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Economics 50: Intermediate Microeconomics

Summer 2010
Stanford University
Michael Bailey
Lecture 4: Expenditure Minimization Problem; Substitution and Income Eects
Overview
The Expenditure Minimization Problem (EMP) has the same rst order condition as the Utility Max-
imization Problem (UMP)
Compensated demand functions solve the EMP and indicate the cheapest bundle that yields utility u
The EMP and UMP have a very specic relationship; The indirect utility function and the expenditure
function are inverses of each other
The substitution eect is the change in demand given a price change if utility is held constant
The income eect is the change in demand after a price change once the substitution eect is accounted
for
The change in consumers surplus is a very popular measure of the welfare loss due to a price change
and is the area between the price and under the demand curve
EV and CV are two alternative measures of the welfare loss due to a price change and measure the
expenditure needed to return to the original utility level. The CV measures the change in expenditure
needed to return to original utility using new prices, whereas CV uses old prices
Expenditure Minimization Problem
Suppose that instead of maximizing utility subject to the budget constraint, the consumer set a target utility
level u and minimized expenditure on bundle x (min p x) such that u(x) = u: This is called the expenditure
minimization problem (EMP) and has a very interesting relationship with the utility maximization problem
(UMP). Mathematically, the two problems are duals of each other, the UMP is the primal and the EMP is
the dual. Formally, the EMP is written:
minp x such that x X and u(x) = u for u R
1
The lagrangian for the problem is:
/ = p x (u(x) u)
which has rst-order conditions:
@/
@x
i
= p
i

@u(x)
@x
i
= 0 \i
@/
@
= u(x) u = 0
Solving for the lagrange multiplier, we see that =
pi
MUx
i
: This has a very intuitive interpretation,
remember that the lagrange multiplier is the value, in terms of increasing the max or decreasing the min,
of relaxing the constraint by one unit. In this case, because we are trying to minimize expenditure, the
lagrange multiplier is the additional expenditure we would have to provide for raising our target utility by
one unit. To get that additional unit of utility, we would need to buy more of good x
i
; at a cost of p
i
per
unit. Each x
i
that is purchased will provide us with MU
xi
units of additionally utility. Thus we would have
to buy
1
MUx
i
units of x
i
to get that additional unit of utility and the total cost would be
pi
MUx
i
:
At the minimum, this condition would need to hold for every good x
i
, otherwise we could buy more of
one good, and less of another, and get the same utility for a cheaper cost. This can be seen by rearranging
the rst order conditions for goods x
i
and x
j
:
=
p
i
MU
xi
=
p
j
MU
xj
==
p
i
p
j
=
MU
xi
MU
xj
= MRS
xi;xj
But this is the same rst-order condition as in the UMP. It doesnt matter whether we are trying to nd
the highest indierence curve given the budget line (UMP) or the lowest budget line given the indierence
curve (EMP), the curves will be tangent. This implies that the ratio between two goods will be equivalent
in both problems. To solve either the UMP or the EMP, always begin with setting
pi
pj
= MRS
xi;xj
; for
the UMP, plug back into the budget constraint, for the EMP, plug back into the target utility constraint
u(x) = u:
The solution to the EMP, x
H
i
(p
x
; p
y
; u) = arg minp x s.t. u(x; y) = u; is called the compensated demand
function
1
for good x
i
and tells us how much of good x
i
will be demanded at the minimal expenditure level
to achieve utility u given prices. Notice that income does not appear anywhere in this problem, we assume
1
Also known as the "Hicksian" demand function, after Sir John Hicks, a nobel laureate in economics. This is why there is
an "H" superscript on the compensated demand function. We often call the solution to the UMP "Marshallian" demand after
Alfred Marshall, a famous classical economist.
2
the consumer has innite income and is trying to nd the cheapest way to achieve utility u: The demand is
called a "compensated" demand because when prices change, we give income or take away income from the
consumer such that they achieve u(x; y) = u: So the consumer is in eect "compensated" for price increases
and is brought back to utility u.
0 1 2 3 4 5 6 7 8 9 10
0
1
2
3
4
5
6
7
8
9
10
x
y
Figure 1: The UMP: get to the highest indierence curve subject to the budget constraint (must stay on
budget line)
3
0 1 2 3 4 5 6 7 8 9 10
0
1
2
3
4
5
6
7
8
9
10
x
y
Figure 2: The EMP: get to the lowest expenditure (budget line) given the target utility constraint (must
stay on IC)
Example 1 Cobb-Douglas u(x; y) = x
a
y
b
; minp
x
x + p
y
y s.t. u(x; y) = u
MRS
x;y
=
ax
a1
y
b
bx
a
y
b1
=
a
b
y
x
=
p
x
p
y
== x =
a
b
p
y
p
x
y
==
_
a
b
p
y
p
x
y
_
a
y
b
= u (plugging into target utility constraint)
== y
a+b
= u
_
a
b
p
y
p
x
_
a
== y
H
(p
x
; p
y
; u) =
_
u
_
b
a
p
x
p
y
_
a
_
1
a+b
== x
H
(p
x
; p
y
; u) =
_
u
_
a
b
p
y
p
x
_
b
_ 1
a+b
Remark 2 The same caveats when the Lagrangian Method doesnt work in the UMP apply to the EMP
(preferences need to be monotone and strictly convex). When y
H
or x
H
is negative, then the compensated
demand has a corner solution.
Example 3 Perfect Substitutes u(x; y) = ax + by
As we saw in the UMP, the rst-order conditions are not informative. Suppose the consumer is trying to
achieve utilty u in the cheapest way possible. If
a
px
>
b
py
; then utility is more cheaply obtained by purchasing
x, so the consumer will will attain utilty u by purchasing
u
a
units of x and 0 units of y: Similary if
a
px
<
b
py
;
the consumer will attain utilty u by purchasing
u
b
units of y and 0 units of x: When
a
px
=
b
py
; the consumer
4
is indierent between purchasing x or y:
== x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
u
a
; 0
_
if
a
b
>
px
py
_
0;
u
b
_
if
a
b
<
px
py
_
z
u
a
; (1 z)
u
b
_
for z [0; 1] if
a
b
=
px
py
Example 4 Perfect Complements u(x; y) = min(ax; by)
Recall that for perfect complements, the consumer only consumes where ax = by = utility because
otherwise the consumer could reduce expenditure on one of the goods and be at the same level of utility. If
the consumer is trying to attain u in the cheaest way possible, she will demand ax = by = u; which implies:
x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
u
a
;
u
b
_
Example 5 Quasi-Linear Preferences u(x; y) = 4
_
x + y
The rst-order condition is:
2x
1=2
=
p
x
p
y
== x =
_
2p
y
p
x
_
2
4
_
_
2p
y
p
x
_
2
+ y = u (plugging x into utility constraint)
== y = u
8p
y
p
x
Notice however that y is only positive when u _ 8
py
px
which means that when u < 8
py
px
; y
H
= 0: if y
H
= 0;
then all income must be spent on x, which means that at this corner solution u = 4
_
x
H
== x
H
=
u
2
16
:
== x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
_
2py
px
_
2
; u 8
py
px
_
if u _ 8
py
px
_
u
2
16
; 0
_
if u < 8
py
px
Remark 6 Notice that at the interior solution for quasi-linear demand x
H
(p
x
; p
y
; u) = x

