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AM1 Lecture 4

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Yasamin Dn
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Advanced Microeconomics | Consumer Theory Prof. Germain Gaudin Winter Term 2022/2023 Lecture 4 Course Outline @ Consumer Theory @ Axioms of consumer choice and utility function © Tha ememarts petite © Indirect utility and expenditure @ Marshallian and Hicksian demands @ Topics in Consumer Theory @ Theory of the Firm @ Partial Equilibrium @ General Equilibrium Recap of Chapter 1 so far We started with five axioms of consumer choice, related to an individual's preference relation, =: . Axiom 1. Completeness: For every x,y € X either x > y or y = x, or both; Axiom 2. Transitivity: For every x,y,z € X if x = y and y Dathenx =z. Axiom 3. Continuity: For all x € X, the ‘at least as good’ set, = (x), and the ‘no better than’ set, X (x), are closed in X. Axiom 4. Strict monotonicity: For all x°,x? € R%, if x° > xt then x° > x!, while if x° >> x? then x° > x? Axiom 5. Strict convexity: If x! # x? and x1 > x?, then tx} + (1 —t)x? > x? for all t € (0,1). (Debreu's) utility representation theorem: The individual's preference relation satisfying the axioms above can be represented by a continuous utility function, w(-). This helped us to express the consumer's maximization problem: a te <4 po p:xu xeR? The solution to this problem is given by the Hicksian demand function: x"(p, u) The expenditure function is defined by e(p,u) = p- x'(p,u). We have e(p, v(p, y)) = y and u(p, e(p, u)) = u. Dead Consumer Theory Indirect utility and expenditure Relation between the two functions 94/131 Dead Relation between the two functions So far, in order to derive a consumer's indirect utility function and her expenditure function we need to solve two separate constrained optimization problems Now, we show that both of these problems are two faces of the same coin. Theorem Let v(p, y) and e(p, w) be the indirect utility function and expenditure function for some consumer whose utility function is continuous and strictly increasing. Then for all p > 0, y > 0, and uel: 1. e(p,o(p,y)) = 2. v(p,e(p,u)) =u 95 /131 Dead Sketch of the proof: Part 1. We have e(p, v(p, y)) < y by definition. Suppose e(p, u) < y and choose ¢ > Ost. e(p,u+e) ye. We have: u(p, ye) > u As v(-) is strictly in- creasing in income y: u = v(p,y) > v(p, ye) > ute; a contradiction Part 2. We have v(p, e(p, u)) > u by definition. Suppose y = e(p, u) and v(p, y) > u. Because e(-) is increasing in u and e(p, u(0)) = 0, we have y > 0. We choose e > 0 s.t. v(p,y—e) > wand y—e>0. Thus, income y — ¢ is sufficient, at this set of prices, to achieve a utility greater than u; hence: e(p,w) < y—e. This contradicts y=e(p,u). 96 /131 We know that the indirect utility function is strictly increasing in y. As it is also continuous, we can invert this function in its income variable. From v(p, e(p, u)) = u, we obtain: e(p,u) =v (p;u) Similarly, from e(p, v(p, y)) = y we obtain: v(p, y) =e *(p;y) 97/131 The utility maximization problem gives rise to the Marshallian demand The expenditure minimization problem gives rise to the Hicksian demand. The relationship between the indirect utility function and the expendi- ture function may also imply some relation between both demands.. 98 /131 Dead Theorem: When the consumer's preference relation is complete, transitive, continuous, strictly monotonic and strictly convex on R, we have the following relations between the Hicksian and Marshallian demand functions for p> 0, y >0, w€U, andi =1,...,n: 1. ai(p,y) = 22(p, o(p, 9) 2. af(p,u) = 2i(p, e(P, u)) a 99/131 The first relation says that the Marshallian demand at prices p and income y is equal to the Hicksian demand at prices p and the utility level that is the maximum that can be achieved at prices p and income y The second says that the Hicksian demand at any prices p and utility level wu is the same as the Marshallian demand at those prices and an income level equal to the minimum expenditure necessary at those prices to achieve that utility level. 100 /131 ecard The expenditure function Indirect utlity end ex oa eR eee a yipy Figure: Expenditure minimization and utility maximization 101/131 ecard cere eames oa eR eee Indirect utility and ex Hp.) = eel.) (0.3) =a1(p.060.9)) afi.) = nl, e(P, 1) af axle) Ao) =") © Figure: Relation between the two functions and the two demands. 