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Lecture Notes on Microeconomic Theory

Takashi Kunimoto
Department of Economics McGill University

First Version: December 2005 This Version: March 25, 2009

Abstract. The theme of this note is economics of resource allocations in perfectly competitive markets. The topics which will be covered include the theories of consumer and the rm, competitive equilibrium of an economy and its properties (existence, local and global uniqueness, the Sonnenschein-Mantel-Debreu Theorem, the rst and second welfare theorems, the core), decision making under uncertainty , and consumer and producer surplus. Finally, I extend all the analyses to economies under uncertainty in which the Arrow-Debreu contingent markets, sequential markets, and their (non-)equivalence are discussed.

I am thankful to the students for their comments, questions, and suggestions. Yet, I believe that there are still many errors in this manuscript. Of course, all remaining ones are my own. Department of Economics, McGill University, 855 Sherbrooke Street West, Montreal, Quebec, H3A2T7, CANADA, takashi.kunimoto@mcgill.ca URL: http://people.mcgill.ca/takashi.kunimoto/

Syllabus
Econ 610: Microeconomic Theory I
Fall 2008, McGill University Tuesdays and Thursdays, 1:05pm - 2:25pm; at Leacock 15 Instructor: Takashi Kunimoto Email: takashi.kunimoto@mcgill.ca Class Web: the WebCT Oce: Leacock 438 READING: 1. Advanced Microeconomic Theory Second Edition, by Georey A. Jehle and Philip J. Reny, Addison Wesley, 2000 (This is the main textbook. I abbreviate AMT for this book.) 2. Microeconomic Analysis Third Edition, by Hal R. Varian, W.W. Norton and Company, 1992 (This is a supplementary text book. I abbreviate Varian for this book.) 3. Microeconomic Theory, by Andreu Mas-Colell, Michael D. Whinston, and Jerry R. Green, Oxford University Press, 1995. (This is also a supplementary textbook. I abbreviate MWG for this book.) 4. Lecture Notes on Microeconomic Theory, by Takashi Kunimoto, 2007. (This is the main content of the course. This note is based largely on AMT and partly on MWG. You can nd it on the WebCT. Note also that this note will have been continuously updated in the course until the end of the course.) 5. Lecture Notes for Econ633 Mathematics for Economists, by Takashi Kunimoto, 2007. (This is the lecture note on mathematics which was taught in this summer. You can nd it on the WebCT). All the above three books, AMT, Varian, and MWG should be available in the reserve desk at the library. I also assume that you have knowledge on mathematics covered by my lecture notes on mathematics. If you dont, please study them during the semester. In any case, it is your responsibility to understand what is required for this course by checking the lecture notes on mathematics at the WebCT. TA: Maryam Esmaeilpour
In the semester, I might send emails to all students through the WebCT. But, do not email (or reply to) me through the WebCT. You should directly use takashi.kunimoto@mcgill.ca to contact me.
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COURSE DESCRIPTION: The theme of Econ 610 is economics of resource allocations in perfectly competitive markets. The topics which will be covered include the theories of consumer (Chapters 1 and 2 of AMT, Chapters 7, 8, and 9 of Varian, and Chapters 2 and 3 of MWG) and the rm (Chapter 3 of AMT, Chapters 1, 2, 3, 4, and 5 of Varian, and Chapter 5 of MWG), competitive equilibrium of an economy and its properties, existence, uniqueness, the Sonnenschein-Mantel-Debreu Theorem, the rst and second welfare theorems, the core of an economy (Chapter 5 of AMT, Chapters 17 and 21 of Varian, and Chapters 15, 16, 17, 18.B of MWG), preferences under uncertainty (Chapter 2.4 of AMT, Chapter 11 of Varian, and Chapter 6 of MWG), and consumer and producer surplus (Chapters 4.1 and 4.3 of AMT, Chapter 10 of Varian, and Chapter 10 of MWG). Finally, we extend all the analyses to economies under uncertainty in which the Arrow-Debreu contingent markets, sequential markets, and their equivalence are discussed (Chapter 20 of Varian and Chapter 19 of MWG). I will not answer how to use the WebCT. If you dont ocially register this course but want to access to the WebCT, please give your name, aliation, and ID number via email by September 12 (Fri), 2007 to takashi.kunimoto@mcgill.ca I will not give the authorization to access to the WebCT to any person who did not email me by that date. OFFICE HOURS: Wednesdays and Thursdays, 11:30am - 12:50pm

PROBLEM SETS: There will be approximately 7 problem sets. Problem sets are essential to help you understand the course and to develop your skill to analyze economic problems. Besides, it should be expected that these problems sets are very good proxies for the exams. You have to hand in your work on each problem set to our TA. Do not hand in your homework to me. Please take the copy of your answer for the problem set before the submission. Because there might be some delay for the TA to return your homework. All problem sets are given to you only through the WebCT. Again, I will not provide any copy of them with you.

ASSESSMENT: Problem sets 10%, midterm exam 30%, and nal exam (comprehensive) 60%. 4 Only if he/she has a serious reason why he/she cannot take the midterm exam, the grade of that person will be solely based on the nal exam and the problem sets. In other words, there is no makeup midterm exam. However, this treatment is very exceptional. You must take both exams.
McGill University values academic integrity. Therefore all students must understand the meaning and consequences of cheating, plagiarism and other academic oences under the code of student conduct and disciplinary procedures (See www.mcgill.ca/integrity for more information.
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Contents
1 Introduction 2 Consumer Theory 2.1 Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 Preference Relations . . . . . . . . . . . . . . . . . . . . . . . 2.2 The Utility Function . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 The Consumers Optimization Problem . . . . . . . . . . . . . . . . 2.4 The Indirect Utility Function . . . . . . . . . . . . . . . . . . . . . . 2.5 The Expenditure Function . . . . . . . . . . . . . . . . . . . . . . . . 2.6 Relations between the Indirect Utility Function and the Expenditure Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.7 The Relation between x(p, y) and xh (p, u) . . . . . . . . . . . . . . . 2.8 Income and Substitution Eects . . . . . . . . . . . . . . . . . . . . . 2.9 More Restrictions on the Ordinary Demand . . . . . . . . . . . . . . 2.10 Weak Axiom of Revealed Preference (WARP) . . . . . . . . . . . . . 2.11 Appendix: Integrability . . . . . . . . . . . . . . . . . . . . . . . . . 2.11.1 Recovering Preferences from the Expenditure Function . . . . 2.11.2 Recovering the Expenditure Function from Demand . . . . . 3 Production 3.1 Properties of Production Sets . . . . . . . 3.2 Production Functions . . . . . . . . . . . 3.2.1 More about Production Functions 3.2.2 Returns to Scale of the Production 3.3 Cost Minimization . . . . . . . . . . . . . 3.3.1 Properties of the Cost Functions . 3.4 Prot Maximization . . . . . . . . . . . . 3.4.1 More about Prot Maximization . 3.5 Appendix . . . . . . . . . . . . . . . . . . 3.5.1 More on Homothetic Functions . . 7 10 10 10 13 15 19 20 23 24 24 28 30 34 34 35 36 36 38 40 41 41 43 46 48 50 50

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CONTENTS 4 Partial Equilibrium 4.1 Price and Individual Welfare . . . . . . . . 4.2 Quasi-Linear Preference . . . . . . . . . . . 4.3 Pareto Eciency . . . . . . . . . . . . . . . 4.4 The Prot Maximization Problem Revisited 4.5 The Market Supply Function . . . . . . . . 4.6 The Market Demand Function . . . . . . . 4.7 Market Equilibrium . . . . . . . . . . . . . 52 52 54 55 55 56 56 57 58 58 59 60 61 65 67 68 68 69 70 74 74 75 76 76 78 81 81 83 83 84 86 86 87 89 89 91 92 95 96 98 99

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5 General Equilibrium 5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Exchange Economy . . . . . . . . . . . . . . . . . . . . . . . 5.3 Equilibrium in Competitive Market Systems . . . . . . . . . 5.4 Existence of Walrasian Equilibrium . . . . . . . . . . . . . . 5.5 Regular Economies and Local Uniqueness . . . . . . . . . . 5.6 Anything Goes: The Sonnenschein-Mantel-Debreu Theorem 5.7 Properties of the Set of Walrasian Allocations . . . . . . . . 5.7.1 The Edgeworth Box Diagram . . . . . . . . . . . . . 5.7.2 Core of an Economy and the First Welfare Theorem 5.7.3 The Second Welfare Theorem . . . . . . . . . . . . . 5.8 Walrasian Equilibrium with Production . . . . . . . . . . . 5.8.1 Producers . . . . . . . . . . . . . . . . . . . . . . . . 5.8.2 Consumers . . . . . . . . . . . . . . . . . . . . . . . 5.8.3 Feasibility and Eciency in Production Economies . 5.8.4 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 5.9 Walrasian Allocations in Economies with Production . . . . 5.10 Uniqueness of Equilibria . . . . . . . . . . . . . . . . . . . . 5.10.1 The Weak Axiom for Aggregate Excess Demand . . 5.10.2 Gross Substitution . . . . . . . . . . . . . . . . . . . 5.11 Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.12 Appendix: Generalization of General Equilibrium Theory 6 Choice under Uncertainty 6.1 Preferences over Gambles . . . . . . . . . . . . . 6.2 Axioms . . . . . . . . . . . . . . . . . . . . . . . 6.3 Von Neumann-Morgenstern (VNM) Utility . . . 6.4 Existence of VNM Utility Function . . . . . . . . 6.5 Uniqueness up to Positive Ane Transformations 6.6 Risk Aversion . . . . . . . . . . . . . . . . . . . . 6.7 Measures of Risk Aversion . . . . . . . . . . . . . 6.7.1 Comparisons across Individuals . . . . . . 6.7.2 Comparisons across wealth levels . . . . . 6.8 State-Dependent Utility . . . . . . . . . . . . . .

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CONTENTS 6.8.1 6.8.2 State-Dependent Preferences and the Extended VNM Utility Representation . . . . . . . . . . . . . . . . . . . . . . . . . . Existence of an Extended VNM Utility Representation . . . .

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7 General Equilibrium under Uncertainty 101 7.1 A Market Economy with Contingent Commodities . . . . . . . . . . 101 7.2 Arrow-Debreu Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 103 7.3 The Working of the Arrow-Debreu Economy . . . . . . . . . . . . . . 104 7.3.1 Ex Ante V.S. Ex Post . . . . . . . . . . . . . . . . . . . . . . 105 7.3.2 No market at date 1 and No real transaction at date 0 . . . . 105 7.3.3 No need to open spot markets at date 1 . . . . . . . . . . . . 105 7.3.4 Each consumer has a single budget . . . . . . . . . . . . . . . 106 7.4 Sequential Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 7.4.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 7.4.2 Arrow Security . . . . . . . . . . . . . . . . . . . . . . . . . . 108 7.4.3 Implementing the Arrow-Debreu equilibrium allocations . . . 109 7.5 Asset Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 7.6 Multi-Period Exchange Economies . . . . . . . . . . . . . . . . . . . 118 7.6.1 Implementing the A-D equilibria by Trading Long-lived Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 7.6.2 Genericity of the Case M = X with K or More Securities . . 124 7.7 Incomplete Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

List of Figures
5.1 6.1 7.1 7.2 7.3 7.4 7.5 The Edgeworth Box . . . . . . . . . . . . . . . . . . . . . . . . . . . The Relationship between u and v through h . . . . . . . . . . . . . Construction of the No-arbitrage Weights . . . . . . . Existence of an inadmissible z if q T is not proportional An information tree: gradual release of information . . Dividend Structure of a Radner Equilibrium (a) . . . . Dividend Structure of a Radner Equilibrium (b) . . . . . . . to . . . . . . . . . . . . R. . . . . . . . . . . . . . . . . . . . 69 96 113 114 119 122 123

Chapter 1

Introduction
I start my lecture with Rakesh Vohras message about what economic theory is. He is a professor at Northwestern university. 1 All of economic theorizing reduces, in the end to the solution of one of three problems. Given a function f and a set S: 1. Find an x such that f (x) is in S. This is the feasibility question. 2. Find an x in S that optimizes f (x). This is the problem of optimality. 3. Find an x in S such that f (x) = x, this is the xed point problem. These three problems are, in general, quite dicult. However, if one is prepared to make assumptions about the nature of the underlying function (say it is linear, convex or continuous) and the nature of the set S (convex, compact etc.) it is possible to provide answers and very nice ones at that. I think this is the biggest picture of microeconomic theory you could have as you go along this course. Whenever you are at a loss, please come back to this message.

Since we want to study economic theory from micro perspective, we build our theory on individuals. Assume that all commodities are traded in the centralized markets. Throughout this course, we assume that each individual (consumer and rm) takes prices as given. We call this the price taking behavior assumption. You might ask why individuals are price takers. My answer would be why not? Let us go as far as we can with this behavioral assumption and thereafter try to see the limitation of the assumption. However, you have to wait for Microeconomic theory II
1 See http://www.kellogg.northwestern.edu/faculty/vohra/htm/vohra.htm for more information.

CHAPTER 1. INTRODUCTION for how to relax this assumption. So, stick with this assumption. For each consumer, we want to know 1. What is the set of physically feasible bundles? Is there any such a bundle at all (feasibility)? We call this set the consumption set. 2. What is the set of nancially feasible bundles? Is there any such a bundle at all (feasibility)? We call this set the budget set. 3. What is the best bundle to the consumer among all feasible bundles (optimality)? We call this bundle the consumers demand. We can make the exact parallel argument for the rm. What is the set of technically feasible inputs (feasibility)? We call this the production set of the rm. What is the best combination of inputs to maximize its prot (optimality)? We call this the rms supply. Once we gure out what are feasible and best choices to each consumer and each rm under any possible circumstance, we want to know if there is any coherent state of aairs where everybody makes her best choice. In particular, all markets must clear. We call this coherent state Walrasian (competitive) equilibrium. (a xed point). The next important question is whether such an equilibrium exists or under what circumstances it exists. This is a problem of existence of competitive equilibrium of an economy. Suppose now that there is at least one Walrasian equilibrium of a given economy. Then we want to know what properties this equilibrium possesses: Is the equilibrium allocation ecient? Under what circumstances is it ecient? Under what circumstances, is any ecient allocation can be regarded as a result of a competitive equilibrium with income transfer (the second welfare theorem)? Is the equilibrium unique? Under what circumstances is it unique? Are there many equilibria? How many? Under some reasonable assumptions on the economy, what we know is 1. equilibrium exists, 2. equilibrium allocation is ecient (the First Welfare theorem), 3. equilibrium allocation is in the core 2 and the set of competitive equilibrium allocations coincides with the core allocations when the economy is large (The core limit theorem). 4. the equilibrium is not unique, in general, but we know some of conditions which guarantee the uniqueness of equilibria.
Given an allocation x, a coalition S makes a justiable objection to x if there is a redistribution of goods feasible only within S such that every member of S is better o from the redistribution. An allocation x is said to be in the core if no coalition has any justiable objection to x.
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CHAPTER 1. INTRODUCTION 5. the number of equilibria is typically nite and odd number (local uniqueness of equilibria) 3 , 6. in general, equilibrium is not stable in the sense of dynamical systems, but under some known conditions which guarantee the uniqueness, the equilibrium is stable, as well. Very loosely speaking, the equilibrium is unique, it is stable, as well. 7. there is a precise sense in which we (economists) cannot know anything about the economy beyond the properties mentioned above unless we make more assumptions on the economy (The Sonnenschein-Mantel-Debreu theorem: Anything goes). So far, I have assumed that each individual acts in a world of absolute certainty. The consumer knows the qualities of all commodities, for example. Clearly, this is not true in the real world. Then, many economic decisions contain some element of uncertainty. Let A = {a1 , . . . , an } denote a nite set of outcomes. We refer to u(ai ) as simply the utility of the outcome ai . Let g = (p1 a1 , . . . , pn an ) denote a gamble that outcome ai occurs with probability pi for each i = 1, . . . , n. An individual evaluates this gamble g according to the von Neumann-Morgenstern utility V if
n

V (g) =
i=1

pi u(ai ).

One of the most important questions is to ask under what conditions the von Neumann-Morgenstern utility representation is valid. Furthermore, what we want to know is 1. when we can unambiguously say that one gamble is better than another, 2. when we can unambiguously say that one individual is more risk averse than another. This note takes the Denition-Theorem-Proof style. You have to provide any statement in terms of mathematics. If you think the statement you made is true, you must prove it. If you think the statement is wrong, you must provide a counterexample.

Technically, it is very important to articulate what I mean by typically. But I will not discuss this here.

Chapter 2

Consumer Theory
2.1 Environment

The number of commodities is nite and equal to n (indexed by i = 1, . . . , n). each commodity is measured in some innitely divisible units. x = (x1 , . . . , xn ) Rn is a consumption bundle. + X is a consumption set that is the set of bundles the consumer can conceive. Usually, we take X = Rn . + The minimal requirements on the consumption set are = X Rn ; there is a choice + X is closed; a technical condition needed for divisible commodities X is convex; a technical condition needed for divisible commodities 0 X; no consumption is always possible

2.1.1

Preference Relations

We represent the consumers preferences by a binary relation, , dened on the consumption set, X. If x x , we say that x is at least as good as x , for this consumer. Consumer preferences are characterized axiomatically. These axioms of consumer choice formalize the view that the consumer can choose and that choices are consistent in a particular way. Denition 2.1.1 (Axiom 1: Completeness) The preference relation x. complete if, for any x, x X, we have either x x or x on X is

Whenever the consumer is asked which bundle is better for him, he never say I dont know, if his preference is complete. 10

CHAPTER 2. CONSUMER THEORY Denition 2.1.2 (Axiom 2: Transitivity) The preference relation transitive if, for all x, y, z X, if x y and y z, then x z. on X is

Transitivity is a particular form of consistency of the consumers choice. We say that the consumer is rational if her preference relation on X is complete and transitive. Throughout this course, these two axioms continue to be satised. In particular, completeness and transitivity together imply that the consumer can completely rank any nite number of elements in the consumption set, X, from best to worst, possibly with some ties. Denition 2.1.3 The binary relation on X is said to be strict preference rex. lation if, x x if and only if x x but x Denition 2.1.4 The binary relation on X is said to be indierence relation x. if, x x if and only if x x and x Let x0 be any point in the consumption set X. Relative to any such point, we can dene the following subsets of X: 1. 2. (x0 ) {x X|x set. (x0 ) {x X|x0 x0 }; the at least as good as set or the upper contour x}; the no better than set or the lower contour set. x}; the worse than set, or the strict lower contour set. x0 }; the preferred to set, or the strict upper contour

3. (x0 ) {x X|x0 4. (x0 ) {x X|x set.

5. (x0 ) {x X|x x0 }; the indierence set. Denition 2.1.5 (Axiom 3: Continuity (Cont)) Let X = Rn . The preference + relation on Rn is continuous if, for all x Rn , the at least as good as set + + (x) and the no better than set (x) are closed in Rn . That is, for any sequence + of pairs {(xn , y n )} with xn y n for all n, x = limn xn , and y = limn y n , n=1 we have x y. The continuity axiom guarantees that sudden preference reversals do not occur. Example: The lexicographic preference relation: y if either x1 > y1 or For simplicity, assume that X = R2 . Dene x + x1 = y1 and x2 y2 . This is known as the lexicographic preference relation. I claim that lexicographic preferences are not continuous. To see this, consider the sequence of bundles xn = (1/n, 0) and y n = (0, 1). We have that xn y n for each n. However, limn y n = (0, 1) (0, 0) = limn xn . This contradicts the continuity requirement. 11

CHAPTER 2. CONSUMER THEORY Exercise 2.1.1 Verify the lexicographic preferences are complete, transitive, strongly monotone, and strictly convex. Let B (x0 ) denote the open ball of radius centered at x0 . That is, B (x0 ) = x Rn + x x0 < .

Denition 2.1.6 (Axiom 4 : Local Nonsatiation (LNS)) The preference relation on Rn is locally nonsatiated if, for all x0 Rn , and for all > 0, there + + exists some x B (x0 ) Rn such that x x0 . + For example, a thick indierence curve violates local nonsatiation. The preference relation is globally nonsatiated if there is no bundle x0 Rn such that x0 y for + any y Rn . So, a thick indierence curve is compatible with global nonsatiation. + If the bundle x contains at least as much of every good as x , i.e., xi xi for i = 1, . . . , n, we write x x , while if x contains strictly more of every good than x . x , i.e., xi > xi for all i = 1, . . . , n, we write x Denition 2.1.7 (Axiom 4: Monotonicity (M)) The preference relation on Rn is monotone if for all x, x Rn , if x x then x x , while if x x , then + + x x. y whenever x The preference relation on Rn is weakly monotone if x + y. If the consumer is completely indierent among all bundles, his preference is compatible with weak monotonicity. Therefore, in some cases, weak monotonicity is not compatible with local nonsatiation. The preference relation on Rn is strongly + monotone if y x and y = x implies y x. Exercise 2.1.2 Show the following: 1. If 2. If is strongly monotone, then it is monotonic. is monotone, then it is locally non-satiated. on

Denition 2.1.8 (Axiom 5 : Convexity (Conv)) The preference relation x for all t [0, 1]. Rn is convex if, whenever x x , tx + (1 t)x +

The convexity of preferences respects for preferences for diversied bundles. It can be interpreted in term of diminishing marginal rates of substitution. Exercise 2.1.3 Verify the preference relation on X is convex if and only if for every x X, the at least as good as set (x) is convex. Exercise 2.1.4 Let u(x) = x2 + x2 . Check that u represents non-convex preference 1 2 relation.

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CHAPTER 2. CONSUMER THEORY Denition 2.1.9 (Axiom 5: Strict Convexity) The preference relation on Rn + is strictly convex if, whenever x = x and x x , then tx + (1 t)x x for all t (0, 1) Exercise 2.1.5 Let u(x) = min{x1 , x2 } represent the Leontief preferences. Check the Leontief utility function represents convex preferences but not strictly convex preferences. be the Cobb-Douglas utility function for some Exercise 2.1.6 Let u(x) = x x2 1 (0, 1). Check the Cobb-Douglas utility function exhibits strict convexity.
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2.2

The Utility Function

In modern theory, the preference relation is taken to be the primitive, most fundamental characterization of preferences. The utility function merely represents, or summarizes, the information conveyed by the preference relation. Denition 2.2.1 A real-valued function u : Rn R is called a utility function + representing the preference relation on Rn , if for all x, x Rn , + + u(x) u(x ) x . Exercise 2.2.1 Show that if a preference relation on Rn can be represented by a + utility function, then it is rational, i.e., complete and transitive. An important question is one of existence of a continuous utility function representing preference relation. Theorem 2.2.1 (Existence of a utility function, Debreu (59)) Suppose that the preference relation on Rn is complete, transitive (so, rational), and continuous. + Then there is a continuous utility function u : Rn R that represents . + Proof of Theorem 2.3.1: Only for the sake of simplication of the proof, we assume that preferences are monotone as well as continuous. Let e (1, . . . , 1) Rn + be a vector of ones, and consider the mapping u : Rn R dened so that the + following condition () is satised: u(x)e x. for any x Rn () + In order to prove the theorem, there are four steps to be checked: 1. There always exists a number u(x) satisfying property (). 2. The number u(x) is uniquely determined, i.e., x y u(x) = u(y). 13 x

CHAPTER 2. CONSUMER THEORY 3. u() represents , i.e., x y u(x) u(y).

4. The constructed u() is indeed continuous. Step 1: Note that for every x Rn , monotonicity implies that x + x Rn and consider the following two subsets of real numbers: + A {t 0|te x} and B {t 0|x te}. 0 Rn . Fix

If t A B, then t e x, so that setting u(x) = t would satisfy property (). Thus, we must show that A B is guaranteed to be nonempty. The continuity of implies that both A and B are closed in R+ . By monotonicity, t A implies that t A if t t. Consequently, A must be a closed interval of the form [t, ]. Similarly, monotonicity and continuity imply that B must be a closed interval of the form [0, t]. Completeness implies that t A B for any t 0. But this means that R+ = [0, ) A B = [0, t] [t, ]. So, we conclude that t t so that A B = . Step 2: We must show that there is only one number t 0 such that te x. If t1 e x and t2 e x, by transitivity, t1 e t2 e. So, by monotonicity, it must be the case that t1 = t2 . Step 3: Consider two bundles x and y, and their associated utility numbers u(x) and u(y), which by denition satisfy u(x)e x and u(y)e y. Then, x y u(x)e x u(x)e u(x) u(y) y u(y)e ( transitivity) ( monotonicity)

u(y)e

Step 4: Consider a sequence of bundles {xk } for which xk Rn for each k and + xk x as k . Suppose, by way of contradiction, that the constructed u() is not continuous. Then, we have limk u(xk ) = u(x). Without loss of generality, we can assume that limk u(xk ) > u(x). By Step 1, for each xk , there is a scalar tk 0 such that tk e xk . Let te x. Let t limk tk . Then, the hypothesis that limk u(xk ) > u(x) means that t > t by monotonicity of . Since tk t as k , we must have tk > t for k large enough. By monotonicity of , we have tk e te for k large enough. By Step 1, this means that xk x for k large enough. By continuity of , we have x x in the limit. Hence, we have u(x) > u(x) by Step 3. This is a contradiction to the uniqueness of u() in Step 2. Exercise 2.2.2 Show that if u() is a continuous utility function representing then is continuous. f : R R is said to be strictly increasing if f (x) > f (y) whenever x > y. 14 ,

CHAPTER 2. CONSUMER THEORY Theorem 2.2.2 (Uniqueness up to positive monotone transformation) Let be a preference relation on Rn and suppose that u() is a utility function that rep+ resents it. Then v() 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(). Proof of Theorem 2.3.2: (=). This direction is easier. Let v(x) = f (u(x)) where f : R R is strictly increasing. Then, x y u(x) u(y) v(x) v(y).

(=) Suppose u() and v() represent the same preference relation . Then, there must exist a function f : R R such that v(x) = f (u(x)) for any x Rn . What + we want to show is that f () must be strictly increasing. Suppose not, that is, there are x, y Rn with u(x) > u(y) such that v(x) = f (u(x)) f (u(y)) = v(y). Since + u() represents , we have x y. At the same time, v() also represents , we have y x. This is a contradiction. Exercise 2.2.3 Provide several examples of positive monotonic transformation. u() is said to be increasing if u(x) u(y) whenever x y, while if u(x) > u(y) whenever x y. u() is said to be strongly increasing if u(x) > u(y) whenever x y and x = y. u() is said to be quasi-concave if for any x, x Rn , u(tx + (1 t)x ) + min{u(x), u(x )} for any t [0, 1]. u() is said to be strictly quasi-concave if for any x, x with x = x , u(tx + (1 t)x ) > min{u(x), u(x )} for any t (0, 1). See my lecture notes on mathematics for the details. Theorem 2.2.3 Let be represented by u : Rn R. Then: + is (strongly) monotone.

1. u() is (strongly) increasing if and only if 2. u() is quasi-concave if and only if

is convex. is strictly convex.

3. u() is strictly quasi-concave if and only if Exercise 2.2.4 Prove Theorem 2.3.3.

2.3

The Consumers Optimization Problem

We collect all the consumers circumstances into a feasible set, B Rn . The con+ sumer seeks x B such that x x for all x B.

The consumers preference relation is complete, transitive, continuous, monotone, and strictly convex on Rn . Therefore, it can be represented by a real-valued + utility function, u(), that is continuous, increasing, and strictly quasi-concave on Rn . + 15

CHAPTER 2. CONSUMER THEORY We are concerned with an individual consumer operating within a market economy. By a market economy, we mean an economic system in which transactions between agents are mediated by markets. There is a market for each commodity, and in these markets, a price pi prevails for each commodity i. We suppose that prices are strictly positive, so pi > 0, i = 1, . . . , n. We take the vector of market prices, p 0, as xed from the consumers point of view. We call this the price taking behavior assumption. The consumer is endowed with a xed amount of money income y 0. We summarize these assumptions on the economic environment of the consumer by specifying the following structure on the feasible set, B(p, y), called the budget set: B(p, y) = {x Rn | px y}. + Lemma 2.3.1 Suppose that p nonempty, convex, and compact. 0 and y 0. Then, the budget set B(p, y) is

Recall that a set S in Rn is said to be compact if it is closed and bounded. + Exercise 2.3.1 Prove Lemma 2.4.1. Theorem 2.3.1 (Weierstrass theorem) Any continuous real-valued function whose domain is a compact nonempty set has both the maximum and minimum of it. Proof of Weierstrass Theorem: See my Lecture Note on Mathematics for Economists. Now, the consumers utility maximization problem (UMP) is written
x

max u(x) subject to x B(p, y). n


+

If x solves the UMP, then u(x ) u(x) for all x B(p, y), which means that x x for all x B(p, y). Theorem 2.3.2 Suppose that p 0, y 0 and u : Rn R is continuous. Then, + the utility maximization problem (UMP) has a solution. Furthermore, if u() is strictly quasi-concave, the solution is unique. Proof of Theorem 2.4.2: The rst part directly comes from Weierstrass theorem. Suppose, for the second part, that there are two distinct solutions x, x to the UMP even if u() is strictly quasi-concave. Let xt = tx + (1 t)x for some t (0, 1). Since x and x are within the budget set and the budget set is convex, xt is also within the budget set. By strict quasi-concavity, we have that u(xt ) > u(x) = u(x ), which contradicts our hypothesis that both x and x are solutions to the UMP.

