Advanced Microeconomic

Theory
Chapter 1: Preferences and Utility

Advanced Microeconomic Theory

 Outline
• Preference and Choice
• Preference-Based Approach
• Utility Function
• Indifference Sets, Convexity, and Quasiconcavity
• Special and Continuous Preference Relations
• Social and Reference-Dependent Preferences
• Hyperbolic and Quasi-Hyperbolic Discounting
• Choice-Based Approach
• Weak Axiom of Revealed Preference (WARP)
• Consumption Sets and Constraints
Advanced Microeconomic Theory 2
Preference and Choice

Advanced Microeconomic Theory 3

 Preference and Choice
• We begin our analysis of individual decision-
making in an abstract setting.
• Let 𝑋𝑋 ⊆ ℝ𝑁𝑁
+ be a set of possible alternatives for a
particular decision maker.
– It might include the consumption bundles that an
individual is considering to buy.
– Example:
𝑋𝑋 = {𝑥𝑥, 𝑦𝑦, 𝑧𝑧, … }
𝑋𝑋 = {Apple, Orange, Banana, … }

Advanced Microeconomic Theory 4

 Preference and Choice
• Two ways to approach the decision making
process:
1) Preference-based approach: analyzing how the
individual uses his preferences to choose an
element(s) from the set of alternatives 𝑋𝑋.
2) Choice-based approach: analyzing the actual
choices the individual makes when he is called to
choose element(s) from the set of possible
alternatives.

Advanced Microeconomic Theory 5

 Preference and Choice
• Advantages of the Choice-based approach:
– It is based on observables (actual choices) rather
than on unobservables (individual preferences)

• Advantages of Preference-based approach:

– More tractable when the set of alternatives 𝑋𝑋 has
many elements.

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 Preference and Choice
• After describing both approaches, and the
assumptions on each approach, we want to
understand:
Rational Preferences ⟹ Consistent Choice behavior
Rational Preferences ⟸ Consistent Choice behavior

Advanced Microeconomic Theory 7

Preference-Based Approach

Advanced Microeconomic Theory 8

 Preference-Based Approach
• Preferences: “attitudes” of the decision-maker
towards a set of possible alternatives 𝑋𝑋.
• For any 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋, how do you compare 𝑥𝑥 and 𝑦𝑦?
 I prefer 𝑥𝑥 to 𝑦𝑦 (𝑥𝑥 ≻ 𝑦𝑦)
 I prefer 𝑦𝑦 to 𝑥𝑥 (𝑦𝑦 ≻ 𝑥𝑥)
 I am indifferent (𝑥𝑥 ∼ 𝑦𝑦)

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 Preference-Based Approach
By asking: We impose the assumption:

Check one box Completeness: individuals must

(i.e., not refrain from compare any two alternatives,
answering) even the ones they don’t know.
Check only one box The individual is capable of
comparing any pair of
alternatives.
Don’t add any new box in We don’t allow the individual to
which the individual says, “I specify the intensity of his
love 𝑥𝑥 and hate 𝑦𝑦” preferences.

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 Preference-Based Approach
• Completeness:
– For any pair of alternatives 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋, the individual
decision maker:
 𝑥𝑥 ≻ 𝑦𝑦, or
 𝑦𝑦 ≻ 𝑥𝑥, or
 both, i.e., 𝑥𝑥 ∼ 𝑦𝑦
 (The decision maker is allowed to choose one, and
only one, of the above boxes).

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 Preference-Based Approach
• Not all binary relations satisfy Completeness.
• Example:
– “Is the brother of”: John ⊁ Bob and Bob ⊁ John if
they are not brothers.
– “Is the father of”: John ⊁ Bob and Bob ⊁ John if
the two individuals are not related.

• Not all pairs of alternatives are comparable

according to these two relations.

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 Preference-Based Approach
• Weak preferences:
– Consider the following questionnaire:
– For all 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋, where 𝑥𝑥 and 𝑦𝑦 are not necessarily
distinct, is 𝑥𝑥 at least as preferred to 𝑦𝑦?
 Yes (𝑥𝑥 ≿ 𝑦𝑦)
 No (𝑦𝑦 ≿ 𝑥𝑥)
– Respondents must answer yes, no, or both
 Checking both boxes reveals that the individual is indifferent
between 𝑥𝑥 and 𝑦𝑦.
 Note that the above statement relates to completeness, but
in the context of weak preference ≿ rather than strict
preference ≻.
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 Preference-Based Approach
• Reflexivity: every alternative 𝑥𝑥 is weakly
preferred to, at least, one alternative: itself.
• A preference relation satisfies reflexivity if for any
alternative 𝑥𝑥 ∈ 𝑋𝑋, we have that:
1) 𝑥𝑥 ∼ 𝑥𝑥: any bundle is indifferent to itself.
2) 𝑥𝑥 ≿ 𝑥𝑥: any bundle is preferred or indifferent to
itself.
3) 𝑥𝑥 ⊁ 𝑥𝑥: any bundle belongs to at least one
indifference set, namely, the set containing itself
if nothing else.

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 Preference-Based Approach
• The preference relation ≿ is rational if it
possesses the following two properties:
a) Completeness: for all 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋,
either 𝑥𝑥 ≿ 𝑦𝑦, or 𝑦𝑦 ≿ 𝑥𝑥, or both.
b) Transitivity: for all 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ∈ 𝑋𝑋,
if 𝑥𝑥 ≿ 𝑦𝑦 and 𝑦𝑦 ≿ 𝑧𝑧, then it must be that 𝑥𝑥 ≿ 𝑧𝑧.

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 Preference-Based Approach
• Example 1.1.
Consider the preference relation
𝑁𝑁 𝑁𝑁
𝑥𝑥 ≿ 𝑦𝑦 if and only if ∑𝑖𝑖=1 𝑥𝑥𝑖𝑖 ≥ ∑𝑖𝑖=1 𝑦𝑦𝑖𝑖
In words, the consumer prefers bundle 𝑥𝑥 to 𝑦𝑦 if the
total number of goods in bundle 𝑥𝑥 is larger than in
bundle 𝑦𝑦.

Graphical interpretation in ℝ2 (diagonal above

another diagonal). Hyperplanes for 𝑁𝑁 > 2.

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 Preference-Based Approach
• Example 1.1 (continues).
• Completeness:
– either ∑𝑁𝑁 𝑥𝑥
𝑖𝑖=1 𝑖𝑖 ≥ ∑ 𝑁𝑁
𝑖𝑖=1 𝑦𝑦𝑖𝑖 (which implies 𝑥𝑥 ≿ 𝑦𝑦), or
– ∑𝑁𝑁 𝑦𝑦
𝑖𝑖=1 𝑖𝑖 ≥ ∑ 𝑁𝑁
𝑖𝑖=1 𝑥𝑥𝑖𝑖 (which implies 𝑦𝑦 ≿ 𝑥𝑥), or
– both, ∑𝑁𝑁 𝑖𝑖=1 𝑥𝑥𝑖𝑖 = ∑ 𝑁𝑁
𝑖𝑖=1 𝑦𝑦𝑖𝑖 (which implies 𝑥𝑥 ∼ 𝑦𝑦).

• Transitivity:
– If 𝑥𝑥 ≿ 𝑦𝑦, ∑𝑁𝑁 𝑥𝑥
𝑖𝑖=1 𝑖𝑖 ≥ ∑ 𝑁𝑁
𝑖𝑖=1 𝑦𝑦𝑖𝑖 , and
– 𝑦𝑦 ≿ 𝑧𝑧, ∑𝑁𝑁 𝑦𝑦
𝑖𝑖=1 𝑖𝑖 ≥ ∑ 𝑁𝑁
𝑖𝑖=1 𝑧𝑧𝑖𝑖 ,
– Then it must be that ∑𝑁𝑁 𝑖𝑖=1 𝑖𝑖𝑥𝑥 ≥ ∑ 𝑁𝑁
𝑖𝑖=1 𝑧𝑧𝑖𝑖 (which implies
𝑥𝑥 ≿ 𝑧𝑧, as required).
Advanced Microeconomic Theory 17
 Preference-Based Approach
• The assumption of transitivity is understood as
that preferences should not cycle.
• Example violating transitivity:
𝑎𝑎𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 ≿ 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 ≿ 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎≿𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 (by transitivity)
but 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 ≻ 𝑎𝑎𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝.
• Otherwise, we could start the cycle all over again,
and extract infinite amount of money from
individuals with intransitive preferences.
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 Preference-Based Approach
• Sources of intransitivity:
a) Indistinguishable alternatives
b) Framing effects
c) Aggregation of criteria
d) Change in preferences

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 Preference-Based Approach
• Example 1.2 (Indistinguishable alternatives):
– Take 𝑋𝑋 = ℝ, such as a piece of pie.
– An individual is indifferent between 𝑥𝑥 and 𝑦𝑦 when 𝑥𝑥 − 𝑦𝑦 < 1 .
• This means that −1 < 𝑥𝑥 − 𝑦𝑦 < 1 or, after rearranging, 𝑦𝑦 − 1 < 𝑥𝑥 < 𝑦𝑦 +
1.
• In other words, when 𝑥𝑥 satisfies both:
– 𝑥𝑥 > 𝑦𝑦 − 1 and
– 𝑥𝑥 < 𝑦𝑦 + 1 ,
the individual is indifferent between 𝑥𝑥 and 𝑦𝑦.
• Intuitively, when alternatives are relatively similar (see figure), the
individual cannot tell them apart.
x = y -1 x=y+1
0
y x
LCS, y ≻ x IND, x ~ y UCS, x ≻ y
Advanced Microeconomic Theory 20
 Preference-Based Approach
• Example 1.2 (Indistinguishable alternatives):
– However, he strictly prefers 𝑥𝑥 to 𝑦𝑦 when 𝑥𝑥 ≥ 𝑦𝑦 + 1,
meaning that 𝑥𝑥 is at least one unit larger than 𝑦𝑦.
• See UCS at the right-hand of the figure.
– In contrast, he strictly prefers 𝑦𝑦 to 𝑥𝑥 when 𝑥𝑥 ≤ 𝑦𝑦 −
1, which means that 𝑦𝑦 is at least one unit larger
than 𝑥𝑥.
• See LCS at the left-hand of the figure.

x = y -1 x=y+1
0
y x
LCS, y ≻ x IND, x ~ y UCS, x ≻ y
Advanced Microeconomic Theory 21
 Preference-Based Approach
• Example 1.2 (Indistinguishable alternatives):
– Completeness. The above preference relation is
complete:
• For a given bundle 𝑥𝑥, another bundle 𝑦𝑦 must lie in the UCS,
IND, or LCS of 𝑥𝑥 (see figure).
– Transitivity. It does not hold:
• Construct a counterexample, such as:
1.5~0.8 since 1.5 − 0.8 = 0.7 < 1
0.8~0.3 since 0.8 − 0.3 = 0.5 < 1
• By transitivity, we would have 1.5~0.3, but in fact 1.5 ≻ 0.3
(intransitive preference relation).

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 Preference-Based Approach
• Other examples:
– similar shades of gray paint
– milligrams of sugar in your coffee

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 Preference-Based Approach
• Example 1.3 (Framing effects):
– Transitivity might be violated because of the way
in which alternatives are presented to the
individual decision-maker.
– What holiday package do you prefer?
a) A weekend in Paris for $574 at a four-star hotel.
b) A weekend in Paris at the four-star hotel for $574.
c) A weekend in Rome at the five-star hotel for $612.
– By transitivity, we should expect that if 𝑎𝑎 ∼ 𝑏𝑏 and
𝑏𝑏 ≻ 𝑐𝑐, then 𝑎𝑎 ≻ 𝑐𝑐.
Advanced Microeconomic Theory 24
 Preference-Based Approach
• Example 1.3 (continued):
– However, this did not happen!
– More than 50% of the students responded 𝑐𝑐 ≻ 𝑎𝑎.
– Such intransitive preference relation is induced by
the framing of the options.

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 Preference-Based Approach
• Example 1.4 (Aggregation of criteria):
– Aggregation of several individual preferences
might violate transitivity.
– Consider 𝑋𝑋 = {𝑀𝑀𝑀𝑀𝑀𝑀, 𝑊𝑊𝑊𝑊𝑊𝑊, 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈}
– When considering which university to attend, you
might compare:
a) Academic prestige (criterion #1)
≻1 : 𝑀𝑀𝑀𝑀𝑀𝑀 ≻1 𝑊𝑊𝑊𝑊𝑊𝑊 ≻1 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈.
b) City size/congestion (criterion #2)
≻2 : 𝑊𝑊𝑊𝑊𝑊𝑊 ≻2 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈. ≻2 𝑀𝑀𝑀𝑀𝑀𝑀
c) Proximity to family and friends (criterion #3)
≻3 : 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈. ≻3 𝑀𝑀𝑀𝑀𝑀𝑀 ≻3 𝑊𝑊𝑊𝑊𝑊𝑊 26
Advanced Microeconomic Theory
 Preference-Based Approach
• Example 1.4 (continued):
– By majority of these considerations:
𝑀𝑀𝑀𝑀𝑀𝑀 ≻ 𝑊𝑊𝑊𝑊𝑊𝑊 ≻ 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 ≻ 𝑀𝑀𝑀𝑀𝑀𝑀
criteria 1 & 3 criteria 1 & 2 criteria 2 & 3

– Transitivity is violated due to a cycle.

– A similar argument can be used for the
aggregation of individual preferences in group
decision-making:
 Every person in the group has a different (transitive)
preference relation but the group preferences are not
necessarily transitive (“Condorcet paradox”).
Advanced Microeconomic Theory 27
 Preference-Based Approach
• Intransitivity due to a change in preferences
– When you start smoking
One cigarette ≿ No smoking ≿ Smoking heavily
By transitivity,
One cigarette ≿ Smoking heavily
– Once you started
Smoking heavily ≿ One cigarette ≿ No smoking
By transitivity,
Smoking heavily ≿ One cigarette
– But this contradicts the individual’s past
preferences when he started to smoke.
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Utility Function

Advanced Microeconomic Theory 29

 Utility Function
• A function 𝑢𝑢: 𝑋𝑋 → ℝ is a utility function
representing preference relations ≿ if, for every
pair of alternatives 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋,
𝑥𝑥 ≿ 𝑦𝑦 ⟺ 𝑢𝑢(𝑥𝑥) ≥ 𝑢𝑢(𝑦𝑦)

Advanced Microeconomic Theory 30

 Utility Function
• Two points:
1) Only the ranking of alternatives matters.
– That is, it does not matter if
𝑢𝑢 𝑥𝑥 = 14 or if 𝑢𝑢 𝑥𝑥 = 2000
𝑢𝑢 𝑦𝑦 = 10 or if 𝑢𝑢 𝑦𝑦 = 3

– We do not care about cardinality (the number

that the utility function associates with each
alternative) but instead care about ordinality
(ranking of utility values among alternatives).

