Diapositivas Micro

The Aim of this Course
 To deepen your understanding of economics

 To introduce you to a variety of issues and
situations where economic reasoning is relevant
and useful
 To give you the skill and confidence to do
rigorous economic analysis on your own using
words, diagrams and mathematics
The Language of Economics
 Mathematics
 Diagrams
 Words
 Any concept or reasoning in microeconomics
can be described equally well using any one of
these.
 In this course, you will learn to use all three.
 But when you first try to understand a concept or
explanation, choose whichever you are most
comfortable with.
Theories and Assumptions
 economics is about using simple models to get

some understanding of ‘real world’ phenomena.
 The simpler the model the better, provided that
it tells you something useful.
 Simplicity is gained through Assumptions.
 Understanding is derived through Theorems.
Theories and Assumptions
Assumptions Predictions
Consumer Optimisation
•Preferences •Consumer Behaviour
Profit Maximisation
•Technology •Firm Output
Market Clearing
•Endowments •Prices
Microeconomics
Introduction
Which part of Economics is
‘Microeconomics’?
Many economic concepts deal with aggregate variables
which describe some characteristic of an entire economy:
inflation, unemployment, interest rates, GDP growth, etc.
But what underlies these variables are decisions made by

individuals and firms that, when taken together, have an
impact on the wider economy.
Microeconomics focuses on these individual and firm-level

decisions, and understand how changes in prices, policy
reforms and economic shocks would affect individual
behaviour.
Microeconomics is …
 especially good at understanding what happens in
market settings: (firms, consumers, perfect competition)
Alfred Marshall
 but recent advances have extended microeconomic

analysis to settings where markets don’t exist or don’t
function well: (imperfect competition, market failure,
what happens inside firms and households)
Gary Becker, Joseph Stiglitz, etc.
A road map
The Theory of the Firm
The Theory of the
consumer
Factor
Firm supply Firm pricing
demands
Labour
Consumer IO: Firm interaction
supply
demand
Consumer
saving and
borrowing
Market Failure
General Equilibrium
Overview
Product
Markets
Households Firm Profits via stocks, bonds, etc. Firms
Factor Markets
Examples of the use of
Microeconomic Theory
 Consumer Optimisation
 Profit Maximisation
 Market Equilibrium
The Budget Constraint
What is the ‘Budget Constraint’ ?
 The budget constraint tells us what a consumer (a
household or an individual) can afford.
 It is used in economics to analyse how changes in prices,
taxes, benefits, rationing, etc. affects a consumer’s
choices.
 We will combine the budget constraint with a notion of
`consumer preferences’ to develop a theory of how
consumers choose.
Buying Food and Drink for a Party
 Suppose you had £100 pounds to buy food and drinks
for a party.
 You are thinking of spending it on drinks and crisps.
The crisps cost £1 each and the drinks £2 each.
 So you could buy
o 60 packets of crisps and 20 bottles of drinks or
o 50 packets of crisps and 25 bottles of drinks or
o 40 packets of crisps and 30 bottles of drinks etc.
All of these choices will be within your budget constraint.

The Mathematics of …
If you were buying X packets of crisps and Y bottles of
drinks, you could afford this with £100 if
X + 2Y ≤ 100
The Mathematics of …
If you were buying X packets of crisps and Y bottles of
drinks, you could afford this with £100 if
X + 2Y ≤ 100
More generally, if crisps were £ PX each and drinks £ PY

each, and you had £ M to spend on the party, then the
budget would be given by
X PX + Y PY ≤ M
The Graphics of …
We can rewrite the last inequality as follows:
𝑀 𝑃𝑋
Y≤ –X
𝑃𝑌 𝑃𝑌
The Graphics of …
𝑀 𝑃𝑋
Y≤ –X
Y (Drinks) 𝑃𝑌 𝑃𝑌
X (Crisps)
The Graphics of …
𝑀 𝑃𝑋
Y≤ –X
M/PY
X (Crisps)
M/PX
The Graphics of …
The green line represents the equation
𝑀 𝑃𝑋
Y= –X
M/PY
X (Crisps)
M/PX
The Graphics of …
You can buy any combination of crisps and drinks that
lies on or in the triangle with a budget of M.
Y (Drinks)
M/PY
X (Crisps)
M/PX
The Graphics of …
The combination of food and drink represented by point
A is affordable on a budget of £100 but B is not.
Y (Drinks)
M/PY
B
A
X (Crisps)
M/PX
The Graphics of …
The slope of the line is equal to the negative of the ratio
of prices.
Y (Drinks)
M/PY 𝑃𝑋
slope = –
𝑃𝑌
X (Crips)
M/PX
The Graphics of …
Using M = 100, PX = 1 and PY = 2, we obtain
Y (Drinks)
100/2 1
slope = –
2
X (Crisps)
100/1
Fuel Costs and the Budget Constraint
 Suppose we wish to analyse how changes in the price
of fuel, or changes in fuel subsidies affects the
household budget.
 We can do this using the same mathematical and
graphical framework.
 A household will obviously buy many goods besides
fuel.
 But it is possible and convenient to do the analysis in
a ‘two-good framework’.
Suppose the household consumes X units of fuel, and
spends £ Y on other goods. Let PX be the price of fuel
and let PY = 1.
Suppose the household consumes X units of fuel, and
spends £ Y on other goods. Let PX be the price of fuel
and let PY = 1.
Then, the budget constraint can be written as
X PX + Y ≤ M
As before, we can represent this budget constraint
graphically.
£ spent on
Other Goods
X PX + Y ≤ M
Fuel
M/PX
Comparative Statics
What happens if there is an increase in the price of fuel
from PX to P2 (where P2 > PX)?
Other Goods
Fuel
M/P2 M/PX
Comparative Statics
Then the budget line shifts inwards, so that the triangle
becomes smaller.
Other Goods
Fuel
M/P2 M/PX
Comparative Statics
Similarly, if the price of fuel goes down, then the budget
line rotates outwards (here P2 < PX).
Other Goods
Fuel
M/PX M/P2
Comparative Statics
What if there is an increase in income from M to M2 ?
(M2 > M)
Other Goods
M2
M
Fuel
M/PX M2/PX
Comparative Statics
Then the budget line shifts outwards. The triangle
becomes larger.
Other Goods
M2
M
Fuel
M/PX M2/PX
Comparative Statics
Similarly if there is a decrease in income, then the
budget line shifts inwards (M2 < M).
Other Goods
M2
Fuel
M2/PX M/PX
Subsidies
 Suppose there is an increase in the price of fuel from
£10/unit to £12.5/unit.
 However, to help poor families, the government
supplies them fuel at a subsidised price of £8/unit for
the first 40 units consumed.
 How would this change the budget set for a family on
an income of £1000?
 Can they afford everything they could before the price
increase?
Subsidies
First, we draw the initial budget set (1000/10 = 100).
Other Goods
1000
Fuel (units)
100
Subsidies
The budget line rotates inwards as the price of fuel
increases (1000/12.5 = 80).
Other Goods
1000
Fuel (units)
80 100
Subsidies
If the fuel subsidy were made available for any level of
consumption, then the new budget line would be as
follows (red dash line) 1000/8 =125:
Other Goods
1000
Fuel (units)
80 100 125
Subsidies
But as the subsidy is provided for just the first 40 units,
we have (solid red line) 40 + (1000 – 320)/12.5 = 94.4:
Other Goods
1000
Fuel (units)
40 80 94.4 125
Non-Linear Pricing
 In our previous example, households are able to buy
the first 40 units of fuel at a price of £8/unit (with the
government subsidy) and additional units at a price of
£12.5/unit.
 This is an example of non-linear pricing : the price per
unit depends on the number of units purchased.
 Examples of non-linear pricing:
 ‘Bulk buys’ : buy one, get one free
 ‘Two-part tariffs’ : £10 a month and 5p per text message
 ‘Rationing’: can invest up to £5000
 With non-linear pricing, the budget line will no longer
be a straight line.
Rationing
 Let us return to our example on fuel consumption.
 Suppose, (in a fuel crisis) the government rations fuel
consumption to 60 units per household.
 The price of fuel remains at £10/unit.
 How would this affect the budget set of a household
on an income of £1000?
Rationing
The dotted line shows the budget constraint without
rationing.
Other Goods
1000
Fuel (units)
100
Rationing
The budget constraint with rationing is given by the
solid line.
Other Goods
1000
Fuel (units)
60 100
Preferences and the
Utility Function
 We introduced the concept of a ‘budget
constraint’ to represent what an individual can
afford.
 But we need some additional concepts to talk
about what choice an individual will actually
make.
M/PY
X
M/PX
Preferences
 To analyse choices that individuals actually make, we
introduce the concept of preferences.
 Suppose an individual is faced with the following
choices:
 A = going to the movies
 B = going to a music concert
 C = staying at home
 We use preference relations to rank these choices.
 A ~ B means the individual is indifferent between A and B
 A f
~
B means A is weakly preferred to B
or A is at least as good as B
Preferences
 If A f
~ B and B f A, then A ~ B
 i.e. if A is at least~
as good as B and B is at least as good as A, then I
must be indifferent between A and B
 If A f~ B but B is not f A, then we write A B
p

