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1
Book used :
Jehle, G.A. and Reny, P.J.
Second Edition
You might also have a look at
Microeconomic Theory by
Mas-Collel, Whinston and Green
Microeconomic Analysis by
Varian
2
Outline of Part I
Chapter I: Consumer Theory:
Preferences
Utility functions
The consumers problem
Indirect utility and expenditure
Properties of consumer demand
Chapter II: Advanced topics of consumer theory
Duality
Revealed preferences
Risk and uncertainty
2
3
Chapter III: Theory of the firm
Technology, production function
Cost functions
Profit maximization under perfect competition
Chapter IV: Partial Analysis
Partial equilibrium
monopoly
(Duopoly -> part of game theory, Horst Raff does that)
4
Chapter V: General Equilibrium
Definition
Existence
Efficiency
Uniqueness and Stability
3
5
Chapter 1: Consumer Theory
1.1 Primitive Notions
4 building blocks:
consumption set
the feasible set
the preference relation
the behavioral assumptions
6
Chapter 1: Consumer Theory
consumption set := set of all alternatives a consumer can
conceive.
We assume that the commodity space is infinitely
divisible.
n= dimension of the commodity space.
Let represent the number of units of
good
is called a consumption
bundle or consumption plan.
0 ,
i i
x IR x
n
n
IR x x
+
= ) ,..., (
1
x
. , , 1 , n i i =
4
7
Chapter 1: Consumer Theory
Assumption 1.1
[Properties of the Consumption Set X ]
1. X is nonempty and
2. X is closed.
3. X is convex.
4.
(Diagram: Consumption Set)
X 0
n
IR X
+

8
Chapter 1: Consumer Theory
Feasible set = set of all alternatives that are achievable
for the consumer:
B can be for example the budget set.
But it can also be determined by institutional rules, e.g.
rationing.
Note that different consumers usually have different
feasible sets.
X B
5
9
1.2 Preferences and Utility
1.2.1 Preference relations
Consumer preferences are characterized axiomatically.
Formally, a preference relation is a binary relation on X
means is as least as good as
Two axioms:
Axiom 1: Completeness: For all and in X
or
Axiom 2: Transitivity: For all and in X :
If and then
2 1
x x
1
x
2
x
1
x
2
x
2 1
x x
1 2
x x
2 1
, x x
3
x
2 1
x x
3 2
x x
3 1
x x
10
1.2 Preferences and Utility
Definition 1.1 [preference relation]
A binary relation on X that satisfies the two axioms is called
a preference relation.
Definition 1.2 [Strict preference relation]
is strictly better than if and only if
and not:
Definition 1.3 [Indifference relation]
if and only if and
2 1
x x
2 1
x x
1 2
x x
2 1
~ x x
2 1
x x
1 2
x x
1
x
2
x
6
11
1.2 Preferences and Utility
Definition 1.4 [Sets in X derived from the preference
relation]
1.
is called the as least as good set
2.
is called the no better set
3.
is called the worse than set
4.
is called the preferred to set
5.
is called the indifference set
} , | { ) (
0 0
x x X x x x =
} , | { ) (
0 0
x x X x x x =
} , | { ) (
0 0
x x X x x x =
} , | { ) (
0 0
x x X x x x =
} ~ , | { ) ( ~
0 0
x x X x x x =
12
1.2 Preferences and Utility
Axiom 3: [Continuity]: For all
The as least as good set
and the no better set
are closed in
The continuity axioms rules out that sudden preference
reversals occur.
Example for a non-continuous preference relation is the
lexicographic preference relation.
+
n
IR x
+
n
IR
) (x
) (x
7
13
1.2 Preferences and Utility
Axiom 4: [Local Non-satiation]: For all
and all there exists some
such that
is a ball with radius around x
0
This axiom rules out the possibility of having thick zones of
indifference
+
n
IR x
0
0 >
+
n
IR x B x ) (
0

