Course: Advanced Microeconomics (805)

Semester: Spring, 2020

Assignment No. 1
Q.No.1 Discuss the markup rule for price determination and illustrate the subjective estimation of
desired price.
The price determination involves two distinct stages. First, the firms defines the price hat it would like to charge
(P) in order to cover its total costs when its plant is operated within its optimal range of capacity and earn a
(subjectively determined level of) ‘reasonable’ profit.
Secondly, the firm compares its estimated price with the level of price at which entry would occur, and sets the
price at a level (P*) which would effectively deter entry. Let us examine this procedure of price determination
in some detail.
SUBJECTIVE ESTIMATE OF THE ‘DESIRED’ PRICE:
The firm uses the ‘mark-up’ rule
P = AVC + GPM
The average variable cost (AVC) is assumed known to the firm with certainty. The firm concentrates on the
straight stretch of the SAVC curve which represents normal utilization of its plant capacity. The firm looks at its
long-run position and aims at the long-run profit maximization.
However, given the uncertainty in the environment, the firm bases its price on the short-run AVC; the firm
believes that its costs will not increase if it expands its scale (in the long run) and probably they will be lower
than in the short run. Thus the short-run AC is thought by businessmen to be a good approximation to the long-
run average cost.
The gross profit margin will cover the average fixed cost (AFC) and yield a normal profit
GPM = AFC + NPM
where NPM = net profit margin. The AFC element is determined by dividing the total fixed cost (TFC) by a
‘planned’ or ‘budgeted’ or ‘normal’ level of output (X*). This is a level of output (within the range for which
the plant has been set up) which the firm expects to produce and sell with normal utilization of its plant. Thus
AFC = TFC / X*
where X* = ‘planned’, or ‘budgeted’, or ‘normal’ output.
The net profit margin is assumed to be known to the established firms ‘as a matter of experience’: it should
yield a ‘fair’ return on capital (so that capital keeps flowing regularly in the industry for investment in the long
run) and cover all risks peculiar to the product. For an already-produced commodity, firms have formed a fair
view of what the net profit margin is from their past experience. For a new product the firm is assumed to make
a fair judgement about what the NPM is ‘safe’, in the sense of not attracting entrants.
The addition of AVC, AFC and NPM gives an estimate of the ‘desired’ price, that is, the price which the firm
would wish to charge if it is to cover all its costs (with a normal utilization of its plant) and make what it thinks
to be a normal profit.
ACTUAL PRICE SETTING:

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 Course: Advanced Microeconomics (805)
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However, the thus estimated price will not necessarily be charged. The ‘desired’ or ‘standard’ price will be
taken as the initial basis of the price that will actually be charged (P*). The level of actual price depends mainly
on the threat of potential entry (potential competition). Actual competition by existing firms is resolved by
either tacit collusion or by price leadership. Tacit collusion takes various forms.
Typically it is realized within trade associations, which publish industry-wide average-cost information by
product line. This information then becomes, by the common consent of the firms belonging to the particular
trade association the basis of price calculations.
When firms in the industry have widely different costs, pricing on the basis of average costs by each firm
independently may result in market instability and price wars. The ‘orderly co-ordination’ and functioning of
the industry is often attained by price leadership. The price leader is among the largest firms with the lowest
costs. The less efficient firms will be effectively price-takers. The price leader makes his price calculations
according to the average-costing rule, but will actually charge a price, P, which depends
(a) On potential competition
(b) On general economic conditions (booming or depressed business).
Thus, if there are barriers to entry, P* will be higher than the normal price (P), and the price leader (and
possibly other less efficient firms) will be making abnormal profit. However, if the threat of potential entry is
strong, the quoted price (P*) will be equal to the leader’s normal price (P), who will be earning just normal
profits. Thus the effective (realized) gross profit margin is competitively determined, by the threat of potential
entrants.
There is also evidence that the gross profit margin is readjusted when an entrant charges a lower price, and
when the general market conditions deviate from the normal in a sellers’ market a higher GPM is often charged
while in periods of depressed trade the GPM is downward readjusted (see below).
The determination of price in our ‘representative’ average-cost pricing model. It should be stressed that the
horizontal lines are not demand curves, but show the price that would be charged under certain conditions. At
this price the firms would be prepared to sell whatever they could produce with their plant capacity. Their sales
in any one period is ultimately determined by their ‘goodwill’.
The SATC curve includes the net profit margin which the firms consider normal for the particular product. The
price leader, given his cost structure, would normally desire to charge the price P which would cover his SAVC
and his ‘normal gross profit margin’ (ab). At this price the firm leader would be prepared to sell what the
market would take. (It should be noted that P is calculated on the assumption that the budgeted output will be
X*.)
If barriers to entry exist (or sometimes in persistent booming trade) the leader would charge the price P* which
would yield abnormal profits (at outputs equal or greater than the budgeted output) clearly the effective GPM at
P* is ac > ab. If potential competition (threat of entry) is strong (or sometimes in periods of depressed business)

