mortorella

Chapter Two
Introduction to the Theory of Consumer Behavior
2.1 UTILITY
Consumer theory relies only on the assumption that consumers can provide relative
rankings of market baskets. It is often useful to assign numerical values to individual
baskets. Using this numerical approach, it is possible to describe consumer
preferences by assigning scores to the levels of satisfaction associated with each
indifference curve. Generally, the word utility means benefit or well-being.
In the language of economics, the concept of utility refers to the numerical score
representing the satisfaction that a consumer gets from a market basket. In
other words, utility is a device used to simplify the ranking of market baskets. Ex: If
buying three copies of a textbook gives, you more pleasure than buying one shirt,
then it is said that the books give you more utility than the shirt.
2.1.i UTILITY FUNCTIONS
A utility function is a formula that assigns a level of utility to each market basket. For
example, that a consumers utility function for food (F) and clothing (C) is
u(F,C,)=F+2C. In this case, a market basket consisting of 8 units of food and 3 units
of clothing generates a utility of 8 + (2) (3) = 14. Consumer is therefore indifferent
between this market basket and a market basket containing 6 units of food and 4
units of clothing (6+(2)(4) = 14).
Not all kinds of preferences can be represented by a utility function. For example,
suppose someone had intransitive preferences so that A B C A . Then a utility
function for these preferences would have to consist of numbers u(A), and u(B) and
u(C) such that u(A)>u(B)>u(C)>u(A). However, this is impossible. So such kind of
perverse cases not considered for construction of utility function.
The figure 1 and illustration gives the details of constructing a utility function. A utility
function is a way to label the indifference curves such that higher indifference curves
get larger numbers. To do this, draw the diagonal line illustrated and label each
indifference curve with its distance from the origin measured among the curve.
How do you know this as a utility function? It is not difficult to see that preferences
are monotonic then the line through the origin must intersect every indifference curve
exactly once. Thus, every bundle is getting larger labels and that is all it takes to be
a utility function. This is one way to find labeling of indifference curves, at least as
long as preferences are monotonic. This at least shows that ordinal utility function is
quite general: nearly any kind of reasonable preferences can be represented by a
utility function.

X2

Measures
distance
from origin

Indifferenc
e curves

X1
2.1.ii ORDINAL UTILITY
A utility Figure
function
that generates
in order
of most to least preferred of market
1: Constructing
a utilityranking
function from
indifference
baskets curves.
is called
ordinalline
utility
function.
In fact, numerical values are arbitrary,
Drawan
a diagonal
and label
each indifference
interpersonal
comparisons
utility
curve with
how fat it isoffrom
the are
originimpossible.
measured along
The only
property
of
a
utility
assignment
that is important is how it orders the
the line.
bundles of goods. The magnitude of the utility function is only important insofar as it
ranks the different consumption bundles; the size of the utility difference between any
two consumption bundles does not matter. Because of this emphasis on ordering
bundles of goods, this kind of utility is referred to as ordinal utility.
Consider the following table 1. where several different ways of assigning utilities to
three bundles of goods is illustrated, all of which order the bundles in the same way.
In this example, the consumer prefers A to B and B to C. All of the way indicated are
valid utility functions that describe the same preferences because they all have the
property that A is assigned a higher number than B, which in turn in assigned a
higher number than C.
Table : 1 Different ways to assign utilities.
Bundles U1
U2
U3
A
3
17
-1
B
2
10
-2
C
1
0.002
-3
Since only the ranking of the bundles matters, there can be no unique way to assign
utilities to bundles of goods.
2.1. iii CARDINAL UTILITY
A utility function that describes by how much one market basket is preferred to
another is called cardinal utility function. Unlike ordinal utility functions, a cardinal
utility function attaches to market baskets numerical values that cannot arbitrarily be
doubled or tripled without altering the differences between values of various market
baskets.
There are some theories of utility that attach a significance to the magnitude of utility.
These are known as cardinal utility theories. In a theory of cardinal utility, the size of
the utility difference between two bundles of goods is supposed to have some sort of
significance.
In fact, there is no hard and fast rule to measure utility. It is almost not possible to
say, whether a person gets twice as much satisfaction from one market value as from
another. Not it is not known whether one person gets twice as much satisfaction as
2

another from consuming the same basket. In fact as far as theory is concerned this
constraint is not important. Because the objective is to understand consumer behavior
all that matters is knowing how consumers rank different baskets.
2.1. iv Marginal Utility
Consider a consumer who is consuming some bundle of goods, (x 1,x2). How does this
consumers utility change as we give a little more of good 1? This rate of change is
called the marginal utility with respect to good 1. We write it as MU 1 and think of it
as being ratio,
U u ( x1 x1 , x2 ) u ( x1 , x2 )
MU1

x1
x1
That measures the rate of change in utility (U) associated with a small change in the
amount of good 1 (x1). Good 2 is held fixed.
This definition implies that to calculate the change in utility associated with a small
change in consumption of good1, just multiply the change in consumption by the
marginal utility of the good.
U = MU1X1.
The marginal utility with respect to good 2 is defined in a similar manner:
U u ( x1 , x2 x2 ) u ( x1 , x2 )

x2
x2
When computing the marginal utility with respect to good 2 keep the amount of good
1 constant. We can calculate the change in utility associated with a change in the
consumption of good2 by the formula
U = MU2X2.
Marginal utility depends on the particular utility function that we use to reflect the
preference ordering and its magnitude has no particular significance.
MU 2

Because of conceptual problems, economists have abandoned the old-fashioned view

of utility as being a measure of happiness. Instead the theory of consumer behavior
has been reformulated entirely in terms of consumer preferences, and utility is seen
only a s a way to describe preferences.
2.1.ii. Indifference Curves
Consumer preferences are graphically shown with the use of indifference curves.
Definition: An indifference curve represents all combinations of market
baskets that provide a consumer with the same level of satisfaction.
Given the three assumptions about preferences, it is known that a consumer can
always indicate either a preference for one market basket over another or indifference
between the two. By using this information, it is possible to rank all potential
consumer choices. In order to appreciate this principle in graphic form, assume that
there are only two goods available for consumption: food F and clothing C. In this
case, all market baskets describe combinations of food and clothing that a person
might wish to consume. The following table provides baskets containing various
amounts of food and clothing.
3

Table1. Alternative Market Baskets for Food and Clothing.

MARKET
BASKET
A

20

UNITS OF
CLOTHING
30

B
D
E
G

10
40
30
10

50
20
40
20

10

40

UNITS OF FOOD

The following figure shows the same baskets listed in the table above.
Figure 1 Describing Individual Preferences
Clothin
g

*B

50
*H
*E

40

30

*A
10

20

40

20

30

Food
(Units perWeek)

*G
The horizontal
axis measures the number of units of food purchased each week; the
*D
10
vertical
axis
measures
the number of units of clothing. Market basket A, with 20 units
(Units/
ofweek)
food and 30 units of clothing, is preferred to basket G because A contains more
food and more clothing (third assumption non-satiation). Similarly, market basket E,
which contains even more food and even more clothing preferred to A. In fact, it is
easy to compare all market baskets in the two shaded areas (such as E and G) to A
because they all contain either more or less of both food and clothing. Note, however,
that B contains more clothing but less food than A. Likewise, D contains more food
but less clothing than A. Therefore, comparisons of market baskets A with baskets B,
D, and H are not possible without more information about the consumers ranking.

The following figure 2 shows an indifference curve, labeled U1, that passes through
points A, B, and D. This curve indicates that the consumer is indifferent among these
three market baskets.
It shows that in moving from market basket A to market basket B, the
consumer feels neither better nor worse off in giving up 10 units of food to 20 units of
clothing. Likewise, the consumer is indifferent between points A and D. He or she will
give up 10 units of clothing to obtain 20 units of food. On the other hand, consumer
prefers A to H, which lies below u1.
4

Indifference curve in the figure 2 slopes downwards from left to right. To understand
why this must be the case, suppose instead it sloped upward from A to E. This would
violate the assumption that more of any commodity is preferred less. Because
market basket E has more of food and clothing than market basket A, it must be
preferred to A and therefore cannot be on the same indifference curve as A. In fact,
any market basket lying above to the right of indifference curve u 1 in figure 2 is
preferred to any market basket on u1.

Figure 2 AN INDIFFERENCE CURVE

Clothing
(Units/week)
50
40

*B

30
*H

*E

20
10
*A
10
20
40 Food

30Food
(Units per
week)

*G
*D
u1
2.1.iii. CHARACTERISTICS
OF INDIFFERENCE CURVES
Indifference curves have certain characteristics that reflect assumptions about
consumer behavior. In fact, one of the major uses of indifference curves is to examine
the kinds of consumer behavior implied by different preferences, prices, and incomes.
For simplicity, assume there are only two goods, Food and Clothing.
1. An indifference curve passes through each point in the commodity space.
2. Indifference curves cannot intersect.
3. Indifference curves are negatively sloped.
4. Indifference curves are convex in shape.
5. The higher or further to the right is an indifference curve, the higher the bundles
on
that curve are in the consumers preference ordering, that is, baskets on
higher indifference curves re preferred to bundles on lower indifference curves.
5

2.1.iv. THE MARGINAL RATE OF SUBSTITUTION (MRS)

To quantify the amount of one good that a consumer will give up to obtain more of
another, we use a measure called the marginal rate of substitution (MRS). The MRS of
food F for clothing C is the amount of clothing that a person is willing to give up to
obtain one additional unit of food. Suppose, for instance, the MRS is 3. This means
that the consumer will give up 3 units of clothing to obtain 1 additional unit of food. If
the MRS is 1/2, the consumer is willing to give up only unit of clothing. Thus, the
MRS measures the value that the individual places on 1 extra unit of one good in
terms of another.
Figure 3. The Marginal Rate of Substitution
A

Cloth 16
Units/wee

-6

10
1
-4

06

D
1

04

-2

-1

02

5 Food Units/week

In figure 3 note that clothing appears on the vertical axis and food on the horizontal
axis. When we describe the MRS, we must be clear about which good we are giving
up and which we are getting more of. We define MRS in consistent terms as the
amount of the good on the vertical axis that the consumer is willing to give
up to obtain 1 extra unit of the good on the horizontal axis. In figure 3 the MRS
refers to the amount of clothing that the consumer is willing to give up to obtain an
additional unit of food. If we denote the change in clothing buy C and the change in
food by F, the MRS can be written as -C/F. We add the negative to make the
marginal rate of substitution a positive number (C is always negative; the consumer
give up clothing to obtain additional food.)
Thus, the MRS at any point is equal in magnitude to the slope of the indifference
curve. In Figure 3 for example, the MRS between points A and B is 6: The consumer
is willing to give up 6 units of clothing to obtain 1 additional unit of food. Between
points B and D, however, the MRS is 4: With these quantities of food and clothing, the
consumer is willing to give up only 4 units of clothing to obtain 1 additional unit of
food.
CONVEXITY Also observe in figure 3 that the MRS falls as we move down the
indifference curve. This is not a coincidence. This decline in the MRS reflects an
important characteristic of consumer preferences. To understand this, we will add an
additional assumption regarding consumer preferences to the three that we discussed
earlier in the chapter:
2.1.v Diminishing marginal rate of substitution: (Assumption 4 of Consumer
Preferences) Indifference curves are convex or bowed inward. The term convex
6

means that the slope of the indifference curve increase (i.e., becomes less negative)
as we move down along the curve. In other words, an indifference curve is convex if
the MRS diminishes along the curve. The indifference curve in Fig 3 is convex. As we
have seen, starting with market basket A in Figure and moving to basket B, the MRS
of Food F for Clothing C is -C/F = -(-6)/1 = 6. However, when we start at basket B
and move from B to D, the MRS fall to 4. If we start at basket D and move to E, the
MRS is 2. Starting at E and moving to G, we get an MRS of 1. As food consumption
increases, the slope of the indifference curve falls in magnitude. Thus the MRS also
falls. (With non-convex preferences, the MRS increases as the amount of the good
measured on the horizontal axis increases along any indifference curve. This unlikely
possibility might arise if one or both goods are addictive. For example, the willingness
to substitute an addictive drug for other goods might increase as the use of the
addictive drug increased).
Is it reasonable to expect indifference curves to be convex? Yes, as more and more of
one good is consumed, we can expect that a consumer will prefer to give up fewer
and fewer units of a second good to get additional units of the first one. As we moved
down the indifference curve in figure 3 and consumption of food increases, the
additional satisfaction that a consumer gets from still more food will diminish. Thus,
he will give unless and less clothing to obtain additional food.
Another way of describing this principle is to say that consumers generally prefer
balanced market baskets to market baskets that contain all of one good and none of
another. Note from Figure 3 that a relatively balanced market basket containing 3
units of food and 6 units of clothing (basket D) generates as much satisfaction as
another market basket containing 1 unit of food and 16 units of clothing (Basket A). It
follows that a balanced market basket containing (for example) 6 units of food and 8
units of clothing will generate a higher level of satisfaction.
2.1.vi. PERFECT SUBSTITUTES AND COMPLIMENTS
The shape of an indifference curve describes the willingness of a consumer to
substitute one good for another. An indifference curve with a different shape implies a
different willingness to substitute.
The goods are substitutes when an increase in the price of one leads to an increase
in the quantity demanded of the other. In general, perfect substitutes when the
marginal rate of substitution of one for the other is a constant. The indifference
curves describing the trade-off between the consumption of the goods are straight
lines. The slope of the indifference curves need not be-1 in the case of perfect
substitutes. For more illustration, see the fig 3.a.
This fig 3.a shows preferences of a consumer for apple juice and orange juice. These
two goods are perfect substitutes for a consumer because he is entirely indifferent
between having a glass of one or the other. In this case, the MRS of apple juice for
orange juice is 1: consumer is always willing to trade 1 glass of one for 1 glass of the
other.
Goods are compliments when an increase in the price of one leads to a decrease in
the quantity demanded of the other. Two goods are perfect compliments when the
indifference curves for both are shaped as right angles. The following figure 3.b
illustrates a consumer preferences for left shoe and right shoe. For a consumer, the
7

two goods are perfect complements because a left shoe will not increase her
satisfaction unless he/she can obtain the matching right shoe. In this case, the MRS
of left shoes for right shoes is zero whenever there are more right shoes than left
shoes; consumer will not give up any left shoes to get additional right shoes.
Correspondingly, the MRS is infinite whenever there are more left shoes than right
because consumer will give up all but one of his/her excess left shoes than obtain an
additional right shoe.
Fig. 3.a Perfect substitutes
Apple Juice
(glasses)
4

4
Orange Juice (glasses)

2
3.b. Perfect
Compliments.

Apple Juice
1

(glasses)
4

3
4
Orange Juice

(glasses)
Bads so
far, all the examples mentioned above have involved only commodities that
have been considered as goods i.e., cases in which more of a commodity is
preferred to less. But in the world there are also bad commodities which are preferred
by certain
groups of consumers. Bads are those commodities less of them is preferred
2
to more. Air Pollution and asbestos in housing insulation are some of the examples of
this kind of commodities.
To analyze the consumer preferences for these
commodities, they have to be redefined under study so that the consumer tastes are
represented as the preference for less of the bad. This reversal turns the bads into
goods. For instance, instead of preference for air pollution, it can be discussed as the
1
preference
for clean air, which can measure the degree of reduction in air pollution.
Similarly, instead of referring to asbestos as a bad, it can be referred to
corresponding good, the removal of asbestos.

With this simple adaptation, all four of the basic assumptions of consumer theory
continue to hold.
2.2 BUDGET CONSTRAINTS
The budget constraints are that consumers face because of their limited incomes.
People are compelled to determine their behavior in light of limited financial
resources. For the theory of consumer behavior, this means that each consumer has a
maximum amount that can be spent per period of time. The consumers problem is to
spend this amount in the way they yield maximum satisfaction.
The Consumption Basket of a consumer (x 1,x2) is simply a list of two numbers that
tells us how much the consumer is choosing to consume of good 1, x 1, and how much
the consumer is choosing to consume of good 2, x 2. Sometimes it is convenient to
denote the consumers bundle by a single symbol like X, where X is simply an
abbreviation for the list of two numbers (x1,x2).
We suppose that we can observe the prices of the two goods, (p 1,p2) and the amount
of money the consumer has to spend m, then the budget constraint of the consumer
can be written as
p1x1 + p2x2 < m -------------------------------------------------(1)
Here p1x1 is the amount of money the consumer is spending on good 1, and p 2x2 is
the amount of money the consumer is spending on good 2. The budget constraint of
the consumer requires that the amount of money spent on the two goods be no more
than the total amount the consumer has to spend. The consumers affordable
consumption bundles are those that do not cost any more than m.
i. Two Goods Are Often Enough.
The two-goods assumption is more general. Because it is often interpreted as one of
the goods are representing everything else the consumer might want to consume. For
example, if we are interested in studying a consumers demand for milk, let x1
measure his or her consumption of milk in quarts per month. Then let x 2 stand for
everything else the consumer might want to consume.
When you adopt this interpretation, it is convenient to think of good 2 as being the
money that the consumer can use to spend on other goods. Under this interpretation,
the price of good 2 will automatically be 1, since the price of one birr is one birr. Thus,
the budget constraint will take the form
p1x1+x2 < m -------------------------------------------------------(2)
This expression simply says that the amount of money spent on good 1, p 1x1, plus the
amount of money spent on all other goods, x 2, must be no more than the total
amount of money the consumer has to spend, m.
Good 2 represents a composite good that stands for everything else that the
consumer might want to consume other than good 1. Such a composite good is
invariably measured in birr to be spent on goods other than good 1. As far as the
algebraic form of the budget constraint is concerned, equation (2) is just a special
case of the formula given in the equation (1)., with p 2 = 1, so everything that we
9

have to say about the budget constraint in general will hold under composite good
interpretation.
ii. Properties of the Budget Set.
The budget line is the set of bundles that cost exactly m:
p1x1 + p2x2 = m----------------------------------------------(3)
These are the bundles of goods that just exhaust the consumers income. The budget
set is depicted in Fig 1. The heavy line is the budget line the bundles that cost
exactly m and the bundles below this line are those that cost strictly less than m.
Figure 1 Budget Line.

