Consumer Theory

The theory of consumer and choice is the branch of microeconomics that relates preferences to consumption
expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their
consumption as measured by their preferences subject to limitations on their expenditures, by maximizing
utility subject to a consumer budget constraint.

Consumption is separated from production, logically, because two different economic agents are involved. In
the first case consumption is by the primary individual; in the second case, a producer might make something
that he would not consume himself. Therefore, different motivations and abilities are involved. The models
that make up consumer theory are used to represent prospectively observable demand patterns for an
individual buyer on the hypothesis of constrained optimization. Prominent variables used to explain the rate
at which the good is purchased (demanded) are the price per unit of that good, prices of related goods, and
wealth of the consumer.

The law of demand states that the rate of consumption falls as the price of the good rises, even when the
consumer is monetarily compensated for the effect of the higher price; this is called the substitution effect. As
the price of a good rises, consumers will substitute away from that good, choosing more of other alternatives.
If no compensation for the price rise occurs, as is usual, then the decline in overall purchasing power due to
the price rise leads, for most goods, to a further decline in the quantity demanded; this is called the income
effect.

In addition, as the wealth of the individual rises, demand for most products increases, shifting the demand
curve higher at all possible prices.

The basic problem of consumer theory takes the following inputs:

 The consumption set C – the set of all bundles that the consumer could conceivably consume.
 A preference relation over the bundles of C. This preference relation can be described as an ordinal
utility function, describing the utility that the consumer derives from each bundle.
 A price system, which is a function assigning a price to each bundle.
 An initial endowment, which is a bundle from C that the consumer initially holds. The consumer can
sell all or some of his initial bundle in the given prices, and can buy another bundle in the given
prices. He has to decide which bundle to buy, under the given prices and budget, in order to maximize
his utility.

Assumptions

The behavioral assumption of the consumer theory proposed herein is that all consumers seek to maximize
utility. In the mainstream economics tradition, this activity of maximizing utility has been deemed as the
"rational" behavior of decision makers. More specifically, in the eyes of economists, all consumers seek to
maximize a utility function subject to a budgetary constraint.[4] In other words, economists assume that
consumers will always choose the "best" bundle of goods they can afford. Consumer theory is therefore based
on generating refutable hypotheses about the nature of consumer demand from this behavioral postulate.

In order to reason from the central postulate towards a useful model of consumer choice, it is necessary to
make additional assumptions about the certain preferences that consumers employ when selecting their
preferred "bundle" of goods. These are relatively strict, allowing for the model to generate more useful
hypotheses with regard to consumer behaviour than weaker assumptions, which would allow any empirical
data to be explained in terms of stupidity, ignorance, or some other factor, and hence would not be able to
generate any predictions about future demand at all. For the most part, however, they represent statements
which would only be contradicted if a consumer was acting in (what was widely regarded as) a strange
manner.
Revealed Preference Theory

Indifference Curve analysis shifted the approach from cardinalism to ordinalism. At the same time, it
retained the assumption of introspection. Prof. Samuelson attempted to shift the basis from introspection
to observation. Thus revealed preference theory is a behaviourist ordinal utility analysis. The revealed
preference hypothesis has made possible the establishment of the ‗law of demand‘ directly on the basis of
the revealed preference axiom. Thus this hypothesis (R.P hypothesis) is considered as a major
breakthrough in the theory of demand.

Revealed Preference Axiom

Prof. Samuelson‘s theory of demand is based on revealed preference axiom which states that choice reveals
preference. According to this hypothesis, the consumer is supposed to reveal the nature of his preferences.
He shows the good he would prefer to purchase in a given situation even though he may not be able to
show his scale of preference on an indifference map.
Preferences are complete
Consumer choice theory is based on the assumption that the consumer fully understands his or her
own preferences, allowing for a simple but accurate comparison between any two bundles of good
presented. That is to say, it is assumed that if a consumer is presented with two consumption bundles
A and B each containing different combinations of n goods, the consumer can unambiguously decide
if (s)he prefers A to B, B to A, or is indifferent to both. The few scenarios where it is possible to
imagine that decision-making would be very difficult are thus placed "outside the domain of
economic analysis".However, discoveries in behavioral economics has found that actual decision
making is affected by various factors, such as whether choices are presented together or separately
through the distinction bias.

Preferences are reflexive

Means that if A and B are in all respect identical the consumer will consider A to be at least as good
as (i.e. weakly preferred to) B.[5] Alternatively, the axiom can be modified to read that the consumer is
indifferent with regard to A and B.[7]
Preference are transitive
If A is preferred to B and B is preferred to C then A must be preferred to C.
This also means that if the consumer is indifferent between A and B and is indifferent between B and
C she will be indifferent between A and C.
This is the consistency assumption. This assumption eliminates the possibility of intersecting
indifference curves.
Preferences exhibit non-satiation
This is the "more is always better" assumption; that in general if a consumer is offered two almost
identical bundles A and B, but where B includes more of one particular good, the consumer will
choose B.[8]
Among other things this assumption precludes circular indifference curves. Non-satiation in this sense
is not a necessary but a convenient assumption. It avoids unnecessary complications in the
mathematical models.
Indifference curves exhibit diminishing marginal rates of substitution
This assumption assures that indifference curves are smooth and convex to the origin.
This assumption is implicit in the last assumption.
This assumption also set the stage for using techniques of constrained optimization. Because the
shape of the curve assures that the first derivative is negative and the second is positive.
The MRS tells how much y a person is willing to sacrifice to get one more unit of x.
This assumption incorporates the theory of diminishing marginal utility.
Goods are available in all quantities
It is assumed that a consumer may choose to purchase any quantity of a good (s)he desires, for
example, 2.6 eggs and 4.23 loaves of bread. Whilst this makes the model less precise, it is generally
 acknowledged to provide a useful simplification to the calculations involved in consumer choice
theory, especially since consumer demand is often examined over a considerable period of time. The
more spending rounds are offered, the better approximation the continuous, differentiable function is
for its discrete counterpart. (Whilst the purchase of 2.6 eggs sounds impossible, an average
consumption of 2.6 eggs per day over a month does not.)

Note the assumptions do not guarantee that the demand curve will be negatively sloped. A positively sloped
curve is not inconsistent with the assumptions.

