Environmental Microeconomics

EEP 100 LECTURE 1: INTRODUCTION
ETHAN LIGON
1. Instructor: Ethan Ligon

Email: ligon@are.berkeley.edu
Oce Hours: Giannini 331;
Drop-in: Mondays 1:002:00
Appointment: http://are.berkeley.edu/~ligon/appointment.html
to make an appointment (best), or send me an email.
2. GSIs
2.1. Yue (Luna) Huang.
Email: yuehuang@berkeley.edu
Oce Hours: F 35, 236 Giannini Hall
2.2. Peiley Lau.

Email: peiley@berkeley.edu
Oce Hours: W 1012, 234 Giannini Hall
3. Readings
All the Math You Need to Know to Be an Economist; and/or
Nicholsons Chapter 2.
4. Motivation: What is economics?

Study of the allocation of scarce resources to competing ends.
Study of decision-making and social behavior.
What economists do.
5. What do economists do? (Positive)

Try to understand how people do behave.
Building models which yield testable hypotheses about behavior (applied
theory).
Testing models by comparing predictions with real-world outcomes (econo-
metrics).
Conducting controlled experiments to test models (experimental)
. Date: August 24, 2017.

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6. What would economists do? (Normative)

Try to say how people should behave.
Use best models to predict real world outcomes (for policy or profit)
Use understanding of models to describe how peoples well-being will re-
spond to changes in environment or policy.
7. Economics vs. Other Social Sciences

Other social sciences (e.g., sociology, anthropology, political science, history)
also have traditions of trying to formulate general models or laws describing social
behavior. So what are the most salient dierences?
Economics generally more quantitative and formal. (Yes, there are excep-
tions.)
Economists are paid much more than are other social scientists. (Economists
would argue that this is because because our skills are more valuable.)
8. Data on median earnings of those with a bachelors degree

https://cew.georgetown.edu/report/whats-it-worth-the-economic-value-of-college-majors/
Field Female Male % w/Grad degree
Economics $57,000 $74,000 40
Pol. Sci. $49,000 $63,000 47
Psychology $41,000 $53,000 43
Sociology $42,000 $54,000 34
Accounting $55,000 $75,000 24
Finance $52,000 $70,000 26
Management $50,000 $64,000 20
Marketing $48,000 $65,000 14
Architecture $55,000 $65,000 32
Chemical Engineering $72,000 $92,000 45
Civil Engineering $62,000 $80,000 35
Electrical Engineering $70,000 $86,000 42
Computer Science $70,000 $79,000 28
Mathematics $54,000 $75,000 47
9. Aim of the Course

The chief aim of this course is to put you on the road to being a competent
economist. This is not a survey course, or Microeconomics for Poets. Were going
to learn to use the tools that professional economists use, and that means first and
foremost some simple mathematical tools.
10. What does this course have to do with Environmental and

Resource Economics?
10.1. Environmental economics and resource economics are just an area
of application of economics, not distinct disciplines.
EEP 100 LECTURE 1: INTRODUCTION 3
10.2. Well focus on learning tools with which one can tackle applications.
But we will tend to use examples and problems which pertain to environmental and
resource economics.
11. What makes Environmental & Resource Economics special?

The thing that distinguishes environmental and resource economics from other
areas of application is because some of the societal problems we face in these areas
are extremely important and pressing.
12. Your generation will have to solve many of these problems.

I expect some of you to be among the members of your generation who come up
with solutions, and I regard it as my job to help make sure that youre competent
to do so.
13. Competence in Economics

13.1. Competence in economics depends on being able to use the tools
of the profession.
13.2. Economics is a quantitative discipline, and so competence requires
facility with some simple mathematical tools.
13.3. These tools arent dicult for most people to master; largely a
matter of practice and familiarity.
EEP 100 LECTURE 3: PREFERENCES
ETHAN LIGON
Contents
1. The Coee Pit Experiment 2
1.1. Modeling the Coee Pit Experiment 2
1.2. Constructing Supply 2
1.3. Constructing Demand 2
1.4. Putting Demand and Supply Together 3
2. Trading Results 4
2.1. Trading Results: Cycle 1 4
2.2. Profits from 2017 Coee Pit 4
3. Preferences 5
3.1. Preferences & Demand 5
3.2. Usual Assumptions 5
3.3. Commodity Bundles 5
3.4. Commodity Space 5
4. Time, Goods, and Services 6
4.1. Time, Goods, and Services 6
4.2. Goods (Non-durables) 6
4.3. Services 6
4.4. Durables 6
5. Preference Axioms 7
5.1. Standard Preference Axioms 7
5.2. 1. Completeness 7
5.3. 2. Transitivity 7
5.4. 2. Transitivity (Using a more compact notation) 7
5.5. 3. Non-satiation 7
6. Preference Orderings 7
6.1. Preference Orderings 7
6.2. A Practical Diculty 8
7. Indierence Maps 8
7.1. Indierence Maps 8
7.2. Properties of Indierence Curves 8
7.3. Graphical Representation: Curves cannot cross 8
7.4. Graphical Representation: Curves are downward sloping 8
7.5. Example of an Indierence Curve 9
8. Questions 10
8.1. Questions 10
. Date: August 31, 2017.

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1. The Coffee Pit Experiment

1.1. Modeling the Coee Pit Experiment. Last week we attempted a simple
simulation of trading in a Coee Pit. Lets take a moment to review the predictions
we might have made about outcomes in that experiment.
(1) The chief outcomes of interest for us are:
Prices
Quantities
Profits
1.2. Constructing Supply.

(1) The Supply schedule
Card No. Cum.

2 8 8
3 8 16
4 8 24
5 8 32
6 8 40
7 8 48
8 8 56
9 8 64
10 8 72
(2) Supply curve
1.3. Constructing Demand.

(1) The Demand schedule
EEP 100 LECTURE 3: PREFERENCES 3
Card No. Cum.

10 8 8
9 8 16
8 8 24
7 8 32
6 8 40
5 8 48
4 8 56
3 8 64
2 8 72
(2) Demand curve
1.4. Putting Demand and Supply Together.

4 ETHAN LIGON
(1) Equilibrium
(2) Predictions
Prices?
Quantities?
Profits?
2. Trading Results
2.1. Trading Results: Cycle 1.
2.2. Profits from 2017 Coee Pit.

(1) Distribution of Coee Profits
3. Preferences
3.1. Preferences & Demand. Our goal is to develop a theory of demand which
will allow us to make predictions about how people respond to changes in their
income or in the prices they face.
(1) There are two central ingredients to any theory of demand:
What people want (Preferences)
What people can have (Opportunities)
(2) We begin by devising ways to characterize preferences.
3.2. Usual Assumptions.

People derive utility by consuming goods and services.
Tastes are subjective.
People can consistently rank all conceivable baskets of goods in order of
preference.
3.3. Commodity Bundles. Examples of Commodities:

Food
Clothing
If food and clothing are the commodities people value, then the natural Com-
modity Bundle is a combination of some quantity of food and clothing.
3.4. Commodity Space. A Commodity Space is simply the set of all possible
commodity bundles; hence, the nature of this space depends on the underlying
commodities we assume.
Example Commodities: (Wine,Coee)
6 ETHAN LIGON
Coee
(1) graph Wine

4. Time, Goods, and Services
4.1. Time, Goods, and Services. Most real-world economic behavior involves
making decisions about how to allocate resources over time. Simple textbook ex-
amples often overlook this feature of real-world problems.
Economists have devised a wide range of tools for considering intertemporal
decisions. One of these involves a distinction between consumption Goods and
consumption Services.
4.2. Goods (Non-durables). Think of a consumption good as the sort of com-
modity that gives more-or-less instant gratification, and then is gone (or useless).
For this reason consumption goods are also sometimes called non-durables.
Examples might include
Ice cream
Coee
A newspaper
4.3. Services. Services also gratify. Theyre distinguished from goods by not being
associated with something thats immediately used up, but rather are provided by
something that persists over time.
Here are some examples:
Cars produce transportation services.
Houses produce shelter.
Furnaces produce heating services.
Trees provide environmental services.
Barbers provide hair-cutting services.
Doctors provide health services.
Note that its really the services that people generally value: a car that provided
no transportation services wouldnt be worth much.
4.4. Durables. Durables are things we can own which produce services over time.
Weve already seen some examples of durables:
Cars
Houses
Trees
Furnaces
Doctors and Barbers may be pretty durable (I used to go to a barber who cut
hair from the age of 14 to 94). But since we cant own them, we wouldnt ordinarily
call them durables, but rather providers of services.
5. Preference Axioms
5.1. Standard Preference Axioms. There are three standard preference axioms;
satisfying these three is what we mean when we say that a consumer can consis-
tently rank commodity bundles.
Shorthand for these three axioms (well discuss each individually below):
Completeness
Transitivity
Non-satiation
5.2. 1. Completeness. For any two bundles A and B, the consumer can compare
them, and state that either:
(1) A is preferred to B; A B
(2) B is preferred to A; B A
(3) They are indierent between A and B. A B
Note that though the consumer is allowed to say, I dont care which of A or B
you give me (indierence), they are not allowed to say I dont know which of A
or B I prefer (ignorance).
5.3. 2. Transitivity. For any three bundles A, B, and C,
(1) If A is preferred to B and B is preferred to C, then A is preferred to C;
(2) If A is preferred to B but the consumer is indierent between B and C,
then A is preferred to C;
(3) If the consumer is indierent between A and B and the consumer is indif-
ferent between B and C, then the consumer is indierent between A and
C.
5.4. 2. Transitivity (Using a more compact notation). For any three bun-
dles A, B, and C,
(1) If A B and B C, then A C.
(2) If A B and B C then A C.
5.5. 3. Non-satiation. If bundle A contains at least as much of each commodity
as bundle B, and more of at least one commodity, then A is preferred to B.
The idea of this axiom is sometimes summarized as more is preferred to less.
6. Preference Orderings
6.1. Preference Orderings. We can imagine asking a person to compare all pos-
sible pairs of bundles, and also imagine recording whether every possible bundle A
is preferred to every other possible bundle B or not. A complete record of all such
comparisons would be called the consumers Preference Ordering; if this list of
comparisons satisfied the standard axioms wed say that the preference ordering
was Consistent.
8 ETHAN LIGON
6.2. A Practical Diculty. However, for most interesting commodity spaces,

there are a very large (often infinite) number of possible bundles, so imagining this
exercise is all we can doit would be impractical to actually carry out, and would
provide an inconveniently large record of the consumers preferences.
7. Indifference Maps
7.1. Indierence Maps. Fortunately, theres an easier way.
A consistent preference ordering can be represented by an indierence
map, which in turn comprises a collection of indierence curves.
An indierence curve is the locus of all commodity bundles in the com-
modity space that are equally attractive to the consumer.
7.2. Properties of Indierence Curves.

