CHAPTER -ONE

Theory of Consumer Behaviour and Demand.

Introduction

In our day –to- day life, we buy different goods and services for consumption. As consumer, we
act to derive satisfaction by using goods and services. But, have ever thought of how your
mother or any other person whom you know decides to buy those consumption goods and
services? Consumer theory is based on what people like, so it begins with something that we
can‘t directly measure, but must infer. That is, consumer theory is based on the premise that we
can infer what people like from the choices they make.

Consumer behaviour can be best understood in three steps. First, by examining consumer‘s
preference, we need a practical way to describe how people prefer one good to another. Second,
we must take into account that consumers face budget constraints – they have limited incomes
that restrict the quantities of goods they can buy. Third, we will put consumer preference and
budget constraint together to determine consumer choice.

1.1. Consumer preferences

A consumer makes choices by comparing bundle of goods. Given any two consumption
bundles, the consumer either decides that one of the consumption bundles is strictly better than
the other, or decides that she is indifferent between the two bundles.

In order to tell whether one bundle is preferred to another, we see how the consumer behaves in
choice situations involving two bundles. If she always chooses X when Y is available, then it is
natural to say that this consumer prefers X to Y. We use the symbol ≻ to mean that one bundle is
strictly preferred to another, so that X ≻Y should be interpreted as saying that the consumer
strictly prefers X to Y, in the sense that she definitely wants the X-bundle rather than the Y-
bundle. If the consumer is indifferent between two bundles of goods, we use the symbol ∼ and
write X~Y. Indifference means that the consumer would be just as satisfied, according to her
own preferences, consuming the bundle X as she would be consuming bundle Y. If the consumer

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prefers or is indifferent between the two bundles we say that she weakly prefers X to Y and write
X ⪰ Y.

The relations of strict preference, weak preference, and indifference are not independent
concepts; the relations are themselves related. For example, if X ⪰ Y and Y ⪰ X, we can
conclude that X ~Y. That is, if the consumer thinks that X is at least as good as Y and that Y is at
least as good as X, then she must be indifferent between the two bundles of goods. Similarly, if
X ⪰ Y but we know that it is not the case that X~ Y, we can conclude that X≻Y. This just says
that if the consumer thinks that X is at least as good as Y, and she is not indifferent between the
two bundles, then she thinks that X is strictly better than Y.

1.2 The Concept of Utility.

Economists use the term utility to describe the satisfaction or pleasure derived from the
consumption of a good or service. In other words, utility is the power of the product to satisfy
human wants. Given any two consumption bundles X and Y, the consumer definitely wants the
X-bundle than the Y-bundle if and only if the utility of X is better than the utility of Y.

In defining utility, it is important to bear in mind the following points.

Utility’ and ‘Usefulness’ are not synonymous. For example, paintings by Picasso may be
useless functionally but offer great utility to art lovers. Hence, usefulness is product centric
whereas utility is consumer centric.

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, non-smokers do not derive any utility from cigarettes.

Utility can be different at different places and time. For example, the utility that we get from
drinking coffee early in the morning may be different from the utility we get during lunch time.

1.3 Approaches of measuring utility

There are two major approaches to measure or compare consumer‘s utility: cardinal and ordinal
approaches. The cardinalist school postulated that utility can be measured objectively. According

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to the ordinals school, utility is not measurable in cardinal numbers rather the consumer can rank
or order the utility he derives from different goods and services.

1.3.1 The cardinal utility theory

According to the cardinal utility theory, utility is measurable by arbitrary unit of measurement
called utils in the form of 1, 2, 3 etc. For example, we may say that consumption of an orange
gives Bilen 10 utils and a banana gives her 8 utils, and so on. From this, we can assert that Bilen
gets more satisfaction from orange than from banana.

1.3.1.1 Assumptions of cardinal utility theory

The cardinal approach is based on the following major assumptions.

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 the cardinal approach, the utility or

satisfaction of each commodity is measurable. Utility is measured in subjective units called utils.

3. Constant marginal utility of money. A given unit of money deserves the same value at any
time or place it is to be spent. A person at the start of the month where he has received monthly
salary gives equal value to 1 birr with what he may give it after three weeks or so.

4. Diminishing marginal utility (DMU). The utility derived 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.

1.3.1.2 Total and Marginal Utility

Total Utility (TU) is the total satisfaction a consumer gets from consuming some specific
quantities of a commodity at a particular time. As the consumer consumes more of a good per

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time period, his/her total utility increases. However, there is a saturation point for that
commodity beyond which the consumer will not be capable of enjoying any greater satisfaction
from it.

Marginal Utility (MU) is the extra satisfaction a consumer realizes from an additional unit of
the product. In other words, marginal utility is the change in total utility that results from the
consumption of one more unit of a product. Graphically, it is the slope of total utility.

