Lecture  Notes  
in  
Intermediate  Microeconomic  Theory  I    
 
(MICREC1)  
 
 
 
 
 
Angelo  A.  Unite,  Ph.D.  
Full  Professor  
School  of  Economics  
De  La  Salle  University  
 
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I. Theory of Consumer Behavior

A. Objective

The theory of consumer behavior provides the basic model that economists use
to explain how an individual consumer chooses his consumption bundle.

Provides the theoretical foundation for the derivation of an individual

consumer’s demand functions for consumption goods.

B. Consumer Preferences

1. Utility

The overall satisfaction that the consumer derives from consuming various
quantities of commodities or goods.

Assume n different goods available for consumption in an economy.

Let the vector x = ⎡⎣ x1 , x2 ,K , xn ⎤⎦ , xi ≥ 0

be the consumer’s consumption bundle containing the n goods, where xi is the
quantity of good i.

2. Assumptions about the Consumer’s Preferences

Definitions:

If a consumer derives more utility from bundle xʹ′ than from bundle xʹ′ʹ′ , the
consumer is said to prefer x’ to x”.

Hence, if consumer were presented with the alternatives of receiving either xʹ′ or
xʹ′ʹ′ , he would choose or rather have xʹ′ than xʹ′ʹ′ .

Note: The term ‘prefer’ is void of any connotation of sensuous pleasure; i.e., it is
assumed that the overall satisfaction derived by the consumer from a
consumption bundle is a function only of the quantities of the goods in the
bundle, not from the pleasurable sensations connected with the act of consuming
the goods.
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It is assumed that consumers are RATIONAL in their choice making decisions –
i.e., in ranking alternative consumption bundles according to their preferences.

The assumption of rationality is equivalent to the following two assumptions:

A1. Completeness

For all possible pairs of alternative consumption bundles xʹ′ and xʹ′ʹ′ , the
consumer can always specify exactly one of the following possibilities:

Consumer prefers xʹ′ to xʹ′ʹ′ or

Consumer prefers xʹ′ʹ′ to xʹ′ or
Consumer is indifferent between xʹ′ and xʹ′ʹ′ .

Indifference is taken to mean that the consumer receives equal satisfaction from
the bundles to which he is indifferent to.

This assumption implies that the consumer is never paralyzed by indecision.

A2. Transitivity

If the consumer prefers xʹ′ to xʹ′ʹ′ and prefers xʹ′ʹ′ to xʹ′ʹ′ʹ′ , then he must also report
that he prefers xʹ′ to xʹ′ʹ′ʹ′ .

That is, the consumer’s preferences are internally consistent.

Notes:

The rationality assumption (assumptions A1 and A2 merely requires that the

consumer be able to rank alternative consumption bundles in order of
preferences.

In rank ordering bundles, the consumer possesses an ordinal measure of utility;

he need not be able to assign numbers that represent the degree or the amount
or intensity of satisfaction that he derives from the consumption bundle.

Additional Assumptions on Consumer Preferences:

The following assumptions are imposed to ensure that there are no problems in
arriving at the solution to the consumer’s problem when we use a mathematical
theory of choice which will be discussed later on.
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A3. Continuity

If the consumer reports that he prefers xʹ′ to xʹ′ʹ′ , then consumption bundles that
are suitably close to bundle xʹ′ must also be preferred by the consumer to bundle
xʹ′ʹ′ .

This assumption is necessary if we wish to analyze the consumer’s responses to

relatively small changes in income and prices of the goods.
This assumption also rules out certain kinds of discontinuous preferences that
pose problems for a mathematical theory of choice.

A4. Nonsatiation or Monotonicity

In the utility function, the xi’s are assumed to be “goods”. Hence, it is reasonable
to assume that the consumer always prefers more to less. That is, he will always
prefer a bundle with more of at least one good and none less of the others. This
implies that the consumer will never be completely satisfied (nonsatiated).

For example, say n = 2. If the consumer is presented the following bundles,

xʹ′ = ⎡⎣1,1⎤⎦ and xʹ′ʹ′ = ⎡⎣1, 2⎤⎦ then he will prefer x” to x’ by nonsatiation.

A5. Strict Convexity

The assumption that a consumer’s preferences are strictly convex is equivalent

to the assumption that the consumer prefers averages to extremes: that is, the
consumer prefers average consumption bundles to extreme consumption
bundles.

C. Utility Function

All information pertaining to the satisfaction that the consumer derives from
consuming various quantities of goods is contained in his utility function. This
function must also reflect that assumptions about the consumer’s preferences
discussed in Section B.

Given assumptions A1, A2 and A3, it is possible to show that people are able to
rank in order all possible consumption bundless from least desirable to most.
Economists call this ranking utility.
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The utility function, U = U ( x) , is a mathematical expression of the consumer’s

ranking of alternative consumption bundles, x, according to his preferences.

The function U ( x ) associates a specific number, U, with the corresponding

consumption bundle x. However, the number provides only a ranking or
ordering of preferences, not the intensity of satisfaction received by the
consumer from the bundle x.

If the consumer prefers x’ to x”, then U ( xʹ′ ) > U ( xʹ′ʹ′ ).

If the consumer prefers x” to x’, then U ( xʹ′ʹ′ ) > U ( xʹ′ ).
If the consumer is indifferent between x’ and x”, then U ( xʹ′ ) = U ( xʹ′ʹ′ ) .

For example, if U ( xʹ′ ) = 15 and U ( xʹ′ʹ′ ) = 45 , it means the consumer prefers

bundle x” to bundle x’. However, it is meaningless to say that the consumer likes
x” three times as strongly as x’.

For this course, we will only consider the case of n = 2. Hence, in this case,

the consumer preferences can be represented by U = U ( x1 , x2 ) for x1 ≥ 0 and

x2 ≥ 0 .

Note: x1 ≥ 0 and x2 ≥ 0 is the domain of the utility function. The economically

sensible values of quantities of the goods are zero and positive. In most cases,
however, we will assume that the domain includes only the positive quantities,
x1 > 0 and x2 > 0 .

Assumptions about the Utility Function

Below are the mathematical assumptions on the consumer’s utility function that
are equivalent to the qualitative assumptions discussed in Section B.

a. Continuous for all values x1 > 0 and x2 > 0 in the domain of the function
(assumptions A1 and A3)

The utility function is a single-valued function that always associates a specific

number for any and all possible consumption bundles.
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b. It is at least twice differentiable and has continuous first- and second-order
partial derivatives.

Like the continuity assumption, this is only a mathematical assumption

necessary for us to be able to use a mathematical optimization technique
(Lagrangian Method) to solve the consumer’s problem.

As will be shown later, there are cases when a consumer’s preferences may be
represented by discontinuous and non-twice differentiable utility functions.

For our purposes, we will use the following notations:

The first-order partial derivatives:

∂U ( x1 , x2 ) ∂U ( x1 , x2 )
≡ U1 ( x1 , x2 ) and ≡ U 2 ( x1 , x2 ) .
∂x1 ∂ x2

The second-order partial derivatives:

∂ 2U ( x1 , x2 ) ∂ 2U ( x1 , x2 ) ∂ 2U ( x1 , x2 ) ∂ 2U ( x1 , x2 )
≡ U11 , = U12 , = U 21 , ≡ U 22 .
∂x12 ∂x1∂x2 ∂x2∂x1 ∂x22

Notes:

(i) By Young’s Theorem, U12 ≡ U 21 .

(ii) Twice differentiability assumption requires that at least one of the second-

order partial derivatives is non-zero.

(iii) The second-order partial derivatives can also be viewed as the derivative

of the first-order derivative:

∂ 2U (⋅ ) ∂U1 (⋅ ) ∂ 2U (⋅ ) ∂U1 (⋅ ) ∂U 2 (⋅ ) ∂ 2U (⋅ )
= ≡ U11 , = ≡ U12 ≡ U 21 = = ,
∂x12 ∂x1 ∂x1∂x2 ∂x2 ∂x1 ∂x2∂x1

∂ 2U (⋅ ) ∂U 2 (⋅ )
= ≡ U 22
∂x22 ∂x2
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c. Positive first-order derivatives (assumption A4)

U1 = marginal utility or additional utility from additional consumption of

good 1, ceteris paribus.

U2 = marginal utility from additional consumption of good 2, ceteris paribus

By the nonsatiation assumption (A4), it must be that U1 > 0 and U2 > 0 for all
values x1 > 0 and x2 > 0 .

That is, utility is increasing in x1 and x2. The consumer assigns a higher utility
number whenever in a consumption bundle, the quantity of a good increases
while the quantity of the other good is unchanged.

d. Strictly quasiconcave function (A5)

For the utility function to be strictly quasiconcave, it must be that

2U12U1U2 − U11U22 − U22U12 > 0 for all values x1 > 0 and x2 > 0 .

Whenever the utility function is strictly quasi-concave, then preferences will be

strictly convex. This mathematical assumption will ensure that there will be a
unique optimal consumption bundle solution to the consumer’s utility
maximization problem.

Notes:

(i) In general, utility is affected not only by the quantities consumed of the
physical commodities, but also by psychological attitudes, peer group
pressures, personal experiences, and the general cultural environment.
However, economists generally devote attention only to the quantifiable
options while holding constant the other things that affect utility (ceteris
paribus assumption).

(ii) The assumptions on consumer preferences stated above are sometimes

modified to cover special cases (e.g., linear preferences and Leontief
preferences).

(iii) As mentioned earlier, the domain for the utility function is usually
nonnegative consumption bundles, where xi ≥ 0 for i = 1, 2. However, in
most examples, we will limit the domain to positive quantities, xi > 0 for
i = 1, 2.
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(iv) The consumer’s utility function above is defined with reference to
consumption during a single time period. No account is taken of the
possibility of transferring consumption expenditures from one period to
another. The case of intertemporal consumption is discussed in another
course.

(v) The consumer’s utility function is not unique. The numbers assigned by a
utility function to the alternative consumption bundles need not have
cardinal significance. They need only to serve as an index of consumer’s
ordering of overall satisfaction received from the alternative bundles.

For example, say xʹ′ = ⎡⎣1,1⎤⎦ and xʹ′ʹ′ = ⎡⎣1, 2⎤⎦ then the consumer will prefer xʹ′ʹ′ to xʹ′
by nonsatiation.

The utility function should assign numbers to these alternative bundles to reflect
the consumer’s preference in such a way that U ( xʹ′ʹ′ ) > U ( xʹ′ ) . However, the
numbers assigned to these two alternative bundles are arbitrary in the sense that
the difference between them has no meaning.

For example, since xʹ′ʹ′ is preferred to xʹ′ , the number 3 could be assigned to
bundle x’ and the number 4 to x”. However, any other set of numbers would
serve as well, as long as the number assigned to xʹ′ʹ′ exceeds that assigned to xʹ′ .
Say, the number 3 assigned for xʹ′ and 400 for xʹ′ʹ′ would provide an equally
satisfactory utility index.

In general, if a particular set of numbers associated with various consumption

bundles is a utility index, then any positive monotonic transformation of it is also
a utility index representing the same preferences [Equivalent Utility Functions].

Let U = U ( x1 , x2 ) be the original utility function representing a particular

consumer’s preferences. Then, another function V = V ( x1 , x2 ) can equivalently
represent this same consumer’s preferences as long as the function V (⋅ ) is a
positive monotonic transformation of the function U (⋅ ) since such
transformation is rank-order preserving. That is,

(
(i) V = V (U ) = V U ( x1 , x2 ) ) and
(ii) V U 1 > V U 0 whenever U 1 > U 0 , where Uj is the number assigned by the
( ) ( )
original utility function U to consumption bundle xj.
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Examples: Say, U = U ( x1 , x2 )

Linear transformation: V = aU ( x1 , x2 ) + b = aU + b where a and b are constants,

provided that a > 0 (while the sign of b is unrestricted).

2
Square transformation: V = ⎡U ( x1 , x2 ) ⎤ = U 2 , provided that the numbers
⎣ ⎦
assigned by the original utility function U are nonnegative.

Log transformation: V = ln ⎡U ( x1 , x2 ) ⎤ + b = ln (U )

⎣ ⎦

0.5
Square root transformation: V = ⎡U ( x1 , x2 ) ⎤ = U 0.5 , provided that the numbers
⎣ ⎦
assigned by the original utility function U are nonnegative.

D. Indifference Curves – Graphical Representation of Consumer’s

Preferences

Suppose U = U ( x1 , x2 ) represents a consumer’s preferences. A particular level

of utility can be derived from many possible combinations of x1 and x2.

The locus of combinations of x1 and x2 that give the same utility level to the
consumer and for which the consumer is indifferent to is known as an
Indifference Curve (IC). Hence, ICs are level sets of the utility function.

Consider the utility function U = x10.5 x20.5 for x1 > 0 and x2 > 0 , which is plotted in
FIGURE 1.

We can show that this utility function satisfies the assumptions given above.

[BOARD WORK: Show (1) twice differentiability, (2) nonsatiation, (3) strict
convexity]
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Utility Function: U = x10.5 x20.5

x2 100
80
60
40
20
0
100

HL
U x1,x2
75

50

25

0
0 20 40
60 80 100
x1

FIGURE 1

Now, suppose we want to find the combinations of x1 and x2 that give the same
utility level. These combinations can be obtained by fixing utility level in the
utility function at some constant value and “slicing” the utility function at this
constant utility level. The level sets obtained at different constant levels of utility
are given by the ICs of the utility function [See FIGURE 2]
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Indifference Curves Associated with the Utility Function U = x10.5 x20.5

x2

100

80

60

40

20

0
0 20 40 60 80 100
x1
FIGURE 2

For example, say we fix the utility level at U = 10. Then, 10 = x10.5 x20.5 . Solving for
Solving for x2, we get x2 = 100/ x1. This is the equation of the IC for U = 10.

We can thus find the alternative combinations of x1 and x2 that give the utility
level of 10 from this equation and then graph these combinations.
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U = 10
x1 x2
1 100
2 50
4 25
5 20
10 10
20 5

[BOARD WORK: Graph IC for U = 10.]

We can also obtain the ICs for other constant levels of utility using the same
procedure as above. To generalize, the equation of the IC for a given utility level
U1 is obtained by setting U = U1 in the consumer’s utility function and solving it
for x2 in terms of x1. The resultant graph obtained by plotting the combinations
of x1 and x2 that give utility level U = U1. As long as the utility function satisfies
the assumptions given above, its associated ICs will be of the following slope and
shape. [See FIGURE 3]
x2

Combinations (x11, x21) and (x12, x22)

provide the same level of utility U1

x2 1

x2 2 U1

x1
1
x1 x1 2

We see that (i) the IC is downward sloping and (ii) strictly convex.

(i) The negative slope of the IC is an implication of the assumption of non-

satiation.
 12
Proof:

Slope at any point along the IC for U = U1 (and along any IC, for that matter) is
dx2 dx
. If the IC is downward sloping, then 2 < 0 at any point along the
dx1 U =U 1 dx1 U =U 1
IC.

Now, for a movement along the IC, both x1 and x2 change while utility level is
unchanged. We can measure this mathematically by taking the total differential
of the utility function U = U ( x1 , x2 ) :

dU = U1 (⋅ ) ⋅ dx1 + U2 (⋅) ⋅ dx2

Since utility is constant at U = U1 as one moves along the IC, then dU = 0. Hence,
dx2 U (⋅ )
0 = U1 (⋅ ) ⋅ dx1 + U2 (⋅) ⋅ dx2 ⇒ =− 1 .
dx1 U =U 1 U 2 (⋅ )

Since the nonsatiation assumption requires that U1 > 0 and U2 > 0 for all values
dx
x1 > 0 and x2 > 0 , then clearly 2 < 0.
dx1 U =U 1

Marginal Rate of Substitution

The negative of the slope of the indifference curve at any point is called the
marginal rate of substitution (MRS) between the two goods.

dx2
MRS12 = −
dx1 U =U 1
 13

(ii) The strictly convex shape of the IC is an implication of the strict

convexity of preferences assumption

Proof:

When the IC is strictly convex, then it must be that d x22

2
> 0 . This
dx1 U =U 1
means that the slope of the IC increases (becomes less negative) as one moves
⎛ dx ⎞
d ⎜ 2 ⎟⎟
d 2 x2 ⎜ dx1
⎝ U =U 1 ⎠
down the IC since = > 0.
dx12 U =U 1 dx1

dx2 U (⋅ )
Now, recall that along the IC, the slope is =− 1 .
dx1 U =U 1 U 2 (⋅ )

Since both x1 and x2 change as one moves down the IC, then the change in the
slope of the slope of the IC for U = U1 can be obtained by taking the total
differential of the slope of the IC for U = U1.

⎛ dx ⎞ ⎡ U ⋅ dU − U dU ⎤
2 ⎟ = − ⎢ 2 1
d ⎜ 1 2
⎥
⎜ dx1 1
⎟ ⎢ ( U )
2
⎥⎦
⎝ U =U ⎠ ⎣ 2

But

dU1 = ⎡⎣U11dx1 + U12dx2 ⎤⎦ and dU 2 = ⎡⎣U 21dx1 + U 22dx2 ⎤⎦ , so

⎛ dx ⎞ ⎡ U ⋅ ⎡U dx + U dx ⎤ − U ⎡U dx + U dx ⎤ ⎤
d ⎜ 2 ⎟ = − ⎢ 2 ⎣ 11 1 12 2 ⎦ 1 ⎣ 21 1 22 2 ⎦
⎥ or
⎜ dx1 ⎟ ⎢ (U 2 )
2
⎥
⎝ U =U 1 ⎠ ⎣ ⎦
.

Dividing through by dx1, we get

 14

⎛ dx ⎞ ⎡ ⎡ dx ⎤ ⎡ dx ⎤ ⎤
2
d ⎜ ⎟ ⎢ U 2 ⋅ ⎢U11 + U12 2 ⎥ − U1 ⎢U 21 + U 22 2 ⎥ ⎥
⎜ dx1 ⎟ ⎢ dx1 ⎦⎥ dx1 ⎦⎥ ⎥
⎝ U =U 1 ⎠
= − ⎢ ⎣⎢ ⎣⎢
dx1 2 ⎥
⎢ (U 2 ) ⎥
⎢ ⎥
⎣ ⎦

dx2 U (⋅ )
But =− 1 .
dx1 U =U 1 U 2 (⋅ )

Hence,
⎡ ⎡ ⎛ U ⎞ ⎤ ⎡ ⎛ U ⎞ ⎤ ⎤
⎢ U 2 ⋅ ⎢U11 + U12 ⎜ − 1 ⎟ ⎥ − U1 ⎢U 21 + U 22 ⎜ − 1 ⎟ ⎥ ⎥
d 2 x2 ⎢ ⎢⎣ ⎝ U 2 ⎠ ⎥⎦ ⎢⎣ ⎝ U 2 ⎠ ⎥⎦ ⎥
= − ⎢ ⎥ or
dx12 U =U 1 ⎢ (U 2 )
2
⎥
⎢ ⎥
⎣⎢ ⎥⎦

d 2 x2 1
2
= 3 ⎡⎣ 2U12U1U2 − U11U22 − U22U12 ⎤⎦ since U12 ≡ U 21
dx1 U2

Now, by assumption of nonsatiation U2 ( g) > 0 ⇒ U 23 > 0 for all values

x1 > 0 and x2 > 0 .

By assumption of strict convexity of preferences

2U12U1U2 − U11U22 − U22U12 > 0 for all values x1 > 0 and x2 > 0 .

Therefore,
d 2 x2 1 d 2 x2
= 3 ⎡⎣ 2U12U1U 2 − U11U 22 − U 22U 22 ⎤⎦ > 0 ⇒ > 0.
2
dx1 U 2 dx12 U =U 1

d 2 x2
Now, since > 0 , then the slope of the IC increases as one moves down
dx12 U =U 1
dx2
the IC. But since MRS12 = − then
dx1 U =U 1
 15

⎛ dx2 ⎞
d ⎜ − ⎟
d 2 x2 ⎜ dx1 ⎟ d ( MRS12 ) 1 ⎡
⎝ U =U 1 ⎠ 2 2 ⎤
− 2 = = =− 3 ⎣ 2U12U1U 2 − U11U 2 − U 22U 2 ⎦ < 0
dx1 dx1 dx1 U2
U =U 1

This means that when the consumer’s preferences are strictly convex, hiss MRS
between the two goods decreases as the consumer moves down the IC. This
reflects a change in the individual’s willingness to trade x2 for x1. [See FIGURE
4]

1 1
x2 At (x1 , x2 ), the indifference curve is
steeper. Consumer would be willing to give
up more x2 to gain additional units of x1

2 2
At (x1 , x2 ), the indifference
curve is flatter. Consumer
would be willing to give up less
x2 1 y to gain additional units of x

x2 2 U1

x1
1
x1 x1 2

FIGURE 4

As the consumer moves down the IC, he acquires more of good 1 and less of
good 2 and the rate at which he is willing to give up good 2 for extra good 2
declines.

This is because the when consumer prefers average consumption bundles to

extreme consumption bundles, the increasing relative scarcity of good 2
increases its relative value to the consumer and the increasing relative
abundance of good 1 decreases its relative value.
 16
Hence, to remain indifferent the individual’s willingness to trade x2 for x1
(MRS12) decreases.

This is known as the Law of Diminishing MRS. Note that this ‘law’ is an
implication of the assumption that preferences are nonsatiated and strictly
convex. This ‘law’ does not satisfied whenever preferences do not satisfy these
two assumptions.

Indifference Curve Map

The collection of ICs corresponding to the consumer’s different levels of

satisfaction.

By the assumption of complete preferences then each feasible consumption

bundle (point) must have an indifference curve through it. [See FIGURE 5]

x2

Increasing utility

U3 U1 < U2 < U3
U2

U1
x1

FIGURE 5

By the nonsatiation assumption, consumption bundles that lie along higher ICs
give the consumer higher levels of satisfaction (utility is increasing towards the
northeasterly direction.
 17

Transitivity

By the assumption of transitivity of preferences, any two of an individual’s

indifference curves can never intersect. [See FIGURE 6]

x2

C B
U2
A
U1

x1
FIGURE 6
Proof:

The individual is indifferent between bundles A and C.

