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Hicksian Demand and Expenditure Function Duality, Slutsky Equation

Outline

Econ 2100

Fall 2017

Lecture 6, September 14

1 Applications of Envelope Theorem

2 Hicksian Demand

3 Duality

4 Connections between Walrasian and Hicksian demand functions.

5 Slutsky Decomposition: Income and Substitution E§ects

Envelope Theorem With Constraints

The maximization problem is:

x ( q) = arg

max

F ( x ; q)= 0 k

( x ; q)

Using the Chain Rule, the change of ( q) = ( x ( q); q ) is:

D q ( x ( q); q) = D q ( x ; q)j q= q, x = x ( q) + D x ( x ; q)j q= q, x = x ( q) D q x ( q)

Because the constraints hold, F ( x ; q) = 0 k and thus D x F ( x ; q) D q x ( q) = D q F ( x ; q)

From FOC we get

D x ( x ; q) = > D x F ( x ; q)

Thus, D x ( x ; q)j q= q, x = x ( q) D q x ( q) = > D x F ( x ; q) D q x ( q) = > D q F ( x ; q) Envelope Theorem With Constraints Then, the change in the objective function due to a change in q is: D q ( x ( q); q) = D q ( x ; q)j q = q; x = x ( q ) ( ( q)) > D q F ( x ; q)j q= q; x = x ( q )

Envelope Theorem (With Constraints)

Summary The Envelope Theorem is:
D q ( x ( q); q) = D q ( x ; q)j q= q, x = x ( q) ( ( q)) > D q F ( x ; q)j q = q, x = x ( q)

The direct e§ect of the parameter q is on both the value of evaluated at the

maximizer x ( q) but also on the constraints.

In the consumerís problem, the entire di§erential e§ect of price and wage changes on indirect utility occurs via the budget constraint.

is the utility function u , and ( x ( ); ) is u ( x ( )) (the indirect utility function v ( p ; w ) )

F is the budget constraint p x w ;

one can then Ögure out how the equality above would work if (some) prices and

income change. Exercise
Compute the price e§ects, @ x ( p ; w ) with k = 1 ; 2 for the CobbñDouglas utility
@ p k
function on R 2
.
+

Application: Royís Identity

Walrasian demand is

x ( q ) = arg max u ( x ) subject to p x w = 0

Use the previous results with

( x ; q ) = u ( x ) , ( x ( q

); q

) = u ( x ( p ; w ))

= v ( p ; w ) , and F ( x ; q ) = p x w :

the e§ect of prices and wage on utility is only via the budget constraint.

The Envelope theorem says:

D q ( x ( q ); q

)

= D q ( x ; q )j x = x ( q ) ; q = q

[ ( q

)] > D q F ( x ; q )j x = x ( q ) ; q = q

Thus @ v = @ u

@

p i

@

p i

x = x ( p ; w )

@( p x w )

@

p i

= ( p ; w ) x = x ( p ; w )

=

0 x i j = ( p ; w ) x = x ( p ; w )

=

( p ; w ) x

i

@ v = @ u

@

w

@

w

x = x ( p ; w )

@( p x w )

@

w

= ( p ; w ) x = x ( p ; w )

=

0 + j = ( p ; w ) x = x ( p ; w )

= ( p ; w )

( p ; w )

the Lagrange multiplier equals the marginal utility of a change in income.

Divide one of the two expressions above by the other and obtain

i

x

( p ; w ) =

@ v

@ p i v

@ w

@

:

This is expression gives

Royís Identity:

@ p

i

= x ( p ; w )

i

@ w :

@ v

@ v

Hicksian Demand DeÖnition Given a utility function u : R + ! R , the Hicksian demand correspondence h : R ++ u ( R + ) ! R + is deÖned by

n

n

n

n

 h ( p ; v ) = arg min p x x 2 R n +

subject to u ( x ) v :

Hicksian demand Önds the cheapest consumption bundle that achieves a given utility level.

