Advanced Microeconomics

Consumer theory
Preferences ∙ Utility functions exist and have certain properties linked to preferences ∙
Consumer’s problem ∙ CES utility ∙ Properties of the indirect utility function∙ Roy’s
identity ∙ Testing for properties

Advanced Microeconomics BEC 371 Class notes 2022, Sikota Sharper.

 Outline
• Preferences
• Utility functions exist and have certain properties linked to preferences ∙
• Consumer’s problem
• CES utility
• Properties of the indirect utility function
• Roy’s identity
• Testing for properties

Advanced Microeconomics BEC 371 Class notes 2022, Sikota Sharper.

 Ambitions
To understand market exchange when goods exchange at predictable prices.
Key questions include
• Why do goods exchange at those rates?
• How do demand and supply change if prices change? If incomes change?
• Does market exchange lead to stable outcomes? (“equilibrium”)

Questions that are ignored

• How do people come to like/dislike goods?
• Hoe does equilibrium come about?
• How does exchange work “off equilibrium”?

Advanced Microeconomics BEC 371 Class notes 2022, Sikota Sharper.

 Advanced Microeconomics
• The analysis of the behaviour of individual economic agents; and the
aggregation of their actions in an institutional framework.
• Four key elements are relevant in such definition:
• 1. individual agents: typically a consumer or a firm (producer);
• 2. behaviour: traditionally utility maximization or profit maximization;
• 3. the institutional framework: traditionally, the price mechanism in an
impersonal market place or a game theoretic setting,
• 4. the mode of analysis: equilibrium analysis.
• What do we intend to get out?
• A better understanding of economic activity and outcomes.
Advanced Microeconomics BEC 371 Class notes 2022, Sikota Sharper.
 Consumer theory case

• Consumer Theory
• The agent: individual (consumer);
• the activity: consume a whole set of commodities (goods and
services). We focus on L commodities l = 1,...,L;
• the framework: consumption feasible set

Advanced Microeconomics BEC 371 Class notes 2022, Sikota Sharper.

 Consumption set and its feasible subset
It is impossible to consume non-goods. Therefore the consumption set 𝑋 is restricted to
the non-negative orthant of the 𝑛-dimensional hyperplane, ℝ𝑛+ .

The feasible set is a subset of the consumption set:

• 𝑥𝑖 is a non-negative quantity of a specific consumer good

• 𝐱 is a consumption bundle consisting of goods 𝑖 = 1 ⋯ 𝑛
• 𝑋 is a consumption or choice set consisting of all the possible consumption bundles 𝐱 𝒋
• 𝐱 ∈ 𝑋 and 𝐱 ∈ 𝐵, the consumption bundle must be possible and feasible

Advanced Microeconomics BEC 371 Class notes 2022, Sikota Sharper.

 BASICS OF CONSUMER THEORY

Assumption 1.1 Properties of the consumption set

The minimal requirements on the consumption set 𝑋 are:

1. ∅ ≠ 𝑋 ⊆ ℝ𝑛+
2. 𝑋 is closed Closed means that the consumption set includes its own
3. 𝑋 is convex boundary and convex means that a combination of any two
4. 𝟎∈𝑋 𝐱 ∈ 𝑋 is itself in 𝑋. Zero consumption is a possibility

Advanced Microeconomics BEC 371 Class notes 2022, Sikota Sharper.

 Axioms of choice
Axiom 1 Completeness Consumer can detect the difference
For all 𝐱1 and 𝐱 2 in 𝑋, either 𝐱1 ≽ 𝐱 2 or 𝐱 2 ≽ 𝐱1
≽ reads “as good as”
𝐱 i reads bundle 1 and bundle 2

Axiom 2 Transitivity Consistently links pairwise comparisons

For any three bundles 𝐱1 𝐱 2 𝐱 3 in 𝑋, if 𝐱1 ≽ 𝐱 2 and 𝐱 2 ≽ 𝐱 3 , then 𝐱1 ≽ 𝐱 3
 These definitions say
Definition 1.1 Preference relation that there are three
The binary relation ≽ on the consumption set 𝑋 is a preference mutually exclusive
possibilities, either A is
relation if it satisfies Axioms 1 and 2.
preferred to B, or B is
preferred to A or A and
B rank indifferent.
Definition 1.2 Strict preference relation
The binary relation ≽ on the consumption set 𝑋 is defined as follows:
𝐱1 ≻ 𝐱 2 if and only if 𝐱1 ≽ 𝐱 2 and not 𝐱 2 ≽ 𝐱1

Definition 1.3 Indifference relation

The binary relation ∼ on the consumption set 𝑋 is defined as follows:
𝐱1 ∼ 𝐱 2 if and only if 𝐱1 ≽ 𝐱 2 and 𝐱 2 ≽ 𝐱1
Mutually exclusive options: Either 𝐴 ≻ 𝐵 or 𝐵 ≻ 𝐴 or 𝐴~𝐵
Definition 1.4 Subsets in 𝑋 derived from the preference relation

Let 𝐱 0 be any point in the consumption set 𝑋. Relative to such a point, we can
define the following subsets of 𝑋

1. ≽ 𝐱0 ≡ 𝐱|𝐱 ∈ 𝑋, 𝐱 ≽ 𝐱 0 , called the “at least as good as” 𝐱 0 set

2. ≼ 𝐱0 ≡ 𝐱|𝐱 ∈ 𝑋, 𝐱 0 ≽ 𝐱 , called the “no better than” 𝐱 0 set
3. ≺ 𝐱0 ≡ 𝐱|𝐱 ∈ 𝑋, 𝐱 0 ≻ 𝐱 , called the “worse than” 𝐱 0 set
4. ≻ 𝐱0 ≡ 𝐱|𝐱 ∈ 𝑋, 𝐱 ≻ 𝐱 0 , called the “preferred to” 𝐱 0 set
5. ∼ 𝐱0 ≡ 𝐱|𝐱 ∈ 𝑋, 𝐱 ∼ 𝐱 0 , called the “indifference” 𝐱 0 set
Axiom 3 Continuity
For all 𝐱 in ℝn+ the at least as good as set, ≽ 𝐱, and the no better than set, ≼ 𝐱,
are closed in ℝn+

Think of continuity as ensuring that indifference curves do not have gaps; the adjacent bundle is
always the same as, better than or worse than the reference bundle. This is the line in the diagram
below.