16

CHAPTER 2. CONSUMER THEORY If the solution x to the UMP is unique for given values of p and y, we can properly view the solution to the UMP as a function from the set of prices and income to the set of quantities, X = Rn . When viewed as functions of p and y, the + solution to the UMP are known as demand functions, x = x(p, y). Proposition 2.3.1 (Walras law) If u() is increasing, the solution x to the utility maximization problem has the property that px = y for each p Rn and ++ y R+ . Proof of Proposition 2.4.1: Suppose px < y. Let e = (1, . . . , 1) Rn . + Choose > 0 small enough so that p(x + e) < y. This new bundle (x + e) is still within the budget set and, by monotonicity, gives the consumer strictly higher utility than u(x ). Then, this contradicts our hypothesis that x is the solution to the UMP. Exercise 2.3.2 Prove that if the underlying preference relation is locally non to the UMP has the property that px = y, i.e., Walras satiated, the solution x law. Proposition 2.3.2 (Homogeneity of Degree 0 of the Demand Function) Assume that p 0 and y 0. Suppose that u() is a continuous utility function representing the preference relation on Rn . Then, the demand function x(p, y) is homoge+ neous of degree of 0 in (p, y). Namely, x(p, y) = x(p, y) for any > 0. Proof of Proposition 2.10.1: For any scalar > 0, we have {x Rn | px y} = {x Rn | px y} = B(p, y). + + That is, the set of feasible bundles in the UMP does not change when all prices and wealth are multiplied by a constant > 0. Therefore, the solution to the UMP must be the same. The consumers utility maximization problem is
x

max u(x) subject to x B(p, y) = {x Rn | px y}. + n


+

If we impose dierentiability on u(), we can characterize the solution x via the 0. Then, if x x(p, y) is a rst order conditions (FOCs). Assume that x solution to the UMP, then there exists a Lagrange multiplier 0 such that for all i = 1, . . . , n: u(x ) = pi . xi In particular, these FOCs are reduced to M RSjk u(x )/xj pj = for any j and k, )/x u(x pk k

where M RSjk stands for the marginal rate of substitution of j for k at x . 17

CHAPTER 2. CONSUMER THEORY Theorem 2.3.3 (Suciency of the FOCs) Suppose that u() is continuous and 0. If u() is dierentiable at x , and quasi-concave on Rn , and that (p, y) + , ) solves the UMP at prices p and income (x 0 solves the FOCs, then x y. Proof of Theorem 2.4.3: Our proof relies on the following theorem. You can nd this theorem and its proof in my lecture note on mathematics. Theorem 5.10 in Lecture Note on Mathematics for Economists: Let u : S R be a C 1 function dened on an open convex set S in Rn . Then, u() is quasiconcave on S if and only if for all x, x0 S, u(x) u(x0 ) = u(x0 ) (x x0 ) 0

Now, suppose that u(x ) = 0 and (x , ) of the Lagrangian function. Then, u(x ) = p p x = y

0 solves the rst order condition

If x is not a utility maximizing plan, there must be some x0 Rn such that + u(x0 ) > u(x ) p x0 y Because u() is continuous and y > 0, there exists (0, 1) suciently close to 1 such that u(x0 ) > u(x ) p x0 < y Let x = x0 . We execute a series of computations: u(x ) (x x ) = ( p) (x x ) ( u(x ) = p) = (p x p x ) < (y y) ( p x < y) = 0 Hence, we have u(x ) (x x ) < 0 which contradicts the above theorem on the characterization of quasiconcavity. In order to ensure the existence of competitive equilibrium, we want the demand function to be continuous. It turns out that we have already made enough assumptions that x(p, y) is continuous on Rn . ++ 18

CHAPTER 2. CONSUMER THEORY Lemma 2.3.2 (Continuity of the demand function) Suppose that u() is a continuous, increasing, and strictly quasi-concave utility function. Then, the derived demand function x(p, y) is continuous at all p 0 and y > 0. If you are interested in the proof of this lemma, please consult Appendix A in Chapter 3 of MWG. However, I do not expect you to understand this proof. Just accept the result. In many cases, we shall want the demand function to be more than continuous, namely, dierentiable. 0 solve the UMP at prices Theorem 2.3.4 (Dierentiable Demand) Let x 0 and y 0 > 0. Suppose that the following three conditions are satised. p0 u() is twice continuously dierentiable on Rn . ++ u(x ) = 0 u(x )/xi > 0 for some i = 1, . . . , n. the Hessian of u() has a nonzero determinant at x on the subspace M = {z Rn |u(x )z = 0}. Then, x(p, y) is dierentiable at (p0 , y 0 ). x The last condition of the above theorem says that the indierence set through is not at. The same remark applies here as well. Just understand that we need more assumptions to guarantee dierentiable demand than Lemma 2.4.2 above.

2.4

The Indirect Utility Function

Given prices p and income y, the consumer chooses a utility-maximizing bundle x(p, y). The level of utility achieved when x(p, y) is chosen thus will be the highest level permitted by the consumers budget constraint facing prices p and income y. The relationship among prices, income, and the maximized value of utility can be summarized by a real-valued function v : Rn R+ R dened as follows: + v(p, y) = max u(x) subject to px y. n
x
+

The function v(p, y) is called the indirect utility function. When u() is continuous, v(p, y) is well-dened for all p 0 and y 0 because a solution to the UMP is guaranteed to exist. If, in addition, u() is strictly quasi-concave, then the solution is unique. Then, v(p, y) = u(x(p, y)). Theorem 2.4.1 (Properties of the Indirect Utility Function) Suppose that u() is continuous and increasing. Then, the indirect utility function v(p, y) is 19

CHAPTER 2. CONSUMER THEORY 1. Continuous on Rn R+ , ++ 2. Homogeneous of degree zero in (p, y), i.e., v(p, y) = v(p, y) for any > 0 3. Increasing in y, i.e., v(p, y ) v(p, y) whenever y y and v(p, y ) > v(p, y) y whenever y 4. Decreasing in p, i.e., v(p , y) v(p, y) whenever p p and v(p , y) < v(p, y) whenever p p 5. Quasi-convex in (p, y), 6. Roys identity: If v(p, y) is dierentiable at (p0 , y 0 ) and v(p0 , y 0 )/y = 0, then xi (p0 , y 0 ) = v(p0 , y 0 )/pi , i = 1, . . . , n. v(p0 , y 0 )/y

v(p, y) is said to be quasi-convex if for any (p, y), (p , y ) Rn R+ , v(p , y ) ++ max{v(p, y), v(p , y )} for any [0, 1], where p = p + (1 )p and y = y + (1 )y . Property 1 is proved by the theorem of maximum. So, just accept property 1 without proof. Here I relegate the proof of Roys identity to the section of expenditure function. Exercise 2.4.1 Show properties 2,3,4, and 5 in the previous theorem.

2.5

The Expenditure Function

To construct the expenditure function, we ask: What is the minimum level of money expenditure the consumer must make facing a given set of prices to achieve a given level of utility? This is called the expenditure minimization problem (EMP). We dene the expenditure function as the minimum-value function, e(p, u) min px subject to u(x) u, n
x
+

for all p 0 and all attainable utility levels u. Let U = {u(x)| x Rn } denote the + set of attainable utility levels. If u() is continuous and strictly quasi-concave, the solution will be unique, so we can denote the solution as the function xh (p, u) 0. Thus, if xh (p, u) is the solution to the EMP, we have e(p, u) = pxh (p, u). xh (p, u) is called the compensated or Hicksian demand function if it is singlevalued.

20

CHAPTER 2. CONSUMER THEORY Theorem 2.5.1 (Properties of the Expenditure Function) Suppose that u() is continuous and increasing. Then e(p, u) is 1. Zero when u() takes on the lowest level of utility in U . 2. Continuous on its domain Rn U. ++ 3. For all p 0, increasing and unbounded above in u, i.e., e(p, u ) e(p, u) whenever u u and e(p, u ) > e(p, u ) whenever u > u; and for any M R+ , there exists u U such that e(p, u) > M . 4. Increasing in p, i.e., e(p , u) e(p, u) whenever p p and e(p , u) > e(p, u) p. whenever p 5. Homogeneous of degree 1 in p, i.e, e(p, u) = e(p, u) for any > 0. 6. Concave in p, i.e., e(p + (1 )p , u) e(p, u) + (1 )e(p , u) for any p, p Rn and any [0, 1]. Let e(, u) : Rn R be a twice dierentiable ++ ++ function. If e(, u) is concave, then, for any p Rn , we have ++ 2 e(p, u) 0 for any i = 1, . . . , n. p2 i 7. Shephards lemma: If, in addition, u() is strictly quasi-concave and e(p, u) is 0, then we have dierentiable in p at (p0 , u0 ) with p0 e(p0 , u0 ) = xh (p0 , u0 ), i = 1, . . . , n. i pi Proof of Shephards lemma: We omit the proof of property 2 which comes from the theorem of maximum. We focus only on property 7 and leave the rest as 0 and we assume that exercise. For simplicity, we focus on the case where xh (p, u) xh (p, u) is dierentiable at (p0 , u0 ). Using the chain rule, the change in expenditure can be written as p e(p0 , u0 ) = p [pxh (p0 , u0 )] = xh (p0 , u0 ) + [pDp xh (p0 , u0 )]T . Or, for each commodity i, we have e(p0 , u0 ) = xh (p0 , u0 ) + i pi
n j=1

p0 j

xh (p0 , u0 ) j pi

n 0 h 0 0 where e(p0 , u0 ) = j=1 pj xj (p , u ). Substituting from the FOCs for an interior solution to the EMP, p = x u(xh (p0 , u0 )) (or p0 = u/xj ), yields j

p e(p0 , u0 ) = xh (p0 , u0 ) + [x u(xh (p0 , u0 )) Dp xh (p0 , u0 )]T . 21

CHAPTER 2. CONSUMER THEORY Or, for each i, we have e(p0 , u0 ) = xh (p0 , u0 ) + i pi u(xh (p, u0 )) u0
n j=1

u xh (p0 , u0 ) j xj pi

But since the constraint = holds for all p in the EMP, we know that h (p0 , u0 )) D xh (p0 , u0 ) = 0, and so we have the result. Or, for each i, we x u(x p know that
n j=1

u xh (p0 , u0 ) j xj pi

Again, we obtain the result. Exercise 2.5.1 Prove properties 1, 3, 4, 5, and 6 in the previous theorem. With the concept of the expenditure functions, we can now prove Roys identity. Proof of Roys Identity: Let u0 = v(p0 , y 0 ). Because the identity v(p, e(p, u0 )) = holds for all p, dierentiating v(p, e(p, u0 )) = u0 with respect to p and evaluating it at p = p0 yields p v(p0 , e(p0 , u0 )) + v(p0 , e(p0 , u0 )) p e(p0 , u0 ) = 0. y

u0

But p e(p0 , u0 ) = xh (p0 , u0 ) by Shephards lemma, and so we can substitute and get p v(p0 , e(p0 , u0 )) + v(p0 , e(p0 , u0 )) h 0 0 x (p , u ) = 0. y v(p0 , y 0 ) x(p0 , y 0 ) = 0. y

Finally, since y 0 = e(p0 , u0 ), we can write p v(p0 , y 0 ) + Rearranging, this yields the result. The idea behind Shephards lemma is as follows: If we are at an optimum in the EMP, the changes in demand caused by price changes have no rst-order eect on the consumers expenditure. The proof uses the chain rule to break the total eect of the price change into two eects: a direct eect on expenditure from the change in prices holding demand xed (the rst term) and an indirect eect on expenditure caused by the induced change in demand holding prices xed (the second term). However, because we are at an expenditure minimizing bundle, the FOCs for the EMP imply that this latter eect is zero. 1
More general argument can be made by the envelope theorem. Those who are interested in this theorem are referred to either pp. 504-509, Chapter A2 of AMT or my lecture notes on mathematics.
1

22

CHAPTER 2. CONSUMER THEORY

2.6

Relations between the Indirect Utility Function and the Expenditure Function

Though the indirect utility function and the expenditure function are conceptually distinct, there is a close relationship between them. Fix (p, y) and let u = v(p, y). Recall now that e(p, u) is the smallest expenditure needed to attain a level of utility at least u. Hence, we must have e(p, u) y. Consequently, e(p, v(p, y)) y, (p, y) 0.

Example 2.6.1 Consider the consumers UMP whose preference admits a thick indierence curve. Then, we have e(p, v(p, y)) < y. Next, x (p, u) and let y = e(p, u). Because v(p, y) is the largest utility level attainable at prices p and with income y, this implies that v(p, y) u. Consequently, v(p, e(p, u)) u, (p, u) Rn U. ++ Example 2.6.2 If u() is not continuous, it is possible to have v(p, e(p, u)) > u. The next theorem demonstrates that under certain familiar conditions on preferences, both of these inequalities, in fact, must be equalities. Theorem 2.6.1 (When UMP=EMP) Let v(p, y) and e(p, u) be the indirect utility function and expenditure function for some consumer whose utility function is continuous and increasing. Then, for all p 0, y 0, and u U: 1. e(p, v(p, y)) = y. 2. v(p, e(p, u)) = u. Proof of Theorem 2.6.1: (1) UMP EMP: Let x be the solution to the UMP given p and y. Suppose, to the contrary, that x is not the solution to the EMP to achieve the required level of utility u(x ). Then, there exists x such that u(x ) u(x ) and px < px y. Let e = (1, . . . , 1) as usual. We can choose > 0 small enough so that px < p(x + e) < y. This implies that x + e B(p, y), i.e., a feasible bundle. Since u() is increasing, we have u(x + e) > u(x ), which contradicts the hypothesis that x is the solution to the UMP. (2) EMP UMP: Let x be the solution to the EMP given p and u. Assume, for simplicity, that 0. Suppose, on u > u(0). Then, x = 0, which implies that px > 0 because p the contrary, that x is not the solution to the UMP. Then, there exists x such that u(x ) > u(x ) and px y. Due to the fact that x is the solution to the EMP, we also have px px . However, if u() is increasing, we must have px = y. As a result, we must assume that px = px . Consider a bundle x = x for (0, 1). By continuity of u(), if is close enough to 1, we must have u(x ) u(x ) and 0. However, this contradicts the hypothesis that x is the px < px . Because p solution to the EMP.

23

CHAPTER 2. CONSUMER THEORY

2.7

The Relation between x(p, y) and xh (p, u)

Theorem 2.7.1 (When x = xh ) Assume that u() is continuous, increasing, and strictly quasi-concave on Rn . For p 0, y 0, and u U: + 1. x(p, y) = xh (p, v(p, y)). 2. xh (p, u) = x(p, e(p, u)). The rst relation says that the ordinary demand at prices p and income y is equal to the compensated demand at prices p and the utility level that is the maximum that can be achieved at prices p and income y. The second says that the compensated demand at any prices p and utility level u is the same as the ordinary demand at those prices and an income level equal to the minimum expenditure necessarily at those prices to achieve that utility level. Proof of Theorem 2.8.1: (UMP EMP): Let x0 = x(p0 , y 0 ) and let u0 = Then, we have v(p0 , y 0 ) = u0 by denition of the indirect utility function v(). Since u() is increasing, px0 = y 0 (Walras law). We also know the relation that e(p0 , v(p0 , y 0 )) = e(p0 , u0 ) = y 0 (Remember Theorem 2.7.1 (UMP=EMP)). Now, we have that u(x0 ) = u0 and p0 x0 = y 0 , which imply that x0 solves the EMP as well when (p, u) = (p0 , u0 ). Hence, x0 = xh (p0 , u0 ), that is, x(p0 , y 0 ) = xh (p0 , v(p0 , y 0 )). (EMP UMP): Let x0 = xh (p0 , u0 ) and let y 0 = p0 x0 . Then, we have e(p0 , u0 ) = y 0 by denition of the expenditure function e(). Since u() is continuous, u(x0 ) = u0 . We also know the relation that v(p0 , e(p0 , u0 ) = v(p0 , y 0 ) = u0 . Then, the fact that xh (p0 , u0 ) = x(p0 , v(p0 , v 0 ) = x(p0 , y 0 ) and v(p0 , u0 ) = u0 implies that x0 also solves the UMP. u(x0 ).

2.8

Income and Substitution Eects

When the price of a good declines, there are at least two conceptually separate reasons why we expect some change in the quantity demanded. First, that good becomes relatively cheaper compared to other goods. Because all goods are desirable, even if the consumers purchasing power over goods were unchanged, we would expect her to substitute the relatively cheaper good for the now relatively more expensive ones. This is the substitution eect. At the same time, however, whenever a price changes, the consumers purchasing power is eectively increased, allowing her to change her purchases of all goods in any way she sees t. The eect on quantity demanded of this generalized increase in purchasing power is called the income eect.

John Hicks proposed a way of decomposing the total eect of a price change. It is based on the observation that the consumer achieves some level of utility at the original prices before any change has occurred. The formalization of this is given as follows: The substitution eect is that hypothetical change in consumption that 24

CHAPTER 2. CONSUMER THEORY would occur if relative prices were to change to their new levels but the maximum utility the consumer can achieve were kept the same as before the price change. The income eect is then dened as whatever is left of the total eect after the substitution eect. The relationships between total eect, substitution eect, and income eect are summarized in the Slutsky equation. For the most of time in this course, I assume that u() is continuous, increasing, strictly quasi-concave and assume furthermore that we will freely dierentiate whenever necessary. Theorem 2.8.1 (The Slutsky Equation) Let x(p, y) be the consumers ordinal demand function. Let u be the level of utility the consumer achieves at prices p and income y. Then, for any i, j = 1, . . . , n, we have xh (p, u ) xi (p, y) xi (p, y) i = xj (p, y) . pj pj y Total Substitution Income

Proof of Theorem 2.9.1: Because of the dual relation between the ordinary demand and the compensated demand, that is, x(p, y) = xh (p, u), we have xh (p, u) = x(p, e(p, u)). Dierentiating this with respect to p, we have xi (p, y) xi (p, y) e(p, u) xh (p, u) i = + , i, j = 1, . . . , n. pj pj y pj By Shephards lemma, we can rewrite the above equation as follows: xi (p, y) xi (p, y) h xh (p, u) i xj (p, u), i, j = 1, . . . , n. = + pj pj y Rearranging this and taking into account xh (p, u) = x(p, y), we complete the proof.

Thanks to the Slutsky equation, whatever we learn about substitution terms then can be translated into knowledge about observable ordinary demands. Classical statements of the Law of Demand were rather strong: If price goes down, quantity demanded goes up. This seemed generally to conform to observations of how people behave, but there were some troubling exceptions. The famous Giens paradox was the most outstanding of these. What is really true is as follows: prices and demanded quantities move in opposite directions for price changes that leave the achieved level of utility unchanged. This is called the Compensated Law of Demand.

25

CHAPTER 2. CONSUMER THEORY Theorem 2.8.2 (The Compensated Law of Demand) Let xh (p, u) be the comi pensated demand for good i. Then xh (p, u) i 0, i = 1, . . . , n. pi Proof of Theorem 2.9.3: By Shephards lemma, we know that 2 e(p, u) xh (p, u) i = , i = 1, . . . , n. pi p2 i Since e(p, u) is concave in p, 2 e(p, u)/p2 0 for all i = 1, . . . , n. We are done. i Consider a 2 2 matrix A given below. A= a11 a12 a21 a22

Then, the matrix A is negative semidenite if and only if a11 0, a22 0, and a11 a22 a12 a21 0. See my lecture notes on mathematics for more details. Theorem 2.8.3 (Symmetric Substitution Terms) Let xh (p, u) be the consumers compensated demand and suppose that e(, u) is twice continuously dierentiable. Then, for any i, j = 1, . . . , n, we have xh (p, u) xh (p, u) j i = . pj pi Proof of Theorem 2.8.3: Taking into account Shephards lemma, what we want is 2 e(p, u) 2 e(p, u) = , for any i, j = 1, . . . , n. pi pj pj pi This is proved by the following Youngs theorem. Theorem 2.8.4 (Youngs Theorem) For any twice continuously dierentiable function f (), 2 f (x) 2 f (x) = , for all i, j = 1, . . . , n. xi xj xj xi We accept Youngs theorem without proof. Before stating other results, we quickly review some of mathematical notions used for the results.

26

CHAPTER 2. CONSUMER THEORY Denition 2.8.1 The n n matrix M is negative semidenite if z M z 0, for all z Rn . If the inequality is strict for all z = 0, then the matrix M is negative denite. The next theorem is a characterization of quasi-concavity of a function in terms of negative semideniteness of the matrix. See also my lecture notes on mathematics for more details. Theorem 2.8.5 Let u be the level of utility. The twice continuously dierentiable 2 function e(, u ) : Rn R is concave if and only if Dp e(p, u ) is negative semidef++ 2 inite for every p Rn . If Dp e(p, u ) is negative denite for every p Rn , then ++ ++ the function is strictly concave. Theorem 2.8.6 (Negative Semidenite Substitution Matrix) Let xh (p, u) be the consumers compensated demand, and let xh (p,u) xh (p,u) 1 1 pn p1 . . .. , . . (p, u) . . . xh (p,u) xh (p,u) n n p1 pn called the substitution matrix, contain all the compensated substitution terms. Then the matrix (p, u) is negative semidenite. Proof of Theorem 2.8.6: By Shephards lemma, 2 e(p,u) xh (p,u) xh (p,u) 1 1 2 pn p1 p1 . . . .. = . . . . . . . e(p,u) xh (p,u) xh (p,u) n n p1 pn p1 pn we have .. .
e(p,u) pn p1

. . .

e(p,u) p2 n

By theorem 2.8.3, this matrix is symmetric. Using theorem 2.8.5 and taking into account the fact that e(, u) is concave in p, this matrix is also negative semidenite.

Note that a square matrix A is said to be symmetric if A = A , where A is the transpose of A. See my lecture note on mathematics for these denitions. Theorem 2.8.7 Let x(p, y) be the consumers ordinal demand function. Dene the (i, j)-th Slutsky term as xi (p, y) xi (p, y) , + xj (p, y) pj y

27

CHAPTER 2. CONSUMER THEORY and form the entire nn Slutsky matrix of prices and income responses as follows: x1 (p,y) 1 (p,y) + x1 (p, y) x1 (p,y) xpn + xn (p, y) x1 (p,y) p1 y y . . .. . . . S(p, y) = . . . xn (p,y) n (p,y) + x1 (p, y) xn (p,y) xpn + xn (p, y) xn (p,y) p1 y y Then S(p, y) is symmetric and negative semidenite. Proof of Theorem 2.8.7: Let u be the maximum utility the consumer achieves at prices p and income y, so u = v(p, y). By Theorem 2.9.1, we know that xi (p, y) xi (p, y) xh (p, u ) i . = + xj (p, y) pj pj y By Shephards lemma, we have 2 e(p, u ) xh (p, u ) i = . pj pj pi By Theorem 2.8.3, S(p, y) is symmetric. Since e(p, u) is concave in p, S(p, y) is also negative semidenite. The Slutsky matrix is given as follows: s11 (p, y) s12 (p, y) s21 (p, y) s22 (p, y) S(p, y) = . . .. . . . . . sn1 (p, y) sn2 (p, y) where the (i, j)-th entry is sij (p, y) = xi (p, y) xi (p, y) . + xj (p, y) pj y

s1n (p, y) s2n (p, y) . . . snn (p, y)

2.9

More Restrictions on the Ordinary Demand

The requirements that consumer demand satisfy homogeneity of degree 0 in (p, y) and Walras law (i.e., px = y whenever x x(p, y)), and that the associated Slutsky matrix be symmetric and negative semidenite, provide a set of restrictions on allowable values for the parameters in any empirically estimated ordinary demand system - if that system is to be viewed as belonging to a price-taking, utility-maximizing consumer. There are other testable restrictions implied by the theory

28

CHAPTER 2. CONSUMER THEORY Denition 2.9.1 (Demand Elasticities and Income Shares) Let xi (p, y) be the consumers ordinary demand for good i. Then let i
ij

y xi (p, y) y xi (p, y) xi (p, y) pj pj xi (p, y)

and let si pi xi (p, y) so that si 0 and y


n

si = 1.
i=1

The symbol i denotes the income elasticity of demand for good i, and measures the percentage change in the quantity of i demanded per 1 percent change in income. The symbol ij denotes the price elasticity of demand for good i, and measures the percentage change in the quantity of i demanded per 1 percent change in the price pj . If j = i, ii is called the own-price elasticity of demand for good i. If j = i, ij is called the cross-price elasticity of demand for good i with respect to pj . The symbol si denotes the income share, spent on purchases of good i. Theorem 2.9.1 (Aggregation in Consumer Demand) Let x(p, y) be the consumers demand. Then, the following relations must hold among income shares, price, and income elasticities of demand: 1. Engel aggregation: 2. Cournot aggregation:
n i=1 si i

= 1. = sj , j = 1, . . . , n.

n i=1 si ij

Proof of Theorem 2.9.1: (Engel aggregation): From Walras law, we have y = p x(p, y) for all p and y. Dierentiating this with respect to y yields
n

1=
i=1

pi

xi . y

Multiplying and dividing each element in the summation by xi , y, we obtain


n

1=
i=1

pi xi xi y . y y xi

Using the notations introduced above, we have


n

1=
i=1

si i .

29

CHAPTER 2. CONSUMER THEORY


n (Cournot aggregation): Dierentiating y = i=1 pi xi (p, y) with respect to pj yields xi xj 0= pi . + xj + pj pj pj i=j

Note that y = pj xj (p, y) + as follows:

i=j

pi xi (p, y). We can rearrange the above expression


n

xj =
i=1

pi

xi . pj

Multiplying pj /y on the both hand sides, we obtain pj xj = y


n i=1

pi xi pj . y pj

Rearranging the above expression, we get pj xj = y


n i=1

pi xi xi pj . y pj xi

Using the notations introduced above, we have


n

sj =
i=1

si

ij ,

j = 1, . . . , n.

2.10

Weak Axiom of Revealed Preference (WARP)

So far, we have approached demand theory by assuming that the consumer has preferences satisfying certain properties (completeness, transitivity, and monotonicity); then we have tried to deduce all of the observable properties of market demand that follow as a consequence (homogeneity of degree 0 in (p, y), Walras law, symmetry and negative semideniteness of the Slutsky matrix). Thus, we have begun by assuming something we cannot observe - preferences - to ultimately make predictions about something we can observe - consumer demand behavior. In his remarkable Foundations of Economic Analysis, Paul Samuelson (1947) suggested an alternative approach. Why not start and nish with observable behavior? He showed how virtually every prediction ordinary consumer theory makes can also be derived from a few simple and sensible assumptions about the consumers observable choices themselves, rather than about his unobservable preferences.

30

CHAPTER 2. CONSUMER THEORY Denition 2.10.1 (WARP) A consumers choice behavior satises WARP if for every distinct pair of bundles x, x for which x is chosen at p and x is chosen at p , px px = p x > p x . In other words, WARP holds if whenever x is revealed preferred to x , x is never revealed preferred to x. Suppose that a consumers choice behavior satises WARP. Let x(p, y) denote the choice made by this consumer when faced with prices p and income y. In addition to WARP, we will requires the consumers choice to satisfy Walras law, i.e., p x(p, y) = y. Proposition 2.10.1 If x(p, y) satises WARP and Walras law, then it is homogeneous of degree 0 in (p, y). Proof of Proposition 2.10.1: Suppose that x(p, y) is chosen when prices are p and income y, and suppose that x(p , y ) is chosen when prices are p = p and income is y = y for > 0. What we want is x(p, y) = x(p , y ). From Walras law, we have p x(p , y ) = y = y = p x(p, y) Since p = p, we have p x(p , y ) = p x(p, y). () If x(p, y) = x(p , y ), the above equality () is satised and we obtain what we want. Thus, assume, on the contrary, that x(p, y) = x(p , y ). Note that x(p, y) is aordable under (p , y ), i.e., p x(p, y) p x(p , y ). Then, WARP implies that p x(p , y ) > p x(p, y). However, this contradicts the equality (). Proposition 2.10.2 (The Compensated Law of Demand) Suppose that the choice function x(p, y) is homogeneous of degree zero and satises Walras law. Then x(p, y) satises the WARP if and only if the following property holds: For any compensated price change from an initial situation (p, y) to a new priceincome pair (p , y ) = (p , p x(p, y)), we have (p p) x(p , y ) x(p, y) 0, with strict inequality whenever x(p, y) = x(p , y ).