The individual is indifferent between bundles B and C.

Transitivity suggests that the individual should be indifferent between bundles A

and B.

But B is preferred to A by nonsatiation because B contains more x1 and x2 than

A.

Therefore, intersecting ICs violate the transitivity assumption.

 18
Convexity

A set of points is convex if any two points can be joined by a straight line that is
contained completely within the set. [See FIGURE 7]

x2

x2*
U1

x1
x1*

FIGURE 7

The assumption of strictly convex preferences (and therefore diminishing MRS)

is equivalent to the assumption that all combinations of x1 and x2 which are
preferred to x1* and x2* form a convex set. Such combinations lie along the
chord connecting any two points along the IC on which the bundle (to x1*, x2*)
lies.

If the indifference curve is strictly convex, then the combination

(x11 + x12)/2, (x21 + x22)/2 will be preferred to either (x11, x21) or (x12, x22).
[See FIGURE 8]
 19

x2

x2 1
(x21 + x22)/2

x2 2 U1

x1
1 1 2
x1 (x1 + x1 )/2 x1 2

FIGURE 8

This implies that “well-balanced” bundles are preferred to bundles that are
heavily weighted toward one commodity
 20
Examples of Utility Functions

• Cobb-Douglas Utility

U ( x1 , x2 ) =x1α x2β for x1 > 0, x2 > 0

where α and β are positive constants

– The relative sizes of α and β indicate the relative importance of the goods

The indifference curves will be downward sloping and strictly convex.

• Perfect Substitutes

U ( x1 , x2 ) =α x1 + β x2 for x1 ≥ 0, x2 ≥ 0

where α and β are positive constants

[See Linear Utility.pdf]

The indifference curves will be downward sloping and linear (weakly convex).

The MRS will be constant along the indifference curve.

x2

U3

1 U2
U
x1
 21

• Perfect Complements

U ( x1 , x2 ) = min {α x1 , β x2 } for x1 > 0 , x2 > 0

where α and β are positive constants

[See Leontief Utility.pdf]

The indifference curves will be L-shaped (weakly convex). Only by choosing

more of the two goods together can utility be increased.

x2

U3

U2

U1
x1

• CES Utility (Constant elasticity of substitution)

x1δ x2δ
U ( x1 , x2 ) = + when δ ≠0
δ δ

and U ( x1 , x2 ) = ln x1 + ln x2 when δ =0

– Perfect substitutes ⇒ δ = 1
– Cobb-Douglas ⇒ δ = 0
 22

– Perfect complements ⇒ δ = - ∞
– The elasticity of substitution (σ ) is equal to 1/(1 - δ )

• Perfect substitutes ⇒ σ =∞
• Fixed proportions ⇒ σ =0

Homothetic Preferences

• If the MRS depends only on the ratio of the amounts of the two goods, not
on the quantities of the goods, the utility function is homothetic

Examples:

Perfect substitutes ⇒ MRS is the same at every point

Perfect complements ⇒

MRS = ∞ if x2/x1 > α/β,

MRS = undefined if x2/x1 = α/β, and

MRS = 0 if x2/x1 < α/β

For the general Cobb-Douglas function, the MRS can be found as

α x1α −1 x2β α x2
MRS = = ⋅
β x1α x2β −1 β x1

• Some utility functions do not exhibit homothetic preferences

Example: Quasi-linear Utility

Utility = U(x1,x2) = x1 + ln x2

[See Quasi Linear Utility.pdf]

1
MRS = = x2
1
x2
 23
E. Utility Maximization and Choice

• The economic model of consumer choice assumes the rationale consumer

chooses his/her consumption bundle so as to maximize his/her utility.

Optimization Principle

• To maximize utility, given a fixed amount of income to spend, an

individual will buy the goods and services:

– that exhaust his or her total income

– for which the psychic rate of trade-off between any goods (the MRS)
is equal to the rate at which goods can be traded for one another in
the marketplace

The Budget Constraint

• Assume the individual has given m pesos to allocate between good 1 and
good 2 and buys these goods at given prices p1 and p2. Then, the consumer’s
budget constraint is

p1 x1 + p2 x2 ≤ m
Graphically,

x2 If all income is spent

on good 2, this is the amount
m
of good 2that can be purchased
p2

If all income is spent

on good 1, this is the amount
of good 1 that can be purchased

x1
m
p1
 24
The individual can afford to choose only combinations of x1 and x2 in the shaded
triangle.

The downward sloping boundary of the budget constraint is known as the

Budget Line (BL). Bundles along the BL exhaust entire income, i.e.,

p1 x1 + p2 x2 = m

For bundles below the BL, p1x1 + p2x2 < m.

p1
The slope of the BL is − . Higher BLs imply higher levels of income.
p2

First-Order Conditions (FOCs) for a Utility Maximum

• We can add the individual’s utility map to show the utility-maximization

process

x2
A

C
B
U3

U2
U1

x1

The individual can do better than bundle A by reallocating his budget

The individual cannot have point C because income is not large enough

Point B is the point of utility maximization

 25
• Utility is maximized where the indifference curve is tangent to the budget
constraint

x2 p1
slope of budget constraint = −
p2

dx2
slope of indifference curve =
dx1
B U = constant

p1
at B = MRS12
p2

x1

Second-Order Condition (SOC) for a Maximum

• The tangency rule is only necessary but not sufficient unless we assume
that MRS is diminishing at the tangency bundle

– if MRS is diminishing, then indifference curves are strictly convex

• If MRS is not diminishing, then we must check second-order conditions to

ensure that we are at a maximum. The tangency rule is only a necessary
condition. We also need MRS to be diminishing
x2
There is a tangency at point A,
but the individual can reach a higher
level of utility at point B

A
U2
U1

x1
 26
Lagrangian Method for Solving the Consumer’s Problem

- Applicable whenever the utility function is twice differentiable.

The 2-Good Case (Assume an interior solution)

• The individual’s objective is to maximize

U = U(x1,x2) for x1 > 0 and x2 > 0

subject to the budget constraint

m = p1 x1 + p2 x2 ⇒ m − p1 x1 − p2 x2 = 0

• Set up the Lagrangian Function:

max L = U(x1,x2) + λ[m − p1x1 − p2x2]

• FOCs for an interior maximum:

∂L/∂λ = m - p1x1 - p2x2 = 0

∂L/∂x1 = ∂U/∂x1 - λp1 = 0

∂L/∂x2 = ∂U/∂x2 - λp2 = 0

Implications of the FOCs

• The first FOC requires that the consumer spend his entire income on the
two goods.

• The last two FOCS require that require that

∂U / ∂x1 p1
=
∂U / ∂x2 p2

• This implies that at the optimal allocation of income

p
MRS12 = 1
p2
 27
Interpreting the Lagrangian Multiplier

∂U / ∂x1 ∂U / ∂x2 MU1 MU 2

λ= = λ= =
p1 p2 p1 p2

• λ is the marginal utility of an extra peso of consumption expenditure

(marginal utility of income)

• At the margin, the price of a good represents the consumer’s evaluation of

the utility of the last unit consumed or how much the consumer is willing
to pay for the last unit

MU i
pi =
λ

The FOCs can be solved for the optimal values of x1 and x2 (and λ ). These
optimal values will depend on the prices of all goods and income:

x1* = x1 ( p1 , p2 ,m ) and x*2 = x2 ( p1 , p2 ,m )

These utility maximizing quantities are known as the ordinary or Marshallian or

uncompensated demand functions for goods 1 and 2.

• Second-order condition requires that the ICs be strictly convex.

As long as the utility function is strictly quasiconcave, then the ICs will be
strictly convex. Therefore, SOC for a maximum utility is that
2U12U1U2 − U11U22 − U22U12 > 0 at the values x1* and x*2 .

Example 1: Cobb-Douglas Utility Function - U = x1 x2 for x1 > 0 and x2 > 0 .

(a) Find the utility maximizing values of x1 and x2 (i.e, the Marshallian demand
functions for the two goods).
(b) Show that the SOC for a maximum utility is satisfied at the values of x1 and
x2 that you found in part (a).
(c) Suppose m =100, p1 = 5 and p2 = 10, how much of each good should the
consumer purchase to maximize his utility?
(d) Graphically illustrate the situation in part (c) and show that at the optimal
values of x1 and x2 , (i) the consumer exhausts his entire income and (ii) his MRS
for the two goods equals the two good’s price ratio.
 28
Example 2 (To Do): Answer questions (a) through (d) assuming the consumer’s
utility function is U = x1 x2 + x1 + x2 for x1 > 0 and x2 > 0 .

CAUTION: The preceding FOCs and SOC are sufficient but not necessary
conditions for a unique maximum utility. Two cases when a unique maximum
exists but do not satisfy above FOCs and SOC: (1) Perfect Substitutes and (2)
Perfect Complements.

(1) Perfect Substitutes: U = x1 + x2 [Board Work]

(2) Perfect Complements: U = min{x1,4x2} [Board Work]

F. Indirect Utility Function

It is often possible to manipulate first-order conditions to solve for optimal

values of x1 and x2

Recall that the optimal values of x1 and x2 will depend on the prices of all goods
and income

x*1 = x1(p1,p2,m)
x*2 = x2(p1,p2,m)

• We can use the optimal values of the xis to find the maximum utility level
given the prices of all goods and income. This is known as the indirect
utility function

U* = U(x*1,x*2)

Substituting for each x*i, we get U* = U(x1(p1,p2,m), x2(p1,p2,m))

U* = V(p1,p2,m)

• The optimal level of utility will depend indirectly on prices and income–if
either prices or income were to change, the maximum possible utility will
change
 29
Example. Consider Example 1, we know that

m m
x1* = x2* =
2 p1 2 p2

So the indirect utility function is

⎛ m ⎞ ⎛ m ⎞
( )( )
U * = x1* x2* = ⎜ ⎟ ⎜ ⎟
⎝ 2 p1 ⎠ ⎝ 2 p2 ⎠
m2
= = V ( p1 ,p2 ,m )
4 p1 p2

Suppose initially that m =100, p1 = 5 and p2 = 10. Further assume that a per unit
tax of ₧1 was imposed on good 1. What happens to the quantity demanded of
good 1? What happens to the individual’s indirect utility? Suppose instead that
the government imposed an income tax that will raise the same total tax
revenues as the per unit tax. What happens to the individual’s indirect utility?
Which type of tax will the individual consumer prefer? Why?

To Do: Answer the questions above for U = min{x1,4x2}.

Aside: Roy’s Identity

Given the indirect utility function, we can derive the utility maximizing quantity
for each good i as the negative of the ratio of the partial derivatives of the
indirect utility function with respect to price and with respect to income.

∂V ( p1 ,p2 ,m )
∂pi
xi* = −
∂V ( p1 ,p2 ,m )
∂m

Example: Consider the indirect utility function for Example 1. Demonstrate

Roy’s Identity.

To Do: Demonstrate Roy’s Identity for U = min{x1,4x2}.

 30
G. Expenditure Minimization

• Dual minimization problem for utility maximization

– allocating income in such a way as to achieve a given level of utility

with the minimal expenditure

– this means that the goal and the constraint have been reversed

Point C is the solution to the dual

problem

Expenditure level E2 provides just enough to reach U1

x2

Expenditure level E3 will allow the

individual to reach U1 but is not the
minimal expenditure required to do
so

C
Expenditure level E1 is too small to achieve U1

x1

• The individual’s problem is to choose x1 and x2 to minimize total

expenditures,

E = p1 x1 + p2 x2

subject to the constraint

U = U(x1,x2), where U is some given target utility level.

min L = p1x1 − p2x2 + λ[ U – U(x1,x2)]

 31

• FOCs for an interior minimum:

∂L/∂λ = U – U(x1,x2) = 0

∂L/∂x1 = p1 - λ∂U/∂x1 = 0

∂L/∂x2 = p2 - λ∂U/∂x2 = 0

• The optimal amounts of x1 and x2 can be solved from the FOCs and they
will depend on the prices of the goods and the required utility level.

x1c = x1c ( p1 , p2 ,U ) and x2c = x2c ( p1 , p2 ,U )

These expenditure minimizing quantities are known as the Hicksian or

compensated demand functions for goods 1 and 2.

• The expenditure function shows the minimal expenditures necessary to

achieve a given utility level for a particular set of prices. It is obtained by
substituting the optimal values of x1 and x2 in the definition of expenditure

E ʹ′ = p1 x1c + p2 x2c = p1 ⋅ x1c ( p1 , p2 ,U ) + p2 ⋅ x2c ( p1 , p2 ,U )

E’ = E(p1,p2,U)

Notes:

• The expenditure function and the indirect utility function are inversely
related. Both depend on market prices but involve different constraints (U
for expenditure function and m for indirect utility function).

• By the duality theorem, it can be shown that whenever the target utility
level U in the expenditure minimization problem is equal to the maximum
utility U* in the utility maximization problem, then xic = x*i for i = 1,2.
Equivalently, since U = U*, then the minimum expenditure necessary to
achieve U will be such that E’ = m.
 32
• Therefore, by the duality theorem, there is no need to solve the
expenditure minimization problem to determine the expenditure function.
As long as U = U* in the expenditure minimization problem then given the
indirect utility function from the utility maximization problem, we can
interchange the role of utility and income (expenditure) and we will have
the expenditure function.

Suppose we know U* = V(p1,p2,m).

Let U = U*, then U = V(p1,p2,m).

Invert this and solve for m. In this case, m = m(p1,p2,U)

Since E’ = m whenever U = U*, then we have the expenditure function

E’ = E(p1,p2,U)

Aside: Shephard’s Lemma

Given the expenditure function, we can derive the expenditure minimizing

quantity for each good i as the partial derivative of the expenditure function
with respect to price.

∂E ( p1 ,p2 ,U )
xic =
∂pi

Example. Consider Example 1’s indirect utility function. Find the individual’s
expenditure function. Use Shephard’s Lemma to derive the individual’s
Hicksian demand functions for goods 1 and 2.

To Do: Find the individual’s expenditure function from the indirect utility
function for U = min{x1,4x2}. Use Shephard’s Lemma to derive the individual’s
Hicksian demand functions for goods 1 and 2.
 33

H. Demand Functions (Ordinary/Marshallian/Uncompensated)

Derived from the solution to the consumer’s utility maximization

problem.

x1* = x1 ( p1 , p2 ,m ) and x*2 = x2 ( p1 , p2 ,m )

A consumer’s ordinary demand function for a good gives the quantity

of a good that he will buy as a function of the good’s prices and his
income.

In these demand functions, prices and income are exogenous - the

individual has no control over these parameters.

Example: Consider the utility maximizing quantities for the uility

function in Example I - U = x1 x2 for x1 > 0 and x2 > 0 .

m m
x1* = and x*2 =
2 p1 2 p2

To Do: Find the Marshallian demand functions for the case of the CES
0.5 0.5
utility function U = x1 + x2 .

Some Properties of Marshallian Demand Functions

1. Demand for any good is a single-valued function of prices and

income.

The consumer has only one utility-maximizing consumption bundle

corresponding to a given set of prices and income. This property follows
from the strict quasiconcavity of the utility function.

2. Simultaneous Changes in All Prices and Income.

Demand functions are homogeneous of degree zero in prices and

income, i.e., if all prices and income change by the same proportion,
t > 0, the quantities demanded remain unchanged.
 34

xi ( tp1 ,tp2 ,tm ) = xi ( p1 , p2 ,m )

For example, a doubling of all prices and income would leave x1*
and x*2 unaffected.

Implications:

An individual’s demand for any good will not be affected by a ‘pure’

inflation during which all prices and income rise proportionally. The
individual will still continue to demand the same bundle of goods. If
inflation is not ‘pure’ (say, some prices rose more rapidly than others),
then this won’t be the case.

Demand functions that are not homogeneous cannot reflect utility

maximization since homogeneity of demand is a direct result of the
utility maximization assertion.

Consider Example 1. Demonstrate homogeneity property

` [Board Work]

3. Changes in Income, ceteris paribus.

• An increase in income will cause the budget constraint to shift out

in a parallel fashion

• Since p1/p2 does not change, the MRS will stay constant at
the new consumer’s utility-maximizing choices
 35

Discrete Increase in Nominal Income

• If both x1 and x2 increase as income rises, goods 1 and 2 are

normal goods
x2

C
B

A U3
1
U2
U
x1
As income rises, the individual chooses to consume more goods 1 and 2.

• If x1decreases as income rises, good 1 is an inferior good

x2

B U3

U
2
A
U1
x1

As income rises, the individual chooses to consume less good 1 and more
good 2.
 36

Infinitesimally Small Change in Nominal Income

• A good i for which ∂xi*/∂m ≥ 0 over some range of income is a

normal good in that income range

• A good i for which ∂xi*/∂m < 0 over some range of income is an

inferior good in that income range

4. Changes in a Good’s Own-Price, ceteris paribus

• A change in the price of a good alters the slope of the budget

constraint

– it also changes the MRS at the new consumer’s utility-

maximizing choices

• When the price changes, two effects come into play

– substitution effect (SE)

– income effect (IE)

• SE: Even if the individual remained on the same indifference

curve when the price changes, his optimal choice will change
because the MRS must equal the new price ratio. As long as the
individual is nonsatiated (have downward sloping ICs), a decrease
(increase) will always cause the individual to consume more (less)
of a good.

• IE: The price change alters the individual’s “real” income and
therefore he must move to a new indifference curve. This causes a
further change in the amount consumed of the good whose price
has changed.
 37

Suppose the consumer is maximizing utility at point A. If the price of

good 1 falls, the consumer will maximize utility at point B. The total
effect (TE) of the decrease in the price of good 1 is an increase is the
movement from point A to point B.

x2

A
U2

U1

X1
Total increase in x1

To isolate the substitution effect, we hold “real” income constant but

allow the relative price of good 1 to change. Real income is kept
constant by ‘compensating’ the individual after the decrease in the price
of good 1, just enough for him to stay in the original utility level after
the price change. For a price decrease, the ‘compensation’is negative – it
involves taking away income from the individual. For a price increase,
the ‘compensation’ is positive.
 38

The substitution effect is the movement from point A to point C

The individual substitutes good 1 for good 2 because it is now

relatively cheaper

x2

•
A C

U1

x1

Substitution effect
 39

The income effect occurs because the individual’s “real” income

changes when the price of good 1 changes

The income effect is the movement from point C to point B

If good 1 is a NORMAL good, the individual will buy more

because “real” income increased

x2

B
•
A C
•
U2

U1

x1

Income
effect
 40

An increase in the price of good 1 means that the budget constraint gets
steeper

The substitution effect is the movement from point A to point C

The income effect is the movement from point C to point B

x2

• A
•
B
U1

U
2

x1
Substitution effect

Income effect

Price Changes for Normal Goods

• If a good is normal, substitution and income effects reinforce one

another
– when price falls, both effects lead to a rise in quantity
demanded
– when price rises, both effects lead to a drop in quantity
demanded
 41

Price Changes for Inferior Goods

• If a good is inferior, substitution and income effects move in

opposite directions

• The total effect is indeterminate

– when price rises, the substitution effect leads to a drop in

quantity demanded, but the income effect is opposite

– when price falls, the substitution effect leads to a rise in

quantity demanded, but the income effect is opposite

Giffen’s Paradox

• If the income effect of a price change is strong enough, there could

be a positive relationship between price and quantity demanded

– an increase in price leads to a drop in real income

– since the good is inferior, a drop in income causes quantity

demanded to rise

The Individual’s (Marshallian/Uncompensated) Demand Curve

• An individual’s Marshallian or uncompensated demand for good

1 depends on preferences, all prices, and income:

x1* = x1(p1,p2,m)

• It may be convenient to graph the individual’s demand for good 1

assuming that income (m) and the price of good 2 (p2) are held
constant. This graph is known as the individual’s demand curve
for good 1.
 42

• An individual’s Marshallian or uncompensated demand curve shows the relationship between the
price of a good and the quantity of that good purchased by an individual assuming that all other
determinants of demand are held constant

x2 As the price p1
of good 1 falls...

…quantity of good 1
demanded rises.

p1 ’

p1’’

p1’’’

U3
1 U 2 x1 *
U

x1 ’ x1 ” x1’’’ x1 x1 ’ x1 ” x1’’’ x1

m = p1x1’ + p2x2 m = p1x1’’ + m = p1x1’’’ + p2x2

p2x2
 43

The Marshallian or uncompensated demand curve for each good is

obtained from the good’s demand function by holding all other
variables constant except the good’s own price , i.e., x1* = x1(p1).

