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Introduction

This chapter provides some key results from consumer demand theory.

It is not meant to be

exhaustive but should be viewed as a necessary prelude to studying some aspects of public

economics.

Those who want to understand theoretical background fully, are suggested to read

basic microeconomic text books such as A Mas-Colell, M.D. Whinston and J.R. Green (1995)

Microeconomic Theory (Oxford University Press).

Key Definition1

1) Weak preference relation or ordering

In the classical theory of consumer demand the basic weak preference relation for any

consumer i is written as Ri (read as at least as good as).

baskets available to individual i and if it is xRiy, then it implies that commodity bundle x is

considered by individual i to be at least as good as commodity bundle y. If at the same

time, y is not Rix then commodity bundle x is strictly preferred by individual i to

commodity bundle y.

The weak preference relation Ri is rational if it possesses the following properties.

(i) Completeness

The ordering Ri must be defined over all pairs of consumption baskets in Xi, that is,

for all consumption baskets a,b Xi, we must have either aRib, bRia or both (aRia is

referred to as reflexivity).

When comparing two alternatives a and b, it is not necessary to appeal to any third

alternative c.

alternative or binariness.

(ii) Forms of transitivity and rationality

Full transitivity requires that if aRib and bRic then aRic.

Typically, to consider an

P.1 of 24

called quasi-transitivity.

A still weaker requirement is that of acyclicity Pi is acyclic if there does not exist a

sequence of consumption baskets a,b, l such that aPib and bPic and kPil and lPia.

Another requirement is called non-satiation, i.e. more is always at least as good as

less.

another consumption basket u, with |ua|< witharbitrarily small such that uPia.

(iii) Convexity

The ordering Ri on Xi is convex if for every a Xi the upper contour set is convex.

In other words, for a, b, cXi, if aRib and bRic then [a + (1 )b ]Ri c for 0 1 .

Strong convexity is defined as for a, b, c Xi, if aRib and bRic then

[a + (1 )b]Pi c for

0 1.

convexity.

3) Continuity

The ordering Ri on Xi is continuous if it is presented under limits, i.e. for any sequence of

pairs

{(x

, yn

)}

n =1

n

When an ordering is continuous it can be represented by a real valued utility function such

that when xRiy then U ( x) U ( y ) where U(1) is the real valued utility function 2 .

Utility functions 3

For analytical puposes, utility function is usually assumed to be twice continuously

differentiable.

From the property of convexity of weak preferences we can deduce that U() is

quasiconcave.

The utility function U() is quasiconcave if the set is convex for all x or,

implies

U ( x) U ( x' )

if and

only if R is an ordering on Xi and there exists a countable subset of Xi that is P order dense in Xi (Cantors theorem).

This part is drawn hearvily from Jha (1998, PartI).

P.2 of 24

In the consumers choice problem, the consumer is assumed to have a rational, continuous

and locally non-satiated weak preference.

The usual set-up of utility maximization problem is defined such that,

max U ( x)

subject to

x0

where y = income,

p.x y

(1)

p = price vector.

Marshallian Demand 4

The Marshallian demand function can be derived from (1.1) such that x = g(y,p).

This is the

uncompensated or ordinary demand function. This demand function possesses the following

properties;

(i) Homogeneity of degree zero in (y,p), i.e. X (y, p ) = X ( y, p ) for any y,p and any

scalar >0.

(iii) Convexity: If Ri is convex, so that U() is quasi-concave, then x(y,p) is a convex set.

If

Ri is strictly convex, so that U() is strictly quasi-concave, then x(y,p) consists of a single

element.

If U() is continuously differentiable, an optimal consumption bundle x * X ( y, p ) can be

characterized by means of first-order conditions.

U ( x ) xi = pi

(2)

If we have an interior solution then it must be the case that for any two goods r and t:

U ( x) xr

p

= r

U ( x) xt

pt

(3)

The expression on the lefthand side is the marginal rate of substitution of good r for good t.

The Lagrange multiplier in the first-order condition (1.2) gives the marginal or shadow

P.3 of 24

For each (y,p)>0, the utility value of the utility maximization problem is denoted as V(y,p).