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 Utility Function
2) If we apply any strictly increasing function 𝑓𝑓(�)
on 𝑢𝑢 𝑥𝑥 , i.e.,
𝑓𝑓: ℝ → ℝ such that 𝑣𝑣 𝑥𝑥 = 𝑓𝑓(𝑢𝑢 𝑥𝑥 )
the new function keeps the ranking of
alternatives intact and, therefore, the new
function still represents the same preference
relation.
– Example:
𝑣𝑣 𝑥𝑥 = 3𝑢𝑢(𝑥𝑥)
𝑣𝑣 𝑥𝑥 = 5𝑢𝑢 𝑥𝑥 + 8
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Desirability

Advanced Microeconomic Theory 33

 Desirability
• We can express desirability in different ways.
– Monotonicity
– Strong monotonicity
– Non-satiation
– Local non-satiation
• In all the above definitions, consider that 𝑥𝑥 is an 𝑛𝑛-
dimensional bundle
𝑥𝑥 ∈ ℝ𝑛𝑛 , i.e., 𝑥𝑥 = 𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑁𝑁
where its 𝑘𝑘 𝑡𝑡𝑡 component represents the amount of
good (or service) 𝑘𝑘, 𝑥𝑥𝑘𝑘 ∈ ℝ+ .
Advanced Microeconomic Theory 34
 Desirability
• Monotonicity:
– A preference relation satisfies monotonicity if, for
all 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋, where 𝑥𝑥 ≠ 𝑦𝑦,
a) 𝑥𝑥𝑘𝑘 ≥ 𝑦𝑦𝑘𝑘 for every good 𝑘𝑘 implies 𝑥𝑥 ≿ 𝑦𝑦
b) 𝑥𝑥𝑘𝑘 > 𝑦𝑦𝑘𝑘 for every good 𝑘𝑘 implies 𝑥𝑥 ≻ 𝑦𝑦
– That is,
 increasing the amounts of some commodities (without
reducing the amount of any other commodity) cannot
hurt, 𝑥𝑥 ≿ 𝑦𝑦 ; and
 increasing the amounts of all commodities is strictly
preferred, 𝑥𝑥 ≻ 𝑦𝑦.
Advanced Microeconomic Theory 35
 Desirability
• Strong Monotonicity:
– A preference relation satisfies strong monotonicity
if, for all 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋, where 𝑥𝑥 ≠ 𝑦𝑦,
𝑥𝑥𝑘𝑘 ≥ 𝑦𝑦𝑘𝑘 for every good 𝑘𝑘 implies 𝑥𝑥 ≻ 𝑦𝑦
and 𝑥𝑥𝑙𝑙 ≥ 𝑦𝑦𝑙𝑙 for at least one good 𝑙𝑙
– That is, even if we increase the amounts of only
one of the commodities, we make the consumer
strictly better off.

Advanced Microeconomic Theory 36

 Desirability
• Relationship between monotonicity and utility
function:
– Monotonicity in preferences implies that the
utility function is weakly monotonic (weakly
increasing) in its arguments
 That is, increasing some of its arguments weakly
increases the value of the utility function, and
increasing all its arguments strictly increases its value.

– For any scalar 𝛼𝛼 > 1,

𝑢𝑢(𝛼𝛼𝑥𝑥1 , 𝑥𝑥2 ) ≥ 𝑢𝑢(𝑥𝑥1 , 𝑥𝑥2 )
𝑢𝑢 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 > 𝑢𝑢(𝑥𝑥1 , 𝑥𝑥2 )
Advanced Microeconomic Theory 37
 Desirability
• Relationship between strong monotonicity and
utility function:
– Strong monotonicity in preferences implies that
the utility function is strictly monotonic (strictly
increasing) in all its arguments.
 That is, increasing some of its arguments strictly
increases the value of the utility function.

– For any scalar 𝛼𝛼 > 1,

𝑢𝑢 𝛼𝛼𝑥𝑥1 , 𝑥𝑥2 > 𝑢𝑢(𝑥𝑥1 , 𝑥𝑥2 )

Advanced Microeconomic Theory 38

 Desirability
• Example 1.5: 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = min{𝑥𝑥1 , 𝑥𝑥2 }
– Monotone, since
min 𝑥𝑥1 + 𝛿𝛿, 𝑥𝑥2 + 𝛿𝛿 > min{𝑥𝑥1 , 𝑥𝑥2 }
for all 𝛿𝛿 > 0.
– Not strongly monotone, since
min 𝑥𝑥1 + 𝛿𝛿, 𝑥𝑥2 ≯ min{𝑥𝑥1 , 𝑥𝑥2 }
if min 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥2 .

Advanced Microeconomic Theory 39

 Desirability
• Example 1.6: 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 + 𝑥𝑥2
– Monotone, since
(𝑥𝑥1 + 𝛿𝛿) + (𝑥𝑥2 + 𝛿𝛿) > 𝑥𝑥1 + 𝑥𝑥2
for all 𝛿𝛿 > 0.
– Strongly monotone, since
(𝑥𝑥1 + 𝛿𝛿) + 𝑥𝑥2 > 𝑥𝑥1 + 𝑥𝑥2
• Hence, strong monotonicity implies monotonicity,
but the converse is not necessarily true.

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 Desirability
• Non-satiation (NS):
– A preference relation satisfies NS if, for every 𝑥𝑥 ∈
𝑋𝑋, there is another bundle in set 𝑋𝑋, 𝑦𝑦 ∈ 𝑋𝑋, which
is strictly preferred to 𝑥𝑥, i.e., 𝑦𝑦 ≻ 𝑥𝑥.
 NS is too general, since we could think about a bundle
𝑦𝑦 containing extremely larger amounts of some goods
than 𝑥𝑥.
 How far away are 𝑦𝑦 and 𝑥𝑥?

Advanced Microeconomic Theory 41

 Desirability
• Local non-satiation (LNS):
– A preference relation satisfies LNS if, for every
bundle 𝑥𝑥 ∈ 𝑋𝑋 and every 𝜀𝜀 > 0, there is another
bundle 𝑦𝑦 ∈ 𝑋𝑋 which is less than 𝜀𝜀-away from 𝑥𝑥,
𝑦𝑦 − 𝑥𝑥 < 𝜀𝜀, and for which 𝑦𝑦 ≻ 𝑥𝑥.
 𝑦𝑦 − 𝑥𝑥 = 𝑦𝑦1 − 𝑥𝑥1 2 + 𝑦𝑦2 − 𝑥𝑥2 2 is the Euclidean
distance between 𝑥𝑥 and 𝑦𝑦, where 𝑥𝑥, 𝑦𝑦 ∈ ℝ2+ .
 In words, for every bundle 𝑥𝑥, and for every distance 𝜀𝜀
from 𝑥𝑥, we can find a more preferred bundle 𝑦𝑦.

Advanced Microeconomic Theory 42

 Desirability
– A preference relation
satisfies 𝑦𝑦 ≻ 𝑥𝑥 even if x2

}
ε -ball
bundle 𝑦𝑦 contains less
of good 2 (but more of ε
good 1) than bundle 𝑥𝑥. x2 x
y2 y

Distance between x and y

x1 y1 x1

Advanced Microeconomic Theory 43

 Desirability
– A preference relation
satisfies 𝑦𝑦 ≻ 𝑥𝑥 even if
bundle 𝑦𝑦 contains less
of both goods than
bundle 𝑥𝑥.

Advanced Microeconomic Theory 44

 Desirability
• Violation of LNS
– LNS rules out the case
in which the decision-
maker regards all
goods as bads.
– Although 𝑦𝑦 ≻ 𝑥𝑥, 𝑦𝑦 is
unfeasible given that it
lies away from the
consumption set, i.e.,
𝑦𝑦 ∉ ℝ2+ .

Advanced Microeconomic Theory 45

 Desirability
• Violation of LNS x2

– LNS also rules out y − x < ε , but y~x

“thick” indifference
sets. ε y
x

{
– Bundles 𝑦𝑦 and 𝑥𝑥 lie on
the same indifference
curve.
– Hence, decision maker Thick indifference curve
is indifferent between x1
𝑥𝑥 and 𝑦𝑦, i.e., 𝑦𝑦 ∼ 𝑥𝑥.
Advanced Microeconomic Theory 46
 Desirability
• Note:
– If a preference relation satisfies monotonicity, it
must also satisfy LNS.
 Given a bundle 𝑥𝑥 = (𝑥𝑥1 , 𝑥𝑥2 ), increasing all of its
components yields a bundle (𝑥𝑥1 + 𝛿𝛿, 𝑥𝑥2 + 𝛿𝛿),
which is strictly preferred to bundle (𝑥𝑥1 , 𝑥𝑥2 ) by
monotonicity.
 Hence, there is a bundle 𝑦𝑦 = (𝑥𝑥1 + 𝛿𝛿, 𝑥𝑥2 + 𝛿𝛿) such
that 𝑦𝑦 ≻ 𝑥𝑥 and 𝑦𝑦 − 𝑥𝑥 < 𝜀𝜀.

Advanced Microeconomic Theory 47

Indifference sets

Advanced Microeconomic Theory 48

 Indifference sets
• The indifference set of a bundle 𝑥𝑥 ∈ 𝑋𝑋 is the set
of all bundles 𝑦𝑦 ∈ 𝑋𝑋, such that 𝑦𝑦 ∼ 𝑥𝑥.
𝐼𝐼𝐼𝐼𝐼𝐼 𝑥𝑥 = {𝑦𝑦 ∈ 𝑋𝑋: 𝑦𝑦 ∼ 𝑥𝑥}
• The upper-contour set of bundle 𝑥𝑥 is the set of all
bundles 𝑦𝑦 ∈ 𝑋𝑋, such that 𝑦𝑦 ≿ 𝑥𝑥.
𝑈𝑈𝑈𝑈𝑈𝑈 𝑥𝑥 = {𝑦𝑦 ∈ 𝑋𝑋: 𝑦𝑦 ≿ 𝑥𝑥}
• The lower-contour set of bundle 𝑥𝑥 is the set of all
bundles 𝑦𝑦 ∈ 𝑋𝑋, such that 𝑥𝑥 ≿ 𝑦𝑦.
𝐿𝐿𝐶𝐶𝐶𝐶 𝑥𝑥 = {𝑦𝑦 ∈ 𝑋𝑋: 𝑥𝑥 ≿ 𝑦𝑦}
Advanced Microeconomic Theory 49
 Indifference sets
• Therefore, 𝐼𝐼𝐼𝐼𝐼𝐼 𝑥𝑥 is the intersection of
𝑈𝑈𝑈𝑈𝑈𝑈 𝑥𝑥 and 𝐿𝐿𝐿𝐿𝐿𝐿 𝑥𝑥 , that is,
𝐼𝐼𝐼𝐼𝐼𝐼 𝑥𝑥 = 𝑈𝑈𝑈𝑈𝑈𝑈 𝑥𝑥 ∩ 𝐿𝐿𝐿𝐿𝐿𝐿 𝑥𝑥 .

LCS(x) IND(x) UCS(x)

Advanced Microeconomic Theory 50

 Indifference sets
x2
Upper contour set (UCS)
{y ∈ ℝ +2: y ≿ x}

Indifference set
{y ∈ ℝ +2: y ~ x}

Lower contour set (LCS)

{y ∈ ℝ +2: y ≾ x}

x1
Advanced Microeconomic Theory 51
 Indifference sets
• Strong monotonicity implies that indifference
curves must be negatively sloped.
x2

Region A y >> x

x
z << x Region B

Advanced Microeconomic Theory x1 52

 Indifference sets
• Note:
– Strong monotonicity implies that indifference
curves must be negatively sloped.
– In contrast, if an individual preference relation
satisfies LNS, indifference curves can be upward
sloping.
• This can happen if, for instance, the individual regards
good 2 as desirable but good 1 as a bad.

Advanced Microeconomic Theory 53

Convexity of Preferences

Advanced Microeconomic Theory 54

 Convexity of Preferences
• Convexity 1: A preference relation satisfies
convexity if, for all 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋,
𝑥𝑥 ≿ 𝑦𝑦 ⟹ 𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑦𝑦 ≿ 𝑦𝑦
for all 𝛼𝛼 ∈ (0,1).

Advanced Microeconomic Theory 55

 Convexity of Preferences
• Convexity 1

Advanced Microeconomic Theory 56

 Convexity of Preferences
• Convexity 2: A preference relation satisfies
convexity if, for every bundle 𝑥𝑥, its upper contour
set is convex.
𝑈𝑈𝑈𝑈𝑈𝑈 𝑥𝑥 = {𝑦𝑦 ∈ 𝑋𝑋: 𝑦𝑦 ≿ 𝑥𝑥} is convex
• That is, for every two bundles 𝑦𝑦 and 𝑧𝑧,
𝑦𝑦 ≿ 𝑥𝑥
� ⟹ 𝜆𝜆𝑦𝑦 + 1 − 𝜆𝜆 𝑧𝑧 ≿ 𝑥𝑥
𝑧𝑧 ≿ 𝑥𝑥
for any 𝜆𝜆 ∈ 0,1 .
• Hence, points 𝑦𝑦, 𝑧𝑧, and their convex combination
belong to the UCS of 𝑥𝑥.
Advanced Microeconomic Theory 57
 Convexity of Preferences
• Convexity 2

Advanced Microeconomic Theory 58

 Convexity of Preferences
• Strict convexity: A preference relation satisfies
strict convexity if, for every 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋 where 𝑥𝑥 ≠ 𝑦𝑦,

𝑥𝑥 ≿ 𝑧𝑧
� ⟹ 𝜆𝜆𝑥𝑥 + 1 − 𝜆𝜆 𝑦𝑦 ≻ 𝑧𝑧
𝑦𝑦 ≿ 𝑧𝑧

for all 𝜆𝜆 ∈ 0,1 .

Advanced Microeconomic Theory 59

 Convexity of Preferences
• Strictly convex preferences
x2
x
x λx + (1−λ)y ≻z

UCS
z
y
y

x1
Advanced Microeconomic Theory 60
 Convexity of Preferences
• Convex but not strict convex preferences
– 𝜆𝜆𝑥𝑥 + 1 − 𝜆𝜆 𝑦𝑦~𝑧𝑧
– This type of preference
relation is represented
by linear utility
functions such as
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑎𝑎𝑥𝑥1 + 𝑏𝑏𝑥𝑥2
where 𝑥𝑥1 and 𝑥𝑥2 are
regarded as substitutes.

