70 C H A P T E R 3 : C L A S S I C A L D E M A N D T H E O R Y

twice c o n t i n u o u s l y differentiable concave function, it has a symmetric and negative

semidefinite Hessian (i.e., second derivative) matrix (see Section M.C of the Mathe­

matical Appendix). Finally, for property (iv), note that because h(p, u) is homogeneous

of degree zero in p, h(ap, u) - h(p, u ) = O for ali a; differentiating this expression with

rcspcct to a yiclds D p h ( p , u)p = O. [Note that because h(p, u) is homogeneous of

dcgrcc zcro, D P h ( p , u)p = O also follows directly from Euler's formula; see Section

M . 8 of the M a t h c m a t i c a l Appendix.J •

The negative semidefiniteness of D P h ( p , u) is the differential analog of

the compensated law of demand, condition (3.E.5). In particular, the differential

version of ( 3 . E . 5 ) is d p · d h ( p , u) s; O. Since dh(p, u ) = Dph(p, u) dp, substituting gives

dp · D P h ( p, u ) dp s; O for ali dp; therefore, Dph(p, u) is negative semidefinite. Note that

ncgativc s e m i d c f i n i t c n e s s implies that a h ( p , u)/ap s; O for ali t ; that is, compensated

1 1

own-pricc cffccts are nonpositive, a conclusion that we have also derived directly

from condition (3.E.5).

Thc symrnctry of D P h ( p , u) is an unexpected property. lt implies that compensated

price c r o s s - d e r i v a t i v e s between any two goods t and k must satisfy ah (p, u)/apk =
1

ilhk(P, u)/Dp,. Symmetry is not easy to interpret in plain economic terms. As

emphasized by Samuelson ( 1 9 4 7 ) , it is a property j u s t beyond what one would derive

without the hclp of mathematics. Once we know that Dph(p, u) = V;e(p, u), the

symmctry propcrty rcflccts thc fact t h a t the cross derivatives of a (twice continuously

differentiable) function are equal. In i n t u i t i v e terms, this says that when you climb

1 7
a m o u n t a i n , yo u will cover the same net height regardless of the route. As we discuss

in Sections 13.H and 13.J, this path - independence feature is closely lin k ed to the

t r a n s i t i v i t y , or "no-cycling", aspect of rational preferences.

Wc de fi ne two goods t and k to be substitutes at (p, u) if ah 1 (p, u)/apk :2: O and

complements if t h i s derivative is nonpositive [ when W alrasian demands have these

rclationships at ( p , w), thc goods are referred to as gross substitutes and gross

c o m pl e m e n t s at ( p , w), respectively ] . Because ah,(p, u)/ap s; O, pro pe rty (iv) of

1

P ro p osition 3.G.2 i m p l i e s that there must be a g ood k for which ah 1 (p, u)/apk :2: O.

Hencc, P r o p o s i t i o n 3 . G . 2 implies that every good has at least one substitute.

17. To see why this is so, eonsider the twice continuously differentiable function f(x, y). We can

cxpress the c h u n g o in this íunction's value from (x', y') to (x", y") as the summation (technically, the

integral) of two different paths of incremental change: f(x",y") - f(x',y') = J( [of(x', 1)/oy] di +

Jt [ílf(s, y")/tix] ds and [tx", y") - f(x', y ' ) = Jt [of(s, y')/ox] ds + J( [of(x", t)/oy] dt. For these

two to be equal (as they must be), we should have

v" [[)f(x", 1) _ of(x", t ) J dt = f x'' [ªf(s,y") _ of(s,y')J ds

fy' íJy [)y x' OX OX

or

2 2

y" {f x" [� fis,!)J ds} dt = f »: {f y" [º f(s, t)J dt} ds.

f
y X ay OX x' y OX oy

So equality of cross-derivatives implies that these two different ways of "climbing the function "

yicld thc samc rcsult. Likewise, if the cross-partíais were not equal to (x", y"), then for (x', y') close

enough to (x", y"), the last equality would be violated.

 S E C T I O N 3 . G : D E M A N D , 1 N D I R E C T U T I L I T Y , A N D E X P E N D I T U R E F U N C T I O N S 71

The ll icksian ami Walrasian Demand Functions

Although the Hicksian demand function is not directly observable (it has the

consurner's u t i l i t y leve! a s a n argument), we now show that D p h ( p , u) can nevertheless

be computed from t h e observable W a l r a s i a n demand function x(p, w) (its arguments

are ali observable in p r i n c i p i e ) . T h i s i m p o r t a n t result, known as the Slutsky equation,

means that the properties listed in Proposition 3.G.2 translate into restrictions on

the observable W a l r a s i a n demand function x(p, w).

Proposltlon 3.G.3: ( The S/utsky Equation) Suppose that u(·) is a continuous utility

f u n c t i o n r e p r e s e n t i n g a l o c a l l y n o n s a t i a t e d a n d s t r i c t l y c o n v e x preference r e l a t i o n

?:: defined on the c o n s u m p t i o n set X = IR \ . T h e n for a l l (p, w), and u = v(p, w ) ,

we have

ilh (p,u) ax (p,w) ox (p,w)

1 1 1
= · ··· · ·· + · xk(P, w) for a l i t, k (3.G.3)

ilpk Dpk Dw

or e q u i v a l e n t l y , in matrix notation,

D p h ( p , u ) = Dpx(p, w) + D w x ( p , w ) x ( p , w)T. (3.G.4)

Proof: C o n s i d c r a consumer facing the price-wealth pair ( p , w) and attaining utility

levcl ü . N o t e t h a t her wealth leve! w m u s t satisfy w = e(p, ü). From condition ( 3 . E . 4 ) ,

we know that for ali (p, u), h (p, u ) = x

1
( p , e(p, u)). Differentiating this cxpression
1

with respcct t o p. und c v a l u a t i n g it at ( p , ü), we get

i ) h ¡ ( fi , ü) < J X ¡ ( fi , e ( fi , ü)) Dx¡(p, e(p, ü)) ae(p, ü)

= + ·······--·-······· .
aPk Dpk Dw apk

Using P r o p o s i t i o n 3 . G . I , t h i s yields

1lh ( fi , ü) Dx ( p , e(p, ü)) Dx (p, e(p, ü)) _ _

1 1 1
= + hk(P, u ) .
<1pk upk Dw

F i n a l l y , since w = c(¡1, ü ) a nd hk(¡3, ü) = xk(fi, e(p, ü ) ) = xk(P, w), we have

1lh
1
(p, u) D x 1 ( fi , w) ox 1 (p, w) ( - _ )

= + xk p, w . •
i7pk Dpk ow

F igure 3 .G. I ( a) depicts the W al r a sian and H icksian demand c u rves for good t

as a function of p
1,
holding o t h e r prices fi xed at p_1 [w e use p_1 to denote a vector

Figure 3 . G .1

P1 The Walrasian and

H i c k s i a n demand

functions for good l.

(a) Normal good.

(b) Inferior good.

Pi ·· - ·

h 1 ( p , u( P. w))

A m o u n l of A m o u n t of

Good ( Good l
(a) (b)
72 C H A P T E R 3 : e L A s s I C A L D E M A N D T H E o R Y

including ali prices other than p, and abuse notation by writing the price vector as

p = (p1, p 1
)j. The fi g u r e shows thc Walrasian demand function x(p, w) and the

Hicksian dernund function hi p, ü) with rcquired utility leve! ü = v((p

1,
p_
1
), w). Note

that the two dcrnand Iunctions are equal when p

1
= p1. Thc Slutsky equation

describes the rclai i o n s h i p hetween the slopcs of these two functions at price p1. In

Figure 3.G.1 (a), the slope of the Walrasian demand curve at p1 is less negative than

thc slopc of the Hicksian demand curve at that price. From inspection of the Slutsky

cquation, this corrcsponds to a situation wherc good t is a normal good al ( jj , w ) .

When p1 incrcascs abovc p1, wc must incrcasc the c o n s u rn e r ' s wealth if we are to

kccp her at thc s a rn e levcl of utility. Thcrcfore, if good t is normal, its demand falls

by more in thc ubscncc of this compcnsati on. Fi gure 3. G.l(b) il lustrates a case in

which good ( i s a n i n f e r i or good. In this case , the Walrasian dernand curve has a

more n e g a t i v e slopc than t he Hicksi an curve.