Every point in commodity space associated with one and only one indier-
ence curve. (Why?)
Curves cannot cross
Higher curves associated with preferred bundles (Why?)
Curves are downward sloping (Why?)
7.3. Graphical Representation: Curves cannot cross.

x2
A B
(1) graph x1
7.4. Graphical Representation: Curves are downward sloping.
x2
(1) graph x1
7.5. Example of an Indierence Curve.

10 ETHAN LIGON
x2
(1) graph 0 x1
8. Questions
8.1. Questions.
(1) Commodity Bundles and Spaces: Consider the activities sleeping, exercis-
ing, and studying. The number of hours you spend doing one thing is the
quantity for that commodity. Which of the following commodity bundles
are part of this commodity space?
12 hours sleeping, 4 hours exercising, and 8 hours studying
8 hours sleeping, 1 hour exercising, 2 hours studying
24 hours sleeping, 24 hours exercising, 24 hours studying
(2) Preference Axioms: Describe a set of preferences over the three bundles
listed above that would not be transitive.
EEP 100 LECTURE 4: INDIFFERENCE CURVES & ORDINAL
UTILITY
ETHAN LIGON
1. Introduction
1.1. Einstein and Schopenhauer.
(1) Einstein
(2) QOTD
a human can very well do what he wants, but can not will what he
wants Albert Einstein from Mein Glaubensbekenntnis (1932),
paraphrasing Schopenhauer (1818).
. Date: September 5, 2017.

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(3) Schopenhauer
2. Preference Axioms
2.1. Standard Preference Axioms. There are three standard preference axioms;
satisfying these three is what we mean when we say that a consumer can consis-
tently rank commodity bundles.
Shorthand for these three axioms (well discuss each individually below):
Completeness
Transitivity
Non-satiation
2.2. 1. Completeness. For any two bundles A and B, the consumer can compare
them, and state that either:
(1) A is preferred to B; A B
(2) B is preferred to A; B A
(3) They are indierent between A and B. A B
Note that though the consumer is allowed to say, I dont care which of A or B
you give me (indierence), they are not allowed to say I dont know which of A
or B I prefer (ignorance).
EEP 100 LECTURE 4: INDIFFERENCE CURVES & ORDINAL UTILITY 3
2.3. 2. Transitivity. For any three bundles A, B, and C,

(1) If A is preferred to B and B is preferred to C, then A is preferred to C;
(2) If A is preferred to B but the consumer is indierent between B and C,
then A is preferred to C;
(3) If the consumer is indierent between A and B and the consumer is indif-
ferent between B and C, then the consumer is indierent between A and
C.
2.4. 2. Transitivity (Using a more compact notation). For any three bun-
dles A, B, and C,
(1) If A B and B C, then A C.
2.5. 3. Non-satiation. If bundle A contains at least as much of each commodity

as bundle B, and more of at least one commodity, then A is preferred to B.
The idea of this axiom is sometimes summarized as more is preferred to less.
3. Preference Orderings
3.1. Preference Orderings. We can imagine asking a person to compare all pos-
sible pairs of bundles, and also imagine recording whether every possible bundle A
is preferred to every other possible bundle B or not. A complete record of all such
comparisons would be called the consumers Preference Ordering; if this list of
comparisons satisfied the standard axioms wed say that the preference ordering
was Consistent.
3.2. A Practical Diculty. However, for most interesting commodity spaces,

there are a very large (often infinite) number of possible bundles, so imagining this
exercise is all we can doit would be impractical to actually carry out, and would
provide an inconveniently large record of the consumers preferences.
4. Indifference Maps
4.1. Indierence Maps. Fortunately, theres an easier way.
A consistent preference ordering can be represented by an indierence
map, which in turn comprises a collection of indierence curves.
An indierence curve is the locus of all commodity bundles in the com-
modity space that are equally attractive to the consumer.
4.2. Properties of Indierence Curves.

Curves cannot cross
Every point in commodity space associated with one and only one indier-
ence curve. (Why?)
Higher curves associated with preferred bundles (Why?)
Curves are downward sloping (Why?)
4 ETHAN LIGON
4.3. Graphical Representation: Curves cannot cross.
x2
A B
(1) graph x1
4.4. Graphical Representation: Curves are downward sloping.

x2
(1) graph x1
4.5. Example of an Indierence Curve.

6 ETHAN LIGON
x2
(1) graph 0 x1
5. El Capitan
5.1. El Capitan.
5.2. El Capitan Topographic Map.

(1) graph
6. Ordinal Utility
6.1. Ordinal Utility. We can rank indierence curves by associating higher curves
with higher real numbers.
For goods x1 and x2 , consider using a function which assigns these numbers:
Call this U (x1 , x2 ); it is an Ordinal Utility Function.
Properties:
(1) Ordinal utility functions are not uniquemany other functions can also
represent the same indierence curves.
(2) Any function will do, so long as
Rank number is the same for all bundles on the same indierence curve;
and
Higher curves have higher rank numbers.
6.2. From Indierence Curves Ordinal Utility Functions.
(1) Remarks
We can construct an ordinal utility function by starting with an
indierence map, and then simply assigning rank numbers to the
dierent indierence curves.
8 ETHAN LIGON
4
Coee
6
3
1 2
(2) Figure
0 Wine
6.3. Using Ordinal Utility to Construct Indierence Curves. We can also

go the other waystart with an ordinal utility function U (x1 , x2 ), and then figure
out what indierence curves are implied by this function.
(1) Example ordinal utility function
U (x1 , x2 ) = log(1 + x1 ) + log(1 + x2 ).
6.4. Graph of utility function.
U (x1 , x2 ) = log(1 + x1 ) + log(1 + x2 ).

6.5. Using Ordinal Utility Construct Indierence Curves. To compute the

formula for indierence curves from an ordinal utility function you just need to
notice one
Key fact: The level of utility is unchanging along an indierence curve.
(1) Using Algebra to Describe Indierence Curves Suppose that we want to
find the formula of the indierence curve for which the consumer receives U0
utils. Using the ordinal utility function U (x1 , x2 ) = log(x1 +1)+log(x2 +1),
set
U0 = log(x1 + 1) + log(x2 + 1),
and then solve for x2 in terms of U0 and x1 . This gives us
eU0
x2 = 1.
x1 + 1
(We may want to restrict this to be non-negative.)
7. Questions
7.1. Questions.
(1) Commodity Bundles and Spaces: Consider the activities sleeping, exercis-
ing, and studying. The number of hours you spend per day doing one thing
is the quantity for that commodity. Which of the following commodity
bundles are part of this commodity space?
12 hours sleeping, 4 hours exercising, and 8 hours studying
8 hours sleeping, 1 hour exercising, 2 hours studying
24 hours sleeping, 24 hours exercising, 24 hours studying
(2) Preference Axioms: Describe a set of preferences over the three bundles
listed above that would not be transitive.
10 ETHAN LIGON
(3) If you like both coee and wine, then consider how happy youd be if you
had 3 cups of coee and 3 glasses of wine; call this level of happiness 1
(if you dont like these commodities, think of some others that suit you
better). Construct (graphically) the indierence curve corresponding to
your own preferences which passes through the (3, 3) bundle. What does
this indierence curve tell us about your preferences?
(4) In a commodity space with three goods, what would indierence curves
look like? In a commodity space with one good?
(5) What are the most important services you consume, as measured by your
expenditures on those services?
(6) Given the ordinal utility function
U0 = log(x1 + 1) + log(x2 + 1) + log(x3 ),
Find a mathematical expression for the indierence curve.
EEP 100 LECTURE 5: CARDINAL UTILITY & THE MARGINAL
RATE OF SUBSTITUTION
ETHAN LIGON
Contents
1. Introduction 1
2. Cardinal Utility 2
3. Eliciting Utilities 3
4. Marginal rates of substitution 3
5. Examples of Indierence Curves 4
6. Marginal Utility 7
7. Slopes of Indierence Curves 8
8. Marginal Rate of Substitution 10
9. Questions 12
1. Introduction
1.1. Jeremy Bentham.
(1) Benthams picture

(2) QOTD

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Nature has placed mankind under the governance of two sovereign

masters, pain and pleasure. . . the principle of utility recognizes
this subjection. . . .
Jeremy Bentham (1823)
1.2. Reading.
http://en.wikipedia.org/wiki/Contingent_valuation
Hindustan Times: Delhi pays huge price for power from pollution-heavy
Badarpur Plant
Nicholson-Snyder Chapter 3
(Optional) Hanemann (1994), Valuing the environment through contingent
valuation http://www.jstor.org/stable/2138337
2. Cardinal Utility
2.1. Ordinal Utility. We talked last lecture about ordinal utility functions. An
ordinal utility function:
(1) Implies an indierence mapping that in turn implies a complete preference
ordering.
(2) A preference ordering is just that: an ordering. It can tell us that a con-
sumer prefers a bundle A to a bundle B, and from this we can infer that A
makes the consumer happier than B would.
(3) The catch: if the utility function is merely ordinal, it cant tell us how much
happier the consumer is made by consuming A than B.
2.2. Cardinal Utility. In contrast, if utility is cardinal, then the utility function
tells us not only a preference ordering, but also tells us how happy a consumer is
made by consuming dierent bundles.
(1) Picture of Cardinal

2.3. Interpersonal Utility Comparisons. Its often claimed that its impossible
to make interpersonal utility comparisons. This claim depends on two observa-
tions:
(1) One cant use information from indierence map to infer how happy some-
one is; can only make relative statements about happiness (e.g., Im happier
with two cups of coee than I would be with one).
(2) Individuals reports about how happy they are in dierent situations may
be dicult to compare across individuals. One persons ecstatic may be
another persons content.
2.4. Is it possible to measure happiness?
Surveys?
Suicide rates?
Observing physical signs of excitement?
Cortisol levels?
Looking at brain activity?
EEP 100 LECTURE 5: CARDINAL UTILITY & THE MARGINAL RATE OF SUBSTITUTION3
Assuming that people have similar utility functions?
3. Eliciting Utilities
3.1. Eliciting Utilities.
(1) graph
3.2. Eliciting Utilities. Given their initial wealths and our calculation of their
cardinal utility functions, to whom should we give a dollar?
(1) Classroom example
Wealth Student A Student B
0.125
0.25
0.5
1
2
4
8
This table records a cardinal utility for the participants in this exper-
iment. But note the normalization that utility at current wealth is 100!
(2) Cardinal Utility
4. Marginal rates of substitution

