Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Monotonic Transformations

Properties of Consumer Demand • Because utility is an ordinal concept, the specific number
assigned by u(x) to each consumption plan in the choice set is
irrelevant, as long as the order of preference of these
consumption plans given by the underlying preference relation is
Malcolm Keswell preserved by u(x), whatever it’s form.
Eco5020F • So two different utility functions can represent the same
Advanced Microeconomics preferences, as long as there is some underlying connection
Lecture 3
between them.
10/03/2011 • Consider the bundle u(x1 ) = (x11 , x12 )
• When two utility functions u(x1 ) and v(u(x1 )) return the same
preference ranking, we say that v(u(x1 )) is a monotonic
transformation of u(x1 ).

2 / 41

Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

• How can we check if one utility function is a monotonic

transformation of another?
• Totally differentiate v(u(x)) and rearrange to get:
• Check if both give the same marginal rate of substitution.
⇥u(x1 ) ⇥u(x1 )
• Totally differentiate u(x) and rearrange to get: v Õ (u) dxi + v Õ (u) dxj = 0
⇥xi ⇥xj
⇥u(x1 ) ⇥u(x1 )
1
)
dxi + dxj = 0 dxj v Õ (u) ⇥u(x
⇥xi ⇥xj = ⇥xi
1)
dxi v Õ (u) ⇥u(x
⇥u(x1 ) ⇥xj
dxj ⇥u(x1 )
= ⇥xi
⇥u(x1 )
dxi
⇥xj = ⇥xi
⇥u(x1 )
⇥xj
• Key idea: total differential is 0. Why?
• What about the MRS for v(u(x1 ))?

3 / 41 4 / 41
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Properties of the Indirect Utility Function Properties of the Expenditure Function

• If we denote the solution to the consumer’s minimization problem
(also known as the dual problem) by xh (p, u), then another way
• Recall the indirect utility function defined above. This function, of defining the expenditure function is e(p, u) = p · xh (p, u)
v(p, y), gives maximum utility as a function of p and y. It has the • Properties of e(p, u):
following properties: 1 e(p, u) is nondecreasing in p
1 v(p, y) is nonincreasing in p; that is, if pÕ ⇧ p, 2 e(p, u) is homogeneous of degree 1 in p
v(pÕ , y) ⌅ v(p, y). Similarly, v(p, y) is nondecreasing in y 3 e(p, u) is concave in p
and will be strictly increasing if local nonsatiation is 4 e(p, u) is continuous in p
satisfied. ⇥e(p, u)
5 e(p, u) satisfies Shephard’s lemma: xhi (p, u) =
2 v(p, y) is homogeneous of degree 0 in (p, y). ⇥pi
3 v(p, y) is quasiconvex in p; that is, {p : v(p, y) ⌅ k} is a • The last result follow’s from a direct application of the Envelope
convex set for all k. Theorem.
4 v(p, y) is continuous at all p ⌃ 0, y > 0.
• The function xhi (p, u) is called the Hicksian demand function.
functions of the firm. This function tells us what consumption
bundle achieves a target level of utility and minimizes total
expenditure.
5 / 41 6 / 41

Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Some important Identities CHAPTER

I
Roy’s Identity
Figure 1.17. Expenditure minimization and utility • Identity 2 leads to a very useful result.
• The indirect utility function maps prices and budget into maximal
maximization.
utility: u ⇤ v(p, y) • If x(p, y) is the Marshallian demand function, then
v(p,y)
• The expenditure function maps prices and utility into minimal
xi (p, y) = = xúi
pi

budget: y ⇤ e(p, u). v(p,y)

y

• Therefore we have, y ⇤ e(p, v(p, y)) and u ⇤ v(p, e(p, u)) • To show this, start with u ⇥ v(p, e(p, u)).
1 xi (p, y) ⇤ xhi (p, v(p, y)) • Then differentiate with respect to pi to get
2 xhi (p, u) ⇤ xi (p, e(p, u)) ⇥v(p, y) ⇥v(p, y) ⇥e(p, u)
3 x(pú , y ú ) ⇤ xh (pú , uú ) + = 0
⇥pi ⇥y ⇥pi
⇥v(p, y) ⇥v(p, y) h
To prove the first relation,let x0 : x(pO,y0), and let uo : a(xo). Then u(p0, y0) = ,0 + xi (p, u) = 0
by definition of u(.), and p0 . x0: y0 because,by Assumption 1.2, u(.) is strictly increas- ⇥pi ⇥y
ing. By Theorem1.8, e(pO,u(p0,y0)):y0 or, equivalently,e(pD,u0)-y0. But because v(p,y)
z(x0;: u0 andp0 . x0: )0,this impliesthatx0solves(1.14)when(p, u) = (p0,,0).Hence, xhi (p, u) = = xi (p, y)
pi
v(p,y)
x0 : xh(pO,a0) and so x(po,y0) : xi(pO,u(pO,y0)). I y

DGl,tPtE 1.5 Let's confirm Theorem 1.9 for a CES consumer.From Example
• The last line is established by identity 5.
Forward
1.3, the
Hicksian demandsare • We can achieve the same result by applying the envelope theorem.
7 / 41 8 / 41
x ! @ ,u ) : u ( n i+ p ; ) " / " - tp i - t , i : r,2. (E.1.)

