Microeconomics I

c
Leopold Sogner

Department of Economics and Finance

Institute for Advanced Studies
Stumpergasse 56
1060 Wien
Tel: +43-1-59991 182
soegner@ihs.ac.at
http://www.ihs.ac.at/soegner

September, 2012
 Course Outline (1)
Micro I

Learning Objectives:

This course covers key concepts of microeconomic theory. The

main goal of this course is to provide students with both, a basic
understanding and analytical traceability of these concepts.

The main concepts are discussed in detail during the lectures. In

addition students have to work through the textbooks and have
to solve problems to improve their understanding and to acquire
skills to apply these tools to related problems.

1
 Course Outline (2)
Micro I

Literature:

Andreu Mas-Colell, A., Whinston, M.D., Green, J.R.,

Microeconomic Theory, Oxford University Press, 1995.

Supplementary Literature:

Gilboa, I., Theory of Decision under Uncertainty, Cambridge University Press,

2009.
Gollier C., The Economics of Risk and Time, Mit Press, 2004.
Jehle G.A. and P. J. Reny, Advanced Microeconomic Theory, Addison-Wesley
Series in Economics, Longman, Amsterdam, 2000.
Ritzberger, K., Foundations of Non-Cooperative Game Theory, Oxford
University Press, 2002.

2
 Course Outline (3)
Micro I

Decision Theory: Rationality, Preference primitives and axioms,

revealed preference theory, preference representations.
Mas-Colell. Chapter 1-3D.

Theory of the Consumer: Walrasian and Hicksian demand,

comparative statics, indirect utility, Slutsky equation, (duality
theory), (integrability of demand), welfare measures, aggregate
demand. Mas-Colell. Chapter 1-3D, 3E-H, 4.

Production: Production sets and returns to scale, production

functions, cost minimization, profit maximization. Mas-Colell.
Chapter 5

3
 Course Outline (4)
Micro I

Decision Theory, Decisions under Uncertainty: von

Neumann-Morgenstern expected utility theory, risk-aversion,
stochastic dominance, states and state dependent utility.
Mas-Colell. Chapter 6; Ritzberger Chapter 2.

Partial Equilibrium Theory: Pareto optimality and competitive

equilibrium, welfare theorems, the competitive model, (bilaterial
externality, public goods, second best, monopoly, Cournot model,
Betrand model, competitive limit.) Mas-Colell, Chapter 10 A-D,
F, (11 A,B,C,E, 12 A,B,C,F too optimistic)

4
 Course Outline (5)
Micro I

Winter Term 2012

Time schedule - received from Eva?
Practice session will be organized by David Koll.

5
 Course Outline (6)
Micro I

Some more comments on homework and grading:

Mid term (40%),

Final test (40%),

Homework and class-room participation (20%).

Mid term, final test & retake: tba

6
 Consumer Theory (1)
Rationality and Preferences
Micro I

Consumption set X

Rationality

Preference relations and utility

Choice correspondences and the weak axiom of revealed

preference

Relationship between the axiomatic approach and the revealed

preference approach

Mas-Colell, chapter 1
7
 Consumer Theory (1)
Rationality (1)
Micro I

We consider agents/individuals and goods that are available for

purchase in the market.

Definition: The set X of all possible mutually exclusive

alternatives (complete consumption plans) is called
consumption set or choice set.

Simplest form of a consumption set: We assume that each

good, xl x, l = 1, . . . , L can be consumed in infinitely divisible
units, i.e. xl R. With L goods we get the commodity vector
x in the commodity space RL.

8
 Consumer Theory (1)
Rationality (2)
Micro I

The elements of X are e.g. x and y. We assume that each good,

xl x, l = 1, . . . , L can be consumed in infinitely divisible units,
i.e. xl R.

In most parts of the course we assume xl 0, i.e. only positive

amounts of xi can be consumed. xi = 0 is possible. I.e. X = RL +.

9
 Consumer Theory (1)
Rationality (3)
Micro I

Approach I: describe behavior by means of preference relations;

preference relation is the primitive characteristic of the individual.