Consider a reference bundle and two adjacent bundles

• Move from 𝐱 0 ≼ 𝐱1 is an example of strict monotonicity
• But 𝐱 2 ≼ 𝐱 0 is an example of local non-satiation
• Local non-satiation refers to changes not increases
• See axiom 4 and 4’
Axiom 4’ Local non-satiation
For all 𝐱 in ℝn+ and for all ε > 0 there exists some 𝐱 ∈ B𝛆 𝐱 0 ∩ ℝn+ such that 𝐱 ≻ 𝐱 0

This reads: Within any vicinity of a bundle 𝐱 0 , no matter how small that vicinity, there will always be a
bundle that is more preferred than 𝐱 0

Axiom 4 Strict monotonicity

For all 𝐱 0 , 𝐱1 ∈ ℝ𝑛+ , if 𝐱 0 ≥ 𝐱1 then 𝐱 0 ≽ 𝐱1 while if 𝐱 0 ≫ 𝐱1 then 𝐱 0 ≻ 𝐱1
≫ reads “contains strictly more of every good” than the other bundle
Axiom 5’ Convexity
If 𝐱1 ≽ 𝐱 0 then 𝑡𝐱1 + 1 − 𝑡 𝐱 0 ≽ 𝐱 0 for all 𝑡 ∈ 0,1
0,1 reads “closed interval from zero to one”

Axiom 5 Strict convexity

If 𝐱1 ≠ 𝐱 0 and 𝐱1 ≽ 𝐱 0 , then 𝑡𝐱1 + 1 − 𝑡 𝐱 0 ≻ 𝐱 0 for all 𝑡 ∈ 0,1
0,1 "reads open interval from zero to one”

Reflexivity: Any bundle x is always at least as preferred as itself; i.e.

x f x.
~
Utility functions
Ordinal vs. cardinal
The utility function as mathematical representation of the preference
relation is not unique. Any positive monotonic transform like 𝑣 = 𝑢 + 5
or 𝑣 = 𝑢3 holds the same information.

This is convenient, as it allows one to look for a functional form that is

easy to manipulate. On the other hand it places a restriction on the
function, which is that the absolute value number generated at/by 𝑢∗ is
meaningless beyond its ability to rank preferences.
Theorem 1.1 Existence of the utility function
If the binary relation ≽ is complete, transitive, continuous and strictly monotonic, there
exists a continuous real-valued function 𝑢: ℝ𝑛+ → ℝ, which represents ≽.
• A preference relation satisfying completeness, transitivity and reflexivity is termed rational
• One of the key results of consumer theory is: the representation theorem.

• Representation Theorem If preferences are rational (complete, reflexive and transitive) and
continuous;

Set-up for Varian’s proof of existence

• Let the preference relation ≽ be complete, transitive, continuous and strictly monotonic.
• Define 𝐞 ≡ 1, ⋯ , 1 ∈ ℝ𝑛+ as a vector of ones in n-dimensional real space
• Take any bundle 𝐱 in the domain ℝn+ and assign to it a number u 𝐱 such that 𝑢 𝐱 𝐞~𝐱
• Consider two bundles 𝐱1 and 𝐱 2 and their associated utility numbers 𝑢 𝐱1 and 𝑢 𝐱 2
which by definition satisfy the requirement that 𝑢 𝐱1 𝐞~𝐱1 and 𝑢 𝐱 2 𝐞~𝐱 2

• Then we have the following

𝐱1 ≽ 𝐱 2
⇔ 𝑢 𝐱1 𝐞~𝐱1 ≽ 𝐱 2 ~𝑢 𝐱 2 𝐞 by the definition of 𝑢 𝐱
⇔ 𝑢 𝐱1 𝐞 ≽ 𝑢 𝐱 2 𝐞 by transitivity
⇔ 𝑢 𝐱1 ≥ 𝑢 𝐱 2 by the monotonicity of ≽
• So that 𝐱1 ≽ 𝐱 2 if and only if 𝑢 𝐱1 ≥ 𝑢 𝐱 2 as we set out to show.
Theorem 1.2 Order preserving utility functions
(without proof)
Let ≽ be a preference relation on ℝ𝑛+ and suppose that 𝑢 𝐱 is a utility function that
captures these preferences. Then 𝑣 𝐱 represents ≽ if and only if 𝑣 𝐱 = 𝑓 𝑢 𝐱 is
strictly increasing on the set of values taken on by 𝑢.