~
This symbol should be read as A is strictly preferred to B
Rationality
 Using these concepts, we have a definition of
Rationality in microeconomics which is the following.
 Given the set of possible choices A, B, C, etc. a person
is said to have Rational Preferences if
 Completeness: For any choice A and B, we have
either Af
~
B or Bf
~ A or both.
 Transitivity: For any choices A, B and C, whenever
f
A B and B
~ f
~ f
C, we also have A C.
~
Rationality
 Whether, in real life, our preferences satisfy these
properties is a matter of debate.
 There are well-known examples, verified in
psychological experiments, where these properties do
not hold.
 So, whenever we wish to analyse a problem using
consumer choice theory, we should ensure that the
assumption of rational preferences are plausible.
Rationality
 It is easy to see why these assumptions are important
for doing any analysis regarding individual
behaviour.
 Suppose your preferences between going to the
movies, going to a music concert and staying at
f
home do not satisfy transitivity: A B, B
~ f
~ C, but
f
A is not
~
p
C. So C A. You will keep changing
your mind about what to do.
 If your preferences do not satisfy completeness, and
you have no preference relation between A and B,
then we cannot predict what you will do when
faced with these two choices.
 Once we have defined preferences that are
transitive and complete, we can represent them
graphically using the concept of indifference curves.
 To see how indifference curves can be used to
depict preferences, we return to the two-good
framework.
X
 Rather than simple choices A,B and C, we now
consider choices that are bundles of consumption
goods (X,Y).
 Recall that any point in the diagram represents
such a bundle.
(X,Y)
Quantity of Y
X
Quantity of X
 Suppose we identify two consumption bundles
(X1,Y1) and (X2,Y2) such that
(X1,Y1) ~ (X2,Y2)
(X2,Y2)
(X1,Y1)
X
 In fact, suppose we discover an entire curve such
that an individual is indifferent between any two
consumption bundles which lie on the curve.
(X1,Y1) ~ (X2,Y2)
(X2,Y2)
(X1,Y1)
X
 This is called an indifference curve.
 We can identify the region of the curve in which
the individual strictly prefers any bundle to (X1,Y1).
(X3,Y3)
p (X1,Y1)
(X3,Y3)
(X1,Y1)
X
 The individual will be worse off at all other points
in the graph.
(X1,Y1)
p (X4,Y4)
(X3,Y3)
(X1,Y1)
(X4,Y4)
X
 Note that we can draw many indifference curves
in this manner (in fact, there are infinitely many).
 We draw only the ones that are relevant for our
analysis.
X
 If we don’t specify anything else about
preferences other than completeness and
transitivity, then the indifference curves can take
any shape.
 But there is one important rule we need to bear in
mind: Indifference curves do not touch or cross.
X
 Suppose we did have two indifference curves
which crossed as below.
 The bundle (X3,Y3) is on both indifference curves.
 So, (X1,Y1) ~ (X3,Y3) and (X2,Y2) ~ (X3,Y3)
 Using transitivity, we must have (X1,Y1) ~ (X2,Y2).
So they must be on the same indifference curve.
Y
(X1,Y1)
(X2,Y2)
(X3,Y3)
X
Additional Properties of Preferences
& Indifference Curves
 Monotonicity: More is better.
If X2 > X1 and Y2 > Y1, then (X2, Y2)
p (X1, Y1)
 Convexity: Averages are better.

If (X2, Y2) ~ (X3, Y3) and
X4 = pX1 + (1—p)X3 and Y4 = pY1 + (1—p)Y3, then
(X4, Y4)
p (X2, Y2)
(X4, Y4)
p (X3, Y3)
where 0 < p < 1
 Monotonicity implies anything in the shaded region will
be on a higher indifference curve. So each indifference
curve must be downward sloping.
(X2,Y2)
(X1,Y1)
X
 If we assume monotonicity, we cannot have an
indifference curve which looks like the one below.
(X2,Y2)
(X1,Y1)
X
 Convexity means that any line connecting two
points on an indifference curve will be on a higher
indifference curve.
(X2,Y2)
(X1,Y1)
X
 If we assume convexity, we cannot have an
indifference curve which looks like this.
strictly preferred
Y
region
(X2,Y2)
(X1,Y1)
X
Marginal Rate of Substitution
 The marginal rate of substitution (MRS) is related to the
following question.
 Suppose we initially have a bundle of consumption
goods (X,Y) and we were made to give up a small
amount of good X. How much of good Y would we
need to make us as happy as we were before?
 We can represent the concept using indifference
curves as follows:
increase Y
to get back
on same
indifference
curve (X,Y)
decrease
in X
X
 If we keep making the change in X smaller, then the
ratio of the change of Y to the change in X will be the
slope of the indifference curve at the initial bundle.
Y
MRS
corresponds (X,Y)
to this slope
X
 Note that the MRS depends on what bundle we start
with. In the case of convex preferences, the less we have
of good X, the more we need of good Y to compensate a
marginal decline in X. This property is called diminishing
marginal rate of substitution.
Y
(X,Y)
X
Perfect Substitutes
 If the marginal rate of substitution is constant at all
points on the indifference curve then we say that
goods X and Y are perfect substitutes.
 It means that you are always happy to swap one
unit of good X with some fixed quantity of good
Y. Y
X
Utility Functions
 When we analyse behaviour using consumer theory,
we are more likely to work with utility functions rather
than preferences.
 Utility functions are a way of representing preferences
 Given preferences over different combinations of
goods X and Y, we define an equivalent utility
function U(X,Y) as follows:
 If (X1,Y1) ~ (X2,Y2), we let U(X1,Y1) = U(X2,Y2)
p
 If (X1,Y1) (X2,Y2), we let U(X1,Y1) > U(X2,Y2)
Utility Functions
 Note that the same preferences can be represented by
many different utility functions.
 e.g. let V(X,Y) = aU(X,Y) + b where a,b >0
 Then, if (X1,Y1) ~ (X2,Y2), we have
 U(X1,Y1) = U(X2,Y2)
 Therefore, V(X1,Y1) = V(X2,Y2)

p
If (X1,Y1) (X2,Y2), we have
 U(X1,Y1) > U(X2,Y2)
 Therefore V(X1,Y1) > V(X2,Y2)
 So V(.) can represent the same preferences.

Utility & Indifference Curves
 Note that all consumption bundles on an
indifference curve will provide the same utility.
 So, we can represent indifference curves using
equations of the form U(X,Y) = K
U(X,Y)=10
U(X,Y)=6
U(X,Y)=2
X
Utility & the Marginal Rate of
Substitution
 Using the utility function, we can also derive a
mathematical formula for the marginal rate of substitution.
 Recall that we said that MRS is equal to the slope of the
indifference curve.
 We also established that the indifference curve can be
represented by the equation U(X,Y) = K
 Differentiate throughout this equation with respect to X:
(∂U/ ∂X) + (∂U/ ∂Y) × (∂Y/ ∂X) = 0
Therefore,
∂Y/ ∂X = − (∂U/ ∂X) / (∂U/ ∂Y)
= MRSYX
Consumer
Optimisation
Overview
 We looked at ways of representing what an individual
can afford.
 We looked at ways of representing an individual
preferences given hypothetical choices.
 Now, we will consider what an individual would
actually choose, given preferences, prices and wealth.
 As usual, all of the following are key:
 Diagrams
 Mathematics
 Intuition, explained in words
Hunger and
Consumption Preferences
 According to the Food and Agricultural

Organization, more than 1 billion people
around the world were suffering from
hunger in 2009.
 The UN’s first Millennium Development

Goal is “to reduce poverty and hunger”, and
governments in developing countries often
provide large amounts of food subsidies to
address this issue.
Hunger and
 But even among those living in extreme poverty, not
every additional dollar that they earn is spent on food. A
number of economists have calculated that the
proportion of any additional income that is spent on
basic food items is between one-fourth and two-thirds.
 Deaton and Subramanian (1996) for India
 Strauss and Thomas (1997) for Brazil
 A study by Banerjee and Duflo (2006) found that the
extreme poor in a number of developing countries spend
a non-negligible amount of their budget on non-basic
items, such as tobacco and alcohol.
 4% in Papua New Guinea, 5% in India, 6% in Indonesia, 8% in
Mexico
Hunger and
 What does this say about their preferences regarding
basic food and other items? Why do they have such
preferences?
 These are important questions because the evidence
suggests that increasing income will not, by itself,
eradicate malnutrition because of the way that
additional income is spent.
 The analytical tools we start developing and using today
provide a basis for addressing these questions.
The Basic Problem
 We start with a specific problem.
 Two goods X and Y
 An individual has preferences over X and Y which are
rational (i.e. complete and transitive), monotonic and
convex.
 Price of good X is PX and price of good Y is PY
 The individual has wealth M
 How much X and Y would she/he decide to buy?
 This is known as a Consumer Optimisation problem.
Graphical Representation
of the Problem
We start by drawing the budget constraint.
M/PY
X
M/PX
of the Problem
Consider a particular allocation (X1, Y1) which lies
on the budget line.
M/PY
(X1,Y1)
X
M/PX
of the Problem
There is one and only one indifference curve which
passes through (X1, Y1). Let us draw the indifference
curve.
M/PY
(X1,Y1)
X
M/PX
of the Problem
Because the preferences are monotonic and convex,
the individual will prefer any consumption bundle
in the shaded region to (X1, Y1).
M/PY
(X1,Y1)
X
M/PX
of the Problem
In particular, the individual will prefer (X2, Y2) to
(X1, Y1).
M/PY
(X2,Y2)
(X1,Y1)
X
M/PX
of the Problem
Because (X2, Y2) lies within the budget constraint, it
is affordable. So, an individual who is trying to
choose the best consumption bundle for herself will
not choose (X1, Y1).
Y
M/PY
(X2,Y2)
(X1,Y1)
X
M/PX
 For any consumption bundle which lies on or
below the budget line, we ought to be able to
make a similar argument.
 The only situation when we cannot make such an
argument is when the indifference curve passing
through the chosen consumption bundle just
touches the budget line, as below.
Y
M/PY
(X1,Y1)
X
M/PX
 In this situation, any consumption bundle that the
individual prefers to (X1, Y1) lies above the budget
line; i.e. is unaffordable.
 In this situation, the individual cannot do any
better than to choose (X1, Y1).
 So (X1, Y1) is the solution to the consumer
optimisation problem.
Y
M/PY
(X2,Y2)
(X1,Y1)
X
M/PX
Finding a Mathematical Solution to
the Problem
 Note that, at (X1, Y1), the budget line is tangent to
the indifference curve.
 i.e. the slope of the indifference curve is equal to
the slope of the budget line.
Y
M/PY
(X1,Y1)
X
M/PX
the Problem
 Recall that the slope of the budget line is equal to
− PX / P Y
 Recall that the slope of the indifference curve is
equal to the Marginal Rate of Substitution (MRS)
 So, when the individual is choosing her most
preferred consumption bundle, we have
MRS = − PX / PY
the Problem
 Recall that if we are given a utility function
U(X,Y) which represents the individual’s
preferences, then we can find the MRS as follows.
 Along an indifference curve, we have
U(X,Y) = K
 Differentiating throughout with respect to X, we
obtain
(∂U/ ∂X) + (∂U/ ∂Y) × (∂Y/ ∂X) = 0
 Therefore,
∂Y/ ∂X = − (∂U/ ∂X) / (∂U/ ∂Y)
= MRSYX
the Problem
 Therefore, when the individual chooses her most
preferred bundle, we have
PX / PY = (∂U/ ∂X) / (∂U/ ∂Y)
 Under the following conditions …

 preferences are convex
 we know that the individual will consume a

positive quantity of each good
 … this equation (called the tangency condition),
along with the budget equation, is sufficient to
compute the individual’s most preferred
consumption bundle.
Interpreting the Tangency Condition
 We can rewrite the tangency condition as follows:
(∂U/ ∂Y) / PY = (∂U/ ∂X) / PX
 We can describe the equation as follows:

