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Advanced Microeconomics
Consumer theory: optimization and duality
Jan Hagemejer
Introduction
The plan:
or: choose a bundle x y for x and any y 's in the budget set B ,
given prices p and wealth w
or: if we have a utility function representing , maximize utility
subject to the budget constraint (given by p and w ).
the correspondence between prices p , wealth w and the consumer
chosen bundle is the demand correspondence.
Maxx 0 u (x )
subject to px w
If u (x ) is well behaved, then this problem has a solution x (p, w )
which is the so-called Walrasian demand correspondence
L = u (x ) (p x w )
u (x )
x1 p1 0
. u (x )
.
= ppl
x
.
u (x )
which gives (if interior solution) l
u (x ) for all l, k
pL 0 x k
k
xL
px w 0
and hence: MRSlk = ppkl
Lets assume that dxl 6= 0 and dxk 6= 0 and all other dxn = 0:
u (x ) u (x )
0 = dxl + dxk
xl xk
Rearrange:
u (x )
dxl xl
= = MRSlk
dxk u (x )
xk
The UMP
l =1 l =1
l l
L = a1 x1 + a2 x2 0 ( pl xl w ) + l (xl )
X X
l =1 l =1
FOC's are:
[x1 ] a1 0 p1 + 1 = 0
[x2 ] a2 0 p2 + 2 = 0
[0 ] p1 x1 + p2 x2 w 0, 0, (w p1 x1 p2 x2 ) = 0,
[1 ] x1 0, 1 0, 1 x1 = 0
[2 ] x2 0, 2 0, 2 x2 = 0
Case 1: 0 > 0, and all l = 0, therefore all xl > 0 (interior solution)
a a
from rst 2 FOCs we have: 1 = 0 and 2 = 0 1 / 1 = 2 / 2 or
p1 p2 a p a p
p1 a1 a1 a2
p2 = a2 or better p1 = p2 (the expenditures on one unit of MU are
equal).
Case 2:
x1 = p1 , x2 = 0.
w a1 a2
if
p1 > p2
x (p) = x1 , x2 : p1 x1 + p2 x2 = w if
p1 a1
p2 = a2
x2 = pw2 , x1 = 0 if
a1 a2
p1 < p2
As long as the bang for the buck is equal, we have the interior solution,
otherwise only corner solutions.
luxury >1
Wealth eects
Price eects
In matrix notation
x1 (p ,w ) x1 (p ,w )
p1 pL
Dp x (p, w ) = . ..
. .
.
xL (p ,w ) xL (p ,w )
p1 ... pL
Oer curve
OC - a locus of points demanded in over all possible values of one of the
prices (in R2 ).
Once we have the optimal choice, x (p, w ) we can plug it back into
the utility function.
What for?
Expenditure minimization
Instead of UMP, let us think of the consumer that has a desired level
of utility.
obvious
minx 0 px subject to u (x ) u
The solution is h(p, u ), the demand for goods given prices and
utility, the so called Hicksian demand (contrast it to x (p, w )).
Once we have the solution to the problem, we can calculate the actual
expenditure:
L
e (p , u ) = pl h(p, u )
X
l =1
Why is it useful?
Expenditure minimization
h (p , u ) = p e (p , u )
1
x (p , w ) = p v (p , w )
w v (p , w )
hl (p , u ) xl ( p , w ) x (p , w )
xk ( p , w ) = l
p w pk
| {zk } | {z }
Substitution eect Income eect
Recap