EET 200: MICROECONOMICS THEORY II

1.0 Consumer Theory

In your elementary microeconomics, the basic principles of consumer behaviour were
introduced by laying a strong foundation on the theory of demand on which premise
the consumer behaviour is build upon. The consumer behaviour is introduced as a
utility maximising behaviour but subject to consumer’s ability to purchase. A consumer
is portrayed as an agent who goes for the best that he/she can afford.

In the intermediate level we describe more precisely what we mean by ‘best’ and ‘I can
afford’. In the first section, we will examine how to describe what a consumer can
afford; the next section will focus on the concept of how the consumer determines what
is best. We will then be able to undertake a detailed study of the implications of this
simple mode of consumer behaviour.

1.1 The Budget Constraint

Suppose that there is some set of goods from which the consumer can choose. In real
life there are many goods to consume but we will consider two.

Let the consumer’s consumption bundle be ( X 1 X 2 ) where X 1 , represents the number

of units the consumer chooses of good 1 and X 2 is the number of units of good to be
chosen by the consumer.

Let p1 and p 2 represent the unit prices for the two goods respectively; and M to
represent the amount of money the consumer has to spend.

The budget constraint of the consumer can be written as:

P1 X 1 + P2 X 2  M

Where P1 X1 is expenditure for good 1 and P2 X 2 is expenditure on good 2.

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The budget constraint of the consumer requires that the amount of money spent on the
two goods is no more than the total amount the consumer has to spend. The consumer’s
affordable consumption bundles are those that do not costs any more than M. The set
of affordable consumption bundles at prices P1 P2 and income M is called the budget set
of the consumer.
The set of bundles that cost exactly M is called the budget line.

P1 X 1 + P2 X 2 = M

These are the bundles of goods that just exhaust the consumer’s income. The budget is
set is shown below:

X2

M
P2 Budget line
P1
Slope = −
P2

Budget set

M X1
P1

The budget set consists of all bundles that are affordable at the given prices and income.

Re-arranging equations (2)

M P1
X2 = − X 1............................................. ( 3)
P2 P2

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 M
This is an equation for a straight line with a vertical intercept of and a slope of
P2

P1
−
P2

The example tells how many units of good 2 the consumer needs to consume in order
to just satisfy the budget constraint, if she is consuming X 1 units of good 1.

The slope of the budget line measures the rate at which the market is willing to
substitute good 1 for good 2.

X 2 P
=− 1
X 1 P2

The slope of the budget line is also said to be an opportunity cost of consuming good
one. In order to consume more of good 1, one has to give up some consumption of
good 2. Giving up the opportunity to consume good 2 is the true economic cost of more
of consumption of good 1 and that cost is measured by the slope of the budget line.

1.2 Consumer Preferences

This section is devoted to clarifying the economic concept of “best things” now that the
meaning of “can afford” is clear.

The objects of consumer choice are consumption bundles. This is a complete list of the
goods and services that are involved in the choice problem faced by a consumer.

Suppose there are two consumption bundles ( X 1 X 2 ) and (Y1Y2 ) . The consumer can
rank them as to their desirability. That is, the consumer can determine that one of the
bundles is strictly better than the other, or decide that she is indifferent between the two
bundles.

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1.2.1 Assumptions about Preferences
1. Completeness: It is assumed that any two bundles can be compared. That is,
given any X bundle and any Y bundle, then ( X 1 X 2 )  (Y1Y2 ) or (Y1Y2 )  ( X 1 X 2 )
or both, in which case the consumer is indifferent between the two bundles.
This is to say that the consumer can make a choice.

2. Reflexive: We assume that any bundle is at least as good as itself

(X 1 X 2 )  (X 1 X 2 )

3. Transitive: If ( X 1 X 2 )  (Y1Y2 ) and (Y1Y2 )  (Z1 Z 2 ) then we assume that

consumer thinks that X is at least as good as Y and that Y is at least as good as
Z, then the consumer thinks that X is at least as Z.

1.2.2 Indifference Curves emphasise on curves

The whole theory of consumer choice can be formulated in terms of preferences that
satisfy the three axioms above. However, it is convenient to describe preferences
graphically using indifference curves.

Consider a consumer’s consumption of goods 1 and 2:

X2

X 2*

0 X 1* X1

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If ( X 1 X 2 ) is a certain consumption bundle, the consumption bundle in the shaded region

are weakly preferred to ( X 1 X 2 ) . It is called the weakly preferred set. The bundles on
the boundary of this set for which the consumer is just indifferent to ( X 1 X 2 ) form the
indifference curve. It consists of all bundles of goods that leave the consumer
indifferent to the given bundle.

1.2.3 Shapes of Indifferent Curves

If no further assumptions about preferences are made, ICs can take very peculiar shapes.

1. Perfect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one
good for the other at a constant rate. The simplest case of perfect substitutes
occurs when the consumer is willing to substitute the goods on a one to one
basis. ICs for such a consumer are all parallel straight lines.

X2

IC S
Linear ICs, perfect substitution

0 X1

2. Perfect Complements
Perfect complements are goods that are always consumed together in fixed
proportions, e.g. shoes (left and right). The ICs are L shaped, with the vertex
of the L occurring where the number of one good equals the number of the other
good.
?

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 X2

0
X1
3. Bad Goods
A bad is a commodity that the consumer doesn’t like. Suppose that the two
commodities are meat and pepper, the consumer loves meat but dislikes pepper.
But suppose there is some trade off possible between meat and pepper i.e. there
would be some amount of meat in samosa that could compensate the consumer
for having to consume a given amount of pepper, if more pepper is given in the
samosa, more meat has to be given to compensate for having to put up with the
pepper. Thus this consumer will have indifference curves that slope up and to
the right.

X2
(Bad )

ICs

0 X1
(Good )

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4. Neutral Goods
A good is a neutral good if the consumer doesn’t care about it one way or the
other. Suppose in the above case the consumer is just neutral about pepper ( X 2 )
. The IC would be vertical lines as depicted below. The consumer only cares
about the amount of X 1 and doesn’t care at all about how much of X 2 he/she

has. The more of X 1 the better but adding more X 2 doesn’t affect him.

X2

IC

Adding X 1

0 X1

5. Imperfect Substitutes
If the rate at which one good is substituted for another is not constant, but
diminishing, then the two goods are imperfect substitutes. As more and more
of one good is given up successively larger units of the other good are consumed
to compensate the consumer for the loss. Such goods will have indifference
curves that are rounded, i.e. the ICs are strictly convex.

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 X2

X1

1.2.4 The Marginal Rate of Substitution

The slope of the IC is known as the MRS. It measures the rate at which the consumer is
just willing to substitute one good for another.

Suppose that we take a little of good 1, X 1 away from the consumer. Then we give
him X 2 , an amount i.e. just sufficient to put him back on his/her IC, so that he is just

as well off after this substitution of X 2 for X 1 as he was before.

X 2
The ratio is thought as being the rate at which the consumer is willing to substitute
X 1
good 1 for good 2 and is called the MRS.

The MRS measures an interesting measure of consumer behaviour. Suppose that the
consumer has well behaved preferences, i.e., preferences which are monotonic and
convex to the origin, and currently consuming some bundle ( X 1 X 2 ) . The consumer is
now offered to trade off ie, to exchange good 1 for 2 or good 2 for 1 in any amount at
a “rate of exchange” of E.
I.e. if the consumer gives up X 1 units of good 1, he can get EX 1 units of good 2 in

X 2
exchange or conversely, if he gives up X 2 , units of good 2, he can get units of
E
good 1.

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 X 2
MRS = =E
X 1
X 2 = EX 1
X 2
X 1 =
E

Geometrically, we are offering the consumer an opportunity to move to any point along
a line with a slope that passes through X 1 X 2 as depicted.

IC
X2

X2

X 2
=E
X

X1 X1

Moving up and to the left from X 1 to X 2 involves exchange of good 1 for good 2, and
moving down to the right involves exchanging good 2 for good 1. In either movement
the exchange rate is E. Since exchange always involves giving up one good in exchange
for another, the exchange rate E corresponds to slope at E.

The point of tangency between the budget line and the indifference curve is referred to
as the consumer equilibrium.

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1.2.5 Behaviour of the Marginal Rate of Substitution
1. Perfect substitute’s indifference curves are characterized by the fact that the
MRS is constant at -1.
2. The neutral case is characterized by the fact that the MRS is everywhere infinite.
The preference for perfect complements are characterised by the fact that the
MRS is either 0 or infinite and nothing in between.
3. The assumption of monotonicity implies that ICs must have a negative slope,
so the MRS always involves reducing the consumption of one good in order to
get more of another for monotonic preferences.
4. Diminishing MRS. The case of convex ICs exhibits yet another kind of
behaviour for the MRS. For convex ICs, the MRS decreases as more of X1 is
consumed. Thus the IC exhibits a diminishing MRS. Convexity of ICs implies
that the more of a good consumed, the more willing is a consumer is to give
some of it up in exchange for the other goods. This seems very natural for a
consumer and hence convexity if ICs becomes both necessary and sufficient
conditions for consumer equilibrium besides just having a point of tangency
between the consumer’s budget line and the IC.

