1.

3 Expenditure
minimization and
compensated demand

Expenditure minimization and compensated

demand
1. Definitions of compensated & uncompensated demand

2. Definition of the expenditure function & intuition

3. Homogeneity of the compensated demand and

expenditure functions

4. Compensated demand curves cannot slope upwards

5. Compensated demand & the expenditure function with

Cobb-Douglas utility

6. Income and substitution effects

1.3 Expenditure minimization and compensated demand 1

 Expenditure minimization and compensated
demand
7. Compensated demand & the expenditure function with
perfect complements

8. Compensated demand & the expenditure function with

perfect substitutes

9. Compensated demand & the expenditure function with

quasilinear utility

10. Properties of the expenditure function

11. The Slutsky equation

Expenditure minimization and compensated

demand

Why bother?
1. Income and substitution effects, essential for
understanding the effects of changes in wages and
taxes on labour supply and interest rates on savings.

2. Expenditure function, essential for consumer

surplus and welfare economics.

1.3 Expenditure minimization and compensated demand 2

 1. Definitions of
compensated and
uncompensated
demand

Definitions of compensated and

uncompensated demand
What we have been calling demand up to now is
uncompensated (Marshallian ) demand which
maximizes utility u given prices p1 and p2 and income m,
so is a function of p1, p2, m,

notation x1(p1,p2,m), x2(p1,p2,m).

Compensated (Hicksian) demand minimizes the cost of

obtaining utility u at prices p1 and p2 and is a function of
utility u, p1, p2, notation h1(p1,p2,u), h2(p1,p2,u).

1.3 Expenditure minimization and compensated demand 3

 To get uncompensated demand fix
x2
income and prices which fixes the
budget line.

Get onto highest possible

indifference curve.
0 x1

x2 To get compensated demand fix

utility and prices which fixes the
indifference curve and gradient of
budget line.
Get onto lowest possible budget
line.
0 x1 IC diagram

To get uncompensated demand fix

x2
income and prices which fixes the
budget line.

Get onto highest possible

indifference curve.
0 x1

x2 To get compensated demand fix

utility and prices which fixes the
indifference curve and gradient of
budget line.
Get onto lowest possible budget
line.
0 x1 IC diagram

1.3 Expenditure minimization and compensated demand 4

 2. Definition of the
expenditure function
and intuition

Definition of the expenditure function

The expenditure function E (p1, p2,u) is the minimum

amount of money you have to spend to get utility u with
prices p1 and p2. It is a function of p1, p2 and u.

The amount of goods which minimizes the cost of

getting utility u is compensated demand h1 (p1, p2,u),
h2 (p1, p2,u)

so E(p1, p2,u)= p1h1 (p1, p2,u) + p2 h2 (p1, p2,u).

1.3 Expenditure minimization and compensated demand 5

 Intuition for the expenditure function

A student buys 100 packs of sandwiches a year. The sandwich

price rises from £1 to £1.50. Could the student maintain the
same level of utility with

£50 more?

£60 more?

£40 more?

£20 more?

© Getty Images

(x1, x2), uncompensated

demand maximizes utility
x2 u subject to the budget
constraint at prices p1, p2.

u
m
( x1,x2)
p2

gradient – p1/p2

0 m x1
p1

IC diagram

1.3 Expenditure minimization and compensated demand 6

 (h1, h2), compensated
demand minimizes the
x2
cost of getting utility u at
prices p1, p2.

u
E(p1,p2,u)
( h1,h2)
p2

gradient – p1/p2

0 E(p1A,p2,uA) x1
p1

IC diagram

3. Homogeneity of the
compensated demand
and expenditure functions

1.3 Expenditure minimization and compensated demand 7

 Mathematical definition of homogeneous functions

A function f(z1,z2,z3…..zn) is homogeneous of degree zero if for all

numbers t > 0

f(tz1,tz2,tz3…..tzn) = t0 f(z1,z2,z3…..zn) = f(z1,z2,z3…..zn)

(You are using the fact that t0 = 1 here.)

Multiplying z1,z2,…..zn by t > 0 does not change the value of f .

reminder

Mathematical definition of homogeneous functions

A function f(z1,z2,z3…..zn) is homogeneous of degree one if for all

numbers t > 0

f(tz1,tz2,tz3…..tzn) = t1 f(z1,z2,z3…..zn) = t f(z1,z2,z3…..zn)

(You are using the fact that t1 = t here.)

Multiplying z1, z2 …zn multiplies the value of f by t

reminder

1.3 Expenditure minimization and compensated demand 8

 3. Homogeneity of the compensated
demand and expenditure functions
Compensated demand is homogeneous of degree 0 in
prices.

If t > 0 h1(tp1,tp2,u) = h1(p1,p2,u).

Expenditure function is homogeneous of degree 1 in prices.

If t > 0 E(tp1,tp2,u) = t E(p1,p2,u).

The next slides explain why.

x2 To get compensated demand fix

utility and prices which fixes the
indifference curve and gradient of
budget line.
Get onto lowest possible budget
line.
0 x1

Compensated demand depends on the indifference curve

and the slope –p1/p2 of the budget line.

Multiplying p1 and p2 by t does not change the slope so does

not change compensated demand so

h1(p1,p2,u) = h1(tp1,tp2,u) h2(p1,p2,u) = h2(tp1,tp2,u).

Compensated demand is homogeneous of degree 0 in

prices. IC diagram

1.3 Expenditure minimization and compensated demand 9

 The expenditure function is homogeneous of
degree 1: intuition
• If all prices are multiplied by t the cheapest way of
getting utility u doesn’t change.

• But the cost of the cheapest way of getting utility does

change: it is multiplied by t.

• The expenditure function is homogeneous of degree 1 in

prices.

