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MICROECONOMICS

Theory of Consumer Behavior


ASISTENSI-3 & 4

Program Pascasarjana
Universitas Indonesia
Ilmu Ekonomi
Harry Patria
15 Maret 2016

Scope
3.1 Problem Exercises: Maximization Utility
3.2 Problem Exercises: Expenditure Minimization
3.3 Problem Exercises: Slutsky & Hicksian
3.4 Problem Exercises: Roys identity

3.5 Graphical Derivation (Marshall, Hicks & Slutsky)

UMP & EMP Schematic Diagram

UMP & EMP Schematic Diagram

Please explore:
a) Marshallian Demand
b) Indirect Utility
c) Hicksian Demand
d) Expenditure Function
e) Roys identity
f) Sheppard Lemma
g) Slutsky Equation
h) Substitution Effect

3.1 Problem Exercises: Maximum Utility


Jika fungsi utilitas untuk barang X dan Y adalah U = 7200X 0.75 Y 0.25
dengan harga $90 per unit X dan $ 30 per unit Y serta income total
$ 1200, Tentukan:
a) berapa unit X dan Y yang memaksimalkan utilitas?
b) Utilitas maksimum?
c) Nilai dari lamda dan interpretasinya?
d) Intepretasi nilai lamda pada jawaban c?

3.1 Problem Exercises: Maximum Utility

3.1 Problem Exercises: Maximum Utility

3.1 Problem Exercises: Maximum Utility

3.2 Problem Exercises: Expenditure Minimization


Formulasikan soal sebelumnya dengan expenditure minimization,

Tentukan:
a) berapa unit X dan Y?
b) Minimum expenditure?
c) Nilai dari lamda dan interpretasinya?
d) Intepretasi nilai lamda pada jawaban c?

3.2 Problem Exercises: Expenditure Minimization

3.2 Problem Exercises: Expenditure Minimization

3.2 Problem Exercises: Expenditure Minimization

3.3

Problem Exercises: Slutsky & Hicksian

Assume a person has a utility function U = XY, and money income of


$10,000, facing an initial price of X of $10 and price of Y of $15. If
the price of X increases to $15, answer the following questions:
a) What was the initial utility maximizing quantity of X and Y?
b) What is the new utility maximizing quantity of X and Y
following the increase in the price of X to $15?
c) What is the Hicks compensating variation in income that would
leave this person equally well off following the price increase?
What is the Slutsky compensating variation in income?
d) Calculate the pure substitution effect and the real income
effect on X of this increase in the price of X. Distinguish
between the calculation of these effects using the Hicksian
analysis vs. the Slutsky analysis.

3.3

Problem Exercises: Slutsky & Hicksian

a. There are two related approaches. Both approaches require


the simple derivation of the first order condition for maximizing
utility subject to a budget constraint:
MU(x) /MU(y) = P(x)/(P(y)
In this simple case, this becomes Y / X = 10 / 15 = .67, or Y = .67 X
and X = 1.5 Y.
Thus, any optimal consumption combination must have this
relationship between X and Y.
Approach 1 uses this information to solve for either X or Y by
simple substitution into the budget equation M = P(x) X + P(y) Y.
For example, substituting X = 1.5 Y yields the following:
10,000 = $10 (1.5Y) + $15 Y

3.3

Problem Exercises: Slutsky & Hicksian

a. There are two related approaches. Both approaches require


the simple derivation of the first order condition for maximizing
utility subject to a budget constraint:
MU(x) /MU(y) = P(x)/(P(y)
In this simple case, this becomes Y / X = 10 / 15 = .67, or Y = .67 X
and X = 1.5 Y.
Approach 1 uses this information to solve for either X or Y by
simple substitution into the budget equation M = P(x) X + P(y) Y.
For example, substituting X = 1.5 Y yields the following:
10,000 = $10 (1.5Y) + $15 Y
10,000 = 15 Y + 15 Y = 30Y so Y = 333.33, and X = 1.5Y = 500

