Part 1: Individual Values and Choices

We want a formal and reproducible description of how individuals value choice objects, in a way that it is identiable from actual choices.

1
1.1

Preferences
General Formulation and Assumptions
may or may not be available or aordable. : preference relation dened over X, with being its asymmetric component and being its symmetric component. Similar to , >, =, but not quite (why?). Given any x, y X, x y is read as x is at least as good as y. x y is read as x is better than y. x y is read as x is as good as y, or the decision maker is indierent between x and y. Two properties are assumed throughout. 1. Completeness: For all x, y X, either x y or y x holds. It is possible that both x y and y x hold, and then we write x y. 2. Transitivity: For all x, y, z X, if x y and y z then x z.

X: set of all the possible/conceivable alternatives or objects of choice, which

1.2

Preference over Consumptions

understanding the point.

Assume that there are just two goods. Sounds stupid, but this is enough for

Mostly we take the set of all the possible alternatives to be X = R2 , the non+ negative quadrant. x = (x1 , x2 ) is read as... 1

 Notice two underlying assumptions Divisibility Homogeneity Two applications Consumption over time Uncertain consumption Indierence Curves: Graphical description of preference

Examples Perfect substitution Perfect complements Smooth preferences between the above two Two more properties are assumed on preference over consumptions. 1. Monotonicity: For all (x1 , x2 ) R2 and c > 0, + (x1 + c, x2 ) x and (x1 , x2 + c) (x1 , x2 ). 2. Convexity: For all (x1 , x2 ), (y1 , y2 ) R2 with (x1 , x2 ) = (y1 , y2 ), + ( ) x1 + y1 x2 + y2 (x1 , x2 ) (y1 , y2 ) implies , (x1 , x2 ). 2 2 Basic properties of indierence curves You can draw them = Completeness They do not cross. = Transitivity Downward-sloping = Monotonicity Not thick = Monotonicity Better set is convex = Convexity 2

1.3

Marginal Rate of Substitution

Measure of subjective relative value To illustrate, consider the case of perfect substitution. How valuable is good 1 for you, compared to good 2? Restate

To get one more unit of good 1, how much of good 2 are you willing to give up?

Marginal rate of substitution of good 2 for good 1= amount of good 2 you are willing to give up, to obtain one extra unit of good 1. The roles of good 1, good 2, respectively, are xed throughout the course. Why marginal? Slope changes point by point. Look at local slope of the indierence curve At (x1 , x2 ), to get additional x1 units of good 1, you are willing to sacrice x2 units of good 2, so that (x1 , x2 ) (x1 + x1 , x2 + x2 ) Per one more unit of good 1, you are willing to sacrice good 2 by Taking the limit, M RS(x1 , x2 ) = x2 x1 dx2 dx1

1.4

Implication of convexity on MRS

Diminishing MRS: A good is relatively less important as it is more abundant. ( ) d dx2 <0 dx1 dx1 3

Representation of Preference, a.k.a. Utility Function

2.1

Denition

Denition 1 A function u : X R represents preference dened over X if x y u(x) u(y). for all x, y X. Implication x y u(x) > u(y). x y u(x) = u(y).

2.2

One preference may have dierent representations

Consider u(x1 , x2 ) = x1 x2 v(x1 , x2 ) = x1 x2 + 6 v(x1 , x2 ) = 2x1 x2 v(x1 , x2 ) = 2x1 x2 + 6 v(x1 , x2 ) = ln(x1 x2 ) = ln x1 + ln x2 In general, consider any f monotone (increasing) function. Proposition 2.1 If u represents , then v = f (u) also. Ordinal Utility: It is no more than a representation of a ranking, and the assigned numbers have no quantitative meanings. Q: Then why do we consider such a thing if it has no quantitative meaning? A: It makes analysis much more operational than directly looking at preference does. Youll see. 4

2.3

Examples

Perfect substitutes Perfect complements Cobb-Douglas

2.4

Marginal Utility

How can we measure the impacts of increasing amounts of goods? Keeping in your mind that it has no economic content per se, consider MU = increase of utility when you add one unit of good 1 good case u u(x + x) u(x) = x x du(x) dx

