Course Contents

Page No.

Block 1 CONSUMER THEORY 7

UNIT 1 Preferences and Utility 9
UNIT 2 Consumer’s Equilibrium 25
UNIT 3 Consumer’s Surplus 53
UNIT 4 Choice under Uncertainty and Intertemporal Choice 74

Block 2 PRODUCTION AND COST 101

UNIT 5 Production Function with One and More Variable Inputs 103
UNIT 6 Cost Function 131

Block 3 EQUILIBRIUM UNDER PERFECT COMPETITION 147

UNIT 7 Profit Maximisation by a Competitive Firm 149
UNIT 8 Efficiency of a Competitive Market 182

KEY WORDS 200

SOME USEFUL BOOKS 208
COURSE INTRODUCTION: INTERMEDIATE
MICROECONOMICS-I
Economics is a live subject and helps the economic agents in their decision making like:
Which commodities to produce? How to produce? Which techniques to use? Which
factors or resources to use, in which combinations to produce? What quantity of a
commodity to produce? How consumers make purchasing decisions and how their
choices are affected by changing prices and incomes? How firms decide how many
workers to hire and how workers decide where to work and how much to work?
Basically, it involves analysing the rational choice behaviour of individual economic
agents.
This course on Intermediate microeconomics builds up on the Principles of
Microeconomics course studied in Semester 1 and provides an analysis of how the
economic theory developed can be directly applied to help economic agents in taking
decisions pertaining to maximising utility, minimising cost, maximising profit, taking
output or pricing decisions, etc. It achieves this through combining microeconomic theory
with the application part using graphical analysis, algebra and calculus. In order to grasp
this course well, a student is expected to have passed an introductory microeconomics
course, and have some working knowledge of calculus (mostly derivatives), basic algebra
and graphing skills.
The course structure is divided into 3 Blocks. Each block is further sub-divided in a
number of Units. Each Unit in itself is self-contained and has organic linkages with all
other Units. Throughout the course, in each unit, student will encounter a synchronized
set of introductory theory, illustrative examples and check your progress exercises—
designed to provide conceptual clarity to the student. In a way, this allows students
to develop their abilities to evaluate, analyse and synthesise economic information.
The course broadly throws light on the consumer and producer theory, along with
analysing the optimising behaviour of consumers and firms. It also takes up discussion on
a competitive market structure and shed light on the efficiency status of it towards the
end. The other market structures (like Monopoly, Monopolistic competition, Oligopoly)
are discussed in Intermediate Microeconomics Part II that you will come across in
Semester IV.
Unit 1 introduces consumer’s theory with a discussion on consumer’s preferences and
utility. Unit 2 integrates the concepts discussed in Unit 1 and illustrates consumer’s
equilibrium using both the graphical and Lagrangian methods. Further it covers, how a
commodity and income tax impact consumer’s equilibrium, and how changes in
commodity price and income influence consumer’s equilibrium (using both Slutsky’s and
Hicksian’s approach). Unit 3 explains the concept of consumer’s surplus, while Unit 4
discusses choice under uncertainty and inter-temporal choice. Producer’s theory begins
with Unit 5 which covers a discussion on the firm's production functions, the condition of
producer’s equilibrium and technological progress. The cost function, the condition of
cost minimisation and factor demand functions have been covered in Unit 6. This lays the
foundation for the study of behaviour of firms under different forms of market structure.
For this semester we have restricted ourselves to the perfect competitive market in Unit
7. Finally, Unit 8 of the course concludes with a discussion on the concept of efficiency or
Pareto optimality, and analyses on the efficiency of a competitive market.
 Mathematical Symbols/ Notations used in the Course
Symbol Symbol Name/Meaning Attached Usage
≻ Weak Preference A ≻ B, alternative A is weakly preferred to B
∼ Indifference A ∼ B, consumer is indifferent between
alternative A and B
≻ Strict Preference A ≻ B, alternative A is strictly preferred to B
>; <; ≥; ≤ Greater than; Less than; Greater A > B, A is greater than B; A < B, A is less than
than or equal to; Less than or B; A ≥ B, A is greater than or equal to B; A ≤ B,
equal to, respectively A is less than or equal to B, respectively

[a, b] Closed interval [0, 2], an interval containing the set of real
numbers that lie between numbers 0 and 2,
including the numbers 0 and 2 themselves.
(a, b) Open interval (0, 2), an interval containing the set of real
numbers that lie between numbers 0 and 2, and
not the numbers 0 and 2.
∈ Element of t ∈ [0,1], t is an element of the closed interval
[0,1]
Δ Delta/Change in ΔX, change in value of X
dx Differential dx, represents an infinitely small change in the
variable x
⇒ Implies A⇒B, if A is true, then B is also true
F(.) or f (.) A function F(x) or f (x), a function of x
F′(x) or y′ or First-order derivative Given y = F(x)—y a function of x,
�� ��
��
F′(x) or y′ or �� represent first-order derivative
of function F(x) with respect to x
F′′ (.)or y′′ or Second-order derivative Given y = F(x)—y a function of x,
�� � �� �
�� �
F′′ (.)or y′′ or �� � represent second-order
derivative of function F(x) with respect to x
lim �(�) Limit lim �(�), limit value of function f(x) as x
∆�→ � ∆�→ �
approaches 0.
��(�,�)
or
�� Partial derivative Given y = f (x, y)—y a function of x and y,
�� �� ��(�,�) ��
��
or �� represent partial derivative of
function f (x, y) with respect to x
ln Natural log lnx, log of x to the base e, where e = 2.718…
� Definite Integral �
�� �(�)�� �� �(�)�� = F(b) – F(a), where F′(x) = f(x)

Some Greek Alphabets (and corresponding symbols) you may encounter:

Symbol Greek Alphabet Symbol Greek Alphabet
α Alpha θ Theta
β Beta λ Lamda
γ Gamma π Pi
δ Delta σ Sigma
ε Epsilon χ Chi
Ψ Psi μ Mu
� Rho � Omega
 Block 1
Consumer Theory
 Preferences and Utility
UNIT 1 PREFERENCES AND UTILITY
Structure
1.0 Objectives
1.1 Introduction
1.2 Consumer’s Preferences
1.2.1 Weak and Strict Preferences
1.2.2 Assumptions about Preferences
1.2.3 The Indifference Curve
1.2.4 Well-behaved Preferences
1.2.5 Marginal Rate of Substitution (MRS)
1.2.6 Properties of Indifference Curves

1.3 Utility
1.3.1 Utility Function and Preferences
1.3.2 Utility Function and Indifference Curve
1.3.3 Marginal Utility (MU)
1.3.4 Relationship between MU and MRS
1.3.5 Utility Functions and Underlying Indifference Curves: Some Examples

1.4 Let Us Sum Up

1.5 References
1.6 Answers or Hints to Check Your Progress Exercises

1.0 OBJECTIVES
After going through this unit, you should be able to:
• justify why a consumer prefers a particular bundle over the other
available bundle;
• differentiate between weak and strict preferences;
• analyse the assumptions regarding well-behaved preferences;
• define marginal rate of substitution and underline importance of it for
analysing consumers’ behaviour;
• define properties of an indifference curve;
• establish link between a Utility function and Preference relation;
• construct an indifference curve from the given utility function;
• explain the link between the marginal utilities and the marginal rate of
substitution; and
• figure out some examples of the utility functions and the underlying
indifference curves.

9
Consumer Theory
1.1 INTRODUCTION
You were comprehensively introduced to the concepts of consumer
behaviour through cardinal and ordinal approaches in Units 4 and 5 of your
Introductory Microeconomics course of Semester 1 (BECC-101). The present
unit makes use of that theory base and the mathematical techniques you
came across in your Mathematical Methods in Economics course of
Semester 1 (BECC-107) for examining the economic behaviour of the
consumer. A consumer, be it an individual or a household, makes decision
regarding which commodity or service to be purchased and in what
quantities. What guides this decision making? Why does a consumer
purchase a certain bundle of commodities? We know that he gets
satisfaction or utility from consumption of commodities, but there also exist
alternatives which can give him similar satisfaction. So why does our
consumer choose a particular bundle of commodities over the other
available bundles? What determines the preference behaviour? We shall
discuss various aspects of preferences in Section 1.2.
A consumer derives utility or satisfaction from consumption of commodities.
The extent of satisfaction can be estimated by a utility function, which gives
an ordinal value to the consumption of a particular bundle of commodities.
In the subsequent section, you will come across a concept like utility
function, representing a specific preference relation. After deriving an
expression for marginal utility, a relationship between the marginal rate of
substitution and the marginal utilities will be established. The discussion
will end with some examples of utility functions and the underlying
indifference curves— both representing the same preference ordering.

1.2 CONSUMER’S PREFERENCES

A consumer makes decision about allocating his limited income among
available goods in order to obtain maximum satisfaction or utility. For this,
he/she chooses the best commodity bundle that he/she can afford. The
affordability is determined by the budget constraint the consumer faces—
which, in turn, depends upon his/her income and prices of the commodities;
while the choice of the best bundle is guided by consumer’s preferences.
Preferences are subjective individual tastes that permit a consumer to rank
different bundles of goods on the basis of the utility they give to the
consumer. Independent of consumer’s income and goods’ prices,
preferences establish the relationships between the bundles of the
commodities that a consumer faces. Assuming N commodities available for
consumption, a commodity bundle is given by, A = (x1, x2, x3,…,xN), where xi
with i = 1,2,3,..N represents respective quantity of good 1,2,3, …,N. Given
two bundles, A and B, if a consumer opts for bundle A when bundle B is
available, then clearly bundle A is preferred to bundle B by this consumer.
Please note — preferences establish relationship between bundles of
commodities and not among individual commodities.

10
The consumer may prefer bundle A strictly over bundle B, or he/she might Preferences and Utility

regard bundle A at least as good as bundle B (that is, not inferior to B).
There may be a possibility that consumer fails to prefer bundle A over B—
he/she may find them as good as one another. We are going to use certain
symbols to denote various notions of preferences.

1.2.1 Weak and Strict Preference

Weak Preference : When a consumer considers bundle A to be at least as
good as bundle B, we say he weekly prefers bundle A over B. Symbolically,
this is denoted by: A ≻ B
Indifference: When both bundles A and B are regarded as good as one
another. That is:
A ≻ B and B ≻ A
We say that consumer is indifferent between bundle A and B, denoted by:
A∼B
Strict Preference: When bundle A is regarded as superior to B, then the
relationship is that of strict preference, represented by: A ≻ B
So, if A ≻ B and neither A ∼ B nor B ≻ A, then we have A ≻ B, or in words, “A
is strictly preferred over B”.

1.2.2 Assumptions about Preferences

Here, we are specifying certain assumptions about preferences. These
assumptions help us in developing the theory of consumers’ choice in a
systematic manner. Preferences exhibit three important properties. They
are:
• Completeness
• Reflexivity
• Transitivity
Completeness
By completeness it simply means, available bundle options can be
compared. That is, for bundles A and B, either A ≻ B, or B ≻ A, or both (i.e.,
A ∼ B). This means that it is always possible for a consumer to say whether
or not he/she would prefer one bundle to another. There is no gap in the
choice set, the consumer can make unambiguous choices on the assumption
that he/she does not suffer from lack of information about the bundles
he/she is asked to make a choice from.
Reflexivity
For any bundle A, A ≻ A. That is to say, any bundle A is at least as good as
itself.
Transitivity
If bundle A is at least as good as bundle B, bundle B is at least as good as
bundle C, then bundle A is at least as good as bundle C. Symbolically, 11
Consumer Theory If A ≻ B and B ≻ C
Then, A ≻ C
If this condition is not satisfied the consumers’ behaviour may suffer from
irrational preference circularity, he may end up saying A ≻ B and B ≻ C but C
≻ A!
Given this background we can move into depiction of preferences with help
of indifference curves.
Please Note: You were comprehensibly introduced to the concepts related
to consumer theory in your Introductory Microeconomics course of
Semester 1. We briefly present some concepts and theory here.

1.2.3 The Indifference Curve

Indifference curve is a locus of all the combinations of two goods that
provide a constant level of satisfaction or utility to a consumer. Consider
Fig. 1.1 below. Here combination bundles represented by point A, B, C give
the consumer same level of utility, so that A ∼ B ∼ C.

B
C
IC
0 X
Fig. 1.1: An Indifference Curve

In Fig. 1.2 (a) and (b), we represent the set of bundles (given by the shaded
region) weakly preferred to bundle A, and the set of bundles strictly
preferred to bundle A, respectively. As you may notice,
In part (a) indifference curve forms the part of the set (the shaded area) of
the bundles weakly preferred to bundle A. For instance, consumer will be
indifferent between bundle B which belongs to this set and bundle A, as
both are a part of the indifference curve, whereas bundle C which also is a
part of this set, will be strictly preferred to bundle A or B, as it contains more
of both the goods (X and Y) than is contained in bundles A or B.
In part (b) indifference curve is not included in the set (the shaded area) of
bundles strictly preferred to bundle A, to show which we have constructed a
dotted curve. Here, consumer is indifferent between bundle A and B, the
reason bundle B does not forms the part of the set of bundles strictly
preferred to bundle A. Bundle C on the other hand is strictly preferred to
bundle A and thus forms the part of this set.

12
 Preferences and Utility
Y Y

A C A C

B B
IC IC
0 X 0 X
Fig. 1.2 (a): Set of Bundles Weakly Fig. 1.2 (b): Set of Bundles Strictly
preferred to A preferred to A

Indifference Map
Entire set of indifference curves reflecting tastes and preference of a
consumer in the form of different utility levels for the two goods is referred
to as the indifference map. In Fig. 1.3, IC1, IC2, IC3 represent such a set.

Fig. 1.3: Indifference Map

1.2.4 Well-behaved Preferences

In addition to the assumptions of reflexivity, transitivity and completeness,
we usually make two further assumptions about consumers’ well-behaved
preferences. A preference relation is said to be “well-behaved” if it is
monotonic and convex.
i) Monotonicity: Monotonic preference means that a rational consumer
always prefers more of a commodity as it offers him a higher level of
satisfaction. Monotone preferences essentially say that "more" is
preferred to "less".
A consumer’s preferences are said to be weakly monotonic if, given a
consumption bundle A (X1, Y1), the agent prefers all consumption
bundles B (X2, Y2), that have more of every good, �.�., X2 > X1 and Y2 >
Y1 (� ��� ��������� ���������) implies B ≻ A. A consumer's
preferences are said to be strongly monotonic if, given a consumption
bundle A (X1, Y1), the agent prefers all consumption bundles B (X2, Y2) 13
Consumer Theory that have more of at least one good, and not less in any other good,
�.�., either X2 > X1 and Y2 = Y1 �� X2 = X1, Y2 > Y1 (� ��� ���������
���������) imply B ≻ A. This assumption simply says— “the more,
the better”, so that a consumer prefers consuming more of a good to
consuming less of it. That is, considering two bundles A and B, with
bundle B having at least as much of all the goods as bundle A, and
more of one, then B ≻ A. This implies that indifference curve has a
negative slope. You may observe this yourself (just think of a positively
sloped indifference curve representing bundles of commodities with
more of both the goods).
Note that, assumption of monotonicity cannot determine the order of
two bundles if one bundle has higher quantity of some commodities
and smaller quantity of others.
ii) Convexity: The assumption of convexity says that weighted average of
commodity bundles is preferred to extreme bundles. Consider two
commodity bundles A and B on the indifference curve in Fig. 1.4.
Weighted average of these bundles will be given by any point
(depending upon the weight given to extreme bundles) on the line
connecting both of them. As you may notice, the weighted average
points lie on the area representing bundles which are preferred to the
indifference curve on which extreme bundles (A and B) lies. This
explains why consumer prefers weighted average to extremes. The
assumption of convexity implies consumer’s preference is subject to
diminishing marginal utility.
Symbolically, bundle C, where C is given by tA + (1 – t)B or [tX1 + (1 –
t)X2 , tY1 + (1 – t)Y2] with t ∈ [0,1] will be preferred to bundle A (X1, Y1)
or B (X2, Y2).

Y1 A

C [tX1 + (1 – t)X2 , tY1 + (1 – t)Y2]

B
Y2
IC
0 X1 X2 X
Fig. 1.4: Convex preferences

1.2.5 Marginal Rate of Substitution (MRS)

MRS is the rate at which consumer is willing to trade-off consumption of one
commodity for consumption of the other, without affecting his level of
satisfaction. Consider Fig. 1.5, suppose consumer is initially consuming
bundle A. If he increases consumption of good Y by ΔY and reduces that of
good X by ΔX, then marginal rate of substitution between good X and Y
��
(MRSXY) will be given by ��.
14
. Preferences and Utility
Y

E
∆�
A
∆�
IC

0 X
Fig. 1.5: Marginal Rate of Substitution

��
If we allow ΔX and ΔY to be very small, the ratio �� will approach slope of IC
��
at point E, which is then given by the slope of the tangent (i.e. ��) to the
point E. Thus, with infinitesimal small ΔX and ΔY, MRSXY represent slope of
indifference curve at a point. Mathematically,
∆� ��
MRSXY = − lim∆�→ � ∆� = − ��
∆�
That is, MRSXY represents the limiting value of the ratio ∆� as the
denominator approaches zero. As you may notice, we have inserted a
negative sign in order to get MRSXY as a positive quantity. This is done
��
because indifference curve is negatively sloped with ratio �� already
possessing a negative sign.

1.2.6 Properties of Indifference Curves

1) Indifference curves are negatively sloped.
2) Indifference curves describing two distinct levels of utility cannot
intersect or cross each other. This is a result of the transitivity
assumption.
Proof: Consider Fig. 1.6, where we have two intersecting alleged ICs, IC1
and IC2. Consider points A and B, they lie on IC2 therefore, A ∼ B.

Fig. 1.6

15
Consumer Theory But A and C lie on IC1, therefore A ∼ C. However, B lies to North-east of
C, therefore B ≻ C. Hence we have a contradiction: A ∼ C and A ∼ B ⇒
B ∼ C (from transitivity assumption), but B ≻ C. Both these statements
cannot hold together. Therefore, IC1 and IC2 cannot intersect.
3) An indifference curve is usually convex to the origin. That is, slope
diminishes as consumer substitute commodity X for commodity Y. This
results from the fact that MRSXY falls as we move down along an
indifference curve. As more and more units of commodity X are
consumed, consumer is willing to give up lesser and lesser units of
commodity Y. The reason for this is that marginal utility from
consumption of a good falls as more and more units of it are consumed.
So with increase in consumption of X, marginal utility of it falls, while
marginal utility of commodity Y rises, resulting in consumer’s willingness
to give up fewer units of Y for X.
Check Your Progress 1
1) Differentiate between strict and weak preference.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
2) Explain the three important properties of preferences with examples.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
3) Explain the properties of indifference curves?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
4) What is the notion of:
i) Convexity
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
ii) Monotonicity
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

16
 Preferences and Utility
1.3 UTILITY
Synonymous with “satisfaction”, “well-being”, “pleasure”, etc., the concept
of utility has evolved over time in economic literature. Alfred Marshall
considered utility to be real, measurable, i.e. of cardinal scale. He had
assumed that utility accruing to a consumer from consumption of a unit of a
commodity could be measured in terms of a cardinal number having the
unit called ‘util’. But the problem in this approach was that of unavailability
of an appropriate measurement index giving that cardinal number. For
instance — whether 1 util for consumer A is equivalent to 1 util for
consumer B? or does increasing utility from 1 to 2 utils indicate doubling of
the utility attained? — are some of the issues left unsolved by the cardinal
approach. Ordinal approach by J.R. Hicks, being unit-free, was able to
overcome these problems, by way of ‘ranking’ and ‘preference-ordering’
bundles. According to this approach, one could ‘order’ different bundles as
‘better’, ‘worse’, or ‘as good as’, but saying nothing about the strength of
the preferences.

1.3.1 Utility Function and Preferences

A utility function (U) defines the level of utility attained by a consumer as a
function of the amount of commodities consumed by him. The function
takes the following form:
U1 = U(X, Y)
where X and Y represent the quantities of commodities consumed by the
consumer, and U1 is the utility level (a number) obtained from consuming
this commodity bundle.
The utility function can be derived from preferences, or in other words,
preferences can be represented by utility functions. The function U assigns
values to different bundles that exactly reflect consumer’s preferences, that
is,
U(A) ≻ U(B) if and only if A ≻ B
Now, here A and B represent bundles of commodities X and Y.
As you may notice above, the preference relation among the bundles is
preserved by the utility function. That is, if a consumer weakly prefers
bundle A to B, then utility obtained from consumption of bundle A will not
be less than that obtained from consumption of bundle B. For utility
function to represent preference ordering, preference relation must be
complete, transitive, reflexive, and continuous. By continuity it means that
the preference relation has "no jumps”, that is, if bundle A is strictly
preferred to B, then bundles “close to” A are also preferred to B.
Remember: Values given by utility functions only have ordinal meaning,
that is, only the ordering of the numbers matter and not the cardinality (the
difference between the numbers). It simply means a utility function U
representing preference for bundles A, B and C by assigning utility numbers
as U(A) = 1, U(B) = 2 and U(C) = 3, will represent the same preferences if
17
Consumer Theory utility numbers would have been U(A) = 1, U(B) = 1.5 and U(C) = 2. This
implies that same preferences could be represented by many utility
functions.
Relation between two Utility functions representing same Preferences:
Considering two utility functions— U and V. They both will represent same
preference if and only if, there exists a strictly increasing function F such
that
V = F (U), such that F′(U) > 0
For instance, if we define V= U + C, where C is any constant, then V(A) ≻
V(B) if and only if U(A) ≻ U(B), if and only if A ≻ B. Function V is any
transformation of function U that leaves the preference ordering
representation intact. Such transformations are called monotonic
transformation. Thus, if a utility function represents a consumer’s
preferences, then a monotonic transformation of that utility function will
result in another utility function representing the same preferences.

1.3.2 Utility Function and Indifference Curve

We just discussed— a utility function U1 = U(X, Y) represents the preferences
of a consumer. Also, we know that an Indifference curve links bundles which
yield the same level of utility. Thus, an indifference curve can be graphically
represented by a function of quantities of two commodities yielding same
level of utility, or in other words, a representation of a utility function with a
given level of utility value. We can obtain such a function by setting U1 on
the left-hand side of the utility function equal to some constant value, like
10, 12, etc. and then express Y as a function of X. Let us consider an
example:
Let our utility function be given by, U(X, Y) = XY, setting it equal to a constant
number ‘K’, we get,
XY = K
�
It can be solved for Y, such that Y = �

Now, for different levels of K, i.e. 1, 2, 3, we can obtain a set of indifference

curves, which constitute our indifference map in Fig. 1.7.

Fig. 1.7

18
 Preferences and Utility
1.3.3 Marginal Utility (MU)
Marginal utility is the change in total utility resulting from a small change in
the quantity of one of the commodities consumed holding constant the
quantity of the other commodity. For a given utility function U(X,Y),
marginal utility with respect to commodity X will be given by,
� �(����,�)� �(�,�)
MUX= lim∆�→� Δ� = lim ��
∆�→�

This implies, change in total utility resulting from change in consumption of

commodity X, ΔU = MUX ΔX
Similarly, marginal utility with respect to commodity Y will be given by,
� �(�,�� �)� �(�,�)
MUY = lim Δ�
= lim Δ�
∆�→� ∆�→�

With change in total utility resulting from change in consumption of

commodity Y,
ΔU = MUY ΔY
When ΔX and ΔY approaches zero, or in other words, when change in the
commodities become infinite small, then the marginal utilities are derived as
a partial derivative of the utility function with respect to X in case of MUX
and with respect to Y in case of MUY, that is
��(�,�) ��(�,�)
MU� = ��
and MU� = ��

Remember: The magnitudes of MU will depend upon the specific utility

function reflecting consumer’s preference behaviour, that is, their own
magnitude will have no particular significance. Despite having no
behavioural content of its own, the MU can help in calculating something
with behavioural content. This is marginal rate of substitution (MRS).

1.3.4 Relationship between MU and MRS

Indifference curve is a locus of those bundles of X and Y which give same
level of utility or satisfaction to our consumer. Therefore, it can be
represented in a functional form:
U(X, Y) = U1
where U1 represents a given utility level.
Differentiating this function totally, we get
�U(X, Y) ∂U(X, Y)
. dX + dY = dU�
�X ∂Y
As utility remains constant along an IC, therefore dU� will be 0.
MU� dX + MU� dY = 0
��(�,�) ��(�,�)
[where MU� = ��
and MU� = ��
]
or MU� dX = − MU� dY
19
Consumer Theory

��� ��
or ���
= − �� = MRSXY

This makes possible another interpretation of the MRS. Marginal Rate of

Substitution is ratio of marginal utilities of the two goods.

1.3.5 Utility Functions and Underlying Indifference Curves:

Some Examples
Let us now consider some examples of utility functions and the underlying
indifference curves:
Perfect Substitutes
Commodities which are Perfect substitute to each other are said to have a
constant rate of trade-off (MRSXY) between them. Utility function in this case
takes the form:
U(X, Y) = aX + bY, where a, b > 0
where ‘a’ units of X can be substituted for by ‘b’ units of Y. Now,
��(�,�) ��(�,�)
MU� = �� = a and MU� = �� = b

slope is given by
�� �
MRSXY = ��� ⟹ MRSXY = � (which is a constant, independent of X and Y)
�

�
Underlying indifference curve will be linear with a constant slope, − � (refer
Fig.1.8)
Y

�
Slope =−
�

IC1 IC2 IC3

0 X
Fig.1.8: Indifference Curves when goods are Perfect Substitutes

Perfect Compliments
When commodities are perfect compliments, they are consumed in fixed
proportion (not necessarily 1:1). Utility function takes the form:

U(X, Y) = min (aX, bY), where a, b > 0

Indifference curves will have L-shape with kinks at points A, B, C, where aX =

bY (refer Fig. 1.9). MRSXY equals 0 along the vertical part of the curve, and
infinity along the horizontal part of the curve, whereas, along the kinks,
MRSXY is not defined (as you may notice no unique tangent can be drawn at
20 the kinks).
 Preferences and Utility
Y
aX = bY

IC2
IC1

0 X
Fig. 1.9: Indifference Curves when goods are Perfect Complements

Cobb-Douglas
Cobb-Douglas utility function is used very often in economic analysis. It is
specified as:
U(X, Y) = Xc Yd
where positive numbers c, d, describes relative importance of the
commodities.
�� ����� �� � �
MRSXY = ��� ⟹ MRSXY = ��� ���� = � �
�

In the utility function U(X, Y) = Xc Yd, let the utility level be K, i.e. we have K =
Xc Yd ⟹ Y = K1/d X– c/d . Substituting value of Y in expression for MRSXY, we get
�
MRSXY = � K �⁄� X �(���)⁄�
����
Here MRSXY decreases ( �� �� < 0) with increase in X, that is, MRSXY is
diminishing as we move down the indifference curve, resulting in convex-
shaped ICs. General shapes for Cobb-Douglas indifference curves are
indicated in Fig. 1.10a and 1.10b. Note that shapes vary as per relative
magnitudes of c and d.

Fig. 1.10 (a) Fig. 1.10 (b)

One reason for popularity of C-D indifference curves is that these are well
behaved indifference curves. The formula U = Xc Yd, where c + d = 1 is the
21
Consumer Theory simplest algebraic expression that generates well-behaved ICs. Their
monotonic transformation will also give same well behaved set of ICs. For
example: if we have U(X, Y) = Xc Yd, then a utility function given by V = ln [U
(X, Y)] ⟹ V= ln (Xc Yd) = c lnX + d lnY gives the same preference relation or
set of ICs. We can generate similar ICs through another transformation.
We have U(X, Y) = Xc Yd
�
Raising utility function to the power ���, we get

[U(X, Y)]1/(c+d) = Xc/(c+d). Yd/(c+d)

� � �
Assuming a = ���, then 1– a = 1– ��� = ���

Now, we can rewrite the above function as

U(X, Y) = Xa Y1-a
Thus, a monotonic transformation of a Cobb-Douglas utility function will be
Cobb-Douglas function whose exponents add up to unity.
Quasi-linear
Quasi-linear utility function is a function which is linear in one commodity
(let say Y) and non-linear in the other (here X), that reason it is called quasi-
linear. The function is given by

U(X, Y) = f (X) + Y ; f′(X) > 0, �′′(X) < 0

��
Now, MRSXY will be given by, MRSXY = ��� ⟹ MRSXY = fˊ(X).
�

Note here that MRSXY only depends upon X and not on Y; hence ICs are
parallel shifts of each other as shown in Fig. 1.11.

IC3
IC2
IC1

0 X
Fig. 1.11 : Quasi-linear (non-linear in X here)

An example of a quasi-linear function could be, U(X, Y) = ln X + Y, where ‘ln’

�
represents ‘natural log— log to the base e’. Here, MRSXY = �.

22
Check Your Progress 2 Preferences and Utility

1) Distinguish between cardinal and ordinal utility.

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
2) A preference relation, in order to be represented by a utility function
must satisfy what all properties?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
3) Derive the relation between the Marginal rate of substitution and the
marginal utilities.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

1.4 LET US SUM UP

The unit has described the theory of consumer’s preferences. We had some
detailed discussion about the concepts related to the preferences. We
distinguished between weak and strict preferences, defined the notion of
indifference curves and map, discussed assumptions about preferences, and
particularly about well-behaved preferences. All this has set forth the base
for analysing a particular preference behaviour of a consumer.
After some brief introduction of the concept of utility, we came across the
function that assigns a numerical value corresponding to the level of utility
obtained from consumption of commodities bundles — called the utility
function. We established the link between the utility function and the
indifference curve, as both represented the same preference ordering.
Subsequently, the concept of marginal utility was explained, and further to
this, relationship between marginal rate of substitution and marginal
utilities was derived. We concluded the unit by presenting some examples
of utility functions along with the underlying indifference curves, with both
representing the same preference relation.

1.5 REFERENCES
1) Varian, HR, (1999). Intermediate Microeconomics: A Modern Approach
5th Edition.
2) Newman , Peter, (1965). Theory of Exchange.

23
Consumer Theory
1.6 ANSWERS OR HINTS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1) Strict preference: A is at least as good as B and B is not at least as good
as A. Weak preference: A is at least as good as B but A need not be
superior to B.
2) Reflexivity, for all A, A ≻ A.
Completeness, for all A, B either A ≻ B or B ≻ A;
Transitive, for all A, B and C, if A ≻ B and B ≻ C then A ≻ C
3) A normal well-behaved indifference curve is:
i) Higher Indifference curve indicate higher level of utility;
ii) Monotonically sloping downwards to the right;
iii) Convex to the origin; and
iv) Two indifference curves do not touch or intersect.
4) Refer Sub-section 1.2.4 and answer.
Check Your Progress 2
1) Cardinal Utility: Utility is exactly measurable, Ordinal utility: Utility is not
exactly measurable but ordered so that one can compare utilities from
two bundles and say which one is giving higher satisfaction.
2) For utility function to represent preference ordering, preference
relation must be complete, transitive, reflexive, and continuous.
3) Refer Sub-section 1.3.4 and answer.

24
 Consumer’s
UNIT 2 CONSUMER’S EQUILIBRIUM Equilibrium

Structure
2.0 Objectives
2.1 Introduction
2.2 The Concept of Consumer’s Equilibrium
2.3 Consumer’s Equilibrium with the Method of Lagrangian Multiplier
2.3.1 The Equi-marginal Principle
2.3.2 Marginal Rate of Substitution
2.3.3 Marginal Utility of Income
2.3.4 Indirect Utility Function and Expenditure Function

2.4 Consumer’s Equilibrium with Income Tax vs Quantity Tax

2.5 Consumer’s Equilibrium with Change in Price
2.5.1 Slutsky’s Approach
2.5.2 Hicksian Approach
2.5.3 Estimation of Substitution and Income Effect through Slutsky’s and Hicksian
Approach

2.6 Consumer’s Equilibrium under Special Circumstances

2.6.1 Perfect Complements
2.6.2 Perfect Substitutes
2.6.3 Quasi Linear Preferences

2.7 Let Us Sum Up

2.8 References
2.9 Answers or Hints to Check Your Progress Exercises

2.0 OBJECTIVES
After going through this unit, you will be able to :
• state the concept of consumer’s equilibrium;
• find out the optimal consumption bundle of the consumer using the
Lagrangian method;
• describe the indirect utility function, the expenditure function, the equi-
marginal principle, marginal rate of substitution and the marginal utility
of income;
• critically analyse the consumer’s equilibrium in the real world
phenomena;
• discuss the impact of economic policy tool such as taxes on the
consumer’s equilibrium;
• use Slutsky’s and Hicksian approach to decompose the price effect into
income effect and substitution effect; and 25
Consumer Theory
• explain the extent of substitution and the income effect of a price
change in case of perfect substitutes, perfect compliments and quasi-
linear preferences.

2.1 INTRODUCTION
How does a consumer with a limited income decide which goods and
services to buy, constitutes the essence of consumer behaviour. In this
context it becomes relevant to know how consumers allocate their incomes
across goods and services. This, in turn, enables us to know how changes in
income and prices affect the demand for goods and services. To answer
these questions you need to be exposed to the consumer preferences,
budget constraints and consumer choices. Hence all these three concepts
have been explained in Unit 1.
We have learned in the previous unit that consumers as an economic agent
have preferences among the various goods and services available to them.
Further they face budget constraints which put limits on what they can buy.
In this unit we shall explain the consumer’s optimisation (consumer’s
equilibrium) i.e. how the consumers decide which combination of goods and
services to buy, given their income and prices so as to maximise their
satisfaction, pre-supposing that consumers are rational and well informed.
For this purpose we shall illustrate the application of Lagrangian method.
The impact of income tax vs commodity tax on consumer’s equilibrium will
be examined in the subsequent section. How the changes in price and
income influence the consumer’s equilibrium have also been elaborated
with the help of Slutsky’s approach and Hicksian’s approach.
Let us begin with explaining the concept of consumer’s equilibrium.

2.2 THE CONCEPT OF CONSUMER’S EQUILIBRIUM

This section focuses on what are thought to be fairly common factors that
influence consumer behaviour. Two factors are emphasised. First is the
objective ability of the consumer to acquire goods, which is determined by
income and by the prices of the goods. Second are the subjective attitudes,
or tastes, of the consumer concerning the relative desirability of various
combinations of goods and services. Indifference curves represent the
consumer’s subjective attitude towards various market baskets whereas the
budget line shows what market baskets the consumer can afford. Putting
the two pieces of apparatus together, we can determine what market
basket the consumer will actually choose.
The consumer is said to be in equilibrium when he maximises his
satisfaction, given his money income and the prices of the commodities he
consumes.
The following assumptions are made in order to explain how a consumer
reaches the equilibrium position:
1) The consumer acts rationally, that is, he is guided by the objective to
26 maximise his satisfaction.
2) The prices of the goods are given and remain unchanged. Consumer’s
Equilibrium
3) He has a given amount of money income to spend on the goods. There
are no savings.
4) The scale of preferences of the consumer for various combinations of
the two goods, X and Y, are represented by an indifference map, which
is defined by his utility function. This scale of preferences remains the
same throughout the analysis.
5) Each of the good is an economic ‘good’ and is assumed to be completely
divisible.
The two conditions need to be fulfilled for a consumer to be in equilibrium:
Necessary Condition
The budget line must be tangent to the indifference curve i.e.
�� ��
MRS�,� = ��� = ��
�

Marginal rate of substitution (MRS) is a measure of the consumer’s

subjective marginal benefit. On the other hand, the price ratio is effectively
a measure of marginal cost. At equilibrium, marginal benefit is equal to
marginal cost. This is necessary but not a sufficient condition for
equilibrium.
Sufficient Condition
At the point of tangency, the indifference curve must be convex to the
origin, that is, MRSxy must be diminishing at the point of tangency.
Graphically, given the indifference map of the consumer and his budget line,
the equilibrium is defined by the point of tangency of the budget line with
the highest possible indifference curve as is represented by point e* in Fig.
2.1. The consumer will reach equilibrium at point e* (i.e. he will purchase
OX* units of good X and OY* units of good Y) where the budget line RS is
tangent to the highest possible indifference curve IC2.

Fig. 2.1

27
Consumer Theory
i) The consumer would not like to choose a combination of X and Y
represented by point T or W (although they lie on the budget line RS),
because he will be on a lower indifference curve IC1 and would thus be
getting less satisfaction vis-à-vis point e*, which is on the same budget
line RS but on a higher indifference curve, IC2.
ii) The consumer cannot move to indifference curve IC3, as this is beyond
his means (money income) given by the budget line.
iii) Even on the indifference curve IC2, all other points, except e*, are
beyond his means.
Therefore, the optimal consumption position is where the indifference curve
is tangent to the budget line, given by e* = (X*, Y*), where
Slope of indifference curve = Slope of budget line
�
MRSxy = ��
�

2.3 CONSUMER’S EQUILIBRIUM WITH THE METHOD

OF LAGRANGIAN MULTIPLIER
The method of Lagrangian multiplier is a technique that can be used to
maximise or minimise a function subject to one or more constraints. The
aim of the consumer is to purchase some quantities of the two goods which
maximise his total utility i.e.
Maximise U(X, Y) (1)
subject to the constraint that all income is spent on the two goods:
Px X + Py Y = M (2)
Here, U(X, Y) is the utility function, X and Y the quantities of the two goods
purchased, Px and Py the prices of the goods, and M is the income.
This is a constrained optimisation problem which can be solved for optimal
quantities of the two goods (X* and Y*) through a mathematical technique
called Lagrangian method which is explained below:
1) Stating the Problem: First, we write the Lagrangian for the problem.
The Lagrangian is the function to be maximised or minimised (here,
utility is being maximised), plus a variable denoted by ‘λ’ times the
constraint (here, the consumer’s budget constraint), λ > 0.
The Lagrangian function is then given by
ℒ = U (X, Y) – λ (Px X + Py Y – M) (3)
Note that we have written the budget constraint as
Px X + Py Y – M = 0
i.e., entire income is exhausted in consumption of X and Y. We then
multiplied it by λ and subtracted it from U function.
28
2) Differentiating the Lagrangian: If we choose values of X and Y that Consumer’s
satisfy the budget constraint, then the second term in Equation (3) will Equilibrium

be zero. Maximising will therefore be equivalent to maximising U(X, Y).

By differentiating ℒ with respect to X, Y and λ and then equating the
derivatives to zero, we obtain the necessary conditions for a maximum.
You should note that these conditions are necessary for an ‘interior’
solution in which the consumer consumes positive amounts of both
goods. The solution, however, could be a “corner” solution in which all
of one good and none of the o�her is consumed. But the corner solution
cannot be solved by the Lagrangian technique. The implicit assumption
of Lagrangian technique is that the solution is interior.
The resulting equations from the first order conditions are:

�ℒ ��(�,�)
��
= ��
− λP� = 0 ⟹ MU� = λP�
�ℒ ��(�,�)
��
= ��
− λP� = 0 ⟹ MU� = λP� (4)
�ℒ
��
= P� X + P� Y − M = 0 ⟹ P� X + P� Y = M

�� (�,�)
Here as before, MU stands for marginal utility. That is, MUX = �� ,
the incremental change in utility from a very small increase in the
consumption of good X.
3) Solving the Resulting Equations: The three Equations in (4) can be
rewritten as
MUX = λPX
MUY = λPY (5)
PX X + PyY = M
Now we can solve these three equations for the three unknowns (X, Y and λ)
in terms of the parameters PX, PY, M. The resulting values of X and Y are the
solution to the consumer’s optimisation problem. Thus the utility
maximising quantities are X ∗( PX, PY, M) ��� Y∗( PX, PY, M). The functions
X∗and Y ∗, called the ordinary or uncompensated or Walrasian or Marshallian
demand functions, are the functions of own price (Px), cross price (PY) and
income (M) of the consumer.

2.3.1 The Equi-Marginal Principle

The third equation in the Equation set (5) is the consumer’s budget
constraint with which we started. The first two equations in (5) tell us that
each good will be consumed up to the point at which the marginal utility
from consumption is a multiple (λ) of the price of the good. To see the
implication of this, we combine these first two equations to obtain the equi-
marginal principle:

29
Consumer Theory ��� ���
λ= ��
= ��
(6)

In other words, the marginal utility of each good divided by its price is the
same. To optimise, the consumer must get the same utility from the last
rupee spent by consuming either X or Y. If this is not the case, consuming
more of one good and less of the other would increase utility.
To characterise the individual’s optimum in more detail, we can rewrite the
information in (6) to obtain
��� �
���
= �� (7)
�

In other words, the ratio of the marginal utilities is equal to the ratio of the
prices.
Disequilibrium Cases
�� �� � ��� ���
• If MRSxy > ��
⟹ �� � > �� ⟹ ��
> ��
, the consumer must increase
� �
the consumption of good X (as he obtains greater per rupee utility from
consumption of good X) till the equality between the MRSXY and the
price ratio is restored.
�� �� � ��� ���
• If MRSxy < ��
⟹ �� � < �� ⟹ ��
< ��
the consumer must increase
� �
the consumption of good Y (as he obtains greater per rupee utility from
consumption of good Y) till the equality between the MRSXY and the
price ratio is restored.