Hicksian demand is also called compensated since along it one can measure the impact of price changes for Öxed utility.

Walrasian demand x ( p ; w ) is also called uncompensated since along it price changes can make the consumer better-o§ or worse-o§.

Draw a picture.

The constraint is in ìutilsî while the objective function is in money.

For Walrasian (uncompensated) demand, the constraint is in money while the objective is in ìutilsî.

This is the dual of the utility maximization problem:

the solutions to the two problems are connected when prices are the same.

Properties of Hicksian Demand

Proposition

If u is continuous, then h ( p ; v ) is nonempty and compact.

Proof.

By continuity, fx 2 R + : u ( x ) v g, the upper contour set of x , is closed.

n

For a su¢ ciently large M , the closed set fx 2 R + : p x M g and the upper contour set of x are not disjoint.

Then

n

u ( x ) v and

h ( p ; v ) = arg min

x 2 R

n

p x subject to

+ p x M

The modiÖed constraint set is closed and bounded.

from here on, the proof follows the proof that Walrasian demand is nonempty and compact (Öll in the details as exercise). Hicksian Demand Is Downward Sloping Law of Demand: as the price of a good increases the compensated quantity demanded of that good cannot increase. Take two price vectors p and q , and deÖne

x

= h ( p ; v )

and

y = h ( q ; v )

The following is a ërevealed preferenceíargument:

1

2

3

4

5

6

y could have been chosen at prices p but was not, hence y cannot be cheaper than x at prices p.

x could have been chosen at prices q but was not, hence x cannot be cheaper than y at prices q

 ) p x p y p ( x y ) 0 ) q x q y

Adding 2. and 4. we get

q ( x y ) 0 or q ( x y ) 0

( p q ) ( x y ) 0

Choose p and q so that p i 6= q i and p j = q j for all j 6= i:

( p i q i ) ( x i y i ) 0

A similar result does not hold for Walrasian demand.

The Expenditure Function

DeÖnition

Given a continuous utility function u : R + ! R , the expenditure function

e

n

: R ++ u ( R + ) ! R + is deÖned by

n

n

e ( p; v ) = p x

for some x 2 h ( p; v ) .

This is the function that tracks the minimized value of the amount spent by the consumer as prices and utility change.

Proposition

If the utility function is continuous and locally nonsatiated, then the expenditure

functions is homogeneous of degree 1 and concave in p. Proof. Question 5, Problem Set 4. Walrasian and Hicksian Demand Are Equal

Proposition

Suppose u is continuous and locally nonsatiated. If v > u ( 0 n ) , then:

 x ( p; w ) = h ( p; v ( p; w )); h ( p; v ) = x ( p; e ( p; v )):

These are sets: the consumption bundles that maximize utility are the same as the consumption bundles that minimize expenditure, provided the constraints of the two problems ìmatch upî.

The income level for the constraint in the utility maximization problem must be

w = p x where x 2 h ( p; v ) .

The utility level for the constraint in the expenditure minimization problem

must be v = u ( x ) where x 2 x ( p; v ) .

Walrasian and Hicksian demand must coincide when computed according to the same prices, income, and utility.

The proposition implies that

e ( p; v ( p; w )) = w and v ( p; e ( p; v )) = v

so for a Öxed price vector ^p , e (^p ; ) and v (^p ; ) are inverses of each other.

Walrasian and Hicksian Demand Are Equal

We want to show that x 2 x ( p ; w ) solves min p x

We want to show that x 2 h ( p ; v ) solves max u ( x ) subject to p x p x

subject to u ( x ) u ( x )

Proof.

Pick x 2 x ( p ; w ) , and suppose but not expenditure minimizer.

x 2= h ( p ; u ( x )) :

x is a utility maximizer

Then 9 x 0 s.t. By local nonsatiation,

p x " < w and u ( x ") > u ( x 0 ) contradicting the fact that x is a utility maximizer. Therefore x must also be a expenditure minimizer.

p

x 0 < p x w 9x " (close to x 0 )

and u ( x 0 ) u ( x ) s.t.

