Econ 710: Lec2 Consumer Choice

Econ 710
Lecture Slides 2
Consumer Choice, Preferences and Utility
Fei Li
University of North Carolina, Chapel Hill
August 29, 2013
Fei Li (UNC) Lecture 2 August 29, 2013 1 / 30
Consumer Theory
Consumer is the DM,
Commodities (Goods) l = 1, ...L,
Consumption Set X
contains all commodity bundles that can be conceivably consumed,
reects physical constraints (cannot consume negative amounts of
food, discrete goods, survival needs, cannot work more than 24 hr per
day),
reects institutional constraints (zero pork consumption in Muslim
countries, cannot work 1 minutes per day in a regular position, cannot
buy gun in many countries)
Main example: X = R
L
+
.
Consumption Set Assumptions
Nonnegative: X R
L
+
perfectly divisible good.
Not important.
Closed: X is a closed set
Not economically important.
Convexity: X is a convex set
any x, y X and (0, 1), we have x + (1 )y X.
Both technically and economically important.
lunch in DC and NYC at the same time.
Competitive Budget Sets
Competitive Markets
all goods can be purchased in any amount at known prices,
p = (p
1
, ....p
L
)
all prices are positive: p 0
the consumer is a price taker
Walrasian (Competitive) Budget Set
Given the price vector p and the consumers income m _ 0, his budget
set is
B(p, m) := x X : p x _ m
B(p, m) is the consumers feasible set.
It reects the economic constraint.
Competitive Budget Sets
Since we are in R
L
space and p 0, B(p, m) is compact (closed and
bounded).
B(p, m) = B(p, m) for > 0
B(p, m) is a convex set.
if x, y B(p, m), for any , x + (1 )y B(p, m).
it rules out some relevant case: many employment contracts require
working for no less than 8 hr per day.
Budget Hyperplane: x R
L
+
: p x = m
describes a family of (just aordable) consumption bundles,
budget line when L = 2, and the slop p
1
/p
2
captures the rate of
exchange between the two goods.
Demand Correspondences
The consumers choice correspondence, dened on the set of all
budget sets, is called his (Marshallian) demand correspondence.
For all (p, m),
x(p, m) B(p, m) X
If x(p, m) contains a single points for each (p, m) R
L
++
R
+
, we
say it is a demand function.
Denition
A demand correspondence x(p, m) satises Walras Law i for all
(p, m) R
L
++
R
+
,
p x = m for each x x(p, m)
Demand only on the budget hyperplane. (expends all income)
At this point, Walras law is just a property our economic intuition
tells us should be plausible.
When we get to the preference-based approach to consumer theory,
we shall nd fairly weak conditions under which Walras law must
hold.
Denition
A demand correspondence x(p, m) satises Homogeneous of Degree
Zero i for all (p, m) R
L
++
R
+
,
x(p, m) = x(p, m) for all > 0
No framing eects since B(p, m) and B(p, m) are the same set.
No money or price illusion.
Example
Consider the following demand function.
x
1
(p, m) =
p
2
p
1
+p
2
m
p
1
, and x
2
(p, m) =
p
1
p
1
+p
2
m
p
2
Does it satises (1) homogeneous of degree zero and (2) Walras law?
1
yes for all , R.
2
yes only if = = 1 since
p x = [
p
2
p
1
+p
2
+
p
1
p
1
+p
2
]m.
Demand Function Comparative Statics
The comparative statics properties of a demand function x (p, m)
consist of how it changes when its arguments change.
The most common comparative statics questions are about the signs
of changes, e.g., is x
l
> 0 if m > 0 and p = 0?
We often assume x (p, m) is dierentiable. Then the questions are
about the signs of the partial derivatives,
x
l
(p, m)
p
k
and
x
l
(p, m)
m
for l , k 1, 2, ...K.
Income Eects
Normal (x
l
/m > 0) v.s. inferior (x
l
/m < 0) goods
these are local properties.
