Beruflich Dokumente
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Contents
Preface
iii
1 Preference
1.1
Preference relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2
2 Utility
2.1
Utility functions
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2
10
2.3
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11
2.4
12
2.5
Continuous utility
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
13
2.6
16
3 Choice
22
3.1
3.2
Revealed preference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
23
3.3
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
24
22
26
4.1
4.2
. . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . .
28
4.3
31
4.4
. . . . . . . . . . . . . . . . . . . . . . . . . .
34
4.5
36
4.6
38
26
40
5.1
Production sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
40
5.2
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
40
5.3
43
5.4
45
5.5
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
46
5.6
47
5.7
Eciency
49
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6 General equilibrium
50
6.1
What is an equilibrium? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
50
6.2
51
6.3
Welfare analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
52
6.4
53
6.5
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
55
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
57
7.1
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
57
7.2
58
7.3
. . . . . . . . . . . . . . . . . . . . .
60
7.4
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
62
8 Risk attitudes
63
8.1
In for a gamble?
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
63
8.2
64
8.3
65
8.4
66
67
9.1
9.2
Allais' paradox
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
67
9.3
Probability matching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
68
9.4
68
10 Time preference
67
70
70
72
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
73
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
75
11 Probabilistic choice
77
77
80
82
11.4 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
84
85
Notation
88
References
89
Suggested solutions
91
ii
Preface
Overview
The purpose of these notes is to introduce you to some mathematical foundations of economic
theory. These are building blocks of economics that hopefully contribute to your understanding of
formal modeling in your other courses and in the research papers you will read and eventually
write.
The typical model of the behavior of an economic agent requires careful answers to the
following questions:
(Q1) What can the agent choose from, i.e., what is the set of feasible alternatives?
(Q2) What does the agent like, i.e., what are the preferences over alternatives?
(Q3) How are the former two combined to make a choice, i.e., to select among alternatives?
Although we make some brief excursions into bounded rationality, the main building block of
traditional economics is rational choice: choose from your set of feasible alternatives a most
preferred one. This raises important related questions:
The fourth question is extremely important: you'd be surprised about how many people simply
skip over the existence issue and write papers about how solutions to economic problems are
aected by parameter changes, without ever wondering whether there even is a solution. The
fth question concerns things like how a consumer's demand is aected by price changes, wage
increases, etc.
Try to keep this in mind, because this is what will occupy us most of the time and constitutes
the red line of the course: regardless of the setting, we rst have to answer (Q1) to (Q3) to provide
a meaningful microfounded model of an economic agent's behavior. Sections 1 to 3 provide a
general framework for modeling preferences over and choice from a feasible set of alternatives.
This general framework is then applied to a number of specic cases: traditional models of
consumer choice (Section 4), producer choice (Section 5), choice over outcomes that are no longer
deterministic, but occur with certain probabilities (Section 7), choice over outcomes occurring
over time (Section 10), and even the modeling of seemingly suboptimal choices (Section 11).
Special features
Every course reects some of the teacher's own preferences. Although the material covered here
is pretty standard for a rst PhD course in microeconomic theory, what distinguishes these notes
from other graduate texts is:
Focus on preferences:
utility functions. Utility functions are practical in the sense that they allow you to use standard
calculus tools, but this tends to blur the picture by making economics into an exercise in advanced
dierentiation. I try to avoid this. Although people make statements like I like coee more than
tea, you hardly ever see them in a supermarket with a calculator and their utility function
written on a piece of paper.
This allows us to give a much more general answer with a remarkably simple proof to
the question when most preferred elements exist; see Proposition 3.1.
Graduate texts
So the question remains, when does a utility function exist? Section 2.4 provides necessary
and sucient conditions.
As an important special case, when does a continous utility function exist? Proposition 2.6
provides a detailed proof. Remarkably, not even Fishburn (1970a), the standard reference
on utility theory, contains such a proof, and neither does any of the standard textbooks in
microeconomic theory.
I don't actually expect you to know the proof, I just wanted to ll a gap and make sure
you have access to it.
Miscellanea:
Some excursions into the realm of bounded rationality, with brief discussions of hyperbolic
discounting (Section 10.2), probabilistic choice (Section 11), and some exotic preferences
(Section 3.3).
Solutions manual:
solutions to all
can treat the worked exercises as a collection of a few dozen (cleverly disguised) examples and
applications.
Recommended reading
The lecture notes are the reading material for the course. You may omit the proof of Propositions
2.5 and 2.6, as well as the more mathematical exercises in Section 10.3. For the interested reader,
the following table refers to related material in Mas-Colell, Whinston, and Greene (1995, MWG),
which is by no means obligatory.
Lecture notes
1. Preference
2. Utility
3.C
3. Choice
1.CD, 2.D
4. Choices of a consumer
2.E, 3.DE, G, I
5. Choices of a producer
5.AC, FG
6. General equilibrium
6.AB
8. Risk attitudes
6.C
9. Some critique
6.B
20.AB
none
Well, almost all exercises, as a couple of them will be used as this year's home assignments...
iv
Terminology
In economics, there is little consensus on terminology.
and Fishburn (1970b), I refer to a complete transitive binary relation that models an economic
agent's preferences as a `weak order'. Other names include `rational preference relation' (MasColell et al., 1995), a very loaded term, simply `preference relation' (Rubinstein, 2006), `complete
preordering' (Debreu, 1959), `complete weak order' (Fishburn, 1979), and `complete ordering'
(Debreu, 1954). The Micro I course and its exam use the denitions from these lecture notes.
1.
Preference
1.1.
Preference relations
Rational choice essentially means choosing from a set of feasible options a most preferred alternative. Let
be a set of alternatives. A
preference relation
x%y
% is a binary
x, y X , read
relation on
A binary relation
is a
weak order
X,
y .
if it satises:
listed.
(b)
%,
Strict preference:
to
x, y X : x % y
if and only if
knows
y.
y ).
Indierence:
xy
if
We sometimes write
y-x
instead of
x%y
and
y%x
x%y
( x and
and
yx
instead of
x y.
Preferences are deterministic: they are not susceptible to a change of mind or mood shocks.
Statements like I like coee more than tea at any time, but today I prefer a cup of tea.
are ruled out.
Preferences are ordinal: the intensity of preferences as in I'm rather fond of the 6
o'clock news, but detest soap operas. plays no role.
a, b, c
as follows:
a 1 b 1 c
and
c 2 a 2 b
and
b 3 c 3 a.
This involves a slight but common abuse of notation: although this was not stated explicitly,
the notation above is taken to suggest, for instance, that also
relation
a b,
a 1 c.
strictly prefers
b.
over
bc
Similarly,
and
c a,
in stimuli unless they exceed a certain threshold. For instance, you will typically not sense the
dierence between a cup of tea with
nN
n+1
you will be indierent between them. If preferences are transitive, you will be indierent between
a cup of tea with 1 grain of sugar, 2 grains of sugar, 3 grains of sugar. . . one kilo of sugar. Are
you? This example is related to the more general issue of similarity: nearby alternatives may be
perceived similar and therefore equally good. But with a long chain of nearby alternatives, you
can create a huge change between alternatives, so that you may no longer be indierent between
them.
Properties of
relation
.
and
;
check
Proposition 1.1
Let
reexivity:
x X : x x.
symmetry:
x, y X :
transitivity:
if
irreexivity:
x y,
x, y, z X :
X.
be a weak order on
x X :
if
not
asymmetry:
x, y X :
transitivity:
x, y, z X :
if
then
xy
y x.
and
y z,
x z.
satises:
x x.
x y,
if
then not
xy
and
x, y, z X :
if
xy
and
y % z,
then
x % z.
(d)
x, y, z X :
if
xy
and
y % z,
then
x z.
Proof. (d):
Let
Exercise 1.2
then
x z.
y % z . By denition of , x y implies x % y .
With y % z and transitivity of %, this implies x % z . It is not true that z % x: if it were, it
would imply with y % z and transitivity of % that y % x, contradicting that x y . Since x % z ,
but not z % x: x z .
1.2.
with
xy
y x.
y z,
(c)
x, y, z X
then
and
L
taken to be R or
RL
+ for some
L N.
is usually
L commodities, in
x = (x1 , . . . , xL ) X is
quantity of commodity k .
The additional structure obtained this way allows us to introduce a number of new properties;
throughout this subsection, assume therefore that
typically illustrated using indierence curves. The
set
{y X : x y}
equals
RL
+
RL .
or
x.
x, y RL
is dened as
v
u L
uX
kx yk = t (x` y` )2 .
`=1
The preference relation
over
satises
yX
with
kx yk <
xX
>0
and each
there is a
y x.
and
Monotonicity properties come in dierent varieties, all reecting the intuition that more is
better.
Let
k {1, . . . , L}
and let
ek RL
denote the
k -th
coordinate equal to one and all other coordinates equal to zero. For
x, y RL ,
xy
if
xi yi
i = 1, . . . , L,
x>y
if
xi > yi
i = 1, . . . , L.
k -th
write
is:
xX
and each
k if increasing this
> 0 : x + ek x.
strongly monotonic if an increase in at least one coordinate gives better alternatives: for all
x, y X ,
if
xy
and
x 6= y ,
then
x y.
is transitive.
Exercise 1.3
(a) Prove the previous two sentences.
R2+
k=1
and
X = RL
+
k = 2,
%,
imply that
both
x 6= y
k,
x y.
xy
and
X = RL .
Each of the three monotonicity properties implies local nonsatiation. On the other hand, local
nonsatiation has no implications for monotonicity: the preference relation
on
R2+
with
x2
3
2
1
0
x1
0
Figure 1:
origin and shows that small increases in one or both of the coordinates may lead into areas
with strictly worse alternatives.
Figure 2 summarizes the relations between the three monotonicity relations and local nonsatiation. An arrow from strong monotonicity to monotonicity means that the former implies the
latter; the absence of an arrow in the opposite direction means that the converse is not true.
strongly monotonic
monotonic
@
@
@
@
R
@
?
locally nonsatiated
Figure 2:
A preference relation
is
continuous
y
RL
or
RL
+.
y X , the set {x X : x % y} of
{x X : x - y} of alternatives weakly worse than
if for every
Proposition 1.2
(a)
Let
be a weak order on
y X,
X.
the sets
{x X : x % y}
and
{x X : x - y}
closed.
(b) For every
(c) The graph
y X,
the sets
{x X : x y}
{(x, y) X X : x % y}
of
and
{x X : x y}
is closed.
are open.
are
(xn )nN
x % y.
n N,
then also
x, y X ,
containing x) and
Proof.
and
(yn )nN
in
X,
if
x n x , yn y ,
and
xn % yn
x y,
for all
Ux
Statements (a) and (b) are equivalent, since the complement of an open set is closed,
and vice versa. Also the equivalence of (c) and (d) is a matter of denition:
an element of the graph of
if and only if
xn % yn .
(xn , yn ) X X
is
the circle and make sure that all ve statements are equivalent:
Case 1:
There is an
Assume (e) holds. To establish (c), we need to show that the complement of
{(x, y) X X : x % y}
is open. By completeness of
%,
S = {(x, y) X X : x y}.
(x, y) S , x, using (e),
0
x Ux , y 0 Uy . Conclude that
For each
neighborhoods
(x, y) S :
Taking the union over all
(x, y) S ,
Ux
of
and
Uy
of
such that
x0 y 0
for all
(x, y) Ux Uy S.
one obtains
S = (x,y)S Ux Uy .
As the union of open sets,
is
The following proof is more general, but requires some knowledge of topology. In case of emergency, don't
worry. Simply forget that this footnote even exists!
[(c) implies (b)]: Assume (c) holds, i.e., the set S dened above is open. Let y X . We show that
L(y) = {x X : x y} is open; establishing that also the set {x X : x y} is open is analogous.
Let x L(y). Then (x, y) S. Since S is open in the product topology generated by Cartesian products of
open sets in X , we can x neighborhoods U of x and U of y such that U U S. In particular, for each
x U , it follows that (x , y) U U , so x y . Conclude that
2
x L(y) :
x Ux L(y).
L(y) = xL(y) Ux .
Let
be a sequence in
Very roughly speaking, continuity of preferences requires that the strict preference relation is
unaected by small changes in the alternatives: if
is better than
y,
alternatives.
X.
and
X = RL
+.
y:
v
u L
uX
kx yk = t (x` y` )2 .
`=1
A subset
xX
Y X
is
open if each y Y
suciently close to
there is an
lie in
>0
is an interior point of
Y,
y Y,
all points
as well:
xX
with
kx yk < :
Many people overlook a slight subtlety, namely the statement . . . for all
looks innocuous: if you want to dene whether a subset of
X.
X = R2+
xY.
x X. . .
(1)
in (1). This
Y 1 = R2+ ,
X = R2
sets like
X = RL
+ is endowed
L
with the
that it inherits from the larger set R : a set Y X is open if and
L
only if Y = X O , where O is an open set in the larger space R . This provides quick proofs
1
2
3
2
that the sets Y , Y , Y are open subsets of X = R+ :
are open. You might want to draw their pictures. In topological language,
relative topology
Y 1 = X R2 ,
Y 2 = X {y R2 : y1 < 1},
R2 ,
are open in
{y R2 : y1 < 1},
{y R2 : y1 + 2y2 < 4}
R2 .
The next two properties are related to other changes, namely shifts in or rescaling of the coordinates. The preference relation
is:
quasilinear in coordinate k if, for all x, y X and all > 0, x % y implies that
x + ek % y + ek :
homothetic if rescaling the coordinates does not aect the preferences: for all x, y
X
and all
> 0,
if
x % y,
then
x % y .
Of course, this requires knowing which subsets of X are open. In general as you will recall from the math
course this requires X to be a topological space, i.e., it comes equipped with a denition of open sets, subject
to three restrictions: (1) the empty set and X are open, (2) unions of open sets are open, (3) intersections of
nitely many open sets are open.
3
For instance, any preference relation where only the dierence between the rst coordinates
matters, like
or money and the economic idea is that not the exact amounts of money associated with
two alternatives matter, but the dierence between them.
and
denote vectors of
be weakly preferable to
y.
Then also
any preference relation dened in terms of a homogeneous function is homothetic. Recall that
f : RL
+ R is homogeneous of degree
k
f (x). Suppose that x % y if and only if
a function
f (x) =
k R if for each x RL
+ and each > 0:
f (x) f (y). Then % is homothetic:
f (x1 , x2 ) = min{x1 , x2 }
and
f (x1 , x2 ) = x1 x32
generate homoth-
etic preferences.
Exercise 1.4
on
R2+
that satises:
Exercise 1.5
(a) Prove: if
is continuous, then
X = RL
+
xy
x > y.
on
with
if
x%y
if
x y.
Your favorite drink requires mixing its two ingredients in the same
amount: if
drink, but also feel it is unfortunate to waste ingredients, the following weak order
reect your preferences: for all
x
x
x, y
R2+ ,
x%y
drink, whereas
the amount of
on
R2+
may
if and only if
but
Show that
xy
whenever
A preference relation
is
x > y,
convex
if for each
y X,
x%y
the set
if
x y.
{x X : x % y}
of weakly better
alternatives is convex.
Proposition 1.3
with
x%y
and all
Exercise 1.6
(a) Prove this proposition.
% is strictly convex
x + (1 )y y .
x 6= y
and
x%y
and all
(0, 1),
it holds that
if for all
x, y X
This property implies that if you are indierent between two distinct alternatives
1
you can still improve upon them: by strict convexity, the alternative x
2
with
x, y X ,
1
2 y is strictly better.
2.
Utility
2.1.
Utility functions
In many cases, preferences over alternatives can be evaluated by some numerical assessment: I
prefer the alternative with the higher percentage of alcohol or I prefer the alternative yielding
the higher prot. In that case, we say that these functions in the latter case the function
assigning to each alternative its associated prot represent the decision maker's preferences.
Formally, a function
u:XR
is a
(2)
%.
relation
Proposition 2.1
Let
and let
u:X R
be a
represents
%;
x, y X :
if
if
x y,
x y,
then
then
Proof. (a) (b): Assume (a) holds. Let x, y X . If x y , by denition of : x % y and not
y % x. Hence, by denition of a utility function, u(x) u(y) and not u(y) u(x). Conclude
that u(x) > u(y). Similarly, if x y , u(x) = u(y).
(b) (a): Assume (b) holds. Let x, y X . To show:
x % y u(x) u(y).
One direction is easy: if
Hence
x % y , then x y
Suppose
Exercise 2.1
The completeness condition in Proposition 2.1 cannot be omitted. Indeed, consider the
preference relation
on
with
x, y R :
and the function
(a)
(b)
u:RR
with
u(x) = x
for all
x%y xy+1
x R.
Show that:
if preferences
are represented by a prot function, then also twice the prot or prot to the power three
represent the same preference relation. In general:
Proposition 2.2
function
Proof.
u : X R represents % and f : R R
v : X R dened by v(x) = f (u(x)) represents %.
If
x, y X :
represents
Since the
%.
ordering of the real numbers is complete and transitive, a preference relation that
can be represented by a utility function is necessarily complete and transitive: it must be a weak
order. But is being a weak order enough to guarantee the existence of a utility function? The
answer is positive for nite or countable sets.
2.2.
Representing a weak order on a nite set by means of a utility function is easy: the more preferred
an alternative
xX
Proposition 2.3
Therefore, counting
Assume:
is nite,
is a weak order on
X.
Proof.
x.
%.
{z X : x % z} = {z X : y % z}.
Hence
u(x) = u(y).
If
x y,
let
So
(3)
{z X : x % z} {z X : y % z}.
Hence
If
(4)
is countable, simply counting the number of weakly worse alternatives does not work: there
may be innitely many of them. But we can give each element a positive weight, make sure that
the weights have a well-dened sum even if we add innitely many of them, and use the total
weight of the elements weakly worse than
X = {x1 , x2 , . . .}
2 ) to
the remainder (weight 2
Proposition 2.4
Assume:
is countable;
is a weak order on
x.
21 )
X.
%.
10
x1 ,
x3 ,
then half of
and so on.
Proof.
Since
u(x) =
n : X N.
For each
x X,
dene
2n(z) .
zX:x%z
P
(2n )nN has a nite sum nN 2n = 1, so u is well-dened. To see that u
represents %, let x, y X . If x y , (3) holds, so u(x) = u(y). If x y , (4) holds, so
u(x) u(y) 2n(x) > 0.
The sequence
2.3.
Not all preference relations not even weak orders can be represented by means of a utility
function. Graduate textbooks usually give exactly one example (lexicographic preferences), as if
it concerns an exotic phenomenon. This section gives some counterweight by providing several
economically relevant examples, all arising from the following general principle.
Fix a set of alternatives
countable set
I R,
X.
g(z) b(z).
z < z0,
0
with z :
Secondly, if
associated
(5)
z, z 0 I :
(6)
Combining (5) and (6), representing such preferences by a utility function requires, for
z < z0:
length must somehow be placed on the real line without any two of them intersecting.
This
Lexicographic preferences.
or
X = R2 .
(x1 = y1
Dene
and
as follows:
x2 y2 ) .
Alternatives are compared according to their rst coordinates; if these happen to be equal, they
are compared according to their second coordinates.
a dictionary.
z R, let b(z) = (z, 0) and g(z) = (z, 1). Then g(z) b(z) and, if
g(z) = (z, 1) (z 0 , 0) = b(z 0 ). So (5) and (6) hold: this preference relation
For each
z, z 0 R, z < z 0 ,
then
11
zR
be a certain threshold.
if
x < z,
[z, ).
lies in
with
R.
x = z:
all numbers
xz
can be perfectly distinguished, but larger ones not. Assume it is preferable to have more precise
information, i.e., ner information partitions (partition
from
Also if
z < z0,
partition
b(z 0 )
Q).
Partition
g(z)
g(z),
so
b(z 0 ) g(z).
b(z),
Q
so
if every set
g(z) b(z).
Similarly, alternative
g(z)
g(z)(t) =
By the monotonicity requirement,
g(z) b(z)
1
0
if
t z,
otherwise.
and if
2.4.
We saw above that preference relations where there are uncountably many disjoint intervals between bad and good alternatives cannot be represented by means of a utility function. On the
other hand, complete and transitive preferences on a countable set do have a utility representation. Is there something in between these two cases that allows uncountably many alternatives,
but still has enough of a countable character that it allows a utility representation?
Let
X
x, y X :
CX
x y,
is
X.
The pair
Jaray order-separable
c1 , c2 C
s.t.
(X, %)
or, with
if there is a countable
x % c1 c2 % y.
x, y X
whereas y
The condition roughly says that countably many alternatives suce to keep all pairs
with
x y
apart:
c1
and
c2 ,
lies on the other. This condition is both necessary and sucient for the existence of a utility
representation:
12
Proposition 2.5
Let
X.
if and only if
Exercise 2.2
This exercise guides you through the steps of the proof. Assume that
is Jaray order-separable.
of
u.
represents
%.
Let
elements of
U : (u1 , u2 ) U = .
contains at most countably many jumps. (Suppose not. Use the idea behind (5) and
(u1 , u2 ), x a point x(u1 , u2 ) with utility u1 and a point y(u1 , u2 ) with utility u2 . Let
J = {x(u1 , u2 ), y(u1 , u2 )} be the union (over all jumps (u1 , u2 )) of these points. By (a), J is countable.
Next, for each pair of rational numbers r1 , r2 Q with r1 < r2 and (r1 , r2 ) U 6= , x an element
x(r1 , r2 ) X with utility in (r1 , r2 ) U . Let R be the union of all such points x(r1 , r2 ). Since there are
only countably many pairs (r1 , r2 ) as above, R is countable. Let C = J R.
