CHAPTER ONE

THEORY OF CONSUMER BEHAVIOR AND DEMAND

Introduction
The theory of consumer behavior is the concern of how consumers decide on the basket of
goods and services they consume in order to maximize their satisfaction. It is essentially a
decision-making behavior.

 Consumer is a decision making unit (an individual or a household) who uses or consumes
a commodity or service.
People demand goods and services because they satisfy the wants of the people.
Theory of consumer behavior is the basis for the theory of demand. In explaining the
consumer behavior, we assume that:
i. The consumer is rational. Given his/her income and the market price of the commodities,
he/she plans the spending of his/her income so as to attain the highest possible satisfaction
or utility. This is also known as the axiom of utility maximization.
ii. The consumer has complete knowledge of all the information relevant to his/her decision.
That is, he/she has complete knowledge of;
 all the available commodities,
 the price of the commodities,
 his/her income, and
 the product ability to satisfy his/her wants.
1.1. Consumer's Preferences and Utility
Consumer preferences
The theory consumer behavior begins with assumptions about consumer’s preferences for
one consumption bundle versus another. The consumption bundles of a consumer are a
complete list of the goods and services that are involved in the choice problem.
Let us assume that the consumer's consumption bundle consists of two goods, X and Y and
let X1 denote the amount of good X and Y 1 the amount of good Y. The complete
consumption bundle is therefore denoted by (X1, Y1).
We will suppose that given any two consumption bundles, (X 1, Y1) and (X2, Y2), the
consumer can rank them as to their desirability. That is, the consumer can determine that one
of the consumption bundles is strictly better than the other, or the consumer can decide that
he is indifferent between the bundles.

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We use the symbol “>” to mean that one bundle is strictly preferred to another bundle so that
(X1, Y1) > (X2, Y2) should be interpreted as saying that the consumer strictly prefers (X 1, Y1)
to (X2, Y2), in the sense that he definitely wants the first bundle rather than the second-
bundle. If the consumer prefers one bundle to another, it means that he would choose one
over the other.
If the consumer is indifferent between two bundles of goods, we use the symbol “=” and
write (X1, Y1) = (X2, Y2). Indifference means that the consumer would be just as satisfied
consuming the bundle (X1, Y1) as he would be consuming the other bundle, (X 2, Y2)
according to his own preferences.
If the consumer prefers or is indifferent between the two bundles we say that he weakly
prefers (X1, Y1) to (X2, Y2) and write (X1, Y1) (X2, Y2). If X1, Y1)  (X2, Y2) and (X2, Y2) 
(X1, Y1), we can conclude that (X1, Y1) = (X2, Y2). That is, if the consumer thinks that (X 1,
Y1) is at least as good as (X 2, Y2) and that (X2, Y2) is at least as good as (X 1, Y1), then the
consumer must be indifferent between the two bundles.
Assumptions about preferences
Economists usually make some assumptions about the "consistency" of consumers'
preferences. For instance, it unreasonable to have a situation where (X 1, Y1) > (X2, Y2) and at
the same time (X2, Y2) > (X1, Y1). This would mean that the consumer strictly prefers the
first bundle to the second bundle, and the vice-versa, which is unrealistic. We, therefore,
usually make some assumptions about how the preference relations work. Some of the
assumptions about preferences are so fundamental that we can refer to them as "axioms" of
consumer preferences. Here are four such axioms about consumer's preferences.
1. Completeness: preferences are assumed complete, i.e., consumers can compare and rank
all possible bundles. That is, given any two bundles, (X 1, Y1) and (X2, Y2), the consumer
may;
 prefer (X1, Y1) to (X2, Y2) -- (X1, Y1) > (X2, Y2),
 prefer (X2, Y2) to (X1, Y1) -- (X2, Y2) >(X1, Y1), or
 indifferent between the two bundles -- (X2, Y2) = (X1, Y1)
To say that any two bundles can be compared is simply to say that the consumer is able to
make a choice between any two given bundles.
2. More is better than less: The consumer is assumed prefers bundles of goods with more
quantity to bundles of goods with less quantity.
3. Reflexivity: We assume that any bundle is at least as good as itself: (X1, Y1)  (X1, Y1).

2
4. Transitivity: If (X1, Y1)  (X2, Y2) and (X2, Y2)  (X3, Y3), then we assume that (X1, Y1) 
(X3, Y3). Stated differently, if the first consumption bundle is preferred to the second
consumption bundle, and the second consumption bundle is preferred to the third consumption
bundle, then the first consumption bundle is preferred to the third consumption bundle.
Consumer preferences are represented by utility functions.

 Utility is the level of satisfaction that a consumer obtains by consuming a

commodity/service or undertaking an activity. It is also defined as the power of a
commodity/service to satisfy human wants.
Characteristics of utility
Relativity: The utility of a commodity is subjective to a person’s need. It is not absolute
(objectively determined).
Subjectivity: Utility varies with different persons. Different persons derive different amounts
of utility from a given good. The desire for a commodity by a person depends on the utility
he expects to obtain from it. The greater the utility he/she expects from a commodity, the
greater his/her desire for that commodity.
Utility and moral values: Utility is free from moral values. For example, eating a food item,
which may be immoral in a society, may yield utility as long as it satisfies hunger. It is also
the case that utility is “ethically neutral” between good and bad, and harmful and useful. For
example, drug yields utility to the drug-takers.
1.2. Approaches to Analyze Utility
In order to maximize utility, the consumer must be able to compare the utility of the various
baskets of goods which he/she can buy with his/her income. There are two approaches to the
problem of comparison (measurability) of utility: These are cardinal and ordinal utility
approaches.
1.2.1. The Cardinal Utility Approach
The cardinal school postulated that utility can be measured by absolute unit of measurement.
The measure of utility is called ‘utils’. Cardinalists proposed that the amount of money that
the consumer is willing to sacrifice for another unit of a commodity can be used to measure
utility. Based on the amount of utils derived, the consumer chooses the bundle which gives
him/her the highest possible satisfaction.
Assumptions:
i. Rationality: The goal of the consumer is to maximize his/her satisfaction given his/her
limited budget or income. Thus, the consumer can reason out what is good and what is bad

3
 for him, and he buys first a commodity that yields the highest utility and he buys last a
commodity which gives the last utility.
ii. Cardinal utility: The utility of each commodity is measurable. Money is the most
convenient measurement of utility. In other words, the amount of money that the
consumer is prepared to pay for another unit of commodity measures utility or
satisfaction.
iii.Constant marginal utility of money: The utility that one derives from each successive unit
of money income remains constant.
iv.Diminishing marginal utility (DMU): The marginal utility of a commodity diminishes as
the consumer acquires more and more of it.
v. Utility is additive: Cardinalists maintain that utility is not only cardinally measurable but
also utility derived from various goods and services consumed by a consumer can be
added together to obtain the total utility. Suppose that the basket of goods and services
consumed by a consumer contains n items, and their quantities may be expressed as X 1,
X2, X3… Xn. The total utility of a basket of goods and services depends on the quantities of
the individual commodities. That is: U = f(X 1, X2, X3… Xn). Given the utility function, the
total utility obtained from n items may be expressed as U n = U1(X1) + U2(X2) + --- + Un
(Xn).
vi.Limited money income: The consumer has a limited money income to spend on the goods
and services he chooses to consume.
Total Utility (TU) and Marginal Utility (MU)
Total Utility: refers to the total amount of satisfaction a consumer gets from consuming or
possessing some specific quantities of a commodity at a particular time. Suppose a consumer
consumes 4 units of a commodity and derives U 1, U2, U3 and U4 from the successive units
consumed, then TU (4 units) = U1+U2+U3+U4. In case of more than one commodity, then TU=
TUA TUB + TUC +…+TUZ.
Marginal Utility (MU): is the additional utility obtained from consuming an additional
utility of a commodity. In other words, it is the change in the total utility resulting from unit
change in commodity consumed. It is the slope of total utility, MU = rTU/rX; where
rTU = Change in Total Utility and rX = Change in quantity consumed. For infinitesimal

change (a very small change), we use derivative formula as:

Table 1: An individual consumer’s utility schedule (where utility is measured by utils)

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 Drinks consumed (X) Total utility ( units of Marginal utility (extra units
satisfaction) of satisfaction)
0 0 __
1 3 3
2 8 5
3 15 7
4 20 5
5 23 3
6 25 2
7 26 1
8 26 0
9 24 -2
10 20 -4
Saturation point
TUX
30
Marginal utility (units)

25

20

15

10

50 1 2 3 4 5 6 7 8 9 10 Units of X

10

0 1 2 3 4 5 6 7 8 9 10 Units of X

MUX
From
-5 the above figure, we establish the following points;

-10
5
 As the consumer consumes more of the commodity, his total utility initially increases,
however, there is a saturation point for that commodity at which the consumer will not be
capable of enjoying any greater satisfaction from it.
 Marginal utility continuously declines as the consumer consumes more of the
commodity.
 When total utility is increasing, marginal utility is falling but positive.
 When total utility is at maximum (neither increasing nor decreasing), marginal utility is
zero. This is the saturation point.
 When total utility is falling, marginal utility is negative.
The Law of Diminishing Marginal Utility (LDMU)
An individual consumer demands a particular commodity because of the satisfaction or
utility he/she derives from consuming it. As an individual consumer consumes more of a
commodity per time, the extra or marginal utility received from consuming each additional
unit of the commodity declines. This is referred to as the law of diminishing marginal utility
(LDMU). The law of diminishing marginal utility (LDMU) asserts that each additional unit
consumed of a commodity yields less marginal utility than previous units.
The law of diminishing marginal utility (LDMU) is based on the following assumptions:
1) The consumer is a rational utility maximizing person. The typical consumer does not have
to behave irrationally.
2) There is a single homogeneous commodity.
3) There are no changes in the tastes (preferences) and the income of the consumer within a
given period of time.
4) Commodities are of ordinary type. Otherwise, if they are commodities of high worth such
as jewels, diamonds, gold, etc, the law of diminishing marginal utility (LDMU) may not be applied.

EQUILIBRIUM OF THE CONSUMER (With one commodity):

Let’s assume that the consumer consumes a single commodity, X. The consumer can either
buy X or retain his money income. Under these conditions the consumer is in equilibrium
when the marginal utility of X is equated to its market price (PX).
Symbolically,
MUX = PX
Mathematically, we can derive the equilibrium of the consumer as follows:
The consumer equilibrium can be expressed using simple calculus. The utility function is
given by U = f (X), where utility is measured in monetary units. For a purchase of X, the
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consumer must spend PXX. We assume that the consumer seeks to maximize the difference
between the utility gained from purchase and the cost of purchase, i.e. maximize U – PXX.

The necessary condition for a maximum is that the partial derivative of the function with
respect to X be equal to zero.

 ;
Solving and rearranging the above equation, we have:



 If MUx > Px, the consumer can increase his/her welfare by purchasing more unit of X,
and if the MUx < Px, welfare can be increased by reducing the consumption of X.

In the case of n commodities, the condition for optimality of the consumer is the equality of
the ratios of MU of the individual commodities to their prices, i.e. the utility derived from
spending an additional unit of money must be the same for all commodities:

Suppose that the following holds in two commodities:

 ⇒ the consumer should buy more of good 1 to maximize his/her utility.

 ⇒ he/she should buy more of good 2 to maximize utility.

 This is called equi-marginal principle (in two commodities - world).

CRITICS OF CARDINAL UTILTYAPPROCH

1. The satisfaction derived from the various commodities cannot be measured
objectively. The cardinality of the utility is extremely doubtful.
2. The assumption of constant MU of money is unrealistic because as income changes
the MU of money changes.
3. The additive assumption of utility is unrealistic.
2. THE ORDINAL UTILITY THEORY
The Ordinalist school suggests that utility is not measurable, but it is an ordinal magnitude.
That is, to make his/her choice, the consumer need not know the utility of various
commodities in specific unit, but be able to rank the various basket of goods (order of

7
 preference) according to the satisfaction that each bundle gives. There are two main theories
in the ordinal approach:
1) The Indifference Curve Theory, and
2) The revealed preference hypothesis/theory
THE INDIFFERENCE CURVE THEORY
Indifference curve(IC): is the locus of points of different combinations of two goods (a
bundle of goods) which yields the consumer the same level of satisfaction (utility) so that
he/she is indifferent as to the particular combination he/she consumes. Indifference curve is
also known as iso utility curve (“iso” means same).

Table: Indifference Schedule of good A and good B

Combination Units of good A Units of good B

a 4 24
b 8 12
c 12 8
d 16 5
e 20 3
f 24 2
Units of good B

24 * If the consumer could choose

among all the combination of
20 good A and good B on the
a
indifference curve, he would

16 b be indifferent because all of

the combinations provide the
c
same level of utility.
12
d
Figure: Consumer’s indifference Curve
e
f
An Indifference Map: shows a set of all the ICs, whichIC rank the preference of the consumer.
8
Combination of goods situated on an IC yields the same level of utility. Combination of
goods lying
0
on
4
a higher
8 12
IC yields
16
higher
20
level of satisfaction and are preferred.
24 units of good A

8
Figure: Indifference map
ASSUMPTIONS OF ORDINAL APPROACH:
1) Rationality: the consumer is assumed to be rational.
2) Utility is ordinal: the consumer can rank his/her preference (order the various baskets of
goods) according to the satisfaction of each basket.
3) Diminishing marginal rate of substitution (DMRS): preferences are ranked in terms of ICs,
which are assumed to be convex to the origin. This implies that the slope of IC (MRS)
decreases in absolute terms.
4) The total utility of the consumer depends on the quantities of the commodities consumed.
That is, U = f (X1, X2… Xn)
5) Consistency and transitivity of choices:
═> If bundle A>B, then B is not greater than A
═> If bundle A >B and B>C, then A>C.
6) Non-Satiation: In any two consumption bundle A and B, A is preferred to B, if A contains,
at least more of one commodity. That is, more is preferred to less under normal condition.
7) Limited money income.
Generally, Ordinalist school simply argue that,
 individual tends to make consistent choice,
the law of preference represents a good approximation of actual behavior of consumer,
and thus, the law of preference are rules of rational choice.