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 Course: Advanced Microeconomics (805)
Semester: Spring, 2020
the leader would actually charge the price P** (lower than the ‘desired’ or ‘initial-base’ price P) and at this
price his effective GPM would be ad, which is smaller than the desired one ab.
The average-cost pricing model apparently discards demand curves. Price is based on the costs of the firm and
in particular on the short-run costs, since the long-run costs are blurred with uncertainty. If the product is
technically homogeneous there will be a unique price in the market in the long run.
However, if products are differentiated (either with brand names, or in style and quality) there will be a cluster
of prices in the industry, reflecting the differences in costs or the degree of strength of the preferences of the
customers.
Q.No.2 How does a growth maximizing firm achieve its objectives?
Profit Maximisation. The most basic model of a firm assumes firms wish to maximise their profit. They will
do this by increasing revenue (price * quantity sold) and reducing costs. Higher profits enable a firm to pay
higher wages, more dividends to shareholders and survive an economic downturn. Many other objectives such
as corporate image an increasing market share can be a way to maximise long-term profit.
Growth Maximisation. An alternative to profit maximisation is for a firm to try and increase market share and
increase the size of the firm. They can do this by cutting price and increasing sales. Growth maximisation may
come at the expense of lower profits. For example, starting a price war can lead to lower profits but enable
higher sales. However, increasing market share can be a way to increase profits in the long-term. A firm like
Walmart and Amazon have often pursued this goal of maximising market share. It gives a strong position to
dominate the market in the future.
Social / Ethical concerns. A firm may not be motivated by money but may seek to offer a service to the local
community. They may voluntarily take decisions which help the environment / local community.  Many big
firms now place a key role in promoting their ethical policies; arguably there may also be some marketing
benefits to promoting ethical and social concerns. It could have a tie-up with profit maximisation.
Corporate Image. Related to social/ethical concerns is the image/brand of a firm. It may wish to cultivate a
certain image and brand. Google – ‘do no evil. BP – “Beyond Petroleum”. Body Shop ‘leader in human and
animal rights.’ This corporate image may be part of a business strategy to maximise profits, but it could also be
a genuine desire to promote altruistic goals.
Stakeholders Well Being. A firm may also be concerned about the welfare of its stakeholders – suppliers,
workers and customers. For example, giving training and long-term job security to its workers. Co-operative
businesses are founded on the goal of sharing proceeds of business with whole community – customers and
workers.
Survival. For many businesses, it seems a matter of surviving – breaking even. In desperate times, firms may be
forced to sell off assets to keep their creditors at bay. For many small local businesses struggling in a highly
competitive market, survival may be the best they can hope for. In a way survival strategies is a form of profit