X2
Vertical
intercept = m/p2
Budget line;
slope = -p1/p2

Horizontal Intercept = m/p1

X1

Fig . 1

The budget set consists of all bundles that are affordable at the given prices and
income.
Rearrange the budget line in equation (3) to get the formula
x2 = m/p2 p1/p2 * x1 ----------------------------------------------------(4)
This is the formula for a straight line with a vertical intercept of m/p 2 and a slope of
p1/p2. The formula tells how many units of good 2 the consumer needs to consume in
order to just satisfy the budget constraint if he or she consuming x 1 units of good 1.
The slope of the budget line measures the rate at which the market is willing to
substitute good 1 for good2. For example that the consumer is going to increase her
consumption of good 1 by x1.
How much will consumption of good 2 have to change in order to satisfy her budget
constraint?
p1x1 + p2x2 = m
and

p1(x1+x1) + p2(x2+x2) = m.

Subtracting the first equation from the second gives

10

p1x1 +p2x2 = 0.
This says that the total value of the change in consumption must be zero. Solving for
x2/x1, the rate at which good 2 can be substituted for good 1 while still satisfying
the budget constraint, gives
x2
p
1
x1
p2

This is just slope of the budget line. The negative sign is there since x 1 and x2 must
always have opposite signs. Because consumption of more of good1 leads to
consumption of less of good 2 and vice versa, as long as the consumer continue to
satisfy the budget constraint.
iii. How the Budget Line Changes
When prices and incomes change, the set of goods that a consumer can afford
changes as well. To find out, how these changes affect budget set? First consider
changes in income. It easy to see from equation (4) that all increase in income will
increase the vertical intercept and not affect the slope of the line. Thus an increase in
income will result in a parallel shift outward of the budget line as in the following
figure 2. Similarly, decrease in income will cause a parallel shift inward.
X2
m/p1
m/p2

m/p1

m/p1

X1

Fig. 2

To identify changes in prices? First, consider increasing price 1 while holding price 2
and income fixed. According to equation (4) increase in p1 will not change the
vertical intercept, but it will make the budget line steeper since p1/p2 will become
larger.

X2
m/p2

Budget Lines

Slope =
-p1/p2

Slope = -p1/p2

11

m/p` 1

m/p1

X1

Fig. 3
Increasing Price. If good 1 becomes more expensive, the
budget
becomes
What happens to
the line
budget
linesteeper.
when we change the prices of good 1
the same time? For example, if the prices of both goods 1 and 2 gets
the horizontal and vertical intercepts shift inward by a factor of
therefore the budget line shifts inwards by one-half as well. Multiplying
two is just like dividing income by 2.

and good 2 at
doubled, both
one-half, and
both prices by

To show this algebraically. Suppose our original budget line is

p1x1 + p2x2 = m
Now suppose that both prices become t times as large. Multiplying both prices by t
yields
tp1x1 +t p2x2 = m
However, this equation is same as
p1x1 + p2x2 = m/t.
Thus multiplying both prices by a constant amount t is just like dividing income by the
same constant t. It follows that if we multiply both prices by t and we multiply income
by t. then budget line will not change at all.
What happens if both prices go up and incomes go down?
If m decreases, p1, and p2 both increase, then the intercepts m/p1 and m/p 2 must
both decrease. This means that the budget line will shift inward. How about the slope
of budget line? If price 2 increases more than price 1, so that p 1/p2 decreases ( in
absolute value) then the budget line will be flatter; if price 2 increases less than 1,
the budget line will be steeper.
The budget line is defined by two prices and one income, but one of these variables is
redundant. We could peg one of the prices, or the income, to some fixed value, and
adjust the other variables to describe exactly the same budget set. Thus the budget
line
p1x1 + p2x2 = m
exactly the same budget line as
p1/p2. x1+x2 =m/p2
or
p1/m. x1 +p2/m. x2 = 1.
Since the first budget line results from dividing everything by p 2, and the second
budget line results from dividing everything by m. In the first case, we have pegged
12

p2 = 1, and in the second case, we have pegged m = 1. Pegging the price of one of
the goods or income to 1 and adjusting the other prices to 1, as we did above we
often refer to that as the numeraire price. The numeraire price is the price relative
to which we are measuring the other price and income. It will occasionally be
convenient to think of one of the goods and being a numeraire good, since there will
then be one less price to worry about.
2.3 CONSUMER PREFERENCES
The theory of consumer behavior begins with three basic assumptions about peoples
preferences for one market basket versus another. These assumptions hold for most
people in most situations.
2.3.i. Assumptions:
1. Completeness: Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets. Thus, for any two market
baskets A and B, a consumer will prefer A to B, will prefer B to A, or will be indifferent
between the two. By indifferent we mean that a person will be equally satisfied with
either basket. Note that these preferences ignore costs. A consumer might prefer
steak to hamburger but by hamburger because it is cheaper.
2. Transitivity: Preferences are transitive. Transitivity means that if a consumer
prefers basket A to basket B and basket B to basket C, then the consumer also
prefers A to C. For example, if a Ford is preferred to a Toyota and a Toyota to a
Chevrolet, then Ford is also preferred to a Chevrolet. Transitivity is normally regarded
as necessary for consumer consistency.
3. More is better than less (Nonsatiation): Goods are assumed to be desirable
i.e., to be good. Consequently, consumers always prefer more of any good to less. In
addition, consumers are never satisfied or satiated; more is always better, even if
just a little better. This assumption is made for academic reasons; namely, it
simplifies the graphical analysis. Of course, some goods such as air pollution may be
undesirable, and consumers will always prefer less.
These three assumptions form the basis of consumer theory. They do not explain
consumer preferences, but they do impose a degree of rationality and reasonableness
on them.

2.4 CONSUMER CHOICE

Given preferences and budget constraints, it is possible to determine how individual
consumers choose how much of each good to buy. The basic assumption is that
consumers make this choice in a rational way that they choose goods to maximize
the satisfaction they can achieve, given the limited budget available to them.
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of goods and services.
13

These two conditions reduce the problem of maximizing consumer satisfaction to one
of picking point on the budget line.
We can graphically illustrate the solution to the consumers choice problem.

U3

U1

Clothing

D
B

Budget line
A

Indifference curve
U2

Food
Fig 1 Maximizing consumer satisfaction.
The above figure 1 shows how the problem is solved. Here, three indifference curves
describe a consumers preferences for food and clothing. Remember that of the three
curves, the outer most curve u3, yields the greatest amount of satisfaction, curve
u2the next greatest amount, and curve u1 the least.
The point B on indifference curve u 1 is not the most preferred choice, because a
reallocation of income in which more is spent on food and less on clothing can
increase the consumers satisfaction. In particular, by moving to point A, the
consumer spends the same amount of money and achieves the increased level of
satisfaction associated with indifference curve u2 like the basket associated with D on
indifference curve u3, achieve a higher level of satisfaction but cannot be purchased
with the available income. Therefore, A maximizes the consumers satisfaction.
*If you know the consumer choices that a consumer made, how to determine his
preferences?
REVEALED PREFERENCES THEORY
The basic idea is simple. If a consumer chooses one market basket over another, and
if the chosen market basket is more expensive than the alternative, then the
consumer must prefer the chosen market basket.
L1
X2

*
(Y1,Y2)

(X1,X2)

14

Consider figure 2 where a consumers demanded bundle (x 1, x2) and another arbitrary
Preferences:
Two Budget Lines
X1 line are depicted. The bundle (y 1,
bundle Figure
(y1, y22.) Revealed
i.e., beneath
the consumers
budget
The
bundle
(x1,x2),
that
the
consumer
chooses
is
revealed
preferred
to the bundleconsumer could have
y2) is certainly an affordable purchase at the given budget-the
(y1,y2),
bundle
that he could
have
chosen.
boughtait,
if preferred,
and
would
even have had money left over. Since (x1, x2) is the
optimal bundle, it must be better than anything else that the consumer could afford.
Hence, in particular it must be better than (y1, y2).
The same argument holds for any bundle on or underneath the budget line other than
the demanded bundle. Since it could have been bought at the given budget but was
not, then what was bought must be better. Here is where we use the assumption that
there is a unique demanded bundle for each budget. If preferences are not strictly
convex, so that indifference curves have flat spots, it may be that some bundles that
are on the budget line might be just as good as the demanded bundle.
In figure 2 all of the bundles underneath the budget line are revealed worse than the
demanded bundle (x1, x2). This is because they could have been chose, but were
rejected in favor of (x1, x2).
Let (x1, x2) be the bundle purchased at prices (p 1, p2) when the consumer has income
m.
p1 y1 p2 y2 m.

Since (x1, x2) is actually bought at the given budget, it must satisfy the budget
constraint with equality
p1 x1 p2 x2 m .

Putting these two equation together, the fact that (y 1, y2) is affordable at the budget
(p1, p2, m) means that
p1 x1 p2 x2 p1 y1 p2 y2 .

If the above inequality is satisfied and (y 1, y2) is actually a different bundle from (x 1,
x2), then (x1, x2) is directly revealed to (y1, y2).
Important point is that the left hand side of this inequality is the expenditure on the
bundle that is actually chosen at prices (p 1, p2). Thus, revealed preference is a
relation that holds between the bundle that is actually demanded at some budget and
the bundles that could have been demanded at that budget. When we say that X is
revealed preferred to Y, it means that X is chosen when Y could have been chose; that
is, that
p1 x1 p2 x2 p1 y1 p2 y2

15

Optimum of the Consumer

A consumer is said to be at optimum when he/she maximizes utility subject to income
constraint.
Consider U = f(x), price of Px.
The consumer can either buy an additional unit of X or keep the income, which was to
be spent on that additional unit of X unspent. Both give some satisfaction to the
consumer. To determine the optimum of the consumer will need to compare the MU x
and Px.
MUx
Px

which the consumer will have to pay.

What the consumer has to pay.

MUx > Px
good of X.

the consumer can raise his/her satisfaction by purchasing more units of

MUx <Px
consumption of x.

The consumer can raise his level of satisfaction by reducing

MUx = Px
Optimum of the consumer. When the utility function of the consumer
contains more than one good. U = f (x 1,x2,.xn). The optimum of the consumer
receives the following conditions to be fulfilled.
The condition.

MU x1 MU 2
MU xn

.....
Px1
Px 2
Pxn

MU x1
The satisfaction the consumer derives by spending one unit of money x 1.
PX 1
Spending one unit of money should result in the same satisfaction regardless of the
good it is spent on. If spending one unit of money results in higher satisfaction when
it is spent on x1 compared to other goods. The consumer can raise his satisfaction by
spending more on x1 and less on other unit the above condition is fulfilled.

Appendix: Mathematical Derivation of Optimum of Consumer

Though the measurement of marginal utility is unnecessary the optimality condition.
We arrive at through the ordinal approach is the same that of the cardinal approach.
Mathematically the optimum of the consumer can be derived by maximizing the utility
subject to the budget constraint.
max.u(x1 . x2)
subject to P1X1+P2X2 < m to combine the two use what is called a Langragean
function.
L = U (X1/X2) (P1X1+P2X2 m)
16

The Lagrangian theorem states that the optimum of the consumer should fulfill the
following three first order conditions.
L
u

P1
X
x1

Condition 1.

L
u

P2 0
X 2
x2

Condition 2.

L
P1 X 1 P2 X 2 m 0
L

Condition 3.

From (1)
From (2)

MUX1 = P1
MUX2 = P2

MUX1
MUX 2
,

P1
P2
MUX 1 MUX 2

P1
P2

for the Cobb-Douglas utility function

u (X1.X2) = X1c X2d
MUX 1 c X 2 MUX 1 c X 2 P1

MUX 2
d X 1 MUX 2 d X 1 P2

P2cX2=P1dX1
P1dX 1
P2cX 2
X1
P2c
P1d
From (condition 3)
X2

P1 X 1 P2 X 2 m 0

P1

( P2cX 2 )
P cX
P2 X 2 m 0 where X 1 2 2
P1d
P1d

P2cX 2
P2 X 2 m 0
d

( P2c P )
.x2 m
d
X1

c
m
.
c d p1

17

X2

d
m
.
c d p2

The proposition of income spent on x1 at the consumer optimum.

P1 X 1 P1
c m
c
(
. )
m
m c d P1
cd
P2 . X 2 P2 d m
d
(
. )
m
m c d p2
cd
a

The % of income which is spent on the X1.

Proposition of m spent on X1 and

X2 respectively.
The % of income which is spent on X2.

1 a

U ( X 1. X 2 ) X 1 X 2
a

in the proportion of m spent on X1

1-a

in the proportion of m spent on X2

U = f (X1,X2,..,Xn)
MUX 1 MUX 2
MUX n

..........
P1
P2
Pn

U ( X 1 , X 2 ,.......... X n ) ( P1 X 1 P2 X 2 .......Pn X n )
n 1

Example:
Suppose a consumer spends his/ her entire income on food (x 1) and clothing (x2) and
25% of the total income is spend on food. If price of x 1 = 2, prices of X2=3, m = 200,
estimate function & determine the optimum quantity of x1 & x2.
u (x1. x2) = X1 , X2
x1

c
m
.
c d p1

x1= 0.25*200/2 = 25,

x2

c
m
.
x = 0.75*200/3=50
c d p2 2

2.5 OFFER CURVES OF INCOME AND PRICE CONSUMPTION

1. Introduction
18

The consumers demand function gives the optimal amounts of each of the goods as
a function of the prices and income faced by the consumer. The demand function is
written as
x1=x1 (p1,p2,m)
x2=x2 (p1,p2,m).
The left hand side of each equation stands for the quantity demanded. The right-hand
side of each equation is the function that relates the prices and income to that
quantity.
Studying how a choice responds to changes in the economic environment is known as
comparative statics. Comparative means that we want to compare situations:
before and after the change in the economic environment. Statics means that we are
not concerned with any adjustment process may be involved in moving from one
choice to another, others be examined in equilibrium choice. In the case of consumer,
there are two things in the model that affect optimal choice: price and income. Two
comparative statics questions in consumer theory therefore involve investigating how
demand changes when prices and income changes.
2. Normal and Inferior Goods
Normal goods are those goods when their demand for each good would increase when
income increases. If good 1 is a normal good, then the demand for it increases when
income increases, and decreases when income decreases. For a normal good, the
quantity demanded always changes in the same way as income changes. Graphical
representation is shown in the following figure 1
x1
0.
m
Indifference curves
X2

Optimal choices
Budget lines

X1

Fig. 1 Normal Goods: The demand for both goods increases when income
increases.
If something is called normal, there must be possibility of being abnormal. where an
increase of income result in a reduction in the consumption of one of the goods. Such
goods are called as Inferior Goods. There are many goods for which demand
decreases as income increases: example, gruel, bologna, shacks, or nearly any kind
of low quality good.
19

Whether a good is inferior or not depends on the income level that we examining. It
might very well be that very poor people consume more bologna as their income
increases. But after a point, the consumption of bologna would probably decline as
income continued to increase. Since in real life the consumption of goods can increase
when income increases. Fig 2 shows the graphical presentation of inferior good.
X1

Budget lines

Optimal
choices

X2

Fig. 2 An Inferior Good: Good 1 is an inferior good, which means that the demand
for it decreases when income increases.
3. Income Offer Curves and Engel Curves
Income offer curve is constructed by shifting the budget line outward. This curve
illustrates the bundles of goods that are demanded at the different levels of income,
as depicted in figure 3.a.
For each level of income, m, there will be some optimal choice for each of the goods.
First focus on good 1 and consider the optimal choice of each set of prices and
income, x1(p1.p2.m). This is simply the demand function for good1. If prices of goods
1 and 2 are held fixed and look at how demand changes because of change income,
for that purpose Engel Curve is generated. The Engel curve is a graph of the demand
for one of the goods as a function of income, with all prices being held constant. See
figure 3.b
X2

Income offer curve

Engel Curve

Indifference curves

3.a Income Offer Curve

x1

3.b Engel Curve

x1
20

How demand changes as income changes. The income offer curve (or income expansion path)
shown in panel A depicts the optimal choice at different levels of income and constant prices.
When you plot the optimal choice of good 1 against income, m, we get the Engel curve, depicted
in panel B.
The income offer (for the consumption) curve is obtained by connecting successive
optimum points arising from increasing income. The curve is sloped positively, when
X1 and X2 are normal goods. But if one of the goods is inferior then the curve is
negatively sloped.
4. The Price Offer Curve and the Demand Curve
Suppose the price of good 1 change while p 2 and income are fixed. Geometrically this
involves pivoting the budget line. To construct price offer curve optimal points be
connected together as illustrated in figure 4.a.This curve represents the bundles that
would be demanded at different prices for good 1.
In other words, hold the price of good2 and money income fixed, and for each
different value of p1 plot the optimal level of consumption of good1. The result is the
demand curve depicted in figure 4.b. The demand curve is a plot of the demand
function, x1(p1, p2, m), holding p2 and m fixed at some predetermined values.
Ordinarily, when the price of a good increases, the demand for the good will decrease.
Thus the price and quantity of a good will move in opposite directions, which means
that the demand curve will typically have a negative slope. In terms of rates of
change,
x1
0 , which simply says that demand curves usually have a negative slope.
p1
X2

P1

Indifference curves

Demand Curve
Price Offer
Curve

4.a Price Offer Curve

X1

4.b Demand Curve

X1

The price offer curve and demand curve. Panel A contains a price offer
curve, which depicts the optimal choices as the price of good1, changes. Panel
B contains the associated demand curve, which depicts a plot of the optimal
choice of good 1 as a function of its price.

21

The price offer curve is obtained as a locus of successive optimum points resulting
from successive changes in price of one of the goods keeping income and prices of
the price offer curve shows you what happens in the optimal of consumer
consumption with respect to the decrease in price of X1.