For each jump
makes
X is
2n(c) .
Conversely, assume
u(x) =
cC:c-x
Jaray order-separable.
represents
%.
X,
simply let
C=X
C.
n:CN
Let
to show that
be injective. Dene
by
preferences over uncountable sets, additional restrictions are required. We will see in Proposition
2.8, for instance, that on
2.5.
RL
+,
Continuous utility
Economists usually work with continuous utility functions. Establishing existence of a continuous
utility function is troublesome: not even Fishburn (1970a), the standard reference in the eld,
bothers to give the proof. A well-known continuity result is often wrongly attributed to Debreu
(1954). However, his proof is awed (Debreu, 1964) and a more general continuity result was
already known from much older research on order types in the classical theory of sets, due to
Georg Cantor. See, for instance, Kamke (1950). The proof of Proposition 2.6 is not obligatory
reading; it follows Jaray (1975).
Proposition 2.6
Assume:
X;
is a weak order on
is Jaray order-separable;
X is endowed with
{x X : x y} are
y X,
Let
C X
make
and
%.
C if
c, c0 C
c c0 or c0 c.
[Dene utility on C :] Since C is countable, label C = {c1 , c2 , . . .}. Since the set Q = (0, 1) Q
of rationals in (0, 1) is countable, label Q = {q1 , q2 , . . .}. Dene a utility function f : C Q
by induction: f (c1 ) := q1 . Let n N, n 2, and assume f was dened on {c1 , . . . , cn1 }. To
with
c 6= c0 ,
{x X : x y}
is continuous.
Proof.
the sets
either
13
q` Q
with smallest
k {1, . . . , n 1} :
A useful implication: let
a, b C
with
a b.
q` > f (ck ) cn ck .
If the set of points in
(7)
between
and
b,
(a, b) = {c C : a c b},
cm . By construction, cm is the rst element
(a, b) to be assigned its value by f and therefore its image f (cm ) is the rst element in
(f (a), f (b)) Q.
[Extend utility to X :] For each x X , dene u(x) = sup {f (c) : c C, c - x}. The set over
which the supremum is taken is nonempty (it contains x) and bounded from above (by 1), so
this supremum exists. Moreover, u represents %. Let x, y X . If x y , the supremum is taken
over the same set, so u(x) = u(y). If x y , there exist, by Jaray order-separability, elements
a, b C with x % a b % y , so that u(x) f (a) > f (b) u(y).
[Establish continuity of utility:] The usual topology on R is generated by the intervals
(, r) and (r, ), with r rational. Therefore, it suces to prove that u1 ((, r)) and
u1 ((r, )) are open for all r Q. Let's do the former; the latter is similar.
1 ((, r)) equals (i) if r inf f (C), (ii) X if r > sup f (C) or if r = sup f (C) and
Now u
r
/ f (C), (iii) {x X : x f 1 (r)} if r f (C). By assumption, all these sets are open.
The only remaining case is when r
/ f (C) and inf f (C) < r < sup f (C). We show that r
belongs to a jump of f (C). Recall from Exercise 2.2 that a jump in f (C) is a pair of points
(f1 , f2 ) f (C) f (C) with f1 < f2 and (f1 , f2 ) f (C) = .
Suppose not. Since inf f (C) < r < sup f (C), there exist a, b C with f (a) < r < f (b). Let
m N be the maximum of the indices of f (a), r, f (b) Q. Then {q1 , . . . , qm } contains r and
0
0
elements p, p f (C) with p < r < p . Let n N be the smallest index for which {q1 , . . . , qn }
(r, p2 ) {q1 , . . . , qn } = .
so
(p1 , r) {q1 , . . . , qn } = ,
and b2 is nonempty. Let b be its rst element. By the implication following (7), its image f (b )
must be the rst element of (p1 , p2 ), which was r . But r
/ f (C), a contradiction.
1 ((, r)) = {x X : x
This shows that r belong to a jump (f1 , f2 ) of f (C). But then u
1
f (f2 )}, which is open by assumption.
So
RL
+
can be represented by a
continuous utility function. We rst establish an auxiliary result that is of interest in its own
right whenever we want to nd alternatives in between two others.
Caveat: `rst element' is dened in terms of the chosen enumerations of C and Q. This allows us to speak,
for instance, of the rst element in (0, 1), which makes absolutely no sense if one mistakenly were to believe
it was dened in terms of the usual order on R.
4
14
Proposition 2.7
X = RL
+
is a connected subset of
for some
L N;
X;
X.
xX
(b) If
y, y 0 Y
Proof. (a):
element of
and
y, y 0 Y
then there is a
Y,
y0,
the latter
y.
As
y 00 Y
then there is a
y 00 Y
with
with
x y 00 .
y y 00 y 0 .
x. That is, each
B = {z X : z x}.
connected set
and
y y0,
y % x % y0,
(b):
A = {z X : z x} and
B are open by continuity,
and
a contradiction.
B = {z X : z y 0 }.
Y,
y0,
the latter
y.
As
and
a contradiction.
A = {z X : y z}
B are open by conti
X , as in
:
x
=
= xL }
{x RL
1
+
Proposition 2.8
X = RL
+
Assume:
for some
L N;
X.
Proof.
C = QL
+ makes X Jaray
is a z X with x z y .
%.
order-separable: let
x, y X
with
x y.
{a X : x a z} = {a X : x a} {a X : a z}
is the intersection of two open sets, hence open itself. It is nonempty by Proposition 2.7. The
set
is dense in
there is a
Below we present a special case of Proposition 2.8 with a particularly simple proof.
Proposition 2.9
X=
Assume:
L
R+ for some L
N;
X.
15
%.
x X.
Choose
max{x1 , . . . , xL }.
By monotonicity,
e % x % 0e.
By Proposition
{x RL
+ : x1 = = xL },
being connected, contains an element equivalent to
follows from monotonicity: increasing
Step 2:
x:
there is an
x 0
with
x x e .
Unicity
is open. Now
u1 ((, )) = {x X : x e} {x X : x e}
x x e,
Corollary 2.10
%
so
u(x) = x = u(x).
x x e
and
This proves:
%.
The next exercise studies the connection between continuous preferences and continuous utility.
The fact that statement (a) in that exercise is true, is useful: you will have relatively little trouble
recognizing continuous functions, and continuous utility implies continuous preferences !
Exercise 2.3
% on topological space X
u : X R.
(b) If
2.6.
is continuous, then
is continuous, then
is continuous.
is continuous.
Recall that if a preference relation over commodity bundles is quasilinear in some coordinate, this
coordinate is often referred to by economists as `money' or a `numeraire'. Under mild additional
assumptions, such quasilinear preferences can be represented by means of a utility function of
the form `money plus whatever utility I get from the other commodities'.
Proposition 2.11
Assume:
L
R+ for some L N;
X=
is a weak order on
X;
x (y1 + v, y2 , . . . , yL ).
16
x % (0, . . . , 0)
x, y X :
if
for every
x % y,
x X;
there is a
v0
Proof.
Let
x X.
u(x) = x1 + v(x2 , . . . , xL )
representing
%.
By assumption:
v(x2 , . . . , xL ) 0
s.t.
x1 0
to
u:XR
u(x) = x1 + v(x2 , . . . , xL )
with
represents
%:
The proof establishes that each alternative is equivalent with receiving a suciently large amount
of just the rst commodity: utility can be measured in units of commodity 1. This explains the
frequent use of quasilinear preferences: only if they are measured on the same scale can one do
meaningful comparisons between, say, your utility and mine.
Exercise 2.4
x, y X :
if
x % y,
there is a
v0
s.t.
x y + ve1
(8)
Exercise 2.5
(a) Let
a, a0 A.
a, a0 A and m, m0 , w, w0 R+
m m0 = w w 0 .
(b) Let
a A.
v(a) = m m,
Such
m, m
satisfy
(a, m) (a0 , m0 )
m, m
m, m0 R
v:AR
such that
and
(a, m) (a0 , m0 ).
(a, w) (a0 , w0 ).
a A:
(a , m ) (a, m).
17
Show that
m, m
by (b), so
u:XR
with
u(a, m) = v(a) + m
%.
Also convexity and strict convexity of preferences have implications for the form of the utility
function. Recall that a real-valued function
on a convex domain
(Why convex?) is
Proposition 2.12
X = RL
+
u:XR
Then
Assume:
for some
L N;
is quasiconcave. If
Proof.
X;
%.
%
is strictly convex,
Let
u(x) u(y),
is strictly quasiconcave.
%: x + (1 )y % y ,
x % y.
Then
so
Exercise 2.6
r R,
X,
u : X R
is (strictly) convex.
Next, we provide conditions for a weak order to be representable by a linear utility function.
Although we go into more detail, the proof follows Diecidue and Wakker (2002). A convenient
mathematical tool is treated in the following exercise.
Exercise 2.7
Cauchy's functional equation: On two domains, we show that, under mild assump-
f :RR
be additive:
x.
f (x + y) = f (x) + f (y)
for all
x, y R.
x N,
then for
Setting
Q.
u = 1
and
c = f (1),
it follows that
f (x) = cx
x,
i.e.,
Approximating real numbers by rational ones and taking limits, it follows that
functions
f :RR
18
continuous additive
(b) Suppose
is
not linear on
R.
{(x, y) R2 | y = f (x)}
is dense.
include continuity in a single point, boundedness/sign restrictions on small intervals, monotonicity, etc.
We now extend the domain to
F (x) + F (y)
for all
x, y R
n-dimensional
F : Rn R
be additive:
F (x + y) =
(c) Reduce this to the previously solved case by showing that there exist additive functions
for
i = 1, . . . , n
fi : R R
With this tool in our baggage, we can prove the linear representation result:
Proposition 2.13
Assume:
L
R for some L N;
X=
% is a weak order on X ;
% is strongly monotonic;
% is additive: for all x, y, z X , if x % y , then x + z % y + z ;
For each x X there is a constant R such that x (1, . . . , 1).
Then there are 1 , . . . , L R++ such that the function u : X R with u(x) = 1 x1 + +L xL
represents %.
Proof.
x X,
a number
So the function
%.
u is additive. Let x, y X . Using additivity of % twice (for % and -), x u(x)e
implies that x + y u(x)e + y . Similarly, y u(y)e implies that u(x)e + y u(x)e + u(y)e =
(u(x) + u(y))e. By transitivity, x + y (u(x) + u(y))e. Hence u(x + y) = u(x) + u(y).
L
As u : R R satises Cauchy's functional equation, Exercise 2.7 implies that there are
PL
additive functions ui : R R (i = 1, . . . , L) with u(x) =
i=1 ui (xi ). By strong monotonicity,
each ui is strictly increasing: its graph cannot be dense. Hence, each ui is linear: there are
P
1 , . . . , L R such that u(x) = L
i=1 i xi . The constants 1 , . . . , L are positive by strict
monotonicity.
represents preferences
Moreover,
Most assumptions are familiar. Strong monotonicity assures that all the
milder monotonicity requirements, one can only assure that some of them are.
If you don't
like the nal assumption, recall from Proposition 2.9 that it can be replaced by continuity.
Additivity of preferences is obviously the key assumption. It essentially states that in evaluating
two alternatives
x, y X ,
xy
matters:
translations.
With later applications in mind (see Proposition 2.14), there is no nonnegativity assumption
on the vectors over which preferences were dened:
X = RL ,
not
RL
+.
vous, notice that the proof hinges on the linearity of the function satisfying Cauchy's functional
equation. Fortunately, linearity can be derived even if additivity holds only on the nonnegative
orthant.
The remainder of this section is based on Voorneveld (2008), which contains more general
results. Due to its analytical tractability, the
u : RL
+ R
with
L
Y
i=1
19
xai i
(L N, a1 , . . . , aL > 0)
which? .
Cobb and Douglas (1928), who used it in the context of production theory. What properties of
an agent's preferences assure that they can be represented by a Cobb-Douglas utility function?
Part of the trick is in exploiting the fact that this function also goes under the name of
L
X
ai ln xi
i=1
L
X
ai ln yi .
i=1
This reduces preferences to a linear utility function in the logarithm of the variables, allowing us
to exploit Proposition 2.13. Of course, this trick goes only part of the way, as one cannot take
logarithms on the boundary of
Proposition 2.14
X = RL
+
is a weak order on
is strongly monotonic;
for some
L N;
X;
if
x % y,
For each
Then
Assume:
RL
+,
Proof.
then
xX
there is a constant
R+
such that
x (1, . . . , 1).
function on
RL
++ .
RL
+.
L
f : RL RL
++ for each x R by f (x) = (exp x1 , . . . , exp xL ).
1
L
L
1
Notice that f and its inverse f
: R++ R with f (y) = (ln y1 , . . . , ln yL ) are continuous.
L
L
Given the weak order % on R++ , dene a weak order %f on R as follows:
Dene
x, y RL :
x %f y
f (x) % f (y).
(9)
%f :
x f (1, . . . , 1).
x, y, t RL
++ :
Hence, by denition (9),
x%y
x RL ,
a scalar
such that
(t1 x1 , . . . , tL xL ) % (t1 y1 , . . . , tL yL ).
(ln x1 , . . . , ln xL ) %f (ln y1 , . . . , ln yL )
implies that
%f is additive.
RL satises all assumptions of Proposition 2.13: there are a1 , . . . , aL > 0
PL
L
represented by the utility function x 7
i=1 ai xi . By (9), for all x, y R++ :
Conclude that
such that
%f
x%y
is
%f
on
(ln x1 , . . . , ln xL ) %f (ln y1 , . . . , ln yL )
L
X
i=1
20
ai ln xi
L
X
i=1
ai ln yi .
Taking exponentials,
QL
ai
n
i=1 xi on R++ .
L
on the entire domain R+ , we must establish
with
u(x) =
to zero:
As
all
x x + (1/n)e n e
for
21
3.
Choice
3.1.
Hitherto, we discussed how microeconomists usually model what economic agents want .
The
obvious next step is to consider what they actually do . The rationality paradigm underlying the
classical microeconomic theory requires that given (1) a set of mutually exclusive alternatives
and (2) a nicely behaved preference relation/utility function over the alternatives, the agent will
choose a most preferred alternative. This sounds pretty obvious, but an abundance of economic
terminology sometimes blurs the picture: most of traditional microeconomics is plain and simple
constrained optimization.
This begs the question: when do most preferred alternatives exist? This is not straightforward: if you have strongly monotonic preferences over apples and face no consumption constraints
whatsoever, there is no optimal amount of apples. Here is a very general existence result:
Proposition 3.1
Assume:
X;
x X,
L(x) = {y X | y x}
is open;
Then
X.
y Y :
Proof.
{L(y) : y Y }
y Y
y % y
there is a
for all
y0 Y
y Y.
with
y0 y.
it contains a most preferred element y . But then L(y ) covers Y , i.e., y is a best element of Y ,
contradicting our assumption.
sets
Let
on
X = RL
+.
vector is
p RL
++ .
The
budget set
B(p, w) = {x RL
+ | p x w}.
This set is:
0 xi w/pi
i,
22
(10)
: a x c}
or {x R
, where a R ,
: a x c}
theorem,
B(p, w)
order, the budget set contains at least one most preferred alternative.
Exercise 3.1
R2 :
over
(x1 = y1
x2 y2 ) .
and
upper semicontinuous?
3.2.
or
Y R2
Revealed preference
Rather than going from preferences to choices, this subsection, based on Arrow (1959), tries
to move in the opposite direction: can we under suitable assumptions explain observed
choices by constructing a preference relation that makes such choices rational?
Formally, a
is a nonempty subset
B X,
B .'
B B :
C(B) = {x B | x % y
for all
y B}.
(11)
(X, B, C)
satises WARP if
A, B B, x, y A B :
if
x C(A), y C(B),
and
then
B,
x C(B).
alternatives
and
are
available. If
Similarly, if
equivalent
A, B B :
if
AB
and
C(B) A 6= ,
A.
If
C(A) = C(B) A.
then
B,
23
B.
Proposition 3.2
(X, B, C).
(X, B, C)
Proof. (a):
a, b A B,
a
C(A),
b
C(B).
b C(B) A.
B,
then
is rationalizable.
To show:
and
a C(B), b C(A).
x, y X , the set {x, y} lies in B by the assumption on B . Hence, we may dene
x % y if x C({x, y}). We need to check three things:
[% is complete:] Let x, y X . By nonemptiness, either x C({x, y}) or y C({x, y}), i.e.,
x % y or y % x.
[% is transitive:] Let x, y, z X and assume that x % y and y % z . By denition of %:
x C({x, y}) and y C({y, z}). To show: x % z , i.e., x C({x, z}).
If x = y or y = z , this follows immediately. If x = z , then x % z is the same as x % x, which
follows from completeness. So let x, y, z be distinct and consider the set {x, y, z} B . It suces
to show that x C({x, y, z}), because then x C({x, z}) by IIA.
Suppose, to the contrary, that x
/ C({x, y, z}). By nonemptiness of C , C({x, y, z}){y, z} =
6
. By IIA and y % z : y C({y, z}) = C({x, y, z}) {y, z}. So C({x, y, z}) {x, y} 6= .
By IIA and x % y : x C({x, y}) = C({x, y, z}) {x, y}, contradicting the assumption that
x
/ C({x, y, z}).
[% rationalizes (X, B, C):] To show that (11) holds, let B B.
Firstly, let z C(B). To show: z % y for all y B . So let y B . Then {y, z} B, {y, z}
B , and z C(B) {y, z} =
6 . By IIA, z C({y, z}). So z % y .
Secondly, let z B satisfy z % y for all y B . To show: z C(B). By nonemptiness, there
is a y C(B). Then {y, z} B, {y, z} B , and y C(B) {y, z} =
6 . By z % y and IIA:
z C({y, z}) = C(B) {y, z}, so z C(B).
By WARP,
(b):
For all
Exercise 3.3 investigates the other relations between rationalizability, WARP, and IIA.
3.3.
Exercises
Exercise 3.2
function
f :XR
Exercise 3.3
(a) Show that if
(X, B, C)
24
Exercise 3.4
X.
Let
X = {1, 2, . . . , n}
for some
C,
n N, n 3,
and let
rationalizing it.
choose the rst satisfactory one. If no such element exists, choose the nal (i.e., largest) element
of
B.
% on X in which no two distinct elements
B B with two/more elements, you politely abstain from
C(B) = {x B | y B : y x}.
Exercise 3.5
A taste for precious metals: A consumer faces two luxury goods, the rst is gold,
the second platinum, and spends the entire wealth on the good with the highest price.
If prices are
equal, half of the wealth is spent on each good. To investigate the rationality of such behavior, consider
a choice structure
(X, B, C),
C(B2 )
where
B1
and
B2
C(B1 )
sets:
and
(X, B, C)
satisfy IIA?
(X, B, C)
satisfy WARP?
(X, B, C)
rationalizable?
p denoted u(x, p)
(p, w) R3++ .
vector
25
4.
4.1.
Section 3.1 set the stage for the classical model of consumer behavior.
of a specication of:
he can choose from; (iii) what the consumer putting these two together nds the most
preferable commodity bundles. Formally:
there are
L N
commodity space is
a price vector
X = RL
+;
p RL
++
i {1, . . . , L}
w > 0,
a price
pi > 0;
on
u : X R
B(p, w) = {x RL
+ : p x w}
species the commodity bundles the consumer can aord. At this stage, it would be a good idea
to look back at Section 3.1 to recapitulate some properties of this budget set.
solves the following
%-MP:
budget set
B(p, w).
u,
UMP:
Solve
max u(x)
s.t.
The consumer
in the
x B(p, w).
It is common economic practice to assign special names to the set of solutions and in case
a utility function is given the corresponding optimal value of such optimization problems.
The
(Walrasian) demand correspondence assigns to each price vector p RL++ and wealth
w>0
x(p, w)
x(p, w) = {x B(p, w) : x % y
for all
= {x B(p, w) : u(x) =
y B(p, w)}
max u(y)}.
yB(p,w)
u,
RL
++ and wealth
the
w>0
v : RL+1
++ R
is easy:
v(p, w) = u(x ),
where
choice of x
x(p, w):
x x(p, w),
(p, w).
since all such vectors are utility maximizers, their utility is the same.
26
Remark 4.1
u is a C 1 -function
containing X ), the UMP
max u(x)
s.t.
p x w,
x1 0,
.
.
.
xL 0,
/
Remark 4.2
(p, w)
x(p, w)
consists
RL+1
++ , it is common to treat demand as a function, rather
/
than a correspondence.
Let us conclude this subsection with an example involving a well-known type of utility function.
Leontiev utility:
(a1 , . . . , aL )
L 2 ingredients:
x RL
+,
RL
++ of ingredients. Given ingredient vector
how much cake can you produce? Well, looking at the i-th ingredient, your guess will be at most
xi /ai
units.
x.
(12)
Exercise 4.1
Check that the associated preference relation is continuous, monotonic (but not strongly),
(p, w) RL+1
++ .
B(p, w) nonempty and compact, there is at least one solution to the UMP
x(p, w) 6= . Let's compute it. Firstly, if x solves the UMP, it must be that
x1 /a1 = = xL /aL .
(13)
Then you're using the ingredients in the wrong proportions: you can only make u(x ) =
min{x1 /a1 , . . . , xL /aL } units of cake, but there are commodities i where you have enough for
xi /ai = max{x1 /a1 , . . . , xL /aL } units, an utter waste. If you were to trade a small amount of
Why?
these wasted ingredients for the non-wasted ones, you would still be in your budget set, but able
to make more cake. Hurray!