31

CHAPTER 2. CONSUMER THEORY Proof of Proposition 2.10.2: (WARP the compensated law of demand): If x(p , y ) = x(p, y), it follows that (p p ) [x(p , y ) x(p, y)] = 0. Then we are done. Thus, assume that x(p, y) = x(p , y ). Consider the following. (p p) x(p , y ) x(p, y) = p [x(p , y ) x(p, y)] p [x(p , y ) x(p, y)] = p [x(p , y ) x(p, y)] ( p x(p , y ) = y from Walras law and y = p x(p, y)) = [p x(p , y ) p x(p, y)] = [p x(p , y ) y] (by Walras law) Since p x(p, y) = y , x(p, y) is aordable under (p , y ). The WARP implies that x(p , y ) must not be aordable under (p, y). Hence, we have p x(p , y ) > y. Since p x(p, y) = y from Walras law, we obtain the desired inequality. (The compensated law of demand WARP): Suppose, on the contrary, that the WARP is not satised. Then, the following properties are given: 1. p x(p, y) = y (Walras law) 2. p x(p, y) = y (The Slutsky compensation) 3. x(p, y) = x(p , y ) (WARP) 4. p x(p , y ) y (our hypothesis for contradiction) Then, using the properties used in the rst part of the proof, we have (p p) x(p , y ) x(p, y) = < p [x(p , y ) x(p, y)] 0 ( p x(p, y) = y and p x(p , y ) y.) 0 ( the compensated law of demand if x(p, y) = x(p , y ))

Contradiction! Thus, we complete the proof. Proposition 2.10.3 If a dierentiable choice function x(p, y) satises Walras law, homogeneity of degree zero, and the WARP, then at any (p, y), the Slutsky matrix S(p, y) is negative semi-denite, i.e., z S(p, y)z 0 for any z Rn . Proof of Proposition 2.11.3: If the choice function x(p, y) is dierentiable, the compensated law of demand is summarized as dp dx 0. Proposition 2.10.2 tells us that dp dx 0. 32

CHAPTER 2. CONSUMER THEORY Using the chain rule, the dierential change in demand induced by this compensated price change can be written as dx = Dp x(p, y)dp + Dy x(p, y)dy = Dp x(p, y) + Dy x(p, y) (x(p, y)) dp (because dy = (x(p, y)) dp)

Then, we obtain dp dx 0 dp Dp x(p, y) + Dy x(p, y) (x(p, y)) dp 0 dp S(p, y)dp 0 You should understand this dierential version of the compensated law of demand is equivalent to the negative semideniteness of the Slutsky matrix. However, the compensation we have to take care is not the Hicksian compensation but the Slutsky compensation. The Slutsky compensation means that we consider any price change under which the consumers original bundle (not utility!) is just aordable. So far, we have seen that if a choice function satises WARP and Walras law, then homogeneity of degree zero and negative semideniteness of the Slutsky matrix are implied by utility maximization. Then, a natural question is whether symmetry of the Slutsky matrix are also implied by WARP and Walras law. The answer is yes if there are only two goods in the economy and no in general. Exercise 2.10.1 (Hicks (1957)) In a three-commodity world, consider the three budget sets determined by the price vectors p1 = (2, 1, 2), p2 = (2, 2, 1), and p3 = (1, 2, 2) and income y = 8 (the same for the three budgets). Suppose that the respective unique choices are x1 = (1, 2, 2), x2 = (2, 1, 2), and x3 = (2, 2, 1). Verify that any two pairs of choices satisfy the WARP but that x3 is reveled preferred to x2 , x2 is revealed preferred to x1 , and x1 is revealed preferred to x3 . This implies that the revealed preference is not transitive. The next question is as follows: How must we strengthen WARP to obtain a theory of revealed preference that is equivalent to the theory of utility maximization? The answer lies in the Strong Axiom of Revealed Preference. Denition 2.10.2 The choice function x(p, y) satises the strong axiom of revealed preference (the SARP) if for any list, (p1 , y 1 ), . . . , (pK , y K ) with x(pk+1 , y k+1 ) = x(pk , y k ) for all k K 1, we have pK x(p1 , y 1 ) > y K whenever pk x(pk+1 , y k+1 ) y k for all k K 1. Then, we have the following result. Just accept the result. Proposition 2.10.4 (Houthakker (1950) and Richter (1966)) If the choice function x(p, y) satises the SARP, then there is a complete and transitive preference such that for all (p, y), x(p, y) z for every z = x(p, y) with z B(p, y). 33

CHAPTER 2. CONSUMER THEORY Proof of Proposition 2.10.4: Dene a relation 1 on commodity vectors by letting x 1 x whenever x = x and we have x = x(p, y) and p x y for some (p, y). The relation 1 can be read as directly revealed preferred to. From 1 dene a new relation 2 , to be read as directly or indirectly revealed preferred to, by letting x 2 x whenever there is a chain x1 1 x2 1 1 xN with x1 = x and xN = x . Observe that, by construction, 2 is transitive. According to the SA, 2 is also irreexive (i.e., x 2 x is impossible). A certain axiom of set theory (known as Zorns lemma) tells us the following: Every relation 2 that is transitive and irreexive (called a partial order ) has a total extension 3 , an irreexive and transitive relation such that, rst, x 2 x implies x 3 x and, second, whenever x = x , we have either x 3 x or x 3 x. Finally, we can dene by letting x x whenever x = x or x 3 x . It is not dicult now to verify that is complete and transitive and that x(p, y) x whenever p x y and x = x(p, y).

2.11

Appendix: Integrability

If a continuously dierentiable demand function x(p, y) is generated by rational preferences, then we have seen that it must be homogeneous of degree zero, satisfy Walras law, and have a substitution matrix S(p, y) that is symmetric and negative semidenite (NSD) at all (p, y). We now pose the reverse question: If we observe a demand function x(p, y) that has these properties, can we nd preferences that rationalize x(). As we show in this section, the answer is yes; these conditions are sucient for the existence of rational generating preferences. This problem, known as the integrability problem, has a long tradition in economic theory. This result tells us that not only are the properties of homogeneity of degree zero, satisfaction of Walras law, and a symmetric and negative semidenite substitution matrix necessary consequences of the preference-based demand theory, but these are also all of its consequences. As long as consumer demand satises these properties, there is some rational preference relation that could have generated this demand. The problem of recovering preferences from x(p, y) can be subdivided into two parts: (i) recovering an expenditure function e(p, u) from x(p, y), and (ii) recovering preferences from the expenditure function e(p, u).

2.11.1

Recovering Preferences from the Expenditure Function

Proposition 2.11.1 Suppose that e(p, u) is strictly increasing in u and is continuous, increasing, homogeneous of degree one, concave, and dierentiable in p. Then, for every utility level u, e(p, u) is the expenditure function associated with the atleast-as-good-as set Vu = x Rn | p x e(p, u) p + That is, e(p, u) = min{p x | x Vu } for all p 34 0. 0 .

CHAPTER 2. CONSUMER THEORY

2.11.2

Recovering the Expenditure Function from Demand

35

Chapter 3

Production
Many aspects enter a full description of a rm: Who owns it? Who manages it? How is it managed? How is it organized? How is it nanced? What can it do? Of all these questions, we concentrate on the last one, what can the rm do? Our justication is not that the other questions are not interesting (indeed, they are), but that we want to arrive as quickly as possible at a minimal conceptual apparatus that allows us to analyze market behavior. Then, the rm is viewed merely as a black box, able to transform inputs into outputs. The most general way is to think of the rm as having a production possibility set, Y Rm , where each vector y = (y1 , . . . , ym ) Y is a production plan whose components indicate the amounts of the various inputs and outputs. We write elements of y Y so that yi < 0 if resource i is used up in the production plan, and yi > 0 if resource i is produced in the production plan.

3.1

Properties of Production Sets

1. Y is nonempty. Otherwise, there is no production problem! 2. Y is closed. Consider a sequence {y k } converging to y for which y k Y for each k. If Y is closed, y Y . 3. Y satises no free lunch if, whenever y Y and y 0, then y = 0. It is not possible to produce something from nothing. Geometrically, Y Rn {0}. + 4. Y has the possibility of inaction if 0 Y . In particular, Y is then nonempty. Because the rm always has the option of producing nothing. 5. Y satises free disposal if y Y and y y, then y Y . Namely, Y Rn . + The extra amount of inputs can be disposed of or eliminated at no cost. This assumption is important for the competitive equilibrium price to be nonnegative.

36

CHAPTER 3. PRODUCTION 6. Y exhibits nonincreasing returns to scale if for any y Y , we have y Y for any [0, 1]. 7. Y exhibits nondecreasing returns to scale if for any y Y , we have y Y for any 1. 8. Y exhibits constant returns to scale if y Y implies that y Y for any 0. 9. Y is convex if for any y, y Y , we have y + (1 )y Y for any [0, 1]. 10. Y is strictly convex if for any y, y Y with y = y , we have y + (1 )y Int(Y ) for any (0, 1). Here Int(Y ) denotes the interior of Y . 11. Y is additive if for any y, y Y , we have y + y Y . Additivity is related to the idea of entry. If y Y is being produced by a rm and another rm enters and produces y Y , then the net result is the vector y + y . Hence, the aggregate production set must satisfy additivity whenever free entry is possible. Then, the number of rms in the market will be determined at the point where all rms make zero prot. 12. Y is a convex cone if for any y, y Y and any 0, and any 0, we have y + y Y . Proposition 3.1.1 The production set Y is additive and exhibits the nonincreasing returns to scale if and only if it is a convex cone. Proof of Proposition 3.1.1: (=) Fix y, y Y . Let [0, 1] and = 0. Since Y is convex cone, we have y + y = y Y . This implies that Y is nonincreasing returns to scale. Fix y, y Y . Let = 1 and = 1. Since Y is convex cone, we have y + y = y + y Y , which shows the additivity of Y . (=) Fix y, y Y and > 0 and > 0. Let k > max{, }. By additivity of Y , ky Y and ky Y . Since (/k) < 1 by construction and thus y = (/k)ky, the nonincreasing returns to scale of Y implies that y Y . Similarly, y Y . Finally, again by additivity of Y , y + y Y as desired. Here is a more important thing than the proof per se: If Y is convex cone, Y is, in particular, convex. Thus, Proposition 3.1.1 is a justication for the convexity assumption in production It is sometimes convenient to describe the production set Y using a function F (), called the transformation function. The transformation function F () has the property that Y = {y Rm | F (y) 0} and F (y) = 0 if and only if y is an element of the boundary of Y . The set of boundary points of Y, {y Rm | F (y) = 0}, is known as the transformation frontier.

37

CHAPTER 3. PRODUCTION If F () is dierentiable, and if the production vector y satises F () = 0, then y for any commodities i and j, the ratio y M RT Sij () = F ()/yi y F ()/yj y

is called the marginal rate of technical substitution (MRTS) of good i for good j at y. Exercise 3.1.1 Let F (y) = 3y1 + y2 . Dene Y = {y R2 | F (y) 0}. Draw the graph of Y . What is the marginal rate of technical substitution?

3.2

Production Functions

The production set is by far the most general way to characterize the rms technology because it allows for multiple inputs and multiple outputs. However, for the case in which the rm produces only a single output from many inputs, it is more convenient to describe the rms technology in terms of production function. Then, we shall denote the amount of output by y, and the amount of input i by xi , so that with n inputs, the entire vector of inputs is denoted by x = (x1 , . . . , xn ). Of course, the input vector as well as the amount of output must be nonnegative, so we require x 0 and y 0. The production function, f , is therefore a mapping from Rn R+ with a generic element y = f (x). We shall maintain the following + assumption on the production function f (). Assumption 3.2.1 (Properties of the Production Function) The production function, f : Rn R+ , is + continuous (cf. closedness of Y ), increasing: x x f (x ) f (x) and x x f (x ) > f (x),

strictly quasi-concave (cf. Strict convexity of Y ), and f (0) = 0 (No free lunch and the possibility of inaction). Exercise 3.2.1 Show that for a single-output technology, the production set Y is convex if and only if the production function f () is concave. When the production function is dierentiable, its partial derivative, f (x)/xi , is called the marginal product of input i and gives the rate at which output changes per additional unit of input i employed. For any xed level of output, y, the set of input vectors producing y units of output is called the y-level isoquant. An isoquant is then just a level set of f , which is denoted as Q(y) as follows: Q(y) {x Rn | f (x) = y}. + 38

CHAPTER 3. PRODUCTION For the case of production function, the marginal rate of technical substitution of good i for good j at x is given as follows: M RT Sij (x) = f (x)/xi . f (x)/xj

The MRTS is one local measure of substitutability between inputs in producing a given unit of output. Since economists favor unit-free elasticities as such things, the most common one is the elasticity of substitution, . Then, measures curvature of an isoquant. Denition 3.2.1 (The Elasticity of Substitution) For a production function f (x), the elasticity of substitution between inputs i and j at the point x is dened as ij M RT Sij d(xj /xi ) xj /xi d(M RT Sij ) = = Let y = xj /xi . Note that d ln(y) = = ln y dy y dy = d(xj /xi )/(xj /xi ). y d(xj /xi ) fi (x)/fj (x) xj /xi d(fi (x)/fj (x)) d ln(xj /xi ) d ln (fi (x)/fj (x))

Exercise 3.2.2 Consider the following CES (constant elasticity of substitution) production f : R2 R+ with the following form: + f (x) = [1 x + 2 x ] 1 2
1/

where 0 = = 1 and 1 , 2 > 0. Answer the following questions: 1. Show that when = 1, isoquant curves are linear. What is the elasticity of substitution of this technology? 2. Show that as 0, this production function f () comes to represent f (x) = x1 x2 . Here assume that 1 + 2 = 1 (Hint: Use LHopitals rule). What is 1 2 the elasticity of substitution of this technology? 3. Show that as , the production function becomes f (x) = min{x1 , x2 }. What is the elasticity of substitution of this technology?

39

CHAPTER 3. PRODUCTION

3.2.1

More about Production Functions

A function f : Rn R+ is said to be homogeneous of degree one if, for any x Rn + + and any > 0, f (x) = f (x). In particular, the CES production function which is widely used in empirical researches, is homogeneous of degree one. Do you see why? The next theorem says that under the assumption that f () is continuous, increasing, and has the property that f (0) = 0, homogeneity of degree one as well as quasiconcavity implies concavity. Note that concavity always implies quasiconcavity. To see this, you are referred to my lecture note on mathematics. Theorem 3.2.1 Let f () be a production function that is continuous, increasing, strictly quasi-concave with the property that f (0) = 0. If f () is homogeneous of degree one, then f () is concave. 0 and let y = f (x) and Proof of Theorem 3.2.1: Take any x 0 and x y = f (x ). Then y, y > 0 because f (0) = 0 and f () is increasing. Since f () is homogeneous of degree one, we have f (x) = y > 0 and f (x ) = y > 0. Plugging = 1/y and = 1/y into the above equations, respectively, we obtain f x y =f x y = 1.

Since f () is quasi-concave, we have f x (1 )x + y y 1 for all [0, 1].

Choosing = y/(y + y ), we rearrange the above equation as follows: f x x + y+y y+y 1.

Again, appealing to homogeneity of degree one, we have f (x + x ) = f (y + y ) x x + y+y y+y x x + y+y y+y f x x + y+y y+y 1

= (y + y )f y+y

= f (x) + f (x ) (). 40

CHAPTER 3. PRODUCTION Thus, the above equation () holds for all x, x 0. But the continuity of f guarantees that this () also holds for all x, x 0. Consider any two vectors x, x 0 and any [0, 1]. Homogeneity of degree one of f ensures that f (x) = f (x), f (1 )x = (1 )f (x ).

Taking into account the equation () which is satised for any x, x 0, we have f x + (1 )x as desired. Exercise 3.2.3 Suppose that f () is the production function associated with a singleoutput technology, and let Y be the production set of this technology. Show that Y satises constant returns to scale if and only if f () is homogeneous of degree one. f (x) + (1 )f (x ),

3.2.2

Returns to Scale of the Production Function

Denition 3.2.2 A production function f () is 1. constant returns to scale if f (x) = f (x) for all > 0 and all x Rn , + 2. increasing returns to scale if f (x) > f (x) for all > 1 and all x Rn , + 3. decreasing returns to scale if f (x) < f (x) for all > 1 and all x Rn . +

3.3

Cost Minimization

If the objective of the rm is to maximize prots, it will necessarily choose the least costly, or cost-minimizing, production plan for every level of output. We will assume throughout that rms are perfectly competitive on their input markets and that therefore they face xed input prices and take them as given. This is indeed the price-taking behavior. Let w = (w1 , . . . , wn ) 0 be a vector of prevailing market prices at which the rm can buy inputs x = (x1 , . . . , xn ). Denition 3.3.1 The cost function, dened for all input prices w output levels y f (Rn ) is the minimum-value function, + c(w, y) min w x subject to f (x) y. n
x
+

0 and all

If x(w, y) solves the cost minimization problem, then c(w, y) = w x(w, y).

41

CHAPTER 3. PRODUCTION If f () is increasing, the constraint will be always binding at a solution. Consequently, the cost minimization problem (CMP) is equivalent to
x

min w x subject to f (x) = y. n


+

0, and Let x be the solution to the CMP. To keep things simple, we will assume x 0. Thus, we are able to characterize that f () is dierentiable at x with f (x ) the following FOCs: There is a R such that wi = Since w 0, we have wi f (x )/xi = . )/x f (x wj j Thus, cost minimization implies that the marginal rate of substitution between any two inputs is equal to the ratio of their prices. The solution x(w, y) to the CMP is referred to as the rms conditional input demand, because it is conditional on the level of output y, which at this point is arbitrary and so may or may not be prot maximizing. With two inputs, an interior solution corresponds to a point of tangency between the y-level isoquant and an isocost line of the form w x = for some > 0. If x1 (w, y) and x2 (w, y) are solutions, then c(w, y) = w1 x1 (w, y) + w2 x2 (w, y). Theorem 3.3.1 (Properties of the Cost Function) If f is continuous and increasing, then c(w, y) is 1. Zero when y = 0. 2. Continuous on its domain. 3. For all w 0, increasing and unbounded above in y. f (x ) , i = 1, . . . , n xi

4. Increasing in w. 5. Homogeneous of degree one in w. 6. Concave in w. 7. Shephards lemma: Assume further that f () is strictly quasi-concave. Then 0, and c(w, y) is dierentiable in w at (w0 , y 0 ) whenever w0 c(w0 , y 0 ) = xi (w0 , y 0 ), i = 1, . . . , n. wi

42

CHAPTER 3. PRODUCTION Exercise 3.3.1 Prove Theorem 3.3.1. The proof must be similar to that of Theorem 2.6.1 (Properties of the Expenditure Function). Theorem 3.3.2 (Properties of Conditional Input Demands) Suppose the production function is continuous, increasing, and strictly quasi-concave and satises the property that f (0) = 0, and that the associated cost function is twice continuously dierentiable. Then 1. x(w, y) is homogeneous of degree zero in w. 2. The substitution matrix, dened and denoted x1 (w,y) w1 . .. . (w, y) . .
xn (w,y) w1

x1 (w,y) wn

. . .

xn (w,y) wn

is symmetric and negative semi-denite. In particular, the negative semideniteness property implies that xi (w, y)/wi 0 for all i = 1, . . . , n. Exercise 3.3.2 Prove Theorem 3.3.2. The latter part of the proof is similar to that of Theorem 2.9.6.

3.3.1

Properties of the Cost Functions

Denition 3.3.2 An increasing function F : Rn R is said to be homothetic if, + there exist an increasing function f : R R and a function g : Rn R which is + homogeneous of degree one such that F (x) = f (g(x)) for any x Rn . + Proposition 3.3.1 (A Characterization of Homothetic Functions) An increasing function F : Rn R is homothetic only if, whenever F (x) = F (y), then + F (x) = F (y) for any 0. 1 Proof of Proposition 3.3.1: Assume that F (x) = F (y). I execute the following series of deductions. F (x) = F (y) = f (g(x)) = f (g(y)) (by denition) = g(x) = g(y) (because f () is increasing.) = g(x) = g(y) 0 = g(x) = g(y) (because g() is homogeneous of degree one.) = f (g(x)) = f (g(y)) = F (x) = F (y) (by denition) Homotheticity of the production function means that all isoquant sets (in particular, curves when n = 2) are related by proportional expansion along rays. Consider,
1

In the Appendix, I introduce an extra condition under which if part can also be proved.

43

CHAPTER 3. PRODUCTION for example, that F (x) = x x2 1 homothetic.


(1)

, where (0, 1). You can check this F () is

Theorem 3.3.3 When the production function F () f (g()) is continuous, increasing, strictly quasi-concave, and homothetic and satises the property that f (0) = 0. the cost function c() is multiplicatively separable in input prices and output and can be written c(w, y) = h(y)c(w, 1), where h() is increasing and c(w, 1) is the unit cost function. the conditional input demands x() are multiplicatively separable in input prices and output and can be written x(w, y) = h(y)x(w, 1), where h (y) > 0 and x(w, 1) is the conditional input demand for one unit of output. Proof of Theorem 3.3.3: Let F () denote the production function which is increasing. Because it is homothetic, it can be written as F (x) = f (g(x)), where f () is strictly increasing, and g() is homogeneous of degree one. First, I claim the following: Claim 3.3.1 f 1 (y) > 0 for all y > 0. For all y > 0, there exists x Rn such that + y = F (x). This is straightforward from the properties that f () is increasing and f (0) = 0. For simplicity, we shall assume that the image of F is all of R+ . 2 Fix such y > 0. Let = f 1 (1)/f 1 (y) > 0. Consider the following chain of relations: F (x) y f (g(x)) y g(x) f
1

( F (x) = f (g(x))) ( g() is homogeneous of degree one) ( = f 1 (1)/f 1 (y))

(y) (1)

g(x) f 1 (y) g(x) f


1

f (g(x)) 1 Accordingly, we may express the cost function as follows: c(w, y) = = = = =


2

x x

min w x n
+ +

subject to subject to

f (g(x)) y f (g(x)) 1

min w x n

1 min w x subject to f (g(x)) 1 x n + 1 min w z subject to f (g(z)) 1 z n + f 1 (y) c(w, 1), f 1 (1)
+

The image of F is all of

if for any y

+,

there exists x

n +

such that f (x) = y.

44

CHAPTER 3. PRODUCTION where we let z x. When dening h(y) = f 1 (y)/f 1 (1), we complete the proof for any y > 0. Since F (0) = 0 and g() is homogeneous of degree one, we know that c(w, 0) = 0 and g(0) = 0. This implies that the result holds for any y 0. When the rm is stuck with xed amounts of certain inputs in the short run, rather than being free to choose those inputs optimally as it can in the long run, we should expect its costs in the short run to dier from its costs in the long run. Denition 3.3.3 (The Short-Run Cost Function) Let the production function be f (z), where z (x, x). Suppose that x is a subvector of variable inputs and x is a subvector of xed inputs. Let w and w be the associated input prices for the variable and xed inputs, respectively. The short-run total cost function is dened as SC(w, w, y; x) min w x + w x subject to f (x, x) y.
x

If x(w, w, y; x) solves this minimization problem, then SC(w, w, y; x) = w x(w, w, y; x) + w x. The optimized cost of the variable inputs, w x(w, w, y; x), is called total variable cost. The cost of the xed inputs, w x, is called total xed cost. Let x(y) denote the optimal choice of the xed inputs to minimize short-run cost of output y at the given input prices. The following must be true: c(w, w, y) SC(w, w, y; x(y)) y > 0. Furthermore, because we have chosen the xed inputs to minimize short-run costs, the optimal amounts x(y) must satisfy the FOCs for a minimum: SC(w, w, y; x(y)) 0, xi for all xed inputs i. Now dierentiate the above identity with respect to y, we have direct eect dc(w, w, y) dy = SC(w, w, y; x(y)) + y indirect eect SC(w, w, y; x(y)) xi (y) xi y
=0 i =0

as a result

SC(w, w, y; x(y) . y

We summarize: First, the short-run cost minimization problem involves more constraints on the rm than the long-run problem, so we know that SC(w, w, y; x) c(w, w, y) for all levels of output and levels of the xed inputs. Second, for every 45

CHAPTER 3. PRODUCTION level of output, the short-run and long-run costs will coincide for some short-run cost function associated with some level of the xed inputs. Finally, the slope of this short-run cost function will be equal to the slope of the long-run cost function in the cost-output plane. In other words, the long-run total cost curve is the lower envelope of the entire family of short-run total cost curves!

3.4

Prot Maximization

Prot is the dierence between revenue from selling output and the cost of acquiring the inputs necessary to produce it. The competitive (i.e., price-taking) rm can sell each unit of output at the market price, p. Its revenues are therefore a simple function of output, R(y) = py. Here we assume that the objective of the rm is to maximize its prot. Then, the rms prot maximization problem (PMP) is given as follows:
(x,y)0

max py w x subject to f (x) y.

where f () is a production function which is continuous, increasing, and strictly quasi-concave and satises the property that f (0) = 0. Since f () is increasing, the constraint is binding, that is, f (x) = y. Then, the PMP is rewritten as follows.
x

max pf (x) w x. n
+

0. Then, I Let x be the solution to the PMP under (p, w). Assume that x can characterize the solution to the PMP by way of the rst order conditions (FOCs). Namely, p Assuming further that w for the prot maximization: f (x ) = wi , i = 1, . . . , n. xi 0, we derive the following implication from the FOCs f (x )/xi wi = , i, j. )/x f (x wj j

M RT Sij (x ) = This means that

Prot Maximization Cost Minimization. This fact allows us to simply the PMP further. max py c(w, y)
y0

Let y = f (x ). The FOC for the prot maximization is reduced to p dc(w, y ) = 0. dy 46

CHAPTER 3. PRODUCTION The prot maximizing choice of output, y y(p, w), is called the rms output supply function, and the prot maximizing choice of inputs, x x(p, w), gives the vector of rm input demand functions. Denition 3.4.1 The rms prot function depends only on input and output prices and is dened as the maximum value function, (p, w) max py w x subject to f (x) y.
(x,y)0

Note that the price system may be such that there is no bound on how high prots may be. Suppose, for example, that a rm with constant returns to scale technology produces one unit of a single output (the price is p) for every unit of a single input (the price is w). Then, (p, w) = 0 whenever p w. But (p, w) = + if p > w. Theorem 3.4.1 (Properties of the Prot Function) Suppose that the production function f () is continuous, increasing, and strictly quasi-concave and satises the property that f (0) = 0. Then, for p 0 and w 0, the prot function (p, w), where well-dened, is continuous and 1. increasing in p. 2. decreasing in w. 3. homogeneous of degree one in (p, w). 4. convex in (p, w). 5. If dierentiable in (p, w) (p, w) = y(p, w) p 0, Hotellings lemma follows: and (p, w) = xi (p, w), wi i = 1, . . . , n.

Proof of Theorem 3.4.1: I prove only convexity of and Hotellings lemma. The proofs of the rest of the properties are left as exercise. Convexity of (p, w): Let (x, y) and (x , y ) be the solutions to the PMP under (p, w) and under (p , w ), respectively. Thus, we have (p, w) = py w x (p , w ) = p y w x . (3.1) (3.2)

47

CHAPTER 3. PRODUCTION Let p = p + (1 )p and w = w + (1 )w for [0, 1]. Let (x , y ) be the solution to the PMP under (p , w ). Then, we do the following computation: (p , w ) = p y w x = p + (1 )p y w + (1 )w x

= [py w x ] + (1 ) p y w x [py w x] + (1 ) p y w x = (p, w) + (1 )(p , w ). This completes the proof. x Hotellings Lemma: Suppose that y is a prot maximizing output vector and is a prot maximizing input vector at prices (p , w ). Dene the function g(p, w) = (p, w) py
n i=1

wi x . i

Since the prot maximizing production plan at prices (p, w) will always be at least as protable as the production plan (x , y ). However, the plan (x , y ) will be a prot maximizing plan at prices (p , w ), so the function g() reaches a minimum value of 0 at (p , w ). Namely, g(p, w) 0 for all p, w and g(p , w ) = 0. The FOCs for a minimum then imply that g(p , w ) p g(p , w ) wi We obtain the results. Exercise 3.4.1 Verify properties 1, 2, and 3 in Theorem 3.4.1. = = (p , w ) y = 0 and p (p , w ) + x = 0 i = 1, . . . , n. i wi

3.4.1

More about Prot Maximization

Theorem 3.4.2 Let (p, w) be a twice continuously dierentiable prot function for some competitive rm. Then, for all p > 0 and w 0 where it is well dened: 1. Homogeneity of degree zero: y(p, w) = y(p, w) > 0, xi (p, w) = xi (p, w) > 0 and i = 1, . . . , n.

48

CHAPTER 3. PRODUCTION 2. (Law of Supply) Own-price eects: y(p, w) p xi (p, w) wi 0, 0 i = 1, . . . , n.

3. The (n + 1) (n + 1) substitution matrix (p,w) (p,w) y(p,w) (p,w) 2 w1 p wn p p xp (p,w) (p,w) (p,w) (p,w) wn w1 1p 2 pw1 w1 = . . . . .. . . . . . . . . . xn (p,w) (p,w) (p,w) (p,w) p pwn w1 wn w 2
n

y(p,w) w1 1 (p,w) xw1

.. .

. . .

y(p,w) wn 1 (p,w) xwn

. . .

n (p,w) xw1

n (p,w) xwn

is symmetric and positive semidenite. Theorem 3.4.3 Let the production function be f (x, x), where x is a subvector of variable inputs and x is a subvector of xed inputs. Let w and w be the associated input prices for variable and xed inputs, respectively. The short-run prot function is dened as (p, w, w, x) max py w x w x subject to f (x, x) y.
y,x

The solutions y(p, w, w, x) and x(p, w, w, x) are called the short-run output supply and variable input demand functions, respectively. Exercise 3.4.2 Consider the following short-run prot maximization problem: max py w1 x1 w2 x2 subject to x x1 y, 1 2
y,x1

where 0 < < 1. Assume an interior solution to the short-run PMP. Answer the following questions: 1. Derive the short-run output supply and variable input demand. 2. Derive the short-run prot function. 3. Conrm Hotellings lemma. 4. Show that the short-run prot function is convex in (p, w1 ).