From Example 1.2, the indirect utility function is

 Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise 46Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand
CHAPTERI Exercise

CHAPTER
I

zation and utility

u: v(p,y): u(p,a(p,r))
• The figure illustrates duality
between Marshallian and y _ e(p'u(p,)))
Hicksian demand functions. Pr Pt
(a.,
• The solutions to the primal
problem are also the solutions to
the dual problem and vice versa.

x{p,y) : 'f(p,r(p,y))
r|fu, r) : -r,(p,e(p,u))
n,let x0 : x(pO,y0), and let uo : a(xo). Then u(p0, y0) = ,0
x i : x l @ , u ) : ' f ( p , u ( p , y ):) x r b , y )
0: y0 because,by Assumption 1.2, u(.) is strictly increas-
(b)
p0,y0)):y0 or, equivalently,e(pD,u0)-y0. But because
Figure 1.18. Illustrationof Theorems1.8 and 1.9.
impliesthatx0solves(1.14)when(p, u) = (p0,,0).Hence,
) : xi(pO,u(pO,y0)). I 9 / 41 10 / 41
1.5 Pnoprnnrs
oF CoNSUMER
DEMAND
The theory of consumer behavior leads to a number of predictions about behavior in the
heorem 1.9 forMonotonic
a CESTransformations Properties
consumer.From of Indirect1.3,
Example Utilitythe
and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations
marketplace.Properties
We will see of that
Indirect Utility and Expenditure
r/preferences, objectives, and Properties of Consumer
circumstances Demand
are as we've Exercise
modeled them to be, then demand behavior must display certain observablecharacteris-
tics. One then can test the theory by comparing these theoretical restrictions on demand
Proof of the Slutsky Equation Using Duality Theory behavior to actual demand behavior. Once a certain degree of confidence in the theory
u ( n i+ p ; ) " / " - tp i - t , i : r,2. (E.1.) ERI CONSUMER
THEORY has been gained,it can be put to further use. For example,to statisticallyestimatecon-49
sumer demand systems,characteristicsof demand behavior predicted by the theory can
be used to provide restictions on the values that estimated parameters are allowed to
utility function is • What can we learn from the theory of consumer choice thus
\\'ed far? take. This application of the theory helps to improve the statistical precision of the es-
timates obtained. For both theoretical and empirical purposes,therefore, it is extremely
• One natural question we might wish to ask is: what happens to important that we wring all the implications for observable demand behavior we pos-
sibly can from our model of the utility-maximizing consumer.This is the task of this
u(p,y) : ybi + p;)-'t'x(p,
. m) when p and/or m(8.2)
increases? section.

• Answering this type of question, allows us to infer the shapes of

(E.1) gives
demand curves.
• We shall see that “abnormal” behaviour is perfectly permissible
: u(p,y)(pi+ or1(r/n-t
y)) ,r-r
in the framework we have set up.
and
I the x1 x1
: y(pi+ pi)-t/'@i•+ p51{t/')-r
o'-t "f "]
01
xt:xt ,l ,l
This is perhaps the most powerful feature of the modern theory
(a) (b) (c)
: ypi-t@\+ fi)-' of consumer demand. (8.3)
Figure 1.19. Response of quantity demanded to a change in price.

