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1
12. Consumer Theory
Econ 494
Spring 2013
2
Agenda
Shifting gears…Focus on the consumer, rather than the firm Axioms of rational choice Primal: Utility maximization Marshallian
demands Dual: Expenditure minimization Hicksian
demands Link between utility max and expenditure min. Welfare measures
Readings Silb. Ch 10; also p 53-55
3
Introduction
Consumers purchase goods, x1…xn, at prices, p1…pn.
Consumers have a budget or income (M) with which to purchase these goods/services
How do consumers decide what to buy? Buy goods to make them happy Derive satisfaction from consumption This satisfaction can be described by a utility function Consumers will maximize utility s.t. budget constraint
1
1,
1
, subject to n
n
n i ix x
i
Max U x x M p x
4
Axioms of rational choice
These are behavioral postulates no need to prove
Budget constraint is straightforward, but notion of a utility function is not.
We assert that consumer preferences must exhibit the following characteristics:
5
1. Completeness
Individuals are always able to choose between two bundles
Consumers can rank bundles
Binary preference comparison
One of the following must be true:A is preferred to BB is preferred to AA and B are equally preferred
A B
or B A
or A B
6
2. Transitivity
The rankings consumers assign to bundles must be consistent or transitive
We only require that consumers can compare 2 bundles at a time, but the pairwise comparisons must be linked
Transitivity: If A is preferred to B,And if B is preferred to C,Then A must be preferred to C.
A BA C
B C
7
Comment on transitivityAssuming transitivity is somewhat controversialThere is some evidence that indicates that
choices are not always transitive
3. Reflexivity
Bundle A is at least as preferred as itself
Almost obvious, requires only very weak logical behavior
A A
8
The 1st 3 axioms The first 3 axioms: Completeness Transitivity Reflexivity
These formalize the notion that the consumer’s choices are rational or logically consistent.These require that individuals can rank choices ordinal measure of satisfaction/utilityDoes not require individuals to assign some level or degree of satisfaction with these choices not cardinal measure
Utility function is only a ranking. If A is preferred to B, then U(A) > U(B)
9
Utility is an ordinal measure
Ordinality individuals can rank bundles
If U(A)=50 and U(B)=25, then A is preferred to B, but we cannot say that A is preferred twice as much as B.
Utility function is not unique – can take a monotonic transformationAny transformation that preserves rankingsU0(x) = x2 or U1(x) = 2ln(x) will work just as well
10
4. Continuity & differentiability
Mathematical assumptions about utility function
Continuity If A is strictly preferred to B, then there is a
bundle “close” to A that is also preferred to B
DifferentiabilityUtility function is twice differentiable
11
5. Non-satiation
The utility function is monotonically increasing in the consumption of each good
“More is preferred to less”
0ii
UU
x
12
6. Substitution
Consumers can make trade-offs among goods
Assume bundles are perfectly divisible
The maximum x2 a consumer will give up to get 1 unit of x1 is the amount that will leave her indifferent between old and new situation Indifference curves (analogous to isoquants)
Slope of indifference curve represents trade-offs person is willing to make
Indifference curve – locus of consumption bundles that yield same level of utility
13
Indifference curves slope down
An explicit function for an indifference curve:0
2 2 1( , )x x x U
0 01 2 1, ( , )U x x x U U
Substitute into utility function to get identity:
Differentiate identity wrt x1:2
1 2 1
0U U x
x x x
Rearrange terms:
2 1 1
1 2 2
0 since 0i
x U x UU
x U x U
Downward sloping indifference curves is implied by assumption of nonsatiation
14
Marginal rate of substitution
A negatively sloped indifference curve means consumers are willing to make trade-offs less of one good for more of the other
Marginal rate of substitution (MRS)2 1
1 2
x U
MRSx U
15
Indifference curves are convex
The marginal value of any good decreases as more of that good is consumed.