49

CHAPTER 3. PRODUCTION

3.5
3.5.1

Appendix
More on Homothetic Functions

Here, I shall follow Homothetic functions revisited, by P.O. Lindberg, E. Anders Eriksson, and Lars-Goran Mattsson (henceforth, LEM), in Economic Theory, 2002, vol. 19, 417-427. This paper examines the proposition that homotheticity is equivalent to the property that the marginal rate of substitution is constant along any ray from the origin. This claim is made in many places, but hitherto the prerequisites have not been stated explicitly. Thus, they show that an additional condition (called nowhere ray constancy) is required for the claim to hold. It turns out that this condition is implied by assumptions often made in production theory. The standard denition of homotheticity is that the real-valued function f is homothetic if f (x) = h(g(x)) () where g is homogeneous of degree one and h is strictly increasing. The economic rationale behind homotheticity is that it is sucient for marginal rates of substitution to be constant along rays, viz. fi (x) fi (x) = , i = j and > 0. (2) fj (x) fj (x) Many authors seem to believe that homotheticity is also necessary for Equation (2). It is easy to see, however, that (2) also holds for f homogeneous of degree zero, e.g., f (x) = x1 /x2 for x R2 . This function is not representable in the form ++ of Equation (). x The ray through x = 0 is dened by {x Rn |x = , > 0}. A union of a set of rays (possibly with addition of the origin) is termed a cone. Assume that (2) to be valid for some function f on a cone C in Rn . If fi (x) = 0, we must have fi (x) = 0 for all > 0. For all i with fi (x) = 0, on the other hand, () can be rewritten in the form fj (x) fi (x) = = k(, x). fi (x) fj (x) Combining these two cases, we have f (x) = k(, x)f (x), (3) i.e., the gradient at x is parallel to that at x. We will say that a function f satisfying (3) for all nonzero x C and > 0, has ray parallel gradients. Note that using condition (3) rather than (2) we can drop the requirement that f (x) = 0. If equation (3) holds, then f ( ) = 0 implies f ( ) = 0 for all > 0. We also x x need some topological concepts. A set C is termed weakly solid if its interior, IntC,

50

CHAPTER 3. PRODUCTION is connected and contains C in its closure. Connected open cones such as Rn \0, and convex cones with nonempty interior, such as Rn are weakly solid. + We say that a function f is ray constant at x if f ( ) = f ( ) for all > 0. x x Further, we say that f is nowhere ray constant on a cone C in Rn if for all x C with x = 0, there is > 0 such that f (x) = f (x). The set C\0 is denoted by C0 . Theorem 3.5.1 (LEM (2002)) Let the continuous function f be dened on a weakly solid cone C in Rn , and continuously dierentiable on IntC0 . Suppose that f is nowhere ray constant. Then f is homothetic if and only if it has ray parallel gradients on IntC0 . I can restate the condition of nowhere ray constancy into a more technical one which is more eective in the proofs, viz, the following nonorthogonality condition: f (x) x = 0 x = 0 (4) The following lemma shows that this condition in our setting is equivalent to the condition of nowhere ray constancy. Lemma 3.5.1 (LEM (2002)) Let the continuously dierentiable function f be dened on a cone K in Rn . If f fullls the nonorthogonality condition (4), then it is nowhere ray constant. If moreover f has ray parallel gradients on K, then also the reverse implication holds. A set D in Rn is called locally connected if for each x D (where D stands for the closure of D) and every > 0, there is an open neighborhood O of x + B (where B is the open unit ball) such that O D is connected. In our situation with a function f dened on a cone C, let CE = {x C|f (x) = f (x) > 0} and CN E = C\CE . Note that CE and hence CN E are cones. Moreover, 0 CE and hence CN E C0 . It turns out that CE is closed in C. When f is dierentiable at x, then x CE implies f (x) x = 0. Theorem 3.5.2 (LEM (2002)) Let the continuous function f be dened on a weakly solid cone C in Rn , and continuously dierentiable on IntC0 . Suppose that IntC0 is locally connected and that f has ray parallel gradients on IntC0 . Then 1. on CE , f is ray constant, and 2. CN E decomposes into a denumerable disjoint union CN E = i Ci of cones Ci , closed in CN E , such that f has a homothetic representation f (x) = hi (gi (x)) on each Ci .

51

Chapter 4

Partial Equilibrium
4.1 Price and Individual Welfare

In this note, I consider an entire economy in which consumers and rms interact through perfectly competitive markets. The approach I take here is somewhat restrictive. It is called the partial equilibrium approach, which envisions the market for a single good for which each consumers expenditure constitutes only a small fraction of his overall budget. When this is the case, it is reasonable to assume that changes in the market for this good will leave the prices of all other commodities approximately unaected and that there will be, in addition, negligible income eects in the market under investigation. If the price of the good q is p, and the vector of all other prices is p, then I shall simply write the consumers indirect utility function as v(p, y). Then, it will be convenient to introduce a composite commodity, m, as the amount of income spent on all goods other than the current good q. The consumers optimization problem is given as follows: max u(q, m) subject to pq + m y,
q,m

and the maximized value of u is v(p, y). It is often the case that the eect of a new policy essentially reduces to a change in prices that consumers face. Taxes and subsidies are obvious examples. Consider a particular consumer whose income is y 0 . Suppose that the initial price of the good is p0 and that it will fall to p1 . Let v(p0 , y 0 ) the consumers utility before the price fall and v(p1 , y 0 ) his utility after the price falls. Letting CV denote this change in the consumers income that would leave him as well o after the price falls as he was before, we have v(p1 , y 0 + CV ) = v(p0 , y 0 ).

52

CHAPTER 4. PARTIAL EQUILIBRIUM This change in income, CV , required to keep a consumers utility constant as a result of a price change, is called the compensating variation. Using the dual relation between indirect utility and expenditure function, I have e(p1 , v(p0 , y 0 )) = e p1 , v(p1 , y 0 + CV ) = y 0 + CV. Because I know that y 0 = e(p0 , v(p0 , y 0 )), I have CV = e(p1 , v 0 ) e(p0 , v 0 ), where I let v 0 v(p0 , y 0 ). By Shephards lemma, we obtain the following: CV = e(p1 , v 0 ) e(p0 , v 0 )
p1

= =

p0 p1 p0

e(p, v 0 ) dp p q h (p, v 0 )dp.

The compensating variation makes good sense as a dollar-denominated measure of the welfare impact a price change will have. Unfortunately, CV will always be the area to the left of some Hicksian demand curve, which is unobservable from economists point of view. Despite this, I can still take advantage of the relation between Hicksian and Marshallian demands expressed by the Slutsky equation to obtain an estimate of CV . The two demands generally diverge, and diverge precisely because of the income eect of a price change. Recall that at the price-income pair (p0 , y 0 ), consumer surplus, CS(p0 , y 0 ), is simply the area under the Marshallian demand curve (given y 0 ) and above the price, p0 . The gain in consumer surplus due to the price fall from p0 to p1 is CS CS(p , y ) CS(p , y ) =
1 0 0 0 p1 p0

q(p, y 0 )dp.

We now turn to producer surplus, which is simply the rms revenue over and above its variable costs. Dene p() as the inverse demand. We express the sum of

53

CHAPTER 4. PARTIAL EQUILIBRIUM consumer surplus and producer surplus as


q

TS Total Surplus

= CS + P S =
0 q

p()d p(q)q +

[p(q)q T V C(q)]
(Revenue

Total Variable Cost)

=
0 q

p()d T V C(q) p() M C()

d.

=
0

Marginal Cost

4.2

Quasi-Linear Preference

To ll the gap between compensating variation (CV ) and consumer surplus (CS), we focus on the following special form of preferences: Denition 4.2.1 The preference relation with respect to commodity 1 if
n1 on (, ) R+ is quasi-linear

1. If x y, then (x + e1 ) (y + e1 ) for e1 = (1, 0, . . . , 0) and any R. 2. x + e1 x for all x and all > 0.

The quasi-linear preference of the consumer is represented by u(q, m) = (q) + m. where () is twice continuously dierentiable, with (q) > 0 and (q) < 0 at all q 0. The form of quasi-linearity implies that there is no income eects for the commodity we are concerned with. Therefore, there is no dierence between the Marshallian demand curve and Hicksian demand curve for the commodity. The quasi-linear preference of consumer i is represented by ui (q, m) = i (q) + m. Consider the marginal rate of substitution for the good q over m. M RSqm = u(q, m)/q = i (q) u(q, m)/m

This implies that the demand for the good q does not depend upon m. Hence, as long as we are concerned only with good q, we can focus only on this good q market.

54

CHAPTER 4. PARTIAL EQUILIBRIUM

4.3

Pareto Eciency

When it is possible to make someone better o and no one worse o, we say that a Pareto improvement can be made. If there is no way at all to make a Pareto improvement, then we say that the situation is Pareto ecient (optimal). If monetary transfer is possible across individuals (i.e., each individual has a quasi-liner utility function), the situation is Pareto ecient if and only if the total surplus is maximized.

4.4

The Prot Maximization Problem Revisited


max py c(y) = y [p c(y)/y] = y [p AC(y)] ,
y

Consider the competitive rm who must choose output y so as to solve

where AC(y) stands for the average cost when the rm produces output y. Now, we have a familiar formula: p = AC if and only if the rm makes zero prot. The FOCs and second-order conditions (SOCs) for an interior solutions are p = c (y ) and c (y ) 0. The supply function gives the prot-maximizing output at each price. Therefore, the supply function y(p) satises the FOCs: p c (y(p)), and the SOC c (y(p)) 0. Let us write the cost function as c(y) = cv (y) + F , so that total cost (T C) are expressed as the sum of variable costs (V C) and xed costs (F C). We assume that the xed cost must be paid even if output is zero. Then, the rm will nd it protable to produce a positive level of output when the prots from doing so exceed the prots from producing zero: py(p) cv (y(p)) F F

py(p) cv (y(p)) 0 y(p) [p cv (y(p))/y] 0 y(p) [p AV C(y(p))] 0, where AV C(y) stands for the average variable cost when the rm produces output y. Example: Let c(y) = ay 2 + by + c be the cost function, where a, b, and c > 0. We calculate the following: 55

CHAPTER 4. PARTIAL EQUILIBRIUM M C(y) = c (y) = 2ay + b, AC(y) = c(y)/y = ay + b + c/y V C(y) = ay 2 + by AV C(y) = ay + b We can derive the supply function as the expression that p = M C(y) = 2ay + b: pb if p b, 2a y = 0 if p < b. y = Note that b = AV C(0). Consider the following relation between M C and V C. V C(y) = ay 2 + by = a2 + b y y
y 0 y y

=
0

(2a + b) d = y y
0

M C()d. y y

4.5

The Market Supply Function

If q j (p) is the supply function for rm j in a market for the commodity q with J rms, the market supply function is given by
J

q (p)
s j=1

q j (p, w)

When we do partial equilibrium analysis for the good q, we ignore the dependence of the supply upon input prices, or we consider the case in which the input prices are xed throughout our exercise.

4.6

The Market Demand Function

If q i (p, p, y i ) is consumer is demand for the good q as a function of its own price, p, and prices, p, for all other goods, the market demand function is given by
I

q d (p)
i=1

q i (p, p, y i ).

When we do partial equilibrium analysis for good q, we ignore the dependence of the demand upon all other prices, or we consider the case in which the eects of all other prices are negligible for the good q. For example, this is indeed the case if each consumer has a quasi-linear preference over good q and the composite good m.

56

CHAPTER 4. PARTIAL EQUILIBRIUM

4.7

Market Equilibrium

An equilibrium price is a price where the amount demanded equals the amount supplied. If we let q i (p) be the demand function of consumer i and y j (p) be the supply function of rm j, then an equilibrium price is simply a solution to the equation
I J

q i (p) =
i=1 j=1

q j (p).

57

Chapter 5

General Equilibrium
5.1 Introduction

It is time to bring building blocks all together and to ask if there is any coherent state of aairs (namely, general equilibrium) in which each individual optimizes his objective subject to his constraint and all markets clear. We start our discussion with the following quotation from The Wealth of Nations, by Adam Smith. He (each individual) generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand (emphasis supplied) to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more eectually than when he really intends to promote it. Economists came up with the two concepts, the competitive market and Pareto eciency in order to articulate what Adam Smith meant and to what extent he was right. 1 The strategy we adopt in the section of general equilibrium is as follows: First, we consider an exchange economy (i.e., no production at all) and derive all the conclusions. Second, we will argue how we can introduce production into the economy and argue how to extend all our conclusions to production economies. This second part is going to be as brief as our discussion of production was quick compared to the consumer theory.
Surprisingly, at least to me, Adam Smith mentioned the invisible hand only once in his gigantic book.
1

58

CHAPTER 5. GENERAL EQUILIBRIUM

5.2

Exchange Economy
I = {1, . . . , I}

Consider now the case of many consumers and many goods. Let

index the set of consumers, and suppose there are n goods. Each consumer i I has a preference relation, i , and is endowed with a nonnegative vector of the n goods, i , ei denes an exchange ei = (ei , . . . , ei ). Altogether, the collection E = n 1 iI economy. Let e (e1 , . . . , eI ) denote the economys endowment vector, and dene an allocation as a vector x (x1 , . . . , xI ), where xi (xi , . . . , xi ) denotes consumer is bundle according to the allocation. n 1 The set of feasible allocations in this economy is given by F (e) x RnI +
iI

xi
iI

ei

Denition 5.2.1 A feasible allocation, x F (e), is Pareto ecient if there is no other feasible allocation, y F (e), such that y i xi for each consumer i I, with at least one preference strict. So, an allocation is Pareto ecient if it is not possible to make someone strictly better o without making someone else strictly worse o. Denition 5.2.2 Let S I denote a coalition of consumers. We say that S blocks x F (e) if there is an allocation y such that: 1. 2. y i
iS i

yi

iS

ei .

xi for all i S, with at least one preference strict.

Consider the following scenario: All members of the economy agreed to hire one mediator. The jobs of the mediator are threefold. (1) the mediator must propose an allocation to the consumers until all consumers unanimously agree to it; (2) The mediator must give up his original proposal and makes a new proposal to the consumer as long as a group of consumers makes a justiable objection to the original proposal; and (3) the mediator implements a given allocation if the allocation is unanimously agreed. We say that a group of consumers S makes a justiable objection to a given allocation x if S blocks x in the sense of the above denition. We say that a given allocation is unanimously agreed if there is no group of consumers which makes a justiable objection to it. 59

CHAPTER 5. GENERAL EQUILIBRIUM Denition 5.2.3 The core of an exchange economy with endowment e, denoted Core(e), is the set of all unblocked feasible allocations.

5.3

Equilibrium in Competitive Market Systems

In a perfectly competitive market system, all transactions between individuals are mediated by impersonal markets. By impersonal I mean that the market treats every individual anonymously. The market does not care about who you are. It cares only about whether you are willing to buy or sell the good at the prevailing price. Assumption 5.3.1 For each i I, utility function ui is continuous, strongly increasing, and strictly quasi-concave on Rn . 2 + On competitive markets, every consumer takes prices as given (remember the price taking behavior assumption), whether acting as a buyer or a seller. If p 0 is the vector of market prices, then each consumer solves (p1 , . . . , pn )
xi

max ui (xi ) subject to p xi p ei . n


+

Theorem 5.3.1 If ui () is continuous, strongly increasing, and strictly quasi-concave, then for each p 0, the consumers optimization problem has a unique solution xi (p, p ei ). In addition, xi (p, p ei ) is continuous in p Rn . ++ The proof of Theorem 5.3.1 is obtained by appealing to Theorem 2.4.2 and Lemma 2.4.2. Denition 5.3.1 The aggregate excess demand function for good k is the real valued function, zk (p)
iI

xi (p, p ei ) k
iI

ei . k

The aggregate excess demand function is the vector-valued function z(p) (z1 (p), . . . , zn (p)) . When zk (p) > 0, there is excess demand for good k. When zk (p) < 0, there is excess supply of good k. Theorem 5.3.2 Suppose that for each consumer i I, ui () is continuous, strongly 0, the aggregate increasing, and strictly quasi-concave on Rn . Then, for all p + n Rn has the following three properties: demand function z : R
2 i

u is strongly increasing if u(x ) > u(x) whenever x x and x = x.

60

CHAPTER 5. GENERAL EQUILIBRIUM 1. Continuity: z() is continuous at p. 2. Homogeneity: z(p) = z(p) for all > 0. 3. Walras law: p z(p) = 0. Proof of Theorem 5.3.2: (Continuity): This comes from the fact that the sum of continuous functions is continuous. (Homogeneity): It follows that each individual demand function is homogeneous of degree zero in (p, y). Here, note that for each consumer i I, y = p ei means that y = (p) ei . (Walras law): Since ui () is strongly increasing, each individual demand satises Walras law, i.e., pxi (p, y i ) = y i , where y i = pei . We do the following computation:
n

p z(p) =
iI k=1 n

pk xi (p, pei ) ei k k pk xi (p, pei ) pk ei k k


iI k=1

= =
iI

p xi (p, pei ) p ei p xi (p, y i ) y i


iI

( y i = pei )

= 0 ( pxi (p, y i ) = y i i I) Consider a market system described by some excess demand function z(). If, at some prices p, we had z(p) = 0, or demand equal to supply in every market, then we would say that the system of markets is in general equilibrium. Denition 5.3.2 A vector p Rn is said to be a Walrasian equilibrium price ++ vector if z(p ) = 0. Denition 5.3.3 Let p Rn be a Walrasian equilibrium price vector. Dene ++ x = (xi )iI ei + z i (p) iI , where z i () is the excess demand function for consumer i I. Then, x is said to be a Walrasain allocation.

5.4

Existence of Walrasian Equilibrium

Consider the following scenario. This is sometimes called the verication scenario. There is an auctioneer in this economy. The auctioneer is an omniscient oracle. So, he knows everything. By everything I mean everything. What the auctioneer wants is to implement a Walrasian allocation. Even if the auctioneer is an oracle and therefore, he knows what is a Walrasian allocation, he has to verify it to all the members of the economy who are ignorant about the economy but sophisticated enough to solve the constrained optimization problem. Then, the auctioneer proposes 61

CHAPTER 5. GENERAL EQUILIBRIUM the following communication protocol to nd a Walrasian equilibrium price vector p so that all the members of the economy will be convinced that the nal allocation generated by the protocol is indeed Walrasian. Dene
n

Rn +
i=1

pi = 1 .

Dene also a mapping f : with the property that for any p , f (p) = arg max pz(p).
p

The communication protocol I describe here is a game between an auctioneer and all the members of the economy. The game is played alternatively between the auctioneer and the consumers as follows: First, the auctioneer announces some p. Given this p, the consumers announce z(p). 3 Given this z(p), the auctioneer announces p such that p = arg maxp pz(p). Given this p , the consumers announce z(p ). Given this z(p ), the auctioneer announces p such that p = arg maxp pz(p ). And so on so forth. Therefore, the communication between them is described as a sequence of prices {pk } with the property that pk+1 = f (pk ) for each k 1. This k=1 communication stops if there is a p such that p = f (). Here, p is called a xed point p of f (). The above communication protocol is the one proposed by the auctioneer to verify to the consumers that it yields a Walrasian allocation. To complete this verication process, the auctioneer must show the two more things: (1) There exists a xed point of f (); and (2) the xed point p is a Walrasian equilibrium price. The rst part is easy to establish. Since is a compact set and f () is continuous (because z() is continuous), we know that f () is also compact. That is, for any sequence {pk } generated by f (), there exists a subsequence {pkm } which m=1 converges to p . This p is a xed point of f (). The second part entails more subtle issues. Dene {p | pi > 0 i = 1, . . . , n} . By construction is a compact set. 4 Note also that as 0. Suppose that there exists > 0 small enough so that the xed point p . Then, we must n . I claim the following. have that p R++
This simply means that each consumer announces his demand after solving the UMP under p. So, this is a sense in which each consumer cares only about himself. Remember the comments by Adam Smith. 4 Those who are concerned with this compactness should pay attention to the following mathematical result: Any closed subset of a compact set is compact. Why is it closed? You should be able to prove it yourself.
3

62

CHAPTER 5. GENERAL EQUILIBRIUM Claim 5.4.1 Suppose that p Rn is a xed point of f (). Then, z() = 0. p ++ Proof of Claim 5.4.1: Suppose not, that is, z() = 0. By Walras law, pz() = p p p p 0. Then, there must exist two commodities i and j such that zi () > 0 and zj () < 0. j Let p = p with the property that p = pi + pj , p = 0, and p = pk for any k = i, j. i k Thus, we have p p p z() > p z() = 0, which contradicts the hypothesis that p is a xed point of f (). This claim shows that if a xed point belongs to the interior of , i.e., p , it corresponds to a Walrasian equilibrium price vector, as well. However, there is one more problem. We really do not know a priori whether or not the xed point belongs to the interior of . All we know is that p . The nal question we are concerned with is to ask under what conditions the xed point cannot be on the boundary of , i.e., we want to avoid the case in which p for any > 0. Let / be the boundary of . I claim the following: Claim 5.4.2 Let p be a xed point of f (). Assume that if pm p as m , then there exists a commodity k such that zk (pm ) as m . Then, there exists > 0 such that p . Proof of Claim 5.4.2: Assume that p . Let
k

p = (0, . . . , 0, 1 , 0, . . . , 0).
1,... ,k1 k+1,... ,n

p Since zk () = by our assumption, we have p p p z() = = arg max pz().


p

Since p is a xed point, we must have pz() = , which contradicts Walras law. p Thus, p . There is no xed points on the boundary of . By taking > 0 / small enough, we can always make sure that p . Claim 5.4.2 shows that under the assumption described above, a xed point p of f () belongs to the interior of . Combining Claim 1 and 2 together, we have the following corollary. Corollary 5.4.1 Let p be a xed point of f (). Assume that if pm p as m , then there exists a commodity k such that zk (pm ) as m . Then, z() = 0. p

63

CHAPTER 5. GENERAL EQUILIBRIUM This corollary says that any xed point p generated by the communication pro tocol corresponds to a Walrasian equilibrium price vector. So, the auctioneer indeed veried to the consumers that the communication protocol guarantees a Walrasian allocation. We should, however, be worried about how to justify the assumption to rule out the possibility that p . For this, we need strong increasingness of utility function. 0. 5 Suppose that each consumer is utility Theorem 5.4.1 Assume that iI ei function is continuous, strictly quasi-concave, and strongly increasing. If pm p as m , then there exists a commodity k such that zk (pm ) as m . Proof of Theorem 5.4.1: Consider a sequence of price vectors {pm } conm=1 0 for each m and pk = 0 for some commodity k. verging to p = 0 such that pm 0, we must have p iI ei > 0. This implies that iI pei > 0. Because iI ei Therefore, there must exist at least one consumer i I for whom pei > 0. This means that consumer is demand behaves continuously when pm p as m . 6 Let z i (pm ) be the excess demand of consumer i at pm . Since ui () is strongly increasing, Walras law follows, and therefore we have for each m, pm z i (pm ) = 0. Dene xi (pm ) = ei + z i (pm ) as consumer is demand at pm . Dene also
k

k = (0, . . . , 0, , 0, . . . , 0).
1,... ,k1 k+1,... ,n

Let xi (pm ) = xi (pm ) + k . By construction, we have xi (p) xi (p) for any p. If p xi () = xi (), the strong increasingness of ui () concludes that p x p p ui (i ()) > ui (xi ()). p However, this contradicts the fact that xi () is the solution to the UMP. The only way to avoid this contradiction is to have xi () = . Since xi () is continuous k p provided that p 0 and y i > 0 (his income is positive). Thus, we must have xi (pm ) as m . Since 0 < pei < (i.e., consumer is income is bounded), k i (pm ) . As a result, we have z (pm ) . this implies zk k Combining Corollary 1 and Theorem 1 together, I have the following corollary which guarantees the existence of Walrasian equilibrium. Corollary 5.4.2 (Existence of Walrasian Equilibrium) Assume that iI ei 0. Suppose that each consumer is utility function is continuous, strictly quasiconcave, and strongly increasing. Then, there exists at least one Walrasian equilibrium.
This assumption is innocuous. If it is not satised for some commodity i, then we should exclude the commodity i from the beginning of analysis. 6 See Lemma 2.4.2 for this fact.
5

64

CHAPTER 5. GENERAL EQUILIBRIUM

5.5

Regular Economies and Local Uniqueness

Because we can only hope to determine relative prices, we normalize pn = 1 and denote by z (p) = (z1 (p), . . . , zn1 (p)) the vector of excess demands for the rst n 1 goods. A normalized price vector p = (p1 , . . . , pn1 , 1) constitutes a Walrasian equilibrium if and ony if it solves the system of n 1 equations in n 1 unknowns: z (p) = 0. Denition 5.5.1 An equilibrium price vector p = (p1 , . . . , pn1 ) is regular if the (n 1) (n 1) matrix of price eects D(p) is nonsingular, that is, has rank n 1. z If every normalized equilibrium price vector is regular, we say that the economy is regular. Proposition 5.5.1 Any regular (normalized) equilibrium price vector (p1 , . . . , pn1 , 1) is locally unique (locally isolated). That is, there is an > 0 such that if p = p, pn = pn = 1, and p p < , then z(p ) = 0. Moreover, if the economy is regular, then, the number of normalized equilibrium price vector is nite. Denition 5.5.2 Suppose that p = (p1 , . . . , pn1 , 1) is a regular equilibrium of the economy. Then, we denote z index p = (1)n1 sign |D(p)|, where |D(p)| is the determinant of the (n 1) (n 1) matrix D(p). z z If n = 2, then |D(p)| is merely the slope of z1 () at p. Hence, we see that for this z case, the index is +1 or 1 according to whether the slope is negative or positive. A regular economy has a nite number of equilibria. Therefore, for a regular economy, the expression index p
{p| z(p)=0, pn =1}

makes sense. The next proposition (the index theorem) says that the value of this expression is always equal to +1. Proposition 5.5.2 (The Index Theorem) For any regular economy, we have index p = +1
{p| z(p)=0, pn =1}

65

CHAPTER 5. GENERAL EQUILIBRIUM Note rst that the number of equilibria of a regular economy is odd. In particular, this number cannot be zero; so the existence of at least one equilibrium in a regular economy is a particular case of the above proposition. Second, the index concept provides a classication of equilibria into two types: the type with positive index is more fundamental because the presence of at least one equilibrium of positive type is unavoidable. I next proceed to argue that typically (or, in the usual jargon, generically), economies are regular. Hence, generically, the solutions to the excess demand equations are locally isolated and nite in number, and the index formula holds. The essence of genericity analysis rests on counting equations and unknowns. Suppose we have a system of M equations in N unknowns: f1 (v1 , . . . , vN ) = 0, . . . fM (v1 , . . . , vN ) = 0, or, more compactly, f (v) = 0. The normal situation should be one in which, with N unknowns and M equations, we have N M degrees of freedom available for the description of the solution set. In particular, if M > N , the system should be over-determined and have no solution; if M = N , the system should be exactly determined with the solutions locally isolated; and if M < N , the system should be under-determined and the solutions not locally isolated. Denition 5.5.3 The system of M equations in N unknowns f (v) = 0 is regular if rank Df (v) = M whenever f (v) = 0. For a regular system, the implicit function theorem yields the existence of the right number of degrees of freedom. If M < N , we can choose M variables corresponding to M linearly independent columns of Df (v) and we can express the values of these M variables that solve the M equations f (v) = 0 as a function of the N M remaining variables. 7 If M = N , equilibria must be locally isolated for the same reasons. And if M > N , then rank Df (v) N < M for all v; in this case, the above denition simply says that the equation system f (v) = 0 is regular if and only if the system admits no solution. It remains to be argued that the regular case is the normal one. Suppose there are some parameters q = (q1 , . . . , qS ) such that, for every q, I have a system of equations f (v; q) = 0 as above. The set of possible parameter values is RS (or an open subset of RS ). I can then justiably say that f (; q ) is a perturbation of f (; q) if q is close to q. Hence, the notion that the regularity of a system f (; q) = 0 is typical,
7

See my lecture note on Mathematics for the detail.

66

CHAPTER 5. GENERAL EQUILIBRIUM or generic, could be captured by demanding that for almost every q, f (; q) = 0 be regular. In other words, nonregular systems have probability zero of occurring. Proposition 5.5.3 (The Transversality Theorem) If the M (N + S) matrix Df (v; q) has rank M whenever f (v; q) = 0, then, for almost every q, the M N matrix Dv f (v; q) has rank M whenever f (v; q) = 0. If Df (v; q) has rank M whenever f (v; q) = 0, then from any solution, it is always possible to (dierentially) alter the values of the function f in any prescribed direction by adjusting the v and q variables. The conclusion of the theorem is that, if this can always be done, then whenever we are initially at a nonregular situation, an arbitrary random displacement in q breaks us away from nonregularity. Let me now specialize our discussion to the case of a system of n 1 excess demand equations in n 1 unknowns, z (p) = 0. A natural set of parameters is the initial endowments: e = (e1 , . . . , e1 , . . . , eI , . . . , eI ) RnI . 1 n 1 n ++ I can write the dependence of the economys excess demand function on endowments explicitly as z (p; e). I then have the following proposition. Proposition 5.5.4 For any p and e, rank De z (p; e) = n 1. I skip the proof. I am now ready to state the main result of this section due to Debreu (1970). Proposition 5.5.5 (Debreu (1970)) For almost every vector of initial endowments (e1 , . . . , eI ) RnI , the economy dened by ( i , ei )iI is regular. ++ Corollary 5.5.1 The set of Walrasian equilibrium prices is locally unique for almost every economy E = (ui , ei )iN . Moreover, the number of Walrasian equilibrium prices is nite, most of the time.

