Advanced Microeconomics Lecture Notes

Anders Munk-Nielsen
Fall, 2012
Disclaimer. These notes are my own personal notes from taking this course at the University of
Copenhagen in the fall of 2012. The lecturer is in no way responsible or related to this material
and I am merely putting these notes out to help fellow students of economics.
1
Contents
1 2012-09-04 First lecture 5
1.1 Preparations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Lecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.1 Plan (?) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.2 Commodity space . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.3 Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.4 Production (possibility) sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.3 Assumptions on the producer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3.1 Assumption P1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3.2 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3.3 More assumptions (P2 among other things) . . . . . . . . . . . . . . . . . . . . . 8
2 2012-09-05 8
2.1 General stu . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.1 More on the assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2 The aggregate production set . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2.1 Ecient productions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2.2 Producers problem (PP) (MWG: Producers maximization problem) . . . . . . . 11
2.2.3 Something . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3 2012-09-11 11
3.1 FB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3.3 Thm [4.2].1 red proof (p. 29 NotesThPr) . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.3.1 Proof of (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.3.2 Proof of (b) (on my own!!) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.3.3 Proof of (c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.3.4 Proof of (d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.4 Subspaces and linear functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3.5 A Decentralization Theorem (thm. 7.1, p 35 NotesThPr.) . . . . . . . . . . . . . . . . . 15
3.5.1 Proof of part (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3.5.2 Proof of part (a) LEFT FOR US TO DO BY OURSELVES . . . . . . . . . . 16
3.6 Representing production sets with production functions . . . . . . . . . . . . . . . . . . 16
4 2012-09-12 17
4.1 Representing production sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.2 Thm. [8.2.].1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
4.2.1 Law of supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
4.3 Moving on to consumers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.4 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.4.1 F1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
5 2012-09-18 20
5.1 Last time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
5.2 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
5.2.1 Proof of continuity sketch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
5.2.2 Monotonicity assumptions F2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
5.2.3 Convex preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
5.2.4 Strictly convex preferences (F3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
5.3 Towards calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
5.3.1 Assumption of dierentiability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2
5.3.2 Assumption F4 bordered Hessian . . . . . . . . . . . . . . . . . . . . . . . . . 22
5.4 Consumer problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
5.4.1 Proposition 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
6 2012-09-19 23
6.1 Stu . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
6.1.1 Recapping the proof of proposition 1 . . . . . . . . . . . . . . . . . . . . . . . . . 24
6.2 Proposition 2 solution to the CP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
6.2.1 Marshallian Demand Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
6.2.2 UMP and Expenditure Minimization . . . . . . . . . . . . . . . . . . . . . . . . . 27
6.2.3 Walrasian Demand Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7 2012-09-25 27
7.1 Last time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.2 Concluding the study of the consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.2.1 Prop 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.2.2 Proving proposition 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.2.3 Proposition 6 dierentiable demand . . . . . . . . . . . . . . . . . . . . . . . . 30
7.3 Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
7.3.1 Notation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
7.3.2 Example: Edgeworth box . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
7.3.3 Pareto optimal allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
7.3.4 Proposition concerning Assumption F2 (variant of F2) . . . . . . . . . . . . . . 31
8 2012-09-26 31
8.1 Last time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
8.1.1 Proposition 5 characterizing the solution . . . . . . . . . . . . . . . . . . . . . 31
8.1.2 Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
8.2 Economies contd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
8.2.1 Koopman diagram . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
8.2.2 Assumption F2 Strong monotonicity. . . . . . . . . . . . . . . . . . . . . . . 32
8.2.3 Proposition [2.3.2].1 in NotesOpt. . . . . . . . . . . . . . . . . . . . . . . . . . . 32
8.2.4 Proposition [2.3.2].2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
8.2.5 Section 2.3.3: Fairness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
8.3 Section 3.1: Social utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
8.4 Arrows impossibility theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
8.4.1 The problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
8.4.2 Assumptions on the Social Welfare Function (SWF) . . . . . . . . . . . . . . . . 33
8.4.3 Arrows Impossibility Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
8.5 Market Equilibrium (in MWG: Equilibrium with Transfers) . . . . . . . . . . . . . . . . 34
8.5.1 Theorem [4.2].1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
9 2012-10-02 35
9.1 Propositions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
9.1.1 Proposition 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
9.1.2 Proposition 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
9.2 Something . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
9.3 The rst theorem of welfare economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
9.3.1 Theorem [4.2].1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
9.4 The Second Theorem of Welfare Economics: Dierentiable Approach . . . . . . . . . . . 37
9.4.1 Lemma [5.2].1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
9.4.2 Theorem [5.2].1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3
9.4.3 Holy fuck in the structure... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
9.4.4 Lagrangian . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
9.5 Sum of two no-worse-than sets The Scitovsky contour . . . . . . . . . . . . . . . . 39
10 2012-10-03 40
10.1 Towards the theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
10.1.1 Mathematical background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
10.2 Separating Hyperplane Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
10.2.1 Extension boundary piont. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
10.2.2 Addendum Dierence sets and separating hyperplanes . . . . . . . . . . . . . 43
10.3 The Second Theorem of Welfare Economics . . . . . . . . . . . . . . . . . . . . . . . . . 43
10.3.1 Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
10.3.2 Lemma required to be proven rst . . . . . . . . . . . . . . . . . . . . . . . . . . 43
10.3.3 Proof of the Second Welfare Theorem of Economics . . . . . . . . . . . . . . . . 44
11 2012-10-10 45
11.1 Last time (I wasnt there!!) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
11.2 Long proof Theorem 10 Existence of Walras EQ . . . . . . . . . . . . . . . . . . . 46
11.2.1 Theorem 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
11.2.2 Extra stu . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
11.3 Uniqueness of Walras Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
11.3.1 Intro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
11.3.2 New assumption Gross Substitutes . . . . . . . . . . . . . . . . . . . . . . . . 50
11.3.3 Theorem 17 Uniqueness of W EQ . . . . . . . . . . . . . . . . . . . . . . . . . 50
12 2012-10-23 Uncertainty and time 50
12.1 Multi-period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
12.1.1 Proposition 2.3.A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
12.2 Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
13 2012-10-24 Uncertainty contd 53
13.1 Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
13.2 Farkas Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
13.3 Existence of Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
13.3.1 Corollary (V, q) arbitrage free . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
4
1 2012-09-04 First lecture
1.1 Preparations
Q. How do MWG use inequalities on vectors? Does y 0 mean y
1
0 ... y
L
0?
Q. Set operations. Is /B = / B?
A. No!
Answer. Take A, B R
L
. Then
A + B = x R
L
[x = a +b, a A, b B.
all vectors that can be created as the sum of a vector from A and one from B. Similarly,
AB = x R
L
[x = a b, a A, b B.
1.2 Lecture
1.2.1 Plan (?)
Production. PMP (Prot Maximization Problem)
Consumers. UMP (Utility Maximization Problem)
Also. Indirect utility functions and expenditure function.
Interesting relationships (duality?)
Welfare thms.
Existence of Walras equilibria. And uniqueness and stability.
Time and uncertainty.
Why?
Production. We start with production because he nds that simpler...
1.2.2 Commodity space
(well forget this after today (??))
Space. The set of commodities is L = 1, ..., L.
Commodity concept. We consider a nite number of (pysical characteristics, delivery times, delivery
locations, ...).
1.2.3 Production
Production. Consider
F : R
q
+
R,
where
R
k
+
= x R
k
[x
i
0, i = 1, ..., k
R
k
++
= x R
k
[x
i
> 0, i = 1, ..., k.
5
Normally. Normally, we think of a production function as a function that produces output Z as
Z = F(K, L).
This has three important characteristics,
1. Single output (Z R).
(a) Rarely true (e.g. dierent vintages of wine from the same wineyard)
2. Know inputs and output.
(a) A farmer may buy or sell young calves depending on prices (is it more protable to sell
them quickly (meet very pricy) or to get the milk (milk pricy)).
3. Technological maximization is implicit we think of Z as the highest possible output...
i.e. on the production possibility frontier.
4. Positive marginal product but diminishing returns
(a)
F
K
(K, L) 0 (positive MP) but

2
F
K
2
(K, L) < 0.
(b) Turns out this will be captured by (something something convexity??) of the production
possibilities set...
5. Non-increasing returns to scale.
(a) [0; 1], then F(K, L) F(K, L).
1.2.4 Production (possibility) sets
Example. Suppose we have hay, livestock and fertilizer.
Input, a Output, b Net Output, b a
Hay 10 0 -10
Livestock 5 10 5
Fertilizer 0 0 0
Result. By considering net output, we get that inputs have a negative sign and outputs have a
positive.
Decomposing the net output vector Suppose we have some y R
k
. Then we can always write
y = y
+
y

, y
+
, y

R
k
+
.
This decomposition is unique when we couple it with the assumption that we know what is inputs and
outputs.
Further requirement. Furthermore, we require that any commodity is either an input or an output.
Otherwise, you could have (y
+
+a)(y

+a) = y as well and the decomposition would no longer

be unique.
Production process. Is like y

y
+
.
Example. Consider
(1, 2, 3, 0, 5) = (0, 2, 3, 0, 0)
. .
y
+
, outputs
(1, 0, 0, 0, 5)
. .
y
+
, inputs
.
6
1.3 Assumptions on the producer
Consider Y R
L
and a specic y Y .
1.3.1 Assumption P1
Assume that
(a) 0 Y inaction is a possibility.
(b) Y is a closed set consider y
n

nN
with y
n
y and y
n
Y for all n. Then y Y .
Otherwise wed have to work with suprema instead of maxima.
(c) Y is a convex set.
(d) y Y and y Y implies that y = 0 R
L
irreversibility.
(e) Take y Y and z R
L
+
. Then y z Y free disposability.
Implications
(a) and (c). If 0 Y and Y is convex, then we have non-increasing returns to scale.
Proof. Let y Y and [0; 1]. Then y Y because Y y + (1 )0 = y.
(d). Consider a production where we take 1 horse and 1 chicken to make chicken patty. That is, the
net production vector is y = (1, 1, 1). Reversing is y = (1, 1, 1) would imply making one
horse and one chicken from a chicken patty, which is clearly impossible.
(e). Consider y z and look at the th element, y

. Since z R
L
+
, z

0, meaning that we
destroy some of the net output.
Actually what the assumption says is that we can do this freely.
Moreoverpos MP. Its also related to the assumption of positive MP. Suppose for contra-
diction that Y is the area below a x
2
+ x + . Then theres a toppunkt and to the
left of that we cant produce. So taking z = (2, 0) would take us to an impossible set.
Why? In this case, taking in more y
1
will actually at one point, for y
2
xed, destroy the
output (shown by the fact that we suddenly end up outside of Y ).
Tell apart the following!
Non-decreasing returns to scale. Take y Y, 1, then y Y .
Non-increasing returns to scale. Take y Y, [0; 1], then y Y (?? is this correct??)
(this is correct: F(K, L) F(K, L))
1.3.2 Example
Consider the set
Y =
_
y R
3

y
2
, y
3
0, y
1
F(y
2
, y
3
)
_
Example 2.3.2. Let
Y =
_
y R
4

_
y
2
1
+y
2
2
_

(y
3
)

(y
4
)

0, y
3
0, y
4
0
_
.
Four variables, so impossible to draw. But of course, we could x some and look at the remaining
variables.
7
Y. Look in the (y
1
, y
2
)-plane. The set is a circle, but only a quarter (pizza slize) of it.
Problem. We dont have free disposal because the Y set ends when y
1
, y
2
falls below zero.
Solution. Consider the set Y R
4
+
. That would be Y { all the stu created by subtracting
from it... i.e. the circle casts shadows down the negative plane... }
Contour lines. In y
4
, y
3
its like x 1/x mirrored in x x.
1.3.3 More assumptions (P2 among other things)
Additivity. y Y y + y Y . ALso, y, y

Y y + y

Y .
Assumption P2. This assumption states that Y is a cone.
y Y, 0 y Y.
P2+Convexity Y convex cone. If we also have the convexity assumption from P1, then Y is a
convex cone! That is
, R
+
, y, y

Y = y + y

Y.
So any non-negative linear combination will be in Y .
Sub-space? NO! Because we restrict , to be non-negative.
Result in MWG. Take any Y R
L
, then you can dene some Y

R
L+1
which is consistent with
CRS.
2 2012-09-05
2.1 General stu
Setup. We have the goods L = 1, ..., L goods (with member ).
Spaces. Vectors will be in
R
L
R R,
and
R
L
+
x R
L
[x