0
x x
0
( ) B x

14
1.2 Preferences and Utility
Axiom 4: [Strict Monotonicity ]: For all
If then while if then
Where means for all i
and means for all i.
Monotonicity is stronger than local non-satiation!
(Diagram: Non-Satiation/Monotonicity)
+
n
IR x x
1 0
,
,
1 0
x x
.
1 0
x x ,
1 0
x x ,
1 0
x x >>
1 0
x x
1 0
i i
x x
1 0
x x >>
1 0
i i
x x >
8
15
1.2 Preferences and Utility
Axiom 5: [Convexity ]:
If then for all
Axiom 5: [Strict Convexity ]:
If and then for all
(Diagram: Convexity)
1 0
x x
] 1 , 0 [ t
1 1 0
) 1 ( x x t tx +
1 0
x x
1 0
x x
1 1 0
) 1 ( x x t tx +
) 1 , 0 ( t
16
1.2 Preferences and Utility
The marginal rate of substitution (MRS):
indicates how much a consumer is willing to give up of
good 1, say, to obtain 1 more unit of good 2.
The slope of the indifference curve is exactly the MRS.
Often we observe: a diminishing marginal rate of
substitution :
The less we have of one good, the less we are willing to
give up of this good for more units of an other good.
The principle of a diminishing marginal rate of substitution
and convexity of preferences are closely related.
9
17
1.2.2 The Utility Function
Definition 1.5 [A utility function representing the
preference relation _ ]
A real-valued function
is called a utility function representing the preference
relation _ , if for all :
_
IR IR u
n

+
:

n
IR x x
+
,
1 0
1 0 1 0
x ) ( ) ( x x u x u

18
1.2.2 The Utility Function
Does a representing utility function always exists?
Yes, if preference relation is rational and continuous [Debreu
`54]
Its easier to prove the result for monotonic preferences!
Theorem 1.1: (Existence Theorem)
If a binary relation is complete, transitive, continuous, and
strictly monotonic,
there exists a continuous function,
which represents .
, : IR IR u
n

10
19
1.2.2 The Utility Function
Proof: (to find at least one such function)
Step 1: [Construction]:
Define and consider
defined such that is satisfied. (P.1)
Note:
i.e. u(x)e is a point on a ray from 0 to e!
(Diagram: Constructing the Mapping u next page)
n
IR e
+
= ) 1 ,..., 1 (
} ) ( , ), ( { ) (
times
_

n
x u x u e x u =
x e x u ~ ) (
, : IR IR u
n

+
20
1.2.2 The Utility Function
2
x
1
x
1
1
e
) (x u
) (x u
x
e x u ) (
11
21
1.2.2 The Utility Function
Step 2: [Existence of such a number ]
Define:
If we find then
and satisfies (P.1).
By monotonicity:
By continuity of , A and B are closed.
Hence:
) (x u
} | 0 { x e t t A
} | 0 { x e t t B
B A t
*
, ~
*
x e t
) (
*
x u t =
t t B t B t
t t A t A t

] , [ = t A
] , 0 [ t B =

22
1.2.2 The Utility Function
Now completeness implies:
_ or _
But this implies
i.e. there is at least one t satisfying (P.1).
x e t x e t
B A t
[ ] [ ] = =
+
, , 0 t t B A IR
B A t t
12
23
1.2.2 The Utility Function
Step 3: [Uniqueness of t]
Assume there are numbers with
and then, by transitivity,
and, by monotonicity,
Step 4: [u(x) represents ]
Consider two bundles and their associated
utility numbers
with
2 1
, t t
x e t ~
1
, ~
2
x e t e t e t
2 1
~
2 1
, x x
) ( ), (
2 1
x u x u
. ~ ) ( , ~ ) (
2 2 1 1
x e x u x e x u
.
2 1
t t =

24
1.2.2 The Utility Function
Then:
_
_ [by (P.1)]
_ [Transitivity]
[Monotonicity]
_
Step 5: [Continuity]
Theorem A1.6:
2 1
x x

e x u x x e x u ) ( ~ ~ ) (
2 2 1 1

e x u e x u ) ( ) (
2 1

) ( ) (
2 1
x u x u
represents ) (x u
( ) { } interval. open an also is ) , ( ) ( , | ) , (
image inverse the , ) , ( interval open every for
if only and if continuous is :
1
b a x u IR x x b a u
IR b a
IR IR u
n
n
=

+
13
25
1.2.2 The Utility Function
a < b.

