PhD Micro Theory Lecture Notes

Nathan Yoder

University of Georgia

August 10, 2017

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Contents

1 Consumer Theory 1

1.1 Preference and Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.1.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.1.2 Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.1.3 Revealed Preference . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.2 Consumer Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1.2.1 Important Properties of Consumer Preferences . . . . . . . . . . . . . 5

1.2.2 Utility Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1.2.3 Demand Correspondences and Utility Maximization . . . . . . . . . 6

1.2.4 Solving the UMP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1.2.5 Indirect Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1.3 Expenditure Minimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1.3.1 Duality Between the EMP and the UMP . . . . . . . . . . . . . . . . . 13

1.3.2 Properties of Expenditure and Hicksian Demand . . . . . . . . . . . 14

1.3.3 Shephard’s Lemma and Roy’s Identity . . . . . . . . . . . . . . . . . . 16

1.4 Comparative Statics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.4.1 Income Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.4.2 Effects of a Price Change . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2 Producer Theory 27
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2.1 Profit Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

2.2 Cost Minimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

3 Aggregation 33
3.1 Aggregate Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.2 Aggregate Demand and the Weak Axiom . . . . . . . . . . . . . . . . . . . . 34
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Chapter 1

Consumer Theory

1.1 Preference and Choice

• Economics is about agents making decisions. How do we model this?

• Two ways:

– Take preferences — the way an agent ranks their available options from better
to worse — as given and derive choices as a function (or correspondence) of
available options

– Take choices as given and derive the preferences that generate them

We’ll see that these approaches are generally equivalent. This is critical for much of
what we do in economics:

– If we couldn’t figure out the choices we expect to observe given the preferences
we write down, then our theoretical models would have no predictive power
and we wouldn’t really be doing science

– If we couldn’t figure out the preferences that agents have from the choices that
they make, that would limit the usefulness of empirical work: no welfare anal-
ysis, for instance.
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1.1.1 Preferences

Ingredients:

• the set X of alternatives (e.g., possible consumption bundles)

• a binary preference relation  on X describing how the agent feels about different
elements of X

– If the agent thinks y is at least as good as x, we write y  x and say y is weakly

preferred to x

– If y  x and x  y, then we write y ∼ x and say the agent is indifferent

between y and x

– If y  x and x 6 y, then we write y  x and say y is strictly preferred to x

Things we assume about the agent’s preferences:

• Preferences are complete: for any x, y ∈ X, either x  y or y  x

– So when given two alternatives, the agent can always rank them

– Implies that preferences are reflexive: for all x ∈ X, x  x

• Preferences are transitive: x  y and y  z implies x  z

– In other words, agents’ preferences are consistent across different sets of alter-
natives (e.g., different budget sets) they might be presented with

• When preferences are complete and transitive, we say they are rational

1.1.2 Choice

Given a set of available alternatives B ⊆ X (a budget set), preferences tell us what the
agent is going to choose to do
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• Let B represent the collection of budget sets we want to consider

• Define an agent’s choice from B as

C ( B) ≡ { x ∈ B : x  y∀y ∈ B}

Note that C ( B) may contain more than one element. That is, there might be multiple
elements of B that are at least as good as all of the others. It also might contain no
elements at all.

– To see how C ( B) might be empty, suppose that

∗ B = {0, 1, 2, . . .} is quantities of cheese in pounds

∗ I like cheese: y  x if and only if y ≥ x

– Then there’s no element of B that I like at least as much as all the others: there’s
always a larger amount of cheese in the budget set

• When B is such that C ( B) 6= ∅∀ B ∈ B , the tuple (B , C ) is a choice structure

• When C ( B) is a single element for each B ∈ B , it’s a function C : B → X.

• But in general, C is a generalization of the idea of a function called a correspon-

dence.

Correspondences

A correspondence allows a given element of its domain (here: a given B ∈ B ) to map

to an arbitrary set of elements in its range (here: an arbitrary C ( B) ⊆ X) instead of just
one. To note this, we add an extra arrow when we’re describing correspondences: e.g.,
C : B ⇒ X.
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Hemicontinuity

For functions, we said that a function f : X → Y is continuous if for all sequences

xn → x, f ( xn ) → f ( x ). Or equivalently, f has a closed graph. We can carry this notion
over to correspondences: we say a correspondence G : X ⇒ Y is upper hemicontinuous
(UHC) if for all pairs of sequences xn → x in X and yn → y in y, if yn ∈ G ( xn ) for all n
then y ∈ G ( x ). (Or equivalently, G has a closed graph.) That is, the correspondence might
get discontinuously larger, but it will never get discontinuously smaller or jump around
discontinuously.
If a correspondence is UHC and single-valued (i.e., a function) that’s equivalent to
continuity.

1.1.3 Revealed Preference

As discussed earlier, we can also take choices as primitive and recover preferences, so
long as they are well behaved.

• Define the revealed preference relation  R as follows:

x  R y ⇔ x ∈ C ( B) for some B ∈ B with y ∈ B

In this case we say that x is weakly revealed preferred to y.

• In other words, if the agent had y available but picked x, we can infer that she likes
x as much or more than y.

