Microeconomics I

CHAPTER ONE

THE THEORY OF CONSUMER BEHAVIOR

In this section you will see how consumers allocate their limited income among different
number of goods and services and you will learn how consumer allocation decisions
determine quantity demand of goods and services.
1.1 Consumer Preference
Given any two consumption bundles available for purchase how a consumer compares
the goods? Does he prefer one good to another or does he indifferent between the two
groups.
Given any two consumption bundles the consumer can either decide that one of
consumption bundles is strictly better than the other or decide that he is indifferent
between the two bundles.
Assumptions
1. The consumer is rational:- given his/her income and the market price of the
commodities, he/she plans the spending of his/her income so as to attain the highest
possible satisfaction or utility. This is the axiom of utility maximization
2. The consumer has complete knowledge of all the information relevant to his/her
decision. I.e. he/she has complete knowledge of all the available commodities, complete
knowledge of the price of the commodities, complete knowledge of his/her income.
3. Completeness
For any two commodity bundles X and Y a consumer will prefer X to Y,Y to X or will be
indifferent between the two.
4. Transitivity and consistency
It means that if a consumer prefers basket A to basket B and to basket C then the
consumer also prefers A to C.
5. No satiation or more is better than less
Consumers always prefer more of any good to less and they are never satisfied or
satiated. However, bad goods are not desirable and consumers will always prefer less of
them.

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2.2 Utility

Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service.
Definition

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

undertaking an activity.
In defining strict preference, we said that given any two consumption bundles(X1, X2)
and (Y1, Y2), the consumer definitely wants the X bundle than the Y bundle if (X1, X2)
> (Y1, Y2).This means, the consumer preferred bundle (X1, X2) to bundle (Y1, Y2) if
and only if the utility (X1, X2) is larger than the utility of (Y1, Y2).
The concept of utility is characterized with the following properties:
 ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso
may be useless functionally but offer great utility to art lovers.
 Utility is subjective. The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a
product may not be the same. For example, no-smokers do not derive any utility from
cigarettes.
 The utility of a product can be different at different places and time. For example, the
utility that we get from meat during fasting is not the same as any time else.

A Consumer considers the following points to get maximum utility or level of

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

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

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2.3 . Approaches to measure Utility

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

Section2: The Cardinal Utility theory

Overview

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

Objectives

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

 explain the concept of cardinal approach;

 explain the assumptions of the cardinal approach; and
 determine utility maximization of the consumer.

Activity

Suppose a consumer derived 5 utils of satisfaction from consuming the first bread and 7
utils from the second bread. By how much is higher the second bread than the first.

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2.4 Assumptions of Cardinal Utility theory

1. Rationality of Consumers. The main objective of the consumer is to maximize
his/her satisfaction given his/her limited budget or income. Thus, in order to
maximize his/her satisfaction, the consumer has to be rational.
2. Utility is Cardinally Measurable. According to this approach, the utility or
satisfaction of each commodity is measurable. Money is the most convenient
measurement of utility. In other words, the monetary unit that the consumer is
prepared to pay for another unit of commodity measures utility or satisfaction.
3. Constant Marginal Utility of Money. According to assumption number two,
money is the most convenient measurement of utility. However, if the marginal
utility of money changes with the level of income (wealth) of the consumer, then
money cannot be considered as a measurement of utility.
4. Limited Money Income. The consumer has limited money income to spend on
the goods and services he/she chooses to consume.
5. Diminishing Marginal Utility (DMU).The utility derived from each from each
successive units of a commodity diminishes. In other words, the marginal utility
of a commodity diminishes as the consumer acquires larger quantities of it.
6. The total utility of a basket of goods depends on the quantities of the individual
commodities.
If there are n commodities in the bundle with quantities, X 1 , X 2 ,... X n the total
utility is given by:
TU=f ( X 1 , X 2 ...... X n )

2.5 Total and Marginal Utility

Definitions
Total Utility (TU):It refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity at a particular time. As
the consumer consumes more of a good per time period, his/her total utility increases.
However, there is a saturation point for that commodity in which the consumer will not
be capable of enjoying any greater satisfaction from it.

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

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

2.6 Law of diminishing marginal Utility (LDMU)

Dear learner, is the utility you get from consumption of the first orange is the same as the
second orange?

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

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

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

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

Units of
Quantity(x) 0 1st 2nd 5th 6th
rd 4th
consumed U un 3 unit
Unit nit it unit Unit Unit
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2

20
TUX
15
Total Utility

10

Quantity X
Marginal Utility

10

Quantity X
1 2 3 4 5
MUX

Fig.2.1Derivation of marginal utility from total utility

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

The total utility curve reaches its pick point (Saturation point) at point A. This Saturation
point indicates that by consuming 5 oranges, the consumer attains its highest satisfaction
of 11 utils. However, Consumption beyond this point results in Dissatisfaction, because

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consuming the 6th and more orange brings a lesser additional utility than the previous
orange. Point B where the MU curve reaches its maximum point is called an inflexion
point or the point of Diminishing Marginal utility.

Equilibrium of a consumer

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

For example, if the consumer consumes a bundle of n commodities i.e x1,x2,…,xn,he/she

would be in equilibrium or utility is maximized if and only if:

MU X 1 MU X 2 MU X n
  .........   MU m Where: MU-marginal utility of
PX 1 PX 2 PX n
money

Diagrammatically,

A

C
PX 

 B

MUX

Figure 2.2 marginal utility of a consumer

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

Table2.2 Utility schedule for a single commodity

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

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

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

occurs when the marginal utility of X is equal to its market price.

MU X  PX

Proof

The utility function is:

U  f (X )
If the consumer buys commodity X, then his expenditure will be Q X PX .Thus, the
consumer wants to maximize the difference between his/her utility and expenditure

Max(U  Q X PX )
The necessary condition for maximization is equating the derivative of a function with
zero. Thus,X

dU d (Q X PX )
 0
dQ X dQ X

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dU
 PX  0  MU X  PX
dQ X

Table2.3 Utility schedule for two commodities

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

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

Dear learner, as we discussed earlier, utility is maximized when the condition of marginal
utility of one commodity divided by its market price is equal to the marginal utility of the

MU 1 MU 2
other commodity divided by its market price MU i.e. 
P1 P2

Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and

MU orange MU banana 4 8
4 quantities of banana, because    2
Porange Pbanana 2 4

2.7 Derivation of the Cardinalist Demand

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Dear learner, how could you derive demand curve from the given total utility curve?
________________________________________________________________________
________________________________________________________________

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

a
P1
b
P
Price

c
P2
MUX
O Quantity

P1
Price

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

Limitation of the Cardinalist approach

The Cardinalist approach involves the following three weaknesses:

1. The assumption of cardinal utility is doubtful because utility may not be

quantified.
2. Utility can not be measured absolutely (objectively). The satisfaction obtained
from different commodities can not be measured objectively.

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3. The assumption of constant MU of money is unrealistic because as income

increases, the marginal utility of money changes.

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Section3: The Ordinal Utility Theory

Overview

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

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

Objectives

After completing this section you will be able to:

 Describe the assumption of ordinal utility approach

 Define an indifference curve and a budget line
 Identify the properties of indifference curve;
 Derive an income-consumption curve and price-consumption curve.
 Derive the income and substitution effects.
 Distinguish the difference between substitution and income effects

2.8 Assumptions of Ordinal Utility theory

Dear learner, like the previous approach, this approach is based on the following
assumptions:

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1. The Consumers are rational-they aim at maximizing their satisfaction or utility

given their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers
are required only to order or rank their preference for various bundles of
commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of
substitution is the rate at which a consumer is willing to substitute one commodity (x)
for another commodity (y) so that his total satisfaction remains the same. When a
consumer continues to substitute X for Y the rate goes decreasing and it is the slope
of the Indifference curve.
4. The total utility of the consumer depends on the quantities of the commodities
consumed, i.e., U=f (X1, X2 …Xn)
5. Preferences are transitive or consistent:

 It is transitive in the senses that if the consumer prefers market basket X to market
basket Y, and prefers Y to Z, and then the consumer also prefers X to Z.
 When we said consistent it means that If market basket X is greater than market
basket Y (X>Y) then Y not greater than X (Y not >Y).

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

2.9 Indifference Set, Curve and Map

Dear learner, can you give your own definition on the indifference curve?
(You can use the space left below to write your response)
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

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

indifferent, preferring none of any others. It shows the various combinations of goods
from which the consumer derives the same level of utility.

Table2.4 Indifference Schedule

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1

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

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

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

indifference curve.
Banana (Y)

10 A
Good B

Indifferenc
B
6 e
Curve (IC)
C
2 IC3
D IC2
1
IC1
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1 2 4 7 Good A
OrangeX
Microeconomics I

Indifference curve Indifference map

Fig2.4 indifference curves and indifference map.

Indifference Map: To describe a person’s preferences for all combinations potato and
meat, we can graph a set of indifference curves called an indifference map. In other
words it is the entire set of indifference curves is known as an indifference map, which
reflects the entire set of tastes and preferences of the consumer. A higher indifference
curve refers to a higher level of satisfaction and a lower indifference curve shows lesser
satisfaction. IC2 reflects higher level of utility than that of IC1.Any consumer has lots of
indifference curves, not just one.

Properties of Indifference Curves:

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

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

Indifference curves are negatively sloped because the consumption level of
one commodity can be increased only by reducing the consumption level of
the other commodity. That means, if the quantity of one commodity increases
with the quantity of the other remaining constant, the total utility of the
consumer increases. On the other hand, if the quantity of one commodity
decreases with the quantity of the other remaining constant, the total utility of

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

X
Banana

Fig.2.5 positively sloped and intersected indifference curves

Banana

B
E

Dear learner, as we discussed earlier, Indifference curves cannot intersect eachDother.ICIf2
C
A would be indifferent between C and E, (Right panel of figure 2.6)
they did, the consumer
IC1
since both are on indifference curve one (IC1). Similarly, the consumer would be
Orange Orange

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indifferent between points D and E, since they are on the same indifference curve, IC2.By
transitivity, the consumer must also be indifferent between C and D. However, a rational
consumer would prefer D to C because he/she can have more Orange at point D (more
Orange by an amount of X).

2.10 The Marginal rate of substitution (MRS)

Dear learner, how do you perceive the concept of marginal rate of substitution?
(You can use the space left below to write your response)
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Dear learner, to quantify the amount of one good that a consumer will give up to obtain
more of another, we often use marginal rate of substitution as a measurement (MRS).

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

commodity Y that must be given up in exchange for an extra unit of commodity of X so
that the consumer maintains the same level of satisfaction.

Number of units of Y given up

MRS X ,Y 
Number of units of X gained

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

i.e., Slope of indifference curve

y
 MRS X ,Y
x

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

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Note that ( MRS X ,Y ) measures the downward vertical distance (the amount of y that the
individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of

Y
x required) to remain on the same indifference curve. That is, MRS X ,Y   because
X
of the reduction in Y, MRS is negative. However, we multiply by negative one and
express MRS X ,Y as a positive value.

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

Table2.5 level of consumption of good X and Y

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1

Y 4
MRS X ,Y (between points A and B   4
X 1

Dear learner, in the above case the consumer is willing to forgo 4 units of Banana to
obtain 1 more unit of Orange. If the consumer moves from point B to point C, he is
willing to give up only 2 units of Banana(Y) to obtain 1 unit of Orange (X), so the MRS
is 2(∆Y/∆X =4/2). Having still less of Banana and more of Orange at point D, the
consumer is willing to give up only 1 unit of Banana so as to obtain 3 units of Orange. In
this case, the MRS falls to ⅓. In general, as the amount of Y increases, the marginal
utility of additional units of Y decreases. Similarly, as the quantity of X decreases, its
marginal utility increases. In addition, the MRS decreases as one move downwards to the
right.

Marginal Utility and Marginal rate of Substitution

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

MU X
MRS X ,Y 
MU Y

Proof:

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

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

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

U U
dU  dX  dY  0
X Y

MU X dX  MU Y dY  0

MU X dY
  MRS X ,Y
MU Y dX

MU Y dX
Or,   MRS Y , X
MU X dY

Example

X4
Suppose a consumer’s utility function is given by U  5  2 .Compute the
Y
MRSX ,Y .

MU X
MRS X ,Y 
MU Y

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dU dU
MU X  and MU Y 
dX dY

Therefore, MU X  4( X 41Y 2 )  4( X 3Y 2 ) and MU Y  2( X 4Y 21 )  2 X 4Y

MU X 4 X 3Y 2 Y
MRS X ,Y   4
2
MU Y 2X Y X

Special Indifference Curves

Dear learner, convexity or down ward sloping is among the characteristics of indifference
curve and this shape of indifference curve is for most goods. In this situation, we assume
that two commodities such as x and y can substitute one another to a certain extent but
are not perfect substitutes. However, the shape of the indifference curve will be different
if commodities have some other unique relationship such as perfect substitution or
complementary.

Here, are some of the ways in which indifference curves/maps might be used to reflect
preferences for three special cases.

I. Perfect substitutes: If two commodities are perfect substitutes (if they are essentially
the same), the indifference curve becomes a straight line with a negative slope. MRS for
perfect substitutes is constant. (Panel a)
Out dated books

IC3 IC1 IC2 IC3

IC2
IC1
Right shoe

Panel a Panel b Panel c

IC3
Total

IC2
IC1
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Fig.2.6 Special cases of indifference curves

II. Perfect complements: If two commodities are perfect complements the indifference
curve takes the shape of a right angle. Suppose that an individual prefers to consume left
shoes (on the horizontal axis) and right shoes on the vertical axis in pairs. For example, if
an individual has two pairs of shoes, additional right or left shoes provide no more utility
for him/her. MRS for perfect complements is zero (both MRS XY and MRS XY is the
same, i.e. zero).
III.A useless good: Panel C in the above figure shows an individual’s indifference curve
for food (on the horizontal axis) and an out-dated book, a useless good, (on the vertical
axis). Since they are totally useless, increasing purchases of out-dated books does not
increase utility. This person enjoys a higher level of utility only by getting additional food
consumption. For example, the vertical indifference curve IC 2 shows that utility will be
IC 2 as long as this person has some units of food no matter how many out dated books

he/she has.

2.11 The Budget Line or the Price line

Dear learner, how do you explain the idea of the budget line?
(You can use the space left below to write your response)
______________________________________________________________________________
______________________________________________________________________________

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Dear learner, indifference curves only tell us about the consumer’s preferences for any
two goods but they can not tell us which combinations of the two goods will be chosen or
bought..

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

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

Assumptions for the use of the budget line

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

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

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

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

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

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

This means that the amount of money spent on X plus the amount spent on Y equals the
consumer’s money income.

Suppose for example a household with 30 Birr per day to spend on banana(X) at 5 Birr
each and Orange(Y) at 2 Birr each. That is, PX  5, PY  2, M  30birr .

Therefore, our budget line equation will be:

5 X  2Y  30

Table2.6 Alternative purchase possibilities of the two goods

Consumption
A B C D E F
Alternatives
Kgs of
0 1 2 3 4 6
banana (X)
Kgs of 15 12.5 10 7.5 5 0

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Orange(Y)
Total
30 30 30 30 30 30
Expenditure

At alternative A, the consumer is using all of his /her income for good Y. Mathematically
it is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income
for good X. mathematically; it is the x-intercept (6, 0). We may present the income
constraint graphically by the budget line whose equation is derived from the budget
equation.

M  PX X  PY Y
M  XPX  YPY

By rearranging the above equation we can derive the general equation of a budget line,

M P
Y  X X
PY PY
M
= Vertical Intercept (Y-intercept), when X=0.
PY
PX
 = slope of the budget line (the ratio of the prices of the two goods)
PY

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

M PX
 X 0
PY PY

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Microeconomics I

M PX
 X
PY PY

M
X
PX

M/PY

B


A


M/PX
Fig.2.7 Derivation of the Budget Line

Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent.

2.12 Factors Affecting the Budget Line

Effects of changes in income

If the income of the consumer changes (keeping the prices of the commodities
unchanged) the budget line also shifts (changes). Increase in income causes an upward
shift of the budget line that allows the consumer to buy more goods and services and
decreases in income causes a downward shift of the budget line that leads the consumer
to buy less quantity of the two goods. It is important to note that the slope of the budget

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Microeconomics I

line (the ratio of the two prices) does not change when income rises or falls. The budget
line shifts from B to B1 when income decreases and to B2 when income rises.

M2/Py

M/Py Where M2>M>M1

M1/Py
B B2

B1

M1/PX M/PX M2/PX

Fig.2.8 Effects of change in income

Effects of Changes in Price of the commodities

Y Y

B1 B1
B
B
X X
Fig.a Fig.b

Fig.2.9 Effects of change in price

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

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

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

M/py A

Here Px ’ < Px, hence M/Px <M/Px1

B B’
M/Px M/Px ' X

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

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

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 Microeconomics I

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

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

A
M/Py

B
B’

M/Px1 M/Px2

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

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

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

Y A
M/py
A’
M/py'

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Microeconomics I

B
M/Px X

Fig.2.12 Effect of a raise in price of Y on the budget line

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

Y
M/py' A’

M/py A

B
M/Px X

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

The above figure shows what happens to the budget line when the price of Y increases while the
price of good X and money income held constant. Since P y decreases, M/Py increases thereby the
budget line shifts outward.

