Micro I. Lesson 5: Consumer Equilibrium 5.1 Optimal Choice: MU P MU P

Microecono mics I. Antonio Zabalza.
University of Valencia 1
Micro I. Lesson 5 : Consumer Equilibrium
5.1 Optimal Choice
If preferences are well behaved (smooth, convex,

continuous and negatively sloped), then at the
optimal choice of the consumer,
Slope of i.c. = Slope of b.c.
MRS = Price ratio
MU x px
=
MU y p y
Optimal Choice
Why?
Consider a situation in which the above equality
does not hold. Also, remember that moving along
the bc is equivalent to using the market. Moving
along the ic shows the minimum amount of y I need
to compensate for loss of x. If the market gives me
an amount of y that is greater than the minimum I
require, I will follow the market.
Microecono mics I. Antonio Zabalza. University of Valencia 2
U(C)
U(B)
B
B’ U(A)
A x
B’’
At A, for instance, if I give up 1 unit of x (distance

AB’’), the market gives me 1 unit of y (distance
B’’B). But I would be satisfied with less; say, 0.25
units of y (distance B’B’’). Then, it is optimal for me
to trade in the market, and go to point B where my
utility U(B) is higher than that at point a, U(A).
If I keep applying this reasoning I end up at point C.

(Check that you understand this). Point C represents
the best I can do, given my opportunities. Point C
therefore represents the optimal choice, the
equilibrium, of the consumer. Going beyond point
C, would lower again my utility.
Mathematics: Maximization of utility subject to a

given budget constraint. Method of Lagrange.
Max U = U (x , y )
x, y
s.t. px x + py y = m
L = U ( x , y ) + λ  m − px x − p y y 
First order (necessary) conditions
δ L δU
= − λ px = 0 (1)
δx δx
δ L δU
= − λ py = 0 (2)
δy δy
δL
= m − px x − p y y = 0 (3)
δy
This is a system of 3 equations in 3 unknowns: x, y

and λ. From (1) and (2) we have that
δ U δ x MU x
λ= =
px px
δ U δ y MU y
λ= =
py py
MU x MU y MU x px
= ⇒ =
px py MU y px
Then, to solve for x and y we consider equation (3)

to get this more simplified form of the above system.
MU x px
= (4)
MU y px
m = px x + py y (5)
This is a system of 2 equations with two unknowns

(x,y). (Notice that in general the marginal utilities
will depend on x and y). Equation (4) is the equality
of slopes of bc and ic discussed above. What the
result above says is that this condition is not enough;
we need also that the budget constraint is fulfilled
(equation 5).
Solving this system will, in general, give us the two

demand functions for x and y that we are after.
x = x ( px , p y , m)
y = y ( px , p y , m )
The purpose of this lesson is to find out how the

three variables ( px , p y , m) influence the demand for
x and y. Before, we give an example of this
derivation for a particular utility function: Cobb-
Douglas.
Example:
Cobb-Douglas (CD) utility function:
U (x , y) = x a y b
Max U = x a y b
x, y
s.t. px x + py y = m
L = x a y b + λ  m − px x − p y y 
Necessary conditions:
δL
= ax a −1 y b − λ p x = 0 (1)
δx
δL
= bx a y b−1 − λ p y = 0 (2)
δy
δL
= m − px x − py y = 0 (3)
δy
Eliminate λ from (1) and (2), and together with (3)

you obtain
ax a −1 y b bx a y b −1
= (4)
px py
m = px x + py y (5)
System of two equations with two unknowns.

Equation (4) can be expressed in the form

MU x px
= ,
MU y p y
which for this particular case is
ax a −1 y b px
a b −1
=
bx y py
or,
ay px
= .
bx p y
So the system, in this simplified form is

ay px
= (4)
bx p y
m = px x + py y (5)
Solving for x and for y, we find the two demand

equations:
a m
x=
a + b px
b m
y=
a + b py
With a CD utility function, the demand for each

good depends on income (positively) and its own
price (negatively). It does not depend on the price of
the other good.
Another characteristic of this utility function is that

the parameters of the function give information
about the expenditure shares on each good.
px x a
Share of expenditure on x : =
m a+b
py y b
Share of expenditure on y : =
m a+b
Sufficient condition
Equations (1), (2) and (3) are the necessary
conditions. They are not sufficient. For instance,
consider the following situation:
Point of
tangency
Point of maximum
A utility
At A, the first order conditions are met and yet utility

is not maximized. You need also another set of
conditions which are sufficient. These conditions
boil down to the requirement that preferences have
to be convex. See that in the figure they are concave.
Extreme examples
Corner solutions
Maximum utility, but at this point

