Consumer theory

Preference based theory. Let us next assume that consumers have unobservable n. preferences over consumption bundles in X R+ Formally preferences are a binary relation Most of the time x 1, x 2 is denoted x1 X X. x 2.

Interpretation is that x 1 is at least as good as x 2 . We require some minimal features that preferences must satisfy.

Consumer theory

Completeness: For any x 1 , x 2 X , either x 1 Transitivity: For any x 1 , x 2 , x 3 X , if x 1 then x 1 x 3 .

x 2 or x 2

x 1. x3

x 2 and x 2

A binary relation on X satisfying Axioms 1 and 2 is called a preference relation. Two other relations are derivable from i) x 1 is strictly preferred to x 2 , x 1 x 2 , i x 1 x 2 and x 2 x 1 , ii) x 1 is indierent to x 2 , x 1 x 2 , i x 1 x 2 and x 2 x 1 . It is straightforward that for any x 1 , x 2 X exactly one of the following holds: x 1 x 2 or x 2 x 1 or x 1 x 2 .

Consumer theory

In many text books a consumer with preference relation is called rational. This is incorrect since we need to make a Behavioural assumption: Consumer chooses a maximal element (according to ) in his/her feasible set B X . Consider the set of l = {(ak ) k =0 , ak R} of sequences of real numbers. Binary relation l l is dened by (ak ) (bk ) k =0 k =0 i there exists k such that for all k k it holds that ak bk . Relation is transitive but not complete. Restricted to the set c of converging sequences, is relation a preference relation?

Consumer theory

Fix x 0 X . One can dene so called upper and lower contour sets with strict versions. x0 = x X : x set. Dene the remaining four sets yourself. x 0 is called "at least as good as x 0

Consumer theory

To make preferences easier to deal with several additional properties are usually required of them. Continuity: For all x Rn + sets x 0, x 1 (x ) and Rn + x 1. if x0 (x ) are closed. x 1 then Strict monotonicity: For all x 0 x 1 , and if x 0 >> x 1 then x 0

Convexity: If x 0 x 1 , then tx 0 + (1 t )x 1 x 1 for t [0, 1]. If x 0 = x 1 and tx 0 + (1 t )x 1 x 1 we have strict convexity.

Consumer theory

Postulating these additional axioms the indierence curves have the familiar form that feature diminishing marginal rate of substitution. The really important thing to remember/understand is that consumers choice is intended to have a close relation to his/her consumption. All of the above has been presented without any reference to the time dimension. Consumption, however, is a ow, and one should think that consumption bundle x = (x1 , x2 ) actually means amount x1 of good 1 per time unit (perhaps week), and amount x2 of good 2 per time unit. This way convexity may be seen as a natural assumption.

Consumer theory

Usually theorising is done with utility functions instead of preference relations. What has to be assummed about preferences in order to guarantee a well behaved utility function? Function u : Rn + R is a utility function representing preference relation i for all x 0 , x 1 Rn + the following holds: u x0 u x1 x0 x1

Consumer theory

Theorem If is complete, transitive, continuous and strictly monotonic there exists a continuous u : Rn . + R that represents

Consumer theory

Proof. Just the idea: 1. Measure the distance along the 45-degree line to each indierence curve. Associate to each bundle on an indierence curve the same number (as the bundle on the 45-degree line). 2. Show that this number exists and is unique. 3. Show that the constructed utility function represents . 4. Show that u is continuous. Note that showing closedness of sets A and B in the proof (in the textbook) requires knowledge that scalar product is a continuous mapping.

Consumer theory

Theorem If u : Rn + R is a utility function representing preference relation and f : R R is increasing then f (u ) : Rn . + R also represents n Let u : R+ R represent . i ) u is strictly increasing i is strictly monotonic. ii ) u is quasiconcave i is convex. iii ) u is strictly quasiconcave i is strictly convex.

Consumer theory

When u is dierentiable (as is usually assumed) the marginal utility of good i . The ratio MRSij
u xi u xj

u xi

is called

is called the marginal rate of

substitution of good i for good j . It is the slope of the indierence surface in the i j -co-ordinate system.
u Notice that xi is a function and to get a numerical value it must be evaluated at some point. The same holds for MRSij .

