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Micro Economics I Module I

UNIT ONE

BASICS OF ECONOMICS

Introduction

Dear learner microeconomics is the study of the decision making process of individual
economic unit. Any individual or entity such as consumers, workers, firms etc that play a
significant role in the functioning of our economy are considered as an economic unit or
economic agent. Microeconomics explains how and why these economic units make
economic decisions. It also explains how consumers and firms make decisions in buying
out puts and selling inputs respectively and how their choices are affected by changing
prices / costs and incomes/revenues. Consumers, workers, firms etc are interested to know
causes of price and output instability as well as unemployment. Moreover, most of our
issues and problems are related to economic matters. In general, an individual who does not
understand basic economic principles will not appreciate and evaluate public issues that are
most of them are related with economics. This unit is divided in to two sections. In the first
section of the unit, you will see the definitions and the central aims of economics. The
second section focuses on the resource availability and its impact on the production and
consumption of goods and services.

Objectives

After successful completion of this unit, you will be able to:


 define what economics is and its purpose;
 explain the central aim of economics;
 explain how the problem of scarcity is the basic problem in any
economy;
 discuss the problem of scarcity of factors of production and opportunity cost

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Section 1: The Concept of Economics

Overview

Dear learner the nature and scope of the science of economics has dramatically grown and
it has become very wide and vast. In this section, we will define economics from different
angles like scarcity, unlimited wants, choices etc. You will also try to understand the nature
and scope of economics.

Objectives

After completing this section, you will be able to:


 define the term economics;
 explain the major divisions of Economics;
 discuss the central aim of economics;
 explain the alternative methods of economic analysis; and
 explain the basic economic problems

1.1 Definition of Economics

Dear learner, what do you understand from the word Economics?


(Use the space left below to write your answer)
_________________________________________________________________________
_________________________________________________________________________

Economics is a branch of social science which deals with efficient utilization of scarce or
limited resources to fulfill the unlimited human wants. Economics is the study of efficient
allocation of resources in order to attain the maximum fulfillment of unlimited human
wants or needs. It is also defined as the study of how people make choices to cope with
scarcity and how people consume goods and services and how they trade.

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In the above definition, efficiency, unlimited human wants, scarce resources and choices
are the key phrases. Thus, it is important to look at each one of them thoroughly.

Unlimited wants and scarce resources

Human wants and needs are unlimited and insatiable. These needs have a recurring nature
and are subject to diversification through time. Human beings want food, clothes, shelter
and other variety of goods and services for their survival. These human wants are unlimited
and increase from time to time; however, economic resources that include Land, Labor,
Capital and Entrepreneurship are scarce by their nature. Even though society produces what
it wants using these economic resources, it can not produce and consume all the goods and
services it wants due to limited availability of resources. Thus, economics describes various
sets of tools that enable societies to use their scarce resources efficiently in order to achieve
the highest possible standard of living.

1.2 The Central Aim of Economics

Dear learner! What is the aim of economics?


(Use the space left below to write your response)
_________________________________________________________________________
_______________________________________________________________________

Dear learner! As we have discussed above human wants are unlimited while they live in a
world of scarce resources. Scarcity refers to a physical condition where the quantity desired
of a particular resource exceeds the quantity available. Therefore, since the available
resources are scarce, the ability of every society to produce goods and services are limited.
The need to balance unlimited wants with limited resources has raised the question of
efficient utilization of scarce resources. Therefore, the central aim of economics is the
efficient use of the scarce resources by minimizing loss so as to get the maximum possible
satisfaction. In the absence of scarcity, there will be no need of economizing. Therefore,

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the foundation of economics lies on the concepts of scarcity and choice (unlimited human
wants). Generally, the field of economics bases itself on two fundamental facts. These are:
a) The existence of limited resources and
b) The existence unlimited human wants

1.3 Opportunity cost and making choice

Dear learner! Please write one sentence definition for the term opportunity cost?
(Use the space left below to write your response)
_________________________________________________________________________
_______________________________________________________________________

Opportunity cost is the value of the next best alternative forgone or sacrificed to get one
more unit of an item or a commodity. It is the most important concept for making
optimizing choices. An opportunity cost of any action is the best alternative forgone. The
real opportunity cost of an action is measured in goods and services forgone, not in
monetary units. It is not the sum of all alternatives forgone rather it is the value of the
activity sacrificed which is next to the current decision.

To make economic choices in an activity both marginal costs (the additional opportunity
cost that can be incurred) and marginal benefits (the additional benefit that can be obtained)
are considered. If marginal benefit exceeds the marginal cost, an individual prefers
increasing the activity.

Whenever the opportunity cost of an activity increases, individuals substitute other


activities in its place. Thus, changes in marginal cost (opportunity cost) and marginal
benefits change the incentives people face and change their actions.

1.4 Major Economic Problems

Dear learner! the fact that we face scarcity of economic resources in this world and
unlimited human wants creates three basic economic problems. These economic problems

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are universal problems that must be answered by all countries. These economic problems
are what, how and for whom to produce.

What to produce: It refers to the quantity of the goods and services the economy should
produce by using its scarce resources. Since resources are scarce or limited, an economy
can not produce as much of every good and service as desired by all members of a society.
For this reason, more of one good or service means less of others. Therefore, every society
must choose exactly which goods and services to produce and in what quantities. In other
words, what to produce refers to the problem of allocation of scarce resource between their
alternative uses.

How to produce: The “how to produce” question refers to the methods of production. It
refers to the choice of the combination of factors and the particular technique to use in
producing a good or service. Different techniques of production can be used to produce
goods and services. Even if resources are generally scarce, some resources may be
relatively abundant than others in a country. For instance, in Ethiopia labor is relatively
abundant than capital. If the country uses more of labor and less of capital it minimizes cost
of production. The government of Ethiopia generally encourages labor intensive
technologies than capital intensive ones due to relative abundance of labor in the country

For whom to produce: The “for whom to produce” question refers to identification of
target consumers. This question refers to how the total output produced is to be divided
among different consumers. In every economy, due to scarcity no nation is capable of
satisfying all the needs of its society. As a result, the nation has to choose how to distribute
the output. For example, in market economy the distribution of goods and services depends
on the distribution of money income. That means, those who have more income can enjoy
more of the goods and services and those who have less income can enjoy less of the goods
and services.

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1.5 Methods of Economic Analysis

Dear learner! How do economists solve the basic economic problems?


(Use the space left below to write your response)
_________________________________________________________________________
_______________________________________________________________________
In order to solve the basic economic problems (What, how and for whom to produce)
economists devise policies based up on principles or theories .This principles or theories
can be derived from facts. Economic theories/analysis are drawn from facts through
induction (from particular to general) and deduction (from general to particular) methods.

1.6 Theories and Economic Models

Like other sciences, economics is concerned with the explanation and prediction of
observations or phenomenon. These explanation and prediction of phenomenon is based on
the use of theories.
Theory: A theory is developed to explain observed phenomenon based on a set of basic
rules and assumptions. It is a framework that helps us to understand the relationship
between cause and effect. It is simplification of an actual relationship and a hypothesis that
has been successfully tested .It can be true in general or on average and is often subject to
exceptions because of individual differences. For example, according to the theory of
demand, other things remaining constant, when price of a product decreases, the quantity
demanded of the product increases. This is generally true. However, there may be some
exceptional individuals who may not like to buy cheaper products and decide to stop
buying any quantity of a product when its price decreases.

Dear learner! As we have discussed above, the objective of a theory is to predict and
explain the cause of phenomena we observe. Thus, it simplifies, generalizes, predicts and
explains the event. For instance, the theory of demand helps us to predict by how much the
quantity demanded of a product increases if its price falls by a certain amount and explains
the reasons for such negative relationship.

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By applying statistical tools and econometric techniques, models can be constructed from
economic theories.

Economic Models: It is a skeletal and rough representation of the actual economy which
can be represented by using graphs, mathematical equations, computer programs etc. In
other words, it is a simplified representation of the real situation that is achieved by a set of
meaningful and consistent assumptions. We use models in order to simplify our complex
real world and to minimize the costs we incur while obtaining information. We evaluate
models based on their assumptions, generality, simplicity and how well it predicts its
phenomenon.

1.7 Microeconomics and Macroeconomics


Dear learner! Try to define microeconomics and macroeconomics?
(Use the space left below to write your response)
_________________________________________________________________________
_______________________________________________________________________
Generally, Economics is categorized into two broad categories as microeconomics and
macroeconomics. Let us see each of them some what briefly:

Microeconomics: It is a branch of economics which deals with the decision making


behavior of individual economic actors/agents such as individuals, households, business
firms, industries. In other words, microeconomics is concerned with the ‘elements’ of an
economic system, the firms and the consumers. It refers to the study of economic motives
and behavior of individual consumers and producers and the principles involved in
organizing and operating the individual firms or industries.

Macroeconomics: It is a branch of economic analysis that examines the economy as a


whole or its basic sub-divisions or aggregates such as the government, household and
business sector. It is the study of the behavior of the economy as a whole. It deals with the
aggregates and averages of the system rather than with particular parts of it and attempts to

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define these aggregates in a useful manner and to examine how they are related and
determined.

1.8 Positive and Normative Economics

Positive economics deals with specific statements that are capable of verification by
reference to the facts about economic behavior. It deals with facts or relationships which
can be proved or disproved. It involves describing things and facts as they are.
Examples of positive economic statements are:
 The Gross Domestic Product (GDP) of Ethiopia for the 2005/06 fiscal year was
slightly over 115 billion Birr.
 Increase in the value of domestic currency in relation to foreign currency, makes
imported products relatively cheaper.
 An increase in interest rate reduces investment in an economy

Normative economics involves someone’s opinion or value judgment about an economic


issue. Such a statement can never be proven. It has a moral or ethical aspect and goes
beyond what a science can say.
.
Examples of normative economic statements are:

 The government should raise the GDP of the country as 115 billion Birr reported
for the 2005/06 fiscal year is quite small.
 We need to try to lower the value of Birr in order to discourage the importation of
foreign goods into this country.
 Families with income below birr $3,500 per year should be exempted from income
taxes.

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Check your progress Activity

Answer the following questions on the spaces provided below.

1. What is economics?
___________________________________________________________________
___________________________________________________________________
2. What are the foundations of economics?
___________________________________________________________________
___________________________________________________________________
3. What is the central aim of economics?
___________________________________________________________________
___________________________________________________________________

4. What is micro economics?


___________________________________________________________________
___________________________________________________________________
5. What is macro economics?
___________________________________________________________________
___________________________________________________________________
6. Indicate each of the following sentences whether they are micro economics or
macro economics?
 The inflation rate in Ethiopia in 2008 is 19 %
___________________________________________________________________
___________________________________________________________________
 The overall annual production of Muger Cement factory is only a small
percentage of its market demand
___________________________________________________________________
___________________________________________________________________

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7. What is positive economics?


______________________________________________________________________
______________________________________________________________________
8. What is normative economics?
______________________________________________________________________
______________________________________________________________________

9. Write “Normative economics” if the statement reflects Normative economics and


“positive economics” if it reflects Positive economics for the following statements.
 The rich should pay taxes.
______________________________________________________________________
______________________________________________________________________
 The inflation rate of the country has grown this year by 10%.
______________________________________________________________________
______________________________________________________________________
 The government should reduce poverty in the country.
______________________________________________________________________
______________________________________________________________________
 The salary of Government employees is increased by 17% this year.
______________________________________________________________________
_________________________________________________________________________________________________________

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 Checklist

Dear learner have you achieved the entire objectives of the unit? Below are some of
the most important points drawn from the unit you have been studying up to now.
Please put a tick (√) mark in front of the point you have understood well in the box
under "Yes" and in the box under "No" for points you have not understood well yet.
And if the tick marks under "No" are more than those under “Yes" it means you are left
with lots of points to understand in the unit and you have not yet achieved the
objectives indicated at the beginning of the unit. This tells you to go back and read the
sections you passed through.

I can: Yes No
1. define the term economics
2. explain the central aim of economics
3. explain the foundations of economics
4. discuss about the methods of economic analysis

5. define microeconomics and macroeconomics

6. explain the difference between positive and


normative economics.

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Summary

Economics is the study of efficient allocation of scarce resources in order to attain the
maximum fulfillment of unlimited human wants. Scarcity refers to a physical condition
where the quantity desired of a particular resource exceeds the quantity available. This
scarcity of resources created three major problems that every society faces. These
economic problems are what, how and for whom to produce.

Moreover, since the available resources are scarce, the ability of every society to produce
goods and services are limited. The need to balance unlimited wants with limited resources
has raised the question of optimum utilization of scarce resources. Therefore, the central
aim of economics is the efficient use of the scarce resources by minimizing loss so as to get
the maximum possible satisfaction

A theory is a framework that helps us to understand cause and effect relationships. It is a


simplification of actual relationships. It is developed to explain observed phenomenon
based on a set of basic rules and assumptions.

Economics is divided in to two broad categories. These are microeconomics and


macroeconomics. Microeconomics is a branch of economics which deals with behavior of
individual decision making units such as individuals, households, business firms etc while
Macroeconomics is the study of the behavior of the economy as a whole.

In terms of the approach of study, economics is categorized in to two - Positive economics


and normative economics. Positive economics deals with specific statements that are
capable of verification by reference to the facts about economic behavior. In other words, it
is an economic analysis that provides statements about “what is", “what was” or “what will
be " rather than “what should be". Normative Economics is someone’s opinion or value

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judgment about an economic issue. In other words, it is concerned with “what ought to be”
or “what should be” done about the economy or the variable under consideration.

Self-check Exercise

Part I: True or False Items

Direction: Write “True" if the statement is true and “False" if it is not true on the
space provided before each question.

_______1. Economics is the study of how societies choose to use scarce resources to
produce commodities of various kinds.
_______ 2. Scarcity refers to the imbalance between human desires and means of
satisfying them.
_______ 3. A theory is a rough representation of the actual economy.
_______ 4. Microeconomics deals with the total out put level of an economy.
__ _____5.The following is an example of a positive economic statement,” the
quantity demanded for imported goods must be discouraged by imposing
tariffs and quotas”.

Part II: Completion Item types

Direction: Complete the blank space with appropriate word or term.


1. ________ is the study of the behavior of individual decision makers.
2. _________ is statements concerned with values or opinions of what ought to be.
3. _________is the skeletal or rough representation of the actual economy.
4. _________is part of an economic analysis that concerns with statements that can be
proved or disproved.
5. _________refers to a physical condition where the quantity desired of a particular
resource exceeds the quantity available.

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Part III: Multiple-choice Items

Direction: Select the correct answer from the given alternatives and write the letter
of your choice.

_________1. Which of the following statement describes macroeconomics?


A) It studies the problems of aggregate production and consumption.
B) It studies the behavior of individual firms or consumers.
C) It studies inflation and unemployment of a given nation.
D) A and C
E) All

_________2. Which of the following statements is correct?


A) Macroeconomics deals with the study of individual decision making unit
B) Microeconomics is the study of aggregate economy.
C) Positive economics is concerned with statements about “what should be”.
D) Normative economics is concerned with statements about "what is".
E) None

________3. Which concept describes the best alternative forgone?


A) Theory
B) Opportunity cost
C) Economics
D) Scarcity
E) Principles

________4. Which of the following statements is a correct statement?


A) An opportunity cost is the allocation of scarce resources.
B) Scarcity refers to the imbalance between human wants and means of satisfying their
needs.
C) Economizing refers to using resources abundantly.

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D) Since society can use resources efficiently they always satisfy their desires.
E) None

Suggested readings
 Agarwal H. (1998) Principles of Economics 7th Revised and Enlarged Edition.
 Ayele Kuris (2001) Introductory Economics. Addis Ababa, Ethiopia
 David N. Hyman (1988) Modern Microeconomics Analysis and Application. 2nd
edition, North Carolina State University, USA.
 McConnell, Campbell (1999) Microeconomics, Principles, Problems and Policies,
14th edition, McGraw Hill, New-York, USA.

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UNIT TWO
THEORY OF CONSUMER BEHAVIOR AND DEMAND

Introduction

Dear learner, we are now moving to the first real microeconomics study by considering the
consumers. The theory of consumer behavior is based on the assumption of the consumer
being rational to maximize level of satisfaction. The consumer makes the buying decision
by comparing available bundle of goods. The study of consumer behavior is done by the
two approaches which are different in their assumptions about measurability of utility or
satisfaction. The two approaches are called cardinal and ordinal utility approaches.

Objectives

After completing this unit, you will be able to:

 explain the concepts of cardinal and ordinal utility approach;


 discuss the properties of indifference curve;
 derive the budget line
 show optimum combination of goods
 state effects of changes in money income and price on equilibrium;
 Define and show graphically the income and substitution effect of a price change
 state and explain consumer and producer surplus;
 derive an individual demand curve;

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Section 1: Consumer Preferences and Utility

Overview

Dear learner, in this section you will see how consumers allocate their limited income
among different number of goods and services so as maximize their satisfaction .Besides,
you will learn how consumers allocation decisions determine quantity demand of goods
and services.

Objectives

After completing this section, you will be able to:

 Describe the theory of consumer preference an choice


 Explain the assumptions of consumer preference

2.1 Consumer Preference


Dear learner, being a member of consumers in this world, how do you compare goods? Do
you prefer one good to another, or treat any two goods as equal (indifferent between the
two groups)?

Given any two consumption bundles, the consumer can either decide that one of
consumption bundles is strictly better than the other, or decide that he is indifferent
between the two bundles. Commodities are desired because of their ability to satisfy wants.
Goods and services however differ in their ability to satisfy a want. An individual may
prefer coffee to tea. Another person may prefer tea to coffee but both consumers will derive
some level of satisfaction by consuming the good they have chosen.

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Strict preference

Given any two consumption bundles(X1, X2) and (Y1, Y2), if(X1, X2) > (Y1, Y2) or if he
chooses (X1, X2) when (Y1, Y2) is available the consumer definitely wants the X-bundle
than Y. The consumer prefers the X bundles than the Y bundles.

Weak preference

Given any two consumption bundles(X1, X2) and (Y1, Y2), if the consumer is indifferent
between the two commodity bundles or if (X1, X2)  (Y1, Y2), the consumer would be
equally satisfied if he consumes (X1, X2) or (Y1, Y2).

Completeness

Completeness of preference assumption implies that the consumer can compare two or
more goods and can easily indicate his preference. For any two commodity bundles X and
Y, a consumer will prefer X to Y, Y to X or will be indifferent between the two.

Transitivity

According to this rule, if a consumer prefers basket A to basket B and basket B to C, then
the consumer also prefers basket A to basket C. Or if the consumer is indifferent between
basket A and basket B and basket B and basket C, then he will be indifferent between
basket A and basket C

More is better than less

Consumers always prefer more of any good to less and they are never satisfied or satiated.
In any two consumption bundles A and B, A is preferred to B if A contains at least more of
one commodity than B. However, bad goods are not desirable and consumers will always
prefer less of them.

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2.2 Utility
Dear learner economists use the term utility to describe the satisfaction or enjoyment
derived from the consumption of a good or service.

Definition

Utility is the level of satisfaction that is obtained by consuming a commodity or


undertaking an activity.

In defining strict preference, we said that given any two consumption bundles (X1, X2) and
(Y1, Y2), the consumer definitely wants the X bundle than the Y bundle if (X1, X2) > (Y1,
Y2).This means, the consumer prefers bundle (X1, X2) to bundle (Y1, Y2) if and only if the
utility (X1, X2) is larger than the utility of (Y1, Y2).

The concept of utility is characterized with the following properties:

 ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso
may be useless functionally but offer great utility to art lovers.
 Utility is subjective. The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a
product may not be the same. For example, non-smokers do not derive any utility
from cigarettes.
 The utility of a product can be different at different places and time. For example,
the utility that we get from meat during fasting is not the same as any time else.

A Consumer considers the following points to get maximum utility or level of satisfaction:
 How much satisfaction he gets from buying and then consuming an extra unit of a
good or service.
 The price he pays to get the good.
 The satisfaction he gets from consuming alternative products.
 The prices of alternative goods and services.