Consider Example 1. Derive the equation of the demand curve for

each good and plot this curve. [Board Work]

Shifts in the Marshallian or Uncompensated Demand Curve

• Three factors are held constant when a demand curve is derived

– income (m)
– prices of other goods (p2)
– the individual’s preferences

• If any of these factors change, the demand curve will shift to a

new position

• A movement along a given demand curve is caused by a change in

the price of the good – a change in quantity demanded

• A shift in the demand curve is caused by changes in income,

prices of other goods, or preferences – a change in demand

I. Hicksian or Compensated Demand Functions and Curves

• An individual’s Hicksian or compensated demand for good 1

depends on preferences, all prices, and utility level:
c c
x1 = x1 (p1,p2,U)
 44

• Actual level of utility varies along the Marshallian demand curve

• As the price of good 1 falls, the individual moves to higher

indifference curves

– it is assumed that nominal income is held constant as the

demand curve is derived

– this means that “real” income rises as the price of good 1

falls

• An alternative approach holds real income (or utility) constant

while examining reactions to changes in p1

– the effects of the price change are “compensated” so as to

constrain the individual to remain on the same indifference
curve

– reactions to price changes include only substitution effects

• MATHEMATICALLY, a compensated (Hicksian) demand curve

shows the relationship between the price of a good and the
quantity purchased assuming that other prices and utility are held
c c
constant, i.e., x1 = x1 (p1)
 45

Compensated Demand Curves

Holding utility constant, as price falls...

x2
p1
p1'
slope = − …quantity demanded
p2
rises.

p1 '' p1 ’
slope = −
p2

p1’’
p1 '''
slope = − p1’’’
p2

x1 c
U2

x1’ x’’ x’’’ x1 x1 ’ x’’ x’’’ x1

 46
Compensated & Uncompensated Demand

p1
At p1’’, the curves intersect because
the individual’s income is just sufficient to
attain utility level U2

p1’’
*
x1

c
x1

x1’’ x1

At prices above p1”, income compensation

p1
is positive because the individual needs
some help to remain on U2

p1 ’

p1’’

x1 *

x1 C

x1 ’ x1 * x1
 47

p1

At prices below p1’’, income compensation

is negative to prevent an increase in utility
from a lower price

p1’’
p1’’’ x1 *

x1 c

x1** x1’’ x1
* ’

• For a normal good, the compensated demand curve is less responsive to

price changes than is the uncompensated demand curve

– the uncompensated demand curve reflects both income and

substitution effects

– the compensated demand curve reflects only substitution effects

A Mathematical Examination of a Change in Own-Price

• Our goal is to examine how the (Marshallian) quantity demanded for good 1
changes when p1 changes, ceteris paribus

∂x1*/∂p1

• Remember the expenditure function

E’ = E(p1,p2,U)
 48
• Then, by definition
c
x1 (p1,p2,U) = x1[p1,p2,E(p1,p2,U)]

– quantity demanded is equal for both Hicksian and Marshallian

demand functions when income is exactly what is needed to attain
the required utility level

• We can differentiate the compensated demand function and get

∂x1* ∂x1c ∂x1* ∂E
= − ⋅
∂p1 ∂p1 ∂E ∂p1

The first term is the slope of the compensated demand curve

– the mathematical representation of the substitution effect

The second term measures the way in which changes in p1 affect the
demand for 1 through changes in purchasing power

– the mathematical representation of the income effect

The Slutsky Equation

• The substitution effect can be written as

∂x1c ∂x1*
substitution effect = =
∂p1 ∂p1
U = constant

• The income effect can be written as

∂x1* ∂E ∂x* ∂E ∂x*

income effect = − ⋅ = − 1⋅ = − 1 ⋅ x1*
∂E ∂p1 ∂m ∂p1 ∂m

* Note that by Shephard’s Lemma ∂E/∂p1 = x1*

• Therefore, the utility-maximization hypothesis shows that the

substitution and income effects arising from a price change can be
represented by
 49

∂x1*
= substitution effect + income effect
∂p1
∂x1* ∂x1* ∂x1*
= − x1*
∂p1 ∂p1 ∂m
U = constant

• The first term is the substitution effect

– always negative as long as MRS is diminishing (strictly convex

preferences)

– the slope of the compensated demand curve must be negative

• The second term is the income effect

– if good 1 is a normal good, then ∂x1*/∂m > 0

• the entire income effect is negative

– if x is an inferior good, then ∂x1*/∂m < 0

• the entire income effect is positive

Note: We can calculate the substitution effect from the Marshallian demand
function for good 1 as follows:

∂x1c ∂x1* ∂x1* ∂m

= + ⋅
∂p1 ∂p1 ∂m ∂p1

Example: Consider Example 1. The Marshallian (uncompensated) demand

function for good 1 was
0.5m
x1 ( p1 , p2 , m ) =
p1
The Hicksian (compensated) demand function for good 1 was
c Up20.5
x1 ( p1 , p2 ,U ) = 0.5
p1

Find the total effect of an infinitesimally small own-price change on the demand
for 1. Decompose the total effect into the substitution effect and income effect.
 50
J. Marshallian Demand Elasticities

• Most of the commonly used demand elasticities are derived from the
Marshallian demand function x1(p1,p2,m)

• Price elasticity of demand (ex1,p1)

Δx1* / x1* ∂x1* p1

e x1 , p1 = = ⋅
Δp1 / p1 ∂p1 x1*

• Income elasticity of demand (ex1,m)

Δx1* / x1* ∂x1* m

e x1 ,m = = ⋅
Δm / m ∂m x1*

• Cross-price elasticity of demand (ex1,p2)

Δx1* / x1* ∂x1* p2

e x1 , p2 = = ⋅
Δp2 / p2 ∂p2 x1*

Own-Price Elasticity of Demand

• Own-price elasticity of demand is always negative

– the only exception is Giffen’s paradox

• The size of the elasticity is important

– if ex1,p1 < − 1, demand is elastic

– if ex1,p1 > − 1, demand is inelastic

– if ex1,p1 = − 1, demand is unit elastic

 51
Own-Price Elasticity and Total Spending

• Total (utility-maximizing) spending on good 1 is equal to p1x1*

• Using elasticity, we can determine how total spending changes when the
price of good 1 changes

∂ ( p1 x1* ) ∂x1*
= p1 ⋅ + x1* = x1* [e x1 , p1 + 1]
∂p1 ∂p1

• The sign of this derivative depends on whether ex1,p1 is greater or less

than – 1

if ex1,p1 > − 1, demand is inelastic and price and total spending

move in the same direction

if ex1,p1 < − 1, demand is elastic and price and total spending move
in opposite directions
 52
Income Elasticity of Demand (ex1,m)

ex1 ,m ≥ 0 ⇒ good 1 is normal

ex1 ,m < 0 ⇒ good 1 is inferior

If good 1 is normal, then if

ex1 ,m > 1 ⇒ good 1 is a luxury

ex1 ,m ≤ 1 ⇒ good 1 is a necessity

Cross-price Elasticity of Demand (ex1,p2)

ex1 , p > 0
2
⇒ good 1 is a gross substitute for good 2
ex1 , p < 0
2
⇒ good 1 is a gross complement for good 2

Slutsky Equation for Cross-Price Change

∂x1* ∂x1c ∂x * ∂x1c ∂x1* ∂x*

= − x2* 1 ⇒ = + x2* 1
∂p2 ∂p2 ∂m ∂p2 ∂p2 ∂m

K. Compensated Price Elasticities

• It is also useful to define elasticities based on the compensated demand

function
c c
• If the compensated demand function for good i is xi = xi (p1,p2,U)
we can calculate

– compensated own price elasticity of demand, ecx ,p

i i

– compensated cross-price elasticity of demand, e cx ,p for i ≠  j

i j
 53
Consider good 1

• The compensated own price elasticity of demand is

Δx1c / x1c ∂x1c p1

e cx1 , p1 = = ⋅
Δp1 / p1 ∂p1 x1c

• The compensated cross-price elasticity of demand is

Δx1c / x1c ∂x1c p2

e cx1 , p2 = = ⋅
Δp2 / p2 ∂p2 x1c

If ex1 , p > 0
2
⇒ good 1 is a net substitute for good 2
If ex1 , p < 0
2
⇒ good 1 is a net complement for good 2

• The relationship between Marshallian and compensated price elasticities

can be shown using the Slutsky equation.

For own-price change, multiply both sides of the Slutsky equation by

p1/ x1* and m/m, and note that x1*= x1c when E’ = m, then
p1 ∂x1* p1 ∂x1c p1 * ∂x1* m
⋅ = ⋅ − ⋅x ⋅ ⋅
x1* ∂p1 x1c ∂p1 x1* 1 ∂m m

If s1 = p1x1*/m, then

e x1 , p1 = e cx1 , p1 − s1e x1 ,m ⇒ e xc1 , p1 =e x1 , p1 +s1e x1 ,m

For cross-price change, multiply both sides of the Slutsky equation by

p2/x1* and m/m, and note that x1*= x1c when E’ = m, then

p2 ∂x1* p2 ∂x1c p2 * ∂x1* m

⋅ = ⋅ − ⋅x ⋅ ⋅ .
x1* ∂p2 x1c ∂p2 x1* 2 ∂m m

If s2 = p2x2*/m, then

e x1 , p2 = e cx1 , p2 − s2 e x1 ,m ⇒ e xc1 , p2 = e x1 , p2 +s2 e x1 ,m

 54
L. Elasticity-based Properties of Marshallian Demand Functions

Homogeneity

• Demand functions are homogeneous of degree zero in all prices and

income

• Euler’s theorem for homogenous functions shows that

∂x1* ∂x1* ∂x1*
0 = p1 ⋅ + p2 ⋅ + m⋅
∂p1 ∂p2 ∂m

• Dividing by x1*, we get

0 = ex1 , p1 + ex1 , p2 + ex1 ,m

• Any proportional change in all prices and income will leave the quantity of
good 1 demanded unchanged

Engel Aggregation

• Engel’s law suggests that the income elasticity of demand for food items is
less than one

– this implies that the income elasticity of demand for all nonfood
items must be greater than one

• We can see this by differentiating the budget constraint with respect to

income (treating prices as constant)

∂x1* ∂x2*
1 = p1 ⋅ + p2 ⋅
∂m ∂m
* *
∂x1 x1 ⋅ m ∂x2* x2* ⋅ m
1 = p1 ⋅ ⋅ + p2 ⋅ ⋅ =se +s e
∂m x1* ⋅ m ∂m x2* ⋅ m 1 x1 ,m 2 x2 ,m
 55
Cournot Aggregation

• The size of the cross-price effect of a change in the price of good 1 on the
quantity of good 2 consumed is restricted because of the budget constraint

• We can demonstrate this by differentiating the budget constraint with

respect to p1

∂x1* ∂x *
0 = p1 ⋅ + x1* + p2 ⋅ 2
∂p1 ∂p1

∂x1* p1 x1* * p1 ∂x2* p1 x2*

0 = p1 ⋅ ⋅ ⋅ + x1 ⋅ + p2 ⋅ ⋅ ⋅
∂p1 m x1* m ∂p1 m x2*

0 = s1e x1 , p1 + s1 + s2 e x2 , p1

s1e x1 , p1 + s2 e x2 , p1 = − s1

Example:

Consider Example 1. The demand functions for good 1 and good 2 are

0.5m 0.5m
x1* = x*2 =
p1 p2

Calculate:
(1) the elasticities of the Marshallian demand function for good 1.

(2) Demonstrate (a) homogeneity in terms of the Marshallian demand

elasticities, (b) Engel aggregation, and (c) Cournot aggregation.

(3) Calculate the elasticities of the Hicksian demand function for good 1.

To Do: Answer questions above for the utility function U = x10.5 + x20.5.
 56
M. Measurement of Welfare Change and Consumer Surplus

• An important problem in welfare economics is to devise a monetary

measure of the gains and losses that individuals experience when prices
change

• ( ) ( )
Say, two budgets p10 , p20 ,m 0 and p11 , p20 ,m 0 which measure prices and
income a consumer would face under two differential prices for good 1.

One could think of the change in utility as

( ) (
ΔU = V p11 , p20 ,m 0 − V p10 , p20 ,m 0 . )
If ΔU > 0 ⇒ the price change is utility increasing.

If ΔU < 0 ⇒ the price change is utility decreasing.

However utility is ordinal and thus we need some monetary measure of

welfare changes.

1. Compensating Variation (CV)

• One way to evaluate the welfare cost of a price increase for good 1 (from
0 1
p1 to p1 ) would be to compare the expenditures required to achieve the
0
original utility level U under these two situations
0 0 0 0 0
expenditure at p1 : E = E(p1 , p2 , U )

1 1 1 0 0
expenditure at p1 : E = E(px , p2 U )

In the case of a price increase, the individual experiences a welfare loss since the
minimum expenditure to maintain his original utility is now higher, i.e., E1 > E0.

• In order to compensate for the price rise, this person would require a
compensating variation (CV) of
1 0 0 0 0 0
CV = E(p1 , p2 , U ) - E(p1 , p2 , U )

For a price decrease, the individual experiences a welfare gain as E1 < E0.
 57
Suppose the consumer is maximizing utility at point A. If the price of good 1
rises, the consumer will maximize utility at point B. The consumer’s utility falls
x2 from U0 to U1.

B
U0

U1

x1
The consumer could be compensated so that he can afford to remain on U0.
x2 CV is the amount that the individual would need to be compensated

B
U0

U1

x1
 58
• Another way to look at this issue is to ask how much the person would be
willing to pay for the right to consume all of this good that he wanted at
0
the market price of p1 rather than forced to do without the good.

• The area below the compensated demand curve and above the market
price is called the Hicksian consumer surplus, which is a measure of
consumer welfare.

– the extra benefit the person receives by being able to make market
transactions at the prevailing market price

[Board Work: Graph of Hicksian Consumer Surplus]

Now, consider an ‘infinitesimally small’ change in the price of good 1, ceteris

paribus.

• Recall that by Shephard’s Lemma, the derivative of the expenditure

function with respect to p1 is the compensated demand function for good 1
∂E ( p1 , p2 , U 0 )
= x1c ( p1 , p2 ,U 0 )
∂p1

• The amount of CV required can be found by integrating across a sequence

0 1
of small increments to the price of good 1 from p1 to p1

– this integral is the area to the left of the compensated demand curve
0 1
between p1 to p1

p11 p11
c 0
CV = ∫ dE = ∫ x1 ( p1 , p2 ,U )dp1
p10 p10

This area is known as the change in the Hicksian Consumer Surplus and
measures the loss in consumer welfare as a result of the increase in the
price of good 1.
1 0
That is, is the consumer’s loss in welfare is the area p1 CAp1 [using
c
x1 (p1,p2,U0)].
 59

p1

p1 1 C
A
p1 0
x1(p1,p2,m)

x1c(p1,p2,U0)

x1c(p1,p2,U1)

x1 1 x1 0 x1

NOTE:

Because a price change generally involves both income and substitution

effects, it is unclear which compensated demand curve should be used.

• Do we use the compensated demand curve for the original target utility
(U0) or the new level of utility after the price change (U1)?

2. Equivalent Variation (EV)

EV is the change in income, at initial prices, that would take the individual to the
utility level U1 they would have had if he/she accepted the price change.

( ) (
EV = E p11 , p20 ,U 1 − E p10 , p20 ,U 1 )
Alternatively, EV is the change in income an individual would require in lieu of
a price change (i.e., to ‘bribe’ consumer not to take the price change).
 60
Note that for EV, compensation takes place before the price change occurs so the
target utility is U1. For CV, compensation takes place after the price change has
occurred so the target utility if U0.

Alternatively, we can view EV as the decrease in Hicksian Consumer Surplus

c
using the compensated demand curve x1 (p1,p2,U1). Suppose the price of good 1
increases from p10 to p11 .

p11 p11
c 1
EV = Δ ∫ dE = ∫ x1 ( p1 , p2 ,U )dp1
p10 p10

1 0
That is, is the consumer’s loss in welfare is the area p1 BDp1 [using
c
x1 (p1,p2,U1)].

p1

B
p1 1

p1 0
D x1(p1,p2,m)

x1c(p1,p2,U0)

x1c(p1,p2,U1)

x1 1 x1 0 x1
 61

3. Change in Marshallian Consumer Surplus (ΔMCS)

1 0
Is the consumer’s loss in welfare best described by area p1 CAp1 [using
c 1 0 c
x1 (p1,p2,U0)] or by area p1 BDp1 [using x1 (p1,p2,U1)]?

In most actual situations, the price increase in good 1 will result in both SE and
IE and a loss in utility from U0 to U1 (a movement along the Marshallian
demand curve).

We can use the Marshallian demand curve as a compromise. We will define the
Marshallian consumer surplus as the area below the Marshallian demand curve
and above the prevailing market price.

– shows what an individual would pay for the right to make voluntary
transactions at this price rather than being forced to do without the
good

– changes in Marshallian consumer surplus measure the welfare

effects of price changes
1 0
The area p1 BAp1 falls between the sizes of the welfare losses defined by the
c c
Hicksian demand curves x1 (p1,p2,U0) and x1 (p1,p2,U1). For a price increase, this
p11
is given by Δ MCS = ∫ x1( p1 , p20 ,m 0 )dp1 .
p10
 62

p1

B C
p1 1
A
p1 0
D
x1(p1,p2,m)
x1c(p1,p2,U0)

x1c(p1,p2,U1)

x1 1 x1 0 x1
Notes:

(i) CV, EV and ΔMCS > (<) 0 for p i0 < (>) p i1 ⇒ the consumer requires
additional (is giving up) income to stay in the same utility.

(ii) CV, EV and ΔMCS > (<) ⇒ welfare loss (gain).

(iii) If several goods’ price change simultaneously, the computations can be

messy.

It can be shown that for:

⎛ ∂x* ⎞
(i) Normal goods ⎜ i > 0 ⎟ ⇒ CV > ΔMCS > EV
⎜ ∂m ⎟
⎝ ⎠
⎛ ∂x* ⎞
(ii) No income effect ⎜ i = 0 ⎟ ⇒ CV = ΔMCS = EV
⎜ ∂m ⎟
⎝ ⎠
 63

⎛ ∂x* ⎞
i
(iii) Inferior goods ⎜ < 0 ⎟ ⇒ CV < ΔMCS < EV
⎜ ∂m ⎟
⎝ ⎠
The magnitudes or size of CV and EV may differ because the value of the peso
income compensation will depend on what the relevant prices are (i.e.,
compensate at prices before the price change or compensate at prices after the
new or proposed price change). However, their signs will always be the same.

Example:
m
Consider Example 1, x1* = . Suppose initially that m =100, p1 = 5 and p2 = 10.
2 p1
Calcualte CV, EV and ΔMCS when the price of good 1 increases from ₧5 to ₧8.
 1

Theory of Consumer Behavior Examples Part 1

Utility Functions and Preferences: An individual’s preferences are represented by the

utility function U = x1 x2 for x1 > 0 and x2 > 0 , where x1 and x2 are the quantities
consumed of good 1 and good 2, respectively. For the following questions, assume that x1 is
plotted on the x-axis and x 2 on the y-axis.

1. Find this individual’s marginal utility function for each good and show that you are
nonsatiated.

Nonsation requires that the individual’s marginal utility of each good i be positive, i.e.,
∂U
Ui = > 0 for all x1 > 0 and x2 > 0 .
∂xi

Now U 1 = x2 > 0 and U 2 = x1 > 0 for all x1 > 0 and x2 > 0 , which implies that I am
nonsatiated.

2. Does this individual’s preferences obey the law of diminishing marginal utility for
each good?

∂ 2U
Diminishing marginal utility for each good i requires that U ii = < 0 for all x1 > 0 and
∂xi2
x2 > 0 .
Now U 11 = 0 and U 22 = 0 for all x1 > 0 and x2 > 0 , which implies that the individual’s
marginal utility remains unchanged as he consumes more of each good. Thus, the
individual’s utility function does not obey the law of diminishing marginal utility.

3. Derive this individual’s marginal rate of substitution between goods 1 and 2, MRS12
. Show that this individual’s utility function satisfies the law of diminishing marginal
rate of substitution.

U1
By definition, MRS12 =
U2
From part 1, we got U 1 = x2 and U 2 = x1 .
x2
⇒ MRS12 =
x1

dMRS12
Now, diminishing marginal rate of substitution requires that < 0 for all x1 > 0
dx1 dU =0

and x2 > 0 .
 2

From the lecture notes, the behaviour of MRS12 as x1 is increased (and x2 reduced) while
keeping utility level constant is given by the following derivative:

dMRS12 1
=− ⎡ 2U U U − U 22U 11 − U 12U 22 ⎤⎦
dx1 dU =0
U 23 ⎣ 1 2 12

From part 1, we got U 1 = x2 and U 2 = x1 .

From part 2, we got U 11 = 0 and U 22 = 0 . In addition, U 12 = U 21 = 1

Therefore,
dMRS12
=−
1
( ) ( )
⎡ 2 ( x2 ) ( x1 ) (1 ) − x12 ( 0 ) − x22 ( 0 ) ⎤
⎣ ⎦
(x )
3
dx1 dU =0 1

dMRS12 2x2
⇒ =− <0 for all x1 > 0 and x2 > 0 ,
dx1 dU =0
x12

which implies that this ndividual’s utility function satisfies the law of diminishing marginal
rate of substitution.

( ) ( )
Note 1: ⎡⎣ 2U 1U 2U 12 − U 22U 11 − U 12U 22 ⎤⎦ = ⎡⎣ 2 ( x2 ) ( x1 ) (1 ) − x12 ( 0 ) − x22 ( 0 ) ⎤⎦ = 2x1 x2 > 0
for all x1 > 0 and x2 > 0 . This implies that the individual’s utility function is strictly
dMRS12
quasiconcave. This shape of his utility function drives the negative sign of .
dx1 dU =0
Therefore, we have just demonstrated that when an individual’s utility function is strictly
quasiconcave, his preferences will obey the law of diminishing marginal rate of
substitution.

Note 2: Based on the results in parts 2 and 3, we see that diminishing marginal rate of
substitution between two goods does not require diminishing marginal utility for each
good.

4. Is the individual’s preferences homothetic? Why or why not?

Preferences are homothetic if my MRS12 independent of the levels of x1 and x2. At most, it
x
depends only on the ratio 2 but not the levels of x1 and/or x 2 .
x1
x2 x
Clearly, MRS12 = implies that this individual’s MRS12 is simply the the ratio 2 and
x1 x1
x
therefore implies that MRS12 simply depends on the ratio 2 and not the level of x1 or x 2 ,
x1
not the level of x1 or x 2 . Hence, this individual’s preferences are homothetic.
 3

5. Find and describe this individual’s elasticity of substitution.

⎛x ⎞
d⎜ 2⎟
⎝ x1 ⎠ MRS12
By definition, the elasticity of substitution is given by σ = ⋅ .
dMRS12 x2
x1
x2 x2
Since MRS12 = ⇒ = MRS12 .
x1 x1
⎛x ⎞ x2
d⎜ 2⎟
⎝ x1 ⎠ x
then, = 1 and that σ = 1 ⋅ 1 ⇒ σ = 1 which is a constant and independent of the
dMRS12 x2
x1
level of x1 and/or x 2 .