1.3 UTILITY
The theory of consumer behaviour has been formulated with an objective of utility
maximization. Utility refers to the ability of/in a good to satisfy the consumer.

Cardinalist v/s ordinalist

There are several approaches to the study of utility with one theory attaching
significance to the magnitude utility and is know as the cardinal utility theory. In this
theory the utility can be measured in units called utils.

Another theory formulates the consumer behaviour entirely in terms of consumer

preferences and utility is seen only as a way to describe preferences by ranking bundles
according to utility derived from each bundle. The proponents of this theory recognized
that all that mattered about utility as far as choice behaviour was concerned was whether
one bundle had a higher utility than another but how much higher didn’t matter (ranking

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was the only matter). Proponents of this theory where utility cant be measured but
individual can rank preferences are refered to as ordinalist.

1.3.1 The Utility Function

A utility function measures welfare or satisfaction of a consumer as a function of
consumption of real goods, such as food and or clothing
Utility function is a way of assigning a number to every possible consumption bundle
such that more preferred bundles get assigned larger numbers than less preferred
bundles.

A utility function is a way to label indifference curves. Since every bundle of an IC

must have the same utility, a utility function is a way to assign number to the different
indifference curves in a way that higher ICs get assigned larger numbers. As long as
ICs containing more preferred bundles get a larger label than indifference curves
containing less preferred bundles, the labelling will represent the different preferences.

However, not all kinds of preferences can be represented by a utility function for
example, suppose a consumer had intransitive preferences so that A>B>C>A. Then a
utility function for these preferences would have to consist of numbers U(A), U(B) and
U(C) such that U(A)>U(B)>U(C)U(A), which is impossible.

Examples of Utility Functions

1. Perfect Substitutes goods

Preferences for perfect substitutes are represented by linear utility functions of
the form.

U ( X 1 X 2 ) = X 1 +  X 2

Where  ,   0 , numbers that measure the value of goods 1 and 2 to be

consumed. By plotting all the points ( X 1 X 2 ) such that U ( X 1 X 2 ) equals a

constant, yields a linear indifference curve with a slope − . For every different


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 
value of a constant, there is a different IC, but having a similar slope of − .

Each represents utility functions which are monotonic transformations to each
other.

X2

a
ICs with a slope =
b

X1

2. Complementary Goods
These are goods which are used together. The preferences for complementary
goods take utility functions of the form.

U ( X 1 X 2 ) = Min( X 1 X 2 ) = Min(X 1 , X 2 )

Where  and  are positive numbers that indicate the proportion in which the
goods are consumed, e.g. if X 1  X 2 , then U ( X 1 X 2 = aX 1 ) if aX 1  bX 2

then U ( X 1 X 2 ) = bX 2

Any monotonic transformation of this utility function will describe the same
preferences which are presented by L-shaped ICs.

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 X2

Good X 1 and X 2 are perfect

complements

0
X1

3. Imperfect Substitutes
Perfect substitutes have an additive utility function which implies that a
consumer will yield some level of utility even by consuming only one of the
goods.

However, many cases are such that some level of utility is only possible when
a combination of the goods is consumed, i.e. no amount of utility is achievable
from consuming zero amount of one good. Such goods are said to be imperfect
substitutes and their preferences take multiplicative form of utility functions.

U ( X 1 X 2 ) = X 1 X 2
This kind of a function is referred to as a Cobb-douglas utility function. It yields
a convex monotonic indifference curve and are said to be well behaved.

It is the most useful preference in presenting algebraic examples of the

economic ideas. A monotonic transformation of the Cobb-Douglas utility
function above will represent exactly the same preferences as:

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X2

Convex ICs

U4
U3

U2

U1

X1

1.3.2 Marginal Utility and Marginal Rate of Substitution

Consider a consumer consuming bundle ( X 1 X 2 ) . The amount by which the total utility

changes U ( X 1 X 2 ) when an extra unit of a good is consumed is the marginal utility

with respect to the good.

Suppose an extra unit of good 1 is consumed such that total utility changes from
U ( X 1 X 2 ) to U ( X 1 + X 1 , X 2 ) the MU of good 1 is written as:

U U ( X 1 + X 1 , X 2 ) − U ( X 1 X 2 )
MU 1 = =
X 1 X 1

It measures the rate of change in utility (∆U) associated with a small change in the
amount of good 1 (X 1 ) . Therefore to calculate the change in utility associated with a
small change in consumption of good 1, we can multiply the change in consumption by
the MU of the good.

U = MU 1 X 1
Similarly,
U U ( X 1 , X 2 + X 2 ) − U ( X 1 X 2 )
MU 2 = =
X 2 X 2

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 U = MU 2 X 2

Recall that the MRS measures the slope of the IC at a given bundle of goods.

Consider now a change in the consumption of each good (X 1 X 2 ) that keeps utility
constant, i.e., a change in consumption that moves us along the IC, then

MU 1 X 1 + MU 2 X 2 = U = 0
Solving for the slope of the IC we have,
X 2 MU 1
MRS = =−
X 1 MU 2

But U = 0 since utility does not change along the indifference curve.

MU x1 .X 1 = − MU x 2 .X 2
X 2 MU x1
− =
X 1 MU x 2

The slope is negative since to get more of one good, lesser units of the other good must
be consumed in order to keep the same level of utility. For example if
X 2 MU 1
=− = −2
X 1 MU 2
Give up 2 units of good 2 to consume an extra unit of good 1.

1.3.3 Consumer Equilibrium

This section concentrates with putting together the budget line and the theory of
preference in order to examine the optimal choice of consumers. We have noted that
the economic model of consumer choice is that consumers choose the best bundle they
can afford, i.e. the consumers choose the most preferred bundle from their budget set.

Suppose the budget set and the well behaved consumer preferences are drawn on the
same diagram as:

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X2

The consumer
equilibrium

X 2*

X 1* X1

The bundle of goods that is associated with the highest indifference curve and is
( )
affordable is X 1* X 2* . Any bundle above this one is unaffordable, such a bundle that
appears on a point of tangency between the indifference curves and the budget line is
the consumers optimal choice and is also referred to as the consumer’s equilibrium
choice. The point of tangency is called the consumer equilibrium point. Since a
solution as is represented above is an interior solution, where the consumers optimal
choice involves both goods. A situation where optimal consumption involves
consuming 0 units of one good and some units of another is called a boundary
solution/optimum. For example:

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X2

IC

Budget line

0 X 1* X1

Boundary optimum: The optimum consumption involves consuming 0 units of good

2 and the indifference curve is not tangent to the budget line.

The tangency condition is only a necessary condition to have an optimal choice but not
a sufficient condition. However, there is one important case where it is sufficient, the
case of convex preferences. In the case of convex preferences, any point that satisfies

?
the tangency condition must be an optimal point.

Generally there may be more than one optimal bundle that satisfies the MRS condition
as show below:

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X2

Optimal bundle

Non − optimal bundle

•
•

0 X1

In such a case, there are three tangencies but only two optimal points, so the tangency
condition is necessary but not sufficient. However, convexity implies a restriction. If
the indifference curves are strictly convex, then there will be only one optimal choice
in each budget line.

Recall that the marginal rate of substitution is the rate of exchange at which the
consumer is just willing to stay put. On the other hand, the market is offering a rate of
P1
exchange to the consumer of − (the slope of the budget line).
P2

If the consumer is at a consumption bundle where he/she is willing to stay put, it must
be one where the MRS is equal to this rate of exchange.

P1
MRS = −
P2

MU 1 MU 2
=
P1 P2
Hence
MU 1 P
MRS = − =− 1
MU 2 P2

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Or simply
MU1 P1
= consumer equilibrium condition
MU 2 P2
The equilibrium point (optimal choice) has this characteristic that the slope of the IC
(MRS) is equal to the slope of the budget line. The consumer’s choice model can be
used to find the optimal choices for other preferences. Some examples include:

1. Perfect Substitutes
Recall that perfect substitutes have linear indifference curves, just similar to a
budget line. If P2  P1 , then the slope of the budget line is flatter than the slope of
the indifference curves. In such a case, the optimal bundle is where the consumer
spends all income on good 1.

If P1  P2 , then the consumer purchases only good 2. If P1 = P2 , there is a whole

range of optimal choices and any amounts of goods 1 and 2 that satisfies the budget
constraint is optimal.
The graph below illustrates an optimal choice with perfect substitutes which
provide a boundary solution.

X2

Indifference curve

Budget line

Optimal choise

M X1
X 1* =
P1

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In summury
M
 P if P1  P2
 1
 M
X 1 = any number between 0 and if P1 = P2
 P1
0 if P1  P2



2. Perfect Complements
In this case, the optimal choice must always lie on the diagonal, where the
consumer is purchasing equal amounts of both goods, no matter what prices are.
The optimal choice can be illustrated as: MRS = 0
X2

Indiffrence curves

Optimal choice

X 2*
Budget line

0 X 1* X1

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 3. Concave preferences

X2

Indifference curve

Non optimal choice

Budget line
X

Optimal choice

Z X1

The optimal choice is always going to be a boundary choice/solution such as

bundle z.

