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Theory
Consumer Theory.
Partial Equilibrium
General Equilibrium
— future prices
— future income
Theoretical starting-point
Question:
• How does consumption vector depend on prices, income and pref-
erences?
Important:
• understand relation between assumptions and conclusions - not just
conclusions.
Goal of the chapter:
Consumer Choice
Overview
Behavioral Assumption
Preference Relations
• We represent the consumer’s preferences by a binary relation, %,
defined on the consumption set, X.
• If x1 % x2, we say that ”x1 is at least as good as x2”, for this
consumer.
Axiom 1: Completeness
For all x1 and x2 in X, either x1 % x2 or x2 % x1
Axiom 2: Reflexivity
For all x, in X, x % x
Axiom 3: Transitivity
For any x1, x2 and x3 in X, if x1 % x2 and x2 % x3 then x1 % x3.
Definition 1:
The binary relation % on the consumption set X is called a preference
relation if it is complete, reflexive and transitive.
Induced Preference Relations
Definition 2:
• The binary relation  on the consumption set X is defined as fol-
lows:
x1 Â x2 if and only if x1 % x2 and x2 ´ x1.
The relation  is called the strict preference relation induced by
%, or simply the strict preference relation when % is clear. The
phrase x1 Â x2 is read, ”x1 is strictly preferred to x2.”
Definition 3:
• The binary relation ∼ on the consumption set X is defined as fol-
lows:
x1 ∼ x2 if and only if x1 % x2 and x2 % x1.
The relation ∼ is called the indifference relation induced by %, or
simply the indifference relation when % is clear. The phrase x1 ∼ x2
is read, ”x1 is indifferent to x2.”
Sets in X derived from the Preference Relations
Definition 4:
Axiom 4: Continuity
+, the ”at least as good as” set, % (x), and the ”no
• For all x ∈ Rn
better than” set - (x), are closed in Rn
+.
with radius ε.
then x0 Â x1.
Figure 1: Hypothetical preferences satisfying Axioms 1, 2, 3 and 4
Hypothetical preferences satisfying Axioms 1, 2, 3, 4 and 5´
Hypothetical preferences satisfying Axions 1, 2, 3, 4 and 5´
Hypothetical preferences satisfying Axioms 1, 2, 3, 4 and 5
Axiom 6´: Convexity
Definition 5:
A real valued function u: Rn+ → R is called a utility function represent-
ing the preference relation %, if for all x0, x1 ∈ Rn
+,
³ ´ ³ ´
u x ≥ u x1 ⇐⇒
0 x0 % x1.
Note:
• It can be shown that any binary relation that is complete, transi-
tive, and continuous can be represented by a continuous real-valued
utility function.
• Here we will take a detailed look at a slightly less general result.
Representation of Preferences
Theorem 1:
If the binary relation % is complete, transitive, continuous, and strictly
monotonic, there exists a continuous real-valued function, u: Rn +→R
which represents %.
Interpretation:
The result frees us to represent preferences either in terms of the prim-
itive set-theoretic preference relation or in terms of a numerical repre-
sentation, a continuous utility function.
Sketch of Proof:
• Let the relation % be complete, transitive, continuous, and strictly
monotonic. Let e ≡ (1, ..., 1) ∈ Rn + be a vector of ones, and
consider the mapping u: Rn + → R defined so that the following
condition is satisfied:
u (x) e ∼ x (1)
Remaining issues:
• First, does there always exist a number u (x) satisfying (1)?
• Second, is it uniquely determined, so that u (x) is a well-defined
function?
+ → R representing % continuous?
• Third, is the utility function u: Rn
Constructing the mapping
Monotone Transformations
Theorem 2:
Theorem 3:
Let % be represented by u: Rn
+ → R. Then:
1. u (x) is strictly increasing if and only if % is strictly monotonic.
2. u (x) is quasiconcave if and only if % is convex.
3. u (x) is strictly quasiconcave if and only if % is strictly convex.
Differentiable Utility Functions
• marginal utility of good i = ∂u (x) /∂xi
• For the case of two goods, we defined the marginal rate of substi-
tution as the absolute value of the slope of an indifference curve.
• Let x2 = f (x1) be the function describing the indifference curve in
the (x1, x2) plane.
³ ´ ³ ´ ³ ´
• Therefore MRS12 x1, x2 ≡| f´ x1 |= −f´ x11
1 1 0 1 0 (2)
• Suppose ∂u (x) /∂xi > 0 for “almost all” bundels x, and all i =
³ ´
1, ..., n. Then ³ ´ ∂u x1 /∂x
1 1
M RS12 x = ³ ´ .
1
∂u x /∂x2