Advanced Microeconomic Theory 61

 Convexity of Preferences
• Convex but not strict convex preferences
– Other example: If a
preference relation is
represented by utility
functions such as
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = min{𝑎𝑎𝑥𝑥1 , 𝑏𝑏𝑥𝑥2 }
where 𝑎𝑎, 𝑏𝑏 > 0, then
the pref. relation
satisfies convexity, but
not strict convexity.
Advanced Microeconomic Theory 62
 Convexity of Preferences
• Example 1.7

𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 Satisfies convexity Satisfies strict convexity

𝑎𝑎𝑥𝑥1 + 𝑏𝑏𝑥𝑥2 √ X
min{𝑎𝑎𝑥𝑥1 , 𝑏𝑏𝑥𝑥2 } √ X
1 1
√ √
𝑎𝑎𝑥𝑥12 × 𝑏𝑏𝑥𝑥22
𝑎𝑎𝑥𝑥12 × 𝑏𝑏𝑥𝑥22 √ √
1 1
√ √
𝑎𝑎𝑥𝑥12 + 𝑏𝑏𝑥𝑥22
𝑎𝑎𝑥𝑥12 + 𝑏𝑏𝑥𝑥22 X X
Advanced Microeconomic Theory 63
 Convexity of Preferences
• Interpretation of convexity
1) Taste for
diversification:
– An individual with
convex preferences
prefers the convex
combination of
bundles 𝑥𝑥 and 𝑦𝑦,
than either of those
bundles alone.
Advanced Microeconomic Theory 64
 Convexity of Preferences
• Interpretation of convexity
2) Diminishing marginal rate of substitution:
𝜕𝜕𝜕𝜕/𝜕𝜕𝑥𝑥1
𝑀𝑀𝑀𝑀𝑀𝑀1,2 ≡
𝜕𝜕𝜕𝜕/𝜕𝜕𝑥𝑥2
– MRS describes the additional amount of good 1
that the consumer needs to receive in order to
keep her utility level unaffected, when the amount
of good 2 is reduced by one unit.
– Hence, a diminishing MRS implies that the
consumer needs to receive increasingly larger
amounts of good 1 in order to accept further
reductions of good 2.
Advanced Microeconomic Theory 65
 Convexity of Preferences
• Diminishing marginal rate of substitution
x2
A

1 unit = ∇x2
B

1 unit = ∇x2
D

∇x1 ∇∇x1 x1

Advanced Microeconomic Theory 66

 Convexity of Preferences
• Remark:
– Let us show that the slope of the indifference
curve is given by the MRS.
– Consider a continuous and differentiable utility
function 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 .
– Totally differentiating, we obtain
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑 = 𝑑𝑑𝑥𝑥1 + 𝑑𝑑𝑥𝑥2 + ⋯+ 𝑑𝑑𝑥𝑥𝑛𝑛
𝜕𝜕𝑥𝑥1 𝜕𝜕𝑥𝑥2 𝜕𝜕𝑥𝑥𝑛𝑛

– But since we move along the same indifference

curve, 𝑑𝑑𝑑𝑑 = 0.
Advanced Microeconomic Theory 67
 Convexity of Preferences
– Inserting 𝑑𝑑𝑑𝑑 = 0,
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
0= 𝑑𝑑𝑥𝑥𝑖𝑖 + 𝑑𝑑𝑥𝑥𝑗𝑗
𝜕𝜕𝑥𝑥𝑖𝑖 𝜕𝜕𝑥𝑥𝑗𝑗
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
or − 𝑑𝑑𝑥𝑥𝑖𝑖 = 𝑑𝑑𝑥𝑥𝑗𝑗
𝜕𝜕𝑥𝑥𝑖𝑖 𝜕𝜕𝑥𝑥𝑗𝑗
– If we want to analyze the rate at which the
consumer substitutes units of good 𝑖𝑖 for good 𝑗𝑗,
𝑑𝑑𝑥𝑥𝑗𝑗
we must solve for , to obtain
𝑑𝑑𝑥𝑥𝑖𝑖
𝜕𝜕𝜕𝜕
𝑑𝑑𝑥𝑥𝑗𝑗 𝜕𝜕𝑥𝑥𝑖𝑖
− = 𝜕𝜕𝜕𝜕 ≡ 𝑀𝑀𝑀𝑀𝑀𝑀𝑖𝑖,𝑗𝑗
𝑑𝑑𝑥𝑥𝑖𝑖
𝜕𝜕𝑥𝑥𝑗𝑗
Advanced Microeconomic Theory 68
Quasiconcavity

Advanced Microeconomic Theory 69

 Quasiconcavity
• A utility function 𝑢𝑢(�) is quasiconcave if, for every
bundle 𝑥𝑥 ∈ 𝑋𝑋, the set of all bundles for which the
consumer experiences a higher utility, i.e., the
𝑈𝑈𝑈𝑈𝑈𝑈 𝑥𝑥 = 𝑦𝑦 ∈ 𝑋𝑋 𝑢𝑢(𝑦𝑦) ≥ 𝑢𝑢(𝑥𝑥)} is convex.
• The following three properties are equivalent:

Convexity of preferences ⟺ 𝑈𝑈𝑈𝑈𝑈𝑈 𝑥𝑥 is convex ⟺ 𝑢𝑢 � is quasiconcave

Advanced Microeconomic Theory 70

 Quasiconcavity
• Alternative definition of quasiconcavity:
– A utility function 𝑢𝑢(�) satisfies quasiconcavity if,
for every two bundles 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋, the utility of
consuming the convex combination of these two
bundles, 𝑢𝑢(𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑦𝑦), is weakly higher than
the minimal utility from consuming each bundle
separately, min 𝑢𝑢 𝑥𝑥 , 𝑢𝑢 𝑦𝑦 :
𝑢𝑢(𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑦𝑦) ≥ min 𝑢𝑢 𝑥𝑥 , 𝑢𝑢 𝑦𝑦

Advanced Microeconomic Theory 71

 Quasiconcavity
• Quasiconcavity (second definition)

Advanced Microeconomic Theory 72

 Quasiconcavity
• Strict quasiconcavity:
– A utility function 𝑢𝑢(�) satisfies strict
quasiconcavity if, for every two bundles 𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋,
the utility of consuming the convex combination
of these two bundles, 𝑢𝑢(𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑦𝑦), is
strictly higher than the minimal utility from
consuming each bundle separately,
min 𝑢𝑢 𝑥𝑥 , 𝑢𝑢 𝑦𝑦 :
𝑢𝑢 𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑦𝑦 > min 𝑢𝑢 𝑥𝑥 , 𝑢𝑢 𝑦𝑦

Advanced Microeconomic Theory 73

 Quasiconcavity
• What if bundles 𝑥𝑥 and
𝑦𝑦 lie on the same x2
indifference curve?
• Then, 𝑢𝑢 𝑥𝑥 = 𝑢𝑢(𝑦𝑦). x
α x + (1 − α ) y
• Since indifference curves
are strictly convex, 𝑢𝑢(�) u (α x + (1 − α ) y )
satisfies quasiconcavity. y u ( x) = u ( y)

x1

Advanced Microeconomic Theory 74

 Quasiconcavity
• What if indifference
curves are linear?
• 𝑢𝑢(�) satisfies the
definition of a
quasiconcavity since
𝑢𝑢 𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑦𝑦
= min 𝑢𝑢 𝑥𝑥 , 𝑢𝑢 𝑦𝑦

• But 𝑢𝑢(�) does not satisfy

strict quasiconcavity.

Advanced Microeconomic Theory 75

 Quasiconcavity
• Relationship between concavity and
quasiconcavity:
⟹
Concavity Quasiconcavity
⇍
– If a function 𝑓𝑓(�) is concave, then for any two points
𝑥𝑥, 𝑦𝑦 ∈ 𝑋𝑋,
𝑓𝑓 𝛼𝛼𝛼𝛼 + 1 − 𝛼𝛼 𝑦𝑦 ≥ 𝛼𝛼𝛼𝛼 𝑥𝑥 + 1 − 𝛼𝛼 𝑓𝑓 𝑦𝑦
≥ min 𝑓𝑓 𝑥𝑥 , 𝑓𝑓 𝑦𝑦
for all 𝛼𝛼 ∈ 0,1 .
 The first inequality follows from the definition of concavity,
while the second holds true for all concave functions.
 Hence, quasiconcavity is a weaker condition than concavity.
Advanced Microeconomic Theory 76
 Quasiconcavity
• Concavity implies quasiconcavity

Advanced Microeconomic Theory 77

 Quasiconcavity
• A concave 𝑢𝑢 � exhibits diminishing marginal
utility.
– That is, for an increase in the consumption bundle,
the increase in utility is smaller as we move away from
the origin.
• The “jump” from one indifference curve to
another requires:
– a slight increase in the amount of 𝑥𝑥1 and 𝑥𝑥2 when we
are close to the origin
– a large increase in the amount of 𝑥𝑥1 and 𝑥𝑥2 as we get
further away from the origin

Advanced Microeconomic Theory 78

 Quasiconcavity
• Concave and quasiconcave utility function (3D)
1 1
u ( x1 , x2 ) = x x
4 4
1 2

u
x1
x2

Advanced Microeconomic Theory 79

 Quasiconcavity
• Concave and quasiconcave utility function (2D)

UCS ( x )
x

Advanced Microeconomic Theory 80

 Quasiconcavity
• A convex 𝑢𝑢 � exhibits increasing marginal utility.
– That is, for an increase in the consumption bundle,
the increase in utility is larger as we move away from
the origin.
• The “jump” from one indifference curve to
another requires:
– a large increase in the amount of 𝑥𝑥1 and 𝑥𝑥2 when we
are close to the origin, but…
– a small increase in the amount of 𝑥𝑥1 and 𝑥𝑥2 as we get
further away from the origin

Advanced Microeconomic Theory 81

 Quasiconcavity
• Convex but quasiconcave utility function (3D)

6 6
v ( x1 , x2 ) = x x
4 4
1 2

x1
x2
Advanced Microeconomic Theory 82
 Quasiconcavity
• Convex but quasiconcave utility function (2D)

x UCS ( x )

Advanced Microeconomic Theory 83

 Quasiconcavity
• Note:
6 6
– Utility function 𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 𝑥𝑥2 is a strictly
4 4
1 1
monotonic transformation of 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 𝑥𝑥2 , 4 4

• That is, 𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2 = 𝑓𝑓(𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 ), where 𝑓𝑓 𝑢𝑢 = 𝑢𝑢6 .

– Therefore, utility functions 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 and 𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2

represent the same preference relation.
– Both utility functions are quasiconcave although one
of them is concave and the other is convex.
– Hence, we normally require utility functions to satisfy
quasiconcavity alone.
Advanced Microeconomic Theory 84
 Quasiconcavity
• Example 1.8 (Testing properties of preference
relations):
– Consider an individual decision maker who consumes
bundles in ℝ𝐿𝐿+ .
– Informally, he “prefers more of everything”
– Formally, for two bundles 𝑥𝑥, 𝑦𝑦 ∈ ℝ𝐿𝐿+ , bundle 𝑥𝑥 is
weakly preferred to bundle 𝑦𝑦, 𝑥𝑥 ≿ 𝑦𝑦, iff bundle 𝑥𝑥
contains more units of every good than bundle 𝑦𝑦
does, i.e., 𝑥𝑥𝑘𝑘 ≥ 𝑦𝑦𝑘𝑘 for every good 𝑘𝑘.
– Let us check if this preference relation satisfies: (a)
completeness, (b) transitivity, (c) strong monotonicity,
(d) strict convexity, and (e) local non-satiation.
Advanced Microeconomic Theory 85
 Quasiconcavity
• Example 1.8 (continued):
– Let us consider the case of only two goods, 𝐿𝐿 = 2.
– Then, an individual prefers a bundle 𝑥𝑥 = (𝑥𝑥1 , 𝑥𝑥2 )
to another bundle 𝑦𝑦 = (𝑦𝑦1 , 𝑦𝑦2 ) iff 𝑥𝑥 contains more
units of both goods than bundle 𝑦𝑦, i.e., 𝑥𝑥1 ≥ 𝑦𝑦1
and 𝑥𝑥2 ≥ 𝑦𝑦2 .
– For illustration purposes, let us take bundle such
as (2,1).

Advanced Microeconomic Theory 86

 Quasiconcavity
• Example 1.8 (continued):

Advanced Microeconomic Theory 87

 Quasiconcavity
• Example 1.8 (continued):
1) UCS:
– The upper contour set of bundle (2,1) contains
bundles (𝑥𝑥1 , 𝑥𝑥2 ) with weakly more than 2 units
of good 1 and/or weakly more than 1 unit of
good 2:
𝑈𝑈𝑈𝑈𝑈𝑈 2,1 = {(𝑥𝑥1 , 𝑥𝑥2 ) ≿ (2,1) ⟺ 𝑥𝑥1 ≥ 2, 𝑥𝑥2 ≥ 1}

– The frontiers of the UCS region also represent

bundles preferred to (2,1).
Advanced Microeconomic Theory 88
 Quasiconcavity
• Example 1.8 (continued):
2) LCS:
– The bundles in the lower contour set of bundle
(2,1) contain fewer units of both goods:
𝐿𝐿𝐶𝐶𝐶𝐶 2,1 = {(2,1) ≿ (𝑥𝑥1 , 𝑥𝑥2 ) ⟺ 𝑥𝑥1 ≤ 2, 𝑥𝑥2 ≤ 1}

– The frontiers of the LCS region also represent

bundles with fewer unis of either good 1 or
good 2.

Advanced Microeconomic Theory 89

 Quasiconcavity
• Example 1.8 (continued):
3) IND:
– The indifference set comprising bundles (𝑥𝑥1 , 𝑥𝑥2 )
for which the consumer is indifferent between
(𝑥𝑥1 , 𝑥𝑥2 ) and (2,1) is a singleton (itself):
𝐼𝐼𝐼𝐼𝐼𝐼 2,1 = 2,1 ∼ 𝑥𝑥1 , 𝑥𝑥2 = { 2,1 }
– There is no other bundle making the consumer
indifferent between (2,1) and such a bundle.
– There is no region for which the UCS and LCS
overlap. These sets only “touch” at bundle (2,1).

Advanced Microeconomic Theory 90

 Quasiconcavity
• Example 1.8 (continued):
4) Regions A and B:
– Region 𝐴𝐴 contains bundles with more units of
good 2 but fewer units of good 1 (the opposite
argument applies to region 𝐵𝐵).
– The consumer cannot compare bundles in
either of these regions against bundle 2,1 .
– For him to be able to rank one bundle against
another, one of the bundles must contain the
same or more units of all goods.
Advanced Microeconomic Theory 91
 Quasiconcavity
• Example 1.8 (continued):
5) Preference relation is not complete:
– Completeness requires for every pair 𝑥𝑥 and 𝑦𝑦,
either 𝑥𝑥 ≿ 𝑦𝑦 or 𝑦𝑦 ≿ 𝑥𝑥 (or both).
– Consider two bundles 𝑥𝑥, 𝑦𝑦 ∈ ℝ2+ with bundle 𝑥𝑥
containing more units of good 1 than bundle 𝑦𝑦
but fewer units of good 2, i.e., 𝑥𝑥1 > 𝑦𝑦1 and
𝑥𝑥2 < 𝑦𝑦2 (as in Region B)
– Then, we have neither 𝑥𝑥 ≿ 𝑦𝑦 (UCS) nor 𝑦𝑦 ≿ 𝑥𝑥
(LCS).

Advanced Microeconomic Theory 92

 Quasiconcavity
• Example 1.8 (continued):
6) Preference relation is transitive:
– Transitivity requires that, for any three bundles
𝑥𝑥, 𝑦𝑦 and 𝑧𝑧, if 𝑥𝑥 ≿ 𝑦𝑦 and 𝑦𝑦 ≿ 𝑧𝑧 then 𝑥𝑥 ≿ 𝑧𝑧.
– Now 𝑥𝑥 ≿ 𝑦𝑦 and 𝑦𝑦 ≿ 𝑧𝑧 means 𝑥𝑥𝑘𝑘 ≥ 𝑦𝑦𝑘𝑘 and
𝑦𝑦𝑘𝑘 ≥ 𝑧𝑧𝑘𝑘 for all 𝑘𝑘 goods.
– Then, 𝑥𝑥𝑘𝑘 ≥ 𝑧𝑧𝑘𝑘 implies 𝑥𝑥 ≿ 𝑧𝑧.