0, L,
R
L
++
x R
L
[x

> 0, L.
Vector inequalities.
x R
L
: x 0 x

0 L
x R
L
: x > 0 x

0 x ,= 0, 0 R
L
x R
L
0 x

> 0 L
For x 0 we say that x is strongly greater than 0 (he just made that up :)
Intuition. x > 0 think x is at least as great as but not equal to 0.
Operations on sets. Let A, B R
L
.
A + B z R
L
[z = x
A
+ x
B
, x
A
A, x
B
B.
Also, for R,
A z R
L
[z = x
A
, x
A
A.
Since we can do this for < 0, we can do
AB A + (1B).
8
Free disposabilityInterpretation. Suppose you hav a point a R
2
and you want the set
that is the rectangle that has upper-right corner in a and tends to , . Then the free
disposability assumption is that if a Y , then a R
2
+
Y . Or in other words,
free disposability Y R
2
+
Y.
(isnt it???)
Convexity. Take A R
L
.
A is a convex set a, a

A [0; 1] it holds that a + (1 )a

A.
(in his exposition he uses , 0 where + = 1 and then a + a

)
DenitionCone. C R
L
is a cone if
c C, 0 c C.
Convex cone. C is a convex cone if it is a convex set and it is a cone.
Proposition.
C is a convex cone c, c

C, , 0 c +

c C.
Proof.
. CASE: If , = 0, then take some c, c

C c +c

= 0 +0 = 0 and 0 C since we
know that C is a cone (just set = 0 in the denition of a cone).
CASE: Suppose either ,= 0 or ,= 0. Consider some c, c

+
c +

+
c

(which is ne because at least one of them is non-zero so we dont divide by zero)

+
c +

+
c

=

+
c +
_
1

+
_
c

C
because C is a convex set. Ok so we now have some number in C so because C is a
cone, we may multiply by any so let := + , then we have
C c + c

,
which is precisely what we wanted.
. To prove a cone, take = 0 and vary the . To prove convexity, we have to restrict
, to + = 1. But this is a subset of the parameters for which it holds so in
particular it holds for , [ + = 1.
In more detail. Todo: Prove that C is a cone and convex. We know: c, c

C, ,
0 c +

c C.
Cone: Just set = 0.
Convex: It holds for all , 0. Then restrict attention to , [ + = 1. For
the larger set, the linear sum is in C but we only needs it to hold for the subset of
the parameters.
Decomposition. Consider y R
L
. Lets decompose
y = y
+
y

.
The decomposition is not unique unless we demand something more, lets demand that
y
+

= 0 L.
Hence, for some y = (y
1
, ..., y
L
), we must have that either y
+

or y

is equal to zero (or both)!

That is the assumption that it is either an input or an output (or not relevant).
9
2.1.1 More on the assumptions
Assumptions (from last time).
Irreversibility. The intuitive argument is that production is a linear process in time input
today, output tomorrow. Example: We cant bring the dead cow meat back to life.
Free disposal.
(free disposal ass.) : y Y, z R
L
+
= y z Y.
He would also call it that its Downward comprehensive (in the sense that the set expands
to in all directions... we can always put less stu into the machine and just destroy it).
MWG writes
Y R
L
+
Y.
2.2 The aggregate production set
NowMany rms. Now we have many rms were interested in what they can do together and
look at the aggregate production process.
Turns out. The aggregate production set, Y , is
Y = Y
1
+ Y
2
+ ... + Y
N
,
where Y
i
are the individual rm production sets.
Notation. Note how nicely the + notation for sets work for this.
Implicit complexity. The notation hides some of the complexity the rst rms output can
be the input for the second and so forth.
Howto? Sum over the indices separately. y
out
1
= y
11
+ y
12
+ ... + y
1N
.
Nice? Yes, because with production functions, its very dicult to nd the aggregate production
vector.
Inheritance of properties.
Q. If the individual production sets have all the nice properties, will the aggregate also have
them?
A. No, some of them are inherited but not necessarily all. Additional assumptions can be made
to rectify the situation.
2.2.1 Ecient productions
Goal. Single out production plans where we dont waste resources.
DenitionDomination. We say that for y, y Y ,
y dominates y if y > y,
that is y y and y ,= y.
ExampleFree lunch. If you can produce the same output without using any more input.
DenitionEciency. We say that y Y is an ecient production if
y Y : y > y.
ExampleGraphics. If you draw the rectangle that has the point y as the lower-left point
(i.e. everything to the up-right of the point) and there is nothing there you could have
chosen instead, then youre good.
10
2.2.2 Producers problem (PP) (MWG: Producers maximization problem)
Interest: Existence of solutions and their properties.
The Producers problem (PP). Given prices p R
L
+
, p ,= 0,
(PP) : max
yY
py = p
1
y
1
+ ... + p
L
y
L
.
Alternatively, we might write
py = p(y
+
y

) = py
+
py

= revenue cost.
Drawing. Consider the (y
1
, y
2
)-plane and a vector p, say p = (1, 2). Then p denes a hyperplane,
H
k
= y[py = k for some k 0, then for dierent k, you get dierent hyperplanes (just
lines in R
2
) that are parallel. We want to get to the hyperplane corresponding to the highest
k-value.
(notation) He writes y py for the notation y py.
Multidimension. Here, the hyperplane is simply orthogonal to the gradient!!! The gradient is
orthogonal to the tangent of the set.
Example. If the production set has an asymptotic tangent that is orthogonal to the prices (i.e. the
optimal hyperplane, H
k
, are asymptotically tangent to the hyperplane), then there might never
be an optimal production plan, cause youd always keep moving out along the frontier, all the
time improving.
SurpriseP1 ok. You can make up production sets that satisfy P1 and are strictly convex
and still may end up in that weird asymptote case.
In MWGexposition. They allow p R ... when they say p = is the solution, we will
say that no solution exists.
2.2.3 Something
Consider. The PP and assume that P1 and P2 are satised. And lets draw on the simplest case
that y
1
is input and y
2
is output.
(graph) see the iPad from notes from today for a nice simple example with a piece-wise linear bound-
ary.
READ ON YOUR OWN. Theres a simple proof (in his notes or MWG?)
3 2012-09-11
3.1 FB
Consumption set. X R
L
represents the non-economic restrictions on consumption.
Assumptions:
X is non-empty.
X is closed.
X is convex.
X is a lower bounded set (in vector ordering).
11
I.e. b R
L
: x X x b.
(recall that x b x

; x > b x

b x ,= b; x b x

> b

)
X is upward comprehensive.
x X, z R
L
+
x + z X.
Preference relation.
Continuous utility. The preference relation can be represtented by a continuous utility
function if it holds that
x X : x X[u(x) u( x) and x X[u(x) u( x) are closed sets in X,
and that
x X : x X[u(x) > u( x) and x X[u(x) < u( x) are open sets in X.
Convexity. is convex if the set if for all x X, the set x

X[x

x is convex.
Utility. If u represents , then is convex i u is quasi-concave.
Strict convexity. If
x
1
, x
2
, x
3
X, x
1
x
2
, x
3
= x
1
+ (1 )x
2
, (0; 1) x
3
~ x
2
.
Utility.
u(x
1
) u(x
2
), x
3
= x
1
+ (1 )x
2
, (0; 1) u(x
3
) > u(x
2
).
Dierentiable. is dierentiable if there exists a continuous utility function, u, representing
such that
1. Each partial derivative, u(x)/x

, exists for x intX.

2. The partial derivatives, u(x)/x

: intX R, L, are continuous.

3. The gradient is not the zero vector, i.e.
u(x) =
_
u
x1
(x),
u
x
L
(x)
_
,= 0x intX.
Dierentiable demand fct? To obtain this, we need a strong assumption.
Required assumption: There exists a utility function, u, with continuous rst and second
order partial derivatives representing such that det

H ,= 0 where

H is the bordered
Hessian,

H =
_
_
_
_
_
_
_
D
2
11
u(x) D
2
12
u(x) D
2
1L
u(x) D
1
u(x)
D
2
21
u(x) D
2
22
u(x) D
2
2L
u(x) D
2
u(x)
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
D
2
L1
u(x) D
2
L2
u(x) D
2
LL
u(x) D
L
u(x)
D
1
u(x) D
2
u(x) D
L
u(x) 0
_
_
_
_
_
_
_
.
3.2 Introduction
Notationagain.
Number spaces. Recall that z R
L
++
z >> 0.
Mapping (function). He would write (y
1
, y
2
, y
3
) y
1
for the function I would write as
(y
1
, y
2
, y
3
) y
1
.
12
Convexity. He argues that if F is concave, then y
1
F(y
2
, y
3
) is convex because
(y
1
, y
2
, y
3
) y
1
is convex and (y
1
, y
2
, y
3
) F(y
2
, y
3
).
Lower contour set. He looks at the lower contour set of a number c R as
lower contour set of c : (
c
= y R
L
[y
1
F(y
2
, y
3
) c
contour set of c : (
c
= y R
L
[y
1
F(y
2
, y
3
) = c
upper contour set of c : (
c
= y R
L
[y
1
F(y
2
, y
3
) c.
Hold on. If the contour set is generated by a function (y
1
, y
2
, y
3
) y
1
F(y
2
, y
3
) that
is convex, then ... ???
But for utility functions, the upper contour set will most often be a convex set.
Q from student last time. R
Returns to scale. Consider y Y . If then y Y for , then XXX
1. = [0; 1]; Y exhibits non-increasing returns to scale
2. = [1; ); Y exhibits non-decreasing returns to scale
3. = [0; ); Y exhibits constant returns to scale.
(see) the drawing I did in hand today...
Producers max problem (PMP).
(PMP) : max
yY
py,
i.e. nd y
0
Y s.t. py
0
pyy Y .
Cost-revenue.
= py = py
+
py

.
Isoprot hyperplanes. Important to study. Hyperplanes are the contour sets for a linear function
hence they get almost full dimension. Say, 2-dimensional in R
3
.
Supply correspondance. The set of productions, y Y , giving maximal prot,
(p) = y Y [py py y Y .
Often contains more than one vector, may be empty.
MWG notation. MWG use y for the production and use y(p) for the supply curve.
3.3 Thm [4.2].1 red proof (p. 29 NotesThPr)
Let p R
L
+
, p ,= 0 and let Y satisfy assumption P1. Then the following hold
(a) (p) is a convex set, possibly empty
(b) (p) = (p) for > 0, R
++
.
(c) py 0 for y (p) and py is constant on (p).
(d) if p R
L
++
then each y (p) is an ecient production in Y .
further if P1 and P2 are satised, then
(e) py = 0 for each y (p)
(f) if (p) is non-empty, then (p) is a convex cone which may be degenerate, that is, (p) = 0.
13
3.3.1 Proof of (a)
Proposition. p R
L
+
, p ,= 0 and let Y satisfy assumption P1. Then (p) is a convex set, possibly
empty.
Proof. Assume that y, y (p) and let , [0; 1] be given s.t. + = 1. Choose some arbitrary
y Y . Then we know that
py py p y py,
because of the denition of (p). From the simple rules of inequalities and multiplying with a
scalar,
py py p y py.
Now add the inequalities,
py + p y py + py
p(y + y) py,
which proves that y + y (p).
3.3.2 Proof of (b) (on my own!!)
Proposition. (p) = (p) for all R
++
(i.e. scalars > 0.
Proof.
. Take y (p). To show: y (p). To whos this, take some y Y , it must then hold
that py p y. But we know that
(p)y (p) y
py p y.
. As above.
3.3.3 Proof of (c)
Proof. Let y, y (p). By P1, we know that 0 Y , and py p0. Then py pyy Y so in
particular for y = y, i.e. py p y. Similarly, since y (p), p y py. Thus, py = p y.
Intuition. The prot at maximum is unique... although the way of getting there need not be.
3.3.4 Proof of (d)
Proposition. If p R
L
++
then each y (p) is an ecient production in Y .
Note. Note that now weve strengthened from p R
L
+
to p R
L
++
.
To show. Show that y (p) is ecient.
Method. Proof by contradiction.
Proof.
14
Assume contradiction. We assume that y is not ecient. Then, there is a y Y that domi-
nates y, i.e. y > y. Elementwise, this means that
y

and l : y
l
> y
l
with strict inequality for at least one . Now multiply prices on both sides, maintaining
inequality (note that prices are non-zero)
p

and summing gives

p y > py
(due to the at least one surviving strict inequality). Hence, y / (p). `
Note. It was essential that p

,= 0 for all (or at least for the where the inequality was strict).
3.4 Subspaces and linear functions
Linear functions. Are functions R
2
R. For a given p, we are in particular interested in y py.
Homogenous hyperplane. A hyperplane that contains the zero vector. Hence, the family of hyper-
planes,
]

