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1
Lecture 6: Theory of the Consumer:
Demand
Changes in income
Income changes and offer curves and Engel
curves
Changes in prices
Price offer curve and demand curves
Substitutes and complements
Inverse demand function
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2
Consumers demand functions give the
optimal amounts of each of the goods as
a function of the prices and income
faced by the consumer.
) , , (
) , , (
2 1 2 2
2 1 1 1
y p p x x
y p p x x
=
=
Change the consumers income, holding prices as
fixed
Increase in income shifts the budget line outward
in a parallel fashion
Effects on quantity demanded:
the quantity demanded increases as income increases
the quantity demanded decreases as income increases
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Income offer curve- set of bundles of goods that are
demanded at different levels of income.
Derived by connecting together the bundles that are
obtained as the budget line is shifted outwards.
Income offer curve is also known as the income
expansion path
If both goods are normal goods, then the income
expansion path will have a positive slope.
Engel curve graph of one of goods as a
function of income, with all prices being held
constant.
Derived by holding prices of good 1 and 2 fixed,
and then changing income, much like the
derivation of the income expansion path.
We then plot the quantity demanded of one good
as a function of income
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x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

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x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
x
1
*
x
2
*
y
y
x
1

x
1

x
1

x
2

x
2

x
2

y
y
y
y
y
y
Engel
curve;
good 2
Engel
curve;
good 1
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An example of computing the equations of
Engel curves; the Cobb-Douglas case.
The ordinary demand equations are
U x x x x
a b
( , ) .
1 2 1 2
=
x
ay
a b p
x
by
a b p
1
1
2
2
* *
( )
;
( )
. =
+
=
+
x
ay
a b p
x
by
a b p
1
1
2
2
* *
( )
;
( )
. =
+
=
+
Rearranged to isolate y, these are:
y
a b p
a
x
y
a b p
b
x
=
+
=
+
( )
( )
*
*
1
1
2
2
Engel curve for good 1
Engel curve for good 2
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y
y
x
1
*
x
2
*
y
a b p
a
x =
+ ( )
*
1
1
Engel curve
for good 1
y
a b p
b
x =
+ ( )
*
2
2
Engel curve
for good 2
Perfect complements
income offer curve- straight line through the
quantities demanded since the consumer will always
consume the same amount of each good no matter
what.
The Engel curve is therefore a straight line with slope:
This is just derived from the demand for good 1:
2 1
p p +
) /(
2 1 1
p p y x + =
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Rearranged to isolate y, these are:
y p p x
y p p x
= +
= +
( )
( )
*
*
1 2 1
1 2 2
Engel curve for good 1
x x
y
p p
1 2
1 2
* *
. = =
+
Engel curve for good 2
Income Changes
x
1
x
2
y < y < y
x
1

x
1

x
2

x
2

x
2

x
1
x
1
*
x
2
*
y
y
x
2

x
2

x
2

y
y
y
y
y
y
Engel
curve;
good 2
Engel
curve;
good 1
x
1

x
1

x
1

Fixed p
1
and p
2
.
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Income Changes
x
1
*
x
2
*
y
y
x
2

x
2

x
2

y
y
y
y
y
y
x
1

x
1

x
1

*
2 2 1
) ( x p p y + =
Engel
curve;
good 2
Engel
curve;
good 1
Fixed p
1
and p
2
.
*
1 2 1
) ( x p p y + =
Perfect substitutes
If the consumer is specializing in
the consumption of good 1. If his income
increases, so will his consumption of good 1.
Thus the income offer is the horizontal axis.
The Engel curve will be a straight line with a
slope of p
1
.
2 1
p p <
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The perfect-substitution case.
The ordinary demand equations are
U x x x x ( , ) .
1 2 1 2
= +
x p p y
if p p
y p if p p
1 1 2
1 2
1 1 2
0
*
( , , )
,
/ ,
=
>
<