we shall see when we consider preference-based demand, that even
under standard assumptions goods can be inferior or normal.
Engel curves describe how household expenditure on particular goods
or services depends on household income.
Engels law:
It is an empirical observation in Engel (1857).
It states that the poorer a family is, the larger the budget share it
spends on nourishment.
Chai, Andreas, and Alessio Moneta. 2010. "Retrospectives: Engel
Curves." Journal of Economic Perspectives, 24(1): 225-40.
Price Eects
A demand function x
l
(p, m) satises the Law of Demand i
x
l
/p
l
< 0.
We shall see that preference-based demand, even under standard
assumptions, may not satisfy the Law of Demand.
Good l is called a Gien good if its demand curve slopes up
x
l
/p
l
> 0.
Good k is a (gross) substitute for good l i x
l
/p
k
> 0.
Good k is a (gross) complement for good l i x
l
/p
k
< 0.
Preference-Based Demand Correspondences
We start from the choice itself, and some of its desirable properties.
Question:
Where the demand function x (p, m) comes from?
Answer:
A consumers rational choice.
Basic problem in the preference-based Consumer theory:
to choose a feasible bundle x B (p, m) .
Preference-Based Demand Correspondences
Assume that for a rational preference relation _,
x(p, m) = C
+
(B(p, m), _)
In other words, the demand results from a rational choice.
Since B(p, m) = B(p, m), we have an immediate result.
Theorem
Preference-based demand correspondences are homogenous of degree zero
in (p, m).
Without loss of any generality, we can normalize the price of a good to be
one.
Restrictions on the Consumers Preference
Denition
A preference _ on X is
locally non-satiated (NS) if any open neighborhood of any x X
contains a bundle y s.t. y ~ x.
monotone (M) if x y =x ~ y.
strongly monotone (SM) if x _ y and x ,= y implies x ~ y.
Immediately, we have
(SM) =(M) =(NS).
Restrictions on the Consumers Preference
More implications:
Theorem
If _ satises NS, then x(p, m) = C
+
(B(p, m), _) satises Walras law.
Proof.
Suppose not. x (p, m) p < m. Then > 0, such that \
x
/
N
[x (p, m)], x
/
p < m. By (NS), there is a x
/
~ x, which is a
contradiction!
Lemma
Suppose a rational preference _ is monotone and it is represented by u.
Then u is nondecreasing.
Proof.
Exercise.
Continuity
Denition
A preference _ on X is continuous i for any sequence [x
n
[ with x
n
x
and x
n
_ y for all n, we have x _ y.
a
a
The denition is dierent from Denition 3.C.1 in MWG.
Example (Lexicographic preferences)
x
n
= (1/n, 0) and y = (0, 1). For each n, we have x
n
~ y. But
y = (0, 1) ~ (0, 0) = lim
n
x
n
.
Continuity
Lemma
The following statements are equivalent:
1
A preference is continuous,
2
the upper and lower contour sets, y X : y _ x and
y X : x _ y, are closed.
3
the strict upper and lower contour sets, y X : y ~ x and
y X : x ~ y, are open.
4
if x ~ y, then neighborhoods, N
x
exist s.t. x
/
~ y for all x
/
N
x
.
Intuition on BB.
Proof.
Key: NWT (y) = x[x _ y and BT (y) = x[x ~ y.
Utility Representation Theorem
Theorem (Monotone Representation Theorem)
A continuous rational preference _ on R
L
+
that is monotone is
representable by a continuous function u.
When L = 1, trivial!
Suppose L = 2, see the graph on BB for intuition.
Proof: construction
Let x R
L
+
. Dene two subsets of R
L
+
:
A
+
(x) := R
+
: e _ x, and A
(x) := R
+
: x _ e
where e = (1, 1....1).
by monotonicity A
+
(x) is nonempty. Since (0, ...0) A
(x), A
(x)
is nonempty too.
By continuity, both sets are closed.
By completeness, A
+
(x)
S
A
(x) = R
+
,
Since R
+
is connected, A
+
(x)
T
A
(x) ,= ?. (otherwise, one of

