Economics 101A Section Notes GSI: David Albouy

Consumer Theory and the Envelope Theorem

1 Utility Maximization Problem
Two goods: x and y with prices px and py . Conusumers facing a budget constraint px x + py y I, where I is income.Consumers maximize utility U (x, y) which is increasing in both arguments and quasi-concave in (x, y). Also the non-negativity constraints x 0 and y 0 must hold as consumption cannot be negative. Competition in this world is "perfect" or "pure" so consumers are price takers, i.e. px and py are xed for them. This may be justied by postulating a large number of consumers. Since utility is increasing in both x and y we can safely assume that the budget constraint px x + py y I is satised with equality. We will also assume that the non-negativity constraints are slack so that x > 0 and y > 0. Setting the inequalities to equality, combining the two constraints, and rearranging a bit we get the standard utility maximization problem (UMP for short) max U (x, y)
x,y

The consumer problem looked at here involves

s.t. px x + py y = I

(UMP)

The solution to this problem is typically found by writing the Lagrangean L (x, y, l) = U (x, y) + (I px x py y) and taking the rst order conditions1 U xd , y d L = d p x = 0 x x U xd , y d L = d p y = 0 y y L = I px xd py y d = 0 The superscript "d " is used to refer to the fact that these solutions are the consumers demands. Solving yields the Lagrange multiplier d = d (px , py , I) and the demand functions xd (px , py , I) y d (px , py , I) To be more general we call these the uncompensated (or Marshallian or Walrasian) demand functions. These functions are "uncompensated" since price changes will cause utility changes: a situation that does not occur with compensated demand curves. Substituting these solutions back into the utility function,
1 If

the we did not assume the non-negativity constraints held the rst two rst order conditions would be U xD , yD L = px < 0, with " = " if xD > 0 x x D D U x , y L = py < 0, with " = " if y D > 0 y y

Note that this is a simplication of the Kuhn-Tucker conditions described previously.

the maximand, we get the actual utility achieved as a function of prices and income. This function is known as the indirect utility function V (px , py , I) U xd (px , py , I) , y d (px , py , I) (Indirect Utility Function) This function says how much utility consumers are getting when they face prices (px , py ) and have income I. An interesting question is how much utility changes when either prices or income change. As shown in the "Calculus and Optimization" hand-out we should expect that giving the person one dollar in income should increase her utility by the Lagrange multiplier d

V = d I Taking the total derivative of Indirect Utility Function with respect to px yields U xd U y d V = + px x px y px (1)

This expression does not tell us much, however it can be simplied with the two useful substitutions. First the the rst two rst order conditions tell us that U U = d px and = d py x y so substituting these in to 1 we have xd y d xd y d V d d d = px + py = px + py px px px px px Second take the total derivative of the budget constraint px xd + py y d = I with respect to px to get xd + px xd y d xd y d + py = 0 px + py = xd px px px px V = d xd px (2)

Substituting this in to 2 we get a result known as Roys Identity (Roys Identity)

A basic (albeit somewhat awed) intuition for this identity is straightforward: if px goes up by one dollar then the consumer will lose xd number of dollars, which each have utility value d , so that utility drops by d xd . The more correct intuition is that xd and y d are changing in response to the price increase, but because the consumer is optimizing the entire time and facing a budget constraint, these indirect eects sum up to zero. A similar result holds for y that V = d y d py which you can prove for yourself. Note that if you were just given the indirect utility function you could solve for xd , y d , and d , just be taking combining the derivatives of V appropriately, e.g. xd = (V /p) /d = (V /p) / (V /I). Example 1 Quasilinear utility takes a form where one of the goods consumed enters linearly into the utility function, which in this case we take to be U (x, y) = x + h (y) where h0 (y) > 0 and h00 (y) < 0. (The reader may like try the case where h (x) = x) The rst order conditions for this problem simplify to d to d 1 = d px , h0 y = py , and px xd + py y d = I . Solving yields d = 1/px
d

