Consumer and Producer Theory

Lecture
Consumer Choice and the Utility Function
 Class Start : 8:30
 Break : 9:45 to 10:15 AM
 Class End : 11:30 AM
 General Overview

Consumer and Producer Theory

AIM: To understand the theoretical

structure underpinning the analysis of
consumer and producer theory, and to
be able to apply and manipulate the
theory in alternative settings
 Lecture Structure
1. Consumer choice and the utility function
2. Direct and indirect utility functions
3. Duality, Slutsky equation and revealed
preference
4. Welfare and project choice
5. Different domains: Intertemporal choice, labour
6. Production functions and profit maximisation
7. Cost functions and duality
8. Applications: Monopoly pricing
 Core Texts
 Varian H. Intermediate Microeconomics: A modern
approach (6th/7th edition), W.W. Norton & Co,
2003/2006
 Katz and Rosen Microeconomics (3rd edition) Nicholson
Microeconomic Theory (8th edition)
 Perloff Microeconomics (2nd edition)
 Pindyck & Rubinfeld Microeconomics (5th edition)
 Gravelle H. & R. Rees Microeconomics (2nd edition)
 Varian H. Microeconomic Analysis (3rd edition)
 Jehle G. & P. Reny Advanced Microeconomic Theory
(2nd edition).
 Today’s Outline
 Define and analyse a consumer’s preferences

 Assumptions on preferences

 Representation: From preferences to utility

 Ordinality and cardinality

 Consumer Theory
 A theory of consumer behaviour requires three
steps:
 Identify the consumer’s preferences
 Identify constraints facing the consumer
 Identify the consumer’s choice, given these
 Rationality: Consumers choose most preferred
option, given constrains.
 Consumer Theory
 A consumer’s preference ordering can be
represented by a (real valued) utility function u(.)
if, for any two bundles x and y,
x y if and only if u(x) > u(y)

 Question:
Question What restrictions over preferences
are required for the preference ordering to be
represented by a utility function?
 The Utility Function
 Any function is a mapping from a domain to a
range

Domain Range
 The Mapping
 Specifically: A function is a mapping where, for
every element in the domain there exists one,
and only one, element in the range
 Axiom of choice: Completeness
 Any two elements can be compared
 Axiom of choice: Reflexivity
 Any element is at least as good as itself
 The Range
 The real line is adopted as the range of the utility
function, with higher numbers representing more
preferred options

 Axiom of Choice: Transitivity

 If an apple is preferred to an orange and an
orange is preferred to a banana, then an apple
is preferred to a banana
 The Basic Axioms
Completeness:
Completeness For any two bundles x and y:
x“ y or y“ x

Reflexivity:
Reflexivity For any bundle x: x“ x

Transitivity:
Transitivity For any bundles x, y and z:
x “ y and y “ z then x “ z
 Conditions, conditions…
 Completeness, Reflexivity and Transitivity are
necessary conditions for the preference ordering
to be represented by a utility function

 But are they also sufficient conditions? That is, if

a consumer’s preference ordering satisfies these
three conditions can it be represented by a utility
function?

NO!
 Lexicographic Preferences
 A consumer has lexicographic preferences if, no
matter what, he prefers more of one commodity
(say commodity x) than less but, given the same
amount of x, prefers more of another commodity
(say y) to less

 These preferences satisfy the three axioms of

choice identified, but cannot be represented by a
utility function
 Further Restriction
 Continuity: Small changes in the quantity of one
commodity can be ‘compensated’ by small
changes in the quantity of another commodity

 More formally: For every element in the domain,

the set of ‘weakly preferred’ elements and the
set of ‘weakly less preferred’ elements are
closed
 Theorem
Gerard Debreu (1954):
 A consumer’s preference ordering can be
represented by a (continuous) utility function if
and only if the preferences ordering is complete,
reflexive, transitive and continuous

 Furthermore, the preferences can be

represented graphically by continuous
indifference curves
 Uniqueness
 Given these restrictions - will the utility function
describing preferences be unique? No!
 If u(x) is a function representing a consumer’s
preferences then any monotonic transformation
of that function will also represent the
consumer’s preferences
 E.g. u(x)+, log[u(x)], u(x) (when  >0)
 Lesson: Utility functions are ordinal, not cardinal
 Well-Behaved Preferences
 Common to additionally assume that:
 More is better (monotonicity)
 So indifference curves downward sloping,
‘thin’ and all elements of the domain are ‘good’
 (marginal utility is positive)
 Strictly convex preferences
 So indifference curves strictly convex and
solution to the maximisation problem is unique
 (utility function is strictly quasi-concave)
 An Indifference Curve

x2 x’  x”  x”’
x’

x”

x”’

x1
 The Domain
 The domain of the utility function will depend on
the problem we wish to analyse
 We will consider a number of different domains
in this course, namely
 Commodity space
 Consumption/income space
 Intertemporal consumption/income
space
 State (of the world) space (really!)
 Homo Economicus
 Somebody whose preferences can be
represented by a utility function, and whose
choices can be modeled as the solution to the
‘utility maximisation’ problem

 Does this imply greed? Or selfishness?

 Utility Maximisation
 If consumer choice is to be represented in the
(constrained) utility maximisation problem
max u(x) s.t. x  C  X
 then we need everything that influences the
consumer’s choice to be included in the
domain
 we also need the ‘process’ by which the
constraint is imposed to have no impact on the
choice
 Things Outside the Domain
 Things not explicitly included in the domain will
have no impact on the consumer’s decision if
- they have no impact on the preference
ordering
- they remain unchanged (ceteris paribus
assumption)
 Common Assumption

 The domain of a consumer’s utility function only

includes goods/resources allocated explicitly to
that consumer
 Summary
 Have taken a first look at consumer preferences

 Under some assumptions, preferences may be

represented by utility functions

 This step immensely eases formal analysis

 Readings
 Varian Intermediate Economics (7th ed.)
chapter 3.
 Debreu G. (1954) ‘Representation of a Preference
Ordering by a Numerical Function’ in R’. Thrall et al.
Decision Processes. Reprinted in G. Debreu (1983):
Mathematical Economics.
 Next Time…
 Indifference curves