Proposition :HU implies that the matri x of price derivatives D p h ( p , u) of the

H icksian dcmund íu n c t i o n is eq u a l to thc rn atrix

1 1
, [ s ( p , w )

S ( p , w) = :

s u ( P , w)

with s
1.(¡1,
w) = ?x
1
( p , w)/1lpk + [ n x 1 ( p , w ) / i l w ] x k ( P , w). This matrix is known as the

S/111sky s11/Js/ it 111 ion mal rix, No t e , in particular, th at S( p, w) is directly com putable

from kn owledge of t h e (observable) Wa l r a s i a n dem and f unc t ion xi p, w). Because

S ( p , w) = D)1 (p, 11), Proposition 3. G.2 implies that when demand is gencrated from

prclcrcncc ma x i m i z a t i o n , S( P . w) must posscss t h e fo l l o w i n g three properties: it must

he n c q a t i re scmideíinit e, svmmetric, and satis/y S(p, w ) p = O.

In Scction 2.1.-, t hc Slutsky substitution matrix S(p, w) was shown to be the matrix of

compcns.ucd dcmand d e ri v a t i v o s arising from a different form of wealth cornpensation, thc

so-callcd S/111sky \\'eulth compcnsat ion. l nstead of varying wealth to keep utility fixed, as we

do hcrc, Slutsky cornpcnsution adjusts wcalth so that the initial consumption bundle x is j u s t

a f l o rd a b l c at t hc ncw priccs, Thus, wc havc the rcmarkable conclusion that the derivative o/

t h c llidsia11 dcniand [unction is cqual to ihe dcriuatiuc o/ this alternatioe Slutsky compensated

dcmand.

Wc can undcrsiand this rcsuft as follows: Suppose we have a utility function u(·) and are

at initial position (p, w) with .

x = xi p, w ) and ü = u(x). As we ehange prices top', we want to

change wcalth in order to compcnsate for the wealth effeet arising from this price ehange. In

principie, thc c o rn p c n s a t i o n can be done in two ways. By changing wealth by amount

L'i. 1 1 \ i u " k ' = ¡,· \((), w) - 11', wc lcave thc eonsumer just able to afford her initial bundle .x.

A l t c rn a t i v c l y , we can chango wcalth by amount L'i. w H i c k s = et p', ü) - w to keep her utility leve!

unchangcd. Wc havc L'i.,,'ttkh s Ll. w s , u i s k y • and the inequality will, in general, be strict for any

discreto chungo ( scc Figure 3.G.2). But beca u se VPe(p, ü) = h(p, ü) = x(p, w), these two

compensations ar e ulent icat for a dif fc rential pric e change starting at p. Intuitively, this is due

to thc samc fuct that lcd to Proposition 3.G.1: F or a di ff erential c hange in prices, the total

cflcct o n t he c x p c n d i t urc required to achieve utility leve ! ü ( the H i e k s i a n compensation level)

is simply t h c dircct cflcct of the price chango, assuming that the eonsumption b u n d le x d oes

not changc. But th is is precisely the calculation done for Slutsky com pc nsation. H ence , t he

derivativos of thc compcns.ucd demand functions that arise from t hese two com p ensation

m c c h a n i s m s a re t hc samc.
 S E C T I O N 3 . G : D E M A N D , 1 N O I R E C T U T I L I T Y , A N D E X P E N D I T U R E F U N C T I O N S 73

/ Slutsky Compensation
/

Hicksian Compensation

Figure 3.G.2

H i c k s i a n versus

Slutsky wealth
X¡

cornpcnsation.

Thc fact that D P h ( p , u ) = S(p, w) allows us to compare the implications of the

prcfcrcncc-based approach to consumer demand with those derived in Section 2.F

using a choicc-based approach buiit on the weak axiom. Our discussion in Scction

2 . F concludcd that if x ( p , w) satisfies the weak axiom ( p l u s homogeneity of degree

zcro and Walras' law), then S(p, w) is negative semidefinite with S(p, w ) p = O.

Moreover, wc argucd that except when L = 2, demand satisfying thc wcak axiom

necd not have a symmctric Slutsky substitution matrix. Therefore, the results herc

tell us t h a t the restrictions imposcd on demand in the preference-based approach are

strongcr t h a n those arising in thc choice-based theory b u i l t on the weak axiom. In

fact, it is i m p o s s i b l c t o find preferences that rationalize demand whcn the substitution

m a t r i x is not symmctric. I n Section 3 . 1 , we explore further the role that t h i s symmetry

property plays in t h c relation bctween the preference and choice-based approaches

to d e m a n d .

Walrasian Demand and the Indirect Utility Function

Wc havc sccn t h a t the m i n i m i z i n g vector of the E M P , h(p, u), is the derivative with

respect t o p of t h c EM P's value function e(p, u). The exactly analogous statement for

thc U M P <loes not h o l d . The Walrasian demand, an ordinal concept, cannot equal

the price d e r i v a t i v c of the indirect u t i l i t y function, which is not invariant to increasing

transformations of u t i l i t y . But with a small correction in which we normalize the

d e r i v a ti ves of v( p, w) w i t h respect t o p by the marginal utility of wealth, it h o l d s true.

This proposition, called Roy's identity (after René Roy), is the parallel result to

Proposition 3.G.1 for the demand and value functions of the UMP. As with

Proposition 3 . G . 1 , we offer severa] proofs.

Proposltion 3 . G . 4 : iRov's ldentity). S u p p o s e that u ( · ) is a continuous utility function

representi ng a locally nonsatiated and strictly convex preference relation �

defined on the consumption set X = IR � . Suppose also that the indirect utility

function is d i f f e r e n t i a b l e at ( {J . w) » O. Then

1
x ( fJ , w) = - -- . -- VP v(fJ, w ) .
V w v ( p , w)

That i s , for every ! = 1 , . . . , L :

<1v(fJ, w)/ilp1
X ¡ ( {J , IN ) =
Dv(p, w)/aw
74 C H A P T E R 3 : C L A S S I C A L D E M A N D T H E O R Y

Proof 1 : Lct ú = P(p, w), Because the identity v(p, e(p, u ) ) = u holds for ali p, differ­

entiating with rcspcct to p and evaluating at p = f5 yields

- - - av(p, e(p, ü)) - -

Vrv(p, e(p, u ) ) + Vpe(p, u ) = O .
Dw

But V,,e( ¡1, ü ) = h( p, ü) by Proposition 3 . G . 1 , and and so we can substitute and get

n ( _ '( _ _ )) Dv(p, e(p, ü)) h( _ _) = O

V P V p, e p, U + p, U •

aw

Finally, since w = e ( p , ü), we can writc

. _ _ Dv( p, w) _ _
V,,v(p, w) + ---,�- x(p, w) = O.
uw

R e a r r a n g i n g , t h i s yiclds the rcsult. •

Proof I of Roy's i d e n t i t y derives the result using Proposition 3.G. I . Proofs 2 and

3 h i g h l i g h t t h c fact that both results actually follow from the same idea: Because we

are al an optimum, the dcrnand response to a price change can be ignored in

c a l c u l a t i n g thc clfcct of a diffcrential price change on the value function. Thus, Roy's

identity and Proposition 3.G. I should be viewed as parallcl rcsults for thc UMP

and E M P. (Indecd, Exercise 3.G. I asks you to derive Proposition 3.G.1 as a

consequcncc of R o y ' s idcntity, thercby showing that the direction of the argument

in Proof I can be reversed.)

Proof 2: iFirst-Urder Conditions Argument). Assume that x(p, w) is differentiable and

x ( p , w ) » O. By t h c c h a i n rule, wc can write

nv(p, w) = Í D u ( x ( p ,_ iv ) ) (};(k(p,_iv).

ap1 k � 1 axk Dp1

S u b s t i t u t i n g fo r ? u ( x ( p , w ) ) / D x k using the first-order conditions for the U M P , we have

,lv( p, w) = Í Apk Dxk( p, w)

(}p1 k � 1 ºPr

= - h 1 ( p , w),

sincc Lk Pk(,1 xk(P, w)/í"!p

1)
= -x
1
( p , w ) (Proposition 2.E.2). Finally, we have already

1
argued t h a t A = , v(p, w)/aw (scc Section 3 . D ) ; use of this fact yields the result. •

Proof 2 is again esscntially a proof of the envelope theorem, this time for the case

where t h e pararnctcr that varíes cnters only the constraint. The next result uses the

cnvelope thcorcm directly.

