Lecture-2: Multivariable Optimisation

Techniques-Partial Differentiation, Hessian

Matrix
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 Conditions for Maximum and Minimum Values

Quick Recap

Steps to ascertain the Maximum or Minimum Value of a Function:

Step-1: Ascertain f '(x) and set it equal to 0 and calculate the value of x
Step-2: Ascertain f ''(x) and substitute the value of x as calculated in Step-1.
Step-3: If f ''(x) < 0, then the function has a minimum point at that value of x,
which gives the f ''(x) < 0; else If f ''(x) > 0, then the function has a maximum
point at that value of x, which gives the f ''(x) > 0
Optimisation: Multi-Variable Case

Q
Optimisation: Multi-Variable Case- Introduction
 Optimisation: Multi-Variable Case

Optimisation implies maximum or minimum. An optimal value can be a maximum value

or a minimal value depending upon whether we aiming at maximization or minimization
problem. Example, in case of profit maximization, we would like to find out the maximum
level of output that can lead to profit maximization; similarly, in case of cost
minimization, we would like to find out the minimum level of inputs required, which can
lead to minimum cost.
 Optimisation: Multi-Variable Case [Unconstrained]

Single Variable

Steps to ascertain the Maximum or Minimum Value of a Function:

Step-1: Ascertain f '(x) and set it equal to 0 and calculate the value of x
Step-2: Ascertain f ''(x) and substitute the value of x as calculated in Step-1.
Step-3: If f ''(x) < 0, then the function has a minimum point at that value of x, which gives the f ''(x) < 0; else
If f ''(x) > 0, then the function has a maximum point at that value of x, which gives the f ''(x) > 0
 Optimisation: Multi-Variable Case [Unconstrained]

Single Variable

Steps to ascertain the Maximum or Minimum Value of a Function:

Step-1: Ascertain f '(x) and set it equal to 0 and calculate the value of x
Step-2: Ascertain f ''(x) and substitute the value of x as calculated in Step-1.
Step-3: If f ''(x) < 0, then the function has a minimum point at that value of x, which gives the f ''(x) < 0; else
If f ''(x) > 0, then the function has a maximum point at that value of x, which gives the f ''(x) > 0

Multi Variable
 Optimisation: Multi-Variable Case [Unconstrained]

Multi Variable

Steps to ascertain the Maximum or Minimum Value of a Function:

Step-1: Ascertain f '(x) & f’(y) and set it equal to 0 and calculate the value of x & y

Step-2: d  df → a
SOC f xx =   11
dx dx
 
d 
f =  df → a H1 = a11
xy   12
dy  dx   a11 a12 
d  df  H2 = 
f = →a a 21 a22 
yx   21
dx dy
 
d  df 
f yy =  → a 22
dy dy
 
 Optimisation: Multi-Variable Case [Unconstrained]

Multi Variable

= d  df  → a11 = d  df  → a23 H =a
fxx dx dx 
f yz dz dy


1 11
    a a12 
H 2 =  11
= d  df  → a12 = d  df  a a 
fxy dy dx

fzx dx dz  → a31


 21 22 

d  df  d  df  a11 a13 
f = →a f = →a a12
xz   13 zy   32 H = a a a 
dz  dx  dy  dz  3  21 22 23 
 a31 a33 
= d  df  → a21 = d  df  a32
f yx dx dy fzz dz dz  → a33
   
d  df 
f = →a
yy
dy  dy  22
 d  d 
f =  df → a f =  df → a
xx
dx  dx  11 yz
dz  dy  23
   
d  d 
f =  df → a f =  df → a
xy
dy  dx  12 zx
dx  dz  31
   
d  d 
f =  df → a f =  df → a
xz
dz  dx  13 zy
dy  dz  32
   
d  d 
f =  df → a f =  df → a
yx
dx  dy  21 zz
dz  dz  33

   
d  df 
f = →a
yy
dy  dy  22
Optimisation: Multi-Variable Case [Unconstrained]
Optimisation: Multi-Variable Case [Unconstrained]

Q
 Optimisation: Multi-Variable Case [Unconstrained]
Example-3: Check whether the following polynomial is maximum or minimum
Good Question
−x 3 + 3xz + 2 y − y2 − 3z 2
Optimisation: Multi-Variable Case

Q
Optimisation: Multi-Variable Case [Constrained]

Q
Optimisation: Multi-Variable Case [Constrained]

Q
Optimisation: Multi-Variable Case
Optimisation: Multi-Variable Case

Q
Homogenous & Homotheticity
 Homotheticity

Q
 Homotheticity

Note: All homogenous

functions are homothetic
but not all homothetic
functions are homogenous.
Lecture-3: Cardinal & Ordinal
Utility Analysis
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
Free Sessions
 Theories of Utility

There are five main utility theories

(1) introspective cardinalist—Marshall (1890)
(2) introspective ordinalist—Hicks (1934)
(3) behaviourist ordinalist—Samuelson (1938)
(4) behaviourist cardinalist—Morgenstern-Neumann (1947)
(5) introspective cardinal-revivalist-Armstrong (1958)
 Cardinal & Ordinal Utility Analysis

Consumer Behaviour Analysis

It analyses how a consumer chooses among different available goods and services given his income and prices
of goods and services, in order to achieve the maximum satisfaction level, which is also termed as consumer
equilibrium point.
There are two approaches to determine and study consumer equilibrium
• Cardinal Approach:
✓ Given by Alfred Marshall in his book Principles of Economics (1890)
✓ Satisfaction can be measured in absolute numbers
✓ Standard unit is utils
 Cardinal & Ordinal Utility Analysis

Consumer Behaviour Analysis

It analyses how a consumer chooses among different available goods and services given his income and prices
of goods and services, in order to achieve the maximum satisfaction level, which is also termed as consumer
equilibrium point.
There are two approaches to determine and study consumer equilibrium
• Cardinal Approach:
✓ Given by Alfred Marshall in his book Principles of Economics (1890)
✓ Satisfaction can be measured in absolute numbers
✓ Standard unit is utils
• Ordinal Approach:
✓ Originally introduced by Pareto in 1906
✓ Satisfaction cannot be measured in absolute numbers, indeed can be ranked in order of preferences
✓ Indifference Curve Analysis (initially developed by Francis Ysidro Edgeworth in 1881). Later on
Pareto was the first one to actually draw these curves in 1906. Hicks and R.G.D. Allen published their
comprehensive work based upon Edgeworth, Pareto & Slutsky in 1934
✓ Revealed Preference Theory (Paul Samuelson- 1938)
 Cardinal & Ordinal Utility Analysis
Utility
• Want satisfying power of a Commodity
• is a Psychological Phenomenon.
Features of Utility
• Utility is Subjective: It is mental satisfaction. Example, drunkard has utility for liquor, but for a teetotaler, liquor has
no utility.
• Utility is Relative: It varies with time, place, persons.
• Utility is Not Necessarily Useful: Cigarettes is not useful, but they satisfy the utility of a smoker.

Utility Satisfaction
 Cardinal & Ordinal Utility Analysis
Utility
• Want satisfying power of a Commodity
• is a Psychological Phenomenon.
Features of Utility
• Utility is Subjective: It is mental satisfaction. Example, drunkard has utility for liquor, but for a teetotaler, liquor has
no utility.
• Utility is Relative: It varies with time, place, persons.
• Utility is Not Necessarily Useful: Cigarettes is not useful, but they satisfy the utility of a smoker.

Utility Satisfaction
• utility is the cause • satisfaction is the effect.

• utility is the inherent ability of the • satisfaction is what comes from the
commodity to satisfy a want consumption of that commodity.

• utility is already present in the good • satisfaction is not obtained if not

irrespective of whether it is consumed or not consumed.
 Cardinal & Ordinal Utility Analysis
1699: Development of law of demand, which was for the first time stated by Charles Davenant in 1699.
There are sufficient instances which indicates that George King during 17th century also demonstrated the law
of demand.
1890: However, it was Alfred Marshall, who documented the graphical presentation of law of Demand in his
book ‘Principles of Economics, 1890’. In his masterpiece, he has reconciled demand and supply into a single
analytical framework and compared upper blade and under blade of a scissor with demand and supply to
determine price.
1738: The term ‘Utility’ was coined by Daniel Bernoulli in 1738 (paper drafted in 1731) while he was
attempting to answer St. Petersburg Paradox (we will deal with this topic during Risk Analysis).
1780: Later, in the year 1780, Jeremy Bentham (who is regarded as Father of Utilitarianism) advocated utility
principle in his book An Introduction to the Principles of Morals and Legislation. Bentham was the first
philosopher to develop and defend the utilitarian theory of ethics. He was followed by John Stuart Mill.
1854: Law of diminishing marginal utility was first formulated by Herman Gossen in 1854 who stated: “The
magnitude of one and the same satisfaction, when we continue to enjoy it without interruption continually
decreases until satisfaction is reached.” He was the first one to introduce the concept of marginal utility. But
remained unnamed till Marginalist Revolution.
1881: Francis Ysidro Edgeworth presented the indifference curve
 Cardinal & Ordinal Utility Analysis
First Generation of Marginalist Revolution: Late 19th Century.
1. Stanley Jevons was inspired and influenced by Bentham and Mill’s work and published a paper in 1862 followed by
the book ‘The Theory of Political Economy in 1871’ emphasizing that value depends upon utility.
2. Carl Menger from Austrian’s School published a book Principles of Economics in 1871
3. Leon Walras published Éléments d'économie politique pure in 1874.
Second Generation of Marginalist Revolution: Early 20th Century
This phase includes economists such as Marshall, Wicksteed, Eugen von Bohm-Bawerk, Pareto, and they took forward
the marginalist revolution.
1890: Marshall continued Gossen’s Law of Diminishing Marginal Utility by stating that the additional benefit which a
person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has.
Two results follow:
1. Total utility, as the happiness derived of consuming some commodity increases, when the consumer consumes more
of it.
2. The marginal utility, as the speed with which total utility increases or the satisfaction which every next unit consumed
brings to the consumer, decreases.
 Cardinal & Ordinal Utility Analysis
1906: Pareto was the first one to actually draw the indifference curves in 1906.
1915: Slutsky derived a theory of consumer’s choice based upon the properties of indifference curve but since it was the
war time, the work didn’t get notice.

1934: Hicks and R.G.D. Allen published their comprehensive work based upon Edgeworth, Pareto & Slutsky in 1934.
Hicks introduced the concept of diminishing marginal rate of substitution in 1934.

1938: Revealed Preference Theory, it relies on the information collected by the researcher himself. It was propounded by
Paul Samuelson in 1938. This theory studies the behaviour of the People while they are making choices. This is why it is
also termed as Behaviourial Ordinal Utility Theory. Unlike Utility and IC analysis, this method is not introspective (self-
analysing).
 Cardinal & Ordinal Utility Analysis
1906: Pareto was the first one to actually draw the indifference curves in 1906.
1915: Slutsky derived a theory of consumer’s choice based upon the properties of indifference curve but since it was the
war time, the work didn’t get notice.

1934: Hicks and R.G.D. Allen published their comprehensive work based upon Edgeworth, Pareto & Slutsky in 1934.
Hicks introduced the concept of diminishing marginal rate of substitution in 1934.
 Cardinal & Ordinal Utility Analysis
1906: Pareto was the first one to actually draw the indifference curves in 1906.
1915: Slutsky derived a theory of consumer’s choice based upon the properties of indifference curve but since it was the
war time, the work didn’t get notice.

1934: Hicks and R.G.D. Allen published their comprehensive work based upon Edgeworth, Pareto & Slutsky in 1934.
Hicks introduced the concept of diminishing marginal rate of substitution in 1934.
 Marginal Utility Analysis [Marshall in 1890]
Assumptions:
1. Cardinal Measurability of Utility: Utility is a Measureable & Quantifiable Entity.
2. Money is the Measuring Rod of Utility: The amount of money which a person is prepared to pay for a
unit of good rather than go without it is a measure of utility derived
3. Constancy of the Marginal Utility of Money
4. Hypothesis of Independent Utility: Total utility derived from total collection of goods is the sum total of
separate utilities of the good.
5. Law of Diminishing Marginal Utility: The additional benefit which a person derives from a given
increase in stock of a thing diminishes with every increase in the stock that he already has.
6. Marginal Utility of every good is independent.
7. Every unit of the good so consumed is of same quality & size.
8. There is a continuous consumption of the good.
9. Suitable quantity of the good is being consumed.
10. No change in the income, tastes, fashion and habits of the consumer.
11. No change in the price of the substitutes and complements
Marginal Utility Analysis [Marshall in 1890]

✓ When TU rises at an decreasing rate, MU falls MUn = TUn − TU

✓ When TU reaches its maximum point, MU is 0 T
MU =
✓ When TU starts falling at decreasing rate, MU
continues to falls and becomes negative

Gossen First Law (By Herman Heinrich

Gossen 1850s)
The additional utility which a person derive
from the consumption a commodity
diminishes, that is Total Utility increase at a
diminishing rate. In short, MU continues to
diminish.
Cardinal Approach in One Good Case & Two Good Case:

MUx
MUm =
Px

MUm = MUx = MUy

Px Py

Gossen Second Law (By Herman Heinrich Gossen 1850s)

At equilibrium an agent will allocate expenditures so that the
ratio of marginal utility
to price (marginal cost of acquisition) is equal across all
goods and services.
Law of Equi-Marginal Utility
Cardinal Approach in One Good Case & Two Good Case:

MUx
MUm =
Px

MUm = MUx = MUy

Px Py

Gossen Second Law (By Herman Heinrich Gossen 1850s)

Gossen's Third Law is At equilibrium an agent will allocate expenditures so that the
that scarcity is a
ratio of marginal utility
precondition for economic
value. to price (marginal cost of acquisition) is equal across all
goods and services.
Law of Equi-Marginal Utility
Cardinal Approach in One Good Case & Two Good Case:
FOC & SOC for Consumer’s Equilibrium (One Good Case)

MUx
MUm =
Px
 Cardinal Approach in One Good Case & Two Good Case:
FOC & SOC for Consumer’s Equilibrium (One Good Case)

MUx
MUm =
Px

Let a consumer consumes q1 units of a good and he derives utility as:

U1 = U1 ( q1 )  Total Utility
U ' = U ' ( q ) = dU1  Marginal Utility, such that;
1 1 1
dq1
dU1 d 2U 1
 0 and  0  TU is rising at a decreasing rate and MU is positive but decreases as
2
dq1 dq 1
more and more units of q1 are being consumed.
 Cardinal Approach in One Good Case & Two Good Case:
Marginal Utility of Money
Marginal utility of money refers to the valuation of an unit of rupee for a consumer. It is a subjective concept and the
consumer himself defines the marginal utility of money. The marginal utility of money is assumed to be constant in the
Utility Analysis.
Cardinal Approach in One Good Case & Two Good Case:
Derivation of Demand Curve under Marshallian Utility Approach
 Cardinal Approach in One Good Case & Two Good Case:
Derivation of Demand Curve under Marshallian Utility Approach

As per the FOC, MUx = ʎPx or Px = MUx/ʎ

Let Px rises, MUm i.e. ʎ is constant by assumption, this
implies the LHS is greater than RHS. To bring back the
equilibrium, the RHS component should rise. This implies
MUx should rise. This further implies that MUx can only
rise, when quantity consumed of x is reduced due to
LDMU. Hence, Px when rises, X falls or vice-versa.
MUx
Px =  Inverse Demand Function

 Cardinal Approach in One Good Case & Two Good Case:
Nature of Demand Curve under Marshallian Approach

As per the FOC, MUx = ʎPx or Px = MUx/ʎ

Let Px rises, MUm i.e. ʎ is constant by assumption, this
implies the LHS is greater than RHS. To bring back the
equilibrium, the RHS component should rise. This implies
MUx should rise. This further implies that MUx can only
rise, when quantity consumed of x is reduced due to
LDMU. Hence, Px when rises, X falls or vice-versa.
MUx
Px =  Inverse Demand Function

 Cardinal Approach in One Good Case & Two Good Case:

Limitations
• Utility is not cardinally measurable
• MUm is not constant
• Utilities are not independent
• Fails to explain Giffen Paradox
• Marshall ignored income effect and can’t separate
Income Effect and Substitution Effect

As per the FOC, MUx = ʎPx or Px = MUx/ʎ

Let Px rises, MUm i.e. ʎ is constant by assumption, this
implies the LHS is greater than RHS. To bring back the
equilibrium, the RHS component should rise. This implies
MUx should rise. This further implies that MUx can only
rise, when quantity consumed of x is reduced due to
LDMU. Hence, Px when rises, X falls or vice-versa.
MUx
Px =  Inverse Demand Function

 Ordinal Approach
Ordinal Approach:
✓ Originally introduced by Pareto in 1906
✓ Satisfaction cannot be measured in absolute numbers, indeed can be ranked in order of preferences
✓ Indifference Curve Analysis (initially developed by Francis Ysidro Edgeworth in 1881). Later on Pareto was the
first one to actually draw these curves in 1906. Hicks and R.G.D. Allen published their comprehensive work based
upon Edgeworth, Pareto & Slutsky in 1934

Ordinal Approach
✓ Ordinal Approach postulates that a consumer cannot measure the satisfaction that he/she derives from the
consumption of a particular good or service. Further, it asserts that measurement of satisfaction in specific units is not
required. In fact, a consumer ranks different goods and services as per his/her preferences. In other words, it asserts that
a consumer takes his consumption decisions on the basis of the ranks assigned in order of his/her preferences.
 Indifference Curve [Special Cases]

Neutral Good: When a

consumer is indifferent
between having more or
less of the commodity

X normal & Y Neutral

X Neutral & Y Normal
Indifference Curves between Indifference Curves between Indifference Curves between
Bad and Good Neutral and Good Neutral and Good
 Indifference Curve [Special Cases]
Fixed Proportion or Leontief Consumption Function Linear Consumption Function

U (x, y) = min{ax, by}

The slope of the axis is then a/b.
 Indifference Curve [Special Cases]
Cobb Douglas Consumption Function Quasi Linear Consumption Function

U(x1, x2) = f(x1) + x2

It is linear in just x2 and is called
quasilinear.
E.g. U(x1, x2) = 2x1 1/2 + x2
U(x1, x2) = logx1 + x2
 Indifference Curve [Special Cases]
Quasi Linear Consumption Function

The marginal rate of substitution equals U(x1, x2) = f(x1) + x2

It is linear in just x2 and is called
quasilinear.
Observe that MRS only depends on x1, and not x2. This E.g. U(x1, x2) = 2x1 1/2 + x2
means that the indifference curves are vertical parallel U(x1, x2) = logx1 + x2
shifts of each other, as shown in figure 13. As a
consequence, preferences are convex if and only if v(x1)
is a concave function, so the marginal utility of x1
decreases in x1. As we will see later, quasilinear
preferences have the attractive property that the
consumption of x1 is independent of the agent’s income
(ignoring boundary constraints).
 Indifference Curve [Special Cases]
Satiation point is said to occur when MUx = 0 or MUy = 0. In the figure, after
ox1, the consumer is attaining the point of satiation in good x, where MUx < 0
becomes negative. After ox1, the good x is bad, but MUy > 0, so the MRSxy =
MUx/MUy > 0, which implies IC curve is upwards sloping. Similarly, after
point oy1, the good y becomes bad.
If both x and y becomes bad, then MUx < 0 and MUy < 0, then IC is negatively
sloped, but is concave to the origin. In this case, the consumer can attain higher
satisfaction by moving down to point S, which is termed as Bliss Point.

IC, Bliss Point and Point of Satiation

Bliss Point. Utility is maximised at (x1,

y1). Indifference curves are circles
around this bliss point.
Indifference Curve [Special Cases]

Constant Elasticity of Substitution (CES) Preferences

CES preferences have the form

where δ  0 and δ < 1. This utility function can approximate the above
examples. As δ → 0 the limit of the above utility function becomes
u(x1, x2) = ln x1 + ln x2
which is the same as Cobb-Douglas with equal exponents. As δ → 1,
the preferences approximate perfect substitutes. As δ → −∞, the
preferences approximate perfect complements.
The MRS is

The last expression is convenient since 1 − δ > 0. Substituting for x2 in

this equation and differentiating, one can show that MRS is decreasing
in x1, so the preferences are convex.
 Consumer’s Budget
The maximising behaviour of the consumer is constrained by his limited income. With only a limited income a consumer
cannot purchase all that he/she wants. The availability of consumption bundles to a consumer depends mainly on the
following two factors.
• Price of goods and services ( P )
• Income of the consumer ( M )
Given the income of the consumer and the prices of the goods and services, a consumer can purchase only those
combinations of goods and services such that his total expenditure on the goods and services is less than or equal to his
income.
Budget Set
A budget set represents those combinations of consumption bundles that are available to the consumer given his/her
income level and at the existing market prices. In other words, it represents those consumption bundles that the consumer
can purchase using his/her money income ( M ).
 Consumer’s Budget

Note: The use of ≤ sign in the constraint, implies that the total amount spent on two goods together should be less than or
equal to his/her given income level. In other words, a particular consumption bundle is available or affordable to a
consumer if the total money spent on both the goods is less than or equal to the total available money income.

The budget equation is of the following form

P1x1 + P2x2 = M
Solving for x2 :
P2x2 = M – P1x1

is the vertical intercept. It represents the amount of x 2 that the

consumer can purchase if he spends his entire income on good 2.
represents the slope of budget line. This is also called the price ratio .
The negative sign depicts the negative slope of the budget line from left
to right.
Cardinal & Ordinal Utility Analysis
 Cardinal & Ordinal Utility Analysis

It should be noted that all other points lying on the budget

line (such as point B and point C ) are inferior to ( x 1 * x
2 *) as they lie on a lower IC . Thus, the consumer can
rearrange his consumption and again reach equilibrium
where the marginal rate of substitution is equal to the
price ratio.
For example, at point B , MRS is greater than the price
ratio (i.e.
In this case, the consumer would tend to
move towards point E by giving up some amount of good
2 to increase the consumption of good 1.
Similarly, at point C , MRS is less than price ratio (i.e.

In this case the consumer would tend to move towards

point E by giving up some amount of good 1 to increase
the consumption of good 2.
 Do it on your own

For graphs in Panel A and Panel B, these are the

situations where even though the IC is convex,
but still there exists corner solution. In these
cases, the IC is either steep or less step than the
budget line throughout the whole graph. In such
as even though the SOC is fulfilled, but the FOC
is not fulfilled. Thus, consumer ends up
consuming only one good at equilibrium.
Concavity implies Increasing MRS, consumer will When Px/Py < or > MRSxy throughout
choose only one good. Equilibrium is at point Q or No interior solution is possible
P and not at R
 Do it on your own
A: U (x , x ) = x2 y3
1 2

B : U ( x, y ) = x2/5
C : U (x ,
D:

Px = Re 1, Py = Rs 2, M = Rs 50
1) Calculate the Consumer's equilibrium
2) Find the demand function
Lecture-4: Bandwagon, Snob,
Veblen Effects, ICC, PCC &
Engle Curves
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 Bandwagon, Snob, Veblen Effects

• H. Leibenstein in May 1950 has published a paper in OUP titled ‘Bandwagon, Snob, and Veblen Effects in
the Theory of Consumers' Demand.’

• He has demonstrated that if we assume consumer’s preferences are not selfish, then the market demand
curve is not simply the horizontal summation of the individual demand curves
 Bandwagon, Snob, Veblen Effects

Bandwagon Effect: It is said to exists, if any consumer purchases a good under influence of the other
consumers with the motive of being in fashion. Thus, if the demand of a set of consumers for a good has
increased, then a particular consumer who identifies himself in relative to the set of above consumers will also
demand more of the good. Consequently, the market demand curve becomes more elastic.
 Bandwagon, Snob, Veblen Effects

Bandwagon Effect: It is said to exists, if any consumer purchases a good under influence of the other
consumers with the motive of being in fashion. Thus, if the demand of a set of consumers for a good has
increased, then a particular consumer who identifies himself in relative to the set of above consumers will also
demand more of the good. Consequently, the market demand curve becomes more elastic.
In the figure, Dx is the original market demand curve. When the
axiom of selfish is prevailing, then at price p1, we are on point A1
with quantity demand is q1. Let the price falls to p2. Due to the
fall in the price of the good, we move along the demand curve
from point A1 to A2 and now at price p2, q2 units of the goods are
being demanded. This is the case, when bandwagon effect is zero.
 Bandwagon, Snob, Veblen Effects

Bandwagon Effect: It is said to exists, if any consumer purchases a good under influence of the other
consumers with the motive of being in fashion. Thus, if the demand of a set of consumers for a good has
increased, then a particular consumer who identifies himself in relative to the set of above consumers will also
demand more of the good. Consequently, the market demand curve becomes more elastic.
In the figure, Dx is the original market demand curve. When the
axiom of selfish is prevailing, then at price p1, we are on point A1
with quantity demand is q1. Let the price falls to p2. Due to the
fall in the price of the good, we move along the demand curve
from point A1 to A2 and now at price p2, q2 units of the goods are
being demanded. This is the case, when bandwagon effect is zero.

Now, if we assume that people are not selfish and to keep up with
Joneses, they will demand more. Due to this, the demand curve
will shift (factors other than price change) to Dx’. Now at price
OP2, q3 units are being demanded. This makes the market demand
curve more elastic.
 Bandwagon, Snob, Veblen Effects
Snob Effect: It is said to exists, if the consumer tries to distinguish
himself/herself from the crowd by buying goods that are out of
fashion and are not being bought by the buyers with whom he
identifies himself/herself. This is opposite to bandwagon effect and
hence, makes the demand curve more inelastic.
 Bandwagon, Snob, Veblen Effects
Snob Effect: It is said to exists, if the consumer tries to distinguish
himself/herself from the crowd by buying goods that are out of
fashion and are not being bought by the buyers with whom he
identifies himself/herself. This is opposite to bandwagon effect and
hence, makes the demand curve more inelastic.
In the figure, Dx is the original market demand curve. When the
axiom of selfish is prevailing, then at price p1, we are on point A1
with quantity demand is q1. Let the price falls to p2. Due to the fall in the
price of the good, we move along the demand curve from point A1 to A2 and
now at price p2, q2 units of the goods are being demanded. This is the case,
when bandwagon effect is zero.
 Bandwagon, Snob, Veblen Effects
Snob Effect: It is said to exists, if the consumer tries to distinguish
himself/herself from the crowd by buying goods that are out of fashion
and are not being bought by the buyers with whom he identifies
himself/herself. This is opposite to bandwagon effect and hence, makes
the demand curve more inelastic.
In the figure, Dx is the original market demand curve. When the axiom
of selfish is prevailing, then at price p1, we are on point A1 with
quantity demand is q1. Let the price falls to p2. Due to the fall in the price
of the good, we move along the demand curve from point A1 to A2 and now at
price p2, q2 units of the goods are being demanded. This is the case, when
bandwagon effect is zero.
But suppose that more people are snobs and they will reduce the demand for
this good. In this case, the demand curve will shift to D’x and at price p2, q3
market demand will exist. The new market demand curve is more inelastic.
 Bandwagon, Snob, Veblen Effects
Veblen Effect: It is said to exists, if the consumer judges quality of a
commodity by its prices. Say if a consumer assumes that i-phone is better
because it is priced higher. In this case, as soon as the price of i-phone
falls, then its quantity demanded will also fall. This is Veblen effect
named after Thorstein Veblen.
Dx is the market demand curve under normal conditions with zero
bandwagon and snob effect. Initially, suppose we are at point A1 on Dx,
the price is OP1 and quantity demanded in the market is Oq1.
 Bandwagon, Snob, Veblen Effects
Veblen Effect: It is said to exists, if the consumer judges quality of a
commodity by its prices. Say if a consumer assumes that i-phone is better
because it is priced higher. In this case, as soon as the price of i-phone
falls, then its quantity demanded will also fall. This is Veblen effect
named after Thorstein Veblen.
Dx is the market demand curve under normal conditions with zero
bandwagon and snob effect. Initially, suppose we are at point A1 on Dx,
the price is OP1 and quantity demanded in the market is Oq1.

Let the price falls to OP2. Now, people will assume that since it is low
priced, so its quality is not so good and they will reduce its demand and
the units demanded in the market is Oq3 instead of Oq2. Thus, the market
demand curve should be D’x, which is more inelastic.

If the Veblen effect is more and significant, then it can make the market
demand curve as upward sloping, which will be contrary to the law of
demand. This is being demonstrated when the demand curve is D’’x.
 Bandwagon, Snob, Veblen Effects

These three effects when operational indicates that consumer buying decisions are dependent upon each
other. However, under normal conditions, these three effects will not affect the validity of law of demand, as
usually these effects nullify each other.
 Price Consumption Curve or Offer Curve
PCC explains how the consumer reacts to charges in the price of a good, his money income, tastes and prices
of other goods remaining the same. Price effect shows this reaction of the consumer and measures the full
effect of the change in the price of a good on the quantity purchased since no compensating variation in
income is made in this case.

