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.
In consumer theory, we distinguish between two types of demand functions based on what variables are held constant during a price change.
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.
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) |
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:
When the price of a good changes, it affects demand through two channels.
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.
The change in consumption resulting from the change in the consumer's purchasing power (real income).
This application uses indifference curve analysis to explain how individuals decide between working (to earn income) and leisure.
Governments often debate whether to give poor citizens direct cash or specific goods (like food).
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.