(p
x
; p
y
; I): This
is because there are no income eects for x; so compensated demand and marshallian demand co-incide.
Indirect Utility and Expenditure
Suppose that after solving the UMP and obtaining demand x

(p; I); you plugged it back into the utility


function: u(x

(p; I)): Since x

(p; I) is the bundle that gives highest utility given prices and income, u(x

(p; I))
is the highest utility attainable given prices and income. Alternatively, if we plugged in the compensated
5
demand back into the expenditure, p x
H
(p; u); we would nd the lowest expenditure attainable given prices
and income to achieve utility u:
Denition 7 V (p; I) = u(x

(p; I)) is the highest utility attainable given prices and income and is called the
indirect utility function.
Denition 8 e(p; u) = p x
H
(p; u) is the lowest expenditure attainable given prices and income to achieve
utility u and is called the expenditure function.
Example 9 Cobb-Douglas u(x; y) = x
a
y
b
We know that the demand functions for C-D preferences are x

(p; I); y

(p; I) =
_
a
a+b
I
px
;
b
a+b
I
py
_
and
compensated demand is x
H
(p; u) =
_
u
_
a
b
py
px
_
b
_ 1
a+b
and y
H
(p; u) =
_
u
_
b
a
px
py
_
a
_
1
a+b
: The indirect utility
function and expenditure function is thus:
V (p; I) = u(x

(p; I); y

(p; I))
=
_
a
a + b
I
p
x
_
a
_
b
a + b
I
p
y
_
b
= (a + b)
(a+b)
I
a+b
_
a
p
x
_
a
_
b
p
y
_
b
e(p; u) = p
x
x
H
(p; u) + p
y
y
H
(p; u)
= p
x
_
u
_
a
b
p
y
p
x
_
b
_ 1
a+b
+ p
y
_
u
_
b
a
p
x
p
y
_
a
_
1
a+b
=
_
up
a
x
p
b
y
_
1
a+b
_
_
a
b
_ b
a+b
+
_
b
a
_ a
a+b
_
=
_
up
a
x
p
b
y
_
a + b
a
_
a
_
a + b
b
_
b
_ 1
a+b
= (a + b)
_
u
_
p
x
a
_
a
_
p
y
b
_
b
_ 1
a+b
Example 10 Perfect Substitutes u(x; y) = ax + by
The demand function for perfect substitutes is given by:
x

(p
x
; p
y
; I); y

(p
x
; p
y
; I) =
(
I
px
; 0) if
a
b
>
px
py
(0;
I
py
) if
a
b
<
px
py
(z
I
px
; (1 z)
I
py
) for z [0; 1] if
a
b
=
px
py
and compensated demand is:
6
== x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
u
a
; 0
_
if
a
b
>
px
py
_
0;
u
b
_
if
a
b
<
px
py
_
z
u
a
; z
u
b
_
for z [0; 1] if
a
b
=
px
py
The indirect utility function and expenditure function is thus:
V (p; I) =
aI
px
if
a
b
>
px
py
bI
py
if
a
b
<
px
py
_
z
aI
px
; (1 z)
bI
py
_
for z [0; 1] if
a
b
=
px
py
e(p; u) =
p
x
u
a
if
a
b
>
px
py
p
y
u
b
if
a
b
<
px
py
_
zp
x
u
a
; (1 z)p
y
u
b
_
for z [0; 1] if
a
b
=
px
py
Example 11 Perfect Complements u(x; y) = min(ax; by)
The demand function for perfect complements is given by x

(p; I) =
I
px+
a
b
py
and y

(p; I) =
I
b
a
px+py
and
compensated demand is x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
u
a
;
u
b
_
: The indirect utility function and expenditure
function is thus:
V (p; I) = u(x