Proof 3: (Enoeíape Theorem Aryument) Applied to the U M P , the envelope theorem

tells us d i r c c t l y t h a t the u t i l i t y effect of a marginal change in Pr is equal to its effect

on the consumcr's budget constraint weighted by the Lagrange multiplier A of the

c o n s u rn c r ' s wealth constraint. That is, ov(p, w)/op 1 = - h ¡ ( p , w), Similarly, the

u t i l i t y cflcct of a differential change in wealth Dv(p, w)/Dw is just A. Combining these

two facts y i e l d s the result. •

P r o p o s i i i o n 3 . G . 4 p r o v i d e s a s u b s t a n t i a l payoff. Walrasian demand is much easier

to c o m p u t e Irorn i n d i r e c t than from direct utility. To derive x(p, w) from the indircct
 S E C T I O N 3 . H : 1 N T E G R A B I L I T Y 75

"DUAL" PROBLEMS
The l J M P Thc E M P
(Proposition 3 . E . 1 )

Slutsky Equation
-----------------------
(for derivatives) h(p, u)

-.,.......,.-- "", \

\ h(p, 11) =

J v,« p, u)
h(p, ot :
J - t( / Figure 3.G.3
. P. e(,, I
,., lt)) ............--,.,/ Relationships bet wecn
e( p, u ) = v ( p, e(p, u))

the U M P and the

v( p, w) = e( p, v( p, w))
EMP.

utility Iunction. no more than the c a l c u l a t i o n of derivatives is involved; no system

of first-ordcr condition cquations needs to be solved. Thus, it may often be more

convenicnt to cxpress lastes in indirect utility form. In Chapter 4, for example, we

will he i ru e r e s t e d in prcfcrences with the property that wealth expansion paths are

linear over sorne rangc of w c a l t h , lt is simple to verify using Roy's identity that

indircct u t i l i t i c s of t h e Gorman form v(p, w) = a ( p ) + b ( p ) w have this property (see

Excrcise 3 . G . 1 1 ).

F i g u r e 3 . G . 3 s u r n m a r i z e s t h e conncction between the demand and value functions

arising from thc U M P and the E M P; a similar figure appears in Deaton and

M ucllbaucr ( 1980). The solid arrows indica te the derivations discussed in Sections

3 . D und 3 . E . S t u r t i n g from a given u t i l i t y íunction in the U M P or the E M P , we can

derive thc o p t i m a ! c o n s u m p t i o n b u n d l c s x(p, w) and h(p, u) and the value functions

P ( p , w ) a n d et», u ) . I n a d d i t i o n , wc c a n g o back and forth between the value functions

and d c rn a n d functíons of the two problems using relationships (3.E.1) and (3.E.4 ).

The rclatíonshíps developed in this section are represented in Figure 3.G.3 by

dashed arrows. Wc havo sccn here that the demand vector for each problem can be

calculatcd Irorn íts v a l u c function and that the derivatives of the Hicksian demand

functíon can be calculated frorn the observable Walrasian demand using Slutsky's

cquatíon.

3.H Integrability

lf a continuously d i ff e r e n t i a b l e dcmand function x(p, w) is generated by rational

prcfercnccs, thcn we have seen that it must be homogeneous of degree zero, satisfy

Walras' law, and have a s u b s t i t u t i o n matrix S(p, w) that is symmetric and negative

scmidefinite ( n . s . d . ) at ali (p, w). We now pose the reverse question : Jf we observe a

ilcmand [unct ion x( p, w) I hat has these properties, can we find preferences that

ratianali:e x( · ) ? A s wc show in this section ( albeit so m ewhat unri g o rously ) , th e

a nswer is yes; thes c conditions are s u f fi c i e n t for the e x istence of ration a l generatíng

prcfcrcnccs, T h i s p roblem , k nown as the integrabi/icy problem, has a long tradition

in c c o n o rn i c theory, bcginning with A n t onel li ( 18 86); we follow the approach

of Hu rwícz a nd Uzawa ( 1 9 7 1 ) .

Thcrc are severa ! thcoretical and p ractica ! rcasons w h y this q uestion and result

a re o f intcresl.

O n a thcorctical Icvel, thc r c s u l t t e l l s us two t h i n g s . F i r st , it tells us that not o n l y

are thc propcrtics of homogencit y of degree zero, satisfact i on of Walras' law, a nd a

76 e H A P T E R 3 : e L A S S I e A L D E M A N D T H E o R Y

syrnrnctric and ncgativc semidefinite substitution matrix necessary consequences of

the preference-based demand theory, but these are also ali of its consequences. As

long as consumer demand satisfies these properties, there is sorne rational preference

relation that could have generated this demand.

Sccond, thc rcsult completes our study of the relation between the preferencc­

bascd thcory of dcmand and the choicc-based theory of demand built on the weak

axiom. We havc already seen, in Section 2.F, that although a rational preference

rclation always gcncratcs dcmand possessing a symmetric substitution matrix, the

wcak axiom nccd not do so. Therefore, we already know that when S(p, w) is not

s y m m c t r i c , d c m a n d satisfying the weak axiom cannot be rationalized by preferences.

The r e s u l t s t u d i e d here tightens this relationship by showing that demand satisfying

the weak axiom (plus homogeneity of degree zero and Walras' law) can be

rationalized by preferences il and only if it has a symmetric substitution matrix

S( p, w). Hcnce, the only thing added to the properties of demand by the rational

prefercncc h y p o t h e s i s , bcyond what is implied by the weak axiom, homogeneity of

degrcc zcro, and Walras' law, is symmetry of the substitution matrix.

On a practica! lcvcl, the result is of interest for at least two reasons. First, as we

shall discuss in Scction 3.J, to draw conclusions about welfare effects we need to

know thc consumer's preferences ( or, at the least, her expenditure function). The

result tells h o w and when we can recover this information from observation of the

consumcr's dcmand behavior.

Sccond, w h c n c o n d u c t i n g empirical analyses of demand, we often wish to estima te

d c m a n d f u n c t i o n s of a relatively simple form. If we want to allow only functions that

can be ticd back to an underlying prcference relation, there are two ways to do this.

One is to spccify various utility functions and derive the demand functions that they

lcad to u n t i l wc find onc that scems statistically tractable. However, the result studied

herc givcs us an casier way; it allows us instead to begin by specifying a tractable

dcmand íu n c t i o n and thcn simply check whether it satisfies the necessary and

s u f l i c i c n t c o n d i t i o n s t h a t we identify in t h i s section. We do not need to actually derive

t h c u t i l i t y Iunction: the result allows us to check whether it is, in principie, possible

to do so.

Thc p r o b l c m of rccovcring preferences ;:::: from x(p, w) can be subdivided into two

parts: ( i ) rccovcring an cxpenditurc function e(p, u) from x(p, w), and (ii) recovering

prcfercnccs from thc expenditurc function e(p, u). Because it is the more straight­

forward of the two tasks, we discuss (ii) first.

Recooerinq Preferences from the Expenditure Function

Supposc t h a t e(p, u) is the consumer's expenditure function. By Proposition 3.E.2, it

is strictly increasing in u and is continuous, nondecreasing, homogeneous of degree

one, and concave in p. In addition, because we are assuming that demand is

s i n g l c - v a l u c d , wc k n o w t h a t e(p, u) m u s t be differentiable (by Propositions 3 . F . 1 and

3.G.1).

G i v e n t h i s Iunction e(p, u), how can we r e c o v e r a preference relation that generales

i t ? D o i n g so rcquircs finding, for each utility leve! u, an at-least-as-good-as set V.. e IRIL

such t h a t e( P . u ) is thc minimal expenditure required for the consumer to purchase

a b u n d l e in V.. at prices p » O. That is, we want to identify a set V.. such that, for ali
 S E C T I O N 3 . H : 1 N T E G R A B I L I T Y 77

p » O, we havc

ei p, u ) = Min p·x

x ;» O

S.t. X E V., .

I n t h c frarncwork of Scction 3 . F , V., is a set whose support function is precisely e(p, u).

Thc r c s u l t i n P r o p o s i t i o n 3 . H . I shows that the set V., = {x E [ij \ : p · x � e(p, u) for

ali p » O) a c c o m p l i s h e s t h i s objective.

