Microeconomics Lecture Notes

Karel Janda

1 MWG Chapter 1 Preference and Choice

1.1 MWG 1.B Preference Relations
Def.: Preference relation % is a binary relation on X, allowing the comparison of pairs of
alternatives x, y ∈ X.
Def. 1.B.1 The preference relation % is rational if it is
1. Complete:
2. Transitive:
Def 1.B.2 A function u : X → R is a utility function representing preference relation % if
∀x, y ∈ X, x % y ⇔ u(x) ≥ u(y).
Prop. 1.B.2 If % can be represented by a utility function ⇒ % is rational.

1.2 MWG 1.C Choice Rules

Def. Choice structure (B, C(·)).
Example 1.C.1 Let X = {x, y, z}, B ={{x, y}, {x, y, z}.
1. Possible (B, C1 (·))|C1 ({x, y}) = {x} ∧ C1 ({x, y, z}) = {x}.
2. Possible (B, C2 (·))|C2 ({x, y}) = {x} ∧ C2 ({x, y, z}) = {x, y}.
Def. 1.C.1 Let (B, C(·)) be a choice structure. Let B, B 0 ∈ B with x, y ∈ B, B 0 .
(B, C(·)) satisfies the WARP if x ∈ C(B) ∧ y ∈ C(B 0 ) ⇒ x ∈ C(B 0 ).
Def. 1.C.2 Given (B, C(·)), revealed preference relation %∗ is defined by:
x %∗ y ⇔ ∃B ∈ B| x, y ∈ B ∧ x ∈ C(B).

1.3 MWG 1.D The Relationship between Preference Relations

and Choice Rules
Def: Choice structure generated by rational %: C ∗ (B, %) = {x ∈ B : x % y∀y ∈ B}.
Prop. 1.D.1 Suppose % is rational. Then (B, C ∗ (B, %)) satisfies WARP.
Proof: Suppose ∃B ∈ B|x, y ∈ B ∧ x ∈ C ∗ (B, %). By the definition of C ∗ (B, %), this
implies x % y. To check if WARP holds, suppose ∃B 0 ∈ B|x, y ∈ B 0 ∧ y ∈ C ∗ (B 0 , %)).
⇒ y % z∀z ∈ B 0 . But we already know x % y. So by transitivity x % z∀z ∈ B 0 , so
x ∈ C ∗ (B 0 , %). This is the conclusion that WARP demands. Q.E.D.
Def. 1.D.1 Given (B, C(·)), rational % rationalizes C(·) relative to B if: C(B) = C ∗ (B, %
)∀B ∈ B.
Prop. 1.D.2 Given (B, C(·))|

1
 1. WARP satisfied
2. B includes all subsets of X up to 3 elements.
Then ∃! rational % |C(B) = C ∗ (B, %)∀B ∈ B.

2 MWG Chapter 2 Consumer Choice

2.1 MWG 2.D Competitive Budgets
Set of feasible consumption bundles = Walrasian (competitive) budget set = {x ∈ RL+ :
p · x ≤ w} = Bp,w

2.2 MWG 2.E Demand Functions and Comparative Statics

Wealth effects
∂x1 (p,w)
 
∂w
.. L
Dw x(p, w) =  ∈R
 
.
∂xL (p,w)
∂w
Price effects  ∂x1 (p,w) ∂x1 (p,w) 
∂p1
··· ∂pL
Dp x(p, w) = 
 .. ... .. 
. . 
∂xL (p,w) ∂xL (p,w)
∂p1
··· ∂pL

Implications of homogeneity of degree 0 and Walras’ law for price and wealth effects.
Prop. 2.E.1 If the Walrasian demand function x(p, w) is homogeneous of degree 0, then
for all p and w
Dp x(p, w)p + Dw x(p, w)w = 0.
Prop. 2.E.2 If the Walrasian demand function x(p, w) satisfies Walras’ law, then for all p
and w
p · Dp x(p, w) + x(p, w)T = 0T .
Prop. 2.E.3 If the Walrasian demand function x(p, w) satisfies Walras’ law, then for all p
and w
p · Dw x(p, w) = 1.

2.3 MWG 2.F WARP and Law od Demand

Def. 2.F.1 The Walrasian demand function x(p, w) satisfies WARP if for any (p, w) and
(p0 , w0 ):
If p · x(p0 , w0 ) ≤ w ∧ x(p0 , w0 ) 6= x(p, w) ⇒ p0 · x(p, w) > w0 .
Implications of WARP
Slutsky wealth compensation:

2
Originally: p, w → x(p, w).
Change p → p0 ⇒ w0 = p0 · x(p, w).
Wealth adjustment is ∆w = ∆p · x(p, w).
Prop. 2.F.1 Suppose that the Walrasian demand function x(p, w) is homogeneous of degree
0 and satisfies Walras’ law. Then x(p, w) satisfies WARP if and only if the following
property holds:
For any (Slutsky) compensated price change from an initial situation (p, w) to a new price
wealth pair (p0 , w0 ) = (p0 , p0 · x(p, w)) we have
(p0 − p) · [x(p0 , w0 ) − x(p, w)] ≤ 0,
with strict inequality whenever x(p, w) 6= x(p0 , w0 ).
Slutsky (or substitution) matrix: S(p, w) = Dp x(p, w) + Dw x(p, w)x(p, w)T
meaning  
s11 (p, w) · · · s1L (p, w)
S(p, w) =  .. .. ..
,
 
