Chapt

erone

TheTheor
yofConsumerBehav
ior

1.
1Int
roduct
ion

Thet
heor
yofconsumerbehav
iori
stheconcer
nofhowconsumer
sdeci
deont
he
basketofgoods and ser
vices t
hey consume i
n or
dert
o maxi
mize t
hei
r
sat
isf
act
ion.Thet
heor
yofdemandst
art
swi
tht
heexami
nat
ionoft
hebehav
iorof
t
heconsumer
,si
ncet
hemar
ketdemandi
sassumedt
obet
hesummat
ionoft
he
demandoft
hei
ndi
vi
dual
consumer
s.
I
nexpl
aini
ngt
heconsumerbehav
ior
,whi
chi
sthebasi
sfort
het
heor
yofdemand,
weassumet
hat
:
. Theconsumeri
i srat
ional
:-gi
venhi
s/heri
ncomeandt
hemar
ketpr
iceof
t
hecommodi
ti
es,he/
shepl
anst
hespendi
ngofhi
s/heri
ncomesoast
o
at
tai
nthehi
ghestpossi
blesat
isf
act
ionorut
il
it
y.Thi
sist
heaxi
om ofut
il
it
y
maxi
mizat
ion.
. Theconsumerhascompl
i
i eteknowl
edgeofal
lthei
nfor
mat
ionr
elev
antt
o
hi
s/herdeci
si
on,
i.
e.,
he/
shehas
- Compl
eteknowl
edgeofal
ltheav
ail
abl
ecommodi
ti
es,
- Compl
eteknowl
edgeoft
hepr
iceoft
hecommodi
ti
es,
- Compl
eteknowl
edgeofhi
s/heri
ncome.
i
i
i. Thet
heor
yofconsumerbehav
ioral
sobasi
sthef
oll
owi
ngt
hreebasi
c
assumpt
ionswi
thr
egar
dtopr
efer
ence:
a.Pr
efer e compl
encesar ete,meansconsumer
scancompar
eand
r
ank al
lmar
ketbasket
s.Foranymar
ketbasket
s A and B,a
consumerwi
l
lpr
eferAt
oB,Bt
oAormaybei
ndi
ff
erentbet
ween
t
het
woi
gnor
ingt
hei
rcost
s.
b.Pr
efer eTr
encesar ansi
ti
ve,meansi
faconsumerpr
efer
smar
ket
basketAt
omar
ketbasketB,
andpr
efer
sBt
oA,
thent
heconsumer
pr
efer
sAt
oC.
c.Leav
ingcost
sasi
de,consumerpr
efer
smor
eofagoodt
oless
assumi
ngal
lgoodsar
e“good”
.
1|Page
1.
2SomeBasi
cConcept
s
Consumer
:-Adeci
si
onmaki
nguni
t(ani
ndi
vi
dualorahousehol
d)whousesor
consumesacommodi
tyorser
vice.
Ut
il
it
y:-
Thepowerofacommodi
tyt
osat
isf
yhumanwant
s.I
tist
hesat
isf
act
ion
orsubj
ect
ivepl
easur
ethatoneget
sfr
om consumi
ngagoodorser
vice.
Rel
ati
vi
tyOfUt
il
it
y:-Theut
il
it
yofacommodi
tyi
ssubj
ect
ivet
oaper
son’
sneed.
I
tisnotabsol
ute(
obj
ect
ivel
ydet
ermi
ned)
.
Ut
il
it
yAndMor
alVal
ues:-Ut
il
it
yisf
reef
rom mor
alv
alues.Forexampl
e,eat
inga
f
oodi
tem whi
chmaybei
mmor
ali
nasoci
etyy
iel
dsut
il
it
yasl
ongasi
tsat
isf
ies
hunger
.Iti
sal
sot
hecaset
hatut
il
it
yis“
ethi
cal
l
yneut
ral
”bet
weengoodandbad,
andhar
mful
andusef
ul.Forexampl
e,dr
ugy
iel
dsut
il
it
ytot
hedr
ug-
taker
s.
I
nor
dert
omaxi
mizeut
il
it
y,t
heconsumermustbeabl
etocompar
etheut
il
it
yof
t
hev
ari
ousbasket
sofgoodswhi
chhe/
shecanbuywi
thhi
s/heri
ncome.Ther
e
ar
etwoappr
oachest
othepr
obl
em ofcompar
ison(
measur
abi
l
ity
)ofut
il
it
y:
I
. t
hecar
dinal
appr
oach
I
I. t
heor
dinal
appr
oach
1.
3TheCar
dinalUt
il
it
yAppr
oach
Thecar
dinalschoolpost
ulat
edt
hatut
il
it
ycanbemeasur
edi
nmonet
aryuni
ts
(
i.
e.,
byt
heamountofmoneyt
hatt
heconsumeri
swi
l
li
ngt
osacr
if
icef
oranot
her
uni
tofacommodi
ty)orbysubj
ect
iveuni
tcal
l
ed“
uti
l
s”.
a.Assumpt
ions
. Rat
i ional
i
ty:
-theconsumeri
sassumedt
ober
ati
onali
nasi
ncet
hat
he/
sheai
msatt
hemaxi
mizat
ionof hi
s/herut
il
it
ysubj
ectt
othe
const
rai
ntsi
mposedbyhi
s/heri
ncome.
. Car
i
i dinalut
il
it
y:-t
heut
il
it
yofeachcommodi
tyi
smeasur
abl
e,wi
tht
he
mostconv
eni
entmeasur
ebei
ngmoney
.
i
i
i. Const
antmar
ginalut
il
it
yofmoney:-t
heut
il
it
ythatoneder
ivesf
rom
eachsuccessi
veuni
tofmoneyi
ncomer
emai
nsconst
ant
.
i
v. Di
mini
shi
ngmar
ginalut
il
it
y(DMU)
:-t
heMUofacommodi
tydi
mini
shes
ast
heconsumeracqui
resmor
eandmor
eofi
t.
. Addi
v ti
venat
ureofut
il
it
y:-event
houghdr
oppedi
nthel
att
erv
ersi
onof
2|Page
 t
heappr
oach,ut
il
it
ywasassumedt
obeaddi
ti
vei
ntheear
li
erv
ersi
on.
Thati
s:
Q1) +U2(
U =U1( Q2) +--- +Un(
Qn)
v
i. Thet
otalut
il
it
yofabasketofgoodsandser
vicesdependsont
he
quant
it
iesof t
hei
ndi
vi
dual
commodi
ti
es.Thati
s:
U =f
(Q1,
Q2,
…,Qn)
b.Equi
li
bri
um oft
heConsumer
Let
’s assume t
hatt
he consumerconsumes a si
ngl
e commodi
ty,“
X”.The
consumercanei
therbuy
s“X”orr
etai
nhi
smoneyi
ncome“
Y”.Undert
hese
condi
ti
onst
heconsumeri
sinequi
l
ibr
ium whent
hemar
ginalut
il
it
yof“
X”i
sequal
t
oit
smar
ketpr
ice(
PX)
.
Sy
mbol
i
cal
l
y,
MUx =Px
Mat
hemat
ical
l
y,wecander
ivet
heequi
l
ibr
ium oft
heconsumerasf
oll
ows:
Theut
il
it
yfunct
ioni
s,
Qx)
U =f(
Wher
eut
il
it
yismeasur
ed i
n monet
aryuni
tsand Qx i
sthequant
it
yof“
X”
consumedbyt
heconsumer
.
I
ftheconsumerbuy
sQx,hi
s/herexpendi
tur
eisQXPX.Pr
esumabl
ytheconsumer
seekst
omaxi
mizet
hedi
ff
erencebet
weenhi
s/herut
il
it
yandt
otalexpendi
tur
e.
Thati
s:
U–QXPX
Thenecessar
ycondi
ti
onf
oramaxi
mum i
sthatt
hepar
ti
alder
ivat
ivesoft
he
abov
efunct
ionwi
thr oQXshoul
espectt dbeequal
tozer
o.Thus,
U–QXPX)
d(
=0
dQX
dU dQXPX
⇒ - =0
dQX dQX
dU dQX
⇒ -
PX * =0
dQX dQX

3|Page
 dU
⇒ =PX
dQX
⇒MUX =PX
I
fMUx >Px,
theconsumercani
ncr
easehi
s/herwel
far
ebypur
chasi
ngmor
euni
t
of“
X”,andi
ftheMUx <Px,hi
s/herwel
far
ecanbei
ncr
easedbyr
educi
ngt
he
consumpt
ionof“
X”.
I
nthecaset
her
ear
emor
ecommodi
ti
es,t
hecondi
ti
onf
oropt
imal
i
tyoft
he
consumeri
stheequal
i
tyoft
her
ati
osofMUoft
hei
ndi
vi
dualcommodi
ti
est
o
t
hei
rpr
ices,i
.e.t
heut
il
it
yder
ivedf
rom spendi
nganaddi
ti
onaluni
tofmoney
mustbet
hesamef
oral
lcommodi
ti
es.
MU1 MU2 MUn
= =.
.…= =
P1 P2 Pn
c.Der
ivat
ionoft
heDemandCur
ve
Theder
ivat
ionofdemandi
sbasedont
heaxi
om ofdi
mini
shi
ngmar
ginalut
il
it
y.
TheMUofcommodi
tyXi
sdepi
ctedbyal
i
newi
thanegat
ivesl
opewhi
chi
sthe
sl
opeoft
otalut
il
it
yfunct
ion,U =f
(QX)
.Assuccessi
vel
yincr
easi
ngquant
it
iesof
Xar
econsumed,t
het
otalut
il
it
yincr
easesbutatadecr
easi
ngr
ate(
recal
lthe
assumpt
ion ofDMU)
,reaches a maxi
mum atquant
it
yX*and t
hen st
art
s
decl
i
ning.Accor
dingl
y,t
heMUx decl
i
nescont
inuousl
yandbecomesnegat
ive
bey
ondX*
.
dTUx
MUx =sl
opeofTUx =
dQX

4|Page
 Thusi
tcanbeshownt
hatt
hedemandcur
vef
orcommodi
tyXi
sident
icalt
othe
posi
ti
vesegmentoft
heMUxcur
ve.Forexampl
e,atX1 t
heMUi
sMU1 whi
chi
s
equal
toP1att
heopt
imum poi
nt.HenceatP1t
heconsumerdemandsX1quant
it
y.
Si
mil
arl
yatX2 t
hemar
ginalut
il
it
yisMU2whi
chi
sequalt
oP2.HenceatP2 t
he
consumerdemandsX2andsoon.Thi
sfor
mst
hedemandcur
vef
orcommodi
tyX.
Asnegat
ivepr
icedonotmakesensei
neconomi
cs,t
henegat
ivepot
ionofMUx
doesnotf
orm par
toft
hedemandcur
ve.
Pr
ice

0 x1 x2 x3 x*
Panel
A:TheMUcur
ve Panel
B:Thedemandcur
ve
Thedemandcur
vei
ssi
mpl
ythegr
aphi
calr
epr
esent
ati
onoft
her
elat
ionshi
pbet
weenpr
ice
andquant
it
ydemanded.
d.Cr
it
iquesOfTheCar
dinalAppr
oach
1)The sat
isf
act
ion der
ived f
rom t
he v
ari
ous commodi
ti
es cannotbe
measur
edobj
ect
ive.Thecar
dinal
i
tyoft
heut
il
it
yisext
remel
ydoubt
ful
.
2)Theassumpt
ion ofconst
antMU ofmoneyi
sunr
eal
i
sti
cbecauseas
i
ncomechangest
heMUofmoneychanges.
3)Theaddi
ti
venat
ureofut
il
it
yassumpt
ioni
sunr
eal
i
sti
c.
1.
4TheOr
dinalUt
il
it
yTheor
y
Theor
dinal
s’schoolsuggest
sthatut
il
it
yisnotmeasur
abl
e,buti
sanor
dinal
magni
tude.Thati
s,t
omakehi
s/herchoi
ce,t
heconsumerneednotknow t
he
ut
il
it
yofv
ari
ouscommodi
ti
esi
nspeci
fi
cuni
t,butbeabl
etor
ankt
hev
ari
ous

5|Page
basketofgoods(
orderofpr
efer
ence)accor
dingt
othesat
isf
act
iont
hateach
bundl
egi
ves.Ther
ear
etwomai
ntheor
iesi
ntheor
dinal
appr
oach:
1)TheI
ndi
ff
erenceCur
veTheor
y,and
2)Ther
eveal
edpr
efer
encehy
pot
hesi
s
1.
4.1 TheI
ndi
ff
erenceCur
veTheor
y
I
ndi
ff
erencecur
ve(
IC)
:-i
sthel
ocusofpoi
ntsofdi
ff
erentcombi
nat
ionsoft
wo
goods (
a bundl
e ofgoods)whi
ch y
iel
ds t
he consumert
he same l
evelof
sat
isf
act
ion(
uti
l
ity
)sot
hathei
sindi
ff
erentast
othepar
ti
cul
arcombi
nat
ion
he/
sheconsumes.
AnI
ndi
ff
erenceMap:-showsasetofal
ltheI
Cs,
whi
chr
ankt
hepr
efer
enceoft
he
consumer
.Combi
nat
ionofgoodssi
tuat
edonanI
Cyi
eldst
hesamel
evel
ofut
il
it
y.
Combi
nat
ionofgoodsl
yi
ngonahi
gherI
Cyi
eldshi
gherl
evelofsat
isf
act
ionand
ar
epr
efer
red.

A.Assumpt
ions
1)Rat
ional
i
ty:-t
heconsumeri
sassumedt
ober
ati
onal
.
2)Ut
il
it
yisor
dinal
:-t
heconsumercanr
ankhi
s/herpr
efer
ence(
ordert
he
v
ari
ousbasket
sofgoods)accor
dingt
othesat
isf
act
ionofeachbasket
.
3)Di
mini
shi
ngmar
ginalr
ateofsubst
it
uti
on(
DMRS)
:-pr
efer
encesar
eranked
i
nter
msofI
Cs,
whi
char
eassumedt
obeconv
ext
otheor
igi
n.Thi
simpl
i
es
t
hatt
hesl
opeofI
C(MRS)decr
easesi
nabsol
utet
erms.
4)The t
otalut
il
it
y oft
he consumerdepends on t
he quant
it
ies oft
he
commodi
ti
esconsumed.
U=f(
q1,
q2…qn)

6|Page
 5)Consi
stencyandt
ransi
ti
vi
tyofchoi
ces:
-
═>I
fbundl
eA>B,
thenBi
snotgr
eat
ert
hanA
═>I
fbundl
eA>BandB>C,
thenA>C.
B.Pr
oper
ti
esOfWel
lBehav
edI
ndi
ff
erenceCur
ves
1)Ani
ndi
ff
erencecur
vehasanegat
ivesl
ope:
-whi
chdenot
est
hati
fthe
quant
it
yofonecommodi
ty(
Y)decr
easest
hequant
it
yoft
heot
her(
X)
musti
ncr
ease,
ift
heconsumeri
stost
ayont
hesamel
evel
ofsat
isf
act
ion.
2)Thef
urt
herawayf
rom t
heor
igi
nanI
Cli
es,t
hehi
gherl
evelofut
il
it
yit
denot
es.
3)I
Csdonoti
nter
sect
.Ift
heydi
d,t
hepoi
ntoft
hei
rint
ersect
ionwoul
dimpl
y
t
wodi
ff
erentl
evel
ofsat
isf
act
ion,
whi
chi
simpossi
ble.
4)I
Csar
econv
ext
otheor
igi
n:-t
hisi
mpl
i
est
hatt
hesl
opeofanI
C(MRS)
decr
eases(i
nabsol
utet
erms)aswemov
eal
ongt
hecur
vef
rom t
hel
eft
downwar
dst
other
ight
.
C.TheMar
ginalRat
eOfSubst
it
uti
on(
MRS)
Themar
ginal
rat
eofsubst
it
uti
onofXandY(
MRSx,
y)i
sdef
inedast
henumberof
uni
tsofcommodi
tyYt
hatmustbegi
venupi
nexchangef
oranext
rauni
tof
commodi
tyXsot
hatt
heconsumermai
ntai
nst
hesamel
evelofsat
isf
act
ion.I
tis
t
henegat
iveoft
hesl
opeofanI
Catanyonepoi
ntandi
sgi
venbyt
hesl
opeoft
he
t
angentl
i
neatt
hatpoi
nt:

∆y
Sl
opeofI
C = =MRSx,y
∆x
Theconceptofmar
ginalut
il
it
yisi
mpl
i
citi
nthedef
ini
ti
onofMRSsi
ncei
tcanbe
pr
ovedt
hatt
heMRS(
thesl
opeofI
C)i
sequalt
other
ati
ooft
hemar
ginalut
il
it
ies
oft
hecommodi
ti
esi
ntheut
il
it
yfunct
ion.
MUx
MRSx,
y=
MUy
Pr
oof
:
Thet
otal
uti
l
ityf
unct
ioni
nthecaseoft
wocommodi
ti
esX&Yi
s
U =f
(x,
y)
Theequat
ionofanI
Cis

7|Page
 U =f
(x,
y) =K,
wher
eKi
sconst
ant
.
Atequi
l
ibr
ium,
thet
otal
der
ivat
iveofUi
sequal
tozer
o.
∂U ∂U
⇒du= dx+ dy=0
∂x ∂y
= (MUx) MUy
dx +( )dy=0
Al
onganypar
ti
cul
arI
C,t
het
otal
dif
fer
ent
ial
isbydef
ini
ti
onequal
tozer
o.
⇒MUydy =-MUxdx
-dy MUx
⇒ = =MRSx
,y
dx MUy
D.TheOpti
mum/Equi
li
bri
um oftheConsumer
Todef
inet
heopt
imum oftheconsumer,weshoul
dint
roducet
heconceptoft
he
budgetl
i
ne.Thebudgetl
i
nei
sthesetofbundl
esofgoodst
hatcostexact
lyt
he
consumer
’si
ncome.Thi
simpl
i
est
hati
ncomeact
sasaconst
rai
nti
ntheat
tempt
ofmaxi
mizi
ngut
il
it
y.
Assumi
ngt
wogoods(
x,y
),t
hebudgetl
i
newi
l
lhav
etheequat
ion:
Px.
X +Py
.Y =M
1 Px
Y = .M– .X
Py Py
Wher
eM =f
ixedmoneyi
ncome
Px =Thepr
iceofgoodX
Py =Thepr
iceofgoodY
Assi
gni
ngsuccessi
vev
aluest
oX(
giv
eni
ncome,M andt
hecommodi
ti
espr
ice,
PxandPy
),wemayf
indt
hecor
respondi
ngv
aluesofY.Thus,
I
fX =O(
ift
heconsumerspendsal
lhi
s/heri
ncomeonY)
,theconsumercan
buy M/
Pyuni
tsofY.
I
fY =O,
theconsumercanbuyM/
Pyuni
tsofX.
I
fwej
oint
heset
wopoi
ntsbyal
i
ne,
weobt
aint
hebudgetl
i
ne.
Y
M
Py

8|Page
 0 X
M
Px
M/Py M -Px
Sl
opeoft
hebudgetl
i
ne = = .
-
M/Px Py M
-Px
=
Py
Mat
hemat
ical
l
y,sl
opeoft
hebudgetl
i
nei
stheder
ivat
iveoft
hebudgetequat
ion:
1 Px
∂( .M– . X)
∂Y Py Py
=
∂X ∂X
∂Y -Px
=
∂X Py
Theconsumeri
sinequi
l
ibr
ium whenhe/
shemaxi
mizeshi
s/herut
il
it
y,gi
ven
i
ncomeandt
hemar
ketpr
ices.Twocondi
ti
onsmustbef
ulf
il
ledf
ort
heconsumer
t
obei
nequi
l
ibr
ium.
1)MRSx,
y =MUx/
MUy =Px/
Py,
whi
chi
sthenecessar
ycondi
ti
on.
2)TheI
Cbeconv
ext
otheor
igi
n(decr
easi
ngMRSx,
y)
Gr
aphi
cal
l
y,t
heequi
l
ibr
ium oft
heconsumeri
satt
hepoi
ntoft
angencyoft
he
budgetl
i
neandt
hehi
ghestpossi
bleI
C(atpoi
nte)
.

9|Page
Att
hepoi
ntoft
angency(
poi
nte)t
hesl
opeoft
hebudgetl
i
ne(
Px/
Py)andoft
he
I
C(MRSx,
y =MUx/
MUy
)ar
eequal
.
MRSx,
y =MUx
/MUy =Px/
Py,
whi
chi
stheFOC.
The SOC i
simpl
i
ed by t
he conv
ex shape oft
he I
C.Thus,t
he consumer
maxi
mizesut
il
it
ybybuy
ingX*&Y*oft
het
wocommodi
ti
es.
Mat
hemat
ical
der
ivat
ionoft
heequi
l
ibr
ium oft
heconsumeri
sasf
oll
ows:
* Assume t
hatt
her
e ar
etwo commodi
ti
es,X&Y.The consumeri
sin
equi
l
ibr
ium whenhe/
shemaxi
mizesut
il
it
ygi
venhi
s/heri
ncomeandt
he
mar
ketpr
iceoft
hecommodi
ti
es.
* For
mal
l
ythepr
obl
em canbest
atedas:
Maxi
mizeobj
ect
ivef
unct
ion: U =f
(x,
y)
Subj
ectt
oconst
rai
nt: M =Px
.X +Py
.Y
* Byusi
ngt
hel
agr
angi
anmet
hod,
thest
epsi
nvol
vedar
e:
a)Rewr
it
etheconst
rai
ntas
Px
.X +Py
.Y–M =O
b)Mul
ti
plyt
heconst
rai
ntbyaconst
ant(
lagr
angi
anmul
ti
pli
er)
(
Px.
X +Py
.Y–M) =O
c)Subt
ractf
rom t
heobj
ect
ivef
unct
iont
oobt
ainacomposi
tef
unct
ion.
L =U -(
Px.
X +Py
.Y–M)
d)Der
ivat
eLwi
thr
espectt
oX,
Y,&andequat
etozer
o.

10|Page
 ∂L ∂U
= -Px =O
∂X ∂X
∂U
=> =Px
∂X
=>MUx =Px
=> =MUx/Px……………………………………….
.……(
1)
∂L ∂U
= -Py =O
∂Y ∂Y
∂U
=> =Py
∂Y
=>MUy =Py
=> =MUy
/Py
…………………………………………….
.(2)
∂L
=Px
.X +Py
.Y–M =O…………….
……………….
..(
3)
∂λ
Fr
om (
1)and(
2),
wecani
nfert
hat
 = MUx/Px =MUy/
Py
MUx/Px =MUy
/Py
MUx/
MUy =Px/Py =MRSx,
y
We obser
vet
hatt
he equi
l
ibr
ium condi
ti
ons ar
eident
icali
nthe car
dinal
’
s
appr
oachandi
ntheI
ndi
ff
erencecur
veappr
oach.I
nbot
htheor
ieswehav
e:
MUx/Px =MUy
/Py =----=MUn/
Pn
Exampl
e:
Letusassumet
hatani
ndi
vi
dual
,whosei
ncomei
sbi
rr10consumest
wot
ypesof
goods,
X&Y,
whosepr
icesar
ePx =2bi
rrandPy =1bi
rr
,spendal
lhi
sincome
ont
hesegoods.Byusi
ngt
heabov
einf
ormat
ionandt
heMU t
abl
efort
het
wo
goods,
det
ermi
net
hef
oll
owi
ngt
hings/answert
hef
oll
owi
ngquest
ions.
a.I
ndi
cat
ehowmuchofX&Yt
hei
ndi
vi
dual
shoul
dpur
chaset
omaxi
mizeut
il
it
y.
b.Showt
hatt
hecondi
ti
onf
orconst
rai
nedut
il
it
ymaxi
mizat
ioni
sachi
eved.
c. Det
ermi
ne how much t
otalut
il
it
ythe i
ndi
vi
dualr
ecei
ves when he /
she
maxi
mizesut
il
it
y.Howmuchut
il
it
ywoul
dthei
ndi
vi
dual
geti
fhe/
shespental
l
i
ncomeonX?