Numerical Example
A person has $ 100 to spend on two goods(X,Y) whose respective prices are $3 and $5.
a) Draw the budget line.
b) What happens to the original budget line if the budget falls by 25%?
c) What happens to the original budget line if the price of X doubles?
d) What happens to the original budget line if the price of Y falls to 4?

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

PX X  PY Y  M

3 X  5Y  100
5Y  100  3 X
100 3
Y   X
5 5
3
Y  20  X
5
When the person spends all of his income only on the consumption of good Y,we can get
the Y intercept that is(0,20).However, when the consumer spends all of his income on the
consumption of only good X,then we get the X intercept that is (33.33,0). Using these
two points we can draw the budget line. Thus, the budget line will be:

A
Y
20
A’

B’ B
33.33 X

If the budget decreases by 25%, then the budget will be reduced to 75.As a result the
budget line will be shifted in-ward that is indicated by (A’B’).This forces the person to
buy less quantity of the two goods. The equation for the new budget line can be solved as
follows:

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3 X  5Y  75
5Y  75  3 X
75 3
Y   X
5 5
3
Y  15  X
5
Therefore, the Y-intercept is 15 while the X-intercept is 25.However, since the ratio of the
prices does not change the slope of the budget line remains constant.

If the price of good X doubles the equation of the budget line will be 6 X  5Y  100 and
if the price of good Y falls to 4, the equation for the new budget line will be
6 X  4Y  100 .

2.13 Optimum of the Consumer

Dear learner, a rational consumer seeks to maximize his utility or satisfaction by

spending his or her income. It maximizes the utility by trying to attain the highest
possible indifference curve, given the budget line. This occurs where an indifference
curve is tangent to the budget line so that the slope of the indifference curve ( MRS XY ) is

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

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

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

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

However, the consumer cannot purchase any bundle lying above and to the right of the
budget line. Because Indifference curves above the region of the budget line are beyond

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the reach of the consumer and are irrelevant for equilibrium consideration. The question
then arises as to which combinations of X and Y the rational consumer will purchase.

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

Y
A

B
E
IC4

C IC3

IC2
D
IC1
Figure2.14 Consumer equilibrium
X

At point ‘A’ on the budget line, the consumer gets IC 1 level of satisfaction. When he/she
moves down to point ‘B’ by reallocating his total income in favor of X he/she derives
greater level of satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point
‘A’. Moving further down to point ‘E’, the consumer obtains the greatest level of
satisfaction (IC3) relative to other indifference curves.

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

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

PX MU X MU Y MU X P
MRS XY  , But we know   .......MU X PY  MU Y PX ...,  X
PY PX PY MU Y PY

2.14 Effects of Changes in Income and Prices on Consumer

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

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

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

If we connect all of the points representing equilibrium market baskets corresponding to

all possible levels of money income, the resulting curve is called the Income
consumption curve (ICC) or Income expansion curve (IEC). The Income Consumption
Curve is a curve joining the points of consumer optimum (equilibrium) as income
changes (ceteris paribus). Or, it is the locus of consumer equilibrium points resulting
when only the consumer’s income varies.

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Commodity Y

ICC

E3
E2
E1

Commodity X
Figure2.15 the income –consumption and
the Engle curves
Engle Curve
Income

I3
I2

1
I
Bonga University, Department of economics 34

X1 X2 X3 Commodity X
Microeconomics I

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

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

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

For example, in the figure below good Y is a normal good while good X is a normal good
until the person’s level of income reaches M2 .Thus, when income increases beyond M2,
the person will buy less of good X as his income increases. Therefore, good X is a normal
good Up to point A and becomes an inferior good as the income consumption curve
bends backward.
M3/Py
M3/Py M2/Py
M1/Py
M2/Py

M1/Py

M1/Px M2/Px M3/Px M1/Px M2/Px M3/Px

Figure2.16 income consumption curve

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

Demand Curve

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

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

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

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

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

PCC

Commodity X
Price of X

Px1

Px2
Individual
Px demand curve
3
Bonga University, Department of economics 36

X1 X2 X3 Commodity X
Microeconomics I

Figure2.17 the PPC and derivation of the demand curve

Mathematical derivation of equilibrium

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

The maximization problem will be formulated as follows:

MaximizeU  f ( X , Y )

Subject to PX X  PY Y  M

We can rewrite the constraint as follows:

M  PX X  PY Y  0 or PX X  PY Y  M  0

Multiplying the constraint by Lagrange multiplier 

 ( M  PX X  PY Y )  0

Forming a composite function gives as the Lagrange function:

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

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

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The first order condition requires that the partial derivatives of the Lagrange function
with respect to the two goods and the langrage multiplier be zero.

 U  U 
  PX  0 ;   PY  0 and  ( PX X  PY Y  M )  0
X X Y Y 

From the above equations we obtain:

U U
 PX and  PY
X Y

U U
 MU X and  MU Y
X Y

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

MU X MU Y
 
PX PY

By rearranging we get:

MU X P
 X
MU Y PY

The second order condition for maximum requires that the second order partial
derivatives of the Lagrange function with respect to the two goods must be negative.

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

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Example
A consumer consuming two commodities X and Y has the following utility function
U  XY  2 X .If the price of the two commodities are 4 and 2 respectively and his/her
budget is birr 60.
a) Find the quantities of good X and Y which will maximize utility.
b) Find the MRS X ,Y at optimum.

Solution
The Lagrange equation will be written as follows:
  XY  2 X   (60  4 X  2Y )


 Y  2   4  0 ……………………….. (1)
X

 X   2  0 …………………………… (2)
Y

 60  4 X  2Y  0 …………………… (3)


From equation (1) we get Y  2  4 and from equation (2) we get X  2 .Thus, we can

Y 2 1
get that X  and equation (2) gives as   X .
2 2

Y 2
By substituting X  in to equation (2) we get Y  14 and X  8.
2

MU X
MRS X ,Y 
MU Y
Y 2

X

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Microeconomics I

After inserting the optimum value of Y=14 and X=8 we get 2 which equals to the price

PX 4
ratio of the two goods (   2) .
PY 2

2.15 Income and Substitution Effects

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

 Let us Consider the case of a price-decline:

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

I/py1

Note that:
I’/py1
A B IC2X 1 X 3 =NE= Total (net) effect
  X 1 X 2 = SE=Substitution effect
C IC1 X 2 X 3 = IE=Income effect


Bonga University, Department of economics

IE 40
x1 SE
x2 x3 I’/px1 I/px2
NE
Microeconomics I

Figure2.18 Income and Substitution effect for a normal good

Suppose initially the income of the consumer is I 1 , price of goodY is Py1 , and Price of

I I
good X is Px1 , we have the budget line with y-intercept and X-intercept .
Py1 Px1

The consumer’s equilibrium is point A that indicates the point of tangency between the
budget line and indifference curve IC1 . As a result of a decrease in the price of X from

I I
Px1 to Px 2 the budget line shifts outward with y-intercept & X-Intercept .
Py1 Px 2

The consumer’s new equilibrium will be on point B.

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

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

The Substitution Effect

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

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Microeconomics I

in the consumer’s real income, as evidenced by the movement to a higher indifference

curve even though money income remains fixed.

Now, imagine that we decrease the consumer’s income by an amount just sufficient to
return to the same level of satisfaction enjoyed before the price decline. Graphically, this
is accomplished by drawing a fictitious (imaginary) line of attainable combinations with a

Px 2
slope corresponding to new ratio of the product price so that it is just tangent to the
Py1

original indifference curve IC1 .

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

The Income Effect

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

In figure 2.18, letting the consumer’s real income rise from its imaginary level (defined
by the line of attainable combinations tangent to point C) back to its true level (defined
by the line of attainable combinations tangent to point B) gives the income effect. Thus,
the income effect is indicated by the movement from the imaginary equilibrium at point
C to the actual new equilibrium at point B, the increase in the quantity of X purchased
from X2 to X3 is the income effect.

The income effect of a change in the price of good shows the change in quantity
demanded via change in real income, while the relative price ratio remains constant. This

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Microeconomics I

movement does not involve any change in prices; the price ratio is the same in budget
line 1 as in budget line 2. It is due to a change in total satisfaction and such a change is a
movement from one indifference curve to another.

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

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

Usually, the income and substitution effects reinforce one another i.e. they operate in the
same direction. The substitution effect is always negative. i.e. if the price of a good X
increases and real income is held constant, there will always be a decrease in the
consumption of good X, and vise versa. This result follows from the fact that indifference
curves have negative slopes. However, the income effect is not predictable from the
theory alone. In most cases, one would expect that increases in real income would result
in increases in consumption of a good. This is the case for so called Normal goods.

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

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Microeconomics I

income effect works counter to the substitution effect, it does not override it. Hence, the
demand curve for inferior goods is still negatively sloped.

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

IC2

Y KEY:
IC1 X1X3= NE=Net effect
X1X2= SE=Substitution effect
E3 X2 X3= IE=Income effect

Figure 2.19 Income, Substitution, and Net effect for an inferior commodity
E1
In very rare occasions, a good may be soEstrongly inferior that the income effect actually
2
overrides the substitute effect. Such an occurrence means that a decline in the price of a
good would lead to a decline in the quantity demanded and that a rise in price will induce
X1 XIn3 other
an increase in quantity demanded. X2 words, price and quantity moveX in the same
IE
direction. The name given to suchNEa unique situation is Giffen paradox; and it constitutes
an exception to the Law of demand.
SE
That is for Giffen goods the income effect (which
decreases the quantity demanded) is so strong that it offsets the substitution effect (which

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Microeconomics I

increases the quantity demanded), with the result that the quantity demanded is directly
related to the price, at least over some range of variation of price.

E3
IC2

E1
E2
IC1

X3 X1 X2 X
SE
NE
. Figure 2.20Income, Substitution and net effects for a Giffen good,
When there is a price decline.
IE

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2.16 The Slutsky Equation

Dear learner, can you explain Slutsky equation ?

(You can use the space left below to write your response)
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Dear learner as we have discussed earlier,when the price of a good decreases,there will be
two effects in consumption.The change in relative prices makes the consumer to consume
more of the cheaper good-substitution effect.The increase in purchasing power due to the
lower price may increase or decrease consumtion of the good-income effect.

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

Numerical Example

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

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

200
Therfore,his demand for good X will be 20   28 per month.
52
Suppose that the price of the good falls to 4 per kilogram.Therfore,the new demand at the

200
new price will be: 20   32.5 per month.
42
Thus,the total change in demand is 4.5 that is 32.5-28.
When the price falls the purchasing power of the consumer changes.Hence,iin order to
make the origiinal consumption of good X,the consumer adjusts his income.This can be
calculated as follows:

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Microeconomics I

M 1  P1' X  P2Y
M  P1 X  P2Y

Subtracting the second equation from the first gives:4-

M 1  M  X [ P1'  P1 ]
M  XP1

Therfore,new income to make the original consumption affordable when price falls to 4
is:
M  XP1
M  28 * [4  5]  28

Hence,the level of iincome necessary to keep purchasing power constant is

M 1  M  M  200  28  172
The consumers new demand at the new price and income will be :
172
X (4,172)  20   30.75
42
Therfore,the substitution efffect will be:
X  X (4,172)  X (5,200)  30.75  28  2.75

The income effect will be:

X (4,200)  X ( 4,172)  32.5  30.75  1.75

Since the result We obtained is positive we can conclude that the good is a normal good.

2.17 The Consumer Surplus

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

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

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While consumers purchas goods and services,they offten pay less than what they are
willing to pay.Thus,the difference between what they are willing to pay and what they
actually paid is considered as their surplus.

Therfore,consumer surplus is the difference between what a consumer is willing to pay

and what he actually pays.Graphically,it is measured by the area below the demand curve
and above the price level.

CS
P E

0
Q

Numerical Example

Suppose the demand function of a consumer is given by: Q  15  p

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

Solution

When Price is zero the demand for quantity purchased will be 15 and when the demand
for quantity is put to zero then the price level will be 15.And finally,when we insert the
given price level 2 in the demand equation we get the level of qunatity demanded that is
13.Hence,we can easily compute the area of the triangle that is found above the given
price level that is 2.

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15 Panel a. Panel b
15
2
4

13 a, 15the area of the triangle11above 15

In panel price that is the consumer surplus is

1
* 13 * 13  84.5 and in panel b the consumer surplus is 60.5.Therfoere,due to a change
2
in the price level the consumer surplus will be 84.5  60.5  24.5

Check your progress Activity

Answer the following questions on the spaces provided below.

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

3. What are the assumptions underlying the cardinal approach?

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

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

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

Based on the given information, answer the following questions.

a. Compute the marginal utility of the two goods

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

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

6. What is the relationship among total utility, marginal utility and the demand
curves.
________________________________________________________________________
______________________________________________________________________

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7. What are the assumptions underlying the Ordinal approach?

________________________________________________________________________
________________________________________________________________________

6. What are the major properties of indifference curves?

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

a. Express the budget line of the consumer both algebraically and diagrammatically.
________________________________________________________________________
________________________________________________________________________
b. Compute the equation of the budget line.
________________________________________________________________________
________________________________________________________________________
c. Determine the slope of the budget line and interpret the result
________________________________________________________________________
________________________________________________________________________
e. What will happen to the original budget line?
i. If money income doubles.
__________________________________________________________________
__________________________________________________________________
ii. If the price levels increases by 50%.
__________________________________________________________________
__________________________________________________________________
iii. If price of good Y doubles.
__________________________________________________________________
__________________________________________________________________
8. Suppose the demand function of an individual for a given good X is given by:

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X  3MP 3
And the originally the income of the consumer is birr 100 per month and the price of the
good is 2 per unit. Based on the given information, answer the following questions:
a. Compute the substitution effect
b. Compute the income effect
c. Is the good normal, inferior, or giffen and why?
9. Suppose that the demand and supply equations of a consumer are given by:
Q dd  150  50 P
Q ss  60  40 P

Compute the consumer surplus.

The theory of consumer behavior is the concern of how consumers decide on the basket
of goods and services they consume in order to maximize their satisfaction. The theory of
demand starts with the examination of the behavior of the consumer since the market
demand is assumed to be the summation of the demand of the individual consumers.

Assume
The consumer is rational: - given his/her income and the market price of the
commodities, he/she plans the spending of his/her income so as to attain the highest
possible satisfaction or utility. This is the axiom of utility maximization.
i) The consumer has complete knowledge of all the information relevant to his/her
decision, i.e., he/she has
-Complete knowledge of all the available commodities,
-Complete knowledge of the price of the commodities,
-Complete knowledge of his/her income.

SOME BASIC CONCEPTS

CONSUMER: - A decision making unit (an individual or a household) who uses or

consumes a commodity or service.

UTILITY:-The power of a commodity to satisfy human wants. It is the satisfaction or

subjective pleasure that one gets from consuming a good or service.

RELATIVITY OF UTILITY: - The utility of a commodity is subjective to a person’s

need. It is not absolute (objectively determined).

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UTILITY AND MORAL VALUES: - Utility is free from moral values. For example,
eating a food item which may be immoral in a society yields utility as long as it satisfies
hunger. It is also the case that utility is “ethically neutral” between good and bad, and
harmful and useful. For example, drug yields utility to the drug-takers.

In order to maximize utility, the consumer must be able to compare the utility of the
various baskets of goods which he/she can buy with his/her income. There are two
approaches to the problem of comparison (measurability) of utility:
i) the cardinal approach
ii) the ordinal approach

2.1 THE CARDINAL UTILITY APPROCH

The cardinal school postulated that utility can be measured in monetary units (i.e., by the
amount of money that the consumer is willing to sacrifice for another unit of a
commodity) or by subjective unit called “utils”.
Assumptions

i) Rationality:- the consumer is assumed to be rational in a since that he/she

aims at the maximization of his/her utility subject to the constraints imposed
by his/her income.
ii) Cardinal utility: - the utility of each commodity is measurable, with the most
convenient measure being money.
iii) Constant marginal utility of money:- the utility that one derives from each
successive unit of money income remains constant.
iv) Diminishing marginal utility (DMU):- the MU of a commodity diminishes as
the consumer acquires mire and more of it.
v) Additively of utility: - even though dropped in the latter version of the
approach, utility was assumed to be additive in the earlier version. That is:
U = U1(X1) + U2(X2) + --- + Un (Xn)
vi) The total utility of a basket of goods and services depends on the quantities of
the individual commodities. That is:
U = f(x1, x2… xn)

EQUILIBRIUM OF THE CONSUMER

Let’s assume that the consumer consumes a single commodity, x. The consumer can
either buy x or retain his money income Y. Under these conditions the consumer is in
equilibrium when the marginal utility of X is equated to its market price (px).
Symbolically,
MUx = Px
Mathematically, we can derive the equilibrium of the consumer as follows:
- The utility function is

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U = f (qx), where utility is measured in monetary units and qx is the quantity

of x consumed by the consumer.
If the consumer buys qx, his/her expenditure is pxqx. Presumably the consumer seeks to
maximize the difference between his/her utility and total expenditure. That is:
U – Pxqx
The necessary condition for a maximum is that the partial derivative of a function with
respect to qx be equal to zero. Thus,
d (U – pxqx)
= O
dqx

═> dU d (pxqx)
- = O
dqx dqx
═> dU dqx
- px = O
dqx dqx

═> dU = px
dqx

═> MUx = Px

If MUx > Px, the consumer can increase his/her welfare by purchasing more unit of X,
and if the MUx < Px, welfare can be increased by reducing the consumption of X.
In the case there are more commodities, the condition for optimality of the consumer is
the equality of the ratios of MU of the individual commodities to their prices, i.e. the
utility derived from spending an additional unit of money must be the same for all
commodities.

