ECO 305 — FALL 2003 — September 25

INDIRECT UTILITY FUNCTION

U ∗ (Px , Py , M ) = max { U (x, y) | Px x + Py y ≤ M }

= U (x∗ , y ∗ )
= U (Dx (Px , Py , M), Dy (Px , Py , M ) )

PROPERTIES OF U ∗ :
(1) No money illusion — Homogeneous degree zero:

U ∗ (k Px , k Py , kM ) = U ∗ (Px , Py , M )

(2) As money income changes:

¯ ¯
∂U ∗
∂U ¯¯ ∂x ∗
∂U ¯¯ ∂y ∗
= ¯ + ¯
∂M ∂x ¯∗ ∂M ∂y ¯ ∗
∂M
" #
∗ ∗
∂x ∂y
= λ Px + Py
∂M ∂M
∂M
= λ =λ
∂M
(3) As price changes:
¯ ¯
∂U ∗
∂U ¯¯ ∂x ∗
∂U ¯¯ ∂y ∗
= ¯ + ¯
∂Px ∂x ¯ ∗
∂Px ∂y ¯∗
∂Px

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 " #
∗ ∗
∂x ∂y
= λ Px + Py
∂Px ∂Px
= −λ x∗ (just like M ↓ by x∗ )

(Last step: differentiate adding-up identity w.r.t. Px :

Px x∗ + Py y∗ = M

∗ ∂x∗ ∂y ∗
x + Px + Py =0)
∂Px ∂Px
Divide price- and income-change equations :

∗∂U ∗ /∂Px
Roy’s Identity: x = −
∂U ∗ /∂M
(4) Contours of U ∗ in (Px , Py ) space with M fixed:

(Like theater with stage at NE corner)

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 EXPENDITURE FUNCTION
Solve the indirect utility function for income:
u = U ∗ (Px , Py , M) ⇐⇒ M = M ∗ (Px , Py , u)
M ∗ (Px , Py , u) = min { Px x + Py y | U (x, y) ≥ u }
“Dual” or mirror image of utility maximization problem.
Economics — income compensation for price changes
Optimum quantities — Compensated or Hicksian demands
x∗ = DxH (Px , Py , u) , y ∗ = DyH (Px , Py , u)

PROPERTIES OF M ∗ :
(1) Homogeneous degree 1 in (Px , Py ) holding u fixed:
M ∗ (k Px , k Py , u) = k M ∗ (Px , Py , u)
(2) Hotelling’s or Shepherd’s Lemma —
Compensated demands partial derivatives w.r.t. prices:
DxH (Px , Py , u) = ∂M ∗ /∂Px , DyH (Px , Py , u) = ∂M ∗ /∂Py
Proof: M ∗ = Px DxH + Py DyH , u = U (DxH , DyH ). So
∂M ∗ /∂Px = DxH + Px ∂DxH /∂Px + Py ∂DyH /∂Px
0 = Ux ∂DxH /∂Px + Uy ∂DyH /∂Px
= λ [ Px ∂DxH /∂Px + Py ∂DyH /∂Px ]

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 (3) “Weakly” concave in (Px , Py ) holding u fixed.
Cobb-Douglas example: (Px )1/3 (Py )2/3

PROPERTIES OF HICKSIAN DEMAND FUNCTIONS:

(1) Own substitution effect negative:
¯
∂x ¯¯ ∂DxH ∂ 2M ∗
¯ = = ≤0
∂Px ¯
u=const
∂P x ∂P 2
x

(2) Symmetry of cross-price effects:

∂DxH ∂ 2M ∗ ∂DyH
= =
∂Py ∂Px ∂Py ∂Px
(Net) substitutes if > 0, complements if < 0
General concept : Comparative statics

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 COBB-DOUGLAS EXAMPLE
(Direct) UTILITY FUNCTION:

U (x, y) = α ln(x) + β ln(y), α+β =1

x∗ = α M/Px , y ∗ = β M/Py
INDIRECT UTILITY FUNCTION

U ∗ (Px , Py , M) = α [ln(α) + ln(M) − ln(Px ) ]

+β [ln(β) + ln(M ) − ln(Py ) ]
= junk + ln(M ) − α ln(Px ) − β ln(Py )

Roy’s Identity:

∂U ∗ /∂Px − α/Px αM ∗
− = − = = x
∂U ∗ /∂M 1/M Px

EXPENDITURE FUNCTION

M ∗ = M ∗ (Px , Py , u) = eu (Px )α (Py )β

Hicksian demand functions

xH = α eu (Px )α−1 (Py )β , y H = β eu (Px )α (Py )β−1

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 SLUTSKY EQUATION
Link between Marshallian and Hicksian demands
Equal if u = U ∗ (Px , Py , M ), M = M ∗ (Px , Py , u).
For good i where i may be either x or y,

DiH (Px , Py , u) = DiM (Px , Py , M ∗ (Px , Py , u) )

Now let Pj change, where j may be x or y

∂DiH ∂DiM ∂DiM ∂M ∗

= +
∂Pj ∂Pj ∂M ∂Pj
∂DiM ∂DiM H
= + Dj
∂Pj ∂M
∂DiM ∂DiM M
= + Dj
∂Pj ∂M

For example
¯ ¯
∂x ¯¯ ∂x ¯¯ ∂x
¯ = ¯ +y
∂Py ¯ u=const
∂Py ¯ M =const
∂M

Price derivative of compensated demand =

Price derivative of uncompensated demand
+ Income effect of compensation.
If i = j, LHS is negative. Then Giffen implies Inferior