The expenditure function is homogeneous of

degree 1: algebra
From the definition of the expenditure function

E(p1, p2,u)= p1h1 (p1, p2,u) + p2 h2 (p1, p2,u)

E(tp1, tp2,u)= tp1h1 (tp1, tp2,u) + tp2 h2 (tp1, tp2,u)

As h1(p1,p2,u) = h1(tp1,tp2,u), h2(p1,p2,u) = h2(tp1,tp2,u).

E(tp1, tp2,u) = t [p1h1 (p1, p2,u) + p2 h2 (p1, p2,u)] = t E(p1, p2,u).

1.3 Expenditure minimization and compensated demand 10

 Easy to lose exam marks
EC201 always requires explanations

Asked what happens to compensated demand and the

expenditure function when prices are multiplied by 2

saying nothing happens because compensated demand is

homogeneous of degree 0 in prices.

This is a statement of what happens – it is not an

explanation.

4. Compensated demand
curves cannot slope
upwards.

1.3 Expenditure minimization and compensated demand 11

 The slope of compensated demand
curves
The substitution effect of an increase in the price of a
good decreases or leaves unchanged the demand for
the good.

The compensated demand curve can never slope

upwards.
IMPORTANT
p1 RESULT
compensated
demand curve

0 x1
DC diagram
.

The logic of compensated

demand and the expenditure
function

1.3 Expenditure minimization and compensated demand 12

 Suppose you come to LSE 4 days a week and

• bus is the cheapest way of getting to LSE

• You always use the bus at a cost of 4*5 = £20 per week.

Therefore any other way of getting to LSE costs £20 or more.

Photo credit Antea Sieveking,

Wellcome Images

• By definition

compensated demand h1(p1,p2,u), h2(p1,p2,u)

is the cheapest way of getting utility u at prices p1, p2

and costs p1 h1(p1,p2,u) + p2 h2(p1,p2,u) = E(p1,p2,u)

• Therefore any other way of getting utility u costs the

same or more at prices p1, p2

• Thus if u(x1,x2) = u then E(p1,p2,u) ≤ p1x1 + p2x2

1.3 Expenditure minimization and compensated demand 13

 • The proof that compensated demand curves cannot
slope upwards can be done with geometry or algebra.

• You only need to know one of these proofs.

Compensated demand
curves cannot slope
upwards:
geometric proof

1.3 Expenditure minimization and compensated demand 14

 IC diagram (h1,h2) compensated
demand is by
definition the cheapest
way of getting utility u
x2
at prices (p1, p2).

(h1,h2)
slope At prices (p1, p2) any
- p1/p2 other way of getting
utility u must cost the
same or more than
0 x1
(h1,h2) so must lie on
or above the budget
This diagram graph has x1 and x2
line through (h1,h2)
on the axes and shows budget
constraints. with slope - p1/p2.

IC diagram (h1,h2) is by definition

the cheapest way of
getting utility u at
prices (p1, p2).
x2

(h1,h2) So at prices (p1, p2)

slope
any other (x1, x2) with
- p1/p2 utility u cannot lie in
the shaded area
0 x1 below the budget line
through (h1,h2) with
This diagram graph has x1 and x2 slope - p1/p2
on the axes and shows budget
constraints.

1.3 Expenditure minimization and compensated demand 15

 Geometric proof that the compensated
demand curve cannot slope upwards
Use notation h1A = h1(p1A,p2,u), h2A = h2(p1A,p2,u)

compensated demand with prices p1A,p2 and utility u.

Therefore u(h1A,h2A) = u.

h1B = h1(p1B,p2,u) h2B = h2(p1B,p2,u)

compensated demand with prices p1B,p2 and utility u.

Therefore u(h1B,h2B) = u.

h1A, h2A is the cheapest way of getting

utility u at prices p1A,p2

h1B,h2B is another way of getting utility u

therefore h1B,h2B cannot cost less than h1A,h2A at prices p1A,p2

1.3 Expenditure minimization and compensated demand 16

 IC diagram

x2

(h1A,h2A)
slope
- p1A/p2

0 x1

h1B,h2B cannot cost less than h1A,h2A at prices p1A,p2

so (h1B,h2B) cannot lie in the shaded area.

h1B, h2B is the cheapest way of getting

utility u at prices p1B,p2

u(h1A,h2A) = u so h1A,h2A is another way of getting

utility u

therefore h1B,h2B cannot cost more than h1A,h2A at prices

p1B,p2

1.3 Expenditure minimization and compensated demand 17

 IC diagram

x2

(h1A,h2A)
slope
- p1B/p2

0 x1
h1B,h2B cannot cost more than h1A,h2A at prices p1B,p2
so (h1B,h2B) cannot lie in the shaded area.

IC diagram
slope
- p1B/p2

x2

slope (h1A,h2A)

- p1A/p2

0 x1
Here p1B > p1A
(h1B,h2B) cannot lie in either shaded area
(h1B,h2B) must lies in the white triangle, so h1B ≤ h1A.

1.3 Expenditure minimization and compensated demand 18

 Remember the structure of the argument

• h1A, h2A is the cheapest way of getting

utility u at prices (p1A,p2)

• Use this to shade in an area where any other way of

getting utility u can’t be.

• As h1B, h2B give utility u it can’t be in this area.

Remember the structure of the argument

• As h1B, h2B is the cheapest way of getting utility u at

prices (p1B,p2) it can’t cost more than any other way of
getting utility u at these prices.

• In particular h1B, h2B can’t cost more than h1A, h2A at

prices (p1B,p2).

• Use this to shade in an area where h1B, h2B can’t be.

• Put the two shaded areas together in one diagram.

1.3 Expenditure minimization and compensated demand 19

 Compensated demand
curves cannot slope
upwards:
algebraic proof

Use notation

h1A = h1( p1A,p2,u) h2A = h2 (p1A,p2,u)

is compensated demand at prices p1A, p2.

h1B = h1( p1B,p2,u) h2B = h2 (p1B,p2,u)

is compensated demand at prices p1B, p2.

