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Advanced Microeconomics

Topic 2: Individual Preferences
Primary Readings: DL – Chaper !" #R $ Chaper %" &arian – Chaper '
In most economic models, we start with an agent's utility function. The utility function basically
maps from bundles that the agent might choose, to the real line. The utility function is quite
convenient: it can be maximized and manipulated using mathematical tools. ut the question is:
Is it valid to reduce a simple, real!value function, something as complicated as an agent's
preferences over a wide variety of bundles" #hat does it really mean about the agent's
preferences" $re we imposing some hidden or desirable assumptions when we ta%e this approach"
In this lecture, we will try to answer these questions by analyzing the relationships between
a(ioms about an agent's preferences, and then establishing the existence of a utility function that
represens the agent's preferences.
2)* The Consumer+s Preferences
&.'.' (onsumption )et
#e let the consumpion se, X, represent 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. *very element of X is called a consumpion -undle or a consumpion plan.
• X captures the universe of all possible choices a consumer may have. +or this reason, the
consumption set is also %nown as the choice se.
• ,ormally, X ⊂ R
m
+
! the entire nonnegative orthant of the real space R
m
.
• #e will always assume that X is a closed and convex set.
&.'.& asic -roperties . $xioms of -references
• +or (, y ∈ X, when we write ( y, we mean that /the consumer thin%s that the bundle (
is at least as good as bundle y./ #e call a preference relation on X.
• #e say, /( is 0wea%ly1 preferred to y/.
• It is clear that is a binary relation defined on X.
$s the final purpose of introducing a preference relation is to order the set of consumption
bundles, we need to assume a number of axioms. These a(ioms of consumer choice are intended
to give formal mathematical expression to fundamental aspects of consumer behavior and altitudes
toward the ob2ects of choice.
A.I/M *: 0(ompleteness1 ∀ (, y ∈ X, 0( y1 ∨ 0y (1. 0,ote: ∨ 3 /or/1
• To satisfy the completeness axiom, the preference canno be defined so that ( y
⇔ x
j
≥ y
j
, ∀j. 04eason: it is only a partial ordering.1
0,ote: #hile this axiom appears innocuous, in combination with the usual confinement of the
consumption set to the consumption of the individual only, it rules out externalities in
consumption.1
'
A.I/M 2: 04eflexivity1 ∀ ( ∈ X, ( (.
A.I/M %: 0Transitivity1 0( y1 . 0y 01 ⇒ ( 0. 0,ote: . 3 /and/1
,ote:
• The first assumption says that any two bundles can be compared, the second is trivial,
and the third is necessary for any discussions of preference maximization: for if
preferences were not transitive, there might be sets of bundles which had no best
elements.
It is useful to extend our notation:
• #e write ( φ y and say that ( is strictly preferred to y. #e sometime also write not y
(, meaning y is not preferred to (, which is the same as ( φ y, given completeness.
• #e write ( 5 y if 0( y1 . 0( y1 and say that ( is indifferent to y.
*xamples:
0a1 +inite )et
• If X is a finite set, then a preference relation on X will partition X into a finite number
of subsets such that
• elements within a subset are all indifferent6
• There will be a strict preference for elements from different subsets.
0b1 )ummation 7rdering:
• 8et X 3 R
m
.
• 9efine ( y to mean that .
' '
∑ ∑
· ·