x p p y
if p p
y p if p p
2 1 2
1 2
2 1 2
0
*
( , , )
,
/ , .
=
<
>

Suppose p
1
< p
2
. Then
x
y
p
1
1
*
=
x
2
0
*
=
and
x
2
0
*
. = y p x =
1 1
*
and
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x
2
0
*
. =
y p x =
1 1
*
y y
x
1
* x
2
*
0
Engel curve
for good 1
Engel curve
for good 2
Homothetic preferences result in straight line
Engel curves or where the demand for the good goes
up by the same proportion as income.
Homothetic preferences consumers preferences
depend on the ratio of good 1 to good 2.
Given:
Then for any positive value of t:
) , ( ) , ( s.t. ), , ( ), , (
2 1 2 1 2 1 2 1
y y x x y y x x
) , ( ) , (
2 1 2 1
ty ty tx tx
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Homothetic preferences
Three examples are perfect complements, perfect
substitutes and Cobb-Douglas
If the consumer has homothetic preferences, then
the income offer curves are all straight lines
through the origin.
If preferences are homothetic, scaling income up
or down by t will scale the quantity demanded by
the same amount.
The consumers MRS is the same anywhere on a
straight line drawn from the origin.
Engel curves do not have to be straight lines. In
general, when income goes up, the demand for a
good goes up by a greater proportion than
income.
Luxury good when demand for the good
increases by a greater proportion than the
increase in income
Necessary good when the demand for that
good increases by a lesser proportion than the
increase in income.
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Quasilinear preferences Example of non-homothetic preferences
The utility function for these preferences take the form:
If an indifference curve is tangent to the budget line at
then another indifference curve must also be tangent at
for any constant k.
2 1
) ( x x v u + =
) , (
*
2
*
1
x x
) , (
*
2
*
1
k x x +
Quasilinear preferences Example of non-homothetic
preferences
Increasing income doesnt change the demand for
good 1 at all, and all the extra income goes entirely to
the consumption of good 2.
With quasilinear preferences, there is a zero income
effect for good 1.
Engel curve for good 1 is a vertical line, as you
change income, the demand for good 1 remains
constant.
This kind of income offer curve is relevant for some
items that do not form a large amount of the
consumers budget.
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Quasilinear preferences are not homothetic.
For example,
U x x f x x ( , ) ( ) .
1 2 1 2
= +
U x x x x ( , ) .
1 2 1 2
= +
x
2
x
1
Each curve is a vertically shifted
copy of the others.
Each curve intersects
both axes.
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Income Changes; Quasilinear
Utility
x
2
x
1
x
1
~
x
1
*
x
2
*
y
y
x
1
~
Engel
curve
for
good 2
Engel
curve
for
good 1
Normal good- a good is a normal good when
the demand for the good increases as income
increases, and decreases when income
decreases.
the quantity demanded always changes the
same way as income changes:
A normal goods Engel curve is positively
sloping
0 /
1
> A A m x
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Inferior good a good whose quantity
demanded decreases as income
increases.
examples are low quality goods
normality or inferiority of a good depends on
the income range that we are considering
An income inferior goods Engel curve is
negatively sloped.
x
2
x
1
Income Changes; Goods
1 & 2 Normal
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
x
1
*
x
2
*
y
y
x
1

