Documente Academic
Documente Profesional
Documente Cultură
Matthew Basilico
Chapter 2
Denition 2.F.1: The Walrasian demand function x(p, w) satises the weak
axiom of revealed preference if the following property holds for any two price-
wealth situations (p, w) and (p0 , w0 ):
0 0 0 0
If p x(p , w ) w and x(p, w) 6= x(p , w ) then:
0 0
p x(p, w) > w
Intuition: If the new bundle was aordable at the old prices, and the new
and old bundles aren't equal, then the old bundle must not be aordable at the
new prices.
What are the two ways in which price changes aect consumers?
1
2. They change the consumer's real wealth
[Slutsky anaylsis attempts to isolate rst eect]
No: it is not sucient to yield the law of demand for price changes that are
not compensated.
(law of demand = price and demand move in opposite directions)
2
If x(p,w) is a dierentiable function of p and w, what is the com-
pensated law of demand for dierential changes in price and wealth
dp and dx?
dp dx 0
dp [Dp x(p, w) + Dw x(p, w)x(p, w)T ]dp 0
The expression in brackets from the compensated law of demand for dier-
ential changes, [Dp x(p, w) + Dw x(p, w)x(p, w)T ]
is an L L matrix denoted by S(p, w).
Formally
s11 (p, w) s1L (p, w)
. .. .
S(p, w) = . .
. . .
sL1 (p, w) sLL (p, w)
3
The substitution terminology is apt because the term slk (p, w) measures the
dierential change in the consumption of commodity l (i.e. the substitution to or
from other commodities) due to a dierential change in the price of commodity
k when wealth is adjusted so that the consumer can still just aord his original
consumption bundle (i.e. due solely to a change in relative prices).
To see this, note that the change in demand for good l if wealth is left
xl (p,w)
unchanged is
pk dp k .
For the consumer to be able to just aord his original consumption bundle,
his wealth must vary by the amount xk (p, w)dpk .
xl (p,w)
The eect of this wealth change on the demand for good l is then w [xk (p, w)dpk ].
The sum of these two eects is therefore exactly slk (p, w)dpk .
What does v S(p, w)v 0 for any vRL imply for S(p, w)?
Is S(p, w) symmetric?
4
Suppose that the Walrasian demand function x(p, w) is dieren-
tiable, homogenous of degree zero, and satises Walras' law.
What is p S(p, w)?
Proposition 2.F.3:
p S(p, w) = 0 and
S(p, w)p = 0 for any (p, w)
Chapter 3
1. Desirability assumptions
Capturing the idea that more goods are generally preferred to less
Includes locally non-satiated, monotone, strongly monotone
2. Convexity assumptions
Concerns trade-os that consumer is willing to make among dierent goods
Includes convexity, stricy convexity
Denition 3.B.3: The preference relation is locally nonsatiated if for every
xX and every > 0, there exists yX such that ||y x|| < and y x.
Says that there is a preferred bundle in an arbitrary small distance from x.
Note that this bundle y could have less of every commodity than x. However,
this does rule out the extreme case that all goods are bads, in which case 0 would
be a satiation point.
Also, local nonsatiation (and hence monotonicity) rules out thick indifer-
ence sets.
When is monotone?
5
bad, can redene consumption activity as the absence of that bad to recover
monotonicity. ]
Indierence set containing point x is the set of all bundles that are indierent
to x: formally {yX : y x}.
Upper contour set of bundle x is the set of all bundles that are as least as
good as x: {yX : y x}.
Lower contour set of bundle x is the set of all bundles that x is at least as
good as: {yX : x y}.
Local nonsatiation rules out thick indierence sets.
When is convex?
6
Denition 3.B.5: The preference relation is strictly convex if for every
xX , we have that y x, z x and y 6= z implies y + (1 )z x for all
(0, 1).
What are two classes of preference relations for which it is possible to deduce
the consumer's entire preference relation from a single indierence set?
When is homothetic?
When is quasilinear?
L1
Denition 3.B.7: The preference relation on X = (, ) R+ is
quasilinear with respect to commodity 1 (called in this case, the numeraire
commodity) if:
i. All the indierence sets are parallel displacements of each other along the
axis of commodity 1.