## By continuity _ and _ are closed sets, hence their

complements and are open.
The intersection is open. QED
) (ae
) ( ) ( be ae
( ) { }
) ( ) (
(P.1) } ) ( {
ty monotonici } {
} ) ( {
image inverse def. ) , ( ) ( , | ) , (
1
be ae
be e x u ae IR x
be x ae IR x
b x u a IR x
b a x u IR x x b a u
n
n
n
n

=
=
=
< < =
=
+
+
+
+

) (ae ) (be
) (be
26
1.2.2 The Utility Function
Theorem 1.2: [Invariance of utility function to
positive monotonic transformations]
Let _ be a preference relation on and let
represent it.
Then also represents _ if an only if
where is a strictly increasing function. IR IR f :

) (x u
) (x v
, )) ( ( ) (
n
IR x x u f x v
+
=
n
IR
+
14
27
1.2.2 The Utility Function
Definition: A function is (strictly)
quasi-concave if the superior set
is (strictly) convex for all . (Diagram: Quasi-C)
Theorem 1.3 [Properties of Preferences and utility
functions]
Let _ be represented by
Then: 1.) is strictly increasing
_ is strictly monotonic.
2.) is (strictly) quasi-concave
_ is (strictly) convex.
IR IR f
n
:
IR a
} ) ( | { a x f x

) (x u
) (x u
IR IR u
n

+
:
28
1.2.2 The Utility Function
Representing preferences by utility functions makes life
easier.
If necessary, we assume to be differentiable.
marginal utility w.r.t. commodity i.
The marginal rate of substitution (MRS)
Consider the utility function
The indifference curve at
) (x u
=

i
x
u
) , (
2 1
x x u u =
) , (
1
2
1
1
1
x x x =
15
29
1.2.2 The Utility Function
is given by
MRS is given by
The MRS says how much a consumer is willing
to give up of commodity 2 (or to pay in terms
of commodity 2) to get one more (small) unit of
commodity 1.
If preference are strictly convex, then MRS is strictly
diminishing
( ) ( )
. 0
, ,
) (
!
2
2
1
2
1
1
1
1
1
2
1
1 1
=

= dx
x
x x u
dx
x
x x u
x du
( )
( )
.
,
,
) (
2
1
2
1
1
1
1
2
1
1
1
2 1
12
x x x u
x x x u
dx
dx
x MRS

= =
30
Definition: [quasi-concavity]
is quasi-concave if and only if
Define
as the superior set for level
Theorem A1.14:
is a quasi-concave function
if is a convex set for all .
IR D f :
: ,
2 1
D x x
} ) ( , | { ) (
0 0
y x f D x x y S
)} ( ), ( min{ ) ) 1 ( (
2 1 2 1
x f x f x t tx f + ] 1 , 0 [ t
0
y
IR D f :
) ( y S IR y
16
31
1.3 The Consumer`s Problem
Behavioral Assumption:
The consumer seeks such that _
for all
Assumption 1.2 [Consumers Preferences]
Consumers preferences satisfy Axioms 1-5 (complete-
ness, transitivity, continuity, strict monotonicity, strict
convexity), hence can be represented by a continuous,
strictly increasing, strictly quasi-concave utility function.
Assumption: Market economy, i.e, consumers take
prices as given, where
n
IR B x
+

*
x x
*
. B x
. 0 ) , , (
1
>> =
n
p p p
32
1.3 The Consumer`s Problem
The budget set: given income
where
The utility maximization problem:
(UM)
} | | { y x p IR x x B
n
=
+

=
=
n
i
i i
x p x p
1
) ( max x u . .t s y x p
n
IR x
+

, 0 y
17
33
1.3 The Consumer`s Problem
Note that if solves the problem, then
hence _
Note also, since is compact, there is always a solution
to (UM) by the Theorem of Weierstra (A1.10).
Since is convex and is strictly quasi-concave the
solution is unique and lies on the boundary of B.
Solution is function of y and p and called
Marshallian demand function
*
x
B x x u x u ) ( ) (
*
B x x x
*

B
B u
) , (
*
y p x x
i i
=
34
1.3 The Consumer`s Problem
Budget set,
in the case of two commodities
1
x
2
x
B

2
/ p y
1
/ p y
} , | { y x p IR x x B
n
=
+
2
1
tan
p
p
=
18
35
1.3 The Consumer`s Problem
2
x
1
x
*
1
x
*
x
*
2
x
The solution of the consumers
Utility-maximization problem.
2
/ p y
1
/ p y
36
1.3 The Consumer`s Problem
0
2
0
p y
) , , (
0 0
2
0
1 2
y p p x
0
2
0
1
p p
2
x
1
x
The consumers problem and
consumer demand behavior (1)
0
2
1
1
p p
) , , (
0 0
2
1
1 2
y p p x
) , , (
0 0
2
0
1 1
y p p x ) , , (
0 0
2
1
1 1
y p p x
19
37
1.3 The Consumer`s Problem
The consumers problem and
consumer demand behavior (2)
0
1
p
1
p
1
x
1
1
p
) , , (
0 0
2
0
1 1
y p p x ) , , (
0 0
2
1
1 1
y p p x
) , , (
0 0
2 1 1
y p p x
38
1.3 The Consumer`s Problem
including differentiability, to solve the problem, we
employ the Kuhn-Tucker-method (note: x>>0,0)
Lagrangian:
FOCs:
Since u is monotonic, (1) holds with equality and (2) is
redundant. (Diagram: Kuhn-Tucker)
] [ ) ( ) , ( x p y x u x L + =
(2) . 0 ] [
(1) , 0
(0) , , 1 , 0
) (
* *
*
*
*
=