Consumer theory
CONSUMERS PROBLEM His/her aim is to choose a maximal element of his/her feasible set. Unless otherwise stated for the remainder of the presentation we make the following Assumption. Preference relation is complete, transitive, continuous, strictly monotonic and strictly convex on Rn +. Generally the consumer is assumed to face a xed set of prices p = (p1 , ..., pn ) and income y . His/her problem is given by
n x R+

max u (x ) subject to n

i =1

pi xi y

(1)

Consumer theory
The necessary conditions for interior solution x are given by
u xi u xj

(x ) (x )

pi pj

(2)

This is seen by forming the Lagrangean

n

= u (x )

i =1

pi xi y

(3)

The rst order conditions (FOCs) are given by u (x ) = (x ) pi = 0 xi xi

i =1

pi xi y = 0

(4)

Notice that these equality conditions apply only to interior solutions. More correctly one should use the

Consumer theory

Assume that u is continuous and quasiconcave, and that (p , y ) >> 0. If u is dierentiable at x and (x , ) >> 0 satises (4) then x solves the consumers problem. More generally, if a maximisation problem is quasiconcave then the necessary conditions for maximum are also sucient.

Consumer theory

Example Here the Assumption does not hold. Let u (x1 , x2 ) = min {ax1 , bx2 } where a, b > 0. This utility function is not dierentiable. Assume that prices are p = (p1 , p2 ) >> 0. The indierence curves have a a x1 , and the optimum is at a kink. 90-degree kink on the line x2 = b a Substituting into the budget constraint we get p1 x1 + p2 b x1 = y . by Consequently, the consumers optimal choice is x1 = bp1 +ap2 and ay = x2 bp1 +ap2 .

Consumer theory
The important point to understand is that in the consumers problem prices and income are xed but arbitrary. The solution can be thought of as a function of p and y and x (p , y ) = (x1 (p , y ), ..., xn (p , y )) is called the Marshalian demand. This only makes sense if the solution is unique but this is guaranteed by Assumption. In the graph of the standard demand curve xi (pi , pi , y ) only pi is allowed to change. Berges Maximum Theorem guarantees that the Marshalian demand is a continuous function of (p , y ). Roughly assuming that u is k times dierentiable and some regularity conditions guarantees that the Marshalian demand is k 1 times dierentiable. In the sequel dierentiability is assumed when useful.

Consumer theory

INDIRECT UTILITY AND EXPENDITURE FUNCTIONS The objective is to study the maximised value of a consumers utility passing the optimal bundle that generates that value. This is given by u (x ) subject to px y v (p , y ) = max n
x R+

Given Assumption this is well-dened and v (p , y ) = u (x (p , y ))

Consumer theory

Theorem
n+1 If u is continuous and strictly increasing on Rn + then v : R++ R is/satises i) Continuous on Rn ++ R+ . ii) Homogeneous of degree zero in (p , y ). iii) Strictly increasing in y . iv) Decreasing in p. v) Quasiconvex in (p , y ). v (p 0 ,y 0 )/ p vi) xi p 0 , y 0 = v (p0 ,y 0 )/ yi for all i {1, 2, ..., n} if v is

dierentiable at p 0 , y 0 and v p 0 , y 0 / y = 0 (Roys identity).

Consumer theory

Proof. i) This follows from the Berges Maximum Theorem. ii) B = {x : px y } = {x : tpx ty } for t > 0. iii) Let y > y . Now {x : px y } {x : px y }. Clearly there is > 0 such that the -neighbourhood of x (p , y )is contained in {x : px y }. Strict monotonicity of preferences implies the result. iv) Consider prices p 0 p 1 , and notice that p 0 p 1 x p 0 , y 0. Thus, x p 0 , y is feasible at prices p 1 , and consequently v p1, y v p0, y .

Consumer theory
Proof. (Continued) v) This is equivalent to the set L(p , y , k ) = {(p , y ) : v (p , y ) k } being convex for all k > 0. Assume that p 0 , y 0 , p 1 , y 1 L(p , y , k ), and consider (p t , y t ) = t p 0 , y 0 + (1 t ) p 1 , y 1 where t (0, 1). If (p t , y t ) / L(p , y , k ) then u (x (p t , y t )) > k . Now p t x (p t , y t ) = y t and p 0 x (p t , y t ) > y 0 and p 1 x (p t , y t ) > y 1 . The last two inequalities are equivalent to tp 0 x (p t , y t ) > ty 0 and (1 t )p 1 x (p t , y t ) > (1 t )y 1 . Summing these yields p t x (p t , y t ) > y t which is a contradiction. vi) The Lagrangean of the consumers problem is given by L v L = u (x ) (px y ). By the envelope theorem pi = pi = xi , and
v y

L y

= .