“The marginal utility from an additional pound
spent on good Y equals the marginal utility from
an additional pound spent on X.”
 If the marginal utility from an additional pound
on Y is greater, then we can improve utility by
spending a bit less on X and a bit more on Y.
 If the marginal utility from an additional pound
on X is greater, then we can improve utility by
spending a bit less on Y and a bit more on X.
Mathematical Example
 Suppose U(X,Y) = XY
 PX = 1, PY = 2 and M = 12
 How much of X and Y will the individual
consume?
 Suppose U(X,Y) = XY
 PX = 1, PY = 2 and M = 12
 How much of X and Y will the individual
consume?
 We need to find the values of X and Y for which
PX / PY = (∂U/ ∂X) / (∂U/ ∂Y)
 We proceed as follows:
 ∂U/ ∂X = Y
 ∂U/ ∂Y = X
 So, (∂U/ ∂X) / (∂U/ ∂Y) = Y / X
 PX / P Y = ½
 So, the equation becomes ½ = Y / X

 So we know that when the individual
chooses the most preferred bundle, we
have
X = 2Y
 Also, because preferences are monotonic,
the individual will use all her available
money.
 So, using the budget constraint, we have
X P X + Y PY = M
i.e.
X + 2Y = 12
X = 2Y
X + 2Y = 12
 Solving these equations simultaneously,
we obtain X = 6, Y = 3
 Therefore, the individual’s most preferred
bundle within her budget is 6 units of X
and 3 units of Y.
 We say that the individual maximises her
utility at X = 6, Y = 3.
Sufficient Conditions
 Why do we need convex preferences for the mathematical
procedure to work?
 Here is an example with preferences that are not convex.
 The budget line is tangent to the indifference curve at (X1,
Y1) but this is not the optimal bundle. The individual does
better with, for example, (X2, Y2).
strictly preferred
region
(X2,Y2)
(X1,Y1)
X
Sufficient Conditions
 Why do we need to make sure that the individual is
consuming positive amounts of both goods?
 Here is an example where X = 0 in the preferred bundle.
 The budget line does not have the same slope as the tangent
to the indifference curve. So, the tangency condition is not
valid.
Y
M/PY
(X1,Y1)
X
Revisiting the Hunger Problem
• The conventional view of basic needs such as
proper nutrition is that households and families
would aim to satisfy these needs before spending
their money on anything else.
• The quasi-linear utility function is a concise way of
representing such preferences.
• However, the findings on actual expenditure
patterns of the extreme poor suggest that the
logarithmic utility function may be a better
representation of preferences even for households
on very low income.
• They would like to spend something on tobacco, alcohol,
festivals, etc. even when they don’t have enough
resources to satisfy the daily calorie requirements.
Consumer Optimisation
& Comparative Statics
Overview
 We looked at two ways of determining what, given
prices, wealth and preferences, an individual would
choose to buy.
 Graphically, using the budget line and indifference
curves
 Mathematically, using the tangency condition and the
budget equation
 Now, we will also see how changes in prices and wealth
affects an individual’s choices.
 We also look at consumer optimisation with the most
common utility functions, and thus try to understand
what sort of preferences they represent.
Comparative Statics in
Wealth and Prices
 One of the most common policy-related questions that
microeconomics deals with is how households and
families cope with economic shocks that affects their
disposal income or the prices of consumer goods.
 Changes in income tax
 Changes in VAT
 Increase in food prices or fuel prices because of global

supply constraints
 Changes in disposable income due to economic
booms and busts
 With information on consumer preferences, we can
analyse how households will respond to such changes.
Changes in Income
Suppose there are two goods X and Y with prices PX
and PY and an individual initially has wealth M.
With this information, we can draw the now familiar
budget line as below.
Y
M/PY
X
M/PX
Changes in Income
If we also have information about the individual’s
preferences, we can draw indifference curves on the
diagram. Suppose the indifference curve
corresponding to the optimal consumption bundle is
as below. Y
M/PY
(X0,Y0)
X
M/PX
Changes in Income
Now suppose that the individual experiences an
increase in income from M to M1 where M1 > M.
Then, we can draw a new budget line corresponding
to income M1 as below.
Y
M1/PY
M/PY
(X0,Y0)
X
M/PX M1/PX
Changes in Income
We can locate the new optimal consumption bundle
by drawing the ‘highest’ indifference curve that the
individual can reach using the new budget
constraint.
Y
M1/PY
M/PY
(X1,Y1)
(X0,Y0)
X
M/PX M1/PX
Changes in Income
Note that X1 > X0 and Y1 > Y0
So, an increase in income leads to an increase in
consumption of both goods X and Y.
When this happens, we call X and Y normal goods.
Y
M1/PY
M/PY
(X1,Y1)
(X0,Y0)
X
M/PX M1/PX
However, depending on preferences, an increase in
income can also lead to a decrease in consumption of
one of the goods. Below, we draw an alternative
indifference curves such that consumption of good X
is lower following the increase in income.
In this case, we call X an inferior good.
Y
M1/PY
M/PY
(X1,Y1)
(X0,Y0)
X
M/PX M1/PX
Inferior goods are not uncommon in practice.
Deaton and Subramanian (1996) found that poor
families in India reduce their consumption of coarse
cereals in favour of rice and wheat as incomes
increase.
M1/PY
M/PY
(X1,Y1)
(X0,Y0)
X
M/PX M1/PX
Changes in Prices
Now suppose that the individual experiences an
increase in the price of good X from PX to P1 .
Then, we can draw a new budget line corresponding
to price P1 for good X as below.
Y
M/PY
(X0,Y0)
X
M/P1 M/PX
As before, we can locate a new optimal consumption
bundle by drawing the highest indifference curve
that the individual can reach at the new prices.
The individual reduces consumption of good X, but
also that of good Y. In this situation, Y is called a
complement of good X.
Y
M/PY
(X0,Y0)
(X1,Y1)
X
M/P1 M/PX
But note that it isn’t strictly necessary that an
increase in the price of X would lead to a decrease in
the consumption of Y.
With a different set of indifference curves, as below,
an increase in the price of X actually leads to an
increase in the consumption of Y. In this case Y is
called a substitute of X.
Y
M/PY
(X1,Y1)
(X0,Y0)
X
M/P1 M/PX
Increase in Increase in
Increase in Price of Price of
Income Good X Good Y
Increased
X normal X Giffen X and Y
Consumption
good good substitutes
of X
Decreased
X inferior X ordinary X and Y
Consumption
good good complements
of X
Another Look at the Procedure for
Computing the Optimal Bundle
You are given U(X,Y), prices PX and PY and wealth M.

1. Check if preferences are convex.
 (∂U/ ∂X) / (∂U/ ∂Y) should be decreasing in X and/or increasing in Y
2. Check if we have an interior solution.
 For an interior solution, we need
 (∂U/ ∂X)/PX > (∂U/ ∂Y)/PY when X = 0, Y = M/ PY and
 (∂U/ ∂X)/PX < (∂U/ ∂Y)/PY when Y = 0, X = M/ PX
 Otherwise, we have a corner solution
3.If you have verified both convexity and an interior solution,
then use the tangency condition along with the budget
equation to find the solution.
Why do convex preferences imply that (∂U/ ∂X)/(∂U/ ∂Y) is
decreasing in X and/or increasing in Y ?
 Recall that convex preferences imply diminishing
marginal rate of substitution; i.e. as we go down an
indifference curve, the slope becomes flatter.
 The magnitude of the slope is equal to (∂U/ ∂X)/(∂U/ ∂Y)
 As we go down an indifference curve, we are increasing

X and decreasing Y. So, for convex preferences, the ratio
should decline as X increases and Y decreases.
Y
(X,Y)
X
Consumer Demand
Overview
 So far, we have seen how, given information about prices
and a person’s preferences and wealth, we can calculate
the person’s optimal consumption choice.
 We have also seen how this optimal consumption choice
varies when there is a change in prices or in the person’s
wealth.
 Hence, we introduce the concepts of Demand Curves and
Engel Curves, that can be used to study how households
will respond to economic shocks or changes in prices.
How Tools of Consumer Optimisation
are used in Practice
 In the real world, how do we actually use consumer
optimisation?
 It would be very expensive to gather information on
people’s preferences directly (and the data would
probably be unreliable).
 It is easier to collect data on what people actually buy
along with information on their incomes, and prices.
 The Office of National Statistics compiles and maintains
data from regular Consumption Expenditures and Price
surveys.
Office of National Statistics
Family Spending 2007
Using Consumption Expenditures
Data
 Data on Consumption Expenditures can be used to
estimate utility functions.
 With these utility functions, we can predict what a
household would buy at different prices and income
levels using methods of consumer optimisation.
 Then, we can analyse how an economic shock or a policy
change would impact upon these households; e.g.
 How would an increase in fuel prices affect fuel
consumption? And expenditures on other goods?
 How would an increase in VAT affect alcohol
consumption?
Engel Curve and Demand Curve
 We can answer these questions if we know the Engel
curve and the Demand curve of the relevant households.
 The Engel curve shows how much of each good a
household would consume at different levels of income.
 The Demand curve (of good X) shows how much of X a
household would consume at different prices for good X.
Deriving an Engel curve
Y We are given a set of preferences, PX and
PY and want to derive the Engel curve for
good X.
M X
X
good X.
For wealth M1, find the optimum

(X1,Y1) consumption bundle. This gives
a point on the Engel curve.
M X
M1
X1 X
good X.
(X2,Y2)
(X1,Y1)
M X Increase wealth to M2 and find the

new optimum consumption
bundle. This gives the next point
M3 on the Engel Curve.
M2
M1
X1 X2 X
good X.
(X3,Y3)
(X2,Y2)
(X1,Y1)
M X
M3
M2
And so on, plotting the points
M1
along the Engel curve.
X1 X2 X3 X
Deriving a Demand Curve
Y We are given a set of preferences, wealth
M and price of good Y, PY and want to
derive the demand curve for good X.
M X
X
We are given a set of preferences, wealth M
Y
and price of good Y, PY and want to derive
the demand curve for good X.
(X1,Y1) For price P1 , find the optimum

consumption bundle. This gives a
point on the demand curve.
PX X
P1
X1 X
Y
(X1,Y1) (X2,Y2)
Increase the price to P2 , find the