MU1 = MU2 = ….. = MUn

P1 P2 Pn

DERIVATION OF THE DEMAND CURVE

The derivation of demand is based on the axiom of diminishing marginal utility. The MU
of commodity X is depicted by a line with a negative slope which is the slope of total
utility function, U =f(qx). As successively increasing quantities of X are consumed, the
total utility increases but at a decreasing rate (recall the assumption of DMU), reaches a
maximum at quantity X* and then starts declining. Accordingly, the MUx declines
continuously and becomes negative beyond X*.

MUx = slope of TUx = dTU

dqx

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Thus it can be shown that the demand curve for commodity X is identical to the
positive segment of the MUx curve. For example, at X 1 the MU is MU1 which is equal to
P1 at the optimum point. Hence at P1 the consumer demands X1 quantity. Similarly at X2
the marginal utility is MU2 which is equal to P2. Hence at P2 the consumer demands X2

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and so on. This forms the demand curve for commodity X. As negative price do not make
sense in economics, the negative potion of MUx does not form part of the demand curve.

O X1 X2 X3 X*
Panel A: The MU curve Panel B: The demand curve

The demand curve is simply the graphical representation of the relationship between
price and quantity demanded.

CRITIQUES OF THE APPROCH

1) The satisfaction derived from the various commodities can not be measured
objective. The cardinality of the utility is extremely doubtful.
2) The assumption of constant MU of money is unrealistic because as income
changes the MU of money changes.
3) The additivity assumption of utility is unrealistic.

2.2 THE ORDINAL UTILITY THEORY

The ordinalist school suggests that utility is not measurable, but is an ordinal magnitude.
That is, to make his/her choice, the consumer need not know the utility of various
commodities in specific unit, but be able to rank the various basket of goods(order of
preference) according to the satisfaction that each bundle gives. There are two main
theories in the ordinal approach:
1) The Indifference Curve Theory, and
2) The revealed preference hypothesis

2.2.1 THE INDIFFERENCE CURVE THEORY

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Indifference curve(IC):- is the locus of points of different combinations of two goods (a

bundle of goods) which yields the consumer the same level of satisfaction (utility) so that
he is indifferent as to the particular combination he/she consumes.

An Indifference Map: - shows a set of all the ICs, which rank the preference of the
consumer. Combination of goods situated on an IC yields the same level of utility.
Combination of goods lying on a higher IC yields higher level of satisfaction and are
preferred.

ASSUMPTIONS

1) Rationality: - the consumer is assumed to be rational.

2) Utility is ordinal: - the consumer can rank his/her preference (order the various
baskets of goods) according to the satisfaction of each basket.
3) Diminishing marginal rate of substitution (DMRS):- preferences are ranked in
terms of ICs, which are assumed to be convex to the origin. This implies that the
slope of IC (MRS) decreases in absolute terms.
4) The total utility of the consumer depends on the quantities of the commodities
consumed.
U = f (q1, q2… qn)
5) Consistency and transitivity of choices:-
═> If bundle A>B, then B is not greater than A
═> If bundle A >B and B>C, then A>C.

PROPERTIES OF WELL BEHAVED INDIFFERENCE CURVES

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1) An indifference curve has a negative slope:- which denotes that if the quantity of
one commodity(Y) decreases the quantity of the other (X) must increase, if the
consumer is to stay on the same level of satisfaction.
2) The further away from the origin an IC lies, the higher level of utility it denotes.
3) ICs do not intersect. If they did, the point of their intersection would imply two
different level of satisfaction, which is impossible.
4) ICs are convex to the origin:- this implies that the slope of an IC (MRS)
decreases( in absolute terms) as we move along the curve from the left down
wards to the right.

THE MARGINAL RATE OF SUBISTITUTION (MRS)

The marginal rate of substitution of X and Y (MRSx,y) is defined as the number of units
of commodity Y that must be given up in exchange for an extra unit of commodity X so
that the consumer maintains the same level of satisfaction. It is the negative of the slope
of an IC at any one point and is given by the slope of the tangent line at that point:

Slope of IC = -dy
= MRSx,y
dx

The concept of marginal utility is implicit in the definition of MRS since it can be proved
that the MRS (the slope of IC) is equal to the ratio of the marginal utilities of the
commodities in the utility function.

MUx OR MUy
MRSx,y = MRSy,x =
MUy MUx

Proof:
The total utility function in the case of two commodities X&Y is
U = f(x, y)
The equation of an IC is
U = f(x, y) = K, where K is constant.
At equilibrium, the total derivative of U is equal to zero.
ӘU ӘU
═> du = dy + dx
Әy Әx
= (MUy) dy + (MUx) dx
Along any particular IC, the total differential is by definition equal to zero.
═> du = (MUy) dy + (MUx) dx = o

═> MUy dy = - MUx dx

═> - dy + MUx = MRSx,y

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Dx MUy

THE OPTIMUM OF THE CONSUMER

To define the optimum of the consumer, we should introduce the concept of the budget
line. The budget line is the set of bundles of goods that cost exactly the consumer’s
income. This implies that income acts as a constraint in the attempt of maximizing utility.
Assuming two goods (x,y), the budget line will have the equation:
Px.X +Py.Y= M
Y = 1/Py.M – Px/Py.X
Where M= is fixed money income
Px = is the price of good X
Py = is the price of good Y
Assigning successive values to X (given income, M and the commodities price, Px and
Py), we may find the corresponding values of Y. Thus,
If X = O (if the consumer spends all his/her income on Y), the consumer can buy
M/Py units ofY.
If Y = O, the consumer can buy M/Py units of X.
If we join these two points by a line, we obtain the budget line.
Y

M
Py

O M X
Px

M/Py M Px
Slope of the budget line = = .
M/Px Py M

= Px
Py
Mathematically, slope of the budget line is the derivative of the budget equation:
ӘY Ә (1/Px.M – Px/Py.X)
=
ӘX ӘX

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ӘY Px
=
ӘX Py
The consumer is in equilibrium when he/she maximizes his/her utility, given income and
the market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.
1) MRSx,y = MUx/MUy = Px/Py, which is the necessary condition.
2) The IC be convex to the origin (decreasing MRSx,y)
Graphically, the equilibrium of the consumer is at the point of tangency of the budget line
and the highest possible IC (at point e).

At the point of tangency (point e) the slope of the budget line (Px/Py) and of the IC
(MRSx,y = MUx/MUy) are equal.

MRSx,y = MUx/MUy = Px/Py, which is the FOC.

The SOC is implied by the convex shape of the IC. Thus, the consumer maximizes utility
by buying X* & Y* of the two commodities.

Mathematical derivation of the equilibrium of the consumer is as follows:

- Assume that there are two commodities, X&Y. The consumer is in equilibrium
when he/she maximizes utility given hi/her income and the market price of the
commodities.
- Formally the problem can be stated as:
Maximize U = f(x,y)
Subject to M = Px.X + Py.Y

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- By using the lagrangian method, the steps involved are:

a) rewrite the constraint as
Px.X + Py.Y – M = O
b) Multiply the constraint by a constant  (lagrangian multiplier)
(Px.X + Py.Y – M) = O
C) Subtract from the objective function to obtain a composite function.
L = U - (Px.X + Py.Y – M)
D) Derivate L with respect to X, Y, & and equate to zero.
L/X = U/X - Px = O
=> U/X = Px
=>MUx = Px
=>  = MUx/ Px………………………………………… (1)
L/y = U/y - Py =O
=> U/y = Py
=>MUy = Py
=>  = MUy/Py………………………………………….. (2)
L/ = Px.X + Py.Y – M = O…………………………... (3)
From (1) and (2), we can infer that
 = MUx/ Px = MUy/Py
 MUx/ Px = MUy/Py
 MUx/MUy = Px/ Py = MRSx,y

We observe that the equilibrium conditions are identical in the cardinal’s approach and in
the Indifference curve approach. In both theories we have:
MUx/ Px = MUy/Py = ---- = MUn/Pn
EXAMPLE

Let us assume that an individual, whose income is birr 10 consumes two types of goods,
X & Y, whose prices are Px = 2 and Py = 1, spend all his income on these goods. By
using the above information and the MU table for the two goods, determine the following
things/ answer the following questions.
(A) Indicate how much of X & Y the individual should purchase to maximize utility.
(B) Show that the condition for constrained utility maximization is achieved.
(C) Determine how much total utility the individual receives when he /she maximizes
utility. How much utility would the individual get if he/she spent all income on
X/Y?

Qx MUx Qy MUy MUx/Px MUy/Py

1 10 4 5 5 5
2 6 5 4 3 4
3 4 6 3 2 3
4 2 7 2 1 2
5 0 8 1 0 1
Solution:

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(A) the individual maximizes his/her utility when he/she consumes 2 units of X and 6
units of Y since at this point MUx/Px = MUy/Py, i.e, 6/2 = 3/1.
(B) The condition for utility maximization is that MUx/Px = MUy/Py, give that all
the consumer income is spent.
Thus at the optimum of the consumer,
MUx/Px = MUy/Py i.e. 6/3 = 3/1 => 3 = 3 and
PxX + PyY = I
 2(2) + 1(6) = 10
 10 = 10
(C) TU = ∑MUs = ∑MUx + ∑Muy
 TU = (10 + 6)x + (5 + 4 + 3)y
 TU = (16)x + ( 12 )y
 TU = 28
 If the individual spend all his/her income, he/she will get the total utility of:
Tux = ∑MUx
Tux = 10 + 6 + 4 + 2 + 0
Tux = 22
This is because the consumer can consume 5 units of X given that his/her income is
10 birr and Px is 2 birr.

 if the consumer spend all his/her income on Y:

Tux = ∑MUx
Tux = 5 + 4 + 3 + 1
Tux = 13

CORNER SOLUTIONS

If ICs are every where either flatter or steeper than the budget line, or if they are concave
rather than convex to the origin, then the consumer maximizes utility by spending all
income on either good Y or X. These are called the corner solutions.
Y Y Y
U1 U2 U3 J
Y* J U3 J Y*

U2

B U1 L B

U1 U2 U3
O K X O
O K X X* X

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In the left panel, ICs are every where flatter than the BL, and U2 is the highest IC that the consumer can
reach by purchasing Y* of Y (point J). The middle panel shows ICs every where steeper than the BL,
and U2 is the highest IC that the consumer can reach by spending all income to purchase X* of X (point
K). In the right panel, concave IC U2 is tangent to the budget line at point B, but this is not the optimum
point because the consumer can reach higher IC U2 by consuming only good Y (point J).

INCOME CONSUMPTION CURVE (ICC)

Increase in income shifts the budget line outward in a parallel manner (if commodities prices are kept
constant). If we go on increasing income (i.e., shifting the budget line outward), we will have a set of
optimum points corresponding to each budget line. The curve which connects these optimum points is
called the Income Consumption Curve (ICC). It is the locus consumer optimum points resulting only
when the consumer income changes. The ICC is also known as the Income Offer Curve or the Income
Expansion Path. From the ICC we can then derive the consumer Engle Curve. The Engle curve shows
the amount of a good (X) that the consumer would purchase per unit of time at various income levels. To
derive the Engle curve we keep the same horizontal scale as in the top panel but measure money income
on the vertical axis.
Y A’’

A’

A ICC
E2 E3
E1
U2 U3
U1

O X1 X2 X3 B B’ B’’ X
M

Engle curve

M3
E3’
M2
E2’
M1
E1’

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O X
X1 X2 X3
At income level M1, the consumer is in equilibrium at point E1 by consuming X1 units of X and this is
shown by point E1’ on the M-X plane. When income of the consumer increases to M2, the budget line
shifts to A’B’ and the consumer will a higher IC U2 at point E2 by purchasing X2 units of X. this is
shown by point E2’ on the second panel. Similarly, when income increase to M3, the consumer is in
equilibrium at point E3 by purchasing X3 of X and this is shown by point E3’ on the second panel.
If we connect equilibrium points of the consumer in the first panel we obtain the Income Consumption
Curve. Similarly, if we connect the points on the second panel, we obtain the Engle Curve.

NORMAL AND INFERIOR GOODS

A normal good is one of which the consumer purchases more with an increase in income.
An inferior good is one of which the consumer purchases less with an increase in income.
Good X in the above figure is a normal good because the consumer purchases more of it
with an increase in income. This is shown by a positively sloping income consumption
curve and the Engle curve. However, for an inferior good, the income consumption curve
and the Engle curve are negatively sloping because as income increases, the consumer
purchases less of these commodities. This can be shown by the following graph.

A’
ICC
E2
A
U2

E1

U1

O X
X2 X1 B B’
M

M2 E2

E1
M1

Engle curve

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O X
X2 X1
 The classification of goods as normal or inferior depends only on how a specific consumer views the
particular good.
Thus, the same good X can be regarded as a normal good by another consumer.
 Furthermore, a good can be regarded as a normal good by a consumer at a particular level of income
and as an inferior good by the same consumer at a higher level of income.
 A normal good can be further classified as a necessity or a luxury depending on whether the quantity
purchased increases proportionately more or less than the increase in income.

PRICE CONSUMPTION (OFFER) CURVE

When the price of a good (say X) decreases the budget line becomes flatter (rotates to the right) from its
initial position (AB) to a new position (AB’) due to the increase in the purchasing of the given income
of the consumer. The new budget line is tangent to a higher IC at point E2 showing that as price of X
falls, more of commodity X will be bought. If we allow price of X to fall continuously and we join the
points of tangencies of successive budget lines and the higher ICs, We form the so called price
consumption curve from which we derive the demand curve for commodity X. at point E1 the consumer
buys quantity X1 at price P1. At point E2 the price P2 is lower than P1 and the quantity demanded has
increased to X2 and so on.
Y

PCC
E3
E2
E1 I3
I2
I1
O
X1 X2 B X3 B’ B’’ X
P

P1

P2

P3
DD-Curve

O X

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X1 X2 X3
Thus, we derive the demand curve by plotting the price quantity pairs defined by the points of
equilibrium (on the price consumption curve) on the price quantity space.
The demand curve for normal goods (goods whose demand increases with increase in income) will
always have a negative slope denoting the law of demand which states that the quantity demanded
increases as price increases and vice versa. In the case of giffen goods the demand for a good decreases
when its price decreases.
Mathematical derivation of the demand curve:
Derive the demand function for good X and Y given
U(x, y) = 1/4QxQy, Px, Py, &M.
Solution
=> M = QxPx + QyPy
At the optimum choice, the slope of IC (MRSx,y = MUx/MUy) is equal to the slope of the budget
line(Px/Py). That is,
MUx/ MUy = Px/ Py
But MUx = U/ X = ¼ Qy and
MUy = U/ Y = ¼ Qx
 ¼ Qy/ ¼ Qx = Px/ Py
 QyPy = QxPx----------------------------------------(1)
The budget constraint is
M = QxPx + QyPy
=> Qy = M/ Py – Px/ Py Qx------------------------------ (2)
Substitute (2) in to (1)
 Py ( M/ Py – Px/ Py Qx) = Qx Px
 M – PxQx = QxPx
 2PxQx = M
 Qx = 1 M
2Px
To obtain the demand function for Y:
M = PxQx + PyQy
=> PxQx = M – PyQy
Qx = 1/ PxM – (Py/Px)Qy--------------------------------(3)
Substitute (3) into (1)
 PxQx = PyQy
 Px(1/PxM – Py/PxQy) = PyQy
 M – PyQy = PyQy
 2PyQy = M
 Qy = 1 x M  is the demand function for Y.
2Py

Example: given utility U(x, y) = X1/3Y2/3 , Px = 2, Py = 5 and M = 400, find:

(1) The demand equation for X and Y.
(2) The utility maximizing levels of X and Y.
(3) The maximum utility
(4) The MRSx,y at the optimum level.
Solution:1

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U(x, y) = X1/3Y2/3
At equilibrium, MUx/MUy= Px/Py
But, MUx = U/ /X = 1/3 X-2/3Y2/3
MUy = U/ /Y = 2/3X1/3 Y-1/3
=> 1/3 X-2/3Y2/3 Px
=
1/3 -1/3
2/3X Y Py

=> X-2/3Y2/3 . 3 Px
=
3 2X1/3 Y-1/3 Py

=> X-2/3Y2/3 Px
1/3 -1/3 =
2X Y Py

=> X-1Y Px
=
2 Py

=> Y Px
=
2X Py

=> Py Y = 2 Px X-------------------------------------------------(1)

But, M = Py Y + PxX  Is the budget constraint.