m
i
i
m
i
i
y x
• It is easy to show that this summation ordering is complete, reflective and transitive.
0c1 8exicographic 7rdering
• 8et X 3 R
m
:
.
• ( y if and only if
• either, there exists some j such that x
i
3 y
i
for i ; j and x
j
< y
j
6
• or, x
i
3 y
i
for '≤ i ≤ m.
• *ssentially, the lexicographic ordering compares the components one at a time
beginning with the first, and determines the ordering based one the first a difference
is found.
• This implies that the vector with greatest component is ra%ed the highest.
The above three axioms are the basic properties of a preference relation. $ny relation satisfying
these = axioms is called an ordering. In order to have a functional representation, we may
need a few more axioms 0assumptions1. 0If X is countable, no additional axiom is needed.1
A.I/M !: 0(ontinuity1 +or all y in X, the sets >(: ( y? and >(: y (? are closed sets. It
follows that the sets >(: ( φ y? and >(: y φ (? are open sets.
• This assumption is necessary to rule out certain discontinuous behavior.
• It says that, if 0 (
i
1 is a sequence of consumption bundles that are all at least as good as y
and if this sequence converges to some bundle (
@
, then (
1
is at least as good as y.
• The %ey consequence of continuity is as follows: if y is strictly preferred to 0 and if ( is
bundle that is close enough to y, then ( must be strictly preferred to 0.
&
*xamples
• )ummation ordering is continuous.
• 8exicographic order is discontinuous 0see the following diagram on R
2
2
1
A.I/M !A: 0)trong Aonotonicity1 If ( ≥ y and ( ≠ y, then ( φ y.
A.I/M !3: 0#ea% Aonotonicity1 If x
i
≥ y
i
for all i, then ( y.
• #ea% monotonicity says that /at least as much of everything is at least as good./ If the
consumer can costlessly dispose of unwanted goods, this assumption is trivial.
• )trong monotonicity says that at least as much of every good, and strictly more of some good,
is strictly better. This is simply says assuming that goods are good.
• If one of the goods is a /bad/, such as garbage or pollution, then strong monotonicity will not
be satisfied. ut we can easily get around this problem by respecifying the good to be absence
of garbage, or absence of pollution, which will normally lead to strong monotonicity.
A.I/M 4: 08ocal" ,onsatiation1 Biven any ( in X and ε < C, then there is some bundle y in X
with DD ( ! y DD ; ε such that y φ (.
0$n alternative definition: requiring this to hold over some set that contain the set defined by the
relevant budget constraint.1
• 8ocal nonsatiation says that one can always do a little bit better, even if one is
restricted to only small change in the consumption bundle.
• It can be shown that strong monotonicity implies local nonsatiation but not vice
versa.
• Eey consequence of local nonsatiation rules out /thic%/ indifference curves.
The following two assumptions are often used to guarantee nice behavior of consumer demand
functions.
A.I/M 5A: 0(onvexity1 Biven (, y, 0 ∈ X such that ( 0 and y 0, then t( : 0'!t1y 0 for all
C ≤ t ≤ '.
A.I/M 53: 0)trict (onvexity1 Biven ( ≠ y, 0 ∈ X such that ( 0 and y 0, then t( : 0'!t1y φ 0
for all C ; t ; '.
• (onvexity implies that an agent prefers average to extremes.
• (onvexity is a generalization of the neoclassical assumption of /diminishing marginal
rates of substitution./
efore we move on the functional representation of the preference relation, we must emphasize
that the a preference relation is an ordinal, rather than cardinal, concept even though we have
=
x&
>0x', x&1 φ 0', '1?
'
' x'
attempted to incorporate additional structures by imposing some of the above assumptions.
2)2 6iliy 7uncions
$ utility function is a real!valued function u defined on the consumption set X such that preference
ran%ings are preserved by the magnitude of u. That is, a utility function u has the property that
given any two elements (, y in X, u0(1 ≥ u0y1 if and only if ( y.
ut not all preference relations can be represented by utility functions. $ rather general result is
that any continuous preference ordering can be represented by a continuous utility function. This
is a very difficult result to prove 09ebreu 0'FGF11. 0Aoreover, while any continuous ordering is
always representable, continuity is not necessary. The necessary and sufficient conditions for
representation is rather technical6 see ,g 'FHFIJ=, $pp. '.1 #e will focus on a somewhat simpler
result ! the one that can be proved constructively. The main ideas are:
• #e select arbitrary fixed line that cuts all of the indifference curves 0or surfaces1.
• 7nce utility is defined along this line, the utility of any other point is found by tracing
the appropriate indifference curve to the line and using the utility value there.
• The assumption of strong monotonicity guarantees that the indifference curves exit
and that any line of the form α e, α < C and e < 8, cuts them all.
*xistence of Ktility +unction s
• )uppose that a reference relation on X 3 R
m
:
is complete, reflexive, transitive, continuous, and
strongly monotone. Then there exists a continuous utility function u: R
m
:
→ R which
represents the preference relation.
-roof
8et e be the vector in R
m
:
consisting of all
ones. Then given any vector (, let
u0(1 3 α such that ( 5 αe)
#e now need to show that u0(1 is well!
defined, i.e., it exists and unique.
9efine the following two sets:
A 3 >α: α ≥ C, αe (?
B 3 >α: α ≥ C, ( αe?
L
x&
αe
x'
Then by strong monotonicity, A is nonempty. B is certainly nonempty since C ∈ B. oth A and B
are closed by the continuity assumption. 7n the other hand, by the completeness assumption, we
%now that every α 0≥ C1 must belong to A∪, that is, A∪ 3 R
2
.
,ote that if α
@
∈ A∩, then α
@
e 5 ( so that we can let u0(1 3 α
@
. Therefore, we need to prove that
A∩ is nonempty.
y monotonicity, it follows that α ∈ A implies that α' ∈ A for all α' ≥ α. )ince A is closed subset
of R
:
, it must be in a form of closed interval Mα
@
, :∞1, which implies that B 3 MC, α
@
N since B is a
nonempty closed set such that A∪ 3 R
2
.
#e now have to prove that the value α
@
must be unique. 8et α
'
e 5 ( and α
&
e 5 (. Then it is clear
that α
'
e 5 α
'
e 0transitivity property of /5/1. y strong monotonicity, it must be the case that α
'
9
α
&
)
8et us prove that the above!defined utility function actually represents the preference relation.
(onsider two bundles ( and y, and their associated utility levels u0(1 and u0y1, which by definition
satisfy u0(1e 5 ( and u0y1e 5 y. ,ow,
( y ⇔ u0(1e 5 ( y 5 u0y1e ⇔ u0(1e u0y1e ⇔ u0(1 ≥ u0y1.
Oere the last equivalence follows from strong monotonicity.
#e now prove the continuity of u0(1. )uppose that >(
i
?is a sequence with (
i
→ (. #e want to
prove that u0(
i
1 → u0(1. )uppose this is not true. Then there exists some ε < C and an infinite set of
i's such that u0(
i
1 < u0(1 : ε or an infinite set of i's such that u0(
i
1 ; u0(1 ! ε. 8et us assume the first
case. This implies that
(
i
5 u0(
i
1e u0(1e : εe 5 ( : εe
⇒ (
i
( : εe
7n the other hand, since (
i
→ (, it follows that for very large value of i in this infinite set, we must
have ( : εe < (
i
which implies that ( : εe φ (
i
by strong monotonicity. This leads to a
contradiction. 

