LECON2111: Advanced microeconomics I

Lecture 2

Amma Panin

26 September 2022
Last lecture

• Introduction to the course

Last lecture

• Introduction to the course

• Remember the goal of this section: how can we model

individual agents’ decisions?
Last lecture

• Introduction to the course

• Remember the goal of this section: how can we model

individual agents’ decisions?
• Examined preference relations
Last lecture

• Introduction to the course

• Remember the goal of this section: how can we model

individual agents’ decisions?
• Examined preference relations
▶ ≿ “x is as good as y”
Last lecture

• Introduction to the course

• Remember the goal of this section: how can we model

individual agents’ decisions?
• Examined preference relations
▶ ≿ “x is as good as y”
▶ Rationality: completeness and transitivity
Last lecture

• Introduction to the course

• Remember the goal of this section: how can we model

individual agents’ decisions?
• Examined preference relations
▶ ≿ “x is as good as y”
▶ Rationality: completeness and transitivity

• Utility functions - a mapping from preferences to R

Last lecture

• Introduction to the course

• Remember the goal of this section: how can we model

individual agents’ decisions?
• Examined preference relations
▶ ≿ “x is as good as y”
▶ Rationality: completeness and transitivity

• Utility functions - a mapping from preferences to R

• Announcement about tutorial + Questions?

Tutorial sessions
Today

• Prove Proposition 1.B.2: ≿ can be represented by a utility

funciton only if ≿ is rational
Today

• Prove Proposition 1.B.2: ≿ can be represented by a utility

funciton only if ≿ is rational
• Introduce some elements of consumer demand
Today

• Prove Proposition 1.B.2: ≿ can be represented by a utility

funciton only if ≿ is rational
• Introduce some elements of consumer demand
▶ Consumption sets, prices, budgets
Today

• Prove Proposition 1.B.2: ≿ can be represented by a utility

funciton only if ≿ is rational
• Introduce some elements of consumer demand
▶ Consumption sets, prices, budgets

• What is it all good for? We can start modelling how

consumers make choices under constraints
A utility function maps from prefrences to real numbers

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )

Proposition (1.B.2)
A preference relation ≿ can be represented by a utility function
only if the preference relation is rational
Only rational preference relations can be represented by
utility functions

Steps towards the proof

• Define all your terms
• What does it mean for a preference relation to be represented
by a utility function?
Only rational preference relations can be represented by
utility functions

Steps towards the proof

• Define all your terms
• What does it mean for a preference relation to be represented
by a utility function?

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )
Only rational preference relations can be represented by
utility functions, Pg 2

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )

Two things to show

i If u(.) represents ≿ then for all x, y , ∈ X , either x ≿ y or
y ≿ x or both
ii If u(.) represents ≿ then for all x, y , z ∈ X , if x ≿ y and
y ≿ z then x ≿ z
Only rational preference relations can be represented by
utility functions, Pg 2

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )

Two things to show

i If u(.) represents ≿ then for all x, y , ∈ X , either x ≿ y or
y ≿ x or both
ii If u(.) represents ≿ then for all x, y , z ∈ X , if x ≿ y and
y ≿ z then x ≿ z
Why these two things?
Only rational preference relations can be represented by
utility functions, Pg 3

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )

Proof
i If u(.) represents ≿ then for all x, y , ∈ X , we have u(x) and
u(y ). Since u(x) and u(y) are real numbers, we will either
have u(x) ≥ u(y ) or u(y ) ≥ u(x) or both
Only rational preference relations can be represented by
utility functions, Pg 3

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )

Proof
i If u(.) represents ≿ then for all x, y , ∈ X , we have u(x) and
u(y ). Since u(x) and u(y) are real numbers, we will either
have u(x) ≥ u(y ) or u(y ) ≥ u(x) or both
ii If u(.) represents ≿ then for all x, y , z ∈ X , if x ≿ y , then we
have u(x) ≥ u(y )
Only rational preference relations can be represented by
utility functions, Pg 3

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )

Proof
i If u(.) represents ≿ then for all x, y , ∈ X , we have u(x) and
u(y ). Since u(x) and u(y) are real numbers, we will either
have u(x) ≥ u(y ) or u(y ) ≥ u(x) or both
ii If u(.) represents ≿ then for all x, y , z ∈ X , if x ≿ y , then we
have u(x) ≥ u(y ) and if y ≿ z then we have u(y ) ≥ u(z).
Therefore, u(x) ≥ u(y )
Only rational preference relations can be represented by
utility functions, Pg 3