• By well-behaved, we mean that (B , C ) satisfies the weak axiom of revealed pref-

erence: If for B, B0 ∈ B with x, y ∈ B, B0 , we have x ∈ C ( B) and y ∈ C ( B0 ), then
x ∈ C ( B 0 ).

• In other words, if an agent ever chooses x over y, then it’s inconsistent with the
weak axiom for him to choose y but not x when x is available.
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• MWG Proposition 1.D.1: If  is rational, then any choice structure it generates sat-
isfies the weak axiom.

• MWG Proposition 1.D.2: If (B , C ) satisfies the weak axiom and B contains all B ⊆ X
with three or fewer elements, then  R is rational.

1.2 Consumer Choice

Now we’ll apply the insights of the last section to perhaps the most basic of all eco-
nomic problems:

• the choices of a consumer,

• trying to decide how to expend her wealth w ≥ 0,

• on a bundle x ∈ R+
L of commodities,

• which are sold at set prices p ∈ R+

L.

Translating this into the language of the previous section:

• the set of alternatives is given by X ⊆ R+

L

• the budget set is of the form B p,w ≡ { x ∈ R+

L : p · x ≤ w }. This is called the

competitive or Walrasian budget set

1.2.1 Important Properties of Consumer Preferences

Properties of  which are important in this environment:

• Preferences are monotone if whenever x >> y (i.e., when x` > y` for all ` ∈ L) we
have x  y.

• Preferences are locally nonsatiated if ∀ x ∈ X, e > 0, there exists y ∈ X with | x −

y| ≤ e such that y  x.
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• Preferences are convex if whenever y  x and z  x, λy + (1 − λ)z  x for all

λ ∈ (0, 1). They are strictly convex if the latter preference is strict.

• Preferences are continuous if for all x ∈ X, the sets {y ∈ X : y  x } and {y ∈ X :

y  x } are closed.

– In other words, preference is preserved under limits: if x  yn for n = 1, 2, . . .

and yn → y then x  y.

1.2.2 Utility Functions

• Frequently we can represent preferences with a function u : X → R instead of a

binary relation: x  y iff u( x ) ≥ u(y)

• Can only do this when preferences are rational (MWG Proposition 1.B.2)

• When preferences are continuous and rational and X ⊆ R+

L , we can do this and

what’s more, u is continuous (MWG Proposition 3.C.1)

• When  is convex, any u that represents it is quasiconcave: For all x, y ∈ R+

L and

α > 0, u(αx + (1 − α)y ≥ min{u( x ), u(y)}. This is an ordinal generalization of

concavity.

• We call the utility function’s level curves { x : u( x ) = ū} indifference curves (be-
cause the consumer is indifferent among the elements they contain)

• Note: if u represents  then so does f ◦ u for all monotone f : R → R. So only the

ordinal properties of u are derived from 

1.2.3 Demand Correspondences and Utility Maximization

When B is the collection of Walrasian budget sets B p,w :

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• We call the agent’s choice correspondence the Walrasian demand correspondence

and for given prices and wealth denote it x ( p, w) ≡ C ( B p,w ).

• When  is continuous and rational (and so we can find a u that represents it), x ( p, w)
solves the utility maximization problem (UMP) for ( p, w):

max u( x ) s.t. p · x ≤ w
x ≥0

• The UMP has a solution for all p, w (MWG Prop 3.D.1).

• Note that this implies that ({ B p,w : p >> 0, w > 0}, x ) is a coherent choice struc-
ture and we can apply things we learned from Chapter 1 about choice structures
generated by preferences

Properties of the Walrasian demand correspondence generated by continuous, rational

preferences : (MWG Prop 3.D.2)

• Homogeneity of Degree Zero: x (αp, αw) = x ( p, w)∀α > 0, w > 0, p >> 0.

– Obviously the constraints αp · x ≤ αw and p · x ≤ w are the same

• (If  is locally nonsatiated) Walras’ law: p · x ( p, w) = w.

– If p · x ( p, w) < w, choose e > 0 such that | x ( p, w) − y| ≥ e for all y ∈

/ B p,w .
From local nonsatiation, there is some y with | x ( p, w) − y| < e, and thus with
y ∈ B p,w , such that y  x ( p, w). Then x ( p, w) does not solve the UMP for
( p, w), a contradiction.

• (If  is convex) x is convex-valued.

– First note that Walrasian budget sets are convex, so αy + (1 − α)y0 ∈ B p,w for
all α ∈ (0, 1) and y, y0 ∈ B p,w .
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– Suppose y, y0 ∈ x ( p, w). Then y  z and y0  z for all z ∈ B p,w . Then from

convexity, ∀α ∈ (0, 1), αy + (1 − α)y0  z for all z ∈ B p,w . It follows that
αy + (1 − α)y0 ∈ x ( p, w).

• (If  is strictly convex) x is single-valued. (So it’s a function, not a correspondence.)

– Suppose y, y0 ∈ x ( p, w). Then y  y and y0  y. From strict convexity, ∀α ∈

(0, 1), αy + (1 − α)y0  y, a contradiction.