PROPERTIES OF WELL BEHAVED (NORMAL) INDIFFERENCE CURVES:

1) An indifference curve has a negative slope: which denotes that if the quantity of one
commodity(Y) decreases the quantity of the other (X) must increase, if the consumer is to
stay on the same level of satisfaction.
2) The further away from the origin an IC lay, the higher level of utility it denotes.
3) ICs do not intersect nor are they become tangent to each other. If they did, the point of their
intersection would imply two different level of satisfaction, which is impossible.
4) ICs are convex to the origin: this implies that the slope of an IC (MRS) decreases (in
absolute terms) as we move along the curve from the left down wards to the right.
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THE MARGINAL RATE OF SUBISTITUTION (MRS)
The marginal rate of substitution of X and Y (MRSx, y) is defined as the number of units of
commodity Y that must be given up in exchange for an extra unit of commodity X so that the
consumer maintains the same level of satisfaction. It is the negative of the slope of an IC at
any one point and is given by the slope of the tangent line at that point:

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

Proof:
The total utility function in the case of two commodities X&Y is: U = f(X, Y)
The equation of an IC is: U = f(X, Y) = K, where K is constant.
At equilibrium, the total derivative of U is equal to zero.

 Along any particular IC, the total differential is by definition equal to zero.

EXCEPTIONAL INDIFFERENCE CURVES

1. Prefect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one good for the
other at a constant rate. The simplest case of perfect substitutes occurs when the consumer is
willing to substitute the goods on a one-to-one basis. The indifference curves for this
Blue pens

consumer are all parallel straight lines with a constant slope.

Indifference curves
Slope = -1

10

0
Black pens
Figure: Perfect substitutes

2. Perfect complements
Perfect complements are goods that are always consumed together in fixed proportions. In
some sense the goods "complement" each other. A glaring example of perfect complements
is that of right shoes and left shoes. Thus, the indifference curves are L-shaped with the
vertex of the L occurring where the number of left shoes equals the number of right shoes.
Left shoes

Increasing both the number of left shoes and right shoes at the same time will move the consumer to a
more preferred position so that the direction of increasing preference is again up and to the right.

Indifference curves

0
Right shoes
Figure: Prefect complements

BUDGET CONSTRAINT
If each consumer had unlimited money income - in other words, if there were unlimited pool
of resources - there would be no problems of "economizing", nor would there be
"economics." This utopian state does not exist, even for the richest members of our society.
Consumers (people) are compelled to determine their behavior in light of limited financial
resources. Thus, the consumer's income limits the combination of goods that he/she can
choose to consume provided that there is some sets of goods from which the consumer can
choose. In real life there are so many goods to consume, but for the sake of simplicity it is
convenient to consider only the case of two goods.
Thus, assuming that there are only two goods bought, the consumption bundle of the
consumer is indicated by (X, Y) which tells us how many units of good X and good Y the
consumer is choosing to consume. We also assume that we can observe the prices of the two
goods (PX, PY) and the amount of money the consumer has to spend, M. Then, the budget
constraint of the consumer can be written as .

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Here, is the amount of money the consumer is spending on good X and is the
amount of money the consumer is spending on good Y. The budget constraint of the
consumer requires that the amount of money spent on the two goods be no more than the
total amount the consumer has to spend. The consumer's affordable consumption bundles are
those that do not cost any more than M.
The Budget Set
The set of affordable consumption bundles at prices ( ) and money income, M is called
the budget set of the consumer. The budget set is the set of consumption bundles that cost
exactly M:
…………………………………………………………………………. (1)

Note that consumption bundles refer to the collection of different quantities of commodities
at their respective prices. The budget set consists of all consumption bundles that are
affordable at the given prices and money income and these consumption bundles just exhaust
the consumer's money income on the budget line as depicted in fig. 1 below:
Y

A
M PX
Y  X
PY PY

B
M X
0
PX
Figure: The budget line
The heavy line in figure above is the budget line - the line where the consumption bundles
cost exactly M. The consumption bundles below this line are those that cost strictly less than
M. The consumption bundles above/beyond the budget line are those that cost strictly more
than M. These consumption bundles are, therefore, infeasible due to the budget constraint.
The budget line in equation (1) can be re-expressed as:

…………………………………………………………………………… (2)

This formula is a straight line with Y-intercept of , X-intercept of , and slope of .

The slope of the budget line is the negative of the price ratio ( ) which can be derived as follows:

12
The slope of the budget line has serious economic interpretation. It measures the rate at
which the consumer is willing to substitute good Y for good X. Suppose that the consumer is
going to increase his/her consumption of good X by X. To know the change in Y (Y):
…………………………………………………………………….. (3), and

……………………………………………………… (4)

Subtracting equation (3) from equation (4) gives:

This is just the slope of the budget line, which measures the rate at which good Y can be
substituted for good X while satisfying the budget constraint. If you consume more of good
X you have to consume less of good Y and the vice-versa. Economists sometimes say that the slope
of the budget line measures the opportunity cost of consuming good X. In other words, the budget line is
interpreted as the trade-off between good Y and good X that is imposed by having finite resources at given
market prices.

Changes in the Budget Line:

When prices and income change, the set of goods that a consumer can afford changes as well.
1. Suppose money income increases from M to M', (M'>M), money prices remaining
unchanged. The consumer can now purchase more-more of Y, more of X, or more of
both. Conversely, a fall in consumer's money income, with constant money prices,
reduces consumption. Thus, the consumer can purchase less-less of Y, or less of X, or
less of both following a fall in money income.
The effect of change in money income on the budget line can be depicted in Figure
Quantity of Y

below:
Y

M’/Py
NOTE: M’ > M; but M’’ < M
M/Py

M”/Py

13

0 X
M”/Px M/Px M’/Px Quantity of X
 Figure: Effects of change in money income on the budget line, prices remaining unchanged

In summary, an increase or a decrease in consumer’s money income will not change the
slope of the budget line, because money prices are assumed to remain intact. An increase in
money income, prices remaining unaltered, is shown graphically by parallel shift of the
budget line upward to the right whereas a fall in money income is depicted graphically by
parallel shift of the budget line in the direction of the origin (leftwards).
2. Figure below shows what happens to the budget line when the money price of X
increases, the money price of Y and money income remaining unaltered.
Quantity of Y

M/Py A

O B
B' Quantity of X

Figure: Effects on the budget line of increase in price of X, price of Y and money income remaining unaffected

Let the price of X increase from to . Since and M are unchanged, the ordinate
intercept does not change-it is in each case as depicted in Fig. 3 above. But, the slope of

the budget line, the negative of the price ratio, changes from to . Since > ,

< . In other words, the slope of the budget line becomes steeper. Thus, an
increase in the price of X is shown by rotating the budget line clockwise around the ordinate
intercept as a pivot. That is, the X-intercept of the budget line must shift inward (the
budget line becomes steeper) as depicted in Figure above.

Note that other things remaining the same, a decrease in the price of X will have the opposite
effect on the budget line and X-intercept in that the budget line will rotate counter-clockwise
(the budget line becomes flatter) and the X-intercept increases, say from to

14
3. Let us now introduce the change (increase) in the price of Y, keeping the price of X and
money income unchanged. What will happen to the budget line?

Quantity of Y
M A
PY

M
P 'Y

B X
O M
PX Quantity of X
Figure: Effect on the budget line of increase in price of Y, price of X and money income remaining intact

Suppose that the price of Y increases from to , and , and M remain unchanged.
Since and M are constant, the X-intercept does not change-it is in each case as

depicted in Figure above. But, the slope of the budget line changes from to .

Since > , > and the Y-intercept is lower in the second case ( < ) and

the X-intercept is independent of . Thus, a rise in price of Y from to rotates the

budget line counter-clockwise around the X-intercept.
It is crucial to note here that a fall in the price of Y, all other things remaining the same, has
an opposite effect on the budget line and Y-intercept while the X-intercept is still
independent of . Here, due to a decrease in price from to , the Y-intercept increases

from to and the budget line increases ( < ) since < .

Quantity of Y

This can be shown graphically as follows:

0 M/Px Quantity of X
Figure: Effects on the budget line of a fall in price of Y, keeping price of X and money income unchanged

15
Note that figure above is the exact opposite of figure that precedes it. Here, the budget line is
steeper since > but in Fig. 4, the budget line is flatter since < .
What happens to the budget line when we change the price of good X and good Y at the
same time, keeping money income the same? Suppose for example that we double the prices
of both goods X and Y. In this case, both the X and Y intercepts shift inward by one-half as
well. Multiplying both prices by two is just like dividing income by 2. We can also see this
algebraically. Suppose our original budget line is:
Now suppose that both prices become two times as large. Multiplying both prices by t yields:

Thus, multiplying both prices by a constant amount t is just like dividing income by t. It
follows, therefore, that doubling the prices of both goods at the same time is tantamount to
dividing income by the same price and hence will not change the slope of the budget line at all.
In summary,
1. A change in money income, prices unchanged, is shown by a parallel shift of the budget
line-outward and to the right for an increase in money income, and in the direction of the
origin for a decrease in money income.
2. A change in the price of X, the price of Y and money income constant, is shown by
rotating the budget line around the ordinate intercept – to the left for a price increase, and
to the right for a decrease in price.
3. A change in the price of Y, the price of X and money income constant, is shown by rotating
the budget line around the X-intercept – up for a price decrease and down for a price increase.
REVEALED PREFERENCES HYPOTHESIS
The basic idea is simple. If a consumer chooses one market basket over another, and if the chosen market basket
is more expensive than the alternative, then the consumer must prefer the chosen market basket.

X2

(X1, X2)
**

*
(Y1, Y2)

X1
Figure: Revealed Preferences: Two Budget Lines
Consider figure (X
The bundle above
1, X2)where a consumer’s
that the demanded
consumer chooses bundle preferred
is revealed (X 1, X2) and another
to the bundlearbitrary
(Y , Y ), a bundle that he could have chosen.
bundle1(Y12, Y2) i.e., beneath the consumer’s budget line are depicted. The bundle (Y 1, Y2) is
certainly an affordable purchase at the given budget-the consumer could have bought it, if
16
preferred, and would even have had money left over. Since (X 1, X2) is the optimal bundle, it
must be better than anything else that the consumer could afford. Hence, in particular it must
be better than (Y1, Y2).
The same argument holds for any bundle on or underneath the budget line other than the
demanded bundle. Since it could have been bought at the given budget but was not, then
what was bought must be better. Here is where we use the assumption that there is a unique
demanded bundle for each budget. If preferences are not strictly convex, so that indifference
curves have flat spots, it may be that some bundles that are on the budget line might be just
as good as the demanded bundle.
In figure above, all of the bundles underneath the budget line are revealed worse than the
demanded bundle (X1, X2). This is because they could have been chosen, but were rejected in
favor of (X1, X2).
Let (X1, X2) be the bundle purchased at prices (P1, P2) when the consumer has income M:

Since (X1, X2) is actually bought at the given budget, it must satisfy the budget constraint
with equality:
.
Putting these two equations together, the fact that (Y 1, Y2) is affordable at the budget (P 1, P2,
M) means that:
.
If the above inequality is satisfied and (Y1, Y2) is actually a different bundle from (X1, X2),
then (X1, X2) is directly revealed to (Y1, Y2).
Important point is that the left hand side of this inequality is the expenditure on the bundle
that is actually chosen at prices (P 1, P2). Thus, revealed preference is a relation that holds
between the bundle that is actually demanded at some budget and the bundles that could have
been demanded at that budget. When we say that X is revealed preferred to Y, it means that
X is chosen when Y could have been chose; that is, that:

THE OPTIMUM OF THE CONSUMER:

The consumer is in equilibrium when he/she maximizes his/her utility, given income and the
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.

1) , which is the necessary condition.

2) The IC is convex to the origin (decreasing MRSx, y).

Graphically, the equilibrium of the consumer is at the point of tangency of the budget line
and the highest possible IC (at point e).

