Lecture 5 Rationalizable Demand Functions

1. So far our approach is to begin with assumptions about consumer prefer-

ences and rationality, and derive the restrictions these assumptions impose
on consumer choices. Alternatively, we can begin with consumer choices,
and ask whether these choices could have been made by a rational con-
sumer whose preferences satisfy our axioms. If so, we say that the choices
are rationalizable or consistent with rational behavior.
2. Question: How do we know whether a dierentiable demand function
x(p; y) is a solution to a utility maximization problem:
max
x
u(x)
s:t: px _ y;
x _ 0;
for some quasiconcave, increasing utility function u?
3. The question can be answered in the two steps. First, any function
E : +
n
++
+
+
+
+
that satises properties 1 through 6 in Thm 1.7
and is dierentiable is the expenditure function of an increasing, quasi-
concave utility function. (This is known as the duality problem.) Second,
any x(p; y) that satises budget balancedness and has a negative semidef-
inite and symmetric Slutsky matrix can be derived from an dierentiable
expenditure function that satises properties 1 through 6 (concavity, in-
creasing in p, strictly increasing in u, etc.) in Thm 1.7.
0.1 Recovering the utility function from an expenditure
function
1. Before doing the math, it is useful to explain the idea informally. Suppose
e (p; u) is an expenditure function of a continuous, quasiconcave, strictly
increasing utility function u. Then, for all x such that u(x) _ u,
x[px _ e (p; u)
with the equality sign holds for some x

where u(x

) = u. We say the
hyperplane
px = e (p; u)
supports the better-than set x[u(x) _ u.
2. For a xed u, each hyperplane is associated with a price vector p. Take
intersection over all p >> 0, we have
A(u) =
_
x +
n
+
[p:x _ e (p; u) for all p >> 0
_
: (1)
1
Since for each p,
x[u(x) _ u x[px _ e (p; u) ;
it follows that
x[u(x) _ u A(u) :
In addition, every x
0
not belonging to the better-than set is excluded from
A(u). The reason is that the better-than set is convex and closed when
u is quasiconcave. By the separating hyperplane theorem, there exists a
hyperplane that separates x
0
from the better than set. If a hyperplane
separates x
0
from the better-than set, so does the supporting hyperplane
with the same slope.
3. Thus, A(u) = x[u(x) _ uthe set bounded by supporting hyperplanes
and the better-than set are equivalent. We have used the better-than set
to derive the expenditure function. It is also possible to do it the other way
roundusing the the expenditure function to derive the utility function.
4. So we start with A(u) dened in (1). Recall that for any p

(from the
discussion of the Shepards lemma)
px
h
(p

; u) e (p

; u) _ 0:
Thus, A(u) is non-empty (as x
h
(p

; u) A(u)). For each p, the set

x +
+
[p:x _ e (p; u) is obviously closed and convex. Since the inter-
section of closed and convex sets is closed and convex, A(u) is closed and
convex. Furthermore, it is clear from the denition that A is bounded
from below. Since e is increasing in u, if x A
_
u
1
_
then x A
_
u
2
_
for
all u
2
_ u
1
. Hence, A
_
u
1
_
A
_
u
2
_
for all u
2
_ u
1
.Thus, each of A(u)
can be treated as a better-than set of a convex preference relation. The
following theorem shows that this preference relation can be represented
by a utility function dened by 2).
5. Theorem 2.1 and 2.2 (Reny), Theorem 3.H.1 (Mas-Colell). Let U be a
connected subset of +. Suppose e : +
n
++
U +
+
is continuous, strictly
increasing, and unbounded in u, dierentiable, strictly increasing, concave
and homogeneous of degree one in p (properties 2 through 6 in Renys
Theorem 1.7). Then the function u : +
n
+
+
+
given by
u(x) = max u _ 0[x A(u) (2)
(A(u) as dened in (1)) is increasing and quasiconcave, and e is the ex-
penditure function of u; that is,
e (p; u) = min
x
p:x s.t. u(x) _ u:
6. Proof:
2
(a) Step 0: A(u) is non-empty. For any p; p

e (p; u) _ e (p

; u) +\e (p

; u) (p p

)
= p

\e (p

; u) (p p

) +\e (p

; u) (p p

)
= \e (p

; u) p:
The inequality follows from the concavity of e, and the equality fol-
lows from the fact that e is homogeneous of degree one in p. Finally,
\e (p

