Advanced Microeconomics II: Consumer

Theory

Maria Saez Marti Office 210, IEW

tel. 044 634 37 13 e-mail: saez@iew.uzh.ch

 This course

Consumer Theory.

Theory of the firm.

Partial Equilibrium

General Equilibrium

(Social Choice and Welfare)

Lectures (MSM) and Classes (Bernhard Ganglmair). Important that

you participate in the Classes.
Bibliography:

Jehle and Reny: Advanced Microeconomic Theory.

If you are interested in a more advanced book, you can read

Mas Collell et al: Microeconomic Theory

 1.1 Intoduction

The choice problem of a household

Consumers decide about

• savings vs. consumption

• composition of consumption
• composition of wealth
• labor supply
• type of job
• number of children
• education
Decisions depend on:
• tastes (including time and risk preferences)
• wealth (including human capital)
• prices
• expectations about

— future prices

— own future preferences

— future income
Theoretical starting-point

• Consumer knows set of goods, prices and income; based on them,

he decides on consumption vector once and for all.
• Thus the problem is simplified in that
— choices concern only consumption
— choices are not sequential
— the future is certain

Question:
• How does consumption vector depend on prices, income and pref-
erences?

Important:
• understand relation between assumptions and conclusions - not just
conclusions.
 Goal of the chapter:

• formal representation of the consumer’s choice problem

• characterization of his behavior on the market

• Important: consumer theory is not an end itself, rather a building

block of the explanation in the economic system.
 1.2 Primitive Notions

Consumer Choice
Overview

Four building blocks in any model of consumer choice

• consumption set
• feasible set
• preference relation
• behavioral assumption
Consumption Set
• Consumption set represents the set of all alternatives, or complete
consumption plans, that the consumer can conceive - whether some
of them will be achievable in practice or not
• Let each commodity be measured in some infinitely divisible units.
• xi ∈ R represents the number of units of good i
• x = (x1, ..., xn) is the vector containing different quantities of each
of the n commodities (x is called a consumption bundle or a con-
sumption plan)
• Think of the consumption set as the entire nonnegative orthant,
X = Rn+.
Properties of the Consumption Set

Assumption 1 The minimal requirements on the consumption set are

1. ∅ 6= X ⊆ Rn
+
2. X is closed
3. X is convex
4. 0 ∈ X
Feasible Set

• The feasible set B represents all those alternative consumption

plans that are both conceivable and realistically obtainable given
the consumer’s circumstances.
• The feasible set B then is that subset of the consumption set X
that remains after we have accounted for any constraints on the
consumer’s access to commodities due to the practical, institutional,
or economic realities of the world.
Preference Relation

A preference relation typically specifies the limits, if any, on the con-

sumer’s ability to perceive in situations involving choice, the form of
consistency or inconsistency in the consumer’s choices, and information
about the consumer’s tastes for the different objects of choice.

Behavioral Assumption

The consumer seeks to identify and select an available alternative that

is most preferred in the light of his personal tastes.
 1.3 Preferences and Utility

Preference Relations
• We represent the consumer’s preferences by a binary relation, %,
defined on the consumption set, X.
• If x1 % x2, we say that ”x1 is at least as good as x2”, for this
consumer.
Axiom 1: Completeness
For all x1 and x2 in X, either x1 % x2 or x2 % x1

Axiom 2: Reflexivity
For all x, in X, x % x

Axiom 3: Transitivity
For any x1, x2 and x3 in X, if x1 % x2 and x2 % x3 then x1 % x3.

Definition 1:
The binary relation % on the consumption set X is called a preference
relation if it is complete, reflexive and transitive.
Induced Preference Relations
Definition 2:
• The binary relation  on the consumption set X is defined as fol-
lows:
x1 Â x2 if and only if x1 % x2 and x2 ´ x1.
The relation  is called the strict preference relation induced by
%, or simply the strict preference relation when % is clear. The
phrase x1 Â x2 is read, ”x1 is strictly preferred to x2.”

Definition 3:
• The binary relation ∼ on the consumption set X is defined as fol-
lows:
x1 ∼ x2 if and only if x1 % x2 and x2 % x1.
The relation ∼ is called the indifference relation induced by %, or
simply the indifference relation when % is clear. The phrase x1 ∼ x2
is read, ”x1 is indifferent to x2.”
Sets in X derived from the Preference Relations
Definition 4:

Let x0 be any point in the consumption set, X. Relative to any such

point, we can define the following subsets of X :
³ ´ n o
1. % x0 ≡ x | x ∈X, x % 0
x , called the ”at least as good as”
set.
³ ´ n o
2. - x ≡ x | x ∈X, x % x , called the ”no better than” set.
0 0
³ ´ n o
0 0
3. ≺ x ≡ x | x ∈X, x  x , called the ”worse than” set.
³ ´ n o
0 0
4. ∼ x ≡ x | x ∈X, x ∼ x , called the ”indifference” set.
Hypothetical preferences satisfying Axioms 1, 2 and 3
Further Assumptions on Preferences

Axiom 4: Continuity
+, the ”at least as good as” set, % (x), and the ”no
• For all x ∈ Rn
better than” set - (x), are closed in Rn
+.