-roperties of Ktility +unctions
Proposiion: 8et be represented by u: R
n
2
→ R. Then
0a1 u0(1 is strictly increasing ⇔ is strictly monotonic.
0b1 u0(1 is quasiconcave ⇔ is convex.
0c1 u0(1 is strictly quasiconcave ⇔ is strictly convex.
Proof: #e 2ust need to remind the following definition of 0strict1 quasiconcavity.
u0(1 is 0strictly1 quasiconcave ⇔ the set >(: u0(1 ≥ c? is 0strictly1 convex for all c.
2)% Indirec 6iliy 7uncions and :(pendiure 7uncions
&.=.' The (onsumer's Ktility!Aaximizing -roblem
In the basic problem of preference maximization, the set of affordable consumption plans for the
consumer is 2ust the set of all bundles that satisfy the budget constraint. 8et y be the fixed amount
of money available to a consumer and let p 3 0p
'
, P, p
m
1 be the price vectors of goods, ', P, m.
Then the consumer's problem is to solve the following optimization problem:
max u0(1
s.t. p⋅( ≤ y
( ∈ X
G
,otes:
• The ob2ective function is continuous. It is clear that the constraint set is compact
0closed and bounded1. Then by #eierstrass Theorem 0*xistence of *xtreme Qalues,
in 8ecture '1, the above optimization problem does have a global maximum.
Lemma: If the preference relation satisfies local nonsatiation, then the budget constraint must be
binding at the optimal choice of the consumption bundle.
Proof: )uppose that (1 is an optimal solution to the consumer's problem such that
p⋅(1 ; y
)ince p⋅( is a continuous function of (, it follows that there exists some ε < C such that
p⋅( ; y for all ( ∈ X: DD( ! (1DD ; ε
7n the other hand, according to local nonsatiation, for the given (1 and the above ε, there exist
some y in X with DDy ! (1DD ; ε such that y φ (1, which implies that u0y1 < u0(11. This contradicts to
the assumption that (1 is an optimal solution. Therefore the budget constraint be must binding at
(1. 
&.=.& Indirect Ktility +unction
Therefore, as a result of the above lemma, under the local nonsatiation assumption, a utility!
maximizing problem can be restated as:
v0p, y1 3 max u0(1
s.t. p⋅( 3 y
The function v0p, y1 that gives the answer to the consumer's problem is called indirect utility
function. The value of ( that solves this problem is called the consumer's demandable bundle: it
gives how much of each good the consumer desires at a given level of prices and income.
Proposiion: The indirect utility function has the following properties:
0a1 v0p, y1 is homogeneous of degree C in 0p, y16
0b1 v0p, y1 is nonincreasing in p and increasing in y.
0c1 v0p, y1 is quasi!convex with respect to p, that is, the set >p: v0p, y1 ≤ c? is convex for very
y < C and c.
Proof: -arts 0a1 and 0b1 are straightforward. 8et us prove 0c1. +or any real number c, suppose v0p
'
,
y1 ≤ c and v0p
&
, y1 ≤ c. Then for any t: C ; t ; ', let p 3 tp
'
: 0'!t1p
&
. 9efine C
i
3>(: p
i
⋅( ≤ y? for i
3 ' and &, C 3>(: p⋅( ≤ y?. #e claim that C ⊂ C
'
∪ C
&
. It suffices to show that C
c
⊃ 0C
'
∪ C
&
1
c
.
This is true since
( ∈ 0C
'
∪ C
&
1
c
⇒ p
'
⋅( < y and p
&
⋅( < y
⇒ p⋅( 3 tp
'
⋅( : 0'!t1p
&
⋅( < y ⇒ ( ∈ C
c
,ow, v0p, y1 3 max>u0(1: ( ∈ C?. 8et (1 be an optimal solution, then
(1 ∈ C
'
∪ C
&
⇒ u0(11 ≤ v0p
'
, y1 or u0(11 ≤ v0p
&
, y1
⇒ v0p, y1 3 u0(11 ≤ max0v0p
'
, y1, v0p
'
, y11 ≤ c.
Oence p ≡ tp
'
: 0'!t1p
&
∈ >p: v0p, y1 ≤ c?. 
*xample ' 0 Co--$Douglas 6iliy 7uncion 1:
. ,..., ' , C , 1 0
'
m i x x u
i
m
i
i
i
· > ·