= =

px y
px y
n i p
x
x u
x
L
i
i
i
i

20
39
(0) implies
Theorem 1.4 [Sufficiency of F.O.C.s]
If is continuous and quasi-concave and
, then the solution to (0), (1) solves the
consumers problem.
1.3 The Consumer`s Problem
) (x u
0 ) , ( >> y p
k
j
x
u
x
u
jk
p
p
MRS
k
i
= =

40
1.4 Indirect Utility & Expenditure
1.4.1 The Indirect utility function
Direct utility function: represents direct utility from
the consumption of commodity bundles
Indirect utility: gives the utility depending on prices
and income after the utility maximization process has
been carried out
Definition:
Hence,
. s.t. ) ( max ) , ( y x p x u y p v
n
IR x
=
+

. )) , ( ( ) , ( y p x u y p v =
21
41
1.4.1 Indirect Utility Function
2 1
/ tan p p =
2
x
1
x
2
/ p y
) , ( y p
1
/ p y

42
1.4.1 Indirect Utility Function
Theorem 1.6 [Properties of the indirect utility function]
If is continuous and strictly increasing on ,
then is
1. Continuous on
2. Homogeneous of degree zero in
3. Strictly increasing in
4. Decreasing in
5. Quasi-convex in
6. Roys identity: if is differentiable at and
then:
) (x u
n
IR
+
). , ( y p
, p
,
+ + +
IR IR
n
), , ( y p
, y
) , ( y p v
, ) , (
) , (
) , (
0 0
0 0
0 0
y
y p
p
y p
i
i
y p x

. ,..., 1 n i =
) , ( y p v ) , (
0 0
y p
0 ) , (
0 0
y p v
y
22
43
1.4.1 Indirect Utility Function
Theorem 1.6 [Properties of the indirect utility function]
If is continuous and strictly increasing on ,
then is
1. Continuous on
2. Homogeneous of degree zero in
3. Strictly increasing in
4. Decreasing in
5. Quasi-convex in
6. Roys identity: if is differentiable at and
then:
) (x u
n
IR
+
). , ( y p
, p
,
+ + +
IR IR
n
), , ( y p
, y
) , ( y p v
, ) , (
) , (
) , (
0 0
0 0
0 0
y
y p
p
y p
i
i
y p x

. ,..., 1 n i =
) , ( y p v ) , (
0 0
y p
0 ) , (
0 0
y p v
y
44
1.4.1 Indirect Utility Function
Homogeneity of the indirect utility
function in prices and income
2 1 2 1
/ / p p tp tp =
2
x
1
x
2 2
p y tp ty =
) , ( ) , ( y p v ty tp v =
1 1
p y tp ty =
) , ( ) , ( y p v ty tp v =
23
45
1.4.1 Indirect Utility Function
Proof of some of the properties:
1. Follows from Theorem of Maximum (A2.4).
2.
3. In order to prove increasingness, we assume that v
is strictly positive and differentiable, where (p,y)>>0
and that is differentiable with
) , (
] . . ) ( max[
] . . ) ( max[ ) , (
y p v
y x p t s x u
ty x p t t s x u ty tp v
=
=
=
) ( u . 0 0 / ) ( >> > x x x u
i
46
A: The Envelope Theorem
Here we apply the Envelope Theorem:
As is increasing, the budget constraint is binding.
Hence,
Lagrangian:
Let solve the problem. Hence, there must be
some such that
As and
Envelope Theorem:
. . ) ( max ) , ( y px s.t x u y p v
n
R x
= =
+

