*** Introduction

** Economic Rationality
Consider a decision-maker facing a particular economic situation.
Let
x = (x1, , xn) be a (n1) vector of decision variables
f(x, ) be the (direct) objective function,
= (1, , m) be a (m1) vector of parameters representing the economic
environment
g(x, ) = 0 be a constraint on the choice of x, reflecting technological feasibility
and/or resource scarcity (e.g. budget constraint).
Then, economic rationality is defined by the following optimization problem
L*() = maxx {f(x, ): subject to g(x, ) = 0},
where L*() is the indirect objective function.
Let x*() be the decision rule obtained as the solution of the optimization problem. By
definition, we have L*() = f(x*(), ).
In a given situation , assume that the decision-maker chooses xa.
- We may want to investigate whether or not xa = x*(). In the case where xa
x*(), this corresponds to a lack of economic rationality. If in addition
f(xa, ) < f(x*(), ) = L*(), then a lack of economic rationality implies a
welfare loss for the decision maker. In this context, we may want to know
the welfare implications of actual behavior. This corresponds to normative
economic analysis.
- If we assume that the decision-maker is rational, then xa = x*(). Then the
properties of actual observed behavior xa are the same as the properties of
x*(). In this context, the investigation of actual economic behavior
corresponds to positive economic analysis.
** Measurement
In any empirical economic analysis, it is necessary to obtain measurements on f(x, ) and
g(x, ). We will present the arguments using the utility function f(x, ) = f(x, )
representing the preferences of the decision maker. However, keep in mind that similar
arguments can be presented with respect to the function g(x, ) = g(x, ).
* Ordinal Measurement
The function f(x, ) can be measured based on an ordinal scale. This is a situation where
f(x, ) is defined up to a monotonic increasing transformation
fo(x, ) = F(f(x, )), where F(f) is an increasing function.
o
Then, f and f give representations of the same preference structure.
Note that, under differentiability,
fo/x = (F/f)(f/x),

implying that sign[fo/x] = sign[f/x], since F/f > 0.

Also, in the case where x is a scalar,
2fo/x2 = (F/f)(2f/x2) + (2F/f2)(f/x)2.
Since (2F/f2) can be either positive or negative, it follows that sign[2f/x2] may differ
from sign[2fo/x2]. This implies that sign[2f/x2] is not meaningful.
Example: Consumer theory, where diminishing marginal utility is not meaningful.
* Cardinal Measurement
- Interval scale:
The function f(x, ) can be measured based on an interval scale. This is a situation where
f(x, ) is defined up to a positive linear transformation
fo(x, ) = a + b f(x, ), where b > 0.
Then, fo and f give representations of the same preference structure.
Note that, with a 0, f(x, ) = 0 does not imply fo(x, ) = 0. This implies that zero is not
meaningful.
Under differentiability,
fo/x = b (f/x),
implying that sign[fo/x] = sign[f/x], since b > 0.
Also,
2fo/x2 = b (2f/x2).
Since b > 0, it follows that sign[2f/x2] = sign[2fo/x2]. This implies that sign[2f/x2] is
meaningful.
Examples:
Temperature measurement: C = -160/9 + (5/9) F, where C = degree Celsius and F
= degree Fahrenheit.
Utility function under risk in the expected utility model, where diminishing
marginal utility is meaningful.
- Ratio scale:
The function f(x, ) can be measured based on a ratio scale. This is an interval scale
measurement with a = 0.
fo(x, ) = b f(x, ), where b > 0.
Then, fo and f give representations of the same preference structure.
Note that, with a = 0, f(x, ) = 0 implies fo(x, ) = 0. This implies that zero is
meaningful.

And as in the interval scale measurement, sign[fo/x] = sign[f/x], and sign[2f/x2] =

sign[2fo/x2]. This implies that sign[2f/x2] is meaningful.
Examples:
prices, quantities
revenue, cost, profit
production theory, where diminishing marginal productivity is meaningful.
** Basic Structure
In any empirical economic analysis, it is often useful to make some specific assumptions
about the functions f(x, ) and g(x, ). We will present the arguments using the objective
function f(x, ) = f(x, ) representing the preferences of the decision maker. However,
keep in mind that similar arguments can be presented with respect to the function g(x, ) =
g(x, ).
Assume that the function f(x, ) is twice continuously differentiable. Let
f/x = [f/x1, , f/xn] be a (1n) vector

f/x =
2

2f
x 12
2f
x 2 x 1

2f
x n x 1

2f
x 1x 2
2f
x 22

2f
x n x 2

2f

x 1x n
2f

x 2 x n be a (nn) symmetric matrix.