17
At the point of tangency (point e) the slope of the budget line and of the IC

are equal. Thus, the consumer maximizes utility by buying X* & Y* of

the two commodities.
Mathematical derivation of the equilibrium of the consumer is as follows:
- Assume that there are two commodities, X & Y. The consumer is in equilibrium when
he/she maximizes utility given hi/her income and the market price of the commodities.
- Formally the problem can be stated as:
Maximize U = f(X, Y)
Subject to M = PX.X + PY.Y
- By using the Lagrangean method, the steps involved are:
a) rewrite the constraint as: Px.X + Py.Y – M = 0
b) Multiply the constraint by a constant  (Lagrangean multiplier) (Px.X + Py.Y – M) = 0
c) Subtract from the objective function to obtain a composite function.
 L = U - (Px.X + Py.Y – M)
d) Derivate L with respect to X, Y, &  and equate to zero.
1. L/X = U/X - Px = 0
=> U/X = Px
=>MUx = Px
=>  = MUx/ Px……………………………………………. (1)
2. L/Y = U/y - Py =0
=> U/y = Py
=>MUy = Py
=>  = MUy/Py…………………………………………….. (2)
3. L/ = Px.X + Py.Y – M = 0…………………………... (3)
From (1) and (2), we can infer that =:
 MUx/ Px = MUy/Py
 MUx/ Px = MUy/Py

18
 We observe that the equilibrium conditions are identical in the cardinal’s approach and in
the Indifference curve approach. In both theories we have:
EXAMPLE
Let us assume that an individual, whose income is birr 10 consumes two types of goods, X &
Y, whose prices are Px = 2 and Py = 1, spend all his income on these goods. By using the
above information and the MU table given below for the two goods, answer the following questions.
(A) Indicate how much of X & Y the individual should purchase to maximize utility.
(B) Show that the condition for constrained utility maximization is achieved.
(C) Determine how much total utility the individual receives when he/she maximizes
utility. How much utility would the individual get if he/she spent all income on X/Y?
X MUx Y MUy MUx/Px MUy/Py
1 10 4 5 5 5
2 6 5 4 3 4
3 4 6 3 2 3
4 2 7 1 1 2
5 0 8 0 0 1

Solution:
(A) The individual maximizes his/her utility when he/she consumes 2 units of X and 6
units of Y since at this point MUx/Px = MUy/Py
(B) The condition for utility maximization is that MUx/Px = MUy/Py, give that all the
consumer income is spent.
Thus, at the optimum of the consumer,
MUx/Px = MUy/Py => 3 = 3 and PxX + PyY = M
 2(2) + 1(6) = 10
 10 = 10
(C) TU = ∑MUs = ∑MUx + ∑MUy (i.e., summation of MUs up to respective optimal level)
 TU = (10 + 6)X + (5 + 4 + 3)Y
 TU = (16)X + ( 12 )Y
= 28

 If the individual spend all his/her income on X only, he/she will get the total utility of:
TUx = ∑MUx
= 10 + 6 + 4 + 2 + 0
= 22
This is because the consumer can consume 5 units of X given that his/her income is 10 birr
and Px is 2 birr.
 if the consumer spend all his/her income on Y:
TUy = ∑MUy
=5+4+3+1+0

19
 = 13
INCOME CONSUMPTION CURVE (ICC) AND ENGEL CURVE:
Increase in income shifts the budget line outward in a parallel manner (if commodities prices are kept
constant). If we go on increasing income (i.e., shifting the budget line outward), we will have a set of
optimum points corresponding to each budget line. The curve which connects these optimum points is
called the Income Consumption Curve (ICC). It is the locus consumer optimum points resulting only when the
consumer income changes. The ICC is also known as the Income Offer Curve or the Income Expansion Path.
From the ICC we can then derive the consumer Engle Curve. The Engle curve shows the amount of a
good (X) that the consumer would purchase per unit of time at various income levels. To derive the Engle
curve we keep the same horizontal scale as in the top panel but measure money income on the vertical axis.
NORMAL AND INFERIOR GOODS:
A normal good is one of which the consumer purchases more with an increase in income. An inferior good
is one of which the consumer purchases less with an increase in income. If Good X is a normal good
because the consumer purchases more of it with an increase in income. This is shown by a positively
sloping income consumption curve and the Engle curve. However, for an inferior good, the income
consumption curve and the Engle curve are negatively sloping because as income increases, the consumer
purchases less of these commodities. These are shown by the following graphs.
The classification of goods as normal or inferior depends only on how a specific consumer views the
particular good. Thus, the same good X can be regarded as a normal good by another consumer.
 Furthermore, a good can be regarded as a normal good by a consumer at a particular level of income
and as an inferior good by the same consumer at a higher level of income.
 A normal good can be further classified as a necessity or a luxury depending on whether the quantity
purchased increases proportionately more or less than the increase in income.
Quantity of Y

Quantity of Y

ICC
L’' ICC L''
L' c
L' IC3
Quantity of good x

L Q R IC3
L b
IC2 IC2
P Engel
IC1 curve a
Engel
curve

IC1
Quantity C'
Quantity
OX3 X1 X2 X3 R'
M'' of X X1
O X3 X2 X1 of X
M M' B' M M' M''
X2 Q'
Figure: Income consumption curve (for aX2 Figure: Income consumption
A'curve (for an
X1
P' good)
normal inferior good)
X3
Money 20
O M2 M3 income
M 1

O M1 M2 M3 Money
Figure: Engel curve for a normal good Figure: Engle curve for an inferior good income
Engle Curve

The above two curves are called Engel curves after a German statistician Ernst Engel, an
economist of the 19th century (1821 - 1896) who first studied the relationship between family
incomes and quantities demanded of different goods. Engel curves show the relations
between consumer incomes and dollar expenditures. There is also Engel law, which states
that the lower a family's income, the greater is the proportion of it spent on food. Engel's
conclusion was based on a budget study of 153 Belgian families and was later verified by a
number of other statistical inquiries into consumer behavior. Therefore, the Engel curve
shows the quantities of a good demanded at various income levels, holding money prices constant.

The Engel curve is very often positively sloped so that the quantity of the good demanded
rises with income. This type of good is called a normal good. The Engel curve need not
always be positively sloped so that an increase in income leads to a decrease in quantity
demanded. In this case, the good is an inferior good. Thus, for inferior goods, the Engel
curve is downward-sloping.

The Engel curves for food, housing and diamond are depicted here under:
Diamond
Income
Food
Housing

O
Expenditure
Figure: Engel curves for food, housing and Diamond

21
The figure shows that families with low incomes spend more on food than on housing
whereas families with high incomes spend more on housing than on food. Expenditures on
diamond are zero for families with low incomes and high for families with large incomes.
The figure also shows that although expenditures on all three commodities are larger for
families with higher incomes, food expenditure increases less proportionately to incomes
whereas housing expenditure increases proportionately to income after some initial level.
Expenditure on diamond increases more proportionately to income. In other words, the
income elasticity of demand for food is less than unity, that of housing is unity, and that of
diamond is greater than unity.
PRICE CONSUMPTION CURVE AND CONSUMER'S DEMAND CURVE:
Assume that money income and the nominal price of good Y remain constant while the
nominal price of good X falls. Thus, we can generate a set of budget lines by holding the
price of good Y and money income constant while varying the price of good X (see figure below).
Quantity of Y

M
A
Py

Price-consumption curve

P Q R
IC3
IC2
IC1
Quantity of Y

O X1 B X2 X3 B' B''

P' Quantity of X

Q'
R' Individual demand curve

O X1 and Individual
Figure: Price-Consumption Curve X2 X3 Demand
Quantity
Curve of X

The individual consumer's demand curve for a commodity can be derived from the price consumption
curve. When the price of good X is given by the slope of AB, OX 1 units of X are purchased. Similarly,
when the price of good X falls to the level indicated by the slope of AB', quantity purchased increases to
22
 OX2. Finally, when price of good X further falls to the level indicated by the slope of AB", quantity
purchased increases to OX3. Plotting all points so obtained and connecting them with a line generates the
consumer demand curve. The law of demand from the consumer demand curve states that quantity
demanded varies inversely with price of good X, nominal price of good Y and money income remaining intact.
Thus, we derive the demand curve by plotting the price quantity pairs defined by the points of equilibrium
(on the price consumption curve) on the price quantity space. The demand curve for normal goods (goods
whose demand increases with increase in income) will always have a negative slope denoting the law of
demand which states that the quantity demanded increases as price increases and vice versa. In the case of
Giffen goods the demand for a good decreases when its price decreases.

Mathematical derivation of the demand curve:

Derive the demand function for good X and Y, given Px, Py, & M and the utility function as:
.
Solution
=> M = PxX + PyY
At the optimum choice, the slope of IC (MRSx,y = MUx/MUy) is equal to the slope of the budget
line(Px/Py). That is, MUx/ MUy = Px/ Py
But MUx = U/ X = ¼ Y and
MUy = U/ Y = ¼ X
 ¼ Y/ ¼ X = Px/ Py
 PyY = PxX----------------------------------------(1)
The budget constraint is M = PxX + PyY
=> Y = M/ Py – Px/Py X------------------------------ (2)
Substitute (2) in to (1):
 Py ( M/ Py – Px/ Py X) = PxX
 M – PxX = PxX
 2PxX = M
 → is the demand function for X.
To obtain the demand function for Y:
M = PxX + PyY
=> PxX = M – PyY
X = 1/PxM – (Py/Px) Y-------------------------------- (3)
Substitute (3) into (1)
 PxX = PyY
 Px(1/PxM – Py/PxY) = PyY
 M – PyY = PyY
 2PyY = M
 → is the demand function for Y.

For Cobb-Douglas utility function: U (X1, X2) = X1c X2d

23
cP2X2= dP1X1

From (condition 3):

where

e)
f)

The proportion of income spent on X1 and X2 at the consumer optimum becomes:

The % of income which is spent on X1

Proportion of m spent on X1 and X2, respectively

The % of income which is spent on X2

a is the proportion of m spent on X1

1-a is the proportion of m spent on X2
U = f (X1, X2, ........, Xn)

Example:
Suppose a consumer spends his/her entire income on food (X 1) and clothing (X2) and 25% of
the total income is spent on food. If price of X 1 = 2, prices of X2=3, M = 200, estimate
function & determine the optimum quantity of X1 & X2.

U (X1, X2) = X1¼, X2 ¾

 X1= 0.25*200/2 = 25,

 X2 = 0.75*200/3=50
24
Exercise: Given utility function: U(x, y) = X1/3Y2/3, Px = 2, Py = 5 and M = 400, find:
(1) The demand equation for X and Y.
(2) The utility maximizing levels of X and Y.
(3) The maximum utility.
(4) The MRSx, y at the optimum level.

25
 DECOMPOSITION OF INCOME AND SUBISTITUTION EFFECTS
A fall in the price of a good has two effects:
(1) The consumer will tend to buy more of a good that has become cheaper and less of those
goods that are now relatively expensive. The consumer will tend to substitute cheaper
commodity for relatively expensive one. This response to the change in relative prices of
goods is called the substitution effect.
(2) Because one of the goods is now cheaper, the consumer enjoys an increase in real
purchasing power. The consumer is better off because he/she can buy the same amount of
the good for less money and thus money left over for additional purchases. The change in
demand resulting from this change in real purchasing power is called the income effect.

The substitution effect is the increase in the quantity bought as the price of the commodity
falls after adjusting income so as to keep the real purchasing power of the consumer the same
as before. This adjustment in income is called compensating variation and is shown
graphically by a parallel shift of the new budget line until it becomes tangent to the initial IC.
The purpose of the compensating variation is to allow the consumer to remain on the same
level of satisfaction as before the price change.

In the following graph, the consumer was initially at point E 1 on the budget line AB. When
the price of X falls, the budget line has rotated from AB to AB’ is resulting in a new
equilibrium point E2. The increase in the consumption of X from X 1 to X3 is the total effect of
a fall in the price of X which can be decomposed into substitution effect and income effect.
In order to split these two effects, we draw a parallel budget line (compensating budget line)
which is tangent to the original indifference curve (IC1).

This allows the real purchasing power of the consumer to remain as before and thus to reject
the income effect so the consumer will be on the same level of satisfaction as before.
Accordingly, the movement from point E1 to E1’ shows the substitution effect of the price
change (the consumer buys more of X now that it is cheaper, substituting X for Y).
 Y

A’

E1 E2

E1’ IC2

IC1

O X
X1 X2 B X3 A’ B’
The substitution effect is negative for all goods since the consumer substitutes the cheaper for
more expensive one. This implies a decrease in price leads to an increase in quantity
demanded.

The movement from E1’ to E2 is the income effect of the fall in the price of X. To isolate the
income effect, we assume that the relative price of the goods has not changed (shown by the
parallel line AB’ and A’A’). The income effect in this case can be thought of as being
negative (comparing the direction of the change in price and quantity demanded of a good) or
a positive (comparing the direction of the change in the purchasing power of the consumer
and the quantity demanded).
=> For normal good, income effect of a price change is negative, i.e. Px =>PP=> X.
Ultimately, Px => X.
=> For inferior good, income effect of a price change is positive, i.e. Px =>PP=> X.
Ultimately, Px => X.
 PANEL A PANEL B
Y Y

A
A
E2

A’
A’ E2
E1
E1 U2

U2 E1’
E1’

U1 U1
O B X
X1 X3 X2 A’ B’ X3 X1 X2 B A’ B’
SE
SE
IE IE
TE TE
TE = SE + IE TE = SE + IE
X1X3 = X1X2 +X2X3 X1X3 = X1X2 +X2X3
For an inferior good whose negative substitution effect more offsets than the positive income
effect (panel A above), the total effect will be negative (Px  => Qx) and thus the law of
demand holds. If, however, the IE is positive and very strong that it offsets more than the
negative SE, the demand curve will have a positive slope (Px => Qx)  the GIFFEN
PARADOX. A Giffen good is a good whose demand curve slopes upward because the
positive IE is larger than the negative SE (panel B).
Table. Substitution and Income Effects of a price fall on quantity demanded (summary)
Types of Good Substitution Effect Income Effect Total Effect
Normal Increase Increase Increase
Inferior (but not Giffen) Increase Decrease Increase
Giffen Increase Decrease Decrease

The Total Change in Demand

In general, to calculate how much we have to adjust money income in order to keep the old
bundle just affordable. Let M1 be the amount of money income that will just make the
original consumption bundle affordable; this will be the amount of money income associated
with the pivoted budget line. Since (X1, X2) is affordable at (P1, P2, and M1), we have:
Subtracting the second equation from the first gives:

This equation says that the change in money income necessary to make the old bundle
affordable at the new prices is just the original amount of consumption of good X times the
change in prices.