• We shall see shortly that, in fact, the sort of comparative zero

static
i :1,2,analysis raised by this question, can be used to test the ) ln-
lpi
: ______;,
pi+ pL underlying assumptions of our model in a very real sense. Let's approachit intuitively first. When the price of a good declines,there are at least
rd to two conceptually separatereasonswhy we expect some changein the quantity demanded.
r this First, that good becomesrelatively cheapercomparedto other goods.Becauseall goods are
ht-hand side of (E.3) gives the Marshallian demands we t desirable, even if the consumer's total command over goods were unchanged,we would
lving the consumer'sutility-maximization problem. This r any expect her to substitutethe relatively cheapergood for the now relatively more expensive
11 / 41 12 / 41
em 1.9. the n ones. This is the substitution effect (SE). At the same time, however, whenever a price
llPn changes, the consumer's command over goods in general is r?o/ unchanged.When the
price of any one good declines,the consumer'stotal command over all goods is effectively
 that will prove more analytically useful. The relationshipsbetweentotal effect, substitution
effect, and income effect are summarizedin the S/ats[7 equation. The Slutsky equation is
sometimescalled the "Fundamental Equation of Demand Theory," so what follows merits
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonicthinking about rather
Transformations carefully.
Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise
CHAPTER
I I
CHAPTER Throughout the remainderof this chapter,Assumption 1.2 will be in effect, and,
moreover, we will freely differentiate whenevernecessary.
rERI CONSUMER
THEORY 53
left-handside,becauseitytpl dependsonly directly on prices,is straightforwardto differentiate. CHAPTER I
I.I I
THEOREM TheSlutskyEquotion
The Marshalliandemandon theright-handside,however.dependsdirectly on pricesthrough
:late. Slutsky equationsprovide neat analytical expressionsfor substitutionand income
prices the expenditure function Let x(p, y) be the consumer'sMarshallian demandsystem.Let u* be the levelof utility the
its price
left-handargument,side,becausebut it also it dependsdepends only indirectly
directly on onprices, isttu'ough
straightforward .)u-ghto differentiate. effects. They alsogive us anp"accounting framework," detailinghow thesemust combineto
---\ CHAPTERCHAPTER I I consumer achieves at prices and incomey. Then,
in itsThe income argument.
Marshallian
(a)
demand We
42 - o on -will a ; -have
- rthe - - - \ to apply
-right-hand side, the chain depends
however. rule to differentiate directly-'tion on prices right-hand
the through explainany total effect ofa given price change.Yet by themselves,the Slutskyrelationsdo
this in mind,
I
butxit2 also wes El +depends : - - - - - l I indirectly on pricesttu'oughthe expenditure function
side.its Keeping
price argument, - - - - - -(obtain
s
x2
-trJ
--J hand not answerany E x ,of p _, questions
_ (the yE)x i ( p , uwe setout to address.In fact, you might think that all this
. )implications
_ x i ( p , ) , ) qfor
+ : obsert,able
} ) , i , j : behavior
in its
left-handside, income argument.
because it We
depends will havedirectly
only to apply on theprices,
chain rule to differentiate to
is straightforward right-hand
thedifferentiate. has only maded nit, harder to ddeduce r , . . . , nfrom
. our theory.
left-handside,becauseit depends only directly on prices, is straightforward /,Y to
and differentiate. "rJ n
-rJ : dy
Theside. Keeping
Marshallian this
demand
oxl(p, inu.) mind,on thewe
8 x iobtain
right-hand
( p , e ( p , u side,
* ) ) however.
3 x ; ( p .edepends
( p .u " l \directly
3 e ( p .r on
r * )prices
r v e laprices
0. through After all, the\-\/-
only thing we've
-/--/- done so far is decompose an observable total effect into (1) an
The Marshalliandemand the on right-hand side, however.
, depends
- on pricesttu'oughthe expenditure directly on through
(P.l) TE S E(2) I E
its price argument,but it alsodepends indirectly function observableincome effect and anunobservablesubstitutioneffect. For example,consider
0p; 0p; u * ) ) on3 xprices a()pttu'ough \ 3 e (the
a pr*tP) l )
p .r rexpenditure
Inge on
CHAPTER
function I
its price
in itsargument,
income argument. but it also
oxl(p, u.)
We depends
will8have x i ( pindirectly
,eto( papply
, the, chain ; ( p .erule .uto" ldifferentiate r ] .Tright-hand
) .the o (P.l) what Slutsky tells us about the specialcaseof an own-pricechange.From Theorem I . I I,
- Proof:The proof of this remarkable theorem is quite easy,though you must follow it quite
in its income
side.Now Keepingargument.this in We
0p;
mind, will we have
obtain to0p; apply the chain a rule
) to differentiate
a p t lowing the right-hand we have that
if we look at (P.I ) carefully, and rememberthe significanceof the ,inal o original level carefully to avoid gettinglost. We beginby recallingone of the links betweenHicksian and
side. Keeping this in mind, we obtain on prices, isassumption,
straightforward l*'el toudifferentiate. ar,.(p,y) From a.r,t(p, a-)1.9,we know that
left-hand
of utility side, u*. because
we can itmake
depends some
at (P.I 8
only critical directlysubstitutions. By r.r* :is the
prices utility the Marshalliandemandfunctions. _ Theorem _ xi(p,),)9192 ( 1.20)
Now if oxl(p,
demand
we looku.)
on the
) carefully,
x
right-hand i ( p , e ( p and
, u *
side, ) remember
) however.3 x ; ( p the.e ( significance
p
depends . e ( pof.rrrthe
u " l \ 3directly *the) onoriginal level
prices through op, op, o1
Theconsumer
Marshallian
of utilityachieves
u*. we facing
can make p and
some y. Therefore,
critical -
substitutions.
,u*: u(p, By )). The
assumption, minimum r.r* is
lre at int
the expenditure
and
utility ( P
the . l at
)
p andoxl(p, but0p; u.) 8 x i ( will p ,e0p;
p and y. indirectly
p ,uthe
(be * ) )same 3 xprices ( pa.e)ttu'ough
; the ( p .u " l \ 3the aep(expenditure
t .r expenditure
p r,rcrease
* ) at prices function
at (pP . l )
x ! t P .u * ) : x i ( P 'e ( P 'u * ) )
its price
prices argument,
consumer utility
achieves it also
u* therefore
facing depends Therefore, -, onu*:as u(p, minimum )). The minimum expenditure
--cs p The term on the left is the slope of the Marshallian demandcurve for good i -the response
in its
and income
utility
pricesp and0p;
argument.
u(p, y).From
utilityWe will have
Theorem
u* therefore 0p; tobe
1.8,
will apply
however,
the same the we chain
as the know arule ) that
minimum to differentiate
the allture
minimum
expenditure p tI'rom would the
at right-hand
expenditure
prices p of quantity demandedto a changein own price-and this isp what we want to explain.To
prices Because holds for theall equation
)) 0, we can differentiate
Now if we look at (P.ITheorem carefully,
)obtain and remember the significance p and of the original
x!
is equallevel
to
The
for any
do•that, equality
howeveq wefollows
and level
apparentlyfrom,r*.
of utility identity
need to know 2.this
Because
something about the firstholds term onforthe
all right.
side. prices
atKeeping
and utilityp and maximum
thisu(p,in mind,y).From weutility that1.8, can be achieved
however, we know atx prices
t @tthat
, p ! . y ) the minimum income
rul to expenditure .r' bothpsides
of utility u*. we can make some critical substitutions. By assumption,
prices p and income r.r* isiects
the is
onutility
equal the
to This, ⇤ 0,
however,
with respectto p; and the equality is preserved.The Hicksian demandon the
weis can
the differentiate
slope of a both
Hicksian sides
demand with
curve,respect
and to pj and
Hicksian still curvesare
demand
income
Now at prices
ify. we
We plook
and maximum
have, (P.I ) carefully,
attherefore, utilitythatthatand can be achievedat
remember the significanceof the .r' original level
facing p andthat y. Therefore,u*: u(p, )). The minimum expenditure at preserve the equality.
income achieves
consumer y. We have, therefore, r.r* CHAPTER the I not directly observable. What can we know aboutHicksiandemandcurveswhen we cannot
of utility u*. we oxl(p,
can make u.)
pricesp and utility u* thereforewill be- the some 8 x i critical
( p ,e ( p ,substitutions.
u * ) )same , 3 x
as ; (
the p By.e ( p
minimumassumption,
.u " l \ 3 e (
expenditurep r
. r * )is at the utility
prices p even see them?
ey. Axr -
,u * ) - e ( p , uu*:
( p Therefore, ( p , 1u(p, : y . r P . 2 ) (P.2)( P . l )
consumer achieves u(p,0p; facing p Theorem and ' ) ) a ))).that The minimum a p t expenditure expenditure at
and utility y).From Figure 1.20. e (0p; 1.8,
pThe ) however,
,u *Hicksian ( p , u ( pwe
edecomposition , 1 'ofknow
) )a:price y .change.the minimum (P.2) Surprisingly,our theory tells us quite a bit about Hicksian demands,and so quite a
prices p
left-hand
at and
prices utility
side,
p and u*
because
maximum therefore
it depends