Definition (1.B.2)
A function u : X → R is a utility function representing preference
relation ≿ if, for all x, y , ∈ X , x ≿ y ⇐⇒ u(x) ≥ u(y )

Proof
i If u(.) represents ≿ then for all x, y , ∈ X , we have u(x) and
u(y ). Since u(x) and u(y) are real numbers, we will either
have u(x) ≥ u(y ) or u(y ) ≥ u(x) or both
ii If u(.) represents ≿ then for all x, y , z ∈ X , if x ≿ y , then we
have u(x) ≥ u(y ) and if y ≿ z then we have u(y ) ≥ u(z).
Therefore, u(x) ≥ u(y )
iii Why do these two relationships tell us that preferences are
rational?
From preferences to choice

• What have we learnt so far

From preferences to choice

• What have we learnt so far

▶ We have discussed preferences
From preferences to choice

• What have we learnt so far

▶ We have discussed preferences
▶ Rationality of preferences, i.e. complete and transitive
From preferences to choice

• What have we learnt so far

▶ We have discussed preferences
▶ Rationality of preferences, i.e. complete and transitive
▶ Utility functions represent preferences by mapping relationship
onto real line
From preferences to choice

• What have we learnt so far

▶ We have discussed preferences
▶ Rationality of preferences, i.e. complete and transitive
▶ Utility functions represent preferences by mapping relationship
onto real line
▶ Only rational preferences can be represented by utility
functions
From preferences to choice

• What have we learnt so far

▶ We have discussed preferences
▶ Rationality of preferences, i.e. complete and transitive
▶ Utility functions represent preferences by mapping relationship
onto real line
▶ Only rational preferences can be represented by utility
functions

• Now apply these ways of thinking to important decision

problem: how to model the decision to purchase goods and
services that have a price?
From preferences to choice

• What have we learnt so far

▶ We have discussed preferences
▶ Rationality of preferences, i.e. complete and transitive
▶ Utility functions represent preferences by mapping relationship
onto real line
▶ Only rational preferences can be represented by utility
functions

• Now apply these ways of thinking to important decision

problem: how to model the decision to purchase goods and
services that have a price?

• Consumer decision problem in a market economy

Definitions of the consumer decision problem

• Commodities

• Consumption set

• Budgets – prices and wealth

• Demand – what is chosen?

Commodities
• Goods and services that we consume
Commodities
• Goods and services that we consume

• Number is finite and equal to L

Commodities
• Goods and services that we consume

• Number is finite and equal to L

• List of commodities (ℓ = 1, ..., L)

Commodities
• Goods and services that we consume

• Number is finite and equal to L

• List of commodities (ℓ = 1, ..., L)

• Q:If the only things available for consumption are apples,

waffles and coffee, what would L be?
Commodities
• Goods and services that we consume

• Number is finite and equal to L

• List of commodities (ℓ = 1, ..., L)

• Q:If the only things available for consumption are apples,

waffles and coffee, what would L be?
• A commodity vector is a list of amounts of commodities
x = (x1 , x2 , ..., xL )
Commodities
• Goods and services that we consume

• Number is finite and equal to L

• List of commodities (ℓ = 1, ..., L)

• Q:If the only things available for consumption are apples,

waffles and coffee, what would L be?
• A commodity vector is a list of amounts of commodities
x = (x1 , x2 , ..., xL )
• Commodity vector is a point in RL
Commodities
• Goods and services that we consume

• Number is finite and equal to L

• List of commodities (ℓ = 1, ..., L)

• Q:If the only things available for consumption are apples,

waffles and coffee, what would L be?
• A commodity vector is a list of amounts of commodities
x = (x1 , x2 , ..., xL )
• Commodity vector is a point in RL

• The consumption bundle is a commodity vector representing

the amount a consumer consumes
Commodities
• Goods and services that we consume

• Number is finite and equal to L

• List of commodities (ℓ = 1, ..., L)

• Q:If the only things available for consumption are apples,

waffles and coffee, what would L be?
• A commodity vector is a list of amounts of commodities
x = (x1 , x2 , ..., xL )
• Commodity vector is a point in RL

• The consumption bundle is a commodity vector representing

the amount a consumer consumes
• Time, place, uncertainty can be incorporated into the
description of commodities
Consumption sets