Taking the limit, you get or simply u (x). In the 2 goods case, how? Slice, and look at good 1 only:

M U1 = increase of utility when you add one unit of good 1, keeping the amount of good 2 the same u u(x1 + x1 , x2 ) u(x1 , x2 ) = x1 x1 Taking the limit, you get u(x1 , x2 ) x1

which is the slope along x1 -axis

 Similarly for 2:

u(x1 , x2 ) x2

The law of diminishing MU has no economic content It depends on which representation to use u(x1 , x2 ) = x2 x2 and 1 2 v(x1 , x2 ) = ln x1 + ln x2 Which way of measurement is independent of which representation to use? = MRS

2.5

From MU to MRS

Local change of u by (x1 , x2 ) = (x1 + dx1 , x2 + dx2 ): du = For keeping du = 0, u(x1 , x2 ) u(x1 , x2 ) dx1 + dx2 = 0 x1 x2 Then, dx2 M RS(x1 , x2 ) = = dx1
u(x1 ,x2 ) x1 u(x1 ,x2 ) x2

u(x1 , x2 ) u(x1 , x2 ) dx1 + dx2 x1 x2

Notice: Beware of the numerators and the denominators. MRS is independent of which representation to use, whereas MU is dependent. Why? Take one representation u(x1 , x2 ), then M RS(x1 , x2 ) =
u(x1 ,x2 ) x1 u(x1 ,x2 ) x2

Now take another representation f (u(x1 , x2 )). Then, M RS(x1 , x2 ) =

f (u(x1 ,x2 )) x1 f (u(x1 ,x2 )) x2

f (u(x1 , x2 )) f (u(x1 , x2 ))

u(x1 ,x2 ) x1 u(x1 ,x2 ) x2

u(x1 ,x2 ) x1 u(x1 ,x2 ) x2

 Try with the above example. 1: Consider the preference represented by u(x1 , x2 ) = xa xb . 1 2 (a) What is the marginal utility of good 1 at (x1 , x2 )? MU of good 1 is given as the partial derivative w.r.t. x1 . Thus, u(x1 , x2 ) = axa1 xb 1 2 x1 (b) What is the marginal utility of good 2 at (x1 , x2 )? MU of good 2 is given as the partial derivative w.r.t. x2 . Thus, u(x1 , x2 ) = bxa xb1 1 2 x2 (c) What is the marginal rate of substitution of good 2 for good 1 (I mean dx2 /dx1 ) at (x1 , x2 )? Recall that dx2 M RS(x1 , x2 ) = = dx1
u(x1 ,x2 ) x1 u(x1 ,x2 ) x2

By plugging the results of (a) and (b) in, we obtain M RS(x1 , x2 ) = axa1 xb ax2 1 2 = a b1 bx1 bx1 x2

2: Let me try with another representation v(x1 , x2 ) = ln(xa xb ) = a ln x1 + b ln x2 . 1 2 What does it change and what does not? (a) What is the marginal utility of good 1 at (x1 , x2 )? MU of good 1 is given as the partial derivative w.r.t. x1 . Thus, v(x1 , x2 ) a = x1 x1 (b) What is the marginal utility of good 2 at (x1 , x2 )? MU of good 2 is given as the partial derivative w.r.t. x2 . Thus, b v(x1 , x2 ) = x2 x2 (c) What is the marginal rate of substitution of good 2 for good 1 (I mean dx2 /dx1 ) at (x1 , x2 )? Recall that dx2 = M RS(x1 , x2 ) = dx1 7
u(x1 ,x2 ) x1 u(x1 ,x2 ) x2

By plugging the results of (a) and (b) in, we obtain M RS(x1 , x2 ) =

a x1 b x2

ax2 , bx1

which is the same as what we obtained previously.