It is equal to U(x*) for any x * x( y, p ) .

function.

Suppose that U( ) is a continuous utility function representing a locally non-satiated

preference relation Ri defined on the consumption set x.

(ii) strictly increasing in y and non-increasing in pk for any commodity k;

(iii) quasiconvex, i.e. the set

V ;

The expenditure minimization problem

For p>0 and U > 0 , minimize p,x subject to U

( ) U .

This problem is to calculate the minimum level of income required to reach the level of utility

U . The expenditure minimization problem is the dual to the utility maximization problem.

This duality can be expressed in a formal way.

(i) If x* is optimal in the utility maximization problem when income is y>0, then x* is

optimal in the expenditure minimization problem when the required utility level is U(x*).

Moreover, the minimized expenditure level in this expenditure minimization problem is

exactly y.

(ii) If x* is optimal in the expenditure minimization problem.

level in U > U (0) , then x is optimal in the utility maximization problem when income

*

is p,x*.

exactly U .

The expenditure function

Given prices p>0 and required utility level U > U (0) , the value of the expenditure

minimization problem is denoted e(u , p ) , the expenditure function. It is

(i) homogeneour of degree one in p;

(ii) strictly increasing in U and nondecreasing in pk for any k;

(iii) concave in p;

4

P.4 of 24

For any p>0, y>0 and U > U (0) , it must be the case that;

This relationship states the equivalence between the conpensating variation and the equivalent

variation of a price change.

The set of optimal commodity vectors in the expenditure minimization problem is denoted

(i) homogeneity of degree zero in p: i.e. h(U , p ) = h(U , p ) for any p, U and >0.

(ii) No excess utility: for any x h(U , p ), U ( x) = U .

(iii) convexity: if Ri is convex, h(u,p) is a convex set; and if Ri is strictly convex, U() is

strictly quasi-concave, then there is a unique element in h(U,p).

Along the Hicksian demand function demand changes in the opposite direction of the price

change, i.e. for all Pi Pj

(P

Pi ) h(U , p j ) h(U , pi ) 0

How can we measure the total price change effect when income also changes?

Slutsky equation

hi (u, p) = xi ( y, p )

(4)

hi ( p, u ) xi ( p, e( p, u )) xi ( p, e( p, u )) e( p, u )

=

+

p k

p k

y

p k

as

y = e( p , u )

expenditure

P.5 of 24

e( p, u )

= hk ( p, u )

p k

(5)

hk ( p, u ) = x k ( p, e( p, u )) = x k ( p, y ) , thus

hi ( p, u ) xi ( p, y ) hi ( p, u )

=

+

x k ( p, y )

p k

p k

y

(6)

The Slutsky equation is, therefore, the partial derivative of Hicksian (compensated) demand for

good i with respect to price pk.

demand function) = substitution effect (along the Hicksian demand function) income effect.

Shaphards lemma

The partial derivative of the cost function with respect to price is the Hicksian (compensated)

demand function, that is,

C (u , p )

= hi ( p, u ) = xi

pi

(7)

Roys Identity

xk =

v p k

v

v

v

= x k = x k where =

= marginal utility of income

v y

p k

y

dy

P.6 of 24

Figure 1

Duality

Max U(x)

Subject to px = y

Subject to U(x) = u

Solve

Solve

Marshallian Demand

Slutsky equation

x = g(y,p)

Roys

Identity

Min p.x

Hicksian Demand

x = h(u,p)

Substitute

Shephards

Lemma

Inversion

V = V(y,p)

Observable

Substitute

Cost Function

y = c(u,p)

Unobservable

P.7 of 24

Suppose that we know the consumers preferences f and that indirect utility function v(p,y)

can be derived from f , then it is a simple matter to determine whether the price change makes

the consumer better or worse off, depending on the sign of v(p1,y)- v(p0,y).

In case of welfare change measurement, money metric indirect utility functions can be

constructed by means of the expenditure function. Starting from any indirect utility function

v(,), choose an arbitrary price vector p >> 0 , and consider the function e( p , v ( p, y )).

This function gives the wealth required to reach the utility level v(p,) when prices are p .