Since p x = w

Pick x 2 h ( p ; v ) , and

minimizer but not a utility maximizer.

by full expenditure, we also have e ( p ; v ( p ; w )) = w .

suppose x 2= x ( p ; p x ) : x an expenditure

Then 9 x 0 s.t.

Consider the bundle x 0 with < 1. By continuity of u ,

u ( x 0 ) > u ( x ) and p x 0 p x

u ( x 0 ) > u ( x ) v for < 1 ; ! 1 :

Therefore,

contradicting the fact that x is an expenditure minimizer. Therefore x must

also be a utility maximizer.

p

x 0 < p x 0 p x

Support Function

DeÖnition

Given a closed set K R n , the support function K : R n ! R [ f 1g is

K ( p) =

inf K p x :

x

2

It can equal 1 since there might exists x 2 K such that p x becomes unboundedly negative for a closed set.

for example: K = f x 2 R 2 : x 1 2 R , x 2 2 [ 0 ; 1)g , and p = ( 1 ; 0 ) . if K is convex (closed and bounded in R n ), the support function is Önite.

When a set K is convex, one can ërecoveríit using the support function:

given a

furthermore, K is the intersection of all such half spaces (for all p ).

p 2 R n , f x 2 R n : p x K ( p )g is an half space that contains K ;

If K is not convex, the intersection of all sets f x 2 R n : p x

smallest closed convex set containing K (this is called the convex hull).

K ( p )g is the

Theorem (Duality Theorem)

Let K be a nonempty closed set. There exists a unique x 2 K such that p x = K ( p) if and only if K is di§erentiable at p. If so, r K ( p) = x .

The support function is ëlinearíin p. e ( p ; v ) is the support function of the set K = fx 2 R + : u ( x ) v g.

n

Properties of the Expenditure Function

Proposition

If u ( x ) is continuous, locally nonsatiated, and strictly quasiconcave, then e ( p ; v ) is di§erentiable in p.

Proof.

Immediate from the previous theorem (verify the assumptions hold). Question 6 Problem Set 4

Using the result above and the fact that h ( p ; v ) = x ( p ; e ( p ; v )) , provide su¢ cient conditions for di§erentiability with respect to p of the indirect utility function, and extend the su¢ cient conditions for continuity and di§erentiability in p of Walrasian demand to Hicksian demand.

Shephardís Lemma

Proposition (Shephardís Lemma)

Suppose u : R + ! R is a continuous, locally nonsatiated, and strictly quasiconcave utility function. Then, for all p 2 R ++ and v 2 R ,

h ( p ; v ) = r p e ( p ; v ):

n

n

Hicksian demand is the derivative of the expenditure function. There are di§rent ways to prove Shephardís Lemma:
Use the duality theorem.
Use the envelope theorem:
let ( x ; q ) = p x , ( x ( q ); q ) = e ( p ; v ) , and F ( x ; q ) = u ( x ) v ,
then:
D q ( x ( q
becomes
); q
[ ( q
) = D q ( x ; q )j x = x ( q ); q = q
)] > D q F ( x ; q )j x = x ( q ); q = q
r p e ( p ; v ) = h ( p ; v ) 0
since F does not depend on p .
Brute force (next slide).

Shephardís Lemma: Proof Proof. We want to show that h ( p ; v ) = r p e ( p ; v ) .

