Advanced Microeconomics II: Consumer Theory

Maria Saez Marti

Oce 210, IEW

tel. 044 634 37 13 e-mail: saez@iew.uzh.ch

This course
Consumer Theory. Theory of the rm. Partial Equilibrium General Equilibrium (Social Choice and Welfare) Lectures (MSM) and Classes (Bernhard Ganglmair). Important that you participate in the Classes.

Bibliography: Jehle and Reny: Advanced Microeconomic Theory. If you are interested in a more advanced book, you can read Mas Collell et al: Microeconomic Theory

1.1 Intoduction
The choice problem of a household
Consumers decide about

savings vs. consumption composition of consumption composition of wealth labor supply type of job number of children education

Decisions depend on:

tastes (including time and risk preferences) wealth (including human capital) prices expectations about future prices own future preferences future income

Theoretical starting-point
Consumer knows set of goods, prices and income; based on them, he decides on consumption vector once and for all. Thus the problem is simplied in that choices concern only consumption choices are not sequential the future is certain

Question:
How does consumption vector depend on prices, income and preferences?

Important:
understand relation between assumptions and conclusions - not just conclusions.

Goal of the chapter:

formal representation of the consumers choice problem characterization of his behavior on the market Important: consumer theory is not an end itself, rather a building block of the explanation in the economic system.

1.2 Primitive Notions Consumer Choice

Overview
Four building blocks in any model of consumer choice consumption set feasible set preference relation behavioral assumption

Consumption Set
Consumption set represents the set of all alternatives, or complete consumption plans, that the consumer can conceive - whether some of them will be achievable in practice or not Let each commodity be measured in some innitely divisible units. xi R represents the number of units of good i x = (x1, ..., xn) is the vector containing dierent quantities of each of the n commodities (x is called a consumption bundle or a consumption plan) Think of the consumption set as the entire nonnegative orthant, X = Rn . +

Properties of the Consumption Set

Assumption 1 The minimal requirements on the consumption set are 1. 6= X Rn + 2. X is closed 3. X is convex 4. 0 X

Feasible Set
The feasible set B represents all those alternative consumption plans that are both conceivable and realistically obtainable given the consumers circumstances. The feasible set B then is that subset of the consumption set X that remains after we have accounted for any constraints on the consumers access to commodities due to the practical, institutional, or economic realities of the world.

Preference Relation
A preference relation typically species the limits, if any, on the consumers ability to perceive in situations involving choice, the form of consistency or inconsistency in the consumers choices, and information about the consumers tastes for the dierent objects of choice.

Behavioral Assumption
The consumer seeks to identify and select an available alternative that is most preferred in the light of his personal tastes.

1.3 Preferences and Utility

Preference Relations
We represent the consumers preferences by a binary relation, %, dened on the consumption set, X. If x1 % x2, we say that x1 is at least as good as x2, for this consumer.

Axiom 1: Completeness
Axiom 2: Reexivity
For all x, in X, x % x

For all x1 and x2 in X, either x1 % x2 or x2 % x1

Axiom 3: Transitivity

For any x1, x2 and x3 in X, if x1 % x2 and x2 % x3 then x1 % x3.

Denition 1:

The binary relation % on the consumption set X is called a preference relation if it is complete, reexive and transitive.

Induced Preference Relations

Denition 2:
The binary relation on the consumption set X is dened as follows: x1 x2 if and only if x1 % x2 and x2 x1. The relation is called the strict preference relation induced by %, or simply the strict preference relation when % is clear. The phrase x1 x2 is read, x1 is strictly preferred to x2.

Denition 3:
The binary relation on the consumption set X is dened as follows: x1 x2 if and only if x1 % x2 and x2 % x1. The relation is called the indierence relation induced by %, or simply the indierence relation when % is clear. The phrase x1 x2 is read, x1 is indierent to x2.