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Dear learners, how do you measure the satisfaction level (Utility) that you get from goods
and services that you consume?

2.3 Approaches to measure Utility

There are two major approaches of measuring utility. These are Cardinal and Ordinal
approaches. This sub unit is divided into two Sections. In Section one, the Cardinal utility
approach will be discussed while in Section two the concept of ordinal Utility will be
addressed.

Section2: The Cardinal Utility theory

Overview

Dear learner, Utility maximization theories are important to deal with consumer behavior.
Thus, in this section, you will learn about the Cardinal utility theory. Neo classical
economists argued that utility is measurable like weight, height, temperature and they
suggested a unit of measurement of satisfaction called utils. A util is a cardinal number like
1, 2, 3 etc simply attached to utility. Hence, utility can be quantitatively measured.

Objectives

After completing your study on this section, you will be able to:

 explain the concept of cardinal approach;


 explain the assumptions of the cardinal approach;
 calculate marginal utility from total utility;
 derive individual demand curve and
 determine utility maximization of the consumer.

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2.4 Assumptions of Cardinal Utility theory

Dear learner! the major difference between the two approaches of utility lies in their
assumptions and implications of those assumptions. The basic assumptions of cardinal
utility theory are given below.

1. Rationality of Consumers. The main objective of the consumer is to maximize


his/her satisfaction given his/her limited budget or income. Thus, in order to
maximize his/her satisfaction, the consumer has to be rational.
2. Utility is Cardinally Measurable. According to this approach, the utility or
satisfaction of each commodity is measurable in cardinal numbers. Money is the
most convenient measurement of utility. In other words, the monetary unit that the
consumer is prepared to pay for another unit of commodity measures utility or
satisfaction.
3. Constant Marginal Utility of Money. According to assumption number two, money
is the most convenient measurement of utility. However, if the marginal utility of
money changes with the level of income (wealth) of the consumer, then money can
not be considered as a measurement of utility. The essential feature of a standard
unit of measurement is that it is constant.
4. Limited Money Income. The consumer has limited money income to spend on the
goods and services he/she chooses to consume making choice mandatory for the
consumer
5. Diminishing Marginal Utility (DMU).The utility derived from each successive
units of a commodity diminishes. Generally, the utility of the last unit consumed is
less than the utility of the previous item consumed of the same good. In other
words, the marginal utility of a commodity diminishes as the consumer acquires
larger quantities of it.
6. The total utility of a basket of goods depends on the quantities of the individual
commodities consumed.

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If there are n commodities in the bundle with quantities, X 1 , X 2 ,... X n the total
utility is given by:
TU=f ( X 1 , X 2 ...... X n )

In other words, total utility is a positive function of the quantities of goods


consumed.

2.5 Total and Marginal Utility

Definitions

Total Utility (TU) refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity at a particular time. As
the consumer consumes more of a good per time period, his/her total utility increases.
However, total utility can not be increased indefinitely. There is a point in which the
consumer will not be capable of enjoying any greater satisfaction from it. There is a point
at which total satisfaction reaches maximum and this point is called saturation point.

Marginal Utility (MU) refers to the additional utility obtained from consuming an
additional unit of a commodity. In other words, marginal utility is the change in total utility
resulting from the consumption of one or more unit of a product per unit of time. Precisely,
it is the slope of the total utility function.

Mathematically, the formula for marginal utility is:

TU
MU  Where, TU is the change in Total Utility, and,
Q
Q is change in the amount of product consumed.

2.6 Law of Diminishing Marginal Utility (LDMU)

Dear learner, do you think that the utility you derive from consumption of the first, the
second, and the third, etc cup of tea all the same? If not what happens?

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The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc.

The Law of Diminishing Marginal Utility (LDMU) states that as the quantity consumed of
a commodity increases per unit of time, the utility derived from each successive unit
decreases, consumption of all other commodities remaining constant.

The LDMU is best explained by the MU curve that is derived from the relationship
between the TU and total quantity consumed.

Table2.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Quantity of 0 1st 2nd 3rd 4th 5th 6th


X consumed Unit Unit unit unit unit Unit Unit
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2

A
20
TUX
Total Utility

15

10

Quantity X
Marginal Utility

B
10

Quantity X
1 2 3 4 5
MUX

Fig.2.1Derivation of marginal utility from total utility

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Dear learner as indicated in the above figure, as the consumer consumes more of a good
over time period, the total utility increases, at an increasing rate and then increases at a
decreasing rate when the marginal utility starts to decrease and reaches maximum when the
marginal utility is Zero.

The total utility curve reaches its pick point (Saturation point) at point A. This Saturation
point indicates that by consuming 5 units of X, the consumer attains its highest satisfaction
of 22 utils. However, Consumption beyond this point results in dissatisfaction, because
consuming the 6th and more units of X brings a negative utility than the previous orange.

2.7 Equilibrium of a consumer

A) one commodity case

Suppose the consumer’s utility function is giver as U  f (X ) and his/her total income
spent (expenditure) on commodity X would be: Total Expenditure TE  QX PX where Qx is
amount of commodity and Px is price of good X. The consumer would like to maximize the
difference between the utility (satisfaction) and expenditure (sacrifice).The problem is
simple maximization of the function.
MaxU  TE
That is:
U  Q X PX

According to the necessary condition (First Order Condition) for Optimization, for utility
to reach maximum, the derivative of the function with respect to Qx must be equal to zero.

dU d (Q X PX )
 0
dQ X dQ X
 MUx - Px =0
 MU X  PX or
MUx
1
Px

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Mathematically, the equilibrium condition of a consumer that consumes a single good X


occurs when the marginal utility of X is equal to its market price and the whole income has
been consumed (Total Expenditure =Total Income)

B) n-commodity case(General Case)

A consumer that maximizes utility reaches his/her equilibrium position when allocation of
his/her expenditure is such that the last birr spent on each commodity yields the same
utility.

For example, if the consumer consumes a bundle of n commodities i.e X1, X2 X3…… Xn
he/she would be in equilibrium or utility is maximized if and only if:

MU X 1 MU X 2 MU X n
  .........   MU m and
PX1 PX 2 PX n
Total expenditure(TE) equals to total income
Where: MUm –marginal utility of money

Diagrammatically,

A

C
PX 

 B

MUX Quantity X

Figure 2.2 marginal utility of a consumer

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Note that: at any point above point C like point A where MUX> Px, it pays the consumer
to consume more. At any point below point C like point B where MUX< Px the consumer
consumes less of X. However, at point C where MUx=Px the consumer is at equilibrium.
Table2.2 Utility schedule for a single commodity

Marginal utility
Quantity of Marginal utility
Total utility Marginal utility per Birr(price=2
Orange of money
birr)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1

For consumption level lower than three quantities of oranges, since the marginal utility of
orange is higher than the price, the consumer can increase his/her utility by consuming
more quantities of oranges. On the other hand, for quantities higher than three, since the
marginal utility of orange is lower than the price, the consumer can increase his/her utility
by reducing its consumption of oranges.

Suppose that a consumer consumes two commodities, Orange and Banana. The total
income of the consumer is Birr 20.If price of Orange is Birr 2 per unit and Birr 4 per unit
for Banana. If the utility schedule of the consumer is as indicated below the optimum
combination of the two goods can be calculated as follows.

Table2.3 Utility schedule for two commodities

Orange, Price=2birr Banana, Price=4birr


Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 6
2 10 4 2 2 22 16 4
3 12 2 1 3 32 12 3
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.85
6 11 -2 -1 6 48 3 0.75

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Dear learner, as we discussed earlier, utility is maximized when the condition of marginal
utility of one commodity divided by its market price is equal to the marginal utility of the
MU 1 MU 2
other commodity divided by its market price MU i.e.  and income equals
P1 P2
expenditure.

Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and 4
MU orange MU banana 4 8
quantities of banana, because     2 and
Porange Pbanana 2 4

His total income of birr 20 equals to the total expenditure on 2 units of orange (2X2= birr
4) and 4 units of banana (4x4=birr16)

2.7 Derivation of the Cardinalist Demand


Dear learner, we discussed that marginal utility is the slope of the total utility function. The
derivation of demand curve is based on the concept of diminishing marginal utility. If the
marginal utility is measured using monetary units the demand curve for a commodity is the
same as the positive segment of the marginal utility curve.

a
P1
b
P
Price

c
P2
MUX
O Quantity

P1
Price

P
Demand
P2 Curve
O Quantity
Q1 Q Q2
Figure 2.3 Derivation of Demand curve

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Limitation of the Cardinalist approach


The Cardinalist approach involves the following three weaknesses:

1. The assumption of cardinal utility is doubtful because utility may not be quantified.
2. Utility can not be measured absolutely (objectively). The satisfaction obtained from
different commodities can not be measured objectively.
3. The assumption of constant MU of money is unrealistic because as income
increases, the marginal utility of money changes.

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Section3: The Ordinal Utility Theory

Overview

Dear learner, in the previous section, we have seen cardinal approach of utility
measurement. In this section, we will discuss the second approach that is the ordinal utility
approach.

In the ordinal utility approach, utility cannot be measured in cardinal numbers or


absolutely. The consumer is expected to rank different consumption bundles according to
his/her preferences. The ordinal utility concept is based on the fact that it may not be
possible for consumers to express the utility of various commodities they consume in
absolute terms, like, 1 util, 2 utils, or 3 utils, but it is always possible for the consumers to
express the utility in relative terms. It is practically possible for the consumers to rank
st nd rd
commodities in the order of their preference as 1 2 3 and so on.

Objectives

After completing this section you will be able to:

 Explain the assumptions of ordinal utility approach


 Define an indifference curve and a budget line
 Identify the properties of indifference curve;
 Determine utility maximizing combinations of goods for a given consumer
 Derive an income-consumption curve and price-consumption curve.
 Show the effect of change in income on optimum consumption bundles
 Distinguish the difference between substitution and income effects of a price
change

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2.8 Assumptions of Ordinal Utility Theory

Dear learner, like the previous approach, this approach is based on simplifying
assumptions. Most of which are indicated here under:
1. The Consumers are rational-they aim at maximizing their satisfaction or utility
given their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers are
required only to order or rank their preference for various bundles of commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution
is the rate at which a consumer is willing to substitute one commodity (x) for
another commodity (y) so that his total satisfaction remains the same. Marginal rate
of substitution is the slope of the Indifference curve. When a consumer continues to
substitute X for Y the rate goes on decreasing as the two goods are assumed to be
imperfect substitutes in a standard case.
4. The total utility of the consumer depends on the quantities of the commodities
consumed, i.e., U=f (X1 ,X2, X3,--- Xn,)
5. Preferences are transitive or consistent:
 It is transitive in the senses that if the consumer prefers market basket X to market
basket Y, and prefers Y to Z, and then the consumer also prefers X to Z.
 Consistency of preference implies that If market basket X is preferred to market
basket Y (X>Y) then Y can not be preferred to X at another time(Y not >X).
6. Limited money income.
The consumer is confronted with limited money income so that optimization is
mandatory.
7. Non – satiation assumption
Consumers always prefer more of any good to less and they are never satisfied or
satiated. In any two consumption bundles A and B, A is preferred to B if A
contains at least more of one commodity. However, bad goods are not desirable
and consumers will always prefer less of them.

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The ordinal utility approach is expressed or explained with the help of indifference curves.
An indifference curve is a concept used to represent an ordinal measure of the tastes and
preferences of the consumer and to show how he/she maximizes utility in spending income.
Since it uses ICs to study the consumer’s behavior, the ordinal utility theory is also known
as the Indifference Curve Analysis.

2.9 Indifference Set, Curve and Map

Dear learner, can you write one sentence definition for an indifference curve?
(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________

Indifference Set/ Schedule: It is a combination of goods for which the consumer is


indifferent, preferring none of the consumption bundles. It is a tabular presentation of the
various combinations of goods from which the consumer derives the same level of utility.

Table 2.4 Indifference Schedule

Bundle A B C D
(Combination)
Orange(X) 1 3 5 7

Banana (Y) 23 15 9 6

Each combination of good X and Y gives the consumer equal level of total utility. Thus,
the individual is indifferent whether he consumes combination A, B, C or D.

Indifference Curves: an indifference curve shows the various combinations of two goods
that provide the consumer the same level of utility or satisfaction. It is the locus of points
(particular combinations or bundles of good), which yield the same utility (level of
satisfaction) to the consumer, so that the consumer is indifferent as to the particular
combination he/she consumes. An indifference curve is an iso or equal utility curve.

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By transforming the above indifference schedule into graphical representation, we get an


indifference curve.

10 A

Indifference
B
Banana (Y)

6 Curve (IC)

Good B
C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
OrangeX
)) (X)

Indifference curve Indifference map


Fig2.4 indifference curves and indifference map.

Indifference Map: It is a set of indifference curves with different levels of satisfaction. It is


the entire set of indifference curves, which reflects the complete set of tastes and
preferences of the consumer. A higher indifference curve refers to a higher level of
satisfaction and a lower indifference curve shows lesser satisfaction. IC2 reflects higher
level of utility than that of IC1.Any consumer has lots of indifference curves, not just one.

Properties of Indifference Curves:

Indifference curves have certain unique characteristics with which their foundation is
based.

1. Indifference curves have negative slope (downward sloping to the right).


Indifference curves are negatively sloped because the consumption level of one
commodity can be increased only by reducing the consumption level of the
other commodity for a movement along an indifference curve. That means, if

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the quantity of one commodity increases with the quantity of the other
remaining constant, the total utility of the consumer increases. On the other
hand, if the quantity of one commodity decreases with the quantity of the other
remaining constant, the total utility of the consumer reduces. Hence, in order to
keep the utility of the consumer constant, as the quantity of one commodity is
increased, the quantity of the other must be decreased.
2. Indifference curves do not intersect each other. Intersection between two
indifference curves is inconsistent with the reflection of indifference curves. If
they do intersect, the point of their intersection would mean two different levels
of satisfaction from a single combination of goods, which is impossible.
3. A higher Indifference curve is always preferred to a lower one. The further
away from the origin an indifferent curve lies, the higher the level of utility it
denotes: baskets of goods on a higher indifference curve are preferred by the
rational consumer, because they contain more of the two commodities than the
lower ones.
4. Indifference curves are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve
from the left downwards to the right. This assumption implies that the
commodities can substitute one another at any point on an indifference curve,
but are not perfect substitutes.

B
Banana

Banana

E

D IC2
C
A
IC1
X
Orange Orange
Fig.2.5 positively sloped and intersected indifference curves

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Dear learner, as we discussed earlier, Indifference curves cannot intersect each other. If
they did, the consumer would be indifferent between C and E, (Right panel of figure 2.5)
since both are on indifference curve one (IC1). Similarly, the consumer would be
indifferent between points D and E, since they are on the same indifference curve, IC 2.By
transitivity, the consumer must also be indifferent between C and D. However, a rational
consumer would prefer D to C because he/she can have more Orange at point D (more
Orange by an amount of X).

The left panel of figure 2.5 summarizes the implication of an upward sloping indifference
curve. Point A and B are two points on the same indifference curve which must give the
consumer the same satisfaction. But the consumer is not indifferent between the two
consumption bundles since consumption bundle B contains more of both orange and
banana.

2.10 The Marginal rate of substitution (MRS)

Definition

Marginal rate of substitution of X for Y is defined as the number of units of commodity Y


that must be given up in exchange for an extra unit of commodity of X so that the
consumer maintains the same level of satisfaction. It is the rate at which one commodity
can be substituted for another while keeping the level of satisfaction the same.

Number of units of Y given up


MRS X ,Y 
Number of units of X gained

It is the negative of the slope of an indifference curve at any point for any two commodities
such as X and Y, and is given by the slope of the tangent line at that point:

i.e., Slope of indifference curve


y
 MRS X ,Y
x

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In other words, MRS refers to the amount of one commodity that an individual is willing to
give up to get an additional unit of another good while maintaining the same level of
satisfaction or remaining on the same indifference curve. The diminishing slope of the
indifference curve means the willingness to substitute X for Y diminishes as one move
down the curve.

Note that ( MRS X ,Y ) measures the downward vertical distance (the amount of y that the

individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of x
Y
required) to remain on the same indifference curve. That is, MRS X ,Y   because of the
X
reduction in Y, MRS is negative. However, we multiply by negative one and express
MRS X ,Y as a positive value. MRS is defined for a movement along the same indifference

curve.

The rationale behind the convexity, that is, diminishing MRS, is that a consumer’s
subjective willingness to substitute X for Y (or Y for X) will depend on the amounts of Y
and X he/she possesses.

Table2.5 level of consumption of good X and Y


Bundle A B C D
(Combination)
Orange(X) 1 3 5 7

Banana (Y) 23 15 9 6

Y 8
MRS X ,Y (between points A and B)   4
X 2

Dear learner, in the above case the consumer is willing to forgo 8 units of Banana to obtain
2 more unit of Orange. If the consumer moves from point B to point C, he is willing to give

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up only 6 units of Banana(Y) to obtain 2 unit of Orange (X), so the MRS is 3(∆Y/∆X
=6/2). Having still less of Banana and more of Orange at point D, the consumer is willing
to give up only 3 unit of Banana so as to obtain the same 2 units of Orange. In this case, the
MRS falls to 3/2. In general, as the amount of Y increases, the marginal utility of additional
units of Y decreases. Similarly, as the quantity of X decreases, its marginal utility
increases. In addition, the MRS decreases as one move downwards to the right.

Marginal Utility and Marginal rate of Substitution


Dear learner, it is also possible to show the derivation of the MRS using MU concepts. The
MRS X ,Y is related to the MUx and the MUy as follows:

MU X
MRS X ,Y 
MU Y

Proof:

Suppose the utility function for two commodities X and Y is defined as:

U  f ( X ,Y )
Since utility is constant on the same indifference curve:

U  f ( X ,Y )  C
The total differential of the utility function is:

U U
dU  dX  dY  0 since there is no change in utility for any
X Y
movement along the same indifference curve.

U U
MU X dX  MU Y dY  0 , = MUX and = MUy
X Y

MU X dY
  MRS X ,Y
MU Y dX

MU Y dX
Or,   MRS Y , X
MU X dY

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Example

Suppose a consumer’s utility function is given by U  10 X 2Y .Compute MRS X ,Y .

MU X
MRS X ,Y 
MU Y

dU dU
MU X  and MU Y 
dX dY

Therefore, MU X  20( X 21Y )  20 XY and MU Y  10( X 2Y 11 )  10 X 2

MU X 20 XY 2Y
MRS X ,Y   
MU Y 10 X 2 X

Exceptional Indifference Curves


Dear learner, in a standard case indifference curves are convex to the origin and downward
sloping as we have seen earlier and this shape of indifference curve is true for most goods.
In this situation, we assume that the two commodities such as X and Y can substitute one
another to a certain extent but are not perfect substitutes. However, the shape of the
indifference curve will be different if commodities have some other unique relationship
such as perfect substitution or complementary. Here, are some of the ways in which
indifference curves/maps might be used to reflect preferences for three special cases.

1. Perfect substitutes: perfect substitutes are goods which can be replaced for one another
at a constant rate. If two commodities are perfect substitutes (if they are essentially the
same), the indifference curve becomes a straight line with a negative slope. MRS for
perfect substitutes is constant. (Panel a)

2. Perfect complements: perfect complements are goods which are to be consumed jointly
at a constant rate. If two commodities are perfect complements the indifference curve takes
the shape of a right angle. Suppose that an individual prefers to consume left shoes (on the
horizontal axis) and right shoes on the vertical axis in pairs. If an individual has two pairs

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of shoes, additional right or left shoes provide no more utility for him/her. MRS for perfect
complements is zero i.e. there is no substitution between the two goods.