PX X new optimum consumption bundle.
P1 This gives the next point on the
demand curve.
P2
X1 X2 X
Y
(X2,Y2) (X3,Y3)
(X1,Y1)
PX
X
P1
P2 And so on, plotting the points along

the demand curve.
P3
X1 X2 X3 X
Demand Functions
 A demand function (for good X) specifies how

much of good X a household would choose to
purchase given wealth (M) and prices of all
goods (PX and PY).
 Thus, the demand function includes the
information contained in both the Engel curve
and the demand curve.
 The demand function (for good X) would usually
be written as X(PX , PY , M).
Deriving the Demand Function
 Note that we have already derived the demand

function for a number of different utility
functions.
 These expressions tell us how the demand for X

and Y change with wealth and with prices.
Deriving the Demand Function
 Utility Function U(X,Y)

 Prices PX and PY and wealth M
 What will the consumer choose?
 Note that whenever you solve a consumer
optimisation problem with variables M, PX and
PY rather than numbers, you will automatically
generate the demand function.
Classifying goods using the Engel Curve
Inferior goods. Demand decreases as income increases;

e.g. cheap food items.
Normal good. Demand increases as income increases. e.g.
restaurant meals, holidays.
Homothetic preferences. Demand increases proportionally

with income e.g. house you buy.
Necessary good. Demand increases by a lesser proportion
than income e.g. clothes, heating, petrol.
Luxury good. Demand increases by a greater proportion than
income e.g. yacht.
But the consumer must buy more of
something as income increases!
 It cannot be that all goods are inferior.
 It cannot even be that all goods are necessary goods.
 It also could not be that all goods are luxury goods.
 The Engel curves of goods X and Y (and Z…) are
interrelated.
 The demand for different types of goods depends on
how we ‘aggregate’ them. Larger good categories are
more likely to be normal goods with expenditures
increasing almost proportionally with income.
Income and Substitution
Effects
What happens when the price
of good X increases
 Substitution effect: good X is relatively
more expensive so the consumer may
substitute good Y for good X.
 Income effect: the consumer has relatively
less income so may change consumption of
both goods.
 Overall effect = substitution + income effect
Normal (Marshallian)
demand curve
 Previously we derived the normal (or
Marshallian) demand curve.
 This shows the change in demand for a good
when the price of that good changes, keeping
NOMINAL INCOME constant.
 It includes both the substitution and income
effect.
 To isolate the substitution effect we need to
somehow measure REAL INCOME.
What is real income?
To measure the substitution effect in isolation
we need to keep REAL INCOME constant.
There are two definitions of real income:
1. The Slutsky measure is PURCHASING
POWER – real income is how much the
consumer can purchase.
2. The Hicks measure is UTILITY – real
income is the utility of the consumer
Hicksian or compensated
demand curve
 This shows the change in demand for a good
when the price of that good changes keeping
UTILITY constant.
 So, if the price of the good goes up the
consumer is given enough nominal income
so that he can afford his initial utility.
Deriving a compensated demand curve
We are given a set of preferences, m and py and want
to derive the compensated demand curve for good X.
B.C.(p’’,m’)
y U=k Fix a price, px = p’ and find x*.
Increase the price, px = p’’ and find the
new x*. This gives the overall change in
demand (the normal demand curve).
To find the substitution

effect we give the consumer
B.C.(p’) enough nominal income
B.C.(p’’) (m’) to achieve U = k at the
X** X*** x* higher price.
x
Substitution effect = change in
Income effect = change in demand demand with real income constant
due to change in real income.
Deriving a compensated demand curve
U=k
Fix a price, px = p’ and find x*. This
B.C.(p’’,m’)
y gives a point on the normal and
compensated demand curve,
Increase the price, px = p’’

and find the new x*. This
B.C.(p’) gives the next point on the
B.C.(p’’) normal demand curve.
x
pX Compensate the consumer
p’’ and find his demand. This
compensated gives the next point on the
demand curve compensated demand
p’
curve.
Normal demand
curve
X** X*** x* x
Slutsky demand curve
 Shows the change in demand for a good
when the price of the good changes keeping
PURCHASING POWER constant.
 So, if the price of the good goes up the
consumer is given enough money to be able
to afford his initial bundle.
Deriving a Slutsky demand curve
We are given a set of preferences, m and py and want
to derive compensated demand for good X.
B.C.(p’’,m’)
y U=k Fix a price, px = p’ and find x*.
Increase the price, px = p’’ and find the
new x*. This gives the overall change in
demand (the normal demand curve).

effect we give the consumer
B.C.(p’) enough nominal income to
B.C.(p’’) afford his initial bundle at
X** X*** x* the higher price.
x
Deriving a Slutsky demand curve
U=k
Fix a price, px = p’ and find x*. This
B.C.(p’’,m’)
y gives a point on the normal and
Slutsky demand curve,
Increase the price, px = p’’

and find the new x*. This
B.C.(p’) gives the next point on the
B.C.(p’’) normal demand curve.
x
pX Give the consumer enough
p’’ so he can afford his initial
Slutsky demand bundle. This gives the next
curve point on the Slutsky demand
p’
curve.
Normal demand
curve
X** X*** x* x
Doing the algebra
 Suppose the consumer is optimising his utility by
consuming bundle (x*,y*) and his utility is U*. Then the
price of good x changes to p’x.
 To calculate the overall (normal) change in demand we
solve Max U ( x, y )
subject to px x  p y y  m
 To calculate the Hicks change in demand we solve
Min px x  p y y
subject to U (x, y)  U*
 To calculate the Slutsky change in demand we solve
Max U ( x, y)
subject to p' x x  p y y  p' x x*  p y y*
A Numerical Example
 Suppose that Fred has £100 a week to spend on
food. He buys vegetables, that cost £1 per kilo,
and/or meat, that costs £1 per kilo. His utility
function is
U(veg,meat) = 0.5 x ‘kilos of veg’ x ‘kilos of meat’
 What happens if the price of veg increases to £2
per kilo?
 We can derive the optimal bundle (see previous

lectures) to get that
m m
veg 
*
and meat 
*
.
2 pveg 2 pmeat
Example continued
Initially Fred would buy veg* = 50,
meat* = 50 and get utility 1250.
100
After the price rise he
90 consumes veg* = 25, meat* =
80
50 and gets utility U* = 625.
quantity of meat (lbs)
70
60
50 Overall change in
40
30 demand for veg is 25.
20
B.C. (p_veg = 1, m = 100)
10
0
U = 1250
0 20 40 60 80 100 U = 625
quantity of veg (Kgs) B.C. (p_veg = 2, m = 100)
Compensated demand
To calculate the compensated change we need to
keep utility at 1250 even though the price is £2
1250  U (veg, meat )  0.5  veg  meat 
 m  m    
m m m 2
140 2
0.5 
 
  0.5     .
 2p  2p  4  2  16
100
 veg  meat  16
90
80
When m = 140 we get
70 veg* = 35. So, the

60
50 substitution effect is 15
40
30
and the income effect 10.
20
10
0
0 20 40 60 80 100
B.C. (p_veg = 2, m = 140)
quantity of veg (Kgs)
Slutsky demand
To calculate the Slutsky change in demand we
need that the consumer can afford veg = 50 and
meat = 50 when pveg = 2. So,
m  50  2  50 1  150.
100
90 When m = 150 we get
80
70 veg* = 37.5. So, the
60
50
substitution effect is 12.5
40 and the income effect
30
20 12.5.
10
0
0 20 40 60 80 100 B.C. (p_veg = 2, m = 150)
quantity of veg (Kgs) U = 1406.25
Summary
Scenario veg meat U m
Originally 50 50 1250 100
After price rise 25 50 625 100
If Hicks real income 35 70 1250 140
constant
If Slutsky real 37.5 75 1406.25 150
income constant
Hicks substitution Slutsky substitution

effect is 15 effect is 12.5
Slutsky vs Hicks
 Slutsky and Hicks described two different
ways to measure the same thing.
 Neither is better than the other.
 Typically, we would think of Hicks as defining
a more pure measure.
 But, the Slutsky measure is more easy to
calculate.
Slutsky identity
 The total change in demand = substitution effect +
income effect.
Δ𝑋 Δ𝑋𝑆 Δ𝑋𝑀
= − 𝑋
Δ𝑃𝑋 Δ𝑃𝑋 Δ𝑀
 In the example
 According to Slutsky definition of real income: 25 =
12.5 + 12.5.
 According to Hicks definition of real income: 25 = 15 +
10.
A negative substitution effect
 The substitution effect is always negative.
 This means that an increase in price causes a
fall in demand keeping real income constant.
An increase in px increases the slope of

