Professional Documents
Culture Documents
Preferences
Preferences
Preferences
Contents
Preface 1 Preference
1.1 1.2 Preference relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preference over commodity bundles . . . . . . . . . . . . . . . . . . . . . . . . . .
iii 1
1 2
2 Utility
2.1 2.2 2.3 2.4 2.5 2.6 Utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From preference to utility: nite or countable sets . . . . . . . . . . . . . . . . . . Preference, but no utility Continuous utility In no-man's-land: A necessary and sucient condition for utility representation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Some special functional forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9
9 10 11 12 13 16
3 Choice
3.1 3.2 3.3 Existence of most preferred elements . . . . . . . . . . . . . . . . . . . . . . . . . Revealed preference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
22
22 23 24
26
26 28 31 34 36 38
40
40 40 43 45 46 47 49
6 General equilibrium
6.1 6.2 6.3 6.4 6.5 What is an equilibrium? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pure exchange economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Welfare analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Private ownership economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
50
50 51 52 53 55
57
57 58 60 62
8 Risk attitudes
8.1 8.2 8.3 8.4 In for a gamble? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certainty equivalent and risk premium . . . . . . . . . . . . . . . . . . . . . . . . Arrow-Pratt measure of absolute risk aversion . . . . . . . . . . . . . . . . . . . . A derivation of the Arrow-Pratt measure . . . . . . . . . . . . . . . . . . . . . . .
63
63 64 65 66
67
67 67 68 68
10 Time preference
10.1 Stationarity and exponential discounting . . . . . . . . . . . . . . . . . . . . . . . 10.2 Preference reversal and hyperbolic discounting . . . . . . . . . . . . . . . . . . . . 10.3 Limit-of-means and overtaking 10.4 Better may be worse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
70
70 72 73 75
11 Probabilistic choice
11.1 The Luce model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.2 The logit model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.3 The linear probability model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.4 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
77
77 80 82 84
85 88 89 91
ii
Preface
Overview
The purpose of these notes is to introduce you to some mathematical foundations of economic theory. These are building blocks of economics that hopefully contribute to your understanding of formal modeling in your other courses and in the research papers you will read and eventually write. The typical model of the behavior of an economic agent requires careful answers to the following questions:
(Q1) What can the agent choose from, i.e., what is the set of feasible alternatives? (Q2) What does the agent like, i.e., what are the preferences over alternatives? (Q3) How are the former two combined to make a choice, i.e., to select among alternatives?
Although we make some brief excursions into bounded rationality, the main building block of traditional economics is rational choice: choose from your set of feasible alternatives a most preferred one. This raises important related questions:
(Q4) When do most preferred elements exist? (Q5) How are they aected when the agent's environment changes?
The fourth question is extremely important: you'd be surprised about how many people simply skip over the existence issue and write papers about how solutions to economic problems are aected by parameter changes, without ever wondering whether there even is a solution. The fth question concerns things like how a consumer's demand is aected by price changes, wage increases, etc. Try to keep this in mind, because this is what will occupy us most of the time and constitutes the red line of the course: regardless of the setting, we rst have to answer (Q1) to (Q3) to provide a meaningful microfounded model of an economic agent's behavior. Sections 1 to 3 provide a general framework for modeling preferences over and choice from a feasible set of alternatives. This general framework is then applied to a number of specic cases: traditional models of consumer choice (Section 4), producer choice (Section 5), choice over outcomes that are no longer deterministic, but occur with certain probabilities (Section 7), choice over outcomes occurring over time (Section 10), and even the modeling of seemingly suboptimal choices (Section 11).
Special features
Every course reects some of the teacher's own preferences. Although the material covered here is pretty standard for a rst PhD course in microeconomic theory, what distinguishes these notes from other graduate texts is:
Focus on preferences:
utility functions. Utility functions are practical in the sense that they allow you to use standard calculus tools, but this tends to blur the picture by making economics into an exercise in advanced dierentiation. I try to avoid this. Although people make statements like I like coee more than tea, you hardly ever see them in a supermarket with a calculator and their utility function written on a piece of paper. This allows us to give a much more general answer with a remarkably simple proof to the question when most preferred elements exist; see Proposition 3.1.
Graduate texts
typically give exactly one example, lexicographic preferences, as if it concerns an exotic phenomenon. These notes try to give some counterweight by providing several economically relevant examples, all arising from the same general principle; see Section 2.3. So the question remains, when does a utility function exist? Section 2.4 provides necessary and sucient conditions. As an important special case, when does a continous utility function exist? Proposition 2.6 provides a detailed proof. Remarkably, not even Fishburn (1970a), the standard reference on utility theory, contains such a proof, and neither does any of the standard textbooks in microeconomic theory. I don't actually expect you to know the proof, I just wanted to ll a gap and make sure you have access to it.
Miscellanea:
An existence result for Walrasian equilibria in terms of excess demand correspondences, rather than excess demand functions; see Proposition 6.5. Some excursions into the realm of bounded rationality, with brief discussions of hyperbolic discounting (Section 10.2), probabilistic choice (Section 11), and some exotic preferences (Section 3.3).
Solutions manual:
solutions to all
1
can treat the worked exercises as a collection of a few dozen (cleverly disguised) examples and
Recommended reading
The lecture notes are the reading material for the course. You may omit the proof of Propositions 2.5 and 2.6, as well as the more mathematical exercises in Section 10.3. For the interested reader, the following table refers to related material in Mas-Colell, Whinston, and Greene (1995, MWG), which is by no means obligatory. Lecture notes 1. Preference 2. Utility 3. Choice 4. Choices of a consumer 5. Choices of a producer 6. General equilibrium 7. Expected utility theory 8. Risk attitudes 9. Some critique 10. Time preference 11. Probabilistic choice See also MWG 1.AB, 2.AC, 3.B 3.C 1.CD, 2.D 2.E, 3.DE, G, I 5.AC, FG 15.AC, 16.AD, 17.AC, 18.AB 6.AB 6.C 6.B 20.AB none
Well, almost all exercises, as a couple of them will be used as this year's home assignments...
iv
Terminology
In economics, there is little consensus on terminology. For instance, following Arrow (1959)
and Fishburn (1970b), I refer to a complete transitive binary relation that models an economic agent's preferences as a `weak order'. Other names include `rational preference relation' (MasColell et al., 1995), a very loaded term, simply `preference relation' (Rubinstein, 2006), `complete preordering' (Debreu, 1959), `complete weak order' (Fishburn, 1979), and `complete ordering' (Debreu, 1954). The Micro I course and its exam use the denitions from these lecture notes.
1.
1.1.
Preference
Preference relations
Rational choice essentially means choosing from a set of feasible options a most preferred alternative. Let
be a set of alternatives. A
preference relation
X,
x, y X ,
y .
A binary relation
weak order
if it satises:
or
x y
(or both).
and
z,
then
z.
X X
x, y X : x
if and only if
knows
y.
Strict preference:
to
x
if
y if x x y
y , but not y
and
y ). xy y x y y x
( x and
Indierence:
We sometimes write
instead of
and
instead of
y.
heavily on preferences. You should be aware of some hidden assumptions: Preferences are deterministic: they are not susceptible to a change of mind or mood shocks. Statements like I like coee more than tea at any time, but today I prefer a cup of tea. are ruled out. Preferences are ordinal: the intensity of preferences as in I'm rather fond of the 6
o'clock news, but detest soap operas. plays no role. Preference is a binary relation: it compares pairs of alternatives, independently of external factors. Conditional statements like If there are twenty types of coee to choose from, I prefer tea to any type of coee. Otherwise, I take an espresso. are ruled out. Also completeness and transitivity deserve scrutiny. Completeness rules out the existence of
a, b, c
as follows:
and
and
c a
a. c.
Dene a new preference
This involves a slight but common abuse of notation: although this was not stated explicitly, the notation above is taken to suggest, for instance, that also relation via majority rule voting:
b,
strictly prefers
over
b.
Similarly,
and
a,
in stimuli unless they exceed a certain threshold. For instance, you will typically not sense the
nN
n+1
you will be indierent between them. If preferences are transitive, you will be indierent between a cup of tea with 1 grain of sugar, 2 grains of sugar, 3 grains of sugar. . . one kilo of sugar. Are you? This example is related to the more general issue of similarity: nearby alternatives may be perceived similar and therefore equally good. But with a long chain of nearby alternatives, you can create a huge change between alternatives, so that you may no longer be indierent between them. Properties of relation imply some properties of the indierence relation
and
; check
Proposition 1.1
Let
be a weak order on
X.
(c) (d)
reexivity: symmetry:
x X : x x. x, y X :
if
x y,
if
then
y x. y z,
then
transitivity:
x, y, z X :
xy
and
x z.
satises:
x X :
not if
x x
if
x. y, x
then not
x, y X :
y z,
x.
then
x, y, z X :
and and
and
z.
x, y, z X : x, y, z X :
Let
xy x y
y y x
z, z,
then then
x x y
z. z.
Proof. (d):
z . By denition of , x y implies x y . With y z and transitivity of , this implies x z . It is not true that z x: if it were, it would imply with y z and transitivity of that y x, contradicting that x y . Since x z , but not z x: x z .
with and
x, y, z X
Exercise 1.2
1.2.
is usually
L taken to be R or
called a
RL for some +
L N.
The additional structure obtained this way allows us to introduce a number of new properties; throughout this subsection, assume therefore that typically illustrated using indierence curves. The set
{y X : x y}
equals
RL +
or
RL .
x.
xy =
=1
The preference relation over and
(x y )2 .
satises
>0
there is a
yX
with Let
xy <
x. ek RL
denote the
Monotonicity properties come in dierent varieties, all reecting the intuition that more is better.
k {1, . . . , L} xy x>y
and let
k -th
k -th
coordinate equal to one and all other coordinates equal to zero. For if if
x, y RL ,
write
xi yi xi > yi
i = 1, . . . , L, i = 1, . . . , L.
is:
xX
if
and each
strongly monotonic if an increase in at least one coordinate gives better alternatives: for all
x, y X ,
xy
and
x = y,
y. y,
and
x>y
implies
y.
Exercise 1.3
(a) Prove the previous two sentences. (b) Give an example of a preference relation over for (c) Let
R2 +
k,
both
k=1
and
k = 2,
X = RL +
xy
and
x=y
imply that
y.
X = RL .
Each of the three monotonicity properties implies local nonsatiation. On the other hand, local nonsatiation has no implications for monotonicity: the preference relation on
R2 +
with
(x1 , x2 )
is locally nonsatiated, but satises none of the monotonicity properties. Figure 1 contains three indierence curves of this preference relation with the better ones further away from the
x2 3 2 1 0 0
Figure 1:
x1 1 2 3
origin and shows that small increases in one or both of the coordinates may lead into areas with strictly worse alternatives. Figure 2 summarizes the relations between the three monotonicity relations and local nonsatiation. An arrow from strong monotonicity to monotonicity means that the former implies the latter; the absence of an arrow in the opposite direction means that the converse is not true.
strongly monotonic
E d d d d d c
locally nonsatiated
monotonic
RL
or
Figure 2:
RL . +
A preference relation
is
continuous
y
and the set
if for every
Proposition 1.2
(a) closed. (b) For every (c) The graph
Let
be a weak order on
X.
y X,
the sets
{x X : x {x X : x
y} y}
and
{x X : x
y}
are
y X,
the sets
{x X : x y}
of
y}
and
are open.
{(x, y) X X : x
is closed.
n N,
(e) For all
then also
(xn )nN x y.
if
and
(yn )nN
in
X,
if
x n x , yn y , Ux
for of
and
xn
yn
for all
x, y X , containing x) and
y,
a neighborhood
Uy
of
such that
Proof.
Statements (a) and (b) are equivalent, since the complement of an open set is closed, if and only if
and vice versa. Also the equivalence of (c) and (d) is a matter of denition: an element of the graph of
xn
yn .
the circle and make sure that all ve statements are equivalent:
x, y X with x y . Distinguish two cases: m X with x m y . Dene Ux = {z X : z m} and Uy = {z X : m z}. These sets are open by (b). Moreover, x Ux and y Uy by assumption. Let x Ux , y Uy . Then x m and m y . By Proposition 1.1, is transitive, so x y , as we had to show. Case 2: There is no m X with x m y. Dene Ux = {z X : z y} and Uy = {z X : x z}. These sets are open by (b). Moreover, x Ux and y Uy by assumption. Let x Ux , y Uy . Then x y . It cannot be that x x , otherwise we would have x x y . By completeness, x x. Similarly, y y . So x x y y . By Proposition 1.1, x y , as we had to show.
Assume (b) holds. Let There is an
Conclude from cases 1 and 2 that (e) holds. Assume (e) holds. To establish (c), we need to show that the complement of
{(x, y) X X : x
y}
is open. By completeness of
S = {(x, y) X X : x
For each
y}.
and
neighborhoods
Ux
of
Uy
of
such that
for all
(x, y) S :
Taking the union over all
(x, y) Ux Uy S.
(x, y) S ,
one obtains
S = (x,y)S Ux Uy .
As the union of open sets,
The following proof is more general, but requires some knowledge of topology. In case of emergency, don't worry. Simply forget that this footnote even exists! [(c) implies (b)]: Assume (c) holds, i.e., the set S dened above is open. Let y X . We show that L(y) = {x X : x y} is open; establishing that also the set {x X : x y} is open is analogous. Let x L(y). Then (x, y) S. Since S is open in the product topology generated by Cartesian products of open sets in X , we can x neighborhoods U of x and U of y such that U U S. In particular, for each x U , it follows that (x , y) U U , so x y . Conclude that
2
x y x y x x y
y}
is
x L(y) :
x Ux L(y).
L(y) = xL(y) Ux .
{x X : x y} with limit x . We need to show that x also lies in this set. By denition, (xn , y)nN is a sequence in the graph of , which is closed by assumption. Therefore, it contains the limit (x , y), i.e., x y , as we had to show.
Let
(xn )nN
be a sequence in
Very roughly speaking, continuity of preferences requires that the strict preference relation is unaected by small changes in the alternatives: if alternatives.
is better than
y,
X.
X = RL . +
x
L
and
y:
xy =
=1
A subset
(x y )2 . Y,
i.e., if for each
Y X
is
xX
open if each y Y
y
lie in
is an interior point of
y Y,
all points
as well:
>0
xX
with
x y < : X
xY. x X. . .
Many people overlook a slight subtlety, namely the statement . . . for all looks innocuous: if you want to dene whether a subset of interested in stu that is outside of for instance, that as subsets of
X. X = R2 +
But it does matter in identifying open subsets! Notice, but not as subsets of
X = R2
sets like
Y 1 = R2 , +
Y 2 = {y R2 : y1 < 1}, +
Y 3 = {y R2 : y1 + 2y2 < 4} +
are open. You might want to draw their pictures. In topological language,
X = RL is endowed + L : a set Y X is open if and with the that it inherits from the larger set R L only if Y = X O , where O is an open set in the larger space R . This provides quick proofs 1 , Y 2 , Y 3 are open subsets of X = R2 : that the sets Y +
relative topology
Y 1 = X R2 ,
and the sets
{y R2 : y1 + 2y2 < 4}
are open in
R2 .
is:
The next two properties are related to other changes, namely shifts in or rescaling of the coordinates. The preference relation
implies that
homothetic if rescaling the coordinates does not aect the preferences: for all x, y
Of course, this requires knowing which subsets of X are open. In general as you will recall from the math course this requires X to be a topological space, i.e., it comes equipped with a denition of open sets, subject to three restrictions: (1) the empty set and X are open, (2) unions of open sets are open, (3) intersections of nitely many open sets are open.
3
6
and all
> 0,
if
y,
then
y .
For instance, any preference relation where only the dierence between the rst coordinates matters, like
(x1 , x2 )
or money and the economic idea is that not the exact amounts of money associated with two alternatives matter, but the dierence between them. ingredients and let preferences arises in most linear production processes: let alternatives
and
denote vectors of
be weakly preferable to
y.
Then also
y if the ingredients of x suce to make at least as x yields at least as much cake as y . More generally, k R if for each x RL and each > 0: + f (x) f (y). Then is homothetic: y.
generate homoth-
any preference relation dened in terms of a homogeneous function is homothetic. Recall that
f (x) =
f (x1 , x2 ) = x1 x3 2
Exercise 1.4
on
that satises:
(a) strong monotonicity in coordinate 1, but not quasilinearity in coordinate 1. (b) quasilinearity in coordinate 1, but not strong monotonicity in coordinate 1. (c) homotheticity, but none of the three monotonicity properties. (d) all three monotonicity properties, but not homotheticity.
Exercise 1.5
(a) Prove: if
on
X = RL +
with
if
x > y. x y
if
x y.
drink, whereas the amount of on
Your favorite drink requires mixing its two ingredients in the same
x1 , x2 0 indicate the two amounts, you can mix min{x1 , x2 } of your max{x1 , x2 } min{x1 , x2 } goes to waste. If you are primarily concerned about x, y R2 , + x y
if and only if
drink, but also feel it is unfortunate to waste ingredients, the following weak order reect your preferences: for all
R2 +
may
x x
but
y : min{x1 , x2 } > min{y1 , y2 }, or y , but not more waste: min{x1 , x2 } = min{y1 , y2 }, max{x1 , x2 } min{x1 , x2 } max{y1 , y2 } min{y1 , y2 }. x y
whenever
Show that
x > y,
if
x y.
is
convex
also
if for each
y X,
the set
{x X : x
y}
of weakly better
Proposition 1.3
with
Let
be a weak order on
and all
[0, 1],
X . Then is convex if and only if for all x, y X x + (1 )y y . Informally, if x is at least as good as y , y to x is a weak improvement.
Exercise 1.6
(a) Prove this proposition.
is
x=y
and
and all
(0, 1),
it holds that
x + (1 )y
This property implies that if you are indierent between two distinct alternatives
1 you can still improve upon them: by strict convexity, the alternative x 2
2.
2.1.
Utility
Utility functions
In many cases, preferences over alternatives can be evaluated by some numerical assessment: I prefer the alternative with the higher percentage of alcohol or I prefer the alternative yielding the higher prot. In that case, we say that these functions in the latter case the function assigning to each alternative its associated prot represent the decision maker's preferences. Formally, a function
u:XR
is a
if for all
x, y X :
(2)
One often uses the following simple result to verify that relation .
Proposition 2.1
(a)
Let
and let
u:X R
be a
represents
x, y X :
if if
x y, x y,
then then
Assume (a) holds. Let x, y X . If x y , by denition of : x y and not x. Hence, by denition of a utility function, u(x) u(y) and not u(y) u(x). Conclude that u(x) > u(y). Similarly, if x y , u(x) = u(y). (b) (a): Assume (b) holds. Let x, y X . To show:
x
One direction is easy: if Hence Suppose
y u(x) u(y). y
or
y , then x
x y , so by (b), either u(x) > u(y) or u(x) = u(y). assume that u(x) u(y). By completeness, x y or y x. y x, so by (b), u(y) > u(x), a contradiction.
Exercise 2.1
The completeness condition in Proposition 2.1 cannot be omitted. Indeed, consider the on
preference relation
with
x, y R :
and the function (a) (b)
y xy+1
Show that:
u:RR
with
u(x) = x
for all
x R.
If one function represents a preference relation, then many others do as well: represent the same preference relation. In general:
if preferences
are represented by a prot function, then also twice the prot or prot to the power three
Proposition 2.2
function
Proof.
x, y X :
x
so
represents
Since the
ordering of the real numbers is complete and transitive, a preference relation that
can be represented by a utility function is necessarily complete and transitive: it must be a weak order. But is being a weak order enough to guarantee the existence of a utility function? The answer is positive for nite or countable sets.
2.2.
Representing a weak order on a nite set by means of a utility function is easy: the more preferred an alternative
xX
x.
Therefore, counting
Proposition 2.3
X
is nite,
Assume:
is a weak order on
X.
.
let So
Proof.
For each
x, y X . If {z X : y
x X , dene u(x) = |{z X : x z}|. Then u : X R represents : x y , then for each z X with y z , Proposition 1.1(c) gives that x z. z} {z X : x z}. Similarly, the converse inclusion holds, so {z X : x z} = {z X : y z}. x
Hence
u(x) = u(y).
If
y,
{z X : x
Hence
z} {z X : y
z}.
If
is countable, simply counting the number of weakly worse alternatives does not work: there
may be innitely many of them. But we can give each element a positive weight, make sure that the weights have a well-dened sum even if we add innitely many of them, and use the total weight of the elements weakly worse than
X = {x1 , x2 , . . .}
x. 21 )
x1 ,
then half of
x3 ,
and so on.
Proposition 2.4
X
Assume:
X.
.
10
Proof.
Since
n : X N.
For each
x X,
dene
u(x) =
zX:x z
The sequence
2n(z) .
(2n )nN has a nite sum nN 2n = 1, so u is well-dened. To see that u represents , let x, y X . If x y , (3) holds, so u(x) = u(y). If x y , (4) holds, so n(x) > 0. u(x) u(y) 2
2.3. Preference, but no utility
Not all preference relations not even weak orders can be represented by means of a utility function. Graduate textbooks usually give exactly one example (lexicographic preferences), as if it concerns an exotic phenomenon. This section gives some counterweight by providing several economically relevant examples, all arising from the following general principle. Fix a set of alternatives countable set bad one:
X.
I R,
z in some unb(z) X and one good alternative g(z) X with the each z I , the good alternative is strictly preferred to the g(z) b(z). z
(5) is worse than the bad alternative (6)
Secondly, if
associated with
z<z, z:
z, z I :
z < z b(z )
g(z).
Combining (5) and (6), representing such preferences by a utility function requires, for
z<z:
the intervals
z I , the interval [u(b(z)), u(g(z))] has positive length and if z, z I have z = z , [u(b(z)), u(g(z))] and [u(b(z )), u(g(z ))] are disjoint: one of them lies entirely to the left of the other on the real axis. So uncountably many intervals [u(b(z)), u(g(z))] of positive
length must somehow be placed on the real line without any two of them intersecting. is impossible: we simply run out of space! Formally, each interval This
[u(b(z)), u(g(z))] contains a rational number r(z) Q. Since the intervals associated with dierent values of z are disjoint: z = z implies r(z) = r(z ), i.e., the function r : I Q is injective. But I is uncountable and Q
is countable, a contradiction. Some examples:
Lexicographic preferences.
X = R2 .
Dene
as follows:
(x1 , x2 )
(y1 , y2 ) x1 > y1
(x1 = y1
and
x2 y2 ) .
Alternatives are compared according to their rst coordinates; if these happen to be equal, they are compared according to their second coordinates. a dictionary. For each , then Think of the way words are ordered in
z, z R, z < z
z R, let b(z) = (z, 0) and g(z) = (z, 1). Then g(z) b(z) and, if g(z) = (z, 1) (z , 0) = b(z ). So (5) and (6) hold: this preference relation
(Dubra and Echenique, 2001) It is common in economics
zR
be a certain threshold.
11
if
x < z,
lies in
with
x R: you are told the exact value the interval [z, ). That means you can x < z , but cannot distinguish between the
[z, ).
R.
x = z:
all numbers
xz
can be perfectly distinguished, but larger ones not. Assume it is preferable to have more precise information, i.e., ner information partitions (partition from
Q
so
if every set
Q).
Partition
g(z)
b(z),
g(z)
b(z).
Also if
z<z,
partition
b(z )
g(z),
so
b(z )
g(z).
At every moment in time t [0, ), an agent receives x is simply a function x : [0, ) {0, 1}. Suppose preferences satisfy the following monotonicity condition: if x(t) y(t) at all times t, with strict inequality for at least one time period, then x y . Dene, for each z [0, ), the alternative b(z) giving payo one before time z and payo zero afterwards:
b(z)(t) =
Similarly, alternative
1 0
if
t < z, z
and payo zero afterwards:
otherwise.
g(z)
g(z)(t) =
By the monotonicity requirement,
1 0
if
t z, z<z
:
otherwise.
g(z)
b(z)
and if
b(z )
g(z).
2.4.