Remember the logic used here to derive the inequalities

1.3 Expenditure minimization and compensated demand 20

 h1A, h2A is the cheapest way of getting utility u at prices p1A, p2.

h1B, h2B is another way of getting utility u.

Thus p1Ah1A + p2h2A ≤ p1Ah1B + p2h2B

Remember the logic used here to derive the inequalities

h1B, h2B is the cheapest way of getting utility u at prices p1B, p2.

h1A, h2A is another way of getting utility u.

Thus p1Bh1B + p2h2B ≤ p1Bh1A + p2h2A

Remember the logic used here to derive the inequalities

1.3 Expenditure minimization and compensated demand 21

 Inequalities from the two previous slides

p1Ah1A + p2h2A ≤ p1Ah1B + p2h2B

p1Bh1B + p2h2B ≤ p1Bh1A + p2h2A

Add the inequalities to get

p1Ah1A + p2h2A + p1Bh1B + p2h2B

≤ p1Ah1B + p2h2B + p1Bh1A + p2h2A

Remember the logic used here and derive the inequalities

Everything that follows comes from simplifying this inequality.

Simplify the inequality from the previous slides

p1Ah1A + p2h2A + p1Bh1B + p2h2B

≤ p1Ah1B + p2h2B + p1Bh1A + p2h2A

Subtract p2h2A and p2h2B from both sides to get

p1Ah1A + p1Bh1B + ≤ p1Ah1B + p1Bh1A

Remember the logic used here and derive the inequalities

Everything that follows comes from simplifying this inequality.

1.3 Expenditure minimization and compensated demand 22

 From the previous slide

p1Ah1A + p1Bh1B + ≤ p1Ah1B + p1Bh1A

Rearrange to get p1A ( h1A – h1B) ≤ p1B ( h1A – h1B)

Note that ( h1A – h1B) appears so both sides of this inequality

so the inequality can be rewritten as

0 ≤ ( p1B - p1A ) ( h1A – h1B).

If the price rises from p1A to p1B so p1B - p1A > 0

either h1A – h1B = 0 so compensated demand does not change

or h1A – h1B > 0 so compensated demand falls.

5. Compensated
demand and the
expenditure function
with Cobb-Douglas
utility
Consumer Theory Worked example 4

1.3 Expenditure minimization and compensated demand 23

 Compensated demand and the expenditure
function with Cobb-Douglas utility

Step 1: What problem are you solving?

The problem is minimising expenditure p1x1 + p2x2 subject to

non-negativity constraints x1 ≥ 0 x2 ≥ 0

and the utility constraint u(x1,x2) = x12/5x23/5 ≥ u.

Step 2: What is the solution a function of?

Compensated demand is a function of prices & utility so is

h1(p1,p2,u) h2(p1,p2,u)

Finding compensated demand with Cobb-

Douglas utility
Step 3: Check for nonsatiation and convexity
We have already done this, both are satisfied.

Why does this matter?

See the next slide.

1.3 Expenditure minimization and compensated demand 24

 Essential logic

With nonsatiation and convexity

if there is a tangency
point such as A
x2 utility u
where MRS = p1/p2
and utility is u
A
this is compensated
demand
B
because any cheaper
point such as B gives
lower utility.
0 x1
IC diagram

Finding compensated demand with Cobb-

Douglas utility

Step 4: Use the tangency and utility

conditions
Tangency requires that MRS = p1

p2
here we have already found

∂u 2 −3 / 5 3 / 5
MRS = x1 x 2
∂x 5 2x 2
− 1 = − = −
∂u 3 2 / 5 −2 / 5 3x 1
x1 x 2
∂x 2 5

1.3 Expenditure minimization and compensated demand 25

 Finding compensated demand with Cobb-
Douglas utility

Step 4: Use the tangency and utility conditions

2x2 = p1
tangency condition
3x1 p2

utility condition x12/5 x23/5 = u

because if x12/5 x23/5 > u there is a

cheaper way of getting utility u or more.

Finding compensated demand with Cobb-

Douglas utility
Step 5: Draw a diagram based on the tangency and utility
conditions if you have not done so already.

x2 utility u

0 x1 IC diagram

1.3 Expenditure minimization and compensated demand 26

 Finding compensated demand with Cobb-
Douglas utility
Step 6: Remind yourself what you are
finding and what it depends on.
You are finding compensated demand h1 and h2
which are functions of p1, p2 and u.

Step 7: Write down the equations to be

solved.
The equations are x12/5 x23/5 = u and
2x2 = p1
3x1 p2

Finding compensated demand with Cobb-

Douglas utility
Step 8 solve the equations and write down
the solution as a function.
3/ 5 2/5
 2p   3p 
This gives x1 =  2  u x2 =  1  u
 3 p1   2 p2 
using notation h1 ( p1 , p2 , u ) h2 ( p1 , p2 , u )
for compensated demand
3/ 5 2/5
 2p   3p 
h1 ( p1 , p2 , u ) =  2  u h2 ( p1 , p2 , u ) =  1  u.
 3 p1   2 p2 
Note h1 ( p1 , p2 , u ) > 0, h2 ( p1 , p2 , u ) > 0.

1.3 Expenditure minimization and compensated demand 27

 Problems with the maths?

Mathematics for EC201

Example 1: working with indices.