= y Y [py =
have only one member that is homogenous and that is ]
0
.
Subspace. Note that the homogenous hyperplanes are all linear subspaces (I think?).
Ane subspaces. Any hyperplane is an ane subspace. However, these are not very studied
by mathematicians.
3.5 A Decentralization Theorem (thm. 7.1, p 35 NotesThPr.)
Let Y
j

jJ
be J production sets and p R
L
+
, p ,= 0. Consider the J individual PMP,
max
yjYj
py
j
and the aggregate PMP
max
yY1+Y2+...+Y
J
py.
Notation. Recall that
/+B = c[a /, b B : c = a +b.
Proposition.
(a) If
_
y
j
_
jJ
solves the individual PMP, then y = y
1
+ ... + y
J
solves the aggregate PMP.
(b) If y Y
1
+ ... + Y
J
solves the aggregate PMP then for any y
j
Y
j
, j J such that
y = y
1
+ ... + y
J
it is the case that y
j
solves the individual PMP for j J.
15
3.5.1 Proof of part (b)
Setup. We are given y

jJ
Y
j
and we know that
py pyy

Y
j
.
We also know that since y

jJ
Y
j
that there exist y
1
, ..., y
J
such that
y = y
1
+ ... + y
J
.
Assume the contradiction. Assume that one y
j
violates producer js problem (it could be that
multiple did it but this will suce). And lets consider j = 1 for notation.
Then there is
y
1
Y
1
: p y
1
> py
1
.
But. Then compare the aggregate production plan y = y
1
+y
2
+...+y
J
with

y = y
1
+y
2
+...+y
J
.
We know that

y

j
Y
j
because all the elements are in the respective ones. Now consider
py =

j
py
j
< p y
1
+
J

j=2
py
j
= p

y.
Hence,

j
Y
j
: p

y > py. `
contradiction!
Hence. we conclude that y
j
must solve the PMP for each individual producer j.
3.5.2 Proof of part (a) LEFT FOR US TO DO BY OURSELVES
Setup. Suppose that y
j
solves producer js problem for each j J. To show: y

j
y
j
solves the
aggregate problem.
My idea. Well if you maximize each component of the sum then of course the sum itself must be
maximized.
3.6 Representing production sets with production functions
(also: transformation functions)
First stupid attempt. Let Y be given, Y R
L
. We can always describe Y with a function, for
example 1
Y
(y) (the indicator function for the set...).
Second attempt. We want to use calculus.
Production function. Y R
L
can be described by a production function if there a function
F : R
L
R (note, F must be dened on all of R
L
!) such that
(i) F(y) 0 whenever y Y .
That is, Y should be the lower contour set of F.
(ii) F(y) = 0 if and only if y is an ecient production in Y .
(iii) F C
1
(so F has continuous partial derivatives; continuously dierentiable) on all of R
L
!
(no problem with interiors here!!)
16
The problem. There will often be kinks, for example at zero. And this cant always be C
1
.
But. Often, productions after kinks (e.g. on the second axis when we have a negativity
constraint) are often inecient
Idea. We only need sensible behaviour close to the optimal solution.
4 2012-09-12
4.1 Representing production sets
Representing production. We can always represent Y by a function. We might just use the indi-
cator function.
Pro. Always feasible
Con. Not a nice function... wed like to use dierential calculus.
Alternatively.
F : R
L
R represents Y i the following hold
(i) : F(y) 0 if y Y
(ii) : F(y) = 0 i y is an ecient production plan
(iii) : F C
1
(R
L
).
Pro. Nicer
Con. Often there will be kinks in the Y frontier, for example due to non-negativity sets.
IMPORTANT: Suppose Y is the entire South-West (third quadrant) plus the part of the 4th
quadrant that is below a mirrored log function.
Then in the 3rd quadrant, F(y) 0 (cause y Y ) and in the 2nd quadrant F(y) > 0
(because y / Y ).
BUT! What about the 2nd axis? Its between them so for continuity we need F(0, y
2
) = 0
but its not ecient, which doesnt work with (ii).
SolutionVicinity. Consider y Y R
L
and let | R
L
be the open sphere centored on y.
Local representation.
F : | R locally represents Y at y i
(i) : F(y) 0 for y Y |
(ii) : F(y) = 0 i y is an ecient production in Y |
(iii) : F C
1
(|).
Tangent hyperplane. To get the hyperplane, consider gradF(y). The tangent hyperplane is tangen-
tial to the gradient!
Moving the coordinate system. You should move the coordinate system to have the origin
centered at 0 := y and then look at the vector F as eminating from that point.
Example. Consider Example [8.2].1 which we did in the tutorials.
17
4.2 Thm. [8.2.].1
Assume. Assume that the prdocution possibility set Y can be locally represented by the production
function F at y and p R
L
++
.
Proposition. The proposition has two parts, (I) and (II).
(I) If y is a solution to the PMP at prices p, then
F(y) = 0 and F(y) = p for some R and if F(y) ,= 0, > 0.
Intuition. doesnt mean anything only relative prices matter....
F sign. F(y) 0 for y | Y and F(y) 0 for y | Y because F(y) 0 respectively
of which side of the frontier y falls in.
Hence, F points in the direction of outside Y . Thats why itll always point in the
same direction as p. And therefore, 0 always. Hence, R
+
.
Think. y solves max py s.t. F(y) = 0.
Problem. What if y is not a solution to the PMP?
Then. it might just be a local optimum...
Graphs. Look at [8.2].1 and [8.2].2 depict examples (with a wavy frontier).
(II) If for some > 0, y Y satises
F(y) = 0 F(y) = p Y is convex,
then y is a solution to PMP.
(if F(y) = 0 (the zero vector) there is a problem... but he doesnt have anything to say about
it!)
Intuition. The dierential calculus provides us with the candidate solutions,
candidates = y Y [F(y) = 0, F(y) = p, > 0.
4.2.1 Law of supply
Suppose.
y
0
solves PMP at prices p
0
,
y
1
solves PMP at pricse p
1
,
which of couse implies that p
0
y
0
p
0
y
1
and vice versa. Using these, we get
p
0
(y
0
y
1
) 0
and 0 p
1
(y
0
y
1
)
p
0
(y
0
y
1
) p
1
(y
0
y
1
)
(p
0
p
1
)(y
0
y
1
) 0,
or, py 0, i.e. signp = signp. That is, p

.
(note the sign conventions, p

< 0 for an input where means closer to zero, so cheaper:)

Comparison to Slutsky. For the producer, we have nice and sensible substitution patterns in
the directions wed assume
18
4.3 Moving on to consumers
Time constraints we skip talking about expenditure functions and indirect utility functions and
only use what is necessary to get onwards to the welfare stu.
NotationWealth, w. He originally the latex w which is very close to . He wanted to change it
to w.
Consumption (possibility) sets.
MWG. They just set X = R
L
+
.
Here. We want to allow more general X.
What is it? Non-economic constraints: For example nutritional requirements, cant work neg-
ative hours,
Demand function.
MWG. They use the demand function (p, w) x(p, w), where x(, ) is a function.
Here. Since x could also be a variable x X, we instead use (p, w) (p, w), where x :
R
L
+
R X.
SetupConsumer stu.
Commodities. L = 1, 2, ..., L commodities.
Sign stu.
Recall for producers. There, we had y

Y
1
+ ... + Y
J
y
+
, where y

was inputs with

positive sign.
(and recall how deliveries from rm j to k cancelled out in the aggregate...)
ConsumersDecomposition. Here, we also decompose
R
L
X x = x
+
x

4.4 Assumptions
4.4.1 F1
The consumption set X R
L
satises
(a) X is non-empty.
(b) X is a closed set.
(c) X is a convex set.
(d) X is a lower bounded set in the vector ordering (b R
L
x X : x b)
(e) X is upward comprehensive (x X, z R
L
+
x + z X).
Note. These requirements are non-economic in the sense that there are no prices and so forth.
Notes.
(c) Convexity implies that all goods should be divisible!! (because if e

= (0, ..., 0, 1, 0, ..., 0) X,

then e

X)
19
(d) The lower bound requires that no consumer can supply of anything! Visually, in R
2
, it
means that we can put down a 90-degree triangle (parallel to the axes) and then its lines
never touch X.
(e) Upward comprehensibility
Boundedness. A vector can be bounded in several senses:
Lower bounded. (in vector ordering)
Upper bounded. (in vector ordering)
Bounded. (in norm) A set / R
L
is bounded if there exists an > 0 and a point (any point?)
a / such that the sphere centered on a with radius , S(a, ) = x /[d(x, a) < ,
conttains / fully.
(alternatively, have the sphere centored on the origin i.e. there exists > 0 such that
a / : |a| < .
Note: Lower bounded + upper bounded bounded.
5 2012-09-18
5.1 Last time
Discussed the consumer
Assumption F1.
The consumption set X R
L
satises
(a) X is non-empty.
(b) X is a closed set (mathematical convenience).
(c) X is a convex set (implies that commodities are divisible counter-example is discrete
goods).
(d) X is a lower bounded set in the vector ordering (b R
L
x X : x b) means that
the consumer cant deliver of any ressource to the rms.
(e) X is upward comprehensive (x X, z R
L
+
x + z X) MWG write X +R
L
+
X.
5.2 Preferences
Rational preference relation.
Rationality. Means that the preference relation is Total and Transitive (completeness is not a
part of the denition).
Total. x, x

X implies x x

or x

x.
Transitive. x, x

, x

X and x x

and x

implies x x

.
Other properties.
Reexive. Often welll assume this as well: x X then x x.
Monotonicity. A set of assumption F2 shown later in this note.
Intuition. Monotonicity ensures that we will get scarcity ( positive prices, etc.)
Satiation/bliss point. We want exclude this.
20
Local non-satiation. For any x X, > 0x

o(x, ) X : x

x, where o(x, ) is the

sphere with center x and radius .
Noteintersection. We need o(x, ) X because x might for example be on the edge of
X.
Convexity. See below
Relations.
Strictly preferred. Let x, x

X. Then x ~ x

if x x

but it is not the case that x

x.
Indierence. Let x, x

X. Then x x

if x x

and x

x.
5.2.1 Proof of continuity sketch
Goal. Constructing a utility function for and proving continuity.
IdeaConstructive. Consider the (x
1
, x
2
)-plane and consider the 45

line. Then think of all the

indierence curves as Cobb-Douglas-style and they cut the 45

-line further and further out. Then

let the utility function, u(), simply assign how far out of the 45

-line you went before you got

to the intersection with the indierence curve on which (x
1
, x
2
).
Now. u : X R represents . But take any : R R, increasing, and consider u this
function will also represent .
Requirement for existence. Assume that X is closed and non-empty. Then can be represented
by a continuous utility function if and only if x X, both the upper and lower contour sets,
x X[x x and x X[x x respectively, are closed sets.
Small note. For closedness, we require a metric, but recall that X R
L
so the euclidean
distance is used (I guess?).
DenitionContinuous preference relation. We actually say that is continuous if it
the lower and upper contour sets of any x X are closed (i.e. it can be represented by a
continuous u).
Contour sets. Note that under
x X[x x = x X[u(x) u(x),
and assuming that the preferences are continuous,
x X[x x = u
1
_
[u(x); )
_
which will be closed ...
Further onAlways assume continuity.
5.2.2 Monotonicity assumptions F2
F2. x
1
, x
2
X and x
1
x
2
x
1
x
2
.
F2 MWG Def 3.B.2. x
1
, x
2
X and x
1
>> x
2
x
1
~ x
2
Think. We want to exclude thick indierence curves however Leontief (90

indi curves)
where if you get more of some goods but not all (and you start in an optimal point) then
you are indierent!!
F2 strong monotonicity MWG Def 3.B.2. x
1
, x
2
X and x
1
> x
2
x
1
~ x
2
.
21
5.2.3 Convex preferences
DenitionConvexity. We say that a preference relation, , is a convex preference relation i for
any x X, the set x

X[x

x is a convex set. (MWG def 3.B.2)

Utility. If u represents , then is convex i u is quasi-concave.
Quasi-concavity.
f : R R increasing = f quasi-concave.
ExampleCobb-Douglas. Something something u = x

1
x

2
, when + = 1 lower contour
sets (??) are concave but + > 1 ruins concavity but something something (x

1
x

2
)
2
retains quasi-concavity...
5.2.4 Strictly convex preferences (F3)
Setup. Let x
1
, x
2
, x
3
X such that x
3
= tx
1
+ (1 t)x
2
for some t (0; 1) (note that t ,= 0, t ,= 1)
and x
1
,= x
2
.
Preferences. is a strictly convex preference relation if x
1
x
2
implies x
3
x
2
.
Utility version. The utility function is strictly quasi-concave if u(x
1
) u(x
2
), then u(x
3
) u(x
2
).
Alternative. An alternative combination could be
u
_
tx
1
+ (1 t)x
2

> min
_
u(x
1
), u(x
2
)

.
Interpretation. A proper convex combination of two dierent points is better than either of the two.
Purpose. Prevents at sets on the indierence curves.
Note, it also prevents fat indierence curves because you can choose two points in the fat
indierence and then the line between is also in the indierence set.
5.3 Towards calculus
5.3.1 Assumption of dierentiability
Denition. We say that is di if
1. Each partial deriv exists
2. The partial derivatives, D
l
u(x) =
u
x
l
(x), are continuous on intX.
3. For any x intX, the gradient, u(x) = (D
1
u(x), ..., D
L
u(x)), is not the zero vector (i.e.
not all the partial derivatives can be zero in the same point).
5.3.2 Assumption F4 bordered Hessian
Assumption F4. There exists a utility function, u, with continuous rst and second order partial
derivatives representing such that det

