Topics in Consumer Behaviour

Instructor: Dyotona Dasgupta

October 21, 2018

Indirect Utility Function and Expenditure
Function

Suppose the optimal choices be x1∗ (p1 , p2 , M) and

x2∗ (p1 , p2 , M). The Indirect Utility Function (V ) is
 
V =U x1∗ (p1 , p2 , M), x2∗ (p1 , p2 , M) .

The individual’s Expenditure Function shows the

minimal expenditures necessary to achieve a given
utility level for a particular set of prices. That is,

Minimum Expenditure = e(p1 , p2 , U).

Reservation Price: Discrete Goods
◮ The price at which the consumer is just indifferent to
consuming or not consuming the good is called the
reservation price.
◮ Suppose r1 is the price where the consumer is just
indifferent between consuming 0 or 1 unit of good 1,
so it must satisfy the equation

u(0, M) = u(1, M − r1 ).

◮ Similarly, r2 satisfies the equation

u(1, M − r2 ) = u(2, M − 2r2 ).

Reservation Price: Discrete Goods with
Quasilinear Utility

◮ Suppose the utility function is quasilinear:

u(x1 , M) = v (x1 ) + M and suppose v (0) = 0.
◮ Then, we can write r1 = v (1) and r2 = v (2) − v (1).
◮ Implication of convex preference relation:
r1 > r2 > r3 > ...
Reservation Price: Discrete Goods with
Quasilinear Utility
◮ Suppose we observe that a consumer is buying 6
units of good 1 at price p.
◮ Also, suppose the consumer maximizes her utility.
◮ Can we say that r6 ≥ p1 ≥ r7 ?
◮ The consumer is utility maximizer:

v (6) + (M − 6p1 ) ≥ v (x1 ) + ((M − p1 x1 ).

◮ v (6) + (M − 6p1 ) ≥ v (5) + ((M − 5p1 )

⇒ r6 = v (6) − v (5) ≥ p1
◮ v (6) + (M − 6p1 ) ≥ v (7) + ((M − 7p1 )
⇒ p1 ≥ v (7) − v (6) = r7 .
◮ Hence, r6 ≥ p1 ≥ r7 .
Consumer’s Surplus
◮ The utility from consuming n units of the discrete
good is the area of the first n bars which make up the
demand function. This area is called the gross
benefit or the gross consumer’s surplus associated
with the consumption of the good.
◮ The consumer’s surplus or the net consumer’s
surplus measures the net benefits from consuming n
units of the discrete good:
CS = (r1 −p1 )+(r2 −p2 )+...+(rn −pn ) = (r1 +...+rn )−np1 = v (n)−n
◮ Alternative interpretation: How much money would
he need to induce him to give up his entire
consumption of this good?
◮ Let R denote that amount, then R must satisfy:
v (0) + M + R = v (n) + M − np1 ⇒ R = v (n) − np1 .
Consumer’s Surplus and Income Effect
◮ In general the price at which a consumer is willing to
purchase some amount of good 1 will depend on how
much money he has for consuming other goods.
◮ This means that in general the reservation prices for
good 1 will depend on how much good 2 is being
consumed.
◮ Since income effect of a quasiliniear utility function is
zero, the reservation prices are independent of the
amount of money the consumer has to spend on the
other good.
◮ This allows us to calculate utility in a simple manner.
◮ It may often be a good approximation when income
effect is low.
Change in Consumer’s Surplus due to
Change in Price

◮ Suppose, the price of good 1 changes from p1 to p1′ .

◮ There are 2 effects:
◮ The consumer pays more for all the units she
continues to consume.
◮ Due to the increase in the price of the good 1, the
consumer has decided to consume less of it than she
was before.
Equivalent Variation and Compensating
Variation

◮ Let p0 = (p10 , p20 ) and p1 = (p11 , p21 )

◮ e(p0 , u 0 ) = M and e(p1 , u 1 ) = M.
Equivalent Variation

The Equivalent Variation can be thought of as the

amount of money that the consumer would be
indifferent about accepting in lieu of the price change:
that is, it is the change in her wealth that would be
equivalent to the price change in terms of its welfare
impact.

EV (p0 , p1 , M) = e(p0 , u 1 ) − e(p0 , u 0 ) = e(p0 , u 1 ) − M.

◮ So, it is negative if the price change would make the

consumer worse off.
Compensating Variation

The Compensating Variation measures the net

revenue of the planner who must compensate the
consumer for the price change after it occurs,
bringing her back to her original utility level u ) .

CV (p0 , p1 , M) = e(p1 , u 1 ) − e(p1 , u 0 ) = M − e(p1 , u 0 ).

◮ Hence, it is negative if the planner would have to pay

the consumer a positive level of compensation
because the price change makes her worse off.
Index Number

Study Index Numbers on your own from Varian (Ch.

7).
Demand Elasticities

Own-Price Elasticity of demand (ǫii ): This measures

the proportionate change in quantity demanded in
response to a proportionate change in a good’s own
price.
∂xi /xi ∂xi pi
ǫii = = .
∂pi /pi ∂pi xi
Demand Elasticities

Income Elasticity of demand (ǫMi ): This measures the

proportionate change in quantity demanded in
response to a proportionate change in income.

∂xi /xi ∂xi M

ǫiM = = .
∂M/M ∂M xi
Demand Elasticities

Cross Price Elasticity of demand (ǫij ): This measures

the proportionate change in the quantity of good i
demanded in response to a proportionate change in
the price of good j.

∂xi /xi ∂xi pj

ǫij = = .
∂pj /pj ∂pj xi
Own Price Elasticity in details

◮ Consider the linear demand curve xi = a − bpi .

where a, b : constants.
−bpi −bpi
ǫii = = .
xi a − bpi
◮ When price is zero, the elasticity is zero.
◮ When xi = 0, the elasticity of demand is (negative)
infinity.
◮ At what value of price is the elasticity of demand
a
equal to −1? pi = .
2b
Elasticity and Demand

◮ An elastic demand curve is one for which the quantity

demanded is very responsive to price: if price is
increased by 1 percent, the quantity demanded
decreases by more than 1 percent.
◮ If a good has an elasticity of demand greater than 1 in
absolute value we say that it has an elastic demand.
◮ If the elasticity is less than 1 in absolute value we say
that it has an inelastic demand.
◮ If it has an elasticity of exactly −1, we say it has unit
elastic demand.
Elasticity and Total Revenue
◮ The price elasticity of demand determines how a
change in price, ceteris paribus, affects total
spending on a good.
◮ If the price of a good increases, then the quantity sold
decreases, so revenue may increase or decrease.
(Diagram)
◮ Total Revenue (R) is the price of a good times the
quantity sold of that good: R = pq

∂R ∂(pi xi ) ∂xi
= = pi + xi = xi [ǫii + 1].
∂pi ∂pi ∂pi
◮ So, the sign of this derivative depends on whether ǫii
is larger or smaller than −1.
Elasticity and Total Revenue

◮ If demand is inelastic (0 > ǫii > −1), the derivative is

positive and price and total spending move in the
same direction.
◮ Intuitively, if price does not affect quantity demanded
very much, then quantity stays relatively constant as
price changes and total spending reflects mainly
those price movements.
Elasticity and Total Revenue

◮ If demand is elastic (ǫii < −1), reactions to a price

change are so large that the effect on total spending
is reversed: a rise in price causes total revenue to fall
(because quantity falls a lot) and a fall in price causes
total revenue to rise (quantity increases significantly).
◮ For the unit elastic case (ǫii = −1), total spending is
constant no matter how price changes.