Using the deÖnition, and then the chain rule r p e ( p ; v ) = r p [ p h ( p ; u )] = h ( p ; u ) + [ p D p h ( p ; u )] >

The Örst order conditions of the minimization problem say

p = r p u ( h ( p ; u ))

Therefore

r p e ( p ; v ) = h ( p ; u ) + [r p u ( h ( p ; u )) D p h ( p ; u )] > At an optimum, the constraint must bind and so u ( h ( p ; u )) = v

Thus

r p u ( h ( p ; u )) D p h ( p ; u ) = 0

and therefore

h ( p ; v ) = r p e ( p ; v ):

as desired. Royís Identity Proposition (Royís identity)
Suppose u is continuous, locally nonsatiated, and strictly quasiconcave and v is
di§erentiable at ( p ; w ) 6= 0 . Then
1
x ( p ; w ) =
r p v ( p ; w );
@ v ( p ; w )
@ w
This can be also written as
@ v ( p ; w )
@ p k
( p ; w ) =
; for all k
x k
@ v ( p ; w )
@ w

Walrasian demand equals the derivative of the indirect utility function multiplied by a ìcorrection termî.

This correction normalizes by the marginal utility of wealth.

There are di§rent ways to prove Royís Identity

Use the envelope theorem (earlier).

Use the chain rule and the Örst order conditions.

Brute force (next slide).

Royís Identity Proof. We want to show that

x k

( p ; w ) =

@ v ( p ; w )

@ p k

@ v ( p ; w )

@ w

Fix some p

; w and let u

= v ( p

; w ) .

The following identity holds for all p

v ( p ; e ( p ; u

)) = u

di§erentiating w.r.t p k we get

@

@

v

p k

@

v

@

+

+

@ v @ e @ w @ p k

@

v

= 0

and therefore

@

w h k = 0

p k Let x k = x k ( p ; w ) and evaluate the previous equality at p ; w :

@

@

v

p k

+

@

@

v

w

x k = 0

Solve for x k to get the result.

Slutsky Matrix

DeÖnition

The Slutsky matrix , denoted D p h ( p ; v ) , is the n n matrix of derivative of the Hicksian demand function with respect to price (its Örst n dimensions).

Notice this says ìfunctionî, so the Slutsky matrix is deÖned only when Hicksian demand is unique.

Proposition

Suppose u : R + ! R is continuous, locally nonsatiated, strictly quasiconcave and h ( ) is continuously di§erentiable at ( p ; v ) . Then:

n

1

2

3

The Slutsky matrix is the Hessian of the expenditure function:

D

The Slutsky matrix is symmetric and negative semideÖnite;

D p h ( p ; v ) p = 0 n .

2

p h ( p ; v ) = D pp e ( p ; v ) ; Proof. Question 8, Problem Set 4. Slutsky Decomposition Proposition
If u is continuous, locally nonsatiated, and strictly quasiconcave, and h is
di§erentiable, then: for all ( p ; w )
D p h ( p ; v ( p ; w )) = D p x ( p ; w ) + D w
x ( p ; w ) x ( p ; w ) >
or
@ h ( p ; v ( p ; w ))
@ x ( p ; w ) + @ x ( p ; w )
j
j
j
=
x
( p ; w );
for all j ; k
k
@ p k
@
p k
@ w Proof.
Remember that
h ( p ; v ) = x ( p ; e ( p ; v )):
Take the equality for good j and di§erentiate with respect to p k
@ h
@ x + @ x
@ e
@ x + @ x
j
j
j
j
j
=
=
k
@ p k
Evaluate this for some p ; w
@ p k
@ w @ p k
@ p k
@ w h
and u = v ( p ; w ) so that h ( ) = x ( )
@ h
@ x + @ x
j
j
j
=
k
@ p k
@ p k
@ w x

Slutsky Equation

Hicksian decomposition of demand

Rearranging from the previous proposition:

@ x ( p ; w )

@ h ( p ; v ( p ; w ))

j

j

=

@

p k

|

@

p k

{z

substitution e§ect

}

@ x ( p ; w )

j

@

w

k

x

( p ; w )

|

{z

income e§ect

}

This is also known as the Slutsky equation:

it connects the derivatives of compensated and uncompensated demands.

