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Advanced Microeconomics Topic 3: Consumer Demand Primary Readings: DL – Chapter 5; JR - Chapter 3; Varian, Chapters 7-9. 3.1 Marshallian Demand Functions Let X be the consumer's consumption set and assume that the X = Rm+. For a given price vector p of commodities and the level of income y, the consumer tries to solve the following problem: max u(x) subject to px = y xX • The function x(p, y) that solves the above problem is called the consumer's demand function. • It is also referred as the Marshallian demand function. Other commonly known names include Walrasian demand correspondence/function, ordinary demand functions, market demand functions, and money income demands. • The binding property of the budget constraint at the optimal solution, i.e., px = y, is the Walras’ Law. • It is easy to see that x(p, y) is homogeneous of degree 0 in p and y. Examples: (1) Cobb-Douglas Utility Function: m u(x) xi i , i 0,i 1,...,m. i 1 From the example in the last lecture, the Marshallian demand functions are: xi where i y . pi m i i . 1 (2) CES Utility Functions: u(x1, x2 ) (x1 x2 )1/ (0 1) Then the Marshallian demands are: x1(p, y) p1r 1 y ; p1r p2r x2 (p, y) p2r 1 y , p1r p2r where r = /( -1). And the corresponding indirect utility function is given by v(p, y) y( p1r p2r )1/ r Let us derive these results. Note that the indirect utility function is the result of the utility maximization problem: max(x1 x2 )1/ x1,x2 subject to p1x1 p2 x2 y Define the Lagrangian function: L(x1, x2 , ) (x1 x2 )1/ ( p1x1 p2 x2 y) 1 The FOCs are: L (x1 x2 )(1/ )1 x1 1 p1 0 x1 L (x1 x2 )(1/ )1 x2 1 p2 0 x2 Eliminating , we get L p1x1 p2 x2 y 0 1/( 1) p1 x1 x2 p 2 y p1x1 p2x2 So the Marshallian demand functions are: x1 x1(p, y) p1r 1 y p1r p2r p2r 1 y x2 x2 (p, y) r p1 p2r with r = /(-1). So the corresponding indirect utility function is given by: v(p, y) u(x1(p, y), x2 (p, y)) y( p1r p2r )1/ r 3.2 Optimality Conditions for Consumer’s Problem First-Order Conditions The Lagrangian for the utility maximization problem can be written as L = u(x) - ( px - y). Then the first-order conditions for an interior solution are: u(x) pi i; i.e. u(x) p xi px y 2 (1) Rewriting the first set of conditions in (1) leads to MRSkj MU j pj , j k, MU k pk which is a direct generalization of the tangency condition for two-commodity case. x2 u(x1, x2 = u slope = - MRS21 slope = - p1/p2 x1 Sufficiency of First-Order Conditions Proposition: Suppose that u(x) is continuous and quasiconcave on Rm+, and that (p, y) > 0. If u if differentiable at x*, and (x*, *) > 0 solves (1), then x* solve the consumer's utility maximization problem at prices p and income y. Proof. We will use the following fact without a proof: • For all x, x' 0 such that u(x') u(x), if u is quasiconcave and differentiable at x, then u(x)(x' - x) 0. Now suppose that u(x*) exists and (x*, *) > 0 solves (1). Then, u(x*) = *p, px* = y. If x* is not utility-maximizing, then must exist some x0 0 such that u(x0) > u(x*) and px0 y. Since u is continuous and y > 0, the above inequalities implies that u(tx0) > u(x*) and p(tx0) < y for some t [0, 1] close enough to one. Letting x' = tx0, we then have u(x*)(x' - x) = (*p)( x' - x) = *( px' - px) < *(y - y) = 0, which contradicts to the fact presented at the beginning of the proof since u(x1) > u(x*). Remark • Note that the requirement that (x*, *) > 0 means that the result is true only for interior solutions. Roy's Identity Note that the indirect utility function is defined as the "value function" of the utility maximization problem. Therefore, we can use the Envelope Theorem to quickly derive the famous Roy's identity. Proposition (Roy's Identity?): If the indirect utility function