Consumer Preferences

We assume that each consumer has well defined preferences over

consumption bundles. A bundle x = (x1 , x2 , . . . , xn ) specifies the
quantity xi of each good i = 1, 2, . . . , n. Let X Rn be the set of
ECON-UA 11 feasible bundles.
Micro Theory & Analysis Given two bundles x, y 2 X , we write
Lecture Notes #1
x y

Ennio Stacchetti if the consumer likes x at least as much as y . If x y and y 6 x

we say that x is strictly preferred to y and write x y . If x y
and y x we say that the consumer is indierent between x and y
2016 and write x y .
We assume that the preference satisfies the following properties.
For any x, y , z 2 X Rn
(i) transitivity: if x y and y z then x z.
(ii) completeness: x y or y x (or both).
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 Definition
Usually, we will also assume that is continuous. That is, for all satisfies local nonsatiation if for any x 2 X there exists y 2 X
x 2 X , the upper countour set arbitrarily close to x such that y x:
(x ) = {y 2 X | y x } 8x 2 X and 8e > 0, 9y 2 X such that ||y x || < e and y x.
is closed. If is continuous, one can show that the lower countour With local nonsatiation, indierence curves are indeed curves (i.e.,
set they are not thick sets). A stronger property that implies local
(x ) = {y 2 X | y x } nonsatiation is strict monotonicity: is strictly monotone if for
is also closed. any x, y 2 X with x y and x 6= y we have that x y (more is
always better).
Definition
The indierence curve through x is the set A shape assumption often made about is convexity: is
convex if the upper contour set (x ) is convex for each x 2 X .
(x ) = {y 2 X | y x }. This typically requires that the feasible set X itself be convex.
Definition
Unless we make additional assumptions, an indierence curve Working with directly is not very convenient. A utility function
could be thick. U : X ! R represents on X if for all x, y 2 X ,

3 / 24 x y () U (x ) U (y ). 4 / 24
If U represents , then there are lots of utility functions that
represent . For example
U (x ) = 10U (x ) + 5 and U (x ) = e U (x )
also represent . In general, if f : R ! R is any strictly increasing
function, then U (x ) = f (U (x )) also represents .
Cardinal comparisons of utilities make no sense. For example, I
like chocolate twice as much as you do or I like chocolate twice
as much as I like wine have no meaning.
Exercise: Assume that U represents on a convex set X Rn .
Show that is convex if and only if U is quasiconcave.
Is there always a utility function U that represents ? The answer
in general is no. But, if is continuous, a utility function that
represents always exists.
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Example: Lexicographic Preferences. Assume X R2+ . Let x y
if either x1 > y1 or x1 = y1 and x2 y2 . One can easily see that
upper contour sets (x ) are not closed, so is not continuous.
The lexicographic preferences do not have a utility representation.
Suppose by contradiction that U represents . Then, for any
x1 0, (x1 , 2) (x1 , 1) and we must have U (x1 , 2) > U (x1 , 1).
But then, there exists a rational number R (x1 ) such that
U (x1 , 2) > R (x1 ) > U (x1 , 1). Now, for any x1 > x10 ,
R (x1 ) > U (x1 , 1) > U (x10 , 2) > R (x10 ). This implies that the
function R : R + ! R is one-to-one: R (x1 ) 6= R (x10 ) for all
x1 6= x10 . But this is a contradiction, because the function R would
then assign a dierent rational number to each (positive) real
number, so the positive real line would be a countable set and we
know that the positive real line is uncountable.
Hereafter we will assume is continuous and that it has a utility
representation.
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 The marginal utility of xi is
Consumer Demand
U
Given a price vector p = (p1 , . . . , pn ) and a budget (or income) I , MUi (x ) = (x ).
xi
the classic consumer problem is
MUi (x ) is the rate at which the utility of the consumer increases
max U (x ) subject to p x I, for each additional unit of xi :
x 2X
U
U (x1 , . . . , xi + D, . . . , xn ) U (x ) + (x )D.
where p x = p1 x1 + p2 x2 + + pn xn is the total cost of xi
purchasing bundle x = (x1 , . . . , xn ). Let x denote an (the) Assume n = 2. A bundle x is on the budget line if
optimal solution.
p1 I
Observation: Usually, the feasible set is X = Rn+ . In this case, if p1 x1 + p2 x2 = I or x2 = x1 + .
p2 p2
U satisfies local nonsatiation, then p x = I .
So the slope of the budget line is constant and equal to p1 /p2 .
Assume that X = Rn+ and that is convex. Then the indierence The indierence curve through x is
curves are convex. If x is an interior point for X , then it must be
(x ) = {x 2 Rn+ | U (x ) = u },
that the budget line and the indierence curve (x ) are tangent
at x . If U is dierentiable, then the budget line and the where u = U (x ). The equation U (x ) = u implicitly defines x2
indierence curve are tangent at x if and only if they have the as a function of x1 . In particular, x2 (x1 ) = x2 because
same slope at x . U (x1 , x2 ) = u .
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Since U (x1 , x2 (x1 )) = u for all x1 > 0, we have that If x1 decreases D1 and x2 increases D2 = MRS21 (x )D1 , then
d dx2 U ( x1 D 1 , x2 + D 2 ) U ( x ) .
0= U (x1 , x2 (x1 ))|x1 = MU1 (x ) + MU2 (x ) (x )
dx1 dx1 1
Assume that n = 2. Let x 0 and x 00 be two bundles on the same
and thus the slope of the indierence curve at x is indierence curve (U (x 0 ) = U (x 00 )) such that x10 < x100 . If is
dx2 MU1 (x ) convex (or equivalently, if U is quasi-concave) then
(x ) =
dx1 MU2 (x ) MRS21 (x 0 ) MRS21 (x 00 ) (diminishing MRS).
and the tangency condition is Benchmark Examples:
MU1 (x )
p1 (1) Cobb-Douglas utility function: U (x1 , x2 ) = x1a x21 a , where
MRS21 (x ) =
= . a 2 (0, 1). In this case,
MU2 (x ) p2