QED . 0
) , ( ) , (
*
* *
> =

y
x L
y
y p v
). ( ) ( ) , ( px y x u x L + =
) ( u
0 ) , (
*
>> = y p x x
IR
*
.
) ( ) , (
*
* * *
i
i i
p
x
x u
x
x L

i
p . 0 0 / ) (
* *
> >
i
x x u
24
47
1.4.1 Indirect Utility Function
Theorem 1.6 [Properties of the indirect utility function]
If is continuous and strictly increasing on ,
then is
1. Continuous on
2. Homogeneous of degree zero in
3. Strictly increasing in
4. Decreasing in
5. Quasi-convex in
6. Roys identity: if is differentiable at and
then:
) (x u
n
IR
+
). , ( y p
, p
,
+ + +
IR IR
n
), , ( y p
, y
) , ( y p v
, ) , (
) , (
) , (
0 0
0 0
0 0
y
y p
p
y p
i
i
y p x

. ,..., 1 n i =
) , ( y p v ) , (
0 0
y p
0 ) , (
0 0
y p v
y
48
A: The Envelope Theorem
Excursion: The Envelope Theorem
Consider the maximization problem
x is a vector of choice variables and a is a vector of
exogenous parameters.
Suppose, that for each a the solution is unique and
denoted by x(a).
We define the maximum-value function:
0. x and 0 ) , ( . s.t ) , ( max = a x g a x f
x
. 0 and 0 ) , ( s.t. ) , ( max ) ( = = x a x g a x f a M
x
25
49
A: The Envelope Theorem
Then (Envelope Theorem):
where
Proof: see the Appendix of Jehiel and Reny, p. 506-507.
The Envelope Theorem says that if you change the
exogenous parameters of a maximized function,
then the variation of that function is completely determined by
the direct effect,
and you can neglect indirect effects, because it is already
chosen optimally.
) ( ), (
) (
a a x
j j
a
L
a
a M

). , ( ) , ( a x g a x f L + =
50
1.4.1 Indirect Utility Function
6. Proof of Roys identity:
Employing the envelope theorem:
Hence,
Accordingly:
QED
. and
* *
=

y
L
y
v
x
p
L
p
v
i
i i
] [ ) ( x p y x u L + =

*
*
* *
) , (
) , (
) (
i
i
y
y p
p
y p
x
x
i
=

26
51
1.4.1 Indirect Utility Function
Theorem 1.6 [Properties of the indirect utility function]
If is continuous and strictly increasing on ,
then is
1. Continuous on
2. Homogeneous of degree zero in
3. Strictly increasing in
4. Decreasing in
5. Quasi-convex in
6. Roys identity: if is differentiable at and
then:
) (x u
n
IR
+
). , ( y p
, p
,
+ + +
IR IR
n
), , ( y p
, y
) , ( y p v
, ) , (
) , (
) , (
0 0
0 0
0 0
y
y p
p
y p
i
i
y p x

. ,..., 1 n i =
) , ( y p v ) , (
0 0
y p
0 ) , (
0 0
y p v
y
52
1.4.2 The Expenditure Function
Question: What is the minimum level of expenditure to
achieve a certain utility level?
Look at:
For different this equation generates iso-expenditure
curves.
Definition: the expenditure function is defined as
2 2 1 1
x p x p e + =
e
. ) ( s.t.
min
) , ( u x u x p u p e
n
IR x

+

27
53
The solution is called Hicksian demand
or compensated demand.
Thus:
1.4.2 The Expenditure Function
)) , ( ),..., , ( ), , ( (
2 1
u p x u p x u p x x
h
n
h h h
=
) , ( ) , ( u p x p u p e
h
=
54
1.4.2 The Expenditure Function
Finding the lowest level of
expenditure to a achieve
utility level u
2 1
/ p p
1
x
2
*
/ p e
2
3
/ p e
1
3
/ p e
1
*
/ p e
1
1
/ p e
1
2
/ p e
h
x
u
u
) , (
2
u p x
h
) , (
1
u p x
h
2
x
28
55
1.4.2 The Expenditure Function
The Hicksian demand for good 1 as
a function of price:
Fig.1.16 (a)
1
x
2
x
0
2
0
1
/ p p
) , , (
0
2
0
1 2
u p p x
h
u
) , , (
0
2
1
1 2
u p p x
h
) , , (
0
2
1
1 1
u p p x
h
) , , (
0
2
0
1 1
u p p x
h
0
2
1
1
/ p p
56
1.4.2 The Expenditure Function
1
x
1
p
0
1
p
1
1
p
) , , (
0
2
1
1 1
u p p x
h
) , , (
0
2
0
1 1
u p p x
h
) , , (
0
2 1 1
u p p x
h
The Hicksian demand for good 1 as
a function of price:
Fig.1.16 (b)
29
57
1.4.2 The Expenditure Function
Theorem 1.7: (Properties of the expenditure function)
If is strictly increasing and continuous,
then is
a) Zero for the lowest utility level in U.
b) Continuous on its domain .
c) For all strictly increasing and unbounded
above in .
d) Increasing in .
e) Homogeneous of degree 1 in .
) ( u
) , ( u p e
U IR
n

