HE 601: Advanced Microeconomics I

Class Notes
©Syed M. Ahsan

Spring, 2023
 Lecture 3: Consumer Choice
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Outline of Lecture
▪ 3.1 Introduction
▪ 3.2 Commodities
▪ 3.3 The Consumption Set
▪ 3.4 Competitive Budgets
▪ 3.5 Demand Functions & Comparative
Statics
▪ 3.6 WARP & the Law of Demand
▪ 3.7 Conclusion

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 3.1 Introduction
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 In this lecture we try to explore how a consumer would go about

making a purchase in a market economy, i.e., at known prices.
 MWG defines a ‘market economy’ at this juncture in a most elementary
manner, as a context where goods can be traded among participants at
given prices.
 Haggling or the process of price discovery is left out of purview for the
moment.
▪ We move from the concept of (a) Commodities to (b) the Consumption
Set, (c) Competitive Budgets, (d) Demand Functions, (e) Comparative
Statics, and finally, (f) WARP & the Law of Demand.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 3.2 Commodities
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 Commodities are either goods (papayas) or services (haircuts).

 Consider a finite set of L- goods/commodities, indexed by l (= 1, 2,..,
L). A vector of L-goods may be written as
x = [x1, x2, …, xL]T ∈ RL,
where xl denotes the quantity of the l -th good. We would normally
write this as a column vector, i.e., xT, but to save space, is being written
as a row-vector.
 One can think of this to be an element (point) in RL, the commodity
space.
 When a commodity vector indicates the consumption level of a
consumer, we can refer to that as a consumption vector, or the
consumption bundle.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Commodities
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 Note that time or ‘states of nature’ can be built into the concept of a
commodity space by alternatively interpreting l (= 1, 2,.., ), as
consumption at date- l or consumption in state- l.
 Definition: ‘States of nature’. Under conditions of uncertainty, it is
often convenient to describe the yet unknown realised value at a future
point in time of, say consumption or wealth, to depend on the state of
nature (e.g., some good , some bad). In the context of a finite number
of possibilism, we may have l –states of nature.
 Arrow had defined a ‘states of nature’ as a description so complete that
if/once known, all uncertainty would be resolved.
 Examples of ‘states’: portfolio returns in financial markets, farmer's
harvest of rain-fed crops, milk yielded by a cow/buffalo on the quality
of the feed.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 3.3 The Consumption Set
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 Definitionally, a ‘consumption set’ is a subset of consumption bundles

X ⊂ RL, that one can conceivably have access to on account of physical
or natural constraints obtaining in the specific context/environment.
 These constraints, to repeat, are not due to affordability etc, but are
strictly physical or natural (e.g., the hours of sunlight in a day).
 Fig 3.3 (next slide) presents four examples for L =2.
 (a) Top-left panel (a) describes x2 (leisure hours per day) that has a
natural cap on top (here 24); in real-life possibly 15 or so in view of
minimum rest required for bodily sustenance. … Definitional issue.
 (b) The top-right illustrates the case where x2 availability is strictly in
non-negative integers (e.g., quantity of hotel accommodation while a
guest); only in special cases half days may be added at the end.
 (c) The bottom-right depicts what is the daily necessity for human
survival, a bowl of rice, brown or white (here 4 pcs of some bread).
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 Fig 3.1 Possible Consumption Sets (Fig 2.C in MWG)
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Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Consumption Set
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 (d) The final illustration is an environment where it is only feasible to

have one of the two goods at a time, i.e., the consumption set consists
of points along only one of the two axes.
 Note that here the same good in different locations are being treated as
different goods.
 The constraints cited above include those of an institutional nature as
well, such as max working hours per day/week/year.
 Generic definition of a consumption set:
X = RL+ = {x ∈ RL: xl  0, for l (= 1, 2,..,L)}.
 Note that X admits only non-negative values of x. This is depicted by
the right-panel of Fig 3.2 (next slide, right panel).
 The left-panel in the figure is supposed to describe the fact that leisure
(Z), must be constrained: if work 0  H  16, H+ Z = 24, or, Z = 24 –H
= 24 – [0,16], i.e., 24  Z  8.
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 Fig 3.2 Examples of Consumption Sets (MWG)
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 A more meaningful interpretation of the labour market would be claim

that everyone needs a minimum of 8 hrs/day as minimum rest, thus
only 16 hr are available for work or what we can call ‘discretionary’
leisure, i.e., H+Z =16, then 16  Z  8. This would require a re-labelling
of the graph.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 Math Appendix, … Fig 3.3 Convex Sets
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 Math Definitions, Convex Set: The set A ⊂ RN is a convex set if

{x +(1- )x} ∈ A whenever x and x ∈ A, and  ∈ [0,1]. Illustration
next slide.