Uncompensated and compensated demand

with Cobb-Douglas utility

Uncompensated demand
2m 3 m
x1 ( p1 , p2 , m) = x2 ( p1 , p2 , m) =
5 p1 5 p2
Compensated demand
3/ 5 2/5
 2p   3p 
h1 ( p1 , p2 , u ) =  2  u h2 ( p1 , p2 , u ) =  1  u.
 3 p1   2 p2 

1.3 Expenditure minimization and compensated demand 28

 ଷ/ହ
2‫݌‬ଶ
compensated demand ℎଵ = ‫ݑ‬
p1 3‫݌‬ଵ

2‫݌‬ଶ ିହ/ଷ
equation of compensated ‫݌‬ଵ = ‫ݑ‬ହ/ଷ ‫ݔ‬ଵ
3
demand curve

0 x1
Compensated demand curve with Cobb-Douglas utility
DC diagram

The expenditure function with Cobb-Douglas

utility
Compensated demand is
3/ 5 2/5
 2p   3p 
h1 ( p1 , p2 , u ) =  2  u h2 ( p1 , p2 , u ) =  1  u
 3 p1   2 p2 
so the expenditure function is
E ( p1 , p2 , u ) = p1h1 ( p1 , p2 , u ) + p2 h2 ( p1 , p2 , u )
3/ 5 2/5
 2p   3p 
= p1  2  u + p2  1  u
 3 p1   2 p2 
  2 3 / 5  3  2 / 5 
=p 2/5
p    +   u
3/ 5
1 2 3   2  


1.3 Expenditure minimization and compensated demand 29

 Check

Compensated demand is function of prices and utility.

It homogeneous of degree 0 in prices.

The expenditure function is a function of prices and utility.

It homogeneous of degree 1 in prices.

6. Income and
substitution effects

1.3 Expenditure minimization and compensated demand 30

 Income and substitution effects and
compensated and uncompensated
demand with Cobb-Douglas utility.

Income and substitution effects

The price of good 1

x2 increases from p1A to
p1B
Uncompensated
demand moves from A
to C.
C A

0 m/p1B m/p1A x1 IC diagram

1.3 Expenditure minimization and compensated demand 31

 Income and substitution effects

The price of good 1

x2 increases from p1A to
B
p1B
Compensated
demand moves from A
to B.
A

0 m/p1B m/p1A x1 IC diagram

Income and substitution effects

Prices are (p1B ,p2).

x2
B Income falls but prices
don’t change.
Uncompensated
demand moves from B
to C.
C

0 m/p1B m/p1A x1 IC diagram

1.3 Expenditure minimization and compensated demand 32

 Income and substitution effects
The price of good 1
increases from p1A to p1B.
x2 effect A to B,
B change in
demand due to
effect B to C,
change in
demand due
C A
effect A to C change
in
demand due to

0 m/p1B m/p1A x1 IC diagram

Uncompensated and compensated demand

with Cobb-Douglas utility

Uncompensa ted demand

2 m 3 m
x1 ( p1 , p 2 , m ) = x 2 ( p1 , p 2 , m ) =
5 p1 5 p 21
Compensate d demand
3/ 5 2/5
 2p   3p 
h1 ( p1 , p 2 , u ) =  2  u h2 ( p1 , p2 , u ) =  1  u.
 3 p1   2 p2 

1.3 Expenditure minimization and compensated demand 33

 Income and substitution effects with
Cobb-Douglas utility

∂x1 2 1
income effect = >0
∂m 5 p1

∂h1
3/ 5
 3  2 p  −8 / 5
substitution effect = −   2  p1 u<0
∂p1  5  3 

Income and substitution effects with

Cobb-Douglas utility

∂x1 p1
own price elasticity uncompensated demand = −1
∂p1 x1
∂x1 m
income elasticity uncompensated demand =1
∂m x1

You have already seen this.

1.3 Expenditure minimization and compensated demand 34

 Income and substitution effects with
Cobb-Douglas utility

3/ 5
 2p 
Writing h1 ( p1 , p2 , u ) as sp1−3 / 5 where s =  2  u
 3 
you can get
∂h1 p1 3
own price elasticity compensated demand =−
∂p1 h1 5

You can use income and substitution effects

to look at the impact of any change in the
budget constraint.

Income and substitution effects of a fall in the price of good 2.

1.3 Expenditure minimization and compensated demand 35

 x2
m/p2B’ Income and substitution effects
of a fall in the price of good 2
from p2A to p2B.
m/p2A
C
A

0 m/p1 x1

Fall in the price of good 2 moves the consumer from A to C.

IC diagram

x2
m/p2B’ Income and substitution effects
of a fall in the price of good 2
from p2A to p2B.
m/p2A
C
B
A

0 m/p1 x1
Substitution effect A to B, good 1 is relatively more expensive,
Consume less good 1.
Income effect B to C consumer is better off. If x1 is normal
consume more good 1.
IC diagram

1.3 Expenditure minimization and compensated demand 36

 x2
m/p2B’ Income and substitution effects
of a fall in the price of good 2
from p2A to p2B.
m/p2A
C
B
A

0 m/p1 x1

Income and substitution effects on x1 work in opposite

directions.
Here the income effect dominates, consumer more x1.

IC diagram

x2
m/p2B’ Income and substitution effects
of a fall in the price of good 2
from p2A to p2B.
m/p2A C
B
A

0 m/p1 x1

Income and substitution effects on x1 work in opposite

directions.
Here the substitution effect dominates, consume less x1.

IC diagram

1.3 Expenditure minimization and compensated demand 37

 7. Compensated demand
& the expenditure function
with perfect complements

Consumer Theory
Worked Examples 7

Compensated demand and the expenditure

function with perfect complements utility

u(x1,x2) = min( ½ x1,x2)

frames x1 bicycle wheels,
x2 x2 bicycle frames
x2 = ½ x1
if x2 < ½ x1 increasing x1
does not change utility

if x2 > ½ x1 increasing x1
increases utility.

wheels x1
IC diagram

1.3 Expenditure minimization and compensated demand 38

 Finding compensated demand with perfect
complements utility
u(x1,x2) = min( ½ x1,x2) = u
min( ½ x1,x2) = u
Expenditure minimization
implies that (x1,x2)

x2 lies at the kink of the

indifference curves so
x2 = ½ x1
x2 = ½ x1

and gives utility u so

½ x1 = x2 = u. IC diagram
0 x1
h1(p1,p2,u) = 2u, h2(p1,p2,u) = u.

Finding compensated demand with perfect

complements utility
u(x1,x2) = min( ½ x1,x2) = u
min( ½ x1,x2) = u
h1(p1,p2,u) = 2u, h2(p1,p2,u) = u.