; u) _ 0 as e increases in p. It follows \e (p

; u) A(u).
(b) Step 1: u is well-dened. Since e (p; u) is strictly increasing and
unbounded in u, the set u _ 0[x A(u) is bounded from above.
Let u

denote supu _ 0[x A(u), and u

1
; u
2
; :::be a sequence that
converges to u

, with u
i
u _ 0[x A(u) for all i. Suppose u

=
u _ 0[x A(u). Then there exists some p

>> 0 such that p

x <
e (p

; u

). But since e is continuous in u, p

x < e (p

; u
n
) for n
suciently large, a contradiction.
(c) Step 2: u is increasing. Consider x
1
_ x
2
. Since px
1
_ px
2
for all p,
x
2
A(u) whenever x
1
A(u). Hence, u
_
x
2
_
must be as least as
great as u
_
x
1
_
.
(d) Step 3: u is quasiconcave. We want to show that for any x
1
and x
2
and any [0; 1] ;
u
_
x
1
+ (1 ) x
2
_
_ min
_
u
_
x
1
_
; u
_
x
2
_
:
In order words, we want to show that the better than set of x is
convex. But the better than set is simply A(u(x)) which is convex
by denition. (Here is the math: For convenience, suppose u
_
x
1
_
_
u
_
x
2
_
. Since e is increasing in u, we have
e
_
p; u
_
x
1
__
+ (1 ) e
_
p; u
_
x
2
__
_ e
_
p; u
_
x
1
__
:
By denition of u
px
1
_ e
_
p; u
_
x
1
__
px
2
_ e
_
p; u
_
x
2
__
It then follows that
p
_
x
1
+ (1 ) x
2
_
_ e
_
p; u
_
x
1
__
:
which implies that u
_
x
1
+ (1 ) x
2
_
_ u
_
x
1
_
.)
(e) We now proceed to show that
e (p; u) = min
x
p:x s.t. u(x) _ u:
3
Note that for all x such that u(x) _ u;
p:x _ e (p; u(x)) (by defn of u(x) ),
_ e (p; u) (e is increasing in u).
Hence,
e (p; u) _ min
x
p:x s.t. u(x) _ u:
To complete the proof we will show that
e (p; u) _ min
x
p:x s.t. u(x) _ u:
Since e is concave in p, for any p, p
0
and u
e (p; u) +\
p
e (p; u) (p
0
p) _ e (p
0
; u) :
Since e is h.o.d 1 in p,
e (p; u) = p:\
p
e (p; u)
by the Euler equation. Combining the two equations, we have for all
p
0
p
0
\
p
e (p; u) _ e (p
0
; u) :
Since e is increasing in p, \
p
e (p; u) +
n
+
. It follows that, \
p
e (p; u)
A(u) and, hence, u(\
p
e (p; u)) _ u. This implies that
e (p; u) = p:\
p
e (p; u) _ min
x
p:x s.t. u(x) _ u:
Note that we are using the concavity of e only in the last step.
7. Note: Suppose e is the expenditure function generated by a non-convex
preference relation. In general, e will not be dierentiable. The above
proof will still work with minor changes. But the A(u) recovered will
be the convex hull of the underlying better-than set, which may be non-
convex. Thus, there is no way we can tell from the expenditure function
whether the underlying preference relation is truly convex. In this sense,
convexity can be assumed without loss of generalityany rational con-
sumer choice is consistent with some convex preference relation.
8. Finding u algebraically. Suppose e = u(p
r
1
+ p
r
e
)
1=r
. How can we nd
u? The above discussion shows that we can construct u by solving the
following problem:
u(x) = max
u
u s.t. px _ e (p; u) \p >> 0: (3)
(Note that x is xed in this problem.) This problem is hard to solve at
the rst glance because it involves an innite number of constraints. But
we can transform this problem into one that is solvable.
4
9. Dene
v (p; y) = max
u
u s.t. e (p; u) _ y:
Solving this problem is easy as e is increasing in u. Just set e (p; u) = y.
For example, if e = u(p
r
1
+ p
r
e
)
1=r
, then
v = y (p
r
1
+ p
r
e
)
1=r
:
10. Instead of solving (3), we rst x p >> 0 and consider the problem:
max
u
u s.t. px _ e (p; u) : (4)
11. By construction, the solution to this problem is v (p; px). Since we consider
in (4) only a subet of constraints in (3) (as a result, any feasible solution
to (3) is feasible in (4)) for any p >> 0; v (p; px) _ u(x). Hence
min
p>>0
v (p; px) _ u(x) :
12. On the other hand, since e is increasing in u; for all p >> 0
px _ e (p; v (p; px)) _ e
_
p; min
p
v (p; px)
_
:
Hence, min
p
v (p; px) is a feasible solution to (3); therefore,
u(x) _ min
p
v (p; px) :
13. It follows that
u(x) = min
p
v (p; px) : (5)
This problem can be solved readily. See Reny pp. 78 for an example.
14. Here we dene v from e. There is an alternative interpretation. (5) will
hold if u is a utility function satisfying the standard properties and v is
the corresponding indirect utility function. See Reny pp. 79.
0.2 Integrability
1. We have shown how to construct a utility function from an expenditure
function. Now, we can show that a demand function x(p; y) is the solution