. . .
sL1 (p, w) · · · sLL (p, w)
where slk (p, w) = ∂x∂p
l (p,w)
k
+ ∂xl∂w
(p,w)
xk (p, w).
Prop. 2.F.2 If a differentiable Walrasian demand function x(p, w) satisfies Walras’ law,
homogeneity of degree 0, and WARP, then at any (p, w) the Slutsky matrix S(p, w) is
negative semidefinite.
Prop. 2.F.3 Suppose that the Walrasian demand function x(p, w) is differentiable, homo-
geneous of degree 0, and satisfies Walras’ law. Then p · S(p, w) = 0 and S(p, w) · p = 0 for
any (p, w).

To be remembered:
1. WARP ⇔ Compensated Law of Demand.
2. Compensated Law of Demand ⇒ negative semidefinite Slutsky matrix.
3. WARP does not imply symmetry of Slutsky matrix.

3 MWG Chapter 3 Classical Demand Theory

3.1 MWG 3.B Preference Relations: Basic Properties
Def. 3.B.2 The preference relation % on X is monotone if x ∈ X and y  x implies
y  x.
Def. Given % and consumption vector x, the upper contour set of bundle x is {y ∈
X : y % x}.
Def. 3.B.4 The preference relation % on X is convex if ∀x ∈ X, the upper contour
set is convex; that is y % x and z % x ⇒ αy + (1 − α)z % x∀α ∈ [0, 1].

3
3.2 MWG 3.C Preference and Utility
Example 3.C.1 The Lexicographic Preference Relation.
Assume X = R2+ . x % y if [x1  y1 ∨ (x1 = y1 ∧ x2 ≥ y2 )].
Def. 3.C.1 The preference relation % on X is continuous if it is preserved under limits.
That is, for any sequence of pairs {xn , y n }∞ n n
n=1 with x % y ∀n, x = limn→∞ x , and
n

y = limn→∞ y n , we have x % y.
Thm. Equivalently, % on X is continuous if ∀x ∈ X upper contour set and lower contour
set are closed.
Example 3.C.1 continued: Lexicographic preferences are not continuous. Consider se-
quences of bundles xn = ( n1 , 0), y n = (0, 1). ∀n xn  y n . But limn→∞ y n = (0, 1)  (0, 0) =
limn→∞ xn .
Prop. 3.C.1 Suppose that the rational preference relation % on X is continuous. Then
there is a continuous utility function u(x) that represents %.
Def. A point p is a limit point of the set E if every neighborhood of p contains a point
q 6= p|q ∈ E.
Def. Closure of E is Ē = E ∪ E 0 , where E 0 is a set of all limit points of E.
Def. Two subsets A and B of a metric space X are said to be separated if both A ∩ B̄ and
Ā ∩ B are empty, i.e., if no point of A lies in the closure of B and no point of B lies in the
closure of A.
A set E ⊂ X is said to be connected if E is not a union of two nonempty separated sets.

3.3 MWG 3.D The Utility Maximization Problem (UMP)

Given p  0, w > 0, then UMP is

max u(x)
x≥0
s.t. p · x ≤ w.

Prop. 3.D.1 If p  0 ∧ u(·) is continuous then UMP has a solution.

3.3.1 The Walrasian Demand Correspondence/Function

Prop. 3.D.2 Suppose u(·) is continuous function representing locally nonsatiated % defined
on X = RL+ . Then Walrasian demand correspondence x(p, w) possesses the following
properties:

1. Homogeneity of degree 0 in (p, w).

2. Walras’ law

3. Convexity/uniqueness: If % in convex (⇒ u(·) is quasiconcave) ⇒ x(p, w) is a convex

set. If % is strictly convex (⇒ u(·) is strictly quasiconcave) ⇒ x(p, w) is a singleton
set.

4
 4. Continuous (if function, upper hemicontinuous if correspondence).

5. Differentiable ⇔ the determinant of the bordered Hessian of u(·) is nonzero at x(p, w).

3.3.2 The Indirect Utility Function

Prop. 3.D.3 Suppose u(·) is a continuous utility function representing a locally nonsatiated
preference relation % on the consumption set X = RL+ . The indirect utility function v(p, w)
is

1. Homogeneous of degree zero.

2. Strictly increasing in w and nonincreasing in pl for any l.

3. Quasiconvex; that is, the set {(p, w) : v(p, w) ≤ v̄} is convex for any v̄.

4. Continuous in p and w.

3.4 MWG 3.E The Expenditure Minimization Problem (EMP)

Given p  0, u > u(0), then EMP is

min p · x
x≥0
s.t. u(x) ≥ u.