The total utility first increases, reaches the maximum (when the consumer consumes 6 units) and
then declines as the quantity consumed increases. On the other hand, the marginal utility
continuously declines (even becomes zero or negative) as quantity consumed increases.

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As it can be observed from the above figure,

 When TU is increasing, MU is positive.

 When TU is maximized, MU is zero.
 When TU is decreasing, MU is negative.

1.3.1.3 Law of Diminishing Marginal Utility (LDMU)

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. In other words, the extra satisfaction that a
consumer derives declines as he/she consumes more and more of the product in a given period of
time. This gives sense in that the first banana a person consumes gives him more marginal utility

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than the second and the second banana also gives him higher marginal utility than the third and
so on (see figure 3.1).

The law of diminishing marginal utility is based on the following assumptions.

 The consumer is rational

 The consumer consumes identical or homogenous product. The commodity to be
consumed should have similar quality, color, design, etc.
 There is no time gap in consumption of the good
 The consumer taste/preferences remain unchanged

1.3.1.4 Equilibrium of a consumer

The objective of a rational consumer is to maximize total utility. As long as the additional unit
consumed brings a positive marginal utility, the consumer wants to consumer more of the
product because total utility increases. However, given his limited income and the price level of
goods and services, what combination of goods and services should he consume so as to get the
maximum total utility?

a) The case of one commodity

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.

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At any point above point C (like point A) where MUX > PX, it pays the consumer to consume
more. When MUX < PX (like point B), the consumer should consume less of X. At point C
where MUX = PX the consumer is at equilibrium.

b) The case of two or more commodities

For the case of two or more goods, the consumer‘s equilibrium is achieved when the marginal
utility per money spent is equal for each good purchased and his money income available for the
purchase of the goods is exhausted. That is,

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Recall that 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 other commodity divided by its market
price.

In table 3.2, there are two different combinations of the two goods where the MU of the last birr
spent on each commodity is equal. However, only one of the two combinations is consistent with
the prices of the goods and her income. Saron will be at equilibrium when she consumes 3 units
of banana and 1 loaf of bread. At this equilibrium,

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Given her fixed income and the price level of the two goods, no combination of the two goods
will give her higher TU than this level of utility.

Limitation of the cardinal approach

1. The assumption of cardinal utility is doubtful because utility may not be quantified. Utility
cannot be measured absolutely (objectively).

2. The assumption of constant MU of money is unrealistic because as income increases, the

marginal utility of money changes.

1.3.2 The ordinal utility theory

In the ordinal utility approach, it is not possible for consumers to express the utility of various
commodities they consume in absolute terms, like 1 util, 2 utils, or 3 utils but it is possible to
express the utility in relative terms. The consumers can rank commodities in the order of their
preferences as 1st 2nd 3rd and so on. Therefore, the consumer need not know in specific units
the utility of various commodities to make his choice. It suffices for him to be able to rank the
various baskets of goods according to the satisfaction that each bundle gives him.

1.3.2.1 Assumptions of ordinal utility theory.

The ordinal approach is based on the following assumptions.

Consumers are rational - they maximize their satisfaction or utility given their income and
market prices.

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 Utility is ordinal - utility is not absolutely (cardinally) measurable. Consumers are required
only to order or rank their preference for various bundles of commodities.

Diminishing marginal rate of substitution: The marginal rate of substitution is the rate at
which a consumer is willing to substitute one commodity for another commodity so that his total
satisfaction remains the same. The rate at which one good can be substituted for another in
consumer‘s basket of goods diminishes as the consumer consumes more and more of the good.

The total utility of a consumer is measured by the amount (quantities) of all items he/she
consumes from his/her consumption basket.

Consumer’s preferences are consistent. For example, if there are three goods in a given
consumer‘s basket, say, X, Y, Z and if he prefers X to Y and Y to Z, then the consumer is
expected to prefer X to Z. This property is known as axioms of transitivity. The ordinal utility
approach is explained with the help of indifference curves. Therefore, the ordinal utility theory is
also known as the indifference curve approach.

1.3.2.2 Indifference set, curve and map

Indifference set/ schedule is a combination of goods for which the consumer is indifferent. It
shows the various combinations of goods from which the consumer derives the same level of
satisfaction.

Consider a consumer who consumes two goods X and Y (table 3.3).

In table 3.3 above, 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.

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Indifference curve: When the indifference set/schedule is expressed graphically, it is called an
indifference curve. An indifference curve shows different combinations of two goods which
yield the same utility (level of satisfaction) to the consumer. A set of indifference curves is
called indifference map.

1.3.2.3 Properties of indifference curves

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. In other words, 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 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. The convexity of indifference curves is the reflection of the diminishing marginal rate of
substitution. This assumption implies that the commodities can substitute one another at any
point on an indifference curve but are not perfect substitutes.