When, the price of good changes, the consumer would be either better off or worse off than before, depending upon
whether the price falls or rises. In other words, as a result of change in price of a good, his equilibrium position would lie
at a higher indifference curve in case of the fall in price and at a lower indifference curve in case of the rise in price.
 Price Consumption Curve or Offer Curve
Downward sloping PCC for Good X:
• In the figure, original budget line is PL1 and initial IC is at
point Q with N1 units and M1 units of Good Y and Good X
being demanded.
• If the price of Good X falls, then the budget line pivots to PL2
and the new equilibrium is at R, where the units of Good Y has
been reduced and that of Good X is increased.
• In the same manner, if the price of Good X further falls, then
the budget line further pivots to PL3 and PL4 respectively.
• Joining the equilibrium points Q, R, S, T, we get a PCC for
Good X.
• The downward sloping PCC for Good X indicates that Good X
is a normal good and has elastic demand.
 Price Consumption Curve or Offer Curve
Upward sloping PCC for Good X:
It indicates that as price of good x falls, then consumer is buying more of Good
X and Good Y. In this case, the demand for Good X is inelastic E<1

Horizontal PCC for Good X: It means that when the

price of the good X declines, its quantity purchased rises
proportionately but quantity purchased of Y remains the
same. We obtain horizontal price consumption curve of
good X when the price elasticity of demand for good X is
equal to unity.
 Price Consumption Curve or Offer Curve
Upward sloping PCC for Good X:
It indicates that as price of good x falls, then consumer is buying more of Good
X and Good Y. In this case, the demand for Good X is inelastic E<1

Backward bending PCC for Good X: Backward-sloping price

consumption curve for good X indicates that when price of X falls, after a
point smaller quantity of it is demanded or purchased. This is true in case
of exceptional type of goods called Giffen Goods.
Horizontal PCC for Good X: It means that when the
price of the good X declines, its quantity purchased rises
proportionately but quantity purchased of Y remains the
same. We obtain horizontal price consumption curve of
good X when the price elasticity of demand for good X is
equal to unity.
 Price Consumption Curve or Offer Curve
Vertical PCC for Good X: When price falls, the quantity demanded for X is
not changing at all. This implies that elasticity is 0.

U-shaped PCC: PCC has different slopes at different price ranges. At

higher price levels it generally slopes downward, and it may then have a
horizontal shape for some price ranges but ultimately it will be sloping
upward. For some price ranges it can be backward sloping as in case of
Giffen goods.
 Price Consumption Curve or Offer Curve
Derivation of Demand Curve from PCC
Money is taken on the vertical axis in rupees and good X on the horizontal axis.
PQ, PQ1 and PQ2 are the budget lines of the consumer on which R, S and T are
the equilibrium positions forming the PCC curve.
 Derivation of Demand Curve from PCC
Money is taken on the vertical axis in rupees and good X on the horizontal axis.
PQ, PQ1 and PQ2 are the budget lines of the consumer on which R, S and T are
the equilibrium positions forming the PCC curve.
He buys OA, OB and OC unit of X respectively at these points on the PCC
curve. If the total money income of the consumer is divided by the number of
goods to be bought with it, we get per unit price of the good. For OA unit of X,
he pays OP/OQ price; for OB units, OP/OQ1 price; and for OC units, OP/OQ2.
This is, in fact, the consumer’s price-demand schedule for good X. The price-
demand schedule of the consumer for good X shows that given his money
income OP (Rs.10) when he spends his income in buying OQ quantity (2 units),
it means that the price of X is OP/OQ (Rs.5) as per budget line PQ at which the
consumer buys OA (one unit) of good X. This is shown by point R on the F
curve. When the price of good A” as determined by the budget line PQ, is
OP/OQ, (Rs. 2), the price-consumption curve shows that he buys OB (4 units) of
X. This is shown by point S on the curve I2. When the price of good X is
determined as OP/OQ2 (=Re 1) on the budget line PQ2 and the curve L at point
T, the consumer buys OC (7 units) of X. Point R, S and T on the PCC curve
show price-quantity relationships for good X.
 Derivation of Demand Curve from PCC
These points are plotted on the lower diagram in the figure. The price of X is
taken on the vertical axis and quantity demanded on the horizontal axis. To draw
the demand curve from the PCC, draw a perpendicular on the lower figure from
point R in the upper portion of the figure which should pass through point A.
Then draw a line for point P1 (=5) on the price axis (lower figure) which should
cut the perpendicular at point F.

The points G and H are drawn in a similar fashion. They are joined by a line to
form the demand curve D. This curve shows the amount of X demanded by the
consumer at various prices. With the fall in the price of X the consumer buys
more units of it and the demand curve D slopes downward to the right.
 Income Consumption Curve
The Engel curve, named after the German statistician Ernst Engel (1821-96), is a
relation between the demand for a good and the income of its buyers, as
D = f (M)
The Engel curve of an individual consumer can be obtained from his ICC. As,
every point on the ICC for an individual consumer, is a combination of three
items—his money income (M), his demand for good X and that for good Y.

Point E1 is a combination of money income, L1M1 i.e., the money income

represented by the budget line L1M1, demand for good X = x1 and the demand
for good Y = y1, i.e., the point E1 is a combination (L1M1, x1, y1). Similarly,
the point E2 is a combination of (L2M2, x2, y2), and so on.

Therefore, the points on the ICC gives a set of combinations of money income
and demand for X like (L1M1, x1), (L2M2, x2), etc. and another set of
combinations of money income and the demand for good Y like (L1M1, y1),
(L2M2, y2), etc.
 Income Consumption Curve
• If both the goods are normal goods, then the consumer purchases more of both the goods as income rises. A good is
said to be normal good if consumer buys more units of this good as his income rises, prices remaining constant. On
the contrary, a good is said to be inferior,, if the consumer purchases less of the good when his money income rises,
prices remaining constant.
• If X becomes an inferior good to the consumer when his income rises beyond a certain level, then the ICC would be
bending to the y-axis
• If Y becomes an inferior good to the consumer when his income rises beyond a certain level, then the ICC would be
bending to the x-axis respectively.
• That is deviate towards the normal good axis and deviates farther from the inferior good axis

ICC when Y is inferior and X ICC when X is inferior and Y

Normal Normal
 Income Consumption Curve
It should be noted that both the goods at the same time cannot be inferior. It is because, if that is the case, then as the money
income rises, the demand for both the inferior goods will fall and his money income will not be spent totally, which is
against the assumption of the IC.
• Positive Income Effect: For Normal Goods
• Negative Income Effect: For Inferior Goods
• Zero Income Effect: Quasi-linear utility based goods, on which the consumer spent too little amount of income.
There is no definite sign of income effect. It can be positive, negative and zero depending upon the nature of the good;
unlike Substitution Effect.

ICC when Y is inferior and X ICC when X is inferior and Y ICC under different ICC under different
Normal Normal conditions conditions
 Engel Curve
• If the consumer increases the purchase of both the goods, X and Y,
proportionately, as his money income rises, prices remaining constant, then his
ICC also would be an upward sloping straight line from the origin.
• On the other hand, there are some goods (e.g., food) the consumer’s purchase of
which increases less than proportionately as his money income rises. For such a
good, his Engel curve would be upward sloping and concave downwards.
• If the consumer increases the demand for some
goods (luxury items) more than proportionately as
his money income rises. The Engel curve for such
a good will be upward sloping and convex

Income
downwards.
Income

QDx

QDx
Convex or Concave Downwards Engle Curve
[Necessity Goods]
Convex Downward/ Concave Engle Curve
Neutral Goods
[Luxury Goods] Inferior Goods
 Engel Curve
The elasticity of the Engel curve is known as Income Elasticity of demand. It
indicates the percentage change in quantity demanded due to 1% change in
income, price remaining the same.

Engle Law: As income rises the proportion of income spent on food grains or basic goods
decreases. In other words, income elasticity of demand for basic goods is less than 1.
Engel Curve
 Optimisation: Multi-Variable Case [Unconstrained]
Example-3: Check whether the following polynomial is maximum or minimum
Good Question
−x 3 + 3xz + 2 y − y2 − 3z 2
 Do it on your own
A: U (x , x ) = x2 y3
1 2

B : U ( x, y ) = x2/5
C : U (x ,
D:

Px = Re 1, Py = Rs 2, M = Rs 50
1) Calculate the Consumer's equilibrium
2) Find the demand function
Do it on your own
Do it on your own
Do it on your own
NTA-UGC-NET | Additional Points (only in study notes
 NTA-UGC-NET | Additional Points (only in study notes
Demand indicates the consumer's ability and willingness to pay for goods and services to buy them. It is
inclusive of and is a function of the consumer's income, expectation, tastes, and preferences and his
expected utility that can be fetched by consumption of goods and services. It is also known as (aka)
Notional Demand, which consists of further two terms- latent demand and effective demand.
Latent Demand: This in simple terms is termed as need which is not backed by sufficient purchasing
power. Another way around, say he might be having purchasing power, but no information whether a
particular good and service is available in the market or not. The net result of both these reasons (no
purchasing power and lack of information), renders him as unconstrained, as their is no constraint- budget
line or theory of choice (in case of lack of information). The firms can increase their sales of these
products either by reducing the prices (for those consumers who dont have or have less purchasing
power) or by increasing marketing or selling activities (to make uninformed customers aware of the
availability of those goods)
Effective Demand: It is a proxy for the actual quantity of goods and services that a buyer actually ends
up buying. Thus, it implies how much the factors affecting demand outweigh the factor affecting latent
demand and the net result is that the consumer has bought the good.
Lecture-5: Price Effect, Hicksian
Demand, Marshallian Demand &
Slutsky Equation
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 Price Effect

Why demand varies inversely with the price? The answer to this question deals with two aspects- Substitution
Effect and Income Effect which are related to the change in the nominal price of a good.

Substitution Effect (or Pure Price Effect): It is related to the change in the relative price ratio of one good
with another good. Due to this change in the relative price ratio, there exists a change in the rate of exchange
of one good for another. Due to a fall in price of one good, there arises consumer’s attractiveness for the
(now) cheaper good in comparison to the relative expensive good. Say, if the price of good x has fallen, then
the good x has become relatively cheaper, which increases the consumer preferences for it and the consumer
reduces the consumption of the other good say Y.
 Price Effect

Why demand varies inversely with the price? The answer to this question deals with two aspects- Substitution
Effect and Income Effect which are related to the change in the nominal price of a good.

Substitution Effect (or Pure Price Effect): It is related to the change in the relative price ratio of one good
with another good. Due to this change in the relative price ratio, there exists a change in the rate of exchange
of one good for another. Due to a fall in price of one good, there arises consumer’s attractiveness for the
(now) cheaper good in comparison to the relative expensive good. Say, if the price of good x has fallen, then
the good x has become relatively cheaper, which increases the consumer preferences for it and the consumer
reduces the consumption of the other good say Y.
As Px falls, Py & M held constant, the relative price ratio ie Px/PY falls, which leads to consumer’s
attractiveness towards X good and he will substitute more of X for Y and demand for X rises. This is shown
by dx/dPx. The sign of SE is always negative, which implies a negative relationship between quantity
demanded for X and its price.

dx  Px  
SE = → always (−)ve  when Px →   → Substitute more of X for Y → Demand x 
dPx  Py 
 Price Effect

(Real) Income Effect: Due to the fall in the price of a good (while nominal money income unchanged), the
consumer feels psychologically richer, as he is left with some income unspent (if he continues to buy the old
consumption bundle). This unspent amount of money can be used up to buy more of Good X.
As Px falls, Py and M held constant, the real income rises i.e. M/P’x, which implies the consumer will
demand more of Good X now after the price fall. This is shown by dx/d(M/Px). The sign of IE is negative for
normal goods, while that of for inferior and giffen goods is positive. This implies for normal goods, when the
Px falls, M/P’x rises and consumer buys more of Good X.

dx  
IE = → Normal Goods (−)ve  when Px →  M  → Purchasing power or real income → Demand x 
M   Px  
d 
 Px 
dx → Inferior & Giffen Goods (+)ve  when Px →  M  → Purchasing power or real income → Demand x 
IE =  
M   Px  
d 
 Px 
 Price Effect

Price Effect or Total Price Effect: Due to the fall in the price of one good, there exists a change in the quantity
demanded for that good, considering M and Py constant.
PE = SE + IE
Approaches to Study Price Effect:
There are two methods proposed by two economists regarding the decomposition of Price Effect into SE
and IE. These approaches are Hicksian Decomposition of PE and Slutsky Decomposition of PE. Both the
methods are different but the conclusions are the same.
 Price Effect

Price Effect or Total Price Effect: Due to the fall in the price of one good, there exists a change in the quantity
demanded for that good, considering M and Py constant.
PE = SE + IE
Approaches to Study Price Effect:
There are two methods proposed by two economists regarding the decomposition of Price Effect into SE
and IE. These approaches are Hicksian Decomposition of PE and Slutsky Decomposition of PE. Both the
methods are different but the conclusions are the same.
 Decomposition of Price Effect
1) Initial equilibrium is at point E1, with X1 units of Good X being consumed at price Px and original budget
line is AB and Price of good Y is Py.
2) Let Px falls to P2. Budget line pivots from AB to AB’ due to the fall in Price of Good X.
(Above two points are common for both the approaches)
Decomposition of Price Effect
Decomposition of Price Effect
Decomposition of Price Effect
Decomposition of Price Effect
Decomposition of Price Effect
Decomposition of Price Effect
* Readers should note that this is not equivalent to the nominal
income effect which is related to the increase in the nominal
money income. Nominal Income Effect will be positive for
normal goods, negative for inferior and giffen goods.
Guňuamantňa for SE and Income Effect
 Guňuamantňa for SE and Income Effect
1) If IE < 0 and |SE| >|IE|, then PE < 0 and the law of demand holds → Normal Good
2) If IE > 0 and |SE| >|IE|, then PE < 0 and the law of demand holds → Inferior Good
3) If IE = 0 and |SE| >|IE|, then PE <0 and the law of demand holds → Perfectly Income Inelastic Good
4) If IE >0 and |SE| = |IE|, then PE = 0 and SE and IE are equal in magnitude (in absolute value)
and they nullifies each other. In this case, PE = 0 → Perfectly Price Inelastic Good (Vertical Demand Curve)
5) If IE > 0 and |SE| < |IE|, then PE > 0. Law of demand does not hold → Giffen Goods
NTA-UGC-NET | 3 Demand Curves

Compensated Demand Curve

 NTA-UGC-NET | Ordinary & Compensated Demand
1) Ordinary demand functions are derived from Utility
maximization problem (UMP) and captures the entire price
effect. On the other hand, the compensated demand
functions are derived from the Expenditure Minimisation
Problem (EMP) and captures only the substitution effect
2) As the SE is always negative irrespective of the nature of
the good, the compensated demand functions are always
negatively sloped i.e.  dh1 ( p1 , p2 ,U )  0
 dp1 
 
But ordinary demand functions cane be:
(
 dx p1 , p2 , M )
a) Negatively sloped  0
 dp1 
 

b) Vertical 
(
 dx p1 , p2 , M )=0
sloped
 dp1 
 
(
 dx p1 , p2 , M  )
c) Positively sloped  0
 dp1 
 
 NTA-UGC-NET | 3 Demand Curves

Relationship between Own Price Elasticity & Price Elasticity of Compensated Demand & Income Elasticity
Px
Own Price Elasticity = Price Elasticity of Compensated Demand + Income Elasticity
M
=  xx + Reciprocal of Income spent on X (  mx )
C
 xx
M
 Compensating Variation and Equivalent Variation
CV and EV are measured on Hicksian (compensated) demand
curves. There are two types of income changes that take
place when the price of a good gets changed.
1) Compensating Variation CV: It is the adjustment in
income that returns the consumer to the original utility
after a fall in the price of a good. That is how much
change in income is required, so that the consumer is
pushed to the original utility after the price fall.
Compensating Variation = e ( p, u ) − e ( p, u ) = m − e ( p, u )
e ( p, u ) : Old expenditure with old price and old utility
e ( p’, u ) : New expenditure with new price and old utility
m = fixed income

Change in income to compensate the change in prices? = Compensating Variation (CV)

 Compensating Variation and Equivalent Variation
CV and EV are measured on Hicksian (compensated) demand
curves. There are two types of income changes that take
place when the price of a good gets changed.
1) Compensating Variation CV: It is the adjustment in
income that returns the consumer to the original utility
after a fall in the price of a good. In the case of a positive
economic change (such as a fall in price of a good), CV is
referred to as the maximum a consumer is willing to pay
in order to have the economic change happen. When there
is a negative economic change, CV is the minimum the
consumer needs in order to accept the economic change.
After introducing a change, how much money would have Compensating Variation = e(p, u) − e(p ′ , u) = m − e(p ′ , u)
to be given to or taken away from a consumer e(p,u): Old expenditure with old price and old utility
e(p’,u): New expenditure with new price and old utility
(compensation) to place them at their original level of m= fixed income
utility – Action is undertaken but income provided to or
taken away to place the consumer at the previous level of
utility. (prices do change)
Change in income to compensate the change in prices? = Compensating Variation (CV)
 Compensating Variation and Equivalent Variation
Equivalent Variation: EV is the adjustment in income that
changes the consumer’s utility equal to the level that would
occur if the event had happened. In the case of a positive
economic change, such as a fall in price, EV would be the
increase in income that would give the consumer the same
additional utility that would happen if a price did fall. In the
case of a negative economic change, EV would be the amount
of income that would be taken away to lower the consumer’s
utility to the level that would happen if the change had
occurred.
How much money would have to be given to or taken away
from the consumer to give them the equivalent utility of the
proposed action. – Consumer moves to new utility level, but
the action not undertaken (prices do not change)
Equivalent Variation = e ( p, u) − e ( p, u) = e ( p, u) − m
e ( p, u) : Old expenditure with old price and new utility
e ( p, u) : New expenditure with new price and new utility
m = fixed income Change in income equivalent to the change
in prices? = Equivalent Variation (EV)
Compensating Variation and Equivalent Variation

Equivalence of EV and CV
• EV for price decrease = CV for price increase
• CV for price decrease = EV for price increase
 Compensating Variation and Equivalent Variation

Relationship between CS, CV, EV

• The relationship between  CS, CV, and EV depends upon whether the good is normal or inferior.
• For a normal good, the Hicksian demand curve is steeper than the Marshallian demand curve.
EV < CS < CV
Because Income and substitution effects go in the same direction.
• For an inferior good, the Hicksian demand curve is flatter than the Marshallian demand curve.
Because Income and substitution effects go in opposite directions.
CV < CS < EV
• For Quasi-linear preferences, CV = CS = EV
Because Marshallian Demand Curve = Hicksian Demand Curve [No income effect]
Lecture-6: Indirect Utility Function,
Roy's Identity, Expenditure
Minimisation
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 Consumption Duality Prob: Duality in General

The concept will be dealt

in-depth during
Mathematical Economics.

Primal Problem: Dual Problem:

Maximise Z = C1x1 + C2 x2 Minimise W = b y + b y + b y
1 1 2 2 3 3
Subject to a11x1 + a12 x2  b1 Subject to a y + a y + a y  C
11 1 21 2 31 3 1
a21 x1 + a22 x2  b2 a y +a y +a y C
12 1 22 2 32 3 2
a31 x1 + a32 x2  b3 y  0, y  0, y  0
1 2 3
x1  0, x2  0
 Relationship between Primal Problem and Dual:
Consumption
1) No. of variables in dual problems Duality
(3: Y1, Prob:
Y2, Y3)= No.Duality in General
of constraints in original problem (3)
2) No. of constraints in dual problems (2) = No. of variables in original problem (2).
3) Maximisation of dual = Minimisation of primal and vice-versa
4) a) Coefficients of the objective function (original problem) appear as the constant terms of the
constraints of the dual and
b) Constant terms of the original constraints are the coefficients of the objective function of the dual.
5) Coefficients of a single variable in the original constraints become the coefficients of a single constraint
in the dual. Each column of coefficients in the constraints of the original problem becomes a row of
coefficients in the dual.
6) The inequalities in the original problems will be reversed in the dual problem, except that the
inequalities restricting the variables to be non-negative have the same in the primal and the dual.
Primal Problem: Dual Problem:
Maximise Z = C1x1 + C2 x2 Minimise W = b y + b y + b y
1 1 2 2 3 3
Subject to a11x1 + a12 x2  b1 Subject to a y + a y + a y  C
11 1 21 2 31 3 1
a21 x1 + a22 x2  b2 a y +a y +a y C
a x +a x b This slide has been taken 12 1 22 2 32 3 2

31 1 32 2 3 from Lecture-4 of y1  0, y2  0, y3  0
x1  0, x2  0 Mathematical Economics.
 Consumption Duality Prob

Primal Problem Dual Problem

Max U (x, y) Min px x + py y
s.t. px x + py y  M s.t. U (x, y)  U
s.t. px x + py y = M s.t. U (x, y) = U
 
x marshall = x ( px , p y , M ) (
x hicksian = x px , p y ,U )
Subsituting xmarshall in Utility Function Substituting xhicksianin Budget line
Indirect Utility Function Expenditure Function
V=V ( px , py , M ) (
E = E px , p y ,U )
 Consumption Duality Prob

Primal Problem Dual Problem

Max U (x, y) Min px x + py y
s.t. px x + py y  M s.t. U (x, y)  U
s.t. px x + py y = M s.t. U (x, y) = U
 
xmarshall = x ( px , p y , M ) (
xhicksian = x px , p y ,U )
Subsituting xmarshall in Utility Function Substituting xhicksianin Budget line
Indirect Utility Function Expenditure Function
V=V ( px , py , M ) (
E = E px , p y ,U )
 UMP
Let us consider a two commodity framework (x and y) in which the representative consumer is entitled to
consume; Pl and P2 are the prices of the two commodities, exogenously given and M is the given income of the
consumer. Thus, the total expenditure of the consumer is [P1x + P2y].

Derivation of Utility Maximisation Problem

Maximise utility function U(x,y)
subject to
PlX + P2Y ≤ M and
non-negativity constraints x > 0 and y > 0
We set the Lagrangian expression like:
 UMP
Derivation of Utility Maximisation Problem
Maximise utility function U(x,y)
subject to
PlX + P2Y ≤ M and
non-negativity constraints x > 0 and y > 0
We set the Lagrange expression like:

Max L = Max {U (x, y) +  [M − P1 x − P2 y]},   0

FOC
y)
dL dU (x,
= − P = 0 ...(1)
1
dx dx
y)
dL dU (x,
= − P = 0 ... ( 2 )
2
dy dy
dL
= M − Px − P y = 0 ...(3)
d 1 2
 UMP
Derivation of Utility Maximisation Problem Dividing Eq (1) by Eq (2), we get:
Maximise utility function U(x,y) dU (x, y)
subject to
dx P1
PlX + P2Y ≤ M and =
dU (x, y) P2
non-negativity constraints x > 0 and y > 0 dy
We set the Lagrange expression like: MUx
=M
Max L = Max {U (x, y) +  [M − P1 x − P2 y]},   0 MUy

FOC Using this equation, we can solve for x = f ( y) & Substitute this value in Eq (3)
y)
dL dU (x, − P = 0 ...(1) x* = x* ( P1, P2, M ) ...(5) Marshallian or Walrasian
= 1  
 or Ordinary Demand 

dx dx y* = y* ( P , P , M ) ...(6)
1 2
 Function 
y)
dL dU (x,
= − P = 0 ...(2) * = * (P , 1P , M
2
) ... ( 7)
2
dy dy
dL
= M − Px − P y = 0 ...(3)
d 1 2
 UMP 1 1

U ( x, y ) = x 2 y 2
Advisory Disclaimer: Can be ignored
by learners at their own discretion
 1 1

UMP U ( x, y ) = x 2 y 2

Max L = Max {U (x, y) +  [M − P1x − P2 y]},   0

FOC
y)
dL dU (x,
= − P = 0 ...(1)
1
dx dx
dL dU (x, y) − P = 0 ...( 2)
= 2
dy dy
dL
= M − P1 x − P2 y = 0 ... ( 3)
d
Dividing Eq (1) by Eq (2), we get:
dU (x, y)
dx =  P1 ...( 4)
dU (x, y)  P
2
dy
MUx P
= MRSxy = 1
MUy P2
Using this equation, we can solve for x = f ( y) & Substitute this value in Eq (3)
x* = x* ( P1 , P2 , M ) ...(5)  Marshallian or Walrasian or Ordinary Demand Function
y* = y* ( P1, P2 , M ) ... (6)
* = * ( P1 , P2 , M ) ...( 7)
 UMP
Max L = Max {U (x, y) +  [M − P1x − P2 y]},   0
FOC
y)
dL dU (x,
= − P = 0 ...(1)
1
dx dx
y)
dL dU (x,
= − P = 0 ...( 2)
2
dy dy
dL
= M − P1 x − P2 y = 0 ... ( 3)
d
Dividing Eq (1) by Eq (2), we get:
dU (x, y)
dx =  P1 ...( 4)
dU (x, y)  P
2
dy
MUx P
= MRSxy = 1
MUy P2
Using this equation, we can solve for x = f ( y) & Substitute this value in Eq (3)
x* = x* ( P1 , P2 , M ) ...(5)  Marshallian or Walrasian or Ordinary Demand Function
y* = y* ( P1, P2 , M ) ... (6)
* = * ( P1 , P2 , M ) ...( 7)
 Indirect Utility Function
Direct and Indirect Utility Function
U = U (x, y) → Direct Utility Function
Now, if we substitute the values of x* and y* in the direct utility function, we get the indirect utility function.
 Engel Aggregation
U = U (x, y) → Direct Utility Function
 Direct Utility Function
U = U (x, y) → Direct Utility Function Interpretation of Lambda (ʎ)
The Lagrangian multiplier ʎ can be
interpreted as the marginal utility of
income. That is how much utility can
be gained or lost, if one unit of Money
is increased or decreased.
 Engel Aggregation
U = U (x, y) → Direct Utility Function
 Engel Aggregation
U = U (x, y) → Direct Utility Function Engel Aggregation
p1 x p2 y
1=  xm +  ym
M M
where,
p1x
= Share of money spent on good x
M
xm = Income elasticity of demand for good x
p2 y
= Share of money spent on good y
M
ym = Income elasticity of demand for good y
 EMP

In UMP, we have maximise utility given the expenditure or budget. Now, in EMP our aim is to minimize
expenditure or budget for a given utility level. Thus, our aim is ascertain that consumption bundle, which will
minimize the expenditure while achieving the given utility function. This is the dual problem of the primal
proble which is UMP.

Mathematical Derivation of EMP

We need to Min E = p1x + p2y,
 EMP
Mathematical Derivation of EMP
We need to Min E = p1x + p2y,
 EMP
Mathematical Derivation of EMP
We need to Min E = p1x + p2y,
subject to the utility constraint U ( x, y )  U
Minimise Z = p1 x + p2 y +  U −U (x, y) 
dZ dU (x, y)
= p1 −  =0 ...(10)
dx dx
dZ dU (x, y)
= p2 −  =0 ...(11)
dy dy
dZ
= U −U (x, y) = 0 ...(12)
d
Dividing Eq 10 by Eq 11, we get
dZ

dU (x, y) Using this equation, we can solve for x = f ( y) & Substitute this value in Eq (12)
dx p1 = dx
=
( )
dZ dU (x, y)
...(13)  Hicksian or Compensated Demand Function
p2
dy
 x* = x* P1 , P2 ,U
dy

MUx  dU dx
(x, y) y = y ( P , P ,U )
* *
1 2 ...(14)
p1
= =
MUy p2 
dU (x, y)
 =  ( P , P ,U )
* *
1 2 ...(15)
dy
Advisory Disclaimer: Can be ignored UMP
by learners at their own discretion
 EMP
Mathematical Derivation of EMP
We need to Min E = p1x + p2y,
subject to the utility constraint U ( x, y )  U
Minimise Z = p1 x + p2 y +  U −U (x, y) 
dZ dU (x, y)
= p1 −  =0 ...(10)
dx dx
dZ dU (x, y)
= p2 −  =0 ...(11)
dy dy
dZ
= U −U (x, y) = 0 ...(12)
d
Dividing Eq 10 by Eq 11, we get
dZ

dU (x, y) Using this equation, we can solve for x = f ( y) & Substitute this value in Eq (12)
dx p1 = dx
=
( )
dZ dU (x, y)
...(13)  Hicksian or Compensated Demand Function
p2
dy
 x* = x* P1 , P2 ,U
dy

MUx  dU dx
(x, y) y = y ( P , P ,U )
* *
1 2 ...(14)
p1
= =
MUy p2 
dU (x, y)
 =  ( P , P ,U )
* *
1 2 ...(15)
dy
 EMP
Using this equation, we can solve for x = f ( y) & Substitute this value in Eq (12)
( )
x** = x** P1 , P2 ,U ...(13)

Demand or Compensated 
Hicksian Function
y = y ( P , P ,U )
1 2 ...(14)  

 =  ( P , P ,U )
* *
1 2 ...(15)
Using this equation, we can solve for x = f ( y) & Substitute this value in Eq (3)
x* = x* ( P , P , M ) ...(5) Marshallian or Walrasian
1 2
  or Ordinary Demand 
y = y (P , P , M )
* *
...(6)
1 2
 Function 
* = * ( P ,1P , 2M ) ... ( 7)

Hicksian demand function captures only the substitution effect and is therefore, always negative. This why,
Hicksian demand function is always negative or downward sloping for normal, giffen and for inferior goods.
Substituting the values or demand functions of x and y in the original expenditure function i.e. objective
function, we get the expenditure function, as E = f ( p1 , p2 ,U )
, This is the minimum expenditure in the equilibrium which fetch the U bar level of utility at the given prices.
 Roy’s Identity
Roy’s Identity
Roy's identity provides a way of obtaining a demand function from an indirect utility function.
 Roy’s Identity
Roy’s Identity
Roy's identity provides a way of obtaining a demand function from an indirect utility function.