Utility Functions and Indifference Curves. Consider the above individual whose preferences
are represented by the utility function U = x1 x2 for x1 > 0 and x2 > 0 .

1. Show that the nonsatiated individual’s typical indifference curve is downward

sloping.

dx2 U
For an indifference curve to be downward sloping, need to show that = − 1 <0
∂x1 dU =0 U2
for all x1 > 0 and x2 > 0 .

dx2 x
Now, = − 2 < 0 for all x1 > 0 and x2 > 0 , which implies that the individual’s
∂x1 dU =0 x1
typical indifference curve is downward sloping.

Note: We just demonstrated that nonsatiated individuals have downward sloping

indifference curves.

2. Show that the individual’s typical indifference curve is strictly convex (he prefers
average consumption bundles to extreme consumption bundles).

d 2 x2
For his typical indifference curve to be strictly convex, we need to show that >0
dx12 dU=0

for all x1 > 0 and x2 > 0 .

From the lecture notes, we have that

d 2 x2 1 dMRS12
2
= 3 ⎡⎣ 2U1U2U12 − U22U11 − U12U22 ⎤⎦ = −
dx1 dU=0 U2 dx1 dU=0
 4

Since we showed in part 3 of the first section on utility function and preferences that
dMRS12 2x
= − 22 < 0
dx1 dU =0 x1

d 2 x2 ⎡ 2x ⎤ 2x
then = − ⎢ − 22 ⎥ = 22 > 0 for all x1 > 0 and x2 > 0 .
dx12 dU=0 ⎣ x1 ⎦ x1

Thus, this individual’s typical indifference curve is strictly convex.

d 2 x2 dMRS12
Note: Since =− , we have just demonstrated that an individual with
dx12 dU=0
dx1 dU=0
strictly convex indifference curves obey the law of diminishing marginal rate of
substitution between two goods.
 Theory of Consumer Behavior Examples Part 2

Marshallian Demand Functions

Consider Example 1: U = x1 x2 for x1 > 0 , x2 > 0 .

(a) Find the utility maximizing values of x1 and x2 (i.e, the Marshallian
demand functions for the two goods).

Since the utility function is twice differentiable in x1 and x2 , we can use the
mathematical approach to find the utility maximizing x1 and x2 . According
to this approach the utility maximizing x1 and x2 satisfy two FOCs for a
p
maximum: (i) MRS12 = 1 and (ii) p1 x1 + p2 x2 = m ,
p2
∂U / ∂x1
where MRS12 ≡ .
∂U / ∂x 2

∂U / ∂x1 x2
Since MRS12 ≡ = then FOC (i) can be written as
∂U / ∂x2 x1
x2 p1 p
= ⇒ x2 = 1 x1 .
x1 p2 p2

Substituting this in FOC (ii) gives

⎛ p ⎞ m
m = p1 x1 + p2 ⎜ 1 x1 ⎟ ⇒ m = 2 p1 x1 ⇒ x1* =
⎝ p2 ⎠ 2 p1
p1 * p1 ⎛ m ⎞ m
and x2* = x = ⎜ ⎟ ⇒ x2* =
p2 1 p2 ⎜⎝ 2 p1 ⎟⎠ 2 p2

Note: since m, p1, p2 > 0, then x1* , x2* > 0

(b) Show that the SOC for a maximum utility is satisfied at the values of x1
and x2 that you found in part (a).
Need to show that the utility function is strictly quasiconcave, i.e.,
2U1U2U12 − U11U22 − U22U12 > 0 at the values x1* and x*2 .
( ) ( )
Now, 2 (1) ( x2 ) x1 − 0 x12 − 0 x22 = 2x1 x2 > 0 at x1* and x*2 since x1* , x2* > 0 .
Thus, the utility function is strictly quasiconcave.

1
(c) Suppose m =100, p1 = 5 and p2 = 10, how much of each good should the
consumer purchase to maximize his utility?

100 100
x1* = = 10 x2* = =5
2 ( 5) 2 (10 )

(d) Graphically illustrate the situation in part (c) and show that at the optimal
values of x1 and x2 , (i) the consumer exhausts his entire income and (ii) his
MRS for the two goods equals the two good’s price ratio.

Graph

Notes: At the utility maximizing consumption bundle:

∂U / ∂x1 x2 5 p1 5
MRS12 = = = = 0.5 and = = 0.5 thus MRS for the
∂U / ∂x2 x1 10 p2 10
two goods equals the two good’s price ratio and

100 = 5(10) + 10(5) = 100 thus the entire income is consumed.

CAUTION:

(1) Perfect Substitutes Ex. U = x1 +x2 for x1 ≥ 0 and x2 ≥ 0

p U 1
Slope of BL is − 1 . Slope of given IC is − 1 = − = − 1
p2 U2 1
Note that both BL and the ICs are straight lines since their slopes are
constant.

p1
Case (a): p1 < p2 ⇒ − > −1 ⇒ BL flatter than the ICs
p2

Graph:

m
In this case, the Marshallian demand functions are x1* = and x2* = 0 .
p1

2
 p1
Case (b): p1 > p2 ⇒ − < −1 ⇒ BL steeper than the ICs
p2

Graph:

m
In this case, the Marshallian demand functions are x1* = 0 and x2* = .
p2

p1
Case (c): p1 = p2 ⇒ − = −1 ⇒ BL has same slope as the ICs.
p2

Graph:

In this case, one IC will coincide with the BL and the optimal quantities
demanded are any x1 and x2 such that m = p1x1 + p2x2.

(2) Perfect Complements: Ex. U ( x1 , x2 ) =min { x1 , 4 x2 } for x1 > 0 and x2 > 0

Since the utility function is not differentiable, the mathematical approach

cannot be used. Instead, the two conditions that must be satisfied by the utility
maximizing consumption bundle x1 and x2 are:

(i) the optimal quantities demanded will be at the vertex of an IC where

α x1 = β x2 and
(ii) the optimal quantities must also lie along the consumer’s budget line
where m = p1x1 + p2x2

Now, the two conditions can be written as

(i) (i) x1 = 4 x2 and (ii) m = p1x1 + p2x2

Solving the two conditions for the unknowns,

m
m = p1 ( 4 x2 ) + p2 x2 ⇒ m = ( 4 p1 + p2 ) x2 ⇒ x*2 =
( 4 p1 + p2 )
⎛ m ⎞ m
x1* = 4x*2 = 4 ⎜ ⎟ ⇒ x1* =
⎜⎝ ( 4 p1 + p2 ) ⎟⎠ ( p1 + 0.25 p2 )

3
Indirect Utility Function

m2
Consider Example 1 where V ( p1 ,p2 ,m ) = . Suppose initially that
4 p1 p2
m =100, p1 = 5 and p2 = 10. Further assume that a per unit tax of ₧1 was
imposed on good 1.

(a) What happens to the quantity demanded of good 1?

100
With the per unit tax t = 1, then new p1 = 5 + 1 = 6. Then, x1* = = 8.33 .
2 ( 6)
The quantity demanded of good 1 decreases.

(b) What happens to the individual’s indirect utility?

1002
Old indirect utility: U *0 = = 50 .
4 ( 5) (10)
1002
New indirect utility: U *1 = = 41.67 .
4 ( 6)(10)
Thus, utility decreases by 8.33. The consumer suffers a reduction in utility as
a result of the per unit tax on good 1.

(c) Suppose instead that the government imposed an income tax that will raise
the same total tax revenues as the per unit tax. What happens to the
individual’s indirect utility?

Income tax T must satisfy T = t ⋅ new x1* = 1 ( 8.33 ) = 8.33 . Thus, after tax
income is m − T = 100 − 8.33 = 91.67 . In this case, new utility becomes

91.672
U *1 = = 42.02 . Thus, utility decreases by 7.98. The consumer suffers a
2 ( 5) (10)
reduction in utility as a result of the income tax.

(d) Which type of tax will the individual consumer prefer? Why?

Since the reduction in utility from the income tax imposition (7.98) is less than
the reduction in utility from the per unit tax imposition (8.33), the consumer
will prefer the income tax as long as he is nonsatiated.

4
Roy’s Identity and Marshallian Demand Functions

Consider the indirect utility function for Example 1. Demonstrate Roy’s

Identity.

m2
Given V ( p1 ,p2 ,m ) = . Then, by Roy’s Identity
4 p1 p2

2
∂V ( p1 ,p2 ,m ) − ⎛⎜ − m ⎞⎟
− ⎜ 4 p2 p ⎟
∂p1 m2 4p p m
*
x1 = = ⎝ 1 2 ⎠ = 2 × 1 2 ⇒ x1* =
∂V ( p1 ,p2 ,m ) 2m 4 p1 p2 2m 2 p1
∂m 4 p1 p2
2
∂V ( p1 ,p2 ,m ) − ⎛⎜ − m ⎞⎟
− ⎜ 4 p p 2 ⎟
∂p2 m2 4p p m
*
x2 = = ⎝ 1 2 ⎠ = × 1 2 ⇒ x2* =
∂V ( p1 ,p2 ,m ) 2m 2
4 p1 p2 2m 2 p2
∂m 4 p1 p2

5
Expenditure Function, Shephard’s Lemma and Hicksian Demand Functions

m2
Consider Example 1’s indirect utility function. V ( p1 ,p2 ,m) = = U*
4 p1 p2

By the duality theorem, let U = U* be the target utility level in the expenditure
minimization problem, where U is some constant. Then,

m2
U= .
4 p1 p2

Solving for m, we get m = 2 p10.5 p20.5U 0.5 .

But as long as U = U* then E’ = m .
0.5
Therefore, E ' = 2 p10.5 p20.5U 0.5 ⇒ E ' = 2 ( p1 p2U ) = E ( p1 , p2 ,U )

Use Shephard’s Lemma to derive the individual’s Hicksian demand functions

for goods 1 and 2.

By Shephard’s Lemma,
0.5
∂E(i) p20.5U 0.5 ⎛ p U ⎞
x1c = = or x1c = ⎜⎜ 2 ⎟⎟ and
∂ p1 p10.5 ⎝ p1 ⎠
0.5
∂E(i) p10.5U 0.5 ⎛ p U ⎞
x2c = = or x2c = ⎜⎜ 1 ⎟⎟
∂ p2 p20.5 ⎝ p2 ⎠

Aside: At the original prices and income p1 =5, p2 =10 and m =100, we showed
that x1* = 10, x2* = 5 and U* = 50 in the utility maximization problem.

Now, let U = U* = 50 in the expenditure minimization problem. Then.

0.5 0.5
⎛ 10 × 50 ⎞ 0.5 ⎛ 5 × 50 ⎞ 0.5
x1c = ⎜ ⎟ = (100) = 10 = x1* , x2c = ⎜ ⎟ = ( 25) = 5 = x2*
⎝ 5 ⎠ ⎝ 10 ⎠

0.5
and E ' = 2 ( 5 × 10 × 50) = 2 ( 50) = 100 = m

6
Some Properties of Marshallian Demand Functions

m m
Consider Example 1 where x1* = and x*2 = . Demonstrate
2 p1 2 p2
2. Homogeneity

m m
Given x1* = and x*2 = . Let t > 0 be the proportion change in all
2 p1 2 p2
prices and income, then
x1 ( tp1 ,tp2 ,tm ) =
( tm ) = tm = m = x p , p ,m
1( 1 2 )
2 ( tp1 ) t 2 p1 2 p1

x2 ( tp1 ,tp2 ,tm ) =

( tm ) =
tm
=
m
= x2 ( p1 , p2 ,m )
2 ( tp2 ) t 2 p2 2 p2

3. Changes in Income, ceteris paribus.

∂x1* 1
= > 0 for all p1, p2, m > 0 ⇒ good 1 is normal
∂m 2 p1

∂x*2 1
= > 0 for all p1, p2, m > 0 ⇒ good 2 is normal
∂m 2 p2

4. Changes in a Good’s Own-Price, ceteris paribus – Discrete Price Change

m
Consider Example 1 in which x1* = .
2 p1
At p1 =5, p2 =10 and m =100, we showed that x1* = 10 and U* = 50.
We also showed that at these initial prices, income and utility level,
x1c = x1* = 10.

Now, suppose the price of good 1 decreases to 4, ceteris paribus. Find the total
effect (TE) of a price increase on the quantity demanded of good 1.
Decompose this total change into the substitution effect (SE) and the income
effect (IE).

7
The TE is the movement along the Marshallian demand curve as the price of
good 1 changes, ceteris paribus.

At the original prices and income, x1*0 = 10.

At the new p1, x1*1 = 100/2(4) = 12.5

So, TE = = x1*1 – x1*0 = 12.5 – 10 = 2.5

The SE is a movement along the Hicksian demand curve for good 1 at the
original utility level before the price increase, U = 50.
0.5
⎛ p U ⎞
Recall that x1c = ⎜⎜ 2 ⎟⎟ .
⎝ p1 ⎠

Note that at the original prices and utility, x1c = x1* = 10.

Hence, x1c0 = x1*0 = 10

Now, at the new p1, x1c1 = (10×50/4)0.5 = 11.18

So, SE = x1c1 – x1c0 = 11.18 – 10 = 1.18

Finally, IE is a movement from new x1c to new x1* so

IE = x1*1 – x1c1 = 12.5 – 11.18 = 1.32

or IE = TE – SE = 2.5 – 1.18 = 1.32

8
What compensation is required by this individual after the price of good 1 has
decreased, so that even after the price of good 1 has decreased, he still
experiences the original utility level he U = 50?

By definition,

Compensation = minimum expenditure to achieve old utility after the price

change – minimum expenditure to achieve the original
utility before the price chage.

Compensation = E’1 – E’0

0.5
Recall that E ' = 2 ( p1 p2U ) = E ( p1 , p2 ,U ) .

At the original price of good 1 with target utility being the original utility level
U = 50,

E’0 = 2(5×10×50)0.5 = 100 = m0

At the new price of good 1,

E’1 = 2(4×10×50)0.5 = 89.44

Thus,

Compensation = E’1 – E’0 = 89.44 – 100 = – 10. 56

The negative compensation implies that for a price decrease, there is a need to
“take away” money from the consumer so he will be able to consume at the
original utility level.

Note: For a price increase, the compensation is positive.

9
Slutsky Equation for Own-Price Change – Infinitesimally Small Price Change

Consider Example 1. Find the total effect of an infinitesimally small own-price

change on the demand for 1. Decompose the total effect into the substitution
effect and income effect. Assume that the initial income and prices are m =100,
m
p1 = 5 and p2 = 10. Given x1* =
2 p1
∂x1* − m − 100
TE = = 2 ⇒ TE = =−2
∂p1 2 p1 2 52 ( )
∂x1* ⎛ m ⎞ ⎛ 1 ⎞ m 100
IE = − x ⋅ *
= − ⎜ ⎟ = − ⇒ IE = − = −1
1
∂m ⎟ ⎜
⎝ 2 p1 ⎠ ⎝ 2 p1 ⎠ 4 p12 ( )
4 52
−m −m −m 100
SE = TE − IE = ⇒ SE = − = −1
( )
− =
2 p12 4 p12 4 p12 4 52

10
Elasticities of Demand

Consider Example 1. The demand functions for good 1 and good 2 are
m m
x1* = and x*2 =
2 p1 2 p2

Assume that the initial income and prices are m =100, p1 = 5 and p2 = 10.

(1) Calculate the elasticities of the Marshallian demand function for good 1.

• Price elasticity of demand (ex1,p1)

∂x1* p1 ⎛ −m ⎞ 5 ⎛ −100 ⎞ ⎛ 5 ⎞
e x1 , p1 = ⋅ = ⋅ =⎜ ⎟⋅ = −1
⎝ ( )
∂ p1 x1* ⎜⎝ 2 p12 ⎟⎠ 10 ⎜ 2 55 ⎟ ⎜⎝ 10 ⎟⎠
⎠

m 100
where at the initial income and prices, x1* = = = 10
2 p1 2 ( 5 )

Since e x1 , p1 = 1 ⇒ demand for good 1 is unit elastic

• Income elasticity of demand (ex1,m)

∂x1* m ⎛ 1 ⎞ 100 ⎛ 1 ⎞
ex1 ,m = ⋅ = ⋅ =⎜ ⎟ (10 ) = 1 > 0
∂m x1* ⎜⎝ 2 p1 ⎟⎠ 10 ⎜⎝ 2 ( 5 ) ⎟⎠
Since ex1 ,m = 1 > 0 ⇒ good 2 is normal and since ex1 ,m = 1 , it is a necessity

• Cross-price elasticity of demand (ex1,p2)

∂x1* p2 10
e x1 ,p2 = ⋅ * = ( 0) = 0
∂ p2 x1 10

Since e x1 ,p2 = 0 ⇒ good 1 is neither a gross substitute nor a gross

complement for good 2

11
(2) Demonstrate

(a) homogeneity in terms of the Marshallian demand elasticities,

Need to show ex1 , p1 + ex1 , p2 + ex1 ,m = 0

Now, ex1 , p1 + ex1 , p2 + ex1 ,m = −1 + 0 + 1 = 0

(b) Engel aggregation

Need to show s1ex1 ,m + s2ex2 ,m = 1

Now, s1ex1 ,m + s2ex2 ,m = 0.5 (1) + 0.5 (1) = 0.5 + 0.5 = 1
where
p x* 5
s1 = 1 1 =
m 100
(10) = 0.5 ⇒ s2 = 1 − s1 = 1 − 0.5 = 0.5
m 100
x*2 = = =5
2 p2 2 (10 )

∂x2* m ⎛ 1 ⎞ 100 ⎛ 1 ⎞
ex2 ,m = ⋅ = ⋅ =⎜ ⎟ ( 20 ) = 1
∂m x2* ⎜⎝ 2 p2 ⎟⎠ 5 ⎜⎝ 2 (10 ) ⎟⎠

(c) Cournot aggregation.

Need to show s1ex1 , p1 + s2e x2 , p1 = − s1

Now, s1ex1 , p1 + s2ex2 , p1 = 0.5 ( − 1) + 0.5 ( 0 ) = − 0.5 = − s1

(3) Calculate the elasticities of the Hicksian demand function for good 1.

Compensated own-price elasticity: exc1 , p1 =ex1 , p1 +s1ex1 ,m = − 1 + 0.5 (1) = − 0.5

Since exc1 , p1 =0.5 < 1 , the demand for good 1 is inelastic (after removing the
income effect).

Compensated cross-price elasticity: exc1 , p2 = ex1 , p2 +s2ex1 ,m = 0 + 0.5 (1) = 0.5 > 0
Since exc1 , p2 = 0.5 > 0 ⇒ good 1 is a net substitute for good 2

12
Measurement of Welfare Change and Consumer Surplus

m
Example: Consider Example 1, x1* = . Suppose initially that m =100, p1 = 5
2 p1
and p2 = 10. Calculate CV, EV and ΔMCS when the price of good 1 increases
from ₧5 to ₧8.

Compensating Variation:

m2 0.5
Recall that V ( p1 ,p2 ,m ) = and E ( p1 , p2 ,U ) = 2 ( p1 p2U ) .
4 p1 p2
Recall that U 0 = 50 and at the original prices, E p10 , p20 ,U 0 = m . Thus, ( )
0.5
CV = E p11 , p20 ,U 0 − m 0 = ⎡⎢ 2 ( 8 × 10 × 50 ) ⎤⎥ − 100 = 126.49 − 100
( )
⎣ ⎦
CV = 26.49

Equivalent Variation:

1002
Since U 1 = = 31.25, then
4 ( 8)(10)
0.5
EV = m 0 − E p10 , p20 ,U 1 = 100 − ⎡⎢ 2 ( 5 × 10 × 31.25) ⎤⎥ = 100 − 79.06
( ) ⎣ ⎦
EV = 20.94

Change in Marshallian Consumer Surplus:

Given m = 100 and p2 = 10, we can get the M.D. curve equation for good 1 as
50 25
x1* = or x1* = . Thus,
2 p1 p1
p11 p1 = 8 p =8
⎡ 25 ⎤ 1
⎡ 1 ⎤ p1 = 8
ΔMCS = ∫ x1 ( p1 , p20 ,m 0 )dp1 = ∫ ⎢ ⎥ dp1 = 25 ∫⎢ ⎥ dp1 = 25 ⎡⎣ ln p1 ⎤⎦ p = 5
p10 ⎣ p1 ⎥⎦
p1 = 5 ⎢ ⎣ p1 ⎥⎦
p1 = 5 ⎢
1

ΔMCS = 25 ⎡⎣ ln ( 8 ) − ln ( 5 ) ⎤⎦ .

ΔMCS = 23.5

Note that 26.49 > 23.5 > 20.94 ⇒ CV > ΔMCS > EV since we showed earlier
that good 1 is normal.

13
 II. THEORY OF THE FIRM – PRODUCTION FUNCTIONS

Objective: To examine the behavior of a typical firm in terms of its decision-

making with respect to a firm’s principal activity – PRODUCTION.

A. Definitions

Firm: A technical unit in which goods are produced.

Entrepreneur: Owner and manager of the firm who decides how

much of and how one or more goods will be produced.

Gains the profit or bears the loss which results from

his/her decision.

Transforms inputs into outputs, subject to technical rules

specified by the firm’s production function.

Profit: Revenue from sales of outputs (R) less Total Costs of inputs
used in the production of outputs (C)

Production Function:

A mathematical function that gives mathematical

expression to the relationship between the quantities of
inputs the firm uses and the quantities of output that are
produced from such inputs.

Input: Any good or service which contributes to the production of

production of an output.