x
1

x
1

x
2

x
2

x
2

y
y
y
y
y
y
Engel
curve;
good 2
Engel
curve;
good 1
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Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
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Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
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Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
Income
offer curve
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Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
x
1
*
y
Engel curve
for good 1
Income Changes; Good 2 Is Normal,
Good 1 Becomes Income Inferior
x
2
x
1
x
1
*
x
2
*
y
y
Engel curve
for good 2
Engel curve
for good 1
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Decrease the price of good 1 holding the price
of good 2 and income constant.
Depict changes via price offer curve and
ordinary demand curve
Price offer curve depicts the optimal choices
as the price of good 1 changes.
Demand curve shows for each level of p
1
the
optimal level of consumption of good 1. The
demand curve is a plot of the demand function:
holding p
2
and m constant.
) , , (
2 1 1 1
y p p x x =
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Two alternative effects:
the consumption of good 1 increases
the consumption of good 1 decreases
Ordinary good when the quantity demanded
of the good increases as the price of the good is
decreased
Giffen good a good such that when its price
declines, the quantity demanded of the good
declines as well.
the reduction in the price of good 1 has freed up
some extra money that can be spent on other
things, so much so that consumer decides to
consume more of the other good and reduce your
consumption of this good
The price change is to some extent like an income
change. Even though money income remains the
same, the change in the price of one good changes
purchasing power and thus changes demand.
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Fixed p
2
and y.
x
1
x
2
Fixed p
2
and y.
x
1
x
2
p
1
price
offer
curve
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Fixed p
2
and y.
x
1
x
2
p
1
price
offer
curve
x
1
*
Downward-sloping
demand curve
Good 1 is
ordinary

p
1
Fixed p
2
and y.
x
1
x
2
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Fixed p
2
and y.
x
1
x
2 p
1
price offer
curve
Fixed p
2
and y.
x
1
x
2 p
1
price offer
curve
x
1
*
Demand curve has
a positively
sloped part
Good 1 is
Giffen

p
1
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Ordinarily, when the price of a good decreases,
the demand for the good will increase and vice
versa. Thus the demand curve has a negative
slope since price and consumption move in
opposite directions.
Therefore:
0
1
1
<
A
A
p
x
x
1
x
2
p
1
= p
1

Fixed p
2
and y.
p
1
x
1
+ p
2
x
2
= y
Own-Price Changes
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Own-Price Changes
x
1
x
2
p
1
= p
1

p
1
= p
1

Fixed p
2
and y.
p
1
x
1
+ p
2
x
2
= y
Own-Price Changes
x
1
x
2
p
1
= p
1

p
1
=
p
1

Fixed p
2
and y.
p
1
= p
1

p
1
x
1
+ p
2
x
2
= y
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x
2
x
1
p
1
= p
1

Own-Price Changes
Fixed p
2
and y.
x
2
x
1
x
1
*(p
1
)
Own-Price Changes
p
1
= p
1

Fixed p
2
and y.
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x
2
x
1
x
1
*(p
1
)
p
1
x
1
*(p
1
)
p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
p
1
= p
1

x
2
x
1
x
1
*(p
1
)
p
1
x
1
*(p
1
)
p
1

p
1
= p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
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x
2
x
1
x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
)
p
1

p
1
= p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
x
2
x
1
x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
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x
2
x
1
x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1
= p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1
= p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
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x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
Fixed p
2
and y.
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x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
Fixed p
2
and y.
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
p
1
price
offer
curve
Fixed p
2
and y.
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For Cobb-Douglas preferences
Take
Then the ordinary demand functions for
commodities 1 and 2 are
U x x x x
a b
( , ) .
1 2 1 2
=
x p p y
a
a b
y
p
1 1 2
1
*
( , , ) =
+

x p p y
b
a b
y
p
2 1 2
2
*
( , , ) . =
+

and
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x p p y
a
a b
y
p
1 1 2
1
*
( , , ) =
+

x p p y
b
a b
y
p
2 1 2
2
*
( , , ) . =
+

and
Notice that x
2
* does not vary with p
1
so the p
1
price offer curve is flat and the ordinary demand
curve for commodity 1 is a rectangular hyperbola.
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
x
2
x
1
p
1
x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
is
Fixed p
2
and y.
x
by
a b p
2
2
*
( )
=
+
x
ay
a b p
1
1
*
( )
=
+
x
ay
a b p
1
1
*
( )
=
+
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For a perfect-complements utility function
} {
U x x x x ( , ) min , .
1 2 1 2
=
Then the ordinary demand functions
for commodities 1 and 2 are
x p p y x p p y
y
p p
1 1 2 2 1 2
1 2
* *
( , , ) ( , , ) . = =
+
With p
2
and y fixed, higher p
1
causes smaller x
1
* and x
2
*.
p x x
y
p
1 1 2
2
0 = , .
* *
As
p x x
1 1 2
0 = , .
* *
As
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Fixed p
2
and y.
x
1
x
2
p
1
x
1
*
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
x
1
x
2
p
1

