Chapter 1

Getamesay.B(PhD)
Consumption theory
1
1.1. Introduction
• In this chapter, we will explore the essential features of modern
consumer theory—a bedrock foundation for theoretical structures
in economics.
• A consumer can be characterized by many factors and aspects such
as sex, age, lifestyle, wealth, parentage, ability, intelligence, etc.
• But, which factors are most important ones for us to study
consumer’s behavior in making choices?

Getamesay.B(PhD)
• To grasp the most important features in studying consumer
behavior and choices in modern consumer theory, it is assumed
that the
• A consumer consists of three essential components:
• The consumption set, Initial endowments, and the Preference
relation.
• Consumer’s characteristic together with the behavior assumption 2
are building blocks in any model of consumer theory. So,
• The consumption set represents the set of all individually
feasible alternatives or consumption plans and sometimes
also called the choice set.
• An initial endowment represents the amount of various
goods the consumer initially has and can consume or trade
with other individuals.
• The preference relation specifies the consumer’s tastes or
satisfactions for the different objects of choice.

Getamesay.B(PhD)
• The behavior assumption expresses the guiding principle the
consumer uses to make final choices and identifies the
ultimate objects in choice.
• It is generally assumed that the consumer seeks to identify
and select an available alternative that is most preferred in
the light of his/her personal tastes/interstes.
3
1.2.Consumption set and budget constraints
•

Getamesay.B(PhD)
4
• We consider a consumer faced with possible consumption
bundles in consumption set X.
• We usually assume that X is the nonnegative orthant in RL as
shown in the right figure in Figure 2.1, but more specific
consumption sets may be used.
• For example, it may allow consumptions of some good in a
suitable interval as such leisure as shown in the left figure in
Figure 2.1, or

Getamesay.B(PhD)
• we might only include bundles that would give the consumer
at least a subsistence existence or that consists of only
integer units of consumptions as shown in Figure 2.2.
• We assume that X is a closed and convex set .
• The convexity of a consumption set means that every good is
divisible and can be consumed by fraction units.
5
Budget Constraint
• In the basic problem of consumer’s choice, not all
consumptions bundles are affordable in a limited resource
economy, and a consumer is constrained by his/her wealth.
• In a market economy, the wealth may be determined by the
value of his/her initial endowment and/or income from
stock-holdings of firms.
• It is assumed that the income or wealth of the consumer is

Getamesay.B(PhD)
fixed and the prices of goods cannot be affected by the
consumer’s consumption when discussing a consumer’s
choice.
• Let m be the fixed amount of money available to a consumer,
and let p = (p1, ..., pL) be the vector of prices of goods, 1, . . .
,L.
• The set of affordable alternatives is thus just the set of all
bundles that satisfy the consumer’s budget constraint 6
 Getamesay.B(PhD)
7
• .The set of affordable bundles, the budget set of the consumer, is
given by

Getamesay.B(PhD)
8
• Thus, the budget set reflects consumer’s objective
ability of purchasing commodities and the scarcity of
resources.
• And, It also significantly restricts the consumer
choices.
• To determine the optimal consumption bundles,

Getamesay.B(PhD)
• one needs to combine consumer objective ability of
purchasing various commodities with
• subjective taste on various consumptions bundles
which are characterized by the notion of preference
or utility.

9
 Getamesay.B(PhD)
• Now look at the mathematical derivation of The budget set 10
• Now look at the mathematical derivation of
Marginal Rate of substitution(MRS) and The budget
set
• See page 1 and 2

Getamesay.B(PhD)
11
1.3 Preferences and Utility
• 1.3.1. Preferences
• The consumer is assumed to have preferences on the
consumption bundles in X so that he can compare and rank
various goods available in the economy.
• When we write x ≽ y, we mean “the consumer thinks that the
bundle x is at last as good as the bundle y.”
• We want the preferences to order the set of bundles.

Getamesay.B(PhD)
Therefore, we need to assume that they satisfy the following
standard properties.
• COMPLETE. For all x and y in X, either x ≽ y or y ≽ x or both.
• i.e consumer thinks bundle X is at least as good as bundle y.
• REFLEXIVE. For all x in X, x ≽ x.
• TRANSITIVE. For all x, y and z in X, if x ≽ y and y ≽ z, then x ≽
z. 12
• Thus, it shows preference ordering
• Generally,
• The first assumption is just says that any two bundles can be
compared,
• the second is minor(minor) and says that every consumption
bundle is as good as itself, and
• the third requires the consumer’s choice be consistent. A
preference relation that satisfies these three properties is

Getamesay.B(PhD)
called a preference ordering.
• Given an ordering ≽ describing “weak preference,” we can
define the strict preference ≻ by x ≻ y to mean not y ≽ x .
• We read x ≻ y as “x is strictly preferred to y.”
• Similarly, we define a notion of indifference by x
indifferences y if and only if x ≽ y and y ≽ x.
13
• The set of all consumption bundles that are indifferent to
each other is called an indifference curve.
• For a two-good case, the slope of an indifference curve at a
point measures marginal rate of substitution between
goods x1 and x2.
• For a L-dimensional case, the marginal rate of substitution
between two goods is the slope of an indifference surface,
measured in a particular direction.

