Course: Advanced Macroeconomics (805)

Semester: Autumn, 2021

ASSIGNMENT No. 1
Q.1 In practice most of the firms apply average cost pricing rather than marginal cost pricing criterion.
Why?
While the sales tax impacts an inward shift within supply curve, it similarly has secondary impact on a product's
equilibrium price. The sales tax tends to increase goods' prices as it leads to a fall in equilibrium price. This
increases the equilibrium output of a product.
Fixed costs are expenditures that do not change regardless of the level of production, at least not in the short
term. Whether you produce a lot or a little, the fixed costs are the same. One example is the rent on a factory or
a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until
the lease runs out. Fixed costs can take many other forms: for example, the cost of machinery or equipment to
produce the product, research and development costs to develop new products, even an expense like advertising
to popularize a brand name. The level of fixed costs varies according to the specific line of business: for
instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business
can get by with almost no fixed costs at all if it rents trucks by the day when needed.
Variable costs, on the other hand, are incurred in the act of producing—the more you produce, the greater the
variable cost. Labor is treated as a variable cost, since producing a greater quantity of a good or service
typically requires more workers or more work hours. Variable costs would also include raw materials.
The relationship between the quantity of output being produced and the cost of producing that output is shown
graphically in the figure. The fixed costs are always shown as the vertical intercept of the total cost curve; that
is, they are the costs incurred when output is zero so there are no variable costs.
You can see from the graph that once production starts, total costs and variable costs rise. While variable costs
may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is
caused by diminishing marginal returns, discussed in the chapter on Choice in a World of Scarcity, which is
easiest to see with an example. As the number of barbers increases from zero to one in the table, output
increases from 0 to 16 for a marginal gain of 16; as the number rises from one to two barbers, output increases
from 16 to 40, a marginal gain of 24. From that point on, though, the marginal gain in output diminishes as each
additional barber is added. For example, as the number of barbers rises from two to three, the marginal output
gain is only 20; and as the number rises from three to four, the marginal gain is only 12.
To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The
single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep up, and run
the cash register. A second barber reduces the level of disruption from jumping back and forth between these
tasks, and allows a greater division of labor and specialization. The result can be greater increasing marginal
returns. However, as other barbers are added, the advantage of each additional barber is less, since the
specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
at the door will have less impact than the second one did. This is the pattern of diminishing marginal returns. As
a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may
even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In
this case, the addition of still more barbers would actually cause output to decrease.
This pattern of diminishing marginal returns is common in production. As another example, consider the
problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the
water that can be added to the land is the key variable cost. As the farmer adds water to the land, output
increases. But adding more and more water brings smaller and smaller increases in output, until at some point
the water floods the field and actually reduces output. Diminishing marginal returns occur because, at a given
level of fixed costs, each additional input contributes less and less to overall production.

Average Average
Fixed Variable Total Marginal
Labor Quantity Total Variable
Cost Cost Cost Cost
Cost Cost