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 Course: Advanced Microeconomics (805)
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maximization as survival will still involve trying to increase revenue and reduce costs.
Another issue for firms is:
Profit Satisficing. This is a situation where there is a separation of ownership and control in a firm. The owners
(shareholders) wish to maximise profit, but the managers and workers don’t feel the same incentive. Therefore,
they do enough to keep the owners happy but then pursue other objectives such as having a good time at work.
BEHAVIOURAL THEORIES AND OBJECTIVES OF FIRMS
In recent years, behavioural economics has looked at psychological influences which can explain consumer
behaviour. Behavioural economics suggests economics has been too narrow in reducing owners to rational
profit maximisers. In the real world, profit is only one motivating factor. Business owners and workers may
value enjoying work, the prestige of a good company and make irrational decisions based on emotion, e.g.
keeping the family business going in one direction because of tradition.
FUNCTIONAL OBJECTIVES OF FIRMS
A functional objective of a firm is achievable goals or targets of different parts of a business structure as it tries
to achieve wider business objectives.
Examples of Functional Objectives
 Minimise costs. This may involve better management of raw materials and supplies, e.g. implementing
just in time management and stock control.
 Raise profile of business. A successful marketing strategy to raise brand awareness and increase sales.
 Improving Staff Loyalty and Motivation. Human resource department might find ways to promote a
greater feeling of worker loyalty and willingness to work for company. For example, giving workers
targets and rewards for achieving them. This can help the objectives of worker satisfaction and in the
long run, contribute to the improved performance of the firm.
 Development of Products. No market is static, therefore a firm will need to find ways to improve the
quality and uniqueness of its market.
 Increase Market Share. An objective may be to increase sales and take market share from other firms,
e.g. it may try and do this through a selective price war.
FUNCTIONAL OBJECTIVES AND BUSINESS STRATEGIES
To achieve functional objectives, a firm may use different business strategies. For example, if the firm has an
objective to reduce staff turnover, it may pursue a new strategy of employer feedback where the firm gives staff
the opportunity to have a say in the running of the business.
 An objective to increase sales could be achieved by a marketing strategy to raise brand awareness.
FUNCTIONAL OBJECTIVES AND CORPORATE OBJECTIVES.
A corporate objective is something like profit maximisation or diversification of business. These objectives are
quite general. Functional objectives help these to become a reality. e.g. to achieve the maximum rate of return
for shareholders, firms may need practical functional objectives such as increasing sales.

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 Course: Advanced Microeconomics (805)
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Sometimes there is an overlap of objectives. For example, seeking to increase market share, may lead to lower
profits in the short-term, but enable profit maximisation in the long run.

PROFIT MAXIMISATION
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit means:
 Higher dividends for shareholders.
 More profit can be used to finance research and development.
 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers
See more on: Profit maximisation
ALTERNATIVE AIMS OF FIRMS
However, in the real world, firms may pursue other objectives apart from profit maximisation.
1. PROFIT SATISFICING

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 Course: Advanced Microeconomics (805)
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 In many firms, there is a separation of ownership and control. Those who own the company
(shareholders) often do not get involved in the day to day running of the company.
 This is a problem because although the owners may want to maximise profits, the managers have much
less incentive to maximise profits because they do not get the same rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the shareholders happy, but then
maximise other objectives, such as enjoying work, getting on with other workers. (e.g. not sacking them)
This is the problem of separation between owners and managers.
 This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers share options
and performance related pay although in some industries it is difficult to measure performance.
 More on profit-satisficing.
2. SALES MAXIMISATION
Firms often seek to increase their market share – even if it means less profit. This could occur for various
reasons:
 Increased market share increases monopoly power and may enable the firm to put up prices and make
more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries.
 Increasing market share may force rivals out of business. E.g. the growth of supermarkets have lead to
the demise of many local shops. Some firms may actually engage in predatory pricing which involves
making a loss to force a rival out of business.
3. GROWTH MAXIMISATION

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 Course: Advanced Microeconomics (805)
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This is similar to sales maximisation and may involve mergers and takeovers. With this objective, the firm may
be willing to make lower levels of profit in order to increase in size and gain more market share. More market
share increases its monopoly power and ability to be a price setter.
4. LONG RUN PROFIT MAXIMISATION
In some cases, firms may sacrifice profits in the short term to increase profits in the long run. For example, by
investing heavily in new capacity, firms may make a loss in the short run but enable higher profits in the future.
5. SOCIAL/ENVIRONMENTAL CONCERNS
A firm may incur extra expense to choose products which don’t harm the environment or products not tested on
animals. Alternatively, firms may be concerned about local community / charitable concerns.
 Some firms may adopt social/environmental concerns as part of their branding. This can ultimately help
profitability as the brand becomes more attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone – even if it does little to
improve sales/brand image.
6. CO-OPERATIVES
Co-operatives may have completely different objectives to a typical PLC. A co-operative is run to maximise the
welfare of all stakeholders – especially workers. Any profit the co-operative makes will be shared amongst all
members.
DIAGRAM SHOWING DIFFERENT OBJECTIVES OF FIRMS