=> PyY = M – PxX

=> Y = M/ Py – Px/ Py X-----------------------------------------(2)

And PxX = M – PyY
=> X = M/Px –(Py/Px)Y-------------------------------------------(3)
Substitute equation (2) into (1)
 PyY = 2 PxX
 Py(M/Py – Px/Py X) = 2PxX
 M – Px X = 2PxX
 3PxX = M
 X=M
 Is the demand equation for X.
3Px
Similarly, substitute equation (3) into (1).
PyY = 2PxX
 2Px(M/Px – Py/PxY) = PyY
 2M – 2PyY =PyY
 3PyY = 2M
 Y = 2M
 Is the demand function for commodity Y.

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2Py

(2) The above functions of X & Y are derived from the equilibrium position of the
consumer. Thus, substitute the value of M, Px and Py in the demand equations to find the
optimum value of X and Y.
X = M/ 3Px = 400/ 3(2) = 400/6 = 200/3=66.7
Y = 2M/3Py = 2(400)/3(5) = 160/3 = 53.3
(3) U = X1/3Y2/3
= (66.7)1/3(53.3)2/3 = 57.5 is the maximum utility.
(4) At the equilibrium or at the optimum point,
MRSx,y = MUx/MUy = Px/Py
=>MRSx,y = 2/5 = 0.4
OR MRSx,y = MUx/MUy =1/3 X-2/3Y2/3 Y 160/3
= =
2/3X1/3 Y-1/3 2X 2(200/3)
= 160/3 80 40
= = = 0.4
400/3 200 100

DECOMPOSITION OF INCOME AND SUBISTITUTION EFFECTS

A fall in the price of a good has two effects:

(1) The consumer will tend to buy more of a good that has become cheaper and less
of those goods that are now relatively expensive. The consumer will tend to
substitute cheaper commodity for relatively expensive one. This response to the
change in relative prices of goods is called the substitution effect.
(2) Because one of the goods is now cheaper, the consumer enjoys an increase in real
purchasing power. The consumer is better of because he/she can buy the same
amount of the good for less money and thus money left over for additional
purchases. The change in demand resulting from this change in real purchasing
power is called the income effect.

The substitution effect is the increase in the quantity bought as the price of the
commodity falls after adjusting income so as to keep the real purchasing power of the
consumer the same as before. This adjustment in income is called compensating
variation and is shown graphically by a parallel shift of the new budget line until it
becomes tangent to the initial IC. The purpose of the compensating variation is to
allow the consumer to remain on the same level of satisfaction as before the price
change.
In the following graph, the consumer was initially at point E1 on the budget line AB.
When the price of X falls, the budget line has rotated from AB to AB’ resulting in
anew equilibrium point E2. The increase in the consumption of X from X1 to X3 is
the total effect of a fall in the price of X which can be splited into substitution effect

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and income effect. In order to split these two effects we draw a parallel budget line
(compensating budget line) which is tangent to the new budget line.
This allows the real purchasing power of the consumer to remain as before and thus
to reject the income effect so the consumer will be on the same level of satisfaction as
before. Accordingly, the movement from point E1 to E1’ shows the substitution effect
of the price change (the consumer buys more of X now that it cheaper, substituting X
for Y).
Y

A’
E1
E2

E1’ U1

U2

O X
X1 X2 B X3 A’ B’

The substitution effect is negative for all goods since the consumer substitutes the
cheaper for more expensive one. This implies a decrease in price leads to an increase in
quantity demanded.

The movement from E1’ to E2 is the income effect of the fall in the price of X. to isolate
the income effect, we assume that the relative price of the goods has not changed (shown
by the parallel line AB’ and A’A’). The income effect in this case can be thought of as
being negative (comparing the direction of the change in price and quantity demanded of
a good) or a positive (comparing the direction of the change in the purchasing power of
the consumer and the quantity demanded).

=> For normal good, income effect of a price change is negative, i.e. Px =>PP=> Qx.
Ultimately, Px => Qx.

=> For inferior good, income effect of a price change is positive, i.e. Px =>PP=> Qx.
Ultimately, Px => Qx.

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PANEL A PANEL B
Y Y

A
A
E2

A’
A’ E2
E1
E1 U2

U2 E1’
E1’

U1 U1
O B XO X
X1 X3 X2 A’ B’ X3 X1 X2 B A’ B’

SE SE

IE IE

TE TE

TE = SE + IE TE = SE + IE
X1X3 = X1X2 +X2X3 X1X3 = X1X2 +X2X3

For an inferior good whose negative substitution effect more than offsets the positive
income effect (panel A above), the total effect will be negative (Px  => Qx) and thus
the law of demand holds. If, however, the IE is positive and very strong that it more than
offsets the negative SE, the demand curve will have a positive slope (Px => Qx)  the
GIFFEN PARADOX. A Giffen good is a good whose demand curve slopes down ward
because the positive IE is larger than the negative SE (panel B).

Good IE SE TPE
Normal Negative Negative Negative

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inferior Positive Negative Ambiguous

THE REVEALED PREFERENCE HYPOTHESIS

The revealed preference hypothesis is considered as a major break through in the theory
of demand because it has made possible the establishment of the law of demand directly
on the basis of the revealed preference axiom without the use of indifference curves and
all their restrictive assumptions.
ASSUMPTIONS:
(1) Rationality: the consumer is assumed to behave rationally, in that he prefers
bundles of goods that include more quantities of the commodities.
(2) Consistency: if A > B, then B is not greater than A.
(3) Transitivity: if in any particular situation A > B and B > C, then A > C.
(4) The revealed preference axiom: the consumer, by choosing a collection of goods
in any one situation, reveals his/her preference for that particular collection. The
chosen basket of goods maximizes the utility of the consumer.
(5)
DERIVATION OF THE DEMAND CURVE

Assume that the consumer has the budget line AB in the figure below and chooses the
collection of goods denoted by point Z, thus revealing hi/her preference for this basket.
This bundle of goods defines the equilibrium of the consumer which maximizes his/her
utility. Suppose that the price of X falls so that the new budget line facing the consumer is
AC. We will show (proof) that the new bundle of goods includes more of X.
Y

A’

W N

X
O X1 X2 B B’ X3 C

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In order to split the SE & IE , we make a compensating variation shown by a parallel

budget line to the new budget line, which passes through the point Z. in this case the
consumer has enough income to buy Z combinations if he/she so wishes. Since the
collection Z is available to the consumer, he/she will not choose any bundle to the left of
Z on the segment A’Z because they contain less quantity of X & Y than bundles on the
segment AZ. Hence the consumers will either continuo to buy Z (in which case the
substitution effect is zero) or he/she will choose a bundle on ZB’, such as W, which
includes a larger quantity of X (namely X2). Secondly, if we allow the income effect and
hence the consumer to move on the new budget line AC, he/she will choose a bundle to
the right of W (such as N) if the commodity X is normal with the positive income effect.
The new revealed equilibrium position (N) includes a larger quantity of X (i.e. X3)
resulting from a fall in price. Thus we derive the demand curve directly from the revealed
preference axiom (i.e. as a price X falls the demand for X increases).

DERIVATION OF THE MARKET DEMAND

In our previous discussion we have derived the individual demand curve from the utility
maximization behavior of consumers. Now we will derive the market demand from this
individual demand curves. As it has been proved, the individual demand is negatively
related to the price commodity in the sense that when price decrease, the individual
consumer purchases more of the commodity in order to maximize his/her utility. The
market demand curve for the commodity is simply the horizontal summation of the
demand curve of all the consumers in the market. In other words the quantity demanded
in the market at each price is the sum of the individual demands of all consumers at that
price.
EXAMPLE:
Assume that there are two consumers in the market for a particular commodity X ( say
hamburger) and their demand at each price is given as follow:
Price ($) Qx dded by A Qx dded by B Market demand
2 2 2 4
1 6 4 10
0.5 10 6 16

Graphically the market demand can be derived as follows:

Px Px Px
Individual A Individual B Market demand

2------ --------------------------- ------------------------------------- -------------

1--------------------------------- ------------------------------------ ------------------------

0.5-------------------------------- ------------------------------------ ------------------------------------

d1 d2 MD

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O 2 6 10 O 2 4 6 O 4 10 16

Thus, the market demand fort a commodity shows the various quantities of the
commodity demanded in the market per unit of time at various alternative price of the
commodity while holding every thin else constant. The market demand for a commodity
is negatively sloped (just as an individual demand curve), indicating that price and
quantity are inversely related. That is, the quantity demanded of the commodity increases
when its price falls and decreases when its price rises.

DETERMINANTS OF DEMAND

Determinants of demand are factors that cause the consumer to increase or decrease its
demand for a particular commodity. Demand is a multi-variety function in a sense that
it’s determined by many factors/variables. The most important determinants of market
demand are considered to be the price of the commodity in question, the price of other
related commodities, the consumer income and testes. The result of change in the price of
the commodity is shown by a movement from one point to another on the same demand
curve, while the effect of changes in other determinants is shown by a shift of demand
curve and these factors are called shift factors.
Px

P2----------- B

P ------------------------------

P1--------------------------- A

D D’ D’’
D
Qx Qx
O X2 X1 O X1 X2 X3

Movement along the demand curve Shifts of the demand curve as, for exam-
as the price of X changes. ple income increases

Apart from the above determinants, demand is affected by numerous other factors, such
as the distribution of income, total population and its consumption, wealth, credit
availability, change in expectation about the future price of the commodity, etc.

ELASTICITY OF DEMAND

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The concept of elasticity is used to measure the amount by which the quantity demanded
changes when its determinants change. There are as many elasticities of demand as there
are its determinants. The most important of these elasticities are:

(A) The price elasticity of demand

(B) The income elasticity of demand
(C) The cross-elasticity of demanded.

THE PRICE ELASTICITY OF DEMAND

The price elasticity is a measure of the responsiveness of demand to changes in the
commodity’s own price. If the changes in price are very small we use as a measure of the
responsiveness of demand the point elasticity of demand. If the changes in price are not
small we use the arc elasticity of demand as a relevant measure.
The point elasticity of demand is defined as the proportionate change in the quantity
demanded resulting from a very small proportionate change in price. Symbolically, we
may write as:
ep = dQ/Q dQ P
OR ep = x
dP/P dP Q
If the demand is linear
Q = bo – b1P, its slope is dQ/dP = -b1. Substituting in the formula we obtain,
ep = -b1.P/Q.
Graphically, the point elasticity of a linear demand curve is shown by the ratio of the
segments of the line to the right and to the left of the particular point. For example, in the
figure below the elasticity at point F is the ratio:
ep = FD’/FD
P

P1---------------- F

P2------------------------ F’
E

Q
O Q1 Q2 D’

Proof:
From the above figure we see that:
P = P1P2 = EF
Q = Q1Q2 = EF’
P = OP1

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Q = OQ1
If we consider very small change in P and Q, then P = dP and Q. Thus, substituting in
the formula for the point elasticity, we obtain:

Ep = (dQ/dP) P/Q = Q1Q2 OP1 EF’ OP1

x = x
P1P2 OQ1 EF OQ1
From the figure we can also see that the triangles FEF’ and FQ1D’ are similar (because
each corresponding angles are equal).
Hence, EF’ Q1D’ Q1D’
= =
EF FQ1 OP1

Q1D’ OP1 Q1D’

Thus, ep = x =
OP1 OQ1 OQ1
Furthermore the triangles DP1F and FQ1D’ are similar, so that
Q1D’ P1F OQ1
= =
FD’ FD FD
Rearranging we obtain:
Q1D’ FD’
=
OQ1 FD
Thus, the price elasticity at point F is
Q1D’ FD’
Ep = =
OQ1 FD
Given this graphical measurement of point elasticity it is obvious that at the mid-point of
a linear demand curve ep = 1 (point M). At any point to the right of M the point elasticity
is less than unity (ep < 1); finally at any point to the left of M, ep > 1. At point D, the
ep  , while at point D’ the ep = O. The price elasticity is always negative because of
the inverse relationship between Q and P implied by the law of demand. However, the
negative sign is omitted when writing the formula of the elasticity.
The range of values of the elasticity is O  ep  .
(1) If ep = O, then the demand is perfectly inelastic
(2) If ep = 1, then the demand is unitary elastic
(3) If ep = , then the demand is perfectly elastic
(4) If O< ep < 1, then the demand is inelastic
(5) If 1 < ep < , then the demand is elastic.
Px
D ep

ep>1

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M ep = 1

ep<1

o ep = O
P P P

P D

Q o Q Q
ep = o ep = 1 ep = 

The above formula for the price elasticity is applicable only for infinitesimal changes in
the price. If the price changes appreciably we use the following formula, which measures
the arc elasticity of demand:
Q P1 + P2 Q P1 + P2
ep = x 2 x
P = P Q1 + Q2
Q1 + Q2

2
The arc elasticity is a measure of the average elasticity, i.e. the elasticity at the mid-point
of the two points A and B on the demand curve defined by the initial and the new price
levels.
P

P1---------- A

P2--------------------------------B

D
Q
O Q1 Q2

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

The basic determinants of the elasticity of demand of a commodity with respect to its
own price are:

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(1) The availability of substitute; the demand for a commodity is more elastic if there
are close substitute for it.
(2) The nature of the need that the commodity satisfies. In general, luxury good are
price elastic, while the necessity is price inelastic.
(3) The time period; demand is more elastic in the long run.
(4) The number of uses to which a commodity can be put. The more the possible uses
of a commodity, the greater its price elasticity will be.
(5) The proportion of income spent on the particular commodity.

INCOME ELASTICITY OF DEMAND

The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in income.
ey = dQ/Q dQ Y
= x
dY/Y dY Q

If ey > o, then the commodity is normal.

If ey < o, “ “ “ inferior.
If ey > 1, “ “ “ luxury.
If o < ey < 1, “ “ necessity.

The main determinants of income elasticity are

(1) The nature of the need that the commodity covers: the percentage of income spent
on food declines as income increases.
(2) The initial level of income of a country. For example, a TV set is a luxury in
underdeveloped countries while it is a necessity in a country with high per capital
income.
(3) The time period, because consumption patterns adjust with a time lag to changes
in income.
THE CROSS- ELASTICITY OF DEAMADN
The cross elasticity of demand is defined as the proportionate change in quantity demand
of X resulting from a proportionate change in the price of Y.
dQx/Qx dQx Py
exy = = x
dPy/Py dPy Qx
If exy < o, then X & Y are complementary goods.
If exy > o, “ “ substitute goods.

The main determinants of the cross elasticity is the nature of the commodities relative to
their use. If two commodities can satisfy equally well the same need, cross elasticity is
high and vice versa.

PRICE ELASTICITY AND TOTAL EXPENDITURE

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An important relationship exists between the price elasticity of demand and the total
expenditure of consumers on the commodity (total revenue of producers). It postulates
that a decline in the commodity price results in an increase in total expenditures if
demand is elastic leaves total expenditure unchanged if demand is unitary elastic, and
results in a decline in total expenditure if demand is inelastic.
Specifically when the price of the commodity falls, total expenditure (price times
quantity) increase if demand is elastic because the percentage increase in quantity (which
by itself tends to increase total expenditure) exceeds the percentage decline in price
(which by itself tends to decline total expenditure). Total expenditures are maximum
when /ep/ = 1and decline thereafter. That is, when /ep/ < 1, a reduction in the commodity
price leads to a percentage increase in the quantity demanded of the commodity that is
smaller than the percentage reduction in price, and so total expenditure on the commodity
decline. This can be shown by the following table.

point Price of X (Px) Quantity (Qx) Total Absolute value

expenditure(TE of ep /ep/
)
A 2.00 0 0 
C 1.50 3 4.50 3
E 1.00 6 6.00 1
F 0.50 9 4.50 1/3
H 0 12 0 0

From the above table we see that between points A and E, /e p/>1 and total expenditure on
the commodity increases as the commodity price declines. The opposite is true between
points E and F over which /ep/<1. Total expenditures are maximum at point E (the
geometric mid-point of the demand curve). The general rule summarizing the relationship
among total expenditures, price and the price elasticity of demand is that total
expenditures and price move in opposite directions if demand is elastic and in the same
direction if demand is inelastic.