to a utility maximization problem if we can show that x can be generated
by an expenditure function.
2. Specically, given x(p; y) we want to know whether there exists e (p; u)
such that for i = 1; :::; n;
@e (p; u)
@p
i
= x(p; e (p; u)) : (6)
This is called the integrability problem because we are trying to solve a
system of partial dierential equations.
5
3. First of all, note that if such a function e exists, then by dierentiating
the above equation with respect to p
j
we obtain
@
2
e (p; u)
@p
i
@p
j
=
@x(p; e (p; u))
@p
j
+
@x(p; e (p; u))
@y
x(p; e (p; u)) ;
which is simply the ij element of the substitution matrix. Since
@
2
e(p;u)
@pi@pj
=
@
2
e(p;u)
@pj@pi
, the substitution matrix must be symmetry. Thus a necessary
condition for the existence of a solution to the integrability problem is
that the substitution matrix is symmetric.
4. It turns out that by the Frobenius theorem that this condition is sucient
as well. If e is a solution to (6), we still need to show that e processes all
the properties of an expenditure function.
5. Theorem: e processes all the properties of an expenditure function if and
only if x(p; y) satises budget balancedness, and its substitution matrix
is symmetry and negative semidenite.
6. We wont go through the proof. Only note that we have the Sheppards
lemma by construction. Since x _ 0, e must be increasing in p = p:Also by
denition, e is concave if and only if the substitution matrix is negative
semidenite. You are asked to show in the problem set that x satises
budget balancedness if and only if e is homogeneous to degree one.
7. To conclude, we have showed that any demand function x that satises
budget balancedness and possesses a symmetric and negative semide-
nite substitution matrix is rationalizable by a strictly increasing quasicon-
cave utility function. Since we have already shown that x generated by a
strictly increasing quasiconcave utility function must possess these proper-
ties. Thus, budget balancedness, symmetry and negative semideniteness
is the only conclusions we can draw if all we know is that the consumer
has a quasiconcave, strictly increasing utility function.
8. This is an extremely important result because it allows economists to
directly write down demand functions that possess additional properties
that are desirable for empirical estimation. As long as the function satises
budget balancedness, symmetry and negative semideniteness, we know
that it is consistent with rational behavior. There is thus no need to start
explicitly with a utility function. The problem with the latter approach
is that it is dicult to make sure that the demand function generated by
a utility function possesses the properties we want.
9. Here we present the duality theorem as an intermediate step of recovering
the underlying utility function. But the result is important in its own
right. Later on we will learn that the exact same argument allows us to
recover the production function from the cost function.
6
1 Revealed Preference
1. Thus far, we have developed consumer theory on the basis of axioms im-
posed on consumer preferences. One (minor) drawback of this approach is
that preferences are not directly observablewhat we observe are choices
and not the underlying preferences. In this section, we can actually obtain
the same consumer theories on the basis of axioms imposed on consumer
choices.
2. Denition: A consumers choice behavior satises the Weak Axiom of
Revealed Preference (WARP) if for every distinct pair of bundles x
0
, x
1
with x
0
chosen at prices p
0
and x
1
chosen at prices p
1
, then
p
0
:x
1
_ p
0
:x
0
=p
1
:x
0
> p
1
:x
1
:
The Weak Axiom says that if a consumer chooses x
0
at some p
0
when x
1
is
also feasible, then he will never choose x
1
over x
0
when both are feasible.
If the consumer chooses x
1
at p
1
, then x
0
must be infeasible at p
1
.
3. Note that the Weak Axiom requires only pairwise consistency; it does not
incorporate any notion of transitivity. Thus, a consumer who obey the
Weak Axiom may not the rational. On the other hand, a consumer whose
preferences are complete, transitive, and strictly convex will always obey
the Weak Axiom. (Note that convexity is needed to ensure the uniqueness
of the optimal consumption bundle.)
4. Examples: Do the following consumer behavior satises the Weak Axiom?
