Aggregate demand: A note for Micro 3

David Dreyer Lassen

University of Copenhagen

November 2004

We will often be interested in looking at the aggregate behavior of a collective of con-

sumers; a household, a municipality or an entire economy. The microeconomic theory of
demand, on the other hand, is developed in the context of an individual consumer. In
Micro 2 and 3, we derived the properties of the individual demand function: it satis…ed
continuity, homogeneity of degree zero and Walras’law, and, importantly, the weak ax-
iom of revealed preference. Recall that WARP serves as a check on whether consumers
do in fact maximize utility, arguably a central concern to economists. Do these proper-
ties hold in the aggregate? (short answer: some, but not all). By looking at aggregate
behavior, can we infer anything about individual demands and, in the case of WARP,
individual rationality? Similarly, in the real world we will often have data only at an
aggregate level (say, the household or a country) and life as an econometrician would
be a good deal simpler if we could model aggregate demand, say of the household, as a
function of the household’s aggregate wealth or income. Is this possible?
This brief note considers some issues in aggregate demand – for a more complete
description refer to Mas-Colell, Whinston and Green (1995, ch. 4), on which this note is
based, or Deaton and Muellbauer (1980). First, we look at whether aggregate demand
can be expressed as a function of aggregate income in a meaningful way; second, we
show, by example, that the WARP does not hold in the aggregate and we conclude by
some remarks on the appropriateness of representative consumers.
Prepared for Micro 3 at Department of Economics, University of Copenhagen. I thank Peter Norman
Sørensen for comments and suggestions. Comments most welcome at david.dreyer.lassen at econ.ku.dk.

1
1 Aggregate income and aggregate demand
Consider a groups of consumers 1; : : : ; n each of whom has a demand founction x for
some k commodities: xi (p; mi ) = x1i (p; mi ) ; : : : ; xki (p; mi ) : De…ne aggregate demand
as
X n
X (p; m1 ; : : : ; mn ) = xi (p; mi ) :
i=1

Just as is the case for individual demand functions, the aggregate demand function
exhibits continuity and homogeneity of degree zero, and satis…es Walras’law. In general,
aggregate demand depends on prices and on the consumers’speci…c income levels or, in
other words, on the income distribution. We …rst explore the conditions under which
aggregate demand can be written as a function only of aggregate income.
Suppose that we observe only a household’s total income, rather than the contri-
butions by each household member. For tax policy analysis, we could be interested in
looking at the household’s aggregate demand for goods and commodities as a function
of both prices and incomes; is it permissible to model aggregate demand as a function of
P
total income only, in which case we could write X (p; m1 ; : : : ; mn ) = X (p; i mi )? For
this to be the case, aggregate demand must be the same for any given level of aggre-
P
gate income M = i mi regardless of the distribution of this aggregate income: That
is, for any two income distributions m0 = (m01 ; : : : ; m0n ) and m00 = (m001 ; : : : ; m00n ) where
P 0 P 00 0 0 00 00
i mi = i mi ; it must be the case that X (p; m1 ; : : : ; mn ) = X (p; m1 ; : : : ; mn ) :
Consider, from an initial distribution (m1 ; : : : ; mn ) ; a small income redistribution
P
(dm1 ; : : : ; dmn ) where i dmi = 0 such that we collect and distribute di¤erential amounts
in a way that satis…es budget balance. Then, if aggregate demand can be written as a
function of aggregate income it must be the case that

X
n
@xj (p; mi )
i
dmi = 0 for every j = 1; : : : ; k:
i=1
@mi
P
This will be true for all budget neutral redistributions i dmi = 0 if and only if the
coe¢ cients above are the same for all consumers:

@xji (p; mi ) @xjh (p; mh )

=
@mi @mh

for any commodity j; any pair of consumers i and h and all income distributions. This

2
good 2
Income expansion path for consumer i

B(p,mi)