11|Page
Qx MUx Qy MUy MUx/
Px MUy
/Py
1 10 1 5 5 5
2 6 2 4 3 4
3 4 3 3 2 3
4 2 4 2 1 2
5 0 5 1 0 1
Sol
uti
on:
a. Thei
ndi
vi
dualmaxi
mizeshi
s/herut
il
it
ywhenhe/
sheconsumes3uni
tsof
Xand4uni
tsofYsi
nceatt
hispoi
ntMUx/
Px=MUy
/Py
,i.
e,4/
2=2/
1.
b. Thecondi
ti
onf
orut
il
it
ymaxi
mizat
ioni
sthatMUx/
Px =MUy
/Py
,gi
vet
hat
al
ltheconsumeri
ncomei
sspent
.
Thusatt
heopt
imum oft
heconsumer
,
MUx/
Px =MUy
/Pyi
.e.4/
2 =2/
1=>2=2and
Px
X +Py
Y =M
3(
2)+1(
4)=10
10=10
c. TU =∑MUs =∑MUx +∑Muy
TU=(
10+6+4)
x+(
5+4+3+2)
y
TU=(
20)
x+(14)
y
TU=34
 I
fthei
ndi
vi
dual
spendal
lhi
s/heri
ncome,
he/
shewi
l
lgett
het
otal
uti
l
ityof
:
Tux=∑MUx
Tux=10+6+4+2+0
Tux=22
Thi
sisbecauset
heconsumercanconsume5uni
tsofXgi
vent
hathi
s/her
i
ncomei
s10bi
rrandPxi
s2bi
rr
.
I
ftheconsumerspendsal
lhi
s/heri
ncomeonY:
Tux=∑MUx
Tux=5+4+3+1
Tux=13

12|Page
 E.Cor
nerSol
uti
ons
I
fICsar
eev
ery
wher
eei
therf
lat
terorst
eepert
hant
hebudgetl
i
ne,ori
ftheyar
e
concav
erat
hert
hanconv
ext
otheor
igi
n,t
hent
heconsumermaxi
mizesut
il
it
yby
spendi
ngal
li
ncomeonei
thergoodYorX.Thesear
ecal
l
edt
hecor
nersol
uti
ons.
Y Y Y
U1 U2 U3 J
Y*J U3 J Y*

U2

B U1 L B

U1 U2 U3
O K XO
O K X X* X

I
nthel
eftpanel
,ICsar
eev
ery
wher
efl
att
ert
hant
heBL,andU2i
sthehi
ghestI
Cthatt
he
consumercanr
eachbypur
chasi
ngY*ofY(
poi
ntJ)
.Themi
ddl
epanelshowsI
Csev
ery
wher
e
st
eepert
hant
heBL,andU2i
sthehi
ghestI
Cthatt
heconsumercanr
eachbyspendi
ngal
l
i
ncomet
opur
chaseX*ofX(
poi
ntK)
.Int
her
ightpanel
,concav
eICU2i
stangentt
othebudget
l
i
neatpoi
ntB,
butt
hisi
snott
heopt
imum poi
ntbecauset
heconsumercanr
eachhi
gherI
CU2
byconsumi
ngonl
ygoodY(
poi
ntJ)
.
F.I
ncomeConsumpt
ionCur
ve(
Icc)
I
ncr
easei
nincomeshi
ft
sthebudgetl
i
neout
war
dinapar
all
elmanner(
ifcommodi
ti
espr
ices
ar
ekeptconst
ant
).I
fwegooni
ncr
easi
ngi
ncome(
i.
e.,shi
ft
ingt
hebudgetl
i
neout
war
d),we
wi
l
lhav
easetofopt
imum poi
ntscor
respondi
ng t
o each budgetl
i
ne.Thecur
vewhi
ch
connect
stheseopt
imum poi
ntsi
scal
l heI
edt ncomeConsumpt
ionCur
ve(
ICC)
.Iti
sthel
ocus
consumeropt
imum poi
ntsr
esul
ti
ngonl
ywhent
heconsumeri
ncomechanges.TheI
CCi
sal
so
knownast
heI
ncomeOf
ferCur
veort
heI
ncomeExpansi
onPat
h.Fr
om t
heI
CCwecant
hen
der
ivet
heconsumerEngl
eCur
ve.TheEngl
ecur
veshowst
heamountofagood(
X)t
hatt
he
consumerwoul
dpur
chaseperuni
toft
imeatv
ari
ousi
ncomel
evel
s.Toder
ivet
heEngl
ecur
ve
wekeept
hesamehor
izont
alscal
easi
nthet
oppanelbutmeasur
emoneyi
ncomeont
he
v
ert
ical
axi
s.
13|Page
 Y

U3
U2
U1 E3 I
CC

A” E2
A` E1
A

0
B B` B”
X
M

Engl
ecur
ve
M3 E3

M2 E2

M1 E1

0 B B` B`
` X
Ati
ncomel
evelM1,
theconsumeri
sinequi
l
ibr
ium atpoi
ntE1byconsumi
ngX1uni
tsofXand
t
hisi
sshownbypoi
ntE1’ont
heM-
Xpl
ane.Wheni
ncomeoft
heconsumeri
ncr
easest
oM2,
t
hebudgetl
i
neshi
ft
stoA’
B’andt
heconsumerwi
l
lahi
gherI
CU2atpoi
ntE2bypur
chasi
ngX2
uni
tsofX.t
hisi
sshownbypoi
ntE2’ont
hesecondpanel
.Si
mil
arl
y,wheni
ncomei
ncr
easet
o
M3,
theconsumeri
sinequi
l
ibr
ium atpoi
ntE3bypur
chasi
ngX3ofXandt
hisi
sshownbypoi
nt
E3’
ont
hesecondpanel
.
I
fweconnectequi
l
ibr
ium poi
ntsoft
heconsumeri
nthef
ir
stpanelweobt
aint
heI
ncome
Consumpt
ionCur
ve.Si
mil
arl
y,i
fweconnectt
hepoi
ntsont
hesecondpanel
,weobt
aint
he
Engl
eCur
ve.
Nor
malandI
nfer
iorGoodsandt
heEngelcur
ve
Anor
mal
goodi
soneofwhi
cht
heconsumerpur
chasesmor
ewi
thani
ncr
easei
nincome.

14|Page
Ani
nfer
iorgoodi
soneofwhi
cht
heconsumerpur
chasesl
esswi
thani
ncr
easei
n
i
ncome.GoodX i
ntheabov
efi
gur
eisanor
malgoodbecauset
heconsumer
pur
chasesmor
eofi
twi
thani
ncr
easei
nincome.Thi
sisshownbyaposi
ti
vel
y
sl
opi
ngi
ncomeconsumpt
ioncur
veandt
heEngl
ecur
ve.Howev
er,f
orani
nfer
ior
good,t
hei
ncomeconsumpt
ioncur
veandt
heEngl
ecur
vear
enegat
ivel
ysl
opi
ng
becauseasi
ncomei
ncr
eases,
theconsumerpur
chasesl
essoft
hesecommodi
ti
es.
Thi
scanbeshownbyt
hef
oll
owi
nggr
aph.

Y
A’
I
CC
E2
A
U2

E1

U1

O X
X2 X1 B B’
M

M2 E2

E1
M1

Engl
ecur
ve

O X
X2 X1
Thecl
assi
fi
cat
ionofgoodsasnor
malori
nfer
iordependsonl
yonhow aspeci
fi
cconsumer
v
iewst
hepar
ti
cul
argood.
Thus,
thesamegoodXcanber
egar
dedasanor
mal
goodbyanot
herconsumer
.
Fur
ther
mor
e,agoodcanber
egar
dedasanor
malgoodbyaconsumeratapar
ti
cul
arl
evelof
i
ncomeandasani
nfer
iorgoodbyt
hesameconsumeratahi
gherl
evel
ofi
ncome.

15|Page
Anor
malgoodcanbef
urt
hercl
assi
fi
edasanecessi
tyoral
uxur
ydependi
ngonwhet
hert
he
quant
it
ypur
chasedi
ncr
easespr
opor
ti
onat
elymor
eorl
esst
hant
hei
ncr
easei
nincome.
G.Pr
iceConsumpt
ion(
Off
er)Cur
ve
Whent
hepr
iceofagood(
sayX)decr
easest
hebudgetl
i
nebecomesf
lat
ter(
rot
atest
othe
r
ight
)fr
om i
tsi
nit
ialposi
ti
on(
AB)t
oanewposi
ti
on(
AB’
)duet
othei
ncr
easei
nthepur
chasi
ng
oft
hegi
veni
ncomeoft
heconsumer
.Thenewbudgetl
i
nei
stangentt
oahi
gherI
Catpoi
ntE2
showi
ngt
hataspr
iceofXf
all
s,mor
eofcommodi
tyXwi
l
lbebought
.Ifweal
l
owpr
iceofXt
o
f
allcont
inuousl
yandwej
oint
hepoi
ntsoft
angenci
esofsuccessi
vebudgetl
i
nesandt
he
hi
gherI
Cs,Wef
ormt
hesocal
l
edpr
iceconsumpt
ioncur
vef
rom whi
chweder
ivet
hedemand
cur
vef
orcommodi
tyX.atpoi
ntE1t
heconsumerbuy
squant
it
yX1atpr
iceP1.Atpoi
ntE2t
he
pr
iceP2i
slowert
hanP1andt
hequant
it
ydemandedhasi
ncr
easedt
oX2andsoon.
Y

PCC
E3
E2
E1 I
3
I
2
I
1
O
X1 X2BX3 B’ B’
’ X
P

P1

P2

P3
DD-
Cur
ve

O X
X1 X2 X3
Thus,weder
ivet
hedemandcur
vebypl
ott
ingt
hepr
icequant
it
ypai
rsdef
inedbyt
hepoi
ntsof

16|Page
equi
l
ibr
ium (
ont
hepr
iceconsumpt
ioncur
ve)ont
hepr
icequant
it
yspace.
Thedemandcur
v ornor
ef malgoods(
goodswhosedemandi
ncr
easeswi
thi
ncr
easei
nincome)
wi
l
lal
way
shav
eanegat
ivesl
opedenot
ingt
hel
awofdemandwhi
chst
atest
hatt
hequant
it
y
demandedi
ncr
easesaspr
icei
ncr
easesandv
icev
ersa.I
nthecaseofgi
ff
engoods t
he
demandf
oragooddecr
easeswheni
tspr
icedecr
eases.
Mat
hemat
icalder
ivat
ionoft
hedemandcur
ve:
Der
ivet
hedemandf
unct
ionf
orgoodXandYgi
ven
U(
x,y
) =1/
4QxQy
,Px,
Py,
&M.
Sol
uti
on
=>M =QxPx +Qy
Py
Att
heopt
imum choi
ce,t
hesl
opeofI
C(MRSx,
y =MUx/
MUy)i
sequalt
othesl
opeoft
he
budgetl
i
ne(
Px/
Py)
.Thati
s,
MUx/MUy =Px/Py
ButMUx =
U/
X =¼Qyand
MUy =
U/
Y =¼Qx
¼Qy
/¼Qx =Px/Py
Qy
Py =QxPx-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
(1)
Thebudgetconst
rai
nti
s
M =QxPx +Qy
Py
=>Qy =M/Py–Px
/PyQx-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-(2)
Subst
it
ute(
2)i
nto(
1)
Py(M/Py–Px/PyQx) =QxPx
M –PxQx=QxPx
2Px
Qx =M
M
Qx =
2Px
Toobt
aint
hedemandf
unct
ionf
orY:
M =PxQx +Py
Qy
=>PxQx =M –Py
Qy
Qx =1/PxM –(
Py/
Px)
Qy-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-(
3)
Subst
it
ute(
3)i
nto(
1)

17|Page
 Px
Qx =Py
Qy
Px
(1/
PxM –Py
/PxQy
) =Py
Qy
M –Py
Qy =Py
Qy
2Py
Qy =M
M
Qy =  i
sthedemandf
unct
ionf
orY.
2Py
Exampl
e:gi
venut
il
it
y(x,
y) =X1/3Y2/3,
Px=2,
Py=5andM =400,
find:
(
1)Thedemandequat
ionf
orXandY.
(
2)Theut
il
it
ymaxi
mizi
ngl
evel
sofXandY.
(
3)Themaxi
mum ut
il
it
y
(
4)TheMRSx
,yatt
heopt
imum l
evel
.
Sol
uti
on:
1
1 2

U(
x,)=X3Y3
y

Atequi
l
ibr
ium,
MUx/
MUy=Px
/Py But
,
∂U 1 -2/3 2/3
MUx = = X Y
∂X 3
∂U 2 1/3 -1/3
MUy = =X Y
∂Y 3
1 -2 2
3 3
3X Y Px
=> =
2 1 -1 Py
3 3
3X Y
2 2
-
3 3
XY Px
=> .
3 =
1
3
1
-
3
Py
3.2X Y
=>Py
.Y =2Px.X-
--
--
--
---
---
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-(1)

But
,M =PyY +PxX i
sthebudgetconst
rai
nt
=>Py .Y =M –PxX

=>Y =M/Py–Px/PyX- -
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
---(
2)
AndPx X =M –Py Y
=>X =M/ Px–(Py/Px)
Y---
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--(3)
Subst
it
uteequat
ion(2)i
nto(1)
Py.
Y =2Px. X
Py(M/Py–Px/ PyX) =2PxX
M –PxX =2PxX

18|Page
 3Px
X =M
M
X =  Ist
hedemandequat
ionf
orX.
3Px

Simil
arl
y,subst
it
uteequati
on(3)i
nto(1)
.
PyY =2PxX
2Px(M/Px–Py/PxY) =PyY
2M –2PyY =Py Y
3PyY =2M
2M
Y =  Isthedemandfuncti
onforcommodit
yY.
3Py
(2)Theabov ef
uncti
onsofX&Yar ederi
vedfr
om theequil
i
bri
um posi
ti
onoft
he
consumer
.Thus,
subst
it
utet
hev
alueofM,
PxandPyi
nthedemandequat
ionst
o
f
indt
heopt
imum v
alueofXandY.
X =M/3Px =400/3(
2) =400/
6 =200/
3 =66.
7
Y =2M/
3Py =2(
400)
/3(
5) =160/
3 =53.
3
3)U=X1/3Y2/3
(
1/
3 2/
3
=(
66.
7) (53.
3) =57.
5ist
hemaxi
mum ut
il
it
y.
(
4)Att
heequi
l
ibr
ium oratt
heopti
mum point
,
MRSx,
y =MUx/ MUy =Px/Py
=>MRSx,
y =2/ 5 =0.
4
1 -2 2
3 3
MUx 3X Y Y 160/3 80
⇒MRSx,y= = = = = =0.
4
MUy 2 1 -1 2X 2( 3) 200
200/
3 3
3X Y

H.Decomposi
ti
onofI
ncomeandSubst
it
uti
onEf
fect
s
Af
all
int
hepr
iceofagoodhast
woef
fect
s:
(
1)Theconsumerwi
l
ltendt
obuymor
eofagoodt
hathasbecomecheaper
andl
essoft
hosegoodst
hatar
enowr
elat
ivel
yexpensi
ve.Theconsumer
wi
l
ltendt
osubst
it
utecheapercommodi
tyf
orr
elat
ivel
yexpensi
veone.
Thi
sresponset
othechangei
nrel
ati
vepr
icesofgoodsi ed t
scal
l he
subst
it
uti
onef
fect
.
(
2)Becauseoneoft
hegoodsi
snow cheaper
,theconsumerenj
oysan
i
ncr
easei
nrealpur
chasi
ngpower
.Theconsumeri
sbet
terof
fbecause
he/
shecanbuyt
hesameamountoft
hegoodf
orl
essmoneyandt
hus

19|Page
 moneyl
eftov
erf
oraddi
ti
onalpur
chases.Thechangei
ndemandr
esul
ti
ng
f
rom t
hischangei
nreal
pur
chasi
ngpoweri edt
scal
l hei
ncomeef
fect
.
Thesubst
it
uti
onef
fecti
sthei
ncr
easei
nthequant
it
yboughtast
hepr
iceof
t
hecommodi
tyf
all
saf
teradj
ust
ingi
ncomesoast
okeept
her
ealpur
chasi
ng
poweroft
heconsumert
hesameasbef
ore.Thi
sadj
ust
menti
nincomei
s
edcompensat
cal
l ingvar
iat
ionandi
sshowngr
aphi
cal
l
ybyapar
all
elshi
ftof
t
henewbudgetl
i
neunt
ili
tbecomest
angentt
othei
nit
ialI
C.Thepur
poseof
t
hecompensat
ingv
ari
ati
oni
stoal
l
owt
heconsumert
oremai
nont
hesame
l
evel
ofsat
isf
act
ionasbef
oret
hepr
icechange.
I
nthef
oll
owi
nggr
aph,t
heconsumerwasi
nit
ial
l
yatpoi
ntE1ont
hebudget
l
i
neAB.Whent
hepr
iceofXf
all
s,t
hebudgetl
i
nehasr
otat
edf
rom ABt
oAB’
r
esul
tsi
nanew equi
l
ibr
ium poi
ntE2.Thei
ncr
easei
ntheconsumpt
ionofX
f
rom X1t
oX3i
sthet
otalef
fectofaf
alli
nthepr
iceofXwhi
chcanbespl
i
ted
i
ntosubst
it
uti
onef
fectandi
ncomeef
fect
.Inor
dert
ospl
i
ttheset
woef
fect
s
wedr
awapar
all
elbudgetl
i
ne(
compensat
ingbudgetl
i
ne)whi
chi
stangentt
o
t
henewbudgetl
i
ne.
Thi
sal
l
owst
her
ealpur
chasi
ngpoweroft
heconsumert
oremai
nasbef
ore
andt
hust
orej
ectt
hei
ncomeef
fectsot
heconsumerwi
l
lbeont
hesame
l
evelofsat
isf
act
ionasbef
ore.Accor
dingl
y,t
hemov
ementf
rom poi
ntE1t
o
E1’showst
hesubst
it
uti
onef
fectoft
hepr
icechange(
theconsumerbuy
s
mor
eofXnowt
hati
tcheaper
,subst
it
uti
ngXf
orY)
.
Y

A’
E1
E2

E1’ U1

20|Page
 U2

O X
X1 X2 B X3 A’ B’

Thesubst
it
uti
onef
fecti
snegat
ivef
oral
lgoodssi
ncet
heconsumersubst
it
utes
t
hecheaperf
ormor
eex
pensi
veone.Thi
simpl
i
esadecr
easei
npr
icel
eadst
oan
i
ncr
easei
nquant
it
ydemanded.
Themov
ementf
rom E1’
toE2i
sthei
ncomeef
fectoft
hef
alli
nthepr
iceofX.t
o
i
sol
atet
hei
ncomeef
fect
,weassumet
hatt
her
elat
ivepr
iceoft
hegoodshasnot
changed(
shownbyt
hepar
all
ell
i
neAB’
andA’
A’)
.Thei
ncomeef
fecti
nthi
scase
canbet
houghtofasbei
ngnegat
ive(
compar
ingt
hedi
rect
ionoft
hechangei
n
pr
iceandquant
it
ydemandedofagood)oraposi
ti
ve(
compar
ingt
hedi
rect
ionof
t
he change i
nthe pur
chasi
ng poweroft
he consumerand t
he quant
it
y
demanded)
.
=>Fornor
malgood,i
ncomeef
fectofa pr
icechangei
snegat
ive,i
.e.Px
=>PP=>Qx.
Ul
ti
mat
ely
,Px=>Qx.
=>Fori
nfer
iorgood,
incomeef
fectofapr
icechangei
sposi
ti
ve,
i.
e.Px=>PP=>
Qx.
Ul
ti
mat
ely
,Px=>Qx.

PANELA PANELB
Y Y

A
A
E2

A’
A’ E2
E1

21|Page
 E1 U2

U2 E1’
E1’

U1 U1
O B XO X
X1 X3X2 A’ B’ X3X1 X2 B A’ B’

SE SE

I
E I
E

TE TE

TE=SE+IE TE=SE+IE
X1X3=X1X2+X2X3 X1X3=X1X2+X2X3

Forani
nfer
iorgoodwhosenegat
ivesubst
it
uti
onef
fectmor
ethanof
fset
sthe
posi
ti
vei
ncomeef
fect(
panelAabov
e),t
het
otalef
fectwi
l
lbenegat
ive(
Px=>
Qx)andt
hust
hel
aw ofdemandhol
ds.I
f,howev
er,t
heI
Eisposi
ti
veandv
ery
st
rongt
hati
tmor
ethanof
fset
sthenegat
iveSE,t
hedemandcur
vewi
l
lhav
ea
posi
ti
vesl
ope(
Px=>Qx) t
heGI
FFENPARADOX.AGi
ff
engoodi
sagood
whosedemandcur
vesl
opesdownwar
dbecauset
heposi
ti
veI
Eisl
argert
hant
he
negat
iveSE(
panel
B).
Good I
E SE TPE
Nor
mal Negat
ive Negat
ive Negat
ive
i
nfer
ior Posi
ti
ve Negat
ive Ambi
guous

1.
4.2 TheRev
eal
edPr
efer
enceHy
pot
hesi
s
Ther
eveal
edpr
efer
encehy
pot
hesi
sisconsi
der
edasamaj
orbr
eakt
hroughi
nthe
t
heor
yofdemandbecausei
thasmadepossi
blet
heest
abl
i
shmentoft
hel
awof
demanddi
rect
lyont
hebasi
soft
her
eveal
edpr
efer
enceaxi
om wi
thoutt
heuseof
i
ndi
ff
erencecur
vesandal
lthei
rrest
ri
cti
veassumpt
ions.
Assumpt
ions:
(
1)Rat
ional
i
ty:t
heconsumeri
sassumedt
o behav
erat
ional
l
y,i
nthathe
pr
efer
sbundl
esofgoodst
hati
ncl
udemor
equant
it
iesoft
hecommodi
ti
es.

22|Page
 (
2)Consi
stency
:ifA>B,
thenBi
snotgr
eat
ert
hanA.
(
3)Tr
ansi
ti
vi
ty:
ifi
nanypar
ti
cul
arsi
tuat
ionA>BandB>C,
thenA>C.
(
4)Ther
eveal
edpr
efer
enceaxi
om:t
heconsumer
,bychoosi
ngacol
l
ect
ionof
goodsi
nanyonesi
tuat
ion,r
eveal
shi
s/herpr
efer
encef
ort
hatpar
ti
cul
ar
col
l
ect
ion.The chosen basketofgoods maxi
mizes t
he ut
il
it
yoft
he
consumer
.
1.
5Der
ivat
ionoft
heDemandCur
ve
Assumet
hatt
heconsumerhast
hebudgetl
i
neAB i
nthef
igur
ebel
ow and
chooses t
he col
l
ect
ion ofgoods denot
ed bypoi
ntZ,t
hus r
eveal
i
ng hi
/her
pr
efer
encef
ort
hisbasket
.Thi
sbundl
eofgoodsdef
inest
heequi
l
ibr
ium oft
he
consumerwhi
chmaxi
mizeshi
s/herut
il
it
y.Supposet
hatt
hepr
iceofXf
all
sso
t
hatt
henewbudgetl
i
nef
aci
ngt
heconsumeri
sAC.Wewi
l
lshow(
proof
)thatt
he
newbundl
eofgoodsi
ncl
udesmor
eofX.