2.3.2 Marginal Rate of Substitution

An indifference curve is the locus of all possible commodity baskets that give
the consumer the same level of utility. If U* is a fixed utility level, the
equation of the indifference curve that corresponds to this utility level is
given by
U (X, Y) = U*
As the commodity baskets are changed by adding small amounts of X and
subtracting small amounts of Y, the total change in utility must equal to zero
along the indifference curve.
On total differentiating the above utility function we get,
�� ��
dX + �� = �� ∗
�� ��
Here, along an Indifference curve utility remains constant, that is, dU ∗ the
erefore,= 0.
Thus, we get MUX dX + MUY dY = 0 (8)
�� ��
where, ��
= MUX and �� = MUY
Rearranging,
�� ��
− �� = ��� = MRSXY (9)
�

30
where MRSXY represents the individual’s marginal rate of substitution of X Consumer’s
for Y. Because the left-hand side of (9) represents the negative slope of the Equilibrium

indifference curve, it follows that at the point of tangency, individual’s

MRSXY (which trades off goods while keeping utility constant) is equal to the
ratio of marginal utilities of the two goods X and Y, which in turn is equal to
the ratio of the prices of the two goods from Equation (7). When the
individual indifference curves are convex, the tangency of the indifference
curve to the budget line solves the consumer’s optimisation problem.

2.3.3 Marginal Utility of Income

Whatever be the form of the utility function, the Lagrangian multiplier λ
represents the extra utility generated when the budget constraint is
relaxed— in this case by adding one rupee to the budget. To show how the
principle works, we differentiate the utility function U(X, Y) totally with
respect to M:
�� �� ��
��
= ��� ���� + ��� ���� (10)

Substituting from (4) into (10), we get

dU dX dY
= λP� � � + λP� � �
dM dM dM
�� �� ��
��
= λ � P� ���� + P� ����� (11)

Because any increment in income must be divided between the two goods,
by differentiating the budget equation with respect to income (M) it follows
that
�� ��
1 = PX �� + PY�� (12)

Substituting Equation (12) in Equation (11), we get

��
��
= λ(1) = λ

Thus, the Lagrangian multiplier is the extra utility that results from extra
rupee of income.

2.3.4 Indirect Utility Function and Expenditure Function

When we plug the values of optimal quantities of both the goods, that is, X*
and Y* (or Marshallian/ Walrasian/ ordinary demand functions) into the
original utility function U(X, Y), we obtain the indirect utility function—a
function of prices and income only. That is,
V(PX, PY, M) = U[X∗(PX, PY, M), Y∗(PX, PY, M)]
where, V(�X, �Y, �) represents the indirect utility function, giving the
maximum utility that can be achieved given the prices (PX, PY) and income
levels (M). It is indirect because while utility is a function of the commodity
bundle consumed — X and Y, indirect utility function is a function of
commodity prices and income—PX, PY and M.
31
Consumer Theory
Instead of maximising utility [U(X, Y)] subject to a given income (M) we can
also minimise expenditure incurred on consumption of commodities (X and
� . In this case, the consumer
Y) subject to achieving a given level of utility U
optimises by spending as little money as possible to enjoy a certain utility
level. Formally, the optimisation exercise now becomes
Minimise Px X + Py Y
subject to the constraint of the given level of utility
�
U (X, Y) ≥ U
Solving the above optimisation problem using the method of Lagrangian like
we did in the case of utility maximisation yields Compensated or Hicksian
demand functions given by X∗(PX, PY, U � ) and Y∗(PX, PY, U
� ), which are a
function of prices (PX, PY) and given utility level (U � ). On plugging the
compensated demand functions into the objective function (PX X + PY Y), we
obtain the expenditure function E(PX, PY, U � )—a function of prices (PX, PY) and
� ). It measures the minimal amount of money required to
given utility level (U
buy a bundle that yields a utility of U�.

Example
Consider a Cobb-Douglas utility function
U (x1, x2) = x1αx2β
Assuming price of good x1 and good x2 to be P1 and P2, respectively and
income be M. Determine the optimal choice of consumption of goods x1 and
x2. Also find the expression for the indirect utility function.
Solution
Solving the problem using the equilibrium condition
��
����� �� =
��
�
�� (�� , �� )⁄� �� ������ ��
����� ,�� = − = −
�� (�� , �� )⁄� �� ���
��� ���

αx������ αx�
= − �����
⟹−
βx� βx�
�� �
Now, MRS�� �� = − ��� and slope of the budget line is − ��
� �

�� ���
Therefore, − ��� = ��
or – αx2P2 = – βx1P1
�

��� ��
���
= x� (13)

Equation of the budget constraint is given by P1x1 + P2x2 = M

On inserting the value of x1 from (13) in this constraint, we get
32
 ��� �� Consumer’s
P� � ���
� + P� x� = M
Equilibrium
��� ��
�
+ P� x� = M ⟹ αP� x� + βx� P� = Mβ

⟹ (α + �)x� P� = Mβ
� �
⟹ x� = ����� � (14)
�

Now, substituting value of x2 from (14) in Equation (13) we get

� �
��� � �
�����
x� = ���
= ����� �
�

� � � �
Therefore, x� = ��� . � and x� = ��� . � are the ordinary or Walrasian or
� �
Marshallian demand functions.
For Indirect utility function, substitute the optimal values of x1 and x2 in the
original utility function U (x1, x2) = x1αx2β . Thus, expression for Indirect utility
function is given by,
V(P1, P2, M) = U[x1(P1, P2, M), x2(P1, P2, M)]
� � � � � �
⟹ V(P , P2, M) = ������ � � ������ � �
� �

� ��� � � � �
⟹ V(�1, �2, �) = ����� �� � �� � is the required indirect
� �
utility function.
Suppose consumer purchase x1* units of good x1. Therefore, the total
expenditure on x1* will be x1*P1. The fraction of income spent on good x1
�∗� ��
shall be �
� � � � � �
We know ��∗ = ���
. � .Therefore, ������ . � . �� � = ����� will be the
� �
� � � �
fraction of income spent on good x1. Also, ������ . � . �� � = ����� will be
�
the fraction of income spent on good x2. Thus, a consumer having Cobb-
Douglas utility function always spends a fixed fraction of his income on each
good.
Check Your Progress 1
1) Consumer A consuming goods x1 and x2 has utility function of form U(x1,
x2) = 4√�� + x2
a) ‘A’ originally consumed 9 units of x1 and 10 units of x2. His
consumption of x1 is reduced to 4 units. After change, how much of
x2 should he be consuming to maintain same level of utility?
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
………………………………………………………………………………………………………… 33
Consumer Theory
b) If A is consuming the bundle (9, 20), what would be his MRS (x1, x2)
and when is he consuming (9, 10)? Also, write MRS in general form.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
2) Utility function of an individual is given by U(X, Y) = X3/4 ��/� . Find out
the optimal quantities of the two goods X and Y using Lagrangian
method, if it is given that price of good X is Rs 6 per unit, price of good Y
is Rs. 3 per unit and income of the individual is equal to Rs. 120.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

2.4 CONSUMER’S EQUILIBRIUM WITH INCOME TAX

VS QUANTITY TAX
There are various economic policy tools (such as taxes, subsidies, rationing,
etc.) that affect the budget constraint of the consumer. In this section, we
shall study the impact of quantity tax and income tax on the consumer’s
equilibrium.
In case of a quantity tax, the consumer has to pay a certain amount to the
government for each unit of the good purchased on which the tax is
imposed. Suppose, before any quantity tax, the price of good X is PX. Now
the government imposes a quantity tax of Rs. t per unit on good X. This
quantity tax changes the price of good from PX to PX + t. Graphically, this
would cause the budget line to become steeper. An income tax on the other
hand is a tax on the income of the consumer. Graphically, this would cause
the budget line to shift parallel leftwards as if the income has fallen.
The analysis is based on the following assumptions:
1) The consumer initially has a money income M, and the prices of the two
goods X and Y are PX and PY respectively.
2) The government has two economic policy tools to raise revenue:
a) Quantity tax of Rs. t per unit on good X
b) Income tax
3) The magnitude of revenue collected from taxes, is the same, either
from quantity tax or income tax. The economic implication of this
assumption is that the government is indifferent as to whether tax
revenue is collected from quantity tax or income tax.
4) The consumer is rational guided by the objective of utility maximisation
subject to the budget constraint.
34
 Consumer’s
Equilibrium

Good Y A

F Original choice
Optimal choice
e1 with income tax

Optimal e2
choice with IC3
quantity tax e3 Budget constraint
with income tax
�
Slope = − ��
�
IC1 IC2
O XB XA XC C G B
Budget constraint with quantity Good X
(�� � �)
tax, Slope = −
��

Fig. 2.2: Consumer’s Equilibrium with Income Tax vs Quantity Tax

Now, consider Fig. 2.2 above. The consumer is initially in equilibrium at

point e1 where the budget line AB is tangent to IC3. AB is defined by the
equation
P XX + PY Y = M (15)
and consumer consumes OXA units of good X and e1XA units of good Y. Note
�
that the coordinate of X intercept at the point B is �� , 0�, and that of Y
�
�
intercept at the point A is �0, � �. Now government imposes a quantity tax
�
of Rs. t per unit on good X, so the post tax price of commodity X is (PX + t)
with PY being the price of commodity Y remaining unchanged. This causes
the budget line to pivot leftwards from AB to AC. AC is defined by the
equation
(PX + t) X + PYY = M (16)
The new equilibrium is established at e2 where the budget line AC is tangent
to IC1. The consumer is consuming OXB units of good X and e2XB units of
good Y. The government is able to collect tax revenue R, equal to tXB. At
equilibrium e2, we know
(PX + t)XB + PY (e2XB) = M (17)
As a policy option, if the government had imposed an income tax equal to
tXB, then the original budget constraint AB would have shifted parallel
leftwards to FG, passing through point e2. FG passes through e2 because
R = tXB (18)
Income after tax = M − tXB
35
Consumer Theory
Therefore, equation of the new budget line becomes, PXX + PYY = M − tXB,
�
which has a slope of – �� and will pass through (XB, e2XB) as it will be a
�
transformed form of Equation (17)⇒ PXXB + PY(e2XB) = M − tXB with an
income tax, equilibrium is established at e3 when the budget line FG is
tangent to IC2.
Now comparing a quantity tax with an income tax we find that the
consumer is better off with an income tax. This is because with an income
tax, consumer attained an equilibrium point e3 on IC2 and with a quantity tax
he attained an equilibrium point e2 on IC1, and as you may notice, IC2
provides a higher level of satisfaction than IC1.
Check Your Progress 2
1) In a two-good world (x1, x2) with prices (p1, p2), assume that a consumer
has a utility function U = x11/2.x21/2 with a budget constraint p1x1 + p2x2 =
M. Initially, price of good x1 is Rs. 2 and of good x2 is Rs. 8. The income
of the consumer is Rs. 400.
a) Let the government impose a quantity tax of Rs. 2 per unit on
good x1. What happens to the optimal consumption bundles and
find the amount of tax collected.
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
b) Suppose the government replaces the quantity tax by an
equivalent income tax. Find the optimal consumption bundle. Is
the consumer better or worse off compared to the quantity tax
situation.
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
2) Priya spends all her income of Rs. 5000 on food (F) and clothing (C). The
price of food is Rs. 250 and that of cloth is Rs.100 and her monthly
consumption of food is 10 units and that of clothing is 25 units. MRSFC =
��
��
. Is she in equilibrium with this consumption, which commodity she
will substitute for the other to reach equilibrium position?
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
36 ……………………………………………………………………………………………………………….
 Consumer’s
2.5 CONSUMER’S EQUILIBRIUM WITH CHANGE IN Equilibrium
PRICE
In this section, we shall study the impact on consumer equilibrium when
price of one of the goods changes. Considering a 2-good model, when price
of one good, let say good X changes, this brings change in the price of good
X (i.e., PX) relative to good Y, and also in the real income of the consumer.
The overall change in quantity demanded of good X due to a change in its
price, ceteris paribus, is called the price effect. This change can be further
broken down into two components:
a) Substitution effect: Substitution implies a movement away from the
relatively expensive good. Controlling for the change in real income,
substitution effect captures the effect of change in the relative price
ratio on the quantity demanded of the good whose price has changed.
b) Income effect, on the other hand measures the effect of change in the
real income on the quantity demanded of the good whose price has
changed.
This decomposition of the price effect into substitution and income effect
can be done by way of two approaches:
i) Slutsky’s approach
ii) Hicksian approach

2.5.1 Slutsky’s Approach

We shall use Slutsky’s method to break the price effect into income effect
and substitution effect for good X wherein
Case 1 Good X is a normal good
Case 2 Good X is an inferior good
Case 3 Good X is a giffen good
We make the following assumptions for all the three cases:
1) The consumer is consuming two goods; good X and good Y.
2) The initial nominal income of the consumer is given by M.
3) The initial prices of the two goods are PX and PY.
4) All income is spent on the two goods and no part of the income is
saved.
5) The initial budget line faced by the consumer is given by AB.
6) The consumer is initially in equilibrium at e1, where the budget line AB is
tangent to IC1.
Case 1: Good X1 is a normal good.

37
Consumer Theory

Fig. 2.3: Decomposition of Price effect into Substitution effect and Income effect in case
of Normal Good using Slutsky’s approach

Consider Fig. 2.3, where budget line AB is tangent to IC1 and initial
equilibrium is given by e1, with consumer consuming OXA units of good X.
Let the price of good X fall from PX to PX', ceteris paribus. This causes the
budget line to pivot from AB to AC. The new equilibrium is established at e2
where the budget line AC is tangent to IC3. The consumer now purchases
OXB units of good X. The total change in demand for good X is given by, ∆X =
(OXB – OXA). This represents the magnitude of the price effect, which can be
broken down into Substitution and the Income effect.
We know that when price of good X falls, the real purchasing power of the
� �
consumer rises �� < � � �. To eliminate this increase in real purchasing
� �
power, the money income of the consumer is reduced temporarily (say by
taxation) by such an amount that the consumer is just able to afford his
�� �
original preferred bundle (defined by e1), at the new price ratio ��
. That is,
allowing only for the change in the relative price ratio, while the real
purchasing power is held constant. This is graphically achieved by
introducing an income compensated budget line FG [defined by parameters
(PX', PY, M')] parallel to AC and passing through e1 (the original preferred
bundle).
The consumer now attains equilibrium at point e3 where FG is tangent to IC2.
The movement from e1 to e3 shows that the consumer increased his
demand for good X from OXA to OXC as good X became relatively cheaper to
good Y. Therefore, OXC – OXA defines the substitution effect resulting from a
change in the price of good X relative to good Y, with real income remaining
constant.
To study the income effect, we now restore the money income of the
consumer that was taken away. This is graphically achieved by shifting the
budget line from FG to AC. The consumer moves from e3 on IC2 to e2 on IC3.
38 Consumer increases his consumption of good X from OXC to OXB. This
increase in quantity demanded (OXB – OXC) measures the magnitude of the Consumer’s
income effect. Equilibrium

We are now in a position to explain symbolically how the price effect is split
into income and substitution effect.
1) OXA is calculated with parameters (PX, PY, M)
2) OXB is calculated with parameters (PX’, PY, M)
3) OXC is calculated with parameters (PX’, PY, M’)
Now, how to determine M’?
We know that point e1 lies on two budget lines, AB and FG. There, the
consumption bundle of good X and Y, given by (OXA, e1XA) is the same for
two budget lines AB and FG. Thus (OXA, e1XA) is affordable at (PX, PY, M) and
(PX', PY, M'). That is, e1 on AB shall satisfy the following equation
P X X + PY Y = M (19)
and e1 on FG shall satisfy the following equation
PX'X + PY Y = M' (20)
Subtracting Equation (19) from Equation (20) i.e. [(20) – (19)], we get
M' – M = PX' X – PX X
M' – M = X (PX' – PX)
In simple words,
(New money income – original money income) = [(original quantity of good
X demanded) multiplied by (new price – old price)]
Or ∆M = X∆P�
Remember:
∆M and ∆P will always move in the same direction.
• If the price of a good falls, we shall need to reduce money income to
keep the original bundle affordable at the new price ratio.
• If the price of a good rises, we shall need to increase money income of
the consumer to keep the original bundle affordable, at the new price
ratio.
Let us now symbolically represent the price effect (PE) as the sum of income
effect (IE) and substitution effect (SE):
PE = SE + IE
∆X = ∆XS + ∆XN
where, ∆X = Total price effect
∆XS = the substitution effect
∆XN = the income effect
Now, ∆X = X (PX’, PY, M) – X (PX, PY, M)
∆XS = X (PX ’, PY, M’) – X (PX, PY, M)
∆XN = X (PX ’, PY, M) – X (PX ’, PY, M’)
39
Consumer Theory
We have ∆X = ∆XS + ∆XN
X (PX’, PY, M) – X (PX, PY, M) = [X (PX ’, PY, M’) – X (PX, PY, M)] +
[X (PX ’, PY, M) – X (PX ’, PY, M’)]
The above equation is referred as the Slutsky’s Identity. The above equation
is an identity because the left hand side is equal to the right hand side as the
first and the fourth terms on the right side cancel out.
Case 2: Good X is an inferior good
In case of an inferior good, increase in income of the consumer causes fall in
the demand of that good. Good X is assumed to an inferior good. The initial
equilibrium of the consumer is given by point e1 on budget line AB, where
AB is tangent to IC1, with consumer consuming OXA units of good X. (Refer
Fig. 2.4)

J
e2
Good Y (Normal)

e1
IC3
e3
S.E

IC1 IC2
P.E I.E
O XA XB XC B K C
Good X (Inferior)

Fig. 2.4: Decomposition of Price effect into substitution effect and Income effect in case of
an Inferior Good using Slutsky’s approach

Let price of the inferior good X falls from PX to PX'. This causes the budget
line to pivot from AB to AC. Consumer reaches new equilibrium at e2,
purchasing OXB units of goods X. The total change in demand of good X, ∆X
= (OXB – OXA) gives the magnitude of the price effect (notice that the law of
demand holds true for an inferior good X).
Like we did in case of normal good, to cancel the income effect, we
introduce an income compensated budget line JK parallel to AC (reflecting
the new price ratio), by withdrawing some income of the consumer, so that
the consumer can buy the original commodity bundle at the new price
(hence JK is passing through e1). At new equilibrium e3, given by the
tangency of JK and IC2, consumer purchases OXC units of good X. Movement
from e1 to e3 shows that the consumer increased his demand for the inferior
good X from OXA to OXC by substituting the dearer commodity Y for the
cheaper commodity X giving the magnitude of the substitution effect as OXC
– OXA. On restoring the money income of the consumer, equilibrium moves
from e3 on IC2 to e2 on IC3. The consumer decreases his consumption of
40
good X from OXC to OXB under the income effect as good X is an inferior Consumer’s
good. Equilibrium

You will notice that while the substitution effect causes an increase in
quantity demanded (from OXA to OXC), the income effect causes a decrease
in the quantity demanded (from OXC to OXB). You can further see that the
strength of the substitution effect is relatively stronger than the strength of
the income effect. The final result (of price effect) from the sum of the
substitution effect and income effect is that there is still rise in quantity
demanded (OXA to OXB) for the inferior good X when its prices have
decreased from PX to PX'. Thus, the law of demand operates even in case of
inferior goods.
Case 3: Good X is a Giffen good
It was observed by Sir Robert Giffen, a British economist of the 19th century,
that as the price of bread rose in England, many low paid workers began to
purchase more bread. This observation was contrary to the law of demand.
A good which behave contrary to the law of demand is known as a “Giffen-
type” good and the phenomenon as “Giffen’s Paradox”. The cardinal utility
analysis could not explain this “Giffen’s Paradox”, as it did not treat the price
effect as a combination of substitution and income effect. It completely
ignored the income effect of a price change, by assuming constant marginal
utility of money. Indifference curve analysis has been successful in
overcoming this limitation of cardinal utility analysis. It has been able to
resolve the “Giffen’s paradox”. Even in case of a “Giffen” good, the
substitution effect causes an increase in quantity demanded for a fall in
price of the Giffen good, but simultaneously the income effect acts to
reduce the quantity demanded as all Giffen goods are inferior goods.
However in this case, the dominance of income effect over the substitution
effect makes the price effect positive (fall in price of good X is accompanied
by rise in quantity demanded) leading to the violation of law of demand.
This is explained with the help of Fig. 2.5 below. Let us assume that good X is
a Giffen good. The consumer is initially in equilibrium at point e1, purchasing
OXA units of good X.

A
e2
Good Y (Normal)

M IC3

e1 e3
P.E S.E IC2
I.E IC1
O XB XA XC B N C
Good X (Giffen)

Fig. 2.5: Decomposition of Price effect into substitution effect and Income effect in case of
a Giffen Good using Slutsky’s approach 41
Consumer Theory
With a fall in price of good X (which is a Giffen good), the budget line pivots
from AB to AC, with consumer reaching equilibrium at e2. The consumer
now demands a lower quantity of good X, although he/she is on a higher
indifference curve. The quantity decreases by (OXB – OXA), giving the price
effect.
Now, using the same methodology of separating substitution effect from
income effect, we draw income compensated budget line MN parallel to AC,
passing through e1. The new equilibrium is established at point e3 on IC2,
with consumption of good X increased to OXC. The increase in quantity
demanded (OXC – OXA) defines the substitution effect. To study the income
effect, the money income that was taken away from the consumer is
restored. The consumer moves from point e3 on IC2 to e2 on IC3. The
consumer reduces his consumption from OXC to OXB because Giffen good X
is an inferior good. The decrease in quantity demanded (OXC – OXB)
measures the income effect.
While the substitution effect caused an increase in quantity demanded for a
fall in price, the income effect caused a substantial decrease in quantity
demanded. In case of a Giffen good, the strength of the income effect is so
strong that it outweighs the substitution effect, causing a decrease in
quantity demanded from OXA to OXB, with a fall in price of good X. Thus, the
“Giffen’s paradox” is a strong exception to the law of demand.

2.5.2 Hicksian Approach

In Slutsky’s approach, substitution effect is given by the change in demand
of the good whose price changes, holding constant consumer’s real income.
This we measured by constructing an income compensated budget line (by
introducing a compensated change in income of the consumer opposite to
the change in price) parallel to the pivoted budget line after the price
change, reflecting new price ratio but compensated income and passing
through the original equilibrium bundle.
Hicksian approach, on the other hand, involves measurement of the
substitution effect as the change in the demand of the good whose price has
changed, holding utility constant. Now, this will involve constructing the
income compensated new budget line reflecting new price ratio, parallel to
the pivoted budget line and tangent to the original indifference curve. This is
the point of difference between the Slutsky’s and the Hicksian approach,
while the former requires keeping constant the initial purchasing power (so
that the consumer can buy the initial commodity bundle at the new price),
the latter involves keeping constant the original utility level (so that the
consumer can attain the initial utility level at the new price), but both the
approaches involve altering the money income of the consumer after the
price change to separate substitution effect from the income effect. Let us
graphically present the Hicksian approach (refer Fig. 2.6).
We assume the same case-I that we did under Slutsky’s approach in Fig. 2.3.
Consumer’s initial equilibrium is given by e1, where budget line AB is tangent
to IC1, with consumer consuming OXA units of good X. Let the price of good X
42 fall from PX to PX’, ceteris paribus. This causes the budget line to pivot from
AB to AC. At new equilibrium e2 consumer consumes OXB units of good X. Consumer’s
The total change in demand for good X is given by, ∆X = (OXB – OXA). This Equilibrium

represents the magnitude of the price effect.

Now as per Hicksian approach, substitution effect is separated from the
income effect by drawing income compensated budget line JK parallel to AC,
but tangent to the original indifference curve, IC1 (Refer Fig. 2.6). That is,
after the fall in the price of good X, money income is reduced to the extent
that consumer can afford the previous utility level. Equilibrium e2, given by
the tangency of JK and IC1, marks the change in demand of good X resulting
from change in the price ratio, keeping constant the utility level. Thus,
substitution effect is given by OXC – OXA. The remaining change in the
quantity demanded of good X from OXC to OXB account for the income
effect.

e1 e2
Good Y

e3
IC2
S.E I.E
IC1
P.E
A
O X XC XB B K C
Good X

Fig. 2.6: Decomposition of Price effect into substitution effect and Income effect in case of
a Normal good using Hicksian approach

The other cases, of that of an inferior good and a Giffen good, can be
similarly analysed.

2.5.3 Estimation of Substitution and Income Effect through

Slutsky’s and Hicksian Approach
Consider two goods, X and Y, priced at PX and PY. Let M be the income of the
consumer. Initial demand for both the goods will be a function of (Px, PY, M),
given by
XO (PX, PY, M) for good X and YO (PX, PY, M) for good Y
Now let price of good X fall from PX to PX’. Final demand for the both the
goods will be a function of (PX’, PY, M), given by, XF (PX’, PY, M) for good X
and YF (PX’, PY, M) for good Y. Now, price effect equals, XF (PX’, PY, M) – XO
(PX, PY, M). This can be further separated into substitution and income effect
by Slutsky’s and Hicksian approach.

43
Consumer Theory
i) Slutsky’s Approach
This approach involves finding out the intermediate demand for good X
� ’
at the new price ratio �� , keeping constant the original purchasing
�
power or the real income of the consumer. Let Ms be the altered money
income spending which consumer can consume the original bundle of
both the goods i.e., (XO, YO) after PX changes to PX’. That is, we have
M s = P X’ X O + P Y Y O
This represents equation of the income compensated budget line,
which we draw parallel to the pivoted budget line, after passing through
the original consumption bundle. Now, optimal consumption of good X
on this new budget line will be a function of (PX’, PY, Ms), let us denote it
by, XS (PX’, PY, Ms), with Ms itself given by (PX’, PY, XO, YO), we can also
write XS (PX’, PY, XO, YO).
Now, Substitution effect = XS – XO
and Income effect = XF – XS
ii) Hicksian Approach
The sole difference between the Slutsky’s and Hicksian approach is the
estimation of the intermediate demand. Hicksian approach involves
finding out the intermediate demand for good X at the new price ratio
�� ’
�
, keeping constant the original utility level of the consumer. Let Mh be
�
the altered money income spending which consumer can attain the
original utility level (let say UO) after PX changes to PX’. That is, we have
UO = U [X(PX’, PY, Mh), Y(PX’, PY, Mh)]
where utility function is given by U(X, Y), with X and Y themselves being
a function of (PX’, PY, Mh). The optimal demand for good X associated
with income Mh is given by Xh (PX’, PY, Mh), where Mh itself is a function
of (PX’, PY, UO), thus we can write Xh (PX’, PY, UO).
Now, Substitution effect = Xh – XO
and Income effect = XF – Xh
Example
Suppose consumer ‘A’ has utility function of the form U (x1, x2) = x1x2. Let
price of good x1 be P1 = Rs. 2 and good x2 be P2 = Re 1. Now let price of x1
falls from Rs. 2 to Re 1. A’s income is Rs. 40/day. Answer the following:
a) Before the price change what was A’s consumption bundle?
b) After the price change, if A’s income had changed, so that he could
afford old bundle exactly, what would A’s income be? What is the
consumption bundle with new income and price?
c) Break up the price effect into substitution effect and income effect.

44
Solution Consumer’s
Equilibrium
�
a) Using the equilibrium condition �� = MRS12, we can determine A’s
�
consumption function before the price change.
��
��� � � � � �
We have MRS12 = �� = �� and �� = �, for equilibrium, �� = �
⟹ x2 = 2x1
� � �
���
(21)
Using Equation (21) and the budget constraint, given by 40 = 2x1 + x2,
we get x10 = 10, x20 = 20.
b) Going by the Slutsky’s approach, income required to exactly afford
original bundle would be given by, Ms = p1’x10 + p2x20, where p1’= 1, x10 =
10, p2 = 1, x20 = 20. Thus, we get Ms = 30.
��
Using equilibrium condition, ��
= 1 ⟹ x2 = x1 and the new budget
constraint given by 30 = x1 + x2, we get the consumption levels with new
income (Ms = 30) and price (p1’= 1), given by x1S = 15 and x2 S = 15.
c) Now, in order to break up price effect into substitution effect and
income effect, we need to derive demand for good x1 after its price
changes, keeping constant all the other parameters. Using equilibrium
� � ’ �
condition �� = �� ⟹ �� = 1 ⟹ x2 = x1 and pivoted budget line
� � �
equation, 40 = x1 + x2, we get x1’= 20 and x2’ = 20.
Now, Substitution effect = x1s – x10 = 15 – 10 = 5
and Income effect = x1’ – x1s = 20 – 15 = 5

2.6 CONSUMER’S EQUILIBRIUM UNDER SPECIAL

CIRCUMSTANCES
2.6.1 Perfect Complements
We now consider a case where good X and good Y are always consumed
together in a fixed proportion. Thus, good X and good Y are perfect
complements.

Fig. 2.7
45
Consumer Theory
In Fig. 2.7, the consumer is initially in equilibrium at point e1 where the
budget line AB is tangent to the L-shaped IC1. The consumer is initially
consuming OXA units of good X and e1XA units of good Y. The budget line is
defined by parameters (PX, PY, M).
Let the price of good X fall from PX to PX', ceteris paribus. This causes the
budget line to pivot rightwards from AB to AC. The new equilibrium is
established at point e2 where the budget line AC becomes tangential to IC2.
The consumer now consumes OXB units of good X and e2XB units of good Y.
The change in quantity demanded of good X due to a change in its price is
the magnitude of the price effect which equals OXB – OXA.
We now break up the price effect into substitution and income effect. We
first cancel the income effect by reducing the nominal income of the
consumer from M to M' such that the real purchasing power is held
constant and the original preferred bundle e1 is just affordable. This is
graphically achieved by shifting the budget line AC parallel downwards to FG
till it passes through e1. The new equilibrium is once again established at e1
when FG is tangent to IC1. This means that the magnitude of the substitution
effect is zero. Intuitively, we can say that the substitution effect is zero as
good X and good Y are perfect complements and there is no possibility of
substitution of one good by the other complementary good.
We now restore the money income of the consumer that had earlier been
taken away to measure the magnitude of the income effect. This is
graphically achieved by shifting the budget line from FG to AC. The
equilibrium is established at e2 on IC2. The change in demand due to the
income effect is OXB – OXA. Therefore, the entire price effect is equal to the
income effect (because substitution effect is zero). Thus, in case of perfect
compliments, price effect equals income effect and substitution effect
equals zero.

2.6.2 Perfect Substitutes

Let good X and good Y be perfect substitutes with MRSXY = 1 (in absolute
terms). This implies that one unit of X can be equally well replaced by one
unit of Y or vice-versa. This further implies that the indifference curves shall
be linear (making a 45o angle with the axes).

46 Fig. 2.8
In Fig. 2.8, let PX be greater than PY initially. This implies that the budget line Consumer’s
(drawn as AB) shall be steeper than the indifference curves (IC1, IC2 etc) Equilibrium

because if PX > PY, then slope of AB, given by PX/PY > slope of IC’s (which
equals 1). The consumer shall initially be in equilibrium at point A = e1 (on
the y-axis) only consuming good Y. (Intuitively, the consumer shall not
purchase any units of X as X and Y are perfect substitutes and the price of
good X is greater than price of good Y).
Now let price of good X fall from PX to PX' such that PX' falls below PY. This
causes the budget line to pivot from AB to AC. As you may notice, new
budget line AC is now flatter than the indifference curves, because if PX' < PY,
then PX'/PY (slope of AC) < 1 (slope of IC's). New equilibrium is established at
point C = e2. The consumer now purchases only good X and zero units of
good Y. This is because PX' < PY and X and Y are perfect substitutes. The
consumer was initially purchasing zero units of good X and after the price
change the consumer purchases OC units of good X. Therefore, the total
change in demand for good X due to the change in price is OC. OC is
therefore the magnitude of the price effect (PE) = e2 – e1 = OC – 0 = OC.
In order to decompose the price effect into substitution effect and income
effect we first eliminate the income effect. This would be attained
graphically by shifting the budget line parallel downwards till the original
bundle (in this case point A) is just affordable. Since point A lies on AC we
cannot shift the budget line parallel downwards. This implies that income
effect shall be zero. As the budget line after cancelling the income effect
stays at AC, the magnitude of the substitution effect is OC, which is also
equal to the price effect. In case of perfect substitutes, the total change in
demand is due to the substitution effect and income effect is zero.

2.6.3 Quasi Linear Preferences

Let the consumer face quasi linear preferences and his utility function is
defined by U(X, Y) = V(X) + Y. The indifference curve map faced by the
consumer is drawn in the Fig. 2.9 below.

Fig. 2.9

47
Consumer Theory
The budget line AB is defined by parameters (PX, PY, M). The consumer is
initially in equilibrium at e1 when the budget line AB is tangent to IC1. The
consumer is initially consuming OXA units of good X and e1XA unit of good Y.
Let price of good X fall from PX to PX', ceteris paribus. This causes the budget
line to pivot from AB to AC. The new equilibrium is established at e2 where
AC is tangent to IC3. The consumer, after the price change, is consuming OXB
units of good X and e2XB units of good Y. The total change in demand for
good X is OXB – OXA (which is the magnitude of the price effect) resulting
from the price change.
We now break up the price effect into income and substitution effects using
Slutsky’s method. We first eliminate the income effect by reducing the
money income of the consumer to an extent that the consumer is just able
to afford the original preferred bundle at the new price ratio. This is
graphically achieved by shifting the budget line parallel downwards from AC
to FG, with FG passing through point e1 (ensuring that the original preferred
bundle is still affordable). The new equilibrium is established vertically
below e2 at e3. This is because each indifference curve is a vertical translate
of the original indifference curve, and with the budget line also shifting
parallel downwards, there is no option but for the new equilibrium to be
established at e3 on IC2.
Having eliminated the income effect, the consumer now consumes OXB units
of good X and e3XB units of good Y. Therefore, the magnitude of the
substitution effect is OXB – OXA. We now restore the money income to
measure the magnitude of income effect. This is graphically achieved by
shifting the budget line from FG to AC. The consumer moves from e3 on IC2
to e2 on IC3. There is no change in the consumption of good X. Therefore,
the magnitude of income effect of the price change on good X is zero. The
entire magnitude of the price effect is the substitution effect. Thus, in case
of quasilinear preferences, price effect equals substitution effect and
income effect is zero.
Check Your Progress 3
1) Consider a consumer with the utility function given by, U (X, Y) = XY,
where X and Y represent the two goods of consumption, priced at Px
and PY, respectively. Assuming income of this consumer to be Rs. 120,
Px = Rs. 3 and PY = Re. 1.
a) Find the equilibrium quantities of consumption of both the goods.
b) Suppose price of good X fall to Rs. 2.5, what will be the impact on
consumption quantities of both the goods?
c) Estimate the price effect of the price fall on consumption of good X.
d) Decompose the price effect into substitution and income effect for good X.
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
2) A spends all his income on x1 and x2. According to him, x1 and x2 are
perfect substitutes. Given, P1 = Rs. 4, P2 = Rs. 5, answer the following:
48
 a) Suppose price of x1 falls to Rs. 3, will its quantity demanded Consumer’s
increase? Why? Equilibrium

b) Now suppose P2 falls to Rs. 3 and P1 does not change. What

happens to its quantity demanded and why? Represent the
situation graphically.
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
3) Two goods are perfect complements. If price of one good changes, what
part of change in demand is due to income effect (IE) and what part is
due to substitution effect (SE)?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

2.7 LET US SUM UP

The theory of consumer choice is designed to explain how and why
consumers purchase the combination of goods and services they do. The
theory emphasises on two factors: the consumer’s budget line, which shows
the market baskets that can be bought; and the consumer’s preferences,
which indicate the subjective ranking of different market baskets. The effect
of a price change on the quantity demanded of a good can be broken into
two parts: a substitution effect, in which the level of real income remains
constant while price changes, and an income effect, in which the price
remains constant while the level of real income changes. Because the
income effect can be positive or negative, a price change can have a small or
a large effect on quantity demanded. In the unusual case of a so-called
Giffen good, the quantity demanded may move in the same direction as the
price change thereby generating an upward-sloping individual demand
curve.
We began by explaining the theory of consumer’s behaviour, i.e., the
explanation of how consumers allocate incomes to purchase different goods
and services. Further, we explained using indifference curve analysis that
the consumer shall be better off under an income tax vis-à-vis a commodity
tax, given the assumption that the revenue collected from both types of
taxes is the same for the government. The discussion ended on splitting up
price effect into income effect and substitution effect using Slutsky’s and
Hicksian methods. 49
Consumer Theory
2.8 REFERENCES
1) Hal R. Varian. Intermediate Microeconomics: A Modern Approach;
Eighth Edition.
2) Robert S. Pindyck, Daniel L. Rubinfeld and Prem L. Mehta.
Microeconomics, Pearson; Seventh Edition.
3) Alpha C. Chiang and Kevin Wainwright. Fundamental Methods of
Mathematical Economics; Fourth Edition.
4) Dr. H.L Ahuja. Advanced Economic Theory: Microeconomic Analysis;
Revised Edition.
5) A. Koutsoyiannis. Modern Microeconomics, Second Edition.

2.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) a) x2 = 14 units
�� �� �� �� ��
b) MRSx1x2 = ��� ; MRS (9, 20) = = �
; MRS (9, 10) = = �
� √� √�
Therefore, MRS is indifferent of the value of x2.

2) x = 15, y = 10
Lagrangian expression for the given problem will be
L = x3/4y1/4 + λ (120 – 6x – 3y)
� ��� ��
� �� � ��
Equation condition will be �
� �� ��� = ��
� �� �
�

Check Your Progress 2

1) a) Given: U = x11/2 x21/2
Post tax optimal bundle: (50, 25)
Amount of tax collected = Rs 100
Hint: At the optimum consumption bundle,
�
MRS �� �� = ��
�

Taking the log transformation of the utility function, we get, V = ln (U)

� �
V = � ln x� + �
ln x�
� � � �
MV1 = � × ��
and MV2 = � × ��

��� ��
Now, ���
= ��
� �
× �� �� �� �� ��
� ��
� � = ⇒ = ⇒ x� =
× �� �� �� ��
� ��

50 On solving we will get pre tax bundle (x1*, x2*) = (100, 25)
 Now, the government imposes a quantity tax of Rs. 2 per unit on good x1 Consumer’s
��� Equilibrium
Now P1 = 4, ∴ x 1* = �×�
= 50 ∴ Post tax bundle (50, 25)
The amount of tax collected = 2 × 50 = Rs 100
b) New Bundle: (75, 18.75) consumer is better off
Hint: Income tax = 100
M = 400 – 100 = 300
��� ���
x1* = � × � = 75 , x2* = � × � = 18.75

Original bundle Quantity tax bundle Income tax bundle

(100, 25) (50, 25) (75, 18.75)

Original utility U0 = (100)1/2 (25)1/2 = 10 × 5 = 50

Utility after quantity tax U1 = (50)1/2 (25)1/2 = 7.07 × 5 = 35.35
Utility after income tax U2 = (75)1/2 (18.75)1/2 = 8.66 × 4.33 = 37.49
∴ U2 > U1 , meaning that the consumer is better off under income tax
compared to the quantity tax situation.
2) Given, MRSFC = 1
� ���
Also, �� = ��� = 2.5
�
�� �
⟹ ����� < ��
But for equilibrium, �� = �����
�

Therefore, presently she is not in equilibrium position. Now, since in the

market with the given prices of the two goods, she can exchange 1 unit
of F for 2.5 units of C while she is willing to forego 1 unit of F for 1 unit
of C to keep her satisfaction constant, she will be increasing her
satisfaction by consuming less of food and substituting C for it. This is
because with loss of 1 unit of food she will be having extra 2.5 units of
C, while only one unit of C is sufficient to compensate her for the loss of
1 unit of F.
Check Your Progress 3
1) a) X0 = 20 and Y0 = 20
�
Hint: We use the equilibrium condition, �� = MRSXY, where PX = 3, PY
�
�
= 1, MRS = � and the budget line equation, 120 = 3X + Y to arrive at
X0 = 20 and Y0 = 60 (original bundle).
b) X’ = 24 and Y’ = 60
� �� ’
Hint: We use the equilibrium condition, � = ��
, where P X′ = 2.5, PY
= 1 and the budget line equation, 120 = 2.5X + Y to arrive at X’ = 24
and Y’ = 60 (final bundle).
c) Price effect = X’ – X0 = 24 – 20 = 4
d) Substitution effect = 2 and Income effect = 2
51
Consumer Theory
2) a) Yes. It is given that x1 and x2 are perfect substitutes for A. x1 is
cheaper. So A would consume only x1. When price of x1 falls
further to Rs. 3 and with same money income he would be able to
buy more of x1. Hence, A starts to consume more of x1. It is due to
income effect.
b) Refer Sub-section 2.6.2 and draw
Hint: As P2 falls to Rs. 3 and x1 and x2 being perfect substitute, A
will spend his entire income to buy x2 as P2 < P1.
New budget line: 4x1 + 3x2 = 120
When x2 = 0, x1 = 30 and x1 = 0, x2 = 40. Hence, New equilibrium
bundle is (0, 40)
3) In this case entire change is due to income effect. So, PE = IE and SE=0.