4.1. Marginal Rate of Substitution.
4 ETHAN LIGON
(1) A consumers marginal rate of substitution Measures the rate at which a

consumer is willing to trade o increases in one good for a decrease in
another.
(2) Relation to the indierence curve
Amounts to moving along an indierence curve.
Holding utility constant; equal to (minus) the slope of the indierence
curve at a point.
4.2. Marginal Rate of Substitution.

x2 U0 U1
-Slope = MRS
(1) Graphical Representation: MRS x1
4.3. Shapes of Indierence Curves. Lets return our attention to the indier-
ence curves which represent a consumers preference ordering.
(1) Aside from telling us about the consumers sets of indierence (that is, what
commodity bundles the consumer is indierent between), what else can we
learn from indierence curves?
5. Examples of Indifference Curves

5.1. Examples of Indierence Curves.
U(x1 , x2 ) = log(x1 ) + log(x2 )
x2
(1) Example 1a 0 x1
U(x1 , x2 ) = x1 + x2
x2
(2) Example 1b 0 x1
6 ETHAN LIGON
U(x1 , x2 ) = min(x1 , x2 )
x2
(3) Example 2a 0 x1
U(x1 , x2 ) = x21 + x22
x2
(4) Example 2b 0 x1
6. Marginal Utility
6.1. Marginal Utility. We begin with a definition. For a consumer with utility
function U consuming a bundle x = (x1 , x2 , . . . , xn ), the marginal utility of a
particular good xi is another name for the partial derivative of U at x, or
@U
Marginal utility of good i (x).
@xi
6.2. Utility Function. Heres a utility function: U (x1 , x2 ) = log(x1 +1)+log(x2 +

1).
8 ETHAN LIGON
6.3. Slice of Utility function.
7. Slopes of Indifference Curves

7.1. What does the slope of indierence curves tell us? The (negative of
the) slope of the indierence curve tells us the rate at which the consumer is willing
to trade one good for another.
7.2. Graphical Representation: Slopes of Indierence Curves. log(x1 ) +

x12 1
, where = 1 and = 2.
1
x2
(1) graph 0 x1
7.3. Graphical Representation: Slopes of Indierence Curves. log(x1 ) +

x12 1
, where = 2 and = 2
1
10 ETHAN LIGON
x2
(1) graph 0 x1
8. Marginal Rate of Substitution

8.1. Marginal Rate of Substitution. The (negative) of the slope of the indif-
ference curves is called the Marginal Rate of Substitution.
A particular indierence curve can be written as a function
x2 (x1 ; U ).
Interpretation: given x1 , how much x2 is required to yield utility U ?
The MRS of this indierence curve is just (the negative) of its slope, or partial
derivative with respect to x1
@x2
MRS = (x1 ; U ).
@x1
8.2. Facts about the MRS.

The MRS is the negative of the slope of the indierence curve at a point.
The MRS can change both along a given indierence curve, and across
indierence curves.
The MRS may not exist at some points (example?).
8.3. Computing the MRS from an Ordinal Utility Function. Heres an

elegant, handy trick for computing the Marginal Rate of Substitution given an
ordinal utility function U (x1 , x2 ).
EEP 100 LECTURE 5: CARDINAL UTILITY & THE MARGINAL RATE OF SUBSTITUTION
11
Start by totally dierentiating the ordinal utility function, yielding

@U @U
dU = dx1 + dx2 .
@x1 @x2
This just says that the total change in utility is equal to the change in x1 and x2
multiplied times their respective partial derivatives (for a small change in x1 and
x2 ). Now, were interested in changes in x1 and x2 along an indierence curve, so
the total change in utility is zero. Using this fact, we have
@U @U
dx1 + dx2 = 0.
@x1 @x2
8.4. Computing the MRS from an Ordinal Utility Function. Rearranging

gives
@U/@x1 dx2
= ( MRS).
@U/@x2 dx1
This is just how we defined the MRS to begin with. In words, the MRS is equal to
the ratio of marginal utilities.
8.5. Example 1. Let U (x1 , x2 ) = x1 x2 . Then, derive general formula for indier-
ence curves:
U = x1 x2
That gives
U
x2 =
x1
Treat x2 as an implicit function, F (U, x1 ) and dierentiate:
@x2 (U, x1 ) @ xU1 U

M RS = = =
@x1 @x1 x21
and
U
M RS =
x21
or, to make MRS just depend on bundle, substitute U = x1 x2
x2
M RS =
x1
8.6. Example 2. Let U (x1 , x2 ) = log(x1 ) + log(x2 ). Then:

@U
@x1 is x1 ;

and
@U
@x2 is x2 .
Then we have
@U/@x1 /x1
M RS = =
@U/@x2 /x2
or
x2
M RS = .
x1
12 ETHAN LIGON
9. Questions
9.1. Questions.
(1) (T,F,U) Suppose that A has a total wealth of $10,000, and a utility function
U (x) = log(x). B has the same wealth as A, but her utility function is
U (x) = 2 log(x). Because B values wealth more than A does, it makes
sense to transfer resources from A to B.
(2) (T,F,U) Suppose that a consumer values goods x1 and x2 symmetrically;
that is, her ordinal utility function U satisfies U (x1 , x2 ) = U (x2 , x1 ) for
any values of x1 and x2 , and her indierence curves are symmetrical about
the 45 degree line. It follows that for this consumer x1 and x2 are perfect
substitutes.
EEP 100 LECTURE 6: MARGINAL RATES OF SUBSTITUTION
AND MONOTONIC TRANSFORMATIONS
ETHAN LIGON
Contents
1. Introduction 1
2. Marginal Utility 2
3. Slopes of Indierence Curves 3
4. Marginal Rate of Substitution & Marginal Utilities 5
5. Monotonic Transformations of Utility 6
6. Non-monotonic transformations 12
7. Questions 14
1. Introduction
(1) Jeremy Bentham

1
2 ETHAN LIGON
(a) Benthams picture

(b) QOTD
It is vain to talk of the interest of the community, without
understanding what is the interest of the individual.
Jeremy Bentham
2. Marginal Utility
(1) Marginal Utility We begin with a definition. For a consumer with utility
function U consuming a bundle x = (x1 , x2 , . . . , xn ), the marginal utility
of a particular good xi is another name for the partial derivative of U at x,
or
@U
Marginal utility of good i (x).
@xi
(2) Utility Function Heres a utility function: U (x1 , x2 ) = log(x1 +1)+log(x2 +
1).
EEP 100 LECTURE 6: MARGINAL RATES OF SUBSTITUTION AND MONOTONIC TRANSFORMATIONS
3
(3) Slice of Utility function
3. Slopes of Indifference Curves

(1) What does the slope of indierence curves tell us?
The (negative of the) slope of the indierence curve tells us the rate at
which the consumer is willing to trade one good for another.
(a) Example: Travel Cost vs. Scenic Wonders
(2) Graphical Representation: Slopes of Indierence Curves
x12 1
U (x1 , x2 ) = log(x1 ) +
1
4 ETHAN LIGON
x2
(a) = 1 and = 1/2 0 x1

x2
(b) = 2 and = 1/2 0 x1

5
4. Marginal Rate of Substitution & Marginal Utilities

(1) Marginal Rate of Substitution
The (negative) of the slope of the indierence curves is called the Mar-
ginal Rate of Substitution.
A particular indierence curve can be written as a function
x2 (x1 ; U ).
Interpretation: given x1 , how much x2 is required to yield utility U ?
The MRS of this indierence curve is just (the negative) of its slope, or
partial derivative with respect to x1
@x2
MRS = (x1 ; U ).
@x1
(2) Facts about the MRS
The MRS is the negative of the slope of the indierence curve at a
point.
The MRS can change both along a given indierence curve, and across
indierence curves.
The MRS may not exist at some points (example?).
(3) Computing the MRS from an Ordinal Utility Function Heres an elegant,
handy trick for computing the Marginal Rate of Substitution given an or-
dinal utility function U (x1 , x2 ).
Start by totally dierentiating the ordinal utility function, yielding
@U @U
dU = dx1 + dx2 .
@x1 @x2
This just says that the total change in utility is equal to the change in
x1 and x2 multiplied times their respective partial derivatives (for a small
change in x1 and x2 ). Now, were interested in changes in x1 and x2 along
an indierence curve, so the total change in utility is zero. Using this fact,
we have
@U @U
dx1 + dx2 = 0.
@x1 @x2
(4) Computing the MRS from an Ordinal Utility Function Rearranging gives
@U/@x1 dx2
= ( MRS).
@U/@x2 dx1
This is just how we defined the MRS to begin with. In words, the MRS is
equal to the ratio of marginal utilities.
(5) Examples
(a) Example 1 Let U (x1 , x2 ) = x1 x2 . Then, derive general formula for
indierence curves:
U = x1 x2
That gives
U
x2 =
x1
6 ETHAN LIGON
Treat x2 as an implicit function, F (U, x1 ) and dierentiate:
@x2 (U, x1 ) @ xU1 U

M RS = = =
@x1 @x1 x21
and
U
M RS =
x21
or, to make MRS just depend on bundle, substitute U = x1 x2
x2
M RS =
x1
(b) Example 2
Let U (x1 , x2 ) = log(x1 ) + log(x2 ). Then:
@x1 is x1 ; and
@U
@x2 is x2 .
@U
Then we have
@U/@x1 /x1
M RS = =
@U/@x2 /x2
or
x2
M RS = .
x1
5. Monotonic Transformations of Utility

(1) Monotonic Transformations of Utility Let U (x) = log(1 + x). The utility
function U maps points in the commodity space into R.
(a) Consider dierent transformations of U . How do dierent transfor-
mations aect indierence curves?
7
(b) 2D
(2) Monotonic Transformations of Utility
x
8 ETHAN LIGON
(T U)(x) = 1 + U(x)
5
0
(a) 1+U (x) 0 2 4 6 8
9
(T U)(x) = 2U(x)
5
0
(a) 2U (x) 0 2 4 6 8
10 ETHAN LIGON
q
(T U)(x) = U(x)
5
0
p
(a) (U (x)) 0 2 4 6 8
11
(T U)(x) = U(x)3
14
12
10
0
(a) U (x)3 0 2 4 6 8
Three things to notice about these transformations:
These are all monotone transformations. (They may change the rate
at which utility increases, but they dont change direction.)
Monotone transformations dont change the indierence map (i.e., the
indierence map for U is the same as the indierence map for T U ).
If one person has utility function U and another has T U (where T
is a monotone transformation) then both people will have the same
preference orderings.
12 ETHAN LIGON
6. Non-monotonic transformations
(1) Non-monotonic transformations In contrast, an non-monotonic transfor-
mation can change the indierence map and imply a violation of the axiom
of non-satiation. For example. . .
(2) Non-monotonic transformations
(T U)(x) = 5 U(x)
(a) 5 U (x) 2 4 6 8
(3) Non-monotonic transformations
13
(T U)(x) = 1 (U(x) 1
3
3
(a) 1 (U (x) 1)4 0 2 4 6 8
(4) The MRS isnt aected by monotonic transformations A monotonic trans-
formation of the utility function doesnt aect the marginal rate of sub-
stitution, because monotonic transformations dont change the indierence
map.
(a) Example: whats the MRS of
2U (x1 , x2 ) = 2[ log(x1 ) + log(x2 )]?