A’

W N

X
O X1 X2B B’X3 C

I
nor
dert
ospl
i
ttheSE&I
E,wemakeacompensat
ingv
ari
ati
onshownbya
par
all
elbudgetl
i
net
othenewbudgetl
i
ne,whi
chpassest
hrought
hepoi
ntZ.i
n
t
hiscaset
heconsumerhasenoughi
ncomet
obuyZcombi
nat
ionsi
fhe/
sheso
wi
shes.Si
ncet
hecol
l
ect
ionZ i
sav
ail
abl
etot
heconsumer
,he/
shewi
l
lnot
chooseanybundl
etot
hel
eftofZont
hesegmentA’
Zbecauset
heycont
ainl
ess
23|Page
quant
it
yofX&Yt
hanbundl
esont
hesegmentAZ.Hencet
heconsumer
swi
l
l
ei
thercont
inuot
obuyZ(
inwhi
chcaset
hesubst
it
uti
onef
fecti
szer
o)orhe/
she
wi
l
lchooseabundl
eonZB’
,suchasW,whi
chi
ncl
udesal
argerquant
it
yofX
(
namel
yX2)
.Secondl
y,i
fweal
l
owt
hei
ncomeef
fectandhencet
heconsumert
o
mov
eont
henewbudgetl
i
neAC,he/
shewi
l
lchooseabundl
etot
her
ightofW
(
suchasN)i
fthecommodi
tyXi
snor
malwi
tht
heposi
ti
vei
ncomeef
fect
.The
new r
eveal
edequi
l
ibr
ium posi
ti
on(
N)i
ncl
udesal
argerquant
it
yofX(
i.
e.X3)
r
esul
ti
ngf
rom af
alli
npr
ice.Thusweder
ivet
hedemandcur
vedi
rect
lyf
rom t
he
r
eveal
edpr
efer
enceaxi
om (
i.
e.asapr
iceXf
all
sthedemandf
orXi
ncr
eases)
.
1.
5.1 Der
ivat
ionoftheMarketDemand
I
nourprevi
ousdiscussi
onwehav eder
ivedt
hei
ndi
vi
dualdemandcur
vef
rom t
he
ut
il
it
ymaxi
mizat
ion behav
iorofconsumer
s.Now wewi
l
lder
ivet
hemar
ket
demandf
rom t
hisi
ndi
vi
dualdemandcur
ves.Asi
thasbeenpr
oved,
thei
ndi
vi
dual
demandi
snegat
ivel
yrel
atedt
othepr
icecommodi
tyi
nthesenset
hatwhenpr
ice
decr
ease,t
hei
ndi
vi
dualconsumerpur
chasesmor
eoft
hecommodi
tyi
nor
dert
o
maxi
mizehi
s/herut
il
it
y.Themar
ketdemandcur
vef
ort
hecommodi
tyi
ssi
mpl
y
t
hehor
izont
alsummat
ionoft
hedemandcur
veofal
ltheconsumer
sint
he
mar
ket
.Inot
herwor
dst
hequant
it
ydemandedi
nthemar
ketateachpr
icei
sthe
sum oft
hei
ndi
vi
dual
demandsofal
lconsumer
satt
hatpr
ice.
Exampl
e:
Assumet
hatt
her
ear
etwoconsumer
sint
hemar
ketf
orapar
ti
cul
arcommodi
tyX
(sayhambur
ger
)andt
hei
rdemandateachpr
icei
sgi
venasf
oll
ow:
Pr
ice(
$) QxddedbyA QxddedbyB Mar
ketdemand
2 2 2 4
1 6 4 10
0.
5 10 6 16
Gr
aphi
cal
l
ythemar
ketdemandcanbeder
ivedasf
oll
ows:
Px Px Px
Indi
vi
dualA I
ndi
vi
dualB Mar
ket
demand

24|Page
2

0.
5-
d1 d2 MD

O 2 6 10 O 2 4 6 O 4 10 16
Thus,t
hemarketdemandf
oracommodi
tyshowst
hev
ari
ousquant
it
iesoft
he
commodi
tydemandedi
nthemar
ketperuni
toft
imeatv
ari
ousal
ter
nat
ivepr
ice
oft
hecommodi
tywhi
l
ehol
dingev
eryt
hinel
seconst
ant
.Themar
ketdemandf
or
acommodi
tyi
snegat
ivel
ysl
oped(
justasani
ndi
vi
dualdemandcur
ve)
,indi
cat
ing
t
hatpr
iceandquant
it
yar
einv
ersel
yrel
ated.Thati
s,t
hequant
it
ydemandedof
t
hecommodi
tyi
ncr
easeswheni
tspr
icef
all
sanddecr
easeswheni
tspr
icer
ises.

1.
5.2 Det
ermi
nant
sofDemand
Det
ermi
nant
sofdemandar
efact
orst
hatcauset
heconsumert
oincr
easeor
decr
easei
tsdemand f
orapar
ti
cul
arcommodi
ty.Demand i
samul
ti
-var
iet
y
f
unct
ioni
nasenset
hati
t’
sdet
ermi
nedbymanyf
act
ors/
var
iabl
es.Themost
i
mpor
tantdet
ermi
nant
sofmar
ketdemandar
econsi
der
edt
obet
hepr
iceoft
he
commodi
tyi
nquest
ion,t
hepr
iceofot
herr
elat
edcommodi
ti
es,t
heconsumer
i
ncomeandt
est
es.Ther
esul
tofchangei
nthepr
iceoft
hecommodi
tyi
sshown
byamov
ementf
rom onepoi
ntt
oanot
heront
hesamedemandcur
ve,whi
l
ethe
ef
fectofchangesi
not
herdet
ermi
nant
sisshownbyashi
ftofdemandcur
veand
t
hesef
act
orsar
ecal
l
edshi
ftf
act
ors.
Px

P2 B

25|Page
 P

P1 A

D D’D’
’
D
Qx Qx
O X2 X1 O X1X2 X3

Mov
emental
ongt
hedemandcur
ve Shi
ft
s of t
he demand cur
vef
or
ast
hepr
iceofxchanges exampl
eas,
incomei
ncr
eases
Apar
tfr
om t
heabov
edet
ermi
nant
s,demandi
saf
fect
edbynumer
ousot
her
f
act
ors,
suchast
hedi
str
ibut
ionofi
ncome,
tot
alpopul
ati
onandi
tsconsumpt
ion,
weal
th,cr
edi
tav
ail
abi
l
ity
,changei
nexpect
ati
onaboutt
hef
utur
epr
iceoft
he
commodi
ty,
etc.
1.
5.3 El
ast
ici
tyofDemand
Theconceptofel
ast
ici
tyi
susedt
omeasur
etheamountbywhi
cht
hequant
it
y
demanded changes when i
ts det
ermi
nant
s change.Ther
e ar
e as many
el
ast
ici
ti
esofdemandast
her
ear
eit
sdet
ermi
nant
s.Themosti
mpor
tantof
t
heseel
ast
ici
ti
esar
e:
(
A)Thepr
iceel
ast
ici
tyofdemand
(
B)Thei
ncomeel
ast
ici
tyofdemand
(
C)Thecr
oss-
elast
ici
tyofdemanded.
a.ThePr
iceEl
ast
ici
tyOfDemand
Thepr
iceel
ast
ici
tyi
sameasur
eoft
her
esponsi
venessofdemandt
ochangesi
n
t
hecommodi
ty’
sownpr
ice.I
fthechangesi
npr
icear
ever
ysmal
lweuseasa
measur
eoft
her
esponsi
venessofdemandt
hepoi
ntel
ast
ici
tyofdemand.I
fthe
changesi
npr
icear
enotsmal
lweuset
hear
cel
ast
ici
tyofdemandasar
elev
ant
measur
e.
Thepoi
ntel
ast
ici
tyofdemandi
sdef
inedast
hepr
opor
ti
onat
echangei
nthe
quant
it
ydemandedr
esul
ti
ngf
rom av
erysmal
lpr
opor
ti
onat
echangei
npr
ice.
Sy
mbol
i
cal
l
y,wemaywr
it
eas:

26|Page
 dQ
Q dQ P
ep = = ×
dP dP Q
P
I
fthedemandi
sli
near
Q =bo–b1P,i
tssl
opei
sdQ/
dP =-
b1.Subst
it
uti
ngi
nthef
ormul
awe
obt
ain, ep =-
b1.
P/Q.
Gr
aphi
cal
l
y,t
hepoi
ntel
ast
ici
tyofal
i
neardemandcur
vei
sshownbyt
her
ati
oof
t
hesegment
soft
hel
i
net
other
ightandt
othel
eftoft
hepar
ti
cul
arpoi
nt.For
exampl
e,i
nthef
igur
ebel
owt
heel
ast
ici
tyatpoi
ntFi
sther
ati
o:
ep =FD’
/FD
P

P1 F

P2 F’
E

Q
O Q1 Q2 D’

Pr
oof
:
From t
heabovefi
gureweseethat:
P =P1P2 =EF
Q =Q1Q2 =EF’
P =OP1
Q =OQ1
Ifweconsiderver
ysmal lchangeinP andQ,t hen P =dP and Q.Thus,
subst
it
uti
nginthefor
mulaforthepoi
ntel
ast
ici
ty,
weobt ai
n:

dQ P Q1Q2 OP1 EF’ OP1

Ep = () = * = *
dPQ P1P2 OQ1 EF OQ1

From thefigur
ewecanal soseet hatthetri
angl
esFEF’andFQ1D’ar
esi
mil
ar
(becauseeachcor
respondi
nganglesareequal
).
EF’ Q1D’ Q1D’
Hence, = =
EF FQ1 OP1

27|Page
 Thus,
Q1D’ OP1 Q1D’
Ep = × =
OP1 OQ1 OQ1

Furt
hermorethetr
ianglesDP1FandFQ1D’ aresimil
ar,sothat
Q1D’ P1F OQ1
= =
FD’ FD FD
Rearr
angingweobt ai
n:
Q1D’ FD’
=
OQ1 FD
Thus,t
hepr i
ceel
ast i
cit
yatpointFis
Q1D’ FD’
Ep = =
OQ1 FD
Giv
ent hi
sgraphi
calmeasur ementofpointelasti
cit
yitisobvi
oust
hatatt
hemi
d-
poi
ntofal
i
neardemandcur
veep=1(
poi
ntM)
.Atanypoi
ntt
other
ightofM t
he
poi
ntel
ast
ici
tyi
slesst
hanuni
ty(
ep<1)
;fi
nal
l
yatanypoi
ntt
othel
eftofM,
ep>
1.Atpoi
ntD,t
he ep ,whi
l
eatpoi
ntD’t
heep=O.Thepr
iceel
ast
ici
tyi
s
al
way
snegat
ivebecauseoft
hei
nver
ser
elat
ionshi
pbet
weenQandPi
mpl
i
edby
t
hel
aw ofdemand.However
,thenegat
ivesi
gni
somi
tt
edwhenwr
it
ingt
he
f
ormul
aoft
heel
ast
ici
ty.
Ther
angeofv
aluesoft
heel
ast
ici
tyi
sOep.
a.I
fep=O,
thent
hedemandi
sper
fect
lyi
nel
ast
ic
b.I
fep=1,
thent
hedemandi
suni
tar
yel
ast
ic
c.I
fep=,
thent
hedemandi
sper
fect
lyel
ast
ic
d.I
fO<ep<1,
thent
hedemandi
sinel
ast
ic
e.I
f1<ep<,
thent
hedemandi
sel
ast
ic.

D ep=
ep>1
ep=1
M
ep<1
ep=O
0 Q

28|Page
P P P
D D

0 Q o Q Q
ep=o ep=1 ep=

Theabov
efor
mul
afort
hepr
iceel
ast
ici
tyi
sappl
i
cabl
eonl
yfori
nfi
nit
esi
mal
changesi
nthepr
ice.I
fthepr
icechangesappr
eci
abl
yweuset
hef
oll
owi
ng
f
ormul
a,whi
chmeasur
est
hear
cel
ast
ici
tyofdemand:
Q (
P1 +P2)
/2 Q P1 +P2
Ep = × = ×
P (Q1 +Q2)
/2 P Q1 +Q2
Thear
cel
ast
ici
tyi
sameasur
eoft
heav
erageel
ast
ici
ty,i
.e.t
heel
ast
ici
tyatt
he
mi
d-poi
ntoft
het
wopoi
ntsAandBont
hedemandcur
vedef
inedbyt
hei
nit
ial
andt
henewpr
icel
evel
s.
P

P1 A

P2 B

D Q
0 Q1 Q2

Det
ermi
nant
sofPr
iceEl
ast
ici
tyofDemand
Thebasi
cdet
ermi
nant
soft
heel
ast
ici
tyofdemandofacommodi
tywi
thr
espect
t
oit
sownpr
icear
e:
(
1)Theav
ail
abi
l
ityofsubst
it
ute;t
hedemandf
oracommodi
tyi
smor
eel
ast
ic
i
fther
ear
ecl
osesubst
it
utef
ori
t.
(
2)Thenat
ureoft
heneedt
hatt
hecommodi
tysat
isf
ies.I
ngener
al,l
uxur
y
goodar
epr
iceel
ast
ic,
whi
l
ethenecessi
tyi
spr
icei
nel
ast
ic.

29|Page
 (
3)Thet
imeper
iod;
demandi
smor
eel
ast
ici
nthel
ongr
un.
(
4)Thenumberofusest
owhi
chacommodi
tycanbeput
.Themor
ethe
possi
bleusesofacommodi
ty,
thegr
eat
eri
tspr
iceel
ast
ici
tywi
l
lbe.
(
5)Thepr
opor
ti
onofi
ncomespentont
hepar
ti
cul
arcommodi
ty.
b.I
ncomeEl
ast
ici
tyOfDemand
Thei
ncomeel
ast
ici
tyi
sdef
inedast
hepr
opor
ti
onat
echangei
nthequant
it
y
demandedr
esul
ti
ngf
rom apr
opor
ti
onat
echangei
nincome.
dQ/
Q dQ Y
Ey= = ×
Y dY Q
dY/
I
fey >o,
thent
hecommodi
tyi
snor
mal
I
fey <o,“ “ “ i
nfer
ior
I
fey >1, “ “ “ l
uxur
y
I
fo <ey <1, “ “ necessi
ty
Themai
ndet
ermi
nant
sofi
ncomeel
ast
ici
tyar
e
(
1)Thenat
ureoft
heneedt
hatt
hecommodi
tycov
ers:t
heper
cent
ageof
i
ncomespentonf
ooddecl
i
nesasi
ncomei
ncr
eases.
(
2)Thei
nit
iall
evelofi
ncomeofacount
ry.Forexampl
e,aTVseti
sal
uxur
yin
under
dev
elopedcount
ri
eswhi
l
eiti
sanecessi
tyi
nacount
rywi
thhi
ghper
capi
tal
income.
(
3)Thet
imeper
iod,becauseconsumpt
ionpat
ter
nsadj
ustwi
that
imel
agt
o
changesi
nincome.
c.TheCr
oss-El
ast
ici
tyOfDemand
Thecr
ossel
ast
ici
tyofdemandi
sdef
inedast
hepr
opor
ti
onat
echangei
nquant
it
y
demandofXr
esul
ti
ngf
rom apr
opor
ti
onat
echangei
nthepr
iceofY.
Qx dQx Py
dQx/
Exy= = ×
dPyPy dPy Qx
/
I
fExy <0,
thenX&Yar
ecompl
ement
arygoods
I
fExy >0,“ “ subst
it
utegoods
I
fExy =0,“ “ nonr
elat
edgoods
Themai
ndet
ermi
nant
soft
hecr
ossel
ast
ici
tyi
sthenat
ureoft
hecommodi
ti
es
r
elat
ivet
othei
ruse.I
ftwocommodi
ti
escansat
isf
yequal
l
ywel
lthesameneed,

30|Page
cr
ossel
ast
ici
tyi
shi
ghandv
icev
ersa.
1.
5.4 Pr
iceEl
ast
ici
tyAndTot
alExpendi
tur
e
Ani
mpor
tantr
elat
ionshi
pexi
stsbet
weent
hepr
iceel
ast
ici
tyofdemandandt
he
t
otal
expendi
tur
eofconsumer
sont
hecommodi
ty(
tot
alr
evenueofpr
oducer
s).I
t
post
ulat
est
hatadecl
i
nei
nthecommodi
typr
icer
esul
tsi
nani
ncr
easei
ntot
al
expendi
tur
esi
fdemandi
sel
ast
icl
eav
est
otalex
pendi
tur
eunchangedi
fdemand
i
suni
tar
yel
ast
ic,andr
esul
tsi
nadecl
i
nei
ntot
alexpendi
tur
eifdemandi
s
i
nel
ast
ic.
Speci
fi
cal
l
ywhent
hepr
iceoft
hecommodi
tyf
all
s,t
otalexpendi
tur
e(pr
icet
imes
quant
it
y)i
ncr
easei
fdemand i
sel
ast
icbecause t
heper
cent
age i
ncr
ease i
n
quant
it
y(whi
ch by i
tsel
ftends t
oincr
ease t
otalexpendi
tur
e)exceeds t
he
per
cent
agedecl
i
nei
npr
ice(
whi
chbyi
tsel
ftendst
odecl
i
net
otalexpendi
tur
e).
Tot
alexpendi
tur
esar
emaxi
mum when/
ep/=1anddecl
i
net
her
eaf
ter
.Thati
s,
when/
ep/<1,
areduct
ioni
nthecommodi
typr
icel
eadst
oaper
cent
agei
ncr
ease
i
nthequant
it
ydemandedoft
hecommodi
tyt
hati
ssmal
l
ert
hant
heper
cent
age
r
educt
ioni
npr
ice,andsot
otalexpendi
tur
eont
hecommodi
tydecl
i
ne.Thi
scan
beshownbyt
hef
oll
owi
ngt
abl
e.

Poi
nt Pr
iceofX(
Px) Quant
it
y(Qx) Total Absol
ute
expendi
tur
e(T val
ue of ep,
E) ep|
|
A 2.
00 0 0 
C 1.
50 3 4.50 3
E 1.
00 6 6.00 1
F 0.
50 9 4.50 1/3
H 0 12 0 0

Fr
om t
heabov
etabl
eweseet
hatbet
weenpoi
ntsA andE,/
ep/
>1andt
otal
expendi
tur
eont
hecommodi
tyi
ncr
easesast
hecommodi
typr
icedecl
i
nes.The
opposi
tei
str
uebet
weenpoi
ntsEandFov
erwhi
ch/
ep/
<1.Tot
alexpendi
tur
esar
e
maxi
mum atpoi
ntE(
thegeomet
ri
cmi
d-poi
ntoft
hedemandcur
ve)
.Thegener
al
r
ulesummar
izi
ngt
her
elat
ionshi
pamongt
otalexpendi
tur
es,pr
iceandt
hepr
ice
el
ast
ici
tyofdemand i
sthatt
otalexpendi
tur
esand pr
ice mov
ein opposi
te
di
rect
ionsi
fdemandi
sel
ast
icandi
nthesamedi
rect
ioni
fdemandi
sinel
ast
ic.
31|Page
1.
5.5 Mar
ketDemand,
TRandMR
Fr
om t
hemar
ketdemand cur
vewecander
ivet
het
otalexpendi
tur
eoft
he
consumer
,whi
chf
ormst
het
otalr
evenueoff
ir
mssel
l
ingt
hepar
ti
cul
arpr
oduct
.
Thet
otal
rev
enuei
sthepr
oductoft
hequant
it
ysol
dandt
hepr
ice.
TR =P.
Q
I
fthemar
ketdemandi
sli
neart
heTRcur
vewi
l
lbeacur
vewhi
chi
nit
ial
l
ysl
opes
upwar
ds,r
eachesamaxi
mum andt
henst
art
sdecl
i
ning.Wecanpr
ooft
hisf
rom
ourpr
evi
ousdi
scussi
onoft
her
elat
ionshi
pbet
weenel
ast
ici
tyandTR/
TE

P TR
Rmax
P1 A
B
P* ep=1
C
P2
D’ TR
0 Q1 Q* Q2 Q O Q* Q

Anot
heri
mpor
tantpoi
nti
nthet
heor
yoff
ir
mist
heMR.t
hemar
ginal
rev
enuei
s
t
hechangei
ntot
alr
evenuer
esul
ti
ngf
rom sel
l
inganaddi
ti
onal
uni
toft
he
commodi
ty.Gr
aphi
cal
l
y,MRi
sthesl
opeoft
otal
rev
enuecur
veatanyonepoi
nt.
I
fthedemandcur
vei
sli
near
,theMRcur
vei
stwi
ceasst
eepast
hedemandcur
ve.
P
D

D’ Q
O MR
Thi
scanbepr
ovedmat
hemat
ical
l
yasf
oll
ows:
MRi
stheder
ivat
iveofTRf
unct
ion:
MR =d(TR)
/dQ
d(
PQ)
=
dQ

32|Page
 =P +Q.
dP/
dQ
I
fthedemandcur
vei
sli
neari
tsequat
ioni
nter
msofpr
icei
s:
P =ao–a1Q
Subst
it
uti
ngPi
ntheTRf
unct
ionwef
ind
TR =PQ =aoQ–a1Q2
TheMRi
sthenMR =d(
TR)
/dQ
=ao–2a1Q
Thi
spr
ovest
hatt
heMRcur
vest
art
sfr
om t
hesamepoi
nt(
ao)ast
hedemand
cur
ve,
andt
hatt
heMRi
sast
rai
ghtl
i
newi
thanegat
ivesl
opet
wiceasst
eepas
t
hesl
opeoft
hedemandcur
ve.
1.
5.6 Therelati
onshi
pbetweenMRandpr iceel
ast
ici
ty
TheMRi sr
elatedtothepr
iceel
ast
ici
tyofdemandwiththef
ormul
a
MR =P( 1–1/ep)
Pr
oof
:
Assumet hatthedemandf uncti
onisP =f (Q)
ThetotalrevenueisTR =PQ =[ f
(Q) ]
Q
TheMRi s
d(
PQ)
MR =
dQ
dQ dP
MR =P* +Q *
dQ dQ
dP
=P +Q *
dQ
Thepriceelasti
cit
yofdemandi sdef i
nedas
dQ P
ep =- ×
dP Q
Rearr
angingweobt ain
Q dQ
-ep =
P dP
-
P dP
=
ep* Q dQ
Substi
tuti
ngdP/ dQi ntheexpressi
onoft heMRwef i
nd
dP P 1
MR =P +Q * =P- Q =P(1- )
dQ ep* Q ep
1.
5.7 Tot alRevenue, Margi
nalRev enueandPriceElast
ici
ty
Wesai
dthati
fthedemandcur
vei
sfal
l
ingt
heTRcur
vei
nit
ial
l
yincr
eases,
r
eachesamaxi
mum,
andt
henst
art
sdecl
i
ning.Wecanuset
heear
li
erder
ived
r
elat
ionshi
pbet
weenMR,
Pandet
oest
abl
i
sht
heshapeoft
het
otal
rev
enue

33|Page
cur
ve.
Thet
otal
rev
enuecur
ver
eachesi
tsmaxi
mum att
hepoi
ntwher
ee=1,
because
att
hispoi
nti
tssl
ope,
theMR,
isequal
tozer
o:
MR =P(
1–1/
1) =0
I
fep>1t
heTRcur
vehasaposi
ti
vesl
ope,
thati
s,i
tisst
il
li
ncr
easi
ngandhence
hasnotr
eachedi
tsmaxi
mum poi
ntgi
vent
hat
P >0,
and(
1–1/
ep) >0;
henceMR >0
fep<1t
I heTRcur
vehasanegat
ivesl
ope,
thati
s,i
tisf
all
i
nggi
ven
P >0,
and(
1–1/
ep) <0;
henceMR <0
Wemaysummar
izet
heser
esul
tsasf
oll
ows:
* I
fthedemandi
sinel
ast
ic(
ep<1)
,ani
ncr
easei
npr
icel
eadst
oan
i
ncr
easei
nTR,
andadecr
easei
npr
icel
eadst
oaf
all
inTR.
* I
fthedemandi
sel
ast
ic(
ep>1)
,ani
ncr
easei
npr
icewi
l
lresul
tina
decr
easeofTR,
whi
l
eadecr
easei
npr
icewi
l
lresul
tinani
ncr
easei
nTR.
* I
fthedemandi
suni
tar
yel
ast
ic,
TRi
snotaf
fect
edbychangei
npr
ice
si
nceep =1andMR =0.
Revi
ewQuestionsf
orChapt
erI
1.Whatdoest
ransi
ti
vi
tyofpr
efer
encemeans?
2.Expl
ainwhyt
woi
ndi
ff
erencecur
vescannoti
nter
sect
.
3.Expl
ainwhymar
ginal
rat
eofsubst
it
uti
onbet
weent
wogoodsmustequal
t
her
ati
ooft
hepr
icesatmaxi
mum l
evel
ofsat
isf
act
ion.

Chapt
erTwo
Choi
ceunderUncer
tai
nty
2.
1Int
roduct
ion

34|Page
Tr
adi
ti
onaldemandt
heor
y,asexami
nedunt
ilnow,
impl
i
cit
lyassumedar
iskl
ess
wor
ld.I
tassumedt
hatconsumer
sfacecompl
etecer
tai
ntyast
other
esul
tsof
t
hechoi
cest
heymake.Cl
ear
ly,
thi
sisnott
hecasei
nmosti
nst
ances.I
ncont
rar
y
t
o ourassumpt
ionsofpr
icei
ncomeand ot
herv
ari
abl
est
o beknown wi
th
cer
tai
nty
,manyoft
hechoi
cest
hatpeopl
emakei
nvol
veconsi
der
abl
euncer
tai
nty
.

