Econ 601

I.

Graduate Microeconomics
Lecture Notes

Lau
Fall 2014

Consumer Theory

Consumer theory is developed to

i)
explain the consumption pattern of an individual (household/family) and
ii)
carry out welfare analysis of an individual (household/family).
Indifference Curve Analysis
Definition:

An indifference curve plots all the consumption bundles which are viewed as
indifference to each other by a consumer.

Definition:

An indifference map consists of a set of indifference curves.

Definition:

A consumers marginal rate of substitution (MRSXY) between X and Y is the

maximum amount of Y a consumer is willing to give up to obtain an additional unit of X.

MRSXY slope of IC (X on the horizontal axis and Y on the vertical axis)

MU X
Y

Remark:
On an IC, U ( X , Y ) constant (MU X )X (MU Y )Y 0
X
MUY
Properties of indifference curves:
1.
There are infinitely many indifference curves. (Each consumption bundle is passed through by
an indifference curve.)
2.
No two indifference curves cross each other.
Remark:

Y
contradiction

U=15
U=10
X

3.
4.

The further away from the origin, the higher is the utility.
Indifference curves are convex to the origin.

2
Y

U1
U0
X

Special case: U ( X , Y ) X Y

perfect substitutes

Y
10
U=10

U=20

X
5

Special case:

10

U ( X , Y ) min( X , Y )

perfect complements (Leontief Utility Function)

8
5

U=8
U=5

X
5

Remark:
Remark:

Different individuals have different indifference maps which are determined by the
preference (taste) of the individuals.
Preference is assumed to be constant, at least in the short run.

Budget line and budget set

Definition:
A feasible consumption bundle is a consumer bundle that a consumer can afford to
purchase with his/her income ( I ) under the current market prices PX and PY .
Definition:

A budget set is the set of all feasible consumption bundles.

B {( X , Y ) : PX X PY Y I }

3
A budget line represents the maximum combination of X and Y that a consumer can
afford to purchase.

Definition:

PX X PY Y I

Y
I/PY
feasible set

budget line

slope of budget line

I
P
P
Y X
I
PY
PX

X
I/PX

Assumption: A consumer is a utility-maximizer.

Consumer equilibrium
Remark:

At equilbrium, in general, the indifference curve is tangent to the budget line.

Y

I
PY

E
Y*
U0

X
X*

I
PX

Changes in income
Definition:
If I () X (), then X is a normal good.
Definition:
If I () X (), then X is an inferior good.

4
Y
I/PY

X: normal good
Y: normal good

I/PY

Y
E
Y
Y*

E
U1
U0

X
X* X

I/P X

income
consumption
curve

I/PX
X

Y
I/PY
I/PY

X: inferior good
Y: normal good

Y
U1
E
Y*
U0

X
X X*

I/P X

I/PX

Y
I/PY

X: normal good
Y: inferior good

I/PY

E
E

Y*
Y

U1
U0
X
X*

I/P X

I/PX

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Deriving the ordinary demand curve /Marshallian demand curve
Y
PX1 > PX2
PX
I/PY
P X1
E
P X2

Y2
Y1

E
U1
D
U0
X
X1

X2

I/PX2

X1

PY1 > PY2

Y
I/PY

I/PX1

X2

PY

I/PY1

P Y1

E
Y2

P Y2
Y1
E

U1
U0
D
X

X2 X1

I/PX

Y
Y1

Y2

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Changes in price and price-consumption curve
Y

I/PY
price consumption curve

Y*
U1
U0
X
I/P X1

X*

I/PX2

Effect of change in prices and income on welfare

Example:
A consumer has an income of $180. When PX $6 and PY $4 , her consumption
bundle is ( X , Y ) (20,15) . Suppose her income decreases to $105, PX decreases to $3 and PY
decreases to $3. With the aid of a diagram, determine how would her utility be affected?
Y

Note that with the new prices, the

consumer can just afford to
buy the bundle (X,Y)=(20,15).
Hence the new budget line will
pass through the point (20,15)
[($3)(20)+($3)(15)=$105]

15
U1
U0

X
20

new budget line

3
slope
3

initial budget line

6
slope
4

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Applications of indifference curve analysis
1.

Food stamp program

OG
food stamp
(F#)
I

budget line with food stamp

i)
ii)

OG
OG*

the consumer will be better off

it is unclear whether the
consumer will consumer more or
less food

E
E
U1
U0
Food
F#

F*

I/PF+F#

I/P F

2.

Cash grant program

OG

I' I PF F#
I

I
OG

i)
ii)

The consumer will be better off.

It is unclear whether the
consumer will consume more or
less food.

E
OG*

U1
U0

F* F

Food
I/PF=I/PF+F#

I/P F

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3.

Food stamp program vs cash grant

OG

Case 1 UFS=UCG; FFS=FCG

budget line with cash grant

I
E

E
OG*

UFS=UCG
U0

Food
F# F*

I/PF+F#

I/P F

budget line with food stamp

OG

Case 2 UFS<UCG; FFS>FCG

I
ECG

EFS
UCG

I
UFS

E
OG*
U0

Food
F# F*

I/PF+F#

I/P F

budget line with food stamp

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4.

Sales tax
PX=PX + t
OG

The consumer will be worse off.

tax revenue
OG
E

OG
U0
U-1

X
X

5.