 Marginal rates of substitution

 Marshallian demand functions

 Types of goods

 Indirect utility function

 Consumer surplus and welfare

 Part IIA, Paper 1
Consumer and Producer Theory

Lecture 2
Direct and Indirect Utility Functions
Flavio Toxvaerd
 Today’s Outline
 Indifference curves
 Marginal rates of substitution
 Marshallian demand functions
 Types of goods
 Indirect utility function
 Consumer surplus and welfare
 Some mathematical results (Envelope Thm.)
 Roy’s Identity
 Utility Function
 Recall from last lecture – given Axioms of Choice,
continuity and local non-satiation - a consumer’s
preference ordering can be represented by a utility
function
 Simplifying Assumption: The domain consists of only two
types of commodities, types 1 and 2
 A specific consumption bundle, x, will be represented by
a vector x = (x1,x2) and we can write the utility function
as u(x1,x2)
 Indifference Curves
 Indifference curves show combinations of
commodities for which utility is constant
Mathematically, we require that du ( x1, x2 )  0
u ( x1, x2 ) u ( x1, x2 )
dx1  dx2  0
x1 x2
u ( x1, x2 )
dx2 x1
 
dx1 u ( x1, x2 )
x1
Slope
Slopeof
ofIndifference
IndifferenceCurve
Curve==
Marginal
Marginal Rate
Rateof
of
Substitution
Substitution
 Utility Maximisation
max u ( x1 , x 2 )
x1 , x2

subject to p1 x1  p 2 x 2  m
L  u ( x1 , x 2 )  [m  p1 x1  p 2 x 2 ]

u ( x1 , x 2 )
First
Firstorder
orderconditions:
conditions:  p1
x1
u ( x1 , x 2 )
 p 2
x 2
p1 x1  p 2 x 2  m
 Utility Maximisation
Eliminating the Lagrange Multiplier () gives
u ( x1, x2 ) MRS
MRS==Ratio
Ratioof
ofPrices
Prices
x2 p2
 Slope
Slopeof
ofIndifference
IndifferenceCurve
Curve
u ( x1, x2 ) p1
==Slope
Slopeof
ofBudget
BudgetLine
Line
x1

and p1x1  p2 x2  m Budget

BudgetLine
Line
Note, with more than two commodities have FOC
u
xi MUxi
    MU of income
pi pi
 Utility Maximisation
To solve: move along budget line, until point of
tangency with the indifference curve

x2 x2

A
D
C
B

x1 x1
 Demand Function
When the indifference curves are strictly convex
the solution is unique, say x*, where

x1*= x1(p1,p2,m) , x2*= x2(p1,p2,m)

giving demand as a function of prices and income

Marshallian
Marshallian Demand
Demand Functions
Functions
' Ordinary' Good :
dx1 ( p1 , p2 , m)
Goods
0 x2
dp1
Giffen Good : m Price expansion path
p2
dx1 ( p1 , p2 , m)
0
dp1

Complements :
dx2 ( p1 , p2 , m) m m x1
0 p1 p '1
dp1
Substitutes : p1
Demand Curve
dx2 ( p1 , p2 , m)
0 p’1
dp1
x1(p1,p2,m) x1(p’1,p2,m) x1
 Goods
dx1 ( p1, p2 , m)
 0 : Inferior Good  < 0
dm
dx1 ( p1, p2 , m)
 0 : Normal Good  > 0
dm
dx1 ( p1, p2 , m) x1
 : Superior Good  > 1
dm m
Income Elasticity of Demand :
Graphically:
dx1 m
 . Engel Curve
dm x1
 Practice
 Problem 1: 1
 Show that the Marshallian Demand Function is
homogenous degree zero. (So consumers never
suffer from Money Illusion)
 Problem 2: 2
 Show that consumers’ purchase decisions are
unaffected by any monotonic transformation of
the utility function.
 (Hint: A monotonic transformation can be
represented by a strictly increasing function f(.).
Use the chain rule to show that the MRS remains
unaffected)
 Convex Indifference Curves
 Convex indifference curves means that the
(absolute value of the) slope of the indifference
curve is decreasing as x1 increases
 That is: Diminishing MRS
 Problem 3:3
 Show that diminishing marginal utilities is
neither a necessary nor a sufficient condition
for convex indifference curves
 Example: Cobb-Douglas Utility
 1
u ( x1, x2 )  x1 x2
 1
Lagrangian : L  x 1 x2   ( p1x1  p2 x2  m)

x1 1x12  p1

 
First
First Order
Order Conditions
Conditions (1   ) x1 x2  p2
p1 x1  p2 x2  m
 Example: Cobb-Douglas Utility
Eliminating  gives:
(1   ) x1 p2
MRS  
x2 p1
Substitution into the budget constraint gives the solution
m
x *1  x1 ( p1 , p2 , m) 
p1
(1   ) m
x *2  x2 ( p1 , p2 , m) 
p2
With Cobb-Douglas Utility the consumer spends a
fixed proportion of income on each commodity
 Indirect Utility Function
It is often useful to consider the utility obtained by
a consumer indirectly, as a function of prices and
income rather than the quantities actually
consumed

Let v( p1 , p2 , m)  u ( x *1 , x *2 )  u ( x1 ( p1 , p2 , m), x2 ( p1 , p2 , m))

 max u ( x1 , x2 ) such that p1 x1  p2 x2  m

v( p1 , p2 , m) is called the Indirect Utility Function

 Properties of Indirect Utility Fn
 Property 1:
1 v(p,m) is non-increasing in prices
(p), and non-decreasing in income (m).
 Proof: Diagramatically, it is clear that any increase in
prices or decrease in income contracts the ‘affordable’
set of commodities – as nothing new is available to
the consumer utility cannot increase
 Property 2:
2 v(p,m) is homogeneous degree
zero.
 Proof: No change in the affordable set, or in
preferences
Properties of Indirect Utility Fn

These
These two
two are
are General
General Properties
Properties and
and
NOT
NOT reliant
reliant on
on additional
additional restrictions
restrictions
such
such as
as convexity
convexity ofof indifference
indifference
curve,
curve, more
more is
is better
better etc.
etc.
 Direct and Indirect Utility
We will see that direct and indirect utility functions are
closely related - and that any preference ordering that can
be represented by a utility function can also be represented
by an indirect utility function. This means we are free to use
whichever specification we please

For Example:
Example
If the price of commodity 1 changes from, say, p1=a to
p1=b, we may want to use the indirect utility function to
measure the change in consumer welfare:

 (utility)  v(b, p2 , m)  v(a, p2 , m)

 Mathematical Digression
 The Envelope Theorem:
If M (a )  max x , x g ( x1 , x2 , a ) s.t. h( x1 , x2 , a )  0
1 2

 g ( x *1 , x *2 , a )
for which the Lagrangian can be written
L  g ( x1 , x2 , a ) -  h( x1 , x2 , a )
then
M L Evaluated at the
 ( x *1 , x *2 , a ) maximising
a a values

Proof: See Varian Microeconomic Analysis, p. 502.