5.6

Anything Goes: The Sonnenschein-Mantel-Debreu Theorem

Theorem 5.6.1 (Sonnenschein (73), Mantel (74), Debreu (74), and Mantel (76)) Suppose that z() is a continuous function dened on P = p Rn | pi /pj i, j + and with values in Rn . Assume that, in addition, z() is homogeneous of degree zero and satises Walrass law. Then, there is an economy of n consumers whose aggregate excess demand function coincides with z(p) in the domain P . 67

CHAPTER 5. GENERAL EQUILIBRIUM I skip the proof of Theorem 5.6.1 because it is extremely tedious. Interested readers should refer to Proposition 17.E.3 in MWG in pp. 602-603 for the proof when the number of commodities is 2 (n = 2). The question was posed by Sonnenschein (1973). He conjectured that the answer was that, indeed, on the domain where pi for all i, the three properties were not only necessary but also sucient; that is, we could always such an economy. He also proved that this is so for the twocommodity case. The problem was then solved by Mantel (1974) for any number of commodities. Mantel made use of 2n consumers. Shortly afterwards, Debreu (1974) gave a dierent and very simple proof requiring the indispensable minimum of n consumers. This was topped by Mantel (1976), who rened his earlier proof to show that n homothetic consumers (with no restrictions in their initial endowments) would do. The Sonnenschein-Mantel-Debreu theorem implied that the aggregate excess demand function as a function of prices only has no structure. The situation is quite dierent when one explicitly assumes the distribution of endowments in the economy. Proposition 5.6.1 (Brown and Matzkin (1996)) There are prices and individual endowments (p, (ei )iI ) and (q, (f i )iI ) such that it is impossible that p is a Walrasian equilibrium price vector for the economy (ui , ei )iI and q is a Walrasian equilibrium price vector for the economy (ui , f i )iI . This theorem is remarkable because it provides a very simple way to show that not anything goes in general equilibrium theory.

5.7
5.7.1

Properties of the Set of Walrasian Allocations


The Edgeworth Box Diagram

Suppose that there are only two consumers in this society, consumer 1 and consumer 2, and only two goods, x1 and x2 . Let e1 (e1 , e1 ) denote the nonnegative endow1 2 ment of the two goods owned by consumer 1, and e2 (e2 , e2 ) the endowment of 1 2 consumer 2. The total amount of each good available in this society then can be summarized by the vector e1 + e2 = (e1 + e2 , e1 + e2 ). 1 1 2 2 In the gure, units of x1 are measured along each horizontal side and units of x2 along each vertical side. The southwest corner is consumer 1s origin and the northeast corner consumer 2s origin. Increasing amounts of x1 for consumer 1 are measured rightward from O1 along the bottom side, and increasing amounts of x1 for consumer 2 are measured leftward from O2 along the top side. Similarly, x2 for consumer 1 is measured vertically up from O1 on the left, and for consumer 2, vertically down on the right. The Edgeworth box is constructed so that its width measured the total endowment of x1 and its height the total endowment of x2 .

68

CHAPTER 5. GENERAL EQUILIBRIUM x2 1 (x1 , x2 ) e2 1 O2

e1 2 x1 2

e2 2

x2 2

e1 2

(e1 , e2 )

e2 2

O1

x1 1 Figure 5.1: The Edgeworth Box

e1 1

e1 + e2 1 1

Notice that each point in the Edgeworth box has four coordinates - two indicating some amount of each good for consumer 1 and two indicating some amount of each good for consumer 2. Because the dimensions of the box are xed by the total endowments, each set of four coordinates represents some division of the total amount of each good between the two consumers. Every possible allocation of the totals between the consumers is represented by some point in the box. The Edgeworth box therefore provides a complete picture of every feasible distribution of existing commodities between consumers.

5.7.2

Core of an Economy and the First Welfare Theorem

Lemma 5.7.1 Suppose that ui () is increasing on Rn . Let xi Rn be consumer is + + demand (i.e., the solution to the UMP) at p 0. Then, for any xi Rn , we have + the following: x x 1. ui (xi ) > ui (i ) pxi > pi : x x 2. ui (xi ) ui (i ) pxi pi : any strictly better bundle cannot be aordable. any weakly better bundle cannot be cheaper.

I leave the proof of this lemma as an exercise. Exercise 5.7.1 Show Lemma 5.6.1. 69

CHAPTER 5. GENERAL EQUILIBRIUM Theorem 5.7.1 Consider an exchange economy (ui , ei )iI . If each consumer is utility function ui () is increasing on Rn , then every Walrasian allocation is in the + core. Proof of Theorem 5.6.2: Let x(p ) be a Walrasain allocation associated with the Walrasian equilibrium price vector p . Suppose, on the contrary, that x(p ) is not in the core. Then, we can nd a coalition S and another allocation y such that yi =
iS i i

ei
iS i i

u (y ) u (x (p , p ei )) i S, with at least one strict inequality. The feasibility of (y)iS within S described above implies p
iS

y i = p
iS

ei ()

By Lemma 5.6.1, we conclude that for each i S, p y i p xi (p , p ei ) = p ei , with at least one inequality strict. Summing over all consumers in S, we obtain p
iS

y i > p
iS

ei ,

which contradicts (). Note that all core allocations are indeed Pareto ecient. Hence, we have the immediate corollary below. This is called the First Welfare Theorem (FWT). For competitive market economies, it provides a formal and very general conrmation of Adam Smiths asserted invisible hand property of the market. Corollary 5.7.1 (The First Welfare Theorem) Consider an exchange economy (ui , ei )iI . If each consumer is utility function ui () is increasing on Rn , then every + Walrasian allocation is Pareto ecient. Proof of Corollary 5.6.1: It directly follows from the previous theorem when we take S as the set of all consumers, I.

5.7.3

The Second Welfare Theorem

The second welfare theorem gives conditions under which any Pareto ecient allocation can be supported as a Walrasian equilibrium with the appropriate income transfers. It is a converse of the rst welfare theorem in some sense. To establish 70

CHAPTER 5. GENERAL EQUILIBRIUM the second welfare theorem, we rely on the following mathematical result with no proof. 8 Theorem 5.7.2 (Separating Hyperplane Theorem) Suppose that the convex sets A, B Rn are disjoint (i.e., A B = ). Then, there is p Rn with p = 0 and a value r R, such that p x r for every x A and p y r for every y B. That is, there is a hyperplane that separates A and B, leaving A and B on dierent sides of it. Now, we are ready to state the second welfare theorem. Theorem 5.7.3 (The Second Welfare Theorem) Consider an exchange econi omy (ui , ei )iI with e = 0. Assume that each ui () is continuous, iI e strictly quasi-concave, and increasing. Then, for any Pareto ecient allocation x = (x1 , . . . , xI ), there are a price vector p = 0 and an assignment of income levels e (y 1 , . . . , y I ) with iI y i = p such that (x1 , . . . , xI ) is equivalent to x1 (p, y 1 ), . . . , xI (p, y I ) which constitutes a Walrasian allocation associated with p, where xi (p, y i ) is consumer is ordinary demand at (p, y i ). Note that continuity and quasi-concavity of utility functions are only needed to guarantee the existence of equilibrium. This point is enlarged in the Appendix. Proof of Theorem 5.7.3: The proof consists of 9 steps. I must admit that it is indeed a long proof. But hang on the chain of the argument. For every consumer i I, we dene the set of consumptions strictly preferred to xi , that is Bi (xi ) = {z i Rn | ui (z i ) > ui (xi )}}. + Dene also, B() = x
iI

Bi (xi ) =

z Rn

z=
iI

z i and z i Bi (xi ) i I

Step 1 through 3 are preliminary lemmas for Step 4. Step 4 is an application of the separating hyperplane theorem. Hence, in Step 4, we have a candidate for a Walrasian equilibrium price vector. Step 5 through 7 are preliminary lemmas for Step 8, where we are able to make sure that the Pareto ecient allocation to which our attention is paid indeed corresponds to each consumers utility maximizing bundle subject to his budget constraint associated with the supporting price vector we found in Step 4. Step 1: Every Bi (xi ) is convex. It follows from the fact that ui () is quasi-concave. Do you see why?
8

See my lecture note on mathematics for the detail.

71

CHAPTER 5. GENERAL EQUILIBRIUM Step 2: B() and {} are convex. x e It follows from the fact that the sum of any two convex sets are convex. I leave this as an exercise. Step 3: B() {} = x e Suppose not, that is, there is z B() {}. Then, there is (z 1 , . . . , z I ) with x e i such that ui (z i ) > ui (xi ) for every i I. Because z {}, this e z = iI z (z 1 , . . . , z I ) is a feasible allocation as well. This contradicts the hypothesis that x is Pareto ecient. Step 4: There is p = (p1 , . . . , pn ) = 0 and a number r such that p z r for every z B() and p z r for every z = e. x This is a direct consequence of the separating hyperplane theorem. Check if we have made enough assumptions to apply the separating hyperplane theorem. Step 5: ui (z i ) ui (xi ) i I = p
iI

z i r.

Let 1 = (1, . . . , 1) Rn . Consider a sequence {k } for which k > 0 for each k=1 k and k 0 as k . Since ui () is increasing, we have, for each i and for each k, ui (z i + k 1) > ui (z i ) ui (xi ). Together with Step 4 this implies that for each i and each k, we have p
iI

zi

+ Ik 1 r.

When k , then Ik 1 0, because of the continuity of the inner product operation (i.e., p x is continuous with respect to x), we have p
iI

zi

r,

as desired. Step 6: p
iI

xi = p e = r.

i r. 9 Since (x1 , . . . , xI ) is a Pareto By step 5, we know that p iI x i ecient allocation and in particular, a feasible allocation, we have iI x e. i () is increasing, we have i = e. 10 This concludes that Because each u iI x xi = p e. From Step 4, this implies that p x r. Therefore, we have p iI i = r. p iI x
9 10

This is because when you replace z i with xi , the identical argument goes through in Step 5. Namely, no resources are wasted.

72

CHAPTER 5. GENERAL EQUILIBRIUM Step 7: ui (z i ) > ui (xi ) = p z i p xi for every i I (any strictly better bundle cannot be cheapter) Consider any z i for which ui (z i ) > ui (xi ). From Step 5 and 6, we have p z i +
k=i

xk r = p xi +
k=i

xk .

Hence, p xi p xi . Step 8: Assume p xi > 0 for each i 11 . Then, ui (z i ) > ui (xi ) p z i > p xi . (any strictly better bundle should be more expensive) From Step 7, we know ui (z i ) > ui (xi ) p z i p xi . Now, what we want to show is that the inequality is strict. Suppose not, that is, there is a bundle z i such that ui (z i ) > ui (xi ) and p z i = p xi > 0. Since p xi > 0 we x can nd a cheaper bundle xi such that p xi < p xi . 12 Dene xi = z i + (1 )i for (0, 1). Since 0 < < 1, we know that p xi < p xi . If we take close enough to 1, because of the continuity of the utility function, we have ui (xi ) > ui (xi ) and p xi < p xi . However, this contradicts our hypothesis supported by Step 7. Step 9: xi = xi (p, y i ) for each i I, where y i = p xi . If we take the contraposition of Step 8, we have x p xi y i = ui (i ) ui (xi ). This means that xi is the solution to the UMP under (p, y i ). Thus, the income levels x y i = p xi for i = 1, . . . , I support (1 , . . . , xn ) as a Walrasian allocation associated with the Walrasian equilibrium price p. We complete the proof.
11 This assumption is not innocuous. But we ignore this point in this course. One sucient 0 for each i I. That is, each consumers demand lies on the interior condition for this is that xi of Rn . + 12 If p xi = 0, you have no way of nding a cheaper bundle so that the rest of the argument does not go through. This is a reason why I need the assumption that p xi > 0 for each i I. However, there is a generalized version of the second welfare theorem which does not require p xi > 0 for each i I. Interested readers should be referred to Chapter 16.D of MWG.

73

CHAPTER 5. GENERAL EQUILIBRIUM

5.8
5.8.1

Walrasian Equilibrium with Production


Producers

We suppose there is a xed number J of rms that we index by the set J = {1, . . . , J}. We now let y j Rn be a production plan for rm j, and observe the convention of j j writing yk < 0 if commodity k is an input used in the production plan and yk > 0 if it is an output produced from the production plan. To summarize the technological possibilities in production, I suppose that rm j possesses a production possibility set, Y j . We make the following assumption throughout this section Assumption [The Individual Firm] 1. 0 Y j Rn . (Possibility of inaction) 2. Y j Rn {0} (No free lunch) + 3. Y j is closed and bounded, i.e., compact. 4. Y j is strongly convex. That is, for all distinct y, y Y j and all (0, 1), y = y + (1 )y Int(Y ). 13 The rst of these guarantees rm prots are bounded from below by zero. The second guarantees that production of output always requires some inputs. The closedness assumption imposes continuity. It says that the limits of possible production plans are themselves possible production plans. The boundedness assumption is particulary strong and more than necessary. But it is going to be very useful for making simple the argument for existence of equilibrium. So, I keep assuming this. 14 Strong convexity rules out constant and increasing returns to scale in production and ensures that the rms prot-maximizing production plan is unique. Each rm faces xed commodity prices p 0 and chooses a production plan to maximize its prot. Thus, each rm solves the problem
y j Y j
13 14

max p y j .

Int(Y ) stands for the interior of Y . Those who are concerned with the restrictiveness of the boundedness assumption should be referred to Chapter 17BB of MWG. The basic idea is as follows. First, we put the bound on both the consumption set and the production set. Accordingly, we can dene the truncated economy. Then, we can establish an existence of equilibrium of the truncated economy. Next, we make the bound unlimited. After this operation, we can make sure that the equilibrium of the truncated economy continues to be an equilibrium of the untruncated economy.

74

CHAPTER 5. GENERAL EQUILIBRIUM Because the objective function is continuous and the constraint set is compact, a maximum of rm prot will exist. So, for all p 0, let j (p) max p y j
y j Y j

denote rm js prot function. By the theorem of maximum, j () is continuous on Rn . + Next I consider aggregate production possibilities economy-wide. I suppose there are no externalities in production between rms, and dene the aggregate production possibility set, n j j j y and y Y j J y= Y yR
jJ

The set Y will inherit all the properties of the individual production sets. The following theorem says that y Y maximizes aggregate prot if and only if it can be decomposed into individual rm prot-maximizing production plans. Theorem 5.8.1 (Aggregate Prot Maximization) For any prices p 0, we have p y p y y Y if and only if there is (1 , . . . , y J ) with the property that y = y for each j J such that p y j p y j y j Y j and j J . We leave the proof of this theorem as an exercise. Check p. 208 in AMT.
jJ

y j and y j Y j

5.8.2

Consumers

In a private ownership economy, which we shall consider here, consumers own shares in rms and rms prots are distributed to shareholders. Consumer is shares in i rm j entitle her to some proportion 0 j 1 of the prots of rm j. Of course, these shares, summed over all consumers in the economy, must sum to 1. Thus,
i 0 j 1 for all i I and for all j J ,

where
i j = 1 j J . iI

In our economy with production and private ownership of rms, a consumers income can arise from two sources - from selling an endowment of commodities 75

CHAPTER 5. GENERAL EQUILIBRIUM already owned, and from shares in the prots of any number of rms. If p 0 is the vector of market prices, one for each commodity, the consumers budget constraint is p xi p ei +
jJ i j j (p).

By letting mi (p) denote the right hand side of the above expression, the consumers problem is summarized as follows:
xi

max ui (xi ) subject to p xi mi (p). n


+

Now, under the assumptions we have made, each rm will earn nonnegative prots because each can always choose the zero production vector. Consequently, mi (p) 0 because p 0 and ei Rn . We denote consumer is demand by xi (p, mi (p)), where + mi (p) is just the consumer is income.

5.8.3

Feasibility and Eciency in Production Economies

An allocation (x, y) = (x1 , . . . , xI ), (y 1 , . . . , y J ) , of bundles to consumers and production plans to rms is feasible if 1. xi Rn for all i I; + 2. y j Y j for all j J ; and 3.
iI

xi =

iI

ei +

jJ

yj .

Denition 5.8.1 The feasible allocation (x, y) is Pareto ecient if there is no x other feasible allocation (, y ) such that ui (i ) ui (xi ) for all i I with at least one x strict inequality.

5.8.4

Equilibrium

Aggregate excess demand for commodity k is zk (p)


iI

xi (p, mi (p)) k
jJ

j yk (p) iI

ei , k

and the aggregate excess demand vector is z(p) (z1 (p), . . . , zn (p)) . As before, a vector p Rn is said to be a Walrasian equilibrium price vector if ++ z(p) = 0.

76

CHAPTER 5. GENERAL EQUILIBRIUM Denition 5.8.2 Let p be a Walrasian equilibrium price vector. Dene x = (xi )iI (ei + z i (p))iI and y = (y j )jJ y j (p), where z i (p) is the excess demand at p for consumer i and y j (p) is the prot maximizing production plan at p for rm j. Then, a prole (p, x, y) is said to be a Walrasian equilibrium. Theorem 5.8.2 (Existence of Walrasian Equilibrium with Production) Consider i the economy (ui , ei , j , Y j )iI, jJ . Suppose that each ui () is continuous, strongly increasing, and strictly quasi-concave. Assume that Y j is compact, strictly convex, and satises possibility of inaction and no free lunch. Assume further that there is 0. Then, there exists an aggregate production plan y Y for which y + iI ei at least one Walrasian equilibrium. Proof of Theorem 5.7.2: Our proof is reduced to checking the following four properties of the aggregate excess demand function. Remember the existence proof in exchange economies. 1. z() is continuous. 2. z(p) = z(p) for any > 0. (Homogeneity of degree zero) 3. p z(p) = 0. (Walras law) 4. If pm p as m , then there is a commodity k such that zk (pm ) as m . 15 I focus only on property 4 here, while I leave the proof for the rest of the properties as an exercise. Consider a sequence of price vectors {pm } with the properties m=1 0 for each m, pm p = 0 as m , and pk = 0. that pm Because y + must have
iI

ei

0 for some aggregate production vector y, and p 0, we

y+
iI

ei

> 0.

Recall also that both mi (p) and j (p) are well dened for all p 0. We do the following computation:
15

stands for the boundary of .

77

CHAPTER 5. GENERAL EQUILIBRIUM

mi (p) =
iI iI

i j j () p jJ

p ei + p ei +
iI jJ

j () p

iI

i j = 1 j J

iI

p ei + p y
jJ

j () p y from Theorem 1 p

= p

y+
iI

ei

> 0 ( p 0 and p = 0). Therefore, there must exist at least one consumer whose income at price vector p p is positive, i.e., mi () > 0. Since ui is strongly increasing, we are able to mimic the argument we made in the existence theorem without production. In eect, consumer is demand for commodity k goes to innity, i.e., xi (pm , mi (pm )) as m . k Because of the compactness of the aggregate set of feasible allocations, we must have zk (pm ) as m .

5.9

Walrasian Allocations in Economies with Production

I consider an economy with I consumers. There is also publicly available constant returns convex technology, Y Rn . The set of feasible allocations in the production economy is given by F (e, Y ) = x RnI +
iI

xi y +
iI

ei for some y Y

Denition 5.9.1 Let S I denote a coalition of consumers. We say that S blocks x F (e, Y ) if there is an allocation x such that 1. 2. xi
iS i

xi = y +

iS

ei for some y Y

xi for all i S, with at least one preference strict.

The above denition says that a coalition S can improve upon a feasible allocation x if there is some way that, by using only their endowments iS ei and the publicly available technology Y , the coalition can produce an aggregate commodity bundle that can then be distributed to the members of S so as to make each of them better o. An allocation x F (e, Y ) is said to be in the core if there is no coalition S which blocks x in the above sense. 78

CHAPTER 5. GENERAL EQUILIBRIUM Theorem 5.9.1 (The Core Property of Production Economies) Consider a production economy (ui , ei , Y )iI, jJ where Y is the publicly available production technology to which any consumer can access. If ui () is increasing and Y is a constant returns to scale convex, then every Walrasian allocation is in the core. Theorem 5.9.2 (The First Welfare Theorem with Production) Assume that each ui () is increasing. Then, every Walrasian allocation is Pareto ecient. We omit the proof. The proof is almost the same as the counterpart in exchange economies. Theorem 5.9.3 (The Second Welfare Theorem with Production) Consider i a production economy (ui , ei , j , Y j )iI,jJ with y+ 0 for some aggregate produce tion plan y Y , where e = iI ei . Assume that each ui () is continuous, strictly quasi-concave, and increasing. Assume further that each Y j is closed, convex, and satises the possibility of inaction and no free lunch. Then, for any Pareto ecient allocation (x, y), there are a price vector p = 0 and an assignment of income levels j such that (x1 , . . . , xI ), (y 1 , . . . , y J ) e ( 1 , . . . , I ) with iI i = p+p jJ y is equivalent to x1 (p, 1 ), . . . , xI (p, I ) , (y 1 (p), . . . , y J (p) which constitutes a Walrasian allocation associated with p, where xi (p, i ) is consumer is ordinary demand at (p, i ), y j (p) is rm js prot-maximizing production plan under p. Proof of Theorem 5.8.2: The proof consists of 9+1 steps. This extra step is needed for establishing each rm js prot maximization plan is indeed y j under p. Try to remember what we did in proving the same existence theorem without production. In other words, if you fully understand the proof for exchange economies, it is not dicult at all to go through this proof. For every consumer i I, we dene the set of consumptions strictly preferred to xi , that is Bi (zi ) = {z i Rn | ui (z i ) > ui (xi )}}. + Dene also, B() = x
iI

Bi (xi ) =

z Rn

z=
iI

z i and z i Bi (xi ) i I

Step 1 through 3 are preliminary lemmas for Step 4. Step 4 is an application of the separating hyperplane theorem. Then, from Step 4, we have a candidate for a Walrasian equilibrium price vector. Step 5 through 7 are preliminary lemmas for Step 8, where we are able to make sure that the Pareto ecient allocation to which our attention is paid indeed corresponds to each consumers utility maximizing bundle subject to his budget constraint associated with the supporting price vector we found in Step 4. Finally, we establish each rms prot maximizing behavior in Step 9.

79

CHAPTER 5. GENERAL EQUILIBRIUM Step 1: Every Bi (xi ) is convex. This is the same as exchange economies. Step 2: B() and Y + {} are convex. x e It follows from the fact that the sum of any two convex sets are convex. I leave this as an exercise. Step 3: B() (Y + {}) = x e Suppose not, that is, there is z B() (Y + {}). Then, there are (z 1 , . . . , z I ) x e y e with z = iI z i and (1 , . . . , y J ) with z = jJ y j Y + {} such that ui (z i ) > i (xi ) for every i I and y j Y j for each j J . Thus, (z 1 , . . . , z I ), (1 , . . . , y J ) y u is a feasible allocation as well. This contradicts the hypothesis that (x, y) is Pareto ecient. Step 4: There is p = (p1 , . . . , pn ) = 0 and a number r such that p z r for every z B() and p z r for every z Y + {}. x e This is a direct consequence of the separating hyperplane theorem. Check if we have made enough assumptions to apply the separating hyperplane theorem. Step 5: ui (z i ) ui (xi ) i I p
iI

z i r.

This is the same as exchange economies. Step 6: p


iI

xi = p e +

jJ

y j = r.

i 16 Since (x, y) = (x1 , . . . , xI , y 1 , . . . , y J ) By step 5, we know that p iI x r. is a Pareto ecient allocation and in particular, a feasible allocation, we have i j i i iI x e + jJ y . Because each u () is increasing, we have iI x = i r. Therefore, e + jJ y j . 17 From Step 4, this implies that p iI x

we have p

iI

xi = p e +

jJ

y j = r.

Step 7: ui (z i ) > ui (xi ) p z i p xi for every i I This is the same as exchange economies. Step 8: Assume p xi > 0 for each i
16 17

18 .

Then, ui (z i ) > ui (xi ) pz i > pxi .

When you replace z i with xi , the identical argument goes through in Step 5. Namely, no resources are wasted. 18 This assumption is not innocuous. One sucient condition for this is that xi 0 for each i I. That is, each consumers demand lies on the interior of Rn . You should be referred to footnotes in + the second welfare theorem in exchange economies.

80

CHAPTER 5. GENERAL EQUILIBRIUM This is the same as exchange economies. Step 9: p y j p y j for any y j Y j and j J (Prot Maximization) For any y j Y j , we have yj +
h=j

y h Y.

From Steps 4 (the separating hyperplane theorem) and 6, we have p e + y j +


h=j

y h r = p e + y j +
h=j

yh ,

which implies that p y j p y j . Step 10: xi = xi (p, i ) for each i I, where i = p xi . If we take the contraposition of Step 8, we have p z i i ui (xi ) ui (z i ). This means that xi is the solution to the UMP under (p, i ). Thus, the income levels i = p xi for i = 1, . . . , I support (x, y) as a Walrasian allocation associated with the Walrasian equilibrium price p. We complete the proof.

5.10

Uniqueness of Equilibria

Up to this point, I have concentrated on the determination of the general properties of the competitive market. In this section, I focus on a special class of environments in which the uniqueness of equilibria obtains.

5.10.1

The Weak Axiom for Aggregate Excess Demand


iI

To begin, suppose that z(p) = mand function of the consumers.

xi (p, p ei ) ei is the aggregate excess de-

Proposition 5.10.1 Given an economy specied by the constant returns technology Y and the aggregate excess demand function of the consumers z(), a price vector p is a Walrasian equilibrium price vector if and only if 1. p y 0 for every y Y , and 2. z(p) is a feasible production; that is, z(p) Y . 81

CHAPTER 5. GENERAL EQUILIBRIUM Proof of Proposition 5.9.1: (=) If p is a Walrasian equilibrium price vector, then (2) follows from market clearing and (1) is a necessary condition for prot maximization with a constant returns technology. (=) Let the consumptions be x = xi (p, p ei ) for i = 1, . . . , I and the production vector be y = z(p) Y for i some price vector p. To verify p is a Walrasian equilibrium price vector, the only condition that is not immediate is prot maximization. Because p y 0 for all y Y from (2) and p y = p z(p) = 0 from Walras law, y = z(p) Y is prot maximizing. Denition 5.10.1 (The Weak Axiom for Excess Demand Functions) The excess demand function z() satises the weak axiom of revealed preference (WA) if for any pair of price vectors p and p , we have z(p) = z(p ) and p z(p ) 0 = p z(p) > 0. Lemma 5.10.1 (Uniqueness implies WA) Suppose that the excess demand function z() is such that, for any constant returns convex technology Y , the economy formed by z() and Y has a unique (normalized) equilibrium price vector. Then z() satises the weak axiom. Proof of Lemma 5.10.1: We argue by contradiction. Suppose that the WA was violated; that is, suppose that for some p and p we have z(p) = z(p ), p z(p ) 0, and p z(p) 0. Then we claim that both p and p are equilibrium prices for the convex constant returns production set given by Y = y Rn | p y 0 and p y 0 Thus, by the above proposition, p is an equilibrium price vector. The same is true for p . Since z(p) = z(p ), we conclude that the equilibrium is not unique for the economy formed by z() and the production set Y . This is a contradiction. Proposition 5.10.2 (WA generally implies Uniqueness) If z() satises the weak axiom, then, for any constant returns convex technology Y , the set of equilibrium price vectors is convex. Furthermore, if the set of normalized price equilibria is nite, there can be at most one normalized price equilibrium. Proof of Proposition 5.10.2: Suppose that p and p are equilibrium price vectors for the constant returns convex technology Y ; that is, z(p) Y, z(p ) Y , and, for any y Y, p y 0 and p y 0. Let p = p + (1 )p for [0, 1]. Note that p y = p y + (1 )p y 0. Hence (1) follows in Proposition 5.9.1. To show that p is an equilibrium price vector, we must show that z(p ) Y by Proposition 5.9.1. Because p z(p ) = 0 (by Walras law) and p z(p ) = p z(p ) + (1 )p z(p ), we must have either 82

CHAPTER 5. GENERAL EQUILIBRIUM p z(p ) 0 or p z(p ) 0. Suppose that the rst possibility holds, so that p z(p ) 0 (a parallel argument applies if, instead, p z(p ) 0). Since z(p) Y , we have p z(p) 0. This is because p z(p) = p z(p) + (1 )p z(p) 0 ( p y 0 and p y 0 for any y Y ) But with p z(p) 0 and p z(p ) 0, a contradiction to the WA can be avoided only if z(p ) = z(p). Hence z(p ) Y . 19

5.10.2

Gross Substitution

Denition 5.10.2 (Gross Substitution) The function z() has the gross substitute (GS) property if whenever p and p are such that for some i, pi > pi and pk = pk for k = i, we have zk (p ) > zk (p) for k = i. Proposition 5.10.3 (GS implies Uniqueness) An aggregate excess demand function z() that satises the gross substitute property has at most one exchange equilibrium; that is, z(p) = 0 has at most one (normalized) solution. Proof of Proposition 5.10.3: It suces to show that z(p) = z(p ) cannot occur whenever p and p are two price vectors that are not collinear. By homogeneity of degree zero, we can assume that p p and pi = pi for some i (This can be done by choosing p p by choosing > 0). Now consider altering the price vector p to obtain the price vector p in n 1 steps, lowering (or keeping unaltered) the price of every commodity k = i one at a time. By gross substitution, the excess demand of good i cannot decrease in any step, and because p = p , it will actually increase in at least one step. Hence, zi (p ) > zi (p). This implies that z(p) = z(p ).

