EC109: Microeconomics I

2019 – 2020
University of Warwick
Department of Economics

Terms 1 and 2

Professor Elizabeth Jones

Welcome!!
 This is the first part of a 2-year long microeconomics module:
EC109 and EC202
 EC109 Module Leader: Professor Elizabeth Jones
 Social Sciences S0.79
 Elizabeth.H.Jones@warwick.ac.uk
 Advice and Feedback Hours: See my personal website

 EC109 Lecturer: Dr. Andrew Harkins

 Social Sciences S1.113b
 Email Address: Andrew.Harkins@warwick.ac.uk
 Advice and Feedback Hours: See personal website

1
 Organisation
 Lecture times (2 x 1 hour lectures) term 1:
 Tuesday 2 – 3pm in R0.21
 Thursday 12 – 1pm in OC1.05
 Lecture times (2 x 1 hour lectures) term 2:
 Tuesday 2 – 3pm in R0.21
 Thursday 12 – 1pm in OC1.05
 8 x 1 hour Workshops (fortnightly meetings weeks 3 – 10; 17 - 24)
 8 x 1 hour classes (fortnightly meetings weeks 3 – 10; 17 - 24)
 Sign up to a class time/group: stick to it
 Only the UG office can give you permission to switch to
another group (not your tutor)
 Class/Workshop materials will be on the module webpage

Assessment
 2 x Tests (20% in total)
 One covering term 1 topics, worth 10%
 One covering term 2 topics, worth 10%
 Further details of time/location will be made
available
 New format this year – all MCQs
 Exam (80%)
 Past papers available online

2
  The Syllabus
Resources
 Lectures and the lecturers
 Advice and Feedback hours: lecturers and tutors
 Support and Feedback Classes and Class Tutors
 Revision Sessions
 Textbooks
 Online resources
 Forum
 Tabula

Microeconomics Textbooks
 ‘Intermediate Microeconomics’ by Varian (WW Norton)
 ‘Microeconomics' by Perloff (Pearson) - easier
 A suite of online resources is available if you purchase a
new textbook with an access code
 ‘Game Theory: An Introduction’ by Tadelis (Princeton)
 There are many other intermediate microeconomics
textbooks that will cover the material – find one that
suits you

3
 Module Aims
 Across the two years, you will study a range of topics
and learn to
 Develop analysis which combines mathematical,
graphical and intuitive skills
 Apply theoretical concepts and analytical tools
 Understand how theoretical concepts can be applied
to various economic situations
 Develop critical analysis skills and an ability to question
rational economic thought
 Understand the policy implications of microeconomic
theory

Module Structure
 View EC109 as part 1 of your micro modules
 Topics are split between years 1 and 2
 Aim: by the end of year 2, you can approach:
 Mas-Colell’s ‘Microeconomic Theory’ or
 Varian’s ‘Microeconomic Analysis’
 We start by showing you the final goal: where your
studies of microeconomics can take you
 1 lecture by a researcher in an area of applied
microeconomics (8/10/19): Robbie Akerlof
 Content is non-examinable, but link to and application of theory
can be examined

4
 The 2 year road map
 The plan for your 2 years in microeconomics
 The core topics; The core skills; The tools of the trade
EC109 EC202
 Consumer Theory  Choice under
 Producer Theory Uncertainty

 Market structure and firm behaviour  Game Theory

 Intro to Game Theory  General equilibrium

 Partial equilibrium  Market failure

EC109

CONSUMER THEORY
Elizabeth Jones

10

5
 The Topics
Budget Constraints and the feasible set
Preferences
Indifference curves and utility functions
Revealed Preferences
Optimisation
Comparative statics
Changes in welfare
Applications

11

An example
If you and I go shopping in our respective local towns,
why is it unlikely we will each come out of the shop
with the same amount of each good in our baskets?
If I buy more milk than you, what are the possible
explanations?
Differences in behaviour can emerge from
– Different tastes
– Different circumstances
We optimise subject to our constraints

12

6
 BUDGET CONSTRAINTS

13

Budget constraint I
Income and prices affect the quantity consumers demand
– Income can be determined exogenously as an amount, M
– Or determined endogenously from resources
Assume my weekly income is £200 and I spend money on
food at £5/g and clothes at £10/unit.
 M= × if I decide to only consume food.
 200 = ×5→ = 40 =

 M= × if I decide to only buy clothes.

 200 = × 10 → = 20 =

14

7
 Budget constraint II
Veggie
Burgers
Given your income, you
40 can afford to buy 40
veggie burgers if you do
not buy any beef burgers.

Given your income, you

can afford to buy 20 beef
burgers if you do not buy
any veggie burgers.

20 Beef Burgers

15

Budget Constraint III

If you invite meat and veggie lovers to the BBQ, you
may want more balanced consumption, but it must be
true that you do not spend more than your income:
≥ × + ×
With veggie burgers on the vertical axis, constraint is:
= −

We can now determine the vertical intercept and the

slope of the budget constraint

16

8
 The feasible set
Veggie
burgers
40 Given your income, any Plugging in the values for
bundle below the budget
constraint is affordable.
, and allows us to
Any bundle on the budget construct the budget
constraint is just
affordable constraint and determine
the feasible set:
200 = 5 + 10

200 10
= −
20
5 5
Beef Burgers

17

Budget constraint IV
The slope measures the rate the market ‘substitutes’ good
1 for good 2: it’s the opportunity cost of consuming good 1
If we consume more good 1, ∆ , by how much must good
2 change to continue to satisfy the budget constraint?
+ = (1)
( +∆ )+ ( +∆ )= (2)
Subtract (1) from (2) to find: ∆ + ∆ =0
∆
Thus: =−
∆

18

9
 Changing prices and income
Veggie
Burgers
Returning in each case to
40
= £200; = £5; = £10
Income falls to £100
Price of beef burgers
falls from £10 to £8
Both prices double
Prices of veggie and
beef burgers rise and
20 Beef Burgers income falls

19

PREFERENCES

20

10
 Preferences
We assume consumers choose what they want the most
Specifying preferences tells us something about a
consumer’s choice.
Consider the bundle ( , ) and compare it with ( , )
to determine the preference ordering:
– Strict preference ≻
– Weak preference ≽
– Indifference ∽
We only care about ordinal relations

21

Properties of Preferences
Completeness
– The consumer can always compare/rank bundles. Either
X≻ , ≻ , ∽
Transitivity
– If ≽ and ≽ then ≽
Continuous
– If X is preferred to Y, and there is a third bundle Z which lies
within a small radius of Y, then X will be preferred to Z.
– Tiny changes in bundles will not change preference ordering

22

11
 Well-behaved preferences
Monotonicity (non-satiation)
– We are talking about goods and not bads >> More is better!
– Consider two bundles X and Y. If Y has at least as much of both
goods, and more of one, then ( , ) ≻ ( , )
Convexity
– Averages are better than extremes (or at least not worse)
– An average of two bundles on the same indifference curve will
be (at least weakly) preferred, for any 0 < < 1
=( + 1− , + 1− )≽( , )

23

Veggie
Preference map
Burgers
More is better A E B
D Can we use more
tells us … is better
A property to
15 compare bundles
C A, C, E?