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

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higher indifference curve are preferred by the rational consumer because they contain more of
the two commodities than the lower ones.

4. Indifference curves never cross each other (cannot intersect). The assumptions of
consistency and transitivity will rule out the intersection of indifference curves. Figure 3.4
shows the violations of the assumptions of preferences due to the intersection of indifference

curves.

In the above figure, the consumer prefers bundle B to bundle C. On the other hand, following
indifference curve 1 (IC1), the consumer is indifferent between bundle A and C, and along
indifference curve 2 (IC2) the consumer is indifferent between bundle A and B. According to the
principle of transitivity, this implies that the consumer is indifferent between bundle B and C
which is contradictory or inconsistent with the initial statement where the consumer prefers
bundle B to C. Therefore, indifference curves never cross each other.

1.3.2.4 Marginal Rate of Substitution (MRS)

Marginal rate of substitution is a rate at which consumers are willing to substitute one
commodity for another in such a way that the consumer remains on the same indifference curve.
It shows a consumer‘s willingness to substitute one good for another while he/she is indifferent
between the bundles. 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 X so that the
consumer maintains the same level of satisfaction. Since one of the goods is scarified to obtain
more of the other good, the MRS is negative. Hence, usually we take the absolute value of the
slope.

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From the above graph, MRSX,Y associated with the movement from point A to B, point B to C
and point C to D is 2.0,1.6, and 0.8 respectively. That is, for the same increase in the
consumption of good X, the amount of good Y the consumer is willing to scarify diminishes.
This principle of marginal rate of substitution is reflected by the convex shape of the indifference
curve and is called diminishing marginal rate of substitution.

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 1.3.2.5 The budget line or the price line

Indifference curves only tell us about consumer preferences for any two goods but they cannot
show which combinations of the two goods will be bought. In reality, the consumer is
constrained by his/her income and prices of the two commodities. This constraint is often
presented with the help of the budget line.

The budget line: is a set of the commodity bundles that can be purchased if the entire income is
spent. It is a graph which shows the various combinations of two goods that a consumer can
purchase given his/her limited income and the prices of the two goods.

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

 There are only two goods bought in quantities, say, X and Y.

 Each consumer is confronted with market determined prices, PX and PY.
 The consumer has a known and fixed money income (M).

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

Example: A consumer has $100 to spend on two goods X and Y with prices $3 and $5
respectively. Derive the equation of the budget line and sketch the graph. Solution: The equation
of the budget line can be derived as follows.

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When the consumer spends all of her income on good Y, we get the Y- intercept (0,20).
Similarly, when the consumer spends all of her income on good X, we obtain the X- intercept
(33.3,0). Using these two points we can sketch the graph of the budget line. Recall that a budget
is drawn for given prices and fixed consumer‘s income. Hence, the changes in prices or income
will affect the budget line.

Change 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/outward shift in the budget line that allows the consumer to buy more goods and services
and decreases in income causes a downward/inward shift in 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 line (the ratio of the two prices) does not change when income rises or falls.

Change in prices: An equal increase in the prices of the two goods shifts the budget line inward.
Since the two goods become expensive, the consumer can purchase the lesser amount of the two
goods. An equal decrease in the prices of the two goods, one the other hand, shifts the budget

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line out ward. Since the two goods become cheaper, the consumer can purchase the more
amounts of the two goods.

An increase or decrease in the price of one of the two goods, keeping the price of the other good
and income constant, changes the slope of the budget line by affecting only the intercept of the
commodity that records the change in the price. For instance, if the price of good X decreases
while both the price of good Y and consumer‘s income remain unchanged, the horizontal
intercept moves outward and makes the budget line flatter. The reverse is true if the price of
good X increases. On the other hand, if the price of good Y decreases while both the price of
good X and consumer‘s income remain unchanged, the vertical intercept moves upward and
makes the budget line steeper. The reverse is true for an increase in the price of good Y.

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 3.3.2.6 Equilibrium of the Consumer

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 UNIT THREE

THE THEORY OF PRODUCTION

3.1 Introduction: Definition and basic concepts

To an economist production means creation of utility for sales. Alternatively, production may be
defined as the act of creating those goods/services which have exchange value for sale (not for
personal consumption).Raw materials yield less satisfaction to the consumer by themselves. In
order to get utility from raw materials, first they must be transformed into output. However,
transforming raw materials into final products require factor inputs such as land, labor, and
capital and entrepreneurial ability.

Thus, no production (transforming raw material into output) can take place without the use of
inputs.