Letting represents the change in price 1, and represents the

change in income necessary to make the old bundle just affordable, we have:

Now we have a formula for the pivoted budget line: it is just the budget line at the new price
with income change by ∆M. Note that if the price of good 1 goes down, a consumer’s
purchasing power goes up, so we will have to decrease the consumer’s income in order to
keep purchasing power fixed. Similarly, when a price goes up, purchasing power constant
must be positive.
The substitution effect is the change in the demand for good X when the price of good
X changes to P 1 and, at the same time, money income changes to M1:
1

In order to determine the substitution effect, use the consumer’s demand function to calculate
the optimal choices at (P11, M1) and (P1, M). The change in demand for good X may be large
or small, depending on the shape of the consumer’s indifference curves.
The substitution effect is sometimes called the change in compensated demand. The idea is
that the consumer is being compensated for a price rise by having enough income given back
to him to purchase his old bundle. Of course, if the price goes down he is compensated by
having money taken away from him.
More precisely, the income effect, , is the change in the demand for good X when we
change income from M , to M, holding the price of good X fixed at P11:
1

The total change in demand, ΔX1 is the change in demand due to the change in price, holding
income constant;
.

This can be broken up into substitution effect and the income effect. In terms of symbols
defined above,

This equation is called Slutsky’s Identity (Named after Russian economist Eugen Slutsky,
1880-1948). In words, this equation says that the total change in demand equals the
substitution effect plus the income effect. It is called identity because; it is true for all values
of P1, P|1, M and M|. The first and fourth terms on the right hand side cancel out, so the right
hand side is identically equal to the left hand side.

The content comes from the interpretation of two terms on the right hand side: substitution
effect and the income effect. While substitution effect must always be negative (i.e., opposite
the change in the price), the income effect can go either way. Thus, the total effect may be
positive or negative. However, if we have normal good, then the substitution effect and the
income effect work in the same direction. An increase in price means that the demand will
go down due to the substitution effect. If price goes up, it is like decrease in income, which,
for a normal good, means a decrease in demand.

The Law of Demand: If the demand for a good increases when income increases, then the
demand for that good must decrease when its price increases.
This follows directly from the Slutsky equation: if the demand increases when income
increases, we have normal good. In addition, if we have a normal good then the substitution
effect and the income effect reinforce each other, and an increase in price definitely reduce
demand.
Some Examples with Perfect complements and substitutes:
Slutsky’s decomposition is illustrated in the first figure below. When we pivot the budget
line around the chosen point, the optimal choice at the new budget line is the same as at the
old one – this means that the substitution effect is zero. The change in demand is due
entirely to the income effect.
The case of perfect substitutes illustrated in the second figure below. It describes when we tilt
the budget line, the demand bundle jumps from the vertical axis to the horizontal axis. This
is because of the entire change in the demand is due to the substitution effect.
X2 Indifference curves

Original budget
line

Final budget line

Pivot Shift

Income effect = Total effect

X1

Figure: Perfect Complements. Slutsky decomposition with perfect complements

 X2
Indifference curves

Final budget line

Original Choice

Final Choice
Original budget line

Substitution effect = total effect X1

Figure : Perfect substitutes. Slutsky decomposition with perfect substitutes

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

A Numerical Example: Calculating the Substitution Effect

Suppose that the consumer has a demand function for milk of the form .
Originally his income is Br.120 per week and the price of milk is Br.3 per unit. Thus, his
demand for milk will be units per week. Now suppose that the price of milk

falls to Br.2 per unit. Then his demand at this new price will be units of milk
per week. The total change in demand is +2 units a week.

In order to calculate the substitution effect, we must first calculate how much income would
have to change in order to make the original consumption of milk just affordable when the
price of milk is Br.2 per unit. We apply the formula

Thus, the level of income necessary to keep purchasing power constant is

What is the consumer’s demand for milk at the new price,
Br.2 per unit, and this level of income? Just plug numbers into the demand function to find.

Thus the substitution effect is .

Calculating the Income Effect:

Thus, the income effect for this problem is:

. Since milk is a normal good for this
consumer, the demand for milk increases when income increases.

DERIVATION OF THE MARKET DEMAND

 In our previous discussion, we have derived the individual demand curve from the utility
maximization behavior of consumers. Now we will derive the market demand from this
individual demand curves. As it has been proved, the individual demand is negatively related
to the price commodity in the sense that when price decrease, the individual consumer
purchases more of the commodity in order to maximize his/her utility. The market demand
curve for the commodity is simply the horizontal summation of the demand curve of all the
consumers in the market. In other words, the quantity demanded in the market at each price is
the sum of the individual demands of all consumers at that price.

EXAMPLE
Assume that there are two consumers in the market for a particular commodity X (say
hamburger) and their demand at each price is given as follow:
Price ($) Qx dded by A Qx dded by B Market demand
2 2 2 4
1 6 4 10
0.5 10 6 16

Graphically, the market demand can be derived as follows:

Px Px Px
Individual A Individual B Market demand

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

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

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

d1 d2 Mkt DD

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

Thus, the market demand for a commodity shows the various quantities of the commodity
demanded in the market per unit of time at various alternative price of the commodity while
holding everything else constant. The market demand for a commodity is negatively sloped
(just as an individual demand curve), indicating that price and quantity are inversely related.
That is, the quantity demanded of the commodity increases when its price falls and decreases
when its price rises. Price
Consumer's Surplus
N
Consumer's surplus is the difference between what a consumer actually pays for a good or
service and what he would have been willing to pay. It is a deduction from the law of
R
diminishing marginal utility. In the precedingP0 session, we said that a consumer keeps on
0O
buying more and more of a good until that good's marginal utility falls to the price
D level. The
O
Q0 Quantity
price a consumer pays for a good, therefore, measures only the marginal utility, but not the
total utility. Table below reveals this fact.

Table. Consumer Surplus Analysis

Price Quantity
8 1
6 2
4 3
2 4

As the Table shows, when the price of the good is birr 8, the consumer is willing and able to
buy 1 unit. This implies that from the first unit of the good he expects to get satisfaction
worth at least birr 8. If price decreases to birr 6, he/she will buy the second unit which means
that from the second unit he obtains additional satisfaction worth birr 6. He pursues the same
analogy to buy the third and fourth units.

Suppose the market price for the good is birr 2 per unit and the consumer decides to buy 4
units. Even though the consumer is willing and able to pay the different prices for the
different units of the good, in the market, there cannot be more than one price for the
different units of the same good. This means that all the 4 units are purchased at the same
price (birr 2 per unit). From the definition of consumer surplus it follows that consumer
surplus from the first unit equals birr 6 (8 - 2). The second unit yields surplus of birr 4(6 - 2).
Consumer surplus on the third unit is birr 2(4 - 2). On the fourth unit, however, since the
marginal utility and price are equal, there is no consumer surplus - marginal utility minus
market price equals 0(2 - 2). Therefore, the total consumer surplus equals birr 12(6+4+2).
The other way to determine consumer surplus is total utility minus total expenditure. In this
particular case, total utility derived from the 4 units is birr 20(8+6+4+2), but the total
expenditure on the four units is birr 8(4X2). Thus, consumer surplus equals birr 12(20 - 8).

Geometrically, consumer surplus is illustrated in figure above where P 0 is the market price
and Q0 is the quantity purchased. The area under the demand curve ONRQ 0 is the total utility
obtained (the total expenditure the consumer is willing and able to make). The rectangular
are OP0RQ0 is the total expenditure actually made (P 0 X Q0). The difference between the two
areas which equals the triangular area (P0NR) is the consumer's surplus.

Equation form of Consumer's Surplus:

Suppose the demand for a certain good is given by the following equation: Q x = 75 - 3Px. If
price equals $15,
a. what will be the quantity demanded (bought) by the consumer?
 b. what will be total consumer's expenditure?
c. what will be the value of consumer's surplus?
Solution
a) Qx = 75 - 3Px
= 75 - 3(15)
= 75 - 45
= 30 units
b) Total Expenditure = Price X Quantity bought
= $15/unit X 30 units
= $ 450

c) Qx = 75 - 3 Px 25 d Consumer's Surplus =

= -3Px + 75 = Qx 10
= -3 Px = Qx - 75
15
30
=> Px = - Qx + 25 d

O 30
 what the consumer would be willing to pay for 30 units is $450 + $150 = $600
 what the consumer actually paid for 30 units is $450 ($15X30)
 consumer's surplus = $600 - $450 = $150

ELASTICITY OF DEMAND
The concept of elasticity is used to measure the amount by which the quantity demanded
changes when its determinants change. There are as many elasticities of demand as there are
its determinants. The most important of these elasticities are:
(A) The price elasticity of demand
(B) The income elasticity of demand
(C) The cross-elasticity of demanded

THE PRICE ELASTICITY OF DEMAND

The price elasticity is a measure of the responsiveness of demand to changes in the
commodity’s own price. If the changes in price are very small we use as a measure of the
responsiveness of demand the point elasticity of demand. If the changes in price are not small
we use the arc elasticity of demand as a relevant measure.

The point elasticity of demand is defined as the proportionate change in the quantity
demanded resulting from a very small proportionate change in price. Symbolically, we may write as:
Arc price elasticity is given by:

At the mid-point of a linear demand curve ep = 1 (point M). At any point to the right of M
the point elasticity is less than unity (ep < 1); finally at any point to the left of M, ep > 1. At
point D, the ep  , while at point D’ the ep = 0.The price elasticity is always negative
because of the inverse relationship between Q and P implied by the law of demand.
However, the negative sign is omitted when writing the formula of the elasticity.
The range of values of the elasticity is 0  ep  .
(1) If ep = 0, then the demand is perfectly inelastic
(2) If ep = 1, then the demand is unitary elastic
(3) If ep = , then the demand is perfectly elastic
(4) If 0< ep < 1, then the demand is inelastic
(5) If 1 < ep <, then the demand is elastic.
Px
D  ep=
ep>1

M ep = 1

ep<1

ep = 0
0
INCOME ELASTICITY OF DEMAND
The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in income.

If ey > 0, then the commodity is normal

If ey < 0, “ “ “ inferior.
If ey > 1, “ “ “ luxury.
If 0 < ey < 1, “ “ necessity

THE CROSS- ELASTICITY OF DEMAND

The cross elasticity of demand is defined as the proportionate change in quantity demand of
X resulting from a proportionate change in the price of Y.

If exy < 0, then X & Y are complementary goods

If exy > 0, “ “ substitute goods.
If exy = 0, then X & Y are unrelated goods
 CHAPTER 2: CHOICE UNDER RISK AND UNCERTAINTY
2.1. Introduction
So far we have been implicitly assuming that information on prices and income is known by
the consumer (decision maker). But many of the choice problems that the consumers face
entail uncertainty about the possible outcomes of income price and other variables. Note
that, information is a key input in decision making. Decision made under uncertainty of
information involves some kind of risk.

Uncertainty is a situation which can result in a number of outcomes but one is not sure as to
which outcome is to be materialized. On the other hand, risk is a consequence that one has to
face as a result of the variability of outcomes from uncertain situation.

To analyze the choice behavior under uncertainty we need to quantify/measure/ risk. To

quantify risk, we need to know all the possible outcomes of an uncertain situation and the
likely hood of occurrence of each of these events => Probability.

Example: If we toss a fair die there are six equally likely outcomes. The probability that
each side turn up is 1/6.

Probability can either be objective or subjective. We say probability is objective, when

probability is assigned based on observation with regard to the frequency at which the
outcome occurred in the past. On the other hand, probability is called subjective probability,
when probability is assigned based on personal assumption.

Utility Function under Uncertainty

If the consumer has reasonable preferences about consumption in different circumstances, a utility
function can be used to describe these preferences. However, under conditions of uncertainty some
additional structure, called probability, needs to be added to the choice problem.

Thus the utility function is defined based on the consumption levels as well as the
probabilities of the state of nature. Let C 1 & C2 represent consumptions in two states and let
& be their respective probabilities, then we can write our utility function for the
different consumption states as U (C1, C2, & ).

2.2. Expected Utility

Expected Utility – it is outcome expected on average. It is the weighted average of all
possible outcomes of an event (the weights being probabilities).
Example: Take an event that can result in two possible outcomes.
X1 = Outcome 1
X2 = Outcome 2
E(X) = Expected Outcome
Let is the probability of outcome 1 & is the probability of outcome 2, then:
E(X) = X1 + X2.
The formalization of consumer choice theory under uncertainty was initially by Neuman and
Morgenton. The central premise of the theory is that consumer’s choose the alternative with
the highest expected utility rather than the highest value.

Like other utility functions, the expected utility function can be subject to monotonic
transformation. The specific form of the utility function depends on the nature of individual
consumer preferences. In consumption possibilities state 1 & 2 are perfect substitute U (C 1,
C2, & )= X1 + X2. The Cobb Douglas form is also possible. U (C 1, C2, &

)= . By taking the monotonic transformation we can re-write the utility function as

lnC1 + lnC2. But, the former representation doesn’t have the expected utility property,
while the latter does.

On the other hand, the expected utility function can be subject to some kinds of monotonic
transformation and still have expected utility property. This special kind of monotonic
transformation is called positive affine transformation which has the form of V (U) = au + b,
where a > 0. Positive affine transformation means multiplying the utility function by some
positive number and adding a constant.

Economists argue that we can apply an affine transformation to expected utility and get
another expected utility function that represents the same preferences. However, if any other
kind of transformation is applied, it will destroy the expected utility property.