14 ETHAN LIGON
7. Questions
(1) Calculate the marginal rate of substitution for consumers with each of the
following ordinal utility functions, defined over goods x1 and x2 :
U (x1 , x2 ) = A + 1 log x1 + 2 log x2 , with i 0 for i = 1, 2, and A
a constant.
U (x1 , x2 ) = Ax1 2
1 x2 , with i 0 for i = 1, 2, and A a constant.
U (x1 , x2 ) = min(1 x1 , 2 log x2 ), with i 0 for i = 1, 2.
U (x1 , x2 ) = A + 1 x1 + 2 x2 , with i 0 for i = 1, 2, and A a
constant.
EEP 100 LECTURE 7: MARSHALLIAN DEMANDS
ETHAN LIGON
Contents
1. Introduction 2
2. Budget Sets 2
3. The Consumers Maximization Problem 3
4. Graphical and Mathematical Version of Preferences 3
5. Solving the Problem 5
6. A Detailed Example 6
7. Solution to the Consumers Problem 7
8. Varying Prices or Income 7
9. Questions 9

1
2 ETHAN LIGON
1. Introduction
You cant always get what you want, but if you try sometime,
yeah, you just might find you get what you need.
Jagger-Richards (1969)
2. Budget Sets
2.1. Budget Sets. Suppose that we have a commodity space X = R2 .
(1) Two assumptions about the consumers budget:
(a) A consumer has income y;
(b) The price of good one is p1 , and of good two p2 .
(2) Expenditures and Budget
Expenditures on the ith good are then pi xi .
Total expenditures cant exceed income.
2.2. Budget Sets. This gives us the budget constraint
p1 x1 + p2 x2 y.
Which in turn defines the budget set
{(x1 , x2 ) 2 X|p1 x1 + p2 x2 y}.
Note that the set depends on prices (p1 , p2 ) and on income y.
EEP 100 LECTURE 7: MARSHALLIAN DEMANDS 3
2.3. Budget Sets.
(1) graph
3. The Consumers Maximization Problem

3.1. The Consumers Maximization Problem. Now consider a consumer who
faces fixed prices p1 and p2 , and who has a fixed income y. The consumer has a
utility function given by
(1) U (x1 , x2 ) = log x1 + log x2 ,
with both and greater than zero.
The consumers problem is how to best allocate her income across goods (x1 , x2 ),
given the budget constraint
(2) p1 x1 + p2 x2 y.
4. Graphical and Mathematical Version of Preferences

4 ETHAN LIGON
4.1. Graphical Version of Preferences - In Three Dimensions.
4.2. Graphical Version of Preferences - In Three Dimensions. With Indif-

ference Curves
4.3. Graphical Version of Preferences - In Three Dimensions. With Budget

Constraint
4.4. Graphical Version of Preferences - In Two Dimensions.
(1) graph
5. Solving the Problem

5.1. Mathematical Version of the Problem. The consumers problem is to
maximize her utility by choosing what quantities of goods to consume subject to
not exceeding her budget, or
6 ETHAN LIGON
max log x1 + log x2

x1 ,x2
s.t. p1 x1 + p2 x2 y
5.2. Strategies for Solving This Problem. Three strategies for solving this
problem:
(1) Solve this constrained maximization problem with an inequality con-
straint using the method of Kuhn-Tucker (see All the Math You Need
to Know. . . ); or
(2) Assume that the budget inequality is satisfied with equality (the constraint
is binding) at the solution, and formulate the problem as a Lagrangian (this
may follow from non-satiation); or
(3) Again assumption on budget equality, and use the budget constraint to
solve for one of the choice variables. Then substitute into the objective
function.
Any of these strategies will yield an unconstrained maximization problem, which
can then be solved using the usual tricks of calculus.
6. A Detailed Example
6.1. A Detailed Example. Lets pursue the third strategy, since its easy to check
that the constraint is binding in this case. So: assume that the constraint binds,
and solve for x1 :
y p2 x2
x1 = .
p1
6.2. Substituting out the constraint to get an unconstrained problem.

Now, using the result that x1 = y pp12 x2 :
(1) Substitute the constraint into the objective function
y p2 x2
max log + log x2
x2 p1
(2) Simplify:
max log(y p2 x2 ) log p1 + log x2 .
x2
6.3. Solving the unconstrained problem. So, we now have the problem of
finding the maximum of the function
max log(y p2 x2 ) log p1 + log x2 .
x2
To find the maximum:

Take the partial derivative of the objective with respect to x2 and set equal to
zero to obtain the first order condition:
p2 1
+ = 0.
y p2 x2 x2
6.4. Solving the First Order Conditions. To solve for x2 use the first order
condition
(1)
p2 x2
+ =0
y p2 x2
(2)
p2 x2 + (y p2 x2 ) = 0
(3)
p2 x2 ( + ) = y
(4)
y
x2 = .
+ p2
7. Solution to the Consumers Problem

7.1. Solution to the Consumers Problem. Now, using the solution for x2 , we
can substitute this back into the budget constraint, yielding

y
p1 x1 + p2 = y.
+ p2
Solving this expression for x1 gives us

y
x1 = .
+ p1
7.2. Marshallian Demand Functions. This last result expresses x1 and x2 as

functions of prices and income, and is an example of a Marshallian demand function.
Well often write this as an explicit function of prices and income, e.g.,
x1 (p1 , p2 , y), or letting p = (p1 , p2 ), simply x1 (p, y).
8. Varying Prices or Income

8.1. Varying Prices or Income. Here are two graphs, based on varying income
y (holding prices p1 fixed), and varying prices p1 (holding income y fixed).
8.2. Varying income, prices fixed.

8 ETHAN LIGON
Engel Curve Example: x1 = py1

10
6
x1
4
0
0 2 4 6 8 10
(1) graph
y
8.3. Varying prices, income fixed.

y
Marshallian Demand Curve: x1 =
p1
10
6
p1
4
0
0 2 4 6 8 10
(1) graph x1
Note that everything hinges on the space one is working in! Also note
that units matter. . .
9. Questions
Weve seen in the example utility function weve developed that Marshallian
demands depend only on the own price; that is, demand for a good x1 depended
only on income and p1 , and not on p2 . This is not a property of all Marshallian
demands.
Consider a slightly more complicated utility function, with
U (x1 , x2 ) = log(x1 ) + log(x2 ) + x1 x2 .
(1) What conditions are necessary to guarantee that the preference orderings
implied by this utility function are consistent?
(2) Assuming these conditions are satisfied, compute a formula describing the
indierence curves corresponding to this utility function.
(3) Whats the marginal rate of substitution for this consumer?
(4) Calculate the Marshallian demand functions for this consumer. How do
they depend on own and other prices?
EEP 100 LECTURE 8: INDIRECT UTILITY
ETHAN LIGON
Contents
1. Introduction 1
2. Marshallian Demands and Indirect Utility 3
3. Homogeneous functions and Homotheticity 6
4. Indirect Utility Functions 7
5. Questions 7
1. Introduction
1.1. The Beatles.
(1) The Beatles in 1964

I dont care too much for money, money cant buy me love.

1
2 ETHAN LIGON
Lennon-McCartney (1964)
(2) The Beatles in 1967

All you need is love, love; Love is all you need.
Lennon-McCartney (1967)
1.2. The Beatles Indierence Curves?

EEP 100 LECTURE 8: INDIRECT UTILITY 3
Love ~
1964-wealthy 1967-filthy rich
0 Money $
(1) graph
2. Marshallian Demands and Indirect Utility

2.1. Marshallian Demands. A consumer has a direct utility function
U (x1 , x2 ) = log x1 + (1 ) log x2
so called because she derives utility directly from the consumption of (x1 , x2 ).
Given some set of prices p = (p1 , p2 ) and income y, we predict that such a
consumer will choose
y y
x1 = x1 (p, y) = and x2 = x2 (p, y) = (1 ) ;
p1 p2
these Marshallian demands tell us how much of each good will be consumed
given prices and income.
2.2. Indirect Utility or Value Functions.

Last time we asked the question:
Given prices and income, what consumption bundle will a con-
sumer choose?
The answer to this question is given by the Marshallian demand functions.
Today, well ask the question:
If a consumer faces prices p, how much does she value income y?
or alternatively
If a consumer faces prices p, how much utility does she indirectly
get from income y?
4 ETHAN LIGON
The answer to these last two questions is given by the Indirect Utility
Function, or (synonymously) the Value function.
2.3. Marshallian Demands. Take as given a consumers utility function

U (x1 , x2 ) = 1 log x1 + 2 log x2 ,
where 1 + 2 = 1. Marshallian demands can be derived by the Lagrangian ap-
proach, as follows:
L(x1 , x2 , ) = log x1 + (1 ) log(x2 ) + (y p1 x1 p2 x2 )
Taking partial derivatives,
x1 : @x
@L
1
= 1
x1 p1
x2 : @x
@L
2
= 2
x2 p2
: @ =y
@L
p1 x1 p2 x2
2.4. Marshallian Demands. Setting the partial derivatives of the Lagrangian all
equal to zero and solving for x1 and x2 , we obtain the familiar expressions
x1 = 1 py1 ; and
x2 = 2 py2 .
These are the Marshallian demands, expressing the quantities of x1 and x2 the
consumer would choose as a function of prices and income.
2.5. Marshallian Demands.
x1
1
x1 = (1 y)
p1
(1) Quantity vs. Price

p1
x1
!
1
x1 = y
p1
(2) Quantity vs. Income

y
2.6. Interpretation of Cobb-Douglas Preference Parameters. The utility
function weve chosen as an example is a special case of the Cobb-Douglas utility
function,
n
X n
X
U (x1 , x2 , . . . , xn ) = i log xi , where i = 1.
i=1 i=1
The Cobb-Douglas function has some convenient features:

Parameters i are equal to consumers expenditure shares.
Linear Engel curves
Hyperbolic function of own price
Depends only on own price, not on price of other goods.
2.7. Invariance of Demand to Monotone transformations of Ordinal Util-

ity. Let F : R ! R be some arbitrary function mapping the real number line into
itself; we require that F be { strictly increasing}; i.e., that for any x0 > x we have
F (x0 ) > F (x).
Suppose that instead a utility function U (x1 , x2 ), our consumer has utility
F (U (x1 , x2 )).
This is called a monotonic transformation of U .

