HS 212: Theoretical Tools for Public Economics (Topic

2)

Bodhisattva Sengupta/ Department of HSS

August 18, 2022

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 Learning Objectives

Consumer Theory
Producer Theory.
Market equilibrium and welfare properties.
Role of Government.

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 Preference and Utility

Consumers derive psychological bene…t from di¤erent goods and

services.
Given di¤erent bundles of goods and services X ,Y and Z
Either X Y or Y X or both (X Y ): comparison is always
possible.
If X Y and Y Z , then X Z :transitive
Strict Preference: X Y if X Y but Y X
Utility function: if (x1 , x2 ) (y1 , y2 ) then U (x1 , x2 ) U (y1 , y2 ):
rationality is necessary condition./

∂U
0: each good is desirable, marginal bene…t is positive(1)
∂xi
∂2 U
< 0: marginal bene…t increases at a decreasing rate (2)
∂xi2

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 Indi¤erence Curve

Set of all points such that U (x1 , x2 ) = Ū

Slope of indi¤erence curve (Marginal Rate of Substitution)

dx2 U2
MRS = j =
dx1 U =Ū U1
The value of MRS increases if x1 is increased (in x1 x2 plane)

d (jMRS j) U11 U22 + U22 U12 2U12 U1 U2

= (3)
dx1 U13
Indi¤erence Curves are ‘bowed’inwards: mix is better.
Indi¤erence curves cannot cross.

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 Budget Constraint

If price of good xi is pi and consumers’total income is M, then

consumers budget constraint is ∑ pi xi M.
Slope and intercept of the budget line.
Consumer: maximizes utility subject to the budget constraint.
Form the Lagrangian function L = u (x1 , x2 ) + λ (M ∑ pi xi )
FOC

∂U
= λpi (4)
∂xi
M ∑ pi xi = 0 (5)

Solving this, one can express xi = xi (p1 , p2 , ..pi , ..., M )

This is known as demand function.
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 Demand Curve

The plot of pi against xi is known as demand curve.

If pi changes: movement along demand curve.
If income or other prices change: shift of the demand curve.
For normal commodity, higher income increases consumption, so
demand curve shifts to right.
For inferior commodity, higher income decreases consumption, so
demand curve shifts to left.
If two goods are substitutes (tea and co¤ee), then increase in price of
one will cause a rightward shift of demand curve of the other
commodity.
If two goods are complements (petrol and petrol car), then increase in
price of one will cause a left ward shift of demand curve of the other
commodity.

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 Elasticity

The concept comes from physical sciences.

Suppose pi changes, how does it changes "demand" for a good?
Own price elasticity, cross price elasticity and income elasticity.
Mathematical de…nitions

∂xi pi
η ii = : own price
∂pi xi
∂xi pj
η ij = : cross price
∂pj xi
∂xi M
η iM = : income
∂M xi
"Elastic" and "inelastic" demand (own price)
Cross elasticity: positive/negative.
Normal or Inferior; luxury and necessities.
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 Price Elasticity and Revenue

Many prices are government administered.

Given the government price (p0 ), suppose government earns R0 =
p0 q0
Suppose that government increases the price to p1 . As a result, the
new revenue is R1 = p1 q1 .
Whether ∆R is positive or negative, depends crucially on values of
demand elasticity.

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 Indirect Utility

Plugging in the utility maximizing demand functions in utility

function, we get the maximized value of utility given prices and
income.
v (p1 , p2 , M ) = u (x1 (p1 , p2 , M ) , x2 (p1 , p2 , M ))
This is known as indirect utility function.
Can be used to compute welfare changes when multiple prices and
income change (due to Government action/inaction).
∂v
It can be shown that λ(Lagrange multiplier)= ∂M . So that is just the
marginal utility of money.

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 Welfare Measure

Suppose price-income situation changes from(p1 , p2 , M ) to

(p10 , p2 , M ), with p10 > p1
How do we measure welfare change?
De…ne v0 = v (p1 , p2 , M ) and v00 = v (p1 , p2 , M )
Compensating variation measure of welfare change: a value of money,
∆M such that v (p10 , p2 , M + ∆M ) = v0
Equivalent variation measure of welfare change: a value of money,
∆M such that v (p1 , p2 , M ∆M ) = v00

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 Income and Substitution E¤ect

As price goes down (say of good 1) it becomes relatively cheaper.