We saw above that preference relations where there are uncountably many disjoint intervals between bad and good alternatives cannot be represented by means of a utility function. On the other hand, complete and transitive preferences on a countable set do have a utility representation. Is there something in between these two cases that allows uncountably many alternatives, but still has enough of a countable character that it allows a utility representation? Let subset be a complete, transitive preference relation over a set a minor abuse of notation, the set
CX
X x, y X :
is
Jaray order-separable
c1 , c2 C
s.t.
X.
The pair
(X, )
or, with
if there is a countable
x x
y,
c1
c2
y. c1
and
The condition roughly says that countably many alternatives suce to keep all pairs with
apart:
c2 ,
x, y X whereas y
lies on the other. This condition is both necessary and sucient for the existence of a utility representation:
12
Proposition 2.5
if and only if
Let
X.
is Jaray order-separable.
Exercise 2.2
This exercise guides you through the steps of the proof. Assume that of
u.
represents
. Let
elements of
contains at most countably many jumps. (Suppose not. Use the idea behind (5) and
(u1 , u2 ), x a point x(u1 , u2 ) with utility u1 and a point y(u1 , u2 ) with utility u2 . Let J = {x(u1 , u2 ), y(u1 , u2 )} be the union (over all jumps (u1 , u2 )) of these points. By (a), J is countable. Next, for each pair of rational numbers r1 , r2 Q with r1 < r2 and (r1 , r2 ) U = , x an element x(r1 , r2 ) X with utility in (r1 , r2 ) U . Let R be the union of all such points x(r1 , r2 ). Since there are only countably many pairs (r1 , r2 ) as above, R is countable. Let C = J R.
For each jump (b) Show that
makes
Jaray order-separable.
Conversely, assume
u(x) =
cC:c x
X is 2n(c) .
C.
Let
n:CN
be injective. Dene
by
represents
X,
simply let
C=X
to show that
preferences over uncountable sets, additional restrictions are required. We will see in Proposition
RL , +
2.5.
Continuous utility
Economists usually work with continuous utility functions. Establishing existence of a continuous utility function is troublesome: not even Fishburn (1970a), the standard reference in the eld, bothers to give the proof. A well-known continuity result is often wrongly attributed to Debreu (1954). However, his proof is awed (Debreu, 1964) and a more general continuity result was already known from much older research on order types in the classical theory of sets, due to Georg Cantor. See, for instance, Kamke (1950). The proof of Proposition 2.6 is not obligatory reading; it follows Jaray (1975).
Proposition 2.6
X
Assume:
is a weak order on
X; y X,
the sets .
{x X : x
y}
and
is continuous.
Proof.
with
Let
C X
either
make
X c
C if c, c C
[Dene utility on C :]
of rationals in by induction:
c=c,
or
c. C
is countable, label C = {c1 , c2 , . . .}. Since the set Q = (0, 1) Q (0, 1) is countable, label Q = {q1 , q2 , . . .}. Dene a utility function f : C Q f (c1 ) := q1 . Let n N, n 2, and assume f was dened on {c1 , . . . , cn1 }. To Since
13
{c1 , . . . , cn },
dene
f (cn )
to be rst element of
(dened
as the
q Q
k {1, . . . , n 1} :
A useful implication: let
q > f (ck ) cn
If the set of points in
ck . C
between
(7)
a, b C
with
b.
and
b,
(a, b) = {c C : a
is nonempty, it has a rst element (Why?), say in
b},
cm . By construction, cm is the rst element (a, b) to be assigned its value by f and therefore its image f (cm ) is the rst element in (f (a), f (b)) Q. [Extend utility to X :] For each x X , dene u(x) = sup {f (c) : c C, c x}. The set over which the supremum is taken is nonempty (it contains x) and bounded from above (by 1), so this supremum exists. Moreover, u represents . Let x, y X . If x y , the supremum is taken over the same set, so u(x) = u(y). If x y , there exist, by Jaray order-separability, elements a, b C with x a b y , so that u(x) f (a) > f (b) u(y). [Establish continuity of utility:] The usual topology on R is generated by the intervals (, r) and (r, ), with r rational. Therefore, it suces to prove that u1 ((, r)) and u1 ((r, )) are open for all r Q. Let's do the former; the latter is similar. 1 ((, r)) equals (i) if r inf f (C), (ii) X if r > sup f (C) or if r = sup f (C) and Now u r f (C), (iii) {x X : x f 1 (r)} if r f (C). By assumption, all these sets are open. / The only remaining case is when r f (C) and inf f (C) < r < sup f (C). We show that r / belongs to a jump of f (C). Recall from Exercise 2.2 that a jump in f (C) is a pair of points (f1 , f2 ) f (C) f (C) with f1 < f2 and (f1 , f2 ) f (C) = . Suppose not. Since inf f (C) < r < sup f (C), there exist a, b C with f (a) < r < f (b). Let m N be the maximum of the indices of f (a), r, f (b) Q. Then {q1 , . . . , qm } contains r and elements p, p f (C) with p < r < p . Let n N be the smallest index for which {q1 , . . . , qn }
has this property. Let
so
(p1 , r) {q1 , . . . , qn } = ,
(r, p2 ) {q1 , . . . , qn } = .
(p1 , p2 ). Since it contains r, the interval (p1 , p2 ) cannot be a jump, i.e., it contains elements from f (C). We show that this yields a contradiction. Since p1 , p2 f (C), there exist b1 , b2 C with p1 = f (b1 ), p2 = f (b2 ). Since (p1 , p2 )f (C) = , there is a p C with f (p1 ) < f (p) < f (p2 ), i.e., the set (b1 , b2 ) of points in C between b1 and b2 is nonempty. Let b be its rst element. By the implication following (7), its image f (b ) must be the rst element of (p1 , p2 ), which was r . But r f (C), a contradiction. / 1 ((, r)) = {x X : x This shows that r belong to a jump (f1 , f2 ) of f (C). But then u 1 (f )}, which is open by assumption. f 2
is the rst element of Let us apply this result to show that continuous weak orders on
RL +
can be represented by a
continuous utility function. We rst establish an auxiliary result that is of interest in its own right whenever we want to nd alternatives in between two others.
Caveat: `rst element' is dened in terms of the chosen enumerations of C and Q. This allows us to speak, for instance, of the rst element in (0, 1), which makes absolutely no sense if one mistakenly were to believe it was dened in terms of the usual order on R.
4
14
Proposition 2.7
X = RL + Y
for some
L N; X; X.
xX
and
y, y Y
y,
then there is a
y Y y
with
xy
y, y Y
y,
then there is a
y Y
with
Proof. (a):
element of
y,
the latter
y.
As
and
(b):
and
Y,
a contradiction.
B = {z X : z
y }.
y,
the latter
y.
As
and
Y,
a contradiction.
X , as in {x RL : x1 = = xL } +
Proposition 2.8
X = RL +
Assume:
for some
L N; X.
.
Proof.
order-separable: let
x, y X
with
y.
{a X : x
a} {a X : a
z}
is the intersection of two open sets, hence open itself. It is nonempty by Proposition 2.7. The set
is dense in
there is a
c1
X : every nonempty, open set in X has a nonempty intersection with C . Hence, c1 C with x c1 z . Similarly, there is a c2 C with z c2 y . Conclude that c2 y , in correspondence with the requirement for Jaray order-separability. Now all
conditions of Proposition 2.6 are satised. Below we present a special case of Proposition 2.8 with a particularly simple proof.
Proposition 2.9
X=
N; X.
.
15
Proof. Let e = (1, . . . , 1) RL denote the vector of ones. + Step 1: For each x X , there is a unique x 0 with x x e.
Let
x X.
Choose
max{x1 , . . . , xL }.
By monotonicity,
0e.
By Proposition
{x RL : x1 = = xL }, +
being connected, contains an element equivalent to follows from monotonicity: increasing
x:
there is an
x 0
with
x x e .
Unicity
Step 2:
Let
Dene u(x) = x . Then u represents . x, y X . Then x y x e y e u(x) = x y = u(y). Step 3: u is continuous. 1 ((, )) of every open interval (, ) It suces to show that the preimage u
is open. Now
u1 ((, )) = {x X : x
e} {x X : x
e}
As a simple application, suppose that preferences are also homothetic. Then implies that
x x e
and
x x e,
so
u(x) = x = u(x).
This proves:
Corollary 2.10
The next exercise studies the connection between continuous preferences and continuous utility. The fact that statement (a) in that exercise is true, is useful: you will have relatively little trouble recognizing continuous functions, and continuous utility implies continuous preferences !
Exercise 2.3
(a) If (b) If
on topological space
u : X R.
is continuous.
is continuous.
2.6.
Recall that if a preference relation over commodity bundles is quasilinear in some coordinate, this coordinate is often referred to by economists as `money' or a `numeraire'. Under mild additional assumptions, such quasilinear preferences can be represented by means of a utility function of the form `money plus whatever utility I get from the other commodities'.
Proposition 2.11
X=
is a weak order on
X; x (0, . . . , 0)
if for every
is quasilinear and strongly monotonic in the rst coordinate; Getting something is at least as good as getting nothing: Any dierence can be compensated for by money: s.t.
x X; v0
x, y X :
y,
there is a
x (y1 + v, y2 , . . . , yL ).
16
u(x) = x1 + v(x2 , . . . , xL )
representing
Proof.
Let
x X.
By assumption:
(0, x2 , . . . , xL )
Hence there is a number
(0, . . . , 0).
v(x2 , . . . , xL ) 0
s.t.
x1 0
to
u:XR
with
u(x) = x1 + v(x2 , . . . , xL )
represents
x, y X : x
y (x1 + v(x2 , . . . , xL ), 0, . . . , 0)
(y1 + v(y2 , . . . , yL ), 0, . . . , 0)
x1 + v(x2 , . . . , xL ) y1 + v(y2 , . . . , yL ),
where the second equivalence follows from strong monotonicity of in the rst coordinate.
The proof establishes that each alternative is equivalent with receiving a suciently large amount of just the rst commodity: utility can be measured in units of commodity 1. This explains the frequent use of quasilinear preferences: only if they are measured on the same scale can one do meaningful comparisons between, say, your utility and mine.
Exercise 2.4
x, y X :
if
y,
there is a
v0
s.t.
x y + ve1
(8)
Exercise 2.5
is interpreted as receiving on
(a, m) and (a , m ) in X : m 0 such that (a, m) (a , m ). is strongly monotonic in money: for all a A and m, m R+ : if m > m , then (a, m) (a, m ). indierence is insensitive to shifts in money: for all alternatives (a, m) and (a , m ) in X and all c 0: if (a, m) (a , m ), then (a, m + c) (a , m + c). We construct a utility function assigning to each (a, m) X a utility of the form money plus utility from a.
strict preference can be compensated for by money: for all alternatives if
(a, m)
(a , m ),
there is a number
a, a A.
m, m R
such that
(a, m) (a , m ).
Show that
a, a A and m, m , w, w R+ mm =ww . a A.
(a, m) (a , m ) v:AR
and
(a, w) (a , w ). a A:
v(a) = m m,
Such
m, m v
(a , m ) (a, m). m, m
by (b), so
m, m
17
u:XR
with
u(a, m) = v(a) + m
Also convexity and strict convexity of preferences have implications for the form of the utility function. Recall that a real-valued function
on a convex domain
(Why convex?) is
Proposition 2.12
X = RL +
Assume:
for some
L N; X; u
is strictly quasiconcave. . is strictly convex,
u:XR
Then
represents
is quasiconcave. If
Let
Proof.
u(x) u(y),
y.
Then
x + (1 )y
y,
so
Exercise 2.6
(a) An equivalent way of dening a quasiconcave function
r R,
u on a convex domain X is that for all Xu (r) = {x X : u(x) r} is convex. Provide a second proof of u : X R
is a (strictly) quasiconcave utility is (strictly) convex.
Proposition 2.12, using this denition. (b) As a converse to Proposition 2.12, prove that if function on a convex set
X,
Next, we provide conditions for a weak order to be representable by a linear utility function. Although we go into more detail, the proof follows Diecidue and Wakker (2002). A convenient mathematical tool is treated in the following exercise.
Exercise 2.7
(a) Let
Cauchy's functional equation: On two domains, we show that, under mild assump-
f :RR
be additive:
f (x + y) = f (x) + f (y)
for all
x, y R. x N,
x.
u = 1
c = f (1),
it follows that
f (x) = cx
x,
i.e.,
Q.
Approximating real numbers by rational ones and taking limits, it follows that
continuous additive
functions
f :RR
18
(b) Suppose
is
not linear on
R.
{(x, y) R2 | y = f (x)} f
is dense.
So any assumption that prevents the graph of We now extend the domain to
include continuity in a single point, boundedness/sign restrictions on small intervals, monotonicity, etc.
n-dimensional
F : Rn R
F (x + y) = fi : R R
F (x) + F (y)
for
for all
x, y R
(c) Reduce this to the previously solved case by showing that there exist additive functions
i = 1, . . . , n
With this tool in our baggage, we can prove the linear representation result:
Proposition 2.13
X=
is a weak order on
X; x, y, z X ,
if
is strongly monotonic;
x y , then x + z y + z ; For each x X there is a constant R such that x (1, . . . , 1). Then there are 1 , . . . , L R++ such that the function u : X R with u(x) = 1 x1 + +L xL
is additive: for all represents .
Proof.
x X,
a number
So the function
u is additive. Let x, y X . Using additivity of twice (for and ), x u(x)e implies that x + y u(x)e + y . Similarly, y u(y)e implies that u(x)e + y u(x)e + u(y)e = (u(x) + u(y))e. By transitivity, x + y (u(x) + u(y))e. Hence u(x + y) = u(x) + u(y). L As u : R R satises Cauchy's functional equation, Exercise 2.7 implies that there are L additive functions ui : R R (i = 1, . . . , L) with u(x) = i=1 ui (xi ). By strong monotonicity, each ui is strictly increasing: its graph cannot be dense. Hence, each ui is linear: there are 1 , . . . , L R such that u(x) = L i xi . The constants 1 , . . . , L are positive by strict i=1
monotonicity. Most assumptions are familiar. Strong monotonicity assures that all the
milder monotonicity requirements, one can only assure that some of them are.
like the nal assumption, recall from Proposition 2.9 that it can be replaced by continuity. Additivity of preferences is obviously the key assumption. It essentially states that in evaluating two alternatives translations. With later applications in mind (see Proposition 2.14), there is no nonnegativity assumption on the vectors over which preferences were dened:
x, y X ,
xy
matters:
X = RL ,
not
RL . +
vous, notice that the proof hinges on the linearity of the function satisfying Cauchy's functional equation. Fortunately, linearity can be derived even if additivity holds only on the nonnegative orthant. The remainder of this section is based on Voorneveld (2008), which contains more general results. Due to its analytical tractability, the
u : RL R +
with
xai i
(L N, a1 , . . . , aL > 0)
which? .
Cobb and Douglas (1928), who used it in the context of production theory. What properties of an agent's preferences assure that they can be represented by a Cobb-Douglas utility function? Part of the trick is in exploiting the fact that this function also goes under the name of
y
i=1
ai ln xi
i=1
ai ln yi .
This reduces preferences to a linear utility function in the logarithm of the variables, allowing us to exploit Proposition 2.13. Of course, this trick goes only part of the way, as one cannot take logarithms on the boundary of
RL , +
Proposition 2.14
X = RL +
Assume:
for some
L N; X; i {1, . . . , L}, all x, y X , and each t > 0: (y1 , . . . , yi1 , tyi , yi+1 , . . . , yL ). x (1, . . . , 1).
is a weak order on
y,
then
xX
R+
such that
Proof.
function on
f : RL RL for each x RL by f (x) = (exp x1 , . . . , exp xL ). ++ 1 : RL RL with f 1 (y) = (ln y , . . . , ln y ) are continuous. Notice that f and its inverse f 1 L ++ L L Given the weak order on R++ , dene a weak order f on R as follows:
Dene
Step 1, domain RL : ++
RL . ++
RL . +
x, y RL :
f (x)
f (y).
(9)
The exponential function is strictly increasing, so by substitution in (9), properties imposed on carry over in a straightforward way to properties of order satisfying strong monotonicity, and there exists, for each
x f (1, . . . , 1).
x, y, t RL : ++
Hence, by denition (9),
(t1 x1 , . . . , tL xL ) (ln y1 , . . . , ln yL )
f
(t1 y1 , . . . , tL yL ).
(ln x1 , . . . , ln xL )
implies that
(ln x1 , . . . , ln xL ) + (ln t1 , . . . , ln tL )
As
(ln y1 , . . . , ln yL ) + (ln t1 , . . . , ln tL ).
f is additive.
f is
RL satises all assumptions of Proposition 2.13: there are a1 , . . . , aL > 0 L L represented by the utility function x i=1 ai xi . By (9), for all x, y R++ :
f on L L
(ln x1 , . . . , ln xL )
(ln y1 , . . . , ln yL )
i=1
ai ln xi
i=1
ai ln yi .
20
To see that u represents x (0, . . . , 0) for each x RL with some, but not all, coordinates equal to zero. Pick such + L an x. As x + (1/n)e R++ for each n N, strong monotonicity implies (0, . . . , 0) x + (1/n)e. Hence, there is an n > 0 with x + (1/n)e n e. As at least one coordinate of x + (1/n)e goes that to zero:
Step 2, domain RL : +
Taking exponentials,
with
u(x) =
a1 + + aL > 0, it follows that limn n = 0. By assumption, x e for some 0. Positive n N and limn n = 0. So must be zero.
x + (1/n)e n e
for
21
3.
3.1.
Choice
Existence of most preferred elements
The
Hitherto, we discussed how microeconomists usually model what economic agents want .
obvious next step is to consider what they actually do . The rationality paradigm underlying the classical microeconomic theory requires that given (1) a set of mutually exclusive alternatives and (2) a nicely behaved preference relation/utility function over the alternatives, the agent will choose a most preferred alternative. This sounds pretty obvious, but an abundance of economic terminology sometimes blurs the picture: most of traditional microeconomics is plain and simple constrained optimization. This begs the question: when do most preferred alternatives exist? This is not straightforward: if you have strongly monotonic preferences over apples and face no consumption constraints whatsoever, there is no optimal amount of apples. Here is a very general existence result:
Proposition 3.1
Assume:
X; x X, X.
the lower contour set
L(x) = {y X | y
x}
Y
Then
y Y :
for all
y Y.
with
Proof.
sets
y y . Then the lower contour Y . By compactness, there is a nite subcovering, i.e., a nite subset Y Y such that {L(y ) : y Y } covers Y . Since Y is nite, it contains a most preferred element y . But then L(y ) covers Y , i.e., y is a best element of Y ,
Suppose not: for every there is a
y Y
y Y
{L(y) : y Y }
Let
X = RL . +
on
w > 0 in his pocket (w for wealth). Suppose the price B(p, w) at prices p and wealth w consists of all aordable
p RL . ++
The
budget set
B(p, w) = {x RL | p x w}. +
This set is: nonempty: it contains the zero vector, closed: it is the intersection of nitely many closed halfspaces:
5
(10)
0 xi w/pi
i,
n
: a x c}
or {x R
: a x c}
, where a R ,
n
22
B(p, w)
order, the budget set contains at least one most preferred alternative.
Exercise 3.1
over and
R2 : x2 y2 ) .
(x1 , x2 )
(a) Is upper semicontinuous?
(y1 , y2 ) x1 > y1
or
(x1 = y1
Y R2
3.2.
Revealed preference
Rather than going from preferences to choices, this subsection, based on Arrow (1959), tries to move in the opposite direction: can we under suitable assumptions explain observed choices by constructing a preference relation that makes such choices rational? Formally, a
is a nonempty subset
B X,
interpreted as a potential problem for a decision-maker: `Please choose from is a choice rule, assigning to each choice set
B .'
B B a nonempty set C(B) B , interpreted B that the decision maker nds acceptable. The choice structure (X, B, C) is rationalizable if there is a weak order on X such that for each choice set B B , the associated choices C(B) are the most preferred ones under :
as those elements from
B B :
C(B) = {x B | x
for all
y B}.
(11)
(X, B, C)
A, B B, x, y A B :
if
x C(A), y C(B), A
and
then
x C(B). x
and
The idea behind WARP is this: in both choice problems available. If Similarly, if equivalent
B,
alternatives
are
x C(A), this reveals x to be at least good as y ; otherwise x wouldn't be acceptable. y C(B), then y must be at least as good as x. But then x and y ought to be and you should nd x acceptable also in B .
A, B B :
if
AB
and
C(B) A = , B
then
C(A) = C(B) A.
A.
If
B,
B.
23
Proposition 3.2
(X, B, C).
(a) If it satises WARP, then it satises IIA. (b) If it satises IIA and all choice sets with at most three elements are contained in
B,
then
(X, B, C)
is rationalizable.
Proof. (a):
b C(B) A.
A, B be as in the denition of IIA. Let a C(A) a C(B) A, b C(A). Since C(A) A B , we have a, b A B, a C(A), b C(B).
and
a C(B), b C(A). x, y X , the set {x, y} lies in B by the assumption on B . Hence, we may dene x y if x C({x, y}). We need to check three things: [ is complete:] Let x, y X . By nonemptiness, either x C({x, y}) or y C({x, y}), i.e., x y or y x. [ is transitive:] Let x, y, z X and assume that x y and y z . By denition of : x C({x, y}) and y C({y, z}). To show: x z , i.e., x C({x, z}). If x = y or y = z , this follows immediately. If x = z , then x z is the same as x x, which follows from completeness. So let x, y, z be distinct and consider the set {x, y, z} B . It suces to show that x C({x, y, z}), because then x C({x, z}) by IIA. Suppose, to the contrary, that x C({x, y, z}). By nonemptiness of C , C({x, y, z}){y, z} = / . By IIA and y z : y C({y, z}) = C({x, y, z}) {y, z}. So C({x, y, z}) {x, y} = . By IIA and x y : x C({x, y}) = C({x, y, z}) {x, y}, contradicting the assumption that x C({x, y, z}). / [ rationalizes (X, B, C):] To show that (11) holds, let B B. Firstly, let z C(B). To show: z y for all y B . So let y B . Then {y, z} B, {y, z} B , and z C(B) {y, z} = . By IIA, z C({y, z}). So z y . Secondly, let z B satisfy z y for all y B . To show: z C(B). By nonemptiness, there is a y C(B). Then {y, z} B, {y, z} B , and y C(B) {y, z} = . By z y and IIA: z C({y, z}) = C(B) {y, z}, so z C(B).
(b):
By WARP,
For all
Exercise 3.3 investigates the other relations between rationalizability, WARP, and IIA.
3.3.
Exercises
Weierstrass' Maximum Theorem:
Exercise 3.2
function
f :XR
Exercise 3.3
(a) Show that if
(X, B, C)
24
Exercise 3.4
Let
X = {1, 2, . . . , n}
for some
n N, n 3,
and let
X.
C,
and/or IIA. If possible, construct a weak order (a) Satisficing (Simon, 1955): A function
v : X R assigns to each alternative x X a value v(x) R. Those with a value at/above a given threshold r R are deemed `satisfactory'. For each B B , the choice C(B) is dened as follows: go through the elements of B in increasing order and
choose the rst satisfactory one. If no such element exists, choose the nal (i.e., largest) element of
B.
For each choice set on X in which no two distinct elements B B with two/more elements, you politely abstain from C(B) = {x B | y B : y x}.
(b) Madly in love: Assume your partner has a weak order are equivalent. choosing your partner's favorite:
Exercise 3.5
A taste for precious metals: A consumer faces two luxury goods, the rst is gold,
the second platinum, and spends the entire wealth on the good with the highest price. a choice structure
equal, half of the wealth is spent on each good. To investigate the rationality of such behavior, consider
(X, B, C),
where
X = R2 , the commodity space, and B consists of two choice + prices p = (2, 1) and wealth w = 2, and B2 = B((1, 2), 2).
in the same gure. Given the assumptions above, nd
B1
and
B2
C(B1 )
and
(b) Does the choice structure (c) Does the choice structure (d) Is the choice structure
(X, B, C) (X, B, C)
(X, B, C)
rationalizable?
Economic models of luxury goods often allow price-dependent preferences. (e) Give an example of a utility function depending both on the commodity bundle
25
4.
4.1.