3.3

Problem Exercises: Slutsky & Hicksian

Approach 2 is a bit more general, deriving the demand functions


for both X and Y and then substituting the relevant parameter
values. From above, the first order condition was Y / X = P(x) /
P(y), which can be manipulated to be P(y) Y = P(x) X, or total
expenditures on X = total expenditures on Y
The next step is again to substitute back into the budget
equation to derive a more general demand function for X and Y.
That is, M = P(x) X + P(y)Y, but since P(x)X = P(y)Y, this becomes
either M = 2 P(x) X or M = 2 P(y)Y, and finally:
X = M / 2 P(x) and Y = M / 2 P(y), which given M = 10,000,
P(x) = 10 and P(y) = 15 yields Y = 333.33 and X = 500 as with
Approach 1.

3.3

Problem Exercises: Slutsky & Hicksian

b. It is then easy, especially with Approach 2 to determine how


the optimal consumption bundle changes as the price of X
increases to $15. The quantity of Y does not change (essentially
the pure substitution effect and real income effects for Y are
totally counterbalancing, so that Y does not change another
unique result of Cobb-Douglas utility functions). However, the
optimal X does change, dropping from 500 to 333.33, or by a
total of 166.67.
So the answer to b. is Y = no change; X = 333.33, a reduction of
167.67.

3.3

Problem Exercises: Slutsky & Hicksian

c. The Hicksian compensating variation in income is that amount of M,


holding the price of X constant at its higher level of $15, that will allow the
person to as well off as they were before the price increase. In Hicksian terms
of course, being equally well off means having the same level of utility.
Original utility was U = XY = (333.33)(500) = 166,665.
Methodological footnote: Note that any monotonic transformation of this
utility function such as U = X 2 Y 2, or U = X . 5 Y .5 will only change the total
number of utils (which is irrelevant, since utility in this context is only an
ordinal concept (ordering from less to more rather than a cardinal concept
having a specific quantity). Thus, when X and Y are especially large numbers,
it is easier to use the square root transformation above to generate lower
and easier to work with numbers.

3.3

Problem Exercises: Slutsky & Hicksian

Back to the problem: When the price ratio of X to Y had been 10/15, we
observed above that Y = .67 X and X = 1.5 Y. Now, with both prices equal to
$15, the price ratio is 1:1, and Y = X, meaning that the utility maximizing
bundle at the new relative price ratio on the original indifference curve must
have the same quantity of X and Y. Substitution allows the following result:
U = XY, but if X=Y, U = X 2 or original utility 166,665 = X 2 or X = 408.25 and Y
= 408.25. Note that on a graph, these would be the quantities at the
tangency point of the shifted budget line (with the higher relative price of X)
and the original indifference curve.

Final step is to calculate the amount of M that must be spent to achieve X = Y


= 408.25, which is M = $15 (408.25) + $15 (408.25) = $12,247.50. Original M
was $10,000, so the Hicksian compensating variation of income (HCV) =
$12,247.50 - $10,000 = $2,247.50.

3.3

Problem Exercises: Slutsky & Hicksian

The Slutsky compensating variation (SCV) is much easier to calculate: At the


new prices the money income required to consume the original X,Y bundle of
X = 500, Y = 333.33 is simply: M = $15 (500) + $15 (333.33) = $12,499.95.
This is the money income required to allow a budget line at the new slope
(with higher price of X) to go through the original consumption point. Since
$12,499.95 - $10,000 = $2,499.95, that is the SCV. Note that in this case, with
the price of X having gone up, the SCV > HCV by $252.45.
So, to summarize the answer to this part: HCV = $2,247.50 and SCV =
$2,499.95