502
 Application 1
 Marginal utility of Income
As v( p1 , p2 , m)  max x , x u ( x1 , x2 ) s.t. p1 x1  p2 x2  m  0
1 2

and the Lagrangian

L  u ( x1 , x2 ) -  ( p1 x1  p2 x2  m)
then, by the Envelope Theorem,
v L
 ( x *1 , x *2 , p1 , p2 , m)  
m m

The marginal utility of income is

given by the Lagrange multiplier
 Application 2
 Roy’s Identity
Similarly, by the Envelope Theorem,
v( p1, p2 , m) L( x1* , x1* )
   x1 ( p1, p2 , m)
p1 p1
and so,
v( p1, p2 , m)
p1 Roy’s
x1 ( p1, p2 , m)  
v( p1, p2 , m) Identity
m
 Consumer Surplus and Welfare
We saw earlier that, following a price change,
 (utility)  v(b, p2 , m)  v(a, p2 , m)
a
v( p1, p2 , m)
  dp1
b p1
a
v( p1, p2 , m)
 .x1( p1, p2 , m) dp1
b m
a
   x1( p1, p2 , m) dp1 ,
b
v( p1, p2 , m)
if constant
m
Consumer Surplus and Welfare
a

 x ( p , p , m)dp
b
1 1 2 1  (Consumer Surplus)

So, ( Utility)  (Consumer Surplus)

p1

b Marshallian Demand

x1
 Summary
 Indifference curves
 Marginal rates of substitution
 Marshallian demand functions
 Types of goods
 Indirect utility function
 Consumer surplus and welfare
 Roy’s Identity
 Readings
 Texts:
 Varian, Intermediate Economics (7th ed.)
chapters 4, 5, 6, 14.
 Varian, Microeconomic Analysis, chapter 7
 Part IIA, Paper 1
Consumer and Producer Theory

Lecture 3
Duality and the Slutsky Equation
Flavio Toxvaerd
 Today’s Outline
 Dual approaches to consumer’s problem

 Hicksian demand function

 Expenditure function

 Shephard’s lemma

 Slutsky equation

 The big picture (various relations)

 Recap
max u x1 , x 2 
s.t. p1 x1  p 2 x 2  m Solve

Marshallian demand
x1(p,m) and x2(p,m)

Roy’s Substitute
identity into u(x,y)

Indirect utility
v(p,m)
The Envelope Theorem
The Envelope Theorem
 Application 1 (again…)
 Marginal utility of Income
As v( p1 , p2 , m)  max x , x u ( x1 , x2 ) s.t. p1 x1  p2 x2  m  0
1 2

and the Lagrangian

L  u ( x1 , x2 ) -  ( p1 x1  p2 x2  m)
then, by the Envelope Theorem,
v L
 ( x *1 , x *2 , p1 , p2 , m)  
m m

The marginal utility of income is

given by the Lagrange multiplier
 Application 2 (again…)
 Roy’s Identity
Similarly, by the Envelope Theorem,
v( p1, p2 , m) L( x1* , x1* )
   x1 ( p1, p2 , m)
p1 p1
and so,
v( p1, p2 , m)
p1 Roy’s
x1 ( p1, p2 , m)  
v( p1, p2 , m) Identity
m
 Duality
Primal Problem Dual Problem
max u ( x1, x2 ) min p1 x1  p2 x2 
s.t. p1x1  p2 x2  m s.t. u ( x1 , x2 )  u

x2 x2 u
m
p2

m x1 x2
p1
 Dual Problem
min p1 x1  p2 x2 s.t. u ( x1 , x2 )  u
The dual problem gives us the minimum
expenditure required for the consumer to achieve
a particular level of utility.
L  p1x1  p2 x2   ( u ( x1, x2 )  u )
u ( x1, x2 )
p1   0
x1
u ( x1, x2 ) First Order Conditions
p2   0
x2
u ( x1, x2 )  u
 Dual Problem
Eliminating the Lagrange multiplier () gives
u ( x1, x2 )
MRS = Ratio of Prices
x2 p2

u ( x1, x2 ) p1 Slope of Indifference Curve
x1 = Slope of Budget Line

u ( x1, x2 )  u Utility Constraint

 Hicksian Demand Function
 Solving these two equations, gives the levels of
demand which achieve the desired utility level at
the lowest cost
 When indifference curves are strictly convex the
solution is unique and we may write demand as
a function of prices and the desired utility level
xˆ1  h1 ( p1, p2 , u ) , xˆ2  h2 ( p1, p2 , u )

These are called Hicksian/Compensated

Demand Functions
 Hicksian Demand Function
x2
p1
slope  
p2

p '1
slope  
p2 u
x1
p1
Hicksian (Compensated)
Demand Curve
p1
p’1

(Hicksian Demand) h1(p1,p2,m) h1(p’1,p2,m) x1

= Substitution Effect
 Expenditure Function
We can now determine the minimum expenditure
required to achieve a specific utility level, given the
prices:

Let e( p1 , p2 , u )  min p1 x1  p2 x2  s.t. u ( x1 , x2 )  u

 p1h1 ( p1 , p2 , u )  p2 h2 ( p1 , p2 , u )
Properties of the Expenditure Function
 Homogeneous of degree 1 in prices
 Proof: No change in relative prices, so no change in
optimal solution - so expenditure changes by same
proportion.
 Concave in prices
 Proof: If prices change, expenditure will increase
linearly if consumption bundle unchanged. Thus any
change in consumption reduces expenditure - and
expenditure increases less than linearly.
 Increasing in prices if u(x) is an increasing
function
 Shephard’s Lemma
As e( p1 , p2 , u )  min p1 x1  p2 x2  s.t. u ( x1 , x2 )  u
and the Lagrangian
L  p1 x1  p2 x2   (u ( x1 , x2 )  u )

we can apply the envelope theorem to get

e( p1 , p2 , u )
 xˆ1  h1 ( p1 , p2 , u )
p1

Shephard’s Lemma
 e Passive
Expenditure
Indirect Effect

x̂1 Actual
Expenditure
p 2 x̂ 2
p10 p11 p1
(1) Will not do any worse than “Passive Expenditure”
(2) As change in Px goes to zero, indirect effect becomes
irrelevant because original choice very close to optimal
Indirect Utility and Expenditure Functions
 Recall: Indirect utility function gave us the level
of utility given prices and income
 Expenditure function gives us level of income
required to achieve a specified utility level
 Thus the indirect utility function is just the inverse
of the expenditure function - and vice versa
 Duality in Demand Functions

Note that, when x2 u u0

m  e( p1, p2 , u ),

xi ( p1, p2 , m)  hi ( p1, p2 , u )
e0

m x1
So, we can write p1

xi ( p1, p2 , e( p1, p2 , u ))  hi ( p1, p2 , u )

 Slutsky Equation
We have shown that
xi ( p1, p2 , e( p1, p2 , u ))  hi ( p1, p2 , u )
Differentiating both sides w.r.t. p j ,
xi xi e hi
 . 
p j m p j p j
and so
xi hi xi e hi xi
  .   xˆ j Slutsky Equation
p j p j m p j p j m

Substitution Effect Income Effect

 Primal Approach Dual Approach
max u x1 , x 2  Duality minp1 x1  p2 x2 
s.t. p1 x1  p 2 x 2  m s.t. u x1 , x2   u
Integrability Solve Solve
problem