3. A useless good: Panel C in the above figure shows an individual’s indifference curve for
food (on the horizontal axis) and an out-dated book, a useless good, (on the vertical axis).
Since they are totally useless, increasing purchases of out-dated books does not increase
utility. This person enjoys a higher level of utility only by getting additional food
consumption. For example, the vertical indifference curve shows that utility will be the
same as long as this person has same units of food no matter how many out dated books
he/she has.

IC3 IC1 IC2 IC3

Out dated books


IC2
Right shoe

IC1
IC3
Total

IC2
IC1

Mobile Left shoe Food


Panel a Panel b Panel c

Fig.2.6 Special cases of indifference curves

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2.11 The Budget Line or the Price line

Dear learner, What is a budget line?


(You can use the space left below to write your response)
_______________________________________________________________________________
_______________________________________________________________________________

Dear learner, indifference curves show how the rate at which the consumer is willing to
substitute one good for another utility remaining the same. It only tells us the consumer’s
preferences for any two goods but they can not tell us which combinations of the two goods
will be chosen or bought.

A utility maximizing consumer would like to reach the highest possible indifference curve
on his/her indifference map. But the consumer’s decision is constrained by his/her money
income and prices of the two commodities. Therefore, in addition to consumer preferences,
we need to know the consumer’s income and prices of the goods. In other words, individual
choices are also affected by budget constraints that limit people’s ability to consume in
light of prices they must pay for various goods and services. Whether or not a particular
indifference curve is attainable depends on the consumer’s money income and on
commodity prices. A consumer while maximizing utility is constrained by the amount of
income and prices of goods that must be paid. This constraint is often presented with the
help of the budget line constructed by possible alternative purchases of any two goods.
Therefore, before we discuss consumer’s equilibrium, it is better to understand his/ her
budget line.

The budget line is a line or a graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, the budget line
shows the market basket that the consumer can purchase, given the consumer’s income and
prevailing market prices.

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Assumptions for the use of the budget line

In order to draw the budget line facing the consumer, we consider the following assumptions:

1. there are only two goods, X and Y, bought in quantities X and Y;


2. each consumer is confronted with market determined prices, Px and Py, of good X and
good Y respectivley; and
3. the consumer has a known and fixed money income (M).

By assuming that the consumer spends all his/her income on two goods (X and Y), we can
express the budget constraint as:

M  PX X  PY Y Where, PX=price of good X


PY=price of good Y
X=quantity of good X
Y=quantity of good Y
M=consumer’s money income

According to the above budget equation, the amount of money spent on X plus the amount
spent on Y equals the consumer’s money income.

Suppose for example a household with 60 Birr per day to spend on banana(X) at Birr 2
each and Orange(Y) at Birr 4 each. That is, PX  2, PY  4, M  60birr .

Therefore, our budget line equation will be:


2 X  4Y  60

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Table2.6 Alternative purchase possibilities of the two goods


Consumption
A B C D E F
Alternatives
banana (X) in
0 1 2 3 4 5
(kgs)
Orange(Y) in
15 14.5 14 13.5 13 12.5
(kgs)
Total
60 60 60 60 60 60
Expenditure

At alternative A, the consumer is using all of his /her income for good Y. Mathematically,
it is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income
for good X. Mathematically it is the X-intercept (5, 0). We may present the income
constraint graphically by the budget line whose equation is derived from the budget
equation.

M  PX X  PY Y
M  XPX  YPY

By rearranging the above equation we can derive the general equation of a budget line,
M PX
Y  X
PY PY
M
= Vertical Intercept (Y-intercept), when X=0.
PY
P
 X = slope of the budget line (the ratio of the prices of the two goods)
PY

The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is given by:

M PX
 X 0
PY PY
M PX
 X
PY PY

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M
X 
PX

M/PY

B

A

M/PX
Fig.2.7 Derivation of the Budget Line

Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent. Given any budget line, there are two
possible areas indicated by point A and point B. The area outside the budget line represents
non- feasible (un-attainable) area because it is beyond the reach of the consumer. On the
other hand, the area inside or on the budget line denotes feasible or achievable area.

2.12 Factors Affecting the Budget Line

Dear learner! What do you think are the factors that affect the position of a budget line?
(You can use the space left below to write your response)
_______________________________________________________________________________
_______________________________________________________________________________

Dear learner! Budget line depends on the price of the two goods and the income of the
consumer. Any change in the income of the goods or the income of the consumer results in
a shift in the budget line. Let us examine the impact of these changes one by one.

a. Effects of changes in income

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If the income of the consumer changes (keeping the prices of the commodities unchanged)
the budget line also shifts (changes). Increase in income causes an upward shift of the
budget line that allows the consumer to buy more goods and services and decreases in
income causes a downward shift of the budget line that leads the consumer to buy less
quantity of the two goods. It is important to note that the slope of the budget line (the ratio
of the two prices) does not change when income rises or falls. The budget line shifts from
Bo to B1 when income decreases and to B2 when income rises.

M2/Py

Where M2>Mo>M1
Mo/Py

M1/Py
Bo B2

B1

M1/PX Mo/PX M2/PX

Fig.2.8 Effects of change in income

b. Effects of Changes in Price of the commodities

Changes in the prices of X and Y is reflected in the shift of the budget lines. In the figures
below (fig.a), a price decline of good X results in the shift from B to B1.A fall in the price
of good Y in figure (b) is reflected by the shift of the budget line from B to B1.We can
notice that changes in the prices of the commodities change the position and the slope of
the budget line. But, proportional increases or decreases in the price of the two
commodities (keeping income unchanged) do not change the slope of the budget line if it is
in the sameYdirection. Y

B1 B1
B
B
X X

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Fig. a Fig.b

Fig.2.9 Effects of change in price

Let us now consider the effects of each price changes on the budget line

 What would happen if price of x falls, while the price of good Y and money incme
remaining constant?

A
M/py

Here PX1, < Pxo, hence M/Pxo <M/Px1

B B’

M/PX0 M/Px1 X

Fig. 2.10 Effect of a decrease in price of x on the budget line

Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y
by spending the entire money income on Y regardless of the price of X. We can see from
the above figure that a decrease in the price of X, money income and price of Y held
constant, pivots the budget line out-ward, as from AB to AB’.

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 What would happen if price of X rises, while the price of good Y and money incme
remaining constant?
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y
by spending the entire money income on Y regardless of the price of X. We can see from
the figure below that an increase in the price of X, money income and price of Y held
constant, pivots the budget line in-ward, as from AB to AB’.

A
M/Py

B
B’

M/Px1 M/Px2

Fig. 2.11 Effect of an increase in price of x on the budget line

 What would happen if price of Y rises, while the price of good X and money incme
remaining constant?
Y
A
M/py

A’
M/py'

B
M/Px X
Fig.2.12 Effect of a raise in price of Y on the budget line

Since the X-intercept (M/Py) is constant, the consumer can purchase the same amount of X
by spending the entire money income on X regardless of the price of Y. We can see from

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the above figure that an increase in the price of Y, money income and price of X held
constant, pivots the budget line in-ward, as from AB to A’B.

 What would happen if price of Y falls, while the price of good X and money incme
remaining constant?

Y
M/py' A’

M/py A

B
M/Px X

Fig.2.13 Effect of a fall in price of Y on the budget line

The above figure shows what happens to the budget line when the price of Y increases while the
price of good X and money income held constant. Since Py decreases, M/Py increases thereby the
budget line shifts outward.
 Dear colleague some times the price of the two commodities may change proportionally in
the same direction and this will have a shifting impact on the budget line.
Proportional increase in the prices of both goods (X and Y), income remaining the same, reduces
the total quantity of the two goods that the consumer can buy with the given income. For example
if the price of the two goods doubles, the quantity of the two goods bought decreases by half. Since
the slope of the budget line which is the ratio of the prices of the two goods remains the same,
there will be a parallel inward shift of the budget line.
When there is proportional (equal) decrease in price of the two goods income remaining the same,
the quantity bought of the two goods increases which leads o a parallel out ward shift in the budget
line

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M/Py2
Where PX1>PXo > PX2 and

M/Pyo
Where PY1>PYo > PT2

M/Py1 Bo B2

B1

M/PX1 M/PXo M/PX2

Example
A person has Birr 60 to spend on two goods(X, Y) whose respective prices are Birr 3 and
Birr 6.
a) Draw the budget line.
b) What happens to the original budget line if the budget increases by 50%?
c) What happens to the original budget line if the price of Y doubles?
d) What happens to the original budget line if the price of X falls to Birr 2?
e) What happens to the original budget line if price of both X and Y is doubled?

Dear learner from our previous discussion the budget line for two commodities is expressed
as:

PX X  PY Y  M

3 X  6Y  60
6Y  60  3 X
60 3
Y  X
6 6
1
Y  10  X
2
Y  10  0.5 X

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When the person spends all of his income only on the consumption of good Y, we can get
the Y intercept that is(0,10).However, when the consumer spends all of his income on the
consumption of only good X, then we get the X intercept that is (20,0). Using these two
points we can draw the budget line. Thus, the budget line will be:
Y

10 A

A’

B’ B
20 X

If the budget decreases by 50%, then the budget will be reduced to 30.As a result, the
budget line will be shifted in-ward as indicated by (A’B’).This forces the person to buy less
quantity of the two goods. The equation for the new budget line can be solved as follows:
3 X  6Y  30
6Y  30  3 X
30 3
Y   X
6 6
1
Y  5 X
2
Y  5  0.5 X
Therefore, the Y-intercept decreases to 5 units while the X-intercept is only 10 units.
However, since the ratio of the prices does not change the slope of the budget line remains
constant.

If the price of good Y doubles the equation of the budget line will be 3 X  12Y  60 and if
the price of good X falls to Birr 2, the equation for the new budget line will be
2 X  6Y  60 .

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If price of both X and Y is doubled, the new budget line equation will be 6X+12Y=60.The
X-intercept and Y-intercept decreases to 10 units and 5 unity respectively. The slope
remaining the same (-0.5), the budget line shifts inward in a parallel way.

2.13 Optimum of the Consumer

Dear learner, a rational consumer seeks to maximize his utility or satisfaction by spending
his or her income. It maximizes the utility by trying to attain the highest possible
indifference curve, given the budget line. This occurs where an indifference curve is
tangent to the budget line so that the slope of the indifference curve ( MRS X ,Y ) is equal to

the slope of the budget line ( PX / PY ).

Thus, the condition for utility maximization, consumer optimization, or consumer


equilibrium occurs where the consumer spends all income (i.e. he/she is on the budget line)
and the slope of the indifference curve equals to the slope of the budget
line MRS X ,Y  PX / PY .

The preferences of the consumer (what he/she wishes) are indicated by the indifference
curve and the budget line specifies the different combinations of X and Y the consumer can
purchase with the limited income. Therefore, the consumer tries to obtain the highest
possible satisfaction with in his budget line.

However, the consumer cannot purchase any bundle lying above and to the right of the
budget line. Because, Indifference curves above the region of the budget line are beyond
the reach of the consumer and are irrelevant for equilibrium consideration. The question
then arises as to which combinations of X and Y the rational consumer will purchase.

Graphically, the consumer optimum or equilibrium is depicted as follows:

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Y
A

B
E
IC4

C IC3

IC2
D
IC1

X
Figure2.14 Consumer equilibrium

At point ‘A’ on the budget line, the consumer gets IC1 level of satisfaction. When he/she
moves down to point ‘B’ by reallocating his/her total income in favor of X he/she derives
greater level of satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point
‘A’. Moving further down to point ‘E’, the consumer obtains the greatest level of
satisfaction (IC3) relative to other indifference curves.

Therefore, point ‘E’ (which represents combination X and Y) is the most preferred position
by the consumer since he/she attains the highest level of satisfaction within his/her reach
and point ’E’ is known as the point of consumer equilibrium (or consumer optimum). This
equilibrium occurs at the point of tangency between the highest possible indifference curve
and the budget line. Put differently, equilibrium is established at the point where the slope
of the budget line is equal to the slope of the indifference curve.

Mathematically, consumer optimum (equilibrium) is attained at the point where:

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PX MU X
MRS X ,Y  , But we know MRS X ,Y 
PY MU Y
MU X PX MU X MU X
  , or  
MU Y PY Px Py

Mathematical derivation of equilibrium

Suppose that the consumer consumes two commodities X and Y given their prices and
level of money income M. Thus, the objective of the consumer is maximizing his utility
function subject to his limited income and market prices. In utility maximization, the
function that represents the objective that the consumer tries too achieve is called the
objective function and the constraint that the consumer faces is called constraint function.

The maximization problem may be formulated as follows:

MaximizeU  f ( X , Y )

Subject to PX X  PY Y  M

To solve the constrained problem; we use the Lagrange Multiplier Method. The steps
involved are:

A) Rewrite the constraint function as follows:


M  PX X  PY Y  0(  will have positive value) or
PX X  PY Y  M  0 , will have negative value

B) Multiply the constraint by Lagrange multiplier 

 (M  PX X  PY Y )  0 ,  will have positive value

  ( PX X  PY Y  M )  0 ,  will have negative value

C) Form a composite function or the Lagrange function:

  U ( X , Y )   (M  PX X  PY Y )

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Or,   U ( X , Y )   ( PX X  PY Y  M )

D) The first order condition requires that the partial derivatives of the Lagrange function
with respect to the two goods and the langrage multiplier be zero.
 U  U 
  PX  0 ;   PY  0 and  ( PX X  PY Y  M )  0
X X Y Y 

From the above equations we obtain:

U U
 PX and  PY
X Y

U U
 MU X and  MU Y
X Y

Therefore, substituting and solving for  we get the equilibrium condition:

MU X MU Y
 
PX PY
By rearranging we get:

MU X PX
 = MRS x,y
MU Y PY
E) The second order condition for maximum requires that the second order partial
derivatives of the Lagrange function with respect to the two goods must be negative.

 2 U 2  2 U 2
  0 and  0
X 2 X 2 Y 2 Y 2

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Example 1
A consumer consuming two commodities X and Y has the following utility function
U  X 1.5Y .If the price of the two commodities are 3 and 4 respectively and his/her budget
is birr 100.
a) Find the quantities of good X and Y which will maximize utility.
b) Total utility at equilibrium.
c) Find the MRS X ,Y at optimum point

Solution
A) The Lagrange equation will be written as follows:
  X 1.5Y   (3 X  4Y  100)

 1.5 X 0.5Y  3  0 ……………………….. (1)
X

 X 1.5  4  0 …………………………… (2)
Y

 100  3 X  4Y  0 …………………… (3)


From equation (1) we get 1.5 X 0.5Y  3 and from equation (2) we get X 1.5  4 .By
1.5
1.5 X 0.5Y X
further simplification, we can get that   and equation (2) gives as .
3 4
Equating  with 
1.5
1.5 X 0.5Y X
   By rearranging and solving for X, we get
3 4
X=2Y--------------------------------------------------------------- (4)
Substituting Equation (4) in equation (3) or the constraint function,
3X +4Y=100 Since X= 2Y from equation (4)
3(2Y) +4Y=100 X=2(10)
10Y=100 X= 20units
Y=10units and;

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Therefore, optimum combination of the two goods is 10 units of Y and 20 units of X

B) The total utility at equilibrium is calculated by inserting the corresponding quantities of


X and Y in the total utility function
U  X 1.5Y When X= 20 and Y= 10,
U  (20)1.5 10
U= 894
MU X
C) MRS X ,Y  ,
MU Y
U U
MU X   1.5 X 0.5Y and MU Y   X 1.5
X Y
1.5(20) 0.5 (10)
MRS X ,Y  , at optimum point
201.5
67
=
89.4
=0.75
After inserting the optimum value of Y=10 and X=20 we get 0.75 which equals to the price
PX 3
ratio of the two goods (   0.75) .
PY 4
Example 2
A consumer consuming two commodities X and Y has the following utility function
U  X 2Y 2 .If the price of the two commodities are Birr 1 and 4 respectively and his/her
budget is birr 10.
A) Find the quantities of good X and Y which will maximize utility.
B) Find the MRS X ,Y at optimum.

C) Total utility at optimum point


D) The amount by which optimum utility changes when quantity of X or Y changes by
one unit(  ).

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Solution
A) The Lagrange equation will be written as follows:
  X 2Y 2   ( X  4Y  10)

 2 XY 2    0 ……………………….. (1)
X

 2YX 2  4  0 …………………………… (2)
Y

 X  4Y  10  0 …………………… (3)

YX 2
From equation (1) we get   2XY 2 and from equation (2) we get   .
2
Since  equals to  , we can solve for either X or Y
 =
2
2YX
2XY =
2
YX 2 = 4XY 2
X = 4Y--------------------------------- (4)
By substituting equation (4) in to equation (3) we get,
X+4Y=10
4Y+4Y=10, since X= 4Y
8Y=10
Y= 1.25 and X=4Y, X=4(1.25) =5
Thus optimum combination of the two goods is 5 for X and 1.25 for Y.
B) MRS X ,Y at optimum.

MU X
MRS X ,Y  , MU X = 2XY 2 and MUy = 2YX 2
MU Y

2 XY 2

2YX 2
Y
=
X

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After inserting the optimum value of Y=1.25 and X=5 we get 0.25 which equals to the
PX 1
price ratio of the two goods (   0.25) .
PY 4

C) TU  5 2 (1.25) 2
=25(1.56)
=39
D)   2XY 2 ,x= 5& Y=1.25
 2(5)(1.25) 2
=15.625

2.14 Effects of Changes in Income and Prices on Consumer‘s


equilibrium

Dear learner, let us now analyze the effect of changes in consumer’s income and the price
of the good that are the two important determinants of quantity demanded (or also
consumer equilibrium). Let us first consider the effect of change in income on the
equilibrium of the consumer all other things remaining constant.

A. Changes In Income: Income Consumption Curve and the Engel Curve

i. The case of normal goods

In our previous discussion, we noted that an increase in the consumer’s income (all other
things held constant) results in an upward parallel shift of the budget line. This allows the
consumer to buy more of the two goods. And when the consumer’s income falls, ceteris
paribus, the budget line shifts downward, remaining parallel to the original one.

If we connect all of the points representing equilibrium market baskets corresponding to all
possible levels of money income, the resulting curve is called the Income consumption
curve (ICC) or Income expansion curve (IEC).ICC is a locus of points representing

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various combinations of the two commodities purchased by the consumer at different levels
of his income, all other things remaining the same The Income Consumption Curve is a
curve joining the points of consumer optimum (equilibrium) as income changes (ceteris
paribus). Or, it is the locus of consumer equilibrium points resulting when only the
consumer’s income varies.

ICC
Commodity Y

E3
E2
E1

Commodity X

Engle Curve
I3
Income

I2

I1

X1 X2 X3 Commodity X

Figure2.15 the income –consumption and the Engle curves for normal goods

From the Income Consumption Curve, we can derive the Engle Curve. The Engle curve is
named after Ernest Engel, the German Statistician who pioneered studies of family budgets
and expenditure positions.

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The Engle Curve is the relationship between the equilibrium quantity purchased of a good
and the level of income. It shows the equilibrium (utility maximizing) quantities of a
commodity, which a consumer will purchase at various levels of income; (celeries paribus)
per unit of time.

In relation to the shape of the income-consumption and Engle curves, goods can be
categorized as normal (superior) and inferior goods. Thus, commodities are said to be
normal, when the income consumption curve and its Engle curve are positively sloped;
meaning that more of the goods are purchased at higher levels of income. On the other
hand, commodities are said to be inferior when the income consumption curve and Engle
curve is negatively sloped, i.e. their purchase decreases when income increases.

ii. The case of inferior goods

An inferior commodity is a consumption good whose consumption decreases as income


increases. Y

ICC

ICC
X
X
Figure2.16 the income –consumption Figure2.17 the income –consumption
curve when good X is inferior curve when good y is inferior

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Income

Engel curve for


inferior good

Good X

Figure2.18 Engel curve for inferior goods

B. Changes in Price: Price Consumption Curve (PCC) and Individual


Demand Curve

We now look at the second factor that affects the equilibrium of the consumer that is price
of the goods. The effect of price on the consumption of good is even more important to
economists than the effect of changes in income. Here, we hold money income constant
and let price change to analyze the effect on consumer behavior.