Consumer theory
The important point is that the Theorem is a characterisation of indirect utility function: Any function satisfying properties i) - vi) is an indirect utility function. Since v is strictly increasing in y it can be inverted. This provides another (dual) view of consumers problem given by e (p , u ) minx Rn px subject to u (x ) u 0 . +
n +1 R is a minimum value Expenditure function e : R++ function and has properties analogous to the indirect utility function because expenditure and indirect utility function are each others inverses.

Denote the expenditure minimising bundle for arbitrary utility level u by x h (p , u ) so that e (p , u ) = px h (p , u ). It is called the Hicksian demand.

Consumer theory
Theorem
n+1 If u is continuous and strictly increasing on Rn + then e : R++ R is/satises i) Zero when u has its lowest value on U = u R : u = u (x ) , x Rn + , n ii) Continuous on R++ U, iii) For p >> 0 strictly increasing and unbounded in u, iv) Increasing in p, v) Homogeneous of degree one in p, vi) Concave in p, vii) Shephards lemma: e is dierentiable in p at p 0 , u 0 when e (p 0 ,u 0 ) for i {1, 2, ..., n} if u is p 0 >> 0, and xih p 0 , u 0 = pi strictly quasiconcave.

Consumer theory
Proof. i) Immediate. ii) This follows from Berges theorem of maximum. iii) Consider u 0 < u 1 and the corresponding bundles that minimise expenditures, namely x 0 and x 1 . Assume that e p , u 1 e p , u 0 . Now for t (0, 1) suciently close to unity bundle tx 1 cost less than e p , u 0 and yields utility higher than u 0 which is a contradiction. and Assume that e is bounded in u such that for all u e (p , u ) e is the least upper bound. Let {ui }i =1 be a sequence assume that e . Assume that {ui } such that e (p , ui ) e i =1 is an increasing sequence and consider the cost minimising bundles {xi } i =1 that also generate the utilities {ui }i =1 . Because e converges to e {xi } = u ( converges to some x . By continuity of u we have u x ). i =1 yields more utility than x and costs 2e which is a Bundle 2x contradiction.

Consumer theory
Proof. (Continued) iv) Follows from vii), v) Clear vi) Fix the utility level. Consider the convex combination of two prices p t = tp 0 + (1 t )p 1 and the convex combination of the two cost minimising bundles x t = tx 0 + (1 t )x 1 . Assume that the cost minimising bundle at prices p t is x . Now p 0 x 0 p 0 x and p 1 x 1 p 1 x . Multiply the rst inequality by t and the second by 1 t and add to get tp 0 x 0 + (1)tp 1 x 1 p t x which is equivalent to te p 0 , u + (1 t )e p 1 , u e (p t , u ). vii) The Lagrangean of the consumers problem is given by L = px u 0 u (x ) . By the envelope theorem e L h pi = pi = xi (p , u ).

Consumer theory

The indirect utility function and expenditure function are closely related. Indeed, if u is continuous and strictly increasing then Theorem For all p >> 0, y 0, u U i) e (p , v (p , y )) = y and ii) v (p , e (p , u )) = u. In other words, xing p e and v are inverses.

Consumer theory

We know that when u (x1 , x2 ) = min {ax1 , bx2 } then ay by = x1 bp1 +ap2 and x2 = bp1 +ap2 . The indirect utility function is
aby given by v (p , y ) = bp1 +ap2 . The cost minimising bundle, i.e., a the Hicksian demand is such that x2 = b x1 . To achieve utility u , level u the consumer needs bundle u a b , and the expenditure u function is given by e (p , u ) = p1 u + p 2 b . Denoting e (p , u ) = y a and inverting one gets u = bp1ab +ap2 y . Denoting the utility level by u = v (p , y ) shows that even when the assumptions of Theorem do not hold the expenditure and indirect utility functions may be inverses.

Consumer theory

Under Assumption Theorem For p >> 0, y 0, u U , i {1, ..., n} i) xi (p , y ) = xih (p , v (p , y )), and ii) xih (p , u ) = xi (p , e (p , u )). Proof. Evident, though hard to decipher from the text book.

Consumer theory

Properties of the consumer demand Demand depends only on relative prices. This can be seen by dividing the price vector and income by one of the prices, say pi , in the consumers problem, and trying to gure out whether the optimising bundle remains the same. Real income refers to the maximum number of (real) commodities that can be bought. Under Assumption xi (p , y ) is homogeneous of degree zero in prices and income. The Marshalian demand satises budget balancedness, i.e., the consumer uses all his/her income. If not s/he could buy some more which would increase utility.