Unit 1: Consumer Behaviour
Course Code: ECODSC 251 (Intermediate Microeconomics)
This unit builds upon introductory microeconomics to provide a deep analytical understanding of how consumers make choices, evaluate trade-offs, and respond to policy changes.
Table of Contents
1. Ordinary vs Compensated Demand Curves
In consumer theory, we distinguish between two types of demand functions based on what variables are held constant during a price change.
Ordinary (Marshallian) Demand Curve
The ordinary demand curve shows the relationship between the price of a good and the quantity demanded, holding nominal income (M) constant. It is derived from the utility maximization problem where the consumer maximizes utility subject to a budget constraint.
Compensated (Hicksian) Demand Curve
The compensated demand curve shows the relationship between price and quantity while holding the utility level (U) constant. It is derived from the expenditure minimization problem, where the consumer tries to minimize the cost of achieving a specific level of satisfaction.
| Feature | Ordinary Demand | Compensated Demand |
|---|---|---|
| Variable Held Constant | Nominal Income (M) | Utility (U) |
| Effects Included | Substitution + Income Effect | Substitution Effect only |
| Real World Use | Measuring actual market behavior | Welfare analysis (Consumer Surplus) |
2. Indirect Utility Function
While a direct utility function (U = f(x, y)) expresses utility in terms of quantities consumed, the Indirect Utility Function expresses the maximum utility reachable given market prices and income.
Formula: V(Px, Py, M) = max U(x, y) subject to Px.x + Py.y = M
Key Properties:
- Non-increasing in prices: If prices go up, maximum reachable utility falls.
- Non-decreasing in income: If income rises, utility rises or stays the same.
- Homogeneous of degree zero: If prices and income double, utility remains the same.
3. Income and Substitution Effects
When the price of a good changes, it affects demand through two channels.
Substitution Effect
The change in consumption that occurs because the good has become relatively cheaper or more expensive compared to other goods, keeping utility constant. This is always negative; if price falls, quantity demanded increases under the substitution effect.
Income Effect
The change in consumption resulting from the change in the consumer's purchasing power (real income).
- Normal Goods: A fall in price increases real income, which leads to increased demand.
- Inferior Goods: A fall in price increases real income, which leads to decreased demand.
4. Application: Labour-Leisure Trade-off
This application uses indifference curve analysis to explain how individuals decide between working (to earn income) and leisure.
- The Constraint: Total time is fixed (e.g., 24 hours). The "price" of an hour of leisure is the wage rate (w) given up by not working.
- Wage Increase: A higher wage has two effects:
- Substitution Effect: Leisure becomes more expensive; the individual works more.
- Income Effect: The individual is richer and wants more of the normal good (leisure); the individual works less.
5. Application: Cash Subsidy vs Food Transfer
Governments often debate whether to give poor citizens direct cash or specific goods (like food).
- Food Transfer (In-kind): Restricts choice. The consumer must consume a certain amount of food and may end up on a lower indifference curve than if they had the cash equivalent.
- Cash Subsidy: Increases the budget set uniformly. It allows the consumer to reach the highest possible indifference curve because they can allocate the money according to their personal preferences.
6. Revealed Preference Theory
Developed by Paul Samuelson, this theory argues that consumer preferences can be "revealed" by observing their choices in the market, without needing to assume a utility function beforehand.
Weak Axiom of Revealed Preference (WARP): If Bundle A is chosen over Bundle B when both were affordable, then B can never be chosen in any situation where A is also affordable.