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3.1

Optimal Choice
General Denition

Denition 2 Let X be the universal set and be a preference dened over X. Given an opportunity set A X, its element x A is said to be optimal in A for if x y for all y A. Equivalently saying, x A is optimal in A for if there is no y A such that y x. Optimal choice is described as if the consumer is solving the problem: max u(x)
x

subject to x A Interpretation

3.2

Optimal Consumption Choice

p and m given Budget set:

2 B(p, m) = {x R+ | p1 x1 + p2 x2 m}

x B(p, m) is optimal in B(p, m) if x y for all y B(p, m). In other words, x B(p, m) is optimal in B(p, m) if there is no y B(p, m) such that y x.

3.3

The tangency condition

We mostly focus on the case that Budget constraint met with equality = strict monotonicity Unique optimum = strict convexity Interior optimum (No boundary optimum) = Perfect substitutes ruled out Tangency = Perfect complements ruled out That is, we focus on smooth choice. At optimal choice (x1 , x2 ), M RS(x1 , x2 ) = and p1 x1 + p2 x2 = m The Cobb-Douglas example The Lagrange multiplier method Pretend that it is an unconstrained problem, where the budget constraint is taken into account as a penalty term. Set up the Lagrangean L(x1 , x2 , ) = u(x1 , x2 ) (p1 x1 + p2 x2 m) The rst-order condition u(x1 , x2 ) L(x1 , x2 , ) = p1 = 0 x1 x1 u(x1 , x2 ) L(x1 , x2 , ) = p2 = 0 x2 x2 L(x1 , x2 , ) = (p1 x1 + p2 x2 m) = 0 By combining the rst two equations you get the tangency condition. 9 u(x1 , x2 )/x1 p1 = u(x1 , x2 )/x2 p2

3.4

Some important exceptions/extreme cases

Perfect Substitutes Multiple optima and corner solution Perfect Complements Interior optimum where the tangency condition fails

Revealed preference
How can you say that choices are based on preference maximization? Start from a series of observed choices, ask whether it can be explained by preference maximization. : Choice function that describes the series of input-output data. When a set of alternatives B is given, it selects (B) B. Ties are excluded for simplicity of exposition.

Denition 3 is rationalizable if there is a complete/transitive ordering over X such that (B) y for all B and all y B. Denition 4 satises contraction if for every B, C with C B and (B) C, (C) = (B). For simplicity, here assume X is nite. Theorem 4.1 is rationalizable if and only if it satises contraction. Choices not rationalized by a single preference: 1. Framing, reference points and loss aversion 2. Self-control problem 3. Choices driven by anticipated regret, e.g., minmax regret choice

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5
5.1

Demand
How does your choice change when the price/income change?
Your choice is a function of price/income. Demand Function: x1 = x1 (p1 , p2 , m) x2 = x2 (p1 , p2 , m) Function of three variables into two variables CD preference, separable preference

5.2
5.2.1

Response to income changes

Normal and Inferior Goods

Normal Good: Demand increases when income increases. Good 1 is a normal good if x1 > 0. m

Inferior Good: Demand decreases when income increases Good 1 is an inferior good if x1 < 0. m

CD example: Both are normal.

5.3
5.3.1

Response to price changes

Own-price change

Change of demand for a good when its own price changes Ordinary Good: Demand decreases when its own price increases. 11

 Good 1 is an ordinary good if

x1 < 0. p1

Gien Good: Demand increases when its own price increases. Good 1 is a normal good if x1 > 0. p1

CD example: Both are ordinary. 5.3.2 Cross-price change

Change of demand for a good when the price of another good changes Good 1 is a gross substitute of good 2 if x1 (p1 , p2 , m) > 0. p2 Good 1 is a gross complement of good 2 if x1 (p1 , p2 , m) < 0. p2 CD preference, separable preference

5.4

Substitution and income eects

and complementarity?

What did I mean by putting gross in the previous denition of substitution

Eect of price change is decomposed into two, the change of relative price, and the change of real income. First is called substitution eect, second is called income eect. In terms of pure eect, substitution eect of own-price change is always nonpositive, and the substitution eect of cross-price change is always non-negative.