Approach II: the choice behavior is the primitive behavior of an

individual.

10
 Consumer Theory 1
Rationality (4)
Micro I

Consider the binary relation at least good as, abbreviated by

the symbol .

For x, y X, x  y implies that from a particular consumers

point of view x is preferred to y or that he/she is indifferent
between consuming x and y.

From  we derive the strict preference relation : x  y if

x  y but not y  x and the indifference relation where
x  y and y  x.

11
 Consumer Theory 1
Rationality (5)
Micro I

Often we require that pair-wise comparisons of consumption

bundles are possible for all elements of X.

Completeness: For all x, y X either x  y, y  x or both.

Transitivity: For the elements x, y, z X: If x  y and y  z,

then x  z

Definition[D 1.B.1]: The preference relation  is called rational

if it is complete and transitive.

Remark: Reflexive x  x follows from completeness [D 1.B.1];

alternative terms: weak order, complete preorder.
12
 Consumer Theory
Rationality (6) - Remarks (1)
Micro I

Definition - Relation: A subset of a product set Y Y is called

relation.

Properties of a Relation:

reflexive: xRx for all x X .

irreflexive: there is no x X such at xRx.
symmetric: if xRy then yRx.
asymmetric: there are no x, y X such that xRy and yRx.
transitive: if xRy and yRz then xRz .
complete: for all x, y X either xRy , yRx or both.
complete comparable; irreflexive = nonreflexive.
comparable: for all x, y X , where x 6= y , either xRy , yRx or both.
13
 Consumer Theory 1
Rationality (7) - Remarks (2)
Micro I

Example: Equality relation =. For S R and the product set

S S we define xRy if x = y and xR /y if x 6= y.

For each x S we get the pair (x, x) S S.

For all x the equality relation generates the subset

{(x, x)|x S}.

For preferences: for each pair x, y in X X a consumer is able

to assign one of the following statements: xRy or yR/x

The assignments of the one of these statements to any pair

(x, y) is called binary relation on X.

All these pairs x, y constitute a subset of the product set of X.

14
 Consumer Theory 1
Rationality (8) - Remarks (3)
Micro I
Partial Orders

Strict Partial Order: A relation is called strict partial ordering if it

is irreflexive and transitive.

Weak Partial Order: A relation is called non-strict or weak partial

ordering if it is reflexive and transitive.

Order Relation: A relation is called strict ordering if it is

comparable, irreflexive and transitive.

Weak Order: A relation is a weak order if it is complete, reflexive

and transitive.

Equivalence Relation: A relation is called equivalence relation if is

reflexive, symmetric and transitive. 15
 Consumer Theory 1
Rationality (9) - Remarks (4)
Micro I

Partial Orders

 is irreflexive and transitive such that it fulfills the requirements

of a strict partial order.

 is reflexive and transitive and fulfills the requirements of a

weak partial Order.

is reflexive and transitive and fulfills the requirement of an

equivalence relation.

Chains: all elements of X are comparable, i.e. xRy or yRx.

16
 Consumer Theory 1
Rationality (10) - Remarks (5)
Micro I

Partial Orders and Partitions:

Definition - Partition of a Set S: A decomposition of S into

nonempty and disjoint subsets such that each element is exactly
in one subset is called partition. These subsets are called cells.

Theorem - Partition and Equivalence Relation: If S is not

empty and is an equivalence relation on S, then yields a
partition with cells (x0) = {x|x S , x x0}.

Proof: Since is reflexive, every element x is at least contained in one cell,

e.g. (xA). We have to show that if x (xA) and x (xB ) then
(xA) = (xB ). If x (xA) and x (xB ), transitivity results in
x xA xB , for all x in (xA). Therefore (xA) (xB ).
(xB ) (xA) is derived in the same way.
17
 Consumer Theory 1
Rationality (11)
Micro I

Based on these remarks it follows that:

Proposition [P 1.B.1]: If  is rational then,
 is transitive and irreflexive.
is transitive, reflexive and symmetric.
If x  y  z then x  z.