• Weak Axiom of Revealed Preference: For all p, p0 , w, w0 and all y ∈ x ( p, w), y0 ∈

x ( p0 , w0 ), if p · y0 ≤ w and y0 ∈
/ x ( p, w) then p0 · y > w0 .

– Follows from MWG Proposition 1.D.1

– When x is single-valued, this reduces to the version of WARP in your textbook:

For all p, p0 , w, w0 , if p · x ( p0 , w0 ) ≤ w and x ( p0 , w0 ) 6= x ( p, w) then p0 · x ( p, w) >
w0 .

• x is upper hemicontinuous for ( p, w) >> 0.

– Proven in MWG Chapter 3 Appendix A when  is locally nonsatiated, but true

more generally

– (Note: UHC/continuity is a generic property of solutions to well-behaved op-

timization problems, a result which we’ll talk more about in the game theory
portion of the course)

1.2.4 Solving the UMP

When u is continuously differentiable, we can solve the UMP using the method of
Kuhn-Tucker:

• If x ∗ ∈ x ( p, w) then there exists λ ∈ R, µ ∈ R+

L such that

∇u( x ∗ ) = λp − µ and µ · x ∗ = 0
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• We can equivalently write

∇u( x ∗ ) ≤ λp and (∇u( x ∗ ) − λp) · x ∗ = 0

• Note that at an interior solution this reduces to an equality — i.e., we are using the
method of Lagrange

• In this case, we can take the individual good FOCs

∂u( x ∗ )
= λp`
∂x`
∂u( x ∗ )
= λpk
∂xk

and divide them by each other to get

∂u( x ∗ )/∂x` p`
=
∂u( x ∗ )/∂xk pk

The fraction on the left is called the marginal rate of substitution of ` for k at x ∗ : the
amount of good k we have to give the consumer to leave her with the same utility
after we take a unit of good ` from her. (I.e., the slope of the indifference curve.)

Example 1 (Cobb-Douglas Utility). Suppose that there are two goods and that

u( x ) = Ax1α x21−α

Or equivalently (since log is a monotone function)

u( x ) = C + α log x1 + (1 − α) log x2

This is called Cobb-Douglas Utility.

We know we have an interior solution since marginal utility goes to infinity as xi be-
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comes small.
Our Lagrangean is

L( x ) = C + α log x1 + (1 − α) log x2 − λ( p · x − w)

First order conditions are

α
= λp1
x1
1−α
= λp2
x2

Doing some algebra yields

1 = λ ( p1 x1 + p2 x2 )

λ = 1/w

This gives us demands of

αw
x1 =
p1
(1 − α ) w
x2 =
p2

Note that

p1 x1 = αw

p2 x2 = (1 − α ) w

With Cobb-Douglas utility, the consumer always spends a fixed fraction of their wealth
on each good.

When u isn’t continuously differentiable, we have to use alternative methods

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Example 2 (Leontief Utility). Suppose again two goods and that

u( x ) = min{αx1 , βx2 }

This isn’t differentiable. Fortunately, we can look at it and see that no utility maximizer
would want to buy x2 > αβ x1 , since the extra x2 is wasted and they could take the money
they spent on it to increase both x1 and x2 – and thus their utility. Likewise, we cannot
β
have x1 > α x2 . So we must have αx1 = βx2 . Plugging this into the budget constraint gets
us

β
p1 x1 + p2 x1 = w
α
α
p2 x2 + p1 x2 = w
β
w
x1 = β
p1 + p2 α
w
x2 =
p2 + p1 αβ

1.2.5 Indirect Utility

• Sometimes we are interested in the effects on a consumer’s utility of changing the

budget set he faces.

• In other words, we are interested in the indirect utility function

v( p, w) ≡ u( x ( p, w))

Properties of the indirect utility function generated by continuous, rational preferences

: (MWG Prop 3.D.3)

• Homogeneity of degree zero.

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– Follows from x being HD0

• (If  is locally nonsatiated) Strictly increasing in w and nonincreasing in p.

– Follows from Walras’ law: When we increase wealth from w to w0 , x ∗ ∈ x ( p, w)

is now interior and so not in x ( p, w0 ). That means the consumer is strictly better
off at x ( p, w0 ).

– Similar logic for p, but note that if x ∗ ∈ x ( p, w) is a corner solution where we

don’t buy any xk , then decreasing pk won’t make x ∗ interior. So we might just
keep buying the same bundle. But we can never be worse off, since all of the
bundles that were available before the price decrease are still in our budget set.

• Quasiconvex: the set {( p, w) : v( p, w) ≤ v̄} is convex for all v̄.