5.11

Stability

I consider an exchange economy formalized by means of an excess demand function z(). Suppose that I have an initial p that is not an equilibrium price vector, so that z(p) = 0. For example, the economy may have undergone a shock and p may be the preshock equilibrium price vector. Then the demand-and-supply principle suggests that prices will adjust upward for goods in excess demand and downward for those in excess supply. This is what was proposed by Walras; in a dierential equation version put forward by Samuelson (1947), it takes the specic form dpk = ck zk (p) k = 1, . . . , n dt ()

where dpk /dt is the rate of change of the price for the k-th good and ck > 0 is a constant aecting the speed of adjustment.
We now establish that either z(p ) = z(p) or z(p ) = z(p ). Since this is true for any [0, 1], and since the function z() is continuous, this implies that z(p) = z(p ) for any two equilibrium price vectors p and p .
19

83

CHAPTER 5. GENERAL EQUILIBRIUM Proposition 5.11.1 Suppose that z(p ) = 0 and p z(p) > 0 for every p not proportional to p . Then, the relative prices of any solution trajectory of the dierential equation () converge to the relative prices of p .

5.12

Appendix: Generalization of General Equilibrium Theory

Here, we follow On the fundamental theorems of general equilibrium, by Eric Maskin and Kevin Roberts in Economic Theory, 2008, vol. 35, 233-240. The main objective of this section is to provide a very simple proof of the second welfare theorem. This can be done by taking a roundabout of establishing a simple generalization of the existence theorem to economies where Walras law need not be satised out of equilibrium. Therefore, it is demonstrated that the only diculty for the proof of the standard second welfare theorem lies in establishing existence part. A generalized competitive mechanism (GCM) is a rule that, for each vector of prices p (in the unit simplex) and each specication {y j }jJ of production plans by rms (where y j Y j for all j J), assigns to each consumer i an income W i (p, {y j }j ). One example of a GCM is, of course, the ordinary competitive mechai nism, in which consumer i is assigned income p ei + j j (p y j ). Another example y is the mechanism that, given some xed allocation ({i }i , {j }j ) and prices p, gives x consumer i income p xi . Denition 5.12.1 An equilibrium of a GCM is a price vector p and an allocation ({xi }iI , {y j }jJ ) such that 1. for each i I, xi is preference-maximizing in Rn , subject to the constraint + p xi W i (p, {y j }j ); 2. for each j J, y j is prot-maximizing in Y j given prices p; and 3.
i

xi =

yj +

i ie .

Given a GCM, let Z() be the corresponding aggregate excess demand correspondence. That is, for any prices p, (xi ei ) y j such that requirement 1 and 2 below hold Z(p) = z Rn z =
iN jJ

1. xi maximizes

subject to p xi W i (p, {y j }j )

2. For all j J, y j maximizes rm js prot in Y j given prices p. Lemma 5.12.1 (Maskin and Roberts (2008)) Given a GCM, suppose that Z() is well-dened, upper-hemicontinuous, and convex- and compact-valued. Suppose that if p is such that pk = 0 for some commodity k, then for all z Z(p), zk > 0. 84

CHAPTER 5. GENERAL EQUILIBRIUM Finally, suppose that, for all p and all z Z(p), either (a) z=0 or (b) there exist k and such that zk > 0 and z 0. (Note that this last hypothesis constitutes a weakening of Walras law.) Then, there exists an equilibrium. Theorem 5.12.1 (Maskin and Roberts (2008)) (Existence of equilibrium at a Pareto ecient allocation): Let the allocation ({i }i , {j }j ) be Pareto ecient, x y and suppose that, for all i, all components of xi are strictly positive. Suppose that, for all i N and p, W i (p, {y j }j ) = p xi . Assume that preferences are convex, continuous, and strongly monotone, and that production sets are convex, closed, and bounded. Then, an equilibrium exists. The next theorem is nothing but the rst welfare theorem. Theorem 5.12.2 (Maskin and Roberts (2008), First Welfare Theorem) If preferences are strongly monotone, then any equilibrium of a GCM is Pareto ecient. Theorem 5.12.3 (Maskin and Roberts (2008)) Assume that preferences are strongly y monotone. Suppose that allocation ({i }i , {j }j ) is Pareto ecient. Consider the x GCM in which, given prices p, consumer i receives income W i = p xi . Then, if y an equilibrium of this GCM exists, ({i }i , {j }j ) is an equilibrium allocation of the x GCM. It is worth emphasizing that the above theorem requires no convexity assumptions. The theorem illustrates that convexity in the second welfare theorem is needed only to show that equilibrium exists; it is not required to show that the equilibrium occurs at the Pareto ecient allocation. Indeed, it follows directly that if a Pareto ecient allocation cannot be supported as an equilibrium, then starting at this allocation, no equilibrium can exist. Theorem 5.12.4 (Maskin and Roberts (2008), Second Welfare Theorem) Suppose that preferences and production sets satisfy the hypotheses of the previous y theorem. Then, if ({i }i , {j }j ) is Pareto ecient and, for all i I, all components x of xi are strictly positive, there exists a price p and balanced transfers {T i } (i.e., sum i } , {j } ) is an equilibrium allocation with respect to the ming to zero) such that ({ i y j x i GCM mechanism that, for each p, gives consumer i the income pei + j j p y j +T i .

85

Chapter 6

Choice under Uncertainty


6.1 Preferences over Gambles

Until now, we have assumed that decision makers act in a world of absolute certainty. As soon as you apply this assumption to the real world, you immediately realize that this assumption is simply a lie, but, I hope you think, a useful one. Many economic decisions contain a signicant amount of uncertainty. Here, I would like to discuss how to incorporate the aspects of uncertainty into the decision making problem. We will maintain the notion of preference relation but, instead of consumption bundles, the individual will be assumed to have a preference relation over gambles. Let A = {a1 , . . . , an } denote a nite set of outcomes (consequences). The ai s might well be consumption bundles, amounts of money (positive or negative), or anything at all. The main point is that the ai s themselves involve no uncertainty. g is said to be a simple gamble if it assigns a probability pi , to each of the outcomes ai , in A. Note that pi 0 and n pi = 1. We denote this simple gamble g by i=1 (p1 a1 , . . . , pn an ). Denition 6.1.1 Let A = {a1 , . . . , an } be the set of outcomes. Then GS , the set of simple gambles (on A), is given by
n

GS

(p1 a1 , . . . , pn an )
i=1

pi = 1 and pi 0 for each i = 1, . . . , n .

The simple gamble ( a1 , 0 a2 , . . . , 0 an1 , (1 ) an ) would be written as ( a1 , (1 ) an ). Note that GS contains A because for each i, (1 ai ), the gamble yielding ai with probability one, is in GS . Namely, we consistently expand the set of choices, A, for the individual to a bigger one, GS . Gambles whose prizes are themselves gambles are called compound gambles. For example, let A = {a1 , a2 , a3 }. Consider the following gamble g = (1/3 g1 , 1/3

86

CHAPTER 6. CHOICE UNDER UNCERTAINTY g2 , 1/3 g3 ), where gk GS for k = 1, 2, 3 with the properties that g1 = (1 a1 ); g2 = (1/4 a1 , 3/8 a2 , 3/8 a3 ); and g3 = (1/4 a1 , 3/8 a2 , 3/8 a3 ). Let gs be the simple lottery induced by g . Then, gs = (1/2 a1 , 1/4 a2 , 1/4 a3 ) When I discuss the preference relations over set of gambles, the decision maker is supposed to be indierent between g and gs . Let G denote the set of all gambles, both simple and compound. G is dened inductively as follows: Let G0 = A. For each j 1, let Gj = p 1 g 1 , . . . , pk g k
j=0 Gj . k

k 1; pi 0 and gi Gj1 i = 1, . . . , k; and


i=1

pi = 1 .

Then, G =

6.2

Axioms

Analogous to the case of consumer theory, we shall suppose that the decision maker has preferences, , over the set of gambles, G. We proceed by positing a number of axioms for the decision makers preference relation, . Axiom G1: (Completeness) g, g G, we have either g Axiom G2: (Transitivity) g, g , g G, if g g and g g or g g , then g g. g .

Let us assume without loss of generality that the elements of A have been indexed so that a1 a2 an . Axiom G3: (Continuity) g G, there is some probability [0, 1] such that g ( a1 , (1 ) an ). The continuity axiom is, typically, the one that causes most people to express doubts. Consider the following example (adapted from Notes on the Theory of Choice, by David Kreps (1988)): f is a gamble in which you get $1000 for sure; g is a gamble in which you get $10 for sure; and h is a gamble in which you are killed for sure. Most people would express the preference f g h. And so, the axiom holds, there must exist a probability (0, 1), presumably close to 1, such that f + (1 )h g. That is, you are willing to risk a small (but nonzero) chance of your death, to trade up from $10 to $1000. This, many people say, is rather dubious. 87

CHAPTER 6. CHOICE UNDER UNCERTAINTY But consider: Suppose I told you that you could either have $10 right now, or if you were willing to drive ve miles (pick some location ve miles away from where you are), an envelope with $1000 was waiting for you. Most people would get out their car keys at such a prospect, even though driving the ve miles increases ever so slightly the chances of a fatal accident. So, perhaps the axiom isnt so bad. Axiom G4: (Monotonicity) , [0, 1], ( a1 , (1 ) an ) ( a1 , (1 ) an ) = . Moreover, , [0, 1], ( a1 , (1 ) an ) ( a1 , (1 ) an ) > .

an , and so the case in which the Note that monotonicity implies that a1 decision maker is indierent among all the outcomes in A is ruled out. Axiom G5: (Substitution) If g = p1 g1 , . . . , pk gk , and h = p1 h1 , . . . , pk hk are in G, and if hi gi for every i = 1, . . . , k, then h g. Together with the completeness axiom, the substitution axiom implies that when the decision maker is indierent between two gambles, he must be indierent between all convex combinations of them. 1 Most people, viewing the substitution axiom for the rst time, think it looks pretty convincing on rst principles for choice under uncertainty. There are, however, a number of well-known cases in which the substitution axiom, as a description of how people do choose, is falsied empirically. The next question you might ask is how often the axiom is falsied empirically. The answer is not often, though. Axiom G6: (Reduction to Simple Gambles) g G, if (p1 a1 , . . . , pn an ) is the simple gamble induced by g, then (p1 a1 , . . . , pn an ) g. The reduction to simple gambles axiom rests on a basic consequentialist premise: We assume that for any risky alternatives, only the reduced simple gamble is of relevance to the decision maker. In other words, the decision maker should care about what outcome he nally receives (i.e., consequences) but should not care about how the gamble results in the nal outcome (i.e., procedure or process of resolution of the uncertainty).
Formally, I have the following: for any f, g G, if f g, then f + (1 )g f g for any [0, 1]. This is also known as the betweeness axiom in Dekel (1986). In some other times, the expected (VNM) utility function is axiomatized using the independence axiom. We say that over G satises the independence axiom if, for any f, g, h G, f g f +(1)h g+(1)h for any [0, 1]. In particular, the independence axiom implies that f g f +(1)h g+(1)h for any [0, 1]. Since h can be any gamble, I take h to be either f or g. Hence, with the completeness axiom, the independence axiom implies the substitution axiom, but the converse is not true.
1

88

CHAPTER 6. CHOICE UNDER UNCERTAINTY

6.3

Von Neumann-Morgenstern (VNM) Utility

In this section, we would like to know not only whether there is a representation for preferences over gambles which satisfy all the axioms provided above (indeed, there is!) but also how nice (yet to be dened) the structure of the representation is. Suppose that V : G R is a utility function representing on G. So, for every g G, V (g) denotes the utility number assigned to the gamble g. Let u(ai ) denote the utility generated from a simple gamble that ai occurs with probability one. Denition 6.3.1 The function V : G R has the expected utility property if there is an assignment of numbers (u(a1 ), . . . , u(an )) to the n outcomes such that for every g G,
n

V (g) =
i=1

pi u(ai ),

where (p1 a1 , . . . , pn an ) is the simple gamble induced by g. If an individuals preferences are represented by a utility function with the expected utility property, and if that person always chooses his most preferred alternative available, then that individual will choose one gamble over another if and only if the expected utility of the one exceeds that of the other. Consequently, such an individual is an expected utility maximizer.

6.4

Existence of VNM Utility Function

Theorem 6.4.1 (Existence of VNM Utility Function on G) Let preferences over gambles in G satisfy axioms G1 through G6. Then there is a function V : G R representing on G such that V has the expected utility property. Proof of Theorem 6.4.1: Step 1: For any g G, there is a unique V (g) [0, 1] such that g (V (g) a1 , (1 V (g)) an ). Consider an arbitrary gamble g from G. Dene V (g) to be the number satisfying g (V (g) a1 , (1 V (g)) an ) . By the continuity axiom (G3), such a number exists. The uniqueness follows from the monotonicity axiom (G4). Do you see why? Step 2: g g V (g) V (g ).

89

CHAPTER 6. CHOICE UNDER UNCERTAINTY Let g, g G be arbitrary gambles. Assume without loss of generality that g By step 1, we have (V (g) a1 , (1 V (g)) an ) g g V (g ) a1 , (1 V (g )) an . g.

By the transitivity axiom (G2), we obtain (V (g) a1 , (1 V (g)) an ) V (g ) a1 , (1 V (g)) an .

By the monotonicity axiom (G4), we conclude that V (g) V (g ). Step 3: For any g G, V (g) has the expected utility property. Let g G be an arbitrary gamble and let gs (p1 a1 , . . . , pn an ) GS be the simple gamble induced by g. By Step 1, for each outcome ai for i = 1, . . . , n, there is a unique assignment of number u(ai ) [0, 1] such that (1 ai ) (u(ai ) a1 , (1 u(ai )) an ) . By the reduction to simple gambles axiom (G6), we have g gs . By Step 2, we know that V represents and therefore, we must have V (g) = V (gs ). Hence, what we want to show is
n

V (gs ) =
i=1

pi u(ai ).

denote the simple gamble with the property that hi = For every i = 1, . . . , n, let (u(ai ) a1 , (1 u(ai )) an ). Dene g p1 h1 , , pn hn . By construction, hi ai for every i = 1, . . . , n. By the substitution axiom (G5), we have g = p1 h1 , , pn hn (p1 a1 , , pn an ) = gs = g gs We now wish to derive the simple gamble gs induced by the compound gamble g . For each i = 1, . . . , n, there is a probability of pi u(ai ) that a1 will result. Because the occurrences of the hi s are mutually exclusive, the eective probability that n a1 results is the sum i=1 pi u(ai ). Similarly, for each i = 1, . . . , n, there is a probability of pi [1 u(ai )] that an will result. The eective probability that an n n results is i=1 pi [1 u(ai )], which is equal to 1 i=1 pi u(ai ). Therefore, the simple gamble gs induced by g is
n n

hi

gs
i=1

pi u(ai ) a1 , 1
i=1

pi u(ai ) an

By the reduction to simple gambles axiom (G6), we have g gs . By the transitivity axiom (G2), we obtain
n n

gs
i=1

pi u(ai ) a1 , 1
i=1

pi u(ai ) an 90

( g gs and g gs ) ().

CHAPTER 6. CHOICE UNDER UNCERTAINTY By Step 1, there is a unique number V (gs ) satisfying gs (V (gs ) a1 , [1 V (gs )] an ) (). Therefore, comparing () with (), we conclude that
n

V (gs ) =
i=1

pi u(ai ),

as desired.

6.5

Uniqueness up to Positive Ane Transformations

In the consumer theory case, the utility numbers themselves have only ordinal meaning. Any strictly monotonic transformation of one utility representation yields another one. On the other hand, the utility numbers associated with a VNM utility representation of preferences over gambles have content beyond ordinality. Suppose that A = {a, b, c}, where a b c, and that satises all the six axioms I provided in the previous section. By the continuity axiom and the monotonicity axiom, there is a unique (0, 1) satisfying b ( a, (1 ) c) . Let V be some VNM utility representation of relation implies that V (b) = V (( a, (1 ) c) = V (a) + (1 )V (c). (because V has the expected utility property). This equality can be rearranged to yield 1 V (a) V (b) = . V (b) V (c) Consequently, the ratios of the dierences between the preceding utility numbers are uniquely determined by . But because the number was uniquely determined by the decision makers preferences, so is the preceding ratio of utility dierences. Then, a strictly increasing transformation of a VNM utility representation might not yield another VNM utility representation. Here, we ask the following question: What is the class of VNM utility representations of a given preference ordering? Theorem 6.5.1 (Uniqueness up to Positive Ane Transformation) Suppose that the VNM utility function V () represents . Then the VNM utility function, V () represents the same preferences if and only if there exists > 0 and R such that V (g) = V (g) + , for any gamble g G. 91 . Then, the preceding indierence

CHAPTER 6. CHOICE UNDER UNCERTAINTY Proof of Theorem 6.5.1: It is very easy to show that V and V represents the same preference relation on G when V (g) = V (g) + , where > 0 and R. Do you agree? Hence, we focus on the opposite direction. Suppose that both V and V represents the same preference over G with the expected utility property. By the monotonicity axiom (G4), we know that V (a1 ) > V (an ). By the continuity axiom (G3), for any g G, there exists g [0, 1] such that V (g) = g V (a1 ) + (1 g )V (an ). This implies g = V (g) V (an ) . V (a1 ) V (an )

By the reduction to simple gambles axiom (G6), we have g V (a1 ) + (1 g )V (an ) = V ((g a1 , (1 g ) an )) . Because V represents , it follows that g (g a1 , (1 g ) an ). Since V represents the same preference, we have V (g) = V ((g a1 , (1 g ) an )) = g V (a1 ) + (1 g )V (an ) = g V (a1 ) V (an ) + V (an ) ( V is a VNM utility function.) = = = V (g) V (an ) V (g) V (an ) V (a1 ) V (an ) + V (an ) g = V (a1 ) V (an ) V (a1 ) V (an ) V (a1 ) V (an ) (V (g) V (an )) + V (an ) V (a1 ) V (an ) V (a1 ) V (an ) V (a1 ) V (an ) V (an ) V (g) + V (an ) V (a1 ) V (an ) V (a1 ) V (an )
= =

= V (g) + .

6.6

Risk Aversion

In many economic settings, individuals seem to display aversion to risk. In this section, we formalize the notion of risk aversion and study some of its property. For simplicity, we shall conne our attention to gambles whose outcomes consist of dierent amounts of wealth (monetary income). Thus, let A = R+ . Even though the set of outcomes now contain innitely many elements, we continue to consider gambles giving only nitely many outcomes a strictly positive eective probability. A simple gamble takes the form (p1 w1 , . . . , pn wn ), where n is some positive integer, the wi s are nonnegative wealth levels, and the nonnegative probabilities, p1 , . . . , pn , 92

CHAPTER 6. CHOICE UNDER UNCERTAINTY sum to 1. Let u(wi ) be the level of utility from wealth wi for each i = 1, . . . , n. We call this u : R+ R the Bernoulli utility function. Finally, we shall assume that the individuals Bernoulli function, u() is dierentiable with u (w) > 0 for any w 0. The expected value of the simple gamble g oering wi with probability pi for any i = 1, . . . , n is given by E(g) = n pi wi . Now suppose the agent is given a i=1 choice between accepting the gamble g on the one hand or receiving with certainty (i.e., with probability one) the expected value of g on the other. If V : G R is the agents VNM utility function, we can evaluate these two alternatives as follows:
n

V (g) =
i=1

pi u(wi ),
n

V (E(g)) = u
i=1

pi wi

When someone would rather receive the expected value of a gamble with certainty than face the risk inherent in the gamble itself, we say that he is risk averse. Denition 6.6.1 Let V : G R be an individuals VNM utility function for gambles over nonnegative levels of wealth. Then, for the simple gamble g = (p1 w1 , . . . , pn wn ), the individual is said to be 1. risk averse at g if V (E(g)) > V (g); 2. risk neutral at g if V (E(g)) = V (g); 3. risk loving at g if V (E(g)) < V (g). If the individual is risk averse at every nondegenerate simple gamble, g, then the individual is said simply to be risk averse. 2 Consider a simple gamble involving two outcomes: g (p w1 , (1 p) ww ). Now suppose the individual is oered a choice between receiving wealth equal to E(g) = pw1 + (1 p)w2 with certainty (,i.e., probability one) or receiving the gamble g itself. We can assess the alternatives as follows: V (g) = pu(w1 ) + (1 p)u(w2 ), V (E(g)) = u (pw1 + (1 p)w2 ) .
2 A simple gamble is nondegenerate if it assigns strictly positive probability to at least two distinct wealth levels.

93

CHAPTER 6. CHOICE UNDER UNCERTAINTY If the Bernoulli utility function u() is strictly concave, we have V (E(g)) > V (g), so the individual is risk averse. 3 In the case of the risk averse individual, there will be some amount of money we could oer with certainty that would make him indierent between accepting that wealth with certainty and facing the gamble g. We call this amount of money the certainty equivalent of the gamble g. Denition 6.6.2 The certainty equivalent of any simple gamble g over wealth levels is an amount of wealth, CE(g), oered with certainty, such that V (g) u(CE(g)). The risk premium is an amount of wealth, P (g), such that V (g) u(E(g) P (g)). Clearly, P (g) E(g) CE(g). Exercise 6.6.1 Consider an individual whose preferences over gambles is represented by the VNM utility function. Verify that the individual is risk averse over gambles involving nonnegative wealth levels if and only if her Bernoulli utility function is strictly concave on R+ . I want to attach meaning to the expression: A gamble g yields unambiguously higher returns than a gamble g . The following result does not depend upon how rich and how risk averse the decision maker is. Proposition 6.6.1 (The First-Order Stochastic Dominance (FOSD)) Assume without loss of generality that w1 w2 wn 0. Assume further that u(0) = 0 and u() is increasing. Let g = (p1 w1 , . . . , pn wn ) and g = (p1 w1 , . . . , pn wn ). Then, V (g) V (g ) if k pi k pi for each k = 1, . . . , n 4 i=1 i=1 Proof of Proposition 6.6.1 Let u() be the Bernoulli utility function of the
This comes from Jensens inequality. Those who dont know what Jensens inequality is should consult my lecture notes on mathematics. Or, you can talk to people who do either statistics or econometrics, or both. 4 Suppose, instead that the domain of monetary incomes is given as + , i.e., a continuum. Then, any gamble is represented by a probability distribution function. Let F () and G() be two distribuif tion functions dened on + . Then, F () rst-order stochastically dominates G() F (x) G(x) for any x + . Then, Proposition 6.6.1 is re-formalized as follows: V (F ) = u(x)dF (x) u(x)dG(x) = V (G) if F () rst-order stochastically dominates G().
3

94

CHAPTER 6. CHOICE UNDER UNCERTAINTY decision maker. What we want to show is V (g) V (g ) 0. V (g) V (g )
n

=
i=1 n

pi u(wi )
i=1

pi u(wi )

=
i=1

(pi pi )u(wi )
n

= (p1 p1 )u(w1 ) +
i=2 n

(pi pi )u(wi ) (pi pi )u(wi ) ( p1 p1 and u(w1 ) u(w2 ) 0)


i=2 n

(p1 p1 )u(w2 ) +
2

= u(w2 )
i=1 2

(pi pi ) +
i=3 n

(pi pi )
2 2

u(w3 )
i=1 3

(pi pi ) +
i=3 n

(pi pi )

i=1

pi
i=1

pi and u(w2 ) u(w3 ) 0

= u(w3 )
i=1

(pi pi ) +
i=4

(pi pi )u(wi ) . . .

. . . u(wn ) 0

. . .
n

. . . (pi pi )

. . .

i=1 n

i=1

pi
i=1

pi and u(wn ) 0 .

6.7

Measures of Risk Aversion

Many times, we not only want to know whether someone is risk averse, but also how risk averse they are. Ideally, wed like a summary measure that allows us both to compare the degree of risk aversion across individuals and to gauge how the degree of risk aversion for a single individual might vary with the level of their wealth. Arrow (1970) and Pratt (1964) have proposed the following measure of risk aversion. Denition 6.7.1 Given a (twice-dierentiable) Bernoulli utility function u() for money, the Arrow-Pratt measure of absolute risk aversion is given by Ra (w) u (w) u (w)

95

CHAPTER 6. CHOICE UNDER UNCERTAINTY v 1

R+

R+

R+

R+

h u u

R Figure 6.1: The Relationship between u and v through h

The sign of this measure immediately tells us the basic attitude toward risk: Ra (w) is positive, negative, or zero as the agent is risk averse, risk loving, or risk neutral, respectively. In addition, any positive ane transformation of VNM utility will leave the measure unchanged. Exercise 6.7.1 The Bernoulli utility function of the decision maker is given as: u(x) = exp(x) where > 0. Show that the Arrow-Pratt measure of absolute risk aversion of the decision maker is constant for any x.

6.7.1

Comparisons across Individuals

Suppose that there are two individuals, 1 and 2, and that individual 1 has a Bernoulli utility function u(), and individual 2 has a Bernoulli utility function v(). Lets suppose that at every wealth level, w, individual 1s Arrow-Pratt measure of risk aversion is larger than individual 2s. That is,
1 Ra (w) =

v (w) u (w) 2 > = Ra (w) w 0 (), u (w) v (w)

where both u and v are always strictly positive. Assume that v() takes on all values in [0, ). Then, I can always dene a mapping h : R R such that u(x) = h(v(x)) for any x R+ . Consequently, we may describe h : R R as follows: h(x) = u(v1 (x)) x 0. Therefore, h inherits twice dierentiability from u and v with h (x) = u (v1 (x) > 0, and v (v1 (x)) u (v1 (x)) u (v1 (x))/u (v1 (x)) v (v1 (x))/v (v1 (x)) [v (v1 (x))] 96
2

h (x) =

<0

CHAPTER 6. CHOICE UNDER UNCERTAINTY for all x > 0, where the rst inequality follows because u , v > 0, and the second inequality follows from the relation (). 5 Therefore, h is a strictly increasing, strictly concave function. Consider a gamble g = (p1 w1 , . . . , pn wn ) over wealth levels. Let CE i (g) denote consumer is certainty equivalent for the gamble g.
n i=1 n i=1

pi u(wi ) = u(CE 1 (g)), pi v(wi ) = v(CE 2 (g))

Claim 6.7.1 CE 1 (g) < CE 2 (g). Proof of Claim 6.7.1: Recall u(CE (g)) =
i=1 1 n

pi u(wi )

(6.1) (6.2)

h(x) = u(v1 (x)). Substituting v 1 (x) for x in equation (2), we have h(v(x)) = u(x). () Plugging () into the above equation (1), we do the following computation. u(CE 1 (g)) =
n

pi h(v(wi ))
i=1 n

< h
i=1

pi v(wi )

(because h() is strictly concave.)

= h v(CE 2 (g)) = u(CE 2 (g)). Since u is increasing, we have CE 1 (g) < CE 2 (g). In particular, Jensens inequality is employed in the second line of the above derivation. 6
5

h (x) = u (v 1 (x))

d 1 v (x) dx

Let f (x) = v 1 (x). Then, we have x = v(f (x)). Dierentiating this equation with respect to d x yields 1 = v (f (x))f (x). Taking into account the relation that f (x) = dx (v 1 (x)), we have 1 1 d (v (x)) = 1/v (v (x)). dx 6 You should consult my lecture notes on mathematics for Jensens inequality.

97

CHAPTER 6. CHOICE UNDER UNCERTAINTY Corollary 6.7.1 (Comparisons across individuals) Suppose that two Bernoulli utility functions u() for individual 1 and v() for individual 2 are given. We say unambiguously say that individual 1 is more risk averse than individual 2 when
1 2 1. Ra (x) > Ra (x) for every x;

2. There exists an increasing, strictly concave function h() such that u(x) = h(v(x)) at all x; 3. CE 1 (g) < CE 2 (g) for any gamble g G 4. P 1 (g) > P 2 (g) for any gamble g G In fact, these four denitions are equivalent.