• Consumption set is the subset of RL that is actually feasible –

physical or institutional constraints
Consumption sets

• Consumption set is the subset of RL that is actually feasible –

physical or institutional constraints

• e.g. cannot consume more than 24 hours of Netflix per day

Consumption sets

• Consumption set is the subset of RL that is actually feasible –

physical or institutional constraints

• e.g. cannot consume more than 24 hours of Netflix per day

• Develop theory with non-negative consumption

x = (x1 , x2 , ..., xL ) ∈ RL+ and non-negative prices
Consumption sets

• Consumption set is the subset of RL that is actually feasible –

physical or institutional constraints

• e.g. cannot consume more than 24 hours of Netflix per day

• Develop theory with non-negative consumption

x = (x1 , x2 , ..., xL ) ∈ RL+ and non-negative prices

• Q:Write down three possible consumption bundles from the

consumption set of {waffles, apples and coffee }
Consumption sets

• Consumption set is the subset of RL that is actually feasible –

physical or institutional constraints

• e.g. cannot consume more than 24 hours of Netflix per day

• Develop theory with non-negative consumption

x = (x1 , x2 , ..., xL ) ∈ RL+ and non-negative prices

• Q:Write down three possible consumption bundles from the

consumption set of {waffles, apples and coffee }

• Remember that we are dealing with vectors!

Budgets
• Consumption is limited by what a consumer can afford
Budgets
• Consumption is limited by what a consumer can afford

• Affordability is driven by two things: prices and wealth

Budgets
• Consumption is limited by what a consumer can afford

• Affordability is driven by two things: prices and wealth

• Assume that commodities are traded at prices

p = (p1 , p2 , ...pL ) ∈ RL+
Budgets
• Consumption is limited by what a consumer can afford

• Affordability is driven by two things: prices and wealth

• Assume that commodities are traded at prices

p = (p1 , p2 , ...pL ) ∈ RL+
• Consumers are price takers
Budgets
• Consumption is limited by what a consumer can afford

• Affordability is driven by two things: prices and wealth

• Assume that commodities are traded at prices

p = (p1 , p2 , ...pL ) ∈ RL+
• Consumers are price takers
▶ Demand of individual consumer does not influence price
Budgets
• Consumption is limited by what a consumer can afford

• Affordability is driven by two things: prices and wealth

• Assume that commodities are traded at prices

p = (p1 , p2 , ...pL ) ∈ RL+
• Consumers are price takers
▶ Demand of individual consumer does not influence price

• Bundle x is affordable if its total cost does not exceed the

consumer’s wealth
Budgets
• Consumption is limited by what a consumer can afford

• Affordability is driven by two things: prices and wealth

• Assume that commodities are traded at prices

p = (p1 , p2 , ...pL ) ∈ RL+
• Consumers are price takers
▶ Demand of individual consumer does not influence price

• Bundle x is affordable if its total cost does not exceed the

consumer’s wealth
p.x = p1 x1 + ... + pL xL ≤ w
Budgets
• Consumption is limited by what a consumer can afford

• Affordability is driven by two things: prices and wealth

• Assume that commodities are traded at prices

p = (p1 , p2 , ...pL ) ∈ RL+
• Consumers are price takers
▶ Demand of individual consumer does not influence price

• Bundle x is affordable if its total cost does not exceed the

consumer’s wealth
p.x = p1 x1 + ... + pL xL ≤ w

Definition (2.D.1)
Walrasian budget set Bp,w = {x ∈ RL+ : p.x ≤ w } is the set of
consumption bundles that a consumer can afford when prices are p
and wealth is w
The Walrasian budget set

Definition (2.D.1)
Walrasian budget set Bp,w = {x ∈ RL+ : p.x ≤ w } is the set of
consumption bundles that a consumer can afford when prices are p
and wealth is w
• The set {x ∈ RL : x.p = w } is called the budget hyperplane
▶ Also known as the less glamourous budget line in R2

• The Walrasian budget set is a convex set

▶ Convex set means that if x and x’ ∈ Bp.w then
x′′ = αx + (1 − α)x’ ∈ Bp.w

• Q:Show that the Walrasian budget set is a convex set

Definition of a convex sets

Definition (M.G.1)
The set A ⊂ RN is convex if αx + (1 − α)x ′ ∈ A whenever
x, x ′ ∈ A and α ∈ [0, 1]
Demand correspondence