That is, if x y, then x + e1 y + e1 for e1 = (1, 0, ..., 0) and any R
ii. Good 1 is desirable; that is x + e1 x for all x and > 0.
Note that in denition there is no lower bound on the possible consumption
of the rst commodity.
7
What are the assumptions needed to ensure the existance of a
utility function?
When is continuous?
What does this imply about the upper contour set and lower con-
tour set?
x,
An equivalent way of stating the notion of continuity is to say that for all
the upper contour set {yX : y x}and the lower contour set {yX : x y}are
both closed, that is, they include their boundaries.
No, any strictly increasing transformation of u(), say v(x) = f (u()), where
f () is a strictly increasing function, also represents .
8
What is another common convenience assumption about utility
functions?
What is an important counter-example?
00 00 0 0
Leontief preferences: x00 x0 min{x1 , x2 } min{x1 , x2 }
The nondierentiability arises because of the kink in the indierence curves
when x1 = x2 .
9
When is a continuous homothetic?
Which of the following properties are ordinal and which are car-
dinal? Which are preserved under arbitrary increasing transforma-
tions?
increasing; quasiconcave; homothetic; quasilinear
If p0 and u() is continuous, then the utility maximization problem has
a solution.
10
What is the rule that assigns the set of optimal consumption vec-
tors in the UMP?
The rule that assigns the optimal consumption vectors in the UMP to each
price-waelth situation (p, w) x is denoted by x(p, w) and is known as the
Walrasian (or ordinary or market) demand correspondance. As a general matter,
for a given (p, w) 0 the optimal set x(p, w) may have more than one element.
When x(p, w) is single valued for all (p, w), we refer to it as the Walrasian
(or market or ordinary) demand function (or Marshallian demand function).
Proposition 3.G.2:
i. Homogeneity of degree zero in (p, w) : x(p, w) = x(p, w) for any p, w
and scalar > 0.
ii. Walras' law: px=w for all xx(p, w).
iii. Convexity and uniqueness, with conditions (see below)
11
An equivalent formulation:
u(x)
x1
.
If we denote the gradient vector of u() at x as u(x) =
.
.
u(x)
xL
we can write the above notation in matrix form: u(x) p
and x [u(x) p] = 0.
At an interior optimum (i.e. if x 0), we have
u(x) = p.
What does the above discussion imply about the relationship be-
tween two important vectors at an interior optimum?
What is the relationship for two goods l and k involving the gra-
dient vector of u() and the price vector, formally and verbally?
u(x)
xl pl
Where is there an exception to the formula u(x) = pk ?
xk
12
#Will generally assume Walrasian demand to be suitably continuous and
dierentiable.
[These properties hold under general conditions if preferences are contin-
uous, strictly convex, locally nonsatiated]
The indirect utility function (p, w) is an analytic tool for measuring the util-
ity value at any x x(p, w). The utility value of the UMP is denoted (p, w)R
for each (p, w) 0.
It is equal to u(x ) for any x x(p, w).
What are key properties of the indirect utility function (p, w)?
(4) What assumptions need to be made?
13
Whereas the UMP computes the maximal level of utility that can be obtained
given the wealth w, the EMP computes the minimal level of wealth required
required to reach utility level u.
It captures the same aim of ecient use of the consumer's purchasing power
while reversing the roles of objective function and constraint.
The optimal consumption bundle x is the least costly bundle that still allows
the consumer to achieve the utility level u.
Given prices p 0 and required utility level u > u(0), the value of the EMP
is denoted e(p, u). The function e(p, u) is called the expenditure function.
Its value for any (p, u) is simply p x ,where x is any solution to the EMP.
Proposition 3.E.2's characterization of the basic properties of the expendi-
ture function parallel the properties of the indirect utility function for UMP.
What are the key properties of the expenditure function e(p, u)?
(4) What assumptions need to be made?
Proposition 3.E.2: Suppose that that u() is a continuous utility function rep-
resenting a locally nonsatiated preference relation dened on the consumption
set X = RL
+.
The expenditure function e(p, u) is:
i. Homogenous of degree one in p.
ii. Strictly increasing in u and nondecreasing in pl for any l.
iii. *Concave* in p.
iv. Continuous in p and u.
14
What is the formal relationship between the expenditure function
and the indirect utility function?