x
y
p p
1
1 2
*
=
+

p
1
= p
1

y/p
2
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p
1
x
1
*
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
x
1
x
2
p
1

p
1

p
1
= p
1

x
y
p p
1
1 2
*
=
+

y/p
2
p
1
x
1
*
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
x
1
x
2
p
1

p
1

p
1

x
y
p p
1
1 2
*
=
+
p
1
= p
1

y/p
2
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p
1
x
1
*
Ordinary
demand curve
for commodity 1
is
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
x
y
p p
1
1 2
*
. =
+
x
1
x
2
p
1

p
1

p
1

y
p
2
y/p
2
For a perfect-substitutes utility
function
U x x x x ( , ) .
1 2 1 2
= +
Then the ordinary demand functions
for commodities 1 and 2 are
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x p p y
if p p
y p if p p
1 1 2
1 2
1 1 2
0
*
( , , )
,
/ ,
=
>
<

x p p y
if p p
y p if p p
2 1 2
1 2
2 1 2
0
*
( , , )
,
/ , .
=
<
>

and
Fixed p
2
and y.
x
2
x
1
p
1
x
1
*
Fixed p
2
and y.
x
2
0
*
=
x
y
p
1
1
*
=
p
1

p
1
= p
1
< p
2

x
y
p
1
1
*
=

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41
Fixed p
2
and y.
x
2
x
1
p
1
x
1
*
Fixed p
2
and y.
x
2
0
*
=
x
y
p
1
2
*
=
p
1

p
1
= p
1
= p
2

x
1
0
*
=

x
y
p
2
2
*
=

0
1
2
s s x
y
p
*

p
2
= p
1

Fixed p
2
and y.
x
2
x
1
p
1
x
1
*
Fixed p
2
and y.
x
y
p
2
2
*
=
x
1
0
*
=
p
1

p
1

x
1
0
*
=
p
2
= p
1

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42
Fixed p
2
and y.
x
2
x
1
p
1
x
1
*
Fixed p
2
and y.
p
1

p
2
= p
1

p
1

x
y
p
1
1
*
=

0
1
2
s s x
y
p
*
y
p
2
p
1
price
offer
curve
Ordinary
demand curve
for commodity 1
Discrete good - Suppose that good 1 is a
discrete good.
At some high price, consumption will be
zero
At some low price, consumption will be
one unit
At some price r
1
, the consumer will be
indifferent between consuming good 1
or not consuming it.
r
1
is called the reservation price.
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43
Demand behavior can be described by a
sequence of reservation prices at which
the consumer is just willing to purchase
another unit of the good.
at a price r
1
, he is just willing to
purchase one unit,
at a price r
2
, he is just willing to
purchase another unit.
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44
Reservation prices can be described in
terms of the original utility function.
r
1
satisfies the condition:
r
2
satisfies the condition:
) , 1 ( ) , (
1
r m u m o u =
) 2 , 2 ( ) , 1 (
2 2
r m u r m u =
For quasilinear utilities - the formulas
describing the reservation prices are simpler:
) 1 (
, r for solving
, ) 1 ( ) 0 (
: as equation first the write can we , 0 ) 0 ( and
2 ) ( ) , (
1
1
1
1 2 1
v r
r m v m m v
v
x x v x x u
=
+ = = +
=
+ =
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45
Similarly, we can write the second equation as:
Proceeding in this manner, the reservation price for
the third unit is just:
) 1 ( ) 2 (
: g rearrangin and terms canceling
, 2 ) 2 ( ) 1 (
2
2 2
v v r
r m v r m v
=
+ = +
) 2 ( ) 3 (
3
v v r =
In each case, the reservation price measures the
increment in utility necessary to induce the
consumer to choose an additional unit of the good.
Assumption of convex preferences mean that the
sequence of reservation prices must decrease:
Given any price p, we just find where it falls in the
list of reservation prices.
3 2 1
r r r > >
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46
Suppose p is between r
6
and r
7
.
r
6
> p means that the consumer is willing
to give up p pesos per unit bought to get 6
units of good 1
p > r
7
means that the consumer is not
willing to give up p pesos to get the 7th
unit of good 1.
Substitutes If the demand for good 1 goes
up when the price of good 2 goes up, then we
say that good 1 is a substitute for good 2:
Complements If the demand for good 1
goes down as the price of good 2 increases,
we say that good 1 is a complement to good
2:
. 0
2
1
>
A
A
p
x
. 0
2
1
<
A
A
p
x
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47
A perfect-complements example:
x
y
p p
1
1 2
*
=
+
( )
c
c
x
p
y
p p
1
2
1 2
2
0
*
. =
+
<
so
Therefore commodity 2 is a gross complement
for commodity 1.
p
1
x
1
*
p
1

