12 CHAPTER 2.

DEMAND THEORY: A QUICK REVIEW

Aggregate demand trivially inherits several properties from individual

demand, i.e., dierentiability, homeogeneity of degree 0, Walras Law. But
does x(p; m) satisfy WARP? Not, typically. Take (p; m) and (p0 ; m0 ) such
that x (p0 ; m0 ) 6= x (p; m) and

p x (p0 ; m0 ) m:

It is immediate to see that the following inequality can still hold:

p0 x (p; m) m0

(because p x (p0 ; m0 ) m does not imply p xi (p0 ; mi0 ) mi for all i; similarly
for p0 x (p; m) m0 .)
A su cient condition for aggregate demand x (p; m) to satisfy WARP
is that individual Marshallian demands satisfy the (uncompensated) law of
demand, that is, substitution eects prevail over income eects.

Proposition 5 Suppose xi (p; mi ) satises the (uncompensated) law of de-

mand, that is,
Dp xi (p; mi ) is negative semi-denite
for all i: Then x (p; m) also satises the (uncompensated) law of demand
and hence WARP.

2.2 Producer theory

We shall study the production activity of rms operating in competitive
markets. A production plan is a y 2 RL , interpreted as the net output of the
L goods:

yi < 0 : input
yi > 0 : output

The production set is the set of (technologically feasible) production plans:

Y RL :

Whenever the commodities which are outputs in the production set are xed,
O f1; ::; Lg (and hence also the complementary set of those which are in-
puts), the outer boundary of Y can typically be represented by a (continuous)
2.2. PRODUCER THEORY 13

production function, describing the maximal output level attainable for any
level of inputs. In the case where O = f1g ; e.g.,

y1 = f (z) i
(y1 ; z) 2 Y
@y1 > y1 : (y10 ; z) 2 Y
0

We assume that Y and and f : RL+ 1

! R+ satisfy the following assump-
tions:

Regularity Y is nonempty, closed, Y \ RL+ = f0g (no free lunch and

possibility of inaction), and it satises free disposal:

y 2 Y and y 0 y ) y0 2 Y

Correspondingly, f : RL+ 1
! R+ is monotonically increasing.

Convexity Y is strictly convex:

y; y 0 2 Y ) y + (1 )y 0 2 intY

Correspondingly, f : RL+ 1 ! R+ is strictly concave (has decreasing

returns to scale). (Y is convex,

y 2 Y ) y 2 Y for all 2 [0; 1]

corresponds to f : RL+ 1
! R+ is concave - has non-increasing returns
to scale.)

Any rm chooses a production plan so as to maximize prots:

max p y
s.t. y 2 Y

Existence of a solution requires conditions ensuring that Y is bounded

above. For every p 0, a solution induces a net supply correspondence
y(p):

Proposition 6 The net supply correspondence y(p) satises the following

properties:
14 CHAPTER 2. DEMAND THEORY: A QUICK REVIEW

y(p) is homogeneous of degree 0 in p;

y(p) is a convex-valued correspondence (a single valued function if f :
RL+ 1 ! R+ is strictly concave).
The value of the solution is a prot function (p) = p y(p):
Proposition 7 The prot function (p) satises the following properties:
(p) is homogeneous of degree 1 in p;
(p) is a convex function.
Proof. The properties are straighforward consequences of the properties
of y(p): We leave them to the reader, except convexity; which is proved as
follows. Take any pair p0 ; p00 and consider p^ = p0 + (1 )p00 for 2 (0; 1).
Note that (^ p) = y(^p) ( p0 + (1 )p00 ) y(p0 ) p0 + (1 )y(p00 ) p00
= (p0 ) + (1 ) (p00 ):
Suppose Y is a convex cone,
y 2 Y ) y 2 Y for all > 0;
that is, the technology has constant returns to scale: Correspondingly, the
production function f : RL+ 1 ! R+ is homogeneous of degree 1 in its argu-
ments and,
- y 2 y(p) ) y 2 y(p) for all > 0;
- (p) = 0 for all p:
Whenever f is dierentiable, any solution of the rms problem satisfy
the following system of focs (stated here for the case of interior solutions):
p1 Df = w:
Focs are also su cient if f is concave.
Assume f is continuously dierentiable and strictly concave. Applying
the Implicit Function theorem to focs, we obtain:
1 1
Dw z = D2 f is symmetric, negative denite
p1
Furthermore, by the envelope theorem, y(p) = Dp , so that Dp y = D2
is:
2.2. PRODUCER THEORY 15

- symmetric,

- positive - recall z = (y2 ; ::; yL ) ! - semidenite (by the convexity of ) and

- such that Dp y p = 0 (by the homogeneity of y(p)).

p1 y1
Let p = and y = : The input level z which solves the rms
w z
choice problem also solves the following problem:

min C = wz
z2RL
+
1

s:t: f (z) y1 :
This is perfectly analogous to expenditure minimization problem of con-
sumer. Hence we know that:

- C(w; y1 ) is concave in w and such that @C=@y1 > 0 and @C=@wl 0;

l = 1; ::; L 1;

- z(w; y1 ) = Dw C exhibits the properties of a compensated demand function.

16 CHAPTER 2. DEMAND THEORY: A QUICK REVIEW