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INTRODUCTION

With the possibility of a duality which allow a work back from the expenditure
function to the direct utility function, because the expenditure and the indirect
utility functions are so closely related (i.e inverse of each other). It should come
as no surprise that it is also possible to begin with an indirect utility function and
work back to the underlying utility direct utility function.

THE INDIRECT UTILITY FUNCTION

The ordinary utility function, u(x), is dened over the consumption set X and
represents the consumers preferences directly, as we have seen. It is therefore
referred to as the direct utility function. Given prices p and income y, the
consumer chooses a utility maximising bundle x (p, y). The level of utility
achieved when x (p, y) is chosen thus will be the highest level permitted by the
consumers budget constraint facing prices p and income y. Different prices or
incomes, giving different budget constraints, will generally give rise to different
choices by the consumer and so to different levels of maximized utility. The
relationship among prices, income, and the maximised value of utility can be
summarised by a real-valued function dened as follows:

v(p, y) = max u(x) s.t. p x y (1)

where, X Rn+

The function v(p, y) is called the indirect utility function. It is the maximum-
value function corresponding to the consumers utility maximisation problem.
When u(x) is continuous, v(p, y) is well-dened for all p>0 and y0 because a
solution to the maximization problem (1) is guaranteed to exist. If, in addition,
u(x) is strictly quasiconcave, then the solution is unique and we write it as x(p,
y), the consumers demand function. The maximum level of utility that can be
achieved when facing prices p and income y therefore will be that which is
realised when x(p, y) is chosen. Hence,

v (p, y) = u (x(p, y)). (2)

PROPERTIES OF THE INDIRECT UTILITY FUNCTION

i. Homogeneous of degree zero in (p, y),


ii. Strictly increasing in y,
iii. Decreasing in p,
iv. Quasiconvex in (p, y),

Lets take the below direct utility function as an example,

U(X1,X2) = max X1 X2 subject to the constraint P1X1 + P2 X2 = Y


(3)

Step 1

From (3) we can derive the indirect utility function. To do this we obtain the
marshallian demand functions by getting the maximising values of X1 and X2,
using the lagrangian.
L = X1 X2 (P1X1 + P2 X2 Y) (4)

LX1 = X2 - P1 = 0 (5)

LX2 = X1 - P1 = 0 (6)

L = P1X1 + P2 X2 Y = 0 (7)

Divide 5 by 6 to eliminate

X2 P1
X1 = P2

P1X1 = P2 X2

X1 = X2 ( PP 21 )

Substitute X1 into the budget function in (7)

P1.X2 ( PP 21 ) + P 2 X2 = Y

P2 X2 + P2 X2 = Y

2 P2 X2 = Y

Y
X2 = 2 P2

Substitutes X2 into X1

X1 = X2 ( PP 21 )
X1 = ( PP 21 ) 2YP 2
Y
X1 = 2 P1

Y Y
X1 = 2 P1 , X2 = 2 P2 are the Marshallian demand function.
Step 2

Having derived the maximising value of X1 and X2, we can obtain the indirect
utility function by plugging the value of X1 and X2 into the objective function
U(x).

U (X1 X2) = X1 X2

Y Y
V (p,y) = 2 P1 . 2 P2

Y2
V (p,y) = 4 P1 P 2 .. The indirect utility function explained

by income and prices.

The indirect utility function satises the properties of homogenous of degree


zero, monotonicity i.e increasing in Y and decreasing in P, and other relevant
properties.

Proof 1: it is homogenous of degree zero

Any increase in the level of the indirect utility function will make the direct utility
function unchanged.

i.e V (p,y) = V (tp,ty) t>0

tY 2
From the indirect utility function, V (p,y) = 4 tP 1 P2

Y2
= 4 P1 P 2

V (p,y) = V (tp,ty)

Proof 2: V (p,y) is increasing in Y and decreasing in P

v ( P ,Y )
Here, Y >0 must be satised

4 P1 P2


=
4 P1 P 2(2Y )

2Y Y
4 P1 P 2 = 2 P1 P 2 >0
Proof 3: V (p,y) is decreasing in P

v ( P ,Y )
P <0

2
4 P

(Y 2)

= 4 P1 P2



Y 2
= 4 P21 P 2 <0

DUALITY BETWEEN DIRECT AND INDIRECT UTILITY FUNCTIONS

Suppose that U(x) generates the indirect utility function V (p,y). Then by
denition,

+n
X R then V(p, p.x) U(x) holds for every P > 0. In addition,

there will typically be some price vector for which the inequality is equality.
Evidently, then we may write;

U(x) = min V(p, p.x) (8)

In (8) provides a means for recovering the utility function U(x) from only
the knowledge of

the indirect utility function. The theorem below gives one version of the
result.

The Duality theorem

+n
Suppose that U(x) is quasi-concave and differentiable on R with

+n
strictly positive partial derivations there. Then for all X R , V(p, p.x),
the indirect utility function generated by U(x), achieves a minimum in P on
+n
R ,therefore,

U(x) = min V(p, p.x)

Example,
From our derived indirect utility function which satises necessary
properties of an indirect utility function. We will use (8) to recover U(x).
The direct utility function therefore will be the minimum-value function.

Y2
U (X1 X2) = min 4 P1 P 2 s.t P1X1 + P2 X2 = Y (9)

Step 3

Solve the minimisation problem and then evaluate the objective function at the
solution to form the objective minimum value function.

Y2
L= 4 P1 P 2 - (P1X1 + P2 X2 Y) (10)

4 P1 P2


Lp1 = - X1 = 0
4 P1 P 2( 0)Y 2 (4 P 2)

2
Y
Lp1 = 2
4 P1 P 2 - X1 = 0 (11)

4 P1 P 2


Lp2 = = - X2 = 0
4 P1 P 2(0)Y 2 (4 P 1)

2
Y
= 2
4 P1 P 2 - X2 = 0 (12)
Divide (11) by (12)

Y 2
4 P 21 P2 X 1
Y 2 = X 2
4 P 1 P22

P2 X1
=
P1 X2

P2 = P1 ( XX 12 )
Substitute P2 into the budget constraint to get p1
P1X1 + P2 X2 = Y

P1X1 + 1 . X2 ( XX 12 ) =Y

P1X1 + P1X1 = Y

2P1X1 = Y

Y
P1 = 2X1

P2
Substitute P1 into

P2 = P1 ( XX 12 )
Y
P2 = P1 ( XX 12 ) . 2X1

Y
P2 = 2X2
Step 4

Substitute P1 and P2 into the objective function

Y2
V (p,y) = 4 P1 P 2

Y2
= Y Y
4( )( )
2 X 1 2 X2

2
X1X 2
= Y . Y2

= X 1 X 2 = U(x) = the direct utility function