(p; I); y

(p; I))
= min
_
aI
p
x
+
a
b
p
y
;
bI
b
a
p
x
+ p
y
_
=
abI
bp
x
+ ap
y
e(p; u) = p
x
x
H
(p; u) + p
y
y
H
(p; u)
= p
x
u
a
+ p
y
u
b
Example 12 Quasi-Linear Preferences u(x; y) = 4
_
x + y
The demand function given these preferences is:
x

(p
x
; p
y
; I); y

(p
x
; p
y
; I) =
_
_
2
py
px
_
2
;
I
py
4
py
px
_
if I _ 4
p
2
y
px
_
I
px
; 0
_
if I < 4
p
2
y
px
7
and compensated demand is:
== x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
_
2py
px
_
2
; u 8
py
px
_
if u _ 8
py
px
_
u
2
16
; 0
_
if u < 8
py
px
The indirect utility function and expenditure function is thus:
V (p; I) =
4
py
px
+
I
py
if I _ 4
p
2
y
px
4
_
I
px
if I < 4
p
2
y
px
e(p; u) =
p
x
_
2py
px
_
2
+ p
y
_
u 8
py
px
_
if u _ 8
py
px
p
x
u
2
16
if u < 8
py
px
Relationship Between UMP and EMP
Suppose that you had solved either the UMP or the EMP. Is there a way to get the solutions to the other
problem without resolving? The following identities give the relationship between the indirect utility function
and the expenditure function and the demand and compensated demand functions.
Proposition 13 V (p; e(p; u)) = u
Proposition 14 e(p; V (p; I)) = I
Proposition 15 x

(p; e(p; u)) = x


H
(p; u)
Proposition 16 x
H
(p; V (p; I) = x

(p; I)
These identities tell us that indirect utility and minimum expenditure are just inverses of each other.
To solve for minimum expenditure from the indirect utility function, just plug in e(p; u) for I and set it
equal to u; then solve for I. Plugging in e(p; u) for I in the demand function will give the compensated
demand function. Analogously after solving for the expenditure function and the compensated demand, we
can invert and get the indirect utility function and demand functions.
What is the intuition behind these identities? If you give the consumer the minimum amount of income
needed to attain utility u; then the maximum utility the consumer can attain is u: Similarly if the maximum
utility the consumer can attain with income I is V (p; I); then the minimum expenditure to attain utility
V (p; I) is I: If this didnt hold, then the consumer must not be a maximizer.
Example 17 Cobb-Douglas u(x; y) = x
a
y
b
8
Setting the indirect utility function equal to u and solving for I :
V (p; I) = (a + b)
(a+b)
I
a+b
_
a
p
x
_
a
_
b
p
y
_
b
= u
== I
a+b
= (a + b)
(a+b)
u
_
a
p
x
_
a
_
b
p
y
_
b
== I
a+b
= (a + b)
(a+b)
u
_
p
x
a
_
a
_
p
y
b
_
b
== I = (a + b)
_
u
_
p
x
a
_
a
_
p
y
b
_
b
_ 1
a+b
= e(p; u)
Plugging e(p; u) into the demand function for I :
x

(p; e(p; u)) =


a
a + b
e(p; u)
p
x
=
a
a + b
1
p
x
(a + b)
_
u
_
p
x
a
_
a
_
p
y
b
_
b
_ 1
a+b
=
p
x
a
1
_
p
x
a
_ a
a+b
_
u
_
p
y
b
_
b
_ 1
a+b
=
p
x
a
b
a+b
_
u
_
p
y
b
_
b
_ 1
a+b
=
_
u
_
a
b
p
y
p
x
_
b
_ 1
a+b
= x
H
(p
x
; p
y
; u)
Remark that we could go in the opposite direction; start with e(p; u) and work up to V (p; I); start with
x
H
(p
x
; p
y
; u) and work up to x

(p; e(p; u)):


Example 18 Perfect Complements u(x; y) = min(ax; by)
V (p; I) =
abI
bp
x
+ ap
y
= u
I = e(p; u) =
u(bp
x
+ ap
y
)
ab
= p
x
u
a
+ p
y
u
b
Relationship between V (p; I) and x

(p; I); e(p; u) and x


H
(p; u)
The following two equations give the relationship between V (p; I) and x

(p; I); e(p; u) and x


H
(p; u) :
Proposition 19 Shephards Lemma: x
H
i
(p; u) =
@e(p;u)
@pi
9
Proposition 20 Roys Identity: x

i
(p; I) =
@V (p;I)
@p
i
@V (p;I)
@I
The proof of these is beyond the scope of this class, it relies on the envelope theorem.
Example 21 Cobb-Douglas u(x; y) = x
a
y
b
@e(p; u)
@p
x
=
a
a + b
p
b
a+b
x
(a + b)
_
u
_
1
a
_
a _
p
y
b
_
b
_
1
a+b
=
p
x
a
b
a+b
_
u
_
p
y
b
_
b
_ 1
a+b
=
_
u
_
a
b
p
y
p
x
_
b
_ 1
a+b
= x
H
(p
x
; p
y
; u)
@V (p; I)
@p
x
= a (p
x
)
a1
(a + b)
(a+b)
I
a+b
(a)
a
_
b
p
y
_
b
ap
1
x
(a + b)
(a+b)
I
a+b
_
a
p
x
_
a
_
b
p
y
_
b
@V (p; I)
@I
= (a + b)I
1
(a + b)
(a+b)
I
a+b
_
a
p
x
_
a
_
b
p
y
_
b
==
@V (p;I)
@px
@V (p;I)
@I
=
ap
1
x
(a + b)I
1
=
a
a + b
I
p
x
= x