I/P X

I/P X

Income tax
OG
income tax
I

I-T
E
OG*
E
OG

U0
U-1
X
X X*

(I-T)/PX

I/PX

10
6a.

Income tax vs sales tax

OG
budget line under income tax

original budget line

tax revenue

EIT

EST
UIT
UST

budget line under sales tax

(I-T)/PX

I/PX

X
X

6b.

for the same utility, Revenueincome tax Revenuesales tax

Income tax vs sales tax

Revenuesales tax vertical distance between the two parallel budget lines
Revenueincome tax
revenuesales tax
revenueincome tax
EST

EIT

sales tax

income tax

10

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7a.

Sales subsidy vs income subsidy

OG

budget line with income subsidy

EIS

ESS
budget line with sales subsidy
UIS

cost to
government

USS

original budget line

X
X

7b.

Sales subsidy vs income subsidy

OG

budget line with income subsidy

EIS

ESS
budget line with sales subsidy

cost to
government
under income
subsidy
original budget line

USS=UIS

X
cost to government under sales subsidy

11

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Substitution effect (EA) and income effect (AE)
PX
Y

X: NORMAL GOOD

X: INFERIOR GOOD

A
A
E

E
E

U0

U0
U-1
U-1
X
X

XA

X
X A X X*

X*

Substitution effect (EA) and income effect (AE)

PY
Y

Y*

Y: NORMAL GOOD

YA

A
U0

Y*
Y
YA

E
Y

Y: INFERIOR GOOD

U-1

E
A

U-1
X

12

U0

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Normal good, inferior good and Giffen good ( PX )
Y
normal good

inferior good

Giffen good

A Giffen good must be an

inferior good, but not vice
versa.

PX

13

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Normal good, inferior good and Giffen good ( PX )
Y
inferior good

normal good

Giffen good

A Giffen good must be an

inferior good, but not vice
versa.

PX

14

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What happen if the demand curve is not downward sloping?
Defnition: An equilibrium is Walrasian stable if P P * , then P will converge to P * .
Defnition: An equilibrium is Marshallian stable if Q Q * , then Q will converge to Q * .
P

Marshallian stable
and
Walrasian stable

P*

D
Q
Q*
P

S
Marshallian unstable
and
Walrasian stable

E
P*

Q
Q*
P

Marsahallian stable
and
Walrasian unstable

E
P*

Q
Q*

15

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Application of the concept of substitution effect and income effect
1.

Will an orange producer consumes more oranges (i.e. sell fewer oranges) when PO ?

PO income of orange producers

substitution effect:

PO

CO

income effect:

income CO
(if orange is a normal good)
CO same (if orange has no income effect)
CO

(if orange is an inferior good)

total effect:
if orange is a normal good, then CO ?
if orange has no income effect, then CO
if orange is an inferior good, then CO
Y
POO#

inferior
good

normal
good

normal
good

A
P OO #
new budget line
E
initial budget line
oranges
O*

O#

# of oranges available

16

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2.

Will a worker work more when the wage rate goes up?

w
substitution effect: enjoys less leisure, work more
income effect:

enjoys more leisure (assume normal good), work less

total effect:

$
24W
IE<SE

IE>SE

24W
A
E

leisure
24
wage

supply curve of labor

labor hours

17

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3.

Inter-temporal consumer choice

Y1 : income in year 1

Y2 : income in year 2

C1 : consumption in year 1

C2 : consumption in year 2

Inter-temporal Budget Constraint:

Y1

r : interest rate

Y2
C
C1 2
1 r
1 r

Y1 0, Y2 0 S1 Y1 C1 0, S2 0

Case 1:
C2
Y1(1+r)

slope
C2*

Y1 (1 r )
(1 r )
Y1

E
U0

C1
C1*

Y1

Y1 0, Y2 0 S1 Y1 C1 0, S2 0

Case 2:

C2
Y2

slope
C2*

E
U0

C1
C1*

Y2/(1+r)

18

Y2
(1 r )
Y2
1 r

19
Y1 0, Y2 0

Case 3:

Saving in the first period

C2
Borrowing in the first period
Y2+Y1(1+r)

slope

C2*

Y2 Y1 (1 r )
Y Y (1 r )
2 1
(1 r )
Y2
Y1 (1 r ) Y2
Y1
1 r
1 r

U0
Y2

C2*

E
C1*

Y1

U0
C1* Y1+Y2/(1+r)

C1

How an increase in the real interest rate affects consumption (assume both C1 and C2 are normal
goods)
borrowing in the first period: r income
substitution effect
C1 , C2
income effect:
C1 , C2
total effect

C1 , C2 ?

welfare loss

saving in the first period:

r income
substitution effect
C1 , C2
income effect:
C1 , C2
total effect

C1 ?, C2

welfare gain

19

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Case 3a:

Y1 0, Y2 0

C2

Borrowing in the first period

Y2

C2*

E
E'

U0

(1 r ')

U-1
Y1

C1

C1*

Y1 0, Y2 0

Case 3b:

(1 r )

Saving in the first period

C2
E'
C2*

E
U1
U0

Y2

C1
C1*

Y1

20

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Deriving the Hicksian Demand Curve/ Compensated Demand Curve
Hicksian demand curve is derived by holding utility constant
P X > P X

PX

slope= PX/PY
Y
P X

PX
Y*
U0

DH
slope= PX/PY
X

X*

X
X

X*

Remark:
1.
The Hicksian demand curve is never upward sloping. It is a vertical line if the indifference
curves are of the Lenotief type.
Y

U0
X

2.

