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Review of Demand Theory

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Preferences

Let X be the consumption set, where X RL

+ . An element of X is a consumption bundle. Usually L = 2, which allows for a graphical representation
of bundles. Consumers will be able to rank consumption bundles by means of
their individual-specific preferences, denoted by % .
Preferences % on X are rational if they are:
1) Complete: the consumer is able to rank any two bundles x and y. x, y
X, x < y or y < x or both.
2) Transitive: x, y, z X, if x < y and y < z, then x < z.
The set of bundles y such that both x < y and y < x is the indifference
curve that contains bundle x. The MRS is the slope of the indifference curve at
any point.
3) Reflexive: x X, x < x.
If a preference relation % on X satisfies all three properties, then it is rational.

4) Continuity: & on X is continuous if for any sequence {(xn , y n )}n=1 with

xn < y n n, and x = lim xn , y = lim y n , then x < y.
n
n
Lexicographic preferences do not satisfy continuity. For instance, take xn =
( n1 , 0) and y n = (0, 1). In this case, it is true that xn < y n n. However, lim xn =
(0, 0), whereas lim y n = (0, 1) and (0, 1)  (0, 0).

5) Strong Monotonicity: & on X are strongly monotone if for all x, y X,

if x y but x 6= y, then y  x. Monotonicity: & on X are monotone if for
all x, y X, if x > y, then y  x. Local non-satiation: & on X are locally
nonsatiated if x X, > 0 y X s.t. ky xk < and y  x.
6) Convexity: & on X are convex if x X, the upper contour set {y X : y < x}
is convex, i.e. if y < x, z < x, y + (1 )z < x, [0, 1].
In words, the preferred to set is convex, i.e. a convex combination of any
two points in that set also belongs to that set.
Preferences that exhibit increasing MRS do not satisfy the convexity assumption.
If x X, y < x, z < x, y 6= z y + (1 )z < x, [0, 1], then the
consumers preferences are strictly convex.
7) & on X are homothetic if x y x y, 0.
8) & on X are quasilinear with respect to commodity 1 if
i) if x y (x + e1 ) (y + e1 ), where e1 = (1, 0, ..., 0) R
ii) x + e1  x x, > 0.

Utility functions

If the preference relation is continuous, then there is a continuous utility function

u(x) that represents < .
Lexicographic preferences do not satisfy continuity, and thus, have no utility
representation.
The utility function that represents < is not unique. Any strictly increasing
transformation f (u(x)) also represents < . This implies that u(x1 , x2 ) = x1 x2
and v(x1 , x2 ) = ln x1 + ln x2 represent the same preferences. This is a consequence of the fact that preferences are ordinal (and not cardinal) rankings of
bundles. We will normally assume u() to be twice continuously differentiable.
If preferences are convex, then the utiliy function is quasiconcave, i.e. {y
RL
+ : u(y) u(x)} is a convex set, x. Increasing MRS violates convexity and
hence, quasiconcavity. Quasiconcavity does not necessarily imply concavity.

Choice and demand

Given the utility function that represents the consumers preferences, we want
to determine his optimal choice. In order to properly define the consumers
utility maximization problem, we need to specify his budget set, i.e. the set of
feasible bundles, given prices and income. Once prices and income are known,
the consumer makes his choice by solving his utility maximization problem:
maxu(x)
x0

s.t. p x

with p >> 0 and w > 0. The Walrasian

budget set (the set of feasible alloca
tions) is Bp,w = x RL
+ :pxw
The solution to the consumers utility maximization problem is the Walrasian demand correspondence (function if single-valued) x(p, w). If preferences
are not strictly convex, the Walrasian demand may fail to be a correspondence.
The indirect utility function is v(p, w) = u(x(p, w)), where x(p, w) is the Walrasian demand.
Equivalently, we can define the consumers expenditure minimization problem as
minp x
x0

s.t. u(x) u
with p >> 0, u > u(0). The solution to this problem is the Hicksian demand correspondence (or function) h(p, u). This is the Hicksian or compensated demand,
in the sense that the level of utility is maintained constant. When comparing
the Walrasian and Hicksian demands, slopes are different due to the income
effect. The expenditure function is e(p, u) = p h(p, u).