DEMAND THEORY (MARSHALL AND HICKS DEMAND FUNCTIONS)

Marshallian demand function

In microeconomics, a consumer's Marshallian demand function (named after Alfred Marshall) specifies
what the consumer would buy in each price and income or wealth situation, assuming it perfectly solves the
utility maximization problem. Marshallian demand is sometimes called Walrasian demand (named after
Léon Walras) or uncompensated demand function instead, because the original Marshallian analysis
ignored wealth effects. According to the utility maximization problem, there are L commodities with price
vector p and choosable quantity vector x. The consumer has income I, and hence a set of affordable packages
The consumer's Marshallian demand correspondence is defined to be

Marshallian and Hicksian demands stem from two ways of looking at the same problem- how to obtain the
utility we crave with the budget we have. Consumption duality expresses this problem as two sides of the
same coin: keeping our budget fixed and maximising utility (primal demand, which leads us to Marshallian
demand curves) or setting a target level of utility and minimising the cost associated with it (dual demand,
which gives us Hicksian demand curves). We must also look at the Lagrangian functions where we obtain
the first derivatives. This leads us to the main difference between the two types of demand: Marshallian
demand curves simply show the relationship between the price of a good and the quantity demanded of it.
Hicksian demand curves show the relationship between the price of a good and the quantity demanded of it
assuming that the prices of other goods and our level of utility remain constant. This makes sense when we
look at consumption duality: for dual (Hicksian) demand, we maintain a fixed level of utility, and so our level
of wealth, or income, must remain constant. We simply cannot be as satisfied if we do not maintain equal
purchasing power.

Marshallian and Hicksian demand curves meet where the quantity demanded is equal for both sides of the
consumer choice problem (maximising utility or minimising cost). For prices above this equilibrium point,
consumer wealth is higher with Hicksian demand curves than Marshallian demand curves, because to
maintain utility constant, Hicksian demand curves assume real wealth remains unchanged. Marshallian
demand assumes only nominal wealth remains equal. The opposite is true for prices below this point:
Marshallian demand assumes that as nominal wealth remains the same but price levels drop (negative
inflation), the consumer is better off. Hicksian demand assumes real wealth is constant, so the individual is
worse off. This is why Marshallian demand curves are more ‘stable’: they reflect both rent effect and
substitution effect. Hicksian demand curves only show substitution effects (utility is constant, therefore rent
must remain constant), which means that demand varies with price only because other options become more
attractive.

Hicksian demand (hX1) is a function of the price of

X1, the price of X2 (assuming two goods) and the
level of utility we opt for (U):

X*=hX1(PX1,PX2,U)
Marshallian demand (dX1) is a function of the price
of X1, the price of X2 (assuming two goods) and the
level of income or wealth (m):

X*=dX1(PX1, PX2, m)
For an individual problem, these are obtained from the first order conditions (maximising the first
derivatives) of the Lagrangian for either a primal or dual demand problem. Marshallian demand makes more
sense when we look at goods or services that make up a large part of our expenses. Here, the income effect is
very large.

MARSHALIAN DEMAND FUNCTION (ORDINARY-UNCOMPENSATED DEMAND

FUNCTIONS)
Assume:
U= X1X2
M=P1X1+P2X2
U=X1X2+λ(M-P1X1-P2X2)
∂U/∂X1=X2- λ P1=0
X2= λ P1
X2/P1= λ
∂U/∂X2=X1- λ P2=0
X1= λ P2
X1/P2= λ
Since λ = λ
X2/P1 = X1/P2
X2 = (P1/P2) X1
M – P1X1-P2(P1/P2) X1=0
M – P1X1-P1X1=0
M – 2P1X1= 0
M = 2P1X1
M/2P1 = *X1………………………………………………………….(1)
Since X2/P1 = X1/P2
X1 =( P2/P1) X2
M – P1X1-P2X2 =0
M – P1(P2/P1)X2 – P2X2 =0
M – P2X2 – P2X2 =0
M – 2P2X2 = 0
M = 2P2X2
M/2P2 =*X2…………………………………………………………………(2)

Example
Suppose a consumer has 900,000/= to be allocated between commodities X & Y. The price of commodity Y
is 2000, find the demand functions for X and Y if the commodity if the Utility function is U=LogX + 2LogY
L = LogX +2LogY + λ (900,000 – PxX – 2000Y)
Lx = 1/X – λ PX = 0…………………………………………………………(1)
Ly = 2/Y - 2000 λ = 0……………………………………………………….(2)
L λ = 900,000 – PxX – 2000Y = 0……………………………………..(3)
From equation (1), 1/X = λ Px λ = 1/PxX
From equation (2) 2/Y = 2000 λ λ = 1/1000Y
Since λ = λ
1/PxX = 1/1000Y
PxX = 1000Y
X = (1000Y)/Px
Y = (PxX)/1000
So let’s substitute to see what we can get:
900,000 – PxX – 2000Y =0
900,000 – PxX – 2000(PxX/1000) = 0
900,000 = 3PxX
*X = 300,000/Px…………………………………………………………………..(4)
This is the optimal quantity for commodity X consumed.
900,000 – Px(1000Y/Px) – 2000Y =0
*Y = 3000………………………………………………………………………………(5)

HICKSIAN DEMAND FUNCTION (Compensated Demand Function)

Assume:
U= X1X2
M=P1X1+P2X2
U=X1X2+λ(M-P1X1-P2X2)
∂U/∂X1=X2- λ P1=0
X2= λ P1
X2/P1= λ
∂U/∂X2=X1- λ P2=0
X1= λ P2
X1/P2= λ
Since λ = λ
X2/P1 = X1/P2
X2 = (P1/P2) X1……………………………………………………………………………..(1)
X1 = (P2/P1)X2………………………………………………………………………………(2)
Substitute equation (1) and (2) in the objective function
U =X1X2
U-X1X2=0
U-X1[(P1/P2)X2] =0
U = [P1/P2]X21
X21 =(P2/P1)U
*X1 = [(P2/P1) U]1/2…………………………………………………………………..(3) Optimal bundle of X1
We can similarly solve for X2
Since U= X1X2
U-X1X2 =0
U-[ (P2/P1)X2]X2 =0
U=[ P2/P1]X22
*X2 = [(P1/P2)U]1/2………………………………………………………………….(4) Optimal bundle for X2