Slope of ic > slope bc
MRS > price ratio
A particular example of a corner solution is when

the two goods are perfect substitutes: Suppose
U=x+y and px = 2; p y = 4; and m = 12 .
ic slope: 1
bc slope: 1/2
3
Maximum U
6
Here
px MU x 1
< ; <1
py MU y 2
Maximum is obtained at point A, where only x is
consumed. So the demand function in this case is
m
x=
px
Kinky solutions
Suppose the two goods are perfect complements

with the following utility function:
U = min { x, y}
and px = 2; p y = 4; and m = 24 .
y
4
A
x
4 12
The optimal choice must lie on the diagonal and on

the budget constraint. Therefore, the optimal choice
is found by solving the system
y=x
m = px x + py y
The solution is
m
x= y=
px + p y
For the particular example used here
24
x= y= =4
6
5.2 Changes in the equilibrium position
Now we want to investigate how the equilibrium just

studied is altered (displaced) by changes in the
exogenous variables of this problem. In particular,
we want to know how the equilibrium changes
when, m, px and py change. Or to put it in other
words. The result of the previous analysis was the
derivation of two demand curves
x = x ( px , p y , m)
y = y ( px , p y , m )
We want to sign the partial effects of the three
exogenous variables m, px and py on the demand of
x and y.
We will consider three types of changes:

a) Simultaneous change in prices and income by
the same proportion.
b) Change in income only.
c) Change in one price only.
Equiproportional change in prices and income
If m, px and py all move by the same proportion, the

bc does not change and therefore the point of
equilibrium does not change either.
Suppose initial bc is
m0 = p0x x + p0y y
Multiply all prices and income by k (if, for instance,
k=1.1, then all variables increase by 10%). The new
bc is
km0 = kp0x x + kp 0y y
But k can be cancelled out by dividing both sides of
the equation by k. So, the original bc remains
unchanged.
m0 = p0x x + p0y y
Change in m only
We know that an increase in m moves the bc out.

The position of the final equilibrium depends on
whether the goods are normal or inferior. Suppose
first that both goods are normal. Then, if there is an
increase in income from m0 to m′ , more of both
goods will be bought. This is represented in the
following figure.
B m0
∆y
A
m′
x
∆x
The demand curve that treats prices as given

parameters and income as a variable, is known as the
Engle curve. It takes the form: x = x ( m, p x , p y ) .
( px , p y )
B
m′
m0
A
x
x 0
x′
We say that a good is inferior if when income is

raised, holding everything else constant, less of this
good is bought. Say x is inferior. Then,
m0
∆y
A
m′
x
∇x
Exercise: Derive the shape of the Engle curve

corresponding to good x, when x is an inferior good.
Property: The sum of the income elasticities of each

good, weighted by its corresponding expenditure
share, must be equal to one.
We start with the budget constraint:
m = px x + py y
Then, differentiating both sides of the equality by m,

we find:
dm ∂x ∂y
= px + py
dm ∂m ∂m
∂x ∂y
1 = px + py
∂m ∂m
px x  ∂x m  p y y  ∂y m 
1=  +
m  ∂m x  m  ∂m y 
1 = s xε xm + s yε ym
As we were looking for, the weighted average of

income elasticities must add up to 1.
Implications of this result:

a) Not all goods can be inferior. Not all Engle
curves can have negative slope.
b) Goods that take a large share of expenditures
are unlikely to have either very large or very
low income elasticities, since the average must
equal one.
Problem for home: Say we divide goods in two

types: food and non-food. We know food takes 60%
of expenditures, and the income elasticity of non-
food is 2. What is the income elasticity of food?
Exercise: Find the slope and graphical shape of the

Engle curve for good x when the utility function is
Cobb – Douglas. What about when the goods are
perfect substitutes? And perfect complements? You
will see in this exercise that all Engle curves for

these specific cases are straight lines. This is like
this because the points of equilibrium in the goods
space when income rises is also a straight line from
the origin. In these cases we say that preferences are
homothetic.
Change in one price (holding constant m and the

other price)
Suppose px decreases with p y and m constant.

y
B
p0x
px'
A
x
∆x
Normally if the price of one good goes down, the

quantity consumed of that good goes up.
∇px ⇒ ∆x
and viceversa.
The demand curve

The following graph shows how the demand curve is
derived out of the consumer equilibrium. In fact,
each point in the demand curve is a point of
equilibrium for the consumer at different price
levels.
y
B
p0x
px'
A
x
∆x
px
A
p0x
B
p1x
Demand curve
x ( p x , p y , m)
x
∆x
Exercise: Draw the demand curves (and identify the

slope of the curve) for CD preferences, for perfect
substitutes and for perfect complements.
The demand curve not always is downward sloping.

