Advanced Microeconomics Relations Summary

1. The model of the Marshallian demand function which is a function of

income and price, xi(m,pi), is:
• Objective Function: Maximize utility, U (x1, x2)
• Subjected to budget constraint: M = p1x1 + p2x2
2. Marshallian demand can be derived from the indirect utility function as:

𝝏𝒗/𝝏𝒑𝒊
xi (p,m) =
𝝏𝒗/𝝏𝒎
--------Roy’s identity

3. The Marshallian demand function can be derived from the Hicksian demand
function by substituting the direct utility,u, in the Hicksian demand function
by the indirect utility, v(p,m):
xi(p,m) = hi(p,v(p,m))

this is the Marshallian demand at income m is the same as the Hicksian

demand at utility v(p, m).

or

substitute u=m/e(p,u) in the Hicksian demand to find the corresponding

Marshallian demand. e(p,u) should be computed by substituting the optimal
Hicksian demands into the budget constraint, that is

e(p,u) = xhpx + yhpy

4. Marshallian demand functions are homogeneous of degree zero in prices

and money income.
5. The model of the Hicksian demand function which is a function of utility
and price, xi(u,pi), is:
• Objective Function: Minimize expenditure, E = p1x1 + p2x2
• Subjected to the given utility, u (x1, x2)
6. The slope of the Hicksian or compensated demand curve, 𝝏Hi/𝝏pi (i _ 1, . . . ,
n), is the substitution effect of the price change.

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7. The Hicksian and Marshallian demand functions are related by the Slutsky
equation:

𝝏𝒙𝒎 𝝏𝒙𝒉 𝝏𝒙𝒎

= -x
𝝏𝒑𝒙 𝝏𝒑𝒙 𝝏𝒎

Where xm is the Marshallian demand function and xhis the Hicksian demand.

8. In the two good case, the Slutsky equation looks like this:

Expanding the last term gives:

9. The Hicksian demand function can be derived from the Marshallian demand
function by replacing m in the Marshallian demand function by expenditure
function, e(p,u):
Hi(p,u) = xi(p,e(p,u))
10. By substituting the optimal bundles x* in the direct utility function
u(x), we get the indirect utility function which is the maximum utility
achievable at the given price and income. That is:

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 v (p1, p2, m) = u(x*)

11. The expenditure function shows the minimum level of expenditure

necessary to achieve a given utility level as a function of prices and the
required utility level, that is, e(p, u).
12. The expenditure function can be derived from the Hicksian demand
function by substituting the Hicksian demands Xhi into the Hicksian
h h
constraint equation that is e (p,u) = x 1 p1 + x 2 p2.
13. Shepard’s Lemma tie together the expenditure function, the indirect
utility function, the Marshallian demand function and the Hicksian demand
function.

𝝏e(p,u)/𝝏pi = Hi (p,u), that is:

For two goods case, the Shepard’s Lemma identity will reduce to:

𝝏𝒆(𝒑,𝒖) 𝝏𝒙𝟏∗ 𝝏𝒙𝟐∗

= x1* + p1 + p2
𝝏𝒑𝟏 𝝏𝒑𝟏 𝝏𝒑𝟏

14. The expenditure function is homogeneous of degree 1 in prices. That

is:

e(kp,u) = kpu = ke(p,u)

where k is a constant.

15. To derive the expenditure function from the indirect utility function:
1. In the indirect utility function, express m in terms of the other parts
of the equation, that is m=----
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 2. Then e(p1, p2, u) = m
16. The minimum expenditure necessary to reach utility v(p,m) is found
by substituting the direct utility, u in the expenditure function by the
indirect utility function v(p,m), that is:
e(p,u) = e(p, v(p,m)) = m
17. The minimum expenditure necessary to reach utility u is found by
substituting the Hicksian demand into the budget constraint equation. That
is;
e(p,u) = p1xh1 + p2 xh2 = p1h1(p,u) + p2h2(p,u)
18. The local non-satiation assumption implies that v(p,m) is strictly
increasing in m.
19. To get the maximum utility u from income, m, substitute m by e(p,u)
in the indirect utility function, that is:

v(p, m) = v(p,e(p,u)) = u

20. The expenditure function is concave which means:

21. Roy’s identity

Where x(p,m) is the Marshallian demand function.

That is, the Marshallian demand function of good i is equal to the negative
of the partial derivative of the indirect utility function wrt price of i divided
by the partial derivative of the indirect utility function wrt income.

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22. Direct money metric utility function, m(p,x), gives the minimum
expenditure at prices p necessary to purchase a bundle at least as good as
x. That is,

Min pz

Such that u(z) ≥ u(x)

m(p,x) = e(p,u(x))

23. The money metric indirect utility function is given by:

It measures how much money one would need at prices p to be as well as

one would be facing prices q and having income m, as shown on below
figure:

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24. Substitution and income effect
Let the price of x changes from px0 to px1, then:
• Substitution effect =

• Income effect =

Where:

x1(p1',m') is the optimal choice at (p1',m').

x1(p1,m) is the optimal choice at (p1,m).

P1 is the original price of x1.

P1' is the new price of x1.

m is the original income of the consumer and m' is the new income.

m1 = m0 + ∆m

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∆m = x1*( p1'– p1).

