ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONMICS

DEPARTMENT OF ECONMICS

Microeconomics for Management

October, 2023
Micro Economics for Management (Econ2021)

CHAPTER ONE
THEORY OF CONSUMER BEHAVIOR
1.1 Introduction
Economics is the study of efficient allocation of resources in order to attain the
maximum fulfillment of unlimited human wants or needs. It is also defined as the study
of how people make choices to cope with scarcity. Economics studies how people choose
to use scarce resources to produce various commodities, how people consume goods and
services and how they trade.
In the above definition, efficiency, unlimited human wants, scarce resources and choices
are the key phrases in the study of the subject matter of economics.
Unlimited wants and scarce resources
Human beings want food, clothes, shelter and other variety of goods and services for their
survival. These human wants are unlimited and increase from time to time; however,
economic resources that include Land, Labor, Capital and Entrepreneurship are scarce by
their nature. Although using these economic resources society produces what it wants, it
will not be able to produce and consume all the goods and services it wants. Thus,
economics describes various sets of tools that enable societies to use their scarce
resources efficiently in order to achieve the highest possible standard of living.

Microeconomics deals with the behavior of individual economic units. Any individual or
entity such as consumers, workers, firms etc that play a role in the functioning of our
economy considered as an economic unit. Microeconomics explains how and why these
economic units make economic decisions. It also explains how consumers and firms buy
out puts and sale inputs and how their choices are affected by changing prices/costs and
incomes/revenues. Consumers, workers, firms etc are interested to know causes of price
and output instability as well as unemployment. Moreover, most of our issues and
problems are related to economic matters. In general, an individual who does not
understand basic economic principles will not appreciate and evaluate public issues that
are most of them are related with economics.

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As a consumer, we take numerous decisions in our daily life: should we take tea or coffee
in the morning? Should we carry lunch packet or take lunch in the cafeteria? The way
-making
behavior.

The theory of consumer choice lies on the assumption of the consumer being rational to
maximize his level of satisfaction. The consumer makes choices by comparing bundle of
goods to maximize utility. Therefore consumers utility maximizing decision does not
only depend on the level of income but also determined by his preferences. Thus
preferences + budget constraint = choice of goods that can give maximum satisfaction.

1.2. Consumer Preference

Given any two consumption bundles (groups of goods) available for purchase, how a
consumer compares the goods? Does he prefer one good to another, or does he be
indifferent between the two groups?
Given any two consumption bundles, the consumer can either decide that one of
consumption bundles is strictly better than the other, or decide that he is indifferent
between the two bundles. Accordingly we will have two types of preferences.
Strict preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if (X1,X2)>(Y1,Y2) or if he
chooses (X1,X2) when (Y1,Y2) is available the consumer definitely wants the X-bundle
than Y and we can say that (X1,X2) is strictly preferred to (Y1,Y2).
Weak preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if the consumer is indifferent
between the two commodity bundles or if (X1,X2) (Y1,Y2),the consumer would be
equally satisfied and if he consumes (X1,X2) or (Y1,Y2) we can say (X1,X2) is weakly
preferred to (Y1,Y2,) or the reverse.
Assumptions on preferences
Completeness
For any two commodity bundles X and Y, a consumer will prefer X to Y,Y to X or will
be indifferent between the two.
Transitivity

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It means that if a consumer prefers basket A to basket B and to basket C, then the
consumer also prefers A to C.
More is better than less given that all goods are desirable
Consumers always prefer more of any good to less and they are never satisfied or
satiated. However, bad goods are not desirable and consumers will always prefer less of
them.
1.3 Utility
Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service.
Definition
Utility is the level of satisfaction that is obtained by consuming or having a commodity or
undertaking an activity.
In defining strict preference, we said that given any two consumption bundles(X1,X2)
and (Y1,Y2),the consumer definitely wants the X bundle than the Y bundle if (X1,X2) >
(Y1,Y2).This means, the consumer preferred bundle (X1,X2) to bundle (Y1,Y2) if and
only if the utility (X1,X2) is larger than the utility of (Y1,Y2).
The concept of utility is characterized with the following properties:

may be useless functionally but offer great utility to art lovers.

Utility is subjective. The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a
product may not be the same. For example, no-smokers do not derive any utility
from cigarettes.
The utility of a product can be different at different places and time. For example,
the utility that we get from meat during fasting is not the same as any time else.
A Consumer considers the following points to get maximum utility or level of
satisfaction:
How much satisfaction he gets from buying and then consuming an extra unit of a
good or service.
The price he pays to get the good.
The satisfaction he gets from consuming alternative products.
The prices of alternative goods and services.

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Can we measure utility? If yes how do we measure the satisfaction level (Utility) that we
get from goods and services?
1.4. Approaches to measure Utility

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

1. Rationality of Consumers. The main objective of the consumer is to maximize

his/her satisfaction given his/her limited budget or income. Thus, in order to
maximize his/her satisfaction, the consumer has to be rational. By rational it is to
mean that he can reason out as to what is good and what is bad for him and he
prefers more of good to less of it further more he aims at the maximization of his
utility subject to the constraint imposed by his income .
2. Utility is cardinally Measurable. According to this approach, the utility or
satisfaction of each commodity is measurable. Money is the most convenient
measurement unit of utility. In other words, the monetary unit that the consumer
is prepared to pay for another unit of commodity measures utility or satisfaction.
3. Constant Marginal Utility of Money. According to assumption number two,
money is the most convenient measurement of utility. However, if the marginal
utility of money changes with the level of income (wealth) of the consumer, then
money can not be considered as a measurement of utility.
4. Limited Money Income. The consumer has limited money income to spend on
the goods and services he/she chooses to consume.

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5. Diminishing Marginal Utility (DMU).The utility derived from each from each
successive units of a commodity diminishes. In other words, the marginal utility
of a commodity diminishes as the consumer acquires larger quantities of it.
6. The total utility of a basket of goods depends on the quantities of the individual
commodities.
If there are n commodities in the bundle with quantities, X 1 , X 2 ,... X n the total
utility is given by:
TU=f ( X 1 , X 2 ...... X n )
1.6. Total and Marginal Utility
Definitions
Total Utility (TU): It refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity or commodities at a
particular time. TU=U1+U2+U3 s.
TU=TUx+TUy+TUz
As the consumer consumes more of a good per time period, his/her total utility increases.
However, there is a saturation point for that commodity in which the consumer will not
be capable of enjoying any greater satisfaction from it.
Marginal Utility (MU): It refers to the additional utility obtained from consuming an
additional unit of a commodity. In other words, marginal utility is the change in total
utility resulting from the consumption of one or more unit of a product per unit of time.
Graphically, it is the slope of total utility.
Mathematically, the formula for marginal utility is:

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

Law of diminishing marginal Utility (LDMU)

Assume you are consuming orange, is the utility you get from consumption of the first
orange is the same as the second orange?
The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc. this condition is

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explained in the Law of Diminishing Marginal Utility which is stated as as the quantity
consumed of a commodity increases per unit of time, the utility derived from the
successive unit decreases, given consumption of all other commodities remaining
constant .
The LDMU is best explained by the MU curve that is derived from the relationship
between the TU and total quantity consumed.
Table 1.1 Hypothetical table showing TU and MU of consuming Oranges (X)
Units of
0 1st 2nd 3rd 4th 5th 6th
Quantity(x)
consumed Unit Unit unit unit Unit Unit
unit
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2

20
TUX
15
Total Utility

10

Quantity X
Marginal Utility

10

Quantity X
1 2 3 4 5
MUX

Fig.1.1 Derivation of marginal utility from total utility

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

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The total utility curve reaches its pick point (Saturation point) at point A. This Saturation
point indicates that by consuming 5 oranges, the consumer attains its highest satisfaction
of 22 utils. However, Consumption beyond this point results in Dissatisfaction, because
consuming the 6th and more orange brings a lesser additional utility than the previous
orange. Point B where the MU curve reaches its maximum point is called an inflexion
point or the point of Diminishing Marginal utility.
The law of diminishing marginal utility holds only under certain given conditions. These
conditions are
I. The unit of the consumer goods must be standard i.e It the units are too small
or large, the law may not hold.
II.
consumption.
III. There must be continuity in consumption and where break in continuity
necessary, it must be appropriately short.
IV. The mental condition of the consumer must remain normal during the period
of consumption of a commodity.
1.7. Equilibrium of a consumer
A consumer that maximizes utility reaches his/her equilibrium position when allocation
of his/her expenditure is such that the last birr spent on each commodity yields the same
utility.

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

MU X 1 MU X 2 MU X n
......... MU m Where: MUm marginal utility of money
PX1 PX 2 PX n
Diagrammatically,

C
PX

MUX

Figure 1.2 marginal utility of a consumer

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

TABLE 1.2 Utility schedule for a single commodity

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

For consumption level lower than three quantities of oranges, since the marginal utility of
orange is higher than the price, the consumer can increase his/her utility by consuming
more quantities of oranges. On the other hand, for quantities higher than three, since the
marginal utility of orange is lower than the price, the consumer can increase his/her
utility by reducing its consumption of oranges.
Mathematically, the equilibrium condition of a consumer that consumes a single good X
occurs when the marginal utility of X is equal to its market price.
MU X PX

Table 1.3 Utility schedule for two commodities

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

Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 1.5
2 10 4 2 2 22 16 4
3 12 2 1 3 32 10 10/4
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 5/4
6 11 -2 -1 6 48 3 0.75

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As we discussed earlier, utility is maximized when the condition of marginal utility of

one commodity divided by its market price is equal to the marginal utility of the other
MU 1 MU 2
commodity divided by its market price MU i.e.
P1 P2
Thus, the consumer will be at equilibrium when he consumes 2 Orange and 4 banana,
MU orange MU banana 4 8
because 2
Porange Pbanana 2 4

1.8. Derivation of the Cardinalist Demand

We discussed that marginal utility is the slope of the total utility function. The derivation
of demand curve is based on the concept of diminishing marginal utility. If the marginal
utility is measured using monetary units the demand curve for a commodity is the same
as the positive segment of the marginal utility curve.

a
P1
b
P
Price

c
P2
MUX
O Quantity

P1
Price

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

1.9. Limitation of the Cardinalist approach

The Cardinalist approach involves the following three weaknesses:

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

quantified.
2. Utility can not be measured absolutely (objectively). The satisfaction obtained
from different commodities can not be measured objectively.
3. The assumption of constant MU of money is unrealistic because as income
increases, the marginal utility of money changes.