Differentiating each term of the indirect utility function V(p1,p2, M) with respect to p1, p2 and M, we get:
dV ( p, M ) Example: U = xy, subject to M = Pxx+Pyy
x (p , p ,M) = − dp1 = x Marshall demand

dV ( p, M )
1 1 2 1

dM
dV ( p, M )
x (p , p ,M) = − dp2
= x Marshall demand
2 1 2
dV ( p, M ) 2

dM
 Consumption Duality

Primal Problem Dual Problem

Max U (x, y) Min px x + py y
s.t. px x + py y  M s.t. U (x, y)  U
s.t. px x + py y = M s.t. U (x, y) = U
 
xmarshall = x ( px , p y , M ) (
xhicksian = x px , p y ,U )
Subsituting xmarshall in Utility Function Substituting xhicksianin Budget line
Indirect Utility Function Expenditure Function
V=V ( px , p y , M ) (
E = E px , p y ,U )
 Consumption Duality

Primal Problem Dual Problem

Max U (x, y) Min px x + py y
s.t. px x + py y  M s.t. U (x, y)  U
s.t. px x + py y = M s.t. U (x, y) = U
 
xmarshall = x ( px , p y , M ) (
xhicksian = x px , p y ,U )
Subsituting xmarshall in Utility Function Substituting xhicksianin Budget line
Indirect Utility Function Expenditure Function
V=V ( px , p y , M ) (
E = E px , p y ,U )
 Consumption Duality

Primal Problem Dual Problem

Max U (x, y) Min px x + py y
s.t. px x + py y  M s.t. U (x, y)  U
s.t. px x + py y = M s.t. U (x, y) = U
Roy’s
 Identity 
xmarshall = x ( px , p y , M ) (
xhicksian = x px , p y ,U )
Subsituting xmarshall in Utility Function Substituting xhicksianin Budget line
Indirect Utility Function Expenditure Function
V=V ( px , p y , M ) (
E = E px , p y ,U )
 Consumption Duality
Shephard ' s Lemma
Primal Problem Dual Problem
Expenditure Function
Max U (x, y) Min p x +
( ) py y
E = E px , py ,U x
s.t. p x + p y  M dE ( p s.t.
, p ,UU) (x, y)  U dE ( p , p ,U )
x y
− =x − = y
x y hicksian x y hicksian

s.t. p x + p y = M dpx
s.t. U (x, y) = U
dpy
x y
Roy’s Shephard’s
 Identity  lemma

xmarshall = x ( px , p y , M ) (
xhicksian = x px , p y ,U )
Subsituting xmarshall in Utility Function Substituting xhicksianin Budget line
Indirect Utility Function Expenditure Function
V=V ( px , p y , M ) (
E = E px , p y ,U )
 Consumption Duality
Slutsky’s
Primal Problem Equation
Dual Problem
Min p x x + p y y
marshall
Max U (x, y) dx marshall
=
dx hicksian
dx
−y
dpx dpx dM
s.t. px x + py y  M Or s.t. U (x, y)  U
s.t. p x + p y = M s.t. U (x, y) = U
marshall
dymarshall dyhicksian dy
x y = −x
dpy dpy dM
 
xmarshall = x ( px , p y , M ) (
xhicksian = x px , p y ,U )
Subsituting xmarshall in Utility Function Substituting xhicksianin Budget line
Indirect Utility Function Expenditure Function
V=V ( px , p y , M ) (
E = E px , p y ,U )
Lecture-7: Law of Demand,
Movement & Shifts, Price
Elasticity
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
Today’s Class on Youtube @ 9 p.m.
Useful Point
 Demand, Desire, Wish
Desire refers to those wishes that a human being cherishes, such as, walking on moon, to be a billionaire, to buy a Rolls-
Royce, etc. These wishes may not be always backed by enough finance to realise. However, when a desire is backed with
sufficient purchasing power along with the consumer’s readiness to spend on materialising the wish, the desire becomes
demand. Thus, until and unless a consumer is having sufficient money and is willing to spend, a desire will remain a
desire. On this note, let us go through the definition of demand.
Demand for a commodity refers to the quantity of a commodity that a consumer is willing and is able to purchase at a
particular price at any particular point of time.
 Demand
Demand indicates the consumer's ability and willingness to pay for goods and services to buy them. It is
inclusive of and is a function of the consumer's income, expectation, tastes, and preferences and his expected
utility that can be fetched by consumption of goods and services.

Latent Demand or Notional Demand: It is the demand that occurs when purchasers are not constrained in
any other market. This in simple terms is termed as need which is not backed by sufficient purchasing power.
Another way around, say he might be having purchasing power, but no information whether a particular good
and service is available in the market or not. The net result of both these reasons (no purchasing power and
lack of information), renders him as unconstrained, as their is no constraint- budget line or theory of choice (in
case of lack of information). The firms can increase their sales of these products either by reducing the prices
(for those consumers who dont have or have less purchasing power) or by increasing marketing or selling
activities (to make uninformed customers aware of the availability of those goods)

Effective Demand: Effective demand (ED) in a market is the demand for a product or service which occurs
when purchasers are constrained in a different market. It is a proxy for the actual quantity of goods and services
that a buyer actually ends up buying. Thus, it implies how much the factors affecting demand outweigh the
factor affecting latent demand and the net result is that the consumer has bought the good.

In the aggregated market for goods in general, demand, notional or effective, is referred to as aggregate
demand.
 Demand
Consider the following statements : [UGC NET June 2018]

(a) Effective demand in a market is the demand for a product or service which occurs when purchasers are constrained in a different
market.
(b) Notional demand is the demand that occurs when purchasers are not constrained in any market.
Which of the above statements is/are correct ? Answer from the code below :
A. Only (a) is correct
B. Only (b) is correct
C. Both (a) and (b) are correct
D. Neither (a) nor (b) is correct
Demand Function & Inverse Demand Function
 Types of Demand Function (only in study notes)
Short run demand curves
1. Price demand function: Qdx = f(Px)
2. Income demand function: Dx = f(M)
3. Cross price demand function: Dx = f(Py)
Long Run Demand function
Qdx = f(Px, Py, M, Price expectations, Tastes and Preferences, Other factors affecting demand)
Linear Demand Function
Qdx = a - bPx
where, a = autonomous demand at zero price
b = slope of demand function
Rectangular Hyperbola Demand function
(Qdx)(Px) = Constant
Inverse Demand function
Px = f (Qdx)
 NTA-UGC-NET | Elasticity
Elasticity
• It means flexibility ore responsiveness of demand to the change in its
different determining factors.
✓ Price of good
✓ Price of related goods Elasticity Concept
✓ Income of the consumers
✓ Tastes and Preferences
✓ Population Size
✓ Distribution of Income

Elasticity Types
✓ Price Elasticity : Qd w.r.t price
(Responsiveness of demand for a good to change in its price)
✓ Cross Elasticity (Price of related goods) : Qd w.r.t. price of related good
(Responsiveness of demand for a good to change in the price of related goods)
✓ Income Elasticity: Qd w.r.t. income
(Responsiveness of demand for a good to change in consumer’s income)
 NTA-UGC-NET | Elasticity
Price Elasticity
✓ Price Elasticity : Qd w.r.t price
(Responsiveness of demand for a good to change in its price)
It measures the degree of responsiveness of the demanded quantity of a good
to a change in its price.
 NTA-UGC-NET | Elasticity
Price Elasticity
✓ Price Elasticity : Qd w.r.t price
(Responsiveness of demand for a good to change in its price)
It measures the degree of responsiveness of the demanded quantity of a good
to a change in its price.

Note the negative sign used in the formula. It denotes the negative relationship
between price & demand and Elasticity of demand is a negative number like
-1, -2, etc.
Mathematically, -1 > -2 | But in context of elasticity, -2 > -1
That is, we put minus sign and ignore it, so that we can compare the
coefficients of ed easily.
 NTA-UGC-NET | Elasticity
Price Elasticity
✓ Price Elasticity : Qd w.r.t price
(Responsiveness of demand for a good to change in its price)
It measures the degree of responsiveness of the demanded quantity of a good
to a change in its price.

CAUTION!!

If in the question, ed has been given with a ‘-’ sign like ed = -1, then never prefix
‘-’ sign to the formula of the elasticity of demand
 NTA-UGC-NET | Elasticity
Values of Price Elasticity [0  ed  ]
 NTA-UGC-NET | Elasticity
Values of Price Elasticity [0  ed  ]
 NTA-UGC-NET | Elasticity
Methods of Calculating Price Elasticity of Demand
• Percentage or Proportionate Method: Elasticity is measured as the ratio
of % change in quantity demanded to % change in price
• Geometric or Point Method: It measures elasticities at different points on
a demand curve
• Total Expenditure Method: It examines how the total expenditure incurred
on a good changes with a change in the price of the good.
 NTA-UGC-NET | Elasticity
Question-1: What can you say about the nature of the elasticity of
demand, when price rises from Rs 10 to Rs 12 and QD falls from 50 units
to 45 units?
a. Inelastic
b. Elastic
c. Unitary Elastic
d. Perfectly Inelastic
 NTA-UGC-NET | Elasticity
Question-1: What can you say about the nature of the elasticity of
demand, when price rises from Rs 10 to Rs 12 and QD falls from 50 units
to 45 units?
Inelastic
Elastic
Unitary Elastic
Perfectly Inelastic
 NTA-UGC-NET | Elasticity
Geometric / Point Method
 NTA-UGC-NET | Elasticity
Total Expenditure Method (Given by Marshall)
 NTA-UGC-NET | Elasticity
Arc-Elasticity Method or Average Elasticity Method
• It measures elasticity between two points on a curve- using a mid-point
between two curves
(Q1+ Q2)
Mid-Point Q =
2

Mid-Point P =
( P1+ P2)
2
(Q2 − Q1)
(Q1+ Q2)
Arc Elasticity of Demand = 2
(P2 − P1)
( P1+ P2)
2
NTA-UGC-NET | Elasticity
NTA-UGC-NET | Elasticity
NTA-UGC-NET | Price Elasticity
Questions
Which of the following is a correct description of inverse demand curve?
a. P = f(D)
b. D = f(p)
c. D = f (1/P)
d. P = f(D, 1/Y)
NTA-UGC-NET | Price Elasticity
Questions
For a demand function, p = 16 – q - 0.5q2, then the price elasticity of
demand at q = 4 is
+0.5
+0.2
+0.7
+0.3.
 NTA-UGC-NET | Elasticity
Question: Price elasticity of demand of a good is -1. At a given price the
consumer buys 60 units of the good. How many units will the consumer
buy if the price falls by 10%?
6 units
-6 units
66 unit
54 units
 NTA-UGC-NET | Elasticity
Question: Price elasticity of demand of a good is -1. At a given price the
consumer buys 60 units of the good. How many units will the consumer
buy if the price falls by 10%?
6 units
-6 units
66 unit
54 units
 NTA-UGC-NET | Elasticity
The government wants to reduce the consumption of electricity by 5%. The price elasticity of
demand for electricity is 0.4. The government should:

raise the price of electricity by .08%.

raise the price of electricity by 4%.
raise the price of electricity by 0.4%.
raise the price of electricity by 12.5%.
 NTA-UGC-NET | Elasticity
2. Mr. Pitambar is fond of Muffins. Recently, the prices of Muffins
increased by 20% and the total spending by Mr.Pitambar on Muffins
increased by 15%. What is the price elasticity of demand for Muffins
by Mr. Pitambar?

(A) 1/5
(B) ¼
(C) ½
(D) 1/6
 NTA-UGC-NET | Elasticity
2. Mr. Pitambar is fond of Muffins. Recently, the prices of Muffins
increased by 20% and the total spending by Mr.Pitambar on Muffins
increased by 15%. What is the price elasticity of demand for Muffins
by Mr. Pitambar?
 NTA-UGC-NET | Elasticity
3. Let’s say in equilibrium, Sarat (a consumer) was buying 5 units of
goods A and some of goods B. His income was Rs. 100 and the
prices were PA= Rs. 8 and PB = Rs. 5. Now the price of goods A falls
to Rs. 5. By how much does Sarat’s income need to be compensated,
so that he is able to buy the (old) bundle at the original equilibrium –

(A) Sarat’s income should be increased by Rs. 15

(B) Sarat’s income should be decreased by Rs. 15
(C) Sarat’s income should not be changed
(D) Sarat’s income should be increased by Rs. 10
NTA-UGC-NET | Elasticity
 NTA-UGC-NET | Price Elasticity

1. Elasticity of the demand curve may be same for different slopes of the curve
If the elasticities of demand at each price are equal on two different demand curves, then the two
demand curves are said to be iso-elastic.
 NTA-UGC-NET | Price Elasticity

1. Elasticity of the demand curve may be same for different slopes of the curve
If the elasticities of demand at each price are equal on two different demand curves, then the two
demand curves are said to be iso-elastic.
1. Parallel Demand Curves: Parallel demand curves, it should be remembered that even if the slopes of
two straight line demand curves are equal, i.e., even if the two such demand curves are parallel, they are
not iso-elastic.
 NTA-UGC-NET | Price Elasticity

1. Elasticity of the demand curve may be same for different slopes of the curve
If the elasticities of demand at each price are equal on two different demand curves, then the two
demand curves are said to be iso-elastic.
1. Parallel Demand Curves: Parallel demand curves, it should be remembered that even if the slopes of
two straight line demand curves are equal, i.e., even if the two such demand curves are parallel, they are
not iso-elastic.
2. If two straight-line demand curve with different slope intersect each other at a particular point
then elasticity of the steeper curve will be lower than the elasticity of the less steep demand curve.
NTA-UGC-NET | Price Elasticity
Questions
Consider the following diagram with two parallel demand curves AB and
CD. The price elasticity of demand at
a. Points R and S is equal
b. Point R is > than that at point S
c. Point R is less than that at point S
d. Point R and S is infinity
NTA-UGC-NET | Price Elasticity
Questions
Consider the following diagram with two parallel demand curves AB and
CD. The price elasticity of demand at
Sol:
Two demand curves are parallel, indicating the same slope. At price OP
elasticity on two demand curves AB and CD is different.
At price OP the corresponding points on the two demand curves are Q and R.

The elasticity of demand on AB at R is RB/RA and

Now, in triangle OAB, PR || OB, so→ RB/RA = OP/PA
So, the elasticity at point R on demand curve is AB = OP/PA

Similarly, in triangle OCD, PS || OD, and at Point S on CD, price elasticity is

SD/SC
Therefore, SD/SC = OP/PC

Thus, OP/PA > OP/PC→ Elasticity at point S on CD is less than at point R on

AB
 Lecture-8: Cross Price, Income
Elasticity, Consumer & Producer
Surplus & Reservation Price
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Elasticity
2. Mr. Pitambar is fond of Muffins. Recently, the prices of Muffins increased by 20% and the
total spending by Mr.Pitambar on Muffins increased by 15%. What is the price elasticity of
demand for Muffins by Mr. Pitambar?

(A) 1/5
(B) ¼
(C) ½
(D) 1/6
 NTA-UGC-NET | Elasticity
2. Mr. Pitambar is fond of Muffins. Recently, the prices of Muffins
increased by 20% and the total spending by Mr.Pitambar on Muffins
increased by 15%. What is the price elasticity of demand for Muffins
by Mr. Pitambar?
NTA-UGC-NET | Elasticity
 NTA-UGC-NET | Price Elasticity

1. Elasticity of the demand curve may be same for different slopes of the curve
If the elasticities of demand at each price are equal on two different demand curves, then the two
demand curves are said to be iso-elastic.
 NTA-UGC-NET | Price Elasticity

1. Elasticity of the demand curve may be same for different slopes of the curve
If the elasticities of demand at each price are equal on two different demand curves, then the two
demand curves are said to be iso-elastic.
1. Parallel Demand Curves: Parallel demand curves, it should be remembered that even if the slopes of
two straight line demand curves are equal, i.e., even if the two such demand curves are parallel, they are
not iso-elastic.
 NTA-UGC-NET | Price Elasticity

1. Elasticity of the demand curve may be same for different slopes of the curve
If the elasticities of demand at each price are equal on two different demand curves, then the two
demand curves are said to be iso-elastic.
1. Parallel Demand Curves: Parallel demand curves, it should be remembered that even if the slopes of
two straight line demand curves are equal, i.e., even if the two such demand curves are parallel, they are
not iso-elastic.
2. If two straight-line demand curve with different slope intersect each other at a particular point
then elasticity of the steeper curve will be lower than the elasticity of the less steep demand curve.
NTA-UGC-NET | Price Elasticity
Questions
Consider the following diagram with two parallel demand curves AB and
CD. The price elasticity of demand at
a. Points R and S is equal
b. Point R is > than that at point S
c. Point R is less than that at point S
d. Point R and S is infinity
NTA-UGC-NET | Price Elasticity
Questions
Consider the following diagram with two parallel demand curves AB and
CD. The price elasticity of demand at
Sol:
Two demand curves are parallel, indicating the same slope. At price OP
elasticity on two demand curves AB and CD is different.
At price OP the corresponding points on the two demand curves are Q and R.

The elasticity of demand on AB at R is RB/RA and

Now, in triangle OAB, PR || OB, so→ RB/RA = OP/PA
So, the elasticity at point R on demand curve is AB = OP/PA

Similarly, in triangle OCD, PS || OD, and at Point S on CD, price elasticity is

SD/SC
Therefore, SD/SC = OP/PC

Thus, OP/PA > OP/PC→ Elasticity at point S on CD is less than at point R on

AB
 Cross Price and Income Elasticity
To derive the formula for Cross Price and Income Elasticity, let’s revisit the formula for Price Elasticity of
Demand.
Qdx
Qd Proportionate Change in P = P Proportionate Change in Qdx
Proportionate Change in Qd = Elasticity of Qd w.r.t. Cross Price = = Qdx
Qd P Py
Proportionate Change in Py
Qd Py
Proportionate Change in Qd Qd or
Elasticity of Qd w.r.t. Price = =
Proportionate Change in P P Qdx
Percentage Change in Qd 100
P Qdx
Elasticity of Qd w.r.t. Cross Price = =
or Percentage Change in P Py
100
Qd Py
100
Percentage Change in Qd Qd Qdx Py Qdx Py
Elasticity of Y w.r.t. X = Percentage Change in P = P  xp =  = 
y
Qdx Py Py Qdx
100
P
Qd P P Qd
 =  = 
Qd P Qd P
Qd
Where,  Marginal Change in Qd due to P i.e. Slope of Demand Curve
P
P
 Reciprocal of Average Change in Qd due to P
Qd
P  Qd Marginal Change
 = P =
Qd Average Change
 Cross Price and Income Elasticity
To derive the formula for Cross Price and Income Elasticity, let’s revisit the formula for Price Elasticity of
Demand.
Qdx
Proportionate Change in Qdx Qdx
Elasticity of Qd w.r.t. Cross Price = =
Proportionate Change in Py Py
Py
or
Qdx
100
Percentage Change in Qd Qdx
Elasticity of Qd w.r.t. Cross Price = = Py
Percentage Change in P 100
Py
Qdx Py Qdx Py
 xpy =  = 
Qdx Py Py Qdx
Qdx
(−)ve → When Py  then Qdy  and if Qdx also , then  xpy will have negative relationship: Complementary Good
Py
Qdx
(+)ve → When Py  then Qdy  and if Qdx also , then  xpy will have positive relationship: Substitute Good
Py
Qdx
0 → Not related goods
Py
 Cross Price and Income Elasticity
Cross price elasticity of demand for good x due to change in the price of good y indicates the percentage
change in demand of x good due to one percent change in price of y good. In similar manner, Cross price
elasticity of demand for good y due to change in the price of good x indicates the percentage change in
demand of y good due to one percent change in price of x good.
• The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of
demand
• + → Perfect Substitute
• - → Perfect Complementary

Qdx Py Qdx Py
 xpy =  = 
Qdx Py Py Qdx
Qdx
(−)ve → When Py  then Qdy  and if Qdx also , then xp y will have negative relationship: Complementary Good
Py
Qdx
(+)ve → When Py  then Qdy  and if Qdx also , then xp y will have positive relationship: Substitute Good
Py
Qdx
0 → Not related goods
Py
 Cross Price and Income Elasticity
Example-1: [UGC NET 2020]
Cross Price and Income Elasticity
[UGC NET Dec 2022]
Cross Price and Income Elasticity
[UGC NET Dec 2022 | S-2]
Cross Price and Income Elasticity
[UGC NET Dec 2022 | S-2]
Cross Price and Income Elasticity
[UGC NET Dec 2022 | S-2]
 Cross Price and Income Elasticity
Sl. No.5 QBID:11005 [UGC NET Dec 2022 | S-2]
 Income Elasticity
Income Elasticity of Demand:
If all prices are assumed to be constant and only income of the consumer is assumed to be variable, then as
income changes, there will be an increase in demand for the product. This is termed as Nominal Income Effect.
In such a case, the demand is a function of income only, which is represented as:
Q = Q (Y)
This is the functional form of Engel Curve, which is also termed as Income Demand Curve.
Income elasticity of demand is the elasticity of this function.
Income elasticity indicates the percentage change in demand due to one percent change in income of the
consumer.
 Income Elasticity
Income Elasticity of Demand:
Income elasticity indicates the percentage change in demand due to one percent change in income of the
consumer. Qdx
Proportionate Change in Qdx Qdx
Elasticity of Qd w.r.t. Income = =
Proportionate Change in Income M
M
or
Qdx
100
Percentage Change in Qdx Qdx
Elasticity of Qd w.r.t. Cross Price = =
Percentage Change in Income M
100
M
Qdx M Qdx M
xM =  = 
Qdx M M Qdx
Qdx
(−)ve → When M  then Qdx , then xM will have negative relationship: Inferior Good
M
Qdx
(+)ve → When Py  then Qdx , then xM will have positive relationship: Normal Good
M
Qdx
If = 0, then, income elasticity is also 0
M
 Income Elasticity

X
 Income Elasticity

X
 Income Elasticity

X
 Income Elasticity
Engel Expenditure Curve: it represents the relation between the income and total consumer expenditure on specific
goods. It depicts the relationship between P, Q and M

Good X is Necessary Item, as Good X is Luxury Item, as Good X is Inferior Item, as

expenditure rises slowly with expenditure rises fastly with expenditure falls with the rise
the rise in income the rise in income in income
 Income Elasticity
Engel Aggregation Example-2: Assume that the consumption basket of a utility
p1 x maximising consumer consists of only two goods x and y.
1=  xm + p2 y  ym Assume further that she spends a quarter of her income on good x
M M and the income elasticity of demand for good x is 0.5. What is the
where, income elasticity of demand for good y? [JNU PhD Economics]
p1x
= Share of money spent on good x A) 1.17
M
xm = Income elasticity of demand for good x B) 1.19
p2 y C) 1.15
= Share of money spent on good y
M D) 1.21
ym = Income elasticity of demand for good y
 Income Elasticity
Engle Law: As income rises the proportion of income spent on food grains or basic goods decreases. In
other words, income elasticity of demand for basic goods is less than 1.
Example-3: The MPC of a consumer is 0.80 and APC is 0.40, then the income elasticity would be:
[MH-SET]
a) 0.5
b) 2.00
c) 1.20
d) 0.40
 Cournot Aggregation Condition
11 : Own price elasticity of demand for Q1
21 : Cross price elasticity of demand for Q2 due to change in P1
Then, 111 + 221 = −1
where,
1 & 2 represent proportions of income spent on Q1 and Q2.
Similarly,
21 : Own price elasticity of demand for Q2
22 : Cross price elasticity of demand for Q1 due to change in P2
Then, 121 + 222 = −2
where,
1 & 2 represent proportions of income spent on Q1 and Q2.
 Relationship between the three Elasticities

One of the properties of demand curve is that is homogenous of degree 0 in all prices and the level of income.
This means that if all prices and the level of income are increased by k times, the quantity demanded of the two
goods will remain unaffected. This implies that consumer is not suffering from money illusion.

11 +12 +1m = 0

where,
11 : Own price elasticity
12 : Cross price elasticity
1m : Income elasticity
 Consumer Surplus: Using Marshallian Analysis

• The concept of consumer surplus was first introduced by Marshall. It indicates the difference between the maximum
price what the consumer is willing to pay and the price what she actually ends up paying.
• It is denoted by the area under the demand curve and above the price level. DNPU
• Algebraically, it is calculated by area under the demand curve formula using integration approach.