15
h(p, u) = x(p, e(p, u)) and x(p, w) = h(p, v(p, w))
As prices vary, h(p, u) gives precisely the level of demand that would arise if
the consumer's wealth were simlataneously adjusted to keep her utility level at
u.
This type of of wealth compensation is known as Hicksian wealth compen-
sation.
[As p p0 , whicks = e(p0 , u)w. Thus the demand function h(p, u) keeps
the consumer's utility level xed as prices change, in contrast with Walrasian
demand which keeps money wealth xed but allows utility to vary.]
16
No: Walrasian demand need not satisfy the law of demand.
For example, the demand for a good can decrease when its price falls.
How can e(p, u) be written in terms of the Hicksian demand h(p, u)?
e(p, u) = p h(p, u)
h(p, u) = p e(p, u)
e(p,u)
That is, hl (p, u) =
pl for all l = 1, . . . , L.
Thus, given the expenditure function, we can calculate the consumer's Hick-
sian demand function simply by dierentiating.
17
What does the negative semideniteness of Dp h(p, u) imply?
It implies that the cross-derivates between any two goods l and k must
satisfy:
hl (p,u)
pk = hkp(p,u)
l
[Not easy to interepret in plain economic termssays that 'when you clime
a mountain, you will cover the same height regardless of route.']
18
hl (p, u) xl (p, w) xl (p, w)
= + xk (p, w) [f or all l, k]
pk pk w
Equivalently, in matrix notation:
s11 (p, w) s1L (p, w)
. .. .
S(p, w) = . .
. . .
sL1 (p, w) sLL (p, w)
Where
xl (p, w) xl (p, w)
Slk (p, w) = + xk (p, w)
pk w
First term: unconpensated change in demand of good l due to a change in
pk (when multiplied by dpk )
Second term: eect of wealth change on demand of good l [see below] (when
multiplied by dpk )
What does this tell us about the Slutsky matrix when demand is
generated from preference maximization?
How does this dier from the choice-based theory?
19
negative semidenite, symmetric, and satisfy S(p, w)p = 0.
This is because Dp h(p, u) = S(p, w)
The dierence is *symmetry*: In the choice-based approach, discussed in
section 2.F, saw that if x(p, w) satises WARP, Walras' law, and homogeneity
of degree zero, then S(p, w) is negative semidenite with S(p, w)p = 0. How-
ever, we saw that unless L = 2, the Slutsky substitution matrix need not be
symmetric.
=Restrictions imposed on demand in the preference-based approach are
stronger than those arising in the choice-based theory built on WARP
=In 3.I, see that it is impossible to nd preferences that rationalize demand
when Slutsky matrix is not symmetric.
So e(p, u) is the value function of the EMP, and we saw that the
minimizing vector of the EMP,h(p, u), is equivalent to the derivative
of e(p, u) with respect to p : h(p, u) = p e(p, u).
Why can't we say that Walrasian demand x(p, w) is equivalent to
the derivative with respect to p of its value function v(p, w)?
The Walrasian demand, an ordinal concept, cannot equal the price derivative
of the indirect utility function, which can vary with increasing transformations
of utility.
However, with a small correction in which we normalize the derivatives of
v(p, u) with respect to p by the marginal utility of wealth, it holds true.
1
x(p, w) = p v(p, w)
w v(p, w)
That is, for every l = 1, . . . , L:
v(p,w)
p
xl (p, w) = v(p,lw)
w
20
Roy's identity provides a substantial payo: Walrasian demand is much
easier to compute from indirect than from direct utility.
To derive x(p, w) from the indirect utility function, no more than the calcu-
lation of derivatives is involved; no system of rst-order equations needs to be
solved.
Thus, it may often be more conveenient to express tastes in indirect utility
form.
Although money metric utility function (above) can be constructed for any
p 0, two natural choices for p are p0 [EV] and p1 [CV].
0 0 1
1
Let u = v(p , w) and u = v(p , w).
0 0 1 1
We also note that e(p , u ) = e(p , u ) = w. Then dene:
EV (p , p , w) = e(p , u ) e(p , u ) = e(p0 , u1 ) w
0 1 0 1 0 0
21
her wealth that woudl be equivalent to the price change in terms of its welfare
impact.
CV: Net revenue of a planner who compensates a consumer for the price
change after it occurs, bringing her back to her original utility level.