2.6 INCOME AND SUBSTITUTION EFFECTS (Slutsky Equation)

Slutsky equation is the equation showing how the effect on demand for a good of a
change in price can be decomposed into the substitution effect, which shows the
effect of a change in relative prices at an unchanged level of real income, and the
income effect, which shows the effect of change in real income holding prices
constant.
When the price of a good changes, there are two sorts of effects: the rate at which
you can exchange one good for another changes, and the total purchasing power of
your income is altered. For example, if good1 becomes cheaper, it means that you
have to give up less of good 2 to purchase good1. The change in the price of good
1has changes the rate at which the market allows you to substitute good 2 for good
1. The trade-off between the two goods that the market presents the consumer has
changed.
At the same time, if good1 becomes cheaper it means that your money income will
buy more of good 1. The purchasing power of your money has gone up although the
number of dollars you have is the same, the amount that they will buy has increased.
The Substitution Effect: The part of the effect of a price change on demand due to
the change in relative prices, assuming that the consumers compensated sufficiently
to remain at the same level of utility.
The change in demand due to the change in the rate of exchange between the two
goods is called substitution effect.
Original Budget Line

X2

Indifference Curves
Original Choice

X2

Final Choice

Final Budget line

x1
Figure 1. Pivot and Shift. When the price of good 1 changes and income stays fixed, the
budget line pivots around the vertical axis. We will view this adjustment as occurring in
two stages: first pivot the budget line around the original choice, and then shift this line
outward to the new demanded bundle.
X1

What are the economic meanings of the pivoted and shifted budget lines?
22

This pivot-shift operation gives us a convenient way to decompose the change in

demand into two pieces. The first step- the pivot- is a movement where the slope of
the budget line changes while its purchasing power stays constant, while the second
step is a movement where the slope stays constant and the purchasing power
changes. This decomposition is only a hypothetical construction the consumer
simply observes a change in price and chooses a new bundle of goods in response.
But in analyzing how the consumers choice changes, it is useful to think of budget
line change in two stages first pivot and then the shift.
First, consider the pivoted line. Here is a budget line with the same slope and thus the
same relative prices as the final budget line. However, the money income associated
with this budget line is different. Since the vertical intercept is different. Since the
original consumption bundle (x 1,x2) lies on the pivoted budget line, that consumption
bundle is just affordable. The purchasing power of the consumer has remained
constant in the sense that the original bundle of goods is just affordable at the new
pivoted line.
Calculate how much we have to adjust money income in order to keep the old bundle
just affordable. Letm1 be the amount of money income that will just make the
original consumption bundle affordable; this will be the amount of money income
associated with the pivoted budget line. Since (x 1, x2) is affordable at both (p 1, p2,
m|), we have

m1 p11 x1 p2 x2
m p1 x1 p2 x2

Subtracting the second equation from the first gives

m1 m x1 p|1 p1

This equation says that the change in money income necessary to make the old
bundle affordable at the new prices is just the original amount of consumption of
good 1 times the change in prices.
Letting

p1 p11 p1 represents the change in price 1, and

m m1 m represents the

change in income necessary to make the old bundle just affordable, we have
m x1p1

Now we have a formula for the pivoted budget line: it is just the budget line at the
new price with income change by m. Note that if the price of good 1 goes down, a
consumers purchasing power goes up, so we will have to decrease the consumers
income in order to keep purchasing power fixed. Similarly, when a price goes up,
purchasing power constant must be positive.
The substitution effect x1 is the change in the demand for good1 when the price of
good 1 changes to p|1 and, at the same time, money income changes to m|:
s

x1s x1 ( p11 , m1 ) x1 ( p1 , m)
In order to determine the substitution effect, use the consumers demand function to
calculate the optimal choices at (p11,m1) and (p1,m). The change in demand for good
1 may be large or small, depending on the shape of the consumers indifference
curves.

23

The substitution effect is sometimes called the change in compensated demand.

The idea is that the consumer is being compensated for a price rise by having enough
income given back to him to purchase his old bundle. Of course, if the price goes
down he is compensated by having money taken away from him.
The Income Effect
The change in demand due to having more purchasing power is called income effect.
This is the part of the response in the demand for a good to a change in its price
which is due to the rise in the real income of consumer resulting from a price
decrease.
A parallel shift of the budget line is the movement that occurs when income changes
while relative prices remain constant. This second stage of price adjustment is called
income effect. Simply change the consumers income from m | to m, keeping the
prices constant at (p11, p2). In figure 2 this change moves us from the point Y to Z.
It is natural to call this last movement the income effect because changing the income
while keeping the prices fixed at the new prices.
n
More precisely, the income effect, x1 , is the change in the demand for good 1 when
we change income from m1, to m, holding the price of good 1 fixed at p` 1:

x1n x1 ( p|1 , m) x1 ( p|1 , m| ) .

When the price of a good decreases, we need to decrease income in order to keep
purchasing power constant. If the good is a normal good, then this decrease in
income will lead to a decrease in income will lead to a decrease in demand. If the
good is an inferior good, then the decrease in income will lead to an increase in
demand.
X2

Indifference Curves

m/p2

m1/P2

z
x

Substitution
effect

Income
effect

X1

Figure 2: Substitution effect and Income effect. The pivot gives the
substitution effect and the shift gives the income effect.
The Total Change in Demand
The total change in demand x 1, is the change in demand due to the change in price,
holding income constant;

x1 x1 p11 , m x1 p1, m .
24

This can be broken up into substitution effect and the income effect.
symbols defined above,

In terms of

x1 x s1 x n1
x1 ( p 11 , m) x1 ( p1 , m) [ x1 ( p |1 , m | ) x1 ( p1 , m)] [ x1 ( p | 1 , m) x1 ( p |1 , m | )]
This equation is called Slutskys Identity (Named after Russian economist Eugen
Slutskey, 1880-1948). In words, this equation says that the total change in demand
equals the substitution effect plus the income effect. It is called identity because; it is
true for all values of p1, p|1, m and m|. The first and fourth terms on the right hand
side cancel out, so the right hand side is identically equal to the left hand side.
The content comes from the interpretation of two terms on the right hand side:
substitution effect and the income effect. While substitution effect must always be
negative-opposite the change in the price-the income effect can go either way. Thus
the total effect may be positive or negative. However, if we have normal good, then
the substitution effect and the income effect work in the same direction. An increase
in price means that the demand will go down due to the substitution effect. If price
goes up, it is like decrease in income, which, for a normal good, means a decrease in
demand.
The Law of Demand: If the demand for a good increases when income increases,
then the demand for that good must decrease when its price increases.
This follows directly from the Slutsky equation: if the demand increases when income
increases, we have normal good. In addition, if we have a normal good then the
substitution effect and the income effect reinforce each other, and an increase in price
definitely reduce demand.
Some Examples with Perfect compliments and substitutes.
Slutskys decomposition is illustrated in the fig 3. When we pivot the budget line
around the chosen point, the optimal choice at the new budget line is the same as at
the old one this means that the substitution effect is zero. The change in demand is
due entirely to the income effect.
The case of perfect substitutes illustrated in figure 4. When we tilt the budget line,
the demand bundle jumps from the vertical axis to the horizontal axis. This is
because of the entire change in the demand due to the substitution effect.

X2

Indifference curves

Original budget
line

Final budget line

Pivot
Income effect = Total effect

Shift

X1

Figure 3
Perfect Compliments. Slutsky decomposition with perfect
compliments

25

X2

Indifference curves

Final budget line

Original Choice

Final Choice
Original budget line
Substitution effect = total effect

X1

Figure 4
Perfect substitutes. Slutsky decomposition with perfect substitutes.

To conclude, Slutsky equation says that the total change in demand is the sum of the
substitution effect and the income effect.
A Numerical Example: Calculating the Substitution Effect
m

Suppose that the consumer has a demand function for milk of the form x1 10 10 p .
1

Originally his income is Br.120 per week and the price of milk is Br.3 per quart. Thus
120
14 quarts per week. Now suppose that the price
10 * 3
120
16
of milk falls to Br.2 per quart. Then his demand at this new price will be 10
10 * 2

his demand for milk will be 10

quarts of milk per week. The total change in demand is +2 quarts a week.

In order to calculate the substitution effect, we must first calculate how much income
would have to change in order to make the original consumption of milk just
affordable when the price of milk is Br.2 a quart.
We apply the formula
m x1p1 14 * (2 3) Br.14.
Thus the level of income necessary to keep purchasing power constant is
m' m m 120 14 106. what is the consumers demand for milk at the new price,
Br.2 per quart, and this level of income? Just plug numbers into the demand function
to find.
x1 ( p '1 , m' ) x1 (2,106) 10

106
15.3
10 * 2

Thus the substitution effect is x

s
1

x1 (2,106) x1 (3,120) 15.3 14 1.3 .

Calculating the Income Effect.

x1 ( p '1 , m) x1 (2,120) 16
x1 ( p '1 , m' ) x1 (2,106) 15.3

Thus the income effect for this problem is

x n1 x1 (2,120) x1 (2,106) 16 15.3 0.7 .

26

Since milk is a normal good for this consumer, the demand for milk increases when
income increases.
2.7 DERIVATION OF CONSUMER DEMAND
The derivation of demand is based on the axiom of diminishing marginal utility. The
marginal utility of commodity x may be depicted by a line with a negative slope (fig.
2). Geometrically the marginal utility of x is the slope of the total utility function
U=f(qx). The total utility increases, but at a decreasing rate, up to quantity x and then
starts declining (fig. 1).
Ux

MUx

TU

x
Fig. 1

qx

qx

Fig. 2

MUx

Accordingly the marginal utility of x declines continuously, and becomes negative

beyond quantity x. If the marginal utility is measured in monetary units, the demand
curve for x is identical to the positive segment of the marginal utility curve. At x t the
marginal utility is MU1 (fig. 3). This is equal to P 1, by definition. Hence, at P 1 the
consumer demand x1 quantity (fig. 4).
MUx

Px

MU1
MU2
MU3

P1
P2
P3
0

x1

x2
Fig. 3

x3

MUx

x1

x2
Fig. 4

x3

qx

Similarly, at x2 the marginal utility is MU2, which is equal to P2. Hence, at P2 the
consumer will buy x2, and so on. The negative section of MU curve does not form part
of the demand curve, since negative quantities do not make sense in economics.
Graphical Presentation of the Equilibrium of the Consumer:
Given the indifference map of the consumer and his budget line, the equilibrium is
defined by the point of tangency of the budget line with the highest possible
indifference curve (point e in fig. 5).
27

Y
A

Y*

x*
Fig. 5

At the point of tangency the slopes of the budget line (P x/Py) and of the indifference
curve (MRSx,y=MUx/MUy) are equal:
MU x
P
x
MU y
Py

Thus the first-order condition is denoted graphically by the point of tangency of the
two relevant curves. The second-order condition is implied by the convex shape of
the indifference curves. The consumer maximizes his utility by buying x* and y* of
the two commodities.
Mathematical derivation of the equilibrium:
Given the market prices and his income, the consumer aims at the maximization of
his utility. Assume that there are n commodities available to the consumer, with
given market prices P1,P2,.Pn. The consumer has a money income (Y) which he
spends on the available commodities.
Formally, the problem may be stated as follows:
Maximise

U = f(q1,q2,.,qn)
n

Subject to

q P q P q P
t 1

1 1

1 1

2 2

.... qn Pn Y

We use the Langrangian multipliers method for the solution of this constrained
maximum.
The steps involved in this method may be outlined as follows:
(a) Rewrite the constraint in the form
(q1P1+q2P2++qnPn - Y) = 0
(b) Multiply the constraint by a constant , which is the Lagrangian multiplier.
(q1P1+q1P2+..qnPn Y) = 0.

28

(c) Subtract the above constraint from the utility function and obtain the composite
function.
= U (q1P1+q2P2+..qnPn Y)
It can be shown that maximization of the composite function implies maximization of
the utility function.
The first condition for the maximization of a function is that its partial derivatives be
equal to zero. Differentiating with respect to q 1,qn and and equating to zero we
find

( P1 ) 0
q1
q1

( P2 ) 0
q2
q2

( Pn ) 0
qn
qn

(q1 P1 q2 P2 .......qn Pn Y ) 0

From these equation we obtain

U
P1
q1
U
P2
q2

U
Pn
qn

U
U
U
MU1 ,
MU 2 ,.......
MU n
q1
q2
qn

Substituting and solving for we find

MU1 MU 2
MU n

.....
P1
P2
Pn

Alternatively, we may divide the preceding equation corresponding to commodity x,

by the equation which refers to commodity y, and obtain
MU x
P
x MRS x , y
MU y
Py

We observe that the equilibrium conditions are identical in the cardinalist approach
and in the indifference curves approach. In both theories we have
MU y
MU1
MU 2
MU x
MU n

....

....
P1
P2
Px
Py
Pn

29

Thus, although in the indifference curves approach cardinality of utility is not

required. The MRS requires knowledge of the ratio of the marginal utilities, given that
the first order condition for any two commodities may be written as
MU x
P
x MRS x , y
MU y
Py

Hence, the concept of marginal utility is implicit in the definition of the slope of the
indifference curves, although its measurement is not required by this approach. What
is preceded is a diminishing marginal rate of substitution, which of course does not
require diminishing marginal utilities of the commodities involved in the utility
function.
2.8 THE CONSUMERS SURPLUS
The consumers surplus is a concept introduced by Marshall, who maintained that it
can be measured in monetary units, and is equal to the difference between the
amount of money that a consumer actually pays to buy a certain quantity of
commodity x, and the amount that he would be willing to pay for this quantity rather
than do with it.
Graphically the consumers surplus may be found by his demand curve for commodity
x and the current market price. Assume that the consumers demand for x is a
straight line (AB in Figure 1) and the market price is P. At this price the consumer
buys q units of x and pays an amount (q).(P) for it. However, he would be willing to
pay p1 for q1, P2 for q2, P3 for q3 and so on. The fact that the price in the market is
lower than the price he would be willing to pay for the initial units of x implies that his
actual expenditure is less than he would be willing to spend to acquire the quantity q.
This difference is the consumers surplus, and is the area of the triangle PAC in figure
1.
Px

A
P1
P2
C
P3
P
0

q1 q2 q3

Figure 1
The Marshallian consumers surplus can also be measured by using indifference
curves analysis. In figure 2 the good measured on the horizontal axis is x, while on
the vertical axis we measure the consumers money income. The budget line of the
consumer is MM1 and its slope is equal to the price of the commodity x (since the
price of one unit of monetary unit is 1). Given P x, the consumer is in equilibrium at E:
he buys OQ quantity of x and pays AM` of his income for it, being left with OA
amount of money to spend on all other commodities.
30

Next, find the amount of money which consumer would be willing to pay for OQ
quantity of x rather than do without it.
M
Income
M1

A
A|

I1

B
O

M|

Fig. 2
This is attained by drawing an indifference curve passing through M. Under
Marshallian assumption that the MU of money income is constant, this indifference
curve will be vertically parallel to the indifference curve I 1; the indifference curves will
have the same slope at any given quantity of x. for example, at Q the slope of I 1 is
the same as the I0
Slope I1 for Q units of X

= MRS

x,M

MU x
=
MU x
1

(Given that MUM = 1)

Similarly
Slope I0 for Q units of X

= MRS

x,M

MU x
=
MU x
1

Given that the quantity of x is the same at E and B, the two slopes are equal.
The indifference curve I0 shows that the consumer would be willing to pay A1M for
the quantity OQ, since point B shows indifference of the consumer between having
OQ of x and OA` of income to spend on other goods, or having none of x and
spending all his income M on other goods. In other words A`M is the amount of
money that the consumer would be willing to pay for OQ rather than do without it.
The difference A`M - AM = AA` = EB is the difference between what the consumer
actually pays and what he would be willing to pay for OQ of x. This difference is the
Marshallian Consumer Surplus.
Other Interpretation of Consumers Surplus
31

There is also another way to think about consumers surplus. Suppose that the price
of the discrete goods is p. Then the value that the consumer places on the first unit
of consumption of that good is r 1, but he only has to pay p for it. This gives him a
surplus of r1-p on the first unit of consumption. He values the second unit of
consumption of at r2, but again he only has to pay p for it. This gives him a surplus of
r2-p on that unit. If we add this up- over all n units the consumer chooses, we get his
total consumers surplus:
CS r1 p r2 p ......rn p r1 .....rn np

Since the sum of the reservation prices just gives us the utility of consumption of
good 1. We can also write this as
CS v( n) pn

From Consumers surplus to Consumers surplus:

So fare we are considering the case of a single consumer. If several consumers are
involved we can ad up each consumers surplus across the consumers to create an
aggregate measure of the consumers surplus. Observe carefully the distinction
between the two concepts: consumers surplus refers to the surplus of single
consumer: consumers surplus refers to the sum of the surpluses across a number of
consumers.
Consumers surplus serves as a convenient measure of the aggregate gains from
trade, just as consumers surplus serves as a measure of the individual gains from
trade.
Interpreting the changes in Consumers Surplus
Demand Curve

Change in consumer surplus

P11

R
T

P1

X11

X1

Fig. 3 Change in consumers surplus. The change in consumers surplus will be

the difference between two roughly triangular areas, and thus will have a roughly
trapezoidal shape.

In Figure 3 the change in consumers surplus associated with a change in price. The
change in consumers surplus is the difference between two roughly triangular regions
and will there has trapezoidal shape. The trapezoid is further composed of two
regions, the rectangle indicated buy R and the roughly triangular region indicated by
T.