Secondly, preferences are monotonic, so you will use your entire budget on ingredients:
w.
Combining this with (13) gives us that there is a unique solution to the UMP at
x =
a1 w
PL
aL w
i=1 ai pi
, . . . , PL
27
i=1 ai pi
!
.
px =
(p, w) RL+1
++ :
aL w
a1 w
x(p, w) =
PL
i=1 ai pi
, . . . , PL
i=1 ai pi
(
(p, w) RL+1
++ :
a1 w
x(p, w) =
aL w
PL
i=1 ai pi
!)
.
, . . . , PL
i=1 ai pi
Substituting the demand vector in the utility function, we nd the indirect utility function:
(p, w)
Exercise 4.2
L+1
R++
v(p, w) = u
PL
i=1 ai pi
aL w
, . . . , PL
i=1 ai pi
= PL
i=1 ai pi
Our denition of the budget set is standard, but other realistic restrictions can be modeled
a1 w
X = R2+ ,
p = (8, 4).
specify the budget set given the additional information. Does the new budget set necessarily contain at
least one most preferred bundle?
(a) Indivisibilities: The commodities cannot be cut into ever smaller pieces. Only integer quantities
are feasible.
(b) Rationing: The consumer is not allowed to buy more than three units of the rst commodity.
(c) Rebates 1: If the consumer buys more than ve units of the second commodity, these additional
units in excess of the rst ve have a lower price, namely two.
(d) Rebates 2: If the consumer buys more than ve units of the second commodity, the price of this
commodity (also the rst ve units) is decreased to two.
(e) Initial endowment: Instead of having wealth
4.2.
Section 1 listed a lot of properties that can be imposed on the consumer's preferences. The next
result indicates the consequences of such restrictions on the demand correspondence.
Proposition 4.3
Let
X = RL
+
for some
LN
and let
be a weak order on
X.
The Walrasian
(b) If
x(p, w)
(p, w) RL+1
++ .
is continuous, the Walrasian demand correspondence has a closed graph: for each
L+1
n
n
n
(pn , wn , xn )nN in R++
X with limit (p, w, x) RL+1
++ X : if x x(p , w )
for all n N, then also x x(p, w).
sequence
28
% is convex,
(p, w) RL+1
++ .
(d) If
(e) If
(p, w) RL+1
++ , > 0 : x(p, w) = x(p, w).
or equivalently, if
is quasiconcave, then
x(p, w)
x(p, w)
contains
Walras' law:
(p, w) RL+1
++
px = w
for all
x x(p, w).
L+1
RL+1
++ X with limit (p, w, x) R++ X . Assume
n
n
n
that x x(p , w ) for all n N. To show: x x(p, w).
n
n
n
Firstly, x X and p x w , so taking limits: p x w . Conclude that x B(p, w).
Suppose that x
/ x(p, w): there is a y B(p, w) with y x. By continuity of % and
0
0
0 0
Proposition 1.2, there are neighborhoods Ux of x and Uy of y such that y x for all (x , y )
Ux Uy .
0
0
Choose y Uy with p y < w . This is possible: y B(p, w) implies that p y w . In case
0
of strict inequality, take y = y . In case of equality, small decreases in the positive coordinates
0
of y will give the desired y .
n
n
n 0
n
0
n
n
As (p , w ) (p, w), it follows that p y w for n suciently large, so y B(p , w )Uy .
n
n
n
0
n
n
As x x, x Ux for n suciently large. Hence, for large n, x Ux and y B(p , w ) Uy .
0
n
n
n
n
But then y x , contradicting that x was optimal at prices p and wealth w .
(c): Since B(p, w) = {x RL+ : (p) x w} = {x RL+ : p x w} = B(p, w), the %-MP
sequence in
has the same domain before and after rescaling and therefore the same set of solutions.
(d):
An important consequence of the closed-graph property is that if Walrasian demand is singlevalued, the Walrasian demand function is continuous!
Exercise 4.3
If
To formulate properties of indirect utility, we will need to assume (Surprise!) that preferences
are represented by means of a utility function and that the demand correspondence is non-empty
valued: otherwise, indirect utility is undened.
Proposition 4.4
X=
Assume:
L
R+ for some L
N;
29
u : X R;
(p, w) RL+1
++ , x(p, w) 6= .
(p, w) RL+1
++ , > 0: v(p, w) = v(p, w).
better o ).
(c)
is nondecreasing in wealth; if
is locally nonsatiated,
wealth.
(d)
is quasiconvex:
(e) If
r R : {(p, w) RL+1
++ : v(p, w) r}
u,
max
yB(p0 ,w)
then
is continuous.
be a commodity. Let
0
strict increase in the price of commodity i. Then B(p , w)
v(p0 , w) =
is a convex set.
u(y)
p0
B(p, w),
be obtained from
by a
so
(c):
The nondecreasing part is similar to (b), so we will only do the strictly-increasing part.
0
0
p RL
++ and 0 < w < w . To show: v(p, w) < v(p, w ).
0
0
Let
Then x B(p, w), so p x w < w . Since p x < w , for > 0 suciently
0
small, the entire neighborhood {y X : kx yk < } is contained in the budget set B(p, w ).
By local nonsatiation, this neighborhood contains a point y with y x. Conclude that
% is locally
x x(p, w).
Assume
nonsatiated. Let
(d):
max
zB(p,w0 )
u(z) = v(p, w0 ).
L+1
r R. If {(p, w) R++
: v(p, w) r} = , it is convex. If it is nonempty, let
0
0
(p, w), (p , w ) lie in this set and let [0, 1]. Write (p00 , w00 ) = (p, w) + (1 )(p0 , w0 ). To
00
00
00
00
show: v(p , w ) r , i.e., u(x) r for all x B(p , w ).
00
00
L
0
0
Let x B(p , w ). Then x R+ and (p x) + (1 )(p x) w + (1 )w . Therefore,
p x w or p0 x w0 (or both). W.l.o.g., p x w. Then x B(p, w), so u(x) v(p, w) r.
(e): Follows from Proposition 4.3(b).
Let
Exercise 4.4
(a) Proposition 4.4(c) might suggest that also (b) can be strengthened a bit: If
indirect utility is strictly decreasing in the price of commodity
(b) Write out the proof of Proposition 4.4(e) in detail.
(c) Why not just write If
is continuous,
is continuous?
30
i.
% is locally nonsatiated,
4.3.
L
u : RL
+ R, prices p R++ , and a utility level u R.
What is the minimal amount the consumer has to pay, i.e., the minimal level of wealth needed to
reach utility level
u?
min p x
s.t.
x RL
+,
u(x) u.
The
h(p, u) = {x RL
+ : u(x) u
h(p, u)
and
pxpy
for all
y RL
+
with
u(y) u}.
The Hicksian demand correspondence species the set of consumption bundles solving the EMP,
the
min
xRL
+ ,u(x)u
p x = p x
for all
x h(p, u).
Similar to our earlier approach to Walrasian demand and indirect utility, one can derive properties
of Hicksian demand and the expenditure function. To make the proposition at all sensible, one
needs to restrict attention to utility levels that are actually reachable; therefore, let
x RL
+}
Proposition 4.5
order
%.
(a) If
Let
X = RL
+
for some
LN
and let
% is convex, or equivalently,
(p, u) RL
++ U .
(c) If
h(p, u)
h(p, u)
u u(0, . . . , 0)
(p0
u(x) = u
for all
(p, u) RL
++ U
with
x h(p, u).
h(p, u)
and all
(p, u) RL
++ U .
(p, u) RL
++ U, > 0 : h(p, u) = h(p, u).
x00
u:XR
(f )
U = {u(x) :
u.
p00 )
(x0
p0 , p00 RL
++
x ) 0.
let
00
and
u U.
If
x0 h(p0 , u)
and
Why this restriction? Well, suppose that u < u(0, . . . , 0). Since p x 0 for all x R , it follows that
h(p, u) = {(0, . . . , 0)}: expenditure is not minimal at utility u, because the zero vector, with higher utility, is the
cheapest option. Under suitable monotonicity restrictions, however, this will turn out to be an exotic case: the
zero vector will often give you the lowest utility in R , so that this footnote becomes irrelevant.
6
L
+
L
+
31
Proof. (a):
(p, u) RL
+ U . By feasibility, u(y) = u for some y X . By upper
semicontinuity of preferences, the set {x X : u(x) u} = {x X : x % y} is closed. Therefore,
L
L
the solution of the EMP lies in the nonempty set {x R+ : u(x) u} {x R+ : p x p y},
Let
which is the intersection of a closed and a compact set and therefore compact. The goal function
x 7 p x is continuous.
(b):
(c):
Minimizing
Let
By
denition,
L
h(p, u) = {x RL
+ : u(x) u} {x R+ : p x p y}
is the intersection of convex sets, hence convex.
(d):
p0 x0 p0 x00 .
Similarly,
for Walrasian demand (see Remark 4.2). The compensated law of demand implies that if you
raise the price of one of the goods, then the Hicksian demand for this good will not increase.
The next proposition states some properties of the expenditure function. Given the similarity
with earlier results, proofs are left as an exercise.
Proposition 4.6
X = RL
+
Assume:
for some
L N;
e:
RL
++
(p, u)
U R
RL
++
u : X R;
U : h(p, u) 6= .
(p, u) RL
++ U, > 0 : e(p, u) = e(p, u).
32
u: If
u(0, . . . , 0) u < u00 :
(b) Monotonicity in
0
p RL
++
and all
u0 , u00 U
with
u U , e(, u)
Exercise 4.5
is concave in
p.
Remark 4.7
straightforward than for Walrasian demand and indirect utility. Concave functions are continuous, so Proposition 4.6(d) implies that expenditure is continuous in prices. The utility function
u : R+ R
with
continuous in
Since
p > 0, e(p, )
has a discontinuity at
u = 0.
e : RL
++ U R
can be established using a result known as Berge's Maximum Theorem. Contrary to what most
textbooks (which do not provide the proof ) suggest, the proof is not straightforward. To establish
(p0 , u0 ) RL
++ U , local nonsatiation is used to establish existence of
0
a y
u(y) > u . Next, on a neighborhood of (p0 , u0 ), the EMP reduces to minimizing
p x subject to x {z RL
+ : u(z) u, p z p y}. This nal condition assures that the
continuity at an arbitrary
RL
+ with
U = R+ .
L
In order not to waste resources, a solution x to the EMP at (p, u) R++ U must satisfy
(13). Moreover, by continuity, it satises u(x ) = u. Combining these two conditions gives us
The Leontiev utility function in (12) has range
(p, u),
namely
x = (a1 u, . . . , aL u).
Since the
solution is unique, it is common to write the result as a Hicksian demand function, rather than
a correspondence:
h(p, u) = (a1 u, . . . , aL u)
and
Proposition 4.8
h(p, u)
` = 1, . . . , L
and
e(p, u)
PL
i=1 ai pi .
u : RL
+ R is continuous and represents locally
L
for all p R++ and all u > u(0, . . . , 0), Hicksian
p` :
` = 1, . . . , L :
e(p, u) = p (a1 u, . . . , aL u) = u
h` (p, u) =
33
e(p, u)
.
p`
(14)
Proof.
h()
as a function.
demand at prices
Fix
p RL
++ and u U and let x = h(p, u)
u. For every price vector p0 RL
++ ,
e(p0 , u) =
p0 = p.
= p. By
with equality if
0
maximized at p
min
0
x0 RL
+ ,u(x )u
p0 x0 p0 x,
` = 1, . . . , L :
f (p0 ) = e(p0 , u) p0 x
derivatives at p must be zero:
f : RL
++ R
denote Hicksian
with
f (p)
e(p, u)
e(p, u)
=
x` =
h` (p, u) = 0,
p`
p`
p`
Exercise 4.6
u : RL
+ R
(p, w) with p RL
++ and w > 0.
` = 1, . . . , L can be found as follows:
at a point
f : RL
++ R
v()
is dierentiable
` = 1, . . . , L : x` (p, w) =
4.4.
is
with
v(p, w)/p`
.
v(p, w)/w
where
x = x(p, w),
achieves
p = p.
Proposition 4.9
u : RL
+ R
L
p R++ . Then:
is optimal in the UMP with wealth w > 0, then x is optimal in the EMP with utility
(a) If
and
e(p, u(x )) = w.
is optimal in the EMP with utility level u U , u > u(0, . . . , 0), then x is optimal in
the UMP with wealth w = p x . Moreover, the indirect utility level in this UMP is exactly
(b) If
u:
x h(p, u) x x(p, p x )
Proof. (a):
with prices
and
e(p, u(x )) = p x p x = w
and
v(p, p x ) = u
Bundle
denition,
u(x) u(x ).
It follows from a duality result in convex analysis: for xed u, e(, u) is the support function of the strictly
convex set {x X : u(x) u}.
8
34
x B(p, w). But then its utility cannot exceed that of the utility
x(p, w). So u(x) = u(x ) and by Walras' law:
maximizing bundle x
e(p, u(x )) = p x = p x = w.
x h(p, u(x )) and e(p, u(x )) = w.
(b):
h(p, u). By Proposition 4.5(e), u(x ) = u. Bundle x
Let x
and
px=p
p x p x .
(p, u).
x . By Proposition 4.5(e),
x x(p, p x )
and
v(p, p x ) = u.
Under the assumptions above, we obtain important relations between the UMP and EMP:
Proof. (15):
(15)
(16)
(17)
(18)
These results give convenient ways to nd solutions to the UMP from those of the EMP and vice
versa. Let us illustrate this in our Leontiev example.
v(p, w) = PL
i=1 ai pi
Recall that
and
x(p, w) =
a1 w
PL
aL w
i=1 ai pi
e(p,u)
PL
, so
i=1 ai pi
, . . . , PL
i=1 ai pi
e(p, u) = u
!
.
PL
news, isn't it!) as we saw before. Hicksian demand can now be found in dierent ways. Firstly,
using Proposition 4.8:
` = 1, . . . , L :
and, secondly, using (18):
h(p, u)
h` (p, u) =
e(p, u)
= a` u,
p`
solves
a1 e(p, u)
aL e(p, u)
, . . . , PL
PL
i=1 ai pi
i=1 ai pi
35
!
= (a1 u, . . . , aL u).
Exercise 4.7
For Leontiev utility, use (15) and (17) to nd Walrasian demand and indirect utility from
Exercise 4.8
Slutsky equation:
u : RL
+ R
convex preferences. We know that in this case there are unique solutions to the UMP and EMP: we can
consider Walrasian and Hicksian demand functions.
holds. Fix
(p, w) RL+1
++
k, `
{1, . . . , L}:
x` (p, w) x` (p, w)
h` (p, u)
=
+
xk (p, w).
pk
pk
w
Prove (19) as follows: You know from (18) that
pk ,
(19)
using the Chain rule. Continue by substituting (14), (15), and (18).
4.5.
Welfare analysis studies how changes in the consumer's environment in our case: the budget
set aect his well-being. Let
B0
B1
change. Assuming that optimal bundles exist, the consumer is better o after the change if and
only if whatever is optimal in
B1
B0 .
This is welfare
analysis in a nutshell. Some obvious ways of detecting changes that are (at least weakly) welfare
improving are:
Exercise 4.9
B0
B0 B1 .
remains feasible in
B1 .
How is the consumer's welfare aected by the changes described in Exercise 4.2?
Whereas the above describes the idea behind welfare analysis in its full generality and simplicity,
economic textbooks tend to restrict attention to changes only in prices and wealth. The initial
vector of prices and wealth is denoted
(p0 , w0 ) RL+1
++
L+1
1
1
after the change is denoted (p , w ) R++ . This allows changes in prices only, keeping wealth
0
1
0
1
0
1
0
1
constant (p 6= p , w = w ), changes in wealth only, keeping prices constant (p = p , w 6= w ),
0
6= p1 , w0 6= w1 ).
Exercise 4.10
(p1 , w1 ).
L
0
0
Let % be a locally nonsatiated weak order on R+ . Consider a change from (p , w ) to
x0 x(p0 , w0 ). Show that if p1 x0 < w1 , the consumer is strictly better o under (p1 , w1 )
(p0 , w0 ).
Let
than under
can be repre-
sented by means of a utility function. We can derive the consumer's indirect utility function
1
1
and conclude that the consumer is better o after the change if and only if v(p , w )
>
v(p0 , w0 ).
However, since the indirect utility function depends on which utility function is chosen to
represent
%,
this does not tell us how much better o the consumer is.
To express welfare
This inequality holds because the zero vector cannot solve the utility maximization problem: by local nonsatiation and strict positivity of prices and wealth, there is an aordable bundle preferred to the zero vector.
9
36
utility function using the expenditure function. Fix an arbitrary price vector
the real-valued function
e(
p, ).
p RL
++ .
Consider
e(
p, v(p1 , w1 )) > e(
p, v(p0 , w0 )) v(p1 , w1 ) > v(p0 , w0 ).
Moreover, since the expenditure function is expressed in monetary units,
e(
p, v(p1 , w1 )) e(
p, v(p0 , w0 ))
(20)
can be used as a monetary measure of welfare change: if it is positive, the welfare of the consumer
increases as a consequence of the change from
of the consumer has decreased.
(p0 , w0 )
to
(p1 , w1 ),
on the choice of utility function representing the consumer's preferences. This follows from the
fact that expenditure can be expressed in a form independent of the utility function: for all
(p, u) RL
++ U ,
there is a
y RL
+
with
u(y) = u,
so
e(p, u) = min p x
= min p x
L
s.t.
x R+
s.t.
x RL
+
u(x) u
x%y
In (20), two natural choices for
p0
equivalent
1
of prices p . These choices give rise to two well-known measures of welfare change:
0
0
0
1
and
. Let u = v(p , w ) and u =
variation (EV)
0 0
Notice that e(p , u )
w0 and
e(p1 , u1 )
v(p1 , w1 ).
1
1
changes either to (p , w ) or
(p2 , w2 ).
EV
p0 and
Both
p1 and
CV
(p0 , w0 )
((p0 , w0 ), (p2 , w2 ))
EV
suppose
However,
utility follow immediately from the indirect utility function and expenditure function computed
earlier:
w0
u0 = v(p0 , w0 ) = PL
0
i=1 ai pi
and
w1
u1 = v(p1 , w1 ) = PL
,
1
i=1 ai pi
so
EV
((p0 , w0 ), (p1 , w1 ))
e(p0 , u1 )
e(p0 , u0 )
w1
P
lump-sum tax
(p1 , w1 )
(p0 , w0 ),
L
Pi=1
L
i=1
ai p0i
w0 ,
ai p1i
P
L
1
0
i=1 ai pi
w PL
.
0
i=1 ai pi
Then
w0 T ,
so
This is intuitive:
Deadweight loss:
T .
RL
+.
u1 = v(p1 , w)
as before.
T directly
T .
0
w T . So x B(p , w T ), i.e.,
B(p0 +te
` , w), so p x +tx`
consumer cannot be worse o under lump-sum taxation than under commodity taxation.
Therefore,
e(p0 , u1 ) w T .
The dierence
w T e(p0 , u1 ) 0
is called the
Exercise 4.11
Cobb-Douglas utility:
running example to illustrate all denitions. Go through the same steps, now using the Cobb-Douglas
utility function
4.6.
u : RL
+ R
x RL
+
by
where
a1 , . . . , aL > 0.
Assume that the preferences of the consumer are continuous, locally nonsatiated and strictly
convex. If the only change is in the price of a single good, equivalent and compensating variation
can simply be expressed in terms of the Hicksian demand function.
To somewhat simplify
0
obtained from p by changing the price of good
0
So given initial prices and wealth (p , w), suppose that only the price of good
0
1
1 0
1
is changed to p` 6= p` , giving rise to (p , w) = ((p` , p` ), w). Recall that
e(p, u)
= h` (p, u)
p`
and
` {1, . . . , L}
e(p1 , u1 ) = w.
Hence
38
(21)
Similarly,
p0`
(22)
This means that the equivalent and compensating variation due to such a simple price change
can be represented by areas to the left of the Hicksian demand curve.
Normal goods:
Suppose good
is a
normal good
h` (p` , p0` , u0 ) = x` (p` , p0` , e(p` , p0` , u0 )) x` (p` , p0` , e(p` , p0` , u1 )) = h` (p` , p0` , u1 )
for all
p` > 0.
0
p0`
p1`
p0`
=
p1`
0.
39
p0`
p1`
h` (p` , p0` , u1 ) h` (p` , p0` , u0 ) dp`
5.
5.1.
Production sets
Having treated the demand side of the economy in detail, we now turn to the supply side. The
supply side consists of rms that use a technology to convert one set of commodities (inputs)
to another (outputs). Just as for consumers, it is assumed that rms take prices as given and
that all commodities are traded at the market at publicly quoted prices. Consider an economy
with
LN
production plan
production vector
or
y = (y1 , . . . , yL )
L commodities. If y` < 0, we say that good ` is used as an input in the production plan y , if
y` > 0, we say that good ` is used as an output in y . For instance, if L = 2, the production
plan y = (2, 6) indicates that two units of the rst commodity are used as an input to produce
an output of 6 units of the second commodity. The
production vectors is denoted by
production set
of technologically feasible
Transformation functions:
using a function
F :
RL
called the
Y = {y RL : F (y) 0}
The set of boundary points
and
F (y) = 0
{y RL : F (y) = 0}
Single-output technologies:
if
is called the
Y.
transformation frontier .