(p
x
; p
y
; I)
Homogeneity Properties
1. Demand x

(p; I) is homogenous of degree r = 0 in prices and income (p; I) :


x

(p; I) = x

(p; I)
There is no "money illusion", if we double prices and income the budget constraint does not change.
2. The indirect utility function V (p; I) is homogenous of degree r = 0 in prices and income (p; I) :
V (p; I) = V (p; I)
10
3. Compensated demand x
H
(p; u) is homogenous of degree r = 0 in prices p :
x
H
(p; u) = x
H
(p; u)
The EMP only depends on relative prices, the bundle that is the cheapest under some set of prices is
going to be cheapest when all prices are changed by the same amount.
4. Expenditure is homogenous of degree r = 1 in prices p :
e(p; u) = e(p; u)
If we change all prices by some factor ; the optimal bundle does not change, but costs times as
much.
Income and Substitution Eects
Changing the price of a good has two distinct eects: (1) changes the relative prices and (2) changes the
purchasing power of the consumer. For example, if good x becomes more expensive (p
x
increases), then
good x will be relatively more expensive and if the consumer was consuming any amount of x, purchasing
that amount will be more expensive, so the consumer has less purchasing power. The rst eect is the
substitution eect is the change in demand that arises from changes in relative prices only. The second eect
is the income eect and is the change in demand arising from changes in income only.
Suppose that prices change from p
1
to p
2
, the optimal demand changes from x
1
(p
1
; I) to x
2
(p
2
; I); and
the utility attained changes from V (p
1
; I) = u
1
to V (p
2
; I) = u
2
:
Denition 22 The substitution eect is the change in the demand given a change in price (p
1
to p
2
), holding
utility constant:
Substitution Eect = x
H
(p
2
; u
1
) x
1
(p
1
; I)
Denition 23 The income eect is the change in demand from the optimal bundle at the old indierence
curve (u(x) = u
1
)) to the optimal bundle at the new indierence curve (u(x) = u
2
), holding prices constant
at the new price level p
2
:
Income Eect = x
2
(p
2
; I) x
H
(p
2
; u
1
)
11
Denition 24 The total eect is the change in demand given a price change:
Total Eect = x
2
(p
2
; I) x
1
(p
1
; I)
= Substitution Eect + Income Eect
To get the substitution eect, we rotate the budget line around the indierence curve (keeping it tangent)
until its slope is equal to the new relative prices. This, in eect, answers the hypothetical "What bundle
would the consumer choose if she were given enough income to consume a bundle on the old indierence
curve holding relative prices constant at their new level?" The direction of the substitution eect is always
opposite (at least weakly) that of the relative price change. If the price of good x increases, the substitution
eect pushes the consumer to consume less of x and more of other goods:
Figure 3: The substitution eect when the price of good x increases and both goods are normal
To get the income eect, start at the compensated demand at the new prices and old utility. Then
decrease income until the budget line is tangent to the new indierence curve. This shows how responsive
demand for the two goods is to changes in income.
12
Figure 4: The income eect when the price of good x increases and both goods are normal
Figure 5: Income and substitution eects for good x when both goods are normal
13
Example 25 Cobb-Douglas, u(x; y) = xy; (p
1
x
:p
1
y
; I) = (10; 1; 120) and (p
2
x
:p
2
y
; I) = (12; 1; 120): Compute
the income and substitution eects associated with this price change.
The demand functions for C-D preferences are x

(p; I) =
1
2
I
px
and y

(p; I) =
1
2
I
py
and compensated
demand is x
H
(p; u) =
_
u
_
py
px
_
and y
H
(p; u) =
_
u
_
px
py
_
:The bundles demanded at new and old prices are:
x

(p
1
; I); y

(p
1
; I) = (6; 60)
x

(p
2
; I); y

(p
2
; I) = (5; 60)
== Total Eect = (1; 0)
To get the substitution eect, we need to compute the compensated demand at the new prices and old
utility:
V (p
1
; I) = u
1
= 6 60 = 360
x
H
(p
2
; u
1
); y
H
(p
2
; u
1
) =
_
_
360
12
;
_
360 12
_
= (
_
30; 12
_
30)
== Substitution Eect
= x
H
(p
2
; u
1
); y
H
(p
2
; u
1
) x

(p
1
; I); y

(p
1
; I)
= (
_
30; 12
_
30) (6; 60)
= (0:522; 5; 726)
== Income Eect
= x

(p
2
; I); y

(p
2
; I) x
H
(p
2
; u
1
); y
H
(p
2
; u
1
)
= (5; 60) (
_
30; 12
_
30)
= (:477; 5:726)
Slutsky Equation
What happens as we let the price change tend to 0, can we break up the innitesmal change in demand into
a substitution and income eect? It turns out that we can through the slutsky equation:
@x

i
(p; I)
@p
i
=
@x
H
i
(p; u)
@p
i
. .
Sub Eect

@x

i
(p; I)
@I
x
i
. .
Income Eect
The slutsky equation tells us how much of the derivative is due to the substitution and income eects and
14
is useful if we are trying to determine the importance of substitution or income eects at specic bundle.
Example 26 Cobb-Douglas, u(x; y) = xy; p
1
x
:p
1
y
; I = (10; 1; 120): Find how the marginal change in x for a
change in p
x
and break the marginal change into a substitution and income eect.
The original bundle demanded is x; y = (6; 60) with u = 360 :
@x
H
(p
x
; p
y
; u)
@p
x
=
1
2
p
3=2
x
_
up
y
@x