52
 Consumer’s Surplus
UNIT 3 CONSUMER’S SURPLUS
Structure
3.0 Objectives
3.1 Introduction
3.2 The Concept of Consumer’s Surplus
3.3 Consumer’s Surplus and the Demand Curve
3.3.1 Consumer’s Surplus for a Discrete Good
3.3.2 Consumer’s Surplus for a Non-discrete Good
3.4 Change in Consumer’s Surplus
3.4.1 Effect of Price Change on Consumer’s Surplus
3.4.2 Quasi-linear Preferences and Change in Consumer’s Surplus
3.5 Compensating and Equivalent Variations
3.5.1 Indifference Curve Analysis
3.5.2 Relation between Consumer’s Surplus, Compensating Variation and
Equivalent Variation
3.6 Let Us Sum Up
3.7 References
3.8 Answers or Hints to Check Your Progress Exercises

3.0 OBJECTIVES
After going through this unit, you will be able to:
• get an insight into the concept of Consumer’s Surplus;
• explain the concept of Consumer’s Surplus for a discrete and a non-
discrete goods;
• estimate Change in Consumer’s Surplus resulting from price changes in
case of observable demand curves;
• get an introduction to the concept of Quasi-linear utility and analyse it
as the measure of a ‘Change in consumer’s surplus’;
• discuss the three measures of change in utility viz. change in consumer’s
surplus, equivalent variation and compensating variation; and
• identify the relationship between the three measures of change in
utility.

3.1 INTRODUCTION
Several factors affect market participants as they are present in the market
for utility gains. Any change in the market conditions, for instance, change in
the prices of the commodities available for sale or purchase, or change in
the resources available with the participant, has an effect on the
participant’s behaviour and utility, be it the consumer of the commodity or
the producer of it. In the previous units, we have discussed in detail about
the consumer theory, wherein, the behaviour of the consumer as the
participant in the market for utility gains was explained. You were
introduced to the concepts of demand theory in the earlier course entitled,
53
Consumer Theory “Introductory Microeconomics” in semester one. Followed by this, the
learner got insight into the consumer’s behaviour and attainment of
equilibrium through Cardinal utility and Ordinal utility approaches.
A consumer participates in the market with the main objective of getting
maximum satisfaction from spending his given income on various goods and
services. The satisfaction he attains results not only from the consumption
of the goods or services but also from the gains that arise when he ends up
paying less than the amount he was willing to pay for consumption of the
good or service. In simple terms, this is what is referred to as the consumer’s
surplus.
In this unit, with the help of diagrams, we will discuss the concept of
consumer’s surplus, in case of both discrete and non-discrete goods. This
discussion will be based on Marshallian demand curves, where surplus to a
consumer will be measured by his demand curve for good or service and the
current market price. Followed by this, we shall explain the effects of a
change in price on the consumer’s surplus. We shall further discuss the
concept of Quasi-linear utility and the underlying connection between the
consumer’s surplus and the change in utility in case of quasi-linear
preferences. Refuting the assumption of constant marginal utility of money
as was assumed under Marshallian approach, you will also be introduced to
two alternative measures of change in utility viz. Compensating variation
and Equivalent variation introduced by John R. Hicks. In the end, we shall
explain the relationship between the three measures of utility change, of
which consumer’s surplus is just one part. You will observe that only in case
of quasi-linear preferences, the three measures (that is, change in
consumer’s surplus, equivalent variation and compensating variation) are
equal.

3.2 THE CONCEPT OF CONSUMER’S SURPLUS

Alfred Marhall in his famous book “Principles of Economics” (first published
in 1890) introduced, among other things, a theory of consumer and
producer behaviour, derived demand and supply curves and used them in
partial equilibrium analysis. The concept of Consumer’s surplus was an
integral part of this analysis. In order to understand the concept of
Consumer’s surplus, also known as Buyer’s surplus, let us consider a
hypothetical market situation. Suppose there is a commodity ‘X’ in the
market, and you intend to participate in the market as a buyer. You are
willing to pay Rs. 50 for one unit of commodity X based on its worth to you.
However, as you enter the market and enquire about its price from the
seller, you get to know that the price of the commodity is Rs. 25. Here, the
difference between what you are willing to pay for commodity X and the
actual market price of that commodity (Rs. 50 − Rs. 25 = Rs. 25 in our
example) is called consumer’s or buyer’s surplus. It measures the utility gain
to the group or individuals who purchase a particular good (commodity X
here) at a particular price (Rs. 25 here).

54
Now, we come to a formal definition of Consumer’s Surplus— Consumer’s Consumer’s Surplus
surplus is defined as the difference between what consumers are willing to
pay for a unit of the commodity and the amount the consumers actually pay
for that commodity. Willingness to pay can be read of as an individual or a
market demand curve for a product. The market demand curve shows the
quantity of the good that would be demanded by all consumers at each and
every price that might prevail. Read the other way: the demand curve tells
us the maximum price that consumers would be willing to pay for any
quantity supplied to the market.
An illustration of the consumer’s surplus can be derived by considering the
following exercise. Consider Table 3.1, with four potential buyers (A, B, C
and D) and their willingness to pay, representing the maximum amount a
buyer will pay for a good.
Table 3.1: Buyers with their willingness to pay

Buyers Willingness to Pay (Rs)

A 2000
B 1700
C 1500
D 1200

If the market price of the good is Rs. 1200 per unit, then A earns consumer’s
surplus of Rs. 800, since he was willing to pay Rs. 2000, but only had to pay
Rs. 1200. Similarly, B earns Rs. 500 of consumer’s surplus, and C earns
Rs. 300 of consumer’s surplus. Buyer D is willing to pay Rs. 1200 for a unit,
but since the market price is Rs. 1200, D gets no consumer’s surplus; hence
he is the so-called "marginal" buyer.

3.3 CONSUMER’S SURPLUS AND THE DEMAND CURVE

3.3.1 Consumer’s Surplus for a Discrete Good
Let us begin our estimation of the consumer’s surplus from the case of a
discrete good — that is, one that can be bought and sold only in integer
units. Here, you should be clear about the concept of a reservation price as
well. The maximum price that the consumer is willing to pay for a unit of a
good than go without, is the reservation price for the unit purchased. In
simple words, it is the monetary value of the one unit of a good consumed.
It measures the marginal utility to the consumer from the purchase and
consumption of a unit of the good. Symbolically, reservation price rn (per
unit) is the price at which consumer is indifferent between buying n and
(n – 1) units of the good.
Note:
1) An individual does not buy the good if it costs more than his reservation
price for that good, but is eager to do so if it costs less.
2) If the price of a good is just equal to an individual’s willingness to pay,
he is indifferent between buying and not buying.
55
Consumer Theory Now, consider Table 3.2 showing five potential buyers of commodity X,
listed in order of their willingness to pay. At one extreme is individual A,
who is willing to pay a price of Rs. 59 for a unit of commodity X. Individual B
is less willing to have a unit of this good, and will buy one only if the price is
Rs. 45 or less. C is willing to pay only Rs. 35, D only Rs. 25, and E, with the
least willingness for the good, will buy one only if it costs not more than
Rs. 10. How many of these five buyers will actually buy a unit of commodity
X? It depends on the price. If the price of a unit is Rs. 55, only A buys one
unit of commodity X; if the price is Rs. 40, A and B both buy a unit of
commodity X, and so on. So the information in the table on willingness to
pay also defines the demand schedule for commodity X. As we saw in Unit 1,
we can use this demand schedule to derive the market demand curve shown
in Fig. 3.1. Here we are considering only a small number of buyers, hence
this curve doesn’t look like the smooth demand curve you are familiar with,
where markets contain hundreds or thousands of buyers. This demand
curve is step-shaped, with alternating horizontal and vertical segments. Each
horizontal segment, i.e. each step corresponds to one potential buyer’s
willingness to pay. However, we will see further in the unit that for the
analysis of consumer’s surplus it doesn’t matter whether the demand curve
is stepped or whether there are many consumers, making the curve smooth.
Table 3.2: Potential buyers and their Willingness to Pay

Potential Buyers Willingness to Pay

A 59
B 45
C 35
D 25
E 10
Price

59 A

45 B

35 C

25 D

10 E

0 1 2 3 4 5
Commodity X

Fig. 3.1: Demand function for discrete commodity X

56
Now, suppose market price of commodity X is Rs. 30 per unit. At this price, Consumer’s Surplus
individual A, B and C will buy the commodity. Do they gain from their
purchases, and if so, how much? Individual A would have been willing to pay
Rs. 59, so his net gain is Rs. 29 (= 59 – 30). Such a gain is possible due to the
fact that the willingness to pay of the individual for one unit of the good is
greater than the market price he actually paid for it. Similarly, individual B’s
net gain is Rs. 15 (= 45 – 30); C’s net gain is Rs. 5 (= 35 – 30). Individual D and
E, however, won’t be willing to buy commodity X at a price of Rs. 30, so they
neither gain nor lose. The net gain that a buyer achieves from the purchase
of a good is called that buyer’s individual consumer’s surplus. The sum of the
individual consumer’s surpluses achieved by all the buyers of a good is
known as the total consumer’s surplus achieved in the market. In Fig. 3.2,
the total consumer’s surplus is the sum of the individual consumer’s
surpluses achieved by A, B, and C: Rs. 49 (=29 +15 +5), shown by the shaded
area.
Price

59 A

45 B

35 C
30 Price = Rs 30
25 D

10 E

0 1 2 3 4 5
Commodity X
Fig. 3.2: Consumer’s Surplus when market price is Rs 30

Another way to say this is that total consumer’s surplus is equal to the area
under the demand curve but above the price. The same principle applies
regardless of the number of consumers. That is, when there are many
potential buyers in the market for a commodity, then the demand curve is
smooth without steps. The consumer’s surplus in such a case is given by the
same principle (the area below the demand curve but above the price).
(Refer Fig. 3.3)

57
Consumer Theory

Price Price = P

0
Commodity X
Fig. 3.3: Consumer’s Surplus with many potential buyers in the market

3.3.2 Consumer’s Surplus for a Non-discrete Good

Consumer’s surplus for a non-discrete good is the area under the demand
curve above the price line, found using a definite integral. Refer Fig. 3.4.
Price

P*
D’

x* Commodity x

Fig. 3.4: Consumer’s Surplus for Non-discrete good

Here, P* is the market price; x* the quantity demanded at P*. Consumer’s

surplus in this case also will be given by the area below the demand curve
and above the market price line. The formula for calculation of consumer’s
surplus in case of continuous commodity involves the application of
integration technique you have learnt in Unit 14 of your course on
Mathematical Methods in Economics during first semester (BECC-102).

58
 �∗ Consumer’s Surplus
Consumer’s Surplus = �� (Inverse demand function − P∗ ) dx.

In other words,
� ���������� �� ����� ����
� �(Upper function) − (Lower function)�
� ���������� �� ���� ����

You will be able to understand better with an illustration below:

Example 1: Let us calculate the consumer’s surplus for the following
demand function given in Fig. 3.5.
Price (Rs)

750

p = –50x + 2000

0 25
Commodity x
Fig. 3.5: Consumer’s Surplus for Non-discrete good

Solution:
Look again at the shaded area for Consumer’s Surplus. The left edge of the
triangle has an x-coordinate of 0, and the right edge is our equilibrium point,
which has an x-coordinate of 25.
The top of the triangle is the inverse demand equation p = – 50x + 2000, and
the base of the triangle is our constant equilibrium price, Rs. 750. So,
��
Consumer’s Surplus = �� �(−50� + 2000) − (750)���

= �−25� � + 2000� − 750��|��

�

= [− 25(25)2 + 2000 (25) – 750 (25)] – [− 25(0)2

+ 2000 (0) – 750 (0)]
= 15,625 units
Check Your Progress 1
1) What is consumer’s surplus, and how is it measured?
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
59
Consumer Theory 2) Consider an individual who participates in the market as the buyer of
shirts. His willingness to pay for subsequent units of Shirts is presented
in the following Table 3.3 below:
Table 3.3: Willingness to pay for units of Shirts

Units of Shirts Willingness to Pay

st
1 unit 60
nd
2 unit 50
3rd unit 40
th
4 unit 30
th
5 unit 20
6th unit 10
i) Use this information to construct individual’s demand curve for
shirts.
ii) If the price of a shirt is Rs. 20, how many units of shirts will the
individual buy?
iii) Find consumer’s surplus if the market price of a shirt is Rs. 20?
iv) If the price of a shirt rises to Rs. 40, how many units would he
purchase?
3) Consider an individual demand curve given by the following equation,
q = – 0.5p + 70. Find the consumer’s surplus for this individual when
market price faced by him is Rs.100 per unit. (Note: In the question, the
given equation is different from the one we considered in Example 1.
There we encountered an inverse demand function. So the right
approach will be to first convert the given equation into an inverse
demand function and then proceed).
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….

3.4 CHANGE IN CONSUMER’S SURPLUS

Consumer’s surplus, as we know by now, is determined by the willingness to
pay for a good, given by the demand curve and the market price of that
good. Thus, change in any one or both these determinants will have an
impact on the consumer’s surplus. Moreover, all the factors affecting the
demand for a commodity by a potential buyer, like price of the commodity,
price elasticity of demand, income, etc. will, in turn, affect the consumer’s
surplus too.

3.4.1 Effect of Price Changes on Consumer’s Surplus

It is often important to know how much the consumer’s surplus changes
when the price changes. There exists an inverse relationship between
consumer’s surplus and the price.
60
 Consumer’s Surplus
Given the demand curve, i.e. willingness to pay by a potential buyer, a rise in
the market price of the commodity reduces consumer’s surplus, whereas a
fall in the market price of the commodity, increases consumer’s surplus.

The same approach we have used to derive consumer’s surplus can be used
to illustrate the above statement. Let us return to the example of the
market for commodity X. Suppose that the market price fell from Rs. 30 to
Rs. 20 owing too excess supply. How much would this increase consumer’s
surplus? The answer is illustrated in Fig. 3.6. As shown in the figure, there
are two parts to the increase in consumer’s surplus. Part I is the gain to
those who would have bought commodity X even at Rs. 30. After the price
fall, A, B and C, who would have bought X at Rs. 30, each gains Rs. 10 in
consumer’s surplus from the fall in price to Rs. 20. Part II is the gain to those
who would not have bought X at Rs. 30 but are willing to pay more than
Rs. 20. In this case comes the individual D, who would not have bought X at
Rs. 30 but now does buy one at Rs. 20, gaining Rs. 5 (= 25 − 20). The total
increase in consumer’s surplus is Rs. 35 (Sum of the areas of Part I and II).
Likewise, a rise in market price from Rs. 20 back to Rs. 30 would decrease
consumer’s surplus by an amount equal to the sum of areas of Part I and II.
Price

Part I = Rs 30
59 A
Part II = Rs 5

45 B

35 C
30 Price = Rs 30
25 D
20 New Price = Rs 20

10 E

0 1 2 3 4 5
Commodity X
Fig. 3.6: Change in Consumer’s Surplus resulting from a Price change for discrete good

Fig. 3.6 illustrates that when the price of a good falls, the total consumer’s
surplus (i.e., the area under the demand curve but above the price)
increases. Fig. 3.7 shows the same result for the case of a smooth
demand curve. Here we assume that the price of commodity X falls from P
to P1, leading to an increase in the quantity demanded from Q to Q1 units
and an increase in consumer’s surplus (as given by the sum of the shaded
areas).

61
Consumer Theory

Price
Increase in CS to original buyers.
CS gained by new buyers.

P1

0 Q Q1
Commodity X
Fig. 3.7: Change in Consumer’s Surplus resulting from a Price change for
Non-discrete good

Example 2: When demand is estimated to be p = 6 – 0.5x, calculate the loss

in consumer’s surplus when a tax drives price from Re. 1 to Rs. 2.
Solution:
In order to calculate the loss in the consumer’s surplus resulting from a price
rise, first we plot the demand curve. The demand curve will be linear and
downward sloping as presented in Fig. 3.8. The position of the demand
curve will be determined by its intercepts with the price (p) and the quantity
(x) axis.
When p = 6, consumer buys no amount of commodity x. Hence, the vertical
intercept is at p = 6. When p falls to 0, our consumer is willing to consume
not more than 12 units of commodity x. So x = 12 is the horizontal intercept.
The demand curve as a straight line must pass through these intercept
points.
Price

2 b c
1 a e d
Commodity X
0 8 10 12

Fig. 3.8: Change in Consumer’s Surplus resulting from a Price change

62
When p = 1, x = 10 and when p = 2, x = 8. Consumer’s Surplus

Loss in consumer’s surplus = Area abcd

= Area abce + Area ecd
�
= (8 × 1) + � × (10 − 8) × 1
= 8 + 1 = Rs. 9
Check Your Progress 2
1) Other things remaining equal, assuming demand relation holds for an
individual and is observable, what happens to consumer’s surplus if the
price of a good rises? Illustrate using a demand curve.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) Consider a market for good X represented by the following demand
function, q = 125 – 25 p. Now assume the market price of this good to
be Rs. 3, calculate
a) The initial consumer’s surplus at market price of Rs. 3.
b) The change in consumer’s surplus when price falls to Re 1.
c) The gain due to fall in price to the consumers who could buy at old
price of Rs. 3 (that is, the gain to the old buyers); also the gain to
the new buyers of good X at lower price of Re 1.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
3) Assume that a market demand curve of a commodity is given as q = 20 –
p2. What will be the change in Consumer’s surplus when market price of
that commodity will rise from Rs. 2 to Rs. 3?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

3.4.2 Quasi-linear Preferences and Change in Consumer’s

Surplus
We have already learnt the concept of Quasi-linear preferences in Sub-
section 2.9.3 of Unit 2. In practice, to compute the change in consumer’s
surplus, we need to first have an estimate of the consumer’s demand
function. Besides demand curve analysis, there also exists an indifference
analysis approach to measure change in consumer’s surplus. It depends
upon some specific assumptions about the preferences of the consumer.
63
Consumer Theory Now, let us bring into picture quasi-linear preferences and the underlying
relation between change in consumer’s surplus and change in utility. They
both coincide when utility function is quasi-linear. Such a utility function is
given by
U(x1, x2, …xk, y) = y + v (x1,..xk); v’(.) > 0, v’’(.) < 0 (1)
Following is the specific form of quasi linear utility function:
U(x, y) = y + 5 log x
Function (1) is linear in one good, here y, but non-linear in the other goods
(here x). For this reason, this is called a quasi-linear utility function. For our
two goods analysis, we will consider k =1 in the utility function (1) to get,
U(x, y) = y + v (x) ; v’(.) > 0, v’’(.) < 0
U(x) is assumed to be a strictly concave function, an assumption which
would imply that indifference curves will be strictly convex. In utility
functions of this form, utility is measured in the same units as the y-good,
that is, every unit increase in y is a unit increase in utility; and if an increase
or decrease in x yields a change in utility of ∆U, the same change in utility
could have been brought about by instead changing y by the amount ∆U.
Indifference curves of a quasi-linear utility function are parallel shifts of each
other as shown in the following Fig. 3.9.
Commodity Y

U4
U3
U2
U1

Commodity X
Fig. 3.9: Quasi-linear Indifference Curves

In case of Quasi-linear utility functions, Consumer’s surplus is equal to the

gain in utility. Let us consider an example to prove this statement. Consider
�
a consumer with the utility function given by U(x, y) = y + 12x − � x � , having
a demand function x = 12 – p for good x, where we have assumed price of
good y to be Re 1, price of good x to be Rs. p per unit, and income of the
consumer to be Rs. 100. Suppose, consumer opts for a bundle (x = 0, y =
�
100), then his utility, given by U = 100 + 12(0)− � (0)� = 100. If he then
64 purchases x = 8 at a price of p = Rs. 4, leaving him with y = 68, his utility will
 � Consumer’s Surplus
be U = 68 + (12) (8) – ��� 64 = 132, a gain in utility of 32 units, or Rs. 32
worth of utility. One can easily check that his consumer’s surplus, estimated
as the area under the demand curve but the above the price line is also
Rs. 32.

3.5 COMPENSATING AND EQUIVALENT VARIATIONS

Alfred Marshall definition of consumer's surplus assumed that the marginal
utility of money is constant. Such an assumption was refuted by John Hicks.
He proposed two methods as ‘willingness to pay measures’ to allow for
monetary measurement of changes in utility. According to him, if
consumer’s preferences are known, it is possible to estimate the effect of
variation in the prices of the goods on the consumer’s utility in monetary
terms by using two alternative measures called Compensating and
Equivalent variation.
The compensating variation measure of a change in utility of a price
variation is concerned with asking— How much do we have to increase or
decrease consumer’s income to completely offset the effect of a price
variation on his utility? In other words, what change in consumer’s money
income will ensure that his utility remains same even after the price
change? Here, consumer is compensated for the price change and hence the
measure is called the compensating variation (CV). Thus, compensating
variation refers to the amount of additional money a consumer is needed to
be compensated, to reach their initial utility, after a change in prices. CV
reflects new prices and the old utility level.
The equivalent variation measure on the other hand asks— How much
increase or decrease in consumer’s income will cause him same utility loss
as will be caused by a price variation? Equivalent variation (EV) is a closely
related measure that uses old prices and the new utility level. The
equivalent variation is the change in wealth (or income), at current prices,
that would have the same effect on consumer welfare as would the change
in prices, with income unchanged. Both, compensating variation and
equivalent variation answer the same question— how much of an income
change is required to offset a price change, so that a consumer's utility is
unchanged?
Note:
1) Compensating variation is the income change needed after price change
to restore utility to pre-price change level.
2) Equivalent variation is the income change needed to bring utility to
post-price change level.
3) Both of these variations are observable only when demand functions
are observable and they satisfy the conditions implied by utility
maximisation.

65
Consumer Theory
3.5.1 Indifference Curve Analysis
Indifference curves can be used to analyse the effect of a price rise on
consumer’s utility. Consider again a hypothetical situation where an
individual chooses between good X and good Y in the following Fig. 3.10.
Here, we are considering good Y to be a numeraire good with price of Re 1
per unit. Let the original price of good X be p1 and income of the individual
be M. The budget constraint of this individual at the original prices
is ML1 and has a slope of − p1. The equilibrium is attained at the tangency of
the utility function and the budget constraint given by point A.
Now, suppose price of good X rises to p2 . Individual’s new budget constraint
becomes ML2, with a slope of − p2. After the price increase, individual’s new
equilibrium is given by point C. Clearly, this individual is worse off because of
the price rise, as evident from the fact that his new equilibrium bundle
choice (C) lies on a lower indifference curve I2 giving a corresponding utility
level U2, instead of I1 with a utility level U1 (where, U1 > U2).
Good Y

M + CV

M
B

M−EV C
A

D I1 (U1)

I2 (U2)

L2 L2* L1* L1
0 Good X
� � + �� � − �� �
�� �� �� ��

Fig. 3.10: Compensation and Equivalent variations

As discussed before, compensating variation (CV) is given by the amount of

money that would fully compensate this individual for a price increase.
Considering the above figure, as the price of good X increases from p1 to p2,
individual is given enough extra income (that is CV) to bring the budget line
back up to the old indifference curve (I1), so that his utility remains at U1. At
the new income of M + CV, individual's budget line becomes L2*, having the
same slope, − p2, as L2. Under such conditions — that are of the price rise
66 and the income compensation — individual would buy bundle represented
by point B. Since we have assumed good Y to be numeraire, the monetary Consumer’s Surplus
measure of the compensating variation will be equal to the difference
between the two intercept values of good Y given by the Budget line, L2 (i.e.,
M) and the after-compensation Budget line, L2* (i.e., M + CV).

Equivalent Variation will be given by the amount of income that if taken

from the individual, would lower his utility by the same amount as the price
increase would have done. In Fig. 3.10, with price of good X remaining same
at p1, the harm that will be caused by the increase in price of good X to
p2 will have to be caused by an income fall. For this, individual's income
would have to fall by enough to shift the original budget constraint, L1, down
to L1*, where it is tangent to I2 at Bundle D. Since, we have a numeraire good
on the vertical axis, equivalent variation will be given by the distance
between the intercept of L1 and that of L1* on the axis representing good Y.
The key distinction between these two measures of utility change, is that
the equivalent variation is calculated using the new (lower) utility level,
whereas the compensating variation is based on the original utility level.

3.5.2 Relation between Consumer’s Surplus, Compensating

Variation and Equivalent Variation
In general, Compensating Variation, Equivalent Variation, and Change in
Consumer’s Surplus (∆ CS) are not the same. But they do coincide if utility is
quasi-linear. Here, we can easily make out that compensating and
equivalent variations will be equal due to the fact that the resulting
indifference curves are parallel. Our good Y being a numeraire good will
ensure that the change in utility (equal to the compensating and equivalent
variation measure), will in turn be equal to the change in consumer’s
surplus, as we observed in Sub-section 3.4.2. Now, let us look into the proof
of this statement.

Consider a Quasi-linear utility function given by, U (x, y) = v (x) + y, where x

and y are the two goods of consumption. Now, assume income of the
consumer to be Rs. M, price of good x to be Rs. p and that of good y to be
Re. 1 (i.e., good y is assumed to be a numeraire good). If a consumer
consumes x1 units of good x, his consumption of good y will be M – px1.

Now, Indirect Utility Function* will be, V (px, py, M) = v (x1) + M – px1

* We have seen in Unit 2 that the constraint optimisation of utility function U(x, y),
subject to the budget constraint yields the demand functions x(px, py, M) and y(px,
py, M). Plugging these two optimal values in the Utility function we get U[x (px, py,
M), y (px, py, M)] = V (px, py, M). This function is called Indirect Utility function. Thus,
an indirect utility function gives the maximal utility the consumer can reach given
the prices and income. It is obtained by substituting the utility maximising levels of
goods x and y, given the set of prices, px, py, and the income, M, into the utility
function.

67
 Consumer’s Surplus

Good Y
U1

M + CV
U2

M B

M−EV C
A

D
I1 (U1)

I2 (U2)

L2 L2* L1* L1
0 � � + �� � − �� �
Good X
�� �� �� ��

Fig. 3.11: Compensation and Equivalent variations and change in consumer’s surplus

As per Fig. 3.11, EV = CV = U1 – U2. This holds only in case of quasi-linear

preferences.
It can also be shown (though using techniques outside the scope of this unit)
that in general when the preferences are not quasi-linear, the change in the
surplus is between the compensating and equivalent variations.
Example 3: Consider an individual buyer with a quasi-linear utility
preference over two goods X and Y, given by the relation U(X, Y) = 10(X)1/2 +
Y. Here, good Y is the numeraire good with price (py) as Re 1. Let price of
good X (px) be Re 1, which further rises to Rs. 2. Assuming individual’s
income to be Rs. 200, ascertain the two measures of utility change, that is,
Compensating and Equivalent variation of a price change.
Solution:
We will start with solving for the equilibrium level of consumption of good X
and good Y. That is,
The consumer will maximize U(X, Y) subject to the constraint, pxX + pyY = M.
For maximisation, the resultant lagrangean equation is given by
L = 10(X)1/2 + Y + λ [200 − (1)X − (1)Y]

69
Consumer Theory Differentiating L with respect to X, Y, and λ, setting the derivatives equal to
zero, and solving the resultant equations, we get the following optimal
values of X and Y:
X* = 25 ; Y* = 175
After the price increase, the optimal bundle of consumption become:
��
X** = �
; Y** = 187.5

In case of Quasi-linear utility functions, change in consumer’s surplus is

equal to the change in utility with different bundles of X and Y before and
after the price change.
��
Thus, Change in Consumer’s Surplus = U (25, 175) – U ( � , 175)
�
�� �
= 10(25)� + 175 − 10( � )� − 187.5

= 12.5
For computing Compensating Variation (CV), we will consider the following
relation:
��
U (25, 175) == U ( � , 187.5 + CV)
� 25 �
10(25)� + 175 = 10( )� + 187.5 + CV
4
CV == 12.5
Now, for computing Equivalent Variation (EV), we will consider the following
relation:
��
U ( � , 187.5) == U (25, 175 – EV)

25 � �
10( )� + 187.5 = 10(25)� + 175 − EV
4
EV == 12.5
In this case, change in consumer’s surplus equals compensating variation
which equals equivalent variation.
Check Your Progress 3
1) What is meant by Quasi-linear preferences? What special feature does
the indifference curve depicting such preferences possess?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
70
2) What are the two monetary measures of consumer utility change proposed Consumer’s Surplus
by Hicks? Explain with the help of diagram the relationship between these
measure and change in consumer’s surplus in case of quasi-linear
preference relation.
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
3) Consider the preference relation of an individual for two goods x and y to be
given by, U (x, y) = min[x, y]. Also assume income of this individual to be
Rs. 12. Given the market price of good x (px) as Re 1 and that of good y (py)
as Rs. 2, calculate the amount of compensating and equivalent variation for
this individual when the price of good x increases to Rs. 2.
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………

3.6 LET US SUM UP

The concept of consumer’s surplus is often used when economists are
deciding how scarce resources should be employed. This is a measure of the
benefits which accrue, above the costs, to the users of the resource in
question. In the present unit, we discussed the consumption theory further
in respect of the resultant gains to the consumer from market participation.
We learnt about consumer’s surplus, which was initially presented by Alfred
Marshall as an economic tool to measure benefits and losses resulting from
changes in market conditions. In case of observable demand curve, we
observed and estimated the amount of consumer’s surplus, be it for discrete
or for non-discrete goods consumption, as the difference between the
amount of money that a consumer actually pays to buy a certain quantity of
a good or service, and the amount that he would be willing to pay for this
quantity rather than do without it. We even calculated the extent of utility
change in terms of change in the amount of consumer’s surplus resulting
from price change of the good or service consumed.
As Marshallian consumer’s surplus concept assumes constant marginal
utility of money, which may not be the case always, subsequently the
concept was redefined by John Hicks using indifference analysis, inducing
the use of compensating and equivalent variations in utility economics. It
answered the very relevant question, how does consumer utility change
when the price changes? Equivalent variation answered it in terms of the
amount of money we would have to take away from the consumer before
the price change to leave him just as well off as he would be after the price
change. Whereas, compensating variation answered it in terms of the
amount of extra money needed to give to the consumer after the price
change to make him just as well off as he was before the price change. We
also learnt about the quasi-linear preferences and that consumer’s surplus is
71
Consumer Theory equal to the change in utility in case of such preferences. At the end, we
touched upon the relationship existing between the change in consumer’s
surplus, compensating variation and equivalent variation, noticed with proof
that the three measures of utility change are equal in case of quasi-linear
utility preferences.

3.8 REFERENCES
1) Varian, H. R. (2010). Intermediate Microeconomics: A modern
approach (8th ed.). New York: W.W. Norton & Co.
2) Mankiw, N. G. (2012). Principles of Economics (7th ed.). New Delhi:
Cengage Learning.
3) Morey, E. R. (2002). Exact Consumer Surplus Measures and Utility
Theoretic Demand Systems: A Historical Review. Retrieved from
https://www.colorado.edu/economics/morey/8545/cs/cs-histrev.pdf
4) Camm, F. Consumer Surplus, Demand Functions, and Policy Analysis,
Santa Monica, Calif.: RAND Corporation, R-3048-RC, 1983. As of May 04,
2018: https://www.rand.org/pubs/reports/R3048.html
5) “Consumer and Producer Surplus”. Retrieved from https://people.ses.
wsu.edu/galinatog/wp-
content/uploads/sites/289/2017/01/KW_CH6.pdf

3.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Read Section 3.2 about specifying a set.
2) i) Read Section 3.3 and draw the demand curve; ii) 5 units of good X ; iii)
At a price of Rs. 20, individual’s consumer’s Surplus would be Rs.100 ;
iv) only 3 units of good X
3) Rs. 400
Check Your Progress 2
1) Consumer’s surplus, as the area below the demand curve and above the
price line will fall due to price rise. Refer sub-section 3.4.1 and explain
with the help of a diagram.
2) i) Rs. 50
ii) Rs. 150
iii) CS gain to old buyers = Rs. 100 ; CS gain to new buyers Rs. 50.
(Hint: Plot the demand curve by keeping q = 0 for vertical intercept, and
finding q at the price level of Rs. 3 and then at Re 1. You may also refer to
72 Example 2 and proceed.)
 �� Consumer’s Surplus
3. − �
� �
(Hint: Change in Consumer’s surplus = �� (20 − �� )dp = 20p − � p� � ��
� � ��
= 20 × 2 − � × 8 − �20 × 3 − � × 27� = − � )]

Check Your Progress 3

1) Refer Sub-section 3.4.2 and answer. The indifference curves
representing such preferences are parallel, or in other words are
vertically shifted versions of one indifference curve.
2) The two monetary measures of consumer utility change proposed by
Hicks are Compensating and Equivalent variation. Refer sub-section
3.5.2 to explain and answer the second part.
3) CV = 4 ; EV = 3
[Hint: Given the utility function, U(x, y) = min [x, y], indirect utility function V
�
(px, py, M) will be given by, V (px, py, M) = � �� .
� �

For CV, insert values in the relation, V (px, py, M) = V (px′, py, M + CV), where
px′ = 2 (the increased price of good x).
For EV, insert values in the relation, V (px, py, M – EV) = V (px′, py, M)]

73
Consumer Theory
UNIT 4 CHOICE UNDER UNCERTAINTY AND
INTERTEMPORAL CHOICE
Structure
4.0 Objectives
4.1 Introduction
4.2 Representation of Uncertainty— Probability Distribution
4.3 Decision-making under Uncertainty
4.3.1 The von Neumann-Morgenstern Expected Utility Function

4.4 Attitude Towards Risk

4.4.1 Risk
4.4.2 Risk Neutrality
4.4.3 Risk Aversion
4.4.4 Risk Preferring

4.5 Risk Aversion and Insurance

4.6 Intertemporal Decision-making
4.6.1 Intertemporal Budget Constraint
4.6.2 Preferences over Two Time Periods: Indifference Curves
4.6.3 Case of a Borrower and a Lender

4.7 Let Us Sum Up

4.8 References
4.9 Answers or Hints to Check Your Progress Exercises

4.0 OBJECTIVES
After going through this unit, you will be able to:
• state the concept of uncertainty and risk;
• discuss the expected utility function and its properties;
• explain how to maximise utility under uncertainty;
• discuss the attitude of an individual towards Risk;
• elucidate how risk aversion is dealt with institution of insurance; and
• appreciate the process of the intertemporal decision-making by the
consumer.

4.1 INTRODUCTION
We have learned in Unit 2 how a consumer decides which combination of
goods and services to buy, given his income and prices of the goods, in order
to maximise his satisfaction. For this, there is a pre-supposition that the
consumer has complete and perfect information and knowledge about the
74
transaction. However, in real life situations, there are many uncertainties Choice Under Uncertainty
and Intertemporal Choice
that consumers have to face before they decide. Uncertainty is a fact of life.
In decision-making process, there are many uncertainties and randomness
that a consumer has to take into consideration. For example:
i) Used Car: When you buy a used car, you are very unsure about its
condition. You might be lucky and get a beautifully maintained car with
no mechanical problems, or you might get a lemon or damaged car
(whose mechanical problems are not easily observable).
ii) College/University: Suppose you choose a university for an
undergraduate degree. Your university is very expensive. During the
time of making decision about your college/university choice, how
much do you know about it (or them)? Do you know how many
professors are interesting and informative, and how many are deadly
dull and uninterested in teaching? Do you know what your major will
be? Do you know what a blessings or a curse your roommates or
classmates might be?
iii) Life Insurance and Annuities: If all the events and contingencies are well
known in life, then there is no need for insurance in such a society.
However, when significant uncertainties are present, insurances solve
the problem for such a society. You fear you may die too young, and
you want to buy a life insurance policy to protect your spouse and
children in the vent of your premature death. What kind of policy
should you buy, and how much insurance should you have?
Alternatively, you think you may live too long and you may run out of
savings before you go. You do not want to be a burden to your children.
You heard that you can buy an insurance against this possibility also.
Should you buy an annuity, and how big an annuity should you get?
iv) Investments: You have some money that you are going to invest in bank
term deposits (with minimal risks and also minimal rewards), or in
shares of stocks (with considerable risks but greater rewards). What
should you do?
v) Dangerous activities: You travel between home and college by car, or by
train. Be it any mode, each time you face some risk of a fatal accident.
Do you know what the odds of a road accident are? Suppose you own a
car and are good at driving. But you do not know whether everyone
around on the road is a careful driver. Someone may hit your car and
the damages can be huge and varied. Hence, whenever you drive out
from your house, you are uncertain that you will come back without
getting hit or what will be the amount of accumulated damage in any
accident.
There are countless examples in real life which involve uncertainty. Many of
the things we do increase uncertainty in our lives, whereas other things
reduce it. Sometimes we pay money to buy risks (like gamble, lottery) at
other times we pay money to avoid risks. Under such uncertainties, there
often exist difficulties in decision-making. To tackle this, institutions exist.
Insurance in an economy is another such institution which helps in
75
Consumer Theory mitigating risks that arise due to uncertainties. With uncertainties, you
might like to get insurance cover against car accidents. For this reason
agents buy various kinds of insurance (life insurance, car insurance, fire
insurance, crop insurance etc), to cover up for the risk involved or an
unforeseen contingency.
In this unit we shall explain the notion of uncertainty and how it impacts the
consumer’s behaviour. The concept of expected utility function will be
introduced in order to understand consumer’s decision-making under
uncertainty. In this connection, we will explain the concept of risk and an
individual’s attitude towards risk and the basic principle of choosing
insurance.
We shall also throw light on intertemporal decision making, where Inter-
temporal means across the time period. We shall take into consideration the
saving and borrowing by a consumer and how does they affect his/her
decision-making. This we will attempt to discuss with the help of an inter-
temporal budget constraint.

4.2 REPRESENTATION OF UNCERTAINTY—

PROBABILITY DISTRIBUTION

How does uncertainty affect consumer’s decision-making? In the presence

of uncertainty we have what is called— probability of occurrence of an
event. For example, if probability that a consumer’s income will increase is
90 per cent, then there is 10 per cent chance that his income might stay the
same. If there is complete information about the probability of occurrence
of an event, we can construct what is called a probability distribution. A
probability distribution shows the likelihood that a given random variable
will take up any of the given values. For example, the random variable in our
example is the individual’s salary hike. Table 4.1 shows probability
distribution of individual’s salary hike, that is it shows the likelihood that
income hike of the individual will take various values.

Table 4.1: Probability distribution of an Individual’s Salary Hike

Salary Hike (Rs.) Probability

0 (No change) 0.1
1000 0.1
3000 0.1
5000 0.4
7000 0.2
9000 0.1

76
This probability distribution is represented below in the Fig. 4.1. Choice Under Uncertainty
and Intertemporal Choice

Probability

0.5

0.4

0.3

0.2

0.1

0 1000 3000 5000 7000 9000 Salary Hike

Fig. 4.1: Discrete Probability Distribution

In the above diagram, we see probabilities of occurrence on the y-axis and

salary hike on the x-axis. Since there is finite number of events in this
example, we call it discrete probability distribution. Given the above
example, we can now say, probability that the salary hike will be Rs. 5000 is
40 per cent and that the hike will be Rs. 9000 the probability is only 10 per
cent.
Next, let us calculate, expected salary hike given the information regarding
the probability of their occurrence. So to calculate expected salary hike, we
multiply each salary hike with its respective probabilities, so we get,
Expected Salary Hike = 0(0.1) + 1000 (0.1) + 3000 (0.1) +
5000 (0.4) + 7000 (0.2) + 9000 (0.1) = 4700
Therefore, expected salary hike is equal to Rs. 4700.
Hence the expected value is nothing but the mean or the weighted average
of a random variable X. The data on random variable will be scattered
around its mean, that is, around its expected value.
Symbolically, Expected Value (EV) = ∑ X� P�
where X� is the random variable value at i and P� is the associated
probability. Accordingly, we require 0 < P� < 1 and also ∑ P� = 1
In the example that we are discussing here, the number of events (salary
hikes) is finite and the probability distribution is simply the vertical bars that
we see in Fig. 4.1. If, however, the number of events (let say height in
centimeters) were infinite, then the probability distribution would look like
the smooth curve as in Fig. 4.2. Such a probability distribution is called a
continuous probability distribution. 77
Consumer Theory

Probability
0
Height (in cm)
cm)
Fig. 4.2: Continuous Probability Distribution

4.3 DECISION-MAKING UNDER UNCERTAINTY

In the previous units, we discussed about the choices that the agents make
under the conditions of certainty. When uncertainty is involved, altogether a
different decision-making process will be followed. Consider an agent who is
to make a choice between two possible investment projects offering
different payoffs with respective probabilities. Please note here that the
decision-maker does not know what would happen once he decides
between the two investment plans, i.e. investment A or B. The outcome
here depends upon some random factors which are out of control of the
decision-maker. The random variable here will be the payoff or benefit to
the decision-maker by investing in either plan. Consider Table 4.2, giving
different payoffs from each plan along with their respective probabilities.
Table 4.2: Probability distribution of payoffs from different investment
Plans

Payoff from Plan A Probability Payoff from Plan B Probability

10 0.1 10 0.0
20 0.3 20 0.3
30 0.2 30 0.4
40 0.2 40 0.3
50 0.2 50 0.0

This is how the payoffs are read— there is 10 per cent chance of getting
Rs. 10 payoff, 30 per cent chance of getting Rs. 20 payoff and 20 per cent
chance each of getting payoff as Rs. 30, Rs. 40 and Rs. 50. Similarly for plan
B, we have the outcomes (payoffs) and their respective probabilities. Now to
choose between plan A or plan B, agent needs to calculate the expected
payoff from each plan.
78
From Plan A, his expected payoff = 10(0.1) + 20(0.3) + 30(0.2) + Choice Under Uncertainty
and Intertemporal Choice
40(0.2) + 50(0.2) = 31.
Similarly, from Plan B, expected payoff = 30.
As we might expect, our agent’s first inclination is to choose the investment
that provides the highest expected monetary value. This approach seems to
make sense. Most people would want to consider the investment from
which they can expect the greatest return. On such basis, our agent will
choose plan A because its expected payoff value is greater than the
expected payoff value of plan B. Hence when faced with uncertainties, it is
natural to believe that the agents maximise their expected monetary
benefits which, in turn, maximises their expected utility. But this is not true
in all cases. Now let us discuss a situation in which maximising expected
monetary value may render different result than maximising expected
utility.

