Microeconomics I Fall 2007 Prof. I. Hafalir: Chris Almost
Microeconomics I Fall 2007 Prof. I. Hafalir: Chris Almost
Microeconomics I Fall 2007 Prof. I. Hafalir: Chris Almost
Fall 2007
Prof. I. Hafalir∗
Chris Almost†
Contents
Contents 1
1 Demand Theory 2
1.1 Preference relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Choice functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.4 Consumer preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.5 Comparative statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.6 Weak axiom of revealed preference . . . . . . . . . . . . . . . . . . . . 8
1.7 Utility maximization problem . . . . . . . . . . . . . . . . . . . . . . . 10
1.8 Expenditure minimization problem . . . . . . . . . . . . . . . . . . . . 13
1.9 Strong axiom of revealed preference . . . . . . . . . . . . . . . . . . . 17
2 Aggregate Demand 19
3 Production 22
3.1 Properties of production sets . . . . . . . . . . . . . . . . . . . . . . . . 22
3.2 Profit maximization and cost minimization . . . . . . . . . . . . . . . 23
3.3 Single-output firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.4 Aggregation of production . . . . . . . . . . . . . . . . . . . . . . . . . 25
Index 33
∗
[email protected]
†
[email protected]
1
2 Microeconomics I
1 Demand Theory
1. a is weakly preferred to b if a ¥ b.
2. a is indifferent to b if a ∼ b.
3. a is strictly preferred to b if a b.
1.1.2 Exercises.
1. is irreflexive and transitive.
3. If x y ¥ z then x z.
4. ¥ is acyclic.
1.1.3 Example. Suppose we have a family with a mother, father, and child that
makes decisions on what to do for fun by majority rule. Suppose they choose
between opera, skating, and concert and the preferences are as follows: mother
likes o s c, father likes c o s, and the child likes s c o. But then
o s c o by the family, so democratic preference is not rational. This is
known as the Condecet paradox.
PROOF: Suppose that u : X = [0, 1] × [0, 1] → R represents ¥ L . For any a ∈ [0, 1],
(a, 1) L (a, 0), so u(a, 1) > u(a, 0). Let q : [0, 1] → Q be a map such that
u(a, 1) > q(a) > u(a, 0). If a0 > a then q(a0 ) > q(a) by definition of lexicographic
preference. But then q is one-to-one since it is increasing, which contradicts that
[0, 1] is not countable.
1.2.12 Theorem. Suppose that ¥ is rational and continuous. Then there exists a
continuous utility function that represents this preference relation.
PROOF: For this proof we will also suppose that ¥ is monotone. Let e be the unit
n
vector in the direction of the vector of all ones. For every x ∈ R+ , monotonicity
implies that x ¥ 0. There is some ᾱ such that ᾱe x, so ᾱe x. Continuity
implies that there is some α(x) such that α(x)e ∼ x. We will show that u(x) =
α(x) is a utility representation. Now x ¥ y if and only if α(x)e ¥ α( y)e, if and
only if α(x) ≥ α( y) again by monotonicity since these points are on the diagonal
ray. That α is continuous is in Problem Set 1 (the proof is also in MWG).
1.3.1 Definition. A choice function is a function c : B → 2X \ {∅} such that for all
B ∈ B, c(B) ⊆ B.
1.3.2 Definition. The choice function c satisfies the weak axiom of revealed pref-
erence (or WARP) if the following holds. If there is B ∈ B with x, y ∈ B such that
x ∈ c(B) then for any B 0 ∈ B with x, y ∈ B 0 , if y ∈ c(B 0 ) then x ∈ c(B 0 ). In words,
“if x is ever chosen when y is available then there can be no feasible set for which
y is chosen but x is not.”
1.3.3 Definition. Given a choice structure (B, c), the revealed preference relation
¥∗ is defined by x ¥∗ y if and only if there is B ∈ B such that x, y ∈ B and
x ∈ c(B). The strict preference becomes x ∗ y if and only if there is B ∈ B such
that x, y ∈ B and x ∈ c(B) and y ∈/ c(B).
1.3.6 Example. Let X = {x, y, z}, B = {{x, y}, {x, z}, { y, z}}. Define
PROOF: In this case the revealed preference relation ¥∗ rationalizes (B, c).
1.4.3 Examples.
p p
1. u(x) = x 1 + x 2 is strictly convex.