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6
6.1

Choice over time

Lifetime consumption and saving

For simplicity, assume two dates, today and tomorrow (or young/old). (x1 , x2 ) You consume x1 today and x2 tomorrow. Endowment: (1 , 2 ) Today you earn 1 units of consumption good, and 2 tomorrow. Assume no ination for a moment. Price level is 1 at each period. Interest rate r You save 1 x1 . If its negative, you are borrowing. Consumption tomorrow is x2 = 2 + (1 + r)(1 x1 ) Two alternative expressions of the budget equation: (1 + r)x1 + x2 = (1 + r)1 + 2 and x1 + x2 2 = 1 + 1+r 1+r

(1 + r)1 + 2 = Future value of lifetime income amounts of consumption tomorrow if you save all. 1 +
2 1+r

= Present value of lifetime income

amounts of consumption today if you borrow up to the limit.

6.2

Ination

Ination rate Price level today = 1 Price level tomorrow = 1 + Nominal interest rate r

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 Today you save 1 x1 . Budget constraint is (1 + )x2 = (1 + )2 + (1 + r)(1 x1 ) or equivalently, x2 = 2 + Real interest rate is dened by 1+= Approximately, r BC is written as (1 + )x1 + x2 = (1 + )1 + 2 in the future value form, and x1 + in the present value form. Since ination can be adjusted without loss, we focus on the no-ination case later on. x2 2 = 1 + 1+ 1+ 1+r 1+ 1+r (1 x1 ) 1+

6.3

More on present value

terms of consumption good. When the interest rate is 20%, how much of value does it have, in terms of todays consumption?

An IBM stock gives you 40 units of the share today and 60 units tomorrow, in

Present value of (40, 60) is 40 + 60 = 90 1 + 0.2

No Arbitrage Condition = (Under certainty,) Asset price should be equal to its present value. 14

 The case of more than 2-periods: When the interest rate is r, present value of the sequence (1 , 2 , 3 , , T ) is 1 1 + 2 + 1+r ( 1 1+r )2 3 + + ( 1 1+r )T 1
T ( 1 )t1 T = t 1+r t=1

1. Here is a bond which pays you $10 every year and matures in 20 years. Upon maturity, it pays you $100. What is the present value of this bond when the interest rate is 5%? 2. When the interest rate is 5%, what is the present value of a bond which gives you $30 of coupon every period? 3. UT-Econ. Co. earns $5 million every year. Assuming that the interest rate is 10%, what is the present value of this company?

6.4
6.4.1

Preferences
Impatience and consumption smoothing

Which do you prefer, (10, 5) or (5, 10)? Impatience: Future consumptions are discounted. Which do you prefer, (10, 0) or (5, 5)? Consumption smoothing: Fluctuation is disliked. 6.4.2 Discounted utility

Discounted utility: u is called discounted utility when it has the form u(x1 , x2 ) = v(x1 ) + v(x2 ) : discount factor, 0 < 1 v(): period utility index

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6.4.3

Properties of period utility index

Period utility index explains attitude toward consumption uctuation/smoothing. As it is more curvy, the consumer has more preference for consumption smoothing. Period utility index is a component of utility function, and NOT a utility function. Utility function is ordinal (no quantitative meaning), but period utility index is cardinal (having quantitative meanings). Still, it has nothing to say about how happy you are. Recall that one preference can have many utility functions for it. It allows any increasing transformation. i.e., if u represents , f (u) does also. But period utility index does not allow arbitrary. You cannot in general do an operation like f (v(x1 ) + v(x2 )) = f (v(x1 )) + f (v(x2 )) For example, compare v(x) = x and v (x) = v(x) = x.

Assuming = 1, compare (100, 0) and (49, 49). When v is more concave, you want more consumption smoothing. One preference can have essentially only one period utility index. In other words, even if one preference has several period utility indices, they must be congruent. If you change the curvature of period utility index, it changes preference for consumption smoothing. So, transformations are allowed only in the way that you dont change the curvature. Remember, still the overall representation is ordinal. That is, for any transformation f , f (u(x1 , x2 )) = f (v(x1 ) + v(x2 )) represents the same preference as u(x1 , x2 ) does. 16

Theorem 6.1 Suppose v is a period utility index which represents the preference in the discounted utility form. Then av + b does also, where a > 0. Moreover, if v and v are two period utility indices representing the same preference in the discounted utility form, there must be a, b with a > 0 such that v = av + b. We say, period utility index is unique upto positive linear transformations. The case of more than 2-periods: u(x1 , x2 , x3 , , xT ) = v(x1 ) + v(x2 ) + 2 v(x3 ) + + T 1 v(xT ) T = t1 v(xt )
t=1

Assume the utility index is v(x) =

x and = 0.9

Two options. One is that you consume 10 units every period. The other one is that you consume 25 units in odd periods and 4 in even periods. Which option do you prefer?

