Household Demand and Supply: Microeconomics

Prerequisites
Prerequisites
Almost
Almostessential
essential
Consumer:
Consumer:Optimisation
Optimisation
Useful,
Useful,but
butoptional
optional
Firm:
Firm:Optimisation
Optimisation
HOUSEHOLD DEMAND
AND SUPPLY
MICROECONOMICS
Principles and Analysis
Frank Cowell
March 2012
Frank Cowell: Household Demand & Supply
Working out consumer responses

The analysis of consumer optimisation gives us some
powerful tools:
The primal problem of the consumer is what we are really
interested in
Related dual problem can help us understand it
The analogy with the firm helps solve the dual
The work we have done can map out the consumer's
responses
to changes in prices
to changes in income
what
whatwe
weknow
know
about
the
about theprimal
primal
March 2012
Overview
Household
Demand & Supply
Response
functions
The basics of the

consumer demand
system
Slutsky
equation
Supply of
factors
Examples
March 2012
Solving the max-utility problem
The primal problem and its solution

n
max U(x) + [ y pi xi ]
Lagrangean for the max U problem
i=1
U1(x*) = p1
U2(x*) = p2

U
(x*) = pn
n n
pixi* = y
The n+1 first-order conditions,

assuming all goods purchased
i=1
Solve this set of equations:
x1* = D1(p, y)
x2* = D2(p, y)

xnn* = Dn(p, y)
piDi(p, y) = y
Gives a set of demand functions, one

for each good: functions of prices and
incomes
A restriction on the n equations. Follows
from the budget constraint
i=1
31 October 2012
The response function

The response function for the primal
problem is demand for good i:
xi* = Di(p,y)
The system of equations must have
an adding-up property:
n
pi Di(p, y) = y
Should be treated as just one

of a set of n equations
Reason? Follows immediately
from the budget constraint: lefthand side is total expenditure
i=1
Each equation in the system must be

Reason? Again follows from
homogeneous of degree 0 in prices and the budget constraint
income. For any t > 0:
xi* = Di(p, y )= Di(tp, ty)
To make more progress we need to exploit the relationship
between primal and dual approaches again
March 2012
How you would use this in practice

Consumer surveys give data on expenditure for each
household over a number of categories

and perhaps income, hours worked etc as well
Market data are available on prices
Given some assumptions about the structure of
preferences
we can estimate household demand functions for
commodities
From this we can recover information about utility
functions
March 2012
Overview
Household
Demand & Supply
Response
functions
A fundamental
decomposition of
the effects of a
price change
Slutsky
equation
Supply of
factors
Examples
March 2012
Consumers demand responses

Whats the effect of a budget change on demand?
Depends on the type of budget constraint
Fixed income?
Income endogenously determined?
And on the type of budget change
Income alone?
Price in primal type problem?
Price in dual type problem?
So lets tackle the question in stages
Begin with a type 1 (exogenous income) budget
constraint
March 2012
Effect of a change in income

Take the basic equilibrium
Suppose income rises
x2
The effect of the income increase
Demand for each good does not

fall if it is normal
x**
x*
But could the opposite happen?
x1
March 2012
An inferior good
Take same original prices, but
different preferences
Again suppose income rises
The effect of the income increase
x2
Demand for good 1 rises,

but
Demand for inferior good 2
falls a little
x*
Can you think of any goods

like this?
x**
How might it depend on the

categorisation of goods?
x1
March 2012
10
A glimpse ahead
We can use the idea of an income effect in many applications
Basic to an understanding of the effects of prices on the
consumer
Because a price cut makes a person better off, as would an
income increase
March 2012
11
Effect of a change in price

Again take the basic equilibrium
x2
Allow price of good 1 to fall

The effect of the price fall
The journey from x* to x**
broken into two parts
income
incomesubstitution
substitution
effect
effect effect
effect
x*
x**
x1
March 2012
12
And now lets look at it in maths

We want to take both primal and dual aspects of the problem
and work out the relationship between the response
functions
using properties of the solution functions
(Yes, its time for Shephards lemma again)
March 2012
13
A fundamental decomposition
compensated
compensated
demand
demand
ordinary
ordinary
demand
demand
Take the two methods of writing xi*:

Hi(p,) = Di(p,y)
Use cost function to substitute for y:
Hi(p,) = Di(p, C(p,))
Differentiate with respect to pj :
Hji(p,) = Dji(p,y) + Dyi(p,y)Cj(p,)
Simplify :
Hji(p,) = Dji(p,y) + Dyi(p,y) Hj(p,)
And so we get:
Dj (p,y) = Hj (p,) xj Dy (p,y)

March 2012
Gives us an implicit relation in

prices and utility
Uses y = C(p,) and function-of-afunction rule again
Using cost function and Shephards
Lemma
From the comp. demand function
= Dji(p,y) + Dyi(p,y) xj*

i
Remember: they are two ways of

representing the same thing
This is the Slutsky equation
14
The Slutsky equation

Dji(p,y) = Hji(p,) xj*Dyi(p,y)
Gives fundamental breakdown
of effects of a price change
March 2012
x*
x**
Income effect: I'm better off if

the price of jelly falls, so I buy
more things, including icecream.
Im worse off if the price of jelly
rises, so I buy less icecream
Substitution effect: When the
price of jelly falls and Im kept on
the same utility level, I prefer to
switch from icecream for dessert
15
Slutsky: Points to watch