 Asf
 The left panel is of curse convex, but not the ones to its right. The last has
holes on its boundary (all sides), though the interior of the set is convex.
 Note that the intersection of all convex sets is always convex, but not their
union. An easy illustration: Take a square and a rhombus of equal base.
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 … Math Appendix, Fig 3.4 Convex Hull
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 Convex Hull: For a set B ⊂ RN, has a convex hull, C0B, if that is the
smallest convex set containing B (i.e., containing all points in B), that is
the intersection of all convex sets that contain B.
 Obviously the issue arises when B itself is not convex. Note that the non-
convex part (rt-panel) is being made convex by a straight line at the
boundary points.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … … Math Appendix
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 Q: What would be a convex hull of the square, i.e., the figure in the
right panel of Fig 3.3?
 Returning to the idea consumption sets, RL+, is a convex set.
 Of the six examples of consumption sets, in figures 3.1 and 3.2,
determine if any of these are not convex?
 Most of the discussion on consumption sets to follow require the
assumption of convexity.
 Incidentally, Figs 3.3 and 3.4 are taken from lecture notes (Boyd &
Vandenberghe, www.stanford.edu/class/ee364a/lectures/sets.pdf).
 You would agree that many figures in the MWG text are poorly
executed.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 3.4 Competitive Budgets
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 We now turn to the question of a consumer’s affordability as this

relates to a possible consumption set.
 To start off we make two assumptions: (a) ‘Universality of markets’, a
term Arrow (1970) had used, which requires that all L-goods to trade in
the market at prices known at the time of making choices, i.e., there is
exists a price vector p = [p1, p2, .. ., pL]T ∈ RL. Here T-denotes the
transpose of the row-vector.
 Though negative prices can be interpreted (e.g., in case of ‘bads’), we
shall assume hereafter that p ≫ 0, i.e., pl >0, all l .
 (b) the second assumption we make is the price-taking behaviour,
implying that each consumers likely demand for a good is small in view
of the market for that good.
 Recall that this is a defining feature of a competitive market.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Consumer’s Budget
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 Idea of a budget constraint: Let w be the wealth of a person which can

be spent on goods, x ∈ RL. Now we define affordability: A bundle
x ∈ RL is affordable if the expenditure does not exceed the available
wealth (w), i.e.,
p.x = l (pl xl )  w, for l = 1, 2, …, L.
 Income vs wealth: Note the conventional use of ‘income’ in consumer
budget analysis; wealth may be more appropriate in a more general
life-cycle context of consumption allocation over time.
 Def: A competitive budget (or, a Walrasian budget),
Bp,w = {x ∈ RL+ : p.x  w},
consists of all feasible allocations that are affordable given p and w.
 The ‘consumer choice problem’, or simply the consumer problem is
merely: to choose a consumption bundle x given Bp,w .
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 Fig 3.5 Examples of Competitive Budget Sets
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 To be relevant, we assume w>0.

 Here the left panel shows the budget set, Bp,w, while the right panel
illustrates the impact of decline in the price of the second of the two
goods. This widens the consumption set considerably.

 dfsdf

 Df

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Consumer’s Budget
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 The set {x ∈ RL+ : p.x  w}, namely the upper boundary of the budget
set, is called a budget hyperplane, which of course in 2-good case,
becomes the budget line. See illustrations in Fig 3.5.
 Convexity of the Budget set: The Walrasian budget set Bp,w is convex.
Thus if both bundles x and x are elements of Bp,w , so is the bundle
x = {x +(1- )x},  ∈ [0,1].
 This can be verified easily. First note that so long as both x and x >0,
so is x ∈ RL+. Next, we show that the cost of x will not exceed w.
 Since both p.x  w and p. x  w. Thus p.x = {(p.x) +(1- )(p. x)}  w.
Thus x∈ Bp,w = {x ∈ RL+ : p.x  w}.
 It happens that the convexity of the budget set is derived form he
convexity of the consumption set, RL+.
 While we mostly analyse convex budget sets, an important non-convex
example has been studied in labour economics (supply of work hours).
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 Non-convex Budget: A Labour Market Example
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 The MWG text refers to a famous, but realistic description of the

market trade-off between a consumption good and leisure, involving
taxes, subsidies, and several wage rates.
 The Context: There are two goods. The price of the consumption good
is 1, and the consumer earns wage rate s per hour for the first 8 hours
of work and s > s for any additional (‘overtime’) hours. He also faces a
tax rate t per dollar on labor income earned above amount M (> 8s). Is
the budget set a triangle? Is it convex?