Note that the change in income, ∆m, is calculated at the original optimal
point, x0*, calculated at the original price, px0, not at the new optimal point
when the price changes to px1.

The total change in demand equals the substitution effect plus the income
effect. This equation is called the Slutsky identity. That is

For a normal good, an increase in price means that demand will go down
due to the substitution effect. If the price goes up, it is like a decrease in
income, which, for a normal good, means a decrease in demand. Both
effects reinforce each other. That is,

The income effect can be positive or negative, depending on whether the

good is a normal good or an inferior good.

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 If the price of a good goes down then the change in the demand for the
good due to the substitution effect must be nonnegative. That is, if p1 > p1'
then the substitution effect must be positive.

A negative substitution effect implies that the good is an ordinary good and
it is resulted when there is a price increase. The interpretation of a
negative SE is the demand for the good due to the substitution effect
decreases.

For a price decrease, if the income effect > substitution effect, the good is a
Giffen good and if the income effect < substitution effect, it is a inferior
good.

OR , Another approach is:

I. Calculate the first optimal bundles using the first prices given.
II. Write the constraint equation using the new price, original income and
price.
III. Using the Langragian, express good 1 and in terms of good 2 of vice
versa. That is x in terms of y or y in terms of x.
IV. Calculate the final optimal bundles using the changed price given.
V. Calculate utility using the first optimal bundles on step a.
VI. Equate this utility value to the original function. Like, 100 = xy.
VII. Substitute the value of one of the variables from step c. This will give
you the decomposition bundles.
VIII. SE = decomposition bundle – the first optimal bundle
IX. IE = Final optimal bundle – decomposition bundle.
25. The Hicks substitution effect

In the Slutsky substitution effect, the budget line is pivoted around the
original consumption bundle. However, in the Hicks substitution effect, the
budget line is pivoted around the indifference curve. In this way we present
the consumer with a new budget line that has the same relative prices as
the final budget line but has a different income.

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 Thus the Hicks substitution effect keeps utility constant rather than keeping
purchasing power constant. The Slutsky substitution effect gives the
consumer just enough money to get back to his old level of consumption,
while the Hicks substitution effect gives the consumer just enough money to
get back to his old indifference curve.

26. Income and cross elasticity of demand

Given the demand function of good 1:

Q1 = a - bP1 + cP2 + zM

Where M=income; P2 = price of substitute good; a,b,c & z are constants.

• The price elasticity of good 1 is given by:

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 𝝏𝑸𝟏 𝝏𝑷𝟏 𝝏𝑸𝟏
ɛp1 = / = (P1/Q1)
𝑸𝟏 𝑷𝟏 𝝏𝑷𝟏

𝝏𝑸𝟏
since = -b (negative), ɛp1 is inelastic meaning a price change in
𝝏𝑷𝟏
good 1 will cause a less than proportional decrease in consumption,
this means the expenditure will increase.

• The income elasticity of demand is given by:

𝝏𝑸𝟏 𝝏𝑴 𝝏𝑸𝟏
ɛm = / = (M/Q1) = z(M/Q1)
𝑸𝟏 𝑴 𝝏𝑴

• The cross-elasticity of demand is given by:

𝝏𝑸𝟏 𝝏𝑷𝟐 𝝏𝑸𝟏
ɛc = / = (P2/Q1)
𝑸𝟏 𝑷𝟐 𝝏𝑷𝟐

When the demand is given in double-log format, the coefficients of the

independent variables serve as elasticities of the given demand in response
to the 1% changes in the variables.

Eg. For the demand function given by:

ln(Q1) = -8.3 - 0.68ln(P1) + 0.35ln(P2) + 0.49ln(P3) + 0.81ln(M)

Then:

• The demand elasticity of good 1 with 1% change in price of good 3

(cross elasticity) is 0.49.
• The demand elasticity of good 1 with 1% change in price of good 1
(own price) is -0.68.
• The demand elasticity of good 1 with 1% change in income is 0.81.
• The demand elasticity of good 1 with 1% change in price of good 2
(cross elasticity) is 0.35.

The homogeneity of degree zero property demand functions requires that:

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 sum (own price, cross price, income elasticities) = 0.

If the sum is not equal to zero, the sum should be equal to the elasticity of a
good that wasnot included in the demand function but has an important
effect on the demand.

For the above demand function, sum = -0.68 + 0.35 + 0.49 + 0.81=0.97,
different from Zero. Hence there should be a good 4 which the elasticity of
the demand function with respect to the price of good 4 =0.97 and good 4
has an important effect on the demand function.

NB:

If the economy grow by some percent, like 5%, the income elasticity of the
demand will change by the multiple of 5%. That is, ɛm = 0.81x5 =4.05.

27. Inputs to production are called factors of production.

28. The set of all combinations of inputs and outputs that comprise a
technologically feasible way to produce is called a production set.
29. The production function measures the maximum possible output that you
can get from a given amount of input.
30. An isoquant is the set of all possible combinations of inputs 1 and 2
that are just sufficient to produce a given amount of output. Isoquants are
labeled with the amount of output they can produce.
31. Technologies are monotonic, that is, if you increase the amount of at
least one of the inputs, it should be possible to produce at least as much
output as you were producing originally.
32. Technology is convex. This means that if you have two ways to

produce y units of output, (x1, x2) and (z1, z2), then their weighted average

will produce at least y units of output.