Al
thoughr
iskanduncer
tai
ntyar
eusual
l
yusedi
nter
changeabl
y,somepeopl
e
di
sti
ngui
shbet
weent
het
wo.
(
I) Uncer
tai
nty:r
efert
o asi
tuat
ionwhent
her
ear
emor
ethanpossi
ble
out
comest
o a deci
sion and wher
ethepr
obabi
l
ityofeach speci
fi
c
out
comei
snotknown.Thi
smaybeduet
oinsuf
fi
cientpasti
nfor
mat
ion
ori
nst
abi
l
ityi
nthest
ruct
ureoft
hev
ari
abl
es.
(
II
) Ri
sk:r
efer
sto asi
tuat
ion wher
ether
ear
emor
ethan onepossi
ble
out
comet
oadeci
sionandt
hepr
obabi
l
ityofeachspeci
fi
cout
comei
s
knownorcanbeest
imat
ed.
(
II
I) Cer
tai
nty:r
efer
stoasi
tuat
ionwher
ether
eisonl
yonepossi
bleout
come
t
o a deci
sion and t
his out
come i
s known pr
eci
sel
y.Forexampl
e,
i
nvest
ingont
reasur
ybi
l
lsl
eadst
oonl
yoneout
come(
i.
e.t
heamountof
t
hey
iel
d),
andt
hisi
sknownwi
thcer
tai
nty
.
Weneedt
womeasur
est
odescr
ibeandcompar
eri
skchoi
ces.Thesemeasur
es
ar
e:
(
I)Expect
edval
ue:i
sthewei
ght
edav
erageofal
lpossi
blepay
off
s/out
comest
hat
canr
esul
tfr
om adeci
si
onundert
hev
ari
ousst
ateofnat
ure,wi
tht
hepr
obabi
l
ity
oft
hosepay
off
susedaswei
ght
s.I
tmeasur
est
hev
aluet
hatwewoul
dexpecton
av
erage.I
fwemul
ti
plyeachpossi
bleout
comeorpay
offbyi
tspr
obabi
l
ityof
occur
renceandaddt
hesepr
oduct
s,wegett
heexpect
edv
alue.I
f,f
ori
nst
ance,
t
her
e ar
etwo possi
ble out
comes hav
ing pay
off
s X1 and X2 and i
fthe
pr
obabi
l
iti
esofeachout
comear
egi
venbyP1andP2,
thent
heexpect
edv
aluei
s:
E(
X)=P1*
X1 +P2*
X2
Exampl
e:I
fthepr
obabi
l
ityt
hatanoi
lexpl
orat
ionpr
ojecti
ssuccessf
uli
s¼and
t
hepr
obabi
l
ityt
hati
tisunsuccessf
uli
s¾andi
fsuccessy
iel
dsapay
offof40bi
rr

35|Page
pershar
ewhi
l
efai
l
ureapay
offof20bi
rrpershar
e,t
heexpect
edv
aluei
s:
EV =p(
success)
(40bi
rr
/shar
e) +p(
fai
l
ure)
(20bi
rr
/shar
e)
=¼(
40)+¾(
20)
=25bi
rr
/shar
e
(
II
)Var
iabi
l
ity
:ist
heext
entt
owhi
chpossi
bleout
comesofanuncer
tai
nev
ent
maydi
ff
er.Wemeasur
evar
iabi
l
itybyr
ecogni
zi
ngt
hatl
argedi
ff
erencesbet
ween
act
ual
andexpect
edv
aluei
mpl
ygr
eat
err
isk.St
andar
ddev
iat
ioni
stheof
tenused
measur
eofv
ari
abi
l
ity
.St
andar
ddev
iat
ionmeasur
est
hedi
sper
sionofpossi
ble
out
comesf
rom t
heexpect
edv
alue.Thesmal
l
ert
hev
alueofsd,t
het
ight
eror
l
essdi
sper
sedt
hedi
str
ibut
ioni
sandt
hel
owert
her
iskat
tachedt
oitandv
ice
v
ersa.
2 2
St
andar
ddev
iat
ion(
sd)σ =P1(
X1-
E(X)
) +P2(
X2-
E(X)
)
I
ftwoal
ter
nat
ivest
ochoosef
rom hav
ethesameexpect
edv
alue,t
heonewi
th
t
hel
ower
/smal
l
erst
andar
ddev
iat
ioni
slessr
iskyandhencei
spr
efer
red.I
f,
howev
er,oneal
ter
nat
iveof
fer
sahi
gherexpect
edv
aluebuti
smuchr
iski
ert
han
t
heot
heroneandv
isev
ersa,
thepr
efer
encedependsont
hei
ndi
vi
dual–whet
her
he/
shei
sar
iskav
erse,
riskneut
ral
orar
iskl
ovi
ngper
son.
2.
2Di
ff
erentPr
efer
encest
owar
dsRi
sk
a.ARi
skAver
sePer
son:
Ri
skav
erseper
soni
saper
sonpr
efer
ri
ngacer
tai
nincomet
oar
iskyi
ncomewi
th
t
hesameexpect
edv
alue.Forar
iskav
erseper
sonl
ossesar
emor
eimpor
tant(
in
t
ermsoft
hechangei
nut
il
it
y)t
hangai
ns.Losseshur
thi
m/hermor
eser
iousl
y
t
hangai
nsbenef
ithi
m/her
.Thus,
theMUofi
ncomedi
mini
shesasi
ncomer
ises.
Assumet
hatt
heper
soncanei
therhav
eacer
tai
nincomeofbi
rr20,oran
al
ter
nat
ivedeci
si
ony
iel
dingani
ncomeof30bi
rrwi
thpr
obabi
l
ityof0.
5andan
i
ncomeof10bi
rrwi
thpr
obabi
l
ity0.
5.Theexpect
edi
ncomeoft
hisal
ter
nat
ivei
s,
EV=0.
5(30)+0.
5(10)=20bi
rr
.Thi
sist
hesameast
hei
ncomeear
nedwi
thout
r
isk.He/
shepr
efer
stoconsumet
her
iskl
ess20bi
rrt
otr
yingt
heal
ter
nat
ivei
n
whi
ch he/
she coul
d hav
e consumed 30 bi
rri
fsuccessf
ulor10 bi
rri
f
unsuccessf
ul.Ut
il
it
yatB>ut
il
it
yatC(
16>14)
.Ther
iskav
erseper
sonachi
eves

36|Page
t
heex
pect
edut
il
it
yof14atal
owerbutr
iskl
essi
ncomeof16bi
rr
.Thus,he/
she
i
swi
l
li
ngt
opaybi
rr4(
20-
16)t
oav
oidt
aki
ngr
isk.Themaxi
mum amountof
money(
4inourcase)t
hatar
iskav
erseper
sonwi
l
lpayt
oav
oidt
aki
ngar
iski
s
cal
l
edar
iskpr
emi
um.
Ut
il
it
yoft
hisr
iskav
erseper
soni
s14=0.
5(10)+0.
5(18)
.
Consi
dert
hef
oll
owi
nggr
aphf
ort
heabov
eexpl
anat
ion.
Ut
il
it
y

18 E
16 B
14 D C
10 A

I
ncome
O 10 16 20 30

b.ARi
skNeut
ral
Per
son:
He/
shei
saper
soni
ndi
ff
erentbet
weenacer
tai
nincomeandanuncer
tai
n
i
ncomewi
tht
hesameexpect
edv
alue.Fort
hisper
son,t
heMUofi
ncomei
s
const
ant
.
E(
U)=0.
5U(
10)+0.
5U(
30)
=0.
5(6)+0.
5(18)
=12
=>E(
U)=U(
20)=12
Ut
il
it
y
18 E

12 C

6 A
37|Page
O 10 20 30 I
ncome
c.ARi
skLov
ingPer
son:
-
She/
hei
saper
sonpr
efer
ri
ngar
iskyi
ncomet
oacer
tai
nincomewi
tht
he
sameexpect
edv
alue.Thi
sper
sonpr
efer
sanuncer
tai
nincomet
oacer
tai
n
one,
eveni
ftheexpect
edv
alueoft
heuncer
tai
nincomei
slesst
hant
hatoft
he
cer
tai
nincome.
E(
U)=0.
5U(
10)+0.
5U(
30)
=0.
5(3)+0.
5(18)
=10.
5
E(
U)>U(
20)
10.
5>8
Theex
pect
edut
il
it
yoft
heuncer
tai
nincomei
sgr
eat
ert
hant
heut
il
it
yofacer
tai
n
i
ncomef
orar
iskl
ovi
ngper
sonandt
hust
hei
rut
il
it
yofi
ncomecur
vei
supwar
d
bendi
ng.

Ut
il
it
y
18 E

10.
5 C

8 A
I
ncome
O 10 20 30
* Ri
skl
ovi
ngpeopl
ear
efew,atl
eastwi
thr
espectt
omaj
orpur
chasesor
l
argeamount
sofi
ncomeorweal
th.
* Ri
skl
ovi
ngpeopl
epr
eferal
ter
nat
iveswi
thhi
ghexpect
edv
alueandhi
gh
st
andar
d dev
iat
ion (
ri
sk)t
oal
owerpay
ing butl
essr
iskyal
ter
nat
ive
(
unl
i
ket
her
iskav
ersepeopl
e).
38|Page
 NB:Expect
ed ut
il
it
yE(
U)i
sthesum oft
he ut
il
it
iesassoci
ated wi
th al
l
possi
bleout
comes,
wei
ght
edbyt
hepr
obabi
l
ityt
hateachout
comewi
l
loccur
.

2.
3Ri
skAv
ersi
onAndI
ndi
ff
erenceCur
ves
Weal
sodescr
ibet
heext
entofaper
son’
sri
skav
ersi
oni
nter
msofi
ndi
ff
erence
cur
vest
hatr
elat
etheexpect
edi
ncomet
othev
ari
abi
l
ityofi
ncome,t
hel
att
er
bei
ngmeasur
edbyt
hest
andar
ddev
iat
ion.AnI
C showst
hecombi
nat
ionof
expect
edi
ncomeandst
andar
ddev
iat
ionofi
ncomet
hatgi
vet
hei
ndi
vi
dualt
he
same amountofut
il
it
y.I
Cs ar
e upwar
d sl
opi
ng.Thi
sis because r
isk i
s
undesi
rabl
esot
hatt
hegr
eat
ert
heamountofr
isk,t
hegr
eat
ert
heamountof
i
ncome needed t
o make t
he i
ndi
vi
dualequal
l
ywel
l
-of
f.An i
ncr
ease i
nthe
st
andar
ddev
iat
ion(
ahi
gherv
ari
abi
l
ityofi
ncome)mustbecompensat
edbya
hi
gherexpect
edi
ncomesoast
oav
eryl
eav
ear
iskav
erseper
sonont
hesame
l
evelofut
il
it
y.I
nthecaseofasl
i
ght
lyr
iskav
erseper
son,al
argei
ncr
easei
nthe
st
andar
ddev
iat
ionofi
ncomer
equi
resonl
yasmal
li
ncr
easei
nexpect
edi
ncome.

E(
I) U3 E(
I)
U2
U3
U2
U1
U1

O O
St
andar
ddev
iat
ionofi
ncome(
) St
andar
ddev
iat
ionofi
ncome
(
)
(
A)Ahi
ghr
iskav
erseper
son (
B)Asl
i
ght
lyr
iskav
erseper
son
2.
4TheTr
adeOf
fBet
weenRi
skAndRet
urn

39|Page
Supposeaconsumerorani
nvest
orwant
stoal
l
ocat
ehi
sincomebet
weent
wo
asset
s-oner
iskyandt
heot
herr
iskf
ree.Hemi
ghtal
l
ocat
ehi
sent
ir
eincomeonl
y
t
other
iskf
ree,
onl
ytot
her
isky
,ort
osomecombi
nat
ionsoft
het
wo.
Lett
heexpect
edr
etur
nfr
om t
her
iskyassetbe“
Rr”andt
heact
ualr
etur
nbe“
r”
r.
Letal
sot
her
iskf
reer
etur
nfr
om t
her
iskf
reeassetbe“
Rf”
.Inor
derf
ort
he
consumert
ohav
ethecombi
nat
ionoft
het
woasset
sorgoodsandt
oconst
ruct
t
he budgetl
i
ne,assume t
hat Rr >Rf . The expect
ed r
etur
n on t
he t
otal
expendi
tur
e,Rp,
isawei
ght
edav
erageoft
heexpect
edr
etur
nont
het
woasset
s.
Rp=R(
brr+(
1-b)
Rf)=E(
br)+E(
r (1-
b)Rf)
Rp=bRr+(
1-b)
Rf-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--(
1)

Thest
andar
ddev
iat
ionoft
het
otalal
l
ocat
ion,
p(
wit
honer
iskyandoner
iskf
ree
asset
),i
sthef
ract
ionoft
hef
undal
l
ocat
edt
other
iskyassett
imest
hest
andar
d
dev
iat
ionoft
heasset
.
p=br-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-(2)
Equat
ion(
1)abov
ecanber
ewr
it
tenas:
Rp=Rf+b(
Rr–Rf)-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--(
3)
Subst
it
uti
ngt
hev
alueofb(
from equat
ion2)i
ntoequat
ion3.
Rp=Rf+(
Rr–Rf)p
r
Thi
sequat
ioni
sabudgetl
i
nebecausei
tdescr
ibest
het
rade-
offbet
weenr
isk(
p)
andexpect
edr
etur
n(Rp)
.BecauseRf
,Rrandrar
econst
ant
,thi
sequat
ioni
san
equat
ionf
orast
rai
ghtl
i
ne(
thesl
ope(
Rr-
Rf)
/ri
saconst
ant
).Thi
ssl
opet
ell
sus
how much ext
rar
iskt
heconsumer(
inv
est
or)musti
ncurt
o enj
oyahi
gher
expect
edr
etur
nRp.Thusi
tist
hepr
iceofr
isk.
I
fal
lincomei
sal
l
ocat
edt
other
iskf
reeasset(
b=0)
,anexpect
edr
etur
nofRf
woul
dber
ecei
vedbutwi
thr
iskashi
ghasr
.Ahi
gherexpect
edi
ncomeanda
r
educed(
mini
mi
zed)r
iskar
eachi
evedatt
hepoi
ntoft
angencyoft
hebudgetl
i
neandt
he
i
ndi
ff
erencecur
ve.Al
essr
iskav
erse(
ri
skl
over
)per
soni
satt
heopt
imum ata

40|Page
hi
gherl
evelofr
etur
n(al
l
ocat
ingmor
eincomet
other
iskyasset
)buti
ncur
ri
ng
mor
eri
sk.

U3
E(
I) U2 UB
U1 Budgetl
i
ne

Rr Eb

R* E

Rf

O * r 
Aswehav
edi
scussedear
li
erar
iskav
erseper
sonhasani
ndi
ff
erencecur
ve
whi
chi
sst
eeperandt
hust
heequi
l
ibr
ium poi
ntf
ort
hisper
soni
satpoi
ntEwi
th
R*r
etur
nand*v
ari
abi
l
ity
.Fort
her
iskl
ovi
ngper
sont
heequi
l
ibr
ium poi
nti
sat
Ebwher
ethef
lat
teri
ndi
ff
erencecur
vei
stangentt
othebudgetl
i
ne.Att
hispoi
nt
t
heper
songet
sRrr
etur
nwi
thrv
ari
abi
l
itywhi
chgr
eat
ert
hant
hatoft
her
isk
av
erseper
son.
2.
5Reduci
ngRi
sk
I
nthef
aceofabr
oadv
ari
etyofr
iskysi
tuat
ions,
peopl
ear
egener
all
yri
skav
erse.
Consumer
sandmanager
scommonl
yreducer
iski
nvar
iousway
s.Themaj
or

41|Page
onesar
edi
ver
sif
icat
ion,
insur
anceandobt
aini
ngmor
einf
ormat
ion.
Di
ver
sif
icat
ion:-r
educi
ngr
iskbyal
l
ocat
ingr
esour
cest
oav
ari
etyofact
ivi
ti
es
whoseout comesar enotcloselyr elated–“ Don’tputal l
youreggsi nonebasket .”
Insur ance:-I ft hecostofi nsur ancei sequalt ot heexpect edl oss,ri
skav erse
peoplewi llbuyenoughi nsurancet or ecoverf ullyf r
om anyl ossest heymi ght
suffer.Forar i
skav er
seconsumer ,theguar anteeoft hesamei ncomer egardless
oftheout comegener at
esmor eut il
itythanwoul dbet hecasei fthatpersonhad
ahighi ncomewhent herewasnol ossandal owi ncomewhenal ossoccur r
ed.
The val ue ofi nformation:-peopl e often make deci si
onsbased on l i
mited
i
nfor mat i
on.I f mor ei nformat i
on wer e av ailable,one coul d make bet ter
predicti
onsandr educer i
sk.Ev ent houghf orecast ingi sinev i
tablyimperfect,it
maybewor thinv esti
nginamar ket ingstudyt hatpr ovi
desar easonableforecast
forthef uture.

Chapt
erThr
ee
TheTheor
yofPr
oduct
ion

3.
1ThePr
oduct
ionFunct
ion
I
nthe pr
oduct
ion pr
ocess/ act
ivi
ty,f
ir
ms t
urni
nput
sint
o out
put
.Thi
s
t
ransf
ormat
ionofi
nput
s(f
act
orofpr
oduct
ions)i
ntoout
putatapar
ti
cul
art
ime
per
iodandatagi
vent
echnol
ogy(
stat
eofknowl
edgeaboutt
hev
ari
ousmet
hods
t
hatmi
ghtbeusedt
otr
ansf
ormi
nput
sint
oout
put
s)i
sdescr
ibedbyapr
oduct
ion
f
unct
ion.
Thepr
oduct
ionf
unct
ioni
saf
unct
iont
hatshowst
hehi
ghestout
putt
hataf
ir
m
canpr
oducef
orev
eryspeci
fi
edcombi
nat
ionofi
nput
s.I
tisapur
elyt
echni
cal
r
elat
ionwhi
chconnect
sfact
ori
nput
stoout
put
s.Assumi
ngl
abor(
L)andcapi
tal
(
K)ast
heonl
yinput
s,t
hepr
oduct
ionf
unct
ioncanbewr
it
tenas:
Q=f
(L,
K).
Thepr
oduct
ionf
unct
ional
l
owsi
nput
stobecombi
nedi
nvar
yingpr
opor
ti
onsso
t
hatout
putcanbepr
oducedi
nmanyway
s(usi
ngei
thermor
ecapi
talorl
ess
l
abororv
isev
ersa)
.Forexampl
e,auni
tofcommodi
tyXmaybepr
oducedbyt
he
f
oll
owi
ngpr
ocesses:

Pr
ocessP1 Pr
ocessP2 Pr
ocessP3
Laboruni
ts 2 3 1
Capit
aluni
ts 3 2 4
42|Page
Act
ivi
ti
esort
hesemet
hodsofpr
oduct
ionscanbeshownbyal
i
nef
rom t
heor
igi
n
t
othepoi
ntdet
ermi
nedbyt
hel
aborandcapi
tal
input
scombi
nat
ion.
K

3 p1
2 p2

1 p3

0 2 3 4 L

Thepr
oduct
ionf
unct
ion(
apur
elyt
echni
calr
elat
ionshi
pwhi
chconnect
sfact
or
i
nput
sandout
put
s)i
ncl
udesal
lthet
echni
cal
l
yef
fi
cientmet
hodsofpr
oduct
ion.
Thet
echni
cal
l
yinef
fi
ci
entmet
hodsar
enoti
ncl
udedi
nthepr
oduct
ionf
unct
ions.
Amet
hodofpr
oduct
ionAi
stechni
cal
l
yef
fi
cientt
hananyot
hermet
hodBi
fA
usesl
essofatl
eastonei
nputandnomor
eoft
heot
herf
act
orsascompar
ed
wi
thB.Forexampl
e,commodi
tyYcanbepr
oducedbyt
womet
hods,AandBas
f
oll
ows:
A B
Labor 2 3
Capi
tal 3 3
Met
hodAi
sconsi
der
edast
echni
cal
l
yef
fi
cientmet
hodascompar
edwi
thB.The
basi
ctheor
yofpr
oduct
ionconcent
rat
esonl
yonef
fi
cientmet
hodsandt
hus
i
nef
fi
cientmet
hodswi
l
lnotbeusedbyr
ati
onal
producer
.
I
fapr
ocessA usesl
essofsomef
act
or(
s)andmor
eofsomeot
her
(s)as
compar
edwi
thB,t
henAandBcannotbedi
rect
lycompar
edont
hecr
it
eri
onof
t
echni
cal
eff
ici
ency
.Forexampl
e,t
heact
ivi
ti
es
A B
Labor 2 1
Capi
tal 3 4
ar
enotdi
rect
lycompar
ed.Bot
hpr
ocessesar
econsi
der
edast
echni
cal
l
yef
fi
cient
andar
eincl
udedi
nthepr
oduct
ionf
unct
ion.Whi
choneoft
hem wi
l
lbechosenat
anypar
ti
cul
art
imedependsont
hepr
iceoff
act
ors(
input
s).
Thechoi
ceofany

43|Page
par
ti
cul
art
echni
que among t
he setoft
echni
cal
l
yef
fi
cientpr
ocessesi
san
economi
cone,whi
chi
sbasedont
hepr
iceoff
act
orsofpr
oduct
ion.Not
ethata
t
echni
cal
l
yef
fi
ci
entmet
hodi
snotnecessar
il
yeconomi
cal
l
yef
fi
cient
.
3.
2Iso-
Quant
s
Assumi
ngthatl
aborandcapi
talar
etheonl
ytwoi
nput
susedt
opr
oduceani
tem,
t
heout
putachi
evabl
eforv
ari
ouscombi
nat
ionsofi
nput
scanbeshownbyusi
ng
i
so-
quant
s.Ani
so-
quanti
sthel
ocusofal
lthet
echni
cal
l
yef
fi
cientmet
hods(
or
al
lthecombi
nat
ionsoff
act
orsofpr
oduct
ion)f
orpr
oduci
ngagi
venl
evelof
out
put
.Iti
sacur
veshowi
ngal
lpossi
blecombi
nat
ionsofi
nput
sthaty
iel
dthe
sameout
put
.Thepr
oduct
ioni
so-
quantmayassumedi
ff
erentshapesdependi
ng
ont
hedegr
eeofsubst
it
utabi
l
ityoff
act
ors.Thesear
e:
1)Li
( neari
so-
quant
:thi
sty
peassumesper
fectsubst
it
utabi
l
ityoff
act
ors:a
gi
venout
putmaybepr
oducedbyonl
ylabor
,oronl
ycapi
tal
,orbyan
i
nfi
nit
ecombi
nat
ionsofKandL.Seef
igur
eAbel
ow.
2)I
( nput
-out
puti
soquant
:thi
s assumes st
ri
ctcompl
ement
ari
l
y(i
.e.zer
o
subst
it
utabi
l
ity
)oft
hef
act
orsofpr
oduct
ion.Ther
eisonl
yonemet
hodof
pr
oduct
ionf
oranyonecommodi
ty.Thei
soquantt
akest
heshapeofr
ight
angl
etr
iangl
e.Thi
sty
peofi
soquanti
scal
l
ed“
Liont
iefi
soquant
”af
tert
he
nameLeont
iefwhoi
nvent
edt
hei
nputout
putanal
ysi
s.Seef
igur
eBbel
ow.
3)Ki
( nkedi
soquant
:thi
sassumesl
i
mit
edsubst
it
utabi
l
ityofKandL.t
her
ear
e
onl
yfewpr
ocessesf
orpr
oduci
ngapar
ti
cul
arcommodi
ty.Subst
it
utabi
l
ity
oft
hef
act
orsi
spossi
bleonl
yatt
heki
nks.Seef
igur
eCbel
ow.
4)Smoot
( horconvexi
soquant
:thi
sfor
m assumescont
inuoussubst
it
utabi
l
ity
ofK and Lonl
yov
eracer
tai
nrange,bey
ond whi
chf
act
orscannot
subst
it
uteeachot
her
.Thei
soquanti
sasmoot
hcur
vewhi
chi
sconv
ext
o
t
heor
igi
n.Consi
derf
igur
eDbel
ow.