Section 3.1 set the stage for the classical model of consumer behavior. of a specication of:
he can choose from; (iii) what the consumer putting these two together nds the most preferable commodity bundles. Formally: there are
L N
X = RL ; +
assigns to each commodity
p RL ++
i {1, . . . , L}
a price
pi > 0;
the consumer has a given income/`wealth' buying a commodity bundle; the consumer has a preference relation representing these preferences.
w > 0,
on
u : X R
B(p, w) = {x RL : p x w} +
species the commodity bundles the consumer can aord. At this stage, it would be a good idea to look back at Section 3.1 to recapitulate some properties of this budget set. solves the following The consumer
-MP:
budget set
in the
B(p, w). u,
this yields the s.t.
UMP:
The
Solve
max u(x)
x B(p, w).
It is common economic practice to assign special names to the set of solutions and in case a utility function is given the corresponding optimal value of such optimization problems.
w>0
x(p, w)
x(p, w) = {x B(p, w) : x
for all
y B(p, w)}
= {x B(p, w) : u(x) =
Given a utility function vector
max u(y)}.
yB(p,w)
u,
the
RL and wealth ++
v : RL+1 R ++
w>0
is easy:
v(p, w) = u(x ),
choice of x
x x(p, w),
This is independent of the particular
(p, w).
x(p, w):
since all such vectors are utility maximizers, their utility is the same.
26
Remark 4.1
xL 0,
is usually solved using the associated Kuhn-Tucker conditions.
Remark 4.2
x(p, w)
consists
(p, w)
Let us conclude this subsection with an example involving a well-known type of utility function.
Leontiev utility:
(a1 , . . . , aL )
L 2 ingredients: x RL , +
how much cake can you produce? Well, looking at the i-th ingredient, your guess will be at most
xi /ai
units.
(12)
x.
Exercise 4.1
Check that the associated preference relation is continuous, monotonic (but not strongly),
(p, w) RL+1 . ++
Since preferences are continuous and the budget set (see Section 3.1):
B(p, w) nonempty and compact, there is at least one solution to the UMP x(p, w) = . Let's compute it. Firstly, if x solves the UMP, it must be that x /a1 = = x /aL . 1 L
Why? Well, suppose this were not true:
(13)
min{x /a1 , . . . , x /aL } < max{x /a1 , . . . , x /aL }. 1 1 L L Then you're using the ingredients in the wrong proportions: you can only make u(x ) = /a , . . . , x /a } units of cake, but there are commodities i where you have enough for min{x1 1 L L x /ai = max{x /a1 , . . . , x /aL } units, an utter waste. If you were to trade a small amount of 1 i L
these wasted ingredients for the non-wasted ones, you would still be in your budget set, but able to make more cake. Hurray! Secondly, preferences are monotonic, so you will use your entire budget on ingredients:
px =
w.
Combining this with (13) gives us that there is a unique solution to the UMP at
x =
a1 w ,..., L i=1 ai pi
27
aL w L i=1 ai pi
(p, w) RL+1 : ++
x(p, w) =
a1 w ,..., L i=1 ai pi
aL w L i=1 ai pi
(p, w) RL+1 : ++
x(p, w) =
a1 w ,..., L i=1 ai pi
aL w L i=1 ai pi
Substituting the demand vector in the utility function, we nd the indirect utility function:
v(p, w) = u
a1 w ,..., L i=1 ai pi
aL w L i=1 ai pi
w
L i=1 ai pi
Exercise 4.2
wealth
Our denition of the budget set is standard, but other realistic restrictions can be modeled
X = R2 , +
p = (8, 4).
X.
specify the budget set given the additional information. Does the new budget set necessarily contain at least one most preferred bundle? (a) Indivisibilities: The commodities cannot be cut into ever smaller pieces. Only integer quantities are feasible. (b) Rationing: The consumer is not allowed to buy more than three units of the rst commodity. (c) Rebates 1: If the consumer buys more than ve units of the second commodity, these additional units in excess of the rst ve have a lower price, namely two. (d) Rebates 2: If the consumer buys more than ve units of the second commodity, the price of this commodity (also the rst ve units) is decreased to two. (e) Initial endowment: Instead of having wealth
income to purchase other commodity bundles. (f ) Package deal: The consumer has to buy the same quantity of both commodities. (g) Gift certificate: The consumer has received a gift certicate of one monetary unit, which he can spend in its entirety on commodity one.
4.2.
Section 1 listed a lot of properties that can be imposed on the consumer's preferences. The next result indicates the consequences of such restrictions on the demand correspondence.
Proposition 4.3
(a) If (b) If
Let
X = RL +
for some
LN
and let
be a weak order on
X.
The Walrasian
x(p, w)
(p, w) RL+1 . ++
sequence
is continuous, the Walrasian demand correspondence has a closed graph: for each L+1 (pn , wn , xn )nN in R++ X with limit (p, w, x) RL+1 X : if xn x(pn , wn ) ++ for all n N, then also x x(p, w).
28
is convex, or equivalently, if
x(p, w)
(p, w) RL+1 . ++
(e) If at most one element for all (f ) is strictly convex, or equivalently, if u is strictly quasiconcave, then (p, w) RL+1 . ++ All money is spent: If and is locally nonsatiated, then
x(p, w)
contains
(p, w) RL+1 ++
Walras' law:
px = w
for all
x x(p, w).
RL+1 X with limit (p, w, x) RL+1 X . Assume ++ ++ n n n that x x(p , w ) for all n N. To show: x x(p, w). n n n Firstly, x X and p x w , so taking limits: p x w . Conclude that x B(p, w). Suppose that x x(p, w): there is a y B(p, w) with y / x. By continuity of and Proposition 1.2, there are neighborhoods Ux of x and Uy of y such that y x for all (x , y ) Ux Uy . Choose y Uy with p y < w . This is possible: y B(p, w) implies that p y w . In case of strict inequality, take y = y . In case of equality, small decreases in the positive coordinates of y will give the desired y . n n n n n n As (p , w ) (p, w), it follows that p y w for n suciently large, so y B(p , w )Uy . n n n n n As x x, x Ux for n suciently large. Hence, for large n, x Ux and y B(p , w ) Uy . n , contradicting that xn was optimal at prices pn and wealth w n . But then y x (c): Since B(p, w) = {x RL : (p) x w} = {x RL : p x w} = B(p, w), the -MP + +
sequence in has the same domain before and after rescaling and therefore the same set of solutions.
x(p, w) = , it is convex. If x(p, w) = , let x x(p, w). Then x(p, w) = B(p, w) {x X : x x } is the intersection of two convex sets and therefore convex. 1 (e): Assume is strictly convex. Suppose there are x, y x(p, w), x = y . Then 2 x + 1 y lies in 2 B(p, w) by convexity of B(p, w). By strict convexity of , this bundle is strictly better than x and y , contradicting that these were most preferred bundles in B(p, w). (f): Assume is locally nonsatiated. Let x x(p, w). Then p x w, since x B(p, w). Suppose p x < w . For > 0 suciently small, the entire neighborhood {y X : x y < } is contained in the budget set. By local nonsatiation, this neighborhood contains a point y with y x, contradicting that x is a most preferred bundle in the budget set.
Assume is convex. If An important consequence of the closed-graph property is that if Walrasian demand is singlevalued, the Walrasian demand function is continuous!
(d):
Exercise 4.3
If
To formulate properties of indirect utility, we will need to assume (Surprise!) that preferences are represented by means of a utility function and that the demand correspondence is non-empty valued: otherwise, indirect utility is undened.
Proposition 4.4
X=
N;
is represented by utility function
u : X R;
29
Then the indirect utility function has the following properties: (a) Homogeneity of degree zero: (b) For each commodity i, better o ). (c)
v v
is nondecreasing in wealth; if
is locally nonsatiated,
is a convex set.
(e) If
then
is continuous.
Proof. (a): Follows from Proposition 4.3(c). L+1 (b): Let (p, w) R++ and let i {1, . . . , L}
strict increase in the price of commodity
be a commodity. Let
i.
Then
obtained from
by a
v(p , w) =
max
yB(p ,w)
u(y)
yB(p,w)
(c):
The nondecreasing part is similar to (b), so we will only do the strictly-increasing part. is locally nonsatiated. Let
Assume
p RL and 0 < w < w . To show: v(p, w) < v(p, w ). ++ Let x x(p, w). Then x B(p, w), so p x w < w . Since p x < w , for > 0 suciently small, the entire neighborhood {y X : x y < } is contained in the budget set B(p, w ). By local nonsatiation, this neighborhood contains a point y with y x. Conclude that v(p, w) = u(x) < u(y) max
zB(p,w ) L+1 r R. If {(p, w) R++ : v(p, w) r} = , it is convex. If it is nonempty, let (p, w), (p , w ) lie in this set and let [0, 1]. Write (p , w ) = (p, w) + (1 )(p , w ). To show: v(p , w ) r , i.e., u(x) r for all x B(p , w ). L Let x B(p , w ). Then x R+ and (p x) + (1 )(p x) w + (1 )w . Therefore, p x w or p x w (or both). W.l.o.g., p x w. Then x B(p, w), so u(x) v(p, w) r.
Let Follows from Proposition 4.3(b).
u(z) = v(p, w ).
(d):
(e):
Exercise 4.4
(a) Proposition 4.4(c) might suggest that also (b) can be strengthened a bit: If indirect utility is strictly decreasing in the price of commodity (b) Write out the proof of Proposition 4.4(e) in detail. (c) Why not just write If is continuous, is locally nonsatiated,
i.
is continuous?
30
4.3.
What is the minimal amount the consumer has to pay, i.e., the minimal level of wealth needed to
u?
h(p, u)
h(p, u) = {x RL : u(x) u +
the
and
pxpy
y RL +
with
u(y) u}.
The Hicksian demand correspondence species the set of consumption bundles solving the EMP,
min
p x = p x
for all
x h(p, u).
Similar to our earlier approach to Walrasian demand and indirect utility, one can derive properties of Hicksian demand and the expenditure function. To make the proposition at all sensible, one needs to restrict attention to utility levels that are actually reachable; therefore, let
U = {u(x) :
x RL } +
u.
and let
Proposition 4.5
order (a) If
Let
X = RL +
for some
LN h(p, u)
u:XR
. The Hicksian demand correspondence has the following properties: is upper semicontinuous, then is nonempty for all
(p, u) RL U . ++
(p, u) RL U . ++
(d) If utility is continuous and concave, then
h(p, u)
u(x) = u
and
for all
(p, u) RL U ++
If
with
u u(0, . . . , 0)
(f )
and all
x h(p, u).
let
p ,p (p p ) (x x ) 0.
RL ++
u U.
x h(p , u)
L +
and
Why this restriction? Well, suppose that u < u(0, . . . , 0). Since p x 0 for all x R , it follows that h(p, u) = {(0, . . . , 0)}: expenditure is not minimal at utility u, because the zero vector, with higher utility, is the cheapest option. Under suitable monotonicity restrictions, however, this will turn out to be an exotic case: the zero vector will often give you the lowest utility in R , so that this footnote becomes irrelevant.
6
L +
31
(p, u) RL U . By feasibility, u(y) = u for some y X . By upper + semicontinuity of preferences, the set {x X : u(x) u} = {x X : x y} is closed. Therefore, L L the solution of the EMP lies in the nonempty set {x R+ : u(x) u} {x R+ : p x p y},
Let which is the intersection of a closed and a compact set and therefore compact. The goal function
Proof. (a):
x p x is continuous.
see Section 3.1.
(b): (c):
Minimizing Let
x (p) x gives the same solutions as minimizing x p x. (p, u) RL U . If h(p, u) = , it is convex. If h(p, u) = , let y h(p, u). ++ h(p, u) = {x RL : u(x) u} {x RL : p x p y} + +
By
denition,
(d):
u u(0, . . . , 0), as h(p, u) = {(0, . . . , 0)} in those cases. So let u > u(0, . . . , 0). Suppose h(p, u) contains two distinct alternatives, x, x . By strict convexity, (x + x )/2 is strictly better, yet causes the same expenses. As (x + x )/2 x (0, . . . , 0), (x + x )/2 = (0, . . . , 0): some of its coordinates are positive. By continuity, slight decreases in these coordinates still yield alternatives at least as good as x, i.e., they remain feasible in the EMP at (p, u), but cheaper than x, a contradiction. (e): Assume the utility function is continuous. Let (p, u) RL U with u u(0, . . . , 0) and ++ x h(p, u). If u = u(0, . . . , 0), then h(p, u) = {(0, . . . , 0)}, so the result is true: u(x) = u(0, . . . , 0) = u. Next, let u > u(0, . . . , 0). Suppose u(x) > u. Then x = (0, . . . , 0), so that at least some coordinates of x exceed zero. By continuity, u(y) > u for all y in a neighborhood of x. By continuity, lim1 u(x) = u(x) > u, so u(x) > u for (0, 1) close to one. But p (x) = (p x) < p x, contradicting that x h(p, u). (f): Since x is optimal and x feasible in the EMP at (p , u), it follows that
The result is true if
p x p x .
Similarly,
p x p x.
Adding these inequalities and rewriting gives the compensated law of demand. If
for Walrasian demand (see Remark 4.2). The compensated law of demand implies that if you raise the price of one of the goods, then the Hicksian demand for this good will not increase. The next proposition states some properties of the expenditure function. Given the similarity with earlier results, proofs are left as an exercise.
Proposition 4.6
X = RL +
Assume:
for some
L N;
is represented by utility function
The consumer's preference relation Hicksian demand is nonempty-valued: Then the expenditure function
u : X R;
(p, u)
RL ++
U : h(p, u) = .
e:
RL ++
U R
(b) Monotonicity in
u: If u(0, . . . , 0) u < u :
p RL ++
and all
u ,u U
with
u U , e(, u)
is concave in
p.
Exercise 4.5
Remark 4.7
u : R+ R
straightforward than for Walrasian demand and indirect utility. Concave functions are continuous, so Proposition 4.6(d) implies that expenditure is continuous in prices. The utility function with utility levels. Letting
u(x) = max{0, x 1} shows that expenditure is not necessarily p > 0 be the price of the only commodity, one nds e(p, u) = 0 p(u + 1) u = 0.
if if
continuous in
u = 0, u > 0. e : RL U R ++
Since
p > 0, e(p, )
has a discontinuity at
can be established using a result known as Berge's Maximum Theorem. Contrary to what most textbooks (which do not provide the proof ) suggest, the proof is not straightforward. To establish
(p0 , u0 ) RL U , local nonsatiation is used to establish existence of ++ 0 . Next, on a neighborhood of (p0 , u0 ), the EMP reduces to minimizing a y u(y) > u p x subject to x {z RL : u(z) u, p z p y}. This nal condition assures that the +
continuity at an arbitrary
RL with +
conditions of the Maximum Theorem are satised. Let us proceed with the example on Leontiev utility functions.
U = R+ . to the EMP at (p, u) RL U must satisfy In order not to waste resources, a solution x ++ (13). Moreover, by continuity, it satises u(x ) = u. Combining these two conditions gives us
The Leontiev utility function in (12) has range that there is a unique solution to the EMP at a correspondence:
(p, u),
namely
x = (a1 u, . . . , aL u).
Since the
solution is unique, it is common to write the result as a Hicksian demand function, rather than
h(p, u) = (a1 u, . . . , aL u)
and
e(p, u) = p (a1 u, . . . , aL u) = u
and
L i=1 ai pi .
h(p, u)
e(p, u)
Proposition 4.8
nonsatiated, strictly convex preferences. Then demand for each good respect to the price
u : RL R is continuous and represents locally + L for all p R++ and all u > u(0, . . . , 0), Hicksian e(p, u) . p
= 1, . . . , L
= 1, . . . , L :
7
h (p, u) =
(14)
33
Proof.
proof proceeds as follows. By strict convexity of preferences, Hicksian demand is single-valued, so we treat
h()
as a function.
Fix
demand at prices
e(p , u) =
with equality if maximized at
min
p x p x,
with
p = p. p = p. By
f : RL R ++
is
= 1, . . . , L :
proving the result.
Exercise 4.6
u : RL R +
v()
is dierentiable
= 1, . . . , L : x (p, w) =
Do this by showing that the function its minimum at
f : RL R ++
with
f (p ) = v(p , p x),
x = x(p, w),
achieves
p = p.
4.4.
Proposition 4.9
(a) If
u : RL R + p RL . Then: ++
is optimal in the UMP with wealth w > 0, then x is optimal in the EMP with utility ). Moreover, the expenditure level in this EMP is exactly p x = w : level u = u(x
and
e(p, u(x )) = w.
is optimal in the EMP with utility level u U , u > u(0, . . . , 0), then x is optimal in the UMP with wealth w = p x . Moreover, the indirect utility level in this UMP is exactly
u: x h(p, u) x x(p, p x )
and
v(p, p x ) = u
Bundle
Proof. (a):
with prices
x x(p, w). By Walras' law, p x = w. p and utility level u(x ). Let x h(p, u(x )). By
Let
denition,
e(p, u(x )) = p x p x = w
8
and
u(x) u(x ).
It follows from a duality result in convex analysis: for xed u, e(, u) is the support function of the strictly convex set {x X : u(x) u}.
34
maximizing bundle x
x B(p, w). But then its utility cannot exceed that of the utility x(p, w). So u(x) = u(x ) and by Walras' law: e(p, u(x )) = p x = p x = w.
x h(p, u(x )) and e(p, u(x )) = w. (b): h(p, u). By Proposition 4.5(e), u(x ) = u. Bundle x prices p and wealth p x . Let x x(p, p x ). By denition,
Conclude that
Let x
and
p x p x .
But then the inequality in the
(p, u).
px=p
x . By Proposition 4.5(e),
x x(p, p x )
and
v(p, p x ) = u.
Under the assumptions above, we obtain important relations between the UMP and EMP:
e(p, v(p, w)) = w v(p, e(p, u)) = u x(p, w) = h(p, v(p, w)) h(p, u) = x(p, e(p, u))
x x(p, w). By denition, v(p, w) = u(x ). By Proposition 4.9(a), e(p, v(p, w)) = e(p, u(x )) = w. (17): We rst show that x(p, w) h(p, v(p, w)). Let x x(p, w). Then u(x) = v(p, w), so x h(p, u(x)) = h(p, v(p, w)) by Proposition 4.9(a). Secondly, we show that h(p, v(p, w)) x(p, w). Let x h(p, v(p, w)). By Proposition 4.9(b), x x(p, p x). Moreover, x h(p, v(p, w)) and (15) imply that p x = e(p, v(p, w)) = w . Conclude that x x(p, p x) = x(p, w).
Let
Proof. (15):
(16), (18):
Similar.
These results give convenient ways to nd solutions to the UMP from those of the EMP and vice versa. Let us illustrate this in our Leontiev example.
Recall that
v(p, w) =
By (16), expenditure solves
w
L i=1 ai pi
and
x(p, w) =
aL w L i=1 ai pi
e(p,u) , so L i=1 ai pi
news, isn't it!) as we saw before. Hicksian demand can now be found in dierent ways. Firstly, using Proposition 4.8:
= 1, . . . , L :
and, secondly, using (18):
h (p, u) =
e(p, u) = a u, p
h(p, u)
solves
a1 e(p, u)
L i=1 ai pi
,...,
aL e(p, u)
L i=1 ai pi
= (a1 u, . . . , aL u).
35
Exercise 4.7
For Leontiev utility, use (15) and (17) to nd Walrasian demand and indirect utility from
Exercise 4.8
Slutsky equation:
The so-called Slutsky equation provides a relation between the is continuous and represents locally nonsatiated, strictly If these functions are dierentiable, the following Then for all commodities
sensitivity to price changes of the Walrasian and Hicksian demand functions. Assume the utility function
u : RL R +
convex preferences. We know that in this case there are unique solutions to the UMP and EMP: we can consider Walrasian and Hicksian demand functions. holds. Fix
(p, w) RL+1 ++
k,
(19)
pk ,
using the Chain rule. Continue by substituting (14), (15), and (18).
4.5.
Welfare analysis studies how changes in the consumer's environment in our case: the budget
set aect his well-being. Let only if whatever is optimal in improving are: The budget set has grown: An optimal bundle in
B0
B1
change. Assuming that optimal bundles exist, the consumer is better o after the change if and
B1
B0 .
This is welfare
analysis in a nutshell. Some obvious ways of detecting changes that are (at least weakly) welfare
B0 B1 . B1 .
B0
remains feasible in
Exercise 4.9
How is the consumer's welfare aected by the changes described in Exercise 4.2?
Whereas the above describes the idea behind welfare analysis in its full generality and simplicity, economic textbooks tend to restrict attention to changes only in prices and wealth. The initial vector of prices and wealth is denoted
(p0 , w0 ) RL+1 ++
L+1 1 1 after the change is denoted (p , w ) R++ . This allows changes in prices only, keeping wealth 0 = p1 , w 0 = w 1 ), changes in wealth only, keeping prices constant (p0 = p1 , w 0 = w 1 ), constant (p
or simultaneous changes in prices and wealth (p
= p1 , w0 = w1 ).
RL . +
Consider a change from the consumer is strictly better o under
Exercise 4.10
Let
(p1 , w1 ).
Let
than under
x0 x(p0 , w0 ). (p0 , w0 ).
p 1 x0 < w 1 ,
(p0 , w0 ) to (p1 , w1 )
can be repre-
sented by means of a utility function. We can derive the consumer's indirect utility function
1 1 and conclude that the consumer is better o after the change if and only if v(p , w )
represent , this does not tell us how much better o the consumer is.
>
v(p0 , w0 ).
However, since the indirect utility function depends on which utility function is chosen to changes unambiguously in monetary units, one constructs a so-called
This inequality holds because the zero vector cannot solve the utility maximization problem: by local nonsatiation and strict positivity of prices and wealth, there is an aordable bundle preferred to the zero vector.
9
36
To express welfare
utility function using the expenditure function. Fix an arbitrary price vector the real-valued function
p RL . ++
Consider
e(, ). p
(20)
can be used as a monetary measure of welfare change: if it is positive, the welfare of the consumer increases as a consequence of the change from of the consumer has decreased. to if it is negative, the welfare It remains to prove that this money metric does not depend
on the choice of utility function representing the consumer's preferences. This follows from the fact that expenditure can be expressed in a form independent of the utility function: for all
(p, u) RL U , ++
there is a
y RL +
with
u(y) = u,
so
p0
1 of prices p . These choices give rise to two well-known measures of welfare change: 0 0 0 1 and . Let u = v(p , w ) and u = 0 0 Notice that e(p , u )
variation (EV)
equivalent
v(p1 , w1 ).
EV ((p0 , w0 ), (p1 , w1 )) = e(p0 , u1 ) e(p0 , u0 ) = e(p0 , u1 ) w0 , CV ((p0 , w0 ), (p1 , w1 )) = e(p1 , u1 ) e(p1 , u0 ) = w1 e(p1 , u0 ).
There is no obvious way to say that one of the measures is better than the other, although the equivalent variation has an advantage when comparing alternative changes: suppose
(p0 , w0 )
1 1 changes either to (p , w ) or
(p2 , w2 ).
Both
EV p0 and
EV
((p0 , w0 ), (p2 , w2 ))
However,
utility follow immediately from the indirect utility function and expenditure function computed
u0 = v(p0 , w0 ) =
so
w0
L 0 i=1 ai pi
and
u1 = v(p1 , w1 ) =
w1
L 1 i=1 ai pi
L i=1 L i=1
ai p0 i ai p1 i
L i=1 L i=1
w0 ,
ai p1 i ai p0 i
(p1 , w1 )
lump-sum tax
=
(p0 , w0 ),
T (0, w0 ) on the consumer's wealth, keeping prices unchanged. (p0 , w0 T ). Hence e(p0 , u0 ) = e(p1 , u0 ) = w0 and e(p1 , u1 ) = e(p0 , u1 ) = w1 =
37
w0 T ,
so
This is intuitive:
remain unchanged, the monetary measure of welfare change as a consequence of a decrease of in the consumer's wealth should equal
Deadweight loss:
government levies a
p1 = p0 + te coordinate 1
RL . +
p 0 RL ++
and wealth
w > 0.
e = (0, . . . , 0, 1, 0, . . . , 0) is the -th standard basis vector of RL 1 other coordinates 0. The total tax revenue is T = tx (p , w) and EV ((p0 , w), (p1 , w)) = e(p0 , u1 ) w 0,
where
u1 = v(p1 , w)
as before.