33. The marginal product of factor 1, MP1(x1,x2) is given by:

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 It is the extra output we get from having “one” more unit of factor 1.

34. The technical rate of substitution measures the tradeoff between two
inputs in production. It measures the rate at which the firm will have to
substitute one input for another in order to keep output constant. It is just
the slope of the isoquant.
35. TRS is calculated as:

36. The marginal product of a factor will diminish as we get more and
more of that factor. This is called the law of diminishing marginal product,
that is dMPx/dx < 0. It is important to emphasize that the law of
diminishing marginal product applies only when all other inputs are being
held fixed.
37. The Diminishing technical rate of substitution says that as we
increase the amount of factor 1, and adjust factor 2 so as to stay on the
same isoquant, the technical rate of substitution declines. Roughly
speaking, the assumption of diminishing TRS means that the slope of an
isoquant must decrease in absolute value as we move along the isoquant in
the direction of increasing x1, and it must increase as we move in the
direction of increasing x2.
38. The difference between the diminishing marginal product and
diminishing TRS is that diminishing marginal product is an assumption
about how the marginal product changes as we increase the amount of one
factor, holding the other factor fixed. Diminishing TRS is about how the ratio of the
marginal products—the slope of the isoquant—changes as we increase the
amount of one factor and reduce the amount of the other factor so as to
stay on the same isoquant.

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39. For the production function q = f (k, l), the elasticity of substitution (σ)
measures the proportionate change in k/l relative to the proportionate
change in the TRS along an isoquant. That is,

The elasticity of substitution of a Leontief technology is zero since there is

no substitution in this technology.

The elasticity of substitution of a Cobb-Douglas function is 1. Because:

40. The economist’s distinction between the long run and the short run is
this: in the short run there is at least one factor of production that is fixed:
a fixed amount of land, a fixed plant size, a fixed number of machines, or
whatever. In the long run, all the factors of production can be varied.

41. If we scale all of the inputs up by some amount t, constant returns to

scale implies that we should get t times as much output. That is:

If the firm has twice as much of each input, it can just set up two plants
side by side and thereby get twice as much output. With three times as
much of each input, it can set up three plants, and so on.

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42. The difference between returns to scale and diminishing marginal
product is that returns to scale describes what happens when you increase
all inputs, while diminishing marginal product describes what happens
when you increase one of the inputs and hold the others fixed.
43. Increasing returns to scale is that if we scale up both inputs by some
factor t, we get more than t times as much output. Mathematically,

for all t >1.

While decreasing returns to scale is the opposite:

for all t >1.

44. Check the type of returns to scale for the below production function:

Ans:
Let’s double x1 and x2 and see the effect on the output.
f = 4 (2x1)1/2 (2x2)1/3 = 4(2)1/2 (2)1/3x11/2x21/3 = 4 (2) ½+1/3x11/2x21/3 = 4(2)5/6 x11/2x21/3 =
22(2)5/6 x11/2x21/3 = 217/6 x11/2x21/3 = 217/6 f(x1,x2). Since 217/6>1, it is increasing
returns to scale.
45. A Cobb-Douglas production function can exhibit any degree of
returns to scale depending on the values of a and b. Given f(k,l) = Akalb

Suppose all the inputs are increased by a factor of t, then:

f(tk,tl) = A(tk)a(tl)b = Ata+b kalb = ta+b f(k,l). hence when

a+b = 1, CD function exihibits constant returns to scale, when a+b > 1, CD
will be increasing returns to scale and if a+b < 1, CD will be decreasing
returns to scale.
46. Quasi-fixed factors are factors of production that must be used in a
fixed amount, independent of the output of the firm, as long as the output
is positive. Example is electrical power.
47. The production function of the form shown below is called the
Leontief technologies:

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Here, there are no substitution possibilities between the inputs—they are

complements in that the two inputs are always used in fixed proportions
according to the ratio b : a.

Suppose a firm has access to two Leontief technologies q1 and q2 with

labor l and capital k inputs:

Then the firm’s overall production function is;

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 In Figure 7.1, the isoquants for each plant are shown: the orange
isoquant is for plant 1 and the green one for plant 2 when the level
of production in each plant is 6.

The least amount of inputs necessary to produce 6 units of output for

plant 1 is A (3,6) and for plant 2 is B(6,3). Note that A(3,6) for plant 1
means min(2x3=6, 6) = 6. Similarly for B(6,3) for plant 2 means
min(6, 3x2=6) = 6.

For the input combination C(2,4), since it is on q1, means min(2x2=4,

4) = 4.

For the input combination D(2,1), since it is on q2, means min(2,

1x2=2) = 2.

Any input bundle at the line connecting A & B (blue line) is the sum of
the combinations of the inputs at the line OA and OB. For example,
the input bundle E (4,5) is the sum of the input combinations C & D.
that is the output of E is 6 (=4+2).

Other input combinations on the blue dotted line segment between A

and B in Figure 7.1 will also generate an output of 6.