The optimal choice is the boundary point z, not the interior tangency point X
because Z lies on a higher indifference curve.

1.4 The Consumer Demand Functions

The consumer’s demand functions give the optimal amounts of each of the goods as a
function of the prices and income faced by the consumer. The demand function are
written as:

X 1 = X 1 (P1 P2 M )
X 2 = X 2 (P1 P2 M )

In elementary microeconomics, a clear distinction is made between the normal, inferior

and giffen goods.

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When the consumer income changes, the optimal choice for the goods changes yielding
an income expansion path. The income consumption path is used to derive an Engel
curve. On the other hand, a change in price also changes the optimal choice of the
consumer yielding a price offer curve which is used to derive the demand curve.

In this level we give it a mathematical approach where we seek to determine the demand
functions for the optimal choice bundle of the consumer.

The consumer problem is stated as:

MaxU ( X 1 X 2 )...........................................(i )
st
P1 X 1 + P2 X 2 = M ......................................(ii )

Introducing a langrangian multiplier and converting (1) and (2) into a composite
function we have:

L = U ( X 1 X 2 ) −  ( P1 X 1 + P2 X 2 − M )

Obtaining the first order conditions,

L U
= − P1 = 0.............................................(iii )
X 1 X 1
L U
= − P2 = 0.............................................(iv )
X 2 X 2

L
= P1 X 1 + P2 X 2 − M = 0..................................(v )


Re- writing equations (3) and (4) and dividing them yields:
U
X 1 P
= 1
U P2
X 2
MU X 1 P1
=
MU X 2 P2

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This is a similar concept to what was earlier called the consumer equilibrium h h
the budget line from the graphical approach discussed in the previous sections.

Solving equations (iii), (iv) and (v) above simultaneously, we obtain the demand
functions for the optimal choice bundle. This is best demonstrated using a specific
consumer preference and in this case the Cobb-Douglas preference.
Suppose a utility function is specified as
U ( X 1 X 2 ) = X 1 X 2
The consumer problem is stated as
MaxU = X 1 X 2
st
P1 X 1 + P2 X 2 = M

L = X 1 X 2 −  (P1 X 2 + P2 X 2 − M )
L
= X 1 −1 X 2 − P1 = 0.......................(i )
X 1
L
= X 1 X 2 −1 − P2 = 0.........................(ii )
X 2
L
= P1 X 1 + P2 X 2 − M = 0.........................(iii )

Re-writing and dividing equation 1 and 2 above we obtain
X 1 −1 X 2 P1
=
X 1 X 2 −1 P2
P1
X 1 −1− X 2 −(  −1) =
P2
X 2 P1
=
X 1 P2
Such that
P1 
X2 = X 1 ...................................(iv )
P2 
 P2 X 2
X1 = ....................................(v )
 P1
Equation (4) and (5) represent the income expansion paths or the income offer curve.
Substituting equation (4) and (5) into equation (3) one at a time we obtain.

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P1 X 1 + P2 X 2 = M
  P1 X 1 
P1 X 1 + P2   = M
  P 2 


P1 X 1 + P1 X 1 = M

 
1 +  P1 X 1 = M
 
 +  
  P1 X 1 = M
  
M
X1 =
 
1 +  P1
 
M
X 1* =
 +
P1

 M
X 1* = demand function for X 1
 +  P1
 M
X 2* = demand funtion for X 2
 +  P2
X 1* and X 2* are referred to as the demand function that represents the optimal choice

bundle X 1* X 2* . They provide the solution to the consumer utility maximising problem.
Given the market prices and the income level for a consumer then the functions describe
the exact amount of both goods that the consumer would have to consume so as to
maximise utility.

Given the following utility maximination problem

Maximize utility (U) = X10.5 X20.5

St: P1X1 + P2X2 = M
Work out
i) The optimal value of X1
ii) The optimal value of X2
iii) What is total utility
iv) Is the consumer maximizing utility? Show your working
v) Interpret labda

1.5 Revealed Preference

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We have seen how we can use information about the consumer’s preferences and the
budget constraints to determine his/her demand. However, in real life, preferences are
not directly observable. We discover people’s preferences from observing their
behaviour. The revealed preference theory shows how we can use information about
the consumers demand to discover information about his/her preferences.

The theory adopts a maintained hypothesis that the consumers preferences are stable
over the time period for which his/her behaviour is observed-whether they may be – are
known to be strictly convex. Thus there will be a unique demanded bundle at each
budget.

Consider the figure below, where we have depicted a consumer’s demanded bundle
( X 1 X 2 ) and another arbitrary bundle (Y1Y2 ) i.e. beneath the consumer’s budget line.

good 2

• X1X 2

• Y1Y2

good 1

Bundle (Y1Y2 ) is certainly an affordable purchase at the given budget. The consumer

could have bought it if he/she wanted to and even had money left over. Since ( X 1 X 2 )
is the optimal bundle it must be better than anything else that the consumer could afford.
Hence it must be better than (Y1Y2 ) or any other bundle on or beneath the budget line.

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Let ( X 1 X 2 ) be the bundle purchased at prices ( P1 P2 ) when the consumer has income

M. Since (Y1Y2 ) is affordable at these prices and income, then:

P1Y1 + P2Y2  M
Since X1X2 is actually bought at the given budget, then

P1 X 1 + P2 X 2 = M

Putting these two equations together

P1 X 1 + P2 X 2  PY
1 1 + P2Y2

If the above inequality is satisfied and (Y1Y2 ) is actually a different bundle from ( X 1 X 2 )
, then (X 1 X 2 ) is said to be directly revealed preferred to (Y1Y2 ) . This revealed
preference is a relation that holds between the bundle that is actually demanded at some
budget and the bundles that could have been demanded at that budget. The principle of
revealed preference is therefore stated as:-

Let ( X 1 X 2 ) be the chosen bundle when prices are ( P1 P2 ) and let (Y1Y2 ) be some other

bundle such that:

P1 X 1 + P2 X 2  PY
1 1 + P2Y2 . Then if the consumer is choosing the most preferred bundle,

he can afford, we must have ( X 1 X 2 )  (Y1Y2 ) .

Suppose further that (Y1Y2 ) is a demanded bundle at prices (q1 q 2 ) and that (Y1Y2 ) is itself
revealed preferred to some other bundle Z 1 Z 2 . That is:
q1 y1 + q 2 y 2  q1 z1 + q1 z 2 .

Then ( X 1 X 2 )  (Y1Y2 ) and (Y1Y1 )  (Z 1 Z 2 ) . From the transitivity assumption, we can

conclude that ( X 1 X 2 )  (Z 1 Z 2 ) .

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This is illustrated:

good 2 A<B WEAK

B<A

• X1X 2
•
Y1Y2 budget lines

• Z1 Z 2
good 1

Revealed preference and transitivity assumption tell us that ( X 1 X 2 ) must be better than
(Z1 Z 2 ) for the consumer who made the illustrated choices. In this case ( X 1 X 2 ) is said
to be indirectly revealed proffered to (Z 1 Z 2 ) . The chain of direct comparisons can be
of any length such that if bundle A is directly revealed to B, and B to C, C to D… all
the way to Z, then bundle A is still indirectly revealed to Z.

If a bundle is either directly or indirectly revealed preferred to another bundle, we will

say that the first bundle is revealed preferred to the second.

From the figure below, since ( X 1 X 2 ) is revealed preferred, either directly, to all of the
bundles below (shaded area) either budget lines, ( X 1 X 2 ) is in fact preferred to those
bundles by the consumer. That is, the true indifference curve through (X 1 X 2 ),
whatever it is, must lie above the shaded region. It therefore also follows that, the true
indifference curve through (Y1Y2 ) must lie above the flatter budget line.

1.5.2 The Weak Axiom of Revealed Preference

We have so far supposed that the consumer has preferences and that he/she is always
choosing the best bundle of goods affordable. If the consumer is not behaving this way,
the estimates of the indifference curves that we have constructed are meaningless.

- 27 -
Consider:

good 2

•
X1X 2 budget lines

• Y1Y2

good 1

According to the logic of revealed preference, the diagram allows us to conclude two
things.
(i) ( X 1 X 2 ) is preferred to (Y1Y2 ) and
(ii) (Y1Y2 ) is preferred to ( X 1 X 2 )

That is, the consumer has apparently chosen ( X 1 X 2 ) when he/she could have chosen
(Y1Y2 ) indicating that ( X 1 X 2 ) was preferred to (Y1Y2 ) indicating that ( X 1 X 2 ) was

preferred to (Y1Y2 ) but then he/she indicating the opposite. This situation is absurd and
violates the weak Axiom of Revealed Preference.

Clearly this consumer cannot be a maximizing consumer. Either the consumer is not
choosing the best bundle he/she can afford or there is some other aspect of the choice
problem that has changed that we have not observed. Perhaps the consumer’s tastes or
some other aspect of his/her economic environment have changed. If consumers are
choosing the best bundles that are affordable, but not chosen must be worse than what
is chosen. Economists have therefore formulated this simple point in a basic axiom of
consumer theory referred to as the weak axiom of revealed preference (WARP) it states
that ‘if ( X 1 X 2 ) is directly revealed preferred to (Y1Y2 ) and the two bundles are not the

same, then it cannot happen that (Y1Y2 ) is directly revealed preferred to ( X 1 X 2 ) .