d py 0 1 y = (h ) py = (h ) px py I py y d I py 1 (h0 ) = xd = px px px px 2
0 1

Notice that y d does not depend on income I, only on relative prices py /px . Indirect utility is given by V (px , py , I) = xd + h y d py py py I 0 1 0 1 (h ) + h (h ) = px px px px It is fairly easy to see that V /I = 1/px = d . Roys identity is more dicult to check V 1 py py 1 py 1 1 1 0 1 0 0 1 = (h ) + h (h ) 00 (p /p ) p 00 (p /p ) p py px px px h px h y x x y x x 1 1 1 py py py 1 1 1 = (h0 ) + px px px h00 (py /px ) px px h00 (py /px ) px 1 py 1 = (h0 ) px px = d y d The reader is invited to check Roys Identity for themselves in the case of x.

Expenditure Minimization Problem

The consumer problem can be approached in a dierent way which produces some useful tools. Instead of maximizing utility given a certain income, imagine how much income it would take to achieve a certain level of utility. In other words consider the following expenditure minimization problem (EMP for short), which as always take prices as given min px x + py y
x,y

s.t. U (x, y) u

(EMP)

This problem looks very much like the UMP above except that the objective function and constraint have been switched around. We wish to minimize the income I = px x+py y needed achieve a xed level of income u, for given prices (px , py ). Our third parameter in parameter in this problem (after px and py ) is no longer I, but u. This problem can typically be solved by writing the Lagrangean L (x, y, ) = px x + py y + [u U (x, y)] Assuming the constraint holds with equality, the rst order conditions are U (xc , y c ) L =0 = px c x xc L U (xc , y c ) =0 = py c y y c L = u U (xc , y c ) = 0 The rst two FOC are quite similar to above replacing c with 1/d , but the third constraint corresponding to the constraint is very dierent. Solving these three equations in the three unknowns yields the Lagrange multiplier c = c (px , py , u), the shadow price in dollars of having to provide an extra unit of utility to this consumer, as well as the compensated demands xc (px , py , u) y c (px , py , u)

which are a function now of the required utility u, not income I. Note here that even though utility stays the same, quantities demanded will change as px and py change since the individual is trying to minimize her expenditures on consumption. Levels of required income I are assumed to automatically adjust to let make sure that individual can still achieve utility u, although not necessarily the bundle of goods previously 3

consumed. The individual is fully compensated for changes in price which could otherwise aect her utility if I were held xed. Substituting in the solutions back into the objective function, the minimand, we get the expenditure function E (px , py , u) px xc (px , py , u) + py y c (px , py , u) (Expenditure Function)

which is precisely the amount I needed to maintain utility level u, for given prices px and py . As before we can dierentiate E with respect to u to get E/u = . Taking the total derivative of E with respect to px we get E xc y c = xc + px + py (3) px px px We can simplify this expression with two substitutions. First we substitute in the rst order conditions which imply, px = c U/x and py = c U/y into 3 to get c c c U y c E c c U x c U y c c U x =x + + =x + + (4) px x px y px x px y px Second we dierentiate the constraint U (xc , y c ) = u totally with respect to px to get U xc U y c + x px y px which implies that the second term in 4 is zero. This implies the result known as Shepards Lemma (the analogue to Roys Identity) that E = xc (Shepards Lemma) px Again the (somewhat misleading) intuition for this is clear. If px changes by a small amount then xc will not change by very much and so the increased cost of consuming these units is precisely xc . The better intuition is that there are changes in xc and y c , but because of optimizing behavior, the consumer avoids spending any more than xc , although since she was optimizing before she cannot avoid spending any less. The case for y is identical E = yc py Thus, given the expenditure function you can derive the compensated demands just be taking the partial derivatives of E. The UMP and EMP are mathematically known as "dual" problems. What is a constraint in one is the objective in the other and vice-versa. Because of this a useful identities relating compensated and uncompensated demands holds, namely xd (px , py , I) = xc (px , py , V (px , py , I)) x (px , py , u) = x (px , py , E (px , py , u)) Similarly there are two identities relating the indirect utility function with the expenditure function V (px , py , E (px , py , u)) = u E (px , py , V (px , py , I)) = I (ID3) (ID4)
c d