There are compelling reasons why expected utility is a reasonable for choice problems in the
face of uncertainty. The fact that outcomes of the random choice are consumption goods that
will be consumed in different circumstances means that ultimately only one of those
outcomes is actually going to occur.

The consumption that will be available to the consumer under the two states of nature can be
taken as independent with what the consumer will have if it didn’t occur. And such additive
form of expected utility function is acceptable for mutually exclusive uncertain outcomes.

If there are n outcomes with their respective probability, C 1- , C2- , C3- - - -Cn- , then
the Expected utility will be E (U) = C1+ C2 + C3+-- - - + Cn
N.B: The expected utility function satisfies the condition that the marginal rate of
substitution between the two goods is independent of how much there is of the 3 rd good. For
example U (C1, C2, C3 , & ) for a given utility function MRS 12=MU1/MU2=

Thus, from this we can conclude that U (3) will not be involved in the calculation of MRS12.

Variability
Variability – refers to the event to which the individual outcomes are likely to vary from their
expected value. We use variance or standard deviation to see the variation of individual
outcomes from their expected value.

Variance = =

= [X1 – E(X1)]2 + [X2-E(X2)]2 +------ + [Xn-E(Xn)]2

Choice with high variability results in high risk and similarly choice with low variability
results in low risks.
Example
Outcome 1 Outcome 2
Income probability Income probability
Business 1 2000 0.5 1000 0.5
Business 2 1510 0.99 510 0.01

Expected income of business 1 =>E (1) = 0.5(2000) +0.5(1000) =1500

Expected income of business 2 =>E (2) = 0.99 (1510) +0.01(510) = 1500

Variance= =

Variance 1=0.5(250,000) +0.5(250,000) = 250,000

Variance 2= 0.99(100) +) 0.01(980100) = 9900

The outcome of the first business deviate from their expected value more than the second
business and so is more risky. The preference of an individual will depend on his risk behavior.

Risk Aversion
Risk aversion is a tendency to prefer a given amount of income with certainty than taking a
gamble with high possible return and possible loss. For risk averse person the utility from a
given amount of income is greater than the expected utility from different levels of income
with similar expected value.
Take a person whose utility depends on the level of income as follows. Suppose the person
currently has 20,000 she is considering a business which will increase her wealth to 30,000 if
the business succeeds but reduce her wealth to 100,000 if it fails.

Each success and failure has equal probability of 0.5. A utility for each state is given as follows.
U(20,000) = 16, U(10,000) = 10, U(30,000) = 18
Expected utility of wealth = 0.5U (30) + 0.5U (10)
= 0.5(18) + 0.5(10)
= 14
U (20) > E(U), for U(20) is 16 and E(U) is 14. Because of this the risk averse consumer
accepts this gamble.

Note that: Risk aversion prefers a certain income to a risky income with the same
expected value.

This is depicted in the following figure.

Th
UTILITY

u (30)=18 u (wealth)
u (20)=16
.5u(10)+.5u(30)=1
4

u(10) =10

10 20 30 WEALTH
Risk Aversion. For a risk-averse consumer the utility of the expected value of
wealth, u(20), is greater than the expected utility of wealth, .5u(10)+.5u(30).

e risk averse consumer has a concave utility curve. This implies that the slope of a utility
curve gets flatter as wealth increases. The reason is that risk averse consumer has a
diminishing marginal utility of income.
The marginal utility of income decreases with increasing level of wealth. This implies that
the gain in utility from a given amount of additional wealth is smaller than the loss in utility
from a comparable loss in wealth. That is why such a person always refuses to accept a
gamble whose expected value is less than expected utility.
 Risk Loving
This is a situation where the utility from a given amount of wealth (income) is less than the
expected utility.

Utility
U (wealth)

U(30)=18
E (U)=

.5U(10)+.5u(30

U(20) =8

U(10)=3

10 20 30 Wealth

The risk lover consumer has a convex utility function. The slope of the utility function gets
steeper and steeper as wealth increases. For such consumer, marginal utility increases with
increasing level of wealth. This implies that the gain in utility from a given amount of
additional wealth is greater than the loss in utility from a comparable loss in wealth. That is
when such a person always accepts a fair gamble.

The curvature of the utility function measures the consumer’s attitude towards risk. The
more concave the utility curve, the more risk averse the consumer is. In contrast, the more
convex the utility curve, the more risk lover the consumer is.
RISK NEUTRAL
If a person is indifferent between a given amount of wealth with certainty and expected value
the person is said to be risk neutral.

Utility

U(30)=1 u (wealth)
8
Given U(10)=6
U(20)=12
U(30)=18
U(20)=12

U(10)=
6

5 10 15 Wealth

A risk neutral consumer has straight line utility curve.

Exercise:
There are two outcomes if the person succeed he will get additional birr of 20, and if he loses
he will lose 20 birr. Each, loss and success, have 0.5 probability. Will the person accept the
gamble, if he is risk neutral?

2.4 DIVERSIFICATION
Given that a consumer is a risk averse. He minimizes the risks of uncertainty, by
diversifying his holding or assets. When one puts his effort in different types of (unrelated)
activities, the loss from badly performing activities can be compensated by gain from well
performing activities. By this method one can minimize his/her risk, this method of
minimizing risk is said to be diversification.

Example: Consider a person thinking of investing Br. 1000 in two companies, one is heater
producing and the other is air conditioners producing company. The share of stock for both
companies currently is sold for Br. 100 each. The next season is equally likely to be hot or
cold. If the next season turns out to be cold, the securities of the heaters company will be
worth Br.200 each and securities of Air Conditioners Company will be worth of Br.50 each.
And if the next season turns out to be hot the reverse will happen.
Let’s compare two cases:
1) If the person puts the whole investment in one of the companies say heater.
 Outcomes Probabilities
Cold 200,000 (200X1000) .5
Hot 50,000 (50X1000) .5

2) If the person equally divides his investment and put in the two companies: and if the
weather turns out to be cold.
Outcomes
From heater 100,000 (200x500) 125,000 certain income
Air conditioner 25,000 (50x 500)

If the weather turns out to be hot:

From Air conditioner 100,000 (200x500) 125,000 certain income
Heater 25,000 (50x500)

2.5 RISK SPREADING

In the absence of formal insurance, a group of individuals can agree to share a loss incurred
by each individual from their group. Each consumer (individual) in a group spreads his/her
risk over all of the other consumers and there by reduces the amounts of risk.

Example: Consider a situation of an individual who had Br.3500 and faced a 0.1 probability
of Br.10, 000 losses. Suppose that there were 1000 such individuals. On an average, 10
losses are expected to occur, thus Br.100, 000 will be lost each year.

Suppose that the 1000 individuals decide to insure one another. If anybody incurs 10,000
loss, each of the 1000 individuals contribute Br.10 to the loss that individual is facing. By
this they minimize their loss. On average one individual is expected to pay Br100.
 CHAPTER 3: THE THEORY OF PRODUCTION

3.1. THE PRODUCTION FUNCTION

In the production process/activity, firms turn inputs into output. This transformation of inputs
(factor of productions) into output at a particular time period and at a given technology (state
of knowledge about the various methods that might be used to transform inputs into outputs)
is described by a production function.
The production function is a function that shows the highest output that a firm can produce
for every specified combination of inputs. It is a purely technical relation which connects
factor inputs to outputs. Assuming labor (L) and capital (K) as the only inputs, the production
function can be written as: Q = f (L, K).
The production function allows inputs to be combined in varying proportions so that output
can be produced in many ways (using either more capital or less labor or vise versa). For
example, a unit of commodity X may be produced by the following processes:
Process P1 Process P2 Process P3
Labor units 2 3 1
Capital units 3 2 4
Activities or these methods of productions can be shown by a line from the origin to the point
determined by the labor and capital inputs combination.
K

3 p1
2 p2

1 p3

0 2 3 4 L

The production function (a purely technical relationship which connects factor inputs and
outputs) includes all the technically efficient methods of production. The technically
inefficient methods are not included in the production functions. A method of production A
is technically efficient than any other method B if A uses less of at least one input and no
more of the other factors as compared with B. For example, commodity Y can be produced
by two methods, A and B as follows:
A B
Labor 2 3
Capital 3 3
Method A is considered as technically efficient method as compared with B. The basic
theory of production concentrates only on efficient methods and thus inefficient methods will
not be used by rational producer.
If a process A uses less of some factor(s) and more of some other(s) as compared with B,
then A and B cannot be directly compared on the criterion of technical efficiency. For
example, the activities are not directly compared.
A B
Labor 2 1
Capital 3 4
Both processes are considered as technically efficient and are included in the production
function. Which one of them will be chosen at any particular time depends on the price of
factors (inputs).The choice of any particular technique among the set of technically efficient
processes is an economic one, which is based on the price of factors of production. Note that
a technically efficient method is not necessarily economically efficient.
SHORT RUN PRODUCTION FUNCTION AND STAGES OF PRODUCTION

The production function in the traditional theory assumes the form:

Q = f (L, K, r, y)

Where L is labor, K is capital, r is returns to scale which refers to the long run analysis of the
laws of production since it assumes change in the plant, and y is the efficiency parameter
related to the organizational and entrepreneurial aspect of the production.

Graphically, the production function can be shown as follows:

Q Panel A Q Panel B

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

Q=f (L) k1, r1, y1

Q=f (K) L1, r1, y1

O L O K

In panel A, as labor increases, ceteris paribus, output increases: we move along the curve
depicting the production function. If K and/or r, and/or y increase, the production function
shifts upwards. The same is true for panel B.

The slope of the production function is the marginal products of the factors of production.
The MP of a factor is defined as the change in output resulting from the change in the factor,
keeping all other factors constant. That is,
MPL = Q and MPK = Q
L K

Graphically, the MPL is shown by the slope of the production function Q=f (L) and the MP K
is shown by the slope of the production function Q=f (K). The slope of a curve at any one
point is the slope of a tangent line at that point.
Q MPL=Q = 0 MPK=Q = 0
L K
Q=f (L) Q=f (K)
 O A’ B’ L O C’ D’ K
MPL MPK

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

APL APK

O A B L O C D
MPL MPK

From the above graph we can understand that as the labor units used in the production
processes goes on increasing, the output initially increases at an increasing rate, then starts
rising at a decreasing rate, reaches a maximum and then starts falling. As a result the MP
initially increases, reaches a maximum, and then starts declining since it is the slope of the
TP curve. The MP is even negative when the TP declines. On the other hand, the AP is given
by the slope of the line drawn from the origin to the corresponding point on the TP curve.
Thus, the AP initially increases, reaches a maximum at A’ level of input and then starts
declining. AP and MP are equal at the maximum of the AP. Accordingly we can divide this
production function into three stages as stage I (from zero TP, MP, & AP up to the maximum
of AP), stage II (from the maximum of AP to zero MP), and stage III (from zero MP onwards).

At stage I, MP>AP and both of them are rising initially and MP falls latter on. Since each
additional unit of labor (on panel A) is coming up with contribution larger than the average, it
is rational to hire more labor and produce more. Thus, it is not reasonable to produce at this stage.
At the third stage where both APL and MPL are declining and MPL< APL, it is not rational to
produce at all because each additional unit of labor added makes the total product to decline
(i.e. its contribution is negative).
Thus, it is in the second stage that a rational firm operates. Here each additional labor
contributes positively to the production but less than the average. At this stage as the use of a
variable input (labor) increases with other inputs (capital) being fixed, the resulting additions
to output (MPL) will eventually decrease. This principle is known as the law of variable
proportions or the law of diminishing marginal returns.

In summary, the production theories concentrate only on the efficient part of the production
function, that is, on the ranges of output over which the MP’s are positive. No rational firm
would employ labor beyond OB or capital beyond OD since an increase in the factors beyond
these levels would result in the reduction of the TP of the firm. Thus, the basic theory of
production concentrates on the range of output over which the MPs are although positive,
decreases (i.e. A’B’ and C’D’). This means over the range where:
 MPL > 0 but (MPL) < 0 and MPK > 0 but (MPK) < 0
L K
ISOQUANTS
Assuming that labor and capital are the only two inputs used to produce an item, the output
achievable for various combinations of inputs can be shown by using isoquants. An isoquant
is the locus of all the technically efficient methods (or all the combinations of factors of
production) for producing a given level of output. It is a curve showing all possible
combinations of inputs that yield the same output. The production isoquant may assume
different shapes depending on the degree of substitutability of factors. These are:
(1) Linear isoquant: this type assumes perfect substitutability of factors: a given output
may be produced by only labor, or only capital, or by an infinite combinations of K
and L. See figure A below.
(2) Input-output isoquant: this assumes strict complementarily (i.e. zero substitutability)
of the factors of production. There is only one method of production for any one
commodity. The isoquant takes the shape of right angle triangle. This type of isoquant
is called “Liontief isoquant” after the name Leontief who invented the input output
analysis. See figure B below.
(3) Kinked isoquant: this assumes limited substitutability of K and L. there is only few
processes for producing a particular commodity. Substitutability of the factors is
possible only at the kinks. See figure C below.
(4) Smooth or convex isoquant: this form assumes continuous substitutability of K and L
only over a certain range, beyond which factors cannot substitute each other. The
isoquant is a smooth curve which is convex to the origin. Consider figure D below.

K K

O L O L
A. Linear isoquant B. Input-output isoquant

K K
P1
P2
Q
P3

P4 Q

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

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

*A
*C

Q=100
*B
Q=50

O L

The condition of negative first derivative of marginal products with respect to the input
implies that the tradition theory of production concentrates on the range of the isoquants over
which their slope is negative and convex to the origin. In the figure above, the production
function is depicted by a set of isoquants. Similar to the case of indifference curves, the
further away from the origin an isoquant lays, the higher the level of output it represents and
isoquants do not intersect.