MARKET DEMAND, TR AND MR

From the market demand curve we can derive the total expenditure of the consumer,
which forms the total revenue of firms selling the particular product. The total revenue is
the product of the quantity sold and the price.
TR = P.Q
If the market demand is linear the TR curve will be a curve which initially slopes
upwards, reaches a maximum and then starts declining. We can proof this from our
previous discussion of the relationship between elasticity and TR/TE.
P TR
D
Rmax
P1 A
B
P* ep = 1

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C
P2
D’ TR
O Q1 Q* Q2 Q O Q* Q

Another important point in the theory of firm is the MR. the marginal revenue is the
change in total revenue resulting from selling an additional unit of the commodity.
Graphically, MR is the slope of total revenue curve at any one point. If the demand curve
is linear, the MR curve is twice as steep as the demand curve.
P
D

D’
O Q

MR
This can be proved mathematically as follows:
MR is the derivative of TR function:
MR = d(TR)
dQ
= d(PQ)
dQ
= P + Q.dP
dQ
if the demand curve is linear its equation in terms of price is:
P = ao – a1Q
Substituting P in the TR function we find
TR = PQ = aoQ – a1Q2

The MR is then MR = d(TR)

dQ
= ao – 2a1Q
This proves that the MR curve starts from the same point (ao) as the demand curve, and
that the MR is a straight line with a negative slope twice as steep as the slope of the
demand curve.

The relationship between MR and price elasticity

The MR is related to the price elasticity of demand with the formula

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MR = P(1 – 1/e)
Proof:
Assume that the demand function is P = f(Q)
The total revenue is TR = PQ = [f(Q)]Q

The MR is
MR = d(PQ)
dQ
= P.dQ + Q.dP
dQ dQ
= P + Q.dP
dQ
The price elasticity of demand is defined as
e = - dQ .P
dP Q
Rearranging we obtain
-eQ = dQ
P dP
-P = dP
eQ dQ
Substituting dP/dQ in the expression of the MR we find
MR = P + QdP
dQ
= P – Q.P
eQ
=P–P
e
MR = P(1 – 1/e)

Total revenue, marginal revenue and price elasticity

We said that if the demand curve is falling the TR curve initially increases, reaches a
maximum, and then starts declining. We can use the earlier derived relationship between
MR, P and e to establish the shape of the total revenue curve.
The total revenue curve reaches its maximum at the point where e = 1, because at this
point its slope, the MR, is equal to zero:
MR = P(1 – 1/1) = 0
If e>1 the TR curve has a positive slope, that is, it is still increasing and hence has not
reached its maximum point given that
P > 0 and (1 – 1/e) >0; hence MR > 0
If e<1 the TR curve has a negative slope, that is, it is falling given
P > 0 and (1 – 1/e) < 0; hence MR < 0
We may summarize these results as follows:
- If the demand is inelastic (e<1), an increase in price leads to an increase in TR,
and a decrease in price leads to a fall in TR.

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- If the demand is elastic (e>1), an increase in price will result in a decrease of TR,
while a decrease in price will result in an increase in TR.
- If the demand is unitary elastic, TR is not affected by change in price since e=1
and MR=0.

CHOICE UNDER UNCERTAINITY

Traditional demand theory, as examined until now, implicitly assumed a risk less world. It
assumed that consumers face complete certainty as to the results of the choices they
make. Clearly, this is not the case in most instances. In contrary to our assumptions of
price income and other variables to be known with certainty, many of the choices that
people make involve considerable uncertainty.

Although risk and uncertainty are usually used interchangeably, some people distinguish
between the two.
(I) Uncertainty: refer to a situation when there are more than possible outcomes
to a decision and where the probability of each specific outcome is not known.
This may be due to insufficient past information or instability in the structure
of the variables.
(II) Risk: refers to a situation where there are more than one possible outcome to a
decision and the probability of each specific outcome is known or can be
estimated.
(III) Certainty: refers to a situation where there is only one possible outcome to a
decision and this outcome is known precisely. For example, investing on
treasury bills leads to only one outcome (i.e. the amount of the yield), and this
is known with certainty.
We need two measures to describe and compare risk choices. These measures are:
(I) Expected value: is the weighted average of all possible payoffs/outcomes that can
result from a decision under the various state of nature, with the probability of those
payoffs used as weights. It measures the value that we would expect on average. If we
multiply each possible outcome or payoff by its probability of occurrence and add these
products, we get the expected value. If, for instance, there are two possible outcomes
having payoffs X1 and X2 and if the probabilities of each outcome are given by P1 and
P2, then the expected value is:
E(X) = P1X1 + P2X2
Example: If the probability that an oil exploration project is successful is ¼ and the
probability that it is unsuccessful is ¾ and if success yields a payoff of 40 birr per share
while failure a payoff of 20 birr per share, the expected value is:
EV = p(success)(40 birr/share) + p(failure)(20birr/share)
= ¼ (40) + ¾ (20)
= 25 birr/share
(II) Variability: is the extent to which possible outcomes of an uncertain event may differ.
We measure variability by recognizing that large differences between actual and expected
value imply greater risk. Standard deviation is the often used measure of variability.

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Standard deviation measures the dispersion of possible outcomes from the expected
value. The smaller the value of sd, the tighter or less dispersed the distribution is and the
lower the risk attached to it and vise versa.

Standard deviation (sd) -  =  P1(X1-E(X))2 + P2(X2-E(X))2

If two alternatives to choose from have the same expected value, the one with the
lower/smaller standard deviation is less risky and hence is preferred. If, however, one
alternative offers a higher expected value but is much riskier than the other one and vise
versa, the preference depends on the individual – whether he/she is a risk averse, risk
neutral or a risk loving person.

DIFFERENT PREFERNCE TOWARDS RISK

A RISK AVERSE PERSON: is a person preferring a certain income to a risky income with
the same expected value. For a risk averse person losses are more important (in terms of
the change in utility) than gains. Losses hurt him/her more seriously than gains benefit
him/her. Thus, the MU of income diminishes as income rises.
Assume that the person can either have a certain income of birr 20, or an alternative
decision yielding an income of 30 birr with probability of 0.5 and an income of 10 birr
with probability 0.5. The expected income of this alternative is, EV = 0.5(30) + 0.5(10) =
20 birr. This is the same as the income earned without risk. He/she prefers to consume the
risk less 20 birr to trying the alternative in which he/she could have consumed 30 birr if
successful or 10 birr if unsuccessful. Utility at B > utility at C (16>14). The risk averse
person achieves the expected utility of 14 at a lower but risk less income of 16 birr. Thus,
he/she is willing to pay birr 4 (20-16) to avoid taking risk. The maximum amount of
money (4 in our case) that a risk averse person will pay to avoid taking a risk is called a
risk premium.
Utility of this risk averse person is 14 = 0.5(10) + 0.5(18).
Consider the following graph for the above explanation.

Utility

18 E
16 B
14 D C

A
10

Income
O 10 16 20 30

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A RISK NEUTRAL PERSON: is a person indifferent between a certain income and an

uncertain income with the same expected value. For this person, the MU of income is
constant.
E(U) = 0.5U(10) + 0.5U(30)
= 0.5(6) + 0.5(18)
= 12
=> E(U) = U(20) = 12
Utility

18 E

12 C

6 A

O Income
10 20 30

A RISK LOVING PERSON: - is a person preferring a risky income to a certain income

with the same expected value. This person prefers an uncertain income to a certain one,
even if the expected value of the uncertain income is less than that of the certain income.
E(U) = 0.5U(10) +0.5U(30)
= 0.5(3) + 0.5(18)
= 10.5
 E(U) > U(20)
 10.5 > 8
The expected utility of the uncertain income is greater than the utility of a certain income
for a risk loving person and thus their utility of income curve is upward bending.
Utility
E
18

10.5

8 ------------------ C

3 A
Income
O 10 20 30

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- Risk loving people are few, at least with respect to major purchases or large
amounts of income or wealth.
- Risk loving people prefer alternatives with high expected value and high standard
deviation (risk) to a lower paying but less risky alternative (unlike the risk averse
people).
NB: Expected utility E(U) is the sum of the utilities associated with all possible
outcomes, weighted by the probability that each outcome will occur.

RISK AVERSION AND INDIFFERENCE CURVES

We also describe the extent of a person’s risk aversion in terms of indifference curves that
relate the expected income to the variability of income, the latter being measured by the
standard deviation. An IC shows the combination of expected income and standard
deviation of income that give the individual the same amount of utility. ICs are upward
sloping. This is because risk is undesirable so that the greater the amount of risk, the
greater the amount of income needed to make the individual equally well-off. An increase
in the standard deviation (a higher variability of income) must be compensated by a
higher expected income so as to a very leave a risk averse person on the same level of
utility. In the case of a slightly risk averse person, a large increase in the standard
deviation of income requires only a small increase in expected income.

E(I) U3 E(I)
U2
U3
U2
U1
U1

O O
Standard deviation of income () Standard deviation of income ()
(A) A high risk averse person (B) A slightly risk averse person

THE TRADE OFF BETWEEN RISK AND RETURN

Suppose a consumer or an investor wants to allocate his income between two assets- one
risky and the other risk free. He might allocate his entire income only to the risk free,
only to the risky, or to some combinations of the two.
Let the expected return from the risky asset be Rr and the actual return be rr. Let also the
risk free return from the risk free asset be Rf. In order for the consumer to have the

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combination of the two assets or goods and to construct the budget line, assume that R r >
Rf. The expected return on the total expenditure, Rp, is a weighted average of the
expected return on the two assets.
Rp = R(brr + (1-b)Rf) = E(brr) + E((1-b)Rf)
Rp = bRr + (1-b)Rf ------------------------------------------- (1)

The standard deviation of the total allocation, p (with one risky and one risk free asset),
is the fraction of the fund allocated to the risky asset times the standard deviation of the
asset.
p = br ------------------------------------------------------ (2)
Equation (1) above can be rewritten as:
Rp = Rf + b(Rr – Rf) --------------------------------------- (3)
Substituting the value of b(from equation 2) into equation 3.
Rp = Rf + (Rr – Rf) p
r
This equation is a budget line because it describes the trade-off between risk (p) and
expected return (Rp). Because Rf, Rr and r are constant, this equation is an equation for
a straight line (the slope (Rr-Rf)/ r is a constant). This slope tells us how much extra risk
the consumer (investor) must incur to enjoy a higher expected return Rp. Thus it is the
price of risk.
If all income is allocated to the risk free asset (b=0), an expected return of Rf would be
received but with risk as high as r. A higher expected income and a reduced (minimi
zed) risk are achieved at the point of tangency of the budget line and the indifference
curve. A less risk averse (risk lover) person is at the optimum at a higher level of return
(allocating more income to the risky asset) but incurring more risk.
E(I) U3 U2 Ub
U1

Budget line
Rr Eb

R* E

Rf

O 
* r

As we have discussed earlier a risk averse person has an indifference curve which is
steeper and thus the equilibrium point for this person is at point E with R* return and *
variability. For the risk loving person the equilibrium point is at Eb where the flatter
indifference curve is tangent to the budget line. At this point the person gets Rr return
with r variability which greater than that of the risk averse person.

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REDUCING RISK

In the face of a broad variety of risky situations, people are generally risk averse.
Consumers and managers commonly reduce risk in various ways. The major ones are
diversification, insurance and obtaining more information.

Diversification: - reducing risk by allocating resources to a variety of activities whose

outcomes are not closely related –“Don’t put all your eggs in one basket.”

Insurance: - If the cost of insurance is equal to the expected loss, risk averse people will
buy enough insurance to recover fully from any losses they might suffer. For a risk averse
consumer, the guarantee of the same income regardless of the outcome generates more
utility than would be the case if that person had a high income when there was no loss
and a low income when a loss occurred.

The value of information: - people often make decisions based on limited information. If
more information were available, one could make better predictions and reduce risk.
Even though forecasting is inevitably imperfect, it may be worth investing in a marketing
study that provides a reasonable forecast for the future.

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CHAPTER THREE
THE THEORY OF PRODUCTION

3.1 THE PRODUCTION FUNCTION

In the production process/ activity, firms turn inputs into output. This transformation of
inputs (factor of productions) into output at a particular time period and at a given
technology (state of knowledge about the various methods that might be used to
transform inputs into outputs) is described by a production function.
The production function is a function that shows the highest output that a firm can
produce for every specified combination of inputs. It is a purely technical relation which
connects factor inputs to outputs. Assuming labor (L) and capital (K) as the only inputs,
the production function can be written as: Q = f(L,K).
The production function allows inputs to be combined in varying proportions so that
output can be produced in many ways (using either more capital or less labor or vise
versa). For example, a unit of commodity X may be produced by the following processes:

Process P1 Process P2 Process P3

Labor units 2 3 1
Capital units 3 2 4

Activities or these methods of productions can be shown by a line from the origin to the
point determined by the labor and capital inputs combination.
K

3 p1
2 p2

1 p3

0 2 3 4 L

The production function (a purely technical relationship which connects factor inputs and
outputs) includes all the technically efficient methods of production. The technically
inefficient methods are not included in the production functions. A method of production
A is technically efficient than any other method B if A uses less of at least one input and
no more of the other factors as compared with B. For example, commodity Y can be
produced by two methods, A and B as follows:
A B
Labor 2 3

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Capital 3 3
Method A is considered as technically efficient method as compared with B. The basic
theory of production concentrates only on efficient methods and thus inefficient methods
will not be used by rational producer.
If a process A uses less of some factor(s) and more of some other(s) as compared with B,
then A and B cannot be directly compared on the criterion of technical efficiency. For
example, the activities
A B
Labor 2 1
Capital 3 4
are not directly compared. Both processes are considered as technically efficient and are
included in the production function. Which one of them will be chosen at any particular
time depends on the price of factors (inputs).The choice of any particular technique
among the set of technically efficient processes is an economic one, which is based on the
price of factors of production. Note that a technically efficient method is not necessarily
economically efficient.
ISOQUANTS
Assuming that labor and capital are the only two inputs used to produce an item, the
output achievable for various combinations of inputs can be shown by using isoquants.
An isoquant is the locus of all the technically efficient methods (or all the combinations
of factors of production) for producing a given level of output. It is a curve showing all
possible combinations of inputs that yield the same output. The production isoquant may
assume different shapes depending on the degree of substitutability of factors. These are:
(1) Linear isoquant: this type assumes perfect substitutability of factors: a given
output may be produced by only labor, or only capital, or by an infinite
combinations of K and L. See figure A below.
(2) Input-output isoquant: this assumes strict complementarily (i.e. zero
substitutability) of the factors of production. There is only one method of
production for any one commodity. The isoquant takes the shape of right angle
triangle. This type of isoquant is called “Liontief isoquant” after the name
Leontief who invented the input output analysis. See figure B below.
(3) Kinked isoquant: this assumes limited substitutability of K and L. there are only
few processes for producing a particular commodity. Substitutability of the factors
is possible only at the kinks. See figure C below.
(4) Smooth or convex isoquant: this form assumes continuous substitutability of K
and L only over a certain range, beyond which factors can not substitute each
other. The isoquant is a smooth curve which is convex to the origin. Consider
figure D below.

K K

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O L O L
A. Linear isoquant B. Input-output isoquant
K K
P1
P2
X
P3

P4 X

O L O L
C. Kinked isoquant D. Convex isoquant

Even though the kinked isoquant is more realistic, most of the time the smooth or convex
isoquant is used in the tradition economic theory because it is mathematically simpler to
handle by the simple rules of calculus.
Isoquant map: is a graph combining several or a set of isoquants. An isoquant map is
another way of describing a production function, just as an indifference map is a way of
describing a utility function. The level of output increases as we move upward to the right
where as it remains constant along an isoquant (see points A, B & C in the figure below).
K

*A
*C

Q=100
*B
Q=50

O L
SHORT RUN PRODUCTION FUNCTION AND STAGES OF PRODUCTION
The production function in the traditional theory assumes the form:
X = f(L, K, r, y)
Where L is labor, K is capital, r is returns to scale which refers to the long run analysis of
the laws of production since it assumes change in the plant, and y is the efficiency
parameter related to the organizational and entrepreneurial aspect of the production.
Graphically, the production function can be shown as follows:
X Panel A X Panel B

X=f(L)k3,r3,y3 X=f(K)L3,r3,y3

X=f(L)k1,r1,y1
X=f(K)L1,r1,y1

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O L O K
In panel A, as labor increases, ceteris paribus, output increases: we move along the curve
depicting the production function. If K and/or r, and/or y increase, the production
function shifts upwards. The same is true for panel B.
The slope of the production function is the marginal products of the factors of production.
The MP of a factor is defined as the change in output resulting from the change in the
factor, keeping all other factors constant. That is
MPL = X and MPK = X
L K
Graphically, the MPL is shown by the slope of the production function X=f(L) and the
MPK is shown by the slope of the production function X=f(K). The slope of a curve at
any one point is the slope of a tangent line at that point.

