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# Introduction

## The consumer problem

Duality

Consumer theory: optimization and duality

Jan Hagemejer

## 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

## choose the best bundle that the consumer can aord

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

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

locally nonsatiated preference relation.

preferences

## the consumption set is X = RL+

The utility maximization problem is dened 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

## 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

## Let's totally dierentiate 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 )
satisied with inequality, i.e.
xl < pL (corner solution)

## Jan Hagemejer Advanced Microeconomics

Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

## 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

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

## 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

## 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,

## Jan Hagemejer Advanced Microeconomics

Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

## Jan Hagemejer Advanced Microeconomics

Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

## Properties of Walrasian demand

Wealth eects 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 eects

## Jan Hagemejer Advanced Microeconomics

Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Price eects

## We can measure the eects of prices on the demand for goods.

xl (p ,w )
The price eect is dened as:
pk and usually > 0. If <0 then

## so-called Gien 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 dene 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

## Jan Hagemejer Advanced Microeconomics

Introduction The UMP
The consumer problem Walrasian demand
Duality The EMP

Oer 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

## 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 redene our problem.

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

expenditure.

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?

## 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

## Jan Hagemejer Advanced Microeconomics

Introduction
The consumer problem
Duality

## 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

## with respect to prices.

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

## 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

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

nonsatiated and strictly convex preference relation  dened 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 eect Income eect

## Jan Hagemejer Advanced Microeconomics

Introduction
The consumer problem
Duality

Recap