(p; I)
@I
=
1
2
p
1
x
@x

(p; I)
@p
x
=
1
2
p
3=2
x
_
up
y

1
2
p
1
x
x via slutsky
=
1
2
10
3=2
_
360
1
2
1
10
6
= 0:3 0:3
We nd that the income and substitution eect are equal to each other at this point, and x is changing by
about 0:6 for an increase in p
x
at the margin. This is a good approximation to what we found earlier with
a price increase of 2 where x increased by 1 and the substitution eect and income eect were very close to
each other.
Predicting Direction of Income Eect
We always know the substitution eect is in a direction opposite the relative price change. The income
eects depends on how the demand changes with income, in other words whether the good is normal or not.
If the good is normal, then an increase (decrease) in income means that the demand for the good will go
up (down). Therefore, if good X is normal, then the income eect for good X will be negative for price
increases and positive for price decreases and visa versa if good X is inferior: A price increase (decrease)
always acts to decrease (increase) purchasing power, so if good X is normal, an increase in the price of X
(or some other good Y ) will decrease purchasing power, or income, for the consumer and thus less will be
spent on good X: Equivalently, a price decrease increases purchasing power and thus the income eect will
be positive for a normal good.
What about the total eect? If the income eect and substitution eect are working in the same direction,
then we can unambiguously state the direction of change in demand for a good for a change in the price.
Otherwise, it depends on whether the income or substitution eect is larger. For example, if good X is
normal, then an increase in the price of X causes the consumer to substitute away from good X. The
increase in price means the consumer loses purchasing power, so less will be spent on X, so the income eect
15
is negative as well, and the total eect must be negative. The following table summarizes these ndings with
two goods:
p
x
increases Substitution Eect Income Eect Total Eect
x and y both normal x |; y x |; y | x |; y?
x normal, y inferior x |; y x |; y x |; y
x inferior, y normal x |; y x ; y | x?; y?
Note that we would just get the opposite directions with a price decrease and the goods switched if it
were the price of y changing.
Figure 6: Income and substitution eects for good x which is neither normal nor inferior given good y is
normal when the price of x increases
Remark 27 A Gien good must be inferior; if the price of a good increases demand, then the total eect
must be positive, and the income eect must be positive for a price increase to oset the substitution eect.
Problem 28 Is it possible for both x and y to be inferior?
Problem 29 In the case where x is inferior and y is normal, could both x and y increase? decrease?
16
Figure 7: Income and substitution eects for good x which is inferior given good y is normal when the price
of x increases
Figure 8: Income and substitution eects for good x which is a Gien good given good y is normal when
the price of x increases
17
Figure 9: Income and substitution eects for good y which is an inferior good given good x is normal when
the price of y increases
Figure 10: Income and substitution eects for perfect complements when the price of good y increases. The
substitution eect is 0 and both goods are normal
18
Graphing Compensated Demand
Both x

(p; I) and x
H
(p; u) are a function of demand and prices, so they can be represented on the same
graph. Notice that the two will share a point by identity 15: x

(p; e(p; u)) = x


H
(p; u): The intuition behind
this identity is that if we pick a target utility, u; and gave the consumer the minimum amount of income
needed to attain u; her Marshallian demand would be equal to the compensated demand for x given u:
Equivalently, we could maximize utility given income, nd the utility attained by consuming x

(p; I); then


set u equal to that utility and x
H
(p; u) would be equal to Marshallian demand.
Because of the substiution eect, x
H
(p; u) is downward sloping; if the price of x increases, the consumer
will substitute away from x: Therefore, if the law of demand holds, both Marshallian and compensated
demand will be downward sloping. The relative slops of the curve depends upon the income eect. Recall
that the change in compensated demand measures the substitution eect and the change in Marshallian
demand is the total eect, so the dierence is the income eect.
Theorem 30 If there are no income eect for x; then the compensated demand and Marshallian demand
co-incide.
This can be seen through the slutsky equation, if there are no income eects (good x is neither a normal
good, nor an inferior good), then
@x

i
(p;I)
@pi
=
@x
H
i
(p;u)
@pi
: Since the two lines share a point and have the same
slope, they must co-incide.
If good x is normal then an increase in the price of x will cause the demand and compensated demand for x
to decrease. Because the income eect is negative, Marshallian demand will decrease more than compensated
demand, and so will be less downward sloping. Similarly, if good x is inferior, compensated demand will be
less downward sloping (more at) than Marshallian demand.
Theorem 31 If good x is normal, compensated demand will be more downward sloping than demand. If
good x is inferior, then compensated demand will be atter than the demand curve.
19
Figure 11: If good x is normal, the compensated demand will be more downward sloping than the Marshallian
demand.
Figure 12: If good x is inferior, the compensated demand will be atter than the Marshallian demand.
20
Equivalent Variation, Compensating Variation, and Consumers
Surplus
Consumers Surplus
Suppose that we wanted to gure out the welfare cost of the price change on the consumer. For example,
pretend you are a government agency and you considering putting a tax on motorized scooters. In dollar
terms, how costly would this be to consumers? One popular measure would be to take the change in the
consumers surplus as a measure of the welfare loss. This measures how much "surplus" the consumer would
lose, how much money she would have been willing to pay above the reservation price for each unit of the
good. Recall the consumers surplus is the area under the demand curve, and above the price:
Denition 32 The consumers surplus is the area above the price of the good and below the demand curve.
The change in consumers surplus is the area below the demand curve and between the old and new price.
CS for good i =
p
2
i
_
p
1
i
x

i
(p; I)dp
i
We put a minus sign in front of the intergral to indicate that consumers surplus is shrinking with a price
increase, and growing with a price decrease.
Example 33 Cobb-Douglas, u(x; y) = xy; (p
1
x
:p
1
y
; I) = (10; 1; 120) and (p
2
x
:p
2
y
; I) = (12; 1; 120): Compute
the change in consumers surplus associated with this price change.
CS =
p2
_
p1
x