Each point on the DH corresponds to a different level of money income. Hence the Hicksian
demand curve is also called an (Income)-Compensated Demand Curve.

21

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II.

General Equilbrium I

Two-person exchange economy

Let X# and Y# be the goods available in an economy.
Definition:

A feasible allocation is an array of consumption bundles

{( X A , YA ),( X B , YB ) : X A X B X # , YA YB Y # }
Edgeworth Box

XB
OB

XA+XB=X#
YA+YB=Y#

YB

YA
OA

XA

Remark:

We only consider feasible allocation in our discussion.

Definition:

An allocation {( X A *, YA *),( X B *, YB *)} is Pareto Superior to another allocation

{( X A ', YA '),( X B ', YB ')} if either
U ( X A *, YA *) U ( X A ', YA ') and U ( X B *, YB *) U ( X B ', YB ') or
i)
U ( X B *, YB *) U ( X B ', YB ') and U ( X A *, YA *) U ( X A ', YA ')
ii)

The welfare of one person increases without hurting the welfare of the other individual.
Definition:

An allocation is Pareto optimal (efficient) if there is no allocation which is Pareto

Superios to it.

Definition:

An allocation is inefficent if it is not efficient.

Definition:

The set of all Pareto Optimal allocations is called the contract curve.

Remark:

A contract curve may not look like a curve.

Note:

At the efficient point, the ICs of the two individuals are (usually) tangent to each other.
efficient (cannot increase the utility of one without
lowering the utiltiy of the other)

U 1A
inefficient
(can increase the utility of A without
lowering the utility of B)

U0B

U0A

22

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Edgeworth Box

XB
OB

XA+XB=X#
YA+YB=Y#

YB

U A1

UB2

U A2
UB1

YA

efficient point
OA

XA

Note: From the contract curve, we can plot the utility frontier which is the best combination of UA
and UB which can be attained by the 2 individuals.
Utility frontier
UB
social optium

social indifference curve

UA

Proposition: If the endowment is not on the contract curve, there will be gain from trade.
XB
OB
core

YB

YA

contract curve

OA

XA

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Two person competitve economy
XB
OB

XA+XB=X#
YA+YB=Y#

YB

U A2
contract curve
UB1
YA
competitive equilibrium
OA

XA

Proposition: (Fundamental Theorem of Welfare Economcis)

A competitve equilibrium is Pareto optimal.

Proprosition: A Pareto optimal allocation is a competitive equilibrium with lump sum transfer.

24

25
Production economy: 2 2 2 model (2 agents, 2 goods and 2 inputs)
LB
LA+LB=L#
KA+KB=K#

(K/L)B
efficient allocation

contract curve
(K/L)A
KA
OA

LA

Determining the output in a production economy

closed economy
QB
social optium

Production
Possibility
Frontier
social indifference curve

QA

open economy
QB
production point (P)

Production
Possibility
Frontier
C
PX/PY
QA

25

OB
KB

26
Arrows Impossibility Theorem
Proposition:
There is no social welfare function which satisfies the following reasonable assumptions:
1.

Pareto rule
If every one prefers X1 to X2, then X1 is preferable by the society. It is true for any other pair
(Xi, Xj).

2.

Independence of irrelveaant alternatives

Whether a society is better off with X1 or X2 should depend only on individual preference
between X1 or X2, but not on any consumption bundle X3 or X4.

3.

Unrestricted domain
The rule must hold for all logically possible sets of preferences.

4.

Nondictatorship
We do not allow a rule whereby the social ordering is automatically taken to be the same as one
particular individuals prefereences, irrespective of the preferences of the others.

26

27
III.

Consumer Theory II

Indirect utility function and Marshallian demand functions

n

s.t. M Pi X i 0

v( P, M ) max U ( X 1 ,..., X n )
X1 ,..., X n

i 1

P ( P1 ,..., Pn )

Proposition: The utility function is unique up to a monotonic transformation, i,e. if U ( X1 , X 2 ) is an

utility function representing the underlying preference, then F[U ( X1 , X 2 )], F ' 0 is also an appropriate
utility function.
Proof:
This proposition can be proved by the following theorem.
Theorem:
Let W ( X1 , X 2 ) F[U ( X1 , X 2 )] where F (.) is an increasing function.
If ( X1 *, X 2 *) maximizes U ( X 1 , X 2 ) s.t. g ( X 1 , X 2 ) 0,

then ( X1 *, X 2 *) maximizes W ( X 1 , X 2 ) s.t. g ( X 1 , X 2 ) 0.