• We are interested in the x that a consumber chooses out of

Bp,w
Demand correspondence

• We are interested in the x that a consumber chooses out of

Bp,w
• We will usually work with a function x(p, w ) that assigns a
set of consumption bundles for each price-wealth pair
Demand correspondence

• We are interested in the x that a consumber chooses out of

Bp,w
• We will usually work with a function x(p, w ) that assigns a
set of consumption bundles for each price-wealth pair
• x(p, w ) might assign a set of consumption bundles
{x} = x(p, w )
Demand correspondence

• We are interested in the x that a consumber chooses out of

Bp,w
• We will usually work with a function x(p, w ) that assigns a
set of consumption bundles for each price-wealth pair
• x(p, w ) might assign a set of consumption bundles
{x} = x(p, w )
• Or it might assign a single bundle x = x(p, w ), in which case
it is a demand function
Demand correspondence

• We are interested in the x that a consumber chooses out of

Bp,w
• We will usually work with a function x(p, w ) that assigns a
set of consumption bundles for each price-wealth pair
• x(p, w ) might assign a set of consumption bundles
{x} = x(p, w )
• Or it might assign a single bundle x = x(p, w ), in which case
it is a demand function
▶ Assume x(.) is a demand function
Demand correspondence

• We are interested in the x that a consumber chooses out of

Bp,w
• We will usually work with a function x(p, w ) that assigns a
set of consumption bundles for each price-wealth pair
• x(p, w ) might assign a set of consumption bundles
{x} = x(p, w )
• Or it might assign a single bundle x = x(p, w ), in which case
it is a demand function
▶ Assume x(.) is a demand function
▶ Q:What are the arguments of x(.)? How many arguments
does x(.) have?
Demand correspondence

• We are interested in the x that a consumber chooses out of

Bp,w
• We will usually work with a function x(p, w ) that assigns a
set of consumption bundles for each price-wealth pair
• x(p, w ) might assign a set of consumption bundles
{x} = x(p, w )
• Or it might assign a single bundle x = x(p, w ), in which case
it is a demand function
▶ Assume x(.) is a demand function
▶ Q:What are the arguments of x(.)? How many arguments
does x(.) have?
▶ Q:Describe in words, what is the output of x(.)?
Two assumptions about the demand correspondence,
x(p, w )

Definition (2.E.1)
The demand correspondence x(p, w ) is homogenous of degree
zero: x(αp, αw ) = x(p, w ) for any p, w and α > 0
Two assumptions about the demand correspondence,
x(p, w )

Definition (2.E.1)
The demand correspondence x(p, w ) is homogenous of degree
zero: x(αp, αw ) = x(p, w ) for any p, w and α > 0

Definition (2.E.2)
The demand correspondence x(p, w ) satisfies Walras’s law if for
every p ≫ 0 and w > 0 we have p.x = w for all x ∈ x(p, w )
Two assumptions about the demand correspondence,
x(p, w )

Definition (2.E.1)
The demand correspondence x(p, w ) is homogenous of degree
zero: x(αp, αw ) = x(p, w ) for any p, w and α > 0

Definition (2.E.2)
The demand correspondence x(p, w ) satisfies Walras’s law if for
every p ≫ 0 and w > 0 we have p.x = w for all x ∈ x(p, w )

In words
• If prices and wealth change in the same proportion, the
chosen consumption bundle does not change

• The consumer spends all her wealth

Terminology related to wealth effects

• Engel function tracks how demand responds to changes in

wealth for fixed prices p̄
Terminology related to wealth effects

• Engel function tracks how demand responds to changes in

wealth for fixed prices p̄
▶ Ep = {x(p̄, w ) : w > 0}
Terminology related to wealth effects

• Engel function tracks how demand responds to changes in

wealth for fixed prices p̄
▶ Ep = {x(p̄, w ) : w > 0}

• The wealth effect for commodity ℓ is the derivative δxℓ /δw

evaluated at (p, w )
Terminology related to wealth effects

• Engel function tracks how demand responds to changes in

wealth for fixed prices p̄
▶ Ep = {x(p̄, w ) : w > 0}

• The wealth effect for commodity ℓ is the derivative δxℓ /δw

evaluated at (p, w )
• Commodity ℓ is a normal good at (p, w )if δxℓ /δw evaluated
at (p, w ) is positive
Terminology related to wealth effects