v(p, y) is differentiable at (p0, y0) and assume that v(p0, y0)/ y 0, then 3 v(p0 , y0 ) pi xi (p0 , y0 ) , v(p0 , y0 ) y i 1,...,m. Proof. Let x* = x(p, y) and * be the optimal solution associated with the Lagrangian function: L = u(x) - ( px - y). First applying the Envelope Theorem, to evaluate v(p0, y0)/ pi gives v(p, y) L(x*,*) * xi* . pi pi But it is clear that * = v(p, y)/ y, which immediately leads to the Roy's identity. Exercise • Verify the Roy's identity for CES utility function. Inverse Demand Functions Sometimes, it is convenient to express price vector in terms of the quantity demanded, which leads to the so-called inverse demand functions. • the inverse demand function may not always exist. But the following conditions will guarantee the existence of p(x): • u is continuous, strictly monotonic and strictly quasiconcave. (In fact, these conditions will imply that the Marshallian demand functions are uniquely defined.) Exercise (Duality of Indirect and Direct Demand Functions): (1) Show that for y = 1 the inverse demand function p = p(x) is given by: u(x) xi pi (x) m , i 1,...,m. u(x) j 1 x xj j (Consult JR, pp.79-80.) (2) Show that for y = 1, the (direct) demand function x = x(p, 1) satisfies v(p,1) pi xi (p,1) m , i 1,...,m. v(p,1) j 1 p pj j (Hint: Use Roy’s identity and the homogeneity of degree zero of the indirect utility function.) 3.3 Hicksian Demand Functions Recall that the expenditure function e(p, u) is the minimum-value function of the following optimization problem: e(p,u) min px m x R for all p > 0 and all attainable utility levels. 4 s.t. u(x) u, It is clear that e(p, u) is well-defined because for p Rm++, x Rm+, px 0. If the utility function u is continuous and strictly quasiconcave, then the solution to the above problem is unique, so we can denote the solution as the function xh(p, u) 0. By definition, it follows that e(p, u) = pxh(p, u). • xh(p, u) is called the compensated demand functions, also commonly known as Hicksian demand functions, named after John Hicks when he first discussed this type of demand functions in 1939. x2 u(x1, x2) = u slope = - p10 / p20 x2h ( p10 , p20 ,u) slope = - p11 / p20 x2h ( p11, p20 , u) x1h ( p10 , p20 , u) x1h ( p11, p20 , u) x1 p1 p10 Hicksian demand function p11 x1h ( p10 , p20 , u) x1h ( p11, p20 , u) x1 Remarks 1. The reason that they are called "compensated" demand function is that we must impose an artificial income adjustment when the price of one good is changing while the utility level is assumed to be fixed. 2. It is important to understand that, in contrast with the Marshallian demands, the Hicksian demands are not directly observable. As usual, it should be no longer a surprise that there is a close link between the expenditure function and the Hicksian demands, as summarized in the following result, which is again a direct application of the Envelope Theorem.. Proposition (Shephard's Lemma for Consumer): If e(p, u) is differentiable in p at (p0, u0) with p0 > 0, then, xih (p0 ,u0 ) Example: e(p0 ,u0 ) , pi CES Utility Functions 5 i 1,...,m. u(x1, x2 ) (x1 x2 )1/ (0 1) Let us now derive the Hicksian demands and the corresponding expenditure function. min {p1x1 + p2x2} subject to (x1 x2 )1/ u The Lagrangian function is L(x1, x2 , ) p1x1 p2 x2 ((x1 x2 )1/ u) Then the FOCs are: L p1 ((x1 x2 )1/ 1 x1 1 0 x1 L p2 ((x1 x2 )1/ 1 x2 1 0 x2 Eliminating , we get L u (x1 x2 )1/ 0 1/( 1) p1 x1 x2 p 2 u (x1 x2 )1/ From these, it is easy to derive the Hicksian demand functions given by: x1h (p,u) u( p1r p2r )(1/ r )1 p1r 1 x2h (p,u) u( p1r p2r )(1/ r )1 p2r 1 where r = /(-1). And the expenditure function is e(p,u) p1x1h (p,u) p2 x2h (p,u) u( p1r p2r )1/ r . 