Theorem 1.3 Properties of preferences and utility functions

(without proof)
Let ≽ be represented by 𝑢: ℝ𝑛+ → ℝ. Then
1. 𝑢 𝐱 is strictly increasing if an only if ≽ is strictly monotonic
2. 𝑢 𝐱 is quasi-concave if and only if ≽ is convex
3. 𝑢 𝐱 is strictly quasi-concave if an only if ≽ is strictly convex
Theorem 1.1 proved the existence of a continuous utility function,
which is not the same as differentiability. Differentiability is
essential for optimisation using calculus methods. Instead of
proving it, we will simply assume differentiability where
necessary. This means that many of the proofs that follow starts
out by saying “Let 𝑓 𝐱 by a twice differentiable continuous
function…”
Other properties of interest
• The marginal utility of good 𝑖 is defined as
𝜕𝑢 𝐱
𝑀𝑈𝑖 =
𝜕𝑥𝑖
• The marginal rate of substitution is defined as the slope of the indifference curve, which is itself
a level set of the utility function where d𝑢 = 0.
𝜕𝑢 𝐱 𝜕𝑢 𝐱
𝑑𝑥𝑖 + 𝑑𝑥𝑗 = 0
𝜕𝑥𝑖 𝜕𝑥𝑗
𝜕𝑢 𝐱
𝑑𝑥𝑗 𝜕𝑥𝑖
𝑀𝑅𝑆𝑗𝑖 = =−
𝑑𝑥𝑖 𝜕𝑢 𝐱
+
𝜕𝑥𝑗
• MRS is sometimes defined as the absolute value of the ratio of marginal utilities. The negative
sign tells us that the upper level set of the utility function is convex.
• MRS does not depend on a specific utility function, because we can relabel the indifference map
with any monotonic transformation of the original utility function.
 𝐲

• When 𝑢 𝐱 is differentiable on ℝ𝑛++ and preferences

are strictly monotonic, 𝑀𝑈 is virtually always strictly
positive
𝜕𝑢 𝐱
> 0 for almost all i = 1, ⋯ n
𝜕𝑥𝑖
• When preferences are strictly convex, the MRS is
always strictly diminishing along the level set of the
utility function
• More generally, for any quasi-concave utility function,
the Hessian matrix, 𝐇 𝐱 , will satisfy
𝐲 𝑡 𝐇𝐲 ≤ 𝟎 for all vectors 𝐲 such that ∇𝑢 𝐱 ∙ 𝐲 = 0

Directional derivative This says that moving from 𝐱 in the direction of

𝐲 that is tangent to the indifference surface
through 𝐱 will lower utility. In this case 𝐱 is a
bundle on the surface and 𝐲 is the tangent
hyperplane
Assumption 1.2 Consumer preferences

The consumer’s preference relation ≽ is complete, transitive,

continuous, strictly monotonic and strictly convex on 𝑅+𝑛 .
Therefore, by Theorems 1.1 (Existence) and 1.3 (Properties of
the utility function), the consumer’s preference relation can
be represented by a real-valued utility function 𝑢 that is
continuous, strictly increasing, strictly quasi-concave on 𝑅+𝑛 .
A function is strictly quasi-concave if and only if for any two points 𝑢
and 𝑣 in the domain of 𝑓 and for 0 < 𝑡 < 1
𝑓 𝑣 ≥ 𝑓 𝑢 ⇒ 𝑓 𝑡𝑢 + 1 − 𝑡 𝑣 ≥ 𝑓 𝑢

To visualise what this means, label 𝑓 𝑢 = 𝑀 and 𝑓 𝑣 = 𝑁

• From 𝑀 we can either move uphill in the direction of 𝑁 or around the
contour in the direction of 𝑁′
• Going uphill, 𝑓 𝑡𝑢 + 1 − 𝑡 𝑣 > 𝑓 𝑢
• Going around the contour, 𝑓 𝑡𝑢 + 1 − 𝑡 𝑣 = 𝑓 𝑢

Properties of level sets of a strictly quasi-concave, continuous and

strictly increasing utility function are :
• Non-intersecting
• Strictly convex to the origin
• Increase in a north-easterly direction on the indifference map
To summarise
In the most abstract terms consumer behaviour can be described as follows

• The consumer has a consumption set defined in the positive orthant of the 𝑛-
dimensional hyperplane 𝑋 = 𝑅+𝑛 . We will refer to either 𝑋 or 𝑅+𝑛 as the consumption
set. This is a closed set.
• His preferences are captured by the preference relation ≽ (at least as good as) defined
on 𝑅+𝑛 (the consumption set)
• All conceivable bundles are not feasible. The feasible portion of the consumption set is
called the budget set 𝐵 ⊂ 𝑅+𝑛 . This is a closed set.
• We assume that the consumer will choose his most preferred feasible bundle
𝐱 ∗ ∈ 𝐵 such that 𝐱 ∗ ≽ 𝐱 for all 𝐱 ∈ 𝐁
The consumer in the economy
Some notation describing the market economy
• (Interesting) goods trade at positive prices, 𝐩 ≫ 0
• Price taking behaviour means prices are exogenous
• The consumer has a fixed income 𝑦 ≥ 0 which implies that 𝐩𝐱 ≤ y and a
budget set
𝐵 = 𝐱|𝐱 ∈ ℝ,𝒏 + , 𝐩𝐱 ≤ 𝑦

• As a subset of the consumption set 𝑋 = 𝑅+𝑛 , the budget set 𝐵 inherits the
properties of non-emptiness, closedness and convexity from the consumption
set (assumption 1.1)
• This has implications for the maximum value of the consumer’s indirect utility
function
Mathematical structure of the consumer’s problem

The statement about the most preferred bundle in the budget set
𝐱 ∗ ∈ 𝐵 such that 𝐱 ∗ ≽ 𝐱 for all 𝐱 ∈ 𝐁
[1]
becomes
max 𝑢 𝐱 s. t. 𝐩⋅𝐱≤ 𝑦
𝐱 ∈ℝ,𝒏
+

which can be rearranged as

max 𝑢 𝐱 s. t. 𝑦 − 𝐩 ⋅ 𝐱 ≥ 0
𝐱 ∈ℝ,𝒏
+

[2]
Note that if 𝐱 ∗ solves this problem, then 𝑢 𝐱 ∗ ≥ 𝑢 𝐱 for all 𝐱 ∈ 𝐵, which means that 𝐱 ∗ ≽ 𝐱
for all 𝐱 ∈ 𝐵. That means the solution to [1] is a solution to [2] and vice versa.
Important questions about the consumer’s problem
• Does a solution to this problem exist?
• Is the solution unique?