Includes raw materials, labor, land, capital (machinery and

equipment; factory/plant), entrepreneurship

1
Production Time Frames:

Short-Run: a specified time period

(1) short enough such that the quantity used of at least one input cannot
be immediately changed in response to a desired change in output
level

(2) sufficiently short so that the shape of the production function is not
altered through technological improvements

(3) sufficiently long to allow the completion of the necessary technical

processes

Fixed Input: An input necessary for production, but its quantity is

invariant to the quantity of output produced.

Variable Input: An input whose quantity depends on the quantity of

output produced.

Note: The distinction between fixed and variable inputs is temporal.

Inputs that are fixed for one period of time are variable for a longer
period.

Long-Run: Same conditions as the short-run except that condition (1) is

relaxed and defining the production function for a period
long enough to allow variation of the fixed inputs. Thus, in
the long-run all inputs are variable.

B. Production Function

Assumptions:

(1) Firm produces a single output or product.

Let q = amount of the single output produced (output level)

Assume q is divisible.

2
(2) Firm utilizes only two inputs which are both variable.
Let L = amount of labor input used (labor hours)
K = amount of capital input used (machine hours)

Assume all inputs are divisible and the quantities of L and K are
continuous variables.

(3) Firm uses the most technically efficient production process from among
the available techniques (that is, process reflects best utilization of any
input combination).

This implies that output level cannot be increased without increasing at least
one input’s quantity.

Why assume technical efficiency?

The best utilization of any particular input combination (technical efficiency)

is a technical and not an economic problem.

The selection of the best input combination for production of a particular

output level depends on input and output prices and is the subject of economic
analysis.

Given these assumptions, the technological relationship between inputs and

output level is given by the production function:

q = f(L, K)

It shows the maximum output obtainable from every possible combination of

L and K.

Other Assumptions:

(1) The production function is defined only for nonnegative values of the input
and output levels. That is, q ≥ 0, L ≥ 0, and K ≥ 0.

However, the domain of the production function may not include all of the
nonnegative quadrant in some cases. That is L > 0 and K > 0 in some cases.

(2) Usually,f(0,0) = 0, without inputs there is no output.

3
(3) Increasing in its domain.

∂f ( L,K ) ∂f ( L,K )
That is f L = >0 and fK = >0
∂L ∂K

This implies that output increases as long as the amount of at least one input is
increased, without using less of the other input.

fL = marginal product of labor (MPL)

= change in output level due to a change in the usage of labor
input, holding capital usage constant.

fK = marginal product of capital (MPK)

= change in output level due to a change in the usage of capital
input, holding labor usage constant.

(4) A single-valued continuous function with continuous first- and second-

order derivatives.

This implies that f L = f L ( L,K ) and f K = f K ( L,K ) .

Hence, we can take the second-order derivatives:

∂ 2 f ( L,K ) ∂f L ∂MPL
f LL = = ≡ - slope of MPL (rate at which MPL changes
∂L2 ∂L ∂L
as L changes, holding K constant)
2
∂ f ( L,K ) ∂f K ∂MPK
f KK = = ≡ - slope of MPK (rate at which MPK
∂K 2 ∂K ∂K
changes as K changes, holding L constant)
2
∂ f ( L,K ) ∂f L ∂MPL
f LK = = ≡ - change in MPL when K changes, holding
∂L∂K ∂K ∂K
L constant
2
∂ f ( L,K ) ∂f K ∂MPK
f KL = = ≡ - change in MPK when L changes, holding K
∂K ∂L ∂L ∂L
constant

By Young’s Theorem, fLK = fKL.

4
(5) Finally, production function is assumed to be (a) a strictly quasiconcave
function when cost is minimized, and (b) strictly concave when profit is
maximized.

(a) requires that 2 f L f K f LK − f L2 f KK − f K2 f LL > 0 at the cost-minimizing values

of L and K while

2
(b) requires that f LL < 0 , f KK < 0 , and f LL f KK − f LK > 0 at the profit-
maximizing values of L and K

C. Marginal Physical Product (MP)

To study variation in a single input, we define marginal physical product as

the additional output that can be produced by employing one more unit of
that input while holding other inputs constant

∂f ( ⋅ )
marginal physical product of capital = MPK = ≡ fK
∂K

∂f ( ⋅ )
marginal physical product of labor = MPL = ≡ fL
∂L

Note: MP is measured in terms of physical units of the output.

Given that the production function is twice differentiable, then

MPL = MPL ( L,K ) and MPK = MPK ( L,K )

i.e., the MP of an input depends on how much of that input is used (as well as
how much of the other input is used).

Diminishing Marginal Productivity

In general, we assume diminishing marginal productivity

∂MPL ∂ 2 f (⋅ ) ∂MPK ∂ 2 f (⋅ )
= ≡ f LL < 0 = ≡ f KK < 0
∂L ∂L2 ∂K ∂K 2

5
Since we are employing the amount of the other input constant or fixed, then
an increase in say, labor, keeping capital fixed will eventually cause labor to
exhibit some deterioration in productivity.

A similar argument can be made for the case of MPK as capital increases
keeping labor fixed.

• Because of diminishing marginal productivity, 19th century economist

Thomas Malthus worried about the effect of population growth on labor
productivity

• But changes in the marginal productivity of labor over time also depend
on changes in other inputs such as capital

∂MPL ∂ 2 f (⋅ )
– we need to consider = ≡ f LK which is often > 0
∂K ∂L∂K

Intuitively, it seems reasonable that fLK = fKL should be positive

– if workers have more capital, they will be more productive

But some production functions have fLK < 0 over some input ranges

D. Average Physical Product (AP)

• Labor productivity is often measured by average productivity

output q f (⋅ )
APL = = =
labor input L L

• Note that APL also depends on the amount of capital employed

APL = APL ( L, K )

6
Short-Run Production Function Example:

Consider the cubic production function (output q is cubic in both L and K):
2 2 3 3
q = f(L,K) = 600L K - L K .

Suppose that in the short run, capital is fixed at K = 10.

• The short run production function is then given by

2 3
q = 60,000L – 1000L = TPL

which represents the total product of labor function(TPL).

• Since capital is fixed at K = 10.The marginal product of

labor function is

dTPL dq
= = MPL = 2 ( 60,000 ) L2 − 3 (1,000 ) L3
dL dL

MPL = 120,000L – 3000L2

Note that MPL can also be viewed as the slope of TPL.

MPL > 0, when 120,000L – 3000L2 > 0. In this case, TPL rises as L increases.

MPL = 0, when 120,000L – 3000L2 = 0.

MPL < 0, when 120,000L – 3000L2 < 0. In this case, TPL decreases as L
increases.

When its slope is zero, MPL = 0, this means that the TPL function has a
maximum value at some positive value of L. This occurs at

120,000L – 3000L2 = 0
40L = L2
L = 40

7
Implications:

When 0 < L < 40, then MPL > 0. Thus, when the L rises from 0 to
40, TPL increases.

When L = 40, then MPL = 0. The firm’s total output is at a

maximum when it uses 40 units of labor.

When L > 40, then MPL < 0. Thus, when the L rises beyond 40, TPL
decreases.

• Now,  let  us  examine  the  behavior  of  MPL  as  the  firm  uses  more  L,  
holding  K  fixed  at  10.  

MPLL = 120,000 – 6000L (slope of MPL)

MPLL > 0 when 120,000 – 6000L > 0

which occurs over the range 0 < L < 20.

Thus, when L rises from 0 to 20, MPL increases.

MPLL = 0 when 120,000 – 6000L = 0

which occurs at L = 20.

Thus, when L reaches 20, MPL is at a maximum.

Eventually, MPLL < 0 when 120,000 – 6000L < 0

which occurs when L > 20.

Thus, when L increases beyond 20, MPL diminishes.

The above results imply that MPL has a maximum value which occurs when
its slope MPLL = 0. This occurs when L = 20.

• Now, to find average product of labor function, we hold

TPL q 60,000L − 1,000L2
K = 10 and solve = = APL =
L L L

APL = 60,000L – 1000L2

8
Let us examine the behavior of APL.

Note: APLL = 60,000 – 2000L (slope of APL)

APLL > 0 when 60,000 – 2000L > 0

which occurs in the range 0 < L < 30.

Thus, when L rises from 0 to 30, APL increases.

APLL = 0 when 60,000 – 2000L =0

which occurs when L = 30.

When L reaches 30, APL is at a maximum.

APLL < 0 when 60,000 – 2000L < 0

which occurs when L > 30.

When L increases beyond 30, APL diminishes.

The above imply that APL has a maximum when its slope
APLL = 0. This occurs when L = 30.

Relationship between MPL and APL

q
Recall that APL = where q = f(L, K).
L
∂APL
The relationship between MPL and APL is defined by the slope of APL, .
∂L

∂q ∂ f (i) q
∂ APL L⋅ − q L⋅ − q L⋅ MP − q MP
= ∂L = ∂L = L = L − L
∂L L2
L2 L2 L L

∂APL MPL APL ⎛ ∂APL ⎞

= − ⇒ APL = MPL − ⎜ ⎟ ⋅ L.
∂L L L ⎝ ∂L ⎠

9
Therefore, for L > 0

∂APL
Behavior of APL ∂L Relationship between MPL and APL
APL is increasing with L >0 MPL > APL
APL is decreasing with L <0 MPL < APL
APL is at its maximum =0 MPL = APL

• In our example, when L = 30, both APL and MPL are equal to 900,000

E. Isoquant Maps

• To illustrate the possible substitution of one input for another, we use

an isoquant map

• An isoquant shows those combinations of L and K that can produce a

fixed level of output (q)

f(L,K) = q

Isoquants are level sets or curves of the production function.

The assumption that output increases as long as the amount of at least one
input is increased, without using less of the other input implies that isoquants
are downward sloping.

dK
slope of an isoquant = <0
dL q=cons tan t

Proof: Along an isoquant, both L and K change.

• Take the total differential of the production function:

∂f ∂f
dq = ⋅ dL + ⋅ dK = MPL ⋅ dL + MPK ⋅ dK
∂L ∂K

• Along an isoquant output is constant so dq = 0

dK MPL
0 = MPL ⋅ dL + MPK ⋅ dK ⇒ =−
dL q=constant MPK
10
Since MPL > 0 and MPK > 0 when we assume that output increases as the
amount of an input is increased (with the other input constant), then the slope
dK MPL
of an isoquant is negative, =− .
dL q=constant MPK

Moreover, because of the above assumption each isoquant represents a

different level of output.

K– output rises as we move northeast

q = 30
q = 20

• When the production function is assumed to be strictly quasiconcave

d2K
then the associated isoquants are strictly convex, i.e., > 0.
dL2 q=constant

Marginal Rate of Technical Substitution (MRTSLK)

• The marginal rate of technical substitution (MRTSLK) shows the rate at

which labor can be substituted for capital while holding output constant
along an isoquant

• The negative of the slope of an isoquant shows the rate at which L can
be substituted for K (MRTSLK)

− slope = MRTSLK
11
Note:

dK MPL
Since − = and MPL and MPK will both be positive by the
dL q=constant MPK
previous assumption, then MRTSLK > 0.

In addition, when the isoquant is strictly convex then along an isoquant

MRTSLK is diminishing for increasing inputs of labor.
MRTS and Marginal Productivities

Recall that

− dK MPL f
MRTSLK = = ≡ L
dL q = cons tan t MPK f K

• However, it is generally not possible to derive a diminishing MRTS from

the assumption of diminishing marginal productivity alone.

• To show that strictly convex isoquants imply diminishing MRTSLK as L

increases along a given isoquant, need to show that d(MRTSLK)/dL < 0.

• Given that the production function is twice differentiable, then

f L = f L ( L,K ) and f K = f K ( L,K )

Since both L and K change along a given isoquant, take the total differential of
MRTSLK

[ f K ( f LL dL + f LK dK ) − f L ( f KL dL + f KK dK )]
dMRTS LK = d ( f L / f K ) =
f K2

Dividing through by dL, we get

dK dK
dMRTS LK [ f K ( f LL + f LK ⋅ dL ) − f L ( f KL + f KK ⋅ dL )]
=
dL f K2

12
• Using the fact that dK/dL = − fL/fK along an isoquant and Young’s
theorem (fLK = fKL)

dMRTS LK ( f K2 f LL − 2 f K f L f KL + f L2 f KK )
=
dL ( f K )3

• Because we have assumed assumed that the isoquant is strictly convex,

it must be that the production function is strictly quasiconcave, i.e.,

2 f L f K f LK − f L2 f KK − f K2 f LL > 0

Therefore,

− 2 f L f K f LK − f L2 f KK − f K2 f LL = f K2 f LL − 2 f K f L f KL + f L2 f KK < 0
( ) ( )
Hence, since we assumed that fK > 0, then

dMRTS LK ( f K2 f LL − 2 f K f L f KL + f L2 f KK )
= <0
dL ( f K )3

That is, as L increases along an isoquant then MRTSLK diminishes.

F. Returns to Scale (RTS)

• How does output respond to increases in all inputs together?

– suppose that all inputs are doubled, would output double?

• Returns to scale have been of interest to economists since the days of

Adam Smith

• Smith identified two forces that come into operation as inputs are
doubled

– greater division of labor and specialization of function

– loss in efficiency because management may become more difficult
given the larger scale of the firm

13
• The returns to scale exhibited by a production function record how
output responds to proportionate increases in all inputs

• If the production function is given by q = f(L,K) and all inputs are

multiplied by the same positive constant (t >1), then

Effect on Output Returns to Scale

Proportion increase in
output = proportion increase Constant
in all inputs
Proportion increase in
output < proportion increase Decreasing
in all inputs
Proportion increase in
output > proportion increase Increasing
in all inputs

14
 • Returns to Scale and Isoquants

Constant RTS Decreasing RTS

Increasing Returns to Scale

These graphs show that the spacing of the isoquant determines the RTS. The
closer together the q = 100 and q =200 isoquants, the greater the degree of
RTS.

15
• Variable Returns to Scale

It is possible for a production function to exhibit constant RTS for some

levels of input usage and increasing RTS or decreasing RTS for other
levels

– when a firm is small, increasing labor and capital allows for gains
from cooperation between workers and greater specialization of
workers and equipment (returns to specialization), so there are
increasing RTS

– as the firm grows, returns to scale are eventually exhausted – there

are no more returns to specialization, so the production process has
constant RTS

– if the firm continues to grow, the owner starts having difficulty

managing everyone, so the firm suffers from decreasing RTS

The spacing of the isoquants reflects the RTS. When both L and K are
doubled from 1 to 2, output more than doubles from 1 to 3.

When both Land K are further doubled from 2 to 4, output just doubles
form 3 to 6.

Finally, further doubling both L and K from 4 to 8 leads to an increase

in output of less than double from 6 to 8.
16
Homogeneous Production Functions and Returns to Scale

If the production function q = f(L,K) is homogeneous of degree k in L

and K, then if all inputs are multiplied by a positive constant t, we have

f(tL,tK) = tkf(L,K) = tkq

– If k = 1, we have constant returns to scale

– If k < 1, we have decreasing returns to scale
– If k > 1, we have increasing returns to scale

In addition, if a production function is homogeneous of degree k, its

derivatives are homogeneous of degree k-1.

• This implies that for constant RTS production function, the marginal
productivity functions are homogeneous of degree zero
• The marginal productivity of any input depends on the ratio of capital
and labor (not on the absolute levels of these inputs)

• The MRTS between K and L depends only on the ratio of K to L, not the
scale of operation, then the production function will be homothetic

• Geometrically, all of the isoquants are radial expansions of one another

Along a ray from the origin (constant K/L), the MRTSLK will be the same
on all isoquants. The isoquants are equally spaced as output expands.
K

q=3

q=2
q=1

17
G. Elasticity of Substitution

• The elasticity of substitution (σ) measures the proportionate change in

K/L relative to the proportionate change in the MRTSLK along an
isoquant

%Δ( K / L) d ( K / L) MRTS LK ∂ ln( K / L)

σ= = ⋅ =
%ΔMRTS LK dMRTS LK K/L ∂ ln MRTS LK

• The value of σ will always be positive because K/L and MRTSLK move in
the same direction

• Both MRTSLK and K/L will change as we move from point A to point B

σ is the ratio of these proportional changes

σ measures the curvature of the isoquant

K

MRTSA

MRTSB

(K/L)A q

(K/L)B
L

• If σ is high, the MRTSLK will not change much relative to K/L the
isoquant will be relatively flat

• If σ is low, the MRTSLK will change by a substantial amount as K/L

changes the isoquant will be sharply curved

18
• It is possible for σ to change along an isoquant or as the scale of
production changes

• Generalizing the elasticity of substitution to the many-input case raises

several complications

– If we define the elasticity of substitution between two inputs to be

the proportionate change in the ratio of the two inputs to the
proportionate change in MRTSLK, we need to hold output and the
levels of other inputs constant

Examples of Production Functions:

The Linear Production Function

• Suppose that the production function is

q = f(L,K) = aL + bK for L ≥ 0 and K ≥ 0 where a,b > 0

• Capital and labor are perfect substitutes

• This production function exhibits constant returns to scale

f(tL,tK) = a(tL) + b(tK) = t(aL + bK) = tf(L,K)

• All isoquants are straight lines

– MRTSLK is constant

– σ =∞

19
 MRTSLK is constant as K/L changes

slope = -b/a

σ=∞

q1 q2 q3
L

Fixed Proportions Production Function

• Suppose that the production function is

q = min {aL,bK} for L > 0 and K > 0, where a,b > 0

• Capital and labor must always be used in a fixed ratio

– the firm will always operate along a ray where K/L is constant

• Because K/L is constant, σ = 0

No substitution between labor and capital is possible

20
 K K/L is fixed at b/a

σ=0

q3 / q3
a
q2

q1
L
q3/b

Cobb-Douglas Production Function

• Suppose that the production function is

q = f(L,K) = ALaKb for L > 0 and K > 0, where A,a,b > 0

• This production function can exhibit any returns to scale

f(tL,tK) = A(tL)a(tK)b = Ata+b LaKb = ta+bf(L,K)

– if a + b = 1 ⇒ constant returns to scale

– if a + b > 1 ⇒ increasing returns to scale

– if a + b < 1 ⇒ decreasing returns to scale

21
• The Cobb-Douglas production function is linear in logarithms

ln q = ln A + aln L + bln K

– a is the elasticity of output with respect to L

– b is the elasticity of output with respect to K

CES Production Function

• Suppose that the production function is

γ
( )
q = f L, K = ⎡⎣ aLρ + bK ρ ⎤⎦ ρ a > 0, b > 0, ρ ≤ 1, ρ ≠ 0, γ > 0

– γ > 1 ⇒ increasing returns to scale

– γ < 1 ⇒ decreasing returns to scale

– γ = 1 ⇒ constant returns to scale

• For this production function, when a = 1, b = 1, and γ = 1 then

σ = 1/(1-ρ)

Note:

ρ =1 ⇒ linear production function

ρ =− ∞ ⇒ fixed proportions production function

ρ =0 ⇒ Cobb-Douglas production function

22
Long-Run Production Function Example:

A firm’s production function is given by q = 4L0.25 K 0.25 for K > 0 and L > 0.

1. Find  the  firm’s  marginal  product  of  labor  and  marginal  product  of  
capital.  Verify  if  the  production  function  exhibits  diminishing  
marginal  productivity  of  labor  and  marginal  productivity  of  
capital.  

The marginal productivity functions for labor and capital, respectively, are:

K 0.25 K 0.25 K 0.25

MPL = 4 ( 0.25 ) = 0.75 MPL =
L0.75 L ⇒ L0.75

L0.25 L0.25 L0.25

MPK = 4 ( 0.25 ) = MPK =
K 0.75 K 0.75 ⇒ K 0.75

Now, the slope of the marginal productivity of labor is:

∂MPL K 0.25
= MPLL = − 0.75 1.75 < 0
∂L L

for all K > 0 and L > 0. This implies that as the firm uses more labor, holding
capital constant, the marginal productivity of labor decreases.

Now, the slope of the marginal productivity of capital is:

∂MPK L0.25
= MPKK = − 0.75 1.75 < 0
∂K K

for all K > 0 and L > 0. This implies that as the firm uses more capital, holding
labor constant, the marginal productivity of capital decreases.

Clearly, the firm’s production function exhibit diminishing marginal

productivities of labor and capital.

23
 2. Find the derivatives that describe the slope and shape of a typical
isoquant associated with the firm’s production function. Then, describe
the typical isoquant in terms of its slope and shape.
 
The slope of a typical isoquant is given by:

K 0.25
dK MPL 0.75 dK K
=− = − L0.25 =−
dL dq=0 MPK L ⇒ dL dq=0 L
K 0.75

dK K
Clearly, dL dq=0
= − <0 for all K > 0 and L > 0, therefore the typical
L
isoquant is downward sloping.

The shape of a typical isoquant is indicated by:

d2K (2 f K f L f KL − f K2 f LL − f L2 f KK )
=
dL2 dq=0
( f K )3

From part 1, we obtained the following derivatives of the firm’s production

function:

K 0.25 L0.25
f L ≡ MPL = f K ≡ MPK =
L0.75 K 0.75
K 0.25 L0.25
f LL ≡ MPLL = − 0.75 1.75 f KK ≡ MPKK = − 0.75 1.75
L K

∂MPL 0.25
In addition, f KL ≡ f LK ≡ = MPLK = 0.75 0.75
∂K K L

Thus,
⎛ ⎛ L0.25 ⎞ ⎛ K 0.25 ⎞ ⎛ 0.25 ⎞ ⎛ L0.25 ⎞ 2 ⎛ 2
K 0.25 ⎞ ⎛ K 0.25 ⎞ ⎛ L0.25 ⎞ ⎞
⎜ 2 ⎜ 0.75 ⎟ ⎜ 0.75 ⎟ ⎜ 0.75 0.75 ⎟ − ⎜ 0.75 ⎟ ⎜ − 0.75 1.75 ⎟ − ⎜ 0.75 ⎟ ⎜ − 0.75 1.75 ⎟ ⎟
d2K ⎝ ⎝K ⎠⎝ L ⎠⎝K L ⎠ ⎝K ⎠ ⎝ L ⎠ ⎝ L ⎠ ⎝ K ⎠⎠
=
dL2 dq=0 ⎛ L0.25 ⎞
3

⎜⎝ K 0.75 ⎟⎠

24
d2K 2K for all K > 0 and L > 0.
= >0
dL2 dq=0
L2

Thus, the slope of a typical isoquant increases as the firm uses more labor to
produce the same output along a given isoquant. This implies that the firm’s
typical isoquant is strictly convex in shape.