Getamesay.B(PhD)
14
• For a given consumption bundle y, let P(y) = {x in X: x ≽ y}
be the set of all bundles on or above the indifference curve
through y and it is called the upper contour set at y,
• Ps(y) = {x in X: x ≻ y} be the set of all bundles above the
indifference curve through y and it is called the strictly
upper contour set at y,
• L(y) = {x in X: x ≼ y} be the set of all bundles on or below

Getamesay.B(PhD)
the indifference curve through y and it is called the lower
contour set at y , and
• Ls(y) = {x in X: x < y} be the set of all bundles on or below
the indifference curve through y and it is called the strictly
lower contour set at y.

15
• CONTINUITY. For all y in X, the upper and lower contour sets
P(y) and L(y), are closed. It follows that the strictly upper and
lower contour sets, Ps(y) and Ls(y), are open sets.
• This assumption is necessary to rule out certain
discontinuous behavior; it says that if (xi) is a sequence of
consumption bundles that are all at least as good as a bundle
y, and if this sequence converges to some bundle x∗, then x∗
is at least as good as y.

Getamesay.B(PhD)
• The most important consequence of continuity is this:
• if y is strictly preferred to z and if x is a bundle that is close
enough to y, then x must be strictly preferred to z.
• When there is violation of continuity , the graph seems like

16
• Lexicographic Ordering

Getamesay.B(PhD)
17
• Weak monotonicity says that “at least as much of everything
is at least as good,” which ensures a commodity is a “good”,
but not a “bad”.
• Monotonicity says that strictly more of every good is strictly

Getamesay.B(PhD)
better. Strong monotonicity says that strictly more of some
good, is strictly better.

• LOCAL NON-SATIATION. Given any x in X and any ϵ > 0, then

Getamesay.B(PhD)
19
• See numeric example and its summery part from
exercise book page 03 and 04.

Getamesay.B(PhD)
20
1.3.2. The Utility Function
• it is easier to work with preferences that can be
represented by a utility function; that is,
• a function u: X → R such that x ≽ y if and only if u(x) = u(y).
In the following,
• we give some examples of utility functions.

Getamesay.B(PhD)
21
 Getamesay.B(PhD)
22
• Utility functions can be estimated in terms of its MRS

Getamesay.B(PhD)
• Or,

23
 Getamesay.B(PhD)
24
 Getamesay.B(PhD)
25
 Getamesay.B(PhD)
26
• See mathematical derivation from page 05
from Exercise book

Getamesay.B(PhD)
27
1.4 Utility Maximization and Optimal Choice
1.4.1. Utility Maximization
• On individual behavior in modern economics in general and
the consumer theory in particular is that a rational agent will
always choose a most preferred bundle from the set of
affordable alternatives.
• We will derive demand functions by considering a model of

Getamesay.B(PhD)
utility-maximizing behavior coupled with a description of
underlying economic constraints.
1.4.2 Consumer’s Optimal Choice
• In the basic problem of utility maximization, the set of
affordable alternatives is just the set of all bundles that satisfy
the consumer’s budget constraint we discussed before.
• That is, the problem of utility maximization can be written as: 28
• There will exist a solution to this problem if the utility
function is continuous and that the constraint set is closed

Getamesay.B(PhD)
and bounded.
• The constraint set is certainly closed. If pi > 0 for i = 1, ..., k
and m > 0, it is not difficult to show that the constraint set
will be bounded.
• If some price is zero, the consumer might want an infinite
amount of the corresponding good. So, it leads to not
existence of markets.
• So, 29
• Proposition 1. Under the local non satiation assumption, a
utility-maximizing bundle x∗ must meet the budget constraint
with equality.
• Proof. Suppose we get an x∗ where px∗ < m. Since x∗ price
strictly less than m, every bundle in X close enough to x∗ also
costs less than m and is therefore feasible.
• But, according to the local non-satiation hypothesis, there
must be some bundle x which is close to x∗ and which is

Getamesay.B(PhD)
preferred to x∗.
• But, this means that x∗ could not maximize preferences on
the budget set B(p,m).