48. For production functions that are homogeneous of degree r,

Where q0 is the original production output.

When r=1, the production function will be constant returns to scale; when
r>1, the production function will be increasing returns to scale and when
r<1 the production function will be decreasing returns to scale.

Thus the degree of homogeneity, r, is an index of the returns to scale in the

case of homogeneous production functions.

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 1. For linear technology, q0=x1 + x2,
qn = (tx1) + (tx2) = t(x1 + x2) = tq0 , Which is Constant returns to scale.

2. For a Cobb-Douglas production function of the form q=Ax1ax2b, its

degree of homogeneity is a+b. So, for a+b =1, the Cobb-Douglas
production function will be constant returns to scale, for a+b >1
Cobb-Douglas production function will be increasing returns to scale
and for a+b<1, it will be decreasing returns to scale.

49. The economic profit function is given by:

Π (q) = R(q) – C(q) = p(q).q – C(q)

Where q=level of output, R(q) revenue, p(q) is price of output per unit, C(q)
is cost

The necessary condition for choosing the value of q that maximizes profits is
found by:

Hence, the FOC for a maximum profit is:

That is, MR = MC.

The sufficient condition for profit maximization is:

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 That is “marginal” profit must be decreasing at the optimal level of q.

For q less than q* (the optimal level of output), profit must be increasing [π'Þ
> 0]; and for q greater than q*, profit must be decreasing [π'Þ < 0].

50. The profit of a firm can be expressed as:

Where, yi=outputs, pi = prices of outputs, xi=inputs, wi=prices of inputs.

Let’s consider the short-run profit-maximization problem when input

2 is fixed at some level 𝒙
̅2. Then the profit-maximization problem
facing the firm can be written as:

If x1* is the profit-maximizing choice of factor 1, then the output price

times the marginal product of factor 1 should equal the price of
factor 1. That is,

the value of the marginal product of a factor should equal its price.

51. Isoprofit lines are all combinations of the input goods and the output
good that give a constant level of profit.
From

We can solve for y to get:

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This equation describes isoprofit lines.

Slope = w1/p and vertical intercept of π/p + w2𝒙

̅2/p

The profit maximizing combination of input and output is found at

the tangent point between the production function and isoprofit line.
That when the slope of the production function and isoprofit line is
the same. Hence with the slope of the production function is the
marginal product, and the slope of the isoprofit line is w1/p,

In the long-run, all inputs are variable. Thus,

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 And

52. The marginal revenue is directly related to the elasticity of the

demand curve.

Remember that the elasticity of demand (eq, p) is defined as the percentage

change in quantity demanded that results from a 1 percent change in price:

And MR = dR/dq = d[p(q).q]/dq = p + qdp/dq = p(1+q/p dp/dq) = p(1+ 1/eq,p)

• If eq,p elastic (<-1), then MR will be positive.

• If eq,p inelastic (>-1), then MR will be negative.
• If eq,p infinitely elastic (=-ꝏ), then MR will equal price.
• If eq,p = -1, MR = 0
53. For a profit: Π = Pq – C = Pf(x1, x2) – w1x1 – w2x2

Where, q = f(x1, x2)

The profit function given by :

Π(P,w1,w2) max π(x1, x2) = max[Pf(x1, x2)- w1x1 – w2x2]

Properties of the profit function:

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 1. Homogeneity. A doubling of all of the prices in the profit function will
precisely double profits—that is, the profit function is homogeneous of
degree 1 in all prices.
2. Profit functions are nondecreasing in output price, P. This result seems
obvious—a firm could always respond to a rise in the price of its
output by not changing its input or output plans.
3. Profit functions are nonincreasing in input prices, w1, and w2
4. Profit functions are convex in output prices. This important feature of
profit functions says that the profits obtainable by averaging those
available from two different output prices will be at least as large as
those obtainable from the average9 of the two prices.
Mathematically,

54. From the profit function, we can drive the firm’s supply function and
input demand functions using the Envelop theorem. That is:
• 𝝏π (P,w1,w2)/ 𝝏P = q(P, w1,w2) --------Firm’s supply function
• 𝝏π (P,w1,w2)/ 𝝏w1= -x1(P, w1,w2) --------Input 1 demand function
• 𝝏π (P,w1,w2)/ 𝝏w2= -x2(P, w1,w2) --------Input 2 demand function

From these equations, we can see that a small change in output price will
increase profits in proportion to how much the firm is producing, whereas a
small increase in the price of an input will reduce profits in proportion to
the amount of that input being employed.

Because the profit function itself is homogeneous of degree 1, all of the

supply and input demand functions derived above are homogeneous of
degree 0. That is, a doubling of both output and input prices will not
change the input levels that the firm chooses; nor will this change the firm’s
profit-maximizing output level.

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55. From π(x ,x ) = Pq – C(q) = Pf(w ,w ) – (w x
1 2 1 2 1 1 + w2x2)

𝝏π/𝝏x1 = P 𝝏f/𝝏x1 - w1 = 0 that is 𝝏f/𝝏x1 = MP1 = w1/P

𝝏π/𝝏x2 = P 𝝏f/𝝏x2 – w2 = 0 that is 𝝏f/𝝏x2 = MP2 = w2/P

From these equations we can see that a profit-maximizing firm should

hire any input up to the point at which the input’s marginal
contribution to revenue is equal to the marginal cost of hiring the
input.

