Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
This worksheet illustrates the relationship between primal and dual repre-
sentations of consumer preferences. We illustrate this with a constant elasticity
of substitution (CES) utility function, of the form:
1/
U (x, y) = (x + (1 )y )
in which x and y represent consumption levels.
1
By symmetry, we then have the demand function for y as:
(py /(1 ))
y= M
p1
x + (1 ) p1
y
Calibration
In many applications of consumer choice theory, we are given a reference equi-
librium choice, and we must infer properties of of the consumer utility function
given these values. In the present model, the benchmark would consist of ref-
erence prices (
px and py ) and reference quantities (x and y). The elasticity
parameter is typically regarded as a free parameter, the value of which is exoge-
nously specified. We then determine the implicit value of which is consistent
with these observations. From the demand functions, we can conclude that:
x px /
=
y py /(1 )
A bit of algebra solves this expression for in terms of the given values:
px / y 1/
=
py /(1 ) x
(1 ) 1/ =
px x py y1/
and
1/
px x
= 1/
px x
+ py y1/
A Convenient Normalization
The reference utility level can then be evaluated as:
1/
u x + (1 )
= ( y )
u
(x, y) = u(x, y)
2
The Calibrated Share Form
It is a tedious algebraic exercise to show that when the constant elasticity utility
function is scaled such that the utility level is equal to one at the reference point,
it can be parameterized as:
1/
x y
u
(x, y) = + (1 )
x
y
where
px x
= .
px x
+ py y
It also can be shown that with utility function u
, demand functions can be
written as:
c M
x=x
px /px cM
is benchmark expenditure, and c is the cost of living index:
where M
1 1 !1/(1)
px py
c= + (1 )
px py
Indirect Utility
Indirect utility takes goods prices and income as arguments, i.e. v(px , py , M ).
The indirect utility function if formally defined as:
s.t.
px x + py y m
Alternatively, the indirect utility function can be found by substituting the
demand functions into the primal utility function:
It is then straight-forward but messy to show that given preference u(x, y),
we have:
1/ M
v(px , py , M ) = 1+ p
x + (1 )1+ p
y
p1
x + (1 ) p1
y
When we work with the scaled utility function u , the indirect utility function
is simply:
M
v(px , py , M ) =
M c(px , py )
3
The Expenditure Function
The expenditure function relates the minimum expenditure required to achieve
a given utility level, here denoted e(px , py , u). Formally, this is defined as:
e(px , py , u ) = min px x + py y
s.t.
u(x, y) u
This function can be alternatively be derived by solving for M in the ex-
pression:
v(px , py , M ) = u
With CES prferences (
u) we solve the equation:
M
c(px , py ) = u
M
hence,
1 1 !1/(1)
u px py
e(px , py , u) = M + (1 )
px py
Duality
As noted in the previous lecture, there is a close connection between the primal
and dual representation of the consumer demand model. In the primal model,
we take the budget constraint as exogenous and choose the largest indifference
curves. In the dual model, we fix the indifference curve and choose the smallest
budget line. This defines the expenditure function:
e(px , py , u) = min px x + py y
x,y
s.t.
u(x, y) = 1
Alternatively, we could define the cost minimization problem with prices
rather than quantities as decision variables, given have a consumption bundle
(x, y) for which u
(x, y) = 1 and solve:
min px x + py y
px ,py
4
s.t.
v(py , py , M ) = 1
In the primal model, the first order conditions imply that the slope of the
indifference curve at the optimal point, the marginal rate of substitution, is equal
to the price ratio. In the dual model, we have a similar condition, namely:
py e(px , py , 1)/px x
= =
px u=1
e(px , py , 1)/py y
Hence, the slope of the expenditure funciton level set is simply equal the ratio
of the optimal choices at that price level.
What about the curvature of the indifference curve and the minimum ex-
penditure curves? It turns out that the curvature of these two functions are
inversely related: if the minimum expenditure curve is very curve, the indiffer-
ence curve is rather flat and vice-versa. We can see this by considering a specific
point (px , py ) on the expenditure curve and then moving this to some (p0x , p0y )
far away on the same expenditure curve. Suppose that we find the slope of
the expenditure curve doesnt change very much, i.e. the minimum expenditure
curve is fairly flat. The slope of the minimum expenditure curve is simply the
ratio of the optimal demands, then if this slope remains constant, it implies
that final demands do not change much. In the limit, where the demands are
constant, the indifference curve must be L-shaped.
5
Rearranging, the Slutsky equation follows directly. This expression decom-
poses demand changes induced by a price change py into two separate effects:
the substitution effect and the income effect:
x hx x
x py = py ypy
py py m
| {z }
| {z } | {z }
changeindemand Substitutioneffect Incomeeffect
v(p0x , p0y , m + C) = v(
px , py , m)
or
C = e(p0x , p0y , v) m
where
v = v(
px , py , m)
Working with the calibrated share form, we have v = 1, and the compesating
variation can be written as:
0 1 0 1 !1/(1)
px p y
C = m + (1 ) 1
px py
p, m E) = v(p0 , m)
v(
or
E = e(p0 , v 0 ) e(
p, v 0 )
6
where
v 0 = v(p0 , m).
Working with the calibrated share form the equivalent variation can be writ-
ten as:
1
E = m 1
0 1 0 1 1/(1)
p p
pxx + (1 ) pyy