Many of the elements of the Weierstrass theorem (A1.10) apply to the consumer’s problem:
• The budget set is non-empty and compact
• The utility function is continuous, strictly increasing and strictly quasiconcave
• Therefore the consumer’s problem has a solution, which we call Marshallian demand
𝐱 ∗ = 𝐱 𝐩, 𝑦
• Since the utility function is strictly quasiconcave and the budget set is convex, the
maximising solution is also unique.
Graphical derivation
• Holding income and other prices constant, the
Marshallian demand function can be derived by
applying different prices for good 1 to the
budget set.
• This will generate a set of tangencies which can
be plotted as price-quantity pairs that can be
used to derive Marshallian demand.
 Calculus methods
max,𝒏 𝑢 𝐱 s. t. 𝐩⋅𝐱≤𝑦
𝐱 ∈ℝ+

This expression is an example of a nonlinear programming problem with one inequality constraint. Theorem
A2.19 proved that a solution exists, and thus a Lagrange expression can be formed.
ℒ 𝐱𝜆 ≡ 𝑢 𝐱 + 𝜆 𝑦 − 𝐩 ∙ 𝐱
Assuming that 𝐱 ∗ is an interior solution, there exists 𝜆∗ ≥ 0 such that the solution 𝐱 ∗ , 𝜆∗ satisfies the Kuhn
Tucker conditions (Theorem A2.20).
𝜕ℒ 𝜕𝑢 𝐱 ∗
= − 𝜆∗ 𝑝𝑖 = 0 for all 𝑖 = 1, ⋯ , 𝑛
𝜕𝑥𝑖 𝜕𝑥𝑖
[1]
𝑦 − 𝐩 ∙ 𝐱∗ ≥ 0
[2]
𝜆∗ 𝑦 − 𝐩 ∙ 𝐱 ∗ = 0
[3]
By strict monotonicity of the utility function, expression [2] holds with equality (the budget is exhausted),
which makes [3] obsolete. Therefore the necessary FOC for a maximum simplify to
𝜕ℒ 𝜕𝑢 𝐱 ∗
= − 𝜆∗ 𝑝1 = 0
𝜕𝑥1 𝜕𝑥1
⋮
𝜕ℒ 𝜕𝑢 𝐱 ∗
= − 𝜆∗ 𝑝𝑛 = 0
𝜕𝑥𝑛 𝜕𝑥1
𝜕ℒ
= 𝑦 − 𝐩 ∙ 𝐱∗ = 0
𝜕𝜆

These FOC’s cover two eventualities. Either, ∇𝑢 𝐱 ∗ = 𝟎, which means that the consumer has enough
resources to maximise utility or that ∇𝑢 𝐱 ∗ ≠ 𝟎 because there is a binding resource constraint. The
second case is more likely than the first, and by strict monotonicity,
𝜕𝑢 𝐱 ∗
>0 for some 𝑖 = 1, ⋯ , 𝑛
𝜕𝑥1
Line [1] provides an expression for lambda

∗
𝑢𝑖 𝐱
𝜆 =
𝑝𝑖
[4]
Since 𝑢𝑖 𝐱 is assumed to be positive for most consumers in most cases, and 𝑝𝑖 is positive in the
market economy, 𝜆∗ > 0. Since [4] holds for any two consumer goods, we have
𝑢𝑖 𝐱 𝑢𝑗 𝐱
=
𝑝𝑖 𝑝𝑗
And by rearranging we get
𝑢𝑖 𝐱 𝑝𝑖
=
𝑢𝑗 𝐱 𝑝𝑗
At the optimum, MRS on the left is equal to the price ratio on the right. In the two-good case, these
are the slopes of the indifference curve and budget line. In the consumer’s problem the necessary
Kuhn Tucker FOCs are also sufficient for a maximum. This is in Theorem 1.4.
Example: CES utility function
 For a CES utility function,
1ൗ
𝜌 𝜌 𝜌
𝑢 𝑥1 , 𝑥2 = 𝑥1 + 𝑥2
Solve for the optimal consumer bundle and the indirect utility function.

1ൗ
𝜌 𝜌 𝜌
max ℒ = 𝑥1 + 𝑥2 + 𝜆 𝑚 − 𝑝1 𝑥1 − 𝑝2 𝑥2

FOCs: Exponents inside

1ൗ −1 and outside the
𝜕ℒ 𝜌 𝜌 𝜌 𝜌−1
= 1ൗ𝜌 𝑥1 + 𝑥2 𝜌𝑥1 − 𝜆𝑝1 = 0 bracket cancel
𝜕𝑥1 out
𝜕ℒ 𝜌
1
𝜌 ൗ𝜌−1 𝜌−1
= 𝑥1 + 𝑥2 𝑥2 − 𝜆𝑝2 = 0
𝜕𝑥2
𝜕ℒ
= 𝑚 − 𝑝1 𝑥1 − 𝑝2 𝑥2 = 0
𝜕𝜆
Dividing the 1st by the 2nd FOC gives the expansion path
1ൗ −1
𝜌 𝜌 𝜌 𝜌−1
𝑥1 + 𝑥2 𝑥1 𝜆𝑝1
1 =
𝜌 𝜌 ൗ𝜌−1 𝜌−1 𝜆𝑝2
𝑥1 + 𝑥2 𝑥2
𝜌−1
𝑥1 𝑝1
𝜌−1 =
𝑥2 𝑝2
1ൗ
𝑝1 𝜌−1
𝑥1 = 𝑥2
𝑝2