H ,= 0 where

H is the bordered Hessian,

H =
_
_
_
_
_
_
_
D
2
11
u(x) D
2
12
u(x) D
2
1L
u(x) D
1
u(x)
D
2
21
u(x) D
2
22
u(x) D
2
2L
u(x) D
2
u(x)
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
D
2
L1
u(x) D
2
L2
u(x) D
2
LL
u(x) D
L
u(x)
D
1
u(x) D
2
u(x) D
L
u(x) 0
_
_
_
_
_
_
_
.
Mechanics. Prevents the Gaussian curvature from being zero.
22
5.4 Consumer problem
Setup. Were given (p, w), prices and wealth (in notes: he half-heartedly changed w to w to avoid
confusion with .
Budget constraint.
x X : p x w.
Zero prices. ALWAYS take note of whether we assume p R
L
+
or p R
L
++
.
5.4.1 Proposition 1
Proposition 1. Let (X, u) be a consumer. Assume that
(i) X satises F1 (non-empty, closed, convex, lower bounded, upward comprehensive).
(ii) p R
L
++
(positive strictly positive) and w min
xX
p x (MWG use inf
xX
p x but its
an irrelevant problem here).
Then the budget set,
B(p, w) x X[p x w,
is a non-empty, compact set.
Notes.
Non-empty. Follows from (ii).
ProofCompactness.
Step 1: Closedness. Note that
B(p, w) = x R
L
[p x w X.
If we can show that the two sets are closed then the intersection is closed. The rst of the
two is the inverse image (urbillede) of the linear function x p x on the set (; w] and
the inverse image of a linear function on a closed set is closed. X is closed by assumption.
QED.
Step 2: Boundedness. Let x X. To show: There exists > 0 such that |x| < . First, note
that by F1, there is b R
L
+
such that x b (if the lower bound has positive coordinates,
we can always nd an even lower bound that has all negative coordinates). Now note that
p
1
(x
1
b
1
) p
1
(x
1
b
1
) + ... + p
L
(x
L
b
L
) p x p b w p b
x
1
b
1
+
w p b
p
1
= d
1
.
so since x
l
d
l
for all l, |x| |d| =: .
6 2012-09-19
6.1 Stu
RecallBudget set. B(p, w) = x X[p x w.
Proposition 1.
Assume. 1) X satises F1 and 2) p R
L
++
and w min
xX
p x.
Note. Part 2) ensures that B(p, w) is non-empty.
Then. B(p, w) is a non-empty, compact and convex set.
23
6.1.1 Recapping the proof of proposition 1
Proof of closedness. We have that
B(p, w) = x R
L
[p x w X =
1
_
(; w]
_
X,
where (x) = p x so the inverse image of a closed set by a continuous function is closed.
Also X is closed by F1.
Hence, the intersection is closed.
Proof of boundedness. To show: x B(p, w)k R : |x| k.
Use lower boundedness of X. By F1 we know that b R
L
: x X x b. Now, choose
c even smaller than the guarenteed b so that b R
L
+
(i.e. all non-positive entries) and so
that p x > p c.
WARNING! He uses b as my c!
Consider the set
C = x R
L
[x b, p x w.
Now note that.
p
l
(x
l
b
l
)

jL
p
j
(x
j
b
j
) = p x p b w p b
b
l
x
l
b
l
+
w p b
p
l
=: d
l
.
WarningSign! We do not know the sign and we want to take the square. So if its
negative, x
2
l
> d
2
l
. But then were saved by the other end point since then b
2
l
> x
2
l
> d
2
l
.
Hence, in a coordinate-wise fashion, we have
x
2
l
max(b
2
l
, d
2
l
)
Hence, the summation over l L will maintain the inequality,

lL
x
2
l

lL
max(b
2
l
, d
2
l
)
|x| |e|,
where
e =
_
max(b
2
1
, d
2
1
), ..., max(b
2
L
, d
2
L
)
_
.
Proof that B(p, w) is non-empty. Let x X be given and let w = px. We know that B(p, w) is
compact so the function x p x attains a minimum on B(p, w) because x p x is linear and
thus continuous.
Then. There is x B(p, w) such that it is cheaper than all other bundles, i.e.
x B(p, w)x B(p, w) : p x p x
and p x w since x B(p, w). Then consider any x X B(p, w), it must hold that
p x w because otherwise x B(p, w). Hence, in particular, p x p x.
Hence, p x = min
xX
p x.
24
Proof that B(p, w) is a convex set. Note that
B(p, w) =
_
x R
L
[p x w
_
X =
1
_
(; w]
_
X,
which is again the intersection of two convex sets because X is convex by F1 and it is a mathe-
matical fact that the rst set is the half-space of R
L
(partitioned by a hyperplane) which is very
easy to prove:
Proposition. / =
_
x R
L
[p x w
_
is convex.
Proof. Take x, x

/ and [0; 1]. Then

px w, px

w
px w, (1 )px

(1 )w
px + (1 )px

w + (1 )w
p [x + (1 )x

] w
x + (1 )x

/.
Intuition. The lower boundedness and the positive prices are what ensures a compact choice set.
6.2 Proposition 2 solution to the CP
Sequences. Any innite sequence on a compact set will have a convergent subsequence.
Assumptions. Let (X, u) be a consumer where X satises F1 and let p R
L
++
and w min
xX
p x.
Proposition 2 (with proofs?). The following hold.
(a) There is a solution to the CP.
Proof. Consider the restriction of u to B(p, w). That function is continuous. Then there
is x B(p, w) such that
x B(p, w) : u(x) u(x),
that is, there is a solution to the Consumer Problem.
(b) If u satises F2 then each solution to the CP belongs to the budget hyperplane.
Proof by contradiction. Assume that there is a solution x B(p, w) with p x < w
(below the budget hyperplane). To do: construct x such that x x. Let
x = x + (w p x)
1
L
_
1
p
1
,
1
p
2
, ...,
1
p
L
_
.
Claim. x B(p, w).
Proof.
p x = p x + (w p x)
1
L
p
_
1
p
1
,
1
p
2
, ...,
1
p
L
_
= p x + (w p x)
1
L
L

l=1
p
l
p
l
= p x + (w p x)
1
L
L
= w.
25
Claim. x x.
Proof. Since x
l
> x
l
in all coordinates (because w > p x and p
1
l
> 0 for all l) and
since F2 (normal monotonicity) gives that x
l
> x

l
l x ~ x

, we have x x. If
we assume strong monotonicity, then because x
l
> x
l
for all l L, x ~ x.
WARNING! I think we actually assumed strong monotonicity above.
(c) If u satises F3 then there is a unique solution to the CP.
Proof. Assume that x, x with x ,= x are both solutions to the UMP, i.e.
u(x) = u( x).
Then consider the convex combination by = , x

= x + x. By convexity of
B(p, w), x

B(p, w). By strict convexity of u,

u(x

) = u(x + x) > min [u(x), u( x)] = u(x) = u( x).

But that contradicts that these could be solutions to UMP.
Comments.
(b) and F2
0
. In this we have weak monotonicity. That allows for thick curves. But then the
ones on the budget hyper plane are equivalent to ones just close to them (still on the thick
area).
(c) and F3. If we dont have convexity, there might be several solutions to the UMP (if the
slope is the same over a region)
6.2.1 Marshallian Demand Functions
Setup. X satises F1, u is continuous and u satises F2 and F3.
Consider.
D = (p, w) R
L+1
[p R
L
++
, w min
xX
p x.
(recall) then a unique solution exists in the budget hyperplane.
Denition. Then the Marshallian Demand function is
(p, w), : D R
L
(MWG use x(p, w)) and we can characterize it as
u[(p, w)] u(x), x B(p, w)
Continuity. is continuous for (p, w) such that w > min
xX
p x.
ProofNot shown here!! Follows from Claude Berges theorem of maixmum or something...
Minimum wealth situation. Is when w = min
xX
p x.
Illustration of the problem.
To show. An example where we have a sequence p
n
, w
n

nN
where (p
n
, w
n
) = 0 for all
n but lim
n
(p
n
, w
n
) > 0.
How? Let X be on the 1st axis until (0,0) where it turns into the line x x and after a
while it kinks and is parallel to the 2nd axis.
Notes: See the consumption notes p. 17 its drawn there!!
What happens? When the prices are p = (1, 1
1
n
) and w = 0, the optimum is x = (0, 0)
but if p = (1, 1) and w = 0, the optimum is at the point before it goes vertical. So it
jumps across the part where the frontier of X is x x.
26
6.2.2 UMP and Expenditure Minimization
Assumptions. Let (X, u) be a consumer satisfying F1 and let p R
L
++
.
The following hold.
(a) If the consumer satises F2 and x solves the CP given (p, w), then x solves the expenditure
minimization problem,
min p x s.t. u(x) u(x).
(b) Let x be a solution to the expenditure minimization given p and u = u( x). Put w = p x . If
w = p x > min
xX
p x, then x is a solution to the Consumer Problem given (p, w)
Why F2 under (a)? Because you might have a thick indierence curve if the solution is inside
the thick part of it, then some of them are solutions but waste money (it just wouldnt help to
save money).
Local nonsatiation. Would work too. We essentially just need to disallow thick indierence
curves.
6.2.3 Walrasian Demand Function
Setup. Consider (X, u, e), where e X is an initial endownment.
Wealth? Simply follows from the price system, p e, p R
L
+
.
Consider. The mapping p (p, p e) (p, p e).
Typical assumption? e int(X) so as to avoid the minimum wealth situation.
MWG. They dont make a distinction between the Walrasian and the Marshallian demand.
7 2012-09-25
7.1 Last time
Example with disc. He constructed an example where the demand fct. was discontinuous
Kinked cons. set. We condisdered a consumption set where the frontier was (x-axis until (0,0))
+ (kinked line with slope -1 up until about (-1,-1)) + (line parallel to y-axis (at x = -1) up
to ).
Prices. p
n
, w
n
= (1 n
1
, 1, 0).
Demand. (p
n
, w
n
) = (0, 0) for all n N. But (lim
n
(p
n
, w
n
)) = (1, 1) = (1, 1)
because when prices become tangential to the slope -1 part of the X-frontier, we follow
the indierence curves upwards (at each jump increasing utility) until we reach the next
kink point at (-1,-1).
Properties of demand.
Homogenous of deg. 0.
(p, w) =
0
(p, w) = (p, w).
Budget hyperplane.
B(p, aw) = B(p, w).
27
Walras law.
p(p, w) = w
(we always choose something on the budget hyperplane)
Problem set 3Revisions. In the CES function it said that > 1 it should be 1.
CES fct.
Leontief. (small elasticity of subst) tends to 90

legs.
Cobb-Douglas. = 0. Here, the axes are asymptotes for the indierence curves.
(0; 1). Now indi curves touch the axes.
7.2 Concluding the study of the consumer
7.2.1 Prop 5
Let (X, u) be aconsumer satisfying F1, F2 and dierentiability and (p, w) D.
Proposition 5.
(a) If x int(X) is a solution to the CP then there is > 0 s.t.
_
gradu(x) p = 0
w px = 0.
(b) If furthermore F3 is satised and x int(X) is a consumption which for some > 0 satises
_
gradu(x) p = 0
w px = 0,
then x is the unique solution to the CP.
Thinking.
(a) Something something we could rescale u =
1
u...
(b) We already know that by F1F3 there is a unique solution. So this thm. says whwat the
solution actually is.
7.2.2 Proving proposition 5
We know.
To show. x solves the expendituer minimization problem. That is
u( x) u(x) p x px.
(recall theres a proposition that the two are equivalent under certain restrictions)
We know. p = grad(x).
Let x be such that u( x) u(x).
Now consider
x +t( x x) = (1 t) x + tx, t [0; 1]
which is the line segment from x to x.
28
By F3. We want to take the derivative of
u[x + t( x x)] ,
so we put forth the newtonian,
lim
t0
u[x + t( x x)] u(x)
t
.
Digression. Think of this as f [x(t), y(t), z(t)]. To take this derivative, use the total derivative,
d
dt
f(x, y, z) = x

(t)f

1
+ y

(t)f

2
+ z

(t)f

3
= grad(f)
_
x

_
,
where () is the scalar product.
Applying this.
lim
t0
u[x + t( x x)] u(x)
t
= grad(u)
_
x +t( x x)
1
x +t( x x)
2
x + t( x x)
L

