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Indirectutility PDF

The document discusses how to prove two economic concepts: 1) It shows that the indirect utility function is quasi-convex by showing that the utility of a convex combination of budgets must be less than or equal to the better of the original budgets. 2) It derives Roy's Identity, which relates the demand for a good to the marginal utility of income and price. It shows that demand is equal to the negative of the ratio of the marginal utility of price to the marginal utility of income.

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Maimoona Ghani
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96 views2 pages

Indirectutility PDF

The document discusses how to prove two economic concepts: 1) It shows that the indirect utility function is quasi-convex by showing that the utility of a convex combination of budgets must be less than or equal to the better of the original budgets. 2) It derives Roy's Identity, which relates the demand for a good to the marginal utility of income and price. It shows that demand is equal to the negative of the ratio of the marginal utility of price to the marginal utility of income.

Uploaded by

Maimoona Ghani
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
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Notes on Indirect Utility

How do we show that the indirect utility function is quasi-convex?


We want to show that if v(p, m) v(p0 , m0 ), then the indirect utility of
the convex combination budget is worse than the indirect utility of the (p, m)
budget. That is, for any such that 0 < > 1,

v (p + (1 )p0 , m + (1 )m0 ) v(p, m).

The key is that anything in the convex combination budget can be afforded
with one or the other of the original budgets. Therefore at least one of these
two budgets is at least a good as the convex combination budget. So the convex
combination is worse than the better one.
How do we show this?
Where 0 < < 1, let p = p + (1 )p0 and m = m + (1 )m0 .
Let x = x(p , m ). Then p x m (since x = x(p , m ) is something
you can afford with income m .) But this means that px + (1 )p0 x
m + (1 )m0 . This implies that (m px) + (1 )(m0 p0 x) 0, which
implies that either m px or m0 p0 x , (or possibly both) which implies
that at least one of the following two things are true: px m and hence
v(p , m ) v(p, m) or p0 x m0 and hence v(p , m ) v(p0 , m0 ). So it must
be that v(p , m ) max{v(p, m), v(p0 , m0 )}.

Proof of Roys Identity


Roys identity is as follows:
v(p, m) v(p, m)
xj (p, m) = . (1)
pj m)

By definition, v(p, m) = u (x(p, m)). Where ui (x) denotes the partial deriva-
tive of u with respect to its ith argument, the first order conditions for maxi-
mization tell us that for some (p, m) > 0 and all i = 1, . . . n,

ui (x(p, m)) = (p, m)pi . (2)

We first show that


v(p, m)
= (p, m). (3)
m
We know that
v(p, m) X dxi (p, m) X dxi (p, m)
= ui (x(p, m)) = pi . (4)
m i
dm i
dm
P
We also know that for all m, i pi xi (p, m) = m. Therefore it must be that
X dxi (p, m)
pi = 1.
i
dm

1
It follows that
v(p, m) X dxi (p, m)
= pi = . (5)
m i
dm
Now let us differentiate with respect to pj .

v(p, m) X dxi (p, m) X dxi (p, m)


= ui (x(p, m)) = pi . (6)
pj i
dpj i
dpj

Differentiate both sides of the budget equation with respect to pj to see that
X dxi (p, m)
pi + xj (p, m) = 0.
i
dpj

Therefore
X dxi (p, m)
pi = xj (p, m). (7)
i
dpj
Substitute Equation 7 into Equation 6 to find that

v(p, m)
= xj (p, m).
pj

Recalling Equation 5, we then have Equation 1, which is Roys Identity.

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