Plug into the budget constraint

 𝑚 = 𝑝1 ∙ 𝑥1 + 𝑥2 ∙ 𝑝2
1ൗ
𝑝1 𝜌−1
𝑚 = 𝑝1 ∙ 𝑥2 + 𝑥2 ∙ 𝑝2
𝑝2
𝜌−1 Τ 𝜌−1 𝜌−1 Τ 𝜌−1
Rewrite the first 𝑝1 on the first term to 𝑝1 and 𝑝2 on the second term to 𝑝2
which gives
1ൗ
𝑝1 𝜌−1
𝜌−1 Τ 𝜌−1 𝜌−1 Τ 𝜌−1
𝑚= 𝑝1 ∙ 𝑥2 + 𝑥2 ∙ 𝑝2
𝑝2
−1Τ 𝜌−1
Now, factoring out the common terms 𝑥2 and 𝑝2 leaves and from there solving for 𝑥2∗
𝜌Τ 𝜌−1 𝜌Τ 𝜌−1 −1Τ 𝜌−1
𝑚 = 𝑥2 𝑝1 + 𝑝2 𝑝2
1ൗ
𝜌−1
𝑝2
𝑥2∗ = 𝑚 𝜌 𝜌
ൗ 𝜌−1 ൗ 𝜌−1
𝑝1 + 𝑝2
The expansion path recovers 𝑥1∗ .
1ൗ
𝜌−1
𝑚𝑝1
𝑥1∗ = 𝜌 𝜌
ൗ 𝜌−1 ൗ 𝜌−1
𝑝1 + 𝑝2

𝜌
Simplify the exponents by setting 𝑟=
𝜌−1
This gives more compact statements of the Marshallian demand system
𝑚𝑝1𝑟−1 𝑚𝑝2𝑟−1
𝑥1∗ = and 𝑥2∗ =
𝑝1𝑟 +𝑝2𝑟 𝑝1𝑟 +𝑝2𝑟
To form the indirect utility function
1ൗ
𝜌 𝜌 𝜌
𝑣 𝑥1 , 𝑥2 = 𝑥1 + 𝑥2
1ൗ
𝜌 𝜌 𝜌
𝑚𝑝1𝑟−1 𝑚𝑝2𝑟−1
𝑣 𝐩, 𝑚 = +
𝑝1𝑟 + 𝑝2𝑟 𝑝1𝑟 + 𝑝2𝑟 Factor out m

1ൗ
𝜌 𝜌 𝜌
𝑝1𝑟−1 𝑝2𝑟−1
𝑣 𝐩, 𝑚 = 𝑚 +
𝑝1𝑟 + 𝑝2𝑟 𝑝1𝑟 + 𝑝2𝑟 Split the fractions and
raise both numerator and
denominator to rho. Then
put the stuff inside the
1ൗ square bracket on a
𝑟−1 𝜌 𝑟−1 𝜌 𝜌
𝑝1 + 𝑝2 common denominator
𝑣 𝐩, 𝑚 = 𝑚
𝑝1𝑟 + 𝑝2𝑟 𝜌
 Remember that
1ൗ 𝜌
𝑟−1 𝜌 𝑟−1 𝜌 𝜌 𝑟=
𝑝1 + 𝑝2 𝜌−1
𝑣 𝐩, 𝑚 = 𝑚
𝑝1𝑟 + 𝑝2𝑟 𝜌 𝜌 𝜌− 𝜌−1
∴ 𝑟−1 𝜌= −1 𝜌= 𝜌
𝜌−1 𝜌−1
𝜌
= =𝑟
𝜌−1
1ൗ
𝜌
𝑝1𝑟 + 𝑝2𝑟
𝑣 𝐩, 𝑚 = 𝑚
𝑝1𝑟 + 𝑝2𝑟 𝜌
−𝜌
𝑟 1ൗ𝜌 ൗ𝜌
𝑣 𝐩, 𝑚 = 𝑚 𝑝1𝑟 + 𝑝2 ∙ 𝑝1𝑟 + 𝑝2𝑟 ∙

𝑟 −1ൗ𝑟
𝑣 𝐩, 𝑚 = 𝑚 𝑝1𝑟 + 𝑝2
Note the following
1. The Marshallian demand functions and the indirect utility function depend only on the
parameters of the problem, namely income and prices.
2. We have made enough assumptions to ensure that the vector 𝐱 𝐩, 𝑚 is continuous on
ℝ𝑛++ but since we would like to do some comparative statics, we also assume that
𝐱 𝐩, 𝑚 is differentiable when we need it to be.
3. For the assumption set out in point 2 to be true, we need Theorem 1.5 on differentiable
demand (see below).
Theorem 1.5 Differentiable demand
(without proof)

Let 𝐱 ∗ ≫ 0 solve the consumer’s maximisation problem at 𝐩0 ≫ 0 and 𝑦 0 > 0. If

1. 𝑢 is twice continuously differentiable on ℝ𝑛++
2. 𝜕𝑢ൗ𝜕𝑥𝑖 > 0 for some (nearly all) 𝑖 = 1 ⋯ 𝑛 and
3. The bordered Hessian of 𝑢 𝐱 ∗ has a non-zero determinant at 𝐱 ∗

Then 𝐱 𝐩, 𝑦 is differentiable at 𝐩0 , 𝑦 0 .
Indirect utility function
Definition Indirect utility function

