Consumer Theory: Examples and Exercises

HS 12

The CES utility function

u(x1 , x2 ) = x1 + x2

1/

with 0 = < 1.

You can easily verify that this utility function represents preferences that are strictly monotonic and strictly convex. JR, page 25. Have you done so? Did you nd it easy? (Did you spot a problem before embarking on this?)

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Transforming the CES utility function

Consider the utility function x x v(x1 , x2 ) = 1 + 2

This utility function represents the same preference relation as the CES utility function. (Why?) 1 . . . because v(x1 , x2 ) = f (u(x1 , x2 ) with f (u) = u1/

The utility function v(x1 , x2 ) is strictly increasing and strictly concave

How do you show that? . . . which implies that the CES utility function does indeed represent strictly monotonic and strictly concave preferences.

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Solving the Consumer Problem

From the Lagrange conditions the solution to the consumer problem satises x1
1 1 x2

p1 , p2

y = p1 x1 + p2 x2 .
Do we really need Lagrange to do this? How do we know the solution satises (x1 , x2 )

(0, 0)?

Solving these equations and setting r = /( 1) yields the Marshallian demand function(s) x1 (p1 , p2 , y) = x2 (p1 , p2 , y) =
Advanced Economic Theory Consumer Theory: Examples and Exercises

pr1 y 1 pr + pr 1 2 pr1 y 2 . pr + pr 1 2
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Comparative Statics of Marshallian Demand

Taking the derivative with respect to y: pr1 xi (p1 , p2 , y) = r i r >0 y p1 + p2 Calculate the own-price effects and cross-price effects!

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Budget Balance and Homogeneity

Budget balance: p1 x1 (p1 , p2 , y) + p2 x2 (p1 , p2 , y) = Homogeneity: xi (t p1 ,t p2 ,ty) = t r pr1 y (t pi )r1ty = r r i r = xi (p1 , p2 , y). (t p1 )r + (t p2 )r t (p1 + p2 ) pr y pr y 1 + r 2 r = y. pr + pr p1 + p2 1 2

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Indirect utility function

The indirect utility function is given by v(p1 , p2 , y) = u(x1 (p1 , p2 , y), x2 (p1 , p2 , y)) = (pr + pr )1/r y 1 2
Did you check this calculation? If not, observing that (r 1) = r and (1 )/ = 1/r will help

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Roys identity
Indirect utility function: v(p1 , p2 , y) = (pr + pr )1/r y 1 2 Derivative with respect to y: v(p1 , p2 , y) = (pr + pr )1/r 1 2 y Derivative with respect to pi : v(p1 , p2 , y) 1 = (pr + pr )1/r1 rpr1 y 2 i pi r 1 = (pr + pr )1/r1 pr1 y 1 2 i Taking the ratio of the two derivatives: pr1 y v(p1 , p2 , y)/ pi = ri r v(p1 , p2 , y)/ y p1 + p2 = xi (p1 , p2 , y)
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Expenditure minimization and Hicksian demand

Problem to be solved min p1 x1 + p2 x2 s.t. (x1 + x2 )1/ u.
x1 ,x2

From the Lagrange conditions: x1

1

1 x2

p1 , p2
1/

u = x1 + x2

Solving these two equations yields the Hicksian demand functions:

h x1 (p1 , p2 , u) = u (pr + pr )1/r1 pr1 1 2 1 h x2 (p1 , p2 , u) = u (pr + pr )1/r1 pr1 1 2 2
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Expenditure function and Shepards lemma

The expenditure function is
h h e(p1 , p2 , u) = p1 x1 (p1 , p2 , u) + p2 x2 (p1 , p2 , u)

= u (pr + pr )1/r1 pr + u (pr + pr )1/r1 pr 1 2 1 1 2 2 = u (pr + pr )1/r 1 2 Taking the derivative of the expenditure function with respect to pi : e(p1 , p2 , u) 1 = u (pr + pr )1/r1 rpr1 2 i pi r 1 h = xi (p1 , p2 , u).

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Duality relationships

(See Examples 1.4 and 1.5)

h xi (p1 , p2 , y) = xi (p1 , p2 , v(p1 , p2 , y)) h xi (p1 , p2 , u) = xi (p1 , p2 , e(p1 , p2 , u))

e(p1 , p2 , v(p1 , p2 , y)) = y v(p1 , p2 , e(p1 , p2 , u)) = u

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Substitution Terms for Hicksian Demand

Recall
h x1 (p1 , p2 , u) = u (pr + pr )1/r1 pr1 1 2 1 h x2 (p1 , p2 , u) = u (pr + pr )1/r1 pr1 1 2 2

Own-substitution terms (Check this calculation!)

h x1 (p1 , p2 , u) = u(1 r) (pr + pr )1/r2 pr2 pr < 0 1 2 2 1 p1 h x2 (p1 , p2 , u) = u(1 r) (pr + pr )1/r2 pr2 pr < 0 1 2 1 2 p2

Cross-substitution terms (Check this calculation!

h x1 (p1 , p2 , u) = u(1 r) (pr + pr )1/r2 pr1 pr1 > 0 1 2 2 1 p2 h x2 (p1 , p2 , u) = u(1 r) (pr + pr )1/r2 pr1 pr1 > 0 1 2 1 2 p1
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Substitution Terms for Hicksian Demand

Because the cross-substitution terms are identical, the substitution matrix for the Hicksian demand function is symmetric Because the own-substitution terms are negative and pr2 pr 2 1 pr2 pr pr1 pr1 1 2 1 2
2

= 0.

the substitution matrix for the Hicksian demand function is also negative semidenite.

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