X MPL=X = 0 MPK=X = 0
L K
X=f(L) X=f(K)

O A’ B’ L O C’ D’ K
MPL MPK

Stage I Stage II Stage III Stage I Stage II Stage III

APL APK
O A B L O C D
MPL MPK

From the above graph we can understand that as the labor units used in the production
processes goes on increasing, the output initially increases at an increasing rate, then
starts rising at a decreasing rate, reaches a maximum and then starts falling. As a result

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the MP initially increases, reaches a maximum, and then starts declining since it is the
slope of the TP curve. The MP is even negative when the TP declines. On the other hand,
the AP is given by the slope of the line drawn from the origin to the corresponding point
on the TP curve. Thus, the AP initially increases, reaches a maximum at A’ level of input
and then starts declining. AP and MP are equal at the maximum of the AP. Accordingly
we can divide this production function into three stages as stage I (from zero TP, MP, &
AP up to the maximum of AP), stage II (from the maximum of AP to zero MP), and stage
III (from zero MP onwards).
At stage I, MP>AP and both of them are rising initially and MP falls latter on. Since each
additional unit of labor (on panel A) is coming up with contribution larger than the
average, it is rational to hire more labor and produce more. Thus, it is not reasonable to
produce at this stage.
At the third stage where both APL and MPL are declining and MPL<APL, it is not
rational to produce at all because each additional unit of labor added makes the total
product to decline (i.e. its contribution is negative).
Thus, it is in the second stage that a rational firm operates. Here each additional labor
contributes positively to the production but less than the average. At this stage as the use
of a variable input (labor) increases with other inputs (capital) being fixed, the resulting
additions to output (MPL) will eventually decrease. This principle is known as the law of
variable proportion or the law of diminishing marginal returns.
In summary, the production theories concentrate only on the efficient part of the
production function, that is, on the ranges of output over which the MP’s are positive. No
rational firm would employ labor beyond OB or capital beyond OD since an increase in
the factors beyond these levels would result in the reduction of the TP of the firm. Thus,
the basic theory of production concentrates on the range of output over which the MPs
are although positive, decreases (i.e. A’B’ and C’D’). This means over the range where
MPL > 0 but (MPL) < 0 and MPK > 0 but (MPK) < 0
L K
This condition implies that the tradition theory of production concentrates on the range of
the isoquants over which their slope is negative and convex to the origin. In the figure
below, the production function is depicted by a set of isoquants. Similar to the case of
indifference curves, the further away from the origin an isoquant lies, the higher the level
of output it represents and isoquants do not intersect.
The locus of points of isoquants where the marginal products of the factors are zero forms
the ridge line. At points A, B, &C the MPK is zero and hence forms the upper ridge line.
The lower ridge line shows that the MPL is zero. Thus, production techniques are only
efficient inside the ridge lines. Outside the ridge lines the marginal product of the factors
is negative and the methods of productions are inefficient, since they require more
quantities of both factors for producing a given level of output.
K
Upper ridge line (MPK = 0)
A B C
Lower ridge line (MPL = 0)

F X3
X2

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E
X1
D
O L
The slope of the isoquant (dK/dL) defines the degree of substitutability of the factors of
production. This slope decreases (in absolute terms) as we move downwards along the
isoquant, showing the increasing difficulty in substituting L for K. The slope of the
isoquant is called the rate of technical substitution, or the marginal rate of technical
substitution (MRTS) of factors:
MRTSL,K = -K = slope of an isoquant.
L
MRTSL,K is defined as the amount of K that the firm must sacrifice in order to obtain one
more unit of L so that it produces the same level of output. It is the slope of an isoquant.
It can be proved that the MRTS is equal to the ratio of the marginal products of the
factors. That is,
MRSL,K = -K = X/L = MPL
L X/K MPK
Proof:
The production function can be written as X = f(K,L)= C. It is equal to C because along
an isoquant the TP is constant.
The slope of a curve is the slope of a tangent line at that point. The slope of a tangent line
is defined by the total differential. The total differential (dX) is zero along an isoquant
since the TP is constant. Thus,
dX = (X/K)K + (X/L)L = 0
 (MPK)K + (MPL)L = 0
 -(MPK)K = (MPL)L
 -K/L = MPL/MPK
Along the upper ridge line we have
MRTSL,K = MPL/MPK = ∞ => MPK = 0
And along the lower ridge line
MRTSL,K = MPL/MPK = 0 => MPL = 0
The MRTS as a measure of the degree of substitutability of factors has a serious defect
since it depends on the units of measurement of the factors. A better measure of factor
substitutability is provided by the elasticity of substitution. It is given by:
 = percentage change in K/L
Percentage change in MRS
 = d(K/L)/(K/L)
d(MRTS)/(MRTS)
The elasticity of substitution is a pure number independent of the unit of measurement of
K and L since both the numerator and the denominator are measured in the same units.

FACTOR INTENCITY
Factor intensity refers to a measure of the intensity of a method of production in the sense
that a measure of whether a given method of production is labor intensive (uses more
labor than capital) or capital intensive (uses more capital than labor). It can be measured
by the slope of the line from the origin to a particular point on the isoquant representing a

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particular process. Factor intensity can also be measured by the capital labor ratio. In the
figure below process P1 is more capital intensive than process P2 because the slope of the
line OP1 is higher than the slope of OP2 or the ratio K1/L1 is greater than K2/L2. This
implies that the upper part of the isoquant includes more capital intensive techniques
where as the lower part includes more labor intensive techniques.
K

K1 P1

P2
K2 X

O L
L1 L2

EXAMPLE:
Let us illustrate the above concepts with a specific form of production function, namely
the Cobb-Douglas production function. This form is the most popular in applied research,
because it is easier to handle mathematically. It is of the form:
X = bo.Lb1.Kb2
1. The marginal product of factors
MPL = X/L = b1.bo.Lb1-1.Kb2
= b1(boLb1Kb2)L-1
= b1.X/L = b1(APL) since X = bo.Lb1.Kb2
and APL = X/L
MPK = b2.X/K = b2(APK)
2. The marginal rate of substitution
MRSL,K = X/L = b1(X/L) = b1 . K
X/k b2(X/K) b2 L`
3. The elasticity of substitution
 = d(K/L)/(K/L) = 1
d(MRS)/(MRS)
Proof:
Substitute the MRS in to the elasticity formula and obtain
 =d(K/L)
(K/L)
d(b1/b2.K/L)
(b1/b2.K/L)

= d(K/L) . (b1/b2)(K/L)
(K/L) d(K/L)(b1/b2)

= d(K/L)(b1/b2) = 1
d(K/L)(b1/b2)

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4. Factor intensity. In a Cobb-Douglas function factor intensity is measured by the ratio

b1/b2. The higher the ratio the more labor intensive the technique is and vise versa.
3. The efficiency of production. The efficiency in the organization of factors of
production is measured by the coefficient bo. It is clear that if two firms have the same K,
L, b1, and b2 and still produce different quantities of output, the difference can be due to
the superior organization and entrepreneurship of one firm which resulted in production
difference. The more efficient firms will have a higher bo than the less efficient one.
4. The returns to scale. In the Cobb-Douglas production function, the returns to scale are
measured by the sum of the coefficients b1+b2. It will be discussed latter on.

LAWS OF PRODUCTION
The laws of production describe the technically possible ways of increasing the level of
production. This can be in various ways. Output can be increased by changing all factors
of production which is possible in the long run. This is called the law of returns to scale.
On the other hand output can be increased by changing only the variable input while
keeping the fixed inputs constant, which is possible in the short run. The MP of the
variable factor will decline eventually as more and more quantities of this factor are
combined with the other constant factors. This is known as the law of variable proportion.
Let us see these laws one by one.

1. THE LAW OF VARIABLE PROPORTION

This is a law for the case of short run where there is at least one fixed inputs. In our
earlier discussion of the short run production function and stages of production, we have
assumed labor as a variable input and capital as a fixed input. From that graph, what we
can understand is that as the use of a variable input (labor) increases with other inputs
(capital) fixed, the resulting addition to output will eventually decreases. This is shown
by a downward sloping MPL curve after its maximum point. This principle is known as
the law of variable proportion or the law of Diminishing returns.

2. LAWS OF RETURNS TO SCALE

The law of returns to scale refers to the long run analysis of production. In the long run,
where all inputs are variable output can be increased by changing all factors by the same
proportion. The rate at which output increases as inputs are increased by the same
proportion is called returns to scale. We have three cases of returns to scale: increasing,
constant and decreasing returns to scale.
I) Increase returns to scale: this is the case where increasing all factors by the
same proportion, m, leads to an increase in output by more than m scale.
II) Constant returns to scale: if we increase input by some factor, m and output is
increased by the same proportion as inputs, m, then it is called constant
returns to scale. In this case the size of the firm’s operation doesn’t affect the
productivity of its factors.
III) Decreasing returns to scale: if scaling up all inputs by m scales output up by
less than m, it is called decreasing returns to scale. This is because, may be

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difficulties in organizing and running a large scale operation may lead to

decreased production of both labor and capital.

Examples

1. If Q = 2K + 3L. We will increase both K and L by m and create a new production

function Q*. Then we will compare Q* to Q.

Q* = 2(Km) + 3(Lm) = 2Km + 3Lm = m(2K + 3L) = mQ

After factoring, we can replace (2K + 3L) with Q, as we were given that from the start.
Since Q* = mQ, we note that by increasing all of our inputs by the multiplier m we have
increased production by exactly m. So we have constant returns to scale.

2. Q=.5KL Again we put in our multipliers and create our new production function.

Q* = .5(Km)(Lm) = .5KLm2 = Qm2. Since m > 1, then m2 > m. this implies our new
production has increased by more than m.. so we have increasing returns to scale.

3. Q=K0.3L0.2 Again we put in our multipliers and create our new production function.
Q* = (Km)0.3(Lm)0.2 = K0.3L0.2m0.5 = Q m0.5. Since m > 1, then m0.5 < m. Our new
production has increased by less than m. so we have decreasing returns to scale.

RETURNS TO SCALE AND HOMOGENIETY OF THE PRODUCTION

FUNCTION

Suppose we increase both factors of production function X=f(L, K) by the same

proportion m, and we observe the resulting new level of output X* as X* = f(mK, mL). If
m can be factored out (that is, can be taken out of the bracket as a common factor), then
the new level of output can be expressed as a function of m (to the power n) and the
initial level of output as follows: X* = m nf(L, K) or X* = mnX. If so, the function is
called homogeneous. If m cannot be factored out, the production function is called non-
homogeneous. The above three examples are a homogeneous functions since m can be
factored out. Thus, a homogeneous function a function such that if each of the inputs is
multiplied by m, the m can be completely factored out of the function. The power n of m
is called the degree of homogeneity and is a measure of the returns to scale.
If n=1, we have a CRS.
If n <1, “ DRS.
If n >1, “ IRS.

Given a Cobb-Douglas production function Q=boLb1Kb2, returns to scale is measured by

the sum of the powers of the factors. That is,
If b1 + b2 =1, then there is a CRS
If b1 + b2 >1, “ “ IRS
If b1 + b2 <1, “ “ DRS
Proof

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Let L and K increases by m. The new level of output is

X*=bo(mL)b1(mK)b2
= bomb1Lb1mb2Kb2
X* =mb1+b2(boLb1Kb2)
X*= mb1+b2X
This implies the function is homogeneous of degree b1+b2 and the returns to scale
depend on the sum.

PRODUCT LINE: It shows a physical movement from one isoquant to another as we

change either both factors or a single factor. It describes the technically possible
alternative paths of expanding output. What path will actually chosen by the firm will
depend on the prices of factors. The product curve passes through the origin if both
factors are variable. But if only one factor variable (the other being kept constant), the
product line is a straight line parallel to the axis of the variable factor.
K K K

PL (Isoclines) PL
(Points with constant PL
MRTSL,K are joined)
PL
K PL

O L O L O L
Product line for homogen Non-homogeneous function Product line where K is fixed.
eous function. (Here, the K/L ratio diminishes)

A special type of product line which is the locus of points of different isoquants at which
the MRS of factors is constant is called an isocline. For homogeneous production
functions the isoclines are straight lines through the origin. In such case, the K/L ratio is
constant along any isocline (refer to the first graph).

GRAPHICAL PRESENTATION OF RETURNS TO SCALE FOR

HOMOGENEOUS PRODUCTION FUNCTION
Constant returns to scale: Along any isocline, the distance between successive isoquants
is constant. Doubling the factor inputs double the level of output, tripling inputs results in
triple output, and so on.
K
In this case, there is a constant
C PL returns to scale because OA=AB=BC.
3K
2K B 3Q1

K A 2Q1

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Q1
O L
L 2L 3L
Decreasing returns to scale: the distance between consecutive isoquant increases. By
doubling inputs, output increases by less than twice its original level.
K
In this case, there is a decreasing
PL returns to scale because doubling
Inputs will bring an output which is l
3K C 3Q1 less than double.

2K B <3Q1
2Q1
K A
Q1 <2Q1
O L
L 2L 3L

Increasing returns to scale: the distance between consecutive isoquant decreases. By

doubling inputs, output is more than doubled.
K
PL In this case there is an increasing return
To scale because doubling inputs results
3K in an output which is more than double.

C >3Q1
2K
B >2Q1 3Q1
K A 2Q1

Q1
O L 2L 3L L

TECHNICAL PROGRESS AND THE PRODUCTION FUNCTION

As knowledge of new and more efficient methods of production become available,

technology changes. Furthermore new inventions may result in increase of the efficiency
of all methods of production. These changes in technology constitute technical progress.
Graphically, the effect of technical progress is shown with an upward shift of the
production function or a downward movement of the isoquant. This shift shows that the
same output may be produced by less factor inputs, or more output may be produced with
the same inputs.

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X K

X’ X’=f(L)
X=f(L)
X

Xo

Xo
O L O L
L*

Technical progress may also change the shape (as well as produce a shift) of the isquant.
Hicks has distinguished three types of technical progress, depending on its effect on the
rate of substitution of the factors of production.
Capital deepening technical progress: a technical progress which increases the MPK by
more than the MPL. For this kind of technical progress, along a line on which the K/L
ratio is constant, the MRTSL,K decreases in absolute terms (the slope of an isoquant
declines). The slope of the shifting isoquants becomes less steep along any given radius.
This type of technical progress is also called capital saving or labor using technical
progress.
K
Isocline

A’
A’’

O L

Labor deepening technical progress: a technical progress which increases the MPL by
more than the MPK. Along a line on which the K/L ratio is constant, the MRTSL,K
increases(the slope of an isoquant increases in absolute value). It is also called labor
saving or capital using technical progress.
K
Isocline

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A’
A’’
Neutral technical progress: a technical progress that increases the MPL and MPK by the
same percentage, so that the MRTSL, K (along any radius) remains constant. The
isoquant shifts downwards parallel to itself.
K
Isoline

A
A’

A’’
O L

EQUILIBRIUM OF THE FIRM: CHOICE OF OPTIMAL COMBINATION OF

FACTORS OF PRODUCTION

A firm is said to be in equilibrium when it employs those levels of inputs that will
maximize its profit. This means the goal of the firm is profit maximization (maximizing
the difference between revenue and cost). Thus the problem facing the firm is that of
constrained profit maximization, which may take one of the following forms:
a) Maximizing profit subject to a cost constraint. In this case total cost and prices are
given and the problem may be stated as follows
Max П = R – C
П = PxX – C
Clearly maximization of П is achieved in this case if X is maximized, since C and Px are
constants.
b) Maximize profit for a given level of output.
Max П = R- C
П = PxX –C
Clearly in this case maximization of profit is achieved by minimizing cost, since X and
Px are given.

To derive graphically the equilibrium point of the firm, we will use the isoquant map and
the isocost line. An isoquant is a curve that shows the various combinations of K and L
that will give the same level of output. It is convex to the origin whose slope is defined
as:
- ∂K/∂L = MRSL,K = MPL/MPK = ∂X/∂L
∂X/∂K
The isocost line is defined by the cost equation
C = rK + wL
Where w=wage rate, and r=price of capital services.

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The isocost line is the locus of all combinations of factors that the firm can purchase with
a given monetary cost outlay. The slope of the isocost line is equal to the ratio of the
prices of the factors of production, w/r.
K the isocost equation is given by C=wL + rK
C/r => rK = C - wL
=> K = C/r – w/r L
From this the slope is –w/r or it is the
vertical change over the horizontal change.
=> Slope = C/r
C/w
=> Slope = C/r.w/C
=> Slope = w/r.
O C/w L
Case 1: Maximization of output subject to a cost constraint.
Given the level of cost and the price of the factors and output, the firm will be in
equilibrium when it maximizes its output. This is at the point of tangency of the isocost
line to the highest possible isoquant curve. In the following graph, it is at point e where
the firm produces X2 with K1 and L1 units of the two inputs. Higher levels of output to the
right of e are desirable but not attainable due to the cost constraint. Other points below
the isocost line lie on a lower isoquant than X 2. Hence X2 is the maximum output that can
be achieved given the above assumptions (C, w, r, & Px being constant).
K
A

K1 e X3

X2
X1

O B L
L1
At the point of tangency:
a. slope of isoquant = slope of isocost
w/r = MPL/MPK = MRSL,K. this is a necessary condition.
b. the isoquant is convex to the origin. This is the sufficient condition.
NOTE: If the isoquant is concave to the origin, the point of tangency does not define the
equilibrium position.
K

e1
e

X2

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O e2 L

Output X2 depicted by the concave isoquant can be produced with lower cost at e2 which
lies on a lower isocost curve than e (corner solution).