The specic dollar amounts calculated using the EV and CV will dier be-
cause of the diering price vectors at which compensation is assumed to occur.
For simplicity, assume only the price of good 1 changes, so that p01 6= p11 and
p0l = p1l for all l 6= 1.
We have the Hicksian demand: h1 (p, u) = e(p,u)
p1
We also note that e(p , u ) = e(p1 , u1 ) = w.
0 0
For EV:
EV (p0 , p1 , w) = e(p0 , u1 ) e(p0 , u0 ) = e(p0 , u1 ) w =
p01
0 1
EV (p , p , w) = h1 (p1 , p1 , u1 )dp1
p11
For CV:
CV (p0 , p1 , w) = e(p1 , u1 ) e(p1 , u0 ) = w e(p1 , u0 )=
p01
0 1
CV (p , p , w) = h1 (p1 , p1 , u0 )dp1
p11
22
[EV left, CV right]
p01
From the equation, EV (p0 , p1 , w) = h1 (p1 , p1 , u1 )dp1 , we see that
p11
the
1 0
EV can be represented as the area lying between p1 and p1 to the left of the
1
Hicksian demand curve for good 1 associated with utility level u .
The above graph depicts the situation where good 1 is normal.
If good 1 is normal, EV (p0 , p1 , w) > CV (p0 , p1 , w).
0 1 0 1
If good 1 is inferior, EV (p , p , w) < CV (p , p , w).
When are EV and CV the same for a single good price change?
If there is no wealth eect for good 1, the EV measures are the same because
we have
h1 (p1 , p1 , u1 ) = h1 (p1 , p1 , u0 ) = x1 (p1 , p1 , w)
In the case of no wealth eects, we call the common value of CV and EV,
which is also the value of the area lying between p01 and p11 and to the left of
the market (Walrasian) demand curve for good 1, the change in Marshallian
consumer surplus.
[One example of this could arise if the underlying preferences are quasilinear
with respect to some good l 6= 1]
23
p01 +t
h1 (p1 , p1 , u1 ) h1 (p01 + t, p1 , u1 ) dp1
=
p01
The Marshallian surplus (or average variation), which is what you see in
many undergraduate textbooks, is used frequently as an approximation to EV
and CV. It is equal to the area under the Marshallian demand curve:
24
p01
0 1
AV (p , p , w) = x1 (p1 , p1 , w)dp1
p11
Only correct (and same to EV and CV) when there are no wealth eects.
For a normal good and a price decline, compare the graphs of EV,
CV and AV. What is their order from biggest to smallest?
For a normal good and a price decline, EV > AV > CV. This will be
reversed for a price rise or an inferior good.
Proposition 3.I.1: Suppose that the consumer has a locally nonsatiated ra-
tional preference relation %.
If (p1 p0 )x0 < 0, then the consumer is strictly better o under price-wealth
1 0
situation (p , w) than under (p , w).
[If (p1 p0 )x0 > 0, what can we say about the change in consumer's
welfare?]
The short answer is that you can't say anything: it could go up or down.
This is because of the convexity of the indierence curvethe new price vector
may still be outside the indierence curve. However, if this dierence is scaled
by some (0, 1), then it will make the consumer worse o:
Proposition 3.I.2: Suppose that the consumer has a dierentiable expendi-
ture function.
Then if (p1 p0 ) x0 > 0, there is a suciently small (0, 1) such that for
1 0 0
all < , we have e(p + (1 )p , u ) > w , and so the consumer is strictly
0 1 0
better o under price-wealth situation (p , w) than under (p + (1 )p , w).
25
Chapter 4
Let xi (p1 , p2 , . . . , pL , w) denote the demand for the ith consumer out of a
total of I consumers.
Aggregate demand is
I
X
x(p1 , p2 , . . . , pL , w) = xi (p1 , p2 , . . . , pL , w)
i=1
The necessary and sucient condition for this to be the case is for preferences
to admit an indirect utility function of the Gorman polar form.
That is, it can be written as:
26
[Note that b(p), the coecient on the wi , is the same for everyone, but the
ai can change]
#This must hold because aggregate demand must be the same for two dif-
ferent distributions of wealth with the same aggregate wealth.