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 Course: Advanced Microeconomics (805)
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 Q1 = Profit maximisation (MR=MC)

 Q2 = Revenue Maximisation (MR=0)
 Q3 = Marginal cost pricing (P=MC) – allocative efficiency
 Q4 = Sales maximisation – maximum sales while still making normal profit (AR=ATC)

Q.No.3 Compose the salient features of behavariol and traditional theory of firm.
The traditional theory conceives the firm as synonymous with the entrepreneur. The owner-businessman is at
the same time the manager of the firm. The ‘members’ of the firm are the entrepreneur and the owners of the
factors of production, whose demands are satisfied via money payments. Consequently there is no conflict since
the entrepreneur pays to the factors of production in his employment their market prices (opportunity cost).
The firm of the traditional theory has a single goal, that of profit maximisation. The behavioural theory
recognizes that the modern corporate business has a multiplicity of goals. The goals are ultimately set by the top
management through a continuous process of bargaining. These goals take the form of aspiration levels rather
than strict maximising constraints. Attainment of the aspiration level ‘satisfices’ the firm: the contemporary
firm’s behaviour is satisficing rather than maximising. The firm seeks levels of profits, sales, rate of growth
(and similar magnitudes) that are ‘satisfactory’, not maxima.

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 Course: Advanced Microeconomics (805)
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The behavioural theory is the only theory that postulates satisficing behaviour as opposed to the maximising
behaviour of other theories. Satisficing is considered as rational, given the limited information, time, and
computational abilities of the top management. Thus the behavioural theory redefines rationality: it introduces
the concept of ‘bounded’ or ‘limited’ rationality, as opposed to the ‘global’ rationality of the-traditional theory
of the firm.
The traditional theory of the firm initially assumed that in deciding the allocation of resources (within the firm)
the entrepreneur equates marginal revenue to opportunity cost. This behaviour implicitly assumes global
rationality, that is, perfect knowledge of all alternatives, examination of all possible alternatives and certainty
about future returns. Later theorists recognized uncertainty as a fact of the real business world and introduced a
probabilistic approach to the above decision rule for the allocation of internal resources.
The entrepreneur was assumed to be able to assign definite probabilities to future returns and he equated
expected returns with opportunity costs. Furthermore, later theorists recognised the fact that the entrepreneur
has limited knowledge, limited information, which is not costless, but is acquired at a cost.
The allocation of resources to search activity (activity aiming at acquisition of information) was assumed to be
decided by comparing expected profitability of the information with its cost. That is, search activity was treated
by the traditional theory as an activity, like all the other activities of the firm, which absorbs resources and
hence must be judged on marginalistic rules like the other activities.
In general, traditional theory postulated that the decisions about resource allocation are taken by comparing
marginal (expected) return to marginal cost. The probabilistic approach was attacked and other theories were
developed to cope with uncertainty. The most important of these theories is the theory of games, which,
however, has not as yet been generally accepted.
Cyert and March criticized the probabilistic-marginalistic behaviour of the traditional theory on the
following grounds:
Firstly, the traditional theory assumed continuous competition among all alternative resource uses. In the actual
world we observe local problem-solving rather than general planning for all activities of the firm
simultaneously.
Secondly, the traditional theory treats ‘search’ as another investment decision, that is, in terms of calculable
returns and costs. In reality, it has been observed that search is problem-oriented and is not decided on
marginalistic rules.
Thirdly, traditional theory assumes substantial computational ability of the firm projects are decided after
screening of all alternatives on the basis of detailed calculations of all direct and indirect benefits and costs.
Reality suggests that firms are of limited computational ability and do not make decisions on the basis of
detailed studies or marginalistic rules.
Fourthly, the traditional theory treats expectations as exogenously determined. In reality expectations are to a
large extent endogenous, being affected by various internal factors, for example, the desires-aspirations of