1.10. The Ordinal Utility Theory

In the previous section, we have discussed one of the approaches for measurement of
utility that is cardinal utility approach. In this section, we will discuss the second
approach that is the ordinal utility approach.
In the ordinal utility approach, utility cannot be measured absolutely but different
consumption bundles are ranked according to preferences. The concept is based on the
fact that it may not be possible for consumers to express the utility of various
commodities they consume in absolute terms, like, 1 util, 2 util, or 3 util, but it is always
possible for the consumers to express the utility in relative terms. It is practically possible
st nd rd
for the consumers to rank commodities in the order of their preference as 1 2 3 and so
on.
Assumptions of Ordinal Utility theory
Like the previous approach, this approach is based on the following assumptions:
1. The Consumers are rational-they aim at maximizing their satisfaction or utility
given their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers
are required only to order or rank their preference for various bundles of
commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of
substitution is the rate at which a consumer is willing to substitute one commodity (x)
for another commodity (y) so that his total satisfaction remains the same. When a
consumer continues to substitute X for Y the rate goes decreasing and it is the slope
of the Indifference curve.

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4. The total utility of the consumer depends on the quantities of the commodities

consumed, i.e., U=f ( X 1 , X 2 ...... X n )

5. Preferences are transitive or consistent:
It is transitive in the senses that if the consumer prefers market basket X to market
basket Y, and prefers Y to Z, and then the consumer also prefers X to Z.
When we said consistent it means that If market basket X is greater than market
basket Y (X>Y) then Y not greater than X (Y not >Y).
The ordinal utility approach is expressed or explained with the help of indifference
curves. An indifference curve is a concept used to represent an ordinal measure of the
tastes and preferences of the consumer and to show how he/she maximizes utility in
spending inc
theory is also known as the Indifference Curve Analysis.
Indifference Set, Curve and Map
Indifference Set/ Schedule: It is a combination of goods for which the consumer is
indifferent, preferring none of any others. It shows the various combinations of goods
from which the consumer derives the same level of utility.
Table 1.4 Indifference Schedule

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7

Banana (Y) 10 6 3 1

Each combination of good X and Y gives the consumer equal level of total utility. Thus,
the individual is indifferent whether he consumes combination A, B, C or D.
Indifference Curves: an indifference curve shows the various combinations of two goods
that provide the consumer the same level of utility or satisfaction. It is the locus of points
(particular combinations or bundles of good), which yield the same utility (level of
satisfaction) to the consumer, so that the consumer is indifferent as to the particular
combination he/she consumes.

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

indifference curve.

10 A

Indifference
B
Banana (Y)

6 Curve (IC)

Good B
C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
OrangeX

Indifference curve Indifference map

Fig 1.4 indifference curves and indifference map.

meat, we can graph a set of indifference curves called an indifference map. In other
words it is the entire set of indifference curves is known as an indifference map, which
reflects the entire set of tastes and preferences of the consumer. A higher indifference
curve refers to a higher level of satisfaction and a lower indifference curve shows lesser
satisfaction. IC2 reflects higher level of utility than that of IC1.Any consumer has lots of
indifference curves, not just one.
Properties of Indifference Curves:
Indifference curves have certain unique characteristics with which their foundation is
based.
1. Indifference curves have negative slope (downward sloping to the right).
Indifference curves are negatively sloped because the consumption level of
one commodity can be increased only by reducing the consumption level of
the other commodity. That means, if the quantity of one commodity increases
with the quantity of the other remaining constant, the total utility of the

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consumer increases. On the other hand, if the quantity of one commodity

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

B
Banana

Banana

E
D IC2
C
A
IC1
X
Orange Orange
Fig.1.5 positively sloped and intersected indifference curves

As we discussed earlier, Indifference curves cannot intersect each other. If they did, the
consumer would be indifferent between C and E, (Right panel of figure 2.6) since both
are on indifference curve one (IC1). Similarly, the consumer would be indifferent

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between points D and E, since they are on the same indifference curve, IC2.By
transitivity, the consumer must also be indifferent between C and D. However, a rational
consumer would prefer D to C because he/she can have more Orange at point D (more
Orange by an amount of X).
The Marginal rate of substitution (MRS)
To quantify the amount of one good that a consumer will give up to obtain more of
another, we often use marginal rate of substitution as a measurement (MRS).
Definition: Marginal rate of substitution of X for Y is defined as the number of units of
commodity Y that must be given up in exchange for an extra unit of commodity of X so
that the consumer maintains the same level of satisfaction.
Number of units of Y given up
MRS X ,Y
Number of units of X gained
It is the negative of the slope of an indifference curve at any point of any two
commodities such as X and Y, and is given by the slope of the tangent at that point:
i.e., Slope of indifference curve
y
MRS X ,Y
x
In other words, MRS refers to the amount of one commodity that an individual is willing
to give up to get an additional unit of another good while maintaining the same level of
satisfaction or remaining on the same indifference curve. The diminishing slope of the
indifference curve means the willingness to substitute X for Y diminishes as one move
down the curve.
Note that ( MRS X ,Y ) measures the downward vertical distance (the amount of y that the

individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of
Y
x required) to remain on the same indifference curve. That is, MRS X ,Y because of
X
the reduction in Y, MRS is negative. However, we multiply by negative one and express
MRS X ,Y as a positive value.

subjective willingness to substitute A for B (or B for A) will depend on the amounts of B
and A he/she possesses.

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Table 1.5 level of consumption of good X and Y

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7

Banana (Y) 10 6 3 1

Y 4
MRS X ,Y (between points A and B 4
X 1
, in the above case the consumer is willing to forgo 4 units of Banana to obtain 1 more
unit of Orange. If the consumer moves from point B to point C, he is willing to give up
only 2 units of Banana(Y) to obtain 1 unit of Oran
Having still less of Banana and more of Orange at point D, the consumer is willing to
give up only 1 unit of Banana so as to obtain 3 units of Orange. In this case, the MRS
reases, the marginal utility of additional units
of Y decreases. Similarly, as the quantity of X decreases, its marginal utility increases. In
addition, the MRS decreases as one move downwards to the right.
Marginal Utility and Marginal rate of Substitution

It is also possible to show the derivation of the MRS using MU concepts. The MRS X ,Y is

related to the MUx and the MUy :

MU X
MRS X ,Y
MU Y
Proof:
Suppose the utility function for two commodities X and Y is defined as:
U f ( X ,Y )
Since utility is constant on the same indifference curve:
U f ( X ,Y ) C
The total differential of the utility function is:
U U
dU dX dY 0
X Y
MU X dX MUY dY 0
MU X dY
MRS X ,Y
MU Y dX

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MU Y dX
Or, MRS Y , X
MU X dY

Example
X4
U .Compute the MRSX ,Y .
Y 2
MU X
MRS X ,Y
MU Y
dU dU
MU X and MU Y
dX dY
Therefore, MU X 4 1 2
4( X Y ) 4( X 3Y 2 ) and MU Y 2( X 4Y 2 1 ) 2 X 4Y
MU X 4 X 3Y 2 Y
MRS X ,Y 4
2
MU Y 2X Y X
Special Indifference Curves
Convexity or down ward sloping is among the characteristics of indifference curve and
this shape of indifference curve is for most goods. In this situation, we assume that two
commodities such as x and y can substitute one another to a certain extent but are not
perfect substitutes. However, the shape of the indifference curve will be different if
commodities have some other unique relationship such as perfect substitution or
complementary.
Here, are some of the ways in which indifference curves/maps might be used to reflect
preferences for three special cases.
I. Perfect substitutes: If two commodities are perfect substitutes (if they are essentially
the same), the indifference curve becomes a straight line with a negative slope. MRS for
perfect substitutes is constant. (Panel a)

IC3 IC1 IC2 IC3

Out dated books

IC2
IC1
Right shoe

IC3
Total

IC2
IC1

Mobil Left shoe Food

Panel a Panel b Panel c

Fig.1.6 Special cases of indifference curves

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II. Perfect complements: If two commodities are perfect complements, the indifference
curve takes the shape of a right angle. Suppose that an individual prefers to consume left
shoes (on the horizontal axis) and right shoes on the vertical axis in pairs. For example, if
an individual has two pairs of shoes, additional right or left shoes provide no more utility
for him/her. MRS for perfect complements is zero (both MRS XY and MRS XY is the same,
i.e. zero).
III.A useless good: Panel C in the above figure shows an ind
for food (on the horizontal axis) and an out-dated book, a useless good, (on the vertical
axis). Since they are totally useless, increasing purchases of out-dated books does not
increase utility. This person enjoys a higher level of utility only by getting additional
food consumption. For example, the vertical indifference curve IC 2 shows that utility will
be IC 2 as long as this person has some units of food no matter how many out dated books
he/she has.
1.11 The Budget Line or the Price line
I o goods but
they can not tell us which combinations of the two goods will be chosen or bought..
In reality, the consumer is constrained by his/her money income and prices of the two
commodities. Therefore, in addition to consumer preferences, we need to know the

affected by budget constraints that

must pay for various goods and services. Whether or not a particular indifference curve is

consumer while maximizing utility is constrained by the amount of income and prices of
goods that must be paid. This constraint is often presented with the help of the budget
line constructing by alternative purchase possibilities of two goods. Therefore, before we

The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, the budget line

and prevailing market prices.

Assumptions for the use of the budget line

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In order to draw the budget line facing the consumer, we consider the following assumptions:
1. there are only two goods, X and Y, bought in quantities X and Y;
2. each consumer is confronted with market determined prices, Px and Py, of good X and
good Y respectivley; and
3. the consumer has a known and fixed money income (M).
By assuming that the consumer spends all his/her income on two goods (X and Y), we
can express the budget constraint as:
M PX X PY Y Where, PX=price of good X
PY=price of good Y
X=quantity of good X
Y=quantity of good Y

This means that the amount of money spent on X plus the amount spent on Y equals the
money income.
Suppose for example a household with 30 Birr per day to spend on banana(X) at 5 Birr
each and Orange(Y) at 2 Birr each. That is, PX 5, PY 2, M 30birr .
Therefore, our budget line equation will be:
5X 2Y 30
Table 1.6 Alternative purchase possibilities of the two goods

Consumption
A B C D E F
Alternatives
Kgs of banana (X) 0 1 2 3 4 6
Kgs of Orange(Y) 15 12.5 10 7.5 5 0
Total Expenditure 30 30 30 30 30 30

At alternative A, the consumer is using all of his /her income for good Y. Mathematically
it is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income
for good X. mathematically; it is the x-intercept (6, 0). We may present the income
constraint graphically by the budget line whose equation is derived from the budget
equation.
M PX X PY Y
M XPX YPY
By rearranging the above equation we can derive the general equation of a budget line,

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M PX
Y X
PY PY
M
= Vertical Intercept (Y-intercept), when X=0.
PY
PX
= slope of the budget line (the ratio of the prices of the two goods)
PY
The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is given by:
M PX
X 0 M/PY
PY PY
M PX
X B
PY PY

M A
X
PX

M/PX
Fig.1.7 Derivation of the Budget Line
Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent.