Marshallian Demand Equivalent if Hicksian Demand

x1(p,m) and x2(p,m) m  e p, u  h1  p, u  and h2  p, u 

Roy’s Substitute Shephard’s Substitute

Identity into u(x,y) Lemma into cost
equation
Indirect Utility Invert Expenditure Function
v(p,m) e p , u 
 Integrability Problem
 The problem with all of this is that the utility
function is not observable - only behaviour
(demand) is observable
 Thus we are in danger of having a wonderfully
elegant theory of consumer behaviour - which
relies on an unobservable function!
 The Slutsky equation is defined for every
price/commodity combination
 Integrability Problem
 The ‘nice’ assumption of convexity and more is
better on the utility function impose restrictions
on the nature of the matrix of Slutsky equations
 These conditions turn out to be both necessary
and sufficient for the demand function to be
generated by a utility function which possesses
these ‘nice’ properties.
 Thus we can now identify precisely whether or
not our theoretical framework is appropriate
 Summary
 Can approach consumer’s problem from different
angles

 Having one function, may recover other functions

 Readings
 Varian, Microeconomic Analysis, chapters 6, 7, 8
 Next Time…
 Revealed preferences

 WARP, SARP, GARP

 Indices
 Part IIA, Paper 1
Consumer and Producer Theory

Lecture 4
Revealed Preferences and Consumer Welfare
Flavio Toxvaerd
 Today’s Outline
 Leftovers from Lecture 2

 Revealed preferences

 WARP, SARP, GARP

 Indices
 Primal Approach Dual Approach
max u x1 , x 2  Duality minp1 x1  p2 x2 
s.t. p1 x1  p 2 x 2  m s.t. u x1 , x2   u
Integrability Solve Solve
problem

Marshallian Demand Equivalent if Hicksian Demand

x1(p,m) and x2(p,m) m  e p, u  h1  p, u  and h2  p, u 

Roy’s Substitute Shephard’s Substitute

Identity into u(x,y) Lemma into cost
equation
Indirect Utility Invert Expenditure Function
v(p,m) e p , u 
 Consumer Surplus and Welfare
Following a price change,
 (utility)  v(b, p2 , m)  v(a, p2 , m)
a
v( p1, p2 , m)
  dp1
b p1
a
v( p1, p2 , m)
 .x1( p1, p2 , m) dp1
b m
a
   x1( p1, p2 , m) dp1 ,
b
v( p1, p2 , m)
if constant
m
Consumer Surplus and Welfare
a

 x ( p , p , m)dp
b
1 1 2 1  (Consumer Surplus)

So, ( Utility)  (Consumer Surplus)

p1

b Marshallian Demand

x1
 Question
 Question: What can we say about consumer
preferences from observations of choice
decisions?
 Recall ‘rationality’ assumption: Consumers select
‘most preferred’ option available
 So observed selection has been revealed as
‘preferred’ to all other available options
 Revealed Preference
If, at prices p1 , p2 and
x2
income m, a
consumer purchases
a consumption bundle
a, then this bundle is
a
said to have been
Directly Revealed
Preferred to all other
affordable bundles x1
Weak Axiom of Revealed Preference (WARP)
No two different bundles, a and b, can be
directly revealed preferred to each other
That is, if at prices (p1,p2) bundle (a1,a2) is
chosen, and at prices (q1,q2) bundle (b1,b2) is
chosen, then it cannot be the case that

p1a1  p2 a2  p1b1  p2b2 , b affordable when a chosen

and
q1b1  q2b2  q1a1  q2 a2 , a affordable when b chosen
Weak Axiom of Revealed Preference (WARP)

x2
Graphically, we cannot have

x1
 Indirect Revealed Preference
If a bundle a is directly x2
revealed preferred to a
different bundle b, and
bundle b is directly a
revealed preferred to an
alternative bundle c,
then we can say that
bundle a is Indirectly b
Revealed Preferred to c
bundle c.
x1
Strong Axiom of Revealed Preference (SARP)
 No two different bundles, a and c, can be
either directly or indirectly revealed preferred
to each other
 Note that both the strong and weak axioms of
revealed preference require consumers to select
a unique consumption bundle at any budget
constraint
Generalised Axiom of Revealed Preference
(GARP)
 If bundle a is indirectly revealed preferred to
bundle c then whenever c is purchased the
purchase of a would have been more expensive,
that is pca  pcc
 This is a more general specification, as it allows
the consumer to be indifferent between two
affordable consumption bundles. Effectively
allowing flat spots in the indifference curves
 Afriat’s Theorem
 For any finite number of price/consumption
observations, there exists a continuous utility
functions satisfying the condition that more is
better,
better and with convex indifference curves
which ‘rationalises’ the data if and only if the
observations satisfy GARP
 Here is Homo Economicus
 Question
 Is the utility function obtained by this process
unique?
NO!
 Utility functions are ordinal, so the same set of
indifference curves may be generated by many
different utility functions
 Practically, any finite number of observations
may be ‘explained’ by a number of different
indifference maps, each generating different ‘out-
of-sample’ behaviour
 Index Numbers
 Consider a consumer who, in some base period,
is observed consuming a bundle b when prices
are pb and in some subsequent period is
observed consuming bundle c when prices are pc
 Can anything be said about the welfare of this
consumer over the interval?
 From revealed preference: If pb.b > pb.c then
the consumer is worse off. If pc.c > pc.b then the
consumer is better off
 Indices
Laspeyres Quantity Index

LQ 
p bc

i i xi
p b c

 1  worse off
p bb  i
b b
p x
i i

Paasche Quantity Index

PQ 
p cc

px
i
c c
i i
 1  better off
p cb px
i
c b
i i
 Indices
Laspeyres Quantity Index

LQ 
p bc

i i xi
p b c


p cc
 M  better off
pbb i pi xi pbb
b b

Paasche Quantity Index

PQ 
p cc

 i
pic xic

p cc
 M  worse off
p cb  i
c b
pi xi p bb
 Consumer Price Index
The Consumer Price Index (CPI) measures the
proportional change in the cost of purchasing a
‘given’ bundle of commodities. Specifically,
1 0 1 0
p1 x1  p2 x2
CPI  0 0 0 0
 LP
p1 x1  p2 x2
The CPI is commonly compared with the growth in
nominal incomes to assess ‘real’ income changes

Is this comparison justifiable?