+ +
0 >> p
u
p
p
58
1.4.2 The Expenditure Function
f) Concave in .
g) If, in addition, is strictly quasiconcave, we have
Shephard's Lemma:
is differentiable in at and
p
p
) , ( u p e
. , , 1 , ) , (
) , (
0 0
0 0
n i u p x
p
u p e
h
i
i
= =

) ( u
, 0 ), , (
0 0
>> p u p
o
30
59
Proof of f):
Assume and are two price vectors
We have to show:
Let minimize
Let minimize
Let minimize
1.4.2 The Expenditure Function
1
p
1 0 t
2
p
2 1
) 1 ( p t tp p
t
+ =
1
x
) , ( ) , ( ) 1 ( ) , (
2 1
u p e u p e t u p te
t
+
) , (
1
u p e
) , (
2
u p e
) , ( u p e
t
2
x
*
x
) , (
*
u p e
2
p
t
p
1
p
60
1.4.2 The Expenditure Function
Then it must hold: that achieve u.
In particular,
Multiplying by and , respectively, adding up:
by definition:
QED
x p x p
x p x p
2 2 2
1 1 1

t
) , ( ) , ( ) 1 ( ) , (
2 1
u p e u p e t u p te
t
+
* * 2 1 2 2 1 1
] ) 1 ( [ ) 1 ( x p x p t tp x p t x tp
t
= + +
) 1 ( t
x
) 1 , 0 ( t
.
* 2 2 2
* 1 1 1
x p x p
x p x p

31
61
u u p e p = )) , ( , (
1.4.3 Relation between Indirect
Utility and Expenditure Function
We observe that
and
Theorem 1.8 [Relations between indirect utility and
expenditure functions]
Let and be continuous and strictly
increasing. Then for
1.)
2.)
The proof is a bit technical, and can be found in the book.
y y p v p e )) , ( , (
u u p e p v )) , ( , (
. ) , ( U IR u p
n

+
) , ( y p v ) , ( u p e
U u y p >> , 0 , 0
y y p v p e = )) , ( , (
0 ) , ( >> y p
62
1.4.3 Relation between Indirect
Utility and Expenditure Function
Observe that for fixed :
Theorem 1.9: [Duality between Marshallian and
Hicksian Demand Function]
a)
b)
p

u u p e p v = )) , ( , (
) : ( ) , (
1
u p v u p e

=
y u p v e = )) , ( (
) : ( ) , (
1
y p e y p v

=
)) , ( , ( ) , ( y p v p x y p x
h
i i
=

)) , ( , ( ) , ( u p e p x u p x
i
h
i
=
32
63
1.4.3 Relation between Indirect
Utility and Expenditure Function
Proof of a):
Let and
Then
By Theorem 1.8:
or
But this means solves .
Hence and so
.
) , (
0 0 0
y p x x = ) (
0 0
x u u =
0 0 0 0 0 0
) ( ) , ( ( ) , ( u x u y p x u y p v = = =
0
) ( s.t. } min{ u x u x p
0 0 0 0
)) , ( , ( y y p v p e =
0
x
) , (
0 0 0
u p x x
h
=
)) , ( , ( ) , (
0 0 0 0 0
y p v p x y p x
h
=
0 0 0
) , ( y u p e =
64
1.4.3 Relation between Indirect
Utility and Expenditure Function
Proof of a):
Let and
Then
By Theorem 1.8:
or
But this means solves .
Hence and so
.
) , (
0 0 0
y p x x = ) (
0 0
x u u =
0 0 0 0 0 0
) ( ) , ( ( ) , ( u x u y p x u y p v = = =
0
) ( s.t. } min{ u x u x p
0 0 0 0
)) , ( , ( y y p v p e =
0
x
) , (
0 0 0
u p x x
h
=
)) , ( , ( ) , (
0 0 0 0 0
y p v p x y p x
h
=
0 0 0
) , ( y u p e =
33
65
1.4.3 Relation between Indirect
Utility and Expenditure Function
1
x
2
/ p y
1 1
)) , ( , (
p
y p v p e
p
y
=
h
x
)) , ( , ( ) , ( u p e p v y p v u = =
u
*
2
x
*
1
x
2
x
Illustration of Theorems 1.8
and 1.9
66
1.4.3 Relation between Indirect
Utility and Expenditure Function
1
x
2
/ p y
h
x
)) , ( , ( ) , (
1 1
y p v p x y p x
h
=
u
*
2
x
) , ( )) , ( , ( ) , (
1 1 1
*
1
y p x y p v p x u p x x
h h
= = =
1
p
Illustration of Theorems 1.8
and 1.9
)) , ( , ( ) , (
1 1
u p e p x u p x
h
=
34
67
1.5 Properties of Consumer Demand
1.5.1 Relative Prices and Relative Income
Note that real price ratios have dimension units/unit:
Real income:
For the utility maximizing consumer only relative prices and real
income matter.
In other words: there is no money illusion.
In reality, of course, consumers are not always free of money
illusion.
i
j j
i j
i
p
p
j
i
unit
unit
EUR
unit
unit
EUR
unit / EUR
unit / EUR
= = =
j
j p
y
j
of units
of units / EUR
EUR
= =
68
1.5.1 Relative Prices and Relative Income 1.5.1 Relative Prices and Relative Income 1.5.1 Relative Prices and Relative Income 1.5.1 Relative Prices and Relative Income
Theorem 1.10: [Homogeneity and Budget Balancedness]
If the consumers preference relation is continuous,
strictly monotonic, and strictly convex, the consumers
demand satisfies budged balancedness:
and is homogeneous of degree 0.
|
|

