Part IIA, Paper 1

Consumer and Producer Theory

Lecture 3
Duality and the Slutsky Equation
Flavio Toxvaerd

Todays Outline
Dual approaches to consumers problem
Hicksian demand function
Expenditure function
Shephards lemma
Slutsky equation
The big picture (various relations)

Recap
max ux1 , x2
s.t. p1 x1 p2 x2 m

Solve

Marshallian demand
x1(p,m) and x2(p,m)
Roys
identity

Substitute
into u(x,y)

Indirect utility
v(p,m)

The Envelope Theorem

The Envelope Theorem

Application 1 (again)
Marginal utility of Income
As v( p1, p2 , m) max x , x u ( x1, x2 ) s.t. p1x1 p2 x2 m 0
1

and the Lagrangian

L u ( x1, x2 ) - ( p1x1 p2 x2 m)
then, by the Envelope Theorem,
v L

( x *1, x *2 , p1, p2 , m)
m m

The marginal utility of income is

given by the Lagrange multiplier

Application 2 (again)
Roys Identity

Similarly, by the Envelope Theorem,

v( p1, p2 , m) L( x1* , x1* )

x1( p1, p2 , m)
p1
p1
and so,
v( p1, p2 , m)
p1
x1( p1, p2 , m)
v( p1, p2 , m)
m

Roys
Identity

Duality
Primal Problem

max u ( x1, x2 )
s.t. p1x1 p2 x2 m
x2

Dual Problem

min p1 x1 p2 x2
s.t. u ( x1 , x2 ) u
x2

m
p2

p1

x1

x2

min

Dual Problem
p1 x1 p2 x2 s.t. u ( x1 , x2 ) u

The dual problem gives us the minimum

expenditure required for the consumer to achieve
a particular level of utility.

L p1x1 p2 x2 ( u ( x1, x2 ) u )
u ( x1, x2 )
p1
0
x1
u ( x1, x2 )
p2
0
x2
u ( x1, x2 ) u

First Order Conditions

Dual Problem
Eliminating the Lagrange multiplier () gives

u ( x1, x2 )
x2
u ( x1, x2 )
x1

p2
p1

u ( x1, x2 ) u

MRS = Ratio of Prices

Slope of Indifference Curve
= Slope of Budget Line

Utility Constraint

Hicksian Demand Function

Solving these two equations, gives the levels of
demand which achieve the desired utility level at
the lowest cost
When indifference curves are strictly convex the
solution is unique and we may write demand as
a function of prices and the desired utility level

x1 h1 ( p1, p2 , u ) ,

x2 h2 ( p1, p2 , u )

These are called Hicksian/Compensated

Demand Functions

Hicksian Demand Function

x2
slope

p1
p2

slope

p '1
p2

u
x1

Hicksian (Compensated)
Demand Curve

p1
p1
p1

(Hicksian Demand)
= Substitution Effect

h1(p1,p2,m) h1(p1,p2,m)

x1

Expenditure Function
We can now determine the minimum expenditure
required to achieve a specific utility level, given the
prices:

Let e( p1 , p2 , u ) min p1 x1 p2 x2 s.t. u( x1 , x2 ) u

p1h1 ( p1 , p2 , u ) p2 h2 ( p1 , p2 , u )

Properties of the Expenditure Function

Homogeneous of degree 1 in prices
Proof: No change in relative prices, so no change in
optimal solution - so expenditure changes by same
proportion.

Concave in prices
Proof: If prices change, expenditure will increase
linearly if consumption bundle unchanged. Thus any
change in consumption reduces expenditure - and
expenditure increases less than linearly.

Increasing in prices if u(x) is an increasing

function

Shephards Lemma
As e( p1 , p2 , u ) min p1 x1 p2 x2 s.t. u ( x1 , x2 ) u
and the Lagrangian
L p1 x1 p2 x2 (u ( x1 , x2 ) u )

we can apply the envelope theorem to get

e( p1 , p2 , u )
x1 h1 ( p1 , p2 , u )
p1
Shephards Lemma

Passive
Expenditure

Indirect Effect

p 2 x 2

x 1

Actual
Expenditure

p10

p11

p1

(1) Will not do any worse than Passive Expenditure

(2) As change in Px goes to zero, indirect effect becomes
irrelevant because original choice very close to optimal

Indirect Utility and Expenditure Functions

Recall: Indirect utility function gave us the level
of utility given prices and income
Expenditure function gives us level of income
required to achieve a specified utility level
Thus the indirect utility function is just the inverse
of the expenditure function - and vice versa

Duality in Demand Functions

Note that, when
m e( p1, p2 , u ),
xi ( p1, p2 , m) hi ( p1, p2 , u )

x2

u0

e0

So, we can write

xi ( p1, p2 , e( p1, p2 , u )) hi ( p1, p2 , u )

p1

x1

Slutsky Equation
We have shown that
xi ( p1, p2 , e( p1, p2 , u )) hi ( p1, p2 , u )

Differentiating both sides w.r.t.p j ,

xi xi e hi

p j m p j p j
and so
xi hi xi e hi
xi

x j
p j p j m p j p j
m
Substitution Effect

Slutsky Equation

Income Effect

Primal Approach
max ux1 , x2

Dual Approach
Duality

s.t. u x1 , x2 u

s.t. p1 x1 p2 x2 m
Integrability
problem

minp1 x1 p2 x2

Solve

Solve

Hicksian Demand
Marshallian Demand Equivalent if
x1(p,m) and x2(p,m) m e p, u h1 p, u and h2 p, u
Roys
Identity

Substitute
into u(x,y)

Indirect Utility
v(p,m)

Shephards
Lemma

Invert

Substitute
into cost
equation

Expenditure Function

e p , u

Integrability Problem
The problem with all of this is that the utility
function is not observable - only behaviour
(demand) is observable
Thus we are in danger of having a wonderfully
elegant theory of consumer behaviour - which
relies on an unobservable function!
The Slutsky equation is defined for every
price/commodity combination

Integrability Problem
The nice assumption of convexity and more is
better on the utility function impose restrictions
on the nature of the matrix of Slutsky equations
These conditions turn out to be both necessary
and sufficient for the demand function to be
generated by a utility function which possesses
these nice properties.
Thus we can now identify precisely whether or
not our theoretical framework is appropriate

Summary
Can approach consumers problem from different
angles
Having one function, may recover other functions

Readings
Varian, Microeconomic Analysis, chapters 6, 7, 8

Next Time
Revealed preferences
WARP, SARP, GARP
Indices