Advanced Microeconomic Theory 93

 Quasiconcavity
• Example 1.8 (continued):
7) Preference relation is strongly monotone:
– Strong monotonicity requires that if we
increase one of the goods in a given bundle 𝑦𝑦,
then the newly created bundle 𝑥𝑥 must be
strictly preferred to the original bundle.
– Now 𝑥𝑥 ≥ 𝑦𝑦 and 𝑥𝑥 ≠ 𝑦𝑦 implies that 𝑥𝑥𝑙𝑙 ≥ 𝑦𝑦𝑙𝑙 for
all good 𝑙𝑙 and 𝑥𝑥𝑘𝑘 > 𝑦𝑦𝑘𝑘 for at least one good 𝑘𝑘.
– Thus, 𝑥𝑥 ≥ 𝑦𝑦 and 𝑥𝑥 ≠ 𝑦𝑦 implies 𝑥𝑥 ≿ 𝑦𝑦 and not
𝑦𝑦 ≿ 𝑥𝑥.
– Thus, we can conclude that 𝑥𝑥 ≻ 𝑦𝑦.
Advanced Microeconomic Theory 94
 Quasiconcavity
• Example 1.8 (continued):
8) Preference relation is strictly convex:
– Strict convexity requires that if 𝑥𝑥 ≿ 𝑧𝑧 and 𝑦𝑦 ≿ 𝑧𝑧
and 𝑥𝑥 ≠ 𝑦𝑦, then 𝛼𝛼𝛼𝛼 + 1 − 𝛼𝛼 𝑦𝑦 ≻ 𝑧𝑧 for all 𝛼𝛼 ∈
0,1 .
– Now 𝑥𝑥 ≿ 𝑧𝑧 and 𝑦𝑦 ≿ 𝑧𝑧 implies that 𝑥𝑥𝑙𝑙 ≥ 𝑦𝑦𝑙𝑙 and
𝑦𝑦𝑙𝑙 ≥ 𝑧𝑧𝑙𝑙 for all good 𝑙𝑙.
– 𝑥𝑥 ≠ 𝑧𝑧 implies, for some good 𝑘𝑘, we must have
𝑥𝑥𝑘𝑘 > 𝑧𝑧𝑘𝑘 .
Advanced Microeconomic Theory 95
 Quasiconcavity
• Example 1.8 (continued):
– Hence, for any 𝛼𝛼 ∈ 0,1 , we must have that
𝛼𝛼𝑥𝑥𝑙𝑙 + 1 − 𝛼𝛼 𝑦𝑦𝑙𝑙 ≥ 𝑧𝑧𝑙𝑙 for every good 𝑙𝑙
𝛼𝛼𝑥𝑥𝑘𝑘 + 1 − 𝛼𝛼 𝑦𝑦𝑘𝑘 > 𝑧𝑧𝑘𝑘 for some 𝑘𝑘
– Thus, we have that 𝛼𝛼𝛼𝛼 + 1 − 𝛼𝛼 𝑦𝑦 ≥ 𝑧𝑧 and
𝛼𝛼𝛼𝛼 + 1 − 𝛼𝛼 𝑦𝑦 ≠ 𝑧𝑧, and so
𝛼𝛼𝛼𝛼 + 1 − 𝛼𝛼 𝑦𝑦 ≿ 𝑧𝑧
and not 𝑧𝑧 ≿ 𝛼𝛼𝛼𝛼 + 1 − 𝛼𝛼 𝑦𝑦
– Therefore, 𝛼𝛼𝛼𝛼 + 1 − 𝛼𝛼 𝑦𝑦 ≻ 𝑧𝑧.
Advanced Microeconomic Theory 96
 Quasiconcavity
• Example 1.8 (continued):
9) Preference relation satisfies LNS:
– Take any bundle (𝑥𝑥1 , 𝑥𝑥2 ) and a scalar 𝜀𝜀 > 0.

– Let us define a new bundle (𝑦𝑦1 , 𝑦𝑦2 ) where

𝜀𝜀 𝜀𝜀
𝑦𝑦1 , 𝑦𝑦2 ≡ 𝑥𝑥1 + , 𝑥𝑥 +
2 2 2
so that 𝑦𝑦1 > 𝑥𝑥1 and 𝑦𝑦2 > 𝑥𝑥2 .

– Hence, 𝑦𝑦 ≿ 𝑥𝑥 but not 𝑥𝑥 ≿ 𝑦𝑦, which implies 𝑦𝑦 ≻

𝑥𝑥.
Advanced Microeconomic Theory 97
 Quasiconcavity
• Example 1.8 (continued):
– Let us know check if bundle 𝑦𝑦 is within an 𝜀𝜀-ball
around 𝑥𝑥.
– The Cartesian distance between 𝑥𝑥 and 𝑦𝑦 is
𝜀𝜀 2 𝜀𝜀 2 𝜀𝜀
𝑥𝑥 − 𝑦𝑦 = 𝑥𝑥1 − 𝑥𝑥1 + + 𝑥𝑥2 − 𝑥𝑥2 + =
2 2 2

which is smaller than 𝜀𝜀 for all 𝜀𝜀 > 0.

Advanced Microeconomic Theory 98

Common Utility Functions

Advanced Microeconomic Theory 99

 Common Utility Functions
• Cobb-Douglas utility functions:
– In the case of two goods, 𝑥𝑥1 and 𝑥𝑥2 ,
𝛽𝛽
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝐴𝐴𝑥𝑥1𝛼𝛼 𝑥𝑥2
where 𝐴𝐴, 𝛼𝛼, 𝛽𝛽 > 0.
– Applying logs on both sides
log 𝑢𝑢 = log 𝐴𝐴 + 𝛼𝛼 log 𝑥𝑥1 + 𝛽𝛽 log 𝑥𝑥2
– Hence, the exponents in the original 𝑢𝑢(�) can be
interpreted as elasticities:
𝜕𝜕𝜕𝜕 𝑥𝑥1 ,𝑥𝑥2 𝑥𝑥1 𝛼𝛼−1 𝛽𝛽 𝑥𝑥1
𝜀𝜀𝑢𝑢,𝑥𝑥1 = � = 𝛼𝛼𝛼𝛼𝑥𝑥1 𝑥𝑥2 � 𝛽𝛽 = 𝛼𝛼
𝜕𝜕𝑥𝑥1 𝑢𝑢 𝑥𝑥1 ,𝑥𝑥2 𝐴𝐴𝑥𝑥1𝛼𝛼 𝑥𝑥2
Advanced Microeconomic Theory 100
 Common Utility Functions
– Intuitively, a one-percent increase in the amount
of good 𝑥𝑥1 increases individual utility by 𝛼𝛼
percent.
– Similarly, 𝜀𝜀𝑢𝑢,𝑥𝑥2 = 𝛽𝛽.

– Special cases:
 𝛼𝛼 + 𝛽𝛽 = 1: 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝐴𝐴𝑥𝑥1𝛼𝛼 𝑥𝑥21−𝛼𝛼
𝛼𝛼 𝛽𝛽
 𝐴𝐴 = 1: 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 𝑥𝑥2
 𝐴𝐴 = 𝛼𝛼 = 𝛽𝛽 = 1: 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 𝑥𝑥2

Advanced Microeconomic Theory 101

 Common Utility Functions
– Marginal utilities:
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
> 0 and >0
𝜕𝜕𝑥𝑥1 𝜕𝜕𝑥𝑥2
– Diminishing MRS, since
𝛼𝛼−1 𝛽𝛽
𝛼𝛼𝛼𝛼𝑥𝑥1 𝑥𝑥2 𝛼𝛼𝑥𝑥2
𝑀𝑀𝑀𝑀𝑆𝑆𝑥𝑥1 ,𝑥𝑥2 = 𝛽𝛽−1
=
𝛽𝛽𝛽𝛽𝑥𝑥1𝛼𝛼 𝑥𝑥2 𝛽𝛽𝑥𝑥1
which is decreasing in 𝑥𝑥1 .
 Hence, indifference curves become flatter as 𝑥𝑥1
increases.

Advanced Microeconomic Theory 102

 Common Utility Functions
• Cobb-Douglas preference
x2

A
∇∇
in x2
B

C
∇x2 D
IC

1 unit 1 unit
x1
Advanced Microeconomic Theory 103
 Common Utility Functions
• Perfect substitutes:
– In the case of two goods, 𝑥𝑥1 and 𝑥𝑥2 ,
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝐴𝐴𝑥𝑥1 + 𝐵𝐵𝑥𝑥2
where 𝐴𝐴, 𝐵𝐵 > 0.
– Hence, the marginal utility of every good is
constant:
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
= 𝐴𝐴 and = 𝐵𝐵
𝜕𝜕𝑥𝑥1 𝜕𝜕𝑥𝑥2
𝐴𝐴
– 𝑀𝑀𝑀𝑀𝑀𝑀 is also constant, i.e., 𝑀𝑀𝑀𝑀𝑀𝑀𝑥𝑥1 ,𝑥𝑥2 =
𝐵𝐵
 Therefore, indifference curves are straight lines with a
𝐴𝐴
slope of − . Advanced Microeconomic Theory
𝐵𝐵 104
 Common Utility Functions
• Perfect substitutes
x2
A
2A slope = −
B

B 2B x1
Advanced Microeconomic Theory 105
 Common Utility Functions
𝐴𝐴
– Intuitively, the individual is willing to give up
𝐵𝐵
units of 𝑥𝑥2 to obtain one more unit of 𝑥𝑥1 and keep
his utility level unaffected.
– Unlike in the Cobb-Douglas case, such willingness
is independent in the relative abundance of the
two goods.
– Examples: butter and margarine, coffee and black
tea, or two brands of unflavored mineral water

Advanced Microeconomic Theory 106

 Common Utility Functions
• Perfect Complements:
– In the case of two goods, 𝑥𝑥1 and 𝑥𝑥2 ,
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝐴𝐴 � min 𝛼𝛼𝑥𝑥1 , 𝛽𝛽𝑥𝑥2
where 𝐴𝐴, 𝛼𝛼, 𝛽𝛽 > 0.
– Intuitively, increasing one of the goods without
increasing the amount of the other good entails
no increase in utility.
 The amounts of both goods must increase for the utility
to go up.
– The indifference curve is right angle with a kink at
𝛼𝛼𝑥𝑥1 = 𝛽𝛽𝑥𝑥2 .
Advanced Microeconomic Theory 107
 Common Utility Functions
• Perfect complements
x2

α
x2 = x
β 1

α
2 u2 = 2aα
β

α
β u1 = aα

α
β
1 2 x1
Advanced Microeconomic Theory 108
 Common Utility Functions
𝛽𝛽 𝛽𝛽
– The slope of a ray 𝑥𝑥2 = 𝑥𝑥1 , , indicates the rate
𝛼𝛼 𝛼𝛼
at which goods 𝑥𝑥1 and 𝑥𝑥2 must be consumed in
order to achieve utility gains.
– Special case: 𝛼𝛼 = 𝛽𝛽
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝐴𝐴 � min 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2
= 𝐴𝐴𝐴𝐴 � min 𝑥𝑥1 , 𝑥𝑥2
= 𝐵𝐵 � min 𝑥𝑥1 , 𝑥𝑥2 if 𝐵𝐵 ≡ 𝐴𝐴𝐴𝐴
– Examples: cars and gasoline, or peanut butter and
jelly. Other food recipes, which often require the
use of ingredients in a fixed proportion, are good
examples as well.
Advanced Microeconomic Theory 109
 Common Utility Functions
• CES utility function:
– In the case of two goods, 𝑥𝑥1 and 𝑥𝑥2 ,
𝜎𝜎
𝜎𝜎−1 𝜎𝜎−1 𝜎𝜎−1
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑎𝑎𝑥𝑥1 + 𝑏𝑏𝑥𝑥2 𝜎𝜎 𝜎𝜎

where 𝜎𝜎 measures the elasticity of substitution

between goods 𝑥𝑥1 and 𝑥𝑥2 .
– In particular,
𝑥𝑥2
𝜕𝜕 𝑀𝑀𝑀𝑀𝑆𝑆1,2
𝑥𝑥1
𝜎𝜎 = � 𝑥𝑥2
𝜕𝜕𝜕𝜕𝜕𝜕𝑆𝑆1,2
𝑥𝑥1

Advanced Microeconomic Theory 110

 Common Utility Functions
• CES preferences
x2

σ = 0 Perfect complement

}
σ = 0.2
σ =1 Cobb-Douglas

σ=∞ σ =8
Perfect substitutes
x1
Advanced Microeconomic Theory 111
 Common Utility Functions
– CES utility function is often presented as
1
𝜌𝜌 𝜌𝜌
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑎𝑎𝑥𝑥1 + 𝑏𝑏𝑥𝑥2 𝜌𝜌
𝜎𝜎−1
where 𝜌𝜌 ≡ .
𝜎𝜎

Advanced Microeconomic Theory 112

 Common Utility Functions
• Quasilinear utility function:
– In the case of two goods, 𝑥𝑥1 and 𝑥𝑥2 ,
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑣𝑣 𝑥𝑥1 + 𝑏𝑏𝑥𝑥2
where 𝑥𝑥2 enters linearly, 𝑏𝑏 > 0, and 𝑣𝑣(𝑥𝑥1 ) is a
nonlinear function of 𝑥𝑥1 .
 For example, 𝑣𝑣 𝑥𝑥1 = 𝑎𝑎 ln 𝑥𝑥1 or 𝑣𝑣 𝑥𝑥1 = 𝑎𝑎𝑥𝑥1𝛼𝛼 , where
𝑎𝑎 > 0 and 𝛼𝛼 ≠ 1.

– The MRS is constant in the good that enters

linearly in the utility function (𝑥𝑥2 in our case).

Advanced Microeconomic Theory 113

 Common Utility Functions
• MRS of quasilinear preferences

Advanced Microeconomic Theory 114

 Common Utility Functions
– For 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑣𝑣 𝑥𝑥1 + 𝑏𝑏𝑥𝑥2 , the marginal utilities are
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 𝜕𝜕𝑣𝑣
= 𝑏𝑏 and =
𝜕𝜕𝑥𝑥2 𝜕𝜕𝑥𝑥1 𝜕𝜕𝑥𝑥1
which implies
𝜕𝜕𝜕𝜕
𝜕𝜕𝑥𝑥1
𝑀𝑀𝑀𝑀𝑀𝑀𝑥𝑥1 ,𝑥𝑥2 =
𝑏𝑏
which is constant in the good entering linearly, 𝑥𝑥2
– Quasilinear preferences are often used to represent
the consumption of goods that are relatively
insensitive to income.
– Examples: garlic, toothpaste, etc.
Advanced Microeconomic Theory 115
Properties of Preference
Relations

Advanced Microeconomic Theory 116

Properties of Preference Relations
• Homogeneity:
– A utility function is homogeneous of degree 𝑘𝑘 if
varying the amounts of all goods by a common
factor 𝛼𝛼 > 0 produces an increase in the utility
level by 𝛼𝛼 𝑘𝑘 .
– That is, for the case of two goods,
𝑢𝑢 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 = 𝛼𝛼 𝑘𝑘 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2
where 𝛼𝛼 > 0. This allows for:
 𝛼𝛼 > 1 in the case of a common increase
 0 < 𝛼𝛼 < 1 in the case of a common decrease

Advanced Microeconomic Theory 117

Properties of Preference Relations
– Three properties:
1) The first-order derivative of a function
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 which is homogeneous of degree 𝑘𝑘
is homogeneous of degree 𝑘𝑘 − 1.
 Given 𝑢𝑢 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 = 𝛼𝛼 𝑘𝑘 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 , we can show
that
𝜕𝜕𝜕𝜕 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 𝑘𝑘
𝜕𝜕𝜕𝜕 𝑥𝑥1 , 𝑥𝑥2
� 𝛼𝛼 = 𝛼𝛼 �
𝜕𝜕𝑥𝑥𝑖𝑖 𝜕𝜕𝑥𝑥𝑖𝑖
or re-arranging
𝑢𝑢′ 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 = 𝛼𝛼 𝑘𝑘−1 𝑢𝑢′ 𝑥𝑥1 , 𝑥𝑥2
Advanced Microeconomic Theory 118
Properties of Preference Relations
2) The indifference curves of homogeneous
functions are radial expansions of one
another.
 That is, if two bundles 𝑦𝑦 and 𝑧𝑧 lie on the same
indifference curve, i.e., 𝑢𝑢 𝑦𝑦 = 𝑢𝑢(𝑧𝑧), bundles 𝛼𝛼𝛼𝛼
and 𝛼𝛼𝛼𝛼 also lie on the same indifference curve,
i.e., 𝑢𝑢 𝛼𝛼𝛼𝛼 = 𝑢𝑢(𝛼𝛼𝛼𝛼).