– Consider ( p, w), ( p0 , w0 ) ∈ {( p, w) : v( p, w) ≤ v̄}. For α ∈ (0, 1), let p00 =

αp + (1 − α) p0 and w00 = αw + (1 − α)w0 . If x ∈ B p00 ,w00 then

αx · p + (1 − α) x · p0 ≤ αw + (1 − α)w0

so either x · p ≤ w (and u( x ) ≤ v( p, w) ≤ v̄) or x · p0 ≤ w0 (and u( x ) ≤

v( p0 , w0 ) ≤ v̄)

• Continuous

– Follows from continuity of x in the strictly convex case, but is true more gener-
ally

Example 3 (Cobb-Douglas Indirect Utility). Suppose again that there are two goods and
that
u( x ) = C + α log x1 + (1 − α) log x2
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Plugging in our Walrasian demand functions yields

v( p, w) = C + α log α + α log w − α log p1 + (1 − α) log(1 − α) + (1 − α) log w − (1 − α) log p2

Rearranging terms:

v( p, w) = C + α log α + (1 − α) log(1 − α) + log w − α log p1 − (1 − α) log p2

1.3 Expenditure Minimization

So far, we’ve been asking how a consumer can spend their given money to achieve as
much happiness as possible

• Closely related problem: how can a consumer minimize their spending to achieve a
given utility level? This is the expenditure minimization problem (EMP) for ( p, ū):

min p · x s.t. u( x ) ≥ ū
x ≥0

– Its solution h( p, ū) is called the Hicksian or compensated demand correspon-

dence

– Its maximized level e( p, ū) ≡ p · h( p, ū) is called the expenditure function

1.3.1 Duality Between the EMP and the UMP

The EMP is the dual problem to the UMP. In the words of MWG, “it captures the
same aim of efficient use of the consumer’s purchasing power while reversing the roles
of objective function and constraint.”

• That is, instead of trying to find the highest indifference curve (of given preferences)
that intersects a certain budget line, we’re trying to find the lowest budget line (at a
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given slope) that intersects a certain indifference curve

This causes them to be related more formally (MWG Proposition 3.E.1): Suppose u repre-
sents a continuous and locally nonsatiated preference relation and that p >> 0.

• If x ∗ solves the UMP for ( p, w) then it solves the EMP for ( p, u( x ∗ )), and e( p, u( x ∗ )) =
w.

• If x ∗ solves the EMP for ( p, ū) then it solves the UMP for ( p, p · x ∗ ), and v( p, p · x ∗ ) =
ū.

This allows us to relate Hicksian and Walrasian demand:

h( p, ū) = x ( p, e( p, ū))

x ( p, w) = h( p, v( p, w))

as well as the expenditure and indirect utility functions:

e( p, v( p, w)) = w

v( p, e( p, ū)) = ū

1.3.2 Properties of Expenditure and Hicksian Demand

Properties of the expenditure function generated by continuous, rational, locally non-

satiated preferences: (MWG Proposition 3.E.2)

• Homogeneity of degree one in prices (e(αp, ū) = αe( p, ū) for all α > 0, p >> 0, ū)

– For α > 0,

min{αp · x s.t. u( x ) ≥ ū} = α min{ p · x s.t. u( x ) ≥ ū}.

x x

• Strictly increasing in ū and nondecreasing in p.

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– Strictly increasing in ū: Any x we could choose when the required utility level
is ū can also be chosen when it is ū0 < ū. So we cannot have e( p, ū) < e( p, ū0 ).

Suppose e( p, ū) = e( p, ū0 ). By continuity, there exists e ∈ (0, 1) such that u((1 −
e)h( p, ū)) > ū0 . So (1 − e)h( p, ū) is available in the EMP for ( p, ū). But (1 −
e) p · h( p, ū) < e( p, ū) = e( p, ū0 ), a contradiction.

– Nondecreasing in p: For p ≤ p0 we have

e( p, ū) = p · h( p, ū) ≤ p · h( p0 , ū) ≤ p0 · h( p0 , ū) = e( p0 , ū).

The first inequality is true because h( p, ū) solves the EMP for ( p, ū), and the
second is true because h( p, ū) ≥ 0 and p ≤ p0 .

• Concave in p.

– For α ∈ (0, 1) and p, p0 >> 0,

e(αp + (1 − α) p0 , ū) = min αp · x + (1 − α) p0 · x ≥ α min p · x + (1 − α) min p0 · y

u( x )≥ū u( x )≥ū u(y)≥ū

= αe( p, ū) + (1 − α)e( p0 , ū),

because on the right hand side we get to potentially choose different consump-
tion bundles for each price vector.

• Continuous.

– Follows from Theorem of the Maximum.

• (If h is single-valued) Compensated law of demand: For all p, p0 >> 0 we have

( p0 − p) · (h( p0 , ū) − h( p, ū)) ≤ 0

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Properties of Hicksian demand generated by continuous, rational, locally nonsatiated

preferences: (MWG Proposition 3.E.3)

• Homogeneity of degree zero in prices (h(αp, ū) = h( p, ū) for all α > 0, p >> 0, ū)

– For α > 0,

min{αp · x s.t. u( x ) ≥ ū} = α min{ p · x s.t. u( x ) ≥ ū},

x x

so the two programs have the same solutions.

• No excess utility: u(h( p, ū)) = ū.

– Suppose u( x ∗ ) > ū for x ∗ ∈ h( p, ū). Then since

x ∗ ∈ arg min{ p · x s.t. u( x ) ≥ ū}

x

we must also have

x ∗ ∈ arg min{ p · x s.t. u( x ) ≥ u( x ∗ )}

x

since the latter problem has a more stringent constraint. But then e( p, ū) =
p · x ∗ = e( p, u( x ∗ )), which is impossible since expenditure is strictly increasing
in the required utility level.