Alternatively, to raise the same amount, the government can on the wealth of the consumer, keeping prices xed, yielding an
T directly T .
B(p0 +te
, w), so p0 x +tx
consumer cannot be worse o under lump-sum taxation than under commodity taxation.
e(p0 , u1 ) w T .
The dierence
w T e(p0 , u1 ) 0
is called the
Exercise 4.11
utility function
running example to illustrate all denitions. Go through the same steps, now using the Cobb-Douglas
u : RL R +
x RL +
where
a1 , . . . , aL > 0.
4.6.
Assume that the preferences of the consumer are continuous, locally nonsatiated and strictly convex. If the only change is in the price of a single good, equivalent and compensating variation can simply be expressed in terms of the Hicksian demand function. notation, we denote for an arbitrary price vector obtained from is changed to To somewhat simplify
and an arbitrary
p > 0
p1 = p0 ,
to p by (p , p ). (p0 , w), suppose that only the price (p1 , w) = ((p1 , p0 ), w). Recall that and
of good
{1, . . . , L}
e(p, u) = h (p, u) p
Hence
e(p1 , u1 ) = w.
=
p1 p0
e(p , p0 , u1 ) dp p h (p , p0 , u1 )dp .
(21)
=
p1
38
Similarly,
p0
h (p , p0 , u0 )dp .
(22)
This means that the equivalent and compensating variation due to such a simple price change can be represented by areas to the left of the Hicksian demand curve.
Normal goods:
Suppose good
is a
p0 > p1 . We claim that EV ((p0 , w), (p1 , w)) 0 , w), (p1 , w)). To see this, write u0 = v(p0 , w) and u1 = v(p1 , w). Since v is nonincreasing CV ((p 0 1 0 0 0 1 in p , u u . Since e is increasing in u, this implies that e(p , p , u ) e(p , p , u ) for all p > 0. Since good is normal and x (p, e(p, u)) = h (p, u), it follows that h (p , p0 , u0 ) = x (p , p0 , e(p , p0 , u0 )) x (p , p0 , e(p , p0 , u1 )) = h (p , p0 , u1 )
for all
normal good
p > 0.
0
p0
p0
h (p
, p0
, u )dp
p1
h (p , p0 , u0 )dp
=
p1
h (p , p0 , u1 ) h (p , p0 , u0 ) dp
0.
39
5.
5.1.
Having treated the demand side of the economy in detail, we now turn to the supply side. The supply side consists of rms that use a technology to convert one set of commodities (inputs) to another (outputs). Just as for consumers, it is assumed that rms take prices as given and that all commodities are traded at the market at publicly quoted prices. Consider an economy with
production plan
LN
y = (y1 , . . . , yL ) L commodities. If y < 0, we say that good is used as an input in the production plan y , if y > 0, we say that good is used as an output in y . For instance, if L = 2, the production plan y = (2, 6) indicates that two units of the rst commodity are used as an input to produce
an output of 6 units of the second commodity. The production vectors is denoted by
production vector
or
production set
of technologically feasible
used as an input in some production vectors, but as an output in others. You may come across the following special cases:
Transformation functions:
using a function
F :
RL
called the
Y = {y RL : F (y) 0}
The set of boundary points
and
Y.
{y RL : F (y) = 0}
is called the
transformation frontier .
Single-output technologies:
L, is an output 1, . . . , L1, as inputs. These are single-output technologies , typically summarized using a production function f : RL1 R that assigns + to each vector of input quantities z the maximal amount f (z) of output that can be produced
In many examples, one of the goods, say good from it. One can then write
and
z RL1 }. +
given by
f : R2 R +
f (z) = z1 z2 ,
, > 0.
Then
Y = {(z1 , z2 , q) R3 : q z1 z2 ,
5.2. Properties of production sets
and
z1 , z2 0}.
Y RL
include:
nonempty : there is at least one feasible production vector. Possibility of inaction : 0 Y . It is possible to do nothing,
Y
is outputs from zero inputs.
closed . This assumption is mainly for mathematical convenience. No free lunch : if y Y RL , then y = 0. It is not possible to produce positive +
Y
is amounts of output without using inputs. 40
and
y y,
then
y Y.
If
is feasible and
uses at least
as much of each input, yet gives no more of the outputs, then also
is feasible.
y Y
and
y = 0,
then
y Y . /
It is impossible to reverse a
feasible production vector, i.e., to turn the outputs into the same amount of inputs used to produce it.
if
y Y yY
and
[0, 1],
then
then
y Y .
This
1,
y Y . y Y .
and
This means
and
0,
then
This is the
Additivity/free entry :
together yielding
if
y, y Y ,
then
y+y Y.
If both
y+y .
Y Y
is
One easily establishes relations between these properties. Possibility of inaction implies nonemptiness. Nondecreasing and nonincreasing returns to scale imply constant returns to scale. Some less trivial ones are:
Proposition 5.1
(a) If (b) (c)
Let
Y RL
is convex and
0Y,
Y Y
Y Y
is convex and has constant returns to scale. is additive and has nonincreasing returns to scale. is a
(d) If
Y satises no free lunch and for all x, y Y and (0, 1), there z x + (1 )y, z = x + (1 )y , then Y satises irreversibility.
z Y
with
let y Y and y Y . Conversely, assume Y is convex and has CRS. To show that Y is a convex cone, let y, y Y and , 0. By CRS, 2y Y 1 1 and 2y Y . By convexity, (2y) + (2y ) = y + y Y . 2 2 (c): If Y is a convex cone, it is additive (take = = 1) and has nonincreasing returns to scale (similar to the proof of CRS above). Conversely, assume that Y is additive and has nonincreasing returns to scale. Let y, y Y and , 0. By additivity, ky Y and ky Y for all k N. Choose k N such that /k 1 and /k 1. Since Y has nonincreasing returns to scale, (/k)y Y and (/k)y Y . By additivity: y = k(/k)y Y and y Y . Again by additivity y + y Y . (d): Let y Y, y = 0, and suppose y Y . By assumption, there is a z Y such that 1 z 1 y + 2 (y) = 0, z = 0, contradicting no free lunch. 2
Proof. (a): Let y Y and [0, 1]. By convexity, y + (1 )0 = y Y . (b): Assume Y is a convex cone. Then Y is trivially convex. To establish CRS,
0.
Since
is a convex cone,
y =
1 2
y+
1 2
41
In the special case of a production function, properties of the production set are related to properties of the production function. For instance:
Proposition 5.2
with
f : RL1 R +
f (0, . . . , 0) = 0,
Y = {(z, q) RL : q f (z)
(a) (b)
and
z RL1 }. +
Y Y
is concave.
returns to scale. and We show that for each
Proof. (a):
z RL1 +
and
> 0.
Y , (z, f (z)) Y .
z = z
RL1 and +
> 0.
: f (z ) f ( z ).
z = z
and
z RL1 +
and each
> 0 : f (z) =
f (z).
So
z RL1 and each + > 0 : f (z) = f (z). To show: Y has CRS, i.e, if (z, q) Y and 0, then (z, q) Y . This follows from the assumption that f (0, . . . , 0) = 0 if = 0. So let (z, q) Y and > 0.
Conversely, assume that
for each
Y , q f (z).
Y , q f (z)
together with
(z, q) Y .
(b):
The function
f : RL1 R +
z RL1 } +
{(z, q) RL : q f (z)
being convex.
z RL1 } = Y +
42
5.3.
species a rm's set of feasible options. To make the choice problem of the
rm complete, we have to endow it with preferences. These preferences are particularly simple. It is assumed that rms maximize prots given the commodity prices and the rm's production set: given production set
problem (PMP) is
The
Y RL
p RL , ++
the
prot maximization
max p y s.t. y Y.
The
supply correspondence
y()
p RL ++
y(p) = {y Y : p y = (p)}.
As opposed to the utility maximization problem, which has a solution under mild conditions (like continuity of the utility function), there may not be a solution to the PMP: prots may be unbounded. In that case, we set
(p) = +.
Proposition 5.3
price vector made, or
p (p) = +.
L Let Y R be nonempty and satisfy nondecreasing returns to scale. For each RL , either p y 0 for all y Y , which means that no positive prot can be ++
p RL . Suppose that p y > 0 for some y Y . Since Y has ++ nondecreasing returns to scale, y Y for all 1, so p (y) = (p y) can be made arbitrarily large by letting go to innity.
Consider a price vector This makes the existence of solutions to the PMP a nontrivial issue. The following two results provide sucient conditions.
Proof.
Proposition 5.4
nonempty, closed,
Y RL
is:
rR
such that
y r
for all
yY
and all
Then the prot maximization problem has at least one solution for each price
Proof.
p RL . By nonemptiness, there is a y Y . A solution to the PMP must lie in ++ L the set P = Y {y R : p y p y }. P is closed: Y is closed by assumption and the second set in the intersection is closed, since
Let it is the upper contour set of a continuous function. The intersection of two closed sets is closed.
is bounded:
Moreover, all coordinates are bounded from below as well: let coordinate
P yP
r.
{1, . . . , L}.
py py ,
it follows that
p y py
k=
pk yk p y
k=
43
pk r,
so
py
k=
pk r /p
Hence,
Y,
there is at least one solution. The following result establishes existence of solutions to the prot maximization problem under resource constraints.
Proposition 5.5
Y RL :
satises possibility of inaction, satises no free lunch, is closed, is convex, has a resource constraint: there is a nonzero vector production to vectors
RL +
yY
with
y . p RL . ++
Then the prot maximization problem has at least one solution for each price vector
Exercise 5.1
Y = Y {y RL : y }
(yn )nN
zn = yn / yn
zn
lies in
and satises
zn + / yn 0. z=0
in
(zn )nN
Y.
is nonempty and compact and the prot function is continuous, a maximum exists!
Thus, whenever we talk about properties of the prot function and the supply correspondence, we implicitly assume that the PMP has a solution, so that
y(p) =
and
(p) < .
Proposition 5.6
Y RL .
(a) The prot function is homogeneous of degree one, the supply correspondence is homogeneous of degree zero. (b) The prot function is convex. (c) If (d)
is convex,
y(p)
p RL . ++
the prot
p RL . If y(p) consists of a single point y , then ++ at p and (p)/p = y for all goods = 1, . . . , L.
and all
p, p RL ++
y y(p)
and
y y(p ):
(p p ) (y y ) 0.
44
Proof. (a): Do this yourself. (b): We give two proofs. First proof: we show that the epigraph epi() = {(p, v) RL R : v (p)} is a convex set. ++
Let let
(p1 , v 1 ), (p2 , v 2 ) epi() and [0, 1]. To show: v 1 + (1 )v 2 (p1 + (1 )p2 ). y y(p1 + (1 )p2 ). Then pi y (pi ) v i for both i = 1, 2, so (p1 + (1 )p2 ) = p1 y + (1 )p2 y v 1 + (1 )v 2 .
So
Second proof:
p1 , p2 RL and all [0, 1] : (p1 + (1 )p2 ) ++ p1 , p2 RL and [0, 1]. Let y y(p1 + (1 )p2 ). Then ++
(p1 + (1 )p2 ) = p1 y + (1 )p2 y (p1 ) + (1 )(p2 ). y(p) = Y {y RL : p y = (p)} is the intersection of Y and a hyperplane. Since both are convex, so is y(p). (d): We prove Hotelling's lemma, assuming that is dierentiable at p. By denition of the L prot function we know that for all p R++ : p y (p ), with equality if p = p. So the L function h : R++ R with h(p ) = (p ) p y achieves its minimum at p. But then its partial derivatives at p must be zero:
Let Then
(c):
p RL . ++
= 1, . . . , L :
proving Hotelling's lemma.
h(p)/p = (p)/p y = 0,
(e):
Notice that
(p p ) (y y ) = (p y p y ) + (p y p y) 0,
where the inequality follows from the denition of prot maximizers:
p y = (p) p y
and
p y = (p ) p y .
5.4. Solving the PMP
Just like in the utility maximization problem UMP, the Kuhn-Tucker conditions can be used to nd necessary rst order conditions for the prot maximization problem PMP: if the production set is
Y = {y RL : F (y) 0},
where
condition for y
p RL , ++
= 1, . . . , L :
(23)
p =
F (y ) . y
45
k,
,k :
p F (y )/y = , pk F (y )/yk y,
the price ratio between two goods equals its so-called
= 1, . . . , L 1
equals
w >0
p > 0. p to
with the wealth
Remark 5.7
level
I don't know the reason for this sudden change of notation from a price vector
(p, w).
If
z 0 p
= 1, . . . , L 1 :
(24)
f (z ) w = z
and
z = 0. =0
for all
>0
for all
, so the rst
= 1, . . . , L 1 : p
so that for all inputs
f (z ) =w , z
(25)
,k :
w f (z )/z = , wk f (z )/zk Y
which has the interpretation that the price ratio between two goods has to equal their so-called marginal rate of technical substitution. Again, if the set in (24) are also sucient for a solution to the PMP. is convex, the rst order conditions
5.5.
In a prot maximizing production plan, there is no way to produce the same amount of outputs at a lower total input cost. This motivates a study of the
which we consider only in the single-output case. Assume the production function is
f : RL1 + q of the
output. What is the minimal amount we have to spend on inputs to achieve this? The answer is given by the CMP:
The
z(w, q)
L1 z(w, q) = {z R+ : f (z) q
wz wz
46
for all
z RL1 +
with
f (z ) q}.
The conditional factor demand correspondence species the set of input vectors solving the CMP, the
min
w z = w z
for all
z z(w, q).
z of the CMP, there must be a Lagrange multiplier 0 with the condition q f (z) 0 and Lagrange multipliers 0 associated with the z 0 such that for all = 1, . . . , L 1 : w = f (z ) + z
and
z = 0.
for all ), this implies that
>0
=0
for
w =
for all and consequently
f (z ) z
w f (z )/z = , wk f (z )/zk
as in (25)!
5.6.
f : RL1 R+ , +
input price
p > 0,
(z, q),
y(p, w) and the maximal prot as (p, w). In a > 0) implies that q = f (z), otherwise the prot
can be increased:
pq w z < pf (z) w z.
Consequently, the PMP simplies to
zRL1 +
max pf (z) w z.
Moreover, production has to be as cheap as possible, so there is a link with the CMP:
47
Proposition 5.8
L1 set {z R+ : f (z) q} is nonempty and p > 0 the output price. Consider the optimization problems
(P1) (P2)
q 0,
the
maxzRL1 pf (z) w z ,
+
The following claims are true: (a) For each (b) For each
z RL1 , + q 0,
there is a
qz 0
with with
there is a
L1 zq R +
(c) If one of the problems (P1) and (P2) has a solution, so does the other and the corresponding maximum values coincide:
zRL1 +
Exercise 5.2
The PMP as formulated in (P2) is particularly easy: given the cost function, the PMP reduces to a single-variable maximization problem. an optimum In practice, this is often the easiest way to solve the PMP. Under suitable dierentiability assumptions, the necessary Kuhn-Tucker condition at
q 0
such that:
p
Assuming
c(w, q ) = q =0
and
q = 0.
q > 0,
q,
f : R+ R with f (z) = y1 }.
z 0.
Y = {(z, q) R2 : q f (z), z 0} = {y R2 : y1 0, y2
Assume that the input price is problem (P1) becomes
w>0
p > 0.
max p z wz.
z0
At
z = 0,
z > 0,
must be satised:
p w = 0, 2 z z =
p p2 2w and prot 2w
so
z =
p 2 2w , yielding output
p2 4w
p2 4w
> 0.
supply function is
y(p, w) =
p 2w
48
p 2w
(26)
(p, w) =
is
min wz s.t. z 0, z q.
At an optimum demand is
z , it is clear z = z(w, q) = q 2
that
z = q:
c(w, q) = wq 2 .
q =
p 2w as in (26).
5.7.
Eciency
A production plan
yY
is
ecient
if there is no
y Y
with
y y
and
y = y.
In words,
there is no dierent production plan producing at least as much output while using at most as much input. There is a close connection between prot maximization and eciency:
Proposition 5.9
(a) If (b) If
Y RL .
i.e., if
yY Y
p RL , ++
y y(p),
then
is ecient.
p RL +
such
Proof. (a):
y is not ecient: there is a y Y with y y, y = y . Then p y > p y : y exceeds that from the prot-maximizing y , a contradiction. (b): Let Z = {y RL : y > y }. Since y is ecient: Z Y = . By the separating hyperplane L theorem, there is a vector p R , p = 0 such that p y p y for all y Z and y Y . Two
the prot from things remain to be shown:
p RL . Suppose, to the contrary, that p < 0 for some coordinate . Then + for some y Z with y y > 0 suciently large. A contradiction. py <py Secondly, that y is prot maximizing at prices p. Let y Y . To show: p y p y . For n = (y + 1/n, . . . , y + 1/n) Z . Then p y n p y . Since each n N, dene the vector y 1 L y n y , it follows that also in the limit p y p y .
Firstly, that
Exercise 5.3
This exercise investigates the need for the dierent assumptions in Proposition 5.9.
maximizes prots at
price vector
p R2 , p = (0, 0), +
(b) Give an example of a convex production set prot maximizing for any
yY
p R2 . ++ Y R2
which is not convex and a point
y Y
which is
ecient, but not prot maximizing for any nonzero price vector
p R2 . +
49
6.
6.1.
General equilibrium
What is an equilibrium?
Earlier, we studied how consumers choose optimal consumption bundles given their preferences, wealth, and the price vector and how rms choose optimal production plans given their technology and the price vector. Are there price vectors where all these optimal choices are actually feasible? You don't, for instance, want people demanding ten apples if there only are ve. Such a price vector and the corresponding demand and supply constitute a foundations it is a description of: something feasible, where each involved agent taking as given those things beyond his control makes a choice that makes him as happy as possible. Notice, in particular, that it involves no statements like markets clear or supply equals demand. Economic agents quite frankly couldn't care less: they have their preferences, some constraints, and all they wish for is to choose optimally. Nevertheless, some people become very nervous when one doesn't assume that markets clear (excess demand equal to zero) in equilibrium. I want to take this concern seriously, so let me briey explain this. Market clearing is an assumption about aggregate behavior that is not in line with the microeconomic idea behind equilibrium that combines feasibility with optimal behavior of
Walrasian equilibrium .
Its
denition follows the central idea behind any economic equilibrium concept with decent micro-
exchange economy
pure
with certain amounts of the dierent goods. This entails no real loss of generality: our main tool will be to study excess demand, regardless of whether it involves producers or not. Walrasian equilibrium is dened and shown to exist in a particularly simple case. result is provided in Section 6.4. Also, we study some of its welfare properties. After introducing producers into the model, a more general existence
50
6.2.
A
h, h) hH , where:
h over
RL , +
where
L N, L
commodities.
h an initial endowment
consumer
RL of the + =
hH
h a commodity bundle x
hH
h.
An
RL . Allocation +
allocation
x
is:
x = (xh )hH
assigns to each
feasible if hH xh , nonwasteful if hH xh = .
If the price vector is can aord bundles
xh ()
p, the initial endowment of consumer h H is worth p h , so consumer h x RL with p x p h , i.e., consumer h's budget set is B h (p, p h ). Let +
h, h)
The basic idea behind equilibria (feasibility and optimal choices) leads to the following denition. A where:
hH is a pair
(p, x),
p RL , p = 0, + x= (xh )
excess demand correspondence z assigning to each price vector p the dierence between total demand for and the total
Properties of Walrasian equilibrium are often studied using the availability of the commodities:
p,
i.e.,
xh xh (p, p h ).
z(p) =
hH
xh (p, p h ) { h } =
hH
xh (p, p h ) {}.
p is an equilibrium price vector if and only if there is a z z(p) where no commodity has positive excess demand,
Therefore, if
> 0.
In the computation
of Walrasian equilibria, this allows some simplications, for instance by assuming that the equilibrium price of one of the goods is equal to one, or that the sum of the prices is equal to one, i.e., they lie in the unit simplex
= {p RL : +
L =1 p
= 1}
(also denoted
if we want to
stress the dimension of the vectors). To illustrate the idea behind existence proofs of Walrasian equilibria, the next result makes a lot of simplications.
Proposition 6.1
z: z : RL ,
51
Proof.
The idea is to change prices by making goods in excess demand relatively more expensive If there are no more changes, there is no excess
f : .
i=1,...,L
by
f (p) =
Function
pi + max{zi (p), 0} 1+
L j=1 max{zj (p), 0}
increases the price of commodities for which excess demand is positive and then
rescales the resulting price vector so that its coordinates add up to one. As the composition of continuous functions,
with
f (p) = p.
We show that
z(p) 0.
By Walras' Law:
L i=1
(27)
0 zi (p)2 > 0
if if
So (27) is the sum of nonnegative terms. The only way in which it can be zero, is if all its terms are zero, i.e., if
zi (p) 0 p
i,
as we had to show.
z(p) 0 together with the allocation x = (xh (p, p h ))hH is a Walrasian equilibrium. Using z(p) 0 and Walras' Law (p z(p) = 0), it follows that excess demand is zero for commodities i with pi > 0: a good can be in excess supply in equilibrium,
The price vector but only if its price equals zero. The desired properties of excess demand are usually derived from conditions on consumer preferences, using Proposition 4.3.
6.3.
Welfare analysis
A feasible allocation
Pareto dominated
hH x as in x
and x h
with
xh
xh
for all
xh for some
h H,
Pareto optimal if it is not Pareto dominated. Call a nonempty collection S H of consumers a coalition . Coalition S can improve upon a
feasible allocation
xh
for all
h S such h hS x =
that
hS
h,
52
The that
core of E is the set of feasible allocations that no coalition can improve upon.
xh h
for all
all members of
xh
xh
for all
h S.
h H. (p, x)
individual rationality .
lies in the core.
simply requires
If
is a Walrasian equilibrium of
E,
then
S H can improve upon x via commodity bundles (h )hS . Then x h h xh for each h S . By denition, xh is a most preferred bundle at prices p, so xh x h h h cannot lie in the budget set B (p, p ), i.e., p x > p . Summing over all h S gives h p hS xh > p hS h . This contradicts that (h )hS redistributes initial endowments: x h = h. hS x hS
Suppose coalition Under weak assumptions, Walrasian equilibrium allocations are Pareto optimal:
Proposition 6.3
rium of
is Pareto optimal.
Proof.
xk
k
Suppose
x: xh h xh for all h H and h p xh = p h for all h H By local nonsatiation, p x So, p xh > p hH h , contradicting feasibility of x: hH
As a partial converse to the previous result, some additional assumptions guarantee that anything that is Pareto optimal can be sustained as a Walrasian equilibrium allocation at least if initial endowments can somehow be redistributed.
Proposition 6.4
for each redistribution of initial endowments in the pure exchange economy equilibrium exists, consumers have strictly convex preferences. If
E,
a Walrasian
x is a Pareto optimal allocation, redistribute initial endowments such that h = xh for all h H . Then x is a Walrasian equilibrium allocation for the resulting pure exchange economy.
Proof.
For each
(, x). p B h (, p xh ), so xh p xh . h h xh for all h H . By Pareto optimality of x, none of these preferences can be strict, so x h = xh for all h H , suppose there is an h H with xh = xh . Consumer h can To see that x h aord ( + x )/2. By strict convexity of preferences, this bundle is strictly preferred to x , xh h contradicting that x is an optimal bundle for the consumer in the Walrasian equilibrium. h
By assumption, the resulting pure exchange economy has a Walrasian equilibrium
h H , xh
is optimal and
xh
6.4.
Let us extend the pure exchange economy by adding rms, owned by the households: each household is entitled to a share (possibly zero) of each rm's prot. Formally, a
economy is a tuple
where:
private ownership
E= (
53
f F has consumer h H
Y f RL ,
where
L N,
a weak order
h over
RL , + h RL + [0, 1]
of the
an initial endowment
commodities,
hf a claim to a share
f F
(where
hH
hf = 1
for all
An
allocation (x, y) = ((xh )hH , (yf )f F ) assigns to each consumer h H a commodity bundle xh RL and to each rm f F a production plan y f Y f . Allocation (x, y) is feasible if +
xh
hH
If the price vector is set
f F ).
h +
hH f F
yf .
has budget
hf y f
, hf
of the prot
receives share
p yf
of rm
f F.