This expenditure is strictly increasing as a function of the level v(p,), thus it is an indirect

Two natural choices for the price vector p are the initial price vector p0 and the new price

vector p1.

Hicks (1939), the equivalent variation (EV) and the compensating variation (CV).

Formally,

0

EV ( p 0 , p 1 , y ) = e( p 0 , u 1 ) e( p 0 , u 0 ) = e( p 0 , u 1 ) y

(8)

and

CV ( p 0 , p 1 , y ) = e( p 1 , u 1 ) e( p 1 , u 0 ) = y e( p 1 , u 0 )

(9)

The equivalent variation implies that it is the change in her wealth that would be equivalent to

the price change in terms of its welfare impact (i.e. the amount of money that the consumer is

indifferent about accepting in lieu of the price change).

level at which the consumer achieves exactly utility level u1, the level generated by the price

change, at price p0.

The compensating variation, on the other hand, measures the net revenue of a planner who

must compensate the consumer for the price change after it occurs, bringing her back to her

original utility level u0.

Figure1.2 depicts the equivalent and compensating variation measures of welfare change.

This part is drown heavily from Mas-Colell, Whinston and Green (1995), in particular, pages 80-91.

P.8 of 24

Figure 2

x2

x2

p 20 = p 12 = 1

p 20 = p 12 = 1

EV

CV

x(p

,y)

x(p

,y)

u

x(p

x(p

,y)

,y)

x1

x1

The equivalent and compensating variations have interesting representations in terms of the

Hicksian demand curve. Suppose, for simplicity, that only the price of good 1 changes, so that

Because w = e( p 0 , u 0 ) = e( p 1 , u 1 ) and

h1 ( p, u ) = e( p, u ) p1 , we can write

EV ( p 0 , p 1 , y ) = e( p 0 , u 1 ) y

= e ( p 0 , u 1 ) e( p 1 , u 1 )

=

p10

p11

(10)

h1 ( p1 , p 1 , u 1 )dp1

where p 1 = ( p 2 ,..., p L ) .

The change in consumer welfare as measured by EV can be represented by the area lying

between p10 and p11 and to the left of the Hicksian demand curve for good 1 associated with

utility level u1 (it is equal to this area if p11 < p10 and is equal to its negative if p11 < p10 ).

The area is depicted as the shaded region in Figure X.2.(a).

Similarly, the compensating variation can be written as

CV ( p 0 , p 1 , w) =

p10

p11

h1 ( p1 , p 1 , u 0 )dp1

(11)

P.9 of 24

Figure 3

h1 ( p1 , p 1 , u 0 )

p2

P1

h1 ( p1 , p 1 , u 0 )

h1 ( p1 , p 1 , u 1 )

0

h1 ( p1 , p 1 , u 1 )

0

p1

p1

1

p1

x(p

,y)

x(p

x1 ( p1 , p 1 , y )

,y)

x1

1

p1

x(p

,y)

x(p

x1 ( p1 , p 1 , y )

,y)

x1

Figure 3 illustrates a case where good 1 is a normal good. As can be seen in Figure 3, we have

EV ( p 0 , p 1 , y ) > CV ( p 0 , p 1 , y ) .

1 is inferior.

However, if there is no wealth effect for good 1, the CV and the EV are the same

because we have

h1 ( p, p 1 , u 0 ) = x1 ( p1 , p 1 , y ) = h1 ( p1 , p 1 , u 1 )

(12)

In absence of wealth effects, the common value of CV and EV is called as the change in

Marshallian consumer surpurs.

Suppose that the government taxes commodity 1, setting a tax on the consumers purchases

of good 1 of t per unit. This tax changes the effective price of good 1 to p11 = p10 + t while

prices for all other commodities ( l 1 ) remain fixed at p l1 (so we have p l1 = p l0 for all

An alternative to this commodity tax that raises the same amount of revenue for the

government without changing prices is imposition of a lump-sum tax of T directly on the

consumers wealth.

Is the consumer better or worse off facing this lump-sum wealth tax rather

She is worse off under the commodity tax if the equivalent variation of the commodity tax

EV ( p 0 , p 1 , y ) , which is negative, is less than T, the amount of wealth she will lose under the

lump-sum tax.