utility will that be
only can the
directly
be same
achieved on as the
prices,
at minimum
prices is straightforward
p and expenditure
income tois at
equal prices
differentiate.
to p bit about substitution terms-whether we can see them or not. Whatever we learn about
liture .r'
In addition. Theorem
y).From 1.7 tells us1.8, theside,
thathowever, partial we with know respect thattoto the p;minimum of the expenditure
expenditure
prices 13 / 41 substitutionterms then can be translatedinto knowledge about observableMarshallian 14 / 41
andThe utility
Now u(p,
ify.we
Marshallian
incomeIn addition. We look demand
have,
Theorem Theorem
attherefore,
(P. Ion
1.7 the
carefully,
tells
)Hicksian thatright-hand
us that and and the
suppose remember
partial however.
with the depends
significance
respect p;directly
ofpof ' )on
. \the
.the ' original
expenditure through
level
(P.1) is just the demand forrhecon^sumer
good j originally
at utility faces a*.
prices p! and r* : u(p, )'),
Because
function in -o
p; prices p the expenditure function
is )'), to demands via the Slutsky equations. This is how the Slutsky equations will help us, and this
at its price
ofprices
utility pu*. argument,
and
function we maximum
(P.1)
incan ana ishas
but itrncome
just also
utility
"-utlll,llt^tjlltt.-1.20(a),
make some depends
they.HicksianHe that
originally
critical can indirectly
demand
buysbequantities
achieved
substitutions. for good on
xf and j at
x! Byat
andprices ttu'ough
utility
assumption,
u"hi"u"5, a*. and
uiitity t"uitincome
Because r.r*r*
,0. is :the u(p,
.r' equal
utility the
this must alsoalsobe Suppose
the Hicksian
the price of good demand 1 falls to pl,. for
- for e good
pot
( and that
good
p , u ( at
77pthe
,at utility
totai : effect
utility u(p,
yProperties
.u(p, y),y),orchange
or on (P.2) will be our strategy.We begin with a preliminary result on own-price effectsthat gives a
in
income its this
y.
Monotonicincome
consumerachieves We must argument.
have,
Transformationsgood be the
therefore,
facing
I Hicksian
We
Properties
consumptionp and will
that
is of
an
e y.( p
demand
have
Indirect
increase
, u * ) to
Utility
Therefore, apply
and the
Expenditure
u*: 1chain
to if , ano ttre total effect on good ' )
u(p, ) ruleof this
The to price
)).2 is a decreare,o rodifferentiate
ofminimum
Consumer Demand the
expenditureright-hand
Exercise at Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise
apply the Hicksian decomposition,we hrst perform the
hint of what is to come.
side.
prices p Keeping
and utilitytheu*this in mind,
therefore we obtain
will be the same ashypothetical experimentofexpenditure
the minimum "";.
allowing at prices p
price of good de ld to(eo (.u
fall otous*.urhe
\* that
\n_ewlevel
In addition. Theorem
and utility u(p, y).From level indffirence 1.7
Theorem
tells
e
curve-
( pIt is , u 1.8,
as*
thepf partial
-however,
if) we e ( p rwhite :hordiig
pwe,r1with
-u-))(consumer
r,the pp: face
..uyuthe
th" conrr*r,
l'(know respect (pnew
.(that pto. .to )' )origittar
)the
the 'p;)minimum
.)prices
. uothe expenditure
of
expenditure (P.2)
function in (P.oxl(p, 1) is justu.)
but reduced hisT
the :
T :
Hicksian
income
8
so that demand
x i ( p , e
" (
"/
p
/i i
,
r
allowed
he faced thefor
u
rp*
p
)
. .
dashed
) good )j ) at utility
to
hypothetical
3 x ; ( p .
e ( p
budget .u "
relative
a*.l \ 3Because
constraint e ( p
and .r r *r*) : u(p, )'), THEOREM
I.I2 Negalive Own - iub sfinfi on Terms
at prices p and maximum
asked him to utility
maximize that
against can be achieved
it. Under thesecircumstances, , at prices p and income
mand .r' is equal ( to. l )
P
this must also be the Hicksian
his consumption of gooddemand
for good -7 good-from xf to rf uno
at utility the codsumer
u(p, y),
would or increase
tet x! 1p,u) be the Hicksian demandfor good i. Then
income
In addition.
But look y. We
But look have,
Theorem
at theat the 0p;
therefore,
righrmost
righrmost
decrease 1.7 tells
term
his consumption that
term us
r-the now relativery cheaper
here. here.
ofthat good
0p;
We Wethe know
know
2-the
partial fromwith
from
now relatively
Theorem
Theorem a ) 1.9
respect 1.9 that , the
to
that p; a
mand
,ouio
the pHicksian
oft thedemand
Hicksian expenditure
demand
.o." expensii," good-from .r!
atinp (P.and theistomaximum utility
xj' These hypothetical
just oachieved atppand foryygood
and in Hicksian
isthe j atequal
turn utility totothe a*. Marshallian
Because demand
r* : u(p, )'),
demand 8"ri'(p, rz)
at p and 1) the Hicksian
utility d e (achieved .uchanges
* \demand
:pis,rinl (turn equal the Marshallian
inat
function the maximum consumption are substitution effects on
= o.
atNowp and if y'!
we Thus,look we at have
(P. I thatcarefully, - and r - )
remember p : .
the u ( p .
significance) ' ) ) . of the original level
(P.2) 'dp, i :1,...,n.
this at p and y'! Thus,
must also be the Hicksian we have T that: )
e (
demandfor p , u * ) " / i good
e r p . 7 at1 'utility
( p , u ( )) y . u(p, y), or
of utility u*. we can make somecritical substitutions.By assumption, (P.3) r.r*is the utility the
0e(p,u*) Proof:This theoremtells us that Hicksian demandcurvesmust alwaysbe as we've shown
consumer
But look achieves
at the righrmost facing d e ( p
term
o and
u
. us * here.
\ y.
0e(p, We the u*)
Therefore,
know partial: from u*:
xj(P' Theorem
with u(p,
-\'). )).
respect 1.9 The that
to minimum
the
p; Hicksian
of theexpenditure (P.3) at
demand
expenditure
In addition. Theorem 1.7 tells that opi : xj(P' (P.3) them in Fig. l.l6 and elsewhere:namely,negatively(nonpositively)slopedwith respectto
prices
at p p
and and
the utility
maximum u* therefore
utility achieved will be
opi
at pthe r
and -same)
y : is r
in l
as (
-\').
turn p
the . u
minimum
equal ( pto . )
the ' ) ) .
expenditure
Marshallian demand prices p
atu(p,
function in (P. 1) is just
y).From
the Hicksiandemand
T :Theorem " / i however,
1.8,
r p . we know that the minimum expenditure
for good j at utility a*. Because
ion in r* : )'), their own price. The proof is easy.
andat
this must
putility
and y'! u(p,
also be the
[Beware
Thus,
here. we have
Take
Hicksian note that
that demand we've shown
for good the price at partial
utility ofu(p, the expenditure
y), or function in The derivativepropertyof the expenditurefunction,Theorem 1.7, part 7, tells us that
7
at prices
[Beware (P.1) p toand
here.
be the maximum
Take note that
Marshallian utility we've
demand that can
shown
for good bethe / ,price
achieved
not good partial i .lprices
at of thepexpenditure and incomefunction .r' is equal in to for any p and a,
But look at the righrmost term here.0e(p, We know u*) from Theorem 1.9that the Hicksiandemand
(P.1) to Marshallian demand good , notand good i .linto (P.1)to obtain
income beTo
y. the
We have,
complete therefore,
the d eproof, o .u *that
(achieved \ for
substitute
p
from:/ (P.2)
y)xj(P' inl -\').
(P.3) (P.3)
demand 0 e ( p ,u )
at p andthe maximum utility
To completethe proof, substitute
at
opi from and r -(P.2) :isrand (turn p
(P.3) . equal
uinto ( p .(P.1) to) the' ) to )Marshallian
.obtain T :r!(P'u)'
at p and y'! Thus,we have Tthat " / i
: e ( p ,u * ) - e ( p ,u ( p ,1 ' ) ): y . r p . (P.2)
Differentiating again with respect to p; showsthat
[Beware here. Take note that we've shown the price partial of the expenditurefunction in
know from Theorem 1.9 that the Hicksian demand
But look(P.1) at
at pInandWith the
the
Tomaximum
righrmost
to be the Marshalliandemand
addition. Theorem
acomplete
bit of rearranging, utility
the
term
1.7 achieved
proof,
tells
we
here.
substitute
0e(p,
haveopi
We
us thatp
for u*) / , not
good
at from
what
the
and
we
: partial
yxj(P'
(P.2)
wanted is and
good
intowith
-\').
(P.3)
turn
show:
i .l
respect
equalinto (P.1) to the totop; of the expenditure
Marshallian
obtain demand (P.3) --fr-: ,^ 02e(p,u) ax!@,u)
i:1,...,n.
function in (P.1)we is just the Hicksiandemandfor good j at utility a*. Becauser* : u(p, )'),
at pWith
and y'! Thus,
a bitalsoof rearranging,
havethat havewhat we wantedto show:
we demandfor good 7 at utility u(p, y), or
this must be 8 xthei ( p Hicksian
.v ) Erltp. r.r-l r,) Because the expenditure function is concave in p, all of it’s second-order own
By Theorem |.7 , part 6, the expenditurefunction is a concavefunction of p. Therefore,by
[Beware here. Take note that _ we've shown - r.i.(,P
h' . .price
the '\')
\3r1(p .
partial ofi . jthe
: 1 . .expenditure
...n function in
api a P0e(p,
i u*) ay partials and non-positive.
(P.1) to be the Marshallian
8 x i ( p .v ) _ demand r\- l good
Edrel t(po..ur .*for /
: , not good r , ) i .l Back (P.3)
- r.i.(,Ph' '.r\.'xj(P'
\ 3 r:1 ( -\').
-
) ) and r p.
l ( p . u (i .pj (P.1)
:.1).'.). .)..n
To complete the proof, substitute opi from (P.2) (P.3) into to obtain
api
With a bit of rearranging,aPi "/irp.
Twe: havewhat we wantedto show: a y
15 / 41 16 / 41