Income effects for some goods may have wrong sign
for inferior goods
get opposite effect to that on previous slide
For n > 2 the substitution effect for some pairs of goods could
be positive
net substitutes
apples and bananas?
while that for others could be negative

net complements
gin and tonic?
Neat result is available if we look at special case where j = i
back
backtotothe
the
maths
maths
March 2012
16
The Slutsky equation: own-price

Set j = i to get the effect of the price of
ice-cream on the demand for ice-cream
Dii(p,y) = Hii(p,) xi*Dyi(p,y)

Own-price substitution effect
must be negative
Follows from the results on

the firm
xi* income effect
Price increase means less

disposable income
is nonpositive for normal goods
So, if the demand for i does not decrease

when y rises, then it must decrease when pi
rises
March 2012
17
Price fall: normal good

p1
ordinary
demand curve
D1(p,y)
The initial equilibrium

price fall: substitution effect
total effect: normal good
compensated
(Hicksian)
demand curve
income effect: normal good
H1(p,)
initial
initial price
price
level
level
price
fall
For normal good income effect

must be positive or zero
x*1
March 2012
x1**
x1
18
Price fall: inferior good

p1
The initial equilibrium

price fall: substitution effect
ordinary
demand curve
total effect: inferior good

income effect: inferior good
Note relative slopes of

these curves in inferiorgood case
For inferior good income
effect must be negative
price
fall
initial
initial price
price
level
level
compensated
demand curve
x*1
March 2012
x1**
x1
19
Features of demand functions

Homogeneous of degree zero
Satisfy the adding-up constraint
Symmetric substitution effects
Negative own-price substitution effects
Income effects could be positive or negative:
in fact they are nearly always a pain
March 2012
20
Overview
Household
Demand & Supply
Response
functions
Extending the
Slutsky analysis
Slutsky
equation
Supply of
factors
Examples
March 2012
21
Consumer demand: alternative approach

Now for an alternative way of modelling consumer responses
Take a type-2 budget constraint (endogenous income)
Analyse the effect of price changes
allowing for the impact of price on the valuation of income
March 2012
22
Consumer equilibrium: another view

x2
Type 2 budget constraint:

fixed resource endowment
Budget constraint with
endogenous income
Consumer's equilibrium
Its interpretation
nn
nn
i=1
i=1
i=1
i=1
{x: pii xii piiRii }

so
so as
as to
to
buy
buy more
more
good
good 22
March 2012
Equilibrium is familiar:
same FOCs as before
x*
consumer
consumer sells
sells
some
of
good
some of good 11
x1
23
Two useful concepts

From the analysis of the endogenous-income case
derive two other tools:
1. The offer curve:
2.
The households supply curve:
March 2012
Path of equilibrium bundles mapped out by prices

Depends on pivot point - the endowment vector R
The mirror image of household demand
Again the role of R is crucial
24
The offer curve

x2
Take the consumer's equilibrium

Let the price of good 1 rise
Let the price of good 1 rise a bit
more
Draw the locus of points
x***
This path is the offer curve
x**
Amount of good 1 that household

supplies to the market
x*
March 2012
x1
25
Household supply
Flip horizontally , to make
supply clearer
Rescale the vertical axis to
measure price of good 1
p1
x2
March 2012
This path is the

households supply curve
of good 1
x***
Plot p1 against x1
x**
x*
supply of
good 1
supply of
good 1
Note that the curve

bends back on itself
Why?
26
Decomposition another look

Take ordinary demand for good i:
xi* = Di(p,y)
Function of prices and income
Substitute in for y :
xi* = Di(p, j pjRj)
Income itself now depends on

prices
direct
direct effect
effect of
of
ppjj on
on demand
demand
Differentiate with respect to pj :

The indirect effect uses functiondxi*
dy
of-a-function rule again
i
i
= Dj (p, y) + Dy (p, y)
dpj
dpj indirect
indirect effect
effect of
of pp on
on
jj
= Dji(p, y) + Dyi(p, y) Rj
Now recall the Slutsky relation:
Dji(p,y) = Hji(p,) xj* Dyi(p,y)
demand
demand via
via the
the impact
impact
on
on income
income
Just the same as on earlier slide
Use this to substitute for Dji in the above:
dxi*
This is the modified Slutsky
i
*
i
= Hj (p,) + [Rj xj ] Dy (p,y)
equation
dpj
March 2012
27
The modified Slutsky equation:

dxi*
= Hji(p,) + [Rj xj*] Dyi(p,y)
dpj
Substitution effect has same interpretation as before
Two terms to consider when interpreting the income effect
This is just the same as before
This term makes all the difference:
Negative if the person is a net
demander
Positive if he is a net supplier
some
some
examples
examples
March 2012
28
Overview
Household
Demand & Supply
Response
functions
Labour supply,
savings
Slutsky
equation
Supply of
factors
Examples
March 2012
29
Some examples
Many important economic issues fit this type of model :
Subsistence farming
Saving
Labour supply
It's important to identify the components of the model
How are the goods to be interpreted?
How are prices to be interpreted?
What fixes the resource endowment?
To see how key questions can be addressed
How does the agent respond to a price change?
Does this depend on the type of resource endowment?
March 2012
30
Subsistence agriculture
x2
Resource endowment
includes a lot of rice
Slope of budget constraint
increases with price of rice
x1,x2 are rice and other goods