1.4.7 Exercises.
1. Prove u is quasi-concave if it is concave.
1.4.8 Definition. The Walrasian budget set for prices p 0 and wealth w ∈ R is
the set of affordable bundles B(p, w) := {x ∈ R+L | p· x ≤ w}. The set {x | p· x = w}
is called the budget hyperplane.
The consumer choice problem is to find the set c ∗ (B(p, w), ¥) of bundles from
B(p, w) that are maximal for a given preference relation ¥.
1.4.9 Proposition. If ¥ is rational and continuous then the consumer choice prob-
lem has a solution (i.e. c ∗ (B(p, w), ¥) 6= ∅).
PROOF: Obviously B(p, w) is convex (it is a half-space intersected with R+L ) and
compact. ¥ can be represented by a continuous utility function u, so u(B(p, w))
attains a (finite) maximum value.
1.4.12 Definition. We say that x(p, w) is homogeneous of degree 0 (or HD0) if for
any α > 0 we have x(αp, αw) = x(p, w) for all p, w, and x(p, w) is said to satisfy
Walras’ Law if for every price p 0 we have p · x(p, w) = w.
∂x
1.5.1 Definition. ∂ w` (p, w) is called the wealth effects for good ` at wealth level
w. A commodity ` is called normal (resp. inferior) at wealth level w if the wealth
effects at that level is non-negative (resp. strictly negative).
Similarly, we may consider the curve x(p̂, w̄) as one price pk varies and w̄ is
held fixed.
∂x
1.5.2 Definition. The price effects of pk on commodity ` is ∂ p ` (p, w). Usually the
k
price effects are strictly negative. A commodity for which the price effects are
sometimes strictly positive is called a Giffen good, otherwise the commodity is an
ordinary good.
We have some relationships between the wealth and price effects. Since x(p, w)
is HD0, for all α > 0 we have x(αp, αw) − x(p, w) = 0. Taking the derivative with
respect to α and setting α = 1, we get
d
0= (x ` (αp, αw) − x ` (p, w))
dα α=1
L
X ∂ ∂
= x ` (αp, αw)pk + x ` (αp, αw)w
k=1
∂ pk ∂w α=1
L
X ∂ ∂
= x ` (p, w)pk + x ` (p, w)w
k=1
∂ pk ∂w
∂ x ` (p, w) pk ∂ x ` (p, w) w
"`k (p, ω) = · and "`w (p, ω) = · .
∂ pk x ` (p, w) ∂w x ` (p, w)
8 Microeconomics I
If the demand function satisfies Walras’ Law (p · x(p, w) = w) then (by differ-
entiating with respect to pk ) we get
X ∂
p` x ` (p, w) + x k (p, w) = 0.
`=1
∂ pk
that total expenditure must change by the size of the wealth changes.
The idea is that if we ever choose x(p, w) when x(p0 , w 0 ) is feasible then choos-
ing x(p0 , w 0 ) implies x(p, w) is not feasible. This is exactly the same WARP as
before but adapted to the specific choice framework we are now dealing with
(specifically, ({B(p, w) | p 0, w ≥ 0}, x(p, w))).
Given an old price and wealth level (p, w) and a new price p0 , the compensated
price change in wealth is w 0 = w +(p0 − p)· x(p, w). The idea is that the new wealth
is chosen so that x(p, w) is still available on the boundary, i.e. p0 · x(p, w) = w 0 .
Compensated price changes preserve a consumer’s real wealth and allow us to
study the effects of changes in the relative costs of commodities.
1.6.2 Definition. x(p, w) satisfies the compensated law of demand (or CLD) if for
any compensated price change from (p, w) to (p0 , w 0 ) = (p0 , p0 · x(p, w)) we have
1.6.3 Proposition. Suppose that x(p, w) is HD0 and satisfies Walras’ Law. Then
x(p, w) satisfies WARP if and only if x(p, w) satisfies CLD.
Demand Theory 9
PROOF: Assume WARP. If x(p, w) = x(p0 , w 0 ) then CLD clearly holds. If x(p, w) 6=
x(p0 , w 0 ) then
Conversely, suppose that CLD holds but WARP does not. Then there are (p, w)
and (p0 , w 0 ) such that p·x(p0 , w 0 ) ≤ w and p0 ·x(p, w) ≤ w 0 and x(p, w) 6= x(p0 , w 0 ).
Without loss of generality we may assume that p · x(p0 , w 0 ) = w (see MWG). But
then
contradicting CLD.
1.6.4 Example. A simple price change is one for which only one component of
p changes. Applying the CLD to simple price changes implies that increasing one
price (and holding all others fixed) decreases the component of the demand func-
tion for that commodity.