Proposition 3 . H . 1 : S u p p o s e that e ( p , u) is strictly increasing in u and is continuous,

increasing, h o m o g e n e o u s of d e g r e e o n e , c o n c a v e , and d i f f e r e n t i a b l e in p. Then,

for every utility level u, e ( p , u) is the expenditure function associated with the

at-least-as-good-as set

Vu = ( x E [ij � : p · x 2': e ( p , u) for a l l p » O } .

That i s , e(p, u ) = Min {p·x: X E Vu} for a l l p » O .

Proof: Thc p r o p c rt i c s of l'(f', u) and thc d c f i n i t i o n of V" imply tha t V" is nonempty, closed, and

boundcd below. G i v c n f J » O , i t c a n be shown that t h e s e c o n d i t i o n s insure that M i n { p · x : x E V.. } .

cxisis. lt is imrncdiatc from thc definition of V" that e ( p , u) :e; M i n { p • x : x E V"}. What remains

in ordcr to cstablish thc rcsult is to s h ow cquality. We do this by showing that e(p, u) ¿

M i n : p · .x : x fe �;. ; .

For any fJ and p', the concavity of l' ( /J , u) in p implies that (see Section M.C of the

Mathcmatical Appcndix )

ei p', u ) :e; l' ( p , u ) + Vpe(p, u ) · ( p ' - p ) .

Beca use e( p, u) is homogcncous of degree one in p, Euler's formula tells us that e(p, u ) =

p · V l ' l' ( p , u ) . Thus, e { fJ ' , u ) :e; p ' · V r e ( p , u ) for ali p'. But sincc VPe(p,u)¿Q, this means that

'vl'e( p, u) E V,,. l t fo l l o w s th a t M i n : P • x : x E V,, } :e; p · Vpe(p, u) = e(p, u), as we wanted (the last

equality uses Lulcr's formula once more). This cstablishes the result. •

Givcn Proposiiion 3.H. 1 , wc can construct a set V., for each leve! of u. Because

e ( p , u) is s t r i c t l y incrcasing in u, it follows that if u ' > u, then V., strictly contains v., . .
In addition, as notcd in thc proof of P r o p o s i t i o n 3 . H . 1 , each V., is closed, convex,

and boundcd hclow. Thcsc v a r i o u s at-least-as-good-as sets then define a preference

relation e that has e(p, u) as its cxpenditure function (see Figure 3 . H . 1 ) .

Figure 3.H.1

Recovering preferences
: x E � 2 1 :p"·x=e(p",uJ}- -
from the expendíture

function.
tx E G{�: p ' < « = l' ( p ' , u ) } - ·

: H IT ! � : ti : x = e ( p , u ) } - - · v,,.

u'> u

X¡
78 e H A P T E R 3 : e L A s S I C A L D E M A N D T H E o R Y

Xz

Boundary of Actual

-----/,, At-Least-As-Good-As Set

-,

\ _/ Boundary of V.,
Figure 3.H.2

\ Recovering prefcrences

from the cxpenditurc

functi o n when the

consurncrs' prcfcrences

X¡ are n o n c o n v c x ,

Proposition :u-1.l r c m ai n s valid, with substantially the same proof, when et p, u) is not

diflcrcntiablc in p. Thc preference relation constructed as in the proof of the proposition

provides a convcx preference relation that generates e(p, u). However, it eould happen that

t h e r e are ulso n o n c o n v e x preferenees that generate e(p, u). Figure 3 . H . 2 illustrates a case where

thc c o n s u r n c r s a c t u a l a t - l e a s t - a s - g o o d - a s set is nonconvex. The houndary of this set is depicted

w i t h a dashcd c u r v e . Thc s o l i d curve shows the boundary o f t h e set V,, = { x E IJ,f;: p :x ¿ ei p, u)

for a l i P »o:. Forrnally, t h i s set is the convex h u l l of the consurner 's actual at-least-as-go o d -a s

set, ami it also g e n e r al e s thc e x p e n d i t u r e fun c tion e(p, u).

lfe(p, u) is diílcrcntiable, t he n an y preference relation that genera l es e(p, u) m u s t he convex .

If it werc not, then thcrc would he so rn e utility leve ! u and price vector p » O wit h sev e ra ! \
e x p c n d i t u rc m i n i m i ze r s (see F igure 3.H.2). At this price · u t ilit y pair, the expenditurc function

would not he d i l lc re n t i a b l e in p.

Recorerinq I he Expenditure Function frorn Dernand

lt rcmains to rccovcr e( p, u ) from observable consumer behavior summarized in the

Walrasian d c rn a n d x( p, w). We now discuss how this task (which is, more properly,

the a c t u a l " i n t c g r a b i l i t y problern ") can be d o n e . We assume throughout t h a t x ( p , w)

satisíics Walras' law and homogeneity of degree zero and that it is single-valued.

Lct us first considcr thc case of two commodities (L = 2). We normalize F: = 1 .

Pick an arhitrary price wealth point (p?, 1, w") and assign a utility value of u º to

bundle x ( p \1 , 1 , w"). We will now recover the value of the expenditure function

e( P
1 ,
1 , u º ) at a l i priccs P
1
> O. Beca use compensated demand is the d e r i v a t i v e of the

expenditure function with respect to prices (Proposition 3 . G . I ), recovering e(·) is

cquivalcnt to bcing able to solvc (to "intégrate") a differential equation with the

indcpcndcnt variable p
1
and t h c dcpendent variable e. W r i t i n g e( P i ) = e( p
1 ,
1 , uº) and

x
1
(p
1 ,
w) = x 1
(p
1 ,
1, w) for simplicity, we need to solve the differential e q u ation,

de(pi)
= X ¡ ( P i , e(p1)), (3.H.1)

eJP i

1 8
with thc initial condition e(p?) = wº.

lf e(p1) solvcs (3.H.I) for e(p?) = w", then e(pi) is the expenditure function

a s s o c i a t cd with the leve ] of utility uº. N ote , in particular , that if the substitution

IX . Tcchnically, (3.H. I ) is a nonaulonomous sys te m in t he (p

1 ,
e) pl a ne. N ote that p , plays the

role of t h c "t" variable.

 S E C T I O N 3 . H : 1 N T E G R A B I L I T Y 79

Slopc = x 1 ( p�. wºk

1
e ( fi , ) _.::.:::��..: / .,.�

l �.,,.

wº ------1 i I //
Figure 3.H.3
1 1 I _

r' -----+--+L____ ........_Slope = x 1 ( p',, e') Recovering the

1 1 1

expenditure functions

p� P, p' , P, from x( p, w).

m a t r i x is n cg ati ve s e m i d e fi n i t e then e( p 1 )
will have ali the properties of an expenditurc

function (with th c pricc of good 2 normalized to equal 1 ). First, because it is thc

solution to a diflcrcntial cquation, it is by construction continuous in p1• Second,

sincc x 1 ( p , w) 2 O, e q u a t i o n ( 3 . H . I ) i mpli es that e ( p 1 ) is nondecreasing in P i - Third,

d i l l c r e n t i a t i n g c q u a t i o n ( 3 . H . I ) tells us that

2
d e(p1) ilx 1
(p
1 ,
1, e(p1)) iJx (p 1 1 ,
1, e(p 1 ) )

= + -·--·-· X1 ( p 1 , 1 , e(p
1))

tlpf 11p
1
Dw

= s
1 1
(p
1 ,
1 , e ( r , ) ) :,::: O,

so t h a l t h e s o l u t i o n e ( p 1 ) i s concave in P i -

Solving cquation (3.H. l ) is a straightforward problem in ordinary differential

c q u a i i o n s t h a t, nonetheless, we will not go into. A few weak regularity assumptions

guarantcc t h a t a s o l u t i o n to ( 3 . H . 1 ) exists for any initial condition (p?, wº). Figure

3 . H . 3 describes t h e cssence of what is in volved: At each price leve! p 1 and expenditure

lcvcl e, wc are g i v c n a direction of movement with slope x 1 ( p 1 , e). For the initial

c o n d i t i o n (p'/, w " ) , thc graph of e ( p 1 ) is thc curve that starts at (p?, wº) and follows

t h c prcscribcd di r cc ti ons of movement.

For t h c general case of L commodities, the situation becomes more complicated.