\
|
= =

n n
n
n
p
y
p
p
p
p
x ty tp x y p x , 1 , ,..., ) , ( ) , (
1 1
y y p x p = ) , (
35
69
1.5.2 Income and Substitution Effects
The Hicksian decomposition
of a price change. (a)
2
x
1
x
0
1
x
0
u
0
2
x
0
2
0
1
/ p p
70
1.5.2 Income and Substitution Effects
The Hicksian decomposition
of a price change. (a)
2
x
1
x
0
1
x
0
u
0
2
x
0
2
0
1
/ p p
0
2
1
1
/ p p
36
71
1.5.2 Income and Substitution Effects
The Hicksian decomposition
of a price change. (a)
2
x
1
x
1
1
x
1
2
x
0
1
x
0
u
1
u
0
2
x
0
2
0
1
/ p p
0
2
1
1
/ p p
72
1.5.2 Income and Substitution Effects
The Hicksian decomposition
of a price change. (a)
2
x
1
x
1
1
x
1
2
x
0
1
x
s
x
1
0
u
1
u
0
2
x
s
x
2
}
SE
_

SE IE
}
}
TE
IE
0
2
0
1
/ p p
0
2
1
1
/ p p
0
2
1
1
/ p p
_

TE
37
73
1.5.2 Income and Substitution Effects
The Hicksian decomposition
of a price change. (b)
1
p
1
x
1
1
x
0
1
x
s
x
1
0
1
p
1
1
p
) , , (
0
2 1
y p p x
) , , (
0
2 1 1
u p p x
h
)) , ( , , (
0
2 1 1
u p e p p x =
_

SE IE
TE
_

_

TE
_

1
x
1
p
{ )) , ( , , (
0
2 1 1
y p v p p x
h
=
74
1.5.2 Income and Substitution Effects
Different possible responses of quantity demanded to a change in price.
2
x
2
x
2
x
1
x 1
x
1
x
0
1
x
1
1
x
1
1
0
1
x x =
0
1
x
1
1
x
) (a ) (c ) (b
38
75
1.5.2 Income and Substitution Effects
Theorem 1.11: [The Slutsky-Equation]
Let be the Marshallian demand.
Let . Then
_
_ _
effect income
effect
on substituti
*
Effect total
TE
) , (
) , (
) , ( ) , (
y
y p x
y p x
p
u p x
p
y p x
i
j
j
h
i
j
i

)) , ( (
*
y p x u u =
) , ( y p x
n j i ,..., 1 , =
76
1.5.2 Income and Substitution Effects
Shepard's Lemma:
Rearranging:
_
j
i
j
i
j
h
i
p
u p e
y
u p e p x
p
u p e p x
p
u p x