Consider (p, w) and a differential price change d p and let dw = x(p, w)d p
be the corresponding compensated price change in wealth. The CLD becomes
d p · d x ≤ 0. We have
∂ x (p,w) ∂ x ` (p,w)
is called the Slutsky matrix. Specifically, S`k = δp
`
+ ∂w
x k (p, w) and is the
k
effect of pk on x ` with compensated price change.
1.6.5 Proposition. Suppose that x(p, w) satisfies WARP, Walras’ Law, and is HD0.
Then at any (p, w), S(p, w) satisfies v · S(p, w)v ≤ 0 for all v ∈ R L (i.e. S(p, w) is
negative semidefinite, or NSD).
In particular, S`` ≤ 0 for all `, so the effect of the price of a commodity on its
consumption is negative. Again,
∂ x ` (p, w) ∂ x ` (p, w)
S`` (p, w) = + x ` (p, w) ≤ 0.
δp` ∂w
10 Microeconomics I
∂ x ` (p,w)
Recall that when δp`
> 0, commodity ` is a Giffen good, and this implies that
∂ x ` (p,w)
δw
< 0, so Giffen goods are inferior.
Now S(p, w) is not symmetric in general (unless L = 2). We will see that
the symmetry of S is connected with it being associated with a demand function
arising from rational preferences.
1.6.8 Summary.
1. WARP (plus HD0 and Walras’ Law) is equivalent to CLD.
3. WARP (plus HD0 and Walras’ Law) does not imply that S(p, w) is symmetric
(except when L = 2).
4. (We will see that) SARP implies that S(p, w) is symmetric and the underlying
(revealed?) preferences are rational.
1.7.6 Exercises.
1. A continuous ¥ is homothetic if it admits a utility representation u which is
HD1, i.e. u(αx) = αu(x).
2. A continuous ¥ is quasi-linear with respect to x 1 if it admits a utility repre-
sentation u which is of the form u(x) = x 1 + ϕ(x 2 , . . . , x n ).
The Kuhn-Tucker conditions for the UMP say that if x ∗ ∈ x(p, w) then there
exists a Lagrange multiplier λ ≥ 0 such that for all ` ∈ {1, . . . , L} we have
∂u
(x ∗ ) ≤ λp`
∂ x`
and the relation holds with equality if x `∗ > 0. Equivalently
∇u(x ∗ ) ≤ λp and x ∗ · (∇u(x ∗ ) − λp) = 0.
(This is complementary-slackness from linear programming.) In particular, when
x ∗ 0 the Kuhn-Tucker conditions imply that ∇u(x ∗ ) = λp, so we have
∂u
∂ x`
(x ∗ ) p`
∂u
= .
∂ xk
(x ∗ ) pk
12 Microeconomics I
The left hand side is known as the marginal rate of substitution (or MRS) of good
` for k at x ∗ . (There is a bit more to say about this. See MWG.) Changes in u
induced by changing w, for x(p, w) 0, satisfy
∂
u(x(p, w)) = ∇u(x(p, w)) · Dw x(p, w) = λp · Dw x(p, w) = λ.
∂w
The marginal change in utility from a marginal increase in wealth is λ. Note that
the K-T conditions are necessary only. If u is quasi-concave and strongly monotone
then they are sufficient. If u is not quasi-concave then x ∗ is a local maximum if
u is locally quasi-concave at x ∗ . See Appendix M in MWG for more equivalent
conditions.
u(x) = kx 1α x 21−α ,
α (1−α)w
We get p1 x 1 = p x ,
1−α 2 2
so a maximizer is x ∗ = ( αw
p
, p2
).
1
1.7.9 Definition. For (p, w) 0, the utility value for the utility maximization
problem is denoted v(p, w), i.e. v(p, w) = u(x ∗ ) for x ∗ ∈ x(p, w). Then v(p, w) is
called the indirect utility function. It is a utility function on price-wealth pairs. See
Rubinstein for examples and explanation.
1. HD0;
4. continuous in p and w.
PROOF:
1. The solution to the UMP does not change when p and w are multiplied by
the same scalar, so the value of v does not change.
∂ v(p,w) ∂ v(p,w)
2. ∂w
= λ > 0 by Kuhn-Tucker, so v is strictly increasing in w, and ∂ p`
≤
0 since B(p, w) gets smaller when p` increases.