Proof:
Suppose ( X1 *, X 2 *) maximizes U ( X1 , X 2 ) s.t. g ( X1 , X 2 ) 0

U ( X1 *, X 2 *) U ( X1 , X 2 )

( X1 , X 2 ) fulfilling g ( X1 , X 2 ) 0

Since F (.) is an incresing function

F [U ( X 1 *, X 2 *)] F [U ( X 1 , X 2 )] ( X 1 , X 2 ) fulfilling g ( X 1 , X 2 ) 0
W ( X 1 *, X 2 *)] W ( X 1 , X 2 )] ( X 1 , X 2 ) fulfilling g ( X 1 , X 2 ) 0
( X 1 *, X 2 *) maximizes W ( X 1 , X 2 ) s.t. g(X 1 , X 2 ) 0

Example:
The following 2 problems are equivalent.

max U ( X 1 , X 2 ) X 1 X 2
a

1)

2)

X1 , X 2

s.t. M P1 X 1 P2 X 2 0
max U ( X 1 , X 2 ) a ln X 1 b ln X 2
X1 , X 2

s.t. M P1 X 1 P2 X 2 0

27

28
Example:
a
b
max U ( X1 , X 2 ) X1 X 2

s.t. M P1 X1 P2 X 2 0

X1 , X 2

Perform a montonic transformation:

max U ( X 1 , X 2 ) a ln X 1 b ln X 2
X1 , X 2

s.t. M P1 X 1 P2 X 2 0

L( X1 , X 2 , ) a ln X1 b ln X 2 [M P1 X1 P2 X 2 ]
FONC:
L
a
LX1

P1 0
X 1 X 1

LX 2

(1)

L
b

P2 0
X 2 X 2

(2)

L M P1 X 1 P2 X 2 0
(3)
Income consumption curve:
a
b
b
(1) and (2)

P2 X 2 P1 X 1
(4)
bP
P1 X1
P2 X 2
a
X 2 1 X1
aP2
b
ab
(4) (3) M P1 X1 ( P1 X1 ) 0 M (
) P1 X 1 0
a
a
a M
X1 *
Marshallian demand function
a b P1
bP X
bP a M
b
b M
P2 X 2 P1 X 1 X 2 1 1 1

Marshallian demand function

a
aP2
aP2 a b P1 a b P2
SOSC:

L
H LX1
LX 2

L X1
LX1 X1
LX 2 X1

0
L X 2
LX1 X 2 P1
LX 2 X 2
P2

Indirect utility function:

P1
a
2
X1
0

P2

aP22
2

X1

bP12
0 (maximum)
X 22

b
2
X2

v( P1 , P2 , M ) (

a M a b M b
a
b
M a b
) (
) ( ) a ( )b (
)
a b P1
a b P2
P1 P2 a b

28

29
Example:
max U ( X1 , X 2 ) X1 X 2 X1 X 2

s.t. M P1 X1 P2 X 2 0

X1 , X 2

L X1 X 2 X1 X 2 [M P1 X1 P2 X 2 ]
FONC:
L
LX1
X 2 1 P1 0
X 1

(1)

L
X 1 1 P2 0
X 2

(2)

LX 2

L
M P1 X 1 P2 X 2 0
(3)

X 1
X 1
P ( X 1)
(1) and (2) 2
1
X1 1 2 2
P1
P2
P1
P ( X 1)
X1 2 2
1
(4) income consumption curve
P1
P ( X 1)
(3) : M P1[ 2 2
1] P2 X 2 0 M P2 ( X 2 1) P1 P2 X 2 0
P1
M P1 P2
M P1 P2 2P2 X 2 X 2 *
(5) Marshallian demand function
2 P2
P ( X 1)
P M P1 P2
P M P1 P2 2P2
(4) : X1 * 2 2
1 2 (
1) 1 2 (
) 1
P1
P1
2 P2
P1
2P2
M P1 P2
M P1 P2 2P1
M P2 P1

1
X1 *
(6) Marshallian demand function
2 P1
2 P1
2 P1
L

Note that X1 * and X 2 * must be non-negative

(5) X 1 0 M P2 P1 0

(6) X 2 0 M P1 P2 0
M
.
P2
M
If M P1 P2 0 , then X 2 * 0 and X 1 *
.
P1

If M P2 P1 0 , then X 1 * 0 and X 2 *

X2
U

U ( X1 , X 2 ) U

The slope of the IC is

MU1
X 1

2
MU 2
X1 1

X1
U

29

30
X2

M
A (0,

@A, slope of IC

P2

P2

P1
B(

P2

, 0)

P1

M
P2

P1

1)
0 1
P2
If the price line is steeper than the IC at that point, then
there will be a corner solution.

M P2

P2

P2

P1 M P2

M P2 P1 0

X1

@B, slope of IC

0 1
M

1
M

1
P1
P1
If the price line is flatter than the IC at this point, there
will be a corner solution.
P1
P1
1

P2 M P1
M
P2
M P1
1
P1

M P1 P2 0

Assume we have interior solution.

v( P1 , P2 , M ) X 1 X 2 X 1 X 2 (

M P2 P1 M P1 P2
M P2 P1 M P1 P2
)(
)

2 P1
2 P2
2 P1
2 P2

Assume M P2 P1 0
v( P1 , P2 , M ) X1 X 2 X1 X 2 (0)(

M
M M
)0

P2
P2 P2

Assume M P1 P2 0

v( P1 , P2 , M ) X 1 X 2 X 1 X 2 (

M1
M
M
)(0) 1 0 1
P1
P1
P1

30

31
f ( x1 ,..., xn ) is homogeneous to degree k

Definition:

if for any 0, k f ( x1 ,..., xn ) f ( x1 ,..., xn )

Example:
a b
f ( x1 , x2 ) x1 x2 is homogemeous to degree a b
f ( x1 , x2 ) ( x1 )a ( x2 )b a b x1 x2 a b f ( x1 , x2 )
a

Example:

f ( x1 , x2 )

x1
x2

is homogeneous to degree 1

f ( x1 , x2 )

( x1 )
x
1 12
2
( x2 )
x2

Example:
xi *( P1 , P2 , M )

M
is homogeneous to degree 0 in ( P1 , P2 , M ).
2 Pi

Note: this is a Marshallian demand function or ordinary demand function.

