Week 5 Consumer Theory (Jehle and Reny, Ch.

2)

Week 5
Consumer Theory
(Jehle and Reny, Ch.2)

Serin ahin
Yldz Technical University

23 October 2012

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Expenditure and Consumer Preferences

Choose (p , u ) Rn++ R+ , and evaluate E there to obtain

the number E (p , u ).
And use this number to construct the (closed) 'half space' in
the consumption set:
0

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Expenditure and Consumer Preferences

Now choose dierent prices p , keep u xed, and construct

the set,
1

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Expenditure and Consumer Preferences

Imagine proceeding like this for all prices p  0 and forming

the innite intersection,

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Expenditure and Consumer Preferences

Theorem 2.1
Constructing a Utility Function From an Expenditure
Function

Let E : Rn++ R+ R+ satisfy properties 1 through 7 of an

expenditure function given in Theorem 1.7.
Let A(u) be as

Then the function u : Rn+ R+ given by

is increasing, unbounded above and quasiconcave.

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Expenditure and Consumer Preferences

Theorem 2.2

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Convexity and Monotonicity

Let e(p, u) be the expenditure function generated by u(x).

Consider the utility function, generated by e(), call it w (x),
regardless of whether or not u(x) is quasiconcave or increasing,
w (x) will be both quasiconcave and increasing.
Then u(x) and w (x) need not coincide.

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Convexity and Monotonicity

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Convexity and Monotonicity

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Convexity and Monotonicity

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Indirect Utility and Consumer Preferences

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Indirect Utility and Consumer Preferences

Because v (p, y ) is homogeneous of degree zero in (p, y ), we

have
v (p, p.x) = v (p/(p.x), 1)
whenever p.x > 0.
Consequently, if x  0 and p  0 minimises v (p, p.x) for
n
b p /(p .x)  0 minimises v (p, 1) for
p R++ , then p
n
p ++ such that p.x = 1.
Moreover, v (p , p .x) = v (bp, 1).
Thus, we may rewrite (T.1) as

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Duality
Indirect Utility and Consumer Preferences

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Integrability

Theorem 2.5: Budget Balancedness and Symmetry

Imply Homogeneity

If x(p, y ) satises budget balancedness and its Slutsky matrix

is symmetric, then it is homogeneous of degree zero in p and y .
Thus if x(p, y ) is a utility maximiser's system of demand
functions, we may summarise the implications for observable
behaviour in the following three items alone:
Budget Balancedness: p.x(p, y ) = y
Negative Semideniteness: The associated Slutsky matrix
s(p, y ) must be negative semidenite.
Symmetry: s(p, y ) must be symmetric.

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Integrability

Theorem 2.6: Integrability Theorem

n+
A continuously dierentiable function x : R++
Rn+ is the
demand function generated by some increasing, quasiconcave
utility function if it satises
1

budget balancedness,
symmetry, and
negative semideniteness.

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty

The individual will be assumed to have a preference relation

over gambles.
Let A = {a , ..., an } denote a nite set of outcomes.
A simple gamble assigns a probability, pi , to each of the
outcomes ai , in A. We denote the simple gamble by
1

Then GS , the set of simple gambles (on A) is given by

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty

Gambles whose prizes are themselves gambles are called

compound gambles.
Let G denote the set of all gambles, both simple and
compound.
So if g is any gamble in G , then
for some k 1 and some gambles g i G , where the g i 's
might be compound gambles, simple gambles, or outcomes.

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Axioms of Choice Under Uncertainty

Axiom 1: Completeness.
0
0
0
For any two gambles, g and g in G , either g  g or g  g .
Axiom 2: Transitivity.
0
00
0
0
00
For any three gambles g , g , g in G , if g  g and g  g ,
00
then g  g .
Axiom 3: Continuity.
For any gamble g in G , there is some probability [0, 1],
such that

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Axioms of Choice Under Uncertainty

Monotonicity.
For all probabilities , [0, 1],
Axiom 4:

if and only if .
Axiom 5:

Substitution.

are in G , and if hi g i for every i , then h g .

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Axioms of Choice Under Uncertainty

For any gamble g G , if pi denotes the eective probability

assigned to ai by g , then we say that g induces the simple

gamble

Axiom 6:

Reduction to Simple Gambles.

For any gamble g G , if (p a , ..., pn an ) is the simple

gamble induced by g , then
1

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Von Neumann-Morgenstern Utility

Suppose that u : G R is a utility function representing  on

G.

So for every g G , u(g ) denotes the utility number assigned

to the gamble g . In particular, for every i , u assigns the
number u(ai ) to the degenerate gamble (1 ai ), in which the
outcome ai occurs with certainty.
We will refer to u(ai ) as simply the utility of the outcome ai .

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Von Neumann-Morgenstern Utility

Expected Utility Property

The utility function u : G R has the expected utility

property if, for every g G ,

where (p a , ..., pn an ) is the simple gamble induced by g .

If an individual's preferences are represented by a utility
function with the expected utility property, and if that person
always chooses his most preferred alternative available, then
that individual will choose one gamble over another if and only
if the expected utility property of the one exceeds that of the
other.
Consequently, such an individual is an expected utility
maximiser.
1

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Von Neumann-Morgenstern Utility

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Risk Aversion

The expected value of the simple gamble g oering wi with

probability pi is given by
Now suppose the agent is given a choice between accepting
the gamble g on the one hand or receiving with certainty the
expected value of g on the other.
If u() is the agent's VNM utility function, we can evaluate
these two alternatives as follows:

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Risk Aversion

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Risk Aversion

Week 5 Consumer Theory (Jehle and Reny, Ch.2)

Choice Under Uncertainty
Risk Aversion