Put in terms of the expenditure function, she is worse off under commodity taxation if

P.10 of 24

y T > e( p 0 , u 1 ) , so that her wealth after the lump-sum tax is greater than the wealth level that

is required at prices p 0 to generate the utility level that she gets under the commodity tax u 1 .

The difference (T ) EV ( p 0 , p 1 , y ) = y T e( p 0 , u 1 ) is known as the deadweight loss of

commodity taxation. It measures the extra amount by which the consumer is made worse off

by commodity taxation above what is necessary to raise the same revenue through a lump-sum

tax.

The deadweight loss measure can be represented in terms of the Hicksian demand curve at

utility level u 1 .

follows:

(T ) EV ( p 0 , p 1 , y ) = e( p 1 , u 1 ) e( p 0 , u 1 ) T

p10 + t

[h ( p , p

p10

p10 + t

p10

1 , u

(13)

) h1 ( p10 + t , p 1 , u 1 ) dp1

positive if h1 ( p, u ) is strictly decreasing in p1 . Figure 4 (a) shows the deadweight loss in

the area of the shaded triangular region (the deadweight loss triangle).

Figure 4

p2

h1 ( p1 , p 1 , u 1 )

p1

h1 ( p1 , p 1 , u 1 )

h1 ( p1 , p 1 , u )

0

p1 + t

p1 + t

x 1 ( p 1 , p 1 , w )

h1 ( p10 + t , p 1 , u 1 )

x1

0

p1

h1 ( p1 , p 1 , u 0 )

0

p1

h1 ( p10 + t , p 1 , u 0 )

x 1 ( p 1 , p 1 , w )

x1

P.11 of 24

Figure 5

x2

p20 = p12 = 1

Deadweight Loss

x(p ,y)

1

x(p0,y)

u0

u1

B p1 , y

Bp0 , y

Bp0 , y T

B p 0 , e ( p 0 ,u 1 )

line associated with budget set B p1 , y , but also on the budget line associated with budget set

B p 0 , y T .

In contrast, the budget set that generates a utility of u1 for the consumer at prices p0 is

B p 0 , e( p 0 ,u 1 ) .

The deadweight loss is the vertical distance between the budget lines associated

A similar deadweight loss triangle can be calculated using the Hicksian demand curve

h1 ( p1 , u 0 ) .

It also measures the loss from commodity taxation, but in a different way.

Suppose that we examine the surplus or deficit that would arise if the government were to

compensate the consumer to keep her welfare under the tax equal to her pretax welfare u0.

The

government would run a deficit if the tax collected th1 ( p1 , u 0 ) is less than CV ( p 0 , p 1 , y ) or,

equivalently, if th1 ( p 1 , u 0 ) < e( p 1 , u 1 ) y .

CV ( p 0 , p 1 , y ) th1 ( p 1 , u ) = e( p 1 , u 0 ) e( p 0 , u 0 ) th1 ( p 1 , u 0 )

p10 + t

[h ( p , p

p10

p10 + t

p10

1 , u

(14)

P.12 of 24

As we have seen above, the welfare change induced by a change in the price of good 1 can be

exactly computed by using the area to the left of an appropriate Hicksian demand curve.

However the Hicksian demand curve is not directly observable.

the Walrasian demand curve instead.

AV ( p 0 , p 1 , y ) =

p10

p11

x1 ( p1 , p 1 , y ) dp1

(15)

As Figure 7 (a) and (b) show, when good 1 is normal good, the area variation measure

overstates the compensating variation and understates the equivalent variation. When good 1

is inferior, the reverse relations hold. Thus when evaluating the welfare change from a change

in prices of several goods, or when comparing two different possible price changes, the area

variation measure need not give a correct evaluation of welfare change.

If the wealth effects for the goods under consideration are small, the approximation errors are

also small and the area variation measure is almost correct.

If ( p11 p10 ) is small, then the error involved using the area variation measure becomes

small as a fraction of the true welfare change.