- 28 -
In other words, if a bundle ( X 1 X 2 ) is purchased at prices (P1 P2 ) and a different bundle
(Y1Y2 ) is purchased at prices q1 q 2 then if.

P1 X 1 + P2 X 2  q1Y1 + q2Y2
It must not be the case that
q1Y1 + q 2Y2  q1 X 1 + q 2 X 2

That is, if the Y bundle is affordable when the x-bundle is purchased, then when the Y-
bundle is purchased, the X bundle must not be affordable.

The consumer in (immediate diagram) has violated the WARP and therefore this
consumers behaviour could not have been maximising behaviour. There is no set of
indifference curves that could make both bundles maximizing bundles.

On the other hand, a consumer who satisfies WARP is said to have a maximizing or
optimal behaviour and for such, it is possible to find indifference curves for which
his/her behaviour is optimal. One possible choice of indifference curves is illustrated
below.

Good 2

• X1X 2
Budget lines

• X1X 2

Good 1

- 29 -
The Strong Axiom of Revealed Preference
The weak axiom of revealed preference requires that if X is directly revealed preferred
to Y, then we should never observe Y being directly revealed to X. The strong axiom
of revealed preference requires that the same sort of condition hold for indirect revealed
preference. The strong Axiom of Revealed Preference. The strong Axiom of Revealed
Preference(SARP) states that:
If ( X 1 X 2 ) is revealed preferred to (Y1Y2 ) either directly or indirectly and (Y1Y2 ) is
different from ( X 1 X 2 ) is revealed preferred to (Y1Y2 ) .

It is therefore clear that if the observed behaviour is optimizing behaviour, then it must
satisfy the strong axiom. For if the consumer is optimising and ( X 1 X 2 ) is revealed
preferred to, either directly or indirectly, then it must be the case that ( X 1 X 2 ) > (Y1Y2 )
. Therefore, having ( X 1 X 2 ) revealed preferred to (Y1Y2 ) and (Y1Y2 ) revealed preferred
to (X 1 X 2 ) would imply that ( X 1 X 2 ) > (Y1Y2 ) and (Y1Y2 ) > ( X 1 X 2 ) , which is a
contradiction. We can conclude that either the consumer must not be optimizing or
some other aspect of the consumers environment such as tastes, other prices etc. must
have changed.

While WARP is a necessary condition for optimizing behaviour. SARP is both

necessary and sufficient in the sense that, if the observed choices satisfy SARP, we can
always find well behaved preferences that could have generated the observed choices.
It ensures both consistency and transitivity of consumer preferences.

The Slutsky Equation

Economists are concerned with how consumer’s behaviour changes in response to
changes in the economic environment. So far, the prices of the goods and the income
are the common variables in the consumer economic environment.

EET100 gives an exposure is done on how the optimal choice by a consumer changes
due to changes in both prices and income. in this case, we consider a detailed analysis
of how a consumer’s choice of a good responds to changes in its price.

- 30 -
When the price of a good changes, there are two types of effects. The rate at which one Coz of
change
in real
can exchange one good for another changes, and the total purchasing power of income income
M/p
changes. These two causes changes in the consumer demand for the goods.

The change in demand due to the change in the rate of exchange between the goods is
called the substitution effect. While the change in demand due to changes in the
purchasing power is called income effect. To give a more precise definition, let us
consider the two effects separately and in details.

The substitution effect

To capture the SE, we let the relative prices to change due to a price change and adjust
money income so as to hold purchasing power constant.

Using the diagram:

Good 2

M
P2

Original BL
Pivot at bandle not good 2
Original choice

Final choice
X2

Pivoted BL

Final Budgetline
Pivot Shift
0 X1 M Good 1
P1

- 31 -
Suppose the price of good 1 falls, this means that the budgetline rotates around the
M
vertical intercept and becomes flatter. This movement of the budgetline can be
P2
broken into two steps:

1. Pivot the budgetline around the original demanded bundle and then,
2. Shift the pivoted line out to the new demanded bundle.

The pivot is a movement where the slope of he budgetline changes while its purchasing
power remains constant, while a shift is a movement where the slope of the BL remains
constant while the purchasing power changes.

These two movements give a convenient way to decompose the change in demand into
two places. This decomposition is only hypothetical and the consumer simply observes
a change in price and chooses a new bundle of goods in response. In analysing how the
consumer’s choice changes it is useful to think of the budgetline changing in two stages
(i) pivot and (ii) shift.

Considering the pivot, the pivoted budgetline has the same slop and thus the same
relative prices as the final budgetline. However, the money income associated with
this budgetlines is different since the vertical intercept are different.

Since the original consumption bundle (X 1 X 2 ) lies on the pivoted BL, that
consumption is just affordable. In this sense, the purchasing power of the consumer
has remained constant in the sense that the original bundle of goods is just affordable
at the new pivoted line. That is after the price of good 1 falls, income must have been
adjusted so as to make the original bundle just affordable at a change in relative prices.

Suppose the original prices for goods 1 and 2 are P1 and P2 respectively and M is the
original income. Let M1 be the amount of money income that will just make the
original consumption bundle affordable this will be the amount of money income
associated with the pivoted budgetline.

- 32 -
Since ( X 1 X 2 ) is affordable at both (P1 P2 M ) and ( P1 ' P2 M ' )

where P1 is the new fallen price of good 1, then we have

M ' = P1' X 1 + P2 X 2
M = P1 X 1 + P2 X 2
Subtracting the two equations M’- M=(P’1 X1+P2X2) – (P1X1+P2X2)
(
M '− M = X 1 P1' − P1 )
That is, the change in money income necessary to make the old bundle affordable at the
new price is just the original amount of consumption of good 1 times the change in
prices.

Let P1 = P1' − P1 . Represent the change in price.

M = M '− M . Represent the change in income necessary to make the old
bundle just affordable.

Then:
M = X 1 P1
NOTE: The change in income and the changes in price will always move in the same
direction: if the price goes up, then we have to raise income to keep the same bundle
affordable.

Although ( X 1 X 2 ) is still affordable, it is not generally the optimal purchase at the

pivoted budgetline. The optimal purchase on the pivoted budgetline is

- 33 -
Good 2

•X

•Z
•Y

Pivot Shift
SE Good 1
IE

Bundle Y, is the optimal when we change the price and adjust income so as to keep the
old bundle of goods just affordable. The movement from X to Y is known as SE. It
indicates how the consumer substitutes one good for the other. When the price changes
while adjusting income to retain the consumer’s purchasing power.

More precisely, the SE X 1 is the change in the demand for good 1, when the price of
good 1 changes to P1 ' from P1 and at the same time, money income changes from M to
M'

( )
X 1S = X 1 P1' M ' − X 1 (P1 M )

The SE is sometimes called the change in compensated demand. The idea is that the
consumer is being compensated for a price change by having his/her income adjusted
accordingly, if the price rises “compensation” is done by giving the consumer some
more income to make the same amount of a good affordable at a higher price and vice
versa.

For example:

- 34 -
Mathematically
Suppose that the consumer has a demand function for good x of the form.

M
X = 10 +
10 P

Let his original income be Kshs.120 per day and let the price of good X be Ksh.3 per
unit. Thus the demand for good X per day is:

X (P, M ) = X (3,120 ) = 10 +
120
= 14 units per day
10(3)

Suppose the price of good X falls to Ksh.2 per unit. His new demand at his new price
would be

X (P' , M ) = X (2,120 ) = 10 +
120
= 16 units per day
10(2 )
The total change in demand is increased by 2 units of good X per day. In order to
calculate the SE, we must first calculate by now much income would have to change in
order to make the original demand of 14 units just affordable when the price is Ksh.2
per unit.
Recall that:

M = X 1 P1
= 14(2 − 3)
= −14

The level of income necessary to keep purchasing power constant is:

M ' = M + M
= 120 − 14
= 106 shillings
The consumer demand at the new price of Kshs.2 and at the new income level of Ksh.
106 is.

- 35 -
 ( )
X P1' M ' = X (2,106 ) = 10 +
106
10(2 )
= 15.3

Thus the SE is
( )
X 1S = X P1' M ' − X (P1 M )

The Income Effect

We have so far considered the pivot of the budgetline, the second stage of the price
adjustment is the shift.

A parallel shift of the budgetline is the movement that occurs when income changes
while relative prices remain constant. Thus the second stage of the price adjustment is
called the income effect. It is a change of the consumers income from M ' back to M
keeping the prices constant at (P1 ' P2 ) . In the last diagram this change moves from the
point Y to Z. It is natural to call this last movement the income effect since all we are
doing is changing income while keeping the prices fixed at the new prices.

Precisely, the income effect X 1n is the change in the demand for good 1 when the

income changes from M ' to M holding the price of good 1 fixed at P1'

( ) (
X 1n = X 1 P1' M − X 1 P1' M ' )

Recall from EC100, that income effect of a price change can operate either way. It will
tend to increase or decrease the demand for good 1 depending on whether good 1 is
Normal or Inferior.