Fixed Vs variable inputs

In economics, inputs can be classified as fixed & variable. Fixed inputs are those inputs whose
quantity can not readily be changed when market conditions indicate that an immediate change
in output is required. In fact no input is ever absolutely fixed, but may be fixed during an
immediate requirement. For example, if the demand for Beer shoots up suddenly in a week, the
brewery factories can not plant additional machinery over a night to respond to the increased
demand. It takes long time to buy new machineries, to plant them and use for production. Thus,
the quantity of machinery is fixed for some times such as a weak. Buildings, machineries and
managerial personnel are examples of fixed inputs because their quantity can not be manipulated
easily in short time periods.

Variable inputs, on the other hand, are those inputs whose quantity can be changed almost
instantaneously in response to desired changes in output. That is, their quantity can easily be
diminished when the market demand for the product decreases and vice versa. The best example
of variable input is unskilled labor. In our previous example, if the brewery factory had idle
machinery before the market demand shot up, the factory can easily and immediately respond to
the market condition by hiring laborers.

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Short run Vs. long run

In economics, short run refers to that period of time in which the quantity of at least one input is
fixed. For example, if it requires a firm one year to change the quantities of all the inputs, those
time periods below one year are considered as short run. Thus, short run is that time period
which is not sufficient to change the quantities of all inputs, so that at least one input remains
fixed. One thing to be noted here is that short run periods of different firms have different
duration. Some firms can change the quantity of all their inputs with in a month while it takes
more than a year to change the quantity of all inputs for another type of firms. For example, the
time required to change the quantities of inputs in an automobile factory is not equal with that of
flour factory. The later takes relatively shorter time. Long run is that time period (planning
horizon) which is sufficient to change the quantities of all inputs. Thus there is no fixed input in
the long -run.

3.2Production in the short run: Production with one variable input

Production with one variable input (while the others are fixed) is obviously a short run
phenomenon because there is no fixed input in the long run.

Assumption of short run production analysis

In order to simplify the analysis of short run production, the classical economist assumed the
following:

1. Perfect divisibility of inputs and outputs

This assumption implies that factor inputs and outputs are so divisible that one can hire, for
example a fraction of labor, a fraction of manager and we can produce a fraction of output, such
as a fraction of automobile.

2. Limited substitution between inputs

Factor inputs can substitute each other up to a certain point, beyond which they can not substitute
each other

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3. Constant technology

They assumed that level of technology of production is constant in the short run.

Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor (which is variable
input). Given the assumptions of short run production, the firm can increase output only by
increasing the amount of labor it uses.

Hence, its production function is

Q = f (L) K - being constant

Where Q is the quantity of production (Output)

L is the quantity of labor used, which is variable, and

K is the quantity of capital (which is fixed)

The production function shows different levels of output that the firm can obtain by efficiently
utilizing different units of labor and the fixed capital. In the above short run production function,
the quantity of capital is fixed. Thus output can change only when the amount of labor used for
production changes. Hence, Q is a function of L only in the short run.

3.3 Total product, marginal product and average product

Total product: is the total amount of output that can be produced by efficiently utilizing a
specific combination of labor and capital. The total product curve, thus, represents various levels
of output that can be obtained from efficient utilization of various combinations of the variable
input, and the fixed input. It shows the output produced for different amounts of the variable
input, labor.

Dear learner, do you think that output can always be increased by increasing the variable input
while there is a fixed input?

Any ways, increasing the variable input (while some other inputs are fixed) can increase the total
product only up to a certain point. Initially, as we combine more and more units of the variable
input with the fixed input output continues to increase. But eventually, increasing the unit of the

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variable input may not help output increase. Even as we employ more and more unit of the
variable input beyond the carrying capacity of a fixed input, out put may tends to decline. Thus
increasing the variable input can increase the level of output only up to a certain point, beyond
which the total product tends to fall as more and more of the variable input is utilized. This tells
us what shape a total product curve assumes. The shape of the total variable curve is nearly S-
shape.

Marginal Product (MP)

The marginal product of variable input is the addition to the total product attributable to the
addition of one unit of the variable input to the production process, other inputs being constant
(fixed). Before deciding whether to hire one more worker, a manager wants to determine how
much this extra worker (L =1) will increase output, q. The change in total output resulting
from using this additional worker (holding other inputs constant) is the marginal product of the
worker. If output changes by q when the number of workers (variable input) changes by ∆L, the
change in out put per worker or marginal product of the variable input, denoted as MP L is found
as

ΔQ dL¿
orMPL=dTP¿ ¿
MPL = ΔL ¿
Thus, MPL measures the slope of the total product curve at a given point. In the short run, the
MP of the variable input first increases reaches its maximum and then tends to decrease to the
extent of being negative. That is, as we continue to combine more and more of the variable
inputs with the fixed input, the marginal product of the variable input increases initially and then
declines.