[Beware here. Take note that we've shown the price partial of the expenditurefunction in
But look at the i ( p .v ) _ Eterm
8 xrighrmost r l t p .here.
r . r - l We know from Theorem 1.9that the Hicksiandemand
(P.1) to be the Marshallian demandfor- good r.i.(,Ph' /'.\,.' \)not ( pr., ) i .l i . j : 1 . . . . . n
3 r 1good
 what that matrix will look like. Theorem 1.12tells us that all elementsalong the principal
might be donewhenwe consideredthe"Law of Demand."There,we askedwhatthemodelof
diagonalwill be nonpositive,and Theorem l.14 tells us the matrix will be symmetric.In
consumerbehaviorimplied for the unobservable, own-substitutioneffects.andthenusedthe
fact, we can say even more than this about the matrix of substitutionterms: It must be Slutskyrelationto translatethatinto a statementon the relationsthatmusthold betweenown-
Monotonic Transformations Properties of Indirect Utility and Expenditure
negative semidefinite Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise
as well. price and incomeresponses in the consumer'sobservableMarshalliander-nand functions.In
view of what we've now learnedaboutthe entire systemof substitutionterms,we neednot
limit ourselvesto statementsaboutown-priceand income changes.We can, in fact, useour
THEOREM
I.I5 NegofiveSemidefiniteSubstitutionMotrix knowledgeof the substitutionmatrix to make a comprehensive deductionaboutthe effects
of all price and income changeson the entire systemof observableMarshalliandemands.
Let xh1p,u) be the consurner'ss)-stemof Hicksian demands,and let

^ h. THEOREM
I.I6 Symmetric
ond NegaliveSemidefiniteSlutskyMotrix
d x i ( p , , /)
'dP^ Let x(p, y) be the consunTer's
Marshallian demands)-stem.Defne tlte ijrh Slutsxya
terrnas

o(p,u)=[& CHAPTER
1 E-ri(p,.,-)
apl
.0ri(p,.r')
+ r,(P' 'ut '
arXfp,
u) iln
called the substitution matrix, contain all the Hicksian substitution terms. Tlrcn the matrir
oPn andform the entire n x n Slutsky matrix of price and incomeresponse.t
ns.follows:
o(p, u) is negatit'esemideJinite.