M
M
M
xi *( P1 , P2 , M )

0
2 Pi 2 Pi
2 Pi

Envelop Theorem for Constrained Optimization

z *(1 , 2 ,..., m ) optimize f ( x1 , x2 ,..., xn ; 1 , 2 ,..., m )

xi : choice variables
j : parameters

x1 , x2 ,..., xn

s.t. g ( x1 , x2 ,..., xn ; 1 , 2 ,..., m ) 0

Let L( x1 , x2 ,..., xn , ; 1 , 2 ,..., m ) f ( x1 , x2 ,..., xn ; 1, 2 ,... , m ) g ( x1 , x2 ,..., xn ; 1 , 2 ,..., m )
Then

z * L *

i i

31

32
Properties of Indirect Utility Function
Let P ( P1 ,..., Pn )
1.
2.

v( P, M ) is nondecreasing in M and nonincreasing in Pi

v( P, M ) is homogeneous to degree 0 in (Pi , M ).

v( P, M )
Pi
xi ( P, M )
Roy's Identity
v( P, M )
M
v( P, M ) is quasi-convex in P ; i.e. A {P : v( P, M ) } is a convex set

3.
4.
Proof:

v( P, M ) L * [U ( x1 ,..., xn ) ( M P1 x1 ... Pn xn )

* 0
M
M
M
When we carry out the differentiation, xi , etc. are treated as constants!!!
is the marginal
utility of income
Also,
v( P, M ) L * [U ( x1 ,..., xn ) ( M P1 x1 ... Pn xn )

* xi * 0
Pi
Pi
Pi

1. By the Envelop Theorem,

2.

2-goods case:

When ( P1 , P2 , M ) are replaced by ( P1 , P2 , M ) , the budget line

remains the same.
M M M M

P1 P1 P2 P2
If the budget line remains the same, E will be the same. Hence
( X1 *, X 2 *) will be the same.

X2
M
P2
X 2*

X1
X 1*

M
P1

In general, X i * ( P, M ) is obtained by solving the problem:

n

max U ( X 1 ,..., X n ) s.t. M Pi X i 0

X1 ,... X n

i 1

When ( P, M ) is replaced by ( P, M ) , there is no change in the

objective function and in the constraint. Hence same solution.

32

33
n

3.

Problem:

s.t. M Pi X i 0

max U ( X 1 ,..., X n )

X1 ,..., X n

i 1

L U ( X 1 ,..., X n ) [ M Pi X i ]
i 1

By the Envelop Theorem:

v( P, M ) L *

* X i *
Pi
Pi

(1)

v( P, M ) L *

*
(2)
M
M
v( P, M )
v( P, M )
* X i *
Pi
Pi
(1)

X i * ( P, M )
v( P, M )
v( P, M )
(2)
*
M
M
Given P A so that v( P, M ) and P ' A so that v( P ', M ) .

4.

Let P " P (1 ) P ' .

P ( P1 ,..., Pn ); P ' ( P1 ',..., Pn '); P " ( P1 ",..., Pn ")

P " A, i.e. v( P ", M )

Want to show:

B { X : Pi X i M }

Define the budget sets

B ' { X : Pi ' X i M }

B " { X : Pi " X i M }

X B " X B or B '

Want to show:
Assume not. i.e.

[ P (1 )P ']X
i

P X M P X M
P ' X M (1 ) P ' X
i
i

M , but

(1 ) M

PX
i

M and Pi ' X i M .

Pi " X i [ Pi (1 ) Pi '] X i M

which contradicts the orginal assumption.

Note that
v( P ", M ) max U ( X ) s.t. X B "
X

max U ( X ) s.t. X B or X B ' since B " B B '

X

since v( P, M ) and v( P ', M )

33

34

Example:
v( P1 , P2 , M )

M2
4 P1 P2

v( P1 , P2 , M )
M2
2 ,
P1
4 P1 P2

v( P1 , P2 , M )
M2

,
2
P2
4 P1 P2

M2
v( P1 , P2 , M )
2
P1
4 P1 P2
M
X1*

v( P1 , P2 , M )
M
2 P1
2 P1 P2
M
M2
v( P1 , P2 , M )

2
P2
4 P1 P2
M
X2*

v( P1 , P2 , M )
M
2 P2
2 P1 P2
M

34

v( P1 , P2 , M )
M

M
2 P1 P2

35
Expenditure function and Hicksian demand function
n

PX

e( P,U ) min

X1 ,..., X n

i 1

Example:
min P1 X1 P2 X 2

s.t. U U ( X 1 ,..., X n )

s.t. U X1 X 2 X1 0

X1 , X 2

L P1 X1 P2 X 2 [U X1 X 2 X1 ]