Figure 6

p1

p11

D

C

B

A

p10

x1 ( p1 , p 1 , y )

h1 ( p1 , p1 , u 0 )

x11

x10

x1

P.13 of 24

In Figure 7, the area B+D, which measures the difference between the area variation and the

true compensating variation becomes small as a fraction of the true compensating variation

when ( p11 p10 ) is small.

However, the approximation error may be quite large as a fraction of the deadweight loss.

In Figure X.5, the deadweight loss calculated using the Warlasian demand curve is the area A+C,

where as the real one is the area A+B.

When ( p11 p10 ) is small, there is a superior approximation procedure available.

0

Suppose

~

h ( p, u 0 ) = h( p 0 , u 0 ) + D p h( p 0 , u 0 )( p p 0 )

(16)

and we calculate

p10

p11

~

h1 ( p1 , p 1 , u 0 )dp1

(17)

Figure 7.

Figure 7

p1

~

h1 ( p1 , p1 , u 0 )

p11

p10

x1 ( p1 , p 1 , w)

0

x1

h1 ( p1 , p1 , u 0 )

x1

Because h1 ( p1 , p 1 , u 0 ) has the same slope as the true Hicksian demand function

P.14 of 24

h1 ( p, u 0 ) at p0, for small price changes, this approximation comes closer than expression

(2.53) to the true welfare change.

The approximation in (17) is directly computable from knowledge of the observable

Walrasian demand function x1(p,y).

~

D p h( p 0 , u 0 ) = s( p 0 , w), h ( p, u 0 ) can be expressed solely in terms that involve the

Walrasian demand function and its derivatives at the point (p0,y).

~

h ( p, u 0 ) = x( p 0 , y ) + s ( p 0 , w)( p p 0 )

(18)

~

h1 ( p1 , p 1 , u 0 ) = x1 ( p10 , p 1 , y ) + s11 ( p10 , p 1 , y )( p1 p10 )

where

s11 ( p10 ,

(19)

x1 ( p 0 , y ) x1 ( p 0 , y )

p 1 , y ) =

+

x1 ( p 0 , y )

p1

w

When (p1- p0) is small, this procedure provides a better approximation to the true

compensating variation than does the area variation measure.

It is entirely possible for the area variation measure to be superior.

guarantees some sensitivity of the approximation to demand behavior away from p0, whereas

There are two fundamental theorems showing the equivalence between Pareto optimality and

the perfectly competitive market mechanism.

The First Fundamental Welfare Theorem.

If every relevant good is traded in a market at

publicly known prices, and if households and firms are perfectly competitively, then the market

outcome is Pareto optimal.

necessarily Pareto optimal (Formally state that, if the price p* and allocation

( x1*x i* , q1*q i* ) constitute a competitive equilibrium, then this allocation is Pareto optimal).

The first welfare theorem provides a set of conditions under which we can be assured that a

market economy will achieve Pareto optimal result.

P.15 of 24

maximization behavior, each economic agent responds to prices by equating his marginal rates

of substitution for consumers and transformation for firms to these prices.

face the same prices, all the marginal rates are equated to each other in the equilibrium.

Combined with market equilibria, these equalities characterize Pareto optima in a convex

environment (i.e. nonincreasing returns for firms and convex preferences for consumers).

The Second Fundamental Welfare Theorem.

sets are convex, there is a complete set of markets with publicly known prices, and every agent

acts as a price taker, then any Pareto optimal outcome can be achieved as a competitive

equilibrium if appropriate lump-sum transfers of wealth are arranged (Formally state that, for

any Pareto optimal levels of utility ( u1*u i* ), there are transfers of the numeraire commodity

( T1 Ti ) satisfying i Ti = 0 , such that a competitive equilibrium reached from the

endowments ( wm1 + T1 ,wmi + Ti ) yields precisely a the utility ( u1*u i* ).

goes further.

This theorem

It states that under the same set of assumptions as the first welfare theorem plus

convexity conditions, all Pareto optimal outcomes can in principle be implemented through the

market mechanism.

optimal outcome may always do so by appropriately redistributing wealth and then letting the

market work (Mas-Colell, Whinston, and Green (1995) p.308).

optimality of the private property competitive equilibrium is satisfactory with respect to the

efficiency criterion but it may lead to undesirable income distributions.

