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You are on page 1of 22

Lecture 5, September 12

Outline

1 Properties of Walrasian Demand

2 Indirect Utility Function

3 Envelope Theorem

Summary of Constrained Optimization

gi (x) 0

When x is solves max f (x) subject to then

i = 1; ::; m

m

X

rL (x ; ) = rf (x ) i rgi (x ) = 0

i =1

and gi (x ) 0, i 0, and i gi (x ) = 0 for i = 1; :::; m.

Important details:

If the better than set or the constraint sets are not convex: big trouble.

If functions are not dierentiable: small trouble.

If the geometry still works we can nd a more general theorem (see convex

analysis).

When does this fail?

If the constraint qualication condition fails.

If the objective function is not quasi concave.

This means you must check the second order conditions when in doubt.

Walrasian Demand

Denition

Given a utility function u : Rn+ ! R, the Walrasian demand correspondence

x : Rn++ R+ ! Rn+ is dened by

x (p; w ) = arg max u(x) where B(p; w ) = fx 2 Rn+ : p x w g:

x2B p;w

When the utility function is quasi-concave and dierentiable, the First Order

Conditions for utility maximization say:

utility budget X non negativity

r( ) budget r( ) non negativity r( )=0

function constraint constraint constraints constraints

So, at a solution x 2 x (p; w ):

@L (x ) @u (x )

= w xi + i = 0 for all i = 1; ::; n

@xi @xi

Marginal Rate of Substitution

consumed in strictly positive amounts.

Then, the corresponding non-negativity constraints hold and the correspoding

multipliers equal 0.

At such a solution x , the rst order condition is:

@u (x )

= w pi for all i such that xi > 0

@xi

@u(x )

@xj pj

@u(x )

= for any j; k such that xj ; xk > 0

pk

@xk

This is the familiar condition about equalizing marginal rates of substituitons

to price ratios.

Marginal Utility Per Dollar Spent

At an optimal consumption bundle x where some goods are consumed in

strictly positive amounts, the rst order condition is:

@u (x )

= w pi for all i such that xi > 0

@xi

@u(x ) @u(x )

@xj @xk

= for any j; k such that xj ; xk > 0

pj pk

the marginal utility per dollar spent must be equal across goods.

@u (x ) @u (x )

If not, there are j and k for which @xj

< pkk

@x

pj

DM can buy p"j less of j, and p"k more of k, so the budget constraint still holds,

and

by Taylors theorem, the utility at the new choice is 0 1

@u (x ) @u (x )

@u (x ) " @u (x ) " B @xk @xj C

u (x )+ + +o (") = u (x )+" @ A+o (")

@xj pj @xk pk pk pj

Think about the case in which some goods are consumed in zero amount.

Demand and Indirect Utility Function

The Walrasian demand correspondence x : Rn++ R+ ! Rn+ is dened by

x (p; w ) = arg max u(x) where B(p; w ) = fx 2 Rn+ : p x w g:

x2B (p;w )

Denition

Given a continuous utility function u : Rn+ ! R, the indirect utility function

v : Rn++ R+ ! R is dened by

v (p; w ) = u(x ) where x 2 x (p; w ):

objective function as the parameters (prices and wages) change and the

consumer adjusts her optimal consumption accordingly.

Results

The Walrasian demand correspondence is upper hemi continuous

To prove this we need properties that characterize continuity for

correspondences.

The indirect utility function is continuous.

To prove this we need properties that characterize continuity for

correspondences.

Berges Theorem of the Maximum

The theorem of the maximum lets us establish the previous two results.

If f : X ! R is a continuous function and ' : Q ! X is a continuous

correspondence with nonempty and compact values, then

the mapping x : Q ! X dened by

x (q) = arg max f (x)

x 2'(q)

is an upper hemicontinuous correspondence and

the mapping v : Q ! R dened by

v (q) = max f (x)

x 2'(q)

is a continuous function.

problem only through the constraints, and do not directly enter the objective

function.

This happens in the consumers problem: prices and income do not enter the

utility function, they only aect the budget set.

Properties of Walrasian Demand

Proposition

If u(x) is continuous, then x (p; w ) is upper hemicontinuous and v (p; w ) is

continuous.

Proof.

Apply Berges Theorem:

If u : Rn+ ! R a continuous function and B (p; w ) : Rn++ R+ ! Rn+ is a

continuous correspondence with nonempty and compact values. Then:

(i): x : Rn++ R+ ! Rn+ dened by x (p; w ) = arg maxx 2B (p;w ) u(x) is an upper

hemicontinuous correspondence and

(ii): v : Rn++ R+ ! R dened by v (p; w ) = maxx 2B (p;w ) u(x) is a continuous

function.

We need continuity of the correspondence from price-wage pairs to budget

sets.

We must show that B : Rn++ R+ ! Rn+ dened by

B (p; w ) = fx 2 Rn+ : p x w g

is continuous and we are done.