=
u
x
1
(x)( x
1
x
1
) + ... +
u
x
L
(x)( x
L
x
L
)
= grad(u) ( x x),
because the inner vector, x +t( x x), has derivative
t
[x + t( x x)] = x x.
Non-negativity. Because we have chosen x so that x x, we know that u( x) u(x). But
this means that since the convex combination is then at least as large as x as well, i.e.
x +t( x x) x, then utility
u( x) u[x + t( x x)] u(x),
so that we know that utility is on the increase in that direction, i.e.
grad[x + t( x x)] 0.
Insert grad(u). By assumption, we know that
grad(u) = p.
Then
p( x x) 0
p x px,
which is what we wanted to prove.
What about uniqueness? We already knew that F1F3 unique solution so it x solves the CP
then it must have been unique.
Understanding. Consider the optimization problem,
max u(x) s.t. p x = w.
I THINK WHAT HE SAYS IS: Suppose that x solves the CP. Then there is such that (x, )
is a critical point of the lagrangian, L(x, ) = u(x) +(w p x). Furthermore, is going to be
the marginal utility of w (income).
Summing up. We got the demand function characterized as the solution to a set of equations.
29
7.2.3 Proposition 6 dierentiable demand
Intro.
F
1
(x, , p, w) =
u
x
1
(x) p
1
= 0
F
2
(x, , p, w) =
u
x
2
(x) p
2
= 0
.
.
.
F
L
(x, , p, w) =
u
x
L
(x) p
L
= 0
F
L+1
(x, , p, w) = w px = 0
Why this system? Im pretty sure that this system is the system of
Linear algebra. If we have a linear system written in matrix algebra as Ax b = 0.
Implicit fct. theorem. Gives us
SOMETHING????? Related to the Ax b system but only a local thing...
Solve we can solve for (x
1
, x
2
, ..., x
L
, ) if the bordered Hessian (from ass. F4) has a non-zero
determinant.
Bordered hessian. It has the Hessian of u inside because we have
u
x

so that

xj
(
u
x

) = D
j
u but

(
u
x

) = p

but we know that marginal utility and prices are

proportional so p

= D

u.
Hence. Whenever the bordered Hessian has non-zero determinant at x, were golden (IN WHAT
SENSE??).
Required assumption. (, ) is dierentiable at (p, w).
7.3 Economies
7.3.1 Notation
Economy : c = ((X
i
, S
i
)
iI
, (Y
j
)
jJ
) .
Private ownership economy : c = ((X
i
, S
i
,
i
)
iI
, (Y
j
)
jJ
, (
ij
)
iI,jJ
) ,
where
ij
is is share of js prots and
i
is is initial endownment.
Pure exchange private ownership economies : c = ((X
i
, S
i
,
i
)
iI
) .
DiagramIllustrating the sign convention. He has a picture where y
+
(output from rms) be-
comes x
+
(income for consumers) and x

(work, etc.) from consumers becomes the input to

production, y

.
Endownments. We may think of the
i
s as inputs and outputs at the initial starting point of
the economy.
DenitionFeasible allocations. A list of I + J vectors in R
L
, (x
1
, x
2
, ..., x
L
, y
1
, y
2
, ..., y
L
) gives
an allocation in c. The allocation is feasible if:
feasible allocation :
_
x
i
X
i
, y
j
Y
j
i, j (individually feasible)

iI
x
i
=

jJ
y
j
+ (market balance).
We can write an allocation as ((x
i
)
iI
, (y
j
)
jJ
).
30
7.3.2 Example: Edgeworth box
Case. When
Edgeworth box : c =
_
(R
2
+
, S
a
), (R
2
+
, S
b
),
_
.
Graph. The Edgeworth graph is nice because only points inside the box are feasible (in that x
1a
+x
1b
=

1
and x
2a
+ x
2b
=
2
.
7.3.3 Pareto optimal allocations
Let ((x
i
)
iI
, (y
j
)
jJ
) be an allocation.
Denition The allocation (( x
i
)
iI
, ( y
j
)
jJ
) dominates ((x
i
)
iI
, (y
j
)
jJ
) if
S
i
( x
i
) S
i
(x
i
)i I and i

I : S
i
( x
i
) > S
i
(x
i
).
Edgeworth box. If the indierence curves in the Edgeworth box are tangential to each other at some
point then that point is pareto optimal (there are no points in the cigar.
Contract cuve. Connecting all the pareto optimal points, you get a curve through the Edgeworth box
(which contains (0,0) and (
1
,
2
) so long as F2 is satised; monotonicity) called the contract
curve.
7.3.4 Proposition concerning Assumption F2 (variant of F2)
RecallF2. Let x
1
, x
2
X with x
1
x
2
and x
1
,= x
2
then S(x
1
) > S(x
2
) (strict inequality).
Proposition. (section 5.2.3, NotesOpt) If the consumer (X, S) satises assumptions F1F3, then
(X, S) satises F2.
8 2012-09-26
8.1 Last time
8.1.1 Proposition 5 characterizing the solution
Point. We wanted to show that the solution to the problem can be found as the solution to a system
of equations.
Considered. We considered
_
gradu(x) p = 0
w px = 0.
as a system of equations in x and (i.e. given (p, w)), as F(x, ) = 0.
Proofidea. The idea for the proof was to take some x and consider the line between x and x
dened as x +t( x x), t [0; 1]. Then we found the newton derivative and let t 0 and found
the derivative and showed that it was positive.
31
8.1.2 Economies
Denitions. We dened a lot of stu.
Utility. Note that utility is S
i
(x
i
) rather than u
i
.
Feasible allocations. Two conditions:
(i) x
i
X
i
and y
j
Y
j
(ii)

i
x
i
=

j
y
j
+ (balanced)
Ad (ii) This is included as the denition of an allocation earlier on.
Edgeworth. Looked at the good ole box.
Pareto domination. Feasible allocation such that S
i
( x
i
) S
i
(x
i
) for all i I and S
i
( x
i
) S
i
(x
i
)
for some i.
Not PO? Then were wasting ressources (given that monotonicity holds).
8.2 Economies contd
8.2.1 Koopman diagram
Direction. Both consumer and production goes outwards (i.e. the diagram turns the right way from
the point of view of both of them.
Consumer. Represented by indierence curves.
Firm. Represented by the set
Y + =
_
x R
L
[x = y + , y Y
_
.
Note that the set Y usually starts in (0,0) so move out in the direction of the vector and from
that point and downwards, its a line parallel to the 2nd axis. From that point upwards, it curves
concavely to the right (but forming a convex set:)
8.2.2 Assumption F2 Strong monotonicity.
Ass F2. Strengthens: x
1
x
2
and x
1
,= x
2
(greater than in some coordinate), then S(x
1
) > S(x
2
).
8.2.3 Proposition [2.3.2].1 in NotesOpt.
Proposition. If the consumer satises assumptions F1, F2 and F3, then he also satises F2.
Note. If consumers a, b satisfy F2, then the southwest and northeast corners are in the contract
curve.
8.2.4 Proposition [2.3.2].2
Let ((x
i
)
iI
, (y
j
)
jJ
) be a pareto optimal allocation for c = (X
i
, S
i
)
iI
, (Y
j
)
jJ
, , where consumers
(X
i
, S
i
) satisfy F1 and F2 (the strong variant).
Proposition. Then

jJ
y
j


jJ
Y
j
is an ecient production in

jJ
Y
j
.
32
8.2.5 Section 2.3.3: Fairness
DenitionFairness. An allocation (x
i
)
iI
(each in R
L
+
) is said to be fair (or envy free) if all
consumers i I prefer no other bundle of any consumer j I, i.e.
(x
i
)
iI
is fair S
i
(x
i
) S
i
(x
j
)j I.
Example. Suppose
x
i
=
1
[I[
,
then (x
i
)
iI
is fair. However, it might be pareto inecient.
IMPORTANT! Suppose x
j
X
j
but x
j
/ X
i
. Then i cant be envious of j because i could never
consume what j is... for example, men cant envy women supplying lesbian porn! Their utility
function isnt dened on that output.
8.3 Section 3.1: Social utility functions
Goal. Dene a function no (x
i
)
iI
that maps into R (utility for the social planner).
(x
i
)
iI

_
S
1
(x
1
), ..., S
|I|
(x
|I|
)
_
U
_
S
1
(x
1
), ..., S
|I|
(x
|I|
)
_
R.
Examples.
Weighted sum. U( ) =

iI

i
S
i
(x
i
).
Min. U( ) = min
iI
S
i
(x
i
).
Arrows impossibility thm. Explains that if you have a few basic requirements for U then its
impossible to nd one!
8.4 Arrows impossibility theorem
8.4.1 The problem
Setup. Assume that there are only three individuals and three alternatives (need at least three).
Rankings: Below, we have the three persons (1,2,3) and how they would choose between the three
alternatives that the society is faced with. Each has their own preferred scenario / choice / policy
(a, b or c).
1 2 3 Social planner
1st choice b c a ?
2nd a b c ?
3rd c a b ?
8.4.2 Assumptions on the Social Welfare Function (SWF)
A1. Unrestricted domain. The SWF should have unrestricted domain.
A2. Pareto compatibility. If in a scheme (preference proles; set of utility functions?) everyone
has x before y, then the SWF should map the scheme into a ranking where x is before y.
A3. Independence of irrelevant (or binarity). Consider the following three schemes:
33
Scheme I.
1 2 3
1st choice a b a
2nd b b
3rd a
Scheme II.
1 2 3
1st choice a b a
2nd a
3rd b b
Scheme III.
1 2 3
1st choice b b b
2nd a
3rd a a
Suppose. Let I and II be two schemes and x, y two alternatives. x, y a, b, c and x ,= y.
Assume that the x-y pattern in I and II are the same.
The assumptionIIA. Then scheme I is mapped to a ranking with x before y if and only if
scheme II is mapped to a ranking with x before y.
Intuition. We have removed the c option from the above matrices to focus on how a and b are
placed relative to each other alone.
A4. No dictator. For each i I = 1, 2, 3 there is some scheme where societys ranking (the SWF)
disagrees with is ranking.
Note. We cant just say that we consider the scheme where S
i
= Si cause we want to consider
all possible schemes.
8.4.3 Arrows Impossibility Theorem
Proposition. There is no Social Welfare Function (SWF) that satises A1A4 if the number of
alternatives is greater than 2.
Alternative formulation. If we have a SWF that satises A1A3, then its a dictator.
2 individuals. Then it is much simpler to show (?)
IMPORTANT!
Allocation vs own bundle. It only holds for these discrete situations where each individual
must have preferences over the allocation, not just over their own bundle!!
Discrete vs continuous. We have only nitely many here.
NoteVoting. If you are voting, then there might be an incentive to vote dierently to tilt the
choice of society (unless theres a dictator).
8.5 Market Equilibrium (in MWG: Equilibrium with Transfers)
8.5.1 Theorem [4.2].1
Assumptions. Consider an economy c = ((X
i
, S
i
)
iI
, (Y
j
)
jJ
, ) where the consumers each satisfy
assumptions F1 and F2. Consider the allocation
_
(x
i
)
iI
, (y
j
)
jJ
, p, (R
i
)
iI
_
,
where R
i
is individual is income.
34
Prices. Prices are p R
L
+
0, i.e. p ,= 0. This is because F2 gives us kind of non-satiation so
we could (?) get u = ...
WAIT! Dont we then need F2?
No. We just say that prices cant all be zero...
MoreoverBalancing. Balancing will also cause something to break down if a price is
zero, I think?
Denition. We say that such an allocation is a market equilibrium if
1. (cons). For i I, x
i
solves the consumers problem given prices and income, (p, R
i
).
(i.e. all consumers have chosen the best consumption in B(p, R
i
), their budget set)
2. (prod). For j J, y
j
solves producer js problem given prices, p.
3. (comp).
_
(x
i
)
iI
, (y
j
)
jJ
_
is a feasible allocation.
Theorem [4.2].1. Then the market equilibrium allocation,
_
(x
i
)
iI
, (y
j
)
jJ
_
, is a pareto optimal
allocation.
ProofTechnique. Assume that we have a pareto dominating allocation then its too expensive.
Proof. By F1 and F2, p R
L
+
0 and
p x
i
= R
i
i I.
2beContd... next time!
9 2012-10-02
Last time. We proved proposition 2.
Assumes p R
L
++
.
Prop 2(b). This says that if u satises F2, then each solution to the CP belongs to the budget
hyperplane.
Wish: We want to extend the proof to hold for p R
L
+
0.
IMPORTANTExtending other propositions. It turns out that a lot of the propositions can
be extended to hold for p R
L
+
0 and not just p R
L
++
as we actually proved them for.
Aected: Propositions 2(b), 4(a), 5(b).
WARNING! Note that if one good has a the price p
l
= 0, then there will often not exist a solution
to the CP!!!!! But all (or almost) of the theorems say if there is a solution to the CP then
something...
9.1 Propositions
9.1.1 Proposition 4
Assume. Let (X, u) be a consumer satisfying F1 and let p R
L
++
.
Proposition.
(a) If ...
See slides...
35
9.1.2 Proposition 5
Assumptions. (X, u) satises F1, F2 and DIerentiability and (p, w) D (positive prices and w
min pw).
Says. Then If x is a solution to the CP then there is > 0 such that it comes from Lagrangian stu.
Also if F3 is satised and x satises Lagrangians, then its a solution to the CP.
Extension. Also holds for p R
L
+
0.
9.2 Something
Basic economy. There is a dierence between the notes and MWG In the notes they didnt care
about who had what of the ressources; In MWG, that should be specied as a part of the
economy.
MWG. In MWG,
c = ((S
i
, X
i
)
iI
, (Y
j
)
jJ
, (
i
)
iI
) .
Notes. In the notes,
c = ((S
i
, X
i
)
iI
, (Y
j
)
jJ
, ) .
Comparison. The notes just use =

i

i
.
Equilibrium with transfers. Then you have (x
i
), (y
j
), p, (t
i
), where

iI
t
i
= 0 (transfers).
Wealth of cons. i. Is given as p
i
+ t
i
.
9.3 The rst theorem of welfare economics.
9.3.1 Theorem [4.2].1
Assume. Consider an economy
c = ((S
i
, X
i
)
iI
, (Y
j
)
jJ
, ) .
Assume that consumers satisfy F1 and F2 and let
_
(x
0
i
), (y
0
j
), p, (R
i
)
_
be a market equilibrium.
Theorem. Then
_
(x
0
i
), (y
0
j
), p, (R
i
)
_
is a pareto optimal allocation.
Proof. By F1 and F2, p R
L
+
0. For i I, px
0
i
= R
i
(by proposition 2(b)).
Assume contradiction. Now we assume that there exists an allocation,
_
(x

i
), (y

j
)
_
, which is
(a) feasible and (b) pareto dominates
_
(x
0
i
), (y
0
j
)
_
.
WoLoG. Assume that it is consumer 1 that is better o, i.e.
S
1
(x