Demand Theory 13
where α ∈ (0, 1). It suffices to show for all x such that p00 · x ≤ w 00 that
u(x) ≤ C (since then it will certainly be true for the maximizing x). Now
αp · x + (1 − α)p0 · x ≤ αw + (1 − α)w 0 ,
PROOF:
1. Suppose that x ∗ is not optimal in the EMP. Then there is some feasible x 0
such that u(x 0 ) ≥ u(x ∗ ) and p · x 0 < p · x ∗ . By LNS there is some x 00 very
close to x 0 such that u(x 00 ) > u(x ∗ ) and p · x 00 < p · x ∗ . This contradicts the
optimality of x ∗ in the UMP.
2. Similarly, suppose that x ∗ is not optimal in the UMP. Then there is some
feasible x 0 such that u(x 0 ) > u(x ∗ ) and p · x 0 ≤ p · x ∗ . Take α ∈ (0, 1) and
consider αx 0 . By continuity, for α close to 1, u(αx 0 ) > u(x ∗ ) and p · (αx 0 ) <
p · x 0 ≤ p · x ∗ , which contradicts the fact that x ∗ is optimal for the EMP.
14 Microeconomics I
1.8.2 Definition. Given p 0 and u > u(0), the value attained in the EMP is
denoted e(p, u) and is called the expenditure function. e(p, u) = p · x ∗ for an
optimal solution x ∗ to the EMP.
1. HD1 in p;
3. concave in p;
4. continuous in p and u.
PROOF: The proofs are in MWG. The intuition for 3. is as follows. For fixed prices
p̄ and optimal x̄, if we change prices to p then the expenditure level for x̄ is p · x̄,
which is linear in p, and probably less than e(p, u). Hence e(p, u) lies below the
line and is concave.
Note these very important facts: e(p, v(p, w)) = w and v(p, e(p, u)) = u.
Denote the set of optimal commodity bundles for the EMP by h(p, u), the Hick-
sian demand function (or Hicksian compensated demand function).
1. HD0 in p;
3. if the preference relation is convex then h(p, u) is a convex set and if the
preference relation is strictly convex then h(p, u) is single-valued;
1.8.5 Exercises.
1. Assume that u is differentiable. Prove the Kuhn-Tucker conditions for the
EMP (or first order conditions)
As prices vary h(p, u) gives the demand if consumer wealth is also adjusted
to keep the utility level constant. This is why h(p, u) is the called a compensated
demand function.
1.8.6 Proposition. Under the usual assumptions and the assumption that h(p, u)
is single-valued, h(p, u) satisfies the CLD, i.e.
PROOF: For p 0, h(p, u) achieves a lower expenditure level than any available
consumption vector, so p00 · h(p00 , u) ≤ p00 · h(p0 , u), and the reverse. Adding these
completes the proof.
1.8.7 Exercise. Find h(p, u) and e(p, u) for the Cobb-Douglas utility function.
PROOF: Recall the Envelope Theorem, that for the minimization problem
∂φ ∂f ∂g
(α) = (x ∗ (α), α) − λ (x ∗ (α), α).
∂ αm ∂ αm ∂α
∂
e(p, u) = x `∗ − λ0 = x `∗ = h` (p, u).
∂ p`
2. D p h(h, u) is NSD
3. D p h(p, u) is symmetric
4. D p h(p, u) · p = 0.
PROOF:
1. 1.8.8.
3. As above.
4. h is HD0 in p.
16 Microeconomics I
PROOF: Consider a consumer facing (p̄, w̄) and attaining ū (note that w̄ = e(p̄, ū)
and hk (p̄, w̄) = x k (p̄, w̄)). Recall h` (p, u) = x ` (p, e(p, u)), so differentiating this
with respect to pk and evaluating at (p̄, w̄) we get the result.
∂x
If ∂ w` > 0 (i.e. good ` is normal) then the slope of the graph of h` with respect
to p` is steeper at (p, w) than the graph of x ` with respect to p` , and visa versa for
inferior goods.
Another implication of 1.8.11 is that D p h(p, u) = S(p, w), the Slutsky matrix,
where w = e(p, u) is the minimized expenditure. We proved in 1.8.9 that D p h(p, u)
is NDS and symmetric, so we obtain that the Slutsky matrix is symmetric when it
comes from the maximization of a utility function. See the discussion in MWG
about the intuition surrounding this result. From before, WARP implied that the
Slutsky matrix was NSD, but that it was not necessarily symmetric for L > 2. In
particular, WARP is not as strong of an assumption as that of preference maxi-
mization.