6.5

Choice
max v(x1 ) + v(x2 )
x1 ,x2

Utility maximization: 2 x2 = 1 + 1+r 1+r v (x1 ) =1+r v (x2 )

subject to x1 + Tangency condition:

M RS(x1 , x2 ) = Interpretation Solve for x1 (r, 1 , 2 ) and x2 (r, 1 , 2 ). Saving = 1 x1 (r, 1 , 2 ) What determines saving? Try with v(x) = ln x. Try with v(x) = x. 17

7
7.1

Choice under risk

Risk and Uncertainty

The distinction attributed to Frank Knight: 1. Risk: Outcomes will occur with known or estimable probability. 2. Uncertainty: Outcomes will occur with a probability that cannot even be estimated. We focus on risk.

7.2

Risk attitudes

What do you care about in choosing between bets? Expected value of the return? 1. Which do you prefer, (100; 0.5, 0; 0.5) or (50; 1)? 2. St. Petersburg paradox 3. Why do people buy a lottery? Expected return is extremely low. Are they rational? Three attitudes 1. Risk averse: If I can get the amount equal to the expected return for sure, thats better for me. 2. Risk neutral: Only the expected return matters for me. 3. Risk loving: Under the same expected return, I would rather bet. In general, expected return is not the only factor. Need to incorporate risk attitudes. = Expected Utility

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7.3

Expected utility: Basic idea

Assume the largest possible prize is 100 and the smallest is 0. Assign v(100) = 1 and v(0) = 0, without loss of generality (in the sense explained later). Consider a lottery (100; 0.5, 0; 0.5). How much of prize if you can get for sure is equally preferable to this bet? Certainty Equivalent Say, CE is 25, which is not necessarily the expected return 50. To be consistent with (100; 0.5, 0; 0.5) (25, 1), assign v(25) = 0.5v(100) + 0.5v(0) = 0.5 Consider another lottery (100; 0.6, 0; 0.4). What is the CE now? Say, CE is 36, again which is not necessarily the expected return 60. To be consistent with (100; 0.6, 0; 0.4) (36, 1), assign v(36) = 0.6v(100) + 0.4v(0) = 0.6 Repeat this procedure. Eventually you get a function v : [0, 100] [0, 1] Consider a lottery (25; 0.5, 81; 0.5). What is the CE? You solve for x such that v(x) = 0.5v(25) + 0.5v(81) For example, suppose v(x) = x/10. Then, whats the CE for (25; 0.5, 81; 0.5)? = solve for x such that x/10 = 0.5 25/10 + 0.5 81/10. You get x = 49, whereas the expected return is 53. How much is the CE for the St. Petersburg lottery?

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7.4

Expected utility: Formulation

and xn(p) with prob. pn(p) , where n(p) denotes the number of outcomes which p assigns positive probabilities.

Lottery, denoted by p = (x1 ; p1 , , xn(p) ; pn(p) ): You get x1 with prob. p1 , ,

: Preference over lotteries (risk preference) pq e.g., (70; 0.6, 20; 0.4) (40; 0.55, 30; 0.2, 10; 0.25). Expected utility: Utility function u represents in the form u(p) =
n(p) k=1

pk v(xk )

where v is called von-Neumann Morgenstern utility index Four axioms which characterize the expected utility theory 1. Completeness: For all p, q, either p q or q p holds. 2. Transitivity: For all p, q, r, p q and q r imply p r. 3. Continuity: preference does not jump 4. Independence: For all p, q, r and 0 < < 1, p q p + (1 )r q + (1 )r. Intuition? Theorem 7.1 satises completeness, transitivity, continuity and independence if and only if there exists a function v such that p q
n(p) k=1

pk v(xk )

n(p) k=1

qk v(yk )