1
) > S
1
(x
0
1
).
Then it must hold that
px

1
> px
0
1
,
because otherwise it violates prop 2(b) (is it? the budget hyperplane one anyways)
36
Also. It must also hold that
S
i
(x

i
) S
i
(x
0
i
).
Well if it gives at least as much it must cost at least as much by expenditure minimization
(prop 4(a) I think). That is,
px

i
px
0
i
, i I 1.
NowProducers.
py
0
j
py

j
due to prot maximization. Rewrite this to get
py
0
j
py

j
, j J.
Add up inequalities.
px

1
+

iI\{1}
px

i
+

jJ
py

j
> px
0
1
+

iI\{1}
px
0
i
+

jJ
py
0
j

iI
p x

jJ
p y

j
>

iI
px
0
i

jJ
py
0
j
p
_
_

iI
x

jJ
y

j
_
_
> p
_
_

iI
x
0
i

jJ
y
0
j
_
_
Now use the fact that

i
x

i
=

j
y

j
+ ,
because it was a feasible allocation by assumption.
p

> p
0
,
but since they are from the same economy, the total amount of ressources was the same

=
0
= ,
so
p > p,
which is a contradiction.
Note.
Assumptions needed. We need F2 to exclude thick indierence curves... otherwise an EQ not
be PO because one consumer might notve cared if we took something from him.
9.4 The Second Theorem of Welfare Economics: Dierentiable Approach
9.4.1 Lemma [5.2].1
Let
_
(x
i
), (y
j
)
_
be a feasible allocation for the economy
c = ((S
i
, X
i
)
iI
, (Y
j
)
jJ
, ) ,
with utility imputation (s
i
) = (S
i
(x
i
)).
Lemma.
37
(a)
_
(x
i
), (y
j
)
_
is a pareto optimal allocation for c if and only if ((x
i
), y) with y =

jJ
y
j
is a
pareto optimal allocation for the economy
c = ((S
i
, X
i
)
iI
, Y, ) , Y

jJ
Y
j
.
(b) Let the consumers in c satisfy F1F4 and dierentiability and assume that Y satises
assumption P1 and that Y can be represented by a production function F : R
L
R.
(A).
(B). ((x
i
), y) solves the problem
max S
1
(x
1
), s.t. x
i
X
i
, i I and
(i) : S
i
(x
i
) = s
i
, i I 1,
(ii) : F(y) = 0,
(iii) :

iI
x
i
= y + .
Cool. (A) implies (B). Furthermore, if for i I, x
i
intX
i
, then (B) implies (A).
Notes.
(a) Means that we can conne our study to economies with only one producer.
9.4.2 Theorem [5.2].1
Theorem. If for i I consumer i satises F1F3, Dierentiability and x
i
intX
i
and the total pro-
duction set Y

j
Y
j
, satises assumption P1 and Y is represented by the production function
F : R
L
R, then there are prices p R
L
++
and wealth (R
i
)
iI
such that
_
(x
i
), (y
j
), p, (R
i
)
_
is a
market EQ.
9.4.3 Holy fuck in the structure...
9.4.4 Lagrangian
Lets go. Were solving.
max S
1
(x
1
), s.t. x
i
X
i
, i I and
(i) : S
i
(x
i
) = s
i
, i I 1,
(ii) : F(y) = 0,
(iii) :

iI
x
i
= y + .
Lagrangian. Becomes
L(x
1
, ..., x
I
, y, , , ) = S
1
(x
1
) +
I

i=2

i
[S
i
(x
i
) s
i
] + F(y)
_
I

i=1
x
i
y
_
,
where R
L
so that we have a
l
for each x
il
, y
l
,
l
touple.
Note that whether you have minus or plus in front of the constraints doesnt matter (absorbed
into mutipliers)
Suppose (x
i
), (y) is a solution to the problem.
38
Then there are , (
i
)
I
i=2
and (
1
, ...,
L
) such that all aprtial derivatives of L evaluated at the
bar values are zero.
Assymetry. We dont have a multiplier for consumer i = 1.
Remedy. We just consider
1
:= 1.
NowConsider. Consider the -derivative for each consumer i and obtain the gradient (in R
L
-space)
evaluated at x,
grad
i
S
i
(x
i
) = 0, i I
gradF(y) = 0.
Dierentiability says that at least one S
i
(x
i
) has strictly positive derivative and by F2 none are
negative (?) so must be positive (?)
Understanding... maybe hes taking the gradient wrt. (x
1
, ..., x
L
)??
Choose. Now choose as prices and give consumer i the income x
i
=: R
i
(so that the consumer
can buy the PO solution).
Use previous results. Since x
i
is the solution to a system of the type we looked on in proposition
5 (??), we know that it is a solution to the CP.
Moreover. When y satises the marginal relations, then we can draw on the results about production
to say that y is a solution to the producer problem, i.e. y y for any y Y .
Decentralization. Now we can draw upon the result about decentralization that y =

j
y
j
.
Since y is a solution to the aggregate problem, the theorem of decentralization gives us that
y
j
must be solution to each of the small rm j problems.
END OF PROOF! We found prices for consumers and rms and showed that given those prices,
everyone was optimizing.
Interpretation of
l
? Well, consider
L

l
=
l
, and
L

h
=
h
,
so
l
/
h
is the economys relative valuation of the two goods. Lagrange multipliers indicate the
value of loosening their respective restrictions.
9.5 Sum of two no-worse-than sets The Scitovsky contour
MotivationGraphical. Its quite hard to grasp, but I think hes moving around the (
1
,
2
)-point
of the graph (i.e. the origin for consumer 2). Then the same indierence curve for consumer
two will be tangential to the same indierence curve for consumer one (which has not moved at
all) at a dierent point. Then we cet a curve of points,
(h)
1
,
(h)
2

h
, which moves the economy
around in a way such that utility is kept constant for each consumer.
Mathematically. Let the two utility-levels, s
1
, s
2
R, be given and consider the upper contour sets
for each consumer,
A(s
1
) = x
1
X
1
[S
1
(x
1
) s
1
,
A(s
2
) = x
2
X
2
[S
2
(x
2
) s
2
.
39
If
A(s
1
) + A(s
2
),
then we can write
= x
1
+ x
2
, x
1
A(s
1
), x
2
A(s
2
).
Moreover, if (x
1
, x
2
) is a pareto optimal allocation in c = ((X
i
, S
i
)
i=1,2
, ) giving utility levels
S
1
(x
1
) = s
1
, S
2
(x
2
) = s
2
, then their sum is a boundary point, i.e. is a boundary point of the
set A(s
1
) + A(s
2
).
Production? We have to do something about production too.
Somethingsomething...
Convexity. Then we have a convex set with a point, , on the boundary of that set. Then we can
nd a hyperplane supporting it by that point (i.e. tangential there). That is prices???
10 2012-10-03
Next week. Lengthy theorem on the existence of Walras equilibria.
Last timePrices and Lagrange. Last time we made a constructive argument where we found
the prices as the lagrange multipliers.
Today: Welfare theorem.
10.1 Towards the theorem
10.1.1 Mathematical background
First. Consider p ,= 0, p : R
L
R dened by z p z (scalar product.
Hyperplane? Recall that pz = w denes a hyperplane when z R
L
and w R. From that we
can dene an upper and a lower half-space of the space.
Optimization. Will be the same whether its maximum or minimum, so lets choose one.
Minimization. Consider the problem
min
cC1+C2+C3
p c,
where C
1
, C
2
, C
3
R
L
.
Suppose. Suppose that c is the minimizer, pc pc for all c C
1
+C
2
+C
3
. By denition, this
means that
c = c
1
+ c
2
+ c
3
, c
i
C
i
, i = 1, 2, 3.
Q. What can be said about c
i
, i = 1, 2, 3?
A. Well, we know that
c
1
C
1
: p (c
1
+ c
2
+c
3
) p (c
1
+c
2
+ c
3
) .
(it holds for all c

C
i
so in particular for that combination.
pc
1
pc
1
.
Conclusion. When weve solved the minimization over the summation set,

3
i=1
C
i
, we have
in particular solved in for any c
i
C
i
considered by itself.
40
10.2 Separating Hyperplane Theorem
Let. Let Z R
L
be a non-empty convex set and let a / Z (where Z is the closure of Z).
Proposition. Then there is p R
L
, p ,= 0, such that
pz pa, for all z Z.
Intuition.
Hyperplanes. For any convex set Z and any point, a, outside of it, there is a hyperplane
through a that has the entire (closure of) Z above it.
Proof.
Let a R
L
be given so that a / Z..
Translation to dierent set. We want to instead consider the set Z a and note that
Z a
_
x R
L
[x = z a, z Z
_
.
We will rst prove that for any z Za, there exists p so that pz > 0 and then conclude
that then in particular, for z Z, note that za Za and so p(za) > 0 pz > pa.
First we need. Not that 0 Z a a Z so 0 / Z a a / Z.
Then we can consider the question of whether or not 0 Z. We have so to speak translated
the problem to considering 0 instead of a.
Secondly: Note that since any continuous function on a closed set has a maximum and a
minimum, we have that there exists a solution to
min |q| , s.t. q Z a ,
because Z a is a closed set.
Nowidea. Since 0 / Z, we can consider the closed point in Z to the origin, 0, and draw the
arrow from 0 to that point. That vector denes the hyperplane we are looking for.
Let p be the solution,
p = arg min
pZ{a}
|p| .
The vector p has the interpretation as the point in Z a closest to the origin.
To prove: p z p 0 = 0 for any z Z a.
Let z Z a be given and consider the vector z which is an arrow from 0 to the point z in
the set.
Then consider the vector from p to z, call it z