 Consumer Price Index
If CPI < M (ratio of incomes) then consumers are better off.
But if CPI > M cannot conclude that consumers are worse off.
x2
u0

Increasing
c
incomes by CPI
will generally
improve welfare
b

x1
 Readings
 Varian, Intermediate Microeconomics, chapter 7

 Varian, Microeconomic Analysis, chapter 8

 Samuelson P. (1948) ‘Consumption theory in terms of

revealed preference’ Econometrica, vol. 15, pp. 243-
253.
 Next Time…
 Welfare

 Consumer surplus

 Equivalent variation

 Compensating variation

 Slutsky vs Hicksian substitution

 Part IIA, Paper 1
Consumer and Producer Theory

Lecture 5
Compensating and Equivalent Variation
Flavio Toxvaerd
 Today’s Outline
 Welfare

 Consumer surplus

 Equivalent variation

 Compensating variation

 Slutsky vs Hicksian substitution

 Consumer Surplus and Welfare
Following a price change,
 (utility)  v(b, p2 , m)  v(a, p2 , m)
a
v( p1, p2 , m)
  dp1
b p1
a
v( p1, p2 , m)
 .x1( p1, p2 , m) dp1
b m
a
   x1( p1, p2 , m) dp1 ,
b
v( p1, p2 , m)
if constant
m
Consumer Surplus and Welfare
a

 x ( p , p , m)dp
b
1 1 2 1  (Consumer Surplus)

So, ( Utility)  (Consumer Surplus)

p1

b Marshallian Demand

x1
 Evaluating Welfare Changes
 Consider the situation where the price of good 1
takes one of two values, p1= p01 or p1= p11, while
the price of good 2 remains unchanged.
 When p1= p01 a consumer with income m will
maximise utility subject to her budget constraint,
and achieve a level of utility u0= v(p01, p2 , m)
(the indirect utility function)
 Evaluating Welfare Changes
 From duality, and the expenditure function, we
also know that e(p01, p2 , u0) = m
 Similarly, when p1= p11 we can write
u1= v(p11,p2 ,m) and e(p11,p2 ,u1) = m

 Now consider e(p01, p2 , u1); this gives the

expenditure required to achieve the new level of
utility, u1 , at the original set of prices, p01.
 Equivalent Variation
EV = e(p0011, p22 , u11) - m

This gives the x2

u1 Evaluated
equivalent change at original
in income that EV prices
u0
would have altered
the utility of the
consumer by the b
a
same amount as
the price
movement
m/p01 m/p11 x1
 Example 1
 Energy assistance for the elderly:
 The Government is concerned about high
energy prices facing the elderly over the
winter months
 Two forms of assistance are proposed:
 A subsidy of s percent of the price of energy
 A lump sum ‘energy rebate’ paid to all pensioners

Which policy should the

government adopt?
 Example 1
The price subsidy will reduce the effective price of electricity,
and so increase demand for electricity from x1(p1,p2,m) to
x1(p1(1-s),p2,m).
x2
The overall cost of the u1
subsidy will be
EV 0
u
S=(sp1) x1(p1(1-s),p2,m).

EV gives the size of a lump

sum ‘rebate’ required to
make the pensioner
indifferent between the
rebate and the subsidy x1
x1(p1) m/p1 x1(p1(1-s)) m/p1(1-s)
 Example 1
So we need to compare the relative magnitudes
of S and EV

EV  e( p1 , p2 , u )  m
1

 e( p1 , p2 , u1 )  e( p1 (1  s ), p2 , u1 )
p1 p1
e( p, p2 , u )
1
  dp   h ( p, p , u ) dp
1 2
1

p1 (1 s )
p p1 (1 s )

EV is area under Hicksian

demand curve at u11
 Example 1
EV = CS if p
income effect Hicksian demand
equals zero.
EV > CS for p1
price fall of
normal good. p1(1-s) Marshallian
demand

Recall Slutsky Eqn:

x1
xi hi xi e hi xi
  .   xˆ j
p j p j m p j p j m
 Example 1: Subsidy
S  x1( p1 (1  s ), p2 , m).sp1
p1
1
 h1( p1 (1  s ), p2 , u ).  dp
p1 (1 s )
p1
1
 h
 1 ( p , p2 , u ) dp  EV
p1 (1 s )

A
A lump
lump sum
sum rebate
rebate isis more
more cost
cost
effective
effective than
than aa price
price subsidy
subsidy
 Example 1: Subsidy
p

Hicksian demand

p1
sp1
subsidy
p1(1-s) Marshallian
demand

x1
x1(p1(1-s),p2,m)
 Example 1: Warning!
 There are many other important aspects of the problem
not addressed in this analysis
 This is a ‘partial equilibrium’
equilibrium analysis. We have not
considered:
 impact of increased electricity demand on the market
price of electricity
 impact of any substitution away from alternative
heating source
 whether or not the government wants to encourage
electricity usage by the elderly, and so reduce winter
medical care
 We have assumed that all consumers are identical -
so no consideration of distribution aspects given
 Compensating Variation
CV  m  e( p11, p2 , u 0 )

Consider the amount of x2 Evaluated

u
1
at
income a consumer would u
0

willingly forsake in exchange new

CV prices
for a change in prices.
CV < 0, positive
compensation required
CV measures the income
effect of a price change
x1
m/p10 m/p11
 Example 2
 Fixed meal charges
 A Cambridge College is considering abandoning
the ‘fixed meal charge’ imposed on students, in
favour of charging higher food prices ‘in hall’

Should the student union

support this proposal?
 Example 2
The proposal will increase food prices from p10 to p11. Without
any change in student income this will lead to a consumption
point, x(p11,p2,m) and utility level u1.
x2
The level of income required
u0
to compensate the consumer
for this price rise will be
determined by
CV 1
u

CV  m  e( p11, p2 , u 0 )
The student union should a
b
support the change if and only
if the fixed meal charge is
greater than the compensating x1
x11 m/p1 x 0
1
variation. m/p10
1
 Evaluation
 The practical difficulty with this analysis is the
measurement of
e(p11,p2,u0)
 the amount a consumer needs to spend to
achieve the original level of utility at the new
vector of prices
 Passive

e Expenditure
Indirect Effect

x̂1 Actual
Expenditure
p 2 x̂ 2

p10 p11 p1
Passive  p1 xˆ1  p2 xˆ 2  e( p1 , p2 , u ( xˆ1 , xˆ 2 ))
When p11  p10 is small, e( p11, p2 , u 0 )  p11x10  p12 x20
 Slutsky vs Hicksian Substitution
Hicksian substitution
keeps utility constant.
x2
Slutsky substitution u0
keeps ‘real’ income
constant, that is - u1
keeps original
consumption bundle
affordable.
Difference is the
‘indirect effect’
effect x1
x11 x10 m/p10
H.S. S.S.
 Example 2, continued
The student union can use the present levels of
consumption to estimate the compensating
variation:
CV  m  e( p11 , p2 , u 0 )
 () m  ( p11 x10  p2 x20 )
 ( p10 x10  p2 x20 )  ( p11 x10  p2 x20 )
 x10 ( p10  p11 )
Thus, the student union should support the
proposal if
FMC  x10 ( p11  p10 )
 Example 2

p11e ( p , p , u 0 
)
0 0 1 0
CV  e( p1 , p2 , u )  e( p1 , p2 , u )     1 2
dp1

p10 p1 
 
p11
  0
p1
h( p1 , p2 , u0 )dp1
h(p1,p2,u0)
p
CV = area h(p1,p2,u1)
under Hicksian
demand curve p1
at u00
Marshallian
p1(1-s) demand

x1
 Readings
 Varian, Intermediate Microeconomics, chapter 14
 Varian, Microeconomic Analysis, chapter 10
 Part IIA, Paper 1
Consumer and Producer Theory