32

The rectangle measures the loss in surplus due to the fact that the consumer is now
paying more for all the units he continues to consume. After the price increases the
consumer continues to consumer x|| units of the good and each unit of the good is
now more expensive by p || - p1. This means he has to spend (p || - p|) x|| more money
than he did before just to consume x|| units of the good.
This is not entire welfare loss. Due to the increase in the price of the x good, the
consumer has decided to consumer less of it than he was before. The triangle T
measures the value of the lost consumption of the x good. The total loss to the
consumer is the sum of these two effects: R measures the loss from having to pay
more for the units he continues to consume, and T measures the loss from the
reduced consumption.
2.9 THE MARKET DEMAND
1. Derivation of the Market Demand
The market demand for a given commodity is the horizontal summation of the
demand of the individual consumers. In other words, the quantity demanded in the
market at each price is the sum of the individual demands of all consumers at that
price.
Table1 Individual and Market Demand
Price demand Quantity
Quantity
Quantity
demanded by demanded by demanded by
consumer A
consumer B
consumer C
2
107
40
4
6
72
24
5
10
50
14
10
14
29
8
5
18
6
4
2
20
3
3
0

Quantity
demanded by
consumer D
45
30
15
10
0
0

Market
18
13
11
6
0
0

P
20
16
14
10
6
2

*
*
*
*
*
**

*
*
*

**

*
*

0 10 20 30 40 50 60 70 80 90 100 110 Q
Fig. 1
Economic theory does not define any particular form of the demand curve. Market
demand is sometimes shown in textbooks as a straight line (linear demand curve)
33

and sometimes as a curve convex to the origin. The linear demand curve (Fig 1) may
be written in the form
Q = b0 b1P
and implies a constant slope, but a changing elasticity at various prices. The most
common form of a non-linear demand curve is the so called constant elasticity
demand curve, which implies constant elasticity at all prices; its mathematical form is
Q = b0.pb1
Where b1 is the constant price elasticity.
2. DETERMINANTS OF DEMAND
Traditionally the most important determinants of the market demand are considered
to be the price of the commodity in question, the prices of other commodities,
consumers income and tastes. The result of a change in the price of the commodity is
shown by a movement from one point to another on the same demand curve. Thus
these factors are called shift factors, and the demand curve is drawn under the ceteris
paribus assumption, that the shift factors are constant. The distinction between
movements along the curve and shifts of the curve is convenient for the graphical
presentation of the demand function. Conceptually, however, demand should be
thought of as being determined by various factors (is multivariate) and the change in
any one of these factors changes the quantity demanded.
Apart from the above determinants, demand is affected by numerous other factors,
such as the distribution of income, total population and its composition, wealth, credit
availability, stocks and habits. The last two factors allow for the influence of past
behavior on the present, thus rendering demand analysis dynamic.
P

P1
P2
D

x1 x2

Fig:2 Movement along the demand curve as the price

Of x changes.

x1

x2

x3

Fig 3: Shifts of the demand curve as, for example

Income increases.

2.10 ELASTICITY OF DEMAND

There are as many, elasticities of demand as its determinants. The most important of
these are (i) the price elasticity, (ii) the income elasticity, (iii) the cross-elasticity of
demand.
(i) The Price Elasticity of Demand:
34

The price elasticity is a measure of the responsiveness of demand to changes in

commoditys own price. If the changes in price are very small, we use a measure of
the responsiveness of demand the point elasticity of demand. If the changes in price
are not small, we use the arc elasticity of demand as the relevant measure.
dQ
ep Q
dP
P
or
ep

dq P
*
dP Q

If the demand curve is linear

Q b0 b1 P

Its slope is dQ / dP b1 . Substituting in the elasticity formula, we obtain

e p b1 *

P
Q

This implies that the elasticity changes at the various points of the linear-demand
curve. Graphically the point elasticity of a linear demand curve is shown by the ratio
of the segments of the line to the right and to the left of the particular point. In figure
1 the elasticity of the linear demand curve at point F is the ratio
P
D

FD`
FD

P1
F1

P2

Q1

Q2

D|

Figure 1

From Fig.1 we see that

P = P1P2 = EF

Q = Q1Q2 = EF|

P = OP1
Q =
OQ1
If we consider very small changes in P and Q, then

P dP

Q dQ

Thus substituting in the formula for the point elasticity, we obtain

ep

dQ P Q1Q2 OP1
EF | OP1
*
*

*
dP Q
P1 P2 OQ1 EF OQ1

From the figure we can also see that the triangles FEF| and FQ1D| are similar
(because each corresponding angle is equal). Hence

35

EF | Q1 D| Q1D|

EF
FQ1
OP1

Thus

ep

Q1D| OP1 Q1D|

*

OP1 OQ1 OQ1

Furthermore the Triangles DP1F and FQ1D| are similar, so that

Q1D| P1F OQ1

FD|
FD
FD
Re Arranging we obtain
Q1D| FD|

OQ1
FD

Thus the price elasticity at point F is

ep

Q1D| FD!

0Q1
FD

ep

P
D

ep>1
ep=1
M

ep<1

Fig. 2

D|

ep=0
Q

Given the graphical measurement of point elasticity it is obvious that at the mid-point
of a linear demand curve ep = 1 (Point M in Fig.2)
At any point to the right of M the point elasticity is less than unity (e p < 1);
finally at any point to the left of M, ep > 1.
At point D the e p , while as point D` the e p = 0. The price elasticity is always
negative because of the inverse relationship between Q and P implied by the law of
demand. However, traditionally the negative sign is omitted when writing the formula
of the elasticity.
The range of values of elasticity are 0 e p
If ep = 0 the demand is perfectly inelastic
if ep=1 the demand has unitary elasticity
If e p , the demand is perfectly elastic.
If 0<e<1, we say that the demand inelastic
if 1<e< , the demand is elastic.
Figures 3, 4, and 5.
D

36

ep =0

Fig 3

ep =1
Fig 4

ep
Fig 5

The basic determinants of the elasticity of demand of a commodity with respect to its
own price are:
(1) The availability of substitutes; the demand for a commodity is more elastic if
there are close substitutes for it.
(2) The nature of the need that the commodity satisfies. In general, luxury goods are
price elastic, while necessities are price inelastic.
(3) The time period. Demand is more elastic in the long run.
(4) The number of uses to which a commodity can be put. The more the possible uses
of a commodity the greater its price elasticity will be.
(5) The proportion of income spent on the particular commodity.
The above formula for the price elasticity is applicable only for extremely small
changes in the price. If the price changes appreciably, we use the following formula,
which measures the arc elasticity of demand:
ep = Q P1+P2/2 = Q (P1+P2)
P Q1+Q2/2
P (Q1+Q2)
The arc elasticity is a measure of the average elasticity, i.e., the elasticity at the mid
point of the chord that connects the two points (A and B) on the demand curve
defined by the initial and the new price levels (fig 6). It should be clear that the
measure of the arc elasticity is an approximation of the true elasticity of the section
AB or if the demand curve, which is used when we know only the two points A and B
from the demand curve is, the poorer the liner approximation attained by the arc
elasticity formula.

P1

Aarc elasticity
B

P2
D

Q1

Q2

Q
Figure 6

(ii) The Income Elasticity of Demand.

37

The income elasticity is defined as the proportionate change in the quantity

demanded resulting from a proportionate change in Income. Symbolically we may
write
ey = dQ/Q = dQ Y
dY/Y
dY Q
The income elasticity is positive for normal goods. A commodity is considered to be a
luxury if its income elasticity is greater than unity. A commodity is a necessity if its
income elasticity is small (less than unity, usually).
The main determinants of income elasticity are:
1. The nature of the need that the commodity covers: the percentage of income
spent on food declines as income increases (this is known as Engels Law and has
some times been used as a measure of welfare and of the development stage of an
economy.)
2. The initial level of income of a country. For example, a TV set is a luxury in an
underdeveloped, poor country while it is a necessity in a country with high per capita
income.
3. The Time period, because consumption patterns adjust with a time-lag to changes
in income.
(iii) The Cross-Elasticity of Demand
The cross-elasticity of demand is defined as the proportionate change in the quantity
demanded of x resulting from a proportionate change in the price of y. Symbolically
we have
e xy

dQx dPy
dQx Py
/

*
Q
Py
dPy Qx

The sign of the cross elasticity is negative if x and y are complementary goods, and
positive if x and y are substitutes. The higher the value of the cross-elasticity the
stronger will be the substitutability or complemetarity of x and y.
The main determinant of cross-elasticity is the nature of the commodities relative to
their use. If two commodities can satisfy equally well the same need, the crosselasticity is high, and vice-versa.
Chapter Three
Theory of production
3.1 The Production Function
i. The Production Function for a single product:
The production function is a purely technical relation which connects factor-inputs and
outputs. It describes the laws of proportion, which is the transformation of factor
inputs into products (outputs) at any particular time period. The production function
represents the technology of a firm of an industry, of the economy as a whole. The
production function includes all the technically efficient methods of production.
The

production

function in traditional economic theory assumes the form

The factor , returns to scale, refer to the long run analysis of the
laws of production.
The efficiency parameter refers to the entrepreneurialorganizational aspects of production.
X f ( L, K , , ) .

38

Graphically,
dimensional
movements
curve. The
1a and 1b.

the production function is usually presented as a curve on two

graphs.
Changes of the relevant variables are shown either by
along the curve that depicts the production function, or by shifts of this
most commonly used diagrams of a single product are shown in figures

X=f(L) k3, 3, 3

X=f(K) L3, 3, 3

X=f(K) L1, 1, 1
X=f(L) k1, 1, 1

Fig.1a.

Fig.1b.

Each curve shows the relation between X and L for given K, , and . As labor
increases, we move along the curve depicting the production function. If capital
increase, the production function X= f(L) moves upwards.
The marginal product of a factor is defined as the change in output resulting from
a very small change of this factor, keeping all other factors constant.
Mathematically the marginal product of each factor is the partial derivative of
production function with respect to this factor. MPL

X
X
and MPK
L
K

Graphically the marginal product of labor is shown by the slope of the

production function. X=f1(L) K, , and the marginal product of capital is shown by the
slope of the production function
X = f2 (K) L, , .
The theory of production concentrates on levels of employment of the factors over
which their marginal products are positive but decrease: in fig.2 the range of
employment of L examined by the theory of production is AB over that range MPL>0
( MP) L
0.
but
L
Similarly in fig.3 the range of employment of capital examined by the theory of
( MP) L
0.
production is CD over that range MPK>0 but
K

X|

X
39

Fig. 2 A|

B|

A method of production is a combination of factor inputs required for the production

of one unit of output. Usually a commodity may be produced by various methods of
production. For example, a unit of commodity x may be produced by the following
process:
Process P1
2

Labor units
Capital Units

Process P2
2

Process P3

1
4

Activities may be presented graphically by the length of lines from the origin to the
point determined by the labor and capital inputs. The three processes above are
shown in Fig. 3.1.
K
4
3
2
0

Fig 1

Labor units

A
2

B
3

Capital Units

A method of production A is technically efficient relative to any other method B, if A

uses less of at least one factor and no more from the other factors compared with B.
Method B is technically inefficient as compared with A. The basic theory of production
concentrates only on efficient methods. Inefficient methods will not be used by
rational entrepreneurs.
Labor units

A
2

B
1
40

Capital Units

Process A uses less of some factor(s) and more of some other(s) as compared with
any other process B, then A and B cannot be directly compared on the criterion of
technical efficiency. For example, the activities are not directly comparable. Both
process are considered as technically efficient and are included in the production
function (the technology). When one of them will be chosen at any particular time
depends on the prices of factors. The theory of production describes the laws of
production. The choice of any particular technique is economic one, based on prices,
and not a technical one. Note that! a technically efficient method is not necessarily
economically efficient. There is difference between technical and economic efficiency.
An isoquant includes all the technically efficient methods (or all the combinations of
factors of production) for producing a given level of output. The production isoquant
may assume various shapes depending on the degree of substitutability of factors.
They are broadly classified as linear isoquant, Input-output isoquant, Kinked Isoquant
and Convex Isoquant.
Linear isoquant: assumes perfect substitutability of factors of production: a given
commodity may be produced by using only capital, or only labor, or by an infinite
combination of K and L. See figure. 2
K
X

Fig.2 Linear Isoquant

Input-output isoquant: assumes strict complimentarity (that is zero substitution) of
the factors of production. There is only one method of production for any one
commodity. The isoquant takes the shape of right angle (fig. 3). This type of
isoquant is also called Leontief isoquant after Leontief, who invented the input output
analysis.
K

Fig.3 Input-Output Isoquant

Kinked isoquant: assumes limited substitutability of K and L. There are only a few
processes for producing any one commodity. Substitutability of the factors is possible
only at the kinks. This form is also called activity analysis-isoquant or linear
programming isoquant, because it is basically used in linear programming.
41

Smooth, convex Isoquant: assumes continuous substitutability of K and L only over

a certain range, beyond which factors cannot substitute each other. The isoquant
appears as a smooth curve, convex to the origin. See fig 5.
The production function describes not only a single isoquant, but the whole array of
isoquants, each of which shows a different level of output. It shows how output
varies as the factor inputs change.
P1

P2

P3
X
P4

B
L

Fig 4. Linear Programming Isoquant

Fig. 5 Convex Isoquant

Cobb-Douglas Production Function: is the most popular in applied research,

because it is easiest to handle mathematically. The Cobb-Douglas function is of the
form

X b0 .Lb1 .K b2
To indicate magnitude of production function we allow parameters to take arbitrary
values. The parameter b measures, the scale of production: how much out put we
would get if we used one unit of each input. The parameter b 1 and b2 measure how
the amount of output responds to the changes in the input.
1. The Marginal Product of factors
a. The MPL

X
b1 .b0 .L
L

b1 1

, K b1

b
b
A
= b1 (b0 L 1 K 2 ) L

= b1 .

X
b1 ( APL )
L

Where APL = the average product of labor

b. Similarly MPK b2 .

X
b2 ( APK )
K

2. Marginal rate of substitution

MRSL,K = X/ L = b1 (X/L) = b1 * K
X/K b2 (X/K)
b2 L
3.2 TECHNOLOGY
Inputs to production are called factors of production. Factors of production are often
classified into broad categories such as land, labor, capital, and raw materials.
Capital goods are those inputs to production that are themselves produced goods.
Capital goods are machines of one sort or another: tractors, buildings, computers, or
whatever.
Sometimes capital is used to describe the money used to start up or maintain a
business. Financial capital is the term that used to describe this concept of capital
goods, or physical capital, for produced factors of production.

42

Inputs and outputs as being measured in flow units: a certain amount of labor per
week and a certain number of machine hours per week will produce a certain amount
of output a week.
Technology changes as knowledge of new and more efficient methods of production
becomes available. In addition, new inventions may result in the increase of the
efficiency of all methods of production. At the same time some techniques may
become inefficient and drop out from the production function. These changes in
technology constitute technological progress.
Graphically the effect of innovation in processes is shown with an upward shift of the
production function (fig. 1), or down ward movement of production isoquant (fig. 2).
This shift shows that the same output may be produced by less factor inputs, or more
output may be obtained with the same inputs.
X

X1=f(L)

X0

X1
X
X=f(L)
X0

0
Fig. 1

L
Fig. 2

Technical progress may also change the shape of isoquant. Hicks has distinguished
three types of technical progress, depending on effect on the rate of substitution of
the factors of production.
Capital-deepening technical progress
Technical progress is capital-deepening or capital using, along a line on which K/L
ratio is constant, the MRS L,K increases. This implies that technical progress increases
the marginal product of capital by more than the marginal product of the labor. The
ratio of marginal products (which is the MRS L,K) decreases in absolute value. But
taking into account that the slope of the isoquant is negative, this sort of technical
progress increases the MRSL,K . The slope of the shifting isoquant becomes less steep
along any given radius. The capital-deepening technical progress is shown in fig.3.

43

A1

A11

Fig3. Capital-deepening technical progress

Labor-deepening technical progress
Technical progress is labour deepening, if along a radius through the origin with
constant K/L ratio), the MRS L,K decreases. This implies that the technical progress
increases the MPL faster than the MPK. Accordingly the MRSL,K, being the ratio of the
marginal products (X / L) / (X / K ) , increases in absolute value. The downwardsshifting isoquant becomes steeper along any given radius through the origin. This is
show in the figure 4
K

B
B11

B1

Fig. 4 Labour-deepening technical progress

Neutral technical progress
Technical progress is neutral if it increases the marginal product of both factors by the
same percentage, so that the MRSL,K (along any radius) remains constant. The
isoquant shifts downwards parallel to itself. This is shown in the fig. 5.
K

C1
C11
0
L

Fig. 5 Neutral Technical progress

Properties of Technology
First, technologies are monotonic. If you increase the amount of at least one of
the inputs, it should be possible to produce at least as much out put as you were
producing originally. This is sometimes referred to as the property of free disposal: if
44

the firm can dispose costlessly any of inputs, having extra inputs around can not
disturb it.
Second, the technology is Convex. This means that if you have two ways to
produce y units of output, (x 1, x2) and (z1, z2) when their weighted average will
produce at least y units of output. One argument for convex technologies goes as
follows. Suppose that you have a way to produce 1 unit of output using L 1 units of
factor (Labour) 1 and K2 units of factor (capital) 2 and that you have another way to
produce 1 unit of output using L 2 units of factor 1 and K 2 units of factor2. These two
ways are called as production techniques.
Furthermore, let us suppose that you are free to scale the output up to arbitrary
amounts so that (100a1, 100b2) will produce 100 units of output. But now note that
if you have (Technique A) 25L 1+75L2, units of factor 1 (Labor) and (Technique B)
25K1+75K2 units of factor 2 (Capital) you can still produce 100 units of output: just
produce 25 units of the output using the a technique and 75 units of the output
using b technique.
This is depicted in the fig.6 by choosing the level at which you operate each of the
two activities, you can produce a given amount of output in a variety of different
ways. In particular, every input combination along the line connecting (100b1.
100b2) will be a feasible way to produce 100 units of output.
X2

(25a1+75b1, 25a2+75b2)
100a2

100b2

100 a1

100 b2

X1

Fig. 6 Convexity: If you can operate production activities independently, then weighted averages of
production plans will also be feasible. Thus the isoquants will have a convex shape.