Let dence
xh () denote the demand correspondence of consumer h H , y f () the supply corresponf of rm f F , and () its prot function. The basic idea behind equilibria (feasibility E
and optimal choices) leads to the following denition. A ownership economy is a triple
Walrasian equilibrium
of a private
(p, x, y),
where
p RL , p = 0, +
is a price vector,
(x, y) = ((xh )hH , (y f )f F ) is a feasible allocation, h for each consumer h H , x is a most preferred bundle at prices xh xh p, p h +
f F
for each rm
p:
hf y f
f F , yf
p: y f y f (p)
and
f (p) = p y f .
Once again, existence of Walrasian equilibrium is usually established by looking at the for and total availability of the commodities:
demand correspondence z assigning to each price vector p the dierence between total demand
z(p) =
hH
and the interest is in nding a price vector to prices in the unit simplex
excess
xh p, p h +
f F
hf f (p)
f F
y f (p) {},
p where z(p) RL = .
1959, Section 5.6) establishes existence of such a price vector; as before, one may restrict attention
. z: Z RL : z(p) Z
for all
Proposition 6.5
p ,
z(p) =
for all
p ,
54
is convex-valued:
z(p)
p ,
is a closed set, all
{(p, z) Z : z z(p)} p
with
p z 0 for z(p) RL = .
and all
z z(p).
Proof.
p z,
Once again, the idea is to make goods with large excess demand expensive in the hope of
decreasing it. This is achieved by maximizing, for a given excess demand vector which requires putting all weight of
correspondence from
to
by
p p z over a nonempty, compact set , is nonemptyz Z and p0 (z). Then (z) = {p RL : p z = p0 z} is the intersection of sets, so is convex-valued. A standard continuity argument shows that has a closed
from and to
with
(p, z) = (z) z(p) and z have these properties. By Kakutani's xed point theorem, there is a (p, z) Z with (p, z) (p, z) = (z)z(p). As z z(p), the weak Walras' Law implies that p z 0. As p (z), p z p z for all p . For each {1, . . . , L}, taking p = e gives that z = p z p z 0, so z 0.
is nonempty-valued, convex-valued, and has a closed graph because The trick, of course, is to derive the desired properties of the excess demand correspondence by imposing properties on the components of the private ownership economy
E.
of Sections 4 and 5, most of them should not come as a surprise. Only the rst is somewhat complicated: what allows us to restrict attention to such a convex, compact set
Z ? Convexity of Z is not the issue: if you can nd a compact set containing all the images z(p), they also lie in a suciently large (convex) ball. Without going into details, compactness of Z is established f by realizing that the relevant production plans, by feasibility, must satisfy f F y + 0.
Following the lines of Proposition 5.5, this set of attainable production plans can be shown to be compact. Appropriate modications of the fundamental welfare theorems continue to hold for private ownership economies. As this section was meant only as a short introduction to the topic, the interested reader is referred to Debreu (1959) for a more comprehensive treatment. Textbooks on general equilibrium theory include Hildenbrand and Kirman (1988) and Starr (1997).
6.5.
Exercises
Exercise 6.1
(a) What is wrong with the following argument: Proposition 6.2 implies Proposition 6.3: if the core, the coalition
lies in
S=H
is Pareto optimal.
(b) Give an example of a pure exchange economy in the core, but is not Pareto optimal.
(p, x)
such that
lies
55
Exercise 6.2
Market clearing:
where
pz =0
and all
z z(p).
Prove:
p RL , z z(p) RL , {1, . . . , L} : +
(b) If prices are positive and
if
p > 0,
then
z = 0.
L1
p RL , z z(p), {1, . . . , L} : ++
Markets clear in most standard applications:
zk = 0
for all
k=
, then
z = 0.
(c) Consider an equilibrium. Suppose (c1) or (c2) is true for at least one consumer (c1) (c2)
h H:
is strongly monotonic on
X=
RL . + h's
least preferred alternatives are on the axes:
x, y RL : +
and
x RL , y RL x / ++ ++
y,
is strongly monotonic on
X = RL . ++
Prove that all markets clear. Cobb-Douglas preferences, for instance, satisfy the requirements in (c2), not those in (c1).
Exercise 6.3
and
Pareto dominated if there is another feasible allocation (, y) with xh x Pareto optimal if it is not Pareto dominated.
xh
h
E.
A feasible allocation
(x, y)
h
is for all
xh
hH
xh
for some
h H.
(a) Why do you think Pareto dominance is dened in terms of consumer preferences, ignoring those of producers? (b) Prove the First fundamental welfare theorem: If and consumers have locally nonsatiated preferences, then
(p, x, y) (x, y) is
Exercise 6.4
(a) no Walrasian equilibrium. (b) exactly one Walrasian equilibrium. (c) exactly two Walrasian equilibria. (d) innitely many Walrasian equilibria. Answer the same question for a private ownership economy by adding 714 producers (yes, seven hundred and fourteen. . . You don't seriously believe I'd ask this if the answer weren't trivial, do you?).
Exercise 6.5
between two women, each claiming that a certain baby is hers, by suggesting to cut it in two with his sword: the true mother is revealed as she is willing to give up her child to the liar, rather than have it killed. Swords make babies divisible commodities, so consider a pure exchange economy with two
x [0, 1] be a share of a baby. The true uT : [0, 1] R with uT (x) = x if x {0, 1} and uT (x) = 1 otherwise. L The liar has utility function u : [0, 1] R with uL (x) = x. Determine for each initial allocation T L 2 ( , ) {z R+ : z1 + z2 = 1} the set of feasible allocations, the set Pareto optimal allocations, the
consumers (the two women), one commodity (the baby). Let core, and the set of Walrasian equilibria.
56
7.
Hitherto, we assumed that decision makers act in a world of absolute certainty; typically, however, the consequences of decisions entail some stochastic elements. This section treats the development of expected utility theory, using the axiomatic approach of von Neumann and Morgenstern.
7.1.
We maintain the notion of preferences, but instead of assuming that a decision maker (DM) has preferences over certain outcomes, we consider preferences over probability distributions over outcomes. Formally, let set of
ai A.
A = {a1 , . . . , an }
g = (p1 a1 , , pn an ).
Probabilities should be nonnegative and add up to one, so the set of simple gambles is
G1 =
(p1 a1 , , pn an ) : p1 , . . . , pn 0,
i=1
pi = 1 .
or tails
(28)
For instance, when tossing a coin, the outcome will be heads fair coin corresponds with the simple gamble
T,
so
A = {H, T }.
( 1 H, 1 T ). 2 2
one often omits outcomes with probability zero from the notation of a simple gamble:
( 1 a1 , 1 an ) 2 2
1 1 a1 , 0 a2 , , 0 an1 , an . 2 2
one often writes
ai
(1 ai ) whose outcome is ai
Not all gambles are simple. Perhaps you decided to bet one dollar on your favorite number in a roulette game, but toss a coin to decide which of two roulette wheels you want to play in a casino: the outcome of the rst gamble (the coin toss) is another gamble (the roulette game). This is an example of a compound gamble. In principle, we can have any level of compound gambles. For convenience, we will assume that a compound gamble ends in a deterministic outcome after only nitely many steps. Formally, the set of compound gambles is dened as follows. Let and, inductively, for each the lower levels
G0 = A
m N, let Gm G0 , . . . , Gm1 :
Gm =
The
(p1 g1 , , pk gk ) : k N, p1 , . . . , pk 0,
i=1
pi = 1,
and
g1 , . . . , gk m1 G =0
G = Gm . m=0
For instance, suppose that probability
Associated with each compound gamble is a simple one, specifying the eective probabilities with which the outcomes in compound gamble
A = {a1 , a2 }
1 .
57
a1
with probability
1 .
a1
probability
(1 )(1 ).
Thus,
(( + (1 )) a1 , (1 )(1 ) a2 ).
Similarly, for every gamble We say that
g induces the simple gamble (p1 a1 , , pn an ) G1 or that the latter is the reduced simple gamble associated with g. Notice that this reduced simple gamble is unique.
7.2. Preferences over gambles
over the set
g G,
let
pi
ai A
by
g.
Assume the DM has a preference relation following properties: (G1) is a weak order.
Given the set of deterministic outcomes described by its vector unit simplex can state: (G2) Continuity on
A = {a1 , . . . , an }, every simple gamble g G1 is fully (p1 , . . . , pn ) Rn of probabilities, i.e., we can interpret G1 simply as the n = {p Rn : i pi = 1}. And in Rn , we know what continuity means, so we + G1 : G1
restricted to
is continuous.
Continuous weak orders have played an extensive role also in our earlier sections; the following properties explicitly exploit the specic structure of our gambling framework. Our next property requires that in considering a gamble, the DM cares only about the eective probabilities assigned to each outcome in
A:
g,
then
g G, g (p1 a1 , , pn an ).
if
(p1 a1 , , pn an )
This is a strong assumption. It rules out, for instance, any preference relation that takes into account the complexity of compound gambles: a DM may strictly prefer the associated reduced simple gamble to some
g G2562 ,
to eventual deterministic outcomes. Our next property, independence, says that if we mix two gambles
and
, then the preference between the mixtures should be independent of the particular choice of
the third gamble. It essentially requires some form of independence of irrelevant alternatives: in the two gambles
( g, (1 ) g )
the gamble gambles
and
( g , (1 ) g ),
According to independence, this means
1 .
that the preference should depend only on the part where the two gambles are dierent, i.e., on
and
g. g, g , g G
and all
(0, 1): ( g , (1 ) g ).
g ( g, (1 ) g )
58
Proposition 7.1
on
in
G1 ,
g G1 : g
g.
g G,
there is a number
g [0, 1]
such that
g (g g , (1 g ) g).
(c) Substitution: let be such that
up to one. Let
g1 , . . . , gk , h1 , . . . , hk G
(p1 g1 , , pk gk ) (p1 h1 , , pk hk ).
Finally, let us assume that (d) Monotonicity: for all
g,
, [0, 1],
> ,
then
( g , (1 ) g)
( g , (1 ) g).
on the compact unit
n . g G and let gs G1 be its reduced simple gamble. Since g gs by (G3) and gs g , it follows from transitivity (G1) that g g g . Let p, p n be the associated probabilities of g and g . By connectedness of the set of convex
combinations of these best and worst gambles in the unit simplex, Proposition 2.7 implies that there is a gamble with probabilities
g p + (1 g )p
equivalent with
g.
g (g g , (1 g ) g)
(c):
By induction on
k N.
k = 1.
Let
k N, k 2,
and suppose
the claim is true for mixtures of less than gambles, notice that
gambles.
(d):
Assume
and let
easily
( g , (1 ) g)
( g, (1 ) g) g
59
Since
( g , (1 ) g)
Denote the left gamble by
g.
g.
Then
( g , (1 ) g) = g ( g , (1 ) g )
( g , (1 ) g)
( g , (1 ) g)
Since is a weak order (G1):
( g , (1 ) g)
as we had to show.
( g , (1 ) g),
7.3.
Equipped with these results, one can show that properties (G1) to (G4) imply the existence of a utility function Formally, a that represents the preference relation on
u:GR
u:GR
g, h G :
u(g) =
i=1
where
pi u(ai ), g.
(p1 a1 , , pn an )
In words: a vNM utility function represents the preferences of the DM and the utility assigned to a gamble equals the expected utility of the induced simple gamble.
If
in
G1 .
In the
g g,
any constant function is a vNM utility function. So assume, w.l.o.g., of a unique number
g. g [0, 1]
such (29)
For each
60
: let
g, h G.
Then
h (g g , (1 g ) g) (h g , (1 h ) g) u(g) = g h = u(h),
and the second equivalence from
where the rst equivalence follows from transitivity (G1) of monotonicity and the denition of simple gamble induced by
u. g G and let gs = (p1 a1 , , pn an ) be the g gs , so u(g) = u(gs ). For each ai A, we know from u(ai ) that
g.
By (G3),
i = 1, . . . , n,
dene
By substitution:
gs = (p1 a1 , , pn an ) (p1 h1 , , pn hn ).
Notice that
h1 , . . . , hn
By computing the
(p1 h1 , , pn hn )
is equivalent with
pi u(ai )
i=1
Combining the above with transitivity of
g, 1
i=1
we nd:
pi u(ai )
g .
g gs (p1 h1 , , pn hn )
i=1
By denition,
pi u(ai ) [0, 1]
g, 1
i=1
pi u(ai )
g .
(30)
u(g)
satisfying
u(g) =
n i=1 pi u(ai ).
Remark 7.3
on
can
be represented by a vNM utility function, it must satisfy properties (G1) to (G4). The linearity requirement on vNM utility implies that the earlier result from utility theory any strictly increasing transformation of the utility function of the consumer still represents the same preferences no longer holds. Indeed, the only transformations of a vNM utility function that remain vNM utility functions, are positive ane transformations:
Proposition 7.4
with
u:GR a, b R
a > 0,
also
au + b
G,
there exist
with
a>0
such
a, b R v : G R is a that v = au + b.
61
Proof.
g.
To establish the
a>0
and
g G.
so (31)
pound gambles of nite length. These assumptions can be relaxed, but at the cost of increased
7.4.
Exercises
Throughout this exercise, let
Exercise 7.1
set
G = Gn n=0
{a1 , . . . , ak } R of k 2 dierent deterministic outcomes. Recall: Gn is the set of n-th level gambles. For each of the preference relations over G dened below, answer the following questions: If possible, nd the best and the worst elements of G.
For each of the four properties (G1) to (G4) guaranteeing the existence of a vNM utility function, check whether satises it. . If (G1) to (G4) are satised, nd a vNM utility function representing
(a) Most likely outcomes: A decision maker bases preferences on the average of the deterministic outcomes that are most likely to occur. simple gamble. Let Let
g G
and let
(p1 a1 , , pk ak )
be its induced
L(g) = {ai : pi pj
relation on
for all
j = 1, . . . , k}
its number of elements. The preference
|L(g)| g, h G:
ai L(g)
1 |L(g)|
ai
1 |L(h)|
ai L(h)
ai .
over
(b) Keeping it simple: A decision maker dislikes complex alternatives and has preferences represented by the following utility function: for each
(p1 a1 , , pk ak )
(c) Satisficing: preference relation
is a unique
n with g Gn . k pm am n. m=1 g G,
Let
The let
(p1 a1 , , pk ak )
u(g) =
i:ai >5 pi .
62
8.
8.1.
Risk attitudes
In for a gamble?
Let us conne attention to cases where the outcomes of the gambles are amounts of money: a convex set in
A is
R.
Despite the fact that we now allow an innite set of outcomes, we will assume The existence
that every gamble assigns positive probability to only nitely many outcomes. to (G4) to innite sets. We assume that the vNM utility function
theorem of vNM utility functions can be adjusted to this case by modifying the properties (G1)
investigate the relation between this function and the DM's attitude towards risk. Consider a nontrivial (i.e., at least two dierent deterministic outcomes have positive probability) simple gamble
g = (p1 w1 , , pn wn )
u(g) =
2. Accept the outcome that gives the expected value of the gamble with certainty (this is where we need convexity of
A!).
E(g) =
u(E(g)) = u(
n i=1 pi wi ).
risk averse at g if u(g) < u(E(g)), risk neutral at g if u(g) = u(E(g)), risk loving at g if u(g) > u(E(g)). The DM is said to be risk averse (on G) if he is risk averse at every nontrivial simple gamble g over outcomes in A. Risk neutral and risk loving behavior are dened analogously. These
risk attitudes directly translate to properties of the associated vNM utility function over money:
Proposition 8.1
function
Let
A R
u.
(a) risk averse if and only if (b) risk neutral if and only if (c) risk loving if and only if
u u
A,
A, A.
is strictly convex on
Proof.
We only prove the rst claim; the others are similar. Risk aversion means that for every
nontrivial gamble
(p1 w1 , , pn wn ),
n n
u(p1 w1 , , pn wn ) =
i=1
p i wi
. u is p1 , . . . , p n > 0
n i=1 pi
=1:
n i=1 pi u(wi )
< u(
n i=1 pi wi ).
w1 , . . . , w n A
and all
g,
he does not have to be risk averse/neutral/loving over the entire collection of lotteries. It may
well be, for instance, that he is risk averse at high-stake lotteries and risk loving at low-stake lotteries.
63
8.2.
The
certainty equivalent
of a simple gamble
is an amount of money
and accepting
with
u(g) = u(CE(g)).
Remark 8.2
on
AR
are continuous.
g)
and a
value theorem for preferences, Proposition 2.7, monotonicity of preferences in money, notion. The
w A (say, weight one on the w A with g w. By the Intermediate there is a CE(g) A with g CE(g). By g,
there is a the certainty equivalent is a well-dened
CE(g) is unique:
risk premium of a simple gamble g is an amount of money P (g) such that u(g) = u(E(g)
Clearly,
P (g)).
amount that makes him indierent between accepting that amount with certainty and accepting
g.
This amount is called the certainty equivalent. It is easy to show (see below) that
for a risk averse DM who strictly prefers more money to less, the certainty equivalent is less than the expected value
E(g)
of money to avoid the gamble's inherent risk. This willingness to pay is the risk premium.
Proposition 8.3
The
g S,
g S.
Proof.
that statements 1 and 2 are equivalent. The DM is risk averse if and only if for every nontrivial
As a simple exercise, try to formulate similar characterizations of risk neutral and risk loving behavior.
u(w) = ln(w) for all w A. This DM is risk averse, since u is strictly concave. Assume DM's initial wealth is w0 and DM faces a gamble g oering 50-50 odds of winning or losing an amount h (0, w0 ) :
Take
Example.
A = R++
64
Hence
CE(g)
must satisfy
1 1 ln(w0 h) + ln(w0 + h) = ln 2 2
2 w0 h2 > 0 .
2 w0 h2 ,
where the nal equation follows from the properties of the natural logarithm. Hence
CE(g) =
2 w0 h2 < w0 = E(g)
8.3.
and
P (g) = w0
Arrow and Pratt considered the problem of measuring the extent of risk aversion. They assumed that the vNM utility function
w : u (w) > 0
Using this, the
and
u (w) < 0.
(32)
Why is this a sensible measure of risk aversion? A heuristic derivation is provided in the next subsection. The intuition is as follows: the more risk averse a DM is, the more he is willing to pay to avoid certain gambles. Thus, the size of the risk premium in some way measures risk aversion. It turns out that the Arrow-Pratt measure of absolute risk aversion is roughly proportional to the risk premium the DM is willing to pay to avoid actuarially fair bets (a bet is actuarially fair if its expected value equals initial wealth: the expected loss/gain is zero). Thus, if DM 1 is more risk averse than DM 2, his risk premium for every nontrivial gamble exceeds that of DM 2, so the same should hold (due to proportionality) for the Arrow-Pratt measures of absolute risk aversion. The actual proof is somewhat more complicated; we omit it.
Proposition 8.4
1.
and
w,
1 2. The risk premium P (g) of the DM with utility function u is strictly larger than the risk 2 premium P (g) of the DM with utility function v for every nontrivial gamble g S.
Notice that positive ane transformations of the utility functions do not aect not depend on the choice of vNM utility function. It is common in the literature on for instance portfolio choice to assume that risk aversion decreases with wealth. This is the
Ra (w):
it does
Ra ()
w.
65
8.4.
The argument in this section is due to Pratt (1964). Assume (32) and let the DM's initial wealth be
w0 .
h:
E(g) = w0 .
Let
P = P (g) > 0
g:
(33)
u(w0 P )
around
w0 :
(34) around
u(w0 h)
and
u(w0 + h)
w0 :
1 u(w0 h) u(w0 ) u (w0 )h + u (w0 )h2 , 2 1 u(w0 + h) u(w0 ) + u (w0 )h + u (w0 )h2 . 2
Consequently,
(35)
1 u (w0 ) P h2 . 2 u (w0 )
Conclude that the Arrow-Pratt measure of absolute risk aversion is approximately proportional to the risk premium losing an amount
P,
h.
66
9.
Expected utility theory is the main tool in economic models involving uncertainty. Nevertheless, expected utility theory has been under constant attack from behavioral economists and psychologists who show that subjects in experiments or real-life situations systematically violate the properties (G1) to (G4) or that mindless application of expected theory leads to counterintuitive conclusions. For this reason, many alternative models for decision making under risk and uncertainty have been developed. Perhaps the most well-known especially since Daniel Kahneman was awarded the 2002 Nobel Prize in economics is Kahneman and Tversky's prospect theory (Kahneman and Tversky, 1964). Although we lack time to go into such alternative models, we stand still for a while and consider a number of blows to the expected utility model.
9.1.
Nothing in the development of our expected utility model required the utility function to be bounded. Unbounded utility functions, however, make decision-makers susceptible to cunning exploitation. Suppose a DM with initial wealth which is not bounded from above. By assumption, there is some wealth
w1
with
0, w1 ),
1 2
w1
money from your hand, retract it, turn your smile back on, and oer him a gamble
w2
u(w1 ) <
1 2 (u(0)
1 ( 2 0, 1 w2 ), 2
+ u(w2 )).
accept. As long as the DM goes on winning, keep oering such 50-50 odds gambles. . . The DM will end up with wealth zero with probability one!
9.2.
Allais' paradox
g1 = (1 $1, 000, 000), g2 = ((0.10) ($5, 000, 000), (0.89) ($1, 000, 000), (0.01) ($0)), g3 = ((0.11) ($1, 000, 000), (0.89) ($0)), g4 = ((0.10) ($5, 000, 000), (0.90) ($0)).
It turns out that in dierent experiments, most people prefer
g1
to
g2 , but g4 u. Then
to
g3 .
This violates
g1
g2 u($1, 000, 000) > 0.10u($5, 000, 000) + 0.89u($1, 000, 000) + 0.01u($0).
g1
g2 0.11u($1, 000, 000) > 0.10u($5, 000, 000) + 0.01u($0) 0.11u($1, 000, 000) + 0.89u($0) > 0.10u($5, 000, 000) + 0.90u($0) g3 g4 , g3
and
where the last equivalence follows from computing the expected utility of
g4 .
67
9.3.
Probability matching
$1 each time you guess correctly whether a red or a green light will ash.
The lights
ash randomly, but the red is set to turn on three times as often as the green. It has been found that many subjects in experiments of this type try to imitate the chance mechanism: they choose red about three quarters of the time and green one quarter. Obviously it would be more protable to always choose red. with probability Formally, the expected utility of the compound lottery of choosing red gives you a one dollar payo with probability
3/4
This type of matching behavior has been frequently observed in real life, as well as laboratory experiments, using both humans and animals as subjects. In an experiment with animals, for instance, foraging behavior of pigeons was studied, using two food patches (call them red and green, as above) with food being dispatched at the red location three quarters of the time and at the green location one quarter of the time. distribution. A small personal anecdote: jointly with two colleagues, I published two papers on a game theoretic model of bounded rationality in which players are assumed to display matching behavior. To explain the type of behavior to laymen and motivate that it is observed in real life, we used dierent examples, among them the pigeon example mentioned above. This led the Dutch Foundation for Mathematical Research, which at that time was nancing my work, to publish a press statement proudly proclaiming: People behave like pigeons when dealing with probability, a press statement that gave us extensive media coverage but where we desperately tried to qualify our employers' overzealous interpretation. So in case you sometimes wonder what you are doing. . . you may just be behaving like a pigeon! The pigeons tried to match this probability
9.4.
Matthew Rabin, one of the world's leading behavioral economists, published a remarkable article (Rabin, 2000) on the consequences of risk aversion with respect to small-stake gambles. Let us start with an example to illustrate the result. Consider a risk averse DM who for each initial wealth level rejects a 50-50 odds gamble of winning
11
dollars or loosing
10
dollars: certainly a
rather unremarkable level of risk aversion. What does this imply about his preferences for other gambles? Consider, for instance, the following statements: 1. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing
150
dollars.
2. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing dollars and a 50 percent chance of gaining
1, 500
dollars.
3. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing dollars and a 50 percent chance of gaining
1, 000, 000
dollars.
68
4. For each level of wealth, the DM will reject the lottery with a 50 percent chance of loosing
100
dollars.