#In particular, starting from any wealth distribution, the aggregate response
better be the same if I increase individual i0 s wealth by dwi and keep everyone
else's wealth constant, or I increase individual j 6= i's wealth by dwj .
#In other words, the wealth expansion paths (Engel curves) must be straight
parellel lines.
What are two cases of the Gorman form that are commonly seen?
When does the aggregate demand function satisfy the weak axiom?
Does this always hold?
Denition 4.C.1: The aggregate demand function x(p, w) satises the weak
axiom if
27
Why are we interested in whether aggregate demand satises the
weak axiom?
Denition 4.C.2: The individual demand function xi (p, w) satises the Un-
compensated Law of Demand if:
(Very similar)
The aggregate demand function x(p, w) satises the Law of Uncompensated
Demand if:
28
What is a property of the individual preference relationship that
will lead to that individual's consumer demand function xi (p, wi ) sat-
isfying the Law of Uncompensated Demand?
29
max W (v1 (p, w1 ), v2 (p, w2 ), . . . , vI (p, wI ))
{u}I1
I
X
s.t. wi w
i=1
where (wi (p, w)) is the distribution rule that is a solution to the social welfare
maximization problem.
Proposition 4.D.1: Suppose that for each level of prices p and aggregate
wealth w the wealth distribution (w1 (p, w), w2 (p, w), . . . , wI (p, w)) solves the
benevolent social planner's problem.
Then the value function v(p, w) is an indirect utility function of a pos-
itive representative consumer for the aggregate demand function x(p, w) =
PI
i=1 xi (p, wi ).
Chapter 5
1. The production vector y [note the lowercase] describes the net output of
L commodities from a production process.
#Negative values correspond to inputs, while positive values correspond to
outputs
30
2. The production set Y [note the uppercase] is the set of all production
vectors that are feasible.
#Can be described by a transformation function F (), which is dened so
that
Y = yRL : F (y) 0
We have F (y) = 0 denes the production possibilities set [also known as the
transformation frontier, and F () is called the transformation function].
You can think of F () as telling you how much you get out for what you put
in.
F () cannot be positive because you can't get out more than what you put
in.
F () could be negative, but you can do better.
max py
y| F (y)0
max p y F (y) =
y
F (y)
p = 0 l =
yl
F (y)
p= l
yl
31
What else is the MRT equal to?
u(x)
xi pi
In the UMP, we had that M RSij = u(x) = pj
xj
pi
So we have: M RTij = M RSij = pj in competitive equilibrium, a classic
result.
i. Y is non-empty
ii. Y is closed.
iii. No free lunch. [Y RL+ {0}]
iv. Possilibility of inaction [0 Y ]
L
v. Free disposal [Y R+ Y ]
vi. Irreversibility [y Y, y 6= 0 = y / Y]
vii. Non-increasing returns to scale [any feasible input-output vector can be
scaled down, that is: y Y = y Y [0, 1]]
viii. Non-decreasing returns to scale [any feasible input-output vector can
be scaled up, that is: y Y = y Y 1]
ix. Constant returns to scale [conjunction of properties vii and viii. Pro-
duction Set exhibits constant returns to scale if y Y = y Y 0.
Geometrically, Y is a cone.]
x. Addivity (or free entry) [y Y, y 0 Y = y + y 0 Y ]
0 0
xi. Convexity [y, y Y, [0, 1] = y + (1 )y Y ]
0
xii. Y is a convex cone. [conjunction of ix and xi. y, y Y, 0,
0
0 = y + y Y
32
max pf (z) w z
z
The nice thing about this approach is that it denes optimal factor demand
functions z (p, w).
The FOC is:
f (z)
p wl l with equality if zl > 0
zl
f (z)
zi wi
M RT Sij = f (z)
=
wj
zj
Asks how to produce at the lowest cost while achieving a minimum amount
of output.
min wz
z0|f (z)q
The factor demands it denes are z(w, q) rather than z(w, p).
Chapter 6
What is a lottery?
33
How can a lottery be represented geometrically?
34
What is the continuity axiom for a preference relation % on the
space of simple lotteries `?
What is the consequence of the continuity axiom?
L % L0 L + (1 )L00 % L0 + (1 )L00
In other words, if we mix each of the two lotteries with a third one, then
the preference ordering of the two resulting mixtures does not depend on (is
independent of ) the particular third lottery used.