) , ( ) , ( , ( ) , ( , ( ) , (
* * * *
) ) , ( , ( ) , (
* *
_
y
i
h
i
u p e p x u p x =
) , (
) , (
*
y p x
p
u p e
j
j
=

y
y p x
y p x
p
u p x
p
u p x
i
j
j
h
i
j
i

) , (
) , (
) , ( ) , (
* *
39
77
1.5.2 Income and Substitution Effects
The own price effect:
Theorem 1.12: [Negative own-substitution-effect]
Proof: Shepard's Lemma:
because expenditure
function is concave.
y
y p x
y p x
p
u p x
p
y p x
i
i
i
h
i
i
i

) , (
) , (
) , ( ) , (
*
) , (
) , (
u p x
p
u p e
h
i
i
=

i
h
i
j
p
u p x
p
u p e

) , (
) (
) , (
0
2
2
0

i
h
i
p
x

78
1.5.2 Income and Substitution Effects
Theorem 1.13 [Law of Demand]
A decrease in the own price of a normal good will
cause quantity demanded to increase.
If a decrease of the own price causes a decrease in
quantity demanded, the good must be inferior.
40
79
1.5.2 Income and Substitution Effects
Theorem 1.14: [Symmetric Substitution Terms]
Let be Hicks-demand. Then
Proof:
i
h
j
j
h
i
p
u p x
p
u p x

) , (
) , (
) , ( u p x
h
j
h
i
j i i j j
h
i
p
u p x
p p
u p e
p p
u p e
p
u p x

) , ( ) , ( ) , ( ) , (
2 2
80
1.5.2 Income and Substitution Effects
Theorem 1.15: [Negative semidefinite Substitution
Matrix]
The matrix
is negative semi definite.
(
(
(
(
(
(

=
n
h
n
h
n
n
h h
p
u p x
p
u p x
p
u p x
p
u p x
u p
) , ( ) , (
) , ( ) , (
) , (
1
1
1
1

41
81
1.5.2 Income and Substitution Effects
Theorem 1.16:
The matrix with
is symmetric and negative semidefinite.
Result is useful for empirical tests!
Note that the right hand side of (*) is observable!
y
y p x
y p x
p
y p x
u p S
i
j
j
i
ij

=
) , (
) , (
) , (
) , (
) , ( y p S
(*)
82
1.5.3 Some elasticity relations
Define:
= income elasticity
= price elasticity
income share on good .
) , (
) , (
y p x
y
y
y p x
i
i
i

=
) , (
) , (
) , (
y p x
p
p
y p x
u p
i
j
j
i
ij

=
, 0
i
s
y
y p x p
s
i i
i
) , (
=
i
1
1
=

=
n
i
i
s
42
83
Theorem 1.17: [Aggregation of Consumer Demand]
a) (Engel aggregation)
b) (Cournot aggregation)
Proof of a):
Differentiate w.r.t. :
1.5.3 Some elasticity relations
1
1
=

=
n
i
i i
s
j
n
i
ij i
s s =

=1

= = =
=

=
n
i
i i
n
i i
i
s
i i i
n
i
i
s
x
y
y
x
y
x p
y
x
p
i
i
1 1 1
1

) , ( y p x p y =
y
(*)
84
1.5.3 Some elasticity relations
Proof of b)
Differentiate (*) w.r.t. :
Multiply by and rearrange: y p
j
/
j
p

=
+

=
n
i
j
j
i
i
x
p
x
p
1
0

= =

=
n
i
s
n
i i
j
j
i i i
j
j
i i
s
j j
n
i
ij i
j
x
p
p
x
y
x p
p
p
x
y
p
y
x p
1 1
1
_
_

43
85
A useful diagram
Relationships between the
UMP and the EMP.
) , ( y p x ) , ( u p h
) , ( y p ) , ( u p e
)) , ( , ( ) , ( u p e p u p e =
Equation Slutsky
Identity
s Roy'
) , (
) , (
u p e
u p h
p

=
)) , ( , ( ) , ( y p p e y p =
s) derivative (for
)) , ( , ( ) , ( u p e p x p h =
)) , ( , ( ) , ( y p p h y p x =
3.E.1) ons (Propositi
PROBLEMS DUAL" "
EMP The UMP The
Lemma
s Shepard'
86
Slutsky vs. Hicksian compensation
Hicksian versus Slutsky
wealth compensation.
1
x
2
x
) , ( w p x
on Compensati Slutsky
on Compensati Hicksian
u x u = ) (
p
w p
B
, w p
B
,
44
87
Definition: [Negative definite]
A matrix is called negative semi-definite, if
:
A matrix is called negative definite if
:
A matrix is positive semi-definite if:
is negative (semi-) definite
A
n
IR z
A
A
0 Az z
T
0 z
0 < Az z
T

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