On figure below, the locus of points of isoquants where the marginal products of the factors
are zero forms the ridge line. At points A, B, &C the MP K is zero and hence forms the upper
ridge line. The lower ridge line shows that the MP L is zero. Thus, production techniques are
only efficient inside the ridge lines. Outside the ridge lines the marginal product of the
factors is negative and the methods of productions are inefficient, since they require more
quantities of both factors for producing a given level of output.
K
Upper ridge line (MPK = 0)
A B C
Lower ridge line (MPL = 0)

F Q3
Q2
E
Q1
D
O L

The slope of the isoquant (dK/dL) defines the degree of substitutability of the factors of
production. This slope decreases (in absolute terms) as we move downwards along the
isoquant, showing the increasing difficulty in substituting L for K. The slope of the isoquant
is called the rate of technical substitution, or the marginal rate of technical substitution
(MRTS) of factors:
MRTSL, K = -K = slope of an isoquant.
L
MRTSL, K is defined as the amount of K that the firm must sacrifice in order to obtain one
more unit of L so that it produces the same level of output. It is the slope of an isoquant.

It can be proved that the MRTS is equal to the ratio of the marginal products of the factors. That is,
MRTSL, K = -K = Q/L = MPL
L Q/K MPK
Proof:
The production function can be written as Q = f (K, L) = C. It is equal to C because along an
isoquant the TP is constant.

The slope of a curve is the slope of a tangent line at that point. The slope of a tangent line is
defined by the total differential. The total differential (dQ) is zero along an isoquant since the
TP is constant. Thus,
dQ = (Q/K)K + (Q/L)L = 0
 (MPK)K + (MPL)L = 0
 -(MPK)K = (MPL)L
 -K/L = MPL/MPK
Along the upper ridge line we have
MRTSL,K = MPL/MPK = ∞ => MPK = 0
And along the lower ridge line
MRTSL,K = MPL/MPK = 0 => MPL = 0

The MRTS as a measure of the degree of substitutability of factors has a serious defect since
it depends on the units of measurement of the factors. A better measure of factor
substitutability is provided by the elasticity of substitution. It is given by:
 = percentage change in K/L
Percentage change in MRTS
 = d (K/L)/ (K/L)
d (MRTS)/(MRTS)

The elasticity of substitution is a pure number independent of the unit of measurement of K

and L since both the numerator and the denominator are measured in the same units.

FACTOR INTENSITY
Factor intensity refers to a measure of the intensity of a method of production in the sense
that a measure of whether a given method of production is labor intensive (uses more labor
than capital) or capital intensive (uses more capital than labor). It can be measured by the
slope of the line from the origin to a particular point on the isoquant representing a particular
process. Factor intensity can also be measured by the capital labor ratio. In the figure below
process P1 is more capital intensive than process P2 because the slope of the line OP1 is
higher than the slope of OP2 or the ratio K1/L1 is greater than K2/L2. This implies that the
upper part of the isoquant includes more capital intensive techniques where as the lower part
includes more labor intensive techniques.
K
 K1 P1

P2
K2 Q

O L
L1 L2
EXAMPLE:
Let us illustrate the above concepts with a specific form of production function, namely the
Cobb-Douglas production function. This form is the most popular in applied research,
because it is easier to handle mathematically. It is of the form:
Q = bo.Lb1.Kb2
1. The marginal product of factors
MPL = X/L = b1.bo.Lb1-1.Kb2
= b1 (boLb1Kb2) L-1
= b1.Q/L = b1 (APL) since Q = bo.Lb1.Kb2 and APL = Q/L
MPK = b2.Q/K = b2 (APK)
2. The marginal rate of technical substitution
MRTSL, K = Q/L = b1 (Q/L) = b1. K
Q/k b2 (Q/K) b2 L`
3. The elasticity of substitution
 = d(K/L)/(K/L) = 1
d(MRS)/(MRTS)
Proof:
Substitute the MRTS in to the elasticity formula and obtain
 =d(K/L)
(K/L)
d(b1/b2.K/L)
(b1/b2.K/L)

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

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

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

b1/b2. The higher the ratio the more labor intensive the technique is and vise versa.
5. The efficiency of production. The efficiency in the organization of factors of production is
measured by the coefficient bo. It is clear that if two firms have the same K, L, b 1, and b2 and
still produce different quantities of output, the difference can be due to the superior
organization and entrepreneurship of one firm which resulted in production difference. The
more efficient firms will have a higher bo than the less efficient one.
6. The returns to scale. In the Cobb-Douglas production function, the returns to scale are
measured by the sum of the coefficients b1+b2. It will be discussed latter on.

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

1. THE LAW OF VARIABLE PROPORTIONS

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

2. LAWS OF RETURNS TO SCALE

The law of returns to scale refers to the long run analysis of production. In the long run,
where all inputs are variable output can be increased by changing all factors by the same
proportion. The rate at which output increases as inputs are increased by the same proportion
is called returns to scale. We have three cases of returns to scale: increasing, constant and
decreasing returns to scale.
I) Increase returns to scale: this is the case where increasing all factors by the same
proportion, m, leads to an increase in output by more than m scale.
II) Constant returns to scale: if we increase input by some factor, m and output is
increased by the same proportion as inputs, m, and then it is called constant returns to
scale. In this case the size of the firm’s operation doesn’t affect the productivity of its factors.
III) Decreasing returns to scale: if scaling up all inputs by m scales output up by less than
m, it is called decreasing returns to scale. This is because, may be difficulties in
organizing and running a large scale operation may lead to decreased production of both
labor and capital.
Examples
1. If Q = 2K + 3L. We will increase both K and L by m and create a new production
function Q*. Then we will compare Q* to Q.
Q* = 2(Km) + 3(Lm) = 2Km + 3Lm = m (2K + 3L) = mQ
After factoring, we can replace (2K + 3L) with Q, as we were given that from the start. Since
Q* = mQ, we note that by increasing all of our inputs by the multiplier m we have increased
production by exactly m. So we have constant returns to scale.
2. Q=0.5KL Again we put in our multipliers and create our new production function.
Q* = 0.5(Km) (Lm) = .5KLm2 = Qm2. Since m > 1, then m2 > m. this implies our new
production has increased by more than m. So we have increasing returns to scale.
3. Q=K0.3L0.2. Again we put in our multipliers and create our new production function as Q*
= (Km) 0.3(Lm) 0.2 = K0.3L0.2m0.5 = Q m0.5. Since m > 1, then m 0.5 < m. Our new production has
increased by less than m. So we have decreasing returns to scale.
RETURNS TO SCALE AND HOMOGENIETY OF THE PRODUCTION FUNCTION
Suppose we increase both factors of production function Q=f(L, K) by the same proportion
m, and we observe the resulting new level of output Q* as Q* = f(mK, mL). If m can be
factored out (that is, can be taken out of the bracket as a common factor), then the new level
of output can be expressed as a function of m (to the power n) and the initial level of output
as follows: Q* = mnf(L, K) or Q* = mnQ. If so, the function is called homogeneous. If m
cannot be factored out, the production function is called non- homogeneous. The above three
examples are a homogeneous functions since m can be factored out. Thus, a homogeneous
function a function such that if each of the inputs is multiplied by m, the m can be completely
factored out of the function. The power n of m is called the degree of homogeneity and is a
measure of the returns to scale.
If n=1, we have a CRS.
If n <1, “ DRS.
If n >1, “ IRS.
Given a Cobb-Douglas production function Q=boL b1Kb2, returns to scale is measured by the
sum of the powers of the factors. That is,
If b1 + b2 =1, then there is a CRS
If b1 + b2 >1, “ “ IRS
If b1 + b2 <1, “ “ DRS
Proof: Let L and K increases by m. The new level of output is
Q*=bo(mL)b1(mK)b2
= bomb1Lb1mb2Kb2
Q* =mb1+b2(boLb1Kb2)
Q*= mb1+b2Q
This implies the function is homogeneous of degree b1+b2 and the returns to scale depend on the sum.
PRODUCT LINE: It shows a physical movement from one isoquant to another as we
change either both of the factors or a single factor. It describes the technically possible
alternative paths of expanding output. What path will actually chosen by the firm will depend
on the prices of factors. The product curve passes through the origin if both factors are
variable. But if only one factor variable (the other being kept constant), the product line is a
straight line parallel to the axis of the variable factor.
K K K

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

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

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

GRAPHICAL PRESENTATION OF RETURNS TO SCALE FOR HOMOGENEOUS

PRODUCTION FUNCTION

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

K A 2Q1
 Q1
O L
L 2L 3L

Decreasing returns to scale: the distance between consecutive isoquant increases. By

doubling inputs, output increases by less than twice its original level.
K
In this case, there is a decreasing
PL returns to scale because doubling
Inputs will bring an output which is l
3K C 3Q1 less than double.

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

Increasing returns to scale: the distance between consecutive isoquant decreases. By doubling
inputs, output is more than doubled.
K
PL In this case there is an increasing return
To scale because doubling inputs results
3K in an output which is more than double.

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

Q1
O L 2L 3L L
TECHNICAL PROGRESS AND THE PRODUCTION FUNCTION
As knowledge of new and more efficient methods of production become available,
technology changes. Furthermore new inventions may result in increase of the efficiency of
all methods of production. These changes in technology constitute technical progress.
Graphically, the effect of technical progress is shown with an upward shift of the production
function or a downward movement of the isoquant. This shift shows that the same output
may be produced by less factor inputs, or more output may be produced with the same inputs.

X K

Q’ Q’=f(L)
Q=f(L)
Q
 Qo

Q1
O L O L
L*
Technical progress may also change the shape (as well as produce a shift) of the isquant.
Hicks has distinguished three types of technical progress, depending on its effect on the rate
of substitution of the factors of production.
Capital deepening technical progress: a technical progress which increases the MPK by more
than the MPL. For this kind of technical progress, along a line on which the K/L ratio is
constant, the MRTSL,K decreases in absolute terms (the slope of an isoquant declines). The
slope of the shifting isoquants becomes less steep along any given radius. This type of
technical progress is also called capital saving or labor using technical progress.
K
Isocline

A’
A’’

O L

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

A’
A’’

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

A
A’

A’’
O L
EQUILIBRIUM OF THE FIRM: CHOICE OF OPTIMAL COMBINATION OF
FACTORS OF PRODUCTION

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

To derive graphically the equilibrium point of the firm, we will use the isoquant map and the
isocost line. An isoquant is a curve that shows the various combinations of K and L that will
give the same level of output. It is convex to the origin whose slope is defined as:
- ∂K/∂L = MRSL,K = MPL/MPK = ∂Q/∂L
∂Q/∂K
The isocost line is defined by the cost equation
C = rK + wL
Where w=wage rate, and r=price of capital services.
The isocost line is the locus of all combinations of factors that the firm can purchase with a
given monetary cost outlay. The slope of the isocost line is equal to the ratio of the prices of
the factors of production, w/r.
K the isocost equation is given by C=wL + rK
C/r => rK = C - wL
=> K = C/r – w/r L
From this the slope is –w/r or it is the vertical
change over the horizontal change.
=> Slope = C/r
C/w
=> Slope = C/r.w/C
=> Slope = w/r
O C/w L

Case 1: Maximization of output subject to a cost constraint.

Given the level of cost and the price of the factors and output, the firm will be in equilibrium
when it maximizes its output. This is at the point of tangency of the isocost line to the highest
possible isoquant curve. In the following graph, it is at point e where the firm produces Q 2
with K1 and L1 units of the two inputs. Higher levels of output to the right of e are desirable
but not attainable due to the cost constraint. Other points below the isocost line lie on a lower
isoquant than Q2. Hence Q2 is the maximum output that can be achieved given the above
assumptions (C, w, r, & PQ being constant).

K
A
 K1 e Q3

Q2
Q1

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

e1

e
Q2

O e2 L
Output Q2 depicted by the concave isoquant can be produced with lower cost at e 2 which lies
on a lower isocost curve than e (corner solution).

Mathematical derivation of the equilibrium of the firm

A rational producer seeks the maximization of its output, given total cost outlay and the
prices of factors. That means:
Maximize Q = f (K, L)
Subject to C = wL + rK
This is a constrained optimization which can be solved by using the lagrangean method. The steps are:
a. rewrite the constraint in the form
wL + rK – C = 0
b. multiply the constraint by a constant which is the lagrangian multiplier
(wL + rK – C) = 0
c. form the composite function
Z = Q - (wL + rK – C)
d. partially derivate the function and then equate to zero
∂Z = ∂Q - w = 0
∂L ∂L
 MPL = w
  = MPL-----------------------------------------------------------------------(1)
w
∂Z = ∂Q - r = 0
∂K ∂K
 MPK = r
  = MPK----------------------------------------------(2)
r
∂Z = rL + rK – C = 0------------------------------------------- (3)
 ∂
From equation (1) and (2) we understand that
MPL = MPK
w r
=> MPL = w
MPK r
This shows that the firm is in equilibrium when it equates the ratio of the marginal
productivities of factors to the ratio of their prices. It can be shown that the second order
conditions for the equilibrium of the firm require that the marginal product curves of the two
factors have a negative slope.
Slope of MPL = ∂2Q
∂L2
Slope of MPK = ∂2Q
∂K2
=> ∂ Q < 0 and ∂2Q < 0
2

∂L2 ∂K2
2
2 2 2
And ∂Q.∂Q> ∂Q
∂L2 ∂K2 ∂L∂K
Case 2: minimization of cost for a given level of output
The condition for the equilibrium of the firm is formally the same as in case 1. That is, there
must be tangency of the given isoquant and the lowest possible isocost line, and the isoquant
must be convex. However, in this case we have a single isoquant which denotes the desired
level of output, but we have a set of isocost lines. Curves closer to the origin show a lower
total cost outlay. Since isocosts are drawn on the assumption of constant prices of factors,
they are parallel to each other and their slopes (w/r) are equal. Thus the firm minimizes its
cost by employing the combination of K and L determined by the point of tangency of Q
isoquant with the lowest possible isocost line. Points below e are desirable because they
show lower cost but are unattainable for output Q. points above e show higher costs. Hence,
point e is the least cost point.
K

K1 e
Q

O L

L1
In this case also the lagrangian method can be followed to derive the equilibrium point
mathematically. But the problem is different.
That is,
Minimize C = wL + rK
Subject to:
Q = f (K, L)
The lagrangian function will be:
Z = (wL + rK) + [Q-f (K, L)]
Partially derivate Z w.r.t L, K, &  and equate to zero.