Uncertainty

Economists set the choice under uncertainty by considering a situation in which alternatives

with uncertain outcomes are describable by means of objectively known probabilities defined

on an abstract set of possible outcomes.

lotteries.

Assuming that the decision maker has a rational preference relation over these

A decision maker faces a choice among a number of risky alternatives.

Each risky

alternative may result in one of a number of possible outcomes, but which outcome will actually

occur is uncertain at the time that he must make his choice.

P.16 of 24

Potential Outcome

Probability

L1

P1

L2

P2

P3

Expected return

L3

EX = P1 L1 + P2 L2 + L + Pi Li + L PN LN

P4

where P=1

L4

PN

L5

L6

An act as a lottery ticket: Consider a ticket that pays $100 if an odd number is drawn from an

urn of 10 equiprobable consequences numbered 1 thorough 10.

How a rational agent evaluates such a lottery? There is a 50% chance of winning $100.

Some might suggest that we use the expected value of the monetary consequences, that is,

0.5$100+0.5$0=$50.

Someone would pay a lottery ticket if it is equal to or less than $50. Consider a repeated

coin toss and the lottery that pays $2 if a head appears for the first time on the n-th toss:

U ( a) = lim

2

n =1

1

n

2 n = +

According to the expected value criterion, this lottery has infinite value, although no one may be

willing to pay $1000 to play this game.

Why?

Let ~

x be a lottery defined by

U (~

x) =

s u( xs )

{x1 L , x s ; 1 , L , s }

so that

= Eu ( x)

S =1

P.17 of 24

Figure 8

U(.)

Eu (x~ )

x1

~

x

x2

1

1

1

1

u ( x1 ) + u ( x2 ) < u x1 + x2

2

2

2

2

Risk loving is represented by the convexity of u(.).

with probability 0.5 and x2 with probability 0.5, the agent prefers to this lottery a certain return

equal to the mean of the returns from the ticket. We define the certainty equivalent of ~

x,

EC~

x as the deterministic return that the agent views as equivalent to the stochastic variable ~

x,

that is,

u ( E (~

x )) = Eu ( ~

x) .

Then we can define the risk premium associated with ~

x , denoted ~

x (i.e. AB in Figure 8) by

~

~

~

u (E ( x ) ) x ) = Eu ( x ) .

The theory of the second best is concerned with the design of government policy in situations

where the economy is characterized by some important distortions that cannot be removed.

This is in contrast to first-best economies, where all the conditions for Pareto efficiency can

be satisfied.

P.18 of 24

fallaciously as saying that as long as there are some distortions, economic theory has nothing to

say.

This is in correct, as we shall shortly show. Economic theory can tell us under what

circumstances two small distortions are preferable to one large one; when it is better to have in

efficiencies in both consumption and production; and when it is better not to have inefficiencies

in production.

economics.

Second-best theory tells us that we cannot blindly apply the lessons of first-best

Finding out what we should do when some distortions exist is often a difficult task,

Because of several reasons, e.g. a monopoly in one sector or increasing returns to scale

somewhere or something else, Lipsey and Lancaster (1957) proved the following theorem.

The general theorem of second best

(1) If all the conditions for Pareto optimality cannot be met then it is not necessarily second

best to satisfy a subset of these conditions;

(2) In general, to attain the second-best optimum it is necessary to violate all the conditions of

Pareto optimality.

The actual source of the second-best constraint and why it should be taken seriously are both

important issues.

because limp-sum taxer are infeasible or because some distortion has to be maintained for

historical reasons.

A question that naturally arises is; when is it appropriate to satisfy the Pareto optimum

conditions in one sector of the economy irrespective of whether such conditions are satisfied

elsewhere.

As a related approach, there is the second-better or n-th best approach. This approach

considers only marginal changes in some distortion and evaluates the welfare consequences of

these changes.

are being evaluated, only local rather than global information is required.

Second, there is no

Third, since only incremental changes are being considered it is possible to derive necessary and

sufficient conditions (Jha (1998), pp. 44-46).