= p + (z p), [0; 1]
= (1 )p +x
and note trivially that
z

Z a
because it is a convex set!!
41
Now: Use the fact that p solved min
Z{a}
|q|. Then note that
p p = |p|
2
and also consider
|z

|
2
= |p + (z p)|
2
= [p + (z p)] [p +(z p)]
|p|
2
,
because p was dened as the minimizer.
Expand.
|z

| = p p + 2p (z p) +
2
(z p) (z p) p p
2p (z p) +
2
(z p) (z p) 0,
for [0; 1]. Restrict to the particular intervalll (0; 1], where
2p (z p) + (z p) (z p) 0.
Since this holds for all (0; 1], by letting 0, it must hold that (you can prove it by
contradiction)
2p (z p) 0
p (z p) 0
p z p p > 0, z Z a,
which proves part of what we needed.
Still missing to prove. p z p a for z Z. Let z Z. Then z a Z a and then use
the result we just proved to note that
p (z a) > 0
p z > p a.
which is what we were required to prove.
CommentClosure. We assumed z Z, we need z Z and in particular boundary points (??) .
10.2.1 Extension boundary piont.
Let. Let Z be a non-empty convex set and a boundary point of Z.
RecallDenition: boundary. A boundary point for all r > 0 and all z Z Z, we have that
B(z, r) has points in common with Z and some points in common with Z
C
.
Proposition. Then there is p R
L
, p ,= 0 such that
p z p a, for z Z.
Intuition. a is a minimizer of the linear function z pz on Z.
ProofIn the notes.
Idea. Take a sequence outside of Z and let them converge to ??? nad prices increase and ???
and then the inequality emerges in the limit case.
42
10.2.2 Addendum Dierence sets and separating hyperplanes
Suppose Z
1
Z
2
= . Then 0 / Z
1
Z
2
.
Proposition. Consider some z
1
z
2
Z
1
Z
2
. Then there is p such that
p(z
1
z
2
) 0
pz
1
pz
2
.
10.3 The Second Theorem of Welfare Economics
10.3.1 Theorem
Consider. Consider an economy c = ((X
i
, S
i
)
iI
, (Y
j
)
jJ
, ) where the consumers satisfy assumptions
F1, F2, F3 and each producer satises P1.
Let
_
(x
i
)
iI
, (y
j
)
jJ
_
be a Pareto Optimal allocation for c with x
0
i
intX
i
all i.
Proposition. Then there is a price system p ,= 0, p R
L
+
and incomes (R
i
)
iI
such that
_
(x
i
)
iI
, (y
j
)
jJ
, p, (R
i
)
iI
_
is a market equilibrium.
Interpretation. If, in some magic way, we have found a pareto optimal allocation, then it can be
supported as a market equilibrium.
NoteNon-negative prices. It is correct that p R
L
+
but it is only proved for p R
L
++
(is it??
something about this) but we proved last time that F1F3 F2 (strong; more of just one is
better).
10.3.2 Lemma required to be proven rst
Introduce stu. Denote s
i
= S
i
(x
i
) for all i I.
Dene
A
i
(s
i
) x X
i
[S
i
(x) s
i
upper contour set.
Dene
Z

iI
A
i
(s
i
)

jJ
Y
j
.
NoteConvexity. Z is convex because all the summation-term-sets are.
To prove: is a boundary point for Z.
Q. Why is the Z set relevant to us?
A.
Suppose we have z Z, i.e. z =

i
x
i

j
y
j
, whre x
i
gives at least the utility of s
i
for
i.

i
x
i
=

j
y
j
+z.
Look. This looks like a market economy relation where the initial endownment is z.
So, interpretation: z Z if an economy with the initial endownment z can achieve at
least the utilities (s
i
)
iI
.
We have. Z because it was a feasible allocation and hence satised the market balance
equation.
43
Assume contradiction. Assume that intZ.
Denition of interior. Then for any > 0 there is r > 0, the sphere B(, r) Z.
Alternative def. Introduce R
L
++
very small and consider , if has entries small
enough, Z.
Then. But
Z =

iI
x
i

jJ
y
j
( x
1
+ ) +

iI\{1}
x
i

jJ
y
j
= 0.
Since R
L
++
, x
1
+ X
1
and there is nothing with a budget set here.
Note. Now note that consumer 1 is strictly better o (he has strictly more) and all other
consumers and all rms are equally well o. Also, the ressource constraint (what was
the name) still holds.
Conclusion (contradiction). We have found a new allocation that pareto dominates the
original one. This is a contradiction with the assumption that the original setup was
pareto optimal.
10.3.3 Proof of the Second Welfare Theorem of Economics
Proof.
Step 1. Dene a suitable convex set,
Z

i
A
i
(s
i
)

j
Y
j
,
and then the lemma from above, showing that
boundary(Z).
Step 2. Invoke the Supporting Hyperplane Theorem. [result that we did not prove]
We know. boundary(Z).
Thus. There is p R
L
, p ,= 0, such that p z p for z Z.
Intuition. Look at the linear functional z p z is a minimizer for that.
Step 3. Show that the prices are non-negative
ProofContradiction. Assume the contradiction; that p
1
< 0. But +(a, 0, ..., 0) with a > 0
belongs to Z (more of the rst good; suppose we give to consumer 1; since F1 it remains in
X
1
and by F2,F3F2 he likes it more). Hence, + ae
1
Z.
But from the above it must hold that p ( + ae
1
) p .
But rewriting this, p
1
a 0 but by the contradictory assumption, p
1
< 0, whereby we arrive
at the contradiction.
Step 4. Show that y
j
is a solution to producer js problem.
Proof.
We know: p p z, for all z Z

i
A
i
(s
i
) +

j
(Y
j
).
44
RecallSmall cute lemma. Suppose
c = arg min
cC1+C2
p c c
1
= arg min
c1C1
p c
1
.
Then. Write =

i
x
i
+

j
(y
j
). But then it follows from the cute lemma that
p (y
j
) p (y
j
), y
j
Y
j
p (y
j
) p (y
j
), y
j
Y
j
y
j
is prot maximizing for rm j.
Step 5. Show that x
i
is a solution to consumer is problem given prices p and income px
i
(he must
be able to buy the preferred thing).
FirstProposition. x
i
is an expenditure minimizer.
Proof. Consider, again =

i
x
i
+

j
(y
j
). Since = arg min p z for z Z, in
particular
p x
i
p x
i
x
i
X
i
x
i
is an expenditure minimizer to achieve utility s
i
given prices p.
SecondProposition.
Motivation. What if x
i
was the very cheapest thing you could nd? Then we wouldnt
be done because you just couldnt aord ... ??? WTF???
Give. Give consumer 1 income R
1
:= p x
1
.
Then. x
i
intX
i
implies that x
1
solves UMP at income (p, R
1
).
Notes.
The set Z. Very important to understand.
Exam question. One possible exam question could be: Prove that / intZ.
MWG proof. They use a separating hyperplane theorem instead. Much easier to remember
and thus nicer but (???)
(something with the diagram where the convex set Y + should be separated from A(s)
(or whatever...????)
... the Robinson Crusoe picture anyways.
11 2012-10-10
11.1 Last time (I wasnt there!!)
DenitionWalras EQ.
Helpful: Consider producers rst.
then put that input into the consumers thing
Then check for balanced.
(a) y
j
solves PP
(b) ...
Walras in pure EQ.
Now: Initial endownment,
i
, that gives the income!
45
Normalization of pricesUnit simplex. Prices can be normalized to be on the unit simplex just
as well as we could normalize prices with the unit circle (or unit sphere in R
L
).
Properties of total excess demand.
Proposition 6. There are (a)(e) properties (e) is very dicult to prove and not proven in
Mas-Colell.
Implication of Walras law. If you nd a price the equilibrates the rst L1 marketse, then
it also satises the Lth market. Holds in market economies as well.
(something) shows that almost any function can be an excess demand function.
FigureWalras EQ L = 2. notice that
1
has subscript 1 something something it doesnt in
the notes.
Continuum of EQ. Non-typical.
Perturbing. If you have an economy with some endownment then if you change endownment a little,
you can easily get to a case with an odd-number of o-zeros???
Brouwers Fixed Point Theorem.
Theorem 9. Let A R
L
be non-empty convex and compact and g : A A be continuous.
Then f has a xed point. That is, there is x A such that
f(x) = x.
ApplyingPrices. We need to consider prices in the unit simplex,

_
p R
L

L
p

= 1
_
.
SimplexHyperplane interpretation. We can interpret (the unit simplex in R
L
) as
the intersection between R
L
+
and a particular hyperplane.
Modied demand. We say; In EQ, the consumers with X
i
= R
L
they cant choose x >> ...
Trying again. Consider the x = 2 where is the total endownment of the economy.
Restrict. Then restrict attention to the kunstige set X := 0 < x (in vector ordering).
Lemma 8. Let p R
L
+
0.
11.2 Long proof Theorem 10 Existence of Walras EQ
11.2.1 Theorem 10
Let c
c
pr
= (X
i
, u
i
,
i
)
iI
.
Method. Find a suitable mapping so that Brouwers xed point thm. can be applied. Then show
that the result is Walras EQ.
Idea: Raise price to remove excess demand.
Proof.
Let g : with
(p) =
+
(p)

(p)
where the sup + or - means that we split in positive and negative prices.
46
A failed attempt at g(p).
g
bad attempt
(p) = p +
+
(p).
Then we take

l
p
l
+

+
l
(p) = 1 +

+
l
(p),
where

p
l
= 1 because p . But then clearly g
bad attempt
(p) / (it has too big norm).
Now its clear that we should dene g component-wise to be
g
l
(p) =
p
l
+
+
l
(p)
1 +

+
l
(p)
Property of g. Now g satises that
g : ,
and clearly g is continuous because its entries, g
l
, are continuous (because excess demand is
continuous (because demand is)).
Brouwer. By Brouwer,
Brouwers FP thm. p

: g
l
(p

) = p

l
, l L.
Use def. From its very denition, we have
g
l
(p

) g
_
_
_
p

1
.
.
.
p

L
_
_
_ = p

l
+
+
l
(p

)
1 +

+
l
(p

)
= p

l
p

l
+
+
l
(p

) =
_
1 +

+
l
(p

)
_
p

l
.
Done. This was the rst step. It will turn out that this mapping is very neat.
NEXT STEPProve p

R
L
++
.
Create a bounded hyper rectangle. Lets consider the rectangle that in R
2
would be
x R
2
[x < 2.
Why 2? Could be arbitrary
x < k, k > 1.
Assume the contradiction p

1
= 0. Then

+
1
(p

) = [I[ (demand from the I consumers of good 1) total initial of 1

= I 2
1

1
> 0.
We know.
p

l
+
+
l
(p

) =
_
1 +

+
l
(p

)
_
p

l
.
47
Here
_
1 +

+
l
(p

l
= 0 because p

l
= 0.
BUT! We know that
+
l
(p

) > 0 from I 2
1

1
> 0.
Contradiction.
Conclusion. p

l
> 0.
Done.
New proposition.

l

+
l
(p

) = 0.
Assume contradiction that

l

+
l
(p

) > 0.
Look at the result
p

l
+
+
l
(p

) =
_
1 +

+
l
(p

)
_
p

l
.
Together, this means that
_
1 +

+
l
(p

)
_
p

l
> p

l
p

l
+
+
l
(p

) > p

l

+
l
(p

) > 0.
But this was for an arbitrary l. In other words,

+
l
(p

) > 0
+
l
(p

) > 0l L.
Now think about where we got the p

from.
Recall that by convention
(p) =
+
(p)

(p),
so

+
l
(p) > 0p
l
(p) =
+
l
(p)!!!
NowWalras law. Walras law gives that
0 = p

(p

).
But we know that
0 = p

(p

) = p

+
(p

)
but
+
l
(p

) > 0l and p

l
> 0l implies that
0 = p

(p

) = p

+
(p

) > 0 CONTRADICTION!
Conclusion. Then it must be the case that

l

+
l
(p

) = 0.
Implication. This implies that
+
l
(p

) = 0 for all l.
(if

i
a
i
= 0 with a
i
0i then a
i
= 0)
Done.
Proposition.

(p

) = 0.
48
Walras law. By Walras law,
0
W

s L
= p

(p

) = p

+
(p

(p

= p

+
(p

)
. .
=0
L1
by above
p

(p

)
= p

(p

),
Implication
0 = p

(p

) p

>> 0
(p

) = 0.
Done.
Proof done.
Oh noProof was for modied demand. But because of some theorem of modied demand,

i
(p

, p

i
) =
i
(p

, p

i
)
and _

i
(p

, p

i
), p

_
is a Walras EQ.
QED.
11.2.2 Extra stu
Figure in MWG.
Walras law. Really states that the excess demand must belong to the homogenous hyperplane
(p(p) = 0 (scalar product)).
(see drawing)
11.3 Uniqueness of Walras Equilibrium
11.3.1 Intro
When X
i
= R
2
, points outside of the box also have interpretations even though we can never be
there...
Moreover. Contract curve might go outside the box.
What to x? We cant really x it so we x the size of the box (??) .
Start to end. If you start outside of the contract curve, then you could imagine several budget
hyperplanes that go through the initial endownment, and thus they could be intersecting the
contract curve many places.
Prices work well when: You are close to the contract curve.
Conversely: They dont work well when you are far away (there are many equilibria).
The theorem. THere is a unique Walras EQ if you are already directly on the contract curve.
49
11.3.2 New assumption Gross Substitutes
Detinition 18. Let : R
L
++
R
L
be the excess demand function for an exchange economy. Then
satises Gross Substitutes property if
(a) is dierentiable
(b) for l L the derivatives

l
p
k
(p) > 0, k L, k ,= l.
Since for l L
l
() is homogenous of degree 0 in price, we have

l
p
1
(p) + ... +p
L

l
p
L
(p) = 0,
implying that

l
p
l
(p) < 0, l L.
11.3.3 Theorem 17 Uniqueness of W EQ
12 2012-10-23 Uncertainty and time
Notation: Let
T 0, 1, ..., T, T
1
1, 2, ..., T
Setup: In period 0, all market activity is carried out.
Time. We write x(t), (t) ( =endownment) and P(t) for t = 0, 1, ..., T. P(t) is the price at date 0
for obtaining a delivery of x(t) at time t.
Budget restriction w/ universal market at date 0. Sell all your endownments, (t)
T
t=0
at time
zero and buy some goods to be delivered at dierent points in time. Then what you get from
selling must not be smaller than what you buy of deliveries in the future.
T