When the price of a good decreases, the income also decreases in order to keep
purchasing power constant. If the good is normal, then this decreases in income will
lead to a decrease in demand. If the good is inferior, then the decrease in income will
lead to an increase in demand.
For example

- 36 -
 ( )
X P1' M = X (2,120 ) = 16
X (P M ') = X (2,106 ) = 15.3
1
'

Thus
X 1n = X 1 (2,120 ) − X 1 (2,106 )
= 16 − 15.3
= 0.7

Since the demand for good X here increases when income increases, then good X is
normal.

The Sign of the Substitution Effect

Consider (last diagram, (the points on pivoted budgetline)) where the amount of good
1 consumed is less than that at the bundle X. These bundles were all affordable at the
old prices (P1 P2 ) but they were not purchased. Instead, the bundle X was purchased. If
the consumer is always choosing the best bundle he/she can afford, then X must be
preferred to all of the bundles on the part of the pivoted budgetline that lies inside the
original budget set.

That is, the optimal choice on the pivoted budgetline must not be one of the bundles
that lies underneath the original budgetline. The optimal choice on the pivoted line
would have to be either X or some point to the right of X. But this means that the new
optimal choice must involve consuming at least as much as good 1 as originally just as
we wanted to show. In the (diag.) the optimal choice at the pivoted budgetline is the
bundle Y, which certainly involves consuming more of good 1 than at the original
consumption point X.

The substitution effect always moves opposite to the price movement. It is said to be
always negative, since the change in demand due to the SE is opposite to the change in
price. If the price increases, the demand for the good due to the SE decreases.

The Total Change

- 37 -
The total change in demand is X 1 , is the change in demand due to the change in price,
holding income constant:

( )
X 1 = X 1 P1' M − X 1 (P1 M )

We have already seen that, this total change can be split into two effects, the substitution
effect X 1S and the income effect X 1n

That is
X 1 = X 1S + X 1N
Hence
( )  ( )   ( ) (
X 1 P1' M − X 1 (P1 M ) = X 1 P1' M − X 1 (P1 M ) + X 1 P1' M − X 1 P1' M ' )
These equations says that the total change in demand equals the substitution effect plus
the income effect. This equation is called the Slutsky’s identity. It is true for all values
of P1 P1' , M and M ' . The first and the fourth terms on the RHS cancel out, so the RHS
is identically equal to the LHS.

Use of the Slutsky’s Equation

The Slutsky’s identity is not just the algebraic identity. The content comes in the
interpretation of the two terms on the RHS. The substitution effect and the income
effect. In particular, the signs of the income and substitution effect can be used to
determine the sign of the total effect, which in turn reveals the type of a good in
question. That is, the total effect reveals whether a good is normal, inferior or giffen.

While the Se must always be negative (opposite to the change in price) the income
effect can go either way. Thus the total effect maybe positive or negative.

Normal Good
If a good is normal, the substitution effect and the income effect work in the same
direction. An increase in the price will mean that demand will go down due to the SE.
If the price goes up, i.e. a decrease in income, which for a normal good means a decrease

- 38 -
demand. Both effects reinforce each other. In terms of our notations, the change in
demand due to a price increase means that

X 1 = X 1S + X 1n
− − −

On the other hand, if we have an inferior good, the income effect is positive. A fall in
price for example is like an increase in income. An increase in income would reduce
the demand for an inferior good.

X 1 = X 1S + X 1n
− − +

However, the second term on the RHS the income effect is less than the first term of
the right hand side. The total change is therefore negative. This would mean that a fall
in price results to an increase in demand.

Giffen good, for a giffen good, the second term on the RHS – income effect is positive
but large enough that the total change could be positive. This would mean that a fall in
price would result to a fall in demand.

X 1 = X 1S + X 1n
+ − +

A fall in price has increased the consumer purchasing power such that, the consumer
has reduced his/her consumption of the inferior good. The slutsky’s identity shows that
his kind of perverse effect can only occur for inferior goods. If the good is normal, then
the income and substtituion effect reinforce each other, so that the total change in
demand is always in the ‘right’ directions. Thus a giffen good must be inferior. But an
inferior good is not necessarily a giffen good. The income effect not only has to be
large enough of the ‘wrong’ sign it also has to be large enough to outweigh the right
sign of the substitution effect. This is why giffen goods are so rarely observed in real
life; they would not only have to be inferior goods, but they would have to be too
inferior.

- 39 -
Income and Substitution Effects for Other Preferences.
A similar analysis could be done for other preferences. A similar analysis could be
done for particular kinds of preferences and decompose the demand changes.

a) perfect compliments:- The slutsky decomposition is shown below:

X2

Indiffrence curves

Original
budget line
Final budget line

 Shift
X1
Pivot Income effect = total effect

When the budgetline pivots around the chosen bundles the optimal choice at the new
budgetline is the same as at the original one – this means that the substitution effect is
zero. The change in demand is entirel due to the income effect.

b) Perfect substitutes
In this case, when the budgetline tilts, the demand bundle moves from the vertical axis
to the horizontal axis. There is no shifting and the entire change in demand is due to
the substitution effect. This is show as:

- 40 -
 X2

Indiffrence curves

Final budget line

Original
choice Final choice

Original
budget line
X1

THE HICKS SUBSTITUTION EFFECT

The substitution effect is the name that economists give to the change in demand when
prices change but a consumer’s purchasing power is held constant, so that the original
bundle remains affordable. This definition is called the slutsky’s substitution effect.

Suppose that instead of pivoting the budgetline around the original consumption
bundle, the budgetline is rolled around the indifference curve through the original
consumption bundle as shown.

- 41 -
 X2

Indiffrence curve

Final budget line

Original choice

Original budget Final choice

0 SE IE X1

The budgetline is pivoted around the indifference curve rather than around the original
choice i.e., the consumers purchasing power will no longer be sufficient to purchase
his/her original bundle of goods, but will be sufficient to purchase a bundle that is just
indifferent to his/her original bundle.

Thus the substitution effect keeps the utility level constant rather than keeping the
purchasing power constant. This SE is called the Hicks SE.

The Slutsky substitution effect gives the consumer just enough money to get back
his/her original level of consumption while the Hicks SE gives the consumer just
enough money to get back to his/her original difference curve.

Despite the difference in definition, it turns out that the Hicks SE must be negative in
the sense that it is a direction opposite that of the price change just like the Slutsky SE.

THE THEORY OF THE FIRM

- 42 -
Production Technology
We examine the constraints on a firm’s behaviour. When a firm makes choices it faces
many constraints. Nature imposes the constraints that are only certain feasible ways to
produce outputs from the inputs; there are only certain kinds of technological choices
that are possible.

Inputs and Outputs

Inputs to production are called factors of production (classified into broad categories
such as land, labour, capital and raw materials). Capital goods are those inputs to
production that are themselves produced goods. Basically capital goods are machines
of one sort or another.

Money used to start up or maintain a business is called financial capital and capital
goods or physical capital used for produced factors of production.

Describing Technological Constraints

Nature imposes technological constraints on firms, only certain combinations of inputs
are feasible ways to produce a given amount of output and the firm must limit itself to
technologically feasible production plans.

The set of all combinations of inputs and outputs that comprise a technologically
feasible way to produce is called a production set.

For example, one input (x) and one output (y) the production set may have the shape

- 43 -
Y = Output
Y = f (X )

production Set

X = Input
The production set shows the possible technological choices facing a firm. As long as
the inputs to the firm are costly it makes sense to limit ourselves to examining the
maximum possible output for a production set depicted. The function depicting the
boundary set is known as the production function. It measures the maximum possible
output that you can get from a given amount of input.

In a two input case f (x1 x 2 ) a convenient way to depict productions is by use of

isoquant. An isoquant is the set of all possible combinations of inputs 1 and 2 that are
just sufficient to produce a given amount of output.

Isoquants are similar to indifference curves, but one difference is that isoquants are
labelled with the amount of output they can produce, not with a utility level. Thus the
labelling of isoquants is fixed by the technology and does not have the kind of arbitrary
nature that the utility labelling has.

Examples of technology
(i) Fixed proportions
Eg. Producing holes, hence one man one shovel. Extra shovels are not worth
anything. Thus the total number of holes that you can produce will be the
minimum of the number of men and the number of shovels that you have.
f (x1 x 2 ) = Minx1 , x 2 

- 44 -
 X2
Case of perfect complements

Isoquant

0 X1

(ii) Perfect substitutes in production

Suppose now that we are producing homework and the inputs are red pencils
and blue pencils. The amount of homework produced depends only on the
total number of pencils, the production function is written as:
f (x1 x 2 ) = x1 + x 2

X2
Case of perfect substitutes

0 X1

- 45 -
Cobb-Douglas
A CD production function is given as:

f (x1 x 2 ) = Ax1a x 2b

Measures the scale of production – how much, output we would get if we used one unit
of each input. The parameters a and b measure how the amount of output responds to
changes in the inputs.