Compensated demand does not

x2 depend on prices.
x2 = ½ x1

0 x1
IC diagram

1.3 Expenditure minimization and compensated demand 39

 p1
Compensated demand curve
with perfect complements

0 x1
With perfect complements compensated demand does
not depend on prices.

Compensated demand is completely inelastic.

The compensated demand curve is vertical. DC diagram

Income and
substitution effects with
perfect complements
utility

1.3 Expenditure minimization and compensated demand 40

 Income and substitution effects with perfect
complements utility

h1(p1,p2,u) = 2u, h2(p1,p2,u) = u.

The price of good 1
increases from p1 to p1’.
x2
There is
x2 = ½ x1

A The income effect

reduces demand for x1
C
and x2.

0 m/p1’ m/p1 x1
IC diagram

The expenditure function with perfect

complements utility

Compensated demand is
h1 ( p1 , p2 , u ) = 2u h2 ( p1 , p2 , u ) = u
so the expenditure function is
E ( p1 , p2 , u ) = p1h1 ( p1 , p2 , u ) + p2 h2 ( p1 , p2 , u )
= p1 2u + p2u = (2 p1 + p2 )u

1.3 Expenditure minimization and compensated demand 41

 8. Compensated
demand and the
expenditure function
with perfect substitutes
utility
Consumer Theory
Worked Example 9

Perfect substitutes utility

In general u(x1,x2) = ax1 + bx2

here u(x1,x2) = 3x1 + 2x2.

x2 indifference curves
u = 3x1 + 2x2
gradient – 3/2

0 x1

IC diagram

1.3 Expenditure minimization and compensated demand 42

 Perfect substitutes utility
x2
u/2
indifference curves
u = 3x1 + 2x2
slope – 3/2

0 u/3 x1

IC diagram

Black lines are indifference curves, gradient = 3/2.

Red lines are budget lines.
x2 x2 x2
A A
A

0 B x1 0 B x1 0 B x
B 1

p1/p2 < 3/2 p1/p2 = 3/2 p1/p2 > 3/2

solution at B solution on solution at A

indiff curve with x1 = 0
x1 = u/3 , x2 = 0
0 ≤ x1 ≤ u/3
x2 = u/2.

IC diagram

1.3 Expenditure minimization and compensated demand 43

 Black lines are indifference curves, gradient = 3/2.
Red lines are budget lines.
x2 x2 x2
A A
A

0 B x1 0 B x1 0 BB x
1

p1/p2 < 3/2 p1/p2 = 3/2 p1/p2 > 3/2

solution at B solution on solution at A

x1 = u/3 , x2 = 0 indiff curve with x1 = 0

0 ≤ x1 ≤ u/3
x2 = u/2.

IC diagram

Black lines are indifference curves, gradient = 3/2.

Red lines are budget lines.
x2 x2 x2
A A
A

0 B x1 0 B x1 0 B x
B 1

p1/p2 < 3/2 p1/p2 = 3/2 p1/p2 > 3/2

solution at B solution on solution at A

indiff curve with
x1 = u/3 , x2 = 0 x1 = 0
0 ≤ x1 ≤ u/3
x2 = u/2.

IC diagram

1.3 Expenditure minimization and compensated demand 44

 Black lines are indifference curves, gradient = 3/2.
Red lines are budget lines.
x2 x2 x2
A A
A

0 B x1 0 B x1 0 B x1

p1/p2 < 3/2 p1/p2 = 3/2 p1/p2 > 3/2

solution at B solution on solution at A

indiff curve with
x1 = u/3 , x2 = 0 x1 = 0
0 ≤ x1 ≤ u/3
x2 = u/2.

IC diagram

compensated
p1 demand
curve with
x2 perfect
substitutes
A
(3/2)p2

0 B x 0 (2m)/3p2 x1
1

indifference curve demand curve

If p1 > (3/2)p2 solution is at A, x1 = 0, x2 = u/2.

Expenditure p2 u/2 .

1.3 Expenditure minimization and compensated demand 45

 compensated
p1 demand
curve with
x2 perfect
substitutes
A
(3/2)p2

0 B x1 0 u/3 x1

indifference curve demand curve

If p1 = (3/2)p2 solution is at x1 with 0 ≤ x1 ≤ u/3.

Expenditure p1 u/3 = p2 u/2 .

compensated
p1 demand
curve with
x2 perfect
substitutes
A
(3/2)p2

0 B x1 0 u/3 x1

indifference curve demand curve

If p1 < (3/2)p2 solution is at x1 = u/3.

Expenditure p1 u/3.

1.3 Expenditure minimization and compensated demand 46

 compensated
If p1 > (3/2)p2, x1 = 0, x2 = u/2, p1 demand
curve with
Expenditure = p2u/2. perfect
substitutes

If p1 = (3/2)p2, 0 ≤ x1 ≤ u/3 (3/2)p2

expenditure p1u/3 = p2u/2.

0 u/3 x1

demand curve
If p1 < (3/2)p2, x1 = u/3, x2 = 0

expenditure p1u/3.

Expenditure = min (p1u/3, p2u/2)

DC diagram

9. Compensated
demand and the
expenditure function
with quasilinear utility
Consumer Theory: Worked example 4
Compensated demand with convexity and a
differentiable utility function.

1.3 Expenditure minimization and compensated demand 47

 With nonsatiation and convexity
Essential logic

x2 If there is a tangency
point such as A
where MRS = p1/p2
and utility is u
this is compensated
A
demand
because any cheaper
B point such as B gives
lower utility.
0 x1
IC diagram

With nonsatiation and convexity

Essential logic

x2
if there is a corner point
such as C where x2 = 0
utility = u
and MRS > p1/p2
this is compensated
demand
because any cheaper
D C point such as D gives
lower utility.
0 x1
IC diagram

1.3 Expenditure minimization and compensated demand 48

 Following the same logic as with Cobb-
Douglas gives
If u(x1 , x2 ) = x11/ 2 + x2
2
 p  p2
then x1 =  2  x2 = u −
 2 p1  2 p1
using notation h1 ( p1 , p2 , u ) h2 ( p1 , p2 , u )
for compensated demand
2
 p  p2
h1 ( p1 , p2 , u ) =  2  h2 ( p1 , p2 , u ) = u −
 2 p1  2 p1
if p1 < p2/(2u) then this formula makes h2 < 0. This is
impossible, in this case there is a corner solution.

