Scribd
Upload
72 views

X y X y : ECO 305 - FALL 2003 - September 25

This document discusses the properties of indirect utility and expenditure functions. It defines the indirect utility function U*(Px, Py, M) as the maximum utility achievable given prices and income. It then defines the expenditure function M*(Px, Py, u) as the minimum income needed to achieve a given utility level given prices. Key properties discussed include: 1) indirect utility is homogeneous of degree zero in prices and income, 2) compensated (Hicksian) demands can be derived from the expenditure function using Hotelling's lemma, and 3) the Slutsky equation decomposes a price effect on demand into a substitution and income effect. An example is provided using a Cobb-Douglas utility function.

Uploaded by

irushad
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
72 views

X y X y : ECO 305 - FALL 2003 - September 25

This document discusses the properties of indirect utility and expenditure functions. It defines the indirect utility function U*(Px, Py, M) as the maximum utility achievable given prices and income. It then defines the expenditure function M*(Px, Py, u) as the minimum income needed to achieve a given utility level given prices. Key properties discussed include: 1) indirect utility is homogeneous of degree zero in prices and income, 2) compensated (Hicksian) demands can be derived from the expenditure function using Hotelling's lemma, and 3) the Slutsky equation decomposes a price effect on demand into a substitution and income effect. An example is provided using a Cobb-Douglas utility function.

Uploaded by

irushad
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 6

ECO 305 FALL 2003 September 25

INDIRECT UTILITY FUNCTION


U (Px , Py , M ) = max { U (x, y) | Px x + Py y M }
= U (x , y )
= U (Dx (Px , Py , M), Dy (Px , Py , M ) )
PROPERTIES OF U :
(1) No money illusion Homogeneous degree zero:
U (k Px , k Py , kM ) = U (Px , Py , M )
(2) As money income changes:

U
M

x
"

x
+
M

y
M

x
y
+ Py
M
M

= Px
=

M
=
M

(3) As price changes:

U
Px

x
+
Px
1

y
Px

"

x
y
+ Py
Px
Px
= x
(just like M by x )
= Px

(Last step: dierentiate adding-up identity w.r.t. Px :


Px x + Py y = M
x
y
+ Py
=0)
x + Px
Px
Px
Divide price- and income-change equations :

U /Px
Roys Identity: x =
U /M

(4) Contours of U in (Px , Py ) space with M fixed:

(Like theater with stage at NE corner)


2

EXPENDITURE FUNCTION
Solve the indirect utility function for income:
u = U (Px , Py , M)

M = M (Px , Py , u)

M (Px , Py , u) = min { Px x + Py y | U (x, y) u }

Dual or mirror image of utility maximization problem.


Economics income compensation for price changes
Optimum quantities Compensated or Hicksian demands
x = DxH (Px , Py , u) ,

y = DyH (Px , Py , u)

PROPERTIES OF M :
(1) Homogeneous degree 1 in (Px , Py ) holding u fixed:
M (k Px , k Py , u) = k M (Px , Py , u)
(2) Hotellings or Shepherds Lemma
Compensated demands partial derivatives w.r.t. prices:
DxH (Px , Py , u) = M /Px , DyH (Px , Py , u) = M /Py
Proof: M = Px DxH + Py DyH , u = U (DxH , DyH ). So
M /Px = DxH + Px DxH /Px + Py DyH /Px
0 = Ux DxH /Px + Uy DyH /Px
= [ Px DxH /Px + Py DyH /Px ]
3

(3) Weakly concave in (Px , Py ) holding u fixed.


Cobb-Douglas example: (Px )1/3 (Py )2/3

PROPERTIES OF HICKSIAN DEMAND FUNCTIONS:


(1) Own substitution eect negative:

Px

DxH
2M
=
=
0
2
P
P
x
x
u=const
(2) Symmetry of cross-price eects:
DyH
DxH
2M
=
=
Py
Px Py
Px
(Net) substitutes if > 0, complements if < 0
General concept : Comparative statics
4

COBB-DOUGLAS EXAMPLE
(Direct) UTILITY FUNCTION:
U (x, y) = ln(x) + ln(y),
x = M/Px ,

+ =1

y = M/Py

INDIRECT UTILITY FUNCTION


U (Px , Py , M) = [ln() + ln(M) ln(Px ) ]
+ [ln() + ln(M ) ln(Py ) ]
= junk + ln(M ) ln(Px ) ln(Py )
Roys Identity:
/Px
M
U /Px

=
=
x

U /M
1/M
Px
EXPENDITURE FUNCTION
M = M (Px , Py , u) = eu (Px ) (Py )
Hicksian demand functions
xH = eu (Px )1 (Py ) , y H = eu (Px ) (Py )1

SLUTSKY EQUATION
Link between Marshallian and Hicksian demands
Equal if u = U (Px , Py , M ), M = M (Px , Py , u).
For good i where i may be either x or y,
DiH (Px , Py , u) = DiM (Px , Py , M (Px , Py , u) )
Now let Pj change, where j may be x or y
DiH
Pj

DiM
DiM M
=
+
Pj
M Pj
DiM
DiM H
Dj
=
+
Pj
M
DiM
DiM M
=
+
Dj
Pj
M

For example

Py

u=const

Py

x
+y
M
M =const

Price derivative of compensated demand =


Price derivative of uncompensated demand
+ Income eect of compensation.
If i = j, LHS is negative. Then Gien implies Inferior
6

You might also like