L, is an output
1, . . . , L1, as inputs. These are single-output
technologies , typically summarized using a production function f : RL1
R that assigns
+
to each vector of input quantities z the maximal amount f (z) of output that can be produced
In many examples, one of the goods, say good
, > 0.
z RL1
+ }.
f : R2+ R
given by
f (z) = z1 z2 ,
Then
Y = {(z1 , z2 , q) R3 : q z1 z2 ,
5.2.
and
and
z1 , z2 0}.
Y RL
include:
is
is
40
Free disposal : if y Y
and
y0 y,
then
y0 Y .
If
y0
is feasible and
uses at least
0
as much of each input, yet gives no more of the outputs, then also y is feasible.
Irreversibility :
if
y Y
and
y 6= 0,
then
y
/ Y.
It is impossible to reverse a
feasible production vector, i.e., to turn the outputs into the same amount of inputs
used to produce it.
if
y Y
and
[0, 1],
y Y .
then
This
if
yY
and
1,
then
y Y .
This means
and
0,
then
y Y .
This is the
Additivity/free entry :
if
y, y 0 Y ,
then
y + y0 Y .
If both
Y
Y
y 0 are feasible,
y , the other y 0 ,
and
y + y0.
is
One easily establishes relations between these properties. Possibility of inaction implies nonemptiness. Nondecreasing and nonincreasing returns to scale imply constant returns to scale. Some
less trivial ones are:
Proposition 5.1
(a) If
Let
Y RL
is convex and
be a production set.
0Y,
then
(b)
(c)
Y satises no free lunch and for all x, y Y and (0, 1), there
z x + (1 )y, z 6= x + (1 )y , then Y satises irreversibility.
(d) If
is a
z Y
with
let y Y and
y Y . Conversely, assume Y is convex
0
and has CRS. To show that Y is a convex cone, let y, y Y and , 0. By CRS, 2y Y
1
1
0
0
0
and 2y Y . By convexity, (2y) + (2y ) = y + y Y .
2
2
(c): If Y is a convex cone, it is additive (take = = 1) and has nonincreasing returns to scale
(similar to the proof of CRS above). Conversely, assume that Y is additive and has nonincreasing
0
0
returns to scale. Let y, y Y and , 0. By additivity, ky Y and ky Y for all k N.
Choose k N such that /k 1 and /k 1. Since Y has nonincreasing returns to scale,
(/k)y Y and (/k)y 0 Y . By additivity: y = k(/k)y Y and y 0 Y . Again by
0
additivity y + y Y .
(d): Let y Y, y 6= 0, and suppose y Y . By assumption, there is a z Y such that
z 12 y + 21 (y) = 0, z 6= 0, contradicting no free lunch.
0.
Since
is a convex cone,
y =
1
2
y+
41
1
2
In the special case of a production function, properties of the production set are related to
properties of the production function. For instance:
Proposition 5.2
with
f (0, . . . , 0) = 0,
so that
Y = {(z, q) RL : q f (z)
(a)
(b)
Proof. (a):
z RL1
+
and
z RL1
+ }.
is concave.
Y satises constant
> 0: f (z) f (z). So let z RL1
+
and
returns to scale.
and
= z
RL1
and
+
Y , (z, f (z)) Y .
(z, f (z)) Y .
Y , (z, f (z)) Y
means that
z RL1
and > 0: f (z) f (z).
+
0
= 1/ > 0.
Substitute
z 0 = z
and
z0
So
and
So let
f (z) f (z).
z RL1
+
and
> 0.
0 : 0 f (z 0 ) f (0 z 0 ).
f (z).
> 0.
0
Fix z
f : RL1
R
+
z RL1
+
and each
> 0 : f (z) =
z RL1
and each
+
> 0 : f (z) = f (z). To show: Y has CRS, i.e, if (z, q) Y and 0, then (z, q) Y .
This follows from the assumption that f (0, . . . , 0) = 0 if = 0. So let (z, q) Y and > 0.
Conversely, assume that
Since
for each
Y , q f (z).
> 0 : q f (z).
f (z) = f (z),
Y , q f (z)
so
q f (z) = f (z).
together with
z RL1
+
implies that
(z, q) Y .
(b):
The function
f : RL1
R
+
{(z, q) RL1
R : q f (z)} = {(z, q) RL : q f (z)
+
is convex. Multiplying the rst
and
z RL1
+ }
with
{(z, q) RL : q f (z)
and
z RL1
+ }=Y
being convex.
42
5.3.
species a rm's set of feasible options. To make the choice problem of the
rm complete, we have to endow it with preferences. These preferences are particularly simple.
It is assumed that rms maximize prots given the commodity prices and the rm's production
set:
problem (PMP) is
The
Y RL
p RL
++ ,
the
prot maximization
max p y
s.t.
y Y.
prot function assigns to every price vector p RL++ the maximal prot
(p) = max{p y : y Y }.
The
supply correspondence
y()
p RL
++
y(p) = {y Y : p y = (p)}.
As opposed to the utility maximization problem, which has a solution under mild conditions
(like continuity of the utility function), there may not be a solution to the PMP: prots may be
unbounded. In that case, we set
(p) = +.
Proposition 5.3
p
(p) = +.
price vector
made, or
Proof.
L
Let Y R be nonempty and satisfy nondecreasing returns to scale. For each
RL
++ , either p y 0 for all y Y , which means that no positive prot can be
p RL
++ . Suppose that p y > 0 for some y Y . Since Y has
nondecreasing returns to scale, y Y for all 1, so p (y) = (p y) can be made arbitrarily
large by letting go to innity.
Consider a price vector
This makes the existence of solutions to the PMP a nontrivial issue. The following two results
provide sucient conditions.
Proposition 5.4
Y RL
is:
nonempty,
closed,
bounded above: there is an
rR
such that
y` r
for all
yY
Then the prot maximization problem has at least one solution for each
Proof.
` {1, . . . , L}.
L
price vector p R++ .
and all
0
p RL
++ . By nonemptiness, there is a y Y . A solution to the PMP must lie in
L
0
the set P = Y {y R : p y p y }.
P is closed: Y is closed by assumption and the second set in the intersection is closed, since
Let
it is the upper contour set of a continuous function. The intersection of two closed sets is closed.
is bounded:
P
yP
` {1, . . . , L}.
p y p y 0 , it follows that
X
X
p` y` p y 0
pk yk p y 0
pk r,
Since
k6=`
k6=`
43
r.
so
y`
Hence,
p y0
p
r
/p` .
k
k6=`
Y,
The following result establishes existence of solutions to the prot maximization problem under
resource constraints.
Proposition 5.5
Y RL :
yY
with
RL
+
y .
Then the prot maximization problem has at least one solution for each price vector
Exercise 5.1
p RL
++ .
Y 0 = Y {y RL : y }
To show that
of vectors in
nN
(zn )nN
large enough,
zn
lies in
and satises
zn + /kyn k 0.
z 6= 0
in
Y.
Y0
is nonempty and compact and the prot function is continuous, a maximum exists!
Thus, whenever we talk about properties of the prot function and the supply correspondence,
we implicitly assume that the PMP has a solution, so that
Proposition 5.6
y(p) 6=
and
(p) < .
Y RL .
(a) The prot function is homogeneous of degree one, the supply correspondence is homogeneous
of degree zero.
(b) The prot function is convex.
(c) If
(d)
(e)
is convex,
y(p)
Hotelling's lemma:
p RL
++ .
function is dierentiable
p RL
++ . If y(p) consists of a single point y , then
at p and (p)/p` = y` for all goods ` = 1, . . . , L.
Law of supply:
p, p0 RL
++
Let
for all
and all
y y(p)
and
(p p0 ) (y y 0 ) 0.
44
y 0 y(p0 ):
the prot
Let
let
So
Second proof:
1
2
p1 , p2 RL
++ and all [0, 1] : (p + (1 )p )
1
2
p1 , p2 RL
++ and [0, 1]. Let y y(p + (1 )p ). Then
so
(c):
p RL
++ .
Then
` = 1, . . . , L :
h(p)/p` = (p)/p` y` = 0,
(e):
Notice that
(p p0 ) (y y 0 ) = (p y p y 0 ) + (p0 y 0 p0 y) 0,
where the inequality follows from the denition of prot maximizers:
p0
y0
5.4.
(p0 )
p0
p y = (p) p y 0
y.
and
Just like in the utility maximization problem UMP, the Kuhn-Tucker conditions can be used to
nd necessary rst order conditions for the prot maximization problem PMP: if the production
set is
Y = {y RL : F (y) 0},
where
condition for y
p RL
++ ,
max p y
s.t.
F (y) 0
is that there exists a Lagrange multiplier
p` =
F (y )
.
y`
45
` = 1, . . . , L :
(23)
`, k :
k,
p`
F (y )/y`
=
,
pk
F (y )/yk
y,
price of input
` = 1, . . . , L 1
Remark 5.7
I don't know the reason for this sudden change of notation from a price vector
equals
(p, w).
p > 0.
p to
If
w` > 0
max pf (z) w z
s.t.
z RL1
+ .
z` 0
p
f (z )
w` = `
z`
>0
for all
`),
and
`, k :
` z` = 0.
` = 1, . . . , L 1 : p
` 0
` = 1, . . . , L 1 :
(24)
` = 0
for all
`,
so the rst
f (z )
= w` ,
z`
w`
f (z )/z`
=
,
wk
f (z )/zk
(25)
which has the interpretation that the price ratio between two goods has to equal their so-called
marginal rate of technical substitution. Again, if the set
5.5.
In a prot maximizing production plan, there is no way to produce the same amount of outputs
which we consider only in the single-output case. Assume the production function is
f : RL1
+
q of the
RL1
++ . We want to produce at least an amount
output. What is the minimal amount we have to spend on inputs to achieve this? The answer
is given by the CMP:
min w z
s.t.
z RL1
+ ,
f (z) q.
The
L1
z(w, q) = {z R+
: f (z) q
and
z(w, q)
w z w z0
46
for all
z 0 RL1
+
with
f (z 0 ) q}.
The conditional factor demand correspondence species the set of input vectors solving the CMP,
the
c(w, q) =
min
,f (z)q
zRL1
+
w z = w z
for all
z z(w, q).
min p x
s.t.
x RL
+
u(x) u
are identical, up to a relabeling of the involved functions. Therefore, rewriting Propositions 4.5,
4.6, and 4.8 provides a long list of properties for conditional factor demand and the cost function.
If the production function
w` =
f (z )
+ `
z`
and
w` =
`
for all
and consequently
` z` = 0.
>0
for all
`),
` = 0
for
f (z )
z`
w`
f (z )/z`
=
,
wk
f (z )/zk
as in (25)!
5.6.
RL1
++ , and output price
p > 0,
f : RL1
R+ ,
+
input price
max pq w z
s.t.
q f (z),
z RL1
+ .
The set of solutions is commonly denoted as
solution
(z, q),
can be increased:
pq w z < pf (z) w z.
Consequently, the PMP simplies to
max pf (z) w z.
zRL1
+
Moreover, production has to be as cheap as possible, so there is a link with the CMP:
47
Proposition 5.8
f : RL1
R+
+
L1
closed. Let w R++
L1
set {z R+
: f (z) q} is nonempty and
p > 0 the output price. Consider the optimization problems
(P1)
maxzRL1 pf (z) w z ,
(P2)
q 0,
the
z RL1
+ ,
q 0,
qz 0
with
L1
zq R +
with
there is a
there is a
(c) If one of the problems (P1) and (P2) has a solution, so does the other and the corresponding
maximum values coincide:
zRL1
+
Exercise 5.2
The PMP as formulated in (P2) is particularly easy: given the cost function, the PMP reduces
to a single-variable maximization problem.
the PMP. Under suitable dierentiability assumptions, the necessary Kuhn-Tucker condition at
an optimum
q 0
such that:
p
Assuming
q > 0,
c(w, q )
=
q
=0
and
q = 0.
q,
f : R+ R with f (z) =
for all
z 0.
Y = {(z, q) R2 : q f (z), z 0} = {y R2 : y1 0, y2
Assume that the input price is
w>0
p > 0.
y1 }.
max p z wz.
z0
At
z = 0,
must be satised:
so
z =
p 2
2w , yielding output
z > 0,
p
w = 0,
2 z
z =
p
p2
2w and prot 2w
p2
4w
p2
4w
> 0.
supply function is
y(p, w) =
p 2 p
,
Y
2w
2w
48
(26)
(p, w) =
p2
4w . The cost minimization problem for production level
is
min wz
s.t.
z 0,
z q.
z , it is clear
z = z(w, q) = q 2
z = q:
At an optimum
that
demand is
c(w, q) = wq 2 .
q0
5.7.
q =
p
2w as in (26).
Eciency
A production plan
yY
is
ecient
if there is no
y0 Y
with
y0 y
y 0 6= y .
and
In words,
there is no dierent production plan producing at least as much output while using at most as
much input. There is a close connection between prot maximization and eciency:
Proposition 5.9
(a) If
yY
p RL
++ ,
(b) If
Y RL .
Proof. (a):
Suppose
i.e., if
y y(p),
then
is ecient.
y0 Y
with
y 0 y, y 0 6= y .
Then
p RL
+
such
p y0 > p y:
0
the prot from y exceeds that from the prot-maximizing y , a contradiction.
(b): Let Z = {y 0 RL : y 0 > y }. Since y is ecient: Z Y = . By the separating hyperplane
L
0
0
theorem, there is a vector p R , p 6= 0 such that p y p y for all y Z and y Y . Two
things remain to be shown:
p RL
+ . Suppose, to the contrary, that p` < 0 for some coordinate `. Then
Firstly, that
y0
each
yn
Exercise 5.3
Then
p yn p y.
Since
This exercise investigates the need for the dierent assumptions in Proposition 5.9.
Y R2 , a point y Y and
prices p, but y is not ecient.
maximizes prots at
Y R2
and a point
price vector
yY
p R2++ .
Y R2
ecient, but not prot maximizing for any nonzero price vector
49
p R2+ .
y Y
which is
6.
General equilibrium
6.1.
What is an equilibrium?
Earlier, we studied how consumers choose optimal consumption bundles given their preferences,
wealth, and the price vector and how rms choose optimal production plans given their technology
and the price vector. Are there price vectors where all these optimal choices are actually feasible?
You don't, for instance, want people demanding ten apples if there only are ve. Such a price
vector and the corresponding demand and supply constitute a
Walrasian equilibrium .
Its
denition follows the central idea behind any economic equilibrium concept with decent microfoundations it is a description of:
Economic agents quite frankly couldn't care less: they have their preferences,
some constraints, and all they wish for is to choose optimally. Nevertheless, some people become
very nervous when one doesn't assume that markets clear (excess demand equal to zero) in
equilibrium. I want to take this concern seriously, so let me briey explain this.
Market clearing is an assumption about aggregate behavior that is not in line with the
microeconomic idea behind equilibrium that combines feasibility with optimal behavior of
Consequently, market clearing is often not a part of the denition of equilibrium. See, for
instance, Arrow and Hahn (1971, p. 107), Kreps (1990, p. 190), Mas-Colell (1985, p. 169),
and Varian (1992, p. 316).
Market clearing in equilibrium, however, turns out to be a consequence of commonly imposed restrictions. You may nd Exercise 6.2(c) helpful.
To illustrate the main ideas behind general equilibrium analysis, we start by studying a
exchange economy
pure
with certain amounts of the dierent goods. This entails no real loss of generality: our main tool
will be to study excess demand, regardless of whether it involves producers or not. Walrasian
equilibrium is dened and shown to exist in a particularly simple case.
of its welfare properties. After introducing producers into the model, a more general existence
result is provided in Section 6.4.
50
6.2.
A
a weak order
h H has
%h over RL
+,
an initial endowment h
where
hH
L N,
RL
+ of the
=
h
a commodity bundle x
hH
commodities.
h.
An
allocation
RL
+ . Allocation
x = (xh )hH
assigns to each
is:
feasible if hH xh ,
P
nonwasteful if hH xh = .
P
xh ()
The basic idea behind equilibria (feasibility and optimal choices) leads to the following denition. A
Walrasian equilibrium of a pure exchange economy E = (%h , h )hH is a pair (p, x),
where:
p RL
+ , p 6= 0,
x=
is a price vector,
(xh )
hH is a feasible allocation,
for each consumer h H , xh is a most preferred bundle at prices
p,
i.e.,
xh xh (p, p h ).
excess demand correspondence z assigning to each price vector p the dierence between total demand for and the total
Properties of Walrasian equilibrium are often studied using the
availability of the commodities:
z(p) =
X
X
xh (p, p h ) { h } =
xh (p, p h ) {}.
hH
hH
z z(p) RL
.
h H, p RL
+ , > 0 :
Therefore, if
for all
> 0.
In the computation
of Walrasian equilibria, this allows some simplications, for instance by assuming that the equilibrium price of one of the goods is equal to one, or that the sum of the prices is equal to one,
i.e., they lie in the unit simplex
= {p RL
+ :
PL
`=1 p`
= 1}
(also denoted
if we want to
Proposition 6.1
z:
51
z : RL ,
Proof.
The idea is to change prices by making goods in excess demand relatively more expensive
pi + max{zi (p), 0}
P
1+ L
j=1 max{zj (p), 0}
f (p) =
Function
f :
!
by
.
i=1,...,L
increases the price of commodities for which excess demand is positive and then
rescales the resulting price vector so that its coordinates add up to one. As the composition of
continuous functions,
f (p) = p.
z(p) 0.
We show that
with
By Walras' Law:
Therefore,
L
X
(27)
i=1
Notice:
max{zi (p), 0}zi (p) =
0
zi (p)2 > 0
if
if
zi (p) 0,
zi (p) > 0.
So (27) is the sum of nonnegative terms. The only way in which it can be zero, is if all its terms
are zero, i.e., if
zi (p) 0
for all
i,
as we had to show.
with
but only if its price equals zero. The desired properties of excess demand are usually derived
from conditions on consumer preferences, using Proposition 4.3.
6.3.
Welfare analysis
A feasible allocation
is:
Pareto dominated
and x
h
hH
x
as in x
h
xh for some
h H,
with
x
h %h xh
for all
x
h
52
h S such that
P
P
h = hS h ,
hS x
for all
all members of
The
x
h xh
for all
h S.
core of E is the set of feasible allocations that no coalition can improve upon.
xh % h
Proposition 6.2
Proof.
h H.
for all
If
(p, x)
is a Walrasian equilibrium of
E,
then
simply requires
individual rationality .
Proposition 6.3
rium of
Proof.
Suppose
is Pareto optimal.
x
: x
h %h xh for all h H and
h
h
h
By local nonsatiation, p x
P
P hp x = p for all h H
h
So, p
> p hH , contradicting feasibility of x
:
hH x
x
k k xk for some k H .
and p x
k >Pp xk = p k .
P
h hH h .
hH x
As a partial converse to the previous result, some additional assumptions guarantee that anything
that is Pareto optimal can be sustained as a Walrasian equilibrium allocation at least if initial
endowments can somehow be redistributed.
Proposition 6.4
E,
a Walrasian
equilibrium exists,
x is a Pareto optimal allocation, redistribute initial endowments such that h = xh for all
h H . Then x is a Walrasian equilibrium allocation for the resulting pure exchange economy.
If
Proof.
(
p, x
).
B h (
p, p xh ), so x
h % xh .
By Pareto optimality of x, none of these preferences can be strict, so x
h h xh for all h H .
To see that x
h = xh for all h H , suppose there is an h H with x
h 6= xh . Consumer h can
h
h
aord (
x + x )/2. By strict convexity of preferences, this bundle is strictly preferred to x
h ,
contradicting that x
h is an optimal bundle for the consumer in the Walrasian equilibrium.
By assumption, the resulting pure exchange economy has a Walrasian equilibrium
For each
6.4.
h H, x
h
is optimal and
xh
Let us extend the pure exchange economy by adding rms, owned by the households: each household is entitled to a share (possibly zero) of each rm's prot. Formally, a
economy is a tuple
E = (%h , h )hH , (Y f )f F , (hf )hH,f F ,
where:
53
private ownership
f F has a production
and each consumer h H has
a weak order %h over RL
+,
each rm
an initial endowment
h RL
+
a claim to a share hf
set
of the
[0, 1]
Y f RL ,
where
L N,
commodities,
f F
(where
hH
hf = 1
for all
f F ).
allocation (x, y) = ((xh )hH , (yf )f F ) assigns to each consumer h H a commodity bundle
f
f
xh RL
+ and to each rm f F a production plan y Y . Allocation (x, y) is feasible if
An
xh
hH
If the price vector is
set
h +
yf .
f F
hH
y
,
+
has budget
f F
h
because the initial endowment is worth p and
receives share
hf
of the prot
p yf
of rm
f F.
xh () denote the demand correspondence of consumer h H , y f () the supply corresponf
of rm f F , and () its prot function. The basic idea behind equilibria (feasibility
Let
dence
p RL
+ , p 6= 0,
is a triple
(p, x, y),
Walrasian equilibrium
of a private
where
is a price vector,
p:
X
hf y f ,
xh xh p, p h +
f F
for each rm
f F , yf
p: y f y f (p)
and
f (p) = p y f .
excess
demand correspondence z assigning to each price vector p the dierence between total demand
for and total availability of the commodities:
z(p) =
X
X
hf f (p)
xh p, p h +
y f (p) {},
f F
hH
and the interest is in nding a price vector
f F
p where z(p) RL
6= .
1959, Section 5.6) establishes existence of such a price vector; as before, one may restrict attention
to prices in the unit simplex
Proposition 6.5
z:
z(p) 6=
for all
p ,
54
Z RL : z(p) Z
for all
p ,
is convex-valued:
z(p)
p ,
{(p, z) Z : z z(p)}
p z 0 for
z(p) RL
6= .
