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Introduction

The consumer problem


Duality

Advanced Microeconomics
Consumer theory: optimization and duality

Jan Hagemejer

October 25, 2011

Jan Hagemejer Advanced Microeconomics


Introduction
The consumer problem Introduction
Duality

Introduction

The plan:

1 The utility maximization


2 The expenditure minimization
3 Duality of the consumer problem
4 Some examples

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The consumer problem

In general, the consumer problem can be state as:

choose the best bundle that the consumer can aord

or: choose a bundle x  y for x and any y 's in the budget set B ,
given prices p and wealth w
or: if we have a utility function representing , maximize utility
subject to the budget constraint (given by p and w ).
the correspondence between prices p , wealth w and the consumer
chosen bundle is the demand correspondence.

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The utility maximization problem (UMP)

We will asume that the consumer has a rational, continuous and


locally nonsatiated preference relation.

u (x ) is a continuous utility function representing consumer


preferences

the consumption set is X = RL+


The utility maximization problem is dened as:

Maxx 0 u (x )
subject to px w
If u (x ) is well behaved, then this problem has a solution x (p, w )
which is the so-called Walrasian demand correspondence

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The UMP (for interior solution)

The UMP is usually set up as a Kuhn-Tucker sort of problem.

Let us write down the Lagrange function:

L = u (x ) (p x w )

The rst order conditions for an interior solution:

u (x )
x1 p1 0
. u (x )
.
= ppl
x
.
u (x )
which gives (if interior solution) l
u (x ) for all l, k
pL 0 x k
k
xL
px w 0
and hence: MRSlk = ppkl

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Marginal rate of substitution

Let's totally dierentiate u = u (x ) for a zero change in utility:


L
u (x )
du = 0 =
X
xl
l =1

Lets assume that dxl 6= 0 and dxk 6= 0 and all other dxn = 0:
u (x ) u (x )
0 = dxl + dxk
xl xk
Rearrange:
u (x )
dxl xl
= = MRSlk
dxk u (x )
xk

So at the optimal choice the ratio in which the consumer is willing


to give away l for k is equal to the ratio of prices.

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The UMP

The KT procedure says that either =0 or the budget constraint is


binding (which is usually the case).

Also, we might have xl = 0 and it that case the relevant FOC is


u (x )
satisied with inequality, i.e.
xl < pL (corner solution)

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The UMP with corner solutions

If we suspect there may be corner solutions xl = 0 for some l , then we


need to set up the full Kuhn-Tucker problem with:
Pl
The budget constraint l =1 pl xl w with the Lagrange multiplier
0
L inequality constraints xl 0 with the L Lagrange multipilers l
l l
L = u (x ) 0 ( p l xl w ) + l (xl )
X X

l =1 l =1

Then for the inequality constraints it is either (l =0 and xl > 0) or


(l >0 and xl = 0). You have to check all the combinations!
PL
Example: For the utility function u (x ) = l =1 al xl , l = 2, nd the
demand function.

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The UMP with corner solutions

l l
L = a1 x1 + a2 x2 0 ( pl xl w ) + l (xl )
X X

l =1 l =1

FOC's are:
[x1 ] a1 0 p1 + 1 = 0
[x2 ] a2 0 p2 + 2 = 0
[0 ] p1 x1 + p2 x2 w 0, 0, (w p1 x1 p2 x2 ) = 0,
[1 ] x1 0, 1 0, 1 x1 = 0
[2 ] x2 0, 2 0, 2 x2 = 0
Case 1: 0 > 0, and all l = 0, therefore all xl > 0 (interior solution)
a a
from rst 2 FOCs we have: 1 = 0 and 2 = 0 1 / 1 = 2 / 2 or
p1 p2 a p a p
p1 a1 a1 a2
p2 = a2 or better p1 = p2 (the expenditures on one unit of MU are
equal).

Only at that price ratio demand is a correspondence: p1 x1 + p2 x2 = w .


All other cases are corner solutions.

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The UMP with corner solutions

Case 2:

0 > 0, and 1 > 0, 2 = 0 therefore x1 = 0 and x2 > 0 (corner solution)


The FOC's become:

p2 x2 = w and therefore x2 = pw2 .


a2 0 p2 = 0 and a1 0 p1 + 1 = 0 pa11 = 0 p11 < 0 = pa22 , so
a1 a2
p1 < p2
Case 3:

0 > 0, and 1 = 0, 2 > 0 therefore x1 > 0 and x2 = 0 (corner solution)


The FOC's become:

p1 x1 = w and therefore x1 = pw1 .


a1 0 p1 = 0 and a2 0 p2 + 2 = 0 pa22 = 0 p22 < 0 = pa11 , so
a2 a1
p2 < p1

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The demand correspondence

In our problem the nal demand is:

x1 = p1 , x2 = 0.
w a1 a2

if
p1 > p2
x (p) = x1 , x2 : p1 x1 + p2 x2 = w if
p1 a1
p2 = a2

x2 = pw2 , x1 = 0 if
a1 a2
p1 < p2

As long as the bang for the buck is equal, we have the interior solution,
otherwise only corner solutions.