Will the supply of rice to export
rise with the world price?
x*
supply
supply
March 2012
x1
31
The savings problem

x2
Resource endowment is noninterest income profile

Slope of budget constraint
increases with interest rate, r
Its interpretation
x1,x2 are consumption today

and tomorrow
Determines time-profile of
consumption
What happens to saving
when the interest rate
changes?
x*
saving
saving
March 2012
1+r
1+r
x1
32
Labour supply
x2
Endowment: total time & non-labour

income
Slope of budget constraint is wage rate
x1,x2 are leisure and consumption

Determines labour supply
labour
labour
supply
supply
x*
Will people work harder if their wage

rate goes up?
wage
wage
rate
rate
R
non-labour
non-labour income
income
x1
March 2012
33
Modified Slutsky: labour supply

Take the modified Slutsky:
The general form. We are going
*
dxi
to make a further simplifying
= Hii(p,) + [Ri xi*] Diy(p,y)
assumption
dpi
Assume that supply of good i is the only Suppose good i is labour time;
source of income (so y= pi[Ri xi]) Then, then Ri xi is the labour you sell
in the market (leisure time not
for the effect of pi on xi* we get:
consumed);
pi is the wage rate
.
dxi*
y
= Hii(p,) + Diy(p,y)
dpi
pi
Rearranging
:
Divide by labour supply; multiply
pi dxi*
pi
y
i
* =
H
(p,)
* Diy(p,y)
j
*
Ri xi dpi
Rixi
Rixi
Write in elasticity form:

etotal = esubst + eincome
.
by (-) wage rate
The Modified Slutsky equation in

a simple form
Estimate the whole demand system from family expenditure data

March 2012
34
Simple facts about labour supply

The estimated elasticities
Men's labour supply is backward bending!
Leisure is a "normal good" for everyone
Children tie down women's substitution effect
Total
subst
income
0.23
+0.13
0.36
No children
+0.43
+0.65
0.22
One child
+0.10
+0.32
0.22
Two
children
0.19
+0.03
0.22
Men:
Women:
Source: Blundell and Walker (Economic Journal, 1982)
March 2012
35
Summary
How it all fits together:
Review
Compensated (H) and ordinary (D) demand functions can be
hooked together.
Review Slutsky equation breaks down effect of price i on demand for j
Review Endogenous income introduces a new twist when prices change
March 2012
36
What next?
The welfare of the consumer
How to aggregate consumer behaviour in the market
March 2012
37

Household Demand and Supply: Microeconomics

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Prerequisites

Frank Cowell: Household Demand & Supply

Working out consumer responses

The primal problem of the consumer is what we are really

The work we have done can map out the consumer's

Frank Cowell: Household Demand & Supply

The basics of the

Frank Cowell: Household Demand & Supply

Solving the max-utility problem

The primal problem and its solution

Lagrangean for the max U problem

The n+1 first-order conditions,

Solve this set of equations:

Gives a set of demand functions, one

Frank Cowell: Household Demand & Supply

The response function

Should be treated as just one

Each equation in the system must be

Frank Cowell: Household Demand & Supply

How you would use this in practice

household over a number of categories

Frank Cowell: Household Demand & Supply

Frank Cowell: Household Demand & Supply

Consumers demand responses

Frank Cowell: Household Demand & Supply

Effect of a change in income

The effect of the income increase

Demand for each good does not

But could the opposite happen?

Frank Cowell: Household Demand & Supply

Demand for good 1 rises,

Can you think of any goods

How might it depend on the

Frank Cowell: Household Demand & Supply

Frank Cowell: Household Demand & Supply

Effect of a change in price

Allow price of good 1 to fall

Frank Cowell: Household Demand & Supply

And now lets look at it in maths

Frank Cowell: Household Demand & Supply

Take the two methods of writing xi*:

Dj (p,y) = Hj (p,) xj Dy (p,y)

Gives us an implicit relation in

= Dji(p,y) + Dyi(p,y) xj*

Remember: they are two ways of

This is the Slutsky equation

Frank Cowell: Household Demand & Supply

The Slutsky equation

Income effect: I'm better off if

Frank Cowell: Household Demand & Supply

Slutsky: Points to watch

while that for others could be negative

Frank Cowell: Household Demand & Supply

The Slutsky equation: own-price

Dii(p,y) = Hii(p,) xi*Dyi(p,y)

Follows from the results on

xi* income effect

Price increase means less

is nonpositive for normal goods

So, if the demand for i does not decrease

Frank Cowell: Household Demand & Supply

Price fall: normal good