Proof.
with
is a closed set,
all
and all
z z(p).
Once again, the idea is to make goods with large excess demand expensive in the hope of
decreasing it. This is achieved by maximizing, for a given excess demand vector
p z,
correspondence from
to
z , the expression
of z . Dene the
by
(z) = {p : p z = max
p0 z}.
0
p
p 7 p z over a nonempty, compact set , is nonemptyz Z and p0 (z). Then (z) = {p RL : p z = p0 z} is the intersection of
sets, so is convex-valued. A standard continuity argument shows that has a closed
from and to
with
The trick, of course, is to derive the desired properties of the excess demand correspondence by
imposing properties on the components of the private ownership economy
E.
of Sections 4 and 5, most of them should not come as a surprise. Only the rst is somewhat
Z ? Convexity
of Z is not the issue: if you can nd a compact set containing all the images z(p), they also lie
in a suciently large (convex) ball. Without going into details, compactness of Z is established
P
f
by realizing that the relevant production plans, by feasibility, must satisfy
f F y + 0.
Following the lines of Proposition 5.5, this set of attainable production plans can be shown to
be compact.
Appropriate modications of the fundamental welfare theorems continue to hold for private
ownership economies. As this section was meant only as a short introduction to the topic, the
interested reader is referred to Debreu (1959) for a more comprehensive treatment. Textbooks
on general equilibrium theory include Hildenbrand and Kirman (1988) and Starr (1997).
6.5.
Exercises
Exercise 6.1
(a) What is wrong with the following argument: Proposition 6.2 implies Proposition 6.3: if
the core, the coalition
S=H
55
lies in
is Pareto optimal.
(p, x)
such that
lies
Exercise 6.2
Market clearing:
pz =0
and all
z z(p).
where
Prove:
L
p RL
+ , z z(p) R , ` {1, . . . , L} :
(b) If prices are positive and
L1
if
p` > 0,
then
z` = 0.
p RL
++ , z z(p), ` {1, . . . , L} :
zk = 0
k 6= `,
then
z` = 0.
(c) Consider an equilibrium. Suppose (c1) or (c2) is true for at least one consumer
h H:
if
for all
(c1)
(c2)
% is strongly monotonic on X =
h has a positive amount of money
RL
+.
to spend,
x, y RL
+ :
and
%h
is strongly monotonic on
h's
h
x RL
/ RL
++ , y
++ x y,
X = RL
++ .
Exercise 6.3
E.
A feasible allocation
(x, y)
is
Pareto dominated if there is another feasible allocation (x, y) with xh %h xh for all h H
and
x
h h x h
for some
h H.
Exercise 6.4
(p, x, y)
(x, y) is
is a Walrasian equilibrium of
Pareto optimal.
Exercise 6.5
between two women, each claiming that a certain baby is hers, by suggesting to cut it in two with his
sword: the true mother is revealed as she is willing to give up her child to the liar, rather than have
it killed.
Swords make babies divisible commodities, so consider a pure exchange economy with two
56
7.
Hitherto, we assumed that decision makers act in a world of absolute certainty; typically, however,
the consequences of decisions entail some stochastic elements. This section treats the development of expected utility theory, using the axiomatic approach of von Neumann and Morgenstern.
7.1.
We maintain the notion of preferences, but instead of assuming that a decision maker (DM) has
preferences over certain outcomes, we consider preferences over
probability distributions over outcomes. Formally, let
set of
A = {a1 , . . . , an }
be a nonempty, nite
ai A.
g = (p1 a1 , , pn an ).
Probabilities should be nonnegative and add up to one, so the set of simple gambles is
(
(p1 a1 , , pn an ) : p1 , . . . , pn 0,
G1 =
n
X
)
pi = 1 .
(28)
i=1
For instance, when tossing a coin, the outcome will be heads
fair coin corresponds with the simple gamble
( 12 H, 12 T ).
or tails
T,
so
A = {H, T }.
one often omits outcomes with probability zero from the notation of a simple gamble:
( 12 a1 , 12 an ) is an abbreviation for the simple gamble
ai
1
1
a1 , 0 a2 , , 0 an1 , an .
2
2
(1 ai ) whose outcome is ai
Not all gambles are simple. Perhaps you decided to bet one dollar on your favorite number in a
roulette game, but toss a coin to decide which of two roulette wheels you want to play in a casino:
the outcome of the rst gamble (the coin toss) is another gamble (the roulette game). This is an
example of a compound gamble. In principle, we can have any level of compound gambles. For
convenience, we will assume that a compound gamble ends in a deterministic outcome after only
nitely many steps. Formally, the set of compound gambles is dened as follows. Let
m N, let Gm
G0 , . . . , Gm1 :
(
Gm =
G0 = A
(p1 g1 , , pk gk ) : k N, p1 , . . . , pk 0,
k
X
)
pi = 1,
and
g1 , . . . , gk m1
`=0 G`
i=1
The
G =
m=0 Gm .
Associated with each compound gamble is a simple one, specifying the eective probabilities
A occur.
g yielding a1 with
compound gamble
probability
57
A = {a1 , a2 }
1 .
a1
1 .
probability
(1 )(1 ).
Thus,
a1
with probability
(( + (1 )) a1 , (1 )(1 ) a2 ).
Similarly, for every gamble
g G,
let
pi
ai A
by
g.
We say that
7.2.
following properties:
(G1)
is a weak order.
G1 :
restricted to
G1
is continuous.
Continuous weak orders have played an extensive role also in our earlier sections; the following
properties explicitly exploit the specic structure of our gambling framework. Our next property
requires that in considering a gamble, the DM cares only about the eective probabilities assigned
to each outcome in
A:
g G,
g (p1 a1 , , pn an ).
g,
then
if
(p1 a1 , , pn an )
This is a strong assumption. It rules out, for instance, any preference relation that takes into
account the complexity of compound gambles: a DM may strictly prefer the associated reduced
simple gamble to some
g G2562 ,
and
g0
g 00 , then the preference between the mixtures should be independent of the particular choice of
the third gamble. It essentially requires some form of independence of irrelevant alternatives: in
the two gambles
( g, (1 ) g 00 )
the gamble
g 00
and
( g 0 , (1 ) g 00 ),
1 .
that the preference should depend only on the part where the two gambles are dierent, i.e., on
gambles
and
g0.
g, g 0 , g 00 G
and all
(0, 1):
g % g 0 ( g, (1 ) g 00 ) % ( g 0 , (1 ) g 00 ).
58
Proposition 7.1
g G,
there is a number
g [0, 1]
on
G1 ,
in
g G1 : g % g % g .
such that
g (g g, (1 g ) g).
k N and let p1 , . . . , pk > 0 add
gi hi for all i = 1, . . . , k . Then
up to one. Let
g1 , . . . , gk , h1 , . . . , hk G
(p1 g1 , , pk gk ) (p1 h1 , , pk hk ).
Finally, let us assume that
(d) Monotonicity: for all
g g ,
, [0, 1],
if
> ,
then
( g, (1 ) g) ( g, (1 ) g).
Proof. (a):
n .
g G and let gs G1 be its reduced simple gamble. Since g gs by (G3) and
g % gs % g , it follows from transitivity (G1) that g % g % g .
Let p, p
n be the associated probabilities of g and g. By connectedness of the set of convex
simplex
(b):
Let
combinations of these best and worst gambles in the unit simplex, Proposition 2.7 implies that
there is a gamble with probabilities
g p + (1 g )p
equivalent with
g.
g (g g, (1 g ) g)
(c):
By induction on
k N.
gambles.
k = 1.
Let
k N, k 2,
and suppose
p2
pk
(p1 g1 , , pk gk ) (p1 g1 , (1 p1 ) ( 1p
g2 , , 1p
gk ))
1
1
p2
pk
h
,
,
(p1 h1 , (1 p1 ) ( 1p
2
1p1 hk ))
1
(p1 h1 , , pk hk )
.
, [0, 1] satisfy > .
(d):
Assume
g g
and let
( g, (1 ) g) ( g, (1 ) g)
g
59
by (G4)
by (G1) and (G3).
easily
Since
( g, (1 ) g) g.
Denote the left gamble by
g.
Then
( g, (1 ) g) = g
( g, (1 ) g)
Since
( g, (1 ) g)
by (G4)
( g, (1 ) g)
( g, (1 ) g) ( g, (1 ) g),
as we had to show.
7.3.
Equipped with these results, one can show that properties (G1) to (G4) imply the existence
of a utility function
Formally, a
u:GR
is a function
u:GR
that
on
g, h G :
G:
g % h u(g) u(h),
g G:
u(g) =
n
X
pi u(ai ),
i=1
where
(p1 a1 , , pn an )
g.
In words: a vNM utility function represents the preferences of the DM and the utility assigned
to a gamble equals the expected utility of the induced simple gamble.
Proposition 7.2
If
Proof.
g g ,
in
G1 .
In the
g g .
g G, Proposition 7.1 implies the existence
g (g g, (1 g ) g). Dene
u(g) = g .
For each
that
%.
60
of a unique number
g [0, 1]
such
(29)
%:
let
g, h G.
Then
g % h (g g, (1 g ) g) % (h g, (1 h ) g)
u(g) = g h = u(h),
where the rst equivalence follows from transitivity (G1) of
monotonicity and the denition of
u.
g G and let gs = (p1 a1 , , pn an ) be the
g gs , so u(g) = u(gs ). For each ai A, we know from
u(ai ) that
g.
By (G3),
i = 1, . . . , n,
dene
By substitution:
gs = (p1 a1 , , pn an ) (p1 h1 , , pn hn ).
Notice that
h1 , . . . , hn
(p1 h1 , , pn hn )
is equivalent with
n
X
!
g, 1
pi u(ai )
i=1
n
X
!
pi u(ai )
!
pi u(ai )
g, 1
i=1
is the unique number in
Remark 7.3
g .
we nd:
n
X
g gs (p1 h1 , , pn hn )
u(g)
i=1
By denition,
By computing the
n
X
!
pi u(ai )
!
g .
(30)
i=1
[0, 1]
satisfying
on
can
The linearity requirement on vNM utility implies that the earlier result from utility theory
any strictly increasing transformation of the utility function of the consumer still represents the
same preferences no longer holds. Indeed, the only transformations of a vNM utility function
that remain vNM utility functions, are positive ane transformations:
Proposition 7.4
with
a > 0,
also
au + b
on
G,
there
61
Proof.
g g .
a>0
and
To establish the
v(
g ) = au(
g ) + b,
v(g) = au(g) + b.
Let
g G.
so
u(g) = u(g)u(
g ) + (1 u(g))u(g),
(31)
and, similarly,
v(g) = u(g)v(
g ) + (1 u(g))v(g)
= u(g)[au(
g ) + b] + (1 u(g))[au(g) + b]
= a[u(g)u(
g ) + (1 u(g))u(g)] + b
= au(g) + b,
pound gambles of nite length. These assumptions can be relaxed, but at the cost of increased
topological and measure-theoretic complexity.
7.4.
Exercises
Exercise 7.1
G =
n=0 Gn
{a1 , . . . , ak } R of k 2 dierent deterministic outcomes. Recall: Gn is the set of n-th level gambles.
For each of the preference relations % over G dened below, answer the following questions:
If possible, nd the best and the worst elements of G.
set
For each of the four properties (G1) to (G4) guaranteeing the existence of a vNM utility function,
check whether
satises it.
%.
(a) Most likely outcomes: A decision maker bases preferences on the average of the deterministic
outcomes that are most likely to occur.
Let
g G
and let
(p1 a1 , , pk ak )
be its induced
L(g) = {ai : pi pj
for all
|L(g)|
g, h G:
on
g%h
j = 1, . . . , k}
its number of elements. The preference
1 X
1 X
ai
ai .
ai L(g)
ai L(h)
|L(g)|
|L(h)|
% over G
g G, there
is a unique n with g Gn . Let
Pk
Then u(g) =
m=1 pm am n.
(b) Keeping it simple: A decision maker dislikes complex alternatives and has preferences
represented by the following utility function: for each
(p1 a1 , , pk ak )
(c) Satisficing:
preference relation
62
for each
The
g G,
let
8.
Risk attitudes
8.1.
In for a gamble?
Let us conne attention to cases where the outcomes of the gambles are amounts of money:
a convex set in
R.
A is
Despite the fact that we now allow an innite set of outcomes, we will assume
that every gamble assigns positive probability to only nitely many outcomes.
The existence
theorem of vNM utility functions can be adjusted to this case by modifying the properties (G1)
to (G4) to innite sets. We assume that the vNM utility function
investigate the relation between this function and the DM's attitude towards risk.
Consider a nontrivial (i.e., at least two dierent deterministic outcomes have positive probability) simple gamble
g = (p1 w1 , , pn wn )
u(g) =
Pn
i=1 pi u(wi ).
2. Accept the outcome that gives the expected value of the gamble with certainty (this is where
we need convexity of
A!).
u(E(g)) = u(
E(g) =
Pn
Pn
i=1 pi wi .
i=1 pi wi ).
risk attitudes directly translate to properties of the associated vNM utility function over money:
Proposition 8.1
function
u.
Let
A R
Proof.
is strictly concave on
is linear on
A,
A,
is strictly convex on
A.
We only prove the rst claim; the others are similar. Risk aversion means that for every
nontrivial gamble
(p1 w1 , , pn wn ),
u(p1 w1 , , pn wn ) =
n
X
i=1
But this is equivalent with strict concavity:
PAn
strictly concave on
with
Pn
i=1 pi
=1:
!
p i wi
i=1
u is
p1 , . . . , p n > 0
i=1 pi u(wi )
n
X
P
< u ( ni=1 pi wi ).
w1 , . . . , w n A
and all
g,
he does not have to be risk averse/neutral/loving over the entire collection of lotteries. It may
well be, for instance, that he is risk averse at high-stake lotteries and risk loving at low-stake
lotteries.
63
8.2.
certainty equivalent
The
of a simple gamble
is an amount of money
CE(g) oered
CE(g):
with
and accepting
u(g) = u(CE(g)).
Remark 8.2
are continuous.
AR
g)
with
w %g
g,
there is a
and a
CE(g) is unique:
notion.
The
risk premium of a simple gamble g is an amount of money P (g) such that u(g) = u(E(g)
P (g)).
Clearly,
amount that makes him indierent between accepting that amount with certainty and accepting
the gamble
g.
This amount is called the certainty equivalent. It is easy to show (see below) that
for a risk averse DM who strictly prefers more money to less, the certainty equivalent is less than
the expected value
E(g)
of money to avoid the gamble's inherent risk. This willingness to pay is the risk premium.
Proposition 8.3
The
3.
P (g) > 0
Proof.
Since
g S,
g S.
that statements 1 and 2 are equivalent. The DM is risk averse if and only if for every nontrivial
with
As a simple exercise, try to formulate similar characterizations of risk neutral and risk loving
behavior.
Example.
A = R++
64
Hence
1
1
ln(w0 h) + ln(w0 + h) = ln
2
2
CE(g)
must satisfy
q
w02 h2 ,
where the nal equation follows from the properties of the natural logarithm. Hence
p
w02 h2 < w0 = E(g)
8.3.
and
P (g) = w0
CE(g) =
p
w02 h2 > 0.
Arrow and Pratt considered the problem of measuring the extent of risk aversion. They assumed
that the vNM utility function
w : u0 (w) > 0
Using this, the
and
(32)
u00 (w)
.
u0 (w)
Why is this a sensible measure of risk aversion? A heuristic derivation is provided in the next
subsection. The intuition is as follows: the more risk averse a DM is, the more he is willing to pay
to avoid certain gambles. Thus, the size of the risk premium in some way measures risk aversion.
It turns out that the Arrow-Pratt measure of absolute risk aversion is roughly proportional to
the risk premium the DM is willing to pay to avoid actuarially fair bets (a bet is actuarially
fair if its expected value equals initial wealth: the expected loss/gain is zero). Thus, if DM 1 is
more risk averse than DM 2, his risk premium for every nontrivial gamble exceeds that of DM 2,
so the same should hold (due to proportionality) for the Arrow-Pratt measures of absolute risk
aversion. The actual proof is somewhat more complicated; we omit it.
Proposition 8.4
and
00
00
(w)
(w)
Ra1 (w) = uu0 (w)
> vv0 (w)
= Ra2 (w)
w,
1
2. The risk premium P (g) of the DM with utility function u is strictly larger than the risk
2
premium P (g) of the DM with utility function v for every nontrivial gamble g S.
Notice that positive ane transformations of the utility functions do not aect
Ra (w):
it does
Ra ()
is a decreasing function of
65
w.
8.4.
The argument in this section is due to Pratt (1964). Assume (32) and let the DM's initial wealth
be
w0 .
h:
E(g) = w0 .
Let
P = P (g) > 0
g:
1
1
u(g) = u(w0 h) + u(w0 + h) = u(E(g) P ) = u(w0 P ).
2
2
Take a rst order Taylor approximation of
u(w0 P )
around
(33)
w0 :
u(w0 h)
and
u(w0 + h)
(34)
around
w0 :
1
u(w0 h) u(w0 ) u0 (w0 )h + u00 (w0 )h2 ,
2
1
0
u(w0 + h) u(w0 ) + u (w0 )h + u00 (w0 )h2 .
2
Consequently,
1
1
1
u(w0 h) + u(w0 + h) u(w0 ) + u00 (w0 )h2 .
2
2
2
(35)
1
u(w0 ) + u00 (w0 )h2 u(w0 ) u0 (w0 )P.
2
Rearranging terms, one nds
1 u00 (w0 )
P h2 0
.
2
u (w0 )
Conclude that the Arrow-Pratt measure of absolute risk aversion is approximately proportional
to the risk premium
losing an amount
P,
h.
66
9.
Expected utility theory is the main tool in economic models involving uncertainty. Nevertheless,
expected utility theory has been under constant attack from behavioral economists and psychologists who show that subjects in experiments or real-life situations systematically violate the
properties (G1) to (G4) or that mindless application of expected theory leads to counterintuitive
conclusions. For this reason, many alternative models for decision making under risk and uncertainty have been developed. Perhaps the most well-known especially since Daniel Kahneman
was awarded the 2002 Nobel Prize in economics is Kahneman and Tversky's prospect theory
(Kahneman and Tversky, 1964). Although we lack time to go into such alternative models, we
stand still for a while and consider a number of blows to the expected utility model.
9.1.
Nothing in the development of our expected utility model required the utility function to be
bounded. Unbounded utility functions, however, make decision-makers susceptible to cunning
exploitation. Suppose a DM with initial wealth
1
victim the gamble (
2
1
2
0, w1 ),
w1
with
w1
money from your hand, retract it, turn your smile back on, and oer him a gamble
where
w2
u(w1 ) <
1
2 (u(0)
+ u(w2 )).
( 21 0, 12 w2 ),
accept.
As long as the DM goes on winning, keep oering such 50-50 odds gambles. . . The DM will
end up with wealth zero with probability one!
9.2.
Allais' paradox
g1
g2 , but g4
u. Then
to
to
g3 .
This violates
g1 g2 u($1, 000, 000) > 0.10u($5, 000, 000) + 0.89u($1, 000, 000) + 0.01u($0).
Rearranging terms, we nd
67
g3
and
g4 .
9.3.
Probability matching
$1 each time you guess correctly whether a red or a green light will ash.
The lights
ash randomly, but the red is set to turn on three times as often as the green. It has been found
that many subjects in experiments of this type try to imitate the chance mechanism: they choose
red about three quarters of the time and green one quarter. Obviously it would be more protable
to always choose red.
with probability
3/4
This type of matching behavior has been frequently observed in real life, as well as laboratory
experiments, using both humans and animals as subjects. In an experiment with animals, for
instance, foraging behavior of pigeons was studied, using two food patches (call them red and
green, as above) with food being dispatched at the red location three quarters of the time and
at the green location one quarter of the time.
distribution.
A small personal anecdote: jointly with two colleagues, I published two papers on a game
theoretic model of bounded rationality in which players are assumed to display matching behavior. To explain the type of behavior to laymen and motivate that it is observed in real life, we
used dierent examples, among them the pigeon example mentioned above. This led the Dutch
Foundation for Mathematical Research, which at that time was nancing my work, to publish
a press statement proudly proclaiming: People behave like pigeons when dealing with probability, a press statement that gave us extensive media coverage but where we desperately tried to
qualify our employers' overzealous interpretation. So in case you sometimes wonder what you
are doing. . . you may just be behaving like a pigeon!
9.4.
Matthew Rabin, one of the world's leading behavioral economists, published a remarkable article
(Rabin, 2000) on the consequences of risk aversion with respect to small-stake gambles. Let us
start with an example to illustrate the result. Consider a risk averse DM who for each initial
wealth level rejects a 50-50 odds gamble of winning
11
dollars or loosing
10
dollars: certainly a
rather unremarkable level of risk aversion. What does this imply about his preferences for other
gambles? Consider, for instance, the following statements:
1. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing
100
150
dollars.
2. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing
100
1, 500
dollars.
3. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing
100
68
1, 000, 000
dollars.
4. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing
100
dollars.
100
G.
Which of these statements are true? The rst and the second may perhaps not be so surprising
and I probably wouldn't be asking you if the question was trivial, so even the third could be
true. On the other hand, one would certainly doubt the sanity of a DM rejecting the bet in the
fourth claim and lingering doubt turns to certainty in the fth case. Yet this is exactly what the
DM will do: no amount of money in the world will make him accept a gamble with a 50 percent
chance of loosing
100
Let us try to establish some intuition. The fact that the DM at each wealth level
rejects
the gamble
1
1
(w 10) , (w + 11)
2
2
implies that
1
1
u(w 10) + u(w + 11) < u(w),
2
2
w :
or, rewriting the expression, that
w :
w :
by at most
10/11
times as
By concavity of the utility function, this means that the marginal utility of the
is at most
10/11
w :
(w 10)-th
u0 (w + 11) <
(w + 11)-th dollar
dollar:
10 0
u (w 10).