Average Product (AP)

The AP of an input is the ratio of total output to the number of variable inputs.

totalproduct TP
APlabour = =
numberofL L

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 The average product of labor first increases with the number of labor (i.e. TP increases faster
than the increase in labor), and eventually it declines.

Graphing the short run production curves

The following figures shows how the TP, MP and AP of the variable (labor) input vary with the
Output
number of the variable input.

TP3

TP2 TP

TP1

Units of labor (variable input)

L1 L2 L3

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APL, MPL

APL
Units of labor (variable input)

L1 L2 L3
MPL

Fig 3.1 Total product, average product and marginal product curves:

The relationship between AP and MP of the variable input

The relationship between MPL and APL can be stated as follows:

 For all number of workers (Labor) below L2, MPL lies above APL.
 At L2, MPL and APL are equal.
 Beyond L2, MPL lies below the APL
Thus, the MPL curve passes through the maximum of the APL curve from above. This
relationship between APL and MPL can be shown algebraically as follows:

Suppose the production function is given as

TP = f (L), K -being constant

Given the total product function,

dTP df ( L) TP f ( L)
MPL= = APL=
dL dL and L = L

df ( L ) f ( L)
dL L
= L - L

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 MPL−APL df ( L) f ( L)
Slope of APL = L , because dL = MPL and L = APL

Now – when MPL > APL, Slope of APL is positive (APL rises)

 When MPL = APL, Slope of APL is zero (APL is at its maximum).

 When MPL < APL, Slope of APL is negative (APL falls)
3.5 Efficient Region of Production in the short-run

Dear learner, we are now not in a position to determine the specific number of the variable input
(labor) that the firm should employ because this depends on several other factors than the
productivity of labor such as the price of labor, the structure of input and output markets, the
demand for output, etc. However, it is possible to determine ranges over which the variable input
(labor) be employed.

To do best with this, let’s refer back to fig 2.1 and divide it into three ranges called stages of
production.

 Stage I – ranges from the origin to the point of equality of the APL and MPL.
 Stage II – starts from the point of equality of MPL and APL and ends at a point where
MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.
Now, which stage of production is efficient and preferable?

To answer the question, let us follow elimination method.

Obviously, a firm should not operate in stage III because in this stage additional units of variable
input are contributing negatively to the total product (MP of the variable input is negative)
because of over crowded working environment i.e., the fixed input is over utilized.

Stage I is also not an efficient region of production though the MP of variable input is positive.
The reason is that the variable input (the number of workers) is too small to efficiently run the
fixed input; so that the fixed input is under utilized (not efficiently utilized)

Thus, the efficient region of production is stage II. At this stage additional inputs are contributing
positively to the total product and MP of successive units of variable input is declining
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(indicating that the fixed input is being optimally used). Hence, the efficient region of production
is over that range of employment of variable input where the marginal product of the variable
input is declining but positive.

3.6 Long run Production: Production with two variable inputs

Dear learner, we have completed our analysis of the short-run production function in which the
firm uses one variable input (labor) and one fixed input (capital). Now we turn to the long run
analysis of production. Remember that long run is a period of time (planning horizon) which is
sufficient for the firm to change the quantity of all inputs. For the sake of simplicity, assume that
the firm uses two inputs (labor and capital) and both are variable.

The firm can now produce its output in a variety of ways by combining different amounts of
labor and capital. With both factors variable, a firm can usually produce a given level of output
by using a great deal of labor and very little capital or a great deal of capital and very little labor
or moderate amount of both. In this section, we will see how a firm can choose among
combinations of labor and capital that generate the same output. To do so, we make the use of
isoquant. So it is necessary to first see what is meant by isoquants and their properties. Dear
learner, what is an isoquant?

Isoquants

An isoquant is a curve that shows all possible efficient combinations of inputs that can yield
equal level of output. If both labor and capital are variable inputs, the production function will
have the following form.

Q = f (L, K)

Given this production function, the equation of an isoquant, where output is held constant at q is

q = f (L, K)

Thus, isoquants show the flexibility that firms have when making production decision: they can
usually obtain a particular output (q) by substituting one input for the other.

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 Isoquant maps: when a number of isoquants are combined in a single graph, we call the graph an
isoquant map. An isoquant map is another way of describing a production function. Each
isoquant represents a different level of output and the level of out puts increases as we move up
and to the right. The following figure shows isoquants and isoquant map.

Capital
3

q3

2 q2
q1
1
1

Labor

1 3 6

Fig 3.2 Isoquant and isoquant map. Isoquants show the fact that long run production process is
very flexible. A firm can produce q1 level of output by using either 3 capital and 1 labor or 2
capital and 3 labor or 1 capital and 6 labor or any other combination of labor and labor on the
curve. The set of isoquant curves q1 q2 & q3 are called isoquant map.