The indirect utility function is the real value function which solves the consumer’s
problem
𝑣 𝐩, 𝑦 = max 𝑢 𝐱 s.t. 𝐩𝐱 ≤ 𝑦
• When 𝑢 𝐱 is continuous 𝑣 𝐩, 𝑦 is well defined for 𝐩 ≫ 0 and 𝑦 ≥ 0 because a solution to the
problem is guaranteed to exist.
• If 𝑢 𝐱 is also strictly quasi-concave, then the solution is unique and can be written as 𝐱 𝐩, 𝑦 .
• Since the maximum level of utility that can be achieved when facing prices 𝐩 with income 𝑦 is
what is realised when 𝐱 𝐩𝑦 is chosen, we have
𝑣 𝐩, 𝑦 = 𝑢 𝐱 𝐩𝑦
• Continuity of the budget constraint in 𝐩 and 𝑦 is sufficient to guarantee that 𝑣 𝐩, 𝑦 will be
continuous in 𝐩 and 𝑦 on ℝ𝑛+ × ℝ+ . This is because small changes in the price and income
environment will result only in small changes in the maximum level of utility that the consumer
can achieve given these parameters.
Theorem 1.6 Properties of the indirect utility function

If 𝑢 𝐱 is continuous and strictly increasing on ℝ𝑛+ the indirect utility function,

𝑣 𝐩, 𝑦 , is
1. Continuous ℝ𝑛++ × ℝ+
2. Homogenous of degree zero in 𝐩, 𝑦
3. Strictly increasing in 𝑦
4. Decreasing in 𝐩
It is also
ഥ <0
5. Quasiconvex in 𝐩, 𝑦 , in other words positive definite s.t. constraint 𝐻
6. and Roy’s identity holds
Proof Theorem 1.6
Property 1 follows from the theorem of the maximum which states the indirect utility
function inherits twice continuous differentiability from the continuous, negative
semidefinite utility function

To prove property 2 (homogeneity of degree zero), we must show that 𝑣 𝐩, 𝑦 =

𝑣 𝑡𝐩, 𝑡𝑦 ∀𝑡 > 0. This part of the proof relies on a property of the budget set.
𝑣 𝑡𝐩, 𝑡𝑦 = max 𝑢 𝐱 𝑠. 𝑡. 𝑡𝐩 ∙ 𝐱 ≤ 𝑡𝑦
But since we can divide both sides of the budget constraint by 𝑡 > 0 without affecting
the bundles available in it,
max 𝑢 𝐱 𝑠. 𝑡. 𝑡𝐩 ∙ 𝐱 ≤ 𝑡𝑦 = max 𝑢 𝐱 𝑠. 𝑡. 𝐩∙𝐱≤𝑦
Consequently
𝑣 𝑡𝐩, 𝑡𝑦 = max 𝑢 𝐱 𝑠. 𝑡. 𝑡𝐩 ∙ 𝐱 ≤ 𝑡𝑦 = 𝑣 𝐩, 𝑦
Reminder Envelope theorem
When evaluated at the optimum, the total derivative of an implicit function with
respect to a parameter 𝑎, reduces to the partial derivative w.r.t. its parameter.
Let 𝑓 𝑥, 𝑎 and 𝑀 𝑎 ≡ 𝑓 𝑥 𝑎 , 𝑎
Differentiating both sides of the identity with respect to 𝑎 gives
𝑑𝑀 𝑎 𝜕𝑓 𝑥 𝑎 , 𝑎 𝜕𝑥 𝑎 𝜕𝑓 𝑥 𝑎 , 𝑎
≡ ∙ +
𝑑𝑎 𝜕𝑥 𝜕𝑎 𝜕𝑎
At the optimum the FOCS imply
𝜕𝑓 𝑥 𝑎 , 𝑎
=0
𝜕𝑥
So that the first term of the RHS drops out, leaving
𝑑𝑀 𝑎 𝜕𝑓 𝑥 𝑎 , 𝑎
=
𝑑𝑎 𝜕𝑎
Property 3: Indirect utility function is strictly increasing in 𝑦
Assume that the consumer’s problem is solved by the Marshallian demand system
ℒ = 𝑢 𝐱 + 𝜆 𝑦 − 𝐩𝐱 𝑦𝐩
𝐱 ∗ = 𝐱 𝐩, 𝑦

For 𝐩, 𝑦 ≫ 0 and interior solutions 𝐱 ∗ ≫ 𝟎 , the value of 𝜆∗ is

𝜕𝑢 𝐱 ൗ
∗ 𝜕𝑥𝑖
𝜆 = >0
𝑝𝑖
By the envelope theorem
𝜕𝑣 𝐩, 𝑦 𝜕ℒ 𝐱 ∗ , 𝜆∗
= = 𝜆∗
𝜕𝑦 𝜕𝑦
And since 𝜆∗ > 0, the indirect utility function must be strictly increasing in income
Property 4: Decreasing in 𝐩 Varian’s proof