How will demand depend on F ?
6 ETHAN LIGON
2.8. Problem for consumer with F (U (x1 , x2 )). The consumers problem is:
max F (U (x1 , x2 ))
x1 ,x2
such that p1 x1 + p2 x2 = y.
2.9. Problem for consumer with F (U (x1 , x2 )). At an optimum, the consumers
demands will satisfy the budget constraint,
p1 x1 + p2 x2 = y
the first order conditions,
@U
F 0 (U (x1 , x2 )) (x1 , x2 ) = p1
@x1
and
@U
F 0 (U (x1 , x2 ))(x1 , x2 ) = p2 ,
@x2
where is the Lagrange multiplier associated with the budget constraint.
2.10. Problem for consumer with F (U (x1 , x2 )). But dividing the first FOC by
the second yields
F 0 (U (x1 , x2 )) @x
@U
(x1 , x2 ) p1
1
=
F (U (x1 , x2 )) @x (x1 , x2 )
0 @U
2
p2
or, simplifying,
@U/@x1 p1
= .
@U/@x2 p2
Notice that the function F has disappeared! This can be used to prove that
F wont aect demand, or that the demand system is invariant to monotonic
transformations of the utility function.
3. Homogeneous functions and Homotheticity

3.1. Homogeneous functions. A function g(x1 , x2 ) is homogeneous of degree
k if
g(bx1 , bx2 ) = bk g(x1 , x2 ) for any b > 0.
Are these homogeneous?
f (x) = x
f (x) = a + x
f (x1 , x2 ) = x1 x2
f (x1 , x2 ) = log(x1 ) + log(x2 )
f (x1 , x2 ) = xx12
3.2. Homothetic functions. A function f (x1 , x2 ) is homothetic if there exists
a transformation F such that the composition F (f (x1 , x2 )) is homogeneous.
Are these homothetic?
f (x) = x
f (x) = a + x
f (x1 , x2 ) = log(x1 ) + log(x2 )
f (x1 , x2 ) = log(x1 + 1 ) + log(x2 + 2 )
Note that f (x1 , x2 ) = log(x1 + 1 ) + log(x2 + 2 ), while not homothetic, is
quasi-homothetic.
4. Indirect Utility Functions

4.1. Indirect Utility (Value Functions). How do consumers value income?
Since we know what bundle our consumer will consume given (p, y), and we know
her utility function, we know that with income y and prices p her utility will be
U (x1 (p, y), x2 (p, y)) = V (p, y)
The function V tells how the consumer values income y given prices, or how much
utility she indirectly derives from (y, p).
Accordingly, we call V a value function, or an indirect utility function.
What will the indirect utility function be for our consumer?
Derivation of the indirect utility function. . . .
4.2. Marshallian Demands and Indirect Utility Functions.
The indirect utility function is defined by
V (p1 , p2 , y) = max U (x1 , x2 )
x1 ,x2
such that p1 x1 + p2 x2 = y.
We call solution x1 (p1 , p2 , y), x2 (p1 , p2 , y). These are called Marshallian
Demands or Uncompensated Demands.
To compute the indirect utility function, substitute Marshallian demands
into the direct utility function, obtaining
V (p1 , p2 , y) = U [x1 (p1 , p2 , y), x2 (p1 , p2 , y)].
5. Questions
5.1. Questions.
(1) Dierent utility functions will yield dierent Marshallian demands. What
are the Marshallian demands for the following utility functions?
U (x1 , x2 ) = log x1 + (1 ) log(x2 )
x1 1 x1 1
U (x1 , x2 ) = 11 + (1 ) 21
U (x1 , x2 ) = log x1 + (1 )x2
U (x1 , x2 ) = x1 + (1 )x2
(2) Monotonic transformations of ordinal utility functions do not aect the cor-
responding demand systems. But what eect with such monotonic trans-
formations have on the indirect utility function?
EEP 100 LECTURE 9: DISCRETE CHOICE, UTILITY AND
NON-MARKET GOODS
ETHAN LIGON
Contents
1. Introduction 1
2. Discrete choices 2
3. Utility and non-market goods 3
4. Existence value 4
5. Existence Values & Voting 4
1. Introduction
1.1. John Krutilla.

1
2 ETHAN LIGON
(1) Krutillas picture

(2) QOTD
When the existence of a grand scenic wonder or a unique and
fragile ecosystem is involved, its preservation and continued avail-
ability are a significant part of the real income of many individu-
als.
John Krutilla (1967)
2. Discrete choices
2.1. Discrete choices and indirect utility.
(1) Choosing between two discrete alternatives Sometimes consumers are forced
to choose between two (or more) discrete alternatives.
(a) Examples:
Vanilla or Chocolate?
EEP 100 LECTURE 9: DISCRETE CHOICE, UTILITY AND NON-MARKET GOODS 3
Where to live?
Purchasing indivisible consumer durables
School or work?
(2) Solving discrete choice consumer problems General approach: calculate the
indirect utility for each of the discrete choices the consumer might make.
Then the consumer will make her choice based on what delivers the greatest
utility.
2.2. Example. Suppose that a consumer is trying to decide where to live. She has
income y and preferences over goods (x1 , x2 ) given by
U (x1 , x2 ) = log(x1 ) + (1 ) log(x2 ).
This gives an indirect utility function
V (p, y) = log(y) log(p1 ) (1 ) log(p2 ) + h(),
where h() = log +(1 ) log(1 ) is just a constant (and hence not interesting
from the standpoint of understanding the consumers decisions).
2.3. Example. Now, suppose a consumer is trying to decide whether to live in

the city or the country. In the city the price of x1 is higher than in the country
(the price of x2 well assume to be the same). But income for city-dwellers is also
greater.
(1) The consumers decision Let p0 be prices in the city, and y 0 income in the
city. Prices in the country are p and y. The consumer will prefer to live in
the city if
Utility in city = V (p0 , y 0 ) V (p, y) = Utility in the country.
3. Utility and non-market goods

3.1. Utility and non-market goods. Our utility framework is good for analyzing
the demand for and value of market goods, but can also accomodate non-market
goods.
(1) Among others
Amenities: E.g., Clean air, the weather
Love: E.g., the Beatles
Altruism: E.g., the family
Humaneness: E.g., humane treatment of animals (Prop 2)
Existence Utility: E.g., natural wonders
3.2. Utility and non-market goods. Suppose a consumer derives utility from
market goods (x1 , x2 ), but also a non-market good z, according to
U (x1 , x2 , z) = log(x1 ) + (1 ) log(x2 ) + log(z).

We assume that although the consumer likes z, she can neither buy nor sell it;
she just has to take it as a given.
4 ETHAN LIGON
3.3. Utility and non-market goods. The indirect utility function for this con-
sumer will depend on prices and income, as before, but also on the amount of z.
Since z enters additively in this case, her indirect utility function (see above) can
be written
V (p, y; z) = log(y) log(p1 ) (1 ) log(p2 ) + h() + log(z),
where h() is just a constant from the consumers point of view (since depends only
on the parameter ).
(1) Money vs. non-market goods Notice the trick above: we now have a repre-
sentation of consumer preferences that looks as though the consumer cares
about income and the non-market good (this helps us in drawing graphs!).
4. Existence value
4.1. Existence value. Even though an individual cant purchase a non-market
good (by definition), society may be able to, by making a collective investment.
This is often the case for dierent sorts of environmental amenities.
(1) Eliciting social values One way economists measure how much society would
collectively be willing to pay for environmental goods is to ask hypothetical
questions about consumers marginal rates of substitution between money
and the environmental good; often this is posed in terms of tax rates (the
idea is that everyone would then pay).
(2) Contingent valuation question Would you vote for a proposition that raised
all Californians taxes by $x and used the resulting revenue to [provide
environmental amenity]?
4.2. Proposition 67 (On 2016 Ballot). A Yes vote approves, and a No vote
rejects, a statute that:
Prohibits grocery and certain other retail stores from providing single-use
plastic or paper carryout bags to customers at point of sale.
Permits sale of recycled paper bags and reusable bags to customers, at a
minimum price of 10 cents per bag.
5. Existence Values & Voting

5.1. Eliciting Existence Values. By posing the question as a vote for or against
a proposition, we make it a discrete choice. The idea is to work out the largest tax
that a consumer would be willing to vote for. Suppose the vote is for two units
of an amenity z instead of one. Then wed look for the value of satisfying
(1) Utility if prop. passes V (p, y ; 2)
= V (p, y; 1) Utility if prop. fails.
EEP 100 LECTURE 10: DEMAND MISCELLANY, COMPOSITE
COMMODITIES, ELASTICITIES, AND AGGREGATE DEMAND
ETHAN LIGON
Contents
1. Introduction 1
2. Marshallian Demands and Indirect Utility 2
3. Hicks Composite Commodity Theorem 3
4. Marshallian Demands from Quadratic Utility 3
5. Elasticities 3
6. Income Elasticities 3
7. Price Elasticities 4
8. Aggregate Demand 5
1. Introduction
1.1. Ernst Engel.