100
G.
Which of these statements are true? The rst and the second may perhaps not be so surprising and I probably wouldn't be asking you if the question was trivial, so even the third could be true. On the other hand, one would certainly doubt the sanity of a DM rejecting the bet in the fourth claim and lingering doubt turns to certainty in the fth case. Yet this is exactly what the DM will do: no amount of money in the world will make him accept a gamble with a 50 percent chance of loosing the gamble
100
Let us try to establish some intuition. The fact that the DM at each wealth level
rejects
1 1 (w 10) , (w + 11) 2 2
implies that
w :
or, rewriting the expression, that
w :
Hence, on average, the DM values each dollar between much as he, on average, values each dollar between
10/11
times as
w :
u(w + 11) u(w) 10 u(w) u(w 10) < . 11 11 10 (w + 11)-th dollar (w 10)-th
dollar:
By concavity of the utility function, this means that the marginal utility of the is at most
10/11
w :
u (w + 11) <
10 u (w 10). 11
times the marginal utility of dollar
(36)
Repeated application of (36) implies an enormous decrease in marginal utility of money: the marginal utility of dollar which is at most dollar
w + 32
is at most
10/11
w + 11,
10/11 times the marginal utility of dollar w 10, so the marginal utility of w + 32 is at most (10/11)2 0.83 times the value of dollar w 10. Similarly, the DM 3 values dollar w + 53 by at most (10/11) 0.75 times the value of dollar w 10. More generally, k+1 times the value of dollar the DM values dollar w + 11 + 21k , where k N, by at most (10/11) w 10, which is an extremely high rate of deterioration for the value of money.
69
10.
Time preference
Discounting essentially means that a given benet is valued higher when it is received immediately than when it is received with a delay. A common economic motivation for discounting is that, say, one dollar today is worth more than one dollar next year, as the immediate reward can be put into a bank at an annual interest rate year.
dollars next
Another motivation, common in evolutionary models, is the risk that a delayed benet
may not be realized: you may die before receiving it (or be interrupted in achieving it, or be cheated in the promise of receiving it). In addition to the question how to model discounting in an appropriate way, decision theory in the presence of time involves a number of careful considerations: Choice of horizon: should one look nitely or innitely far into the future? Keynes' famous quote In the long run, we are all dead could be an argument in favor of a nite horizon. Many economic models involve just two time periods as an abstraction of now and the future. On the other hand, many decisions have no clearly dened nal period: you or in an evolutionary sense as in overlapping generations models, your genes may live to see another day. In such cases, an innite horizon makes sense. Choice of time as a discrete or continuous variable: also here, common sense, the appropriate level of abstraction, and (not rarely) the modeler's choice of mathematical tools is decisive. Unless specied otherwise, this section takes time as being discrete and uses an innite horizon. We derive the standard exponential discounting model from a stationarity assumption on preferences and briey discuss a violation of stationarity and hyperbolic discounting. Section 10.3, based on Osborne and Rubinstein (1994, Sec. 8.3), considers two criteria for evaluating outcomes over time without discounting. The nal section, based on Voorneveld (2007), illustrates the somewhat paradoxical statement that a sequence of utility-maximizing choices can minimize utility.
10.1.
The standard model of preferences over time assumes that: the set of alternatives consists of sequences of outcomes arbitrary set, where preferences
in some
ct
t.
of the form
(t)u(ct ),
(37)
(0) = 1.
the at time
The function in (37) is often interpreted as a sum of discounted instantaneous utilities: outcome
ct
tN
gives utility
u(ct ), but is discounted by a factor (t) (0, 1) as it lies (0) = 1 for current outcomes is mostly cosmetic, facilitating
Exercise 10.1
The expression in (37) involves an innite sum, which may not be well-dened.
70
(b) Prove that the sum is well-dened if the sequence of discount factors is summable ( and the instantaneous utility function
t=0
(t) < )
such
is bounded.
(t) = t
exponential discounting :
there is a
(0, 1)
for all
t,
U (c) =
t=0
t u(ct ). r > 0
(38)
Recall the earlier motivation for discounting of money: given a xed interest rate period, one dollar tomorrow is worth only future money by powers of Preferences satisfy
per
(1 + r)1
= (1 + r)1 .
stationarity
dropped, and the timing of all other outcomes is advanced by one period. By repeated application, it implies that for a comparison between two sequences all initial periods with common outcomes can be dropped, and the rst period of dierent outcomes can be taken as the initial period. Formally, the preference relation is
stationary if for all pairs (ct ) and (dt ) with c0 = d0 : t=0 t=0
(c0 , c1 , c2 , . . .) (d0 , d1 , d2 , . . .) (c1 , c2 , . . .) (d1 , d2 , . . .).
Deriving exponential discounting usually proceeds along the following lines:
Proposition 10.1
preferences
For notational convenience, let 0 be a feasible outcome. Assume that: can be represented by a utility function as in (37),
option 1: option 2:
where
getting getting
(, , 0, 0, . . .)),
u( ) = u( ). (t) =
u()u() u( )u( ) t
.
Let
Proof.
By induction on
u()u() u( )u( )
t.
t = 0.
tN
( ) =
for all
< t.
( 0, . . . , 0 , , , 0, 0, . . .) ( 0, . . . , 0 , , , 0, 0, . . .),
t1
times
t1
times
(t) = (t 1)
u() u() u( ) u( )
u() u() u( ) u( )
71
Exercise 10.2
Rational suicide: A decision maker (DM) lives for at most two periods,
t = 0
and
t = 1. 1/2
At each time
t {0, 1}
to commit suicide. Regardless of his initial mood, at time or happy with probability
t=1
1/2.
on his action but also on the state of the world at time alive and happy, as follows:
t.
1 1 u(s, a) = 0
where
if if if
otherwise,
>0
is the intensity of the depression. Thus, given that you're happy, killing yourself appears
silly, but if you're depressed, it may seem less so. State himself at time
D is irreversible: should the DM decide to kill t = 0, then he receives utility 0 at time t = 1. The DM discounts the future exponentially at rate 0 < < 1, and maximizes expected lifetime utility (of the standard additive form). We solve the decision problem by backward induction, starting with optimal behavior in the nal period t = 1. Assume the DM is alive at time t = 1.
(a) What is the optimal action and the resulting instantaneous utility if the DM at (a2) depressed? Now consider the initial period: assume the DM is depressed at time (b) Assuming optimal behavior at time the answer depends on
t = 1 is (a1) happy?
t = 0. t = 0?
Note:
t = 1,
(i) if
the DM does not kill himself immediately, there is uncertainty about his mood at time
t = 1; (ii)
and
(c) A psychologist claims that the option of future suicide might prevent depressed people from killing themselves straight away. Explain this claim using the answers above.
10.2.
Stationarity requires that if you prefer one apple today over two apples tomorrow, then shifting this choice by one year (one apple next year versus two apples one year and a day from now) doesn't change that you'd still rather have the single apple. On the other hand, empirical evidence (Thaler, 1981) seems to suggest that people are much more sensitive to a waiting time of one day when it occurs right now than to a waiting time in the far future: if you anyway have to wait an entire year for a lousy apple, you might as well wait one day more and double the booty. Dierent attempts to capture such a preference reversal go under the heading of hyperbolic discounting. It simply involves discount factors that are not exponential. Arguably the simplest approach is the so-called for
, (0, 1),
(, )-model of Phelps and Pollak (1968). They dene, 2 3 as (0) = 1, (1) = , (2) = , (3) = , . . ., turning
U (c) = u(c0 ) +
t=1
t u(ct ). u
To see that this model can explain the preference reversal for the apples, assume that utility satises
u(0) = 0
and is strictly increasing in apples. Preferring one apple today over two apples
(39)
Preferring two apples one year and a day from now to one apple a year from now (and assuming we're not in a leap year) means that
(40) to satisfy
(, ) (0, 1) (0, 1)
<
Taking
(t) = (1 + t)/ ,
with
, > 0,
t experimental data well. Show that also this model captures the preference reversal described above.
intertemporal consumption, time periods represent generations and people care about future consumption to the extent that it is exercised by their ospring (children, grandchildren, etc.). To simplify matters, assume that are selected at random and have the relevant gene with probability
(i) a DM cares about consumption of its ospring only if it has a specic gene; (ii) mates [0, 1], (iii) ospring gets in expectation half of its genes from each parent, (iv) we consider one unit of ospring per time period.
(a) Let
instance by conditioning on the giver of the gene, that the probability ospring carrying the gene satises the recurrence relation
pt of pt = 1 pt1 + 1 . 2 2
1 t for all 2
p0 = 1 and t = 0, 1, 2, . . .
pt = + (1 )
With these kinship parameters function becomes increasing, and (c) Let
(pt ) in the place of discount factors, the standard separable utility t=0 U (c) = t=0 pt u(ct ). Assume that consumption is in units of apples, u is strictly u(0) = 0. Let's investigate the opportunity of preference reversal. u be such that the DM prefers 1 T N suciently large, the DM
apple now (t
and
= 0)
Prove: for
T +1
to 1 apple at time
= 1). T.
10.3.
By discounting, less weight is assigned to future utilities. This section introduces two other ways of evaluating sequences of utilities, attaching equal weight to all periods. To save on notation,
(xt ) of real numbers, rather than t=0 . Probably the rst thing that comes to mind is to value a using the more elaborate (u(ct ))t=0 sequence of utilities (xt )t=0 using the long-term average of the utilities:
we will denote a sequence of utilities simply by a sequence
x0 + x1 + + xT 1 . T T lim
However, even if the sequence is bounded, this limit may not exist: the average may continue to oscillate. We verify this statement with a binary (zero-one) sequence. The idea is to append enough ones to increase the average until it achieves a xed high value, then to append enough zeroes to decrease the average until it reaches a xed low value, and continue this process.
An oscillating average:
(0, 1, 1, 0, 0, 0, 1, 1, 1, 1, 1, 1, . . .)
73
obtained by starting with a zero and two ones, and then after each block of zeroes or ones, double the length of the sequence obtained so far with a block of the other number: after the rst block of ones, we have three coordinates, so we double the length to six coordinates by appending some zeroes. Then we double the length to twelve coordinates by adding some ones, etc. A simple inductive proof shows that after the
k -th
3 22k2 1/3.
coordinates,
2/3.
3 22k1
1/2
to
As appending
zeroes decreases, and appending ones increases the average, it follows that the average continues
1/3
and
2/3.
Consider a bounded
Taking, instead, a pessimistic view of how the average utility changes over time will give us a well-dened criterion. sequence This requires some mathematical preliminaries. For each
(xt ) t=0
of real numbers.
t, st = inf{xs : s t}
somewhat colloquial terms, the worst value) of the tail of the sequence from time is weakly increasing: increasing
onwards.
This inmum is well-dened, as the sequence is bounded. Notice also that the sequence
(st ) t=0 is a implies taking the inmum over a smaller set. As (st )t=0
monotonic, bounded sequence, it converges. Its limit is called the lower limit or
limes inferior
lim inf t xt =
if
(xt ) t=0
If it is bounded
from below, but not from above, the sequence of inma may diverge, in which case one sets
lim inf t xt = +.
The following characterization of the lower limit may come in handy. sequence and let Let
(xt ) t=0
be a
c R.
Then
lim inf t xt = c
[L1] for each > 0, there is a T N such that c < xt for all t T , [L2] for each > 0 and each T N, there is a t T with xt < c + .
In words, the sequence eventually remains above matter how small
c ,
c+
innitely often, no
> 0.
Exercise 10.5
Prove this.
The limit-of-means criterion evaluates utility streams by means of the lower limit of the average utility:
Limit of means:
preferred to
Let
x = (xt ) t=0
and
y = (yt ) t=0
be sequences in
R.
Then
is
y,
if and only if
lim inf
T
1 T
T 1
(xt yt ) > 0.
t=0
(41)
Inequality (41) is equivalent with the statement that for some between sequences
> 0,
and
eventually exceeds
: T.
1 T
T 1
(xt yt ) >
t=0
74
Exercise 10.6
Prove this.
Changes in a single coordinate of a sequence become negligible once the average is taken over a long time, so under the limit-of-means criterion, changes in any nite number of periods do not matter. In particular, these preferences are stationary.
Exercise 10.7
1 lim inf T T
Some authors refer to the limit-of-means criterion as the preference relation repre-
T 1 t=0
x = (xt ) t=0
the number
U (x) =
xt .
(a) Why must the sequences be bounded? (b) Aside from this, are the two denitions really the same?
The following criterion also assigns equal weight to periods, but remains sensitive to changes in single coordinates:
Overtaking:
to
Let
x = (xt ) t=0
and
Then
x is preferred
lim inf
T t=0
(xt yt ) > 0.
Let us compare exponential discounting, and the limit-of-means and overtaking criteria.
The
latter were dened in terms of strict preferences. Dene the corresponding indierence relation
as follows:
x L y
if neither
nor
x.
Of course,
is dened similarly.
Comparison:
The sequence counting for
(1, 1, 0, 0, . . .) is preferred to the sequence (0, 0, . . .) under exponential all (0, 1). Under the other two criteria, they are equivalent. (1, 2, 0, 0, . . .)
the sequence is preferred to the sequence
dis-
The sequence
(0, 0, . . .)
criterion. Under the limit-of-means criterion, they are equivalent. For every
n N,
(0, . . . , 0, 1, 1, . . .)
n
is preferred to
times
(1, 0, 0, . . .)
(0, 1),
a large enough delay in a constant stream of ones makes the instant gratication of getting 1 immediately the preferable option.
10.4.
Consider an alcoholic who has to decide at each moment in discrete time whether to take a drink (action 1) or not (action 0). Given his uncertain life-length, common modeling practice is to treat this as an innite horizon problem, discounting the impact of future decisions if so desired.
x = (xt ) of zeroes and ones, with xt = 1 if the alcoholic t=0 takes a drink at time t and xt = 0 otherwise. With a minor abuse of notation, (0, xt ) denotes the drinking pattern obtained from x by not drinking at time t. The pattern (1, xt ) is dened
A drinking pattern is a sequence likewise.
75
The philosophy of Alcoholics Anonymous is to ght the temptations of alcohol by forgetting about the past or the future and concentrate exclusively on the present: simultaneously models: stay away from a drink one day at a time. Let us investigate the possibility of having a utility function
that
Temptation:
at any given day, the alcoholic is at least as well of and sometimes better
by choosing to drink:
t, xt , some t, xt .
minimizes
nevertheless, the best thing is never to drink and the worst thing is
(0, 0, . . .)
maximizes, and
(1, 1, . . .)
U.
This sounds paradoxical and is indeed impossible under a nite horizon: suppose there are only
T N
periods. Start with an arbitrary drinking pattern and switch, one period at a time, any By temptation, each such switch weakly increases the utility So drinking at all times maximizes utility, in conict with health concerns, which
would require that all these weak increases in utility eventually lead to a plunge in utility: it is like climbing a stairway, but ending up lower than before (Figure 3).
Figure 3:
An impossible stairway
The next example shows that temptation and health concerns can be reconciled under an innite horizon.
Drinking paradox:
as follows:
3 0 U (x) =
As a switch from it by
xt = 1 xt = 0
t t
t t xt 2
at time
otherwise.
to
leaves the utility unaected in the rst two cases and increases
2t > 0
76
11.
Probabilistic choice
A of alternatives.
u:AR
a utility
maximizing alternative. However, in numerous experiments, it turns out that DMs: do not always make the same choice under seemingly identical circumstances, sometimes choose seemingly suboptimal alternatives. Such apparently irrational behavior has led to the development of so-called
probabilistic choice
a
should be at
and
b,
b.
This section gives a very short introduction to three probabilistic choice models: the Luce model , the logit model , and the linear probability model . Often, probabilistic choice models are derived in a random utility framework, where the true utility of each alternative consists of a deterministic component plus a random component. Depending on the realization of the random utility component, a feasible choice will look good under some circumstances and bad under others, thus motivating that observed choice is probabilistic: an alternative is only chosen in circumstances where it looks optimal. We will not consider such random utility models: they are (or should be) treated in detail in the econometrics courses. The development of these models was one of the main causes for awarding Daniel McFadden the Nobel Prize in 2000. Instead, we derive the models either axiomatically or via the introduction of
choose optimally, but incur costs to precisely implement their choices. A good introduction to probabilistic choice models can be found in Anderson et al. (1992, Ch. 2) and Ben-Akiva and Lerman (1985, Ch. 3). On the content of this section: The Luce model is due to Luce (1959). The derivation of the logit choice probabilities using the entropy cost function can be found in Mattsson and Weibull (2002). The derivation of the linear probability model using the Euclidean distance as cost function is due to Voorneveld (2006). It is based on an early contribution to the literature on bounded rationality in games by Rosenthal (1989).
11.1.
in the remainder of this section, we assume that the DM has to choose from a subset of alternatives in
containing at least two elements : choosing from a set with only one
alternative is trivial. We will typically denote such sets by If the DM has to make a choice from a set chooses If
SA
aS
or
T A.
S A,
aS
by
PS (a) = 1.
set is
S T A, T by
PT (S) =
aS
By the assumption above:
PT (a). T A.
PT (T ) = 1
for all
77
by removing an element
aA
is denoted by
S \ {a}.
With this notation, the following two properties should be intuitive. The rst property states that if some alternative i.e.,
P{a,b} (a) = 0, T A
then
a T is never chosen in a pairwise comparison with some other b T , a can be deleted from T without aecting the choice probabilities of the bT
a T.
If there exists a
with
P{a,b} (a) = 0,
then
S T.
in (L1), we get
PT (T \ {a}) = PT \{a} (T \ {a}) = 1, so PT (a) = 0. a is always rejected in pairwise comparisons? In that case it is reasonable to assume the following path independence condition: if a S T , then the probability of choosing a from T should be equal to the probability of (i) rst selecting the subset S and (ii) from S choosing the element a. Formally:
What about cases where no alternative (L2) Let
S = T \ {a}
ST A
and
a S.
If
for all
b T,
then
T A,
The
Proposition 11.1
Assume that P{a,b} (a) {0, 1} for all dierent a, b / (L2) holds if and only if there is a function u : A R++ such that
Path independence
PS (a) =
for every
u(a) bS u(b)
(42)
S A.
Proof.
Step 1:
Assume path independence (L2) holds. We rst prove that
PA (a) > 0
for all
a A.
PA (a) = 0
for some
a A.
P{a,b} (a) = 0,
it follows that
for all
b A \ {a}.
Proba-
contradicting
bA PA (b)
= 1.
PA (a) > 0 for all a A, dene u(a) = PA (a). SA: u(a) . bS u(b)
PS (a) =
PA (a) = PA (S)
PA (a) = bS PA (b)
78
Step 2:
u : A R++
such that
PS (a) =
for every
u(a) bS u(b)
and
S A.
ST A
a S.
Then
PT (a) =
Step 3:
u(a) = bT u(b) u
u(b) bT u(b)
bS
and
aA:
PA (a) =
Hence
u(a) = bA u(b) /
u(a) = u (a),
where
bA u(b)
bA u
In words: In Luce's choice model, each alternative can be assigned a positive value such that the probability of choosing a given alternative from a choice set is proportional to its value. Debreu (1960) showed that path independence although reasonable at rst sight can lead to counterintuitive conclusions. Consider, for instance, the following well-known variant of Debreu's argument:
go to his destination by car or by bus. Assume the DM assigns the same probability to both
(43)
Suppose now that two buses can be used, which are completely identical, except in their colors:
A = {car,
bus)
bus).
(44)
Intuitively, since the DM according to (43) doesn't seem to care whether he goes by car or by bus, it would seem reasonable to expect that he will choose to go by car with probability and to go by bus with probability
1/2
1/2,
and
PA (car) = 1/2
PA (blue
bus)
= PA (red
bus)
= 1/4,
or at least that the probability of taking the car should be larger than the probability of taking any of the two buses. However, path independence (L2) implies
PA (car) = PA (blue
To see this, notice that
bus)
= PA (red
bus)
= 1/3.
PA (car)
(L2)
(43)
def
PA ({blue bus, car})P{blue bus, car} (car) 1 PA ({blue bus, car}) 2 1 1 PA (blue bus) + PA (car), 2 2
79
so
PA (car) = PA (blue
PA (car) = PA (red
bus)
bus).
add up to one:
PA (car) = PA (blue
= PA (red
bus)
= 1/3.
So: in the choice problem with only one bus, the DM will choose to go by car or by bus with equal probability, but when faced with the choice between going by car or going by bus in case there are two virtually identical buses, the probability of choosing the car decreases from
1/2
to
1/3.
11.2. The logit model
A = {1, . . . , n}
i A
> 0,
from
logit model
with parameter
PA (i) =
e(i)/ = (j)/ jA e
exp((i)/) . jA exp((j)/)
Our goal will be two-fold:
(45)
Notice from (42) that this is just a special case of Luce's model, where the utility assigned to each alternative
iA
is equal to
1. motivating these choice probabilities by introducing control costs, 2. studying the role of the parameter
> 0.
Control costs.
n =
p Rn : +
i=1
pi = 1 .
the set
A and has preferences over the outcomes such j if and only if (i) (j), the optimal thing to do is to choose only elements from arg maxiA (i) with positive probability. In most real-life situations, the DM cannot
guarantee the exact implementation of his choices: a careless driver may drive of the road, an absentminded shopper may by mistake buy the wrong item. To model this, we assume that it requires eort to implement choices: associated with each choice
control cost c(p) R. The (expected total) utility associated with each choice p n is dened as the dierence
between the expected payo Hence, the DM aims to solve
p n
will be a disutility or
> 0
c(p),
where
is a
positive scalar representing the relative weight assigned to the eort of implementing choice
p.
n pn
max
pi (i) c(p).
i=1
Dierent cost functions give rise to dierent choice probabilities. A common control cost function that appears in many branches of science (physics, chemistry, information science, to name but a few) is the following
entropy function :
c(p) =
i=1
pi ln (pi ) ,
(46)
80
where we use the convention that are chosen with equal probability.
0 ln 0 = 0.
Proposition 11.2
n pn
max
pi (i) c(p),
i=1
(47)
with the control cost function from (46) has a unique maximum location with
i A : pi =
the logit choice probabilities from (45).
exp((i)/) , jA exp((j)/)
Proof.
n i=1 pi (i)
c(p)
is strictly
concave. Since we maximize a strictly concave, continuous function over a compact set, a maximum exists and is unique. Since the feasible set is entirely dened by linear (in)equalities, the Kuhn-Tucker conditions give necessary and sucient conditions for a solution to be a maximum. The condition for an interior solution exists a Lagrange multiplier
p n ,
there
i = 1, . . . , n : (i) (ln pi + 1) + = 0,
since the gradient at
(48) coordinate
n i=1 pi (i)
c(p)
has
i-th
(i)
Rewriting (48) gives, for each
i = 1, . . . , n:
with
pi = c exp((i)/),
As
c = exp(( )/)
a constant.
n j=1 pj
= 1,
it follows that
i = 1, . . . , n :
as we had to show.
pi =
exp((i)/) , jA exp((j)/)
The role of .
Let us investigate what happens with the logit choice probabilities in (45) as Consider two alternatives
and as
i, j A, i = j .
(i) (j)
(49)
to one, their limits must be equal; together with the fact that probabilities add up to one, we conclude that the choice probabilities converge to
1/n
as
81
0,
suppose that
0.
Since we are dealing with probabilities here, which are bounded below by
PA (j) 0.
If we let
(i),
it follows that the probability of choosing an alternative with less than maximal
payo converges to zero. So in the limit, all probability is restricted to optimal alternatives and it is clear from the denition of the choice probabilities that all of these will be chosen with equal probability. In summary, the parameter large values of
the DM chooses by more or less blindly picking any of the alternatives, while
11.3.