Properties of technology
1. Technologies are monotonic – if you increase the amount of at least one of the
inputs, it should be possible to produce at least as much output as you were
producing originally. This is sometimes referred to as the property of free
disposal: if the firm can costlessly dispose of any inputs, having extra inputs
around cant hurt it.

2. Technology is convex – this means that if you have two ways to produce y units
of output, (x1 x 2 ) and ( z1 z 2 ) , then their weighted average will produce at least
units of output. Two ways of producing output is called production techniques.

X2

100a 2 • (100a1 + 100a 2 )

• (25a1 + 75b1 ,25a1 + 75b2 )

100b2 •
(100b2 + 100b )1 Y = 100

100a1 100b1 X1

- 46 -
 Convexity, if you can operate production activities independently then weighted
averages of production plans will also be feasible. Thus the isoquant will have
a convex shape.

The Marginal Product

Suppose that we are operating at some point, (x1x2) and that we consider using a little
bit more of factor 1 while keeping factor 2 fixed at the level x2. How much more output
will we get per additional unit of factor 1?
y f ( x1 + x1 , x2 ) − f ( x1 , x2 )
=
x1 x1

This is called the marginal product of factor 1. Marginal product is a rate; the extra
amount of output per unit of extra input.

The Technical Rate of Substitution

Suppose that we are operating at some point (x1 x 2 ) and that we consider giving up a
little bit of factor 1 and using just enough more of factor to produce the same amount
of output y. How much extra of factor 2, x 2 , do we need if we are going to give up a

little bit of factor 1, x1 ? This is just the slope of the isoquant referred to as the

technical rate of substitution (TRS) denominated by TRS (x1 x 2 ) .

TRS measures the trade off between two inputs in production. It measures the rate at
which the firm will have to substitute one input for another in order to keep output
constant.

Consider a change in our use of factors 1 and 2 that keeps output fixed. Then:

y = MP1 (x1 x 2 )x1 + MP2 (x1 x 2 )x 2 = 0

Which we can solve to get:

x 2 MP1 ( x1 x 2 ) P1
TRS ( x1 x 2 ) = =− =−
x1 MP2 ( x1 x 2 ) P2

- 47 -
Diminishing Marginal Product
As long as we have a monotonic technology, we know that the total output will go up
as we increase the amount of factor one. But it is natural to expect that it will go up at
a decreasing rate. We would typically expect that the marginal product of a factor that
will diminish as we get more and more of that factor. This is called the law of
diminishing marginal product. It only holds when other inputs are fixed.
Diminishing Technical Rate of Substitution
This assumption says that as we increase the amount of factor 1, and adjust factor 2. so
as to stay on the same isoquant, the technical rate of substitution declines. Thus
assumption of diminishing TRS means that the slope of an isoquant must decrease in
absolute value as we move along the isoquant in the direction of increasing x1 . (convex
isoquant).
The Long Run and the Short Run
In the short run, there will be some factors of production that are fixed at predetermined
levels, e.g. land. In the long run all the factors of production can be varied. There is
no specific time interval implied here. The long run and the short run periods depend
on what kinds of choices we are examining.

Let us suppose that factor 2 is fixed at x 2 in the short run. Then the relevant production

function for the short run is f (x1 x 2 ) .

Returns to Scale
We have three types of return to scale.
1. Constant return to scale
Instead of increasing the amount of one input while holding the other input fixed, let us
scale the amount of all inputs up by some constant factor if we get twice as much output,
its referred to as constant returns to scale.

2 f (x1 x1 ) = f (2 x1 2 x 2 )

In general, if we scale all of the inputs by some amount tg, constant returns to scale
implies that we should get t times as much output;

- 48 -
tf (x1 , x 2 ) = f (tx1 , tx 2 )

Returns to scale describes what happens when you increase all inputs, while
diminishing marginal product describes what happens when you increase one of the
inputs and hold the others fixed. (explained)
2. Increasing return to scale

If we scale up both inputs by some factor t, we get more than t times as much as output.
This is called increasing returns to scale, i.e.

f (tx1 , tx 2 )  tf (x1 x1 ) For all t  1

3 Decreasing return to scale

In some instances, we get less than twice as much output from haing twice as much of
each input. This is called decreasing returns to scale.

OPTIMIZATION
f (tx1 , tx 2 )  tf (x1 , x 2 ) for all t  1
Maximization max
Y=X1aX2b st:W1X1+W2X2=M
Maximization max
Profit Maximization Y=X1aX2b st:W1X1+W2X2=M qn pg 56
Short-Run Profit Maximization
Lets consider the short run profit maximization problem when input 2 is fixed at some
level x 2 . Let f (x1 x 2 ) be the production function for the firm, let p be the price of

output, and let w1 and w2 be the prices of the two inputs. Then the profit maximization
problem facing the firm can be written as:
Max p. f ( x1 x2 ) − w1 x1 − w2 x 2
x1

The condition for the optimal choice of factor 1 is not difficult to determine.

If x1* is the profit maximizing choice of factor 1 then the output price times the marginal
product of factor 1 should equal the price of factor 1.

(
pMP1 x1* x 2 = w1 )
VMP = w

- 49 -
I.e. the value of the marginal product of a factor should equal its price.

The same condition can be described graphically (PTO). The curved line represents the
production function holding factor 2 fixed at x 2 . Using y to denote the output of the
firm, profits are given by:

 = py − w1 x1 − w2 x 2

This expression can be solved for y to express output as a function of x1 .

 w w
y= + 2 x 2 + 1 x1 isoprofit line equation
p p p
 
int ercept slope

This equation describes isoprofit lines (combinations of the input goods and the output
good that give a constant level of profit,  ). As  varies, a family of parallel straight
 w2 x 2
lines each with a slope of w1/p and each having a vertical intercept of + , which
p p
measures the profit plus the fixed costs of the firm.

- 50 -
 Output

W1
Isoprofit line scope =
P

Y* Y = f (X 1 , X 2 )
Pr oduction function

 W2 X 2
+
P p

X 1* X1

The firm chooses the input and output combination that lies on the highest isoprofit
(
line. In this care the profit –maximizing points is x1* y * )

The profit maximization problem is then to find the point on the production function
that has the highest associated isoprofit line. As usual it is characterised by a tangency
condition: the slope of the production function should equal the slope of the isoprofit
line. Since the slope of the production function is the marginal product, and the slope
w1
of the isoprofit line is this condition can also be written as:
p1

w1
MP1 =
p
pMP1 = w1

Profit Maximization in the Long Run

In the long run the firm is free to choose the level of all inputs. Thus the LR profit
maximization problem can be posed as:

Max pf ( x1 x 2 ) − w1 x1 − w2 x 2
x1 x2

- 51 -
The condition describing the optimal choices is essentially the same as before, to the
two factors.

( )
PMP1 x1* x 2* = w1
pMP (x x ) = w
2
* *
1 2 2

At the optimal choice, the firm’s profit cannot increase by changing the level of either
input.
CLASS EXAMPLE
Maximize Utility (U ) = 80 X − 2 X 2 − XY − 3Y 2 + 100Y
Subject to : X + Y = 12 .
Work out
i) The optimal value of X
ii) The optimal value of Y
iii) What is total utility
iv) Is the consumer maximizing utility? Show your working
v) Interpret labda

SOLUTION

- 52 -
- 53 -
Inverse Factor Demand Curves
The factor demand curves of a firm measure the relationship between the price of a
factor and the profit – maximizing choices: for any prices, ( p, w1 , w2 ) we just find those

( )
factor demands x1* x 2* , such that the value of the marginal product of each factor equals
its price.

- 54 -
The inverse factor demand curve measures what the factor prices must be for some
given quantity of inputs to be demanded.

The profit – maximization problem of the firm is:

Max pf ( x1 x 2 ) − w1 x1 − w2 x 2
x1 x2

Which has FOC

(
pf x1* x 2*)− w1 = 0
x1
(
pf x1* x 2*)− w2 = 0
x 2

Suppose the CD function is given by f (x1 x 2 ) = x1a x 2b

then the two foc become.

pax1a −1 x 2b − w1 x1 = 0
pbx1a x 2b − w2 x 2 = 0

Multiply the first equation by x1 and the second by x 2 to get.

pax1a x 2b − w1 x1 = 0
pbx1a x 2b − w2 x 2 = 0

Using y = x1a x 2b to denote the level of output of this firm we can rewrite these
expression as:

pay = w1 x1
pby = w2 x 2

Solving for x1 and x 2

- 55 -
 apy 
x1* =
w1 
 gives demand for the factors as a function of the optimal input choice
bpy 
x2 =
*

w2 

Inserting the optimal choice of input to the production function, we have:

a b
 pay   pby 
    = y
 w1   w2 
Factoring out the y gives
a b
 pa   pb  a +b
    y = y
 w1   w2 
a b

 pa  1− a −b  pb  1− a −b

y =     Supply function of the CD firm
 1
w  w2  


This gives a complete solution to the profit maximization problem.