B C

5 Beef Burgers

24

12
 Indifference curves I
Veggie Which bundles do
Burgers
you like equally to
E B bundle A?
Connecting these
15 points (bundles A, C
A
C and E) creates an
indifference curve.
Plotting other
D
indifference curves
creates an
indifference map.
5 Beef Burgers

25

Indifference Curves II
Veggie
Burgers
Bundles on I3 are preferred to
bundles on I2 etc.
Indifference curves are
continuous
Indifference curves cannot cross
Most people’s indifference
I3 curves are convex to the origin
I2 Indifference curves are
I1 downward sloping
Beef Burgers

26

13
 Indifference curves III
Perfect Substitutes – goods with a constant rate of
substitution
Perfect Complements – goods that are always
consumed together
‘Bads’ – a good that you dislike
Neutral goods – a good that you don’t care about
Satiation – an overall best bundle: too much AND
too little is worse

27

Utility I
Utility Functions describe preferences, assigning
higher numbers to more-preferred bundles
– All combinations of two goods that give an individual the same
level of utility lie on the same indifference curve
The further from the origin, the higher the utility
Bundle , ≻ , iff ( , ) ≻ ( , )
We are interested in ordinal and not cardinal utility
– We care about which bundle is preferred and not by how much

28

14
 Utility II
What will the utility functions look like for …
Perfect Substitutes:
Perfect Complements:
Cobb-Douglas
– Between the two extremes: Imperfect Substitutes
– The simplest example of well-behaved preferences
– , = (or , = 2 2 )

– , =
– More generally: , = 2

29

Monotonic transformations
Applying monotonic transformations to a utility function
creates a new function but with the same preferences
– Transforms a set of numbers into another set; preserving the order
– We can’t work back from optimal demands for exact utility function
Consider a utility function ( , ,…, ). Some examples
of monotonic transformations:
– log( , ,…, ) − exp , ,…,
– , ,…, + − ( ( , ,…, ))
– , ,…, n − , ,…,

30

15
31

Behavioural insights I
Which factors affect utility?
Psychological attitudes
Peer group pressures
Personal experiences
The general cultural environment
Ceteris paribus
Only consider choices among quantifiable options
Hold constant other things that affect behaviour

32

16
 Behavioural insights II
Do the axioms always hold? Are consumers truly rational?
– Too many choices/much information; how choices are framed: Prospect Theory
– Loss Aversion: the disutility of giving up an object is greater than the utility
associated with acquiring it (cognitive bias)
– What’s the default option? (e.g. buying something online)
Bounded rationality
– Behaviour is influenced by our environment and the information we have
– Poor feedback restricts information
Can behaviour be influenced to become more rational?

33

Revealed Preferences
If an optimising consumer chooses , over , ,
Good 2 when these bundles are different, it must be that:
+ = and + ≤

X1, X2
+ ≥ +

If this inequality is satisfied, then

Y1, Y2 , is directly revealed preferred:
Good 1 , ≻ ,

34

17
 WARP and SARP
If , ≻ , , then it can’t be that , ≻ ,
– WARP refers to directly revealed preferences
– SARP refers to directly and indirectly revealed preferences
Say that at prices , , bundle , is bought when
, is affordable
This means that if , is purchased at prices , ,
then , must be unaffordable
+ ≥ +
AND NOT + ≥ +

35

The Marginal Rate of Substitution I

Joe consumes a given bundle, ( , )
– If we reduce his consumption of good 1, by ∆ … how much good
2, ∆ , is needed to put Joe back on the same indifference curve?
The rate at which the consumer is just willing to
∆
substitute one good for the other:
∆
With ∆ being a small change, we talk about the
marginal rate of substitution (MRS)
– This is the slope of an indifference curve at a particular point
– It will be negative (which we also know from monotonicity)

36

18
 The Marginal Rate of Substitution II
X2, Food

∆
= =
∆

∆x2

∆x1

X1, Clothes

37

The Marginal Rate of Substitution III

∆ ∆ , ( , )
=∆ = ∆

∆ = ∆
To keep utility constant (∆U = 0), if ↑, ↓

∆ = ∆ + ∆ =0
∆
We know = and so =
∆

38

19
 The Marginal Rate of Substitution IV
We refer to small changes in and and so

( , ) ( , )
= + =0

,
= = MRS
,

39

The MRS and Perfect Substitutes

Coca Cola

, = +
– =
What happens to the MRS as
we move down the
indifference curve?

Pepsi

40

20
 The MRS and Perfect Complements
Left Shoes

, = ,
MRS is:

Right Shoes

41

The MRS and Cobb-Douglas preferences

Good X2

, =
MRS is:
– =

A monotonic transformation
– U , =
– =

– MRS does not depend on the utility

representation
Good X1

42

21
 Diminishing Marginal Rate of Substitution
X2, Olives
For strictly convex indifference
curves, what happens to the
∆x2 slope as we move down the
indifference curve?
– The more of a good you have, the
more willing you are to sacrifice it to
∆x2
gain an additional unit of another
∆x2
good
– Diminishing MRS (absolute value)
∆x1 ∆x1 ∆x1
=1 X1, Peanuts
=1 =1

43

Homothetic tastes I
A situation where the consumer’s preferences depend
solely on the ratio of good 1 to good 2
Homothetic tastes give rise to indifference maps where
the MRS is constant along any ray from the origin.
, ≻ ,
, ≻ ,
When income rises, demand rises by the same
proportion

44

22
 Homothetic tastes II
Tops The relative quantity of
each good remains
constant along any ray
from the origin
When income is scaled up
or down by t > 0, the
demanded bundle scales
up or down by the same
amount.
– The ratio of trousers to tops
remains constant as income
Trousers changes

45

Quasilinear tastes
Tastes are linear in one good, but may not be in the other
good:
, = +
With quasilinear tastes, indifference curves are vertical
translates of one another.
In this case, the MRS is constant along any vertical line
from the x-axis.

46

23
 Coke and all other consumption
At A, MRS = -1: we will
trade $1 for 1 can of coke.
At B, will we value the
50th can of coke the same
as the 25th?
– More likely that the 25th
can is valued the same
regardless of how much in
other consumption we
undertake

47

Elasticity of Substitution I
How does the consumer substitute between and ?
The degree of substitutability measures how responsive the
bundle of goods along an IC is to changes in the MRS
The elasticity of substitution is defined as:

– Perfect substitutes: perfect substitutability: σ = ∞

– Perfect complements: no substitutability: σ = 0
– Cobb-Douglas: σ = 1

48

24
 Elasticity of Substitution II
= 10/2 = 10/2

From A to B,
= 8/4
there is a large
%∆ in x2/x1

From A to B,
there is a smaller
= 4/8 %∆ in x2/x1

49

Elasticity of Substitution III

Consider a 1% change in the MRS

The less curved the IC, the more x2 has to fall and the more
x1 has to increase for the MRS to have changed by 1%
Thus, the less curvature in the IC, the greater is the
% ∆x2/x1 required for the MRS to change by 1%, which
implies a higher elasticity of substitution σ
– i.e. Perfect Substitutes

50

25
 OPTIMISATION

51

Good Y Optimisation I
M/Py
Consumers choose the best
bundle within their feasible set

Remember
Slope of budget constraint:

=
Slope of indifference curve:
MRS =
M/Px
Good X

52

26
 Optimisation II
Consumers maximise utility subject to a budget constraint
This occurs at a tangency, where

( , )⁄
= = =
( , )⁄

Why must this hold for an interior solution?

– Assume two goods X and Y
– What would happen if: ≠ ?

53

Optimisation III
∆
Say: = = = > =
∆

To consume 1 more unit of X, Joe is willing to give up 1Y (MRS)

To consume 1 more unit of X, the market only requires Joe to
give up Y (slope of budget constraint)
If Joe is willing to give up 1 unit of Y, he’ll certainly give up only
Y

Consumption of X will rise and Y will fall until: =

54

27
 Optimisation IV: Corner Solutions
Veggie
Burgers, Y A
If the optimal choice involves
40 consuming both goods, then the
tangency condition must hold
– A necessary condition
What happens at A?

20 Beef Burgers, X

55

Optimisation V: non-convexity
The tangency condition is
necessary for optimality, but it
is not sufficient unless
preferences are convex
If we have a tangency, we don’t
always have an optimal choice
– Points A, B and C are all
interior tangency conditions

56

28
 Equi-marginal Principle I
We can find the optimum bundle by setting the MRS
equal to the price ratio and using the budget constraint.
The solutions give the Marshallian demands – demand is
dependent on prices and income: ∗ , ,
An example: = , with , ,
Find the MRS and set equal to the price ratio: =
Rearrange to give (say): =
Plug into the budget constraint

57

Equi-marginal Principle II
= + But =
= + >> =2
So, we can find: =
Plug the demand for into the budget constraint:
= + >> 2 = +2

= =
Demand is dependent on prices and income

58

29
 Marshallian demands I
What if we have a utility function where there isn’t a
tangency?
Perfect Substitutes
Perfect Complements
– In each case, think about it logically…
– In the diagram, what do we know about how consumers will
allocate their income?
– What do we know about the point at which consumers maximise
their utility?