1
2 ETHAN LIGON
(1) Ernst Engel portrait

(2) QOTD
The poorer the family, the greater the proportion of its total
expenditure that must be devoted to the provision of food. . . . The
proportion of the expenditures used for food, other things being
equal, is the best measure of the material standard of living. . .
Ernst Engel (1861)
2. Marshallian Demands and Indirect Utility

2.1. Marshallian Demands and Indirect Utility. If we know a consumers
Marshallian demands, we know how to compute her indirect utility function. But
its possible to go the other way as well. We can get Marshallian demands from the
indirect utility function using:
EEP 100 LECTURE 10: DEMAND MISCELLANY, COMPOSITE COMMODITIES, ELASTICITIES, AND AGGREGATE DEMAND
3
(1) Roys Identity

@V (p,y)
@pi
xi (p, y) @V (p,y)
.
@y
3. Hicks Composite Commodity Theorem

3.1. Hicks Composite Commodity Theorem. . . . if the prices of a group of
goods change in the same proportion, that group of goods behaves just as if it were
a single commodity.
Sir John Hicks, from Value and Capital (1946).
4. Marshallian Demands from Quadratic Utility

4.1. Marshallian Demands from Quadratic Utility. Weve been assuming a
convenient Cobb-Douglas form for utility functions most of the time. But other
utility functions are possible, of course!
(1) Quadratic Utility If, for example,
1
U (x1 , x2 ) = (x1 1 ) + (x2
2
2)
2
+ x1 x2
2
with xi i for i = 1, 2, we have a quadratic utility function.
What are Marshallian demands with quadratic utility?
5. Elasticities
5.1. Elasticities. An Elasticity is a way of measuring the magnitude of a change
which avoids any units (i.e., an elasticity is dimensionless).
(1) Elasticity In words, the elasticity of a variable x with respect to a variable
y is the percentage change in x occasioned by a percentage change in y.
(2) Some alternative formulae for elasticities:
%% y (for a discrete change)
x
log x
log y (approximate formula for a discrete change)
@x y
@y x (for an infinitesimal change)
@ log x
@ log y (alternative form for an infinitesimal change)
6. Income Elasticities
6.1. Income Elasticities. The income elasticity for a demand function is the an-
swer to the question:
If income increases by x percent, then by what percent does demand
increase?
(1) The Homothetic Case Income elasticities for homothetic preferences arent
very interesting (theyre always exactly equal to one).
6.2. Homotheticity. A function f : X ! R is homothetic if there exists a

monotonic transformation g : R ! R such that g f is a homogeneous function.
Example: f (x) = log(x) is not homogeneous; but choose g(y) = ey , and
g(f (x)) = x, which is (trivially) homogeneous of degree one.
4 ETHAN LIGON
6.3. Homotheticity. Fun Fact: A utility function is homothetic if and only if

all of its Engel curves are linear and pass through the origin.
Log:: log(x1 ) + (1 ) log(x2 )
1
Cobb-Douglas:: x 1 x2
x1
(1) Engel Curves 0 y

6.4. Expenditure Shares. Take U (x1 , x2 ) = x 1
1 x2 . Prices are (p1 , p2 ); income
is y. The Marshallian demand for good one in this case is
y p1 x1
x1 (p, y) = =) = .
p1 y
This allows us to interpret as the expenditure share of good 1.
6.5. Quasi-homotheticity.
(1) Quasi-homotheticity A function f : X ! R is quasi-homothetic if there
exists a monotonic transformation g : R ! R such that g f plus some
constant is a homogeneous function.
(a) Quasi-homotheticity f (x1 , x2 ) = log(x1 + 2) + log(x2 ) is not homo-
geneous; but choose g(y) = ey , and g(f (x1 , x2 )) = (x1 + 2)x2 . This
isnt homogeneous, but if we translate by defining $~ x1 =x1 -2), then
it becomes homogeneous in (x1 , x2 ).
7. Price Elasticities
EEP 100 LECTURE 10: DEMAND MISCELLANY, COMPOSITE COMMODITIES, ELASTICITIES, AND AGGREGATE DEMAND
5
7.1. Price Elasticities and Marshallian Demand Curves. What is the price
elasticity of the demand function
y
x1 = ?
p1
8. Aggregate Demand
8.1. Aggregating Demand. Often the main object of interest when we do some
economic analysis wont be individual demand curves, but instead the aggregate
demand curves for an entire population of consumers.
Weve solved the problem facing a single consumer, and expressed her demand
for goods as function of income and prices. What about the demand from many
consumers?
(1) Characteristics of Population Suppose there are n consumers, indexed by
j = 1, 2, . . . , n. Each consumer j has a Marshallian demand function for
good i given by
xji (p, yj ).
Note the important assumption here that consumers can have dierent
incomes (their yj s can be dierent), but that they all face the same prices
(theres no subscript on the price vector p).
8.2. Aggregate Demand. Suppose there are n people, indexed by i = 1, . . . , n,

and m goods, indexed by j = 1, . . . , m. Then aggregate demand for good i is
simply the sum of individual demands, or
n
X
xi = xji (p, yj ).
j=1
Notice two important things about this:

Prices assumed identical across consumers;
Incomes allowed to vary across consumers.
8.3. Aggregate Demand Example. Suppose we have Marshallian demands from

Cobb-Douglas utility; that is,
yj
xji (p, yj ) = i .
pi
Then the sum of these over n consumers is simply
0 1
Xn n
yj i @X A
xi = i = yj ;
j=1
pi pi j=1
That is, aggregate demand is proportional to aggregate income. (This is a conse-

quence of assuming homothetic utility; it isnt true in general).
6 ETHAN LIGON
8.4. Coda: Quadratic Utility Demand Example. If we have utility

1
U (x1 , x2 ) = (x1 1 ) + (x2
2
2)
2
+ x1 x2
2
what are consumer demands?
Using the quadratic utility defined above, compute Marshallian demands.
1 x1 + x2 = p1 ; (1) and 2 x2 + x1 = p2 (2)
y p1 x1
Substitute p1 x1 + p2 x2 = y which can be arranged as x2 = p2 (3)
y p1 x1
2 + x1 = p2
p2
y p1 x1
) 2 = + x1 = p2
p2 p2
2 y p1 x1
) x1 + =
p2 P22 p22 p2
8.5. Coda: Quadratic Utility Demand Example.
=) x1 =
+ x2 p1 1
y p1 x1
=) x1 = 1 + p1
p2
y p1 p1 p1 y p1 p1
=) x1 = 1 + x1 ( 2 ( )2 x1 + )
p1 p2 p2 p 2 p2 p2 p2
p1 p1 y p1 y
=) x1 (1 + ( )) = 1 + ) ( )( 2 + )
p2 p2 p2 p2 p2
Arrives at
1 p1 y
x1 = p1 p1 ( 1 ( 2 + )+ )
1+ p2 ( p2 ) p2 p22
1 p2 y
x2 = p2 p2 ( 2 ( 1 + ) + 2)
1+ p1 ( p1 ) p1 p1
EEP 100 LECTURE 11: MODAL CHOICE, AND THE DUAL
PROBLEM
ETHAN LIGON
Contents
1. Introduction 1
2. Should You Buy a Car? 2
3. Modal Choice 4
4. The Dual Problem 8
5. Hicksian Demands 9
6. The Expenditure Function 9
1. Introduction
1.1. Adam Smith.

1
2 ETHAN LIGON
(1) Smith
(2) QOTD
Though the principles of common prudence do not always govern
the conduct of every individual, they always influence that of the
majority of every class or order.
Adam Smith (1776)
2. Should You Buy a Car?

EEP 100 LECTURE 11: MODAL CHOICE, AND THE DUAL PROBLEM 3
2.1. Should You Buy a Car?
2.2. Costs of obtaining travel services by buying a car.
(1) Initial costs

Insurance
Taxes & Fees
Car loan payments
(2) But thats not all
Gasoline
Maintenance
Time
2.3. Fixed and Variable Costs.
The IRS estimates the marginal costs of using a car; for 2016 the estimate
it uses was $0.54/mile, but this doesnt count cost of time spent traveling.
Estimate fixed costs at $500/month for a decent used car.
2.4. Consequences for the Budget Set.
(1) The Set Up

Mean monthly expenditures among EEP 100 students in 2016 was
about $2000. Lets say time is worth $15/hour, and average speed
in car would be 30 MPH. Then time cost per mile is an additional
$0.50/mile; Total costs per mile are then $1.04 (=$0.50+$0.54).
4 ETHAN LIGON
3000
2500
Other Goods ($)

2000 No Car
1500 Slope=-1.04
1000
500 Car
0 1000 2000 3000

(2) The Graph
Travel Services (Miles)
3. Modal Choice
3.1. Modal Choice.
(1) Modal Choice A special kind of discrete choice involving decisions about
ones mode of transportation.
(2) Planes, Trains, and Automobiles
Taking a car isnt the only way to travel. We could also choose to fly,
take a train, or simply walk.
Lets think about the costs of walking. . .
3.2. Eects on the feasible set.
(1) Column 1
Mean monthly expenditures among EEP 100 students is about
$2000. Lets say time is worth $15/hour, and walking speed is 4
MPH. Then time cost per mile is $3.75/mile.
2000
1500
Other Goods
1000
Driving
Walking
500
0 500 1000 1500 2000

(2) Column 2
Travel Services (miles)
3.3. Car vs. Walking. The consumer chooses the mode with an indierence curve
tangent to his/her budget set.
6 ETHAN LIGON
Other Goods
miles, goods possible
(1) Other goods vs miles: Budget sets

Other Goods
Chooses Walking?
Chooses Driving!
(2) Other goods vs miles: Indierence curves

3.4. Back to the original question. . . We can model this sort of consumer
choice by working with consumers indirect utility functions.
No car: Income is y, and the price of travel is $3.75/mile.
Car: Income is y 500, and the price of travel is $1.04/mile.
So buy a car if
V (y 500, 1.04, 1) V (y, 3.75, 1).

3.5. Modal Choice.
(1) Assumptions
Let total income be y;
Let cost/mile in taxi be q and in car be q 0 , where q 0 < q;
(2) Fun Fact If U = log(x1 ) + (1 ) log(z) and p2 = 1 (the price of other
goods), then
V (p1 , p2 , y) = A + log(y) log(p1 ).
8 ETHAN LIGON
(Why?)
3.6. Modal Choice. Using Roys identity, the Marshallian demand in this case is
@V (p1 ,p2 ,y)

@p1 p1 y
x1 (p, y) = @V (p1 ,p2 ,y)
= 1 = .
y
p1
@y
3.7. Modal Choice. Let r be the fixed costs of operating the car. Then:
Utility with Taxi: V (q, 1, y)
Utility with Car: V (q 0 , 1, y r)
One should buy the car if
A + log(y r) log(q 0 ) A + log(y) log(q)
that is, if
q y
log log .
q0 y r
4. The Dual Problem

4.1. The Dual Problem. The problem weve been working with involves the
choices a consumer makes so as to maximize utility subject to fixed income and
prices. This is sometimes called the primal consumers problem.
Now we consider another problem: Take the level of utility we want to achieve
as given, and figure out how much income we need to get there.
min p1 x1 + p2 x2
x1 ,x2
such that U (x1 , x2 ) = U .
4.2. Solving the Dual Consumers Problem. Formulate the dual problem as
a Lagrangian. Let
L(x1 , x2 , ) = p1 x1 + p2 x2 + (U U (x1 , x2 ))
and solve
min L(x1 , x2 , ).
x1 ,x2
This gives us first order conditions
@L @U
= pi (x1 , x2 ) = 0 for i = 1, 2; and
@xi @xi
U (x1 , x2 ) = U .
5. Hicksian Demands
Well make progress now by assuming a particular ordinal utility function, e.g.,
U (x1 , x2 ) = 1 log(x1 1) + 2 log(x2 2 ), with 1 + 2 = 1.
Using this assumption, we have