The idea behind the linear probability model is the same as behind Luce's model and the logit model: the probability of choosing an alternative should be (weakly) increasing in the payo associated to the alternative:
(50)
The adjective linear indicates that the dierence between these two probabilities should be linear in the payo dierence: for a parameter we require that (51)
Unfortunately, it is not always possible to combine these two properties for large values of
. Let's consider a simple example with two alternatives: A = {1, 2} and respective payos (1) = 4, (2) = 0. By (50), we want PA (1) PA (2) and by (51), we want PA (1) PA (2) = ((1) (2)) = 4 . If we take = 1/8, this gives PA (1) PA (2) = 1/2. The probabilities have to add up to one, so the unique solution is that PA (1) = 3/4 and PA (2) = 1/4. So far, so good. Now take = 100: PA (1) PA (2) = 4 = 400. Since PA (1) and PA (2) are probabilities between zero and one, making their dierence equal to 400 (or for that matter any number larger than 1) is simply impossible.
So we have to relax our requirements (50) and (51) somewhat. Unwilling to change (50), let us adapt (51). Indeed, we require the linearity condition whenever possible, but when we run into problems like the one in the example above, we simply require that alternatives with low payo are chosen with probability zero. Formally, choice probabilities
iA
satisfy the linear probability model with parameter > 0 if the following holds:
if
PA (i)
PA (i) > 0,
then
for all
j A.
(52)
and
are chosen with positive probability, we nd from (52) that and
82
(i) (j). We need to show that the choice probabilities in the linear probability model satisfy PA (i) PA (j). Discern two cases. First, if PA (j) = 0, it automatically follows that PA (i) 0 = PA (j). If PA (j) > 0, application of (52) yields
The choice probabilities also satisfy (50): take with
i, j A
(i) (j)
and
> 0.
Combining the two points above, we see that the choice probabilities are weakly increasing in the associated payos. By necessity, we had to set the probability of choosing low-payo alternatives equal to zero, but those that are chosen with positive probability still satisfy the linearity requirement.
Control costs.
vector the
The choice probabilities can be derived in the same way as before by making
a clever choice of the cost function. Consider the cost function that assigns to every probability
p n
(1/n, . . . , 1/n)
c(p) =
i=1
pi
1 n
(53)
So choosing all alternatives with equal probability gives zero costs and costs increase the further away you go from the vector
Proposition 11.3
For each
n pn
max
pi (i)
i=1
1 c(p) 2
(54)
with the cost function given in (53). The solution coincides with the choice probabilities in the linear probability model with parameter
.
in the two optimization problems with control
The role of .
costs in (47) and (54), you will notice that they switched roles: large values of
correspond with
a large weight assigned to the control cost function in the logit model, but with a small weight assigned to the control cost function in the linear probability model. This change was necessary because I wanted to follow the standard denition of the linear probability model in (52). But the intuition remains the same: alternative (highest
model: for large values, (52) indicates that the dierence in the probability of choosing an optimal
(i))
the probability of choosing suboptimal alternatives to zero. Conversely, for small values of
(52) indicates that the dierence in the probability of Combining this with the fact that probabilities
add up to one, this implies that in the limit, all alternatives will be chosen with equal probability.
83
11.4.
Exercises
Prove Proposition 11.3. Let
(b) What happens with the choice probabilities as (c) What happens with the choice probabilities as
0?
Interpret. Interpret.
Exercise 11.3
Let
> 0,
(b) Answer the same questions for the linear probability model.
Exercise 11.4
The penalty function approach: Two of the probabilistic choice models considered
above could be rationalized using control cost functions giving a penalty to deviations from uniform randomization. This exercise gives the general argument behind such rationalizations. A penalty function on that
Rn
is a function
c : Rn R+ . A symmetric penalty function is independent n bijection r : {1, . . . , n} {1, . . . , n} and each x R , it follows A = {1, . . . , n}
with
: A R.
0,
P () :
pn
max
Show that the resulting choice probabilities satisfy the desired monotonicity requirement: if and
p solves P ()
then
pi pj .
84
Full circle
To make sure you get the big picture, let us at the end of this course turn back to where we started: the overview of the course goals in the preface, and briey summarize how we achieved them.
(Q1) What can the agent choose from, i.e., what is the set of feasible alternatives? (Q2) What does the agent like, i.e., what are the preferences over alternatives? (Q3) How are the former two combined to make a choice, i.e., to select among alternatives?
We mostly stuck to rational choice: choose from your set of feasible alternatives a most preferred one. Sections 1 to 3 provided a general framework for modeling preferences over and choice from arbitrary sets of alternatives. Important stops along the way included:
Utility theory:
utility functions are convenient tools to summarize an agent's preferences. We provided an exact Moreover, For
we provided conditions under which utility functions had some additional nice structure. terms of a numeraire in Section 2.6.
instance, continuity was studied in Section 2.5, cases where preferences could be expressed in
Existence of solutions:
(Q5) How are most preferred elements aected by changes in the agent's environment?
Below, I will go through these applications, summarize how feasible sets and preferences were dened, and if applicable indicate where we studied the answer to
(Q5).
85
x RL +
in a budget set
B(p, w). X = RL . +
x RL + px
p RL . ++
in a production set
Y RL . p RL . ++
py
at price vector
z RL1 +
wz
w RL1 . ++
G,
under some
assumptions resulting in a von Neumann-Morgenstern utility function. Changes in agent's environment: see Section 8 on risk attitudes.
c = (ct ) t=0
t.
Preferences: come in dierent forms, for instance: 1. represented by a utility function of the form 2. in terms of the limit of means criterion, 3. in terms of the overtaking criterion.
U (c) =
t=0 (t)u(ct ),
in some probabilistic choice models like the logit and linear probability model, agents choose probabilities as if they maximize expected payos subject to implementation costs: Feasible alternatives: choice probabilities assigned to a nite set
of alternatives.
Preferences: represented by a utility function of the form expected payo minus control costs; see Propositions 11.2 and 11.3.
86
I hope that the tools you acquired during this course will help you to address also other economic problems in a structured way.
87
Notation
If
is a nite set,
|X|
A is also an element of B ): A B . B , but A = B ): A B . Set of positive integers: N = {1, 2, 3, . . .}. Set of integers: Z = {. . . , 2, 1, 0, 1, 2, . . .}. Set of rational numbers: Q = {p/q : p, q Z, q = 0}. Set of real numbers: R. For arbitrary L N : L L L Set of vectors in R with nonnegative coordinates: R+ = {x R : x1 , . . . , xL 0}. L with positive coordinates: RL = {x RL : x , . . . , x > 0}. Set of vectors in R 1 L ++ L Sets like Q++ are dened analogously. L For two vectors x, y R , their inner product is denoted by x y = x1 y1 + + xL yL .
Weak set inclusion (each element of Strict/proper set inclusion (A Moreover, write
xy x>y
Relations For
if if
xi yi xi > yi
i = 1, . . . , L, i = 1, . . . , L.
and < are dened analogously. k {1, . . . , L}, ek RL denotes the k -th ek = (0, . . . , 0,
k -th
coordinate equal
k
The vector of ones is denoted by
th coordinate
, 0, . . . , 0).
e = (1, . . . , 1) RL .
88
References
Anderson, S.P., de Palma, A., Thisse, J.-F., 1992. Discrete choice theory of product dierentiation. MIT Press. Arrow, K.J., 1959. Rational choice functions and orderings. Economica 26, 121-126. Arrow, K.J., Hahn, F.J., 1971. General competitive analysis. Amsterdam: North-Holland. Ben-Akiva, M., Lerman, S.R., 1985. Discrete choice analysis. MIT Press. Cobb, C.W., Douglas, P.H., 1928. A theory of production. American Economic Review (supplement) 18, 139-165. Debreu, G., 1954. Representation of a preference ordering by a numerical function. In: Decision Processes. Thrall, Davis, Coombs (eds.), John Wiley, pp. 159-165. Debreu, G., 1959. Theory of value. Yale University Press. Debreu, G., 1960. Review of R.D. Luce, Individual Choice Behavior: A Theoretical Analysis. American Economic Review 50, 186-188. Debreu, G., 1964. Continuity properties of Paretian utility. International Economic Review 5, 285-293. Diecidue, E., Wakker, P.P., 2002. Dutch books: avoiding strategic and dynamic complications, and a comonotonic extension. Mathematical Social Sciences 43, 135-149. Dubra, J., Echenique, F., 2001. Monotone preferences over information. Topics in Theoretical Economics 1, article 1.
http://www.bepress.com/bejte/topics/vol1/iss1/art1
Fishburn, P.C., 1970a. Utility theory for decision making. New York: John Wiley & Sons. Fishburn, P.C., 1970b. Intransitive individual indierence and transitive majorities. Econometrica 38, 482-489. Fishburn, P.C., 1979. Transitivity. Review of Economic Studies 46, 163-173. Hildenbrand, W., Kirman, A.P., 1988. Equilibrium analysis. North-Holland. Jaray, J.-Y., 1975. Existence of a continuous utility function: An elementary proof. Econometrica 43, 981-983. Kahneman, D., Tversky, A., 1964. Prospect theory: an analysis of decision under risk. Econometrica 47, 263-291. Kamke, E., 1950. Theory of sets. New York: Dover Publications. Kaneko, M., 1976. Note on transferable utility. International Journal of Game Theory 5, 183-185. Koopmans, T.C., 1960. Stationary ordinal utility and impatience. Econometrica 28, 287-309. Kreps, D.M., 1990. A course in microeconomic theory. Hertfordshire: Harvester Wheatsheaf. Loewenstein, G., Prelec, D., 1992. Anomalies in intertemporal choice: evidence and interpretation. Quarterly Journal of Economics 107, 573-597. Luce, R.D., 1959. Individual choice behavior: A theoretical analysis. Wiley. Mas-Colell, 1985. The theory of general economic equilibrium; A dierentiable approach. Cambridge: Cambridge University Press. Mas-Colell, A., Whinston, M.D., Green, J.R., 1995. University Press. Mattsson, L.-G., Weibull, J.W., 2002. Probabilistic choice and procedurally bounded rationality. Games and Economic Behavior 41, 61-78. Osborne, M.J, Rubinstein, A., 1994. A course in game theory. Cambridge, MA: MIT Press. Phelps, E.S., Pollak, R.A., 1968. On second-best national saving and game-equilibrium growth. Review of Economic Studies 35, 201-208. Pratt, J.W., 1964. Risk aversion in the small and in the large. Econometrica 32, 122-136. Microeconomic theory. Oxford: Oxford
89
Rabin, M., 2000. Risk aversion and expected-utility theory: a calibration theorem. Econometrica 68, 1281-1292. Rosenthal, R.W., 1989. A bounded-rationality approach to the study of noncooperative games. International Journal of Game Theory 18, 273-292. Rubinstein, A., 2006. Lecture notes in microeconomic theory. Princeton NJ: Princeton University Press. 99-118. Simon, H.A., 1976. From substantive to procedural rationality. In: Method and Appraisal in Economics. Latsis, S.J. (ed.), Cambridge University Press, pp. 129-146. Starr, R.M., 1997. General equilibrium theory. Cambridge University Press. Thaler, R., 1981. 201-207. Varian, H.R., 1992. Microeconomic analysis. New York: W.W. Norton & Company, 3rd edition. Voorneveld, M., 2006. Probabilistic choice in games: properties of Rosenthal's ternational Journal of Game Theory 34, 105-121. Voorneveld, M., 2007. The possibility of impossible stairways: Tail events and countable player sets. To appear in Games and Economic Behavior. Voorneveld, M., 2008. From preferences to Cobb-Douglas utility. SSE/EFI Working Paper Series in Economics and Finance, No. 701. Wrneryd, K., 2007. Sexual reproduction and time-inconsistent preferences. Economics Letters 95, 14-16. Some empirical evidence on dynamic inconsistency. Economics Letters 8,
http://arielrubinstein.tau.ac.il/Rubinstein2007.pdf
A behavioral model of rational choice. Quarterly Journal of Economics 69,
t-solutions.
In-
90
Suggested solutions
These are (sometimes short) solutions to most exercises in the lecture notes. In solutions to the home assignments and exam questions, you are expected to start from relevant denitions, and clearly deduce and motivate your answers. potential mistakes?) are welcome! Suggestions for improvements (and corrections of
x x
is found before or at the same place as (in case the words are identical) word
in the is A
(b):
violation of completeness occurs if there exist people who are unfamiliar with each other. Also violations of transitivity are common: I know my wife, my wife knows her boss, but I do not know my wife's boss.
: x x and (simply changing the : x x. Conclude that is reexive. Let x, y X with x y . By denition of , x y and y x. But this is also the denition of y x. Conclude that is symmetric. [Transitivity of ] Let x, y, z X have x y and y z . By denition of , this means that x y , y x, y z , z y . By transitivity of , x y and y z give x z . Similarly, z y and y x give z x. Since x z and z x: x z . Conclude that is transitive. (b): [Irreexivity of ] Let x X . By denition of , x x would require that x x but not x x, a contradiction. Conclude that is irreexive. [Asymmetry of ] Let x, y X with x y . By denition of , x y but not y x. By denition of , not y x. Conclude that is asymmetric. [Transitivity of ] Let x, y, z X have x y and y z . By denition of , this means that x y but not y x and that y z , but not z y . By transitivity of , x y and y z give x z . It is not true that z x. If it were, transitivity of with z x and x y would imply z y , contradicting y z . Since x z , but not z x: x z . Conclude that is transitive. (c): Let x, y, z X have x y and y z . By denition of , this implies that x y . As x y and y z , transitivity of gives x z . Let By completeness of
x X.
x.
By denition of
> 0.
is
k {1, . . . , L} be one of the coordinates, let x X , x + ek x and x + ek = x, so by strong monotonicity, x + ek x. Conclude strongly monotonic in coordinate k .
is strongly monotonic. Let Then is strongly monotonic in each of its coordinates and transitive. Let
x, y X
for
x y and x = y . To show: x y . Starting with x, change the coordinates one by one to those of y . Formally, let z(0) = x and, k each k {1, . . . , L}, dene z(k) = x + =1 (y x )e . Then either z(k) = z(k 1) if the
with
91
k -th
coordinates of
and
(b):
k -th
R2 +
x, y R2 : + (2, 2)
y xk > yk
k {1, 2}
k for both k = 1 and k = 2, but not strongly monotonic: (1, 1). Notice: in line with (a), relation is not transitive. (c): No. The point (0, . . . , 0) RL cannot be improved upon: since less is better, (0, . . . , 0) x + L for every x R+ with x = (0, . . . , 0).
is strongly monotonic in coordinate is not strictly preferred to
(d):
Yes. Notice that the issue above, that improvements beyond the zero vector are impossible
y = x
2 e1
RL . Then
x RL
and
> 0.
in the rst
with
y = (2, 1).
Then
so
x y.
and
by
> 0.
Then so
x + e1
y + e1 .
(b):
on
for all
x, y ,
monotonic in coordinate 1.
(c): Same preference relation as in (b). (d): The preference relation on R2 with +
x 02 12 , but y
2 4x1 + 3x2 4y1 + 3y2 2
satises all three monotonicity properties, but is not homothetic. For instance,
(1, 0)
(0, 1),
as
41+3
>40+3
2(1, 0)
2(0, 1),
as
42+3
02
<40+3
22 .
x y . For each n N, xn = x + (1/n, . . . , 1/n) RL satises xn > y , + so xn y (in fact, even xn y ). Letting n , continuity implies that limn xn = x y . (b): Let x, y RL have x > y . Then min{x1 , x2 } > min{y1 , y2 }, so x y , but not y x, i.e., + x y . Let x = (2, 1) and y = (1, 1). In both cases, you can only mix one unit of drink, but x wastes one unit of the rst ingredient, so even though x y , x y.
have
Exercise 1.6
92
(a):
that
y X.
To show:
{x X : x
y}
is a
Using completeness of
y,
so
z + (1 )z
y by transitivity of x, y X with x y
. and
[0, 1].
y. Elements x and (by completeness) y both lie in the set {x X : x y}, assumption, so it also contains x + (1 )y . Conclude that x + (1 )y (b): Consider the preference relation on R with x, y R : x y x 0 > y. R+
if if
x + (1 )y
which is convex by
y.
For each
y R: {x R : x x + (1 )y y} = y 0, 0 > y, x = 1, y = 3, = 1/2,
y,
but not
y,
y, y
z.
By denition,
x y+1
and
y z + 1, x,
x y + 1 z + 2 z + 1, x x + 1.
so
z.
Let x, y R. If x y , then x y , so x y + 1. Therefore, u(x) = x y + 1 > y = u(y). Moreover, there are no x, y X with x y (as this would require x y + 1 and y x + 1), so the second condition is vacuous. [Prop. 2.1(a) violated] u does not represent , since is not complete and the order induced by u is.
(u1 , u2 )
(v1 , v2 ).
The intervals
(u1 , u2 )
and
(v1 , v2 )
each such interval contains a rational number, necessarily distinct from the one in the other interval, since these intervals are disjoint. Therefore, there is an injective function from the uncountable set of jumps to the countable set of rational numbers, a contradiction.
J and R and therefore countable itself. Let x, y X y . To show: there are c1 , c2 C with x c1 c2 y . Case 1: (u(y), u(x)) is a jump in U . By denition of J , there are points c1 , c2 J C with utility u(c1 ) = u(x), u(c2 ) = u(y). Hence x c1 c2 y , as in the requirement for Jaray
is the union of two countable sets with
(b): C
x
order-separability. a
Then (u(y), u(x)) U = . By denition of R, there is c R C with u(c) (u(y), u(x)). Now apply the reasoning so far to (u(c), u(x)). If it is a jump in U , Case 1 says that there are c1 , c2 C with x c1 c2 c y , as in the requirement for Jaray order-separability. If it is not a jump, repeating the construction of Case 2 says that there is a
c C
with
so that
y,
Jaray order-separability.
93
(c):
x, y X . If x y , there exist, by Jaray order-separability, c1 , c2 C with x c1 c2 y . Therefore, {c C : c x} {c C : c y}, as the former set includes c1 , whereas the latter doesn't. Conclude that u(x) u(y) 2n(c1 ) > 0. If x y , then {c C : c x} = {c C : c y}, so u(x) = u(y).
Let
Exercise 2.3 (a): True. By denition of a continuous function, pre-images of open sets are open sets.
quently, for each
Conse-
x X,
the sets
{y X : y
x} = u1 ((, u(x))
open
and
{y X : y
x} = u1 ((u(x), ))
open
(b)
on R is represented by the continuous u : R R with u(x) = x and hence, by (a), continuous. However, any strictly function u : R R represents , including the discontinuous function u(x) = x x+1
if if
x < 0, x 0.
Exercise 2.4
No. Lexicographic preferences (modied in such a way that you start comparing the second coordinates, then the rst) on
R2 +
x, y R2 +
have
x2 > y2 . x.
preference started by looking at these second coordinates, so no matter how much money
y,
Here is an example where preferences can be represented by a utility function. It makes having a second coordinate below one so bad, that you can never compensate this with money and make it look as nice as an alternative whose second coordinate is at least one. The preference relation on
R2 +
u(x) =
where
(x1 ) + 1 (x1 )
if if
x2 1, x2 < 1,
: R (0, 1)
satises all properties in Proposition 2.11, except (8). Under additional assumptions (like continuity, monotonicity), the answer is yes. See Rubinstein (2006, Lecture 4).
m = m = 0, or one of the alternatives is strictly preferred over the other, w.l.o.g. (a, 0) (a , 0). In the latter case, invoke the rst property to conclude that there is an amount of money m such that (a, 0) (a , m ). Take m = 0, m = m . (b): W.l.o.g., m w. By the third property with c = w m:
Either in which case we take
(a, 0) (a , 0),
so
(a , w ) (a , m + (w m))
Let
by transitivity of
But then
w = m + (w m)
by strong
monotonicity in money.
(c):
u(a, m) u(a , m ). By the rst two properties, there are unique amounts of money m1 , m2 0 such that (a, m) (a , m1 ) and (a , m ) (a , m2 ). By denition of v , we nd that
To show:
(a, m), (a , m ) X .
(a, m)
(a , m )
if and only if
u(a, m) = (m1 m) + m = m1
Therefore,
u(a , m ) = m2 .
(55)
(a, m)
(a , m ) (a , m1 ) m1 m2
(a , m2 )
u(a, m) u(a , m ),
where the rst equivalence follows from the fact that
(a, m) (a , m1 )
and
(a , m ) (a , m2 ),
the second equivalence from strong monotonicity in money, and the nal one from (55).
Xu (r) contains at most one element, it is convex. If it contains two or more, (0, 1). To show: x + (1 )y Xu (r). Without loss of generality, assume that x y , so that u(x) u(y) r. By convexity of : x + (1 )y y , so u(x + (1 )y) u(y) r, i.e., x + (1 )y Xu (r). (b): Let's do the quasiconcavity part; strict quasiconcavity proceeds similarly. Assume u : X R is quasiconcave. Let y X . To show: {x X : x y} is a convex set. By denition, {x X : x y} = {x X : u(x) u(y)} = Xu (r), with r = u(y). The latter
If
x, y Xu (r)
and let
(c):
A function
on a convex domain
X=R 0 1
if if
u(x) =
This preference relation is convex, as, for each
x 0, x > 0.
the upper contour sets are convex: if if
y X,
{x X : x
Suppose and
y} =
R (0, )
y 0, y > 0.
v : X R were a concave utility function representing . By denition, (1, v(1)) (1, v(1)) are elements of subgraph(v). Take = 1/2 and consider the convex combination 1 1 1 1 (1, v(1)) + (1, v(1)) = (0, v(1) + v(1)). 2 2 2 2
Since
v:
n N, f (nu) = nf (u) by additivity and induction on n. f (0) = f (0 + 0) = f (0) + f (0), so f (0) = 0. Hence f (0u) = 0f (u). For all n N, f (nu) = nf (u): indeed, 0 = f (0) = f (nu + (nu)) = f (nu) + f (nu), so f (nu) = f (nu) = nf (u). So f (xu) = xf (u) for all x Z. For x Q, write x = p/q for some p, q Z, q = 0. Rewriting xu = (p/q)u gives q(xu) = pu. Hence f (q(xu)) = f (pu). By the above, qf (xu) = pf (u), so f (xu) = (p/q)f (u) = xf (u).
For all
(b):
and
If f is not linear, there are x, y R\{0} with f (x)/x = f (y)/y . Hence, vectors a = (x, f (x)) b = (y, f (y)) are linearly independent: vectors a + b with , R span R2 . So vectors a + b with , Q are dense in R2 . The latter vectors are in the graph of f : for , Q, (a) implies that
(c):
For each
i {1, . . . , n},
dene
fi : R R
as follows:
xi R :
Applying additivity of
fi (xi ) = F (xi ei ). x Rn
n
that
F (n 1)
F (x) = F
i=1
To see that each
xi e i
=
i=1
F (xi ei ) =
i=1
fi (xi ). F:
fi
xi , yi R.
By additivity of
f,
on
with
x, y X :
has open lower contour sets: for each
y f (x) f (y)
x X,
L(x) = {y X : y
of
is the pre-image of an open interval. By Proposition 3.1, , this best element is a maximum of
f.
with
x, y X :
y f (x) f (y).
on for
x C(B) = {z B : z
96
y A and x C(A) = {z A : z z for all z A}: x y C(B): y z . Using x y and transitivity of : x z . So x x C(B).
Since
y. z
Let for
(b):
X = {a, b, c, d}, B = {{a, b, c}, {b, c, d}}, C({a, b, c}) = {b}, C({b, c, d}) = {c}.
It trivially satises IIA: there are no distinct sets WARP: in the rst problem, least as good as
A, B B
(c):
b.
So
No.
The choice structure in (b) satises IIA, but is not rationalizable. rationalizes it. Since
contrary, that
C({a, b, c}) = {b}, we must have that b c and b a. Since C({b, c, d}) = {c}, we must have that c b and c d. But then b c, so c b a implies c a. But then c y for all y {a, b, c}, so c should have been included in C({a, b, c}). (d): No. Consider the choice structure with X = {a, b, c}, B = {{a, b}, {b, c}, {a, c}}, C({a, b}) = {a}, C({b, c}) = {b}, C({a, c}) = {c}. As distinct choice sets have only one point in common, WARP is trivially satised. It is not rationalizable, as a rationalizing should satisfy a b, b c, c a, in violation of transitivity.
Let
A, B B , x, y A B , x C(A),
By denition of
and
y C(B).
To show:
x = y.