Mathematical derivation of the equilibrium of the firm.

A rational producer seeks the maximization of its output, given total cost outlay and the
prices of factors. That means:
Maximize X = f (K, L)
Subject to C = wL + rK

This is a constrained optimization which can be solved by using the lagrangean method.
The steps are:
a. rewrite the constraint in the form
wL + rK – C = 0
b. multiply the constraint by a constant which is the lagrangian multiplier
(wL + rK – C) = 0
c. form the composite function
Z = X - (wL + rK – C)
d. partially derivate the function and then equate to zero
∂Z = ∂X - w = 0
∂L ∂L
 MPL = w
  = MPL-----------------------------------------------------------------------(1)
w
∂Z = ∂X - r = 0
∂K ∂K
 MPK = r
  = MPK----------------------------------------------(2)
r
∂Z = rL + rK – C = 0------------------------------------------- (3)
∂
From equation (1) and (2) we understand that
MPL = MPK
w r
=> MPL = w
MPK r
This shows that the firm is in equilibrium when it equates the ratio of the marginal
productivities of factors to the ratio of their prices. It can be shown that the second order
conditions for the equilibrium of the firm require that the marginal product curves of the
two factors have a negative slope.
Slope of MPL = ∂2X
∂L2
Slope of MPK = ∂2X

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∂K2

=> ∂2X < 0 and ∂2X < 0

∂L2 ∂K2
2
And ∂2X . ∂2X > ∂2X
∂L2 ∂K2 ∂L∂K

Case 2: minimization of cost for a given level of output

The condition for the equilibrium of the firm is formally the same as in case 1. That is,
there must be tangency of the given isoquant and the lowest possible isocost line, and the
isoquant must be convex. However, in this case we have a single isoquant which denotes
the desired level of output, but we have a set of isocost lines. Curves closer to the origin
show a lower total cost outlay. Since isocosts are drawn on the assumption of constant
prices of factors, they are parallel to each other and their slopes (w/r) are equal. Thus the
firm minimizes its cost by employing the combination of K and L determined by the
point of tangency of X isoquant with the lowest possible isocost line. Points below e are
desirable because they show lower cost but are unattainable for output X. points above e
show higher costs. Hence point e is the least cost point.

e
K1
X

O L
L1

In this case also the lagrangian method can be followed to derive the equilibrium point
mathematically. But the problem is different. That is,
Minimize C = wL + rK
Subject to X = f(K,L)
The lagrangian function will be:
Z = (wL + rK) + [X-f(K,L)]
Partially derivate Z w.r.t L, K, &  and equate to zero.
∂Z = w -  ∂f(K,L) = 0
∂L ∂L
=> w -  ∂X = 0
∂L

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=> w =  MPL
=>  = MPL ----------------------------------------- (1)
w
∂Z = r -  ∂f(K,L) = 0
∂K ∂K
=> r -  ∂X = 0
∂K
=> r =  MPK
=>  = MPK --------------------------------------- (2)
r
∂Z = X – f(K,L) = 0 ------------------------------------(3)
∂
From equation (1) and (2):
MPL = MPK
w r
=> w = MPL = MRSL,K
r MPK
This is the same as the condition in case one. In a similar way, the second condition will
be:

=> ∂2X < 0 and ∂2X < 0

∂L2 ∂K2
2
And ∂2X . ∂2X > ∂2X
∂L2 ∂K2 ∂L∂K

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CHAPTER-IV
THEORY OF COST

Cost functions are derived functions (derived from production function).Economic theory
distinguishes between short-run and long-run costs. Both in the short-run and in the long-
run, total cost is a multi variable function, i.e. total cost is determined by many factors
such as output, technology, prices of factors and fixed factors. To simplify the analysis we
consider cost as a function of output [c= f(x)] on a ceteris paribus assumption. Thus,
determinants of costs, other than output, are called shift factors.

4.1 Short-Run Costs

Short-run costs are costs over a period during which some factors of production 9usually
capital equipment and management) are fixed. Short-run total costs are split into two
groups: total fixed costs and total variable costs: TC = TFC+TVC.Total variable cost is a
cost that varies as output varies whereas total fixed cost is a cost that does not vary with
the level of output. The fixed costs include:
 Salaries of administrative staff
 Expenses for building depreciation and repairs
 Expenses for land maintenances
 Depreciation of machinery.
The variable costs include:-
 The raw materials cost
 The cost of direct labor
 The running expenses of fixed capital, such as fuel, ordinary repairs and
routine maintenance.
As the total fixed cost (TFC) does not depend on the level of output, it is represented by a
horizontal line.
TC
Cost

TVC

TFC

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O
Output (X)
The total variable cost has usually an inverse-S shape which reflects the law of variable
proportions. According to this law, at the initial stage of production with a given plant, as
more of the variable factors is employed, its productivity increases and thus total variable
cost(TVC) increases at a decreasing rate = AVC declines. When the productivity of the
variable input falls, larger and larger units of the variable input will be needed to increase
output by the same unit and thus TVC and TC increase at increasing rates. By adding the
TFC and TVC we obtain the TC of the firm.
From the total-cost curves we obtain average cost curves.
 AFC is the total fixed cost divided by the amount of output, i.e., AFC= TFC.
X
Since TFC is constant, increase in X reduces the ratio and thus the AFC approaches
the quantity (output) axis as output rises.
 AVC= TVC.
X
Graphically the AVC at each level of output is derived from the slope of a line drawn
from the origin to the point on the TVC curve corresponding to the particular level of
output. For example in the figure below, the AVC at X1 is the slope of the ray oa, the
AVC at X2 is the slope of a ray ob, and so on. It is clear from the figure that the slope of a
ray through the origin declines continuously until the ray becomes tangent to the TVC
curve at c. to the right of this point the slope of rays through the origin starts increasing.
Thus the AVC curve falls initially as the productivity of the variable factor increases,
reaches a maximum when the plant is operated optimally and rises beyond that point.

C C AVC

TVC

d a

c b d
B
a c

o x1 x2 x3 x4 X o x1 x2 x3 x4 X

 ATC or AC = TC = TFC+TVC = AFC + AVC.

X X

Graphically the ATC curve is derived in the same way as the AVC. The ATC at any one
point is the slope of a line from the origin to the point on the TC curve.

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C C ATC

TC

d a

c b d
b
a c

o x1 x2 x3 x4 X o x1 x2 x3 x4 X

 MC = ∆TC = ∆ (TFC+TVC) = ∆TVC.

∆X ∆X ∆X
Graphically the marginal cost is the slope of the TC curve (which of courseis the same at
any point as the slope of the TVC). The slope of the TC curve at any one point is the
slope of a tangent line at that point. As we can see from the following graph, the tangent
line is initially becoming flatter up to X4 level of output and then become steeper as the
output goes on increasing. This implies the slope of the TC curve (MC) is initially
decreasing, reaches a minimum and then starts increasing.

C C
TC

MC

O X4 O X4 X

In summary the traditional theory of cost postulates that in the short run the cost
curves (AVC, ATC and MC) are U-shaped, reflecting the law of variable proportions.
In the short run with a fixed plant there is a phase of increasing productivity (falling
unit costs) and a phase of decreasing productivity (increasing unit costs) of variable
factor. Between these two phases of plant operation there is a single point at which

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unit costs are at a minimum. In general, the short run cost curves can be shown as
follows.

Costs MC
ATC

AVC

AFC
O output (X)

The relationship between ATC and AVC

The AVC is a part of the ATC, given ATC = AFC + AVC. Both AVC and ATC are U-
shaped, reflecting the law of variable proportions. However, the minimum point of the
ATC occurs to the right of the minimum point of the AVC. This is due to the fact that
ATC includes AFC which falls continuously with increase in output. Initially the fall in
the AFC offsets the rise in the AVC and thus the ATC declines. But later on the rise in the
AVC more than offsets the fall in the AFC and thus the ATC will start rising continuously.
The AVC approaches the ATC asymptotically as X increases since the AFC declines
continuously.

The Relationship between MC and ATC

The MC cuts the ATC and the AVC at their minimum points. We said that MC is the
change in the TC for producing an extra unit of output. Assume that we start from a level
of n units of output. If we increase the output by one unit the MC is the change in TC
resulting from the production of the (n+1)th unit.
The AC at each level of output is found by dividing TC by X. Thus the ATC at the level
of Xn is
ATCn = TCn
Xn
And at the level of n+1
ATCn+1 = TCn+1
Xn+1
Clearly TCn+1 = TCn + MC
Thus,
a) if the MC of the (n+1)th unit is less than ATCn ( the ATC of the previous n units)
the ATCn+1will be smaller than the ATCn.

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b) If the MC of the (n+1)th unit is higher than ATCn (the ATC of the previous units)
the ATCn+1 will be higher than the ATCn.
As far as the MC is below the ATC, it pulls the ATC downwards and if the MC is above
the ATC, it pulls the latter upwards. From this it follows that the MC curve intersects the
ATC at the minimum point of the ATC. This can also be proofed by using a simple
calculus.
From ATC = TC => TC= (ATC).X
X
MC = d(TC) by definition.
dX

=> MC = d(ATC.X)
dX
=> MC = ATC.dX + X.d(ATC)
dX dX
=> MC = ATC + (X)(slope of the ATC)

Given that X and ATC are Positive,

 MC<ATC if slope of ATC is negative.
 MC=ATC if slope of ATC=0, (at the minimum of the ATC).
 MC>ATC if slope of ATC>0.

The relationship between MC and AVC

From AVC = TVC , => TVC = (AVC).X

X
MC = d(TC) = d(TFC+TVC) = d(TFC) + d(TVC)
dX dX dX dX

=> MC = d(TVC) , since there is no change in the TFC.

dX
=> MC = d(AVC.X) = AVC.dX + X.d(AVC)
dX dX dX
=> MC = AVC + (X) (slope of AVC)

Given that AVC and X are Positive,

 MC<AVC if slope of AVC<0
 MC =AVC if slope of AVC=0 (at the minimum point of the AVC).
 MC >AVC if slope of AVC>0.

Relationship between Product Curves and Cost Curves

Unit products and unit cost curves are mirror images of each other, i.e.
o when AP(MP) is ring AC(MC) is falling;
o when AP(MP) is falling AC(MC) is rising; and

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o when AP(MP) is maximum AC(MC) is minimum

See below for illustration of these relations.
Let TVC =wL, where w= given wage rate &L =labor input
Thus, AVC= TV = (wL) /Q = w (L /Q) = w
Q (Q/L)
But Q/L=APL, so AVC= w/ APL

Similarly, MC=TVC/Q, since TVC=wL

MC = wL = w (L) = w
Q (Q) (Q/L)
but Q/L =MPL
Thus, MC=w/MPL

Graphically:
AP/MP

APL

AC/MC MPL
MC

AVC

4.2 Long-run costs

The long-run is a period of time of such length that all inputs are variable. It is a
planning horizon in the sense that economic agents can plan ahead and choose many
aspects of the “short-run” in which they will operate in the future. Thus, the long-run
consists of all possible short-run situations among which an economic agent may
choose.

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If a production technology is characterized by constant return to scale (CRS),

doubling output requires doubling of input, which implies doubling of total output
(cost) for given factor prices. Hence, the long-run total cost curve in this case is a
straight line through the origin. This implies that the long-run average and marginal
costs are horizontal lines and equal (LAC = LMC).
TC LAC
LMC
TC(Q)

LAC=LMC

O Q O Q

If we consider the case where total cost first increase at a deceasing rate due to
increasing returns to scale (which implies economies of scale). And then at an
increasing rate attributed to decreasing returns to scale after the optimum size, the
long-run total cost curve will look like the following. The LAC and LMC curves will
be U-shaped. LAC
TC TC(Q) LMC LMC
LAC

O Q O Q

The range from the minimum point of LAC to the left is called the economies of scale
range, which means output can be doubled for less than doubling of cost. The range
from the minimum of LAC to the right is called diseconomies of scale, because a
doubling of output requires more than a doubling of cost. The traditional theory of the
firm assumes that economies of scale exist only up to a certain plant, which is known
as the optimum plant size. With this plant all possible economies of scale are fully
exploited. If the firm increases further than this optimum size there are diseconomies
of scale arising from managerial inefficiencies. It is argued that management becomes
highly complex, managers are overworked and the decision making process become
less efficient.

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When a firm is producing at an output at which the LAC is falling, the LMC is less
than LAC. Conversely, when LAC is rising (increasing), LMC is greater than LAC.
The two curves intersect at a point where the LAC curve achieves its minimum. Like
the short run average cost (SAC) and SMC curves, the LAC and LMC curves are U-
shaped, but for different reasons. In the long-run, the source of the U-shape is
increasing and decreasing returns to scale, rather than diminishing returns to a factor
of production.

The Relationship between Short-run and long-run Average and Marginal costs

Assume that a firm is uncertain about the future demand for its product and is
considering three alternatives plant sizes: Small, Medium and Large. The short-run
average cost curves are SAC1, SAC2 and SAC3 in the figure below.
Cost

SAC1
SAC3
C1 SAC2
C3
C2
C4

O
Q1 Q1* Q2 Q2*

If the firm expects that the demand will expand further than Q 1, it will install the
medium plant, because with this plant outputs larger than Q 1 are produced with a
lower cost (for instance C2<C1 for output equal to Q*1). Similar considerations hold
for the decision of the firm when it reaches the level Q2.
If we relax the assumption of the existence of only three plants and assume that
there is a very large number (infinite number) of plants, we obtain a continuous curve,
which is the planning LAC curve of the firm. LAC curve is the locus of points
denoting the least cost of producing the corresponding output. It is a planning curve
because on the basis of this curve the firm decides what plant to set up in order to
produce optimally (at minimum cost) the expected level of output. The LAC curve is
U-shaped and it is often called the envelop curve because it envelopes the short run
curves.

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C
LAC
SAC1 SAC6
SAC2
SAC3 SAC5
SAC4

O Q
M
Because there are economies of scale and diseconomies of scale in the long-run, the
points of minimum average cost of the smaller and larger plant (plants 1 up to 4 and 5 up
to 7) do not lie on the long-run average cost curve. For example, a plant size 2 operating
at minimum average cost is not efficient because a larger plant can take advantage of
increasing returns to scale to produce at a lower average cost.
Each point of the LAC curve is a point of tangency with the corresponding SAC curve.
The point of tangency occurs to the falling part of the SAC curves for points lying to the
left of M. since the slope of the LAC is negative up to M, the slope of the SAC cures
must also be negative, because at the point of tangency the two curves have the same
slope. By the same logic, the point of tangency for outputs larger than Q occurs to the
rising part of the SAC curves.
Only at the minimum point M of the LAC is the corresponding SAC also at a minimum.
At the falling part of the Lac curve the plants are not worked to full capacity. To the rising
part of the LAC curve the plants are overworked. Only at the minimum point M is the
plant optimally employed.

The LMC is derived from the SMC curves but does not envelop them. The LMC is
formed from points of intersections of the SMC curves with vertical lines drawn from the
points of tangency of the corresponding SAC and the LAC curve.

C LMC
SMC1 SMC3 SAC3
LAC
a

SMC2

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To the left of a, SAC1 is greater than LAC so that SAC1 declines at a faster rate than the
LAC. So they are equal at a. this implies LMC >SMC1 to the left of a. At a, LMC=SMC1
(the same additional costs accrue to both the short-run and the long-run costs so that
SAC1=LAC). To the right of a, LMC<SMC1 (more incremental cost is added to the
short-run cost than to the log-run cost). At the minimum point of the LAC, the LMC
intersects the LAC. At this point, SAC=SMC=LAC=LMC.

DERIVATION OF COST FUNCTION FROM THE PRODUCTION FUNCTION

Cost curves are derived functions in that they are derived from the production function.
Graphically the total cost curve is determined by the locus of points of tangency of
successive isocost lines with highest isoquants.
Mathematically, the cost function can be derived as follows by using the Cobb-Douglus
production function.
X = aLbKc
Given this production function and the cost function
C = wL + rK
We want to derive the cost function, that is, the cost as function of output
C = f(X)
We begin by solving the constrained output maximization problem:
Maximize X = aLbKc
Subject to C = wL + rK
We form the composite function
Z = X - ( wL + rK – C)
Partially derivate Z w.r.t L, K,  and equate to zero.
∂Z = ∂X - w = 0
∂L ∂L

∂Z = ∂X – r  = 0
∂K ∂K

∂Z = wL + rK – C = 0 (complete it by your hand)

∂

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Example:
Given Q=L2/3K1/3 , w=2 and r=4, derive the cost function.
Solution:
The steps that are involved to derive the cost function are:
1. Solve for L in terms of K or K in terms of L from the optimality condition.
2. Substitute the result under (1) into the production function.
3. Solve for L and K in terms of Q from the production function.
4. Substitute the results under (3) into the cost constraint.