1 16 $160 $80 $240 $5.00 $15.00 $5.00

2 40 $160 $160 $320 $3.30 $8.00 $4.00

3 60 $160 $240 $400 $4.00 $6.60 $4.00

4 72 $160 $320 $480 $6.60 $6.60 $4.40

5 80 $160 $400 $560 $10.00 $7.00 $5.00

6 84 $160 $480 $640 $20.00 $7.60 $5.70

Q.2 Contrast Baumol’s sales maximization theory of firm with Marris’s model of managerial enterprise.
Profit Maximisation. The most basic model of a firm assumes firms wish to maximise their profit. They will
do this by increasing revenue (price * quantity sold) and reducing costs. Higher profits enable a firm to pay
higher wages, more dividends to shareholders and survive an economic downturn. Many other objectives such
as corporate image an increasing market share can be a way to maximise long-term profit.
Growth Maximisation. An alternative to profit maximisation is for a firm to try and increase market share and
increase the size of the firm. They can do this by cutting price and increasing sales. Growth maximisation may
come at the expense of lower profits. For example, starting a price war can lead to lower profits but enable
higher sales. However, increasing market share can be a way to increase profits in the long-term. A firm like
Walmart and Amazon have often pursued this goal of maximising market share. It gives a strong position to
dominate the market in the future.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
Social / Ethical concerns. A firm may not be motivated by money but may seek to offer a service to the local
community. They may voluntarily take decisions which help the environment / local community.  Many big
firms now place a key role in promoting their ethical policies; arguably there may also be some marketing
benefits to promoting ethical and social concerns. It could have a tie-up with profit maximisation.
Corporate Image. Related to social/ethical concerns is the image/brand of a firm. It may wish to cultivate a
certain image and brand. Google – ‘do no evil. BP – “Beyond Petroleum”. Body Shop ‘leader in human and
animal rights.’ This corporate image may be part of a business strategy to maximise profits, but it could also be
a genuine desire to promote altruistic goals.
Stakeholders Well Being. A firm may also be concerned about the welfare of its stakeholders – suppliers,
workers and customers. For example, giving training and long-term job security to its workers. Co-operative
businesses are founded on the goal of sharing proceeds of business with whole community – customers and
workers.
Survival. For many businesses, it seems a matter of surviving – breaking even. In desperate times, firms may be
forced to sell off assets to keep their creditors at bay. For many small local businesses struggling in a highly
competitive market, survival may be the best they can hope for. In a way survival strategies is a form of profit
maximization as survival will still involve trying to increase revenue and reduce costs.
Another issue for firms is:
Profit Satisficing. This is a situation where there is a separation of ownership and control in a firm. The owners
(shareholders) wish to maximise profit, but the managers and workers don’t feel the same incentive. Therefore,
they do enough to keep the owners happy but then pursue other objectives such as having a good time at work.
Behavioural theories and objectives of firms
In recent years, behavioural economics has looked at psychological influences which can explain consumer
behaviour. Behavioural economics suggests economics has been too narrow in reducing owners to rational
profit maximisers. In the real world, profit is only one motivating factor. Business owners and workers may
value enjoying work, the prestige of a good company and make irrational decisions based on emotion, e.g.
keeping the family business going in one direction because of tradition.
Functional Objectives of Firms
A functional objective of a firm is achievable goals or targets of different parts of a business structure as it tries
to achieve wider business objectives.
Examples of Functional Objectives
 Minimise costs. This may involve better management of raw materials and supplies, e.g. implementing
just in time management and stock control.
 Raise profile of business. A successful marketing strategy to raise brand awareness and increase sales.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
 Improving Staff Loyalty and Motivation. Human resource department might find ways to promote a
greater feeling of worker loyalty and willingness to work for company. For example, giving workers
targets and rewards for achieving them. This can help the objectives of worker satisfaction and in the
long run, contribute to the improved performance of the firm.
 Development of Products. No market is static, therefore a firm will need to find ways to improve the
quality and uniqueness of its market.
 Increase Market Share. An objective may be to increase sales and take market share from other firms,
e.g. it may try and do this through a selective price war.
Functional Objectives and Business Strategies
To achieve functional objectives, a firm may use different business strategies. For example, if the firm has an
objective to reduce staff turnover, it may pursue a new strategy of employer feedback where the firm gives staff
the opportunity to have a say in the running of the business.
 An objective to increase sales could be achieved by a marketing strategy to raise brand awareness.
Functional Objectives and Corporate Objectives.
A corporate objective is something like profit maximisation or diversification of business. These objectives are
quite general. Functional objectives help these to become a reality. e.g. to achieve the maximum rate of return
for shareholders, firms may need practical functional objectives such as increasing sales.
Sometimes there is an overlap of objectives. For example, seeking to increase market share, may lead to lower
profits in the short-term, but enable profit maximisation in the long run.