y U=k the budget constraint. If we keep utility
constant (or purchasing power) the new
optimum must be where the consumer
chooses less of good x.
B.C.(p’’,m’)
B.C.(p’)
X*** x*
x
The income effect?
The income effect will be The income effect will be
negative for a normal good. positive for an inferior good.
This is because an increase This is because an increase in
in price lowers real income price lowers real income and
and so leads to a reduction so leads to an increase in
in consumption of the good. consumption of the good.
B.C.(p’’) B.C.(p’) B.C.(p’’) B.C.(p’)
x
Normal, Inferior and
Giffen goods
Substitution Income Overall
effect effect effect
Normal negative negative negative
good
Quasi- negative zero negative
linear
Inferior negative positive negative
good
Giffen negative positive positive
good
When do the substitution and
income effect matter?
 When will the substitution effect be small?
 If there are no close substitutes e.g. petrol, cigarettes, public
transport.
 When will the income effect be small?
 If the good is a small proportion of income.
 So, the substitution effect could be small, and income
effect large, or vice versa; it all depends on the good.
Something to think about
 Recent years have seen dramatic increases
in food prices, e.g. wheat.
 How does this translate into demand?
 You might want to compare rich versus poor
people on an international and national level.
Consumer Welfare
Overview
 So far, we have studied how to solve the consumer
optimisation problem and how price and income
changes impact upon the consumer’s choice.
 Now, we will consider how to measure the welfare
impact of a change in prices or, more generally, the
welfare impact of any economic shock or policy change.
 In the process, we will introduce the concepts of
consumer surplus, compensating variation, and equivalent
variation.
Consumer Surplus
The simplest way to introduce the concept of consumer
surplus is to consider the Marshallian demand curve. At
price P0 or above, the consumer will buy nothing of
good X.
Price
of X
P0
Marshallian
demand function
Demand
for X
Consumer Surplus
Only when the price comes down to P1 would the
consumer be willing to buy 1 unit of X. So, we can say
that P1 is how much the consumer values the first unit
of X.
Price
of X
P0
P1
Marshallian
demand function
Demand
1 for X
Consumer Surplus
The consumer will buy 2 units of X when the price
falls to P2. So, we can say that she values the 2nd unit
at P2.
Price
of X
P0
P1
P2
Marshallian
demand function
Demand
1 2 for X
Consumer Surplus
Now, suppose the actual price of the good is P* and
the consumer chooses to buy Q* units of the good.
Price
of X
P0
Marshallian
demand function
P*
Demand
Q* for X
Consumer Surplus
We have argued that she values the 1st unit that she
buys at P1. So, we can say that (P* − P1) is the surplus
that she gets from the 1st unit of the good. This can be
represented (roughly) by the shaded region below.
Price
of X
P0
P1
Marshallian
demand function
P*
Demand
1 Q* for X
Consumer Surplus
She values the 2nd unit at P2 and so (P2 − P*) is the
surplus that she gets from buying the 2nd unit of the
good at price P*. We can represent this by the
additional shaded region.
Price
of X
P0
P1
P2
Marshallian
demand function
P*
Demand
1 2 Q* for X
Consumer Surplus
In this manner, we can argue that the total consumer
surplus from buying Q* units at price P* is the entire
shaded region below the demand curve and above
the price line.
Price
of X
P0
Marshallian
demand function
P*
Demand
Q* for X
Change in Consumer Surplus
Now suppose that the price rises from P* to P**, and
the quantity demanded falls from Q* to Q**. By how
much would this change consumer surplus?
Price
of X
P0
P**
Marshallian
demand function
P*
Demand
Q ** Q* for X
Following the increase in price, the new consumer
surplus is equal to the shaded region below.
Price
of X
P0
P**
Marshallian
demand function
P*
Demand
Q ** Q* for X
Therefore, when the price rises from P* to P**, the
resulting change in consumer surplus is simply equal
to the difference between the two areas.
Price
of X
P0
P**
Marshallian
demand function
P*
Demand
Q ** Q* for X
Consumer Surplus as a Measure of
Welfare
 The consumer surplus is considered an inexact measure of
welfare.
 This is because the Marshallian demand curve shows a
consumer’s demand (and thus valuation) of a good for a
fixed amount of nominal income.
 But as price changes, the consumer’s real income is
changing as well.
 So, it is not the consumer’s ‘true’ valuation of the good:
it incorporates the income effect from the price change.
Example Continued
 Similarly, we can compute the change in consumer
surplus by calculating the area under the Marshallian
demand curve.
Price of
Vegetables We need to calculate the area of the
shaded region.
2
Marshallian
demand function
1
Demand for
Q ** Q* Vegetables
Example Continued
 The equation for the Marshallian demand curve is
m
veg  *
.
2 pveg
 We can compute the area of the shaded region

using integration:
2 2
dpveg  50ln(veg) 1  50ln2.
m 100
CS   dpveg  
2
pveg 1
2 pveg pveg 1
2 pveg
 The change in consumer surplus is (approximately) £35.

What are Compensating Variation and
Equivalent Variation used for?
 Suppose the government would like to help poor

households cope with a rise in food prices. The compensating
variation of the price rise would tell us how much extra cash
such a household would need to be as well off as they were
before the price rise.
 Suppose the government is considering a fuel price subsidy
to help certain poor households. The equivalent variation
allows us to compare the cost of the subsidy programme
with a direct cash transfer that would make these poor
households equally well-off.
Topics in Consumer Theory:
Labour Supply
Overview
 We have now covered the basic concepts and tools in the
theory of the consumer.
 Now, we will consider various applications of consumer
theory in two areas; namely,
 Labour Supply
 Saving and Borrowing
 The aim is to show how the framework of consumer

choice can be adapted to analyse a variety of economic
issues.
Labour Supply
 We are interested in a simple problem. How many hours
(in a fixed period of time) would an individual choose to
work?
 How would the individual’s supply of labour respond to
changes in the wage rate, the price of consumer goods,
the income tax rate, etc.?
The Basic Problem
 A worker faces a wage rate of w.
 She/he can provide a maximum of T hours of labour (per
week).
 She/he gains utility from leisure and a consumption
good that we denote by Y. The price of good Y is p.
 She/he also has, potentially, non-labour income denoted
by M (for example, from interest-earning financial
assets).
 How many hours (per week) would she choose to work?
The Budget Equation
 If she/he chooses to work L hours, her labour income
would equal Lw.
 If her/his preferences for the consumption good Y and
for leisure are monotonic, then she/he will devote any
time she/he does not work to leisure and spend any
income she earns on Y.
 So we must have
pY = M + Lw
The Budget Equation
pY = M + Lw
 To make this equation more like a budget constraint, we

add Tw to both sides:
pY + Tw = M + Lw + Tw
The Budget Equation
pY = M + Lw
 To make this equation more like a budget constraint, we

add Tw to both sides:
pY + Tw = M + Lw + Tw
 Subtracting Lw from both sides, we have

pY + (T − L)w = M + Tw
The Budget Equation
pY + (T − L)w = M + Tw
 Note that (T − L)w is the amount of leisure she enjoys.

 For every hour of leisure, she is giving up an hour of
labour. In this sense, w is the price of leisure.
The Budget Equation
pY + (T − L)w = M + Tw
 On the right-hand side of the equation Tw is her

potential labour earnings from working the maximum of
T hours.
 We can imagine that she/he is selling off all her/his
labour at wage rate w and then buying leisure at a rate
w.
 Then, the equation above looks like a normal budget
equation involving two goods, leisure and Y, and total
earnings of M + Tw.
Budget Constraint
 We can represent the budget equation in a diagram
with leisure on the horizontal axis and the
consumption good Y on the vertical axis.
 Note that the budget line becomes vertical at T
because the worker cannot enjoy more than T hours
of leisure.
Y
(M+Tw)/P
M/P
Leisure
T
Consumer Optimisation with Labour
 In the figure below, if the worker maximises utility,
she will work (T − X) hours, and enjoy X hours of
leisure.
 And she will spend her resulting income of M + (T −
X)w on good Y.
(M+Tw)/P
[M+(T−X)w]/P
M/P
Leisure
X T
Changes in Non-Labour Income
How would the worker’s hours of work change if her

non-labour income suddenly increased?
 How would the worker’s hours of work change if

her non-labour income suddenly increased to M1?
 To answer this question, we redraw the budget line
to reflect the higher non-labour income.
Y
(M1+Tw)/P
(M+Tw)/P
M1/P
Leisure
T
 If the preference for leisure and consumption are

monotonic and convex and leisure is a normal good,
then the worker will choose to consume more leisure
than before.
Y
(M1+Tw)/P
(M+Tw)/P
M1/P
Leisure
X X1 T
Changes in the Wage Rate
 If the wage increased to, say w1, this would rotate
the budget line outward, with a pivot at (T, M/P).
Y
(M+Tw1)/P
(M+Tw)/P
M/P
Leisure
T
 If the wage increased to, say w1, this would rotate
the budget line outward, with a pivot at (T, M/P).
 In the diagram below, this leads to an increase in
leisure, i.e. a decrease in the supply of labour.
Y
(M+Tw1)/P
(M+Tw)/P
M/P
Leisure
X X1 T
 However, with different indifference curves (and
preferences still monotonic and convex), the increase
in wages could lead to a decrease in leisure, i.e. an
increase in the supply of labour.
Y
(M+Tw1)/P
(M+Tw)/P
M/P
Leisure
X1 X T
Income and Substitution Effects from
 An increase in the wage rate involves two different
effects.
 First, the worker’s potential earnings increase. So, we
should see an income effect. If leisure is a normal good, this
should have positive effect on leisure.
 But an increase in the wage rate also increases the
relative price of leisure (compared to good Y). So, we
should see a substitution effect. The worker should
substitute some leisure with consumption of good Y.
 So, the net effect of a rise in wages on leisure and labour
supply is ambiguous.
Income and substitution effects of a
wage increase
m
B.C.(w1) Fix a price, w = w0 and find X0.
Increase the wage, w = w1 and find the

U=k new X1. This gives the overall change in
B.C.(w0) demand (or labour supply).

effect we reduce the
B.C.(w1,m2)
consumer’s nominal income
(m2) to achieve U = k at the
X2 X0 X1 T Leisure
higher wage.
Income and substitution effects of a
wage increase II
m
B.C.(w1) Fix a price, w = w0 and find X0.
Increase the wage, w = w1 and find the

new X1. This gives the overall change in
B.C.(w0) demand (or labour supply).

U=k
effect we reduce the
B.C.(w1,m2) consumers nominal income
(m2) to achieve U = k at the
X2X1 X0 T Leisure
higher wage.
Income and Substitution Effects from
 A long-standing hypothesis in microeconomics is that
the subsitution effect dominates at low wage rates, but the
income effect dominates at high wage rates.
 That is, if you are cleaning dishes in a restaurant and the
wage rate goes up, you would want to work more hours.
 But if you are a skilled professional – a doctor or a
lawyer, then you could actually choose to work less if
your wages went up.
 This is called the backward-bending supply curve of labour.
Drawing the Labour Supply Curve
We can derive the demand for
Y
leisure as with any other good.
For a given wage w, find

the choice of leisure X.
U=k
M/p
T leisure
Increase the wage to w1
w and find the new choice of
leisure X1.
w1
Demand for leisure Note that the demand curve
for leisure slopes upwards.
w
X X1 leisure
The labour supply curve
Given the demand for leisure we can find the
worker’s labour supply curve by subtracting X
from T.
A backward-bending labour supply curve

Labour supply may look like this.
w Income effects
dominate
Substitution effects
dominate
L
Labour Supply and Gov’t Benefits
 How would lowering government benefits affect labour
supply?
 A decrease in government benefits is equivalent to a
decrease in non-labour income.
 We saw previously that, if leisure is a normal good, then
an increase in non-labour income leads to an increase in
leisure; i.e. a decrease in labour supply.
 Therefore, a decrease in government benefits should
lead to an increase in labour supply.
 But beware of caveats: cutting benefits may make labour
less productive, etc.
Labour Supply and Income Tax
 How would raising the income tax rate affect labour
supply?
 An increase in the income tax rate is, effectively,
equivalent to a decrease in the wage rate.
 We saw that the impact of a change in the wage rate on
labour supply is ambiguous. The impact depend on
whether the income effect or the substitution effect is larger.
 If the labour supply curve is backward bending, then
raising the income tax rate for low wage earners would
decrease their labour supply, but raising the tax rate for
very high wage earners would increase their labour
supply.
Does the Labour Supply Curve
Really Bend Backward?
 Camerer et al. (1997), “Labour Supply of New York City
Cab Drivers: One Day at a Time”, by, Quarterly Journal of
Economics, Vol. 112(2)
 The article looks at how long taxi-drivers in New York
work on rainy versus dry days.
 On rainy days, there is a higher demand for taxis; so, in
effect, the taxi-drivers have a higher wage on these days.
 Taxi-drivers seem to quit earlier on rainy days, after they
have reached an earnings target for the day.
 So, labour supply goes down when wages rise.
 For the taxi-drivers, the income effect dominates the
substitution effect.
Topics in Consumer Theory:
Inter-temporal Choice
Overview
 Now, we use consumer theory to study saving and
borrowing behaviour of households.
 In Microeconomics, this topic is often referred to as
‘Inter-temporal Choice’.
 In the process, we will introduce two related concepts:
 Consumption Smoothing
 Life Cycle Hypothesis

