LESSON FOUR: THE CONSUMER

4.0. Introduction
In this lesson, we now turn out attention to another economic agent, who creates demand

for goods and services produced by the firm. The firm is studied in the last three lessons.

4.1. Objectives
At the end of the lesson, the learner should:

• Distinguish between the different consumer demand functions.

• Be able to derive the different demand functions.

• Understand and demonstrate duality in consumption.

4.2. The Consumer Theory/Behavior.

The consumer behavior is modeled as a utility maximizing behavior. The

consumer is assumed to be rational i.e. given some income and prices of goods in the

market; the consumer is able to allocate the income between the goods so as to achieve

the highest possible satisfaction. All information about consumer level of satisfaction is

contained within a utility function. On the other hand, all the information pertaining to

the consumer’s ability to purchase the goods and services is contained in the budget line.

The consumer’s optimal choice is the point of tangency between the budget line

and the highest possible indifference curve. The convexity condition ensures a unique

solution for the consumer where the optimal choice involves a combination of goods.

Such a solution is referred to as an interior solution. There are however special cases,

where an interior solution is not possible.

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 C
Good X 2

B
Good X 1

(i) The concave utility functions.

At point A, the first order condition is met i.e. point of tangency. However, it’s not

the optimal choice for the consumer. Points B & C are the best affordable choices.

However the consumer can only consume either at point B or at point C. The

consumption of such goods is said to be mutually exclusive i.e. when you consume one,

the other one cannot be consumed. Such a solution (B or C) is called a back boundary

solution.

(ii) Kuhn Tucker Condition

This assumes that the consumer may not necessarily exhaust his/her income and

therefore the budget line is an inequality.

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 p1 x1 + p2 x2 ≤ M

The optimal choice occurs at a corner between the budget line and one of the

indifference curves and which is not a point of tangency. This is illustrated in the

diagram below.

Good X 2

Boundary solution

Good X 1

4.2.1. Consumer demand functions

There are two types of demand functions:

(i) Ordinary demand functions / uncompensated / Marshallian demand functions

(ii) Compensated / Hicksian demand functions

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4.2.1.1. The ordinary demand functions
A consumer’s ordinary demand function expresses the quantity demanded of a

product as a function of prices and income. xi ( pi m ) . It is derived from utility

maximizing problem.

e.g. Suppose the utility function is u ( x1 , x 2 ) = x1 x 2 where x1 and x 2 are two

goods. Let p1 and p 2 represent the prices of the two goods respectively. Let M

represent the consumer’s income.

The consumer seeks to maximize utility subject to the budget constraint.

max u = x1 x 2
st
p1 x1 + p 2 x 2 = M

L = x1 x 2 − λ( p1 x1 + p 2 x 2 − M )
∂L
= x 2 − λp1 = 0........( i )
∂x1
∂L
= x1 − λp 2 = 0.......... ..( ii )
∂x 2
∂L
= p1 x1 + p 2 x 2 − M = 0.......... (iii )
∂λ

Dividing the first two equations

x2 p
= 1
x1 p2
p2 x2
x1 =
p1
p1 x1
x2 =
p2

Substituting this into equation (iii)

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 p x 
p1  2 2  + p 2 x 2 = m
 p1 
2 p2 x2 = m
m
x 2* =
2 p2
px 
p1 x1 + p 2  1 1  = m
 p2 
2 p1 x1 = m
m
x1* =
2 p1

x1* andx 2* are the ordinary or Marshalian demand functions and we could verify that by

showing that their slopes are negative ;

∂x 2 −m
=
∂p 2 2 p 22
i.e.
∂x1 −m
=
∂p1 2 p12

There are two basic properties of the ordinary demand functions;

(i) They are single valued functions of prices and income.

(ii) They are homogeneous of degree zero in income and prices. i.e. if the prices

and income change by the same proportions, the demand remains unchanged.

4.2.1.2. The compensated demand functions

They are derived based on the concept of compensation i.e. following any change in

price, the consumer’s income is adjusted. There are two types of compensations,

(i) Hicksian compensation: - it assumes that after the price change, the

consumer’s income is adjusted so as to retain the same level of satisfaction.

(remains on the same indifference curve)

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 (ii) Slutskys compensation: - after a price change, the consumers income is

adjusted so that the initial consumption bundle is still affordable.