In this kind of technology, where you can scale the production process up and down
easily and where separate production processes do not interface with each other,
convexity is a very natural measure.
3.3 LAWS OF PRODUCTION
Introduction
The laws of production describe the technically possible ways of increasing the level of
production. Output may increase in various ways.
Output can be increased by changing all factors of production. Clearly this is possible
only in the long run. Thus the laws of returns to scale refer to the long run analysis
of production.
45

In the short run output may be increased by using more of the variable factor(s),
while capital (and possibly other factors as well) are kept constant. The marginal
product of the variable factor(s) will decline eventually as more and more quantities
of this factor are combined with the other constant factors. The expansion of output
with one factor (at least) constant is described by the law of diminishing returns of
the variable factor, which is often referred to as the law of variable proportions.
Product Lines
To analyze the expansion of output we need a third dimension, since along the two
dimensional diagram we can depict only the isoquant along which the level of output
is constant. Instead of introducing a third dimension it is easier to show the change
of output by shifts of the isoquant and use the concept of product lines to describe
the expansion of output.
Product Line shows the (physical) movement from one isoquant to another as we
change both factors or a single factor. A product curve is drawn independent of the
prices of factors of production. It does not imply any actual choice of expansion,
which is based on the prices of factors and is shown by the expansion path.
The product line describes the technically possible alternative paths of expanding
output. What path will actually be chosen by the line will depend on the prices of
factors.
The product curve passes through the origin if all factors are variable. If only one
factor is variable (the other being kept constant) the product line is straight line
parallel to the axis of the variable factor (Fig. 1). The K/L ratio diminishes along the
product line.
K

Product Lines

Fig.1 Product line for K given L

Among all possible product lines of particular interest are the so called isoclines. An
isocline is the locus of points of different isoquants at which the marginal rate of
substitution (MRS) of factors is constant. If the production function is homogeneous
the isoclines are straight lines through the origin. Along any of one isocline the K/L
ratio is constant (as the MRS of the factors). Of course the K/L ratio (and the MRS is
different technologies (Fig.2).
3.3.1 LAWS OF RETURNS TO SCALE: Long-run Analysis of Production.
The long run expansion of output may be achieved by varying all factors. In the long
run all factors are variable. The laws of returns to scale refer to the effects of scale
relationships.
In the long run output may be increased by changing all factors by the same
proportion, or by different proportions. Traditional theory production concentrates on
the first case that is the study of output as all inputs change by the same proportion.
46

The term returns to scale refers to the changes in output as all factors change by the
same proportion.
Suppose we start from an initial level of inputs and output.
X 0 f ( L, K )

and we increase all the factors by the same proportion k, we will clearly obtain a new
level of output X*, higher than the original level X0,
X * f (kL, kK )

If X* increases by the same proportion k as the inputs, we say that there are
constant returns to scale.
If X* increases less than proportionally with the increase in the factors we have
decreasing returns to scale.
If X* increases more than proportionally with the increase in the factors, we have
increasing returns to scale.
Returns to scale and Homogeneity of the Production Function
Suppose we increase both factors of the function
X0 = f(L,K)
by the same proportion k, and we observe the resulting new level of output X.
X* = f(kL, kK)
If k can be factored out (that is may be taken out of the brackets as a common
factor), then the new level of output X* can be expressed as a function of k and the
initial level of output
X* = kvf(L,K) or X* = kv.X0
And the production function is called homogeneous. If k cannot be factored out, the
production is non-homogeneous. Thus a homogeneous function is a function such that
if each of the inputs is multiplied by k, then k can be completely factored out of the
function. The power v of k is called the degree of homogeneity of the function and is
a measure of the returns to scale.
If v = 1 we have constant returns to scale.
called linear homogeneous.

This production function some times

If v < 1 we have decreasing returns to scale.

If v > 1

we have increasing returns to scale.

Graphical Representation of the Returns to scale for a homogeneous

Production Function
The returns to scale may be shown graphically by the distance (on an isocline)
between successive multiple level of output isoquants, that is isoquants that show
levels of output which are multiples of some base level of output, e.g., X, 2X, 3X,..
etc.

47

Constant Returns to Scale: Along any isocline the distance between successive
multiple isoquants is constant. Doubling the factor inputs achieve double the level of
the initial output; tripling inputs achieves triple output, and so on (fig. 2)
K
3K
2K
3X

2X

0
L 2L 3L
L
Fig.2 Constant Returns to Scale: Oa = Ob = Oc

Decreasing Returns to Scale: The distance between consecutive multiple isoquants

increases. By doubling the inputs, output increases by less than twice its original
level in fig. 3 the point a defined by 2K and 2L, lies on an isoquant below the one
showing 2x.
Increasing returns to scale. The distance between consecutive multiple-isoquants
decreases. By doubling the inputs, output is more than doubled. In fig. 4 doubling K
and L leads to point b which lies on an isoquant above the one denoting 2x.
K

2K
3X

2X

0 L 2L
L
Fig.3 Decreasing Returns to Scale: Oa < Ob < Oc
K

2K

3X

2X

0
L
2L
L
Fig.4 Increasing Returns to Scale: Oa > Ob>< Oc

Returns to scale are usually assumed to be the same everywhere on the production
surface, which is the same along all the expansion product line. All processes are
assumed to show the same returns over all ranges of output: constant returns
everywhere, decreasing returns everywhere, or increasing returns everywhere.
However, the technological conditions of production may be such that returns to scale
may vary over different ranges of output. Over some range we may have constant
returns to scale may vary over different ranges output.
48

With a non-homogeneous production function returns to scale may be increasing,

constant, or decreasing, but their measurement and graphical presentation is not as
straight forward as in the case of the homogeneous production function. The isoclines
will be curves over the production surface and along each one of them the K/L ratio
varies. Homogeneity is assumed to simplify the statistical work.
Homogeneity
however is a special assumption. In some cases a very restrictive one. When the
technology shows increasing or decreasing returns to scale it may or may not imply a
homogeneous production function.
3.3.2 THE LAW OF VARIABLE PROPORTIONS: Short-run Analysis
If one of the factors of the production (usually capital K) is kept constant. The
marginal product of the variable factor (Labour L) will diminish after a certain range of
production.
The traditional theory of production concentrates on the ranges of
output over which the marginal products of the factors are positive but diminishing.
The ranges of increasing returns (to a factor) and the range of negative productivity
are not equilibrium ranges of output.
If production function is homogeneous with constant or decreasing returns to scale
everywhere on the production surface, the productivity of the variable factor will
necessarily be diminishing. If, however, the production function exhibits increasing
returns to scale, the diminishing returns arising from the decreasing marginal product
of the variable factor (labor) may be offset, if the returns to scale are considerable.
This however, is rare.
In general the productivity of single-variable factor is
diminishing.
Let us examine the law of variable proportions or the law of diminishing productivity
(returns) in some detail.
K

A
2x

2K

Product Line

c
0

2L

L*

Fig. 5

If the production function is homogeneous with constant returns to scale everywhere,

the returns to a single-variable factor will be diminishing. This is implied by the
negative slope and the convexity of the isoquants. With constant returns to scale
everywhere on the production surface, doubling both factors (2K, 2L) leads to a
doubling of output. In fig.5 point b on the isocline OA lays on the isoquant 2x.
However, if we keep K constant (at the level K ) and we double only the amount of L,
we reach point c, which clearly lies on a lower isoquant than 2X. If we wanted to
double output with the initial capital K , we would require L* units of labour. Clearly
L* > 2L. Hence doubling L, with K constant, less than doubles output. The variable
factor L exhibits diminishing productivity (diminishing returns).
49

If the production function is homogeneous with decreasing returns to scale, the

returns to a single variable factor will be, a fortiori, diminishing. Since returns to
scale are decreasing, doubling both factors will less than double output. In fig.6 we
see that with 2L and 2K output reaches the level d which is on a lower isoquant than
2x. If we double only labor while keeping capital constant, output reaches the level c,
which lies on a still lower isoquant.
K

b
d

2K

2X

Product Line
X

2L

L
Fig.6

b
a

X
2L

2X
0

Fig. 7

2L

L
Fig. 8

If the production function shows increasing returns to scale, the returns to the single
variable factor L will in general be diminishing (Fig.7), unless the positive returns to
scale are so strong as to offset the diminishing marginal productivity of the single
variable factor. Fig. 8 shows the rare case strong returns to scale which offset the
diminishing productivity of L.
3.4 CHOICE OF OPTIMAL COMBINATION OF FACTORS OF PRODUCTION
In this section we shall show the use of the production function in the choice of the
optimal combination of factors by the firm. In part A we will examine two cases in
which the firm is faced with a single decision, namely maximizing output for a given
cost and minimizing cost subject to a given output. Both these decisions comprise
cases of constrained profit maximization in a single period.
In above cases it is assumed that the firm can choose the optimal combination of
factors, that it can employ any amount of any factor in order to maximize its profits.
This assumption is valid if the firm is new, or if the firm is in the long-run. However,
an existing firm may be pressurized, due to pressure of demand, to expand its output
in the short-run, when at least one factor, usually capital, is constant.
Assumptions:
1. The goal of the firm is profit maximization that is, the maximization of the
difference R C where = profits, R = revenue, and C = cost.
50

2. The price of output is given, Px.

3. The prices of factors are given: w is the given wage rate, r is the given price of
capital services (rental price of machinery).
A.
Single Decision of the Firm
The problem facing the firm is that of constrained profit maximization, which may
take one of the following forms:
a. Maximize profit , subject to a cost constraint. In this case total cost and prices

are given (C, w , r , Px), and the problem may be stated as follows.
max R C
Px X C
Clearly maximization of is achieved in this case if cost C is minimized, given that C
and Px are given constants by the assumption.
b. Maximize profit , for a given level of output. For example, a contractor wants
to build a bridge (X is given) with the maximum profit. In this we have
max R C

Px X C
Clearly maximization of is achieved in this case is cost C is minimized, given that X
and Px are given constants by assumption.
For a graphical presentation of the equilibrium of the firm (its profit maximizing
position) we will use the isoquant map (fig. 1) and the isocost-line(s) fig.2.
K
MPL
X / L
MRS L , K

The slope of an isoquant is:

L
MPK X / K
The isocost line is defined by the cost equation
C (r )( K ) ( w)( L) , where w = wage rate, and r = price of capital services
The isocost line is the locus of all combinations of factors the firm can purchase with
a given monetary cost outlay.
The slope of the isocost line is equal to the ratio of the price of the factors of
production. Slope of isocost line = w/r
K

K
A

Fig. 1

C
r

Fig. 2

Case 1: Maximization of output subject to a cost constraint (Financial

constraint)
Assume (a) A given production function X = f(L,K,v,)
and
(b) given factor prices w, r, for labor and capital respectively.
The firm is in equilibrium when it maximizes its output given its total cost outlay and
the prices of the factors, w and r.
51

In fig.3 the maximum level of output the firm can produce, given the cost constraint,
is X2 defined by the tangency of the isocost line, and the highest isoquant. The
optimal combination factors of production is K2 and L2, for prices w and r. Higher
levels of output (to the right of e) are desirable but not attainable due to the cost
constraint.
X3

X2
A

K2

X
0

L2

Fig. 3

Other points on AB0, below it lie on a lower isoquant than X2. Hence X2 is the
maximum output possible under the above assumptions (of given cost outlay, given
production function, and given factor prices). At the point of tangency (e) the slope
of the isocost line (w/r) is equal to the slope of the isoquant (MP L/MPK). This
constitutes the first condition for equilibrium. The second condition is that the
isoquants be convex to the origin. In summary: the conditions for equilibrium of the
firm are:
w MPL
X / L

MRS L , K
r MPK X / K
(b) The isoquants must be convex to the origin; if the isoquant is concave the point of
tangency of the isocost curves does not define an equilibrium position Fig.3
Output X2 (depicted by the concave isoquant) can be produced with lower cost at e2
which lies on a lower isocost curve than e. (with concave isoquant we have a cornel
solution).
(a) Slope of isoquant = Slope of isocost,

K
e

e1

Isoquant X2

e2

L
Fig. 4

Formal derivation of the equilibrium conditions: The equilibrium conditions may

be obtained by applying calculus and solving a constraint maximum problem which
may be stated as follows. The rational entrepreneur seeks the maximization of his
output, given his total-cost outlay and the prices of factors, formally:
Maximize X = f ( L, K )
52

Subject to C = wL + rK (cost constraint)

This is a problem of constrained maximum and the above conditions for the
equilibrium of firm may be obtained from its solution.
We can solve this problem by using Lagrangian multipliers. The solution involves the
following steps:
Rewrite the constraint in the form C wL rK 0
Multiply the constraint by a constant which is the Lagrangian multiplier:
The Lagrangian multipliers are undefined constraints which are used for solving
constraint maxima or minima. Their value is determined simultaneously with the
values of the other unknown (L and K in our example). There will be as many
Lagrangian multipliers as there are constraints in the problem.
From the composite function X (C wL rK )
It can be shown that maximization of the function implies maximization of the
output.
The first condition for the maximization of a function is that its partial derivatives be
equal to zero. The partial derivatives of the above function with respect to L, K, and
are:

( w) 0
L
L

(1)

( r ) 0
(2)
k K

C wL rK 0
(3)

Solving the first two equations for we obtain

X / L MPL
X
w

or
L
w
w
X / L MPK
X
r

or
K
r
r
The two equations must be equal then
MPL
X / L w
X / L
X / K

or
MPK
X / K
r
w
r
This firm is in equilibrium when it equates the ratio of the marginal productivities of
factors to the ratio of their prices.
It can be shown that the second-order conditions for equilibrium of the firm require
that the marginal product curves of the two factors have a negative slope.
The slope of the marginal product curve of labor is the second derivative of the
production function:
2 X
2 X
Slope of MPL curve =
,
similarly,
for
capital
Slope
of
ML
curve
=
K
L2
K 2
The second order conditions are
2
2 X 2 X
2 X
2 X
2 X

0
0 and
&
2
2
L2
K 2
L K
LK
These conditions are sufficient for establishing the convexity of the isoquants.
Case 2: Minimization of cost for a given level of output
53

The conditions for equilibrium of the firm are formally the same as in case 1. That is
there must be tangency of the (given) isoquant and the lowest possible isocost curve,
and the isoquant must be convex. However, the problem is conceptually different in
the case of cost minimization. The entrepreneur wants to produce a given output for
example, a bridge, a building, or X tons of a commodity with the minimum cost
outlay.
In this case we have a single isoquant (fig.5) which denotes the desired level of
output, but we have a set of isocost curves (fig. 6). Curves closer to the origin show
a lower total-cost outlay. The isocost lines are parallel because they are drawn on the
assumption of constant prices of factors: since w and r do not change, all the isocost
curves have the same slope w/r.
K

K
K

L 0

Fig. 5

Fig.6

L
Fig.7

The firm minimizes its costs by employing the combination of K and L determined by
_

the point of tangency of the X isoquant with the lowest isocost line (fig.7). Points
below e are desirable because they show lower cost but are not attainable for output
_

X . Points above e show higher costs. Hence point e is the least cost point, the
point denoting the least-cost combination of the factors K and L for producing X.
Clearly the conditions for equilibrium (least cost) are the same as in case 1, that is
equality of the slopes of the isoquant and the isocost curves, and convexity of the
isoquant.
Formally:
Minimize: C f ( X ) wL rK
Subject to: X f ( L, K )
Steps we have to follow are:
X f ( L, K ) 0
Rewrite the constraint in the form:
X f ( L, K ) 0
Multiply the constraint by the Lagrangian multiplier .
From the composite function
C X f ( L, K )
wL rK X f ( L, K )
or
Take the partial derivatives of with respect to L, K and and equal to zero.

/( L, K )
X

/( L, K )
X
w
0 w
r
0 r
,
L
L
L
K
K
K

X f ( L, K ) 0

from the first two equations we obtain:

X
,
L

X
K

54

w
X / L

MRS LK
r
X / K

Dividing through these expressions we find:

This condition is the same as in case 1 above. The second sufficient conditions,
concerning the convexity of the isoquants, is fulfilled by the assumption of negative
2 X
2 X

0
0
slopes of the marginal product of factors as in case 1, that is
,
L2
K 2
2 X

2
L

and

2 X

2
K

2 X

LK

CHOICE OF OPTIMAL EXPANSION PATH

We distinguish two cases: expansion of output with all factors variable (the long run),
and expansion of output with some factor(s) constant (short run).
Optimal expansion path in the long run
In the long run all factors of production are variable. There is no limitation (technical
or financial) to the expansion of output. The firms objective is the choice of the
optimal way of expanding its output, so as to maximize profits. With given factor
prices (w, r) and given production function, the optimal expansion path is determined
by the points of tangency of successive isocost lines and successive isoquants.
If he production function is homogeneous the expansion path will be straight line
through the origin whose slope (which determines the optimal K/L ratio) depends on
the ratio of the factor prices.
K

w/r, w/r
B

L
Fig. 8

L
Fig. 9

In fig. 8 the optimal expansion will be OA defined by the locus of points of tangency
of the isoquants with successive parallel isocost lines with a slope of w/r. If prices
increases the isocost lines become flatter (for example, with slope of w/r), and the
optimal expansion path will be the straight line OB. Of course, if the ratio of prices of
factors was initially w/r and subsequently changes to w/r, the expansion path
changes: initially the firm moves along OA, but after the change in the factor prices it
moves along OB.
If the production function is non-homogeneous the optimal expansion path will not be
a straight line, even if the ratio of prices of factors remains constant. This is shown
w/r ratio with MRSL,K, which the same on a curved isocline.
55

Optimal Expansion path in the short run: In the short run, capital is constant and
the firm is coerced to expand along a straight line parallel to the axis on which we
measure the variable factor L. With prices of factors constant the firm does not
maximize its profits in the short run, due to the constraint of the given capital. This
situation is shown in fi.10. The optimal expansion path would be OA were it possible
to increase K. Given the capital equipment, the firm can expand only along KK in the
short run.
K
A