·
α
α
R
Then the corresponding indirect utility function is
y
x y v
m
i
i
i
· ⋅
·

·
( p
p
sub2ect to
max 1 , 0
'
α
Then using the first!order conditions 0λ 3 8agrange multiplier1:
. ,..., ' , C
'
m i p x x
i
i j
j i i
j i
· · −



λ α
α α
Aultiplying x
i
leads to
. ,..., ' , C
'
m i x p x
i i
m
j
j i
j
· · −

·
λ α
α
)umming these equations over i and letting

·
·
m
i
i
'
α α , we get
∏ ∏
· ·
· ⇒ · ⋅ −
m
j
j
m
j
j
j j
x
y
x
' '
C
α α α
λ λ α ( p
which leads to
.
i
i
i
p
y
x
α
α
·
)o the indirect utility function is
∏ ∏
· ·

,
_

¸
¸

,
_

¸
¸
·

,
_

¸
¸
·
m
i i
i
m
i i
i
i i
p
y
p
y
y p v
' '
. 1 , 0
α
α
α
α
α α
α
It is interesting to see that this indirect utility function has the (obb!9ouglas form 0although with
negative coefficients for the prices1.
*xample & 0 Leonief 6iliy 7uncion 1

,
_

¸
¸
·
m
m
a
x
a
x
a
x
u , , , min 1 0
&
&
'
'
 ( .

8et a 3 0a
'
, a
&
, P, a
m
1 < 8. It is clear that 0a1
this is a case of perfect complements, which is
based on an ideal /composite commodity/ a.
The indirect utility function v0p, y1 is normally derived from solving the first!order conditions of
the consumer's utility maximization problem. ut the 8eontief utility function is non!
differentiable6 so we have to use direct argument in finding the maximum. +rom the above figure,
it is evident that the optimal solution is such that
a (
@ @
&
&
'
'
λ λ · ⇒ ≡ · · ·
m
m
a
x
a
x
a
x

H
x&
indifference curves
a& a
p
p⋅( 3 y 0budget line1
a& x'
Then it follows from the budget constraint that
. 1 , 0
@ @
a p
p a
a p
(
a p ⋅
· · ⇒

· ⇒

·
y
y v
y y
λ λ
&.=.= *xpenditure +unction
+or a given utility function, the expenditure function is defined as:
e0p, u1 3 min p⋅(
s.t. u0(1 ≥ u
( ∈ X)
Proposiion: The expenditure function e0p, u1 has the following properties:
0a1 it is homogeneous of degree ' in p6
0b1 it is nondecreasing in p and increasing in u6
0c1 it is concave in p.
Proof: )traightforward.
Proposiion: u is continuous, X 3 R
m
2
. (onsider
¹
'
¹
≤ ⋅
·
y t s
u y v
( p
( p
(
. .
1 0 max 1 , 0
0$1
¹
'
¹

