Handout #2

Derivation of the LES demand system

Consumer’s problem:
Y X
max U = (Xi i)
i
s.t. Y = Pi Xi
Xi
i i
P
where i i = 1:
The Lagrange equation:
!
Y X
L= (Xi i)
i
+ Y Pi Xi
i i

First order conditions:

Y
1 j iU
i (Xi i)
i
Xj j = Pi ) = Pi
j6=i
Xi i
X
Y = Pi Xi
i

Ratio of two FOC’s:

i Xj j Pi
= ) Pj i Xj Pj i j = Pi j (Xi i)
j (Xi i) Pj
Pi j (Xi i ) + Pj i j
Pj Xj =
i

Substitute into budget line:

X X Pi j (Xi i) + Pj i j
Y = Pj Xj =
j j i
P P P
X j Pi Xi j Pi i + i Pj j j j Pi Xi j j Pi i + j i Pj j
Y = =
j i i
P P P
Pi Xi j j Pi i j j + i j Pj j Pi Xi Pi X
i
Y = = + Pj j
i i j

!
Pi Xi Pi X X
i
= Y Pj j ) Pi Xi Pi i = i Y Pj j
i j j
! !
X X
i
Pi Xi = Pi i + i Y Pj j ) Xi = i + Y Pj j
j
Pi j