1.8.12 Proposition (Roy’s Identity). Make the usual assumptions on the demand
function plus differentiability and assume ¥ is strictly convex and differentiable.
Then for any (p, w) 0 we have
∂ v(p, w)/∂ p`
x ` (p, w) = −
∂ v(p, w)/∂ w
PROOF: Recall that v(p, w) is the optimal value of
max u(x) subject to p · x = w.
Whence by the Envelope Theorem
∂ v(p, w) ∂ u(x ∗ ) ∂ (p · x ∗ − w)
= −λ = −λx `∗ .
∂ p` ∂ p` ∂ p`
∂ v(p,w)
and λ = ∂w
, again by the Envelope Theorem, so we are done.
Demand Theory 17
“dual” problems
UMP o / EMP
Slutsky Equation
x(p, w) o / h(p, u)
K D p h=D p x+Dw x x T S
We have seen that rational preferences imply Walras’ Law, HD0, and that
S(p, w) is NSD and symmetric. Do Walras’ Law, HD0, and S(p, w) being NSD
and symmetric imply that the implied preferences are rational? (It turns out to
be “yes.”) To recover ¥ from x(p, w), we precede in two steps. First we recover
e(p, u) from x(p, w) and then recover ¥ from e(p, u).
To do the second of these, given e(p, u) we need to find an at-least-as-good set
Vu ⊆ R+L such that e(p, u) = min x∈Vu p · x. The Vu give the indifference curves for ¥
since we have x x 0 if x ∈ Vu but x 0 ∈/ Vu for some u. Proposition 3.H.1 in MWG
shows that Vu := {x ∈ R+L | p · x ≥ e(p, u)} works.
For the second part, in MWG they show that for a fixed utility level u and
wealth level w we have
∂e
(p) = x ` (p, e(p))
∂ p`
for all ` = 1, . . . , L. This is a system of PDE. Existence of a solution is possible only
when the Hessian matrix D2p e(p) is symmetric. A result called Frobenius’ Theorem
implies that this condition is sufficient. Since D2p e(p) = S(p, w), a solution exists
when the Slutsky matrix is symmetric. Therefore we obtain (along with Walras’
Law, HD0, and NSDness) that ¥ exists if and only if S(p, w) is symmetric.
x 0 ∗ x 1 , x 1 ∗ x 2 , . . . , x n−1 ∗ x n , x n ∗ x.
18 Microeconomics I
1.9.2 Definition. A demand function x(p, w) satisfies the strong axiom of revealed
preference (or SARP) if it is never the case that x ∗∗ x.
x ∗ x 1 ∗ . . . ∗ x n ∗ x,
1.9.3 Proposition.
PROOF:
1. If x 0 ∗ x 00 then u(x 0 ) > u(x 00 ). If SARP did not hold then there would be
x, x 1 , . . . , x n such that u(x) > u(x 1 ) > · · · > u(x n ) > u(x), a contradiction.
3. Exercise.
1.9.4 Proposition. If x(p, w) satisfies SARP then there is ¥ that rationalizes x(p, w),
i.e. x(p, w) y for all y ∈ B(p, w), y 6= x.
PROOF: Define ∗ and ∗∗ as above. Observe that by construction ∗∗ is transitive.
Zorn’s Lemma tells us that every partial order has a total extension (?) so there is
∗∗∗ such that x ∗∗ y implies x ∗∗∗ y and ∗∗∗ is complete. Define indifference
via x ¥ y if x ∗∗∗ y or x = y. Confirm that ¥ is rational and x(p, w) y for all
v ∈ B(p, w), y 6= x.
Aggregate Demand 19
indirect expenditure
utility o / function
hQ
v(p, w) QQQQ ll 5 e(p, w)
QQQ lll
QQQ
QQQ l l lll
l
QQQ lll
Roy’s lll Shepard’s
utility
Identity UMP EMP Lemma
kkk k hypotheses
v: dJJTTTTTT
kk vv JJ
k kkkk vvv JJ TTTTTTT
JJ
76 54 76 u)54
k TTTT
01x(p, w)23 01 23
k v
ukkkk vvv JJ
JJ TT*
vv JJ
vvHouthakker’s integrability JJ
h(p,
vv JJ
v JJ
vv
Theorem problem
JJ
vv
S=D p h
v J
vv
SARP o / symmetric
V NSD
L=2
WARP o / CLD ≈ NSD
2 Aggregate Demand
The sum of the demands arising from all of the economy’s consumers is the ag-
gregate demand. What kind of structure is imposed on aggregate demand when
individual demand is utility driven? Can we find a utility function u such that
it generates aggregate demand? For a representative consumer, would u generate
aggregate demands?