Consumer Surplus Producer Surplus


q*
d (q).dq − p * q * p * q * −  s(q).dq
q*
0 0

where, where,
f (q) : demand function s(q) : supply function
p*: equilibrium price p*: equilibrium price
q*: equilibrium quantity q*: equilibrium quantity
 Consumer Surplus: Using Marshallian Analysis

Steps to calculate Consumer and Producer Surplus:

1) Equate Demand and Supply, if given in the question to find the equilibrium price and equilibrium quantity.
2) If demand function and supply is not given then no need to start with the step-1, directly use q value so
given in the question.
3) Substitute in the above formula
 Consumer Surplus: Using Marshallian Analysis

Example-4: [UGC NET PYQs]

Steps to calculate Consumer and Producer Surplus:

1) Equate Demand and Supply, if given in the question to find the equilibrium price and equilibrium quantity.
2) If demand function and supply is not given then no need to start with the step-1, directly use q value so
given in the question.
3) Substitute in the above formula
 Consumer Surplus: Using Marshallian Analysis

Example-5: [UGC NET PYQs]

Steps to calculate Consumer and Producer Surplus:

1) Equate Demand and Supply, if given in the question to find the equilibrium price and equilibrium quantity.
2) If demand function and supply is not given then no need to start with the step-1, directly use q value so
given in the question.
3) Substitute in the above formula
 Consumer Surplus: Using Marshallian Analysis

Example-6: [UGC NET PYQs]

 Consumer Surplus: Using Marshallian Analysis

Example-6: [UGC NET Dec-22]

Consumer Surplus Producer Surplus

q* q*
0
d (q).dq − p * q * p * q * −  s(q).dq
0

where, where,
f (q) : demand function s(q) : supply function
p*: equilibrium price p*: equilibrium price
q*: equilibrium quantity q*: equilibrium quantity
 Consumer Surplus: Using Marshallian Analysis

Example-6: [UGC NET Dec-22 | S-2]

Consumer Surplus Producer Surplus

q*
p * q * −  s(q).dq
q*
0
d (q).dq − p * q * 0

where, where,
f (q) : demand function s(q) : supply function
p*: equilibrium price p*: equilibrium price
q*: equilibrium quantity q*: equilibrium quantity
 Consumer Surplus: Using Marshallian Analysis

Example-7: [UGC NET PYQs]

 Consumer Surplus: Using IC Analysis

Example-8: [UGC NET PYQs]

In the standard adjoining diagram, the measure of consumer surplus is
1). PA 2) OB
3) AO 4) AB Explanation:
The budget line PQ is tangent to IC2 at point E. The slope of PQ is
equal to price of good X. At point E, the consumer purchases OM units
of good x by spending PA units of money. Thus, he is left with AO
units of money unspent. Now, let’s find out the amount of money
which the consumer would be willing to pay for OM units of good x
rather than do without it. For this, we draw an IC1 which passes
through P. In Marshallian theory, we know that MUm is assumed to be
constant, so the two ICs will be parallel to each other. This implies that
the slope of IC remains constant. IC1 indicates that the consumer has
OM units of good x and OB amount of money he will be indifferent to
the situation where he has no good x and all money. Here PB is the
maximum amount of money that the consumer would be willing to pay
for OM untis of good x, rather than leave it.
 Consumer Surplus: Using IC Analysis

Example-8: [UGC NET PYQs]

In the standard adjoining diagram, the measure of consumer surplus is
1). PA 2) OB
3) AO 4) AB Explanation:
Thus, given the market price of the commodity X, the consumer has
actually spent PA amount of money for acquiring OM amount of
commodity X. But, as mentioned above, he was prepared to forego PB
amount of money for having OA amount of X. Therefore, the
consumer actually pays AB less amount of money than he is prepared
to pay for OA amount of the commodity X rather than go without it.
Thus, AB is the amount of consumer’s surplus which the consumer
derives from purchasing OA amount of the commodity. So, the
difference between PB-PA is what the consumer surplus is, that is AB.
Lecture-9: Revealed Preference
Theory-WARP & SARP
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
NTA-UGC-NET | Revealed Preference Theory

ChoiceReveal
Preferences

As per Microeconomists Revealed Preference

(Ordinalists / Cardinalists) Theory
 NTA-UGC-NET | Revealed Preference Theory

ChoiceReveal
Preferences

As per Microeconomists Revealed Preference

(Ordinalists / Cardinalists) Theory

Marshallian and IC approach are based on introspective method. It implies that both the theories provide
psychological explanation to consumer’s analysis. That is, we determine MU or IC based upon the information
supplied by the consumer. On the other hand, Revealed Preference Theory relies on the information collected
by the researcher himself. It was propounded by Paul Samuelson in 1938. This theory studies the behaviour of
the People while they are making choices. This is why it is also termed as Behaviourial Ordinal Utility
Theory. Unlike Utility and IC analysis, this method is not introspective (self-analysing). This implies that
while the former two assumes that the Consumer knows his/her preferences clearly, based upon which they
make their choices, the latter theory (RP) is non-introspective (indeed observational) as it derives preferences
based upon previous choices made by the consumers.
 NTA-UGC-NET | Revealed Preference Theory
As per RPT, a consumer buys a good x either:
a) When he prefers good x over good y
b) Or when x is cheaper than y and it fits his budget

So, if we have the information about the prices of all the goods and if the consumer opts for Good X, given
all the other goods are affordable to him, then we can say that the consumer has revealed his preference for
good x and all other goods are inferior to good x.
 NTA-UGC-NET | Revealed Preference Theory
As per RPT, a consumer buys a good x either:
a) When he prefers good x over good y
b) Or when x is cheaper than y and it fits his budget

So, if we have the information about the prices of all the goods and if the consumer opts for Good X, given
all the other goods are affordable to him, then we can say that the consumer has revealed his preference for
good x and all other goods are inferior to good x.
Assumptions of RPT
The theory of revealed preference rests on the following assumptions:
1. The tastes of the consumer do not change over the period of the analysis.
2. The consumer’s tastes are consistent, so that if the consumer purchases basket A rather than basket B, the
consumer will never prefer B to A.
3. The consumer’s tastes are transitive, so that if the consumer prefers A to B and B to C, the consumer will
prefer A to C.
4. The consumer can be induced to purchase any basket of commodities if its price is lowered sufficiently.
5. He has assumed positive income elasticity of demand and have ignore the negative income elasticity
instances.
NTA-UGC-NET | Revealed Preference Theory
 NTA-UGC-NET | Revealed Preference Theory
Axioms of Revealed Preference Theory
1. Consumer is faced with a price-income situation and no consumer can influence the prices of the goods.
This implies that a consumer has given fixed income, given prices and a linear budget line.
2. Consumer always buys a bundle at any price-income situation. This implies that it is never ever that he will
not buy anything. This indicates strict convex preference and on every budget line there is an unique point,
where the consumer will buy something.
3. The consumer will always spend the entire amount of money, so there is no saving no borrowing.
4. Both these goods are of MIB (more-is-better) type. This assumption is also known as the assumption of
monotonicity. This assumption implies that the ICs of the consumer are negatively sloped.
5. Weak Axiom of Revealed Preference (WARP): If a consumer chooses the combination of goods say
E1(x1, y1) over another affordable combination E2(x2, y2) in a particular price-income situation, then
under no circumstances would he choose E2 over E1 if E1 is affordable. In other words, if a combination E1
is revealed preferred to E2, then, under no circumstances, E2 can be revealed preferred to E1.
 NTA-UGC-NET | Revealed Preference Theory

Axioms of Revealed Preference Theory

6. Strong Axiom of Revealed Preference (SARP): If the consumer, under different price-income situations,
reveals the combination E1 as preferred to E2, E2 to E3,…, Ek, then Ek would never (under no price-income
situation) be revealed preferred to E1.
7. Consistency, Strong Ordering or Two-Term Consistency: RPT assumes consistency in consumer's
choices. Consistency implicitly implies strong ordering in consumer’s preferences. If a consumers chooses A
bundle instead of B at one instance, then he cannot choose B instead of A in any other situation, provided A is
affordable. Hicks termed this assumption as two-term consistency, as the consistency behaviour is being
studied in two instances.
 NTA-UGC-NET | Revealed Preference Theory

8. RPT assumes Income elasticity of demand is positive, i.e., more commodity is demanded when income
increases, and less when income falls.

As a result:

Samuelson’s revealed preference hypothesis excludes the study of the Giffen Paradox, for it considers only
positive income elasticity of demand. The Giffen case, on the other hand, relates to negative income
elasticity of demand. Like the Marshallian law of demand, the Samuelsonian Theorem fails to distinguish
between negative income effect of a Giffen good combined with a weak substitution effect and a negative
income effect with a powerful substitution effect. Samuelson’s Fundamental Theorem is, therefore, inferior
to and less integrated than the Hicks-Alien price effect which provides an all inclusive explanation of the
income effect, the substitution effect and of Giffen’s Paradox.
 NTA-UGC-NET | Revealed Preference Theory
Assumptions:
(1) No change in the Taste of the consumer.
(2) The choice for a combination reveals consumer’s preference for that.
(3) The consumer chooses only one combination at a given price-income line.
(4) In any situation, the consumer prefers a combination of more goods to less.
(5) The consumer’s choice is based on strong ordering.
(6) It assumes consistency of consumer behaviour. If combination A is preferred to В in one situation, В
cannot be preferred to A in the other situation.
(7) This theory is based on the assumption of transitivity. Transitivity, however, refers to three-term
consistency. If A is preferred to B, and В to C, then the consumer must prefer A to C.
(8) Income elasticity of demand is positive i.e., more commodity is demanded when income increases,
and less when income falls.
 NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP)
Y
In this case, the consumer choses Bundle A over Bundle
B (as per Blue Budget Line). Thus, he is choosing A
when B was affordable.

But, As per Red Budget Line, he choses B over A. A

Thus, there is no consistency in the consumer’s (x1, x2)
preferences, so we can say he is not a maximising
consumer. (y1, y2)
B
X
 NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP)
Y
In this case, the consumer choses Bundle A over Bundle
B (as per Blue Budget Line). Thus, he is choosing A
when B was affordable.

But, As per Red Budget Line, he choses B over A. A

Thus, there is no consistency in the consumer’s (x1, x2)
preferences, so we can say he is not a maximising
consumer. (y1, y2)
B
Y X

Consumer violates WARP &

not a maximising consumer
A
(x1, x2)

(y1, y2)
B
X

If (x1, x2) is directly revealed preferred to (y1, y2),

then it cannot happen that (y1, y2) is directly
revealed preferred to (x1, x2).
 NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP)
Y
In this case, the consumer choses Bundle A over Bundle Consumer violates WARP &
B (as per Blue Budget Line). Thus, he is choosing A not a maximising consumer
when B was affordable.

But, As per Red Budget Line, he choses B over A. A

Thus, there is no consistency in the consumer’s (x1, x2)
preferences, so we can say he is not a maximising
consumer. (y1, y2)
B
X

If (x1, x2) is directly revealed preferred to (y1, y2),

then it cannot happen that (y1, y2) is directly
revealed preferred to (x1, x2).
Y
Consumer satisfies WARP &
is a maximising consumer

A (x1, x2)

B (y1, y2)

X
 NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP)
Y
In this case, the consumer choses Bundle A over Bundle Consumer violates WARP &
B (as per Blue Budget Line). Thus, he is choosing A not a maximising consumer
when B was affordable.

But, As per Red Budget Line, he choses B over A. A

Thus, there is no consistency in the consumer’s (x1, x2)
preferences, so we can say he is not a maximising
consumer. (y1, y2)
B
X

If (x1, x2) is directly revealed preferred to (y1, y2),

then it cannot happen that (y1, y2) is directly
revealed preferred to (x1, x2).
Y Y
Consumer satisfies WARP & Consumer satisfies WARP &
is a maximising consumer is a maximising consumer

A (x1, x2) A (x1, x2)

B
(y1, y2) B (y1, y2)
X X
 NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP)
Y
In this case, theCONDITION
consumer chosesfor Bundle
WARPA over Bundle
Consumer violates WARP &
If a Blue
B (as per bundle (x1, x2)
Budget is purchased
Line). Thus, he at prices A
is choosing not a maximising consumer
(p1, p2) and a different bundle
when B was (y1, y2) is purchased at
affordable.
prices (q1, q2), then if
But, As per Red Budget Line, he choses B over A.
A
p1x1 + p2x2 ≥ p1y1 + p2y2,
Thus, there is no consistency in the consumer’s (x1, x2)
preferences, so we can say he is not a maximising
it must not be the case that:
consumer. (y1, y2)
q1y1 + q2y2 ≥ q1x1 + q2x2 B
X

If (x1, x2) is directly revealed preferred to (y1, y2),

then it cannot happen that (y1, y2) is directly
revealed preferred to (x1, x2).
Y Y
Consumer satisfies WARP & Consumer satisfies WARP &
is a maximising consumer is a maximising consumer

A (x1, x2) A (x1, x2)

B
(y1, y2) B (y1, y2)
X X
NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP) Budget Rs 5

Pepsi Rs 4
GURUMANTRA
If I am purchasing (preferring) Coke (priced at Rs 5) when Coke Rs 5
Pepsi (priced at Rs 4), then I revealed my preference for Coke
over Pepsi. I could have taken Pepsi, but I RP for Coke. Budget Rs 4

Pepsi Rs 4
Now, in some other case, if I am choosing Pepsi, when Coke Coke Rs 5
was not affordable, then also I RP for Pepsi

Budget Rs 5
But if I chose Pepsi when Coke was affordable, then I am not a Pepsi Rs 4
maximising consumer because I have already revealed my
preference for Coke. Coke Rs 5

CONDITION for WARP

If a bundle (x1, x2) is purchased at prices (p1, p2) and a different bundle (y1, y2) is purchased
at prices (q1, q2), then if

p1x1 + p2x2 ≥ p1y1 + p2y2,

it must not be the case that:

q1y1 + q2y2 ≥ q1x1 + q2x2
NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP)
Checking WARP Quantity Price Quantity Price

p1x1 + p2x2 ≥ p1y1 + p2y2, X1 2 P1 1 Y1 3 Q1 3

Exp on X bundle ≥ Exp on Y bundle X2 2 P2 2 Y2 1 Q2 1

1(2) + 2(2) ≥ 1(3) + 2(1) This implies that bundle X is purchased at P1,
6≥5  P2 prices, when bundle Y was affordable

q1y1 + q2y2 ≥ q1x1 + q2x2

This implies that bundle Y is purchased at Q1,
3(3) + 1(1) ≥ 3(2) + 1(2) Q2 prices, when bundle X was affordable and
10 ≥ 8  is rejected. Why???
CONDITION for WARP
If a bundle (x1, x2) is purchased at prices (p1, p2) and a different bundle (y1, y2) is
purchased at prices (q1, q2), then if

p1x1 + p2x2 ≥ p1y1 + p2y2,

it must not be the case that:

q1y1 + q2y2 ≥ q1x1 + q2x2
NTA-UGC-NET | Revealed Preference Theory
Weak Axiomof RevealedPreference(WARP)
Checking WARP Quantity Price Quantity Price

p1x1 + p2x2 ≥ p1y1 + p2y2, X1 2 P1 1 Y1 3 Q1 3

Exp on X bundle ≥ Exp on Y bundle X2 2 P2 2 Y2 1 Q2 1

1(2) + 2(2) ≥ 1(3) + 2(1) This implies that bundle X is purchased at P1,
6≥5  P2 prices, when bundle Y was affordable

q1y1 + q2y2 ≥ q1x1 + q2x2

3(3) + 1(1) ≥ 3(2) + 1(2) This implies that bundle Y is purchased at Q1,

10 ≥ 8 11 Q2 prices, when bundle X was not affordable
hence is rejected.
CONDITION for WARP
If a bundle (x1, x2) is purchased at prices (p1, p2) and a different bundle (y1, y2) is purchased at
prices (q1, q2), then if

p1x1 + p2x2 ≥ p1y1 + p2y2,

it must not be the case that:

q1y1 + q2y2 ≥ q1x1 + q2x2
NTA-UGC-NET | Revealed Preference Theory

StrongAxiomof RevealedPreference WeakAxiomofRevealedPreference

(SARP) (WARP)

If (x1, x2) is directly or indirectly revealed preferred If (x1, x2) is directly revealed preferred to (y1, y2),
to (y1, y2), then it cannot happen that (y1, y2) is then it cannot happen that (y1, y2) is directly
directly or indirectly revealed preferred to (x1, x2). revealed preferred to (x1, x2).

Indirectly: Means Preference revealed by applying Directly: Means Preference is demonstrated by

transitivity to observed choices consumer’s choice
 NTA-UGC-NET | Revealed Preference Theory
18  M  20 Example
Observations P1 P2 X1 X2

1 2 3 3 4

2 3 2 4 3

3 2 2 5 5

EXPENDITURE

Quantity X1=3, X2=4 X1=4, X2=3 X1=5, X2=5

Prices P1=2, P2=3 2(3) + 3(4) = 18 2(4) + 3(3) = 17 2(5) + 3(5) = 25

P1=3, P2=2 3(3) + 2(4) = 17 3(4) + 2(3) = 18 3(5) + 2(5) = 25

P1=2, P2=2 2(3) + 2(4) = 14 2(4) + 2(3) = 14 2(5) + 2(5) = 20

 NTA-UGC-NET | Revealed Preference Theory
18  M  20 Example
Observations P1 P2 X1 X2

1 2 3 3 4

2 3 2 4 3

3 2 2 5 5

EXPENDITURE

Quantity X1=3, X2=4 X1=4, X2=3 X1=5, X2=5

Prices P1=2, P2=3 18 17 25

P1=3, P2=2 17 18 25

P1=2, P2=2 14 14 20

CM
oonstupmrerfearcretudablluyncdhleososes
theasetbhuenydelxehsa&usctotm hp eletely
beuxdhgaeutsatm
somuonntey
 NTA-UGC-NET | Revealed Preference Theory
18  M  20 Example
Observations P1 P2 X1 X2

1 2 3 3 4

2 3 2 4 3

3 2 2 5 5

EXPENDITURE

Quantity X1=3, X2=4 X1=4, X2=3 X1=5, X2=5

Prices P1=2, P2=3 18 17 25

P1=3, P2=2 17 18 25

P1=2, P2=2 14 14 20

1 Now,let’sfigureout the At 1st Instance, Bundle1 ischosenover Bundle2

affordablebundlesat each Bundle1 >Bundle2
pricelevels
But at 2nd Instance, Bundle2 ischosenover Bundle1
Bundle2>Bundle1 (though1 wasaffordable)
2
Now,let’scheck WARP WARPVIOLATED
conditions
 NTA-UGC-NET | Revealed Preference Theory
18  M  20 Example
Observations P1 P2 X1 X2

1 2 3 3 4

2 3 2 4 3

3 2 2 5 5

EXPENDITURE

Quantity X1=3, X2=4 X1=4, X2=3 X1=5, X2=5

Prices P1=2, P2=3 18 17 25

P1=3, P2=2 17 19 18 25 16

P1=2, P2=2 14 25 14 25 20

1 Now,let’sfigureout the At 1st Instance, Bundle1 ischosenover Bundle2

affordablebundlesat each Bundle1 >Bundle2
pricelevels
But at 2nd Instance, Bundle2 ischosenover Bundle1
Bundle2>Bundle1 (when1 wasunaffordable)
2
Now,let’scheck WARP WARPSATISFIED
conditions
NTA-UGC-NET | Revealed Preference Theory
Example
Observations P1 P2 X1 X2

1 2 3 3 4

2 3 2 4 3

3 2 2 5 5

EXPENDITURE

Quantity X1=3, X2=4 X1=4, X2=3 X1=5, X2=5

Prices P1=2, P2=3 18 17* 25 (*)

P1=3, P2=2 19 18 16*

P1=2, P2=2 25 25 20

Bundle1 isdirectlyrevealedpreferredtoBundle2 , *Affordablebut not chosen

(*) Indirectly RP
Bundle2isdirectlyrevealedpreferredtoBundle3

ByTransitivity, wecanconclude, that Thisisbased onour

Bundle1 isindirectlyrevealed preferredtoBundle3 inferenceofconsumer’s
preferences
 Revealed Preference Theory | Limitations
Difficult to separate SE
• Samuelson’s Fundamental Theorem is conditional and not universal. It is based on the postulate that
positive income elasticities imply negative price elasticities. Since the price effect consists of the income
and substitution effects, it is not possible to isolate the substitution effect from the income effect on the
level of observation.
• If the income effect is not positive, price elasticity of demand is indeterminate. On the other hand, if the
income elasticity of demand is positive, the substitution effect following a change in price cannot be
established. Thus, the substitution effect cannot be distinguished from the income effect in the
Samuelsonian Theorem
 Revealed Preference Theory | Limitations
Excludes Giffen Paradox
• Samuelson’s revealed preference hypothesis excludes the study of the Giffen Paradox, for it considers only
positive income elasticity of demand. Like the Marshallian Law of Demand, the Samuelsonian Theorem
fails to distinguish between negative income effect of a Giffen good combined with a weak substitution
effect and a negative income effect with a powerful substitution effect.
• Samuelson’s Fundamental Theorem is, therefore, inferior to and less integrated than the Hicksian price
effect which provides an all inclusive explanation of the income effect, the substitution effect and of
Giffen’s Paradox.
 Derivation of Demand Curve using RPT

Assume that the consumer has the budget line AB in the below figure
and chooses the collection of goods denoted by point Z, thus revealing
his preference for this batch. Suppose that the price of x falls so that
the new budget line facing the consumer is AC. We will show that the
new batch will include a larger quantity of x.
 Derivation of Demand Curve using RPT

Assume that the consumer has the budget line AB in the below figure
and chooses the collection of goods denoted by point Z, thus revealing
his preference for this batch. Suppose that the price of x falls so that
the new budget line facing the consumer is AC. We will show that the
new batch will include a larger quantity of x.
Firstly, we make a 'compensating variation' of the income, which
consists in the reduction of income so that the consumer has just
enough income to enable him to continue purchasing Z if he so
wishes. The compensating variation is shown in figure by a parallel
shift of the new budget line so that the 'compensated' budget line A'B'
passes through Z. Since the collection Z is still available to him, the
consumer will not choose any bundle to the left of Z on the segment
A'Z, because his choice would be inconsistent, given that in the
original situation all the batches on A'Z were revealed inferior to Z.
 Derivation of Demand Curve using RPT

Hence the consumer will either continue to buy Z (in which case the
substitution effect is zero) or he will choose a batch on the segment
ZB', such as W, which includes a larger quantity of x (namely x 2 ).
 Derivation of Demand Curve using RPT

Hence the consumer will either continue to buy Z (in which case the
substitution effect is zero) or he will choose a batch on the segment
ZB', such as W, which includes a larger quantity of x (namely x 2 ).
Secondly, if we remove the (fictitious) reduction in income and allow
the consumer to move on the new budget line AC, he will choose a
batch (such as N) to the right of W (if the commodity x is normal with
a positive income effect). The new revealed equilibrium position (N)
includes a larger quantity of x (i.e. x 3) resulting from the fall in its
price. Thus the revealed preference axiom and the implied consistency
of choice open a direct way to the derivation of the demand curve: as
price falls, more of x is purchased.
 Derivation of Indifference Curve using RPT
The indifference-curves approach requires less information than the neoclassical cardinal utility theory. But still it requires a
lot from the consumer, since the theory expects him to be able to rank rationally and consistently all possible collections of
commodities.
Samuelson's revealed preference theory does not require the consumer to rank his preferences or to give any other
information about his tastes. The revealed preference permits us to construct the indifference map of the consumer just by
observing his behaviour (his choice) at various market prices, provided that (a) his choice is consistent, (b) his tastes are
independent of his choices over time and do not change, (c) that the consumer is rational in the Pareto sense, that is, he
prefers more goods to less.
 Derivation of Indifference Curve using RPT
Assume that the initial budget line of the consumer is AB in the figure and he
chooses the batch Z. All the other points on the budget line and below it
denote inferior batches to Z. If we draw perpendiculars through Z, CZ and
ZD, all the batches on these lines, and in the area defined by them to the right
of Z, are preferred to Z because they contain more quantity of at least one
commodity. Batches of goods in the remaining area (below CZD and above
the budget line) are still not ordered. However, we may rank them relative to
Z by adopting the following procedure.
 Derivation of Indifference Curve using RPT
Assume that the initial budget line of the consumer is AB in the figure and he
chooses the batch Z. All the other points on the budget line and below it
denote inferior batches to Z. If we draw perpendiculars through Z, CZ and
ZD, all the batches on these lines, and in the area defined by them to the right
of Z, are preferred to Z because they contain more quantity of at least one
commodity. Batches of goods in the remaining area (below CZD and above
the budget line) are still not ordered. However, we may rank them relative to
Z by adopting the following procedure.

Let the price of x fall so that the new budget line EF passes below Z
The consumer will choose either G or a point to the right of G (on GF), since
points on EG would imply inconsistent choice, being below the original
budget line and hence inferior to G.
 Derivation of Indifference Curve using RPT

Assume that the consumer chooses G. Using the transitivity assumption we

have

Z>G (in the original situation)

G > (GBF) (in the new budget situation)
Hence, Z > (GBF)
 Derivation of Indifference Curve using RPT

Assume that the consumer chooses G. Using the transitivity assumption we

have

Z>G (in the original situation)

G > (GBF) (in the new budget situation)
Hence, Z > (GBF)
Repeating this procedure we may gradually narrow down the 'ignorance zone'
until we locate the indifference curve within as narrow a range as we wish.
Hence the revealed preference axiom permits us to derive the indifference
curve from the behaviour (actual choice) of the consumer in various market
situations.
 Superiority of RPT

1. This theory does not involve any psychological introspective information about the behaviour of the
consumer. Thus the revealed preference hypothesis is more realistic and scientific than the earlier
demand theorems.
2. It avoids the “continuity” assumption of the utility and indifference curve approaches. An indifference
curve is a continuous curve on which the consumer can have any combination of the two goods.
Samuelson believes that there is discontinuity because the consumer can have only one combination.
 Superiority of RPT

3. The Hicksian demand analysis is based on the assumption that the consumer always behaves rationally to
maximise his satisfaction from a given income. Samuelson’s demand theorem is superior because it completely
dispenses with the assumption that the consumer always maximises his satisfaction, and makes no use of the
dubious hypothesis like the Law of Diminishing Marginal Utility of the Marshallian analysis or the Law of
Diminishing Marginal Rate of Substitution of the Hicksian approach.

4. In the first stage of Samuelson’s demand theorem the ‘over compensation effect’ is more realistic as an
explanation of consumer behaviour than the Hicksian substitution effect. It permits the consumer to shift to a
higher price-income situation in case of rise in the price of X and vice versa. Thus it is an improvement over
Hicks’ substitution effect. Similarly, the second stage of the Samuelsonian Theorem explains the Hicksian
‘income effect in a much simpler way. Hicks himself admits the superiority of Samuelson’s theory when he writes
that as a clear alternative to the indifference technique its presentation is the newest and important contribution of
Samuelson to the theory of demand.
 NTA-UGC-NET | Revealed Preference Theory

Question-1: Which of the following is true for Revealed preference theory? [UGC NET PYQs]
A. Income elasticity of demand should be negative.
B. Consumer preferences are based on observed behaviour
C. Consumer preferences are not based on observed behaviour.
D. Considers the case of inferior goods.

Question-2: The basic tenets of the Revealed preference theory are based on [UGC NET PYQs]

a. Consistency.
b. Strong ordering.
c. Positive elasticity of demand.
d. All of the above
 NTA-UGC-NET | Revealed Preference Theory

Question-3: Revealed preference theory is based on [UGC NET PYQs]

a. Consistency.
b. Strong ordering.
c. Positive income elasticity of demand.
d. All of the above

Question-4: Assertion: The theory of Revealed preference does not explain the case of Giffen goods.
Reason: The theory of Revealed preference only focuses on the negative elasticity of demand.
Codes:
A. Both (A) and (R) are true, and (R) is the correct explanation of (A).
B. Both (A) and (R) are true, and (R) is not the correct explanation of (A).
C. (A) is true but (R) is false
D. Both (A) and (R) is false.
 Lecture-10: Fixed Linear, Cobb-
Douglas, CES, Isoquants, Ridge
Lines, Law of Variable Proportions,
Elasticity of Substitution
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
Free Classes- Today & Tomorrow @ 9:00 p.m.
Production Function
Production Theory
Production Function
Production Function
Production Function [On the basis of Time Horizon]
Types of Production Function
 Features of Production Function

1) Substitutability: The factors of productions are substitutes of one another which make it possible to vary TP
by changing input quantity of one variable, while holding the quantities of all other variables constant. Because
of substitutability, the law of variable proportions arises.
2) Complementary: The production factors are complementary to one another. No production can take place if
the quantity of any input is 0. The returns to scale exists due to complementary feature of production function.
3) Specification: It implies that inputs are specific to the production of a given product. Since inputs can be
used for production of other goods also, so there may not be complete specialisation.
 Production Function
A. Leontief Production Function: It uses fixed proportion of inputs
having no substitutability between them. It is regarded as the
limiting case for constant elasticity of substitution.
Q(K,L) = min(1/6L,K)
Q(K,L) = min(2K,3L) Q(K,L) = min(aK,bL)

• A firm featured with this production function will always operate

along the ray where the ratio K/L is fixed at b/a (or 3/2) and any
point of operation other than at the vertex of the iso-quants would
be inefficient.
• Because K/L is a constant, so elasticity of substitution (σ) equal 0.
• This is a case of perfect complementary.
• Reflects CRS for linear Leontief production function and reflects
increasing or decreasing returns for non-linear Leontief production
function.
 Production Function
B. Linear Production Function: The production function is given by:
q = f (K, L) = aK + bL
• The production function exhibits constant returns to scale
• The iso-quants of the production function are parallel straight lines with
slope (–b/a)
• σ is equal to infinity
• substitute labour for capital or capital for labour without any limit
 Production Function
C. Cobb-Douglas Production Function
1. The Cobb-Douglas production function is given by Charles Cobb and
Paul Douglas in 1928:
• q = f (K, L) = AKaLb
• where A, a, and b are all positive constants.
2. Iso-quants resulting from the functional form have convex shape
3. Returns to Scale
•a + b = 1 implies constant returns to scale
•a + b > 1 implies increasing returns to scale
•a + b < 1 implies decreasing returns-to-scale case.
dq  dq 
 
Allen's definition  = dL  dK  , where q =
AK a L1−a
 d 2q 
q 
 dL.dK 
(1− a )  q  a  q 
=  L   K  =1
 (1− a )( a ) 
q2  
KL
 
Elasticity of substitution is always = 1
 Production Function
C. Cobb-Douglas Production Function

5. C-D function is linear in logarithms,

ln q = ln A + a ln K + b ln L
Where, a is the elasticity of output w.r.t. capital and b
is the elasticity of output w.r.t. labour
6. dq K d ln q
q,K = = =a
dK q d ln K
dq L d ln q
 q,L = = =b
dL q d ln L

7. If one of the factors is zero, then output is also zero.

8. The function can be represented as log-linear model as
lnQ = lnA+ alnK+(1-a)lnL
 Production Function
C. Cobb-Douglas Production Function
9. AP and MP of factors are function of K-L ratio.
 Production Function
C. Cobb-Douglas Production Function
9. AP and MP of factors are function of K-L ratio.
10. a and (1 – a) represent output elasticities of labour and
capital. Say, a is 0.33 and 1 – a = 0.66, then it implies that
when K increases by 1 %, output will increase by 0.33%
holding labour constant and when L increases by 1%,
output will increase by 0.66% holding capital constant.
This implies C-D function indicates Diminishing marginal
productivities for individual inputs but both the factors
together indicate CRS.
 Production Function
C. Cobb-Douglas Production Function
9. AP and MP of factors are function of K-L ratio.
10. a and (1 – a) represent output elasticities of labour and
capital. Say, a is 0.33 and 1 – a = 0.66, then it implies that
when K increases by 1 %, output will increase by 0.33%
holding labour constant and when L increases by 1%,
output will increase by 0.66% holding capital constant.
This implies C-D function indicates Diminishing marginal
productivities for individual inputs but both the factors
together indicate CRS.
Production Function
 Production Function

D. Constant Elasticity of Substitution Production

Function: It is given by Arrow, Chenery, Minhas and
Q = A  L− + (1−  ) K 
− −1

Solow in 1961:
Where,  
A > 0 indicates technological progress or efficiency
parameter
0 ≤  ≤ 1 indicates distribution parameter
 is a constant indicating substitution parameter.
 Production Function

D. Constant Elasticity of Substitution Production Function: −1

It is given by Arrow, Chenery,
Q = A  L− + (1−  ) K 
− 
Minhas and Solow in 1961:
Where,  
A > 0 indicates technological progress or efficiency parameter
0 ≤  ≤ 1 indicates distribution parameter
 is a constant indicating substitution parameter.
1. It is homogenous with degree 1
2. Elasiticity of substitution is constant, which is equal to:  = 1
1+ 
3. When  = 0, then  = 1→ CES is Cobb Douglas Production Function
4. When  = -1, then  =  → CES is Linear Homogenous Production Function
5. When  = , then  = 0→ CES is Fixed Proportion Production Function
6. CES function exhibits:
o Increasing returns to scale, when  > 1
o constant returns to scale, when  = 1
o decreasing returns to scale, when  < 1
 Production Function

D. Constant Elasticity of Substitution Production Function: −1

It is given by Arrow, Chenery,
Q = A  L− + (1−  ) K 
− 
Minhas and Solow in 1961:
Where,  
A > 0 indicates technological progress or efficiency parameter
0 ≤  ≤ 1 indicates distribution parameter
 is a constant indicating substitution parameter.