Adv Micro-I, Lect 01_Ahsan 3/23/2023

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Adv Micro-I, Lect 01_Ahsan 3/23/2023

 3.5 Demand Functions & Comparative Statics
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 Definition: Walrasian/Ordinary demand correspondence x(p,w)

assigns a commodity bundle to each (p,w)-pair. This in principle can
be multi-valued, meaning more than a singe bundle assigned to a
unique (p,w).
 However, whenever the x(p,w) correspondence is unique, i.e., single-
value, we call it a demand function.
 Properties/assumptions of Walrasian demand correspondence: Two.
 (a) HOD‘0’ (homogeneity of degree-zero): The Walrasian demand
correspondence x(p,w) is homogeneous of degree-zero if x(p, w) =
x(p,w), for all (p,w) and any  >0.
 It is elementary to observe that if all prices and wealth rise by the same
proportion, the set of feasible choices, namely the consumption set,
and the choice of the bundle remains unchanged. That is Bp,w and
Bp,w are identical. Give illustrations.
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 … Demand Functions
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 (b) The second assumption is Walras Law: The Walrasian demand

correspondence x(p,w) satisfies the Walras law if for every p ≫ 0 and
w>0, (p.x) = w for all x ∈ x(p,w).
 This basically says that the consumer would always use up the
available resources; it is implicit that the saving decision has already
been made.
 This is more reasonable in an intertemporal context, i.e., an individual
would plan to spend all in one’s own lifetime. Bequest is often
considered as consumption at the time it is made.
 An Illustration: Denote consumption in each period (1: when young,
and 2: when old) by C1 and C2, and correspondingly the earnings as y1
(wages/salaries) and y2 (pension income/odd jobs etc), one can write
the budget constraint as follows (next slide).
 Note that here {y1 , y2, r} are all taken as constants.
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 The Lifetime Consumption Choice
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 Constraints are:
(1) C1 = (y1 –S) and C2 = y2 +S(1 +r),
where r-denotes the rate of return on saving. Substituting for S in the
period-2 constraint, we have
C2 =[y2 +(y1 - C1)(1 +r)], or, re-arranging,
(2) C1(1+r) +C2 = [y1 (1+r) +y2]
 Now dividing through by (1+r),
(3) [C1 + C2 (1+r)-1]= [y1 +y2 (1+r)-1].
 Here the lhs denotes the present value (PV) of life-time consumption,
while the rhs the PV of life-time earnings.
 If we allow bequest at the end of life, in eq (1) the second part would
read (C2+B) = y2 +S(1 +r),
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 … Lifetime Consumption Choice
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 Consequently , eq (2) and (3), respectively, would read as follows:

(2a) C1(1+r) +(C2+B)= [y1 (1+r) +y2]
(3a) [C1 + (C2+B)(1+r)-1]= [y1 +y2 (1+r)-1].
 From (3) by total differentiation, we have the budget line slope as:
dC1 + dC2 (1+r)-1 = 0, C2
or, (4) (dC2 /dC1) = - (1+r).
[(1+r)-1 +y2]
 From (3a), we may similarly
obtain:
(4a) [d(C2 +B)/dC1]= (-)(1+r).
y2
The constraint (4a) may be
interpreted as the budget line drawn
C1
At the right where the vertical axis y1 [y1 +(1+r) y2]
would measure (C2 +B).
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 … Consumer’s Budget
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Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Consumer’s Budget
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 Exercise next slide: Note that here that the demand functions are such that
(i) p1x1 = (1w), (ii) p2x2 = (2w), and if  =1, also (iii) p3x3 = (3w).
 Now it is easy to verify that {1+ 2+ 3} = 1. Hence in this case, i.e., if  =1,
we have p.x = w, i.e., the Walras law is satisfied.
 If  < 1, for the third good, we get p3x3 = ( 3w). Thus
p.x = {1+ 2+  3}w < w since {1+ 2+  3} <1.
 To check for HOD‘0’, it is trivial to establish that there is no issue here.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Consumer’s Budget
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 Later in chapter 3, we shall see that both the above properties hold
under rather general behavioural conditions and hence are not mere
assumptions, but till then these will remain convenient assumptions.
 Normalization: Note that in principle, our demand correspondence
x(p,w) have L+1 independent variables, but we can reduce it to L,
either by setting the price of a (numéraire) good- l to unity, i.e., pl =1,
or alternatively by setting w =1. Thus the effective L-arguments in
x(p,w).
 Gong forward, we also assume x(p,w)-single valued. Thus we can write
the x-vector in terms of individual commodities, x l (p,w):
x(p,w) = [x1(p,w), x2(p,w)…., xL(p,w)]T,
where T-denotes the transpose o the row vector.
 From here on, we also assume that x l (p,w) to be both continuous and
differentiable.
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 Comparative Statics
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 What are Comparative Statics? Or, Samuelson's ‘meaningful