(p
i
; p
j
; I)dp
i
=
px=12
_
px=10
x

(p
x
; p
y
; I)dp
x
=
px=12
_
px=10
1
2
I
p
x
dp
x
=
I
2
px=12
_
px=10
p
1
x
dp
x
=
I
2
(ln(x))
x=12
x=10
=
120
2
(ln(12) ln(10))
- $10:9
21
Thus an increase in price of good x from $10 to $12 would result in a welfare loss of about $11:
Compensating Variation
Another very sensible measure of the welfare loss would be to calcuate how much expenditure the consumer
would need to return to the original utility curve after a price change:
e(p; u
2
) e(p; u
1
)
The problem with this measure is that it depends on what prices are used, do we use the prices before the
price change or after? Only if there are no income eects would the choice of prices not make a dierence.
If we use post-change prices, p
2
; then this would in eect be measuring the amount money we would need to
compensate the consumer for the price change so that she ends up back on the original indierence curve.
This measure is called the compensating variation:
Denition 34 The Compensating Variation is net revenue of someone who must compensate the consumer
for the price change bringing her back to utility u
1
:
CV = e(p
2
; u
2
) e(p
2
; u
1
) = I e(p
2
; u
1
)
Figure 13: The compensating variation for a price increase in good x
The CV is negative if the consumer must be compensated for the price change (i.e. if the prices increase
making her worse o). It can also be thought of as the negative amount the consumer would be willing to
22
Figure 14: The compensating variation for a price increase in good y
accept to allow the price change to happen. We nd the CV by allowing the price change to happen, and
then seeing how much income it would take to bring her back to the original indierence curve. It is best
to use the CV if the price change has occured and we want to calculate the welfare loss of the change. Two
other ways of writing CV are:
CV = e(p
1
; u
1
) e(p
2
; u
1
)
V (p
2
; I CV ) = u
1
The CV has another very convenient representation that allows us to compare the CV to the change in
CS. Recall from Shephards Lemma that x
H
i
(p; u) =
@e(p;u)
@pi
; this implies if we integrate both sides:
p
1
_
p
2
x
H
(p; u
1
)dp
i
=
p
1
_
p
2
@e(p; u
1
)
@p
i
dp
i
= e(p
1
; u
1
) e(p
2
; u
1
)
= I e(p
2
; u
1
)
= CV
The compensating Variation is just the area under the compensated demand at the original utility between
the prices:
p
1
_
p
2
x
H
(p; u
1
)dp
i
= CV .
23
Equivalent Variation
If instead we use the original prices in calculating how much income it takes to return to original utilty after
a price chage we would determine the dollar amount the consumer would be willing to accept so that the
price change DOES NOT happen. This amount is the equivalent variation:
Denition 35 The Equivalent Variation is the dollar amount the consumer would be indierent between
accepting instead of facing the price change
EV = e(p
1
; u
2
) e(p
1
; u
1
) = e(p
1
; u
2
) I
Figure 15: The equivalent variation for a price increase in good x
The EV is the change in the wealth of the consumer that would be equivalent to the price change in
terms of its welfare impact. If EV is negative, the price change makes the consumer worse o. It is more
appropriate to use EV if the price change has not been aected or if original prices are the most relevant
prices to compare. Two alternative ways of writing the EV are:
EV = e(p
1
; u
2
) e(p
2
; u
2
)
V (p
1
; I + EV ) = u
1
24
Figure 16: The equivalent variation for a price increase in good y
Similar to the CV, we can derive that:
EV =
p
1
_
p
2
x
H
(p; u
2
)dp
i
which is the area under the compensated demand curve at the new utility between the two prices. We can
thus compare CV, EV, and CS graphically by looking at the areas under the compensated and marshallian
demand curves between the prices.
Computing and Comparing CV, EV, and CS
Example 36 Cobb-Douglas, u(x; y) = xy; (p
1
x
:p
1
y
; I) = (10; 1; 120) and (p
2
x
:p
2
y
; I) = (12; 1; 120): Compute
the EV and CV associated with this price change.
The expenditure function is e(p; u) = 2
_
up
x
p
y
:
CV = e(p
2
; u
2
) e(p
2
; u
1
) = I e(p
2
; u
1
) = 120 2
_
360 12 - $11:453
EV = e(p
1
; u
2
) e(p
1
; u
1
) = e(p
1
; u
2
) I = 2
_
300 10 120 - $10: 455
Notice that we have CV < CS < EV; this is no coincidence, the CV and EV always bind the CS. CV
is the area under the compensated demand curve at original utility u
1
between the original and new price
and EV is the area under the compensated demand curve at the new utility u
2
between the original and
new price. By identity 15: x