Advanced Microeconomic Theory 119

Properties of Preference Relations
• Homogenous preference
x2

αy

αz u2
z
u1
x1
Advanced Microeconomic Theory 120
Properties of Preference Relations
3) The MRS of a homogeneous function is constant
for all points along each ray from the origin.
 That is, the slope of the indifference curve at point 𝑦𝑦
coincides with the slope at a “scaled-up version” of
point 𝑦𝑦, 𝛼𝛼𝛼𝛼, where 𝛼𝛼 > 1.
 The MRS at bundle 𝑥𝑥 = 𝑥𝑥1 , 𝑥𝑥2 is
𝜕𝜕𝜕𝜕(𝑥𝑥1 , 𝑥𝑥2 )
𝜕𝜕𝑥𝑥1
𝑀𝑀𝑀𝑀𝑆𝑆1,2 𝑥𝑥1 , 𝑥𝑥2 =
𝜕𝜕𝜕𝜕(𝑥𝑥1 , 𝑥𝑥2 )
𝜕𝜕𝑥𝑥2

Advanced Microeconomic Theory 121

Properties of Preference Relations
 The MRS at (𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 ) is
𝜕𝜕𝜕𝜕 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2
𝜕𝜕𝑥𝑥1
𝑀𝑀𝑀𝑀𝑆𝑆1,2 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 =
𝜕𝜕𝜕𝜕 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2
𝜕𝜕𝑥𝑥2
𝜕𝜕𝜕𝜕 𝑥𝑥1 , 𝑥𝑥2 𝜕𝜕𝜕𝜕(𝑥𝑥1 , 𝑥𝑥2 )
𝛼𝛼 𝑘𝑘−1
𝜕𝜕𝑥𝑥1 𝜕𝜕𝑥𝑥1
= =
𝜕𝜕𝜕𝜕 𝑥𝑥1 , 𝑥𝑥2 𝜕𝜕𝜕𝜕(𝑥𝑥1 , 𝑥𝑥2 )
𝛼𝛼 𝑘𝑘−1 𝜕𝜕𝑥𝑥2
𝜕𝜕𝑥𝑥2
where the second equality uses the first property.

 Hence, the MRS is unaffected along all the points

crossed by a ray from the origin.

Advanced Microeconomic Theory 122

Properties of Preference Relations
• Homotheticity:
– A utility function 𝑢𝑢(𝑥𝑥) is homothetic if it is a
monotonic transformation of a homogeneous
function.
– That is, 𝑢𝑢 𝑥𝑥 = 𝑔𝑔(𝑣𝑣 𝑥𝑥 ), where
• 𝑔𝑔: ℝ → ℝ is a strictly increasing function, and
• 𝑣𝑣: ℝ𝑛𝑛 → ℝ is homogeneous of degree 𝑘𝑘.

Advanced Microeconomic Theory 123

Properties of Preference Relations
• Properties:
– If 𝑢𝑢 𝑥𝑥 is homothetic, and two bundles 𝑦𝑦 and 𝑧𝑧 lie
on the same indifference curve, i.e., 𝑢𝑢 𝑦𝑦 = 𝑢𝑢(𝑧𝑧),
bundles 𝛼𝛼𝛼𝛼 and 𝛼𝛼𝛼𝛼 also lie on the same
indifference curve, i.e., 𝑢𝑢 𝛼𝛼𝛼𝛼 = 𝑢𝑢(𝛼𝛼𝛼𝛼) for all 𝛼𝛼 >
0.
 In particular,
𝑢𝑢 𝛼𝛼𝛼𝛼 = 𝑔𝑔(𝑣𝑣 𝛼𝛼𝛼𝛼 ) = 𝑔𝑔(𝛼𝛼 𝑘𝑘 𝑣𝑣 𝑦𝑦 )
𝑢𝑢 𝛼𝛼𝑧𝑧 = 𝑔𝑔(𝑣𝑣 𝛼𝛼𝑧𝑧 ) = 𝑔𝑔(𝛼𝛼 𝑘𝑘 𝑣𝑣 𝑧𝑧 )

Advanced Microeconomic Theory 124

Properties of Preference Relations
– The MRS of a homothetic function is homogeneous of
degree zero.
– In particular,
𝜕𝜕𝜕𝜕 𝛼𝛼𝑥𝑥1 ,𝛼𝛼𝑥𝑥2 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕(𝛼𝛼𝑥𝑥1 ,𝛼𝛼𝑥𝑥2 )
�
𝜕𝜕𝑥𝑥1 𝜕𝜕𝑣𝑣 𝜕𝜕𝑥𝑥1
𝑀𝑀𝑀𝑀𝑆𝑆1,2 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 = 𝜕𝜕𝜕𝜕 𝛼𝛼𝑥𝑥1 ,𝛼𝛼𝑥𝑥2 = 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕(𝛼𝛼𝑥𝑥1 ,𝛼𝛼𝑥𝑥2 )
�
𝜕𝜕𝑥𝑥2 𝜕𝜕𝑣𝑣 𝜕𝜕𝑥𝑥2
where 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 ≡ 𝑔𝑔(𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2 ).
𝜕𝜕𝜕𝜕
– Canceling the terms yields
𝜕𝜕𝑣𝑣
𝜕𝜕𝜕𝜕(𝛼𝛼𝑥𝑥1 ,𝛼𝛼𝑥𝑥2 ) 𝜕𝜕𝜕𝜕(𝑥𝑥1 ,𝑥𝑥2 )
𝛼𝛼 𝑘𝑘−1 �
𝜕𝜕𝑥𝑥1 𝜕𝜕𝑥𝑥1
𝜕𝜕𝜕𝜕(𝛼𝛼𝑥𝑥1 ,𝛼𝛼𝑥𝑥2 ) = 𝜕𝜕𝜕𝜕(𝑥𝑥1 ,𝑥𝑥2 )
𝛼𝛼 𝑘𝑘−1 �
𝜕𝜕𝑥𝑥2 𝜕𝜕𝑥𝑥2

Advanced Microeconomic Theory 125

Properties of Preference Relations
– Canceling the 𝛼𝛼 𝑘𝑘−1 terms yields
𝜕𝜕𝜕𝜕(𝑥𝑥1 ,𝑥𝑥2 )
𝜕𝜕𝑥𝑥1
𝜕𝜕𝜕𝜕(𝑥𝑥1 ,𝑥𝑥2 )
𝜕𝜕𝑥𝑥2
– In summary,
𝜕𝜕𝜕𝜕 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2
𝜕𝜕𝑥𝑥1
𝑀𝑀𝑀𝑀𝑀𝑀1,2 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 = =
𝜕𝜕𝜕𝜕 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2
𝜕𝜕𝑥𝑥2
𝜕𝜕𝜕𝜕(𝑥𝑥1 , 𝑥𝑥2 )
𝜕𝜕𝑥𝑥1
= = 𝑀𝑀𝑀𝑀𝑀𝑀1,2 𝑥𝑥1 , 𝑥𝑥2
𝜕𝜕𝜕𝜕(𝑥𝑥1 , 𝑥𝑥2 )
𝜕𝜕𝑥𝑥2
Advanced Microeconomic Theory 126
Properties of Preference Relations
• Homotheticity (graphical interpretation)
– A preference relation on 𝑋𝑋 = ℝ𝐿𝐿+ is homothetic if
all indifference sets are related to proportional
expansions along the rays.
– That is, if the consumer is indifferent between
bundles 𝑥𝑥 and 𝑦𝑦, i.e., 𝑥𝑥~𝑦𝑦, he must also be
indifferent between a common scaling in these
two bundles, i.e., 𝛼𝛼𝛼𝛼~𝛼𝛼𝛼𝛼, for every scalar 𝛼𝛼 > 0.

Advanced Microeconomic Theory 127

Properties of Preference Relations
– For a given ray from the origin, the slope of the
indifference curves (i.e., the MRS) that the ray crosses
coincides.
 The ratio between the two goods 𝑥𝑥1 /𝑥𝑥2 remains
constant along all points in the ray.
– Intuitively, the rate at which a consumer is willing to
substitute one good for another (his MRS) only
depends on:
• the rate at which he consumes the two goods, i.e., 𝑥𝑥1 /𝑥𝑥2 ,
but does not depend on the utility level he obtains.
– But it is independent in the volume of goods he
consumes, and in the utility he achieves.
Advanced Microeconomic Theory 128
Properties of Preference Relations
• Homogeneity and homotheticity:
– Homogeneous functions are homothetic.
 We only need to apply a monotonic transformation
𝑔𝑔(�) on 𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2 , i.e., 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑔𝑔(𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2 ).
– But homothetic functions are not necessarily
homogeneous.
 Take a homogeneous (of degree two) function
𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 𝑥𝑥2 .
 Apply a monotonic transformation 𝑔𝑔 𝑦𝑦 = 𝑦𝑦 + 𝑎𝑎,
where 𝑎𝑎 > 0, to obtain homothetic function
𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑥𝑥1 𝑥𝑥2 + 𝑎𝑎
Advanced Microeconomic Theory 129
 Properties of Preference Relations
 This function is not homogeneous, since increasing
all arguments by 𝛼𝛼 yields
𝑢𝑢 𝛼𝛼𝑥𝑥1 , 𝛼𝛼𝑥𝑥2 = 𝛼𝛼𝑥𝑥1 𝛼𝛼𝑥𝑥2 + 𝑎𝑎
= 𝛼𝛼 2 𝑣𝑣 𝑥𝑥1 , 𝑥𝑥2 + 𝑎𝑎

 Other monotonic transformations yielding non-

homogeneous utility functions are
𝑔𝑔 𝑦𝑦 = 𝑎𝑎𝑦𝑦 𝛾𝛾 + 𝑏𝑏𝑏𝑏, where 𝑎𝑎, 𝑏𝑏, 𝛾𝛾 > 0, or
𝑔𝑔 𝑦𝑦 = 𝑎𝑎 ln 𝑦𝑦, where 𝑎𝑎 > 0

Advanced Microeconomic Theory 130

 Properties of Preference Relations
• Utility functions that satisfy homotheticity:
– Linear utility function 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝑎𝑎𝑥𝑥1 + 𝑏𝑏𝑥𝑥2 , where
𝑎𝑎, 𝑏𝑏 > 0
 Goods 𝑥𝑥1 and 𝑥𝑥2 are perfect substitutes
𝑎𝑎 𝑎𝑎𝑎𝑎 𝑎𝑎
 𝑀𝑀𝑀𝑀𝑀𝑀 𝑥𝑥1 , 𝑥𝑥2 = and 𝑀𝑀𝑀𝑀𝑀𝑀 𝑡𝑡𝑥𝑥1 , 𝑡𝑡𝑥𝑥2 = =
𝑏𝑏 𝑏𝑏𝑏𝑏 𝑏𝑏
– The Leontief utility function 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = 𝐴𝐴 �
min{𝑎𝑎𝑥𝑥1 , 𝑏𝑏𝑥𝑥2 }, where 𝐴𝐴 > 0
 Goods 𝑥𝑥1 and 𝑥𝑥2 are perfect complements
 We cannot define the MRS along all the points of the
indifference curves
 However, the slope of the indifference curves coincide for
those points where these curves are crossed by a ray from
the origin. Advanced Microeconomic Theory 131
Properties of Preference Relations
• Perfect complements and homotheticity
x2

a
x2 = x1
b

u2 = 2 Aa

u1 = Aa
a
b
x1

Advanced Microeconomic Theory 132

Properties of Preference Relations
• Example 1.9 (Testing for quasiconcavity and
homotheticity):
– Let us determine if 𝑢𝑢 𝑥𝑥1 , 𝑥𝑥2 = ln(𝑥𝑥10.3 𝑥𝑥20.6 ) is
quasiconcave, homothetic, both or neither.
– Quasiconcavity:
 Note that ln(𝑥𝑥10.3 𝑥𝑥20.6 ) is a monotonic transformation of
the Cobb-Douglas function 𝑥𝑥10.3 𝑥𝑥20.6 .
 Since 𝑥𝑥10.3 𝑥𝑥20.6 is a Cobb-Douglas function, where 𝛼𝛼 +
𝛽𝛽 = 0.3 + 0.6 < 1, it must be a concave function.
 Hence, 𝑥𝑥10.3 𝑥𝑥20.6 is also quasiconcave, which implies
ln(𝑥𝑥10.3 𝑥𝑥20.6 ) is quasiconcave (as quasiconcavity is
preserved through a monotonic transformation).
Advanced Microeconomic Theory 133
Properties of Preference Relations
• Example 1.9 (continued):
– Homogeneity:
 Increasing all arguments by a common factor 𝛼𝛼,

𝛼𝛼𝑥𝑥1 0.3
𝛼𝛼𝑥𝑥2 0.6
= 𝛼𝛼 0.3 𝑥𝑥10.3 𝛼𝛼 0.6 𝑥𝑥20.6 = 𝛼𝛼 0.9 𝑥𝑥10.3 𝑥𝑥20.6
 Hence, 𝑥𝑥10.3 𝑥𝑥20.6 is homogeneous of degree 0.9

– Homotheticity:
 Therefore, 𝑥𝑥10.3 𝑥𝑥20.6 is also homothetic.
 As a consequence, its transformation, ln(𝑥𝑥10.3 𝑥𝑥20.6 ), is also
homothetic (as homotheticity is preserved through a
monotonic transformation).

Advanced Microeconomic Theory 134

Properties of Preference Relations
• Quasilinear preference relations:
– The preference relation on 𝑋𝑋 = (−∞, ∞)×ℝ𝐿𝐿−1
+ is
quasilinear with respect to good 1 if:
1) All indifference sets are parallel displacements of
each other along the axis of good 1.
 That is, if 𝑥𝑥~𝑦𝑦, then (𝑥𝑥 + 𝛼𝛼𝑒𝑒1 )~(𝑦𝑦 + 𝛼𝛼𝑒𝑒1 ), where 𝑒𝑒1 =
(1,0, … , 0).
2) Good 1 is desirable.
 That is, 𝑥𝑥 + 𝛼𝛼𝑒𝑒1 ≻ 𝑥𝑥 for all 𝑥𝑥 and 𝛼𝛼 > 0.

Advanced Microeconomic Theory 135

Properties of Preference Relations
• Quasilinear preference-I

x2

y y + αe1 y y + αe1

x x + αe1 x x + αe1

x1
Advanced Microeconomic Theory 136
Properties of Preference Relations
• Notes:
– No lower bound on the consumption of good 1,
i.e., 𝑥𝑥1 ∈ (−∞, ∞).
– If 𝑥𝑥 ≻ 𝑦𝑦, then (𝑥𝑥 + 𝛼𝛼𝑒𝑒1 ) ≻ (𝑦𝑦 + 𝛼𝛼𝑒𝑒1 ).