Why Not Maximise Expected Monetary Returns?

Although it seems logical to use expected monetary value as the criterion
for making investment decisions under conditions of uncertainty, this
approach is actually filled with contradictions. Consider the following
example:
Let us say that a patient leaves a doctor’s office with the sad news that he
has exactly two days to live unless he is able to raise Rs. 20,000 for a heart
operation. The patient spends the next two days calling relatives and friends
but is not able to raise a penny. With one hour left to live, the patient walks
dejectedly down the street and runs into a dealer. Instead of offering the
patient Rs. 20,000 outright, this dealer offers him a choice between two
gambles. In gamble A, he will receive Rs. 10,000 with a probability of 0.50
and Rs. 15,000 with a probability of 0.50. In gamble B, the patient will
receive nothing (Rs. 0) with a probability of 0.99 and Rs. 20,000 with a
probability of 0.01. These gambles are summarised in the following
Table 4.3.

Table 4.3: Probability distribution of payoffs from Gamble A and B

Gamble A Gamble B
Prize (Rs) Probability Utility of Prize (Rs) Probability Utility of
Rupee Rupee
10,000 0.5 0 0 0.99 0
15,000 0.5 0 20,000 0.01 1
Expected monetary value = Rs. Expected monetary value = Rs. 200
12,500 Expected utility = 0.01
Expected utility = 0

Obviously, if our patient is a maximiser of expected monetary value, he

would like to choose gamble A, with expected return of Rs. 12,500, whereas
gamble B’s expected return is only Rs. 200. However, there is a catch here. If 79
Consumer Theory our patient chooses gamble A, then it is certain that he will die in one hour,
but if he chooses gamble B, he has at least a 1% chance to live. Hence, the
money to be received by our patient in gamble A is worthless because he
will die, while gamble B promises a chance to live. Therefore, most people
would say that gamble B is the better choice. The reason is obvious. Most
people are interested in more than just obtaining an amount of money. They
are also interested in what that money will bring in terms of happiness or
satisfaction. In this case, because Rs. 20,000 is needed for a lifesaving
operation, any amount below Rs. 20,000 is worthless. Hence, if we
arbitrarily call the value or utility of death 0 and the value or utility of living
1, we can see that from the patient’s point of view, the expected utility of
gamble A is 0 [0(0.5) + 0(0.5) = 0] and the expected utility of gamble B is 0.01
[0(0.99) +1 (0.01) = 0.01]. If people act, so as to maximise their expected
utility, then gamble B is better than gamble A and it is the one that will be
chosen by our patient.
The point of this example, then, is that when making decisions in situations
involving uncertainty, agents do not simply choose the option that
maximises their expected monetary payoff; they also evaluate the utility of
each payoff. We might say that they behave as if they are assigning utility
numbers to the payoffs and maximising the expected utility that these
payoffs will bring.

4.3.1 The von Neumann-Morgenstern (vNM) Expected

Utility Function
In their book ‘The Theory of Games and Economic Behaviour’, John von
Neumann and Oskar Morgenstern developed mathematical models for
examining the economic behaviour of individuals under conditions of
uncertainty. Note that the new utility function is no longer be purely ordinal,
it will have some properties of cardinal utility function; however it will be
providing the basis for the rigorous analysis of choice under uncertainty.
Consider a risky situation, where the decision-maker does not know
beforehand which state of the world will occur. For simplicity we assume
two possible state of the world situations — 1 and 2, with respective
probabilities of their occurrence as π1 and π2. Let c1 denote individual’s
consumption if state 1 occurs and c2, if state 2. One of the convenient ways
to represent von Neumann-Morgenstern expected utility function is in the
following form:
u(c� , c� ) = π� v(c� ) + π� v(c� )

Where, function v(.)* gives the amount of utility attained from some
amount of consumption. Thus vNM expected utility can be written as a
weighted sum of some function of consumption in each state, v(c1) and
v(c2), where the weights are given by the probabilities π1 and π2 (where 0 <
�� < 1 and also �� = 1 with i = 1, 2). If one of the states is certain, so that
π1 = 1 say, then v(c1) is the utility of certain consumption in state 1. Similarly,
if π2 = 1, v (c2) is the utility of certain consumption in state 2.

80
When we say that a consumer’s preferences can be represented by an Choice Under Uncertainty
and Intertemporal Choice
expected utility function, or that the consumer’s preferences have the
expected utility property, we mean that we can choose a utility function
that has the additive form described above.

VNM utility theory is based on the following assumptions:

1) Completeness and transitivity: The consumer’s preference over all the

alternatives, certain and uncertain, are complete and transitive. It is an
obvious extension of the assumption we made for the standard
consumer theory model.

2) Continuity: Suppose consumer prefers alternative X over Y and Y over Z,

that is Y is somewhere between X and Z in the consumer’s preference
ranking. Then there must exist a probability px, with 0 < px < 1, such that
the consumer is indifferent between the middle alternative Y and the
lottery offering best alternative X with probability px and the worst
alternative Z with probability (1 – px).

3) Independence: Suppose consumer is indifferent between alternatives X

and Y, and Z is any other alternative. Consider two lotteries— one with
outcomes X and Z and the other with Y and Z. Suppose both these
lotteries assign the same probability to the indifferent alternatives (i.e.,
X or Y), and therefore the same probability to the other alternative Z.
Then the consumer must be indifferent between these two lotteries.

4) Unequal probabilities: Suppose consumer prefers alternative X to Y.

Consider two lotteries, both having only X and Y as possible outcomes,
with both attaching different probabilities to the two outcomes; then
consumer prefers the lottery that assigns a higher probability to her
preferred outcome X. Thus a consumer would prefer the gamble that
gives him/her better odds of the preferred prize.

5) Compound lotteries: A consumer is given a choice between lotteries.

Lottery L1 is the straightforward lottery that provides certain outcomes
(X1, X 2,…, X�) with respective probabilities (p1, p2,…, p�). Lottery L2 is a
lottery whose outcomes are other lotteries. However, after the
intermediate lotteries play out, it ultimately ends up with a same
certain outcomes, and with the same respective probabilities (p1, p2,…,
p�). Then the consumer is indifferent between L1 and L2. Thus a rational
consumer would focus on the ultimate probabilities of the ultimate
outcomes.

Thus Von Neumann Morgenstern (vNM) Expected Utility theorem says: Let L
be the risky alternative, that is, any lottery. Suppose its outcomes are (X1,
X2,…, X�). These are certain outcomes or other lotteries with respective
probabilities (p1, p2, … , p�). Then the utility of the risky alternative L is the
expectation of the utilities of its possible outcomes. That is:
U(L) = p1 U(X1) + p2 U(X2) + ⋯ + pnU(Xn)
81
Consumer Theory Check Your Progress 1
1) Which of the following utility functions have the expected utility
property?
a) u(c1, c2) = 5 [π� v(c� ) + π� v(c� )]
b) u(c1, c2) = π1c1 + π2c2
c) u(c1, c2) = π1 ln c1 + π2 ln c2 + 17

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2) What is a probability distribution? How does it explain the choice under

uncertainty?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

3) Consider an individual who invests in different schemes and faces an

uncertain income flow of Rs 5,000, or Rs 8, 000, or Rs 10,000 with
respective probabilities of 10%, 50%, and 35%. Determine the expected
monetary value of the investment schemes.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4) Explain von Neumann Morgenstern utility function.

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4.4 ATTITUDE TOWARDS RISK

How does an individual decide when facing risks? Assuming that the
decision-making by such an individual is rational, his attitude towards risk
82
can be ascertained. In this section we attempt to employ the concept of Choice Under Uncertainty
and Intertemporal Choice
expected utility function to see how ‘rational’ decisions are made in the face
of risk. We will define here, what is called— the risk in choice-making, which
arises due to uncertainty; and how institution of Insurance helps to
overcome such risks.

4.4.1 Risk
Risk is generally perceived as the possibility of facing a misfortune or a loss.
In other words, it is the potential that a choice or a decision made will bring
an undesirable outcome. Like your decision to drive a car on road involves
the risk of your car meeting an accident and hence incurring damage or loss.
That is here, risk is involved with uncertainty of happening or not happening
of an event. Such uncertain situations are often connected to some
associated probabilities of occurrence or non-occurrence of an event.
Now the question arises, “How do people react to events involving risk
compared to those that are risk-free?” There exists heterogeneity in
people’s preference toward risk. Consider an individual, who is asked to
choose between two gambles, G1 and G2. Gamble G1 offers a prize of Rs. 50
with certainty, whereas gamble G2, offers a prize of Rs. 100 with a
probability of 0.50 and no prize with a probability of 0.50. G1 being a sure
thing is obviously less risky than G2. Expected value of the gambles will be
given as follows:
Expected Value (EV) of G1 = 1 × 50 = Rs. 50 (as probability of a certain payoff
is 1.)
Expected Value (EV) of G2 = 0.50 × 100 + 0.50 × 0 = Rs. 50
Although both Gambles have the same EV, one can only be sure about G1 as
G2 is risky in Economic sense. While making a choice between G1 and G2,
some people might be indifferent among G1 and G2; some might prefer G2,
the risky one; and others might choose G1, the safe gamble. From this,
emerges the notion of attitude towards risk. Suppose a consumer is given
the choice between two activities, a risk-free activity with a guaranteed
outcome and a risky activity involving outcomes with some probabilities.
Assuming people prefer to maiximise utility attained from different available
options and not associated monetary payoffs, they can be classified
according to their attitude towards risk into three categories, viz— Risk
Neutral, Risk Averse and Risk Loving. Let’s discuss each one of these three
categories.

4.4.2 Risk Neutrality

A risk neutral person shows no preference between a certain income, and
an uncertain income, given they both have equal expected value. In other
words, he will be indifferent between a risky and a risk-free choice, if both
result in same expected value to him. In our example above of two gambles
(G1 and G2), a risk neutral person would be indifferent between the two, as
both have equal expected value (= Rs. 50).
83
Consumer Theory Now we attempt to graphically present behaviour of such an individual.
Consider an individual facing risky activity A that generates a payoff (X) of
� �
Rs. 100 with probability � and a payoff of Rs. 1000 with probability �.
� �
Expected Value (EV) of activity A will be given by (� × 100) + (� × 1000) =
Rs. 775.
Let utility function representing preferences of this individual be given by
U(X) = 2X, where X represents the payoff in Rupees.
Now, consider Fig. 4.3 where Payoffs (Rs) appear on the horizontal axis and
the utility generated by those payoffs, on the vertical axis.
Utility attained when payoff X = 100 (represented by point a) is given by
U(100) = 2(100) = 200;
Similarly, when payoff X = 1000, utility attained (represented by point b) is
given by U(1000) = 2(1000) = 2000.
Expected Utility [E(U)] of the risky activity A will given by
� � � �
[� × U(100) + � × U(1000)] ⇒ [� × 200 + � × 2000] = 1550, this is nothing but
the height at point c, representing mean value of the line joining points a
and b.
Now, suppose a risk-free activity B is offered to the same individual, where
he receives a certain payoff, which equals the EV (expected value) of the
Risky activity A, i.e. Rs. 775. Then, EV of risk-free activity B will also be
Rs. 775, as individual will be receiving the amount with certainty (i.e.
probability = 1).
Utility attained from activity B [let us denote it by U(EV) as activity B’s payoff
is nothing but equal to the EV of activity A] will be given by
U(775) = 2(775) = 1550, which is again equal to the height at point c.
Now, points a (100, 200), b (1000, 2000) and c (775, 1550) can be joined to
form a straight line, representing individual’s utility function. Every point on
this straight line curve tells us how much utility he will receive from any
given level of rupees.
A straight line utility curve indicates that the individual’s attitude towards
risk will be neutral. This stems up from the fact that when faced with two
activities A and B, with former being risky and the latter, risk-free, just
because they both had same expected payoff value (= Rs. 775), the
individual with the given utility function [U(X) = 2X] attained same utility
from both the activities. That is,
Expected utility of risky activity A [E(U)] = Utility from risk-free activity B
[U(EV) ] = 1550.
Note, however, that because the utility function is a straight line, every time
the agent obtains one more Rupee, his utility increases by the same amount.
84
To put it another way, the marginal utility of an additional Rupee is Choice Under Uncertainty
and Intertemporal Choice
constant, no matter how many Rupees the agent already has.

U = 2X
Utility from Payoff

b
2000

E(U) = U(EV) c
= 1550

a
200

0 100 EV = 775 1000 Payoff (X in Rs.)

Fig. 4.3: Risk Neutrality

4.4.3 Risk Aversion

Now we consider an individual who has an aversion to risk, i.e. one who
strongly dislikes risk. The utility function representing a risk-averse
individual is not a straight line but rather is concave (refer Fig. 4.4).
Concavity of the function implies that its slope is decreasing, which in turn
implies that this individual exhibits diminishing marginal utility for additional
units of payoff. In other words, the risk-averse consumer is not willing to
incur additional risk for the possibility of a higher valued payoff. Unlike his
risk neutral counterpart, such an individual will not be indifferent between a
risk-free and a risky activity, each of which has the same expected monetary
value.
To graphically understand such a behaviour, let us consider an individual
�
who faces an option to either choose a risky activity A with a 20% (= �)
�
chance of obtaining a payoff of Rs. 36 and a 80% (= �) chance of obtaining
Rs. 100, or go for a risk-free activity B with a certain payoff equal to the
� �
expected payoff of the risky activity A, i.e., Rs. 87.2 �= � × 100 + � × 36�.

Now assume this individual has utility function given by U (X) = √X, where X
is the payoff received. We will proceed in the similar way like we did in case
of risk-neutral individual (Refer Fig. 4.4).

U(36) = √36 = 6, the height at point a; U(100) = √100 = 10, height at the
point b.
85
Consumer Theory � � � �
E(U) of the risky activity A = [� × U(36) + � × U(100)] ⇒ [� × 6 + � × 10] = 9.2,
height at point c, representing mean value of the line joining points a and b.
A risk-free activity B will offer a certain payoff of EV of the Risky activity A,
i.e. Rs. 87.2. EV of risk-free activity B will also be Rs. 87.2.
Utility attained from activity B, i.e. [U(EV)] = U(87.2) = √87.2 = 9.338, which is
equal to the height at point d. Here, we get U(EV) > E(U). That is, this
individual attains higher utility from risk-free activity B, as compared to the
expected utility from risky activity A (9.338 > 9.2). Such a behaviour exhibits
an individual’s risk averseness, where expected utility associated with a risky
choice is less than the utility attained from a certain outcome (= the
expected outcome of the risky choice) of a risk-free choice.

U = √�
b
10
d
U(EV) = 9.338
E(U) = 9.2 c

a
Utility from Payoff

0 36 EV = 87.2 100
Payoff (X in Rs.)
Fig. 4.4: Risk Aversion

4.4.4 Risk Preferring

There are some individuals who actually prefer risky activities to risk-free
ones. These individuals are called risk lovers possessing a risk preferring
attitude. A utility function for such an agent is shown in Fig. 4.5. Note that
the utility function in Fig. 4.5 becomes steeper as the agent’s payoff
increases. Hence, a risk-preferring agent has increasing marginal utility for
additional units of payoff represented by convex utility function. This simply
means that the risk preferring individual is quite willing to take on additional
risk for the possibility of a higher valued payoff. To understand such
behaviour better, consider an example of an individual who faces a choice
�
between a risky activity A, with a 50% �= �� chance of obtaining a payoff of
�
Rs. 5 and a 50% �= �� chance of obtaining Rs. 10, or go for a risk-free

86
activity B with a certain payoff equal to the expected payoff of the risky Choice Under Uncertainty
� � and Intertemporal Choice
activity A, i.e., Rs. 7.5 �= � × 5 + � × 10�.

Now assume this individual has utility function given by U (X) = X � , where X
is the payoff received. Here again we proceed in the similar way like we did
in case of risk-neutral and a risk-averse individual.

U(5) = 25, the height at point a; U(10) = 100, height at the point b.
� � �
Expected Utility, i.e. E(U) of the risky activity A = [� × U(5) + � × U(10)] = [� ×
�
25 + � × 100] = 62.50, height at point c, representing mean value of the line
joining points a and b.

A risk-free activity B offering a certain payoff equal to the EV of the Risky

activity A, i.e. Rs. 7.5, will also have an EV of Rs. 7.5 (as probability of a
certain payoff = 1).

Utility attained from activity B, i.e. [U(EV)] = U(7.5)

= (7.5)� = 56.25, which is equal to the height at point d.

Here, you can easily notice from the figure, that height ce > de, that is, we
get E(U) > U(EV). In other words, expected utility attained by this individual
from risky activity A is greater than the utility he receives from risk-free
activity B giving certain outcome (that is, 62.50 > 56.25). Such a behaviour
exhibits that the individual is risk preferring, with expected utility associated
with a risky choice being more than the utility attained from a certain
outcome (= the expected outcome of the risky choice) of a risk-free
choice.

b
100
Utility from Payoff

c
E(U) = 62.50
U(EV) = 56.25
d

a
25

e
0 5 EV = 7.5 10
Payoff (X in Rs.)
Fig. 4.5: Risk Preferring
87
Consumer Theory
4.5 RISK AVERSION AND INSURANCE
In addition to characterising an agent’s attitude toward risk, expected utility
theory can be of use to us in analysing more applied questions about
insurance and about risk-taking in general. To understand the value of
expected utility theory in such areas, let us consider Fig. 4.6.
Fig. 4.6 is identical to Fig. 4.4. It depicts the utility function of an agent who
is averse to risk. Let us assume that this agent owns a house that has a
current value of Rs. 100 and that she is aware of the possibility that the
house may burn down, in which case the land it is on, will be worth Rs. 36
only. Let us also assume that from previous history, we know that there is a
20% chance that the agent’s house will burn down. Therefore, we can say
that during the next period, the agent is actually facing a gamble in which
�
she will have a house worth Rs. 100 with a probability of 80% (= �) , or she
�
will have land worth Rs. 36 with probability 20% (= �).
� �
Expected value of the gamble = � × 100 + � × 36

= Rs. 87.2

Assuming individual’s utility function to be U (X) = √X, where X is the rupee

value.

U(36) = √36 = 6, the height at point a; U(100) = √100 = 10, height at the
point b. Therefore, the expected utility E(U) is
� � � �
E(U) = [� × U(36) + � × U(100)] ⇒ [� × 6 + � × 10] = 9.2,

height at point c, representing mean value of the line joining points a and b.
The utility from the expected value (or income) of the gamble U(EV) is:

U(EV) = U(87.2) = √87.2 = 9.338, height at point d on the utility

function.
If the agent does nothing, her current state (ownership of the house) is
worth the height cg (= 9.2) to her in terms of utility. Could this risk averse
agent be assured of some certain amount (let it be denoted by Rs. C), which
would give her a level of utility equivalent to the expected utility level from
the risky gamble, i.e. 9.2? Point e on the utility function curve represents
such a possibility.
The corresponding Rupee value on the x-axis associated with point e will be
given by
U(C) = 9.2

√C = 9.2 (squaring both sides to get the value of C)

C = 84.64

88
Note that cg and ef are the same height, where ef represents utility to the Choice Under Uncertainty
and Intertemporal Choice
agent (= 9.2) with a sure payoff of Rs. 84.64. This amount of Rs. 84.64 is
known as the Certainty Equivalent of the Gamble.

Certainty Equivalent (CE)

Certainty equivalent (CE) of a risky activity is the amount of money for
which an individual is indifferent between the gamble and the certain
amount. In other words, it is the amount of money received with
certainty giving a utility level to the individual equivalent to the level
attained by risky gamble. It is also called the selling price, from the fact
that it serves as the definite price at which the activity could be sold, or
at which individual will be indifferent between facing and selling a
gamble.

Our agent can obtain Rs. 84.64 for sure if someone is willing to sell her
insurance on the house for a yearly premium (price) of Rs. 2.56 (= Rs.
87.2 − 84.64). This 2.56 amount is nothing but what is called the Risk
Premium. It is simply the amount which the agent is willing to forego in
order to be indifferent in her choice between a risky gamble and the one
with a certain return. The notion of a risk premium is directly applicable to
insurance policies. An individual who purchases an insurance policy willingly
pays a sum of money, known as an insurance premium (or Risk premium), in
order to guarantee a certain level of monetary value generally associated
with some type of risky activity.

U = √�
b
10
d
U(EV) = 9.338 e
E(U) = 9.2 c

a
Utility from Payoff

f g
0 36 84.64 87.2 100
(CE) (EV) Payoff (X in Rs.)

Risk Premium = 2.56

Fig. 4.6: Risk Aversion and Insurance

89
Consumer Theory

Check Your Progress 2

1) Define the concepts of Expected Value and Expected Utility. Explain
their application in determining the attitude of an individual towards
risk.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
2) A risk-averse individual is offered a choice between a gamble that pays
Rs. 1000 with a probability of 25% and Rs. 100 with a probability of 75%,
or a payment of Rs. 325. Which would he choose?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
3) How does insurance help reducing risk?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4.6 INTERTEMPORAL DECISION-MAKING

The word “Intertemporal” simply means “across time”. So far we have
assumed that consumer exhausts all his income in a given time period and
accordingly makes consumption decisions. We did not consider that income
in one time period can be transferred to another time period, that is, our
analysis so far has been static. In this section, we will attempt to look into
decision-making process adopted by an individual across time periods. For
instance, his decision about how to allocate his income through time:
whether to borrow for current consumption or save for retirement; whether
to build up a pension fund or not; whether to save for a holiday or spend all
right away, etc.

4.6.1 Intertemporal Budget Constraint

Under intertemporal decision-making, individual decides about his savings
and borrowings. To begin with this, let us first describe how the budget
constraint changes when there are intertemporal decisions.

90
Up till now, the budget constraint we have been considering is given by, Choice Under Uncertainty
and Intertemporal Choice
p� x� + p� x� = M
Where, p1 is the price of good x1, p2 is the price of good x2 and total income
of the consumer in the given time period is M. Along with this, we have
been assuming that consumer exhausts all his income, so that total
expenditure is equal to total income. Now with intertemporal choices, there
is an intertemporal budget constraint.
Consider an individual who is assumed to live for two periods, 1 and 2,
earning Y1 and Y2 amounts of income, respectively. Let us denote
consumption of this individual in period 1 and 2 by C1 and C2, respectively.
Along with consumption, individual also has an option to either save (then
C1 < Y1) or borrow (then C1 > Y1) in period 1, with savings being given by S1 =
Y1 – C1 (and borrowing is negative saving). The market rate of interest (r) is
assumed to be given and constant, which an individual could earn or pay on
his savings or borrowings, respectively. If consumer saves S1 amount in
period 1, then in period 2 he would earn (1 + r) S1 in income.
Individual under the above conditions is thus faced with the problem of
choosing an optimal consumption stream (C1 and C2) through time, given
the stream of income (Y1 and Y2) and market rate of interest. There are two
possibilities:
If individual decide not to consume the entire Y1 in period 1, i.e., Y1 > C1,
then S1 > 0 (individual saves Y1 – C1 in period 1). Then the budget constraint
of this individual for period 1 will be given by,
C1 + S1 = Y1
Whereas, if he decides to consume more than what he has in period 1, i.e.,
Y1 < C1, then S1 < 0 (individual borrows C1 – Y1 in period 1). This individual
will have to then pay back (1 + r) S1 amount to the lender in period 2. The
budget constraint of this individual for period 2 will be given by,
C2 = Y2 + (1 + r) S1
These two budget constraints can be combined into one by solving for S1.
The intertemporal budget constraint then will be given by,
�� ��
�� + = �� +
1+� 1+�
This means that, if we assume that there are two time periods, then total
��
lifetime income (i.e., Y� + ��� ) is equal to total lifetime consumption (i.e.,
��
C� + ��� ). Which is highlighting the fact that an in lifetime individual cannot
consume more than his income. Income in period 2 is discounted by the
factor (1 + r) to get the present value of future income, this is what is done
with consumption in period 2. Thus, the intertemporal budget constraint
says that the present discounted value of consumption expenditures must
equal the present discounted value of income.

91
Consumer Theory Following is the diagrammatic representation of this budget constraint.
(Fig. 4.7).

C2

�� + �� (� + �) A
Consumer is
a Saver

C2 = Y 2 E

Consumer is
a Borrower

Slope = − (1 + r)

B
0 C1 = Y 1 �� C1
�� +
�+�
Fig. 4.7: Intertemporal Budget Constraint

Graphed in (C1, C2) plane, the intertemporal budget constraint is a straight

line (here AB) with slope – (1 + r). In the above diagram, E is the point of
endowment, which means, consumption in each time period is equal to
respective income. If the consumer chooses a point to the right of the point
E (i.e. in the segment EB), then he is a borrower, as he borrows to consume
in period 1, i.e., C1 > Y1. If he consumes his lifetime income in period 1, then
��
maximum he can consume in period 1 is Y� + , the intercept on
���
horizontal axis. Similarly, if he consumes in any point to the left of the
endowment point (i.e. in the segment AE), then he is a saver in period 1, i.e.,
C1 < Y1. If he saves all his income in period 1, then maximum in period 2 is Y2
+ Y1 (1 + r), the intercept on vertical axis.
Thus intertemporal budget constraint shows all the possible combinations of
consumption in two periods (C1 and C2) available to the consumer, given Y1,
Y2 and r. Given this constraint, the consumer attempts to reach his optimal
by placing his preferences over these allocations. With increase in the rate
of interest, consumption today becomes more expensive than consumption
in the future, hence, the budget constraint becomes steeper around the
endowment and vice versa.

4.6.2 Preferences over Two Time Periods: Indifference Curves

How does a consumer place his preference over consuming today or
tomorrow? Each individual has different preferences. Some might want to
consume all today while some might want to save all today. There might be
92 some who would want to save some today to enjoy higher consumption in
future, while there are others who enjoy greater consumption today Choice Under Uncertainty
and Intertemporal Choice
through borrowing and thus are left with lesser income to consume in
future.
Such differences show that consumer places his preferences over consuming
in two time periods like placing preferences between two goods. Here
consumption in both the time periods (i.e. C1 and C2) will be treated as
“normal goods”, as consumer decides to consume in both the time periods.
This assumption implies that indifference curves showing different
combinations of C1 and C2, keeping consumer utility constant, to be
downward (negative) sloping and convex-shaped (IC1, IC2 and IC3 in the
Fig. 4.8). Downward or a negative slope of IC implies that an increase in
consumption in one period must be accompanied by decrease in
consumption in another period, so as to keep the satisfaction level constant.
The idea of convex indifference curves have been studied in detail earlier.
Convex preferences are a reflection of a decreasing marginal rate of
substitution, which simply means that, as consumption in any one period
increases more and more, the individual will prefer to sacrifice (substitute)
lesser and lesser amounts of consumption in the other period. Fig. 4.8,
shows such preferences.

C2

IC3
IC2
IC1
0 C1
Fig. 4.8: Indifference Curves

How does consumer choose between two time periods, in other words, how
consumer allocates his/her consumption over time? Through intertemporal
budget constraint, all the allocation possible to him/her at the given market
interest rate “r” are derived, and through indifference curves, his/her
preferences over two time periods are described. Consumer optimal is
achieved where the intertemporal budget constraint is tangent to the
convex indifference curve (refer Fig. 4.9). At the point of tangency,
diminishing slope of indifference curve is equal to the constant slope of
intertemporal budget constraint. Thus optimal consumption between two
���
���
time periods (C1*, C2*) occurs where, − �� = −(1 + r)
���
�

Marginal Rate of Substitution (Slope of Indifference curve) is given by

���
���
− �� , and slope of budget constraint is – (1 + r).
���
� 93
Consumer Theory The point of tangency shows consumer choice. The tangency condition is
necessary and sufficient condition to achieve equilibrium, as the preferences
are convex.

C2

�� + �� (� + �)

C 2* (C1*, C2*)

IC

0 C 1* �� C1
�� +
�+�
Fig. 4.9: Optimal Consumption Bundle in Two Periods

4.6.3 Case of a Borrower and a Lender

As we have discussed above, a consumer can choose to save in period 1 by
consuming less than his income for that period, or he may consume more
than the amount earned by borrowing in that period. Now to see whether
the consumer chooses to become saver or borrower in time-period 1,
consider Fig. 4.10 and 4.11 below:

C2 C2

C 2* Y2 E
A (C1*, C2*)

B (C1*, C2*)
Y2 E IC C 2*

IC

0 C 1* Y1 C1 0 Y1 C 1* C1

Fig. 4.10: Case of a Saver Fig. 4.11: Case of a Borrower

94
Fig. 4.10, shows the case of saver. Endowment point in given by point E, Choice Under Uncertainty
and Intertemporal Choice
where C1 = Y1 and C2 = Y2. We can see here that the choice made (C1*, C2*)
is to the left of the endowment (E) given by the tangency of the indifference
curve and the intertemporal budget constraint. That is, the consumer
chooses to consume at point “A” where, C1* < Y1. Hence, this consumer
saves in period 1 and will enjoy greater consumption in period 2.
Fig. 4.11, shows the case when consumer chooses to become borrower in
period 1. Optimal allocation is given by point B (the tangency of the
constraint and the indifference curve), where C1* > Y1. Hence, the consumer
will end up borrowing in period 1 and will have lesser consumption in
period 2.

Changes in Interest Rates

Finally, let us look at what happens when interest rate “r” changes. First we
consider the case when interest rate increases and how this affects
consumer choice? This will be studied under two cases, (a) when individual
initially is a saver, and (b) when he initially is a borrower.

Consider him a saver first (i.e., C10 < Y1), with an initial consumption bundle
given by point A (C10, C20) in Fig. 4.12. When interest rate (r) rises, the
intertemporal budget line (RU initially) pivots around the endowment point
(E) and becomes steeper (TS ultimately). Pivoting of the new intertemporal
budget line around the endowment point indicates that the individual can
always consume the endowment in each period regardless of what “r” is.
The horizontal-axis intercept shifts in to indicate the increased opportunity
cost of present consumption resulting from increased interest rate. In
contrast, the vertical axis intercept must shift up. Now to reach at the new
optimal consumption in two periods bundle, we will be considering both,
the substitution and the income effect of an increase in interest rate.
Substitution effect will cause a fall in C1 and an increase in C2 resulting from
rise in relative price of present consumption (1 + r). C2 will definitely rise, but
nothing can be said about C1. This is due to income effect. An increase in r,
with individual being a saver initially will result in a bigger return on his
savings and hence more income in the next period. Since consumer now has
greater lifetime income, and consumption in both the time period are
considered to be normal goods, both C1 and C2 will increase. For C2, both
substitution effect and income effect works in same direction. But for C1,
they move in opposite direction. Substitution effect decreases C1 while
income effect increases it. Finally whether C1 increases or decreases will
depend on which effect is more dominating. Hence the resultant change in
C1 is ambiguous. Thus, if consumer is a saver and interest rate goes up, he
will continue to be a saver (increased C2 will ensure consumer stays on the
left of the endowment point). This is illustrated in Fig. 4.12, where we
assumed C1 decreased with substitution effect dominating income effect, for
us to be reaching at new optimal consumption bundle (C1*, C2*).

95
Consumer Theory
C2

R
B
C 2*

A
C 20
IC2

IC1
Y2 E

0 C 1* C 10 Y1 S U C1

Fig. 4.12: Consumer initially a Saver and Interest Rate rises

Let us consider the case when interest rate rises and individual was a
borrower in time period 1 (i.e. C10 > Y1). It will become expensive to
consume in first period as relative price of C1 (i.e., 1 + r) will rise, thus
substitution effect will make C1 to fall and C2 to rise like before. An increase
in r, with individual being a borrower initially will result in him paying back
more on its borrowing, reducing his income in period 2 and hence his
lifetime income. Reduced income will induce him to reduce both C1 and C2.
Hence, for a borrower, the income and substitution effects go in the same
direction, leading the individual to definitely reduce C1. But here the result is
ambiguous for C2, as both, income and substitution effects go in opposite
direction.
Check Your Progress 3
1) A consumer, who is initially a lender, remains a lender even after a
decline in interest rates. Is this consumer better off or worse off after
the change in interest rates? If the consumer becomes a borrower after
the change, is he better off or worse off?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
96
2) What is the present value of Rs. 100 one year from now if the interest Choice Under Uncertainty
and Intertemporal Choice
rate is 10%? What is the present value if the interest rate is 5%?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
3) As the interest rate rises, does the inter-temporal budget constraint
become steeper or flatter? Give reason.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4.7 LET US SUM UP

In the earlier units we analysed the rational consumer’s choice with the
assumption of perfect information. However, in a real world situation,
perfect information is far from reality. Such lack of perfect information in
turn results in uncertainties or the situations involving risk. We began with
some real life examples of consumers’ choice under uncertainty and then
introduced the concept of risk in a framework of probability distribution. On
the basis of this the method of finding the expected value of the outcome
associated with a risky/uncertain situation was explained. We proceeded
with our model on consumer choice under uncertainties by bringing into
picture the von Neumann-Morgenstern expected utility function, giving the
average utility, or the expected utility, of the pattern of consumption in
uncertain states. In addition to this, we elaborated the procedure involved
in classification of individuals on the basis of their attitudes towards risk by
comparing Expected Utility of the risky activity [E(U)] with Utility from
expected value of a risk-free activity [U(EV)]. On the basis of such
comparison, we came across three types of individuals with differing
attitude towards risk— Risk Neutral, Risk Averse, and Risk Preferring. The
unit further analysed the importance of Insurance for a Risk Averse
individual. With the help of the concept of Certainty Equivalent, we
discussed the concept of Risk Premium— the amount that an individual is
willing to pay in order to guarantee a certain level of monetary value
generally associated with some type of risky activity.
In further sections, we engaged ourselves to get an insight into the
intertemporal decision-making by an individual. We saw how an individual
choose an optimal consumption stream through time. This was achieved
with the help of intertemporal budget constraint, which simply equated
present value of the consumption stream with the present value of the
income stream. We combined the budget constraint confining to two time
periods, with the Indifference curves giving preferences of an individual over
consumption in the two periods— to get to the optimal intertemporal 97
Consumer Theory choice, given the income stream and the market rate of interest. Lastly, we
discussed the case a lender and a borrower by comparing an individual’s
consumption with his income in each period. We further explored how an
interest rate increase affects a lender’s or a borrower’s intertemporal
consumption.

4.8 REFERENCES
1) Varian H.R, (2010). Intermediate microeconomics, W.W. Norton and
Company,
2) Case K.E., Fair R.C and Oster S.M, (2012). Principles of economics, 10th
edition. Pearson Education, USA
3) Bernheim B.D and Whinston M.D, (2009). Microeconomics. Tata
MacGraw Hill, New Delhi
4) Pindyck R.S and Rubenfeld D.L, (1995). Microeconomic. Prentice Hall
International Inc, China
5) Serrano Roberto and Allan M. Feldman, (2013). A Short Course in
Intermediate Microeconomics with Calculus. Cambridge University
Press.

4.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Functions (a) and (c) have the expected utility property while (b)does
not.
2) See Section 4.2 and answer.
3) Rs. 8,000
4) See Sub-section 4.3.1 and answer.
Check Your Progress 2
1) Hint: Utility of the expected value [U(EV)] of a gamble is compared with
the expected utility [E(U)] of the same gamble to infer about the
individual’s attitude toward risk. If U(EV) > E(U), then individual is risk
averse; if U(EV) < E(U), then he is risk preferring, and if U(EV) = E(U),
individual is risk neutral.
2) Here both, the gamble and the payment offer equal expected payoff of
Rs. 325. Since the individual is risk-averse, he will prefer the risk-free
expected value of the gamble that is Rs. 325 which he receives as
payment, to the gamble itself.
3) See Section 4.5 and answer.

98
Check Your Progress 3 Choice Under Uncertainty
and Intertemporal Choice
1) See Sub-section 4.6.3 and answer.
Hint: Fall in the interest rate will result in fall in consumption in second
period as both substitution and income effects will work in same
direction to reduce it, whereas for consumption in period one, they
work in opposite direction. When consumer decides to remain a lender,
then he will be worse off by settling down with a lower utility level.
Whereas, there is scope of attaining a higher utility level by switching
his behaviour to be that of a borrower after the interest rate fall.
��� ���
2) Present value with 10% interest rate = ���.� = �.�
= 91 (Approx.) and if
interest rate is 5% then it is 95 (Approx.).
3) Steeper, as consumption in period 1 becomes relatively expensive.

99
 Choice Under Uncertainty
and Intertemporal Choice

Block 2
Production and Cost

101
Consumer Theory
 Production Function with
UNIT 5 PRODUCTION FUNCTION WITH ONE One and More Variable
Inputs
AND MORE VARIABLE INPUTS
Structure
5.0 Objectives
5.1 Introduction
5.2 Production Function
5.2.1 Short-run Production Function
5.2.2 Law of Variable Proportions
5.2.3 Long-run Production Function
5.2.4 Isoquants
5.2.5 Marginal Rate of Technical Substitution
5.2.6 Producer’s Equilibrium
5.2.7 Elasticity of Technical Substitution
5.2.8 Economic Region of Production
5.3 Homogenous and Homothetic Functions
5.3.1 Homogeneous Function
5.3.2 Homothetic Function
5.4 Types of Production Functions
5.4.1 Linear Production Function
5.4.2 Leontief Production Function
5.4.3 Cobb-Douglas Production Function
5.4.4 The CES Production Function
5.5 Technological Progress and the Production Function
5.5.1 Hick’s Classification of Technological Progress
5.6 Let Us Sum Up
5.7 References
5.8 Answers or Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After going through this unit, you should be able to:
• understand the concept of production function and its types;
• mathematically comprehend various concepts of production theory
introduced in Introductory Microeconomics of Semester 1;
• explain the concepts of homogeneous and homothetic functions along
with their properties;
• analyse different types of production functions, viz. Linear, Leontief,
Cobb-Douglas and CES production function; and
• discuss the impact of technical progress on the production function or
an isoquant. 103
Production and Cost
5.1 INTRODUCTION
Production in Economics means creation or addition of value. In production
process, economic resources or inputs in the form of raw materials, labour,
capital, land, entrepreneur, etc. are combined and transformed into output.
In other words, firm uses various inputs/factors, combines them with
available technology and transforms them into commodities suitable for
satisfying human wants. For example, for making a wooden chair or table,
raw materials like wood, iron, rubber, labour time, machine time, etc. are
combined in the production process. Similarly, cotton growing in nature
needs to be separated from seeds, carded, woven, finished, printed and
tailored to give us a dress. All the activities involved in transforming raw
cotton into a dress involve existence of some technical relationship between
inputs and output.
The present unit is an attempt to build up on the foundation of the Theory
of Production you learnt in your Introductory Microeconomics course of
Semester 1. Units 6 and 7 of the Introductory Microeconomics course
comprehensively discussed Production function with one variable input and
with two or more variable inputs, respectively. This theoretical base shall be
combined with the mathematical tools you have already learnt in your
Mathematical Economics course of Semester 1. Section 5.2 will give a brief
review along with the Mathematical comprehension of what we already
know about the production theory. Section 5.3 shall explain the concepts of
Homogeneous and Homothetic functions along with their properties.
Further, in Section 5.4 we will elaborate upon the types of production
functions, viz. Linear, Leontief, Conn-Douglas and CES production functions.
This Unit ends with representation of the impact of technological progress
on the production function, along with the Hick’s classification of technical
progress.