Thc ( o r d i n a r y ) difTcrcntial equ a ti on ( 3 . H . l) must be replaced by the system of partial

diffcrcntial c q u a t i o n s :

oe(p)
= X ¡ ( p , e(p))
01
U /J ¡

(3.H.2)

De(p)
:'.l = xL(P, e(p))
up'-

0
for i n i t i a l c o n d i t i o n s p and e(pº) = w". The existence of a solution to ( 3 . H . 2 ) is not

automatically guaranteed wh en L > 2. Tndeed, if there is a solution e(p), then its

H cs s i a n m a t r i x D ¡, e ( p ) m us t be symmetric because the Hessian matrix of any twice

c o n t i n u o u s l y diffcrcntiable function is symmetric. Differentiating equations ( 3 . H . 2 ) ,

w h i c h can he writtcn as Vpe(p) = xi p, e(p)), tells us that

D ¡, e ( p ) = DPx(p, e ( p ) ) + D .,, x ( p , e ( p ) ) x ( p , e(p))T

= St p, e ( p ) ) .

1
80 C H A P T E R 3 : C L A S S I C A L D E M A N D T H E O R Y

Therefore, a necessary c o n d i t i o n for the existence of a solution is the symmetry of

thc S l u t s k y matrix of x(p, w). T h i s i s a comforting fact because we know from previous

s c c t i o n s t h a t if market demand is gcnerated from preferences, then the S l u t s k y m a t r i x

is indeed symmctric. It turns out that symmctry of S ( p , w) is also sufficient for

recovcry of t h e consumer's expenditure function. A basic rcsult of the theory of partial

difTcrcntial cquations (callcd F r o b e n i us ' theoremi tells us that thc symmetry of t h e

L x L derivativo matrix of ( 3 . H . 2 ) at all points of its domain is the necessary and

sufficicnt c o n d i t i o n for t h c existcnce of a solution to ( 3 . H . 2 ) . In addition, if a s o l u t i o n

e ( p 1 , u 0 ) <loes e x i s t , thcn, as l o n g as S ( p , w) is negative semidefinite, it will possess the

p r o p c r t i c s of a n e x p c n d i t u r e function.

Wc t h c r c fo rc concludc t h a t t he necessary and sufficient condition for che recovery

o] an underlvitu¡ expenditure [unct ion is t he symmetr y and neqatioe semidefiniteness o]

the Slussk» m a t r ix . : " Recall Irorn Section 2 . F t h a t a differentiable demand function

s a t i s f y i n g t h c weak a x i o m , h o m o g e n c i t y of dcgree zero, and Walras' law neccssarily

has a n c g a t i v c s c m i d e fi n i t e S l u t s k y m a t r i x . Morcover, when L = 2, the S l u t s k y m a t r i x

is ncccssarily s y rn r n e t r i c (recall Exercisc 2 . F . 1 2 ) . Thus, for the case where L = 2, we

can always lind prcícrcnccs that rationalize any diffcrcntiable demand function

satisfying thcsc threc properties. When L > 2, however, the Slutsky matrix of a

d c m a n d f u n c t i o n satisfying t h e wcak a x i o rn ( a l o n g w i t h homogeneity of degree zero

and Walras' law) nced not be s y m rn c t r i c ; preferences that rationalize a dernand

f u n c t i o n s a t i s f y i n g t h c wcak a x i o rn c x i s t o n l y whcn it is.

Observe t h a t once wc k n o w t h a t St p, w) is symmetric at ali (p, w), we can in fact use ( 3 . H . I )

0
to solve (].11.2). Supposc that with initial conditions p and e ( p º ) = w", we want to recover

e(p). By c h a u g i n g priccs onc al a time, we can decompose this problem into L subproblems

whcrc o n l y onc pricc changos at each step, Say it is price /: Then with fJ. lixed for k =I (, the

! t h c q u a t i o n of (l . 1 1 . 2 ) is an c q u u t i o n of the form ( 3 . H . 1 ), w i t h the subscript I replaced by v

lt can be sol ved by t he mcthods appropriate to ( 3 . H . I ). lterating for different goods, we

c v c n i u a l l y gct to l'(p). lt is w o r t h w h i l e to p o i n t out that this method m a k e s mechanical sense

cvcn if S( /J, w) is not s y m m e t r i e . However, if S( P. w) is not symmetric (and therefore cannot be

ussociatcd w i t h an u n d c r l y i n g prcfcrence r e l a t i o n and e x p e n d i t u r e function), then the valuc of

e ( ¡ , ) w i l l dcpcnd 011 thc particular path [ollowed [rom /' to ji (i.e., on which price is raised first).

By t h i s a b s u r d i t y , t h c m a t h e m a t i c s managc to kccp us h o n e s t !

3.1 Welfare Evaluation of Economic Changes

U p t o t h i s p o i n t , wc havc studied thc preference-based theory of consurner demand

frorn a p o s i t i v c ( b c h a v i o r a l ) perspective. I n this section, we investigate the normative

sidc of c o n s u rn e r theory, called welfare analysis. Welfare analysis concerns itself w i t h

the cvaluation of the effects of changes in the consumer's environrnent on her

wcll-bcing.

A l t h o u g h rn a n y of the positive results in consurner theory could also be deduced

using an approach based on the weak axiom (as we did in Section 2.F), the

prcfercncc-based approach to consurncr demand is of critica] importance for welfare

19. This i, subjcct lo m i n o r tcchnical requirements.

 S E C T I O N 3 . 1 : W E L F A R E E V A L U A T I O N O F E C O N O M I C C H A N G E S 81

analysis. Without it, wc would havc no means of cvaluating the consumer's leve! of

well-being.

In t h i s seciion, wc consider a consumer with a rational, continuous, and locally

nonsatiated prefcrcncc relation <:; . We assume, whenever convenicnt, that the

c o n s u rn e r ' s c x p c n d i t u r e and indircct utility functions are differentiable.

Wc Iocus hcre on thc wclfarc effect of a price change. This is only an example,

albcit a historically important one, in a broad range of possible welfare questions

onc might want t o addrcss, Wc assumc that the consumer has a fixed wealth leve]

w > O and that thc pricc vector is initially pº. We wish to evaluate the impact on
0 1•
thc c o n s u rn e r ' s wclfare of a changc from p to a new price vector p For example,

sorne govcrnmcnt policy that is undcr consideration, such as a tax, might result in

t h i s chango in market prices.i"

Supposc, t o siart, t h a t wc k n o w thc consumer's preferenccs ?: - For example, we

may ha ve d c r i v c d e- from knowledge o f h e r (observable) Walrasian demand function

x ( p , w), as discusscd in Scction 3 . H . Tf so, it is a simple matter to determine whether

thc pricc c h a n g o makcs the consumcr bctter or worse off: if v(p, w) is any indirect

utility function dcrivcd from ?: , thc consumer is worsc off if and only if v ( p 1 , w) -

11( / \ w ) < O.

Although any indircct utility function dcrivcd from ?: sufficcs far making this

c o rn p a r i s o n , onc class of i nd i r c c t utility functions deserves special mentían because

it Icads to mcasurcmcnt of the welfarc change expressed in dollar units. These are

cullcd money met ric indirect utility functions and are constructed by mea ns of the

c x p c n d i t urc fu n c t i o n . I n particular, starting from any indirect utility function v( · , · ),

choosc an arbitrary price vector p » O, and consider the function e(p, v(p, w)). This

f u n c t i o n givcs the wealth requircd to reach the utility leve! v(p, w) when prices are p.
1
N o t e t h a t t h i s c x p e n d i t u r e is strictly increasing as a function of the leve] v(p, w), as

shown in Figure 3.1.1. Thus, viewcd as a function of (p, w), e(p, v(p, w)) is itself an

indircct utility Iu n c t i o n for ?:'.::, and

'

et ii, v ( p 1 , w ) ) - e(p, v ( p º , w))

21
p r o v i d c s a mensure of t h c wclfarc changc expressed in d o l l a r s .

Figure 3.1.1
x, z•(p', w) > z·(p, w)

A moncy mctric

indirect u t i l i t y function,

Bp,c(p.11(p.w))

B p , e ( ¡i . v ( p ' , w ) )

20. For the s a k c of c x p o s i t i o n a l sirnplicity, we do not consider changes that afTect wealth here.

Howcvcr. t h c a n a l y , i s rc a d i l y c x t e n ds to that case (see Exercise 3 . 1.1 2 ) .

21. Note t hat this meas u re is unuffected by the choice of the initial indirect utility function

P(/J, 11•); i t dcpcnd s o n l y on the c o n s u r n e r s preferences ;::::: (see Figure 3.1.1 ).