FONC:
LX1 P1 ( X 2 1) 0

(1)

LX 2 P2 X 1 0

(2)

L U X 1 X 2 X 1 0
(3)
P1
P
P
(1) and (2)
2 X1 2 ( X 2 1)
X2 1
X1
P1

(4)

(3) : U X 1 X 2 X 1 0 U X 1 ( X 2 1) U [
U

P2
UP
UP1
h
( X 2 1)2 0 ( X 2 1) 2 1 X 2
1
P1
P2
P2

X1
h

P2
( X 2 1)]( X 2 1) 0
P1

P2
P
( X 2 1) 2
P1
P1

UP1
UP2
=
P2
P1

(5) Hicksian demand function

(6) Hicksian demand function

Note that X 2 must be non-negative.

(5) X 2h 0

UP1
1 0 UP1 P2
P2

If UP1 P2 , then X 2 0 and X1 U

h

X2
The slope of the IC is

MU1

X2 1

MU 2
@ A , slope of IC
A (U , 0)

X2 1

X1
0 1

X1
U
U
If the price line is flatter than the IC at this point, there
will be a corner solution.
P1
1

P2 UP1
P2 U

X1

35

36
Definition:
f ( x1 ,..., xn ) is a concave function if x0 ( x10 ,..., xn0 ) and x1 ( x11 ,..., x1n ), (0,1), we have
f ( x) f [ x10 (1 ) x11 ,..., xn0 (1 ) x1n ] f ( x10 ,..., xn0 ) (1 ) f ( x11 ,..., x1n )

where x x0 (1 ) x1 ( x10 (1 ) x11 ,..., xn0 (1 ) x1n )

f ( x1 )

f [ x0 (1 ) x1 ]

f ( x0 )

f ( x0 ) (1 ) f ( x1 )
x0

x1

Properties of the Expenditure Function:

e( P,U )
xih ( P,U )
1.
Pi
2.

e( P,U ) is nondecreasing in Pi .

3.
4.

e( P,U ) is concave in ( P).

e( P,U ) is homogeneous to degree 1 in ( P).

Proof:
1) and 2)

By the Envelop Theorem,

e( P,U ) L * [ P1 x1 ... Pn xn (U U ( x1 ,..., xn )]

xih 0
Pi
Pi
Pi

3)
Want to prove: (0,1), e[ P 0 (1 ) P1 ,U ] e( P 0 ,U ) (1 )e( P1 ,U )

where P0 ( P10 ,...,Pn0 ) and P1 ( P11 ,...,Pn1 )

Let x 0 ( x10 ,..., xn0 ) be the cheapest bundle to attain U when P P 0

x1 ( x11 ,..., x1n ) be the cheapest bundle to attain U when P P1
x ( x ,..., x ) be the cheapest bundle to attain U when P P
1

where P ( P1 ,..., Pn ) P0 (1 ) P1 ( P10 (1 ) P11 ,..., Pn0 (1 ) Pn1 )

36

37
Note that
n

P x

e( P 0 , U )

(1) when P P 0 , x 0 is the cheapest bundle, not x

e( P1 ,U )

(2) when P P1 , x1 is the cheapest bundle, not x

i 1

P x
1

i 1

(1) Pi 0 xi e( P 0 , U )

(3)

i 1

(2) (1 ) Pi1 xi (1 )e( P1 , U )

(4)

i 1

(3)+(4) Pi xi (1 ) Pi1 xi e( P 0 , U ) (1 )e( P1 , U )

0

i 1

i 1

[ Pi 0 (1 )Pi1 ]xi e( P 0 , U ) (1 )e( P1 , U )

i 1

e( P , U ) e[ P 0 (1 ) P1 , U ] e( P 0 , U ) (1 )e( P1 , U )

4.

2-goods case

When ( P1 , P2 ) becomes ( P1 , P2 ) , the slope of the iso-cost line remains the same (

P1
P
1 ),
P2
P2

hence the consumer will buy the same bundle ( x1h , x2h )
1
new cost ( P1 ) x1 ( P2 ) x2 ( Px
1 1 P2 x2 ) (cost)

In general, we have e( P,U ) min

Px
i 1

s.t. U U ( x1,..., xn ) 0

i i

Now suppose ( P1 ,..., Pn ) becomes ( P1,..., Pn ), , the constraint will be the same. On the other hand, the

objective function becomes

i 1

i 1

Pxi i Pxi i . Clearly the new objective function is a monotonic

transformation on the original one. Hence after the change in prices, we will still have the same costminimization bundle.
n

i 1

i 1

1
new cost ( Pi ) xi Px
i i (cost)

37

38
Example: ( e( P,U ) is a concave function in P )
A consumer wants to attain U by consuming good 1 and good 2. He is facing an uncertainty on the
prices of the goods. He knows that there is a 50% probability that ( P1 , P2 ) ($2,$2) , and a 50%
probability that ( P1 , P2 ) ($4,$4) . Instead of facing the uncertainty, the consumer can sign a contract
allowing him to buy the goods at ( P1 , P2 ) ($3,$3) without uncertainty.
Question: Should the consumer sign the contract?
Signing the contract:
Facing the uncertainty:

cost e($3,$3,U )
expected cost 0.5e($2,$2,U ) 0.5e($4,$4,U )

Note that
e($3,$3,U ) e[(0.5)($2) (0.5)($4), (0.5)($2) (0.5)($4),U ] 0.5e($2,$2,U ) 0.5e($4,$4,U ),

hence the consumer SHOULD NOT sign the contract

Important identities of duality

1.
e[ P, v( P, M )] M
2.
v[ P, e( P,U )] U
3.
X i ( P, M ) X ih [ P, v( P, M )]
X ih ( P,U ) X i [ P, e( P,U )]

4.