If one takes k = j , the following is the ìown priceî Slutsky equation

@ x ( p ; w )

j

@

p j

=

@ h ( p ; v ( p ; w ))

j

|

@

p j

{z

substitution e§ect

}

@ x ( p ; w )

j

@

w

x j

|

{z

( p ; w ) }

income e§ect

Normal, Inferior, and Gi§en Goods The own price Slutsky equation
@ x ( p ; w )
@ h ( p ; v ( p ; w ))
@ x ( p ; w )
j
j
j
=
( p ; w ) :
x j
@ p j
@ p j
@ w
|
{z
}
|
{z
}
income e§ect
substitution e§ect

Since the Slutsky matrix is negative semideÖnite, @ h k =@ p k 0;

the Örst term is always negative while the second can have either sign; the substitution e§ect always pushes the consumer to purchase less of a commodity when its price increases. Normal, Inferior, and Gi§en Goods
A normal good has a positive income a§ect.
An inferior good has a negative income e§ect.
A
Gi§en good has a negative overall e§ect (i.e. @ x =@ p k > 0);
k
this can happen only if the income e§ect is negative and overwhelms the
substitution e§ect
@ x
< @ h
k
k k 0 :
k
@ w x
@
p

Slutsky Equation and Elasticity DeÖnition
" y ; q = @ y
y q is called the elasticity of y with respect to q
@ q

Elasticity is a unit free measure (percentage change in y for a given percentage change in q ) that is often used to compare price e§ects across di§erent goods.

The own price Slutsky equation

@ x ( p ; w )

j

@ h ( p ; v ( p ; w ))

j

@ x ( p ; w )

j

=

@

p j

@

p j

@

w

x j

( p ; w )

Multiply both sides by p j = x ( ) and rewrite as

j

@ x ( p ; w )

j

p

j

@ h ( p ; v ( p ; w ))

j

p

j

@ x ( p ; w )

j

w

x

j

( p ; w )

@

p j

or

x

j

@

p j

x

j

( p ; w )

@ w

w

( p ; w ) =

p j x ( p ; w )

j

" x j ; p j = " h j ; p j " x j ; w

p j x ( p ; w )

j

w

The elasticty of Walrasian (uncompensated) demand is equal to the elasticity of Hicksian (compensated) demand minus the income elasticity of demand multiplied by the share that good has in the budget.

Gross Substitutes The cross price Slutsky equation
@ x ( p ; w )
@ h ( p ; v ( p ; w ))
@ x ( p ; w )
j
j
j
=
( p ; w )
x j
@ p k
@ p k
@ w

Intuitively, we think of two goods as substitutes if the demand for one increases when the price of the other increases. DeÖnition
( p ; w )
j
We say good j is a gross substitute for k if @ x
0.
@ p k

Unfortunately the deÖnition of substitutes based on Walrasian (uncompensated) demand is not very useful since it does not satisfy symmetry:

we can have @ x

There is a better deÖnition that is based on Hicksian (compensated) demand.

j

( p ; w )

@ p k

> 0

and

@ x

k

( p ; w )

@

p j

< 0.

Net Substitutes DeÖnition
We say goods j and k are
net substitutes if @ h
( p ; w )
( p ; w )
j
j
0
and
net complements if @ h
0.
@ p k
@ p k
( p ; w )
k ( p ; w )
j
This deÖnition is symmetric: @ h
0 if and only if @ h
0 .
@ p k
@ p j
Proof.
@ @ e ( p ; v )
@ h ( p ; w )
j
@ p j
=
by Shephardís Lemma
@ p k
@ p k
@ 2 e ( p ; v )
=
@ p k @ p j
@ 2 e ( p ; v )
=
by Youngís Theorem
@ p j @ p k
@ h k ( p ; w )
=
by Shephardís Lemma again
@ p j

Next Week

Testable Implication of Consumer Theory Firm Behavior