theorems’: “ .. In order for the analysis to be useful it must provide
information concerning the way in which our equilibrium quantities
will change as a result of changes in the parameters taken as
independent data .. he must infer analytically the qualitative direction
of movement of a complex system” (1941).
 Here we would like to know how would demand be affected by changes
in price ad wealth.
 (i) Wealth effects: Holding prices fixed at some level, 𝑝ҧ , we can
examine the behaviour of x(𝑝,w), ҧ which us called a consumer’s Engel
Function, E𝑝 ҧ . Idea is due to Ernst Engel (1821-96, German statistician)
not to be confused with an American statistician/economist, Robert
Engle, the 2003 Laureate.
 Its image in RL+, E = {x(𝑝,w),
ҧ w>0} is called the wealth (more
𝑝ҧ
commonly, the income) expansion path.
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 Fig 3.6 Wealth Expansion Path
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 For a given (p,w), {xl (p,w)/w} is known as the wealth effect of good-l .
 Normalcy/Inferiority: A good x l is normal at (p,w) if {xl (p,w)/w}0,
and is inferior at (p,w) if the derivative is negative.
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 … Consumer’s Budget
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 If all goods are normal at all (p,w), one says that demand is normal.
 Normality makes sense if goods are defined as aggregates such as food,
shelter, holidays, … , rather than spinach, cucumber, …
 In matrix notation, the wealth effects may be expressed as
Dw.x(p,w) = [x1(p,w)/w, x2(p,w)/w, …. , xL(p,w)/w]T ∈ RL

 (ii) Price Effects: Here in general we examine the effect of a change in

one price pk, on the demand for good-l , i.e., xl (p,w)/pk , while of
course w remains unchanged.. For L=2, we will let p1 remain
unchanged, and examine the effect of increases in p2 only.
 The latter changes in R2+ can be seen as the locus of points on various
budget lines, one for each level of p2 , which is often called the offer
curve, (or the price offer curve to distinguish it from the income offer
curve, which we have termed, the wealth expansion path).
Adv Micro-I, Lect 01_Ahsan 3/23/2023
 Fig 3.7 The (Price) Offer Curve
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 Offer Curve: see the illustration below (from MWG)

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Consumer’s Budget
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 The derivative, xl (p,w)/pk, denotes the price effect of a change in pk on the
demand for good-l.
 Own Price Changes: While one would ordinarily expect people to buy
more of a good when its price falls, i.e., xl (p,w)/pk < 0, it is not
unthinkable that the opposite may happen on occasion. Such goods are called
Giffen goods, i.e, xl (p,w)/pk > 0.
 In Fig 3.7 above, in the bottom panel, good-2 is inferior throughout. Moreover
it becomes a Giffen good at {𝑝ഥ1, p2, w).
 Imagine a very poor person spending a lot of money on a basic good such as
potatoes; now if the potato price falls, income remaining the same, he now
becomes able to afford other goods (say corn) and ends up buying less
potatoes.

Adv Micro-I, Lect 01_Ahsan 3/23/2023

 … Price Effects
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 The price effects can be conveniently represented in matrix notation as

follows:

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Adv Micro-I, Lect 01_Ahsan 3/23/2023

 References
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Adv Micro-I, Lect 01_Ahsan 3/23/2023