1.12 Factors Affecting the Budget Line

Effects of changes in income

If the income of the consumer changes (keeping the prices of the commodities
unchanged) the budget line also shifts (changes). Increase in income causes an upward
shift of the budget line that allows the consumer to buy more goods and services and
decreases in income causes a downward shift of the budget line that leads the consumer
to buy less quantity of the two goods. It is important to note that the slope of the budget
line (the ratio of the two prices) does not change when income rises or falls. The budget
line shifts from B to B1 when income decreases and to B2 when income rises.

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M2/Py

M/Py Where M2>M>M1

M1/Py
B B2

B1

M1/PX M/PX M2/PX

Fig.1.8 Effects of change in income

Effects of Changes in Price of the commodities

Y Y

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

Fig.1.9 Effects of change in price

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

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 Micro Economics for Management (Econ2021)

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

M/py A

Here P < Px, hence M/Px <M/Px1

B B
M/Px M/Px ' X
Fig. 1.10 Effect of a decrease in price of x on the budget line

Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of
Y by spending the entire money income on Y regardless of the price of X. We can see
from the above figure that a decrease in the price of X, money income and price of Y
held constant, pivots the budget line out-
What would happen if price of x rises, while the price of good Y and money incme
remaining constant?
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of
Y by spending the entire money income on Y regardless of the price of X. We can see
from the figure below that an increase in the price of X, money income and price of Y
held constant, pivots the budget line in-

A
M/Py

Fig. 1.11 Effect of an increase in price of x on the

B
budget line

M/Px1 M/Px2
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Micro Economics for Management (Econ2021)

What would happen if price of Y rises, while the price of good X and money incme
remaining constant?
Since the X-intercept (M/Py) is constant, the consumer can purchase the same amount of
X by spending the entire money income on X regardless of the price of Y. We can see
from the above figure that an increase in the price of Y, money income and price of X
held constant, pivots the budget line in-ward, a

Y
A
M/py

M/py'

B
M/Px X

Fig.1.12 Effect of a raise in price of Y on the budget line

What would happen if price of Y falls, while the price of good X and money incme
remaining constant?
Y
M/py'

M/py A

B
M/Px X

Fig.1.13 Effect of a fall in price of Y on the budget line

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The above figure shows what happens to the budget line when the price of Y increases while the
price of good X and money income held constant. Since Py decreases, M/Py increases thereby the
budget line shifts outward.
Numerical Example
A person has $ 100 to spend on two goods(X,Y) whose respective prices are $3 and $5.
a) Draw the budget line.
b) What happens to the original budget line if the budget falls by 25%?
c) What happens to the original budget line if the price of X doubles?
d) What happens to the original budget line if the price of Y falls to 4?
from our previous discussion the budget line for two commodities was expressed as:
PX X PY Y M
3X 5Y 100
5Y 100 3 X
100 3
Y X
5 5
3
Y 20 X
5
When the person spends all of his income only on the consumption of good Y,we can get
the Y intercept that is(0,20).However, when the consumer spends all of his income on the
consumption of only good X,then we get the X intercept that is (33.33,0). Using these
two points we can draw the budget line. Thus, the budget line will be:

A
Y
20

B
33.33 X

If the budget decreases by 25%, then the budget will be reduced to 75.As a result the
budget line will be shifted in-ward forces the person to

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Micro Economics for Management (Econ2021)

buy less quantity of the two goods. The equation for the new budget line can be solved as
follows:
3X 5Y 75
5Y 75 3 X
75 3
Y X
5 5
3
Y 15 X
5
Therefore, the Y-intercept is 15 while the X-intercept is 25.However, since the ratio of
the prices does not change the slope of the budget line remains constant.
If the price of good X doubles the equation of the budget line will be 6 X 5Y 100and
if the price of good Y falls to 4, the equation for the new budget line will
be 6 X 4Y 100 .
1.13. Optimum of the Consumer: What a consumer Choose
A rational consumer seeks to maximize his utility or satisfaction by spending his or her
income. It maximizes the utility by trying to attain the highest possible indifference
curve, given the budget line. This occurs where an indifference curve is tangent to the
budget line so that the slope of the indifference curve ( MRS XY ) is equal to the slope of

the budget line ( PX / PY ).

Thus, the condition for utility maximization, consumer optimization, or consumer
equilibrium occurs where the consumer spends all income (i.e. he/she is on the budget
line) and the slope of the indifference curve equals to the slope of the budget
line MRS XY PX / PY .
The preferences of the consumer (what he/she wishes) are indicated by the indifference
curve and the budget line specifies the different combinations of X and Y the consumer
can purchase with the limited income. Therefore, the consumer tries to obtain the highest
possible satisfaction with in his budget line.
However, the consumer cannot purchase any bundle lying above and to the right of the
budget line. Because Indifference curves above the region of the budget line are beyond
the reach of the consumer and are irrelevant for equilibrium consideration. The question
then arises as to which combinations of X and Y the rational consumer will purchase.

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

Y
A

B
E
IC4

C IC3

IC2
D
IC1

X
Figure 1.14 Consumer equilibrium

A 1 level of satisfaction. When he/she

B
greater level of satisfaction that is indicated by IC2 B
A , the consumer obtains the greatest level of
satisfaction (IC3) relative to other indifference curves.
E ) is the most preferred
position by the consumer since he/she attains the highest level of satisfaction within
his/her reach and point E
optimum). This equilibrium occurs at the point of tangency between the highest possible
indifference curve and the budget line. Put differently, equilibrium is established at the
point where the slope of the budget line is equal to the slope of the indifference curve.
Mathematically, consumer optimum (equilibrium) is attained at the point where:
PX MU X MU Y MU X PX
MRS XY , But we know ....... MU X PY MU Y PX ...,
PY PX PY MU Y PY

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1.14 Effects of Changes in Income and Prices on Consumer

Let
that are the two important determinants of quantity demanded (or also consumer
equilibrium). Let us first consider the effect of change in income on the equilibrium of
the consumer all other things remaining constant.
A. Changes In Income: Income Consumption Curve and the Engel Curve
In our previous discus
things held constant) results in an upward parallel shift of the budget line. This allows the
consumer to buy more of the two goods. In addition,
ceteris paribus, the budget line shifts downward, remaining parallel to the original one.
If we connect all of the points representing equilibrium market baskets corresponding to
all possible levels of money income, the resulting curve is called the Income
consumption curve (ICC) or Income expansion curve (IEC). The Income Consumption
Curve is a curve joining the points of consumer optimum (equilibrium) as income
changes (ceteris paribus). Alternatively, it is the locus of consumer equilibrium points
resulting wh

ICC
Commodity Y

E3
E2
E1

Commodity X

Engle Curve
I3
I2
Income

I1

X1 X2 X3 Commodity X
Figure 1.15 the income consumption and
the Engle curves
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Micro Economics for Management (Econ2021)

From the Income Consumption Curve we can derive the Engle Curve. The Engle curve is
named after Ernest Engel, the German Statistician who pioneered studies of family
budgets and expenditure positions
The Engle Curve is the relationship between the equilibrium quantity purchased of a
good and the level of income. It shows the equilibrium (utility maximizing) quantities of
a commodity, which a consumer will purchase at various levels of income; (ceteris
paribus) per unit of time.
In relation to the shape of the income-consumption and Engle curves goods can be
categorized as normal (superior) and inferior goods. Thus, commodities are said to be
normal, when the income consumption curve and its Engle curve are positively sloped;
meaning that more of the goods are purchased at higher levels of income. On the other
hand, commodities are said to be inferior when the income consumption curve and Engle
curve is negatively sloped, i.e. their purchase decreases when income increases.
For example, in the figure below good Y is a normal good while good X is a normal good
until the person level of income reaches M2 .Thus, when income increases beyond M2,
the person will buy less of good X as his income increases. Therefore, good X is a normal
good Up to point A and becomes an inferior good as the income consumption curve
bends backward.

M3/Py M3/Py
M2/Py M2/Py

M1/Py
M1/Py

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

Figure 1.16 income consumption curve

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

Demand Curve

We now look at the second factor that affects the equilibrium of the consumer that is
price of the goods. The effect of price on the consumption of good is even more
important to economists than the effect of changes in income. Here, we hold money
income constant and let price change to analyze the effect on consumer behavior.
In our previous discussion, we have seen that an increase in the price of good X, for
example, increases the absolute value of the slope of the budget line, but it does not affect
the vertical (Y) intercept of the line. Thus, the change in the price of x will result in out
ward shift of the budget line that makes the consumer to buy more of good x.If we
connect all the points representing equilibrium market baskets corresponding to each
price of good X we get a curve called price-consumption curve.
The price-consumption curve is the locus of the utility-maximizing combinations of
products that result from variations in the price of one commodity when other product
prices, the money income and other factors are held constant.
We can derive the demand curve of an individual for a commodity from the price
consumption curve. Below is an illustration of deriving the demand curve when price of
commodity X decreases from Px1 to Px 2 to Px 3 .
Commodity Y

PCC

Commodity X

Px1
Price of X

Px2
Individual
Px3 demand curve

X1 X2 X3 Commodity X

Figure 1.17 the PPC and derivation of the demand curve

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Mathematical derivation of equilibrium

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

MaximizeU f ( X , Y )
Subject to PX X PY Y M
We can rewrite the constraint as follows:

M PX X PY Y 0 or PX X PY Y M 0
Multiplying the constraint by Lagrange multiplier

(M PX X PY Y ) 0

Forming a composite function gives as the Lagrange function:

U ( X ,Y ) (M PX X PY Y )

Or, U(X ,Y) ( PX X PY Y M)

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

U U
PX 0; PY 0 and ( PX X PY Y M) 0
X X Y Y
From the above equations we obtain:

U U
PX and PY
X Y
U U
MU X and MU Y
X Y
Therefore, substituting and solving for we get the equilibrium condition:

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Micro Economics for Management (Econ2021)

MU X MU Y
PX PY
By rearranging, we get:
MU X PX
MU Y PY
The second order condition for maximum requires that the second order partial
derivatives of the Lagrange function with respect to the two goods must be negative.
2
U2 2
U2
0 and 0
X2 X2 Y2 Y2
Example
A consumer consuming two commodities X and Y has the following utility function
U XY 2 X .If the price of the two commodities are 4 and 2 respectively and his/her
budget is birr 60.
a) Find the quantities of good X and Y which will maximize utility.
b) Find the MRS X ,Y at optimum.