1 a

Example:
Let e( P1 , P2 ,U ) P1 P2 U
By the Envelop Theorem, we have
[ P1 X 1 P2 X 2 (U U ( X 1 , X 2 )) L * e( P1 , P2 ,U )
h
a 1 1 a
X1

aP1 P2 U
P1
P1
P1
a

[ P1 X 1 P2 X 2 (U U ( X 1 , X 2 )) L * e( P1 , P2 ,U )
a
a

(1 a) P1 P2 U
P2
P2
P2
By the duality identity, we have
M
a 1 a
a 1 a
e( P1 , P2 ,U ) P1 P2 U M P1 P2 v( P1 , P2 , M ) v( P1 , P2 , M ) a 1a
P1 P2
By the Envelop Theorem, we have
v( P1 , P2 , M )
v( P1 , P2 , M )
v( P1 , P2 , M )
a
a 1
a 1 a 1
a
a2
P1 P2 ,
aMP1 P2 ,
(a 1) MP1 P2
M
P1
P2
X2
h

a 1

Roy's identity X 1 *

v P1
aMP1 P2

a
a 1
v M
P1 P2
a

X2*

v P2
(a 1) MP1 P2

a
a 1
v M
P1 P2

a2

a 1

(1 a) M
P2

38

aM
,
P1

39

Example:

Let v( P1 , P2 , M ) ( P1 P2 ) r M
r

We have
1
v( P1 , P2 , M )
r
r r
( P1 P2 ) ,
M

1
1
v( P1 , P2 , M )
1 r
r r 1
r 1
r
r r 1 r 1
( P1 P2 ) rP1 M ( P1 P2 ) P1 M ,
P1
r

1
1
v( P1 , P2 , M )
1 r
r 1
r 1
r
r 1
r 1
( P1 P2 ) r rP2 M ( P1 P2 ) r P2 M
P2
r
1
1

v P1
( P1r P2 r ) r P1r 1 M
MP1r 1
Roy's identity X 1 *

,
1
r
r

v M
P

P
r
r
1
2
( P1 P2 ) r
1
1
r

v P2
( P P2 ) P2 r 1 M
MP2 r 1
X2*

r
1

v M
P1 P2 r
r
r
r
( P1 P2 )
r
1

By the duality identity, we have

1
r r

1
r r

v( P1 , P2 , M ) ( P P2 ) M U ( P P2 ) e( P1 , P2 ,U ) e( P1 , P2 ,U ) U ( P P2 )
r
1

r
1
1
r r 1

e( P1 , P2 ,U )
1 r
X
U ( P1 P2 )
P1
r
h
1

X2
h

r 1
1

rP

r
1

U ( P P2 )
r
1

1
1
r

1
1
1
1
e( P1 , P2 ,U )
1 r
r
r 1
r
r
r 1
U ( P1 P2 ) r rP2 U ( P1 P2 ) r P2
P2
r

39

r 1

P1

1
r

40
Example:

U min[2 X ,3Y ]

With this utility function, we know that we always buy 2 X 3Y . [i.e. more X than Y]
Hicksian demand function:
In order to attain U , the consumer needs to buy
U
U
U
U U (3PX 2 PY )
X h , Y h e( PX , PY ,U ) PX PY
2
3
2
3
6
v( PX , PY , M )(3PX 2 PY )
6M
v( PX , PY , M )
6
3PX 2 PY
Marshallian demand function:
By duality M

v
P
6M (3PX 2 PY ) 2 (3)
3M
X* X

1
v
6(3PX 2 PY )
3PX 2 PY
M
v
P
6M (3PX 2 PY ) 2 (2)
2M
Y* Y

1
v
6(3PX 2 PY )
3PX 2 PY
M
Note that we can construct baskets of goods like this: ( X ,Y ) (3,2) This basket will give the consumer
6 utils. Each basket costs 3PX 2PY
X* 3

M
3M

3PX 2 PY 3PX 2 PY

M
2M
Y* 2

3PX 2 PY 3PX 2 PY

SAME AS BEFORE

40

41
Numerical example:
U XY
M
M
M2
X*
, Y*
and v( PX , PY , M )
2 PX
2 PY
4 PX PY
Let M $100, PX $4, PY $5 , then

X*

M
100
M 100
M2
1002
=
=12.5, Y *
=
=10, v( PX , PY , M )

125 12.5 10
2 PX 2 4
2 PY 2 5
4 PX PY 4 4 5

Question:

Suppose PX ' $5 , how much extra money is needed to maintain the same utility?

v( PX , PY , M )

e( PX , PY , u )2
M2
u
e( PX , PY , u ) 4PX PY u
4 PX PY
4 PX PY

If u 125, PX ' $5, PY $5 , then e( PX , PY , u) 4PX PY u 4 5 5 125 12500 111.80

Also

Yh

Xh

e
1 1
4 PY u ( ) PX 2
PX
2

PY u
5 125

125 11.18
PX
5

Pu
e
1 1
5 125
4 PX u ( ) PY 2 X
125 11.18
PY
2
PY
5

41

42
Example
1

A household has a utility function U ( H , G) H 2 G 2 where H is the housing consumption in square

feet and G is the amount of money spent on other goods.
a)
Calculate the indirect utility function of this household.

b)

c)
d)
e)

Let PH $10 / square foot and Income $10000 .

