minimise expenditure subject to u(x1 ,...

, xn ) u
n
L pi xi u u(x1 ,..., xn )
i 1
x2
xi (p1 ,.., pn ,u ) Hicksian demand functions

p1 x1 ... pn xn e(p1 ,.., pn ,u ) the expenditure function

x2
the minimum expenditure required
to achieve u , given (p1 ,..., pn ).
u u

0 x1
x1

9
 minimise expenditure subject to u(x1 ,..., xn ) u

xi (p1 ,.., pn ,u ) p1 x1 ... pn xn e(p1 ,.., pn ,u )

Now consider a change in pj, other prices remaining unchanged.

What can we say about the partial derivative ej ?

There is a direct effect on the expenditure function through the term p j x j

There are also indirect effect through changes in each xi (p1 ,.., pn ,u )
But at the optimum these indirect effects sum to zero (see lecture slide 7),
so that simply:
ej x j Shephard’s Lemma

10
L x1 x21 m p1 x1 p2 x2

x1 1 x21 p1 0 x1 x21
p1 x1
1 1
p2 x2 p1 x1
p1 x1 p2 x2
1
(1 )x1 x2 p2 0 x1 x21
p2 x2

p1 x1 p2 x2 m

1 m m
p1 x1 p1 x1 m xˆ1 xˆ2 (1 )
p1 p2

ˆ 1 1 ˆm uˆ ˆ
xˆ1 xˆ21 û û
m m m 11
 m m ˆ 1 1
xˆ1 xˆ2 (1 ) xˆ1 xˆ21 û
p1 p2 m m

1
m m
uˆ (1 ) (1 )1 p1 p2 1m v(p1 , p2 , m)
p1 p2

ˆ 1
û (1 )1 p1 p2 1
vm
m

uˆ ˆ x̂1
p1 1 ˆ m v1
p1 vi
xˆi Roy’s Identity
uˆ vm
(1 )p2 1 ˆ m ˆ x̂2 v2
p2
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L p1 x1 p2 x2 u x1 x21

p1 x1 1
p1 x1 1 x21 0 x1 x2
p2 x2 p1 x1 1 p1
x2 x1
1 p2
p2 x2 1
p2 (1 ) x1 x2 0 x1 x2
1

x1 x21 u

1 1
1 p1 p2 1 p1
x1 x1 u x1 u x2 u
p2 1 p1 p2
13
 1
p2 1 p1
x1 u x2 u
1 p1 p2

1
p2 1 p1
p1 x1 p2 x2 p1 p2 u e(p1 , p2 ,u )
1 p1 p2

1 1
(1 ) p1 p21 (1 ) p1 p21 u

1
(1 ) p1 p21 (1 )u

1
(1 ) p1 p21 u

14
 1
p2 1 p1
x1 u x2 u
1 p1 p2

1
p1 x1 p2 x2 (1 ) p1 p21 u e(p1 , p2 ,u )

p1 x1 p2 x2 1
(1 ) p1 1 p21 u
p1
1
p1 x1 p2 x2 1 1 p2
(1 ) p1 1 p21 u u
p1 1 p1

e1 (p1 , p2 ,u ) x1 Shephard’s Lemma

15
 1
p2 1 p1
x1 u x2 u
1 p1 p2

1
p1 x1 p2 x2 (1 ) p1 p21 u e(p1 , p2 ,u )

compare with (from slide 12):

uˆ xˆ1 xˆ21 (1 )1 p1 p2 1m v(p1 , p2 , m)

The expenditure function and the indirect utility function are inverses of each other.

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 1
p2 1 p1
x1 u x2 u
1 p1 p2

are equal to the Marshallian demands

m m
xˆ1 xˆ2 (1 )
p1 p2

1
if and only if m (1 ) p1 p21 u e(p1 , p2 ,u )

or equivalently u (1 )1 p1 p2 1m v(p1 , p2 , m)

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 1
p2 1 p1
x1 u x2 u
1 p1 p2

are equal to the Marshallian demands x2

m e(p1 , p2 ,u )
m m m p2
xˆ1 xˆ2 (1 ) u v(p1 , p2 , m)
p1 p2
x2

u u

0 x1 m p1
x1

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 xi (p1 ,.., pn ,u ) p1 x1 ... pn xn e(p1 ,.., pn ,u )

ej xj

For a (vanishingly) small increase in pj, …

... this measures the amount (per unit of the price increase) by which expenditure
must increase, in order to maintain a given level of utility u

(So this connects with the compensation criterion and consumer surplus.)

But for a substantive increase p j it is only an approximation.

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 p1 p1 p1 m m p1 x1
is the expenditure now required to
purchase the bundle (x1 , x2 ) …
x2 x2 … but is more than required for u
m p2
m p2 m p2

x2 x2

u u u u

0 x1 m p1 m p1 0 x1 m p1 m p1
x1 x1

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Given any increase p j , with all other prices unchanged …

m m pj x j

m pj x j

m
xj
pj

is the increase in expenditure required to purchase the initial bundle (x1 ,..., xn )

As p j 0 , the increase in expenditure required to maintain the initial utility u

approaches this same value.
So xj is the partial derivative e j (p1 ,.., pn ,u) of the expenditure function.

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Starting from a position where xi xˆi xi

Consider a change in pj, accompanied dm

xj
by a compensating change in m: dp j x2
What happens to xi ? m e(p1 , p2 ,u )
m p2
From the Marshallian demand function: u v(p1 , p2 , m)
xˆi xˆi
xj x2
pj m
From the Hicksian demand function: u u
xi
pj 0 x1 m p1
x1
But these are just two ways of describing the same change.
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Starting from a position where xi xˆi xi

Consider a change in pj, accompanied dm

xj
by a compensating change in m: dp j

xˆi xˆi xi
xj
pj m pj

or equivalently: xˆi xi xˆi

xj
pj pj m

is a Slutsky equation.

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 xˆi xi xˆi
xj a Slutsky equation
pj pj m

Given a change in pj (other prices and m remaining constant) …

the effect on the Marshallian demand for xi can be decomposed into two parts:

xi the change in demand for xi that would

the substitution effect
pj have occurred if m had been adjusted to
maintain u u
xˆi
x j the income effect
m

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