7. The marginal products of labour and capital are always positive if we assume constant returns to scale.

8. The marginal product of an input will increase when other factor inputs increase.

9. The marginal product curves are sloping downward.

10. The estimation of the elasticity of substitution parameter requires the assumption of perfect competition.
 Production Function

E. Variable Elasticity of Substitution Production Function: Developed by Bruno, Knox Lovell and
Revankar in 1973. The production function explaining the relationship between the wage rate and capital-
labour ratio has been developed by Lu and Fletcher.
V
=  +  lnW +  ln K
Elasticity of Substitution L L
 V
 = 1−  1+
WL  where, : Per Labour Value addition
W: Wage
L rate
 rK 
 
K: Capital
L: Labour
1. VES satisfies the requirements of a neo-classical
 ,  ,  are the parameters
production function.

2. VES function includes the fixed co-efficient models.

3. VES production function is more general.

 Isoquants
Isoquant/Iso-product Curve/Equal-product Curve
Isoquant refers to the curve that depicts different input combinations which can produce the same level of output.
Throughout the isoquant curve, we have the same level of output produced but with different input combinations. The
figure below represents IQ 1 as an isoquant curve which is associated with 50 units of output produced.
 Types of Isoquants

Types of Isoquants:
1. Linear isoquant. This type assumes perfect substitutability of factors of production a given commodity may
be produced by using only capital, or only labour, or by an infinite combination of K and L
2. Input-output isoquant: This assumes strict complementarity (that is, zero substitutability) of the factors of
production. There is only one method of production for any one commodity. The isoquant takes the shape
of a right angle. This type of isoquant is also called 'Leontief isoquant' after Leontief, who invented the
input-output analysis.
3. Kinked isoquant: This assumes limited substitutability of K and L. There are only a few processes for
producing any one commodity. Substitutability of the factors is possible only at the kinks. This form is also
called 'activity analysis-isoquant' or 'linear-programming isoquant', because it is basically used in linear
programming.
4. Smooth, convex isoquant. This form assumes continuous substitutability of K and L only over a certain
range, beyond which factors cannot substitute each other. The isoquant appears as a smooth curve convex
to the origin.
Types of Isoquants
Production Stages
 Production Stages
Law of Variable Proportions Law of Diminishing MP
 Production Stages

Stages of Production in terms of Output Elasticities of Labour

Output elasticity of labour is the ratio of percentage change in total
output to percentage change in labour input.
Percentage Change in Output dQ L MPL
YL = =  =
Percentage Change in Labour dL Q AP
L

MPL  1  MP  AP  Stage −1 → Increasing returns to labour

YL = L L
APL
MPL = 1  MP = AP  Stage − 2 → Diminishing returns to labour
YL = L L
APL
MPL  1  MP  AP  Stage − 3 → Negative returns to labour
YL = L L
APL
 Production Function

Positive Marginal Product though Positive but

falling & Ridge Lines
The traditional theory of production usually
concentrates on the range of output over which
the marginal products of factors, although
positive, decrease, that is, over the range of
diminishing (but non-negative) productivity of
the factors of production: the ranges of output
considered by the traditional theory are A'B' in
figure-1 and C'D' in figure-2.
d ( MPL )
MP  0 but  0  Positive MP , but diminishing MP
L L L
dL
d ( MPK )
MP  0 but  0  Positive MP , but diminishing MP
K K K
dK
 Ridge Lines
• As stated above the traditional theory concentrates on efficient ranges of
output, that is, ranges over which the marginal products of factors are
diminishing but positive.
• The locus of points of isoquants where the marginal products of the factors
are zero form the ridge lines.
• The upper ridge line implies that the MP of capital is zero. The lower ridge
line implies that the M P of labour is zero. Thus, along the ridge lines,
MRTS is 0
• Production techniques are only (technically) efficient inside the ridge lines.
Thus, the unshaded region in the below figure is what denotes the positive
but diminishing MPL and MPK, which indicates range of efficient
production. During this range, the isoquants are convex to the origin.
• Outside the ridge lines the marginal products of factors are negative and the
methods of production are inefficient. Such inefficient methods are not
considered by the theory of production, since they imply irrational
behaviour of the firm. Outside the ridge lines, the isoquants are concave to
the origin.
 Ridge Lines

Along the upper ridge line: Along the lower ridge line:
dQ dQ
MPL MPL 0
dL MPL = = dL = = − =0
MRTS
L,K
= dQ = MP 0
MRTS
L,K
= dQ MP MP
K K K
dK dK
dQ dQ
0 MPK
= MP = MP = 0
dK MPK dK MPK = − =
MRTS
K ,L
= MRTS K ,L = dQ = MP 0
dQ L L L
dL dL
 Ridge Lines

Diminishing MRTSL,K and Convex Isoquant

The slope of the isoquant decreases (in absolute terms) as we move
downwards along the isoquant, showing the increasing difficulty in
substituting K for L. The slope of the isoquant is called the marginal rate
of technical substitution, or the marginal rate of substitution.
dQ
MRTS = dL = MPL = − K
L,K dQ MP L
K
dK
 Elasticity of Substitution

MRTS can’t be used as a measure of the degree of substitutability of factors, as it depends on the units of
measurement of the factors. A better measure of the ease of factor substitution is provided by the elasticity of
substitution. The elasticity of substitution is defined as the percentage change in the capital-labour ratio, divided
by the percentage change in the rate of technical substitution. The elasticity of substitution is a pure number
independent of the units of measurement of K and L, since both the numerator and the denominator are
measured in the same units.
 KL ( )
K
% in K / L
= = L
% in MRTS d (MRTS )
MRTS
 Elasticity of Substitution

MRTS can’t be used as a measure of the degree of substitutability of factors, as it depends on the units of
measurement of the factors. A better measure of the ease of factor substitution is provided by the elasticity of
substitution. The elasticity of substitution is defined as the percentage change in the capital-labour ratio, divided
by the percentage change in the rate of technical substitution. The elasticity of substitution is a pure number
independent of the units of measurement of K and L, since both the numerator and the denominator are
measured in the same units.
 KL ( )
K
% in K / L
= = L
% in MRTS d (MRTS )
MRTS
 Factor Intensity

The factor intensity of any process is measured by the slope of the line through the origin to the isoquant. Thus
the factor intensity is the capital-labour ratio.
 Product Lines & Isoclines

The product lines indicate technically possible alternative paths of expansion of output. The optimum path will
be decided by the factor prices. It is the locus of upward shifting isoquants. It indicates physical movement
from one isoquant to another as we change both factors or a single factor. A product line is drawn
independently of factor prices. This is different from the concept of expansion path, which is a similar concept
which considers the factor prices.
Equation of Isocline:
dK
= MRTS = − MPL = Constant
L,K
dL MPK
 w
If we include isocost line now, its slope is − , then isocline is regarded as Expansion Path.
 r
 

Read this part with the

session after two days
 Product Lines & Isoclines
• In SR, with constant capital, isocline is horizontal line parallel to labour-axis
• In Long run, isocline is upward straight line rising through the origin for homogenous production function
• In Long run, isocline is upward rising curve with different curvatures through the origin for non-homogenous
production function.
• Ridge lines are also types of isoclines.
• When isocline coincide with horizontal or labour axis, then MRTSL,K = 0 (lower ridge line).
• When isocline coincide with vertical or capital axis, then MRTSL,K =  (upper ridge line).
• Thus, isocline in a homogenous production function of any degree is a straight line passing through the origin. Thus,
expansion path and ridge lines are considered as isoclines.

Equation of Isocline:
dK
= MRTS = − MPL = Constant
L,K
dL MPK
 w
If we include isocost line now, its slope is − , then isocline is regarded as Expansion Path.
 r
 

Read this part with the

session after two days
 Product Lines & Isoclines
• In SR, with constant capital, isocline is horizontal line parallel to labour-axis
• In Long run, isocline is upward straight line rising through the origin for homogenous production function
• In Long run, isocline is upward rising curve with different curvatures through the origin for non-homogenous
production function.
• Ridge lines are also types of isoclines.
• When isocline coincide with horizontal or labour axis, then MRTSL,K = 0 (lower ridge line).
• When isocline coincide with vertical or capital axis, then MRTSL,K =  (upper ridge line).
• Thus, isocline in a homogenous production function of any degree is a straight line passing through the origin. Thus,
expansion path and ridge lines are considered as isoclines.

Read this part with the

session after two days
 Lecture-11: Returns to Scale,
Homogenous & Homothetic
Production Function, Economies &
Diseconomies
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 Elasticity of Substitution

MRTS can’t be used as a measure of the degree of substitutability of factors, as it depends on the units of
measurement of the factors. A better measure of the ease of factor substitution is provided by the elasticity of
substitution. The elasticity of substitution is defined as the percentage change in the capital-labour ratio, divided
by the percentage change in the rate of technical substitution. The elasticity of substitution is a pure number
independent of the units of measurement of K and L, since both the numerator and the denominator are
measured in the same units.
 KL ( )
K
% in K / L
= = L
% in MRTS d (MRTS )
MRTS
 Factor Intensity

The factor intensity of any process is measured by the slope of the line through the origin to the isoquant. Thus
the factor intensity is the capital-labour ratio.
 Product Lines & Isoclines

The product lines indicate technically possible alternative paths of expansion of output. The optimum path will
be decided by the factor prices. It is the locus of upward shifting isoquants. It indicates physical movement
from one isoquant to another as we change both factors or a single factor. A product line is drawn
independently of factor prices. This is different from the concept of expansion path, which is a similar concept
which considers the factor prices.
Equation of Isocline:
dK
= MRTS = − MPL = Constant
L,K
dL MPK
 w
If we include isocost line now, its slope is − , then isocline is regarded as Expansion Path.
 r
 

Read this part with the

session after two days
 Product Lines & Isoclines
• In SR, with constant capital, isocline is horizontal line parallel to labour-axis
• In Long run, isocline is upward straight line rising through the origin for homogenous production function
• In Long run, isocline is upward rising curve with different curvatures through the origin for non-homogenous
production function.
• Ridge lines are also types of isoclines.
• When isocline coincide with horizontal or labour axis, then MRTSL,K = 0 (lower ridge line).
• When isocline coincide with vertical or capital axis, then MRTSL,K =  (upper ridge line).
• Thus, isocline in a homogenous production function of any degree is a straight line passing through the origin. Thus,
expansion path and ridge lines are considered as isoclines.

Equation of Isocline:
dK
= MRTS = − MPL = Constant
L,K
dL MPK
 w
If we include isocost line now, its slope is − , then isocline is regarded as Expansion Path.
 r
 

Read this part with the

session after two days
 Product Lines & Isoclines
• In SR, with constant capital, isocline is horizontal line parallel to labour-axis
• In Long run, isocline is upward straight line rising through the origin for homogenous production function
• In Long run, isocline is upward rising curve with different curvatures through the origin for non-homogenous
production function.
• Ridge lines are also types of isoclines.
• When isocline coincide with horizontal or labour axis, then MRTSL,K = 0 (lower ridge line).
• When isocline coincide with vertical or capital axis, then MRTSL,K =  (upper ridge line).
• Thus, isocline in a homogenous production function of any degree is a straight line passing through the origin. Thus,
expansion path and ridge lines are considered as isoclines.

Read this part with the

session after two days
 Quick Recap

• In the short run output may be increased by using more of the variable factor(s), while capital (and possibly
other factors as well) are kept constant.
• MP of variable factor(s) will decline eventually as more and more quantities of this factor are combined
with the other constant factors.
• Output expansion with at least one factor constant is described by the law of (eventually) diminishing
returns of the variable factor, which is also referred to as the law of variable proportions.
• In the long run output may be increased by changing all factors by the same proportion or by different
proportions. The term 'returns to scale' refers to the changes in output as all factors change by the same
proportion.
 Homogenous Production Function

Suppose we start from an initial level of inputs and output

X0 = f(L, K)
and we increase all the factors by the same proportion k.
X* = f(kL, kK)
X* = kv f(L, K)
If k can be factored out as common from the new production function, then it is said to be homogenous
production function. If k cannot be factored out, the production function is non-homogeneous.
• If X* increases by the same proportion k as the inputs (i.e. if v = 1), we say that there are constant returns to
scale.
• If X* increases less than proportionally with the increase in the factors (i.e. if v < 1), we have decreasing
returns to scale.
• If X* increases more than proportionally with the increase in the factors (i.e. if v > 1), we have increasing
returns to scale.
 Homogenous Production Function & Euler’s Theorem
From Lecture-21
of Microeconomics

c
 Homogenous Production Function & Euler’s Theorem

• The homogeneous function of the first degree or linear

homogeneous function is written in the following form:

c
 Graphical Presentation of Returns to Scale for Homogenous Production

Causes for Increasing Returns to Scale

Increasing Returns to Scale implicitly implies reduction in the cost of production. The reducing costs may be attributed
to the economies of scale. The economies of scale refer to those benefits that accrue to a particular firm due to increase
its size and expansion of its business overtime. The economies of scale can be further categorised into the following
two types of economies.
• Internal Economies
• External Economies
 Graphical Presentation of Returns to Scale for Homogenous Production

Internal Economies
These are those cost reduction efforts which are created by an individual firm itself with the increase in the scale of
production. Such economies are only limited and specific to a particular firm as they exist due to expansion in the
firm’s size, technological appreciation, employment of well-trained managers and workers, increase in the
specialisation of the employees and scale of operation.
Types of Internal Economies
Alfred Marshall has divided Internal Economies into two parts- Real & Pecuniary Economies.
Real economies are associated with reduction of physical quantity of inputs, raw materials, labour & capital etc.

• Technical Economies - These economies arise because due to the use of better machinery and improved technology
of production. As a firm expands overtime, it earns sufficient funds to install costly and advanced machinery and
also to employ sophisticated technology.
• Managerial Economies - These economies arise due to qualitative and elaborated management, which can be
afforded only by the large firms. These large firms can employ highly skilled managers and can also incur huge and
large scale advertisement.
• Financial Economies - As a large and renowned firm has a good goodwill in the market, so it can issue new shares
and debentures in the primary share market. In addition, it can also get cheaper bank loans.
• Marketing Economies - Due to bulk demand, a big firm purchases raw materials and capital goods at lower and
cheaper rates. It can also set-up its own R&D (research and development) department and wholesale distributor.
 Graphical Presentation of Returns to Scale for Homogenous Production

Internal Economies
• Risk and Survival Economies - Usually the large firms are less prone to shocks and risks. This is because the large
firms often engage in diversification of their business, market and production techniques. This helps them to
minimise the risk involved with the change in the business environment.
Pecuniary Economies: Those which happens when the firms have to pay less for the factors used in the process of
production and distribution. Big firms get raw material at the low price as they buy in bulk, similarly, they get
concessions while borrowing (in terms of lower interest rates) and paying for advertisements.
 Graphical Presentation of Returns to Scale for Homogenous Production

2. External Economies - Unlike internal economies, these economies are not specific to any particular firm. In fact,
these economies are shared by a number of firms within an industry. These economies are exogenous to a particular
firm and occur with the increase in the scale of production (of all the firms) of an industry.
Types of External Economies
a) Economies of Concentration - When many firms of a particular industry establish themselves at one place, then
they enjoy the benefits due to their concentration. Some of these benefits are cheap availability of raw materials,
transport facilities, skilled labour, development of new inventions etc. All these benefits directly or indirectly
contribute to the simultaneous growth of all the firms.
b) Economies of Information - All the firms can join hands together and pool their finance together to invest in R & D
department. Further, the cost of exchanging information and ideas within themselves also reduces. This facilitates in
quality improvement of product of the industry as a whole.
c) Economies of Disintegration - Concentration of firms help the firms to specialise and efficiently produce sub-
products. These individual sub-products are used together for the production of a single final product. For example,
in a car manufacturing industry some firms specialise in the production of wheels, some in the body of the car while
some in the engine of the car. This leads to specialisation and efficient production of the cars by the industry as a
whole.
 Graphical Presentation of Returns to Scale for Homogenous Production

Causes for Decreasing Returns to Scale

Decreasing Returns to Scale implies increasing cost of production. The increase in the cost of production is a result of
diseconomies of scale. Such diseconomies exist when a firm grows and expands beyond its optimum (maximum)
capacity. In other words, a firm faces diseconomies of scale whenever it engages in overproduction. The diseconomies
of scale can be categorised into following two categories.
• Internal Diseconomies
• External Diseconomies
a) Internal Diseconomies are internal and are specific to a particular firm. Such diseconomies obstruct a firm to
produce efficiently at higher levels of output. These may exist due to managerial obstacles, financial obstacles, and
technical obstacles.
b) External Diseconomies are exogenous and external to an individual firm. These diseconomies exist in form of
increase in unit cost of production due to the expansion and growth of the industry. These diseconomies have spill-
over effect on other firms as well.
 Graphical Presentation of Returns to Scale for Homogenous Production

Types of External Diseconomies

i. Technical Diseconomies: This is due to the size of the firm. As firm grows, it uses more complex machinery which
are expensive.
ii. Marketing Diseconomies: This is due to specialization of labour and more output production. After a certain point,
the market is exhausted and there might be reduced demand, which increases the cost of advertisements and selling
activities.
iii. Financial Diseconomies: This is due to financial constraint. As firm grows, there might be time, that its requirement
of big amount of finances may not be fulfilled or at higher rate of interests and / or higher acquisition cost of funds.
iv. Managerial Diseconomies: As the size of a firm increases, administrative problems as well as coordinating
problems may emerge due to the growth of bureaucracy.
 Graphical Presentation of Returns to Scale for Homogenous Production

Economies of Scope:
It refers to reduction of per-unit costs through the production of a wider variety of goods or services. This enables a
firm to reduce the joint cost of production; besides sharing the inputs among similar products.
Economies of Scope is said to exists:
• when the joint production of goods by a single firm is greater than production of these goods in isolation by two
different firms.
• when the cost of joint production of goods is lesser than cost of individual production
Diseconomies of Scope is said to exists:
• when the joint production of goods by a single firm is lesser than production of these goods in isolation by two
different firms.
• when the cost of joint production of goods is greater than cost of individual production

C ( Q1 ) + C ( Q2 ) − C ( Q1 , Q2 )
ES =
C ( Q1 ) + C ( Q2 )
C ( Q1 , Q2 ) is the cost of jointly producing goods 1 and 2;
C ( Q1 ) is the cost of producing good 1 alone;
C ( Q2 ) is the cost of producing good 1 alone
 Graphical Presentation of Returns to Scale for Homogenous Production

Example-2: Let C(Q1) = Rs 112 lakh; C(Q2) = Rs 108 lakh; and C(Q1,Q2) = Rs 117 lakh. Identify, if there exists
Economies or Diseconomies of Scope. C ( Q1 ) + C ( Q2 ) − C ( Q1 , Q2 )
ES =
C ( Q1 ) + C ( Q2 )
C ( Q1 , Q2 ) is the cost of jointly producing goods 1 and 2;
C ( Q1 ) is the cost of producing good 1 alone;
C ( Q2 ) is the cost of producing good 1 alone
 Graphical Presentation of Returns to Scale for Homogenous Production

Economies of scale are measured in terms of cost-output elasticity. Ec is the percentage change in the cost of
production resulting from a one-percent change increase in output.

C
Ec = C = C Q MC
 =
Q C Q AC
Q
MC
If  1  MC  AC → Economies
AC
MC
If = 1  MC = AC → CRS or Neither Economies nor Diseconomies
AC
MC
If  1  MC  AC → Diseconomies
AC
 Graphical Presentation of Returns to Scale for Homogenous Production

Properties of Homogenous Production Function:

1. If a production function is homogenous of degree n, then the marginal productivities of the factors will
be of degree n-1.
2. If a production function is homogenous of degree 1, then the APL, APK and MPK, MPL all depend
only on the K-L ratio.
3. Homogenous production function satisfies Euler’s Theorem
4. If a production function is linear homogenous and if the isoquant is convex then the MPL and MPK
are diminishing.
 Graphical Presentation of Returns to Scale for Homogenous Production

Example-3: [UGC NET PYQPs]

 Graphical Presentation of Returns to Scale for Homogenous Production

Example-4: [GATE-2022]
 Graphical Presentation of Returns to Scale for Homogenous Production

Homotheticity
If Z = f (A) and A = g (x, y,), then Z is a composite function of x and Y, i.e. Z = f[g(x,y)]. In this case, Z is
homothetic, if:

In other words, Z is monotonic transformation of x and y.

Example-5: H =  2 where, = Aab
 Graphical Presentation of Returns to Scale for Homogenous Production

Example-6: [UGC NET 2020]

Lecture-12: Profit Maximisation,
Cost Minimisation, Output
Maximisation
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 Profit Maximisation, Cost Minimisation, Output Maximisation

The three optimization problems faced by a firm are as follows:

A. Output maximization subject to resource constraints [Constrained Optimisation]
B. Cost Minimisation subject to output constraint [Constrained Optimisation]
C. Profit Maximisation [Unconstrained Optimisation]
 Section-A: Output Maximisation

Section-A: Output Maximisation subject to resource constraints [Constrained Optimisation]

Under this segment, our motive is to find out the maximum output that can be produced using the available resources
at the firm’s disposal. The resource disposal is represented by the budget line of the concerned firm.
The budget line of the firm is also termed as isocost line.
C = wL + rK
Assumptions:
1. C0 is the money available to the firm to start the production
2. w: Wage per labour unit
3. r: rent per capital unit

C = wL + rK
rK = C − wL
C w
K= − L
r r
w C
Slope of Isocost Line is − & vertical intercept is
r r
C
Similarly, with rearrangement, we get the horizontal intercept as :
w
C r
L= − K
w w
 Section-A: Output Maximisation

Section-A: Output Maximisation subject to resource constraints [Constrained Optimisation]

Under this segment, our motive is to find out the maximum output that can be produced using the available resources
at the firm’s disposal. The resource disposal is represented by the budget line of the concerned firm.
The budget line of the firm is also termed as isocost line.
C = wL + rK
Assumptions:
1. C0 is the money available to the firm to start the production
2. w: Wage per labour unit
3. r: rent per capital unit

C = wL + rK
rK = C − wL
C w
K= − L
r r
w C
Slope of Isocost Line is − & vertical intercept is At the point of equilibrium, we have tangency between
r r Isoquants and Isocost line:
C
Similarly, with rearrangement, we get the horizontal intercept as : So, Slope of Isoquant = Slope of Isocost line
w
MPL K w
C r  MRTSL,K = = 
=
L= − K MPK L r
w w
 Section-A: Output Maximisation Setting up Lagrangian Multiplier

Maximise : X = f ( K , L )
Subject to: C = wL + rK
Setting up Lagrangian Multiplier

(
Z = f ( K , L ) + C − wL − rK )
 Section-A: Output Maximisation Setting up Lagrangian Multiplier

Maximise : X = f ( K , L )
Subject to: C = wL + rK
Setting up Lagrangian Multiplier
(
Z = f ( K , L ) +  C − wL − rK )
Solving by partial differentiation, we get:
dZ dX −  w = 0
= ...(1)
dL dL
d dX − r = 0 ... (2 )
=
dK dK
Dividing (1) by (2)
d dX
dL = dL w  MRTS MPL K w
= = = =
d r MPK L r
L,K
dX
dK dK
 Section-A: Output Maximisation Setting up Lagrangian Multiplier

Maximise : X = f ( K , L )
Subject to: C = wL + rK
Setting up Lagrangian Multiplier
(
Z = f ( K , L ) +  C − wL − rK )
Solving by partial differentiation, we get:
dZ dX −  w = 0
= ...(1)
dL dL
d dX − r = 0 ... (2 )
=
dK dK The above expresssion can be rearranged as:
Dividing (1) by (2) MPL = MPK = 
w r
d dX This indicates the increase in the output level, if we spend one unit of Rupee
dL = dL w  MRTS MPL K w enitrely on labour or entirely on capital
= = = =
d dX r L,K
MPK L r Thus,  indicates Marginal Productivity of one unit of Money. That is, if we spend
dK dK one unit of Rupee, then how many units of additional output can be produced.
 Section-A: Output Maximisation Setting up Lagrangian Multiplier

Maximise : X = f ( K , L )
Subject to: C = wL + rK
Setting up Lagrangian Multiplier
(
Z = f ( K , L ) +  C − wL − rK )
Solving by partial differentiation, we get:
dZ dX −  w = 0
= ...(1)
dL dL
d dX − r = 0 ... (2 )
=
dK dK The above expresssion can be rearranged as:
Dividing (1) by (2) MPL = MPK = 
w r
d dX This indicates the increase in the output level, if we spend one unit of Rupee
dL = dL w  MRTS MPL K w enitrely on labour or entirely on capital
= = = =
d dX r L,K
MPK L r Thus,  indicates Marginal Productivity of one unit of Money. That is, if we spend
dK dK one unit of Rupee, then how many units of additional output can be produced.
 Section-A: Output Maximisation Setting up Lagrangian Multiplier

Maximise : X = f ( K , L ) Second Order Conditions

It requires that:
Subject to: C = wL + rK
a) slope of MPL and MPK should be negativ
Setting up Lagrangian Multiplier
d2X d2X
(
Z = f ( K , L ) +  C − wL − rK ) dL2
 0 and
dK 2
0

Solving by partial differentiation, we get:  d2X

dZ dX b) 
= − w = 0 ...(1)
dL dL
d dX − r = 0 ... (2 )
=
dK dK The above expresssion can be rearranged as:
Dividing (1) by (2) MPL = MPK = 
w r
d dX This indicates the increase in the output level, if we spend one unit of Rupee
dL = dL w  MRTS MPL K w enitrely on labour or entirely on capital
= = = =
d dX r L,K
MPK L r Thus,  indicates Marginal Productivity of one unit of Money. That is, if we spend
dK dK one unit of Rupee, then how many units of additional output can be produced.
Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2021 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2021 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2021 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2021 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2021 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2021 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET Dec 2022 QP

Section-A: Output Maximisation Setting up Lagrangian Multiplier

UGC NET Dec 2022 QP

 Section-B: Cost Minimisation subject to Output Constraint or
Least Cost Combination [Constrained Optimisation]

Minimise C = wL + rK
Subject to: X = f ( L, K ) or X − f ( L, K ) = 0
Setting up Lagrangian Multiplier
(
 = wL + rK +  X − f ( L, K ) )
FOC:
d dX
= w−  =0 ... (4 )
dL dL
d dX
=r− =0 ...(5)
dK dK
d
= X − f ( L, K ) = 0 ...(6 )
d
Dividing (4) by (5), we get
d dX dX

dL = w = dL  MRTS = w = dL = K
d r  dX
LK
,
r dX L
dK dK dK
 Section-B: Cost Minimisation subject to Output Constraint or
Least Cost Combination [Constrained Optimisation]

Minimise C = wL + rK w
=
MPL

w
=
r
=
Subject to: X = f ( L, K ) or X − f ( L, K ) = 0 r MPK MPL MPK
w
indicates cost if the firm decides to produce
Setting up Lagrangian Multiplier MPL

(
 = wL + rK +  X − f ( L, K ) ) one extra unit of output through employing only the la
r
indicates cost if the firm decides to prod
FOC: MPK
d dX one extra unit of output through emp
=w− =0 ...(4)  indicates increase in the cos
dL dL
d = r −  dX = 0 ...(5) So, simply indicates
dK dK There exists a
d
= X − f ( L, K ) = 0 ...(6) 1
=
d
Dividing (4) by (5), we get
d dX dX

dL = w = dL w dL K
 MRTS L,K = = =
d r  dX r dX L
dK dK dK
 Section-B: Cost Minimisation subject to Output Constraint or
Least Cost Combination [Constrained Optimisation]
Equilibrium by Least Cost Combination
Minimise C = wL + rK
Subject to: X = f ( L, K ) or X − f ( L, K ) = 0
Setting up Lagrangian Multiplier

(
 = wL + rK +  X − f ( L, K ) )
FOC:
d dX
= w−  =0 ... (4 )
dL dL
d dX
=r− =0 ...(5)
dK dK
d
= X − f ( L, K ) = 0 ...(6 )
d
Dividing (4) by (5), we get
d dX dX

dL = w = dL w dL K
 MRTS L,K = = =
d r  dX r dX L
dK dK dK
 Section-B: Cost Minimisation subject to Output Constraint or
Least Cost Combination [Constrained Optimisation]
Equilibrium by Least Cost Combination
Minimise C = wL + rK
Subject to: X = f ( L, K ) or X − f ( L, K ) = 0
Setting up Lagrangian Multiplier