In our earlier previous discussion, we have seen that an increase in the price of good X, for
example, increases the absolute value of the slope of the budget line, but it does not affect
the vertical (Y) intercept of the line. Thus, the change in the price of X will result in out
ward shift of the budget line that makes the consumer to buy more of good X.If we connect
all the points representing equilibrium market baskets corresponding to each price of good
X we get a curve called price-consumption curve.

The price-consumption curve is the locus of the utility-maximizing combinations of


products that result from variations in the price of one commodity when other product
prices, the money income and other factors are held constant.

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We can derive the demand curve of an individual for a commodity from the price
consumption curve. Below is an illustration of deriving the demand curve when price of
commodity X decreases from Px1 to Px 2 to Px3 .

Commodity Y PCC

Commodity X

Px1
Price of X

Px2
Individual
Px3 demand curve

X1 X2 X3 Commodity X

Figure2.19 the PPC and derivation of the demand curve

2.15 Income and Substitution effects of a price change

Dear learner, we now turn to a more complete analysis of why demand curves slope
downward. In our previous discussion, we have noted that there are two effects of a price
change. If price falls (rises), the good becomes cheaper (more expensive) relative to other
goods; and consumers substitute toward (away from) the good. This is the substitution
effect. Also, as price falls (rises), the consumer’s purchasing power or real income
increases (decreases). Since the set of consumption opportunities increases (decreases) as
price changes, the consumer changes the mix of his or her consumption bundle. This effect
is called the income effect. Let us analyze each effect in turn, and then combine the two in
order to see why demand is assumed to be downward sloping.

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A) The effects of a price-decline on consumer’s equilibrium

When the price of a commodity declines ,the budegt line rotates outward causing a shift in
the optimum point.
First, a decrease in price increases the consumer’s real income (purchasing power), thus
enhancing the ability to buy more goods and services to some extent. Second, a decrease in
the price of a commodity induces some consumers (the consumer) to substitute it for
others, which are now relatively expensive (higher price) commodities.The 1st effect is
known as the income effect, and the 2nd effect is known as the substitution effect. The
combined effect of the two is known as the total effect (net effect).

Note that:
I/py1 X 1 X 3 =NE= Total (net) effect
X 1 X 2 = SE=Substitution effect
X 2 X 3 = IE=Income effect
I’/py1
A B IC2
 
C IC1

x1 x2 IE x3 I’/px1 I/px2
SE
NE

Figure2.20 Income and Substitution effect for a normal good

Suppose initially the income of the consumer is I , price of goodY is Py1 , and Price of
I I
good X is Px1 , we have the budget line with y-intercept and X-intercept . The
Py1 Px1
consumer’s equilibrium is point A that indicates the point of tangency between the budget
line and indifference curve IC1 . As a result of a decrease in the price of X from Px1 to Px 2
the budget line shifts outward with y-intercept remaininng the same.Hence the new budget

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I I
line passes through & X-Intercept . The consumer’s new equilibrium will be on
Py1 Px 2
point B.

The total change in the quantity purchased of commodity X from the 1st equilibrium point
at A to the second equilibrium point at B shows the Net effect or total effect of the price
decline (change).

The total effect of the price change can be conceptually decomposed into the substitution
effect and income effect.

The Substitution Effect

The substitution effect refers to the change in the quantity demanded of a Commodity
resulting exclusively from a change in its price when the consumer’s real income is held
constant; thereby restricting the consumer’s reaction to the price change to a movement
along the original indifference curve. The decline in the price of X results in an increase in
the consumer’s real income, as evidenced by the movement to a higher indifference curve
even though money income remains fixed.

Now, imagine that we decrease the consumer’s income by an amount just sufficient to
return to the same level of satisfaction enjoyed before the price decline. Graphically, this is
accomplished by drawing a fictitious (imaginary) line of attainable combinations with a
Px 2
slope corresponding to new ratio of the product price so that it is just tangent to the
Py1

original indifference curve IC1 .

The point of tangency is the imaginary point C (imaginary equilibrium). The movement
from point A to the imaginary intermediate equilibrium at point C, which shows increase in
consumption of X from X1 to X2 is the substitution effect.In other words, the effect of a
decrease in price encourages the consumer to increase consumption of X than Y.

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The Income Effect

The income effect may be defined as the change in the quantity demanded of a commodity
exclusively associated with a change in real income. The income effect is determined by
observing the change in the quantity demanded of a commodity that is associated solely
with the change in the consumer’s real income.

In figure 2.20, letting the consumer’s real income rise from its imaginary level (defined by
the line of attainable combinations tangent to point C) back to its true level (defined by the
line of attainable combinations tangent to point B) gives the income effect. Thus, the
income effect is indicated by the movement from the imaginary equilibrium at point C to
the actual new equilibrium at point B, the increase in the quantity of X purchased from X2
to X3 is the income effect.

The income effect of a change in the price of good shows the change in quantity demanded
via change in real income, while the relative price ratio remains constant. This movement
does not involve any change in prices; the price ratio is the same in budget line 1 as in
budget line 2. It is due to a change in total satisfaction and such a change is a movement
from one indifference curve to another.

When we look at both the substitution and income effects, the magnitude of the substitution
effect is greater than that of the income effect. The reason is that:

 Most goods have suitable substitutes and when the price of good falls, the
quantity of the good purchased is likely to increase very much as consumers
substitute the now cheaper good for others.
 Spending only a small fraction of his /her income, i.e. with the consumers
purchasing many goods and spending only a small fraction of their income on
any one good, the income effect of a price change of any one good is likely to
be small.

Usually, the income and substitution effects reinforce one another i.e. they operate in the
same direction. The substitution effect is always negative. i.e. if the price of a good X

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increases and real income is held constant, there will always be a decrease in the
consumption of good X, and vise versa. This result follows from the fact that indifference
curves have negative slopes. However, the income effect is not predictable from the theory
alone. In most cases, one would expect that increases in real income would result in
increases in consumption of a good. This is the case for so called Normal goods.

In short, in the case of normal goods, the income effect and the substitution effects operate
in the same direction –they reinforce each other. But, not all goods are normal. Some goods
are called inferior goods because the income effect is the opposite (of that of a normal
good) for them-they operate in opposite direction. For an inferior good, a decrease in the
price of the commodity causes the consumer to buy more of it (the substitution effect), but
at the same time the higher real income of the consumer tends to cause him to reduce
consumption of the commodity (the income effect). We usually observe that the
substitution effect still is the more powerful of the two; even though the income effect
works counter to the substitution effect, it does not override it. Hence, the demand curve
for inferior goods is still negatively sloped.

Let us consider the following diagram that shows the income, substitution and net effect for
an inferior commodity in the case of a decline in the price of good X.

Y Where:
X1X3= NE=Net effect
X1X2= SE=Substitution effect
X2 X3= IE=Income effect
E3

E1
E2 IC2

X1 X3 X2 IC1 X
IE
NE

SE

Figure 2.21 Income, Substitution, and Net effect for an inferior commodity

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In very rare occasions, a good may be so strongly inferior that the income effect actually
overrides the substitute effect. Such an occurrence means that a decline in the price of a
good would lead to a decline in the quantity demanded and that a rise in price will induce
an increase in quantity demanded. In other words, price and quantity move in the same
direction. The name given to such a unique situation is Giffen paradox; and it constitutes an
exception to the Law of demand. That is for Giffen goods the income effect (which
decreases the quantity demanded) is so strong that it offsets the substitution effect (which
increases the quantity demanded), with the result that the quantity demanded is directly
related to the price, at least over some range of variation of price.

E3
IC2

E1
E2
IC1

X3 X1 X2 X
SE
NE

IE

Figure 2.22 Income, Substitution and net effects for a Giffen good,
When there is a price decline.

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2.16 The Slutsky Equation

Dear learner, can you explain Slutsky equation ?


(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

Dear learner as we have discussed earlier,when the price of a good decreases,there are two
effects in consumption.The change in relative prices makes the consumer to consume more
of the cheaper good(substitution effect) and the increase in purchasing power or real
income due to the lower price may increase or decrease consumption of the good (income
effect).

Generally,the Slutsky equation says that the total change in demand is the sum of the
substitution effect and the income effect.

Example

Suppose that the consumer has a demand function for good X is given by
2
X  20  MPX

Originally his income is $ 200 per month and the price of the good is 5 per killogram.

200
Therfore,his demand for good X will be 20   28 per month.
52
Suppose that the price of the good falls to 4 per kilogram.Therfore,the new demand at the
200
new price will be: 20   32.5 per month.
42
Thus,the total change in demand is 4.5 that is 32.5-28.

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When the price falls the purchasing power of the consumer changes.Hence,in order to make
the origiinal consumption of good X,the consumer adjusts his income.This can be
calculated as follows:

M 1  P1' X  P2Y
M  P1 X  P2Y

Subtracting the second equation from the first gives:


M 1  M  X [ P1'  P1 ]
M  XP1
Therfore,new income to make the original consumption affordable when price falls to 4 is:
M  XP1
M  28 * [4  5]  28
Hence,the level of income necessary to keep purchasing power constant is
M 1  M  M  200  28  172
The consumers new demand at the new price and income will be :
172
X (4,172)  20   30.75
42
Therfore,the substitution efffect will be:
X  X (4,172)  X (5,200)  30.75  28  2.75
The income effect will be:
X (4,200)  X (4,172)  32.5  30.75  1.75
Since the result We obtained is positive we can conclude that the good is a normal good.

2.17 The Consumer Surplus

Dear learner, how do you explain the concept of consumer surplus?


(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

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Demand curve shows the price that consumers are willing to pay for various quantity
demanded .While consumers purchas goods and services,they offten pay less than what
they are willing to pay.Thus,the difference between what they are willing to pay and what
they actually paid is considered as their surplus.

Therfore,consumer surplus is the difference between what a consumer is willing to pay and
what he actually pays.Graphically,it is measured by the area below the demand curve and
above the price level. More precisely it is the area of the triangle above the price but below
the demand curve.

CS E
A
dd
A
O Q Quantity of good consumed

Figure 2.23 consumer surplus O

Example

Suppose the demand function of a consumer is given by: Q  20  2P


a. Compute the consumer surplus when the price of the good is 2
b. Compute the consumer surplus when the price of the good is 4
c. Compute the change in consumer surplus when the price changes from 2 to 4.

Solution

When Price is zero the demand for quantity purchased will be 20 units and when the
demand for quantity is put to zero then the price level will be 10.And finally,when we

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insert the given price level 2 in the demand equation we get the level of qunatity demanded
that is 16.Hence,we can easily compute the area of the triangle that is found above the
given price level that is 2.
p
P 10 Panel B

Panel A CS
10 4
CS
2

2
16 20 12 20

Figure 2.24 Numerical examples for consumer surplus

In panel A, the area of the triangle above price that is the consumer surplus is
1
(16)8  64 and in panel B the consumer surplus is 36.Therfoere,due to a change in the
2
price level the consumer surplus changes by 64  36  28

2.18. Price Elasticity of Demand

Dear learner! What is price elasticity of Demand? How do we measure it?


(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________

Price elasticity of demand refers to the responsiveness in the quantity commodity


purchased to a change in price of the good, while keeping other things constant. It also
defined as the ratio of the percentage change in quantity demanded to the percentage
change in price of the commodity, other things being constant.

Depending on the magnitude of the change in price and quantity, we have two types of
price elasticity of demand. These are:

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a. Point price elasticity of demand

b. Average or arc price elasticity of demand

2.18.1 Point Price Elasticity of Demand

Point prices elasticity of demand is defined as the proportionate or percentage change in


quantity demand resulting from a very small proportionate change in price. The
responsiveness or sensitivity of consumers to a change in the own price of a commodity is
measured by the product’s price elasticity of demand. Price elasticity of demand measures
the percentage change in quantity demanded of a good or a service as result of 1% change
in the own prices of that good/service at one point on the demand curve.

For a given commodity X, the point price elasticity coefficient (Ed) and its formula are
given below:

% change in qunatity demand of X


Ed 
% change in price of X
 Q2  Q1 
  x100
Ed   
Q 1
P2  P1
( ) x100
P1

changeinQ P Q X p
Ed= x  x
Q ChangeinP P Q X

Where, change in Q=Q2- Q1 and


change in P=P2- P1

Example 1

If consumers decreased their quantity demanded from80 to 40 units because of an increase


in price from birr 2 to birr 4 per unit, then Ed is (given Q2=40, Q1=80, P2=4 and P1=2)

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ChangeinQ P 40  80 2  80
Ed= x  x   0.5
ChangeinP Q 4  2 80 160

Example 2

Suppose that a household demands 50 units of oranges at the price 40 cents per piece. If
the price falls to the price 30 cents per piece, 100 oranges are demanded. What is the
elasticity of demand for Oranges?

Solution

P0=40 cents, P1=30 cents, Q0 =50 and Q1=100

changeinQ P Q p
Ed= x  x
Q Changeinp P Q

 100  50  40 
Thus, Ed=   
 30  40  50 
 50  40 
= -   
 10  50 
=-4
We can interpret our solution as follows: Ed= 4 (in terms of absolute value), means that if
the price of orange falls by one percent, this household shall, ordinarily, demands 4 percent
more oranges. That is a one percent fall in price of orange will raise the demand for orange
by 4 percent for this household.

Ranges and Interpretations of price elasticity of demand

Price elasticity is always a negative unit free number because of the inverse relationship
between price and quantity demanded of a commodity. The value of price elasticity of
demand ranges from zero to infinite. i.e. 0<Ed< - . In absolute terms, the values of price
elasticity of demand ranges from 0<Ed< . Price inelasticity of demand for normal
demand curve is classified into three categories depending up on the response of the
quantity demanded to price change. These are:

a) Elastic Demand
b) Inelastic Demand

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c) Unitary elastic demand

a) Elastic Demand

Demand is said to be elastic if a 1% change in price results in a more than 1 % change in


quantity demanded. In this case, any percentage change in price leads to a more than
proportionate change in quantity demanded. Thus, Ed is greater than one.

%Qd  %P

For example if a 2% decline in price leads to a 6% increase in Qd, then demand is elastic.
That is:

6% 0.06
Ed =   3 (greater than one)
2% 0.02

b) Inelastic Demand

Demand is said to be inelastic if a 1% change in price results in a less than 1% change in


quantity demanded. In this case, any percentage change in price leads to a less than
proportionate change in quantity demanded. Thus, Ed is less than one.

For example if a 2% decline in price leads to a 1% increase in Qd, then demand is inelastic.
That is:

1% 0.01
Ed=   0.5 (less than one)
2% 0.02

c) Unitary Elastic Demand

Demand is said to be unitary elastic if a 1% change in price results in exactly 1% change in


quantity demanded. In this case, percentage change in quantity demanded equals to
percentage change in price. Thus, Ed=1. Example, if a 4% increase in price leads to a 4%
decrease in Qd ,then demand is unitary elastic.

4% 0.04
Ed    1 (equal to one)
4% 0.04

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d) The Two Extreme Cases of Price Elasticity of Demand

Dear learner! What are the two extreme case of price elasticity of demand?
(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________

Dear learner! Perfectly Elastic demand is an extreme situation of an elastic demand where
as a small price reduction would cause buyers to increase their purchase from zero to all
they could obtain , and vice versa. In this case, Ed equals to infinity and the demand cure
is a horizontal line parallel to the X-axis.

Graphically, Price (P)

14

12 AD is a demand curve

10

8 A B D

2
Quantity (Q)
0 5 10 15 20 25 30

Fig 2.25 Perfectly Elastic Demand Curve

Mathematically Ed can be calculated as:

% changein Q p 20  10 8 10 8
Ed  x = x  x 
% Changein P Q 8  8 10 0 10

On the other hand, perfectly inelastic demand is an extreme situation of an inelastic


demand where a price change results in no change in quantity demanded i.e, for any %

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change in P, % change in Qd is equal to zero. Since zero divided by any number is equal to
zero, Ed=o. The demand curve is a vertical line parallel to the Y-axis.

Example
An acute diabetic's demand for insulin or an addict's demand for heroin is perfectly
inelastic.

Graphically,

Price BC is a demand curve


C
30

10

25

20

15

10
B
0 5 10 15 10 20 25 30 25 35 40 45
Quantity

Fig 2.26 Perfectly Inelastic Demand Curve

Thus mathematically, this is expressed as:

%Q  inQ P 15  15 10 0 10
Ed  = x  x  x 0
%P  inP Q 30  10 15 20 15

2.18.2 Average or Arc Price Elasticity of Demand

Arc or average price elasticity of demand is a measure of responsiveness of quantity


demanded to any percentage change in price on average or between two points. This is

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used if the changes in price and quantity are discrete and large. Consider the following
price quantity combination.

Table 2.7 Demand Schedule

Points on demand curve Price Quantity


A 6 4
B 4 6

Point price elasticity leads two different outcomes for the same data depending on the
direction of movement on the demand curve. If you calculate elasticity for a price rise and a
price fall using the same set of data, Point price elasticity results in different elasticity.
Take the above data as an example

%changeinQdd Q  Q1 P1 64 4 8
Ed ( fromAtoB )  ( 2 ) ( )   0.67 (For price fall)
%ChangeinP P2  P1 Q1 4  6 6 12
(demand is some what inelastic)
%changeinQdd Q  Q1 P1 4  6 6 12
Ed ( fromBtoA)  ( 2 ) ( )   1.5 (For price rise)
%ChangeinP P2  P1 Q1 64 4 8
(demand is some what elastic)

Dear learner, which one is correct? Is the demand elastic or inelastic?


A solution to this problem is to use average of the two prices and two quantities as points
of reference. An alternative formula, which we call the mid point formula, of finding Ed
between two points is given as follows. In this case, elasticity is estimated at the mid point
of the relevant price range.

change in Qd Change in P
Ed  /
((Q1  Q2 ) / 2) (( P1  P2 ) / 2)

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Qd (( P1  P2) / 2)
Ed  x  Qd ( P1  P 2) / 2
(Q1  Q2 ) / 2 P  x
P (Q1  Q 2) / 2

Qd ( P1  P2 )
Ed= x
P (Q1  Q2 )
Rechecking our previous example, we calculate that average price elasticity of demand
between the two points as:
changeinQd ( P1  P2) 2 10
Ed= x  x  1 that is the demand is unitary elastic between
ChangeinP (Q1  Q2) 2 10
the two points
Example
If price of good X rises from birr 3 to birr 5 and its quantity demand falls from 240 units to
180 units. Calculate the arc price elasticity of demand.

Solution
Qd ( P1  P2 ) 60 8
Ed= x  x  0.57
P (Q1  Q2 ) 2 420
Ed= -0.57 implies that a 1% increase in price results in a 0.57% decreases in quantity
demanded or a 100% increase in price leads to a 57% decrease in quantity demanded

2.18.3 Price Elasticity of Demand and Total Revenue

Dear learner! Do you think that a decrease in price of a product always leads to a fall
in total sales revenue of the producer?
(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________
Dear learner! In fact the impact of change in price on total revenue depends on the
responsiveness of consumers to a change in price .That is, the nature of change in total
revenue due to a change in price depends on the price elasticity of demand for the good
under consideration.
To make the above notes clear, let us consider the following demand schedule.