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

Y 2 4 0
X

X 2 0
Y

60 4 X 2Y 0 (3)

From -dfrrequation, (1) we get Y 2 4 and from equation (2) we get X 2 .Thus,
Y 2 1
we can get that X and equation (2) gives as X.
2 2
Y 2
By substituting X in to equation (2) we get Y 14 and X 8.
2
MU X
MRS X ,Y
MU Y

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Y 2
X
After inserting the optimum value of Y=14 and X=8 we get 2 which equals to the price
PX 4
ratio of the two goods ( 2) .
PY 2

1.15 Income and Substitution Effects

We now turn to a more complete analysis of why demand curves slope downward. In our
previous discussion, we have noted that there are two effects of a price change. If price
falls (rises), the good becomes cheaper (more expensive) relative to other goods; and
consumers substitute toward (away from) the good. This is the substitution effect. In
addition
Since the set of consumption opportunities increases (decreases) as price changes, the
consumer changes the mix of his or her consumption bundle. This effect is called the
income effect. Let us analyze each effect in turn, and then combine the two in order to
see why demand is assumed to be downward sloping.
Let us Consider the case of a price-decline:
come (purchasing power), thus
enhancing the ability to buy more goods and services to some extent. Second, a decrease
in the price of a commodity induces some consumers (the consumer) to substitute it for
others, which are now relatively expensive (higher price) commodities.The 1st effect is
known as the income effect, and the 2nd effect is known as the substitution effect. The
combined effect of the two is known as the total effect (net effect).

I/py1

Note that:
1 X 1 X 3 =NE= Total (net) effect
A B IC2
X 1 X 2 = SE=Substitution effect
C IC1 X 2 X 3 = IE=Income effect
Figure 1.18 Income and
Substitution effect for a normal good

x1 x2 IE x3 I/px2
1
SE
NE

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Suppose initially the income of the consumer is I 1 , price of goodY is Py1 , and Price of
I I
good X is Px1 , we have the budget line with y-intercept and X-intercept . The
Py1 Px1
A that indicates the point of tangency between the
budget line and indifference curve IC1 . As a result of a decrease in the price of X
I I
from Px1 to Px2 the budget line shifts outward with y-intercept & X-Intercept .
Py1 Px 2
new equilibrium will be on point B.
The total change in the quantity purchased of commodity X from the 1st equilibrium
point at A to the second equilibrium point at B shows the Net effect or total effect of the
price decline (change).
The total effect of the price change can be conceptually decomposed into the substitution
effect and income effect.
The Substitution Effect
The substitution effect refers to the change in the quantity demanded of a Commodity
resulting exclusively from a change in its price wh

along the original indifference curve. The decline in the price of X results in an increase
enced by the movement to a higher indifference
curve even though money income remains fixed.

return to the same level of satisfaction enjoyed before the price decline. Graphically, this
is accomplished by drawing a fictitious (imaginary) line of attainable combinations with a
Px 2
slope corresponding to new ratio of the product price so that it is just tangent to the
Py1

original indifference curve IC1 .

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

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The Income Effect

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

In figure 2.18 defined

by the line of attainable combinations tangent to point C) back to its true level (defined
by the line of attainable combinations tangent to point B) gives the income effect. Thus,
the income effect is indicated by the movement from the imaginary equilibrium at point
C to the actual new equilibrium at point B, the increase in the quantity of X purchased
from X2 to X3 is the income effect.
The income effect of a change in the price of good shows the change in quantity
demanded via change in real income, while the relative price ratio remains constant. This
movement does not involve any change in prices; the price ratio is the same in budget
line 1 as in budget line 2. It is due to a change in total satisfaction and such a change is a
movement from one indifference curve to another.
When we look at both the substitution and income effects, the magnitude of the
substitution effect is greater than that of the income effect. The reason is that:
Most goods have suitable substitutes and when the price of good falls, the
quantity of the good purchased is likely to increase very much as consumers
substitute the now cheaper good for others.
Spending only a small fraction of his /her income, i.e. with the consumers
purchasing many goods and spending only a small fraction of their income on
any one good, the income effect of a price change of any one good is likely to
be small.
Usually, the income and substitution effects reinforce one another i.e. they operate in the
same direction. The substitution effect is always negative. i.e. if the price of a good X
increases and real income is held constant, there will always be a decrease in the
consumption of good X, and vise versa. This result follows from the fact that indifference
curves have negative slopes. However, the income effect is not predictable from the

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theory alone. In most cases, one would expect that increases in real income would result
in increases in consumption of a good. This is the case for so called Normal goods.
In short in the case of normal goods, the income effect and the substitution effect operate
in the same direction they reinforce each other. But not all goods are normal. Some
goods are called inferior goods because the income effect is the opposite (of that of a
normal good) for them-they operate in opposite direction. For an inferior good, a
decrease in the price of the commodity causes the consumer to buy more of it (the
substitution effect), but at the same time the higher real income of the consumer tends to
cause him to reduce consumption of the commodity (the income effect). We usually
observe that the substitution effect still is the more powerful of the two; even though the
income effect works counter to the substitution effect, it does not override it. Hence, the
demand curve for inferior goods is still negatively sloped.
Let us consider the following diagram that shows the income, substitution and net effect
for an inferior commodity in the case of a decline in the price of good X

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

E1
E2 IC2

X1 X3 X2 IC1 X
IE
NE

SE
Figure 2.19 Income, Substitution, and Net effect for an inferior commodity

In very rare occasions, a good may be so strongly inferior that the income effect actually
overrides the substitute effect. Such an occurrence means that a decline in the price of a
good would lead to a decline in the quantity demanded and that a rise in price will induce
an increase in quantity demanded. In other words, price and quantity move in the same
direction. The name given to such a unique situation is Giffen paradox; and it constitutes

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Micro Economics for Management (Econ2021)

an exception to the Law of demand. That is for Giffen goods the income effect (which
decreases the quantity demanded) is so strong that it offsets the substitution effect (which
increases the quantity demanded), with the result that the quantity demanded is directly
related to the price, at least over some range of variation of price.

E3
IC2

E1
E2
IC1

X3 X1 X2 X
SE
NE

IE

. Figure 1.20 Income, Substitution and net effects for a Giffen good,
When there is a price decline.

1.16 The Slutsky Equation

As we have discussed earlier,when the price of a good decreases,there will be two effects
in consumption.The change in relative prices makes the consumer to consume more of
the cheaper good-substitution effect.The increase in purchasing power due to the lower
price may increase or decrease consumtion of the good-income effect.
Generally,the Slutsky equation says that the total change in demand is the sum of the
substitution effect and the income effect.
Numerical Example
Suppose that the consumer has a demand function for good X is given by
2
X 20 MPX
Originally his income is $ 200 per month and the price of the good is 5 per killogram.

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Micro Economics for Management (Econ2021)

200
Therfore,his demand for good X will be 20 28 per month.
52
Suppose that the price of the good falls to 4 per kilogram.Therfore,the new demand at the
200
new price will be: 20 32.5 per month.
42
Thus,the total change in demand is 4.5 that is 32.5-28.
When the price falls the purchasing power of the consumer changes.Hence,iin order to
make the origiinal consumption of good X,the consumer adjusts his income.This can be
calculated as follows:
M1 P1' X P2 Y
M P1 X P2Y
Subtracting the second equation from the first gives:4-
M1 M X [ P1' P1 ]
M X P1
Therfore,new income to make the original consumption affordable when price falls to 4
is:
M X P1
M 28 * [ 4 5] 28
Hence,the level of iincome necessary to keep purchasing power constant is
M1 M M 200 28 172
The consumers new demand at the new price and income will be :
172
X ( 4,172) 20 30.75
42
Therfore,the substitution efffect will be:
X X (4,172) X (5,200) 30.75 28 2.75
The income effect will be:
X (4,200) X (4,172) 32.5 30.75 1.75

Since the result We obtained is positive we can conclude that the good is a normal good.
1.17 The Consumer Surplus:
While consumers purchas goods and services,they offten pay less than what they are
willing to pay.Thus,the difference between what they are willing to pay and what they
actually paid is considered as their surplus.

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 Micro Economics for Management (Econ2021)

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

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

CS
P E

0
Q
Numerical Example
Suppose the demand function of a consumer is given by: Q 15 p
a. Compute the consumer surplus when the price of the good is 2
b. Compute the consumer surplus when the price of the good is 4
c. Compute the change in consumer surplus when the price changes from 2 to 4.
Solution
When Price is zero the demand for quantity purchased will be 15 and when the demand
for quantity is put to zero then the price level will be 15.And finally,when we insert the
given price level 2 in the demand equation we get the level of qunatity demanded that is
13.Hence,we can easily compute the area of the triangle that is found above the given
price level that is 2.