5.2 PRODUCTION FUNCTION

A firm produces output with the help of various combinations of inputs by
harnessing available technology. The production function is a technological
relationship between physical inputs or factors and physical output of a
firm. It is a mathematical relationship between maximum possible amounts
of output that can be obtained from given amount of inputs or factors of
production, given the state of technology. It expresses flow of inputs
resulting in flow of output in a specific period of time. It is also determined
by the state of technology. Algebraically, production function can be written
as:
Q = f (A, B, C, D,….)
where Q stands for the maximum quantity of output, which can be
produced by the inputs represented by A, B, C, D,…, etc. where f (.)
represents the technological constraint of the firm.

104
5.2.1 Short-run Production Function Production Function with
One and More Variable
Inputs
A Short run production function is a technical relationship between the
maximum amount of output produced and the factors of production, with at
least one factor of production kept constant among all the variable factors.
A two factor short run production function can be written as:

Q f (L, K)
where, Q stands for output, L for Labour which is a variable factor here, K for
Capital, and f (.) represents functional relationship. A bar over letter K
indicates that use of capital is kept constant, that is, it is a fixed factor of
production. Supply of capital is usually assumed to be inelastic in the short
run, but elastic in the long run. This inelasticity of the factor is one of the
reasons for it to be considered fixed in the short run. Hence, in the short
run, all changes in output come from altering the use of variable factor of
production, which is labour here.
Total Product (TP)
Total Product (TP) of a factor is the maximum amount of output (Q)
produced at different levels of employment of that factor keeping constant
all the other factors of production. Total product of Labour (TPL) is given by:
TPL = Q = f (L)
Average Product (AP)
Average product is the output produced per unit of factor of production,
given by:
Q
Average Product of Labour, APL = and Average Product of Capital,
�
Q
APK = .
�
Marginal Product (MP)
Marginal Product (MP) of a factor of production is the change in the total
output from a unit change in that factor of production keeping constant all
the other factors of production. It is given by: Marginal Product of Labour,
∆� �� ∆� ��
MPL = or and Marginal Product of Capital, MPK = or , where ∆
∆� �� ∆� ��
stands for “change in” and � denotes partial derivation in case of a function
with more than one variable [here we are considering a production function
with two factors of production, Q = f (L,K)].

Law of Diminishing Marginal Product

The law of diminishing marginal product says that in the production process
as the quantity employed of a variable input increases, keeping constant all
the other factors of production, the marginal product of that variable factor
may at first rise, but eventually a point will be reached after which the
marginal product of that variable input will start falling.
105
Production and Cost
5.2.2 Law of Variable Proportions
Also called the law of non-proportional returns, law of variable proportions
is associated with the short-run production function where some factors of
production are fixed and some are variable. According to this law, when a
variable factor is added more and more to a given quantity of fixed factors in
the production process, the total product may initially increase at an
increasing rate to reach a maximum point after which the resulting increase
in output become smaller and smaller.
G
MPL= 0

F
TPL TPL
Stage I Stage II Stage III

0 Labour (L)
APL/ MPL

H
J

APL
K
0 Labour (L)
MPL

Fig. 5.1: Law of Variable Proportion

Stage 1: This stage begins from origin and ends at point F (in part (a) of the
Fig. 5.1). Corresponding to the point F, you may see the APL reaches
maximum and APL = MPL represented by point J in part (b) of Fig. 5.1. Point E
where the total product stops increasing at an increasing rate and starts
increasing at diminishing rate is called point of inflexion. At point E, TPL
changes its curvature from being convex to concave.
Stage 2: This stage begins from point F and ends at point G (in part (a) of the
Fig. 5.1).
Corresponding to the point F, you may see the AP curve reaches its
maximum (point J) and both AP and MP curves are having falling segments
along with MP reaching 0 i.e., MP curve touches the horizontal axis (at point
K). From point F to point G, the total product increases at a diminishing rate,
marginal product falls but remains positive. At point K marginal product of
the variable factor reduces to zero. Since both the average and marginal
products of the variable factor fall continuously, this stage is known as stage
of diminishing returns.

106
 Stage 3: Beginning from point G, the total product declines and slopes Production Function with
One and More Variable
downward. Marginal product of variable factor is negative. Given the fixed Inputs
factor, the variable factor is too much in proportion and hence this stage is
called stage of negative returns.
Remember: *
����
At point H, slope of MPL = 0, i.e., ��
=0
�� ���
Up to point E (the inflection point) ���
> 0 (denoted by the convexity of
�� ���
the TPL), and from point E onwards till point G, ���
< 0 (denoted by the
concavity of the TPL).
�� �
At point F and J, MPL = APL, i.e., =
�� �
����
At point J, slope of APL = 0, i.e., ��
=0
��
At point G, slope of TPL, i.e. MPL or �� = 0
Point K onwards, MPL < 0
Relationship between Average Product and Marginal Product
1) So long as MP curve lies above AP curve, the AP curve is sloping
upwards. That is, when MP > AP, AP is rising.
2) When MP curve intersects AP curve, this is the maximum point on the
AP curve. That is, when MP = AP, AP reaches its maximum.
3) When MP curve lies below the AP curve, the AP curve slopes
downwards. That is, when MP < AP, AP is falling.
�(�)
Proof: Consider total product of Labour TPL = f (L), then APL = .
�
For maximisation of APL differentiating it w.r.t. L and putting it equal to 0,
� � �(�)
First order condition (FOC): (APL ) = 0 ⇒ � �=0
�� �� �
��(�) � �(�)
. − =0
�� � ��
��(�) �(�)
= …(1)
�� �
⇒ MPL = APL when APL reaches its maximum.
�� (��� ) � � � ��(�)
Second order condition (SOC): ���
≤ 0 ⇒ �� ��� AP� � ≤ 0 ⇒ �� � ��
�≤0

� ��(�) � �(�) �’ (�)�� �(�).�

Using Equation 1, we get, �� � ��
� = �� � �
�= ��

�� (��� ) � �(�) �(�)

Thus, ���
= � �f’(L) − �
� ≤ 0 ⇒ f’(L) ≤ �
⇒ MP� ≤ AP�

* Refer Unit 10 of your course on Mathematical Methods in Economics during first

semester (BECC-102) for the derivative criterion for finding maxima, minima,
point of inflexion. 107
Production and Cost
5.2.3 Long-run Production Function
In long run, all factors can be varied, thus, for a long-run production function
all inputs vary proportionally. Consider a long-run two factor production
function:
Q = f (L, K)
where, Q stands for output, L for Labour and K for Capital (here, K is without
bar, that is, it represents a variable factor like L).
The basic assumption we make about the production function is
monotonicity, which means as the factor labour (L) increases, given the
factor capital (K), the production Q also increases. Similarly as the factor
capital (K) increases, given the factor labour (L), the production Q increases.
Thus, the first derivative of the production function is positive w.r.t. L and K
i.e., f′(L) > 0, f′(K) > 0. In other words the marginal product of labour and
capital are positive. The second assumption we usually make about the
production function is with the curvature. The assumption is the concavity
i.e., f′′(L) < 0, f′′(K) < 0; diminishing returns to the marginal product of L and
K. But the second order cross partial derivative i.e.,
� ��(�,�) � ��(�,�) �� �(�,�)
��
� �� � = �� � �� � = ���� > 0. The two second order cross partial
derivatives are equal by Young’s theorem.
�2 f(K,L) �� �(�,�)
Note that, = f′′(L) and ���
= f′′(K) are the second order own
�L2
partial derivative w.r.t L and K respectively.

Output Elasticity of a Factor

Given the production function, X = f (L) the elasticity of output with respect
to factor (L) is given by the ratio of proportionate change in output (X) to
proportionate change in use of factor (L). Output Elasticity of Factor L (eL) is
given by:
� (��� �) %∆� �� � ��
eL = � (��� �) = %∆� = �� × � = �� �
�

Example 1
Consider a production function as follows: Q = 6K2L2 − 0.10K3L3, where Q is
the total output produced, and K and L the two factors of production. With
factor K fixed at 10 units, determine
a) The total product function for factor L (TPL)
b) The marginal product function for factor L (MPL)
c) The average product function for factor L (APL)
d) Number of units of input L that maximises TPL
e) Number of units of input L that maximises MPL
f) Number of units of input L that maximises APL
g) The boundaries for the three stages of production
108
Solution: Production Function with
One and More Variable
a) TPL = 6 (10)2 L2 − 0.10 (10)3 L3 = 600L2 − 100L3 Inputs

�(��� )
b) MPL = = 1200 L – 300 L2
��
���
c) APL =
�
��� �� ���� ��
= = 600 L – 100 L2
�
�(��� )
d) For maximisation of TPL put =0
��
⇒ 1200 L – 300 L2 = 0
⇒ L (1200 – 300 L) = 0 ⇒ L = 0 or L = 4
�� (��� )
Checking for second order condition for maximisation, i.e., < 0,
���
we get L = 4 that maximises TPL.
�(��� )
e) Condition for maximisation of MPL is given by, =0
��
1200 – 600 L = 0 ⇒ L = 2 maximises MPL
�(��� )
f) Condition for maximisation of APL is given by, =0
��
600 – 200 L = 0 ⇒ L = 3 maximises APL
g) Stage I: Labour units 0 - 3, Begins from origin till the point where APL
reaches its maximum.
Stage II: Labour units 3 - 4, begins at point where APL reaches its
maximum till the point when MPL reduces to 0 with TPL reaching its
maximum.
Stage III: Labour units 4 - ∞, begins at point where MPL = 0 till the point
where MPL < 0.
Example 2
The production function of firm is given by X = 8L + 0.5L2 – 0.2L3 where X is
the output produced and L denotes 100 workers.

a) Determine the point at which MPL = APL

b) Find the range over which production function exhibits the property of
diminishing marginal productivity of labour?

c) How many workers should be employed so that MPL becomes zero?

d) Find TPL, MPL and APL when the firm employs 150 workers.

109
Production and Cost Solution:
a) Total product of labour TPL = X = 8L + 0.5L2 – 0.2L3
��
MPL = �� = 8 + L − 0.6L�
�
APL = � = 8 + 0.5L − 0.2L�

The point at which MPL = APL is given by

8 + L – 0.6L2 = 8 + 0.5L – 0.2L2
0.5L – 0.4L2 = 0
L (0.5 – 0.4L) = 0
�.�
Either L = 0 or L = �.� = 1.25 or 125 workers

Hence the point at which MPL = APL is L = 125 workers

b) The production function exhibits diminishing marginal productivity of
����
labour over range where <0
��
�
That is, 1 – 1.2L < 0 or L > �.� ⇒ L > 0.83 or 83 workers.
Hence the range over which production function exhibits the property
of diminishing marginal product of labour is L > 0.83 or more than 83
workers.
c) The number of workers for MPL to become zero is given by solution
8 + L – 0.6L2 = 0
or 0.6L2 – L– 8 = 0
�� √����.�
Therefore, L = = 4.58 (approx). The other root being negative is
� �.�
neglected. Thus when MPL = 0 about 458 workers are being employed.
d) When firm employs 150 workers, L = 1.5
Substituting this value in TPL, MPL and APL we get
TPL = 8L + 0.5L2 – 0.2L3
= 8 × 1.5 + 0.5 × (1.5)2 – 0.2 (1.5)3 = 12.45 units
MPL = 8 + L – 0.6L2
= 8 + 1.5 – 0.6(1.5)2 = 8.15 units
APL = 8 + 0.5L – 0.2L2
= 8 + 0.5 × 1.5 – 0.2(1.5)2 = 8.3 units

110
5.2.4 Isoquants Production Function with
One and More Variable
Inputs
Isoquants is the locus of all possible input combinations which are capable
of producing the same level of output (Q). In Fig. 5.2, all the possible
combinations of Labour (L) and Capital (K), for instance (L1,K1), (L2,K2) and
(L3,K3), produce a constant level of Output (Q).

Fig. 5.2: Isoquant

Properties of Isoquants
1) Isoquants are negatively sloped.
2) A higher isoquant represents a higher output.
3) No two isoquants intersect each other.
4) Isoquants are convex to the origin. The convexity of isoquant curves
implies diminishing returns to a variable factor.
Isoquant Map
An Isoquant map is a family of isoquant curves, where each curve represents
a specified output level. Three such curves with different output levels (Q1,
Q2 and Q3) forming an Isoquant map is given in Fig. 5.3.

Fig. 5.3: Isoquant Map

111
Production and Cost Isocost Line
An Isocost line represents various combinations of two inputs that may be
employed by a firm in the production process for a given amount of Budget
�
and prices of the factors. Slope of an Isocost line is given by , that is, the
�
factor price ratio, where, w and r represent the prices paid to Labour and
Capital factors, respectively. Refer Fig. 5.4, where we have three different
isocost lines with different budget outlays represented by C1, C2 and C3, such
that C3 > C2 > C1.

Capital (K)

C1 C2 C3
0
Labour (L)

Fig. 5.4: Isocost Lines

5.2.5 Marginal Rate of Technical Substitution

Marginal rate of technical substitution (MRTS) is the rate at which one factor
can be substituted for another along an Isoquant. Along an Isoquant output
remains constant, i.e. (dQ = 0)
K.MPK L.MPL 0

K.MPK L.MPL
K MPL
L MPK

MPL
MRTS LK
MPK

As quantity of labour is increased and quantity of capital employed is

reduced, the amount of capital that is required to be replaced by an
additional unit of labour so as to keep the output constant will diminish.

5.2.6 Producer’s Equilibrium

A rational producer attempts to maximise his profits either by maximising
the production of output for a given level of cost of production or by
minimising the cost of production of a given level of output. Either way the
producer chooses, it will result in employment of an optimum combination
112
of resources in the production process so that MRTSLK equals the price ratio Production Function with
One and More Variable
of the factors. That is, producer’s equilibrium is given by the condition: Inputs
� ��� �
MRTS LK = ⟹ =
� ��� �

The equilibrium condition represents the tangency between the isoquant

�
and the isocost line. In Fig. 5.5, at point E, MRTSLK = .
�
Capital (K)

0
Labour (L)

Fig. 5.5: Producer’s Equilibrium

5.2.7 Elasticity of Technical Substitution

Elasticity of Technical substitution in production is a measure of how easy it
is to shift between factors in the production process. It is given by :

Proportionate change in ratio of inputs (K & L) used

σ=
Proportionate change in marginal rate of technical substitution of L for K

Proportionate change in K/L

=
Proportionate change in MRTSLK

K/L
K/L
MRTSLK / MRTSLK

∆�/�
� �/�
At equilibrium, MRTS LK = , therefore we get, � = ∆�/�
�
�/�

5.2.8 Economic Region of Production

The economic theory focuses on only those combinations of factors which
are technically efficient; i.e., where the marginal products of factors are
diminishing but positive. These combinations, forming the efficient region of
113
Production and Cost production, are represented by the downward sloping and convex to the
origin isoquants. Refer to the following Fig. 5.6 where factors L and K are
assumed to be substitutable but not perfectly. When firm goes on
��
substituting L for K, a point like P is reached where MRTSLK given by �� �
�
diminishes to 0 (as MPL = 0 at point P). This implies, at point P, no more K
can be given up for having more of L. Beyond point P, as L rises, MPL
becomes negative. In order to produce the fixed output (Q1), the
mismanagement caused by the excessive L units needs to be corrected. This
is done by increasing the employment of factor K (since MPK > 0) as L
increase beyond point P. This gives us the positively sloped isoquant below
ridge line OB. Similarly, at point R, MPK = 0. So, as K increases beyond point
R, to make up for the negative MPK, L would also have to be increased.

Ridge Lines
The ridge line OA is the locus of those points of isoquants where marginal
product of capital is zero and ridge line OB is the locus of those points of
isoquants where marginal product of labour is zero. See the following Fig.
5.6. A rational producer will operate in the region bound by the two ridge
lines called the economic region of production. The regions outside the
ridge lines are called regions of economic nonsense (technically inefficient
region).
Capital (K)

A
(MPK) < 0
Economic Region of
B Production

Q2
R

Q1
P
(MPL) < 0

O Labour (L)

Fig. 5.6: Economic Region of Production

5.3 HOMOGENOUS AND HOMOTHETIC FUNCTIONS

5.3.1 Homogenous Function
A function f(X1, X2,…, Xn) is said to be homogenous of degree k if
f (mX1, mX2,…, mXn) = mk f (X1, X2,…, Xn)
where m is any positive number and k is constant.
A zero-degree homogeneous function is one for which
114
 f (mX1, mX2,…, mXn) = m0 f (X1, X2,…,Xn) Production Function with
One and More Variable
In a similar way, Homogeneous production function of first degree can be Inputs
expressed as
f (mX, mY) = m1 f (X, Y)
Here X and Y are the two factors of production. It simply says if factors X and
Y are increased m times, total production also increases m times.
In case of a Linear Homogeneous production function or Homogeneous
production function of first degree with k = 1, if all factors of production are
increased in a given proportion, output also increases in the same
proportion. This represents the case of constant returns to scale (CRS).
When k > 1, production function yields increasing returns to scale (IRS),
whereas when k < 1, it yields decreasing returns to scale (DRS).
Euler’s Theorem
For a homogenous of degree k function f(X1,X2,…,Xn), Euler’s theorem gives
the following relationship between a homogeneous function and its partial
derivatives:
�� �� ��
X1 �� + X2 �� + … + Xn �� = k f(X1,X2,…,Xn)
� � �

Properties of Homogenous Functions

1) If f(X1, X2,…, Xn) is homogenous of degree k then it’s first order partial
derivatives will be homogenous of degree (k – 1).
2) For a homogenous of degree k function f (.), if f(X) = f(Y), then f(tX) =
f(tY).
Proof: We have f(tX) = tkf(X) and f(tY) = tkf(Y) (1)
Given, f(X) = f(Y) (2)
From (1) and (2), we get
f(tX) = f(tY)
3) Level curves of a homogenous function f(X, Y) have constant slopes
along each ray from the origin. That is, if f(X, Y) is a homogeneous
production function of degree k, then the MRTS is constant along rays
extending from the origin.
Returns to Scale
Returns to scale are a measure of technical property of a production
function that examines how output changes subsequent to a proportional
change in all the factors of production. If proportional change in output is
equal to the proportional change in factors, then there are constant returns
to scale (CRS). If proportional change in output is less than the proportional
change in factors, there are decreasing returns to scale (DRS), whereas if
proportional change in output exceeds the proportional change in factors,
there are increasing returns to scale (IRS).
115
Production and Cost A homogenous function of degree k, exhibits
i) Constant Returns to Scale if k = 1
ii) Increasing Returns to Scale if k > 1
iii) Decreasing Returns to Scale if k < 1

5.3.2 Homothetic Function

A Homothetic function is a monotonic transformation* of a homogeneous
function. It is given by the form:

H (X1, X2,…, Xn) = F [f (X1, X2,…, Xn)]

where, f (X1, X2,…, Xn) represents a homogeneous function of degree k, and

F (.) is a monotonically increasing function. In case of such a function, H(X1) ≥
H(X2) ⟺ H(tX1) ≥ H(tX2) for all t > 0, where symbol ⟺ represents “if and only
if.”

Given a homogeneous function of degree 2, f(X, Y) = XY, a homothetic

function H(X, Y), which is the monotonic transformation of f(X, Y) could be
in the following forms:
H1(X, Y) = XY + 2;
H2(X, Y) = (XY)2;
H3(X, Y) = X3Y3 + XY;
H4(X, Y) = ln X + ln Y (where ln stands for “natural log”)
H5(X, Y) = eXY
Important:
A Homogeneous production function implies that it is homothetic as well,
but converse is not true, for instance, f(X,Y) = XY + 1 is homothetic, but not
homogeneous [proof: f(tX, tY) = t2XY + 1 and t2 f(X,Y) = t2XY + t2, here f(tX,
tY) ≠ t2 f(X,Y), hence f(X,Y) = XY + 1 is not homogeneous].

Properties of Homothetic Functions

1) Level curves of a Homothetic function are radial expansion of one
another, i.e., H(X1, Y1) = H(X2, Y2) ⟺ H(mX1, mY1) = H(mX2,mY2) for all
t > 0.
2) Level curves of a Homothetic function H(X, Y) have constant slopes
along each ray from the origin.

* Monotonic transformation— A transformation of a set that preserves the order

of that set. For instance, if the original function is f (X, Y), a monotonic
transformation is represented by F [f(X, Y)] so that, if f1 > f2, then F(f1) > F(f2), where
116 F(.) is the strictly increasing function on f(.).
When we have a homothetic production function, the above property Production Function with
One and More Variable
implies that Isoquants have a constant slope (MRTSXY) along any ray from Inputs
�
origin. MRTSXY only depends on factor proportion ���, that is, it is a
homogenous function of degree 0.
Check Your Progress 1
1) As the quantity of a variable input increases, explain why the point
where marginal product begins to decline is reached before the point
where average product begins to decline. Also explain why the point
where average product begins to decline is reached before the point
where total output begins to decline?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) Given a firm’s production function, X = 50 + 30L – L2, where X is the
output produced and L the amount of Labour employed, also the
Average Revenue function is AR = 1200 – 3X, answer the following:
a) Find MPL and the value of L at which MPL = 0
b) Does the production function show diminishing marginal
productivity of labour?
c) Write down an expression of MRPL as a function of L and find its
value where L = 10.
d) Is it profitable to employ more or less labourers? Explain.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
3) Which of the following functions is homogenous? Write their degrees of
homogeneity.
�
a) �

b) X + Y�
c) X �/� Y�/� + 2X
d) 4X � Y + 5X � Y � − 2X � Y �
e) X � Y + 3X � Y � − 2X � Y �
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
……………………………………………………………………………………………………… 117
Production and Cost
5.4 TYPES OF PRODUCTION FUNCTIONS
In this sub-section we are introducing some functions of more than one
independent variable which have certain unique mathematical properties.
These properties facilitate derivation of certain interesting results which are
attractive for economic analysis.

5.4.1 Linear Production Function

A Linear production function is given by the following form:
Q = αK + βL
Where, Q stands for output, K and L, the two inputs in production, α and β,
the two constant terms. Production function of this form represents inputs
which behave as perfect substitutes to each other in the production process.
For this reason MRTS remains constant along an isoquant resulting in a
straight line downward sloping Isoquant curves. Refer Fig. 5.7 for Isoquants
of a linear production function.
Capital (K)

Q1 Q2 Q3

0 Labour (L)

Fig. 5.7: Isoquants for a Linear Production function

��� �
MRTSLK = = , which is a constant. , Now, Elasticity of Technical
��� �
�
∆
��
�
�
Substitution is given by, � = ∆ ����� . Here along the Isoquant, MRTS
����
remains constant, so that ∆ MRTS = 0. This implies that Elasticity of
Technical Substitution(�) = ∞ for a linear production function. That is,
inputs are perfectly substitutable for each other in the production process.

5.4.2 Leontief Production Function

Production technology sometimes could be such that factors of production
must be employed in a fixed proportion. For instance, to produce a unit of
output, capital and labour must be employed in proportion of 2:1, so that no
118
output increase could be possible by increasing the units of capital alone or Production Function with
One and More Variable
of labour alone, or of both in a different ratio than 2:1. Leontief production Inputs
technology represents the case where inputs must be combined in fixed
proportions, for this reason it is also called a Fixed-proportions production
function. The Leontief production function is given as the following form:
� �
Q = min �� , � �
� �

Where Q is the output produced, K and L represent the factors of

production, θ� and θ� are the unit input requirements. That is, to produce a
single unit of output, θ� unit of factor K and θ� units of factor L are needed.
Consequently for Q units of output, θ� Q units of factor K and θ� Q units of
factor L will be needed. Thus, the fixed proportion of factors to produce
� �
output is given by � = �� . Factors of such production function behave as
�
Perfect compliments to each other in the production process. Refer Fig. 5.8
for L-shaped Isoquants of a Leontief production function.
Capital (K)

��
K= L
��

K3 Q3
K2 Q2
K1 Q1

0 L1 L2 L3 Labour (L)

Fig. 5.8: Isoquants for a Leontief Production function

� �
In Fig. 5.8 you may notice, if K = K1 and L = L2, then we have � � < �� , thus ,
� �

�
Q = � � . In this case, the technically efficient level of L factor would be given
�
�� � �
by, � = � ⟹ L = � � K� , which is, as you may notice from the figure is
� � �
given by L1. The equation for the line from the origin, at which factor
� �
proportion equals �� , is given by K = �� L.
� �

Since there exist no possibility for altering the factor proportion, any change
in MRTS, does not result in change in factor proportion which remains fixed.
�
That is ∆ � � � = 0. This, implies that Elasticity of Technical Substitution(σ) = 0
for a Leontief production function.

5.4.3 Cobb-Douglas Production Function

A widely used form of production function is the Cobb-Douglas production
function which takes the following form: 119
Production and Cost
Q = ALαKβ
where Q is the output, L and K the factors of production, and A, α, β are all
positive constants. The Isoquants of this production function are hyperbolic,
asymptotic to both the axis (i.e. it never touches any axis). Refer Fig. 5.9.

Capital (K)
Q3
Q2
Q1
0
Labour (L)

Fig. 5.9: Isoquants for a Cobb-Douglas production function

Some properties of a Cobb-Douglas production function are as follows:

Returns to Scale
For the Cobb-Douglas production function Q = ALαKβ, when
α + β = 1 there are constants returns to scale (CRS)
α + β > 1 there are increasing returns to scale (IRS)
α + β < 1 there are decreasing returns to scale (DRS)

Average and Marginal Product of Factors

For a Cobb-Douglas Production Function Q = AL� K �
��� ��
Average Product of Labour, APL =
�

= AL��� K �
��� ��
Average Product of Capital, APK =
�

= AL� K ���
��
Marginal Product of Capital, MPk =
��

= βAL� K ���

120
 �� Production Function with
Marginal Product of Labour, MPL = One and More Variable
��
Inputs
= αAL��� K �
Marginal Rate of Technical Substitution (MRTS)
Now, we have MP� = αAL��� K � and MP� = βAL� K ���
��� ������ �� ��
MRTS = = =
��� ���� ���� ��

Product Exhaustion Theorem

In case of a homogeneous production function of degree one, if each unit of
every factor of production is given a reward equal to the marginal product
of that factor, the total output will be exactly divided among those factors.
This is what is referred to as the Product Exhaustion theorem.

Consider a CRS Cobb Douglas production function, Q A.L K , where

.

K L
Now, MPL A. and MPK A.
L K

According to Euler Theorem, if production function is homogeneous of first

degree, then
Total Output (Q) = L. MPL + K.MPK

K L
Q L.A K.A.
L K

Q A. L1 K A. L K1

A.(1 )L1 K A. L K1

A.L1 K
A.L K
=Q
Thus in Cobb Douglas production with 1 if wage rate = MPL and rate
of return on capital (K) = MPK, then total output will be exhausted.
Elasticity of Substitution
�
������������ ������ �� �����
�
es or � =
������������ ������ �� ������

� �
�� � �� �
=
������� ⁄������
121
Production and Cost

� �
�� � �� �
= �� ��
��� � ���� � �

� �
�� � �� �
= � � � � =1
�
.�� � ���� � �

Output Elasticity of Factors

��
�� � ��
Elasticity of Output of Labour = e� = . = �
�� �
�

��� ������ ��
= =
��� ����� ��

e� = α

Q K MPK
Elasticity of Output of Capital = e� = .
K Q APK

���� ����
e� =
��� ����

e� = β
Example 3
Consider the Cobb-Douglas production function below:
Q = 10L0.45K0.30
Where Q is the output produced using factors L (Labour) and K (Capital).
Calculate
a) Output Elasticities for Labour and Capital.
b) Change in Output, when Labour increases by 15%
c) Change in output, when both Labour and Capital increase by 15%
Solution:
�� � ��
a) Elasticity of output with respect to Labour, eL = �� . � = �� �
�

���.�����.�� ��.��
=
�����.�� ��.��
= 0.45
122
 �� � �� Production Function with
Elasticity of output with respect to Capital, eK = �� . � = �� � One and More Variable
�
Inputs
���.����.�� ���.��
=
����.�� ���.��
= 0.30
%∆�
b) eL =
%∆�

We have eL = 0.45 and %∆L = 15, therefore %∆Q = eL× %∆L = 6.75.
Hence, output will increase by 6.75%.
c) Change in Output when Labour increase by 15% = 6.75% (calculated in
part b)
Similarly, change in Output when Capital increases by 15% = eK× %∆K =
4.5%

Therefore, Change in Output when both Capital and Labour increase by

15% = (6.75 + 4.5)% = 11.25%
Example 4
Suppose a commodity (Q) is produced with two inputs, labour (L) and capital
(K) and production function is given by Q 10 LK . What type of returns to
scale does it exhibit?
Solution:
1/2 1/2
The above production function can be rewritten as Q 10.L K

Now, increase both the factors by a positive constant λ.

Q 10( L)1/2 ( K)1/2

1/2 1/2
10L1/2 K1/2
Q Q

Increasing L and K by λ results in increase in output (Q) by λ. Hence this

shows constant returns to scale.

5.4.4 The CES Production Function

Linear, Leontief and Cobb-Douglas production functions are a special case of
the Constant Elasticity of Substitution (CES) production function, which has
been jointly developed by Arrow, Chenery, Minhas and Solow. CES
production function is a general production function wherein elasticity of
factor substitution can take any positive constant value. The function is
given by the following equation:
Q = C [αKρ + (1 − α)Lρ ] 1/ρ
Where, Q stands for output.

123
Production and Cost ‘C ’ is an efficiency parameter, a measure of technical progress. The value of
C > 0 and any change in it resulting from technological or organisational
change causes shift in the production function.
‘α ’ is a distribution parameter, determining factor shares and 0 ≤ α ≤1. It
indicates relative importance of capital (K) and labour (L) in various
production processes.
ρ is a substitution parameter, used to derive elasticity of substitution (σ)
�
between factors K and L, given by σ = ��� . The value of ρ is less than or
equal to 1 and can be −∞. The two extreme cases are when ρ → 1 or ρ
→ −∞.
i) When ρ → 1, the elasticity of substitution tends towards ∞, the case
representing Linear Production function where factors are perfect
substitutes to each other in the production process giving straight line
Isoquants.
ii) When ρ → −∞, the elasticity of substitution tends towards 0, the case
representing Leontief Production function where factors are perfect
compliments to each other in the production process giving L-shaped
Isoquants.
iii) When ρ = 0, the elasticity of substitution = 1, then CES production
function becomes a Cobb-Douglas production function giving convex
Isoquants.
CES Production function are extensively used by economists in the empirical
studies of production processes because it permits the determination of the
value of elasticity of factor-substitution from the data itself rather than prior
fixing of the value of substitution elasticity (σ).
Check Your Progress 2
1) Consider the following production function:

Q L0.75K0.25
a) Find the marginal product of labour, and marginal product of
capital.
b) Show that the law of diminishing returns to the variable factor
holds.
c) Show that if labour and capital are paid rewards equal to their
marginal products, total product would be exhausted.
d) Calculate the marginal rate of technical substitution of capital for
labour.
e) Find out the elasticity of substitution.
f) Show that the function observes constant returns to scale.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
124
2) Consider the following CES production function: Production Function with
One and More Variable
Q = [αLρ + (1 − α)Kρ ] 1/ρ Inputs

Where 0 ≤ α ≤ 1, ρ ≤ 1, Q is output, L and K, the two factors of

production.
a) Find marginal productivities of both the factors L and K.
b) Also give the expression for MRTSLK.
c) Is this function Homothetic?
…………………………………………………………………………………………………………

5.5 TECHNOLOGICAL PROGRESS AND THE

PRODUCTION FUNCTION
Technological progress has been one of the major forces behind Economic
growth overtime. It enables output to rise even when the factors of
production remain at a constant level. Technical progress could be shown
with an upward shift of the production function (Refer Fig. 5.10 A, where
with same level of Labour L1, more of output could be produced, X1 > X) or a
downward movement of the production isoquant (Refer Fig. 5.10 B, where
the same level of output X could be produced by fewer quantities of factors
of production K1 and L1, with K1 < K0 and L1 < L0).

Fig. 5.10A: Technological change and production Fig. 5.10B: Technological change and Isoquant
function

5.5.1 Hicks Classification of Technological Progress

Hicks had distinguished three types of technical progress depending on its
effect on rate of substitution of factors of production. They are as follows:

Capital Deepening Technical Progress

Technical progress is said to be capital-deepening (or Labour saving) when
shifted Isoquant due to technical progress has lower MRTSLK at the
125
Production and Cost equilibrium points. This results as MPK increases more than MPL. It simply
means that the technical progress has resulted in increasing capital per
worker or capital intensity in the economy. Refer Fig. 5.11, where as we
move closer to the origin, MRTSLK falls along the equilibrium points.

Capital (K)

Q
Q

0 Labour (L)
Fig. 5.11: Capital Deepening Technical Progress

Labour Deepening Technical Progress

Technical progress is said to be Labour-deepening (or Capital saving) when
shifted Isoquant due to technical progress has higher MRTSLK at the
equilibrium points. This results as MPL increases more than MPK. This results
when technical progress decreases capital per worker or capital intensity in
the economy. Refer Fig. 5.12, where as we move closer to the origin, MRTSLK
rises along the equilibrium points.
Capital (K)

0 Labour (L)

Fig. 5.12: Labour Deepening Technical Progress

Neutral Technical Progress

Technical progress is said to be neutral when for a shifted Isoquant due to
technical progress MRTSLK does not change at the equilibrium points. Here,
MPK and MPL both increase at same proportion. This is represented in
126
Fig. 5.13, where as we move closer to the origin, MRTSLK remains constant Production Function with
One and More Variable
along the equilibrium points. Inputs
Capital (K)

0 Labour (L)
Fig. 5.13: Neutral Technical Progress

5.6 LET US SUM UP

A production function is a technological relationship between inputs and the
output in a production process. The unit began with defining a production
function, along with its two types— the short run and the long run
production function. A short run production function is a technical
relationship between output and inputs with at least one fixed input,
whereas a long run function is a relationship between output and inputs
with all inputs being variable. Unit proceeded with giving a brief review of
the concepts comprehensively covered in Introductory Microeconomics
course of Semester 1. In connection with the theory, the present unit
discussed Mathematical treatment of the concepts like Total Product,
Marginal Product, Average Product, Law of Variable Proportion, Output
Elasticity of a factor, Marginal rate of technical substitution, Elasticity of
Substitution, Producer’s equilibrium, etc. Followed by this, the concepts of
Homogeneous and Homothetic functions were touched upon. For a
homogenous function, we learnt that the value of the function when all its
arguments are multiplied by positive number m equals mk times the value of
the function with its original arguments. Monotonic transformation of this
function is the Homothetic function. Thus, all the Homogeneous functions
are Homothetic but converse is not true.
Various types of production functions, viz. Linear (Perfect Substitutes),
Leontief (Perfect Compliments), Cobb Douglas, and CES production function
were subsequently discussed. Text explained how a CES production function
as a general function approaches a Leontief or a Linear production function
for different values of ρ, which is referred to as the substitution parameter
�
with the relation given by, σ = ���, where � represents elasticity of
substitution between two factors of production. Unit concluded with a brief
127
Production and Cost discussion about the impact of technological improvement on production
function or an isoquant.

5.7 REFERENCES
1) Koutsoyiannis, A.(1979). Modern Microeconomics, Macmillan;
Macmillan; New York Chapters 3 and 4, page 67-148.
2) Bhardwaj, R.S. (2005). Mathematics for economics and business, Excel
Books.
3) Henderson, M.J. (2003). MicroEconomic Theory A Mathematical
Approach Tata McGrawl-Hill Publiching Company Limited New Delhi.
4) Varian, H.R. (2010). Intermediate Microeconomics, A Modern Approach,
W.W.Norton & Company New York.

5.8 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Due to the operation of diminishing marginal returns, marginal product
begins to decline at some point, but for some range though diminishing
it remains greater than average product. Only when in its diminishing
phase marginal product becomes less than average product, average
product starts declining. That is why marginal product curve cuts the
average product curve at the latter’s highest point.
Marginal product continues to diminish after it is equal to the maximum
average product but remains positive which causes the total output to
continue increasing. Only when marginal product becomes zero, the
total product reaches its maximum level. As a result, total output
continues to increase even after the maximum average product point
and begins to decline only when marginal product becomes negative.
2) a) MPL = 30 − 2L
MPL is 0 at L = 15
� (��� )
b) = −2 < 0
��

Yes, the production function shows diminishing marginal productivity of

labour.
c) – 12L3 + 540L2 – 7200L + 27000; – 3000
Hint: TR = AR × X = (1200 – 3X). X = 1200X – 3X2
Now, MRPL = MR . MPL
� (��) ��
= .
�� ��
128
 = (1200 – 6X) . (30 – 2L) Production Function with
One and More Variable
= [1200 − 6 × (50 + 30L − L� )] (30 − 2L) Inputs

= – 12L3 + 540L2 – 7200L + 27000

d) Since MRPL is negative it is not profitable to employ more
labourers rather it would be profitable to employ less labourers.
3. a) Yes, degree 0
b) No
c) Yes, degree 1
d) Yes, degree 6
e) No
Check Your Progress 2
� �.�� � �.��
1) a) MPL= 0.75 � � � ; MPK = 0.25 ���

b) Law of diminishing returns to variable factor would hold when

���� ����
< 0 and < 0, that is, when marginal product of a factor
�� ��
declines with increase in employment of that factor keeping
constant the employment of other factor of production.
���� K0.25 ����
Since = −0.25 × 0.75� 1.25 � < 0 and = −0.75 ×
�� L ��
L0.75
0.25� � < 0, therefore here law of diminishing returns to
K1.75
variable factor holds true.
c) To show Q = MPL. L + MPK. K (the Product Exhaustion theorem)
� �.�� � �.��
Consider R.H.S, MPL. L + MPK. K ⟹ 0.75 � � � . L + 0.25 ��� .K

⟹ 0.75K0.25L0.75 + 0.25K0.25L0.75
⟹ K0.25L0.75 (0.75 + 0.25)
⟹ L0.75K0.25, which equals Q (the L.H.S).
�
d) MRTSLK = 3� �
�

e) σ=1
K K
Hint: σ L L
MRTS / MRTS
K
Substituting value of MRTS = 3
L

129
Production and Cost K/L K/L
Elasticity of substitution = 1
K K
3 3
L L

2) a) MPL = αLρ – 1 [αLρ + (1 − α)Kρ ] 1/ρ – 1

�
Hint: MPL = � � [αLρ + (1 − α)Kρ ] 1/ρ – 1 ρ αLρ – 1 ⟹ αLρ – 1 [αLρ + (1 −
�
α)Kρ ] 1/ρ – 1
MPK = (1 – α) Kρ – 1 [αLρ + (1 − α)Kρ ] 1/ρ – 1
� � ���
b) MRTSLK = ��� ���

c) Yes, the function is Homothetic since MRTSLK depends upon factor

�
proportion ���.

130
 Cost Function
UNIT 6 COST FUNCTION
Structure
6.0 Objectives
6.1 Introduction
6.2 Cost Minimisation
6.2.1 Graphical Approach for Cost Minimisation
6.2.2 Expansion Path
6.2.3 Analytical Approach for Cost Minimisation
6.3 Conditional Factor Demand Function
6.4 Cost Function
6.4.1 Properties of a Cost Function
6.4.2 Average and Marginal Cost Functions
6.4.3 Relationship between AC and MC Function
6.5 Short-run and Long-run Cost Functions
6.5.1 Short-run Cost Function
6.5.2 Long-run Cost Function
6.6 Let Us Sum Up
6.7 References
6.8 Answers or Hints to Check Your Progress Exercises

6.0 OBJECTIVES
After going through this unit, you should be able to:
• state the concept of cost minimisation;
• graphically and analytically approach the problem of cost minimisation;
• explain and derive conditional factor demand functions as a solution
of the constrained optimisation problem of cost minimisation;
• subsequently derive the cost function as a function of factor prices
and output;
• analyse average cost and marginal cost functions, along with the
relationship between them; and
• discuss the concept of short-run and the long-run cost functions.

6.1 INTRODUCTION
A production activity is undertaken for earning profits, and the producer
decides how much input to use to minimise its costs and maximise its
profits. Profits are given by the difference between the revenue earnings
from and the costs incurred during the production process. Costs, be it
131
Production and Cost implicit or explicit, are the expenses incurred by the producer for
undertaking the production of goods or services. Explicit costs are the out of
pocket expenses which the producer makes payment for, like paying for raw
materials, salaries and wages of staff employed, packaging and distribution
expenses, etc. On the other hand, by implicit it simply means the implied or
the opportunity cost of the self-owned inputs used by the producer in the
production process, like opportunity cost of entrepreneurial skills of the
entrepreneur, self-owned building used as office for business operations,
etc. Economic profits are calculated using both, the explicit as well as the
implicit costs. The optimal output of the firm is decided by maximisation of
profits or by minimisation of costs incurred. The present unit is an attempt
to analyse the approach of cost minimisation.
Unit begins with explaining the concept of cost minimisation. It proceeds
with the sub-sections discussing the graphical and the analytical approach
for cost minimisation. Subsequently, the concept of conditional input/factor
demand functions will be introduced and plugging these optimal values, cost
function will be derived. We will then derive the algebraic expression of
average cost and the marginal cost functions from the cost functions. The
unit also covers a mathematical proof of the relationship between the AC
and the MC curve, which was already covered in Introductory
Microeconomics course of Semester 1 (BECC-101). Towards the end, the
concepts of variable and fixed factors of production, and consequently the
short-run and the long-run cost functions have been discussed.