102 / 131 oN! Consumer Theory Properties of the Marshallian and Hicksian demands 103/131 oN! Consumer Theory Properties of the Marshallian and Hicksian demands Properties of the Marshallian demand 104/131 oN! Properties of the Marshallian Demand 1. a,(p,y) is continuous in (p, y) This is a consequence of the convexity of preferences. 2. x;(p,y) is homogeneous of degree 0 in (p,y), and it satisfies budget balancedness. Proof Once again let us multiply (p,y) by a > 0 to get B(ap, ay) = {x € X|ap-x < ay} = B(p,y), which demonstrates that the solution to the utility maximization problem remains unaltered. 105 /131 Boo) 3. Roy's identity: Au(p°, y°)/d, 2:(p°,y) = —2(P W)/Ori 4, Proof By Constrained Envelope Theorem and the observation that v(p,y) = u(x(p, y)) — A(p, y) [p- x(p,y) — ¥], follows Ov —s Pana ee Opi Ap, y) «i(P,¥) <0, Ov == >0. ay Ap. y) 20 The latter being the marginal utility of income 106 / 131 oN! 4. Adding up results From the identity p-x(p,y)=y Vp follows after differentiation with respect to p; At at least one of the Marshallian demand functions has to be downward sloping in p; since (2) 107 /131 errr eee eee ety) Properties of the Marshallian and Hicksian demands | Elasticity relations We shall classify commodities with respect to the effect of changes in income as prices are held constant @ normal goods Ox; ay ~ ° @ neutral goods Ox, Oy o @ inferior goods Ox, <0. oy Notice that for every level of income y at least one of the n commodities is normal. 108 / 131 Boo) Consumer Theory Properties of the Marshallian and Hicksian demands Substitution and income effects 109/131 ee ‘Substitution and income effects Properties of the Hicksian demand Co eee n and Hicksian demands | Elasticity relations We now hold income fixed and allow prices to vary. If we let p; vary and hold pz and y fixed. This produces a locus known as the price offer curve Price offer curves Ordinary good: demand for good1 4 increases as the price decreases Giffen good: demand for good 1 x decreases as its price decreases 110/131 Figure: Response of quantity demanded to a change in price 11/131 oN! Inne Stan x 112/131 Conc The substitution effect stems from the fact that a good becomes relatively cheaper or more expensive compared to the other goods. We would, for instance, expect the consumer to substitute the (now) relatively cheaper good for the (now) relatively more expensive one. The income effect stems from the fact when the price of a good declines (respectively, increases), the consumer's total command over all goods is effectively increased (resp., decreased), al- lowing her to change her purchases of all goods in any way she sees fit. The total effect is simply the sum of the substitution effect and the income effect. 113/131 ee ‘Substitution and income effects Properties of the Hicksian demand Properties of the Marshallian and Hicksian demands | Elasticity relations Figure: Hicksian decomposition of a price change. 114/131 oN! Price changes and Associated Demands The Hicksian demand curve picks up the substitution effect of a price change. The Marshallian demand curve picks up the total effect of a price change (incl. both substitution and income effects) The difference between both is simply due to the income effect of an own-price change. 115 /131 Boo) Slutsky Equation The Slutsky equation captures this relationship Let x(p,y) be the consumer's Marshallian demand system. Let u* = vu(p, y) be the level of utility the consumer achieves at prices p and income y. Then, Vi, 7: Oxi(P,y) dxi(p,y) _ dxh(p,u*) eed a F — 2A, Y, Op; Op; {oe 116 /131 Boo) Sketch of the proof: ah(p,u*) = 2i(p, e(p,")) deh (p,u*) _ dxi(p,e(p,u*)) , dui(P, e(p.u")) de(p,u") ap; Op; Oy ap; with e(p,u*) = y, as well as: oe a xh(p,u*) eS xh(p,v(p,y)) = 2;(P,y) We thus obtain: dat(pyut) _ Axi(p.y) ) Oxi(P,y) Op; Op; +25(Py oy 117/131 Ree l oN! Consumer Theory Properties of the Marshallian and Hicksian demands Properties of the Hicksian demand 118/131 Ree l oN! Properties of the Hicksian Demand We now want to learn more about the Hicksian demand, in order to be able to say something about the ‘total effects’ of a price changes on consumption. Recall that: dxi(p,y) _ Ox} (p,u") Op; Op; Pe oe ew) 119/131 3s TEC Ca erent _ Cerra eee ee) Properties of the Marshallian