2.0.5 Definition. Suppose there are I consumers with rational preference rela-
tions ¥i , wealths w = (w 1 , . . . , w I ), and Walrasian demand functions x i (p, w i ).
PI
Given prices p ∈ R+L , aggregate demand is x ∗ (p, w) = i=1 x i (p, w i ).
2.0.6 Example. Individual WARP does not imply aggregate demand WARP.
1. Consider two individuals with the same income under two price sets p and
q. They demand x 1 , y 1 and x 2 , y 2 respectively. See diagrams.
PROOF: Suppose all the consumers have the same homothetic preferences.
X X X X
x ∗ (p, w) = x i (p, w i ) = x(p, w i ) = x(p, w)w i = x(p, 1) wi,
i i i i
PROOF: For the forward direction see Deaton and Muellbouer, 1980. For the re-
verse direction notice that
∂ ai
∂ v i (p, w)/∂ p` ∂ p`
(p) + ∂∂ pb (p)w i
`
x `i =− =− ,
∂ v i (p, w)/∂ w i b(p)
∂ x `i
so ∂ wi
= − ∂∂ pb (p)/b(p).
`
2.0.10 Exercise. Show that this condition holds when all consumers have iden-
tical preferences that are homothetic or when all consumers have quasi-linear
preferences with respect to some good.
2.0.13 Proposition. If x i (p, w i ) satisfy the ULD then so does the aggregate de-
mand x ∗ . As a consequence, aggregate demand satisfies WARP.
PROOF: Consider (p, w) and (p0 , w) with x ∗ (p, w) 6= x ∗ (p0 , w). Then we must have
x i (p, w i ) 6= x i (p0 , w i ) for some i. For all i we have the ULD
(p − p0 ) · (x i (p, w i ) − x i (p0 , w i )) ≤ 0,
2.0.15 Proposition. Suppose that each agent i has a fixed share αi of the total
wealth, and that each i has and HD1 utility function (homothetic preferences).
Then there is a utility function U that generates the aggregate demand.
x i = x for feasible x i .
P
where the max is taken over all i
2.0.16 Proposition. Suppose that all consumers have identical preferences with
individual demands x(p, w) and that individual wealth is uniformly distributed
over [0, w̄]. Then the aggregate demand function
Z w̄
x(p) = x ∗ (p, w)dw
0
Note that since the ULD is additive, we don’t need to have identical prefer-
ences for all consumers. We need the distribution of wealth conditional on each
preference to be uniform over some interval that includes zero.
3 Production
2. 0 ∈ Y ;
5. if y ∈ Y and y 6= 0 then − y ∈
/ Y (irreversibility);
10. Y is convex;
Production 23
3.1.1 Exercises.
1. Find a cone that is not a convex cone.
3.2.1 Exercise. Prove that if Y exhibits NIRS then π(p) = ∞ or 0 for all p.
3.2.2 Proposition. Assume the production set Y is closed and has free disposal.
1. π(p) is HD1 in p.
2. y(p) is HD0 in p.
3. π(p) is convex in p.
PROOF:
1. Changing p to αp does not alter Y (as it does not depend upon p at all), but
multiplies the objective function by α.
2. As above.
3.2.7 Theorem. Suppose that the production set Y is closed and satisfies free
disposal. Then there is a continuous function F : R L → R, the transformation
function for Y , such that y ∈ Y if and only if F ( y) ≤ 0, and y ∈ Y e if and only if
F ( y) = 0.
PROOF: Omitted, but similar to the proof of the existence of a utility function.
1. z(w, q) is HD0 in w.
2. c(w, q) is concave in w if and only if Dw2 c(w, q) is NSD.
3. (Shepard’s Lemma) Dw c(w, q) = z(w, q).
4. Dw z(w, q) is NSD, z is downward sloping in w.
5. c(w, q) is HD1 in w and non-decreasing in q.
The property of CRS (constant returns to scale, or that of being a cone) cor-
responds in the single-output case to αq = f (αz) for all α ≥ 0, i.e. that f is
HD1. The property of NIRS (or DRS) corresponds to c(w, q) being convex, and the
property of NDRS (IRS) corresponds to c(w, q) being concave.
Choice Under Uncertainty 25
c(q)
3.3.2 Definition. For fixed prices, the average cost is AC(q) = q
and the marginal
dc(q)
cost is M C(q) = dq
.