Lecture 6
Labour supply, Savings behaviour
Producer Theory: Technology
Flavio Toxvaerd
 Today’s Outline
 Labour supply, savings, asset pricing

 Technology

 Production

 Assumptions
 Labour Supply
Domain:
consumption good c c u3
leisure l u2
u1

Utility function: u(c,l)

Assume well behaved
preferences
c*
Budget constraint:
pc = (24 - l )w + M M/p

l* 24 l
 Mathematically
Primal Problem : Dual problem :
max u (c, l ) min ( pc  (24  l ) w)
s.t. pc  (24  l ) w  M , l  24 s.t. u (c, l )  u 0 , l  24
Solution of Lagrangian gives Solution to Lagrangian
l*  l ( p, w, M )
lˆ( p, w, u 0 )
c*  c( p, w, M )
cˆ( p, w, u 0 )

How will labour supply vary with wages?

 Mathematically
Let E ( p, x, u 0 )  pcˆ  (24  lˆ) w
be the minimum level of non-labour income required
to achieve the utility level u0
From duality, we know that

l ( p, w, E ( p, w, u 0 ))  lˆ( p, w, u 0 )
Differentiating gives:
l l E lˆ Slutsky Eqn.
 . 
w m w w
l lˆ l E lˆ l
   .   (24  l*)
w w m w w m
(<0) (>0) (>0, if l is ‘normal’)
 Labour Supply
Labour supply equals 24 minus leisure time
w
Conclusion: Impact Ls
of increase of wages
on labour supply is
ambiguous
Labour supply may be
backward bending

Labour
 Savings Behaviour
 An important consumer decision is how to
allocate resources over time - that is, how much
to borrow and save
 Will consider a simplified two period model
(periods 1 and 2), where the consumer decides
how much to consume in each period (c1 and c2),
subject to an intertemporal budget constraint
 Domain: consumption in each period, c1 and c2
 Mathematically
Primal problem:
max u(c1,c2) s.t. p2c2= m2+(m1 - p1c1)(1+r)
Lagrangian:
L = u(c1,c2)- λ(p2c2+ p1c1(1+r) - m2 - m1(1+r))

F.O.C.s: Euler
Euler
equation
equation
L u
  p1 (1  r )  0
c1 c1 u (u )(1  r )
c1 c2
L u 
  p2  0 p1 p2
c2 c2
p2c2 m2 Present
Present Value
Value of
of Consumption
Consumption
p1c1   m1  Expenditure
Expenditure
(1  r ) (1  r ) == Present
Present Value
Value of
of Income
Income
 Dual Problem
min (p1c1)(1+r)+ p2c2 s.t. u(c1,c2) = u0

Solution gives cˆi  hi ( p1, p2 , r , u )

Let E2 ( p1 , p2 , r , m1 , u0 )  (1  r ) p1cˆ1  p2cˆ2  (1  r )m1
be the period 2 income required to achieve u0
dE
From Envelope Theorem have  p1cˆ1  m1
that dr
Duality ensures that c1 ( p1, p2 , r , m1, E2 )  cˆ1 ( p1, p2 , r , u0 )
dc1 dcˆ1 dc1 dE2 dcˆ1 dc1
Thus     (m1  p1c1)
dr dr dm2 dr dr dm2
Impact of increase in interest rate on savings is ambiguous
 Savings
 Consider impact of c2
change in interest
rate
 Rise in interest rate
causes budget line
to rotate around
endowment point
c*2
 When c1 is a normal
good, impact on
rate of savings m2 /p2
ambiguous S.E.
I.E. c1
c*1 m1 /p1
 Evaluating Income Streams
 If the interest rate is r, then £1 invested today will
return £(1+r) one year from now.
 If today you invest £ 1/(1+r) then this will return
£1 next year.
 We may say that £1 given to us next year is of
equivalent value to £1/(1+r) today
 Similarly, the present value of a stream of
income m0, m1, m2, can be written
m1 m2
PV  m0  
1  r (1  r ) 2
 Asset Pricing
 How much should you pay for an asset that will
payout £1 next year.
 Answer: PV of asset = 1/(1+r), so price of asset
today = 1/(1+r)

Note:
Note: Price
Price of
of assets
assets will
will vary
vary
inversely
inversely with
with the
the interest
interest rate
rate
 Asset Pricing
What if the asset will generate £1 next year and
in every subsequent year ?
2 3
1  1   1 
PV of asset       ....
1  r 1  r  1  r 
 1   1  1 
2

 1     ...
 1  r  1  r  1  r  
 1  1  r  1
  
 1  r  r  r

Alternatively rV = 1 so V = 1/r
Example 1: ‘The’ Magdalene Bursar
 The Story: In 1600 Magdalene College leased 1
acre around Covent Garden for £30 per annum,
in perpetuity
 Today the College still receives £30 ground rent
for the acre of land, and the Bursar’s ineptitude
is celebrated by the disgusting statue placed on
the side of the river by ‘Henry’s’ bar.
 NPV1600 = 30/r = £600 (if r = 0.05)
 NPV2004 (£600 in 1600) = 600(1+r)404 = £218
billion
How did the College spend this legacy ?!
 Producer Theory
We wish to analyse production decisions of firms with the
same rigour as that used to analyse consumption decisions

Consumer Theory Producer Theory

Represent preferences Represent technology
(Utility function) (Production function)
Utility maximisation Profit maximisation
Dual problem Cost function
(min expenditure to (min expenditure to
obtain desired utility) obtain desired output)
 Technology
What is technology?
May be represented as a mapping from inputs (X) to outputs (Y)
T : X Y
such that, for any vector of inputs xX

T (x)  Y denotes the set of outputs that can be obtained using x

Note: T(x) is not

not a
function, more than
x one output may be
possible with the
same input
Inputs Outputs
 Production Plans
 A production plan is a vector of inputs and
outputs (x,y)
where x = (x1,…,xn) is a vector of inputs

and y = (y1,…,ym) is a vector of outputs

 A production plan (x , y) is feasible if y  T(x)
and so, technology allows the vector of inputs, x,
to be converted into the vector of outputs, y
The Production Function Erdős

“A mathematician is a machine for turning coffee into

theorems”.
 Production Possibility Set
The production possibility set (PPS) is the set of
all feasible production plans
Efficient
production
y