Use of Inter-temporal Choice Theory
 In Development Economics, the theory of inter-temporal
choice is relevant for the study of agricultural
households faced with
 Shocks to agricultural output
 Seasonality of agricultural output
 So, the income of agricultural households is very

variable, but patterns of consumption are generally
smoother than income.
• Income and Consumption Patterns in an Indian village.
• Townsend (1994), “Risk and Insurance in Village India”,
Econometrica, Vol. 62(3).
• The graphs show that household incomes over a 9 year
period were very variable
• But household consumption was much more smooth.
Household Income: Deviation Household Consumption:

from Village Average Deviation from Village Average
Consumption Smoothing
 The graphs show that rural households (in this
particular village) are able to enjoy relatively smooth
consumption despite having very variable income.
 The extent to which households are able to smooth
consumption depends on assets, access to social
networks, etc.
 But the graphs also indicate that the households prefer to
smooth consumption.
 We will see today what sort of preferences and utility
functions can be used to represent a preference for
consumption smoothing.
The Basic Problem
 A consumer has to decide on consumption ‘today’ and
consumption ‘tomorrow’.
 He has an income M1 and he expects to have an income
M2 tomorrow.
 The interest rate for both borrowing and saving is (1 + r).
 How much will he consume today and how much will
he save for tomorrow?
Borrowing or Saving
 If you spend C1 on consumption today, then you save
(M1 – C1) for consumption tomorrow.
 If (M1 – C1) > 0, this is the amount you save.
 If (M1 – C1) < 0, this is the amount you borrow.
 And next period, you will have savings or debt, both of
which can be represented by
(M1 – C1)(1 + r)
Consumption
 So, consumption in the second period is given by
C2 = M2 + (1 + r)(M1– C1)
 We rearrange this equation to make it look more like a
standard budget equation:
C1(1 + r) + C2 = M1 (1 + r) + M2
 Dividing throughout by (1 + r), we obtain
1 1
𝐶1 + 𝐶2 = 𝑀1 + 𝑀2
1+𝑟 1+𝑟
The Budget Equation
 Think of ‘consumption today’ as one good, and
‘consumption tomorrow’ as another good.
 Think of the price of ‘consumption today’ as being equal
to 1, and the price of ‘consumption tomorrow’ as equal
to (1/(1+r)).
 Think of your total income as being M1 + (1/(1+r))M2
(this is called the Net Present Value of an income stream)
 Then the following looks like a budget equation.
1 1
𝐶1 + 𝐶2 = 𝑀1 + 𝑀2
1+𝑟 1+𝑟
Drawing the Budget Line
 We can represent the budget equation in a diagram
with ‘consumption today’ on the horizontal axis and
‘consumption tomorrow’ on the vertical axis.
 The slope of the budget is equal to – (1 + r). So, the
higher the interest rate, the steeper the budget line.
C2
(1+r)M1+M2
M2
C1
M1 M1+(1/(1+r))M2
Convex Preferences
 For the preferences shown below, his consumption
exceeds his income today. So, he borrows (M1 – X).
 And tomorrow, he will need to repay (1/(1 + r))(M1 – X)
out of next period’s income M2 and consume the rest.
C2
(1+r)M1+M2
M2
Y
C1
M1 X M1+(1/(1+r))M2
Consumption Smoothing
 Note that consumption smoothing occurs when
consumption today and consumption tomorrow are
strong complements.
 As the indifference curves become ‘straighter’, the
consumer is more willing to forego either current or
future consumption .
C2
M2
C1
M1
Credit Constrained
 The following represents the budget constraint of a
consumer who can save but cannot borrow.
C2
(1+r)M1+M2
M2
C1
M1
Different Interest Rates for
Loans and Deposits
 The following represents the budget constraint of a
consumer who can both save and borrow but at different
interest rates.
 The interest rate on a loan rl exceeds the interest rate on
a deposit, rd.
C2
(1+rd)M1+M2
M2
C1
M1 M1+(1/(1+rl))M2
Inter-temporal Technology
 Note that the slope of the budget line, more
generally, represents the rate at which you can
convert current income into future income.
 In a modern economy, the most widely used ‘inter-
temporal technology’ are savings and loans with
financial institutions.
C2
(1+r)M1+M2
M2
C1
M1 M1+(1/(1+r))M2
 But in a traditional village economy, without access to
financial markets, the best ‘inter-temporal technology’ you
have may be to keep cash at home and borrowing from
traditional money-lenders at very high interest rates.
C2
M2
C1
M1
 But in a traditional village economy, without access to
financial markets, the best ‘inter-temporal technology’ you
have may be to keep cash at home and borrowing from
traditional money-lenders at very high interest rates.
• Microfinance institutions which offer
loans and saving accounts to poor
C2 households are, in effect, trying to
improve their inter-temporal technology,
and thus their ability to smooth
consumption.
M2
C1
M1
Changing the Interest Rate
 What would happen if the interest rate were to rise?
 Intuition tells us that if you are a saver and there is
an increase in the interest rate, then you will gain. If
you are a borrower, then you will lose.
 But how would it affect actual borrowing and
saving?
 To understand the different effects on borrowing
and saving, it is useful to write down the Slutsky
equation.
Slutsky Equation for
 In the case of inter-temporal choice, the Slutsky
equation looks as follows:
Δ𝐶1 Δ𝐶1𝑆 Δ𝐶1

= + (𝑀1 − 𝐶1 )
Δ𝑃1 Δ𝑃1 Δ𝑀
Δ𝐶1𝑆
 The substitution effect , as always, is negative.
Δ𝑃1
 If we assume that consumption in both periods are
Δ𝐶1
normal goods, then >0
Δ𝑀
 For a saver, (M1 – C1) > 0
 For a borrower, (M1 – C1) < 0
= + (𝑀1 − 𝐶1 )
? − + ?
 An increase in the interest rate should be thought of as an
increase in the price of current consumption P1 .
Then we see that
 it lowers C1 (and borrowing) for a borrower
 it lowers C1 for someone who is neither a lender, nor a

borrower
it has an ambiguous effect for lenders
but for big lenders, it would lead to an increase in C1

(and lower lending) as the income effect comes to
dominate the substitution effect.
− =− − (𝑀1 − 𝐶1 )
? + + ?
 A decrease in the interest rate should be thought of as a
decrease in the price of current consumption P1 .
Then we see that
 it raises C1 (and borrowing) for a borrower
 it raises C1 for someone who is neither a lender, nor a

borrower
it has an ambiguous effect for lenders
but for big lenders, it would lead to an decrease in C1

(and higher lending) as the income effect comes to
dominate the substitution effect.
Representing Interest Rate Changes
 An increase in the interest rate makes future
consumption more affordable, and current
consumption more expensive.
 Note that consuming exactly your income each
period is always exactly affordable.
C2
(1+r)M1+M2
M2
C1
M1 M1+(1/(1+r))M2
Representing Interest Rate Changes
 An increase in the interest rate makes future
consumption more affordable, and current
consumption more expensive.
 Note that consuming exactly your income each
period is always exactly affordable.
C2
(1+r1)M1+M2 • So, as the interest rate rises,
the budget line pivots clockwise
around the point (M1 , M2).
M2
C1
M1 M1+(1/(1+r1))M2
A Numerical Example
 Suppose the consumer’s preferences over consumption
this month and next month is given by
U( C1 , C2 ) = Ln(C1) + βLn(C2)
and β (called the discount factor) is equal to 0.8 .
 Suppose the consumer will earn £1100 in the first month

and £735 in the second month and the interest rate, for
both borrowing and saving, is equal to 5%
 How much will the consumer borrow/save and consume

in the two periods?
A Numerical Example
 The present value of the consumer’s income is equal to
1100 + 735/(1.05) = 1800
 The utility function is simply a logarithmic utility

function. So consumer optimization should yield
P1C1 = (1/(1+β)) × M
P2C2 = (β/(1+β)) × M
where M is the net present value of the consumer’s total

income.
A Numerical Example
 Recall that P1 = 1, and P2 = 1/(1+r)
 So we obtain C1 = 1800/(1.8) = 1000
 And C2 = (1800 − 1000) × (1.05) = 840
 So, the consumer spends £1000 in the first month and

saves £100.
 The savings yield £105 in the second month.
 She spends £735 + £105 = £840 in the second month.
A Numerical Example
 Suppose the interest rate were to increase to 25%
 Then the net present value of income would equal
1100 + 735/(1.25) = 1688
 C1 = 1688/(1.8) = 937.78
 C2 = (1688 − 937.78) × 1.25 = 937.78
 A smaller discount factor encourages current

consumption.
 A higher interest rate encourages future consumption.
 They offset each other exactly when β = 1/(1+r)
The Life-Cycle Hypothesis
 We can apply the idea of consumption smoothing to
a lifetime of earning and spending.
 An individual’s income, in general follows a U-
shape pattern over one’s lifetime.
 If, on the other hand, people prefer to maintain a
roughly stable standard of living, we obtain the
following diagram.
Income
Consumption
Youth Middle Age Old Age

The Life-Cycle Hypothesis
It makes sense that indifference curves should
be convex – a person wants to smooth
consumption over today and tomorrow.
This means that a person early in

c2 their life will be a borrower.
M2(yng)
When earning most the person needs
to be a saver – repay his borrowing
and save for retirement.
M2(earn) U=k In retirement the person

B.C.(r’) may have no future
M2(ret) income
M1(yng) M1(earn) M1(ret) c1
Theory of the Firm:
Technology
Theory of the Firm
 During the next lectures, we study the Theory of the Firm,
which is about how firms make decisions about use of
inputs, production and supply.
 The key building block for the theory of the firm is
something called technology.
Technology
 The technology of a firm describes the different
combinations of inputs and outputs that are feasible.
 For example, if it is possible to produce 10 widgets from
1 hour of machine time and 30 hours of labour, then we
say that
 “(10 widgets, − 1 machine hour, − 30 hours of labour)
is in the production set.”
(The minus signs are used to denote inputs)