Sets in X derived from the Preference Relations

Denition 4:
Let x0 be any point in the consumption set, X. Relative to any such point, we can dene the following subsets of X : 1. % set.

x0

x | x X, x %

o 0 , called the at least as good as x

n o 0 x | x X, x0 % x , called the no better than set. 2. - x n o 0 x | x X, x0 x , called the worse than set. 3. x n o 0 x | x X, x x0 , called the indierence set. 4. x

Hypothetical preferences satisfying Axioms 1, 2 and 3

Further Assumptions on Preferences

Axiom 4: Continuity
For all x Rn , the at least as good as set, % (x), and the no + better than set - (x), are closed in Rn . +

Axiom 5: Local Nonsatiation

For all x0
n , and for all > 0, there exists some x B x0 R+ Rn such that x x0; where B x0 is the neighborhood of x0 +

with radius .

Axiom 5: Strict Monotonicity

For all x0, x1 Rn , if x0 x1 then x0 % x1, while if x0 x1, + 0 x1. then x

Figure 1: Hypothetical preferences satisfying Axioms 1, 2, 3 and 4

Hypothetical preferences satisfying Axioms 1, 2, 3, 4 and 5

Hypothetical preferences satisfying Axions 1, 2, 3, 4 and 5

Hypothetical preferences satisfying Axioms 1, 2, 3, 4 and 5

Axiom 6: Convexity
If x1 % x0, then tx1 + (1 t) x0 % x0 for all t (0, 1) .

Axiom 6: Strict Convexity

If x1 6= x0 and x1 % x0, then tx1 + (1 t) x0 x0 for all t (0, 1) .

Hypothetical preferences satisfying Axioms 1, 2, 3, 4, 5 and 6 or 6

Marginal Rate of Substitution

When X = R2 , the (absolute value of the) slope of an indierence + curve is called the marginal rate of substitution. If preferences are strictly monotonic, any form of convexity requires the indierence curves to be at least weakly convex-shaped relative to the origin.

The Utility Function

Denition 5:
A real valued function u: Rn R is called a utility function represent+ ing the preference relation %, if for all x0, x1 Rn , +
0 u x1 u x

x0 % x1.

Note: It can be shown that any binary relation that is complete, transitive, and continuous can be represented by a continuous real-valued utility function. Here we will take a detailed look at a slightly less general result.

Representation of Preferences
Theorem 1:
If the binary relation % is complete, transitive, continuous, and strictly monotonic, there exists a continuous real-valued function, u: Rn R + which represents %.

Interpretation:
The result frees us to represent preferences either in terms of the primitive set-theoretic preference relation or in terms of a numerical representation, a continuous utility function.

Sketch of Proof:
Let the relation % be complete, transitive, continuous, and strictly monotonic. Let e (1, ..., 1) Rn be a vector of ones, and + consider the mapping u: Rn R dened so that the following + condition is satised: u (x) e x Remaining issues: First, does there always exist a number u (x) satisfying (1)? Second, is it uniquely determined, so that u (x) is a well-dened function? Third, is the utility function u: Rn R representing % continuous? + (1)

Constructing the mapping

Monotone Transformations
Theorem 2:
Let % be a preference relation on Rn and suppose u (x) is a utility + function that represents it. Then v (x) also represents % if and only if v (x) = f (u (x)) for every x, where f : R R is strictly increasing on the set of values taken on by u.

Relation between Preferences and Utility Functions

Theorem 3:
Let % be represented by u: Rn R. Then: +

1. u (x) is strictly increasing if and only if % is strictly monotonic. 3. u (x) is strictly quasiconcave if and only if % is strictly convex.

2. u (x) is quasiconcave if and only if % is convex.

Dierentiable Utility Functions

marginal utility of good i = u (x) /xi For the case of two goods, we dened the marginal rate of substitution as the absolute value of the slope of an indierence curve. Let x2 = f (x1) be the function describing the indierence curve in the (x1, x2) plane. Therefore
1, x1 | f x1 |= f x1 0 0 MRS12 x1 2 1 1

(2)

Suppose u (x) /xi > 0 for almost all bundels x, and all i = 1, ..., n. Then u x1 /x1 . M RS12 x1 = 1 /x u x 2