59

Marshallian demands II
Coca Cola
Perfect Substitutes:

/ <
∗ ∗ =
= 0< < /
0 >
Budget
Constraint Maximise utility on highest IC
subject to BC:
Compare slopes of BC and IC to
Pepsi
determine which good is consumed

60

30
 Marshallian demands III
Perfect Substitutes example:
, =5 +3 ; = 4, = 3, = 200

What is the MRS?

What is the price ratio?
In this case:

IC is than BC so only good is consumed

= ; =

61

Marshallian demands IV
Left Shoes

Perfect complements:
∗
– = /( + )
Consumer will optimise at the
kink, but…
MRS is undefined at kink
Find expression for Indifference
curve at the kink and combine
Right Shoes
this with the Budget constraint
to solve

62

31
 Marshallian demands V
Perfect Complements example:
, = min{4 , 3 } ; = 4, = 3, = 200
How many units of do we have at the kink?
(1)
Find an expression for the BC. (2)

Substitute (1) into (2):

Solve: = ; =

63

Marshallian demands VI
Cobb-Douglas: =
∗ ∗
= and =

It is convenient to write Cobb-Douglas utility functions

with exponents that sum to 1
– Raise utility to power 1⁄ + ≫ =
A fixed proportion of income is spent on each good
– The size is determined by the exponents, e.g. good 1 = α
∗ ( )
– Marshallian demand: ∗ = and =

64

32
 COMPARATIVE STATICS

65

Changing optimal consumption I

All other
goods (£)
When income rises, optimal
120 consumption moves: A – B – C.
This gives the income-offer or
90
income-consumption curve
Could this curve’s shape vary?
60

Income Quantity demanded

120 12

90 8
5 8 10 12 15 20 Fish (Kg/week) 60 5

66

33
 The Engel curve
Income

We derive the Engel curve from

120
the income-offer curve
– Holding prices constant, how does
90
quantity demanded vary with income?
For a normal good, as income
60 rises, quantity demanded rises
For an inferior good, as income
rises, quantity demanded falls
– The Engel curve may not slope
5 8 12 Fish (Kg/week) upwards

67

Changing optimal consumption II

Books
When price falls, optimal
consumption moves: A – B – C.
This gives the price-offer or price-
consumption curve

Price of DVDs Quantity demanded

12 7

6 15

7 15 22 DVDs 4 22

68

34
 The Demand Curve I
Price (P)
DVDs We derive the demand
curve for DVDs from the
price-offer curve
12
– Holding income, other prices
and preferences constant,
how does quantity demanded
6 change following a price
change?
4
– What happens to demand if
income, other prices or
7 15 22 Quantity preferences change?
demanded, DVDs

69

The Demand Curve II

The law of demand
The substitution effect: As ↓, good Y becomes relatively
more expensive and less attractive to the consumer.
Even remaining on the same IC, the price ratio changes
– Optimal demands will change to where: MRS = NEW price ratio
The income effect: As ↓, real income rises. The
consumer now feels richer, so quantity demanded
changes.
– As real income changes, the consumer must move to a new IC

70

35
 Marshallian demand elasticities I
When price falls, quantity demanded rises
– By how much?
The price elasticity of demand , measures the
percentage change in quantity demanded in response to
a percentage change in a good’s own price.
Δ / Δ
, = = =
Δ / Δ

What is the sign of price elasticity of demand?

71

Marshallian demand elasticities II

Income elasticity of demand , measures the
percentage change in quantity demanded in response to
a percentage change in income
Δ / Δ M
, = = =
Δ / Δ
Cross price elasticity of demand, , measures the
percentage change in quantity demanded in response to
a percentage change in the price of another good
Δ / Δ
, = = =
Δ / Δ

72

36
 CONSUMER THEORY IN PRACTICE

73

Income and substitution effects

Two goods: apples and bananas and price of apples falls
Apples are relatively cheaper (substitution effect), so the
consumer can afford to buy more (income effect)
– How many more are bought just because they are cheaper?
– What’s the change in demand ONLY due to the substitution effect?
Graphical analysis: what we do
– When price falls (BC pivots), real income rises … but ignore that by
– … taking some income from the consumer (shift new BC) so that …

74

37
 Income and substitution effects
Either (1)
– Utility is the same after the price change as it was before the price change (that
way the consumer is no better off despite the lower price)
Or (2)
– Purchasing power is the same after the price change as it was before the price
change (the consumer has just enough income to buy the original bundle)
(1): Hicksian
(2): Slutsky
Both only consider the substitution effect (the change in demand
purely because the good is cheaper)

75

What’s the point?

Government is about to introduce an energy tax and is
concerned about the impact on pensioners
– How much less energy will pensioners consume at this higher price?
Government doesn’t want pensioners worse off - key votes!
– By how much should their pension rise so they are no worse off?
As a government economist, you will be asked to find:
– The change in demand due to the substitution effect
– Original welfare of pensioners, to calculate required ‘compensation’
– Then it’s interesting to see how energy consumption has changed
with the tax and the increased pension payments 76

76

38
 The Hicks income and substitution effects:
A normal good
Bananas Bananas

Apples Apples
Total effect

77

The Hicks income and substitution effects:

Bananas Bananas

Apples Apples

Inferior Good Giffen Good

78

39
 Slutsky Substitution
The Hicks substitution compensates the consumer so that
he can remain on the same indifference curve
– It keeps utility constant (following the price change)
The Slutsky substitution compensates the consumer so
that he can still consume his original bundle
– It keeps purchasing power constant (following the price change)
The process is the same as the Hicks substitution effect,
but now the compensated budget line won’t be tangential
to the original indifference curve…
It will pass through the original consumption bundle

79

Slutsky versus Hicks: Normal good

Utility remains constant Purchasing power
Bananas Bananas remains constant
Compare the
position of the
compensated
budget line

Apples Apples

Substitution effect Income effect Substitution effect Income effect

Hicksian Slutsky
80

40
 Hicksian: The Dual Problem I
Find the initial bundle (at original price ratio)
– Utility maximisation: Consume on highest IC subject to BC
Find the change in demand due to the substitution effect
– Expenditure minimisation: what is the least costly way of
achieving the original level of utility at the new price ratio?
Find the new bundle (at new price ratio)
– Utility maximisation (now also takes into account the income
effect)
81

81

Slutsky substitution
Find the change in income needed to make the original
bundle affordable at new price,

Original Income: = +
New Income: = ′ +

∆ = − = − = ∆
The change in income tells us the new amount of income
the consumer needs such that they can just buy the
original bundle at the new set of prices 82

82

41
 Deriving Demand Curves
We have already derived the Marshallian Demand Curve
(taking into account substitution and income effects)
We can also derive a Hicksian demand curve, which just
considers the substitution effect and keeps utility constant
And a Slutsky demand curve, which also just considers the
substitution effect, but this time keeps purchasing power
constant
Consider how the shapes will change if we have (i) a
normal good, (ii) an inferior non-Giffen good (iii) a Giffen
good 83

83

A Comparison: A Normal Good

DM = Marshallian or own
price demand curve

DH = Hicksian Demand
Curve (keeps utility
constant)

DS = Slutsky Demand Curve

(keep purchasing power
constant)

84

42
 OPTIMISING MATHEMATICALLY

85

Optimising mathematically: The Primal

If we know income, prices and the utility function:
max = , + λ( − − )
, ,λ
∗
and solve for the Marshallian demands: , ,
– Demand is homogenous of degree zero
∗ ∗
• , , = , , >0
– If utility is monotonic then the budget binds
Tangency is necessary, not sufficient. Only sufficient if
preferences are convex
– If preferences are not convex, check SOC to ensure a maximum

86

43
 The Lagrange multiplier
Tangency implies:
λ∗ = = =⋯= =⋯=
λ∗ is the marginal utility of an extra £ of expenditure
– The marginal utility of income
– £1 of extra income will increase utility by λ
Price is the consumer’s evaluation of the utility of the last
unit consumed
= for every i

87

A reminder: The Dual Problem I

Find the initial bundle (at original price ratio)
– Utility maximisation: Consume on highest IC subject to BC
Find the change in demand due to the substitution effect
– Expenditure minimisation: what is the least costly way of
achieving the original level of utility at the new price ratio?
Find the new bundle (at new price ratio)
– Utility maximisation (now also takes into account the income
effect)
88