(p; e(p; u)) = x


H
(p; u); demand and compensated demand at original utility
25
u
1
will cross at the original price and demand and compensated demand at the new utility u
2
will cross at
the new price, so the area under demand between the prices is bounded by the area under the compsensated
demand functions between the prices.
Figure 17: The EV , CV , and CS for good x which is normal when the price of good x increases. CV =
A + B + C; CS = A + B; and EV = A
Theorem 37 [min(CV; EV )[ _ [CS[ _ [max(CV; EV )[
We can determine which of CV and EV will be larger if we know whether the good is normal or inferior
(which tells us whether compensated demand is steeper or atter than demand) and whether the price change
is a price increase or decrease:
(Normal, Inferior) (Price; Price|) Signs Numerical Relationship Size of Areas Under Curves
Normal Price CV; EV; CS < 0 CV < CS < EV EV < CS < CV
Normal Price| CV; EV; CS > 0 CV < CS < EV CV < CS < EV
Inferior Price CV; EV; CS < 0 EV < CS < CV CV < CS < EV
Inferior Price| CV; EV; CS > 0 EV < CS < CV EV < CS < CV
Neither Price CV; EV; CS < 0 CV = CS = EV CV = CS = EV
Neither Price| CV; EV; CS > 0 CV = CS = EV CV = CS = EV
Remark 38 When the good is neither normal nor inferior, there are no income eects for the good and the
compensated demand and demand co-incide, then EV = CV = CS:
26
Figure 18: The EV , CV , and CS for good x which is normal when the price of good x decreases. CV = A;
CS = A + B; and EV = A + B + C
Figure 19: The EV , CV , and CS for good x which is inferior when the price of good x increases. CV = A;
CS = A + B; and EV = A + B + C
27
Figure 20: The EV , CV , and CS for good x which is inferior when the price of good x decreases.
CV = A + B + C; CS = A + B; and EV = A
28
Example 39 Perfect Complements u(x; y) = min(3x; 5y); Marshallian demand is x

(p; I) =
I
px+
3
5
py
and
y

(p; I) =
I
5
3
px+py
and compensated demand is x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
u
3
;
u
5
_
: Indirect utility is
15I
5px+3py
and the expenditure function is p
x
u
3
+ p
y
u
5
:
Suppose that prices and income are (p
x
; p
y
; I) = (1; 1; 10) and the price of y decrases to p
y
=
1
2
: What is
the income and substitution eects of this price change? What are the EV,CV and CS associated with the
price change?
x

(1; 1; 10); y

(1; 1; 10) =
_
50
8
;
30
8
_
x

(1;
1
2
; 10); y

(1;
1
2
; 10) =
_
100
13
;
60
13
_
V (1; 1; 10) = u
1
=
75
4
V (1;
1
2
; 10) = u
2
=
300
13
x
H
_
1;
1
2
;
75
4
_
; y
H
_
1;
1
2
;
75
4
_
=
_
75
12
;
75
20
_
=
_
50
8
;
30
8
_
== Substitution Eect
= x
H
(p
2
; u
1
); y
H
(p
2
; u
1
) x

(p
1
; I); y

(p
1
; I)
=
_
50
8
;
30
8
_

_
50
8
;
30
8
_
= (0; 0)
== Income Eect
= x

(p
2
; I); y

(p
2
; I) x
H
(p
2
; u
1
); y
H
(p
2
; u
1
)
=
_
100
13
;
60
13
_

_
50
8
;
30
8
_
=
_
75
52
;
45
52
_
The CV is the amount of income needed to get the consumer back to u
1
after the price change. CV =
I e(p
2
; u
1
) = 10 (
50
8
+
1
2
30
8
) =
15
8
- $1: 88 The EV is the amount of money the consumer would accept in
lieu of the price change, or the expenditure saved by the price change, EV = e(p
1
; u
2
)I =
300
13
1
3
+
300
13
1
5
10 =
29
30
13
- $2: 31 The CS is the area under the demand curve between the prices:
CS =
p2
_
p1
x

(p
i
; p
j
; I)dp
i
=
1=2
_
1
I
5
3
p
x
+ p
y
dp
y
=
1
_
1=2
10
5
3
+ p
y
dp
y
= 10(ln(
5
3
+ p
y
)[
py=1
py=1=2
)
= 10(ln(
5
3
+ 1) ln(
5
3
+
1
2
))
- $2:08
Therefore, the welfare gain of the price change to the consumer is about $2.
Example 40 Perfect Substitutes u(x; y) = 2x + 3y;
The demand function for these preferences is given by:
x

(p
x
; p
y
; I); y

(p
x
; p
y
; I) =
(
I
px
; 0) if
2
3
>
px
py
(0;
I
py
) if
2
3
<
px
py
(z
I
px
; (1 z)
I
py
) for z [0; 1] if
2
3
=
px
py
and compensated demand is:
== x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
u
2
; 0
_
if
2
3
>
px
py
_
0;
u
3
_
if
2
3
<
px
py
_
z
u
2
; z
u
3
_
for z [0; 1] if
2
3
=
px
py
The indirect utility function and expenditure function is thus:
V (p; I) =
2I
px
if
2
3
>
px
py
3I
py
if
2
3
<
px
py
_
z
2I
px
; (1 z)
3I
py
_
for z [0; 1] if
2
3
=
px
py
e(p; u) =
p
x
u
2
if
2
3
>
px
py
p
y
u
3
if
2
3
<
px
py
_
zp
x
u
2
; (1 z)p
y
u
3
_
for z [0; 1] if
2
3
=
px
py
30
Suppose that initial income and prices is given by (p
x
; p
y
; I) = (2; 6; 20) and the price of x increases to
p
x
= 3: What are the income and substiution eects associated with this price change? What if p
x
increases
to p
x
= 6? What are the EV, CV, and CS associated with these price changes?
x

(2; 6; 20); y

(2; 6; 20) = (10; 0)


x

(3; 6; 20); y

(3; 6; 20) =
_
20
3
; 0
_
x

(6; 6; 20); y

(6; 6; 20) =
_
0;
20
6
_
V (2; 6; 20) = u
1
= 20
V (3; 6; 20) = u
2
=
40
3
V (6; 6; 20) = u
3
= 10
x
H
(3; 6; 20) ; y
H
(3; 6; 20) = (10; 0)
x
H
(6; 6; 20) ; y
H
(6; 6; 20) = (0;
20
3
)
== Substitution Eect for p
x
increased to 3:
= x
H
(p
2
; u
1
); y
H
(p
2
; u
1
) x