Profit maximisation
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit means:
 Higher dividends for shareholders.
 More profit can be used to finance research and development.
 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers

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 Course: Advanced Macroeconomics (805)
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See more on: Profit maximisation
Alternative aims of firms
However, in the real world, firms may pursue other objectives apart from profit maximisation.
1. Profit Satisficing

 In many firms, there is a separation of ownership and control. Those who own the company
(shareholders) often do not get involved in the day to day running of the company.
 This is a problem because although the owners may want to maximise profits, the managers have much
less incentive to maximise profits because they do not get the same rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the shareholders happy, but then
maximise other objectives, such as enjoying work, getting on with other workers. (e.g. not sacking them)
This is the problem of separation between owners and managers.
 This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers share options
and performance related pay although in some industries it is difficult to measure performance.
 More on profit-satisficing.
2. Sales maximisation
Firms often seek to increase their market share – even if it means less profit. This could occur for various
reasons:
 Increased market share increases monopoly power and may enable the firm to put up prices and make
more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries.
 Increasing market share may force rivals out of business. E.g. the growth of supermarkets have lead to
the demise of many local shops. Some firms may actually engage in predatory pricing which involves
making a loss to force a rival out of business.

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 Course: Advanced Macroeconomics (805)
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3. Growth maximisation
This is similar to sales maximisation and may involve mergers and takeovers. With this objective, the firm may
be willing to make lower levels of profit in order to increase in size and gain more market share. More market
share increases its monopoly power and ability to be a price setter.
4. Long run profit maximisation
In some cases, firms may sacrifice profits in the short term to increase profits in the long run. For example, by
investing heavily in new capacity, firms may make a loss in the short run but enable higher profits in the future.
5. Social/environmental concerns
A firm may incur extra expense to choose products which don’t harm the environment or products not tested on
animals. Alternatively, firms may be concerned about local community / charitable concerns.
 Some firms may adopt social/environmental concerns as part of their branding. This can ultimately help
profitability as the brand becomes more attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone – even if it does little to
improve sales/brand image.
6. Co-operatives
Co-operatives may have completely different objectives to a typical PLC. A co-operative is run to maximise the
welfare of all stakeholders – especially workers. Any profit the co-operative makes will be shared amongst all
members.
Diagram showing different objectives of firms

 Q1 = Profit maximisation (MR=MC)

 Q2 = Revenue Maximisation (MR=0)
 Q3 = Marginal cost pricing (P=MC) – allocative efficiency

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 Course: Advanced Macroeconomics (805)
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 Q4 = Sales maximisation – maximum sales while still making normal profit (AR=ATC)
Q.3 Explain the behavioral model of a firm introduced by Cyert and March.
The traditional theory conceives the firm as synonymous with the entrepreneur. The owner-businessman is at
the same time the manager of the firm. The ‘members’ of the firm are the entrepreneur and the owners of the
factors of production, whose demands are satisfied via money payments. Consequently there is no conflict since
the entrepreneur pays to the factors of production in his employment their market prices (opportunity cost).
The firm of the traditional theory has a single goal, that of profit maximisation. The behavioural theory
recognizes that the modern corporate business has a multiplicity of goals. The goals are ultimately set by the top
management through a continuous process of bargaining. These goals take the form of aspiration levels rather
than strict maximising constraints. Attainment of the aspiration level ‘satisfices’ the firm: the contemporary
firm’s behaviour is satisficing rather than maximising. The firm seeks levels of profits, sales, rate of growth
(and similar magnitudes) that are ‘satisfactory’, not maxima.
The behavioural theory is the only theory that postulates satisficing behaviour as opposed to the maximising
behaviour of other theories. Satisficing is considered as rational, given the limited information, time, and
computational abilities of the top management. Thus the behavioural theory redefines rationality: it introduces
the concept of ‘bounded’ or ‘limited’ rationality, as opposed to the ‘global’ rationality of the-traditional theory
of the firm.
The traditional theory of the firm initially assumed that in deciding the allocation of resources (within the firm)
the entrepreneur equates marginal revenue to opportunity cost. This behaviour implicitly assumes global
rationality, that is, perfect knowledge of all alternatives, examination of all possible alternatives and certainty
about future returns. Later theorists recognized uncertainty as a fact of the real business world and introduced a
probabilistic approach to the above decision rule for the allocation of internal resources.
The entrepreneur was assumed to be able to assign definite probabilities to future returns and he equated
expected returns with opportunity costs. Furthermore, later theorists recognised the fact that the entrepreneur
has limited knowledge, limited information, which is not costless, but is acquired at a cost.
The allocation of resources to search activity (activity aiming at acquisition of information) was assumed to be
decided by comparing expected profitability of the information with its cost. That is, search activity was treated
by the traditional theory as an activity, like all the other activities of the firm, which absorbs resources and
hence must be judged on marginalistic rules like the other activities.
In general, traditional theory postulated that the decisions about resource allocation are taken by comparing
marginal (expected) return to marginal cost. The probabilistic approach was attacked and other theories were
developed to cope with uncertainty. The most important of these theories is the theory of games, which,
however, has not as yet been generally accepted.