(
 = wL + rK +  X − f ( L, K ) )
FOC:
d dX
= w−  =0 ... (4 )
dL dL
d dX
=r− =0 ...(5)
dK dK Output Maximisation
d
= X − f ( L, K ) = 0 ...(6 )
d
Dividing (4) by (5), we get
d dX dX

dL = w = dL w dL K
 MRTS L,K = = =
d r  dX r dX L
dK dK dK
 Section-B: Cost Minimisation subject to Output Constraint or
Least Cost Combination [Constrained Optimisation]
Equilibrium by Least Cost Combination
Minimise C = wL + rK
Subject to: X = f ( L, K ) or X − f ( L, K ) = 0
Setting up Lagrangian Multiplier

(
 = wL + rK +  X − f ( L, K ) )
FOC:
d dX
−  Conditions
= wOrder
Second =0 ... (4 )
dL
It requires that:
dL
d dX
= rof−MPL
a) slope  and=MPK ...(5)
0 should be negative
dK d 2 X dK d2X
Output Maximisation
d  0 and 0
= X − f ( L, K ) = 0 ...(6 )
2 2
dL dK

d
2
 d 2 X  d 2 X   d 2 X 
b)  2  2 
   Hessian Matrix condition
Dividing  (4)by (5),
dL dK  we get
dLdK 

d dX dX

dL = w = dL w K
 MRTS L,K = = dL =
d r  dX r dX L
dK dK dK
 Section-C: Profit Maximisation [Unconstrained Optimisation]
The goal of the firm is profit maximization; that is to maximise the difference between Total Revenue and Total Costs.
=R–C
where,  = profits | TR = Revenue | TC = Total Costs
Assumptions:
1) Price of the output is constant, Px is given
2) Input prices are constant, w and r are given
3) State of technology is given
 Section-C: Profit Maximisation [Unconstrained Optimisation]
The goal of the firm is profit maximization; that is to maximise the difference between Total Revenue and Total Costs.
=R–C
where,  = profits | TR = Revenue | TC = Total Costs = TR − TC = Px X −[wL + rK ]
Assumptions:  can be maximised when output or X is maximised,
1) Price of the output is constant, Px is given
as TC and Px by assumption.
2) Input prices are constant, w and r are given
3) State of technology is given
 Section-C: Profit Maximisation [Unconstrained Optimisation]
The goal of the firm is profit maximization; that is to maximise the difference between Total Revenue and Total Costs.
=R–C
where,  = profits | TR = Revenue | TC = Total Costs = TR − TC = Px X −[wL + rK ]
Assumptions:  can be maximised when output or X is maximised,
1) Price of the output is constant, Px is given
as TC and Px by assumption.
2) Input prices are constant, w and r are given
3) State of technology is given  = TR − TC = Px X −[wL + rK ]
Solving by partial differentiation, we get:
d dX
=Px − w = 0 ...(1)
dL dL
d dX
=Px − r = 0 ... (2 )
dK dK
Dividing (1) by (2)
d dX
Px w w
dL = dL =  MRTS Px MPL =  MPL w
= =
d dX r
L,K
PxMPK r MPK r
Px
dK dK
 Section-C: Profit Maximisation [Unconstrained Optimisation]
The goal of the firm is profit maximization; that is to maximise the difference between Total Revenue and Total Costs.
=R–C
where,  = profits | TR = Revenue | TC = Total Costs = TR − TC = Px X −[wL + rK ]
Assumptions:  can be maximised when output or X is maximised,
1) Price of the output is constant, Px is given
as TC and Px by assumption.
2) Input prices are constant, w and r are given
3) State of technology is given  = TR − TC = Px X −[wL + rK ]
Solving by partial differentiation, we get:
d dX
=Px − w = 0 ...(1)
dL dL
d dX
=Px − r = 0 ... (2 )
dK dK
Dividing (1) by (2)
Alternatively, we can rearrange the above equation as: d dX
Px w w
P MP w dL = dL =  MRTS Px MPL =  MPL w
= =
x L
= as → P MP = w and P MP = r d
Px
dX r L,K Px MPK r MPK r
x L x K
PxMPK r dK dK
 Section-C: Profit Maximisation [Unconstrained Optimisation]
The goal of the firm is profit maximization; that is to maximise the difference between Total Revenue and Total Costs.
=R–C
where,  = profits | TR = Revenue | TC = Total Costs = TR − TC = Px X −[wL + rK ]
Assumptions:  can be maximised when output or X is maximised,
1) Price of the output is constant, Px is given
as TC and Px by assumption.
2) Input prices are constant, w and r are given
3) State of technology is given  = TR − TC = Px X −[wL + rK ]
Solving by partial differentiation, we get:
d dX
=Px − w = 0 ...(1)
dL dL
d dX
=Px − r = 0 ... (2 )
dK dK
Dividing (1) by (2)
Alternatively, we can rearrange the above equation as: d dX
Px w w
P MP w dL = dL =  MRTS Px MPL =  MPL w
= =
x
=L as → Px MPL = w and Px MPK = r d
Px
dX r L,K Px MPK r MPK r
PxMPK r dK dK
The LHS of the above expressions are MRPL or VMPL or MRPK or
VMPK
 Section-C: Profit Maximisation [Unconstrained Optimisation]

Second Order Conditions = TR − TC = Px X −[wL + rK ]

 can be maximised when output or X is maximised,
d 2 d2X d 2 dX as TC and Px by assumption.
=Px 0 =Px 0
2 2 2 2
dL dL dK
dK  = TR − TC = Px X −[wL + rK ]
 d 2 d 2  Solving by partial differentiation, we get:
 2  dX
d 2 dLdK   0
Hessian Matrix:  dL d − w = 0 ...(1)
=P
 d 2
  dL x
dL
dKdL dK 2  d dX
=Px − r = 0 ... (2 )
dK dK
Dividing (1) by (2)
Alternatively, we can rearrange the above equation as: d dX
Px w w
P MP w dL = dL =  MRTS Px MPL =  MPL w
= =
x
=L as → Px MPL = w and Px MPK = r d
Px
dX r L,K Px MPK r MPK r
PxMPK r dK dK
The LHS of the above expressions are MRPL or VMPL or MRPK or
VMPK
 Output Expansion Path in Long Run
OEP is the locus of all equilibrium input combinations for which MRTS is equal to input price ratio. It indicates
how the optimal input usage changes with the change in output, given the input prices (i.e. w and r are constant).
If OEP is a straight line from the origin, then it indicates a linear homogenous production function or the
production function representing constant returns to scale (Long Run).
Non-Homogenous
production function
 Output Expansion Path in Long Run
OEP is the locus of all equilibrium input combinations for which MRTS is equal to input price ratio. It indicates
how the optimal input usage changes with the change in output, given the input prices (i.e. w and r are constant).
If OEP is a straight line from the origin, then it indicates a linear homogenous production function or the
production function representing constant returns to scale (Long Run).
Let Q = AK L(1− ) Non-Homogenous
production function

OEP Equation:
Slope of Isoquant = Slope of Isocost line
MPL w
=
MPK r
 K w
. =
(1−  ) L r
K = w .(
1−  )
L → Equation of OEP with no intercept
r 
For a production function which is linear homogenous i.e. displaying CRS, OEP is a ray through origin without
any vertical or horizontal intercept.
 Output Expansion Path in Long Run
Since in the short run, capital is constant and the firm is forced to expand along a straight line parallel to the Labour-axis.
With the prices of factors constant the firm does not maximise its profits in the short run, due to the constraint of the given
capital. The optimal expansion path would be OA were it possible to increase K. Given the capital equipment, the firm can
expand only along KK in the short run.
Non-Homogenous
production function

Short Run Expansion Path Long Run Expansion Paths

 Lecture-13: Theories of Cost,
Traditional and Modern Theories ,
Cost Elasticity to Output
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
How to Download Hindi and English Notes 27 hours before Class?
How to Download Hindi and English Notes 27 hours before Class?
How to Download Hindi and English Notes 27 hours before Class?
How to Download Hindi and English Notes 27 hours before Class?
How to Download Hindi and English Notes 27 hours before Class?
 NTA-UGC-NET | Cost Theories
Non-Linear Function: A function which is the exponents of greater than 1 is called nonlinear function. In
other words, a function which does not form a straight line in a graph. The examples of such functions are
exponential function, parabolic function, inverse functions, quadratic function, etc.
From Lecture-1
1) Q = 2L2 + 3L + C → Functional form like
Class
MPL or APL or AC, MC [Parabolic or
Quadratic expressions]. Such functions
have maximum and minimum points.
2) C = 4Q3 + 2Q2 + 3Q + C → Functional form
of Total Cost [Cubic expression].

3) Q = 2/Px → Rectangular
hyperbola, function form of
unitary elastic demand function or
AFC.
 NTA-UGC-NET | Cost Theories
TC = 4Q3 + 2Q2 + 3Q +100
TFC
TVC

TC Q3 Q2 Q 100
AC = =4 + 2 +3 +
Q Q Q Q Q
100
AC = 4Q2 + 2Q + 3 +
Q
AVC
AFC

AC & AVC  Parabolic Expression, whereas, AFC  Rectangular Hyperbola

3 2
dTC dQ dQ dQ d100
MC = =4 +2 +3 +
dQ dQ dQ dQ dQ
MC = 4  3Q2 + 2  2Q + 3 + 0
MC = 12Q2 + 4Q + 3  Parabolic Expression
 NTA-UGC-NET | Cost Theories
TC = 4Q3 + 2Q2 + 3Q +100
TFC
TVC

TC Q3 Q2 Q 100
AC = =4 + 2 + 3 +
Q Q Q Q Q
100
AC = 4Q2 + 2Q + 3 +
Q
AVC
AFC

AC & AVC  Parabolic Expression, whereas, AFC  Rectangular Hyperbola

dTC dQ3 dQ2 dQ d100
MC = =4 +2 +3 +
dQ dQ dQ dQ dQ
MC = 4  3Q2 + 2  2Q + 3 + 0
MC = 12Q2 + 4Q + 3  Parabolic Expression
 NTA-UGC-NET | Cost Theories
TC = 4Q3 + 2Q2 + 3Q +100
TFC
TVC

TC Q3 Q2 Q 100
AC = =4 + 2 + 3 +
Q Q Q Q Q
100
AC = 4Q2 + 2Q + 3 +
Q
AVC
AFC

AC & AVC  Parabolic Expression, whereas, AFC  Rectangular Hyperbola

dTC dQ3 dQ2 dQ d100
MC = =4 +2 +3 + Going backward from MC to TC
dQ dQ dQ dQ dQ
MC = 4  3Q2 + 2  2Q + 3 + 0 MC = 12Q2 + 4Q + 3
MC = 12Q2 + 4Q + 3  Parabolic Expression
 MC =  dQ +  4QdQ + 3dQ
12Q 2

Q3 Q2
= 12
 MC
3
+4
2
+ 3Q + C

 MC = 4Q 3
+ 2Q 2
+ 3Q + C
TFC
TVC
NTA-UGC-NET | Cost Theories
 NTA-UGC-NET | Cost Theories
Selling Cost Production Cost
NTA-UGC-NET | Cost Theories
Explicit Cost Implicit Cost
NTA-UGC-NET | Cost Theories
Some More Concepts
NTA-UGC-NET | Cost Theories
Short Run Cost Long Run Cost
 NTA-UGC-NET | Cost Theories
Total Cost
 NTA-UGC-NET | Cost Theories
Total Cost
 NTA-UGC-NET | Cost Theories
Total Cost
 NTA-UGC-NET | Cost Theories
Average Total Cost
Why AFC curve is unit elastic?
 NTA-UGC-NET | Cost Theories
Average Total Cost
NTA-UGC-NET | Cost Theories
Marginal Cost
NTA-UGC-NET | Cost Theories
Long Run Total Cost Long Run Average Cost
 Graphical Presentation of Returns to Scale for Homogenous Production

Economies of scale are measured in terms of cost- Relationship between LMC and LAC
output elasticity. Ec is the percentage change in the cost
of production resulting from a one-percent change
increase in output.
C
C Q MC
Ec = C =  =
Q C Q AC
Q
MC
If  1  MC  AC → Economies
AC
MC
If = 1  MC = AC → CRS or Neither Economies nor Diseconomies
AC
MC
If  1  MC  AC → Diseconomies
AC
 Why LAC is an envelope curve?
The LAC curve is also known as Envelope curve and Planning curve. While in the short run a firm is working
with a given plant, in the long run the firm moves from one plant to another; it can acquire a big plant if it
wants to increase its output and a small plant if it wants to reduce its output. In other words, long run cost of
production is the least possible cost of producing any given level of output when all individual factors are
variable.
A long run cost curve reveals the functional relationship between output and the long run cost of production.
While constructing long run cost curves, it is assumed that –
• Factor prices are given;
• Technology is given;
• Firms will choose the least cost combination of factors for each given output (i.e. rational behaviour)
Traditional Cost Theory
 Why LAC is an envelope curve?
In order to understand how the LAC is derived, six SAC curves (also called ‘plant curves’) were shown in the above
figure. Given the size of the plant in the short run, the firm will be increasing or decreasing its output by changing the
amount of the variable inputs. But in the long run, the firm will examine with which size of plants or on which SAC curve
it should operate to produce a given level of output, so that the total cost is minimum. Note that ‘if all the factors of
production can be used in varying proportions, it means that the scale of operations of the firm can be changed. Each time
the scale of operations is changed a new short run cost curve will have to be drawn for the firm’

In the long run the firm will produce the output OQo at which SAC
and LAC is minimum and where SAC4 is tangent with LAC
(min.LAC = min. SAC4). In all other output, the LAC curve is not
tangent to any SACs at its minimum. When LAC is declining, it is
tangent to the falling portions of SAC curves. Again, when LAC is
rising, it is tangent to the rising portions of SAC curves. Thus, at any
output less than Qo, although the firm will construct the best possible
plant size, it will operate at less than its full capacity. On the other
hand, for outputs larger than Qo, the firm will construct a plant and
operate it beyond its optimum capacity. OQo is the optimum output.
This is because OQo is being produced at the minimum point of LAC
and corresponding SAC4.
 Why LAC is an envelope curve?
The LAC curve will be a smooth curve enveloping all short run
average cost curves, so it is called ‘envelope curve’. LAC curve is
often called planning curve because a firm plans to produce any output
in the long run by choosing a plant on the LAC curve corresponding to
the given output. The LAC curve helps the firm in the choice of the
size of the plant for producing a specific output at the least possible
cost.
 Modern Cost Theory
• MODERN THEORY OF COST
• Modern economists including Stigler (1939), Andrews and Friedman have questioned the validity of U-
shaped cost curves both theoretical as well as on empirical grounds. Also the long run costs in modern
theory are not U- shaped but L- shaped.

• The Modern theory suggests the existence of built- in- reserve capacity „which imparts flexibility and
enables the plant to produce larger output without adding to the costs. Built –in- reserve capacity are
planned by firms. The short-run cost curve has a saucer- type shape whereas the long-run Average cost
curve is either L-Shaped or inverse J-shaped.

• The Modern theory of cost stresses on the role of economies of scale, which significantly enables the firm
to continue production at the lowest point of average cost for a considerable period of time. The firm
checks dis-economies of scale by planning in advance and enjoys the gains of production in comparison to
the traditional theory where the average cost rises after the firm reaches the optimal level of output
 Modern Cost Theory
AFC as per Modern Theory of Cost
This is the cost of indirect factors and it is the cost of the physical and personal organizations of the firm. The fixed cost
include cost for:
(a) salaries and other expenses of administrative staff
(b) salaries of staff involved directly in production but paid on a fixed term basis
(c) the wear and tear of machinery (standard depreciation allowance
(d) the expenses for maintenance of buildings
(e) the expenses for the maintenance of land on which the plant is installed and operated.
Direct factors on the other hand are related to labour and raw materials. These factors do not limit the size of the firm or the
plant. Whenever required, a firm can easily acquire them from the market without any time lag. However, indirect factors
are important and are considered by a firm while it decides the size of the plant. The business man will start his planning
with a figure for the level of output which he anticipates selling, and he will choose the size of plant which allows him to
produce this level of output more efficiently, and with the maximum flexibility, the business man will want to be able to
meet seasonal and cyclical fluctuations in his demand.
Thus, unlike the traditional theory, in modern theory, a firm will not choose that particular plant, where it is optimizing
its output; rather it is choosing that plant, where it has reserve capacity. This reserve capacity will enable the firm to
produce more output whenever demand increases. In summary, the businessman will not necessarily choose the plant
which will give him the lowest cost, but rather, that equipment which will allow him the greatest possible flexibility for
minor alterations of his product or his technique of production.
 Modern Cost Theories
• The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which imparts flexibility and
enables the plant to produce larger output without adding to the costs.
• Built –in- reserve capacity are planned by firms. Modern theory of costs does not agree with the U-shape of
the cost curves.
• The short-run cost curve has a saucer- type shape whereas the long-run Average cost curve is either L-
Shaped or inverse J-shaped.
• According to the Modern theory of costs, the firm can produce a range of output and not a single level of
output as under the traditional theory of cost.
• Firms build industrial plants with some flexibility in their productive capacity so that instead of a single
output level, there is a whole range of output that can be produced optimally at low cost.
• The ‘Built-in Reserve capacity’ provides ‘maximum flexibility’ in the production process. The Planned
reserve capacity explains the ‘Saucer – shaped’ short run average variable costs.
• The Modern theory of cost stresses on the role of economies of scale, which significantly enables the firm
to continue production at the lowest point of average cost for a considerable period of time.
• The firm checks diseconomies of scale by planning in advance and enjoys the gains of production in
comparison to the traditional theory where the average cost rises after the firm reaches the optimal level of
output. Developments in managerial economies explain the L – Shaped and inverse J –Shaped LAC
Curves.
 Modern Cost Theories
• SHORT-RUN COSTS CURVES UNDER MODERN THEORY:
• The short-run Average costs consist of the Average fixed costs and Average variable costs.
• Because of the U- shaped AVC curve under the traditional theory, the Plant is designed to optimally
produce a single level of output (at the minimum point of AVC CURVE) . In case there is any departure
from the optimizing output, there arises an excess capacity or unplanned capacity.

• If the firm produces a lower level of output OX1 then costs would be high compared to Oxm level of
output. The short- run Average variable costs (SAVC) has a Saucer-type shape where there is a flat- stretch
corresponding to the ‘RESERVE CAPACITY ‘ or the ‘PLANNED CAPACITY ‘ – which the Plant builds
to provide flexibility in the firm’s production process.
 Modern Cost Theories
Excess Capacity v/s Reserve Capacity
Excess capacity pertains to traditional theory, whereas, reserve capacity pertains to the modern theory. Excess
capacity is primarily considered as undesirable as it implies higher costs and lower output which leads to some
monopoly power to the firm. Excess capacity can be conceived as unplanned capacity. It is less than the
optimum level of the firm (minimum point of AC). The difference between Qm and Q indicates excess
capacity. On the other hand, reserve capacity is potential capacity which has been already considered into the
plan while purchasing a machine. Reserve capacity indicates planned capacity which does not lead to increased
cost of production. The magnitude of Q2-Q1 indicates reserve capacity.
 Modern Cost Theories
• AVERAGE FIXED COST

The fixed costs include the costs for:

• The salaries and other expenses of administrative staff.
• The wear and tear of machinery.
• The expenses for maintenance of building.
• The expenses for the maintenance of land on which the plant is installed or operates.
• As in the traditional theory of cost, the average fixed costs in modern microeconomics, also plots as a
rectangular hyperbola.

AVERAGE VARIABLE COST: The Average Variable cost is equal to the total variable cost divided by the
total output. AVC = TVC÷Q = (P × V)÷ Q , where P is the price per unit of input and Vis the quantity of
variable input The Average Variable cost curve is not ‘U’ Shaped as under the traditional theory but ‘trough
shaped/ saucer-shaped’ under the Modern theory of cost due to the ‘RESERVE CAPACITY’ maintained by
the firm
 Modern Cost Theories
Average Variable Costs as Per Modern Theory of Cost:
Similar to the traditional theory, AVC in the modern theory include:
a) direct labour costs
b) raw materials
c) operating expenses of machines and plants

When SAVC > SMC

To the left of this flat base, SAVC > SMC. The falling portion of SAVC indicates fall in the cost because of
better utilization of the fixed factor due to raised efficiency, learning and skill-development of the labour, which
leads to judicious use of the fixed factor.
When SAVC = SMC
SAVC under modern theory is a saucer type and not u-shaped curve. It has a stretched-base which is flat over a
range of output. During this flat phase, SAVC = SMC. This is portion during which with reserve capacity, the
firm is able to maintain the constant level of SAVC for the entire stretch.
When SAVC < SMC
To the right side of the flat portion, SAVC < SMC. The reason for rising SAVC is the overloading of the
labourers, increasing labour costs due to overtime payments, depreciation of the existing machineries, etc.
 Modern Cost Theories
Average Total Cost as Per Modern Theory
Summing up AFC and AVC vertically for all the output levels we get a falling SAC upto the point till which the reserve
capacity has been fully exhausted and after than SAC curve starts rising. The MC will intersect the ATC Curve at its
minimum point.

Beyond that output level, SAC curve rises as output increases. The smooth fall in the SAC curve upto OQ level of output is
because the AFC curve is rectangular hyperbola and the SAVC curve first falls and then become horizontal within the range
of reserve capacity. Beyond OQ level of output, AC starts rising steeply.
 Modern Cost Theories
• LONG RUN AVERAGE COST
•
• Modern economists divide long run costs into production costs and managerial costs/ In the long run, all
costs are variable and they given rise to a long run average cost curve which is roughly L- shaped. This
curve rapidly slopes downwards in the beginning but later remains flat or slopes gently downwards at its
right-hand cost. The long run average cost curve is as follows:

• The Long run average costs curve has two main features:
• It does not rise at every large scale of output.
• It does not envelope the Short run Average Cost but intersects them.
 Modern Cost Theories
• LONG RUN MARGINAL COST

• According to modern theory, shape of long-run marginal cost curve corresponds to the shape of long-run
average cost curve. The given figure shows that when LAC is L- shaped and LAC curve is falling then
LMC curve will also be falling and its falling portion will be below the falling portion of LAC curve..
 Modern Cost Theories
Reasons for L-shaped LAC Curve
Production Costs & Managerial Costs: In the long-run, all costs are variable. As output increases, production costs fall
continuously while managerial cost may rise at very large scales of output. But the fall in production costs outweighs the
increase in managerial costs so that the LAC curve falls with increases in output.
A. Production Costs: Initially with the increase in the production scale, costs of production fall steeply and thereafter the
fall gradually. This is because during the initial phase, firm enjoys technical economies that is associated with large
scale of production. Gradually these technical economies get exhausted and the firm reaches the minimum efficient
scale.
B. Managerial Costs: In modern firms, each plant size there is a corresponding organisational-administrative set-up
appropriate for the smooth operating of that plant. There are small-scale as well as large-scale organizational
techniques. Initially, the management costs first fall up to a certain plant size and at very large scales, managerial costs
rises but very slowly.
Thus, Production costs fall smoothly at very large scales, while managerial
costs may rise only slowly at very large scales. The fall in technical costs more than offsets the probable rise of
managerial costs, so that the LRAC curve falls smoothly or remains constant at very large scales of output. Hence,
LAC curve does not turn up at very large scales of output. It does not envelope the SAC curves but intersects them at
the optimal level of output of each plant.
Read on your own
 Modern Cost Theories
1. Technical Progress: The traditional theory of costs assumes no technical progress while explaining the U-shaped LAC
curve. The empirical results on long-run costs confirm the widespread existence of economies of scale due to technical
progress in firms. The period, between which technical progress has taken place, the long-run average costs show a
falling trend. The evidence on diseconomies is much less certain. So an upturn of the LAC at the top end of the size
scale has not been observed. The L-shape of the LAC curve due to technical progress.
2. Learning: It is one of the results of experience. Due to learning, there exists IRS, which leads to reduced cost per unit
and higher productivity of the workers. Thus the LAC curve is L-shaped due to learning by doing.

Read on your own

 Lecture-14: Perfect Competition-
Short Run and Long Run Equilibrium
Conditions
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
NTA-UGC-NET | Markets
Meaning of Markets
NTA-UGC-NET | Markets
Forms of Markets
NTA-UGC-NET | Markets
Features of Perfect Competition
NTA-UGC-NET | Markets
Features of Perfect Competition
NTA-UGC-NET | Perfect Competition
Features of Perfect Competition
NTA-UGC-NET | Perfect Competition
Features of Perfect Competition
NTA-UGC-NET | Perfect Competition
Features of Perfect Competition
NTA-UGC-NET | Perfect Competition
IMPLICATIONS
NTA-UGC-NET | Perfect Competition
Pure v/s Perfect Competition
NTA-UGC-NET | Perfect Competition
Producer’s Equilibrium
NTA-UGC-NET | Perfect Competition
Producer’s Equilibrium TR-TC Approach
NTA-UGC-NET | Perfect Competition
Producer’s Equilibrium TR-TC Approach
NTA-UGC-NET | Perfect Competition
Producer’s Equilibrium MR-MC Approach
NTA-UGC-NET | Perfect Competition
NTA-UGC-NET | Perfect Competition
Producer’s Equilibrium MR-MC Approach: Long Run

=
NTA-UGC-NET | Perfect Competition
Producer’s Equilibrium MR-MC Approach: Long Run
 NTA-UGC-NET | Supply Curve of a PC Firm (SR)
Supply curve of an individual firm depicts the graphical presentation of different output quantities (plotted on the x -axis)
that the firm wants to supply at the corresponding different prices (plotted on the y -axis). In order to derive the firm's
supply curve, we need to consider firm's responses to different market prices in different time-horizons; Short run and
long run. Let us consider the firm's supply curve in the short run.

Short Run Supply Curve of a firm

The derivation of a firm's short run supply curve involves the following two stages.
Stage 1 : When Price is greater than or equal to minimum SAVC ( P ≥ minimum of SAVC )
 NTA-UGC-NET | Supply Curve of a PC Firm (SR)
Supply curve of an individual firm depicts the graphical presentation of different output quantities (plotted on the x -axis)
that the firm wants to supply at the corresponding different prices (plotted on the y -axis). In order to derive the firm's
supply curve, we need to consider firm's responses to different market prices in different time-horizons; Short run and
long run. Let us consider the firm's supply curve in the short run.

Short Run Supply Curve of a firm

The derivation of a firm's short run supply curve involves the following two stages.
Stage 1 : When Price is greater than or equal to minimum SAVC ( P ≥ minimum of SAVC )

Stage 2 : When Price is lesser than the minimum SAVC ( P < minimum of SAVC )
NTA-UGC-NET | Supply Curve of a PC Firm
NTA-UGC-NET | Supply Curve of a PC Firm (LR)
 NTA-UGC-NET | Supply Curve of a PC Firm (LR)

Example-1: Suppose there are 50 identical firms in a perfectly competitive industry and each firm has short run
total cost function as TC = 0.2q2+5q+10. Calculate the firm’s short run supply curve with q as a function of
market price.
 NTA-UGC-NET | Supply Curve of a PC Firm (LR)
Example-2: [WB-SET]
NTA-UGC-NET | Supply Curve of Market
The short-run market supply curve shows the amount of output
that the industry will produce in the short run for every possible
price. The industry’s output is the sum of the quantities supplied
by all of its individual firms. Therefore, the market supply curve
can be obtained by adding the supply curves of each of these firms.
Each firm’s marginal cost curve is drawn only for the portion that
lies above its average variable cost curve. At any price below P1,
the industry will produce no output because P1 is the minimum
average variable cost of the lowest-cost firm. Between P1 and P2,
only firm 3 will produce. The industry supply curve, therefore, will
be identical to that portion of firm 3’s marginal cost curve MC3.
At price P2, the industry supply will be the sum of the quantity
supplied by all three firms. Firm 1 supplies 2 units, firm 2 supplies
5 units, and firm 3 supplies 8 units. Industry supply is thus 15
units. At price P3, firm 1 supplies 4 units, firm 2 supplies 7 units,
and firm 3 supplies 10 units; the industry supplies 21 units. Note
that the industry supply curve is upward sloping but has a kink at
price P2, the lowest price at which all three firms produce. With
many firms in the market, however, the kink becomes
unimportant.
 NTA-UGC-NET | Supply Curve of Market
Example-3: The cost function of each firm in an industry in the long run is C = Q3 –10Q2 + 35Q. The industry demand is D
= 2500 – 200P. Find the total number of firms in the market. [JNU PhD Entrance]
 NTA-UGC-NET | Supply Curve of Market
Example-4: If the market demand is Q = 3100 – 50P and the competitive firm is in long run with cost function as
C = q2 – 2q + 64. Find out the number of firms in the industry.
NTA-UGC-NET | Constant-cost industry
NTA-UGC-NET | Increasing-cost industry
NTA-UGC-NET | Decreasing-cost industry
 Lecture-15: Monopoly, Price
Discrimination & Monopolistic
Competition
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
NTA-UGC-NET | Monopoly
Monopoly
NTA-UGC-NET | Monopoly
Reasons for Emergence of Monopoly Power
NTA-UGC-NET | Monopoly (SR)
 NTA-UGC-NET | Monopoly (SR)
Situation 1: When the Cost of Production is zero
Let us suppose that there is a village which is situated
sufficiently far away from the other villages and there is only
one well in the village on which all the villagers depend for
their water needs. Assume that this well is owned by a
particular individual and he has the exclusive right over the use
of the well. He also has the right to exclude others from the use
of the well. Thus, he enjoys a monopoly position and can
charge any price that he wishes to charge for the water
(output). This implies that the cost of producing water is zero.
We know that profit of a firm is given by the difference
between Total Revenue and Total Cost
i.e. Profit ( π ) = TR – TC When TC > 0
In the case considered above, TC equals zero (as the cost of Total Revenue = area of rectangle of OP e E q e
producing water is zero). This implies that the profit ( π ) will Profit = area of rectangle of OP e E q e
be maximised where Total Revenue ( TR ) is maximum. Equilibrium Output = Oq e
Equilibrium Price = OP e
 NTA-UGC-NET | Monopoly (SR)
Situation 2: When the Cost of Production is Greater than Zero (i.e Positive)
Short Run Monopolist Equilibrium- By Total Revenue Total Cost
Approach (TR-TC approach)
According to this approach, a monopolist firm attains his equilibrium
at the point where the difference between the Total Revenue ( TR )
and the Total Cost ( TC ) is maximum, i.e. where the profits are
maximised. The short run equilibrium situation using the TR-TC
approach is explained below diagrammatically.
 NTA-UGC-NET | Monopoly (SR)
Situation 2: When the Cost of Production is Greater than Zero (i.e Positive)
Short Run Monopolist Equilibrium- By Marginal Cost-Marginal
Revenue Approach (MR-MC approach)
According to this approach, a monopolist firm attains equilibrium at
that level of output where Marginal Cost ( MC ) faced by the firm is
equal to the Marginal Revenue ( MR) earned by the firm. The short
run equilibrium situation using the MR-MC approach is explained
below diagrammatically.