Continuity for Correspondences

Denition

A correspondence ' : X ! Y is

upper hemicontinuous at x 2 X if for any neighborhood V Y containing

'(x), there exists a neighborhood U X of x such that '(x 0 ) V for all

x 0 2 U.

lower hemicontinuous at x 2 X if for any neighborhood V Y such that

'(x) \ V 6= ;, there exists a neighborhood U X of x such that

'(x 0 ) \ V 6= ; for all x 0 2 U.

A correspondence is upper (lower) hemicontinuous if it is upper (lower)

hemicontinuous for all x 2 X .

A correspondence is continuous if it is both upper and lower hemicontinuous.

Conditions for Continuity (from Math Camp)

Proposition (A)

Suppose X Rm and Y Rn . A compact-valued correspondence ' : X ! Y is

upper hemicontinuous if, and only if, for any domain sequence xj ! x and

corresponding range sequence yj such that yj 2 '(xj ), there exists a convergent

subsequence fyjk g such that lim yjk 2 '(x).

Proposition (B)

Suppose A Rm , B Rn , and ' : A ! B. Then ' is lower hemicontinuous if, and

only if, for all fxm g 2 A such that xm ! x 2 A and y 2 '(x), there exist

ym 2 '(xm ) such that ym ! y .

Continuity for Correspondences: Examples

Exercise

Suppose ' : R ! R is dened by:

f1g if x < 1

'(x) = :

[0; 2] if x 1

Prove that ' is upper hemicontinuous, but not lower hemicontinuous.

Exercise

Suppose ' : R ! R is dened by:

f1g if x 1

'(x) = :

[0; 2] if x > 1

Prove that ' is lower hemicontinuous, but not upper hemicontinuous.

Continuity of the Budget Set Correspondence

Show that the correspondence from price-wage pairs to budget sets,

B : Rn++ R+ ! Rn+ dened by

B(p; w ) = fx 2 Rn+ : p x wg

is continuous.

Then show that B(p; w ) is lower hemi continuous.

In both cases, use the propositions in the previous slide (and

Bolzano-Weierstrass).

There was a very very similar problem in math camp.

Properties of Walrasian Demand

Denitions

Given a utility function u : Rn+ ! R, the Walrasian demand correspondence

x : Rn++ R+ ! Rn+ is dened by

x (p; w ) = arg max u(x) where Bp;w = fx 2 Rn+ : p x w g:

x 2B p;w

and the indirect utility function v : Rn++ R+ ! R is dened by

v (p; w ) = u(x (p; w )) where x (p; w ) 2 arg max u(x):

x 2B p;w

if u is continuous, then x (p; w ) is nonempty and compact.

x (p; w ) is homogeneous of degree zero: for any > 0, x ( p; w ) = x (p; w )

if u represents a locally nonsatiated %, then p x = w for any x 2 x (p; w ).

if u is quasiconcave, then x (p; w ) is convex.

if u is strictly quasiconcave, then x (p; w ) is unique.

If u(x ) is continuous, then x (p; w ) is upper hemicontinuous and v (p; w ) is

continuous.

Next, comparative statics: How does Walrasian Demand change as income

and/or (some) prices change?

Implicit Function Theorem

This is the main tool to perform comparative static analysis (also with constraints)

Same as math camp.

Suppose A is an open set in Rn+m and f : A ! Rn is continuously dierentiable.

Let Dx f be the n n derivative matrix of f with respect to its rst n arguments.

If f (x; q) = 0n and Dx f (x; q) is nonsingular, then there exists a neighborhood B of

q in Rm and a unique continuously dierentiable g : B ! Rn such that

g (q) = x and f (g (q); q) = 0n for all q 2 B

Moreover,

1

Dq g (q) = [Dx f (x; q)] Dq f (x; q):

@fi

Notation: (Dx f )ij = @xj

(dierentiable) function.

We use this in the consumers utility maximization problem by setting f ( ) to

be the FOC for utility maximization;

then g ( ) is the Walrasian demand, and q is a price vector and income.

Bordered Hessian

Denition

Let m = fi : xi (p; w ) > 0g and reindex Rn so these m dimensions come rst. The

bordered Hessian H of u with respect to its rst m dimensions is

2 3

0 u1 u2 um

6 u1 u11 u21 um1 7

6 7 where ui = @u

0 (Dx u)> 6 u2 u12 u22 u 7 @xi

H= 2 = 6 m2 7 ,

@2 u

Dx u Dxx u 6 .. .. .. . . 7 and u ij =

4 . . . .. .. 5 @xi @xj

This only considers demand functions which are not zero and then takes rst

and second derivatives of the utility function with respect to those goods.

Dierentiability of Walrasian Demand

Proposition

Suppose u is twice continuously dierentiable, locally nonsatiated, strictly

quasiconcave, and that there exists " > 0 such that xi (p; w ) > 0 if and only if

xi (p; w ) > 0, for all (p; w ) such that k(p; w ) (p; w )k < ".a If H is nonsingular at

(p; w ), then x (p; w ) is continuously dierentiable at (p; w ).

a This condition is automatically satised if xi > 0 for all i , by continuity of x .

