Appendices

Dirk Van de gaer, SHERPPA

September 2017

1 Mathematical Preliminaries
1.1 Sets and linear spaces
A set is a collection of objects, called elements.

Given a universal space Ω, the complement of the set A ⊆ Ω contains all

elements of Ω that are not in A.

A linear space is a set X whose elements have the following properties:

Additivity: for every x, y ∈ X there exists an element x + y ∈ X such that
(1) x + y = y + x (commutativity),
(2) (x + y) + z = x + (y + z) (associativity),
(3) there is a null element 0 such that x + 0 = x,
(4) for every element x ∈ X there exists a unique element −x ∈ X such that
x + (−x) = 0.
Homogeneity: for every element x ∈ X and number α ∈ R, there exists an
element αx ∈ X, called the scalar multiple of x such that
(5) (αβ) x = α (βx) (associativity),
(6) 1x = x.
Moreover, the two operators of addition and scalar multiplication obey the usual
distributive rules of arithmetic, namely
(7) α (x + y) = αx + αy,
(8) (α + β) x = αx + βx,
for all x, y ∈ X and α, β ∈ R.
Example: Rk is a linear space.

A subset S of a linear space is a convex set if αx + (1 − α) y ∈ S for every

x, y ∈ S and 0 ≤ α ≤ 1.

1.2 Relations, correspondences and functions

Given two sets X and Y , any subset R of their product X × Y is called a
binary relation. For any pair of elements (x, y) ∈ R ⊆ X × Y , we say that x is
related to y and write xRy.

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 Most relations encountered in economics are defined on the elements of a
single set: X = Y . We then speak of a relation on X. A relation R on X is

Reflexive if, for all x ∈ X : xRx,

Irreflexive if, for all x ∈ X it never holds that xRx,
Transitive if, for all x, y and z ∈ X : xRy and yRz ⇒ xRz,
Symmetric if, for all x, y ∈ X : xRy ⇒ yRx,
Complete if, for all x, y ∈ X : either xRy or yRx or both.

Any relation which is reflexive and transitive is called a preorder or quasi-

order. A set on which a preorder is defined is called a preordered set. A symmet-
ric preorder is called an equivalence relation. A preorder that is not symmetric
is called an order relation. Finally, observe that if a relation is complete, it is
automatically reflexive (take y = x in the definition of completeness).

Example: Consider the relation ≥ on Rk . This relation is reflexive, transitive

but not symmetric. Hence the relation ≥ defines an order relation. If k = 1,
the relation is complete, but if k > 1 it is not complete.

Given two sets X and Y , a correspondence ψ : X ⇒ Y is a rule that assigns

to every element x ∈ X a non-empty subset ψ (x) of Y .

A function f : X → Y is a rule that assigns to every element x of X (the

domain) a single element of a set Y (the co-domain).

A function f : S → R is convex if for every x, y in the convex set S,

f (αx + (1 − α) y) ≤ αf (x) + (1 − α) f (y) for every 0 ≤ α ≤ 1.
A function f : S → R is strictly convex if for every x, y in the convex set S
with x 6= y
f (αx + (1 − α) y) < αf (x) + (1 − α) f (y) for every 0 < α < 1.

A function f : S → R is concave if for every x, y in the convex set S,

f (αx + (1 − α) y) ≥ αf (x) + (1 − α) f (y) for every 0 ≤ α ≤ 1.
A function f : S → R is strictly concave if for every x, y in the convex set S
with x 6= y
f (αx + (1 − α) y) > αf (x) + (1 − α) f (y) for every 0 < α < 1.
A function f : S → R is quasiconcave if {x ∈ S : f (x) ≤ α} is convex for
every value of α.
Remark: f is strictly concave ⇒ f is concave ⇒ f is quasiconcave.

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1.3 Metric spaces, sequences and continuity
A metric on a set X is a measure that associates with every pair of points
x, y ∈ X a real number ρ (x, y) satisfying the following properties:
(1) ρ (x, y) ≥ 0,
(2) ρ (x, y) = 0 if and only if x = y,
(3) ρ (x, y) = ρ (y, x) (symmetry),
(4) ρ (x, y) ≤ ρ (x, z) + ρ (z, y) for all z ∈ X (triangular inequality).
A metric space is an ordered pair (X, ρ) where X is a set and ρ its metric.
qP
k k
Example: X = R and ρ (x, y) = i=1 (xi − yi ). Here, ρ (x, y) is the distance
between the vectors x and y.
n
A sequence (x) in X is a list of particular elements x1 , x2 , . . . , xn of X.
Given any point x0 in a metric space (X, ρ) and a distance r > 0, the open
ball about x0 of radius r is the set of points Br (x0 ) = {x ∈ X : ρ (x, x0 ) < r} .
Example: take the metric space from the previous example. The open ball
about x0 contains all points that are within a distance r of the point x0 .
n
A sequence (x) in X converges to x if there exists a stage N such that
x belongs to the open ball Br (x) for all n ≥ N . We then write xn → x or
n

x = lim xn .
n→∞

In a metric space, an open set is a set that contains an open ball around
each of its points. A closed set is a set whose complement is an open set. A
subset S of a metric space (X, ρ) is bounded if it is contained in a ball of finite
radius, i.e. if there exists x in X and r > 0 such that for all s in S, we have
ρ(x, s) < r.
A subsequence is a sequence that can be derived from another sequence by
deleting some elements without changing the order of the remaining elements.
Example: consider the sequence (1, 2, 3, 2, 5). Examples of subsequences are
(1, 3, 5) and (1, 2, 2, 5).