6.2 COST MINIMISATION

By cost minimisation it simply means to produce a specified output at the
minimum cost. This in turn results from employment of a mix of factors or
inputs so that the desired level of output is produced at the least cost.
Consider a production function given by Q = f (K, L), where Q is the output
produced by employing inputs K and L at given per unit factor prices r and w,
respectively. Then total cost of producing a specified output Q will be given
by:
C = Lw + Kr
Now cost minimisation would result in the following constrained
optimisation problem:
Min Lw + Kr
s.t. Q = f (L, K)
Here, the problems entails finding out the cheapest way to produce a given
level of output (Q) by a firm employing inputs K and L at the given inputs
prices and a technology relationship f (L, K). The optimal solution of the
above constrained minimisation problem will be given by (L*, K*) such that
for all (L, K) satisfying Q = f (L, K), we will have L*w + K*r ≤ Lw + Kr.

132
 Cost Function
6.2.1 Graphical Approach for Cost Minimisation
Recall the concept of Producer’s equilibrium we discussed in Unit 7 of your
Introductory Microeconomics course of Semester 1 (BECC-101). A producer
attains equilibrium by minimising the cost of producing output. This in turn
involves employing a particular factor combination at the given factor prices
and the input-output technological relationship. Fig. 6.1 represents such an
optimal factor combination.

C� Q
�0, � A′′
r
C�
�0, � A′ F
r
C� A
�0, �
r

K1 E
K (Capital)

G
Q′

O L1 B B′ B′′
L (Labour)

Fig. 6.1: Cost minimisation combination of factors

Lines AB, A′B′ and A′′B′′ represent Isocost lines. An isocost line is a locus of
various combinations of factor inputs (here K and L) that yield the same total
cost (C) for the firm. The equation of the isocost line is given by,
� �
C = Lw + Kr ⟹ K = − L
� �
�
This is a linear equation with slope , a constant measuring the cost of one
�
factor of production in terms of the other factor. For different values of C in
the above equation, we get different isocost lines. In Fig. 6.1, A′′B′′
� �
representing total cost C1 is given by, K = � − L. Similarly, outlays
� �
represented by A′B′ and AB are C2 and C3, respectively. Given the factor
prices, a higher outlay results in an outward parallel shift of the isocost line,
thus, to the north-east, higher isocost lines correspond to higher levels of
cost. In the above figure we have C1 > C2 > C3.
Curve QQ′ is the isoquant giving various combinations of factor inputs that
yield the same level of output (Q). Fig. 6.1 shows an isoquant representing a
given output level of output (let say Q*). Cost minimisation exercise involves
minimising the total cost of producing a given level of output (here Q*). For
instance, consider three possible factor combinations denoted by points E, F
and G giving different cost of producing output level Q*. Point E provides
factor combination producing output Q* at the cost of C3, while F and G
133
Production and Cost represents factor combinations producing output level Q* at the cost of C2
and C1, respectively. Among these possibilities, point E provides the least
cost (= C3) factor combination to the firm, as we know both C1 and C2 are
higher than C3 (C1 > C2 > C3). Graphically at point E, slope of the isoquant
given by the Marginal Rate of Technical Substitution (MRTSLK— the rate at
which two factors can be substituted with each other in the production of a
constant level of output) equals the slope of the isocost line. Point E, the
tangency point between isoquant and the isocost line gives us the optimal
combination of factors of production, i.e. OL1 amount of labour and OK1
amount of capital. Symbolically, at E we have,
� ��� � ��
MRTSLK = or = (as we know MRTSLK = �� � )
� ��� � �

6.2.2 Expansion Path

How does the cost-minimising factor combination changes as the output
production increases, keeping constant the factor prices?— an expansion
path answers such a question. Given factor prices, a firm can determine cost
minimising combination of factors for every level of output following the
�
rule MRTSLK = , that is the tangency between isoquants and isocost lines.
�
The expansion path is nothing but a locus of such optimal factor
combinations as the scale of production expands. In Fig. 6.2, expansion path
OE is determining minimum cost combinations of labor (L) and capital (K) at
each level of output. As output expands, (represented by higher isoquants
Q3 > Q2 > Q1) total cost of production rises as well, which is depicted in the
figure by parallel rightward shifted isocost lines. The cost minimising factor
combination occurs at point E1, E2, E3, the locus of which, is called the
expansion path.
Remember
The equation of the expansion path is determined by the cost minimisation
�
rule, MRTSLK = .
�
K (Capital)

E3
E2
Q3
E1
Q2
Q1

O L (Labour)
134 Fig. 6.2: Expansion Path
 Cost Function
6.2.3 Analytical Approach for Cost Minimisation
Analytically, optimal combination of factors employed can be ascertained by
finding the solution of the following constrained optimisation problem:
Min Lw + Kr
s.t. Q* = f (L, K)
where Q* is the stipulated level of output produced.
We proceed solving the above problem by finding the Lagrangian function:
ℒ = Lw + Kr + λ [Q* – f (L, K)]
The first-order optimisation conditions are:
�ℒ ��
��
= 0 ⟹ w − λ ���� = 0 ⟹ w = λ MP� 1)
�ℒ ��
��
= 0 ⟹ r − λ ���� = 0 ⟹ r = λ MP� 2)
�ℒ
��
= 0 ⟹ Q∗ − f(L, K) = 0 ⟹ Q∗ = f(L, K) 3)

From (1) and (2) we get

��� �
= 4)
��� �

Same as is given by the tangency of the isocost and the isoquant. Thus, cost
minimisation requires equality between the MRTSLK and factor price ratio.
Equation (4) can also be written as
��� ���
=
� �
The above equation implies that a producer minimises cost of production
when marginal output generated by the last monetary unit spent on each
factor is equal.
Now, Equations (3) and (4) can be solved to arrive at the solution of the
��� �
cost-minimisation problem. That is, we solve = and Q∗ = f(L, K) to
��� �
get optimal inputs (L*, K*). L* and K* represent the amount of labour and
capital factors needed to be employed at the given prices of w and r
respectively, so as to produce output level Q at the minimum cost. This
minimum cost will then be given by
C = L*w + K*r
Example 1
� �
Consider the production function Q = L� K � where output Q is produced
using factors L and K. Given per unit factor prices of L and K as Rs 10 and
Rs. 5, respectively, find the expression for minimum cost of producing
output Q.

135
Production and Cost Solution
We need to find solution (L*, K*) of the following constrained optimisation
problem:
Min 10L + 5K
� �
s.t. Q = L� K �
From the first order condition of the cost minimisation, we get the following
equation:
−1 2
�
��� � L 3 K3 ��
�
= ⇒ 2 −1 =
��� � � �
L3 K 3
�
�
⇒ � = 2 ⇒ K = 2L , substituting this relation in our production
function, we get the two conditional demand functions for input K and L as
follows:
� �
L* = Q�
√�
3
K* = √2 Q4
Therefore, the cost function is given by
3 �
1
C = 10 �√2 Q4 � + 5�√2 Q� �
�
= 10 √2 Q�

Check Your Progress 1

1) Determine the equation for the expansion path of a production function
given by Q = LK2, where Q stands for output produced using factors K
and L priced at Rs. 10 and Rs. 15, respectively.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) Production of a good is represented by the following technological
relationship

Q = 10√KL
Where K and L are the factor inputs and Q is the output. Given per unit
price of factor K as Rs. 3 and that of factor L as Rs. 12, what will be the
minimum cost of producing 1000 units of this good?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
136
 Cost Function
6.3 CONDITIONAL FACTOR DEMAND FUNCTION
As we saw in Sub-section 6.2.3, the solution of the cost minimisation
problem
Min Lw + Kr
s.t. Q* = f (L, K)
gives us L* and K* for the given values of w, r and Q*. That is, we arrive at
the optimum level of factors employed in the production process for the
given output level Q* and factor prices w and r. Any change in any one or all
of these parameters will give us different values of L* and K*. Thus, solution
to the cost minimisation problem involves finding L* and K* as a function of
w, r and Q*. Symbolically, we get
L* (w, r, Q*)
K* (w, r, Q*)
which are known as the conditional factor demand functions as a solution of
the constrained cost minimisation problem for the given production
function, output level Q* and factor prices as w and r.
You might wonder why the word “conditional” before “factor demand
function”. The reason for this is— a factor demand function specifies profit
maximising levels of factor employment at given unit factor price, when
output level is free to be chosen, whereas a conditional factor demand
function gives the cost minimising level of input employment at given unit
factor prices, to produce a given level of output. That is, factor employment
is conditional upon the output level to be produced. So along the
conditional input demand function of L or K the output remains constant at
Q*. Therefore any increase (or decrease) in Q* will be accompanied by a
outward (or inward) shift of conditional demand function of L or K.
Conditional input demand function for labour L (or capital K) is always
negatively sloped with respect to its own price w (or r in case of capital K).
Conditional input demand function captures only the substitution effect
(similar concept like compensated or Hicksian demand functions which you
have done in Consumer theory) and therefore is less elastic as compared to
ordinary input demand function (a function of prices of inputs and output).

6.4 COST FUNCTION

A cost function is derived using production function and factor prices,
assuming the rational of minimisation of the cost of production by the
producer. On inserting conditional demand functions, i.e. L* (w, r, Q*) and
K* (w, r, Q*) in our expression for total cost, C = Lw + Kr, we arrive at the
cost function C (w, r, Q*).
C (w, r, Q*) = L*(w, r, Q*) w + K* (w, r, Q*) r
A function of factor prices and output, the cost function C (w, r, Q*) gives
the minimum cost of producing a specific level of output (Q*) for some given 137
Production and Cost factor prices. You may note that optimisation has already been taken care of
during construction of conditional factor demand functions, thus cost
function gives the optimised solution to the producer regarding how much
to employ of a factor in the production process.
Till now we have been considering a production function with two factor
inputs (L and K), but in reality there can be more than two inputs in the
production process. Let there be “n” factor inputs represented by vector X =
(x1, x2, x3,…. xn) used in the production of output Q, such that our production
function becomes, Q = f (x1, x2, x3,…. xn). Corresponding to factor vector X =
(x1, x2, x3,…. xn), let factor price vector be W = (w1, w2, w3,…., wn). Then, the
conditional factor demand function for factor i (where i = 1, 2,.…, n) will be
represented by xi = (W, Q), total cost function by C (W, Q).

6.4.1 Properties of a Cost Function

Let us now discuss some properties of the cost function:
1) Cost function is non-decreasing in factor prices, that is, considering two
factor price vectors W′ and W, so that W′ ≥ W, then C (W′, Q) ≥ C (W, Q).
Also, the function is strictly increasing in at least one factor price.
2) Cost function is non-decreasing in output. That is, Q′ ≥ Q, then C (W, Q′)
≥ C (W, Q) for W > 0. That is, increasing production increases the cost of
production.
3) Cost function is homogeneous of degree 1 in factor prices. That is, a
simultaneous change in all factor prices by a certain proportion (let say
by λ, where λ > 0), changes the cost of production by the same
proportion (λ). Symbolically,
C (λ W, Q) = λ C (W, Q) for W, Q, λ > 0
Similarly it can be shown that the conditional factor demand functions (L
and K) are homogeneous of degree zero.
4) Cost function is concave in factor prices. Symbolically,
C (t W + (1 ‒ t) W, Q) ≥ t C (W, Q) + (1 ‒ t) C (W, Q) for t ∈[0,1]
5) Shephard’s Lemma: If a cost function C (W, Q) is differentiable at (W, Q)
and wi > 0 for i = 1,2,..,n, then a conditional factor demand function for
factor i, that is, xi (W, Q) is given by
��(�,�)
xi (W, Q) =
���

This lemma allows us to obtain conditional factor demand functions as

partial derivatives of the cost function.

Example 2
� �
For the production function Q = L� K � , where Q is the output, K and L the
production factors with per unit prices as r and w, respectively, determine
the cost function. Check the homogeneity condition and Shephard’s Lemma.
138
Solution Cost Function

Constrained optimisation problem is given by:

Min Lw + Kr
� �
s.t. Q* = L� K �
We solve the above problem by Lagrangian method to arrive at the
following condition pertaining to cost minimisation
−2 1
�
��� � L 3 K3 �
�
= ⇒ 1 −2 =
��� � � �
L3 K 3
�
� � �
⇒ = ⇒ K = L , substituting this relation in our production
� � �
function, we get our conditional factor demand functions:
1
� r 2
L* (w, r, Q*) = Q � � �
w
1
� w 2
K* (w, r, Q*) = Q � � �
r
Therefore, cost function is given by
C (w, r, Q) = L*(w, r, Q*) w + K* (w, r, Q*) r

1 1
� r 2 � w 2
∗�
= w�Q � � � + r�Q∗ � � � �
w r

= 2�Q∗ � wr

In order to check the homogeneity condition, let input prices (w and r)

increase by proportion λ. Therefore the cost function becomes:

C (λw, λr, Q*) = 2�Q∗ � (λw)(λr) = 2λ�Q∗ � wr = λ C (w, r, Q*)

Hence the cost function is homogeneous of degree one. You may also check
the homogeneity condition for the conditional factor demand functions of L
and K.
In order to check for Shephard’s Lemma we differentiate the cost function
with respect to the input price w (and r):

�
��(�,�,�∗ ) ����∗ � �� � �
� �
∗� ∗�
��
= ��
=2× ×Q r=Q �� � ⟹ Conditional input
���∗ � ��
demand function for Labour L.

139
Production and Cost �
��(�,�,�∗ ) ����∗ � �� � �
� �
∗�
��
= ��
= 2× ×Q w= Q∗ � � � � ⟹ Conditional
���∗ � ��
input demand function for capital K.

6.4.2 Average and Marginal Cost Functions

Average Cost Function
Average cost is defined as the cost per unit of output produced. Average
cost function, a function of input vector W and output Q, is derived from the
total cost function as follows:
� (�,�)
AC (W, Q) =
�

The function will determine the minimum per unit cost of producing a
specific level of output, given the factor prices.
Marginal Cost Function
Marginal cost is the addition to total cost as an additional unit of output is
produced. A function of input vector W and output Q, marginal cost function
is derived from total cost function as a partial derivative of it with respect to
the output:
�� (�,�)
MC (W, Q) =
��

It simply determines the minimum addition to the total cost from producing
an additional unit of output, given the factor prices.
Example 3
Given a total cost function, C = 100Q + wrQ2, find the average and marginal
cost functions.
Solution
� (�,�)
Average cost function (AC) =
�

���� �����
= = 100 + wrQ
�
�� (�,�)
Marginal cost function (MC) =
��

������ ����� �
= = 100 + 2wrQ
��

6.4.3 Relationship between AC and MC Function

We present below the relationship between the AC and the MC function.
� (�,�)
We know, AC =
�
140
Rate of change of AC with respect to Q will be given by, Cost Function

� C (W,Q)
� �
�� Q
�� ’(�,�)��(�,�)
⟹
��
C’(W,Q) C(W,Q) � �(�,�)
⟹ − ⟹ � �C’(W, Q) − �
Q Q2 �

�
⟹ � �MC − AC�

From the above result it follows that, for Q > 0:

i) Slope of AC curve or rate of change of AC will be positive, that is
�
(AC) > 0, as long as MC > AC, or in other words, as long as MC curve
��
lies above AC curve.
�
ii) Slope of AC curve or rate of change of AC will be zero, that is �� (AC) =
0, when MC = AC, or in other words when MC curve intersects AC curve.
This happens at the minimum point of the AC curve.
iii) Slope of AC curve or rate of change of AC will be negative, that is
�
(AC) < 0, when MC < AC, or in other words when MC curve lies below
��
AC curve.
Fig. 6.3 represents such a relationship.
AC/MC

MC
AC

O Output

Fig. 6.3: Relationship between AC and MC curve

6.5 SHORT-RUN AND LONG-RUN COST FUNCTIONS

The distinction between the short-run and the long-run is done in terms of
the fixed and variable factors of production. Fixed factors of productions are
inputs in the production process that do not change with the level of output,
generally comprising large capital assets, office building, machinery, etc. On
the other hand, variable factors are inputs that change with the level of
141
Production and Cost output. In the short-run firms may face some constraints in expanding or
contracting their inputs so there exist some fixed factors at some
predetermined levels along with some variable factors, whereas in the long-
run all factors become variable. Let us now try to incorporate the distinction
of short-run and long-run with the concept of cost function.
Let XV represent a vector of variable inputs used in the production process,
and XF be the vector of fixed inputs. Similarly, vector WV and WF be the price
vectors of variable and fixed factors, respectively.

6.5.1 Short-run Cost Function

In the short-run, we just discussed, exist some fixed factors (XF) which are
given, and some variable factors (XV) which vary with the output level Q.
Earlier, in Section 6.4, we derived cost function as a function of given
parameters W and Q, now for the short-run cost function, XF will be
considered as another factor which is given in the short-run. Considering
presence of both, the variable and the fixed factors in the production
process, the short-run cost function will be given by:
CS (W, Q, XF) =WV XV (W, Q, XF) + WFXF
Where, XV (W, Q, XF) is the conditional variable factor demand function,
which in general depends upon the value of the given fixed factor XF.
On the basis of the short-run cost function, we can further define the
following:
�� (�,�,�� )
Short-run average cost (SAC) function =
�
��� (�,�,�� )
Short-run marginal cost (SMC) function =
��

Short-run variable cost (SVC) function = WV XV (W, Q, XF)

�� �� (�,�,�� )
Short-run average variable cost (SAVC) function =
�

Short-run fixed cost (SFC) function = WFXF

�� ��
Short-run average fixed cost (SAFC) function =
�

Remember:
If Q = 0, SVC = 0 as XV = 0, but SFC = WFXF i.e. when output production
reduces to nil, short-run variable cost also reduces to nil as employment of
variable inputs reduces to zero, but short-run fixed costs are still needed to
be incurred regardless of the output level.

6.5.2 Long-run Cost Function

In the long-run, all factors become variable (XV) that is they vary with output
Q. Since there are no fixed factors (XF), and all factors are variable (XV), we
can write vector XV as vector X (our factor vector) with corresponding factor
142 price vector given by W. Then, we get the following long-run cost function:
 CL (W, Q) =W X (W, Q) Cost Function

which is the cost function we discussed in Section 6.4. From the above
function, we can derive the following:
�� (�,�)
Long-run average cost (LAC) function =
�
��� (�,�)
Long-run marginal cost (LMC) function =
��

Check Your Progress 2

1) For the following total cost functions, find the AC, MC, AVC and AFC
functions.
a) C = 5Q3
b) C = 10 + 7Q2
c) C = Q3 – 4Q2 + 10Q + 10
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) Given the technological relationship between output Q and inputs L and
K priced at the per unit rate of w and r, respectively
�
Q = (L� + K � )�
a) Find the conditional factor demand functions L*(w, r, Q) and
K*(w, r, Q)
b) Derive the expression for the Cost function C (w, r, Q).
��(�,�,�)
c) Check for Shephard’s Lemma, that is check whether =
��
��(�,�,�)
L*(w, r, Q) and = K*(w, r, Q)
��
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
3) Use Shephard’s lemma to derive factor demand functions from the
following cost functions:
a) C = Q2 (7w3 + 5r3)
b) C = 2 Q2 √wr
where K and L are the two factors of production with per unit prices r
and w, respectively.
………………………………………………………………………………………………………………
……………………………………………………………………………………………………………… 143
Production and Cost
6.6 LET US SUM UP
The objective of profit maximisation explains the rationale behind cost
minimisation by a producer of a good or a service. Costs incurred to carry
out production include both, the explicit as well as the implicit costs. The
present unit dealt with minimisation of such costs. For this, two approaches
were explained— the graphical and the analytical. Graphical approach
requires tangency between the isoquant curve and the isocost line.
Analytical approach on the other hand involved solving the constrained
optimisation problem of cost minimisation. We adopted the Lagrangian
method for solving our optimisation problem, given the technological
relationship between the factors and the output (i.e. the production
function) and the factor prices.
On the basis of the optimisation exercise, the conditional factor demand
functions— giving the optimum level of factors employed in the production
process for the given output level Q and factor prices w and r, were derived.
These functions were then employed to derive the cost function— a
function of factor prices and output. By linking the production function with
the factor prices, a cost function gives the minimum cost of producing a
specific level of output, given the factor prices. Certain properties of a cost
function were also touched upon. An important one being the Shephard’s
lemma, as per which a differentiable cost function can be used to derive
conditional factor demand functions.
Subsequently, average cost and marginal cost functions were derived from
the cost function. Average cost is the per unit cost of production, while
marginal cost is the addition to cost from producing an additional unit.
Further, the relationship between the AC and MC curve, which you have
already studied in your Introductory Microeconomics course of Semester 1
(BECC-101), was mathematically established. Towards the end, the criterion
distinguishing the short-run cost function from the long-run cost function
was set in place by bringing in the picture the fixed and variable factors of
production. Short-run cost function is composed of the cost incurred on
both, the variable and the fixed factors. Long-run cost function, on the other
hand is composed of the cost incurred on only the variable factors, as in the
long-run all factors become variable. You must be clear with this by now—
short-run and long-run are differentiated on the basis of the presence and
absence of fixed factors of production, respectively.

6.7 REFERENCES
1) Hal R. Varian, (2010). Intermediate Microeconomics, a Modern
Approach, W.W. Norton and company / Affiliated East- West Press
(India), 8th Edition.
2) Shephard, Ronald W, (1981). Cost and Production Functions, Springer-
Verlag Berlin Heidelberg.
3) Nicholson, W., & Snyder, C. (2008). Microeconomic theory: Basic
principles and extensions. Mason, Ohio: Thomson/South-Western.
144
 Cost Function
6.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1) Equation for expansion path is given by, K = 3L
��� �
Hint: Use cost minimisation condition ���
= �
, where MPL = K2, MPK =
2LK, w = 15 and r = 10.
2) Minimum cost = Rs. 1200
� �
Hint: Production function Q = 10√KL can be written as 10K � L�
� ��
��� �
Use cost minimisation condition ���
= �
, where MPL = 5K � L � , MPK
�� �
=5K L , w = 12 and r = 3 to arrive at the relation K = 4L. Then use this
� �

relation in production function Q = 10√KL , where Q = 1000 to get L =

50 and K = 200. Minimum cost thus equals 12(50) + 3(200) = 1200.
Check Your Progress 2
1) a) AC = 5Q2, MC = 15Q2, AVC = 5Q2, AFC = 0
�� ��
b) AC = �
+ 7Q, MC = 14Q, AVC = 7Q, AFC = �
��
c) AC = Q2 – 4Q + 10 + �
, MC = 3Q2 – 8Q + 10, AVC = Q2 – 4Q + 10,
��
AFC = �
�
�����
2) a) L*(w, r, Q) = �
� � �
����� ����� �

�
�����
K*(w, r, Q) = �
� � �
����� � ���� �

Hint: Use the cost-minimisation condition,

1
� ρ ρ ρ−1 ρ−1
��� � (L +K ) ρL �
�
= ⇒ 1 =
��� � � ρ ρ ρ−1 ρ−1 �
(L +K ) ρK
�

� ��� �
⇒ � � =
� �
1
w ρ−1
⇒ L = K�r� 1)

From our production function and Equation (1), we get

145
Production and Cost � � � �
� � ��� � ���
Q = (L + K � )� ⇒ Q = �
�K � � � � �
+K ⇒Q =K � �
�� � � + 1�

� � �
��� � ���� � ����
� � �
⇒Q =K � � � ⇒ K* = �
� � �
���� ��� ���
�� �� �

Substituting value of K*in Equation (1), we get

�
� ����
L* = �
� � �
�� ��� ����� �

���
� �
�
b) C (w, r, Q) = Q �w ��� + r ��� �

Hint: Insert values of L* and K* in the cost function given by,

C (w, r, Q) = L*(w, r, Q) w + K* (w, r, Q) r
3) a) L*(w, r, Q) = 21 Q2w2 and K*(w, r, Q) = 15 Q2r2
��(�,�,�) ��(�,�,�)
Hint: ��
= L*(w, r, Q) = 21 Q2w2 and ��
= K*(w, r, Q) =
15 Q2r2
� �
b) L*(w, r, Q) = Q� �� and K*(w, r, Q) =Q� � �

146
 Cost Function

Block 3
Equilibrium Under Perfect Competition

147
Production and Cost
 Profit Maximisation by a
UNIT 7 PROFIT MAXIMISATION BY A Competitive Firm

COMPETITIVE FIRM
Structure
7.0 Objectives
7.1 Introduction
7.2 Perfect Competition
7.3 Profit Maximisation
7.4 Profit Function
7.4.1 Fixed and Variable Factors
7.4.2 Short-run Profit Maximisation
7.4.3 Long-run Profit Maximisation
7.4.4 Profit Function for Cobb-Douglas Technology
7.4.5 Properties of the Profit Function
7.5 Profit Maximisation Approaches
7.5.1 Total Revenue-Total Cost Approach
7.5.2 Marginal Revenue-Marginal Cost Approach
7.6 Equilibrium under Perfect Competition: Firm
7.6.1 Short-run Equilibrium
7.6.2 Long-run Equilibrium
7.7 Equilibrium under Perfect Competition: Industry
7.7.1 Short-run Equilibrium
7.7.2 Long-run Equilibrium
7.8 Supply Curves
7.8.1 Short-run Supply Curve
7.8.2 Long-run Supply Curve
7.9 Let Us Sum Up
7.10 References
7.11 Answers or Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit, you should be able to:
• revisit the characteristic features of a Competitive market structure;
• identify the concept of profit maximisation, that too in connection with
the competitive market structure;
• define and derive a Profit function under perfect competition;
• explain the short-run and the long-run equilibrium at the firm and
industry level; and
• analyse supply curves in the long-run and the short-run. 149
Equilibrium Under
Perfect Competition 7.1 INTRODUCTION
One of the most fundamental assumptions of economic theory is that of
benefit maximisation. For a consumer, the benefit is the utility received
from consumption of commodity, whereas for a producer, it is the profit
maximisation. Profits are simply the revenue received less of cost incurred in
carrying out any business operation. For a firm, profits equal total revenue
less total costs. Both— total revenue and total costs are determined by the
output level produced by the firm. For a firm aiming at profits maximisation,
the optimal output level produced is determined by the type of market it
caters to viz. perfect competition, monopoly, monopolistic competition and
oligopoly. In the present unit we take up a market structure characterised by
perfect competition. The theoretical aspect of this market structure had
already been comprehensively covered in Unit 9 of Introductory
Microeconomics (BECC-101) course of Semester 1. Here, we intend to
further analyse that theoretical content with the mathematical tools that
you came across in your Mathematical Methods in Economics course of
Semester 1 (BECC-102).
Initially we will revisit the characteristic features of a perfectly competitive
market. Then we will briefly touch upon the concept of profit maximisation.
The objective of profit maximisation will be further analysed in connection
with the firm operating in perfectly competitive market structure. After
deriving the profit function, profit maximisation approaches, that is the TR-
TC and the MC-MR will be given some mathematical treatment. This
treatment will be further carried forward to analyse, both the short-run and
the long-run equilibrium conditions of both the firm and the industry under
a perfect competition market structure. Towards the end, supply curves in
the short-run and in the long-run will be explained.

7.2 PERFECT COMPETITION

You came across the following characteristic features of a Perfectly
Competitive market structure in Unit 9 of your Introductory Microeconomics
course in Semester 1 (BECC-101):
1) Very large number of buyers and sellers in the market;
2) Product sold by all the firms is ‘Homogenous’;
3) Free entry or exit of firms;
4) Perfect information for correct economic decisions available with all
economic participants;
5) Perfect mobility of resources; and
6) No government intervention
A perfectly competitive market structure is said to prevail when firms do not
have any power to influence the prevailing prices in the market. Firms are
unable to influence price because the volume of output, which they sell in
150 the market, is ‘insignificantly small’ as compared to the total size of the
market. The output share of each firm is insignificantly small because the Profit Maximisation by a
Competitive Firm
number of firms in the market is very large and each of them sells
homogeneous product. Free entry and exit by the firms in the market allows
each to earn only normal profits. On the top of that, availability of perfect
information about products and their prices make sure that any change in
prices will immediately be known to all buyers as well as to all sellers. In
other words, price signals work perfectly in efficient allocation of resources
in this market structure.
Perfect competition is an ideal market structure, which does not exist in
reality, since no industry completely satisfies all the conditions mentioned
above. Though markets for homogeneous agriculture produce like wheat,
rice, etc. come close, but Government intervention in such markets keeps
them from fully satisfying all the conditions of this market structure.
If such a market structure does not exist in reality then what is the need to
study it? To understand this, we must define ‘Efficiency’. Efficiency is said to
be the ideal situation when nobody can be made better off without making
someone else worse off. Perfect competition results in an efficient
allocation of resources so that no re-organisation could make someone
better off without making someone else worse off. After analysing this ideal
structure, imperfections can be easily added to it to make it more realistic.
So we study perfect competition to make comparison of an ideal market
structure with less efficient and more realistic market structure(s) of that of
a Monopoly, Monopolistic competition or Oligopoly. Such comparison after
dropping the restrictive assumptions of the ideal market situation would
help us in economising the use of resources according to priorities.

7.3 PROFIT MAXIMISATION

Most of the activities, be it production or consumption, are undertaken in
expectations of some return. A consumer derives return in the form of
utility attained from consumption of a commodity or a service, while for a
producer that return is the profit earned from undertaking the production of
that good or service. Profit is simply the amount left with the entrepreneur
after he has paid for all the expenses incurred in the production process. It is
given by:
Profit = Total Revenue – Total Costs
Total Revenue (TR) is the amount received by a producer from selling the
commodity he deals in. It is given by the product of the quantity of a good
sold and the price of that good (TR = Price × Quantity sold). The concept of
TR is simple and clear, whereas Total Costs could be represented in terms of
two variants— Explicit costs and the Implicit costs. Explicit costs are the
costs that a producer pays for, like wages, rent, advertising, packaging, etc.
On the other hand, Implicit costs are the opportunity costs of the resources
supplied by the producer himself, like implicit salary for the entrepreneurial
services of the producer, implicit rent of a factory building owned by the
producer, etc. It is simply the value, the factors owned by the producer
could have earned if he had chosen to rent them out instead of using them.
151
Equilibrium Under While calculating profits, when only explicit costs are considered, we get
Perfect Competition
Accounting profits, given by Total Revenue – Explicit Costs. Economic profits
on the other hand consider both, the explicit as well as the implicit costs. It
given by:
Economic Profit = Total Revenue – (Implicit Costs + Explicit Costs).
Economic profit are always less than accounting profit for it takes into
account implicit costs as well, which accounting cost does not.
Profit maximisation has been regarded as the sole objective of the business
in any capitalist economy. It is as feasible as the utility maximisation
objective of an individual consumer. At equilibrium, a firm in a perfectly
competitive market earns zero economic profit. Considering the
maximisation objective, why would a firm in such a market settle at zero
economic profit? The explanation to this could be:
1) Zero economic profit condition implies that the firm in perfect
competition is earning normal profits, wherein revenue earned is
sufficient to cover both the implicit as well as the explicit costs;
moreover
2) Free entry and exit of the firms in the industry ensures that all positive
economic profits get competed away by new entrants, while economic
losses get eliminated by exit of the loss-making firms from the
industry— so that in the long-run all firms earn only zero economic
profits.
Keeping the objective of profit maximisation in mind, let us now define the
profit function under a perfect competition.

7.4 PROFIT FUNCTION

Profit function represents the maximum profit a firm may earn for various
combinations of inputs and output prices. Before deriving such a function,
you must be aware of the concepts of profit maximisation, both— in the
long-run and in the short-run. This in turn will require your clear
understanding of the fixed and the variable factors of production.

7.4.1 Fixed and Variable Factors

You are already familiar with the idea of fixed and variable factors of
production. Fixed factor of production is present in fixed amounts, at least in
the short run, like building, machines, etc. On the other hand, a variable
factor can be used in different amounts even in the short run, for instance,
labour, raw materials, etc. In the short run, firms can vary only the variable
factors of production, whereas in the long run, all factors of production can
be varied, i.e. all factors become variable in the long run. Thus, the short run
and the long run time period is something which is defined by the extent
and the timeliness of the variability of factors of production. Factors which
could not be varied for a specific amount of time period, define the extent
of short run time span for that firm to that extent of time period.
152
Presence of Fixed factors in the short run creates the possibility of a firm Profit Maximisation by a
Competitive Firm
earning negative profits in the short run. This is because, even if firm decides
to produce no output, it has to employ and pay for some fixed factors in the
short run. But, in the long run, all factors become variable, this makes it
possible for a firm to go out of business, i.e. produce no output and thus
reduce its cost to zero, and earn zero profits.

7.4.2 Short-run Profit Maximisation

Consider a production function for a firm, given by
� , L)
Q = f (K
Here, Q represents the amount of output produced, K and L are the two
factors of production. Bar over input K signifies that it is fixed at a level, i.e.,
K=K � . Further let P be the price of the output Q, and let r and w be the
prices of the factors K and L, respectively. We assume P, w and r as given.
Total Revenue (TR) equals Price × Output:
� , L)
TR = P × f (K
� and L at
Total Cost (TC) is the cost incurred on employment of factors K
respective rates of r and w: TC = rK � + wL

Profit (π) will be given by TR – TC. Thus, short-run profit maximisation

problem becomes
� , L) −rK
Maximise π = Pf (K � − wL

First-order condition for profit maximisation will be given by

��
��
=0

This gives the following equation for the profit-maximising choice of L, i.e.
L*.
� , L*) = w
P fL´(K (1)

� , L*) is the Marginal Product (MP) of factor Lat L*, and

Where, fL´(K
consecutively P fL´(K � , L*) gives the value of MP of factor L at L*.

Equation (1) gives a general rule—at the profit-maximising level of a factor

� , L*)] should
(here L), value of marginal product of that factor [hereP fL´(K
equal that factor’s price (here w).
The same condition can be derived graphically. Refer Fig. 7.1 below.The
�,
upward sloping concave curve represents the production function Q = f (K
L), where factor K is fixed.

153
Equilibrium Under
Perfect Competition

Q (Output)
π3
Isoprofit
π2 Lines
π1
E � , L)
Q = f (�
Q*

0 L* L(Variable factor)

Fig. 7.1: Profit Maximisation

� − wL
Now, Profit function is given by, π =PQ –rK
Expressing Q as a function of L, the above equation becomes:
� � �
Q= �+
+ �K L (2)
� �

Equation (2) represents an Isoprofit line, where ‘Iso’ means equal. This line
gives all the combinations of Q and L at which, level of profit remains equal
� � �
or constant. Slope of the line is given by � , whereas intercept is � + � K �, a
sum of profit and fixed costs to the firm. With fixed costs remaining fixed,
for different values of π, we get different intercepts, and consequently a
family of parallel isoprofit lines, represented by π1, π2 and π3 in the figure.
Now, profit maximisation occurs where the production function touches the
highest possible isoprofit line. This is happening at point E in Fig. 7.2, where
isoprofit line π2 is tangent to production function. Tangency implies that at
point E, slope of production function, given by fL'(K � , L) equals slope of
�
isoprofit line π2, given by � .

That is, at E � , L) = � ⟹P fL'(K

fL'(K � , L) = w
�

Thus, we get back the same condition that was given by Equation (1).
Dynamics of Change in Factor or Product Prices
Now let us examine the effects of changing input and output prices on the
firm’s input and output choices. First we take up the case when price of
variable factor (i.e., L) changes. Suppose w (the price of factor L) rises. This
�
will raise the slope of the isoprofit line (given by � ), as you may notice in
Fig. 7.2. Tangency of production function with the new steeper isoprofit line
must occur to the left of the tangency with the flatter isoprofit line
154
associated with lower w. This shows— as price of a factor rises, demand for Profit Maximisation by a
Competitive Firm
it falls, that is, the factor demand curve slopes downwards.
Q (Output)

Isoprofit line (high w)

Isoprofit line (low w)

Q = f (� � , L)
E1
E2

0 L*2 L*1 L
Fig.7.2: Change in Factor demand as factor price changes

What will happen, when price of fixed factor (i.e. K) changes? A change in r
(the price of factor K) will not alter firm’s demand for it, at least in the short
run, as it remains fixed at a level given by K � . Also, as you may notice, a
�
change in r will not alter the slope of the isoprofit line � � �. Therefore, there
will be no change in choice of factor L or output Q. The change will come
only in the profits earned by the firm.
Now we look into the case of change in output (Q) price. Suppose P (the
output price) falls. This will again result in increasing the slope of the
�
isoprofit line� � �. Tangency of the production function and the steeper
isoprofit line, as you may notice in Fig. 7.3, will occur to the left of the
tangency of production function and the flatter isoprofit line associated with
higher P. Fall in employment of L with fixed K, will result in fall in output.
This concludes— as price of output falls, production falls, that is, the output
supply curve slopes upwards.
Q (Output)

Isoprofit line (lowP)

Isoprofit line (highP)

Q*1 Q = f (� � , L)
E1
Q*2 E2

0 L*2 L*1 L

Fig. 7.3: Change in output demand as output price changes

155
Equilibrium Under
7.4.3 Long-run Profit Maximisation
Perfect Competition
In the long-run, all inputs become variable for the firm. Thus, production
function faced by the firm becomes
Q = f (K, L)
As you may notice here, K does not have a bar on top, indicating it could be
varied, just like factor L, by the firm. Now, the long-run profit maximisation
problem will be given by

Maximise π =Pf (K, L) –rK − wL (3)

First-order condition for profit maximisation will be given by
��
��
= 0 ⟹ P fL´ (K, L) = w (4)
��
��
= 0 ⟹ P fK´(K, L) = r (5)

Where, fL´ (K, L) is the Marginal Product (MP) of factor L, and consecutively
P fL´ (K, L) gives the value of MP of L. Similarly, P fK´ (K, L) gives the value of
MP of factor K. So we have Equations (4) and (5) to solve for the optimal L
and K in terms of output and input prices (P, w, r). Let us denote the optimal
values by L* and K*.
Thus, profits are maximised, when firm makes optimal choices of factors K
and L, at a level where value of marginal product of each factor equals its
price.
Factor Demand Function
Given the input and output prices (i.e., given the values of w, r and P),
Equations (4) and (5) can be solved for the two unknowns— K* and L* as a
function of these prices. The resulting function, called the Factor Demand
function, gives the relationship between price of a factor and profit
maximising choice of that factor.
Thus, factor demand function for input L will be given by:
L* = F* (P, w, r) (6)
and that for input K will be given by: K* = G* (P, w, r) (7)
Here, F* and G* simply denote profit maximising functions of the output
and input prices.
Profit Function
From Equation (3), (6), and (7), we get the Profit function of a perfectly
competitive firm as a function of the output and the input prices:

π* (P, w, r) = P f [G* (P, w, r), F* (P, w, r)] – r G* (P, w, r) – wF* (P, w, r)

Profit function, given by π* (P, w, r) gives maximum profit that could be
earned by a perfectly competitive firm as a function of P, w and r.
156
7.4.4 Profit Function for Cobb-Douglas Technology Profit Maximisation by a
Competitive Firm
A Cobb-Douglas production function for two inputs x and y, Q = f (x, y) can
be written in the following form:
Q = xayb (8)
where Q is the output produced with employment of two factor inputs x and
y; a and b are the positive constants. A firm in perfect competition
maximises its profits (π) given by:

π = P f (x, y)– w1x – w2y (9)

where P is the price of the output Q; w1 and w2, the prices of the factors
inputs x and y, respectively. The first-order conditions of profit maximisation
are given by:
�� ��(�,�)
��
=p ��
− w� = 0 ⟹ Pax ��� y � = w1 (10)
�� ��(�,�)
��
=p ��
− w� = 0 ⟹Pbx � y ��� = w2 (11)

Given the prices (i.e., P, w1 and w2), Equations (10) and (11) give profit
maximising factor choices of inputs x and y, respectively. Both these
equations can be solved to derive factor demand functions of inputs x and y.
On dividing equation (10) by (11), we get
������ �� � ��
���� ����
= �� ⟹ y = ��� x (12)
� �

Substituting value of y from Equation (12) in Equation (10), we get

�� �
Pax ��� ��� � x� = w1⟹Pa��� b� w���� w��� x ����� = 1
�
�
⟹ Pa ��� �
b w���� w��� = ������

This above equation could be further solved to get profit-maximising firm’s

demand for input x as a function of price of output (P) and prices of both the
inputs (w1 and w2).
x����� = Pa��� b� w���� w���
⟹x=
�(���)� ���
�� ���� �� �����
�P ����� � �a ����� � �b ����� � �w� � �w� ����� � (13)

Now, value of x can be substituted in Equation (12) to get factor demand

function for input y.
��� �(���)�
�� � ����
y = �P ����� � �a ������ � �b ����� � �w �����
� �w �����
� (14)
� �

Now, inserting both the factor demand functions in our production function
given by Equation (8), we get the perfectly competitive firm’s Supply curve.