Remark: A rational preference relation can also be defined in

terms of . If  is comparable, irreflexive and transitive and the
condition if y  x and y 6 z, then z  x holds, then the a
strict preference relation is called rational. if y  x and y 6 z,
then z  x is called the no money pump requirement. When
starting with  fulfilling these requirements it can be shown that
 is complete, transitive and reflexive. For more details see
Ritzberger (2000) [Section 2.1].
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 Consumer Theory 1
Utility (1)
Micro I

Definition : A function X R is a utility function representing

 if for all x, y X x  y u(x) u(y). [D 1.B.2]

Does the assumption of a rational consumer imply that the

preferences can be represented by means of a utility function and
vice versa?

Theorem: If there is a utility function representing , then 

must be complete and transitive. [P 1.B.2]

The other direction requires more assumptions - this comes later

& in Micro II!

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 Consumer Theory 1
Choice Rules (1)
Micro I

Now we follow the behavioral approach (vs. axiomatic approach),

where choice behavior is represented by means of a choice
structure.

Definition - Choice structure: A choice structure (B, C(.))

consists: (i) of a family of nonempty subsets of X; with B X.
The elements of B are the budget sets B. and (ii) a choice rule
C(.) that assigns a nonempty set of chosen elements C(B) B
for every B B.

B is an exhaustive listing of all choice experiments that a

restricted situation can pose on the decision maker. It need not
include all subsets of X.
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 Consumer Theory 1
Choice Rules (2)
Micro I

The choice rule assigns a set C(B) to every element B, i.e. it is

a correspondence.

Example [1.C.1,(i)]: X = {x, y, z}. B = {B1, B2} with

B1 = {x, y} and B2 = {x, y, z}. C(B1) = {x} and
C(B2) = {x}.

Example [1.C.1,(ii)]: X = {x, y, z}. B = {B1, B2} with

B1 = {x, y} and B2 = {x, y, z}. C(B1) = {x} and
C(B2) = {x, y}.

Put structure on choice rule - weak axiom of revealed preference.

21
 Consumer Theory 1
Choice Rules (3)
Micro I

Definition - Weak Axiom of Revealed Preference: A choice

structure (B, C(.)) satisfies the weak axiom of revealed
preference if for some B B with x, y B we have x C(B),
then for any B 0 B with x, y B 0 and y C(B 0) , we must
also have x C(B 0). [D 1.C.1]

I.e. if we have a budget set where both are available and x is

chosen, then there cannot be a budget set containing both
bundles, for which y is chosen and x is not.

Example: C((x, y)) = x, then C((x, y, z)) = y is not possible.

22
 Consumer Theory 1
Choice Rules (4)
Micro I

Definition - Revealed Preference Relation  based on the

Weak Axiom: Given a choice structure (B, C(.)),  is defined
by:
x  y there is some B B such that x, y B and
x C(B). [D 1.C.2]

In other words: If x is revealed at least as good as y, then y

cannot be revealed preferred to x.

Example [1.C.1,(i)] satisfies the weak axiom, Example [1.C.1,(ii)]

does not.

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 Consumer Theory 1
Choice Rules (5)
Micro I

If a decision maker has a rational preference ordering , does the

choice structure satisfy the weak axiom of reveal preferences?

Given a choice structure satisfying the weak axiom, does this

result in a rational preference relation?

24
 Consumer Theory 1
Choice Rules (6)
Micro I

Definition: Choice structure implied by a rational preference

relation : C (B, ) = {x B|x  y for every y B}. Assume
that C (B, ) is nonempty.

Proposition: If  is a rational preference relation, then the

choice structure C (B, ) satisfies the weak axiom. [P 1.D.1]

25
 Consumer Theory 1
Choice Rules (7)
Micro I

Proof:

Suppose that x, y in some B B and x C (B, ), then (i)

x  y.

We have to show that if x, y are in some B 0 and y C (B 0, ),

then also x C (B 0, ).

Suppose that x, y in B 0 B and y C (B 0, ), then (ii) y  z

for all z B 0.