The expenditure function with quasilinear

utility
p2
If p1 ≥ compensate d demand is
4u
2
 p  p
h1 ( p1 , p 2 , u ) =  2  h2 ( p1 , p 2 , u ) = u − 2
 2 p1  2 p1
so the expenditur e function is
E ( p1 , p 2 , u ) = p1h1 ( p1 , p 2 , u ) + p 2 h2 ( p1 , p 2 , u )
2
 p   p 
= p1  2  + p 2  u − 2 
 2 p1   2 p1 
p 22
= p2u −
4 p1

1.3 Expenditure minimization and compensated demand 49

 The expenditure function with quasilinear
utility
p2
If p1 < compensated demand is
2u
h1 ( p1 , p2 , u ) = u 2 h2 ( p1 , p2 , u ) = 0
so the expenditure function is
E ( p1 , p2 , u ) = p1h1 ( p1 , p2 , u ) + p2 h2 ( p1 , p2 , u )
= p1u 2 + p2 0 = p1u 2

Income and
substitution effects
quasilinear utility

1.3 Expenditure minimization and compensated demand 50

 Tangency and corner solutions:
compensated demand.

p2
If p1 ≥ there a tangency solution
2u
2
 p  p
h1 ( p1 , p2 , u ) =  2  h2 ( p1 , p2 , u ) = u − 2
 2 p1  2 p1
p
If p1 < 2 there is a corner solution,
2u
h1 ( p1 , p2 , u ) = u 2 h2 ( p1 , p2 , u ) = 0.

Tangency and corner solutions:

uncompensated demand.

p22 p22
If m ≥ or equivalently p1 ≥
4 p1 4m
there is a tangency solution
p22 m p
x1 ( p1 , p2 , m) = , x2 ( p1 , p2 , m) = − 2
4 p12 p2 4 p1

Reminder from notes 1.2.

1.3 Expenditure minimization and compensated demand 51

 Tangency and corner solutions:
uncompensated demand.

p22 p22
If m < or equivalently p1 <
4 p1 4m
there is a corner solution
m
x1 ( p1 , p2 , m) = , x2 ( p1 , p2 , m) = 0
p1

Reminder from notes 1.2.

p22
If p1 ≥
4m
there is a tangency solution for uncompensated demand.
p22
x1 ( p1 , p2 , m) = . does not depend on m.
4 p12
p2
If p1 ≥
4u
there is a tangency solution for compensated demand
p22
h1 ( p1 , p2 , u ) = . does not depend on u.
4 p12
Uncompensated & compensated demand are the same.

There is no income effect on demand for good 1.

1.3 Expenditure minimization and compensated demand 52

 Income consumption curve with quasilinear
utility
x2 At a tangency solution
When m ≥ p22
compensated
4p1 demand for good
1 depends only on prices
x1 = p22 tangency solution
4p12
uncompensated demand for
good 1 depends only on prices
income m has no effect
on demand for good 1
Income elasticity of demand for
good 1= 0.

0 x1 IC diagram

Income and substitution effects with

quasilinear utility at a point where x1 > 0, x2 > 0

∂x1
income effect =0
∂m

∂h1 1 −3
substitution effect = − p1 p22 < 0
∂p1 2

1.3 Expenditure minimization and compensated demand 53

 Income and substitution effects with
quasilinear utility
The price of good 1
x2 increases from p1A to p1B.
Substitution effect A to B
B
decreases x1
increases x2.
C A
Income effect B to C
does not change x1
decreases x2.
There is no income effect
on demand for x 1.
0 m/p1B m/p1A x1 IC diagram

Income and substitution effects with

quasilinear utility
The price of good 1
x2 increases from p1A to p1B.
Substitution effect A to B
B
decreases x1
increases x2.
C A
Income effect B to C
does not change x1
decreases x2.
There is no income effect
on demand for x 1.
0 m/p1B m/p1A x1 IC diagram

1.3 Expenditure minimization and compensated demand 54

 Income and substitution effects with
quasilinear utility
The price of good 1
x2 increases from p1A to p1B.
Substitution effect A to B
B
decreases x1
increases x2.
C A
Income effect B to C
does not change x1
decreases x2.
There is no income effect
on demand for x 1.
0 m/p1B m/p1A x1 IC diagram

10. Properties of the

expenditure function

1.3 Expenditure minimization and compensated demand 55

 Properties of the Expenditure Function

1. Increasing in utility

2. The expenditure function increases or does not

change when a price increases.

3. Homogeneous of degree 1 in prices.

4. Shephard’s lemma ∂E(p 1 ,p 2 ,u )

= h 1 (p 1 ,p 2 ,u )
∂p 1
5. Concave in prices

Definition of the expenditure function

The expenditure function E (p1, p2,u) is the minimum

amount of money you have to spend to get utility u with
prices p1 and p2. It is a function of p1, p2 and u.

The amount of goods which minimizes the cost of

getting utility u is compensated demand

h1 (p1, p2,u), h2 (p1, p2,u)

so E(p1, p2,u)= p1h1 (p1, p2,u) + p2 h2 (p1, p2,u).

1.3 Expenditure minimization and compensated demand 56

 1. The expenditure function is increasing in
utility
Utility increases
x2 from u1 to u2.
u1
E(p1,p2,u2) The expenditure
p2 u2
function increases.