p
1

p
1

y
p
2

Increase the price of

good 2 from p
2
to p
2

and
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48
p
1
x
1
*
p
1

p
1

p
1

y
p
2

Increase the price of

good 2 from p
2
to p
2

and the demand curve

for good 1 shifts inwards
-- good 2 is a
complement for good 1.
A Cobb- Douglas example:
x
by
a b p
2
2
*
( )
=
+
so
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49
A Cobb- Douglas example:
x
by
a b p
2
2
*
( )
=
+
c
c
x
p
2
1
0
*
. =
so
Therefore commodity 1 is neither a gross
complement nor a gross substitute for
commodity 2.
As long as we have a downward sloping
demand curve, it is meaningful to speak of the
inverse demand function.
Inverse demand function is the demand
function viewing price as a function of
quantity.
Therefore, for each quantity, what would be the
level of prices such that the consumer would
choose that level of consumption.
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50
p
1
x
1
*
p
1

Given p
1
, what quantity is
demanded of commodity 1?
p
1
x
1
*
p
1

Given p
1
, what quantity is
demanded of commodity 1?
Answer: x
1
units.
x
1

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51
p
1
x
1
*
x
1

Given p
1
, what quantity is
demanded of commodity 1?
Answer: x
1
units.
The inverse question is:
Given x
1
units are
demanded, what is the
price of
commodity 1?
p
1
x
1
*
p
1

x
1

Given p
1
, what quantity is
demanded of commodity 1?
Answer: x
1
units.
The inverse question is:
Given x
1
units are
demanded, what is the
price of
commodity 1?
Answer: p
1

8/3/2009
52
A Cobb-Douglas example:
x
ay
a b p
1
1
*
( )
=
+
is the ordinary demand function and
p
ay
a b x
1
1
=
+ ( )
*
is the inverse demand function.
A perfect-complements example:
x
y
p p
1
1 2
*
=
+
is the ordinary demand function and
p
y
x
p
1
1
2
=
*
is the inverse demand function.
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53
An economic interpretation
For well-behaved preferences, the optimal choice
must satisfy the condition that the absolute value of
the MRS equals the price ratio:
This says that at the optimal level of demand for
good 1, we must have:
At the optimal level of good 1, the price of good 1 is
proportional to the absolute value of the MRS
between good 1 and good 2.
2
1
p
p
MRS =
MRS p p
2 1
=
Suppose that p
2
=1, the equation states that at the
optimal level of demand, the price of good 1
measures how much the consumer is willing to give
up of good 2 in order to gain a little of good 1.
If we think of good 2 as the amount of money to
spend on other goods, then we can think of the MRS
as being how many pesos the individual would be
willing to give up in order to have more of good 1.
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54
MRS is therefore the marginal willingness to
pay .
the marginal willingness to pay is just the price of
the good.
At each quantity x1, the inverse demand function
measures how many pesos a consumer is willing
to give up for a little more of good 1.
Marginal willingness to pay, i.e., in the sense
of the marginal willingness to sacrifice good 2
for good 1 is decreasing as we increase the
consumption of good 1.