x2 1 a x1 a
Definition MU1 (x ) = a , MU2 (x ) = (1 a) ,
For any n 2 and any x > 0, x1 x2
a x2
MRS21 (x ) = .
MUi (x ) 1 a x1
MRSji (x ) =
MUj (x )
Therefore, the optimal solution satisfies the two conditions
is the marginal rate of substitution of good j for good i. MRSji (x ) a x2 p1
is the amount that xj must be increased for each unit that xi is p1 x1 + p2 x2 = I and = .
1 a x1 p2
decreased so that the consumers utility remain constant.
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Optimal Solution: Let C = aa (1 a )1 a. Then The optimal solution of an optimization problem has two parts:
aI (1 a )I I (i) the optimizer; (ii) the optimal value. If the optimization
x1 = x2 = , and U (x ) = C . problem contains parameters, these two components of the
p1 p2 p1a p21 a
solution will be functions of these parameters.
Note: if a > 0 and b > 0, U (x1 , x2 ) = x1a x2 and
b
In the consumer optimization problem, the optimal solution x and
U (x1 , x2 ) = a log(x1 ) + b log(x2 ) also represent C-D preferences. optimal value U (x ) are functions of prices p = (p1 , p2 ) and
income I .
(2) Perfect Substitutes utility function U (x1 , x2 ) = ax1 + bx2 .
Definition
(3) Perfect Complements utility function
The maximizer x = D (p, I ) is called the Marshallian Demand and
U (x1 , x2 ) = min {ax1 , bx2 }.
the optimal value V (p, I ) = U (D (p, I )) is called the Indirect
Cobb-Douglas, perfect substitutes and perfect complements are all Utility Function.
convex preferences.
Fix a price vector p and a utility level u. Consider the expenditure
The tangency condition is necessary but not sufficient for minimization problem
optimality. For example, if U (x1 , x2 ) = x12 + x22 and p1 = p2 = 1,
then x1 = x2 = I /2 satisfies the tangency condition and budget min p x subject to U (x ) u.
x 2Rn+
constraint but it is not optimal. There are two optimal solutions
here: x = (I , 0) and x = (0, I ) (corner solutions).
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 Proof: Note that if x is such that U (x ) = u, then
Definition
p x p h (p, u ). Let p 0 and p 1 be two price vectors and
The optimal solution of the expenditure minimization problem is
l 2 (0, 1). Denote p l = lp 1 + (1 l)p 0 . Then
called the Hicksian Demand Function h (p, u ) (or compensated
demand function); the corresponding optimal value function is e (lp 1 + (1 l )p 0 , u ) = p l h (p l , u )
called the Expenditure Function e (p, u ) = p h (p, u ). = lp 1 h(p l , u ) + (1 l )p 0 h (p l , u )
Hold prices fixed. Notice that V maps income (or expenditures) lp 1 h (p 1 , u ) + (1 l )p 0 h (p 0 , u )
into utility and e maps utility into expenditure. Are e and V the = le (p 1 , u ) + (1 l )e (p 0 , u ).
inverses of each other? We have that
Example: Cobb-Douglas. When a = 1/2, we computed earlier
V (p, e (p, u )) = u and e (p, V (p, I )) = I 0 1
I
D (p, e (p, u )) = h (p, u ) and h (p, V (p, I )) = D (p, I ). B 2p1 C I
D (p, I ) = B C
@ I A and V (p, I ) = 2pp1 p2 .
We can say a lot about the shape of e (p, u ) without making any 2p2
assumptions about U. We cant say much about e as a function of
u because many dierent Us represent the same preferences. Let x = D (p, I ) and u = V (p, I ). Since p1 x1 = p2 x2 we get
r r
Lemma p p 1 x1 p2
u = x 1 x2 = x1 () x1 = u .
e (p, u ) is concave in p. p2 p1
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 We can divide the response of Di to an increase in pi into two
One can similarly solve for x2 to obtain parts:
p substitution eect + income eect
u pp2 /p1 p
h (p, u ) = and e (p, u ) = 2u p1 p2 . Substitution eect: change in demand for xi when pi increases
u p1 /p2
and the consumer is compensated (that is, his income is increased)
Comparative Statics of Consumer Demand so he can attain the same level of utility he had before the price
change.
How does consumer demand adjust to changes in prices and
income? We are interested in Income eect: subsequent change in demand for xi when the
compensation is take away.
Di Di Di
, and . Let x = D (p, I ) be the initial demand and u = U (x ) be the initial
I pi pj
utility level. Suppose that p1 increases to p10 > p1 while p2 remains
It would seem natural that constant. The demand after the price is x 00 = D ((p10 , p2 ), I ). The
compensated demand after the price increase is
Di Di
0 and 0, x 0 = h ((p10 , p2 ), u ),
I pi
and we can write
but this is NOT always the case.
x 00 x = [x 0 x ] + [x 00 x 0 ] = substitution eect + income eect.
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For convex preferences, clearly, x10 < x1 . That is, an increase in p1
The Lagrangian for the expenditure problem
decreases the compensated demand for x1 . Is this always the case?
Claim: The compensated demand is always downward slopping. e (p, u ) = min p x subject to U (x ) u
Proof: Fix a utility level u. Let p = (p1 , p2 ) and p 0 = (p10 , p20 ) be is the function L(x, l) = p x l(U (x ) u ). Denote by x the
two price vectors and let optimal solution and by l the corresponding Lagrange multiplier.
x = h (p, u ) and x 0 = h (p 0 , u ). By the envelope theorem