3. Find the firm’s marginal rate of technical substitution between labor

and capital, MRTSLK. Then, verify if the firm’s production function
exhibits diminishing MRTSLK ase it uses more labor to produce the
same output level along the given isoquant.

dK K
From part 2, we got dL dq=0
=− .
L

dK K
Thus,
− = MRTS LK =
dL dq=0 L .

dMRTS LK d2K
Now, since =−
dL dq=0
dL2
dq=0

2
And from part 2 we got d K2 =
2K ,
dL dq=0
L2

dMRTS LK 2K
Then =− <0 for all K > 0 and L > 0.
dL dq=0
L2

This implies that as the firm uses more labor to produce the same output
along a given isoquant, MRTSLK diminishes. As the firm becomes more labor
intensive in its production, it becomes more difficult for the firm to substitute
labor for capital in order to maintain the production of the same output level.

Alternatively, suppose we did not have the result in part 2 and the only
dK K dK K
information we have is that =− and − = MRTS LK = .
dL dq=0 L dL dq=0 L

25
Then, take the total differential of MRTS LK
⎛K⎞ 1
dMRTS LK = − ⎜ 2 ⎟ dL + dK
⎝L ⎠ L
dMRTS LK ⎛ K ⎞ 1 dK
Dividing this by dL, we get = −⎜ 2 ⎟ +
dL ⎝ L ⎠ L dL
dK K
But since =−
dL dq=0 L
dMRTS LK ⎛ K ⎞ 1⎛ K⎞
then = −⎜ 2 ⎟ + ⎜− ⎟
dL ⎝ L ⎠ L⎝ L⎠
dMRTS LK 2K
And =− <0 for all K > 0 and L > 0.
dL dq=0
L2

4. Does this production function exhibit increasing, decreasing, or constant

returns to scale?

Given q = 4L0.25 K 0.25 = f ( L,K ) .

Let t > 1 be the proportion change in both L and K, then
f ( tL,tK ) = 4 ( tL ) ( tK )
0.25 0.25
= 4t 0.25 L0.25 t 0.25 K 0.25
(
f ( tL,tK ) = t 0.5 ⋅ 4L0.25 K 0.25 )
f ( tL,tK ) = t 0.5 ⋅ f ( L,K )

This implies that f ( L,K ) is homogeneous of degree k = 0.5 in L and K.

For, t > 1, then k = 0.5 < 1, which means the production function exhibits
Decreasing Returns to Scale. Specifically, if both L and K increase by the
proportion t > 1, then q increases by the proportion t0.5 < t. For example, every
time the firm doubles the usage of both labor and capital (t = 2), output will
less than doubles (t0.5 = 20.5 =1.4142).

Alternatively, we can use the result that since the firm’s production function
q = 4L0.25 K 0.25 = f ( L,K ) is of the Cobb-Douglas form q = ALa K b = f ( L,K ) ,
where A = 4, a= 0.25, and
b =0.25, then its degree of homogeneity is given by
k = a + b = 0.25 + 0.25. Thus, k = 0.5 < 1 and therefore the production function
exhibits Decreasing Returns to Scale.

26
 5. Find and describe the elasticity of substitution of this firm’s production.

⎛ K⎞
d⎜
⎝ L ⎟⎠ MRTSLK
By definition, σ = ⋅
dMRTSLK K
L

K K
From part 3, we got MRTS LK = ⇒ = MRTS LK
L L

⎛ K⎞
d⎜
⎝ L ⎟⎠ d ( MRTS LK ) K
Thus, = = 1 . Substituting this derivative MRTS LK =
dMRTS LK dMRTS LK L
in the definition of elasticity of substitution, we get

K
So that σ = 1⋅ L ⇒ σ = 1.
K
L

Thus, the elasticity of substitution of the firm’s production function is a

constant 1 for all values of L > 0 and K > 0.

⎛ K⎞
d ln ⎜
⎝ L ⎟⎠
Alternatively, σ =
d ln MRTSLK

K K
Since MRTS LK = ⇒ = MRTS LK
L L
⎛ K⎞
d ln ⎜ ⎟
K ⎝ L⎠
then ln = ln MRTS LK and σ = = 1.
L d ln MRTSLK

27
 Theory  of  the  Firm  -­‐  Production  Functions  Examples  
 
Short-­‐Run  Production  Function:  
 
Consider  the  cubic  production  function  (output  q  is  cubic  in  both    
L  and  K):     q  =  f(L,K)  =  600L2K2  -­‐  L3K3.  
 
Suppose  that  in  the  short  run,  capital  is  fixed  at  K  =  10.  
 
•   The  short  run  production  function  is  then  given  by  
 
q  =  60,000L2  –  1000L3  =  TPL  
 
which  represents  the  total  product  of  labor  function(TPL).  
 
•   Since  capital  is  fixed  at  K  =  10.The  marginal  product  of    
labor  function  is    
 
dTPL dq
= = MPL = 2 ( 60,000 ) L2 − 3 (1,000 ) L3  
dL dL
 
MPL  =  120,000L  –  3000L2  
 
Note  that  MPL  can  also  be  viewed  as  the  slope  of  TPL.  
 
MPL  >  0,  when  120,000L  –  3000L2  >  0.  In  this  case,  TPL  rises  as  L  
increases.  
 
MPL  =  0,  when  120,000L  –  3000L2  =  0.  
 
MPL  <  0,  when  120,000L  –  3000L2  <  0.  In  this  case,  TPL  decreases  
as  L  increases.  
 
When  its  slope  is  zero,  MPL  =  0,  this  means  that  the  TPL  function  
has  a  maximum  value  at  some  positive  value  of  L.  This  occurs  at    
 
120,000L  –  3000L2  =  0  
40L  =  L2                  
L  =  40  
 
 
Implications:  
 
When  0  <  L  <  40,  then  MPL  >  0.  Thus,  when  the  L  rises  from  0  to    
40,  TPL  increases.    
 
When  L  =  40,  then  MPL  =  0.  The  firm’s  total  output  is  at  a    
maximum  when  it  uses  40  units  of  labor.  
 
When  L  >  40,  then  MPL  <  0.  Thus,  when  the  L  rises  beyond  40,  TPL    
decreases.    
 
• Now,  let  us  examine  the  behavior  of  MPL  as  the  firm  uses  
more  L,  holding  K  fixed  at  10.  
 
  MPLL  =  120,000  –  6000L          (slope  of  MPL)  
 
MPLL    >  0  when  120,000  –  6000L    >  0    
which  occurs  over  the  range  0  <  L  <  20.    
 
Thus,  when  L  rises  from  0  to  20,  MPL  increases.  
 
MPLL  =  0  when  120,000  –  6000L    =  0        
which  occurs  at  L  =  20.    
 
Thus,  when  L  reaches  20,  MPL  is  at  a  maximum.    
 
Eventually,  MPLL    <  0  when  120,000  –  6000L  <  0  
which  occurs  when    L  >  20.    
 
Thus,  when  L  increases  beyond  20,  MPL  diminishes.  
 
The  above  results  imply  that  MPL  has  a  maximum  value  which  
occurs  when  its  slope  MPLL  =  0.  This  occurs  when  L  =  20.  
 
•   Now,  to  find  average  product  of  labor  function,  we  hold    
TPL q 60,000L − 1,000L2
K  =  10  and  solve   = = APL =  
L L L
 
APL  =  60,000L  –  1000L2  
 
 
 
Let  us  examine  the  behavior  of  APL.  
 
Note:     APLL  =  60,000  –  2000L    (slope  of  APL)  
 
APLL    >  0  when  60,000  –  2000L  >  0      
which  occurs  in  the  range    0  <  L  <  30.    
 
Thus,  when  L  rises  from  0  to  30,  APL  increases.  
 
APLL  =  0  when  60,000  –  2000L  =0    
which  occurs  when    L  =  30.    
 
When  L  reaches  30,  APL  is  at  a    maximum.    
 
APLL    <  0  when  60,000  –  2000L  <  0      
which  occurs  when      L  >  30.    
 
When  L  increases  beyond  30,  APL  diminishes.  
 
The  above  imply  that  APL  has  a  maximum  when  its  slope    
APLL  =  0.  This  occurs  when  L  =  30.  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Long-­‐Run  Production  Function:  
 
A  firm’s  production  function  is  given  by   q = 4L0.25 K 0.25  for  K  >  0  
and  L  >  0.  
 
1. Find  the  firm’s  marginal  product  of  labor  and  marginal  
product  of  capital.  Verify  if  the  production  function  
exhibits  diminishing  marginal  productivity  of  labor  and  
marginal  productivity  of  capital.  
 
The  marginal  productivity  functions  for  labor  and  capital,  
respectively,  are:  
 
K 0.25 K 0.25 K 0.25
MPL = 4 ( 0.25 ) 0.75 = 0.75   MP =
L L ⇒   L
L0.75  
 
L0.25 L0.25 L0.25
MPK = 4 ( 0.25 ) 0.75 = 0.75   MPK = 0.75  
K K ⇒   K
 
Now,  the  slope  of  the  marginal  productivity  of  labor  is:  
 
∂MPL K 0.25
= MPLL = − 0.75 1.75 < 0  
∂L L
 
for  all  K  >  0  and  L  >  0.  This  implies  that  as  the  firm  uses  more  
labor,  holding  capital  constant,  the  marginal  productivity  of  
labor  decreases.    
 
Now,  the  slope  of  the  marginal  productivity  of  capital  is:  
 
∂MPK L0.25
= MPKK = − 0.75 1.75 < 0  
∂K K
 
for  all  K  >  0  and  L  >  0.  This  implies  that  as  the  firm  uses  more  
capital,  holding  labor  constant,  the  marginal  productivity  of  
capital  decreases.    
 
Clearly,  the  firm’s  production  function  exhibit  diminishing  
marginal  productivities  of  labor  and  capital.  
 
 2. Find  the  derivatives  that  describe  the  slope  and  shape  of  a  
typical  isoquant  associated  with  the  firm’s  production  
function.  Then,  describe  the  typical  isoquant  in  terms  of  its  
slope  and  shape.  
 
The  slope  of  a  typical  isoquant  is  given  by:  
 
K 0.25
dK MPL 0.75 dK K
=− = − L0.25   ⇒   = −  
dL dq=0 MPK L dL dq=0 L
0.75
K
 
dK K
Clearly,   dL dq=0
= − < 0   for  all  K  >  0  and  L  >  0,  therefore  the  
L
typical  isoquant  is  downward  sloping.  
 
The  shape  of  a  typical  isoquant  is  indicated  by:  
 
d2K (2 f K f L f KL − f K2 f LL − f L2 f KK )
=
dL2 dq=0 ( f K )3  
 
From  part  1,  we  obtained  the  following  derivatives  of  the  firm’s  
production  function:  
 
K 0.25 L0.25
f L ≡ MPL = 0.75 f K ≡ MPK = 0.75      
L       K
0.25
K L0.25
f LL ≡ MPLL = − 0.75 1.75   f KK ≡ MPKK = − 0.75 1.75  
L K
 
∂MPL 0.25
In  addition,   f KL ≡ f LK ≡ = MPLK = 0.75 0.75  
∂K K L
 
Thus,  
⎛ ⎛ L0.25 ⎞ ⎛ K 0.25 ⎞ ⎛ 0.25 ⎞ ⎛ L0.25 ⎞ 2 ⎛ 2
K 0.25 ⎞ ⎛ K 0.25 ⎞ ⎛ L0.25 ⎞ ⎞
2 −
⎜ ⎜ 0.75 ⎟ ⎜ 0.75 ⎟ ⎜ 0.75 0.75 ⎟ ⎜ 0.75 ⎟ ⎜ − 0.75 − − 0.75 ⎟
d2K ⎝ ⎝K ⎠⎝ L ⎠⎝K L ⎠ ⎝K ⎠ ⎝ L1.75 ⎟⎠ ⎜⎝ L0.75 ⎟⎠ ⎜⎝ K 1.75 ⎟⎠ ⎠
=
dL2 dq=0 ⎛ L0.25 ⎞
3

⎜⎝ K 0.75 ⎟⎠

 
 d2K 2K
= > 0   for  all  K  >  0  and  L  >  0.  
dL2 dq=0
L2
 
Thus,  the  slope  of  a  typical  isoquant  increases  as  the  firm  uses  
more  labor  to  produce  the  same  output  along  a  given  isoquant.  
This  implies  that  the  firm’s  typical  isoquant  is  strictly  convex  in  
shape.  
 
3. Find  the  firm’s  marginal  rate  of  technical  substitutio  
between  labor  and  capital,  MRTSLK.  Then,  verify  if  the  
firm’s  production  function  exhibits  diminishing  MRTSLK  
ase  it  uses  more  labor  to  produce  the  same  output  level  
along  the  given  isoquant.  
 
dK K
From  part  2,  we  got   dL dq=0
= − .    
L
 
dK K
Thus,   dL dq=0
−= MRTS =    
LK
L .
 
dMRTS LK d2K
Now,  since   =−  
dL dq=0
dL2
dq=0
 
2
And  from  part  2  we  got   d K2 =
2K ,  
dL dq=0
L2
 
dMRTS LK 2K
Then   =− < 0          for  all  K  >  0  and  L  >  0.  
dL dq=0
L2
 
This  implies  that  as  the  firm  uses  more  labor  to  produce  the  
same  output  along  a  given  isoquant,  MRTSLK  diminishes.  As  the  
firm  becomes  more  labor  intensive  in  its  production,  it  becomes  
more  difficult  for  the  firm  to  substitute  labor  for  capital  in  order  
to  maintain  the  production  of  the  same  output  level.  
 
Alternatively,  suppose  we  did  not  have  the  result  in  part  2  and  
dK K
the  only  information  we  have  is  that   = −  and
dL dq=0 L
dK K
− = MRTS LK = .  
dL dq=0 L
 
Then,  take  the  total  differential  of   MRTS LK  
⎛K⎞ 1
dMRTS LK = − ⎜ 2 ⎟ dL + dK  
⎝L ⎠ L
dMRTS LK ⎛ K ⎞ 1 dK
Dividing  this  by  dL,  we  get   = −⎜ 2 ⎟ +  
dL ⎝ L ⎠ L dL
dK K
But  since   = −  
dL dq=0 L
dMRTS LK ⎛ K ⎞ 1⎛ K⎞
then   = − ⎜ 2 ⎟ + ⎜ − ⎟  
dL ⎝ L ⎠ L⎝ L⎠
dMRTS LK 2K
And     =− < 0          for  all  K  >  0  and  L  >  0.  
dL dq=0
L2
 
4. Does  this  production  function  exhibit  increasing,  
decreasing,  or  constant  returns  to  scale?  
 
Given   q = 4L0.25 K 0.25 = f ( L,K ) .  
Let  t  >  1  be  the  proportion  change  in  both  L  and  K,  then  
f ( tL,tK ) = 4 ( tL ) ( tK )
0.25 0.25
= 4t 0.25 L0.25 t 0.25 K 0.25
(
f ( tL,tK ) = t 0.5 ⋅ 4L0.25 K 0.25 )  
f ( tL,tK ) = t 0.5 ⋅ f ( L,K )
 
This  implies  that   f ( L,K )  is  homogeneous  of  degree  k  =  0.5  in  L  
and  K.  
 
For,  t  >  1,  then  k  =  0.5  <  1,  which  means  the  production  function  
exhibits  Decreasing  Returns  to  Scale.  Specifically,  if  both  L  and  K  
increase  by  the  proportion  t  >  1,  then  q  increases  by  the  
proportion  t0.5  <  t.  For  example,  every  time  the  firm  doubles  the  
usage  of  both  labor  and  capital  (t  =  2),  output  will  less  than  
doubles  (t0.5  =  20.5  =1.4142).    
 
Alternatively,  we  can  use  the  result  that  since  the  firm’s  
production  function   q = 4L0.25 K 0.25 = f ( L,K )  is  of  the  Cobb-­‐
Douglas  form   q = ALa K b = f ( L,K ) ,  where  A  =  4,  a=  0.25,  and    
b  =0.25,  then  its  degree  of  homogeneity  is  given  by    
k  =  a  +  b  =  0.25  +  0.25.  Thus,  k  =  0.5  <  1  and  therefore  the  
production  function  exhibits  Decreasing  Returns  to  Scale.  
 
5. Find  and  describe  the  elasticity  of  substitution  of  this  
firm’s  production.  
 
⎛ K⎞
d⎜ ⎟
⎝ L⎠ MRTSLK
By  definition,   σ = ⋅    
dMRTSLK K
L
 
K K
From  part  3,  we  got   MRTS LK =     ⇒   = MRTS LK  
L L
 
⎛ K⎞
d⎜ ⎟
⎝ L⎠ d ( MRTS LK )
Thus,   = = 1 .  Substituting  this  derivative  
dMRTS LK dMRTS LK
K
MRTS LK =  in  the  definition  of  elasticity  of  substitution,  we  get    
L
 
K
So  that   σ = 1⋅ L   ⇒   σ = 1 .  
K
L
 
Thus,  the  elasticity  of  substitution  of  the  firm’s  production  
function  is  a  constant  1  for  all  values  of  L  >  0  and  K  >  0.  
 
⎛ K⎞
d ln ⎜ ⎟
⎝ L⎠
Alternatively,   σ =  
d ln MRTSLK
 
K K
Since   MRTS LK =     ⇒   = MRTS LK  
L L
⎛ K⎞
d ln ⎜ ⎟
K ⎝ L⎠
then   ln = ln MRTS LK  and   σ = = 1 .  
L d ln MRTSLK
  
 
Short-­‐Run  Production  Function  Example  
 
A  firm’s  production  function  is   q = 0.1LK + 3L2 K − 0.1L3 K .  
1. What  is  this  firm’s  marginal  product  of  labor  function?  
2. What  is  this  firm’s  average  product  of  labor  function?  
3. Suppose  that  in  the  short-­‐run  the  firm’s  capital  input  is  fixed  at   K = 10 .  
a. What  is  the  firm’s  short-­‐run  production  function  (or  total  product  of  labor  
function)?    
b. What  is  the  firm’s  marginal  product  of  labor  function?    
c. What  is  the  firm’s  average  product  of  labor  function?  
d. Draw  two  figures,  one  above  the  other.  In  the  top  figure,  show  the  
relationship  between  output  (total  product)  and  labor.  In  the  bottom  
figure  show  the  marginal  product  of  labor  and  average  product  of  labor  
curves.  
4. Is  this  production  function  valid  for  all  values  of  labor?  
 
 
 
 II. THEORY OF THE FIRM – COST FUNCTIONS

Objective: To show how the production function can be used to derive the
costs incurred by the firms in its production activities.

A. Definitions of Costs.

• It is important to differentiate between accounting cost and economic

cost

– the accountant’s view of cost stresses out-of-pocket expenses,

historical costs, depreciation, and other bookkeeping entries

– economists focus more on opportunity cost

• Labor Costs

– to accountants, expenditures on labor are current expenses and

hence costs of production

– to economists, labor is an explicit cost

• labor services are contracted at some wage rate (w) and it is

assumed that this is also what the labor could earn in
alternative employment

• Capital Costs

– accountants use the historical price of the capital and apply some
depreciation rule to determine current costs

– economists refer to the capital’s original price as a “sunk cost”

and instead regard the implicit cost of the capital to be what
someone else would be willing to pay for its use

• we will use r to denote the rental rate per capital

19
• Costs of Entrepreneurial Services

– accountants believe that the owner of a firm is entitled to all

profits

• revenues or losses left over after paying all input costs

– economists consider the opportunity costs of time and funds that

owners devote to the operation of their firms

• part of accounting profits would be considered as

entrepreneurial costs by economists

Economic Cost

• The economic cost of any input is the payment required to keep that
input in its present employment

– the remuneration the input would receive in its best alternative

employment

B. Two Simplifying Assumptions

• There are only two inputs

– homogeneous labor (L), measured in labor-hours

– homogeneous capital (K), measured in machine-hours

• entrepreneurial costs are included in capital costs

⇒ q = f(L,K)

• Inputs are hired in perfectly competitive markets

– firms are price takers in input markets

⇒ w and r are exogenous variables for

the firm

20
Economic Profits

• Total costs for the firm are given by

total costs = C = wL + rK

• Total revenue for the firm is given by

total revenue = R = pq = pf(L,K)

• Economic profits (π) are equal to

π =R-C
π = pq – (wL + rK)

π = pf(L,K) – wL – rK

• Economic profits are a function of the amount of capital and labor

employed

– we could examine how a firm would choose L and K to maximize

profit

• “derived demand” theory of labor and capital inputs

– for now, we will assume that the firm has already chosen its
output level (q) and wants to minimize its costs

C. Cost Minimization

Given the above assumptions, can write firm’s total costs of production
during a single period as

C = wL + rK

Suppose the firm has decided to produce a specific output level q, where q > 0
constant.

Want to examine how firm chooses L and K to produce q units at minimal

costs.

21
Mathematically, we seek to solve the problem

min C = wL + rK

s.t. q = f(L,K)

That is, the firm chooses L and K from the IQ representing q units of output.