PX
Proof:The proof of this is immediatewhen we recallfrom the proof of the previoustheorem E . r1 ( p .y ) C "1r ( p .1 )
that eachterm in this matrix is equal to one of the second-orderprice partial derivativesof + -xr(p,
rrqt*' ^
dP"
r 1,,(P.
3r'
the expenditure function.In particular,we've seenthat ar,i(p, u)l0pi:A2e(p,u\/0p101ti
s(p, ,y) :
I :

:l
for all i and l. so in matrix form we must have
I Ex,,(p.1.) +.rr(p,r)q+P 0x,,(p.r')
^ f J,r(P.
,3.x"(p,,r)
v) d^v
f at'!tp.ut ar{'tp,at\ l\2eQ.ut \ ae' dPu

l#+l * w)
The matrix on the right is simply the Hessianmatrix of second-orderprice partialsof the
expenditurefunction. From Theorem l.7, the expenditurefunction is concavein prices. 17 / 41
Thens(p, y) is s r-mmeticand negativesemidefinite

18 / 41
From Theorem A2.4, the Hessianmatrix of a concavefunction is negativesemidefinite.
Becausethe two matricesare equal,the substitutionmatrix will thereforealso be negative
semidefinite. Properties of Indirect Utility and Expenditure
Monotonic Transformations Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Having spentso much time exploringthe propertiesof the unobservableHicksiande-

Homework Exercise: Solution

mand system,we arefinally in a positionto usethat knowledgeto saysomethingrathercon-
creteand aboutthe consumer'sobservabledemandbehavior.We had a glimpseof how this
• To find the Marshallian demand functions, we need to solve the
consumer’s maximization problem.
might be donewhenwe consideredthe"Law of Demand."There,we askedwhatthemodelof
consumerbehaviorimplied for the unobservable, own-substitutioneffects.andthenusedthe • We will look at the solution to a monotonic transformation of the given
Slutskyrelationto translatethatinto a statementon the relationsthatmusthold betweenown- utility function; namely the log-transform.
•price
Suppose preferences
and incomeresponses
are given by the utility function functions.In
in the consumer'sobservableMarshalliander-nand • Let u(x) = a ln x1 + (1 a) ln x2 Thus we can write the Lagrangian
a 1≠a
view of what we've now learnedaboutthe entire systemof substitutionterms,we neednot
u(x)
limit = x1toxstatements
ourselves 2 . Use theown-price
about identities linking
and income expenditure
changes. functions
We can, in fact, useour
function as
and indirect
knowledge utility functions
of the substitution to work
matrix to make throughdeduction
a comprehensive some results for this
aboutthe effects L = a ln x1 + (1 a) ln x2 (p1 x1 + p2 x2 y)
maximization
of all price and income problem. At entire
changeson the this stage,
systemofyou should
observable be able
Marshallian to do
demands.
From the first-order conditions we get
the following: a
THEOREM
I.I6 Symmetric
ond NegaliveSemidefiniteSlutskyMotrix x1 =
I Maximize utility to find x(p, y). p1
Let x(p, y) be the consunTer's
I Derive v(p, y).
Marshallian demands)-stem.Defne tlte ijrh Slutsxya
terrnas
1 a
x1 =
I Check that Roy’s E-ri(p,.,-)
identity holds.
.0ri(p,.r') p2
+ r,(P' 'ut '
I
apl
Derive e(p, u) from v(p, y). iln p1 x1 + p2 x2 y = 0
I Derive Hicksian demand functions from 1
andform the entire n x n Slutsky matrix of price and income response.t
ns.follows:
Substituting x1 and x2 into the budget constraint, we get = . Then
xhi (p, u) ⇤ xi (p, e(p, u)). y

PX E . r1 ( p .y ) C "1r ( p .1 ) substituting into the expressions for x1 and x2 , we get

I Cross-check + -xr(p,
thisrrqt*'
result by applying dP"Shephard’s lemma.
^ r 1,,(P.
3r' ay
x1 (p, y) =
s(p, ,y) :
I :
p1
I Ex,,(p.1.) +.rr(p,r)q+P 0x,,(p.r')
f J,r(P.
,3.x"(p,,r)
v) d^v (1 a)y
x2 (p, y) =
^
\ ae' dPu
p2
Thens(p, y) is s r-mmeticand negativesemidefinite
19 / 41 20 / 41
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

• Recall that indirect utility is the maximum-value function of the

• To derive e(p, u) from v(p, y), we use the identity v(p, e(p, u)) ⇥ u.
consumer’s maximization problem: i.e., it gives the maximum level of
Thus, we have:
utility attained if the consumer chooses optimally. Formally, we can
write this expression as v(p, y) = u(x(p, m)). Thus, to find v(p, y), just v(p, y) = ln y a ln p1 (1 a) ln p2 + k
substitute the Marshallian demands into the objective function
v(p, e(p, u)) ⇥ u
v(p, y) = u(x(p, y)) u = ln e(p, u) a ln p1 (1 a) ln p2 + k
3 4 3 4
ay (1 a)y ln e(p, u) = u k + a ln p1 + (1 a) ln p2
v(p, y) = a ln + (1 a) ln
p1 p2 e(p, u) = expu≠k pa1 p1≠a
2
= ln y a ln p1 (1 a) ln p2 + (a ln a + (1 a) ln(1 a))
¸ ˚˙ ˝ • Usually, you’ll want to check that e(p, u) satisfies all the properties of an
k
expenditure function. For example, we can check the degree of
• We can check that our answer for v(p, y) is correct, by using Roy’s homogeneity of e(p, u),
identity to derive the Marshallian demand functions. We can then show
⇥v(p, y) a ⇥v(p, y) 1 e(tp, u) = expu≠k (tp1 )a (tp2 )1≠a
that = and that = . Therefore, we have
⇥p1 p1 ⇥y y = ta+1≠a expu≠k pa1 p1≠a
2

v(p,y) = te(p, u)
a 1 ay
x1 (p, y) = = / =
p1
v(p,y)
y
p1 y p1 • Notice that t is raised to a power of 1 in the last line of this equation,
thus confirming that e(p, u) is HD 1 as it should be.
We can do a similar calculation for the second good.
21 / 41 22 / 41

Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

• We can find the consumer’s Hicksian demands directly from their • We can also do this by Shephard’s Lemma. Thus we have
Marshallian demands,
⇥e(p, u)
a = a expu≠k pa≠1
1 p1≠a
2
x1 (p, y) = y ⇥p1
p1 3 41≠a
a p2
x1 (p, e(p, u)) = e(p, u) = a expu≠k
p1 p1
=
a
expu≠k pa1 p1≠a = h1 (p, u)
2
p1 ⇥e(p, u)
= a expu≠k p≠1 a 1≠a = = (1 a) expu≠k pa1 p≠a
2
1 p1 p2 ⇥p2
3 41≠a 3 4a
p2 p1
= a exp u≠k
= (1 a) exp u≠k
p1 p2
= h1 (p, u) = h2 (p, u)

23 / 41 24 / 41
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Checking the Slutsky Relation Now we should be able to verify that the Slutsky equation holds; i.e., we need
to show that
⇥xh1 (p, u) ⇥x1 (p, y) ⇥x1 (p, y)
x1 =
u(x) = xai x1≠a
2
⇥p1 ⇥y ⇥p1
v(p, y) = yp≠a a≠1
1 p2
Notice that we can write
e(p, u) = upa1 p1≠a
2 ⇥xh1 (p, v(p, y))
ay = a(a 1)pa≠2
1 p1≠a
2 yp≠a a≠1
1 p2
x1 (p, m) = ⇥p1
p1
= a(a 1)p≠2
1 y
xh1 (p, u) = apa≠1
1 p1≠a
2 u
⇥x1 (p, y) ay So the left-hand side of the Slutsky equation becomes
=
⇥p1 p21 ⇥xh1 (p, u) ⇥x1 (p, y) a(a 1)y a ay
⇥x1 (p, y) x1 =
=
a ⇥p1 ⇥y p21 p1 p1
⇥y p1 (a(a 1) a2 )y
⇥xh1 (p, u) =
= a(a 1)pa≠2 p1≠a u p21
1 2
⇥p1 ay ⇥x1 (p, y)
⇥xh1 (p, v(p, y)) = =
= a(a 1)pa≠2 p1≠a yp≠a a≠1 p21 ⇥p1
1 2 1 p2
⇥p1

25 / 41 26 / 41

Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

“Classical” Proof of the Slutsky Equation

The duality proof of the Slutsky relation is elegant. A less elegant, Solving simultaneously for the Marshallian Demands:
and somewhat more tedious proof is given in this section. The proof
strategy again, is to show a close connection between the solutions x1 = x1 (p1 , p2 , y)
of the primal and dual problems. We restrict the consumer to choose x2 = x2 (p1 , p2 , y)
over 2 goods. We start with the primal problem: = (p1 , p2 , y) (3)
max u = u(x1 , x2 ) subject to p1 x1 + p2 x2 = y (1) Then substituting 3 into 2 gives:
Then, set up the Lagrangian and find the first-order conditions: u1 (x1 (p1 , p2 , y), x2 (p1 , p2 , y)) (p1 , p2 , y)p1 ⇤ 0
L = u(x1 , x2 ) + (y p1 x1 p2 x2 ) u2 (x1 (p1 , p2 , y), x2 (p1 , p2 , y)) (p1 , p2 , y)p2 ⇤ 0
L1 = u1 (x1 , x2 ) p1 ⇤ 0 y p1 x1 (p1 , p2 , y) p2 x2 (p1 , p2 , y) ⇤ 0 (4)
L2 = u2 (x1 , x2 ) p2 ⇤ 0
L = y p1 x1 p2 x2 ⇤ 0 (2)

27 / 41 28 / 41
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Since we are interested in changes in xj as pj changes, we must We can then represent this system of linear equations in matrix
differentiate 4 with respect to pj . notation as follows:
⇥x1 ⇥x2 ⇥ Q R Q ⇥x1 R Q R
u11 + u12 p1 ⇤0 (5) u11 u12 p1 ⇥p1
⇥p1 ⇥p1 ⇥p1 c dc d c d
c dc d
c ⇥x2 d c d
c u21 u22
c p2 d c ⇥p1 d = c 0 d
d c
d (8)
⇥x1 ⇥x2 ⇥ c d
u21 + u22 p2 ⇤0 (6) a ba b a b
⇥p1 ⇥p1 ⇥p1
p1 p2 0 ⇥
⇥p1
x1
⇥x1 ⇥x2 ¸ ˚˙ ˝
p1 x1 p2 ⇤0 (7) A
⇥p1 ⇥p1