e L
Since x minimizes expenditure with prices p and u (x 1 ) = u, it (p, u ) = (x , l ) = xi = hi (p, u ) Shephards Lemma.
must be that p x p x 0 . Similarly, p 0 x 0 p 0 x. Subtracting pi pi
these two inequalities we obtain Assume that hi (p, u ) is dierentiable with respect to pi . Recall
(p 0
p ) x (p 0
p )x 0
or (p 0
p ) (x 0
x ) 0. that e (p, u ) is concave in p. Therefore

In particular, if p10 > p1 and p20 = p2 , then (p1 p10 )(x1 x10 ) 0 hi 2 e
(p, u ) = 2 (p, u ) 0.
which implies that x1 x10 . (In addition, with local nonsatiation, pi pi
x10 6= x1 and thus x1 > x10 . Can you see why?)
This re-establishes that Hicksian demand is downward sloping
So the Hicksian (compensated) demand is always downward (when the Hicksian demand is dierentiable).
sloping. That is, the substitution eect is always negative.
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 We can also dierentiate hi (p, u ) = Di (p, e (p, u )) with respect to
Slutsky Equation pj with j 6= i:
Recall the identity h (p, u ) = D (p, e (p, u )). This implies that
hi Di D e Di D
hi Di D e Di D = + i = + i hj or
= + i = + i hi pj pj I pj pj I
pi pi I pi pi I
Di h D
Denote xi = hi (p, u ) = Di (p, e (p, u )). Then = i xj i cross price Slutsky equation
pj pj I
Di h D
= i xi i . For a normal good, the income eect is negative and in the same
pi pi I
hi Di direction as the substitution eect. Let x 0 = D (p 0 , I ) and
Here is the substitution eect and xi is the income
pi I u = U (x 0 ). Then h (p 0 , u ) = D (p 0 , I ). If i is a normal good, then
eect. Di h
Good i is normal if
Di
0 and inferior if
Di
<0 i 0.
I I pi pi
Di That is, the Marshallian demand is more sensitive to changes in
Good i is a Gien good if > 0.
pi prices than the Hicksian demand because |Di0 (pi )| |hi0 (pi )|
Since hi /pi 0, from the Slutsky equation, good i is a Gien (keeping fixed all other prices). In this case we say that the
good only if good i is inferior: Marshallian demand is steeper than the Hicksian demand.
Di h Di Di However, the way we draw the graphs (with the axes reversed:
= i xi >0 () < 0.
pi pi I I quantities in the horizontal axis and prices in the vertical axis), the
19 / 24 Hicksian demand looks steeper than the Marshallian demand. 20 / 24
Definition Consumer Surplus
Dj
Good j is a gross substitute for good i if pi 0 and a gross Consider the market for good i. How much does the consumer
D
complement if pij < 0 benefit from the access to this market at some price pi0 , and how
A problem with this definition is that it is not symmetric. It is much benefit does he lose if the price increases from pi0 to pi1 ?
possible that good j is a gross sunstitute for good i while good i is One way of measuring the loss from a price increase from pi0 to pi1
a gross complement for good j. is to compare it to the additional income that would restore the
agents utility to its original level before the price increase. Say
Definition
hj that at pi0 the consumer attains a utility u 0 and spends
Good j is a net substitute for good i if 0 and a net
hj
pi e (p 0 , u 0 ) = I , where p 0 = (p10 , . . . , pi0 , . . . pn0 ). To attain the same