K K

44|Page
 X

O L O L
A.Li
neari
soquant B.I
nput
-out
puti
soquant
K K
P1
P2
X
P3

P4 X

O L O L
C.Ki
nkedi
soquant D.Conv
exi
soquant

Ev
ent
hought
heki
nkedi
soquanti
smor
ereal
i
sti
c,mostoft
het
imet
hesmoot
h
orconv
exi
so-
quanti
sused i
nthet
radi
ti
on economi
ctheor
ybecausei
tis
mat
hemat
ical
l
ysi
mpl
ert
ohandl
ebyt
hesi
mpl
erul
esofcal
cul
us.
I
soquantmap:i
sagr
aphcombi
ningsev
eralorasetofi
soquant
s.Ani
soquant
mapi
sanot
herwayofdescr
ibi
ngapr
oduct
ionf
unct
ion,j
ustasani
ndi
ff
erence
mapi
sawayofdescr
ibi
ngaut
il
it
yfunct
ion.Thel
evelofout
puti
ncr
easesaswe
mov
eupwar
dtot
her
ightwher
easi
tremai
nsconst
antal
ongani
soquant(
see
poi
ntsA,
B&Ci
nthef
igur
ebel
ow)
.
K

*A
*C

Q=100
*B
Q=50

O L
3.
3ShortRunPr
oductionFunct
ionAndStagesOfPr oduct
ion
Thepr
oducti
onfunct
ioninthet
radi
ti
onal
theoryassumesthefor
m:
X =f
(L,
K,r
,y)
Wher
eLi
slabor
,Ki
scapi
tal
,ri
sret
urnst
oscal
ewhi
chr
efer
stot
hel
ongr
un
anal
ysi
soft
hel
awsofpr
oduct
ionsi
ncei
tassumeschangei
nthepl
ant
,andyi
s

45|Page
t
heef
fi
ci
encypar
amet
err
elat
edt
otheor
gani
zat
ionalandent
repr
eneur
ialaspect
oft
hepr
oduct
ion.
Gr
aphi
cal
l
y,t
hepr
oduct
ionf
unct
ioncanbeshownasf
oll
ows:
X Panel
A X Panel
B

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

X=f
(L)
k1,
r1,
y1
X=f
(K)
L1,
r1,
y1

O L O K
I
npanelA,asl
abori
ncr
eases,cet
eri
spar
ibus,out
puti
ncr
eases:wemov
eal
ong
t
hecur
vedepi
cti
ngt
hepr
oduct
ionf
unct
ion.I
fKand/
orr
,and/
oryi
ncr
ease,t
he
pr
oduct
ionf
unct
ionshi
ft
supwar
ds.Thesamei
str
uef
orpanel
B.
Thesl
opeoft
hepr
oduct
ionf
unct
ioni
sthemar
ginalpr
oduct
soft
hef
act
orsof
pr
oduct
ion.TheMPofaf
act
ori
sdef
inedast
hechangei
nout
putr
esul
ti
ngf
rom
t
hechangei
nthef
act
or,
keepi
ngal
lot
herf
act
orsconst
ant
.Thati
s
MPL =
X/L,andMPK =
 X/
K
Graphi
call
y,t
heMPLisshownbyt heslopeoft heproducti
onfuncti
onX=f(L)and
theMPK isshownbytheslopeoftheproductionfunct
ionX=f(K)
.Theslopeofa
curveatanyonepoi
ntist
heslopeofat angentli
neatthatpoi
nt.

X MPL=
X=0 MPK=
X=0


L 
K
X=f
(L) X=f
(K)

O A’ B’ L O C’ D’ K
MPL MPK

46|Page
 St
ageI St
ageI
I St
ageI
II St
ageI St
ageI
I St
age
I
II

APL APK
O A B L O C D
MPL MPK

Fr
om t
heabov
egr
aphwecanunder
standt
hatast
hel
aboruni
tsusedi
nthe
pr
oduct
ionpr
ocessesgoesoni
ncr
easi
ng,t
heout
puti
nit
ial
l
yincr
easesatan
i
ncr
easi
ngr
ate,t
henst
art
sri
singatadecr
easi
ngr
ate,r
eachesamaxi
mum and
t
henst
art
sfal
l
ing.Asar
esul
ttheMPi
nit
ial
l
yincr
eases,
reachesamaxi
mum,
and
t
henst
art
sdecl
i
ningsi
ncei
tist
hesl
opeoft
heTP cur
ve.TheMP i
sev
en
negat
ivewhent
heTPdecl
i
nes.Ont
heot
herhand,
theAPi
sgi
venbyt
hesl
opeof
t
hel
i
nedr
awnf
rom t
heor
igi
ntot
hecor
respondi
ngpoi
ntont
heTPcur
ve.Thus,
t
heAPi
nit
ial
l
yincr
eases,
reachesamaxi
mum atA’
lev
elofi
nputandt
henst
art
s
decl
i
ning.APandMPar
eequalatt
hemaxi
mum oft
heAP.Accor
dingl
ywecan
di
vi
det
hispr
oduct
ionf
unct
ioni
ntot
hreest
agesasst
ageI(
from zer
oTP,MP,&
APupt
othemaxi
mum ofAP)
,st
ageI
I(f
rom t
hemaxi
mum ofAPt
ozer
oMP)
,
andst
ageI
II(
from zer
oMPonwar
ds)
.
Atst ,MP >AP andbot
ageI hoft
hem ar
eri
singi
nit
ial
l
yandMPf
all
slat
teron.
Si
nceeachaddi
ti
onaluni
tofl
abor(
onpanelA)i
scomi
ngupwi
thcont
ri
but
ion
l
argert
hant
heav
erage,i
tisr
ati
onalt
ohi
remor
elaborandpr
oducemor
e.Thus,
i
tisnotr
easonabl
etopr
oduceatt
hisst
age.
Att
het
hir
dst
agewher
ebot
hAPLandMPLar
edecl
i
ningandMPL <APL,
iti
snot
r
ati
onalt
opr
oduceatal
lbecauseeachaddi
ti
onaluni
tofl
aboraddedmakest
he
t
otal
productt
odecl
i
ne(
i.
e.i
tscont
ri
but
ioni
snegat
ive)
.
Thus,
iti
sint
hesecondst
aget
hatar
ati
onalf
ir
m oper
ates.Her
eeachaddi
ti
onal
l
aborcont
ri
but
esposi
ti
vel
ytot
hepr
oduct
ionbutl
esst
hant
heav
erage.Att
his
st
ageast
heuseofav
ari
abl
einput(
labor
)incr
easeswi
thot
heri
nput
s(capi
tal
)
bei
ngf
ixed,t
her
esul
ti
ngaddi
ti
onst
oout
put(
MPL)wi
l
lev
ent
ual
l
ydecr
ease.Thi
s

47|Page
pr
inci
pl sknownast
ei hel
aw ofvar
iabl
epr
opor
ti
onort
hel
aw ofdi
mini
shi
ng
mar
ginalr
etur
ns.
I
nsummar
y,t
hepr
oduct
iont
heor
iesconcent
rat
eonl
yont
heef
fi
cientpar
toft
he
pr
oduct
ionf
unct
ion,t
hati
s,ont
her
angesofout
putov
erwhi
cht
heMP’
sar
e
posi
ti
ve.Nor
ati
onalf
ir
m woul
dempl
oyl
aborbey
ondOBorcapi
talbey
ondOD
si
nceani
ncr
easei
nthef
act
orsbey
ondt
hesel
evel
swoul
dresul
tint
her
educt
ion
oft
heTPoft
hef
ir
m.Thus,t
hebasi
ctheor
yofpr
oduct
ionconcent
rat
esont
he
r
angeofout
putov
erwhi
cht
heMPsar
eal
thoughposi
ti
ve,decr
eases(
i.
e.A’
B’
andC’
D’)
.Thi
smeansov
ert
her
angewher
e
but
MPL >0, (MPL)
/L <0 and MPK >0but
(MPK)
/K <0
Thi
scondi
ti
oni
mpl
i
est
hatt
het
radi
ti
ont
heor
yofpr
oduct
ionconcent
rat
esont
he
r
angeoft
hei
so-
quant
sov
erwhi
cht
hei
rsl
opei
snegat
iveandconv
ext
othe
or
igi
n.I
nthef
igur
ebel
ow,t
hepr
oduct
ionf
unct
ioni
sdepi
ctedbyasetofi
so-
quant
s.Si
mil
art
othecaseofi
ndi
ff
erencecur
ves,t
hef
urt
herawayf
rom t
he
or
igi
nani
so-
quantl
ays,t
hehi
ghert
hel
evelofout
puti
trepr
esent
sandi
so-
quant
sdonoti
nter
sect
.
Thel
ocusofpoi
ntsofi
so-
quant
swher
ethemar
ginalpr
oduct
soft
hef
act
orsar
e
zer
ofor
mst
her
idgel
i
ne.Atpoi
ntsA,
B,&Ct
heMPKi
szer
oandhencef
ormst
he
upperr
idge l
i
ne.The l
owerr
idge l
i
ne shows t
hatt
he MPL i
s zer
o.Thus,
pr
oduct
iont
echni
quesar
eonl
yef
fi
cienti
nsi
det
her
idgel
i
nes.Out
sidet
her
idge
l
i
nes t
he mar
ginalpr
oductoft
he f
act
orsi
s negat
ive and t
he met
hods of
pr
oduct
ionsar
einef
fi
ci
ent
,si
ncet
heyr
equi
remor
equant
it
iesofbot
hfact
orsf
or
pr
oduci
ngagi
venl
evel
ofout
put
.

K
Upperr
idgel
i
ne(
MPK=0)
A B C
Lowerr
idgel
i
ne(
MPL=0)

F X3
X2
E
X1

48|Page
 D
O L
Thesl
opeoft
hei
so-
quant(
dK/
dL)def
inest
hedegr
eeofsubst
it
utabi
l
ityoft
he
f
act
orsofpr
oduct
ion.Thi
ssl
opedecr
eases(
inabsol
utet
erms)aswemov
e
downwar
dsal
ongt
hei
so-
quant
,showi
ngt
hei
ncr
easi
ngdi
ff
icul
tyi
nsubst
it
uti
ng
Lf
orK.Thesl
opeoft
hei
soquanti
scal
l
edt
her
ateoft
echni
calsubst
it
uti
on,or
t
hemar
ginal
rat
eoft
echni
cal
subst
it
uti
on(
MRTS)off
act
ors:
-∂K
MRTSL,
K = =Sl
opeofani
soquant
∂L
MRTSL,
Kisdef
inedast
heamountofKt
hatt
hef
ir
m mustsacr
if
icei
nor
dert
o
obt
ainonemor
euni
tofLsot
hati
tpr
oducest
hesamel
evelofout
put
.Iti
sthe
sl
opeofani
so-
quant
.
I
tcanbepr
ovedt
hatt
heMRTSi
sequal
tot
her
ati
ooft
hemar
ginal
product
sof
t
hef
act
ors.Thati
s,
- ∂L MPL
∂K ∂X/
MRSL,
K = = =
∂L ∂X/∂K MPK
Pr
oof
:
Thepr
oduct
ionf
unct
ioncanbewr
it
tenas X =f
(K,
L)=C.I
tisequalt
oC
becauseal
ongani
so-
quantt
heTPi
sconst
ant
.
Thesl
opeofacur
vei
sthesl
opeofat
angentl
i
neatt
hatpoi
nt.Thesl
opeofa
t
angentl
i
nei
sdef
inedbyt
het
otaldi
ff
erent
ial
.Thet
otaldi
ff
erent
ial(
dX)i
szer
o
al
ongani
soquantsi
ncet
heTPi
sconst
ant
.Thus,
X/
dX =( K) X/
dK +( L)
dL =0
(
MPK)
dK +(
MPL)
dL =0
-
(MPK)
dK =(
MPL)
dL
-
dK/
dL =MPL/
MPK
Al
ongt
heupperr
idgel
i
newehav
e
MRTSL,
K =MPL/
MPK =∞ =>MPK =0
Andal
ongt
hel
owerr
idgel
i
ne
MRTSL,
K =MPL/
MPK =0 =>MPL =0
TheMRTSasameasur
eoft
hedegr
eeofsubst
it
utabi
l
ityoff
act
orshasaser
ious
def
ectsi
ncei
tdependsont
heuni
tsofmeasur
ementoft
hef
act
ors.Abet
ter

49|Page
measur
eoff
act
orsubst
it
utabi
l
ityi
spr
ovi
dedbyt
heel
ast
ici
tyofsubst
it
uti
on.I
tis
gi
venby
:
per
cent
agechangei
nK/
L
=
Per
cent
agechangei
nMRTS
d(
K/L)
/(K/
L)
=
d(
MRTS)
/(MRTS)
Theel
ast
ici
tyofsubst
it
uti
oni
sapur
enumberi
ndependentoft
heuni
tof
measur
ementofKandLsi
ncebot
hthenumer
atorandt
hedenomi
nat
orar
e
measur
edi
nthesameuni
ts.
3.
4Fact
orI
ntensi
ty
Fact
ori
ntensi
tyr
efer
stoameasur
eoft
hei
ntensi
tyofamet
hodofpr
oduct
ioni
n
t
hesenset
hatameasur
eofwhet
heragi
venmet
hodofpr
oduct
ioni
slabor
i
ntensi
ve(
usesmor
elabort
hancapi
tal
)orcapi
tali
ntensi
ve(
usesmor
ecapi
tal
t
hanl
abor
).I
tcanbemeasur
edbyt
hesl
opeoft
hel
i
nef
rom t
heor
igi
ntoa
par
ti
cul
arpoi
nton t
he i
so-
quantr
epr
esent
ing a par
ti
cul
arpr
ocess.Fact
or
i
ntensi
tycanal
sobemeasur
edbyt
hecapi
tall
aborr
ati
o.I
nthef
igur
ebel
ow
pr
ocessP1 i
smor
ecapi
tali
ntensi
vet
hanpr
ocessP2 becauset
hesl
opeoft
he
l
i
neOP1 i
shi
ghert
hant
hesl
opeofOP2 ort
her
ati
oK1/
L1 i
sgr
eat
ert
hanK2/
L2.
Thi
simpl
i
est
hatt
heupperpar
toft
hei
so-
quanti
ncl
udesmor
ecapi
tali
ntensi
ve
t
echni
queswher
east
hel
owerpar
tincl
udesmor
elabori
ntensi
vet
echni
ques.

K1 P1

50|Page
 P2
K2 X

O L
L1 L2
Exampl
e:
Letusi
l
lust
rat
etheabov
econcept
swi
thaspeci
fi
cfor
m ofpr
oduct
ionf
unct
ion,
namel
ytheCobb-
Dougl
aspr
oduct
ionf
unct
ion.Thi
sfor
mist
hemostpopul
ari
n
appl
i
edr
esear
ch,
becausei
tiseasi
ert
ohandl
emat
hemat
ical
l
y.I
tisoft
hef
orm:
β
X =ALαK
1.Themar
ginalpr
oductoff
act
ors:
∂X β
MPL = =αALα-1K =
∂L
β
ALαK)
=α( L-1
α(
X) β
= =α(
APL),
sinceX =ALαK2andAPL =X/
L
L
β(
X)
MPK = APK)
=β(
K
2. Themar
ginalr
ateofsubst
it
uti
on:
L MPL α(
X/ X)
/L αK
MRSL,K = = = =
X/
k MPK β( /
X)K βL
3.Theel
ast
ici
tyofsubst
it
uti
on:
d(
K/L)
/(K/
L)
= =1
d(
MRS)
/(MRS)
Pr
oof
:
Subst
it
utet
heMRSi
ntot
heel
ast
ici
tyf
ormul
aandobt
ain
d(
K/L)
/(K/
L)
=
d(
α/β ×K/
L)/
(α/
β ×K/
L)
d(
K/ L) (α/
β ×K/L)
= ×
(K/L) d(α/β ×K/L)
d(
K/L)
(α/
β)
= =1
d(
K/L)
(α/
β)
4.Fact
ori
ntensi
ty:I
naCobb-
Dougl
asf
unct
ionf
act
ori
ntensi
tyi
smeasur
edby
t
her
ati
oα/
β.Thehi
ghert
her
ati
othemor
elabori
ntensi
vet
het
echni
quei
s

51|Page
 andv
isev
ersa.
5.Theef
fi
ci
encyofpr
oduct
ion:Theef
fi
ciencyi
ntheor
gani
zat
ionoff
act
orsof
pr
oduct
ioni
smeasur
edbyt
hecoef
fi
cientA.I
tiscl
eart
hati
ftwof
ir
mshav
e
t
hesameK,
L,α,andβ andst
il
lpr
oducedi
ff
erentquant
it
iesofout
put
,the
di
ff
erencecanbeduet
othesuper
ioror
gani
zat
ionandent
repr
eneur
shi
pof
onef
ir
m whi
chr
esul
tedi
npr
oduct
iondi
ff
erence.Themor
eef
fi
cientf
ir
mswi
l
l
hav
eahi
gherAt
hant
hel
essef
fi
cientone.
6.Ther
etur
nst
oscal
e:I
ntheCobb-
Dougl
aspr
oduct
ionf
unct
ion,t
her
etur
nst
o
scal
ear
emeasur
edbyt
hesum oft
hecoef
fi
cient
s(α +β)
.Itwi
l
lbedi
scussed
l
att
eron.
3.
5 LawsOfPr
oduct
ion
Thel
awsofpr
oduct
iondescr
ibet
het
echni
cal
l
ypossi
bleway
sofi
ncr
easi
ngt
he
l
evelofpr
oduct
ion.Thi
scanbei
nvar
iousway
s.Out
putcanbei
ncr
easedby
changi
ngal
lfact
orsofpr
oduct
ionwhi
chi
spossi
blei
nthel
ongr
un.Thi
siscal
l
ed
t
hel
aw ofr
etur
nst
oscal
e.Ont
heot
herhandout
putcanbei
ncr
easedby
changi
ngonl
ythev
ari
abl
einputwhi
l
ekeepi
ngt
hef
ixedi
nput
sconst
ant
,whi
chi
s
possi
blei
ntheshor
trun.TheMPoft
hev
ari
abl
efact
orwi
l
ldecl
i
neev
ent
ual
l
yas
mor
eandmor
equant
it
iesoft
hisf
act
orar
ecombi
nedwi
tht
heot
herconst
ant
f
act
ors.Thi
sisknownast
hel
aw ofv
ari
abl
epr
opor
ti
on.Letusseet
hesel
aws
onebyone.
3.
5.1 TheLawOfVar
iabl
ePr
opor
ti
on
Thi
sisal
awf
ort
hecaseofshor
trunwher
ether
eisatl
eastonef
ixedi
nput
s.I
n
ourear
li
erdi
scussi
on oft
he shor
trun pr
oduct
ion f
unct
ion and st
ages of
pr
oduct
ion,wehav
eassumedl
aborasav
ari
abl
einputandcapi
talasaf
ixed
i
nput
.Fr
om t
hatgr
aph,whatwecanunder
standi
sthatast
heuseofav
ari
abl
e
i
nput(
labor
)incr
easeswi
thot
heri
nput
s(capi
tal
)fi
xed,t
her
esul
ti
ngaddi
ti
ont
o
out
putwi
l
lev
ent
ual
l
ydecr
eases.Thi
sisshownbyadownwar
dsl
opi
ngMPL
cur
veaf
teri
tsmaxi
mum poi
nt.Thi
spr
inci
pl sknownast
ei hel
aw ofvar
iabl
e
pr
opor
ti
onort
hel
awofDi
mini
shi
ngr
etur
ns.
3.
5.2 LawsOfRet
urnsToScal
e

52|Page
Thel
aw ofr
etur
nst
oscal
eref
erst
othel
ongr
unanal
ysi
sofpr
oduct
ion.I
nthe
l
ongr
un,wher
eal
linput
sar
evar
iabl
eout
putcanbei
ncr
easedbychangi
ngal
l
f
act
orsbyt
hesamepr
opor
ti
on.Ther
ateatwhi
chout
puti
ncr
easesasi
nput
sar
e
i
ncr
easedbyt
hesamepr
opor
ti
oni
scal
l
edr
etur
nst
oscal
e.Wehav
ethr
eecases
ofr
etur
nst
oscal
e:i
ncr
easi
ng,
const
antanddecr
easi
ngr
etur
nst
oscal
e.
a.I
ncr
easer
etur
nst
oscal
e:t
hisi
sthecasewher
eincr
easi
ngal
lfact
orsby
t
hesamepr
opor
ti
on,m,l
eadst
oani
ncr
easei
nout
putbymor
ethanm
scal
e.
b.Const
antr
etur
nst
oscal
e:i
fwei
ncr
easei
nputbysomef
act
or,m and
out
puti
sincr
easedbyt
hesamepr
opor
ti
onasi
nput
s,m,andt
heni
tis
cal
l
ed const
antr
etur
ns t
o scal
e.I
nthi
s case t
he si
ze oft
he f
ir
m’s
oper
ati
ondoesn’
taf
fectt
hepr
oduct
ivi
tyofi
tsf
act
ors.
c.Decr
easi
ngr
etur
nst
oscal
e:i
fscal
i
ngupal
linput
sbym scal
esout
putup
byl
esst
hanm,i
tiscal
l
eddecr
easi
ngr
etur
nst
oscal
e.Thi
sisbecause,
maybedi
ff
icul
ti
esi
nor
gani
zi
ngandr
unni
ngal
argescal
eoper
ati
onmay
l
eadt
odecr
easedpr
oduct
ionofbot
hlaborandcapi
tal
.

Exampl
es

1.I
fQ =2K +3L,wewi
l
lincr hK andLbym andcr
easebot eat
eanew
pr
oduct
ionf
unct
ionQ *Thenwewi
l
lcompar
eQ*t
oQ.

Q * =2(
Km) +3(
Lm) =2Km +3Lm =m(
2K +3L) =mQ

Af
terf
act
ori
ng,
wecanr
epl
ace(
2K +3L)wi
thQ,
aswewer
egi
vent
hatf
rom t
he
st
art
.Si
nce Q * =mQ,wenot
ethatbyi
ncr
easi
ngal
lofouri
nput
sbyt
he
mul
ti
plerm wehav
i eincr
easedpr
oduct
ionbyexact
lym.Sowehav
econst
ant
r
etur
nst
oscal
e.

2.Q =0.
5KL Agai
nweputi
nourmul
ti
pli
ersandcr
eat
eournew pr
oduct
ion
f
unct
ion.

53|Page
 Q * =0.
5(Km)
( 5KLm2 =Qm2.Si
Lm) =. ncem >1,
thenm2>m.t
hisi
mpl
i
es
ournew pr
oduct
ionhasi
ncr
easedbymor
ethanm.
..sowehav
eincr
easi
ng
r
etur
nst
oscal
e.

3.Q =K0.3L0.2 Agai

nweputi
nourmul
ti
pli
ersandcr
eat
eournew pr
oduct
ion
f
unct
ion.Q * =( 0.
Km)3
( 0.
Lm)2
=K0.3L0.2m0.5 =Qm0.5 ,Si
ncem >1,t
hen
m0.5 <m .Ournew pr
oduct
ionhasi
ncr
easedbyl hanm.sowehav
esst e
decr
easi
ngr
etur
nst
oscal
e.
3.
5.3 Ret
urnst
oScal
eandHomogenei
tyoft
hePr
oduct
ionFunct
ion

Supposewei
ncr
easebot
hfact
orsofpr
oduct
ionf
unct
ionX =f
(L,
K)byt
hesame
pr
opor
ti
on m,and we obser
vet
he r
esul
ti
ng new l
evelofout
putX* as
X* =f
(mK,
mL).I
fm canbef
act
oredout(
thati
s,canbet
akenoutoft
he
br
acketasacommonf
act
or)
,thent
henewl
evelofout
putcanbeexpr
essedasa
f
unct
ion ofm (
tot
he powern)and t
he i
nit
iall
evelofout
putas f
oll
ows:
X* =mnf
( K)orX* =mnX.I
L, fso,t
hef
unct
ioni
scal
l fm
edhomogeneous.I
cannotbef
act
oredout
,thepr
oduct
ionf
unct
ioni
scal
l
ednon-homogeneous.The
abov
ethr
eeexampl
esar
eahomogeneousf
unct
ionssi
ncem canbef
act
oredout
.
Thus,ahomogeneousf
unct
ionaf
unct
ionsucht
hati
feachoft
hei
nput
sis
mul
ti
pli
edbym,
them canbecompl
etel
yfact
oredoutoft
hef
unct
ion.Thepower
nofm i
scal
l
edt
hedegr
eeofhomogenei
tyandi
sameasur
eoft
her
etur
nst
o
scal
e.
- I
fn=1,
wehav
eaConst
antr
etur
ntoscal
e.
- I
fn <1, “ Decr
easi
ngr
etur
ntoscal
e.
- I
fn >1, “ I
ncr
easi
ngr
etur
ntoscal
e.
β
Forexampl
e:Gi
venaCobb-
Dougl
aspr
oduct
ionf
unct
ionQ =ALαK ,r
etur
nst
o
scal
eismeasur
edbyt
hesum oft
hepower
soft
hef
act
ors.Thati
s,
- I
fα +β =1,
thent
her
eisaConst
antr
etur
ntoscal
e.
fα +β >1, “ “
- I I
ncr
easi
ngr
etur
ntoscal
e
fα +β<1, “ “
- I Decr
easi
ngr
etur
ntoscal
e
Pr
oof:

54|Page
LetLandKi
ncr
easesbym.Thenewl
evel
ofout
puti
s
β α
Q * =A(
Lm)(
Km),
β β
=ALαmαKm
β
=mα +βALαK
Q * =mα +βQ
Thi
simpl
i
est
hef
unct
ioni eeα +β andt
shomogeneousofdegr her
etur
nst
o
scal
edependont
hesum.