Let 𝐵 = 𝐱: 𝐩𝐱 ≤ 𝑦 and 𝐵′ = 𝐱: 𝐩′𝐱 ≤ 𝑦 for 𝐩′ ≥ 𝐩. It means that the

budget set 𝐵′ of feasible bundles at the higher price is contained in 𝐵, the
budget set formed at the lower price. Hence the maximum of 𝑢 𝐱 over 𝐵 is
at least as big as the maximum of 𝑢 𝐱 over 𝐵′, and indirect utility falls when
prices rise.
Property 5: Convexity
Suppose that there are two sets of prices, 𝐩 and 𝐩′ such that 𝑣 𝐩, 𝑦 ≤ 𝑘 and
𝑣 𝐩′, 𝑦 ≤ 𝑘. Let 𝐩′′ = 𝑡𝐩 + 1 − 𝑡 𝐩′ . We want to show that 𝑣 𝐩′′, 𝑦 ≤ 𝑘
Define three budget sets 𝐵, 𝐵’ and 𝐵′′ such that
𝐵 = 𝐱: 𝐩𝐱 ≤ y
𝐵′ = 𝐱: 𝐩′𝐱 ≤ y
𝐵′′ = 𝐱: 𝐩′′𝐱 ≤ y
The aim is to show that any 𝐱 in 𝐵′′ must be either in 𝐵 or 𝐵′
The convexity proof begins by assuming that 𝐱 is not in either 𝐵 or 𝐵’.
Then 𝐱 is such that 𝑡𝐩𝐱 + 1 − 𝑡 𝐩′𝐱 ≤ 𝑦 but 𝐩𝐱 > y and 𝐩′ 𝐱 > y

Multiply the second inequality by 𝑡 and the third by 1 − 𝑡 . Added

together, this gives
𝑡𝐩𝐱 > 𝑡y
1 − 𝑡 𝐩′ 𝐱 > 1 − 𝑡 y
𝑡𝐩𝐱 + 1 − 𝑡 𝐩′ 𝐱 > 𝐲
which contradicts the assumption that 𝐱 is affordable at price 𝐩′′
Property 6 Roy’s identity
If 𝑣 𝐩, 𝑦 is differentiable at 𝐩0 , 𝑦 0 and 𝜕𝑣 𝐩,𝑦
ൗ𝜕𝑦 ≠ 0 then

𝜕𝑣 𝐩0 , 𝑦 0 ൘
𝜕𝑝𝑖
𝑥𝑖 𝐩0 , 𝑦 0 =−
𝜕𝑣 𝐩0 , 𝑦 0
൘𝜕𝑦
While the Roy’s identity is usually written with the ratio on the right, the proof starts with applying the
envelope theorem twice, once for the numerator and once for the denominator (as we did to prove
properties 3 and 4).
From property 3 we have
𝜕𝑣 𝐩, 𝑦 𝜕ℒ 𝐱 ∗ , 𝜆∗
= = 𝜆∗
𝜕𝑦 𝜕𝑦
From property 4 we have
𝜕𝑣 𝐩, 𝑦 𝜕ℒ 𝐱 ∗ , 𝜆∗
= = −𝜆∗ 𝑥𝑖∗
𝜕𝑝𝑖 𝜕𝑝𝑖
The 𝜆∗ cancel out, leaving 𝑥𝑖∗ = minus the ratio
Application of theorem 1.6
Does a candidate for indirect utility function meet the properties of one?
Verification of the properties of the indirect utility function
For a Cobb Douglas utility function 𝑢 = 3𝑥12 ∙ 𝑥22 , compute the indirect utility
function and verify that it exhibits the listed properties.

Step 1: Solve the Lagrange problem

ℒ = 3𝑥12 ∙ 𝑥22 + 𝜆 𝑚 − 𝑝1 𝑥1 − 𝑝2 𝑥2
This solves for
FOCs
𝑚
𝜕ℒ 𝑥1∗=
2𝑝1
= 6𝑥1 𝑥22 − 𝜆𝑝1 = 0
𝜕𝑥1 𝑚
∗
𝑥2 =
𝜕ℒ 2𝑝2
= 6𝑥12 𝑥2 − 𝜆𝑝2 = 0
𝜕𝑥2 and
𝜕ℒ 2 2
= 𝑚 − 𝑝1 𝑥1 − 𝑝2 𝑥2 = 0 𝑚 𝑚
𝜕𝜆 𝑣 𝐩, 𝑚 = 3 ∙
2𝑝1 2𝑝1
3 4 −2 −2
= 𝑚 𝑝1 𝑝2
16
Step 2: Compute the second derivatives of the Lagrange

𝜕ℒ
𝜕ℒ 𝜕ℒ = 6𝑥12 𝑥2 − 𝜆𝑝2 = 0
= 𝑚 − 𝑝1 𝑥1 − 𝑝2 𝑥2 = 0 = 6𝑥1 𝑥22 − 𝜆𝑝1 = 0 𝜕𝑥2
𝜕𝜆 𝜕𝑥1
2 𝜕2ℒ
𝜕2ℒ 𝜕 ℒ = −𝑝2
=0 = −𝑝1 𝜕𝑥2 𝜕𝜆
𝜕𝜆𝜕𝜆 𝜕𝑥1 𝜕𝜆
𝜕2ℒ
𝜕2ℒ 𝜕2ℒ = 12𝑥1 𝑥2
= −𝑝1 = 6𝑥22 𝜕𝑥2 𝜕𝑥1
𝜕𝜆𝜕𝑥1 𝜕𝑥1 𝜕𝑥1
𝜕2ℒ
𝜕2ℒ 2
𝜕 ℒ = 6𝑥12
= −𝑝2 = 12𝑥1 𝑥2 𝜕𝑥2 𝜕𝑥2
𝜕𝜆𝜕𝑥2 𝜕𝑥1 𝜕𝑥2

0 𝑝1 𝑝2
ഥ = 𝑝1
𝐻 6𝑥22 12𝑥1 𝑥2
𝑝2 12𝑥1 𝑥2 6𝑥12
 0 𝑝1 𝑝2
ഥ = 𝑝1
𝐻 6𝑥22 12𝑥1 𝑥2
𝑝2 12𝑥1 𝑥2 6𝑥12

𝐻ഥ
= 0 6𝑥22 ∙ 6𝑥12 − 12𝑥1 𝑥2 ∙ 12𝑥1 𝑥2 − 𝑝1 𝑝1 ∙ 6𝑥12 − 𝑝2 ∙ 12𝑥1 𝑥2
+ 𝑝2 𝑝1 ∙ 12𝑥1 𝑥2 − 6𝑥22 ∙ 6𝑥12