(ID1) (ID2)

These identities can be proven formally (the proof is a little bit beyond the scope of this course), but a slow reading of them should show them to be quite intuitive. These identities can be used to simplify problem solving. For instance, solving the UMP one gets xd , y d , d and V . Setting V (px , py , I) = u, and solving for I yields the expenditure function E which can then be dierentiated to get xc , y c and c using Shepards Lemma. Similarly one can proceed from the EMP, and solve the equation E (px , py , u) = I for u to get V , which can then be used to get xd , y d , and d , using Roys Identity. 4

Example 2 Continuing with quasilinear utility, the FOC imply that px = c , py = c h0 (y c ), and xc + h (y c ) = u. Solving the system we get c = px y = (h )
c c 0 1

py 0 1 x = u h (h ) px Notice that y c = y d , as neither involves either u or I, so that the identity holds trivially. The expenditure function is given by E (px , py , u) = px xc + py y c py py 1 1 = px u px h (h0 ) + py (h0 ) px px Solving for u in this equation will yield the indirect utility function derived above. also be veried rather similarly to how Roys Identity was veried. Shepards Lemma can

py px

The Envelope Theorem

The derivations of Roys Identity and Shepards Lemma, as well as the interpretation of the Lagrange multipliers are all special cases of what is known as the envelope theorem. Stated generally, say we wish to solve the maximization problem max f (x, y, )
x,y

s.t. g (x, y, ) c

where x and y are control variables and is a given parameter which eects f and/or g, but over which we do not maximize over, i.e. it is given exogenously. The Lagrangean is then written as L (x, y, , ) = f (x, y, ) + [c g (x, y, )] for which the rst two rst order conditions are given by2 f (x , y , ) g (x , y , ) L = =0 x x x L f (x , y , ) g (x , y , ) = =0 y y y Do not take the derivative with respect to , as is given exogenously. The solution to this problem, given by x () and y (), depends on as dierent values of will imply dierent solutions. Substituting the solutions into the function f gives the value function F () = f [x () , y () , ]
2 Equivalent

is the minimization problem min f (x, y, )

x,y

s.t. g (x, y, ) c

as this is equivalent to the maximization problem max f (x, y, )

x,y

s.t.g (x, y, ) c

Writing out the Lagrangean one gets which gives equivalent rst order conditions as the negative signs cancel. L (x, y, ) = f (x, y, ) + [g (x, y, ) c]

which is the maximized value of f , which ultimately depends on . Taking the total derivative of F () we get dF () f dx f dy f = + + (5) d x d y d The last term represents the direct eect of on f , while the rst two terms represent the indirect eect of on f by changing x and y . This expression can be simplied in two steps. First substituting in the rst order conditions f /x = g/x and f /y = g/y into 5 yields g dx f g dy f dF () g dx g dy = + + = + + (6) d x d y d x d y d Second, dierentiating the constraint g (x , y , ) = c totally with respect to yields g dx g dy g g dx g dy g + + =0 + = x y x y which substituting into 6 and rearranging yields the envelope theorem dF () f L g = = d (Envelope Theorem)

Therefore the change in the value function is given by the partial derivative of the Lagrangean with respect to - a helpful simplication.3 This covers Roys Identity, Shepards Lemma, and the interpretation of the Lagrange multiple (check!).

3 In

the unconstrained case or in the case where the constraint is slack ( = 0) is just a special case with dF () f = d

The total eect is given by just the partial, direct eect seen in f .