ECO 305 FALL 2003 September 25

INDIRECT UTILITY FUNCTION

U (Px , Py , M ) = max { U (x, y) | Px x + Py y M }
= U (x , y )
= U (Dx (Px , Py , M), Dy (Px , Py , M ) )
PROPERTIES OF U :
(1) No money illusion Homogeneous degree zero:
U (k Px , k Py , kM ) = U (Px , Py , M )
(2) As money income changes:

U
M

x
"

x
+
M

y
M

x
y
+ Py
M
M

= Px
=

M
=
M

(3) As price changes:

U
Px

x
+
Px
1

y
Px

"

x
y
+ Py
Px
Px
= x
(just like M by x )
= Px

(Last step: dierentiate adding-up identity w.r.t. Px :

Px x + Py y = M
x
y
+ Py
=0)
x + Px
Px
Px
Divide price- and income-change equations :

U /Px
Roys Identity: x =
U /M

(4) Contours of U in (Px , Py ) space with M fixed:

(Like theater with stage at NE corner)

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EXPENDITURE FUNCTION
Solve the indirect utility function for income:
u = U (Px , Py , M)

M = M (Px , Py , u)

M (Px , Py , u) = min { Px x + Py y | U (x, y) u }

Dual or mirror image of utility maximization problem.

Economics income compensation for price changes
Optimum quantities Compensated or Hicksian demands
x = DxH (Px , Py , u) ,

y = DyH (Px , Py , u)

PROPERTIES OF M :
(1) Homogeneous degree 1 in (Px , Py ) holding u fixed:
M (k Px , k Py , u) = k M (Px , Py , u)
(2) Hotellings or Shepherds Lemma
Compensated demands partial derivatives w.r.t. prices:
DxH (Px , Py , u) = M /Px , DyH (Px , Py , u) = M /Py
Proof: M = Px DxH + Py DyH , u = U (DxH , DyH ). So
M /Px = DxH + Px DxH /Px + Py DyH /Px
0 = Ux DxH /Px + Uy DyH /Px
= [ Px DxH /Px + Py DyH /Px ]
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(3) Weakly concave in (Px , Py ) holding u fixed.

Cobb-Douglas example: (Px )1/3 (Py )2/3

PROPERTIES OF HICKSIAN DEMAND FUNCTIONS:

(1) Own substitution eect negative:

Px

DxH
2M
=
=
0
2
P
P
x
x
u=const
(2) Symmetry of cross-price eects:
DyH
DxH
2M
=
=
Py
Px Py
Px
(Net) substitutes if > 0, complements if < 0
General concept : Comparative statics
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COBB-DOUGLAS EXAMPLE
(Direct) UTILITY FUNCTION:
U (x, y) = ln(x) + ln(y),
x = M/Px ,

+ =1

y = M/Py

INDIRECT UTILITY FUNCTION

U (Px , Py , M) = [ln() + ln(M) ln(Px ) ]
+ [ln() + ln(M ) ln(Py ) ]
= junk + ln(M ) ln(Px ) ln(Py )
Roys Identity:
/Px
M
U /Px

=
=
x

U /M
1/M
Px
EXPENDITURE FUNCTION
M = M (Px , Py , u) = eu (Px ) (Py )
Hicksian demand functions
xH = eu (Px )1 (Py ) , y H = eu (Px ) (Py )1

SLUTSKY EQUATION
Link between Marshallian and Hicksian demands
Equal if u = U (Px , Py , M ), M = M (Px , Py , u).
For good i where i may be either x or y,
DiH (Px , Py , u) = DiM (Px , Py , M (Px , Py , u) )
Now let Pj change, where j may be x or y
DiH
Pj

DiM
DiM M
=
+
Pj
M Pj
DiM
DiM H
Dj
=
+
Pj
M
DiM
DiM M
=
+
Dj
Pj
M

For example

Py

u=const

Py

x
+y
M
M =const

Price derivative of compensated demand =

Price derivative of uncompensated demand
+ Income eect of compensation.
If i = j, LHS is negative. Then Gien implies Inferior
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