Income expansion path for consumer j ≠ i

B(p,mi) is the budget line given prices p and income mi

B(p,mj)

good 1

Figure 1: Invariance of aggregate demand to redistribution

means that income, or wealth, e¤ects must be the same for all consumers at all levels
of income. The increase in demand following an increase in income must be completely
o¤-set by an equivalent decrease in demand from a corresponding decrease in income for
all income levels and all consumers. Graphically (see …gure 1), this implies that income-
expansion paths (or Engel curves) must be straight lines (as it must hold for all income
levels) and parallel (as the e¤ects must be similar across consumers).
It follows that we can treat aggregate demand as a function of aggregate income when
consumers exhibit parallel, straight income expansion paths. We now make precise when
consumers do exactly this:

Proposition 1 (MWG 4.B.1) A set of consumers have straight, parallel income-expansion

paths (and, hence, aggregate demand can be written as a function of prices and aggregate
income) at any price p if and only if preferences admit indirect utility functions of the
Gorman form:
vi (p; mi ) = ai (p) + b (p) mi :
| {z } |{z}
individual common

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Proof. We prove su¢ ciency; see Varian (1992, p. 154) for a sketch of necessity. Use
Roy’s identity to get consumer i’s demand for commodity j:

@vi (p;mi )
@pj
xji (p; mi ) = @vi (p;mi )
@mi
@ai (p)
@pj
+ @b(p)
@pj
mi
= (ROY)
b (p)

Aggregate demand for good j is

X
n
j
X (p; m1 ; : : : ; mn ) = xji (p; mi )
i=1
@ai (p) @b(p)
X
n
@pj
+ @pj
mi
=
i=1
b (p)
@ai (p) @b(p)
X
n
@pj @pj
X
n
= mi
i=1
b (p) b (p) i=1
| {z }
M
j
= X (p; M ) ;

a function of p and M: To see directly that the Gorman form implies parallel, straight
income expansion paths, look at (ROY). The derivative of a particular good j with
respect to income mi is
@b(p)
@xji (p; mi ) @pj
=
@mi b (p)
The slope of the income-expansion path is given by

@xji (p;mi ) @b(p)

@mi @pj
@xki (p;mi )
= @b(p)
@mi @pk

and we see directly that they are linear, since they do not depend on m; and that they
are parallel, as they do not depend on i:
The assumption of Gorman-form indirect utility functions is very restrictive and
excludes most classes of preferences; two common examples that do, however, satisfy
this assumption are (a) homothetic preferences; in this case we can write the expenditure

4
function as e (p; u) = e (p) u which yields the indirect utility function v (p; m) = v (p) m
which is an example of the Gorman form; and (b) quasi-linear preferences with utility
functions such as U (x; m) = m + ui (x) where m is the common numeraire, for example
money.
To conclude, it is possible to identify preferences that allow aggregate demand to be
expressed as a function of aggregate (or, equivalently, average) income;1 and these are in
fact the only class of preferences to allow this. Sometimes more information than simply
the aggregate or mean incomes is available (say, the variance) and allows for weaker
conditions at the price of stronger demands on data.