THE INDIRECT UTILITY FUNCTION

This is the function U(X1,X2,…………………………..Xn) in the original utility maximization program used
to derive the ordinary demand functions
Since U = X1X2
Note X1* M/2P1, X2*= M/2P2
Therefore to get the indirect utility function which is a function of income and Prices we derive the
following:
U = (M/2P1). (M/2P2)
U = M2/(4P1P2) –Indirect utility function
EXPENDITURE FUNCTION
It’s the minimum or the objective function used in deriving the consumer compensated demand function
when X1,X2,……………………………..Xn are expressed as functions of ( P1,P2………….Pn,U) i.e
X1*=X1(P1,U), X2*=X2(P2,U). These can be plugged back in the expenditure function E(X) such that
E=E(PU)
Illustration:
E=P1X1 +P2X2
Recall X1*= [ (P2/P1)U]1/2, X2* =[ (P1/P2)U]1/2
E=P1 [(P2/P1)U ]1/2+ P2 [ (P1/P2)U]1/2
E = [P12 (P2/P1) U]1/2 +[P22(P1/P2)U]1/2
E = [P1P2U]1/2 + [P1P2U]1/2
E = 2 [P1P2U]1/2

Properties of Expenditure Function

- Non decreasing in prices
- Homogeneous of Degree 1 in prices
- Continuous in prices for P>0. If X(PU) is the expenditure minimizing bundle necessary to achieve
utility level (U) at prices P, then X* = ∂E/∂Pi: i= 1,2…….n as long as the derivative is defined and
prices are positive.

HOTELLING’S LEMMA (OR THEORY)

E = 2 [P1P2U]1/2
Let a = P1P2U
∂E/∂P1 = ∂E/∂a . ∂a/∂P1
∂a/∂P1 = P2U
∂E/∂a = a-1/2
But a = P1P2U)
∂E/∂a = (P1P2U)-1/2 = 1/(P1P2U)1/2
So ∂E/∂P1 = P2U/(P1P2U)1/2
(∂E/∂P1)2 =( P22 U2)/(P1P2U)
∂E/∂P1 = [ (P2/P1)U ]1/2 =X1*. Meaning you get back the compensated demand function.

THE ROY’S IDENTITY

If Xi = – (∂U/∂Pi)/( ∂U/∂PM) for i = 1,2,3,……………………..n
As long as the derivative exists and provided that Pi and M are non-negative
NB from the indirect utility function:
U= M2/4P1P2
Recall (∂y/∂x) = (V∂U - U∂V)/(V2)
Xi (P,M) = - [∂U(P,M)/∂Pi]/ [∂U(P,M)/∂M]
X1 (P,M) = - [∂U(P,M)/∂P1]/ [∂U(P,M)/∂M]
∂U(P,M)/∂P1 =[ (4P1P2)0 – M24P2]/16P12P22
= -(M24P2)/16P12P22
Since X1 (P,M) = - [∂U(P,M)/∂P1]/ [∂U(P,M)/∂M] = - [ -(M24P2)/16P12P22]= M/2P1=X1*

Marginal Revenue, Price and Elasticity

So far we analyzed price elasticity of demand from the consumer‘s side only. However,
consumer‘s expenditures on a commodity are the receipts or the total revenues of the sellers of the sellers
of the commodity. Thus, another way of looking at the price elasticity of demand for a good or service is
to see what happens to the total revenue as the price of the good or service changes.

The total amount of money earned by sellers of a commodity is called total revenue (TR). Total revenue
is derived from the sale of any commodity is the price of the product (P) multiplied by the quantity sold
(Q). That is,

TR = P.Q

The marginal revenue (MR) is the changes in total revenue resulting from selling an additional unit of
a commodity. That is, marginal revenue is the addition made to the total revenue by selling an additional
unit of the commodity. Marginal revenue is calculated by dividing the changes in total revenue (ΔTR) by
the change in quantity sold (Δ Q)

That is, MR = ΔTR / Δ Q

The important relationship among marginal revenue, price and price elasticity of demand is given by:

MR = P ( 1-1/η)

This is a crucial relationship for the theory o pricing. If η =1, then MR is equal to zero and TR

reaches its maximum point. That is, if

η =1, hence MR = P (1-1/η)=0.

If η>1, MR will be positive and TR curve has a positive slope and hence has not reached its maximum
point. That is,

η >1, then MR = P (1-1/η)>0 since P>0

If η<1, MR will be negative and TR curve has a negative slope. That is, TR curve is falling. If

η <1, then MR = P (1-1/η) <0 since P>0

We can summarise these results as follows.

(1) If the price elasticity of demand has a unitary elasticity (η =1) total revenue is not affected by
changes in the price. This is because if η =1, then MR=0.

(2) If demand is elastic (η >1) an increase in price will results in decrease in the total revenue while a

decrease in price will results in an increase in total revenue (MR>o).

(3) If demand is inelastic (η <1) an increase in price lead to increase in total revenue and a decrease in
price leads to fall in total revenue (MR >0).

PRODUCTION THEORY

Production Function

Before we get into the discussion on production function, let us see the brief history of production
function

2.(a). History of Production Function

Various Roman and Greek authors have addressed many issues in economics included cursory attention to
production and distribution. The Scholastics, including Saints Augustine and Thomas Aquinas, also devoted
substantial time to economic matters including discussion and inquiries into production. Several authors
associated with the Mercantilist and Physiocratic schools of thought also paid even more careful attention to
matters of production in the economy. For example, Anne Robert Jacques Turgot, a member of the
Physiocrats, is credited with the discovery around 1767 of the concept of diminishing returns in a one input
production function. Of course Adam Smith himself devoted much time to issues concerning productivity
and income distribution in his seminal 1776 book The Wealth of Nations.

The Classical economists who immediately followed Smith expanded on his work in the area of
production theory. In 1815 Thomas Malthus and Sir Edward West discovered that if you were to increase
labour and capital simultaneously then the agricultural production of the land would rise but by a
diminishing amount. They both in effect rediscovered the concept of diminishing returns. David Ricardo
later adopted this result in order to arrive with his theory of income distribution when writing his
economic classic the Principles of Political Economy. The Marginalists also dabbled in the area of
production. During the late 1800‘s W. Stanley Jevons, Carl Menger and Leon Walras all incorporated
ideas of factor value into their writings. What these early post-Smith economists all had in common is
that they all used production functions that were in fixed proportions. In other words the capital to labour
ratios were not allowed to change as the level of output changed. Although interesting, in practice most
production functions probably exhibit variable proportions.
 In the 1840‘s J. H. von Thunen developed the first variable proportions production function. He
was the first to allow the capital to labor ratio to change. Von Thunen noticed that if we were to hold one
input constant and increase the other input then the level of output would rise by diminishing amounts. In
other words he applied the concept of diminishing returns to a two input, variable proportions production
function for the first time. An argument could definitely be made that he is the original discoverer of
modern marginal productivity theory. His work never received the attention it deserved though. Instead
during 1888 American economist John Bates Clark received credit for being the founder of marginal
productivity theory based on his speech at the American Economic Association meetings that year.