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7.5

Properties of the vNM index

It explains the decision makers risk attitude Risk neutral when v is linear, v(x) = ax + b, since
n k=1

pk v(xk ) =

n k=1

pk (axk + b) = a

n k=1 k=1

( pk xk + b = v pk xk .

n k=1

) pk xk

depends only on the expected return Risk averse when v is concave, i.e.,

v(x1 ) + (1 )v(x2 ) < v(x1 + (1 )x2 ). Risk averse when v is convex, i.e., v(x1 ) + (1 )v(x2 ) > v(x1 + (1 )x2 ). What about the following? v(x) = ln x v(x) = x2 v(x) = ex v(x) = ex vNM index is a component of utility function, and NOT a utility function. Utility function is ordinal, but vNM index is cardinal. Recall that one preference can have many utility functions for it. It allows any increasing transformation. i.e., if u represents , f (u) does also. But vNM index is not allow arbitrary transformation. You cannot in general do an operation like ( f
n k=1

) pk v(xk ) =

n k=1

pk f (v(xk ))

For example, consider v(x) = x and v (x) = Compare (100; 0.5, 0; 0.5) and (50; 1). 21

v(x) = x.

 The two correspond to dierent risk preferences. First is risk-neutral, but second is risk-averse. One risk preference can have essentially only one vNM index. In other words, even if one risk preference has several vNM indices, they must be congruent. If you change the curvature of vNM index, it changes risk preference. So, transformations are allowed only in the way that you dont change the curvature. Remember, still the overall representation is ordinal. That is, for any transformation f , f (u(p)) = f (
n k=1

) pk v(xk )
k=1

represents the same preference as u(p) =

pk v(xk ) does.

Theorem 7.2 Suppose v is a vNM index which represents risk preference in the expected utility form. Then av + b does also, where a > 0. Moreover, if v and v are two vNM indices representing the same risk preference in the expected utility form, there must be a, b with a > 0 such that v = av + b. We say, vNM index is unique upto positive linear transformations.

7.6

Application
values as well (equal to (1 , 2 )), and just vary outcomes.

Hereafter, x the number of possible outcomes equal to two, x the probability

Thus the preference over lotteries reduces to a preference over two-dimensional vectors, which is represented in the form u(x1 , x2 ) = 1 v(x1 ) + 2 v(x2 ) 7.6.1 Buying insurance

Your initial income is 400. Youll hit a car-crash with probability 0.01.

22

 If you hit a crash, you lose 400. There is an insurance available. It costs 2 per 1 unit, but it pays you back 80 if you hit a crash. When your risk attitude is described by the vNM index v(x) = ln x, how many units of insurance will you buy? What if you are risk neutral? General setting: Probability of hazard , initial income m, loss by hazard l, insurance cost c, return r. The problem: max v(m l cx + rx) + (1 )v(m cx)
x

First-order condition v (m l cx + rx) r c 1 = (m cx) v c Perfect Insurance if r 1 = c x=

Then, l r cl and you end up with m r , regardless of whether you hit a crash or not. 7.6.2 Portfolio choice 1

Two assets, safe asset and risky asset. Return of safe asset is 1.05, but that of risky asset is 1.2 with probability 0.7 and 0.8 with probability 0.3. You have an income of 100 to be saved. When your risk attitude is described by the vNM index v(x) = ln x, how will you allocate your income? What if you are risk neutral?