This is an anomaly, but in principle it can happen.
p0x
px'
A
x
∆x
Demand curve
px x ( p x , p y , m)
A
p0x
B
p1x
x
∇x
Goods which display this anomalous behaviour are

called Giffen goods. [Illustration concerning
consumption of horse meat].
5.3 Income and substitution effects
Now we want to decompose the effect of the change

in one price in two effects:
a) a first effect which is equivalent to a change in
relative prices holding income constant. This is
called the substitution effect.
b) A second effect which is equivalent to a change
in income holding relative prices constant. This
is called the income effect.
Suppose initially we are at point A ( x 0 , y 0 ) , with

prices ( p0x , p 0y ) and income m0 . Therefore, the
budget constraint at this point is:
p0x x 0 + p 0y y 0 = m 0 (1)
Suppose now the price of x goes down to p1x , and we

ask what is the income the consumer would now
need to buy the old bundle of goods. This income,
m1, is
p1x x 0 + p 0y y 0 = m1 (2)
Clearly m1 < m0 . More precisely, the change in

income can be found substracting equation (1) from
equation (2).
m1 − m 0 = p1x x 0 + py0 y 0 − ( px0 x 0 + p0y y 0 )

= x 0 ( p1x − px0 )
∆m = x 0 ∆p x
So, the change in income needed to buy the old
bundle is equal to the initial quantity of x times the
change in the price of x.
Suppose after the price change in x we take away

∆m from the consumer, so his new bc passes through
A but is flatter than his old bc. Will he remain at A?
Clearly not. He can do better than this by going to B
( x s , y s ) . As compared with point A, the consumer
has adjusted his consumption by buying more of the
good that has become relatively cheaper (x) and less
of the good that has become relatively more
expensive (y). The change from point A to point B is
the substitution effect.
We can represent it formally as a change in the

demand for x from the initial position
x0 = x ( p0x , p y0 ,m 0 ) at point A, to the position
x s = x ( p1x , p y0 , m 1 ) at point B. If we denote ( x s − x0 )
by ∆x s , then
∆x s = x ( p1x , p x0 , m1 ) − x ( p0x , p y0 , m 0 )
x s = x ( p1x , p y0 , m 1 ) is called the compensated demand

for x. “Compensated” because is the demand for x as
a result of a fall in the price of x when the consumer

is compensated for the increase in income generated
by the fall in the price of x.
Income effect
The movement from A to B is a hypothetical

movement. At his final choice, the consumer is
spending all his income; so he will be at a point such
as C in the final budget line, where the demand for x
is x n = x( p1x , p 0y ,m 0 ) . Now, observe that the move
from B to C is like a pure income effect (income
increases from m1 to m0 , while prices remain
constant at p1x and p0y ). If we call x n − x s = ∆x n , we
have that the income effect is,
∆x n = x( p1x , p y0 ,m0 ) − x ( p1x , p 0y , m1 )
Total effect
The total effect is the move from A to C. That is

from x0 to x n . Or using the same terminology as
above,
∆x = x n − x 0
∆x = x( p1x , p y0 ,m 0 ) − x ( px0, p y0 , m0 )
( p0x , p y0 , m 0 )
( p1x , p 0y , m1 )
yn C
y0 A
B
s
y ( p1x , p y0 , m 0 )
x
0 s n
x x x
The Slutsky equation
Notice that the total effect can be written as the sum

of the substitution and income effects.
( x n − x 0 ) = ( xs − x 0 ) + ( x n − x s )
∆x = ∆x s + ∆x n
This expression is called the Slutsky equation.
Signing the substitution effect

If px goes down, as in the figure above, then the
change in demand for x that results from the
substitution effect must be non-negative.
If p1x < p0x ⇒ x( p1x , p 0y , m1 ) ≥ x ( px0 , p y0 ,m 0 )