Advanced Microeconomic Theory 137

 Properties of Preference Relations
• Quasilinear preference-II

x2

x x + αe1

y y + αe1

x1
Advanced Microeconomic Theory 138
Properties of Preference Relations
• The properties we considered so far are not
enough to guarantee that a preference relation
can be represented by a utility function.
• Example:
– Lexicographic preferences cannot be represented by a
utility function.

Advanced Microeconomic Theory 139

 Lexicographic Preferences
– A bundle 𝑥𝑥 = (𝑥𝑥1 , 𝑥𝑥2 ) is weakly preferred to
another bundle 𝑦𝑦 = (𝑦𝑦1 , 𝑦𝑦2 ), i.e., (𝑥𝑥1 , 𝑥𝑥2 ) ≿
(𝑦𝑦1 , 𝑦𝑦2 ), if and only if
𝑥𝑥1 > 𝑦𝑦1 , or if
�
𝑥𝑥1 = 𝑦𝑦1 and 𝑥𝑥2 > 𝑦𝑦2
– Intuition:
 The individual prefers bundle 𝑥𝑥 if it contains more of
good 1 than bundle 𝑦𝑦, i.e., 𝑥𝑥1 > 𝑦𝑦1 .
 If, however, both bundles contain the same amount of
good 1, 𝑥𝑥1 = 𝑦𝑦1 , then the individual prefers bundle 𝑥𝑥 if
it contains more of the second good, i.e., 𝑥𝑥2 > 𝑦𝑦2 .
Advanced Microeconomic Theory 140
 Lexicographic Preferences
– Indifference set cannot be drawn as an
indifference curve.
 For a given bundle 𝑥𝑥 ′ = (𝑥𝑥1′ , 𝑥𝑥2′ ), there are no
more bundles for which the consumer is
indifferent.
 Indifference sets are then singletons (sets
containing only one element).

Advanced Microeconomic Theory 141

 Lexicographic Preferences
• Lexicographic preference relation
x2

LCS

x '2 x' UCS

x '1 x1
Advanced Microeconomic Theory 142
Continuous Preferences

Advanced Microeconomic Theory 143

 Continuous Preferences
• In order to guarantee that preference relations can
be represented by a utility function we need
continuity.
• Continuity: A preference relation defined on 𝑋𝑋 is
continuous if it is preserved under limits.
– That is, for any sequence of pairs
(𝑥𝑥 𝑛𝑛 , 𝑦𝑦 𝑛𝑛 ) ∞ 𝑛𝑛 𝑛𝑛
𝑛𝑛=1 with 𝑥𝑥 ≿ 𝑦𝑦 for all 𝑛𝑛
and where lim 𝑥𝑥 𝑛𝑛 = 𝑥𝑥 and lim 𝑦𝑦 𝑛𝑛 = 𝑦𝑦, the
𝑛𝑛→∞ 𝑛𝑛→∞
preference relation is maintained in the limiting points,
i.e., 𝑥𝑥 ≿ 𝑦𝑦.
Advanced Microeconomic Theory 144
 Continuous Preferences
– Intuitively, there can be no sudden jumps (i.e.,
preference reversals) in an individual preference
over a sequence of bundles.

Advanced Microeconomic Theory 145

 Continuous Preferences
• Lexicographic preferences are not continuous
𝑛𝑛 1
– Consider the sequence 𝑥𝑥 = and 𝑦𝑦 𝑛𝑛 = ,0
𝑛𝑛
(0,1), where 𝑛𝑛 = {1,2,3, … }.
– The sequence 𝑦𝑦 𝑛𝑛 = (0,1) is constant in 𝑛𝑛.
𝑛𝑛 1
– The sequence 𝑥𝑥 = ,0 is not:
𝑛𝑛
 It starts at 𝑥𝑥 1 = 1,0 , and moves leftwards to 𝑥𝑥 2 =
1 1
,0 , 𝑥𝑥 3 = ,0 , etc.
2 3

Advanced Microeconomic Theory 146

 Continuous Preferences
• Thus, the individual
prefers: x2
1
y n, ∀ n , y 1 = y 2 = … = y n

𝑥𝑥 1 = 1,0 ≻ 0,1 = 𝑦𝑦1

1
𝑥𝑥 2 = ,0 ≻ 0,1 = 𝑦𝑦 2
2
1
𝑥𝑥 3 = ,0 ≻ 0,1 = 𝑦𝑦 3
3 lim x n = (0,0)
n →∞
⋮
• But,
lim 𝑥𝑥 𝑛𝑛 = 0,0 ≺ 0,1 = lim 𝑦𝑦 𝑛𝑛 x4 x3 x2 x1
𝑛𝑛→∞ 𝑛𝑛→∞
0 ½ 1 x1
• Preference reversal!
¼ ⅓

Advanced Microeconomic Theory 147

Existence of Utility Function

Advanced Microeconomic Theory 148

 Existence of Utility Function
• If a preference relation satisfies monotonicity and
continuity, then there exists a utility function 𝑢𝑢(�)
representing such preference relation.
• Proof:
– Take a bundle 𝑥𝑥 ≠ 0.
– By monotonicity, 𝑥𝑥 ≿ 0, where 0 = (0,0, … , 0).
 That is, if bundle 𝑥𝑥 ≠ 0, it contains positive
amounts of at least one good and, it is preferred to
bundle 0.
Advanced Microeconomic Theory 149
 Existence of Utility Function
– Let m ≡ max{𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑁𝑁 } be the number of units
of the most abundant good in bundle x.
– Define bundle M as the bundle where all
components coincide with the highest component
of bundle x. That is,
𝑀𝑀 = (𝑚𝑚, 𝑚𝑚, … , 𝑚𝑚).
– Hence, by monotonicity, 𝑀𝑀 ≿ 𝑥𝑥.
– Bundles 0 and 𝑀𝑀 are both on the main diagonal,
since each of them contains the same amount of
good 𝑥𝑥1 and 𝑥𝑥2 .
Advanced Microeconomic Theory 150
Existence of Utility Function
x2

45º, x1 = x2
M

0 x1
Advanced Microeconomic Theory 151
 Existence of Utility Function
– By continuity and monotonicity, there exists a
bundle that is indifferent to 𝑥𝑥 and which lies on
the main diagonal.
– By monotonicity, this bundle is unique
 Otherwise, modifying any of its components would
lead to higher/lower indifference curves.
– Denote such bundle as
𝑡𝑡 𝑥𝑥 , 𝑡𝑡 𝑥𝑥 , … , 𝑡𝑡(𝑥𝑥)
– Let 𝑢𝑢 𝑥𝑥 = 𝑡𝑡 𝑥𝑥 , which is a real number.

Advanced Microeconomic Theory 152

Existence of Utility Function
x2

45º, x1 = x2
M

t(x)

0 t(x) x1
Advanced Microeconomic Theory 153
 Existence of Utility Function
– Applying the same steps to another bundle 𝑦𝑦 ≠ 𝑥𝑥,
we obtain
𝑡𝑡 𝑦𝑦 , 𝑡𝑡 𝑦𝑦 , … , 𝑡𝑡(𝑦𝑦)

and let 𝑢𝑢 𝑦𝑦 = 𝑡𝑡 𝑦𝑦 , which is also a real number.

Advanced Microeconomic Theory 154

Existence of Utility Function
x2

45º, x1 = x2
M
y

t(x)
x
t(y)

0 t(y) t(x) x1
Advanced Microeconomic Theory 155
 Existence of Utility Function
– We know that
𝑥𝑥~ 𝑡𝑡 𝑥𝑥 , 𝑡𝑡 𝑥𝑥 , … , 𝑡𝑡(𝑥𝑥)
𝑦𝑦~ 𝑡𝑡 𝑦𝑦 , 𝑡𝑡 𝑦𝑦 , … , 𝑡𝑡(𝑦𝑦)
𝑥𝑥 ≿ 𝑦𝑦
– Hence, by transitivity, 𝑥𝑥 ≿ 𝑦𝑦 iff
𝑥𝑥~ 𝑡𝑡 𝑥𝑥 , 𝑡𝑡 𝑥𝑥 , … , 𝑡𝑡(𝑥𝑥) ≿ 𝑡𝑡 𝑦𝑦 , 𝑡𝑡 𝑦𝑦 , … , 𝑡𝑡 𝑦𝑦 ~𝑦𝑦
– And by monotonicity,
𝑥𝑥 ≿ 𝑦𝑦 ⟺ 𝑡𝑡 𝑥𝑥 ≥ 𝑡𝑡 𝑦𝑦 ⟺ 𝑢𝑢(𝑥𝑥) ≥ 𝑢𝑢(𝑦𝑦)

Advanced Microeconomic Theory 156

 Existence of Utility Function
– Note: A utility function can satisfy continuity but
still be non-differentiable.
 For instance, the Leontief utility function,
𝐴𝐴min{𝑎𝑎𝑥𝑥1 ,𝑏𝑏𝑥𝑥2 }, is continuous but cannot be
differentiated at the kink.

Advanced Microeconomic Theory 157

Social and Reference-Dependent
Preferences

Advanced Microeconomic Theory 158

 Social Preferences
• We now examine social, as opposed to individual,
preferences.
• Consider additively separable utility functions of
the form
𝑢𝑢𝑖𝑖 (𝑥𝑥𝑖𝑖 , 𝑥𝑥) = 𝑓𝑓(𝑥𝑥𝑖𝑖 ) + 𝑔𝑔𝑖𝑖 (𝑥𝑥)
where
– 𝑓𝑓(𝑥𝑥𝑖𝑖 ) captures individual 𝑖𝑖’s utility from the
monetary amount that he receives, 𝑥𝑥𝑖𝑖 ;
– 𝑔𝑔𝑖𝑖 (𝑥𝑥) measures the utility/disutility he derives from
the distribution of payoffs 𝑥𝑥 = (𝑥𝑥1 , 𝑥𝑥2 , . . . , 𝑥𝑥𝑁𝑁 )
among all 𝑁𝑁 individuals.
Advanced Microeconomic Theory 159
 Social Preferences
• Fehr and Schmidt (1999):
– For the case of two players,
𝑢𝑢𝑖𝑖 (𝑥𝑥𝑖𝑖 , 𝑥𝑥𝑗𝑗 ) = 𝑥𝑥𝑖𝑖 − 𝛼𝛼𝑖𝑖 max 𝑥𝑥𝑗𝑗 − 𝑥𝑥𝑖𝑖 , 0 − 𝛽𝛽𝑖𝑖 max 𝑥𝑥𝑖𝑖 − 𝑥𝑥𝑗𝑗 , 0

where 𝑥𝑥𝑖𝑖 is player 𝑖𝑖's payoff and 𝑗𝑗 ≠ 𝑖𝑖.

– Parameter 𝛼𝛼𝑖𝑖 ≥ 0 represents player 𝑖𝑖’s disutility
from envy
 When 𝑥𝑥𝑖𝑖 < 𝑥𝑥𝑗𝑗 , max 𝑥𝑥𝑗𝑗 − 𝑥𝑥𝑖𝑖 , 0 = 𝑥𝑥𝑗𝑗 − 𝑥𝑥𝑖𝑖 > 0 but
max 𝑥𝑥𝑖𝑖 − 𝑥𝑥𝑗𝑗 , 0 = 0.
 Hence, 𝑢𝑢𝑖𝑖 (𝑥𝑥𝑖𝑖 , 𝑥𝑥𝑗𝑗 ) = 𝑥𝑥𝑖𝑖 − 𝛼𝛼𝑖𝑖 (𝑥𝑥𝑗𝑗 − 𝑥𝑥𝑖𝑖 ).
Advanced Microeconomic Theory 160
 Social Preferences
– Parameter 𝛽𝛽𝑖𝑖 ≥ 0 captures player 𝑖𝑖's disutility
from guilt
 When 𝑥𝑥𝑖𝑖 > 𝑥𝑥𝑗𝑗 , max 𝑥𝑥𝑖𝑖 − 𝑥𝑥𝑗𝑗 , 0 = 𝑥𝑥𝑖𝑖 − 𝑥𝑥𝑗𝑗 > 0 but
max 𝑥𝑥𝑗𝑗 − 𝑥𝑥𝑖𝑖 , 0 = 0.
 Hence, 𝑢𝑢𝑖𝑖 𝑥𝑥𝑖𝑖 , 𝑥𝑥𝑗𝑗 = 𝑥𝑥𝑖𝑖 − 𝛽𝛽𝑖𝑖 (𝑥𝑥𝑖𝑖 − 𝑥𝑥𝑗𝑗 ).

– Players’ envy is stronger than their guilt, i.e., 𝛼𝛼𝑖𝑖 ≥

𝛽𝛽𝑖𝑖 for 0 ≤ 𝛽𝛽𝑖𝑖 < 1.
 Intuitively, players (weakly) suffer more from inequality
directed at them than inequality directed at others.

Advanced Microeconomic Theory 161

 Social Preferences
– Thus players exhibit “concerns for fairness” (or
“social preferences”) in the distribution of payoffs.
– If 𝛼𝛼𝑖𝑖 = 𝛽𝛽𝑖𝑖 = 0 for every player 𝑖𝑖, individuals only
care about their material payoff 𝑢𝑢𝑖𝑖 (𝑥𝑥𝑖𝑖 , 𝑥𝑥𝑗𝑗 ) = 𝑥𝑥𝑖𝑖 .
 Preferences coincide with the individual
preferences.

Advanced Microeconomic Theory 162

 Social Preferences
– Let’s depict the indifference
curves of this utility function
by fixing the utility level at
𝑢𝑢 = 𝑢𝑢.
– When 𝑥𝑥𝑖𝑖 > 𝑥𝑥𝑗𝑗 ,
𝑢𝑢 = 𝑥𝑥𝑖𝑖 − 𝛽𝛽𝑖𝑖 (𝑥𝑥𝑖𝑖 − 𝑥𝑥𝑗𝑗 )
which, solving for 𝑥𝑥𝑗𝑗 , yields
𝑢𝑢 1−𝛽𝛽𝑖𝑖
𝑥𝑥𝑗𝑗 = − 𝑥𝑥𝑖𝑖
𝛽𝛽𝑖𝑖 𝛽𝛽𝑖𝑖
𝑖𝑖 1−𝛽𝛽
with slope − for all
𝛽𝛽𝑖𝑖
points below the 45-degree
line.
– See downward sloping
segment of ICs.
Advanced Microeconomic Theory 163
 Social Preferences
– Similarly, when 𝑥𝑥𝑖𝑖 < 𝑥𝑥𝑗𝑗 ,
𝑢𝑢 = 𝑥𝑥𝑖𝑖 − 𝛼𝛼𝑖𝑖 (𝑥𝑥𝑗𝑗 − 𝑥𝑥𝑖𝑖 ),
which, solving for 𝑥𝑥𝑗𝑗 , yields
𝑢𝑢 1+𝛼𝛼𝑖𝑖
𝑥𝑥𝑗𝑗 =− + 𝑥𝑥𝑖𝑖
𝛼𝛼𝑖𝑖 𝛼𝛼𝑖𝑖
1+𝛼𝛼𝑖𝑖
with slope above 45-
𝛼𝛼𝑖𝑖
degree line.
– See upward sloping
segment of the ICs.
– Note that (𝑥𝑥𝑖𝑖 , 𝑥𝑥𝑗𝑗 )-pairs to
the northeast yield larger
utility levels for individual
𝑖𝑖.
Advanced Microeconomic Theory 164
 Social Preferences
– Remark 1: If
 the disutility from envy is positive, 𝛼𝛼𝑖𝑖 ∈ 0,1 ;
 the disutility from guilt is negative, 𝛽𝛽𝑖𝑖 ∈ (−1,0];
and
 the former dominates the latter in absolute value,
𝛼𝛼𝑖𝑖 ≥ 𝛽𝛽𝑖𝑖 ;
then Fehr and Schmidt's (1999) specification
would capture concerns for status acquisition.