The compensated demand functions are derived from an expenditure minimization

problem and the quantity demanded is expressed as a function of prices and utility. i.e.

given the same information, the consumer seeks to;

min p1 x1 + p 2 x 2
st
U = x1 x 2
L = p1 x1 + p 2 x 2 − λ(U − x1 x 2 )
∂L
= p1 + λx 2 = 0.......... .( i )
∂x1
∂L
= p 2 + λx1 = 0.......... .( ii )
∂x 2
∂L
=U − x1 x 2 = 0.......... ...( iii )
∂λ

Dividing the first two equations;

p1 λx
= 2
p 2 λx 2
p1 x
= 2
p2 x1
p2 x2
x1 =
p1
p1 x1
x2 =
p2

Substituting into equation (iii)

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 px 
U = x1  1 1 
 p2 
p
U = 1 x12
p2
p2
x12 = U
p1
p 2U 
x1* = 
p1 
 Hicksiancompensated demand function
p1U 
x 2* =
p 2 

4.2.2. The indirect utility function

It represents the highest utility achieved by a consumer given some amount of

income. The function is obtained by substituting the ordinary demand functions into the

direct utility function. i.e.

V ( pi , m ) = U ( x1* , x1* )

m m
From the previous example, U = x1 x 2 and x1 = , x2 =
* *

2 p1 2 p2

 m m  m2
So that V ( pi , m ) =  *  = This is the indirect utility function from
 2 p1 2 p 2  4 p1 p 2

the above direct utility function.

4.2.3. Properties of indirect utility functions

(i) It is a single valued function of prices and income.

(ii) It is non-decreasing in income and non-increasing in prices.

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 (iii) It is homogenous of degree zero in prices and income.

Consider an indirect utility function V ( p i , m ) . Totally differentiating this function;

∂V ∂V
∂V = ∂pi + ∂m
∂pi ∂m
but∂V = 0
∂V ∂V
∂pi + ∂m = 0
∂pi ∂m
m = pi x1
∂m
= xi
∂pi
∂m = xi ∂pi
∂V ∂V
∂pi + xi ∂pi = 0
∂pi ∂m
∂V ∂V
xi ∂pi = − ∂pi
∂m ∂pi
 ∂V 
 ∂p 
xi ( pi , m ) = −  i  This is referrred to as the Roy' s identity
∂V
 
 ∂m 

The Roy’s identity is a tool used to recover the ordinary demand functions from

the indirect utility function.

Example

m2
Given the indirect utility function V ( p, m ) =
4 p1 p 2

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  ∂V 
 ∂p 
x1 = −  1
∂V 
 
 ∂m 
∂V m 2 p1−1 − m2
= =
∂p1 4 p2 4 p12 p 2
∂V 2m m
= =
∂m 4 p1 p 2 2 p1 p 2
 − m2 m 
x1 =  2 ÷ 
 4 p1 p 2 2 p1 p 2 
m2 2p p m
= 2
× 1 2 =
4 p1 p 2 m 2 p1

∂V − m2
=
∂p 2 4 p1 p 22
∂V m
=
∂m 2 p1 p 2
 − m2 m 
x 2 = − 2
÷ 
 4 p1 p 2 2 p1 p 2 
m2 2p p m
= 2
× 1 2 =
4 p1 p 2 m 2 p2

4.2.4. The consumer’s expenditure function

It provides the minimum expenditure of obtaining a given level of utility. It is

obtained by substituting the compensated demand functions into the expenditure

equation. i.e.

E ( p, U ) = p1 x1* + p 2 x 2*

p 2U * p1U
From the previous example x1 = x2 =
*

p1 p2

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 p 2U p1U
E = p1 + p2
p1 p2
1 1 1 1 1 1

E = U 2 p 22 p12 + U 2 p 22 p12
E = 2 Up 1 p 2 .......... This is the exp enditure function

4.2.5. Properties of expenditure function

(i) It is non-decreasing in prices.

(ii) It is homogenous of degree one in prices.

(iii) If xi ( pi , U ) is the expenditure minimizing demand that is necessary to

∂E ( p i , U )
achieve the level of utility U at prices p i , then, xi ( piU ) =
∂pi
(shepherds lemma)

Using the shepherd’s Lemma, we can recover the compensated demand functions.

e.g. Consider the expenditure function above E ( p, U ) = 2 Up 1 p 2

1 1 1
∂E
x1 = = 2U 2 p12 p 22
∂p1
1 1 1
−
= U p1 p
2 2 2
2

Up 2
x1* =
p1
1 1 1
x 2 = 2U 2 p12 p 22
1 1 1
−
= U 2 p12 p 2 2
Up 1
x 2* =
p2

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4.2.6. Relationship between the compensated and the uncompensated demand
functions

Price X H ( Hicksian demand curve )

X M ( Masharian demand curve )