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Table 2.8 Relationships between Price Changes, Price Elasticity of Demand and
Total Revenue
Quantity Price per Elasticity Total Elasticity Range
demanded(1) Unit(2) Revenue(2x1)
2 8 8 16 Elastic
4 7 3.5 28 Elastic
6 6 2 36 Elastic
8 5 1.25 40 Elastic
9 4.5 1 40.5 Unit elastic
10 4 0.8 40 Inelastic
12 3 0.5 36 Inelastic
14 2 0.29 28 Inelastic
16 1 0.13 16 Inelastic

Graphically,
Price

Elastic Ed>1
a
Unitary Ed=1

Inelastic Ed<1
Demand curve

Quantity (Q)
Total
Revenue
0
40

TR
Quantity
2 4 6 8 9.510 12 14 16

Fig 2.27 Graphical illustration of the relationship between price elasticity of demand
and total revenue

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From the above table and graph we can note two points.

i. Elasticity varies with price range

For all straight line and most other demand curves, demand is elastic towards the upper left
part than the lower right part of the demand curve. In other words, demand is elastic at
higher prices than at lower prices. In the upper left segment of the demand curve
percentage change in quantity demand is large because the original reference quantity is
small and percentage change in price is small because the original reference is large.

change in Qd % change inQd


Ed=
relatively small % in price
In the lower right segment of the demand curve, the opposite holds true.

ii. Total revenue varies with elasticity

Total revenue and elasticity are related. Total revenue (TR) is the total amount of money
the seller receives from the sale of a product, where Total Revenue (TR) = Price X
Quantity i.e. TR=P.Q
The effect of a change in price on total revenue depends on the price elasticity of demand.
These effects are summarized bellow.
a) When demand is elastic /Ed/ > 1
In this case, a decrease in price causes a large increase in quantity demanded. The
percentage increase in quantity demanded is greater than percentage decrease in price.
Hence, the total revenue increases since the quantity effect out ways the price effect. The
opposite is true when price increases. A rise in price leads to a decrease in total revenue.
Thus when price change causes total revenue to move in the opposite direction, the demand
curve is said to be elastic.

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b) When demand is inelastic /Ed/< 1


If demand is inelastic, an increase in price increases total revenue. The increase in price
leads to a small decrease in quantity demanded since demand is inelastic. Percentage rise in
the price leads to a less than proportionate fall in quantity demanded leading to an increase
in total revenue. On the other hand, a decrease in prices leads to a decrease in total revenue.
Thus, demand is inelastic if a price change causes total revenue to move in the same
direction.
c) When demand is unitary elastic/Ed/= 1
If demand is unitary elastic any decrease or increase in price leads to an equal increase or
decrease in quantity demanded. The decrease in price is the same as or is cancelled out by
an equal increase in quantity demanded. Hence, total revenue remains unchanged.

iii. Price Elasticity and Demand Curve.

Given a demand function as Qd  a  bP , price elasticity of demand can be related to the


slope of the demand function.
Q P dQ P dQ
Ed  x  x , where, is the slope of the demand function.
P Q dP Q dP
dQ
For the given demand function = -b
dP
dQ P P
Ed  x  b( )
dP Q Q
Example
Consider a hypothetical demand curve given as Qd  20  2P .Calculate price elasticity of
demand when P= 4.
Solution
dQ P P
Ed  x  b( ) , when P= 4, Qd  20  2(4)
dP Q Q
Qd  12

P 4
Therefore, E d  b( )  2( )
Q 12

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Ed  0.67 (Inelastic demand)

dQ 1
For an inverse demand function given as P    Q , =  and hence
dP 
dQ P 1 P
Ed  x  ( )
dP Q  Q
2.18.4 Determinants of the Price Elasticity of Demand

Dear learner! Can you list some of the determinants of price elasticity of demand?
(You can use the space left below to write your response)
______________________________________________________________________
_______________________________________________________________________
There are about four factors which affect the degree of elasticity of demand function. These
are:
i.. The Availability of Substitutes
ii. Nature of the Commodity (Luxury Vs Necessity)
iii. Proportion of Income Spent on the commodity
iv. Time Horizon

i. The Availability of Substitutes

All other things remaining the same, the larger the number of substitute goods that are
available for a product, the greater its price elasticity of demand and vice versa. This is
because people will have more alternative and they will be more sensitive to price changes.
The opposite holds true (i.e. people will be less sensitive to price changes) if the
good/service whose price has changed has less or no substitutes. For example, a rise in
price of B-29 soap would initiate consumers to shift to consumption of WABEL soap. The
demand for B-29 soap tends to be price elastic. Salt on the other extreme has no substitute
and you may not respond to an increase in the price of salt.

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ii. Nature of the Commodity (Luxury Vs Necessity)

If a commodity is a luxury rather than a necessity good demand tends to be more elastic,
other things remaining the same. Goods and services that are necessities include bread,
electricity, water, salt, medicine, etc. For example, if the price of gold or silver goes up,
consumers can respond to the change in price by cutting down quantity purchased of these
items .Hence demand tends to be elastic. But, if the price of a kilogram of Teff rises by 75
cents we will still buy it, because it may be hard to live by consuming less of it. If there is
any fall in quantity demanded, it would be very small compared to the initial percentage
change in price of Teff. Hence demand tends to be in elastic.

iii. Proportion of Income Spent on the commodity

Other things being equal, the higher the proportion the consumers’ income spent on the
good, the higher will be the sensitivity of the consumer to any change in the price of the
good. The smaller the proportion of income spent for a good, the less price elastic its
demand would be. Demand would be relatively elastic to a 10% increase in the price of
college tuition fees than a 10% increase in price of salt.

iv. Time Horizon

Generally, product demand becomes more elastic with time. In the long run, consumers
will have the chance to try other products and develop a favorable taste for new products.
From producers’ angel, the longer the time period the higher is the probability of finding
other business firms producing and supplying goods that substitute the product whose price
has increased. Thus, with in a short period of time demand is inelastic while it is elastic in
the long run.

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Check your progress Activity


Answer the following questions on the spaces provided below.

1. Define utility
_________________________________________________________________________
_________________________________________________________________________
2. What are the two approaches to measure utility?
_________________________________________________________________________
_________________________________________________________________________

3. What are the assumptions underlying the cardinal approach?


_________________________________________________________________________
_________________________________________________________________________
4. What are the limitations of Cardinalist theory?
_________________________________________________________________________
_________________________________________________________________________

5. Assume a hypothetical consumer consumes good X and good Y. The price of good X is
1 and price of good Y is 3 and the consumer budget is birr 10 for the two goods. Where: QX
is quantity of good X, QY is quantity of good Y and TUX and TUY is total utility from
consuming good X and good Y respectively.

QX TUX QY TUY
0 0 0 0
1 10 1 24
2 19 2 45
3 27 3 63
4 34 4 78
5 40 5 87
6 44 6 90

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Based on the given information, answer the following questions.

a. Compute the marginal utility of the two goods


_________________________________________________________________________
____________________________________________________________________
b. At what amounts of consumption does diminishing marginal utility starts to occur for the
two goods?
________________________________________________________________________
____________________________________________________________________

c. Determine the quantities of the two goods that the consumer should buy in order to
maximize his total utility.
_________________________________________________________________________
___________________________________________________________________

6. What is the relationship among total utility, marginal utility and the demand
curves.
_________________________________________________________________________
_____________________________________________________________________

7. What are the assumptions underlying the Ordinal approach?


_________________________________________________________________________
_______________________________________________________________________

8. What are the major properties of indifference curves?


_________________________________________________________________________
_______________________________________________________________________
9. Suppose a consumer has income of 200 birr per month and he wants to spend all of his
income on two goods, X and Y, whose prices are birr 4 and birr 5 respectively. Based on
this information answer the following questions:

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a. Express the budget line of the consumer both algebraically and diagrammatically.
_________________________________________________________________________
_______________________________________________________________________
b. Compute the equation of the budget line.
_________________________________________________________________________
_______________________________________________________________________
c. Determine the slope of the budget line and interpret the result
_________________________________________________________________________
_______________________________________________________________________
d. What will happen to the original budget line?
i. If money income doubles.
___________________________________________________________________
_________________________________________________________________
ii. If the price levels increases by 50%.
___________________________________________________________________
_________________________________________________________________
iii. If price of good Y doubles.
___________________________________________________________________
_________________________________________________________________
10. Suppose the demand function of an individual for a given good X is given by:
X  3MP 3
And originally income of the consumer is birr 100 per month and price of the good is 2 per
unit. Assume an increase in price of X to Birr 3 per unit.Based on the given information,
answer the following questions:
a. Compute the substitution effect
b. Compute the income effect
c. Is the good normal, inferior, or Giffen and why?
11. Suppose that the demand and supply equations of a consumer are given by:
Q dd  150  50 P
Q ss  60  40 P
Compute the consumer surplus.

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12. Consider the following demand curve Qd  15  0.5P .Calculate price elasticity of
demand when P= 5.
13. Suppose that a consumer demands 25 units of good X at the price 20 cents per
Kilogram. If the price falls to the price 15 cents per kilogram, 50 quantity of good X
are demanded. What is the elasticity of demand for good X?

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 Checklist

Dear learner have you achieved the entire objectives of the unit? Below are some of
the most important points drawn from the unit you have been studying up to now.
Please put a tick (√) mark in front of the point you have understood well in the box
under "Yes" and in the box under "No" for points you have not understood well yet.
And if the tick marks under "No" are more than those under “Yes" it means you are left
with a lot to understand the unit and you have not yet achieved the objectives indicated
at the beginning of the unit. This tells you to go back and read the sections you passed
through.

I Can: Yes No

 define utility;
 explain the concepts of cardinal and ordinal approaches;
and the properties of indifference curve;
 compute marginal rate of substitution;
 derive the budget line;
 determine the choice of consumer;
 derive Engle's curve from income consumption curve;
 derive demand curve from price consumption curve; and
 distinguish the difference between substitution and income effects.
 Define elasticity
 Explain the difference between point and average price elasticities
 State the relationship between total revenue and price elasticity
 Explain the determinants of price elasticity of demand

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Summary

Consumers given their income and prices of the commodities, they spend their income so
as to attain the highest possible satisfaction or utility from commodities. Utility is thus the
satisfaction obtained from the consumption of a good. The maximization of utility is
referred to as the axiom of utility maximization. To attain this utility maximization
objective, the consumer must be able to compare the utility of the various baskets of goods,
which they can buy with their income. In order to explain the comparison of these
commodities we have two approaches. These are: cardinal approach and the Ordinal
approach.

Cardinalist believed that cardinal numbers could be used to express the utility derived from
the consumption of a commodity while ordinalists believed that utility is not measureable,
but is an ordinal magnitude. The main ordinal theories are the indifferece curves
approache and the revealed preferences hypothesis.These approaches are also known as
the indifference curve theories .

An indifference curve is the locus of points which provide the same level of satisfaction to
the consumer. The slope os an indifferece curve shows the marginal rate os substitution
between goods.

The consumer aims at maximization of utility, given his/her income and market prices of
the commodities available for consumption. Therefore, to determine the equilibrium of the
consumer, we have to bring together the indifference map and the budget line facing the
consumer on the same diagram.

There are two effects of a price change. If price falls (rises), the good becomes cheaper
(more expensive) relative to other goods; and consumers substitute toward (away from) the
good. This is the substitution effect. Also, as price falls (rises), the consumer’s purchasing
power increases (decreases). Since the set of consumption opportunities increases
(decreases) as price changes, the consumer changes the mix of his or her consumption
bundle. This effect is called the income effect.

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Elasticity is a measure of responsiveness of the dependent variable to any percentage


change in the independent variable. Price elasticity of demand is a measure of percentage
change in quantity demanded to a percentage change in price of the same product, ceteris
paribus. Under normal condition price elasticity of demand assumes three values:
Elastic(Ed>1), Inelastic (Ed<1) and Unitary elastic value(Ed=1).Price elasticity of a
product depends on factors like availability of substitutes, nature of the good, proportion of
income spent on the good and the time period.

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Self-Check Exercise

Part I: Completion items

Direction: Complete the blank space with appropriate word or term.

1. The locus of points which provide the same level of satisfaction to the consumer refers to
____________________.
2._____________________ is the amount of change in the holdings of one commodity that
will just offset a unit change in the holdings of another commodity, so that the
consumer's total utility remains the same.
3. The locus of combinations or bundle of goods that can be purchased if the entire money income
is spent is descibed by _______________________.
4. __________________is a curve that connects the equilibrium points of the consumer and shows
how the consumption of a good changes as the consumer’s income increases.
5. The curve connecting all the points of consumer equilibrium as prices change is called
______________.
6. The increase in quantity bought as the price of the commodity falls, after adjusting
income so as to keep the real purchasing power of the consumer the same as before is
called ___________________.
7. ___________ is an equation that sows both the substitution and income effects.
8. ___________is the difference between what a consumer is willing to pay and
what he actually pays.
9. ____________is a measure of responsiveness of quantity demanded to change in price.
10.____________is one of the determiants of price elasticity of demand.

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Part II: Multiple-choice items

Direction: Select the correct answer from the given alternatives and write the letter of
your choice.

1. Which of the following is not explained by Slutsky equation?


A) Substitution effect
B) Income effect
C) Price effect
D) Consumer surplus
E) None

2. Given two commodities X and Y and level of income M, then if price of the
commodities change equally in the same direction, which of the following is not true?
A) The budget line shifts to the right.
B) The budget line shifts to the left.
C) The slope of the budget line changes.
D) The X and Y intercept changes together.
E) None

3. Suppose two goods X and Y. If the income of the consumer raised by 8 %, the prices of
good X increased by 4 % and the price of Y decreased by 6. Which of the following is
true?
A) The budget line shifts outward
B) The budget line rotates inward on the horizontal axis
C) The same slope of the budget line
D) The budget line rotates inward on the horizontal axis and rotates outward on the
vertical axis
E) All

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4. Which One of the following curve shows the relationship between equilibrium quantities
of some inferior good to the level of money income?
A) Income consumption curve
B) Price consumption curve
C) Engle curve
D) Demand curve
E) Expansion curve

5. The difference between the willingness to pay and the actual payment is.
A) Slutsky equation
B) Substitution effect
C) Consumer surplus
D) Price effect
E) Total effect.
6. Given an inverse demand function P  10  0.5Q the price elasticity of the demand
when the price of the commodity is 5 equals to
A) Ed = 2
B) Ed =3
C) Ed =1
D) Ed =4
E) None

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Part III: Work out- items

1. Suppose that the consumer’s utility function is given by U  10 X 1 / 2Y 1 / 4 .Compute


both MRS X ,Y and MRS Y , X .Is there any difference between the two?
2. Suppose a consumer consuming two commodities X and Y has the following
utility function U  X 0.4Y 0.6 .If price of good X and Y are 2 and 3 respectively
and income constraint is Birr 50.
a) Find the quantities of X and Y which maximize utility.
b) Show how a rise in income to Birr 100 will affect the quantity of X
and Y.

Suggested readings

 Chiang, Alpha (1984) Fundamental Method of Mathematical Economics. MCGraw


Hill Book Company.
 Gold and Furguson(1998),Micro-economics theory,Richard D.Irwin,inc.fifth ed.
 Koutsoyiannis A.(1979) Modern Microeconomics, Mac million press Ltd.
 Maddala G.S. (1989) Microeconomics Theory and Application. McGraw Hill book
company.
 Pindyck R.S. and Rubirfeld (1995), Microeconomics. MC Graw Hill Book
Company.
 Varian,R.Hall(1999),Intermediate Micro economics:a modern approach,W.W
Norton and Co,New York

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UNIT THREE
THE THEORY OF PRODUCTION
Introduction

Production is the creation of any good or services that have economic value to either
consumers or producers. Production may be defined as the act of creating those
goods/services which have exchange value for sale (not for personal consumption).Raw
materials yield less satisfaction to the consumer by themselves. In order to get utility from
raw materials, first they must be transformed into output. However, transforming raw
materials into final products require factor inputs such as land, labor,capital and
entrepreneurial ability. Thus, no production (transforming raw material into output) can
take place without the use of inputs.

Objectives
After successful completion of this unit, you will be able to:
 Define production and production function
 Differentiate short run and long run, and fixed and variable inputs
 Explain the concepts of short run production and efficiency
 Explain the concepts of long run production, laws of returns to scale and
 Show optimum combination of inputs.

3.1 Definition and Basic Concepts

Dear learner! how do you define production? What is needed to under take production?
(You can use the space left below to write your response)
_________________________________________________________________________
_______________________________________________________________________

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Production Function
It is a purely technical relationship which connects factors (inputs) to products (outputs) at
any particular time period. It also shows the maximum quantity of output that can be
produced from the given amount of variable inputs for a given technology. It describes the
technical relationship between inputs and out put in physical unit.

Fixed Vs variable inputs

In economics, inputs can be classified as fixed and variable. Fixed inputs are those inputs
whose quantity can not readily be changed when market conditions indicate that an
immediate change in output is required. In fact no input is ever absolutely fixed, but may
be fixed during an immediate requirement. For example, if the demand for Beer shoots up
suddenly in a week, the brewery factories can not plant additional machinery over night to
respond to the increased demand. It takes long time to buy new machineries, to plant them
and use for production purposes. Thus, the quantity of machinery is fixed for some times
such as a weak. Buildings, machineries and managerial personnel are examples of fixed
inputs because their quantity can not be manipulated easily in short time periods.

Variable inputs, on the other hand, are those inputs whose quantity can be changed almost
instantaneously in response to desired changes in output. That is, their quantity can easily
be diminished when the market demand for the product decreases and vise versa. The best
example of variable input is unskilled labor. In our previous example, if the brewery
factory had idle machinery before the market demand increased, the factory can easily and
immediately respond to the market condition by hiring laborers.

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Short run vs long run


Dear learner, what do you think is the major difference between short run and long
run production periods?
(You can use the space left below to write your response)
_________________________________________________________________________
_______________________________________________________________________

Dear learner!in economics, short run refers to a period of time in which the quantity of at
least one input is fixed. For example, if it requires a firm one year to change the quantities
of all the inputs, those time periods below one year are considered as short run. Thus, short
run is a time period which is not sufficient to change the quantities of all inputs, so that at
least one input remains fixed. One thing to be noted here is that short run periods of
different firms have different durations. Some firms can change the quantity of all their
inputs with in a month while it takes more than a year for another type of firms. For
example, the time required to change the quantities of inputs in an automobile factory is not
equal with that of flour factory. The later takes relatively shorter time.On the other hand,
long run is a time period (planning horizon) which is sufficient to change the quantities of
all inputs. Thus, there is no fixed input in the long run

3.2 Production in the short run: Production with one variable input
Short run production function is a production function which combines at least one fixed
input with variable input.

Assumption of short run production analysis

In order to simplify the analysis of short run production, the classical economists assumed
the following conditions:

1. Perfect divisibility of inputs and outputs


This assumption implies that factor inputs and outputs are so divisible that one can hire, for
example a fraction of labor, a fraction of manager and can produce a fraction of output,
such as a fraction of automobile.

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2. Limited substitution between inputs

Factor inputs can be substituted each other up to a certain point, beyond which they can not
be substituted each other. In other words, resources are not perfect substitutes for one
another as they are not identical.

3. Constant technology

It is assumed that level of technology of production is constant in the short run.Suppose a


firm that uses two inputs: Capital (which is a fixed input) and labor (which is variable
input). Given the assumptions of short run production, the firm can increase output only by
increasing the amount of labor it uses. Output varies with the variation of the variable
input.Hence, its production function is:
Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)

The production function shows different levels of output that the firm can obtain by
efficiently utilizing different units of labor and the fixed capital. In the above short run
production function, the quantity of capital is fixed. Thus output can change only when the
amount of labor used for production changes. Hence, Q is a function of L only in the short
run.

3.3 Total Product(TP), Marginal Product (MP) and Average Product(AP)


Dear learner! do you remember what is meant by total utility and marginal utility
from the previous chapter discussion? Can you you define total product, marginal
and average product?
(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________

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Total Product (TP)

Dear learner! Total product is the total amount of output that can be produced efficiently
utilizing a specific combination of labor and capital. The total product curve, thus,
represents various levels of output that can be obtained from efficient utilization of various
combinations of the variable input, and the fixed input. Dear learner, do you think that
output can always be increased by increasing the variable input while there is a fixed input?

