Indirect utility function

Indirect utility function is defined as the maximum utility that can be

attained with given money income and prices of goods. It is derived
from the consumer problem of maximizing utility subject to budget
constraint. The consumption of goods depends on money income and
prices of commodity which indicates that utility also depends on money
income and prices also. So if we specify the relationship between utility,
income and prices in a functional form, it gives us indirect utility
function.

Now let U= f(x, y) be the direct utility function, M be the money

income, Px and Py are the prices of x and y commodity respectively, then

Maximization of U= f(x, y)

Subject to M=Px .X +Py .Y

By solving the constraint optimization problem, we get the optimal

bundle of x and y, as

X*= g (M, Px )

Y*= h (M, Py)

Where x *= and y* are optimal quantity purchases of x and y, which

shows that x* and y* depends on price and income. Now putting the
value of x* and y* into utility function we have

U= f [g (M, Px), h (M, Py)]

:. U= f (M, Px ,Py )----------(1)

The equation (1) is indirect utility function. This shows how income and
price affects the utility. U is decreasing function in prices and increasing
function in income. U is homogenous of degree 0 in prices and income.
Indirect utility function tells that utility depends on maximization
process of price income situation that the consumer faces.
(minimization of expenditure subject to given utility level or
maximization of utility subject to given expenditure)

diagrammatically,

Here y and x is optimal demand bundle associate with prices and

income.

Duality in consumer theory

If we examine the consumer behavior, we can study the behavior in

terms of maximization of utility subject to budget constraint and
minimization of expenditure subject to utility constraint. It means we
can see the consumer behavior from both of these prospective, which
is called consumption duality or duality in consumption theory.

Max. U= f(x1,x2, x3 ---- xn)

Sub. to M= P1 x1 P2 x2 +----Pn xn

This is the case of maximization of utility from given budget and its dual
is

Min. E= P1 X1 +P2 X2 -----Pn Xn

Sub. to U= f(x1, x 2 ---xn )

Expenditure minimization problem allocates the money in such a way

that a given level of utility is achieved with the minimum expenditure.

Expenditure function

The expenditure function shows the minimum expenditure for the

given level of utility and prices. It is derived from the problem of
minimizing the expenditure necessary for a consumer to achieve a
specified level of utility. Let E be the expenditure x i be the ith commodity
and pi is price of ith commodity. U0 is the given level of utility, then the
formulation of problem is

Min. E = p1 x1 +p2 x 2+ ----pn xn

Sub. to U0=f(x1, x2, x3 -----xn )

Since given problem is constraint optimization. Therefore we have to

use Lagrangian function

Ø =p1 x1 +p2 x2 + -------pn x n) + α (U0 – f(x1 ,x 2, ---xn )

First order condition: ∂/∂x =0

∂Ø/∂x= ∂/∂x [(p1 x1 +p2 x2 + ----pn xn )+α (U0 –f(x1 ,x 2, ----xn )]=0

or,pi-αxi =0
or, pi=αxi----------(1)

where xi=MU of xi=∂u/∂xi

again pj= αxj ------(2)

similarly

∂Ø/∂α= ∂/∂α[(p1 x1 +p2 x2 +------p nxn )+α(U 0–f(x1 ,x2 ,---xn)]

Or U0-f(x1 ,x2 , -----xn)=0---------(3)

Dividing equation (1) by (2)

Pi /pj =αxi/αxj

Or pi /pj =xi/xj

This shows that the ratio of prices of i th and jth goods equal to the ratio
of their respective marginal utility.

By solving the equation (1) and putting the value in (3) we get,

Xi =f(U0 ,pi ,pj) and xj =g(U0 ,pi ,pj)

In general form xi=f(U0,p i) here xi is the optimal quantity say xi* then if
we substitute the value of x*(optimal quantity of xi for minimizing
expenditure)into the given expenditure line

E=f(U0, pi) this is the expenditure function which shows the minimum
expenditure for given level of utility and given prices. The expenditure
function is homogenous of degree one or linearly homogenous with
price. It means if price of commodity increases by k times then
expenditure also increased by k times.

Diagrammatically,
Revealed preference theory

P. A. Samuelson introduced the ‘revealed preference’ into economics in

1938. The revealed preference hypothesis is considered as a major
breakthrough (success) in the theory of demand, because it has made
possible the establishment of the law of demand directly without the
use of indifference curve and all their restrictive assumption. It is the
major advancement over the earlier theories of demand. It has many
advantages over Marshallian and Hicksian theories. It provides direct
way to the derivation of demand curve and it proves existence and
convexity of indifference curve under weaker assumption than earlier
theory. It provides basis for the construction of index number and their
uses for consumer welfare. It is more behaviouristic method to derive
demand theorem from observed consumer behavior.