complement if pi <0 level of utility at new prices p 1 = (p10 , . . . , pi1 , . . . , pn0 ), he would
Is this definition symmetric in i and j? Well need e (p 1 , u 0 ). Therefore, to compensate the agent for his loss he
would require an additional income of
hj e 2 e hi e 2 e
= = and = = .
pi pi pj pi pj pj pj pi pj pi CV = e (p 1 , u 0 ) I = e (p 1 , u 0 ) e (p 0 , u 0 ) compensating variation.
Youngs theorem says that From calculus,
2 e 2 e Z x1
pi pj
=
pj pi
. 1
f (x ) 0
f (x ) = f 0 (x )dx.
x0
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Therefore Most empirical studies on demand estimate Marshallian demand
Z p1 Z p1 (because that is what we can observe). What would be the
1 e 1
e (p 1 , u 0 ) e (p 0 , u 0 ) = (p1 , p20 , u 0 )dp1 = h1 (p1 , p20 , u 0 )dp1 . dierence if we use the Marshallian demand instead of the Hicksian
p10 p1 p10
demand to calculate CV? Let
Z
In the usual (x, p )-axes, the compensating demand is the area to
the left of the Hichsian demand function, between p10 and p11 . CS (p10 ) = D1 (p1 , p20 )dp1 consumer surplus.
p10
The total benefit from the access to market i can be measured by As remarked earlier, for normal goods, the Marshallian demand is
how much the consumer is willing to pay for the access to market i steeper than the Hicksian demand. Initially, Di (p 0 , I ) = hi (p 0 , u 0 ).
at current price pi (when initially he has no access). This is the That is, the two demand curves intersect at p 0 . Consequently, for
same as the compensating variation when the price increases from pi1 > pi0 , the area to the left of the Marshallian demand, between
pi to (when pi = , the consumer cannot aord to participate pi0 and pi1 is smaller than the corresponding area to the left of the
in market i): Hicksian demand:
Z
e ((, p20 ), u 0 ) e ((p1 , p20 ), u 0 ) = h1 (p1 , p20 )dp1 . CV > CS (p10 ) CS (p11 ) loss in consumer surplus = DCS.
p10
The dierence is due to the income eect: from the Slutsky
Note that equation
Z p1 Z Z Di h D
1 = i xi i .
CV = h1 (p1 , p20 )dp1 = h1 (p1 , p20 )dp1 h1 (p1 , p20 )dp1 . pi pi I
p10 p10 p11
0 0 0 0 0
Since Di (p , I ) = hi (p , u ), if Di hi , then Di hi .
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Price elasicity of demand:

p Di p h xi I Di
e Di p i = i = i i pi = e hi pi s i e Di I ,
xi pi xi pi I xi I
where si is the fraction of income spent in good i. If si is small,
then eDi pi ehi pi and |DCS | CV .
To define CV we used as a reference the initial utility level u 0 of
the consumer. We could use instead the final utility u 1 of the
consumer after the price for good i increases from pi0 to pi1 . What
loss in income, relative to I , would leave the consumer as badly o,
at original prices, as he is with the new prices and his original
income I ? This is the

EV = I e (p 0 , u 1 ) = e (p 1 , u 1 ) e (p 0 , u 1 ) equivalent variation.

Again, this is the area to the left of the Hicksian demand between
p10 and p11 , but now anchored at u 1 . For a normal good we have
that
EV |DCS | CV .
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