Shortly after in 1894 Philip Wicksteed demonstrated that if production was characterized by a
linearly homogeneous function (in other words one that experiences constant returns to scale) then with
each input receiving its marginal product the total product would then be absorbed in factor payments
without any deficit or surplus. Around the turn of the century Knut Wicksell produced a production
function very similar to the famous Cobb-Douglas production function later developed by Paul Douglas
and Charles W. Cobb.

In 1961, Kenneth Arrow, H.B. Chenery, B.S. Minhas and Robert Solow developed what became
known as the Arrow-Chenery-Minhas-Solow or ACMS production function. Later in the literature this
became known as the constant elasticity of substitution or CES production function. This function

allowed the elasticity of substitution to vary between zero and infinity. Once this value was established it
would remain constant across all output and/or input levels. The Cobb-Douglas, Leontief and Linear
production functions are all special cases of the CES function. In 1968 Y. Lu and L.B. Fletcher developed
a generalized version of the CES production function. Their variable elasticity of substitution function
allowed the elasticity to vary along different levels of output under certain circumstances.

Recently there have been many developments with flexible forms of production functions. The
most popular of these would be the transcendental logarithmic production function which is commonly
referred to as the translog function. The attractiveness of this type of function lies in the relatively few
restrictions placed on items such as the elasticity of scale, homogeneity and elasticity of substitution.
There are still problems with this type of function however. For example, the imposition of separability
on the production function still involves considerable restrictions on parameters which would make the
function less flexible than originally thought. The search for better, more tractable production functions
continues.

In microeconomics, a production function expresses the relationship between an organization's

inputs and its outputs. A production function summarizes the relationship between inputs and outputs. It
indicates, in mathematical or graphical form, what outputs can be obtained from various amounts and
combinations of factor inputs. In particular it shows the maximum possible amount of output that can be
produced per unit of time with all combinations of factor inputs, given current factor endowments and the
state of available technology.

The production function is a purely technical relation which connects the inputs and outputs. It is a
functional relationship between inputs and outputs. The terms technological or functional are used to
indicate the fact that the prices of the factors of production or cost of production are not included in the
production function. A production function describes the laws that govern the processes of transforming
inputs into outputs. Unique production functions can be constructed for every production technology.

In general, a production function is represented

Q = ƒ( x1, x2, x3, .....,xn)

Where,

Q is the maximum quantity of output,

x1, x2, x3, .....,xn are the quantities of various inputs.

The mathematical form of production function contains more details than the above general form.
This is because production function can provide measurement of concepts in economics like the marginal
productivity of factors of production, the marginal rate of substitution, elasticity of substitution, factor
intensity, the efficiency of production, technology, and the return to scale. The general mathematical
form of the production function is:

Q = F(K,L,e)

Where Q is Out-put, K-Capital, L-Labour and e is efficiency

Here the efficiency parameter e is included to represent the fact that two firms with same factor
inputs and same returns to scale can have different output due to efficient entrepreneurship or
management. Production function has been used as an important tool of economic analysis in the
neoclassical tradition. It is generally believed that Philip Wicksteed (1894) was the first economist to
algebraically formulate the relationship between output and inputs as p = f(x 1, x2, …xn) although there are
some evidences suggesting that Johann Von Thunen first formulated it in the 1840‘s . There are several
ways of specifying a production function.

One is as an additive production function, where the variables are added to each other. For example,

Q= a+ b X1 + c X2 + d X3, where a, b, c, and d are parameters that are determined empirically.

Another is multiplicative production function, where the variables are expressed in a multiplicative
relation. For example Q = ALαKβ (the Cobb-Douglas production function, details given later) . Other
forms include the constant elasticity of substitution production function (CES) which is a generalized
form of the Cobb-Douglas function, and the quadratic production function which is a specific type of
additive function. The best form of the equation to use and the values of the parameters (a, b, c, and d)
vary from company to company and industry to industry. In the short run production function, at least one

of the Xs (inputs) is fixed. In the long run all factor inputs are variable at the discretion of management.
There are two special classes of production functions that are frequently mentioned in textbooks but are
seldom seen in reality.

2.1. Homogeneous production functions: The production function Q=f(X1,X2) is said to be

homogeneous of degree n, if given any positive constant k, f(kX1,kX2)=knf(X1,X2).

When n>1, the function exhibits increasing returns, and decreasing returns when n<1. When it is
homogeneous of degree 1, it exhibits constant returns.
2.2. Homothetic functions: are a special class of homogeneous function in which the marginal rate of
technical substitution is constant along the function.

2.3. Aggregate production functions: Production functions are normally built for a firm or industry.
But, in macroeconomics, production functions for whole nations are sometimes constructed. In theory
they are the summation of all the production functions of individual producers, however this is an
impractical way of constructing them. This is because for the economy as a whole there are many types of
outputs and services. Also, there are many types of capital goods including office buildings, factory
equipment, airplanes, and other durable goods. Finally, there are many types of labor, from unskilled
workers to brain surgeons. There are also methodological problems associated with aggregate production
functions. Economists use a process called aggregation to come up with a single measure of output that
summarizes all of the different goods and services produced in the economy. The weights are closely
related to the relative prices of the goods. That is, an expensive surgery will have a higher weight in the
aggregation process than an inexpensive pen. (The aggregate measure of output is called real gross
domestic product, or real GDP.)

2.4. Fixed Coefficients Production Function: A production function associates the maximum level of
output producible with given amounts of inputs. If the inputs must be combined in fixed proportions, like
the ingredients of a recipe in a cookbook, the function is a fixed coefficients production function. It is also
called a Leontief function, after its inventor, the economist and Nobel Prize winner, Wassily Leontif. For
example, call centers require a one-to-one proportion between workers and telecommunication
equipment. The isoquants for such a production function are L-shaped (with the kink on the 45 degree
line). We will now see in detail three types of production functions.

2.5. Linear Production function

The simplest possible production function is a linear production function. A Linear Production Function
is a production function that assumes a perfect linear relationship between inputs and total output.

Example: Given a Linear Production Function Q = 20 K + 40 L. If this firm employed 8 units of capital
and 17 workers then how much output would they produce?

20 x 8 + 40 x 17 = 840 units of output

2.5 (a). Homogenous Production Function

A production function is said to be homogenous if it satisfies the following condition.