88

44
 An example
. .
= , ; = 20; = 10; = 200
. .
= + λ( − − )
FOCs
. .
= 0.5 −λ =0
= >> =
. .
= 0.5 −λ =0
∗
= − − =0 >> =2 ≫ =

89

The Dual Problem II

, = . .
= 20; = 10; = 200. ↓ 10
Step 1
. .
max , = + ≤
∗ ∗
= = =5 and = = = 10
( × ) ( × )
Step 2
– Find the level of utility at the optimal bundle:
– , = . . = 5 . 10 . = 7.071 …
90

90

45
 Hicksian: Expenditure minimisation
For the substitution effect, we want you (the consumer)
to receive a given level of utility, say , at lowest cost
– Minimise your expenditure subject to a given level of utility
Choose , ,…, to solve the following problem:
+ + ⋯+ . . ( , ,…, )≥

The solution to the problem gives the Hicksian demands

of the form: ∗ , ,
– These are also known as the compensated demands

91

The Dual Problem III

Step 3: find the compensated budget
. .
min exp = 10 + 10 = 7.071
. .
= 10 + 10 + λ(7.071 − )
. .
= 10 − 0.5λ =0
=1 ≫ =
. .
= 10 − 0.5λ =0

= 7.071 − . .
=0 = = 7.071
λ
92
Substitution effect: rises from 5 to 7.071

92

46
 The Dual Problem IV
Step 4
. .
max , = + ≤
. .
= 0.5 −λ =0
= ≫ =1
. .
= 0.5 −λ =0 =

∗
200
+ = ≫ = = = 10
+ 10 + 10
Income effect: rises from 7.071 to 10 93

93

Connecting the results I

In both cases, Ps and M are given and we choose optimal
The solutions to the primal and dual must be consistent
Utility maximisation yields the Marshallian demands
∗ ∗
– = , ,
∗ ∗
– = , ,
These ordinary demands are plugged into the utility
function and allow us to find the actual level of utility:
∗ ∗
, , = ( , , , , , )

94

47
 Indirect Utility Function
∗ ∗
, , = ( , , , , , )
This is called the indirect utility function, where optimal
level of utility depends indirectly on prices and income
It has the following properties:
– It is non-increasing in every price, decreasing in at least one price
– Increasing in Income
– Homogeneous of degree zero in price and income

95

Connecting the results II

Utility maximisation gives Marshallian demands and
Indirect Utility Function
Expenditure minimisation yields the Hicksian demands
∗
– = ℎ∗ , ,
∗
– = ℎ∗ , ,
We can use these Hicksian demands to find the minimum
expenditure needed to achieve a given level of utility,

96

48
 Expenditure Function
∗ ∗
= , , = , , + , ,
This is called the Expenditure function, which maps prices
and utility to minimal expenditure
It has the following properties:
– It is non-decreasing in every price, increasing in at least one price
– Increasing in utility
– Homogeneous of degree 1 in all prices p

97

Connecting the results III

Look at the symmetry

= +λ −

= + λ( − )

Constraint in primal becomes objective in dual

= , = , ( , )
= , = ( , , )

98

49
 Duality

99

A familiar example: but now Slutsky

, = . . = 20; = 10; = 200. ↓ 10
We already know initial bundle is: ∗ = 5 and ∗ = 10
Hicksian demands were: = = 7.071
New bundle: = = 10
But, Hicksian demands compensated consumer such that
his utility was unaffected by price change
Slutsky compensates the consumer such that at the new
price ( = 10), he can still consume: ∗ = 5 and ∗ = 10
– To consume this bundle, by how much must income change? 100

100

50
 Slutsky equation I
Find the change in income needed to make the original
bundle (5, 10) affordable at new price,

Original Income: = +
New Income: = ′ +

∆ = − = − = ∆ = 5 10 − 20 = −50
Income must fall by 50, from 200 to 150
This gives consumer just enough income to purchase the
original bundle at the new price ratio 101

101

Slutsky equation II
. .
= + (150 − − )
150
= = = 7.5 =
( + ) (10 + 10)

Under Hicks substitution, increases from 5 to 7.071

– Income effect then causes to rise from 7.071 to 10
Under Slutsky substitution, increases from 5 to 7.5
– Income effect then causes to rise from 7.5 to 10
102

102

51
 Slutsky equation III
Substitution effect: ∆ = , − ,
Income effect: ∆ = , − ′, ′
Total effect: ∆ = , − , =∆ +∆

Express as rates of change by defining ∆ as −∆

∆ =∆ −∆
∆ ∆ ∆
Divide each side by ∆
∆
=∆ − ∆
103

103

Slutsky equation IV
∆ ∆ ∆ ∆
∆
=∆ − ∆
and recall: ∆ = ∆ >> ∆ =
∆ ∆ ∆
Replace denominator in term 3 = −
∆ ∆ ∆

1. Rate of change of following a change in , holding M fixed (total

effect)
2. Rate of change of as changes, adjusting M to keep old bundle
affordable (substitution effect)
3. Rate of change of , holding prices fixed and adjusting M (income
effect) 104

104

52
 WELFARE

105

A change in welfare I
In policy debates it is important to be able to quantify how
consumer “welfare” is affected by changing prices.
– How is welfare affected if fuel tax rises, or a carbon tax is introduced?
– A key part of economists’ role in government, regulators, consulting
We can’t look at utility directly (ordinal utility), so we use a
proxy – income or money
There are 3 ways that changes in welfare can be measured
– Consumer Surplus
– Compensating variation
– Equivalent variation

106

53
 Consumer Surplus I
We use compensated demand (MWTP) to measure it
MWTP tells us how much each unit of a good is valued
given we are consuming at some bundle A.
TWTP for all qA units is: ∑
– The area under the MWTP curve
The difference between the TWTP and the actual amount
paid gives the consumer surplus
When price changes, we measure the change in welfare
by measuring the change in consumer surplus

107

Consumer surplus II
Willingness
to pay, p TWTPA: +

Actual price paid for qA:

Consumer Surplus:

A
Market Price = 2

MWTPA

qA Quantity demanded, Q

108

54
 Consumer surplus III
Willingness
to pay, p At the higher price, consumer surplus falls to

Welfare loss:

Market Price = 3

Market Price = 2

MWTPA

Quantity demanded, Q

109

Compensating Variation I
Say the price of a good rises …
How much money would the government have to give the
consumer after the price change to make him just as well
off as he was before the price change?
– You should recognise this idea!
How far should we shift the new budget line so that it is
just tangential to the original indifference curve?

110

55
 All other Compensating Variation II
goods (£):

Assume is fixed
CV = ∗ ∗ ∗ ∗ ∗
( , , )= +
∗∗∗
This rises to
= ∗∗ ∗∗ ∗∗ ∗∗
= +
∗∗
∗

∗∗ ∗∗ ∗∗∗ ∗∗∗
( , , )= +

∗∗ ∗∗∗ ∗
Fish (Kg/week):
= −

111

Compensating Variation III

Shephard’s Lemma: derivative of expenditure function
with respect to is the compensated demand function
( , , )
, , =

∗∗ ∗
= ( , , )− ( , , )

CV is the integral of the Hicksian demand

This integral is the area to the left of the Hicksian demand
curve between ∗∗ > ∗

112

56
 Equivalent Variation I
Say the price of a good rises …
How much money would have to be taken away from the
consumer before the price change to make him just as
well off as he would be after the price change?
– What is the maximum amount you are willing to pay to avoid the
price change?
How far must we shift the original budget line so that it is
just tangential to the new indifference curve?