Axiom 5´: Local Nonsatiation

³ ´
• For all x0 ∈
R+, and for all ε > 0, there exists some x ∈ Bε x0 ∩
n
³ ´
R+ such that x  x ; where Bε x0 is the neighborhood of x0
n 0

with radius ε.

Axiom 5: Strict Monotonicity

+, if x ≥ x then x % x , while if x À x ,
• For all x0, x1 ∈ Rn 0 1 0 1 0 1

then x0 Â x1.
Figure 1: Hypothetical preferences satisfying Axioms 1, 2, 3 and 4
Hypothetical preferences satisfying Axioms 1, 2, 3, 4 and 5´
Hypothetical preferences satisfying Axions 1, 2, 3, 4 and 5´
Hypothetical preferences satisfying Axioms 1, 2, 3, 4 and 5
Axiom 6´: Convexity

• If x1 % x0, then tx1 + (1 − t) x0 % x0 for all t ∈ (0, 1) .

Axiom 6: Strict Convexity

• If x1 6= x0 and x1 % x0, then tx1 + (1 − t) x0 Â x0 for all t ∈

(0, 1) .
Hypothetical preferences satisfying Axioms 1, 2, 3, 4, 5 and 6´ or 6
Marginal Rate of Substitution
• When X = R2+, the (absolute value of the) slope of an indifference
curve is called the marginal rate of substitution.
• If preferences are strictly monotonic, any form of convexity requires
the indifference curves to be at least weakly convex-shaped relative
to the origin.
The Utility Function

Definition 5:
A real valued function u: Rn+ → R is called a utility function represent-
ing the preference relation %, if for all x0, x1 ∈ Rn
+,
³ ´ ³ ´
u x ≥ u x1 ⇐⇒
0 x0 % x1.

Note:
• It can be shown that any binary relation that is complete, transi-
tive, and continuous can be represented by a continuous real-valued
utility function.
• Here we will take a detailed look at a slightly less general result.
Representation of Preferences

Theorem 1:
If the binary relation % is complete, transitive, continuous, and strictly
monotonic, there exists a continuous real-valued function, u: Rn +→R
which represents %.

Interpretation:
The result frees us to represent preferences either in terms of the prim-
itive set-theoretic preference relation or in terms of a numerical repre-
sentation, a continuous utility function.
Sketch of Proof:
• Let the relation % be complete, transitive, continuous, and strictly
monotonic. Let e ≡ (1, ..., 1) ∈ Rn + be a vector of ones, and
consider the mapping u: Rn + → R defined so that the following
condition is satisfied:
u (x) e ∼ x (1)

Remaining issues:
• First, does there always exist a number u (x) satisfying (1)?
• Second, is it uniquely determined, so that u (x) is a well-defined
function?

+ → R representing % continuous?
• Third, is the utility function u: Rn
Constructing the mapping
Monotone Transformations

Theorem 2:

Let % be a preference relation on Rn + and suppose u (x) is a utility

function that represents it. Then v (x) also represents % if and only if
v (x) = f (u (x)) for every x, where f : R → R is strictly increasing on
the set of values taken on by u.
Relation between Preferences and Utility Func-
tions

Theorem 3:

Let % be represented by u: Rn
+ → R. Then:
1. u (x) is strictly increasing if and only if % is strictly monotonic.
2. u (x) is quasiconcave if and only if % is convex.
3. u (x) is strictly quasiconcave if and only if % is strictly convex.
Differentiable Utility Functions
• marginal utility of good i = ∂u (x) /∂xi
• For the case of two goods, we defined the marginal rate of substi-
tution as the absolute value of the slope of an indifference curve.
• Let x2 = f (x1) be the function describing the indifference curve in
the (x1, x2) plane.
³ ´ ³ ´ ³ ´
• Therefore MRS12 x1, x2 ≡| f´ x1 |= −f´ x11
1 1 0 1 0 (2)

• Suppose ∂u (x) /∂xi > 0 for “almost all” bundels x, and all i =
³ ´
1, ..., n. Then ³ ´ ∂u x1 /∂x
1 1
M RS12 x = ³ ´ .
1
∂u x /∂x2