2
f

x 2n

This implies that 2f/xixj = 2f/xjxi, for all i, j = 1, , n.

* Concavity of f(x, ):
The function f(x, ) is said to be (strongly) concave in x if, for any x,
v [2f/x2] v < 0, for all (n1) vectors v satisfying v 0.
Note: f(x, ) is said to be convex in x if [-f(x, )] is concave in x.
* Quasi-Concavity of f(x, ):
The function f(x, ) is said to be (strongly) quasi-concave in x if, for any x,
v [2f/x2] v < 0, for all (n1) vectors v satisfying (f/x) v = 0 and v 0.
Note: f(x, ) is said to be quasi-convex in x if [-f(x, )] is quasi-concave in x.
Note: A concave (convex) function is always quasi-concave (quasi-convex). However, a
quasi-concave (quasi-convex) function is not necessarily concave (convex). As a
result, concavity (convexity) is a more restrictive assumption than quasi-concavity
(quasi-convexity).
3

** Optimal Behavior
Let x*() be the solution to maxx{f(x, ): subject to g(x, ) = 0}.
Consider the Lagrangean
L(x, , ) = f(x, ) + g(x, ),
where is a Lagrange multiplier.
Assume that
g/x 0 (rank condition -- R)
and

2L

2
(v1 v2) x2
L
x

2L

x
2L
2

v1

< 0, for all scalar v2 and (n1) vector v1 satisfying

v
2

[g/x] v1 = 0, v1 0 (second order condition -- SOC).

Under the rank condition (R) and the second order condition (SOC), the bordered hessian

2L

2
H = x2
L
x

2L

x =
2L

2L
x 2
g
x

'
g

x is a (n+1)(n+1) matrix that is invertible.

Under (R) and (SOC), and assuming an interior solution, the solution x*() necessarily
satisfies the first order condition (FOC)
L/x = 0 (n equations)
and
L/ = 0 (1 equation).
This is a system of (n+1) equations that can be solved for the (n+1) unknown: x*() and
*().
* Comparative Statics
Differentiate the first order condition (evaluated at x*(), *()) with respect to . This
yields
2L/x + (2L/x2)(x*/) + (2L/x)(*/) = 0
and
2L/ + (2L/x)(x*/) + (2L/2)(*/) = 0.
This can be written as

2L 2L

2
x2 x2
L L
x

2L

x
2L
2

x *

* = 0,


4

or

2L

2L
x *
2L

2
x =
x2 H * , where H = x2
2L

L

L

x
2
bordered hessian, or
x *
2L

* H 1 x2 .

L


This gives the properties of the optimal decision rule x*().

2L
x 2
g
x

'
g

x is the

Note: Differentiate g(x, ) = 0 (evaluated at x = x*()) with respect to . This yields

(g/x)(x*/) + g/ = 0.
These are adding-up restrictions that the optimal decision rule x*() must
satisfy.
* Envelop Theorem
Note that
L*() = f(x*(), )
= f(x*(), ) + *() g((x*(), ) (since g(x*(), ) = 0)
= L(x*(), *(), ).
Differentiating this expression with respect to gives
L*/ = (L/x)(x*/) + (L/)(*/) + L/
= L/ since (L/x) = 0 and (L/) = 0 from (FOC).
This gives the envelope theorem:
L*/ = L/, where L(x, , ) is evaluated at x*() and *().
* Primal-Dual Approach
Consider the second order condition (SOC):
v1
< 0, for all scalar v2 and (n1) vector v1, such that [g/x] v1 = 0,
(v1 v2) H
v2
v1 0.
Let v1 = (x*/) w, and v2 = (*/) w, where w is a (m1) vector. Note that (g/x)
(x*/) = -g/ from the adding-up restriction. It follows that [g/x] v1 = 0 implies
[g/] w = 0. This gives
x * /

*
/

w' [(x*/)' (*/)'] H

w < 0, for all vectors w such that [g/] w

= 0, (x*/) w 0.