• (If  is convex) h is convex-valued.

• (If  is strictly convex) h is single-valued.

1.3.3 Shephard’s Lemma and Roy’s Identity

The duality results from earlier (Section 1.3.1) let us relate Walrasian and Hicksian
demand, and expenditure and indirect utility.But we can go further:
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• We can relate expenditure and Hicksian demand through a result called Shephard’s
lemma

• We can then relate indirect utility and Walrasian demand through a result called
Roy’s Identity

Shephard’s lemma: Suppose u represents locally nonsatiated, strictly convex preferences.

Then
∇ p e( p, ū) = h( p, ū).

How do we get this?

The Envelope Theorem

Let’s take a step back from consumer theory and just consider an arbitrary maximiza-
tion problem
V (t) ≡ max f ( x, t),
x∈X

with x and t both real vectors. Note that I’m maximizing with respect to x here (say,
choosing a bundle of goods) given a parameter t (say, a price vector). Suppose I want to
know how V changes as I change t.

The envelope theorem says that so long as V is differentiable at t (which is usually the
case) we have
∇V (t) = ∇t f ( x ∗ , t) for any x ∗ ∈ arg max f ( x, t).
x∈X

That is, the gradient of the maximized value V with respect to the parameter t is just the gra-
dient of the objective function with respect to t, evaluated at the optimal value x ∗ (t). Since
minx∈X f ( x, t) = −(maxx∈X (− f ( x, t))), this works for minima too.
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Applying this to the EMP, we have

∇ p e( p, ū) = ∇ p p · x ∗ for any x ∗ ∈ arg min { p · x }

u( x )≥ū

= x ∗ ∈ arg min { p · x }
u( x )≥ū

= h( p, ū).

Roy’s Identity

Suppose again that u represents locally nonsatiated, strictly convex preferences. We

know that
v( p, e( p, ū)) − ū = 0∀ p, ū.

Since the term on the left-hand side is constant for all p, its derivatives with respect to
price have to be zero. Applying the chain rule, this gives us

∂
∇ p v( p, e( p, ū)) + v( p, e( p, ū))∇ p e( p, ū) = 0.
∂w

Recall that h( p, ū) = x ( p, e( p, ū)), so applying Shephard’s lemma:

∂
∇ p v( p, e( p, ū)) + v( p, e( p, ū)) x ( p, e( p, ū)) = 0.
∂w

Doing some algebra gives us

−1
x ( p, e( p, ū)) = ∂
∇ p v( p, e( p, ū)).
∂w v ( p, e ( p, ū ))

Letting w = e( p, ū):
−1
x ( p, w) = ∂
∇ p v( p, w).
∂w v ( p, w )
This is called Roy’s identity.
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1.4 Comparative Statics

This section asks: What happens when prices and wealth change? To facilitate this
analysis, we’ll assume that Walrasian and Hicksian demands are continuous and differ-
entiable.

1.4.1 Income Effects

We call good ` a normal good at ( p, w) if its income effect ∂x ( p, w)/∂w is positive,

and an inferior good at ( p, w) if its income effect is negative.

• An item might be a normal good at some ( p, w) pairs, but an inferior good at others:

– For instance, my income just went up, and as a result I’m buying way more
airline tickets

– But if my income went up by a billion dollars, that would probably decrease

my demand for airline tickets since I’d get a private jet instead

• Certain preferences generate Walrasian demand functions with well-behaved in-

come effects.

Example 4 (Quasilinear Utility). Preferences are quasilinear with respect to a commod-

ity ` if adding commodity ` to each of two bundles never changes the preference ordering
of those bundles. That is, whenever y ∼ x, x + αe` ∼ y + αe` for all α > 0 where e` is the
unit vector in direction `. We call ` the numeraire good.

With quasilinear preferences, we generally assume for convenience that there is no

L −1
lower bound on the consumption of x` . That is, X = R × R+ . Quasilinear preferences
can be represented by utility functions of the form

u( x ) = x` + φ( x−` )
 20

where p−` is the vector of prices of goods other than the numeraire `. (See MWG Exercise
3.C.5.) Applying Kuhn-Tucker yields first-order conditions

∗ ∗ ∗
∇φ( x−` ) ≤ λp−` (∇φ( x−` ) − λp−` ) · x−` =0

1 = λp`
∗ 1 ∗ 1 ∗
⇒ ∇φ( x−` )≤ p (∇φ( x−` )− p−` ) · x−` =0
p` −` p`

Notice that the solution x−` ( p, w) does not depend on w! With quasilinear utility, the
consumer basically finds the point on an indifference curve which is tangent to the slope
of the budget line, and then adds or subtracts numeraire until she is spending all her
wealth. That is,

x−` ( p, w) = x−` ( p)

x` ( p, w) = w − x−` ( p)

So the income effect for the numeraire is one, and for non-numeraire goods is zero.