113

Equivalent Variation II
All other
Assume is fixed
goods (£):

= ∗ ∗ ∗ ∗
= +
This rises to
= ∗∗ ∗∗ ∗∗ ∗∗
∗∗
= +
∗

∗ ∗∗∗ ∗∗∗
∗∗∗ = +

∗∗ ∗∗∗ ∗ Fish (Kg/week):

E = −

114

57
 A change in welfare II
Consumer surplus, compensating variation and equivalent
variation can give different values
– The same change in price can lead to different changes in welfare,
depending on how we measure it
£1 is worth differing amounts at different prices
CS, CV and EV will only be equal to each other if tastes are
quasilinear
– As here, there is no income effect

115

APPLICATIONS

116

58
 Endowments of goods I
An endowment: A bundle of goods owned by a consumer
and tradable for other goods:( , )
Say you have of good 1, but would choose >
– This means you are a net demander/buyer of good 1
– If you would choose < , you are a net supplier/seller of good 1
Income is determined by your endowments and prices
Consumer’s choice set depends on endowments and prices
, , , = , | + ≤ +

The budget constraint will always pass through ( , )

117

Endowments of goods II
Say you bought 5 pairs of jeans at £20 each and 10
jumpers ( ) at £10 each from John Lewis for your partner
– But they say that you bought the wrong ones and wrong quantities!
You return to John Lewis, but don’t have the receipt
– You get a Gift Certificate for your goods at the current prices
– = 5 + 10
If prices are unchanged, budget constraint is unchanged
If prices have changed, budget constraint must still pass
through ( , ) but will now have a different slope and
intercepts

118

59
 Endowments of goods III
Jumpers X2
Original budget constraint (AB):
20 B
+ =5 + 10
15 B’ Rearranging gives: =5 + 10 −

10 E Intercept = 20 and Slope = -2

If jeans are on sale at 50% off, then
Jeans in E are worth £10 not £20
Budget constraint pivots around E
A A’ (A’B’)
5 10 15 Jeans X1 Intercept = 15 and slope = -1

119

Endogenous versus exogenous income

Utility maximisation with exogenous income implies:
∗
– ( , , )= is independent of
– When changed, we held money income constant
Utility maximisation with endogenous income implies:
∗
– ( , , , )= where = +
– now depends on and
– Now when changes, your money income changes too
What happens to demand for when its price changes?

120

60
 Slutsky: the endowment income effect I
∆ ∆
= −
∆ ∆ ∆
Substitution effect remains the same
But there are now two income effects to consider
– Previously: say falls. Real income rises and so is affected
(ordinary income effect: money income remains fixed)
– But now when falls, your endowment and thus your money
income is affected (endowment income effect)
∆ ∆
= − + endowment income effect
∆ ∆ ∆

121

Slutsky: the endowment income effect II

When changes, the price of the endowment changes
and so money income changes and this changes demand
(i) Change in income when price changes
Endowment income effect = x
(i) Change in demand when income changes
Consider term (i): We know: + =
∆
– Change in income when price changes = =
∆

∆
We already have an expression for term (ii):
∆

122

61
 Slutsky: the endowment income effect III
∆ ∆ ∆
Endowment income effect: =
∆ ∆ ∆

∆ ∆
Revised Slutsky equation: = +( − )
∆ ∆ ∆
Substitution effect is always negative: ↑ → ↓
With a normal good: ordinary income effect > 0
Size of total effect depends on sign of ( − ):
– Net demander: Price of normal good rises, demand must fall
– Net supplier: It depends on the magnitude of the positive combined
income effect, versus negative substitution effect

123

Endowments of goods IV
X2 Original budget constraint (A)
Endowment, E Price of x1 falls
Substitution effect: A-B
Ordinary income effect (holding
money income fixed): B-D
Final Choice
Endowment income effect
(changes value of endowment
Original
and hence income): D-C
Choice – Must go through Endowment, E

A X1
Final budget constraint (C)
B C D

124

62
 Intertemporal Choice I
Should you go to university?
– No: You’ll have a low income as a student and will incur huge debts
– Yes: You’ll have a higher income as a graduate and pensioner
We can apply the consumer choice model to consider:
– How much debt should you accumulate as a student?
– How will the amount of debt depend on the interest rate?
– How much should you save for retirement?
This model is crucial to understanding saving decisions
We treat two time periods (t = 1, 2) exactly like two goods

125

Intertemporal Choice II
I can earn £10,000 (m1) this summer and then travel next
summer, earning £0 (m2). Assume r = 10%
– If c1 = 0, I could consume [ 1 + 0.1 + ] next summer.
– For every £1 consumed today, next year’s consumption falls by (1+r)
– The most I have for consumption next summer is what I would have
had if c1 = 0 minus (1+r) times my actual consumption this summer
≤ 1+ + − 1+

Rearranging 1+ + ≤ 1+ + Future value

gives: + (1 + ) ≤ + (1 + ) Present value

126

63
 Lenders and Borrowers
X2 X2
(1 + ) +

Future value

m2
X*2 Slope = -(1 + r)

X*2
m2
+
(1 + )

Present value

X*1 m1 X1 m1 X*1 X1

127

Intertemporal Choice III

Opportunity cost of consuming £1 today is (1+r) tomorrow
In the N period model, opportunity cost is (1 + )
£10,000 invested today at interest rate r yields:
– After 1 year: £10,000 (1 + r)
– After 2 years: £10,000(1 + r)(1 + r) = 10,000(1 + )
– After n years: £10,000(1 + )
Budget Constraint becomes:
(1 + ) + ≤ (1 + ) +
– This considers income and consumption in period 1 and n
– What about the years in between?

128

64
 Intertemporal Choice IV
Assume I have an idea about my earning in all periods 1 – n
– This gives n different endowments across n years ( , ,…, )
– Assume constant r across all years
If I consume nothing until the last year, I have plus:
– Penultimate year’s endowment and 1 year’s interest: + (1 + )
– Plus second to last year’s endowment and 2 year’s interest, plus…
So the maximum I could consume in last period is:
= + 1+ + (1 + ) + ⋯ + (1 + ) ( )

129

Intertemporal Choice V
The actual amount I can consume depends on how much I
consumed in the previous periods
=
+ 1+ + (1 + ) + ⋯+ 1 +

− 1+ − 1+ − ⋯ − (1 + )

Or
+ 1+ + 1+ + ⋯ + (1 + )

= + 1+ + (1 + ) + ⋯+ 1 +

130

65
 Comparative Statics: Borrowers
X2
What happens to the borrowing
Original decision as ‘r’ changes?
Budget Constraint
A decrease in ‘r’ pivots the
budget constraint
A borrower remains a borrower
m2
By Revealed preference, a
New
borrower will be unambiguously
Consumption better off
Original
Consumption
If ‘r’ increases, a borrower may
remain a borrower or may switch
m1 X1 to become a lender

131

Comparative Statics: Lenders

X2
What happens to the borrowing
New decision as ‘r’ changes?
Consumption
An increase in ‘r’ pivots the
budget constraint
A lender remains a lender
m2
By Revealed preference, a lender
Original
will be unambiguously better off
Original
Consumption
Budget Constraint If ‘r’ decreases, a lender may
remain a lender or may switch to
become a borrower
m1 X1

132

66
 Applications
We can apply the consumer choice model to many areas
and it can give important insights to policy-makers
– Should taxes be increased on certain goods?
– If interest rates change, how will this affect the behaviour of savers
and borrowers?
– If income tax rises, what happens to the supply of labour?
– If in-work or out-of-work benefits change, how will this affect
people’s incentive to work?
You will look at a further application in seminars

133

67
 31/10/2019

EC109

Production Theory
Elizabeth Jones

The Topics
Production functions
Isoquants and MRTS
Returns to scale
Cost functions and cost curves
Cost minimization
Expansion paths
Comparative statics
Short versus long run
Profit functions
Supply functions

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The firm’s problem

Firms make choices:
Which inputs should be used, e.g. capital and labour?
Firms face constraints:
Technological constraints, e.g. how easy it is to convert inputs into
outputs?
Which combinations of inputs will produce a given level of output?
Economic constraints that derive from the prices of inputs and outputs
Maximise profit: difference between revenue and costs
Given input prices, what’s the cheapest way to produce a given quantity?
Given output prices, how much should the firm produce?

Production Functions

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Production functions
Firms convert inputs into outputs: the inputs used are the firm’s
factors of production
The amount of goods and services produced is the firm's output (Q)
Certain combination of inputs will produce given amounts of output

The production function tells us the maximum amount of a good the

firm can produce using various combinations of inputs.
We often assume just 2 inputs (N = 2) with capital (K) and labour (L),
giving a production function of the form:
= ( , )
We also typically assume that Q is concave and monotonic

A short run one input/output model

Consider a case where a producer converts one input into one output!
– SR: one factor of production is fixed, so only one input is varied to increase output
A production plan: shows the number of labour hours (L) needed to
produce a given level of output (Q)
= ≫ = ℎ( )
The producer’s choice set is the set of production plans that are
technologically feasible (inputs are sufficient to produce the output)
The production function: the set of production plans, with no input waste
As more workers are employed, output rises: by how much?
– As more workers are added to a fixed factory space, the additional output
produced by each last worker may rise to begin with, but is then likely to fall

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Production functions

• B uses 20 labour hours to produce Why does the slope on this production
80 units function initially get steeper and then
• What can we say about C and D? get shallower?