COST MINIMIZATION
Suppose that we have two factors of production that have prices w1 and w2 and that we

want to figure out the cheapest way to produce a given level of output., y. If we let x1
and x 2 measure the amount used of the two factors and let f (x1 x 2 ) be the production
function for the firm, the problem can be written as:

Min w1 x1 + w2 x 2
x1 x2

st
y = f ( x1 x 2 )

Minimum cost will depend on w1, w2 and y i.e. C ( w1 , w2 , y ) – cost function which

measures the minimal costs of producing y units of output when factor prices are
(w1 w2 ) .

- 56 -
X2

Optimal choice
iso cos t line
W
X 2* slope = − 1
W2

Isoquant Y = f ( X 1 X 2 )(techno log ical constra int )

X 1* X1

C = w1 x1 + w2 x 2
Rearranging
C w1
x2 = − x1
w2 w2

NB: If the optimal solution involves using some of each factor, and if the isoquant is a
nice smooth curve, then the cost minimizing point will be characterised by a tangency
condition, the slope of the isoquant must be equal to the slope of the isocost curve. i.e.
TRS must equal the factor price ratio.

( )
− MP1 x1* x 2*
( )
w
= TRS x1* x 2* = − 1
* *
MP2 x1 x 2( ) w2

The algebra that lies behind equation above are

( ) ( )
MP1 x1* x 2* x1 + MP2 x1* x 2* x 2 = 0

x1 and x 2 must be of opposite signs, if we are at the cost minimum, then this change
cannot lower costs, so we have

- 57 -
w1 x1 + w2 x 2  0

Now consider the change (− x1 ,−x 2 ) . This also produces a constant level of output,
and it too cannot lower costs. This implies that

− w1 x1 − w2 x 2  0

Putting the above two expressions together gives:

w1 x1 + w2 x 2 = 0

The choices of inputs that yield minimal costs for the firm will in general depend on
the input prices and the level of output that the firm wants to produce written as
x1 (w1 , w2 , y ) and x 2 (w1 , w2 , y ) .

These are called the conditional factor demand functions or derived factor demands.
They measure the relationship between the prices and output and the optimal factor
choice of the firm, conditional on the firm producing a given level of output y.

Note difference between conditional factor demands and profit maximization factor
demands. Conditional factor demand tells us how much of each factor would the firm
use if it wanted to produce a given level of output in the cheapest way.
For example
MinC = w1 x1 + w2 x 2
st
y = x1a x 2b

(
L = w1 x1 + w2 x 2 −  x1a x 2b − y )
L
= w1 − ax1a −1 x 2b = 0
x1
L
= w2 − bx1a x 2b −1 = 0
x1
w1 ax1a −1 x 2b
=
w2 bx1a x 2b −1

- 58 -
w1 a a −1− a b −(b −1)
x1 x2
w2 b

w1 a x 2
=
w2 b x1

a
w1 x1 =   w2 x 2
b
a w2 x 2
x1 =
b w1
a w1 x1
x2 =
b w2
a
 a w2 x 2  b
  x 2 = y
 b w1 
a
a  w2  a +b
  x 2 = y
b  w1 
−a
bw 
x a +b
2 =  2  y
a  w1 
1

b  w  a +b
−a

x 2 =  2  y
a  w1  

−a
bw  a +b a 1+b
=  2  y
a  w1 

MARKETS
1. Competitive Markets

Since the firm is a price taker, the total revenue depends on the amount sold.

TR = P  Q
TR
MR = =P
Q
TR
AR = =P
Q
P = AR = MR

- 59 -
 P

P P = MR = AR

The SMC curve cuts the ATC at its minimum.

At equilibrium
MR = MC
slope of MC  slope of MR

P, C
SATC
SMC

P P = AR = MR

Q Q

 = TR − TC
F.O.C. for  max

- 60 -
 
=0
Q
 TR TC
= − =0
Q Q Q
TR TC
−
Q Q
MR = MC
But MR = P for competitive market. At equilibrium P = MC
The S.O.C for profit maximisation requires that
 2
0
Q 2
 2  2TR  2TC
= − 0
Q 2 Q 2 Q 2
 2TR  2TC

Q 2 Q 2
slope of MR = slope of MC
The MC must be steeper than MR curve hence MC rising.

2. Monopoly
He sets the price hence the amount he sells depend on price, i.e. the demand is
a decreasing function of price. i.e.
Q = f ( p) f ' 0

Specifically:
Q = b0 − b1 p
The demand curve is assumed to be linear with changing elastics at every one
point.

- 61 -
P

p =
B

 p =1
A

p =0
0 C Q

Q
= −b1
P
Q P
p = 
P Q
P
At point B, p = −b1  =
0
0
At point C, p = −b1  =0
Q
At point A,  p = 1

Now

PROOF THAT MR CURVE IS TWICE STEEPER THAN AR CURVE

FOR A MONOPOLIST
TR = P  Q
But Q = b0 − b1 p

- 62 -
 b0 b
P= − Q
b1 b1
TR = P  Q
b 1 
=  0 − Q Q
 b1 b1 
b 1
= 0 Q − Q2
b1 b1
b0 1
AR = − Q
b1 b1
b0 2
MR = − Q
b1 b1
The MR is a straight line with the same intercept as the demand curve but twice
as steep as AR

MR AR = D Q

The AR is the demand curve for a monopolist

Equilibrium requires that MR=MC and slope of MC be greater than slope of

slope of MR at intersection.

- 63 -
 P

SATC
SMC

QM MR AR = D Q

 (Q ) = TR(Q ) − TC (Q )
 TR TC
= − =0
Q Q Q
MR = MC
 2  2TR  2TC
= − 0
Q 2 Q 2 Q 2
slope of MR  slope of MC
e.g.
Q = 50 − 0.5 P , C = 50 + 40Q Work out this one

P = 100 − 2Q
TR = PQ = (100 − 2Q )Q
= 100Q − 2Q 2
TR
MR = = 100 − 4Q
Q
FOC MR=MC
100 – 4Q = 40
60 = 4Q
Q = 15
P = 100 – 2Q
= 100 – 2(15)
=100 – 30

- 64 -
 =70 units
MR MC
SOC = −4, =0
Q Q
-4 < 0

3. The Multiplant Monopolist Here for the monopolist to maximize profit he can either
• Produce more in the plant where he is incurring less
cost
• Or increase price in the market where the demand is
less price elastic (price discriminate)

Here for the monopolist to maximize profit he can either

• Do the question
• Do MR=P(1-1/Ep)
- A monopolist who produces a homogenous product in different plants.
- For simplicity we shall assume two plants.

Assume the monopolist operates two plants A & B with a different cost
structures. He has to make two decisions:
(i) How much output to produce altogether and at what price to sell it
so as to maximize profit.
(ii) How to allocate the proportion of the optimal output between the two
plants.

The monopolist is assumed to know his market demand and the corresponding
MR curve and the cost structure of the different plants.

The total MC curve is a horizontal summation of the MC curve of the individual

plants.

MC = MC1 + MC 2

The monopolist maximizes his profit by utilizing each plant upto the level at
which the marginal cost are equal to each other and to the common MR. This
is *, if the MC of one plant say plant A is lower than the MC of plant B, the
monopolist would increase his profit by increasing the production in A and
decreasing it in B until

- 65 -
MC1 = MC 2 = MR

Given that the market demand

P = f (Q ) = f (Q1 + Q2 )
And the cost structure of the plant
C1 = f (Q1 )
C 2 = f (Q2 )

The monopolist aims at the allocation of his production between plant 1 and 2.

To maximise profits
 = TR − (TC1 + TC 2 )
f.o.c
 
= 0 and =0
Q1 Q2
 TR TC
= − =0
Q1 Q1 Q1
MR1 = MC1
 TR TC
= −
Q 2
Q2 Q2
MR2 = MC 2

But MR1 = MR2 = MR given that each unit of the homogeneous output will be
sold at the same price P and will yield the same MR1 irrespective of the plant.
MR = MC1 
MR = MC1 = MC 2
MR = MC 2 

S.O.C
 2TR  2TC  2TR  2TC
 and 
Q 2 Q12 Q 2 Q2

- 66 -
 Q = 200 − 2 P
P = 100 − 0.5Q
C1 = 10Q1
C 2 = 0.25Q22
 = TR − TC1 − TC 2
TR = PQ
= 100Q − 0.5Q 2
MR = 100 − Q
MR = 100 − (Q1 + Q2 )
MC1 = 10
MC 2 = 0.5Q2
MR = MC1

100 − Q1 − Q2 = 10
100 − Q1 − Q2 = 0.5Q2

Q1 + Q2 = 90
Q1 + Q2 = 100
− 0.5Q2 = −10
− 10
Q2 =
− 0.5
Q2 = 20
Q1 = 70
Q = 20 + 70
= 90
P = 100 − 0.5(90) = 55
Obtain profit

4. Price Discriminating Monopolist

Exist when the same product is sold at different prices to different buyers.

The conditions necessary which must be fulfilled for the implementation of

price discrimination are:
(i) The market must be divided into sub market.
(ii) Different submarkets must have different price elasticities.