Advanced Microeconomic Theory 165

 Social Preferences
– Remark 2: If
1
 the disutility from envy is negative, 𝛼𝛼𝑖𝑖 ∈ − , 0 ;
2
1
 the disutility from guilt is positive, 𝛽𝛽𝑖𝑖 ∈ 0, ; and
2
 the latter dominates the former in absolute value,
𝛼𝛼𝑖𝑖 < 𝛽𝛽𝑖𝑖 ;
then Fehr and Schmidt's (1999) specification would
now capture a preference for efficiency.

That is, a reduction in my own payoff is acceptable

only if the payoff other individuals receive increases
by a larger amount.
Advanced Microeconomic Theory 166
 Social Preferences
• Bolton and Ockenfels (2000):
– Similar to Fehr and Schmidt (1999), but they allow
for nonlinearities
𝑥𝑥𝑖𝑖
𝑢𝑢𝑖𝑖 𝑥𝑥𝑖𝑖 ,
𝑥𝑥𝑖𝑖 +𝑥𝑥𝑗𝑗

where 𝑢𝑢𝑖𝑖 (�)

• increases in 𝑥𝑥𝑖𝑖 (i.e., selfish component)
• decreases in the share of total payoffs that
𝑥𝑥
individual 𝑖𝑖 enjoys, 𝑖𝑖 (i.e., social preferences)
𝑥𝑥𝑖𝑖 +𝑥𝑥𝑗𝑗

Advanced Microeconomic Theory 167

 Social Preferences
– For instance,
1
𝑥𝑥𝑖𝑖 𝑥𝑥𝑖𝑖 2
𝑢𝑢𝑖𝑖 𝑥𝑥𝑖𝑖 , = 𝑥𝑥𝑖𝑖 − 𝛼𝛼
𝑥𝑥𝑖𝑖 +𝑥𝑥𝑗𝑗 𝑥𝑥𝑖𝑖 +𝑥𝑥𝑗𝑗

– Letting 𝑢𝑢 = 𝑢𝑢 and solving for 𝑥𝑥𝑗𝑗 yields the indifference

curve
𝑥𝑥𝑖𝑖 𝛼𝛼 2 − 𝑢𝑢 − 𝑥𝑥𝑖𝑖 2
𝑥𝑥𝑗𝑗 =
𝑢𝑢 − 𝑥𝑥𝑖𝑖 2
which produces nonlinear indifference curves
(nonlinear in 𝑥𝑥𝑖𝑖 ).

Advanced Microeconomic Theory 168

 Social Preferences
• Charness and Rabin (2002):
– Fehr and Schmidt’s (1999) preferences might not
explain individuals’ reactions in strategic settings.
• Example: inferring certain intentions from
individuals who acted before them.
– Utility function that rationalizes such behavior
𝑢𝑢𝑖𝑖 𝑥𝑥𝑖𝑖 , 𝑥𝑥𝑗𝑗 = 𝑥𝑥𝑖𝑖 − 𝛼𝛼𝑖𝑖 − 𝜃𝜃𝛾𝛾𝑗𝑗 max 𝑥𝑥𝑗𝑗 − 𝑥𝑥𝑖𝑖 , 0
−(𝛽𝛽𝑖𝑖 + 𝜃𝜃𝛾𝛾𝑗𝑗 ) max 𝑥𝑥𝑖𝑖 − 𝑥𝑥𝑗𝑗 , 0
where parameter 𝛾𝛾𝑗𝑗 only takes two possible
values, i.e., 𝛾𝛾𝑗𝑗 = {−1,0}.
Advanced Microeconomic Theory 169
 Social Preferences
– If 𝛾𝛾𝑗𝑗 = −1, individual 𝑖𝑖 interprets that 𝑗𝑗 misbehaved,
and thus increases its envy parameter by 𝜃𝜃, or
reduces his guilt parameter by 𝜃𝜃.
– If 𝛾𝛾𝑗𝑗 = 0, individual 𝑖𝑖 interprets that 𝑗𝑗 is well behaved,
implying that the utility function coincides with that in
Fehr and Schmidt's (1999) specification.
– Intuitively, when individuals interpret that others
misbehaved, the envy (guilt) concerns analyzed above
are emphasized (attenuated, respectively).

Advanced Microeconomic Theory 170

 Social Preferences
• Andreoni and Miller (2002):
– A CES utility function
1
𝜌𝜌 𝜌𝜌 𝜌𝜌
𝑢𝑢𝑖𝑖 (𝑥𝑥𝑖𝑖 , 𝑥𝑥𝑗𝑗 ) = 𝛼𝛼𝑥𝑥𝑖𝑖 + 1 − 𝛼𝛼 𝑥𝑥𝑗𝑗
where 𝑥𝑥𝑖𝑖 and 𝑥𝑥𝑗𝑗 are the monetary payoff of individual 𝑖𝑖
rather than the amount of goods.

– If individual 𝑖𝑖 is completely selfish, i.e., 𝛼𝛼 = 1, 𝑢𝑢(𝑥𝑥𝑖𝑖 ) = 𝑥𝑥𝑖𝑖

Advanced Microeconomic Theory 171

 Social Preferences
– If 𝛼𝛼 ∈ (0,1), parameter 𝜌𝜌 captures the elasticity of
substitution between individual 𝑖𝑖's and 𝑗𝑗's payoffs.
 That is, if 𝑥𝑥𝑗𝑗 decreases by one percent, 𝑥𝑥𝑖𝑖 needs to
be increased by 𝜌𝜌 percent for individual 𝑖𝑖 to
maintain his utility level unaffected.

Advanced Microeconomic Theory 172

Hyperbolic and Quasi-
Hyperbolic Discounting

Advanced Microeconomic Theory 173

Exponential discounting (standard)
• The discounted value of an amount of money $𝑥𝑥 received 𝑡𝑡
periods from today is
1
𝑡𝑡
𝑥𝑥
(1 + 𝑟𝑟)
• We can find the “subjective discount rate” which measures how
1
𝑥𝑥 varies along time, relative to its initial value,
(1+𝑟𝑟)𝑡𝑡
1
𝜕𝜕 𝑥𝑥 1
(1 + 𝑟𝑟)𝑡𝑡 −ln(1 + 𝑟𝑟)
(1 + 𝑟𝑟) 𝑡𝑡 𝑥𝑥
𝜕𝜕𝑡𝑡 = = −ln(1 + 𝑟𝑟)
1 1
𝑥𝑥 𝑥𝑥
(1 + 𝑟𝑟)𝑡𝑡 (1 + 𝑟𝑟)𝑡𝑡
which is constant in the time period 𝑡𝑡 when it is evaluated.
• In other words, exponential discounting assumes that the
comparison of $𝑥𝑥 between period 0 and 𝑘𝑘 coincides with the
comparison between period 𝑡𝑡 and 𝑡𝑡 + 𝑘𝑘 since k periods mediated.
Advanced Microeconomic Theory 174
Exponential discounting (standard)
• Not generally confirmed in controlled experiments.
• In particular, individuals exhibit present bias:
– When asked to choose between $100 today or $110
tomorrow, most individuals prefer $100 today.
– However, when the same individuals are asked
between $100 in, for instance, 60 days or $110 in 61
days, some reveal a preference for the $110 in 61
days.
• Individuals show a large discount of future payoffs
• Preferences are time-inconsistent
Advanced Microeconomic Theory 175
 Hyperbolic Discounting
• This approach assumes that the discounted value of an amount
of money $𝑥𝑥 received 𝑡𝑡 periods from today is
1
𝑥𝑥
(1 + 𝑟𝑟𝑟𝑟)𝛾𝛾/𝛼𝛼
where 𝛾𝛾, 𝛼𝛼 > 0. In this setting, the subjective discount rate is
1
𝜕𝜕 𝑥𝑥
(1 + 𝑟𝑟𝑟𝑟)𝛾𝛾/𝛼𝛼
𝜕𝜕𝜕𝜕 −𝛾𝛾𝑟𝑟
=
1 𝛼𝛼(1 + 𝑟𝑟𝑟𝑟)
𝑥𝑥
(1 + 𝑟𝑟𝑟𝑟)𝛾𝛾/𝛼𝛼
which is decreasing in t.
In most applications, 𝛾𝛾 = 𝛼𝛼, yielding a subjective discount rate of

−𝑟𝑟
(1 + 𝑟𝑟𝑟𝑟)
Advanced Microeconomic Theory 176
 Hyperbolic Discounting

• Individuals with hyperbolic discounting exhibit present

bias: relative to standard (exponential) discounting
– They strongly discount payoffs in the nearby future, but
– They do not significantly discount two distant payoffs that are
close to each other.
Advanced Microeconomic Theory 177
 Quasi-Hyperbolic Discounting
• In a discrete time context, individuals discount
future payoffs according to
𝛽𝛽𝛿𝛿 𝑡𝑡
for all 𝑡𝑡 ≥ 1, where parameter 𝛽𝛽 ≤ 1.
– When 𝛽𝛽 = 1, Quasi-hyperbolic discounting embodies
exponential discounting.
– The subjective discount rate is
∆ 𝛽𝛽𝛿𝛿 𝑡𝑡 𝑥𝑥 𝑡𝑡+1 𝑡𝑡
∆𝑡𝑡 𝛽𝛽𝛿𝛿 𝑥𝑥 − 𝛽𝛽𝛿𝛿 𝑥𝑥
𝑡𝑡
= 𝑡𝑡
= 𝛿𝛿 − 1
𝛽𝛽𝛿𝛿 𝑥𝑥 𝛽𝛽𝛿𝛿 𝑥𝑥
which is constant in time, but still allows for present bias
to arise.
Advanced Microeconomic Theory 178
 Quasi-Hyperbolic Discounting
– Consider an individual evaluating today whether to
invest in a firm.
– He will need to incur a cost 𝑐𝑐 > 0 in period 𝑡𝑡, and
obtain a benefit 𝑏𝑏 > 0 with certainty 𝑛𝑛 periods into
the future (in period 𝑡𝑡 + 𝑛𝑛).
– Under exponential discounting, he would invest if
𝛿𝛿 𝑡𝑡 𝑐𝑐 < 𝛿𝛿 𝑡𝑡+𝑛𝑛 𝑏𝑏 or 𝑐𝑐 < 𝛿𝛿 𝑛𝑛 𝑏𝑏
– If this individual is given the opportunity to reconsider
his investment when period 𝑡𝑡 arrives, he will not
reconsider his decision since 𝑐𝑐 < 𝛿𝛿 𝑛𝑛 𝑏𝑏 still holds.

Advanced Microeconomic Theory 179

 Quasi-Hyperbolic Discounting
– Under quasi-hyperbolic discounting, he would invest if
𝛽𝛽𝛿𝛿 𝑡𝑡 𝑐𝑐 < 𝛽𝛽𝛿𝛿 𝑡𝑡+𝑛𝑛 𝑏𝑏 or 𝑐𝑐 < 𝛿𝛿 𝑛𝑛 𝑏𝑏
which is same decision rule as the above time-
consistent individual.
– However, if this individual is given the opportunity to
reconsider his investment when period 𝑡𝑡 arrives, he
will invest only if
𝑐𝑐 < 𝛽𝛽𝛿𝛿 𝑛𝑛 𝑏𝑏
which does not coincide with his decision rule 𝑡𝑡
periods ago.
– Hence, preference reversal occurs if
𝛽𝛽𝛿𝛿 𝑛𝑛 𝑏𝑏 < 𝑐𝑐 < 𝛿𝛿 𝑛𝑛 𝑏𝑏

Advanced Microeconomic Theory 180

Choice Based Approach

Advanced Microeconomic Theory 181

 Choice Based Approach
• We now focus on the actual choice behavior
rather than individual preferences.
– From the alternatives in set 𝐵𝐵, which one would
you choose?

• A choice structure (ℬ, 𝑐𝑐(�)) contains two

elements:
1) ℬ is a family of nonempty subsets of 𝑋𝑋, so that
every element of ℬ is a set 𝐵𝐵 ⊂ 𝑋𝑋.

Advanced Microeconomic Theory 182

 Choice Based Approach
– Example 1: In consumer theory, 𝐵𝐵 is a particular
set of all the affordable bundles for a consumer,
given his wealth and market prices.
– Example 2: 𝐵𝐵 is a particular list of all the
universities where you were admitted, among all
universities in the scope of your imagination 𝑋𝑋,
i.e., 𝐵𝐵 ⊂ 𝑋𝑋.

Advanced Microeconomic Theory 183

 Choice Based Approach
2) 𝑐𝑐(�) is a choice rule that selects, for each budget
set 𝐵𝐵, a subset of elements in 𝐵𝐵, with the
interpretation that 𝑐𝑐(𝐵𝐵) are the chosen elements
from 𝐵𝐵.
– Example 1: In consumer theory, 𝑐𝑐(𝐵𝐵) would be
the bundles that the individual chooses to buy,
among all bundles he can afford in budget set 𝐵𝐵;
– Example 2: In the example of the universities,
𝑐𝑐(𝐵𝐵) would contain the university that you
choose to attend.
Advanced Microeconomic Theory 184
 Choice Based Approach
– Note:
 If 𝑐𝑐(𝐵𝐵) contains a single element, 𝑐𝑐(⋅) is a
function;
 If 𝑐𝑐(𝐵𝐵) contains more than one element, 𝑐𝑐(⋅) is
a correspondence.

Advanced Microeconomic Theory 185

 Choice Based Approach
• Example 1.11 (Choice structures):
– Define the set of alternatives as
𝑋𝑋 = {𝑥𝑥, 𝑦𝑦, 𝑧𝑧}
– Consider two different budget sets
𝐵𝐵1 = {𝑥𝑥, 𝑦𝑦} and 𝐵𝐵2 = {𝑥𝑥, 𝑦𝑦, 𝑧𝑧}
– Choice structure one (ℬ, 𝑐𝑐1 (�))
𝑐𝑐1 𝐵𝐵1 = 𝑐𝑐1 𝑥𝑥, 𝑦𝑦 = {𝑥𝑥}
𝑐𝑐1 𝐵𝐵2 = 𝑐𝑐1 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑥𝑥}

Advanced Microeconomic Theory 186

 Choice Based Approach
• Example 1.11 (continued):
– Choice structure two (ℬ, 𝑐𝑐2 (�))
𝑐𝑐2 𝐵𝐵1 = 𝑐𝑐2 𝑥𝑥, 𝑦𝑦 = {𝑥𝑥}
𝑐𝑐2 𝐵𝐵2 = 𝑐𝑐2 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑦𝑦}
– Is such a choice rule consistent?
 We need to impose a consistency requirement on
the choice-based approach, similar to rationality
assumption on the preference-based approach.