2 Does aggregate demand satisfy WARP?

Recall that individual demand functions derived under standard conditions satisfy the
weak axiom of revealed preference. From a positive viewpoint, this is a central result, as
we can use observed choices by individual consumers to determine whether they utility
maximize or, as it is sometimes put, behave rationally. Does aggregate (or average)
revealed choice reveal anything about the rationality of individual consumers, that is,
if we observe WARP failing for aggregate demand can we deduce that WARP does not
hold for individuals? Unfortunately, this is not the case. A simple example su¢ ces to
prove this (see …gure 2).
In the …gure, there are two consumers and two commodities. The consumers share
aggregate income M equally such that they each get M=2: We consider two price vectors
p and p0 : It is easy to see that the choices of both consumers satisfy WARP individually.
Consider the average demands,2 x (p; M ) = 12 x (p; M ) = 12 x1 (p; M=2) + 21 x2 (p; M=2)
and x (p0 ; M ) = 12 x (p0 ; M ) = 21 x1 (p0 ; M=2) + 12 x2 (p0 ; M=2) : In the …gure, we have
1
2
px (p0 ; M ) < M=2 , px (p0 ; M ) < M: If WARP holds3 then this should imply that
p0 x (p; M ) > M , 21 p0 x (p; M ) > M=2: But, from the …gure, this is clearly not the case
1
Average or aggregate measures are interchangeable when we know the number of individuals in the
economy. Using one or the other is often a matter of conveniency.
2
Here we actually aggregate directly across consumers and de…ne average demand as a function only
of (for simplicity) aggregate income, not the distribution; how does that square with the discussion in
the previous section? If incomes are allocated according to a so-called wealth distribution rule, where
individual income are allocated from aggregate income according to a well-de…ned rule, we can always
write aggregate or average demand as a functions of aggregate or average income (see MWG ch. 4.B).
3
A demand function x (p; m) satis…es WARP if px (p0 ; w) w and x (p0 ; w) 6= x (p; w) implies
0 0
p x (p; w) > w for any set of distinct price vectors (p; p ) :

5
 good 2

x1(p,M/2)
x1(p’,M/2)
x(p’,M) x2(p’,M/2)
x(p,M)

x2(p,M/2)

good 1

Figure 2: Failure of aggregate demand to satisfy WARP

as 12 x (p; M ) is in the interior of the budget set de…ned by p0 and M=2: Hence, WARP
does not hold in the aggregate even if it holds at the individual level. Why is this? The
short answer is that consumers react di¤erently to changes in the budget set and that
these di¤erent responses cannot be guaranteed to add up in a systematic way so as to
secure rationality in the aggregate.4

3 Problems with the Representative Consumer

In economics, we’re ultimately concerned with welfare, rather than commodities in them-
selves, and, hence, we would like to be able to attach welfare signi…cance to the aggregate
demand function in order to evaluate the aggregate welfare consequences of, say, changes
4
The reason that WARP fails in the aggregate can be traced to wealth or income e¤ects. It can be
shown that x(p; M ) satis…es WARP if and only if it satis…es the compensated law of demand, which
roughly says that prices and demand move in opposite directions when price changes are compensated;
for example, if the price of commodity 1 increases and income is adjusted such that the consumer exactly
can a¤ord the initial bundle, then demand for commodity 1 will decrease. To cut a long story short,
the basic problem is that a price-income change that is compensated in the aggregate, i.e. for aggregate
demand, need not be compensated for all consumers, leading to income e¤ects that violate the law of
demand resulting in WARP not being satis…ed; see MWG ch. 4.C.

6
in policy. For this to be possible, we need a representative consumer (RC). There are
two steps to this. We say that a positive RC exists if there exists a rational preference
relation such that the aggregate demand function is precisely the Walrasian demand
function induced by this preferences relation. The RC obviously need not be a physi-
cal consumer, it su¢ ces that we can come up with a preference relation that, following
maximization, would lead to a demand function which happens to be the aggregate one.
That a positive RC exists is not, however, su¢ cient for us to be able to attach welfare
signi…cance to the aggregate demand function. In general, no normative RC exists and,
hence, a representative consumer cannot be trusted for welfare analysis. There are, how-
ever, exeptions to this rule. In particular, if indirect utility functions have the Gorman
form (as above) and the social welfare function is utilitarian, then aggregate demand
can always be viewed as having arisen from a normative RC and, as a consequence, we
are able to give a welfaristic interpretation of the aggregate demand function.

4 References
1. Deaton, A. and J. Muellbauer. 1980. Economics and Consumer Behavior. Cam-
bridge University Press.

2. Mas-Colell, A., M. Whinston and J.R. Green. 1995. Microeconomic Theory. Ox-
ford University Press.