The input’s marginal contribution to revenue is given by the extra

output it produces (the marginal product) times that good’s market
price.

56. For a production function given by q = f(x1, x2), to minimize total

costs, C= w1x1 + w2x2

L = w1x1+ w2x2 + λ(q- f(x1, x2))

𝝏L/𝝏x1 = w1 - λ 𝝏f/𝝏x1 = 0 -------------(a)

𝝏L/𝝏x2 = w2 - λ 𝝏f/𝝏x2 = 0 -------------(b)

𝝏L/𝝏 λ = q- f(x1, x2)= 0-------------(c)

From (a) and (b) we get:

𝝏𝒇/𝝏𝒙𝟏 𝒘𝟏
= = TRS
𝝏𝒇/𝝏𝒙𝟐 𝒘𝟐

Or rearranging the components, we get:

𝝏𝒇/𝝏𝒙𝟏 𝝏𝒇/𝝏𝒙𝟐
=
𝒘𝟏 𝒘𝟐

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 That is: for costs to be minimized, the marginal productivity per dollar
spent should be the same for all inputs. If increasing one input promised to
increase output by a greater amount per dollar spent than did another
input, costs would not be minimal.

57. The cost-minimizing input combination for any given level of output
is one where the isoquant is tangent to the isocost, i.e., where the slope of
the isoquant (−TRS) equals the slope of the isocost (−w1/w2). In other words,

cost minimization requires that TRS = w1/w2.

The isocost line has an equation of the form w1x1 + w2x2 , which is similar to
the budget constraint line.
For example, for the Cobb-Douglas production function indicated with an
orange color below and an isocost line given by x1 + 4x2 with (w1,w2) = (1,4)
The cost-minimizing input combinations will be A, C, & B.

58. The cost function of a Cobb-Douglas production function production

function is derived as below.
Example, for the Cobb-Douglas production function q=(x1x2)1/2
I. Set TRS = w1/w2
𝝏𝒒/𝝏𝒙𝟏
TRS =
𝝏𝒒/𝝏𝒙𝟐

𝝏𝒒/𝝏𝒙𝟏 = ½( x1x2)1/2-1(x2) = ½ x2 ( x1x2)-1/2

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 𝝏𝒒/𝝏𝒙𝟐 = ½( x1x2)1/2-1(x1) = ½ x1 ( x1x2)-1/2
𝝏𝒒/𝝏𝒙𝟏
Hence, TRS = = x2/ x1
𝝏𝒒/𝝏𝒙𝟐

Now, x2/ x1 = w1/w2

Solving for x2 = x1w1/w2 --------------------(a)

Substitute (a) into the production function

q = [(x1w1/w2 ) (x1)]1/2= x1(w1/w2 ) ½

then the least-cost input of x1 will be:

x1* = q(w2/w1 ) ½---------------------(b)

substitute (b) into (a) to get the least-cost input of x2

x2* = q(w2/w1 ) ½( w1/w2) = q(w1/w2 ) ½---------------------(c)

finally, the cost function is found by:

c (w1,w2, q) = w1 x1* + w2 x2* = w1q(w2/w1 ) ½ + w2 q(w1/w2 ) ½ = 2q(w1w2) ½

59. The cost function of a Leontief technology.

In the case of a Leontief technology, the sufficient condition for cost

minimization involving the tangency of the isoquant and isocost is no
longer possible because the slope of a Leontief isoquant at its kink is not
defined.

For a general two-input Leontief technology: q = min{ax1, bx2}

the minimum quantity of inputs necessary to produce any arbitrary output

level q will always be the kink point of the isoquant for this output level
regardless of the slope of the isocost line, that is:

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 x1* = q/a and x2* = q/b

hence the cost function will be:

c (w1,w2, q) = w1 x1* + w2 x2* = w1 q/a + w2 q/b = q(w1/a + w2 /b)

hence for a Leonfief technology, the cost function is derived as:

I. Calculate the input bundle at the kink point only.

II. The cost function is the cost of the kink point.

60. Cost function for a linear technology q = ax1 + bx2

There are three possible cases as illustrated in figure below.

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 I. In the left panel, w1/w2 < a/b because the blue isocost is flatter than
the orange isoquant — the cost-minimizing bundle is given by point A

where only input x1 is employed to produce the output. Hence the least-
cost input x1* will be

x1* = (q/a, 0)

II. In the middle panel, the isoquant and isocost happen to have the same
slope so any input combination (x1, x2) on the isoquant minimizes costs.
III. On the right panel, w1/w2 > a/b because the blue isocost is steeper
than the orange isoquant and costs are minimized at point E. hence,
x2* = (0, q/b)
hence, the cost function will be the min of these three cases:
c(w1,w2, q) = w1x1 + w2x2 = min{w1q/a , w2q/a}
61. For a production function given by:

The MRTS is computed as:

26
62. The elasticity of substitution describes the substitution possibilities of
a technology but does so in percentage terms rather than in absolute terms.
For the above production function on (61), the elasticity is computed as:

63. Normal good: A good whose demand curve is downward sloping.

Giffen good: A good whose demand curve is upward sloping.