U (L) = u1 p1 + + uN pN
A utility function U : ` R with expected utility form is called a von
Neumann-Morgensterm (v.N-M) expected utility function.
35
What functional form must an expected utility function take?
K
! K
X X
U k Lk = k U (Lk )
k=1 k=1
for
P any K lotteries Lk `, k = 1, . . . , K , and probabilities (1 , . . . , K )
0, k k = 1.
U
e (L) = U (L) + for every L`
36
Step 1:
If L L0 and (0, 1), then L L + (1 )L0 L0 .
This follows from the independence axiom, which implies that:
L = L + (1 )L L + (1 )L0 L0 + (1 )L0 = L0
Step 2:
Let, [0, 1]. Then L + (1 )L L + (1 )L > .
Suppose that > . Note rst that we can write
L + (1 )L = L + (1 )[L + (1 )L] where =
1 (0, 1].
Forward:
A. By step 1, we know that L L + (1 )L
B. By step 1, we know that L + (1 )[L + (1 )L] L + (1 )L
So now we conclude that L + (1 )L L + (1 )L
Converse:
Suppose that .
1. If = , L + (1 )L L + (1 )L
we must have
2. Suppose that < . By the argument from the previous paragraph
(reversing the roles of and ), we must have
L + (1 )L L + (1 )L.
Step 3:
For any L`, there is a unique L such that [L L + (1 L )L] L.
Existance of such a L is implied by continuity of % and the fact that
.....
37
PK
that constitute it: F () = k=1 k Fk (x), where Fk () is the distribution of the
payo under lottery Lk .
[The CDF of the total lottery is the sum of the CDFs of the individual
lotteries, weighted by their probabilities ()]
This is an example of the general property that distribution functions pre-
serve the linear structure of lotteries.
# Assume (makes sense in the current monetary context) that the Bernoulli
utility function is increasing and continuous.
# In large part, the analytical power of the expected utility formulation
hinges on specifying the Bernoulli utility function in such a manner that it
captures interesting economic attributes of choice behavior.
38
What are the denitions of risk aversion, risk neutral, and strictly
risk averse?
Denition 6.C.1: A decision maker is a risk averter (or exhibits risk aversion)
if for any lottery F (), the degenerate lottery xdF (x) with certainty is at least
as good as the lottery F () itself.
Risk neutral: decision maker is indierent between F () and xdF (x)
Strictly risk averse: indierence holds only when two lotteries F ()and xdF (x)
are the same [i.e. when F () is degenerate].
The certainty equivalent of F (), denoted c(F, u), is the amount of money
for which the individual is indierent between the gamble F () and the certain
amount c(F, u). That is:
u (c(F, u)) = u(x)dF (x)
For any xed amount of money x and positive number , the probability
premium denoted by (x, , u) is the excess in winning probability over fair
odds that makes the individual indierent between the certain outcome x and
a gamble between the two outcomes x and x + . That is:
1 1
u(x) = + (x, , u) u(x + ) + (x, , u) u(x ).
2 2
i. u() is concave
39
ii. c(F, u) xdF (x) for all F ()
iii. (x, , u) 0 for all x, .
Representing Assets:
If we assume N assets (one of which may be the safe asset) with asset n
giving a return of zn per unit of money invested. These returns are jointly
distributed according to a distribution function F (z1 , . . . , zN ). The utility of a
holding portfolio of assets (1 , . . . , L ) is then:
U (1 , . . . , N ) = u(1 z1 + + N zN )dF (z1 , . . . , zN )
This utility function for portfolios is also increasing, continuous and concave.
u00 (x)
rA (x) =
u0 (x)
This is the amount of money you would pay to avoid an innitesimally small
risk.
It makes sense to relate it to the curvature of the utility function, u00 (x), and
0
to make it independent of transformations, scale by u (x). The negative sign
allows more curvature in the concave state to simply more risk aversion.
xu00 (x)
rR (x, u) =
u0 (x)
This is the fraction of your wealth you would give up to avoid an innitesi-
mally small risk.
40
#If risk aversion allows us to compare risk preferences, stochastic dominance
allows us to compare lotteries.
41
#Consider the possibility that the decision maker may care not only about
his montary returns but also about the underlying events, or states of nature,
that cause them.