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 Course: Advanced Macroeconomics (805)
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Cyert and March criticized the probabilistic-marginalistic behaviour of the traditional theory on the following
grounds:
Firstly, the traditional theory assumed continuous competition among all alternative resource uses. In the actual
world we observe local problem-solving rather than general planning for all activities of the firm
simultaneously.
Secondly, the traditional theory treats ‘search’ as another investment decision, that is, in terms of calculable
returns and costs. In reality, it has been observed that search is problem-oriented and is not decided on
marginalistic rules.
Thirdly, traditional theory assumes substantial computational ability of the firm projects are decided after
screening of all alternatives on the basis of detailed calculations of all direct and indirect benefits and costs.
Reality suggests that firms are of limited computational ability and do not make decisions on the basis of
detailed studies or marginalistic rules.
Fourthly, the traditional theory treats expectations as exogenously determined. In reality expectations are to a
large extent endogenous, being affected by various internal factors, for example, the desires-aspirations of
various groups, the information available and its flow through the various sections of the firm, and from past
attainments of the various groups and of the firm-organisation as a whole.
In the traditional theory there is no conflict of goals between the organisation and its individual members. In the
behavioural theory conflict among the various members of the coalition is inevitable. It is never fully resolved
at any one time. There is rather a continuous process of bargaining between members and the organisation, and
the conflict is quasi-resolved in any one period by money payments, slack adjustment, policy commitments,
delegation of authority (decentralisation of the decision-making activity), and by sequential attention to the
conflicting demands. Such means permit the firm to make decisions with inconsistent goals, and within a
continuously changing internal and external environment.
Unlike the traditional theory, Cyert and March distinguish two sources of uncertainty uncertainty arising from
changes in market conditions (tastes, products and methods of production), and uncertainty arising from
competitors’ behaviour. Market-originated uncertainty is avoided, according to the behavioural school, partly
by search activity, partly by maintaining R&D departments, and partly by concentrating on short-term planning.
Contrary to the traditional theory, Cyert and March postulate that the short run is much more important than the
long run.
In particular, so long as the environment of the firm is unstable (and unpredictably unstable) the heart of the
theory must be the process of short-run, adaptive reactions. It seems to us, however, that unless the long-run
goals are defined, any short-run description of the behaviour of the firm cannot attain the degree of generality
expected from a theory of the firm. Regarding the competitor-originated uncertainty, Cyert and March accept