--- ----· --- ---- --

82 e H A P T E R 3 : C L A S S I C A L O E M A N O T H E O R Y

A money metric indirect utility function can be constructed in this manner for

any pricc vector fi » O. Two particularly natural choices for the price vector p are
1•
thc initial pricc vector o" and the new price vector p These choices lead

to two w c l l - k nown measures of welfare change originating in Hicks (1939), the

equivalen/ rariat ion ( E V) and thc compensatinq oariation ( C V). Formally, letting

1 , 1 )
11° = u ( p º . w) and 11 1 = u(p w), and n o t i n g that e ( p º , u º ) = et p '; u = w, we define

1 )
EV(pº, v'. w) = et p", 11 1 ) - ei p", 11 ° ) = e(pº, u - w ( 3 . 1. 1 )

and

( 3 . 1.2 )

The equivalent variation can be thought of as the dollar amount that the

consumer would be indifferent a b o u t accepting i n lieu of the price change; that is, it

is t h e chango in h e r wealth that would be equioalent to the price change in terms of

its wclfare impact (so it is ncgativc i f the pricc change would make the consumer

1 )
worse off). I n p a r t i c u l a r , note that e( p", u is thc wealth leve! at which the consumer

1 ,
u c h i c v c s c x a c t l y u t i l i t y lcvcl u t h e lcvcl generated by the price change, at prices pº.

1 )

Hcncc, e( p", 1 1 - w is t h e net change i n wealth that causes the consumer to get u t i l i t y

lcvcl 111 at priccs p". We can also express the e q u i v a l e n t variation using thc i n d i r e c t

utility function 1 • ( · , · ) in t h e following way: v(pº, w + EV) = 11 1 . 2 2

Thc compcnsating variation, on the othcr hand, measures the net revenue of a

planner who must compensa/e thc consumer for the price change after it occurs,

b r i n g i n g h e r back to h e r o r i g i n a l u t i l i t y leve ! u º . ( H ence , the co m pensating v a r i a t i o n

is negativo if thc planner would have to pay the consumer a positive level of

c o m p e n s a t i o n beca use thc pricc change m ak e s h e r worse off.) I t can be t h o u g h t of as

thc n e g a t i v o of t h e amount th a t the c onsumer would be j u s t w i l l i n g to accept from

thc planncr to allow the price change to happen. The compensating variation can

also be cxprcsscd in thc f o ll o wing way: v ( p 1 , w - C V ) = uº.

F igur e 3.1.2 dcpicts the equivalen! and c o mpensating variation measures of

wclfarc chango. Beca use both the E V and the C V correspond to measurements of

t h c c h u n g o s i n a m o n e y metric i n d i r e c t u t i l i t y function , both provide a correc t welfare

0 1 ;
r a n k i n g of t h c a l t c r n a t i v c s p and p that is, the consumer is b e tt er o ff under p ' if

and onfy if t hcsc mcasurcs are positive. In general , however , t he s p ecific dollar

Figure 3.1.2

p� = p;= 1
The e q u i v a l e n ! (a) and

compensating (b)

E V ( p", p ' , w){ v a r i at i o n measurcs of

welfare change.

x ( p º , w)
x ( p ' \ w) u1

X¡

(a) (b)

22. Note that i f u ' = 1 1 ( p º , w + E V ) , t h e n e(pº, u ' ) = et p", v(pº, I V + /'.. ' V ) ) = IV + EV. This leads

to (.\1.1).
 S E C T I O N 3 . 1 : W E L F A R E E V A L U A T I O N O F E C O N O M I C C H A N G E S 83

h
1 (
p
1 ,
p:
1
, uº) h,(p,, P- r- uº)

/
h,(p,. p _ ,, u') / h1(P1,P-1,u')

Figure 3.1.3

x,(p,, P-1, w) X 1 ( P 1 , P - 1 , w) (a) The equivalent

variation.
0, 1 ,

x, x (p w) x (p w) X¡
1 1
(b) The compensating
(a) (b) variation.

a m o u n t s calculatcd u s i n g t h e E V and C V measures will ditfer because of the ditfering

pricc vcctors a l which compcnsation is assurned to occur in these two measures of

welfarc changc.

The e q u i v a l e n t and compensating variations have interesting representations in

terms of t h e Hicksian demand curve. Suppose, for simplicity, that only the price

of good I changos, so that py =!= p) and p� = p)- = p1 for all t =!= l . Because

w = e(p'>, 11°) = et n': 111) a n d h 1 ( p , u ) = ae(p, u ) J a p 1 , we can write

1)
E V ( p º , p 1 , w) = ei p", u - w

1 )
= et p", u - ei p " , u ' )

= Jp\' h (p
1 1 ,
p_ 1, u ' ) dp
1,
(3.1.3)

rl

where p 1
= (p
2,
• • • , ¡í¡J. T h u s , the change in consumer welfare as measured by the

c q u i v a l e n t v a r i a t i o n can be rcprcscnted by the arca lying between P? and p\ and to the

1
lcít of thc Hicksian dcmand curve for good 1 associated with utility leve! u (it is

cqual to this arca if p: < p7 and is equal to its negative if p) > p?). The arca is

depicted as t h e shadcd regían i n Figure 3 . I.3 ( a ) .

S i m i l a r l y , t h c c o m p e n s a t i n g v a r i a t i o n can be w r i t t e n as

C V ( p º , p " , w) = f rY h1(p
1,
p_ 1, uº) d p
1.
(3.1.4)

PI

N o t e t h a t we now use the i n i t i a l u t i l i t y leve! uº. See Figures 3 . l . 3 ( b ) for its graphic

reprcsentation.

Figure 3 . 1.3 dcpicts a case whcre good I is a normal good. As can be seen
1,
in the figure, whcn t h i s is so, we have E V(pº, p w) > C V(pº, p ' ; w) (you should check

that thc same is true when p ) > p?). This relation between the E V and the C V reverses

when good I is inferior (see Exercise 3 . 1.3 ). However, if there is no wealth ctfect for

good 1 (e.g., if t h e u n d c r l y i n g prefcrcnces are quasilinear with respect to sorne good

( =!= 1 ), the C V and E V measures are the same because wc then have

h,(P1, P-1, u º ) = x1(p1, P - 1 , w) = h1(P1,P-1, 11 1 ) .

I n t h i s case of no wealth effects, we call the common value of C V and EV, which is

also the v a l u c of t h c arca lying between P? and p ) and to the left of the market (i.e.,
23
W a l r a s i a n ) dcrnand curve for good 1 , the change in Murshallian consumer surplus.

2J. Thc tcrrn origina tes from Marshall ( 1920), who used the area lo the left of the rnarket

dernand c u r v e as a wclfare mensure in the special case where wealth effects are absent.
 ··--------------

84 C H A P T E R 3 : C L A S S I C A L D E M A N D T H E O R Y

1
Exercise 3.1.1: Suppose that the ehange from price vector r" to price vector p

ínvolves a change in the prices of both good 1 (from p? to p l ) and good 2 (from p�

to P1). Express the equivalent variation in terms of the sum of integrals under

appropriate Hicksian demand curves for goods I and 2. Do thc same for the

compensating variation measure. Show also that i f there are no wcalth effects for

c i t h c r good, t h e c o rn p e n s a t i n g and equivalent variations are equal.

Examplc 3 . 1 . 1 : Th e Deadweiqht Loss [rom Commodity Taxation. Considera situation

1
where thc ncw pricc vector p arises because thc government puts a tax 011 sorne

c o m m o d i t y . To be spccific, supposc that the govcrnment taxes c o m m o d i t y 1 , sctting

a tax on thc consumer's purchases of good I of t per unit. This tax changes thc

cllcctivc price of good I to p \ = p? + t whilc prices for ali other commoditics l #- 1

rcmain Iixcd al p�> (so we havc p) = pJ for a l i / #- 1 ) . The total revenue raiscd by
1 ,
thc t a x i s thercfore 7'= l x (p w).
1

An a l t e r n a t i ve to t h i s cornmodity tax that raiscs the sarne amount of revenue for

the governrnent withoul changing prices is imposition of a " I u m p - s u m " tax of T

dircctly 011 thc consurncr's wealth. Is the consumer better or worse off facing this

lump-sum wealth tax rather than thc commodity tax? She is worse off under the

c o m m o d i t y t a x i f t h e c q u i v a l e n t v a r i a t i o n of the commodity tax E V ( p º , p 1 , w), which

is n e g a t i v o , i s less t h a n - T, the a rn o u n t of wealth she w i l l lose under the l u m p - s u m

tax. Put in t e r m s of thc cxpenditure function, this says that she is worse off under
0, 1
c o m m o d i t y t a x a t i o n if w - T > e( p u ), so that her wealth after the lump-sum tax
0
is greater than thc wealth leve) that is rcquircd at prices p to generate the utility
1•
lcvcl t h a t shc gcts under the commodity tax, u The diffcrcnce ( - T ) - E V(pº, p ' ; w) =

1 )
w T - e( r". u is k nown as the deadweiqht loss of commodit y iaxation. I t meas u res

the e x t r a a m o u n t by which thc consumer is made worse off by commodity taxation

ubovc w h a t is nccessary to raise the same revcnue through a lump-sum t a x .