29 / 41 30 / 41

Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Now, solving the dual problem in the same way allows us to draw a Now let |A| = H and |B| = D. Calculating these determinants we can
connection between the two Hessian matrices. To state the dual show that:
problem:
H= p22 u11 + p1 p2 u12 + p1 p2 u21 p21 u22
min y = p1 x1 + p2 x2 subject to u(x1 , x2 ) = uú h 2 h 2
D= u2 u11 h
u1 u2 u12 h
u1 u2 u21 + u1 u22
Solving this problem for the same comparative static effect as we did ! "
= h
u22 u11 u1 u2 (u12 + u21 ) + u21 u22
for the primal problem (i.e., p1 ) will result in the following system:
Q R Now from the first order conditions of the primal problem (i.e., 2), we
Q R ⇥xh1 Q R know that p1 = u1 / and p2 = u2 / . Thus A can be re-written as:
h
u11 h
u12 u1 c ⇥p1 d 1
c dc d c d Q u1 R
c d c ⇥xh d c d u11 u12
c
c
h
u 21
h
u 22 u d c
2 d c ⇥p 2 d
d = c
c 0 d
d (9) c d
a bc 1
d a b c d
a b c u2 d
c d
u1 u2 0 ⇥ h 0 C = c u21 u22 d (10)
¸ ˚˙ ˝ ⇥p1 c d
c d
B a u u2 b
1
0
where B refers to the Hessian matrix of the dual problem.

31 / 41 32 / 41
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Taking the determinant, we obtain:

u22 u11 + u1 u2 (u12 + u21 ) u21 u22 Solving likewise for the first comparative static result of the primal
|C| = 2
=H problem of 8 we get:
- -
Now returning to the dual problem of 13 we can solve for the first - u12 p1 --
-
comparative static result using Cramer’s rule: - -
- -
- - - 0 u22 p -
2 -
- 1 -
-
h
u12 u1 -- - -
- - - -
- - ⇥x1 - x1 p2 0 - H11 x1 H31
- 0 h
u22 u2 -- = = +
- ⇥p1 H H H
- -
- - p22 x1 H31
⇥x1h - 0 u 2 0 - D11 u2 = + (12)
= = = 2 (11) H H
⇥p1 D D D

where D11 is the cofactor of the first row and first column element of
D.

33 / 41 34 / 41

Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

To establish the Slutsky equation we need to connect these two

solutions. What we need to be able to show is that 11 is equal to the
first term of 12. Now recall from the first order condition of the primal If you work out the first-order conditions of the dual problem and then
problem, we have p2 = u2 / . Using this fact, together with the result compare it with those of the primal problem (i.e., 2), you will notice
that H = |C|, we can write equation 12: that = 1/ h .
This is because from the first order conditions of the dual problem, we
⇥x1 p22 x1 H31 p1 p2
= + have = = .
⇥p1 H H u1 u2
3 4 On the other hand, from the first order condition of the primal problem
⇥x1 u22 2
x1 H31
= ⇥ 2 2 + we have
u1
= =
u2
.
⇥p1 2 u2 u11 + u1 u2 (u12 + u21 ) u1 u22 H p1 p2
u22 x1 H31 1
= + Putting these two results together, we have = h
(u22 u11 u1 u2 (u12 + u21 ) + u21 u22 ) H
2
u2 x1 H31
= +
u22 u11 u1 u2 (u12 + u21 ) + u21 u22 H

35 / 41 36 / 41
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

Finally, if instead of differentiating with respect to p1 to get the system

⇥x1
5 – 7, we differentiated with respect to y and then found , we
⇥y
Thus, the last step in 13 can be written as: would be able to show that:

u22 ⇥x1 H31

⇥x1
= +
x1 H31 =
⇥p1 (u22 u11 u1 u2 (u12 + u21 ) + u21 u22 ) H ⇥y H
u22 x1 H31 This expression is exactly equal to the second term in equation 12.
= +
D H Thus, we have demonstrated:
⇥xh1 x1 H31
= + ⇥x1 ⇥xh1 ⇥x1
⇥p1 H = x1
⇥p1 ⇥p1 ⇥y
This proves that 11 is identical to the first term in 12.
A similar approach yields:

⇥x2 ⇥xh2 ⇥x2

= x1
⇥p1 ⇥p1 ⇥y

37 / 41 38 / 41

Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

• We can rearrange these equations as follows:

• All in all, there should be 4 equations (given that there are two
⇥x1 ⇥x1 ⇥xh1 prices and two commodities). To complete the system, we could
+ x1 = calculate:
⇥p1 ⇥y ⇥p1
¸˚˙˝ ¸ ˚˙ ˝ ¸˚˙˝
Own-Price Effect Income Effect Own-Substitution Effect ⇥x1 ⇥x1 ⇥xh1
+ x2 =
⇥p2 ⇥y ⇥p2
⇥x2 ⇥x2 ⇥xh2 ¸˚˙˝ ¸ ˚˙ ˝ ¸˚˙˝
+ x1 = Cross-Price Effect Income Effect Cross-Substitution Effect
⇥p1 ⇥y ⇥p1
¸˚˙˝ ¸ ˚˙ ˝ ¸˚˙˝
Cross-Price Effect Income Effect Cross-Substitution Effect ⇥x2 ⇥x2 ⇥xh2
+ x2 =
• The first of these equations is called an own-price comparative ⇥p2 ⇥y ⇥p2
¸˚˙˝ ¸ ˚˙ ˝ ¸˚˙˝
static, whereas the second is a cross-price comparative static Own-Price Effect Income Effect Own-Substitution Effect
(i.e., what happens to x2 when p1 changes).

39 / 41 40 / 41
Monotonic Transformations Properties of Indirect Utility and Expenditure Properties of Consumer Demand Exercise

• Finally, we could put all of these results into matrix form:

Q ⇥x1 Q ⇥xh ⇥xh R
⇥x1 R
⇥p1 + x1 ⇥y ⇥p2 + x2 ⇥y
⇥x1 ⇥x1 1 1
⇥p1 ⇥p2
c d c d
c ⇥x d=c c
d
d
⇥p1 + x1 ⇥y ⇥p2 + x2 ⇥y
a 2 ⇥x 2 ⇥x 2 ⇥x 2 b h
a ⇥x2 ⇥x2 b
h

⇥p1 ⇥p2

¸ ˚˙ ˝ ¸ ˚˙ ˝
Slutsky Matrix Substitution Matrix

41 / 41