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Lecture 5, September 12
Outline
1 Properties of Walrasian Demand
2 Indirect Utility Function
3 Envelope Theorem
Summary of Constrained Optimization
gi (x) 0
When x is solves max f (x) subject to then
i = 1; ::; m
m
X
rL (x ; ) = rf (x ) i rgi (x ) = 0
i =1
and gi (x ) 0, i 0, and i gi (x ) = 0 for i = 1; :::; m.
Important details:
If the better than set or the constraint sets are not convex: big trouble.
If functions are not dierentiable: small trouble.
If the geometry still works we can nd a more general theorem (see convex
analysis).
When does this fail?
If the constraint qualication condition fails.
If the objective function is not quasi concave.
This means you must check the second order conditions when in doubt.
Walrasian Demand
Denition
Given a utility function u : Rn+ ! R, the Walrasian demand correspondence
x : Rn++ R+ ! Rn+ is dened by
x (p; w ) = arg max u(x) where B(p; w ) = fx 2 Rn+ : p x w g:
x2B p;w
When the utility function is quasi-concave and dierentiable, the First Order
Conditions for utility maximization say:
utility budget X non negativity
r( ) budget r( ) non negativity r( )=0
function constraint constraint constraints constraints
So, at a solution x 2 x (p; w ):
@L (x ) @u (x )
= w xi + i = 0 for all i = 1; ::; n
@xi @xi
Marginal Rate of Substitution
Denition
Given a continuous utility function u : Rn+ ! R, the indirect utility function
v : Rn++ R+ ! R is dened by
v (p; w ) = u(x ) where x 2 x (p; w ):
Proof.
Apply Berges Theorem:
If u : Rn+ ! R a continuous function and B (p; w ) : Rn++ R+ ! Rn+ is a
continuous correspondence with nonempty and compact values. Then:
(i): x : Rn++ R+ ! Rn+ dened by x (p; w ) = arg maxx 2B (p;w ) u(x) is an upper
hemicontinuous correspondence and
(ii): v : Rn++ R+ ! R dened by v (p; w ) = maxx 2B (p;w ) u(x) is a continuous
function.
We need continuity of the correspondence from price-wage pairs to budget
sets.
We must show that B : Rn++ R+ ! Rn+ dened by
B (p; w ) = fx 2 Rn+ : p x w g
is continuous and we are done.
Continuity for Correspondences
Proposition (A)
Suppose X Rm and Y Rn . A compact-valued correspondence ' : X ! Y is
upper hemicontinuous if, and only if, for any domain sequence xj ! x and
corresponding range sequence yj such that yj 2 '(xj ), there exists a convergent
subsequence fyjk g such that lim yjk 2 '(x).
Proposition (B)
Suppose A Rm , B Rn , and ' : A ! B. Then ' is lower hemicontinuous if, and
only if, for all fxm g 2 A such that xm ! x 2 A and y 2 '(x), there exist
ym 2 '(xm ) such that ym ! y .
Continuity for Correspondences: Examples
Exercise
Suppose ' : R ! R is dened by:
f1g if x < 1
'(x) = :
[0; 2] if x 1
Prove that ' is upper hemicontinuous, but not lower hemicontinuous.
Exercise
Suppose ' : R ! R is dened by:
f1g if x 1
'(x) = :
[0; 2] if x > 1
Prove that ' is lower hemicontinuous, but not upper hemicontinuous.
Continuity of the Budget Set Correspondence
@fi
Notation: (Dx f )ij = @xj
Denition
Let m = fi : xi (p; w ) > 0g and reindex Rn so these m dimensions come rst. The
bordered Hessian H of u with respect to its rst m dimensions is
2 3
0 u1 u2 um
6 u1 u11 u21 um1 7
6 7 where ui = @u
0 (Dx u)> 6 u2 u12 u22 u 7 @xi
H= 2 = 6 m2 7 ,
@2 u
Dx u Dxx u 6 .. .. .. . . 7 and u ij =
4 . . . .. .. 5 @xi @xj
This only considers demand functions which are not zero and then takes rst
and second derivatives of the utility function with respect to those goods.
Dierentiability of Walrasian Demand
Proposition
Suppose u is twice continuously dierentiable, locally nonsatiated, strictly
quasiconcave, and that there exists " > 0 such that xi (p; w ) > 0 if and only if
xi (p; w ) > 0, for all (p; w ) such that k(p; w ) (p; w )k < ".a If H is nonsingular at
(p; w ), then x (p; w ) is continuously dierentiable at (p; w ).
a This condition is automatically satised if xi > 0 for all i , by continuity of x .
Proof.
Question 2, Problem Set 3.
Problem
Let : Rn Rm ! R, written (x; q); DM chooses x to maximize ; while q are
parameters she does not control.
Comparative Statics
We want to know how DM adjusts her optimal choice x (q) when the parameters
q change. What is the derivative of x (q)?
the second order eect of how the maximizer x responds to q is irrelevant; only
the rst order eect of how q changes the objective function evaluated at the
xed maximizer x (q) matters. This observation is sometimes called the Envelope
Theorem.
@2
@x @q@x
If x and q are scalars, Dq x (q) becomes @q = @2
@x 2
Comparative Statics With Constraints
There are k equality constraints, Fi (x; q) = 0 with each Fi smooth.