• Engel function tracks how demand responds to changes in

wealth for fixed prices p̄
▶ Ep = {x(p̄, w ) : w > 0}

• The wealth effect for commodity ℓ is the derivative δxℓ /δw

evaluated at (p, w )
• Commodity ℓ is a normal good at (p, w )if δxℓ /δw evaluated
at (p, w ) is positive
• If δxℓ /δw is negative then we call it an inferior good
Terminology related to wealth effects

• Engel function tracks how demand responds to changes in

wealth for fixed prices p̄
▶ Ep = {x(p̄, w ) : w > 0}

• The wealth effect for commodity ℓ is the derivative δxℓ /δw

evaluated at (p, w )
• Commodity ℓ is a normal good at (p, w )if δxℓ /δw evaluated
at (p, w ) is positive
• If δxℓ /δw is negative then we call it an inferior good

• Individual goods may be inferior because of substitution to

higher quality goods
Terminology related to wealth effects

• Engel function tracks how demand responds to changes in

wealth for fixed prices p̄
▶ Ep = {x(p̄, w ) : w > 0}

• The wealth effect for commodity ℓ is the derivative δxℓ /δw

evaluated at (p, w )
• Commodity ℓ is a normal good at (p, w )if δxℓ /δw evaluated
at (p, w ) is positive
• If δxℓ /δw is negative then we call it an inferior good

• Individual goods may be inferior because of substitution to

higher quality goods
• Q:What are some examples of inferior goods in your life?
Terminology related to price effects

• The price effect of commodity k on the demand for

commodity ℓ is the derivative δxl /δpk evaluated at (p, w )
• We are often interested in the price effect of a good on itself
δxℓ /δpℓ
▶ This can sometimes be negative
▶ If δxℓ /δpℓ evaluated at (p, w )is positive, we call ℓ a Giffen
good

• Elasticity of demand for good ℓ with respect to price pk is

given by ϵℓk = δxℓ /δpk × pk /xℓ
• Similar definition for elasticity of wealth ϵℓw = δxℓ /δw × w /xℓ
Implications of homogeneity of degree 0

• Homogeneity of degree 0 implies i) x(αp, αw ) − x(p, w)= 0

for all α > 0
▶ Differentiating expression i) [do this at home!] leads to
following condition

Proposition (2.E.1)
If the Walrasian demand
PLfunction is homogenous of degree zero,
then for all p and w: k=1 δxℓ /δpk .pk + δxl /δpw .w = 0 for
ℓ = 1, 2...L
Implications of homogeneity of degree 0

• Homogeneity of degree 0 implies i) x(αp, αw ) − x(p, w)= 0

for all α > 0
▶ Differentiating expression i) [do this at home!] leads to
following condition

Proposition (2.E.1)
If the Walrasian demandPLfunction is homogenous of degree zero,
then for all p and w: k=1 δxℓ /δpk .pk + δxl /δpw .w = 0 for
ℓ = 1, 2...L
• Restate this in terms of elasticities
Implications of homogeneity of degree 0

• Homogeneity of degree 0 implies i) x(αp, αw ) − x(p, w)= 0

for all α > 0
▶ Differentiating expression i) [do this at home!] leads to
following condition
• Restate this in terms of elasticities
Proposition (2.E.1’)
If the Walrasian demand
PL function is homogenous of degree zero,
then for all p and w: k=1 δxℓ /δpk × pk /xℓ + δxℓ /δw × w /xℓ = 0
for ℓ = 1, 2...L
Implications of homogeneity of degree 0

• Homogeneity of degree 0 implies i) x(αp, αw ) − x(p, w)= 0

for all α > 0
▶ Differentiating expression i) [do this at home!] leads to
following condition
• Restate this in terms of elasticities
Proposition (2.E.1’)
If the Walrasian demand
PL function is homogenous of degree zero,
then for all p and w: k=1 δxℓ /δpk × pk /xℓ + δxℓ /δw × w /xℓ = 0
for ℓ = 1, 2...L

• In words: An equal percentage increase in all prices

(p1 , p2 , ..., pL ) and wealth will not change demand for xℓ
Implications of homogeneity of degree 0

• Homogeneity of degree 0 implies i) x(αp, αw ) − x(p, w)= 0

for all α > 0
▶ Differentiating expression i) [do this at home!] leads to
following condition
• Restate this in terms of elasticities
Proposition (2.E.1’)
If the Walrasian demand
PL function is homogenous of degree zero,
then for all p and w: k=1 δxℓ /δpk × pk /xℓ + δxℓ /δw × w /xℓ = 0
for ℓ = 1, 2...L