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Walrasian demand correspondence

The Walrasian demand correspondence x (p, w ) assigns a set of chosen


consumption bundles for each price-wealth pair (p , w )
It can be multi-valued. If single valued we call it a demand function

Under the conditions of continuity and representation of u (x ) the


Walrasian demand correspondence possesses the following properties:

1 Homogeneity of degree zero in (p , w )


2 Walras law: px =w (the budget constraint is binding)
3 Convexity/uniqueness: if  is convex, so that u () is quasiconcave,

then x (p , w ) is a convex set.

if  is strictly convex, so that u () is strictly quasiconcave, then

x (p , w ) has just one element.

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Walrasian demand correspondence

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Properties of Walrasian demand


Wealth eects given the vector of prices p on the demand for good
xl (p ,w )
l , partial derivative: w .
In matrix notation:
x1 (p ,w )

w
.
.
.

Dw x (p, w ) = xl (p ,w )


w

.

.
.
xL (p ,w )
w
xl (p ,w )
w > 0, good is normal, if all > 0 then demand is normal
xl (p ,w )
w < 0, good is inferior.
Demand as a function of wealth x (p w
, ), Engel function
Wealth expansion path: Ep = {x (p, w ) : w > 0}
Income elasticity of demand: w = x(pw,w ) x (pw,w ) , necessity <1,

luxury >1

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Wealth eects

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Price eects

We can measure the eects of prices on the demand for goods.


xl (p ,w )
The price eect is dened as:
pk and usually > 0. If <0 then

so-called Gien good.

In matrix notation

x1 (p ,w ) x1 (p ,w )

p1 pL
Dp x (p, w ) = . ..

. .
.


xL (p ,w ) xL (p ,w )
p1 ... pL

In that context we can dene the own- and cross-price elasticity of


xl (p ,w ) pl xl (p ,w ) pl
demand
pl xl (p ,w ) and pk xk (p ,w ) where k 6= l

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Demand for good as a function of own price

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Oer curve
OC - a locus of points demanded in over all possible values of one of the
prices (in R2 ).

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The Gien good

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The indirect utility function

Once we have the optimal choice, x (p, w ) we can plug it back into
the utility function.

u (x (p, w )) = v (p, w ) is the indirect utility function


it says what the level of utility is, given prices and wealth and utility
maximization

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

What for?

for example we can nd the or the relationship wealth


levels of prices that generate and utility at xed prices
same utility given wealth

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Expenditure minimization

We can go back and redene our problem.

Instead of UMP, let us think of the consumer that has a desired level
of utility.

He wants to obtain this level of utility at the lowest possible


expenditure.

the analogy of the production level and the cost minimization is

obvious

The problem is set up as follows:

minx 0 px subject to u (x ) u
The solution is h(p, u ), the demand for goods given prices and
utility, the so called Hicksian demand (contrast it to x (p, w )).

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

The expenditure function

Once we have the solution to the problem, we can calculate the actual
expenditure:

L
e (p , u ) = pl h(p, u )
X

l =1

It is the cost of generating/obtaining a level of utility u given the set of


prices.

Why is it useful?

given the prices it determines a one-to-one relationship between

money/expenditure and utility

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Expenditure minimization

Jan Hagemejer Advanced Microeconomics


Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Hicksian demand and eects of a price change

Jan Hagemejer Advanced Microeconomics


Introduction
The consumer problem
Duality

Duality of the consumer problem

The two problems can be related to each other:

1 x (p, w ) = h(p, v (p, w ))


2 x (p, e (p, u )) = h(p, u )
3 e (p, v (p, w )) = w
4 v (p, e (p, u )) = u

Jan Hagemejer Advanced Microeconomics


Introduction
The consumer problem
Duality

Some more nice properties

To recover Hicksian demand from expenditure function

If u () is a continuous utility function. For all p and u the Hicksian

demand h(p , u ) is the derivative vector of the expenditure function

with respect to prices.

h (p , u ) = p e (p , u )

To recover Walrasian demand from indirect utility function (Roy's

identity - check for assumptions):

1
x (p , w ) = p v (p , w )
w v (p , w )

Jan Hagemejer Advanced Microeconomics


Introduction
The consumer problem
Duality

The Slutsky Equation

Suppose that u () is a continuous utility function representing a locally


nonsatiated and strictly convex preference relation  dened on the
consumption set X = RL+ . Then for all (p , w ), and u = v (p, w ), we have
hl ( p , u ) xl (p , w ) xl (p , w )
= + xk (p, w )
pk pk w

and we can also rewrite it as:

hl (p , u ) xl ( p , w ) x (p , w )
xk ( p , w ) = l
p w pk
| {zk } | {z }
Substitution eect Income eect

Jan Hagemejer Advanced Microeconomics


Introduction
The consumer problem
Duality

Recap

Jan Hagemejer Advanced Microeconomics