6.7.2

Comparisons across wealth levels

It is a common contention that wealthier people are willing to bear more risk than poorer people. Although this might be due to dierences in utility functions across people, it is more likely that the source of the dierence lies in the possibility that richer people can aord to take a chance. Hence, I shall consider the following condition. Denition 6.7.2 The Bernoulli utility function u() for money exhibits decreasing absolute risk aversion if Ra (x) is a decreasing function of x. Denition 6.7.3 Given a Bernoulli utility function u(), the coecient of relative risk aversion (CRRA) at x is Rr (x) = xu (x)/u (x). Exercise 6.7.2 The Bernoulli utility function of the decision maker is given as u(x) = x1 1

where < = 1. Show that the coecient of relative risk aversion (CRRA) is constant at any x. Denition 6.7.4 The Bernoulli utility function u() for money exhibits nonincreasing relative risk aversion if Rr (x) is nonincreasing function of x. The assumption of decreasing absolute risk aversion yields many economically reasonable results concerning risk-bearing behavior. However, in applications, it is often complemented by a stronger assumption: nonincreasing relative risk aversion. As an exercise, you are encouraged to show that if Rr (x) is nonincreasing function of x, then Ra (x) is decreasing function of x.

98

CHAPTER 6. CHOICE UNDER UNCERTAINTY

6.8

State-Dependent Utility

In the previous section, we assumed that the decision maker cares solely about the distribution of monetary payos he receives. Here we consider the possibility that the decision maker may care not only about his monetary returns but also about the underlying events, or states of nature, that cause them. We often know that the random outcome is generated by some underlying causes. For example, the monetary payo of an insurance policy might depend on whether or not a certain accident has happened, the payo on a corporate stock on whether the economy is in a recession, and the payo of a casino gamble on the number selected by the roulette wheel. I call these underlying causes states or state of nature. I denote the set of states by S and an individual state by s S. For simplicity, we assume that the set of states S is nite and that each state s has a well dened, objective probability ps > 0 that it occurs. Denition 6.8.1 A random variable is a function g : S R that maps states into monetary outcomes. Every random variable g() gives rise to a monetary lottery describable by the distribution function F () with F (x) =
{sS|g(s)x}

ps x

Note that there is a loss in information in going from the random variable representation of uncertainty to the lottery representation; I do not keep track of which states give rise to a given monetary outcome, and only the aggregate probability of every monetary outcome is retained. Because I take S to be nite, we can represent a random variable with monetary payos by the vector (x1 , . . . , xS ), where ss is the monetary payo in state s S. The set of all random variables is then RS .

6.8.1

State-Dependent Preferences and the Extended VNM Utility Representation

Denition 6.8.2 The preference relation has an extended VNM utility representation if for every s S, there is a function us : R R such that for any (x1 , . . . , xS ) RS and (x1 , . . . , xS ) RS , (x1 , . . . , xS ) (x1 , . . . , xS )
sS

ps us (xs )
sS

ps us (xs ).

6.8.2

Existence of an Extended VNM Utility Representation

Observe rst that since ps > 0 for every s S, we can formally include ps in the denition of the utility function at state s. That is, to nd an extended VNM utility 99

CHAPTER 6. CHOICE UNDER UNCERTAINTY representation, it suces that there be functions us () such that (x1 , . . . , xS ) (x1 , . . . , xS )
sS

us (xs )
sS

us (xs ).

This is because if such functions us exist, then we can dene us () = (1/ps )us () for each s S, and we will have us (xs )
sS sS

us (xs )
sS

ps us (xs )
sS

ps us (xs ). us (),

Thus, from now on, I focus on the existence of an additively separable form and the ps s cease to play any role in the analysis.

sS

I now allow for the possibility that within each state s, the monetary payo is not a certain amount of money xs but a random amount with distribution function Fs (). We denote these uncertain alternatives by g = (F1 , . . . , FS ). Thus, g is a kind of compound lottery that assigns well-dened monetary gambles as prizes contingent on the realization of the state of the world s. We denote G the set of all such possible lotteries. My starting point is now a a rational preference relation on G. Note that

g + (1 )g = F1 + (1 )F1 , . . . , FS + (1 )FS has the usual interpretation as the reduced gamble arising from a randomization between g and g , although here I deal with a reduced lottery within each state s. Denition 6.8.3 (The Extended Expected Utility Property) The function V : G R has the extended expected utility property if for each s S, there is an assignment of numbers (us (a1 ), . . . , us (an )) to the n outcomes such that for every xs G,
n

V (g) =
sS i=1

pi,s us (ai ),

where xs (p1,s a1 , . . . , pn,s an ) is the simple gamble induced by xs G. If I extend the domain of our Axioms G1 through G6 from G to G, I can easily establish the existence of extended VNM utility function below. Theorem 6.8.1 (Existence of the Extended VNM Utility Function on G) Let preferences over gambles in G satisfy axioms G1 through G6. Then there is R representing a function V : G on G such that V has the extended expected utility property.

100

Chapter 7

General Equilibrium under Uncertainty


7.1 A Market Economy with Contingent Commodities

I consider an environment with n physical commodities, I consumers, and J rms. The new element I have to take into account is the fact that technologies, endowments, and preferences are now uncertain. Throughout the argument, I represent uncertainty by assuming that technologies, endowments, and preferences depend on the state of the world. A state of the world is to be understood as a complete description of a possible outcome of uncertainty, the description being suciently ne for any two distinct states of the world to be mutually exclusive. I assume that an exhaustive set S of states of the world is given to us. For simplicity I take S to be nite set with (abusing notation slightly) S elements. A typical element is denoted s = 1, . . . , S. An approach I will take here is, I think, the most cheapest but the most boring one. Namely, I will change the concept of commodity in such a way that all the previous general equilibrium analyses in economies without uncertainty will carry over straightforwardly. Of course, whether or not this new concept of commodity makes sense to you is another issue, though. Indeed, you probably wont nd it useful concept to pay a serious consideration. Denition 7.1.1 For every physical commodity = 1, . . . , n and state s = 1, . . . , S, a unit of state-contingent commodity is a title (right) to receive a unit of the physical good if and only if s occurs. Accordingly, a state-contingent commodity vector is specied by x = x11 , . . . , xn1 , . . . , x1S , . . . , xnS RnS , state 1 101 state S

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY and is understood as an entitlement to receive the commodity vector (x1s , . . . , xns ) if state s occurs. Moreover, a negative entry is understood as an obligation to deliver. With the help of the concept of contingent commodity vectors, we can now describe how the characteristics of economic agents depend on the state of the world. We let the endowments of consumer i = 1, . . . , I be a contingent commodity vector: ei = ei , . . . , ei , . . . , ei , . . . , ei RnS 11 n1 1S nS state 1 state S The meaning of this is that if state s occurs then consumer i has endowment vector (ei , . . . , ei ) Rn . ns 1s The preferences of consumer i may also depend on the state of the world (e.g., the consumers enjoyment of wine may well depend on the state of his health). 1 I represent this dependence formally by dening the consumers preferences over contingent commodity vectors. That is, I let the preferences of consumer i be specied by a rational (complete and transitive) relation i dened on a consumption set X i RnS . Denition 7.1.2 Consumer i evaluates contingent commodity vectors by rst asi signing to state s a probability s (which could be dierent across consumers), then evaluating the physical commodity vectors at state s according to a Bernoulli statedependent utility function ui (xi , . . . , xi ), and nally computing the expected utils 1s ns ity. That is, the preferences of consumer i over two contingent commodity vectors xi , xi X i RnS satisfy
S S i s ui (xi , . . . s 1s s=1

x
i

, xi ) ns

s=1

i s ui (i , . . . , xi ). ns s x1s

Similarly, the technological possibilities of rm j are represented by a production set Y j RnS . The interpretation is that a state-contingent production plan y j RnS j j is a member of Y j if for every s, the input-output vector (y1s , . . . , yns ) of physical commodities is feasible for rm j when state s occurs. Example 7.1.1 Suppose that there are two states s1 and s2 , representing the economy being in the boom and in the recession, respectively. There are two physical commodities: input (commodity 1) and output (commodity 2). In this case, the elements of Y j are four-dimensional vectors. Assume that inputs must be invested before the resolution of the uncertainty about the economic condition and that a unit of inputs produces a unit of output if and only if the economy is in the boom. Then,
j j j j y j = (y11 , y21 , y12 , y22 ) = (1, 1, 1, 0)

In the future, you might get married or not, you might get a baby or not, you might get a new job or lose it. These things potentially aects the way you evaluate the commodities.

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CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY is a feasible plan. To complete the description of an economy in the same manner as we describe economies without uncertainty, it only remains to specify ownership shares for every consumer i and rm j. In principle, these shares could also be state-contingent. It i will be simple, however, to let j 0 be the share of rm j owned by consumer i i whatever the state is. Note that i j = 1 for every j.

7.2

Arrow-Debreu Equilibrium

We have seen in the previous section how an economy where uncertainty matters can be extended to an articial economy which is described by means of a set of states of the world S, a consumption set X i RnS (n stands for the number of physical commodities), an endowment vector ei X i RnS , and a preference relation i on X i for every consumer i, together with a production set Y j RnS and prot shares 1 I (j , . . . , j ) for every rm j. Here I have a big assumption. I postulate the existence of a market for every contingent commodity ( , s). 2 These markets open at date 0 before the resolution of uncertainty. The price of the commodity is denoted p( ,s) . What is being purchased (or sold) in the market for the contingent commodity ( , s) is commitments to receive (or to deliver) amounts of the physical good if, and when, state of the world s occurs. It is important to note that although deliveries are contingent, the payments are not. Furthermore, I should recognize that for this market to be well dened, it is indispensable that all economic agents are able to recognize the occurrence of s. That is, information should be symmetric across economic agents. I can, then, apply the concept of Walrasian equilibrium to our contingent claim market economy. When dealing with contingent commodities it is customary to call the Walrasian equilibrium an Arrow-Debreu equilibrium. Denition 7.2.1 An allocation (1 , . . . , xI , y 1 , . . . , y J ) X 1 X I Y 1 Y J RnS(I+J) x and a system of prices for contingent commodities p = (p(1,1) , . . . , p(n,S) ) RnS constitute an Arrow-Debreu equilibrium if: 1. (Prot Maximization): For every rm j, y j satises p y j p y j for all yj Y j . 2. (Utility Maximization): For every consumer i, xi is maximal for budget set i j p y j . xi X i p xi p ei +
jJ
2

in the

Contingent commodity ( , s) means that a physical commodity

when state s occurs.

103

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY 3. (Market Clearing): xi = yj + ei .

iI

jJ

iI

Standard assumptions we have made for the economy with certainty can be straightforwardly extended to the Arrow-Debreu contingent commodity market economy. As a result, we are able to ensure that the Arrow-Debreu equilibrium exists, equilibrium allocation is Pareto ecient (the rst welfare theorem), and the extended version of the second welfare theorem is established. The eciency implication of Arrow-Debreu equilibrium says, eectively, that the possibility of trading in contingent commodities leads, at equilibrium, to an ecient allocation of risk. It is important to realize that at any production plan, the prot of a rm, p y j , is a non-random amount of dollars. Productions and deliveries of goods do, of course, depend on the state of the world, but the rm is active in all the contingent markets and manages to insure completely.

7.3

The Working of the Arrow-Debreu Economy

Imagine the following story which aims at accounting for the Arrow-Debreu economy. There is only one bank in the world. Dont even distinguish the central bank from commercial banks. In any case, there is only one bank. There is only one centralized market place in which all the commitments are made at date 0 but all the real transactions are carried out at date 1 according to the commitments made at date 0. Every consumer has his personal credit card account provided by the bank. i Consumer is credit limit is given as p ei + j j j (p), i.e., his budget set at date 0. Each rm also has its business credit card account, but with no credit limit. If each consumer or rm buys one unit of contingent commodity ( , s) in the market at date 0, the amount p( ,s) will be debited from his account. In turn, he will receive a receipt from the bank. His receipt says that The bank gives consumer i (rm j) the right to receive one unit of physical commodity at date 1 if and only when state s occurs. When he wakes up tomorrow, then at date 1, he is able to see if state s occurs. It is also common knowledge that all people see what state occurs at date 1. If and only when state s occurs, he brings his receipt with him to the market and receives one unit of good . If each consumer or rm sells one unit of contingent commodity ( , s) in the market at date 0, the amount p ,s will be credited in his account. At the same time, the bank has the receipt which says that The bank has the right to obtain one unit of physical commodity at date 1 from consumer i (rm j) if and only when state s occurs. When he wakes up tomorrow, at date 1, he sees state s occurs. Then, the bank comes to consumer is home (rm js oce) with its receipt and demands one unit of good . Here it is assumed that no one can walk away. After obtaining the commodity, the bank brings it to the market. If state s does not occurs, there is no right whatsoever. The Arrow-Debreu equilibrium of this economy requires that there be a system of state contingent prices {p ,s } such that (1) each consumer maximizes his utility subject to his credit limit; (2) each rm maximizes its prot; (3) all markets clear at date 0; and (4) no one goes bankrupt.

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CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY

7.3.1

Ex Ante V.S. Ex Post

For simplicity, we ignore production. We set up the consumers optimization problem as follows:
S

max
x

nS

s us (xs )
s=1

s.t.

xX pxpe

(1 )

Let x be the solution to the optimization problem (1 ). For each state s S, we set up the following optimization problem.
xs

max us (xs ) n (xs , x ) X p (xs , x ) p e s s (1 )

s.t.

Note that x = (x , . . . , x , x , . . . , x ). The optimization problem (1 ) s 1 s1 s+1 S tries to answer what the optimal consumption plan in state s is if the decision maker made a commitment to x , which is a set of promises (or contracts) he made (at date s 0!) if any other states occur. I claim that one of the solutions to the optimization problem (1 ) is indeed x . Namely, when he contemplates at date 0 what he can do s at date 1, he knows at date 0 that he will not change his mind at date 1. Suppose x x s not, that is, there is xs such that us (s ) > u(x ) and (s , x ) is in the budget set. s Since s > 0 for each s = 1, . . . , S, we must have
S

x s us (s ) +
s =s

s us (x s

)>
s=1

s us (x ). s

This contradicts the fact that x is the solution to the optimization problem (1 ). Therefore, the optimization (1 ) implies that the optimization (1 ) for each s. This is what I mean by Ex ante optimality implies ex post optimality.

7.3.2

No market at date 1 and No real transaction at date 0

This means that each individual carries out all transactions according to the promises all market participants made in the date 0 market. Each individual keeps the promise.

7.3.3

No need to open spot markets at date 1

Consider the Arrow-Debreu economy with no production. Let (1 , . . . , xI ) RnSI x be an Arrow-Debreu equilibrium allocation with prices (p(1,1) , . . . , p(n,S) ) RnS . 105

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY When date 1 arrives, a state of the world s is revealed, contracts (promises) are x(1,s) (n,s) executed, and every consumer i receives xi = (i , . . . , xi ) Rn . Imagine now s i , markets for the n physical that, after this but before the actual consumption of xs goods were to open at date 1. I ask if there would be any incentive to trade in these markets. I claim that the answer is no. I argue by contradiction. Suppose that there were potential gains from trade among the consumers. That is, there were xi = (xi , . . . , xi ) for i = 1, . . . , I, s (1,s) (n,s) such that i xi i ei and (i , . . . , xi , . . . , xi ) i (i , . . . , xi , . . . , xi ) for all i, x1 S x1 s S s s s with at least one preference strict. This contradicts the conclusion of the rst welfare theorem of the Arrow-Debreu economy. 3 Hence, there is no reason for further trade to take place.

7.3.4

Each consumer has a single budget

As I explained above, in the context of the Arrow-Debreu economy, there is no market at date 1 and there is no need to reopen markets at date 1. Since uncertainty will be resolved at date 1, each consumer must contemplate all possible consequences simultaneously when making his contingent plan in the market at date 0. This implies that each consumer has only a single budget in the Arrow-Debreu economy.

7.4
7.4.1

Sequential Trade
Preliminaries

The Arrow-Debreu framework provides a remarkable illustration of the power of general equilibrium theory. Yet, it hardly be realistic. Indeed, at an Arrow-Debreu equilibrium all trade takes place simultaneously and before the uncertainty is resolved. Trade, so to speak, is a one-shot aair. In reality, however, trade takes place to a large extent sequentially over time, and frequently as a consequence of information disclosures. The aim of this section is to introduce a model of sequential trade and show that Arrow-Debreu equilibria can be reinterpreted by means of trading processes that actually unfold through time. For the analysis to be as simple as possible I consider only exchange economies. I take X i = RnS for every consumer i. To begin with, I assume that there are two + dates, t = 0 and t = 1, that there is no information whatsoever at t = 0, and that the uncertainty has resolved completely at t = 1. Again for simplicity, I assume that there is no consumption at t = 0. As I discussed in the previous section, the Arrow-Debreu equilibrium allocation
You can generalize this argument into the subset of consumers so that you appeal to the core property of the Arrow-Debreu equilibrium allocation.
3

106

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY is Pareto ecient and there is no need to reopen markets at t = 1. Matters, however, are dierent if not all the n S contingent commodity markets are available at t = 0. Then the initial trade needed for a Pareto ecient allocation may not be feasible and it is quite possible that ex post (i.e., after the revelation of the state s) the resulting consumption allocation is not Pareto optimal. There would then be an incentive to reopen the markets and retrade. A most interesting possibility, rst observed by Arrow (1953, 1964), is that, even if not all contingent commodities are available at t = 0, it may still be the case under some conditions that the retrading possibilities at t = 1 guarantee that Pareto eciency is reached, nevertheless. That is, the possibility of ex post trade can make up for an absence of some ex ante markets. In what follows, I shall verify that this is the case whenever at least one physical commodity can be traded contingently at t = 0 if, in addition, spot markets open at t = 1 and the spot equilibrium prices are correctly anticipated at t = 0. At t = 0 consumers have expectations regarding the spot market prices prevailing at t = 1 for each possible state s S. Denote the price vector expected to prevail in state s spot market by ps Rn , and the overall expectation vector by p = (p1 , . . . , pS ) RnS . Suppose that, in addition, at date t = 0 there is trade in the S contingent commodities denoted by (1, 1) to (1, S); that is, there is contingent trade only in the physical good with the label 1. We denote the vector of prices for these contingent commodities traded at t = 0 by (q1 , . . . , qS ) RS . Faced with security prices q RS at t = 0 and correctly expected spot market prices (p1 , . . . , pS ) RnS at t = 1, every consumer i formulates a portfolio plan i i (z1 , . . . , zS ) RS for contingent commodities at t = 0, as well as a set of spot market consumption plans (xi , . . . , xi ) RnS for the dierent states that may 1 S occur at t = 1. Let U i () be a utility function for i . Then the problem of consumer i can be expressed formally as (xi , . . . , xi ) RnS + 1 S i i (z1 , . . . , zS ) RS max U i (xi , . . . , xi ) 1 S

s.t. (1)
sS

i qs zs 0;

()

i (2) ps xi ps ei + p(1,s) zs s S. s s

Restriction (1) is the budget constraint corresponding to security trade at t = 0. The family of restrictions (2) are the budget constraints for the dierent spot markets. Observe that we are not imposing any restriction on the sign or the magnitude i i of zs . If zs < ei then one says that at t = 0, consumer i is selling good 1 short. s This is because he is selling at t = 0, contingent on state s occurring, more than he has at t = 1 if s occurs. Hence, if s occurs he will actually have to buy in the 107

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY spot market the extra amount of the rst good required for the fulllment of his commitments. The possibility of selling short is, however, indirectly limited by the fact that consumption, and therefore ex post wealth, must be nonnegative for every s. Observe also that we have taken the wealth at t = 0 to be zero. This is simply a convention. To dene an appropriate notion of sequential trade I shall impose a key condition: Consumers expectations must be self-fullled, or rational; that is, I require that consumers expectations of the prices that will clear the spot markets for the dierent states s do actually clear them once date t = 1 has arrived and state s is revealed. In other words, all agentss expectations about prices are not only common but also correct. Denition 7.4.1 A collection formed by a price vector q = (q1 , . . . , qS ) RS for contingent rst good commodities at t = 0, a spot price vector ps = (p(1,s) , . . . , p(n,s) ) Rn for every s S, and for every consumer i, consumption plans z i = (1 , . . . , zS ) RS zi i i = (i , . . . , xi ) RnS at t = 1 constitutes a Radner equilibrium at t = 0 and x x1 S if: 1. For every i, the portfolio and consumption plans z i , xi solve the constrained maximization problem (). 2. i iI zs 0 and
iI

xi s

i iI es

for every s S (Market Clearing).

7.4.2

Arrow Security

Let us set p(1,s) = 1 for each state s as a normalization. This implies that at each state we use commodity 1 as a unit of account. You could imagine one unit of commodity 1 as one dollar. 4 Note that this still leaves one degree of freedom, that corresponding to the forward trades at date 0 (so I could put q1 = 1, or perhaps s qs = 1). Then, I can rewrite the consumers optimization problem as follows: (xi , . . . , xi ) RnS + 1 S i i (z1 , . . . , zS ) RS max U i (xi , . . . , xi ) 1 S

s.t. (1)
sS

i qs zs 0;

()

i (2) ps xi ps ei + zs s S. s s

Denition 7.4.2 One unit of Arrow Security s (s = 1, . . . , S) is a promise to deliver one unit of physical commodity 1 when state s occurs. Its price qs , payable at date 0, is measured in the unit of account at date 0.
No matter what state occurs, one dollar is one dollar (the nominal value is always the same). However, the purchasing power of one dollar can be dierent across states.
4

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CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY

7.4.3

Implementing the Arrow-Debreu equilibrium allocations

The following two propositions eectively say that the set of Radner equilibrium allocations is the same as the set of Arrow-Debreu equilibrium allocations. Then, the number of asset markets needed at date 0 can be signicantly reduced from nS to S. Proposition 7.4.1 (Arrow-Debreu implies Radner) If the allocation x RnSI and the contingent commodities price vector (1 , . . . , pS ) RnS constitutes an p ++ Arrow-Debreu equilibrium, then there are prices q RS for contingent rst good ++ commodities and consumption plans for these commodities z = (1 , . . . , z I ) RSI z such that the consumption plans x, z , the prices q, and the spot prices (p1 , . . . , pS ) constitutes a Radner equilibrium. Proof of Proposition 7.4.1: Consumer is budget set of the Arrow-Debreu problem is
i BAD =

(xi , . . . , xi ) RnS 1 S +
s

ps (xi ei ) 0 . s s

Consumer is budget set of the Radner problem is


i BR =

(xi , . . . , xi ) RnS 1 S +

i i (z1 , . . . , zS ) s.t. s

i i qs zs 0 and ps (xi ei ) zs s . s s

i i What we want to show are the following three: (1) BAD BR for each i I; (2) i i i i i i z 0; and (3) i (xs es ) 0 for each s. Let x BAD for each i I. Set i = p (xi ei ) for each s and each i I. Because xi B i , we have zs s s s AD i zs = s s

ps (xi ei ) 0 (). s s

Setting qs = 1 for each s, we have


i i qs zs = zs = ps (xi ei ) s (). s s

Summing the above term over s, we have


i qs zs = s s

ps (xi ei ) s s

i xi BAD

0.

i i Setting ps = ps for each s, we have ps (xi ei ) zs for each s. Thus, xi BR . s s Hence, we are done about (1). Since (x, p) constitutes an A-D equilibrium, for each s, we have

(xi ei ) 0 s s
i

109

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY This implies that all spot markets clear, which conrms (3). Summing over i, for each s, we obtain
i zs = ps iI iI

(xi ei ) s s
(x,p)

is an A-D equilibrium

Thus, the security market clear, which completes (2). Proposition 7.4.2 (Radner implies Arrow-Debreu) If the consumption plans x RnSI , z RSI and prices q RS , (p1 , . . . , pS ) RnS constitute a Radner ++ ++ equilibrium, then there is a vector (1 , . . . , pS ) RnS such that the allocation x and p ++ the contingent commodities price vector (1 , . . . , pS ) RnS constitute an Arrowp ++ Debreu equilibrium. Proof of Proposition 7.4.2: What we want to show are the following two: (1) i i BR BAD for each i and (2) i (xi ei ) 0 for each s. Note rst that, since s (x, z, q, p) is a Rander equilibrium, we have i (xi ei ) 0 for each s. Thus, (2) is s s i veried. Let xi BR . Then,
i i ps (xi ei ) zs s = qs ps (xi ei ) qs zs s. s s s s

Set ps = qs ps for each s. Summing the above expression over s, we have ps (xi ei ) s s
s s i qs zs 0.

i This implies that xi BAD associated with the contingent commodity price vector p = (1 , . . . , pS ) = (q1 p1 , . . . , qS pS ). Hence (1) is also veried. p

7.5

Asset Markets

I begin again with the simplest situation, in which we have two dates, t = 0 and t = 1, and all the information is revealed at t = 1. Further, for notational simplicity I assume that consumption takes place only at t = 1. I view an asset, or more precisely, a unit of an asset, as a title to receive either physical goods or dollars at t = 1 in amounts that may depend on which state occurs. The payos of an asset are known as its returns. If the returns are in physical goods, the asset is called real. If they are in paper money, they are called nancial. Here I deal only with the real case and, moreover, I assume that the returns of assets are only in amounts of physical good 1. It is then convenient to normalize the spot price of that good to be 1 in every state, so that, in eect, I am using it as numeraire. Denition 7.5.1 A unit of an asset, or security, is a title to receive an amount rs of good 1 at t = 1 if state s occurs. An asset is therefore characterized by its return vector r = (r1 , . . . , rS ) RS . 110

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY Examples of assets include the following: 1. r = (1, . . . , 1). This asset promises the future noncontingent delivery of one unit of good 1. Its real-world counterparts are the markets for commodity futures. In the special case where there is a single consumption good, I call this asset the safe (or riskless asset. It is important to realize that with more than one physical good, a futures contract is not riskless: its return in terms of purchasing power depends on the spot prices of all the goods. 2. r = (0, . . . , 0, 1, 0, . . . , 0). This asset pays one unit of good 1 if and only if a certain state occurs. In the current theoretical setting, they are often called Arrow securities. Example 7.5.1 (Options) This is an example of a so-called derivative asset, that is, of an asset whose returns are somehow derived from the returns of another asset. Suppose there is a primary asset with return vector r RS . Then a (European) call option on the primary asset at the strike price c R is itself an asset. A unit of this asset gives the option to buy, after the state is revealed (but before the returns are pair), a unit of the primary asset at price c (the price c is in units of the numeraire, that is, of good 1). What is the return vector r(c) of the option? In a given state s, the option will be exercised if and only if rs > c (I neglect the case rs = c). Hence r(c) = (max{0, r1 c}, . . . , max{0, rS c}) . For a primary asset with returns r = (4, 3, 2, 1) specic examples are r(3.5) = (0.5, 0, 0, 0); r(2.5) = (1.5, 0.5, 0, 0); r(1.5) = (2.5, 1.5, 0.5, 0). I proceed to extend the analysis in the previous section by assuming that there is a given set of assets, known as an asset structure, and that these assets can be freely traded at date t = 0. Each asset k is characterized by a vector of returns rk RS . The number of assets is K. As before, I assume that there are no initial endowments of assets and that short sales are possible. The price vector for the assets traded at t = 0 is denoted q = (q1 , . . . , qK ). A vector of trades in these assets, denoted by z = (z1 , . . . , zK ) RK , is called a portfolio. Denition 7.5.2 A collection formed by a price vector q = (q1 , . . . , qK ) RK for assets traded at t = 0, a spot price vector ps = (p1s , . . . , pns ) Rn for every s S, i i and, for every consumer i I, portfolio plan z i = (z1 , . . . , zK ) RK at t = 0 i = (xi , . . . , xi ) RnS at t = 1 constitutes a Radner and consumption plans x 1 S equilibrium if:

111

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY 1. For every i I, the portfolio and consumption plans (z i , xi ) solves the problem (xi , . . . 1 i (z1 , . . . max , xi ) RnS S i , zK ) RK Ui (xi , . . . , xi ) 1 S

s.t. (a)
k

i qk zk 0 i p1s zk rsk s S k

(b) ps xi ps ei + s s 2.
i iI zk

0 and

iI

xi s

i iI es

for every k and s

In the budget set of the above denition, the wealth of consumer i at state s is the sum of the spot value of his initial endowment and the spot value of the return of his portfolio. Note that, without loss of generality, I can put p1s = 1 for all s S. It is convenient to introduce the concept the return matrix R. This is an S K matrix whose kth column is the return vector of the kth asset. Hence, its generic sk entry is rsk : r11 r1K . . .. . R= . . . . rS1 rSK With this notation, the budget constraint of consumer i becomes B i (p, q, R) = x RnS | z i RK with q z i 0 s.t. (p1 (x1 ei ), . . . , pS (xS ei ))T Rz i + 1 S Call the system q RK of asset prices arbitrage-free if there is no portfolio z = (z1 , . . . , zK ) such that q z 0, Rz 0, and Rz = 0. In words, there is no portfolio that is budgetary feasible and that yields a nonnegative return in every state and a strictly positive return in some state. Note that whether an asset price vector is arbitrage free or not depends on the returns of the assets and not on preferences. If I assume that preferences are strongly monotone, then an equilibrium asset price vector q RK must be arbitrage free: if it were not, it would be possible to increase utility merely by adding to any current portfolio a portfolio yielding an arbitrage opportunity. Because there are not restrictions on short sales, this addition is always possible. I now present a very important implication of the assumption that unlimited short sales are possible. Namely, I will establish that knowledge of the return matrix R suces to place signicant restrictions on the asset price vector q = (q1 , . . . , qK ) that could conceivably arise at equilibrium. Proposition 7.5.1 Assume that rk 0 and rk = 0 for all k. Then, for every (column) vector q RK of asset prices arising in a Radner equilibrium, we can nd multiplies = (1 , . . . , S ) 0, such that qk = s s rsk for all k (in matrix notation, q T = R). 112

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY

V RS +

Figure 7.1: Construction of the No-arbitrage Weights Proof: The proof is based on the following lemma. Lemma 7.5.1 If the asset price vector q RK is arbitrage free, then there is a vector of multipliers = (1 , . . . , S ) 0 satisfying q T = R. Proof: Since we deal only with assets having nonnegative, nonzero returns, an arbitrage-free price vector q must have qk > 0 for every k. Also, without loss of generality, we assume that no row of the return matrix R has all of its entries equal to zero. Given an arbitrage-free asset price vector q RK , consider the convex set V = {v RS | v = Rz for some z Rk with q z = 0}. The arbitrage freeness of q implies that V {RS \{0}} = . Since both V and RS \{0} + + are convex sets and the origin ({0}) belongs to V , we can apply the separating hyperplane theorem to obtain a nonzero vector = (1 , . . . , S ) such that v 0 for any v V and v 0 for any v RS . Note that it must be that 0. + Moreover, because v V implies v V (this is because q z = 0 q (z) = q z = 0), it follows that v = 0 for any v V .