1. MPL = w
MPK r
=> 2/3 L-1/3 K1/3 = 2
1/3 K-2/3 L2/3 4
=> 2K = 1
L 2
=> L = 4K
2. Q = L2/3K1/3
Q = (4K)2/3K1/3
Q = 42/3K
=> K = Q
42/3
=> L = 4K = 4 Q
42/3
1/3
=> L = 4 Q
3. C = 2L + 4K
C = 2(41/3Q) + 4(Q/41/3)
C = 25/3Q + 41/3Q
C = (25/3 + 41/3)Q

Dynamic changes in costs – the learning curve

A large firm may have a lower LAC than a smaller firm because of increasing returns to
scale in production, which implies that growing firms with increasing returns to scale
enjoy lower average cost over time. But this may not be necessarily the case. In some
firms, long-run average cost may decline overtime because workers and managers absorb
new technological information as they become more experienced at their jobs. As
management and labor gain experience with production, the firm’s MC and AC of
producing a given level of output fall for 4 reasons:
1. As workers become more adapted to a given task, their speed increases.
2. Managers learn to schedule the production process more effectively.
3. Engineers who are initially cautious in their product designs may gain enough
experience to be able to allow for tolerances in design that save cost without increasing
defects. Better and more specialized tools and plant organization may also lower cost.
4. suppliers of materials may learn how to process materials required more effectively
and may pass on some of this advantage in the form of lower materials cost.

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As a consequence of this, a firm “learns” overtime as cumulative output increases. The

graph (curve) that describes the relationship between a firm’s cumulative output and the
amount of inputs needed to produce each unit of output is known as the learning curve.

Amount of inputs
needed per output.

Learning curve.

Cumulative output

A firm’s average cost of production can decline overtime because of:

a) Growth of sales when increasing returns are present (movement from A to B in the
figure below), or
b) The existence of learning curve/effect (movement from A to C).

AC

C AC1

AC2
Q

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CHAPTER V

PERFECT COMPETITION

Perfect, unlike everyday usage of the word, is characterized by a complete absence of

rivalry (competition) among firms.

Assumptions
- Large number of buyers and sellers: because of the very large number of buyers
and sellers an individual buyer or seller is too small to affect the market price.
- Identical commodities are produced by all firms in an industry in terms of its
technical characteristics and services associated with its sale and delivery ruling
out non-price competition.
- There is free entry to and exit from the industry.

These assumptions will imply that the firms are price takers so they are faced with
perfectly elastic demand curve.
Px

DDx

O Qx

- Profit maximization is the sole objective of firms in the industry (no other
objectives like welfare, etc.)
- No government intervention
- Perfect mobility of productive resources between or among firms.(Skills can be
learned and no factor monopolization and labor unionization.)
- Perfect (complete) knowledge of market condition in the part of sellers and buyers
both of the present and the future, and information is free and costless.
These assumptions rule out any uncertainty.

Short-run Equilibrium of the Firm and the Industry

The equilibrium output of the firm is the output that maximizes its total profit. Total
profits equal the difference between total revenues and total costs, i.e.
∏= TR – TC

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∏= PQ – ATC (Q)
∏= Q (P –ATC)

In a perfectly competitive market structure, price is given (firms are price takers). Thus
firms decide on the level of output (Q) they produce to attain their equilibrium points.
Two approaches are used in determining a firm’s equilibrium.

1. The total approach: total profits are maximized when the positive difference between
total revenues and costs is largest.
TR/TC STC TR

Qe Q

To the left of point B and to the right of C, STC>TR so that the firm is in a loss (negative
∏). Between B and C, however, the firm is enjoying a positive profit and it is maximized
at the point where the vertical difference between the TR and STC is largest (at Qe).
Point B is the break-even point where the firm just covers its cost of production and
operates at zero economic profit.

2. The marginal approach: the perfectly competitive firm is a price taker and faces a
perfectly elastic demand curve. Since marginal revenue (MR) is dTR/dQ and price(P)
is constant, then P = MR.

MR = dTR = d(PQ) = p dQ = P
dQ dQ dQ
Total profit is maximum when the slope of the TR and total cost curves are equal.
That is, when MR (P) = MC

The firm is at equilibrium at quantity level Qe (where MR = P = MC at point E). To

the left of E, MR > MC (i.e., benefits > costs) and it should increase production. To

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the right of E, MC>MR and the firm should cut back its production. This particular
figure represents the case where the firm operates at a loss (= area of rectangle
EFGH).
∏ = Q(P – ATC)
∏ = Qe ( - EF)
∏ = - (EH) (EF)
= - area of EFGH
P/MR MC
MC ATC
AC

AVC

F
G M

H I E P=MR

O Q
Qe
It can be the case that competitive firms may operate at losses, at positive profits, or
at a normal (zero) profit. For instance, a firm operates at a positive profit if the
demand curves (MR) lies above point M. On the other hand, a firm gets only a normal
(zero) profit if the demand curve passes through M. In general,

If Then
P > AC Positive ( economic) profit
P = AC Normal ( zero ) profit, i.e., break-even point
AVC < P < AC Loss, but the firm continues to produce
P = AVC Shut-down point
P < AVC Loss or no operation

N.B.: in the figure above, P(MR) = MC at two points, E and I. But the profit
maximizing level of output is that level of output which corresponds to E. Condition
for profit maximization is
1. MR = MC this implies d∏ = 0
dQ
2
2. MC is rising => d ∏ < 0 or dM∏ < 0
dQ2 dQ
The firm operates at different points at the marginal cost curve depending on the level
of price it faces. Thus, its supply curve is its MC curve but above the shut-down
point. The industry supply curve is the simple horizontal summation of the supply

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curves of the individual firms. Thus, the industry is at equilibrium when the industry
demand curve intersects the industry supply curve.

S
$ $
S

Pe E P = MR Pe E*

O Qe Q O Qe Q

Panel A – short-run equilibrium Panel B – Equilibrium of the

the firm. Industry.

LONG RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

When long-run equilibrium is achieved, product prices will be exactly equal to, and
production will occur at each firm’s point of minimum ATC. This is illustrated below for
a constant cost industry (the case where the expansion of the industry through entry of
new firms will have no effect up on resource prices and, therefore, up on production
costs) and a respective firm.

S0
LMC
ATC
$ S1

P1
P1
P1 = MR1

Po Po= MRo Po D1

D0

Firm Industry

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Suppose that a change in consumer tastes increase and thus product demand from D0 to
D1. This favorable shift in demand obviously makes production profitable; the new price
(P1) exceeds ATC. This economic profit will lure new firms into the industry. As the
firms enter, the industry supply of the product will increase causing product price to
gravitate downward towards the original level. The economic profits caused by the boost
in demand have been completed away to zero and as a result the previous incentive for
more firms to enter the industry has disappeared.
Therefore, in the long-run, all firms operate at a point where
(1) P = MR = LMC = LAC = SMC = SAC for the firm and
(2) Supply curve crosses demand for the industry.
In the long-run, all firms in a perfectly competitive industry (market) enjoy only normal
profit (zero profit) or at the break-even where TR = TC.

EXERCISE

Suppose you are the manager of a watch-making firm operating in a competitive market.
Your cost of production is given by C = 100 + Q 2, where Q is the level of output and C is
total cost.
a) If the price of watches is birr 60, how many watches should you produce to
maximize profit?
b) What will your profit level be?
c) At what minimum price will you produce a positive output?

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CHAPTER VI
PURE MONOPOLY

Pure monopoly is the form of a market in which a single firm sells a commodity for
which there are no close substitutes. Thus the monopolist represents and faces the
industry's negatively sloped demand curve for the commodity.
Monopoly can arise from several causes (barriers to entry). Some are:
1. A firm may own or control the entire supply of essential raw material(s).
2. A firm may own a patent for the exclusive right to produce a commodity or to use a
particular production process.
3. Economies of scale may operate over a sufficiently large range of outputs so as to
leave a single firm supplying the entire market. Such a firm is called Natural
monopoly.
4. Licenses protect present license holders from new competition. i.e., confer
monopoly power to them as a group.

The crucial difference between a pure monopolist and a pure competitive seller lies
on the demand side of the market. A pure monopoly can increase its sales only by
charging a lower unit price for its product. But each additional unit sold will add to
total revenue its price less: the sum of the price cuts which must be taken on all prior
units of output. Price cuts will apply not only to the extra output sold but also to all
other units of output which otherwise could have been sold at a higher price. Hence,
marginal revenue is less than price (average revenue) for every level of output except
the first.

TR PQ
TR  PQ Or AR  Q  Q  P => AR  P

d (TR ) d ( PQ ) dQ dP
MR    P.  Q.
dQ dQ dQ dQ
dP
 MR  P  Q.
dQ
dP
P Since dQ  0, MR
MR  pd 1 equals P + some
negative numbers, =>
 pd  1 MR  P

 pd 1

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Q
MR Demand
Microeconomics I

dP
MR  P  Q.
dQ
 Q dP 
MR  P1  . 
 P dQ 
 1 
MR  P1 
  pd 

 1 
MR  P1 
  pd 


From the above relation it can be shown that:

a) MR is positive (but less than P), when demand is elastic
b) MR is zero when demand is unitary elastic,
c) MR<0 when  p <1, and
d

d) MR=P when  p = 
d

6.1 Short Run and Long Run equilibria

In the short-run, a monopolist maximizes total profits by producing the level of
output at which marginal revenue equals marginal cost or where the distance
between the total revenue and total cost curves is the largest).

  TR  TC
  PQ  Q( ATC )
  Q.( P  ATC )

P
MC

AB
Pe
ATC
C

In this particular case P (=Pe)> ATC and hence the monopolist

Q enjoys a positive
profit equal to the area PQeABC.
e
MR
If P is smaller than ATC at the point where MR = MC, the monopolist will incur a
loss in the short-run. However, if P > AVC, it pays for the monopolist to
continue to produce because production covers part of the fixed costs.

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In the long-run, the best or profit maximizing level of output is given by the
point where the monopolist's LMC = MR (and LMC curve intersects MR curve
from below).
>graph
Even though profits attract additional firms in to the perfectly competitive
industry until just all firms break-even in the long-run, the monopolist can
continue to earn profits in the long-run because of blocked entry.
The monopolist, as opposed to a perfectly competitive firm, doesn't produce at
the lowest point on its LAC curve. Only if the monopolist's MR curve happened
to go through the lowest point on its LAC would this be the case.

6.2. Discriminating Monopoly

To this point it has been assumed that the monopolist charges a uniform price
to all buyers. Under certain conditions the monopolist might be able to exploit
its market position fully and thus increase profits by charging different prices
to different buyers. By doing so the seller is engaging in price discrimination.
Price discrimination refers to charging different prices (for different quantities
of a commodity or in different markets) that are not justified by cost
differences. In general, price discrimination is workable when three conditions
are realized.

1. The seller must possess some degree of monopoly power,

2. The seller must be able to segregate buyers into separate classes where in
each group has a different ability and willingness to pay for the product.
3. The original purchaser cannot resell the product.

Price discrimination (the practice of charging different prices to different

customers for similar goods) can take three broad forms which we call first,
second and third degree price discrimination.

If the monopolist could sell each unit of the commodity separately and charge
the highest price each customer would be willing to pay for the commodity -
reservation price - the monopolist would be able to extract the entire
customer's surplus. This is called first degree or perfect price discrimination.

Pe

R
MC
D
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Qe
MR
Microeconomics I

Without price discrimination, the monopolist charges P e, sells quantity Qe and thus
total revenue equals the area of P eRQeO. With perfect price discrimination, the
monopolist captures the entire consumer surplus ARP e by selling its product at a
maximum price that consumers are willing to pay for the commodity (shown by
point A). this method is also known as “take-it-or-leave-it” price
discrimination, because the monopolist charges the maximum price consumers
are willing to pay.
Knowing the exact shape of each consumer's demand curve (and be able to
charge reservation prices) and be able to prevent arbitrage is impossible or
prohibitively expensive to carry out. Thus, first degree price discrimination is
not very common in the real world. More practical and common is second-
degree or multipart price discrimination. This refers to the charging of a
uniform price per unit for a specific quantity of the commodity, a lower price
for an additional batch or block of the commodity, and so on. Quantity
discounts are an example of second degree price discrimination. Here the
monopolist extracts part, but not all, of the consumer's surplus.

Third degree price discrimination is the practice of dividing consumers in

to two or more groups with separate demand curves and charging different
prices to each group. Some characteristic is used to divide customers in to
distinct group. For many goods, for example, students are usually willing to
pay less on average than the rest of the population.
Pc

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MC
P2

P1

MC=MR E
E1 E2
DT

D2
D1

The total quantity produced, X is

determined by the intersection of the MRT and MC curves. This quantity is then
divided between the two groups of customers (assuming only two groups for
simplicity) so that marginal revenues for each group are equal. Otherwise, the
firm would not be maximizing profit. For example, if MR 1 > MR2, the firm could
clearly do by shifting output from the second group to the first. Not only should
the two marginal revenues equal, but also the marginal cost should be equal to
the marginal revenues. If this were not the case the firm could increase its
profitability by raising or lowering total output (and lowering or raising its
prices to both groups).

Total profit of the firm is given by π = P1Q1 + P2Q2 - C(QT)

Where P1 = the price charged to group one
P2 the price charged to group two
C (QT) = total cost of producing output QT = Q1 + Q2
The firm should increase its sells to each group until the incremental profit
from the last unit sold is zero.
d d
 0, and 0
dQ1 dQ2
Prices and output must be
d ( PQ11 ) dC d ( P Q) 2 set so that MR1 = MR2 = MC
  0, and 0
dQ dQ1 dQ - Recall that
MR1  MC  0, andMR2  MC  0
MR1  MC , andMR2  MC

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 1 
MR  P1 
 e p 

 1   1 
 MR1  P1 1  andMR2  P2 1 
 e p1   e p 2 
 
But , MR1  MR2
 1   1 
 P1 1   P1 1 At the maximum profit
 
e p1   e p 2 
 
Rearranging gives
 
1  1 
P1  e p 2 

p2  
1  1 
 e p1 


If the demand in market segment 2 is relatively elastic,( i.e. if e p 2  e p1 , then

1  1  1  1   1  1   P1  P2
ep 2 e p1  ep 2   ep2 
The higher price will be charged to consumers with the lowest demand
elasticity.

6.3 MULTIPLANT MONOPOLY

A monopolist maximizes profit by setting output at a level where MR =MC. For

many monopolists, production takes place in two or more different plants
whose operating costs can differ. However, the logic used in choosing output
levels is very much similar to that for the single-plant firm. Suppose a firm has
two plants. Whatever the total output, it should be divided between the two
plants so that MC is the same in each plant. Otherwise, the firm could reduce
its costs and increase its profit by reallocating production. For example, if MC1
> MC2, the firm could produce the same output at a lower total cost by
producing less at plant 1 and at plant 2.

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MC1
P
MR MC2
MC
MCT

P*

O Q1 Q2 Q3
Q

Profit is maximized when MR = MC at each plant. If MR > MC, the firm would do better
by producing more at both plants.

∏ = PQt – C1(Q1) – C2(Q2)

 d∏ = d(PQt) – dC1 = 0, and d∏ = d(PQt) – dC2 = 0
dQ1 dQ1 dQ1 dQ2 dQ2 dQ2

 MR = MC1, and MR = MC2

 MR = MC1 = MC2

6.4 SOCIAL COST OF MONOPOLY

In a competitive market, price equals marginal cost. Monopoly power on the other hand,
implies that price exceeds marginal cost. Because monopoly power results in higher
prices and lower quantities produced, we would expect it to make consumers worse off
and the firm better off. Suppose we value welfare of consumers the same as that of
producers. In the aggregate, does monopoly power make consumers and producers better
or worse off?
P
MC
MC
e
Pm
E
F
Pc
G
MR D

Qm Qc

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Pc, the competitive firm’s price, equals MC and thus Qc quantity is produced. If this firm
is replaced by a monopolist, Pm price will be charged and Qm quantity will be produced.
Consumer’s surplus declines from PcEY to PmeY (by the amount equal to PmEPc). But,
only PmeFPc is extracted by the monopolist. Similarly, GEF is the proportion of the
producers’ surplus lost. In sum, while PmeFPc represents transfer from consumers’
surplus to producers, eEF + EFG represents the dead-weight loss due to monopoly – the
social cost of monopoly.

EXERCISE

1) A monopolist is deciding how to allocate output between two markets that are
separated geographically. Demands for the two markets are P1 = 15 –Q1 and P2 = 25 –
2Q2. The monopolist’s TC is C = 5 + 3(Q 1+Q2). What are price, output, profits, and MR
if:
a) The monopolist can price discriminate?
b) The law forbids (prohibits) charging different prices in the two regions?

2) A drug company has a monopoly on a new patented medicine. The product can be
made in either of two plants. The costs of production for the two plants are MC 1 = 10 +
2Q1 and MC2 = 25 + 5Q2. The firm’s estimate of demand for the product is
P = 2000 – 3(Q1+Q2). How much should the firm plan to produce in each plant? At what
price should it plan to sell the product?

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