30
• Proposition 2. (Uniqueness of Demanded Bundle) If
preferences are strictly convex, then for each p > 0 there is a
unique bundle x that maximizes u on the consumer’s budget
set, B(p,m).

• Proof. Suppose x′ and x′′ both maximize u on B(p,m).

Getamesay.B(PhD)
number does not change the budget set at all and thus
cannot change the answer to the utility maximization
problem

31
• Proposition 3. (Homogeneity of Demand Function)
• The consumer’s demand function x(p,m) is homogeneous of
degree 0 in (p,m) > 0, i.e., x(tp,tm) = x(p,m).
• If we multiply both p and m by some constants, the amounts
of X does not changes and also leads to not change in utility.
• Note that a function f(x) is homogeneous of degree k if f(tx) =
tkf(x) for all t > 0.

Getamesay.B(PhD)
32
• So. For optimization,
• The value of x that solves this problem is the consumer’s
demanded bundle:
• it expresses how much of each good the consumer desires at
a given level of prices and income.
• Denote by x(p,m) the set of all utility maximizing
consumption bundles and it is called the consumer’s demand
correspondence.

Getamesay.B(PhD)
• When there is a unique demanded bundle for each (p,m),
x(p,m) becomes a function and thus is called the consumer’s
demand function.
• Then, we can set The lagrangian function to get the optimal
points as
33
1.4.3. Consumer’s First Order-Conditions: it is necessary
condition for optimization
• We can analyze this constrained maximization problem
using the method of Lagrange multipliers.
• The Lagrangian for the utility maximization problem can be
written as

Getamesay.B(PhD)
34
 Getamesay.B(PhD)
35
• It is graphically represented as

Getamesay.B(PhD)
36
 1.4.4. Second order or Sufficiency condition for optimization
• The above first-order conditions are merely necessary
conditions for a local optimum. And, second order is sufficient
condition for optimization
• We then have the following Example for this

Getamesay.B(PhD)
37
 Getamesay.B(PhD)
38
• See the whole derivation process from exercise
book page 07 -10

Getamesay.B(PhD)
39
 Getamesay.B(PhD)
40
 Getamesay.B(PhD)
41
 Getamesay.B(PhD)
42
• Generally, it is easily found out the optimal solutions by
comparing relatives steepness of the indifference curves and
the budget line.
• For instance, as shown in Figure 2.11 below, when a/b >
px/py, the indifference curves become steeper, and thus the
optimal solution is the one the consumer spends his all
income on good x .
• When a/b < px/py, the indifference curves become flatter,

Getamesay.B(PhD)
and thus the optimal solution is the one the consumer spends
his all income on good y.
• When a/b = px/py, the indifference curves and the budget
line are parallel and coincide at the optimal solutions, and
thus the optimal solutions are given by all the points on the
budget line.
43
 Getamesay.B(PhD)
44
 • 1.5 Indirect Utility, and Expenditure, and
Money Metric Utility Functions
1.5.1. The Indirect Utility Function
• The ordinary utility function, u(x), is defined over the consumption
set X and therefore to as the direct utility function. Given prices p
and income m, the consumer chooses a utility-maximizing bundle
x(p,m).i.e. X(p,m) = max u(x) so, it measure the amounts of X

Getamesay.B(PhD)
• The level of utility achieved when x(p,m) is chosen thus will be the
highest level permitted by the consumer’s budget constraint facing
p and m, and can be denoted by
v(p,m) = max u(x)
such that px = m.
• The function v(p,m) that gives us the maximum utility achievable at
given prices and income is called the indirect utility function and
45
thus it is a compose function of u(·) and x(p,m), i.e.,
• v(p,m) = maxu(x(p,m)).it measures utility.
• The properties of the indirect utility function are summarized
in the following proposition.

Getamesay.B(PhD)
46
 Getamesay.B(PhD)
47
 Getamesay.B(PhD)
48
 1.5.2. The Expenditure Function and Hicksian
Demand
• We note that if preferences satisfy the local non satiation
assumption, then v(p,m) will be strictly increasing in m.
• We then can invert the function and solve for m as a function
of the level of utility; that is, given any level of utility, u, then,
• we can find the minimal amount of income necessary to

Getamesay.B(PhD)
achieve utility u at prices p.
• The function that relates income and utility in this way— the
inverse of the indirect utility function – is known as the
expenditure function and is denoted by e(p, u).
• Formally, the expenditure function is given by the following
problem:
49
 Getamesay.B(PhD)
50
• The expenditure function gives the minimum cost or
expenditure of achieving a fixed level of utility.
• The solution which is the function of (p, u) is denoted by h(p,
u) and called the Hicksian demand function.
• The Hicksian demand function tells us what consumption
bundle achieves a target level of utility and minimizes total
expenditure.