@U i
(x1 , x2 ) = .
@xi xi i
Substituting into the first two first order conditions gives

i
pi = for i = 1, 2.
xi i
Dividing this equation at i = 1 by the i = 2 equation, we have

p1 1 x2 2
= .
p2 2 x1 1
Solving these equations for x1 and x2 gives us a set of Hicksian demands.
5.1. To solve in this case. . . We rearrange our expression for the utility function,
obtaining
1/2
eU
x2 = + 2.
(x1 1) 1

Combining these last two yields (after some algebra)

U p2 1 2
x1 = h1 (p, U ) = e

+ 1.
p1 2
This is the Hicksian demand for x1 ; notice that its a function of prices p and
utility U . By symmetry, we also have

U p1 2 1
x2 = h2 (p, U ) = e

+ 2.
p2 1
6. The Expenditure Function

6.1. The Expenditure Function. A question: Given prices p, how much income
does one need to achieve utility U ? The answer is given by the expenditure
function
E(p, U ) = min p1 x1 + p2 x2 such that U (x1 , x2 ) = U .
x1 ,x2
But weve already solved this problem; the solution involved our derivation of the
Hicksian demands h1 (p, U ). So, now we have
E(p, U ) = p1 h1 (p, U ) + p2 h2 (p, U ).
Substituting our solution for the Hicksian demands (and doing quite a bit of
algebratry it!), we obtain

E(p, U ) = A()eU p1 2
1 p 2 + p1 1 + p2 2,
where A() is a positive constant that only depends on i s.

10 ETHAN LIGON
6.2. Shepards Lemma. We derived the expenditure function by first solving

for Hicksian demands. Its possible to go the other way too, using a trick called
Shepards Lemma:
@E(p, U )
hi (p, U ) =
@pi
Note that this works for any number of commodities or utility functions.
EEP 100 LECTURE 12: THE SLUTSKY DECOMPOSITION &
COMPENSATING VARIATION
ETHAN LIGON
Contents
1. Introduction 1
2. The Dual Problem 2
3. Hicksian Demands 3
4. The Expenditure Function 4
5. The Slutsky Equation 4
6. Application: Sustaining Happiness 6
7. Questions 7
1. Introduction
1.1. Eugen Slutsky.
. Date: October 2, 2017.

1
2 ETHAN LIGON
(1) Eugen Slutsky

(2) Need a Quote from Slutsky! QOTD The effect of a change in price on
the quantity demanded can be decomposed into two parts: the first part
involving substitution between goods; and the second involving changes in
real income due to the price change.
Eugen Slutsky, 1915 (translated from the original math by Ethan Ligon)
2. The Dual Problem

2.1. The Dual Problem. The problem weve been working with involves the
choices a consumer makes so as to maximize utility subject to fixed income and
prices. This is sometimes called the primal consumers problem.
Now we consider another problem: Take the level of utility we want to achieve
as given, and figure out how much income we need to get there.
min p1 x1 + p2 x2
x1 ,x2
such that U (x1 , x2 ) = U .

EEP 100 LECTURE 12: THE SLUTSKY DECOMPOSITION & COMPENSATING VARIATION3
2.2. Solving the Dual Consumers Problem. Formulate the dual problem as
a Lagrangian. Let
L(x1 , x2 , ) = p1 x1 + p2 x2 + (U U (x1 , x2 ))
and solve
min L(x1 , x2 , ).
x1 ,x2
This gives us first order conditions

L U
= pi (x1 , x2 ) = 0 for i = 1, 2; and
xi xi
U (x1 , x2 ) = U .
3. Hicksian Demands
Well make progress now by assuming a particular ordinal utility function, e.g.,
U (x1 , x2 ) = 1 log(x1 1 ) + 2 log(x2 2 ), with 1 + 2 = 1.
Using this assumption, we have

U i
(x1 , x2 ) = .
xi xi i
Substituting into the first two first order conditions gives
i
pi = for i = 1, 2.
xi i
Dividing this equation at i = 1 by the i = 2 equation, we have
p1 1 x2 2
= .
p2 2 x1 1
Solving these equations for x1 and x2 gives us a set of Hicksian demands.
3.1. To solve in this case. . . We rearrange our expression for the utility function,
obtaining
3 41/2
eU
x2 = + 2 .
(x1 1 )1
Combining these last two yields (after some algebra)
3 4
p2 1 2
x1 = h1 (p, U ) = e
U
+ 1 .
p1 2
This is the Hicksian demand for x1 ; notice that its a function of prices p and
utility U . By symmetry, we also have
3 4
p1 2 1
x2 = h2 (p, U ) = e
U
+ 2 .
p2 1
4 ETHAN LIGON
4. The Expenditure Function

4.1. The Expenditure Function. A question: Given prices p, how much income
does one need to achieve utility U ? The answer is given by the expenditure
function
E(p, U ) = min p1 x1 + p2 x2 such that U (x1 , x2 ) = U .

x1 ,x2
But weve already solved this problem; the solution involved our derivation of the
Hicksian demands h1 (p, U ). So, now we have
E(p, U ) = p1 h1 (p, U ) + p2 h2 (p, U ).
Substituting our solution for the Hicksian demands (and doing quite a bit of
algebratry it!), we obtain
E(p, U ) = A()eU p
1 p2 + p1 1 + p2 2 ,

1 2
where A() is a positive constant that only depends on i s.
4.2. Shepards Lemma. We derived the expenditure function by first solving

for Hicksian demands. Its possible to go the other way too, using a trick called
Shepards Lemma:
E(p, U )
hi (p, U ) =
pi
Note that this works for any number of commodities or utility functions.
5. The Slutsky Equation

5.1. Substitution & Income Effects. When prices change, one can think of
there being two distinct consumer responses:
Substitution Effect
Income Effect
5.2. Substitution Effect. Because the cost of one good increases relative to oth-
ers, the consumer substitutes toward less expensive goods. Theres no loss of utility
from substitution, per se.
x2
p01
p2
h2 (p0 , U )
p1
p2
h2 (p, U )
h1 (p0 , U ) h1 (p, U ) x1
(1) graph Subst Eect
5.3. Income Effect. Because the price increase reduces the size of the consumers
budget, its also as though the consumer experiences a loss of income, which may
change the composition of her consumption bundle.
x2
y
p2
p01
p2
p1
p2
3
1
2
x1 (p0 , y) h1 (p0 , U ) h1 (p, U ) x1
(1) Income Effect Graph Income Eect Subst Eect
5.4. The Slutsky Decomposition. Formally, the income and substitution effects
come from the Slutsky Decomposition.
The usual way of expressing this:
xi hi xi
= xi .
pi pi y
6 ETHAN LIGON
Its also possible (and sometimes useful) to rewrite this expression in terms of
elasticities: 3 43 4
xi pi hi p1 xi y pi xi
= .
pi xi pi hi y xi y
5.5. Compensating Variation. Suppose that the price of good one increases from
p1 to p1 ; then expenditures must increase in order to maintain the original level of
utility. By how much? Simple:
E(p , U ) E(p, U ).
This difference is called the Compensating Variation. Think of it as the amount
one would have to give a consumer to compensate her for the loss of utility associated
with a price increase. In other words, how much must you be compensated to make
you as well off as you were before the price change?.
6. Application: Sustaining Happiness

6.1. Application: Sustaining Happiness. Idea: Suppose that youre making
plans now about how much to save, study, etc. What should guide these savings
and investment decisions?
Suppose youd like to be at least as happy 20 years from now as at present. Well
solve the problem in two steps.
(1) Figure out how current level of happiness is related to current prices and
income; and
(2) Figure out level of future expenditures necessary to maintain current level
of utility.
6.2. Sustaining Happiness. The first step is to relate current utility to current
prices and income. To do this:
Define the Commodity space: For example, (Food, Other goods).
Assume (for example):
p1 = Price of Food = 1;
p2 = Price of other goods = 1;
Food share() = 20%;
y = Income = 100.
Define preferences over Food and Other goods; e.g.,
U (x1 , x2 ) = log(x1 ) + (1 ) log(x2 ).
This implies an indirect utility function
V (p1 , p2 , y) = A + log(y) log(p1 ) (1 ) log(p2 )

= A + log(100) = U
6.3. Sustaining Happiness. Now, imagine that in the future food prices continue
to fall, while prices for energy and Other goods rise, so that 20 years from now we
have
p1 = 1/2; and
p2 = 2.
How much income will we need to have a utility of at least A + log(100)? The
answer is given by the Expenditure function:
E(p1 , p2 , U ) = min p1 x1 + p2 x2
x1 ,x2
such that log(x1 ) + (1 ) log(x2 ) = U .

6.4. Sustaining Happiness. We already know the form of the expenditure func-
tion for this case: its
1
E(p1 , p2 , U ) = BeU p

1 p2 .
When prices are p1 = p2 = 1 expenditures are 100, so we have 100 = BeA+log 100 ,
so BeA = 1.
Substituting in:
E(p1 , p2 , U ) = 100(1/2) 21 = 100eU (1/2)0.2 20.8 156.

Interpretation: To achieve current level of utility with new prices youll need an
income of approximately $156.
7. Questions
7.1. Questions.
(1) What are Marshallian demands with quadratic utility?
(2) What are Hicksian demands with quadratic utility?
(3) What is aggregate demand over n consumers having quadratic utility func-
tions? Compare with the Cobb-Douglas (logarithmic) case.
(4) Calculate an expression for income elasticities for consumers with quadratic
utility. Compare with the Cobb-Douglas (logarithmic) case.
(5) What are the own- and cross-price elasticities for consumers with quadratic
utility? Compare with the Cobb-Douglas (logarithmic) case.
EEP 100 LECTURE 13: DUALITY, COMPENSATING
VARIATION, AND DEMAND FOR LIGHTING
ETHAN LIGON
Contents
1. Introduction 1
2. The Slutsky Equation 2
3. More on Slutsky and Hicks 4
4. Engel Curves 5
5. The Expenditure Function for Logarithmic Utility 7
6. Compensating Variation 8
7. Example of Lighting Demand 9
1. Introduction
1.1. Alfred Marshall.
(1) Alfred Marshall
. Date: October 5, 2017.