them is open)
(x) = A
+
(x)
T
A
(x) is a singleton. (if there are two: , , then

~ , but then by monotonicity = )
so there exists a unique (x) s.t. (x)e ~ x.
Proof: Representation
(=) Suppose u(x) _ u(y). There are two cases:
1
If they are equal, then x ~ (x)e ~ y, so x _ y.
2
If u(x) > u(y). then u(x)e ~ u(y)e by monotonicity. Since
x ~ u(x)e and y ~ u(y)e, x ~ y.
(=) Suppose x _ y. Then
u(x)e ~ x _ y ~ u(y)e.
Hence u(x)e _ u(y)e. By monotonicity, we must have u(x) _ u(y).
Proof: Continuity
Recall that u is continuous if for any a R, the sets u
1
(a, ) and
u
1
(, a) are open in the domain of u.
Since u(a, ...a) = a, these sets are strict contour sets:
u
1
((a, )) = x : u(x) > u(a) = x : x ~ a
and
u
1
((, a) = x : u (x) < u (a) = x : a ~ x
Hence, the proof is complete.
Debrue Theorem
Monotonicity is not necessary for the utility representation but makes the
proof intuitive. In general, we have
Theorem (Debreus Representation Theorem)
1
For any a and b > a in R, a continuous rational preference on a
connected set X _ R
L
is representable by a continuous function
u : X [a, b].
2
If a continuous function u represents a preference _, then _ is
continuous.
Debrue Theorem: Proof
The proof of the rst part is mathematically technical and not very
economically based. See Rubinstein (2013) for the proof of most of the
theorem. We provide the proof of the second part here.
Proof.
Suppose the preference is not continuous. There exists a sequence
x
n
x, and x
n
_ y for any n but y ~ x. Since _ is represented by
u (), u (x
n
) _ u (y) and u (x) < u (y). By the continuity of u (),
> 0, s.t. \x
/
N
(x), u (x
/
) < u (y) or y ~ x
/
. Contradiction!
Dierentiability
We often assume the utility function is dierentiable for tractability.
A classical non-dierentiable utility is Leontief utility function,
min x
1
, x
2
.
However, there is no generally accepted justication for the
dierentiability of utility functions.
See Rubinstein (2013) for some justications.
Homotheticity
Denition
A preference _ is homothetic i x _ y implies that for any _ 0,
x _ y.
Theorem
A rational preference is continuous, monotone, and homothetic i they can
be represented by a continuous and homogenous utility function:
u(x) = u(x).
Proof.
\ =
//
For any x, there exists a(x), s.t. x ~ (, , ....). We let
u(x) = (x). Since the preference is homothetic,
u(x) ~ (, , ...). So u(x) = = u(x). \ =
//
, obvious.
Notice that u may not be a linear function. For example,
u (x
1
, x
2
) = x
1
x
1
2
for (0, 1).
Separable Utility
In many applications, we always assume the consumers preference is
separable.
Example
1
In Macro, U(c
1
, c
2
, ....c
t
) =
t=1

t
u(c
t
) where (0, 1),
2
In labor, U(c, h) = u(c) +v(h)
3
In IO and auction theory, U(q, m) = u(q) +m
It captures the idea that agents preference over dierent goods are
somehow independent.
What implicit assumptions we made by assuming separable utility?
Separable Utility
Consider a two-goods world.
Denition
A preference _ on X satises double cancellation property i
(x
1
, x
2
) _ (y
1
, y
2
) and (y
1
, z
2
) _ (z
1
, x
2
) implies that (x
1
, z
2
) _ (z
1
, y
2
).
Lemma
Suppose _ is represented by U(x
1
, x
2
). U(x
1
, x
2
) = u
1
(x
1
) +u
2
(x
2
) only
if _ satises double cancellation property.
Proof.
Since (x
1
, x
2
) _ (y
1
, y
2
), (y
1
, z
2
) _ (z
1
, x
2
) and U = u
1
+u
2
represents
_, we must have u
1
(x
1
) +u
2
(x
2
) _ u
1
(y
1
) +u
2
(y
2
), and
u
1
(y
1
) +u
2
(z
2
) _ u
1
(z
1
) +u
2
(x
2
). Adding two inequality together yields
u
1
(x
1
) +u
2
(z
2
) _ u
1
(z
1
) +u
2
(y
2
), so (x
1
, z
2
) _ (z
1
, y
2
).
Quasi-linear Utility
Theorem
A rational preference _ on X = R
2
satises the following three conditions
1
(t is valuable) (t, y) _ (t
/
, y) i t _ t
/
,
2
(compensation is possible) For every y, y
+
R, there exists some
t R s.t. (0, y) ~ (t, y
+
).
3
(no wealth eects) if (t, y) _ (t
/
, y
/
) then for all d R,
(t +d, y) _ (t
/
+d, y
/
).
if and only if it can be represented by a utility function of the form
u(t, y) = t +v(y).
In application, the rst good is interpreted as money, wealth or numerate
good.
Proof
the proof of if part is simply to verify three conditions, so we only show
the Only If part. Fix a y
+
,
by condition (2), dene a function v(y) s.t. (0, y) ~ (v(y), y
+
).
by condition (3), for any (t, y), (t
/
, y
/
), (t, y) ~ (t +v(y), y+) and
(t
/
, y
/
) ~ (t
/
+v(y
/
), y+).
by transitivity, (t, y) _ (t
/
, y
/
) i
(t, y) ~ (t +v(y), y+) _ (t
/
, y
/
) ~ (t
/
+v(y
/
), y+).
by condition (1), this is equivalent to
t +v(y) _ t
/
+v(y
/
)
so (t, y) _ (t
/
, y
/
) i t +v(y) _ t
/
+v(y
/
), and the proof is
complete.

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