• In words: An equal percentage increase in all prices

(p1 , p2 , ..., pL ) and wealth will not change demand for xℓ
• This is simply the formal statement of intuition that comes
with definition of homogeneity of degree 0
Implications of Walras’ law

• Walras’ law states that p.x(p, w)= w

• Differentiating the expression with respect to pk and w yields
the following two results

Proposition (2.E.2)
PL
ℓ=1 δxℓ /δpk .pℓ + xℓ (p, w ) = 0 for (k = 1, 2, ..., L)

Proposition (2.E.3)
PL
ℓ=1 δxℓ /δw .pℓ = 1 for (k = 1, 2, ..., L)
• In words: If demand x(p, w )satisfies Walras’ law, then total
expenditure cannot change in response to prices, and total
expenditure must change by an amount equal to any wealth
changes
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
• We often want to isolate the first effect
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
• We often want to isolate the first effect
• Solution: analyse a change in prices that is accompanied by a
change in wealth just large enough to by previous bundle
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
• We often want to isolate the first effect
• Solution: analyse a change in prices that is accompanied by a
change in wealth just large enough to by previous bundle
▶ i.e. a person is consuming x(p, w )
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
• We often want to isolate the first effect
• Solution: analyse a change in prices that is accompanied by a
change in wealth just large enough to by previous bundle
▶ i.e. a person is consuming x(p, w )
▶ Prices change to p ′
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
• We often want to isolate the first effect
• Solution: analyse a change in prices that is accompanied by a
change in wealth just large enough to by previous bundle
▶ i.e. a person is consuming x(p, w )
▶ Prices change to p ′
▶ Then we imagine that consumers’ wealth is adjusted to
w ′ = p ′ x(p, w )
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
• We often want to isolate the first effect
• Solution: analyse a change in prices that is accompanied by a
change in wealth just large enough to by previous bundle
▶ i.e. a person is consuming x(p, w )
▶ Prices change to p ′
▶ Then we imagine that consumers’ wealth is adjusted to
w ′ = p ′ x(p, w )
▶ ∆w = ∆p x(p, w )
Price changes have two effects

• An increase in price pℓ makes commodity ℓ more expensive

relative to others and reduces real wealth
• We often want to isolate the first effect
• Solution: analyse a change in prices that is accompanied by a
change in wealth just large enough to by previous bundle
▶ i.e. a person is consuming x(p, w )
▶ Prices change to p ′
▶ Then we imagine that consumers’ wealth is adjusted to
w ′ = p ′ x(p, w )
▶ ∆w = ∆p x(p, w )

• Call this a Slutsky wealth compensation

Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect, normal good
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect, normal good, inferior good
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect, normal good, inferior good, Giffen
good
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect, normal good, inferior good, Giffen
good, Slutsky wealth compensation
• And three porpositions that hold if we assume that x(p, w )
satisfies homogeneity of degree 0 and Walras’
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect, normal good, inferior good, Giffen
good, Slutsky wealth compensation
• And three porpositions that hold if we assume that x(p, w )
satisfies homogeneity of degree 0 and Walras’
1. An equal percentage change in prices and wealth will lead to
no change in demand (2.E.1)
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect, normal good, inferior good, Giffen
good, Slutsky wealth compensation
• And three porpositions that hold if we assume that x(p, w )
satisfies homogeneity of degree 0 and Walras’
1. An equal percentage change in prices and wealth will lead to
no change in demand (2.E.1)
2. A change in prices cannot change total expenditure (2.E.2)
Lecture 2 summary
• Utility functions represent preferences. We will come back to
them later.
• We have defined x(p, w ) and made two assumptions about it
▶ x(p, w ) is homogenous of degree 0
▶ x(p, w ) satisfies Walras’ law
• We have started thinking about what happens to x(p, w ) as
prices or wealth change
• First with some useful definitions
▶ Wealth effect, price effect, normal good, inferior good, Giffen
good, Slutsky wealth compensation
• And three porpositions that hold if we assume that x(p, w )
satisfies homogeneity of degree 0 and Walras’
1. An equal percentage change in prices and wealth will lead to
no change in demand (2.E.1)
2. A change in prices cannot change total expenditure (2.E.2)
3. A change in wealth will be matched by an equal-sized change
in expenditure (2.E.3)