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7.6.3

Portfolio choice 2

Two states of the world. Two assets, risky asset 1, risky asset 2. No safe asset. Return table: State 1 Risky asset 1 Risky asset 2 1.2 0.8 State 2 0.9 1.4

You can make a safe asset by combining the two assets. Hedging 7.6.4 Trading Arrow securities

Two states of the world. Two securities, security 1 pays 1 unit of consumption if state 1 occurs and nothing if state 2 occurs, vice versa for security 2. called Arrow securities Return table: State 1 Security 1 Security 2 1 0 State 2 0 1

Risky asset 1 in the previous example can be viewed as a combination of 1.2 units of Arrow security 1 and 0.9 units of Arrow security 2. When (p1 , p2 ) is the price pair of such securities and (1 , 2 ) is the pair of initial security holdings, the choice problem is described by max 1 v(x1 ) + 2 v(x2 ) subject to p1 x1 + p2 x2 = p1 1 + p2 2 This reduces to the abstract optimal consumption problem.

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7.7
7.7.1

Anomalies
Violation of the independence axiom

Example 7.1 (A version of Allais paradox): (A) A1: a sure win of 30, A2: a 80% chance to win 45 (and zero in 20% of the cases). (B): B1: a 25% chance to win 30 B2: a 20% chance to win 45. Example 7.2 Normative violation Society should randomize for the sake of fairness. 7.7.2 Framing eects

Example 7.3 Consider the following two choice problems (A) A1: a sure gain of 20, A2: a 70% chance to gain 30 and 30% chance of no gain. (B) You are initially given 30. B1: a sure loss of 10, B2: a 70% chance of no loss and 30% chance to lose 30.

Monetary Evaluation of Consumptions

In many of economic analysis, we focus on the market for a single commodity and evaluate consumption of it in the monetary term. This is called partial equilibrium analysis. But how can this be well-grounded?

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8.1

Classical (naive) view

Marginal Utility = Willingness to pay for an incremental consumption

Utility = Money

Consumers problem max U (x) px with the assumption U (0) = 0. The maximization condition U (x ) = p which determines the (inverse) demand curve. The maximized consumers surplus is U (x ) px Problems 1. How can you measure (marginal) utility in monetary terms? We learned that utility representations have no quantitative meaning. 2. In the rst place, there is no money in our model yet. 3. We just learned that demand depends on income as well. Where is income?

8.2

Modern explanation
utility.

WTP should be described as marginal rate of substitution, not as marginal

To illustrate, consider two goods. Good 1 = the good in consideration Good 2 = Numeraire good, or reference good (can be positive or negative) Interpretation: composite of all the other commodities, that is, income to be spent on them.

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 Underlying assumption: There are actually very many goods, and good 1 is a tiny tiny part of the entire set of goods, and the composite of all the others is taken to be enormously abundant compared to this tiny piece, hence only the relative gain/loss of it does matter. Quasi-linear preference, represented in the form u(x1 , x2 ) = v(x1 ) + x2 No income eect on good 1: Indierence curves are parallel along the x2 -axis. WTP is independent of x2 . Why? Recall the underlying assumption. Willingness to pay = Willingness to give up the numeraire good for an extra unit of the good in consideration This is exactly the marginal rate of substitution of the numeraire good for the good in consideration. MRS has the form M RS(x1 , x2 ) = v (x1 ) Consumers surplus is measured in terms of the numeraire good. Normalize p2 = 1. Only p1 varies. Suppose you originally have (x1 , x2 ). For extra x1 units of the good in consideration, the WTP should satisfy v(x1 + x1 ) + x2 W T P x1 = v(x1 ) + x2 That is, WTP = Taking the limit, W T P (x1 ) = v (x1 ) For the x1 -th unit of consumption, the marginal surplus measured by the numeraire good is W T P (x1 ) p1 = v (x1 ) p1 27 v(x1 + x1 ) v(x1 ) x1

 Consumers surplus of having x units under the price p1 is 1

0 x 1

(v (x1 ) p1 ) dx1 = v(x ) v(0) p1 x 1 1

8.3

Demand and inverse demand

Recall the normalization p2 = 1. Only p1 can vary. The consumers problem is max v(x1 ) + x2
x1 ,x2

subject to p1 x1 + x2 = m The optimality condition is v (x ) = p1 1 Demand for the good in consideration depends only on p1 . By solving the above for x1 , we get the demand function for the good, x1 (p1 ). In the Marshallian convention, we plot the inverse demand function p(x1 ) = v (x1 )

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