6 Alternatively, since we know that the indirect utility function is given by: v(p, y) y( p1r p2r )1/ r , then by using the identity v(p, e(p, u)) = u, we can find the expenditure function, i.e., e(p,u)( p1r p2r )1/ r u e(p,u) u( p1r p2r )1/ r 3.4 Slutsky Equation Recall that (last lecture) under certain regularity conditions on the utility function, the indirect utility function v(p, y) and the expenditure function e(p, u) satisfy the following identities: (a) e(p, v(p, y)) = y. (b) v(p, e(p, u)) = u. Furthermore, we have shown that the demand points corresponding to the optimal solutions of both optimization problems are identical. This result can be expressed into the following interesting identities between Marshallian demands and Hicksian demands: x(p, y) = xh(p, v(p, y)) xh(p, u) = x(p, e(p, u)) which hold for all values of p, y and u. The second identity leads to a classic differentiation relation between Hicksian demands and Marshallian demands, known as Slutsky equation. Proposition (Slutsky Equation): If the Marshallian and Hicksian demands are all well-defined and continuously differentiable, then for p > 0, x > 0, xi (p, y) xih (p,u) xi (p, y) xj (p, y), pj pj y where u = v(p, y). Proof. It follows easily from taking derivative and applying Shephard's Lemma. Substitution and Income Effects • The significance of Slutsky equation is that it decomposes the change caused by a price change into two effects: a substitution effect and an income effect. • The substitution effect is the change in compensated demand due to the change in relative prices, which is the first item in Slutsky equation. • The income effect is the change in demand due to the effective change in income caused by the price change, which is the second item in Slutsky equation. 7 • The substitution effect is unobservable, while the income effect is observable. x2 SE x1 IE Question: From the above diagram (also know as Hicksian decomposition), can you see crossing property between a Marshallian demand function and the corresponding Hicksian demand? (Hint: there are two general cases.) Slutsky Matrix The substitution effect between good i and good j is measured by xih (p,u) sij , i, j pj So the Slutsky matrix or the substitution matrix is the mm matrix of the substitution items: xih (p,u) S [sij ] pj The following result summarizes the basic properties of the Slutsky matrix. Proposition (Substitution Properties). The Slutsky matrix S is symmetric and negative semidefinite. Proof. By Shephard’s Lemma (for consumer), we know that h xih (p,u) 2e(p,u) 2e(p,u) xj (p,u) sij sji pj pi pj pj pi pi Hence S is symmetric. It is evident that S is the Hessian matrix of the expenditure function e(p, u). Since we know that e(p, u) is concave, so its Hessian matrix must be negative semidefinite. Since the second-order own partial derivatives of a concave function are always nonpositive, this implies that sii 0, i.e., sii xih (p,u) 0, i pi which indicates the intuitive property of a demand function: as its own price increases, the quantity demanded will decrease. You are reminded that this is a general property for Hicksian demands. 8 For the Marshallian demands, note that by Slutsky equation, xi (p, y) xih (p,u) xi (p, y) xi (p, y). pi pi y Then for a small change in pi, we will have the following: xi (p, y) xih (p,u) x (p, y) xi pi pi i xi (p, y)pi . pi pi y The first item, capturing the own price effect of the Hicksian demands, is of course nonpositive. The sign of the second item depends on the nature of the good: • Normal good: xi(p, y)/ y > 0. • This leads to a normal Marshallian demand function: it is decreasing in its own price. • Inferior good: xi(p, y)/ y < 0. • When the substitution effect still dominates the income effect, the resulting Marshallian demand is also decreasing in its own price. • When the substitution effect is dominated by the income effect, it will lead to a Giffen good, that is, its demand function is an increasing function of its own price. Because of Slutsky equation, the Slutsky matrix (i.e., the substitution matrix) also has the following form that is in terms of Marshallian demand functions. xih (p,u) xi (p, y) xi (p, y) S [sij ] xj (p, y) y pj pj We will get back to the above Slutsky matrix in the next lecture when we discuss the integrability problem. 