 2 L

x * /

Using the transpose of the comparative static results 2 H *

yields
L
/

2L

w'
x

2L

x * /

*
/

w > 0, for all w such that [g/] w = 0,

2L

x * /

*
/

w 0, for all vectors w satisfying [g/] w =

(x*/) w 0.

This implies
2L

w'
x
0.

(A1)

Differentiating the envelope theorem L*/ = L/ (where L is evaluated at x*, *) with

respect to gives
2L*/2 = 2L/2 + (2L/x)(x*/) + (2L/)(*/),
or
2L
L / - L/ =
x
2

2L

x * /

*
/

(A2)

Since the left-hand side of (A2) is a (mm) symmetric matrix, it follows that the righthand side of (A2) is also a (mm) symmetric matrix.
Combining (A1) and (A2) yields the primal-dual result:
2L
[ L / - L/ ] =
x
2

2L

x * /

is a (mm) symmetric, positive

*
/

semi-definite matrix "subject to constraint" ([g/] w = 0).

- Case where L(x, , ) is linear in : The linearity of L in implies 2L/2 = 0. It
follows that the indirect objective function L*() has the following property
[2L*/2] is a (mm) symmetric, positive semi-definite matrix "subject to
constraint"
([g/] w = 0).
- Case 1: if g/ = 0, then [2L*/2] is a (mm) symmetric, positive semi-definite
matrix, implying that L* is convex in . Example: the indirect profit
function in production theory.
- Case 2: if g/ 0, then [2L*/2] is a (mm) symmetric, positive semi-definite
matrix subject to constraint, implying that L* is quasi-convex in .
Example: the indirect utility function in consumer theory.
* Some Applications
1- Production Theory
Let
f(x, ) = ' x
x = (n1) vector of netputs (i.e., outputs if positive, and inputs if negative)
= (n1) vector of prices for x

'x = firm profit

g(x) = 0 is a representation of the production function (or production frontier).
We have
L*() = maxx {'x: g(x) = 0}.
where
x*() are the profit maximizing output supply (input demand) functions when
positive (negative)
L(x, , ) = 'x + g(x)
L*() is the indirect profit function.
Note that 2L/x = In, and 2L/ = 0. It follows from the primal-dual result that
[x*/] is a symmetric, positive semi-definite matrix. This means that
xi*/j = xj*/i for all i j, i, j = 1, ..., n (generating (n2 - n)/2 symmetry
restrictions)
and
xi*/i 0 for all i = 1, ..., n, implying that profit maximizing output supply
(input demand) functions are upward-sloping (downward sloping).
The envelope theorem gives
L*/ = x*(), (Hotelling lemma).
Finally, L(x, , ) being linear in with g/ = 0, we have seen above that the indirect
profit function L*() is convex in .
2- Consumer Theory
Let
f(x, ) = f(x) is the utility function representing household preferences
x = (n1) vector of consumer goods
g(x, ) = 0 - 1'x, where ' = (0, 1')
0 > 0 is household income
1 = (n1) vector of prices for x
g(x, ) = 0 - 1'x = 0 is the household budget constraint.
We have
L*() = maxx {f(x): 0 - 1'x = 0}.
where
x*() are the utility maximizing (Marshallian) consumer demand functions
L(x, , ) = f(x) + [0 - 1'x]
L*() is the indirect utility function.
Note that 2L/0x = 0, 2L/1x = - In, and 2L/ = 1. It follows from the
primal-dual result that

 x x * / 1 x * / 0

is a (n+1)(n+1) symmetric, positive semi1 * / 1 * / 0

definite matrix "subject to constraint" ([g/] w = 0).
(A3)
Note that [g/] w = 0 implies w0 - x' w1 = 0, or (w1', w0) = w1' [In, x], where w' = (w1',
w0), w0 being a scalar, and w1 being a (n1) vector. Pre-multiplying the matrix in (A3) by
[In, x] and post-multiplying it by [In, x]' gives
- [x*/1 + (x*/0) x'] is a (nn) symmetric, positive semi-definite matrix,
or, given > 0,
[x*/1 + (x*/0) x'] is a (nn) symmetric, negative semi-definite matrix (A4)
The matrix [x*/1 + (x*/0) x'] is called the Slutsky matrix, measuring "compensated
(or Hicksian) price effects" Equation (A4) states that the Slutsky matrix is symmetric,
negative semi-definite. This means that
xi*/1j + (xi*/0) xj = xj*/1i + (xj*/0) xi for all i j; i, j = 1, ..., n
(generating (n2 - n)/2 symmetry restrictions)
and
xi*/1i + (xi*/0) xi 0 for all i = 1, ..., n, implying that compensated
(Hicksian) demand functions are downward sloping.
I n
0

