ADVANCED MICROECONOMIC

THEORY
 ROY’S IDENTITY

 A full derivation of Roy’s Identity is placed at the end

of this slideshow. Not difficult, just fairly long.
 Ultimately, Roy’s Identity just shows that you can
derive the Marshallian Demand function for any good
‘L’, directly from the Indirect utility function:

 V 
 
 Pl 
xl  
 V 
 
 w 
 AGGREGATION

 Individuals demand functions are

functions of prices and wealth. xli  x p, wi 
 Therefore, total (aggregate)
X  x1  p, w1   ...  xI  p, wI 
demand functions are functions
of prices and everybody’s wealth
(assume a total of I individuals). I
X l   xi  p, wi 
 It is convenient to think of the i 1
aggregate demand function as
variant only on the TOTAL level Aggregation if :
of wealth in society, but when
 I 
X l  x p,  wi 
does this occur?

 Such a definition circumvents

distributional issues.
 i 1 
 AGGREGATION

 Such aggregation occurs when all individuals have STRAIGHT

and PARALLEL ENGEL CURVES (diagram slide after next,
algebra next slide).
 If we change the wealth of individual ‘h’, then the change of
aggregate demand is the same as the change in his personal
demand.
 This is because no-one else’s demand is affected by his
change.
 Keeping prices constant, through a bit of algebra magic (using
the chain rule) we find that the effect of a change in wealth for
‘h’ on h’s demand is the same as the change in aggregate
demand to a change in aggregate wealth, which is the same as
the change in another individual’s (j) demand to a change in j’s
wealth.
 The wealth effect at ‘p’ must be the same for any consumer i =
1... I, at any level of wealth for aggregation to occur 
straight Engel curves.
 AGGREGATION

For Aggregation : The same must hold for

xlh  X l ALL CONSUMERS :
 1
wh wh Xl Xl
 ;jh
wj w

 X l  p, w1  ...  wI   X l p, w


wh wh Hence :
 X l  X l w
 
Xl Xl Xl
wh  w wh
 
wh  w w j
 w   w1  ...  wh  ...  wI 
 1 Subbing in equation (1) :
wh wh
Xl Xl xlh xlj
  1  
wh w wh w j
 AGGREGATION

x2 Engel Curve for XL

consumer ‘j’
B(p,wj)

Engel Curve for XLj

consumer ‘h’

XLh

B(p,wh)
x1 wh wj w
Wealth effects are equal across all
...and across all wealth levels.
consumers...
 AGGREGATION

 A general result under which the above conditions for

Aggregation hold (that is, there are linear and parallel Engel
curves for all consumers), is that consumers have indirect
utility functions of the GORMAN FORM:

Vi  p, wi   ai  P   b P   wi
 This condition is NECESSARY and SUFFICIENT. We should not
attempt to prove necessity, because it’s pretty insane.
Sufficiency can be easily proved: we need to use Roy’s Identity
(just take derivatives and plug them in into the identity).
 Note that ‘ai(p)’ and ‘b(p)’ both have to abide by conditions to
allow Vi(.) to satisfy conditions of an indirect utility function
(homogeneity, increasing in w, non-increasing in p, quasi-
convexity – see Topic 1 slides).
 AGGREGATION

 Regarding Direct Utility Functions:

 No known general functions that allow aggregation to occur (i.e., no

standard direct utility forms always lead to the Gorman form).

 However, a necessary and sufficient restriction on the direct utility

function is that the utility functions are additive (utility of total
consumption is equal to sum of utilities of consuming each individual
good): L
u  x     l  u~  xl   l  Constant
l 1
 Another restriction is that utility functions for individual goods (u~) are
Hyperbolic Absolute Risk Aversion (HARA).

u   a  bx 
~ 

 This gives rise to a broad class of utility functions

 if a=0, it is iso-elastic, if gamma=2, it is quadratic, if gamma  0, it is
logarithmic, if gamma  -∞, it is a negative exponential.
 ROY’S IDENTITY

 Intuition of Roy’s Identity (rearranged):

V V
  xli  Pl , wi  
Pl wi
 If the price of apples rise (Pl) what will be the effect on my indirect utility
function?

 The answer is that it will be negative (I don’t like higher prices) and it will be
proportional to my demand for apples.

 The derivation can seem a bit confusing; there are a couple of places where the
next step is triggered by leaps of logic (‘this bit looks like what we would get if we
differentiated the budget constraint’ ), but otherwise it’s fairly consistent.

 Rule of thumb:

 2 STAGES – FIND dV/dP, then dV/dw

 FOR FIRST, SOLVE THE UMP FOR THE F.O.C., THEN DIFFERENTIATE THE BUDGET
CONSTRAINT W.R.T PRICES.

 FOR SECOND, LEGWORK IS DONE, JUST SUBSTITUTE IN THE UMP RESULT AND
DIFFERENTIATE THE BUDGE CONSTRAINT W.R.T THE WEALTH.
 ROY’S IDENTITY

V  p, w  U  x1  p1 , w ,..., xL  pL w   P x  x Sub  3 into 1 :

  l  xl  Pl l   ...  PL L
Two stages in the derivation :  Pl Pl  Pl
V L  x j 
 x j 
  p j
 p


 4
V L
pl
Stage 1 - What is ?    Pj  xl  0  2 j 1  j 
pl j 1  Pl  Sub  2  into  4  :
V
V  u xl   u xL  Solve UMP, PX is a vector   xl  A 
     ...     pl
pl  xl pl   xL pl  of all Prices and Goods
L
u x j PX  p1x1  ...  p L x L :
  1 Stage 2 :
j 1 x j pl   u  x     w  PX 
Diff. the Budget Constraint : u V
xj   p j  0
  p1 x1  ...  pL xL 
w x j What is ?
pl
u
w
As xl is a function of Pl ,   p j  3
Use the Product rule! x j
 ROY’S IDENTITY

V u x p, w 
w

w   PX  w V
 
L
u x j w w -A Pl x j
  L
 x j   
V 
j 1 x j w
  p j   1
w 
B
Subbing in  3 :
j 1  w
V L
 x j  V
    p j   4 Sub into  4  : 
w j 1  w  Pl
  xj
V V
Now diff the Budget   B
w w
Constraint AGAIN, but
w.r.t ' w':