Properties of isoquants

Isoquants have most of the same properties as indifference curves. The biggest difference
between them is that output is constant along an isoquant where as indifference curves hold
utility constant. Most of the properties of isoquants, results from the word ‘efficient’ in its
definition.

1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs that
yield the same output, isoquants always have negative slope. Isoquants can never be horizontal,
vertical or upward sloping. If for example, isoquants have to assume zero slopes (horizontal line)
only one point on the isoquant is efficient.

28 | P a g e Micro Economics-I
Thus, efficiently requires that isoquants must be negatively sloped. As employment of one factor
increases, the employment of the other factor must decrease to produce the same quantity
efficiently.

2. The further an isoquant lays away from the origin, the greater the level of output it denotes.
Higher isoquants (isoquants further from the origin) denote higher combination of inputs. The
more inputs used, more outputs should be obtained if the firm is producing efficiently. Thus
efficiency requires that higher isoquants must denote higher level of output.

3. Isoquants do not cross each other. This is because such intersections are inconsistent with the
definition of isoquants.

Consider the following figure.

Capital Fig 3.4Efficiency requires that isoquants

do not cross each other, because the
K***
point of their intersection implies that
there is inefficiency at this point.

Q=20 q=50

L*

This figure shows that the firm can produce at either output level (20 or 50) with the same
combination of labor and capital (L* and K*). The firm must be producing inefficiently if it
produces q = 20, because it could produce q = 50 by the same combination of labor and capital
(L* and K*). Thus, efficiency requires that isoquants do not cross each other.

4. Isoquants must be thin. If isoquants are thick, some points on the isoquant will become
inefficient. Consider the following isoquant.

29 | P a g e Micro Economics-I
Capital

A
K1
Labor

Fig.3.5: Iso quants can never be thick. Points A and B are on the same iso quant. But point A
denotes higher amount of capital and the same amount of labor as point B. Hence point A
denotes inefficient combination of inputs and thus it lies out of the iso quant. The iso-quant
should be thin if point A is to be excluded from the iso quant.

Shape of isoquants

Isoquants can have different shapes (curvature) depending on the degree to which factor inputs
can substitute each other.

1-Linear isoquants

Isoquants would be linear when labor and capital are perfect substitutes for each other. In this
case the slope of an iso quant is constant. As a result, the same output can be produced with only
capital or only labor or an infinite combination of both. Graphically.

2. Input output isoquant

It is also called Leontief isoquant. This assumes strict complementarities or zero substitutability
of factors of production. In this case, it is impossible to make any substitution among inputs.
Each level of output requires a specific combination of labor and capital: Additional output
cannot be obtained unless more capital and labor are added in specific proportions. As a result,
the isoquants are L-shaped. See following figure

30 | P a g e Micro Economics-I
 q3

q2
K2

q1
K1
Fig. 2.7 L-shaped isoquant. When isoquants are L-shaped, there is only one efficient way of
L
producing
L1 a given
L2 level of output: Only one combination of labor and capital can be used to
produce a given level of output. To produce q1 level of output there is only one efficient
combination of labor and capital (L1 and K1). Output cannot be increased by keeping one factor
(say labor) constant and increasing the other (capital). To increase output (say from q1 to q2)
both factor inputs should be increased by equal proportion.

3. Kinked isoquants

This assumes limited substitution between inputs. Inputs can substitute each other only at some
points. Thus, the isoquant is kinked and there are only a few alternative combinations of inputs to
produce a given level of output. These isoquants are also called linear programming isoquants or
activity analysis isoquants. See the figure below.

12

C
7

31 | P a g e M i c r o E c o n Lo m i c s - I
 4. Smooth, convex isoquants

This shape of isoquant assumes continuous substitution of capital and labor over a certain range,
beyond which factors cannot substitute each other. Basically, kinked isoquants are more realistic:
There is often limited (not infinite) method of producing a given level of output. However,
traditional economic theory mostly adopted the continuous isoquants because they are
mathematically simple to handle by the simple rule of calculus, and they are approximation of
the more realistic isoquants (the kidded isoquants). From now on we use the smooth and convex
isoquants to analyze the long run production.

The slope of an isoquant: marginal rate of technical

substitution (MRTS)

The slope of an isoquant (-K/L) indicates how the quantity of one input can be traded off
against the quantity of the other, while out put is held constant. The absolute value of the slope
of an isoquant is called marginal rate of technical substitution (MRTS). The MRTS shows the
amount by which the quantity of one input can be reduced when one extra unit of another input is
used, so that output remains constant. MRTS of labor for capital, denoted as MRTS L, K shows the
amount by which the input of capital can be reduced when one extra unit of labor is used, so that
output remains constant.

32 | P a g e Micro Economics-I
This is analogues to the marginal rate of substitution (MRS) in consumer theory.