(a)
p
1
p
2
q
1
q
2
Year 1 1 1 1 3
Year 2 2 1 2 1
p
1
p
2
q
1
q
2
Year 1 1 1 1 3
Year 2 2 1 0.5 4
1.1 Implications of the Weak Axiom
The Weak Axiom, together with budget balancedness, imply 1) that consumer
choice must be homogenous of degree 0 in p and y, and 2) the compensated law
of demand.
(Reny pp. 88) Theorem 1. Let x(p; y) denote the consume choice when the
price vector is p and the income is y. WA and budget balancedness imply that
x(p; y) is h.t.d. 0.
This is straightforward. A proportional change in price and income leaves the
budget set unchanged. And the weak axiom essentially requires that the optimal
consumer choice be unique for each budget set. (Note: Budget balancedness is
7
needed because the current form of WA implies the consistency of pairwise
choice only when the consumer always use up his income. I suppose one may
in principle state a more general form of the WA would imply h.t.d. 0 without
budget balancedness, but I havent done it myself.)
Proof: Suppose x
0
= x
_
p
0
; y
0
_
and x
1
= x
_
tp
0
; ty
0
_
for some t > 0. By
budget balancedness, we have the expenditure in
tp
0
x
1
= ty
0
= tp
0
x
0
:
Hence, by WA, x
1
must equal to x
0
.
Denition: We call (p
0
; y
0
) a Slutsky compensated price change from (p; y)
if p
0
x(p; y) = y
0
. That is if the new income y
0
is adjusted in such a way that
x(p; y) is still feasible under p
0
.
Theorem 2. (Reny pp. 89, Mas-Colell Prop. 2.F.1) Suppose the demand
function x(p; y) satises budget balancedness, then x(p; y) satises WA if and
only if for any compensated price change from an initial situation (p; y) to a
new price-income pair (p
0
; y
0
) = (p
0
; p
0
x(p; y)), we have
(p
0
p) [x(p
0
; y
0
) x(p; y)] _ 0: (7)
The above equation is another version of the compensated law of demand.
We saw before another version where income is adjusted to keep utility constant.
Here the income is changed to keep the optimal bundle under the initial prices
and income feasible. The Sheppards lemma means that for small changes in
prices the two versions is identical. A consumer must consumer less of good i
when it price increases. Since a rational consumer obeys the Weak Axiom, it is
obvious that the compensated law of demand based on constant utility implies
the compensated law of demand based on Slutsky income compensation.
Proof:
1. WA and BB=(7).
The result is immediate if x(p
0
; y
0
) = x(p; y). Suppose x(p
0
; y
0
) ,= x(p; y).
By budget balancedness and the denition of Slutsky income compensation, we
have
p
0
x(p; y) = p
0
x(p
0
; y
0
) :
By WA, x(p
0
; y
0
) is not feasible under (p; y). Thus,
px(p
0
; y
0
) > px(p; y) :
Adding the two equation yields the desired result.
2. (7) and BB=WA
The compensated law of demand would be violated if the Weak Axiom does
not hold for some compensated price changes. Part 2 then follows from the
fact if the Weak Axiom fails at some price-income pairs, then it fails at some
compensated price changes. Formally, the Weak Axiom holds if and only if, for
any two price-income pairs (p; y) and (p
0
; y
0
), we have px(p
0
; y
0
) > w
0
whenever
px(p
0
; w
0
) = w amd x(p; y) ,= x(p
0
; y
0
).
8
Proof: (See Mas-Colell pp.31) Suppose we have (p
0
; y
0
) and (p
00
; y
00
) such
that
x(p
0
; y
0
) ,= x(p
00
; y
00
) ;
p
0
x(p
00
; y
00
) < y
0
;
p
00
x(p
0
; y
0
) < y
00
:
. Draw gure. Now consider the budget line that passes through x(p
0
; w
0
) and
x(p
00
; w
00
). Denote this budget line by px = y. Now, it is clear from the gure
that this new budget line is in the interior of the union of the two initial budget
sets. That is, for all x such that px = y, either p
0
x < y
0
or p
00
x < y
00
. Thus,
either p
0
x(p; y) < y
0
or p
00
x(p; y) < y
00
. In the rst case, we have p
0
x(p; y) < y
0
and px(p
0
; y
0
) = y which violates the compensated law of demand. In the second
case, we have p
00
x(p; y) < y
00
and px(p
00
; y
00
) = y.
The above theorem tells us given BB that WA is equivalent to the compen-
sated law of demand.
Suppose, in addition, that the demand function is dierentiable. We can
write (7) as
(p + tz p) [x(p + tz; (p + tz) x(p; y)) x(p; y)] _ 0;
where z +
n
+
and t +.
Now, for any x +
n
+
, z +
n
dene a dierentiable function g : + + as
g (t) = z [x(p + tz; (p + tz) x(p; y)) x(p; y)]
Dierentiating with respect to t, we have
dg
dt
=
n