3.5. The Elasticity Relations for Marshallian Demand Functions Definition. Let x(p, y) be the consumer’s Marshallian demand functions. Define i xi (p, y) y , y xi (p, y) ij xi (p, y) pj , pj xi (p, y) si pi xi (p, y) . y Then 1. i is called the income elasticity of demand for good i. 2. ij is called the price elasticity of the demand for good i with respect to a price change in good j. ii is the own-price elasticity of the demand for good i. For i j, ij is the cross-price elasticity. 3. si is called the income share spent on good i. The following result summarizes some important relationships among the income shares, income elasticities and the price elasticities. Proposition. Let x(p, y) be the consumer’s Marshallian demand functions. Then 1. Engel aggregation: m i si i 1. 1 9 2. Cournot aggregation: m i si ij sj , j 1,...,m. 1 Proof. Both identities are derived from the Walras’ Law, namely, the fact that the budget is tight or balanced: y = px(p, y) for all p and y. (A) To prove Engel aggregation, we differentiate both sides of (A) w.r.t. y: m xi (p, y) m pi xi (p, y) xi (p, y) y 1 pi si i , y y y xi (p, y) i 1 i 1 i 1 m as required. To prove Cournot aggregation, we differentiate both sides of (A) w.r.t. pj: 0 pi i j xj (p, y) xi (p, y) xj (p, y) pj p j pj m xj (p, y) pi i 1 xi (p, y) . p j Multiplying both sides by pj/y leads to m pj xj (p, y) m pi xi (p, y) p x (p, y) xi (p, y) pj pj i i y p j y p j xi (p, y) i 1 y i 1 m sj si ij i 1 as required too. 3.6 Hicks’ Composite Commodity Theorem Any group of goods & services with no change in relative prices between themselves may be treated as a single composite commodity, with the price of any one of the group used as the price of the composite good and the quantity of the composite good defined as the aggregate value of the whole group divided by this price. Important use in applied economic analysis. 10 Additional References Afriat, S. (1967) "The Construction of Utility Functions from Expenditure Data," International Economic Review, 8, 67-77. Arrow, K. J. 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Clarendon Press, Oxford, England. Katzner, D.W. (1970) Static Demand Theory. MacMillan, New York. Marshall, A. (1920) Principle of Economics, 8th Ed. MacMillan, London. McKenzie, L. (1957) “Demand Theory Without a Utility Index," Review of Economic Studies, 24, 183-189. Pollak, R. (1969) "Conditional Demand Functions and Consumption Theory," Quarterly Journal of Economics, 83, 60-78. Roy, R. (1942) De l'utilite. Hermann, Paris. Roy, R. (1947) "La distribution de revenu entre les divers biens," Econometrica, 15, 205-225. Samuelson, P. A. (1938) "A Note on the Pure Theory of Consumer's Behavior," Econometrica, 5, 61-71, 353-354. Samuelson, P. (1947) Foundations of Economic Analysis. Harvard University Press, Cambridge, Massachusetts. Sen, (1970) Collective Choice and Social Welfare. Holden Day, San Francisco. Stigler, G. (1950) "Development of Utility Theory," Journal of Political Economy, 59, parts 1 & 2, pp. 307-327, 373-396. Varian, H. R. (1992) Microeconomic Analysis. Third Edition. W.W. Norton & Company, New York. (Chapters 7, 8 and 9) Wold, H. and L. Jureen (1953) Demand Analysis. John Wiley & Sons, New York. 11