Diminishing MRS ¶2x1 / ¶x22 > 0
Differentiate MRS wrt
1
2 1 1 2 1
1 2 1 2 1
22 1 1 2 1
21 2 1 2 1
2 211 2 12 1 2 22 13
2
( , ( ))
( , ( ))
( , ( ))
( , ( ))
12 0
x U x x x
x U x x x
x U x x x
x x U x x x
U U U U U U UU
See notes #8 slides 25-26 for derivation
16
Graphical illustration
x2
x1
•
•b
a
U0
1 1
2 2
a b
a b
U U
U U
At point a, consumer is willing to give up more x2 for a unit of x1 than at point b.
17
Indifference curves cannot cross
x2
x1
U1
U2
B
AC
••
•
A and B are on same indifference curve U(A) = U(B) = U1
A and C are on same indifference curve
U(A) = U(C) = U2
By transitivity, it must be true that U(B) = U(C)
But…C includes more of both goods than B. By nonsatiation: U(B) < U(C)
Contradiction curves cannot cross
18
Indifference maps
x2
x1
•
•
U1
U2B
AC
U2 > U1
We can fully describe a utility function, and hence an individuals preferences in (x2, x1) space by an indifference map.
19
Utility maximization
Suppose a consumer gets utility from 2 goods and has income M. The indirect utility function is:
1 21 2 1 2 1 1 2 2
,
1 2 1 2 1 1 2 2
Lagrangian
( , , ) ( , ) . .
( , , ) ( , )
x xV p p M Max U x x s t M p x p x
x x U x x M p x p x
L
Assume person spends all her money.
V (p1, p2, M) is quasi-convex in (p1, p2)
we are not going to prove this
20
FONC
1 21 2 1 2 1 1 2 2
,
1 2 1 2 1 1 2 2
1 1 1 1 1
2 2 2 2 2
1 1 2 2
Lagrangian
FON
( , , ) ( , ) . .
( , , ) ( , )
0price ratio (relative prices)
0
C
0
x xV p p M Max U x x s t M p x p x
x x U x x M p x p x
U p U pMRS
U p U p
M p x p x
L
L
L
L
– Slope of indifference curve
– Slope of budget line
21
Tangency of indifference curve and budget line
22
SOSC
1 1 1
2 2 2
1 1 2 2
FONC
1,0
20
0
ii
U p
U
Up
p
M p x p x
i
L
L
L
11 12 1 11 12 1
21 22 2 12 22 2
1 2 1 2
2 21 2 21 1 22 2 11
2 21 2 21 1 22 2 11
2
0
0 0
2
SO
0
20
SC
U U p
BH U U p
p p
BH p p U p U p U
U U U U U U UBH
L L L
L L L
L L
1,2ii
Up i
Strict quasi-concavity of the utility function assures us that the
indifference curves will be strictly convex
We do NOT know sign of U11 and U22 !! Diminishing marginal utility not implied
23
Marshallian demand functions
By the IFT, if the SOSC are satisfied then the FONC can, in principle, be solved simultaneously for the explicit choice functions (Silb., p. 262, lays the IFT conditions out more formally):
xim(p1, p2, M) i=1,2
lm(p1, p2, M)
xim(p1, p2, M) are utility maximizing demands
also referred to as Marshallian demand functionsor money-income-held-constant demands
24
Elasticities
0 good i
Income e
infe
las
s
0 good
rior
n
ticit
is ormal
y
mi
iMi
ix M
iM x
0 good
Cross-p
and
rice elastic
complements
substit
are
0 good and ar ute es
itym
jiij
j i
p i jx
i jp x
1 good is
= 1 good is
elastic
unit elast
> 1 good
i
is
> 0 good i
Own-price elasticity
c
inelastic
Giffen goo ds a
mi i
iii i
i
ix p
ip x
i
25
Marshallian demands are HOD(0) in prices and income
For prices & income (p1, p2, M), the FONC:
1 11 1 2 2
2 2
and 0U p
M p x p xU p
For prices & income (tp1, tp2, tM), the FONC:
1 11 1 2 2
2 2
1 11 1 2 2
2 2
and 0
and 0
U pM p
tt t tx p x
U p
U pM x p
t
p xU p
Since the FONC are the same for both sets of prices, the solutions must also be the same. Therefore, xi
m(p1, p2, M) = xim(tp1, tp2, tM)
26
Comment on homogeneity
HOD(0) implies that “relative” price matterConsumption choices will not change with
inflation if all prices and wages are increased at the same rate
Consumption opportunities do not change if prices and income change by same proportion.