Pr
oductLi
ne:I
tshowsaphy
sical
mov
ementf
rom onei
so-
quantt
oanot
heraswe
changeei
therbot
hfact
orsand a si
ngl
efact
or.I
tdescr
ibest
het
echni
cal
l
y
possi
bleal
ter
nat
ivepat
hsofexpandi
ngout
put
.Whatpat
hwi
l
lact
ual
l
ychosenby
t
hef
ir
m wi
l
ldependont
hepr
icesoff
act
ors.Thepr
oductcur
vepassest
hrough
t
heor
igi
nifbot
hfact
orsar
evar
iabl
e.Buti
fonl
yonef
act
orv
ari
abl
e(t
heot
her
bei
ngkeptconst
ant
),t
hepr
oductl
i
nei
sast
rai
ghtl
i
nepar
all
elt
otheaxi
soft
he
v
ari
abl
efact
or.
K K K

PL(I
socl i
nes) PL
(
Point
swi thconst
ant PL
MRTSL,Kar
ejoi
ned)
PL
K PL

O L O L O L
Pr
oductli
neforhomogenousProductl
i
neforNon- Productl
inewher
eKisfixed
pr
oduct
ionfunct
ion homogeneousfunct
ion (Here,
theK/Lrat
iodi
minishes)

Aspeci
alt
ypeofpr
oductl
i
newhi
chi
sthel
ocusofpoi
ntsofdi
ff
erenti
soquant
s
atwhi
cht
heMRSoff
act
orsi
sconst
anti
scal
l
edani
socl
ine.Forhomogeneous
pr
oduct
ionf
unct
ionst
hei
socl
i
nesar
est
rai
ghtl
i
nest
hrought
heor
igi
n.I
nsuch
case,
theK/
Lrat
ioi
sconst
antal
onganyi
socl
i
ne(
ref
ert
othef
ir
stgr
aph)
.
3.
5.4 Gr
aphical Present
ati
on Of Ret
urns To Scale For Homogeneous
Pr
oductionFuncti
on
Const
antret
urnstoscale:Al
onganyi
socl
ine,t
hedi
stancebet
weensuccessi
ve

55|Page
i
soquant
sisconst
ant
.Doubl
i
ngt
hef
act
ori
nput
sdoubl
est
hel
evelofout
put
,
t
ri
pli
ngi
nput
sresul
tsi
ntr
ipl
eout
put
,andsoon.
K
PL Inthi
scase,t
her
eisaconst
ant
3K C r
etur
nstoscal
ebecause
OA=AB=BC.

2K B 3Q1

K A 2Q1

Q1
O L
L 2L 3L
Decr
easi
ng r
etur
ns t
o scal
e:t
he di
stance bet
ween consecut
ivei
so-
quant
i
ncreases.Bydoubl
i
ngi
nput
s,outputi
ncr
easesbyl essthant wi
ceitsori
gi nal
l
evel.
K
Inthiscase,ther
eisadecreasing
PL returnstoscalebecausedoubling
Inputswi l
lbr
inganoutputwhich
i
sl
3K C 3Q1 l essthandouble

2K B <3Q1
2Q1
K A
Q1 <2Q1
O L
L 2L 3L
I
ncr
easi
ng r
etur
ns t
o scal
e:t
he di
stance bet
ween consecut
ivei
soquant
decreases.Bydoubl
i
ngi
nput
s,out
puti
smor
ethandoubled.
K
PL I
nthiscasethereisani
ncreasi
ng
retur
n
Toscalebecausedoubl
inginput
s
resul
ts
3K i
nanout putwhichismorethan
double

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

56|Page
 Q1
O L 2L 3L L

3.
6Techni
calPr
ogr
essAndThePr
oduct
ionFunct
ion

As knowl
edge ofnew and mor
e ef
fi
cientmet
hods ofpr
oduct
ion become
av
ail
abl
e,t
echnol
ogy changes.Fur
ther
mor
e new i
nvent
ions may r
esul
tin
i
ncr
ease oft
he ef
fi
ci
encyofal
lmet
hods ofpr
oduct
ion.These changes i
n
t
echnol
ogyconst
it
utet
echni
cal
progr
ess.
Gr
aphi
cal
l
y,t
heef
fectoft
echni
calpr
ogr
essi
sshownwi
thanupwar
dshi
ftoft
he
pr
oduct
ionf
unct
ionoradownwar
dmov
ementoft
hei
so-
quant
.Thi
sshi
ftshows
t
hatt
hesameout
putmaybepr
oducedbyl
essf
act
ori
nput
s,ormor
eout
putmay
bepr
oducedwi
tht
hesamei
nput
s.

X K

X’ X’
=f(
L)
X=f
(L)
X

Xo

Xo
O L O L
L*

Techni
cal
progr
essmayal
sochanget
heshape(
aswel
laspr
oduceashi
ft
)oft
he
i
squant
.Hi
ckshasdi
sti
ngui
shedt
hreet
ypesoft
echni
calpr
ogr
ess,
dependi
ngon
i
tsef
fectont
her
ateofsubst
it
uti
onoft
hef
act
orsofpr
oduct
ion.
A.Capi
taldeepeni
ngt
echni
calpr
ogr
ess:at
echni
cal
progr
esswhi
chi
ncr
eases
t
heMPKbymor
ethant
heMPL.Fort
hiski
ndoft
echni
cal
progr
ess,
alongal
i
ne
onwhi
cht
heK/
Lrat
ioi
sconst
ant
,theMRTSL,Kdecr
easesi
nabsol
utet
erms
(
thesl
opeofani
soquantdecl
i
nes)
.Thesl
opeoft
heshi
ft
ingi
soquant
s

57|Page
 becomesl
essst
eepal
onganygi
venr
adi
us.Thi
sty
peoft
echni
cal
progr
essi
s
al
socal
l
edcapi
tal
sav
ingorl
aborusi
ngt
echni
cal
progr
ess.
K

I
socl
i
ne

A’
A’
’
O L
B.Labordeepeni
ngt
echni
calpr
ogr
ess:at
echni
calpr
ogr
esswhi
chi
ncr
easest
he
MPLbymor
ethant
heMPK.Al
ongal
i
neonwhi
cht
heK/
Lrat
ioi
sconst
ant
,
t
heMRTSL,
Kincr
eases(
thesl
opeofani
soquanti
ncr
easesi
nabsol
utev
alue)
.
I
tisal
socal
l
edl
aborsav
ingorcapi
tal
usi
ngt
echni
cal
progr
ess.

K
I
socl
i
ne

A’
A’
’

C.Neut
ralt
echni
calpr
ogr
ess:at
echni
calpr
ogr
esst
hati
ncr
easest
heMPLand
MPK byt
hesameper
cent
age,so t
hatt
heMRTSL,K (
along anyr
adi
us)
r
emai
nsconst
ant
.Thei
soquantshi
ft
sdownwar
dspar
all
elt
oeachot
her
.
K
I
sol
i
ne

A
A’

A’
’
58|Page
 O L
3.
7Equil
ibr
ium OfTheFirm:ChoiceOfOpti
malCombinat
ionOfFact
orsOf
Producti
on
Afi
rmissaidtobeinequi
l
ibr
ium wheni
templ
oyst
hosel
evel
sofi
nput
sthatwi
l
l
maxi
mizei
tspr
ofi
t.Thi
smeanst
hegoaloft
hef
ir
m i
spr
ofi
tmaxi
mizat
ion
(
maxi
mizi
ngt
hedi
ff
erencebet
weenr
evenueandcost
).Thust
hepr
obl
em f
aci
ng
t
hef
ir
mist
hatofconst
rai
nedpr
ofi
tmaxi
mizat
ion,whi
chmayt
akeoneoft
he
f
oll
owi
ngf
orms:
a)Maxi
mizi
ngpr
ofi
tsubj
ectt
oacostconst
rai
nt:I
nthi
scaset
otalcostand
pr
icesar
egi
venandt
hepr
obl
em maybest
atedasf
oll
ows
MaxП =R–C
П =P ×X–C
Cl
ear
lymaxi
mizat
ionofПi
sachi
evedi
nthi
scasei
fXi
smaxi
mized,
sinceCand
Par
econst
ant
s.
b)Maxi
mizepr
ofi
tforagi
venl
evelofout
put
:
MaxП =R-C
П =P ×X–C
Cl
ear
lyi
nthi
scasemaxi
mizat
ionofpr
ofi
tisachi
evedbymi
nimi
zi
ngcost
,si
nceX
andPar
egi
ven.
Toder
ivegr
aphi
cal
l
ytheequi
l
ibr
ium poi
ntoft
hef
ir
m,wewi
l
luset
hei
soquant
map and t
he i
socostl
i
ne.An i
soquanti
s a cur
vet
hatshows t
he v
ari
ous
combi
nat
ionsofKandLt
hatwi
l
lgi
vet
hesamel
evel
ofout
put
.Iti
sconv
ext
othe
or
igi
nwhosesl
opei
sdef
inedas:
∂K MPL ∂X/
∂L
- =MRSL,K = =
∂L MPK ∂X/
∂K
Thei
socostl
i
nei
sdef
inedbyt
hecostequat
ion
C =r
K +wL
Wher
ew=wager
ate,
andr
=pr
iceofcapi
tal
ser
vices.
Thei
socostl
i
nei
sthel
ocusofal
lcombi
nat
ionsoff
act
orst
hatt
hef
ir
m can
pur
chasewi
thagi
venmonet
arycostout
lay
.Thesl
opeoft
hei
socostl
i
nei
sequal
t
other
ati
ooft
hepr
icesoft
hef
act
orsofpr
oduct
ion,
w/r
.

59|Page
 K Thei
socostequati
oni sgivenby
C =wL +rK
C/
r =>rK =C -wL
=>K =C/ r–w/ rL
From thi
stheslopeis–w/ roriti
sthe
vert
icalchangeov erthehor
izont
al
change.
C/r
=>Slope =
C/w
=>Slope =C/ r×w/ C
=>Slope =w/ r
.
O C/
w L

Case1:Maxi
mizat
ionofout
putsubj
ectt
oacostconst
rai
nt:
Gi
vent
hel
evelofcostandt
hepr
iceoft
hef
act
orsandout
put
,thef
ir
m wi
l
lbei
n
equi
l
ibr
ium wheni
tmaxi
mizesi
tsout
put
.Thi
sisatt
hepoi
ntoft
angencyoft
he
i
socostl
i
net
othehi
ghestpossi
blei
soquantcur
ve.I
nthef
oll
owi
nggr
aph,
iti
sat
poi
ntewher
ethef
ir
m pr
oducesX2 wi
thK1 andL1 uni
tsoft
het
woi
nput
s.Hi
gher
l
evel
sofout
putt
other
ightofear
edesi
rabl
ebutnotat
tai
nabl
eduet
othecost
const
rai
nt.Ot
herpoi
ntsbel
ow t
hei
socostl
i
nel
i
eonal
oweri
soquantt
hanX2.
Hence X2 i
sthe maxi
mum out
putt
hatcan be achi
eved gi
ven t
he abov
e
assumpt
ions(
C,w,
r,&Pxbei
ngconst
ant
).

K
A

K1 e X3

X2
X1

O B L
L1
Att
hepoi
ntoft
angency:
a.sl
opeofi
soquant =sl
opeofi
socost
w/ MPK =MRSL,K.Thi
r =MPL/ sisanecessar
ycondi
ti
on.
b. Thei
so-
quanti
sconv
ext
otheor
igi
n.Thi
sist
hesuf
fi
cientcondi
ti
on.

60|Page
Not
e:I
fthei
so-
quanti
sconcav
etot
heor
igi
n,t
hepoi
ntoft
angencydoesnot
def
inet
heequi
l
ibr
ium posi
ti
on.
K

e1
e

X2

O e2 L

Out
putX2depi
ctedbyt
heconcav
eisoquantcanbepr
oducedwi
thl
owercostat
e2whi
chl
i
esonal
oweri
socostcur
vet
hane(
cor
nersol
uti
on)
.
Mat
hemat
icalder
ivat
ionoft
heequi
li
bri
um oft
hef
ir
m:
Ar
ati
onalpr
oducerseekst
hemaxi
mizat
ionofi
tsout
put
,gi
vent
otalcostout
lay
andt
hepr
icesoff
act
ors.Thatmeans:
Maxi
mizeX =f(K,
L)
Subj
ectt
oC =wL +rK
Thi
sisaconst
rai
nedopt
imi
zat
ionwhi
chcanbesol
vedbyusi
ngt
hel
agr
angi
an
met
hod.Thest
epsar
e:
a.Rewr
it
etheconst
rai
nti
nthef
orm
wL +r K–C =0
b.Mul t
ipl yt
heconst raintbyaconst antwhichisthelagrangi
anmul
ti
pli
er
(wL +r K–C) =0
c.Formt hecomposi tef unct i
on
Z =X -( wL +rK–C)
d.Par t
iallyder
ivatet hef unct i
onandt henequatet
ozer o
 ∂Z/ ∂L =∂X/∂L-w =0
MPL =w
MPL
 =w …………………………………………………………………… (1)
 ∂Z/ ∂K =∂X/ ∂K-r =0
MPK =r
MPK
=r ……………………………………… (
2)
 ∂Z/ ∂ =r L +r K–C =0 …………………… (3)
Fr
om equation(1)and( 2)weunder st andt hat

61|Page
 MPL MPK
=
w r
MPL w
 =
MPK r
Thi
sshowst
hatt
hef
ir
m i
sinequi
l
ibr
ium wheni
tequat
est
her
ati
o oft
he
mar
ginalpr
oduct
ivi
ti
esoff
act
orst
other
ati
ooft
hei
rpr
ices.I
tcanbeshownt
hat
t
hesecondor
dercondi
ti
onsf
ort
heequi
l
ibr
ium oft
hef
ir
m r
equi
ret
hatt
he
mar
ginal
productcur
vesoft
het
wof
act
orshav
eanegat
ivesl
ope.
opeofMPL =∂2X/
Sl ∂L2
∂k2
opeofMPK =∂2X/
Sl
∂2X ∂2X
=> <0,and <0
∂L2 ∂K2
∂2X ∂2X ∂2X
And × >
∂L2 ∂K2 ∂K∂L
Case2:mi
nimi
zat
ionofcostf
oragi
venl
evelofout
put
Thecondi
ti
onf
ort
heequi
l
ibr
ium oft
hef
ir
misf
ormal
l
ythesameasi
ncase1.
Thati
s,t
her
emustbet
angencyoft
hegi
veni
soquantandt
hel
owestpossi
blei
so
-
costl
i
ne,andt
hei
soquantmustbeconv
ex.Howev
er,i
nthi
scasewehav
ea
si
ngl
eisoquantwhi
chdenot
est
hedesi
redl
evelofout
put
,butwehav
easetof
i
socostl
i
nes.Cur
vescl
osert
otheor
igi
nshow al
owert
otalcostout
lay
.Si
nce
i
socost
sar
edr
awnont
heassumpt
ionofconst
antpr
icesoff
act
ors,t
heyar
e
par
all
elt
oeachot
herandt
hei
rsl
opes(
w/r
)ar
eequal
.Thust
hef
ir
m mi
nimi
zes
i
tscostbyempl
oyi
ngt
hecombi
nat
ionofKandLdet
ermi
nedbyt
hepoi
ntof
t
angencyofXi
soquantwi
tht
hel
owestpossi
blei
socostl
i
ne.Poi
ntsbel
owear
e
desi
rabl
ebecauset
heyshowl
owercostbutar
eunat
tai
nabl
eforout
putX.poi
nts
abov
eeshowhi
ghercost
s.Hencepoi
ntei
sthel
eastcostpoi
nt.
K
C/r

e X
K1

O L1 C/
w L

62|Page
I
nthi
scaseal
sot
hel
agr
angi
anmet
hodcanbef
oll
owedt
oder
ivet
heequi
l
ibr
ium
poi
ntmat
hemat
ical
l
y.Butt
hepr
obl
em i
sdi
ff
erent
.Thati
s,
Mi
nimi
zeC =wL +r
K
Subj
ectt
oX =f
(K,
L)
Thelagrangianfunctionwi l
lbe:
Z =( wL +r K) +[ X- f(K,L)]
Part
iall
yderivateZw. r.tL,K, &andequat et ozer o.
Z/ ∂L =w -∂f (K,L)/∂L =0
=>w -∂X/ ∂L =0
=>w =MPL
MPL
 =w …………………………………………………………………… (1)
Z/∂K = =w -∂f (K,L) /∂K =0
=>r-∂X/ ∂K =0
=>r =MPK
MPK
=r …………………………………………… (2)
∂Z
 =X–f (K,L) =0 …………………………………… (3)
∂
From equati
on( 1)and( 2):
MPL MPK
=
w r
MPL w MPL
= = =MRSL,K
MPK r MPK
Thisist hesameast hecondi ti
oni ncaseone.I nasi milarway
,thesecond
condi
ti
onwi
l
lbe:
∂2X ∂2X
=> <0,
and <0
∂L2 ∂K2
∂2X ∂2X ∂2X
And × >
∂L2 ∂K2 ∂K∂L

Chapter
-Four
TheoryofCost

Cost f
unct
ions ar
e der
ived f
unct
ions (
der
ived f
rom pr
oduct
ion
f
unct
ion)
.Economi
ctheor
ydi
sti
ngui
shesbet
weenshor
t-
runandl
ong-
runcost
s.
Bot
hint
heshor
t-
runandi
nthel
ong-
run,
tot
alcosti
samul
tiv
ari
abl
efunct
ion,
i.
e.
t
otalcosti
sdet
ermi
nedbymanyf
act
orssuchasout
put
,technol
ogy
,pr
icesof

63|Page
f
act
orsandf
ixedf
act
ors.Tosi
mpl
i
fyt
heanal
ysi
sweconsi
dercostasaf
unct
ion
ofout
put[
c=f
(x)
]onacet
eri
spar
ibusassumpt
ion.Thus,det
ermi
nant
sofcost
s,
ot
hert
hanout
put
,ar
ecal
l
edshi
ftf
act
ors.
4.
1Shor
t-
RunCost
s
Shor
t-
runcost
sar
ecost
sov
eraper
ioddur
ingwhi
chsomef
act
orsofpr
oduct
ion
9usual
l
ycapi
talequi
pmentandmanagement
)ar
efi
xed.Shor
t-
runt
otalcost
sar
e
spl
i
t i
nto t
wo gr
oups: t
otal f
ixed cost
s and t
otal v
ari
abl
e cost
s:
TC =TFC +TVC.
Tot
alv
ari
abl
ecosti
sacostt
hatv
ari
esasout
putv
ari
es
wher
east
otalf
ixedcosti
sacostt
hatdoesnotv
arywi
tht
hel
evelofout
put
.The
f
ixedcost
sincl
ude:
 Sal
ari
esofadmi
nist
rat
ivest
aff
 Expensesf
orbui
l
dingdepr
eci
ati
onandr
epai
rs
 Expensesf
orl
andmai
ntenances
 Depr
eci
ati
onofmachi
ner
y.
Thev
ari
abl
ecost
sincl
ude:
-
 Ther
awmat
eri
alscost
 Thecostofdi
rectl
abor
 Ther
unni
ngexpensesoff
ixedcapi
tal
,suchasf
uel
,or
dinar
yrepai
rs
andr
out
inemai
ntenance.
Ast
het
otalf
ixedcost(
TFC)doesnotdependont
hel
evelofout
put
,iti
s
r
epr
esent
edbyahor
izont
all
i
ne.
TC TC
Cost TVC

TVC

TFC

O Out
puts(
X)
Thet
otalv
ari
abl
ecosthasusual
l
yani
nver
se-
Sshapewhichr
efl
ect
sthel
awof
v
ari
abl
epr
opor
ti
ons.Accor
dingt
othi
slaw,att
hei
nit
ialst
ageofpr
oduct
ionwi
th
a gi
ven pl
ant
,asmor
eoft
hev
ari
abl
efact
orsi
sempl
oyed,i
tspr
oduct
ivi
ty
i
ncr
easesandt
hust
otalv
ari
abl
ecost
(TVC)i
ncr
easesatadecr
easi
ngr
ate(
AVC
64|Page
decl
i
nes)
.Whent
hepr
oduct
ivi
tyoft
hev
ari
abl
einputf
all
s,l
argerandl
argeruni
ts
oft
hev
ari
abl
einputwi
l
lbeneededt
oincr
easeout
putbyt
hesameuni
tandt
hus
TVCandTCi
ncr
easeati
ncr
easi
ngr
ates.Byaddi
ngt
heTFCandTVCweobt
ain
t
heTCoft
hef
ir
m.
Fr
om t
het
otal
-costcur
vesweobt
ainav
eragecostcur
ves.
 AFC i
st he tot
alf
ixed costdi
vi
ded by t
he amountofout
put
,i.
e.,
AFC =TFC/X.

SinceTFC i sconst
ant,i
ncr
easeinX reducestherati
oandthustheAFC
appr oachest
hequanti
ty(
out
put)axi
sasoutputri
ses.
 AVC =TVC/X
Gr
aphi call
ytheAVCateachl ev
elofoutputisderi
vedfrom t
hesl
opeofali
ne
dr
awnf
rom t
heor
igi
ntot
hepoi
ntont
heTVC cur
vecor
respondi
ng t
othe
par
ti
cul
arl
evelofout
put
.Forexampl
eint
hef
igur
ebel
ow,t
heAVCatX1i
sthe
sl
opeoft
her
ay“
oa”
,theAVCatX2i
sthesl
opeofar
ayob,
andsoon.I
tiscl
ear
f
rom t
hef
igur
ethatt
hesl
opeofar
ayt
hrought
heor
igi
ndecl
i
nescont
inuousl
y
unt
ilt
her
aybecomest
angentt
otheTVCcur
veatc.t
other
ightoft
hispoi
ntt
he
sl
opeofr
ayst
hrought
heor
igi
nst
art
sincr
easi
ng.Thust
heAVC cur
vef
all
s
i
nit
ial
l
yast
hepr
oduct
ivi
tyoft
hev
ari
abl
efact
ori
ncr
eases,r
eachesamaxi
mum
whent
hepl
anti
soper
atedopt
imal
l
yandr
isesbey
ondt
hatpoi
nt.
C C AVC

TVC

d a

c b d
B
a c

o x1 x2 x3 x4 X o x1 x2 x3 x4 X

TC TFC +TVC
 ATC,orAC = = =AFC +AVC.
X X
Gr
aphi
call
ytheATCcurvei
sder
ivedi
nthesamewayast
heAVC.TheATCatany
onepoi
nti
sthesl
opeofal
i
nef
rom t
heor
igi
ntot
hepoi
ntont
heTCcur
ve.
C C ATC

65|Page
 TC

d a

c b d
b
a c

o x1 x2 x3 x4 X o x1 x2 x3 x4 X

∆TC ∆(TFC +TVC) ∆TVC

 MC = = =
∆X ∆X ∆X

Gr
aphi
cal
l
ythemar
ginalcosti
sthesl
opeoft
heTCcur
ve(
whi
chofcour
sei
sthe
sameatanypoi
ntast
hesl
opeoft
heTVC)
.Thesl
opeoft
heTCcur
veatanyone
poi
nti
sthesl
opeofat
angentl
i
neatt
hatpoi
nt.Aswecanseef
rom t
hef
oll
owi
ng
gr
aph,t
het
angentl
i
nei
sini
ti
all
ybecomi
ngf
lat
terupt
oX4l
evelofout
putand
t
henbecomest
eeperast
heout
putgoesoni
ncr
easi
ng.Thi
simpl
i
est
hesl
opeof
t
heTCcur
ve(
MC)i
sini
ti
all
ydecr
easi
ng,r
eachesami
nimum andt
henst
art
s
i
ncr
easi
ng.

C C
TC

MC

O X4 O X4 X
I
nsummar
ythet
radi
ti
onalt
heor
yofcostpost
ulat
esthati
ntheshor
trunt
he
costcur
ves(
AVC,ATCandMC)ar
eU-
shaped,r
efl
ect
ingt
hel
awofv
ari
abl
e
pr
opor
ti
ons.I
ntheshor
trunwi
thaf
ixedpl
antt
her
eisaphaseofi
ncr
easi
ng

66|Page
 pr
oduct
ivi
ty(
fal
l
ing uni
tcost
s)and a phase ofdecr
easi
ng pr
oduct
ivi
ty
(
incr
easi
nguni
tcost
s)ofv
ari
abl
efact
or.Bet
weent
heset
wophasesofpl
ant
oper
ati
ont
her
eisasi
ngl
epoi
ntatwhi
chuni
tcost
sar
eatami
nimum.I
n
gener
al,
theshor
truncostcur
vescanbeshownasf
oll
ows.