Example 5 (Homothetic Utility). Preferences are homothetic if whenever y ∼ x, αy ∼ αx

for all α > 0. Homothetic preferences can be represented by utility functions which are
homogeneous of degree one: u(αx ) = αu( x ). (See MWG Exercise 3.C.5.)
1
Let y = w x. Then the UMP becomes

max{ui (wy) s.t. p · y ≤ 1},

y ≥0

max{wui (y) s.t. p · y ≤ 1},

y ≥0

w max{ui (y) s.t. p · y ≤ 1},

y ≥0

and so for all w,

x ( p, w) = wy∗ ( p)
 21

where
y∗ ( p) = arg max{ui (y) s.t. p · y ≤ 1}.
y ≥0

Thus, wealth effects depend only on prices, and not on wealth.

1.4.2 Effects of a Price Change

When prices go up, we can separate the effect on demand into two parts:

• The substitution effect due to the change in the slope of the budget line (i.e., the
relative prices of goods).

• The income effect due to the budget line shifting inward.

There are two ways to decompose this effect.

Slutsky Decomposition

The Slutsky substitution effect is the change in demand due to a price change together
with compensation which leaves the consumer just able to afford her original bundle. Graphically:

We can use calculus to consider the Slutsky effect from an infinitesimal price change.
The Slutsky substitution effect on good ` from pk at ( p0 , w) can be written


∂ 
s ` k ( p0 , w ) ≡ x` ( p, p · x ( p0 , w))
∂pk p = p0

the change in demand for good ` for a price change for good k together with a wealth
change which leaves the consumer just able to afford her original bundle.

Applying the chain rule:


∂ ∂ 
s ` k ( p0 , w ) = x` ( p, w) + xk ( p, w) x` ( p, w) .
∂pk ∂w p = p0
 22

So we can write
∂ ∂
s`k ( p, w) = x` ( p, w) + xk ( p, w) x` ( p, w),
∂pk ∂w

or equivalently
∂ ∂
x` ( p, w) = s`k ( p, w) − xk ( p, w) x` ( p, w).
∂pk ∂w

The second term above,

∂
− xk ( p, w) x ( p, w),
∂w `

is the income effect: the effect on demand of having the same old wealth w after the price
change — and thus having the budget line shift inward at x ( p, w) — instead of having a
budget line that still left the consumer able to afford x ( p, w).

Hicks Decomposition

The substitution effect described above is not the only way we can think of a com-
pensated price change. The effect of a price change on Hicksian demand — the Hicks
substitution effect — is also a compensated price change, but instead of giving the con-
sumer enough wealth to buy her previous consumption bundle at the new prices, we’re
giving her enough wealth to reach her previous indifference curve.

In general, this compensation is smaller (since the original bundle might be unafford-
able). So the Hicks substitution effect is larger than the Slutsky effect:

Example 6 (Slutsky vs. Hicks Decomposition).

Slutsky Equation

But the Hicks and Slutsky substitution effects from an infinitesimal price change are
the same. To see this, consider that

h` ( p, ū) = x` ( p, e( p, ū)).
 23

Differentiating both sides with respect to pk :

∂h` ( p, ū) ∂ ∂e( p, ū) ∂x` ( p, e( p, ū))

= x` ( p, e( p, ū)) +
∂pk ∂pk ∂pk ∂w
∂h` ( p, ū) ∂x ( p, e( p, ū)) ∂x ( p, e( p, ū))
= ` + hk ( p, ū) `
∂pk ∂pk ∂w
∂h` ( p, ū) ∂x ( p, e( p, ū)) ∂x ( p, e( p, ū))
= ` + xk ( p, e( p, ū)) `
∂pk ∂pk ∂w

= s`k ( p, e( p, ū))

This is, of course, the same as the Slutsky effect at w = e( p, ū).

The Slutsky equation is not useful merely to show that Hicks and Slutsky effects are
the same for infinitesimal price changes. It also allows us to formulate the derivatives
of Hicksian demand (which are not observable) in terms of the derivatives of Walrasian
demand (which are).

Slutsky Matrix

We can write the Slutsky effects in matrix form as

S( p, w) = D p h( p, v( p, w)) = D p x ( p, w) + x ( p, w) Dw x ( p, w)

We can use the compensated law of demand to understand some properties of this
matrix: Let p0 = p + ∆ for some arbitrary vector ∆. Then the compensated law of demand
becomes

(∆) · (h( p + ∆, ū) − h( p, ū)) ≤ 0

As ∆ → 0 this becomes
∆0 D p h( p, ū)∆ ≤ 0

Does this hold in the limit? Yes.

 24

• From Shephard’s lemma, D p h( p, ū) = D2p e( p, ū)

• Because e( p, ū) is concave, its Hessian matrix D2p e( p, ū) is negative semidefinite, i.e.,
D2p e( p, ū) is symmetric and ∆0 D2p e( p, ū)∆ ≤ 0 for all ∆ ∈ R L .

Implications:

• Own-price substitution effects s`` are zero or negative: when the price of good `
increases, I never buy more of it

• Cross-price substitution effects may be negative (if the two goods are complements)
or positive (if they are substitutes)

Welfare Effects

Suppose we want to measure the change in a consumer’s welfare from a price change
from p to p0 .

• We could just measure the change in utility: v( p0 , w) − v( p, w).