157
Equilibrium Under ���� � � ��� ���
Q* = �� ����� � �� ������ � �� ������ � �� �����
� ��� ����� � (15)
Perfect Competition �

Supply curve given by Equation (15) gives a perfectly competitive firm’s

profit maximising output quantity (Q*) as a function of price of output (P),
and prices of inputs (w1 and w2).
Equations (13), (14) and (15) can then be substituted in Equation (9) to get
the profit function π* (P, w, r), given as follows:
�� ��� ���
�����
π (P, w, r) = �P ����� � �w
� � �w� ����� �
�⁄�����
�a� b� − a��� b� − a� b��� �

7.4.5 Properties of the Profit Function

1) Profit function π (P, w, r) is non-decreasing in output prices (P).
If P´ ≥ P, then π (P´, w, r) ≥ π (P, w, r).
2) Profit function is non-increasing in input prices (w and r).
3) Homogeneous of degree one in P, w and r.
π (tP, tw, tr) = t π(P, w, r) for all t ≥ 0
4) Convex in P, w and r.
Let p′′ = tp + (1 − t ) p′ for 0 ≤ t ≤ 1

Then π ( p′′) ≤ tπ ( p ) + (1 − t )π ( p′)

5) Continuous in P, w and r for P, r, w > 0.

6) Derivative property of profit function (Hotelling’s Lemma):
i) If we take the partial derivative of profit function with respect to
��(�,�,�)
output price (p) we get the output supply function i.e., �� =
�(�, �, �).
ii) If we take negative of the partial derivative of profit function with
respect to input price (say w) we get the factor demand function
��(�,�,�)
for labour i.e., − ��
= �(�, �, �). Similarly If we take
negative of the partial derivative of profit function with respect to
input price (say r) we get the factor demand function for capital
��(�,�,�)
i.e., − ��
= �(�, �, �).

Example 1
1) A firm has the following total-cost and demand functions:
�
C = �Q3 – 7Q2 + 111Q + 50

Q = 100 – P

158 a) Write out the Total Revenue function in terms of Q.

 b) Formulate the total profit function (π) in terms of Q. Profit Maximisation by a
Competitive Firm
c) Find the profit-maximising level of output Q*.
d) What is the maximum profit?
Solution
a) Total Revenue = P × Q
TR = (100 –Q) ×Q = 100Q – Q2
b) Total Profit Function (π) = TR – TC
�
π = 100Q – Q2 – (�Q3 – 7 Q2 + 111Q + 50)
�
π = 100Q – Q2–�Q3 + 7 Q2 – 111Q– 50
��
c) ��
= 100 – 2Q – Q2 + 14Q – 111 = 0

– Q2 + 12Q – 11 = 0
–1 (Q2 – 12Q + 11) = 0
Q2– 11Q – Q + 11 = 0
Q (Q– 11) –1 (Q– 11) = 0
Q = 1 or Q = 11
�� �
���
= – 2Q + 12

�� �
If Q = 1 then ��� = −2 + 12 = 10 > 0

�� �
If Q = 11 then ��� = −2 × 11 + 12 = −10 < 0

Hence, profit is maximised when Q = 11

�
d) Maximum Profit = 100 × 11 – (11)2– � × (11)3 + 7 × (11)2 – 111 × 11 – 50

= 1100 – 121 – 443.6 + 847 – 1221 – 50 = 1947 – 1835.6

= 111.4
Hence, the maximum profit is Rs. 111.4
Check Your Progress 1
1) Explain the factors that drive profits to zero in perfectly competitive
markets in the long-run.
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
159
Equilibrium Under 2) A firm’s demand function for good is given by, P = 300 – 2Q, where P
Perfect Competition
stands for price and Q for quantity, whereas its total cost (TC) function
is given by, TC = 200 + 8Q. Derive the profit function of this firm as a
function of output (Q).
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
3) A production function of a firm is given by Q = f (L), where Q is the
output produced and L is the labour input. Considering ‘w’ as the price
of factor L, analyse and illustrate the effect of fall in w on the output
produced.
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
.……………………………………………………………………………………………………...………
4) Consider the following production function of a firm for good X, f (L) =
300L – L2, where L stands for labour factor. Assume price of good X be
Rs. P and that of factor L be Rs. w. Determine the following:
a) Factor demand function for L
.……………………………………………………………………………………………………..
.……………………………………………………………………………………………………..
.……………………………………………………………………………………………………..
b) Profit function
.……………………………………………………………………………………………………..
.……………………………………………………………………………………………………..
.……………………………………………………………………………………………………..
5) Given a Cobb-Douglas production function of the form, Q = K0.4L0.4.
Assuming output price to be P, and price of K and L be r and w,
respectively, derive the expression for the profit function as a function
of output and input prices.
.………………………………………………………………………………………………………………
.………………………………………………………………………………………………………………
.………………………………………………………………………………………………………………
.………………………………………………………………………………………………………………
.………………………………………………………………………………………………………………
160
 Profit Maximisation by a
7.5 PROFIT MAXIMISATION APPROACHES Competitive Firm

Firm is said to be in equilibrium when it has no incentive to change its level

of output. Such a level of output of the firm is indicated at a point where
firm is experiencing maximum level of profit. There are two approaches to
determine firm’s equilibrium level of output, or in other words, its profit
maximisation output level:
i) Total Revenue-Total Cost (TR-TC) Approach
ii) Marginal Revenue-Marginal Cost (MR-MC) Approach.

7.5.1 Total Revenue-Total Cost Approach

Difference between Total Revenue (TR) and Total Cost (TC) gives us profit.
When the gap between TR and TC is largest, firms would be earning
maximum profit in money terms. So let us try to understand shape, slope
and position of TR and TC curve.
As discussed previously MR and AR are equal and constant under perfect
competition. Slope of TR curve is given by MR, which is constant and
positive because prices cannot be negative; hence we have TR curve as an
upward sloping linear curve. At zero quantity, TR would be zero hence TR
curve would start from the origin and will continue to rise with slope equal
to MR. TC on the other hand is non-linear curve, as total cost depends upon
the returns to factors of production. If returns to factors of production are
increasing at increasing rate then TC will increase at decreasing rate and if
returns to factors of production are increasing at decreasing rate then TC
will increase at increasing rate. The fixed costs are assumed away for the
sake of simplicity. But, we will bring them back in the numerical example
towards the end of this sub-section.

Fig. 7.4: Equilibrium of a firm using TR-TC approach

161
Equilibrium Under We will have TR and TC curve under perfect competition as shown in Fig.
Perfect Competition
7.4. Equilibrium will be at level of output where vertical distance between
TR and TC curve is largest, indicating maximum profit [Profit (π) = TR − TC].
This occurs at point M. As you may notice in the figure, at point M, we also
have slope of TR curve equal to the slope of TC curve.
��� ���
Hence, this approach requires, ��
= ��

The above condition reads— derivative of total revenue with respect to Q is

equal to the derivative of total cost with respect to Q.
Up to L-level of output and beyond N-level of output, TC > TR, hence firm
will experience loss. Between L- and N-level of output firm is experiencing
positive money profit. At both these levels of output, firm is experiencing
neither profit nor loss, because TC = TR and this indicates break-even point
or level of output.
It is to be observed that by looking at above figure it cannot be revealed
what is the price which firm would charge for its equilibrium level of output.
We need to do some simple calculation by dividing TR associated with
equilibrium level of output by level of output to determine equilibrium
��
price, TR = P × Q ⟹P = � = AR. This became major limitation of this TR-TC
approach. It is also not easy to determine maximum vertical gap between
TR and TC. This takes us to another approach (MR-MC approach) where
these limitations are addressed.

7.5.2 Marginal Revenue-Marginal Cost Approach

To determine equilibrium for perfectly competitive firm, we need to find the
level of output that would maximise its profit. To maximise its profits for
each unit of increased output, firm compares additional revenue generated
by selling that unit of output [that is marginal revenue (MR)] with additional
cost incurred in producing that unit of output [the marginal cost (MC)]. As
long as,
• MR > MC, additional production adds to profit, thus firm should
produce this additional unit of output.
• MR < MC, additional production reduces profit, thus firm should not
produce this additional unit of output, instead decreasing production
would add to firm’s profits.
• MR = MC, additional production does not impact profit, hence it
provides a point where firm is indifferent in increasing or decreasing
level of output, hence defines its equilibrium level of output.
Using calculus we can derive this condition mathematically,
Profit (π) = TR – TC
First-order maximisation condition is given by:
��
��
=0
162
 ��� ��� Profit Maximisation by a
��
– ��
=0 Competitive Firm

��� ���
��
= ��

Derivative of TR with respect to Q is nothing but the MR, whereas derivative

of TC with respect to Q is MC, so that, profit maximisation problem gives us
the following necessary condition:
MR = MC
To determine sufficient or the second-order condition, we need to
differentiate profit function again.
�� ��� ��� ��
We have, ��= ��
– ��
or��= MR – MC

Now, taking second derivative of the above expression, we get

�� � �� �� �� �� �� � ��� ���
���
= ���
– ���
or ���
= ��
– ��

Second-order profit maximisation condition is:

�� �
���
≤ 0
��� ���
That is, ��
– ��
≤0
��� ���
Or, ��
≤ ��

The above condition says that at profit maximisation output level, slope of
MR ≤ slope of MC, which implies MC curve should cut MR curve from below.
This above arguments can also be understood through following Fig. 7.5.

Fig. 7.5: Equilibrium of a firm using Marginal Revenue and Marginal Cost approach

In Fig. 7.5, MR and MC curves intersects at point A giving equilibrium level of

output Q. At point A, both necessary and sufficient conditions are fulfilled.
Thus, we get profit maximising level of output. Notice that at point A, MC is
163
Equilibrium Under also cutting ATC at its minimum point, which is tangent to AR = MR curve.
Perfect Competition
This results in the break-even level of output production, where the output
produced results in zero economic profit.
Example 2
A firm has the following total revenue and total cost functions:
TR = 320Q – 2Q2
TC = 1800 + 50Q + 3Q2; where 1800 represents fixed cost component.
Determine the level of output that would maximise profit earned by the
firm.
Solution
Profit (π) = TR – TC
π = (320Q – 2Q2 ) – (1800 + 50Q + 3Q2 )
π = – 5Q2 + 270Q – 1800
Maximisation of this equation is found by differentiating it with respect to Q
and setting equal to 0:
��
��
=0
��
��
= −10Q + 270 = 0

10Q = 270
or Q = 27
So level of output which would maximise profit equals 27 units. Let’s see
whether equilibrium will be stable which maximises profit. For this we will
have to verify sufficient condition or second order derivative condition.
�� �
���
≤0

�� �
���
= − 10 < 0

So second order derivative condition is also satisfied, hence 27 units of

output would maximise profit and it would be stable.

7.6 EQUILIBRIUM UNDER PERFECT COMPETITION:

FIRM
7.6.1 Short-run Equilibrium
A perfectly competitive firm faces constant prices and horizontal demand
curve. Firm has to decide in the short-run whether to produce or shut-down
temporarily and how much to produce? In the long-run firm has to decide,
whether to enter, stay or leave the industry; also whether to increase or
decrease the plant size.
164
Equilibrium Under variable cost. So as long as firm is recovering its variable cost, firm will
Perfect Competition
continue to produce. Now, consider the following expression for Total cost:
Total Cost = Total Fixed Cost + Total Variable Cost
On dividing this equation by Q, we get the expression for the Average total
cost (ATC) as a linear function of average fixed cost (AFC) and average
variable cost (AVC).

ATC = AFC + AVC

Fig. 7.7: Firm’s decision to shut-down or continue production in short-run

A perfectly competitive firm takes prices as given because it does not have
any control over prices. Consider Fig. 7.7 above. A firm facing market price
P < SATC (Short-run Average Total Cost), suffers losses in the short-run. It
may decide to continue or shut-down the production. This dilemma results
because in the short-run firm incurs not only the variable cost but also the
fixed cost. On shutting down, firm will get rid of the variable cost, but it will
still have to bear the fixed cost.
The Short-run Average Variable Cost (SRAV) curve represents the variable
cost incurred in the production process. As long as AR is greater than SAVC,
firm is able to recover variable cost. Here, P < SATC, but it is equal to
minimum SAVC. Thus, this firm though suffers a loss, will minimise its losses
by continuing production, as it may recover some component of fixed cost.
Point Z (where MC = minimum SAVC) represents the Shut-down point. If
prices (AR) become less than SAVC at equilibrium level of output; firm will
minimise its losses by shutting down, as now it is not able to recover even its
variable cost. By shutting down, it will just have to suffer the loss from fixed
costs and not any additional variable costs.
Point F, on the other hand represents Break-even point. Here, firm makes
normal profit or zero economic profits, as TR = TC. Hence, even with short-
run losses, firm will continue the production process, as long as market price
166
it faces is above the minimum AVC of production. The moment market price Profit Maximisation by a
Competitive Firm
falls below the shut-down point (Z here), firm decides to shut-down its
operations in the short-run.

7.6.2 Long-run Equilibrium

In the long-run, all factors of production are variable, which means that
there is no difference between variable cost and fixed cost, hence ATC
becomes important in making production decisions. In the long-run firm
faces decisions like— whether to enter, stay or leave the industry; and
whether to increase or decrease the plant size.
If price (AR) is greater than AC then firms would be making super-normal
profit, this would attract new firms to enter the industry and push the price
down because of increased supply in the industry. On the other hand, if
price (AR) is lower than AC, then some firms would leave industry because
they are unable to recover their opportunity cost, in such case there will be
a decline in supply which will push the price up. Hence in either situation,
whether P (AR) is greater or lower than AC, firms would keep entering or
leaving respectively till P or AR is equal to AC.
So in long-run, we have the following two conditions giving the equilibrium
level of output:
i) P (or AR or MR) = MC and
ii) AR = AC
From these two equations we get, P = MC = AC. And since, MC and AC are
equal only at the minimum of AC, so price line (or AR curve) should be
tangent to AC curve at the long-run equilibrium level of output.

Fig. 7.8: Firm’s Long-run equilibrium

Since in the long-run firm operates at the minimum of AC curve, this

signifies that firm is operating with the plant of optimum size. When firm
operates with optimum size, it means that it is enjoying all possible
economies of scale or it has exhausted the economies of scale, and has no
incentive to move to any other point.

167
Equilibrium Under hence entry of new firms would stop and all firms as well as the industry
Perfect Competition
would be in equilibrium.
Check Your Progress 2
1) Explain the difference between Short-run and Long-run equilibrium of
perfectly competitive firm.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) By defining concept of super normal profit, explain equilibrium of an
industry in perfect competitive market structure?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
3) If each firm in an industry is operating where P = LMC, does it imply that
the industry is in long-run equilibrium? Explain.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
4) The market demand for a particular type of carpet has been estimated
as:
P = 40−0.25Q, where P is price (Rs/meter) and Q is rate of sales
(hundreds of meter per month). The market supply is expressed as:
P = 5.0 + 0.05
A typical firm in this market producing q units of output in hundreds of
meter per month,has a total cost function given as: C = 100 − 20.0q +
2
2.0q .
a) Determine the equilibrium market output rate and price.
………………………………………………………………………………………………….
………………………………………………………………………………………………….
………………………………………………………………………………………………….
b) Determine the output rate for a typical firm.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

170
c) Determine the rate of profit (or loss) earned by the typical firm. Profit Maximisation by a
Competitive Firm
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
5) The cost function of firm is assumed to be
C = 0.01x3 + 250x, where x is monthly output in thousands of units. Its
revenue function is given by R = 1500x – 2x2
a) Find the firm’s total cost and marginal cost for producing 10 units.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
b) If the firm decides to produce with a marginal cost of Rs. 298, find
the level of output per month and total cost to the firm.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
c) Find the firm’s average and marginal revenue functions.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
d) If the firm decides to produce with marginal revenue of Rs. 1100,
find firm’s monthly output and monthly revenue.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
e) Obtain the firm’s profit function and marginal profit function.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
f) Find the output required per month to make marginal profit equal
to zero and find the profit at this level of output.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
………………………………………………………………………………………………………… 171
Equilibrium Under g) Find the marginal revenue and marginal cost at this level of output
Perfect Competition
and comment upon the result.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
6) State whether following statements are true or false.
a) In any market, the seller alone determines the price of the product
that is bought and sold. Since the seller has the product, while the
buyer does not have it, buyer must pay what the seller asks.
…………………………………………………………………………………………………………
b) A product’s market demand curve generally slopes upward and to
the right, if the product’s price elasticity of demand is very large.
…………………………………………………………………………………………………………
c) Firm is a price taker in perfect competition.
…………………………………………………………………………………………………………
d) MR-MC approach to determine firm’s equilibrium is better
approach than TR-TC approach even though both gives same
equilibrium level of output.
…………………………………………………………………………………………………………
e) A firm’s total revenue can be determined by adding the values of
MR for each unit sold?
…………………………………………………………………………………………………………

7.8 SUPPLY CURVES

Supply is the relationship between prices and quantity. Higher the price
higher is an incentive to supply goods and services, reflecting a positive
relationship between prices and quantity supplied. Thus, the supply curve is
an upward slopping curve.

7.8.1 Short-run Supply Curve

In the short-run firms faces time constraint in which they cannot change all
their factors of production. Some factors of production will be constant, so
firms can only increase output by using variable factors of production more
intensively. We have learnt while discussing equilibrium of a firm, that firm
will produce till MC becomes equal to prices. We also know that firm under
perfect competition is a price-taker, which makes price line horizontal and
parallel to quantity axis. So if the firm has to decide how much to produce
by equating MC with prices, then MC curve itself would become supply
curve. We have also learnt that firm would not produce beyond a point
172 where prices fall below short-run AVC. So portion of MC curve, which lies
above minimum AVC (i.e., above the shut down point) in short-run, would Profit Maximisation by a
Competitive Firm
become supply curve of the firm.

Fig. 7.11: Firm’s short run supply curve

Assuming all firms in an industry are homogenous and have identical cost
conditions, industry supply curve in the short-run can be derived by
horizontally summing up the short run supply curve of all the existing firms.
For example, if there are 10 firms operating in the industry, with same cost
conditions and each producing 15 units of goods at price P1 , then industry
supply at this price would be 15×10 = 150 units. Similarly, if at price P2 each
firm is producing 20 units, then industry supply will be 200 units. In this way
we can determine industry supply at various prices (Refer Fig. 7.12).
Price (Rs)

MC
Price (Rs)

(a) Firm (b) Industry

Industry
AVC Supply Curve
E2
P2
P2
E1
P1
P1

0 15 20 Output 0 150 200 Output

Fig. 7.12: Industry’s Short-run supply curve derived by horizontally summation of individual firm supply
curve
173
Equilibrium Under
Perfect Competition
Example 3
Consider a firm in a competitive industry with the following short-run total
cost (STC) curve, STC = 30Q2 + 5Q + 300. Assuming there are 120 such firms
in the industry, derive
a) a typical firm’s short-run supply curve;
b) Industry’s short-run supply curve.
Solution
a) Short-run total cost curve given is composed of both, the variable cost
and the fixed (or sunk) cost. Therefore, from the given STC, we have,
Total variable cost (TVC) = 30Q2 + 5Q and Total fixed cost (TFC) = 300
��� ���� ���
Now, Average variable cost (AVC) = �
⟹AVC = �
⟹AVC = 30Q + 5
�(���)
Also, Short-run Marginal cost (SMC) = ��
⟹60Q + 5

We just recalled— a firm’s short-run supply curve is its SMC above the
minimum point of AVC. Thus, we first find the minimum point of AVC, a
point where SMC = AVC.
Therefore, 60Q + 5 = 30Q + 5 ⟹Q = 0.
At Q = 0, minimum AVC is given by, 30(0) + 5 = 5.
Putting value of minimum AVC in equation of SMC, we get the firm’s
short run supply curve S(P)— a function of price P, given by
P−5
� 60 , P ≥ 5
0, 0 ≤ P < 5
b) Given 120 firms in the industry, Industry supply curve, for P ≥ 5 will be
���
given by 120 × S(P) ⟹ 120 � �� � = 2P – 10.

7.8.2 Long-run Supply Curve

In long-run firms can change all its factors of production to vary level of
output produced. We have learnt that firms in long-run would be in
equilibrium at minimum point on the long-run average cost (LRAC) curve.
We also know that Long-run marginal cost (LMC) curve passes through
minimum point of LRAC. Firm equates MC with prices to determine its
equilibrium, so in the long run firms would be producing only at one point
where LRAC = LMC.
We cannot derive the long-run supply curve of the industry by horizontally
summing up the existing firms output, because of the following reasons:

174
1) Firms in long-run produces only at one point i.e., minimum of LRAC Profit Maximisation by a
Competitive Firm
where LRAC= LMC. So entire LMC does not constitute long-run supply
curve of firm.
2) The number of firms in long run does not remain fixed because of
entry and exit of firms depending upon price and demand conditions.
3) With the increase in size of the industry, in the long-run, cost curves
shifts because of external economies and diseconomies.
External economies accrue to the firm, if expansion in the supply of industry
shifts cost curves downward. Shifting of cost curves downwards means that
each level of output can be produced at lower cost. External economies can
arise due to:
a) If the skill enhancement of workers takes place due to expansion in
industry’s output.
b) Better and efficient technology is used with the expansion in supply.
c) With the development of auxiliary industry, cost falls.
d) Betterment and improvement in knowledge leads to reduction in cost,
etc.
External diseconomies accrue to the firm, when increase in the industry’s
output leads to upward shift in cost curves, indicating increase in cost of
production for each level of output. One of the most important factors,
which may lead to external diseconomies, is increase in prices of factors of
production due to their increased demand with the expansion in output.
If external economies are greater than external diseconomies, then industry
would experience net external economies. If net external economies prevail
in the industry then it is known as decreasing cost industry.
If external diseconomies are greater than external economies then industry
would experience net external diseconomies. If net external diseconomies
prevail in the industry then it is known as increasing cost industry.
If external economies are exactly equal to external diseconomies then
advantages from one are balanced out by disadvantages from other, leading
to no change in cost conditions. When there is no change in cost curves
even when there is expansion of supply in the industry, it is known as
constant cost industry.
Therefore supply curve of an industry in long run will have different shape
and slope depending upon type of industry.
• If there is increasing cost industry then its supply curve would be
upward slopping.
• If there is decreasing cost industry then its supply curve would be
downward slopping.
• If there is constant cost industry then its supply curve would be
horizontal to quantity axis.
175
Equilibrium Under Let us try to understand these theoretical concepts using numerical
Perfect Competition
example.
Example 4
The demand curve and long-run supply curve for cars cleaning in the local
market are:
QD = 1,000 – 10P and QS = 640 + 2P. The long-run cost function for a cars
cleaning business is: C(q) = 3q2. The long-run marginal cost function is:
MC(q) = 6q. If the cars cleaning business is competitive, calculate the
optimal output for each firm. How many firms are in the local market? Is
the car cleaning industry an increasing, constant, or decreasing cost
industry?
Solution
To determine optimal firm output, we first must calculate the market price.
To do so we set market demand equal to market supply and solve for price.
That is:
QD = 1,000 – 10P = QS = 640 + 2P ⟹P = 30.
At this market price, 700 cars will be cleaned. Since the industry is
competitive, we know the firms are price takers and will set their marginal
costs equal to the market price. This gives us:
MC (q) = 6q = 30⟹q = 5.
Given each firm is cleaning 5 cars per period and there are a total of 700 cars
cleaned each period in the market, there must be 140 firms. Since each
firm's average costs are:
���
AC (q) = �
= 3q

Any increase in output raises the firm's average cost. Thus, each firm has
increasing costs. Also, since the market supply curve is upward sloping in
the long run, as output expands in the long run the industry is an increasing
price industry.
Check Your Progress 3
1) Differentiate between external diseconomies and external economies of
scale.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) Explain the shape of the long-run supply curve of a constant cost and
increasing cost industry under perfect competitive market structure.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
176
3) Derive short-run supply curve of a firm under perfect competition. Profit Maximisation by a
Competitive Firm
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
4) The demand for pizzas in the local market is given by: QD = 25,000 –
1,500P. There are 100 pizza firms currently in the market. The long-run
cost function for each pizza firm is:
��
C(q, w) = �
wq.

Where w is the wage rate pizza firms pay for a labour hour and q is the
number of pizzas produced. The marginal cost function for each firm is:
��
MC(q, w) = �
w.

If the current wage rate is Rs. 7 and the industry is competitive,

calculate the optimal output of each firm given each firm produces the
same level of output. Do you anticipate firms entering or exiting the
pizza industry? Suppose that the wage rate increases to Rs. 8.40.
Calculate optimal output for each of the 100 firms. Do you anticipate
firms entering or exiting the pizza industry? What happens to the
market output of pizzas with the higher wage rate? What happens to
the market price for pizza?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

7.8 LET US SUM UP

We began the present unit by revising the features of a perfect competitive

market structure. In a perfect competitive industry, a firm is a price-taker, so
that it adjusts the quantity of output at the market determined price level.
The quantity of output produced by the firm is determined by the profit
maximisation objective of that firm. By profit we simply mean the amount
received in excess of the amount spent in carrying out the production
process. We came across two concepts of profit— accounting and economic
profit. Accounting profit is total revenue less explicit costs. Economic profit
on the other hand is total revenue less explicit as well as implicit costs. We
saw how profit maximisation by a firm in a perfect competition entails zero
economic profits.
We proceeded further in the unit by introducing the concept of a profit
function. A profit function exhibits a relationship of maximum profit at
various combinations of the prices of both the input and the output.
Derivation of the function involved discussion about both, the short-run and
the long-run profit maximisation conditions.
177
Equilibrium Under We proceeded further in the unit with the two approaches of profit
Perfect Competition
maximisation under a perfect competitive market structure— TC-TR and
MC-MR approach. TR-TC approach tells us that firm would maximise profit
at a level of output where gap between TR and TC would be largest. MR-MC
approach tells us that firm would maximise profit at an output level where
MR = MC.
Subsequently, equilibrium conditions, both for the firm and the industry, in
the long-run and in the short-run, were discussed along with some
mathematical treatment. Perfectly competitive firm would be in short-run
equilibrium at an output level where MR = MC and slope of MC is greater
than slope of MR. Whereas, in the long-run perfectly competitive firm would
be in equilibrium at a level of output where P = MC and P = AC i.e., condition
which closes all opportunities of entry or exit by any firm. Perfectly
competitive industry would be in short-run equilibrium when (i) short-run
demand and supply is equal in the industry and, (ii) all firms must be in
equilibrium simultaneously. In the long-run, perfectly competitive industry
would be in equilibrium if demand and supply in the industry are equal, all
firms are simultaneously in equilibrium and there is no more entry or exit by
the firms indicating zero economic profit.
By highlighting shut down and break-even points we derive the supply curve
in short-run and long-run for firms and industries. In the short-run, portion
of MC curve above AVC curve serves as the supply curve of the firm.
Industry’s supply curve in the short-run is derived by horizontally summing
up the supply curves of all the existing firms in the industry. In the long-run,
supply curve of an industry will have different shapes and slopes depending
upon whether an industry is increasing cost, decreasing cost or constant
cost industry. Finally, we concluded the unit by examining the role of
external economies and external diseconomies and their impact on slope of
supply curve for industry in long-run.

7.10 REFERENCES
1) Hal R. Varian, (2010). Intermediate Microeconomics, a Modern
Approach, W.W. Norton and company / Affiliated East- West Press
(India), 8th Edition.
2) Pindyck R. S and Rubinfeld D. L, (2009). Microeconomics, Pearson India.
3) Koutsoyiannis, (1979). A, Modern Microeconomics, Macmillan, New
York.
4) C. Snyder and W. Nicholson, (2010). Fundamentals of Microeconomics,
Cengage Learning (India).
5) B. Douglas Bernheim and Michael D. Whinston, (2009).Microeconomics,
Tata McGraw- Hill (India).
6) Salvatore, D, (1983). Microeconomic Theory, Schaum’sOutline Series.

178
 Profit Maximisation by a
7.11 ANSWERS OR HINTS TO CHECK YOUR PROGRESS Competitive Firm
EXERCISES
Check Your Progress 1
1) Refer Section 7.3 and answer.
2) – 2Q2 + 292Q – 200
Hint: Profit function = TR – TC, where TR = P×Q = 300Q – 2Q2 and TC =
200 + 8Q.

3) Refer Sub-section 7.4.2 and answer.

Hint: Fall in w will decrease the slope of isoprofit line so that the
tangency of new flatter isoprofit line will occur towards the right of
steeper isoprofit line associated with higher w, implying a rise in labour
factor employment and hence higher output production.
�
4) a) Factor demand function is given by, L* = 150 – ��

Hint: Derive it using First-order condition for profit maximisation, given

��
by �� = 0 ⟹P f´(L*) = w.
� �
b) Profit function is given by, �150P − � � �150 − ���
�
Hint: Substitute factor demand function L* = 150 – �� in the equation
used for deriving the profit function, given by Pf (L) – wL.
(�.��)� (�.��)�
5) Profit function is given by P � �� ��
�−2 �� ��
Hint: Refer Sub-section 7.4.4 and derive the function.

Check Your Progress 2

1) See Sub-section 7.6.1 and Sub-section 7.6.2.

2) See Sub-section 7.7.1
3) See Sub-section 7.7.2
4) a) Equate supply to demand to get Q.
40 − 0.25Q = 5.0 + 0.05Q
Q = 116.7 (hundreds of meters per month)
P = 40 − 0.25(116.7) = Rs.10.825/meter

b) The typical firm produces where MC equals P.

MC = −20 + 4q
q = 7.71 (hundreds of meters per month)

c) The profit rate is as follows:

TR = PQ = (10.825)(7.71) = 83.461
179
 2
Equilibrium Under
TC = 100 −20(7.71) + 2(7.71) = 64.69
Perfect Competition
Profit = Rs. 18.77 hundreds / month
��
5) a) C= Rs. 2510 and MC = �� = 0.01×3x2 + 250 = Rs. 253.
Hint: x is monthly output in thousands of units, hence for 10,000
units, x = 10.

b) MC = 0.03x2 + 250 = 298⟹x = 40

Total cost C = 0.01×(40)3 + 250 × 40 = Rs. 10,640
� ��
c) AR = � = 1500 – 2x and MR = �� = 1500 – 4x

d) MR = 1500 – 4x = 1100⇒ x = 100. Hence, firms’ monthly output

is 1,00,000 units.
Monthly revenue = 1500 × 100 – 2 × (100)2= Rs. 1,30,000

e) π = TR – TC
= 1500x – 2x2 – 0.01x3– 250x
= 1250x – 2x2 – 0.01x3
��
Marginal profit function = �� = 1250 – 4x – 0.03x2
��
f) ��
= 1250 – 4x – 0.03x2 = 0
��±√����×�.�� ×�����
x= � �.��
= 148 approx.
Hence, the output required per month is 148000 units.
The profit at this level of output= Rs. 108774.08

g) MR =Rs. 908
MC =Rs.907.12 approx or around Rs. 908.
Hence, MR = MC at this level of output.
6) a) False, b) False, c) True, d) True, e) True

Check Your Progress 3

1) See Sub-section 7.8.2

2) See Sub-section 7.8.2

3) See Sub-section 7.8.1

180
4) To determine the optimal output of each firm in a competitive industry, Profit Maximisation by a
Competitive Firm
we know each firm will set their marginal cost to the market price. In
this case, the marginal cost is constant at Rs. 10. Thus, the market price
must be Rs. 10. At this price, 10,000 pizzas are demanded. Since there
are 100 firms in the industry and they divide the industry output
equally, each firm is producing 100 pizzas each period. The average cost
per pizza in the long-run is equivalent to the price firms receive, thus,
the firms are earning only the normal profit. This implies there is no
incentive for firms to enter or exit the industry. If the wage rate rises to
Rs. 8.40, the marginal cost of producing a pizza rises to Rs. 12. This
implies that in the long-run, the market price of pizza will be Rs. 12. At
this price, consumers' quantity demanded of pizzas is 7,000. The
optimal output for the 100 firms is 70 pizzas per firm. Since this is also a
long-run equilibrium, there is no incentive for firms to enter or exit the
industry. At the higher wage rate, the market output of pizzas decline.
Also, the market price for pizzas increased by 20% when the wage rate
increased by 20%.

181
Equilibrium Under
Perfect Competition UNIT 8 EFFICIENCY OF A COMPETITIVE MARKET
Structure
8.0 Objectives
8.1 Introduction
8.2 The Concept of Efficiency
8.3 Pareto Optimality
8.3.1 Edgeworth Box and Pareto Optimal/Efficient Allocations
8.3.2 Market Trade for Equilibrium Attainment
8.4 Competitive Equilibrium
8.5 General Equilibrium and Walras’ Law
8.5.1 Algebra of General Equilibrium
8.5.2 Walras’ Law
8.6 The Efficiency of Competitive Equilibrium
8.6.1 The First Fundamental Theorem of Welfare Economics
8.6.2 The Second Fundamental Theorem of Welfare Economics
8.7 Let Us Sum Up
8.8 References
8.9 Answers or Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this unit, you will be able to:
• get an insight into the concept of Efficiency;
• explain the concept of Pareto Optimality in a General Equilibrium
Framework;
• analyse equilibrium attainment through market trade;
• discuss a Competitive or Walrasian equilibrium in an Edgeworth box
setting;
• estimate the set of competitive equilibrium prices and allocations;
• get an introduction to the algebra of General Equilibrium and the
Walras’ law;
• identify the Pareto optimality of a Competitive Equilibrium; and
• describe the two Fundamental theorems of Welfare Economics.

8.1 INTRODUCTION
Central Economic problem revolves around the notion of scarcity which
arises when limited resources are rendered to satisfy unlimited wants. The
mismatch between needs and means to satisfy those needs exists
everywhere. Be it a consumer attempting to maximise his utility constrained
182
by his limited budget, or a producer whose main concern is to maximise Efficiency of a
Competitive Market
profit by minimising costs of production— all aim at attaining maximum
gains from the limited resources. This is where originates the concept of
Economic Efficiency.
Efficiency in literal sense refers to the process of outcome generation at
lowest possible cost. This in turn results when resources are employed in
the best possible way without any wastage. In Economics, Pareto optimality
and efficiency are often used synonymously. An allocation is referred to as
being Pareto optimal/efficient when there exit no alternate allocations
which can make someone better off without making someone else worse
off. The present unit begins with explaining the concept of Efficiency in a
General Equilibrium framework. Subsequently, necessary tools of this
framework encompassing the Edgeworth box, Pareto optimal allocation, and
market trade leading to achievement of a Competitive Equilibrium, are
discussed to explain the mechanism and the outcome of a free market. This
theoretical stage is then followed by the algebra of General equilibrium, and
later by the Walras’ law.
The two bases, one — the concept of Pareto optimality or efficiency and the
other — the mechanism of reaching a competitive equilibrium by a free
market, will then be combined to establish the notion of “efficiency of a
competitive market”— this will then be underlined by the First Fundamental
theorem of Welfare Economics. The first fundamental theorem of welfare
simply claims— a competitive equilibrium is Pareto efficient. This is
equivalent to say, competitive equilibrium results in efficient resource
allocation, so that no alternate allocation could enhance gain to someone
without harming someone else. Possibility of social undesirability of Pareto
optimal allocation also exists. This happens when the justice and fairness in
terms of distribution of efficient allocation of resources are brought into
consideration. The Second fundamental theorem of Welfare Economics then
comes into picture. Under certain assumptions, it separates the goals of
Efficiency and Equity, emphasising that a society may achieve any Pareto
optimal resource allocation through appropriate initial resources
redistribution and free trade.

8.2 THE CONCEPT OF EFFICIENCY

Scarcity of resources is the fundamental economic problem. As a rescue to
this problem, Efficiency is concerned with optimal allocation of resources
among different economic agents. In absolute terms, a situation can be
called economically efficient if and only if— no one can be made better off
without making someone else worse off. This is referred to as the Pareto
efficient/optimal condition. An efficient condition could also be said to
result when it becomes impossible to generate additional output unless
amounts of factors employed are increased. In other words, it will not be
wrong to say that in an efficient situation, production proceeds at the
lowest possible per-unit cost. These statements claiming efficiency are not
exactly equivalent, but they all dictate the idea that a system is said to be
efficient if nothing more can be achieved given the available resources.
183
Equilibrium Under The equilibrium concepts you have used till now in the earlier units, are
Perfect Competition
what is referred to as attainment of equilibrium by way of partial
equilibrium analysis. As the name suggests, such equilibrium is achieved in
one market holding what occurs in other markets, constant. This assumption
would be correct when a market operates in isolation. A scenario of
isolation does not exist in the present world. There exist complex
interconnections between each market and firm. To get a broad view of the
efficiency criterion in case of a competitive market, we will look into the
general equilibrium framework. The criteria of efficiency will be discussed,
based on which efficiency of a competitive market will be touched upon.
To set the stage for explaining the concept of efficiency in a general
equilibrium framework, we will be adopting the following three essential
assumptions that will simplify our analysis. Nonetheless, the results are still
applicable in a general case.
1) Consumers and producers operate in competitive markets, implying all
agents are price takers, and achieve equilibrium, given the prices.
2) There are only two goods which are produced using only two factors of
production.
3) There are two consumers, each endowed with a certain quantities of
the two goods which they will trade among themselves.
Initially, we will ignore production and will just consider attainment of
equilibrium in consumption case. We will assume that the two consumers
are each endowed with a certain quantities of the two goods, and then we
will examine how they achieve equilibrium through trade with one another.
This is what is typically termed a Pure Exchange economy. The approach
adopted will be further extended to the efficiency attainment in production
case and then to efficient allocation of two goods produced.

8.3 PARETO OPTIMALITY

Recall the concept of Pareto optimality that was introduced to you in
Introductory Microeconomics (BECC-101). Named after the economist
Vilfredo Pareto, Pareto Optimality refers to an economic arrangement
where resources are allocated in such a way that there exist no alternative
feasible resource allocation which will make one person better off without
making someone else worse off. In this context, given a set of alternative
allocations of resources, if a change from one allocation to another can
make at least one individual better off without making any other individual
worse off, it is referred to as Pareto improvement. Consequently, an
allocation will be Pareto optimal when no further Pareto improvements can
be made.