K
O

K
Fig. 10

CHAPTER FOUR
THEORY OF COST
Introduction
Cost functions are derived functions. They are derived from the production function,
which describes the available efficient methods of production at any one time.
Economic theory distinguishes between short-run and long-run costs. Short-run costs
are the costs over a period during which some factors of production (usually capital
equipment and management) are fixed. The long-run costs are those costs over a
period long enough to permit the change of all factors of production. In the long-run
all factors become variable.
Both in the short-run and in the long-run, total cost is a multivariable function, that
is, total cost is determined by many factors. Symbolically long-run cost function can
be written as
C = f (X,T,Pf)
and the short-run cost function as
C = f (X,T,Pf,K)
Where C = Total Cost, X = Output, T = Technology, P f = Prices of factors, K = Fixed
factor(s).
Graphically, costs are shown on two-dimensional diagrams. Such curves imply that
cost is a function of output, C=f(X), ceteris paribus. The clause ceteris paribus
implies that all other factors which determine costs are constant. If these factors do
change, their effect on costs is shown graphically by a shift of the cost curve. This is
the reason why determinants of cost. Other than output, are called shift factors.
Mathematically there is no difference between the various determinants of costs. The
distinction between movements along the cost curve (when output changes) and
shifts of the curve (when the other determinants change) is convenient only
56

pedagogically, because it allows the use of two-dimensional diagrams. But it can be

misleading when studying the determinants of costs. It is important to remember
that if the cost curve shifts, this does not imply that the cost function is
indeterminate.
The factor technology is itself a multidimensional factor, determined by the physical
quantities of factor inputs, the quality of the factor inputs, the efficiency of the
entrepreneur, both in organizing the physical side of the production (technical
efficiency of the entrepreneur), and in making the correct economic choice of
techniques (economic efficiency of the entrepreneur). Thus, any change in these
determinants (e.g., the introduction of a better method of organization of production,
the application of an educational program to the existing labor) will shift the
production function, and hence will result in a shift of the cost curve. Similarly the
improvement of raw materials or the improvement in the use of the same raw
materials will lead to a shift downwards of the cost function.
The short-run costs are the costs at which the firm operates in any one period. The
long-run costs are planning costs or ex ante (based on prior assumptions or
expectations) costs, in that they present the optimal possibilities for expansion of the
output and thus help the entrepreneur is in a long-run situation, in the sense that he
can choose any one of a wide range of alternative investments, defined by the state
of technology. After the investment decision is taken and funds are tied up in fixedcapital equipment, the entrepreneur operates under short-run conditions; he is on a
short cost curve.
A distinction is necessary between internal (to the firm) economies of scale and
external economies. The internal economies are build into the shape of the long-run
cost curve, because they accrue to the firm from its own action as it expands the level
of its output. The external economies arise outside the firm, from improvement (or
depreciation) of the environment in which the firm operates. Such economies
external to the firm may be realized from actions of other firms in the same or in
another industry. The important characteristic of such economies is that they are
independent of the actions of the firm, they are external to it. Their effect is a
change in the prices of the factors employed by the firm (or in a reduction in the
amount of inputs per unit of output), and thus cause a shift of the cost curves, both
the short-run and the long-run.
In summary: while the internal economies of scale relate only to the long-run and
are built into the shape of the long-run cost curve, the external economies affect the
position of the cost curves; both the short-run and the long-run cost curves will shift
if external economies affect the prices of the factors and/or the production function.
Any point on a cost curve shows the minimum cost at which a certain level of output
may be produced. This is the optimality implied by the points of accost curve.
Usually the above optimality is associated with the long-run cost curve. However, a
similar concept may be applied to the short-run, given the plant of the firm in any one
period.
Short-run costs
The Traditional Theory
57

Traditional Theory distinguishes between the short run and the long run. The short
run is the period during which some factor(s) is fixed; usually capital equipment and
entrepreneurship are considered as fixed in the short run. The long run is the period
over which all factors become variable. In the traditional theory of the firm total costs
are split into two groups: total fixed costs and total variable costs:
TC = TFC + TVC
The fixed costs include:
(a)
Salaries of administrative staff
(b)
Depreciation (wear and tear) of machinery
(c)Expenses for building depreciation and repairs
(d)
Expenses for land maintenance and depreciation
Another element that may be treated in the same way as fixed costs is the normal
profit, which is a lump sum, including a percentage return on fixed capital and
allowance for risk.
The variable costs include:
(a)
The raw materials
(b)
The cost of direct labor
(c)The running expenses of fixed capital, such as fuel ordinary repairs and routine
maintenance.
Total fixed cost is graphically denoted by a straight line parallel to the output axis
(fig.1). The total variable cost is the traditional theory of the firm has broadly an
inverse S shape (fig. 2) which reflects the law of variable proportions. According to
this law, at the initial stages of production with a given plant, as more of the variable
factor(s) is employed, its productivity increases and the average variable factor(s)
employed, its productivity increases and the average variable cost falls.
TC

TVC

TVC

TFC

TFC

X
Fig. 1

X
Fig. 2

X
Fig. 3

This continues until optimal combination of the fixed and variable factors is reached.
Beyond this point as increased quantities of the variable factor(s) are combined with
the fixed factor(s) the productivity of the variable factor(s) declines (and the AVC
rises). By adding the TFC and TVC we obtain total cost curves. The average fixed
cost is found by dividing TFC by the level of output: AFC = TFC
X
Graphically the AFC is a rectangular hyperbola, showing at all its points the same
magnitude, that is, the level of TFC. The average variable cost is similarly obtained by
dividing the TVC with the corresponding level of output: AVC = TVC

X
SAVC

58

TVC

c
a

d
b
c

x1

x2
Fig. 5

x3

x4

O x1 x2 x3
Fig. 6

x4

Graphically the AVC at each level of output is derived from the slope of a line drawn
from the origin to the point on the TVC curve corresponding to the particular level of
output. For example fig.5 the AVC at X1 is the slope of the ray 0a, the AVC at X2 is
the slope of a ray 0b and so on. The slope of the ray through the origin declines
continuously until the ray becomes tangent to the TVC curve at c. SAVC falls initially
as the productivity of the variable factor(s) increases, reaches a minimum when the
plant is operated optimally (with the optimal combination of fixed and variable
factors), and rises beyond that point fig.6.
The ATC is obtained by dividing the TC by the corresponding level of output:
ATC

TC TFC TVC

AFC AVC
X
X

Graphically the ATC curve is derived in the same way as the SVAC. The ATC at any
level of output is the slope of the straight line from the origin to the point on the TC
curve corresponding to that particular level of output (fig.7). The shape of the ATC
reaches a minimum at the level of optimal operation of the plant (X M) and
subsequently rises again (fig.8). The U shape of both the AVC reflects the law of
variable proportions or law of eventually decreasing returns to the variable factor(s)
of production. The marginal cost is defined as the change in TC which results from a
unit change in output. Mathematically the marginal cost is the first derivative of the
TC function. Denoting total cost by C and output by X we have MC

C
.
X

TC

SATC

x1 x2 xM

xL

Fig. 8
O

x1

x2
Fig.7

xM xL X

Graphically the MC is the slope of the TC curve (which of course is the same at point
as the slope of the TVC). The slope of a curve at any one of its points is the slope of
the tangent at that point. With an inverse S shape of the TC (and TVC) the MC curve
will be U-shaped. In fig.9, we observe that the slope of the tangent to the total-cost
59

curve declines gradually, until it becomes parallel to the X-axis (with its slope being
equal to zero at this point), and then starts rising. Accordingly we picture the MC
curve in fig.10 as U shaped.
TC

XA

SMC

Fig.9

XA

Fig.10

In summary: the traditional theory of costs postulates that in the short run the cost
curves (AVC, ATC and MC) are U shaped, reflecting the law of variable proportions. In
the short run with a fixed plant there is a phase of increasing productivity (falling unit
costs) and a phase of decreasing productivity (increasing unit costs) of the variable
factor(s). Between these two phases of plant operation there is a single point at which
unit costs are at a minimum. When this point on the SATC is reached the plant is
utilized optimally, that is with the optimal combination (proportions) of fixed and
variable factors.
The relationship between ATC and AVC
The AVC is a part of the ATC, given ATC=AFC+AVC. Both AVC and ATC are U-shaped,
reflecting the law of variable proportions. However, the minimum point of the ATC
occurs to the right of the minimum point of the AVC (fig.11). This is due to the fact
that ATC includes AFC, and the latter falls continuously with increase in output. After
the AVC has reached its lowest point and starts rising, its rise is over a certain range
offset by the fall in the AFC, so that the ATC continues to fall despite the increase in
AVC. However, the rise in AVC eventually becomes greater than the fall in the AFC so
that the ATC starts increasing. The AVC approaches the ATC asymptotically as X
increases.

SMC

SATC

SAVC

AFC
O

X1

X2
Fig.11

In fig.11 the minimum AVC is reached at X 1 at while the ATC is at its minimum at X 2.
Between X1 and X2 the fall in AFC more than offsets the rise in AVC so that the ATC
60

continues to fall. Beyond X 2 the increase in AVC is not offset by the fall in AFC, so
that ATC rises.
The relationship between MC and ATC: The MC cuts the ATC and the AVC at their
lowest points. We will establish this relation only for the ATC and MC, but the relation
between MC, but the relation between MC and AVC can be established on the same
lines of reasoning. The MC is the change in the TC for producing an extra unit of
output. Assume that we start from a level of n units of output. If increase the output
by one unit the MC is the change in total cost resulting from the production of the
(n+1)th unit.
The AC at each level of output is found by dividing TC by X. Thus the AC at the level
TCn
of Xn is ACn
Xn
TCn 1
ACn
and the AC at the level Xn+1 is
X n 1
Clearly,

TCn 1 TCn MC

Thus: 1. If the MC of the (n+1) th unit is less than Can (the AC of the previous n units)
the ACn+1 will be smaller than the ACn.
2. If the MC of the (n+1)th unit is higher than ACn (the AC of the previous n
units) the ACn+1 will be higher than the ACn.
So long as the MC lies below the AC curves, it pulls the latter downwards when the
MC rises above the AC, it pulls the latter upwards. In fig.11 to the left of a the MC
lies below the AC curve, and hence the latter falls downwards. To the right of a the
MC curve lie above the AC curve, so that AC rises. It follows that at point a, where
the intersection of the MC and AC occurs, the Ac has reached its minimum level.
The Modern Theory of Short-run Costs
The U-shaped cost curves of the traditional theory have been questioned by various
writers both on theoretical a priori and on empirical grounds. As early as 1939
George Stigler suggested that the short-run average variable cost has a flat stretch
over a range of output which reflects the fact that firms build plans with some
flexibility in their productive capacity. The reasons for this reserve capacity have
been discussed in detail by various economists. As in the traditional theory, short-run
costs are distinguished into average variable costs (AVC) and average fixed costs
(AFC).
The Average Fixed Cost
This is the cost of indirect factors that is the cost of the physical and personal
organization of the firm. The fixed costs include the costs for:
(a)the salaries and other expenses of administrative staff
(b)the expenses for maintenance of buildings,
(c) the wear and tear of machinery (standard depreciation allowances),
(d)the expenses for maintenance of buildings,
(e)The expenses for the maintenance of land on which the plant is installed and
operates..
61

The planning of the plant (or the firm) consists in deciding the size of these fixed,
indirect factors, which determine the size of the plant, because they set limits to its
production. Direct factors such as labor and raw materials are assumed not to set
limits on size; the firm can acquire them easily with a figure for the level of output
which entrepreneur anticipates selling, and he will choose the size of plant which will
allow him to produce this level of output more efficiently and with the maximum
flexibility. The plant will wants to have some reserve capacity for various reasons.
The businessman will want to be able to meet sensational and cyclical fluctuations in
his demand. Such fluctuations cannot always be met efficiently by a stock-inventory
policy. Reserve capacity will allow the entrepreneur to work with more shifts and with
lower costs than a stock piling policy.
Reserve capacity will give the businessman greater flexibility for repairs for broken
down machinery without disrupting the smooth flow of the production process.
The entrepreneur will want to have more freedom to increase his output if demand
increases. All businessmen hope for growth. In view of anticipated increases in
demand the entrepreneur builds some reserve capacity, because he would not like to
let all new demand go to his rivals, as this may endanger his future old on the
market. It also gives him some flexibility for minor alternations of his product, in
view of changing tastes of customers.
Technology usually makes it necessary to build into the plant some reserve capacity.
Some basic types of machinery may not be technically fully employed when combined
with other small types of machines in certain numbers, more of which may not be
required given the specific size of the chosen plant. Also such basic machinery may
be difficult to install due to time lags in the acquisition. The entrepreneurs will thus
buy from the beginning such a basic machine which allows the highest flexibility, in
view of future growth in demand, even though this is a more expensive alternative
now. Furthermore some machinery may be so specialized as to be available only to
order, which takes time. In this case such machinery will be bought in excess of the
minimum required at present numbers, as a reserve.
A

a
b

XA
Fig.15

XB

Some reserve capacity will always be allowed in the land and buildings, since
expansion of operations may be seriously limited if new land or new buildings have to
be acquired.

62

Finally, there will be some reserve capacity on the organizational and administrative
level. The administrative staff will be hired at such numbers as to allow some
increase in the operations of the firm.
In summary: the businessman will not necessarily choose the plant which will give
him today the lowest cost, but rather that equipment which will allow him the
greatest possible flexibility, for minor alternations of his product or his technique.
Under these conditions the AFC curve will be as in fig.15. The firm has some largestcapacity units of machinery which set an absolute limit to the short-run expansion of
output (boundary b in fig. 15). The firm has also small-unit machinery, which sets a
limit to expansion (boundary A in fig. 15). this is not an absolute boundary, because
the firm can increase its output in the short run(until the absolute limit B is
encountered), either by paying overtime to direct labor for working longer hours (in
this case AFC shown by the dotted line in fig.15), or by buying some additional smallunit types of machinery (in this case the AFC curve shifts upwards, and starts falling
again as shown by the line ab in fig.15).
The Average variable cost
As in the traditional theory, the average variable cost of modern microeconomics
includes the cost of:
(a) Direct labor which varies with output,
(b) Raw materials,
(c)Running expenses of machinery.
The SAVC in modern theory has a saucer-type shape that is broadly shaped but has a
flat stretch over a range of output (fig.16). The flat stretch corresponds to the builtin the plant reserve capacity. Over this stretch the SAVC is equal to the MC, both
being constant per unit of output. To the left of the flat stretch the MC lies below the
SAVC, while to the right of the flat stretch the MC rises above the SAVC. The falling
part of the SAVC shows the reduction in costs due to the better utilization of the fixed
factor and the consequent increase in skills and productivity of the variable factor
(labor) with better skills the wastes in raw materials are also being reduced and a
better utilization of the whole plant is reached.
The increasing part of the SAVC reflects reduction in labor productivity due to the
longer hours of work, the increasing cost of labor due to overtime payment (which is
higher than the current wage), the wastes in materials and the more frequent break
down of machinery as the firm operates with overtime or with more shifts.
C
MC
SAVC
MC

Fig. 16

The innovation of modern microeconomics in this field is the theoretical establishment

of a short-run SAVC curve with a flat stretch over a certain range of output (fig.18).
63

It should be clear that this reserve capacity is planned in order to give the maximum
flexibility in the operation of the firm. It is completely different from the excess
capacity which arises with the U-shaped costs of the traditional theory for the firm.
The traditional theory assumes that each plant is designed without any flexibility: it is
designed to produce optimally only a single level of output (X M in fig. 17). If the firm
produces an output X smaller than XM there is excess (unplanned) capacity, equal to
the difference XM X. This excess capacity is obviously undesirable because it leads
to higher unit costs.
C

SAVC

SAVC

Reserve
Capacity

Excess capacity

XM

Fig. 17

X1

X2

Fig. 18

In the modern theory of costs the range of output X1, X2 in fig. 18 reflects the
planned reserve capacity which does not lead to increases in costs. The firm
anticipates using its plant sometimes closer to X1 and at others closer to X2. On the
average the entrepreneur expects to operate his plant within the X1X2 range. Usually
firms consider that the normal level of utilization of their plant is somewhere
between two-thirds and three-quarters of their capacity, that is, at a point closer to
X2 than X1. The level of utilization of the plant which firms consider as normal is
called the load factor of the plant.
The Average Total Cost
The average total cost is obtained by adding the average fixed (inclusive of normal
profit) and the average variable costs at each level of output. The ATC is shown in
fig.19. The ATC curves falls continuously up to the level of output (X 2) at which the
reserve capacity is exhausted. Beyond that level ATC will start rising. The MC will
intersect the average total-cost curve at its minimum point (which occurs to the right
of the level of output XA at which the flat stretch of the AVC ends).
Mathematically the cost-output relation may be written in the form
C = b0
+
b1X
TC = TFC +
TVC
The TC is a straight line with a positive slope over the range of reserve capacity (fig.
20).
MC

SATC
SAVC

MC

AFC

64

Fig. 19

XA

TC
C

C
TVC

SAC
SAVC=MC

TFC
O

Fig. 20

AFC
O

range of reserve
capacity
Fig. 21

The AFC is a rectangular hyperbola:

AFC = bo

(b1 X )
b1
X
b
The ATC is falling over the range of reserve capacity: ATC 0 b1
X

The AVC is a straight line parallel to the output axis: AVC

The MC is a straight line which coincides with the AVC:

MC=

C
b1
X

Thus the range of reserve capacity we have MC=AVC=b1, while ATC falls continuously
over this range (fig. 21). Note that the above total cost function does not extend to
the increasing part of costs, that is it does not apply to ranges of output beyond the
reserve capacity of the firm.
Long-run costs
Long-run Costs of the Traditional Theory: The Envelope Curve
In the long run all factors are assumed to become variable. It is known that the
long-run cost curve is a planning curve, in the sense that it is a guide to the
entrepreneur in his decision to plan the future expansion of his output. The long run
average cost curve is derived from short-run cost curves. Each point on the LAC
corresponds to a point on a short-run cost curve, which is tangent to the LAC at that
point. Let us examine in detail how the LAC is derived from the SAC curves.
Assume, as a first approximation, that the available technology to the first at a
particular point of time includes three methods of production, each with a different
plant size: a small plant, medium plant and large plant. The small plant operates
with costs denoted by the curve SAC 1, the medium size plant operates with the costs
on SAC2 and the large size plant gives rise to the costs shown on SAC 3 (fig.1).
C1
C| 1
C| 2
C2
C3