Calculate the optimal level of H and G . How many "utils" does it enjoy?
Suppose the government provides a 50% rent subsidy for this household. so that the rent goes
down to $5/ square foot (from the market rent of $10/square foot).
i)
Calculate the optimal level of H and G . How many "utils" does it enjoy?
ii)
What is the cost to the government?
Instead of rent subsidy, the government provides a cash subsidy to this household, how much
cash subsidy is needed to make the household as happy as enjoying the rent subsidy?
If your answer in c) is less than the cost to the government in b), the difference is the dead
weight loss (DWL) of the rent subsidy program. How large is this DWL?
If the government provides a cash subsidy to the household which is equal to your answer in b)
ii), how much utility will the household enjoy?

Solution
a)

This is a Cobb-Douglas utility function.

1
1
M
M
M
PH H 2 M H *
, PG G 2 M G*

1 1
1 1
2 PH
2 PG
2

2 2
2 2
1
1
M 2 M 2
M
v( PH , M ) (
) ( )
2 PH
2
2 PH

M
10000
M 10000

500, G*

5000
2 PH (2)(10)
2
2
M
10000
v( PH , M )

1581.14 500 5000

2 PH
2 10
M
10000
When the subsidized rent $5 , H *

1000,
2 PH (2)(5)
H*

b)

G*

M 10000

5000
2
2

U 1000 5000 2236.07

cost to government market price subsidized price ($10)(1000) ($5)(1000) $5000

c)

d)

Let X be the amount of cash subsidy needed.

10000 X
2236.07 X $4142.15
From b) we have
2 10
DWL $5000 $4142.15 $857.85

e)

From the indirect utility function, U

M 5000
2 PH

42

10000 5000
2 10

2371.71

43

Proposition (Slutsky Equation)

X j ( P, M )
Pi

h j ( P,U )
Pi

X j ( P.M )
M

Xi

Proof:
Let X * be the utility-maximizing bundle at ( P*, M *) and let U * U ( X *) .
It is identically true that h j ( P,U *) X j [ P, e( P,U *)]
Differentiate with respect to Pi and evaluate the derivative at P * :
h j ( P*,U *) X j ( P*, M *) X j ( P*, M *) e( P,U *) X j ( P*, M *) X j ( P*, M *)

Xi *
Pi
Pi
M
Pi
Pi
M
X j ( P*, M *)
h j ( P*,U *)
X j ( P*, M *)
X j
Pi
Pi
X i * Pi
Pi
Pi
M
in income to keep utility constant
total effect

h1

X 1 P1

X 2 h2
P
1

substitution effect

h1
X 1
X
P2 P1 M 1

h2 P2 X 2
X1

P2
M

income effect

X 1

X2
P1
M

P2
X 2

X2
M

43

44
Lancasters characteristic approach to consumer theory
(A New Approach to Consumer Theory, Journal of Political Economy, 1966, pp. 132-57)
Motivation:
We observe that people will (suddenly) quit buying a good when its price goes up. This cannot be
explained by traditional theory.
i)
Y

In this case, a consumer will always buy all

goods.

ii)
Y
In this case, a consumer will always buy all
goods.

iii)
Y
In this case, a consumer will only buy one and
one good only.

44

45
Assumption of Lancasters model:
People consume characteristics which are embodied in the goods.
Protein
C
E

Vitamin

B:
P:
C:
C:

the amount of protein and vitamin embodied in the beef purchased by all the money one has.
the amount of protein and vitamin embodied in the pork purchased by all the money one has.
the amount of protein and vitamin embodied in the chicken purchased by all the money one has.
the amount of protein and vitamin embodied in the chicken purchased by all the money one has
when the price of chicken goes up

At the initial prices, the consumer is going to buy chicken and pork.
When price of chicken goes up, C will move towards the origin. At first, the consumer will continue to
buy chicken and pork. Once the price of chicken rises beyond a certain critical level, then the
consumer will no longer buy any chicken, it will only buy beef and pork.

45

46
Irrational behavior and economic theory
(Becker, Gary (1962): Irrational Behavior and Economic Theory, Journal of Political Economy,
February.)
Motivation:
It is hard to believe people are rational. In this paper, Becker argued that
i)

the empirical results are consistent with the main implication of utility theorya downward
sloping demand curve;

ii)

households can be said to behave as if they are rational.

Y
new budget line

C
C

initial budget line

Assume a person is completely irrational, she/he will randomly pick a consumption bundle, then on
average, she/he will consume at C.
When PX or PY , the budget line becomes the dotted line. The budget set tilts towards Ythe
center of the new budget set is C. Hence PX or PY X , Y
The same result as is under the rational behavior assumption.

46