#Denote set of sates by S and an individual state by sS . For simplicity,
assume set of states is nite and that each state s has a well-dened, objective
probability s > 0 that it occurs.
#Because we take S to be nite, we can represent a random variable with
monetary payos by the vector (x1 , . . . , xS ) where xs is the nonnegative payo
vector in state s.
Proposition 6.E.2: Suppose that there are at least three states and that
the preferences %on RS+ are continuous and satisfy the sure-thing axiom. Then
%admits and extended utility representation:
S
X
U (x1 , . . . , xs ) = s us (xs )
s=1
[If us (xs ) = u(xs ), then preferences are not state-contingent; we are in the
special case of expected utility]
Compensating Dierentials
#Two main types of equilibrium assumptions
First, market clearing supply equals demand
Second, no arbitrage assumption (focus of this topic)
42
#Equalizing dierences or compensating dierentials:
Returns or costs must oset other things.
[Application of the hedonic modelwhich values something by decomposing
it into specic parts, and valuing each component]
u = u(w(z1 , . . . , zn ), z1 , . . . , zn )
This gives us:
u w u
0= +
w zi zi
u w u
= =
w zi zi
u w u
In the above set-up, what does w zi = z mean intuitively?
i
u
Jobs with unpleasant characteristics [where
zi is negative] have higher
wages.
43
u = u(w r(z1 , . . . , zn ), z1 , . . . , zn )
FOC:
u r u
0= x zi
+ zi =
u r u
=
x zi zi
Rents rise exactly to make you pay for characteristics.
#Goal is to capture relationship between distance from city center and hous-
ing prices and housing density.
#Story is going to be all about commuting time
What is the utility function and budget constraint for the AMM
Model?
[Need at least three ingredients:
1. housing consumption (assume just talking about land quantity)
2. cost of commuting
3. some alternative use of money]
Choice variables: A, d
FOC (A) :
u u u u
+ (p(d)) = 0 = = p(d) a.k.a = uA = p(d)uC
A C A C
FOC (d) :
44
u T p T p
w A =0 = w = A a.k.a = wT 0 (d) = Ap0 (d)
C d d d d
0, d
Assume that people live at each distance d on some interval and are
freely mobile.
0, d .
They must be indierent between all values of d on Hence each
consumer has utility value u.
u A
u T p
+ w A =0
A d C d d
A
We have
d = 0. Hence:
T p
w = A
d d
Using the linearized version of T (d) = td, we get:
wt
= p0 (d)
A
This is the same as the 2nd FOC before, but now it holds everywhere, not
just at the optimum.
It pins down the price gradient.
max u(w wT (d) p(d)A, A) and u = u(A (d), w wT (d) p(d)A (d))
A,d
45
The rst is the individual maximization problem. It yields FOCs that hold
at the maximized value for that individual.
The second equation describes the spatial equilibrium for the entire popu-
lation. Using the implicit function theorem and taking the total derivative lets
us derive conditions that hold everywhere, not just as optimum.
Take the FOC of individual's demand curve with respect to A above, and
use the implicit function theorem to dene A (d):
u u
= p(d) = uA (A , wwtdp(d)A )p(d)uC (A , wwtdp(d)A ) = 0 = G(A (d), d)
A C
Taking comparative statics gives (using implicit function theorem):
p p p
A G u
A wt A d u
p(d) C wt A d d u
C
d
= G
= 2u 2
u 2u
d A A2 2p(d) AC + C 2 p(d)
2
p
p
u
A
u
p(d) C wt A d d u
C
= 2u u 2 2u
2p(d) AC + 2
A2 C 2 p(d)
p u
d C
= 2u 2u 2u
2p(d) AC + C 2
A2 2 p(d)
p0 (d)uC
=
[uAA 2p(d)uAC + p(d)2 uCC ]
We know the expression is positive (the denominator is positive by SOC <
u p
0; we know
C > 0 can see d < 0).
Hence lot sizes rise with distrance from city center.
46
#A problem is that we don't have anything we can directly estimate.
For this we need to assume a functional form.
Classic case: u(A, c) = c + ln(A)
Math
G(x, y) = c
G
If
y (x0 , y0 ) 6= 0, then there exists a C1 function y = y(x) dened on an
interval I about the point x0 such that:
47