27
Marshallian demands are invariant to positive monotonic transformation
The demand functions that solve:
1 2
1 2 1 1 2 2,
( , ) . .x x
Max U x x s t M p x p x
Are identical to the demand functions that solve:
1 21 2 1 1 2 2
,
1 2 1 2
ˆ ( , ) . .
where
ˆ ( , ) ( , )
and ( ) 0, ( ) 0
x xMax U x x s t M p x p x
U x x F U x x
F U F U
¤
see Silb p. 53-55, 264-5
Read his discussion on why “diminishing marginal utility” has no meaning with ordinal utility.
28
Proof of invariance to monotonic transformation
1 2
1 2 1 1 2 2,
1 1
2 2
1 1 2 2
FO
( , )
N
. .
0
C
x xMax U x x s t M p x p x
U p
U p
M p x p x
1 2
1 2 1 1 2 2,
1 1 1 1 1
2 2 2 2 2
1 1 2 2
1
2
( , ) . .
FONC
ˆ
0
ˆ
ˆ
x xU
U
Max x x s t M p x p x
p F U p U p
p F U p U p
M p x p
U
x
1 2 1 2( , ) ( , )
and (
ˆ
) 0
x x F UU x x
F U
Since FONCs are identical, xim that solve FONCs must be identical.
Note that U1/U2 = p1/p2 holds if F ' >0 or F ' <0. But if F ' <0, then an increase in both x1 and x2 would decrease utility. Hence, F ' <0 would correspond with minimizing utility. If F ' >0, then U and Û will move in same direction, and U will achieve a maximum IFF Û does. (See Silb p. 264 Proposition 1)
29
Comment on monotonic transformation
This proposition highlights the ordinal nature of preferences.
A positive monotonic transformation preserves the ranking of all bundles
A positive monotonic transformation says nothing about the behavior of the individual
30
Envelope theorem
The indirect objective function is: 1 2 1 1 2 2 1 2( , , ) ( , , ), ( , , )m mV p p M U x p p M x p p M
Apply envelope theorem:
1 2
1 2 1 2
1 2
1 2
1 2 1 2
1 2
1 2
( , , )1 1 1 2( , , ) ( , , )1 1( , , )
( , , )2 2 1 2( , , ) ( , , )2 2( , , )
( , , )(
( , , ) 0
( , , ) 0
m
m m
m
m
m m
m
m
m
m mx x p p M
x x p p M p p Mp p M
m mx x p p M
x x p p M p p Mp p M
x x p p Mp
Vx x p p M
p p
Vx x p p M
p p
V
M M
L
L
L1 2
1 2
1 2
( , , ) 1 2( , , )
, , )
( , , ) 0m
m
mx x p p M
p p Mp M
p p M
31
Characteristics of indirect utility functionIndirect utility function is: Non-increasing in prices
Proof: ¶V / ¶pi < 0 from previous slide Non-decreasing in income
Proof: ¶V / ¶M > 0 from previous slide
Indirect utility function is HOD(0) in prices and income Proof: since Marshallian demands are HOD(0):
Indirect utility fctn is quasi-convex in prices (p1, p2) We will not prove this…
1 2 1 1 2 2 1 2
1 1 2 2 1 2 1 2
( , , ) ( , , ), ( , , )
( , , ), ( , , ) ( , , )
m m
m m
V p p Mt t t tU x p p M x p p M
U x p
t t t t t
p M x p p M V p p M
32
Roy’s identity
Solving for xi, and using lm = ¶V / ¶M :
This relationship is known as Roy’s identity
1 2
1 2 1 2
1 2
( , , ) 1 2( , , ) ( , , )( , , )
( , , )
From before, using Envelope m
0
Th :
m
m m
m
m mx x p p Mi i
x x p p M p p Mi ip p M
Vx x p p M
p p
L
m ii
V px
V M
33
Interpreting l
At any given consumption point, additional utility, Ui, can be gained by consuming “a little more” xi.
