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ECON 7030 Microeconomic Analysis
Lecture 6: Demand
University of Queensland
Semester 1, 2022
Last year. . .
• We have seen how we can find utility maximising and
expenditure minimising bundles
• You may think: Let’s practise calculating the optimal bundle!
• That’s not a bad idea for assessments, but is of limited use in
economic studies
Finding Optimal Bundles is Just the Beginning
• Utility is a theoretical construct, it is not observable
• In applications, we can rarely get the “real” utility function of
an individual and calculate his/her optimal consumption
bundle
• Also, since utility is not observable, if I am looking at a single
choice, I can always come up with an ad-hoc utility function
that makes that choice optimal
Goal: Testable Predictions
• The purpose of utility maximisation and expenditure
minimisation is to be able to give predictions on consumers’
behaviours
• We also want these predictions to be testable — that is,
empirical observations or data can (at least potentially)
differentiate our predictions against alternative predictions.
• One way to do it is to look at how choices change when
observable variables change
• This is also useful for applications, as while we may not have
a “real” utility function, we may still predict the effect of
certain policies
What Are We After?
• Recall that the condition for a utility maximising bundle is
given by
Ux(x , y)
Uy (x , y)
=
Px
Py
Pxx + Pyy = M
• There are two kinds of variables
Endogenous Variables (Choice Variables): x , y
Exogenous Variables (Parameters): Px , Py , M
• What we want: To be able to say how the endogenous
variables change when an exogenous variable change
(This is known as Comparative Statics)
Utility Maximising Bundle as a Function of the
Parameters
• We have two equations in two unknowns:
Ux(x
∗, y∗)
Uy (x∗, y∗)
=
Px
Py
Pxx
∗ + Pyy∗ = M
• Unless we are really unlucky, a solution exists — we will call it
(x∗, y∗)
• Notice that x∗ and y∗ depends on Px , Py and M — when the
value(s) of Px , Py and M change(s), the values of x
∗ and y∗
change
• In other words, x∗ and y∗ are functions of Px , Py and M
(Marshallian) Demand
• We have
x∗ = x∗(Px ,Py ,M)
y∗ = y∗(Px ,Py ,M)
• These functions express the quantity of x and y the consumer
is willing and able to purchase given the prices and income
• Or, these function express the quantity demanded for Good X
and Good Y given the prices and income
• In other words, the functions x∗ and y∗ are our (Marshallian)
demand functions
Comparative Statics
x∗ = xm(Px ,Py ,M)
y∗ = ym(Px ,Py ,M)
• There are three changes (in x∗) that we are interested in
Own Price Effect Change in x∗ due to a change in Px
Cross Price Effect Change in x∗ due to a change in Py
Income Effect Change in x∗ due to a change in M
• Associated with these effects are three elasticities:
Own Price Elasticity % change in x∗ / % change in Px
Cross Price Elasticity % change in x∗ / % change in Py
Income Elasticity % change in x∗ / % change in M
• We are more interested in elasticities than just changes
because elasticity is unit free — even if you change the unit of
measurements, you are not going to change the elasticity
Elasticity: In General
• Suppose I have two variables, v and w , and suppose
v = v(w , α), where α is some other parameters
• The elasticity of v with respect to w is
% change in v
% change in w
=
∆v
v × 100
∆w
w × 100
=
w
v
∆v
∆w
=
w
v
∂v
∂w
A Little Trick for Those Interested
• If both v and w are always positive,
w
v
∂v
∂w
=
∂ ln v
∂ lnw
• Given the Cobb-Douglas Utility, U(x , y) = xαy1−α
We can solve for the utility-maximising x∗ and get
x∗ = α
M
Px
Hence
ln x∗ = lnα + lnM − lnPx
• Which gives
Own Price Elasticity =
∂ ln x∗
∂ lnPx
= −1
Income Elasticity =
∂ ln x∗
∂ lnM
= 1
Digression: A Little Trick for Econometric Estimations
• Due to the little trick, when you run your regression in
econometrics, you can estimate
ln x∗ = β0 +β1 lnPx +β2 lnPy +β3 lnM + other controls, etc.
• Then β1, β2 and β3 will give you the own-price elasticity,
cross-price elasticity and income elasticity, respectively
Rest of This Lecture
1 Change in Income
2 Change in Price
3 Featured Example
Part I
Change in Income
Change in Income
x
y
U0
M
M ′
xA
yA A
B
C
D
• Question: Where should the new bundle be? Like B, C , or D?
Answer:
Both Goods are Normal
x
y
U0
U1
M
M ′
xA
yA
xC
yC
A
C
Both X and Y are normal goods
• The consumption of a normal good increases when income
increases
X is Inferior and Y is Normal
x
y
U0
U1
M
M ′
xA
yA
xB
yB
A
B
X is an inferior good
Y is a normal good
• The consumption of an inferior good decreases when income
increases
X is Normal and Y is Inferior
x
y
U0
U1
M
M ′
xA
yA
xD
yD
A
D
X is a normal good
Y is an inferior good
Can Both Goods Be Inferior?
x
y
U0
M
M ′
xA
yA
xE
yE
A
E
• If consumption of both goods falls, the consumer will not
exhaust his/her budget
Budget Balancedness
• In fact, the prediction that the consumer will exhaust his/her
budget is one that we can test
• We know
Pxx
∗(Px ,Py ,M) + Pyy∗(Px ,Py ,M) = M
When there is a change in M,
Pxx
∗
M
M
x∗
∆x∗
∆M
+
Pyy
∗
M
M
y∗
∆y∗
∆M
= 1
sxηx + syηy = 1
where sx and sy are the expenditure shares of x and y ,
respectively
and ηx and ηy are the income elasticities of x and y ,
respectively
Budget Balancedness
• The equation
sxηx + syηy = 1
says that the weighted average (by expenditure shares) of
income elasticities of all goods has to be 1
• This equation extends to more than 2 goods as well
• This is something that we can test with empirical data
• Also this rules out some possibilities
Some Terminology
Income Elasticity Category Sub-category
Negative Inferior Good
Positive, < 1
Normal Good
Necessity
Positive, ≥ 1 Luxury
• Since the weighted average of income elasticities has to be 1,
there must be at least one luxury good
Engel Curve
• If we trace the path of consumption bundles as income
changes, we get an Engel Curve
0
x
y
Engel CurveM1
U1
xA
yA
M2
U2
xB
yB
M3
U3
xC
yC
Engel Curve can bend
• A good may be normal at some income range but inferior at
another
0
x
y
Engel Curve
M1
U1
xA
yA
M2
U2
xB
yB
M3
U3
xC
yC
Going from Engel Curve to Demand Curves
0
x
y
Engel Curve
xA
yA
xB
yB
xC
yC
0
x
Px
Px
D1 D2 D3
When Income Increases: Summary
Normal Goods Inferior Goods
η Positive
Negative
Demand shifts. . . Right
Left
Engel Curve slope upward* Downward**
*Both goods are normal.
**One good is inferior and another good is normal.
Part II
Change in Price
Change in Price
0
x
y
M1
slope=− px
py
U1
A
xA
yA
slope=− p′x
py