Advanced Microeconomic Theory 187

Consistency on Choices: the Weak
Axiom of Revealed Preference
(WARP)

Advanced Microeconomic Theory 188

 WARP
• Weak Axiom of Revealed Preference (WARP):
The choice structure (ℬ, 𝑐𝑐(�)) satisfies the WARP
if:
1) for some budget set 𝐵𝐵 ∈ ℬ with 𝑥𝑥, 𝑦𝑦 ∈ 𝐵𝐵, we
have that element 𝑥𝑥 is chosen, 𝑥𝑥 ∈ 𝑐𝑐(𝐵𝐵), then
2) for any other budget set 𝐵𝐵′ ∈ ℬ where
alternatives 𝑥𝑥 and 𝑦𝑦 are also available, 𝑥𝑥, 𝑦𝑦 ∈ 𝐵𝐵′,
and where alternative 𝑦𝑦 is chosen, 𝑦𝑦 ∈ 𝑐𝑐(𝐵𝐵′),
then we must have that alternative 𝑥𝑥 is chosen
as well, 𝑥𝑥 ∈ 𝑐𝑐(𝐵𝐵𝐵).

Advanced Microeconomic Theory 189

 WARP
• Example 1.12 (Checking WARP in choice structures):
– Take budget set 𝐵𝐵 = {𝑥𝑥, 𝑦𝑦} with the choice rule of
𝑐𝑐 𝑥𝑥, 𝑦𝑦 = 𝑥𝑥.
– Then, for budget set 𝐵𝐵′ = {𝑥𝑥, 𝑦𝑦, 𝑧𝑧}, the “legal” choice
rules are either:
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑥𝑥}, or
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑧𝑧}, or
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑥𝑥, 𝑧𝑧}

Advanced Microeconomic Theory 190

 WARP
• Example 1.12 (continued):
– This implies that the individual decision-maker
cannot select

𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑦𝑦}

𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑦𝑦, 𝑧𝑧}
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑥𝑥, 𝑦𝑦}
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑥𝑥, 𝑦𝑦, 𝑧𝑧}

Advanced Microeconomic Theory 191

 WARP
• Example 1.13 (More on choice structures
satisfying/violating WARP):
– Take budget set 𝐵𝐵 = {𝑥𝑥, 𝑦𝑦} with the choice rule of
𝑐𝑐 𝑥𝑥, 𝑦𝑦 = {𝑥𝑥, 𝑦𝑦}.
– Then, for budget set 𝐵𝐵𝐵 = {𝑥𝑥, 𝑦𝑦, 𝑧𝑧}, the “legal”
choices according to WARP are either:
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑥𝑥, 𝑦𝑦}, or
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑧𝑧}, or
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 = {𝑥𝑥, 𝑦𝑦, 𝑧𝑧}

Advanced Microeconomic Theory 192

 WARP
• Example 1.13 (continued):
– This implies that the decision-maker cannot select:
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑥𝑥}
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑦𝑦}
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑥𝑥, 𝑧𝑧}
𝑐𝑐 𝑥𝑥, 𝑦𝑦, 𝑧𝑧 ≠ {𝑦𝑦, 𝑧𝑧}
– In summary, when both 𝑥𝑥 and 𝑦𝑦 are available in 𝐵𝐵
and 𝐵𝐵𝐵, as long as they are chosen in 𝐵𝐵, both of them
must be chosen in 𝐵𝐵𝐵.

Advanced Microeconomic Theory 193

 WARP
• Example 1.13 (continued):
– Choice rule satisfying WARP

C(B)
x
y

C(B’)

B’
Advanced Microeconomic Theory 194
 WARP
• Example 1.13 (continued):
– Choice rule violating WARP

B
C(B)

y
C(B’)

B’
Advanced Microeconomic Theory 195
Consumption Sets

Advanced Microeconomic Theory 196

 Consumption Sets
• Consumption set: a subset of the commodity
space ℝ𝑁𝑁 , denoted by 𝑥𝑥 ⊂ ℝ𝑁𝑁 , whose elements
are the consumption bundles that the individual
can conceivably consume, given the physical
constraints imposed by his environment.
• Let us denote a commodity bundle 𝑥𝑥 as a vector
of 𝐿𝐿 components.

Advanced Microeconomic Theory 197

 Consumption Sets
• Physical constraint on the labor market

Advanced Microeconomic Theory 198

 Consumption Sets
• Consumption at two different locations

Beer in
Seattle
at noon

Beer in
Barcelona
at noon
Advanced Microeconomic Theory 199
 Consumption Sets
• Convex consumption sets:
– A consumption set 𝑋𝑋 is convex if, for two
consumption bundles 𝑥𝑥, 𝑥𝑥𝑥 ∈ 𝑋𝑋, the bundle
𝑥𝑥 ′′ = 𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑥𝑥 ′
is also an element of 𝑋𝑋 for any 𝛼𝛼 ∈ (0,1).
– Intuitively, a consumption set is convex if, for any
two bundles that belong to the set, we can
construct a straight line connecting them that lies
completely within the set.
Advanced Microeconomic Theory 200
 Consumption Sets: Economic Constraints

• Assumptions on the price vector in ℝ𝑁𝑁 :

1) All commodities can be traded in a market, at
prices that are publicly observable.
– This is the principle of completeness of markets
– It discards the possibility that some goods cannot
be traded, such as pollution.
2) Prices are strictly positive for all 𝑁𝑁 goods, i.e.,
𝑝𝑝 ≫ 0 for every good 𝑘𝑘.
– Some prices could be negative, such as pollution.

Advanced Microeconomic Theory 201

Consumption Sets: Economic Constraints

3) Price taking assumption: a consumer’s demand

for all 𝑁𝑁 goods represents a small fraction of the
total demand for the good.

Advanced Microeconomic Theory 202

 Consumption Sets: Economic Constraints

• Bundle 𝑥𝑥 ∈ ℝ𝑁𝑁 + is affordable if

𝑝𝑝1 𝑥𝑥1 + 𝑝𝑝2 𝑥𝑥2 + ⋯ + 𝑝𝑝𝑁𝑁 𝑥𝑥𝑁𝑁 ≤ 𝑤𝑤
or, in vector notation, 𝑝𝑝 � 𝑥𝑥 ≤ 𝑤𝑤.
• Note that 𝑝𝑝 � 𝑥𝑥 is the total cost of buying bundle
𝑥𝑥 = (𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑁𝑁 ) at market prices 𝑝𝑝 =
(𝑝𝑝1 , 𝑝𝑝2 , … , 𝑝𝑝𝑁𝑁 ), and 𝑤𝑤 is the total wealth of the
consumer.
• When 𝑥𝑥 ∈ ℝ𝑁𝑁+ then the set of feasible consumption
bundles consists of the elements of the set:
𝐵𝐵𝑝𝑝,𝑤𝑤 = {𝑥𝑥 ∈ ℝ𝑁𝑁
+ : 𝑝𝑝 � 𝑥𝑥 ≤ 𝑤𝑤}
Advanced Microeconomic Theory 203
Consumption Sets: Economic Constraints
• Example for two goods:
𝐵𝐵𝑝𝑝,𝑤𝑤 = {𝑥𝑥 ∈ ℝ2+ : 𝑝𝑝1 𝑥𝑥1 + 𝑝𝑝2 𝑥𝑥2 ≤ 𝑤𝑤}

The budget line is x2

𝑝𝑝1 𝑥𝑥1 + 𝑝𝑝2 𝑥𝑥2 = 𝑤𝑤 .

w p1
Hence, solving for the p2 -
p2
(slope)

good on the vertical

axis, 𝑥𝑥2 , we obtain
𝑤𝑤 𝑝𝑝1 {x ∈ℝ +2:p ∙x = w}
𝑥𝑥2 = − 𝑥𝑥1
𝑝𝑝2 𝑝𝑝2
w x1
p1

Advanced Microeconomic Theory 204

Consumption Sets: Economic Constraints
• Example for three goods:
𝐵𝐵𝑝𝑝,𝑤𝑤 = {𝑥𝑥 ∈ ℝ3+ : 𝑝𝑝1 𝑥𝑥1 + 𝑝𝑝2 𝑥𝑥2 + 𝑝𝑝3 𝑥𝑥3 ≤ 𝑤𝑤}
– The surface 𝑝𝑝1 𝑥𝑥1 + 𝑝𝑝2 𝑥𝑥2 + 𝑝𝑝3 𝑥𝑥3 = 𝑤𝑤 is referred to
as the “Budget hyperplane”
x3

x1

x2
Advanced Microeconomic Theory 205
 Consumption Sets: Economic Constraints

• Price vector 𝑝𝑝 is orthogonal (perpendicular) to

the budget line 𝐵𝐵𝑝𝑝,𝑤𝑤 .
– Note that 𝑝𝑝 � 𝑥𝑥 = 𝑤𝑤 holds for any bundle 𝑥𝑥 on the
budget line.
– Take any other bundle 𝑥𝑥′ which also lies on 𝐵𝐵𝑝𝑝,𝑤𝑤 .
Hence, 𝑝𝑝 � 𝑥𝑥′ = 𝑤𝑤.
– Then,
𝑝𝑝 � 𝑥𝑥 ′ = 𝑝𝑝 � 𝑥𝑥 = 𝑤𝑤
𝑝𝑝 � 𝑥𝑥 ′ − 𝑥𝑥 = 0 or 𝑝𝑝 � ∆𝑥𝑥 = 0
Advanced Microeconomic Theory 206
Consumption Sets: Economic Constraints

– Since this is valid for any two bundles on the

budget line, then 𝑝𝑝 must be perpendicular to
∆𝑥𝑥 on 𝐵𝐵𝑝𝑝,𝑤𝑤 .

– This implies that the price vector is perpendicular

(orthogonal) to 𝐵𝐵𝑝𝑝,𝑤𝑤 .

Advanced Microeconomic Theory 207

 Consumption Sets: Economic Constraints

• The budget set 𝐵𝐵𝑝𝑝,𝑤𝑤 is convex.

– We need that, for any two bundles 𝑥𝑥, 𝑥𝑥𝑥 ∈ 𝐵𝐵𝑝𝑝,𝑤𝑤 ,
their convex combination
𝑥𝑥 ′′ = 𝛼𝛼𝑥𝑥 + 1 − 𝛼𝛼 𝑥𝑥𝑥
also belongs to the 𝐵𝐵𝑝𝑝,𝑤𝑤 , where 𝛼𝛼 ∈ (0,1).

– Since 𝑝𝑝 � 𝑥𝑥 ≤ 𝑤𝑤 and 𝑝𝑝 � 𝑥𝑥′ ≤ 𝑤𝑤, then

𝑝𝑝 � 𝑥𝑥 ′′ = 𝑝𝑝𝛼𝛼𝑥𝑥 + 𝑝𝑝 1 − 𝛼𝛼 𝑥𝑥𝑥
= 𝛼𝛼𝑝𝑝𝑝𝑝 + 1 − 𝛼𝛼 𝑝𝑝𝑝𝑝𝑝 ≤ 𝑤𝑤

Advanced Microeconomic Theory 208

 Appendix 1.1:
Rational Preference Relations
Satisfy the WARP

Advanced Microeconomic Theory 209

 Rational Preferences and WARP
• We can construct the preferences that the individual
“reveals” in his actual choices when he is confronted
to choose an element(s) from different budget sets.
1) If there is some budget set 𝐵𝐵 for which the
individual chooses 𝑥𝑥 ∈ 𝑐𝑐(𝐵𝐵), where 𝑥𝑥, 𝑦𝑦 ∈ 𝐵𝐵, then
we can say that alternative 𝑥𝑥 is revealed at least as
good as alternative 𝑦𝑦, and denote it as 𝑥𝑥 ≿∗ 𝑦𝑦.
2) If there is some budget set 𝐵𝐵 for which the
individual chooses 𝑥𝑥 ∈ 𝑐𝑐(𝐵𝐵) but 𝑦𝑦 ∉ 𝑐𝑐(𝐵𝐵) , where
𝑥𝑥, 𝑦𝑦 ∈ 𝐵𝐵, then we can say that alternative 𝑥𝑥 is
revealed preferred to alternative 𝑦𝑦, and denote it as
𝑥𝑥 ≻∗ 𝑦𝑦.
Advanced Microeconomic Theory 210
 Rational Preferences and WARP
• Let 𝐶𝐶 ∗ (𝐵𝐵, ≿) be the set of optimal choices
generated by the preference relation ≿ when
facing a budget set 𝐵𝐵.
• Using this notation, we can restate the WARP as
follows:
– If alternative 𝑥𝑥 is revealed at least as good as 𝑦𝑦,
then 𝑦𝑦 cannot be revealed preferred to 𝑥𝑥.
– That is, if 𝑥𝑥 ≿∗ 𝑦𝑦, then we cannot have 𝑦𝑦 ≻∗ 𝑥𝑥.

Advanced Microeconomic Theory 211

 Rational Preferences and WARP
• Let us next show that:
Rational preference relation ⟹
Choice structure satisfying WARP
• Proof:
– Suppose that for some budget set 𝐵𝐵 ∈ ℬ, we have
that 𝑥𝑥, 𝑦𝑦 ∈ 𝐵𝐵 and 𝑥𝑥 ∈ 𝐶𝐶 ∗ (𝐵𝐵, ≿).
 That is, 𝑥𝑥 belongs to the set of optimal choices
given the preference relation ≿ when the decision
maker faces a budget set 𝐵𝐵.
– Hence, 𝑥𝑥 ∈ 𝐶𝐶 ∗ 𝐵𝐵′, ≿ ⟹ 𝑥𝑥 ≿ 𝑦𝑦 for all 𝑦𝑦 ∈ 𝐵𝐵.
Advanced Microeconomic Theory 212
 Rational Preferences and WARP
– In order to check WARP, assume some other budget
set 𝐵𝐵′ ∈ ℬ with 𝑥𝑥, 𝑦𝑦 ∈ 𝐵𝐵′ and 𝑦𝑦 ∈ 𝐶𝐶 ∗ (𝐵𝐵′, ≿).
 That is, 𝑦𝑦 belongs to the set of optimal choices given
the preference relation ≿ when the decision maker
faces budget set 𝐵𝐵𝐵.

– Thus, 𝑦𝑦 ∈ 𝐶𝐶 ∗ 𝐵𝐵, ≿ ⟹ 𝑦𝑦 ≿ 𝑧𝑧 for all 𝑧𝑧 ∈ 𝐵𝐵′.

Advanced Microeconomic Theory 213

Rational Preferences and WARP
– Combining the conclusions from the previous two
points, 𝑥𝑥 ≿ 𝑦𝑦 and 𝑦𝑦 ≿ 𝑧𝑧 , we can apply transitivity
(because the preference relation is rational), and
we obtain 𝑥𝑥 ≿ 𝑧𝑧.
– Then 𝑥𝑥 ∈ 𝐶𝐶 ∗ 𝐵𝐵′, ≿ , and we find that
𝑥𝑥, 𝑦𝑦 ∈ 𝐶𝐶 ∗ 𝐵𝐵′, ≿
which proves that WARP is satisfied.

Advanced Microeconomic Theory 214

 Rational Preferences and WARP
• Regarding:
Choice structure satisfying WARP ⟹
Rational preference relation

• It is only true if the budget set 𝐵𝐵 contains three

or fewer elements (See MWG for a proof based
on Arrow (1959)).

Advanced Microeconomic Theory 215