Production Set
 The production set describes all possible output-input combinations.
 Note that, at the moment, we are not concerned with whether the
firm actually has the necessary inputs, but only what production
plans, as described by input and output quantities, are feasible.
Here is one possible production set:
Widgets Machine (Hours) Labour (Hours)

10 1 30
15 1 60
20 2 60
25 2 90
etc.
Production Set
In the case where there is only input and one output, we
can represent the production set graphically:
Widgets Production Set
18
Labour/Hours
60
Production Function
The production function indicates the maximum output that
can be obtained for each level of input.
Production Function
20
Labour/Hours
60
Production Function
 The following is a (mathematical representation of)
production function:
Y = F( K , L )
A firm which has access to this technology can produce Y

units of output with K units of the first input (e.g. capital)
and L units of the second input (e.g. labour).
Returns to Scale in Production
 Suppose that by scaling up the quantity of inputs, we
obtained more than a proportional increase in the
quantity of output. i.e.
F( tK , tL) > t × F( K , L)
where t > 1.
• Then we say that the production function exhibits

increasing returns to scale.
• Similarly,
F( tK , tL) < t × F( K , L) decreasing returns to scale
F( tK , tL) = t × F( K , L) constant returns to scale
Example of a Production Function
 Cobb-Douglas Production Function:
F( K, L ) = KαLβ
where α, β > 0
 Note that
F( tK, tL ) = (tK)α(tL)β
F( K, L ) = KαLβ
where α, β > 0
 Note that
= tαKαtβLβ
= t(α+β) × KαLβ
= t (α+β) × F( K, L)
F( K, L ) = KαLβ
where α, β > 0
 Note that
= tαKαtβLβ
= t(α+β) × KαLβ
= t (α+β) × F( K, L)
 If α + β = 1, then constant returns to scale

 If α + β > 1, then increasing returns to scale
 If α + β < 1, then decreasing returns to scale
Marginal Product
 The marginal product of an input is the increase in output we
would get by increasing its use by one unit.
 Mathematically, the marginal product of input L is given by
MPL = ∂F(K, L)/ ∂L
 For example, if I am growing wheat on 1 hectare of land,

using 30 hours of labour, then the marginal product of labour is
the increase in the output of wheat from (approximately)
using an additional hour of labour.
Marginal Product (2)
 Let us reconsider the Cobb-Douglas Production
Function:
F( K, L ) = KαLβ
where α, β > 0
 We have
∂F(K, L)/ ∂L = β KαL(β-1)
Marginal Product (3)
 Let us reconsider the Cobb-Douglas Production
Function:
F( K, L ) = KαLβ
where α, β > 0
 We have
∂F(K, L)/ ∂L = β KαL(β-1)
 i.e., if we increase labour by 1 unit, output would
increase by β KαL(β-1)
Diminishing Marginal Product
 We have
∂F(K, L)/ ∂L = β KαL(β-1)
 Suppose β < 1
 Then β KαL(β-1) is decreasing in L

 i.e. the larger is L, the smaller is the return from using
any additional unit of labour
 In this case, we say that the production function exhibits
diminishing marginal product of labour.
Diminishing Marginal Product (2)
 Note that returns to scale and marginal product are
related concepts but they are not the same.
 For example, let

F( K, L ) = KαLβ
 Suppose α,β > 0, α + β > 1 and α,β < 1
 Then we can verify that it exhibits increasing returns to

scale but diminishing marginal product in both capital and
labour.
Decreasing Returns to Scale
20
15
Labour/Hours
30 60
Increasing Returns to Scale
35
10
Labour/Hours
40 100
Constant Returns to Scale
25
10
Labour/Hours
20 40 100
Substitution between Inputs
• If there is more than one input involved in the

production process, then it may be possible to produce
the same output using different combinations of
inputs.
• For example, it may possible to produce 20 widgets

with 2 machine hours and 60 hours of labour or with 3
machine hours and 40 hours of labour.
Isoquants
An isoquant is the set of all possible input combinations
that produce the same level of output. In the case where
there are only two inputs involved, we can represent the
isoquant in a diagram.
Machine (hours)
20 widgets
15 widgets
10 widgets
Labour/Hours
Isoquants
 An isoquant is analogous to an indifference curve.
 Recall that the equation U(X,Y) = C corresponds to an
indifference curve.
 Similarly, we can use the equation F(K,L) = C to generate
an isoquant.
Isoquants
 An isoquant is analogous to an indifference curve.
 Recall that the equation U(X,Y) = C corresponds to an
indifference curve.
 Similarly, we can use the equation F(K,L) = C to generate
an isoquant.
 Let us take the total derivative of the equation above
with respect to L:
(∂F/ ∂K) × (∂K/ ∂L) + (∂F/ ∂L) = 0

=> (∂K/ ∂L) = − (∂F/ ∂L) / (∂F/ ∂K)
Technical Rate of Substitution
(∂K/ ∂L) = − (∂F/ ∂L) / (∂F/ ∂K)
 This equation tells us how much we would have to

adjust K to keep output constant if we increased L by
one unit.
 It is called the technical rate of substitution (TRS)
 The slope of the isoquant is equal to TRS
 Note that the TRS is analogous to the MRS
Technical Rate of Substitution (2)
(∂K/ ∂L) = − (∂F/ ∂L) / (∂F/ ∂K)
 In the case of the Cobb-Douglas production function, we

have
∂F/ ∂L = β KαL(β-1)
∂F/ ∂K = α K(α-1)Lβ
 Therefore,
∂K/ ∂L = − (β/α) (K/L)
Technical Rate of Substitution (2)
∂K/ ∂L = − (β/α) (K/L)
 Note that the magnitude of the slope is high when K is

large and L is small.
 And the magnitude of the slope is low when K is small
and L is large.
 Thus we have …
Convexity of Isoquants
 Note that the isoquants in the figure below become
flatter as machine hours are replaced with labour.
 This property is called diminishing technical rate of
substitution.
 It implies that ‘averaging’ across different
combinations of capital/labour inputs will lead to
higher output.
Machine/Hours
Labour/Hours
More Examples of
Production Functions
 Fixed Proportions Technology
F( K, L ) = min { αK, βL }
 In this case, K and L must be used in a fixed

proportion.
 If αK > βL, then increasing K further does not increase
output.
 If βL > αK, then increasing L further does not increase
output.
Fixed Proportions Technology
 If the isoquants appear as ‘right-angles’, they represent a
fixed proportions technology: the two factors must be used
in a precise ratio.
 For example, if a machine needs to be operated by exactly
one worker at all times, then having access to a machine is
useless without a worker and vice versa.
Machine/Hours
10 20 widgets
5 10 widgets
Labour/Hours
5 10
More Examples of
 Perfect Substitutes
F( K, L ) = αK + βL
 In this case, the technical rate of substitution between K

and L is constant.
 1 unit of K can be substituted with exactly (α / β) units
of L to maintain the same level of output.
Perfect Substitutes
 If it is possible to replace one input with some fixed
amount of another, then the two inputs are perfect
substitutes.
 For example, two different types of seeds may serve a
farmer equally well.
Seed B
Seed A
More Examples of
 Recall that in the first lecture, we introduced the
following production function in the context of child
labour:
x = f ( A + γC )
 In this case, one unit of adult labour can always be

substituted with γ units of child labour.
 Therefore, this is another example of perfect
substitutes.
Note that for almost every concept we discuss in
Producer Theory, there is a parallel concept in
Consumer Theory:
Consumer Theory Producer Theory

Preferences Technology
Utility Function Production Function
Marginal Utility Marginal Product
Indifference Curves Isoquants
MRS TRS
Consumer Optimisation Profit Maximisation
An important difference is that for any given

technology, there is a unique production function
unlike the case of preferences and utility functions.
A Glimpse at Profit Maximisation
 We will look at profit maximisation in detail next lecture,
but let’s make a start now.
 What should the firm do if
p  MPL  w
Increase in revenue Cost of hiring
from hiring more labour more labour
 The firm should employ more labour.

Factor input condition
 You can check that if p  MPL  w the firm
should employ less labour.
 So the equilibrium condition is that
w r
MPL  ; MPK  .
p p
 It is important that we also have diminishing

marginal product for labour and capital.
Tangency Condition
 Putting all this together gives us
MPL w
 TRS   .
MPK r
 This will be the tangency condition that lets
us find the profit maximizing optimum for the
firm.
Profit Maximisation
Why maximise profits?
 Firms are typically owned by consumers
(whether as proprietor or shareholder) who
eventually receive the profits as dividends;
higher income => higher utility
 In a perfectly competitive market, a firm that
does not maximise profits will be driven out of
business.
The firm’s problem
 The objective of the firm is to maximise profits.
 In the short run the firm chooses L.
Short run : max L   pf ( L, K )  Lw  Kr.

 In the long run the firm chooses both L and K.
Long run : max L , K   pf ( L, K )  Lw  Kr.