Consider a production function Q = ƒ(X, Y). As you know, in the long run all the factors of production
can be increased. Suppose we increase both the factors x and y by the same proportion, k. To effect this
change we multiply each input factor is by a positive real constant k. The new level of output is Q* and
can be represented as
Q* = ƒ (kX, kY).

Now, if we can take k out of the brackets as a common factor (if k can be completely factored out from
Q*), then the new level of output Q* can be expressed as a product of k (to any power v) and the initial
level of output.

That is Q* =kvf (X, Y) or Q* =kvQ

In such cases, where k can be completely factored out is called a homogeneous production function. The
formal definition is as follows.

A homogenous production function is a function such that if each of the inputs is multiplied by a real
constant k, then k can be completely factored out of the function.

If k can not be completely factored out, the production function is non-homogenous.

The power v of k is called the degree of homogeneity of the function and is used to
measure the return to scale of a function.

As you know returns to scale is the long run analysis of production. The Law of Returns to scale
postulates that when all inputs are increased by 1 %: if output increases by 1% it is constant returns to
scale; if output increases by less than 1% it is decreasing returns to scale; if output increases by more than

1% it is increasing returns to scale.

Using the power v of k, we can state:
If v = 1, it is constant returns to scale

If v < 1, it is decreasing returns to scale

If v > 1, it is increasing returns to scale

A production function for which v = 1 and so returns to scale are constant is called a linearly
homogenous production function. Since this implies that when we increase all the factors of production in
equal proportions, the output is also increased by the same ratio. Hence such production functions are also
called Constant Returns to scale (CRS) production functions. Returns to scale are measured
mathematically by the coefficient of the production function. For example, given a production function
X= b0Lb1Kb2, the returns to scale are measured by the sum b1 + b2.

Examples:

Mathematically, a function z = f (x,y) is homogenous of degree n if for all positive values of k, f (kx,ky) =

kn f (x,y).
1. Examine whether the following production function is homogenous. Also find the returns to scale z =

5x + 4y.

Multiply each input by a real constant k and check whether it can be completely factored out.

f (kx,ky) = 5kx + 4ky = k(5x + 4y)

There is no k inside the bracket. So the function is homogenous. The degree of homogeneity is
given by the power of k. Here the power of k is 1. So the given function is homogenous of degree less
than one and has decreasing returns to scale.

2. z =

f (kx,ky) = = ( )=1( ) since = k0 = 1

There is no k inside the bracket. So the function is homogenous. The power of k is 0. So the given
function is homogenous of degree less than one and has decreasing returns to scale.

3. Z = x3 + 7xy + y3

f (kx,ky) = (kx)3 + 7(kx)( ky) + (ky)3

Factoring k out, k2(k x3 + 7xy + k y3)

Here k can not be completely factored out. There is k reaming inside the bracket. So the function is not
homogenous.

2.6. Cobb Douglas Production Function

Out of all the production functions used in economics, the most popular production function is the
Cobb Douglas production function, also known as the C-D function. In economics, the Cobb Douglas
form of production functions is widely used to represent the relationship of an output to inputs. Though
similar functions were originally used by Knut Wicksell (1851–1926), the Cobb-Douglas form was
developed and tested against statistical evidence by Charles Cobb and Paul Douglas.

In the 1920s the economist Paul Douglas was working on the problem of relating inputs and
output at the national aggregate level. A survey by the National Bureau of Economic Research found that
during the decade 1909-1918, the share of output paid to labour was fairly constant at about 74% , despite
the fact the capital/labour ratio was not constant. He enquired of his friend Charles Cobb, a
mathematician, if any particular production function might account for this. This gave birth to the original
Cobb-Douglas production function which they propounded in their 1928 paper, ‗A Theory of Production‘.

The general form of a C-D function is stated as

where: Q = total production (the monetary value of all goods produced in a year), L = labour
input, K = capital input and A = total factor productivity or technology, which is assumed to be a
constant. Here α and β are the output elasticities of labour and capital, respectively. These values are
constants and are determined by available technology. Output elasticity measures the responsiveness of
output to a change in levels of either labour or capital used in production, ceteris paribus. For example if
α = 0.15, a 1% increase in labour would lead to approximately a 0.15% increase in output.

It is generally said that a strict C-D function assumes constant returns to scale as α + β = 1.(since

the returns to scale are measured mathematically by the coefficient of the production function).

Cobb and Douglas were influenced by statistical evidence that appeared to show that labour and
capital shares of total output were constant over time in developed countries. However, now many
economists doubt whether constancy over time exists. But at your level of understanding, we say that for
a C-D function, α + β = 1

2.6(a). Properties of a Cobb-Douglass function

1). CD function is linearly homogenous of degree one. This means that when input is increased by λ,
output also increases by λ.

2) Average products of capital and labour can be expressed in terms of ratios of inputs.

Average product of labour can be obtained by dividing the production by the amount of labour.
Q = A Lα Kβ

APL = =

= since

Thus we have shown that the AP L can be expressed as the raion of the two inputs K and L
Similarly

APK = =

= since =
3). Marginal product of capital and labour can be expressed in terms
of ratios of inputs.

Thus the marginal product of capital (MPK) can be expressed in terms of ratios of
inputs L and K. It is also equal to β times APK. That is,

Similarly the marginal product of capital (MP L) can be expressed in terms of ratios of

inputs L and K. Symbolically

It is also equal to α times APL. That is,

4. CD function
satisfies Euler‘s
theorem.

5. Elasticity of substitution of a CD
function is unity*.

(*The elasticity of substitution was introduced independently by John Hicks (1932)

and Joan Robinson (1933) to measure the degree of substitutability between any pair
of factors. Elasticity of substitution is the elasticity of the ratio of two inputs to a
production function with respect to the ratio of their marginal products. It measures the
curvature of an isoquant and thus, the substitutability between inputs, i.e. how easy it is
to substitute one input for the other.)

6. Factor intensity: In C-D function Q = A Lα Kβ , the factor intensity is measured by

the ratio . The higher this ratio, the more labour intensive the technique; the lower
the ratio, the more capital intensive the technique.
7. A strict CD function represents constant returns to
scale since α +β = 1.

Importance of CD function

The C-D function is an analytical tool commonly used in economics which has
the following uses.

1. C-D function can be used to determinate marginal productivity of labour and

capital. Hence it can be used in the determination of wages and interest.