Increasing the variable input (while some other inputs are fixed) can increase the total
product only up to a certain point. Initially, as we combine more and more units of the
variable input with the fixed input output continues to increase. But eventually, increasing
the unit of the variable input may not help output increase. Even as we employ more and
more unit of the variable input beyond the carrying capacity of a fixed input, out put may
tends to decline. Thus, increasing the variable input can increase the level of output only up
to a certain point, beyond which the total product tends to fall as more and more of the
variable input is utilized. This tells us what shape a total product curve assumes. The shape
of the total variable curve is nearly S-shape (see fig3.1 Panel A)

Marginal Product (MP)

The marginal product of a variable input is the addition to the total product attributable to
the addition of one unit of the variable input to the production process, other inputs being
constant (fixed). Before deciding whether to hire one more worker, a manager wants to
determine how much this extra worker (L =1) will increase output. The change in total
output resulting from using this additional worker (holding other inputs constant) is the
marginal product of the worker. If output changes by Q when the number of workers
(variable input) changes by ∆L, the change in out put per worker or marginal product of the
variable input, denoted as MPL is found as
Q dTP
MPL = or MPL 
L dL

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Thus, MPL measures the slope of the total product curve at a given point. In the short run,
the MP of the variable input first increases, reaches its maximum and then tends to
decrease to the extent of being negative. That is, as we continue to combine more and more
of the variable inputs with the fixed input, the marginal product of the variable input
increases initially and then declines.

Average Product (AP)

The AP of an input is the ratio of total output to the number of variable inputs.
totalprodu ct TP
APlabor  
numberofL L

The average product of labor first increases with the number of labor (i.e. TP increases
faster than the increase in labor), and eventually it declines. However, average product can
never be zero or negative as it is a ratio of two positive numbers (total output and employed
labor) .

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Short Run Production Curves


The following figures shows how the TP, MP and AP of the variable (labor) input vary
with the number of the variable input.

Output

TP3

TP2 TP

TP1

L1 L2 L3
Units of labor (variable
APL, MPL input)

APL

L1 L2 L3 Units of labor (variable input)


MPL

Fig 3.1 Total product, average product and marginal product curves:

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As the number of the labor hired increases (capital being fixed), the TP curve first rises,
reaches its maximum when L3 amount of labor is employed, beyond which it tends to
decline. Assuming that this short run production curve represents a certain car
manufacturing industry, it implies that L3 numbers of workers are required to efficiently
run the machineries. If the numbers of workers fall below L3, the machine is not fully
operating, resulting in a fall in TP below TP3. On the other hand, increasing the number of
workers above L3 will affect the production process negatively because only L3 number of
workers can efficiently run the machine. Increasing the number of workers above L3, rather
results in lower total product because it results in over crowded and unfavorable working
environment.

Marginal product curve increases until L1 number of labor are employed and reaches its
maximum at L1, and then it tends to fall. The MPL is zero at L3 (when the TP is maximal);
beyond which its value assumes negative value indicating that each additional worker
above L3 tends to create over crowded working condition and reduces the total product.
Thus, in the short run (where some inputs are fixed), the marginal product of successive
units of labor hired increases initially, but not continuously, resulting in the limit to the
total production. Geometrically, the MP curve measures the slope of the TP. The slope of
the TP curve increases (MP increases) up to L1, it decreases from L1 to L3 and it becomes
negative beyond L3.

The average product curve increases up to L2, beyond which it continuously declines. The
AP curve can be measured by the slope of rays originating from the origin to a point on the
TP curve. For example, the APL at L2 is the ratio of TP2 to L2. This is identical to the slope
of ray a.

The Relationship between AP and MP of Variable Input


The relationship between MPL and APL can be stated as follows:
 For all number of workers (Labor) below L2, MPL lies above APL .
 At L2, MPL and APL are equal.

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 Beyond L2, MPL lies below the APL


 Total product reaches maximum when marginal product is zero.
Thus, the MPL curve passes through the maximum of the APL curve from above. This
relationship between APL and MPL can be shown algebraically as follows:
Suppose the production function is given as
TP = f (L), K -being constant
Given the total product function,
dTP df ( L) TP f ( L)
MPL   and APL  =
dL dL L L

To determine the relationship between APL and MPL, consider the slope of the APL
function.
f ( L) df ( L) dL
d( ) .L  . f ( L)
dAPL L dL dL
Slope of APL = = = -------- (quotient rule of
dL dL L2
differentiation)

df ( L)
.L
f ( L) ab a b
Slope of APL = dL2 - 2
----------------------------- (note that   )
L L c c c
df ( L) f ( L)
= dL - L
L L

MPL  APL df ( L) f ( L)
Slope of APL = , because = MPL and = APL
L dL L
Now – when MPL > APL, Slope of APL is positive (APL rises)
 When MPL = APL, Slope of APL is zero (APL is at its maximum).
 When MPL < APL, Slope of APL is negative (APL falls)

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The Law of Diminishing Marginal Returns (LDMRs): Short –Run


Law of Production
Dear learner!The LDMRs states that as the use of an input increases in equal increments
(with other inputs being fixed), a point will eventually be reached at which the resulting
additions to output decreases. When the labor input is small (and capital is fixed), extra
labor adds considerably to output, often because workers get the chance to specialize in one
or few tasks. Eventually, however, the LDMRs operates: when the number of workers
increases further, some workers will inevitably become ineffective and the MPL falls (this
happens when the number of workers exceeds L1 in fig 3.1)

The Law of diminishing marginal returns is based on two very important assumptions.
These are the existence of constant technology and homogeneous labor (the variable input).
The LDMRs operates (MP of successive units of labor decreases) not because highly
qualified laborers are hired first and the least qualified last. Diminishing marginal returns
results from limitations on the use of other fixed inputs (e.g. machinery), not from decline
in worker quality.The LDMR applies to a given production technology (when the level of
technology is fixed). Over time, however, technological improvements in the production
process may allow the entire total product curve to shift upward, so that more output can be
produced with the same level of inputs.

Stages of Production in the short-run or Efficient Region of


Production in the short-run
Dear learner, we are now not in a position to determine the specific number of the variable
input (labor) that the firm should employ. Because, this depends on several other factors
than the productivity of labor such as the price of labor, the structure of input and output
markets, the demand for output, etc. However, it is possible to determine ranges over which
the variable input (labor) be employed.

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To do best with this, let us refer back to fig 3.1 and divide it into three ranges called stages
of production. The production of a firm in the short run can be divided in to three stages of
production.
 Stage I – ranges from the origin to the point of equality of the APL and MPL.
 Stage II – starts from the point of equality of MPL and APL and ends at a point
where MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.
Graphically, the three stages of production are indicated bellow

APL
MPL

Stage I Stage II Stage III

APL

0 Units of labor (variable input)


L1 L2 L3
MPL

Fig 3.2The Three Stages of Production in the Short run

Dear learner, which stage of production do you think is efficient and preferable?

Dear learner!Since additional units of variable inputs are contributing negatively to the
total product a firm should not operate in stage III (MP of the variable input is negative).It
is due to over crowded working environment i.e., the fixed input is over utilized.

Stage I is also not an efficient region of production though the MP of variable input is
positive. The reason is that the variable input (the number of workers) is too small to

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efficiently run the fixed input; so that the fixed input is under utilized (not efficiently
utilized)

Thus, the efficient region of production is stage II. At this stage additional inputs are
contributing positively to the total product and MP of successive units of variable input is
declining (indicating that the fixed input is being optimally used). Hence, the efficient
region of production is over that range of employment of variable input where the marginal
product of the variable input is declining but positive. This stage of production is called
rational or economic stage of production.

Example
Assume that a production function is given as
Q  f ( L)
Q  7 L  10 L2  L3

Determine:
A) The amount of employment which maximizes average productivity
B) The amount of employment which maximizes total production or at which marginal
product is zero.
C) Define the three stages of production for the above production function.
Solution:
A) Average product reaches maximum when the slope of average product curve is zero. In
other words, average product reaches maximum when marginal product equals to average
product.

dAPL TP 7 L  10 L2  L3
Slope of APL   0 , and APL=   7  10 L  L2
dL L L
d (7  10 L  L2 )
Slope of APL  0
dL
 10  2L  0  L  5
L5
Thus, when employment of labor equals to five average product reaches its maximum.

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B) MPL  d (TP)  0
dL
d (7 L  10 L2  L3 )
MPL  0
dL
MPL  7  20L  3L2  0
 7  20L  3L2  0 Using Quadratic solution method, a= 3, b= -20 and c= -7


b b 2  4ac

2a


20 (20) 2  4(3)(7)

2(3)


20 484

6

20 22

6
20  22 20  22
 or  7 or  0.33
6 6

Thus, total product reaches maximum when employment of the variable input equals to
seven.
C) The three stages of production is defined as follows:

Stage one from zero labor to 5 units of labor. Stage two from 5 labor to 7 units of
labor and Stage three above 7 units of employment

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Graphically,

APL
MPL

Stage I Stage II Stage III

APL

0 L1 5 7 Units of labor (variable) input

Fig 3.3 Specific example for the three Stages of Production in the Short run

Check your progress activity


1. Define production, what are the major inputs required for production?
_______________________________________________________________________
2. Which of the following activities is / are considered as production in economies?
a) A mother washing her child’s cloth.______________________________________
b) A farmer producing wheat for self consumption.____________________________
c) A farmer fattening beef for sale._________________________________________
3. Differentiate between:
- Fixed and variable input
________________________________________________________________________
________________________________________________________________________
- Short run and long run
4. List and explain the assumptions of short run production
________________________________________________________________________
________________________________________________________________________

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5. Explain the following terms and concepts


TP____________________________________________________________________
MP___________________________________________________________________
AP____________________________________________________________________
LDMR_________________________________________________________________

6. Which stage of production is efficient region of production? Why?


________________________________________________________________________
________________________________________________________________________
3.6 Long run Production: Production with two variable inputs
Dear learner, in the previous section we have examined the technological relationship
between inputs assuming that the firm uses one variable input (labor) and one fixed input
(capital). Now, let us turn to the long run analysis of production. Remember that long run is
a period of time (planning horizon) which is sufficient for the firm to change the quantity
of all inputs. For the sake of simplicity, assume that the firm uses two inputs (labor and
capital) and both are variable.

The firm can now produce its output in a variety of ways by combining different amounts
of labor and capital. With both factors variable, a firm can usually produce a given level of
output by using a great deal of labor and very little capital or a great deal of capital and
very little labor or moderate amount of both. In this section, we will see how a firm can
choose among combinations of labor and capital that generate the same output. To do so,
we make the use of an isoquant. So it is necessary first to see what is meant by an isoquant
and its properties.

Dear learner, what is an isoquant and isoquant map?


(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________

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Isoquant
Dear learner! An isoquant is a curve which shows alternative combinations of inputs
leading to the same level of output. It shows all possible efficient combinations of inputs
that can yield equal level of output. Every point on an isoquant represents the same level of
output. If both labor and capital are variable inputs, the production function will have the
following form:
Q = f (L, K)
Thus, isoquant shows the flexibility that firms have when making production decision.
They can usually obtain a particular output (Q) by substituting one input for the other.

Isoquant Maps: Isoquant map is a collection of different isoquant curves each representing
a specific out put level. When a number of isoquants are combined in a single graph, we
call the graph an isoquant map. An isoquant map is another way of describing a production
function. Each isoquant represents a different level of output and the level of out put
increases as we move up and to the right. The following figure shows isoquants and
isoquant map.

Capital

3
q3
2
q2
1 q1

1 3 6 Labor

Fig 3.4 Isoquant and isoquant map.


Isoquants show the fact that long run production process is flexible. A firm can produce q1
level of output by using either 3 units of capital and 1 unit of labor or 2 units of capital and

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3 units of labor or 1 unit of capital and 6 units of labor or any other combination of labor
and capital on the curve. The set of isoquant curves q1 q2 and q3 is called isoquant map.

Properties of isoquants

Dear learner, do you remember the properties of a well behaved indifference curve?
(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________
Dear learner! Most of the properties of an isoquant are the same as that of an indifference
curve. The major difference between them is that output is constant along an isoquant
where as indifference curves hold utility constant. Thus, isoquants are:
1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs
that yield the same output, they always have negative slope and can never be horizontal,
vertical or upward sloping. For example, if isoquants are horizontal only one point on the
isoquant is efficient. See the following figures.
Capital
Capital Capital 100kg
100kg
wheat
teff

100kg
A teff
4

B
A
A

5 Labor Labor
2 5
Labor
Panel a Panel b Panel c

Fig 3.5 Isoquants with zero or positive slope

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In fig.3.5 panel (a), the firm can produce 100kg of Teff by using either 4 capitals and 2
labors, or 4 capitals and 5labors or any other combination of labor and capital along the
curve. Obviously, only the first alternative is efficient as it uses the least possible
combination of inputs. Thus, all points, except A, are inefficient and not part of isoquant.
Thus, an isoquant can never be horizontal.

In fig.3.5 panel (b), a firm can produce 100kg of wheat by using any combination of labor
and capital along the isoquant. But only point A is efficient. For example, point B shows
the same number of labor as point A, but higher capital. Thus point B is in efficient because
it shows higher combination of inputs. Thus, isoquants can never be vertical line

In fig.3.5 panel (c), all points above point A utilize higher combination of both inputs to
produce the same output (100 kg coffee). Point A shows the least combination of inputs
that can yield 100 kg coffees. Thus, all other points are inefficient and not part of the
isoquants.

Thus, efficiently requires that isoquants must be negatively sloped. As employment of one
factor increases, the employment of the other factor must decrease to produce the same
quantity efficiently.

2. The further away an isoquant lays from the origin, the greater the level of output it
denotes. Higher isoquants (isoquants further from the origin) denote higher combination of
inputs. The more inputs used, more outputs should be obtained if the firm is producing
efficiently. Thus, efficiency requires that higher isoquants must denote higher level of
output.

3. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.

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Consider the following figure.

Capital

q=50
Q=20
Fig 3.6 Crossing Isoquants

Efficiency requires that isoquants do


not cross each other, because the
point of their intersection implies that
K* there is inefficiency at this point.

L*

This figure shows that the firm can produce at either output level (20 or 50) with the same
combination of labor and capital (L* and K*). The firm must be producing inefficiently if it
produces q = 20, because it could produce q = 50 by the same combination of labor and
capital (L* and K*). Thus, efficiency requires that isoquants do not cross each other.

4) Standard isoquants are convex to the origin

The slope of an isoquant is called marginal rate of technical substitution. Marginal rate of
technical substitution declines as we substitute on input for the other. This makes isoquants
convex to the origin. We will investigate this concept later.

Capital

Labor

Fig.3.7: Convex Isoquants

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Special Shapes of isoquants


Isoquants can have different shapes (curvature) depending on the degree to which factor
inputs can substitute each other.
1-Linear isoquants
Isoquants would be linear when labor and capital are perfect substitutes for each other. In
this case, the slope of an isoquant is constant. As a result, the same output can be produced
with only capital or only labor or an infinite combination of both. Graphically,

10

q=100
8

12 15
L

Fig.3.8: Linear isoquant. Capital and labor can perfectly substitute each other so that the
same output (q=100) can be produced by using either 10k or 8K and12L or 15L or an
infinite combinations of both inputs.

2. Fixed Factor Proportion or L-shaped Isoquants

When a production function assumes fixed proportion between capital and labor, the
isoquant takes “L”-shape. It is also called Leontief isoquant. This assumes strict
complementarities or zero substitutability of factors of production. In this case, it is
impossible to make any substitution among inputs. Each level of output requires a specific
combination of labor and capital: Additional output cannot be obtained unless more capital
and labor are added in specific proportions. As a result, the isoquants are L-shaped. See the
following figure. For example to derive a car we always need one driver for one car which
a one to one ratio in this case.

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q3

q2
K2

q1
K1

L
L1 L2
Fig. 3.9 L-shaped isoquant when isoquants are L-shaped, there is only one efficient way of
producing a given level of output: Only one combination of labor and capital can be used
to produce a given level of output. To produce q1 level of output there is only one efficient
combination of labor and capital (L1 and K1). Output cannot be increased by keeping one
factor (say labor) constant and increasing the other (capital). To increase output (say from
q1 to q2) both factor inputs should be increased by equal proportion.

3. Kinked isoquants
This assumes limited substitutability between inputs. Inputs can substitute each other only
at some points. Substitution of inputs is possible only at the kink points. Thus, the isoquant
is kinked and there are only a few alternative combinations of inputs to produce a given
level of output. These isoquants are also called linear programming isoquants or activity
analysis isoquants. See the figure below.

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12 A

7 B

5 C

D
3
Q=100

L
1 3 5 9

Fig. 3.10: kinked isoquant In this case labor and capital can substitute each other only at
some point at the kink (A, B, C, and D). Thus, there are only four alternative processes of
producing q=100 out put.

4. Smooth, convex isoquants

This shape of isoquant assumes continuous substitution of capital and labor over a certain
range, beyond which factors cannot substitute each other. Basically, kinked isoquants are
more realistic: There is often limited (not infinite) method of producing a given level of
output. However, traditional economic theory mostly adopted the continuous isoquants
because they are mathematically simple to handle by the simple rule of calculus, and they
are approximation of the more realistic isoquants. From now on we use the smooth and
convex isoquants to analyze the long run production.

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∆K=4

∆L=1

∆K=2 ∆K=1/2

∆L=1 Q
∆L=1

L
Fig: 3.11: Smooth and convex isoquant.

This type of isoquant is the limiting case of the kinked isoquant when the number of kink is
infinite. The slope of the isoquant decrease as we move from the top (left) to the right
(bottom) along the isoquant. This indicates that the amount by which the quantity of one
input (capital) can be reduced when one extra unit of another inputs (labor) is used (so that
out put remains constant) decreases as more of the latter input (labor) is used.

Slope of an Isoquant: Marginal Rate of Technical


Substitution (MRTS)
The slope of an isoquant (-K/L) indicates how the quantity of one input can be traded
off against the quantity of the other, while out put is held constant. The absolute value of
the slope of an isoquant is called marginal rate of technical substitution (MRTS). The
MRTS shows the amount by which the quantity of one input can be reduced when one
extra unit of another input is used, so that output remains constant. MRTS of labor for
capital, denoted as MRTS L, K (Marginal rate of technical substitution between labor and

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capital) shows the amount by which the input of capital can be reduced when one extra unit
of labor is used, so that output remains constant.

MRTS L, K decreases as the firm continues to substitute labor for capital (or as more of
labor is used). In fig.3.11 to increase the amount of labor from 1 to 2, the firm reduces 4
units of capital (K=4), to increase labor from 2 to 3, the firm reduce 2 units of capital
(K=2), and so on. Hence, the firm reduces lower and lower number of capital for the
successive one unit of labor. Dear learner, why does this happen?

The reason is that when the number of capital is large and that of labor is low, the
productivity of capital is relatively lower and that of labor is higher (due to the low of
diminishing marginal returns). Thus, at this point relatively large amount of capital is
required to replace one unit of labor (or one unit of labor can replace relatively large
amount of capital). As the employment of labor increases and that of capital decreases (as
we move down ward along the isoquant), quite the reverse will happen. That is,
productivity of capital increases and that of labor decreases. Hence, the amount of capital
that needs to be reduced increase when one extra labor is used decreases. The fact that the
slope of an isoquant is decreasing makes an isoquant convex to the origin.

MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal products of
factors. That is,
K MPL
MRTS L, K   
L MPK

This can be shown algebraically as follows:

Let the production function is given as:

q= f (L, K) Where q- is output


L- is unit of labor employed
K-is the amount of capital employed.

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Given this production function, the equation of a specific isoquant can be obtained by
equating the production function with a given level of output, say q .

q = f (L, K) = q

Total differential of q measures the total change in q that happens as a result of a


simultaneous change in L and K. i.e.,
q f
dq  .dL  .dk  d q
L k

But since q is constant, d q is zero (d q =0)


q q
So, .dL  dk  0
L k

q q
(But,  MPl and  MPk )
L k
Thus, the above equation can be written as:
MPL. dL + MPK.dk = 0
MPL  dK
  = MRTSL,K
MPk dL

There fore, the slope of an isoquant can be given as the ratio of marginal products of inputs.