Giffen goods are an extreme case of inferior goods in which the income
effect actually overwhelms the substitution effect.

64. In a change of p0 to p’ and m0 to m’ due to some policy changes, the

welfare change will be the difference of the indirect utilities.

v(p’, m’) - v(p0, m0)

if this utility difference is positive, then the policy change is worth doing,
otherwise it is not.

65. A standard measure of utility difference to gauge society welfare is

the indirect money metric utility function.

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66. Compensating variation, CV, is the additional income/expenditure
needed to remain at the original level of satisfaction given the price
change.

CV = e(p’, u0) – m0--------------------when the indirect utilty function,v,isnot given.

CV = e(p’, v0) – e(p0, v0)--------- when the indirect utilty function,v,is given.

Where

• e(p,u) is derived by inserting the Hicksian demands into the budget

contraint equation, that is: e(p,u) = xhpx +yhpy
• U is derived by equating m=e(p,u) = xhpx +yhpy
• u0 and v0 are evaluated at the old price.

OR

Where qh is the Hicksian demand.

Note that CV is found by integrating the Hicksian demand.

Equivalent variation, EV, is the amount willing to pay to avoid the price
change.

EV = m0 – e(p0,u’)-------- when the indirect utilty function,v,isnot given.

EV = e(p0, v0) - e(p0,v’)--------- when the indirect utilty function,v,is given.

28
Where u’ and v’ are evaluated at the new price.

Consumer surplus can be computed by integrating the Marshallian demand

over the prices. That is,

Where, q is the Marshallian demand.

Steps to compute CV:

a) From the given utility function and constraint, solve for the Hicksian
demand functions.
b) By plugging the Hicksian demand functions into the constraint
equation, solve for the expenditure function.
c) Equate the expenditure function to original income, m0, and solve for
u.
d) Evaluate u using the original prices and income.
e) Solve the new income, m’, by using the expenditure function with the
new price and original u value found in (d).
f) Then CV = (e) – m0
g) This value of CV is the additional income/expenditure needed for to
remain at the original level of satisfaction.

To compute EV, the steps are:

a) Solve u using the new price

b) Solve the new income , m’, by using the expenditure function with the
old price and u value found in (a).
c) EV = m0 – (b)
d) EV is the payment the consumer should pay to avoid the price
change.

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 For normal goods, CV > EV for a price increase.

To compute the CS for a price changed item.

a) Change the price changed item’s Hicksian demand to Marshallian

demand by using the Hicksian demand with u=m0/e.
b) Solve the Marshallian demand function by using the original income,
the other item’s unchanged price but leave the changed price p as a
variable.
c) Then CS will be the integral of (b) with the initial and changed price
as boundary points.

Note that for the case of a price decrease, EV > CS >CV.

67. Allocative (or price) efficiency is achieved when the cost of producing
a given output is minimized, as evidenced by the equality of the ratio of the
marginal products of inputs to the input price ratio.
68. From the below figure
• Point B is neither technical nor allocative efficient.
• Point T is technical efficient.
• Point A & I are both technical and allocative efficient.

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69.

70. The technical rate of substitution measures the slope of an isoquant

however, the elasticity of substitution measures the curvature of an
isoquant.

The elasticity of substitution is the percentage change in the factor ratio

divided by the percentage change in the TRS. That is:

Or

Or

Note: take the absolute value of TRS before taking its natural logarithm.

71. A function f (x) is homogeneous of degree k if f (tx) = tkf (x) for all t >
0.
72. A homothetic function is a monotonic transformation of a function
that is homogeneous of degree 1.

31
 In other words, f (x) is homothetic if and only if it can be written as f ( x ) =
g(h(x)) where h(.) is homogeneous of degree 1 and g ( . ) is a monotonic
function.

What is the difference between homogenous and homothetic functions?

If f(x) is homogeneous of degree 1, then if x and x' can produce y units of

output it follows that tx and tx' can produce ty units of output.

For a homothetic function, if x and x' produce the same level of output, then
tx and tx' can produce the same level of output-but it won't necessarily be t
times as much as the original output. Just observe the output levels of the
isoquants on the figure below for the homogenous and homothetic cases.

Panel A is homogenous while panel B is homothetic.

73. If f (x) is homogeneous of degree 1, then df(x)/dx, is homogeneous of

degree 0.
74. The situations in which constant returns to scale is not satisfied are
o when we want to subdivide a production process
o when we want to scale operations up by non-integer amounts.
o By being unable to replicate some input.
75. It can always be assumed that decreasing returns to scale is due to
the presence of some fixed input.

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76. The elasticity of scale measures the per cent increase in output due
to a one percent increase in all inputs. The elasticity of scale is given by:

Note that we must evaluate the expression at t = 1 to calculate the elasticity

of scale at the point x.

For e(x)>1 implies increasing returns to scale, e(x)=1 constant returns to

scale and e(x)<1 decreasing returns to scale.

77. The two constraints that a firm faces in determining its optimal
profit policy is:
• Technological constraint: concerns the feasibility of the production
plan.
• Market constraint: the effect of actions of other agents on the firm.
78. In a single input case, the SOC for profit maximization is the second
derivative must be negative.