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 Course: Advanced Microeconomics (805)
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various groups, the information available and its flow through the various sections of the firm, and from past
attainments of the various groups and of the firm-organisation as a whole.
In the traditional theory there is no conflict of goals between the organisation and its individual members. In the
behavioural theory conflict among the various members of the coalition is inevitable. It is never fully resolved
at any one time. There is rather a continuous process of bargaining between members and the organisation, and
the conflict is quasi-resolved in any one period by money payments, slack adjustment, policy commitments,
delegation of authority (decentralisation of the decision-making activity), and by sequential attention to the
conflicting demands. Such means permit the firm to make decisions with inconsistent goals, and within a
continuously changing internal and external environment.
Unlike the traditional theory, Cyert and March distinguish two sources of uncertainty uncertainty arising from
changes in market conditions (tastes, products and methods of production), and uncertainty arising from
competitors’ behaviour. Market-originated uncertainty is avoided, according to the behavioural school, partly
by search activity, partly by maintaining R&D departments, and partly by concentrating on short-term planning.
Contrary to the traditional theory, Cyert and March postulate that the short run is much more important than the
long run.
In particular, so long as the environment of the firm is unstable (and unpredictably unstable) the heart of the
theory must be the process of short-run, adaptive reactions. It seems to us, however, that unless the long-run
goals are defined, any short-run description of the behaviour of the firm cannot attain the degree of generality
expected from a theory of the firm. Regarding the competitor-originated uncertainty, Cyert and March accept
that firms act within a ‘negotiated environment’, that is, firms adopt business practices of a collusive nature.
Thus, the behavioural theory is not applicable to non-collusive oligopolistic markets.
In the behavioural theory the instruments which the firm uses in the decision-making process are the same as
those of the traditional theory: output, price, and sales strategy (the latter including all activities of non-price
competition, such as advertising, salesmanship, service, quality). The difference lies in the way by which the
values of these policy variables are determined. In the traditional theory the firm chooses such values of the
policy variables which will result in the maximisation of the long-run profits. In the behavioural theory the
policies adopted should lead to the ‘satisficing’ level of sales, profits, growth and so on.
Cyert and March postulate that the firm is an adaptive organisation: it learns from its experience. It is not from
the beginning a rational institution in the traditional sense of ‘global’ rationality. In the long run the firm may
tend towards the ‘omniscient rationality’ of profit maximisation, but in the short run there is an adaptive process
of learning there are mistakes, trials and errors. The firm has a memory and learns through its past experience.
It seems strange to us that despite this ‘adaptive learning process’ the firm does not ever seem to acquire the
ability for long-run planning. The behavioural theory is basically a short-run theory. The determination of the
values of the instrumental variables (output, price, sales strategy) does not adequately take into account the
environment past performance and past conditions of the environment are crudely extrapolated into the future.

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 Course: Advanced Microeconomics (805)
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Q.No.4 What are the determinants for the price elasticity of demand for an output?
The price level of an item affects the demand for a good or service, and the price elasticity of demand can be
used to measure the sensitivity of a change in the quantity demanded of a good or service relative to a change in
price. The price elasticity of demand is calculated by dividing the percent change in the quantity demanded of a
good or service by its percent change in its price level.
 Many factors determine the demand elasticity for a product, including price levels, the type of product or
service, income levels, and the availability of any potential substitutes.
 High-priced products often are highly elastic because, if prices fall, consumers are likely to buy at a
lower price.
 Compared to essential goods, luxury items are highly elastic.
 Goods with many alternatives or competitors are elastic because, as the price of the good rises,
consumers shift purchases to the substitute items.
 Incomes and elasticity are related—as consumer incomes increase, demand for products increases as
well.
The following are the main factors which determine the price elasticity of demand for a commodity: 1. The
Availability of Substitutes 2. The Proportion of Consumer’s Income Spent 3. The Number of Uses of a
Commodity 4. Complementarity between Goods 5. Time and Elasticity.
DETERMINANT # 1. THE AVAILABILITY OF SUBSTITUTES:
Of all the factors determining price elasticity of demand the availability of the number and kinds of substitutes
for a commodity is the most important factor. If for a commodity close substitutes are available, its demand
tends to be elastic. If the price of such a commodity goes up, the people will shift to its close substitutes and as a
result the demand for that commodity will greatly decline.
The greater the possibility of substitution, the greater the price elasticity of demand for it. If for a commodity
substitutes are not available, people will have to buy it even when its price rises, and therefore its demand
would tend to be inelastic.
For instance, if the prices of Campa Cola were to increase sharply, many consumers would turn to other kinds
of cold drinks, and as a result, the quantity demanded of Campa Cola will decline very much. On the other
hand, if the price of Campa Cola falls, many consumers will change from other cold drinks to Campa Cola.
Thus, the demand for Campa Cola is elastic. It is the availability of close substitutes that makes the consumers
sensitive to the changes in the price of Campa Cola and this makes the demand for Campa Cola elastic.
Likewise, demand for common salt is inelastic because good substitutes for common salt are not available.
If the price of common salt rises slightly, the people would consume almost the same quantity of salt as before
since good substitutes are not available. The demand for common salt is inelastic also because people spend a
very little part of their income on it and even if its price rises it makes only negligible difference in their budget
allocation for the salt.