C: C(B)
selects one of them. (56)
B B :
if
Distinguish two cases: Then also v(y) < r by (56). Now x C(A) implies that x is the largest A. In particular, since y A: y x. Similarly, y C(B) implies that x y . So x = y C(B). Case 2: v(x) r. Then also v(y) r by (56). Now x C(A) implies that x is the smallest satisfactory element of A. In particular, since y A: x y . Similarly, y C(B) implies that y x. So x = y C(B). element of conditions need to be satised: A satisfactory element
is always preferred to a nonsatisfactory one; Among nonsatisfactory alternatives, the largest is chosen, so there having a high index is preferable. Among satisfactory alternatives, the smallest is chosen, so there having a low index is preferable. One weak order (verify!) rationalizing the choice structure is obtained by writing down (from worst to best) all nonsatisfactory alternatives from smallest to largest, then all satisfactory alternatives from largest to smallest. By denition of
(b): [IIA violated] For each B B, let x (B) be your partner's most preferred element of B .
C : C(B) = B \ {x (B)} for each B B with more than one element. Take B = X, A = C(B). Both sets lie in B and A B . Moreover, C(B) A = C(B) = . IIA would imply that C(A) = C(B) A = C(B), but C(A) = A \ {x (A)} A = C(B), a contradiction.
[WARP violated] WARP implies IIA and is therefore violated as well. [Rationalizability] As WARP is violated, the choice structure is not rationalizable.
Exercise 3.5
97
In
B1 ,
Similarly, lie in
wealth
w=2
on the
Yes, there is no set-inclusion between the two choice sets, so IIA holds vacuously.
x C(B1 )
and
y C(B2 ), x.
whereas if if if
would require
x1 x2 u(x, p) = x1 x2
u,
it is continuous. For-
the set
{x X : x
y}
is closed.
i {1, . . . , L}
such
so
y.
x > y,
then
y.
u(0, . . . , 0) = u(1, 0, . . . , 0) = 0,
i.e., if you start with nothing, but get one unit of the rst ingredient, you still cannot bake a cake due to lack of all the other ingredients!
Let
y RL +
and let
u(y) = .
Then
is the intersection of convex halfspaces and therefore convex. For a violation of strict convexity, take to make one cake: for each
x y x + (1 )y,
in contradiction with strict convexity.
Indivisibilities: B(p, w) Z2 . +
98
p2 = 4 and any additional ones only 2. 2 : x 5, p x w} {x R2 : x > 5, 8x + 2x 40}. Rebates 2: {x R+ 2 2 1 2 + Initial endowment: {x R2 : p x p }. + Package deal: B(p, w) {x R2 : x1 = x2 }. + Gift certificate: B(p, w) {x R2 : x1 1/p1 , p1 (x1 1/p1 ) + p2 x2 w}, +
acquires
being the budget set if he does not use the gift certicate, the second one if he does and therefore
1/p1
Rebates 2, Rebates 2,
the budget sets are nonempty, compact, so a most preferred bundle the budget set is not closed (it doesn't contain the boundary point there is no optimal bundle in the budget set. Drawing the
(30/8, 5))
and a most preferred bundle need not exist. For instance, if the utility function of the
consumer is
budget set and some indierence curves will help you to verify this.
Exercise 4.3
Walrasian demand is homogeneous of degree one in wealth: for all if
and all > 0, x x(p, w). Proof. Suppose not: there is a z B(p, w) with z x. Then y := (1/)z B(p, w). As x x(p, w), x y . As is homothetic, also x y = z , contradicting that z x.
(p, w) RL+1 ++
x x(p, w),
then
u(x) = x1 + x2 .
p1 > p 2 , p1 > p2 .
the consumer spends the entire income on the second commodity, so Increasing
v(p, w) = w/p2
p1
even further does not aect indirect utility, i.e., indirect utility is not
(b):
(pn , wn )nN
in
RL+1 ++
with limit
n N, let xn x(pn , wn ), which is possible by the assumptions in Proposition B(pn , wn ) for all n and (pn , wn ) (p, w), the sequence (xn )nN eventually lies in the slightly enhanced budget set B(p, w + 1), which is compact: taking a subsequence if necesn sary, we may assume w.l.o.g. that the sequence (x )nN is convergent, with limit x X . The n n n sequence (p , w , x )nN satises the properties of Proposition 4.3(b). In particular, x x(p, w), n n n i.e., limn v(p , w ) = limn u(x ) = u(x), by continuity of u.
n 4.4. As x
Proof.
v(p, w).
(c):
utility functions, which may cause jumps in the indirect utility function as well. For instance, suppose a consumer has continuous utility function
U : R+ R
with
U (x) =
min{x, 1}
and hence continuous preferences. These preferences can also be represented by the
u : R+ R
with
u(x) =
Notice that
x 2
if if
x 1, x > 1.
if if
x(p, w) =
w p, w > p.
is
v(p, w) =
with discontinuities at all points where
w/p 2
if if
w p, w > p,
p = w.
(b):
Exercise 4.6
Let
(p, w) RL+1 ++
and
Law,
p x = w.
For each
p RL , x ++
is feasible
f : RL R ++
with
f (p ) = v(p , p x)
p = p.
By the
p:
= 1, . . . , L :
As
x = x(p, w)
and
p x = w,
Exercise 4.7
By (15), indirect utility solves By (17),
L i=1 ai pi .
.
Exercise 4.8
We know from (18) that using the Chain rule gives
pk
and
e(p,u) pk
= hk (p, u):
u = v(p, w)
that
u = v(p, w) that e(p, u) = e(p, v(p, w)) = w h(p, u) = h(p, v(p, w)) = x(p, w), so:
Exercise 4.9
Indivisibilities, rationing, package deals, as well as the specic initial endowment certicate imply a larger budget set and therefore a (weakly) higher welfare.
= (1, 1)
imply smaller budget sets and therefore a (weakly) lower welfare. Rebates 1 and 2 and the gift
Exercise 4.10
As
As
x0
p1 y w 1
for all
with
strictly
Exercise 4.11
Write
A=
x(p, w) = v(p, w) =
aL w a1 w , ..., A p1 A pL w A
A L
, ,
i=1 L
ai pi pi ai pi ai
L
ai
ai /A
h(p, u) = u1/A
i=1 L 1/A i=1
a1 aL ,..., p1 pL ,
ai /A
e(p, u) = Au
p0 i ai
L
ai /A
w0 , p1 i ai
ai /A
It is commonly assumed (w.l.o.g., as this is just a monotonic transformation of the utility) that
A = 1,
Section 5 Exercise 5.1 (a): Y {y RL : y } is the intersection of closed sets, hence closed.
vector It contains the zero suciently large. By assumption,
(b): (c):
Let as
0. (yn )nN
diverges to innity,
yn + 0 , z zn
so dividing by
yn
gives
zn = zn + / yn
1 yn
yn 1 for n yn + 1 y1 0 Y . n 0.
zn
z = 0, as it is the limit of a sequence of vectors of length one. Secondly, Y for n large, and Y is closed, also the limit z lies in Y . (d): Letting n , and realizing that / yn 0, (b) implies that z 0. As z = 0, this
be its limit. Firstly, contradicts no free lunch.
Exercise 5.2
solvable.
(a):
Dene qz = f (z) 0. The CMP at (w, qz ) has a solution and z is feasible in this CMP, so c(w, qz ) w z . Conclude that pf (z) w z pqz c(w, qz ). (b): Let zq solve the CMP at (w, q), i.e., zq RL1 , f (zq ) q , and c(w, q) = w zq . Conclude + that pf (zq ) w zq pq c(w, q). (c): Assume (P1) has a solution z (the case where (P2) has a solution is similar). By (a), there is a feasible qz in (P2) with equal or higher prot. It cannot be higher. Otherwise, by (b), there is a feasible zqz in (P1) yielding a higher prot than qz and therefore higher than the prot maximizing z , a contradiction. Conclude that qz solves (P2) and yields the same prot as z in (P1).
The also
Y = {y R2 : y (1, 1), (y1 1)2 + (y2 1)2 2}. The point (0, 0) is ecient, but not prot maximizing for any nonzero vector p R2 : if p1 p2 , then Y + (1, 1 2) Y yields a positive prot, and if p1 p2 , then (1 2, 1) Y yields a positive prot, whereas (0, 0) Y yields only zero prot.
Consider the production set
(c):
Section 6 Exercise 6.1 (a): Look at the denitions of improvements and Pareto optimality:
S=H
of all consumers cannot improve upon the fact that the coalition
everybody better o. But there may still be room for improvement for some if not all consumers:
it may still be Pareto dominated.
(b):
Consider a pure exchange economy with two consumers and two commodities. The rst con-
u1 (x) = x1 x2 ,
102
1 = 2 = (1, 1),
then
sticks to the initial endowment) is a Walrasian equilibrium. By Proposition 6.2, the allocation lies in the core. But the allocation is not Pareto optimal: giving the total endowment to the rst consumer makes him better o, while not aecting the happiness of the second consumer.
p z = k:pk >0 pk zk = 0. As the sum of nonpositive terms, it can be zero only if z = 0 whenever p > 0. (b): Let p, z, be as in the statement of the exercise. As zk = 0 for k = , Walras' Law implies p z = p z = 0. As p > 0, this implies z = 0. (c): If in equilibrium the market for good {1, . . . , L} does not clear, its price is zero by (a). So consumer h is not constrained in his consumption of . In equilibrium, h must choose a
By Walras' Law, most preferred bundle from the budget set, but there is none: under (c1), each bundle can be improved upon by adding more of good axes, as ; under (c2), a most preferred bundle can't lie on the
RL ; ++
more of good
Preferences of rms
(p, x, y)
be a Walrasian equilibrium of
E.
(, y ) x
Pareto dominating
h H :
nonsatiation implies
h h
xh p xh p xh = p h + xh p xh > p xh = p h +
f F f F
hf y f , hf y f . h H.
By Pareto dominance, such a weak preference holds for all, and strict preference for some Summing over at prices
hH
(y f )f F
gives
p
hH
xh > p
hH
xh p h + hf y f
f F
=
hH
= p+p
f F
yf yf .
f F
p+p
But
hH
xh > p + p
f F
yf
contradicts feasibility of
(, y ). x
Exercise 6.4
Pure exchange economies:
You may verify that the following pure exchange economies
E =(
(a):
1,
Let
R2 , 1 = (1, 0), +
and
2 = (0, 1).
There is
no Walrasian equilibrium:
103
p has both prices positive, then consumer 1 demands 1 (p2 /p1 , 0), so there is excess demand for the rst commodity;
if
if one of the commodities has price zero, demand for this commodity is unbounded.
(b): (c):
and
if one of the commodities has price zero, demand for this commodity is unbounded: there are no Walrasian equilibria at such prices; if both prices are positive and i.e., the bundle the entire
p1 > p2 , the rst consumer demands a bundle with 2x1 = x2 , (p 1 /(p1 + 2p2 ), 2p 1 /(p1 + 2p2 )) and the second consumer spends 2 income on the second commodity, i.e., demands the bundle (0, p /p2 ). In
particular, demand for the second commodity is at least twice the demand for the rst commodity. As the total endowment of both commodities is equal, not both markets can clear at the same time, contradicting the fact that (given local nonsatiation) markets with a positive price must clear. There are no Walrasian equilibria at such prices; similarly, Walrasian equilibria with positive prices and if both prices are positive and equal, i.e., is
p2 > p1
p = (1/2, 1/2),
(d):
Preferences
1,
1 bundles; xh B h (p, p
= h)
2 are such that the consumers are indierent between all commodity (1, 1). Every (p, x) with p and x = (x1 , x2 ) R2 R2 with + +
for both
h = 1, 2
is a Walrasian equilibrium. Take the examples above and give the producers the trivial
{0} consisting of the remarkable feat of producing absolutely nothing using abso-
lutely nothing. If you prefer slightly larger production sets, you may want to choose them equal
R2 ,
containing all production plans producing absolutely nothing, possibly using something.
Exercise 6.5
Feasible allocations: {(xT , xL ) R2 : xT + xL 1}. + Pareto optimal allocations: Must be nonwasteful, otherwise
otherwise the true mother can be made happier by giving her allocations
to the liar, who becomes happier, while the true mother is not harmed. Moreover,
xT (0, 1): /
Only
(0, 1)
and
(1, 0)
Core:
( T , L ).
x=
(xT , xL ).
The liar can improve upon any allocation with For the true mother:
xL < L ,
so
xL L
in the core.
if if
T = 0,
xT {0, 1},
T (0, 1), T = 1,
xT = 1.
104
The coalition of both women can improve upon any feasible allocation with
xT (0, 1)
by
{0, 1}
in the core.
T (0, 1),
Walrasian equilibria:
is
( T , L ).
As
equilibrium involves a nonzero price vector, we may assume w.l.o.g. that the equilibrium price
p > 0.
The true mother demands The liar demands
if
T [0, 1)
and
if
T = 1.
L.
T [0, 1),
T if
= 1.
G:
max{a1 , . . . , ak }.
Worst elements of
G:
min{a1 , . . . , ak }.
(G1) satisfied: (G2) violated:
preferences represented by utility function assume w.l.o.g. that
u(g) =
1 |L(g)|
ai L(g) ai .
and
a1 > a2
a1
(pa1 , (1
the
p) a2 ).
If
p > 1/2, a1
a1 ( 1 a1 , 1 a2 ). 2 2
However, at
p = 1/2,
< a1
preferences are dened in terms of reduced simple gambles: assume w.l.o.g. that
u(g) = u(gs ). g = a1
to
a1 > a 2 .
g = a2 .
( g, (1 ) a1 )
for all
( g , (1 ) a1 ) a1
is the most likely outcome in both
(0, 1).
However, for
close to zero,
gambles, so the DM is indierent between them. As (G2) and (G4) are violated, Remark 7.3 implies that vNM utility function. cannot be represented by a
(b):
105
G: deterministic outcome max{a1 , . . . , ak }. Worst elements of G do not 1 1 exist: for each g G, the gamble ( g, g) has higher complexity and is therefore worse 2 2 than g .
Best element of
G1 ,
u(g) =
k m=1 pm am
is continuous.
1 (G3) violated: the gambles a1 G0 and ( 1 a1 , 2 a1 ) G1 both have reduced simple 2 gamble (1 a1 ), yet the former lies in G0 and is therefore strictly preferred to the latter in
G1 .
(G4) violated:
Let
g g g
Let
= a1 G0 , = ( 1 a1 , 1 a1 ) G1 , 2 2 1 = ( 2 g , 1 g ) G2 . 2
(0, 1).
By construction,
( g, (1 ) g ), ( g , (1 ) g ) G3 .
Hence
u(g) = a1 0, u(g ) = a1 1, u( g, (1 ) g ) = a1 3, u( g , (1 ) g ) = a1 3,
in violation of (G4). As (G3) and (G4) are violated, Remark 7.3 implies that vNM utility function. cannot be represented by a
(c):
To characterize the best and worst elements of 1.
G,
one on outcomes
am > 5
(utility equal
G:
am 5 (utility equal
ak
exceed 5 or all
ak
(one in the former case, zero in the latter), so all gambles are equivalent (and hence both best and worst elements of Shortcut: for each every
G).
i = 1, . . . , k , dene u(ai ) = 0 if ai 5 and u(ai ) = 1 otherwise. Then for g G with reduced simple gamble (p1 a1 , , pk ak ), we have u(g) = i:ai >5 pi = k must satisfy (G1) i=1 pi u(ai ), i.e., this denes a vNM utility function. By Remark 7.3,
to (G4).
106
u(ct ) > 1/(t) for each time t. Then (t)u(ct ) > 1 at each time t and (b): Let u be bounded by B R and let c = (ct ) be an arbitrary t=0 B(t) = B (t) converges. By each t, |(t)u(ct )| B(t) and t=0 t=0 summable sequences, also t=0 (t)u(ct ) converges.
utility
u(h, k) = 1, u(d, k) = 0,
u(h, ) = 1,
so the so the
(a2) k (b) k
u(d, ) = ,
optimal action is
u(d, ) +
1 2 (u(h,
) + u(d, k)) = + k k
1 2 (1
u(d, k) + 0 = 0, 1 + 0) = 2 , so
if
and
1 2 1 if 2 1 if 2
< 0, = 0, > 0.
1 (c) If the severity of the depression is relatively small ( 2 > 0), an initially depressed person
may decide not to take his life in the hope of becoming happy later while still having the option of suicide in case of continued depression.
Exercise 10.3
Preferring one apple today over two apples tomorrow means that
1 1+
Given
1 + 365 1 + 366 /
. simply , > 0
= .
1 1+
or similarly
<
1 + 365 1 + 366
1 < 1+
u(1) u(2)
<
1 + 365 . 1 + 366
107
Notice that
>0
implies that
0<
The expression
(u(1)/u(2))1/ is a continuous function of > 0. As u(1)/u(2) (0, 1), it goes to zero to as 0 and to one as . By the Intermediate Value Theorem, there exists, for 1/ lies between the two desired bounds. each > 0, a > 0 such that (u(1)/u(2))
lim inf t xt = c implies [L1] and [L2]: Let > 0. As limt inf{xs : s t} = c, T N such that c < inf{xs : s t} < c + ,
for all
Exercise 10.5
there is a
t T.
t = T:
c < inf{xs : s T },
so
c < xt for all t T , proving [L1]. Let T N and apply the second inequality
t = max{T, T }:
tT
with
x t < c + ,
> 0.
By [L1] there is a
T N
such that
c /2 < xt
for all
t T.
Hence,
c < c /2 inf{xs : s T }.
As the inmum increases weakly if the bound
t T:
(57)
t T,
there is an
st
such that
xs < c + /2 < c + ,
i.e.,
inf{xs : s t} c + /2 < c + .
Combining (57) and (58) gives that for each
>0
there is a
T N
Exercise 10.6
It suces to show, for an arbitrary sequence
> 0 : xt >
108
t.
(): Assume
lim inf t xt > 0. If the liminf is innite, the weakly increasing sequence of inma inf{xs : s t} diverges, so there is a T N with inf{xs : s T } 1. In particular, xt 1 for all t T . If the liminf is nite, [L1] with = c/2 implies that there is a T N with xt > c = c/2 for all t T . (): Assume there is an > 0 such that xt > for all but nitely many t: there is a T N such that xt > for t T . Then inf{xs : s t} for t T , so also the limit of the inma exceeds : it must be positive!
is unbounded, the liminf of average payos need not converge. For instance,
(b):
1)2
Let
x = (xt ) dened recursively by x0 = 1 and, for all t N, xt = t=0 t1 1 xk , has time average T T 1 xt = T , so its liminf diverges to innity. k=0 t=0 = (xt ) and y = (yt ) be two bounded sequences. We need to investigate whether t=0 t=0 1 lim inf T T
T 1
(xt yt ) > 0
t=0
1 lim inf T T
T 1 t=0
T 1
yt .
t=0
(59)
To see that this is not the case, let using, for any sequence superior is dened
x = (0, 0, . . .) be the zero sequence. Substitution in (59) and z = (zt ) , that lim inf t zt = lim supt zt where the limes t=0 analogously to liminf as lim supt zt = limt (sup{zs : s t}) yields lim sup
T
1 T
T 1
yt < 0
t=0
lim inf
T
1 T
T 1
yt < 0.
t=0
For an explicit example, take the sequence from page 73 with the
1/2 from each entry to obtain a sequence of averages with liminf but limsup equal to 2/3 1/2 = 1/6 > 0.
n i=1 pi (i)
Since we maximize a strictly concave, continuous function over a compact set, a maximum exists and is unique. Notice that the gradient of the goal function has
i-th 1
coordinate
(i)
1 c(p) 1 1 = (i) 2 pi 2 pi 2 n
= (i)
pi
1 n
Since the feasible set is entirely dened by linear (in)equalities, the Kuhn-Tucker conditions give necessary and sucient conditions for a solution to be a maximum. So maximization problem if and only if there are Lagrange multipliers inequality constraints such that for each
solves the
i 0
p 0 and R i i = 1, . . . , n : (i) 1 p i 1 n
n i=1 pi
= 1
+ i + = 0
and
i p = 0. i 1 . n
(60)
Rewriting we nd
i = 1, . . . , n : p = (i) + (i + ) + i
109
Assume that
solves the maximization problem. We check that it satises the linear probability
If
p > 0, i
then
i = 0
j A,
p p = i j
((i) (j)),
where the inequality follows from the fact that (52). Conversely, if
>0
and
j 0.
satises requirement (52), one can easily show that it satises the
p > 0 i
and
p > 0, j
then
p p = ((i) (j)), i j
so
p i
1 n
(i) = p > 0 i p i
p j
1 n
(j).
(61)
Hence if we choose
i {1, . . . , n}
with
and dene
=
we have from (61) that
1 n 1 n
(i) R,
=
for all
p j k:
(j)
with
p > 0. j
k =
To see that
0
1
if
p k
1 n
(k) j
if
p > 0, k p = 0. k p > 0. j
By denition of the linear
k 0
if
p = 0, k
choose an alternative
with
probability model,
p p ((j) (k)), j k
which implies
((j) (k))
Hence
1 p p 0. k j
k = =
1 1
1 n 1 p k n p k
= ((j) (k)) 0,
1 p p k j
110
as we had to show. Substituting the denition of the Lagrange multipliers in (60) shows that the Kuhn-Tucker conditions are satised.
Exercise 11.2 (a): Choice probabilities are weakly increasing in payos, so the probability of choosing 1 must
be positive. If also the probability of choosing
PA (1) + PA (2) = 1,
this gives
PA (1) = 1/4.
4 + 1 1 4 , PA (2) = . 2 2
(62)
Obviously, this is possible if and only if both these probabilities are nonnegative, i.e., if and only if So for and we know that for every we nd
(0, 1/4], the choice probabilities in (62) satisfy the linear probability model there is only one such vector of choice probabilities. For > 1/4, PA (1) = 1, PA (2) = 0.
(63)
(b) (c):
The role of .
> 0,
iA
(64)
PA (i) =
Substituting the payos, we nd:
exp((i)/) . jA exp((j)/)
exp(0/) exp(0/) + exp(2/) + exp(8/) 1 , 1 + exp(2/) + exp(8/) exp(2/) , 1 + exp(2/) + exp(8/) exp(8/) . 1 + exp(2/) + exp(8/)
Since the exponential function takes strictly positive values, all choice probabilities lie in
(0, 1).
The logit model is a special case of Luce's choice model (see (42) and (45)), which satises path independence. Hence the logit model satises path independence. As
1/3.
(b):
Choice probabilities with parameter if
PA (i) > 0,
for all
j A.
(65)
Since choice probabilities are weakly increasing in payos and are three cases to consider:
there
PA (i) > 0
for all
i A.
or equivalently,
PA (3) PA (2) = ((3) (2)) = 6, PA (3) PA (1) = ((3) (1)) = 8, PA (1) + PA (2) + PA (3) = 1.
So:
6 = 8 =
14 3 , 110 3 .
(66)
To make sure that all probabilities are positive, this requires that probabilities in (66) satisfy the linear probability model for Using (65), the second case requires:
So the
PA (3) PA (2) = ((3) (2)) = 6, PA (3) PA (1) = PA (3) ((3) (1)) = 8, PA (1) = 0, PA (1) + PA (2) + PA (3) = 1.
Rewrite:
16 3 ,
(67)
PA (3)
PA (3) =
1 + 6 8, 2
112
[1/10, 1/6). Conclude that the choice probabilities in (67) satisfy the probability model for [1/10, 1/6).
The linear probability model does not satisfy path independence for every particular, we will show that for a specic value of alternatives
This means that we have to consider choice probabilities in the smaller problem with only
and
2.
P{1,2} (1)
P{1,2} (2)
requires that
P{1,2} (2) P{1,2} (1) = ((2) (1)) = 2, P{1,2} (1) + P{1,2} (2) = 1,
so
P{1,2} (1) =
let us choose
= 1/20.
Then
PA (1) =
but
1 10 1 = 3 6 1 10 1 4 + 3 3 2 14 1 2 3 2 (1 7)(1 2) 3 39 200 1 . 6 3 1 2 2
it follows from our earlier analysis that Case 3 is the only feasible one: the with probability one.
Exercise 11.4
Suppose vector
pi < pj .
p.
By construction,
n i=1 pi (i)
solves
> P ().
113