SATC1

65

SATC2

X1

X|1

X||1 X2

X|2 X3

SATC3

Fig. 1

If the firm plans to produce output X 1 it will choose the small plant. If it plants to
produce X2 it will choose medium size plant. If it wishes to produce X 3 it will choose
the large size plant. If the firm starts with the small plant and its demand gradually
increases, it will produce at lower costs (up to level x 1). Beyond that point costs start
increasing. If its demand reaches the level X 1 the firm can either continue to
produce with the small plant or it can install the medium size plant. The decision at
this point depends on not on costs but on the firms expectations about its future
demand. If the firm expects that the demand will expand further thatnX 1 it will
install the medium plant because with this plant outputs larger than X 1 are produced
with a lower cost. Similar considerations hold for the decision of the firm when it
reaches the level X2. If it expects its demand to stay constant at this level, the firm
will not install the large plant, given that it involves a larger investment which is
profitable only if demand expands beyondX 2. For example, the level of output X 3 is
produced at a cost C3 with the large plant, while it costs C3 if produced with medium
size plant (C2 >C3).
Now if we relax the assumption of the existence of only three plants and assume that
the available technology includes many plant sizes, each suitable for a certain level of
output, the points of intersection of consecutive plants are more numerous. In the
limit, if we assume that there are a very large number of plants, we obtain a
continuous curve, which is the planning LAC curve of the firm. Each point of this curve
shows the minimum (optimal) cost for producing the corresponding level of output.
The LAC curve is the locus of points denoting the least cost of producing the
corresponding output. It is a planning curve because on the basis of this curve the
firm decides what plant to set up in order to produce optimally the expected level of
output.
The firm chooses the short-run plant which allows it to produce the
anticipated output at the least possible cost. In the traditional theory of the firm the
LAC curve is U-shaped and it is often called the envelope curve because it envelopes
the SRC curves Fig. 2
Let us examine the U shape of the LAC. This shape reflects the laws of returns to
scale. According to these laws the unit costs of production decreases as plant size
increases, due to the economies of scale which the larger plant size make possible.
The traditional theory of the firm assumes that economies of scale exist only up to a
certain size of plant, which is known as the optimum plant size, because with this
plant size all possible economies of scale are fully exploited.
If the plant increases further than this optimum size there are diseconomies of scale,
arising from managerial inefficiencies. It is argued that management becomes highly
complex, managers are overworked and the decision making process becomes less
66

efficient. The turning-up of the LAC curve is due to managerial diseconomies of scale,
since the technical diseconomies can be avoided by duplicating the optimum technical
plant size.
C

LAC

M
O

Fig. 2

XM

A serious assumption of the traditional U-shaped cost curves is that each plant size is
designed to produce optimally a single level of output (e.g. 1000 units of X). Any
departure from that X no matter how small (e.g., an increase by 1 unit of X) leads to
increased costs. The plant is completely inflexible. There is no reserve capacity, not
even to meet seasonal variations in demand. As a consequence of this assumption
the LAC curve envelopes the SRAC. Each point of the LAC is a point of tangency
with the corresponding SRAC curve. The point of tangency occurs to the falling part
of the SRAC curves for points lying to the left of the minimum point of the LAC: since
the slope of LAC is negative up to M the slope of the SRAC curves must also be
negative, since at the point of their tangency the two curves have the same slope.
The point of tangency for outputs larger than XM occurs to the rising part of the SRAC
curves: since the LAC rises, the SAC must rise at the point of their tangency with the
LAC. Only at the minimum point M of the LAC is the corresponding SAC also at a
minimum. Thus at the falling pat of the LAC the plants are not worked to full capacity
to the rising part of the LAC the plants are overworked; only at the minimum point A
is the (short-run) plant optimally employed.
We stress once more the optimality implied by the LAC planning curve: each point
represents the least unit-cost for producing the corresponding level of output. Any
point above the LAC is inefficient in that it shows a higher cost for producing the
corresponding level of output. Any point below the LAC is economically desirable
because it implies a lower unit-cost, but it is not attainable in the current state of
technology and with the prevailing market prices of factors of production.
The long-run marginal cost is derived from the SRMC curves, but does not envelope
them. The LRMC is formed from the points of intersection of the SRMC curve with
vertical lines (to the x-axis) drawn from the points of tangency of the corresponding
SAC curves and the LRA cost curve (fig. 3).
The LMC must be equal to the SMC for the output at which the corresponding SAC is
tangent to LAC. For levels of X to the left of tangency a the SAC>LAC . At the point
of tangency SAC=LAC. As we move from a position of inequality of SRAC and LRAC
to a position of equality. Hence the change in total cost (i.e. the MC) must be smaller
for the short-run curve than for the long-run curve. Thus, LMC> SMC to the left of a.
67

For an increase in output beyond X1 (e.g.X ||1), the SAC>SMC. That is we move from
the position a of equality of the two costs to the position b where SAC is greater than
LAC. Hence the addition to total cost (= MC) must be larger for the short run curve
than for the long run curve. Thus, LMC<SMC to the right of a.
Since to the left of a, LMC>SMC, and to the right of a, LMC<SMC, it follows that a,
LMC = SMC. If we draw a vertical line from a to the X axis the point at which it
intersects the SMC (point A for SAC1) is a point of the LMC.
If we repeat this procedure for all points of tangency of SRAC and LAC curves to the
left of the minimum point of the LAC, we obtain points of the section of the LMC which
lies below the LAC. At the minimum point M the LMC intersects the LAC. To the right
of M the LMC lies above the LAC curve. At point M we have
SACM = SMCM = LAC = LMC
There are various mathematical forms which give rise to U-shaped unit cost curves.
The simplest total cost function which would incorporate the law of variable
proportions is the cubic polynomial
C

TC =

b0

b1X b1X2 + b3X3

TFC +

The AVC is:

TVC
AVC =

The MC is: MC =

TVC
b1 b2 X b3 X 2
X

C
b1 2b2 X 3b3 X 2
X

C b0
b1 b2 X b3 X 2
X X
The TC curve is roughly S-shaped, while the ATC, the AVC and the MC are all Ushaped; the MC curve intersects the other two curves at their minimum points.
The ATC is:

LMC
a

LAC

SMCM

SMC1

SMC2
M

X|1 X1

X||1

X2

XM

Fig. 3

Long run costs in modern micro economic theory: The L Shaped scale
Curve.
68

These are distinguished into production costs and managerial costs. All costs are
variable in the long run and they give rise to a long-run cost curve which is roughly Lshaped. The production costs fall continuously with increases in output. At very large
scales of output managerial costs may rise. But the fall in production costs more than
offsets the increase in the managerial costs, so that the total LAC falls with increases
in scale.
Production costs
Production costs fall steeply to begin with and then gradually as the scale of
production increases. The L-shape of the production cost curve is explained by the
technical economies of large-scale production.
Initially these economies are
substantial, but after a certain level of output is reached all or most of these
economies are attained and the firm is said to have reached the minimum optimal
scale, given the technology of the industry. If new techniques are invented for larger
scales of output, they must be cheaper to operate. But even with the existing known
techniques some economies can always be achieved at larger outputs:
(a) Economies from further decentralization and improvement in skills;
(b) Lower repairs costs may be attained if the firm reaches a certain size;
(c)The firm, especially if it is multiproduct, may well undertake itself the production
of some of the materials or equipment which it needs instead of buying them from
other firms.
Managerial Costs: In the modern management science for each plant size there is a
corresponding organizational administrative set-up appropriate for the smooth
operating of that plant. There are various levels of management, each with its
appropriate kind of management technique.
Each management technique is
applicable to a range of output. There are small-scale as well as large-scale
organizational techniques. The costs of different techniques of management first fall
up to a certain plant size. At very large scales of output managerial costs may rise,
but very slowly.
In summary: Production costs fall smoothly at very large scales, while managerial
costs may rise only slowly at very large scales. Modern theorists seems to accept
that the fall in technical costs more than offsets the probable rise of managerial costs,
so that the LRAC curve falls smoothly or remains constant at very large scales of
output.
We may draw the LAC implied by the modern theory of costs as follows. For each
short-run period we obtain the SRAC which includes production costs, administration
costs. Other fixed costs and an allowance for normal profit. Assume that we have a
technology with four plant sizes, with costs falling as size increases. We said that in
business practice it is customary to consider that a plant is used normally when it
operates at a level between two-thirds and three-quarters of capacity.
Following this procedure, and assuming that the typical load factor of each plant is
two-thirds of its full capacity (limit capacity), we may draw the LAC curve by joining
the points on the SATC curves corresponding to the two-thirds of the full capacity of
each plant sizes the LAC curve will be continuous (fig.4).
69

SATC1

C
SATC2

Cost

SATC3

SATC4

2/3
2/3

LAC

2/3

2/3

Fig. 4

Output

The characteristic of this LAC curve is that (a) it does not turn up at very large scales
of output; (b) it is not the envelope of the SATC curves, but rather intersects them (at
the level of output defined by the typical load factor of each plant). If, LAC falls
continuously (though smoothly at very large scales of output), the LMC will lie below
the LAC at all scales (fig. 5). If there is a minimum optimal scale of plant (x in fig. 6)
at which all possible scale economies are reaped, beyond that scale the LAC remains
constant. In this case the LMC lies below the LAC until the minimum optimal scale is
reached, and coincides with the LAC beyond the U-shaped costs of traditional theory.
C

LAC = LMC
LAC
LMC
0

Fig. 5

Fig. 6 x
X
Minimum optimal scale

CHAPTER FIVE
PERFECT COMPETITION
5.1 Short-run Equilibrium of the Firm and the Industry
Perfect competition is a market structure by a complete absence of rivalry among the
individual firms.
Thus, perfect competition in economic theory has a meaning
diametrically opposite to the everyday use of this term. In practice businessmen use
the word competition as synonymous to rivalry. In theory perfect competition implies
no rivalry.
The model of perfect competition is based on following assumption.
I. Assumptions:
1. Large numbers of sellers and buyers: The industry or market includes a large
number of firms (and buyers), so that each individual firm, however large, implies
only a small part of the total quantity offered in the market. The buyers also
numerous; that no monopsonistic power can affect the working of the market.
Under these conditions each firm alone cannot affect the price in the market by
changing its output.
70

2. Product homogeneity: The industry is defined as a group of firms producing a

homogeneous product. The technical characteristics of the product as well as the
services associated with its sale and delivery are identical. There is no way in
which a buyer could differentiate among the products of different firms.
3. Free entry and exit of firms: There is no better to entry or exit from the
industry. Entry or exit may take time, but firms have freedom of movement in and
out of the industry. This assumption is supplementary to the assumption of large
numbers.
4. Profit Maximization: The goal of all firms is profit maximization. No other goals
are pursued.
5. No government regulation: No government intervention is there in the market
(tariffs, subsidies, rationing of production or demand and so on are ruled out).The
above assumptions are sufficient for the firm to be a price-taker and have an
infinitely elastic demand curve.
The market structure in which the above
assumptions are fulfilled is called pure competition. It is different from perfect
competition which requires the fulfillment of the following additional assumptions.
6. Perfect mobility of factors of production: factors of production are free to
move from one firm to another throughout the economy. Workers can move
between jobs, which imply that skills can be learned easily. Raw materials and
other resources are not monopolized and labour is not unionized. There is perfect
competition in markets of factors of production.
7. Perfect knowledge: it is assumed that all sellers and buyers have complete
knowledge of the prevailing and future period conditions of the market.
Information is free and costless. Uncertainty about the future development in the
market is ruled out. Under the above assumptions we will examine the equilibrium
of the firm and the industry in the short run and in the long run.
II.
Short-run equilibrium
In order to determine the equilibrium of the industry we need to derive the market
supply. This requires the determination of the supply of the individual firms, since the
market supply is the sum of the supply of all the firms in the industry.
A. Short-run equilibrium of the Firm: The firm is in equilibrium when it maximizes
its profits (), defined as the difference between total cost and total revenue:
= TR TC
Given that the normal rate of profit is included in the cost items of the firm, is the
profit above the normal rate of return on capital and the remuneration for the risk
bearing function of the entrepreneur. The firm is in equilibrium when it produces the
output that maximizes the difference between total receipts and total costs. The
equilibrium of the firm may be shown graphically in two ways. Either by using the TR
and TC curves, or the MR and MC curves. In fig.1 we show the total revenue and
total cost curves of a firm in a perfectly competitive market.
The total revenue curve is a straight line through the origin; showing that the price is
constant at all levels of output. The firm is a price-taker and can sell any amount of
output at the going market price, with its TR increasing proportionately with its sales.
The slope of the TR curve is the marginal revenue. It is constant and equal to the
prevailing market price, since all units are sold at the same price. Thus in pure
competition
MR = AR = P.
The shape of the total-cost curve reflects the U shape of the average-cost curve, that
is, the law of variable proportions. The firm maximizes its profit at the output X C,
71

where the distance between the TR and TC curves is the greatest. At lower and
higher levels of output total profit is not maximized: at levels smaller than X A and
larger than XB the firm has losses.
C
R

TC

TR

Max

XA

XC

XB

Fig. 1

The total-revenue-total-cost approach is awkward to use when firms are combined

together in the study of the industry. The alternative approach, which is based on
marginal cost and marginal revenue, uses price as an explicit variable, and shows
clearly the behavioral rule that leads to profit maximization. In fig.2 we show the
average and marginal cost curves of the firm together with its demand curve.
C
P

SMC
SATC
P=MR
e

P
A

XC

Fig. 2

The demand curve is also the average revenue curve and the marginal revenue curve
of the firm in a perfectly competitive market. The marginal cost cuts the SATC at its
minimum point. Both curves are U-shaped, reflecting the law of variable proportions
which is operative in the short run during which the plant is constant. The firm is in
equilibrium (maximizes its profit) at the level of output defined by the intersection of
the MC and the MR curves (point e in fig. 2). To the left of e profit has not reached its
maximum level because each unit of output to the left of Xe brings to the firm revenue
which is greater than its marginal cost. To the right of X e each additional unit of
output costs more than the revenue earned by its sale, so that a loss is made and
total profit is reduced. In summary:
a. If MR>MC, total profit hasnt been maximized and it pays the firm to expand its
output.
b. If MC>MR, the level of total profit is being reduced and it pays the firm to cut its
output.
c. If MC = MR, short-run profits are maximized.
72

Thus the first condition for the equilibrium of the firm is that marginal cost be equal to
marginal revenue. However, this condition is not sufficient, since it may be fulfilled
and yet the firm may not be in equilibrium. In fig. 3 we observe that the condition
MC = MR is satisfied at point e|, yet clearly the firm is not in equilibrium, hence profit
is maximized at Xe> Xe|
The second condition for equilibrium requires that the MC must cut the MR curve from
below, i.e., the slope of the MC must be steeper than the slope of the MR curve. In
the fig. 3 the slope of MC is positive at e, while the slope of the MR curve is zero at all
levels of output. Thus at e both conditions for equilibrium are satisfied
i.
MC = MR and
ii.
(slope of MC) > (slope of MR).
It should be noted that the MC is always positive, because the firm must spend some
money in order to produce an additional unit of output. Thus at equilibrium the MR is
also positive.
P
C

SMC

SATC

e
e|

X| e

Fig. 3

Xe

The fact that a firm is in short run equilibrium does not necessarily mean that it
makes excess profits. Whether the firm makes excess profits or losses depends on
the level of the ATC at the short-run equilibrium. If the ATC is below the price at
equilibrium (fig. 4) the firm earns excess profits (equal to the area PABe). If,
however, the ATC is above the price (fig. 5) the firm makes a loss (equal to the area
FPeC). In the latter case the firm will continue to produce only if it covers its variable
costs. Otherwise it will close down, since by discontinuing its operations the firm is
better off: it minimizes its losses. The point at which the firm covers its variable costs
is called the closing down point. In fig. 6 the closing-down point of the firm is
denoted by point w. If price falls below P w the firm does not cover its variable costs
and is better off it closes down.
P
C

SMC

PC

SMC

SATC

SATC
C
e

MR

F
P

MR

B
P
C
O

Xe

Fig. 4

Xe
Fig.
5
SMC

SATC
Pw

SAVC
AFC

73

Xw

Fig. 6

Mathematical Derivation of the equilibrium of the Firm

The firm aims at the maximization of its profit

R C , Where,

= Profit,

R = Total Revenue, C = Total Cost

Clearly R = f1(X) and C = f2(X), given the price P.

(a) The first order condition for the maximization of a function is that its first
derivative be equal to zero. Differentiating the total-profit function and equating to
zero we obtain

R
C

0
X
X
X

or

R
C

X
X

The term R / X is the slope of the total revenue curve, that is, the marginal
revenue. The term C / X is the slope of the total cost curve, or the marginal cost.
Thus the first-order condition for profit maximization is
MR = MC.
Given that MC>0, MR must also be positive at equilibrium. Since MR = P the first
order condition may be written as MC = P.
(b) The second order condition for a maximum requires that the second derivative of
function be negative (implying that after its highest point the curve turns
downwards).
The second order derivative of the total-profit function is

2 2 R 2C

X 2 X 2 X 2
This must be negative if the function has been maximized, that is

2 R 2C

0,
X 2 X 2

2 R 2C

which yields the condition,

, but 2 R / X 2 is the slope of the MR curve and
2
2
X
X
2
2
C / X is the slope of the MC must cut the MR curve from below. In pure
competition the slope of the MR curve is zero, hence the second-order condition is
2C
simplified as follows, 0
, which reads: the MC curve must have a positive slope,
X 2
or the MC must be rising.

B. Short-run Equilibrium of the Industry: Given the market demand and the
market supply, the industry is in equilibrium at that price which clears the market
that is at the price at which the quantity demanded is equal to the quantity
supplied. In fig. 7 the industry is in equilibrium at price P, at which the quantity
74

demanded and supplied is Q. However, this will be short run equilibrium, if at the
prevailing price firms are making excess profits fig. 8 or losses Fig. 9. In the long
run, firms that make losses and cannot readjust their plant will close down. Those
that make excess profits will expand their capacity, while excess profits will also
attract new firms into the industry. Entry, exit and readjustment of the remaining
firms in the industry will lead to a long-run equilibrium in which firms will just be
earning normal profits and there will be no entry or exit from the industry.
P

SMC
P
C

P
D

S
0

5.3

Q
Fig. 7

SATC

B
X

Xe
Fig. 8

Xe

Fig. 9

Long-run equilibrium of the firm and the industry

C. Equilibrium of the Firm in the Long Run: In the long run firms are in
equilibrium when they have adjusted their plant so as to produce at the minimum
point of their long-run AC curve, which is tangent (at this point) to the demand
curve defined by the market price.
In the long run the firms will be earning just normal profits, which are included in the
LAC. If they are making excess profits new firms will be attracted in the industry;
this will lead to a fall in price (a downward shift in the individual demand curves) and
an upward shift of the cost curves due to the increase of the prices of factors as the
industry expands. These changes will continue until the LAC is tangent to the
demand curve defined by the market price. If the firms make losses in the long run
they will leave the industry, price will rise and costs may fall as industry contracts
until the remaining firms cover the total cost firms inclusive of the normal rate of
profit.
In fig. 1 we show how firms adjust to their long-run equilibrium position. If the price
is P, the firm is making excess profits working with the plant whose cost is denoted by
SAC1. It will therefore have an incentive to build new capacity and it will move along
its LAC. At the same time new firms will be entering the industry attracted by the
excess profits. As the quantity supplied in the market increases (by the increased
production of expanding old firms and by the newly established ones) supply curve in
the market will shift to the right and price will fall until it reaches the level of P1 (in
fig.1) at which the firm and the industry are in the long-run equilibrium. The LAC in
fig.2 is the final-cost curve including any increase in the prices of factors that may
have taken place as the industry expanded.