Prop. 3.E.1 (Relationship between EMP and UMP) Suppose that u(·) is a continuous
utility function representing a locally nonsatiated preference relation % defined on the
consumption set X = RL+ and that the price vector is p  0. We have

1. If x∗ is optimal in the UMP when wealth is w > 0, then x∗ is optimal in the EMP
when the required utility level is u(x∗ ).The minimized expenditure level in this EMP
is exactly w.

2. If x∗ is optimal in the EMP when the required utility level is u > u(0), then x∗ is
optimal in UMP when wealth is p · x∗ . The maximized utility level in this UMP is
exactly u.

3.4.1 The Hicksian Demand Function

Prop. 3.E.3 Suppose u(·) is a continuous utility function representing a locally nonsatiated
preference relation % defined on the consumption set X = RL+ . Then for any p  0, the
Hicksian demand correspondence h(p, u) has:

1. Homogeneity of degree 0 in p.

2. ∀x ∈ h(p, u), u(x) = u. (No excess utility).

5
 3. Convexity/uniqueness: If % is convex, then h(p, u) is a convex set; if % is strictly
convex (⇒ u(·) is strictly quasiconcave), then there is a unique element in h(p, u).

4. Continuous (essentially the same as for Walrasian demand correspondence).

5. Differentiable (essentially the same as for Walrasian demand correspondence).

Prop. 3.E.4 Suppose that u(·) is a continuous utility function representing a locally non-
satiated preference relation % and that h(p, u)consists of a single element for all p  0.
Then h(p, u) satisfies the compensated law of demand ∀p0 , p00 :

(p00 − p0 ) · [h(p00 , u) − h(p0 , u)] ≤ 0.

3.4.2 The Expenditure Function

Prop. 3.E.2 Suppose that u(·) is a continuous utility function representing a locally non-
satiated preference relation % defined on the consumption set X = RL+ . The expenditure
function e(p, u) is:

1. Homogeneous of degree 1 in p.

2. Strictly increasing in u and nondecreasing in pl ∀l.

3. Concave in p.

4. Continuous in p and u.

Note: For a fixed p̄, e(p̄, ·) and v(p̄, ·) are inverses to one another.

e(p, v(p, w)) = w, v(p, e(p, u)) = u

(In general for inverse function f (f −1 (t)) = t).

3.5 MWG 3.G Relationships between Demand, Indirect Utility,

and Expenditure Functions
Prop. 3.G.1 Suppose that u(·) is a continuous utility function representing a locally nonsa-
tiated and strictly convex preference relation % defined on the consumption set X = RL+ .
For all p and u, the Hicksian demand h(p, u) is

h(p, u) = ∇p e(p, u).

Prop. 3.G.2 Suppose that u(·) is a continuous utility function representing a locally nonsa-
tiated and strictly convex preference relation % defined on the consumption set X = RL+ .
Suppose that h(·, u) ∈ C 1 at (p, u). Then

1. Dp h(p, u) = D2 e(p, u).

6
 2. Dp h(p, u) is a negative semidefinite matrix.

3. Dp h(p, u) is a symmetric matrix.

4. Dp h(p, u)p = 0.

Prop. 3.G.3 (The Slutsky Equation) Suppose that u(·) is a continuous utility function
representing a locally nonsatiated and strictly convex preference relation % defined on the
consumption set X = RL+ . Then for all (p, w), and u = v(p, w) we have

Dp h(p, u) = Dp x(p, w) + Dw x(p, w)x(p, w)T .

Prop. 3.G.4 (Roy’s Identity). Suppose that u(·) is a continuous utility function representing
a locally nonsatiated and strictly convex preference relation % defined on the consumption
set X = RL+ . Suppose also that the indirect utility function v(·, ·) is differentiable at (p̄, w̄).
Then
1
x(p̄, w̄) = ∇p v(p̄, w̄).
∇w v(p̄, w̄)

3.6 MWG 3.I Welfare Evaluation of Economic Changes

Consider fixed wealth w > 0 and change p0 → p1 . If v(p, w) is any indirect utility function
derived from known %, the consumer is worse off ⇔ v(p1 , w) − v(p0 , w) < 0.
Especially convenient money metric indirect utility function: measures in dollars, con-
structed using expenditure function.

e(p̄, v(p1 , w)) − e(p̄, v(p0 , w))

Let u0 = v(p0 , w), u1 = v(p1 , w) and note that e(p0 , u0 ) = e(p1 , u1 ) = w

Def.: EV (p0 , p1 , w) = e(p0 , u1 ) − e(p0 , u0 ) = e(p0 , u1 ) − w,
CV (p0 , p1 , w) = e(p1 , u1 ) − e(p1 , u0 ) = w − e(p1 , u0 ).
Interpretation of EV, CV as areas under Hicksian demand curve:
Z p01
0 1 0 1 0 1 1 1
EV (p , p , w) = e(p , u ) − w = e(p , u ) − e(p , u ) = h1 (p1 , p̄−1 , u1 )dp1 ,
p11

where p̄−1 = (p̄2 , . . . , p̄L )

R p0
Similarly, CV (p0 , p1 , w) = p11 h1 (p1 , p̄−1 , u0 )dp1 ,
1