ഥ = −6𝑝12 𝑥12 + 24𝑝1 𝑝2 𝑥1 𝑥2 − 6𝑝22 𝑥22

𝐻
 A Hessian matrix is a square matrix consisting of the 2nd derivatives of an unconstrained function. A
bordered Hessian is the equivalent for a function optimised subject to a constraint. The border is formed
by the 1st derivatives of constraint and the body of the matrix by the 2nd derivatives of the function.
Theorem A2.11 - test for unconstrained minimums and maximums
Theorem A2.18 – test for constrained optimisation
Let the objective function be 𝑓 𝐱 and the 𝑚 < 𝑛 constraints be 𝑔 𝑗 𝐱 = 0 𝑗 = 1, ⋯ , 𝑚. Let the Lagrange
function be
𝑚

ℒ 𝐱, 𝚲 = 𝑓 𝐱 + ෍ 𝜆𝑗 𝑔 𝑗 𝐱
𝑗=1

Let the vector critical points 𝐱 ∗ 𝚲∗ solve the FOCs of the Lagrangian function.
1. 𝐱 ∗ is a local maximum of 𝑓 𝐱 subject to the constraints if the 𝑛 − 𝑚 principal minors in the bordered
Hessian matrix alternate in sign beginning with positive when evaluated at 𝐱 ∗ 𝚲∗ . This means that
ഥ𝑚+1 > 0, 𝐷
𝐷 ഥ𝑚+2 < 0, etc.
2. 𝐱 ∗ is a local minimum of 𝑓 𝐱 subject to the constraints if the 𝑛 − 𝑚 principal minors in the bordered
Hessian matrix are all negative when evaluated at 𝐱 ∗ 𝚲∗ . This means that 𝐷ഥ𝑚+1 < 0, 𝐷 ഥ𝑚+2 < 0, etc.
 0 𝑝1 𝑝2
ഥ = 𝑝1
𝐻 6𝑥22 12𝑥1 𝑥2
𝑝2 12𝑥1 𝑥2 6𝑥12

0 𝑝1 2
𝐻1 = = −𝑝1
𝑝1 6𝑥22

0 𝑝1 𝑝2
𝐻2 = 𝑝1 6𝑥22 12𝑥1 𝑥2
𝑝2 12𝑥1 𝑥2 6𝑥12
= 0 6𝑥22 ∙ 6𝑥12 − 12𝑥1 𝑥2 ∙ 12𝑥1 𝑥2 − 𝑝1 𝑝1 ∙ 6𝑥12 − 𝑝2 ∙ 12𝑥1 𝑥2
+ 𝑝2 𝑝1 ∙ 12𝑥1 𝑥2 − 6𝑥22 ∙ 6𝑥12
= −6𝑝12 𝑥12 + 24𝑝1 𝑝2 𝑥1 𝑥2 − 6𝑝22 𝑥22

Which must be simplified further to come up

with something sensible
Step 3 – Demonstrate each property listed in theorem1.6

Continuity: Continuity of the budget constraint in 𝐩 and 𝑦 is sufficient to

guarantee that 𝑣 𝐩, 𝑦 will be continuous in 𝐩 and 𝑦 on ℝ𝑛+ × ℝ+ . This is
because small changes in the price and income environment will result only
in small changes in the maximum level of utility that the consumer can
achieve given these parameters.

Homogenous of degree zero in prices and income

3 4 −2 −2
3 4 −2 −2
𝑣 𝐩, 𝑚 = 𝑡𝑚 𝑡𝑝1 𝑡𝑝2 = 𝑡0 ∙ 𝑚 𝑝1 𝑝2
16 16
Strictly increasing in income
𝜕𝑣 3 3 −2 −2
= 4 ∙ 𝑚 𝑝1 𝑝2 > 0
𝜕𝑚 16

Strictly decreasing in prices

𝜕𝑣 3 4 −3 −2
= − 𝑚 𝑝1 𝑝2 < 0
𝜕𝑝1 8
Property 5: Apply the rules in Theorem A2.18 for a test of convexity
0 −𝑝1 −𝑝2
ഥ = −𝑝1
𝐻 6𝑥22 12𝑥1 𝑥2 = −6𝑝12 𝑥12 + 24𝑝1 𝑝2 𝑥1 𝑥2 − 6𝑝22 𝑥22
−𝑝2 12𝑥1 𝑥2 6𝑥12

Simplify by substituting in the Marshallian demand functions

2 2
𝑚 𝑚 𝑚 𝑚
ഥ = −6𝑝12
𝐻 + 24𝑝1 𝑝2 2
− 6𝑝2
2𝑝1 2𝑝1 2𝑝2 2𝑝2
The p’s cancel out, leaving
6 2 24 2 6 2
ഥ = − 𝑚 + 𝑚 − 𝑚 = 3𝑚2 > 0
𝐻
4 4 4

With 𝐻1 < 0 and 𝐻2 > 0, alternating naturally ordered principal minors of the bordered Hessian
starting with <0 indicates a matrix that is negative semi-definite subject to a constraint and that the
value function is convex.
Property 6 Roy’s identity

𝜕𝑣 𝐩0 , 𝑦 0 ൘ 3 4 −3 −2
𝜕𝑝𝑖 − 8 𝑚 𝑝1 𝑝2 𝑚
= =−
𝜕𝑣 𝐩0 , 𝑦 0 3 3 −2 −2 2𝑝1
൘𝜕𝑦 4 ∙ 16 𝑚 𝑝1 𝑝2