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 Course: Advanced Macroeconomics (805)
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that firms act within a ‘negotiated environment’, that is, firms adopt business practices of a collusive nature.
Thus, the behavioural theory is not applicable to non-collusive oligopolistic markets.
In the behavioural theory the instruments which the firm uses in the decision-making process are the same as
those of the traditional theory: output, price, and sales strategy (the latter including all activities of non-price
competition, such as advertising, salesmanship, service, quality). The difference lies in the way by which the
values of these policy variables are determined. In the traditional theory the firm chooses such values of the
policy variables which will result in the maximisation of the long-run profits. In the behavioural theory the
policies adopted should lead to the ‘satisficing’ level of sales, profits, growth and so on.
Cyert and March postulate that the firm is an adaptive organisation: it learns from its experience. It is not from
the beginning a rational institution in the traditional sense of ‘global’ rationality. In the long run the firm may
tend towards the ‘omniscient rationality’ of profit maximisation, but in the short run there is an adaptive process
of learning there are mistakes, trials and errors. The firm has a memory and learns through its past experience.
It seems strange to us that despite this ‘adaptive learning process’ the firm does not ever seem to acquire the
ability for long-run planning. The behavioural theory is basically a short-run theory. The determination of the
values of the instrumental variables (output, price, sales strategy) does not adequately take into account the
environment past performance and past conditions of the environment are crudely extrapolated into the future.
Q.4 What factors influence the shape of supply curves of various factors of production.
We defined demand as the amount of some product a consumer is willing and able to purchase at each price.
That suggests at least two factors in addition to price that affect demand. Willingness to purchase suggests a
desire, based on what economists call tastes and preferences. If you neither need nor want something, you will
not buy it. Ability to purchase suggests that income is important. Professors are usually able to afford better
housing and transportation than students, because they have more income. Prices of related goods can affect
demand also. If you need a new car, the price of a Honda may affect your demand for a Ford. Finally, the size
or composition of the population can affect demand. The more children a family has, the greater their demand
for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less
for diapers and baby formula. These factors matter for both individual and market demand as a whole. Exactly
how do these various factors affect demand, and how do we show the effects graphically? To answer those
questions, we need the ceteris paribus assumption. A demand curve or a supply curve is a relationship between
two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption
behind a demand curve or a supply curve is that no relevant economic factors, other than the product’s price, are
changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.”
Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. A
demand curve or a supply curve is a relationship between two, and only two, variables when all other variables
are kept constant. If all else is not held equal, then the laws of supply and demand will not necessarily hold, as

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 Course: Advanced Macroeconomics (805)
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the following Clear It Up feature shows.We typically apply ceteris paribus when we observe how changes in
price affect demand or supply, but we can apply ceteris paribus more generally. In the real world, demand and
supply depend on more factors than just price. For example, a consumer’s demand depends on income and a
producer’s supply depends on the cost of producing the product. How can we analyze the effect on demand or
supply if multiple factors are changing at the same time—say price rises and income falls? The answer is that
we examine the changes one at a time, assuming the other factors are held constant.
For example, we can say that an increase in the price reduces the amount consumers will buy (assuming
income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the
amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged).
This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor
separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the
higher price and second because of the lower income. Let’s use income as an example of how factors other than
price affect demand. The initial demand for automobiles as D0. At point Q, for example, if the price is $20,000
per car, the quantity of cars demanded is 18 million. D 0 also shows how the quantity of cars demanded would
change as a result of a higher or lower price. For example, if the price of a car rose to $22,000, the quantity
demanded would decrease to 17 million, at point R.
The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no
other economically relevant factors change. Now imagine that the economy expands in a way that raises the
incomes of many people, making cars more affordable. The price of cars is still $20,000, but with higher
incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the
higher income levels, the demand curve shifts to the right to the new demand curve D 1, indicating an increase in
demand. This increased demand would occur at every price, not just the original one.
Increased demand means that at every given price, the quantity demanded is higher, so that the demand curve
shifts to the right from D0 to D1. Decreased demand means that at every given price, the quantity demanded is
lower, so that the demand curve shifts to the left from D0 to D2.
When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by
the same amount. In this example, not everyone would have higher or lower income and not everyone would
buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole.
In the previous section, we argued that higher income causes greater demand at every price. This is true for
most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in
income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is
called a normal good. A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer
generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to
buy new cars. They will be less likely to rent an apartment and more likely to own a home. A product whose