15 Panel a. Panel b
15
2
4

13 15 11 15

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Micro Economics for Management (Econ2021)

In panel a, the area of the triangle above price that is the consumer surplus is
1
* 13 * 13 84.5 and in panel b the consumer surplus is 60.5.Therfoere,due to a change
2
in the price level the consumer surplus will be 84.5 60.5 24.5
Summary
Consumers given their income and prices of the commodities, they spend their income so
as to attain the highest possible satisfaction or utility from commodities. Utility is thus the
satisfaction obtained from the consumption of a good. The maximization of utility is
referred to as the axiom of utility maximization. To attain this utility maximization
objective, the consumer must be able to compare the utility of the various baskets of
goods, which they can buy with their income. In order to explain the comparison of these
commodities we have two approaches. These are: cardinal approach and the Ordinal
approach.
Cardinalist believed that cardinal numbers could be used to express the utility derived
from the consumption of a commodity while ordinalists believed that utility is not
measureable, but is an ordinal magnitude. The main ordinal theories are the indifferece
curves approache and the revealed preferences hypothesis.These approaches are also
known as the indifference curve theories .
An indifference curve is the locus of points which provide the same level of satisfaction
to the consumer. The slope os an indifferece curve shows the marginal rate os
substitution between goods.
The consumer aims at maximization of utility, given his/her income and market prices of
the commodities available for consumption. Therefore, to determine the equilibrium of
the consumer, we have to bring together the indifference map and the budget line facing
the consumer on the same diagram.
There are two effects of a price change. If price falls (rises), the good becomes cheaper
(more expensive) relative to other goods; and consumers substitute toward (away from)
the good. This is the substitution effect
purchasing power increases (decreases). Since the set of consumption opportunities
increases (decreases) as price changes, the consumer changes the mix of his or her
consumption bundle. This effect is called the income effect.

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Micro Economics for Management (Econ2021)

CHAPTER TWO
THE THEORY OF PRODUCTION

2.1 Introduction: Definition and basic concepts

To an economist production means creation of utility for sales. Alternatively, production
may be defined as the act of creating those goods/services which have exchange value for
sale (not for personal consumption).Raw materials yield less satisfaction to the consumer
by themselves. In order to get utility from raw materials, first they must be transformed
into output. However, transforming raw materials into final products require factor inputs
such as land, labor, and capital and entrepreneurial ability.
Thus, no production (transforming raw material into output) can take place without the
use of inputs.
Fixed Vs variable inputs
In economics, inputs can be classified as fixed & variable. Fixed inputs are those inputs
whose quantity can not readily be changed when market conditions indicate that an
immediate change in output is required. In fact no input is ever absolutely fixed, but may
be fixed during an immediate requirement. For example, if the demand for Beer shoots up
suddenly in a week, the brewery factories can not plant additional machinery over a night
to respond to the increased demand. It takes long time to buy new machineries, to plant
them and use for production. Thus, the quantity of machinery is fixed for some times
such as a weak. Buildings, machineries and managerial personnel are examples of fixed
inputs because their quantity can not be manipulated easily in short time periods.
Variable inputs, on the other hand, are those inputs whose quantity can be changed
almost instantaneously in response to desired changes in output. That is, their quantity
can easily be diminished when the market demand for the product decreases and vise
versa. The best example of variable input is unskilled labor.
In our previous example, if the brewery factory had idle machinery before the market
demand shot up, the factory can easily and immediately respond to the market condition
by hiring laborers.
Short run Vs long run

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Micro Economics for Management (Econ2021)

In economics, short run refers to that period of time in which the quantity of at least one
input is fixed. For example, if it requires a firm one year to change the quantities of all
the inputs, those time periods below one year are considered as short run. Thus, short run
is that time period which is not sufficient to change the quantities of all inputs, so that at
least one input remains fixed.
One thing to be noted here is that short run periods of different firms have
different duration. Some firms can change the quantity of all their inputs with in a month
while it takes more than a year to change the quantity of all inputs for another type of
firms. For example, the time required to change the quantities of inputs in an automobile
factory is not equal with that of flour factory. The later takes relatively shorter time. Long
run is that time period (planning horizon) which is sufficient to change the quantities of
all inputs. Thus there is no fixed input in the long -run.
2.2 Production in the short run: Production with one variable input
Production with one variable input (while the others are fixed) is obviously a short run
phenomenon because there is no fixed input in the long run.
Assumption of short run production analysis
In order to simplify the analysis of short run production, the classical economist assumed
the following:
1. Perfect divisibility of inputs and outputs
This assumption implies that factor inputs and outputs are so divisible that one can hire,
for example a fraction of labor, a fraction of manager and we can produce a fraction of
output, such as a fraction of automobile.
2. Limited substitution between inputs
Factor inputs can substitute each other up to a certain point, beyond which they cannot
substitute each other
3. Constant technology
They assumed that level of technology of production is constant in the short run.
Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor (which is
variable input). Given the assumptions of short run production, the firm can increase
output only by increasing the amount of labor it uses.
Hence, its production function is

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Micro Economics for Management (Econ2021)

Q = f (L) K - being constant

Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
The production function shows different levels of output that the firm can obtain by
efficiently utilizing different units of labor and the fixed capital. In the above short run
production function, the quantity of capital is fixed. Thus output can change only when
the amount of labor used for production changes. Hence, Q is a function of L only in the
short run.
2.3 Short Run Total product, marginal product and average product
Total product: is the total amount of output that can be produced by efficiently utilizing
a specific combination of labor and capital. The total product curve, thus, represents
various levels of output that can be obtained from efficient utilization of various
combinations of the variable input, and the fixed input. It shows the output produced for
different amounts of the variable input, labor.
Do you think that output can always be increased by increasing the variable input while
there is a fixed input?
Any ways, increasing the variable input (while some other inputs are fixed) can increase
the total product only up to a certain point. Initially, as we combine more and more units
of the variable input with the fixed input output continues to increase. But eventually,
increasing the unit of the variable input may not help output increase. Even as we employ
more and more unit of the variable input beyond the carrying capacity of a fixed input,
out put may tends to decline. Thus increasing the variable input can increase the level of
output only up to a certain point, beyond which the total product tends to fall as more and
more of the variable input is utilized. This tells us what shape a total product curve
assumes. The shape of the total product curve is nearly S-shape.
Marginal Product (MP)
The marginal product of variable input is the addition to the total product attributable to
the addition of one unit of the variable input to the production process, other inputs being
constant (fixed). Before deciding whether to hire one more worker, a manager wants to
determine how much this extra worker ( L =1) will increase output, q. The change in

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total output resulting from using this additional worker (holding other inputs constant) is
the marginal product of the worker. If output changes by q when the number of workers

the variable input, denoted as MPL is found as

Q dTP
MPL = orMPL
L dL

Thus, MPL measures the slope of the total product curve at a given point. In the short
run, the MP of the variable input first increases reaches its maximum and then tends to
decrease to the extent of being negative. That is, as we continue to combine more and
more of the variable inputs with the fixed input, the marginal product of the variable
input increases initially and then declines.
Average Product (AP)
The AP of an input is the ratio of total output to the number of variable inputs.
totalproduct TP
APlabour
numberofL L
The average product of labor first increases with the number of labor (i.e. TP increases
faster than the increase in labor), and eventually it declines.
Graphing the short run production curves
The following figures shows how the TP, MP and AP of the variable (labor) input vary
with the number of the variable input.

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Output

TP3

TP2 TP

TP1

Units of labor (variable input)

L1 L2 L3
APL, MPL

APL

Units of labor (variable input)

L1 L2 L3
MPL

Fig 2.1 Total product, average product and marginal product curves:
As the number of the labor hired increases (capital being fixed), the TP curve first rises,
reaches its maximum when L3 amount of labor is employed, beyond which it tends to
decline. Assuming that this short run production curve represents a certain car
manufacturing industry, it implies that L3 numbers of workers are required to efficiently

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run the machineries. If the numbers of workers fall below L3, the machine is not fully
operating, resulting in a fall in TP below TP3. On the other hand, increasing the number
of workers above L3 will do nothing for the production process because only L3 number
of workers can efficiently run the machine. Increasing the number of workers above L3,
rather results in lower total product because it results in over crowded and unfavorable
working environment.
Marginal product curve increases until L1 number of labor reaches its maximum at L1,
and then it tends to fall. The MPL is zero at L3 (when the TP is maximal); beyond which
its value assumes zero indicating that each additional worker above L3 tends to create
over crowded working condition and reduces the total product. Thus, in the short run
(where some inputs are fixed), the marginal product of successive units of labor hired
increases initially, but not continuously, resulting in the limit to the total production.
Geometrically, the MP curve measures the slope of the TP. The slope of the TP curve
increases (MP increases) up to L1, it decreases from L1 to L3 and it becomes negative
beyond L3.
The average product curve increases up to L2, beyond which it continuously declines.
The AP curve can be measured by the slope of rays originating from the origin to a point
on the TP curve. For example, the APL at L2 is the ratio of TP2 to L2. This is identical to
the slope of ray a.
The relationship between AP and MP of the variable input
The relationship between MPL and APL can be stated as follows:
For all number of workers (Labor) below L2, MPL lies above APL.
At L2, MPL and APL are equal.
Beyond L2, MPL lies below the APL
Thus, the MPL curve passes through the maximum of the APL curve from above. This
relationship between APL and MPL can be shown algebraically as follows:
Suppose the production function is given as
TP = f (L), K -being constant
Given the total product function,
dTP df ( L) TP f ( L)
MPL and APL =
dL dL L L

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To determine the relationship between APL and MPL, consider the slope of the APL
function.
f ( L) df ( L) dL
d( ) .L . f ( L)
dAPL L dL dL
Slope of APL = = = -------- (quotient rule of
dL dL L2
differentiation)

df ( L)
.L
dL f ( L) a b a b
Slope of APL = 2
- 2
----------------------------- (note that )
L L c c c
df ( L) f ( L)
= dL - L
L L
MPL APL df ( L) f ( L)
Slope of APL = , because = MPL and = APL
L dL L
Now when MPL > APL, Slope of APL is positive (APL rises)
When MPL = APL, Slope of APL is zero (APL is at its maximum).
When MPL < APL, Slope of APL is negative (APL falls)
The law of diminishing marginal returns (LDMR): short run law of production
The LDMR states that as the use of an input increases in equal increments (with other
inputs being fixed), a point will eventually be reached at which the resulting additions to
output decreases. When the labor input is small (and capital is fixed), extra labor adds
considerably to output, often because workers get the chance to specialize in one or few
tasks. Eventually, however, the LDMR operates: when the number of workers increases
further, some workers will inevitably become ineffective and the MPL falls (this happens
when the number of workers exceeds L1 in fig 2.1)
Note that the LDMR operates (MP of successive units of labor decreases) not because
highly qualified laborers are hired first and the least qualified last. Diminishing marginal
returns results from limitations on the use of other fixed inputs (e.g. machinery), not from
decline in worker quality.
The LDMR applies to a given production technology (when the level of technology is
fixed). Over time, however, technological improvements in the production process may

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allow the entire total product curve shift upward, so that more output can be produced
with the same input.
2.5 Efficient Region of Production in the short-run
we are now not in a position to determine the specific number of the variable input
(labor) that the firm should employ because this depends on several other factors than the
productivity of labor such as the price of labor, the structure of input and output markets,
the demand for output, etc. However, it is possible to determine ranges over which the
variable input (labor) be employed.

of production.
Stage I ranges from the origin to the point of equality of the APL and MPL.
Stage II starts from the point of equality of MPL and APL and ends at a point
where MP is equal to zero.
Stage III covers the range of labor over which the MPL is negative.
Now, which stage of production is efficient and preferable?
Obviously, a firm should not operate in stage III because in this stage additional units of
variable input are contributing negatively to the total product (MP of the variable input is
negative) because of over crowded working environment i.e., the fixed input is over
utilized.
Stage I is also not an efficient region of production though the MP of variable input is
positive. The reason is that the variable input (the number of workers) is too small to
efficiently run the fixed input; so that the fixed input is under utilized (not efficiently
utilized)
Thus, the efficient region of production is stage II. At this stage additional inputs are
contributing positively to the total product and MP of successive units of variable input is
declining (indicating that the fixed input is being optimally used). Hence, the efficient
region of production is over that range of employment of variable input where the
marginal product of the variable input is declining but positive.