E(p1,p2,u1)
p2

u2

u1
IC diagram 0 x1

2. The expenditure function increases or

does not change when prices increase
The price of good 1
x2 increases from p1A
E(p1B ,p2,u2) to p1B,
p2 compensated
demand moves
E(p1A ,p2,u1) from A to B.
p2 B
The expenditure
function increases.
A
The expenditure
function does not
change if demand
for good 1 is 0
before the price
IC diagram 0 x1 increase.

1.3 Expenditure minimization and compensated demand 57

 3: The expenditure function is homogeneous
of degree 1 in prices.
Compensated demand is homogeneous of degree 0 in
prices.

If t > 0 h1(tp1,tp2,u) = h1(p1,p2,u).

Expenditure function is homogeneous of degree 1 in prices.

If t > 0 E(tp1,tp2,u) = t E(p1,p2,u).

Already explained.

4. Shephard’s Lemma

∂E(p 1 ,p 2 , u )
= h 1 (p 1 ,p 2 , u )
∂p 1

You need to know the statement.

Proof is not examinable.

1.3 Expenditure minimization and compensated demand 58

 4. Shephard’s Lemma The next
slides
∂E(p 1 ,p 2 ,u ) explain
= h 1 (p 1 ,p 2 ,u )
∂p 1 this.
derivative of expenditure = compensated

function w.r.t. p1 demand for good 1

amount
gradient h1(p1A,p2,u)
spent
£ u constant
E(p1,p2,u)
p2 constant

p1 varies

0 p1A p1

4. Shephard’s Lemma
The diagrams in the discussion of Shephard’s lemma have

price on the horizontal axis

amount spent (expenditure) on the vertical axis.

amount
spent
£
E(p1,p2,u)

0 p1A p1

1.3 Expenditure minimization and compensated demand 59

 • By definition

compensated demand h1(p1,p2,u), h2(p1,p2,u)

is the cheapest way of getting utility u at prices p1, p2

and costs p1 h1(p1,p2,u) + p2 h2(p1,p2,u) = E(p1,p2,u)

• Thus if u(x1, x2) = u then E(p1,p2,u) ≤ p1x1 + p2x2 .

• In particular for all p1 E(p1,p2,u) ≤ p1 h1A + p2h2A where

h1A = h1(p1A,p2,u) and h2A = h2(p1A,p2,u)

And at prices p1A, p2

E(p1A,p2,u) = p1A h1A + p2h2A

• For all p1 E(p1,p2,u) ≤ p1 h1A + p2h2A where

h1A = h1(p1A,p2,u) and h2A = h2(p1A,p2,u)

• At prices p1A, p2

E(p1A,p2,u) = p1A h1A + p2h2A .

1.3 Expenditure minimization and compensated demand 60

 New diagram

In this diagram (h1A,h2A) u and p2 do not vary, p1 varies.

Cost of buying (h1A,h2A) at

prices (p1, p2) is p1h1A + p2 h2A

amount p1h1A + p2 h2A

spent
£ is a straight line
with gradient h1A
E(p1A,p2,u)

0 p1A p1 price

E(p1,p2,u) ≤ p1h1A + p2 h2A for all p1

E(p1A,p2,u) = p1Ah1A + p2 h2A.

The graph of E(p1,p2,u) cannot be anywhere inside

the shaded area.

amount p1h1A + p2 h2A slope h1A

£
spent
£

E(p1A,p2,u)

0 p1A p1 price good 1

1.3 Expenditure minimization and compensated demand 61

 E(p1A,p2,u) = p1Ah1A + p2 h2A

The graph of E(p1,p2,u) meets the line

p1h1A + p2 h2A at ( p1A, E(p1A,p2,u) )

amount p1h1A + p2 h2A slope h1A

£
spent
£
E(p1,p2,u)
E(p1A,p2,u)

0 p1A p1 price

The line p1h1A + p2 h2A with slope h1A

is tangent to the curve E(p1,p2,u) when p1 = p1A.

The slope of the tangent is the derivative of E(p1,p2,u) w.r.t. p1.

amount p1h1A + p2 h2A slope h1A

£
spent
£
E(p1,p2,u)
E(p1A,p2,u)

0 p1A p1 price

1.3 Expenditure minimization and compensated demand 62

 Shepard’s Lemma

The derivative of the expenditure function

E(p1,p2,u) with respect to p1

is compensated demand for good 1

∂E(p 1 ,p 2 ,u )
= h 1 (p 1 ,p 2 ,u )
∂p 1

5. The expenditure function is concave

in prices
£
amount
spent
£

E(p1,p2,u)

because the graph of the

expenditure function lies on or below
all its tangent lines.

0 p1

1.3 Expenditure minimization and compensated demand 63

 11. The Slutsky equation

11. The Slutsky equation

When m = E( p1, p2 , u)

∂x1 ( p1 , p2 , m) total effect of change in price

on demand at constant
∂p1 income

∂h1 ( p1, p2 , u) ∂x1 ( p1 , p2 , m)

= − x1 ( p1 , p2 , m)
∂p1 ∂m

substitution effect income effect of

of change in price change in
on demand, at - income on
constant utility demand

1.3 Expenditure minimization and compensated demand 64

 Why bother with the Slutsky Equation?

It is the only way of knowing how big income and

substitution effects are.

Combined with elasticity estimates it tells us that income

effects are too small to bother with except for goods that
are a large proportion of the budget.

h1(p1, p2,u) compensated demand for good 1.

x2
x 1(p1, p2,m) uncompensated demand for good 1.
B

C A gradient – (p1 + ∆p1)/p2

gradient – p1/p2

0 x1
A to B, change in compensated demand. This is the
substitution effect.

