Advanced Microeconomics 2013/Kultti

What is microeconomics about?

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Theory about the individual responses to incentives. Theory about competing preferences.

What is the role of theory in microtheory? A small set of assumptions/postulates about individual behaviour. In practice economists usually construct models which are something less than theories. In this course the closest things to theory are consumers choice and general equilibrium theory. A good theory should yield some empirically testable predictions/restrictions.

Majority of models in microeconomics focuses on behaviour mediated by the price mechanism. The basic tenet in microeconomics, like in all serious scientic enterprises, is that a mechanism or concept that cannot be formalised, i.e., presented mathematically, is nothing but blabbering. In microeconomics we attempt to be precise about what we talk about, and consequently the theory is mathematical. Almost all microeconomically interesting phenomena are such that there are several forces/tendencies that go to dierent directions. The main task is to evaluate the magnitude of the dierent forces/tendencies.

Revealed preference

CONSUMER/DECISION MAKER The aim is to understand the behaviour of a consumer who has some wealth and faces a set of prices for dierent goods. The consumption set is given by a non-empty X Rn +. It is closed and convex, and contains the zero-vector (origin). A consumption bundle is x = (x1 , x2 , ..., xn1 , xn ) X . The feasible set is given by B X . It incorporates the constraints that the consumer faces. Usually these are given by income y R+ and a price vector n. p = (p1 , p2 , ..., pn1 , pn ) R+

Revealed preference

Revealed preference theory The idea is that theory/model should be based on observables. This idea is not generally sensible. One can observe choices, prices and income. Basic idea: Given prices and income a consumers choice reveals that s/he regards the consumption bundle better than any aordable alternative. The consumer is assumed to be consistent in his/her choices, i.e., rational.

Revealed preference

Denition Weak axiom of revealed preference (WARP). Consider bundle x 0 chosen at prices p 0 , and bundle x 1 chosen at prices p 1 where x 0 = x 1 . If p 0 x 1 p 0 x 0 then p 1 x 1 < p 1 x 0 . Assume that i) consumers choice function x (p , y ) satises WARP, and ii) that the consumer uses all his/her income (budged balancedness).

Revealed preference

Proposition. Consumers choice function is homogeneous of degree zero in (p , y ). Proof. Assume that the choices and corresponding prices and incomes are given by x 0 , p 0 , y 0 , x 1 , p 1 = tp 0 and y 1 = ty 0 for t > 0. By budget balancedness we have p 1 x 1 = y 1 = ty 0 = tp 0 x 0 Substitute tp 0 for p 1 to get tp 0 x 1 = tp 0 x 0 . Divide by t to get p 0 x 1 = p 0 x 0 . Now if x 0 = x 1 then WARP indicates that p 1 x 0 > p 1 x 1 . Next substitute p 1 for tp 0 to get p 1 x 1 = p 1 x 0 .

Revealed preference

Assume that a consumers choice is x 0 at p 0 , y 0 . Let prices change to p and compensate this change to the consumer by giving him/her income y = px 0 . Now his/her choice is x p , px 0 .

Revealed preference

Theorem Consider a compensated price change. If the increase in income aects choice (demand) positively, then an increase in the price of good i leads to decrease in the demand for good i.

Revealed preference
Proof. Let p 0 >> 0, y 0 > 0 and x 0 = x p 0 , y 0 . Let p be any other price (vector) and let x = x p , px 0 . Since px 0 > px WARP implies that p 0 x > p 0 x 0 if x = x 0 . Consequently, p0x 0 p0x Substituting px p , px 0 for y 0 budged balance implies px 0 = px p , px 0 Subtract (1) from (2) p p 0 x 0 p p 0 x p , px 0 (3) (2) (1)

Revealed preference
Proof. (Continued) As (3) holds for any price p it holds in particular for n . Now (3) becomes p = p 0 + tz where t > 0 and z R+ tzx 0 tzx p 0 + tz , p 0 + tz x 0 Dividing (4) by t yields zx 0 zx p 0 + tz , p 0 + tz x 0 (5) (4)

Clearly there exists t (z ) such that p 0 + tz >> 0 for t (0, t (z )). For t = 0 (5) holds as and equality. Thus, for xed z we can dene function f (t ) zx p 0 + tz , p 0 + tz x 0 (6) that attains its maximum at t = 0.

Revealed preference

Proof. (Continued) Assuming dierentiability of the choice function this means that f (0) 0. Taking the derivative of (6) and evaluating it at t = 0
n n

f (0) =

i =1 j =1

zi

xi p 0 , y 0 xi p 0 , y 0 + xj p 0 , y 0 pj y

zj 0 (7)

This is the denition of a negative semidenite matrix with ij -entry xi (p 0 ,y 0 ) xi (p 0 ,y 0 ) + xj p 0 , y 0 . For j = i we know that pj y 0 0 0 0 xi (p ,y ) xi (p ,y ) + xi p 0 , y 0 0. pi y

Envelope theorem

ENVELOPE THEOREM Consider a problem where function f is maximised given a set of constraints. Maxx R n f (x ; q ) such that g1 (x ; q ) = b1 , ..., gm (x ; q ) = bm () where q R s is a vector of parameters and bi are constants. The value function, v or v (q ), associated with the problem gives the (maximum) value that function f achieves at the solution to the problem x (q ).

Envelope theorem

Theorem Let v (q ) be the value function of problem (*). Let it be dierentiable at point q and let i be the Lagrange multipliers associated with the constraints at x (q ). Then v (q ) f (x (q ), q ) m gj (x (q ), q ) = j qi qi qi j =1 for all i = 1, ..., s .

Envelope theorem

Proof. v (q ) = f (x (q ), q ) for all q which means that we can dierentiate an identity. Then we get
n v (q ) f (x (q ), q ) f (x (q ), q ) xk (q ) = + qi qi xk qi k =1

The rst order conditions of problem (*) are

m gj (x (q ), q ) f (x (q ), q ) = j xk xk j =1

Envelope theorem
Proof. (Continued) Insert this into the above expression and change the order of summation to get
n gj (x (q ), q ) xk (q ) v (q ) f (x (q ), q ) m = + j qi qi xk qi j =1 k =1

It is known that gj (x (q ), q ) = bj for all q . Dierentiating this identity one gets gj (x (q ), q ) xk (q ) gj (x (q ), q ) = xk qi qi k =1

n

Inserting this into the expression for

v (q ) qi

the result follows.