The deadwcight loss measure can be represented in terms of the Hicksian demand
1. 1, 1),
curve at u t i l i t y lcvcl u Since T = t x w) = th1(p u we can write the deadweight
1 ( p 1 ,

loss a s follows [ wc again let p_ 1

= (p2, . . . , p¡J, where pJ = p) = p1 for ali / #- 1 ] :

1 , 1 ) 1)
( - 1') ···· EV(pº, r', w) = e(p u - ei p", u - T

p'/+t

1 ) 1 )
= h1(pi, P-1, u dp , - t h 1 ( p ? + t, P-1, u
f PY

r'!+•
1) 1)]
= [h1(p1, p: 1, u - h1(p? + t, P-1, u dp1• (3.1.5)

f PV

Beca use h 1
( p, u) is nonincreasing in p 1 , t h i s expression (and therefore the deadweight

loss of taxation) is nonnegative, and it is strictly positive if h 1 ( p , u) is strictly

decreasing in p 1 • I n Figure 3 . l . 4 ( a ) , the deadweight loss is depicted as the arca of the

crosshatched t r i a n g u l a r region. T h i s region is sometimes called the deadweiqht loss

trianqle.

This deadwcight loss measurc can also be reprcsented in the c o m m o d i t y space. For c x a m p l e ,

1 ,
supposc that l. - 2, and normalize p� = l. Consider Figure 3.I.5. Sincc (p? + t)x
1
(p w) +
1,
p�x2(p w) = w, thc bundle xt p ' ; w) lies not only on thc budget line associated with budget

set H"' · " ' out also on the budgct line associatcd with budget set BP"·"' T. In contrast, the budget

0
set that generales a utility of u' for the c o n s u rn e r at prices p is Bp".e(p".u'> (or, equivalently,
 s E e T I o N 3 . 1 : w E L F A R E E V A L u A T I o N o F E e o N o M I e e H A N G E s 85

p� + t

Figure 3.1.4

The deadweight loss

from commodity

taxation.
x (p
1 1 ,
p_ 1
, w)
(a) Measure based at
X 1 ( P 1 , P - 1 , w)

u'.
1 )

h1(p� + t, p_ 1 , u x
1
h 1
(p�+1,p_ 1
,uº) x
1 (b) Measure based al

uº.
(a) (b)

X¡

Dcadwcight {

Loss

uº
Figure 3.1.5

An altcrnative

depiction of the

deadwcight loss from

commodity t a x a t i o n .

HP"· w , n· ). Thc dcadwcight loss is the vertical distance between the budget lines associated

with budgct sets HP"·"' 1 and HPº·"'''º·"'I (rccall that p� = 1 ) .

A s i m i l a r dcadweight loss triangle can be calculated using the Hicksian demand

curve h 1
( p, u º) . l t also measurcs thc loss from commodity taxation, but in a different

way. In p a r t i c u l a r , supposc t hat wc examine thc surplus or deficit that would arise

if thc g o v c r n m c n t wcrc to compensate the consumer to keep her welfare under the

tax cqual to her pretax wclfare uº. The government would run a deficit if the tax
1 1 1
collected th1(p ,uº) is lcss than -CV(pº,p ,w) or, equivalently, if th
1
(p ,uº)<

1,
e( p u º ) - w. Th us, l he defici t can be wri tten as

0, 1 , 1 ,
---CV(p p w) -- !h (p u ) = et p " , uº) - ei p", uº) - t h uº)
1 1(p1,

p�+t
0)
= h1(p1, fi - 1 , uº) dp , - th1(p? + t, P-1, u

JPV
p':+,

= [ h 1 ( P 1 , fi - 1 , uº) - h 1 ( P ? + t, fi - 1 , uº)] d p 1 •
f
PV

(3.I.6)

which is again strictly positivc as long as h 1 ( p , u) is strictly decreasing in p1• This

dcadweight loss measurc is cqual to the area of the crosshatched triangular region

in Figure 3 . l . 4 ( b ) . •
86 C H A P T E R 3 : C L A S S I C A L D E M A N D T H E O R Y

Exercise 3.1.2: Calculare t h e d e r i v a t i v e of the deadweight loss measures ( 3 . I . 5 ) and

(3.1.6) with rcspcct to t. Show that, cvaluated at l = O, these derivatives are equal to

zero but that if h 1 ( p , uº) is s t r i c t l y decrcasing in p 1 , they are strictly positive a t ali

t > O. 1 n tcrprct.

U p to now, we havc considered only the q u e s t i o n of whether the consumer was better off at

1 11.

p t h a n at the initial pricc vector p We saw that both t:V and C V provide a correcr welfarc
11 1 .
ranking of p and p Supposc, however, that rº is being compared with two possible price

2 1 1,
vcctors p1 and p . 1 n t h i s case, P is better t h a n p2 if and o n l y if E V(pº, p w) > E V(pº, r'. w),

since

1 , 2, 11,
h. V ( p ", p w) - E V(p", p w) = e ( p 111) - e(pº, 11 2 ) .

11, 11, 2,
T h u s , t h e E V mensures E V( p P 1 , w) and E V( p p w) can be used not o n l y to compare these

0
two pricc vcctors w i t h p hut also to determine which of them is better for t h c consumcr. A

1 , 11, 2,
cornpa rison of t he compensa! ing v a r i a t i o n s C V( p", p w) and C V( p p w), however, w i l l not

1 2
necessarily r a n k P and p correctly. The p r o b l e rn is that the C V meas u re uses the new prices as

1
t h c hase prices i n the money m c t r i c i n d i r e c t u t i l i t y fu n c t i o n , using p to calculate C V ( p º , p 1 , w)

2 11, 2,
ami ¡, t o c a l c u l a te C V( ¡, ¡, w). So

11, 11, 2,
C V( p r', w) - C V( p v'. w) = e(p 11 º ) - e( p " , 11 º ) ,

1 2
which nccd not corrcctly rank p and p [sec Exercise 3 . 1 . 4 and Chipman and Moore ( 1 9 8 0 ) ] .

In ot hcr words, fixing r". J;V(pº, · , w) is a v a lid indirect utility fun c tion (in fact, a mone y

11, 24
m etri c onc), hut CV(p · , w) is not.

An interesting cxarnplc of t h e cornparison of s e vera ! possible new price vectors arise s when

a g o v c r n m c n t is c o n s i d e r i n g w h i c h goods to t a x . S u pp ose, for e x ampl c, that two di ff erent ta x es

ar e h e in g considcrcd t h a t c o u l d rais c tax r e ven u e of T: a ta x on good I of t 1

( c reating new pric e

1 ) 2).
v e c t o r /J a n d a t a x on good 2 of 1 2 (creating new price vector p N ote that s ince t h e y raise

1 ,
the s a rn c tax rcvcnuc, we have 1
1
xi(p w) = t
2 x i ( p 2 , w) = T(see F igure 3.1.6). B ecause ta x 1 1

Pi

h 2 ( P2, r° 2, 11 2 )

De ad we i g ht Loss

D c a d w c i g ht Loss
from Tax on
p� + f 2

from T ax on
Good 2
Good I

! x 2( P2· rº 2·
11
·J

1
Figure 3.1.6
1

0 2 2 )
C om p arin g two taxes
/¡ 1 ( P{i + l 1, p° 1 • 1 1 1 ) X 1 h 2
( p � + r
2
, p ,u x2
th a t raise rcvenue T.
1)
= h, ( p ' : u = h ( p 2 , u2)
(a) Tax on good 1 .