B to C income effect. This is the shift in uncompensated

demand when income m changes. IC diagram

1.3 Expenditure minimization and compensated demand 65

 x2 Reminder: special cases
Quasilinear utility

Uncompensated demand for good

1 does not depend on income
except at low levels of income and
is equal to compensated demand.
x1
No income effect.
x2
Perfect complements utility

Compensated demand does not

depend on prices. No substitution
effect.
x1 IC diagram

Intuition for the Slutsky Equation

When p1 rises to p1 + ∆p1 this is as if income falls by x1 ∆p1
because this is how much more it costs to buy x1, so the
effective change in income is ∆m = -x1 ∆p1 .

The change in x1 through the income effect is approximately

∂x1 ∂x1
∆m = − x1 ∆ p1
∂m ∂m
The change in x∂1 h
through ∂ x effect
the substitution is
Total ∆ x
change≈
approximately ∂ p
1
∆ p − 1
x ∆ p
∂m
1 1 1 1

∂h
1
∂x1 ∂h1 1
∆∂ px1 1
= ∂ p −1 x1
∂p1 ∂p1 ∂m
so

1.3 Expenditure minimization and compensated demand 66

 Intuition for the Slutsky Equation
Total change

∂h ∂x1
∆ x1 ≈ 1
∆ p − x1 ∆ p
∂p ∂m
1 1
1

Thus the Slutsky equation

∂x1 ∂h1 ∂x1

= − x1
∂p1 ∂p1 ∂m

Calculus proof of the Slutsky equation, not for EC201

h1 ( p1 , p2 , u ) = x1 ( p1 , p 2 , m ) when m = E ( p1 , p2 , u )
so from the chain rule for partial derivative s
∂h1 ( p1 , p 2 , u ) ∂x1 ( p1 , p 2 , m ) ∂x1 ( p1 , p2 , m ) ∂E ( p1 , p2 , u )
= +
∂p1 ∂p1 ∂m ∂p1
∂E ( p1 , p 2 , u )
But = h1 ( p1 , p 2 , u ) (Shephard' s lemma).
∂p1
As h1 ( p1 , p2 , u ) = x1 ( p1 , p2 , m ) this implies that
∂h1 ( p1 , p 2 , u ) ∂x1 ( p1 , p 2 , m ) ∂x1 ( p1 , p2 , m )
= + x1 ( p1 , p2 , m ) .
∂p1 ∂p1 ∂m
Rearrangin g
∂x1 ( p1 , p 2 , m ) ∂h1 ( p1 , p 2 , u ) ∂x1 ( p1 , p 2 , m )
= − x ( p , p , m) .

1.3 Expenditure minimization and compensated demand 67

 h1 ( pCalculus = x1of
1 , p 2 , u ) proof ( pthe , m ) when
1 , p 2Slutsky m = not
equation, E ( p1for
, p2 , uEC201
)
so from the chain rule for partial derivative s
∂h1 ( p1 , p 2 , u ) ∂x1 ( p1 , p 2 , m ) ∂x1 ( p1 , p2 , m ) ∂E ( p1 , p2 , u )
= +
∂p1 ∂p1 ∂m ∂p1
∂E ( p1 , p 2 , u )
But = h1 ( p1 , p 2 , u ) (Shephard' s lemma).
∂p1
As h1 ( p1 , p2 , u ) = x1 ( p1 , p2 , m ) this implies that
∂h1 ( p1 , p 2 , u ) ∂x1 ( p1 , p 2 , m ) ∂x1 ( p1 , p2 , m )
= + x1 ( p1 , p2 , m ) .
∂p1 ∂p1 ∂m
Rearrangin g
∂x1 ( p1 , p 2 , m ) ∂h1 ( p1 , p 2 , u ) ∂x1 ( p1 , p 2 , m )
= − x1 ( p1 , p2 , m ) .
∂p1 ∂p1 ∂m

The Slutsky Equation in elasticities

Start with the Slutsky equation

∂x1 ∂h1 ∂x1
= − x1
∂p1 ∂p1 ∂m

‫݌‬ଵ ‫݌‬ଵ
multiply by =
‫ݔ‬ଵ ℎଵ

∂x1 p1 ∂h1 p1 ∂ x 1 m  p1 x1 
= −  
∂p1 x1 ∂p1 x1 ∂ m x1  m 

1.3 Expenditure minimization and compensated demand 68

 The Slutsky equation in elasticities

∂x1 p1 ∂h1 p1 ∂ x 1 m  p1 x1 
= −  
∂p1 x1 ∂p1 x1 ∂ m x1  m 

Own price Own price Income budget

elasticity of elasticity of elasticity of share
uncompensated compensated uncompensated
demand demand demand

Income & substitution effects in the Slutsky

equation
subst effect income effect

∂x1 p1 ∂h1 p1 ∂ x 1 m  p1 x1 
= −  
∂p1 x1 ∂p1 x1 ∂ m x1  m 

For a normal Own price Income

good income & budget
subst effects elasticity of elasticity of
share
work in the compensated uncompensated
same direction.
demand. demand.

Negative or Positive for a

zero. normal good.

1.3 Expenditure minimization and compensated demand 69

 Income & substitution effects in the Slutsky
equation
subst effect income effect

∂x1 p1 ∂h1 p1 ∂ x 1 m  p1 x1 
= −  
∂p1 x1 ∂p1 x1 ∂ m x1  m 

Income
budget
Income effects are
elasticity of
share
small if the income
uncompensated
elasticity or the
demand.
budget share are
small.

Elasticity of demand curves

Price of A
good
p1 B

Quantity of good x1

Which demand curve is more elastic A or B?

If good 1 is a normal good which is more elastic,

compensated or uncompensated demand?

If good 1 is an inferior good which is more elastic,

compensated or uncompensated demand? DC diagram

1.3 Expenditure minimization and compensated demand 70

 Expenditure minimization & compensated
demand. What have we achieved?
• Income and substitution effects. Will be important for

• labour supply, saving & borrowing.

• Downward sloping compensated demand

• Result from the Slutsky equation, income effect is small

if budget share is small.

• Foundation for understanding welfare measures

• consumer surplus, price indices, compensating and

equivalent variation.

1.3 Expenditure minimization and compensated demand 71