and Hicksian demands | Elasticity relations First, the Hicksian demand has negative own-substitution terms. x} (psu) Ze(p Indeed: a 2efpa) , which gives: eles) ¢ 8 Op; (p,u) = - 5 . xh (piu) Given that e(p, u) is concave in p, we have = 50, Vi 120/131 Ree l oN! Law of Demand This already implies that: for any normal good (i.e., good with fetes) > 0). Law of demand: A decrease in the own price of a normal good will cause quantity demanded to increase. If an own price decrease causes a decrease in quantity demanded, the good must be inferior 121/131 Boo) Properties of the Hicksian Demand (cont'd) Second, the Hicksian demand has symmetric substitution terms Indeed: «!(p,u) = Sine which gives, Vi, j: 122/131 Conc We can thus write the substitution matrix which contains the Hicksian substitution terms as: dah Ox! a e(p, u) 0?e(p, u) Op "Pn Ge info Oxh Oxh @e(p,u) 0e(p, u) Op, OPn OpiOpn Op2. This matrix is symmetric and negative semidefinite (see RHS: e(p, u) is concave in prices + it can be proven that the Hessian matrix of a concave function is negative semidefinite). 123/131 OE et Cerra eee ee) Properties of the Marshallian and Hicksian demands | Elasticity relations Short remarks on negative semidefinite matrices An xn matrix A is called negative semidefinite if, for all vectors 2 € R", we have 27 Az < 0. The Hessian matrix of a twice-continuously differentiable function is negative semidefinite if and only if the function is concave (not demonstrated in this course). If the inequality is strict, the matrix A is called negative definite. The Hessian matrix of a twice-continuously differentiable function is negative definite if and only if the function is strictly concave. Moreover, A is called positive semidefinite if —A is negative semidefinite. A is called positive definite if —A is negative definite. The Hessian matrix of a twice-continuously differentiable function is positive semidefinite (respecetively, positive definite) if and only if the function is convex (resp., strictly convex). 124/131 Ree l oN! Slutsky Matrix Using the Slutsky equation discussed previously, we obtain the Slutsky matrix of price and income responses: caren Oza dn) Oy Opn” By S(p,y) = : : Oty, ity Oty On any oe ores om This matrix is thus symmetric and negative semidefinite 125/131 oN! Consumer Theory Properties of the Marshallian and Hicksian demands Elasticity relations 126 /131 oN! Relative Prices and Real Income The relative price of good i is the number of units of some other good that must be forgone to acquire 1 extra unit of good i (the ‘money price’ of good i, p;/1, is measured in unit of money per unit of good i): pi/l _ EUR/unit2 — units of 7 pj/1 EUR/unit 7 units of ¢ The real income is the maximum number of units of some commodity the consumer could acquire if she spent her entire money income y EUR g/m (Upon eee 7 pj/l EUR/unitj 2 127/131 Conc ca Note that the consumer's demand behavior displays an absence of money illusion; i.e., only relative prices and real income matter: PL Pk-1 Pk+t Pn Y x(p,y) = x(tp,ty) =x (, ae a +) PR Pk Pk Pk PK Because the Marshallian demand is homogeneous of degree 0, demand for each of the n goods only depends on n — 1 relative prices and the consumer's real income. 128/131 oN! Elasticities The income elasticity of demand for good i measures the percentage change in the quantity of i demanded per 1 per cent change in income: Ox.(P, 9) m(P,¥) = ay zi(p,y) We call the income share of good 7 the proportion of income that the consumer spends on purchases of good i ye pixi(P, y) >0 si(P,y. Fi with }>, 5; = 1 (budget balancedness) 129/131 oN! The own-price elasticity of demand for good 7 measures the percentage change in the quantity of 2 demanded per 1 per cent change in the price pj: zi(P,y) The cross-price elasticity of demand for good i measures the percent- age change in the quantity of 7 demanded per 1 per cent change in the price p;, with j A @: €(P,¥) 130/131 oN! Engel and Cournot Aggregation The following relations hold: 1. Engel aggregation: )7"".) simi = 1 2. Cournot aggregation: 07, sieiy = —8; Engel aggregation says that the share-weighted income elasticities must always sum to unity. Cournot aggregation says that the share-weighted own- and cross-price elasticities must always sum in a particular way. 131/131

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