1. The profit function associated with Y ∗ is the profit function of the aggregate
producer.
4.1 Lotteries
So far we have considered “actions,” “decisions,” and “choice” to be equivalent
and deterministically leading to consequences. In this section we consider where
choices lead to uncertain consequences. The idea is that the decision maker is
choosing a lottery ticket.
Let C = {C1 , . . . , CN } be a finite set of possible outcomes. We assume the
probabilities of the various outcomes to arise are objectively known.
L = {p ∈ RN | p ≥ 0, p · e = 1}.
A compound lottery is a lottery whose outcomes are lotteries. For any com-
pound lottery there is a simple lottery L that
P generates the same ultimate distribu-
tion over the outcomes. It is given by L = k αk L k . The convention that we use in
this class is that only the consequences and their probabilities matter, so the fact
that compound lotteries can be reduced to simple lotteries implies that we need
only consider preferences on simple lotteries.
We assume that the decision maker has a rational preference relation on L .
When can such preferences the preference by a utility function? As before, if the
preference is continuous then a utility representation exists. We consider a “sim-
pler” (more structured) utility representation that assigns utilities to each conse-
quence.
Continuity means that small changes in probabilities should not change the
ordering between lotteries. In other words, preferences are not “overly sensitive”
to small changes in probabilities.
4.1.4 Example. Take C = {trip by car, death by car accident, stay home}. If the
decision maker is a safety fanatic then we would have
for any " > 0. In this case the preference relation is not continuous.
L ¥ L 0 ⇐⇒ αL + (1 − α)L 00 ¥ αL 0 + (1 − α)L 00
In words, if we mix two lotteries with a third one then the preference ordering
should be independent of the third.
4.1.6 Exercise. Show that if ¥ satisfies the independence axiom then and ∼
also do. Also show that L L 0 and L 00 L 000 then
4.1.7 Definition. The utility function u : →R has an expected utility form if there
is an assignment of numbers u1 , . . . , uN to the N outcomes such that for every
simple lottery L we have u(L) = u · L. A utility function with an expected utility
form is called a Von Neumann-Morgenstern (or VNM) expected utility function.
Observe that if we let L n denote the lottery that yields outcome n with proba-
bility one, then u(L n ) = un .
Choice Under Uncertainty 27
PROOF: For the reverse direction, consider forPany simple lottery L the compound
lottery (L 1 , . . . , L N , p1 , . . . , pN ). Then u(L) = i pi u(L i ) so u has an expected util-
ity form. The forward direction is simply linearity of expectation.
The expected utility form of a preference relation (if it has one) is not unique,
as any positive affine transformation also gives an expected utility form. The
converse is also true (exercise).
4.1.9 Proposition. Suppose that u is VNM for ¥. Then ũ is another VNM if and
only if there are two scalars β > 0 and γ such that ũ(L) = βu(L) + γ.
PROOF: Consider the best and worst lotteries L and L such that for all L ∈ L we
have L ¥ L ¥ L and L L. Consider any L ∈ L and define λ L ∈ [0, 1] by
are both closed. Therefore they intersect, and the intersection point is unique by
the last lemma.
and ¨ ¨
$3000 1 $4000 0.8
L3 : and L4 :
$0 0 $0 0.2
Most people would prefer L2 to L1 and L3 to L4 , but these choices are not compat-
ible with the independence axiom. Solutions to this paradox can be obtained by
expanding the utility to consider things like “regret.” There are other issues (see
MWG).
1. F (−∞) = 0;
Choice Under Uncertainty 29
2. F (+∞) = 1;
3. F is non-decreasing; and
4. F is right continuous.
We may also identify a lottery with a random variable with distribution function
F , or with its density function with respect to Lebesgue measure. The Expected
Utility Theorem in the continuous case is as follows.
The idea is that u(x) is the utility of the degenerate lottery that pays x for cer-
tain. We may assume that u is continuous and increasing. It is typically assumed
that u has an upper bound. If u does not then for every m ∈ Z+ there is x m ∈ R
such that u(x m ) > 2m . We obtain the St. Petersburg paradox. Consider the lottery
L that is defined by “toss a coin until tails comes up and P∞ receive x m if the tails
occurs on the mth toss.” Then the utility of this lottery is m=1 21m u(x m ) = +∞.
4.2.2
R Definition. RAn individual with Bernoulli utility function u is risk averse if
u(x)d F (x) ≤ u( x d F (x)) for every given lottery F .