Getamesay.B(PhD)
• A Hicksian demand function is sometimes called a
compensated demand function.
• This terminology comes from viewing the demand function as
being constructed by varying prices and income so as to keep
the consumer at a fixed level of utility.
• Thus, the income changes are arranged to “compensate” for
the price changes.
51
• Hicksian demand functions are not directly
observable since they depend on utility, which is not
directly observable.
• Demand functions expressed as a function of prices
and income are observable; when we want to
emphasize the difference between the Hicksian
demand function and the usual demand function. i.e.

Getamesay.B(PhD)
the Marshallian demand function, x(p,m).
• The Marshallian demand function is just the ordinary
market demand function we have been discussing all
along.

52
 Getamesay.B(PhD)
53
 Getamesay.B(PhD)
54
1.5.3. The Money Metric Utility Functions
• Consider some prices p and some given bundle of goods x.
• We can ask the following question: how much money would
a given consumer need at the prices p to be as well off as he
could be by consuming the bundle of goods x?
• If we know the consumer’s preferences, we can simply solve
the following problem:

Getamesay.B(PhD)
55
• This type of function is called money metric utility function.
• It is also known as the “minimum income function,” the
“direct compensation function,” and by a variety of other
names.
• Since, for fixed p, m(p, x) is simply a monotonic transform of
the utility function and is itself a utility function.
• There is a similar construct for indirect utility known as the

Getamesay.B(PhD)
money metric indirect utility function, which is given by
μ(p; q, m) ≡ e(p, ν(q,m)).
• That is, μ(p; q,m) measures how much money one would
need at prices p to be as well off as one would be facing
prices q and having income m.
• Just as in the direct case, μ(p; q,m) is simply a monotonic
transformation of an indirect utility function. 56
• See the detailed examples from exercise book
example 1 from page 12-15.
• Suppose the preference ordering is represented by the Cobb-
Douglas utility function: U (X1, X2) = X1α X2β subject to Budget
constraint , and, α > 0 and β > 0. and α + β = 1.
• Then, derive
• We have CDUF, from these

Getamesay.B(PhD)
• Derive DDF ?
• Derive IUF?
• Derive Ex-function?
• Derive MMF?
• Derive MMIUF?
57
• See the detailed examples from exercise
book example 2 from page 16-20

Getamesay.B(PhD)
58
• 1.5.4 Some Important Identities

Getamesay.B(PhD)
59
 Getamesay.B(PhD)
60
 Getamesay.B(PhD)
61
 Getamesay.B(PhD)
62
 • Examples

Getamesay.B(PhD)
63
1.6 Duality Between Direct and Indirect Utility
• Here we see how to solve for the direct utility function. The
answer exhibits quite nicely the duality between direct and
indirect utility functions.
• It is most convenient to describe the calculations in terms of
the normalized indirect utility function, where we have
prices divided by income so that expenditure is identically

Getamesay.B(PhD)
one.
• Thus the normalized indirect utility function is given by

64
• Proof.
• Let x be the demanded bundle at the prices p. Then by
definition v(p) = u(x).
• Let p′ be any other price vector that satisfies the budget
constraint so that p′x = 1.
• Then since x is always a feasible choice at the prices p′, due
to the form of the budget set, the utility-maximizing choice

Getamesay.B(PhD)
must yield utility at least as great as the utility yielded by x;
• that is, v(p′) = u(x) = v(p).
• Hence, the minimum of the indirect utility function over all
p’s that satisfy the budget constraint gives us the utility of x.
NB:
• See the following example with its procedure from
65
exercise book to next slide. Or page 22-24.
 Getamesay.B(PhD)
66
 Getamesay.B(PhD)
67
 Getamesay.B(PhD)
68
1.7 Properties of Consumer Demand
• In this section we will examine how the consumer’s demand
changes as prices and income change.
• 1.7.1 Income Changes and Consumption Choice
• Suppose that how the consumer’s demand changes as we hold
prices fixed and allow income to vary; the resulting locus of utility-
maximizing bundles is known as the income expansion path.
• From the income expansion path, we can derive a function that