Or,
If p1x < p0x ⇒ ∆x s ≥ 0
Why is this so? Because the indifference curves are
well behaved (continuous, smooth, negatively sloped
and convex). Convince yourself that with this type
of i.c. it cannot be otherwise. Points to the left of A
will lie on lower i.c. and therefore will not be
chosen. Conclusion: The substitution effect always
moves opposite to the price movement. We say the
substitution effect is negative: if the price goes
down, the demand for the good due to the
substitution effect increases, and vice versa.
Signing the total effect
Contrary to what happens with the substitution

effect, the total effect can be signed most of the
times, but not always. It depends on whether the
good is normal or inferior. To see that, recall the
Slutsky equation.
∆x = ∆x s + ∆x n
Normal goods
∆x = ∆x s + ∆x n
(−) = (− ) + (− )
Both substitution and income effects work in the
same direction. Consequently, as price goes down,
quantity demanded goes up, and vice versa. The
total effect is negative.
Check you understand why income effect in this

case is negative. px ↓⇒ m ↑⇒ x ↑ . Price and good
demanded due to income effect move in opposite
directions.
Inferior goods
∆x = ∆x s + ∆x n
(?) = (− ) + (+ )
Here the sign of the final effect depends on the
relative strength of substitution and income effects.
We have two possibilities:
a) Substitution effect dominates in absolute terms.
Then the total effect is negative. This is what
will usually happen.
b) Income effect dominates in absolute terms.
Then the total effect is positive: as price goes
down, quantity demanded goes up and vice
versa. This means that the demand curve is
upward sloping. We call this type of goods,
Giffen goods. They are very rare.
A conclusion regarding inferior and Giffen goods:

a Giffen good must be an inferior good, but no all
inferior goods are Giffen goods.
Expressing the Slutsky equation in terms of

rates of change with respect the change in
price.
∆x = ∆x s + ∆x n
∆x ∆xs ∆xn
= + (1)
∆ p x ∆ p x ∆p x
Recall previous result,
∆ m = x∆ p x
If the price goes down, this expression gives us a
negative number (the amount of income that, as a
result of the price fall, has to be taken away from the
consumer so that he can just afford the old bundle
A). To identify the income effect from B to C we
want to work with the negative of this (negative)
amount: specifically, with the amount of money that
is given to the consumer so that he can go from the
budget AB to the final budget at C. For this purpose
we define a new change in income, (∆n) , which is
just the negative of the previously defined income
change, ( ∆m) ,
∆n = −∆m
∆n = − x∆p x
∆n
∆px = − (2)
x
Substituting (2) into (1)
∆x ∆x s ∆x n
= −x
∆px ∆px ∆n
Which is the Slutsky equation expressed in terms of

rates of change. Notice that now the income effect is
expressed directly as a change in x due to a change
in income and, therefore, for a normal good, is
positive.
From this equation we state the Law of Demand: If

the demand for a good increases when income
increases (that is, if the good is normal), then the
demand for that good must decrease when its price
increases.
∆x ∆x s ∆x n
= −x
∆px ∆px ∆n
(−) = (− ) − (+ )(+ )
Naturally, this can be said because we know the

substitution effect is always negative.
Another way of measuring the substitution effect:

the “Hicks” substitution effect.
The previous way of measuring the substitution

effect was proposed by an economist called Slutsky.
Another economist (John Hicks) proposed another
way of identifying the substitution effect. To
compare them we define both:
Slutsky substitution effect: Change in demand when

prices change but the consumer’s purchasing power
is held constant so that the original bundle remains
affordable.
Hicks substitution effect: Change in demand when

prices change but the consumer’s income is changed
so that he can reach his original utility level. That is,
change in demand when prices change but
consumer’s utility is held constant at its original
level.
For small (infinitesimal) changes in prices both

measures coincide.
For large (non infinitesimal) changes in prices they

differ. This can be seen graphically.
( p0x , p y0 , m 0 )
( p1x , p 0y , m1 )
B’ ( p1x , p y0 , m 0 )
x
0 s n
x x x
px x sH
p0x A
C
p1x
B’ Demand curve (dc)
Compensated dc (Slutsky)
Compensated dc (Hicks)
x
In the graph we identify three demand curves:
Usual demand curve (dc):
x = x ( p x , p y , m)
Compensated dc (Slutsky):
x = x( px , p y ,purchasing power)
Compensated dc (Hicks):
x = x ( px , p y , u )
Check you understand the ceteris paribus clause of