Quantity

At point A, the income available for consumption will be equal to the minimum

expenditure on the two goods. i.e. the compensated (Hickisian) and the uncompensated

(Marshallian) demand functions yield the same results.

x H ( p iU ) = x M ( p i m ) but m = E ( piU )
x H ( p iU ) = x M ( p i E ( p i U ) )

Partially differentiating with respect to price,

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 ∂x H ( piU ) ∂x M ∂x ∂E
= + M ×
∂pi ∂pi ∂E ∂pi
∂x M ∂x ( p U ) ∂x M ∂E
= H i − ×
∂p i ∂pi ∂E ∂pi
∂x M ∂x ∂x ∂E ∂m
= H − M × but E = m therefore ∂E = ∂m & = xi
∂p i ∂pi ∂E ∂pi ∂pi
∂x M ∂x ∂x M
= H − xi .......... ...... This is referred to as the slutsky ' s equation
∂p i ∂pi ∂m

∂x M
Where is the total effect of a price change. It is measured by the slope of the
∂p i

ordinary demand function.

∂x H
is the substitution effect of a price change. It is measured by the slope of
∂p i

the Hicksian demand function. It is the change in demand resulting from a

price change but holding utility constant.

∂x M
− xi is the income effect of a price change. It may be positive or negative
∂m

depending on the nature of the good. e.g.

∂x M
a) >0 normal good and income effect is negative
∂m

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 ∂x M
b) <0 inf erior good and income effect is positive
∂m

m
x1M =
2 p1
Up 2
x1H =
p1
m
x2M =
2 p2
Up 1
x2H =
p2
∂xM −m
=
∂p1 2 p12
1 3 1
∂xH 1 −
= − U 2 p1 2 p22
∂p1 2

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 ∂x M 1
=
∂m 2 p1
1 3 1
−m 1 2 −2 2 1 m
2
= − U p1 p 2 − ×
2 p1 2 2 p1 2 p1
1 1 1
1 1 1
− 2U p p − m
2 2 2
= 1 2
but 2U p p = E = m
2
1
2 2
2
4 p12
−m−m
=
4 p12
− 2m − m
= =
4 p12 2 p12

4.2.7. Four important identities

(i) The minimum expenditure necessary to reach the maximum utility V ( p, m )

is the income m

E ( p, V ( p, m ) ) ≡ m
from the previous example , E ( p, u ) = 2 Up 1 p 2 ..... Exp function
m2
V ( p, m ) = .......... Indirect Utility function
4 p1 p 2
hence ,
m2
E ( p, V ( p, U ) ) = 2 p1 p 2
4 p1 p 2
m2
=2 =m
4

(ii) The maximum utility from the minimum expenditure E ( p, u ) is U .

V ( p, E ( p, U ) ) ≡ U
m2
V ( p, m ) = ≡U where m = E ( p,U ) = 2 Up1 p 2
4 p1 p 2
so that ,
2 Up1 p 2 ( 2 Up1 p 2 ) 2
= = =U
4 p1 p 2 4 P1 P2

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(iii) The Marshallian demand function at an income level m yields similar results

to the Hickisian demand function at the highest level of utility V ( p, m ) .

xiM ( p, m ) ≡ xiH [ p, V ( p, m ) ]
m
x1M =
2 p1
Up 2
x1H =
p1
m m2 p
≡ × 2
2 p1 4 p1 p 2 p1
m2 m
= 2
=
4 p1 2 p1

(iv) The Hicksian demand function at the utility level U , yields the same results

as the Marshallian demand function at the minimum expenditure E ( p, u )

xiH ( p, U ) ≡ xiM [ p, E ( p, U ) ]
m
x1 =
2 p1
Up 2
x1 =
p1
m = E ( p, U ) = 2 Up 1 p 2
2 Up 1 p 2
x1 =
2 p1
up 2
x1 =
p1

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 Note

A point of tangency between the consumer’s budget line and the indifference curve is

an equilibrium only if the indifference curve is strictly convex.

Question

1
In a two goods world, the marginal rate of substitution is − . If the two goods cost
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$1 each and the consumer’s income is $100 , how many units of each good will

maximize the consumer's utility? Suppose the price of one good changes to $2 , how

would the answer change.

Activity

Using a utility function of your choice, demonstrate the slutsky’s equation.

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 Summary

In this lesson, the consumer is depicted as an agent who allocates his/her income in

such a manner that maximum utility is derived by consuming goods and services. A

consumer who seeks to maximize utility subject to a given budget also succeeds in

minimizing expenditure subject to achieving highest possible utility.

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