Getamesay.B(PhD)
relates income to the demand for each commodity (at constant
prices).
• These functions are called Engel curves. There are two possibilities:
(1) As income increases, the optimal consumption of a good
increases. Such a good is called a normal good.
• (2) As income increases, the optimal consumption of a good
decreases. Such a good is called inferior good.
• For Giffen goods consider As income increases, the optimal 69
consumption of a good decreases and also price decreases.
• For the two-good consumer maximization problem, when
the income expansion path
• (and thus each Engel curve) is upper-ward slopping, both
goods are normal goods.
• When the income expansion path could bend backwards,
there is one and only one good that is inferior when the
utility function is locally non-satiated; increase in income
means the consumer actually wants to consume less of the

Getamesay.B(PhD)
good. (See Figure 2.14)

70
1.7.2 Price Changes and Consumption Choice
• We can also hold income fixed and allow prices to vary. If we
let p1 vary and hold p2 and m fixed, the locus of tangencies
will sweep out a curve known as the price offer curve.
• In the first case in Figure 2.15 we have the ordinary case
where a lower price for good1 leads to greater demand for
the good so that the Law of Demand is satisfied;

Getamesay.B(PhD)
• in the second case we have a situation where a decrease in
the price of good 1 brings about a decreased demand for
good 1. Such a good is called a Giffen good.

71
 Getamesay.B(PhD)
72
 1.7.3 Income-Substitution Effect: The Slutsky
Equation
• In the above we see that a fall in the price of a good may
have two sorts of effects:
• Substitution effect—one commodity will become less
expensive than another, and
• Income effect — total “purchasing power” increases.

Getamesay.B(PhD)
• A fundamental result of the theory of the consumer, the
Slutsky equation, relates these two effects.
• Even though the compensated demand function is not
directly observable, we shall see that its derivative can be
easily calculated from observable things, namely, the
derivative of the Marshallian demand with respect to price
and income. 73
• This relationship is known as the Slutsky equation.
 Getamesay.B(PhD)
74
 Getamesay.B(PhD)
75
 Getamesay.B(PhD)
76
 Getamesay.B(PhD)
77
• Examples
• Please see the procedure from ex-book page
25-26

Getamesay.B(PhD)
78
 Getamesay.B(PhD)
79
1.7.4. Inverse Demand Functions
• In many applications it is of interest to express demand
behavior by describing prices as a function of quantities.
• That is, given some vector of goods x, we would like to find a
vector of prices p and an income m at which x would be the
demanded bundle.
• Since demand functions are homogeneous of degree zero, we

Getamesay.B(PhD)
can fix income at some given level, and simply determine
prices relative to this income level.
• The most convenient choice is to fix m = 1. In this case the
first-order conditions for the utility maximization problem are
simply as

80
 Getamesay.B(PhD)
81
• Given any vector of demands x, we can use this expression to
find the price vector p(x) which will satisfy the necessary
conditions for maximization.
• If the utility function is quasi-concave so that these
necessary conditions are indeed sufficient for maximization,
then this will give us the inverse demand relationship.
• What happens if the utility function is not everywhere quasi-
concave?

Getamesay.B(PhD)
• Then there may be some bundles of goods that will not be
demanded at any price; any bundle on a non-convex part of
an indifference curve will be such a bundle.
• There is a dual version of the above formula for inverse
demands that can be obtained from the duality between
direct utility function and indirect utility function we
discussed earlier. 82
• The argument given there shows that the demanded bundle
x must minimize the
 Getamesay.B(PhD)
83
1.8. The Integrability Problem
• Given a system of demand functions x(p,m). Is there
necessarily a utility function from which these demand
functions can be derived? This question is known as the
integrability problem.
• We will show how to solve this problem by solving a
differential equation and integrating back, ultimately to the

Getamesay.B(PhD)
utility function. Thus,
• The Slutsky matrix plays a key role in this process.
• We have seen that the utility maximization hypothesis
imposes certain observable restrictions on consumer
behavior.
• If a demand function x(p,m) is well-behaved, and, x(p,m)
satisfies the following five conditions: 84
 Getamesay.B(PhD)
85
• Suppose demand function comes from

Getamesay.B(PhD)
86
 Getamesay.B(PhD)
87
 Getamesay.B(PhD)
• Under the assumption that all these properties listed at the
beginning of this section hold, the solution for e function
will be an expenditure function.
• Inverting the found expenditure function, we can find the
indirect utility function.
88
 Getamesay.B(PhD)
89
 Getamesay.B(PhD)
90
 •The End

Getamesay.B(PhD)
91