• But utility is an ordinal concept, so doing so has no inherent meaning except for its
sign

• We need a scale. A natural one is in terms of money:

– Since e( p, v( p, w)) is a monotonic transformation of v( p, w), it is itself an indi-

rect utility function

This allows us to compare welfare changes across individuals in a way that answers
two natural questions about the welfare effects of a policy change:

– Is the increase in welfare of the winners enough that they would be willing to
compensate the losers for the policy change to take effect?
 25

– Is the decrease in welfare of the losers enough that the would be willing to
compensate the winners for the policy change not to take effect?

These are, in fact, two different questions

Compensating and Equivalent Variation

• Compensating variation CV answers the first question: how much would I need to
compensate a consumer after a change in prices such that they are equally as well
off as before?

• Equivalent variation answers the second: what is the change in wealth that the con-
sumer would be indifferent about accepting instead of the price change?

• Formally,

CV ( p0 , p0 , w) = e( p0 , v( p0 , w)) − e( p0 , v( p0 , w)) = w − e( p0 , v( p0 , w))

EV ( p0 , p0 , w) = e( p0 , v( p0 , w)) − e( p0 , v( p0 , w)) = e( p0 , v( p0 , w)) − w

• Using Shepard’s lemma and the fundamental theorem of calculus, can write these
as line integrals:

CV ( p0 , p0 , w) = w − e( p0 , v( p0 , w))

= e( p0 , v( p0 , w)) − e( p0 , v( p0 , w))
Z p0
= h(p, v( p0 , w)) · dp
p0

EV ( p0 , p0 , w) = e( p0 , v( p0 , w)) − w

= e( p0 , v( p0 , w)) − e( p0 , v( p0 , w))
Z p0
= h(p, v( p0 , w)) · dp
p0
 26

• When the price change occurs only for one good k, (i.e., p0` = p0` for ` 6= k), can turn
this into an integral over a real interval:

Z p0
0 0 k
CV ( p , p , w) = hk ( pk , p0−k , v( p0 , w))dpk
p0k
Z p0
0 k
0
EV ( p , p , w) = hk ( pk , p0−k , v( p0 , w))dpk
p0k

• So CV is the area under the compensated demand curve at the new utility level
between the old price and the new price

• EV is the area under the compensated demand curve at the old utility level between
the old price and the new price
 27

Chapter 2

Producer Theory

So far, we have focused on the decisions of consumers in demanding goods. Now we

will move to the decisions of firms in producing goods.

Here, instead of asking how consumers use their wealth in order to maximize their
utility, we ask how firms use their technology for turning some goods into others in order
to maximize profits.

More specifically, we consider

• the choices of a firm,

• trying to decide on a production plan (a vector of net outputs) y ∈ R L ),

• to maximize profits p · y,

• subject to the constraint that the production plan is in the feasible production set
Y ⊂ RL .

Generally, we’ll consider production sets described by a transformation function F: Y =

{y| F (y) ≤ 0}. (We can do so whenever Y is closed and satisfies the free disposal prop-
erty: ∀y ∈ Y, if y0 ≤ y, then y0 ∈ Y.)
 28

• What does the transformation function tell us about how one good can be trans-
formed into another? For any y on the transformation frontier (i.e., with F (y) = 0),
the marginal rate of transformation of good ` for good k is given by

∂F (y)/∂y`
MRT`k (y) ≡
∂F (y)/∂yk

• This tells us how much the firm could increase production (or decrease consump-
tion) of good k by decreasing production (or increasing consumption) of good `.

• It is the counterpart to the marginal rate of substitution in the consumer’s problem.

• In a two-commodity world, − MRT12 is the slope of the transformation frontier

In some cases, we can be more specific and divide the set of commodities y ∈ R L
L− M
into outputs q = y M ∈ R+
M and inputs z = − y
L − M ∈ R+ . (Note that z represents the
consumption, not net production, of an input – i.e., if input ` is sprockets and we purchase
5 sprockets as part of our production plan, then we write y` = −5 and z` = 5.)

• When a technology has distinct inputs and a single output, it is commonly described
L −1
via a production function f : R+ → R+ , which for any vector of inputs tells us
the maximum amount of output that can be produced.

• In this case, the transformation function is given by F (y) = f (z) − q

• Thus, the MRT of one input for another still has the same form:

∂ f (z)/∂y`
MRT`k (z) =
∂ f (z)/∂yk
 29

2.1 Profit Maximization

The firm’s profit maximization problem is given by

max p · y s.t. F (y) ≥ 0

y

• Its solution y( p) is called the firm’s (net) supply correspondence

• Its maximized value π ( p) = p · y( p) is called the firm’s profit function

Hmmm... this looks familiar...

• We can write it

min − p · y s.t. F (y) ≥ 0 (2.1)

y

which looks just like the EMP.

• As you’d expect, lots of properties are the same: (MWG Proposition 5.C.1)

– Just as e is HD1 in prices, so is π.

– Just as h is HD0 in prices, so is y.

– Just as e is concave in prices, π is convex (since −π ( p) is the minimized value

of (2.1)).

– Just as ∇ p e( p, ū) = h( p, ū) by Shepard’s lemma, ∇π ( p) = y( p) whenever y is

single-valued by Hotelling’s lemma.