(p
1
; I); y

(p
1
; I)
= (10; 0) (10; 0)
= (0; 0)
== Income Eect for p
x
increased to 3:
= x

(p
2
; I); y

(p
2
; I) x
H
(p
2
; u
1
); y
H
(p
2
; u
1
)
=
_
20
3
; 0
_
(10; 0)
=
_

10
3
; 0
_
== Substitution Eect for p
x
increased to 6:
= (0;
20
3
) (10; 0)
=
_
10;
20
3
_
== Income Eect for p
x
increased to 6:
=
_
0;
20
6
_
(0;
20
3
)
=
_
0;
20
3
_
Notice that if the price change is big enough to change the relationship between MRS and the price ratio
px
py
; that there will be a huge substitution eect as the consumer moves from consuming all of one good to all
31
of the other good. Otherwise, there is no substitution eect.
CV = I e(p
2
; u
1
) = 20 3 10 = 10
EV = e(p
1
; u
2
) I =
40
3
20 =
20
3
- 6:7
CS =
p2
_
p1
x

(p
i
; p
j
; I)dp
i
=
3
_
2
20
p
x
dp
x
= 20(ln(3) ln(2)) - 8:1
Now we compute the EV; CV; and CS when p
x
increases to p
x
= 6 :
CV = I e(p
3
; u
1
) = 20 6
20
3
= $20
EV = e(p
1
; u
3
) I = 10 20 = $10
CS =
p2
_
p1
x

(p
i
; p
j
; I)dp
i
=
6
_
2
20
p
x
dp
x
=
4
_
2
20
p
x
dp
x

6
_
4
0dp
x
since x

= 0 if p
x
> 4
=
4
_
2
20
p
x
dp
x
= 20(ln(4) ln(2)) - $13:9
Example 41 Quasi-linear utility 4
_
x + y:
The demand function given these preferences is:
x

(p
x
; p
y
; I); y

(p
x
; p
y
; I) =
_
_
2
py
px
_
2
;
I
py
4
py
px
_
if I _ 4
p
2
y
px
_
I
px
; 0
_
if I < 4
p
2
y
px
32
and compensated demand is:
== x
H
(p
x
; p
y
; u); y
H
(p
x
; p
y
; u) =
_
_
2py
px
_
2
; u 8
py
px
_
if u _ 8
py
px
_
u
2
16
; 0
_
if u < 8
py
px
Indirect utility and expenditure is given by:
V (p; I) =
4
py
px
+
I
py
if I _ 4
p
2
y
px
4
_
I
px
if I < 4
p
2
y
px
e(p; u) =
p
x
_
2py
px
_
2
+ p
y
_
u 8
py
px
_
if u _ 8
py
px
p
x
u
2
16
if u < 8
py
px
Suppose that initial income and prices is given by (p
x
; p
y
; I) = (4; 4; 60) and the price of x decreases to
p
x
= 2: What are the income and substiution eects associated with this price change? What if the price of
x decreases to p
x
= 1? What are the EV, CV, and CS associated with these price changes?
Notice that the rst price change will keep us at an interior solution, but the second price change moves
us to the corner solution.
33
x

(4; 4; 60); y

(4; 4; 60) = (4; 11)


x

(2; 4; 60); y

(2; 4; 60) = (16; 7)


x

(1; 4; 60); y

(1; 4; 60) = (60; 0)


V (4; 4; 60) = u
1
= 4 + 15 = 19
V (2; 4; 60) = u
2
= 8 + 15 = 23
V (1; 4; 60) = u
3
= 4
_
60
x
H
(2; 4; 19); y
H
(2; 4; 19) = (16; 3)
x
H
(1; 4; 19) ; y
H
(1; 4; 19) =
_
19
2
16
; 0
_
== Substitution Eect for p
x
decreased to 2:
= x
H
(p
2
; u
1
); y
H
(p
2
; u
1
) x

(p
1
; I); y

(p
1
; I)
= (16; 3) (4; 11)
= (12; 8)
== Income Eect for p
x
decreased to 2:
= x

(p
2
; I); y

(p
2
; I) x
H
(p
2
; u
1
); y
H
(p
2
; u
1
)
= (16; 7) (16; 3)
= (0; 4)
== Substitution Eect for p
x
decreased to 1:
=
_
19
2
16
; 0
_
(4; 11)
=
_
297
16
; 11
_
- (18:6; 11)
== Income Eect for p
x
decreased to 1:
= (60; 0)
_
19
2
16
; 0
_
=
_
599
16
; 0
_
- (37:4; 0)
Notice that there is no income eect for good x when moving between interior solutions. This is a special
feature of quasi-linear preferences.
34
CV = I e(p
2
; u
1
) = 60 (32 + 12) = $16
EV = e(p
1
; u
2
) I = 16 + 60 60 = $16
== CS = $16
Now we compute the EV; CV; and CS for a price change of p
x
decreasing to p
x
= 1 :
CV = I e(p
3
; u
1
) = 60
19
2
16
- $37:4
EV = e(p
1
; u
3
) I = 16 + 4
_
4
_
60 8
_
60 - $47: 9
CS =
p2
_
p1
x

(p
i
; p
j
; I)dp
i
=
1
_
4
x

(p
x
; 4; 60)dp
x
=
4
_
1
x

(p
x
; 4; 60)dp
x
=
64=60
_
1
60
p
x
dp
x
+
4
_
64=60
_
8
p
x
_
2
dp
x
= 60(ln(64=60) ln(1)) + (64p
1
x
[
px=4
px=64=60
)
= 60 ln
_
64
60
_

64
4
+ 60 - $47:8
35