If MR > MC: Profits can be increased by

increasing output
If MR < MC: Profits can be increased by
reducing output
When MR < P: Total Profits maximized &
not profit per unit
 NTA-UGC-NET | Can a Monopolist earn Losses?
Can a Monopolist incur Losses?
The answer is- yes, a monopolist can incur losses. Similar to a firm in
perfect competition market, a monopolist firm can also incur losses
but only in short run . This may be due to the fact that in short run,
some factors of production (such as plant, machinery, etc.) remain
fixed and the monopolist cannot vary the inputs of these factors. The
figure below depicts the short run equilibrium of a monopolist, where
he is incurring losses.
 NTA-UGC-NET | Can a Monopolist earn Losses?
Can a Monopolist incur Losses?
The answer is- yes, a monopolist can incur losses. Similar to a firm in
perfect competition market, a monopolist firm can also incur losses
but only in short run . This may be due to the fact that in short run,
some factors of production (such as plant, machinery, etc.) remain
fixed and the monopolist cannot vary the inputs of these factors. The
figure below depicts the short run equilibrium of a monopolist, where
he is incurring losses.

It should be noted that even if the monopolist is incurring losses, then also he will continue to produce in the short run as
long as the price charged by him covers the Average Variable Cost ( AVC ). This is because, even if he stops production,
then also he has to bear loss equal to the fixed costs incurred. Hence, a monopolist can also incur loss but only in short run
and not in long run. This is a unique feature of the monopoly market that in long run, a monopolist earns the maximum
amount of profits compared to the producer under any other market structure such as perfect competition, monopolistic
and oligopoly market.
 Short Run Supply Curve of the firm
Due to the downward sloping demand curve for the firm as well as for the industry, the decisions on price and quantity are
interdependent. The monopolist can charge lower price and sell more or it can charge higher price and sell less.
Thus, unlike Perfect Competition, where, the rising portion of MC above the minimum point of SAVC is the supply curve,
however, in case of monopoly, we have don’t have such unique conditions and no unique supply curve for the monopolist
derived from his MC.
• Case-1: Given the MC, the same quantity can be offered at different prices depending on the price elasticity of
demand. [Figure-1]
 Short Run Supply Curve of the firm
Due to the downward sloping demand curve for the firm as well as for the industry, the decisions on price and quantity are
interdependent. The monopolist can charge lower price and sell more or it can charge higher price and sell less.
Thus, unlike Perfect Competition, where, the rising portion of MC above the minimum point of SAVC is the supply curve,
however, in case of monopoly, we have don’t have such unique conditions and no unique supply curve for the monopolist
derived from his MC.
• Case-1: Given the MC, the same quantity can be offered at different prices depending on the price elasticity of
demand. [Figure-1]
Or
• Case-2: Given the MC, various quantities can be offered at one price depending on the market demand and
corresponding MC curve. [Figure-2]
 Short Run Supply Curve of the firm
Example-1: Consider the demand curve of a monopolist: X = 100 – P and his cost function as C = 100 + 80 X. Ascertain
the profit maximization output and price for this monopolist.
 Long Run Equilibrium in Monopoly
Long Run Equilibrium in Monopoly Market
A monopolist firm cannot earn loss in long run. This is because in long run, as all factors are variables, so the monopolist
can change the structure and size of the machines. Moreover, as there is no close substitutes available and the monopolist
being the only seller exercises full control over the price, so the probability of monopolist earning profits in the long run is
very high. The following are the long run equilibrium conditions for a monopolist:
• LMC = LMR
• Slope of LMC > Slope of LMR at the point of intersection
• Price > minimum of LAC = MC, i.e. P > MC = MR
Important Note : It should be worth noting that the long run equilibrium price would not be equal to the minimum of
LAC (as in perfect competition), in fact; a monopolist in long run will always charge a price which will be more than
the long run average cost i.e. P > minimum of LAC.
 Imposition of Tax on Monopolist
Imposition of a lump-sum tax: An imposition of a lump-sum tax will reduce the excess profits of the monopolist because
it will increase his total fixed cost. However, the MC curve of the monopolist will not be affected, and hence the
equilibrium in the monopoly market will remain the same even in the long run (provided that the lump-sum tax does not
exceed the supernormal profits of the monopolist).

Imposition of a profits tax: The effects of taxes on the monopoly profits on the equilibrium of the monopolist are the same
as in the case ofthe lump-sum tax: the profits tax reduces the abnormal (monopoly) profits, but the equilibrium in the
market is not affected, so long as the profits tax does not bite into the normal profits of the monopolist, since in this event
the monopolist will not be covering his total costs (inclusive of his normal profit) and will close down.
 Imposition of Tax on Monopolist
Imposition of a specific sales tax: The imposition of the specific tax will shift the MC curve of the monopolist upwards,
which will result in a change of his equilibrium; in the new equilibrium position (e') the price will be higher and the
quantity smaller as compared with the initial equilibrium.
• Firstly. If the MC of the monopolist has a positive slope, the increase in the price will be smaller than the specific tax,
as in the case of pure competition. The monopolist will pass to the consumer part of the specific tax (P < tax).
• Secondly. If the MC of the monopolist is horizontal, the monopolist will raise the price, but not by the full amount of
the tax, as is the case in pure competition. Even when his MC curve is infinitely elastic, the monopolist will bear some
amount of the specific tax
 Price Discrimination
• Discriminating monopoly’ or ‘price discrimination’ occurs when a monopolist charges the same buyer different prices
for the different units of a commodity, even though these units are in fact homogeneous. Such a situation is described
as “perfectly discriminating monopoly”.
 Price Discrimination
• First Degree ('take-it-or-leave-it' price discrimination)
✓ The limit is defined in the concept of discrimination of the first degree, a concept introduced by A.C. Pigou. In
discrimination of the first degree, the monopolist knows the maximum amount of money each consumer will pay for
any quantity. He then fixes up prices accordingly and takes from each consumer the entire amount of his consumer’s
surplus. if the monopolist can charge each customer the highest price that they are willing to pay, then MR will be the
same as price (or demand). D = MR or P = MR
✓ Mrs. Joan Robinson calls this phenomenon perfect discrimination, which is perfect, however, only from the point of
view of the monopolist. When consumers buy more than one unit of the monopolist’s product, they are willing to buy
more units at lower prices. The monopolist must then adjust his units of sale.
 Price Discrimination
• Second Degree
✓ Monopolist captures parts of his buyers’, consumers’, surplus, but not all. This is frequently found in
public utility pricing, mobile phone calls rates
✓ With the known demand curve, the second degree monopolist divides it into small segments, so that, in
effect, it becomes many customers. For each segment, from the highest portion of the demand curve to
the lowest, he charges different prices which reflects the willingness of the customer to buy a given
amount, of say, electricity at that price.
 Price Discrimination
Third Degree- Given by Pigou
• Monopolist divides his customers into two or more classes or groups, charging a different price to each
class of customer.
• Each class is a separate market, e.g., the Gold, Platinum seats in a cinema halls, Business Class and
Executive Class, etc.
• This is the commonest kind of price discrimination. Here, the monopolist sells the same commodity in
two separate markets at two separate prices at the same time.
• This concept applies the equi-marginal principle: the last unit sold in each of the two markets makes
the same addition to total revenue
 Pre-conditions for Price Discrimination
1. Existence of Monopoly
2. Separated & Isolated Markets & Re-sale not allowed
3. Different Elasticity of Demand: The price elasticity of demand for the product should be different in both the
markets. The monopoly firm will then be able to fix a higher price in the market in which the elasticity of demand
is inelastic and fix a lower price in the market having elasticity of demand more elastic.
4. Laziness or Ignorance of Buyers
5. Supply or Sale on Order
6. Legal Acceptance: When a monopoly firm has legal sanction from the government to sell its product at different
prices then the price discrimination is possible. For example, State Electricity Board or Indian Railways has legal
provisions from the government to charge different prices for the use of electricity in agricultural sector and
industrial sector.
 Pre-conditions for Price Discrimination
• Different Consumer Preferences and Habits: Price discrimination is also possible when consumers have
different preferences and habits for the consumption of a product or service. The product can be sold in different
forms and different prices can be charged for the same product. For example, a book is supplied to library in
hardbound while the same book is sold in paperback to the students. The different prices for the same book is
charged by the publisher.
• Different Uses: Price discrimination is also possible when the users of a service or product have different uses. For
example, Indian Railways charge different freight rates for coal and silver.
• Different Transport Charges: When there are different transport charges in different regions then the seller of a
product or service will charge different prices from different buyers.
• Peak and Slack Hours: Some services or products are used by the buyers or customers. Such service may have
busy working hours as well as slack working hours. A monopolist can charge high prices and low prices as per the
working hours from different customers. For example, Ola/Uber charges high prices during surge hours
 Monopoly Power and its Measurements
(1) Lerner’s Index of Monopoly Power (Market Power): The index is the percent markup of price over marginal
cost. Larger the value of L, greater is the monopoly degree and power. L is positive number. In PC, L = 0. Thus,
as e decreases, L increases, i.e., the more inelastic the demand curve, the greater will be the degree of monopoly
power and the larger the amount of monopoly profit.

P − MC AR − MC AR − MR
L= = = ( MR = MCequilib)
P AR AR
1
−
e
 Monopoly Power and its Measurements
(1) Lerner’s Index of Monopoly Power (Market Power): The index is the percent markup of price over marginal
cost. Larger the value of L, greater is the monopoly degree and power. L is positive number. In PC, L = 0. Thus,
as e decreases, L increases, i.e., the more inelastic the demand curve, the greater will be the degree of monopoly
power and the larger the amount of monopoly profit.

P − MC AR − MC AR − MR
L= = = ( MR = MCequilib)
P AR AR
1
−
e

Triffin’s Index of Monopoly Power using Price Cross

Elasticity: He suggested that instead of Price Elasticity, Cross
Price Elasticity should be used. Zero elasticity for pure
monopoly and infinity for perfect competition. Thus, lower the
value of cross elasticity of demand the greater will be the degree
of monopoly power and vice versa.
 Monopoly Power and its Measurements
Measure of Monopoly Power: Rothschild’s Index: This index shows how far a particular firm controls the market
for a particular good. In case of pure monopoly – index is equal to unity. In case of perfect competition – index is
equal to zero.
 Monopoly Power and its Measurements

Concentration Ratios: These ratios measure the size of the largest firm’s share in total industry sales or profit or assets,
which is denoted by CRn. In other words, CRn is the proportion of total industry sales accounted for by the n-largest firms.
Usually, concentration ratios are considered for either four-firm or eight-firm i.e. CR4 and CR8. While in the Perfect
Competitive Market, CR is more evenly distributed, whereas, in monopolistic industry, CR is skewedly distributed and in
pure monopoly, CR is concentrated in a single firm.
Example: Let there be 4 firms in an industry and their
respective shares in terms of market shares have been
arranged in decreasing order as below.

Here, CR1 is 0.50 and CR2 is 0.85. These figures indicate that the first firm is concentrated.
 Monopoly Power and its Measurements
Measure of Monopoly Power: Herfindahl – Hirschman Index: HHI is used popularly to ascertain market concentration.
Calculated by squaring the share of entire market by each firm in the industry and then summing across all firms in the
industry. The value of index zero in case of competitive market to 1 as in monopoly.
n

HI =  Si2
i=1

where, n is the number of firms in the industry and Si is the market share of i-th firm.
HI = ( 0.50 ) + ( 0.35 ) + ( 0.10 ) + ( 0.05 ) = 0.385
2 2 2 2
 Monopoly Power and its Measurements
Measure of Monopoly Power: Herfindahl – Hirschman Index: HHI is used popularly to ascertain market concentration.
Calculated by squaring the share of entire market by each firm in the industry and then summing across all firms in the
industry. The value of index zero in case of competitive market to 1 as in monopoly.
n

HI =  Si2
i=1

where, n is the number of firms in the industry and Si is the market share of i-th firm.
HI = ( 0.50 ) + ( 0.35 ) + ( 0.10 ) + ( 0.05 ) = 0.385
2 2 2 2

If there are n firms in an industry and all have equal shares, the share of each firm will be 1/n and the HI will
be n (1/n) 2 = 1/n which is the reciprocal of the number of firms. If there is only one firm its share is 1 and the
HI is also 1. Thus the HI lies between 1.0 and 1/n where n is the number of firms.
 Price Discrimination: Equilibrium Conditions
• MR1 = MR2: Where the elasticity of demand is different in different markets, then:
✓ Less supply, higher price, where demand is inelastic.
✓ More supply, lower price, where demand is elastic FOC : MC = MR1 = MR2
• MR1 = MR2 = MC d 2TR1 d 2TC d 2TR d 2TC
SOC :  and 2

dq12 dq 2
dq22
dq2
 FOC : MC = MR1 = MR2
Price Discrimination: Equilibrium Cond itionsd 2TR d 2TC d 2TR2 d 2TC
SOC : 1
 and 
Example: Assume that the total demand is P = 100 - 2X dq21 dq2 dq22 dq2
P1 = 80 - 2·5X1
P2 = 180 - 10X2
The cost function is: C = 50 + 40X = 50 + 40(X1 + X2)
 FOC : MC = MR1 = MR2
Price Discrimination: Equilibrium Cond itionsd 2TR d 2TC d 2TR2 d 2TC
SOC : 1
 and 
Example: Assume that the total demand is P = 100 - 2X dq21 dq2 dq22 dq2
P1 = 80 - 2·5X1
P2 = 180 - 10X2
The cost function is: C = 50 + 40X = 50 + 40(X1 + X2)
Compare the price discriminating monopolist with that of non-price
discriminating monopolist
 FOC : MC = MR1 = MR2
Price Discrimination: Equilibrium Cond itionsd 2TR d 2TC d 2TR2 d 2TC
SOC : 1
 and 
Example: Assume that the total demand is P = 100 - 2X dq21 dq2 dq22 dq2
P1 = 80 - 2·5X1
P2 = 180 - 10X2
The cost function is: C = 50 + 40X = 50 + 40(X1 + X2)
Calculate the elasticities for both the market segments and discuss the results.
 Relationship between Price Elasticities and Price Discrimination
 e 
AR = MR
  If e = infinity, MR = AR
 e −1  If e > 1, MR > 0. AR +ve
MR = AR  e −1 
e If e= 1, MR = 0 and AR = 0
 
 1 If e < 1, MR < 0, AR +ve
MR = AR 1−
 e If e = 0, MR <0, AR = 0
 
 Price Discrimination: Equilibrium Conditions
• MR1 = MR2: Where the elasticity of demand is different in different markets, then:
✓ Less supply, higher price, where demand is inelastic.
✓ More supply, lower price, where demand is elastic
• MR1 = MR2 = MC
 Multiplant Monopolist
Case of Multiplant Firm
This is a case of a monopolist who produces a homogeneous product in different plants. Assume that the monopolist
operates two plants, A and B, each with a different cost
Structure. He has to make two decisions:
(1) Firstly, how much output to produce altogether and at what price to sell it so as to maximise profit.
(2) Secondly, how to allocate the production of the optimal (profit-maximising) output between the two plants.
 Multiplant Monopolist
Case of Multiplant Firm
The monopolist is assumed to know his market demand (and the corresponding MR curve) and the cost structure of the
different plants. The total MC curve of the monopolist may be computed from the horizontal summation of the MC curves
of the individual plants Given the MR and MC curves, the monpolist can define the total output and the price at which it
must be sold in order to maximise his profit from the intersection of these two curves.

The allocation of production between the plants is decided by the following rule:
MC1 = MC2 = MR
If MC of plant A, is lower than the MC of plant B, the monopolist would increase his profit by increasing the production in A and
decreasing it in B, until the above equality is met.
The total profit is the sum of profits from the products of the two plants. The profit from plant A is the shaded area abed and the
profit from plant B is the shaded area gfjh.
 Multiplant Monopolist
Example: Monopolist’s demand curve is: The allocation of production between the
X = 100 − P Ascertain the profit maximizing output and plants is decided by the following rule:
C = 5X price charged by this multiplant monopolist MC1 = MC2 = MR
1 1

C2 = 0.125X 22
Monopolistic Competition
 Monopolistic Competition

Selling Costs- Introduced by Chamberlin

Chamberlin introduced selling costs in the theory of the firm for the first time. The recognition of product differentiation
provides the rationale for the selling expenses incurred by the firm: with advertising and other selling activities the firm
seeks to accentuate the difference between its product and the product of other firms in the group; that is, Chamberlin
assumes that advertising in general will shift the demand and will make it less elastic by strengthening the preferences of
the consumers for the advertised product.
Chamberlin argues that the selling-costs curve is U-shaped, that is, there are economies and diseconomies of advertising
as output changes. Initially expansion of output will not require an Equi proportional increase in selling costs, and this
leads to a fall in the average selling expenditure. However, beyond a certain level of output the firm will have to spend
more per unit in order to attract customers from other firms: as output expands the firm has to attract customers which are
well used to the product of other firms. The U-shaped selling cost, added to the U-shaped production cost, yields a U-
shaped A TC curve
 Monopolistic Competition
Monopolistic Equilibrium Conditions
Monopolistic Competition: SR Equilibrium
 Monopolistic Competition: SR Equilibrium
Short Run Equilibrium:
In the short run, Chamberlin’s model of monopolistic competition comes closer
to monopoly. No difference between monopolistic competition and monopoly
in the short run.
In short run, Normal profit if MC = MR < AR = AC occurs. Loss if MC = MR
< AR < AC happens
Chamberlin’s firm may earn supernormal profit, normal profit, or incur loss in
the short run—since entry and exit are not allowed during this time period.
 Monopolistic Competition: LR Equilibrium

When the firms in short run are earning abnormal profit

If in short run, the monopolistic firms are earning supernormal (or abnormal) profit, then this will attract new
firms into the industry. Due to the entry of the new firms, the market supply of the product will increase,
consequently the price will start falling. The price will continue to fall until it become equal to the minimum of
the LAC curve. The equality between the price and the LAC curve implies that all abnormal profits are wiped
out, hence, no new firm will enter the industry. In the figure, the long run equilibrium is determined by the
intersection of LMC and LMR at point E. The equilibrium price is OP e and the equilibrium output is Oq e . At
the long run equilibrium, the monopolistic firm is earning zero-economic profit (or normal profit).
When the firms in short run are earning abnormal loss
On the contrary, if in the short run, the firms are incurring abnormal loss, then some of the existing firms will
start leaving the industry. This will lead to a fall in the market supply and in turn, the market price will rise. The
price will continue to rise until it reaches price OP e , where it becomes equal to the minimum of the LAC curve.
This ensures the disappearance of abnormal losses. The equilibrium is determined at point ' E ', and the
equilibrium price and equilibrium output as OP e and Oq e respectively. It should be noted here that similar to
the above situation, the monopolistic firm earns zero economic profit.
Hence, we can conclude that irrespective of the fact that in the short run whether the firms are earning abnormal
profit or abnormal loss, in the long run they will earn zero-economic profit (or normal profit).
 Monopolistic Competition: LR Equilibrium
Long Run Equilibrium:
In the long run, monopolistic competition comes closer to perfect competition
because the freedom of entry and exit allows firms to enjoy only normal profit.
The difference in output — QMQP— measures excess capacity or unused capacity
faced by monopolistically competitive firms. Production at a higher cost implies
wastage of resources or underutilization of resources.
Since production takes place at the lowest point of AC curve under perfect
competition, there does not occur any wastage of resources. Hence a perfectly
competitive market is ‘efficient’ in the sense that resources are allocated
efficiently. Society gets larger output and consumers get output at a low price.
Thus, as perfect competition maximizes social welfare, it is an ideal market.

But as the monopolistically competitive firm operates to the left of the minimum
point of its AC curve, this market is considered as an ‘inefficient’ one. As a result,
social welfare is not maximized under monopolistic competition since society gets
lower output compared to perfectly competitive output and buyers buy the
differentiated products at a high price.
Lecture-16: Non-Cooperative
Oligopoly: Cournot &
Bertrand (Homogenous and
Heterogenous Goods)
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Cournot Oligopoly Model
Oligopoly Market Structure
Cournot Sweezy
Model Model
Bertrand
Model Non- Collusive
Collusive
Stackelberg
The rival firms enter into collusion to
Model There exists rivalry among the firms as
maximize joint profit by reducing the
Edgeworth they are interdependent upon each other.
uncertainty due to rivalry
Model
Chamberlin
Model
Price Basing Point
Cartels Mergers
Leadership Price System
NTA-UGC-NET | Cournot Oligopoly Model
Non-Collusive Oligopoly Market Structure
Each firm develops an expectation about what the other firms may do in response
(reaction) to its action.

• Cournot Model of Duopoly: Augustin Cournot, 1838

• Bertrand Model of Duopoly: Joseph Bertrand, 1883

• Edgeworth Model: Francis Edgeworth, The Pure Theory of Monopoly, 1897

• Chamberlin’s Oligopoly Model: Edward Chamberlin, 1929

• Stackelberg Model: Heinrich Freiherr von Stackelberg, 1934

• Kinked Demand Curve- Sweezy Model: Paul Sweezy- 1939

 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
[Assume: Output unchanged]
Assumptions:
• Two profit maximisation firms A and B
• Each firm faces a linear market demand curve
• Both sell identical products (in original version of Cournot model, they sell mineral water)
• Cost functions are identical and MC of each firm is 0
• Each firm assumes that the rival firm would continue to produce the same output as in the last period

Horizontal MC
curve
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
[Assume: Output unchanged]
The Model [Stage-1: A enters first and B enters second]
• A start producing quantity OA of mineral water and sell at Price P. He is at equilibrium at point A.
• A finds the total market demand curve DD’ and produces OA that is ½ of the entire market demand OD’.
• At equilibrium, TR of A is ar OACP and TC is OA and elasticity of market demand at OA level of output is 1.
Now B enters the market and assumes that A will continue to produce and sell OA units of water and considers
CD portion of market demand.
• B will produce ½ of his market demand curve (AD’), which is
AB and charges price OP’
• B’s equilibrium is at point B and his TR is ar Obe’P’ and TC is OB.
• A produces ½ of market demand AD’ & B sells ½  ½ of AD’

Firm A’s
Equilibrium
[MR = MC=0]
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
[Assume: Output unchanged]
The Model [Stage-2: A’s action to B and B’s reactions to A]
• A in the next period assumes that B will not change it supply from AB, so he produce ½ of BD’ which is not
supplied by B. That is, A produces ½ (1 – ¼ ) = ½  BD’ = ½  ¾ = 3/8 of AD’

• B now reacts and assume that A will continue to produce 3/8 of AD’ and B produce ½ of unsupplied market
demand which is ½ (1 – 3/8) = 5/16 of AD’
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
[[Assume: Output unchanged]
The Model [Stage-3: A’s action to B and B’s reactions to A]
• A in the third period assumes that B will not change it supply, so he produce ½ of remaining market which is not
supplied by B. That is, A produces ½ (1 – 5/16 ) = ½  11/16 = 11/32 of AD’

• B now reacts and assume that A will continue to produce 11/32 of AD’ and B produce ½ of unsupplied market
demand which is ½ (1 – 11/32) = 21/64 of AD’
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
Firm A’s output [in different rounds] Firm B’s output [in different rounds]
1 11 1
Period-1: Period-1:   =
2 22 4
1 1 3 1 1 1 3 5 1 1
Period-2: 1−  = = − Period-2:  1−  = = +
2 4 8 2 8 2  8  16 4 16
1 5  11 1 1 1 1  11  21 1 1 1
Period-3: 1−  = = − − Period-3:  1−  = = + +
2  16  32 2 8 32 2  32  64 4 16 64
1  21  43 1 1 1 1 1 43  85 1 1 1 1
Period-4: 1− = = − − −
2  64  128 2 8 32 128 Period-4:  1− = = + + +
2  128  256 4 16 64 256
A ' s ProductEquilb. B ' s ProductEquilb.
1
1 1 1
= − − − − ... =
1
+
1
+
1
+
1
+ ...
2 8 32 128 4 16 64 256
1 1 1 1  2 3 4
= − + + + ... 1 1 1 1
2  8 32 128  = +   +   +   + ...
4 4 4  4
1 1 1 1 1  1  1  1  
2 3

= −  +  +    +    ...
2  8 8 4 8  4  8  4  
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
Important Points
• The final equilibrium will be reached in which each firm will produce 1/3rd of the
total market.
• Thus, in total both the firms will supply 2/3rd of the total market demand curve.
• Individually each firm is maximising its profit but industrial profits are not
maximised.
• Firms are naïve and don’t learn from past experiences. If they become clever and
identifies each other mutual interdependence, then they would act as a monopolist,
each producing ½ of the total market demand and will sell at Price OP.
• If there were 3 firms, then each of them would produce 1/4th of the total market
demand and together they can sum-up to cater 3/4th of market demand.
 1 
• Similarly, if there are n firms, each would produce   and together they can
n +1
 
 n 
cater to
  Industry Output
• n+ 
More firms are there, closer it will be to the Perfect Competition market.
1
• Cournot model gives us a STABLE EQUILIBRIUM and is a CLOSED MODEL
(entry not allowed)
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
Equilibrium Using Reaction Functions

Cournot’s Model
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
RFs in Cournot Model
are steeper to rival’s axis Equilibrium Using Reaction Functions
BUT
RFs in Bertrand Model Cournot’s Model
are steeper to own axis

• Concave to the Origin

• Highest points lie left

Closer the iso-profit curve to

the Quantity Axis, higher is
the profit

Bertrand Model
• Convex to the Origin
• Highest point lie right
Farther the iso-profit curve
from the Price Axis, higher is
the profit
 NTA-UGC-NET | Cournot Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Cournot, 1838
Equilibrium Using Reaction Functions
It is a stable equilibrium, if A's reaction curve is steeper than B's reaction curve. Why it is STABLE?
Let A starts with lower quantity A1. Firm B reacts to it considering A will not change, so B produces B1. In the
next period, A assume B will not change and produce higher quantity A2, B reacts by reducing its supply to B2.
This will continue till they reach point e.

Cournot’s
Equilibrium
 NTA-UGC-NET | Cournot Oligopoly Model
Maximum Individual Profits but not Industrial Profits

Cournot’s Model

Contract curve denotes the tangency of iso-profit lines and all points are
optimal
 NTA-UGC-NET | Bertrand’s Oligopoly Model
Bertrand Oligopoly Market Structure- Joseph Bertrand, 1883: THE STORYLINE
• A enters the market first and sets the price = monopoly price, as he is the only seller in the market. This price is
most profitable for him.
• B now enters the market and produces the same product as produced by A. B sets the price based on the
assumption that A will not change the price as currently being charged by A. B sets the price slightly lower than
A’s price → All market demand shifted to B and A’s sales = 0.
• Next A reconsiders his pricing decision assuming that B will not change its prices, and has two options:
• Option-1: Match its price to that of B :→ PA = PB. In this case, both of them will get the half of the market
demand, i.e. Q1 = Q2 = Q/2
• Option-2: Cut down price : → PA < PB → Market Demand = A’s supply = Q = QA and QB =0
• This will go on till, the price = min AC: In this case, neither of them will reduce the price and nor raise the price.
And reaches the stable equilibrium.
• Equilibrium Condition:

• P = Min AC = PA = PB | QA = QB = Q/2 →In this manner, it is closest to Perfect Competition Price & Equilib Output
• If PA > PB | QA = 0, QB = Q
• If PA < PB | QA = Q, QB = 0
 NTA-UGC-NET | Bertrand Oligopoly Model
Bertrand Oligopoly Market Structure- Joseph Bertrand, 1883
• Unlike Cournot’s model, in Bertrand’s model, rival firm is expected to keep the price constant irrespective of
other rival firm’s price decision.