The marginal cost of this extra xi is pi.
The marginal utility per dollar spent on xi is Ui / pi
1 1 1
2 2 2
2
1
2
1
2
1 1 2
0
F NC
0
O
0
U p
U
U U
p pp
M p x p x
L
L
L
See Silb., p. 266-7
34
Use Envelope Theorem to Interpret l
The Lagrange multiplier is always interpreted as the marginal effect on the optimal value of the objective function as the constraint changes.
lm(p1, p2, M) is the marginal utility of income
1 2,,
( , , ) 0m m
m m
m
xx
Vp p M
M M
L
35
Comparative statics
Earlier, we used the IFT to solve the FONC:xi
m(p1, p2, M) i=1,2
lm(p1, p2, M)
If we substitute these explicit choice functions back into the FONC, we get the following identities:
1 1 1 2 2 1 2 1 2 1
2 1 1 2 2 1 2 1 2 2
1 1 1 2 2 2 1 2
( , , ), ( , , ) ( , , ) 0
( , , ), ( , , ) ( , , ) 0
( , , ) ( , , ) 0
m m m
m m m
m m
U x p p M x p p M p p M p
U x p p M x p p M p p M p
M p x p p M p x p p M
36
Comparative statics for p1
Differentiate the identities wrt p1, then express in matrix form:
1
1
1
111 12 1 1 1
21 22 2 2 1 2
1 2 1
11 12 1 1 1
21 22 2 2 1
1 2 1 1
0
0
mp
mp
m
p
m m
m
m m
x p
x p
p
U U p x p
U U p x p
p p p x
LL L L
L L L L
L L L L
37
Apply Cramer’s rule to solve
Signs are indeterminate If M increases, cannot use less of both goods – would
violate budget constraint
Find ¶x2m / ¶p1 on your own
Why is sign indeterminate? Parameters show up in the constraint.
212 12 1 1 22 1 2
1
12 12 1 22
10
10
mm m m
m
xp U x p U x p
p BH
xp U p U
M BH
38
Show: Cannot use less of both goods(when income increases)
Substitute solution back into budget constraint:
1 1 1 2 2 2 1 2, , , ,m mp x p p M p x p p M M
Differentiate wrt M:1 2
1 2 1 at least one comparative static must be 0m mx x
p pM M
39
Engel Aggregation
Convert to elasticity form:
1 21 2 1
m mx xp p
M M
1 1 2 2 1 share-weighted income elasticities
must sum to one.
share of budget spent on good
M M
j jj
s s
p xs j
M
1 21 21 2
1
1 2
1
1m mm m
m m
x xp p
M M
M M
x x
xM M x
1 1 2
1
21 2
2
1m m
m m
m mx p x pM M
M MM
x x
xM x
40
Cournot aggregation
1 11 2 21 1 j jk kj
s s s s s
1 21 11 1 2 2 1
1 11 2
1m mm m
m
m
m
p p p
M M
p x p x x
xp Mxp
x x
1 21 21 2 1
1
1 1 1
1 1
1 21
m m
mm
m m
m
p p p
M
x x
x
x xp p x
p p Mx M
1
1 21 1 2
1 1
Differentiate wrt
0m m
mx xp x p
p p
p
1 1 1 2 2 2 1 2, , ,
Budget identi y
,
tm mp x p p M p x p p M M
41
Cournot and Engel Aggregation
Cournot and Engel aggregation can be useful when estimating demand functionsCan be used as a restriction in a regressionOr, can test whether estimated coefficients are
consistent with this.
42
Slutsky (later we will prove)
Later we will prove:
1 1 11
1 1 000
h m mmx x x
xp p M
Find the sign, using comp. static results:
1 11
1
22 12 1 1 22 1 2 1 2 12 1 22
22
1
10 since 0
m mm
m m m m
m
x xx
p M
p U x p U x p x p U p UBH
p BHBH