Consumers buy more of the cheaper good: substitution e¤ect.
However the consumers’income has gone up.
For a normal (inferior) good, higher income will lead to higher (lower)
consumption.
The e¤ect is ambiguous for inferior goods.

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 Demand and Welfare

Height of the demand curve: marginal utility (or marginal bene…t) for
that unit of demand.
Area under demand curve: total utility (expressed in terms of money).
Area between market price and demand curve: consumer surplus.
Change in price!change in area!measure of welfare change.

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 Producers’Problem

Production process: turns input (capital, labor, managerial ability...)

into output
Production function: Y = F (K , L, M, ....)
Assumptions

∂F
0: marginal product of any input x is positive
∂x
2
∂ F
< 0: marginal product increases at decreasing rate
∂x 2
Y
Average product: APx =
x

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 Short Run and Long Run

Short run: when you can not change one (or more) of the inputs.
Fixed factor, variable factor.
Long Run: when you can change all inputs at your will.
All factors are variable.

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 Returns to Scale

Long Run Property.

If I increase all inputs by the same proportion, and output increases
by same proportion: CRS technology.
-do-, IRS and DRS.

Example
Cobb Douglas Technology: Y = K α LB

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 Cost of Production

Producers objective: minimize cost C = wL + rK Subject to target

output Ȳ = F (K , L)
Cost function C = C (Ȳ , w , r ): Minimum cost of producing a level of
output Ȳ given the factor prices.
Suppressing w , r , espressed only as a function of Y : cost function
C = C (Y ).
Short run: …xed and variable cost.C = φ(Y ) + F , φ(0) = 0
LR: only variable cost.

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 Short Run Cost Concepts

C
Short run average cost SAC = Y
φ (Y )
Short Run average variable cost AVC = Y
F
Short run average …xed cost AFC = Y
Short run marginal cost SMC = φ0 (Y )
Marginal cost: positively sloped (in general), as with increasing Y ,
MC increases (re‡ecting diminishing marginal product).

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 Assumptions

There are many buyers and sellers in the market.

The goods o¤ered by the various sellers are same (not even brand
di¤erentiation).
All sellers have exactly same technology.
Firms can freely enter or exit the market.

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 Outcomes

As a result of its characteristics, the perfectly competitive market has

the following outcomes:
The actions of any single buyer or seller in the market have a
negligible impact on the market price.
Each buyer and seller takes the market price as given (price taker).

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 Pro…t Maximisation

A typical …rm in a competitive environment maximizes

π = pq c (q )

Where pq is the revenue earned from selling q unit and c (q ) is price.

The seller takes p as given.
FOC: p = c 0 (q ) that is, price=marginal cost.

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 Diagram (from Mankiw)

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 Supply Curve

Given market price, the MC curve uniquely determines the quantity

produced and supplied.
Therefore, the MC curve is the supply curve under perfect
competition, as it uniquely links price and quantity supplied.
Horizontal summation of all individual supply curve: market supply
curve.

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 Cost, Technology, and Supply

Price of variable factor(say labour cost such as wage) increases

Marginal cost of production goes up.
For each level of price, …rms will supply less.
Hence market supply curve will shift to left. Conversely, if input prices
fall, market supply shifts to right.
In a similar way, if technology improves (positive technology shock),
the entrepreneur will reduce the inputs to supply the same level of
output.
This causes a fall in MC. So all …rms will increase the level of output,
causing a rightward shift in market supply.
Conversely, a negative technological shock causes a leftward shift in
market supply

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 Price of Related Products and Supply

Change in price of a product may lead to change in price of some

other (related) product.
If price of crude oil increases, suppliers produce more crude oil
(through more drilling). At the same time, one cannot produce crude
oil without producing more natural gas.
So an increase in price of crude oil leads to increase in supply of more
natural gas (SS shifts right). Example of complement in production.
If price of rice increases, probably more farmers will produce rice
instead of wheat (cultivation area might fall).
An increase in price of rice will reduce supply of wheat (SS of wheat
shifts left). Substitutes in production.