X is compact if every sequence has a convergent subsequence.

Remark: a metric space, X is compact if and only if it is closed and bounded.

Remember that, given two sets X and Y , a correspondence ψ : X ⇒ Y is a

rule that assigns to every element x ∈ X a non-empty subset ψ (x) of Y .

A correspondence ϕ : X ⇒ X is said to be upper hemicontinuous if given

∞
any x∗ ∈ X and some sequence (xq )q=1 that converges to x∗ , for every sequence
q ∞
(y )q=1 with y ∈ ϕ (x ) and limit point y ∗ it is true that y ∗ ∈ ϕ (x∗ ).
q q

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 Put differently, ϕ : X ⇒ X is upper hemicontinuous if it is such that,
∞ ∞
if lim (xq )q=1 = x∗ and, lim (y q )q=1 = y ∗ , where each y q ∈ ϕ (xq ), then
q→∞ q→∞
y ∗ ∈ ϕ (x∗ ).
Remark: if X is compact, an equivalent definition is the following:
ϕ : X ⇒ X is said to be upper hemicontinuous if its graph,
g (ϕ) ≡ {(x, y) : x ∈ X, y ∈ ϕ (x)} is a closed set.

A function f : X → Y is continuous if and only if f (x) = limn→∞ f (xn )

for every sequence xn → x.

1.4 Derivatives
The first order partial derivative of the function f : X ⊆ Rk → R at the
point x = a with respect to xi is defined as

∂f (a) f (a1 , a2 , . . . , ai−1 , ai + h, ai+1 , . . . , ak ) − f (a1 , . . . , ak )

= lim .
∂xi h→0 h

A function f (x1 , . . . , xk ) is said to be of class C n in the set S ⊆ Rk if all

partial derivatives of f of order ≤ n are continuous in S.

Implicit Function Theorem: Let f : Rn+m → Rm be a continuously differ-

entiable function, and let Rn+m have coordinates (x, y). Fix a point (a, b) =
(a1 , ..., an , b1 , ..., bm ) with f (a, b) = c, where c ∈ Rm . If the matrix [(∂fi /∂yj )(a, b)]
is invertible, then there exists an open set U containing a, an open set V con-
taining b, and a unique continuously differentiable function g : U → V such that
{(x, g(x))|x ∈ U } = {(x, y) ∈ U × V |f (x, y) = c}.

It can be proven that whenever we have the additional hypothesis that f is

of class C k inside U × V , then the same holds true for the explicit function g
 −1
∂g
inside U and ∂x j
(x) = − ∂f
∂y (x, g(x))
∂f
∂xj (x, g(x)).

Rules for differentiation

∂ [f (x) + g(x)] ∂f (x) ∂g(x)

= + .
∂x ∂x ∂x
∂ [f (x)g(x)] ∂f (x) ∂g(x)
= g(x) + f (x).
∂x ∂x ∂x
∂ [f (g(x))] ∂f (g(x)) ∂g(x)
= .
∂x ∂g(x) ∂x

Derivatives of frequently occuring functions in economics

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 ∂f (x)
f (x) = c ⇒ = 0.
∂x
∂f (x)
f (x) = xn ⇒ = nxn−1 .
∂x
∂f (x) 1
f (x) = ln(x) ⇒ = .
∂x x
∂f (x)
f (x) = exp(x) ⇒ = exp(x).
∂x
∂f (x)
f (x) = ax ⇒ = ax ln(a).
∂x

2 Economic Preliminaries
2.1 Decision Theory Under Certainty
X: set of consumption possibilities. We assume here that X = Rk+ , and the
notation x ≥ y means that each element of the k− dimensional vector x is at
least as large as the corresponding element of y.

Preferences are defined as a relation on X:

x  y means that x is at least as good as y.
From  we can derive the strict preference relation,  and the indifference
relation ∼:
x  y means that it is not the case that y  x,
x ∼ y means that x  y en y  x.
The preference relation  on X is rational if it is complete and tansitive.
If  is rational, then:
(i)  is both irreflexive and transitive;
(ii) ∼ is an equivalence relation (reflexive, transitive and symmetric);
(iii) If x  y  z, then x  z.

Continuity of preferences is a convenient property.