Cost
s MC
ATC

AVC

AFC
O out
put(
X)

a.Ther
elat
ionshi
pbet
weenATCandAVC
TheAVCi
sapar
toft
heATC,
giv
enATC =AFC +AVC.Bot
hAVCandATCar
eU
-
shaped,r
efl
ect
ingt
hel
awofv
ari
abl
epr
opor
ti
ons.Howev
er,t
hemi
nimum poi
nt
oft
heATCoccur
stot
her
ightoft
hemi
nimum poi
ntoft
heAVC.Thi
sisduet
o
t
hef
actt
hatATCi
ncl
udesAFCwhi
chf
all
scont
inuousl
ywi
thi
ncr
easei
nout
put
.
I
nit
ial
l
ythef
alli
ntheAFCof
fset
sther
isei
ntheAVCandt
hust
heATCdecl
i
nes.
Butl
ateront
her
isei
ntheAVCmor
ethanof
fset
sthef
alli
ntheAFCandt
hust
he
ATCwi
l
lst
artr
isi
ngcont
inuousl
y.TheAVCappr
oachest
heATCasy
mpt
oti
cal
l
y
asXi
ncr
easessi
ncet
heAFCdecl
i
nescont
inuousl
y.
b.TheRel
ati
onshi
pbet
weenMCandATC
TheMCcut
stheATCandt
heAVCatt
hei
rmi
nimum poi
nts.Wesai
dthatMCi
s
t
hechangei
ntheTCf
orpr
oduci
nganext
rauni
tofout
put
.Assumet
hatwest
art
f
rom al
evelofnuni
tsofout
put
.Ifwei
ncr
easet
heout
putbyoneuni
ttheMCi
s
th
t
hechangei
nTCr
esul
ti
ngf
rom t
hepr
oduct
ionoft
he(
n +1) uni
t.
TheACateachl
evelofout
puti
sfoundbydi
vi
dingTCbyX.Thust
heATCatt
he
l
evel
ofXni
s
ATCn =TCn/Xn

67|Page
Andatt
hel
evel
ofn +1
ATCn +1 =TCn +1/Xn +1
Cl
ear
lyTCn +1 =TCn +MC
Thus,
th
a)I
ftheMCoft
he(
n +1) uni
tisl hanATCn (
esst theATCoft
hepr
evi
ousn
uni
ts)
,theATCn +1wi
l
lbesmal
l
ert heATCn.
hant
th
b)I
ftheMCoft
he(
n +1) uni
tishi hanATCn(
ghert ATCoft
hepr
evi
ousuni
ts)
heATCn +1wi
t l
lbehi
ghert
hant
heATCn.
Asf
arast
heMCi
sbel
owt
heATC,i
tpul
l
stheATCdownwar
dsandi
ftheMCi
s
abov
etheATC,
itpul
l
sthel
att
erupwar
ds.Fr
om t
hisi
tfol
l
owst
hatt
heMCcur
ve
i
nter
sect
stheATCatt
hemi
nimum poi
ntoft
heATC.Thi
scanal
sobepr
oof
edby
usi
ngasi
mpl
ecal
cul
us.
Fr
om ATC =TC/X =>TC =(
ATC)
.X
d(
TC)
MC = ,bydef
ini
ti
on
dX
=>MC =d(
ATC.
X)/
dX
=>MC =ATC.
dX/
dX +X.
d(ATC)
/dX
=>MC =ATC +(
X)(
slopeoft
heATC)
Gi
vent
hatXandATCar
ePosi
ti
ve,
 MC <ATCi
fsl
opeofATCi
snegat
ive.
 MC =ATC,
ifsl
opeofATC =0,
(att
hemi
nimum oft
heATC)
.
 MC >ATC,
ifsl
opeofATC >0.
c.Ther
elat
ionshi
pbet
weenMCandAVC
Fr
om AVC =TVC/
X,=>TVC =(
AVC)
.X
MC =d(
TC)
/dX =d(
TFC +TVC)
/dX =d(
TFC)
/dX +d(
TVC)
/dX
=>MC =d(
TVC)
/dX,
sincet
her
eisnochangei
ntheTFC.
=>MC =d(
AVC.
X)/dX =AVC.
dX/dX +X.
d(AVC)
/dX
=>MC =AVC +(
X)(
slopeofAVC)
Gi
vent
hatAVCandXar
ePosi
ti
ve,
 MC <AVCi opeofAVC <0
fsl

68|Page
  MC =AVC,
i opeofAVC =0(
fsl att
hemi
nimum poi
ntoft
heAVC)
.
 MC >AVC,
ifsl
opeofAVC >0.

d.Rel
ati
onshi
pbet
weenPr
oductCur
vesandCostCur
ves
Uni
tpr
oduct
sanduni
tcostcur
vesar
emi
rr
ori
magesofeachot
her
,i.
e.
o whenAP(
MP)i
sri
ngAC(
MC)i
sfal
l
ing;
o whenAP(
MP)i
sfal
l
ingAC(
MC)i
sri
sing;
and
o whenAP(
MP)i
smaxi
mum AC(
MC)i
smi
nimum
Seebel
owf
ori
l
lust
rat
ionoft
heser
elat
ions.
LetTVC =wL,
wher
ew =gi
venwager
ate&L =l
abori
nput
Thus,
AVC =TV/
Q =(
wL)/
Q =w(
L/Q) =w/
(Q/
L)
ButQ/
L =APL,
so
 AVC =w/APL
Si
mil
arl
yMC =DTVC/
, DQ,
sinceTVC =wL
MC =DwL/ DL)
DQ =w( /(DQ)=w/
(DQ/
DL)
ButDQ/
DL =MPL
 MC =w/
MPL
Gr
aphi
cal
l
y:
AP,
MP

APL
0 Q
AC,
MC MPL
MC

AVC

0 Q
4.
2Long-
runcost
s

69|Page
 Thel
ong-
runi
saper
iodoft
imeofsuchl
engt
hthatal
li
nput
sar
evar
iabl
e.I
tis
apl
anni
nghor
izoni
nthesenset
hateconomi
cagent
scanpl
anaheadand
choosemanyaspect
soft
he“
shor
t-
run”i
nwhi
cht
heywi
l
loper
atei
nthe
f
utur
e.Thus,t
hel
ong-
runconsi
stsofal
lpossi
bleshor
t-
runsi
tuat
ionsamong
whi
chaneconomi
cagentmaychoose.
I
fapr
oduct
iont
echnol
ogyi
schar
act
eri
zedbyconst
antr
etur
ntoscal
e(CRS)
,
doubl
i
ngout
putr
equi
resdoubl
i
ngofi
nput
,whi
chi
mpl
i
esdoubl
i
ngoft
otal
out
put(
cost
)forgi
venf
act
orpr
ices.Hence,t
hel
ong-
runt
otalcostcur
vei
n
t
hiscasei
sast
rai
ghtl
i
net
hrought
heor
igi
n.Thi
simpl
i
est
hatt
hel
ong-
run
av
erageandmar
ginal
cost
sar
ehor
izont
all
i
nesandequal
(LAC =LMC)
.
TC LAC
LMC
Q)
TC(

LAC=LMC

O Q O Q

I
fweconsi
dert
hecasewher
etot
alcostf
ir
sti
ncr
easeatadeceasi
ngr
atedue
t
oincr
easi
ngr
etur
nst
oscal
e(whi
chi
mpl
i
eseconomi
esofscal
e).Andt
henat
ani
ncr
easi
ngr
ateat
tr
ibut
edt
odecr
easi
ngr
etur
nst
oscal
eaf
tert
heopt
imum
si
ze,t
hel
ong-
runt
otalcostcur
vewi
l
llookl
i
ket
hef
oll
owi
ng.TheLACand
LMCcur
veswi
l
lbeU-
shaped. LAC
TC TC(
Q)LMC LMC
LAC

O Q O Q

70|Page
 Ther
angef
rom t
hemi
nimum poi
ntofLACt
othel
efti
scal
l
edt
heeconomi
es
ofscal
erange,whi
chmeansout
putcanbedoubl
edf
orl
esst
handoubl
i
ngof
cost
.Ther
angef
rom t
hemi
nimum ofLACt
other
ighti
scal
l
eddi
seconomi
es
ofscal
e,becauseadoubl
i
ngofout
putr
equi
resmor
ethanadoubl
i
ngofcost
.
Thet
radi
ti
onalt
heor
yoft
hef
ir
m assumest
hateconomi
esofscal
eexi
stonl
y
upt
oacer
tai
npl
ant
,whi
chi
sknownast
heopt
imum pl
antsi
ze.Wi
tht
his
pl
antal
lpossi
bleeconomi
esofscal
ear
eful
l
yexpl
oit
ed.I
fthef
ir
mincr
eases
f
urt
hert
hant
hisopt
imum si
zet
her
ear
edi
seconomi
esofscal
ear
isi
ngf
rom
manager
iali
nef
fi
ci
enci
es.I
tisar
gued t
hatmanagementbecomeshi
ghl
y
compl
ex,manager
s ar
e ov
erwor
ked and t
he deci
sion maki
ng pr
ocess
becomel
essef
fi
ci
ent
.
Whenaf
ir
mispr
oduci
ngatanout
putatwhi
cht
heLACi
sfal
l
ing,t
heLMCi
s
l
esst
hanLAC.Conv
ersel
y,whenLACi
sri
si
ng(
incr
easi
ng)
,LMCi
sgr
eat
er
t
hanLAC.Thet
wocur
vesi
nter
sectatapoi
ntwher
etheLACcur
veachi
eves
i
tsmi
nimum.Li
ket
heshor
trunav
eragecost(
SAC)andSMCcur
ves,
theLAC
andLMCcur
vesar
eU-
shaped,butf
ordi
ff
erentr
easons.I
nthel
ong-
run,t
he
sour
ceoft
heU-
shapei
sincr
easi
nganddecr
easi
ngr
etur
nst
oscal
e,r
ather
t
handi
mini
shi
ngr
etur
nst
oaf
act
orofpr
oduct
ion.
A.TheRel
ati
onshi
pbet
weenShor
t-
runandl
ong-
runAver
ageandMar
ginal
cost
s
Assumet
hataf
ir
misuncer
tai
naboutt
hef
utur
edemandf
ori
tspr
oductand
i
sconsi
der
ingt
hreeal
ter
nat
ivespl
antsi
zes:Smal
l
,Medi
um andLar
ge.The
shor
t-
runav
eragecostcur
vesar
eSAC1,
SAC2andSAC3i
nthef
igur
ebel
ow.
Cost

SAC1
SAC3
C1 SAC2
C3
C2
C4

71|Page
 O
Q1 Q1* Q2 Q2*

I
fthef
ir
m expect
sthatt
hedemandwi
l
lexpandf
urt
hert
hanQ1,i
twi
l
linst
all
t
he medi
um pl
ant
,because wi
tht
his pl
antout
put
slar
gert
han Q1 ar
e
pr
oducedwi
thal
owercost(
fori
nst
anceC2 <C1 f
orout oQ*1)
putequalt .
Si
mil
arconsi
der
ati
onshol
dfort
hedeci
sionoft
hef
ir
m wheni
treachest
he
l
evel
Q2.
I
fwer
elaxt
heassumpt
ionoft
heexi
stenceofonl
ythr
eepl
ant
sandassume
t
hatt
her
eisav
eryl
argenumber(
inf
ini
tenumber
)ofpl
ant
s,weobt
aina
cont
inuouscur
ve,whi
chi
sthepl
anni
ngLACcur
veoft
hef
ir
m.LACcur
vei
s
t
hel
ocusofpoi
ntsdenot
ingt
hel
eastcostofpr
oduci
ngt
hecor
respondi
ng
out
put
.Iti
sapl
anni
ngcur
vebecauseont
hebasi
soft
hiscur
vet
hef
ir
m
deci
deswhatpl
antt
osetupi
nor
dert
opr
oduceopt
imal
l
y(atmi
nimum cost
)
t
heexpect
edl
evelofout
put
.TheLACcur
vei
sU-
shapedandi
tisof
tencal
l
ed
t
heenv
elopcur
vebecausei
tenv
elopest
heshor
truncur
ves.
C
LAC
SAC1 SAC6
SAC2
SAC3 SAC5
SAC4

O Q
M
Becauset
her
ear
eeconomi
esofscal
eanddi
seconomi
esofscal
eint
hel
ong-
run,
t
hepoi
ntsofmi
nimum av
eragecostoft
hesmal
l
erandl
argerpl
ant(
plant
s1up
t
o4and5upt
o7)donotl
i
eont
hel
ong-
runav
eragecostcur
ve.Forexampl
e,a
pl
antsi
ze2oper
ati
ngatmi
nimum av
eragecosti
snotef
fi
cientbecauseal
arger
pl
antcant
akeadv
ant
ageofi
ncr
easi
ngr
etur
nst
oscal
etopr
oduceatal
ower

72|Page
av
eragecost
.
Eachpoi heLAC cur
ntoft vei
sapoi
ntoft
angencywi
tht
hecor
r ngSAC
espondi
cur
ve.Thepoi
ntoft
angencyoccur
stot
hef
all
i
ngpar heSAC cur
toft vesf
or
poi
ntsl
yi
ngt
othel
eftofM.si
ncet
hesl heLAC i
opeoft snegat
iveupt
oM,t
he
sl heSACcur
opeoft esmustal
sobenegat
ive,becauseatt
hepoi
ntoft
angency
t
het
wocur
veshav
ethesamesl
ope.Byt
hesamel
ogi
c,t
hepoi
ntoft
angencyf
or
out
put
slar
gert
hanQoccur
stot
her
isi
ngpar heSACcur
toft ves.
Onl
yatt
hemi
nimum poi
ntM oft
heLACi
sthecor
respondi
ngSACal
soata
mi
nimum.Att
hef
all
i
ngpar
toft
heLaccur
vet
hepl
ant
sar
enotwor
kedt
oful
l
capaci
ty.Tot
her
isi
ngpar
toft
heLACcur
vet
hepl
ant
sar
eov
erwor
ked.Onl
yat
t
hemi
nimum poi
ntM i
sthepl
antopt
imal
l
yempl
oyed.
TheLMCi
sder
ivedf
rom t
heSMCcur
vesbutdoesnotenv
elopt
hem.TheLMCi
s
f
ormedf
rom poi
ntsofi
nter
sect
ionsoft
heSMCcur
veswi
thv
ert
icall
i
nesdr
awn
f
rom t
hepoi
ntsoft
angencyoft
hecor
respondi
ngSACandt
heLACcur
ve.

C LMC
SMC1 SMC3 SAC3
LAC
a

SMC2

Q
Tot
hel
eftofa,SAC1 i
sgr
eat hanLAC sot
ert hatSAC1 decl
inesataf
ast
err
ate
t
hant
heLAC.Sot
heyar
eequalata.t
hisi esLMC >SMC1 t
mpl
i othel
eftofa.At
a,LMC =SMC1 (
thesameaddi
ti
onalcost
saccr
uet
obot
htheshor
t-
runandt
he
l
ong-
run cost hatSAC1 =LAC)
sso t .To t
her
ightofa,LMC <SMC1 (
mor
e
i
ncr
ement
alcosti
saddedt
otheshor
t-
runcostt
hant
othel
og-
runcost
).Att
he
mi
nimum poi
ntoft he LMC i
he LAC,t nter
sectwi
tht
he LAC.Att
hispoi
nt,
SAC =SMC =LAC =LMC
B.Der
ivat
ionOfCostFunct
ionFr
om ThePr
oduct
ionFunct
ion
Costcur
vesar
eder
ivedf
unct
ionsi
nthatt
heyar
eder
ivedf
rom t
hepr
oduct
ion
73|Page
f
unct
ion.Gr
aphi
cal
l
ythet
otalcostcur
vei
sdet
ermi
nedbyt
hel
ocusofpoi
ntsof
t
angencyofsuccessi
vei
socostl
i
neswi
thhi
ghesti
soquant
s.
Mathemati
cal
ly,t
hecostfunct
ioncanbeder
ivedasf
oll
owsbyusi
ngt
heCobb-
Dougluspr
oducti
onf
uncti
on.
X =ALbKc
Gi
vent
hispr
oduct
ionf
unct
ionandt
hecostf
unct
ion
C =wL +r
K
Wewantt
oder
ivet
hecostf
unct
ion,
thati
s,t
hecostasf
unct
ionofout
put
C =f
(X)
Webegi
nbysol
vi
ngt
heconst
rai
nedout
putmaxi
mizat
ionpr
obl
em:
Maxi
mizeX =ALbKc
Subj
ectt
oC =wL +r
K
Wef
ormt
hecomposi
tef
unct
ion
Z =X -(wL +r
K–C)
Par
ti
all
yder
ivat
eZWi
thr
espectt
oL,
K,andequat
etozer
o.
∂Z/∂L=∂X/∂L-w =0
∂Z/ ∂K–r =0
∂K =∂X/
∂Z/
∂=wL +r
K–C =0 (
Compl
etei
tbyy
ourhand)
Exampl
e:
Gi
ven,Q =L2/3K1/3 w =2andr=4,
der
ivet
hecostf
unct
ion
Sol
uti
on:
Thest
epst
hatar
einv
olv
edt
oder
ivet
hecostf
unct
ionar
e:
1)Sol
vef
orLi
nter
msofKorKi
nter
msofLf
rom t
heopt
imal
i
tycondi
ti
on.
2)Subst
it
utet
her
esul
tunder(
1)i
ntot
hepr
oduct
ionf
unct
ion.
3)Sol
vef
orLandKi
nter
msofQf
rom t
hepr
oduct
ionf
unct
ion.
4)Subst
it
utet
her
esul
tsunder(
3)i
ntot
hecostconst
rai
nt.
1.MPL/
MPK =w/
r
2 -1 1
3 3
(
3*L K)
=> =2/
4
1 -2 2
(
3*K3L3)

74|Page
 2K 1
=> =
L 2
=>L =4K
2.Q =L2/3K1/3 ⇒Q =(
4K)3 1/
2/
K 3 ⇒Q =(
4)2/
3
K
42/3
=>K =Q/
42/3
=>L =4K =4Q/
=>L =41/3Q
3.C =2L +4K
41/3Q) +4(
C =2( Q/42/3)
C =25/3Q +41/3Q
25/3 +41/3)
C =( Q

4.
3Dy
nami
cchangesi
ncost
s–t
hel
ear
ningcur
ve
Al
argef
ir
m mayhav
eal
owerLACt
hanasmal
l
erf
ir
m becauseofi
ncr
easi
ng
r
etur
nst
oscal
einpr
oduct
ion,whi
chi
mpl
i
est
hatgr
owi
ngf
ir
mswi
thi
ncr
easi
ng
r
etur
ns t
o scal
e enj
oyl
owerav
erage costov
ert
ime.Butt
his maynotbe
necessar
il
ythecase.I
nsomef
ir
ms,l
ong-
runav
eragecostmaydecl
i
neov
ert
ime
becausewor
ker
sandmanager
sabsor
bnew t
echnol
ogi
cali
nfor
mat
ionast
hey
become mor
e exper
ienced att
hei
rjobs.As managementand l
aborgai
n
exper
iencewi
thpr
oduct
ion,t
hef
ir
m’sMCandACofpr
oduci
ngagi
venl
evelof
out
putf
all
for4r
easons:
a.Aswor
ker
sbecomemor
eadapt
edt
oagi
vent
ask,
thei
rspeedi
ncr
eases.
b.Manager
slear
ntoschedul
ethepr
oduct
ionpr
ocessmor
eef
fect
ivel
y.
c.Engi
neer
swhoar
eini
ti
all
ycaut
iousi
nthei
rpr
oductdesi
gnsmaygai
nenough
exper
iencet
obeabl
etoal
l
owf
ort
oler
ancesi
ndesi
gnt
hatsav
ecostwi
thout
i
ncr
easi
ngdef
ect
s.Bet
terandmor
especi
ali
zedt
ool
sandpl
antor
gani
zat
ion
mayal
sol
owercost
.
d.Suppl
i
ersofmat
eri
alsmayl
ear
nhow t
opr
ocessmat
eri
alsr
equi
redmor
e
ef
fect
ivel
yandmaypassonsomeoft
hisadv
ant
agei
nthef
orm ofl
ower
mat
eri
alscost
.
Asaconsequenceoft
his,
afi
rm“
lear
ns”ov
ert
imeascumul
ati
veout
put

75|Page
i
ncr
eases.Thegr
aph(
cur
ve)t
hatdescr
ibest
her
elat
ionshi
pbet
weenaf
ir
m’s
cumul
ati
veout
putandt
heamountofi
nput
sneededt
opr
oduceeachuni
tof
out
puti
sknownast
hel
ear
ningcur
ve.

Amountofinput
s
-
neededperoutput

Learningcurve
0 Cumulati
veoutput
Af
irm’saveragecostofproducti
oncandecl ineoverti
mebecauseof:
a)Gr owthofsal eswhenincr
easi
ngreturnsar epresent(movementf
rom At
oB
i
nt hef
igurebelow),or
b)Theexi stenceoflear
ningcur
ve/ef
fect( movementf rom AtoC)
.
AC A

C B
AC2 AC1
Q
Chapt
erV
Per
fectCompet
it
ion
5.
1Int
roduct
ion
Per
fect
,unl
i
keev
ery
dayusageoft
hewor
d,i
schar
act
eri
zed byacompl
ete
absenceofr
ival
ry(
compet
it
ion)amongf
ir
ms.
Assumpt
ions
- Lar
genumberofbuy
ersandsel
l
ers:becauseoft
hev
eryl
argenumberof
buy
ersandsel
l
ersani
ndi
vi
dualbuy
erorsel
l
eri
stoosmal
ltoaf
fectt
he
mar
ketpr
ice.
- I
dent
icalcommodi
ti
esar
epr
oducedbyal
lfi
rmsi
nani
ndust
ryi
nter
msof
i
tst
echni
calchar
act
eri
sti
csandser
vicesassoci
atedwi
thi
tssal
eand
del
i
ver
yrul
i
ngoutnon-
pri
cecompet
it
ion.
- Ther
eisf
reeent
ryt
oandexi
tfr
om t
hei
ndust
ry.
Theseassumpt
ionswi
l
limpl
ythatt
hef
ir
msar
epr
icet
aker
ssot
heyar
efaced
wi
thper
fect
lyel
ast
icdemandcur
ve.
Px
76|Page
 DDx
O Qx
- Pr
ofi
tmaxi
mizat
ioni
sthesol
eobj
ect
iveoff
ir
msi
nthei
ndust
ry(
noot
her
obj
ect
ivesl
i
kewel
far
e,et
c.)
- Nogov
ernmenti
nter
vent
ion
- Per
fectmobi
l
ityofpr
oduct
iver
esour
cesbet
weenoramongf
ir
ms.
(Ski
l
ls
canbel
ear
nedandnof
act
ormonopol
i
zat
ionandl
aboruni
oni
zat
ion.
)
- Per
fect(
compl
ete)knowl
edgeofmar
ketcondi
ti
oni
nthepar
tofsel
l
ers
andbuy
ersbot
hoft
hepr
esentandt
hef
utur
e,andi
nfor
mat
ioni
sfr
eeand
cost
less.
Theseassumpt
ionsr
uleoutanyuncer
tai
nty
.

Shor
t-
runEqui
li
bri
um oft
heFi
rm andt
heI
ndust
ry

Theequi
l
ibr
ium out
putoft
hef
ir
mist
heout
putt
hatmaxi
mizesi
tst
otalpr
ofi
t.
Tot
alpr
ofi
tsequal
thedi
ff
erencebet
weent
otal
rev
enuesandt
otal
cost
s,i
.e.
∏=TR–TC
∏=PQ–ATC(
Q)
∏=Q(
P–ATC)

I
naper
fect
lycompet
it
ivemar
ketst
ruct
ure,
pri
cei
sgi
ven(
fi
rmsar
epr
icet
aker
s).
Thus f
ir
ms deci
de on t
he l
evelofout
put(
Q)t
heypr
oduce t
o at
tai
nthei
r
equi
l
ibr
ium poi
nts.Twoappr
oachesar
eusedi
ndet
ermi
ningaf
ir
m’sequi
l
ibr
ium.

1.Thet
otalappr
oach:t
otalpr
ofi
tsar
emaxi
mizedwhent
heposi
ti
vedi
ff
erence
bet
weent
otal
rev
enuesandcost
sisl
argest
.
TR/
TC STC TR

77|Page
 C

Qe Q

Tot
hel
eftofpoi
ntBandt
other
ightofC,STC>TRsot
hatt
hef
ir
misi
nal
oss
(
negat
ive∏)
.Bet
weenBandC,
howev
er,
thef
ir
misenj
oyi
ngaposi
ti
vepr
ofi
tand
i
tismaxi
mizedatt
hepoi
ntwher
ethev
ert
ical
dif
fer
encebet
weent
heTRandSTC
i
slar
gest(
atQe)
.Poi
ntBi
sthebr
eak-
evenpoi
ntwher
ethef
ir
mjustcov
ersi
ts
costofpr
oduct
ionandoper
atesatzer
oeconomi
cpr
ofi
t.