PPS

x
 Assumptions on the PPS
 Assumption 1: If x = 0 and (x,y)PPS, then y =
0
 Assumption 2: Free disposal
 if (x,y)PPS then
 for all x’x, (x’,y)PPS
 for all y’y,(x,y’)PPS
 Assumption 3: The PPS is closed: so the
boundary of the PPS is contained in the PPS -
and ‘efficient’ production is well defined
 Input Requirement Set
 The input requirement set is the set of vectors of inputs
required to produce a particular vector of outputs

V (y )  {x (x, y )  PPS }
x2
 The efficient boundary
of IRS is an isoquant
 Assumption 4: All
input requirement sets
are convex
 (PPS is quasi-
concave)
x1
 Restricted Production Set
The restricted production set is the set of all the vectors of
outputs that are feasible given a particular vector of inputs,

W ( x)  {y (x, y )  PPS}
Efficient boundary of RPS
y2
is also sometimes called
the production possibility
frontier
or, when there is only one
output, the production
function

y1
 Summary
 Applications of consumer theory

 Technology

 Production
 Readings
 Varian, Intermediate Microeconomics,
chapters 9,10, 11 and 18
 Part IIA, Paper 1
Consumer and Producer Theory

Lecture 7
Production Function and Cost Function
Flavio Toxvaerd
 Today’s Outline
 Quick recap

 The production function

 Isoquants and optimality condition

 The producer’s problem

 Factor demands

 Cost function, short run vs. long run

 Producer Theory
We wish to analyse production decisions of firms with the
same rigour as used to analyse consumption decisions

Consumer Theory Producer Theory

Represent preferences Represent technology
(Utility function) (Production function)
Utility maximisation Profit maximisation
Dual problem Cost function
(min expenditure to (min expenditure to
obtain desired utility) obtain desired output)
 Technology
What is technology?
May be represented as a mapping from inputs (X) to outputs (Y)
T : X Y
such that, for any vector of inputs xX

T (x)  Y denotes the set of outputs that can be obtained using x.

Note: T(x) is not

not a
function, more than
x one output may be
possible with the
same input
Inputs Outputs
 Production Plans
 A production plan is a vector of inputs and
outputs ( x , y )
where x = (x1,…,xn) is a vector of inputs

and y = (y1,…,ym) is a vector of outputs

 A production plan (x , y) is feasible if y  T(x)
and so, technology allows the vector of inputs, x,
to be converted into the vector of outputs, y.
 Production Possibility Set
The production possibility set (PPS) is the set of
all feasible production plans
Efficient
production
y

PPS

x
 Assumptions on the PPS
 Assumption 1: if x = 0 and (x,y)PPS, then y =
0
 Assumption 2: Free disposal
 if (x,y)PPS then
 for all x’x, (x’,y)PPS
 for all y’y, (x,y’)PPS
 Assumption 3: The PPS is closed: so the
boundary of the PPS is contained in the PPS -
and ‘efficient’ production well defined
 Input Requirement Set
 The input requirement set is the set of vectors of inputs
required to produce a particular vector of outputs

V (y )  {x (x, y )  PPS }
x2
 The Efficient boundary
of IRS is an isoquant
 Assumption 4: All
input requirement sets
are convex.
 (PPS is quasi-
concave)
x1
 Restricted Production Set
The restricted production set is the set of all the vectors of
outputs that are feasible given a particular vector of inputs,

W ( x)  {y (x, y )  PPS}
Efficient boundary of RPS
y2
is also sometimes called
the Production Possibility
Frontier
or, when there is only one
output, the production
function

y1
 The Production Function
y = F(x)
 Assumption 1:
1 F(0) = 0
 Assumption 2:2 F(x) is a non-decreasing
function  isoquants are downward sloping
 Assumption 3:
3 production function defined
 Assumption 4: 4 isoquants are convex 
production function is quasi-concave
 Isoquants
Isoquants show combinations of inputs for which
output is constant

Mathematically, we require that dF ( x1 , x2 )  0

F ( x1 , x2 ) F ( x1 , x2 )
dx1  dx2  0
x1 x2
F ( x1 , x2 )
dx2 x1 ||slope
slope of
of isoquant
isoquant|| == Technical
Technical
 
dx1 F ( x1 , x2 ) Rate
Rate of
of Substitution
Substitution
x2
 Production Problem
min p1 x1  p2 x2
x1 , x2

subject to F ( x1 , x2 )  y
L  p1 x1  p2 x2  [ F ( x1 , x2 )  y ]
 F ( x1 , x2 ) 
p1    
 x1 
First order conditions:
 F ( x1 , x2 ) 
p2    
 x2 
F ( x1 , x2 )  y
 Production Problem
Eliminating the Lagrange Multiplier () gives
F ( x1 , x2 )
x2 p2
 RTS
RTS == Ratio
Ratio of
of Prices
Prices
F ( x1 , x2 ) p1
x1
and F ( x1 , x2 )  y Production
Production function
function

Note, with more than two commodities have FOC

pi pi
   Marginal Cost
 F  MPxi
 
 xi 
Conditional Factor Demand Function
 Solution gives the cost minimising levels on
inputs
x1= x1(p1,p2,y) , x2= x2(p1,p2,y)

 Giving demand for inputs as a function of prices

and the desired output level

 This is the Conditional Factor Demand Function

 Cost Function
The cost function C(p,y) gives the minimum cost of
producing a specified output level (y) given the
factor prices (p)

Thus C ( p1 , p2 , y )  min p1 x1  p2 x2 s.t. F ( x1 , x2 )  y

 p1 x1 ( p1 , p2 , y )  p2 x2 ( p1 , p2 , y )

This is just the equivalent of the Expenditure

Function in consumer theory
 Properties of the Cost Function
1. Homogeneous of degree 1 in prices
 Proof: No change in relative prices, so no
change in optimal solution - so expenditure
changes by same proportion.
2. Non-decreasing in prices
3. Concave in prices
 Proof: If prices change, costs will increase
linearly if inputs are unchanged. Thus any
change in input usage must be to reduce
costs - and so costs increases less than
linearly
 Envelope Theorem
How do costs change when prices or desired
output change?
C ( p1 , p2 , y )  min p1 x1  p2 x2 s.t. F ( x1 , x2 )  y