Elasticity of Substitution

MRTS as a measure of the degree of substitutability of factors has a serious defect. It


depends on the units of measurement of factors. A better measure of the ease of factor
substitution is provided by the elasticity of substitution, δ. Elasticity of substitution is
percentage change in capital labor ratio divided by percentage change in marginal rate of
technical substitution. The elasticity of substitution is defined as
K K
% %
 L = L
%MRTS MPL
%
MPK

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K
(
)
d L
K
= L
 MPL  MPL
d  ( )
 MPK  MPK

The elasticity of substitution is a pure number independent of the units of measurement of


K and L, since the numerator and the denominator are measured in the same units and be
cancelled.

Factor Intensity

A process of production can be labor intensive or capital intensive or neutral process. A


process of production is called labor intensive if it uses relatively large amount of labor
than capital. If it uses many capitals and relatively few labor it is called capital intensive
technology. On the other hand, if the process uses equal proportion of both it is called
neutral technology. The factor intensity of any process is measured by the slope of the line
through the origin representing the particular process. Thus, the factor intensity is the
capital-labor ratio. The higher the capital-labor ratio is the higher the capital intensity but
the lower the capital-labor ratio is the higher labor intensity of the process.

Capital

A
K1

B
K2 X

O
L2 Labor
L1
Fig 3.12 Factor Intensity

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Process A uses k1 and L1 units of labor and capital to produce X amount of output. The
factor intensity of this process can be measured by the slope of OA, which equals
OK1 K1
AL1/OL1 = 
OL1 L1

K2
Similarly, factor intensity of process B is given by
L2

K1 K 2
Since  , process A is more capital intensive than process B or B is more labor
L1 L2
intensive than A. The upper part of the isoquant includes more capital intensive processes
and the lower part, labor intensive techniques.
Now let us illustrate the above concepts with the most popular and applicable form of
production function, Cobb-Douglas production function
The Cobb- Douglas production function is of the form
X  b0 Lb1 K b 2
From this production function
X
1. MPL =  b1b0 Lb11 K b2
L
Lb1 b 2
= b0 b1 K since X  b0 Lb1 K b 2
L
X
 b1
L
= b1APL

K
MPK =  b2 b0 Lb1 K b 21
L
X
= b2 since X  b0 Lb1 K b 2
K
= b2 APK

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2. Marginal rate of technical substitution


X
b1
MPL L  b1 . K
(MRT SLK) = 
MPK X b2 L
b2
K
3. The elasticity of substitution
K
 
d L 
K
 L
MPL
d( )
MPK
MPL
MPK

K K
   
d L  d L 
K K
 L  L
bK b
d( 1 L) ( 1 )d ( K L)
b2 b2
b1 K b1 K
b2 L b2 L

 1

4. Factor intensity is measured by the ratio b1/b2. The higher the ratio, the more labor
b1
intensive the technique. Similarly, the lower the ratio of , the more capital intensive the
b2
technique.
5. The efficiency of production. This is measured by the coefficient b0. It is clear that if two
firms have the same K, L, b1 and b2 and still produce different quantities of output, the
difference could be due to the superior organization and entrepreneurship of one of the

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firms, which results in different efficiencies. The more efficient firm will have a larger b 0
than the less efficient one.
.
3.8 The Efficient Region of Production: Long run

In principle, the marginal product of a factor may assume any value, positive, zero or
negative. However, the basic production theory concentrates only on the efficient part of
the production function, i.e. over the range of out put over which the marginal product of
factors are positive and declining. In the short run production function, efficient region of
MPL
production prevails in stage two (stage II), where MPL >O, but < 0.
L

Similarly, efficient region of production in the long run prevails when the marginal product
of all variable inputs is positive but decreasing. In a given isoquant all points are not
economically efficient. Graphically this can be represented by the negatively slopped part
of an isoquant. The locus of points of isoquants where the marginal products of factors are
zero form the ridge lines. The upper ridge line implies that the MP of capital is zero. MPK is
negative for all points above the upper ridge line and positive for points below the ridge
line. The lower ridge line implies that the MP L is zero. For all points, below the lower ridge
line the MPL is negative and positive for points above the line. Production techniques are
technically efficient inside the ridge lines. Symbolically in the long run efficient production
region can be illustrated as:
MPL
MPL >0, but <0
L
MPk
MPk >0, but <0
K
Graphically, efficient region of production is shown as follows:

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Capital
Upper ridge line

Lower ridge line

q3

q2

q1

Labor

Fig 3.13: Economic Region of an Isoquant


Thus efficient region of production is defined by the range of isoquants over which they are
convex to the origin. Or the area between the two ridge lines is called economic region or
technically efficient region of production
MPL
From our previous section we know that MRTS L, K  and along the lower ridge line,
MPK
0 MP
since MPL is zero, MRTSL, K   0 .Along the upper ridge line MRTSL, K  L .since MPK is
MPK MPK
MPL
zero, MRTSL, K    .Note that MRTSK,L equals to zero along the upper ridge line
0
3.9. The Long Run Law of Production: The Law of Returns to Scale
Dear learner! What is the law of returns to scale? How is it related to the law of
marginal returns?
(You can use the space left below to write your response)
_________________________________________________________________________
_________________________________________________________________________

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The laws of production describe the technically possible ways of increasing the level of
production. Output may increase in various ways. In the long run, output can be increased
by changing all factors of production. This long run analysis of production is called Law of
returns to scale.

In the short run, output may be increased by using more of the variable factor, while capital
(and possibly other factors as well) are kept constant. The expansion of output with one
factor (at least) constant is described by the law of variable proportion or the law of returns
to the variable factor.

In the long run, all inputs are variable. Expansion of output may be achieved by varying all
factors of production by the same proportion or by different proportions. The law of returns
to scale measures the change in output when all inputs are altered by same or different
proportion.

The traditional theory of production concentrates on the first case, i.e. the study of output
as all inputs change by the same proportion. The term returns to scale refers to the change
in output as all factors change by the same proportion.

Due to the proportionate change in inputs, output may change in any of the following three
ways.
A) Output changes more proportionately than the change in inputs. This is the case of
Increasing returns to scale (IRS)
B) Output changes less proportionately than the change in inputs. When the percentage
change in output is less than that of the inputs we have what is called decreasing
returns to scale.
C) When output changes by the same percentage that inputs have been changed, the
production function is said to exhibit constant returns to scale (CRS)

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Suppose initially the production function is


X0 = f (L, K)
If we increase all factors by the same proportion c, we clearly obtain a new level of output
X* where,
X* = f (cL, cK)

 If X* increases by the same proportion c or if X* = cX0, we say that there is


constant returns to scale.
 If X* increases less than proportionally with the increase in the factors (or if X*
increases by a proportion less than c), we have decreasing returns to scale.
 If X* increases more than proportionally with the increase in the factors (by a
more than c proportion), we have increasing returns to scale.

Returns to scale and homogeneity of production function

Suppose we increase both factors of the function X0=f (L, K) by the same proportion ‘c’,
and we get the new level of output X = f (cL, cK).

If c 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 c (to any power v) and the
initial level of output. Such production function is called homogeneous production
function. X* = c v f (LK) or X* =c V
X0

If c can not be factored out, the production function is non-homogeneous. Thus, a


homogeneous function is a function such that if each of the input is multiplied by c, then c
can be completely factored out of the function. The power v of c is called degree of
homogeneity of the function and is measure of returns to scale.

If v =1, we have constant returns to scale. This production function is some times called
linear homogeneous.

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If v <1, decreasing return to scale prevails


If v >1, increasing return to scale prevails

For a Cobb-Douglas production function the sum of the power of L and K measures the
nature of returns to scale. Assume a Cobb-Douglas production function given as;
X = b0Lb1 Kb2, v = b1 +b2 and it is a measure of returns to scale.
Proof: Let L and K increase by c. The new level of output is
X* = b0 (cL) b1 (ck) b2
X* = b0 cb1 lb1 cb2kb2
X* = b0Lb1Kb2 cb1+b2
X* = X (c b1+b2)
Thus v = b1+b2

Example

1. If a production function is given by Q0=100 L0.3K 0.4


check whether the production
function exhibits CRS, DRS or IRS?
Solution
Change all inputs by a certain percentage c
Q1 =100 (cL) 0.3 (cK) 0.4
=100(c0.3) L 0.3 (c0.4) K0.4 by distributing the power
=100 c0.3+0.4 (L 0.3 K0.4) by adding the exponent when the base is the same
0.7 0.3 0.4
=c (100 L K ) factoring out the common term
Q1 = c 0.7 (Q0) v=0.7 < 1.
Therefore, the production function exhibits decreasing returns to scale
Or since the above production function is an example of Cobb-Douglas production
function, v= b1 + b2.
v=0.3 +0.4 =0.7(DRS)
2. Assume a production function given as Q0 = 10L+5K.Does the production function have
CRS, DRS or IRS?

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Solution

Similar to the previous example, change all inputs by a certain proportion (c)
Q1 =10(cL)+ 5 (cK)
= c (10L) +c (5K)
= c (10L+5K), by factoring out c
Q1 = c Q0, since v=1, the production function exhibits constant returns to scale

For a homogeneous production function the returns to scale may be represented graphically
in an easy way. Before explaining the graphical representation of the returns to scale it is
useful to introduce the concept of product line and isoclines.

3.10 Product Lines

Dear learner! A product line shows the (physical) movement from one isoquant to another
as we change the employment of either factors or a single factor, and it describes the
technically possible alternative paths of expanding output. The path actually chosen by the
firm will depend on the prices of factors of production.

The product line (curve) passes through the origin if all factors are variable. If only one
factor is variable (the other being constant) the product line is a straight line parallel to the
axis of the variable factor. For such product lines the K/L ratio diminishes along the
product line

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Product
line

Product
line
Product
line Product
line

Product
line

O
O O
Product line for Product line for non -
Product line for one
homogeneous production homogeneous production
factor (K) constant
function function

Fig 3.14 Different forms of a Product line

A product line along which the MRTS of factors is constant is called an isocline. So an
isocline is the locus of points of different isoquants at which MRTS of factors is constant.
If the production function is homogeneous the isoclines are straight lines through the
origin. Along any one isocline the K/L ratio is also constant (as is the MRTS of the
factors). But K/L ratio and the MRTS are different for different isoclines.If the production
is non homogeneous the isocline will not be straight line, but their shape will be twiddle.
The K/L ratio changes along each isocline and on different isoclines.

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3.11 Graphical Presentation of Returns to Scale for Homogeneous


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

Constant returns to scale

Along any isocline the distance between successive multiple- isoquant is constant.
Doubling the factor inputs doubles the level of initial output; trebling inputs trebles output,
and so on.

c
3k

b
2k
3X

a 2X
k
X
O
1L 2L 3L L

Fig.3.15 Constant returns to scale: oa= ab = bc

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Decreasing returns to scale

Here, the distance between consecutive multiple- isoquants decreases. By doubling inputs,
output increases by less than twice of its original level.

c
3k
b 3X
2k 2.5X
a 2X
k
X 1.7x
O
L 2L 3L
Fig 3.16 Constant returns to scale: oa< ab < bc

Increasing returns to scale

The distance between consecutive multiple isoquants increases, by doubling the inputs,
output is more than doubled.
K
3.75X

3K1

c
B’ c 4.5 X
2K1
b
3X
a
K1 2.5X
2X
X
L
O
L1 2L1 3L1

Fig 3.17 Increasing Returns to Scale


Doubling K and L leads to B’ which lies above an isoquant denoting 2X(i.e.,2.5X),and
tripling K and L results in an isoquant which lies above 3X(i.e.,4.5X) and so on.

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Returns to scale are usually assumed to be the same every where on the production surface
i.e., the same along all the expansion product lines. All processes are assumed to show the
same returns to scale over all ranges of output. Either constant returns to scale every where,
or decreasing returns every where, 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, while
over another range we may have increasing or decreasing returns to scale.

K
3.75
XX

3K1 b
7X
c
2K1 c 6X
5X
a 4X
K1 3X
2X
X
L
O
L1 2L1 3L1

Fig3.18 Up to point C, increasing returns to scale prevails in the firm, from C to B


constant returns to scale prevails, and beyond B decreasing returns to scale prevails.

Causes of Increasing and Decreasing Returns to Scale

Dear learner! what do you think are the causes these varying returns to scale?
(You can use the space left below to write your response)
_________________________________________________________________________
_______________________________________________________________________

Dear learner! Technical and /or managerial indivisibility is one of the factor that leads to
increasing returns to scale. Mostly, processes of production can be doubled but it may not

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be possible to half them. When the production system expands, workers will specialize in
one extreme and their productivity increases.

On the other hand, the most common causes of decreasing returns to scale is ‘diminishing
returns to management’. If we expand the out put beyond optimum, the top management
personnel will be over burdened and the productivity of additional unit of the variable
inputs decline eventually. E.g., doubling fishing fleet may not double fish catch.

3.12 Technological process and production function

Technological improvement (progress) makes factors of production more productive or it


makes production system more efficient; so that the firm will get higher output from the
same combinations of labor and capital than before.

Graphically, this can be shown by upward movement of the total product curve (indicating
higher output level can be achieved from the same input) and down ward movement of
isoquant denoting lower combinations of factors of production can produce equal level of
output. See the figures

TP2 TP after
technological
advancement
Isoquant before
TP before technological
technological advancement
K1
advancement
TP1
K2 Isoquant after
technological
advancement

L1 L2 L1

Fig 3.19 Technological progress shifts the TP curve up ward and the isoquant down ward

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3.13 Equilibrium of the firm: Choice of optimal combination of factors of


production
Dear learner, in our previous discussion we have said that an isoquant denotes efficient
combination of labor and capital required to produce a given level of out put. But, this does
not mean that the monetary cost of producing a given level of out put is constant along an
isoquant. That is, though different combinations of labor and capital on a given isoquant
yield the same level of out put, the cost of these different combinations of labor and capital
could differ because the prices of the inputs can differ. Thus, isoquant shows only
technically efficient combinations of inputs, not economically efficient combinations.

Technical efficiency takes in to account the physical quantity of inputs where as economic
efficiency goes beyond technical efficiency and seeks to find the least cost (in monetary
terms) combination of inputs among the various technically efficient combinations. Hence,
technical efficiency is a necessary condition, but not a sufficient condition for economic
efficiency. To determine the economically efficient input combinations we need to have the
prices of inputs.

To determine the economically efficient input combination, the following simplifying


assumptions hold true:

Assumptions

1. The goal of the firm is maximization of profit (  ) where   TR  TC


Where  -Profit, TR- Total Revenue and TC-is total cost outlay.

2. The price of the product is given and it is equal to PX .

3. The prices of inputs are given (constant).Price of a unit of labor is w and that of
capital is r .

Now before we go to the discussion of optimal input combination (or economically


efficient combination), we need to know the isocost line, because optimal input is defined
by the tangency of the isoquant and isocost line.

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Isocost line

Dear learner, do you remember what the budget line denotes?


Isocost lines have the same properties as that of budget lines. An isocost line is the locus
points denoting all combination of factors that a firm can purchase with a given monetary
outlay, given prices of factors.

Suppose the firm has C amount of cost out lay (budget) and prices of labor and capital are
w and r respectively. The equation of the firm’s isocost line is given as:

C  rK  wL , where K and L are quantities of capital and labor


respectively.

Given the cost outlay C , the maximum amounts of capital and labor that the firm can
C C
purchase are equal to and respectively. The straight line that connects these points is
r w
the isocost line. Note that just like a budget line; the slope of the isocost line is given by the
w
factor price ratios. That is Slope of isocost equals to  .See the following figure:
r

Capital

C/r

Isocost
line

Labor
C/w
Fig: 3.20: Isocost line: shows different combinations of labor and capital that the firm
can buy given the cost out lay and prices of the inputs.

Now we are in a position to determine the firm’s optimal in put combination. However, the
problem of determining optimal input combination (economic efficiency) takes two forms.
Some times, situations may happen when a firm has a constant cost outlay and seek to

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maximize its out put, given this constant cost outlay and prices of inputs. Still, there are
also situations when the goal of the firm is to produce a predetermined (given) level of
output with the least possible cost. Below we will discuss the two situations separately.

Case1: Maximization of Output Subject to Cost Constraint


Suppose a firm having a fixed cost out lay (money budget) which is shown by its isocost
line. Here, the firm is in equilibrium when it produces the maximum possible out put, given
the cost outlay and prices of inputs. The equilibrium point (economically efficient
combination) is graphically defined by the tangency of the firm’s isocost line (showing the
budget constraint) with the highest possible isoquant. At this point, the slope of the isocost
w MPL
line ( ) is equal to the slope of the isoquant ( ).
r MPK
The condition of equilibrium under this case is, thus:

w MPL MPL MPK


 or 
r MPK w r

This is the first order (necessary) condition. The second order (sufficient) condition is that
isoquant must be convex to the origin (tangent to the isocost). See the following figure:

Capital

Q3
K1 E

Q2
Q1

L1 B Labor
Fig: 3.21: Optimal combination of inputs ( L1 and K1 )

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Optimal combination of inputs is defined by the tangency of the isocost line (AB) and the
w
highest possible isoquant ( X 2 ), at point E. At this point the slope of isocost line ( ) is
r
MPL
equal to the slope of isoquant ( ).The second order condition is also satisfied by the
MPK
convexity of the isoquant.

Mathematical derivation of the equilibrium condition

The problem can be stated as:

Maximize X  f ( L, K )..........................Objective function


Subject to C  wL  rK..........................Constra int function
or C  wL  rK  C  0
We use the lagrangian method to solve the problem.

The lagrangian equation is written as:

  X   (C )
  
Then we find , , and and set all of them equal to zero to solve for
L K 
L and K.

That is,

  X   (wL  rK  C )

 X MPL
And,   wL  0  MPL  w   
L L w
 X MPK
  r  0  MPK  r   
K K r

 wL  rK  w  0  wL  rK  C


Solving these equations simultaneously, we obtain the equilibrium condition

MPL MPK w MPL


 or 
w r r MPK

The second order condition (the convexity of isoquant) would be insured when:

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2
2 X 2 X  2 X   2 X   2 X 
 0 ,  0 and  2      
L2 K 2  L   K
2
  LK 

Example

Suppose the production function of a firm is given as X  0.5L1 / 2 K 1 / 2 prices of labor and
capital are given as $ 5 and $ 10 respectively, and the firm has a constant cost out lay of $
600.Find the combination of labor and capital that maximizes the firm’s out put and the
maximum out put.

Solution
MPL MPK MPL w
The condition of equilibrium is  or 
w r MPK r

X
MPL   0.25L1 / 2 K 1 / 2
L
X
MPK   0.25L1 / 2 K 1 / 2
K

Thus, the equilibrium exists when,

0.25L1 / 2 K 1 / 2 $5
1 / 2 1 / 2

0.25L K $10

K 1
  L  2 K ...................................(1)
L 2

The constraint equation is:

wL  rK  C
5L  10 K  600......................................(2)

Solving equation (1) and (2) would give us the optimal combination of L and K.

L  2K
5L  10 K  600

 L=60 units and K=30 units.

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Thus, the firm should use 60 units of labor and 30 units of capital to maximize its
production (out put). (Check the second order condition).

The maximum out put can be found by substituting 60 and 30 for L and K in the production
process.

Case -2: Minimization of cost for a given level of output

In this case, consider an entrepreneur (a firm) who wants to produce a given output (for
example a bridge or a building or x tones of a commodity) with minimum cost outlay. That
is, we have a single isoquant which denotes the desired level of output, but there are a set
of isocost lines which denotes the different cost outlays. Higher isocost lines denote higher
production costs. The production costs of a desired level of output will therefore be
minimized when the isoquant line is tangent to the lowest possible isocost line (see fig)
At the point of tangency, the slope of the isoquant and isocost lines are identical.
w MPL
That is 
r MPK

Capital
e

c
K1
a
E

L1 b d f
Labor

Fig: 3.22 Equilibrium Combination of factors

The equilibrium combination of factors is K1 and L1 amounts of capital and labor


respectively. Lower isocost lines such as ‘ab’ are economically desirable but unattainable

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given the desired level of output. So point E shows the least cost combination of labor and
capital to produce X amount of output.