t=0
P(t)x(t)
T

t=0
P(t)(t).
Can be written in terms of the net trades,
T

t=0
P(t) [x(t) (t)] 0. (SIN)
12.1 Multi-period
Goal: Compare with the situation where there is a spot market at each point in time.
Dating and prices? Then at date t, prices should be denominated in day t-prices.
Market for date-prices. At date 0 for date t prices, t T
1
(i.e. t 1, 2, ..., T).
Price of t-crowns?
(t) = price of date t-crowns (in date 0-crowns),
(0) = 1.
50
Budget restrictions.
p(0) [x(0) (0)] r(0)
p(1) [x(1) (1)] r(1)
.
.
.
p(T) [x(T) (T)] r(T)
T

t=0
(t)r(t) = 0
(SEQ)
Here, (??) is the budget restriction with one consumer but sequential periods. r(t) 0 depending
on whether he wants to consume more or less than his endownment in that period.
Last equation:
cost of your future must be zero :
T

t=0
(t)r(t) = 0.
Hence, if

T
t=1
(t)r(t), then you must pay for it by having r(t) < 0.
Something-something. With just one consumer, we can disregard the problem of taking ex-
pectations over future prices... with many, you might assume that people had rational
expectations and solved the full model but then thered be no guarentee that the EQ prices
would be unique!
12.1.1 Proposition 2.3.A
Motivation. With (SEQ) it seems that there are too many goods being traded all the time... can we
maybe somehow reduce to (SIN)?
Let p R
L
++
(spot prices) and the prices for delivery of t-crowns should be (t)
tT
, (0) = 1 and
(t) > 0.
Dene. What x R
L
that the consumer can buy with universal markets at date 0?
A =
_
x R
L
[x satises (SIN) with P(t) = (t)p(t)
_
.
Dene. Another set...
B =
_
x R
L
[r R
T+1
: (x, r) satises (SEQ)
_
.
Proposition. A = B.
Proof part 1: B A. Let x B. Hence, x satises the budget restrictions in (SEQ), i.e. p(t)[x(t)
(t)] r(t) and satises

T
t=0
(t)r(t) = 0.
Now multiply by (t) in each of the (SEQ) equations. Then we get the system of equations
(t)p(t)[x(t) (t)] (t)r(t), t T.
Sum over time periods
T

t=0
(t)p(t)[x(t) (t)]
T

t=0
(t)r(t)
()
= 0,
where () is given by assumption of what satises.
Done.
51
Proof part 2: A B. Then we know that x satises the single budget restriction (SIN) with P(t) =
(t)p(t),
T

t=0
(t)p(t)x(t)
T

t=0
(t)p(t)(t).
Dene as a rst guess r as
r(t)
(t)p(t)[x(t) (t)]
(t)
(t) r(t) = (t)p(t)[x(t) (t)].
Sum over t to get
T

t=0
(t) r(t) =
T

t=0
(t)p(t)[x(t) (t)]
=
T

t=0
P(t)[x(t) (t)]
0,
by assumption, meaning that

T
t=0
(t) r(t) 0.
Hmm this is not quite what we wanted.
Dene the rst period r as
r(0) = r(0)
T

t=0
(t) r(t),
where we know from the inequality above that
r(0) r(0).
Future periods are dened as
r(t) = r(t), t T 0.
Then by construction,
T

t=0
(t)r(t) = 0
Done.
Intuition. There is an asset that can be bought at time 0 (an Arrow-Debreu security) which pays
one t-crown at time t. It costs (???) crowns at period 0.
12.2 Uncertainty
Consumption plans. In this setting, the consumer will have to decide on his plan (or strategy)
which is to say what he will do in any state of the world that he might nd himself in.
Note: Dierence between planned consumption (assigns a consumption to each state of the
world) and realized consumption (what he ends up consuming).
Assets. Assets may have dierent payos in dierent states of the world.
52
Something. Suppose there are J contracts, each paying a particular dividend in each period, as
specied by their dividen vector, v
j
R
T
. A portfolio means deciding on R
J
such that
r =
_
_
_
r(1)
.
.
.
r(T)
_
_
_ =
_
_
_
v
1
(1)
.
.
.
v
1
(T)
_
_
_
1
+ ... +
_
_
_
v
J
(1)
.
.
.
v
J
(T)
_
_
_
J
= V ,
where V is a T J matrix.
Signs. that
j
0 (short or long position) and v
j
(t) 0 depending on whether he has to pay
or not (for example, a loan would have v
j
(1) > 0 and then v
j
(t) < 0, t 2.
NOTE! If the columns of V are linearly independent, then we can get any payment stream r
by simply choosing the
j
s in the correct way ( := V
1
r).
Linear space. Consider the linear space spanned by the colums of V ,
V ) span(v
1
, ..., v
J
).
Complete markets.
markets are complete dim(V )) = T.
Otherwise, there are income stream patterns, r, which we cannot replicate using the contracts,
v
1
, ..., v
J
.
Price of assets at time 0. let q R
J
denote the prices in 0-crowns of each asset.
Extended dividend matrix. Let
W
_
q
V
_

_
_
_
_
_
q
1
q
J
v
1
(1) v
J
(1)
.
.
.
.
.
.
.
.
.
v
1
(T) v
J
(T)
_
_
_
_
_
.
DenitionArbitrage. R
J
is an arbitrage portfolio if W > 0.
Intuition. At some day you get something positive but at no date do you pay anything.
DenitionArbitrage free. W is said to be arbitrage free if
W arbitrage free i W) R
T+1
+
= 0.
Tomorrow: Farkas lemma. Is a separation theorem as well.
13 2012-10-24 Uncertainty contd
13.1 Uncertainty
Result. If a certain connection was between the spot market and the (??? market? Market for future
crowns?), then the consumer is just as well o with the simple market as trading at each point
in time.
Renements of sets. He explains how we get to the whole sigma algebra thing / the sequence of
partitions.
53
Example: At each day 1 and 2 it can either rain or sun.
Outcomes. There are 4 = (su, su), (su, ra), (ra, su), (ra, ra).
Day 0. We know nothing, so the partition is just the whole set, F = .
Day 1. Here, we know the event on the rst coordinate, so either were in (su, su), (su, ra) or
(ra, su), (ra, ra). This is the new partition.
Day 2. Here, the partition is just the set of all singleton sets (weve realized all uncertainty).
Dividend matrix. Consider future dates. If, for example, you are promised a payment stream (1, 1)
then you receive something at each date so if you pay q
1
for that, then you need q
1
> 0 to
avoid an arbitrage.
W =
_
q
V
_
,
where V contains the payments promised by the J contracts and q is the prices of them at
period 0.
Dene.
W =
_
_
q
1
q
2
1 1
1 1
_
_
, q
1
> 0, q
2
< 0, .
(and some restriction must hold on one of these? q
1
= q
2
?
Portfolio: R
J
, species how much of each of the J contracts to buy.
??
r = W,
where we also split up r = r
+
r

(unique by taking positive and negative parts).

Span.
V ) span of column vectors of V.
Hence, W) is the set of payment streams that you can obtain.
DenitionComplete asset markets.
dimV ) = T i complete asset markets.
And
dimV ) < T i incomplete asset markets.
Recall defOrthogonal complement. If dimV ) < T, then dim(OrthComplV )) > 1 (?? or
zero??) and vectors in the orthogonal complement cant be replicated using the asset market.
DenitionArbitrage portfolio.
W R
T+1
+
0 is an arbitrage portfolio.
DenitionArbitrage free. W is arbitrage free i no arbitrage portfolios exist. This is equiv-
alent to
W arbitrage free W) R
T+1
+
= 0.
54
13.2 Farkas Lemma
Let A be a k l matrix.
Claim. Precisely one of the following alternatives is true.
(I) There is x R
l
such that Ax > 0.
(II) There is y R
k
++
such that yA = 0.
Note. Ax > 0 means that the k 1 vector, Ax, has no negative elements but at least one
non-zero element.
Ad (I) Then x corresponds to an arbitrage portfolio.
Ad (II) Think of it as (recalling y = (y
1
, ..., y
k
), row vector)
yA = 0 yA(:, 1) = 0 yA(:, 2) = 0 ... yA(:, l) = 0.
Intuition for proof. Think of the separating hyperplane.
Recall. We looked at a point a and a set ( and said that there existed a hyperplane dened by
some price vector p (that existed) such that a was in the lower half space and all c ( were
in the upper.
Proof.
Proof of (II)(I). Hence, there is y R
k
++
where yA = 0. Now consider for any x R
l
, then
yAx = 0
because yA = 0. Then by the zero rule,
yAx = 0 y = 0 Ax = 0.
But y = 0 cant be cause y R
k
++
. ... IM MISSING SOMETHING HERE!!!
Proof of (I)(II). Assume that (I) is false. To show: (II) is true.
If (I) is false, then A) R
lk
+
= 0 i.e. there is no x R
l
such that Ax > 0.
WARNING! Dimensions fucked up... note that Ax takes x R
l
but A) R
k
because its
the output of z Az.
Introduce . The unit simplex

_
x R
k

i=1
x
i
= 1
_
.
Note that does not intersect the closed set A).
Consider A). If 0 A), then A would have a vector in . Hence, 0 / A).
A) is closed. Clear, because both sets are closed and a sequence in A) requires
a sequence x
n
= (d
n
, a
n
) so there should be a convergent sequence in each of the
sets and then the limit will be in them and then theyre in the dierence-set.
Separate 0 and A). There is y R
k
and such that
y 0 < < y (z x), for z , x A) so that z x A)
0 < < y (z x).
Hence, y denes a hyperplane that separates 0 (the zero vector in R
k
) from the set A).
55
Specializer: Since x = 0 R
k
is a possibility, we get in particular, that
0 < < yz z .
Now consider
e
h
= (0, ..., 0, 1, 0, ..., 0)
(which has a one at the hth coordinate). Then
e
h
,
and hence,
y e
h
= y
h
> 0.
Hence,
y
h
> 0 for all h = 1, ..., l,
y R
k
++
Now rearrange ineq.
y z > y x + > y x for x A) .
Now reduce We can violate this inequality unless some restrictions hold on y z. In particular,
if x A) then also x A) because its a linear subspace. But then we can always violate
it.
y x = 0 for x A) ,
and we know that if y xx A), then in particular y A(:, i) = 0 for i = 1, ..., l (that is,
y is in particular orthogonal to the columns of A (they are the bases for the linear span
A))). But if y is orthogonal to all the column vectors of A, then in particular, yA = 0 R
l
(thats just saying that y is orthogonal in one sentence). That is
yA = 0,
which was what we wanted.
Thus (II) is true.
13.3 Existence of Discount Factors
Let a (V, q) be a market and let
W =
_
q
V
_
.
Theorem. (V, q) is arbitrage free if and only if there is R
T+1
++
(positive!) with (0) = 1 (normal-
ization) such that
W = 0.
(hence, should be orthogonal to each of the column vectors)
Interpretation. At prices , all assets have value zero.
Proof.
If. To be done at the tutorials.
Only if. By assumption here, W) R
T+1
+
= 0. Then, by Farkas lemma, there is R
T+1
++
such
that W = 0.
Thinking. The statement W)R
T+1
+
= 0 means that for all W), the only such that W 0
is = 0 = (0, ..., 0)

.
Comment. Note that Farkas lemma says nothing about uniqueness and often there can indeed be
many prices (even when normalized).
56
13.3.1 Corollary (V, q) arbitrage free
Corollary. If there is (at least one) R
T+1
++
so that W = 0, and in addition rankW = T, then the
following hold:
(a) is unique.
(b) W) =
_
r R
T+1
[r = 0
_
, that is, what you can achieve in the asset markets is exactly the
same as you could from trading in the money market.
Implication. Has all weve done been in vain?
My thinking. I guess (b) is the same as saying W) = diag(r)) (where diag(r) is a matrix that
has (r(0), r(1), ..., r(T)) in the diagonal and zeros everywhere else...). Or alternatively that
e
1
r(0), e
2
r(1), ..., e
T+1
r(T)).
More thinking.
RecallComplete. A market is complete if dimV ) = T.
Complete markets. Suppose markets are complete. Then, for example the stream (1, 0, ..., 0)
costs (1) at time zero, so
W =
_
_
_
_
_
_
_
(1)
1
0
.
.
.
0
_
_
_
_
_
_
_
.
Incomplete markets. With incomplete markets there is no unique discount factor. He then
mentioned suppose you want a payment stream (1, 2, 0, ..., 0) and wrote
W =
_
_
_
_
_
_
_
_
_
(1) 2(2)
1
2
0
.
.
.
0
_
_
_
_
_
_
_
_
_
.
Here, we cant create
An important note. rankW = rankV (or something??? Something with the q row being a linear
combination of the other.....)
57