113

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY {z RK | Rz = 0} RK qT R

0T

Figure 7.2: Existence of an inadmissible z if q T is not proportional to R. We now argue that the row vector q T must be proportional to the row vector R RK . The entries of and of R are all nonnegative and no row of R is null. Therefore R 0T and R = 0T . If q T is not proportional to R, then we z z can nd z RK such that q z = 0 and R > 0. But letting v = R, we would then have v V and v = 0, which we have just seen cannot happen. Hence q T must be proportional to R; that is, q T = R for some real number > 0. Letting = , we have the conclusion of the lemma. This completes the proof of the proposition. As we have already argued, if short sales of assets are possible and preferences are strongly monotone (e.g., if preferences admit an expected utility representation with strictly positive subjective probabilities for the states), then equilibrium asset prices must be arbitrage-free. Denition 7.5.3 An asset structure with an S K return matrix R is complete if rank R = S, that is, if there is some subset of S assets with linearly independent returns. Example 7.5.2 (Asset Structure for Arrow Securities and More) In the case of S Arrow securities, the return matrix is the S S identity matrix. This is the 114

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY canonical example of complete markets. But there are many other ways for a matrix to be nonsingular. Thus, with three states and three assets, we could have the return matrix 1 0 0 R = 1 1 0 , 1 1 1 which has rank equal to 3, the number of states. Example 7.5.3 (Spanning through Options) Suppose that S = 4 and there is a primary asset with returns r = (4, 3, 2, 1). We have seen that, for every strike price c, the option dened by c constitutes an asset with return vector r(c) = (max{0, r1 c}, max{0, r2 c}, max{0, r3 c}, max{0, r4 c}) . Using options I can create a complete asset structure supported entirely on the primary asset r. For example, the return vectors r(3.5), r(2.5), r(1.5), and r are linearly independent. Thus, the asset structure consisting of the primary asset plus three options with strike prices 3.5, 2.5, and 1.5 is complete. More generally, whenever the primary asset is such that rs = rs for all s = s , it is possible to generate a complete asset structure by means of options. If the primary asset does not distinguish between two states, no derived asset can do so either. Proposition 7.5.2 (A-D Radner) Suppose that the asset structure is complete. Then: 1. (A-D Radner): If the consumption plans x = (1 , . . . , xI ) RnSI and the x price vector p = (p1 , . . . , pS ) RnS constitutes an Arrow-Debreu equilibrium, ++ z then there are asset prices q RK and portfolio plans z = (1 , . . . , z I ) RKI ++ such that the consumption plans x, portfolio plans z , asset prices q, and spot prices p = (p1 , . . . , pS ) constitutes a Radner equilibrium. 2. (Radner A-D): If the consumption plans x RnSI , portfolio plans z RKI , and prices q RK , p = (p1 , . . . , pS ) RnS constitutes a Radner equilib++ ++ rium, then there are multipliers (1 , . . . , S ) RS such that the consumption ++ plans x and the contingent commodities price vector (1 p1 , . . . , S pS ) RnS constitutes an Arrow-Debreu equilibrium. (The multiplier s is interpreted as the value, at t = 0, of a dollar at t = 1 and state s; recall that p1s = 1 for each s.) Proof: (A-D Radner): Dene qk = s p1s rsk for every k. Denote by the S S diagonal matrix whose s diagonal entry is p1s : 0 p11 0 0 p12 0 = . . . .. . . . . . . . 0 115 0 p1S

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY Then q T = 1R, where 1 RS is a column vector with all its entries equal to 1. For every i, the (column) vector of wealth transfers across states (at the Arrow-Debreu equilibrium) is x1 xS mi = p1 (i ei ), . . . , pS (i ei ) 1 S
T

By the budget balance, we have 1 mi = 0 for every i and we have iI mi = 0 by market clearing. By completeness, rank R = S and therefore, we can nd vectors z z i RK such that mi = Ri for i = 1, . . . , I 1. Letting z z I = (1 + z I1 ), we also have mI = (m1 + +mI1 ) = RI . Therefore, for each i, the portfolio z i z allows consumer i to reach the Arrow-Debreu consumption in the dierent states at the spot prices (p1 , . . . , pS ). To verify the budget balance note that q z i = 1Ri = z i = 0 for each i. 1m (Radner A-D): Assume, without loss of generality, that p1s = 1 for each s. By the previous proposition, we have q T = R for some arbitrage weights = (1 , . . . , S ). We show that x is an Arrow-Debreu equilibrium with respect to i (1 p1 , . . . , S pS ). Let xi BR . By the completeness assumption, there is z i RK such that (p1 (xi ei ), . . . , pS (xi ei ))T = Rz i and, therefore, q z i = Rz i 0. 1 1 S S Since xi satises the budget constraint of the Radner economy, we must satisfy (p1 (xi ei ), . . . , pS (xi ei ) 1 1 S S Moreover, s ps (xi ei ) Rz i = q z i ( q T = R) s s
s T

Rz i .

0 ( the budget constraint of the Radner economy)

In discussing Radner equilibria, what matters is not so much the particular asset structure but the linear space, Range R = v RS | v = Rz for some portfolio z R RS , the set of wealth vectors that can be spanned by means of the existing assets. It is quite possible for two dierent asset structures to give rise to the same linear space. The next result tells us that, whenever this is so, the set of Radner equilibrium allocations for the two asset structures is the same. Proposition 7.5.3 Suppose that the asset price vector q RK , the spot prices p = (p1 , . . . , pS ) RnS , the consumption plans x = (x1 , . . . , xI ) RnSI , and the + 116

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY portfolio plans z = (z 1 , . . . , z I ) RKI constitutes a Radner equilibrium for an asset structure with S K return matrix R. Let R be the S K return matrix of a second asset structure. If Range R = Range R, then x is still the consumption allocation of a Radner equilibrium in the economy with the second asset structure. Proof: By the previous proposition, the asset prices satisfy the no-arbitrage condition q T = R for some RS . Denote q = [ R ]T . We claim that if + Range R = Range R , then B i (p, q , R ) = B i (p, q, R) i. We show that if xi B i (p, q, R) then xi B i (p, q , R ). To see this, let p1 (xi ei ), . . . , pS (xi ei ) 1 1 S S
T

Rz

and q z 0. Since Range R = Range R , we can nd z RK such that Rz = R z Range R . But then q z = R z ( q = [ R ]T ) = = Rz ( Rz = R z ) = q z ( q T = R) 0. To argue that the asset prices q , the spot prices p = (p1 , . . . , pS ), and the consumption allocation x RnSI are part of a Radner equilibrium in the economy with an asset structure having return matrix R, it suces to nd portfolios z = (z 1 , . . . , z I ) RKI with the following two properties: 1.
iI

z i = 0; and

2. for every consumer i, mi = p1 (xi ei ), . . . , pS (xi ei ) 1 1 S S


T

= R z i.

By strong monotonicity of preferences, we have mi = Rz i for every consumer i. Hence, mi Range R and therefore mi Range R for every i. Choose then z 1 , . . . , z I1 such that mi = R z i for every i = 1, . . . , I 1. Finally, let z I = (z 1 + + z I1 ). Then i z i = 0 and also mI = (m1 + mI1 ) = R (z 1 + + z I1 ) = R z I . Example 7.5.4 (Pricing an Option) Suppose that, with S = 2, there is an asset with non-contingent returns, say r1 = (1, 1) and a second asset r2 = (3 + , 1 ), with > 0. The asset prices are q1 = 1 and q2 . I now consider an (call) option on the second asset that has strike price c (1, 3). Then, there are a, b R such that r2 (c) = (3 + c, 0) = ar2 + br1 = (a(3 + ) + b, a(1 ) + b). 117

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY If I solve the above equation with respect to a and b, I obtain a= (1 )(3 + c) 3+c and b = 2 + 2 2 + 2

Thus, the asset structure R is R= 1 3+ 3+c 1 1 0 .

The no-arbitrage condition requires that there exists = (1 , 2 ) R2 with q T = R. That is, q T = (1, q2 , q2 (c)) = (1 , 2 ) 1 3+ 3+c 1 1 0 = (1 + 2 , 1 (3 + ) + 2 (1 ), 1 (3 + c))

Thus, I obtain q2 (c) = 3+c [q2 (1 )] . 2 + 2

7.6

Multi-Period Exchange Economies

The same methodology developed in the previous section can be used to consider more general multi-period exchange economies. Suppose I have T + 1 dates t = 0, 1, . . . , T and, as before, S states, but assume that the states emerge gradually through a tree. Here nal nodes stand for the possible states realized by time t = T , that is, for complete histories of the uncertain environment. When the path through the tree coincides for two states, s and s , up to time t, this means that in all periods up to and including period t, s and s cannot be distinguished. Subsets of S are called events. A collection of events F is an information structure if it is a partition, that is, if for every state s, there is E F with s E and for any two E, E F , E = E , we have E E = . The interpretation is that if s and s belong to the same event in F then s and s cannot be distinguished in the information structure F . To capture formally a situation with sequential revelation of information, I look at a family of information structures: (F0 , . . . , Ft , . . . , FT ). The process of information revelation makes the Ft increasingly ne: Ft+1 is at least as ne as Ft . It is assumed that F0 is trivial, i.e., F0 = {S} and FT is the discrete partition, i.e., FT = {1, . . . , S} = S. Once one has information sucient to distinguish between two states, the information is not forgotten. The partitions could in principle be dierent across individuals. However, I shall assume that the information structure is the same for all consumers. A pair (t, E) where t is a date and E Ft is called a date-event. Date-events are associated with the nodes of the tree. Each date-event except the rst has a unique predecessor, and each date-event not at the end of the tree has one or more successors. 118

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY

s 1

2 3 4 5 6 t=0 t=1 t=2

Figure 7.3: An information tree: gradual release of information There is a single consumption good which cannot be stored. This good is consumed at each date and the amount consumed at date t can vary across cells of Ft . Thus, I then say that a vector z is measurable with respect to the family of information partitions (F0 , . . . , FT ) if, for every (t, s) and (t, s ), I have that z(t, s) = z(t, s ) whenever s, s belong to the same element of the partition Ft . That is, whenever s and s cannot be distinguished at time t, the consumption goods assigned to the two states cannot be dierent. Finally, I impose on endowments ei = {ei (t, s) R+ | t = 0, . . . , T and s S} and consumption sets X i = {xi (t, s) R+ | t = 0, . . . , T and s S} with the restriction that all their elements be measurable with respect to the family of information partitions. 5 With this, I have reduced the multi-period structure to our original formulation. There are N assets or securities in this economy. There are claims to (state contingent) consumption at date T . They are indexed by n = 1, . . . , N . Security n entitles the bearer (on date T ) to rks units of the consumption good at date T if the state is s. Denote rs (r1s , . . . , rN s ). The net supply of these securities is zero. It is assumed that for every state, there is one of these securities that pays o a nonnegative amount in every state and a strictly positive amount in that state. At each date t T and in every state s S, markets open in which these N
For any t, we must have the following property: ei (t, s) = ei (t, s ) and xi (t, s) = xi (t, s ) whenever s and s belong to the same cell of Ft .
5

119

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY securities can be traded for one another and for the consumption good. The price (in units of the consumption good) of security n at date t in state s will be denoted by qn (t, s). These markets have no transaction costs and no restrictions on short sales. A price system is a vector stochastic process q = {qn (t, s)| n = 1, . . . , N, t = 0, . . . , T, s S and for each t, qn (t, s) = qn (t, s ) whenever s and s belong to the same cell of Ft }. The consumers problem in this economy is to manage a portfolio of these N securities in order to obtain for himself the best possible vector of state contingent consumption. A portfolio strategy is a N dimensional vector stochastic process z = {zk (t, s)| for any t, zn (t, s) = zn (t, s ) whenever s and s belong to the same cell of Ft }. The interpretation is that zn (t, s) is the number of shares of security n held from date t until t + 1 in state s. (For t = T, zn (T, s) is the number of shares from which the dividend is received.) For any state s S, dene the following: xi (z, q, s) = xi (z, q, s), . . . , xi (z, q, s) 0 T xi (z, q, s) = ei (0, s) z i (0, s) q(0, s) 0 xi (z, q, s) = ei (t, s) + z i (t 1, s) z i (t, s) q(t, s) t = 1, . . . , T t xi (z, q, s) = ei (T, s) + z i (T 1, s) z i (T, s) q(T, s) + z i (T, s) rs T Denote xi (z i , q) {xi (s, z i , q)| s S} and xi (z i , q) {xi (z i , q)| t = 0, . . . , T }. A t t t consumption bundle xi is feasible for consumer i at prices q if xi X i and there exists a portfolio strategy z i such that xi xi (z i , q). The set of feasible consumption bundles for consumer i at prices q is denoted X i (q). Denition 7.6.1 A collection formed by a price system q and for every consumer i I, consumption plan xi and portfolio strategy z i constitutes a Radner equilibrium of a multi-period exchange economy if: 1. xi xi (z i , q) and xi X i for all i I; 2. xi is 3. xi
iI i

maximal among all x X i (q) for each i I; and

z i = 0.

The rst condition says that xi is a feasible consumption plan for i and that is feasible if consumer i adopts the portfolio strategy z i . The second condition says that taking prices q as given, consumer i can do no better than xi . The third condition says that securities markets clear exactly. It is relatively easy to see that markets for the consumption good clear as well at a Radner equilibrium. The following alternate characterization of a Radner equilibrium will be useful. Fix a price system q. Dene M i = {x X i | x = xi (z, q) for some portfolio strategy z} Then, dene M i = {x X i | x = m + (, 0, . . . , 0) for some m M i and R}; (7.1) i i (7.2) (m + (, 0, . . . , 0)) = (e ) + for m M and R. 120

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY Clearly M i is a subspace of X i . Proposition 7.6.1 If (q, (xi , z i )iI ) is a Radner equilibrium of a multi-period exchange economy, then there is a strictly positive linear functional : M R such that: 1. M i {x X i | x ei , x = ei } = for all i I (No Arbitrage); and 2. For each i N, xi M i X i , (xi ) (ei ), and xi is {x M i X i | (x) (ei )}.
i

maximal in

Sketch of Proof: Suppose xi and q are given as part of a Radner equilibrium of a multi-period exchange economy. By strong monotonicity of i , there exist z i such that xi = xi (i , q). Let z i = z i for i = 1 and z 1 = i=1 z i . z

7.6.1

Implementing the A-D equilibria by Trading Long-lived Securities

Suppose that for a Radner equilibrium price system q, the corresponding space M is X. Then, the equilibrium allocation (xi )iI is an equilibrium allocation for an ArrowDebreu economy with a complete set of contingent claims markets and therefore is Pareto ecient. Thus, it is natural to seek conditions that yield M = X. Dene for t < T and E Ft , K(t, E) = cardinality{E Ft+1 | E E} K = max{K(t, E)| t < T, E Ft } In words, K(t, E) is the number of subcells of E in Ft+1 . This is a measure of the amount of information that might be received by date t + 1 if at date t, the event E is known to prevail: If K(t, E) = 1, then no new information will be received. If K(t, E) = 2, then new information of an either type will be received, and so on. Proposition 7.6.2 (Kreps (1982)) Let q be a Radner equilibrium price system, and let M be dened from q. A necessary and sucient condition for M = X is that for each t < T and E Ft , Rank {span{q(t + 1, s)| s E} = K(t, E) (7.3)

A paraphrase of this condition is that the conditional support of qt+1 give that s E consists of K(t, E) linearly independent vectors. There are at most K(t, E) vector in this conditional support (because qt+1 is Ft+1 measurable). Thus, K(t, E) is an upper bound on Rank { span {q(t + 1, s)| s E}. The condition is that this upper bound is hit in every instance. Rather than work through the details, a full example will be given which should make both the proposition and its proof transparent.

121

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY

Date: 0

3 State 1 1 1 2 1 3 1 6 1 4 1 5

0.81 1.26 0.729 2.4 0.81 3.75

0.9 1.4

s1 s2 s3 s4 s5 s6

0.9 4.2

0.909 4.2

Figure 7.4: Dividend Structure of a Radner Equilibrium (a) Suppose that there are six states S = {s1 , s2 , s3 , s4 , s5 , s6 } and four dates t = 0, 1, 2, 3. The exogenous information structure is given by the partitions: F0 = {S}; F1 = {{s1 , s2 }, {s3 , s4 , s5 , s6 }}; F2 = {{s1 , s2 }, {s3 , s4 }, {s5 , s6 }}; F3 = S = {{s1 }, {s2 }, {s3 }, {s4 }, {s5 }, {s6 }} Thus, K(1, {s1 , s2 }) = 1 while K(2, {s1 , s2 }) = 2. Suppose that there are two securities whose dividends at date 3 are as the following table: state payo of security #1: r1 () payo of security #2: r2 () s1 1 1 s2 1 2 s3 1 3 s4 1 6 s5 1 4 s6 1 5

Consider two possible equilibrium price systems arising from these data, as depicted in Figure 4 and 5. The column vector in these event trees give the prices of the two securities as a function of the date and state. For example, the column vector 0.9 4.2 which is interpreted to mean q1 (2, s4 ) = 0.9 and q2 (2, s4 ) = 4.2. Note that the tree structure corresponds to the information structure. 122

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY

Date: 0

3 State 1 1 1 2 1 3 1 6 1 4 1 5

0.81 1.26 0.729 2.4 0.81 3.78

0.9 1.4

s1 s2 s3 s4 s5 s6

0.9 4.2

0.909 4.242

Figure 7.5: Dividend Structure of a Radner Equilibrium (b) Does M = X in either or both cases? The answer is yes if and only if for every t > 0 and E Ft , the vector x = (x(0), . . . , x(T )) that is given by x(t) = 0 for t = t and x(t) = 1E is in M . That is, there must exist a portfolio strategy that produces one unit of consumption in event E at date t and nothing at any other date-event pair. Let me begin by asking if this is true for t = 1 and for every E F1 . In each case, the answer is yes the two possible values of q(1) are linearly independent, thus there exist (z1 , z2 ) and (z1 , z2 ) such that q1 (1)z1 + q2 (1)z2 = 1{s1 ,s2 } q1 (1)z1 + q2 (1)z2 = 1{s3 ,s4 ,s5 ,s6 } This clearly suces. Now proceed to ask the question for t = 2. For E = {s1 , s2 }, there is no problem in either case. But matters are not so simple for E = {s3 , s4 }. In case (a), it can be done: First solve 0.9z1 + 4.2z2 = 1 0.909z1 + 4.1z2 = 0. This can done because the two column vectors are linearly independent. Let z1 , z2 ) be the solution. Next solve
0.81z1 + 3.75z2 = 0.81z1 + 3.75z2 .

0.81z1 + 1.26z2 = 0

123

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY


This can be done by the rst step: The solution, denote it (z1 , z2 ), just a scalar multiple of (z1 , z2 ). Then, the strategy of starting with (z1 , z2 ) at date 0, changing , z ) if {s , s , s , s } occurs, and the to (0, 0) at date 1 if {s1 , s2 } occurs and to (z1 2 3 4 5 6 consuming everything at date 2 yields one unit of consumption at date 2 if and only if {s3 , s4 } occurs.

But consider case (b). One cannot solve 0.9z1 + 4.2z2 = 1 0.909z1 + 4.242z2 = 0, because the tow column vectors are linear dependent. Thus, if one consumes one unit at date 2 and nothing at date 3 when {s3 , s4 } occurs, one must either consume something at date 2 or at date 3 when {s5 , s6 } occurs. By inductively applying this sort of logic, one can see that M = X in case (a), but that M = X in case (b). A Radner equilibrium (a) makes the basic idea clear. In this economy there are six states of the world and only two securities, yet markets are complete. This is because the process of learning which of the six states is the true state takes place not all at once but in three steps. Agents can revise their portfolios after each step in the learning process. At each step, at most two signals are possible. And the equilibrium prices of the two securities are well behaved they are linearly independent in a fashion that enables agents to take full advantage of new information as it is received.

7.6.2

Genericity of the Case M = X with K or More Securities

Fix the economic setting; that is, x the state space (S), information structure (F ) and the agents (I). Suppose N securities are selected at random. By a selection of N securities is meant a selection of a point r from the set R which is dened as follows: R {rn (s) R| n = 1, . . . , N, s S} A subset of R will be called sparse if its closure has Lebesgue measure zero. If the selection of r is done randomly enough, there is zero probability that the outcome will land in a given sparse set. Following the terminology of Radner (1979), a result that holds o of a sparse set is called generic. Proposition 7.6.3 (Kreps (1982)) Fix the economic setting (S, F , I). Suppose that, in this setting, there is an equilibrium with equilibrium allocation (xi )iI in an Arrow-Debreu economy. Then, if N K, there is a sparse set R R such that for the economy with K long-lived securities paying r at date T admits a all r R\R, Radner equilibrium with M = X and with equilibrium allocation (xi )iI .

124

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY Proof: In the Arrow-Debreu economy, there is a linear functional : X R that is strictly positive and that satises xi X i , (xi ) (ei ), and xi is
i

maximal in {x X i | (x) (ei )}.

(7.4)

That is, gives the equilibrium prices. Normalize so that ((1, 0, . . . , 0)) = 1. For every t = 0, . . . , T and E Ft , dene t,E by t,E (t) = 0 for t = t and t,E (t) = 1E . That is, t,E is the claim that pays one unit of consumption at date t in the event E. For any r R, dene q from r and as follows: For t T and s S, let E Ft be such that s E. Then, let qk (t, s) =
sE rk (s)

T,{s} . (t,E )

(7.5)

Two things, once demonstrated, give the result. First, except for r from a sparse subset of R, q so dened satises (7.3), and thus M = X. Second, for all such r, the linear functional dened in (7.2) is . For the rst result, it is necessary to show that except for r from a sparse set, the set {q(t + 1, s)| s E} contains K(t, E) linearly independent vectors for every t and E Ft . Since there are nitely many such pairs (t, E) and since the union of a nite number of sparse sets is sparse, it suces to show that for every t and E, the set of r R for which the corresponding {q(t + 1, s)| s E} does not contain K(t, E) linearly independent vectors is sparse. Using (7.5), the set {qn (t + 1, s)| s E} can be written
sE

rn (s) T,{s} E Ft+1 , E E (t,E )

which, letting (t, s) denote the strictly positive scalar T,{s} / (t,E ), is r(s)(t + 1, s) E Ft+1 , E E
sE

The set of r for which this set of K(t, E) vector is linearly dependent is clearly closed. That it has Lebesgue measure zero is also apparent as follows: Let T : R K(t,E) be the map RN T (r) =
sE

r(s)(t + 1)
E Ft+1 , E E

125

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY and let denote Lebesgue measure on R. Then, the measure T 1 on RN is absolutely continuous with respect to Leabesgue measure because (t + 1, s) are K(t,E) K(t,E) of vector [(r)N ]k=1 strictly positive. And the Lebesgue measure in RN n=1 such that (r)n=1,... ,N are linearly dependent is zero, if N K. For the second result, it suces to show that for all portfolio strategies z, (x(z, q)) = (ei ). There is nothing to do but grind this out:
K(t,E)

7.7

Incomplete Markets

Proposition 7.7.1 (Sunspot Free Equilibria) Suppose that the following four assumptions are satised. 1. U i (x1 , . . . , xS ) =
S i s=1 s us (xs )

for any i

i 2. s = s for any i and any s S

3. ui () = ui () and ei = ei for any i and any s S s s 4. ui () is strictly concave. Then, any Pareto ecient allocation must be uniform across states. Proof of Proposition 7.5.3: Let x = (xi , . . . , xi )i=1,... ,n be a Pareto ecient 1 S allocations. For each i and each s, dene xi = s s xi . The new allocation x is s state independent, and it is also feasible because
n n n n n

xi =
i=1 i=1 s

s xi = s
s

s
i=1

xi s

s
i=1

ei

=
i=1

ei

Since ui () is concave, s ui (i ) = ui (i ) = ui x x
s s

s xi s

s ui (xi ) i s

Because of the Pareto eciency of x, the above inequalities must in fact be equality. But, if so, then the strict concavity of ui () yields xi = xi for any s. This implies s that any Pareto ecient allocation is state uniform. From the state independence of Pareto ecient allocations and the rst welfare theorem, I reach the important conclusion that if a system of complete markets over the states S can be organized, then the equilibria are sunspot-free, that is, consumption is uniform across states. It turns out, however, that if there is not a complete set of insurance opportunities, then the above conclusion does not hold true. Sunspot-free Pareto ecient equilibria always exist (just make the market 126

CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY not pay attention to the sunspot). But it is now possible for the consumption allocation of some Radner equilibria to depend on the state, and consequently to fail the Pareto eciency test. In such an equilibrium, consumers expect dierent prices in dierent states, and their expectations end up being self-fullling. The simplest, and most trivial example is when there are not assets whatsoever. Then a system of spot prices (p1 , . . . , pS ) RnS is a Radner equilibrium if and only if every ps is a Walrasian equilibrium price vector for the spot economy dened by {ui (), ei }iI . If, as is perfectly possible, this economy admits several distinct Walrasain equilibria, then by selecting dierent equilibrium price vectors for dierent states, I obtain s sunspot equilibrium, and hence a Pareto inecient Radner equilbirium. I have conrmed that Radner equilibrium allocations need not be Pareto ecient and so, in principle, there may exist reallocations of consumption that make all consumers at least as well o, and at least one consumer strictly better o. It is important to recognize, however, that this need not imply that a welfare authority who is as constrained in interstate transfers as the market is can achieve a Pareto eciency. An allocation that cannot be Pareto improved by such an authority is called a constrained Pareto eciency. A more signicant and reasonable welfare question to ask is, therefore, whether Radner equilibrium allocations are constrained Pareto ecient. For the sake of simplicity, it is assumed here that there is a single commodity per state. The important implication of this assumption is that then the amount of consumption good that any consumer i gets in the dierent states is entirely i determined by the portfolio z i . Indeed, xi = n zn rsn + ei . Hence, I can let s s
i i i i U (z i ) = U (z1 , . . . , zN ) = U i n i zn r1n + ei , . . . , 1 n i zn rSn + ei S

denote the utility induced by the portfolio z i . Denition 7.7.1 The asset allocation (z 1 , . . . , z I ) RN I is constrained Pareto i ecient if it is feasible (i.e., i z 0) and if there is no other feasible asset allocation (1 , . . . , z I ) RN I such that z
i i z U (i ) U (z i ) i I

with at least one inequality strict. In this context, the utility maximization problem of consumer i becomes maxz i
N

i i i U (z1 , . . . , zN )

s.t. q z i 0.
i Suppose that z RN for i I, is a family of solutions to these individual problems, for the asset price vector q RN . Then, q RN is a Radner equilibrium

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CHAPTER 7. GENERAL EQUILIBRIUM UNDER UNCERTAINTY


i price if and only if i z 0. Note that this has become now a perfectly conventional equilibrium problem with N commodities. To it I can apply the rst welfare theorem and reach the following conclusion.

Proposition 7.7.2 Suppose that there are only two periods and only one consumption good in the second period. Then, any Radner equilibrium is constrained Pareto ecient in the sense that there is no possible redistribution of securities in the rst period that leaves every consumer as well o and at least one consumer strictly better o. The situation here is very particular in that once the initial asset portfolio of a consumer is determined, his overall consumption is fully determined: with only one consumption good, there are no possibilities for trade once the state occurs. In particular, second-period relative prices do not matter, simply because there are no such prices. Things change if there is more than one consumption good in the second period, or if there are more than two periods (See the previous section). Consider the two-period case with two consumption goods: Then, I cannot summarize the individual decision problem by means of an indirect utility of the asset portfolio. The relative prices expected in the second period also matter. 6 This substantially complicates the formulation of a notion of constrained Pareto eciency. In it I have an economy with several Radner equilibria where two of them are Pareto ordered. That is, I have a Rander equilibrium that is Pareto dominated by another Radner equilibrium. To the extent that it seems natural to allow a welfare authority, at the very least, to select equilibria, it follows that the rst equilibrium is not constrained Pareto ecient.

Or the relative prices of goods between the second and third period, if I am considering more than two dates, instead.

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