Marginal and Average Product

Marginal product of Labour: The additional output produced by one more
worker (or labour hour)
ℎ in total product ∆
= = = =
ℎ in quantity of labour ∆

Linear Production function: Constant

We normally assume diminishing marginal productivity (flatter function)

= <0

Average product of Labour:

Total product ( , )
= = =
Quantity of labour

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 31/10/2019

Marginal and Average Product

Tonnes of wheat per year

40

30
From the total product function, we
can derive the marginal and average
20 product of labour curves.
10 Point D: Law of diminishing marginal
returns:
0
0 1 2 3 4 5 6 7 8 As variable input increases, with others
14
held fixed, a point will be reached
Tonnes of wheat per year

12
beyond which the marginal product of
10
the variable input will decrease.
8

6 Point E: maximum output (MPL= 0)

4

2
at 5 is the slope of AB
0 at 2 is the slope of OC
0 1 2 3 4 5 6 7 8
-2
Number of farm workers (L)

Two inputs - Robots and humans

Assume now that production requires both Capital and Labour.
200
Q, thousands of
economist
cards/day
150
0 6 12 18 24 30
0 0 0 0 0 0 0
100
6 0 5 15 25 30 23

L 12 0 15 48 81 96 75
50
18 0 25 81 137 162 127
24 0 30 96 162 192 150
0
30 0 23 75 127 150 117 30
24
18 30
Thousands of 24
We can now find marginal
12 18
machine Thousands of
6 12
hours/ day 6 man hours/
products of capital and labour 0 day

ℎ in total product ∆ ℎ in total product ∆

= = = = = = = =
ℎ in quantity of ∆ ℎ in quantity of ∆

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Isoquants

Isoquants
Isoquants show all combinations of labour and capital that produce a given
level of output (Q0)
, =
K, 000s of machine hour a day

0 6 12 18 24 30 18
0 0 0 0 0 0 0
6 0 5 15 25 30 23

L 12 0 15 48 81 96 75

18 0 25 81 137 162 127

24 0 30 96 162 192 150 6
30 0 23 75 127 150 117

6 18
L, 000s of Labour hours a day

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Marginal rate of Technical Substitution

Isoquants slope down: Keeping output
50 A constant, more labour means less capital
– Isoquants are monotonic, thin and do not
K, 000s of machine hour a day

cross
The , (of labour for capital) is the

B
slope of the isoquant
20
= 1000 – How many K must be given up to use 1 more
L, while keeping output constant
– The , diminishes in absolute value as
20 50 we move down the isoquant
L, 000s of labour hours a day Isoquants are convex to the origin.

, and Marginal Products

Analysis here is similar to consumer theory
Take the total differential of the production function:

= · + · = · + ·

Along an isoquant = 0:
· =− ·

, = =

How many units of capital the firm can substitute for one unit of labour
The shape of the isoquant determines the rate of technical substitution

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Isoquants versus indifference curves

Indifference curves represents tastes, while isoquants arise from
production functions, which are the technological constraints faced
by producers
Utility is not measureable, meaning there is no objective
interpretation as to the numbers accompanying indifference curves,
beyond the ordering.
Isoquants reflect output which is measurable
– Doubling all values associated with an indifference map leaves us with the
same tastes as before
– Doubling all values associated with isoquants alters the production technology,
with the new technology producing twice as much output from any bundle of
inputs (Returns to scale)

Convexity under Producer Theory

Vertical and horizontal slices Only horizontal slices
are convex: concave are convex: quasi-concave
production function production function

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Isoquants and Returns to scale I

With , > 0, if all inputs increase simultaneously, total output
must increase: by how much?
%∆ ( )
=
%∆ ( )
Consider a homogeneous production function, such that:
, = , =
– > 1 implies IRS
– = 1 implies CRS
– < 1 implies DRS
For a Cobb-Douglas production function , =
– + > 1 implies IRS
– + = 1 implies CRS
– + < 1 implies DRS

Isoquants and Returns to scale II

The vertical slice lying on this ray has output Q on

vertical axis and both inputs on horizontal axis

The linear shape of the vertical slice indicates CRS

All isoquants are radial expansions of one another:

a CRS production function is homothetic (isoquant
labels increase proportionately with the inputs)

MRTS depends only on ratio of K to L and not on

scale of production

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Isoquants and Returns to scale III

Same map, but the output associated with
each isoquant has changed

This leads to an increasing slope on the

vertical slice and thus IRS

As inputs double, output increases by more

than double (isoquant labels increase
proportionately more than inputs)

An IRS production function that is

homogeneous is homogeneous of degree
greater than 1: exponents sum to > 1

Isoquants and Returns to scale IV

Another map, with changed output for

each isoquant

This isoquant map gives rise to an

decreasing slope on the vertical slice and
thus DRS

As inputs double, output increases by less

than double (isoquant labels increase
proportionately less than inputs)

A DRS production function that is

homogeneous is homogeneous of degree
less than 1: exponents sum to < 1

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Returns to scale and diminishing marginal product I

Consider: , =
Here we have diminishing marginal returns =
to labour, but constant returns to scale. =
The function has diminishing MP iff:
K, units of capital per year

= −1 <0
E
30

20 D = 300
= −1 <0

10
A B
C
If exponents , > 0, the and will
= 200
= 170
= 140
be diminishing iff each exponent < 1 (only
10 20 30
= 100
then is derivative of and negative)
L, units of labour per year

Returns to scale and diminishing marginal product II

Marginal Product and Returns to Scale
, = = = −1

/ / ( , )= / /
( , )=

+b > 1 implies

Increasing Returns to Scale

<1 <0 >1 >0

Diminishing MP Increasing MP

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Linear production functions

Elasticity of substitution: σ = ∞

= , = +
H, High capacity computers

Low capacity and high capacity computers

10
are perfect substitutes (ratio of 2:1)

5 MRTS = − and is constant along linear

isoquants

10 20
Constant returns to scale
L, Low capacity computers

Map of isoquants for data storing = , = + = + = ( , )

Fixed proportions production functions

= , = min + O , > 0}
Elasticity of substitution: σ = 0
Oxygen and Hydrogen atoms are perfect
O, quantity of Oxygen atoms

complements, used in a fixed ratio

The Oxygen-Hydrogen ratio is fixed at

(slope of straight line) and firm operates
along the ray where this is constant 3
2
1
If < , ℎ = (Hydrogen is 2 4 6
the binding constraint) and vice versa H, quantity of Hydrogen atoms

Map of isoquants for molecules of water

If = both inputs are fully utilised

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Cobb Douglas production function

Elasticity of substitution: σ = 1 = , , >0
K, units of capital per day

50
Inputs substitutable in variable proportions
40
along an isoquant
It can exhibit any returns to scale,
30
depending on if ( + ) >, <, = 1
20
=
10

The CD function is linear in logarithms:

10 20 30 40 50 = + +
L, units of labour per day

is elasticity of output with respect to L

is elasticity of output with respect to K

Costs

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 31/10/2019

Economic Costs I
What is the cost of an airline using the planes it owns for scheduled
passenger services?
– Crew salaries, fuel etc.
– Foregone income from not renting the plane to someone else; time
Costs don’t always refer to direct monetary transfers
– Explicit costs refer to those costs needing a direct monetary outlay
– Implicit costs refer to those costs not involving such a monetary outlay
The economic cost of an input is its opportunity cost
– The remuneration the input would receive in its best alternative employment
– It includes both explicit and implicit costs
– A forward looking concept; depends on decision made and current market prices
Accounting costs: all explicit, incurred in the past - on accounting
statements

Economic Costs II
Sunk costs: costs that are already incurred and so cannot be avoided
– They do not (or should not) affect production decisions going forwards
– Behavioural insights?
Say I run a factory which, last year, emitted illegal pollution. I became
aware of this at the start of the year and quietly fixed it. Then I receive
a £10,000 fine for the pollution and am required to fix the problem.
I’ve already fixed it, so now I just have to pay the fine.
– This is a current cost for my business (according to the accountant)
– But, does the size of the fine depend on my current production decisions?
– No: regardless of whether or how much I produce now and in the future, the fine is based
on something that happened in the past. It does not affect economic choices I currently face
– It is not an economic cost of production

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The firm’s problem

Firms aim to maximise profits (difference between TR and TC)
Total Revenue: = = ( , )
Total Costs: = + where w; r = cost of labour and capital respectively

Profits:
π= −( + )= , −( + )
Two options to solve the firm’s problem:
a) One Step solution: Choose (Q, K, L) to maximise π
b) Two-step solution:
- Minimise costs for a given output level,
- Choose output to maximise π

Isocost curves
Isocosts: All the combinations of labour and capital that a producer could
afford to purchase at a given set of input prices (w, r) and a total allowable
cost level TC.
K, Capital

Assume = £10 and

Slope: −
= £20 and a ‘budget’
of £1m.