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2.6 Long run Production: Production with two variable inputs

We have completed our analysis of the short-run production function in which the firm
uses one variable input (labor) and one fixed input (capital). Now we turn to the long run
analysis of production. Remember that long run is a period of time (planning horizon)
which is sufficient for the firm to change the quantity of all inputs. For the sake of
simplicity, assume that the firm uses two inputs (labor and capital) and both are variable.
The firm can now produce its output in a variety of ways by combining different amounts
of labor and capital. With both factors variable, a firm can usually produce a given level
of output by using a great deal of labor and very little capital or a great deal of capital and
very little labor or moderate amount of both. In this section, we will see how a firm can
choose among combinations of labor and capital that generate the same output. To do so,
we make the use of isoquant. So it is necessary to first see what is meant by isoquants and
their properties. , what is an isoquant?
2.7 Isoquants
An isoquant is a curve that shows all possible efficient combinations of inputs that can
yield equal level of output. If both labor and capital are variable inputs, the production
function will have the following form.
Q = f (L, K)
Given this production function, the equation of an isoquant, where output is held constant
at q is
q = f (L, K)
Thus, isoquants show the flexibility that firms have when making production decision:
they can usually obtain a particular output (q) by substituting one input for the other.
Isoquant maps: when a number of isoquants are combined in a single graph, we call the
graph an isoquant map. An isoquant map is another way of describing a production
function. Each isoquant represents a different level of output and the level of out puts
increases as we move up and to the right. The following figure shows isoquants and
isoquant map.

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Capital

q3

2 q2
1 q1
1

1 3 6 Labor

Fig 2.2 Isoquant and isoquant map. Isoquants show the fact that long run production
process is very flexible. A firm can produce q1 level of output by using either 3 capital
and 1 labor or 2 capital and 3 labor or 1 capital and 6 labor or any other combination of
labor and labor on the curve. The set of isoquant curves q1 q2 & q3 are called isoquant
map.
Properties of isoquants
Isoquants have most of the same properties as indifference curves. The biggest difference
between them is that output is constant along an isoquant where as indifference curves
ef
in its definition.
1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs
that yield the same output, isoquants always have negative slope. Isoquants can never be
horizontal, vertical or upward sloping. If for example, isoquants have to assume zero
slopes (horizontal line) only one point on the isoquant is efficient. See the following
figures.

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Fig 2.3 Capital

Capital Capital 100kg
100kg
wheat
teff

100kg
A teff

B
A

Labor A Labor

2 5

A B C
An isoquant can never be In this figure, a firm can produce In this figure, all points above
horizontal. In this figure, the 100kg of wheat by using any point A utilize higher
firm can produce 100kg of combination of labor and capital combination of both inputs to
teff by using either of the along the isoquant. But only point produce the same output (100 kg
following alternatives: 4 A is efficient. For example, point coffee). Point A shows the least
capital and 2 labor,4 capital B shows the same number of combination of inputs that can
and 5 labor or any other labor as point A, but higher yield 100 kg coffees. Thus all
combination of labor and capital. Thus point B is in other points are inefficient and
capital along the curve. efficient because it shows higher not part of the isoquants.
Obviously, only the first combination of inputs. Thus,
alternative is efficient as it isoquants can never be vertical
uses the least possible line
combination of inputs. Thus,
all points, except A, are
inefficient and not part of

Thus, efficiency requires that isoquants must be negatively sloped. As employment of one
factor increases, the employment of the other factor must decrease to produce the same
quantity efficiently.
2. are convex to the origin due to imperfect substitution (declining slope)
3. The further an isoquant lays away from the origin, the greater the level of output
it denotes. Higher isoquants (isoquants further from the origin) denote higher
combination of inputs. The more inputs used, more outputs should be obtained if the firm
is producing efficiently. Thus efficiency requires that higher isoquants must denote
higher level of output.
4. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.
Consider the following figure.

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Capital Fig 3.4Efficiency requires that

isoquants do not cross each other,
Q=20 q=50
because the point of their intersection
implies that there is inefficiency at
this point.

K*

L*
This figure shows that the firm can produce at either output level (20 or 50) with the
same combination of labor and capital (L* and K*). The firm must be producing
inefficiently if it produces q = 20, because it could produce q = 50 by the same
combination of labor and capital (L* and K*). Thus, efficiency requires that isoquants do
not cross each other.
Shape of isoquants
Isoquants can have different shapes (curvature) depending on the degree to which factor
inputs can substitute each other.
1-Linear isoquants
Isoquants would be linear when labor and capital are perfect substitutes for each other. In
this case the slope of an iso quant is constant. As a result, the same output can be
produced with only capital or only labor or an infinite combination of both. Graphically,

K
Fig.2.6 linear isoquant. Capital
and labor can perfectly substitute
10 each other so that the same
output (q=100) can be produced
by using either 10k or 8K and
12L or 15L or an infinite
8 combinations of both inputs.
q=100
L
12 15

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2. Input output isoquant

It is also called Leontief isoquant. This assumes strict complementarities or zero

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

q3
Fig. 2.7 L-shaped isoquant
q2
K2

q1
K1

L
L1 L2
When isoquants are L-shaped, there is only one efficient way of producing a given level
of output: Only one combination of labor and capital can be used to produce a given
level of output. To produce q1 level of output there is only one efficient combination of
labor and capital (L1 and K1). Output cannot be increased by keeping one factor (say
labor) constant and increasing the other (capital). To increase output (say from q1 to q2)
both factor inputs should be increased by equal proportion.
3. Kinked isoquants
This assumes limited substitution between inputs. Inputs can substitute each other only at
some points. Thus, the isoquant is kinked and there are only a few alternative
combinations of inputs to produce a given level of output. These isoquants are also called
linear programming isoquants or activity analysis isoquants. See the figure below.

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12 A

7
B

5
C

3
D

L
1 3 5 9

Fig. 2.8 kinked isoquant in this case labor and capital can substitute each other only at
some point at the kink (A, B, C, and D). Thus, there are only four alternative processes of
producing q=100 out put.
4. Smooth, convex isoquants
This shape of isoquant assumes continuous substitution of capital and labor over a
certain range, beyond which factors cannot substitute each other. Basically, kinked
isoquants are more realistic:
There is often limited (not infinite) method of producing a given level of output.
However, traditional economic theory mostly adopted the continuous isoquants because
they are mathematically simple to handle by the simple rule of calculus, and they are
approximation of the more realistic isoquants (the kidded isoquants). From now on we
use the smooth and convex isoquants to analyze the long run production.

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Fig: 2.9 the smooth and convex isoquant. This type of isoquant is the limiting case of the
kinked isoquant when the number kink is infinite. The slope of the iso quant decrease as
we move from the top (left) to the right (bottom) along the isoquant. This indicates that
the amount by which the quantity of one input (capital)can be reduced when one extra
unit of another inputs(labor)is used ( so that out put remains constant) decreases as more
of the latter input (labor)is used.

The slope of an isoquant: marginal rate of technical

Substitution (MRTS)
The slope of an isoquant (- K/ L) indicates how the quantity of one input can be traded
off against the quantity of the other, while out put is held constant. The absolute value of
the slope of an isoquant is called marginal rate of technical substitution (MRTS). The
MRTS shows the amount by which the quantity of one input can be reduced when one
extra unit of another input is used, so that output remains constant. MRTS of labor for
capital, denoted as MRTS L, K shows the amount by which the input of capital can be
reduced when one extra unit of labor is used, so that output remains constant.
This is analogues to the marginal rate of substitution (MRS) in consumer theory.
MRTS L,K decreases as the firm continues to substitute labor for capital (or as more of
labor is used). In fig.2.9 to increase the amount of labor from 1 to 2, the firm reduces 4

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Micro Economics for Management (Econ2021)

units of capital ( K=4), to increase labor from 2 to 3, the firm reduce 2 unit of capital
( K=2), and so on. Hence, the firm reduces lower and lower number of capital for the
successive one unit of labor. , why does this happen?
The reason is that when the number of capital is large and that of labor is low, the
productivity of capital is relatively lower and that of labor is higher (due to the low of
diminishing marginal returns). Thus, at this point relatively large amount of capital is
required to replace one unit of labor (or one unit of labor can replace relatively large
amount of capital). As the employment of labor increases and that of capital decreases (as
we move down ward along the isoquant), quite the reverse will happen. That is,
productivity of capital increases and that of labor decreases. Hence, the amount of capital
that needs to be reduced increase when one extra labor is used decreases. The fact that the
slope of an isoquant is decreasing makes an isoquant convex to the origin.
MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal products of
factors. That is,
K MPL
MRTS L, K
L MPK

This can be shown algebraically as follows:

Let the production function is given as:
q= f (L, K) Where q- is output
L- is unit of labor employed
K-is the amount of capital employed.