But in the case of multiple inputs, the SOC for profit maximization is the
matrix of second derivatives of the production function (Hessian Matrix)
must be negative semidefinite.

That is, f11, f12, f22, f21. The respective Hessian matrix will be:

𝒇𝟏𝟏 𝒇𝟏𝟐
H=[ ]
𝒇𝟐𝟏 𝒇𝟐𝟐

When |H1| = f11<0 and

|H2| = (f11 f22 – f21 f12) >0 then the SOC is negative definite.

33
 Note that f12 = f21 due to Young’s theorem.

The requirement that the Hessian matrix is negative semidefinite means

that the production function must be locally concave in the neighborhood of
an optimal choice.

79. Given a production function, f(x)

• The factor demand function, x(p,w), will be the first derivative wrt
the input variable equal to input price (w) divided by output price (p).
That is;

𝝏𝒇
x(p,w)= = w/p.
𝝏𝒙

• The supply function,y(p,w), is given by inserting the factor demand

function found on the above step into the production function. That
is:

f(x(p,w))

• The profit function is given by:

π(p,w) = p y(p,w) - w x(p,w)

80. The profit function, π, is non-decreasing in the output price because

if p’>p for all outputs, then π(p’) > π(p).

The profit function, π, is convex. That is let p’’ = tp+(1-t)p’ for 0≤t≤1. Then

π(p’’) ≤ t π(p) + (1-t) π(p’)

Convexity also means profit increases at an increasing rate when output

price increases.

The matrix of second derivatives of π with respect to p-the Hessian matrix-

must be a positive semidefinite matrix.

34
81. Hotelling's lemma: the firm’s net supply function is the first
derivative of the profit function wrt price. That is:

yi(p) = 𝝏π(p)/ 𝝏pi

82.
83. The total cost curve is always assumed to be monotonic in output: the
more you produce, the more it costs.
84. In the short run, the average cost curve first decreases and then
increases. Why?
• In the short run the cost function has two components: fixed costs
and variable costs. That is SAC = SAVC + SAFC.
• SAFC continuously decreases with output while SAVC eventually
increases with output.
• Adding together the average variable cost curve and the average
fixed costs gives us the U-shaped average cost curve, which curve
first decreases and then increases.

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85. The relationship between AVC and MC:
• average variable cost curve is decreasing: Marginal cost curve lies
below AVC curve.
• average variable cost curve is increasing: Marginal cost curve lies
above AVC curve.
• average variable cost curve is minimum: AVC = MC.
86. If production exhibits constant returns to scale in the long run, so
that the cost function is linear in the level of output, then average cost,
average variable cost, and marginal cost are all equal to each other.
87. The long-run cost curve is the lower envelope of all the short run
curves. That is:

36
88.
89. Shephard’s Lemma:

The input demand function is equal to the first derivative of the cost
function wrt to the input factor cost. That is

90. Choices of consumption over time are known as intertemporal

choices.
91. Suppose the consumptions of a good over a two time periods are
denoted by c1 and c2, the prices of consumption in each period are constant
at 1 and the amount of money the consumer will have in each period is
denoted by (m1,m2). Let us allow the consumer to borrow and lend money at
some interest rate r.
I. If the consumer is a saver, he will save m1- c1 in the first period and
this saving will have interest of r(m1- c1). Then the amount he can
consume next period is given by
c2 = m2 + (m1- c1) + r(m1- c1)
then rearranging
c2 = m2 + (1+r)(m1- c1)
II. If the consumer is a borrower, then c1 > m1 and the interest he has to
pay in the second period will be r(c1 > m1). He has to payback also the
amount that he borrowed which is c1 > m1. Then the budget constraint
will be:

37
 c2 = m2 – r(c1 - m1) - r(c1 - m1)
c2 = m2 + (1+r)(m1- c1)
92. Rearranging the above budget constraint equation, we can get;

And

We say that equation (10.2) expresses the budget constraint in terms of

future value and that equation (10.3) expresses the budget constraint in terms
of present value.

The slope of the budget line is –(1+r).

38
 If the consumer chooses a point where c1 < m1, we will say that she is a

lender, and if c1 > m1, we say that she is a borrower. Graphically:

93. How does a consumer react to a change of interest rate?

• The increase in the interest rate increases the slope of the budget line
and it will be more steeper.
• There are two cases, depending on whether the consumer is initially
a borrower or initially a lender. Suppose first that he is a lender.
Then it turns out that if the interest rate increases, the consumer
must remain a lender.
• If the consumer is initially a lender, then his consumption bundle is to
the left of the endowment point. When the interest rate increases, the
budget line will be more steeper and pivoted around the endowment
and the new consumption point will be still to the left of the
endowment. This is shown graphically below.
• if the consumer is initially a borrower, and the interest rate declines,
he or she will remain a borrower.