(a) (b) (b) Tax on good 2.

2,
is bcttcr th a n t ax 1 if and o n l y if E V( pº, p 1 , w) > E V(pº, p w), t is better than t 2 if and on l y
2 1
1 , 2,
if [( - T) - E V( p", p w)] < [( - T) - E V(pº, p w)], that is , if and onl y if thc dead w ei g ht loss

arising u n d c r t ax 1 is lcss than that a ris i ng under tax l i-

1

1 2 1,
24. Of coursc, wc can r a nk p and p correctly by seeing whether C' V ( p p2, w) is po s itive or

negativo.
 S E C T I O N 3 . 1 : W E L F A R E E V A L U A T I O N O F E C O N O M I C C H A N G E S 87

In summary, if wc know the consumcr's expenditurc function, we can precisely

measure t h c wclfarc impact of a priee change; moreover, we can do it in a convenient

way ( i n d o l l a r s ) . In principie, this might well be the end of the story because, as we

saw in Section 3.H, wc can recover thc consurner's preferences and expenditure

25
function from t h c observable Walrasian demand function x(p, w). Befare conclud­

ing, howevcr, wc consider two furthcr issues. We first ask whether we may be able

to say a n y t h i n g a b o u t t h e wclfarc effect of a price change when we do not have enough

information to recover thc consumer's expenditure function. We describe a test that

provides a s u t ti c i c n t condition for the consumer's welfare to increase from the price

0,
chango and that uses i n fo r rn a t i o n only about the two pr i ce vector s p p' and the

0,
initial consumption bundle x( p w). We then conclude by discussing in detail the

extcnt to which th e wclf a re chango can be a p p r ox i m a t c d by means of the arca to

thc lclt of thc market (Walrasian) d cm and c urve , a top i c of signiíicant his torica l

importancc.

Wetfare II nalysis wit h Part ial lnformation

In s o rn e circumstances, we may not be able to derive the consumer's c x penditur e

Iu n c t i o n bccausc wc may h a v e o n l y l i m i t e d information about her Walrasian demand

function. l lcrc wc c o n s i d c r w h a t can be s a id whcn the only inform a tion we possess

0, 1
i s k n o w l c d g c of t h c two pricc vectors p p a nd the consumer's i n i t i a l consumption

0
bundle \ = x(pº, w), We h e g in, in P ropo s ition 3.I.l, by deve l oping a simp l e

suflicicncy test for w h c t h e r the consumcr's welfare improve s as a result of the price

chango.

Proposition 3.1.1: Suppose that the consumer has a locally nonsatiated rational
1
preference r e l a t i o n ?::: . lf ( p - pº) · xº < O, t h e n the c o n s u m e r is s t r i c t l y better off
1,
under price wealth situation (p w) than u n d e r (pº, w ) .

0
Proof: Thc result follows simply from rcvealed preferencc. Since p • x? = w by

1 1
Walras' law, if ( P -- pº) · .x" < O, then p • x" < w. B ut if so , x" is s t i l l a ff ordab le under

pri c c s r' and is , moreovcr, i n t he i n t e r i o r of budget set Bp1.w· By local nonsatiation,

thcrc must t h c rc ío rc be a c o n s u rn p t i o n bundle in BP1,w that the consumcr strict l y

prcfers t o .v''. •

Thc test in Proposition 3 . 1 . 1 can be vi c wed as a fi rst - order approximati o n to the

t r u e w cl f a rc e h a n g e . To sce t h i s , t a k e a first-order T aylor expansion of e(p, u) around

the initial priccs p":

(3.1.7)

1
lf ( p - pº) · V ,l'( p", u º ) < O a nd thc sccond - order remainder term could be ignored,
1

we would havc e( v' , u º ) < e(pº, u º ) = w, and so we cou l d conc l u d e that the con ­

surncr's welfarc is grcatcr after the pricc change, But the concavit y of e ( · , uº) in p

i rn p l i c s that thc r c rn a i n d c r tcr m is nonpositive . Therefore, ignoring the re m ainder

1, 1
term lcads to no error here ; we do havc e(p u º ) < w if ( p - p º ) · V P e ( p º , u º ) < O.

1 1
l J s i n g P ro p o s i t i o n 3 . G. I then tells us that ( p - pº) • Vpe(pº, uº) = ( p - pº) · h(pº, u º ) =
1
(p - pº)·xº, and so we gel cxactly the test in Proposition 3.1.1.

25. A, a practica! maucr, in applications you should use whatever are the state-of-the-art

tcchniquc» for p c rf o rn i i n g this recovery.

88 C H A P T E R 3 : C L A S S I C A L D E M A N D T H E O R Y

Pz

Figure 3.1.7

The welfare test of

/ /
Propositions 3.1.1 and
: f ' E [ f,l � : C'(p, 11º) = e(pº. u"); [p E IR � : e(p, 11º) = e(pº, uº)}
3. 1 . 2 .
1
(a) ( / • - p º ) · x º < O.
(a) (b) (b) (p ' - p º ) · x º > O.

1
What if (p - pº)·xº > O? Can we then say anything about the direction of

chango i n wclfarc? A s a general matter, no. Howevcr, examination of the first-order

T a y l o r e x p a n s i o n ( 3 . 1 . 7 ) t e l l s us that we get a dcfinite conclusion if the price change

is, i n a n a p p r o p r i a t c scnsc, s rn a l l e n o u g h because the remainder term thcn becomes

i n s i g n i f i c a n t r c l a t i v c to t h e ñrst-order term and can be neglected. This gives the result

shown in Proposition 3.1.2.

Proposltlon 3 . 1 . 2 : S u p p o s e that the c o n s u m e r has a d i f f e r e n t i a b l e e x p e n d i t u r e f u n c ­

1
t i o n . Then if ( p - pº) · xº > O, there is a sufliciently small a E (O, 1 ) s u c h that for a l i

ex < ex, we have e ( ( 1 - a)pº + «p 1 . uº) > w, and so the consumer is strictly better
1,
off u n d e r p r i c e w ealth s i t u a t i o n (pº, w) t h a n u n d er ( ( 1 - cx)pº + ap w).

1
F igure 3.1.7 illustratcs th e se resu l t s for the cases where p is s u ch that
1 1
(p - pº)·xº < O [ panel ( a ) ] and ( p - pº)·xº > O [p anel ( b)]. I n the fi gure the set

oí priccs [ p E IR � : e(p, u º ) � et p", uº)} is drawn in price space. T he conca v it y

0
of e ( · , u) givcs it t he shapc depicted. T he initial p rice vector p l ies in this set. By

0 ),
Proposition 3 . G . I . t h e g r a dient of the ex p enditure funetion at this p oint , VPe(pº, u
1
is cquul to x'', thc initial consumption b undle. The vector (p - pº) is the v ector

connecting po int pº to the new pri c e p oint p': F igure 3.l.7(a) s hows a case where

1 1
(p - pº) · .x'' < O . A s c a n be see n there, p lí e s out s ide of the set { p E IR ¡ : e(p, uº) �

dpº, u º ) ) , and s o wc m u s t have et p", u º ) > e i p " , uº). In F igure 3. l . 7 ( b ) , on the o t her

1
hand, wc s h o w a case where ( p - p º ) · x º > O. P r o p osition 3 . 1 . 2 can be inter p reted
1
a s asscrting t hat in this c ase i f ( p - pº) is sma l l enough , then ei p", uº) < ei p " , u"),
1 1
T h i s can b e sccn i n F i g u r e 3. l . 7 ( b ), beca use if ( p - pº) · xº > O and p is el ose enough
1
to pº [ in t hc ray with direct i o n p - pº], then p rice v ector p' li es in the set

{ P E IR ¡ : ci p, u º ) > ei p", uº)}.

Usinq the Arca to the Left of the Walrasian (Market) Demand Curve as an

Approximate Welfare Measure

l m p r o v e m c n t s in computat i on a l a b ilitie s have made the recovery of the con su mer 's

prc f c rcnce s / expcnditurc function from obser v ed demand beha v ior , along the lines
26
discusscd in Sc ction 3 .1, far e as i e r than was pre v ious l y the case. T raditionall y ,

26. Thcy havc also made it much easier to estímate complicated demand systems that are

cxplicitly derivcd from utility rn a x i m i z a t i o n and from which the parameters of the expenditure

íu n c t i o n can he dcrivcd dircctly.