each of these three demand curves.
Exercise:
How would the graph below look like if good x
instead of being normal was inferior? (What will be
the relative configuration of the three demand
curves?)
5.4 Implications of the MRS conditions
Observation of demand behaviour can give us

information about the underlying preferences of
consumers who display that behaviour.
In a competitive market, prices are the same for

everybody. Thus, if consumers are at equilibrium
positions,
px
MRS1 = MRS 2 = MRS 3 = ... = MRSn =
py
Everybody will adjust their consumption of goods
until their own “internal” marginal valuation (MRS)
equals the market’s external valuation ( px p y ) .
Marginal changes in consumption, therefore, will be
valued the same for everybody.
Example (Varian’s): Suppose that in a competitive

market one bottle of milk costs 1€ and one pack of
butter costs 2€. This means that,
MU b p
MRS = = b =2
MU m pm
Any project (policy) that gives people goods for
more than what they value them is profitable, and
vice versa.
Project A: 1 pack of butter is produced with 3 bottles

of milk. This is not a good project. Using market
prices, it is equivalent to saying that 2€ are produced
with 3€. People value more the inputs than the
output of this project.
Project B: 3 bottles of milk are produced with 1 pack

of butter. This project is OK. Using market prices, it
is equivalent to produce 3€ with 2€. Here people
value inputs less than output.
Conclusion: Prices are not arbitrary things; rather,

they reflect how people value things at the margin.

Micro I. Lesson 5: Consumer Equilibrium 5.1 Optimal Choice: MU P MU P

Uploaded by

Copyright:

Available Formats

You might also like

Micro I. Lesson 5: Consumer Equilibrium 5.1 Optimal Choice: MU P MU P

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Micro I. Lesson 5: Consumer Equilibrium 5.1 Optimal Choice: MU P MU P

Uploaded by

Copyright:

Available Formats

Microecono mics I. Antonio Zabalza.

Micro I. Lesson 5 : Consumer Equilibrium

5.1 Optimal Choice

If preferences are well behaved (smooth, convex,

At A, for instance, if I give up 1 unit of x (distance

If I keep applying this reasoning I end up at point C.

Mathematics: Maximization of utility subject to a

First order (necessary) conditions

This is a system of 3 equations in 3 unknowns: x, y

Then, to solve for x and y we consider equation (3)

This is a system of 2 equations with two unknowns

Solving this system will, in general, give us the two

The purpose of this lesson is to find out how the

Eliminate λ from (1) and (2), and together with (3)

System of two equations with two unknowns.

Equation (4) can be expressed in the form

So the system, in this simplified form is

Solving for x and for y, we find the two demand

With a CD utility function, the demand for each

Another characteristic of this utility function is that

At A, the first order conditions are met and yet utility

Maximum utility, but at this point

A particular example of a corner solution is when

Suppose the two goods are perfect complements

The optimal choice must lie on the diagonal and on

5.2 Changes in the equilibrium position

Now we want to investigate how the equilibrium just

We will consider three types of changes:

c) Change in one price only.

Equiproportional change in prices and income

If m, px and py all move by the same proportion, the

We know that an increase in m moves the bc out.

The demand curve that treats prices as given

We say that a good is inferior if when income is

Exercise: Derive the shape of the Engle curve

Property: The sum of the income elasticities of each

We start with the budget constraint:

Then, differentiating both sides of the equality by m,

As we were looking for, the weighted average of

Implications of this result:

Problem for home: Say we divide goods in two

Exercise: Find the slope and graphical shape of the

will see in this exercise that all Engle curves for

Change in one price (holding constant m and the

Suppose px decreases with p y and m constant.

Normally if the price of one good goes down, the

The demand curve

Exercise: Draw the demand curves (and identify the

The demand curve not always is downward sloping.

Goods which display this anomalous behaviour are

5.3 Income and substitution effects

Now we want to decompose the effect of the change

Suppose initially we are at point A ( x 0 , y 0 ) , with

Suppose now the price of x goes down to p1x , and we

Clearly m1 < m0 . More precisely, the change in

m1 − m 0 = p1x x 0 + py0 y 0 − ( px0 x 0 + p0y y 0 )

Suppose after the price change in x we take away