demands
into the expenditure function gives the minimum expenditure
necessary to reach U0 for any given values of p1,p2,U0
• It is called the Indirect Expenditure Function and is denoted E*≡
p1 xH1(p1,p2,U0)+ p2 xH2(p1,p2,U0).
• A consumer's indirect utility function is a function of prices of
goods and the consumer's income or budget.
• The function is typically denoted as v(p,m)
• where p is a vector of prices for goods,
• and m is a budget presented in the same units as the prices
 Envelop Theorem
• Again, the Lagrange multiplier has a special
interpretation.
• The Envelop Theorem implies that = ᶙH(p1,p2,U0),
• meaning that the Lagrange multiplier represents the
rate of change of the expenditure function given a
change in the utility level to reach.
 Is the Theory of the Consumer Realistic

• Strictly speaking, it would be difficult to make a case that

the theory of the consumer conforms to our own
experience of consumption decisions or what we observe
of other consumers. We don’t consciously weigh the
relative marginal utilities of tens of thousands of possible
goods and services we might consume. We don’t know all
the current prices and don’t even know of the existence
of many goods and services. Even if we did, the
computational complexity to solve for optimal
consumption would overwhelm our faculties, and
probably even the fastest computers available.
 Weaknesses of Consumer
Theory Analysis
• Many times we and others don’t think of our
consumption in terms of what gives us the
greatest satisfaction but in terms of what it
takes to get by.
• Consumers who are impoverished or suffer a
major ailment are probably unable to do even a
modest attempt at optimizing consumption.
• Others may simply consume as a matter of
habit rather than conscious choice.
 Weaknesses of Consumer and
Theory Bounded Rationality
• Although our consumption decisions may not
fully conform to the theory of the consumer,
there have been some attempts to argue that
we do approximate.
• Herbert Simon proposed a theory of bounded
rationality that states that humans do behave
rationally with a limited range of options.
 Bounded Rationality Cont
• So if consumers focus on a modest set of important goods
and services, they may be able to achieve something close
to the theoretical optimum in terms of overall utility.
• Simon also observed that human beings may not optimize
so much as they “satisfice,” meaning that they work to
meet a certain level of consumption satisfaction rather
than the very best pattern of consumption.
• If the level of acceptability is reasonably close to the
optimum level, again the results of consumption decisions
may approximate what would occur if the consumers
operated according to this theory.
 Differences between the Theory and Actual
Behaviour
• Another argument suggesting that differences between
the theory and actual behaviour may not result in starkly
different consumption is that we observe how others
behave.
• If someone else, either by active choice or by accidental
discovery, is experiencing greater satisfaction under similar
circumstances of wealth and income, their friends and
neighbours will detect it and start to emulate their
consumption patterns through demonstration effect.
• So our consumption may evolve in the direction of the
optimal pattern.