2. The parameters α and β of the function represents elasticity coefficient. These

elasticity coefficients are helpful in inter-sectoral comparison in an economy and
for the long run analysis of production i.e. returns to scale. As in the usual case of a
C-D function, when α + β = 1, we have constant returns to scale and the function is
linear homogenous.

3. C-D function helps to compute elasticity values for inter

sectoral comparisons.

4. C-D function is widely

used in econometrics.

5. This production function helps us to study the different laws,

of returns to scale.

6. This function is used to test laws of returns and

substitutability of factors

Limitations of a C-D function

Cobb and Douglas were influenced by statistical evidence that appeared to show that
labour and capital shares of total output were constant over time in developed countries;
they explained this by statistical fitting least-squares regression of their production
function. However, there is now doubt over whether constancy over time exists.
Neither Cobb nor Douglas provided any theoretical reason why the coefficients α and β
should be constant over time or be the same between sectors of the economy.
Remember that the nature of the machinery and other capital goods (the K) differs
between time-periods and according to what is being produced. So do the skills of labor
(the L).
The Cobb-Douglas production function was not developed on the basis of any
knowledge of engineering, technology, or management of the production process. It
was instead developed because it had attractive mathematical characteristics, such as
diminishing marginal returns to either factor of production. Crucially, there are no
micro foundations for it. In the modern era, economists have insisted that the micro-
logic of any larger-scale process should be explained. The C-D production function
fails this test. It is thus a mathematical mistake to assume that just because the Cobb-
Douglas function applies at the micro-level, it also applies at the macro-level. Similarly,
there is no reason that a macro Cobb- Douglas applies at the disaggregated level.

1. A C-D function contains only two inputs labour and capital, but actually there may be
more capital.

2. The parameter α and β can represent the labour and capital share only if there is
perfect competition

for labour and capital.

3. In most of the case this production function represents constant returns to scale.
Other possibilities are sidetracked.

4. This function assumes that, technological conditions remain constant. But the
production change due to change in technology is reality. Thus this function is
based on the unrealistic assumption of stagnant technology.

Economic Efficiency and Technical Efficiency

It is relevant to note that among others there are two leading concepts of efficiency
relating to a production system as propounded by Libenstein: the one often called
the ‗technical efficiency‘ and the other called the ‗allocative efficiency‘ The
formulation of production function assumes that the engineering and managerial
problems of technical efficiency have already been addressed and solved, so that
analysis can focus on the problems of allocative efficiency. That is why a production
function is generally defined as a relationship between the maximum technically
feasible output and the inputs needed to produce that output. However, in many
theoretical and most empirical studies it is loosely defined as a technical relationship
between output and inputs, and the assumption that such output is maximum (and
inputs minimum) is often implicit.
We say that a firm is technically efficient when it obtains maximum level of output
from any given combination of inputs. The production function incorporates the
technically efficient method of production. A producer can not decrease one input and
at the same time maintain the output at the same level without increasing one or more
inputs. When economists use production functions, we assume that the maximum
output is obtained from any given combination of inputs. That is, they assume
that production is technically efficient. On the other hand, we say a firm is
economically efficient, when it produces a given amount of output at the lowest
possible cost for a combination of inputs, provided that the prices of inputs are given.
Therefore, when only input combinations are given, we deal with the problem of
technical efficiency; that is, how to produce maximum output. On the other hand, when
input prices are also given in addition to the combination of inputs, we deal with the
problem of economic efficiency; that is, how to produce a given amount of output at the
lowest possible cost.

One has to be careful while interpreting whether a production process is efficient or

inefficient. Certainly a production process can be called efficient if another process
produces the same level of output using one or more inputs, other things remaining
constant. However, if a production process uses less of some inputs and more of
others, the economically efficient method of producing a output depends on the prices
of inputs. Even when two production processes are technically efficient, one process
may be economically efficient under one set of input prices, while the other production
process may be economically efficient at other input prices. Let us take an example to
differentiate between technical efficiency and economic efficiency. A company is
producing ready-made garments using cotton fabric in a certain production process. It is
found that 10 per cent of fabric is wasted in that process. An engineer suggested that the
wastage of fabric can be eliminated by modifying the present production process. To this
suggestion, an economist reacted differently saying that if the cost of wasted fabric is less
than that of modifying production process then it may not be economically efficient to
modify the production process. This example clearly shows that there could be distinctions
between the conditions of economic efficiency and technical efficiency.

Mathematical Characteristics of Production Functions

In explaining some of the history regarding production functions we mentioned several

characteristics that these functions possess. In this section several of the important
characteristics will be explained. The first one that will be covered is the duality
between the production function and the cost function. For well behaved functions we
can produce a cost function from a production and vice versa. This is important due to
the fact that production functions are much harder to estimate econometrically than cost
functions. Cost functions depend on factor prices and output levels which are relatively
easy to observe. Another key characteristic of production functions relate to
homogeneity and homotheticity. All homogeneous functions are homothetic, but not all
homothetic functions are homogeneous. Homogeneity can be of differing degrees. In
economics we typically work with functions that are homogeneous of degree zero or
one. If a production function is shown to be homogeneous of degree k then the first
partials of that function would be homogeneous of degree k-1. For example, if we have
a production function exhibiting linear homogeneity (degree one) then the marginal
product functions would be homogeneous of degree zero meaning that they are
functions of the relative amounts of inputs, but not the absolute amount of any one
input used in the production process. Homogeneity also implies that the isoquant
curves will be radial blowups of one another. In essence the curves will be parallel to
one another, thus if a ray was constructed from the origin the slope of the isoquants
along that ray would all be the same. The famous Euler‘s Theorem also follows from
the assumption of homogeneity. The more general homotheticity has an even more
important role in economics. Since all homogeneous functions are homothetic
everything just stated above would hold true for homothetic functions as well.
Homothetic production functions imply that the output elasticities for all inputs would
be equal at any given point.

This common value can be represented by the ratio of marginal cost to average cost.
Firms with increasing average cost would have output elasticity values greater than
one; firms with decreasing average cost would have output elasticity less than one.
Under the assumption of homotheticity all inputs would have to be normal.
Separability is another key potential feature of a production function. Not all
production functions can be viewed as being separable. Many production processes use
many more than two inputs. This makes studying such a multi-input function rather
difficult. It would be beneficial if we could break the production process down into
various stages where intermediate inputs are produced and then combined with other
intermediate inputs to produce the final output. If we can specify these separate
production functions then the technology is assumed to be separable. This separability
feature has many valuable implications for an economist including the fact that its
presence greatly reduces the number of parameters to be analyzed in an applied
economic analysis of cost or production functions.