11
(36)
Repeated application of (36) implies an enormous decrease in marginal utility of money: the
marginal utility of dollar
w + 32
is at most
10/11
w + 11,
10/11 times the marginal utility of dollar w 10, so the marginal utility of
w + 32 is at most (10/11)2 0.83 times the value of dollar w 10. Similarly, the DM
3
values dollar w + 53 by at most (10/11) 0.75 times the value of dollar w 10. More generally,
k+1 times the value of dollar
the DM values dollar w + 11 + 21k , where k N, by at most (10/11)
w 10, which is an extremely high rate of deterioration for the value of money.
which is at most
dollar
69
10.
Time preference
Discounting essentially means that a given benet is valued higher when it is received immediately
than when it is received with a delay. A common economic motivation for discounting is that,
say, one dollar today is worth more than one dollar next year, as the immediate reward can be
put into a bank at an annual interest rate
year.
dollars next
Another motivation, common in evolutionary models, is the risk that a delayed benet
may not be realized: you may die before receiving it (or be interrupted in achieving it, or be
cheated in the promise of receiving it).
In addition to the question how to model discounting in an appropriate way, decision theory
in the presence of time involves a number of careful considerations:
Choice of horizon: should one look nitely or innitely far into the future? Keynes' famous
quote In the long run, we are all dead could be an argument in favor of a nite horizon.
Many economic models involve just two time periods as an abstraction of now and the
future. On the other hand, many decisions have no clearly dened nal period: you or
in an evolutionary sense as in overlapping generations models, your genes may live to
see another day. In such cases, an innite horizon makes sense.
Choice of time as a discrete or continuous variable: also here, common sense, the appropriate level of abstraction, and (not rarely) the modeler's choice of mathematical tools is
decisive.
Unless specied otherwise, this section takes time as being discrete and uses an innite horizon.
We derive the standard exponential discounting model from a stationarity assumption on preferences and briey discuss a violation of stationarity and hyperbolic discounting. Section 10.3,
based on Osborne and Rubinstein (1994, Sec.
comes over time without discounting. The nal section, based on Voorneveld (2007), illustrates
the somewhat paradoxical statement that a sequence of utility-maximizing choices can minimize
utility.
10.1.
preferences
ct
c = (c0 , c1 , . . .) = (ct )
t=0
in some
t.
of the form
(t)u(ct ),
(37)
t=0
with
(0) = 1.
ct
at time
tN
Exercise 10.1
the
gives utility
The expression in (37) involves an innite sum, which may not be well-dened.
70
(b) Prove that the sum is well-dened if the sequence of discount factors is summable (
(t) = t
for all
t,
t=0
(t) < )
is bounded.
exponential discounting :
there is a
(0, 1)
such
U (c) =
t u(ct ).
(38)
t=0
Recall the earlier motivation for discounting of money: given a xed interest rate
period, one dollar tomorrow is worth only
= (1 + r)1 .
(1 + r)1
r > 0
per
stationarity
satisfy
dropped, and the timing of all other outcomes is advanced by one period. By repeated application, it implies that for a comparison between two sequences all initial periods with common
outcomes can be dropped, and the rst period of dierent outcomes can be taken as the initial
period. Formally, the preference relation
is
(c0 , c1 , c2 , . . .) % (d0 , d1 , d2 , . . .)
Proposition 10.1
preferences
satisfy stationarity,
the decision-maker is indierent between:
option 1:
option 2:
where
getting
getting
today and
today and
0
0
By induction on
u()u()
u( 0 )u(0 )
(, 0 , 0, 0, . . .)),
tomorrow,
u(0 ) 6= u( 0 ).
Proof.
for all
t.
< t.
(t) =
u()u()
u( 0 )u(0 )
t = 0.
t
Let
tN
( ) =
( 0, . . . , 0 , , 0 , 0, 0, . . .) ( 0, . . . , 0 , , 0 , 0, 0, . . .),
| {z }
| {z }
t1
times
t1
times
(t) = (t 1)
u() u()
u( 0 ) u(0 )
=
71
u() u()
u( 0 ) u(0 )
t
,
Exercise 10.2
t = 1.
Rational suicide: A decision maker (DM) lives for at most two periods,
At each time
t {0, 1}
t=1
1/2
1/2.
t.
1
1
u(s, a) =
0
>0
and
as follows:
where
t = 0
if
if
if
otherwise,
is the intensity of the depression. Thus, given that you're happy, killing yourself appears
(a) What is the optimal action and the resulting instantaneous utility if the DM at
t = 1 is (a1) happy?
(a2) depressed?
Now consider the initial period: assume the DM is depressed at time
(b) Assuming optimal behavior at time
t = 1,
t = 0.
t = 0?
Note:
the DM does not kill himself immediately, there is uncertainty about his mood at time
the answer depends on
and
(i) if
t = 1; (ii)
(c) A psychologist claims that the option of future suicide might prevent depressed people from killing
themselves straight away. Explain this claim using the answers above.
10.2.
Stationarity requires that if you prefer one apple today over two apples tomorrow, then shifting
this choice by one year (one apple next year versus two apples one year and a day from now)
doesn't change that you'd still rather have the single apple.
evidence (Thaler, 1981) seems to suggest that people are much more sensitive to a waiting time
of one day when it occurs right now than to a waiting time in the far future: if you anyway
have to wait an entire year for a lousy apple, you might as well wait one day more and double
the booty.
hyperbolic discounting. It simply involves discount factors that are not exponential. Arguably
, (0, 1),
U (c) = u(c0 ) +
t u(ct ).
t=1
To see that this model can explain the preference reversal for the apples, assume that utility
satises
u(0) = 0
and is strictly increasing in apples. Preferring one apple today over two apples
(39)
Preferring two apples one year and a day from now to one apple a year from now (and assuming
we're not in a leap year) means that
<
Taking
(40)
(, ) (0, 1) (0, 1)
to satisfy
u(1)
< .
u(2)
Discount factors
(t) = (1 + t)/ ,
with
, > 0,
t experimental data well. Show that also this model captures the preference reversal described above.
intertemporal consumption, time periods represent generations and people care about future consumption
to the extent that it is exercised by their ospring (children, grandchildren, etc.). To simplify matters,
(i) a DM cares about consumption of its ospring only if it has a specic gene; (ii) mates
[0, 1], (iii) ospring gets in
expectation half of its genes from each parent, (iv) we consider one unit of ospring per time period.
assume that
are selected at random and have the relevant gene with probability
(a) Let
t N. Show, for
t-th period
the DM's
p0 = 1 and
t = 0, 1, 2, . . .
(b) Set
pt of
pt = 12 pt1 + 12 .
t
pt = + (1 ) 12 for all
P (pt )t=0 in the place of discount factors, the standard separable utility
U (c) =
p
u(c
t ). Assume that consumption is in units of apples, u is strictly
t=0 t
u(0) = 0. Let's investigate the opportunity of preference reversal.
and
Prove: for
10.3.
apple now (t
= 0)
T +1
to 1 apple at time
= 1).
T.
By discounting, less weight is assigned to future utilities. This section introduces two other ways
of evaluating sequences of utilities, attaching equal weight to all periods. To save on notation,
(xt )
t=0 of real numbers, rather than
using the more elaborate (u(ct ))t=0 . Probably the rst thing that comes to mind is to value a
sequence of utilities (xt )t=0 using the long-term average of the utilities:
we will denote a sequence of utilities simply by a sequence
x0 + x1 + + xT 1
.
T
T
lim
However, even if the sequence is bounded, this limit may not exist: the average may continue
to oscillate. We verify this statement with a binary (zero-one) sequence. The idea is to append
enough ones to increase the average until it achieves a xed high value, then to append enough
zeroes to decrease the average until it reaches a xed low value, and continue this process.
An oscillating average:
(0, 1, 1, 0, 0, 0, 1, 1, 1, 1, 1, 1, . . .)
73
obtained by starting with a zero and two ones, and then after each block of zeroes or ones, double
the length of the sequence obtained so far with a block of the other number: after the rst block
of ones, we have three coordinates, so we double the length to six coordinates by appending some
zeroes. Then we double the length to twelve coordinates by adding some ones, etc. A simple
inductive proof shows that after the
k -th
2/3.
3 22k2
coordinates,
1/2
1/3.
to
3 22k1
As appending
zeroes decreases, and appending ones increases the average, it follows that the average continues
to oscillate between
1/3
and
2/3.
Taking, instead, a pessimistic view of how the average utility changes over time will give us
a well-dened criterion.
sequence
(xt )
t=0
of real numbers.
For each
t, st = inf{xs : s t}
Consider a bounded
somewhat colloquial terms, the worst value) of the tail of the sequence from time
onwards.
(st )
t=0
This inmum is well-dened, as the sequence is bounded. Notice also that the sequence
is weakly increasing: increasing
monotonic, bounded sequence, it converges. Its limit is called the lower limit or
limes inferior
By convention,
lim inf t xt =
(xt )
t=0
if
If it is bounded
from below, but not from above, the sequence of inma may diverge, in which case one sets
lim inf t xt = +.
The following characterization of the lower limit may come in handy.
sequence and let
c R.
Then
lim inf t xt = c
Let
(xt )
t=0
be a
[L1] for each > 0, there is a T N such that c < xt for all t T ,
[L2] for each > 0 and each T 0 N, there is a t T 0 with xt < c + .
In words, the sequence eventually remains above
matter how small
Exercise 10.5
c ,
c+
innitely often, no
> 0.
Prove this.
The limit-of-means criterion evaluates utility streams by means of the lower limit of the average
utility:
Limit of means:
preferred to
Let
x = (xt )
t=0
y = (yt )
t=0
and
be sequences in
lim inf
T
x L y ,
T 1
1 X
(xt yt ) > 0.
T
and
eventually exceeds
T 1
1 X
(xt yt ) >
T
Then
is
(41)
t=0
R.
if and only if
> 0,
t=0
74
T.
Exercise 10.6
Prove this.
Changes in a single coordinate of a sequence become negligible once the average is taken over a
long time, so under the limit-of-means criterion, changes in any nite number of periods do not
matter. In particular, these preferences are stationary.
Exercise 10.7
Some authors refer to the limit-of-means criterion as the preference relation repre-
x = (xt )
t=0
lim inf T T1
PT 1
t=0
the number
U (x) =
xt .
The following criterion also assigns equal weight to periods, but remains sensitive to changes in
single coordinates:
Overtaking:
to
Let
x = (xt )
t=0
y = (yt )
t=0 be sequences in R.
denoted x O y , if and only if
and
lim inf
T
T
X
Then
x is preferred
(xt yt ) > 0.
t=0
Let us compare exponential discounting, and the limit-of-means and overtaking criteria.
The
latter were dened in terms of strict preferences. Dene the corresponding indierence relation
as follows:
x L y
if neither
x L y
nor
y L x.
Of course,
is dened similarly.
Comparison:
The sequence
counting for
The sequence
(1, 2, 0, 0, . . .)
(0, 0, . . .)
dis-
For every
n N,
the sequence
(0, . . . , 0, 1, 1, . . .)
| {z }
n
is preferred to
(1, 0, 0, . . .)
times
(0, 1),
a large enough delay in a constant stream of ones makes the instant gratication of getting
1 immediately the preferable option.
10.4.
Consider an alcoholic who has to decide at each moment in discrete time whether to take a drink
(action 1) or not (action 0).
treat this as an innite horizon problem, discounting the impact of future decisions if so desired.
x = (xt )
t=0 of zeroes and ones, with xt = 1 if the alcoholic
takes a drink at time t and xt = 0 otherwise. With a minor abuse of notation, (0, xt ) denotes
the drinking pattern obtained from x by not drinking at time t. The pattern (1, xt ) is dened
A drinking pattern is a sequence
likewise.
75
drink one day at a time. Let us investigate the possibility of having a utility function
that
simultaneously models:
Temptation: at any given day, the alcoholic is at least as well of and sometimes better
by choosing to drink:
U (1, xt ) U (0, xt )
U (1, xt ) > U (0, xt )
t, xt ,
some t, xt .
for all
for
Health concerns: nevertheless, the best thing is never to drink and the worst thing is
to drink at all times:
(0, 0, . . .)
maximizes, and
(1, 1, . . .)
minimizes
U.
This sounds paradoxical and is indeed impossible under a nite horizon: suppose there are only
T N
periods. Start with an arbitrary drinking pattern and switch, one period at a time, any
So drinking at all times maximizes utility, in conict with health concerns, which
would require that all these weak increases in utility eventually lead to a plunge in utility: it is
like climbing a stairway, but ending up lower than before (Figure 3).
Figure 3:
An impossible stairway
The next example shows that temptation and health concerns can be reconciled under an
innite horizon.
Drinking paradox:
3
0
U (x) =
P
As a switch from
it by
2t > 0
to
if
if
t
t xt 2
at time
xt = 1
xt = 0
t
t
as follows:
(a rare drinker),
(a heavy addict),
otherwise.
leaves the utility unaected in the rst two cases and increases
76
11.
Probabilistic choice
A of alternatives.
u:AR
a utility
do not always make the same choice under seemingly identical circumstances,
sometimes choose seemingly suboptimal alternatives.
Such apparently irrational behavior has led to the development of so-called
probabilistic choice
if
and
a % b,
should be at
b.
This section gives a very short introduction to three probabilistic choice models: the Luce
model , the logit model , and the linear probability model . Often, probabilistic choice models
are derived in a random utility framework, where the true utility of each alternative consists of
a deterministic component plus a random component.
random utility component, a feasible choice will look good under some circumstances and bad
under others, thus motivating that observed choice is probabilistic: an alternative is only chosen
in circumstances where it looks optimal. We will not consider such random utility models: they
are (or should be) treated in detail in the econometrics courses. The development of these models
was one of the main causes for awarding Daniel McFadden the Nobel Prize in 2000. Instead, we
derive the models either axiomatically or via the introduction of
The derivation of the logit choice probabilities using the entropy cost
function can be found in Mattsson and Weibull (2002). The derivation of the linear probability
model using the Euclidean distance as cost function is due to Voorneveld (2006). It is based on
an early contribution to the literature on bounded rationality in games by Rosenthal (1989).
11.1.
in the remainder of this section, we assume that the DM has to choose from a subset
of alternatives in
containing at least two elements : choosing from a set with only one
If
aS
S T A,
T by
by
S A,
SA
P
set is
PT (a).
aS
By the assumption above:
PT (T ) = 1
for all
77
T A.
PT (S) =
or
T A.
aS
PS (a) = 1.
by removing an element
aA
is denoted by
S \ {a}.
With this notation, the following two properties should be intuitive. The rst property states
that if some alternative
i.e.,
P{a,b} (a) = 0,
then
remaining alternatives:
(L1) Let
T A
and
a T.
If there exists a
bT
with
P{a,b} (a) = 0,
then
S T.
Taking
S = T \ {a}
in (L1), we get
(L2) Let
ST A
and
a S.
If
P{a,b} (a)
/ {0, 1}
for all
b T,
then
T A,
P{a,b} (a)
/ {0, 1} for all a, b T, a 6= b.
The
Proposition 11.1
A.
Path independence
u(a)
bS u(b)
PS (a) = P
for every
S A.
(42)
Proof.
Step 1:
PA (a) = 0
for some
a A.
PA (a) > 0
for all
a A.
b A \ {a} :
0 = PA (a) = PA ({a, b})P{a,b} (a).
Since
P{a,b} (a) 6= 0,
it follows that
for all
b A \ {a}.
Proba-
b A :
contradicting
bA PA (b)
= 1.
PA (b) = 0,
PA (a) > 0 for all a A, dene u(a) = PA (a).
SA:
PS (a) =
PA (a)
PA (a)
u(a)
=P
=P
.
PA (S)
bS PA (b)
bS u(b)
78
Step 2:
u : A R++
such that
u(a)
bS u(b)
PS (a) = P
for every
S A.
S T A and a S . Then
P
u(b)
u(a)
u(a)
PT (a) = P
= PbS
P
= PT (S)PS (a).
bT u(b)
bT u(b)
bS u(b)
Step 3:
and
u0 .
aA:
u(a)
u0 (a)
=P
.
0
bA u(b)
bA u (b)
P
P
0
=
bA u(b) /
bA u (b) > 0.
PA (a) = P
Hence
u(a) = u0 (a),
where
In words: In Luce's choice model, each alternative can be assigned a positive value such that the
probability of choosing a given alternative from a choice set is proportional to its value.
Debreu (1960) showed that path independence although reasonable at rst sight can
lead to counterintuitive conclusions. Consider, for instance, the following well-known variant of
Debreu's argument:
go to his destination by car or by bus. Assume the DM assigns the same probability to both
alternatives:
(43)
Suppose now that two buses can be used, which are completely identical, except in their colors:
one of them is red, the other is blue. So the choice set is
A = {car,
bus)
bus).
(44)
Intuitively, since the DM according to (43) doesn't seem to care whether he goes by car or by
bus, it would seem reasonable to expect that he will choose to go by car with probability
and to go by bus with probability
1/2,
PA (car) = 1/2
and
1/2
PA (blue
bus)
= PA (red
bus)
= 1/4,
or at least that the probability of taking the car should be larger than the probability of
taking any of the two buses. However, path independence (L2) implies
PA (car) = PA (blue
bus)
= PA (red
bus)
= 1/3.
PA (car)
(L2)
(43)
def
so
PA (car) = PA (blue
PA (car) = PA (red
bus).
add up to one:
PA (car) = PA (blue
bus)
= PA (red
bus)
= 1/3.
So: in the choice problem with only one bus, the DM will choose to go by car or by bus with
equal probability, but when faced with the choice between going by car or going by bus in case
there are two virtually identical buses, the probability of choosing the car decreases from
1/2
to
1/3.
11.2.
> 0,
i A
A = {1, . . . , n}
from
(i). In the
A is equal to
logit model
with parameter
e(i)/
exp((i)/)
=P
.
(j)/
jA exp((j)/)
jA e
PA (i) = P
(45)
Notice from (42) that this is just a special case of Luce's model, where the utility assigned to
each alternative
iA
is equal to
Control costs.
> 0.
(
n =
p Rn+ :
n
X
)
pi = 1 .
i=1
guarantee the exact implementation of his choices: a careless driver may drive of the road, an
absentminded shopper may by mistake buy the wrong item. To model this, we assume that it
requires eort to implement choices: associated with each choice
p n
will be a disutility or
n
i=1 pi (i) and
> 0
c(p),
where
is a
positive scalar representing the relative weight assigned to the eort of implementing choice
Hence, the DM aims to solve
max
pn
n
X
p.
pi (i) c(p).
i=1
Dierent cost functions give rise to dierent choice probabilities. A common control cost function
that appears in many branches of science (physics, chemistry, information science, to name but
a few) is the following
entropy function :
c(p) =
n
X
pi ln (pi ) ,
i=1
80
(46)
0 ln 0 = 0.
Proposition 11.2
max
pn
n
X
pi (i) c(p),
(47)
i=1
with the control cost function from (46) has a unique maximum location with
exp((i)/)
,
jA exp((j)/)
i A : pi = P
the logit choice probabilities from (45).
Proof.
Pn
i=1 pi (i)
c(p)
is strictly
concave. Since we maximize a strictly concave, continuous function over a compact set, a maximum exists and is unique. Since the feasible set is entirely dened by linear (in)equalities, the
Kuhn-Tucker conditions give necessary and sucient conditions for a solution to be a maximum.
The condition for an interior solution
exists a Lagrange multiplier
of
p n ,
i = 1, . . . , n : (i) (ln pi + 1) + = 0,
Pn
the goal function
i=1 pi (i) c(p) has i-th
(i)
Pn
j=1 pj
= 1,
with
c = exp(( )/)
and as
coordinate
a constant.
it follows that
exp((i)/)
,
jA exp((j)/)
pi = P
as we had to show.
(48)
i = 1, . . . , n:
i = 1, . . . , n :
The role of .
there
c(p)
= (i) (ln pi + 1).
pi
pi = c exp((i)/),
As
Let us investigate what happens with the logit choice probabilities in (45) as
i, j A, i 6= j .
PA (i)
exp ((i)/)
=
= exp
PA (j)
exp ((j)/)
which converges to one as
(i) (j)
,
(49)
to one, their limits must be equal; together with the fact that probabilities add up to one, we
conclude that the choice probabilities converge to
81
1/n
as
0.
0,
(i),
Since we are dealing with probabilities here, which are bounded below by
suppose that
PA (j) 0.
If we let
it follows that the probability of choosing an alternative with less than maximal
payo converges to zero. So in the limit, all probability is restricted to optimal alternatives and
it is clear from the denition of the choice probabilities that all of these will be chosen with equal
probability.
In summary, the parameter
large values of
the DM chooses by more or less blindly picking any of the alternatives, while
11.3.
The idea behind the linear probability model is the same as behind Luce's model and the logit
model: the probability of choosing an alternative should be (weakly) increasing in the payo
associated to the alternative:
(50)
The adjective linear indicates that the dierence between these two probabilities should be linear
in the payo dierence: for a parameter
> 0,
we require that
(51)
Unfortunately, it is not always possible to combine these two properties for large values of
. Let's consider a simple example with two alternatives: A = {1, 2} and respective payos
(1) = 4, (2) = 0. By (50), we want PA (1) PA (2) and by (51), we want PA (1) PA (2) =
((1) (2)) = 4 . If we take = 1/8, this gives PA (1) PA (2) = 1/2. The probabilities have
to add up to one, so the unique solution is that PA (1) = 3/4 and PA (2) = 1/4. So far, so good.