P.19 of 24

Exercises

1. Consider the three good setting in which the consumer has utility function

U ( x ) = ( x1 b1 ) ( x 2 b2 ) ( x 3 b3 )

(a) Derive the Hicksian demand and expenditure functions.

(b) Show that the derivatives of the expenditure functions are the Hicksian demand

function in (a).

(c) Verigy that the own-substitution terms are negative and that compensated cross-price

effects are symmetric.

2. A consumer in a three-good economy (denoted x1, x2 and x3, prices denoted p1, p2 and p3)

with wealth level w>0 has demand functions for commodities 1 and 2 given by

p1

p

w

+ 2 +

p3

p3

p3

p

p

w

x2 = + 1 + 2 +

p3

p3

p3

x1 = 100 5

(a) Indicate how to calculate the demand for good 3 (but do not actually do it).

(b) Are the demand functions for x, and x 2 appropriately homogeneous?

(c) Calculate the restrictions on the numerical values of , , and implied by utility

maximization.

(d) Given your results in (c), for a fixed level of x3 draw the consumers indifference

curve in the (x1, x2) plane.

(e) What does your answer to (d) imply about the form of the consumers utility function

U(x1, x2, x3,)?

P.20 of 24

References

Deaton, A. and J. Muellbauer (1980) Economics and Consumer Behavior, Cambridge

University Press.

Jha, R. (1998) Modern Public Economics, London, Routledge.

Laffont, J.J. (1988) Fundamentals of Public Economics, translated by Bonin, J.P. and Bonin, H.,

The MIT Press.

Lipsey, R. and Lancaster, K. (1957) The general theorem of second best, Review of Economic

Studies 24, pp.11-32.

Mas-Colell, A., M.D. Whinston and J.R. Green (1995) Microeconomic Theory, Oxford

University Press.

P.21 of 24

Appendix 1

and Hicksian demand

Consider the Cobb-Douglas utility function of the two good economy. The representative

households maximizes their utility function , such that

Max U ( x1 , x 2 ) = x1 x 2

Subject to

p1 x1 + p 2 x 2 = y

(1A.1)

L = ln x1 + (1 ) ln x 2 + [ p1 x1 + p2 x 2 y ]

x1

+ p1 = 0,

1

+ p 2 = 0

x2

(1A.2)

y

p1

, x2 =

(1 ) y

.

p2

Marshallian demands, i.e. xi=g(y,pi) Substituting the first-order conditions (1A.2) into the

constraint u(h1(p,u), h2(p,u)), we obtain,

p2

h1 ( p, u) =

(1 ) p1

(1 ) p1

h2 ( p, u) =

u

p2

These are, in fact, Hicksian demands, i.e. hi=(u,p).

(1A.3)

e( p, u) = ph( p, u) yields

e( p, u ) = (1 ) 1 p1 p 12 u

(1A.4)

How does the Hicksian (compensated) demand change when the (relative) price vector changes

from p to p' ?

P.22 of 24

Figure 1A.1

Notes:

slope of IP =

P1

PI

; slope of IP I = 1I

P2

P2

Hicksian (compensated) demand function comes from viewing the demand function as being

constructed by varying prices and incomes so as to keep the consumer at a fixed level of utility.

Thus, the income changes are arranged to compensate for the price changes. (This is the

reason why it is called compensated demand function)

By the Slutsky equation,

x

x

h1

= S12 = 1 + x 2 1

p 2

p 2

y

h2

x

x

= S 21 = 2 + x1 2

p1

p1

y

From (1A.4)

h1 1

h

y = 2 , thus S12 = S21 < 0 (Symmetry).

=

p 2 p1 p 2

p1

P.23 of 24

h j ( p , u ) 2 e ( p , u )

0

=

pi

pi p j

{from (1.5)}

h j ( p , u ) 2 e ( p , u ) 2 e ( p , u ) h j ( p , u )

=

=

=

pi

pi p j

p j p j

p j

(3) The compensated own price effect is nonpositive

hi ( p, u ) 2 e( p, u )

0

=

2

p i

pi

P.24 of 24

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