2.8. Uses of a production function

A production function is helpful in the following ways.

1. When the physical quantities of inputs are specified, production function helps to
estimate the level of production.

2. When the Q (quantity of output) is fixed, production function gives the different
combination of inputs which yields the same level of output.

3. Production function helps to determine the technically efficient combination of inputs

and also to select the least cost combination of inputs when the budget constraint is
given.
 4. Production function helps to estimate the degree of returns to scale prevailing
in the process of production.

5. The marginal product of different factors can be obtained from production function.

Production function can be fitted to a particular firm or to a sector or industry or to an

economy as a whole. Generally, for a given technology, production function remains
the same. As the technology changes, production function will also change. The nature
and type of production function depends upon data, time period of investigation and the
type of technology employed.

Starting in the early 1950‘s until the late 1970‘s production function attracted many
economists. During the said period a number of specifications or algebraic forms
relating inputs to output were proposed, thoroughly analyzed and used for deriving
various conclusions. Especially after the end of the capital controversy‘, search for new
specification of production functions slowed down considerably.

THEORY OF COSTS
A LeastCost Combination of Inputs is that combination of inputs that will enable
a firm to produce a given level of output at the lowest possible cost. In the two-input
case we have developed, the long-run least cost combination of inputs for any given
output will occur when no substitution of capital for Labouror L for K will cause a
reduction in total cost. This will be true whenever the output produced per
shilling spent on an additional unit of K is equal to the output produced per shilling
spent on an additional unit of L. It will not pay the firm to switch its expenditure from
K to L if a shilling spent on L increases output by the same amount as a shilling spent on
K. For example, if a shilling spent on either K or L yields two units of output. buying
one shilling's worth more of L at the expense of one shilling's worth of K will have a
net effect of + 2- 2 = 0.

3.2 PRODUCER EQUILIBRIUM

How can we determine the number of units of output produced per shilling spent on
additional K or L? The answer is found in the relation of each input's marginal
product to its price per unit which is as given below:
MPL MPK
=

PL PK

3.3 Long-Run Least Cost Condition

The only time that substitution of one input for the other would not yield a cost
reduction would be when MPL MPK
= . Thus, the condition for obtaining a least
PL PK

cost combination of inputs is to arrive at a point where the marginal product per shilling
spent on one input is equal to the marginal product per shilling spent on any other input.
The least-cost condition can be generalized for any number of variable inputs. In other
words, it is applicable to all inputs in the long run and all variable inputs in the
short run. If a firm has n inputs in the long run, we can state the least cost condition
as-follows

The long-run least cost condition is met when, for n inputs, MP1 MP2
= = ... =
P1 P2

MPn
.
Pn
As indicated in the preceding example, any inequality in the ratio of marginal products
to input prices means that the firm has not attained a least cost combination of inputs. In
such a situation, the firm will be able to reduce costs by substituting inputs with higher
marginal products per shilling for those with lower marginal produces per shilling.

Isoquants and Cost Minimization

In the isoquant diagram with two inputs K and L that are variable in the long run,
cost minimization can be viewed as attaining the lowest possible isocost line for any
output (isoquant) the firm chooses to produce. Cost minimization is illustrated when the
isoquant meets the isocost in the figure below

Relation to Least-Cost Condition

At point B in Figure 2-10 tangency of isocost line C1Cl' to isoquant I1 indicates that the
input price ratio (absolute value of slope of C C '), PL/PK is 1equal
l to the MRTSKL on
isoquant I1 (absolute value of slope of I1 at point B). Algebraically, we can state

PL ∆K
,= - .
PK ∆L

Figure 4.1 Cost Minimization for an Output of 50 Units

With a given production function given input prices, and a desired output of 50 units
cost is minimized at point B where the isocost line for TC = N40 is just tangent to
isoquant I1. Points A and D also lie on the so-unit isoquant, but the input
combinations at these points cost N50 instead of N40.

However, from equation above, given previously, we know that the MRTSLK is

also equal to
MPL PL MPL
. Thus, we have ,= .
MPK PK MPK

If both sides of equation 2-9 are multiplied by a common term, MPK/P L, the
following is obtained:
MPK PL MPL MPK
. = . ,
PL PK MPK PL

or

MPK M PL
.
PK PL
Thus we must conclude that tangency of an isocost line to an isoquant is
completely consistent with the general condition for optimum use of variable inputs at
given input prices.

Maximization of Output

The isoquant diagram of Figure 4.1above provides a convenient medium for showing
that the condition for maximization of output from a given budget is the same as that
for cost minimization. Consider point B again. Suppose our problem had been to
maximize output for a budget of N40, rather than to minimize cost for an output of
50 units. Since isocost line C1C1' cannot reach any isoquant higher than I1 = 50, the
maximum output that can be attained with a budget of N40 and the given input prices is
50 units. To accomplish this, the firm would have to use Kb of capital and Lb of labour
at point B. Any other combination of K and L on isocost line C1C1' would
correspond to being on some isoquant lower than I1. Further, such points would be
intersections between isoquants and C1C1` and not tangency points like point B. It
follows
PL MPL MPK
= , and =
that when output is not maximized for a budget of N40,
PK MPK PK

M PL
. At point B of course, both of these ratios are equal.
PL

With input prices given we can conclude that tangency of an isocost line to an isoquant
can be used to represent either (1) cost minimization for a given level of outputs or (2)
output maximization for a given budget. No matter which is the case, the general
condition for a least cost combination of variable inputs will hold at the point of
tangency.
Note:Mathematically, the least-cost combination of inputs is found by solving a
constrained minimization problem as follows:

Minimize TC = K(PK) + L(PL),

Subject to Q = f(K,L) = QO,

Where QO is a given level of output.