Given this production function, the equation of a specific isoquant can be obtained by
equating the production function with a given level of output, say q .

q = f (L, K) = q

Total differential of q measures the total change in q that happens as a result of a

simultaneous change in L and K. i.e,
q f
dq .dL .dk dq
L k
But since q is constant, d q is zero (d q =0)
q q
So, .dL dk 0
L k

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q q
(But, MPl and MPk )
L k
Thus, the above equation can be written as:
MPL. dL + MPK.dk = 0
MPL dK
MPk dL
There fore, the slope of an isoquant can be given as the ratio of marginal products of
inputs.
Elasticity of substitution
MRTS as a measure of the degree of substitutability of factors has a serious defect. It
depends on the units of measurement of factors. A better measure of the ease of factor
substituti
defined as
K K
% %
L = L
% MRTS MPL
%
MPK
K
)(
d L
K
= L
MPL MPL
d ( )
MPK MPK

The elasticity of substitution is a pure number independent of the units of measurement of

K and L, since the numerator and the denominator are measured in the same units and be
cancelled.
Factor intensity
A process of production can be labor intensive or capital intensive or neutral process. A
process of production is called labor intensive if it uses many labors and relatively few
capitals. If it uses many capitals and relatively few labor it is called capital intensive
technology. On the other hand, if the process uses equal proportion of both it is called
neutral technology. The factor intensity of any process is measured by the slope of the

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line through the origin representing the particular process. Thus, the factor intensity is the
capital-labor ratio. The higher the capital-labor ratio is the higher the capital intensity but
the lower the capital-labor ratio is the higher labor intensity of the process.

Capital

A
K1

B
K2 X

O
L1 L2 Labor
Fig 2.10 Process A uses k1 and L1 units of labor and capital to produce x amount of
output. The factor intensity of this process can be measured by the slope of OA, which
OK1 K1
equals AL1/OL1 =
OL1 L1
K2
Similarly, factor intensity of process B is given by
L2
K1 K2
Since , process A is more capital intensive than process B or B is more labor
L1 L2
intensive than A. The upper part of the isoquant includes more capital intensive processes
and the lower part, labor intensive techniques.

production function, Cobb-Douglas production function

The Cobb- Douglas production function is of the form
x b0 Lb1 K b 2
From this production function
2X
1. MPL = b1b0 Lb1 1 K b 2
2L
Lb1 b 2 X
= b0 b1 K bo
L L

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= b0.APL
2K
MPK = b 2b0 Lb1 K b 2 1

2L
X
= bo b0.APK
L
2. Marginal rate of technical substitution
X
b1
MPL L b1 K
(MRT SLK) = .
MPK X b2 L
b2
K
3. The elasticity of substitution
k l
d
l k
MPl MPk
d
MPk MPl
k
d( ) k /l
= l 1
b1k
d( ) b1K / b2l
b2l
4. Factor intensity is measured by the ratio b1/b2. The higher the ratio, the more labor
b1
intensive the technique. Similarly, the lower the ratio the more capital intensive the
b2
technique
5. The efficiency of production. This is measured by the coefficient b0. Obviously it is
clear that if two firms have the same K, L, b1 and b2 and still produce different quantities
of output, the difference could be due to the superior organization and entrepreneurship
of one of the firms, which results in different efficiencies. The more efficient firm will
have a larger b0 than the less efficient one.
2.8 The efficient region of production: long run
In principle the marginal product of a factor may assume any value, positive, zero or
negative. However, the basic production theory concentrates only on the efficient part of
the production function, i.e. over the range of out put over which the marginal product of

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factors are positive and declining. In the short run production function efficient region of
MPL
production prevails in stage two (stage II), where MPL >O, but < 0.
L
Similarly, efficient region of production in the long run prevails when the marginal
product of all variable inputs is positive but decreasing. Graphically this can be
represented by the negatively slopped part of an isoquant. The locus of points of
isoquants where the marginal products of factors are zero form the ridge lines. The upper
ridge line implies that the MP of capital is zero. MPk is negative for all points above the
upper ridge line and positive for points below the ridge line. The lower ridge line implies
that the MPL is zero. For all points below the lower ridge line the MPL is negative and
positive for points above the line. Production techniques are technically efficient inside
the ridge lines symbolically; in the long run efficient production region can be illustrated
as:
MPL
MPL >0, but <0
L
MPk
MPk >0, but <0
K
Graphically, efficient region of production is shown as follow:
Capital
Upper ridge line

Lower ridge line

q3

q2

q1

Labor

Fig 2.11: Thus efficient region of production is defined by the range of isoquants over
which they are convex to the origin.
The long run law of production: The law of returns to scale

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Micro Economics for Management (Econ2021)

The laws of production describe the technically possible ways of increasing the level of
production.
Output may increase in various ways. In the long run output can be increased by
changing all factors of production. This long run analysis of production is called Law of
returns to scale.
In the short run output may be increased by using more of the variable factor, while
capital (and possibly other factors as well) are kept constant. The expansion of output
with one factor (at least) constant is described by the law of variable proportion or the
law of (eventually) diminishing returns of the variable factor.

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

In the long run all inputs are variable. Expansion of output may be achieved by varying
all factors of production by the same proportion or by different proportions.
The traditional theory of production concentrates on the first case, i.e. the study of output
as all inputs change by the same proportion. The term returns to scale refers to the change
in output as all factors change by the same proportion. Suppose initially the production
function is
X0 = f (L, K)
If we increase all factors by the same proportion t, we clearly obtain a new level of output
X* where,
X* = f (tL, tK)
If X* increases by the same proportion t or if X* = tX0, we say that there is
constant returns to scale.
If X* increases less than proportionally with the increase in the factors (or if
X* increases by a proportion less than t), we have decreasing returns to scale.
If X* increases more than proportionally with the increase in the factors (by a
more than t proportion), we have increasing returns to scale.

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2.10 Returns to scale and homogeneity of production function

Suppose we increase both factors of the function X0=f (L, K) by the same ,
and we get the new level of output X = f (tL, tK)
If t can be factored out (that is, may be taken out of the brackets as a common factors),
then the new level of output X* can be expressed as a function of t (to any power V) and
the initial level of output, and the production function is said to be homogeneous.
X* = t v f (LK) or X* = t V
X0
If t can not be factored out, the production function is non-homogeneous. Thus, a
homogeneous function is a function such that if each of the input is multiplied by t, then t
can be completely factored out of the function. The power V of t is called degree of
homogeneity of the function and is measure of returns to scale.
If V=1, we have constant returns to scale. This production function is some times called
linear homogeneous
If V<1, decreasing return to scale prevails
If V>1, increasing return to scale prevails
For a Cobb-Douglas production function
X = b0Lb1 Kb2, V = b1 +b2 and it is a measure of returns to scale.
Proof: Let L and K increase by t. The new level of output is
X* = b0 (tL) b1 (tk) b2
X* = b0 tb1 lb1 tb2kb2
X* = b0Lb1Kb2 tb1+b2
X* = X (t b1+b2)
Thus V = b1+b2
Exercise
1.Which of the following production function is/are homogeneous?
A. q = L+K
B. q = 10L +K
C. q = L+L K +K
2
D. q = L +K
2. Suppose the production function is
3 1

q=L K4 4

A. what is APL, holding capital fixed?

B. Calculate MPL & MPK?
C. Does this production function have increasing, constant or decreasing returns to scale?

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2.11 Graphical presentation of returns to scale for homogeneous

production function
The returns to scale may be shown graphically by the distance between successive
multiple level-of-output ts that show levels of output which are
multiple of some base level such as X, 2X, 3X etc.
Constant returns to scale
Doubling the factor inputs doubles the level of initial output; trebling inputs trebles
output, and so on.

c
3k

b
2k
3X

a 2X
k
X
O L
1L 2L 3L

Fig 2.13 Constant returns to scale: oa= ab = bc

Decreasing returns to scale
Here, the distance between consecutive multiple- isoquants increases. When doubling
inputs output increases by less than twice of its original level.

c
3k
b 3X
2k 2.5X
a 2X
k
X 1.7x
O
L 2 3L
L
Fig 2.14 Constant returns to scale: oa< ab < bc
Increasing returns to scale

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The distance between consecutive multiple isoquants decrease, by doubling the inputs,
output is more than doubled.
K
3.75X

3K1

c
B c
2K1
b
3X
a
K1 2.5X
2X
X
L
O
L1 2L1 3L1

Fig 2.15Doubling K and

trebling K&L results in an isoquant which lies above 3X(i.e.,3.75X) and so on.

Returns to scale are usually assumed to be the same every where on the production
surface i.e., the same along all the expansion product lines. All processes are assumed to
show the same returns to scale over all ranges of output. Either constant returns to scale
every where, or decreasing returns every where, or increasing returns everywhere.
However, the technological conditions of production may be such that returns to scale
may vary over different ranges of output. Over some range we may have constant returns
to scale, while over another range we may have increasing or decreasing returns to scale.

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K 3.75
XX

3K1 b
7X
c
2K1 c 6X
5X
a 4X
K1 3X
2X
X
L
O
L1 2L1 3L1

Fig 2.16 Up to point C, increasing returns to scale prevails in the firm, from C to B
constant returns to scale prevails, and beyond B decreasing returns to scale prevails.

Causes of increasing returns to scale

Technical and /or managerial indivisibility. Mostly, processes of production can be

doubled but it may not be possible to half them. When the production system expands,
workers will specialize in one extreme and their productivity increases.
Causes of decreasing returns to scale
T
put beyond optimum, the top management personnel will be over burdened and the
productivity of additional unit of the variable inputs decline eventually. E.g., doubling
fishing fleet may not double fish catch.

2.12 Technological process and production function

Technological improvement (progress) makes factors of production more productive or it
makes production system more efficient; so that the firm will get higher output from the
same combinations of labor and capital than before.

Graphically, this can be shown by upward movement of the total product curve
(indicating higher output level can be achieved from the same input) and down ward

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movement of isoquant denoting lower combinations of factors of production can produce

equal level of output. See the figures

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

Fig 2.17 technological

L1 progress shifts the TP curve up ward &the isoquant
L2 downL1
ward

2.13 Equilibrium of the firm: Choice of optimal combination of factors

of production
In our previous discussion we have said that an isoquant denotes efficient combination of
labor and capital required to produce a given level of out put. But, this does not mean that
the monetary cost of producing a given level of out put is constant along an isoquant.
That is, though different combinations of labor and capital on a given isoquant yield the
same level of out put, the cost of these different combinations of labor and capital could
differ because the prices of the inputs can differ. Thus, isoquant shows only technically
efficient combinations of inputs, not economically efficient combinations. Technical
efficiency takes in to account the physical quantity of inputs where as economic
efficiency goes beyond technical efficiency and seeks to find the least cost (in monetary
terms) combination of inputs among the various technically efficient combinations.
Hence, technical efficiency is a necessary condition, but not a sufficient condition for
economic efficiency. To determine the economically efficient input combinations we
need to have the prices of inputs.