The envelope theorem gives

L*/0 = *(),
L*/1 = -*() x*().
Assuming that *() > 0, this implies that
x*() = -[L*/1]/[L*/0] (Roy's identity).
Finally, L(x, , ) being linear in with g/ = x, we have seen above that the indirect
utility function L*() is quasi-convex in .
** Additional Structure
Often, one is interested in imposing additional structure in economics, particularly if it
simplifies empirical analysis. One issue then is whether the additional structure may
possibly become "too restrictive" as a representation of the real word.
Again, these restrictions may involve either the function objective function f(x, .) and/or
the constraint g(x, ). For simplicity, we will focus on the function f(x, ), where x =
(x1, ..., xn)' is a (n1) vector.
* Homogeneity
A function f(x) is said to be homogenous of degree k in x if
tk f(x) = f(t x) for any t > 0.
If k = 1, the function is said to be linear homogenous.
If a differentiable function f(x) is homogenous of degree k, then
k f(x) = in1 [(f/xi) xi] (Euler equation).

Proof: Differentiating tk f(x) = f(t x) with respect to t gives

k tk-1 f(x) = in1 [f/(t xi) xi].
Evaluated at t = 1, this yields the desired result.
If a differentiable function f(x) is homogenous of degree k, then f/x is homogenous of
degree
(k-1).
Proof: Differentiating tk f(x) = f(t x) with respect to x gives
tk f/x = f/(t x) t
or
tk-1 f/x = f/(t x),
showing that f/x is homogenous of degree (k-1).
* Homotheticity
A function f(x) is homothetic if
f(x) = F[h(x)],
where F[h] is an increasing function, and h(x) is linear homogenous in x.
If a differentiable function f(x) is homothetic, then MRSij = (f/xi)/(f/xj) is
homogenous of degree zero in x, where MRSij = (f/xi)/(f/xj) is the marginal rate of
substitution between xi and xj. In other words, MRSij(x) = MRSij(t x) for all t > 0. This
means that, for a homothetic function, the marginal rate of substitution is constant along
ray through the origin.
Proof: We have MRSij = (f/xi)/(f/xj). Given f(x) = F[h(x)], it follows that
MRSij = [(F/h)(h/xi)]/[(F/h)(h/xj)]
= (h/xi)/(h/xj).
But h(x) being linear homogenous in x implies that h/x is homogeneous of
degree zero in x. This implies that MRSij = (h/xi)/(h/xj) is also homogenous
of degree zero in x, i.e. that
MRSij(x) = MRSij(t x) for all t > 0.
Note: A homogenous function is always homothetic. However, a homothetic function is
not necessarily homogenous. Thus, homogeneity is a stronger restriction than
homotheticity.
* Weak Separability
Let x = (x11, ..., x1,n1; x21, ..., x2,n2; ...; xK1, ..., xK,nK).
A function f(x) is said to be weakly separable into K groups if
f(x) = F[X1(x11, ..., x1,n1), X2(x21, ..., x2,n2), ..., XK(xK1, ..., xK,nK)],
where F/Xk 0 for k = 1, ..., K
Xk(xk1, ..., xk,nk) is an "aggregator function" for the k-th group, k = 1, ..., K.
If a function f(x) is weakly separable, then
MRSki,kj = (f/xki)/(f/xkj) is independent of xk'm for all k' k.
9

Proof: We have MRSki, kj = (f/xki)/(f/xkj). The definition of weak separability implies