Using Lagrange’s undetermined multiplier method, we form the Lagrangian function H

= K(PK) +L(PL) – λ[f(K,L) – QO], where λ is the undetermined multiplier. To solve for
the optimal levels of K and L, the first-order partial derivatives of the above function
are set equal to zero, yielding a system of three equations in three unknowns, or
 δH
= PK − λf K = 0
δK
δH
= PL − λf K = 0
δL
δH
= − f (K , L) + Q = 0
o
δλ

Restating the first two of the above partials:

δH
= PK - λMPK = 0
δK
 δH
=P
− MP = ;
L L 0
δL

therefore,

PK = λMPK

PL = λMPL, and
PK MPK
=
PL MPL

M PL
,
Multiplying both sides of the last expression by
PK

MPL MPK MPL M PL MPL MPK

. PK = . , or , or = ,
PK PL MPL PK PK PL PK

which is the least-cost condition. In a constrained minimization problem such

as the above, the undetermined multiplier, λ, represents marginal cost, since
δH
=λ
δ QO

If the problem is to obtain the highest output for a given budget, we have then
maximize Q = f(K,L) subject to a total cost constraint. Using Lagrange’s
method again, we have

Maximize Q = f(K,L)

Subject to TC = K(PK) +L(PL) = TCO,

whereTCo is a given level of total cost or budget. The Lagrangian function is

J = f(K,L) – λ[K(PK) +L(PL) - TCO]

Setting the first-order partial derivatives equal to zero, we have

δJ
= f K − λPK = 0
δK
 δJ
= f L − λPL = 0
δL
δJ
= − K ( PK ) − L( PL ) + TCO = 0
δλ
Restating the first two of the above partials.

MPK - λPK = 0,

MPL – λPL = 0, and

MPK PK
=
MPL PL

M PL
yields
Multiplying both sides of the above expression by
PK
 MPK MPL
=
PK PL

In this case λ is interpreted as the marginal product per shilling spent on

δJ
additional inputs, since =λ.
δ TC

3.8 Effect of an Input Price Change

A change in the price of one of the two inputs will lead to substitution off the
input that has be- come relatively cheaper for the one that has be- come
relatively more expensive. For example if the price of labour rises capital will
become cheaper relative to labour and will be substituted for it. In Figure 4.1,
a large increase in the price off labour is used to illustrate such a substitution.
Initially, the firm is at point A where isocost line C1C1' is tangent to isoquant Il.
A large increase in the price of labour shifts the foot of the isocost line inward
to C1”. The isotope line is now C1C1'', and the budget is not sufficient to
produce I1 of output. The firm must increase the budget so that the isocost line
shifts from C1C1'' to C2C2' if output is to continue to be at level I1.

However, because of the change in the input price ratio (slope of the isocost
line) the combination of inputs at point B will now be the least cost
combination. Capital use will be increased and the use of labour will be
reduced.

Something similar to the preceding example has occurred in the Nigeria

Banking industry in recent years. As wage rates have risen it has become
increasingly attractive to substitute robot-type machinery (ATM) for human
labour. Actually two forces have been operating in this case. Not only have
wage rates risen but technological change has made it possible to serve more
customers relatively cheap. Both of these input price changes would tend to
increase the slope of the isocost line as in Figure 4-1.
Figure 4.2: Capital-Labour Substitution in Response to Input Price

Change
 If the firm is initially at point A and the price of a unit of labour (PL) rises, in
the long run it will be rational to substitute capital for labour and move to
point B on isocost line C2C2'. Since C2 is greater than C1 and PK has not
changed more is spent to produce I1 at B than at the original cost-
minimization point, A.

3.9 The Expansion Path

If input prices are given and do not change, it is possible to trace a path of
least-cost input combinations in the isoquant diagram. This path, called the
expansion path, can be obtained by moving the isocost line outward in parallel
fashion and locating points of tangency with successively higher isoquants.

The Expansion Path is the path of tangencies between isoquants and isocost
lines for a given input price ratio. It shows how the firm would expand in the
long run.

Figure 4.3 shows an isoquant diagram with ridge lines (0F and 0G) and an
expansion path. The expansion path, ABCDE, is developed by increasing the
firm’s budget from C1 through C5 and locating the tangencies of successive
parallel isocost lines with isoquants I1 through I5. The path ABCDE is the
expansion path for the ratio of input prices reflected by the slope of the isocost
lines shown in the diagram.

If the input price ratio were to change a new expansion path would result. You
can easily prove this fact for yourself by passing a straightedge (notecard or
pencil) through the diagram in Figure 2-12 and keeping its slope constant but
different from that of the given isocost lines. You will develop a path of
tangencies that is different than the path ABCDE.

3.10 Relationship of the Expansion Path to Long-Run Cost

The relationship between the firm’s cost data and production analysis is
thoroughly discussed in the next module- Theory of Cost. For the long run, all
of the information needed to describe the way the firm's cost varies as output is
increased can be obtained from the isoquant diagram. That is with input prices
given each combination of output level and total cost that the rational firm will
produce corresponds to a point on the expansion path.

For example, in Figure 4.2, if I1 = 100 units of output and C1C1' is the isocost
line for a budget of N1,000, point A tells us that it will cost the firm N1,000 to
produce 100 units of product. Its per unit or average cost of production will be
N1000
= N10 . In other words, the 100 units of output will cost N10 each to
100

produce. How the firm’s total and per unit costs change as it increases its
output in the long run will depend on the nature of the cost-output
combinations at other points, such as B,C,D, and E, that lie further out on the
expansion path. For example if at point D, C4C4' represents a budget of N4,000
and I4 = 250, the firm’s per unit cost would be higher at the 250-unit level of
output than at the 100-unit level, since N4,000/250 = N16.

Figure 4.3. Derivation of the Firm’s Expansion Path

For a given production function and given input prices the firm's expansion
path is derived by finding all points of tangency between successive parallel
isocost lines and the isoquants. Thus the line connecting points A, B, C, D,
and E is an expansion path. It shows all least cost input combinations in the
PL
long run, given a specific input price ratio, .
PK

The precise behaviour of long-run total and per unit cost as output increases
along the expansion path will depend on the mathematical properties of the
firm’s production function. These properties are best discussed in the context of
the long-run cost curves of the firm, a subject to be taken up in Theory of Firm
Cost. At this point it is sufficient to know that the data which describe the
relationship between a firm's output and its production cost in the long run are
obtained from points on the firm's expansion path.
 SELF-ASSESSMENT EXERCISE 1:

Explain how short run expansion path differs from a long run expansion path.

4.0 CONCLUSION

The condition for long-run cost minimization or output maximization in the

MPL MPK
= . This states that the marginal product of one
two input case is
PL PK

shilling’s worth of labour is equal to that of one shilling’s worth of capital.

When
this condition holds at a point of tangency between an isocost line (budget line)
and an isoquant, the firm will not be able to reduce cost by substituting one
input for the other. Conversely, it will not be able to increase output without
spending more money on inputs.
PL
, the path of tangency points between isocost
For a given input price ratio
PK
line and isoquants is called an expansion path. The firm’s long-run cost data are
generated from points on this path.

In the two-input case, capital (K) is the short-run fixed input. The firm can increase
output only by adding more of the variable input, labour (L) to the fixed amount
of capital.