3.3

Problem Exercises: Slutsky & Hicksian

d. Finally, if no compensating variation is actually paid, the full reduction in


the consumption of X is from 500 to 333.33 or 167.67. How much of this
167.67 reduction is due to a pure substitution effect and how much is due to
a real income effect. We can rely on the analysis in c to derive the results for
both the Slutsky and the Hicksian analysis.
Hicksian analysis: We found above that if the real income effect is eliminated
by hypothetically (in this case) giving the person another $2,247.50, the
new point on the original indifference curve is X = 408.25, Y = 408.25.
Therefore, the movement along that original indifference curve representing
the pure substitution effect is 500 408.25 = 91.75. Then, the remaining
change in X of 408.25 333.33 = 74.92 is the real income effect (the result of
now taking that $2,247.50 away from the person, so there is a parallel shift to
the left to the lower indifference curve at X = 333.33 and Y = 333.33).

3.3

Problem Exercises: Slutsky & Hicksian

Slutsky derivation of substitution and income effects: We found above that


the elimination of the real income effect as defined by Slutsky would require
a hypothetical increase in M of $2,499.95 to M = $12,499.95. We also
know as stated earlier that with P(x) = P(y), the first order condition requires
that Y = X. Thus, we can calculate the point on the higher utility indifference
curve that can be achieved with $12,499.95 (and the more steeply sloped
budget line incorporating the higher price of X) as $12,499.95 = $15 X + $15 Y,
or since X = Y, $12,499.95 = 15 X + 15 X, so X = 416.67, and Y = 416.67.
Therefore, the pure substitution effect related to X is 500 416.67 = 83.33
and the real income effect is then the residual of 416.67 333.33 = 83.34
(essentially equal, just a rounding difference).

3.3

Problem Exercises: Slutsky & Hicksian

To summarize the analysis:


Hicks or Hicksian compensating variation in income = $2,247.50
Slutsky compensating variation in income = $2,499.95
Hicksian derived pure substitution effect on X = 91.75
Hicksian derived real income effect on X = 74.92
Slutsky derived pure substitution effect on X = 83.33
Slutsky derived real income effect on X = 83.34
In this case, following a price increase for X, the Slutsky approach understates
the pure substitution effect by giving too much compensating variation of
income to the person (and thus attributing part of the real substitution
effect erroneously to an income effect). Thus, the Slutsky real income effect
is too large and its pure substitution effect is too small relative to the
more theoretically correct, but more difficult to measure, Hicksian analysis.

3.4 Problem Exercises: Roys identity

Exercise

Exercise

Exercise

Exercise

The Marshall, Hicks and Slutsky


Demand Curves
Graphical Derivation

We start with the following diagram:


y

In this part of the diagram we have drawn


the choice between x on the horizontal axis
and y on the vertical axis. Soon we will draw
an indifference curve in here.

x
px

Down below we have drawn the


relationship between x and its price Px.
This is effectively the space in which we
draw the demand curve.

Next we draw in the


indifference curves
showing the consumers
tastes for x and y.

y0

x0

px

Then we draw
in the budget
constraint and
find the initial
equilibrium.

Recall the slope


of the budget
constraint is:

y0

px
dy

dx
py
x0

px

From the initial equilibrium we can


find the first point on the demand
curve

y0

x
px

Projecting x0 into the


diagram below, we
map the demand for x
at px0

px0

x0

Next consider a rise in the price of x,


to px1. This causes the budget
constraint to swing in as px1/py0 is
greater.

y0

x1

To find the demand for x


at the new price we
locate the new
equilibrium quantity of x
demanded.

px

Then we drop a line


down from this point to
the lower diagram.

px1
px0

This shows us the new


level of demand at p1x
x1

x0

We are now in a position to draw


the ordinary demand curve.

y0

First we highlight the


px and x combinations
we have found in the
lower diagram and
then connect them
with a line.

px
px1

This is the Marshallian


demand curve for x.