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To determine the economically efficient input combination, the following simplifying

assumptions hold true:
Assumptions

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

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

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

3. The prices of inputs are given (constant).Price of a unit of labor is w and that of
capital is r .
Now before we go to the discussion of optimal input combination (or economically
efficient combination), we need to know the isocost line, because optimal input is defined
by the tangency of the Isoquant and iso-cost line.
Isocost line
Do you remember what the budget line denotes?
Isocost lines have most of the same properties as that of budget lines, an isocost line is
the locus points denoting all combination of factors that a firm can purchase with a given
monetary outlay, given prices of factors.
Suppose the firm has C amount of cost out lay (budget) and prices of labor and capital
are w and r
C rK wL , where K and L are quantities of capital and labor
respectively.
Given the cost outlay C , the maximum amounts of capital and labor that the firm can
C C
purchase are equal to and respectively. The straight line that connects these points
r w
is the iso-cost line. See the following figure:

Capital

C/r

Iso cost
line

C/w Labor

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Fig: 2.18 the iso cost line: shows different combinations of labor and capital that the firm
can buy given the cost out lay and prices of the inputs.

nation. However,
the problem of determining optimal input combination (economic efficiency) takes two
forms. Some times, situations may happen when a firm has a constant cost outlay and
seek to maximize its out put, given this constant and cost out lay and prices of in puts.
Still, there are also situations when the goal of the firm is to produce a predetermined
(given) level of output with the least possible cost. Under we will discuss the two
situations separately.
Case1: Maximization of output subject to cost constraint
Suppose a firm having a fixed cost out lay (money budget) which is shown by its iso-cost
line. Here, the firm is in equilibrium when it produces the maximum possible out put,
given the cost outlay and prices of input. The equilibrium point (economically efficient
-cost line (showing
the budget constraint) with the highest possible isoquant. At this point, the slope of the
w MPL
iso cost line ( ) is equal to the slope of the isoquant ( ).
r MPK
The condition of equilibrium under this case is, thus:

w MPL MPL MPK

or
r MPK w r

This is the first order (necessary) condition. The second order (sufficient) condition is
that isoquant must be convex to the origin. See the following figure:

Capital

Q3
K1 E

Q2
Q1
L1 B Labor
Fig: 2.19 the optimal combination of inputs ( L1 and K1 ) is defined by the tangency of the
iso-cost line (AB) and the highest possible isoquant ( X 2 ), at point E. At this point the

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w MPL
slope of iso-cost line ( ) is equal to the slope of isoquant X 2 ( ).The second order
r MPK
condition is also satisfied by the convexity of the isoquant.
, do you think that the point of tangency of the iso-cost line and the isoquant represents
equilibrium point when the isoquant is concave?
If isoquant is concave to the origin the point of tangency of the iso cost line and the
isoquant does not define the equilibrium combination of factor inputs. With a concave
isoquant, we have a corner solution. Refer the figure below:

Isoquant: x=100kg

Fig: 2.20 Concave isoquant results in corner solution. The point of tangency between the
isoquant and the iso-cost line does not satisfy the second order condition as the isoquant
is concave. The same level of output(X=100Kg) can be produced with a lower cost out
lay at point A.
Mathematical derivation of the equilibrium condition
The problem can be stated as:

Maximize X f ( L, K )......... .......... .......Objective function

Subject to C wL rK.......... .......... ......Constraint function
or C wL rK C 0
We use the lagrangian method to solve the problem.
The lagrangian equation is written as:
X (C)

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Then we find , , and and set all of them equal to zero to solve for
L K
L and K .
That is,
X ( wL rK C)
X MPL
And, wL 0 MPL w
L L w
X MPK
r 0 MPK r
K K r
wL rK w 0 wL rK C
Solving these equations simultaneously, we obtain the equilibrium condition
MPL MPK w MPL
or
w r r MPK
The second order condition (the convexity of isoquant) would be insured when:
2 2 2 2 2 2
X X X X X
2
0 , 2
0 and 2 2
L K L K L K
Numerical Example
Suppose the production function of a firm is given as X 0.5 L1 / 2 K 1 / 2 prices of labor and
capital are given as $ 5 and $ 10 respectively, and the firm has a constant cost out lay of $

maximum out put.

Solution
MPL MPK MPL w
The condition of equilibrium is or
w r MPK r
X
MPL 0.25L 1 / 2 K 1 / 2
L
X
MPK 0.25L1 / 2 K 1 / 2
K
Thus, the equilibrium exists when,
0.25L 1 / 2 K 1 / 2 $5
1/ 2 1/ 2
0.25L K $10

K 1
L 2 K .......... .......... .......... .....(1)
L 2
The constraint equation is:
wL rK C
5 L 10K 600.......... .......... .......... ........( 2)

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Solving equation (1) and (2) would give us the optimal combination of L and K.
L 2K
5L 10K 600
L=60 units and K=30 units.
Thus, the firm should use 60 units of labor and 30 units of capital to maximize its
production (out put). (Check the second order condition).
The maximum out put can be found by substituting 60 and 30 for L and K in the
production process.

Case -2: Minimization of cost for a given level of output

In this case, consider an entrepreneur (a firm) who wants to produce a given output (for
example a bridge or a building or x tones of a commodity) with minimum cost outlay.
That is, we have a single isoquant which denotes the desired level of output, but there are
a set of isocost lines which denotes the different cost outlays. Higher isocost lines denote
higher production costs. The production costs of a desired level of output will therefore
be minimized when the isoquant line is tangent to the lowest possible isocost line (see
fig) At the point of tangency, the slope of the isoquant and isocost lines are identical.
w MPL
That is
r MPK

Capital

c
a
E
K1 Q

b d f
L1
Labor

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Fig: 2.21 the equilibrium combination of factors is K1 and L1 amounts of capital and

attainable given the desired level of output. So point E shows the least cost combination
of labor and capital to produce X amount of output.
Now let us see the mathematical derivation of the equilibrium condition. As mentioned
earlier, we minimize the cost of producing a given level of output.
Thus, the problem can be stated as:
Minimize C = f (q) = WL + rK ---------------------------------------- (Objective function)
Subject to q = f (L, K) ------------------------------------------------ (Constraint function)
Or f (L, K) q=0
We use the LaGrange an method to obtain the equilibrium condition. Accordingly, the
LaGrange an function will be:
C ( f ( L, K ) q )
WL rK ( f ( L, K ) q )

The condition of equilibrium will be obtained by finding , and and then

L K
solving them simultaneous after equating each to zero.
That is
f ( L, K )
w 0
L L
w
w MPL 0
MPL
f ( L, K )
r 0
K K
r
r MPK 0
MPK

f ( L, K ) q 0

w r
Thus, the equilibrium condition is
MPL MPK
MPL w
Rearranging the above condition, we obtain
MPK r

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MPL W
This condition is only a necessary condition .
MPK r
The sufficient condition is that the isoquant must be convex to the origin. That is
2 2 2 2 2 2
q q q q X
0, 0and
L2 k2 L2 k2 L K

Numerical example:
Suppose a certain contractor wants to maximize from building one bridge. The
contractor uses both labor and capital, and efficient combinations of Labor and capital
1 1

that are sufficient to make a bridge is by the function 0.25 L 2 K 2 . If the prices of labor
(w) and capital (r) are $ 5 and $ 10 respectively.
Find the least cost combination of L and K, and the minimum cost.
Solution:
The contractor wants to build one bridge. Thus, the constraint equation can be written as
1 1
0.25 L k =1
2 2

1 1

MPL = 0.125 L K 2 2

1 1

MPK = 0.125 L K 2 2

MPL W
The equilibrium condition is
MPK r
1 1

0.125L K 2 2
$5
1 1
$10
0.125L K 2 2

K 1
L 2K
L 2
Substituting L = 2K in the constraint equation we obtain
1 1

0.125 (2K) 2
K =1 2

0.125 2 . K=1
1 8
K= K
0.125 2 2

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16
L = 2K
2
16 8
Therefore, efficient combination (least cost combination) of L and K are and
2 2
respectively.
16 8 160
The least cost is C = 5 + 10 =$
2 2 2
Cost minimization with varying out put levels and the derivation of long run total
cost curve

, in the previous chapter we saw how a cost minimizing firm selects a combination of
inputs to produce a given level of out put. Now we extend this analysis to see how the

Expansion
K path

40 80

70
B
3.5 60
A
3 50
30
2
20
10 L
O
3 5 6

Fig 2.22

In the above figure, the firm is assumed to have increasing returns to scale up to point A
(the distance between successive multiple levels of out put decreases), constant returns to
scale between points A and B (the distance between successive multiple levels of out puts

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is constant) and decreasing returns to scale beyond point B (the distance between
successive multiple levels of out put increases).
s and its
isoquants is called expansion path. The expansion path denotes least cost combination of
labor and capital required to produce different levels of out put.
To produce 10 units of out put, the firm uses 2K and 3L, to produce 20 units, the firm
uses 3K and 5L, to produce 30 units it uses 3.5K and 6L, and so on. Hence, as out put
expands at a constant amount, the units of labor and capital increases at a decreasing rate
up to point A. That is, total cost of production increases at a decreasing rate up to point
A. From point A to B, combination of labor and capital increase at a constant rate as out
put increases at a constant rate. Hence, the long run total cost increases at a constant rate
up to point B.
Beyond point B, to expand out put at a constant rate, combination of labor and capital
should be increased at an increasing rate. Assuming that the prices of inputs are constant,
the long run total cost of production increases rapidly (at increasing rate) beyond point B.
From the above discussion, we infer that the long run total cost curve assumes an inverse
S-shape.

Summary
In economics, production means the act of creating those goods or services that have
exchange values. The process of production requires inputs such as land, labor, capital
and entrepreneurial ability, Fixed inputs are those inputs whose quantity can not readily
be changed when market conditions indicate that an immediate change in out put is
required, Variable inputs are those inputs whose quantity can be changed almost
instantaneously in response to derived changes in output.
A production function describes the maximum out put that a firm can produce for each
specified combinations of inputs. In the short run, one or more inputs to the production
process are fixed. In the long run, all inputs are potentially variable.
In the short run the firm is said to be efficient when it operates over the range of
employment of the variable inputs where marginal product of the variable input is
positive but declining.

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