(f/xki)/(f/xkj) = [(F/Xk)(Xk/xki)]/[(F/Xk)(Xk/xkj)]
= (Xk/xki)/(Xk/xkj), which is independent of xk'm for all k' k.
It follows that MRSki, kj is independent of xk'm for all k' k.
This implies that
MRSki,kj/xk'm = 0 for all k' k, and for all i, j and m.
In other words, under weak separability, the marginal rate of substitution among
commodities within a group is independent of the commodities outside this group.
* Strong Separability
Let x = (x11, ..., x1,n1; x21, ..., x2,n2; ...; xK1, ..., xK,nK).
A function f(x) is said to be strongly separable into K groups if
f(x) = F[ K
k 1 Xk(xk1, ..., xk,nk)],
where F/Xk 0
Xk(xk1, ..., xk,nk) is an "aggregator function" for the k-th group, k = 1, ..., K.
If a function f(x) is strongly separable, then
MRSki,k'j = (f/xki)/(f/xk'j) is independent of xk"m for all k" (k or k').
Proof: We have MRSki, k'j = (f/xki)/(f/xk'j). The definition of strong separability
implies
(f/xki)/(f/xk'j) = [(F/Xk)(Xk/xki)]/[(F/Xk')(Xk'/xkj)]
= (Xk/xki)/(Xk'/xk'j), (since F/Xk = F/Xk'), which is
independent of xk"m for all k" (k or k').
It follows that MRSki, k'j is independent of xk"m for all k" (k or k').
This implies that
MRSki,k'j/xk"m = 0 for all k" (k or k'), and for all i, j and m.
In other words, under strong separability, the marginal rate of substitution among
commodities within any two groups is independent of the commodities outside these two
groups.
** Duality
* Let f(x) be an increasing, quasi-concave function in x (e.g., a production function or
a utility function).
1/ Let V(0, 1) = maxx0{f(x): subject to 1' x 0}, where 1 is the vector of prices for
x.
When f(x) is a utility function and 0 is consumer income, then V(0, 1) is an
indirect utility function. In general, V(0, 1) is homogenous of degree zero and
quasi-convex in = (0, 1). And it satisfies Roy's identity x*() = -(V/1)/
(V/0).
2/ Let C(1, y) = minx0{1' x: subject to y f(x)}.

10

When f(x) is a production function and y is an output, then C(1, y) is a cost

function. When f(x) is a utility function and y is a utility level, then C(1, y) is an
expenditure function. In either case, C(1, y) is linear homogenous and concave
in 1. And it satisfies the envelope result x*() = C/1 (Shephard's lemma).
3/ Let D(x, y) = 1 be the implicit solution of f(x/D) = y (and vice versa). The function
D(x, y) is called a radial distance function. It is linear homogenous in x.
4/ Let B(x, y) = Max {: f(x g) y: subject to x g 0}, where g is a reference
bundle satisfying g 0, g 0. When f(x) is a production function and y is an
output, then B(x, y) is a directional distance function: it measures the distance (in
the direction g) between x and the frontier isoquant associated with y. When f(x)
is a utility function and y is a utility level, then B(x, y) is a benefit function: it
measures the willingness-to-pay (in number of units of the reference bundle g) to
reach utility y starting from bundle x. In either case, B(x, y) is concave in x.
5/ Note that C(1, y) = 0 is the implicit solution of V(C, 1) = y. And V(0, 1) = y is the
implicit solution of C(1, y) = 0.
6/ Note that
f(x) = min10{V(0, 1): subject to 1 x = 0}.
7/ Finally, note that
C(1, y) = minx0 {1 x B(x, y) (1 g)}
B(x, y) = min10 {1 x C(1, y): subject to 1 g = 1}
It follows that, when f is increasing and quasi-concave, the functions f, V, C, B and D are
dual to each others in the sense that knowing one is equivalent to knowing the others.
* Let f(x) be an increasing, concave function in x (e.g., a production function).
1/ Let (p, 1) = maxx0,y{p y - 1' x: subject to y f(x)} (profit maximization).
Then (p, 1) is an indirect profit function. It is homogenous of degree one and
convex in prices (p, 1). And it satisfies Hotelling's lemma: /p = y*(p, 1), and
/1 = -x*(p, 1).
2/ Finally, note that
f(x) = min10 {(p, 1)/p + 1' x/p}, where (p, 1)/p is the "normalized profit
function".
It follows that, when f is increasing and concave, the functions , f, V, C, B and D are
dual to each other in the sense that knowing one is equivalent to knowing the others.
Note: Production theory makes use of the functions , f, C, B and D. For example, by
duality, technology can be represented by the production function f, by the cost

11

function C, by the distance functions B or D, or by the profit function . And

consumer theory makes use of the functions f, V, C, B and D.

12