2 CHAPTER 1.

INTRODUCTION

B. Ellickson (1994): Competitive Equilibrium: Theory and Applications,

Cambridge University Press. It contains a useful chapter on non-convex
economies.

M. Magill and M. Quinzii (1996): Theory of Incomplete Markets, MIT Press,

takes a classical theory approach on nancial market equilibrium in
two-period economies.

The approach adopted in these notes aims instead at introducing gen-

eral equilibrium theory per se but also as the canonical microfoundation for
macroeconomics and nance. To this end, the standard theory of general
equilibrium is introduced in its rigour and elegance, but only under restric-
tive assumptions, allowing some shortcuts in analysis and proofs. On the
other hand, we shall be able to introduce nancial market equilibria in two-
period economies after only a few classes, exposing students to fundamen-
tal conceptual notions like complete and incomplete markets, no-arbitrage
pricing, constained e ciency, equilibria in moral hazard and adverse selec-
tion economies, and more. The course ends with a treatment of dynamic
economies and recursive competitive equilibria. Pedagogically, from two-
period to fully dynamic economies the step is rather short, so that we can
concentrate on purely dynamic concepts, like bubbles.
Chapter 2

Demand theory: A quick

review

The consumption set X is the set of admissible levels of consumption of L

existing commodities. In this section we shall assume

X = RL+ ; with generic element x:

X is then a convex set, bounded below. For any x; y 2 X; we say x > y if

xl yl ; for any l = 1; 2; :::; L; and xl > yl for at least one l = 1; 2; :::; L:

Assumption 1 The consumer has a utility function1

U : RL+ ! R

which satises the following properties,

Strong Monotonicity: y > x ) U (y) > U (x); for any x; y 2 RL+ ;

1
In these notes we shall adopt the utility function as a primitive. That is, we shall
assume that any agents underlying preference ordering % on X (is complete, transitive,
and continuous; so that it) can be represented by a utility function; see Rubinstein (2009).
A preference ordering % on X which (is not continuous and hence it) cannot be represented
by a utility function is the Lexicographic ordering:

x % y if x1 y1 or x1 = y1 and xl yl ; for l = 2; :::; L:

3
4 CHAPTER 2. DEMAND THEORY: A QUICK REVIEW

Strict Convexity: U : RL+ ! R is strictly quasi-concave, that is,

U ( x + (1 ) y) U (x) + (1 ) U (y); for any x; y 2 RL+ and 2 [0; 1]; and

U ( x + (1 ) y) > U (x) + (1 ) U (y); if x =
6 y and 2 (0; 1)

Dierentiability: U : RL+ ! R is C 2 on the interior of its domain.

Let rU denote the gradient of the map U : RL+ ! R: Exploiting dier-

entiability strong monotonicity can be equivalently written as

rU (x) 2 RL++ ; for any x 2 RL++ ;

while strict quasi-concavity as

vr2 U (x)v < 0 for any v 6= 0 2 RL such that rU (x)v = 0; for any x 2 RL++ .

Common properties of utility functions at times studied in applications

include:
Quasi-linearity: U (x) = x1 + (x2 ; :::; xL ); for some : RL+ 1 ! R
satisfying strong monotonicity, strict convexity, and dierentiability.

Homotheticity: U ( x) = U (x); for any 2 R++ :

Examples of homothetic utility functions include:

Cobb Douglas: U (x) = x1 x12 ;CES: U (x) = x1 + x2 .

Dierentiability is violated, for instance, by Leontief preferences:

U (x) = min f:::; l xl;::: g ; for some 2 RL++ :

2.1 Consumer theory

Markets are competitive, that is, the consumer takes market prices as given,
independent of his decisions (each agent is a price taker). In addition we
consider the case where:

prices are linear: unit price pl of each commodity l is xed, independent of

level of individual trades (and the same for all agents);
2.1. CONSUMER THEORY 5

prices are non-negative: this is justied under free disposal, that is, when
agents can freely dispose of any amount of any commodity;
markets are complete: for each commodity l in X there is a market where
the commodity can be traded.

Given wealth level m, the budget set is:

( )
X
L
B(p; m) = x2X:p x= pl xl m
l=1

The budget set is convex, compact, and non-empty for p 2 RL++ ; m

0:Furthermore, the budget set is homogeneous of degree 0:

B(p; m) = B( p; m); for all > 0:

Consider the consumers utility maximization problem,

max U (x):
x2B(p;m)

For any p 2 RL++ ; m 0; under our assumptions on U (x), by the Max-

imum theorem, a solution of the consumers problem exists. Furthermore,
the solution of the consumers problem for every p; m induces the consumers
demand correspondence x : RL++ R+ ! RL+ ; x(p; m): Strict quasi-concavity
of U (x); again by the Maximum theorem, implies that x(p; m) is a in fact a
continuous function.

Proposition 1 The individual consumers demand x(p; m) satises the fol-

lowing properties:

Homogeneity of degree zero in p; m:

x(p; m) = x( p; m) for all p 2 RL++ ; > 0;

Continuity: x(p; m) is a continuous function in p; m;

Walras Law: px(p; m) = m;
WARP: for any (p; m); (p0 ; m0 ) 2 RL++ R+ such that x = x(p; m) 6= x0 =
x(p0 ; m0 ):
if px0 m; then p0 x > m0 :
6 CHAPTER 2. DEMAND THEORY: A QUICK REVIEW

Proof. These properties are straightforward consequences of the assump-

tions. Homogeneity of degree zero is a consequence of homogeneity of degree
zero of the budget set. Continuity follows from the Maximum theorem under
strict quasi-concavity of U (x) (weak quasi-concavity would induce an upper-
hemi-continuous, convex valued correspondence x : RL++ R+ ! RL+ : WARP
and Walras law follow easily from strict monotonicity.
It is important to notice that WARP does not imply the (uncompensated)
Law of demand, that is,

(p p0 ) (x(p; m) x(p0 ; m0 )) 0; for m = m0 :

Note also that the (uncompensated) Law of demand is equivalently written,
exploiting dierentiability, as
dpDp x(p; m)dp 0:
Therefore, WARP does not imply that Dp x(p; m) is negative semi-denite.
In general in fact, Dp x(p; m) is NOT negative semi-denite. If preferences
are homothetic, however, the individual consumers demand x(p; m) does
satisfy the (uncompensated) Law of demand. Furthermore, in this case, the
individual consumers demand x(p; m) is homogeneous of degree 1 in m:
x(p; m) = x(p; m) for all p 2 RL++ ; m; > 0:2
WARP on the other hand does imply the (compensated) Law of demand
(p p0 ) (x(p; m) x(p0 ; m0 )) 0; for m m0 = (p p0 )x(p0 ; m0 ):
Once again, exploiting dierentiability we can express the (compensated) Law
of demand through the properties of the Slutsky matrix of compensated price
eects. Consider the following compensated price change:
dp; dm: dm = x dp
The induced demand change is
dx = Dp x(p; m)dp + Dm x(p; m)dm =
= Dp x(p; m) dp + Dm x(p; m)(xdp):
2
This is a consequence of the fact that homotheticity implies that marginal rates of
@U (x)

substitution, @xl
@U (x) ; for any l; l0 ; are invariant with respect to expansions along rays from
@x 0
l
the origin.