1
2 ETHAN LIGON
(2) QOTD
Economics is the study of mankind in the ordinary business of
life.
Alfred Marshall
2. The Slutsky Equation

2.1. Substitution & Income Effects. When prices change, Marshallian demands
will also change, for two distinct reasons:
Substitution effect (captured by changes in Hicksian demands)

Income Effect (changes in prices affect real income).
2.2. Substitution Effect. Because the cost of one good increases relative to oth-
ers, the consumer substitutes toward less expensive goods. Theres no loss of utility
from substitution, per se.
(1) graph
EEP 100 LECTURE 13: DUALITY, COMPENSATING VARIATION, AND DEMAND FOR LIGHTING
3
x2
p01
p2
h2 (p0 , U )
p1
p2
h2 (p, U )
h1 (p0 , U ) h1 (p, U ) x1
Subst Eect
2.3. Income Effect. Because the price increase reduces the size of the consumers
budget, its also as though the consumer experiences a loss of income, which may
change the composition of her consumption bundle.
(1) Income Effect Graph
x2
y
p2
p01
p2
p1
p2
3
1
2
x1 (p0 , y) h1 (p0 , U ) h1 (p, U ) x1

Income Eect Subst Eect
2.4. Demand Identity. We can isolate the substitution effect by changing income
y to compensate for the price change. This gives us
xi (p, E(p, U )) hi (p, U ).
4 ETHAN LIGON
Differentiating this with respect to pi and using the chain rule gives us
xi xi E hi
+ = .
pi y pi pi
2.5. The Slutsky Decomposition. Applying Shepards lemma and rearranging
delivers the Slutsky Decomposition.
The usual way of expressing this:
xi hi xi
= xi .
pi pi y
Its also possible (and sometimes useful) to rewrite this expression in terms of
elasticities: 3 43 4
xi pi hi pi xi y pi xi
= .
pi xi pi hi y xi y
E(p , U ) E(p, U ).
This difference is called the Compensating Variation. Think of it as the amount
with a price increase. In other words, how much must you be compensated to make
you as well off as you were before the price change?.
3. More on Slutsky and Hicks

3.1. Substitution Across Goods. An increase in the price of a good i will typi-
cally affect demand for good i, but may also affect demand for other goods. Theres
a corresponding Slutsky decomposition for this case as well:
xi hi xi
= xj ,
pj pj y
or in elasticity form:
3 43 4
xi pj hi pj xi y pj xj
= .
pj xi pj hi y xi y
3.2. Properties of Hicksian Demand Functions.
(1) Hicksian demands are always downward sloping:
hi
0.
pi
Why?
(2) Hicksian demands are homogeneous of degree zero in prices:
hi (p1 , p2 , U ) = hi (bp1 , bp2 , U ).
Why?
(3) Cross-partials are equal (Symmetry):
hi hj
= .
pj pi
Why?
5
4. Engel Curves
4.1. Engel Curves from Quasi-homothetic utility.
(1) Fun Fact A utility function is quasi-homothetic if and only if all of its Engel
curves are linear; they do not need to pass through the origin.
Log:: log(x1 ) + (1 ) log(x2 1)
1
Cobb-Douglas:: x 1 (x2 1)
(2) Engel Curves
x1
0 y
4.2. Expenditure Shares and Engels Curve. Let U (x1 , x2 ) = log(x1 ) +
(1 ) log(x2 ). Assume that income is large enough that its feasible to choose
x1 > (think of as a starvation level of consumption of good one).
(1) Engel Curves In this case Engel curves dont necessarily pass through the
origin, but are still straight lines. For the utility function assumed here,
the Engel curve is given by
y
x1 = + ,
p1
where y = y p1 is the disposable income available after purchasing
the subsistence level of consumption .
4.3. Engel Curves. Using data collected from EEP 100 students on your expen-
ditures over several weeks, we can also directly estimate an Engel curve for the
average EEP 100 student, assuming that students have quasi-homothetic utility
functions.
6 ETHAN LIGON
(1) Estimation We put the Engel curve into its expenditure form by multi-
plying by prices, obtaining
p1 x1 = p1 + y.
We then use data from the class to get different observations on p1 x1 and
y, and use OLS to estimate the linear Engel curve.
4.4. Class Food Engel Curve.
4.5. Class Food Engel Curve.

7
4.6. EEP 100 Food Engel Curve. In units of current US Dollars:

p1 x1 = 83 + 0.21y
Income elasticity of food expenditures:
p1 x1 y
= .
y p1 x1
In this case, this simplifies to
0.21y
= .
p1 x1
At the mean level of expenditures, we have y = $407 and p1 x1 = $167. So at this
average, = 0.21 $407
$167 = 0.51.
(1) Interpretation For the typical EEP 100 student in 2017, a 1% increase in
total expenditures was met by about 1/2 per cent increase in food expen-
ditures.
4.7. World Food Engel Curve.
5. The Expenditure Function for Logarithmic Utility

5.1. The Expenditure Function. If the consumer has a utility function
U (x1 , x2 ) = log(x1 ) + (1 ) log(x2 ),
then the amount of money needed to reach a level of utility U will be
1
E(p, U ) = BeU p

1 p2 ,
where
B = [ (1 )1 ]1
is a constant.
8 ETHAN LIGON
6. Compensating Variation
E(p , U ) E(p, U ).
This difference is called the Compensating Variation: think of it as the amount

with a price increase.
6.2. Compensating Variation.
(1) graph
x2
y0
p2
CV
p2
y
p2
3
1
2
new budget set

y y x1
p01 p1
price shift
6.3. Compensating Variation.

E(p, U ) p
hi (p, U ) = hi (p, U )dp = E(p, U )
pi 0
s
Where hi (p, U )dp is the area under the Hicksian demand curve.
(1) graph
9
p1
CV=E(p0 , U ) E(p, U )
p01
p1
E(p, U ) h(p, U )
x1
7. Example of Lighting Demand

7.1. Demand for Light. Technological innovations seem likely to dramatically
increase the energy efficiency of lighting, and so reduce the cost.
A paper published in the Journal of Physics D: Applied Physics (Tsao et al
2010) estimates that the widespread adoption of solid state lighting (such as LEDs)
will greatly improve energy efficiency. They estimate that the cost of the energy
necessary to provide one mega-lumen hours (Mlmh; roughly the light provided by
1000 75 watt incandescent bulbs over a one hour period) using current incandescent
technology to be $9. In contrast, they predict that solid state lighting will soon be
able to provide equivalent levels of illumination at an energy cost of only $0.44, or
about five percent of the current cost.
7.2. Demand for Light.
The same paper estimates the global expenditure share of lighting at 0.72
per cent, and argues that this is roughly constant over a wide range of in-
comes and historical periods. This constancy implies that a utility function
U (, z) = log + (1 ) log z,
with = 0.0072, with equal to consumption of lighting (in Mlmhs), and
with z equal to consumption of other goods (measured in 2010 dollars) may
usefully capture global demand behavior.
Assuming the utility function given in (1), give a formula and a graph of
the Engel curve for light when the price of light is $9.00 and the price of
other goods z is $1.00. Repeat for the case in which the price of light is
$0.44.
With a global income equal in value to $60 trillion (the approximate figure
for GDP in 2010 in 2010 US dollars), how much light will be demanded,
using the old technology and price? With a global GDP of $200 trillion (a
predicted global income in 2050; also in 2009 US dollars) how much light
will be demanded, using the new technology and price?
10 ETHAN LIGON

Given a particular lighting technology, the quantity of lighting is roughly
proportional to the quantity of energy expended. The technological im-
provement described above involves a change in this proportion. Let = e
where e is energy, and where reflects the rate at which the current in-
candescent lighting technology converts energy to lumens. Tsao et als
estimates imply that using the new technology changes the relationship be-
$9
tween lumens produced and energy input to = $0.44 e. If this is so, show
that total expenditures on energy for lighting do not change with changes
in . What then is the effect of the introduction of solid state lighting
technology on energy demand? Comment on the prospects for technologi-
cal improvements in lighting efficiency leading to reductions in total energy
demand.

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EEP 100 LECTURE 1: INTRODUCTION

1. Instructor: Ethan Ligon

2.2. Peiley Lau.

4. Motivation: What is economics?

5. What do economists do? (Positive)

. Date: August 24, 2017.

6. What would economists do? (Normative)

7. Economics vs. Other Social Sciences

8. Data on median earnings of those with a bachelors degree

9. Aim of the Course

10. What does this course have to do with Environmental and

11. What makes Environmental & Resource Economics special?

12. Your generation will have to solve many of these problems.

13. Competence in Economics

. Date: August 31, 2017.

1. The Coffee Pit Experiment

1.2. Constructing Supply.

Card No. Cum.

(2) Supply curve

1.3. Constructing Demand.

Card No. Cum.

(2) Demand curve

1.4. Putting Demand and Supply Together.

2.1. Trading Results: Cycle 1.

2.2. Profits from 2017 Coee Pit.

(1) Distribution of Coee Profits

3.2. Usual Assumptions.

3.3. Commodity Bundles. Examples of Commodities:

(1) graph Wine

6.2. A Practical Diculty. However, for most interesting commodity spaces,

7.2. Properties of Indierence Curves.

7.3. Graphical Representation: Curves cannot cross.

7.5. Example of an Indierence Curve.

. Date: September 5, 2017.

2.3. 2. Transitivity. For any three bundles A, B, and C,

2.5. 3. Non-satiation. If bundle A contains at least as much of each commodity

3.2. A Practical Diculty. However, for most interesting commodity spaces,

4.2. Properties of Indierence Curves.

4.3. Graphical Representation: Curves cannot cross.

4.4. Graphical Representation: Curves are downward sloping.

4.5. Example of an Indierence Curve.

5.2. El Capitan Topographic Map.

6.2. From Indierence Curves Ordinal Utility Functions.

6.3. Using Ordinal Utility to Construct Indierence Curves. We can also

(1) Example ordinal utility function

U (x1 , x2 ) = log(1 + x1 ) + log(1 + x2 ).

6.4. Graph of utility function.

U (x1 , x2 ) = log(1 + x1 ) + log(1 + x2 ).

6.5. Using Ordinal Utility Construct Indierence Curves. To compute the

(1) Benthams picture

. Date: September 7, 2017.

Nature has placed mankind under the governance of two sovereign

(1) Picture of Cardinal

Assuming that people have similar utility functions?

4. Marginal rates of substitution

(1) A consumers marginal rate of substitution Measures the rate at which a

4.2. Marginal Rate of Substitution.

(1) Graphical Representation: MRS x1

5. Examples of Indifference Curves

U(x1 , x2 ) = log(x1 ) + log(x2 )

U(x1 , x2 ) = x21 + x22

6.2. Utility Function. Heres a utility function: U (x1 , x2 ) = log(x1 +1)+log(x2 +

6.3. Slice of Utility function.

7. Slopes of Indifference Curves