∂Z = w -  ∂f(K,L) = 0
∂L ∂L
=> w -  ∂Q = 0
∂L
=> w =  MPL
=>  = MPL ----------------------------------------- (1)
w
∂Z = r -  ∂f(K,L) = 0
∂K ∂K

=> r -  ∂Q = 0
∂K
=> r =  MPK
=>  = MPK --------------------------------------- (2)
r
∂Z = Q – f (K, L) = 0 ------------------------------------------ (3)
∂

From equation (1) and (2):

MPL = MPK
w r
=> w = MPL = MRTSL, K
r MPK
This is the same as the condition in case one. In a similar way, the second condition will be:

=> ∂2Q > 0 and ∂2Q > 0

∂L2 ∂K2
2
And ∂2Q . ∂2Q > ∂2Q
∂L2 ∂K2 ∂L∂K
 4. THEORY OF COST
Cost functions are derived functions (derived from production function). Economic theory
distinguishes between short-run and long-run costs. Both in the short-run and in the long-run,
total cost is a multi variable function, i.e. total cost is determined by many factors such as
output, technology, prices of factors and fixed factors. To simplify the analysis we consider
cost as a function of output [C= f (Q)] on a ceteris paribus assumption. Thus, determinants of
costs, other than output, are called shift factors.
4.1 Short-Run Costs
Short-run costs are costs over a period during which some factors of production usually
capital equipment and management) are fixed. Short-run total costs are split into two groups:
total fixed costs and total variable costs: TC = TFC+TVC. Total variable cost is a cost that
varies as output varies whereas total fixed cost is a cost that does not vary with the level of
output. The fixed costs include:
 Salaries of administrative staff
 Expenses for building depreciation and repairs
 Expenses for land maintenances
 Depreciation of machinery.
The variable costs include:-
 The raw materials cost
 The cost of direct labor
The running expenses of fixed capital, such as fuel, ordinary repairs and routine maintenance.
As the total fixed cost (TFC) does not depend on the level of output, it is represented by a
horizontal line.
TC
Cost

TVC

TFC

O Output (Q)
The total variable cost has usually an inverse-S shape which reflects the law of variable
proportions. According to this law, at the initial stage of production with a given plant, as
more of the variable factors is employed, its productivity increases and thus total variable
cost(TVC) increases at a decreasing rate = AVC declines. When the productivity of the
variable input falls, larger and larger units of the variable input will be needed to increase
output by the same unit and thus TVC and TC increase at increasing rates. By adding the TFC and
TVC we obtain the TC of the firm. From the total-cost curves we obtain average cost curves.
 AFC is the total fixed cost divided by the amount of output, i.e., AFC= TFC.
Q
Since TFC is constant, increase in Q reduces the ratio and thus the AFC approaches the
quantity (output) axis as output rises.
 AVC= TVC.
 Q
Graphically the AVC at each level of output is derived from the slope of a line drawn from
the origin to the point on the TVC curve corresponding to the particular level of output. For
example in the figure below, the AVC at Q 1 is the slope of the ray oa, the AVC at Q 2 is the
slope of a ray ob, and so on. It is clear from the figure that the slope of a ray through the
origin declines continuously until the ray becomes tangent to the TVC curve at c. to the right
of this point the slope of rays through the origin starts increasing. Thus, the AVC curve falls
initially as the productivity of the variable factor increases, reaches a maximum when the
plant is operated optimally and rises beyond that point.
C C AVC

TVC

d a

c b d
B
a c

o Q1 Q2 Q3 Q4 Q o Q1 Q2 Q3 Q4 Q

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

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

TC

d a

c b d
b
a c

o Q1 Q2 Q3 Q4 Q o Q1 Q2 Q3 Q4 Q

 MC = ∆TC = ∆ (TFC+TVC) = ∆TVC.

∆Q ∆Q ∆Q

Graphically the marginal cost is the slope of the TC curve (which of course is the same at any
point as the slope of the TVC). The slope of the TC curve at any one point is the slope of a
tangent line at that point. As we can see from the following graph, the tangent line is initially
becoming flatter up to Q4 level of output and then become steeper as the output goes on
increasing. This implies the slope of the TC curve (MC) is initially decreasing, reaches a
minimum and then starts increasing.

C C
TC

MC
 O Q4 O Q4 Q

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

Costs MC
ATC

AVC

AFC
O output (Q)

The relationship between ATC and AVC

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

The Relationship between MC and ATC

The MC cuts the ATC and the AVC at their minimum points. We said that MC is the change
in the TC for producing an extra unit of output. Assume that we start from a level of n units
of output. If we increase the output by one unit the MC is the change in TC resulting from the
production of the (n+1)th unit. The AC at each level of output is found by dividing TC by Q.
Thus the ATC at the level of Qn is
ATCn = TCn
 Qn
And at the level of n+1
ATCn+1 = TCn+1
Qn+1
Clearly TCn+1 = TCn + MC
Thus,
a) If the MC of the (n+1) th unit is less than ATCn (the ATC of the previous n units) the
ATCn+1 will be smaller than the ATCn.
b) If the MC of the (n+1) th unit is higher than ATCn (the ATC of the previous units) the
ATCn+1 will be higher than the ATCn.
As far as the MC is below the ATC, it pulls the ATC downwards and if the MC is above the
ATC, it pulls the latter upwards. From this it follows that the MC curve intersects the ATC at
the minimum point of the ATC. This can also be proofed by using a simple calculus.
From ATC = TC => TC= (ATC).Q
Q
MC = d (TC) by definition.
dQ

=> MC = d (ATC.Q)
dQ
=> MC = ATC.dQ + Q.d (ATC)
dQ dQ
=> MC = ATC + (Q) (slope of the ATC)

Given that Q and ATC are Positive,

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

The relationship between MC and AVC

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

Q

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

dQ dQ dQ dQ

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

dQ
=> MC = d (AVC.Q) = AVC.dQ + Q.d(AVC)
dQ dQ dQ
=> MC = AVC + (Q) (slope of AVC)

Given that AVC and X are Positive,

 MC<AVC if slope of AVC<0
 MC =AVC if slope of AVC=0 (at the minimum point of the AVC).
 MC >AVC if slope of AVC>0.
Relationship between Product Curves and Cost Curves
Unit products and unit cost curves are mirror images of each other, i.e.
o when AP(MP) is rising AC(MC) is falling;
o when AP(MP) is falling AC(MC) is rising; and
o when AP(MP) is maximum AC(MC) is minimum
See below for illustration of these relations.
Let TVC =wL, where w= given wage rate & L =labor input
Thus, AVC= TV = (wL) /Q = w (L /Q) = w
Q (Q/L)
But Q/L=APL, so
AVC= w/APL

Similarly, MC=DTVC/DQ, since TVC=wL

MC = DwL = w (DL) = w
DQ (DQ) (DQ/DL)
But DQ/DL =MPL
Thus, MC=w/MPL

Graphically:
AP/MP

APL

AC/MC MPL
MC

AVC
 Q

4.2 Long-run costs

The long-run is a period of time of such length that all inputs are variable. It is a planning
horizon in the sense that economic agents can plan ahead and choose many aspects of the
“short-run” in which they will operate in the future. Thus, the long-run consists of all
possible short-run situations among which an economic agent may choose.
If a production technology is characterized by constant return to scale (CRS), doubling
output requires doubling of input, which implies doubling of total output (cost) for given
factor prices. Hence, the long-run total cost curve in this case is a straight line through the
origin. This implies that the long-run average and marginal costs are horizontal lines and
equal (LAC = LMC).
TC LAC
LMC
TC (Q)

LAC=LMC

O Q O Q

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

TC
TC (Q) LMC
LAC

O Q O Q

The range from the minimum point of LAC to the left is called the economies of scale range,
which means output can be doubled for less than doubling of cost. The range from the
minimum of LAC to the right is called diseconomies of scale, because a doubling of output
requires more than a doubling of cost. The traditional theory of the firm assumes that
economies of scale exist only up to a certain plant, which is known as the optimum plant
size. With this plant all possible economies of scale are fully exploited. If the firm increases
further than this optimum size there are diseconomies of scale arising from managerial
inefficiencies. It is argued that management becomes highly complex, managers are
overworked and the decision making process become less efficient.
When a firm is producing at an output at which the LAC is falling, the LMC is less than
LAC. Conversely, when LAC is rising (increasing), LMC is greater than LAC. The two
curves intersect at a point where the LAC curve achieves its minimum. Like the short run
average cost (SAC) and SMC curves, the LAC and LMC curves are U-shaped, but for
different reasons. In the long-run, the source of the U-shape is increasing and decreasing
returns to scale, rather than diminishing returns to a factor of production.
The Relationship between Short-run and long-run Average and Marginal costs
Assume that a firm is uncertain about the future demand for its product and is considering
three alternatives plant sizes: Small, Medium and Large. The short-run average cost curves
are SAC1, SAC2 and SAC3 in the figure below.
Cost

SAC1
SAC3
C1 SAC2
C3
C2
C4

O
Q1 Q1* Q2 Q2*
If the firm expects that the demand will expand further than Q 1, it will install the medium
plant, because with this plant outputs larger than Q 1 are produced with a lower cost (for
instance C2<C1 for output equal to Q*1). Similar considerations hold for the decision of the
firm when it reaches the level Q2.

If we relax the assumption of the existence of only three plants and assume that there is a
very large number (infinite number) of plants, we obtain a continuous curve, which is the
planning LAC curve of the firm. LAC curve is the locus of points denoting the least cost of
producing the corresponding output. It is a planning curve because on the basis of this curve
the firm decides what plant to set up in order to produce optimally (at minimum cost) the
expected level of output. The LAC curve is U-shaped and it is often called the envelop curve
because it envelopes the short run curves.

C
LAC
SAC1 SAC6
SAC2
SAC3 SAC5
SAC4

O Q
 M
Because there are economies of scale and diseconomies of scale in the long-run, the points of
minimum average cost of the smaller and larger plant (plants 1 up to 4 and 5 up to 7) do not
lie on the long-run average cost curve. For example, a plant size 2 operating at minimum
average cost is not efficient because a larger plant can take advantage of increasing returns to
scale to produce at a lower average cost.

Each point of the LAC curve is a point of tangency with the corresponding SAC curve. The
point of tangency occurs to the falling part of the SAC curves for points lying to the left of
M. since the slope of the LAC is negative up to M, the slope of the SAC cures must also be
negative, because at the point of tangency the two curves have the same slope. By the same
logic, the point of tangency for outputs larger than Q occurs to the rising part of the SAC curves.

Only at the minimum point M of the LAC is the corresponding SAC also at a minimum. At
the falling part of the LAC curve the plants are not worked to full capacity. To the rising part
of the LAC curve the plants are overworked. Only at the minimum point M is the plant
optimally employed.

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

C LMC
SMC1 SMC3 SAC3
LAC
a

SMC2

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

DERIVATION OF COST FUNCTION FROM THE PRODUCTION FUNCTION

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

∂Z = ∂Q – r  = 0
∂K ∂K

∂Z = wL + rK – C = 0
∂
Example:
Given Q=L2/3K1/3, w=2 and r=4, derive the cost function.
Solution:
The steps that are involved to derive the cost function are:
1. Solve for L in terms of K or K in terms of L from the optimality condition.
2. Substitute the result under (1) into the production function.
3. Solve for L and K in terms of Q from the production function.
4. Substitute the results under (3) into the cost constraint.
1. MPL = w
MPK r
=> 2/3 L-1/3 K1/3 = 2
1/3 K-2/3 L2/3 4
=> 2K = 1
L 2
=> L = 4K
2. Q = L2/3K1/3
Q = (4K) 2/3K1/3
Q = 42/3K
=> K = Q
42/3
=> L = 4K = 4 Q
42/3
1/3
=> L = 4 Q
3. C = 2L + 4K
C = 2(41/3Q) + 4(Q/42/3)
C = 25/3Q + 41/3Q
C = (25/3 + 41/3) Q

DYNAMIC CHANGES IN COSTS – THE LEARNING CURVE

 It is believed that a large firm may have long-run average cost than a small firm: increasing
returns to scale in production. So it is convincing to conclude that firms which enjoy lower
average cost over time are growing firms with increasing returns to scale. But this need not
be true. In some firms, long-run cost may decline over time because workers and managers
absorb new technological information as they become more experienced at their jobs.