Dx

px0

x1

x0

Our next exercise involves giving


the consumer enough income so
that they can reach their original
level of utility U2.

y0

U2
U1
x1

px

x0

px1
px0

Dx

x1

x0

To do this we take the


new budget constraint
and gradually increase
the agents income,
moving the budget
constraint out until we
reach the indifference
curve U2

y0

U2
U1
x1 xH

px

x0

px1
px0

Dx

x1

x0

The new point of


tangency tells us the
demand for x when the
consumer had been
compensated so they
can still achieve utility
level U2, but the relative
price of x and y has
risen to px1/py0.

The level of demand for x


represents the pure
substitution effect of the
increase in the price of x.
This is called the
Hicksian demand for x
and we will label it xH.

We derive the Hicksian


demand curve by projecting
the demand for x downwards
into the demand curve
diagram.

y0

U2
U1

px

x1 xH

x0

px1
px0

To get the Hicksian demand


curve we connect the new
point to the original
demand x0px0

Dx

x1 xH x 0

Notice this is the


compensated
demand for x when
the price is px1.

We label the curve Hx

y0

U2
U1

px

x1 xH

x0

Notice that the Hicksian


demand curve is steeper
than the Marshallian
demand curve when the
good is a normal good.

px1
px0

Dx
Hx
x1 xH x 0

y0

U2

Notice that an
alternative
compensation
scheme would be to
give the consumer
enough income to
buy their original
bundle of goods x0yo

U1
px

x1 xH

x0

In this case the


budget constraint has
to move out even
further until it goes
through the point
x0y0

px1
px0

Dx
Hx
x1 xH x 0

But now the


consumer doesnt
have to consume x0y0

U3

y0

U2

U1
px

x0

x1

So they will choose a


new equilibrium
point on a higher
indifference curve.

px1
px0

Dx

Hx
x1 xH x 0

Once again we find the demand for x at


this new higher level of income by
dropping a line down from the new
equilibrium point to the x axis.

U3

y0

U2

U1
px

x1 xs x0

Once again this income


compensated demand
is measured at the price
px1

px1
px0

Dx

Hx
x1 xHxs x0

We call this xs . It is
the Slutsky demand.

Finally, once again we


can draw the Slutsky
compensated demand
curve through this new
point xspx1 and the
original x0px0

U3

y0

U2

U1
px

x1 xs x0

The new demand curve


Sx is steeper than
either the Marshallian
or the Hicksian curve
when the good is
normal.

px1
px0

Dx

xs

Hx
Sx

Summary
S
H

px
M

We
cannormal
derive three
demand
1.
The
Marshallian
2.
The
Hicksian
compensated
3.
The Slutsky
incomegood
Finally,
for
a basis
normal
curves
on
the
of our
demand
curve
demand
curve
where
agents
compensated
demand
curve
the
Marshallian
demand
indifference
curve
analysis.
are
given
sufficient
where
have
sufficient
curve
isagents
flatter
thanincome
the
to
maintain
theminonturn
their
income
towhich
purchase
their
Hicksian,
is
original
utility
curve.
original
bundle.
flatter than
the
Slutsky
demand curve.

Problems to consider
1.
2.
3.

Consider the shape of the curves if X is an inferior good.


Consider the shape of each of the curves if X is a Giffen good.
Will it matter if Y is a Giffen or an inferior good?

Please watch this video!


A.10 Marshallian and Hicksian demand curves | Consumption Microeconomics
Policonomics
https://www.youtube.com/watch?v=T4GAFG8TVt0
A.9 Income and substitution effects | Consumption - Microeconomics
https://www.youtube.com/watch?v=w9z_I-5QZ0o
Example Income and Substitution Effects For Normal and Inferior Goods
Economicsfun
https://www.youtube.com/watch?v=pLhh_D5b_Lg&ebc=ANyPxKqwG8yJU
L72V2SwEbht8KNHh6Ipdu7qx6upHYo50yTRUgfMm27-DivPovsb200-Gm8S63l
Best Motivational Video For Students - Don't Count The Cost
https://www.youtube.com/watch?v=vVJJj9hshCM

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