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 Course: Advanced Macroeconomics (805)
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demand falls when income rises, and vice versa, is called an inferior good. In other words, when income
increases, the demand curve shifts to the left.
Changes in the prices of related goods such as substitutes or complements also can affect the demand for a
product. A substitute is a good or service that we can use in place of another good or service. As electronic
books, like this one, become more available, you would expect to see a decrease in demand for traditional
printed books. A lower price for a substitute decreases demand for the other product. For example, in recent
years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of
demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which we can
show graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the
reverse effect.
Other goods are complements for each other, meaning we often use the goods together, because consumption of
one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks
and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination
of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity demanded of
golf clubs falls (because of the law of demand), demand for a complement good like golf balls decreases, too.
Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the
left, while a lower price for a complement has the reverse effect.
Q.5 What is quasi-rent? Does it refer to lung run or to the short run? How is it measured?
Let us suppose that a firm uses two inputs, labour (L) and capital (K), to produce its output (Q), and its
production function is
Q = f(L,K)                          
[where L and K are quantities used of inputs labour (L) and capital (K) and Q is the quantity of output
produced]
The function (8.122) is homogeneous of degree n if we have
f(tL, tK) = tn f(L, K) = tnQ                         
where t is a positive real number.
In the theory of production, the concept of homogenous production functions of degree one [n = 1] is widely
used. These functions are also called ‘linearly’ homogeneous production functions.
If the production function is linearly homogeneous, then we would have
f(tL, tK) = tf(L, K) = tQ                                 
From (8.124), it is clear that linear homogeneity means that raising of all inputs (independent variables) by the
factor t will always raise the output (the value of the function) exactly by the factor t. Assumption of linear
homogeneity, therefore, would amount to the assumption of constant returns to scale in economic theory.

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 Course: Advanced Macroeconomics (805)
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Property I:
The average (physical) product of labour (APL) and of capital (APK) can be expressed as functions of capital-
labour ratio (K/L).
To prove this, let us multiply L and K in (8.122) by the factor t = 1/L. Then owing to linear homogeneity, we
would have
f(L/L, K/L) = Q/L
⇒ f [(1,K/L)] = Q/L
⇒ g (K/L) = APL                                 
Similarly, we would have
Q/K = h(L/K)
⇒ APK = h (L/K)                            
Give us that if L and K are increased by the firm in the same proportion, keeping the K/L ratio constant, then
there would be absolutely no change in AP L and APK, i.e., the APL and APK functions are homogeneous of
degree zero in L and K.
Property II:
The marginal physical products, MPL and MPK, are also the functions of the K/L ratio.
We may establish this in the following way.
Q = L.g (K/L)
Therefore, we have
MPL = ∂Q/∂L = g (K/L) + L.g’(K/L)(−K/L2)
= g(K/L) – (K/L)g’(K/L)
= Ψ (K/L)
Also, from (8.127), we have
MPK = ∂Q/∂K = Lg’(K/L) (1/L)
= g’ (K/L)
(8.128) and (8.129) establish Property II. That is, if the production function is homogeneous of degree one, then
both MPL and MPK are homogeneous functions of K and L of degree zero.
Property III:
For the homogeneous production function of degree one as given by (8.122) and (8.124) we would have
We may establish this property in the following way. From (8.128) and (8.129), we have
L(∂Q/∂L) + K (∂Q/∂K) = Q
We may establish this property in the following way.
From (8.128) and (8.129), we have
L(∂Q/∂L) + K (∂Q/∂K)

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 Course: Advanced Macroeconomics (805)
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= Lg (K/L) –L (K/L)g’(K/L) + Kg’(K/L)
= Lg (K/L) – Kg’ (K/L) + Kg’(K/L)
= Lg(K/L) = Q
establishes property III, also known as the Euler’s Theorem.
This property may also be stated like this. If the inputs labour (L) and capital (K) are paid at the rate of their
respective marginal products (∂Q/∂L and ∂Q/∂K) then the total product (Q) would be exhausted, provided the
production function is homogeneous of degree one.
Property IV:
The MRTS in the case of a homogeneous production function (of any degree n) is a function of K/L ratio, and
the expansion path for such a function will be a straight line.
From (8.122) and (8.123), we have
Q = f(L, K)
and f(tL, tK) = tnQ.
where t is a positive real number.

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