As management and labor gain experience with production, the firm’s marginal and average
costs of producing a given level of output fall for four reasons:
1. Workers often take longer to accomplish a given task the first few times they do it. As
they become more adapt, their speed increases.
2. Managers learn to schedule the production process more effectively, from the flow of
materials to the organization of the manufacturing itself.
3. Engineers who are initially cautious in their product designs may gain enough
experience to be able to allow for tolerances in design that save cost without
increasing defects. Better and more specialized tools and plant organization may also
lower cost.
4. Suppliers of materials may learn how to process materials required more effectively
and may pass on some of this advantage in the form of lower materials cost.

As a consequence, a firm “learns” over time as cumulative output increases. Managers can
use this learning process to help plan production and forecast future costs. Fig. 1 illustrates
this process in the form of a learning curve – a curve that describes the relationship between
a firm’s cumulative output and the amount of inputs needed to produce each unit of output.
Hours of labor / machine Lot

10 20 30 40 50
Cumulative Number of Machine Lots Produced

The Learning Curve (Fig. 1): A firm’s production cost may fall over time as managers and
workers become more experienced and more effective at using the available plant and
equipment. The learning curve shows the extent to which hours of labor needed per unit of
output fall as the cumulative output increases.

Graphing the Learning Curve

Fig.1 shows a learning curve for the production of machine tools. The horizontal axis
measures the cumulative number of lots of machine tools (groups of approximately 40) that
the firm has produced. The vertical axis shows the number of hours of labor needed produce
each lot. Labor input per unit of output directly affects the production cost because the fewer
the hours of labor needed the lower the marginal and average cost of production.

The learning curve in fig.1 is based on the relationship L = A + BN-β

Where N is the cumulative units of output produced and L the labor input per unit of output.
A, B, and β are constants, with A and B positive, and β between 0 and 1. When N is equal to
1, L is equal to A + B, so that A + B measures the labor input required to produce the first
unit of output. When β equals 0, labor input per unit of output remains the same as the
cumulative level of output increases; there is no learning. When β is positive and N gets
larger and larger, L becomes arbitrarily close to A. A, therefore represents the minimum
labor input per unit of output after all learning has taken place.

The larger is β, the more important is the learning effect. With β equals to 0.5, for example,
the labor input per unit of output falls proportionally to the square root of the cumulative
output. This degree of learning can substantially reduce the firm’s production costs as the
firm becomes more experienced.
In this machine tool example, the value of β is 0.31. For this particular learning curve, every
doubling in cumulative output causes the input requirement (less the minimum attainable
input requirement) to fall by about 20% (because (L - A) = BN -0.31, we can check that 0.8 (L –
A) is approximately equal to B (2N)-0.31). As fig.1 shows, the learning curve drops sharply as
the cumulative number of lots increases to about 20. Beyond an output of 20 lots, the cost of
savings is relatively small.

Learning versus Economies of Scale

Once the firm has produced 20 or more machine lots, the entire effect of the learning curve
would be complete, and we could use the usual analysis of cost. If, the production process
were relatively new, relatively high cost at low levels of output (and relatively low cost at
higher levels) would indicate learning effects, not economies of scale. With learning, the
cost of production for a mature firm is relatively low regardless of the scale of the firm’s
operation. If a firm that produces machine tools in the lots knows that it enjoys economies of
scale, it should produce its machine in very large lots to take advantage of the lower cost
associated with size. If there is a learning curve, the firm can lower its cost by scheduling the
production of many lots regardless of the individual lot size.

Fig. 2 shows this phenomenon. AC1 represents the long-run average cost of production of a
firm that enjoys economies of scale in production. Thus the change in production from A to
B along AC1 leads to lower cost due to economies of scale. However, the move from A on
AC1 to C on AC2 leads to lower cost due to learning, which shifts the average cost curve
downward.

Cost (Birr/unit
of output)

A Economies of Scale

AC1
Learning C
AC2
 Output

Economies of Scale versus Learning Fig. 2: A firm’s average cost of production can
decline over time because of growth of sales when increasing returns are present ( a move
from A to B on curve AC1), or it can decline because there is a learning curve ( a move from
A on curve AC1 to C on curve AC2.
The learning curve is crucial for a firm that wants to predict the cost of producing a new
product. For example, a firm producing machine tools knows that its labor requirement A is
equal to zero, and b is approximately equal to 0.32. Table 1 calculates the total labor
requirement for producing 80 machines.

Because there is a learning curve, the per-unit labor requirement falls with increased
production. As a result, the total labor requirement for producing more and more output
increases in smaller and smaller increments. Therefore, a firm looking only at the high initial
labor requirement will obtain an overtly pessimistic view of the business. Suppose the firm
plans to be in business for a long time, reducing 10 units per year. Suppose the total labor
requirement for the first year of production, the firm’s cost will be high as it learns the
business. But once the learning effect has taken place, production costs will fall. After 8
years, the labor required to produce 10 units will be only 5.1, and per-unit cost will be
roughly half what it was in the first year of production. Thus the learning curve can be
important for a firm deciding whether it is profitable to enter an industry.

Cumulative Output (N) Per-unit labor Total Labor

requirement for each Requirement
10 units of output (L)*
10 1.00 10.0
20 0.80 18.0 (10.0+8.0)
30 0.70 25.0 (18.0+7.0)
40 0.64 31.4 (25.0+6.4)
50 0.60 37.4 (31.4+6.0)
60 0.56 43.0 (37.4+5.6)
70 0.53 48.3 (43.0+5.3)
80 0.51 53.4 (48.3+5.1)
 5. PERFECT COMPETITION

Perfect, unlike everyday usage of the word, is characterized by a complete absence of rivalry
(competition) among firms.

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

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

DDx

0 Qx

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

Short-run Equilibrium of the Firm and the Industry

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

In a perfectly competitive market structure, price is given (firms are price takers). Thus, firms
decide on the level of output (Q) they produce to attain their equilibrium points.

Two approaches are used in determining a firm’s equilibrium.

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

Qe Q

⇨To the left of point B and to the right of C, STC>TR so that the firm is in a loss (negative
∏). Between B and C, however, the firm is enjoying a positive profit and it is maximized at
the point where the vertical difference between the TR and STC is largest (at Qe). Point B is
the break-even point where the firm just covers its cost of production and operates at zero
economic profit.
2. The marginal approach: the perfectly competitive firm is a price taker and faces a
perfectly elastic demand curve. Since marginal revenue (MR) is dTR/dQ and price(P) is
constant, then P = MR.
MR = dTR = d (PQ) = p dQ = P
dQ dQ dQ
Total profit is maximum when the slope of the TR and total cost curves are equal. That is,
when MR (P) = MC
Short-run profit/loss of a firm
The firm is at equilibrium at quantity level Qe (where MR = P = MC at point E). To the left
of E, MR > MC (i.e., benefits > costs) and it should increase production. To the right of E,
MC>MR and the firm should cut back its production. This particular figure represents the
case where the firm operates at a loss (= area of rectangle EFGH).

∏ = Q (P – ATC)
∏ = Qe (- EF)
∏ = - (EH) (EF)
 = - area of EFGH

P/MR MC
MC ATC
AC

AVC
 F
G M

H I E P=MR

0 Q
Qe

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

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

N.B.: in the figure above, P (MR) = MC at two points, E and I. But the profit maximizing
level of output is that level of output which corresponds to E. Condition for profit
maximization is
1. MR = MC this implies d∏ = 0
dQ
2
2. MC is rising => d ∏ < 0 or dM∏ < 0
dQ2 dQ

The firm operates at different points at the marginal cost curve depending on the level of
price it faces. Thus, its supply curve is its MC curve but above the shut-down point. The
industry supply curve is the simple horizontal summation of the supply curves of the
individual firms. Thus, the industry is at equilibrium when the industry demand curve
intersects the industry supply curve.

S
$ $
S

Pe E P = MR Pe E*
D

Q
 O Qe Q O Qe
Panel A – short-run equilibrium the firm Panel B – Equilibrium of the Industry

LONG RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

When long-run equilibrium is achieved, product prices will be exactly equal to, and
production will occur at each firm’s point of minimum ATC. This is illustrated below for a
constant cost industry (the case where the expansion of the industry through entry of new firms will
have no effect up on resource prices and, therefore, up on production costs) and a respective firm.
S0
ATC
$ LMC S1

P1 P1
P1 = MR1
Po= MRo P0
D1

D0
Q
Firm Industry
Suppose that a change in consumer tastes increase and thus product demand from D 0 to D1.
This favorable shift in demand obviously makes production profitable; the new price (P 1)
exceeds ATC. This economic profit will lure new firms into the industry. As the firms enter,
the industry supply of the product will increase causing product price to gravitate downward
towards the original level. The economic profits caused by the boost in demand have been
completed away to zero and as a result the previous incentive for more firms to enter the
industry has disappeared. Therefore, in the long-run, all firms operate at a point where:
(1) P = MR = LMC = LAC = SMC = SAC for the firm and
(2) Supply curve crosses demand for the industry.
In the long-run, all firms in a perfectly competitive industry (market) enjoy only normal
profit (zero profit) or at the break-even where TR = TC.
EXERCISE
Suppose you are the manager of a watch-making firm operating in a competitive market.
Your cost of production is given by C = 100 + Q2, where Q is the level of output and C is total cost.
a) If the price of watches is birr 60, how many watches should you produce to maximize profit?
b) What will your profit level be?
c) At what minimum price will you produce a positive output?
6. PURE MONOPOLY
Pure monopoly is the form of a market in which a single firm sells a commodity for which there are
no close substitutes. Thus the monopolist represents and faces the industry's negatively sloped
demand curve for the commodity.
Monopoly can arise from several causes (barriers to entry). Some are:
1. A firm may own or control the entire supply of essential raw material(s).
2. A firm may own a patent for the exclusive right to produce a commodity or to use a
particular production process.
3. Economies of scale may operate over a sufficiently large range of outputs so as to leave a
single firm supplying the entire market. Such a firm is called Natural monopoly.
 4. Licenses protect present license holders from new competition. i.e., confer monopoly
power to them as a group.

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

Or =>

Since equals P + some negative numbers, =>

P
MR  pd 1
 pd  1

 pd 1

Q
MR Demand

From the above relation it can be shown that:

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

6.1. Short Run and Long Run Equilibriums

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

A
Pe B
ATC
C

Q
Qe MR
In this particular case P (=Pe)> ATC and hence the monopolist enjoys a positive profit equal
to the area PeABC.
If P is smaller than ATC at the point where MR = MC, the monopolist will incur a loss in the
short-run. However, if P > AVC, it pays for the monopolist to continue to produce because
production covers part of the fixed costs. In the long-run, the best or profit maximizing level
of output is given by the point where the monopolist's LMC = MR (and LMC curve intersects MR
curve from below).

Even though profits attract additional firms in to the perfectly competitive industry until just
all firms break-even in the long-run, the monopolist can continue to earn profits in the long-
run because of blocked entry.
The monopolist, as opposed to a perfectly competitive firm, doesn't produce at the lowest
point on its LAC curve. Only if the monopolist's MR curve happened to go through the
lowest point on its LAC would this be the case.
6.2. Discriminating Monopoly
To this point it has been assumed that the monopolist charges a uniform price to all buyers.
Under certain conditions the monopolist might be able to exploit its market position fully and
thus increase profits by charging different prices to different buyers. By doing so the seller is
engaging in price discrimination. Price discrimination refers to charging different prices (for
different quantities of a commodity or in different markets) that are not justified by cost
differences. In general, price discrimination is workable when three conditions are realized.

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

2. The seller must be able to segregate buyers into separate classes where in each group has a
different ability and willingness to pay for the product.
3. The original purchaser cannot resell the product.
Price discrimination (the practice of charging different prices to different customers for
similar goods) can take three broad forms which we call first, second and third degree price
discrimination.
If the monopolist could sell each unit of the commodity separately and charge the highest
price each customer would be willing to pay for the commodity - reservation price - the
monopolist would be able to extract the entire customer's surplus. This is called first degree
or perfect price discrimination.
P

Pe R
MC

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

Third degree price discrimination is the practice of dividing consumers into group. For two
or more groups with separate demand curves and charging different prices to each group.
Some characteristic is used to divide customers into
distinct any goods, for example, students are usually willing to
pay less on average than the rest of the population.
Pc

MC
P2

P1

E
 MC=MR
E1 E2
DT

D2
D1

The total quantity produced, X is determined by the intersection of the

MRT and MC curves. This quantity is then divided between the two groups of customers
(assuming only two groups for simplicity) so that marginal revenues for each group are
equal. Otherwise, the firm would not be maximizing profit. For example, if MR 1 > MR2, the
firm could clearly do by shifting output from the second group to the first. Not only should
the two marginal revenues equal, but also the marginal cost should be equal to the marginal
revenues. If this were not the case the firm could increase its profitability by raising or
lowering total output (and lowering or raising its prices to both groups).
Total profit of the firm is given by π = P1Q1 + P2Q2 - C (QT)
Where P1 = the price charged to group one
P2 the price charged to group two
C (QT) = total cost of producing output QT = Q1 + Q2
The firm should increase its sells to each group until the incremental profit from the last unit sold is zero.

Prices and output must be set so that MR1 = MR2 = MC

- Recall that
 At the maximum profit

Rearranging gives

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

The higher price will be charged to consumers with the lowest demand elasticity.

6.3 MULTIPLANT MONOPOLY

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

P MC1
MR MC2
MC
MCT

P*

O Q1 Q2 Q3
Q
 Profit is maximized when MR = MC at each plant. If MR > MC, the firm would do better by
producing more at both plants.

∏ = PQt – C1(Q1) – C2(Q2)

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

 MR = MC1, and MR = MC2

 MR = MC1 = MC2

6.4 SOCIAL COST OF MONOPOLY

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

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

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

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