Proof.

Question 2, Problem Set 3.

have axioms on % that deliver a continuously dierentiable utility.

We also assume demand is strictly positive (locally), but this is the very object

we want to characterize.

This is bad math.

Proof.

We want to use the Implicit Funtion Theorem. Things we know right away:

u is strictly quasiconcave ) x is a function.

u is continuously dierentiable ) the rst order conditions are well dened.

u is locally nonsatiated ) the budget constraint binds.

x is strictly positive in the rst m commodities ) ignore corresponding

nonnegativity constraints.

It now su ces to show that x is dierentiable in the rst m prices, and w ,

and ignore the last n m commodities.a

The remainder of the proof uses IFT to show that x is dierentiable as

desired;

Fill in the details.

a There is a neighborhood of (p; w ) where consumption is zero for the last n m commodities,

and these constant dimensions will have no eect on the dierentiability of x .

Comparative Statics

Without constraints this is the same as math camp

Problem

Let : Rn Rm ! R, written (x; q); DM chooses x to maximize ; while q are

parameters she does not control.

Comparative Statics

We want to know how DM adjusts her optimal choice x (q) when the parameters

q change. What is the derivative of x (q)?

Theorem gives the answer.

Envelope Theorem Without Constraints

Dene: x (q) = arg max (x; q): The maximizer solves the rst order condition:

f (x; q) = Dx (x; q) = 0>

n : The Jacobian of f is Dx f (x; q) = Dxx (x; q) , and is

nonsingular (why?).

By IFT: x (q) is continuously dierentiable close to a solution x (q); q, and:

1 1

Dq x (q) = [Dx f (x (q); q)] Dq f (x (q); q) = [Dxx (x (q); q)] Dqx (x (q); q)

| {z }| {z }

n n n m

=0

z }| {

Dq (x (q); q) = Dq (x; q)j q=q + Dx (x; q)j q=q Dq x (q) = Dq (x; q)j q=q

x=x (q) x=x (q) x=x (q)

the second order eect of how the maximizer x responds to q is irrelevant; only

the rst order eect of how q changes the objective function evaluated at the

xed maximizer x (q) matters. This observation is sometimes called the Envelope

Theorem.

@2

@x @q@x

If x and q are scalars, Dq x (q) becomes @q = @2

@x 2

Comparative Statics With Constraints

There are k equality constraints, Fi (x; q) = 0 with each Fi smooth.

x (q) = arg max (x; q)

F (x;q)=0k

>

L( ; x; q) = (x; q) F (x; q):

The derivative of the Lagrangian is:

0 1

1 k

z }| {

B F (x; q) C

B C

B C

f ( ; x; q) D( ;x) L( ; x; q) = B C

| {z } B > C

@Dx (x; q) D F (x;

|{z} | {z }A

x q)

1 (k +n) | {z }

1 n 1 k k n

We can now use IFT on the FOC f ( ; x ; q) = 0>

k +n (it works because the

Jacobian is non singular).

Comparative Statics With Constraints

By IFT, x and are implicit functions of q in a neighborhood of q, and

1

Dq ( (q); x (q)) = D( ;x ) f ( ; x ; q) Dq f ( ; x ; q)

We know f is the derivative of the Lagrangian:

F (x; q)

f ( ; x ; q) = >

Dx (x; q) Dx F (x; q)

So, we can gure out that

0 1

k k k n

z}|{ z }| {

B C

B 0 Dx F (x ; q) C

B C

D( ;x) f ( ; x ; q) = B C

| {z } B D F (x ; q)> D 2 (x ; q) D [ > D F (x ; q)]C

@ x x x A

(k +n) (k +n) | {z } | xx {z }

n k n n

and 0 1

k m

z }| {

B Dq F (x (q); q) C

B C

B C

Dq f ( ; x ; q) = B C

| {z } BD 2 (x ; q) > C

Dq ( Dx F (x ; q)> )A

@ qx

(k +n) m | {z } | {z }

n m n m

Envelope Theorem With Constraints

Now we can gure out the change in the objective function.

Using the Chain Rule, the change of (q) = (x (q); q) is:

Dq (x (q); q) = Dq (x; q)jq=q, x=x (q) + Dx (x; q)jq=q, x=x (q) Dq x (q)

Dx F (x; q)Dq x (q) =Dq F (x; q)

>

From FOC we get Dx (x; q) = Dx F (x; q)

Thus,

> >

Dx (x; q)jq=q, x=x (q) Dq x (q) = Dx F (x; q)Dq x (q) = Dq F (x; q)

Then, the change in the objective function due to a change in q is:

>

Dq (x (q); q) = Dq (x; q)jq=q;x=x (q) ( (q)) Dq F (x; q)jq=q;x=x (q)

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