We apply the same

principles here as with
the budget constraint
in consumer theory L, Labour

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Cost Minimisation I
min + : , =
,
– Shift isocost until it is tangential to isoquant
K, Capital

– B and C are technically efficient, but not cost

minimising
B Cost minimisation occurs at A:
D – A is technically efficient and cost minimising
– The rate at which K can be traded for L in the
production process = rate at which they can
A
∗ be traded in the marketplace
C
Slope of isoquant = Slope of isocost

∗ L, Labour , = =

Cost Minimisation II
The firm’s cost minimisation problem is similar to EMP
min + : , =
,

Set up the Lagrangian:

= + + ( − , )
FOCs:

= −λ =0
= = ,
= −λ =0

= − , =0

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Cost Minimisation III

= = = ,

Rearranging:
= =λ = =λ

The Lagrange multiplier, λ, shows how much the optimal value of the
objective function will change following a change in the constraint
– By how much will costs increase when output constraint is increased marginally
Solving the minimisation problems yields the optimal factor demands:
∗
= ∗ ( , , ); ∗
= ∗( , , )
– These are derived or conditional factor demands, as input demand depends on Q
∗
– Cost function: , , = , , + ∗( , , )

Cost minimisation IV: = ; = ; =

= + + ( − )

= −λ =0
= ≫ =
= −λ =0

= − =0
∗
Solve for: =

∗
Plug expression for L* into = and solve for: =

Cost function: TC = +

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Expansion Path
The set of optimal combinations of L and K
(tangency of isoquants and isocosts)
– How inputs increase with increases in output
The expansion path does not have to be a
straight line or start at the origin
– It depends on the shape of the isoquants
– The use of some inputs may increase faster
than others as output expands
In previous case: =
– MRTS depends on ratio of two inputs: =
– Production function is homothetic and
expansion path is a straight line

Corner solutions
The cost minimizing input combination occurs where the firm uses no Capital:
Tangency condition doesn’t hold at
any point, as the isocost is flatter
K, Capital

than the isoquant at all points:

isoquant The situation is such that:

> ≫ >
C

B
Every dollar spent on labour is more
productive than every dollar spent
on Capital.
A
L, Labour

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Comparative statics: A change in input prices

Suppose the price of capital, , and the quantity of output, , are both held fixed. What
happens if there is an increase in the price of labour, ?
K, Capital

The isocost curve becomes:

With diminishing , , where is the new
optimal point?
What does this mean for the quantities of
capital and labour employed?
Note two important assumptions needed for
those results:
isoquant – , >0
L, Labour
– Convex isoquants

Using comparative statics to derive input demand curves

The top diagram shows the effect of an
increase in the price of labour and a change
K, Capital

in output
B
– As w rises (r falls) optimisation moves from A to
A C B
– As quantity of output changes (keeping w and r
L, Labour
constant) the isoquant (and isocost) shift out
The bottom diagram summarises the
, dollar per unit of Labour

implications for the firm for its demand for

labour
B’
£2 – Following change in input prices, firm moves up
£1 C’ its demand for labour curve A’ to B’
A’
– Following increase in quantity of output, the
Demand for Labour labour demand curve shifts
L, Labour

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Cost Functions I
We have already seen that the firm’s TC is a function of output and
input prices
∗
Total Cost function: C , , = , , + ∗ , ,
– With fixed prices, we often note C
Average Cost (AC) reflects costs per unit of output
( , , )
AC , , =

Marginal Cost (MC) reflects the change in total costs following a

change in output
( , , )
MC , , =

Consider the case of a CRS production technology

Cost Functions II: CRS

For instance, all input bundles on this isoquant will produce
100 units of x “without wasting inputs” – all represent
technologically efficient ways of producing 100 units .
When w =20 and r =10, a budget – or isocost – of $300 is
sufficient to reach production plans on this isoquant.
But a production plan is not economically efficient unless its
inputs are the least-cost way of reaching the output level.
For every output quantity, there is usually one such
economically efficient input bundle where
w
TRS  
r
And when technology is homothetic, the economically
Constant efficient input bundles lie on the same ray from the origin.
Returns to Scale
For each output level, we can then read off the cost of
production assuming the firm cost-minimizes.
From the (total) cost curve, we can derive the marginal and
average cost curves

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Cost Functions III

A concave production function yields a convex cost function
An IRS production function at all Q has a continuously falling AC curve
– MC lies below AC at all levels of output
A production function that is concave for positive quantities but
requires a fixed cost
– Total cost starts at a positive value when q = 0
– AC is u-shaped and starts at an infinite level; reaches a minimum and then rises, pulling
the MC up
A non-concave production function (e.g. cubic) yields a decreasing
then increasing total cost function (as we’ll see next)
– Total costs rise more and more rapidly once diminishing returns set in
– A possible explanation is a 3rd factor of production that is fixed as inputs expand

Cost Functions IV: IRS then DRS

Suppose A is the cost-minimizing input bundle to
produce 10 units of output.
With homothetic technologies, this implies all cost-
minimizing input bundles lie on the same ray.
DRS
From A, we can calculate the cost (A’) and average
IRS cost (A”) of producing 10 units of output (given
input prices w =20 and r =10).

And repeating this for all other

output quantities, we get the (total)
cost and average cost curves.

The slope of the (total) cost curve

becomes the marginal cost curve.

The MC curve that lies above AC

becomes the firm’s supply curve

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Properties of cost functions

Cost functions are homogenous of degree 1 in input prices
– Doubling all input prices won’t change level of inputs used; inflation shifts cost curves up
Cost functions are non-decreasing in Q and in input prices
If Q = f( , ) is convex, it exhibits IRS and C(w, r, ) is concave in Q:
– MC(Q) and AC(Q) fall as Q rises: The firm benefits from economies of scale
If Q = f( , ) is concave, it exhibits DRS and C(w, r, ) is convex in Q:
– MC(Q) and AC(Q) rise as Q rises: The firm suffers from diseconomies of scale
With CRS, output increases proportionally to an increase in all inputs:
AC(Q) remains constant: no economies or diseconomies of scale
– When costs are minimised, the firm is productively efficient: minimum efficient scale
AC(Q) is increasing when MC(Q) ≥ AC(Q) and decreasing when
MC(Q) ≤ AC(Q)

Shifting cost curves I

Any change in technology or input prices
will shift the isocost curve and hence the
cost function
K, Capital services

Starting from point A, where the firm

produces 1 million televisions, on
isocost line .
A
After the price of capital increases, the
B
cost minimising input combination to
produce 1 million units occurs at point B
But, total cost is now greater than it was
1 million TV per year
at point A
= <
Labour services per year

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Shifting cost curves II

Coal fields in Pennsylvania and West
Virginia were opened in 19th century,
TC, dollars per year

cutting the price of coal

– Iron producers substituted coal for wood
( ) before
the decrease in – Fuel and cost curves for iron output shifted
the price of downwards
coal
Cyberspace: acquiring information is now
relatively cheaper with ‘IT’
A ( ) after the This tilts LRTC down and cuts the cost for
decrease in the
price of coal producing a given level of output (A to B)
B
– Or level of output increases for the same costs
This may partly explain the breaking up of
big companies from mid-1970s as the cost
1000
Units of Output
of information for smaller firms fell