39
94. Now instead of keeping the prices constant in the two periods, let
today’s price of consumption be 1 and let p2 be the price of consumption
tomorrow. It is convenient to think of the endowment as being measured in
units of the consumption goods as well, so that the monetary value of the
endowment in period 2 is p2m2 and that of period 1 is p1m1= m1

Then the amount of money the consumer can spend in the second period is
given by:

And the amount of consumption available in period 2 is :

95. For the case of period 1 price p1 and period 2 price p2, then the
amount of money the consumer can spend in the second period is given by:

40
 p2c2 = p2m2 + r(p1m1 – p1c1 ) + (p1m1 – p1c1 )
= p2m2 + r p1(m1 – c1 ) + p1(m1 – c1 )
c2 = m2 + p1/ p2 (1+r) (m1 – c1 )
96. The budget constraint can be expressed in terms of the rate of
inflation. The inflation rate,π, is just the rate at which prices grow.
With p1 = 1, we have p2 = 1 + π. Then

Let ρ be the real interest rate and define it by:

Hence, the budget constraint becomes:

One plus the real interest rate measures how much extra consumption you can
get in period 2 if you give up some consumption in period 1.

Usually the real interest rate is approximated by the difference between the
nominal interest rate and inflation rate. That is:

97. The next period value of 1 dollar today at interest rate of r is (1+r).
While the present value of 1 dollar in the next period at interest rate of r is
1/(1+r).
98. A consumption plan is affordable if the present value of consumption

equals the present value of income.

99. if a consumer can freely borrow and lend at a constant interest rate,
then the consumer would always prefer a pattern of income with a higher
present value to a pattern with a lower present value.

41
100. For three periods time, the budget constraint for a constant interest
rate is expressed as:

If the interest rate varies, say r1 from period 1 to 2 and r2 from period 2 to
3, then the budget constraint is given by:

101. The different outcomes of some random event is called states of

nature.
102. A contingent consumption plan is a specification of what will be
consumed in each different state of nature.
103. For perfect substitutes, the utility function under uncertainty is given
by;

Where c1 and c2 represent consumption in states 1 and 2, and π1 and π2 be

the probabilities that state 1 or state 2 actually occurs.

This expression is known as the expected value. Hence the above utility is
the expected or average utility or a von Neumann-Morgenstern utility
function.

If the two states are mutually exclusive, that is only one of them can

happen, then π2 = 1− π1.

104. We say that a function v(u) is a positive affine transformation if it can

be written in the form: v(u) = au + b where a > 0. A positive affine

42
 transformation simply means multiplying by a positive number and adding
a constant.
105. If you subject an expected utility function to a positive affine
transformation, it not only represents the same preferences but it also still
has the expected utility property.
106. The utility function for contingent consumption will take a very
special structure: it has to be additive across the different contingent
consumption bundles.
107. If an expected utility is expressed as :

Then the marginal rate of substitution between goods 1 and 2 is

given by:

108. For a risk-averse consumer the utility of the expected value is greater
than the expected utility.

For example, for a consumer currently has $10 of wealth and is

contemplating a gamble that gives him a 50 percent probability of winning
$5 and a 50 percent probability of losing $5. His wealth will therefore be
random: he has a 50 percent probability of ending up with $5 and a 50
percent probability of ending up with $15. The expected value of his wealth
is $10, and the expected utility is

If the utility indifference curve is concave then

43
As shown on below figure.

For a risk-lover, the opposite works.

44
109. The curvature of the utility function measures the consumer’s
attitude toward risk. In general, the more concave the utility function, the
more risk averse the consumer will be, and the more convex the utility
function, the more risk loving the consumer will be.
110. For a linear utility function, the consumer is risk neutral: the
expected utility of wealth is the utility of its expected value. In this case the
consumer doesn’t care about the riskiness of his wealth at all—only about
its expected value.
111. Suppose that the consumer has some wealth w and is considering

investing some amount x in a risky asset. This asset could earn a return of

rg in the “good” outcome, or it could earn a return of rb in the “bad”

outcome.

Thus the consumer’s wealth in the good and bad outcomes will be:

Wg = (w-x) + x + xrg = (w-x) + x(1+ rg )

Wb = (w-x) + x(1+ rb )

Suppose that the good outcome occurs with probability π and the bad

outcome with probability (1 − π). Then the expected utility if the consumer

decides to invest x dollars is:

The consumer wants to choose x so as to maximize this expression.

Differentiating with respect to x, we find the way in which utility changes as

x changes:

45
 The second derivative of utility with respect to x is

If the consumer is risk averse his utility function will be concave, which
implies that u’’(w) < 0 for every level of wealth.

The optimal amount for the consumer to invest will be determined by the
condition that the derivative of expected utility with respect to x be equal to

zero. Since the second derivative of utility is automatically negative due to

concavity, this will be a global maximum. That is:

112. How does the level of investment in a risky asset behave when you
tax its return?

If the individual pays taxes at rate t, then the after-tax returns will be (1 −

t)rg and (1−t)rb. Thus the first-order condition determining his optimal

investment, x, will be

Canceling the (1 − t) terms, we have

46
113. If an individual has E(u) < U(EV), he is a risk averse.
Where E(u) is the expected utility and U(EV) is utility of the expected
value. Where:
• EV = event 1 x its probability + event 2 x its probability
• E(u) = (probability 1 x u1) + (probability 2 x u2)
• U(EV) = the value of the utility at EV value.
• U(CE) = E(u)
Where, CE is the certainty equivalent.
114. Risk premium = EV - CE

47