The firm’s solution
Solving for the firm’s optimum gives:
 Factor demand curves. For example, we
obtain the demand for labour as a function of
w, r and p.
 Output function. This details the output of
the firm as a function of w, r and p.
 We can obtain both short run and long run
curves and functions.
Finding the optimum
 At the optimum we should have
w r
MPL  ; MPK  .
p p
 Using this we can find the factor demand
curves and the output function in both the
short and long run.
 Note: We do have to be careful about boundary solutions
but much less careful than in consumer theory. A
consumer may choose to buy no apples but a firm will
usually employ some labour.
Intuition behind the profit
maximising conditions
 Rearranging the equations, we get
pMPL  w pMPK  r.
 If pMPL > w or pMPK > r the firm could
increase its profits by using more
capital/labour? Why?
 If pMPL < w or pMPK < r and K, L > 0 the firm
cannot be maximising profits. Why?
A worked through example
 Suppose that f(L,K) = L0.5 + K0.5
 We first find the marginal products of labour

and capital.
f ( L, K )
MPL   0.5L0.5
L
f ( L, K )
MPK   0.5K 0.5
K
 Set
0.5 w 0.5 r
MPL  0.5L  ; MPK  0.5K 
p p
The example continued
 Rearranging gives factor demand curves
p2 p2
L 2
and K  2
4w 4r
 From f(L,K) = L0.5 + K0.5 we also get the

output function
p  1 1
Long run : Y     and
2 w r 
p
Short run : Y   K 0.5
2w
Short versus long run
 If the wage rate goes up the firm will hire less
labour and produce less output.
 If the interest rate goes up the firm would like
to employ less capital but cannot. This means
 Output will be higher than the firm would like,
 Costs will be higher than it would like,
 Profits will be lower.
p  1 1
2 2 Long run : Y    
L
p p
and K  2 2 w r 
2
4w 4r p
Short run : Y   K 0.5
2w
Iso-Profit Line
 To capture short run comparative statics we
can use iso-profit lines.
 An iso-profit line plots combinations of outputs
and inputs that yield a constant profit.
 It is most useful to look at the short run iso-profit
line. Profits are
  pY  wL  rK
which can be rewritten

 r w
Y  K L
p p p
Using iso-profit lines
We can plot iso-profit lines on
 r w
the same diagram as a Y  K L
production function. p p p
The Y intercept is increasing
Π = 10 in profits. So the firm wants
Y
Π=7
to be on the highest possible
iso-profit line.
The firm maximises short
Π=5
run profits where the iso-
profit line is tangent to the
Production function production function. Where
w
L  MPL
p
Short run comparative statics
 We can use iso-profit lines and production
function to diagrammatically see how the firm
changes output and factor inputs in response
to a change in factor prices or the price of the
product.
Example 1: w increases
Let L* and Y* be the initial
 r w
profit maximising level. Y  K L
p p p
Π=7
Y If w increases then the
Π = 10 slope of the iso-profit line
must increase. We find a
new optima L**, Y**.
Y*
Both labour input and
Y**
output have decreased.
Also profits must have
Production function decreased because the Y
L** L* L intercept is lower
Example 2: p decreases
 r w
p p p
Π=5
Y If p decreases then the
Π = 10 slope of the iso-profit line
must increase. We find a
new optima L**, Y**.
Y*
Both labour input and
Y** output have decreased.
Also profits must have
Production function decreased a lot because
the Y intercept is lower and
L** L* L
p is lower.
Example 3: r increases
 r w
p p p
Y When r increases the slope
Π = 10, 5 of the iso-profit line does
not change. So the
optimum remains L*, Y*.
Y*
The Y intercept is the same
but r has increased so
profits must have
Production function
decreased.
L* L
Summary of examples
 If the price of labour increases, demand for
that factor will decrease, and result in:
 Less output,
 Lower profits.
 If the price of capital increases, the firm
cannot change its demand, so:
 Output stays the same,
 The firm makes less profits.
 In the long run we would expect substitution
away from the relatively more expensive
input.
Long run effect of r increase
 r w
p p p
Y When r increases the slope
Π = 10 of the iso-profit line does
not change. But, In the long
Π=5 run will substitute away
Y* from capital. Implies a new
Y** Production function production function.
with lower k The optimum becomes L**,
Y**.
Production function
L** L* L
Profits and increasing RTS
Suppose we have increasing
 r w
marginal product of labour. Y  K L
This changes the shape of the p p p
production function.
Y Π = 10 Where is the optimum now?

Π=7
The firm can get on as high
Π=5
an indifference curve as it
likes. The tangency
condition gives us the
Production function minimum. There is no
L solution for the maximum!
Cost Minimisation
What is Cost Minimisation?
 Cost Minimisation is a procedure to find out
the least costly way to determine a certain
level of output.
 This depends on the available technology
and factor prices.
 In mathematical notation, we solve
Min(L,K) wL + rK subject to f(L,K) = Y

Using Cost Minimisation
Min(L,K) wL + rK subject to f(L,K) = Y
 Solving the cost minimisation problem

generates the cost function, C(w,r,Y)
 The cost function provides an alternative way
to solve the profit maximisation problem:
Max( Y ) pY – C(w,r,Y)
Iso-Cost Lines
 First, we shall determine the cost
minimisation point graphically. For this
purpose, we introduce the concept of iso-cost
lines.
 If a firm uses L units of labour and K units of
capital, then its total cost is given by
TC = wL + rK
 Rearranging this equation, we obtain

TC wL
K 
r r
Iso-Cost Lines
TC wL
K 
r r
 This is a linear equation of K in terms of L,
with a slope equal to –w/r and an intercept
that depends on the total cost.
Drawing an Iso-Cost Line
Iso-cost lines are straight
lines with slope –w/r. TC wL
K 
K
r r
The further from the origin the

higher the total cost.
TC=10
TC=2 TC=5
L
The Cost Minimising Level
We plot the isoquant corresponding to the
level of output the firm wants to produce.
We then plot on iso-cost curves.

K
The firm minimises cost by being
on the lowest possible iso-cost
curve consistent with producing Y.
The firm minimises costs

where the isoquant and
iso-cost are tangent.
f(K,L)=Y
TC=2 TC=5 TC=10
L
Comparing cost minimization
to utility maximization
Cost minimization we fix the Utility maximization we fix the
isoquant and find the lowest budget constraint and find the
isocost line. highest indifference curve.
K y
px MU x
w MPL
 
r MPK p y MU y
TC=10
f(K,L)=Y
U = 10
TC=5 BC
L U=5 x
The Mathematics of
Cost Minimisation
 Using the diagram on the previous slide, we
can derive a mathematical condition for the
cost minimising point.
 Recall that the slope of the isoquant is equal
to –MPL/MPK (where MPL= ∂F/ ∂L and MPK =
∂F/∂K).
 The slope of the isocost line is equal to –w/r .
 Hence we need
w MPL

r MPK
The Mathematics of
Cost Minimisation
 In words, the ratio of prices is equal to the
technical rate of substitution.
 Rearranging the equation, we obtain
MPL MPK

w r
 This last equation has a simple intuitive
interpretation which may be easier to
remember.
An example
 Suppose that f(L,K) = L0.5 + K0.5.
 We use the tangency condition
0.5 0.5
MPL 0.5L K w w 0.5
 0.5
    K 0.5
 L
MPK 0.5K L r r
 The firm wants to produce Y units

w 0.5 r  w 0.5
L K
0.5 0.5
L  L 
0.5
L Y
r r
Example continued
 Rearranging, we get the optimal level of
capital and labour:
2 2
 Yr   Yw 
L  and K   
 r  w  r  w
 The cost function is therefore:

2 2
   
2
Yr Yw Y wr
C (Y )  wL  rK  w   r  
 r  w  r  w rw
Conditional Factor Demand
2 2
 Yr   Yw 
L  and K   
 r  w  r  w
 The two equations above are known as the

conditional factor demand curves.
 They tell us the level of capital and labour the
firm would demand if it wanted to produce an
output equal to Y.
Profit maximisation
 Once we know the cost function C(Y) then we
can easily find the profit maximising level of
output.
 The firm chooses Y to solve
Max pY – C(Y)
 To solve this problem, we use the following

equation: C
p 0
Y
Example again
 The profit of the firm is
Y 2 wr
  pY  C (Y )  pY 
rw
 We find the optimal profit by setting

C
p 0
Y
 i.e.
Ywr
p2 0
rw
Example again II
 Rearranging the equation, we obtain
p ( r  w)
Y
2 wr
p  1 1
Y    
2 w r
 Note that, whether we compute the profit
maximising level of output directly, as we did
last week, or we make use of the cost function, we
should obtain the same result.
Cost Function for a
Fixed Proportions Technology
 Consider the following production function:
F( K, L ) = min { αK, βL }
 Since the isoquants are right-angles (see Lecture 12), we

cannot use the tangency condition to solve the cost
minimisation problem.
 However, the calculation is straightforward: to produce
Y units, the firm needs at least Y/α units of K and Y/β
units of L.
 So, the minimum cost of producing Y is
r(Y/α) + w(Y/β)
Comparative Statics
 We can use isoquants and iso-costs to see
the comparative statics of a change in w or r.
 In doing this we need to assume that the firm
will keep output constant. In all likelihood,
however, the firm will change output.
An increase in the wage
The firm is cost minimising at L*, K* and
producing Y.
An increase in the wage will make the

high iso-cost line steeper. The firm now
K
wage minimise costs at L**, K**.
As we would expect, the firm is using less

labour and more capital.
K**
To make more profit the firm
K***
may want to change the
K*
amount of output it produces
Y to Y*.
L*** L** L* Y* Low L
wage

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The Aim of this Course

 To deepen your understanding of economics

 economics is about using simple models to get

But what underlies these variables are decisions made by

Microeconomics focuses on these individual and firm-level

 but recent advances have extended microeconomic

Households Firm Profits via stocks, bonds, etc. Firms

All of these choices will be within your budget constraint.

More generally, if crisps were £ PX each and drinks £ PY

Then, the budget constraint can be written as

 Convexity: Averages are better.

 So V(.) can represent the same preferences.

 According to the Food and Agricultural

 The UN’s first Millennium Development

 Under the following conditions …

 we know that the individual will consume a

 We can describe the equation as follows:

 So, (∂U/ ∂X) / (∂U/ ∂Y) = Y / X

 So, the equation becomes ½ = Y / X

 Increase in food prices or fuel prices because of global

You are given U(X,Y), prices PX and PY and wealth M.

 As we go down an indifference curve, we are increasing

For wealth M1, find the optimum

M X Increase wealth to M2 and find the

(X1,Y1) For price P1 , find the optimum

Increase the price to P2 , find the

P2 And so on, plotting the points along

 A demand function (for good X) specifies how

 Note that we have already derived the demand

 These expressions tell us how the demand for X

 Utility Function U(X,Y)

Inferior goods. Demand decreases as income increases;

Homothetic preferences. Demand increases proportionally

To find the substitution

Increase the price, px = p’’

To find the substitution

Increase the price, px = p’’

 We can derive the optimal bundle (see previous

70 veg* = 35. So, the

Hicks substitution Slutsky substitution

An increase in px increases the slope of

B.C.(p’’) B.C.(p’) B.C.(p’’) B.C.(p’)

 We can compute the area of the shaded region

 The change in consumer surplus is (approximately) £35.

 Suppose the government would like to help poor

 The aim is to show how the framework of consumer

 To make this equation more like a budget constraint, we

 To make this equation more like a budget constraint, we

 Subtracting Lw from both sides, we have

 Note that (T − L)w is the amount of leisure she enjoys.

 On the right-hand side of the equation Tw is her

How would the worker’s hours of work change if her

 How would the worker’s hours of work change if

 If the preference for leisure and consumption are

Increase the wage, w = w1 and find the

To find the substitution

Increase the wage, w = w1 and find the

To find the substitution

For a given wage w, find

A backward-bending labour supply curve

 Life Cycle Hypothesis

 Seasonality of agricultural output

 So, the income of agricultural households is very