Sheppard’s C
 xi ( p1 , p2 , y )
Lemma pi
C pi
Marginal Cost  MC ( p1 , p2 , y )   
y MPxi
 Duality
 Duality ensures that there is a direct relationship
between the production function and the cost
function – the cost function fully ‘represents’
production
 For every ‘acceptable’ cost function, there exists
an equivalent production function which
possesses convex isoquants
x2
C0
p2o
x 0
2
C 0  C ( p10 , p20 , y )
1
C C1  C ( p11 , p12 , y )
p12

x1
0 1
x01 C C
p1o p11
 Short Run Cost Function
If not all inputs are variable, then the constrained
optimisation problem is more constrained – minimise costs
subject to some inputs being fixed

min p1 x1  p2 x2 subject to F ( x1 , x2 )  y
x1

Gives constrained solution x1c ( p1 , p1 , y, x2 )

and obtain short run (constrained) cost function

C sr ( p1 , p2 , y, x2 )  min p1 x1  p2 x2 s.t. F ( x1 , x2 )  y
Properties of the SR Cost Function
1. Homogeneous of degree 1 in prices.
2. Non-decreasing in prices.
3. Concave in prices
sr
4. C ( p1, p2 , y, x2 )  C ( p1, p2 , y )
sr
5. C ( p1 , p2 , y, x2 )  C ( p1 , p2 , y )  x2  x2 ( p1 , p2 , y )
sr
6. MC ( p1 , p2 , y, x2 )  MC ( p1 , p2 , y )  x2  x2 ( p1 , p2 , y )
Short Run Vs. Long Run Costs
C C sr ( p1 , p2 , y )

C ( p1 , p2 , y )

y
 Summary
 Production function and isoquants

 The producer’s problem

 Optimality condition

 Dual problem
 Readings
 Varian, Intermediate Micro chapters 17, 19,
20
 Varian, Microeconomics Analysis, chapters
1,4,5,6
 Next Time…
 Profit maximisation

 Factor demands

 The supply function

 Part IIA, Paper 1
Consumer and Producer Theory

Lecture 8
Profit Maximisation and Supply Functions
Flavio Toxvaerd
 Recap and Today’s Outline
 Last lecture looked at problem of cost minimisation, and
obtained Cost function - C(p,y).
 We maintained throughout the analysis that factor prices
were unaffected by the firm’s employment decisions –
that is, the firm was a price taker in the input markets
 Today we look specifically at the problem of profit
maximisation – maintaining the assumption that the firm
is a price taker in the factor markets
 Note: the mathematical requirements for ‘unique’
solutions become more complicated if the assumption is
dropped – but the basic properties of the cost function
remain unchanged
 Profit Maximisation
Two ways to represent profit maximisation problem:

1. max y p y ( y ) y  C ( px , y )

with FOC: p 'y ( y ) y  p y ( y )  C y' ( px , y )  MR  MC  0

dMR dMC MC curve cuts MR

and SOC:  0
dy dy curve from below

2. max y ,x p y ( y ) y  p x x s.t. y  F x 
 Profit Maximisation
Simplifying Assumption:
Firm is a price taker in the output market – thus p(y)=py

Thus maximisation problem 1 becomes:

max y p y y  C ( px , y )
and solution depends on both input and output prices

y* ( p y , p x ) This is the supply function for the firm

dC ( px , y )
As solution obtained from FOC: py   MC
dy
have that supply function is the inverse of the marginal cost curve
 Profit Maximisation
Formulated the second way – we have
max y ,x p y y  p x x s.t. y  F x 
L  p y y  p1 x1  p2 x2  [ F ( x1 , x2 )  y ]

First order conditions: py   MR=MC

  F ( x1 , x2 ) 
 p1    
These are the same   x1 
conditions as those   F ( x1 , x2 ) 
from cost  p2    
  x2 
minimisation
 F ( x1 , x2 )  y
 Profit Maximisation
pxi
Once again we have that: py  
 F ( x1 , x2 ) 
 
 xi 

  p y y  px x
y
y  F (x)
Graphically –
have isoprofit
line tangental
to production
function PPS

x
Supply and Factor Demand Functions
Solution to maximisation problem gives:

y ( p y , p1 , p2 ) Supply Function

x1 ( p y , p1 , p2 ) 

 Factor Demand Functions
x2 ( p y , p1 , p2 ) 

Properties of Supply and Factor Demand Functions
1. Homogeneous degree zero.
zero
Proof: Increasing all prices by the same proportions
leaves the maximisation problem unchanged.

2. Output is increasing and factor demand

decreasing in own price:
price
dy dxi
 0 and 0
dp y dpi
Proof: Follows from second order conditions of
maximisation prob.
 Profit Function
Evaluating the maximisation problem at the optimal solution
gives the Profit Function

 ( p y , p1 , p2 )  p y y*  p1 x1*  p2 x2*

From Envelope Theorem:


 y*  y ( p y , p1 , p2 )  0
p y

  xi*   xi ( p y , p1 , p2 )  0
pi
 Properties of Profit Function
1. Homogeneous of degree 1 in prices
Proof: No change in relative prices, so no change in
optimal solutions - so profit changes by same
proportion.
2. Non-decreasing in output price and non-
increasing in input prices
Proof: Envelope Theorem.
3. Convex in prices
Proof: If prices change, profits will increase linearly if
inputs and outputs are unchanged. Thus any change
must be to increase profits - and so profits increases
more than linearly.
Recovering Production Function from Profit Function

 0  p 0y y  px0 x
y 1
y0
Generates y=F(x)
concave
production
function

y1

x1 x0
 Short Run Profit Function
We may want to consider the profit function when some
inputs are not variable:
 sr ( p y , p1 , p2 ; x2 )

Clearly:
sr
 ( p y , p1 , p2 ; x2 )   ( p y , p1 , p2 )

with equality if and only if

x2  x2 ( p y , p1 , p2 )
 LeChatelier Principle
The price elasticity of supply is greater in the long run than
in the short run. Alternatively, thus the slope of the Supply
Function is lower in the long run.

Proof: Let y* , x1* , x2* 

be the optimal solutions when prices are p*y , p1* , p2* 
and h( p y )   ( p y , p1* , p2* )   sr ( p y , p1* , p2* ; x2* )  0
 LeChatelier Principle
We know that h(py) is minimised at p*y

d 2 h( p*y )  2 ( p* )  2 sr ( p* )
so  
dp 2y 2
p y p 2y
dy ( p* ) dy sr ( p* )
  0
dp y dp y
* * sr * *
dy ( p ) py
dy ( p ) py
and so  *
0 *
dp y y dp y y
 Alternative Specification
Throughout we have kept the vectors of inputs and output
separate.
However we could also consider inputs to be nothing more
than negative outputs – and we could consider a vector of
net outputs from a production process
z = y-x
Profit maximisation becomes
maxz p.z subject to z  Z ,
where Z is the set of feasible (net) production plans.
 Graphically
Isoprofit line
y

PPS

x
 General Equilibrium
We
We have
have developed
developed methods
methods to to generate
generate
demand
demand functions
functions for
for individuals
individuals and
and
supply
supply functions
functions for
for firms
firms –– GIVEN
GIVEN aa
specific
specific vector
vector of
of prices.
prices.
We
We have
have made
made no no effort
effort to
to see
see whether
whether or
or
not
not supply
supply and and demand
demand areare equal
equal at
at those
those
prices
prices –– ifif the
the prices
prices are
are EQUILIBRIUM
EQUILIBRIUM
prices.
prices.
 Readings
 Varian, Intermediate Economics, chapter 19
 Varian, Microeconomic Analysis, chapters 2,3