Now let us see the mathematical derivation of the equilibrium condition. As mentioned
earlier, we minimize the cost of producing a given level of output.
Thus, the problem can be stated as:
Minimize C = f (q) = WL + rK -------------------------------------- (Objective function)
Subject to q = f (L, K) ------------------------------------------------ (Constraint function)
Or f (L, K) – q = 0
We use the LaGrange an method to obtain the equilibrium condition. Accordingly, the
LaGrange an function will be:
  C   ( f ( L, K )  q)
  WL  rK   ( f ( L, K )  q)
  
The condition of equilibrium will be obtained by finding , and and then solving
L K 
them simultaneous after equating each to zero.
That is
 f ( L, K )
 w 0
L L
w
w  MPL  0   
MPL

 f ( L, K )
 r  0
K K

r
r  MPK  0   
MPK


 f ( L, K )  q  0


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w r
Thus, the equilibrium condition is 
MPL MPK
MPL w
Rearranging the above condition, we obtain 
MPK r

 MPL W 
This condition    is only a necessary condition .
 MPK r 
The sufficient condition is that the isoquant must be convex to the origin. That is
2
2q  2q   2 q   2 q    2 X 
 0,  0 and  2  2    
L2 k 2  L  k   LK 

Example
Suppose a certain contractor wants to maximize Profit from building a bridge. The
contractor uses both labor and capital, and efficient combinations of Labor and capital that
1 1
2 2
are sufficient to make a bridge is given by the function 0.25 L K . If the prices of labor
(w) and capital (r) are $ 5 and $ 10 respectively, find the least cost combination of L and K,
and the minimum cost.

Solution

The contractor wants to build one bridge. Thus, the constraint equation can be written as
1 1
0.25 L 2 k 2 =1
1 1
2
MPL = 0.125 L K2
1 1
MPK = 0.125 L 2 K 2

MPL W
The equilibrium condition is 
MPK r

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1 1
2 2
0.125L K $5
1 1

2 2
$10
0.125L K

K 1
  L  2K
L 2

Substituting L = 2K in the constraint equation we obtain


1 1
2 2
0.125 (2K) K =1
0.125 2 . K=1
1 8
K= K
0.125 2 2

16
L = 2K 
2
16 8
Therefore, efficient combination (least cost combination) of L and K are and
2 2
respectively.
 16   8  160
The least cost is C = 5   + 10  =$
 2  2 2

Cost minimization with varying out put levels and the derivation of long
run total cost curve
Dear learner, in the previous chapter we saw how a cost minimizing firm selects a
combination of inputs to produce a given level of out put. Now we extend this analysis to
see how the firm’s costs depend on its out put level. To do best with, refer to the following
figure.

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Expansion
K path

40 80

70
B
3.5 60
A
3 50
2 30
20
10
O
3 5 6 L

Fig 3.23 Expansion Path

In the above figure, the firm is assumed to have increasing returns to scale up to point A
(the distance between successive multiple levels of out put decreases), constant returns to
scale between points A and B (the distance between successive multiple levels of out puts
is constant) and decreasing returns to scale beyond point B (the distance between
successive multiple levels of out put increases).

The curve passing through the points of tangency between the firm’s isocost lines and its
isoquants is called expansion path. The expansion path denotes least cost combination of
labor and capital required to produce different levels of out put.

To produce 10 units of out put, the firm uses 2K and 3L, to produce 20 units, the firm uses
3K and 5L, to produce 30 units it uses 3.5K and 6L, and so on. Hence, as out put expands
at a constant amount, the units of labor and capital increases at a decreasing rate up to point

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A. That is, total cost of production increases at a decreasing rate up to point A. From point
A to B, combination of labor and capital increase at a constant rate as out put increases at a
constant rate. Hence, the long run total cost increases at a constant rate up to point B.

Beyond point B, to expand out put at a constant rate, combination of labor and capital
should be increased at an increasing rate. Assuming that the prices of inputs are constant,
the long run total cost of production increases rapidly (at increasing rate) beyond point B.

From the above discussion, we infer that the long run total cost curve assumes an inverse S-
shape.

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 Checklist

Dear learner have you achieved the entire objectives of the unit? Below are some of
the most important points drawn from the unit you have been studying up to now.
Please put a tick (√) mark in front of the point you have understood well in the box
under "Yes" and in the box under "No" for points you have not understood well yet.
And if the tick marks under "No" are more than those under “Yes" it means you are left
with a lot to understand the unit and you have not yet achieved the objectives indicated
at the beginning of the unit. This tells you to go back and read the sections you passed
through.

I Can: Yes No

 Define production &production function;


 Differentiate between short run and long run, and fixed and
Variable inputs
 Explain short run production and efficiency.
 Define an isoquant and explain its properties;
 Explain long run production decision; and
 Determination of least cost combination of inputs.

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Summary
In economics, production means the act of creating those goods or services that have
exchange values. The process of production requires inputs such as land, labor, capital and
entrepreneurial ability, Fixed inputs are those inputs whose quantity can not readily be
changed when market conditions indicate that an immediate change in out put is required,
Variable inputs are those inputs whose quantity can be changed almost instantaneously in
response to derived changes in out put.

A production function describes the maximum out put that a firm can produce for each
specified combinations of inputs. In the short run, one or more inputs to the production
process are fixed. In the long run, all inputs are potentially variable.

In the short run the firm is said to be efficient when it operates over the range of
employment of the variable inputs where marginal product of the variable input is positive
but declining.

Analysis of long run production makes the use of isoquants (equal product lines).Isoquants
show efficient combination of inputs that yield the firm equal level of out put. Isoquants are
always down ward sloping. Higher isoquants show higher level of out put. Isoquants can
not intersect each other. They are convex to the origin, and they must be thin.

In the long run, efficient region of production is represented by the convex part of
isoquants map.

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Self-check Exercise

1. What does an isocost line show?


2. Why is an isoquant curve convex to the origin?
3. Describe the efficient region of production in the short run and long run.
4. Explain the properties of an isoquant
5. Distinguish between
o Increasing and decreasing returns to scale
o Technical efficiency and Economic efficiency
6. What is the impact of technological progress on
o The Total product Curve
o The isoquant
7. What does the production function denote?

Work out
1. Which of the following production function is/are homogeneous?
A. q = L+K
B. q = 10L +K

C. q = L+L  K
 +K
D. q = L2+K
2. Suppose the production function is
3 1
q=L4K4
A. what is APL, holding capital fixed?
B. Calculate MPL and MPK?
C. Does this production function have increasing, constant or decreasing returns to scale?

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Suggested readings

 Chiang, Alpha (1984) Fundamental Method of Mathematical Economics. MCGraw


Hill Book Company.
 Gold and Furguson(1998),Micro-economics theory,Richard D.Irwin,inc.fifth ed.
 Koutsoyiannis A.(1979) Modern Microeconomics, Mac million press Ltd.
 Maddala G.S. (1989) Microeconomics Theory and Application. McGraw Hill book
company.
 Pindyck R.S. and Rubirfeld (1995), Microeconomics. MC Graw Hill Book
Company.
 Varian,R.Hall(1999),Intermediate Micro economics:a modern approach,W.W
Norton and Co,New York

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Micro Economics I Module I

Answer key
Unit I

I. key for check your progress activities

1. Economics is a branch of social science which deals with efficient utilization of


scarce or limited resources
2. The foundations of economics are the scarcity of resources and the unlimited ness
of human wants.
3. The central aim of economics is to use the scarce resources efficiently to maximize
human gains or benefits.
4. Microeconomics is a branch of economics which deals with the decision making
behavior of individual economic units
5. Macroeconomics refers to the study of the behavior of the economy as a whole
6. 19% inflation rate in Ethiopia is an example of macroeconomic study
 It is microeconomic study as it focuses on a singles firm
7. Positive economics describes things and facts as they are with out including
Value judgment
8. Normative economics involves value judgment of a given in fact or figure by the
writer or reader.
9. a) Normative
b) Positive
c) Normative
d) positive
II. Answer key for self-check exercises

Part I True/False

1. True
2. True
3. False
4. False
5. False

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Part II Completion Item

1. Microeconomics
2. Normative Economic
3. Economic Models
4. Positive Economics
5. Limited resource/scarcity

Part III multiple choice

1. E
2. D
3. B
4. B

Unit Two

I Answer key for Check your progress Activity

1. Utility is the want satisfying power of commodity. It is also defined as the


expected level of satisfaction from consumption of a food or a service
2. The two approaches to measure utility are cardinal and ordinal approach
3. The major assumption of cardinal approach are
a) Rationality of consumers
b) Cardinal measurability of utility
c) Constant marginal utility of money
d) The consumer has got limited money income
e) Diminishing marginal utility.

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4. limitations of cardinalist theory includes:


-cardinal measurability of utility is doubtful.
-the assumption of constant marginal utility of money.

QX Tux QX TUy MUx MUy MUx MUy


Px Py
0 0 0 0 0 0 0 -
1 10 1 24 10 24 10 8
2 19 2 45 9 21 9 7
3 27 3 63 8 18 8 6
4 34 4 78 7 15 7 5
5 40 5 87 6 9 6 3
6 44 6 90 4 3 4 1

TUx TUx2  TU x 1
a) MUx= 
x x2  x1

TUy TUy 2  TU y 1
MUy= 
y y2  y1

10  0
Example, for the 1st unit of x, MUx=  10 while for the 1st unit of y,
1 0
24  0
9 45  24
MUy= 1  0 and MU(2nd unit of y)=  21, e.t.c
2 1

b) The marginal utility tends to diminish right away from the first units of the
two goods.

c) Optimum quantities of the two goods is at a point where


MUx  MUy
and Income  Expenditure
px py

Given Px=1 and Py=3, I(M)=10)

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MUx  MUx
 MUx
px 1

MUy  MUy
,
py 3

MUx  MUy
,
Note : px py 8, when Qx=3 and Qy=1

But since expenditure is less than income this is not optimum consumption level
(Total expenditure =3on X+3 on Y=6 only)

MUx
But: when  MUy  6, when Qx  4 andQy  2
px
Total expenditure =1x4+2x3=10
Total income =10

 Income= expenditure

. The consumer should consumer 4 units of x and 2 units of y to maximize utility.

Note: The consumer needs extra money to consumers 5 units of x and 3 units of
y. This combination also fulfills the necessary condition for equilibrium
i.e.

MUx  MUy
px py =6 but income is less than required expenditure

6. Total Utility (TU) is the sum of satisfaction or utility gained from consumption
process.

- Marginal utility (MU) is the change in total utility when consumption


Tu
changes by one unit (MU= 
Q
- Demand curve which shows inverse relationship between price and
quantity demanded is based the law of diminishing marginal utility

7. Assumptions of ordinal utility theory are:


- Rationality of consumers

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- Ordinal measurability of utility


- Diminishing marginal rate of substitution (DMRS)
- Limited money income for the consumer
- Total utility depends on the quantity consumed

8. The major properties of indifference curve are:


- Negative slope
- Convex to the origin
- Never cross each other
- Upper indifference curve represents higher utility

9. I=M =200200 , Px=4 , Py=5

a) budget line M=PxQx + PyQy


200=4Qx+5Qy

Graphically
200
Qy M/py=  40
5

2 200=4Qx+5Qy

Qy

M 200
  50
Px 4

b) Budget line equation


200=40x+5Qy
 5Qy=200-40Qx
200  40 x
Qy=
5

Qy= 40-4/5+Qx
or
Qx= 50-5/4+Qy

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px
c) slope of budget line =  4/5
py
Intercept
X-intercept = m/px= 200 =50
4
y -intercept =m/py= 200 =40
5

d) i) If money income doubles, the budget line shifts outward in a parallel


way as its x and y intercepts also double
newM 400
new x-intercept=  =100 units
px 4
newM 400
new y-intercept=  =100 units
py 5
ii.) If Px and Py both increase by 50%
new px= px(old)+50% (Px old)
new px=4+0.5(4)
new py=py(old)+50% (Py old)

=5+0.5(5)
new py=7.5

M 200
  33.3(decreases)
new x- intercept = px 6

M 200
  26.67(decreases)
new x- intercept = py 7.5

new slope= px/py =6/7.5=0.8 (no change in slope)

Therefore, the budget line shifts inward parallely


iii) When Py doubles, it is only the y-intercept which will change
M 200
  20(decreaes)
new y-intercept = new py 10

thus, the budget line rotates inward only in the Y-axis

10. x= 3Mpx-3 , M=100,px=2

Originally the quantity demanded

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M 100 3x100
Qd=x- 3. 3
 3. 3   37.5
px 2 8

Assume an increase price of x to Birr 3 per unit


100 300
Final Qd =x=3. 3 = =11.1
3 27

Net (total) change =37.5-11.1=26.4

a) to measure substitution effect let’s keep the real income of the consumers constant by
increasing nominal money income

 M 1  px1Qx  pyQy

-  M 0  Px0Qx0  pyQy

 M=Qx  Px
M1-M0=37.5 (3-2)
=37.5

M1=M+37.5, income should increase by M1=137.5, 37.5 units to keep real income
constant

Therefore, Consumers new demand at the new price and new income is

 137.5  412.5
X (3,137,5)= 3.    15.28
 27  27
:- The substitution effect
=Qx(3,1375)-Qx(2,100)

=15.28-37.5
=-22.22

b) :- The Income effect is


Qx(3,100)-Qx(3,1375,5)
aa.1-15.28=-4.18

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c) This is a normal good since the reduction in real income has reduced consumption
(Direct relationship)

Note also income and substitution effects move in the same direction.

11. Qd =150-50p
Qs=60+40p

Steps: First find equilibrium quantity and price


In equilibrium DD=SS
150-50p =60+40p
90p=90
Pe=1 and Qe=150-50=100

Second find Y intercepts

Y=in terms of DD (Qd=0) P=3

:- consumer surplus = area below ad curve but above equilibrium price

P3
ss
CS
1

d
Q

0 100

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1
CS= bh
2
1
= (100) (3-1)
2
1
= (100) (2)
2
=100 units

12. Qd=15-0.5 p, P=5

dQ P
x , when p=5 ,Qd=15-0.5 (5)
dp Q
=15-2.5
Qd=12.5

dQ
And =-0.5
dp

5
:-ep=-0.5.
12.5
5
=
12.5
=-0.2
 /eP/ =0.2 inelastic demand

Q13. Qd1 =25,P1=20


P2=15,Q2=50

dQ p1  p2
ep =arc/average = .
dp Q1  Q2

 Q  Q1   p1  p2 
ep =  2   
 p2  p1   Q1  Q2 

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 50  50   35 
   
=  15  20   75 

25  35 
=  
5  75 
ep =-2.3
/ ep /=2.3, elastic demand.

Answer for self check Exercise


Part I completion items

1. Indifference curve (IC)


2. Marginal rate of substitution (MRS)
3. Budget constraint
4. Income consumption curve (ICC)
5. Price consumption curve (PCC)
6. Substitution Effect (SE)
7. Slutsky’s Equation
8. Consumer surplus
9. Price elasticity of demand
10. Availability of substitutes, time period….

Part II multiple choice

1. D
2. C
3. A
4. C
5. C
6. C

Part III work out

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¼
1. U=10x1/2 y

Mux u u
i) MRSx,y= , Mux  and Muy 
Muy x x
1 1 1 1
1
MUy= .10 x 2 y 4 =5x 2
y4
2
1 1 1
1
MUy= .10. x y 4
2
4
= 2.5 x1/2 Y -3/4
1/ 2
MUx 5 x y1/ 4
MRsx,y = 
MUy 2.5 x1/ 2 y 
3/ 4

2. y1/ 4 . y 3/ 4
 MRSx,y x1/ 2 .x1/ 2

2 y1/ 4 3/ 4
=
x1/ 2 1/ 2

2y
MRSx,y=
x

Muy 2.5 x1/ 2 y 3/ 4 x1/ 2 y 3/ 4


ii) MRSy,x=  
Mux 5 x 1/ 2 y 1/ 4 2 x 1/ 2 y1/ 4
x1/ 2 . x1/ 2 x1/ 21/ 2 x
 1/ 4 3/ 4
 1/ 4 3/ 4

2. y . y 2y 2y

MRS x,y =x/2y

Note: MRSy ,x is the inverse (reciprocal) of MRS x,y

2. U=X0.4 y0.6 Px=2,Py=3,M=50

a) For the lagrangian version, refer to the module on page 53 , 54 &55


Let’s use the slope method to final the quantities of x and y that maximized
utility. At equilibrium point; the budget line is tangent to the indifference
curve
 Slope of budget line =slope of indifference curve.

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. px Mux
 MRSx, y 
py Muy
S
Step 1 : slope of budget line= Px/Py =2/3…………….. 1
u
Step 2: MUx=  0.4.y0.6x-0.4 =0.4y0.6x-0.6………….…..2
x
U
Step: 3: MUy= = 0.6.X0.4y0.6-1 = 0.6x0.4Y-0.4 ………..3
Y
Step 4: slope of indifference curve , MRSx,y,…………
Mux 0.4 y 0.6 x 0.6
MRSx,y=  by dividing 2 by 3
Muy 0.6 x 0.4 y 0.4

2. y 0.6 y 0.4
MRSx,y = 0.4 0.6 , by takingx  down & y  up 2.
3.x x
2 y 0.6  0.4
MRSx,y=
3. x 0.4  0.6

2y
MRSx,y=
3x

px
Step 5: =MRSx,y at equilibrium point (equate 1 and 4)
py
2 2y

3 3x

 X=Y
Step 6: Form the budget constraint,

M=PxQx+PyQy
50=2x+3y ,from equation 5 , x=y

 50=2x+3x
50=5x
 x=10, and y=10
b) When income increases to 100,
The new budget constraint is
100 = PxQx+PyQy
100=2x+3y…..from equation 5,x=y
100=2x+3y
100=5x
 x=20, and y=20

Doubling of income doubles the equilibrium quantities of both x and y

Adama University, Faculty of Business and Economics, Department of Economics 158


Micro Economics I Module I

consumed

Unit III self check exercise

Part I short answer and explanation

1. An isoquant shows alternative combinations of factors of production leading to the


same output.
2. In standard case isoquants are convex to the origin due to the law of diminishing
marginal rate of technical substitution
3. In the short run it is stage II of production which is efficient region while in the long –
run efficient region of production is indicated by area between the ridge lines on
isoquants.

4. Properties of isoquants
- downward sloping showing the trade off between inputs to produce the same output.
- convex to the origioin due to the law of diminishing marginal rate of technical
substitution (MRTS)
- Isoquants never cross each other as every isoquant represents unique production
level
- upper isoquants represent higher level of output as they denote usage of more of
inputs.
5. Increasing Returns to scale (IRS) is the case where the percentage change in output
is greater than the percentage change in inputs.
- Decreasing Returns to scale (DRS) denotes that there is less than proportion
change in output for a given change inputs.
- Technical efficiency occurs when it is not possible to increase the out put with
out increasing the inputs.
- Economic efficiency occurs when a firm uses the least costly method of producing
a product.
6. Technological progress shifts the total product curve upward (outward) for a given
amount of inputs and inward an isoquant curve..
7. Production function denotes technical relationship between inputs and output.

Adama University, Faculty of Business and Economics, Department of Economics 159


Micro Economics I Module I

Part II work out

1. A, B,
2. Q=L 3/ 4 k 1/ 4

TP L3/ 4 k 1/ 4 L3/ 4 k 1/ 4 3 / 41


   L k 1/ 4
a) APL= L L L

APL =L-1/4K1/4

b) MPL= Q 3/ 4 L3/ 41k 1/ 4  3 L1/ 4 k 1/ 4


L 4
Q 1 3/ 4 1/ 41 1 3/ 4 34
MPk=  L k  L k
k 4 4

c) Since r=   P  3/ 4  1/ 4  1 , the production has constant return to scale (CRS)

Adama University, Faculty of Business and Economics, Department of Economics 160