MRTS L,K decreases as the firm continues to substitute labor for capital (or as more of labor is
used). In fig.2.9 to increase the amount of labor from 1 to 2, the firm reduces 4 units of capital
(K=4), to increase labor from 2 to 3, the firm reduce 2 unit of capital (K=2), and so on.
Hence, the firm reduces lower and lower number of capital for the successive one unit of labor.
Dear learner, why does this happen?

The reason is that when the number of capital is large and that of labor is low, the productivity of
capital is relatively lower and that of labor is higher (due to the low of diminishing marginal
returns). Thus, at this point relatively large amount of capital is required to replace one unit of
labor (or one unit of labor can replace relatively large amount of capital). As the employment of
labor increases and that of capital decreases (as we move down ward along the isoquant), quite
the reverse will happen. That is, productivity of capital increases and that of labor decreases.
Hence, the amount of capital that needs to be reduced increase when one extra labor is used
decreases. The fact that the slope of an isoquant is decreasing makes an isoquant convex to the
origin.

MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal products of
factors. That is,

ΔK MPL
MRTS L, K =− =
ΔL MPK

This can be shown algebraically as follows:

Let the production function is given as:

Where q- is output
q= f (L, K)
L- is unit of labor employed

K-is the amount of capital employed.

33 | P a g e Micro Economics-I
3.8 The efficient region of production: long run

In principle the marginal product of a factor may assume any value, positive, zero or negative.
However, the basic production theory concentrates only on the efficient part of the production
function, i.e. over the range of out put over which the marginal product of factors are positive
and declining.

Similarly, efficient region of production in the long run prevails when the marginal product of all
variable inputs is positive but decreasing. Graphically this can be represented by the negatively
slopped part of an isoquant. The locus of points of isoquants where the marginal products of
factors are zero form the ridge lines. The upper ridge line implies that the MP of capital is zero.
MPk is negative for all points above the upper ridge line and positive for points below the ridge
line. The lower ridge line implies that the MPL is zero. For all points below the lower ridge line
the MPL is negative and positive for points above the line. Production techniques are technically
efficient inside the ridge lines symbolically; in the long run efficient production region can be
illustrated as:

Graphically, efficient region of production is shown as follow:

Capital

Upper ridge line

Lower ridge line

q3

q2

q1

Labor

34 | P a g e Micro Economics-I
Fig 3.11: Thus efficient region of production is defined by the range of isoquants over which they
are convex to the origin.

The long run law of production: The law of returns to scale

The laws of production describe the technically possible ways of increasing the level of
production.

Output may increase in various ways. In the long run output can be increased by changing all
factors of production. This long run analysis of production is called Law of returns to scale.

In the short run output may be increased by using more of the variable factor, while capital (and
possibly other factors as well) are kept constant. The expansion of output with one factor (at
least) constant is described by the law of variable proportion or the law of (eventually)
diminishing returns of the variable factor.

Now let’s have a deep examination of law of returns to scale.

3.9 Laws of returns to scale: long run analysis of production

In the long run all inputs are variable. Expansion of output may be achieved by varying all
factors of production by the same proportion or by different proportions.

The traditional theory of production concentrates on the first case, i.e. the study of output as all
inputs change by the same proportion. The term returns to scale refers to the change in output as
all factors change by the same proportion. Suppose initially the production function is

X0 = f (L, K)

If we increase all factors by the same proportion t, we clearly obtain a new level of output X*
where,

X* = f (tL, tK)

 If X* increases by the same proportion t or if X* = tX 0, we say that there is constant

returns to scale.

35 | P a g e Micro Economics-I
  If X* increases less than proportionally with the increase in the factors (or if X*
increases by a proportion less than t), we have decreasing returns to scale.
 If X* increases more than proportionally with the increase in the factors (by a more
than t proportion), we have increasing returns to scale.
Constant returns to scale

Along any isocline the distance between successive multiple- isoquant is constant. Doubling the
factor inputs doubles the level of initial output; trebling inputs trebles output, and so on.

Decreasing returns to scale

Here, the distance between consecutive multiple- isoquants increases. By doubling inputs output
increases by less than twice of its original level.

Increasing returns to scale

The distance between consecutive multiple isoquants decrease, by doubling the inputs, output is
more than doubled.

Causes of increasing returns to scale

Technical and /or managerial indivisibility. Mostly, processes of production can be doubled but
it may not be possible to half them. When the production system expands, workers will
specialize in one extreme and their productivity increases.

Causes of decreasing returns to scale

The most common causes are ‘diminishing returns to management’. If we expand the out put
beyond optimum, the top management personnel will be over burdened and the productivity of
additional unit of the variable inputs decline eventually. E.g., doubling fishing fleet may not
double fish catch.

