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U.M.P: A SSUMPTIONS AND N OTATION

Commodities:

L Commodities. Identical commodities in different times/locations must be viewed as distinct (bread in the US and bread in the UK).

x, y X R

¨ x1 ¸ © ¹ © /¹ ©x ¹ ª Lº

L

Consumption Bundles:

x and y (which can be vectors), are both members of the Consumption set X (all physically possible consumption bundles). X is a subset of the L-dimensional real numbers (inc. 0).

¨ y1 ¸ © ¹ © / ¹ X ©y ¹ ª Lº

U.M.P: A SSUMPTIONS AND N OTATION

Prices:

Assume exogenously set prices. Represented by a price vector p , which is a member of the real positive numbers. Pi> 0, for all i.

Budget Set:

¨p ¸ © ¹ p ! © / ¹ pi " 0 i ©p ¹ ª Lº

Two conditions:

Physical Feasibility Affordability.

px ! p1 x1 . pL xL px e w w R

Feasibility has already been determined by the consumption bundles. Affordability conditioned by the price vector x consumption bundle. They have to be less than or equal to a set, non-negative level of wealth w .

U.M.P: A SSUMPTIONS AND N OTATION

The budget set is thus denoted as:

The set of all vectors in R L Plus, such that p times x is smaller than or equal to w W is a nonnegative scalar.

Both the Budget and Consumption set are convex (see next slide). When an individual is a price taker, we have a Walrasian/Competitive Budget Set. When equality holds (w=px), we have a budget hyperplane.

B p w ! _ R : px e wa x

A special case of this is when L=2 (two commodity bundles), we have the budget line.

U.M.P: A SSUMPTIONS AND N OTATION

Convexity:

A set X is convex if, for any two vectors from set X (x, x ), a linear combination of x and x will also belong to set X. x =ax + (1-a)x belongs to the convex set X.

x, x' X 1 x' ' ! Ex E x' X E ?0,1A

The Budget set is convex if the consumption set is:

x and x both belong to the budget set (B) X =ax+(1-a)x The first condition means that px=w, px =w, in the limiting condition. X =a[px]+(1-a)[px ]=aw+(1-a)w <w Hence, the Budget set is convex!

x x' B p w x' ' ! Ex E
x'

px e w, px' e w ? x' ' ! E ?px A E
px'A 1 x' ' ! Ew E
w e w 1

U.M.P: A SSUMPTIONS AND N OTATION

Convex!

Not Convex!

x x x

x x x

Set X

Set X

U.M.P: A SSUMPTIONS AND N OTATION

Preferences:

**Rational preference ordering:
**

One bundle is either weakly preferred to another, or they are indifferent.

x y X Either xH ; x R ; x ~ y y y

Transitivity:

If x is weakly preferred to bundle y, and y to z, then x is weakly preferred to z.

x H , y H, y z xH z

x, x' X and xi Hxi'

' x Hx' despite xJ p g, J { i

Continuity:

Rules out Lexicographic Preferences. Would be violated if no amount of another good could compensate for a loss of even one unit of a preferred good in a bundle.

Utility:

If x is weakly preferred to x , then the utility of x is greater than or equal to the utility of x .

xH ' u x u u x' x

U.M.P

The Utility Maximisation Problem:

Solved by maximising the utility function subject to the budget constraint.

max u x
s.t. x R : px e w

x

The solution is a consumption bundle x , that is a function of prices and wealth.

Note that u(x) holds no extra information other than preferences.

x * p, w

It is called the Walrasian Demand Correspondence (Function). Plugging x* back into the utility function gets you the INDIRECT UTILITY FUNCTIONL

I.U.F = V(p,w) = the maximum utility associated with consumption bundle x* .

u?x * p, w A! vp, w

_

a

U.M.P

**Assumptions: The UMP has a solution.
**

As long as P>>0 and u(.) is continuous. If there is a unique solution (the indifference curve is tangential to the budget line at only one point), it is a demand function. If there are multiple solutions (the indifference curve is flat at the point of contact), there is a demand correspondence.

Walrasian demand is homogenous of degree 0 in p and w.

x*(p,w) = x*(tp, tw)

**Walras Law holds.
**

The full budget is exhausted: px = w for all x E x*(p,w) p1x1+...+pLxL = w

U(x) is quasi-concave if the preference ordering is convex; thus the demand correspondence/function x*(p,w) is a convex set. See slide 11.

If x and x are on the flat portion of the tangent where the indifference curve meets budget constraint, so must be x . For strict quasi-convexity there is only one demand function such that x=x =x .

U.M.P

Assumptions about the Indirect Utility Function: Continuous in (p,w)

Follows if x(p,w) and u(x) are continuous

V(p,w) is homogenous of degree 0 in p,w.

V(p,w)=u[x*(p,w)]=u[x*(tp,tw)]=v(tp,tw)

Strictly increasing in w, non-increasing in p.

Like higher wealth, dislike higher prices.

Quasi-convex in (p,w)

Utility of any consumption bundle chosen on a budget constraint that is a linear combination of the two budget constraints upon which two points (x and x ) on an indifference curve of utility U lie cannot exceed U .

U.M.P

Convexity of the I.U.F : If : vp , w
e V , vp ' , w'
e V vp ' ' , w' '
! v? p E
p ' , Ew E
w'Ae V E We can show : p ' '.x e w' '
u x
e V

Convexity o x * (p, w) : Need to show x' ' x * (p, w) u x ! u x' ! U Quasi Concavity : u x' ' u U px e w, px' e w px' ' ! p Ex E x' e w @ ' ' is a easible choice ' ' * p, w

Epx E
p' x e Ew E
w'

Either (or both) : px e w2
px ' e w' 3

2 u x e vp, w e V 3 u x e vp' , w' e V

U.M.P

Solving the Lagrange is pretty typical. The MRS for two goods in the bundle is equal to their relative price:

® L ¾ max : L ! u x
P ¯ w § pi xi ¿ x ,P ° i! À F .O.C :

Li ! ui x
Ppi ! 0

@

ui x pi ! u J x p J

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