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 Course: Advanced Microeconomics (805)
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DETERMINANT # 2. THE PROPORTION OF CONSUMER’S INCOME SPENT:
Another important determinant of the elasticity of demand is how much it accounts for in consumer’s budget. In
other words, the proportion of consumer’s income spent on a particular commodity also influences the elasticity
of demand for it. The greater the proportion of income spent on a commodity, the greater will be generally its
elasticity of demand, and vice versa.
The demand for common salt, soap, matches and such other goods tends to be highly inelastic because the
households spend only a fraction of their income on each of them. When the price of such a commodity rises, it
will not make much difference in consumers’ budget and therefore they will continue to buy almost the same
quantity of that commodity and, therefore, the demand for them will be inelastic.
On the other hand, demand for cloth in a country like India tends to be elastic since households spend a good
part of their income on clothing. If the price of cloth falls, it will mean great saving in the budget of many
households and therefore they will tend to increase the quantity demanded of the cloth. On the other hand, if the
price of cloth rises many households will not afford to buy as much quantity of cloth as before, and therefore,
the quantity demanded of cloth will fall.
DETERMINANT # 3. THE NUMBER OF USES OF A COMMODITY:
The greater the number of uses to which a commodity can be put, the greater will be its price elasticity of
demand. If the price of a commodity having several uses is very high, its demand will be small and it will be put
to the most important uses and if the price of such a commodity falls it will be put to less important uses also
and consequently its quantity demanded will rise significantly.
To illustrate, milk has several uses. If its price rises to a very high level, it will be used only for essential
purposes such as feeding the children and sick persons. If the price of milk falls, it would be devoted to other
uses such as preparation of curd, cream, ghee and sweets. Therefore, the demand for milk tends to be elastic.
DETERMINANT # 4. COMPLEMENTARITY BETWEEN GOODS:
ADVERTISEMENTS:
Complementarity between goods or joint demand for goods also affects the price elasticity of demand.
Households are generally less sensitive to the changes in price of goods that are complementary with each other
or which are jointly used as compared to those goods which have independent demand or used alone. For exam-
ple, for the running of automobiles, besides petrol, lubricating oil is also used.
Now, if the price of lubricating oil goes up, it will mean a very small increase in the total cost of running the
automobile, since the use of oil is much less as compared to other things such as petrol. Thus, the demand for
lubricating oil tends to be inelastic. Similarly, the demand for common salt is inelastic, partly because
consumers do not use it alone but along with other things.
It is worth mentioning here that for assessing the elasticity of demand for a commodity all the above three
factors must be taken into account. The three factors mentioned above may reinforce each other in determining