Shifting cost curves III

TC, dollars

Slope of CD =Marginal Cost

Slope of 0A = Average Cost
B D
( )
An increase in costs
– Tilts TC(Q) upwards
£1,500
A – AC shifts upwards
C
– MC shifts upwards
0 50 Q, units per year The relationship between
= slope
of ( ) MC and AC is such that:
slope of ray from O
B’ to ( ) • When AC is decreasing in Q,
, per

> ( )
When AC is increasing in Q,
,
unit

A’ •
£30
B’ < ( )
A’’
• When AC is at a minimum,
£10
= ( )
50 Q, units per year

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Costs in the short run: Fixed and variable costs

In the short run, the firm faces constraints in its ability to vary the
quantity of some inputs. We will consider a case where the amount
of capital the firm can use is fixed in the short run. We can rewrite
the firm’s total cost such that:
= +
Where represents the fixed amount of capital

The cost of labour constitutes the firm’s total variable cost

– It will vary as the firm chooses to produce more or less output
The cost of capital constitutes the firm’s total fixed cost
– It will not vary as the firm produces more or less output

Cost minimization in the short run I

SR: firms can’t substitute between inputs: LR: optimise at A, B, C (min. cost)
optimality may not involve a tangency SR: units of capital must be used
K, Capital

to produce any output

– D (E): only technically efficient
combination of inputs to produce
( ): combining minimum quantity of L
with fixed
Short run expansion path
C
– To produce , the firm incurs the
D E
B
Isoquant same costs in long run and in short run
A Isoquant Combination of inputs used in SR
Isoquant and LR tend to be different
L, Labour
Cost are typically higher in the SR
than in the LR

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Relationship between the long run and short run total cost
curves
K, Capital

TC, per year

( )

Long run expansion path ( )

B

Short run expansion path

C
C
A
B
A
= 2 million
TVs isoquant

= 1 million
TVs Isoquant

1 million 2 million Q, units per year

L, Labor

The long run average cost curve as an envelope curve

The long run average cost curve

forms a boundary around the set of
Cost, per year

, = shot run average cost curves

, =
corresponding to different levels of
output and fixed input.
, =
Each short run average curve
£60

£50
A corresponds to a different level of
C
fixed capital.
£35 Point A is optimal for the firm to
B
produce 1 million TVs per year, with
fixed level of capital .

1 million 2 million 3 million Q, TVs per year

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Profit Maximisation

Profit Maximisation: 2 step problem

– Minimise costs for a given output level (already done)
– Choose output to maximise π (i.e. revenue minus costs)
Step 2 involves: = − ( , , )
This is an unconstrained maximisation problem
, , , ,
: = − =0 ≫ = = ( )

If revenue from last unit exceeds cost from last unit, then produce more
( )
As ≥0 MC must slope upwards at the optimum
∗
Solving yields optimal output: , ,
∗ ∗
And Profit: ( , , )= − ( , , )

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/ /
Two Step problem: , =
We already know the cost function for , =

TC = + Now set = =1 3

TC = + =2 ( )

We want to maximise profits: = − , , = −2 ( )

: = ≫ =3 ( )

∗ ∗
, , = , , =
9 27

Remember from earlier: = ; = ; =

= + + ( − )

= −λ =0
= ≫ =
= −λ =0

= − =0
∗
Solve for: =

Plug expression for L* into = and solve for: ∗

=

Cost function: = +

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Profit Maximisation: One Step problem

L and K used to produce Q = f( , ) (priced at p), with = ; =
– Assume firm is a price taker in both input and output markets
Firm’s profit maximisation problem involves choosing Q, L, K to:
max = − − = , − −
This is another unconstrained maximisation problem
( , ) ( , )
: − =0 − =0
∗ ∗
These yield the optimal input demands: , , , ,
We can then derive the supply function: ∗ , , = ( ∗ ∗
)
And the Profit function: ∗ = ∗ − ∗ − ∗

/ /
Same problem: One-Step: , =
= − − = − −
FOCS:
1 1
= = 1 = = 2
3 3
Use (1) to find expression for K: = 27 (3)
∗
Plug (3) into (2) to find optimal :
1 1
= ≫ [27 ] = ≫
3 3
∗
= (4)
27

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/ /
One step problem: , =
∗
To find optimal , plug equation (4) into equation (3)

= 27 = 27
27
∗
= (5)
27
To find optimal ∗ : plug optimal inputs (4), (5) into production function

/ / ∗
= = ≫ = (6)
27 27 9
This is the supply function
– Compare it with optimal Q from two step problem
– They are identical

/ /
One step problem: , =
Use (4), (5) and (6) to find Profit function
∗ ∗ ∗ ∗
= − − = − −
9 27 27
∗
( , , )=
27
Compare this with the profit function derived from two-step solutions
– Again, it is identical
Once we know the price of labour and capital, we can then solve to find
how much will be supplied at each price and how much profit the firm
will make

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Profit and Supply Functions

TC(Q)
TR=PQ
Profit function
Costs
Profit is maximised at Q* where:
=
Profits are given by:
∗ ∗
= −
Total profit on top diagram is:
Q* Quantity
= −
Tπ
Price AC(Q)
Total profit on bottom diagram is:
MC(Q)
∗ ∗
= −
P AR = MR
, , increases in p and
decreases in w, r
AC
, , is homogeneous of
degree 1 in , ,
Q* Quantity

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Isoprofit curves I
When more of one input is used, ∆ , output rises by ∆ = ∆
The value of this extra output is p ∆ (where p = price of output)
The cost of this additional output is: w∆ (where w = price of labour)
If the value of using one extra L is greater than its cost, profits rise if
one more L is used
When profits are at a maximum, any change in how much L is used
will cause profits to fall.
At a profit maximising choice of inputs, the value of the marginal
product of labour should equal the price of labour

p ( ∗, ) =

Isoprofit curves II
Assume K is held fixed and x Profits are: = − −
denotes firm’s output Solving yields: = + +
which describes the isoprofit lines
– All combinations of the input goods and output
good that give the same level of profit
– A bit like a firm’s indifference curves
– Slope = Vertical intercept = +
Which measures profits plus fixed costs
– As fixed costs are fixed, the only thing that
changes as we move between isoprofit curves is
the level of profit (higher profit, higher isoprofit
curve)
Profit maximisation: point on production
function with highest isoprofit curve

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Supply I
We assume firms aim to
maximise profits (MC = MR = P) : P> ≫ = ≫ >0
Price
: P> ≫ = ≫ >0
MC(Q) S(Q)

P1 : P= ≫ = ≫ =0
P2
AC(Q)
: P< ≫
– Firm doesn’t respond by producing

P3
– When < 0 the firm produces Q = 0
P4
MC curve shows how much will be
produced at any given price
But if:
Q4 Q3 Q2 Q1
Output < < ; =0

Recall the slide from earlier… (or if not, here it is!!!)

Suppose A is the cost-minimizing input bundle to
produce 10 units of output.
With homothetic technologies, this implies all cost-
minimizing input bundles lie on the same ray.

From A, we can calculate the cost (A’) and average

DRS cost (A”) of producing 10 units of output (given
input prices w =20 and r =10).
IRS

And repeating this for all other

output quantities, we get the (total)
cost and average cost curves.

The slope of the (total) cost curve

becomes the marginal cost curve.

The MC curve that lies above AC

becomes the firm’s supply curve

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Supply II
Long run Supply (MC above AC)
Short run Supply (MC above AVC) - only needs to cover variable costs
Shape of supply depends on: shape of MC and whether there are FC
The supply function is homogeneous of degree 0 (in p, r, w)
– If prices double, profit equation scales up, so optimal output is unaffected
Supply will slope upwards
Long run supply will be flatter than short run supply, due to fixed
input, capital

Conclusion: Combining topics 1 and 2

In topic 1, we looked at the consumption decision
– We derived consumer demand
In topic 2, we have considered the production decision
– We have derived producer supply
We have seen that both the demand and supply functions depend on
the market price of the good
Combining these theories allows us to understand the fundamental
workings of a competitive market
– The interaction between consumers and producers
– How equilibrium is determined in a market via the price mechanism which sends
signals between the two sides

33