If the production function is twice-differentiable, the firm’s problem is

equivalent to

min L = wL + rK + λ[q − f(L,K)]

• FOCs for an interior minimum:

∂ L /∂λ = q − f(L,K) = 0

∂ L /∂L = w – λ∂f(L,K)/∂L = 0

∂ L /∂K = r – ∂λf(L,K)/∂K = 0

Implications of the FOCs

• The first FOC requires that the firm must produce q units of output.

• The last two FOCS require that require that

∂f ( ⋅ ) / ∂L ∂f ( ⋅ ) / ∂K MPL MPK
= ⇒ =
w r w r

That is, to minimize cost, the MP per peso spent on each input should be the
same for all inputs (extra output per extra peso spent on each input are
equal).

Alternatively, the last two FOCS require that

MPL w w
= ⇒ MRTS LK =
MPK r r

22
That is, the cost minimizing firm should equate the MRTS between the two
inputs to the ratio of the two inputs’ prices.

Mathematically, the cost minimizing L and K, L’ and K’ can be obtained by

solving the three FOCs for L and K (and λ ). Note that the optimal L and K
values will be functions of the exogenous variables in the firm’s cost
minimization problem (w, r, q).

Lʹ′ = L ( w,r ,q ) and K ʹ′ = K ( w,r ,q )

These are known as the firm’s conditional or derived demand functions for
labor and for capital, respectively. They are based on the level of the firm’s
output.

Graphically,

• first FOC requires that the optimal L and K lie along the IQ for q units
of output

• last two FOCS require that

w
− MRTS LK = − ⇒ slope of IQ for q units = slope of Isocost
r

This occurs at the tangency between the isoquant and the total cost curve

Proof:

An Isocost represent all combinations of L and K for which the total costs of
production are the same. i.e., C = wL + rK.
w
Since the total cost is constant along an Isocost, then its slope is − in the
r
K-L space.

Isocosts are represented by parallel lines with a slope of − w/r.

Graphically, the constraint that the firm has to produce q units of output is
represented by the IQ for q units of output.

23
K

C1

C3

C2
C1 <C2 < C3

The cost-minimizing L and K to produce the given target output q are found
at the tangency of the IQ for q units of output and the lowest possible Isocost.

The optimal choice is L’, K’. The minimum cost of producing q is C2.

C1

C3

C2

q0

L
’
L

24
D. Firm’s Expansion Path

• The firm can determine the cost-minimizing combinations of L and K

for every level of output

• If input costs remain constant for all amounts of L and K the firm may
demand, we can trace the locus of cost-minimizing choices

– called the firm’s expansion path

The expansion path is the locus of cost-minimizing tangencies. The curve

shows how inputs increase as output increases.

q2

q1

q0
L

• The expansion path does not have to be a straight line

– the use of some inputs may increase faster than others as output
expands, it depends on the shape of the isoquants

• The expansion path does not have to be upward sloping

– if the use of an input falls as output expands, that input is an

inferior input

25
Cost Minimization Example
0.5 0.5
Cobb-Douglas technology q = f(L,K) = L K

FOCs require that:

w
MRTS LK = and q = f(L,K)
r

0.5 K 0.5
MPL K 0.5 0.5
= L 0.5 =
0.5
where, MRTS LK = and f(L,K) = L K .
MPK 0.5 L L
K 0.5

Therefore, need that K w w

= ⇒ K = L . This is the equation
L r r
of the firm’s EP. Substituting in the output constraint, we have that

0.5 0.5 0.5

w w r
q=L K 0.5 0.5
= L ⎛⎜ L ⎞⎟
0.5
⇒ q = ⎛⎜ ⎞⎟ L ⇒ Lʹ′ = ⎛⎜ ⎞⎟ q
⎝ r ⎠ ⎝ r ⎠ ⎝ w ⎠

0.5 0.5
w w r w
K ʹ′ = Lʹ′ = ⎛⎜ ⎞⎟ q ⇒ K ʹ′ = ⎛⎜ ⎞⎟ q
r r ⎝ w ⎠ ⎝ r ⎠

The firm’s cost function is then

0.5 0.5
r ⎛ w ⎞ 0.5 0.5
C = wLʹ′ + rK ʹ′ = w ⎛⎜ ⎞⎟ q + r ⎜ ⎟ q = ( wr ) q + ( wr ) q
⎝ w ⎠ ⎝ r ⎠

0.5
⇒ C = 2 ( wr ) q

• This production function is homothetic

– the MRTSLK depends only on the ratio of the two inputs

– the expansion path is a straight line
– cost function is homogeneous of degree 1
– cost function is linear in output

26
Total Cost Function

• The total cost function shows that for any set of input costs and for any
output level, the minimum cost incurred by the firm is

C = wL’ + rK’ = wL(w,r,q) + rK(w,r,q)

⇒ C = C(w,r,q)

Average Cost Function

• The average cost function (AC) is found by computing total costs per
unit of output
C ( w, r , q)
AC = AC ( w, r , q) =
q

Marginal Cost Function

• The marginal cost function (MC) is found by computing the change in

total costs for a change in output produced

∂C( w,r ,q )
MC = MC( w,r ,q ) =
∂q

Shifts in Cost Curves

• The cost curves are drawn under the assumption that input prices and
the level of technology are held constant

– any change in these factors will cause the cost curves to shift

– the size of the shifts will be determined by the overall importance

of the input and the substitution abilities of the firm

Later, we will assume input prices w and r to remain constant, thus total cost
functions will simply depend on output level q.

27
 Graphical Analysis of Total Costs

1. With constant returns to scale production function, total cost function is

linear in output – total costs increases with output at a constant rate, with
input prices constant .

Since MC is the slope of the C curve, then it must be that MC is a constant

when C is linear in q. In this case, AC = MC and both AC and MC will be
constant.
C

0.5 0.5
Example: q = f(L,K) = L K

Earlier, we showed that this production function exhibits constant returns to

0.5
scale. We derived the total cost function as C = 2 ( wr ) q . With w and r
constant, total cost C is linear in q,

0.5 0.5
AC = 2 ( wr ) and MC = 2 ( wr )

Note that AC = MC and both unit costs are constant, independent of the
output level. For example, say w = r = 4, then C = 0.8q . AC = 8 = MC.

28
2. With increasing returns to scale production function, total cost function is
strictly concave in output – total costs increases with output at a
decreasing rate .

∂ 2C
Since C increases with q at a decreasing rate, then < 0.
∂q2
⎛ ∂C ⎞
∂ ⎜⎜ ⎟⎟
⎝ ∂q ⎠ = ∂MC < 0 . That is, MC decreases as q increases.
2
However,
∂ C
=
∂q 2 ∂q ∂q

In this case, we can show that AC also decreases as q increases, but AC > MC
for all q.

C
Proof: Recall that AC = , where C = C(w,r,q). The slope of AC is
q
∂C ∂C C
q −C
∂AC ∂q ∂q q ∂AC MC AC
= = − ⇒ = −
∂q q 2 q q ∂q q q
⎛ ∂AC ⎞
⇒ AC = MC − ⎜ ⎟ ⋅ q
⎝ ∂q ⎠
∂AC
When AC decreases with q, < 0. ⇒ AC > MC for all q > 0.
∂q

29
Graphically,

MC,
AC

AC

MC

2 2
To Do: Verify using the production function : q = f(L,K) = L K

30
3. With decreasing returns to scale production function, total cost function is
strictly convex in output – total costs increases with output at an increasing
rate .
C

q
∂ 2C
Since C increases with q at an increasing rate, then > 0.
∂q2

∂MC
This implies that > 0 . That is, MC increases as q increases.
∂q

In this case, we can show that AC also increases as q increases, but AC < MC
for all q.

⎛ ∂AC ⎞
Recall that AC = MC − ⎜ ⎟ ⋅ q .
⎝ ∂q ⎠

∂AC
When AC increases with q, > 0. ⇒ AC < MC for all q > 0.
∂q
Graphically,

31
 MC,
AC MC
AC

0.4 0.4
To Do: Verify using the production function : q = f(L,K) = L K

4. Cubic Production Function

In this case, the total cost function will be cubic as well: Total costs start out
as concave and then becomes convex as output increases.

– one possible explanation for this is that there is a third factor of

production that is fixed as capital and labor usage expands

– total costs begin rising rapidly after diminishing returns set in

32
C
C

In the range of q for which C is concave, MC is decreasing. In this output

range, AC is also decreasing and AC > MC.

At the inflection point of C, MC is at its minimum.

In the range of q for which C is convex, MC is increasing. In this output range,

AC is also increasing and AC < MC.

These suggest that both AC and MC are U-shaped curves.

33
AC, MC

MC

AC

minimum

Note: When AC is at a minimum, its slope is zero. Recall that

⎛ ∂AC ⎞
AC = MC − ⎜ ⎟ ⋅ q .
⎝ ∂q ⎠

∂AC
When AC is at a minimum then = 0. ⇒ AC = MC.
∂q

34
Contingent (Conditional) Demand for Inputs and Shephard’s Lemma

• Contingent demand functions for all of the firms’ inputs can be derived
from the cost function using Shephard’s lemma

• the contingent demand function for any input is given by

the partial derivative of the total-cost function with respect
to that input’s price

∂C( w ,r ,q ) ∂C( w ,r ,q )
Lc ( w ,r ,q ) = and K c ( w ,r ,q ) =
∂w ∂r

Short-Run, Long-Run Distinction

• In the short run, economic actors have only limited flexibility in their
actions

• Assume that the capital input is held constant at K0 and the firm is free
to vary only its labor input

• The production function becomes q = f(L,K0)

Short-Run Total Costs

• Short-run total cost for the firm is

SC = wL + rK0

• There are two types of short-run costs:

– short-run fixed costs are costs associated with fixed inputs (rK0)

– short-run variable costs are costs associated with variable inputs

(wL)

35
• Short-run costs are not minimal costs for producing the various output
levels

– the firm does not have the flexibility of input choice

– to vary its output in the short run, the firm must use nonoptimal
input combinations

– the MRTSLK will not be equal to the ratio of input prices

Since capital is fixed at K0, the firm cannot equate MRTSLK with the ratio of
input prices

K0

q2
q1

q0
L
L1 L2 L3

36
 Short-Run Marginal and Average Costs

• The short-run average total cost (SAC) function is

SAC = SC/q

• The short-run marginal cost (SMC) function is

SMC = ∂SC/∂q

Relationship between Short-Run and Long-Run Costs

The long-run C curve can be derived by varying the level of K

SC (k2)
Total
SC (K1)
costs C

SC (K0)

q
q0 q1 q2

37
 The geometric relationship between short-run and long-run AC and MC
can also be shown

Costs

SMC (K0) SAC (K0) MC

AC
SMC (K1) SAC (K1)

q
q0 q1

• At the minimum point of the AC curve:

– the MC curve crosses the AC curve

• MC = AC at this point

– the SAC curve is tangent to the AC curve

• SAC (for this level of k) is minimized at the same level of output as AC

• SMC intersects SAC also at this point

AC = MC = SAC = SMC

38
Short Run Cost Function Example

A firm’s long-run production function is q = L0.5 K 0.5 . Suppose the level of K is

fixed at K0 units in the short-run. Further assume that capital costs ₧4 per
unit, and labor costs ₧4 per unit.

1. Find the equation of the firm’s short-run cost function. Show your work
including the necessary explanation of how you arrived at your answer.

Since K = K0, then the firm’s SR production function is q = L0.5 K 00.5 .

Therefore, the optimal L in the short-run is

q q2
L0.5 = ⇒ Lʹ′ʹ′ =
K 00.5 K0

4q2
Thus, SRC = wLʹ′ʹ′ + rK 0 = 4 Lʹ′ʹ′ + 4 K 0 ⇒ SRC = + 4K0
K0

2. Derive the firm’s long-run cost function from the short-run cost
function you found in part (1). Show your work including the necessary
explanation of how you arrived at your answer.

The SRC minimizing amount of capital satisfies the FOC for a

∂SRC
minimum SRC which is = 0 . Therefore,
∂K 0

q2 q2
−4 +4=0 ⇒ =1 ⇒ K 02 = q 2 ⇒ K0 = q
K 02 K 02

4q 2
Therefore, SRC = + 4q = 8q = LRC ⇒ LRC = 8q
q

39
 1

THEORY OF MARKET STRUCTURE

I. PERFECT COMPETITION

A. AssumPtions

1. Atl firms produce homogenous/identicalproduct'

view in that there
consumers are identical from the sellers' point of
selling to a
are no advantagesor disadvantagesassociatedwith
particular customer
purchasesof each
2. Numerous buyers and sellers,and the salesor
to the aggregateor
individuat unit (buyer or seller) are small relative
market volume of transactions'
about the
3. Both buyers and sellers possesperfect information
of every
prevailing price and current bibs, and they take advantage
opportunify to increaseutilify and profits respectively'
firms and consumers
4. Entry into and exit freirfi the market is free for
in the long run

I3. Implications of,AssurnPtions

Asstn 1 ensuresanonym'ity of firms and consurners'

patents, etc' don't exist
For firms: trademarks, special brand labels,
{irxn to that of
:t consumersb,aven0 reason to prefer the product of trne
the other
vritr!sell to the highest
For consumers: becauseof nnifarmi-ff, a firrn
bidder
as
I custom or rnstitutional rules of thumb s'uch "first-come-first-
don't exist'
served, rule for distributing output among consumers
Asstn 2 ensuresthat many sellersface many buyers.

With many firms: individual firm can decreaseor increaseits output

level (sripply) without any significant effect on the market price.

With many buyers: an individual consumermay decreaseor increaseits

demand without any significant effect on the market price.

+ both individual firm and individual buyer acts as if he had no

influenceon price and merely adjusts to what he considersa given
market situation.

i buyers are price takers in that they adjust the quantities they buy
such that thesequantities will give them maximum utilify given the
prevailing market price, without ever consideringthat their purchases
ffiay, in turn, further affect the price

:+ sellerstake the market price as given and adjust their quantities sold
such that thesequantities are profit maximizing given the market price
without considering that their salesmight affect the price

Ass'n 3 guaranteesperfect information on both sidesof the market.

9 buyers and sellers possesscomplete information on the quality'

nature, and prevailing price of the product

+ sellers cpnnot attempt to charge more that the prevailing price

:+ consumerscannot buy at lessthan the prevailing price

+ since the product is homogenousand everyonehas perfect

information, a single price must prevail in a competitive market

= identical products must sell at identical prices

(Law of One Price)
Asstn 4 ensuresunrestricted flow of resourcesbetweenalternative
employments in the long run.

=) assurilesthat resourcesare mobile and always move into occupations

from which they derive the g"*t"r-dvantageireturn)

= firms move into markets where they can make prolits and
Ieavethose in which they incur losses

= labor resourceswill be attracted to industrieswhoseproducts

are in great demand

:+ inefficient firms are eliminated from the market and renlaced

by efficient ones

NorE: Ass'ns 1to 4 irnply that the market price and its magnitudeare
determinedjointly by the actionsof ail buyers and all sellers(i.e.,by
both market demand and market supply).

C. Market Demand Function for a Good

u Market demand - demand curve faced by alt sellersaltogether

I obtained by summing up the (Marshailian) demand functions of

individual consumers

Individual consumerh's demand function for good i is obtained from

his FOCs for utility maximization, i.e.,

xl = xl(p,,...,p",mn)

Note that here, the consumeris assumedto take the prices of the
goodsas given and will react to a price changeby changinghis
demand for the good.

By the property of Marshalliandemand, ' +.0 assuminggoodi is

0p,
viewed by individual h as normal or inferior but not Giffen.
 Say,we want to isolate the behavior in the market for good i only'
then assumeall other prices and consumerh's income constant.

= *l = *l(p,)

Now, omitting the commodity subscript i, we get xn = *n(p )

Assumethere are H individual consumers,then

eo= I*'b)= eo(p)

h=l

Since u3o.o.
+.o,then
op op

This implies that the market demand curve faced by the aggregateof
all sellers of a good is @.

D. Demand Curve Facedby a Single/IndividualFirm (Firm's Demand

Curve)

Since an individual firm's size is small relative to the market, it doesnot

face the entire market demand function.

An individual firm's demand function reflects its assumption that it can

sell all it desiresat a going market price.

Thus, for a single firm the demand curve is horizontal and peggedat a
going market price, i.e a horizontal line given by p = constant,where the
constant is the prevailing market price p y. Graphically'
 5

Individual firm's total revenue: R - pq

. where q - film's outPutlevel

p - givenmarket price

Individualfirm's marginalrevenue: MR=+=Pr 2s p is a constant

dq

Thus, for a perfectly competitive firm, MR = p

=) firmts MR curve = firmts demand curve

E. Short Run SupplyFunction

1. IndividualFirm's SR SupplyCurve

Obtainedfrom the FOC of profit maximization,assuminginput prices

are fixed and capitalinput K is fixed at someconstantlevel,and
assumingthe SOCfor a maximumis satisfied.

Considera singlefirm's Problem.

max n=R-SRC=pq-SnC(q)
q

(a)FOC:
\/ 9=u-uTt=o
^ + p-SMC=Q + p=SMC'''i
dq dq

Since SMC = SMC(q), then we can solve the FOC for q which gives

q.: q(p)

(b) The SOC for a maximum profit requires that

d ' n_ _ d 2 s R c = _ d s M C . o dsMC>o
+
dq' dq' dq dq

+ SMC curve must be unward slonins

(c) In addition, the firm needsto satisfy a profitabilitv criterion.

When p.< minimum AVC, the firrn will incur a losssuch that n < - FC.
Thus the firm will maximize profit by producing q = 0 since in this case
n: - FC.

Therefore, when the three conditions (a), (b), and (c) are satisfied, the
firm's supply function is given by

q. = q(p) for p ). minimum AVC

q*=o forp<minimumAVC

Graphically, supposethe firm has cubic SRC function, then

5/rAC
gts sA o
h'tu
\

?" dt
J,
f>
I'

$'ttx
If the firm does not have cubic SRC function, then
es' t$u

I lfio
d{

01"t)q
That is, the firm's SR supply curve is identical with that portion of its
SMC curvewhich lies aboveits AVC curvefor p > minimum AVC.
Thus,for p ) minimum AVC,' dIp t o= SR supplycurveis upward
sloping.A firm will supply more quantity of output at higher prices
since the firm can realize higher profits at higher prices and the firm is
a profit maximizer.

2. Market Supply Function

Obtained by summing up the individual firm's supply curvesat the

alternative prices.

That is, assumingthere are a total of F firms in the market

e' = Iq'(p)=q'(p) for p > minimum AVCi do

h=l

Qs=0 for p < minimum AVCi do

where qt is the supply of the t'o firm and minimum AVCr'*o is the value
of the minimum AVC of the firm with the lowest minimum AVC among
all firms in the market.

F
Graphically, f slrc'
f=l

a
Examples:

(1) Considerthe SRC of the t'o firm (drop subscriptfor convenience)

SRC= o.lq'- 2q'+15q+10.

(a) Find the SR supply function of the individual firm.

(b) Supposethat the market is composedof 100 firms with identical SR
cost functions as the firm above.Find the market SR supply
function.

(2) Consider the SRC of the t'o firm (drop subscript for convenience)

SRC-0.01q2+16

(a)Find the SR supply function of the individual firm.

(b)Supposethat the market is composedof 100 firms with identical SR
cost functions as the firm above.Find the market SR supply
function.
 F. Short Run Market Equilibrium

The market forcesas manifestedin aggregate(market)

demandand
aggregate(marke!) sunnlvfor a gooddete-rmine
the market price and
quantity sold by all firms.

In general,the slopeof market demandis negativ.

fg < ol while the
\op )
SR marketsupptycurye,sslopeis positiv.
|.g, 0].
\op )
An equilibrium price-quantity combination
must satisfy both the
market demand and market suppry functions,
and sincethe good is
homogenous,a single market p"i.. must prevail.

At equilibrium,

eo=e' => q"(p)-a'6)

' This can be solvedfor p, such that p = p. = market
equilibrium price.
Now,the marketequilibriumquantityis thus
a"(p")_a'(p")=e(p")=e..
Bxample:

Market demand: eo : - 50p + 2sa sR market

suppry: er = (100i3)p

eo = e' :) _ 50p + 250: (f 00/3)p

solving for p we get, p':3. To get market equ'ibrium quantity,

Qo=-50(3) +250=100 or

Qt=(100/3)(3)=100

Thus, Qo = Qs= 100= e..

Graph.
 10

G. Long Run SupplyCurve

1. IndividualFirm's Long Run Supply

- obtainedfrom firm's LR profit maximizationFoCs assuming

SoC
is satisfiedwhen all inputs are variable

max n=R_LRC=pq_lnC(q)
q

(a)F'OC:*=o-u1*"=o :+ p-LMC=Q = p:LMC

dq^dq

since LMC = LMC(q), thenwe can solvethe Foc for q which gives
*
q = q(p)

(b) The SOC for a maximum profit requires that

=) LMC curve must be upward sloping

(c) Additional condition for lirm to produce a positiveoutput is

p=LMC>LAC,nio =) p>LAC

If p < LAC then the optimal output is q* : g.

 11

2. Long Run Market Suppty (No entry and exit)

Obtained by summing up the individual firm's supply curves at the

alternative prices.

That is, assuming there are a total of F firms in the market

Q' = lq'(p)= q'(p) ror p > LAcr'-i"

h=1

Qt =0 for p < LACr'-io

where qt is the supply of the fo fi"m and minimum LACr'du is the value
of the minimum LAC of the firm with the lowest minimum LAC among
all firms in the market.

In the absenceof entry and exit, the LR market supply curve is upwarcl
. aos>
sloping,i.e., | 0.
op

3. Long Run Market Supply (with free entry and exit) and Long Run
Competitive Equilibrium

(a) Constant Cost Industry

If the capital size (K) is variable, the equilibrium of EXISTING firms in

the market is given by the intersectionof the LR market supply curve
with the correspondingmarket demand curve.

Note that an individual firm's LRC and therefore the LR market supply
curve include a ttnormal profittt, i.e., the minimum renumeration
necessaryfor the firm to remain in the market.