8.3.1 Edgeworth Box and Pareto Optimal/Efficient Allocations

Edgeworth box is a powerful graphical tool in General equilibrium analysis to
study the goods trade in the market for attaining efficiency. In order to bring
two agents in the market under one roof, it merges their indifference maps
184
 by inverting one of the agents ICs. The boxdepicts all possible consumption Efficiency of a
Competitive Market
bundles for both consumers under examination (i.e. all feasible allocations),
as well as preferences of both the individuals. Consider a hypothetical
market situation with two consumers in the economy, A and B and
consuming two goods, x and y. Let A’s consumption bundle be given by XA=
(xA, yA), where xA denotes A’s consumption of good x and yA, of good y.
Similarly, XB= (xB, yB) represents consumption bundle of consumer B.
Furthermore, let ωA = (ωxA, ωyA) denote an initial endowment bundle of
consumer A and ωB = (ωxB, ωyB) of consumer B.
Now assume, ωA = (4, 1) and ωB = (4, 5). An Edgeworth box is given in Fig.
8.1. Height of the box measures the total amount of good y in the economy
(here, 6 units) and the width measures the total amount of good x (here, 8
units). Person A’s consumption choices are measured from the lower left-
hand corner (OA), and that of person B’s from the upper right-hand corner
(OB). Recall that any point inside the Edgeworth box indicates a particular
distribution of the two goods among the two individuals. ‘W’ represents the
initial endowment allocation. ICA and ICB are the Indifference curves
representing preferences of consumer A and B, respectively.
6 OB

IC3B IC2B IC1B

IC4B
Good y

W
1
2
IC1A IC A IC3A IC4A
OA 4 8
Good x
Fig. 8.1: Edgeworth Box

Important:
1) A pair of consumption bundles XA and XB is an Allocation.
2) An allocation is feasible (i.e. affordable), if and only if,
xA+ xB = ωxA + ωxB
yA+ yB = ωyA + ωyB
Now consider Fig. 8.2, notice that ICs of both individuals pass through W (i.e.
the endowment). This implies that agents A and B are indifferent to their
endowment allocation W compared to another points along the ICs passing
through it. Further, note that all the consumption bundles to the north-east
of the indifference curve that passes through W yield a higher level of utility
for agent A.
Similarly, all points to the south-west of the inverted indifference curve
passing through W are preferred by agent B. The lens-shaped area (the
shaded region) formed by ICs of both the individual passing through W
185
Equilibrium Under represents a set of allocation bundles that would make both consumer A
Perfect Competition
and B better off compared to their initial endowment. This is what we
referred to as the Pareto Improvement. Possibility of Pareto improvement in
turn suggests that there can be a possibility of an equilibrium allocation, but
will that be a unique one?
6 OB

IC2B IC1B
IC4B
Good y
IC3B

IC4A
1 W
1
IC A IC2A IC3A
OA 4 8
Good x

Fig. 8.2: Pareto Improvement Set

Suppose scope of Pareto improvement seizes at point Q (refer Fig. 8.3). It is

easy to see that consumer A could achieve it by trading her endowment of
good x to consumer B in return for her endowment of good y. Such a trade
will allow agent A to reach a higher level of utility by consuming more units
of good y than he was endowed with. Similarly, consumer B would enjoy
higher utility by consuming more of good x than the amount he was
endowed with. No reallocation from point Q can make one consumer better
off without making the other worse off. An allocation of such kind is called
Pareto efficient/optimal allocation, given the initial endowment bundle W
and preferences of both the consumers. At such an allocation, all gains from
trade are exhausted.
Notice that at Pareto efficient allocation Q, Marginal Rate of Substitution
(MRS) is same for both the consumers. This is represented by the tangency
of their respective ICs at Q. This tangency is necessary otherwise it will still
be possible for them to trade to another level within the lens-shaped area.
6 OB

IC1B
IC2B
IC3B R
T
Q
Good y

IC 4
B S
P IC4A
1 3
IC1A W IC2A IC A

OA 4 8
Good x
186 Fig. 8.3: Pareto Optimal Allocation and the Contract Curve
Remember that, Pareto efficient point (Q) is not unique. We attained such Efficiency of a
Competitive Market
an allocation for the given initial endowment W. With change in the
endowment, there will be a resultant change in the optimal bundle. Thus,
there exists infinite number of efficient points— the set of which is called a
Pareto Set or the Contract Curve(dotted line in Fig. 8.3). A Pareto set is
composed of all the possible allocations resulting from mutually
advantageous trade from any given endowment. This curve will stretch from
A’s origin to that of B’s. It is a locus of all the points where ICs of the agents
will be tangent. Points P, Q, and R, represent three such points.
Please note: For a given endowment (here W), there exists a subset of
Pareto set (here, curve ST) inside the lens-shaped region formed by ICs
passing through that endowment.
Example 1
Consider two individuals A and B with their preferences represented by the
utility function, UA = (xA) (yA) and UB = (xB) (yB)2, respectively, where x and y
are the two goods in the market. The initial endowment of individual A and
B are given by ωA = (1, 1) and ωB = (2, 1), respectively. Compute the Pareto
set.
Solution: A Pareto set consist of all those allocations of two goods at which
indifference curves of the two individuals are tangent. This implies, a Pareto
set is composed of all those allocations at which MRS of individual A and
MRS of individual B are equal, i.e., MRSA =MRSB.
For an allocation to be feasible, we require,
xA + xB= ωxA + ωxB = 1 + 2 = 3 ⇒ xB= 3 – xA (i)
yA + yB= ωyA + ωyB = 1 + 1 = 2 ⇒ yB= 2 – yA (ii)
Pareto Optimality implies, MRSA = MRSB
��� ���
��� ���
⇒− ���
=− ���
��� ���

�� ��
⇒ − �� = − ��� (iii)
�� ����
From (i), (ii) and (iii), we get, − �� = − �(���� )

⇒ 6y � − 2x � y � = 2x � − x � y �
���
⇒ y � = ���� is the required Pareto Set.

8.3.2 Market Trade for Equilibrium Attainment

Now, let us discuss the mechanism to be adopted in order to reach an
optimal/efficient allocation (like Q) on the contract curve. Recall the
procedure involved for attaining equilibrium by a consumer that we learnt in
Unit 2. An individual attains equilibrium when his indifference curve is
tangent to his budget constraint. That is, when slope of IC (which is MRS) =
187
Equilibrium Under �
Perfect Competition slope of budget constraint [which is the Price ratio��� �, with Px and Py being
�
prices of good x and good y, respectively]. We have just learnt— a contract
curve is nothing but a locus of all equilibrium allocations so that MRS
between two goods (say x and y) is equal among two consumers (say A and
B). This equality does not happen at all price ratios, but only at the one
∗
��
where the market clears, i.e. at price ratio �� � so that MRSA = MRSB
�
∗
��
= �� � .
�
B
xB ωx OB
R

ICB XA
yA
Good y

B ICA yB
X
ω yA W ωyB

S
A
OA x A ωx

Good x
Fig. 8.4: Non-competitive Equilibrium

Consider a market situation represented by an Edgeworth box in the Fig.

8.4. Given the two individuals (A and B), participating in the consumption of
two goods (x and y), in order to maximise the utility, represented by their
ICs (ICA and ICB, for individual A and B, respectively). Let the initial
endowment be represented by bundle W = ((ωxA, ωyA), (ωxB, ωyB)). Budget
�
line RS represents a price ratio �� at which both the individual decides to
�
trade with each other. At this price ratio, individual A demands bundle XA =
(xA, yA) and individual B demands bundle XB = (xB, yB). As you may notice,

Demand for Good 1 is feasible, only when xA + xB= ωxA + ωxB

Demand for Good 2 is feasible, only when yA + yB= ωyA + ωyB

In other words, feasibility condition requires, excess demand of individual A

(or B) for good i (where i ∈ x, y) must match excess supply of individual B (or
A) for that good. But in Fig. 8.4, this is not the case, as excess supply of good
x by individual A, denoted by exA (= ωxA−xA) is greater than excess demand
for good x by individual B, given by exB (= xB−ωxB). Similar situation exists for
good y. Hence, the above situation depicts a situation of Disequilibrium in
the exchange market.
Symbolically, xA + xB ≠ ωxA + ωxB and yA + yB ≠ ωyA + ωyB.

188
Check Your Progress 1 Efficiency of a
Competitive Market
1) Explain the concept of Economic Efficiency? Is it same as Pareto
optimality?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) In a two-good two-individual economy, two individuals A and B are
� �
represented by identical Cobb-Douglas utility function Ui = x� �� y� �� ,
where i ∈ (A, B), and x and y are the two goods in the market. The
initial endowment of individual A and B are given by ωA = (1, 2) and ωB =
(2, 1), respectively.
a) Draw an Edgeworth box for this economy, and mark the
Endowment bundle.
b) Compute the Pareto Set.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
3) “A non-competitive equilibrium is inefficient,” elucidate this statement
with the help of appropriate diagram.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….

8.4 COMPETITIVE EQUILIBRIUM

In Fig. 8.4, there is disequilibrium in the market due to presence of excess
demand for good y and excess supply for good x. The prices in the above
market need to be recalibrated to the point where aggregate demand for a
good equals its aggregate supply, i.e. when amount of a good demanded by
one individual is exactly equal to the amount supplied by the other. Only
then, the market is in a Competitive Equilibrium. This equilibrium is also
called Walrasian Equilibrium.
In Edgeworth box setting, a competitive equilibrium results when ICs of both
the individuals become tangent to each other at the ongoing price ratio. This
happens on the contract curve, at the price ratio which equilibrate the trade
for utility maximisation, given the initial endowment. One such equilibrium
is given by point E in Fig. 8.5, where the budget line through the endowment
point passes through the tangency of the ICs of the two individuals A and B.
Point E ensures that both individuals attain maximum utility by reaching
their highest possible IC through trade, given their initial endowment bundle
W. Trade leading to equilibrium outcome happens at a unique price ratio
∗
�
��� � given by the slope of the budget line passing through common
�
tangency point and the initial endowment bundle W.
Thus at equilibrium, the following must be true:
189
Equilibrium Under ∗ ∗
� ��� � ��� � �
Perfect Competition MRSA = MRSB = ��� � or = = ��� �
� ��� � ��� � �

xB ωx B OB

IC1B
IC2B

yA E yB
Good y

ωy A IC2A
ωy B
W IC1A

OA xA ωxA
Good x

Fig. 8.5: Competitive Equilibrium

Note:
�
A price ratio ��� � and an allocation given by [(xA, yA), (xB, yB)] is a
�
competitive equilibrium if the following condition holds:
I) Each consumer is maximising his/her utility given his/her budget set, and
II) The demand for and the supply of each good are equal, i.e. markets clear.
Example 2
Consider the same market situation we considered above in example 1, with
two individuals A and B. Given their utility functions and endowments same
as was there in Example 1, find the competitive equilibrium in this economy.
Solution: Given the utility functions, we need to first ascertain the demand
functions of both the agents for goods x and y. Assume income as M, and Px
and Py be the prices of good x and goody, respectively. Let Px = 1 (i.e., we are
considering good x to be a numeraire good)*.

* Let A be any individual with his initial endowment bundle for good x and y as (ωxA,
ωyA). Let consumption bundle at Px and Py, (i.e.at the prices of good x and good y), be
(xA, yA) respectively. Then, Budget constraint faced by this individual will be given by:
PxxA +PyyA = PxωxA +PyωyA, where PxωxA +PyωyA represents income of the individual.
Notice that proportional increase in prices (Px and Py) leave no effect on this budget
Each individual will be maximising� his utility subject to the budget
constraint, implying only the price ratio ��� � matters here. This allows us to normalise
constraint, �
the price ofi any onei
good to i
1, which then become the numeraire good. Another
M = P x× x +P y × y , where i ∈ A and B.of a numeraire good is given under
explanation to why we consider the assumption
190 the Sub-section 8.5.2.
Demand functions of individual A for two goods x and y will be given by the Efficiency of a
Competitive Market
solution of the following constrained optimisation problem:
Maximise UA = (xA) (yA)
subject to MA = Px × xA + Py × yA
We employ the Lagrange approach to solve the above optimisation
problem:
ℒ = (xA) (yA) + λ (MA−PxxA−PyyA)
The First order (or necessary) conditions will result in:
�ℒ
���
= 0 ⟹(1)(xA)0 (yA) = λPx⟹yA = λPx (1)
�ℒ
���
= 0 ⟹ (1)(xA) (yA)0= λPy⟹xA = λPy (2)
�ℒ
��
= 0 ⟹MA = PxxA +PyyA (3)

From Equations (1) and (2), we get

PyyA = PxxA (4)
From Equations (3) and (4), we get
MA−PxxA = PxxA
� ��
⟹xA = � � , which is the demand function of individual A for good x. (5)
�

From (3) and (5), we get the demand function of individual A for good y as yA
� ��
=� � .
�

Similar approach can be applied for finding the demand functions of

� �� � ��
individual B for good x and y, which will be given by xB = � � and yB = � � ,
� �
respectively.
Now we solve for the competitive equilibrium:
In Equation (5), MA is the income of individual A, which can be ascertained
from the value of his endowment bundle (ωxA, ωyA) = (1, 1),
i.e., MA = (ωxA) Px + (ωyA) Py = 1+Py 6)
As we assumed Px = 1, from Equations (5) and (6) we get,
�
xA = �(1 + Py) 7)

Similarly, demand function of individual A for good y will become:

� �� � ����
yA = � ��
= �� ��
� 8)

Demand functions of individual B for good x and good y, with MB = (ωxB) Px+
(ωyB) Py = 2+ Py, where (ωxB, ωyB) = (2,1), will be:
191
Equilibrium Under � �� � � �� � ����
Perfect Competition xB =� � = � (2 + P� )and yB = � � = � � ��
� 9)
� �

�
A competitive equilibrium price ratio will result in a price ratio ��� � at which
�
market clears, i.e., aggregate demand for a good equals the aggregate
supply of that good (which is nothing but the endowment of that good).
Thus, at equilibrium, in case of good x,
xA+ xB = ωxA + ωxB
� �
�
(1 + Py) + � (2 + P� ) = 3 [∵ωxA + ωxB = 3]
��
Py = �

From this, we can ascertain equilibrium allocation using the demand

functions given by Equations (7), (8) and (9):
� � � ��
xA = �, yA = ��, xB = � and yB = ��
∗
� �
Competitive equilibrium price ratio ��� � will be given by����, and
�
� � � ��
competitive equilibrium allocation bundle will be given by��� , ��� , �� , ����.

Check Your Progress 2

1) Explain the concept of a Walrasian equilibrium with the help of an
Edgeworth box.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
2) In a two-good two-individual economy, two individuals A and B are
� �
represented by identical Cobb-Douglas utility function Ui = x� �� y� �� ,
where i∈(A, B), and x and y are the two goods in the market. The initial
endowment of individual A and B are given by ωA = (1, 2) and ωB = (2, 1),
respectively. Find Competitive equilibrium price ratio and goods
allocation of this economy.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

8.5 GENERAL EQUILIBRIUM AND WALRAS’ LAW

8.5.1 Algebra of General Equilibrium
Market economies are composed of a complex dynamic system of different
192 economic agents, making supply and demand decisions over different
commodities or factor types in order to maximise their own interests. Efficiency of a
Competitive Market
General Equilibrium theory advocates that such pursuit of private interest by
all the economic units with different motivations, integrated through a
system of free markets, will result in an efficient/optimal allocation of goods
and services in the economy. By General equilibrium it is meant
simultaneous equilibrium in all the markets, that is, the prevalence of
equilibrium in the economy as a whole. A General Equilibrium results in an
array of prices for all goods so that supply equals demand simultaneously
for each good in the economy. We establish the algebra of such equilibrium
below:

Assuming two commodities (x and y) and two agents (A and B) in the

economy, then a typical array of prices is given by a two-dimensional vector
such as (Px, Py). Let the demand function for agent A be xA(Px, Py) and yA(Px,
Py) for commodity x and commodity y, respectively. Similarly for agent B will
be given by xB(Px, Py) and yB(Px, Py); further their endowment bundle be
(ωxi, ωyi), where i ∈ {A, B}.

General Equilibrium in the economy would be established by a price vector

(Px*, Py*), so that Aggregate Demand = Aggregate Supply, for each
commodity. That is,
xA(Px*, Py*) + xB(Px*, Py*) = ωxA + ωxB and
yA(Px*, Py*) + yB(Px*, Py*) = ωyA + ωyB
The above equation can be arranged in terms of Excess demand functions
for the two agents:
[xA(Px*, Py*) − ωxA] + [xB(Px*, Py*) − ωxB] = 0 and (10)

[yA(Px*, Py*) – ωyA] + [yB(Px*, Py*) – ωyB] = 0 (11)

Where, [xA(Px*, Py*) − ωxA] is the excess demand for commodity x by agent A,
similarly [xB(Px*, Py*) − ωxB] is the excess demand for commodity x by agent
B. Equation (10) simply says, equilibrium calls for the sum of the excess
demands for commodity x by both the agents to sum to zero. In other
words, at equilibrium, one agent’s demand for a good must equal another
agent’s supply of that good. This is another way of looking at the condition
of feasibility of the demand for a commodity. Equation (11) can be
interpreted in a similar way.

Above equations can also be presented as follows:

exA(Px, Py) + exB (Px, Py) = 0

Where exA(Px, Py)= [xA(Px*, Py*) − ωxA] and exB(Px, Py)= [xB(Px*, Py*) − ωxB].
Similarly, for commodity y, Equation becomes
eyA (Px, Py) + eyB(Px, Py) = 0

193
Equilibrium Under Further let exA(Px, Py) + exB (Px, Py) = zx(Px, Py) and eyA (Px, Py) + eyB(Px, Py) =
Perfect Competition
zy(Px, Py), then General Equilibrium condition can be stated more precisely
as:
zn(Px, Py) = 0 , where n ∈ {x, y}

8.5.2 Walras’ Law

Walras’ Law is given by:
Pxzx(Px, Py) +Pyzy(Px, Py) ≡ 0
The law simply says that for all prices (and not just the equilibrium prices)
the value of aggregate excess demand is identically zero. The proof of the
law is as follows:
Feasibility of demand by agent A requires:
PxxA(Px, Py) + PyyA(Px, Py) ≡PxωxA + PyωyA
⟹Px [xA(Px, Py) − ωxA] + Py [yA(Px, Py) − ωyA] ≡ 0
⟹PxexA(Px, Py) + PyeyA (Px, Py) ≡ 0 12)
Similar equation holds for feasibility of demand by agent B:
PxexB(Px, Py) + PyeyB (Px, Py) ≡ 0 (13)
Adding Equations (12) and (13), we get
PxexA(Px, Py) + PyeyA (Px, Py) + PxexB(Px, Py) + PyeyB (Px, Py) ≡ 0
⟹Px [exA(Px, Py) +exB(Px, Py)] + Py [eyA (Px, Py) + eyB (Px, Py)] ≡ 0
⟹Pxzx(Px, Py) +Pyzy(Px, Py) ≡ 0 (the Walras’ Law)
Significance of the Walras’ law— Given that a set of prices bring equilibrium
in any one of the markets (let say in market for good x), then as per Walras’
law the remaining markets (here market for good y) would be necessarily in
equilibrium. In other words, the law claims that if demand equals supply in
one market then the same must be true for the other market as well.
From the identity of the law Pxzx(Px, Py) + Pyzy(Px, Py) ≡ 0, if zx(Px, Py) = 0, that
is, if market for good x is in equilibrium so that supply equals the demand
for good x. Given that both Px and Py are positive, for the identity of Walras’
law to hold true, then zy(Px, Py) must also equal 0. It turns out that if demand
equals supply in all but one market, i.e. in (n−1) markets, then demand
must equal supply in the nth market as well. This has an added advantage to
it, for an economy with n goods, one of the prices can be chosen as
numeraire price (a price relative to which all the other prices are measured),
leaving the need to find only (n−1) relative equilibrium prices. This becomes
possible from the Walras’ law identity that states all markets would be in
equilibrium for any set of prices. This is to say, if markets are in equilibrium
at a price vector (P1, P2, P3, …Pn), then for any constant k ∈ R+ (set of positive
real numbers), markets will remain in equilibrium for a price vector
(kP1, kP2, kP3, …kPn). Now, if we take k = (1/Pn) then Pn becomes the
194
numeraire price which will then result in a price vector of (n−1) relative Efficiency of a
� � � Competitive Market
equilibrium prices, given by ��� , �� , �� , … 1�.
� � �

8.6 THE EFFICIENCY OF COMPETITIVE EQUILIBRIUM

On combining Pareto Optimality (Section 8.3) and Competitive Equilibrium
(Section 8.4) conditions, efficiency of a competitive equilibrium can be
verified. In a competitive equilibrium, the amount supplied of a good equals
the amount demanded. This eliminates the scope for further gains from
trade or any reallocation— which is nothing but the condition that needs to
hold for an efficient allocation. Competitive equilibrium E in Fig. 8.5 is
efficient with each individual A and B reaching the highest possible IC given
their initial endowment W, so that neither A nor B can be made better off
without making the other individual worse off. A general proof verifying
efficiency of a competitive equilibrium is as follows:
Consider the similar situation that we have been considering so far, of a two
good (x and y) and two individuals (A and B), with initial endowment W =
�
[(ωxA, ωyA), (ωxB, ωyB)]. Further let trade at price ratio ρ = ��� �leads to
�
competitive equilibrium bundle E = [(xA, yA), (xB, yB)].
Now, suppose equilibrium bundle E is not Pareto efficient. This would mean
that there exists an alternate allocation which will be strictly preferred by A
and B to (xA, yA) and (xB, yB), respectively. Let it be given by[(xaA, yaA), (xaB,
yaB)]. That is,
For individual A, (xaA, yaA)≻(xA, yA)
For individual B, (xaB, yaB)≻(xB, yB)
The preferred allocation must be feasible, that is,
xaA + xaB= ωxA + ωxB and yaA + yaB= ωyA + ωyB (14)
Now, since individual A prefers (xaA, yaA) to (xA, yA), and given that at price
�
ratio ρ = ��� � he opted for (xA, yA), then at ρ, bundle (xaA, yaA) must be
�
unaffordable for A. This implies
PxxaA + PyyaA>PxωxA + PyωyA (15)
The above equation simply means that the money value of bundle (xaA, yaA)
at the given price ratio exceeds the money value of bundle (xA, yA) opted by
A at that price ratio. Similarly for individual B the following relation will hold:
PxxaB + PyyaB > PxωxB + PyωyB (16)
Adding (15) and (16), we get
PxxaA + PyyaA + PxxaB + PyyaB>PxωxA + PyωyA + PxωxB + PyωyB
Px(xaA + xaB) + Py(yaA + yaB)>Px(ωxA + ωxB) + Py(ωyA + ωyB) (17)

195
Equilibrium Under Using Equation (14), the LHS of Equation (17) becomes
Perfect Competition
Px(ωxA + ωxB) + Py(ωyA + ωyB) >Px(ωxA + ωxB) + Py(ωyA + ωyB)

This is an inconsistency as both the right hand side and left handside of the
above inequality are actually the same. This logical inconsistency implies
that the presumption of allocation [(xaA, yaA), (xaB, yaB)]≻[(xA, yA), (xB, yB)]
cannot be true. This gives us the following important theorem.

8.6.1 The First Fundamental Theorem of Welfare Economics

As per First Fundamental Theorem of Welfare Economics, all competitive
equilibria or Walrasian equilibria are Pareto Efficient. The theorem claims
that a competitive equilibrium will exhaust all gains from trade so that an
efficient allocation is attained from any given initial endowment. This
theorem confirms to the result of the classical theory, viz. the Adam Smith’s
“invisible hand” hypothesis, as per which invisible hand of the market forces
of demand and supply will achieve most efficient level of production,
consumption and distribution of good in the society. First fundamental
theorem of welfare economics supports the case for “free markets” or
“Laissez-faire”, where there exists no control by the government on
production or consumption that may interfere with the free market. Only
when the market mechanism fails to achieve an efficient resource allocation
(which is the case of market failure resulting from monopoly, externalities,
or public goods), the government intervention is justified.
However, the First Fundamental theorem — which talks about the Pareto
efficiency of a competitive equilibrium — says nothing about equity or
fairness of the resulting efficient resource allocation among the agents of a
society. Pareto efficiency merely indicates that no one can be made better
off without making someone else worse off, it gives no consideration to the
distributive effects of the resultant efficient allocation. The point to note
here is— Laissez-faire may produce many different Pareto optimal
outcomes, with some being fairer than others, so that not all of them may
be equally desirable by the society. For instance, the outcome in which one
individual A has all the units of commodity x in a single commodity market is
Pareto efficient, since there will be no way to make some other individual
better off without making A worse off. But such an optimal allocation may
not be equitable or socially desirable. This is where the need for rectifying
the distributional inequities of Laissez-faire comes. Now we proceed
towards a socially desirable Pareto optimum solution, with an approach
which is converse to that of the first fundamental theorem of welfare
economics, i.e., we are considering the allocation problem from efficiency to
equilibrium. Given Pareto Efficient equilibrium, as long as individual
preferences are convex, there exists a set of prices at which this equilibrium
becomes competitive or Walrasian equilibrium. This is known as the Second
Fundamental Theorem of Welfare Economics which we further explain
below.

196
 Efficiency of a
8.6.2 The Second Fundamental Theorem of Welfare
Competitive Market
Economics
The second fundamental theorem of welfare economics suggests that the
issues of efficiency and equity are distinct, and that they can be addressed
simultaneously. As per this theorem, any socially desirable optimal
allocation can be reached by way of the market mechanism modified with
the help of lump-sum transfers. Assuming all agents (individuals and
producers) are self-interested price takers, then as per Second Fundamental
Theorem of Welfare Economics, almost any Pareto optimal equilibrium can
be achieved through the competitive mechanism, provided appropriate
lump-sum transfers (which do not change the agents’ behaviour) are made
among agents.
Consider Fig. 8.6 below, where we have two Pareto efficient allocations E
and Eʹ. If it is felt that equilibrium Eʹ is somehow better in terms of being
more fair or just than equilibrium E, then a lumpsum transfer of good X from
individual A to B and simultaneously a transfer of good Y from B to A,
changing the endowment from W to Wʹ, can be made. The price system can
then be allowed to generate a Pareto efficient outcome Eʹ, given the new
endowment Wʹ. Thus, as per the second welfare theorem— given all agents
have convex preferences, after an appropriate assignment of endowments
through redistribution, a society may achieve any Pareto efficient resource
allocation as competitive equilibrium, that is, through market mechanism.

ω'xB ωxB OB

E
E’
Good y

Lumpsum Transfer

ω'yA ω'yB
W’
ωy A ωy B
W

OA ω'xA ωxA
Good x
Lumpsum Transfer

Fig. 8.6: Second Fundamental Theorem of Welfare Economics

Check Your Progress 3

1) a) State and prove the Walras’ Law.
b) In an economy consisting of five markets dealing in five different
commodities, determination of relative equilibrium prices in just
197
Equilibrium Under four markets will suffice as an overall general equilibrium. Briefly
Perfect Competition
explain this claim with reference to the Walras’ law.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
2) Walrasian equilibrium is Pareto optimal, do you agree? Answer with
appropriate proof for your claim.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
3) The Second Fundamental Theorem of Welfare Economics treats the
concepts of efficiency and equity distinctly. Explain.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

8.7 LET US SUM UP

Efficiency or Pareto optimality is the situation of maximum outcome with
minimum costs. In economic theory, Pareto optimality is attained when it
becomes impossible to make someone better off without making someone
else worse off. Such a condition is a characteristic feature of a Competitive
or a Walrasian equilibrium. The present unit explained this feature within a
General Equilibrium framework, where free market trade resulted in a
Pareto optimal/ efficient competitive equilibrium.
We used the tools like an Edgeworth box, to explain the condition for Pareto
Optimality and the market trade mechanism, in order to arrive at
competitive equilibrium. It was followed by the algebra of General
equilibrium, which was then followed by the Walras’ law. Subsequently, a
formal algebraic proof was provided to establish that competitive
equilibrium is Pareto optimal/ efficient. This was further demonstrated in
terms of efficiency and equity by the First and the Second Fundamental
theorems of Welfare Economics.

8.8 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Economic Efficiency refers to a state of optimal allocation of scarce
resources among different economic agents. Yes, both Pareto
Optimality and Economic efficiency mean the same. They both refer to
reaching a best possible allocation of scarce resources, so that no
198
 reallocation can make someone better off without making someone Efficiency of a
Competitive Market
else worse off.
2) a) Refer Section 8.3 and draw.
b) Pareto set is given by xa = ya or xb = yb.
Hint:Refer Example 1 under Sub-section 8.3.1. A Pareto set is composed of
�� ��
all those allocations at MRSA =MRSB. Here, MRSA = � �� and MRSA=� �� .
� �

3) Refer Sub-section 8.3.2 and answer.

Check Your Progress 2
1) Refer Section 8.4 and answer.
∗
� � � �
2) xa = ya = � and xb = yb = �, and equilibrium price ratio ��� � = �.
�

Hint: Refer Example 2 under Section 8.4 and answer. Demand functions
� �� � ��
of each individual for each good will be given by: xA= � ��
; yA = � � ; xB =
�
� �� B � ��
� ��
;y = � ��
.These can then be solved to find the equilibrium price
ratio and the associated quantity demanded of each good.
Check Your Progress 3
1) a) Refer Sub-section 8.5.2 and answer.
b) This is true, that for an economy of five markets, estimation of
relative equilibrium prices of just four markets will be adequate for
determining an overall general equilibrium. This claim is based on
the Walras’ Law identity: Pxzx(Px, Py) + Pyzy(Px, Py) ≡ 0, which holds
true for any price vector and not just equilibrium price vector. That
is, if all the five markets are in equilibrium at a price vector given by
(P1, P2,P3, P4, P5), then they will also be at equilibrium at a relative
� � � �
price vector given by ��� , �� , �� , �� , 1�. Thus, relative equilibrium
� � � �
prices of just four markets will then be required to be estimated for
overall general equilibrium.
2) Refer Section 8.6 and answer.
3) Refer Sub-section 8.6.2 and answer.

8.10 REFERENCES
1) Varian, H. R. (2010). Intermediate Microeconomics: A modern
approach (8th ed.). New York: W.W. Norton & Co.
2) Stiglitz, J. E.& Walsh, C.E. (2006).Principles of Microeconomics (4thed.).
New York: W.W. Norton & Co.
3) Levin, J. (2006). General Equilibrium. Retrieved from https://web.
stanford.edu/~jdlevin/Econ%20202/General%20Equilibrium.pdf
199
Equilibrium Under
Perfect Competition KEY WORDS

Average Cost Function : Derived by dividing cost function with the

output level, average cost function
determines per unit minimum cost of
producing a specific level of output, given
the per unit factor prices.
Average Revenue (AR) : TR per unit of goods and services is AR,
which is determined by dividing TR with
total output.
Break-even : Level of output where TR = TC or AR = AC
and Economic profits are zero or firm is
earning normal profits.
Completeness : For all available alternative bundles A and B,
the consumer should be able to make a
categorical statement as to whether he
regards A to be at least as good as B, B to be
at least as good as A, or both. That means
our consumer does not suffer from lack of
information.
Consumer Surplus : A measure of consumer’s benefit, it is given
by the difference between the amount
the consumers are willing and able to pay
for a good or service and the amount that
they actually pay.
Compensating Variation : As a monetary measure of utility change, it
tells us how much money should be given
to the individual to compensate him or her
for the price change.
Constant Returns to : When all factors of production are
Scale (CRS) increased in a given proportion, output
increases in exactly the same proportion.
Capital Deepening : Technical progress is capital-deepening (or
Technical Progress capital using) if along line on which K/L ratio
is constant, MRTSLK increases.
Concave Function : A function f(x) is said to be concave on an
interval if, for all a and b in that interval, f (t
a + (1 ‒ t) b) ≥ t f (a) + (1 ‒ t) f (b) for t
∈[0,1].
Conditional Factor : A function of factor prices and output,
Demand Functions specifying cost minimising levels of factors
employed to produce a specific level of
output at the given per unit factor prices.
Constrained : It is the process of finding the optimal
200 Optimisation values of certain variables, that is,
 optimising them with respect to one or a Efficiency of a
Key Words
Competitive Market
series of constraints.
Cost Function : It is given by, C (w, r, Q*) = L*(w, r, Q*) w +
K* (w, r, Q*) r.
A function of factor prices and output, cost
function gives the minimum cost of
producing a specific level of output (Q*),
given the per unit factor prices (w and r).
Cost Minimisation : A basic rule determining the optimal mix of
factors to produce a specific level of output
at the least cost.
Convex Function : A function f(x) is said to be convex on an
interval if, for all a and b in that interval, f (t
a + (1 ‒ t) b) ≤ t f (a) + (1 ‒ t) f (b) for t
∈[0,1].
Contract Curve : It is a set of all Pareto optimal allocations of
resources among two economic agents in
the Edgeworth box.
Discrete Good : A good available only in discrete amounts,
i.e. 1,2,3….. etc.
Decreasing Returns to : When all factors of production are
Scale (DRS) increased in a given proportion, output
increases proportionately less than inputs.
Equivalent Variation : As a monetary measure of utility change, it
tells us how much money should be taken
away from the individual at the original
price to have the equivalent effect on his
utility as that of a price change.
Expected Utility : Expected utility of an event having two or
more possible outcomes occurring with
some probabilities, is a weighted average of
the utilities of each of its possible outcomes
(with respective probabilities as weights).

Expected Value : It is the average value that a random

variable takes, given the probability of
occurrence of each value.
Elasticity of Technical : Given by the ratio of proportionate change
Substitution in factor-proportions (or input ratios) to the
proportionate change in marginal rate of
technical substitution.
Expansion Path : A locus of efficient (or minimum cost) factor
combinations, given by the tangency
between the isoquant curves and the
isocost lines, for different output levels.
201
Equilibrium
Key Words Under Equilibrium : Equilibrium indicates state of balance. Firm
Perfect Competition
is said to be in equilibrium when it has no
incentive to change its level of output.
External Diseconomies : External diseconomies accrue to the firm,
when increase in the industry’s output leads
to upward shift in cost curves, indicating
increase in cost of production for each level
of output.
External Economies : External economies accrue to the firm, if
expansion in the supply of industry shifts
cost curves downward, i.e., reduces cost for
each level of production.
Efficiency : It is the state resulting in maximum possible
outcome from employment of minimum
possible inputs.
Edgeworth Box : A tool of General equilibrium analysis, it is
used to analyse market trade between two
economic agents trading in two different
commodities.
Firm : A Unit which employs factors of production
to produce goods and services.
Gamble : A game of chance or an event with
uncertain outcomes.

General Equilibrium : A simultaneous equilibrium situation in all

the markets of the economy. Please note:
General Equilibrium is also sometimes
referred to as the Competitive or Walrasian
Equilibrium.
Homogenous Function : A function f (x) is homogenous of degree k if
f (tx) = t k f ( x) for all t > 0.
Homothetic Function : A monotonic transformation of a
Homogeneous function. f(x) is homothetic if
and only if f(x) = g(h(x)) where h( . ) is
homogenous of degree 1 and g( . ) is a
monotonic function.
Homogenous : Identical in all respects.
Indifference : If a consumer finds bundle A to be at least
as good as bundle B and bundle B to be at
least as good as bundle A, he is said to be
showing indifference between A and B.
Indifference Curve : A locus of all the bundles that give equal
level of utility or satisfaction to the
consumer.
202
 Efficiency of a
Key Words
Competitive Market
Indifference Map : A set of indifference curves in the
commodity space.
Intertemporal Budget : Budget constraint that an individual faces
Constraint when he has to make decision over two or
more time periods. As per it lifetime
consumption equals lifetime income.

Intertemporal Decision- : When decision is made across the time

making periods.

Intertemporal : Preferences of an individual over bundles of

Preferences intertemporal consumption, that is,
preference for consumption in different
time periods.
Isoquants : Isoquants are contour lines representing all
those input combinations which are capable
of producing the same level of output.
Isocost Line : This shows all the different combinations of
two inputs that a firm can purchase or hire
with given input prices and budget.
Increasing Returns to : When all factors of production are
Scale (IRS) increased in a given proportion, output
increases proportionately more than inputs.
Long-run Production : Technical relationship showing maximum
Function output that can be produced by a set of
inputs, assuming quantities of all inputs
vary.
Linear Homogeneous : Homogeneous production function of first
Production Function degree implies that if all factors of
production are increased in a given
proportion, output also increases in the
same proportion. This represents the case
of constant returns to scale.
Labour Deepening : Technical progress is labour-deepening if,
Technical Progress along a radial through the origin (with
constant K/L ratio), MRTSLK increases.
Long-run Cost Function : Given by, CL (W, Q) =W X (W, Q), it gives the
minimum cost of producing a specific level
of output, given the factor prices, in the
long-run, that is when all the factors
become variable.
Long Run : It is a production period in which all factors
of production (inputs) can be changed to
increase output. None of the inputs will
remain fixed. 203
Equilibrium Under
Marginal Rate of : The rate at which the consumer can
Perfect Competition
Substitution substitute one commodity for the other in
his/her consumption bundle without
changing the utility, or while remaining on
the same indifference curve.
Marshallian Demand : Marshallian demand curve gives the
Curve quantity of good demanded by a consumer
at each price, given the income or wealth
situation, and assuming all the other factors
impacting demand for a good as constant.
Marginal Rate of : MRTS is the rate at which one input can be
Technical Substitution substituted for another input with the level
(MRTS) of output remaining constant.
Marginal Cost Function : Derived as a partial derivative of the cost
function with respect to the output level,
marginal cost function determines
minimum addition to the total cost from
producing an additional unit of output.
Marginal Cost (MC) : Change in Total cost (TC) incurred when
there is very small change in quantity (Q)
produced, which is determined by dividing
change in TC with change in Q.
Marginal Revenue (MR) : Change in TR when there is very small
change in quantity (Q) sold, which is
determined by dividing change in TR with
change in Q.
Market : Any medium through which buyers and
sellers interact to exchange their goods and
services.
Non-Discrete Good : Also called continuous goods, such goods
can be purchased and sold in any amounts,
like 0.1, 1.1, 1.5, …etc., and not just in
discrete amounts.
Numeraire Good : A good in terms of which the prices of all
the other goods are expressed. The price of
such a good then becomes Re. 1. For
example, consider two goods X and Y, with
their prices being Rs. 5 and Rs. 10,
respectively. If good X is to be considered as
a numeraire good, then price of good Y will
be Rs. 2X.
Neutral Technical : Technical progress is neutral if it increases
Progress the marginal product of both factors by
same percentage so that MRTSLK (along any
radial) remain constant.
204
 Efficiency of a
Key Words
Normal Profit : It is minimum amount of profit that
Competitive Market
entrepreneurs are seeking to invest their
resources in production. It is their transfer
earning which indicates their returns from
opportunity cost.
Output Elasticity : It measures responsiveness of output to
change in quantity of a factor (or input). For
a production function, Q = f (L), output
elasticity is given by:
% ������ �� �
% ������ �� �
.

Probability Distribution : It is a schedule representing values a

random variable takes, along with their
probability of occurrence.
Perfectly Elastic : Even if there is negligible change in prices,
Demand quantity would change by very large
amount.
Pareto Optimality : An efficient allocation of resources, so that
no further reallocation could make
someone better off without making
someone else worse off.
Pareto Improvement : It is referred to the reallocation of resources
making at least one individual better off
without making someone else worse off.
Quasi-linear : Preferences represented by the utility
Preferences function of the form, U(x, y) = y + v(x),
where y and x are the two goods, and v(x), a
function of good x. Such preferences are
called quasi-linear because the utility
function is linear in one good (y) and non-
linear in the other (x).
Reflexivity : Consumer has fully reflected on available
choices, has no confusion, he does not
waver in his assessment of any bundle A,
that is, he does not end up regarding
bundle A as inferior to itself.
Reservation Price : It is the limit to the price of a good or a
service. From buyer’s point of view it is the
maximum price that a buyer is willing to
pay; and from seller’s point of view, it is the
minimum price that a seller is willing to
accept for selling a good or service.
Risk Aversion : A person who is not ready to take risk is
called a risk averse individual and this
behaviour is termed as risk aversion.

205
Equilibrium
Key Words Under Risk Neutrality : A person who neither likes nor dislikes risk
Perfect Competition
is called a risk neutral individual and this
behaviour is called risk neutrality.
Risk Preference : Completely opposite to risk aversion is risk
preference, where an individual prefers to
take risk.
Strict Preference : If a consumer finds bundle A to be at least
as good as bundle B but B is not at least as
good as bundle A, he is said to be not
indifferent between bundles A and B. Here,
he strictly prefers bundle A over B.
Short-run Production : Technical relationship showing maximum
Function output that can be produced by a set of
inputs, assuming quantity of at least one of
the inputs kept constant.
Short-run Cost Function : Given by, CS (W, Q, XF) =WV XV (W, Q, XF) +
WFXF, it gives the minimum cost of
producing a specific level of output, given
the factor prices, in the short-run, that is
when there exist some fixed and some
variable factors of production.
Short Run : It is a production period in which all factors
of production (inputs) cannot be changed to
increase output. Some inputs remain fixed.
Shut down : It is level of output where AR is equal to the
minimum Average Variable Cost (AVC) and
losses are equal to total fixed cost.
Super Normal Profit : It is also known as Economic profit, that is,
firms are earning more than normal profit
or greater than their opportunity cost.
Scarcity : It refers to the fundamental
economic problem arising from the fact that
resources are limited but society's demand
for them is unlimited.
Transitivity : This property amounts to expecting
consumer to be consistent in his choices. If
bundle A is at least as good as B and bundle
B is at least as good as C, then bundle A
should be at least as good as C.
Total Revenue (TR) : TR is total proceeds from the sale of
quantities of the product in the market. TR
is determined by multiplying quantity with
prices.
Uncertainty : It simply means lack of certainty, that is,
206 when probability of occurrence of an event
 is not 1. Certain events occur with Efficiency of a
Key Words
Competitive Market
probability 1.

Von Neumann- : In decision theory, the von Neumann-

Morgenstern Theorem Morgenstern utility theorem shows that,
under certain axioms of rational behaviour,
a decision-maker faced with risky
(probabilistic) outcomes of different choices
will behave as if he or she is maximising the
expected value of some function defined
over those outcomes. This function is
known as the von Neumann-Morgenstern
utility function.
Weak Preference : Whenever a consumer finds bundle A to be
at least as good as bundle B, we say, he has
weakly preference for bundle A over B.
Walras’ Law : Aggregate value of the excess demands
across all the markets must equal zero. This
implies, for general equilibrium to exist in a
market economy— excess demand in any
one market must be matched by an equal
value of excess supply in some other market
or markets.

207
Equilibrium Under
Perfect Competition
SOME USEFUL BOOKS

1) Hal R Varian, Intermediate Microeconomics, a Modern

Approach, W.W. Norton and Company/ Affiliated East-
West Press (India), 8th Edition, 2010.
2) C. Snyder and W. Nicholson, Fundamentals of
Microeconomics, Cengage Learning (India), 2010.
3) Salvatere, D, Microeconomic Theory, Schaum’s Outline
Series, 1983.
4) Pindyck, Robert S. and Daniel Rubinfield, and Prem L.
Mehta (2006), Micro Economics, An imprint of Pearson
Education
5) Case, Karl E. and Ray C. Fair (2015), Principles of
Economics, Pearson Education, New Delhi

6) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New Delhi

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