- 67 -
 (iii) There must be effective separation of the sub markets, so that no
reselling can take place from a low price market to a high price
market. This condition explains why price discrimination is
easier to apply with commodities like electricity or gas or
services e.g. doctor which are consumed by the buyer and cannot
be resold.
(iv)
MR Vs price elasticity
TR = PQ Alternatively
TR Q P TR = P.Q
MR = =P +Q MR using chain rule
Q Q Q
dTr/dq=P.dQ/dQ+Q.dP/dQ
P get P outside the blakets
MR = P + Q
Q MR=P[1+-1/Ep]
becauseEp = dQ/dP.P/Q
− Q P
but  p =
P Q
1 − P Q
=
p Q P
P 1 P
=
Q  p Q

Recall
P
MR = P + Q
Q
−1 P 
= P + Q 
  p Q 
−1 
= P +  P
  p 
1 
= P + −P 
  p 

 1 
= MR = P1 − 
  
 p 

5. The Impact of Taxes on a Monopolist

- 68 -
For simplicity let us consider a firm with constant MC. When a quantity tax is
imposed the MC will go up by the amount of the tax. What happens to the
price?

We consider a linear demand curve.

P = a − by
Where P is pice
Y is output

TR = py = (a − by )
= ay − by 2
MR = a − 2by

After a quantity tax t, the MC shifts up to the MC + t.

Pr ice

P' After tax

P* Before tax
MC + t
MC = C
AR = P

0 Q' Q * Quantity
MR

The equilibrium moves to the left after the tax. Since the demand curve is half
as steep as the MR curve, the price goes up by half the amount of the tax.
Equilibrium before tax
MR=MC
But after the tax, the MC increases by the text such that:

- 69 -
MR = MC + t
But MC = C
a − 2by = c + t
a − c − t = 2by
2by = a − c − t
a−c−t
y* =
2b
y − 1
=
t 2b

Recall that equal price is

P = a − by *
p
= −b
y

P p Y 
 = chain rule
t Y t 
1 1
= −b  − b =
2 2

Hence the price changes by less than the tax. Specifically for the linear dd, the
price rise by ½ the tax.

Generally: In general, a tax may increase the price by more or less than the
amount of the tax.

 1 
Recall: MR = P1 −
  p 

But MR = MC

- 70 -
  1 
P 1 −  = MC + t
 
 p 
MC + t
P=
1
1−
p

P 1
=
t 1 − 1
p

Since the monopolistic will always operate where the demand is elastic then he
passes on more than the amount of the tax.

Inefficiency of Monopoly
Recall, in a competitive market, P = MC.
In a monopoly, P> MC.
The price will be higher and the output lower, if a firm behaves monopolistically
rather than competitively. For this reason, consumers will typically be worse
off in an industry organized as a monopoly.
However, the firm will be better off by the same token if a firm behave
competitively. Consider a monopoly situation below:
price

MC
Z

Pm em
Pc A B ec
C

AR = P

Ym Yc Output

MR

- 71 -
Suppose that we could somehow costlessly force this firm to behave as a
competitor and take the market price as being set exogenously. Then we would
have ( Pc Yc ) for the competitive price and output.

Alternatively, if the firm recognized its influence on the market price and chose
its level of output so as to maximize profits, we would see the monopoly price
and output PmYm .

Recall that an economic arrangement is pareto efficient if there is no way to

make anyone better off without making somebody worse off.
Is the monopoly level of output pareto efficient?
Recall the inverse demand curve P(Y) measures how much people are willing
to pay for an additional unit of the a good. Since P(Y) is greater than MC(Y) for
all the output levels between Ym and Yc , there is a whole range of output where

people are willing to pay more for a unit of output than it costs to produce it.
Clearly there is a potential for pareto improvement here. Hence a monopoly
would be inefficient.

But just how inefficient is he? Can we measure the total loss in efficiency due
to monopoly?

The consumer’s surplus in the monopoly structure is Pm em Z which would go

up by area A + B if the monopolist behaved competitively.

On the other hand, the area A would just be a transfer from the monopolist to
the consumer.

Under competition, the producer surplus would include area C. However due
to the monopoly charging the price Pm, he denies the consumer surplus (A+B).
Out of this surplus, only A benefits the producer while B is lost. Area C is also
lost since the producer sells Ym instead of Yc .

- 72 -
 The Area B + C is know as the dead weight loss due to the monopoly. It
provides a measure of how much worse off people are paying the monopoly
price than paying the competitive price.

It measures the value of the lost output by valuing each unit of lost output at the
price that people are willing to pay for that unit.

GENERAL EQUILIBRIUM.
The state of efficiency in exchange/consumption i.e. how we can exchange one
good for another but maintaining the same level of utility.

We shall assume two people A & B two goods 1 and 2.

MRS12A = MRS12B Efficiency in exchange

Efficiency in production where we assume two goods 1 and 2 and two inputs L
and K, such that.
MRTS12L = MRTS12K Efficiency in production

The Edgeworth Box Diagram

This is a convenient graphical tool known as the edgeworth box that can be used to
analyze the exchange of two goods between two people. It allows us to depict the
endowments and preferences of two individuals in one convenient diagram.

Let us assume two people involved A & B and two goods 1 & 2.

( )
Let person A’s consumption bundle be X A = X 1A X A2 where X 1A represents A’s

consumption of good 1 and X A2 represents A’s consumption of good 2.

(
B’s consumption bundle of the two goods is X B = X B1 X B2 . )

- 73 -
A pair of consumption bundles X A and X B is called an allocation. An allocation is a
specific allocation if the total amount of each good consumed is equal to the total
amount available.

i.e.
X 1A + X B1 = W A1 + WB1
X A2 + X B2 = W A2 + WB2

where W A1 for instance is the total availability of good 1 to person A and WB1 WB is the
availability of good to person B.

- 74 -
Good 2
X B1 WB1
Person B

x A2 M x B2

Endowment
2 W
w A wB2

Person A

x 1A w1A
Good 1

- 75 -
The width of the box measures the total amount of good 1 in the economy and the height
measures. The total amount of good 2. Persons A’s consumption choices are measured
from the lower left hand corner while person B’s choices are measured from the upper
right.

The bundles in this box indicate the amount of goods that each person can hold. If for
example there are 10 units of good 1 and 20 units of good 2, then if A holds (7,12), then
B must be holding (3,8).

For instance at point M, if person A holds X 1A of good 1, then B holds X B1 of good 1.

if A holds X A2 of good 2, then B holds X B2 of good 2.

Consider Point W
Movement from point W to point M for example puts person A to a higher 1C I MA from

I WA . Hence making person A better off without necessarily making person B worse off.

( )
To move to point M person A have to forego W A1 − X 1A amount of good 1 and have

(X 2
A − W A2 ) amount more of good 2. on the other hand person B has to forego

(W 1
B − X B1 ) amount of good 2 in oder to have more of good 1 i.e. (X 1
B )
− WB1 .

All the same, this movement makes person A better off by putting him on a higher IC.
Similarly, movement from point W to point M will make person B better off without
making person A worse off.

At a pareto efficient allocation each person is on his highest possible IC given the IC
of the other person. A pareto optimal state is therefore a state such that changing the
state will at least make one person better off at the expense of the other. One is made
better off while the other is made worse off.

A line connecting all such points is called consumption contract curve (ccc). It is a
locus off all efficient allocation in consumption.

- 76 -
A long the c.c.c. the MRS for both persons is the same. When this condition is met,
then the first condition for social welfare maximization has been achieved i.e.

MRS12A = MRS12B

Generally:

MRS12A = MRS12B = MRS12C = ... = MRS12n

By definition, a pareto efficient allocation makes each agent as well-off as possible

given the utility of the other agent. Let u be the utility level for agent B, so how can
agent A be made as well-off as possible?

The maximization problem is:

MaxUA ( X 1A , X A2 )
st
UB ( X B1 , X B2 ) = U
X 1A + X B1 = W 1
X A2 + X B2 = W 2

Where.

W 1 = W A1 + WB1 is the total amount of good 1 available and W 2 = W A2 + WB2 is the total
availability of good 2.

( )
We then seek to find X 1A X A2 X B1 X B2 i.e. X A and X B that makes person B’s utility,
and given that the total amount of each good used is equal to the amounts available.

We can write the langrangian for this problem as:

- 77 -
 ( )  ( )  ( ) (
L = UA X 1A X A2 −  UB X B1 X B2 − U − 1 X 1A + X B1 − W 1 −  2 X A2 + X B2 − W 2 )

 is the language multiplier on the utility constraint and  ' s are the language
multipliers of the resource constraints.

Getting the FOC’s.

L UA
= − 1 = 0..................................... ( I )
X 1A X 1A
L UA
= − 1 = 0..................................... ( II )
X A2 X A2
L UB
= − 1 = 0..................................... ( III )
X B1 X B1
L UB
= − 2 = 0..................................... ( IV )
X B2 X B2

If we divide the first equation by the second and the third equation by the fourth we
have:

UA UA 1 1
=  MRS 12
A =
X A X A  2
1 2
2
UB UB 1 
=  MRS B12 = 1
X B X B  2
1 2
2
At a pareto efficient allocation the MRS between the two goods must be the same.

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