Axiom 1 Continuity. ∀y ∈ X : {x ∈ X : x  y} and {x ∈ X : y  x} are

closed sets.

Implication: {x ∈ X : x  y} and {x ∈ X : y  x} are open sets.

We can now formulate a utility representation theorem.

Theorem 2 If the preference relationship  on X is rational and continuous,

then there exists a continuous utility function that represents this preference
relationship: ∃u : X → R : x  y ⇔ u (x) ≥ u (y).

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Remark: the utility function u (.) is ordinal : any strictly increasing transfor-
mation of u (.), say v (.) = f (u (.)) where f (.) is a strictly increasing function
represents the same preference relation as u (.).

Other frequently imposed restrictions on preferences are the following.

Axiom 3 Weak monotonicity. If x ≥ y, then x  y.

Axiom 4 Strong monotonicity. If x ≥ y and x 6= y then x  y.

Axiom 5 Convexity. ∀x, y, z ∈ X that are such that x  z and y  z, we have

that, ∀0 ≤ k ≤ 1, kx + (1 − k) y  z.

Axiom 6 Strict convexity. ∀x, y, z ∈ X that are such that x 6= y, x  z and

y  z, we have that, ∀0 < k < 1, kx + (1 − k) y  z.

2.2 Decision Theory Under Uncertainty

1. Lotteries

C : the set of the prizes of a lottery.

n : cardinality of C.
pi : the probability that prize i is obtained.

A simple lottery L is a list L = (p1 , . . . , pn ) with

n
X
∀i : pi ≥ 0 en pi = 1.
i=1

Remark: lotteries can be depicted in the n − 1 standard or unit simplex, that

is, in the n − 1 dimensional convex hull of the unit vectors e1 , e2 , . . . , en .

2. Preferences over Lotteries

L is the set of all possible lotteries over the set C.

We assume that the decision maker has rational preferences over L, given by
the binary relation <. This means that this relation is complete and transitive.
Given the binary relation <, it is possible to define strict preference and
indifference:
L  L0 means that it is not the case that L0 < L,
L ∼ L0 means that L < L0 and L0 < L,
and these relations have properties similar to the properties of their counterparts
in the theory under certainty (see previous section).
We usually require that the preference order is continuous.

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Axiom 7 The preference order < on the space of simple lotteries L is contin-
uous if,∀L, L0, L00 ∈ L, the sets
A1 = {α ∈ [0, 1] : αL + (1 − α) L0 < L00} and
A2 = {α ∈ [0, 1] : L00 < αL + (1 − α) L0} are closed.

So far the structure is completely analogeous to the structure under cer-

tainty; unsurprisingly, we obtain again a representation theorem:

Theorem 8 If the preference order < is rational and continuous, then there
exists a utility function U : L → R that represents this preference order:

L < L0 ⇐⇒ U (L) ≥ U (L0) .

When modelling behavior under uncertainty, an additional assumption on

preferences is usually imposed:

Axiom 9 The preference order < on the space of simple lotteries L satisfies
the independence axiom if ∀L, L0, L00 ∈ L and α ∈ (0, 1) it is such that

L < L0 ⇐⇒ αL + (1 − α) L00 < αL0 + (1 − α) L00.

Imposing this axiom results in a very simple structure for the utility function:

Theorem 10 If the preference order < is rational, continuous and satisfies the
independence axiom, then there exists a very simple utility function U : L → R
that represents <. We can assign a number ui to each outcome, such that, for
any two lotteries L = (p1 , . . . , pn ) and L0 = (p01 , . . . , p0n )
n
X n
X
L < L0 ⇐⇒ pi ui ≥ p0i ui .
i=1 i=1

This theorem is known as the expected utility theorem. The utility func-
tions having this structure are commonly known as “von Neumann-Morgenstern
expected utility functions”.

Remark: von Neuman-Morgenstern expected utility functions are not unique.

They are cardinal : if the utility function U : L → R is a von Neumann-
Morgenstern utility function representing the preference relation < on L, then
e : L → R is another von Neumann-Morgenstern utility function representing
U
the preference relation < if and only if there are scalars β > 0 and γ such that
e (L) = γ + βU (L) for every L ∈ L.
U

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2.3 Further Economic Preliminaries
Let X ⊆ Rk be the set of feasible allocations of goods, N the set of individuals
and, for all i ∈ N , her preferences over X are given by the relation i , such
that for x, y ∈ X, x i y means that x is at least as good as y for individual i.

An allocation x ∈ X is Pareto efficient if and only if there does not a y ∈ X

such that (i) for all i ∈ N , y i x, and (ii) for at least one i ∈ N , y i x.

Remark: in all standard models used in economics Pareto optimal allocations

exist. Existence can be an issue in economies with an infinite number of goods
(Aruajo (1985), Econometrica). In most models, however, there exists a multi-
tude of Pareto efficient allocations.