Assumptions:
1. Rationality: The consumer is rational in the sense that he prefers
that bundle which includes more quantity of commodity. He prefers
a larger basket of goods to the smaller ones.
2. Consistency: the consumer is consistent in his preference i. e. if
under the given budget condition he prefers A to B, he will not
prefer B to A under the same condition. i. e. A>B then B≠A.
3. Transitivity: consumer’s preferences are transitive i.e. given 3
bundles of commodities, A, B and C. if he prefers A>B and B>C then
A>C.
4. The revealed preference axiom: when a consumer makes a choice
of a particular bundle of commodity then he has revealed his
preference regarding the same. Thus under the given budget
condition, the chosen bundle is one that gives the consumer
maximum satisfaction. It means that when the consumer chooses
bundle A, he considers all other alternative bundles which could
have purchased to be inferior to A. This theory is based on strong
ordering hypothesis which implies definite ordering of various
combinations in consumer’s scale of preference. Diagrammatically
 In fig. If A is preferred bundle in the budget line, then any point below
and above A lies in inferior zone. If he chooses bundle A, he reveals his
preference for A compared to all other points. Any point inside the
budget line represents smaller and cheaper basket hence it is not
revealed preference than A. The preferred zone is where the consumer
would like to be but does not have the budget too. It represents larger
bundle than A. It cannot inferior to A.
Derivation of demand curve for normal goods:
The revealed preference theory has helped us to derive the historical
demand curve supported by the law of demand. Let there are two
commodities X and Y. let the price of X falls, first we examine income
and substitution effect and then derive the law of demand.
In fig. in initial budget line is AB, the consumer chooses point E1. Now
suppose price of x falls, price of y remaining the same, so that his
budget line shifts to AB1 and the consumer shifts to the point E2. Now
decompose the income and substitution effect of the price effect using
Slutskian method, this has been done by drawing a budget line C
through the point E1. He will not choose any point above the E1 as they
are inferior zone. Thus, he moves to another point in the E1C section,
now the point E3 gives higher level of utility. Similarly as income
increases the consumer moves further on point E2, this shows higher
utility for him. In lower fig. when price of x falls, he consumes more of
x. It helps us to derive demand curve sloping downward supporting the
traditional law of demand.

Demand curve for Giffen goods

In fig. consumer’s initial revealed preference was at point E1 on budget
line AB. As price falls budget line shifts to AB1, at a higher real income
level consumer’s revealed preference is at point E2. If we draw CD line
parallel to AB1 and passing through the pointE1, then CE1 falls on the
inferior zone. Therefore assuming consistency in choice, he would try to
move towards E1D to increase his utility. He chooses point E3, which is
the substitution effect. Lower fig. shows demand curve in the case of
Giffen goods, which have upward slopping. Thus as price increases
quantity demanded also increases and vice versa.

Demand curve for inferior goods

Upper fig. shows consumer’s initial revealed preference is at point E1

on AB budget line. Any point below AB would lie on inferior zone. As
price falls budget line shifts to AB1, he chooses E2. Drawing CD parallel
to AB1 and passing through the point E1. Now CE1 segment lies on
inferior zone. He has E1 available but he would not want to move CE1
segment. Thus he would like to move towards higher utility denoted by
point E3. Similarly with an increase in income he moves to point E2.
Lower fig. shows derived demand curve DD which is negatively slopped.
Now to find out whether x commodity is an inferior or not, we have to
look at the income effect. Movement from E3 to E2 is negative. Thus as
income increases quantity demanded decreases, therefore commodity
x is inferior.

Derivation of indifference curve

Samuelson’s revealed preference theory can be used also to construct

indifference curve of a consumer. Revealed preference theory provides
the proof for the existence of indifference curve and its convexity. It
derives such proofs from observed market behavior of the consumer.
The consumer reveals his preference at point M on AB budget line. Any
other point on budget line is revealed inferior to M. The triangle AOB is
inferior zone, the area NML is preferred zone and the area to the right
of MN and above ML represents a basket combining more of both
goods. Therefore any point on the line MN and ML and between them
is preferable to M. thus this area is called preferred zone, but are
beyond the budget constraint. The area NMA and LMB are ignorance
zones. In these areas any combination of two goods will contain more
of one good and less of another compared to M. that is a part of one
good is substituted for another. The consumer’s reaction to such
changes is difficult to know and the consumer’s preferences are
unknown and cannot be determined precisely. Therefore these are
called ignorance zone.

Now in order to derive IC curve we examine two ignorance zones in fig.

Initial budget line is AB. Suppose price of x falls and y rises, budget line
shifts to EF. If G is the revealed point, then he will not choose any point
on EG section as this will lie on inferior zone of his earlier budget
situation. Thus his choice will be in the GF zone. Now

Z > G (in the initial budget situation)

G > GBF (in the new budget situation)

:. Z > GBF (implying transitivity)

Thus by drawing several such points, we come to points where

consumer is indifferent. We can observe upper ignorance zone by the
following diagram.

If price of x rises and price of y falls, then budget line will shift to KL. In
KL line any point on ZL segment lies on the inferior zone. Assuming
consistency, the consumer would choose a point on the ZK segment say
U then,

(MUN) > U (according to current budget line)

U>Z (From the revealed preference principle)

MUN>Z (From the transitivity assumption)

Thus we managed to rank the batches in (MUN) as preferred to Z.

Repeating this procedure we may gradually narrow down the
'ignorance zone' until we locate the indifference curve within as narrow
a range as we wish. Hence, the revealed preference axiom permits us to
derive the indifference curve from the behavior of the consumer in
various market situations.

The convexity of the indifference curve may be established graphically

as follows. Let us redraw the original budget situation. We observe that
the indifference curve through Z must be somewhere in the ignorance
zone and must be convex, because it cannot have any other shape. The
indifference curve cannot be the straight line AB because the choice of
Z shows that all the other points on AB are inferior to Z (hence the
consumer cannot be at the same time indifferent between them). It
cannot be a curve or line cutting AB at Z, because the points below Z
would imply indifference of the consumer, while he has already
revealed his preference for Z. Finally, the indifference curve cannot be
concave through Z, because all its points have already been ranked as
inferior to Z. Hence the only possible shape of the indifference curve is
to be convex to the origin. The entire portion above offer curve is
revealed superior to Z. Indifference cannot passes through preferred
zone. Therefore only probable position of indifference curve is
somewhere in the ignorance zone being convex to the origin to Z.