Normal profit is that profit that accruesto the entrepreneuras payment

for managerialservices,for providing organization,for risk-bearing,
etc. and for the opportunity cost of inputs owned by the entrepreneur
but usedin the production of the firmos product.
 T2

Economicprofit: Total Revenue- EconomicCosts

: Total Revenue- AccountingCosts- Opportunity
Costsof Entrepreneurship
= Total Revenue- AccountingCosts- Normal Profit

If there are no incentivesfor profit maximizingfirms to enter or exit the

industry, then the market is saidto be in LR equilibrium.

This will occurwhen the numberof firms in the marketis suchthat

P: LMC = LAC

and eachfirm operatesat the minimum point of its LAC curve.

This impliesthat at LR equilibrium,EconomicProfit = 0.

If the intersectionof the market demandand LR market supplycurves

occursat a price,sty pl, at which existingfirms in the industiy earn
more than normal profit (Economicprofit t 0), NEW firms may be
inducedto enterthe market.

.As**

,1,
(3

{
q* d,*r

representativefirm market
 l3

The assumption of free entry guaranteesthat new firms are able to

enter the industry, produce the samehomogenousproduct, and possess
the same complete information as the old/existing firms.

The new firms will add their supplies to the already existing supply, and
as a result the LR market supply will shift to the right.

New firms will continue to enter as long as they can make positive
Economic profits and the LR market supply will continue to shift to the
right until it intersectsmarket demand at a price, say p , at which new
entrants would earn ZERO Economic profits.

Assumea constantcost industry. That is, the entry of new firms does
not raise the input prices nor causeexternal coststo the existingfirms
(and new entrants) such as pollufion costs.Then the cost curyes of each
firm, existingand new, will not shift as new firms enter the industry.

When Economic profit = 0, eachfirm in the industry earns only the

normal profit and there is no more incentivefor new firms to enter the
industry.

At p., the market is saidto be in LR equilibrium.

Let the LR supplyof the t'hfirm b" qt= qtp).

Let n = numberof firms in the industry.

Assuminsthat all firms are identicalwith respectto their costfunctions,

the LR market supplycurveis

et = nqr= nqtp)= es(p) (A)

As before, market demand is Qo = Qo(p) (B)

LR market equilibrium requires that for eachfirm

nt: pqr- LRC(q) = o (C)

Note: With our aboveassumptionqr = Qt .

n
 t4

Equations (A), (B), and (c) can be sorvedfor the variables t),
eo(o. qr, p,
and n.

Thus, in the LR, with free entry and exit, forces of perfect competition
determine not only the market price and quantity but the numiler of
firms within the industry as well.

G.raphically,Economic profit:0 for a representativefirm at p* when at

p p: LMC = LAC_io.

optimalify is ensuredas p = LMC while Economic profit: 0 as p - AC.

In the graph, the curryeLRs includessupply by existingfirms only.

Hence, in this casen is fixed.

New entry phifts LRS to the right up to LRS.. Thus the market supply
curve LRS. includessupplies&existing and new firms which is the
relevant curve after new firms have entered.

LRS" is obtained from equation (C) bV letting p = LAC,6. and n is

allowed to vary.

Now, supposethe market demand increasesand the market demand

curve shifts to the right. Further assumethat entry is free and entry
doesnot alter the costsfor a fypical firm. This implies that the typical
firm's cost curves do not shift and thus the position of LAC",I, is
unchanged.

The new market price, p2, is thus the intersection of the new market
demand and the market supply curve LRS.. Howeverr tt p2ra fypical
firm realizes positive Economic profit. This induces entry of new firms
into the industry. Consequently,the curve LRS* shifts to tne right until
it intersect the new market demand curve at atprice such that Jach firm
earns only a normal profit. In our example, this occurs when the LRS.
curve has shifted to the right until it intersectsthe new market demand
curve at the price p", when again eachfirm earns Economic profit = 0
and there is no more incentive for new firms to enter. In this casethe
market is in LR equilibrium.
 t5

Now, with free entry and exit the LR market supply curve (defined as
supplies of existing and new firms) is obtained as the locus of points of
market price and market quantity in which the market is in LR
equilibrium.

since the position of the LACmioof all firms doesnot changewith entry
or exit per assumptionof constantcost industry, then only one price can
prevail in the LR regardlessof how market demand shifts.

In this casethe LR market supply curye (with entry and exit) is

HORIZONTAL at this price, p*.

When the industryis a constantcostindustry,entry or exit of firms does

not affectinput costs.The LR marketsupplycurveis horizontalat the
uniqueLR equilibriummarketprice.

However,the LR market supplycurve is not alwaysupward slopingif

firms do not haveidenticalcostfunctionsand externaleconomiesor
externaldiseconomies causeexistingand new entrantfirmst costcurryes
to change.

(b) IncreasingCostIndustry

Entry increasesinput costsfor both entrantsand existingfirms.

whv?
New and existingfirms competefor scarceinputs thus driving input
prices up.

In addition, it is possiblethat new firms impose66external costs,,on

' existingfirms and themselves,such as air
or water pollution.

Also, new firms may placestrains on governmentalservices(police

forces,sewagetreatment plants, etc.)which may show up as increased
cost for all firms.

In this case,the LR market suppty curve is positively sloped.

 t6

(c) DecreasingCostIndustry

Entry of new firms reducesinput costs.

whv?

Expansionof industry's output may lead to a better trained and more

efficient labor force with a consequentreduction in the costsof the fh
entrant firm for the same output level for this firm.

In this case,LR market supply curve is negativelyslopedif the cost

reductionsdue to expandingindustry output are sufficiently large to
offset the cost increasesdue to expandingfirm outputs (due to rise in
input costs.)

H. Example

(1) A fypical firm in a competitivemarket has the Long Run Cost

function given by LRC = l0 + 2.5q'. Assumethat firms in this industry
have identical cost functions.Further assumethat the market is a
constantcost industry. The market demand curve is Qo = 200-2p.

Questions:
a. Find the typical firm's LR supply function assumingno entry.
b. Supposethere are 15 existing firms before entry of new firms. Find
the LR market supply function.
c. Compute for the LR market price and market quantity assumingno
entry. How much doeseach firm produce? What is profit amount
does.eachof the existing firms reahze?What doesthis indicate?
d. Supposethat entry is allowed. What are the market price and
quantity in long-run equilibrium? How many firms are there and
how much doeseachproduce?
€. Graph your rdsults.
 t7

(2) A typical firm in a competitive market has the Long Run cost
function given by LRC = q3- 20q2+100q+ g000.Assumethat firms in
this industry have identical cost functions. Further assuruethat the
market is a constantcost industry. The market demand curve is
Qo=2,500-3p.

Questions:
f. How much will each firm produce in long-run equilibrium?
g. what are the market price and quantity in long-run equilibrium?
How many firms are there and how much doeseachpioduce?
h. Supposethat the industry is in long run equilibrium thut yo,r found
inlart (a). Further supposethat the market demand shifis our to
Qo:3,000-3p.
(i) In the long run, when the number of firms is fixed at your
answer to part (a), what are the market price and quantity in
short run equilibrium? How much profit doeseachfirm earn
in the short run?
(ii) In the long run, what are the equilibrium market price and
quantity given the new market demand curve? How many
firms are there and how much doeseachfirm produce?
Short-Run Perfectly Competitive Partial Equilibrium Examples

Short-Run Equilibrium Example 1:

A firm sells its output in a perfectly competitive market. The firm’s short-run
cost function is given by SC = 0.1q 3 − 2q 2 + 15q + 10 .

1. Find the short run supply function of a typical firm in this industry. Show
that the FOC and SOC for a maximum as well as the profitability
criterion are satisfied by this function.

FOC: p = SMC
Since SMC = 0.3q 2 − 4q + 15 . Given the price p, then the FOC requires that

p = 0.3q 2 − 4q + 15 ⇒ 0.3q 2 − 4q + 15 − p = 0

In this case, we can solve for q using the quadratic formula.

2
− ( −4 ) ± ( −4 ) − 4 ( 0.3 )(15 − p ) 4 ± 1.2 p − 2
q= =
2 ( 0.3 ) 0.6

Thus, q = 6.67 ± 1.67 1.2 p − 2

dSMC dSMC
SOC: > 0, = 0.6q − 4 .
dq dq
dSMC
Note that > 0 only when 0.6q − 4 > 0 ⇒ q > 6.67 .
dq
Therefore, the SOC will be satisfied only for q > 6.67

Profitability: p ≥ min AVC

VC = 0.1q 3 − 2q 2 + 15q so AVC = 0.1q 2 − 2q + 15 .

Since the minimum AVC occurs at the point at which AVC = SMC, then AVC is
minimum at 0.1q 2 − 2q + 15 = 0.3q 2 − 4q + 15 or 0.2q 2 − 2q = 0 ⇒ 0.2q 2 = 2q which
yields q = 10.
If we substitute q = 0 in the equation of AVC, we find that the minimum value of
2
AVC is min AVC = 0.1 (10) − 2 (10) + 15 ⇒ min AVC = 5
Therefore, profitability criterion requires that p ≥ 5 .
In summary,

The FOC requires that q = 6.67 ± 1.67 1.2 p − 2

The SOC has the SOC will be satisfied only for q > 6.67
The profitability criterion requires that p ≥ 5

Given these three conditions, then the firm’s short-run supply function is

q = 6.67 + 1.67 1.2 p − 2 for p ≥ 5

q=0 for 0 ≤ p < 5

2. Since firms are identical, then the market supply function is

(
Q = 100q = 100 6.67 + 1.67 1.2 p − 2 ) ⇒ Q = 667 + 167 1.2 p − 2 for
p≥5
Q = 100 ( 0) ⇒ Q=0 for 0 ≤ p < 5
Short-Run Equilibrium Example 2:

A firm sells its output in a perfectly competitive market. The firm’s short-run
cost function is given by SC = 0.5q 2 + 20q + 200 .

1. Find the short run supply function of a typical firm in this industry. Show
that the FOC and SOC for a maximum as well as the profitability
criterion are satisfied by this function.

FOC: p = SMC
Since SMC = q + 20 . Given the price p, then the FOC requires that

p = q + 20 ⇒ q = p − 20

dSMC dSMC dSMC

SOC: > 0, = 1 > 0 for all q > 0, since is constant for all q.
dq dq dq
Hence, the SOC is satisfied for all q including the q calculated using the FOC.

Profitability: p ≥ min AVC

VC = 0.5q 2 + 20q so AVC = 0.5q + 20 .
Since the minimum AVC occurs at the point at which AVC = SMC, then AVC is
minimum at 0.5q + 20 = q + 20 or q = 0.
If we substitute q = 0 in the equation of AVC, we find that the minimum value of
AVC is min AVC = 0.5 ( 0) + 20 ⇒ min AVC = 20
Therefore, profitability criterion requires that p ≥ 20 .

In summary,

The FOC requires that q = p − 20

The SOC has been shown to be satisfied for q including the q calculated
using the FOC
The profitability criterion requires that p ≥ 20

Given these three conditions, then the firm’s short-run supply function is

q = p − 20 for p ≥ 20
q=0 for 0 ≤ p < 20
 2. Assume that there are 40 identical firms in this industry. What is the short
run market supply function?

Since firms are identical, then the market supply function is

Q = 40 ( p − 20 ) ⇒ Q = 40 p − 800 for p ≥ 20
Q = 40 ( 0) ⇒ Q=0 for 0 ≤ p < 20

3. Currently, the market demand for these firms’ product is Q = 1, 000 − 2 p .

Determine the short run equilibrium market price.

SR equilibrium market price satisfies Market Demand = Short Run Market Supply .

Therefore, at Short Run Market equilibrium

1,000 − 2 p = 40 p − 800 ⇒ p = 42.86

4. How much does each firm produce in the short run? How much profit
does each firm make? Is there an incentive for new firms to enter the
market? Why or why not?

Since p = 42.86 > 20, then q = 42.86 − 20 ⇒ q = 22.86

π = R − SRC = pq − SRC = 42.86 ( 22.86 ) − ⎡ 0.5 ( 22.86 ) + 20 ( 22.86 ) + 200 ⎤
2

⎣ ⎦
⇒ π = 61.29
Since π = 61.29 > 0, each firm is currently realizing positive economic profits
and this provides an incentive for new firms to enter the market.
Perfectly Competitive Partial Equilibrium

Long Run Equilibrium Example 1

A typical firm in a perfectly competitive market has a long run cost function
given by LRC = q3 − 4q2 + 8q . Assume that firms in this industry have identical
cost functions. Further assume that the market is a constant cost industry.
Currently, market demand in this industry is Q = 1,000 − 100 p . Suppose entry
and exit are allowed.

1. How much output will each firm produce in long run equilibrium?

Since the problem assumes that the market is a constant cost industry, then
entry of and exit of firms will leave a typical firm’s LRC function above
unchanged. Therefore, as new firms enter, the LMC and LAC curves will be
unchanged.

In long-run equilibrium, each firm produces output such that

p = LMC = LAC (which are required by the FOC for a maximum profit and the
dLMC
profitability criterion) and > 0 (which is required by the SOC for a
dq
maximum profit).

This condition necessary requires that the output produced by the firm is such
that
LMC = LAC.

Now, LRC = q3 − 4q2 + 8q ⇒ LAC = q 2 − 4q + 8 and LMC = 3q 2 − 8q + 8

Since the minimum LAC occurs at the point at which LAC = LMC, then LAC is
minimum at q 2 − 4q + 8 = 3q 2 − 8q + 8 ⇒ 2q 2 = 4q which yields q = 2.
Therefore, at long-run equilibrium, each firm produces q = 2.

dLMC
Note that = 6q − 8 = 6 ( 2 ) − 8 = 4 > 0 , thus q = 2 satisfies the SOC for a
dq
maximum profit.
2. What is the long run market equilibrium price and output?

Since long-run equilibrium, requires that p = LMC = LAC, then

if we substitute q = 2 in the equation of LAC (or LMC) we find that

2
LAC = ( 2) − 4 ( 2) + 8 = 4
⇒ p=4

Therefore, the long-run equilibrium market price is p =4.

The long-run market equilibrium output can be obtained using the market
demand function.

Therefore, Q = 1, 000 − 100 ( 4) ⇒ Q = 600 .

3. How many firms are there in long run equilibrium?

Since all firms have identical cost functions, they must have identical output
supplied. Therefore, the total long-run equilibrium market output Q* = F × q*
⇒ F * = Q* q* .

Q 600
Therefore, F = = ⇒ F = 300 .
q 2

4. Suppose the industry is in long run equilibrium that you found in part (1).
Assume that the market demand shifts to Q = 3 , 000 − 100 p .

a. How much output will each firm produce in long run equilibrium?

Since only market demand has changed, then the LRC and therefore the
corresponding LAC and LMC curves will be unchanged. In this case, the output
at which a typical firm’s LAC will be minimum will be unchaged. Hence, at the
new market demand the long-run equilibrium output of each firm in the
industry remains at q = 2.
 b. What is the long run market equilibrium price and output?

Since long-run equilibrium requires that each firm produce at p = LMC = LAC,
and since it is assume that the industry is a constant cost industry, each firm’s
long-run cost function remains unchanged and LMC = LAC = 4 when each firm
produces q = 2. Then the long-run equilibrium market price remains unchanged
at p = 4.

The long-run market equilibrium output can be obtained using the new market
demand function (not the old market demand function, since market demand
has shifted). Therefore, Q = 3 , 000 − 100 ( 4) ⇒ Q = 2 , 600 .

c. How many firms are there in long run equilibrium?

Since firms have identical cost functions, they must have identical output
supplied. Therefore, the total long-run equilibrium market output Q* = F × q*
Q 2 , 600
⇒ F * = Q* q* . Therefore, F = =
q 2
⇒ F = 1, 300.

This implies that 1,000 new firms entered the market (1,300 – 300).

Long Run Equilibrium Example 2

Assume a perfectly competitive market for umbrellas. Firms have identical long
run cost function given by C = 200 + 20q + 0.5q2. The firm only incurs the 200
“fixed cost” if it produces a positive output, otherwise the long run cost is zero if
the firm does not produce any output. Market demand for umbrellas is QD =
1,000 – 2p, where p is the price per umbrella. Currently there are 22 firms in the
industry. Suppose that that the umbrella market is a constant cost industry.
Assume entry and exit are allowed.
1. How much will each firm produce in long-run equilibrium?

LRC = 200 + 20q + 0.5q2 for q > 0 and LRC = 0 for q = 0; Q = 1,000 – 2p;

Now, LAC = 200/q + 20 + 0.5q

LMC = 20 + q
Conditions for long-run equilibrium are:

p = LMC = LAC ⇒ LMC = LAC

dLMC
and > 0.
dq

Given that LAC is quadratic in q, then LMC = LAC when LAC is at a minimum.
dLAC
LAC is at a minimum when = 0 . [Note: You can solve for the q for which
dq
LMC = LAC.]
dLAC −200
Now, = 2 + 0.5 = 0 ⇒ q = 20
dq q

dLMC
Now, = 1 > 0 for all q, including the q = 20 at which LAC is at a minimum.
dq
Thus q = 20 satisfies the SOC for a maximum profit.

2. Assume the umbrella market is a constant cost industry. What are the market
price and quantity in long-run equilibrium? How many firms are there?

The minimum LAC is LAC = 200/20 + 20 + 0.5(20) = 40.

Note that LMC = 20 + 20 = 40 = LAC.

At long-run equilibrium p = LMC = LAC. Thus, long-run market equilibrium

price is p* = 40.

The long-run market equilibrium output can be obtained using the market
demand function.

Therefore, Q = 1, 000 − 2 ( 40 ) ⇒ Q = 920 .

Since firms have identical cost functions, they must have identical output
supplied. Therefore, the total long-run equilibrium market output Q* = F × q*
⇒ F * = Q* q* . Therefore, F * = 920 20 = 46, there are 46 firms in the industry.
3. Suppose that the industry is in long run equilibrium that you found in part
(2). Also assume that the demand for umbrellas shifts out to Q = 1,600 – 2p. In
long run equilibrium,

a. What is the equilibrium market price? How much does each firm produce?

Since constant cost industry, the cost curves of each individual firm do not
change. Consequently, the conditions for long-run equilibrium do not change
and therefore the individual firm’s output and the market price remains the
same at p* = 40 and q* = 20, respectively.

b. How many firms are there?

As in part (2) F * = Q* q*
However, at equilibrium, Q* = 1600 − 2 ( 40) = 1, 520
Therefore, F * = 1, 520 20 = 76 , there are now 76 firms in the industry.

Note: Each firm produces the same output before of q* = 20 but with more
firms producing this output (76 – 46 = 30 new firms entered the market).

4. Graph
 Perfect Competition, Profit Maximization, Input Demand and
Output Supply

• A firm’s output is determined by the amount of inputs it chooses to

employ

the relationship between inputs and outputs is summarized by the

production function q = f(L,K)

• Thus, a firm’s economic profit can also be expressed as a function of

inputs π (L,K) = pq – C = pf(L,K) – (wL + rK)

• Only the variables L and K are under the firm’s control

– the firm chooses levels of these inputs in order to maximize profits

while treating p, w, and r as fixed parameters in its decisions

• The first-order conditions for a maximum are

π ∂/∂L = p[∂f/∂L] – w = 0
π ∂/∂K = p[∂f/∂K] – r = 0

• A profit-maximizing firm should hire any input up to the point at which

its marginal contribution to revenues is equal to the marginal cost of
hiring the input

• These first-order conditions for profit maximization also imply cost

minimization: they imply that MRTSLK = w/r

• To ensure a true maximum, second-order conditions require that

π LL = pfLL < 0
π KK = pfKK < 0
π LL π KK - π LK2 = p2[fLLfKK – fLK2] > 0

1
 Since p > 0, SOCs require that

fLL < 0
fKK < 0
fLLfKK – fLK2 > 0

– capital and labor must exhibit sufficiently diminishing marginal

productivities so that marginal costs rise as output expands

– equivalent to the requirement that the production function f(L,K)

be strictly concave

• In principle, the first-order conditions can be solved for L and K to yield

the unconditional input demand functions

Labor Demand L* = L(w,r,p)

Capital Demand K* = K(w,r,p)

• These demand functions are unconditional

– they implicitly allow the firm to adjust its output to changing

prices

Output Supply Function

• A firm’s supply function shows its profit-maximizing output as a

function of the prices that the firm faces

( ) (
q* = f L* ,K * = f L ( w,r, p ) ,K ( w,r, p ) )
q* = q ( w,r, p )

Given specific values for the input prices r and w, then q* = q ( p ).

2
 This is the same firm’s supply function obtained using the two-step profit
maximization procedure.

• 1. Solve cost minimization problem minC = wL + rK s.t . q = q ( L,K )

L,K
The solutions are the conditional input demand functions:

L’ = L(w,r,q) and K’ = K(w,r,q)

which gives the cost function:

C' = wLʹ′ + rK ʹ′ = wL ( w,r,q ) + rK ( w,r,q ) = C ( w,r,q )

Given specific values for the input prices r and w, then C' = C ( q ) .

• 2. Solve profit maximization problem: max π = pq − C ( q ) .

q

The solution is the firm’s supply function q* = q ( p ).

Profit Function

• A firm’s profit function shows its maximum profit as a function of the

prices that the firm faces
( )
π * = pf L* ,K * − wL* − rK *
π* = pf ( L ( w,r , p ) ,K ( w,r , p ) ) − wL ( w,r , p ) − rK ( w,r , p )
π * = π ( p,r ,w )

• We can apply the envelope theorem to see how profits respond to

changes in output and input prices
∂π ( p,w,r )
= q ( p,w,r ) = q* supply function
∂p

∂π ( p,w,r )
= L ( p,w,r ) = L* unconditional demand for labor
∂w

∂π ( p,w,r )
= K ( p,w,r ) = K * unconditional demand for capital
∂r