75

P
C

P
C

LMC
SAC1

S1

LAC

SMC1

P
SAC

P1

P1
SMC

S1
0

Q1
Fig.1

X
Fig.2

The condition for the long-run equilibrium of the firm is that the marginal cost be
equal to the price and to the long-run average cost
LMC = LAC = P
The firm adjusts its plant size so as to produce that level of output at which the LAC is
the minimum possible, given the technology and the prices of factors of production.
At equilibrium the short-run marginal cost equal to the long-run marginal cost and the
short-run average cost is equal to the long-run average cost. Thus given the above
equilibrium condition, we have:
SAC = SMC = LAC = LMC = P = MR
This implies that at the minimum point of the LAC the corresponding (short-run) plant
is worked at its optimal capacity, so that the minima of the LAC and SAC coincide. On
the other hand, the LMC cuts the LAC at its minimum point and the SMC cuts the SAC
at its minimum point. Thus, at the minimum point of the LAC the above equality
between short-run and long-run costs is satisfied.
D.
Equilibrium of the Industry in the Long-run: The industry is in long-run
equilibrium when a price is reached at which all firms are in equilibrium (proceeding
at the minimum point of their LAC curve and making just normal profits). Under
these conditions there is no further entry or exit of firms in the industry, given the
technology and factor prices. The long-run equilibrium of the industry is shown in
fig. 3. At the market price, P, the firms produce at their minimum cost, earning just
normal profits. The firm is in equilibrium because at the level of output X.
LMC = SMC = P = MR.
This equality ensures that the firm maximizes its profits. At the price P the industry is
in equilibrium because profits are normal and all costs are covered so that there is no
incentive for entry or exit. That the firms earn just normal profit (neither excess
profits nor losses) is shown by the equality;
LAC= SAC= P
This is observed at the minimum point of the LAC curve. With all firms in the industry
being in equilibrium and with no entry or exit, the industry supply remains stable,
and, given the market demand (DD|) in fig.3, the price P is a long run equilibrium
price.
Since the price in the market is unique, this however, does not mean that all firms in
the industry have the same minimum long-run average cost. This, however, does not
mean that all firms are of the same size or have the same efficiency, despite the fact
76

that their LAC is the same in equilibrium. The more efficient firms employ more
productive factors of production and/or more able managers. These more efficient
factors must be remunerated for their higher productivity; otherwise they will be bid
off by the new entrants in the industry. In other words, as the price rises in the
market the more efficient firms earn a rent which they must pay to their superior
resources. Thus rents of more efficient factors become costs for the individual firm,
and hence the LAC of the more efficient firms shifts upwards as the market price
rises, even if the factor prices for the industry as a whole remain constant as the
industry expands. In this situation the LAC of the old, more efficient, firms must be
redrawn so as to be tangent at the higher market price. The LMC of the old firms is
not affected by the rents accruing to its more productive factors. (It will be shifted
only if the prices of factors for the industry in general increase.)
P
C

P
C

S|

LMC
SMC

SAC

LAC
P = MR

D|

Fig. 3
Thus, the more efficient firms will be in equilibrium, producing that output at which
the redrawn LAC is at its minimum (at which point the LAC is cut by the initial LMC
given that factor prices remain constant). Under these conditions, with the superior,
more productive resources properly costed at their opportunity cost, all firms have
the same unit cost in their long-run equilibrium. This is shown in fig 4. At the initial
price P0 the second firm as not in the industry as it could not cover its cots at that
price. However, at the new price, P 1, firm B enters the industry, making just normal
profits. The established firm A earns rents which are imputed costs, so that its LAC
shifts upwards and it reaches a new long-run equilibrium producing a higher level of
output (X|A).

LMCA
P1

LMCA

LAC A

LACB

LACA

D|

0
Market Equilibrium

P1

P1

P0

P0

0
XA A|A
X
Equilibrium of a more efficient firm
Fig. 4

0
XB
X
Equilibrium of a new entrant

77

Chapter-Six
Monopoly Market Structure
Introduction:
In a perfectly competitive market each firm's production is such a small proportion of
industry out put that an individual firm has to influence on the market price. As we
have seen the competitive firm is a price taker. In this unit we will see the opposite
extreme to a purely competitive firm of pure monopoly a single seller in an industry.
The sources of monopoly, price and out put determination in the short and long run
periods, price discrimination by a monopoly and comparison of the price and out put
with perfect competition are some of the points to be discussed in this unit.
Definition
A monopoly is a market structure where there is only one firm that produces and sells
a particular commodity or service and there are no close substitutes available. Since
the monopoly is the seller in the market, the industry is a single firm industry and it
has no direct competitors. However it does not necessarily mean that it is a guarantee
to get an abnormal profit. Monopoly power only guarantees that the monopolist can
make the best of whatever demand and cost conditions exist with out fear of the
entrant of new competing firms.
Source and Types of Monopoly
The rise and existence of monopoly is related to the factors, which prevents the entry
of new firms. The different barriers to entry that are the causes of monopoly are
described below.
i. Legal Restrictions: A monopoly, which are created for the interest of the public.
For example the public utility sectors such as water supply, postal, telegraph and
telephone services, radio and TV services, generation and distribution of electricity
such monopolies are known as public monopolies
ii. Control over key raw materials: some firms may get monopoly power if they
posses certain scarce & key raw materials that are essential for the production of
certain goods or if the supply of a commodity is localized in a single place. This
type monopoly is known as raw material monopoly. For example India possesses
manganese mines, the extraction of diamonds is controlled by South Africa
iii. Efficiency: A primary and technical reason for growth of monopolies is economies
of scale. The most efficient plant (probably large size firm), which can produce at
minimum cost, could eliminate the competitors by cutting down its price for a short
period and can acquire monopoly power. Monopolies created through efficiency are
known as natural monopolies.
iv. Patent rights: - The government has granted firms a patent right, for producing a
commodity of specified quantity and character so that firms will have exclusive
rights to produce the specified commodity. Such monopolies are called patent
monopolies.
Demand, Marginal Revenue and cost curves under Monopoly
In the analysis of consumer behavior you have seen that the demand curve is
generally down ward sloping showing inverse relation ship between price and quantity
demanded.
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In perfectly competitive market the industry faces down ward sloping demand curve;
firms face a horizontal demand curve because of the existence of large number of
producers and homogeneity of the product, the firm can not exert power on the total
industry supply.
The monopoly industry on the other hand is a single firm industry. A monopoly firm
there fore faces a down ward sloping demand curve. It implies given the demand
curve, a monopoly firm has the option to choose between prices to be charged or out
put to be sold. But he cannot simultaneously control both the price and the level of
out put. He can either decide the level of out put, and leave the price of the out put to
be determined by consumer demand or he can fix the price and leave the level of out
put to be decided by the demand for the product at that price. One of the
fundamental differences between a monopolist and a competitor is there fore the
demand (AR) and marginal revenue curves they face. In the case of perfectly
competitive market MR = AR=P=D. But in the case of down ward sloping demand
curve of monopoly marginal revenue curve falls twice as much as the fall of average
revenue curves i.e. the slope of MR is twice as steep as the average revenue curve.
The following figure illustrates this relationship
AR and RM curves for Monopoly

D=AR=P

MR
0

Quantity
M

DM is the demand curve and DT is the marginal revenue curve, which bisects the
quantity demanded OM. Thus the distance OT = TM
This can be shown mathematically as follows assuming linear demand function
1. The demand function
P = a - bx where a = constant, x=quantity demanded
2. The total revenue is
R = Px
= (a - bx)x = ( substituting P = a -bx)
= ax -bx2
3. The Average revenue
AR =

R Px

P a bx
x
x

Thus the demand curve is also the AR curve of the monopolist with slope = -b
4. The marginal revenue (the first derivative of R)
79

dR d (ax bx 2 )

dx
dx

=a-2bx
That is the MR is a straight line with the same intercept (a) as the demand
curve, but twice as steep ( i.e slope = -2b)
Note: - the general relation between P and MR is found as follows
R = Px
dx ( P ) d ( p ) x
(Product rule of differentiation, you have learned in your
MR

dx
dx
quantitative for economists I course)
xd ( p )
MR P
dx

MR P x

dp
dx

(But

dx
dp

is negative due to the inverse relation

between demand & price)

dp
dp
MR P X
P = MR+x
dx
dx

Thus the marginal revenue is smaller than price at all levels of out put.
The nature and shape of cost curves confronting a monopolist are similar to those
faced by a perfectly competitive firm. Because cost depends on the production
function and input prices, irrespective of whether a firm is a monopoly or perfectly
competitive
Short Run Equilibrium of Monopoly
As we know, in the short run period the scale of plant is fixed and the firm is unable
to change it. If the monopolist desires to produce more, he can make an intensive use
of the variable input. Since the monopolist has to incur fixed costs in the short run,
the minimum price acceptable by him must be equal to his average variable cost. For
this reason the equilibrium condition is the same as we have explained under perfect
competition i.e. equilibrium occurs when marginal revenue equals marginal cost. But
for the monopolist, MR does not equal price. The short run price and out put
determination under monopoly, and also the firms equilibrium are illustrated in the
following figure.

80

The monopolist firm is in equilibrium at point E where SMC interests the MR curve

SMC
A

P1

SAC

P2

AR=D
MR

Qe

from below. The profit maximizing (equilibrium) out put is Qe and price is 0P 1. At OQe
level of out put, the average cost is OP 2 (or QeB). Thus the monopolist's per unit
abnormal profit is equal to AB, which is the difference between the price OP1, and the
corresponding average cost of production (OP2). The shaded area; P 1ABP2 represents
the total monopoly profit.
Total revenue = AR x out put sold
= OP1 x OQe
= Area OP1AQe
Total Cost = AC x out put produced
= OP2 x OQe
= Area OP2 BQe
Profits = TR-TC
= Area OP1 AQe - Area OP2 BQe
= Area P1AB P2
Does a monopolistic firm always earn an abnormal profit? Have you said no? Good.
As we explain in the introduction part a monopolistic position does not guarantee
above normal return always weather the monopolist gets profit or not, depends up on
the conditions of demand and costs. It is possible that his entire short run average
cost curve lies above the demand curve or AR curve so that he has to incur a loss.
The following figure illustrates such a situation.

P1
P2
P3

ATC

B
N

AVC

AR=D

MR

Qe
81 0
00

As the figure prevails marginal cost equals marginal revenue at point E where Qe
level of out put is produced and OP2 is the equilibrium price. But average total cost is
OP1 (or QeD). Thus
Total revenue = OP2 x OQe
Total cost = OP1 x OQe
= OP2BQe
= Area OP1 DQe
Total revenue exceeds total cost; hence, the firm makes a loss of P 2 P1DB. The
monopolist would produce rather than shut down in the short run, since price exceeds
the AVC (OP3). If demand decreases so that the monopolist cannot cover all variable
cost at any price, the firm would shut down and lose only fixed cost.
Long Run Equilibrium of Monopoly
Contrary to perfect competition pure economic profit is not eliminated in the long run
under monopoly... As we already discuss a monopoly exists if there is only one firm in
the market. This statement implies that entry in to the market is closed. If a
monopolist should earn a pure profit in the short run, no other producer can enter the
market in the hope of sharing whatever profit potential exists in the long run. Thus a
monopolist will continue to earn abnormal profit even in the long run. The magnitude
of the long run profits will depend up on the cost condition under which he has to
operate production and the demand curve he has to face in the long run.

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If its AR> SMC1, it earns a short run profit at out put Oq1 as shown in the following
figure (area P1 P2AB). The firm would therefore not only continue in the business but
would also expand its business to the size that yields maximum profit in the long run
(a plant with SMC2 and SAC2)

Long run Equilibrium of monopoly

As depicted in the figure, the point of intersection between LMC and MR curves
determine the equilibrium out put at Oq2, price Op3. The total long run profit has been
shown by the area P4P3cd(Total revenue (OP3Cq2)-Total cost (OP4Dq2))
Under perfect competition we have seen that in the long run every firm has be of
optimum size where its long run average cost (LAC) is minimum. Does a monopolistic
firm always produce at the optimum size in the long run? In the cost of monopoly,
the equilibrium level of out put (where LMC=MR) may or may not have the lowest
long run average cost. There are three possibilities to exist depending on the cost
structure of the firm and demand for the product.
i. Under utilization of capacity:- A case in which the market size and cost
conditions lead to maximize profit at lower than optimum size (i.e LMC &MR
intersects out puts less than where LAC is at its minimum
ii. Over utilization of capacity :- A case where in the market is so large that it
forces the monopolist to maximize profit by over utilizing the capacity ( at out puts
greater than where LAC is at its minimum)

83

iii. Optimum size of the plant: - This is the case in which the market size and cost
conditions allow. The monopolist to maximize long run profit at exactly equal to
the optimum plant.
Price Discrimination
A producer, mostly likely a monopolist need not always charge a single price to his
customers since he is the only producer in the market, he has a control over the
supply of the product. He can charge different prices to different consumers or in
different markets. Thus when the same product is sold at different price to different
consumers, it is called price discrimination. The two most important points to note
about the definition of price discrimination are: first, exactly the same products must
have different prices. A trip from Bahir Dar to Gondar is not the same as a trip from
Bahir Dar to Dessie because transportation costs are different and this difference
raises the price of the trip. Second, in order for price discrimination to exist,
production costs must be equal. If costs are different, a profit maximizing firm who
sets MR=MC will usually charge different price for a product. This price difference is
also due tot cost difference not discrimination.
Consumers are discriminated in respect of price on the basis of their incomes,
geographical location, Age, sex, quantity they purchase, frequency of visits to the
shop etc. For instance, price discrimination on the basis of age in airways, railways,
Cinema shows, Musical concerts, charging lower price for teenagers. Doctors has
charged different price for rich and poor persons. But to implement price
discrimination effectively the following conditions has to be full filled.
1.

There must be separate markets, so that no reselling can take place from a low
price market to a high price market. It is most commonly effective for goods that
can not be easily traded (exchange of services for example, a poor receiving
medical care at relatively low price can not resell his or her operation to another
patient, but a lower price buyer of some raw material could resell it to some one
in the higher price market.
2. Differences in the elasticity of demand. It is the difference in price elasticity that
provides opportunity for price discrimination. If price elasticity of demand in
different markets is the same, price discrimination would not be important (gain
full).
Degrees of price discrimination
The main objective of price discrimination is to maximize profit more than that the
firm could obtain by charging the same price defined by the equation of his MC and
MR. The degree of price discrimination, there fore, refers to the extent to which a
seller can divide the market and can take advantage of it in extracting the consumers
surplus. Accordingly there are three degrees of price discrimination practiced by
monopolists
a. First degree price discrimination
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The discriminatory pricing that attempts to take away the entire consumer surplus is
called first-degree discrimination. Under first price discrimination, the firm treats each
individual's demand separately and each consumer is assumed as a separate market.
b. Second -Degree price Discrimination.
First-degree price discrimination is expense to implement. Because dealing each
individual demand curve needs vast information and it is costly. Second degree price
discrimination is some what simpler because it requires the firm to consider groups of
consumers. This is discrimination on the basis of quantity purchased and intends to
take only the major part of consumer surplus rather than the entire.
c. Third degree Price discrimination
Selling the same product with different price in different markets having demand
curves with different elasticity is called third degree price discrimination. Profit in each
market would be maximum only when his MR=MC in each market. The monopolist
there for divides his out put between the markets so that in all markets his MR=MC.
In this case suppose that the monopolist has to sell his product in only two markets A
and B. As a result, the monopolist must allocate out put between the two markets in
such proportion that the necessary condition for profit maximization (i.e. MR = MC) is
satisfied. The equilibrium condition is satisfied i.e. MC=MRa =MR b (common MC equal
individual MR)
Social cost of Monopoly Power
So far we have seen how out put and price is determined in the case of perfect
competition and monopoly. And we have examined the quantity supplied under
perfect competition & monopoly; the price charged by a perfectly competitive and
monopolistic firm. Economists are always criticized monopoly firms in that it is
less efficient than competitive firms and it causes social welfare loss and
distortions in resource allocation.
The most common reason for criticism of monopoly is that price is higher and out put
is lower than in a perfectly competitive market. These fore, we compare the long run
price and out put under monopoly and perfect competition using the following
graphical analysis assuming a constant cost industry ( so that LAC =LMC)

85

q1

q2

LAC=LMC=MR=AR
=DD perfect

Price and output under monopoly & perfect competition

As it is prevailed in the above figure given the cost and revenue conditions, the
perfectly competitive industry will produce Oq 2 at which is LAC = LMC= AR. Its Price
will be OP1.
On the other hand, the monopoly firm produces an out put where LMC = MR.
Monopoly firm produces Oq1 and charges price OP2. Thus, if both monopoly and
competitive industries are faced with identical cost conditions, the out put under
competitive condition is higher than under monopoly (0q2 >0q1), and price in the
competitive industry is lower than in monopoly (OP1<OP2). Perfect competition is
therefore more desirable from social welfare angle. The loss of social welfare is
measured in terms of loss of consumer surplus. The total consumer surplus equals
the difference between the total utility which a society gains from and the total price
which he pays for a given quantity of goods as you have seen in module one.
Consumer surplus under competitive market
- The total utility from oq2 = area OALq2
- Total price paid by the society = area OP1Lq2
- Consumer surplus = area OALq2 = area OP1Lq2
= area ALP1
Consumer surplus under monopoly
- Total utility from Oq2 = area OAJq1
- Total price paid by them society = OP2Jq1
- Consumer surplus = area OAJq1-areaOP2q1
= area AJP2
Thus loss of consumer surplus under monopoly equals
Area ALP1 -Area AJP2 = P2JLP1
Of this total loss of consumer surplus (P2JLP1), P2JkP1 is extracted by the monopolist
as profit, the remaining JKL goes to none and it is termed as dead weight loss to
the society

86