3.12 Technological process and production function

Technological improvement (progress) makes factors of production more productive or it makes

production system more efficient; so that the firm will get higher output from the same
combinations of labor and capital than before.

36 | P a g e Micro Economics-I
 Graphically, this can be shown by upward movement of the total product curve (indicating
higher output level can be achieved from the same input) and down ward movement of isoquant
denoting lower combinations of factors of production can produce equal level of output. See the
figures

TP2 TP after
technological
advancement
Isoquant before
TP before technological
technological K1 advancement
advancement
TP1
K2 Isoquant after
technological
advancement

L1 L2 L1

Fig 3.17 technological progress shifts the TP curve up ward &the isoquant down war

3.13 Equilibrium of the firm: Choice of optimal combination of factors of production

Dear learner, in our previous discussion we have said that an isoquant denotes efficient
combination of labor and capital required to produce a given level of out put. But, this does not
mean that the monetary cost of producing a given level of out put is constant along an isoquant.
That is, though different combinations of labor and capital on a given isoquant yield the same
level of out put, the cost of these different combinations of labor and capital could differ because
the prices of the inputs can differ. Thus, isoquant shows

only technically efficient combinations of inputs, not economically efficient combinations.

Technical efficiency takes in to account the physical quantity of inputs where as economic
efficiency goes beyond technical efficiency and seeks to find the least cost (in monetary terms)
combination of inputs among the various technically efficient combinations. Hence, technical

37 | P a g e Micro Economics-I
efficiency is a necessary condition, but not a sufficient condition for economic efficiency. To
determine the economically efficient input combinations we need to have the prices of inputs.

To determine the economically efficient input combination, the following simplifying

assumptions hold true:

Assumptions

1. The goal of the firm is maximization of profit ( ∏ ¿¿ ) where ∏ ¿ R−C

Where ∏ ¿¿ -Profit, R-revenue and C-is cost outlay.

2. The price of the product is given and it is equal to

PX .

3. The prices of inputs are given (constant).Price of a unit of labor is w and that of capital is
r.
Now before we go to the discussion of optimal input combination (or economically efficient
combination), we need to know the isocost line, because optimal input is defined by the tangency
of the isoquant and isocost line.

Isocost line

Dear learner, do you remember what the budget line denotes?

Isocost lines have most of the same properties as that of budget lines, an isocost line is the locus
points denoting all combination of factors that a firm can purchase with a given monetary outlay,
given prices of factors.

Suppose the firm has C amount of cost out lay (budget) and prices of labor and capital are w and
r respectively. The equation of the firm’s isocost line is given as:

C=rK +wL , where K and L are quantities of capital and labor

respectively.

Given the cost outlay C , the maximum amounts of capital and labor that the firm can purchase
C C
are equal to r and w respectively. The straight line that connects these points is the iso-cost
line.

38 | P a g e Micro Economics-I
See the following figure:

Capital

C/r

Iso cost
line
Labor

C/w

Fig: 3.18 the iso cost line: shows different combinations of labor and capital that the firm can
buy given the cost out lay and prices of the inputs.

Case1: Maximization of output subject to cost constraint

Suppose a firm having a fixed cost out lay (money budget) which is shown by its iso-cost line.
Here, the firm is in equilibrium when it produces the maximum possible out put, given the cost
outlay and prices of input. The equilibrium point (economically efficient combination) is
graphically defined by the tangency of the firm’s iso-cost line (showing the budget constraint)
w
with the highest possible isoquant. At this point, the slope of the iso cost line ( r ) is equal to the
MP L
slope of the isoquant ( MP K ).

The condition of equilibrium under this case is, thus:

w MP L MP L MP K
= or =
r MP K w r

The second order condition (the convexity of isoquant) would be insured when:

39 | P a g e Micro Economics-I
Numerical Example

Suppose the production function of a firm is given as prices of labor and capital are given as $ 5
and $ 10 respectively, and the firm has a constant cost out lay of $ 600.Find the combination of
labor and capital that maximizes the firm’s out put and the maximum out put.

Solution

MP L MP K MP L w
= or =
The condition of equilibrium is w r MP K r

∂X
MP L= =0 .25 L−1/2 K 1/2
∂L

∂X
MP K = =0 .25 L1/2 K−1/2
∂K

Thus, the equilibrium exists when,

−1/2 −1/2
0. 25 L K $5
=
−1/2 −1/2 $ 10
0. 25 L K

K 1
= ⇒ L=2 K ............................. ..... .(1 )
L 2
The constraint equation is:

wL+rK=C
5 L+10 K=600......................................(2)

Solving equation (1) and (2) would give us the optimal combination of L and K.

L=2 K
5 L+10 K =600

⇒ L=60 units and K=30 units.

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41 | P a g e Micro Economics-I