The rational preference relation  is transitive. Hence (i), (ii)

and transitivity imply that x  y  z. Therefore x C (B, )
by the definition of this set.
26
 Consumer Theory 1
Choice Rules (8)
Micro I

Other direction. We want to know whether the choice rule C(B)

is equal to C (B, ) for all B B.

Definition: Given a choice rule C(B).  rationalizes the

choice rule if C(B) = C (B, ) for all B B. [D 1.D.1]

Proposition: If a choice structure (B, C(.)) satisfies the weak

axiom of revealed preference and B includes all subsets of X of
up to three elements, then C(B) = C (B, ). The rational
preference relation is the only preference relation that does
so.[P 1.D.2]

27
 Consumer Theory 1
Choice Rules (9)
Micro I

Example [1.D.1]: counterexample that choice structure cannot be

rationalized. X = {x, y, z}. B = {B1, B2, B3} with B1 = {x, y},
B2 = {y, z} and B3 = {x, z}. C(B1) = {x}, C(B2) = {y} and
C(B3) = {z}. Here the weak axiom is satisfied. To rationalize
this choice structure it would be necessary that x  y, y  z and
z  x, which does not satisfy the transitivity property.

Remark: The more subsets of X we consider, the stronger the

restrictions implied by the weak axiom.

Remark: If the choice structure is defined for all subsets of X,

then the approaches based on the preference relation and on the
weak axiom are equivalent. To consider all budget sets is a strong
requirement. Another way to maintain this problem is the strong
axiom of revealed preference.
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 Consumer Theory 2
Walrasian Demand (1)
Micro I

Feasible set

Competitive budget sets.

Walrasian/Marshallian Demand

Walras law, Cournot and Engel aggregation.

Mas-Colell: Chapter 2

29
 Consumer Theory 2
Consumption Set (1)
Micro I

We have already defined the consumption set: The set of all

alternatives (complete consumption plans). The consumption set
is a subset of the commodity space RL. We assume X = RL +.

Each x represents a different consumption plan.

Physical restrictions: divisibility, time constraints, survival needs,

etc.

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 Consumer Theory 2
Consumption Set (2)
Micro I

Useful properties of a Consumption Set: X

L
1. =
6 X R+

2. X is closed

3. X is a convex set

4. 0 X

31
 Consumer Theory 2
Feasible Set (1)
Micro I

Definition - Feasible Set/Budget Set: B

Due to constraints (e.g. income) we cannot afford all elements in

X, problem of scarcity.

The feasible set B is defined by the elements of X which are

achievable given the economic realities.

B X.

32
 Consumer Theory 2
Feasible Set (2)
Micro I

By the consumption set and the feasible set we can describe a

consumers alternatives of choice.

These sets do not tell us what x is going to be chosen by the

consumer.

To describe the choice of the consumer we need a theory to

model or describe the preferences of a consumer (or the choice
structure).

33
 Consumer Theory 2
Competitive Budgets (1)
Micro I

Assumption: All L goods are traded at the market (principle of

completeness), the prices are given by the price vector p, pl > 0
for all l = 1, . . . , L. Notation: p  0. Assumption - the prices are
constant and not affected by the consumer.

Given a wealth level w, the set of affordable bundles is described

by
p x = p1x1 + + pLxL w.

Definition - Walrasian Budget Set: The set

Bp,w = {x RL+ |p x w} is called Walrasian or competitive
budget set. [D 2.D.1]

Definition - Consumers problem: Given p and w choose the

optimal bundle x from Bp,w .
34
 Consumer Theory 2
Competitive Budgets (2)
Micro I

Definition - Relative Price: The ratios of prices pj /pi are called

Relative Prices.

Here the price of good j is expressed in terms of pi. In other

words: The price of good xi is expressed in the units of good xj .

On the market we receive for one unit of xj , pj /pi 1 units of xi.

Example: pj = 4, pi = 2. Then pj /pi = 2 and we get two units of

xi for one unit of xj .

35
 Consumer Theory 2
Competitive Budgets (3)
Micro I

The budget set B describes the goods a consumer is able to buy

given nominal income/ wealth level w.

The ratio w/pi is the maximum number a consumer can buy of

good i. This ratio is called Real Income in terms of good i.