Now take = 100: PA (1) PA (2) = 4 = 400. Since PA (1) and PA (2) are probabilities between
zero and one, making their dierence equal to 400 (or for that matter any number larger
than 1) is simply impossible.
So we have to relax our requirements (50) and (51) somewhat. Unwilling to change (50), let
us adapt (51). Indeed, we require the linearity condition whenever possible, but when we run
into problems like the one in the example above, we simply require that alternatives with low
payo are chosen with probability zero. Formally, choice probabilities
iA
PA (i)
satisfy the linear probability model with parameter > 0 if the following holds:
if
PA (i) > 0,
then
for all
j A.
If both
and
and
This implies
82
(52)
i, j A
with
(i) (j)
and
> 0.
Combining the two points above, we see that the choice probabilities are weakly increasing
in the associated payos. By necessity, we had to set the probability of choosing low-payo
alternatives equal to zero, but those that are chosen with positive probability still satisfy
the linearity requirement.
Control costs.
The choice probabilities can be derived in the same way as before by making
a clever choice of the cost function. Consider the cost function that assigns to every probability
vector
the
p n
(1/n, . . . , 1/n)
n
X
1 2
c(p) =
pi
.
n
(53)
i=1
So choosing all alternatives with equal probability gives zero costs and costs increase the further
away you go from the vector
(1/n, . . . , 1/n).
Proposition 11.3
> 0,
For each
max
n
X
pn
pi (i)
i=1
1
c(p)
2
(54)
with the cost function given in (53). The solution coincides with the choice probabilities in the
linear probability model with parameter
The role of .
costs in (47) and (54), you will notice that they switched roles: large values of
correspond with
a large weight assigned to the control cost function in the logit model, but with a small weight
assigned to the control cost function in the linear probability model. This change was necessary
because I wanted to follow the standard denition of the linear probability model in (52). But
the intuition remains the same:
model: for large values, (52) indicates that the dierence in the probability of choosing an optimal
alternative (highest
(i))
add up to one, this implies that in the limit, all alternatives will be chosen with equal probability.
83
11.4.
Exercises
Exercise 11.1
Exercise 11.2
Let
>0
0?
Exercise 11.3
Let
Interpret.
Interpret.
> 0,
>0
(b) Answer the same questions for the linear probability model.
Exercise 11.4
The penalty function approach: Two of the probabilistic choice models considered
above could be rationalized using control cost functions giving a penalty to deviations from uniform
randomization. This exercise gives the general argument behind such rationalizations.
A penalty function on
Rn
is a function
: A R.
A = {1, . . . , n}
with
n 2
P () :
max
pn
0,
n
X
i=1
Show that the resulting choice probabilities satisfy the desired monotonicity requirement: if
and
then
elements and
pi pj .
84
p solves P ()
Full circle
To make sure you get the big picture, let us at the end of this course turn back to where we
started: the overview of the course goals in the preface, and briey summarize how we achieved
them.
(Q1) What can the agent choose from, i.e., what is the set of feasible alternatives?
(Q2) What does the agent like, i.e., what are the preferences over alternatives?
(Q3) How are the former two combined to make a choice, i.e., to select among alternatives?
We mostly stuck to rational choice: choose from your set of feasible alternatives a most preferred
one.
Sections 1 to 3 provided a general framework for modeling preferences over and choice from
arbitrary sets of alternatives. Important stops along the way included:
Utility theory:
We provided an exact
Moreover,
we provided conditions under which utility functions had some additional nice structure.
For
instance, continuity was studied in Section 2.5, cases where preferences could be expressed in
terms of a numeraire in Section 2.6.
Existence of solutions:
(Q5) How are most preferred elements aected by changes in the agent's environment?
Below, I will go through these applications, summarize how feasible sets and preferences were
dened, and if applicable indicate where we studied the answer to
85
(Q5).
x RL
+
in a budget set
B(p, w).
X = RL
+.
x RL
+
px
p RL
++ .
in a production set
py
Y RL .
at price vector
p RL
++ .
z RL1
+
wz
w RL1
++ .
G,
under some
c = (ct )
t=0
t.
U (c) =
t=0 (t)u(ct ),
in some probabilistic choice models like the logit and linear probability model, agents choose
probabilities as if they maximize expected payos subject to implementation costs:
of alternatives.
Preferences: represented by a utility function of the form expected payo minus control
costs; see Propositions 11.2 and 11.3.
86
I hope that the tools you acquired during this course will help you to address also other economic
problems in a structured way.
87
Notation
If
is a nite set,
|X|
A is also an element of B ): A B .
B , but A 6= B ): A B .
Set of positive integers: N = {1, 2, 3, . . .}.
Set of integers: Z = {. . . , 2, 1, 0, 1, 2, . . .}.
Set of rational numbers: Q = {p/q : p, q Z, q 6= 0}.
Set of real numbers: R.
For arbitrary L N :
L
L
L
Set of vectors in R with nonnegative coordinates: R+ = {x R : x1 , . . . , xL 0}.
L
L
L
Set of vectors in R with positive coordinates: R++ = {x R : x1 , . . . , xL > 0}.
L
Sets like Q++ are dened analogously.
L
For two vectors x, y R , their inner product is denoted by x y = x1 y1 + + xL yL .
Weak set inclusion (each element of
Moreover, write
xy
if
xi yi
i = 1, . . . , L,
x>y
if
xi > yi
i = 1, . . . , L.
Relations
For
ek = (0, . . . , 0,
1
|{z}
th coordinate
e = (1, . . . , 1) RL .
88
, 0, . . . , 0).
k -th
coordinate equal
References
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Arrow, K.J., 1959. Rational choice functions and orderings. Economica 26, 121-126.
Arrow, K.J., Hahn, F.J., 1971. General competitive analysis. Amsterdam: North-Holland.
Ben-Akiva, M., Lerman, S.R., 1985. Discrete choice analysis. MIT Press.
Cobb, C.W., Douglas, P.H., 1928. A theory of production. American Economic Review (supplement) 18, 139-165.
Debreu, G., 1954. Representation of a preference ordering by a numerical function. In: Decision
Processes. Thrall, Davis, Coombs (eds.), John Wiley, pp. 159-165.
Debreu, G., 1959. Theory of value. Yale University Press.
Debreu, G., 1960. Review of R.D. Luce, Individual Choice Behavior: A Theoretical Analysis.
American Economic Review 50, 186-188.
Debreu, G., 1964. Continuity properties of Paretian utility. International Economic Review 5,
285-293.
Diecidue, E., Wakker, P.P., 2002. Dutch books: avoiding strategic and dynamic complications,
and a comonotonic extension. Mathematical Social Sciences 43, 135-149.
Dubra, J., Echenique, F., 2001. Monotone preferences over information. Topics in Theoretical
Economics 1, article 1.
http://www.bepress.com/bejte/topics/vol1/iss1/art1
Fishburn, P.C., 1970a. Utility theory for decision making. New York: John Wiley & Sons.
Fishburn, P.C., 1970b. Intransitive individual indierence and transitive majorities. Econometrica 38, 482-489.
Fishburn, P.C., 1979. Transitivity. Review of Economic Studies 46, 163-173.
Hildenbrand, W., Kirman, A.P., 1988. Equilibrium analysis. North-Holland.
Jaray, J.-Y., 1975. Existence of a continuous utility function: An elementary proof. Econometrica 43, 981-983.
Kahneman, D., Tversky, A., 1964. Prospect theory: an analysis of decision under risk. Econometrica 47, 263-291.
Kamke, E., 1950. Theory of sets. New York: Dover Publications.
Kaneko, M., 1976. Note on transferable utility. International Journal of Game Theory 5, 183-185.
Koopmans, T.C., 1960. Stationary ordinal utility and impatience. Econometrica 28, 287-309.
Kreps, D.M., 1990. A course in microeconomic theory. Hertfordshire: Harvester Wheatsheaf.
Loewenstein, G., Prelec, D., 1992. Anomalies in intertemporal choice: evidence and interpretation. Quarterly Journal of Economics 107, 573-597.
Luce, R.D., 1959. Individual choice behavior: A theoretical analysis. Wiley.
Mas-Colell, 1985. The theory of general economic equilibrium; A dierentiable approach. Cambridge: Cambridge University Press.
Mas-Colell, A., Whinston, M.D., Green, J.R., 1995.
Microeconomic theory.
Oxford: Oxford
University Press.
Mattsson, L.-G., Weibull, J.W., 2002. Probabilistic choice and procedurally bounded rationality.
Games and Economic Behavior 41, 61-78.
Osborne, M.J, Rubinstein, A., 1994. A course in game theory. Cambridge, MA: MIT Press.
Phelps, E.S., Pollak, R.A., 1968. On second-best national saving and game-equilibrium growth.
Review of Economic Studies 35, 201-208.
Pratt, J.W., 1964. Risk aversion in the small and in the large. Econometrica 32, 122-136.
89
Rabin, M., 2000. Risk aversion and expected-utility theory: a calibration theorem. Econometrica
68, 1281-1292.
Rosenthal, R.W., 1989. A bounded-rationality approach to the study of noncooperative games.
International Journal of Game Theory 18, 273-292.
Rubinstein, A., 2006. Lecture notes in microeconomic theory. Princeton NJ: Princeton University Press.
http://arielrubinstein.tau.ac.il/Rubinstein2007.pdf
99-118.
Simon, H.A., 1976. From substantive to procedural rationality. In: Method and Appraisal in
Economics. Latsis, S.J. (ed.), Cambridge University Press, pp. 129-146.
Starr, R.M., 1997. General equilibrium theory. Cambridge University Press.
Thaler, R., 1981.
Economics Letters 8,
201-207.
Varian, H.R., 1992. Microeconomic analysis. New York: W.W. Norton & Company, 3rd edition.
Voorneveld, M., 2006. Probabilistic choice in games: properties of Rosenthal's
t-solutions.
In-
90
Suggested solutions
These are (sometimes short) solutions to most exercises in the lecture notes. In solutions to the
home assignments and exam questions, you are expected to start from relevant denitions, and
clearly deduce and motivate your answers.
Section 1
Exercise 1.1
(a): Each pair
word
is complete. Moreover, if
is found before or at the same place as (in case the words are identical) word
in the
is
transitive.
(b):
violation of completeness occurs if there exist people who are unfamiliar with each other. Also
violations of transitivity are common: I know my wife, my wife knows her boss, but I do not
know my wife's boss.
Exercise 1.2
(a): [Reexivity of ]
Exercise 1.3
(a): Assume % is strongly monotonic.
91
k -th
coordinates of
and
(b):
z(k 1) z(k) by
x = z(0) z(L) = y .
x, y R2+ :
on
R2+
k -th
with
x % y xk > yk
k {1, 2}
(2, 2)
(d):
Yes. Notice that the issue above, that improvements beyond the zero vector are impossible
y = x
2 e1
RL . Then
Exercise 1.4
(a): The preference relation on R2+
> 0.
in the rst
y = (2, 1).
and
with
x%y
x RL
x = (1, 2)
and
Then
and
by
> 0.
so
x y.
Then
so
x + e1 y + e1 .
(b):
for all
x, y ,
monotonic in coordinate 1.
satises all three monotonicity properties, but is not homothetic. For instance,
41+3
02
>40+3
Exercise 1.5
(a): Let x, y RL+
12 , but
as
42+3
02
<40+3
as
22 .
Exercise 1.6
92
(a):
y X.
To show:
{x X : x % y}
is a
convex set.
x, y R :
For each
x % y x 0 > y.
y R:
{x R : x % y} =
R+
if
if
y 0,
0 > y,
x % y,
but not
x + (1 )y % y ,
x = 1, y = 3, = 1/2,
Section 2
Exercise 2.1
(a): [Transitivity] Let x, y, z R satisfy x % y , y % z .
so
x y + 1 z + 2 z + 1,
so
By denition,
x y+1
and
y z + 1,
x % z.
x x + 1.
Exercise 2.2
(a): Suppose the collection of jumps in U
and
(v1 , v2 ).
The intervals
(u1 , u2 )
and
(v1 , v2 )
(u1 , u2 )
each such interval contains a rational number, necessarily distinct from the one in the other
interval, since these intervals are disjoint.
(b): C
is the union of two countable sets J and R and therefore countable itself. Let x, y X
x y . To show: there are c1 , c2 C with x % c1 c2 % y .
Case 1: (u(y), u(x)) is a jump in U . By denition of J , there are points c1 , c2 J C with
utility u(c1 ) = u(x), u(c2 ) = u(y). Hence x c1 c2 y , as in the requirement for Jaray
with
order-separability.
for Jaray order-separability. If it is not a jump, repeating the construction of Case 2 says that
there is a
c0 C
with
so that
Jaray order-separability.
93
x c0 c y ,
(c):
Exercise 2.3
(a): True. By denition of a continuous function, pre-images of open sets are open sets.
quently, for each
x X,
Conse-
the sets
{y X : y x} = u1 ((, u(x))
| {z }
and
open
{y X : y x} = u1 ((u(x), ))
| {z }
open
(b)
utility function
increasing
Exercise 2.4
No. Lexicographic preferences (modied in such a way that you start comparing the second
2
coordinates, then the rst) on R+ constitute an example where preferences cannot even be
2
represented by a utility function. Let x, y R+ have x2 > y2 . The modied lexicographic
preference started by looking at these second coordinates, so no matter how much money
you add to the rst coordinate of
y,
x.
on
R2+
u(x) =
where
: R (0, 1)
(x1 ) + 1
(x1 )
if
if
x2 1,
x2 < 1,
Under additional assumptions (like continuity, monotonicity), the answer is yes. See Rubinstein (2006, Lecture 4).
Exercise 2.5
(a): Consider (a, 0) and (a0 , 0) in X .
m = m0 = 0,
0
or one of the alternatives is strictly preferred over the other, w.l.o.g. (a, 0) (a , 0). In the
latter case, invoke the rst property to conclude that there is an amount of money m such that
(a, 0) (a0 , m ). Take m = 0, m0 = m .
(b): W.l.o.g., m w. By the third property with c = w m:
Either
so
by transitivity of
But then
w0 = m0 + (w m)
by strong
monotonicity in money.
(c):
u(a, m) u(a0 , m0 ).
By the rst two properties, there are unique amounts of money m1 , m2 0 such that (a, m)
(a , m1 ) and (a0 , m0 ) (a , m2 ). By denition of v , we nd that
Let
To show:
(a, m) % (a0 , m0 )
u(a, m) = (m1 m) + m = m1
if and only if
u(a0 , m0 ) = m2 .
(55)
Therefore,
(a, m) % (a0 , m0 ) (a , m1 ) % (a , m2 )
m1 m2
u(a, m) u(a0 , m0 ),
where the rst equivalence follows from the fact that
(a, m) (a , m1 )
and
(a0 , m0 ) (a , m2 ),
the second equivalence from strong monotonicity in money, and the nal one from (55).
Exercise 2.6
(a): Let r R.
let
x, y Xu (r)
If
and let
(c):
A function
on a convex domain
on
u(x) =
X=R
0
1
if
if
x 0,
x > 0.
Suppose
and
1
1
1
1
(1, v(1)) + (1, v(1)) = (0, v(1) + v(1)).
2
2
2
2
Since
v:
1
1
v(0) = v(1) < v(1) + v(1).
2
2
Exercise 2.7
(a):
95
For all
(b):
If f is not linear, there are x, y R\{0} with f (x)/x 6= f (y)/y . Hence, vectors a = (x, f (x))
b = (y, f (y)) are linearly independent: vectors a + b with , R span R2 . So vectors
a + b with , Q are dense in R2 . The latter vectors are in the graph of f : for , Q,
and
(c):
For each
i {1, . . . , n},
dene
fi : R R
as follows:
xi R :
Applying additivity of
F (n 1)
F (x) = F
fi (xi ) = F (xi ei ).
n
X
!
xi e i
i=1
To see that each
fi
n
X
F (xi ei ) =
i=1
x Rn
that
n
X
fi (xi ).
i=1
xi , yi R.
By additivity of
F:
Section 3
Exercise 3.2
By continuity of
f,
on
with
x, y X :
has open lower contour sets: for each
x % y f (x) f (y)
x X,
x, y X :
x % y f (x) f (y).
Exercise 3.3
(a): Assume (X, B, C) is rationalizable by the weak order % on X .
x C(A), y C(B).
To show:
x C(B) = {z B : z %
96
z 0 for all
A, B B , x, y A B ,
B}.
Let
z0
(b):
z 0 B . Since
0
all z B , i.e.,
Let
for
X = {a, b, c, d}, B = {{a, b, c}, {b, c, d}}, C({a, b, c}) = {b}, C({b, c, d}) = {c}.
It trivially satises IIA: there are no distinct sets
(c):
No.
b.
So
A, B B
Suppose, to the
% rationalizes it. Since C({a, b, c}) = {b}, we must have that b % c and b % a.
Since C({b, c, d}) = {c}, we must have that c % b and c % d. But then b c, so c b % a
implies c % a. But then c % y for all y {a, b, c}, so c should have been included in C({a, b, c}).
(d): No. Consider the choice structure with X = {a, b, c}, B = {{a, b}, {b, c}, {a, c}}, C({a, b}) =
{a}, C({b, c}) = {b}, C({a, c}) = {c}. As distinct choice sets have only one point in common,
WARP is trivially satised. It is not rationalizable, as a rationalizing % should satisfy a b, b
c, c a, in violation of transitivity.
contrary, that
Exercise 3.4
(a): [WARP satised]
Let
A, B B , x, y A B , x C(A),
and
y C(B).
To show:
x C(B).
We will simply show that
B B :
if
x = y.
By denition of
C:
C(B)
(56)
Then also v(y) < r by (56). Now x C(A) implies that x is the largest
A. In particular, since y A: y x. Similarly, y C(B) implies that x y . So
x = y C(B).
Case 2: v(x) r. Then also v(y) r by (56). Now x C(A) implies that x is the smallest
satisfactory element of A. In particular, since y A: x y . Similarly, y C(B) implies that
y x. So x = y C(B).
element of
(b): [IIA violated] For each B B, let x (B) be your partner's most preferred element of B .
C : C(B) = B \ {x (B)} for each B B with more than one element. Take
B = X, A = C(B). Both sets lie in B and A B . Moreover, C(B) A = C(B) 6= . IIA would
imply that C(A) = C(B) A = C(B), but C(A) = A \ {x (A)} A = C(B), a contradiction.
By denition of
Exercise 3.5
97
(a:)
In
B1 ,
(b):
(c):
p1 = 2, so spending
C(B2 ) = {(0, 1)}.
Similarly,
w=2
wealth
on the
Yes, there is no set-inclusion between the two choice sets, so IIA holds vacuously.
No, bundles
lie in
B1 B2 .
Since
x C(B1 )
and
y C(B2 ),
(d): No:
(e): For instance:
whereas
x1
x2
u(x, p) =
x1 x2
if
if
if
C(B2 ) = {y}
would require
y x.
p1 > p2 ,
p2 > p1 ,
p1 = p2 .
Section 4
Exercise 4.1
[Continuity:]
mally, for each
% is
y X,
As
u,
it is continuous. For-
{x X : x - y}
is closed.
x, y RL
+ with x y . There
u(x) = min{x1 /a1 , . . . , xL /aL } = xi /ai . As x y , it follows that
Take
x > y,
then
x y.
is an
so
i {1, . . . , L}
such
x % y.
u(0, . . . , 0) = u(1, 0, . . . , 0) = 0,
i.e., if you start with nothing, but get one unit of the rst ingredient, you still cannot bake a
cake due to lack of all the other ingredients!
Let
y RL
+
and let
u(y) = .
Then
L
{x RL
+ : x % y} = {x R+ : min{x1 /a1 , . . . , xL /aL } }
L
= L
`=1 {x R+ : x` /a` }
is the intersection of convex halfspaces and therefore convex. For a violation of strict convexity,
take
x y x + (1 )y,
in contradiction with strict convexity.
being the budget set if he does not use the gift certicate, the second one if he does and therefore
acquires
1/p1
Except for
exists. Under
(30/8, 5))
Rebates 2,
Rebates 2,
and a most preferred bundle need not exist. For instance, if the utility function of the
consumer is
budget set and some indierence curves will help you to verify this.
Exercise 4.3
(p, w) RL+1
++
if
x x(p, w),
Exercise 4.4
(a): Consider
If
if
p1 > p 2 ,
p1 > p2 .
then
u(x) = x1 + x2 .
p1
v(p, w) = w/p2
even further does not aect indirect utility, i.e., indirect utility is not
(b):
(pn , wn )nN
in
RL+1
++
with limit
n
n
(p, w) RL+1
++ , v(p , w )
v(p, w).
Proof.
n
4.4. As x
(c):
utility functions, which may cause jumps in the indirect utility function as well.
For instance, suppose a consumer has continuous utility function
min{x, 1}
U : R+ R
with
U (x) =
and hence continuous preferences. These preferences can also be represented by the
u : R+ R
with
u(x) =
Notice that
x(p, w) =
x
2
if
if
{w/p}
[1, w/p]
99
x 1,
x > 1.
if
if
w p,
w > p.
is
v(p, w) =
with discontinuities at all points where
w/p
2
if
if
w p,
w > p,
p = w.