i=1
z
i
_
_
n

j=1
@x
i
@p
j
z
j
+
@x
i
@y
n

j=1
x
j
z
j
_
_
(8)
=
n

i=1
n

j=1
z
i
n

j=1
_
@x
i
@p
j
+
@x
i
@y
x
j
_
z
j
:
Since g (t) _ 0 for all t and g (0) = 0, the above expression must be less than or
equal to zero for all z +
n
. This means that the Slutsky substitution matrix
associated with x(p; y) is negative semidenite.
We have therefore prove the following theorem.
Theorem: If the demand function x(p; y) obeys the Weak Axiom, satises
budget balancedness, and is dierentiable, than the associated substitution ma-
trix is negative semidenite.
Recall that a dierentiable Marshallian demand function that is derived from
a consumer with complete, transitive, strictly monotone, and strictly convex
preferences has three properties: budget balancedness, symmetric and negative
semidenite substitution matrix. We have showed that the weak axiom and
budget balancedness imply that the substitution matrix is negative semidnite.
9
The nal property of the Marshallian demand, namely, the symmetry of the
substitution matrix, is not a consequence of the Weak Axiom when there are
more than two goods. (See Mas-Colell Prob 2.F.15 for a counter example.) To
obtain symmetry we need a stronger axiom.
Defn: (Mas-Colell pp. 91) The market demand function x(p; y) satises the
Strong Axiom of Revealed Preference if for any list
_
p
1
; y
1
_
; :::; (p
n
; y
n
)
with x
_
p
i+1
; y
i+1
_
,= x
_
p
i
; y
i
_
for all i _ n 1, we have p
n
x
_
p
1
; y
1
_
> y
n
whenever p
i
x
_
p
i+1
; y
i+1
_
_ y
n
for all i _ n 1.
In words, the Strong Axiom says that if x
i+1
is revealed to be preferred to
x
i
for all i = 1; :::; n 1, then x
1
cannot be revealed to be better than x
1
.
Thm: (Mas-Colell pp.91) If x(p; y) satises the Strong Axiom of Revealed
Preference then there is a rational preference relation that rationalizes x(p; w).
Proof: See Mas-Colell pp.92.
The theorem means that the substitution matrix of x(p; y) that satises
the Strong Axiom must be symmetric as the substitution matrix of a rational
consumer is symmetric.
Note that 1) Any demand function generated a rational preference relation
must by denition obeys the Strong Axiom. 2) While the theorem says that
choice behavior that obeys the Strong Axiom is consistent with rational behav-
ior, it does not say that the consumer must be rational, for SA says nothing
about choice behavior when the choice set is not a budget set.
We wont go over the proof. But the basic idea is the following: the SA
stipulates any observed consumer choices under linear budget constraints must
be transitive. However, some consumption bundles cannot directly or indirectly
compared under linear budget constraints. (For example, a bundle in the non-
convex part of a preference relation is never chosen under any price.) Hence,
the ordering implied by the strong axiom is incomplete. The proof shows that
this partial ordering can be extended to the whole commodity space in a way
that doesnt violate transitivity.
When n = 2, the Weak Axiom and the Strong Axiom are equivalent. We
can show that when n = 2 budget balancedness and homogeneity of degree 0
implies that the substitution matrix is symmetric. (You are asked to prove this
in the problem set.) This means that any demand function that obeys the weak
axiom is consistent with utility maximization and, hence, must also obey the
strong axiom.
10