⋅ ·
u u t s
u e
1 0 . .
min 1 , 0
(
( p p
(
01
Then,
0i1 $ssume that the preference relation satisfies local nonsatiation. If (
1
solves 0$1, then (
1
solves
01 with u 3 v0p, y1.
0ii1 $ssume that p⋅(1 < C. If (1 solves 01, then (1 also solves 0$1 with y 3 e0p, u1.
Proof:
0i1 )uppose (1 solves 0$1, but not 01:
⇒ ∃ ( such that p ( ; p (1 and u0(1 ≥ u ≡ v0p, y1.
8ocal nonsatiation ⇒ ∃ (
'
, near (, such that p (
'
≤ p (1 ≤ y and u0(
'
1 < u0(1 ≥ u.
⇒ (
'
is feasible to 0$1 and u0(
'
1 < v0p, y1, contradicting to the optimality of (
1
.
0ii1 )uppose (1 solves 01. 8et y 3 p (1 < C. #e want to show: if p ( ≤ y, then u0(1 ≤ u0(11.
(onsider such a ( and let (+ 3 α(, C ; α ; '. It is clear that p (+ ; y. Therefore, (+ is infeasible for
01, which implies that u0(+1 ; u0(11. Then by continuity of the utility function u, it follows that
@1 0 1 0 1 0 lim
'
( ( ( u u u ≤ ·

α
α
as required. 
Two Important Identities 09irect 4esults from the $bove -roposition1
0a1 e0p, v0p, y11 3 y.
0b1 v0p, e0p, u11 3 u.
• They together imply that the indirect utility function and the expenditure function are
J
somehow /equivalent/.
2)! Dualiy in Consumer Theory
Dualiy Theorem: $ssume that u is continuous, quasi!concave, and strongly monotone. 8et X 3
R
m
:
. Then
0a1 +or p < 8,
v0p, '1 3 max u0(1
s.t. p⋅( ≤ ' 0(1
( ∈ X)
0b1 +or ( < 8,
u0(1 3 min v0p, '1
s.t. p⋅( ≤ ' 091
p ≥ 8)
Proof. $s part 0a1 is definitional, it needs no proof. 8et us prove part 0b1. +or ease of presentation,
let U0(1 be the optimal value of the following optimization problem:
min v0p, '1
s.t. p⋅( ≤ '
p ≥ 8.
+irst, from part 0a1, it is clear that for any ( ; 8 and p < 8 such that p⋅( 3 ', it must be true that
u0(1 ≤ v0p, '1, which implies that
u0(1 ≤ U0(1.
#e now need to prove that u0(1 ≥ U0(1. To prove this, it suffices to show that for any given (
C
< 8,
there exists some p < C such that p⋅(
C
3 ' and u0(
C
1 3 v0p, '1.
9efine C 3 >(∈X: u0(1 ≥ u0(
C
1?. )ince the utility function u is continuous and quasiconcave, it
follows that C is closed and convex and (
C
is a boundary point of C.
<upporing =yperplane Theorem 098, p.LG= . p.LGG1 8et C be a convex set and let (
C
be a
boundary point of C. Then there is a hyperplane H 3>(: a⋅( 3 a⋅(
C
? 0a ≠ 81 containing (
C
and
containing C in one of its closed half spaces, i.e., either
0 ∈ H
:
≡ >(: a⋅( ≥ a⋅ (
C
?, for all 0 ∈ C 0positive closed half!space1
or,
0 ∈ H
!
≡ >(: a⋅( ≤ a⋅ (
C
?, for all 0 ∈ C 0negative closed half!space1.
+urthermore, if C is monotonic, i.e., C : R
m
:
3 C, then a is a nonnegative vector and C must be in
the positive closed half!space, i.e., a⋅0 ≥ a⋅(
C
for all 0 ∈ C.
+rom the definition of C and from the strong monotonicity of u, we %now that C is indeed
monotonic. ,ow applying the above theorem to your problem, we %now that there exists some
nonzero p ≥ 8 such that
p⋅( ≥ p⋅(
C
, for all ( ∈ C.
)ince (
C
< 8, we can ma%e p⋅(
C
3 ' by properly scaling p. Therefore, (
C
solves the expenditure
problem 01 with u 3 u0(
C
1. y the previous -roposition, (
C
must solve the indirect utility problem
0$1 with v0p, '1 3 u0(
C
1. This proves the result.
F