Definition - Numeraire Good: If all prices pj are expressed in

the prices of good n, then this good is called numeraire. pj /pn,
j = 1, . . . , L. The relative price of the numeraire is 1.

There are L 1 relative prices.

36
 Consumer Theory 2
Competitive Budgets (4)
Micro I

The set {x RL + |p x = w} is called budget hyperplane, for

L = 2 it is called budget line.

Given x and x0 in the budget hyperplane, p x = p x0 = w

holds. This results in p(x x0) = 0, i.e. p and (x x0) are
orthogonal - see Figure 2.D.3 page 22.

The budget hyperplane is a convex set. In addition it is closed

and bounded compact. 0 Bp,w .

37
 Consumer Theory 2
Demand Functions (1)
Micro I

Definition - Walrasian demand correspondence:

Correspondence assigning a pair (p, w) a set of consumption
bundles is called Walrasian demand correspondence x(p, w); i.e.
(p, w)  x(w, p). If x(p, w) is single valued it is called demand
function.

Definition - Homogeneity of degree zero: x(p, w) is

homogeneous of degree zero if x(p, w) = x(p, w) for any p, w
and > 0. [D 2.E.1]

Definition - Walras law, budget balancedness: x(p, w)

satisfies Walras law if for every p  0 and w > 0, we get
p x = w for all x x(p, w). I.e. the consumer spends all income
w with her/his optimal consumption decision. [D 2.E.2]
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 Consumer Theory 2
Demand Functions (2)
Micro I

Assume that x(p, w) is a function:

With p fixed at p, the function x(p, w) is called Engel function.

If the demand function is differentiable we can derive the

gradient vector: Dw x(p, w) = (x1(p, w)/w, . . . , xL(p, w)/w).
If xl(p, w)/w 0, xl is called normal or superior, otherwise it
is inferior.

see Figure 2.E.1, page 25

Notation: Dw x(p, w) results in a 1 L row vector,

>
Dw x(p, w) = (w x(p, w)) .
39
 Consumer Theory 2
Demand Functions (3)
Micro I

With w fixed, we can derive the L L matrix of partial

derivatives with respect to the prices: Dpx(p, w).

xl(p, w)/pk is called the price effect.

A Giffen good is a good where the own price effect is positive,

i.e. xl(p, w)/pl > 0

see Figure 2.E.2-2.E.4, page 26

40
 Consumer Theory 2
Demand Functions (4)
Micro I

Proposition: If a Walrasian demand function x(p, w) is

homogeneous of degree zero and differentiable, then for all p and
w:
L
X xl(p, w) xl(p, w)
pk + w=0
pk w
k=1
for l = 1, . . . , L;, or in matrix notation
Dpx(p, w)p + Dw x(p, w) = 0. [P 2.E.1]

Proof:PBy the Euler theorem (if g(x) is homogeneous of degree r,

then g(x)/x x = rg(x), [P M.B.2]), the result follows
directly when using the stacked vector (p, w)>. Apply this to
x1(p, w), . . . , xL(p, w).

41
 Consumer Theory 2
Demand Functions (5)
Micro I

xi (p,w) pj
Definition - Price Elasticity of Demand: ij = pj xi (p,w) .

xi (p,w) w
Definition - Income Elasticity: iw = w xi (p,w) .

Definition - Income Share:

pixi(p, w)
si = ,
w
Pn
where si 0 and i=1 si = 1.

42
 Consumer Theory 2
Demand Functions (6)
Micro I

Between the income elasticity, income shares and elasticities, two

nice relationships are available:

Engel aggregation: The income share weighted sum of income

elasticities adds up to one.

Cournot aggregation: The income share weighted sum of price

elasticities (with respect to pj , i = 1, . . . , L) adds up to minus
the income share of good xj .

43
 Consumer Theory 2
Demand Functions (7)
Micro I

Theorem - Relationship between Elasticities and Income

Shares: For a Walrasian demand function x(p, w) fulfilling
budget balancedness (Walras law), the following relationships
have to hold: [P 2.E.2, P 2.E.3]
PL
Engel aggregation: i=1 si iw = 1.
PL
Cournot aggregation: i=1 si ij = sj for j = 1, . . . , L.

