ECON3113 Microeconomic Theory I (L1) - Tutorial Five

Jeremy TO
April 16, 2025

1 Lump Sum Principle

• Refer to the diagram below, suppose an individual has an income of I = $10 and is choosing to consume bundle A with
x∗1 = 5 and x∗2 = 5.

• By imposing a sales tax t = $1 on good 1, its price will increase, and the utility-maximizing choice would shift to bundle
B with x∗∗ ∗∗ ∗∗
1 = 2.5 and x2 = 5. Tax revenue to the government would be t × x1 = 1 × 2.5 = $2.5.

• An income tax that shifted the budget constraint inward to the red line would also collect this same amount of revenue
because I = (p1 + t)x1 + p2 x2 and I 0 = I − tx1 = p1 x1 + p2 x2 .
• However, the utility provided by the income tax exceeds that provided by the tax on good 1 alone. Therefore, the
utility burden of the income tax is smaller.
√ √
• Exercise: Let I = 2, px = 0.25, py = 1, U (x, y) = x + y and t = 0.1. Show that the consumer prefers income tax
to sales tax.

1.1 Lump-Sum Principle: Distortions

• An income tax hurts the consumer by depriving her purchasing power.
• A sales tax (with equal tax revenue) hurts the consumer not only by depriving her purchasing power, but also
distorting the relative prices between the goods.
• However, consumers may be heterogeneous and income tax may distort work incentives.

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2 Intertemporal Consumption Choice
2.1 The Budget Constraint
2.1.1 The budget constraint in terms of present value
c2
c1 + =W
1+r

2.1.2 The budget line equation:

(1 + r)c1 + c2
=W
(1 + r)
(1 + r)c1 + c2 = (1 + r)W
c2 = (1 + r)W − (1 + r)c1 = (1 + r)(W − c1 )

• W is the wealth of the consumer (exogenous), c1 consumption is the first period and c2 is the consumption is the second
period.

2.1.3 Separable Time Preferences

1
• We add the discount rate to the consumer’s utility function: u(c1 , c2 ) = u(c1 ) + 1+ρ u(c2 ). The larger the ρ is, the more
the future utility will be discounted, where ρ is a subjective discount rate measuring the degree of impatience of the
consumer.
1 c2
• Utility-maximization problem: max u(c1 ) + 1+ρ u(c2 ) s.t. c1 + 1+r =W
c1 ,c2

∂u(c1 )
0
u0 (c1 )
• Optimal consumption choice: ∂c1
1 ∂u(c2 )
= 1 + r =⇒ (1 + ρ) uu0 (c
(c1 )
2)
= 1 + r =⇒ u0 (c2 ) = 1+r
1+ρ
1+ρ ∂c2

√ √
c2
• Exercise: U (c1 , c2 ) = c1 + 1+ρ

– (1) Find c∗1 and c∗2

∂c∗ ∂c∗ ∂c∗
– (2) Find ∂r
1
and ∂r .
2
What is the interpretation of ∂r ?
1

∂c∗ ∂c∗ ∂c∗

– (3) Find ∂W
1
and ∂W .
2
What is the interpretation of ∂W ?
1

∂c∗ ∂c∗ ∂c∗

– (4) Find ∂ρ
1
and ∂ρ .
2
What is the interpretation of ∂ρ ?
1

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3 Demand Function
3.1 Homogeneity
• If all prices and income are double, the optimal quantities demanded would remain unchanged. For example, p1 x1 +
p2 x2 = I is the same as 2p1 x1 + 2p2 x2 = 2I.
• For any good xi , x∗i = xi (p1 , p2 , ..., pn , I) = xi (tp1 , tp2 , ..., tpn , tI) for any t > 0. Therefore, the individual demand
function are homogeneous of degree 0 in all prices and income.
1−α
• Example: The demand function for good 1 deriving from a Cobb-Douglas utility function u(x1 , x2 ) = xα
1 x2 is
∗ αI
x1 = p1 . Is it homogeneous?

3.2 Changes in Income

∂xi
• Inferior goods: A good xi for which ∂I < 0 over some range of income changes.
∂xi
• Normal goods: A good xi for which ∂I > 0 over some range of income changes.

3.3 Changes in Good Price

• A change in good price involves changing not only one of the intercepts of the budget constraint but also its slope.
Therefore, moving to the new utility-maximizing choice entails not only moving to another indifference curve but also
changing the MRS.
• Two effects will come into play when there is a change in price of a good: (i) Substitution effect (ii) Income effect

• Substitution effect (related to the change in relative price): Even if the individual were to stay on the same indifference
curve, consumption patterns would allocated so as to equate the MRS to the new price ratio.
• Income effect (related to the change real income): A price change necessarily changes an individual’s real income, he
must move to a new indifference curve.

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• Assume the initial budget constraint is given by I = pA A
1 x1 + p2 x2 , the consumer consumes bundle A with x1 and x2
A
B
to maximize utility. Now suppose that the price of good 1 decreases to p1 , then the new budget constraint is given by
I = pB B B
1 x1 + p2 x2 and the consumer consumes bundle B with x1 and x2 to maximize utility.

• Since both the substitution effect and income effect come into play at the same time, we must separate two effects by
isolating one of them first.
• First, we isolate the substitution effect by holding the real income of the consumer unchanged (only allow the
relative price of good 1 to change). To hold the real income constant (by holding utility constant), we hypothetically
reduce the nominal income of the consumer until the hypothetical budget line I 0 = pB
1 x1 + p2 x2 (the dash line in the
diagram) is tangent to the initial indifference curve U1 . (Hicksian method )
• After holding the real income constant, the consumer will consume bundle C (with xC C
1 and x2 ) to maximize utility.
A C
Therefore, change in consumption of good 1 from x1 to x1 (is only due to the change in the relative price) represents
the substitution effect.

• The additional move from bundle C to bundle B (when move the dash budget line back to the initial one) is solely due
to the change in income (no change in relative price). Therefore, this move represents income effect.
• If good 1 is a normal good, the income and substitution effect tend to reinforce one another. But, if good 1 is an
inferior good, two effects will work in opposite direction. Income effect may even dominate substitution effect if the
good is a Giffen good.


 ; Good 1 is a normal good
∂x1
∂p < 0
 1

⇐ Good 1 is a normal good


 ; Good 1 is an inferior good
∂x1
∂p < 0
 1

: Good 1 is an inferior good


 ⇒ Good 1 is an inferior good
∂x1
∂p > 0
 1

: Good 1 is an inferior good

• Exercise: Decomposition of SE and IE: Labor Supply

– (1) If leisure is an inferior good, can the labor supply curve be backward-bending?
– (2) If leisure is a normal good, can the labor supply curve be backward-bending?

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3.4 Gross Substitutes and Complements
∂x
• x and y are gross substitutes if ∂py >0
∂y
• x and y are gross complements if ∂px <0
∂x ∂y
• Exercise 3: U (x, y) = lnx + y. Find ∂py and ∂px .

3.5 (Own-) Price Elasticity of Demand

• A measure of the sensitivity of the demand to changes in its own price.
• Price elasticity of demand of a good is the percentage change in its quantity demanded in response to a unit
percentage change in its price:
∂x(px , py , I) px
εx,px =
∂px x
• This is a unit-free measure of sensitivity.

• Example 1: Cobb-Douglas utility function

u(x, y) = xα y 1−α
αI
x(px , py , I) =
px
∂x(px , py , I) px αI px
εx,px = = − 2 αI = −1 (unit elastic)
∂px x px p
x

• Example 2: Linear demand function

x = a − bpx
∂x(px , py , I) px bpx
εx,px = =−
∂px x a − bpx