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the elasticity of demand for a commodity or they may operate against each other. The elasticity of demand for a
commodity will be the net result of all the forces working on it.
DETERMINANT # 5. TIME AND ELASTICITY:
The element of time also influences the elasticity of demand for a commodity. Demand tends to be more elastic
if the time involved is long. This is because consumers can substitute goods in the long run. In the short run,
substitution of one commodity by another is not so easy. The longer the period of time, the greater is the ease
with which both consumers and businessmen can substitute one commodity for another.
For instance, if the price of fuel oil rises, it may be difficult to substitute fuel oil by other types of fuels such as
coal or cooking gas. But, given sufficient time, people will make adjustments and use coal or cooking gas
instead of the fuel oil whose price has risen. Likewise, when the business firms find that the price of a certain
material has risen, then it may not be possible for them to substitute that material by some other relatively
cheaper one.
But with the passage of time they can undertake research to find substitute material and can redesign the
product or modify the machinery employed in the production of a commodity so as to economise in the use of
the dearer material. Therefore, given the time, they can substitute the material whose price has risen. We thus
see that demand is generally more elastic in the long run than in the short run.
Q.No.5 What is the elasticity of substitution? How it is related to the ratio of capital total income of
labor’s total income?
The elasticity of substitution has interesting expressions when the two-input production function exhibits
constant returns to scale. Firstly, under constant returns to scale, Euler's Theorem implies that Y = ¦ KK + ¦ LL,
thus our expression becomes immediately:
s ={¦ L¦ KY}/{ KL(2¦ KL¦ L¦ K - ¦ LL¦ K2 - ¦ KK¦ L2)}
Now, recall once again, that if the production function ¦ is homogeneous of degree one in the factors (constant
returns), then the marginal product ¦ i is homogeneous of degree zero in teh factors. This implies, again by
Euler's Theorem, that:
¦ KKK + ¦ KLL = 0
¦ LKK + ¦ LLL = 0
so ¦ KK = -¦ KL(L/K) and ¦ LL = -¦ LK(K/L). Thus substituting in:
s ={¦ L¦ KY}/{ KL(2¦ KL¦ L¦ K + ¦ LK(K/L)¦ K2 + ¦ KL(L/K)¦ L2)}
={¦ L¦ KY}/{¦ KL(2¦ L¦ KKL + K2¦ K2 + L2¦ L2)}
={¦ L¦ KY}/{¦ KL(¦ KK + ¦ LL)2}
so, by Euler's Theorem again:
s =¦ L¦ KY/¦ KLY2
or simply:
s = ¦ L¦ K/¦ KLY

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 Course: Advanced Microeconomics (805)
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which is considerably more simple. This expression for the elasticity of substitution in the constant returns to
scale case was precisely the form in which it was first introduced by John Hicks (1932: p.117, 245).
Notice that this form implies that as ¦ KL increases, s declines. This has a very intuitive interpretation.
The easier it is to substitute labor for capital, then the less the marginal rate of technical substitution rises during
the process. This is precisely what the relation between ¦ KL and s expresses: namely, the less an increase in the
amount of labor L raises the marginal product of capital ¦ K, the more is the ease and thus the elasticity of
substitution.
Recall that when we have constant returns to scale, then we can express a production function Y = ¦ (K, L) in
intensive form as y = f (k), where y = Y/L and k = K/L. We also know that ¦ K = f k and ¦ L = y - f kk.
Thus, ¦ L/¦ K = (y-f kk)/f k. As a result, the elasticity of substitution can be written in intensive form as:
s = d ln (K/L)/ d ln (¦ L/¦ K) = d ln k/ d ln ((y-f kk)/f k)
or:
s = [d ln ((y-f kk)/f k)/d ln k]-1
= {[d((y-f kk)/f k)/dk]·[kf k/(y-f kk)]}-1
Now, since d[(y-f kk)/f k]/dk = -f kkf kk - f kk[y - f kk]}/f k2 thus:
s = {[-f kkf kk - f kk[y - f kk]}/f k]·[k/(y-f kk)]}-1
which simplifies to:
s = {- yf kkk/f k(y-f kk)]}-1
or simply:
s = - f k(y-f kk)/yf kkk
which holds for any two-input constant returns to scale production function.
An alternative convenient expression of s in the constant returns case is the following. Recall that since ¦ L = y
- f kk, then d¦ L/dk = -f kkk. Thus, since (dy/d¦ L)·(d¦ L/dk) = f k, then dy/d¦ L = -f k/f kkk. As a result:
d ln y/d ln ¦ L = (dy/d¦ L)·(¦ L/y)
= -[f k/f kkk]·[(y - f kk)/y]
= -f k(y - f kk)/yf kkk
= s
by the expression given earlier. Thus the elasticity of substitution of a constant returns to scale production
function can be expressed as the elasticity of output per capita with respect to the marginal product of labor.

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