44
 Consumer Theory 2
Demand Functions (8)
Micro I

Proof:
PL
Engel aggregation: Walras law implies w = l=1 pl xl (p, w).

Taking the partial derivative with respect to w results in

L
X xl (p, w)
1= pl .
l=1
w

Expand by xl/w for each element and arranging terms yields:

L
X pl xl xl (p, w) w
1= .
w
l=1 |{z} |
w{z x}l
sl iw

45
 Consumer Theory 2
Demand Functions (9)
Micro I

Proof:
PL
Cournot aggregation: Differentiate w = l=1 pl xl (p, w) by pk :

L
X xl(p, w)
0= pl + xk (p, w) .
pk
l=1

(for term k we get xk (p, w) by means of the product rule).

Arranging terms yields:

L
X xl(p, w)
xk = pl .
pk
l=1
46
 Consumer Theory 2
Demand Functions (10)
Micro I

Proof:

Expand both sides by pk /w:

L
pk xk X xl(p, w) pk
= pl .
w pk w
l=1

Multiply each element on the right hand side by xl/xl:

L
pk xk X plxl xl(p, w) pk
= .
| {zw } w | p{z
l=1
|{z} k x}l
sk sl lk

47
 Consumer Theory 2
Demand Functions (11)
Micro I

Discuss how demands have to interact by these relations.

In the two good case: Can two normal goods fulfill these
relationships?

In the two good case: Can two inferior goods fulfill these
relationships?

48
 Consumer Theory 2
Demand Functions (12)
Micro I

For L goods we can derive the matrix S(p, w) with own

substitution terms in the main diagonal and cross-substitution
terms off-diagonal; x(p, w) is a differentiable function.

Definition - Substitution Matrix:

x1 (p,w)

p1+ x1 x1w
(p,w)
x1 (p,w)
pL + xL x1w
(p,w)

S(p, w) :=
.. ... ..

xL (p,w) xL (p,w) xL (p,w) xL (p,w)
p1 + x 1 w p + x L w
L

= Dpx(p, w) + Dw x(p, w)x(p, w)> .

49
 Consumer Theory 2
Demand Functions (13)
Micro I

Theorem - Walras Law and Symmetry of S(p, w) imply

Homogeneity: If a demand system x = x(p, w) is continuously
differentiable, satisfies budget balancedness and the Slutsky
matrix is symmetric, then it is homogeneous of degree zero.

50
 Consumer Theory 2
Demand Functions (14)
Micro I

Proof:

To obtain Cournout and Engel aggregation we had (i)

Pn xj (p,w) Pn x (p,w)
xi = j=1 pj pi and (ii) j=1 pj jw = 1.

To proof to above theorem we have to show that

fi() = xi(p, w) is constant in for > 0.

Taking first derivatives with respect to yields (here w0 = w

and p0i = pi)

L
dfi() X xi(p, w) xi(p, w)
= pj 0 + 0
w.
d j=1
pj w

51
 Consumer Theory 2
Demand Functions (15)
Micro I

Proof:

P
First, budget balancedness results in: p x(p, w) = w
n
j=1 pj xj (p, w) = w.

L
!
dfi() X xi(p, w) xi(p, w)
= pj + xj (p, w) .
d j=1
p0j w0

The substitution matrix is assumed to be symmetric. Therefore

we are allowed to exchange i and j.

52
 Consumer Theory 2
Demand Functions (16)
Micro I
Proof:

L  
dfi() X xj (p, w) xj (p, w)
= pj 0 + 0
xi(p, w)
d j=1
pi w
L L
X xj (p, w) X xj (p, w)
= pj 0 + xi(p, w) pj 0
j=1
pi j=1
w
L n
1X xj (p, w) xi(p, w) X xj (p, w)
= pj + pj
j=1 p0i j=1
w 0
| {z } | {z }
(i) (ii)

1
= (xi(p, w) + xi(p, w)) = 0 .
53