4.2.4 Exercises.
1. An individual is strictly risk averse if and only if u is strictly concave.
R
Notice that if the individual is risk averse then C(F ) < E(x) = x d F (x). The
quantity E(x) − C(F ) is called the risk premium.
30 Microeconomics I
1. if the certainty equivalent for ¥1 is less than the certainty equivalent for ¥2
for all lotteries.
PROOF: u1 ◦ u−1
2 is concave if and only if
d 1
u1 (u−1 0 −1
2 (t)) = u1 (u2 (t))
dt u01 (u−1
2 (t))
is non-increasing. This happens if and only if u01 (x) u0 1(x) is non-increasing, which
1
happens if and only if log of it is non-increasing. This happens when the derivative
is non-positive.
4.2.9 Example. Consider u(x) = −αe−ax + β with α, a > 0. Then u0 (x) = aαe−ax
u00 (x)
and u00 (x) = −a2 αe−ax , so r(x) = − u0 (x) = a. This utility function is the constant
risk aversion function.
PROOF: Define H(x) = F (x) − G(x) and suppose that H(x̄) > 0 for some x̄. Then
Z Z Z
u(x)d F (x) − u(x)d G(x) = 1(x̄,∞) (x)dH(x) = −H(x̄) < 0,
4.2.14 Example.
1
1
( ( (
1 1 1 4
2 2
−1 2
−2 2 1
If F : 1 and H2 : 1 and H3 : 1 then G: 3 2
3 2
1 2
2 2
1
5 4
R∞ R∞
2. −∞
F (z)dz = −∞
G(z)dz.
certainty equivalent, 29
choice function, 4
CLD, 8
CMP, 24
Cobb-Douglas, 12
compensated law of demand, 8
compensated price change, 8
complements, 16
compound lottery, 25
concave, 6
conditional factor demand function, 24
consistent with, 4
constant returns to scale, 22
constant risk aversion function, 30
consumer choice problem, 6
continuous, 3, 26
convex, 5
convex cone, 23
cost function, 24
cost minimization problem, 24
Cournot aggregation, 8
distribution function, 28
efficient, 24
elasticity, 7
EMP, 13
Engel aggregation, 8
Engel curve, 7
expected utility form, 26
expenditure function, 14
expenditure minimization problem, 13
33
34 INDEX
firm, 22
first order conditions, 14
first-order stochastic dominance, 31
FOSD, 31
free disposal, 22
Giffen good, 7
Gorman normal form, 20
HD0, 7
Hicksian compensated demand function, 14
Hicksian demand function, 14
homogeneous of degree 0, 7
homothetic, 10
independence axiom, 26
independent of income distribution, 19
indifferent, 2
indirect utility function, 12
indirectly revealed preferred, 17
inferior, 7
input demand function, 24
irreversibility, 22
law of supply, 24
lexicographic preference, 3
linearity, 27
Liontief preference, 11
LNS, 10
locally non-satiated, 10
lottery, 25, 28
lower contour set, 3
marginal cost, 25
marginal rate of substitution, 12
mean preserving spread, 31
monotone, 4
more concave, 30
more risk averse, 30
MRS, 12
negative semidefinite, 9
negative transitive, 2
no free lunch, 22
non-decreasing returns to scale, 22
INDEX 35
ordinary good, 7
PMP, 23
preference maximizing choice, 4
preference relation, 2
price effects, 7
production set, 22
production vector, 22
profit function, 23
profit maximization problem, 23
quasi-concave, 5
quasi-linear, 11
rational, 2
rationalizes, 4, 18
regular, 2
representative consumer, 19
revealed preference relation, 4
risk averse, 29
risk premium, 29
SARP, 5, 18
second-order stochastic dominance, 31
simple lottery, 25
Slutsky matrix, 9
SOSD, 31
St. Petersburg paradox, 29
strictly convex, 5
strictly preferred, 2
strictly quasi-concave, 6
strong axiom of revealed preference, 5, 18
strongly monotone, 4
substitutes, 16
supply correspondence, 23
supply function, 23
transformation function, 24
ULD, 20
uncompensated law of demand, 20
upper contour set, 3
36 INDEX
usual conditions, 11
utility maximization problem, 11
utility representation, 2
VNM, 26
Von Neumann-Morgenstern, 26
Von Neumann-Morgenstern utility function, 29
Walras’ Law, 7
Walrasian budget set, 6
Walrasian demand function, 6
WARP, 4, 8
weak axiom of revealed preference, 4
weakly preferred, 2
wealth effects, 7
wealth expansion path, 7