If w = e(p, u), then it holds that h(p, u) = x(p, w). At this point, the
Hicksian and Walrasian demands intersect.
There is a relationship between the two formulations of demand, which is
known as the Slutsky Equation:
hl (p, u)
xl (p, w) xl (p, w)
=
+
xk (p, w)
pk
pk
w
which relates the slopes of the Walrasian demand function and the Hicksian
(compensated) demand function when l = k. In particular, the last term takes
into account the existence of income effects. However, we will usually focus on
the utility maximization problem and on the Walrasian demand correspondence.
Example 1 Given a Cobb-Douglas utility function, the UMP becomes
1
max kx
1 x2

x1 ,x2

s.t. p1 x1 + p2 x2

By applying a strictly monotonic transformation to the utility function, we

can rewrite it as
max ln x1 + (1 ) ln x2

x1 ,x2

s.t. p1 x1 + p2 x2

The Lagrangian of this problem is

(x1 , x2 , ) = ln x1 + (1 ) ln x2 (p1 x1 + p2 x2 w)
The first-order conditions are

p1 0
x1
1
p2 0
x2
(p1 x1 + p2 x2 w) = 0

= 0 if x1 > 0
= 0 if x2 > 0

which implies that

==
p1 x1 = p2 x2
p1 x1
p2 x2
1
Making use of the budget constraint,


(1 )w
w
1
= w x2 =
; x1 =
p2 x2
1
p2
p1
In some other cases, the nonnegativity constraints will be binding. An example of this is the case of perfect substitutes. The consumers optimal choice
will typically be a corner solution, unless the consumer is indifferent between
consuming either good in which case, the solution is a correspondence.
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Example 2 Suppose that the consumers utility function is given by u(x1 , x2 ) =

x1 + x2 , and that income is 10. Then, the consumers utility maximization problem is
max x1 + x2

x1 ,x2

10

s.t. p1 x1 + p2 x2

and the Lagrangian is (x1 , x2 , ) = x1 + x2 (p1 x1 + p2 x2 10) . Then, the

first-order conditions are, respectively,
1 p1

0,

= 0 if x1 > 0

1 p2

0,

= 0 if x2 > 0

(p1 x1 + p2 x2 10)

This leads us to consider four possible cases:

1) x1 = x2 = 0. Impossible, since the utility function is increasing.
2) x1 = 0; x2 > 0. Then, it must be true that 1 p1 < 0, = p12 = pp12 > 1.
Using the budget constraint yields x2 = p102 , x1 = 0.
3) x1 > 0; x2 = 0. Then, it must be true that 1 p1 = 0, 1 p2 < 0 =
p1
<
1. Using the budget constraint yields x1 = p101 , x2 = 0.
p2
4) x1 > 0; x2 > 0. Then, it must be true that 1 p1 = 0, 1 p2 = 0 =
p1
=
1 (a necessary condition). From the budget constraint we get x1 + x2 =
p2
10
10
10
p2 x1 = p2 x2 , with x2 [0, p2 ]. In this case, the Walrasian demand is a
correspondence.
The Walrasian demand correspondence (function) has the following properties:
1) x(p, w) is homogeneous of degree zero in (p, w) : x(p, w) = 0 x(p, w).
2) x(p, w) satisfies Walras law: p x = wx x(p, w).
3) If u() is strictly quasiconcave, then x(p, w) is a function.
In economic terms, the MRS is the ratio of marginal utilities, and the interpretation of the multiplier is the marginal utility of wealth. The multiplier
is the marginal utility of wealth because the change in utility from a marginal
increase in w is given by
u(x(p, w)) Dw x(p, w) = p Dw x(p, w) =
because p x(p, w) = w p Dw x(p, w) = 1.

Welfare analysis

A welfare analysis evaluates the effects of changes in the consumers environment

on his well-being. Consider the welfare effect of a price change, from p0 to p1 ,
given a constant wealth level w > 0. Thus, for any indirect utility function
v(p, w), and for an arbitrary price vector p, the expression
e(p, v(p1 , w)) e(p, v(p0 , w))
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is itself an indirect utility function and provides a measure of the welfare change
expressed in monetary units. Depending on our choice of p, we have the equivalent variation or the compensating variation:
EV (p0 , p1 , w)
0

CV (p , p , w)

= e(p0 , u1 ) e(p1 , u1 ) = e(p0 , u1 ) w

= e(p0 , u0 ) e(p1 , u0 ) = w e(p1 , u0 )

Using the fact that the Hicksian demand function is the derivative of the
expenditure function and that w = e(p0 , u0 ) = e(p1 , u1 ), we may rewrite, for
the case in which one of the prices decreases:
EV (p0 , p1 , w)

p01

=
p11

CV (p , p , w)

p01

=
p11

h1 (p1 , p1 , u1 )dp1
h1 (p1 , p1 , u0 )dp1

If income effects are absent, compensating and equivalent variations coincide,

and we call this the change in the Marshallian consumer surplus. Indeed, this
is the usual procedure when making welfare calculations, since they allow for
the use of the Walrasian demand function, which is observable. In this case, the
variation in consumer surplus is
CS(p0 , p1 , w) = EV (p0 , p1 , w) = CV (p0 , p1 , w) =

p01

p11

x1 (p1 , p1 , w)dp1

Otherwise, the consumer surplus will be bounded by the equivalent and

compensating variations. For the case of a decrease in p1 , we get: EV > CS >
CV .