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 Future Expectation, Government Action etc.

Especially for agricultural activities, future expected price (rather than

current price) plays a big role.
If a farmer expects future price of rice to be high, more land will be
devoted to rice (probably at the expense of other crops), leading to
high (future) supply of rice.
Given price and technology, if more suppliers join (e.g. if the pro…t is
positive), then supply curve will shift to right.
Conversely, if suppliers leave the market, supply will shift to left.
Government policies (taxes, subsidies etc.) will change marginal cost
of the …rm, thereby a¤ecting supply curve.

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 Price Elasticity of Supply

(“Own) price elasticity of supply measures the responsiveness of

quantity supplied to a change in the product price. It is denoted by
ηs .
η s = % (change in quantity supplied)/% change in price.
Steeper the supply curve, lower is the elasticity (less price
responsiveness). Conversely, ‡atter supply curve: more price elastic.
Note: we can also de…ne cross price elasticity of supply.

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 Demand and Supply

Demand side: consumers’quantity demanded given price.

Supply side: producer’s quantity supplied given price.
At any given price, there is no guarantee quantity that consumers’
demand will be equal to the quantity that the producers bring to the
market.
If these two are not equal: disequilibrium

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 Market Equilibrium

The interaction between demand and supply determines the

equilibrium quantity exchanged and the equilibrium price.
Equilibrium: if the price/ quantity are at equilibrium, they do not
move.
Quantity demanded= quantity supplied ( “markets clear ”)

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 Equilibrium in Diagrams

P
SS

p*

DD

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37
 Producer Surplus

The total producer surplus is the di¤erence between the revenue that
the producers get and the total cost of production.
The minimum price that the producers are willing to accept for each
unit is the marginal cost of that unit. (Height if the supply curve)
Geometrically, it is the area below the market price and above the
supply curve.

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 Market E¢ ciency

Total (social) e¢ cincy of the market SC = CS + PS

Sum of bene…t that accrues to consumers and bene…t that accrues to
producers.
So a “good” policy increases SC.
A “bad policy” will decrease SC.

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 What Happens at Equilibrium?

SC is maximized.
Marginal bene…t of each individual consumers, MBi equals market
price, which in turn, equals social marginal cost of production

MB1 = MB2 = MB3 = ... = p = SMC

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 First Fundamental Theorem of Welfare Economics

Gruber, pp 50.
The competitive equilibrium, where supply equals demand, maximizes
social e¢ ciency (surplus).

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 Problem

But then, notice that the distribution of welfare (surpluses) within the
economy can be highly unequal.
CS could be very high compared to PS, or vice versa, although the
sum (W) remains intact.
Even di¤erent consumers can get di¤erent amount of CS, producers
can get di¤erent amount of PS.
So government can redistribute income and other resources, and then
let market free market play its own game.
Second Fundamental Theorem of Welfare Economics: society
can attain any e¢ cient outcome (i.e. one that maximises SE) by a
suitable redistribution of resources and free trade (given some
restriction on consumer preferences).
Gruber, page 53.

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 Question

Which outcome is preferred?

Mr. C getting 30, Mr. P 70 or vice versa?
Answer: social welfare function: a function of individual utilities (in
terms of money), basically an alternate form of indirect utility.
W = W (U1 , U2 , U3 , ..UN ). The form of W re‡ects governments
preference.
An allocation that maximizes W is the best allocation.
Maximise W subject to resource constraint!get particular allocation
of income.

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 Some Popular Forms of Social Welfare Function

Benthamite: W = U1 + U2 + U3 + .. + UN
Weighted Benthamite: W = α1 U1 + α2 U2 + ..αN UN where αi > 0
Rawlsian : W = min (U1 , U2 , ...UN )
Which SWF to choose? Ultimately the value judgement of the
decision maker (Government)

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 Role of Government?

None.
Or, in case the special assumptions are met, some redistribution, vide
second fundamental theorem.
If the whole story is true, then this is the end of HS212.
(Un)fortunately it is not, so we will will see in the later chapters.

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