Exercise 4.5
(a): Follows since
e(p, u) = min (p) x
= min p x
= e(p, u).
L,
s.t.
x RL
,
s.t.
x
R
+
+
u(x) u.
u(x) u.
(b):
0 00
0
00
0
p RL
++ . Suppose there are u , u U with u(0, . . . , 0) u < u and e(p, u )
0
0
00
00
00
0
00
Let x h(p, u ) and x h(p, u ). Then x 6= (0, . . . , 0) and p x p x . By
00
00
00
0
00
0
continuity, lim1 u(x ) = u(x ) u > u , so u(x ) > u for (0, 1) close to one. But
00
00
0
0
0
0
then p (x ) = (p x ) (p x ) < p x , contradicting that x h(p, u ).
(c): Let (p, u) RL++ U , i {1, . . . , L}, and > 0. For each x RL+ with u(x) u,
(p + ei ) x p x, so e(p + ei , u) e(p, u).
(d): Let u U . To show: the set {(p, r) RL++ R : r e(p, u)} is convex.
1 1
2 2
1 1
2 2
Let (p , r ), (p , r ) lie in this set, let [0, 1], and dene (p, r) = (p , r ) + (1 )(p , r ).
1
2
Let x h(p, u). Then x is feasible in the EMP at (p , u) and at (p , u), so
Let
e(p, u00 ).
e(p, u) = p x
= (p1 x) + (1 )(p2 x)
e(p1 , u) + (1 )e(p2 , u)
r1 + (1 )r2
= r.
Exercise 4.6
Let
(p, w) RL+1
++
and
Law,
p x = w.
For each
p0 RL
++ , x
is feasible
f : RL
++ R
with
f (p0 ) = v(p0 , p0 x)
` = 1, . . . , L :
As
x = x(p, w)
and
p x = w,
By (17),
By the
p:
f (p)
v(p, p x) v(p, p x)
=
+
x` = 0.
p`
p`
w
Exercise 4.7
By (15), indirect utility solves
p0 = p.
PL
PL
i=1ai pi , so v(p, w) = w/ i=1 ai pi .
= PLa1 w , . . . , PLaL w
.
i=1 ai pi
i=1 ai pi
Exercise 4.8
We know from (18) that
pk
and
h` (p, u)
x` (p, e(p, u)) x` (p, e(p, u)) e(p, u)
=
+
.
pk
pk
w
pk
Recall from (14) that
e(p,u)
pk
= hk (p, u):
h` (p, u)
x` (p, e(p, u)) x` (p, e(p, u))
=
+
hk (p, u).
pk
pk
w
u = v(p, w) that e(p, u) = e(p, v(p, w)) = w
h(p, u) = h(p, v(p, w)) = x(p, w), so:
u = v(p, w)
that
h` (p, u)
x` (p, w) x` (p, w)
=
+
xk (p, w).
pk
pk
w
Exercise 4.9
Indivisibilities, rationing, package deals, as well as the specic initial endowment
= (1, 1)
imply smaller budget sets and therefore a (weakly) lower welfare. Rebates 1 and 2 and the gift
certicate imply a larger budget set and therefore a (weakly) higher welfare.
Exercise 4.10
p1 x0 < w1 , x0 B(p1 , w1 ).
kx yk suciently close to zero.
0
preferred to x .
As
As
x0
p1 y w 1
Exercise 4.11
P
Write
A=
for all
L
i=1 ai . Standard calculations give:
aL w
a1 w
,
, ...,
A p1
A pL
L ai
w A Y
ai
,
A
pi
i=1
L ai /A
Y
pi
a1
aL
1/A
,...,
,
u
ai
p1
pL
i=1
L ai /A
Y
pi
1/A
Au
,
ai
i=1
L 0 ai /A
Y
pi
A(u1 )1/A
w0 ,
ai
i=1
L 1 ai /A
Y
pi
1
0 1/A
w A(u )
.
ai
x(p, w) =
v(p, w) =
h(p, u) =
e(p, u) =
EV ((p0 , w0 ), (p1 , w1 )) =
CV ((p0 , w0 ), (p1 , w1 )) =
i=1
101
with
strictly
It is commonly assumed (w.l.o.g., as this is just a monotonic transformation of the utility) that
A = 1,
Section 5
Exercise 5.1
(a): Y {y RL : y } is the intersection of closed sets, hence closed.
vector
(b):
(yn )nN
yn + 0 ,
so dividing by
All vectors
zn
kyn k
gives
kyn k
1 for n
1
+ 1 kyn k 0 Y .
diverges to innity,
1
kyn k yn
zn =
zn + /kyn k 0.
(c):
0.
suciently large.
By assumption,
Let
as
lies in
Exercise 5.2
solvable.
(a):
Dene qz = f (z) 0. The CMP at (w, qz ) has a solution and z is feasible in this CMP, so
c(w, qz ) w z . Conclude that pf (z) w z pqz c(w, qz ).
(b): Let zq solve the CMP at (w, q), i.e., zq RL1
+ , f (zq ) q , and c(w, q) = w zq . Conclude
that pf (zq ) w zq pq c(w, q).
(c): Assume (P1) has a solution z (the case where (P2) has a solution is similar). By (a), there
is a feasible qz in (P2) with equal or higher prot. It cannot be higher. Otherwise, by (b), there
is a feasible zqz in (P1) yielding a higher prot than qz and therefore higher than the prot
maximizing z , a contradiction. Conclude that qz solves (P2) and yields the same prot as z in
(P1).
Exercise 5.3
(a), (b): Consider
Y = {y R2 : y1 0, y2 y1 }.
2
vector p = (1, 0) R+ , but is not ecient, as
point
The
also
prices.
(c):
Section 6
Exercise 6.1
(a): Look at the denitions of improvements and Pareto optimality:
S=H
everybody better o. But there may still be room for improvement for some if not all consumers:
it may still be Pareto dominated.
(b):
Consider a pure exchange economy with two consumers and two commodities. The rst con-
102
u1 (x) = x1 x2 ,
1 = 2 = (1, 1),
then
sticks to the initial endowment) is a Walrasian equilibrium. By Proposition 6.2, the allocation
lies in the core. But the allocation is not Pareto optimal: giving the total endowment to the rst
consumer makes him better o, while not aecting the happiness of the second consumer.
Exercise 6.2
(a): Let p RL+ , z z(p) RL .
P
p z = k:pk >0 pk zk = 0. As the sum of
nonpositive terms, it can be zero only if z` = 0 whenever p` > 0.
(b): Let p, z, ` be as in the statement of the exercise. As zk = 0 for k 6= `, Walras' Law implies
p z = p` z` = 0. As p` > 0, this implies z` = 0.
(c): If in equilibrium the market for good ` {1, . . . , L} does not clear, its price is zero by
(a). So consumer h is not constrained in his consumption of `. In equilibrium, h must choose a
By Walras' Law,
most preferred bundle from the budget set, but there is none: under (c1), each bundle can be
improved upon by adding more of good
axes, as
`;
more of good
RL
++ ;
`.
Exercise 6.3
(a): Pareto dominance
Preferences of rms
(b):
Let
P
x
h %h xh p x
h p xh = p h + f F hf y f ,
h H :
P
x
h h xh p x
h > p xh = p h + f F hf y f .
(p, x, y)
be a Walrasian equilibrium of
Pareto dominating
By Pareto dominance, such a weak preference holds for all, and strict preference for some
Summing over
at prices
hH
(y f )f F
h H.
gives
x
h > p
hH
xh
hH
X
p h +
hf y f
f F
hH
= p+p
yf
f F
p+p
yf .
f F
But
hH
x
h > p + p
f F
yf
contradicts feasibility of
(
x, y).
Exercise 6.4
Pure exchange economies:
103
and
2 = (0, 1).
There is
if
if one of the commodities has price zero, demand for this commodity is unbounded.
(b):
(c):
and
%2
%1
u2 (x) = x1 + x2 .
Let
if one of the commodities has price zero, demand for this commodity is unbounded: there
are no Walrasian equilibria at such prices;
if both prices are positive and p1 > p2 , the rst consumer demands a bundle with 2x1 = x2 ,
1
1
i.e., the bundle (p /(p1 + 2p2 ), 2p /(p1 + 2p2 )) and the second consumer spends
2
the entire income on the second commodity, i.e., demands the bundle (0, p /p2 ). In
particular, demand for the second commodity is at least twice the demand for the rst
commodity. As the total endowment of both commodities is equal, not both markets can
clear at the same time, contradicting the fact that (given local nonsatiation) markets with
a positive price must clear. There are no Walrasian equilibria at such prices;
p = (1/2, 1/2),
{x R2+ : x1 + x2 =
((2/3, 4/3), (4/3, 2/3)) and
(d):
p2 > p1
clearing) allocations:
%1 , %2 are such that the consumers are indierent between all commodity
=
= (1, 1). Every (p, x) with p and x = (x1 , x2 ) R2+ R2+ with
h ) for both h = 1, 2 is a Walrasian equilibrium.
Preferences
1
bundles;
xh B h (p, p
Take the examples above and give the producers the trivial
{0} consisting of the remarkable feat of producing absolutely nothing using abso-
lutely nothing. If you prefer slightly larger production sets, you may want to choose them equal
to
R2 ,
containing all production plans producing absolutely nothing, possibly using something.
Exercise 6.5
to the liar, who becomes happier, while the true mother is not harmed. Moreover,
otherwise the true mother can be made happier by giving her
allocations
Core:
x=
(0, 1)
and
(1, 0)
xT
/ (0, 1):
Only
( T , L ).
(xT , xL ).
xL < L ,
so
xL L
in the core.
if
T = 0,
if
T (0, 1),
xT {0, 1},
initial allocation,
if
T = 1,
104
xT = 1.
xT (0, 1)
The coalition of both women can improve upon any feasible allocation with
T
giving the liar the entire baby, so x {0, 1} in the core.
by
{(1, 0)}
{(0, x) : L x 1}
{(0, 1)}
Notice that if
T (0, 1),
Walrasian equilibria:
( T , L ) = (1, 0),
T
has (0, 1),
T
L
is ( , ) = (0, 1).
( T , L ).
As
equilibrium involves a nonzero price vector, we may assume w.l.o.g. that the equilibrium price
is
p > 0.
The true mother demands
if
T [0, 1)
and
if
T = 1.
L.
{(p, xT , xL ) R3 : p > 0, xT = 0, xL = L }
{(p, xT , xL ) R3 : p > 0, xT = 1, xL = 0}
T
if
T [0, 1),
= 1.
Section 7
Exercise 7.1
(a):
Best elements of
G:
Worst elements of
G:
max{a1 , . . . , ak }.
min{a1 , . . . , ak }.
(G1) satisfied: preferences represented by utility function
(G2) violated:
p) a2 ).
If
p > 1/2, a1
a1 > a2
a +a2
DM assigns value 1
2
a1 for sure.
a1
ai L(g) ai .
and
< a1
a1 ( 12 a1 , 12 a2 ).
(pa1 , (1
However, at
p = 1/2,
the
(G4) violated:
g 0 = a2 .
1
|L(g)|
(G3) satisfied:
u(g) =
a1 > a 2 .
u(g) = u(gs ).
g = a1
to
( g, (1 ) a1 ) ( g 0 , (1 ) a1 )
for all
(0, 1).
However, for
close to zero,
a1
(b):
105
cannot be represented by a
Best element of
(G2) satisfied:
Pk
m=1 pm am 1 is continuous.
1
1
(G3) violated: the gambles a1 G0 and ( 2 a1 , 2 a1 ) G1 both have reduced simple
gamble (1 a1 ), yet the former lies in G0 and is therefore strictly preferred to the latter in
on
G1 ,
u(g) =
G1 .
(G4) violated:
Let
g = a1
G0 ,
g 0 = ( 12 a1 , 12 a1 ) G1 ,
g 00 = ( 21 g 0 , 12 g 0 ) G2 .
Let
(0, 1).
By construction,
( g, (1 ) g 00 ), ( g 0 , (1 ) g 00 ) G3 .
Hence
u(g) = a1 0,
u(g 0 ) = a1 1,
u( g, (1 ) g 00 ) = a1 3,
u( g 0 , (1 ) g 00 ) = a1 3,
in violation of (G4).
cannot be represented by a
(c):
To characterize the best and worst elements of
1.
G,
one on outcomes
am > 5
(utility equal
G:
am 5 (utility equal
ak
exceed 5 or all
ak
(one in the former case, zero in the latter), so all gambles are equivalent (and hence
both best and worst elements of
G).
to (G4).
106
Section 10
Exercise 10.1
(a): If u has no
u(ct ) > 1/(t) for each time t. Then (t)u(ct ) > 1 at each time t and
(b): Let u be bounded by B P
R and let c =P
(ct )
t=0 be an arbitrary
B(t)
=
B
each t, |(t)u(ct )| B(t) and
t=0 (t) converges. By
P t=0
summable sequences, also
(t)u(c
)
converges.
t
t=0
Exercise 10.2
(a1) k gives instantaneous
optimal action is
(a2) k
(b) k
utility
u(h, k) = 1, `
u(d, `) +
u(h, `) = 1,
so the
u(d, `) = ,
so the
utility
u(d, k) = 0, `
1
2 (u(h, `)
optimal action is
(u(ct ))
t=0 with
u(c
)
diverges.
t
t=0 t
+ u(d, k)) = +
k
k
1
2 (1
1
2
1
if
2
1
if
2
if
and
< 0,
= 0,
> 0.
(c) If the severity of the depression is relatively small ( 21 > 0), an initially depressed person
may decide not to take his life in the hope of becoming happy later while still having the option
of suicide in case of continued depression.
Exercise 10.3
Preferring one apple today over two apples tomorrow means that
Given
1
1+
/
u(1)
<
<
u(2)
means choosing
= .
1 + 365
1 + 366
/
.
solving
1
1+
u(1)
<
<
u(2)
1 + 365
1 + 366
or similarly
1
<
1+
u(1)
u(2)
1/
107
<
1 + 365
.
1 + 366
simply
, > 0
Notice that
>0
implies that
1
1 + 365
<
< 1,
1+
1 + 366
0<
The expression
Exercise 10.5
lim inf t xt = c implies [L1] and [L2]: Let > 0. As limt inf{xs : s t} = c,
T N such that
c < inf{xs : s t} < c + ,
for all
t T.
there is a
t = T:
c < inf{xs : s T },
so
t = max{T, T 0 }:
t T0
with
x t < c + ,
proving [L2].
> 0.
Let
By [L1] there is a
T N
such that
c /2 < xt
for all
t T.
Hence,
c < c /2 inf{xs : s T }.
As the inmum increases weakly if the bound
t T:
t T,
there is an
st
(57)
such that
xs < c + /2 < c + ,
i.e.,
inf{xs : s t} c + /2 < c + .
Combining (57) and (58) gives that for each
>0
there is a
T N
(58)
such that
lim inf t xt = c.
Exercise 10.6
It suces to show, for an arbitrary sequence
(xt )
t=0 :
> 0 : xt >
108
t.
(): Assume
lim inf t xt > 0. If the liminf is innite, the weakly increasing sequence of inma
inf{xs : s t} diverges, so there is a T N with inf{xs : s T } 1. In particular, xt 1 for all
t T . If the liminf is nite, [L1] with = c/2 implies that there is a T N with xt > c = c/2
for all t T .
(): Assume there is an > 0 such that xt > for all but nitely many t: there is a T N
such that xt > for t T . Then inf{xs : s t} for t T , so also the limit of the inma
exceeds : it must be positive!
Exercise 10.7
(a): If a sequence
is unbounded, the liminf of average payos need not converge. For instance,
x = (xt )
t=0 dened
1 PT 1
(t +
1)2
Pt1
T 1
1 X
lim inf
(xt yt ) > 0
T T
T 1
T 1
1 X
1 X
lim inf
xt > lim inf
yt .
T T
T T
t=0
t=0
(59)
t=0
lim sup
T
This is obviously false.
T 1
1 X
yt < 0
T
lim inf
t=0
T 1
1 X
yt < 0.
T
t=0
For an explicit example, take the sequence from page 73 with the
Section 11
Exercise 11.1
The cost function
Pn
i=1 pi (i)
1
2 c(p) is strictly concave.
Since we maximize a strictly concave, continuous function over a compact set, a maximum exists
i-th coordinate
1 c(p)
1
1
1
1
(i)
= (i) 2 pi
= (i)
pi
.
2 pi
2
n
and is unique. Notice that the gradient of the goal function has
Since the feasible set is entirely dened by linear (in)equalities, the Kuhn-Tucker conditions
give necessary and sucient conditions for a solution to be a maximum. So
solves the
i 0 associated
P with the
pi 0 and R associated with the equality constraint ni=1 pi = 1
i = 1, . . . , n :
1
1
(i)
pi
+ i + = 0 and i pi = 0.
(60)
Rewriting we nd
i = 1, . . . , n : pi = (i) + (i + ) +
109
1
.
n
Assume that
solves the maximization problem. We check that it satises the linear probability
j A,
If
pi > 0,
then
i = 0
pi
pj
1
1
(j) + (j + ) +
= (i) + +
n
n
= ((i) (j)) j
((i) (j)),
where the inequality follows from the fact that
>0
and
j 0.
(52).
Conversely, if
satises requirement (52), one can easily show that it satises the
pi > 0
and
pj > 0,
then
pi pj = ((i) (j)),
so
Hence if we choose
pi
i {1, . . . , n}
1
(i) =
1
pj
(j).
n
(61)
=
pi
(i) R,
n
with
1
=
for all
with
pj > 0.
k =
To see that
k 0
if
pk = 0,
pj
(j)
k:
0
1
pk > 0,
pk = 0.
if
pk
1
n
(k)
choose an alternative
if
with
pj > 0.
probability model,
pj pk ((j) (k)),
which implies
((j) (k))
1
pj pk 0.
Hence
k =
=
=
1
pk
1
pk
1
(k)
n
1
1
1
(k)
pj
+ (j)
n
n
1
((j) (k))
pj pk
0,
110
as we had to show. Substituting the denition of the Lagrange multipliers in (60) shows that
the Kuhn-Tucker conditions are satised.
Exercise 11.2
(a): Choice probabilities are weakly increasing in payos, so the probability of choosing 1 must
be positive. If also the probability of choosing
PA (1) + PA (2) = 1,
this gives
PA (1) =
4 + 1
1 4
, PA (2) =
.
2
2
(62)
Obviously, this is possible if and only if both these probabilities are nonnegative, i.e., if and only
if
1/4.
So for
(0, 1/4], the choice probabilities in (62) satisfy the linear probability model
there is only one such vector of choice probabilities. For > 1/4,
PA (1) = 1, PA (2) = 0.
(b) (c):
(63)
The role of .
Solution 11.3
(a):
In the logit model with parameter
is
> 0,
exp((i)/)
.
jA exp((j)/)
PA (i) = P
iA
(64)
PA (1) =
=
PA (2) =
PA (3) =
exp(0/)
exp(0/) + exp(2/) + exp(8/)
1
,
1 + exp(2/) + exp(8/)
exp(2/)
,
1 + exp(2/) + exp(8/)
exp(8/)
.
1 + exp(2/) + exp(8/)
Since the exponential function takes strictly positive values, all choice probabilities lie in
(0, 1).
The logit model is a special case of Luce's choice model (see (42) and (45)), which satises
path independence. Hence the logit model satises path independence.
As
1/3.
(b):
PA (i) for all alternatives i A
> 0 if the following holds:
Choice probabilities
with parameter
if
PA (i) > 0,
then
for all
j A.
(65)
there
Case 1:
PA (i) > 0
Case 2:
Case 3:
for all
i A.
PA (3) = 1.
or equivalently,
PA (2) = PA (3) 6,
PA (1) = PA (3) 8,
3PA (3) 14 = 1.
Conclude that
PA (3) =
P (2) =
A
PA (1) =
1+14
3 ,
1+14
3
1+14
6 =
8 =
14
3 ,
110
3 .
(0, 1/10).
(0, 1/10).
To make sure that all probabilities are positive, this requires that
probabilities in (66) satisfy the linear probability model for
(66)
So the
PA (2) = PA (3) 6,
PA (1) = 0,
PA (3) 8,
2PA (3) 6 = 1.
Conclude that
PA (3) = 1+6
2 ,
PA (2) = 1+6
2 6 =
PA (1) = 0.
PA (2)
and
PA (3)
16
3 ,
PA (3) =
1 + 6
8,
2
112
(67)
[1/10, 1/6). Conclude that the choice probabilities in (67) satisfy the
probability model for [1/10, 1/6).
1/6.
> 0. In
> 0, PA (1) 6= PA ({1, 2})P{1,2} (1).
The linear probability model does not satisfy path independence for every
particular, we will show that for a specic value of
This means that we have to consider choice probabilities in the smaller problem with only
alternatives
and
2.
P{1,2} (1)
and
P{1,2} (2)
requires that
P{1,2} (1) =
1 + 2
1 2
, P{1,2} (2) =
.
2
2
= 1/20.
(0, 1/2).
Now
Then
PA (1) =
1 10
1
=
3
6
but
PA ({1, 2})P{1,2} (1) =
=
=
=
6=
As
1 10 1 4
+
3
3
2 14 1 2
3
2
(1 7)(1 2)
3
39
200
1
.
6
1 2
2
it follows from our earlier analysis that Case 3 is the only feasible one: the
Exercise 11.4
pi < pj . Exchange the
to the i-th and j -th alternative to obtain a
Pn probabilities
Passigned
n
0
0
vector p . By construction,
i=1 pi (i) >
i=1 pi (i), and by symmetry, the control cost term
Suppose
solves
P ().
113