– Just as D2p e( p, ū) = D p h( p, ū) is positive definite, so is D2 π ( p) = Dy( p).

• Assuming prices are positive, we will always want to produce on the transformation
frontier. Thus, when F is differentiable, we can use the method of Lagrange to solve
 30

the PMP, with first-order condition

p = λ∇ F (y)

This implies that

∂F (y( p))/∂y` p
MRT`k (y( p)) = = `
∂F (y( p))/∂yk pk

Just as we set the MRS equal to the price ratio at the optimum in the UMP/EMP, so
too do we set the MRT equal to the price ratio at the optimum in the PMP.

2.2 Cost Minimization

In the single-output case, we might want to know the cheapest way to produce a given
level of output. This is the cost minimization problem:

min w · z s.t. f (z) ≥ q

z ≥0

where w is the input price vector.

• Its solution z(w, q) is called the firm’s conditional factor demand (as opposed to its
factor demand, y L−1 ( p))

• Its minimized value c(w, q) = p · z(w, q) is called the firm’s cost function

This... looks basically the same as the EMP. So again, the properties are similar: (MWG
Proposition 5.C.2)

• Just as e is HD1 in prices, so is c.

• Just as h is HD0 in prices, so is z.

• Just as e is concave in prices, so is c.

 31

• Just as ∇ p e( p, ū) = h( p, ū) by Shepard’s lemma, ∇c(w, q) = z(w, q) whenever z is

single-valued.

• Just as D2p e( p, ū) = D p h( p, ū) is positive definite, so is D2 c(w, q) = Dz(w, q).

Some more properties:

• If f is homogeneous of degree one (i.e., exhibits constant returns to scale) then c and
z are HD1 in q.

• If f is concave, then c is convex in q (i.e., marginal costs are nondecreasing).

If we know the cost function, then we can write the firm’s output decision problem as

max pq − c(w, q)
q ≥0

where p represents the price of output. Obviously the first-order condition here is

∂c(w, q)
p=
∂q

i.e., price equals marginal cost.

32
 33

Chapter 3

Aggregation

So far, we’ve been concerned with individual consumers. But frequently, economists
(especially macroeconomists) are instead interested in the behavior of the market as a
whole. To this end, we ask the following questions:

• When can aggregate demand — the sum of each individual’s demand — be ex-
pressed as a function of prices and aggregate wealth?

• When is aggregate demand well-behaved (i.e., satisfies the weak axiom)?

• What about aggregate supply?

3.1 Aggregate Wealth

Suppose that there are I consumers with Walrasian demand functions xi ( p, wi ) gener-
ated by utility maximization. Then we can write aggregate demand as

I
1 I
x ( p, w , . . . , w ) = ∑ xi ( p, wi )
i =1

When can we write x ( p, w1 , . . . , w I ) = x ( p, w), where w = ∑iI=1 wi ?

 34

• For all p, we must have Dw xi ( p, wi ) = Dw x j ( p, w j ) for each i, j; otherwise, there is

some transfer of wealth from i to j (or vice versa) such that x ( p, w1 , . . . , w I ) changes.

There are two cases we know of where this is true:

• Quasilinear preferences: wealth effects are zero for non-numeraire goods and one
for the numeraire, for all p.

• Identical homothetic preferences: wealth effects are y∗ ( p) for each agent.

Assuming no corner solutions, aggregate demand can be expressed as a function of ag-

gregate wealth if, and only if, each agent i’s preferences admit an indirect utility function
of the form
vi ( p, wi ) = ai ( p) + b( p)wi .

(See MWG Proposition 4.B.1.) This is called the Gorman form.

However, there’s another way we can express aggregate demand as a function of ag-
gregate wealth. If we assume a wealth distribution rule wi (w) with ∑iI=1 wi (w) = w,
then we no longer have to worry about aggregate demand taking the same values for
each wealth distribution of given aggregate wealth:

I
x ( p, w) = ∑ xi ( p, wi (w))
i =1

3.2 Aggregate Demand and the Weak Axiom

Even if individual demands satisfy the weak axiom, aggregate demand may not.
When can we be sure that it will?

• Answer: when individual demand satisfies the uncompensated law of demand:

For all p, p0 , wi , ( p0 − p) · ( xi ( p0 , wi ) − xi ( p, wi )) ≤ 0.
 35

• Can state this property in terms of matrix derivatives: xi satisfies the ULD iff

∆0 D p xi ( p, wi )∆ ≤ 0

for all p, wi >> 0 and all ∆ ∈ R L . In other words, D p xi ( p, wi ) is negative semidefi-

nite.

• If an individual’s demand satisfies the ULD, then it also satisfies the weak axiom.
Further, the ULD aggregates (since the derivative of a sum is a sum of the deriva-
tives).

• So when each individual’s demand satisfies ULD, aggregate demand satisfies the
weak axiom.

• What kind of preferences produce demand functions which satisfy ULD? Homoth-
etic ones (MWG Proposition 4.C.2) and also those which satisfy a condition on the
derivatives of ui (MWG Proposition 4.C.3).