2.Themar
ginalappr
oach:t
heper
fect
lycompet
it
ivef
ir
misapr
icet
akerand
f
acesa per
fect
lyel
ast
icdemand cur
ve.Si
ncemar
ginalr
evenue(
MR)i
s
dTR/
dQandpr
ice(
P)i
sconst
ant
,thenP=MR.

MR=dTR=d(
PQ)=pdQ=P
dQ dQ dQ
Tot
alpr
ofi
tismaxi
mum whent
hesl
opeoft
heTRandt
otalcostcur
vesar
e
78|Page
 equal
.Thati
s,whenMR(
P)=MC

Thef
ir
misatequi
l
ibr
ium atquant
it
ylev
elQe(
wher
eMR=P=MCatpoi
ntE)
.
Tot
hel
eftofE,MR >MC (
i.
e.,benef
it
s>cost
s)andi
tshoul
dincr
ease
pr
oduct
ion.To t
her
ightofE,MC>MR and t
hef
ir
m shoul
d cutbacki
ts
pr
oduct
ion.Thi
spar
ti
cul
arf
igur
erepr
esent
sthecasewher
ethef
ir
m oper
ates
atal
oss(
=ar
eaofr
ect
angl
eEFGH)
.
∏=Q(
P–ATC)
∏=Qe(-EF)
∏=-(
EH)(
EF)
=-ar
eaofEFGH
P/
MR MC
MC ATC
AC

AVC

F
G M

H I E P=MR

O Q
Qe
I
tcanbet
hecaset
hatcompet
it
ivef
ir
msmayoper
ateatl
osses,atposi
ti
ve
pr
ofi
ts,
oratanor
mal(
zer
o)pr
ofi
t.Fori
nst
ance,
afi
rm oper
atesataposi
ti
ve
pr
ofi
tift
hedemandcur
ves(
MR)l
i
esabov
epoi
ntM.Ont
heot
herhand,
afi
rm
get
sonl
yanor
mal(
zer
o)pr
ofi
tift
hedemandcur
vepassest
hroughM.I
n
gener
al,
79|Page
 I
f Then
P>AC Posi
ti
ve(economi
c)pr
ofi
t
P=AC Nor
mal(zer
o)pr
ofi
t,i
.e.
,br
eak-
even
poi
nt
AVC<P<AC Loss,
butt
hef
ir
m cont
inuest
opr
oduce
P=AVC Shut
-downpoi
nt
P<AVC Lossornooper
ati
on

N.
B.:i
nthef
igur
eabov
e,P(
MR)=MCatt
wopoi
nts,EandI
.Butt
hepr
ofi
t
maxi
mizi
ngl
evelofout
puti
sthatl
evelofout
putwhi
chcor
respondst
oE.
Condi
ti
onf
orpr
ofi
tmaxi
mizat
ioni
s
1.MR=MCt
hisi
mpl
i
esd∏=0
dQ
2.MCi
sring=>d2∏<0ordM∏<0
si
dQ2 dQ
Thef
ir
m oper
atesatdi
ff
erentpoi
ntsatt
hemar
ginalcostcur
vedependi
ngon
t
hel
evelofpr
icei
tfaces.Thus,
itssuppl
ycur
vei
sit
sMCcur
vebutabov
ethe
shut
-down poi
nt.The i
ndust
ry suppl
y cur
vei
sthe si
mpl
e hor
izont
al
summat
ionoft
hesuppl
ycur
vesoft
hei
ndi
vi
dualf
ir
ms.Thus,t
hei
ndust
ryi
s
atequi
l
ibr
ium whent
hei
ndust
rydemandcur
vei
nter
sect
sthei
ndust
rysuppl
y
cur
ve.

S
$ $
80|Page S

Pe P=MR
 E Pe E*

O Qe Q O Qe

Panel
A–shor
t-
runequi
l
ibr
ium Panel
B–Equi
l
ibr
ium of
t
he
t
hef
ir
m. I
ndust
ry.

LONGRUNEQUI
LIBRI
UM OFTHEFI
RM ANDI
NDUSTRY

Whenl
ong-
runequi
l
ibr
ium i
sachi
eved,pr
oductpr
iceswi
l
lbeexact
lyequalt
o,
andpr
oduct
ionwi
l
loccurateachf
ir
m’spoi
ntofmi
nimum ATC.Thi
sisi
l
lust
rat
ed
bel
owf
oraconst
antcosti
ndust
ry(
thecasewher
etheexpansi
onoft
hei
ndust
ry
t
hrough ent
ryofnew f
ir
mswi
l
lhav
eno ef
fectup on r
esour
cepr
icesand,
t
her
efor
e,uponpr
oduct
ioncost
s)andar
espect
ivef
ir
m.

S0
LMC
ATC
$
S1
P1
P1=MR1
P1
Po Po=
MRo
81|Page

Q
 Po D1

D0

Fi
rm I
ndust
ry

Supposet
hatachangei
nconsumert
ast
esi
ncr
easeandt
huspr
oductdemand
f
rom D0t
oD1.Thi
sfav
orabl
eshi
fti
ndemandobv
iousl
ymakespr
oduct
ion
pr
ofi
tabl
e;t
henew pr
ice(
P1)exceedsATC.Thi
seconomi
cpr
ofi
twi
l
llur
enew
f
ir
msi
ntot
hei
ndust
ry.Ast
hef
ir
msent
er,t
hei
ndust
rysuppl
yoft
hepr
oductwi
l
l
i
ncr
easecausi
ngpr
oductpr
icet
ogr
avi
tat
edownwar
dtowar
dst
heor
igi
nall
evel
.
Theeconomi
cpr
ofi
tscausedbyt
heboosti
ndemandhav
ebeencompl
etedaway
t
ozer
oandasar
esul
tthepr
evi
ousi
ncent
ivef
ormor
efi
rmst
oent
ert
hei
ndust
ry
hasdi
sappear
ed.
Ther
efor
e,i
nthel
ong-
run,
all
fir
msoper
ateatapoi
ntwher
e
(
1)P=MR=LMC=LAC=SMC=SACf
ort
hef
ir
m and
(
2)Suppl
ycur
vecr
ossesdemandf
ort
hei
ndust
ry.
I
nthel
ong-
run,al
lfi
rmsi
naper
fect
lycompet
it
ivei
ndust
ry(
mar
ket
)enj
oyonl
y
nor
mal
prof
it(
zer
opr
ofi
t)oratt
hebr
eak-
evenwher
eTR=TC.

EXERCI
SE

Supposey
ouar
ethemanagerofawat
ch-
maki
ngf
ir
m oper
ati
ngi
nacompet
it
ive
mar
ket
.Yourcostofpr
oduct
ioni
sgi
venbyC=100+Q2,wher
eQi
sthel
evelof
out
putandCi
stot
alcost
.
a)I
fthepr
iceofwat
chesi
sbi
rr60,howmanywat
chesshoul
dyoupr
oduce

82|Page
 t
omaxi
mizepr
ofi
t?
b)Whatwi
l
lyourpr
ofi
tlev
elbe?
c)Atwhatmi
nimum pr
icewi
l
lyoupr
oduceaposi
ti
veout
put
?

CHAPTERVI
PUREMONOPOLY

Pur
emonopol
yist
hef
orm ofamar
keti
nwhi
chasi
ngl
efi
rm sel
l
sacommodi
ty
83|Page
f
orwhi
cht
her
ear
enocl
osesubst
it
utes.Thust
hemonopol
i
str
epr
esent
sand
f
acest
hei
ndust
ry'
snegat
ivel
ysl
opeddemandcur
vef
ort
hecommodi
ty.
Monopol
ycanar
isef
rom sev
eral
causes(
bar
ri
erst
oent
ry)
.Somear
e:
1.Af
ir
m mayownorcont
rol
theent
ir
esuppl
yofessent
ial
rawmat
eri
al(
s).
2.Af
ir
m mayownapat
entf
ort
heexcl
usi
ver
ightt
opr
oduceacommodi
tyort
o
usea par
ti
cul
arpr
oduct
ionpr
ocess.
3.Economi
esofscal
emayoper
ateov
erasuf
fi
cient
lyl
arger
angeofout
put
sso
ast
o l
eav
easi
ngl
efi
rm suppl
yi
ngt
heent
ir
emar
ket
.Suchaf
ir
miscal
l
ed
Nat
ural monopol
y.
4.Li
censespr
otectpr
esentl
i
censehol
der
sfr
om new compet
it
ion.i
.e.
,conf
er
monopol
ypowert
othem asagr
oup.

Thecr
uci
aldi
ff
erencebet
weenapur
emonopol
i
standapur
ecompet
it
ivesel
l
er
l
i
esont
hedemandsi
deoft
hemar
ket
.Apur
emonopol
ycani
ncr
easei
tssal
es
onl
ybychar
gingal
oweruni
tpr
icef
ori
tspr
oduct
.Buteachaddi
ti
onaluni
tsol
d
wi
l
laddt
otot
alr
evenuei
tspr
icel
ess:t
hesum oft
hepr
icecut
swhi
chmustbe
t
akenonal
lpr
ioruni
tsofout
put
.Pr
icecut
swi
l
lappl
ynotonl
ytot
heext
raout
put
sol
dbutal
sot
oal
lot
heruni
tsofout
putwhi
chot
her
wisecoul
dhav
ebeensol
dat
ahi
gherpr
ice.Hence,mar
ginalr
evenuei
slesst
hanpr
ice(
aver
ager
evenue)f
or
ev
eryl
evel
ofout
putexceptt
hef
ir
st.

Or =>

Si
nce equal
sP+somenegat
ivenumber
s,=>

84|Page
 P
MR

Q
MR Demand

Fr
om t
heabov
erel
ati
oni
tcanbeshownt
hat
:
a)MRi
sposi
ti
ve(
butl
esst
hanP)
,whendemandi
sel
ast
ic
b)MRi
szer
owhendemandi
suni
tar
yel
ast
ic,

c)MR<0when <1,
and

d)MR=Pwhen =

6.
1Shor
tRunandLongRunequi
l
ibr
ia
I
ntheshor
t-
run,amonopol
i
stmaxi
mizest
otalpr
ofi
tsbypr
oduci
ngt
hel
evelof
out
putatwhi
chmar
ginalr
evenueequal
smar
ginalcostorwher
ethedi
stance
bet
weent
het
otal
rev
enueandt
otal
costcur
vesi
sthel
argest
).

P
MC

A
Pe
ATC
C
85|Page
D
 B

I
nthi
spar
ti
cul
arcaseP(
=Pe)
>ATCandhencet
hemonopol
i
stenj
oysaposi
ti
ve
pr
ofi
tequal
tot
hear
eaPeABC.
I
fPi
ssmal
l
ert
hanATCatt
hepoi
ntwher
eMR=MC,t
hemonopol
i
stwi
l
lincura
l
ossi
ntheshor
t-
run.Howev
er,i
fP>AVC,i
tpay
sfort
hemonopol
i
stt
ocont
inue
t
opr
oducebecausepr
oduct
ioncov
erspar
toft
hef
ixedcost
s.
I
nthel
ong-
run,t
hebestorpr
ofi
tmaxi
mizi
ngl
evelofout
puti
sgi
venbyt
hepoi
nt
wher
ethemonopol
i
st'
sLMC=MR(
andLMCcur
vei
nter
sect
sMRcur
vef
rom
bel
ow)
.
>gr
aph
Ev
en t
hough pr
ofi
ts at
tractaddi
ti
onalf
ir
ms i
ntot
he per
fect
lycompet
it
ive
i
ndust
ryunt
ilj
ustal
lfi
rms br
eak-
even i
nthe l
ong-
run,t
he monopol
i
stcan
cont
inuet
oear
npr
ofi
tsi
nthel
ong-
runbecauseofbl
ockedent
ry.
Themonopol
i
st,asopposedt
oaper
fect
lycompet
it
ivef
ir
m,doesn'
tpr
oduceat
t
hel
owestpoi
ntoni
tsLACcur
ve.Onl
yift
hemonopol
i
st'
sMRcur
vehappenedt
o
got
hrought
hel
owestpoi
ntoni
tsLACwoul
dthi
sbet
hecase.

6.
2.Di
scr
imi
nat
ingMonopol
y

Tot
hispoi
nti
thasbeenassumedt
hatt
hemonopol
i
stchar
gesauni
for
m pr
icet
o
86|Page
al
lbuy
ers.Undercer
tai
ncondi
ti
onst
hemonopol
i
stmi
ghtbeabl
etoexpl
oiti
ts
mar
ketposi
ti
onf
ull
yandt
husi
ncr
easepr
ofi
tsbychar
gingdi
ff
erentpr
icest
o
di
ff
erentbuy
ers.Bydoi
ngsot
hesel
l
eri
sengagi
ngi
npr
icedi
scr
imi
nat
ion.Pr
ice
di
scr
imi
nat
ionr
efer
stochar
gingdi
ff
erentpr
ices(
fordi
ff
erentquant
it
iesofa
commodi
tyori
ndi
ff
erentmar
ket
s)t
hatar
enotj
ust
if
iedbycostdi
ff
erences.I
n
gener
al,
pri
cedi
scr
imi
nat
ioni
swor
kabl
ewhent
hreecondi
ti
onsar
ereal
i
zed.

1.Thesel
l
ermustpossesssomedegr
eeofmonopol
ypower
,
2.Thesel
l
ermustbeabl
etosegr
egat
ebuy
ersi
ntosepar
atecl
asseswher
ein
eachgr
ouphasadi
ff
erentabi
l
ityandwi
l
li
ngnesst
opayf
ort
hepr
oduct
.
3.Theor
igi
nal
pur
chasercannotr
esel
lthepr
oduct
.

Pr
ice di
scr
imi
nat
ion (
the pr
act
ice ofchar
ging di
ff
erentpr
ices t
o di
ff
erent
cust
omer
sforsi
mil
argoods)cant
aket
hreebr
oadf
ormswhi
chwecal
lfi
rst
,
secondandt
hir
ddegr
eepr
icedi
scr
imi
nat
ion.

I
fthemonopol
i
stcoul
dsel
leachuni
toft
hecommodi
tysepar
atel
yandchar
ge
t
hehi
ghestpr
iceeachcust
omerwoul
dbewi
l
li
ngt
opayf
ort
hecommodi
ty-
r
eser
vat
ionpr
ice-t
hemonopol
i
stwoul
dbeabl
etoext
ractt
heent
ir
ecust
omer
's
sur
plus.Thi
siscal
l
edf
ir
stdegr
eeorper
fectpr
icedi
scr
imi
nat
ion.

A
Pe
R
MC
87|Page

D
 O

Wi
thoutpr
icedi
scr
imi
nat
ion,t
hemonopol
i
stchar
gesPe,sel
l
squant
it
yQeandt
hus
t
otalr
evenueequal
sthear
eaofPeRQeO.Wi
thper
fectpr
icedi
scr
imi
nat
ion,t
he
monopol
i
stcapt
urest
heent
ir
econsumersur
plusARPebysel
l
ingi
tspr
oductata
maxi
mum pr
icet
hatconsumer
sar
ewi
l
li
ngt
opayf
ort
hecommodi
ty(
shownby
poi
ntA)
.thi
smet
hodi
sal
soknownas“
take-
it
-or
-l
eav
e-i
t”pr
icedi
scr
imi
nat
ion,
becauset
hemonopol
i
stchar
gest
hemaxi
mum pr
iceconsumer
sar
ewi
l
li
ngt
o
pay
.
Knowi
ngt
heexactshapeofeachconsumer
'sdemandcur
ve(
andbeabl
eto
char
ger
eser
vat
ionpr
ices)andbeabl
etopr
eventar
bit
ragei
simpossi
bleor
pr
ohi
bit
ivel
yexpensi
vet
ocar
ryout
.Thus,f
ir
stdegr
eepr
icedi
scr
imi
nat
ioni
snot
v
erycommoni
nther
ealwor
ld.Mor
epr
act
icalandcommoni
ssecond-
degr
eeor
mul
ti
par
tpr
icedi
scr
imi
nat
ion.Thi
sref
erst
othechar
gingofauni
for
m pr
iceper
uni
tforaspeci
fi
cquant
it
yoft
hecommodi
ty,
alowerpr
icef
oranaddi
ti
onal
bat
ch
orbl
ockoft
hecommodi
ty,andsoon.Quant
it
ydi
scount
sar
eanexampl
eof
seconddegr
eepr
icedi
scr
imi
nat
ion.Her
ethemonopol
i
stext
ract
spar
t,butnotal
l
,
oft
heconsumer
'ssur
plus.

88|Page
Thi
rddegr
eepr
icedi
scr
imi
nat
ioni
sthepr
act
iceofdi
vi
dingconsumer
sint
otwo
ormor
egr
oupswi
thsepar
atedemandcur
vesandchar
gingdi
ff
erentpr
icest
o
eachgr
oup.Somechar
act
eri
sti
cisusedt
odi
vi
decust
omer
sint
odi
sti
nctgr
oup.
Formanygoods,
forexampl
e,st
udent
sar
eusual
l
ywi
l
li
ngt
opayl
essonav
erage
t
hant
her
estoft
hepopul
ati
on.
Pc

MC

P2

P1

MC=MR E
E1 E2
DT

D2
D1

89|Page
Thet
otalquant
it
ypr
oduced,Xi
sdet
ermi
nedbyt
hei
nter
sect
ionoft
heMRT and
MCcur
ves.Thi
squant
it
yist
hendi
vi
dedbet
weent
het
wogr
oupsofcust
omer
s
(
assumi
ngonl
ytwogr
oupsf
orsi
mpl
i
cit
y)sot
hatmar
ginalr
evenuesf
oreach
gr
oupar
eequal
.Ot
her
wise,
thef
ir
m woul
dnotbemaxi
mizi
ngpr
ofi
t.Forexampl
e,
i
fMR1>MR2,t
hef
ir
m coul
dcl
ear
lydobyshi
ft
ingout
putf
rom t
hesecondgr
oupt
o
t
hef
ir
st.Notonl
yshoul
dthet
womar
ginalr
evenuesequal
,butal
sot
hemar
ginal
costshoul
dbeequalt
othemar
ginalr
evenues.I
fthi
swer
enott
hecaset
hef
ir
m
coul
dincr
easei
tspr
ofi
tabi
l
itybyr
aisi
ngorl
ower
ingt
otalout
put(
andl
ower
ingor
r
aisi
ngi
tspr
icest
obot
hgr
oups)
.

Tot
alpr
ofi
toft
hef
ir
misgi
venbyπ=P1Q1+P2Q2-C(
QT)
Wher
eP1=t
hepr
icechar
gedt
ogr
oupone
P2t
hepr
icechar
gedt
ogr
oupt
wo
C(
QT)=t
otal
costofpr
oduci
ngout
putQT=Q1+Q2
Thef
ir
m shoul
dincr
easei
tssel
l
stoeachgr
oupunt
ilt
hei
ncr
ement
alpr
ofi
tfr
om
t
hel
astuni
tsol
diszer
o.

Pr
icesandout
putmustbe
setsot
hatMR1=MR2=MC
-Recal
lthat

Att
hemaxi
mum pr
ofi
t

Rear
rangi
nggi
ves

90|Page
I
fthedemandi
nmar
ketsegment2i
srel
ati
vel
yel
ast
ic,
(i.
e.i
f ,
then

Thehi
gherpr
icewi
l
lbechar
gedt
oconsumer
swi
tht
hel
owestdemandel
ast
ici
ty.

6.
3MULTI
PLANTMONOPOLY

Amonopol
i
stmaxi
mizespr
ofi
tbyset
ti
ngout
putatal
evelwher
eMR=MC.For
manymonopol
i
sts,
product
iont
akespl
acei
ntwoormor
edi
ff
erentpl
ant
swhose
oper
ati
ngcost
scandi
ff
er.Howev
er,t
hel
ogi
cusedi
nchoosi
ngout
putl
evel
sis
v
erymuchsi
mil
art
othatf
ort
hesi
ngl
e-pl
antf
ir
m.Supposeaf
ir
m hast
wopl
ant
s.
What
evert
het
otal
out
put
,itshoul
dbedi
vi
dedbet
weent
het
wopl
ant
ssot
hatMC
i
sthesamei
neachpl
ant
.Ot
her
wise,
thef
ir
m coul
dreducei
tscost
sandi
ncr
ease
i
tspr
ofi
tbyr
eal
l
ocat
ingpr
oduct
ion.Forexampl
e,i
fMC1>MC2,t
hef
ir
m coul
d
pr
oducet
hesameout
putatal
owert
otalcostbypr
oduci
ngl
essatpl
ant1andat
pl
ant2.

91|Page
 P MC1
MC2
MR
MC
MCT

P*

O Q1 Q2 Q3
Q

Pr
ofi
tismaxi
mizedwhenMR=MCateachpl
ant
.IfMR>MC,
thef
ir
m woul
ddo
bet
terbypr
oduci
ngmor
eatbot
hpl
ant
s.

∏=PQt–C1(
Q1)–C2(
Q2)
 d∏=d(
PQt
)–dC1=0,
andd∏=d(
PQt
)–dC2=0
dQ1 dQ1 dQ1 dQ2 dQ2 dQ2

 MR=MC1,
andMR=MC2
 MR=MC1=MC2

6.
4 SOCI
ALCOSTOFMONOPOLY

I
n a compet
it
ivemar
ket
,pr
iceequal
smar
ginal
cost
. Monopol
y power on t
he ot
her hand,
92|Page
 i
mpl
i
est
hatpr
iceexceedsmar
ginalcost
.Becausemonopol
ypowerr
esul
tsi
n
hi
gherpr
ices and l
owerquant
it
ies pr
oduced,we woul
d expecti
tto make
consumer
swor
seof
fandt
hef
ir
m bet
terof
f.Supposewev
aluewel
far
eof
consumer
sthesameast
hatofpr
oducer
s.I
ntheaggr
egat
e,doesmonopol
y
powermakeconsumer
sandpr
oducer
sbet
terorwor
seof
f?
P
MC
MC

Pm
E
F
Pc

MR D

Qm Qc

Pc,t
hecompet
it
ivef
ir
m’spr
ice,equal
sMCandt
husQcquant
it
yispr
oduced.I
f
t
hisf
ir
misr
epl
acedbyamonopol
i
st,Pm pr
icewi
l
lbechar
gedandQm quant
it
y
wi
l
lbepr
oduced.Consumer
’ssur
plusdecl
i
nesf
rom PcEY t
o PmeY (
byt
he
amountequalt
oPmEPc)
.But
,onl
yPmeFPci
sext
ract
edbyt
hemonopol
i
st.
Si
mil
arl
y,GEFi
sthepr
opor
ti
onoft
hepr
oducer
s’sur
plusl
ost
.Insum,whi
l
e
PmeFPcr
epr
esent
str
ansf
erf
rom consumer
s’sur
plust
opr
oducer
s,eEF+EFG
r
epr
esent
sthedead-
wei
ghtl
ossduet
omonopol
y–t
hesoci
alcostofmonopol
y.

EXERCI
SE

1)Amonopol
i
sti
sdeci
dinghowt
oal
l
ocat
eout
putbet
weent
womar
ket
sthatar
e
93|Page
separ
atedgeogr
aphi
cal
l
y.Demandsf
ort
het
womar
ket
sar
eP1=15–Q1andP2=
25–2Q2.Themonopol
i
st’
sTCi
sC=5+3(
Q1+Q2)
.Whatar
epr
ice,
out
put
,pr
ofi
ts,
andMRi
f:
a)Themonopol
i
stcanpr
icedi
scr
imi
nat
e?
b)Thel
awf
orbi
ds(
prohi
bit
s)char
gingdi
ff
erentpr
icesi
nthet
wor
egi
ons?

2)Adr
ugcompanyhasamonopol
yonanew pat
ent
edmedi
cine.Thepr
oduct
canbemadei
nei
theroft
wopl
ant
s.Thecost
sofpr
oduct
ionf
ort
het
wopl
ant
s
ar
eMC1 =10+2Q1 andMC2 =25+5Q2.Thef
ir
m’sest
imat
eofdemandf
ort
he
pr
oducti
s
P=2000–3(
Q1+Q2)
.Howmuchshoul
dthef
ir
m pl
ant
opr
oducei
neachpl
ant
?At
whatpr
iceshoul
ditpl
ant
osel
lthepr
oduct
?

94|Page