• This implies that each firm faces the same market demand curve and both aims at their respective profit
maximisation assuming that the rival firm will not change the price.
B’s reaction
• We consider the reaction functions of each duopolists, which are convex to their respective axes functions convex
to PB Axis
A’s reaction
functions convex
to PA Axis
 NTA-UGC-NET | Bertrand Oligopoly Model
Bertrand Oligopoly Market Structure- Joseph Bertrand, 1883
• In order to derive the reaction functions, we first plot the isoprofit curves for A, which shows the same level of
profits that A will get for various prices charged by A and B.
• It shows that A should reduce its price to the minimum price of PAE in response to B’s changes in price to
maintain the same profit levels A2.
• But after price PAE A, can’t sustain the same levels of profits, if B further reduces its price and A will reach
lower isoprofit curve say A1 because it is output beyond optimum level, cost increases for A. Minimum points
lie horizontally
• Minimum points lie right→ When A attains higher profits, it gains some consumers of B, when right to each
B raises its prices and A also raises its prices. Minimum points other
lie vertically right
to each other
 NTA-UGC-NET | Bertrand Oligopoly Model
Bertrand Oligopoly Market Structure- Joseph Bertrand, 1883
• Derivation of Reaction Curves (or Conjectural Variations)- Joining all the minimum points of iso-profit curves
of A, we get the CV or RC of A. Reaction curve for A indicates the locus of points of maximum profits that A
can attain by charging a certain price, given the price of B.
• In the similar manner, we get the RC for B.

Minimum points
lie horizontally
right to each
Minimum points other
lie vertically right
to each other
 NTA-UGC-NET | Bertrand Oligopoly Model
Bertrand Oligopoly Market Structure- Joseph Bertrand, 1883
• Derivation of Reaction Curves (or Conjectural Variations)- Joining all the minimum points of iso-profit curves
of A, we get the CV or RC of A. Reaction curve for A indicates the locus of points of maximum profits that A
can attain by charging a certain price, given the price of B.
• In the similar manner, we get the RC for B.
• Point e, is the STABLE Equilibrium, where RCs of A
and B intersect each other and they charge PAE and PBE
• Why it is Stable? If A choses PA1, then B choses PB1,
then in response to B, A charges PA2, and B reacts by
charging PB2….likewise till they reach e point.
 NTA-UGC-NET | Bertrand Oligopoly Model
Bertrand Oligopoly Market Structure- Joseph Bertrand, 1883
• Both he firms in this model behave naively and will always assume that its rival firm will not change its price.
Naively→ they never learn from past mistakes/experience that indicates that rival will not keep its price same.
• BUT, if they learn from past experience, that is, if they are clever, then????
• THEN, they can maximise the total industry PROFITS and would leave Bertrand Behaviour
 NTA-UGC-NET | Bertrand Oligopoly Model
Bertrand Oligopoly Market Structure- Joseph Bertrand, 1883
• The curve cfd indicates the contract curve which shows the locus of tangent points of iso-profit curves of A & B.
• At point c, B would be at iso-profit curve B6. This is the same iso-profit curve which is at point e. But A is at A9.
• Similarly, at d, A is at original iso-profit curve A5, but B is at B10.
• Between c and d, both firms would realise higher profits, like at f, A7 > A5 and B8 > B6.
• Thus, in this way, both of them if they act as clever & learn
from their previous mistakes, then the industrial profits
can be maximised.
 NTA-UGC-NET | Comparison
Maximum Individual Profits but not Industrial Profits

Bertrand Model Cournot’s Model

Contract curve denotes the tangency of iso-profit lines and all points are
optimal
 NTA-UGC-NET | Numerical Question
Cournot’s Model [MR1 = MC & MR2 = MC] Cartel/Collusion/Monopoly [MR = MC]
Step-1) Calculate the Reaction Curves [sequence does not matter]
TR1 = P (Q) Q1 = P (Q1+Q2) Q1
TR2 = P (Q) Q2 = P (Q1+Q2) Q2
Step-2) Equate MR1 = MC1 and MR2 = MC2 and fetch Q1 = f(Q2) and Q2 = f(Q1)
Step-3) Estimate the values of Q1 and Q2 by substituting | Q1 = Q2 = 1/3 and Market Demand = 2/3
P = 100 – Q & MCA = MCB = 10

Perfect Competition [P = MC = min AC]

 NTA-UGC-NET | Numerical Question
Bertrand Model [Heterogenous or differentiated products]
Step-1) Calculate the Reaction Curves [sequence does not matter]
TR1 = Q P1 = Q (P1+P2) P1
TR2 = Q P2 = Q (P1+P2) P2
Step-2) Equate MR1 = MC1 and MR2 = MC2 and fetch P1 = f(P2) and P2 = f(P1)
Step-3) Estimate the values of P1 and P2 by substituting | P1 = P2 and Q1 = Q2 = Q/2
NTA-UGC-NET | Numerical Question
NTA-UGC-NET | Numerical Question
Bertrand’s Duopoly Heterogenous Products
 Lecture-17: Stackelberg,
Chamberlin, Kinked Demand
Curve
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Numerical Question
Bertrand Model [Heterogenous or differentiated products]
Step-1) Calculate the Reaction Curves [sequence does not matter]
TR1 = Q P1 = Q (P1+P2) P1
TR2 = Q P2 = Q (P1+P2) P2
Step-2) Equate MR1 = MC1 and MR2 = MC2 and fetch P1 = f(P2) and P2 = f(P1)
Step-3) Estimate the values of P1 and P2 by substituting | P1 = P2 and Q1 = Q2 = Q/2

q1 = 72 − 3 p1 + 2 p2 q2 = 72 − 3 p2 + 2 p1 MC = 0
 NTA-UGC-NET | Numerical Question
Bertrand Model [Heterogenous or differentiated products]

q1 = 72 − 3 p1 + 2 p2 q2 = 72 − 3 p2 + 2 p1 MC = 0
NTA-UGC-NET | Numerical Question
NTA-UGC-NET | Numerical Question
NTA-UGC-NET | Numerical Question
 NTA-UGC-NET | Types of Oligopoly Model
Oligopoly Market Structure
Cournot Sweezy
Model Model
Bertrand
Model Non-
Collusive
Collusive
Stackelberg
The rival firms enter into collusion to
Model There exists rivalry among the firms as
maximize joint profit by reducing the
Edgeworth they are interdependent upon each other.
uncertainty due to rivalry
Model
Chamberlin
Model
Price Basing Point
Cartels Mergers
Leadership Price System
NTA-UGC-NET | Chronology of Oligopoly Model
Non-Collusive Oligopoly Market Structure
Each firm develops an expectation about what the other firms may do in response
(reaction) to its action.

• Cournot Model of Duopoly: Augustin Cournot, 1838

• Bertrand Model of Duopoly: Joseph Bertrand, 1883

• Edgeworth Model: Francis Edgeworth, The Pure Theory of Monopoly, 1897

• Chamberlin’s Oligopoly Model: Edward Chamberlin, 1929

• Stackelberg Model: Heinrich Freiherr von Stackelberg, 1934

• Kinked Demand Curve- Sweezy Model: Paul Sweezy- 1939

 NTA-UGC-NET | Stackelberg Oligopoly Model
Cournot Oligopoly Market Structure- Augustin Bertrand Oligopoly Market Structure- Joseph
Cournot, 1838 [Output War] R
E Bertrand, 1883
Assumptions: Assumptions:
• Two profit maximisation firms A and B V • Two profit maximisation firms A and B
• Each firm faces a linear market demand curve I • Each firm faces a linear market demand curve
• Both sell identical products (in original version of S • Both sell identical products ee
Cournot model, they sell mineral water) I
• Cost functions are identical and MC of each firm is 0 O • Cost functions are identical and MC of each firm is 0
• Each firm assumes that the rival firm would continue N • Each firm assumes that the rival firm would continue to
to produce the same output as in the last period keep the price unchanged
Stackelberg Market Structure- Heinrich Freiherr von Stackelberg, 1934
Assumptions:
• Two profit maximisation firms A and B
• Each firm faces a linear market demand curve
• Both sell identical products
• Cost functions are identical and MC of each firm is 0
• Each firm assumes that the rival firm would continue to produce the same
output as in the last period
• The duopolist A conjectures that B will accept A’s output as autonomously
given and B will actually behave in this way. A is the output-leader and B
the output-follower.
 NTA-UGC-NET | Stackelberg Olig opoly Model

Bertrand Model Cournot’s Model

 NTA-UGC-NET | Stackelberg Oligopoly Model
This model was developed by the German economist Heinrich von Stackelberg and is an extension of Cournot's model. It is
assumed, by von Stackelberg, that one duopolist is sufficiently sophisticated to recognise that his competitor acts on the
Coumot assumption. This recognition allows the sophisticated duopolist to determine the reaction curve of his rival and
incorporate it in his own profit function, which he then proceeds to maximise like a monopolist.
 NTA-UGC-NET | Stackelberg Oligopoly Model
If firm A is the sophisticated oligopolist, it will assume that its rival will act
on the basis of its own reaction curve. This recognition will permit firm A to
choose to set its own output at the level which maximises its own profit. This
is point a which lies on the lowest possible isoprofit curve of A, denoting the
maximum profit A can achieve given B's reaction curve.

Firm A, acting as a monopolist (by incorporating B's reaction curve in his

profit-maximising computations) will produce X A, and firm B will react by
producing X 8 according to its reaction curve.

The sophisticated oligopolist becomes in effect the leader, while the naive
rival who acts on the Cournot assumption becomes the follower. Clearly
sophistication is rewarding for A because he reaches an isoprofit curve closer
to his axis than if he behaved with the same naivete as his rival. The naive
follower is worse off as compared with the Cournot equilibrium, since with
this level of output he reaches an isoprofit curve further away from his axis.
 NTA-UGC-NET | Stackelberg Oligopoly Model
If firm B is the sophisticated oligopolist, it will choose to produce X8, corresponding to point b on A's reaction curve,
because this is the largest profit that B can achieve given his isoprofit map and A's reaction curve. Firm B will now be the
leader while firm A becomes the follower. B has a higher profit and the naive firm A has a lower profit as compared with the
Cournot equilibrium.
 NTA-UGC-NET | Stackelberg Oligopoly Model
If firm B is the sophisticated oligopolist, it will choose to produce X8, corresponding to point b on A's reaction curve,
because this is the largest profit that B can achieve given his isoprofit map and A's reaction curve. Firm B will now be the
leader while firm A becomes the follower. B has a higher profit and the naive firm A has a lower profit as compared with the
Cournot equilibrium.

In summary, if only one firm is sophisticated, it will emerge as the leader, and a stable equilibrium will emerge, since the
naive firm will act as a follower.

However, if both firms are sophisticated, then both will want to act as leaders, because this action yields a greater profit to
them. In this case the market situation becomes unstable. The situation is known as Stackelberg's disequilibrium and the
effect will either be a price war until one of the firms surrenders and agrees to act as follower, or a collusion is reached, with
both firms abandoning their naive reaction functions and moving to a point closer to (or on) the Edgeworth contract curve
with both of them attaining higher profits. If the final equilibrium lies on the Edgeworth contract curve the industry profits
(joint profits) are maximized.
 NTA-UGC-NET | Stackelberg Oligopoly Model
• It shows clearly that naive behaviour does not pay. The rivals should recognise their interdependence. By recognising the
other's reactions each duopolist can reach a higher level of profit for himself.

• If both firms start recognising their mutual interdependence, each starts worrying about the rival's profits and the rival's
reactions. If each ignores the other, a price war will be inevitable, as a result of which both will be worse off.

• The model shows that a bargaining procedure and a collusive agreement becomes advantageous to both duopolists. With
such a collusive agreement the duopolists may reach a point on the Edgeworth contract curve, thus attaining joint profit
maximisation.

• It should be noted that Stackelberg's model of sophisticated behaviour is not applicable in a market in which the firms
behave on Bertrand's assumption.

• In a Cournot-type market the sophisticated firm 'bluffs' the rival, by producing a level of output larger than the one that
would be produced in the Cournot equilibrium and the naive rival, sticking to his Cournot behavioural reaction pattern,
will be misled and produce less than in the Cournot equilibrium.

• However, in a Bertrand-type market the sophisticated duopolist can do nothing which would increase his own profit and
persuade the other to stop price-cutting. The most he can do is to keep his own price constant, that is, behave exactly as
his opponent expects him to behave
 NTA-UGC-NET | Stackelberg Oligopoly Model
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists'
costs are C1 = 5X1 and C2 = 0.5X22.
A) Ascertain Stackelberg solution when A is sophisticated leader
 NTA-UGC-NET | Stackelberg Oligopoly Model
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists'
costs are C1 = 5X1 and C2 = 0.5X22.
A) Ascertain Stackelberg solution when A is sophisticated leader
 NTA-UGC-NET | Stackelberg Oligopoly Model
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists'
costs are C1 = 5X1 and C2 = 0.5X22.
A) Ascertain Stackelberg solution when A is sophisticated leader
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists'
costs are C1 = 5X1 and C2 = 0.5X22.
B) Ascertain Stackelberg solution when B is sophisticated leader
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists'
costs are C1 = 5X1 and C2 = 0.5X22.
B) Ascertain Stackelberg solution when B is sophisticated leader
 NTA-UGC-NET | Stackelberg Oligopoly Model
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists'
costs are C1 = 5X1 and C2 = 0.5X22.
A) Ascertain Stackelberg solution when A is sophisticated leader
 NTA-UGC-NET | Stackelberg Oligopoly Model
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists'
costs are C1 = 5X1 and C2 = 0.5X22.
A) Ascertain Stackelberg solution when A is sophisticated leader
 Comparison with Cournot and Bertrand (only in PPT)

• The Stackelberg and Cournot models are similar because in both competition is on quantity.
• The Cournot model considers firms that make an identical product and make output decisions simultaneously.
• The Bertrand model considers firms that make an identical product but compete on price and make their
pricing decisions simultaneously.
• Stackelberg (identical product) is a sequential game, where one firm decides the output before the other
firm.In Stackelberg, the first move gives the leader an advantage.
• There is perfect information in the Stackelberg model, i.e. the follower must observe the quantity chosen by
the leader, else, the model becomes cournot, if the follower does not observe it.
• Cournot, Bertrand and Stackelberg leads to Nash Equilibrium. (Precisely, Stackelberg leads to Subgame
Perfect Nash Equilibrium, i.e. subgame perfect Nash equilibrium or equilibria (SPNE), i.e. the strategy profile
that serves best each player, given the strategies of the other player and that entails every player playing in a
Nash equilibrium in every subgame).
 Comparison with Cournot and Bertrand (only in PPT)
• The aggregate Stackelberg output is greater than the aggregate Cournot output, but less than the aggregate
Bertrand output.
• The Stackelberg price is lower than the Cournot price, but greater than the Bertrand price.
• The Stackelberg consumer surplus is greater than the Cournot consumer surplus, but lower than the Bertrand
consumer surplus.
• The aggregate Stackelberg output is greater than pure monopoly or cartel, but less than the perfectly
competitive output.
• The Stackelberg price is lower than the pure monopoly or cartel price, but greater than the perfectly
competitive price.
NTA-UGC-NET | Stackelberg Oligopoly Model
 NTA-UGC-NET | Chamberlin’s Oligopoly Model
Chamberlin’s Oligopoly Market Structure- Edward Chamberlin, 1933
[The Theory of Monopolistic Competition, 1933]
Assumptions of Cournot Model: Assumptions of Chamberlin’s Model:
• Two profit maximisation firms A and B • Two profit maximisation firms A and B
• Each firm faces a linear market demand curve • Each firm faces a linear market demand curve
• Both sell identical products (in original version of • Both sell identical products (in original version of Cournot
Cournot model, they sell mineral water) model, they sell mineral water)
• Cost functions are identical and MC of each firm is 0 • Cost functions are identical and MC of each firm is 0
• Each firm assumes that the rival firm would continue to • Each firm assumes that the rival firm would continue to
produce the same output as in the last period (naïve produce the same output as in the last period (naïve
behaviour) behaviour) They learn from past experiences.
 Chamberlin’s Oligopoly Market Structure- Edward Chamberlin, 1933
[The Theory of Monopolistic Competition, 1933]
The Model
• DD is the linear demand curve and MC = 0. Firm A starts and produces ½ of DD and attains an equilibrium at
point Xm, where his MC = MR and charges Price OPm and supplies OXm output.
• Now, firm B enters the market, and assumes that the A will not change its output from OXm and considers the
remaining dd curve as CD. So attains equilibrium at point B, where his MC = MR and charge price as OP and
supplies XmB output.
Firm B’s
Same as Cournot Equilibrium
[MR = MC=0]
Model

Firm A’s
Equilibrium
[MR = MC=0]
 NTA-UGC-NET | Chamberlin’s Oligopoly Model
Chamberlin’s Oligopoly Market Structure- Edward Chamberlin, 1933
[The Theory of Monopolistic Competition, 1933]
The Model
• Till now, the total supply in market is OXm + XmB = OB. Now as B is selling at lower Price compared to A, so
the market price falls to OP (A will reduce the price to OP). A also reduces its supply to OA, which is ½ of
OXm and equal to B’s supply of XmB.
• In this way, the total supply in market is now OA + XmB = OXm (as OA = AXm = XmB).
• Since supply has been reduced, marker price rises to OPm.
• Thus, total supply is OXm and market price is OPm.
• Indeed it is the same situation when A entered the market f irst.
 NTA-UGC-NET | Chamberlin’s Oligopoly Model
Chamberlin’s Oligopoly Market Structure- Edward Chamberlin, 1933
[The Theory of Monopolistic Competition, 1933]
The Model
• Till now, the total supply in market is OXm + XmB = OB. Now as B is selling at lower Price compared to A,
so the market price falls to OP (A will reduce the price to OP). A also reduces its supply to OA, which is ½ of
OXm and equal to B’s supply of XmB.
• In this way, the total supply in market is now OA + XmB = OXm (as OA = AXm = XmB).
• Since supply has been reduced, marker price rises to OP m.
• Thus, total supply is OXm and market price is OPm.
• Indeed it is the same situation when A entered the market first.
Thus by recognising their
interdependence, they charge
higher price, supply less and
maximise the industry profits.
In this manner, they both jointly
act as a Monopoly without
collusion
 NTA-UGC-NET | Chamberlin’s Oligopoly Model
Chamberlin’s Oligopoly Market Structure- Edward Chamberlin, 1933
[The Theory of Monopolistic Competition, 1933]
Implications
• Since they are maximising joint profits and that too without collusion, this implies that they have a good
information and knowledge of Cost Curves of rival firms and total supply curve.
• This helps them to develop a market monopoly price which is the best for both the firms.
• The joint profit maximisation without collusion requires identical costs (in this case, horizontal line → MC =0 )
and identical demand.
• It ignores the possible entry of a new entrant.
• It is CLOSED MODEL and leads to STABLE Equilibrium.
NTA-UGC-NET | Sweezy’s Oligopoly Model
Kinked Demand Model: Paul Sweezy 1939
Kinked-demand curve originated from Chamberlin’s intersection of individual
demand curve of the firm and its market share DD’. But he has not explicitly
mentioned about it.

Hall & Hitch ‘Price Theory and Business behaviour’ in 1939, used kinked-
demand curve to explain price determined by Average Cost Principle tends to be
sticky.

It was Paul Sweezy who has used Kinked Demand curve as an operational tool
to explain the price and output determination in oligopoly market structure.
NTA-UGC-NET | Sweezy’s Oligopoly Model
Kinked Demand Model: [Demand Curves and MR Curves]
The figure depicts that the demand curve of the oligopolist has a kink at E.
The kink depicts the behaviourial pattern of the firms in uncertainty of
oligopoly and their expectations that rival will follow price cut, but not
price rise.

If firm A  its price (below P) assuming that firm B too will  its price,
then no change in no. of consumers to A and B. The concerned market
demand curve is ED. (Less Elastic)

If the firm A  its price (above P) assuming that firm B will not follow 
its price, then A will lose customers. The relevant market demand curve is
dE. (More Elastic).
Due to the kink in the demand curve of the oligopolist, his MR curve is
discontinuous at the level of output corresponding to the kink.
The M R has two segments: segment dA corresponds to the upper part of
the demand curve, while the segment from point B corresponds to the
lower part of the kinked-demand curve.
NTA-UGC-NET | Sweezy’s Oligopoly Model
Kinked Demand Model: Equilibrium [at Point E]
All points left to point E, MC < MR

All points right to point E, MC > MR

The equilibrium point is at E, where the total profit is maximised. In this

case, there is no particular point, where MR intersects MC.

The discontinuous range AB of the MR curve indicates that in this range

costs may change without affecting equilibrium price and output of the
firm. This indicates that nevertheless of different cost structures, P and O/P
will not change.

Higher is the difference in the degree of elasticities between dE and ED,

greater will be discontinuous range of AB → wider is the range in which
price and output will not change due to any change in cost structures.
NTA-UGC-NET | Sweezy’s Oligopoly Model
Kinked Demand Model: Important Implications and Limitations
It is realistic in cut-throat competition in real business world.

But this model, does not explain the price and output movements. Howe
the firm decides the price and output to maximise its profits.

It explains the prices are sticky due to differences in the demand

elasticities and also because of no effect of changing cost structures on
price and output.

It does not explain the level of price at which the kink will occur.

It does not explain which kinks out of many kinks will be the equilibrium.
Thus, it is not a theory of pricing but just explains that price once
determined will remain fixed.
NTA-UGC-NET | Oligopoly Questions from PYQPs

The Kinked-Demand curve works well under which of the following conditions:
1. Depression
2. Recession
3. Boom
4. Recovery

Codes:
A. 1 & 2
B. Only 1
C. Only 3
D. Irrespective of business cycle
 NTA-UGC-NET | Oligopoly Questions from PYQPs

The Kinked-Demand curve works well under which of the following conditions:
1. Depression
2. Recession
Solution B 3. Boom
4. Recovery

Codes:
A. 1 & 2
B. Only 1
C. Only 3
D. Irrespective of business cycle
NTA-UGC-NET | Oligopoly Questions from PYQPs
 NTA-UGC-NET | Oligopoly Questions from PYQPs

Solution A
NTA-UGC-NET | Oligopoly Questions from PYQPs

Question-3: Starting with the earliest, arrange the following authors

chronologically in the context
of development of theory of Oligopoly :
(i) E. Stackelberg
(ii) P. Sweezy
(iii) J. Bertrand
(iv) A. Cournot
Code :
(A) (ii), (i), (iii), (iv) (B) (iv), (iii), (ii), (i)
(C) (i), (ii), (iv), (iii) (D) (iii), (iv), (i), (ii)

Question-4: Assertion (A) : There is a natural tendency to collude under oligopoly.

Reason (R) : Inter-dependence of firms in oligopolistic markets.
Codes :
(A) Both (A) and (R) are correct, but (R) is not the correct explanation of (A).
(B) Both (A) and (R) are correct, and (R) is the correct explanation of (A).
(C) (A) is correct, but (R) is incorrect.
(D) (A) is incorrect, but (R) is correct.
NTA-UGC-NET | Oligopoly Questions from PYQPs

Question-5: Which of the following is not relevant in case of Sweezy’s oligopoly model ?
(A) A price cut by a firm is followed by the price cut by the rival firms.
(B) Price hike is not followed by the rival firms.
(C) Firms do not react to price change made by one of the firms.
(D) Firms react to all kinds of price changes made by the rival.

Question-6: A model of oligopoly in which one business sets output before the other
business do is
(A) Cournot oligopoly model
(B) Bertrand oligopoly model
(C) Stackelberg oligopoly model.
(D) Chamberlin oligopoly model
 NTA-UGC-NET | Oligopoly Questions from PYQPs

Question-7: In the Paul Sweezy Model of Oligopoly in the Kinked Demand Curve, the point of kink represents
(A) Quantity Rigidity
(B) Price Rigidity
(C) Both the Price and Quantity Rigidity
(D) Only Price Rigidity

Question-8: The oligopoly model in which the businessman assumes that his competitors output are fixed and
simultaneously decide how much to produce is
(A) Cournot oligopoly model
(B) Stackelberg oligopoly model
(C) Chamberlin’s oligopoly model
(D) Bertrand oligopoly model

Question-9: In the context of oligopoly, consider the following statements :

(a) Cournot’s equilibrium is a Nash equilibrium.
(b) Stackelberg equilibrium is a Nash equilibrium.
Select the correct answer from the code given below :
(1) Only (a) (2) Only (b)
(3) Both (a) and (b ) (4) Neither (a) nor (b)
Lecture-18: Cooperative Oligopoly
Cartel, Price Leadership, Mergers
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Types of Oligopoly Model
Oligopoly Market Structure
Cournot Sweezy
Model Model
Bertrand
Model Non-
Collusive
Collusive
Stackelberg
The rival firms enter into collusion to
Model There exists rivalry among the firms as
maximize joint profit by reducing the
Edgeworth they are interdependent upon each other.
uncertainty due to rivalry
Model
Chamberlin
Model
Price Basing Point
Cartels Mergers
Leadership Price System
 NTA-UGC-NET | Cartels
Oligopoly Market Structure
• Cartels are formed among the firms due to the uncertainty arising out
• of mutual interdependence.

• A cartel is defined as a group of firms that gets together to make output

and price decisions.

• Oligopolistic firms join a cartel to increase their market power, and

members work together to determine jointly the level of output that each
member will produce and/or the price that each member will charge. By
working together, the cartel members are able to behave like a
monopolist. For example, if each firm in an oligopoly sells an
undifferentiated product like oil, the demand curve that each firm faces
will be horizontal at the market price.

• The cartel members choose their combined output at the level where their
combined marginal revenue equals their combined marginal cost. The
cartel price is determined by market demand curve at the level of output
chosen by the cartel.
NTA-UGC-NET | Cartels
Oligopoly Market Structure
There can be two types of cartels, viz.,
a) cartels aiming at joint profit maximisation
b) cartels aiming at the sharing of markets

Case-A: Joint Profit Maximisation

• This case is similar to case of monopolist. All the firms appoint a
central agent, who has the authority to decide the total quantity to be
produced and price to be charged to maximise the joint profit.

• The central agency allocates the output to be produced among the

firms and it distributes the joint profit.

• The central agency has access and information of cost conditions of

all the firms
 NTA-UGC-NET | Cartels
Case-A: Joint Profit Maximisation
• Say there are firms A and B who have formed a cartel for joint profit maximization.
On the basis of the individual MC curves, joint or AMC has been derived by
horizontal summation.

• The joint profit maximization condition is where, market demand DD intersects

AMC.

• Now the central agency allocates the production among firm A and firm B as a
monopolist would do, that is, by equating the MR to the individual MCs. Thus firm A
will produce X 1 and firm B will produce X 2 •
NTA-UGC-NET | Cartels
Case-A: Joint Profit Maximisation
• It should be noted that the firm A has lower costs and hence produces
larger amount of output. But it does not mean that A will capture
more share of joint profit. The total profit is sum of individual profits
denoted by shaded areas.
• The profit distribution is decided by the central agency of the cartel.
NTA-UGC-NET | Cartels
Steps to Solve for Equilibrium Condition:
1) Set up the joint profit equation as TR1 + TR2 - TC1 - TC2. This will have
only Q1 and Q2 as variable.
2) Solve for partial derivatives and equate them to zero
3) Check out the second order derivatives
 NTA-UGC-NET | Cartels
Profit Maximisation Problem of a Cartel:
Maximise  Joint = 1 +  2
Given: P = f (Q1 + Q2 ), Q = Q1 + Q2 , C1 = f (Q 1) and C2 = f (Q2 )
where, 1 = TR1 − TC1 and 1 = TR2 − TC2
Maximise  Joint = 1 +  2 = TR1 − TC1 + TR2 − TC2
Total market MRJoint = MR1 = MR2 → irrespective of which machine is used, additional revenue from
extra unit will fetch same revenue as the price is same for both the firms.
FOC :
d Joint dTR1 dTC1
  MR
dTR1 dTC1 dTR
*
dQ
=
dQ
−
dQ
=0
dQ
=
dQ
=
dQ
= MR = MR  ...(1)

d Joint dTR2 dTC2

  MR
dTR2 dTC2 dTR
* =
dQ
−
dQ
=0
dQ
=
dQ
=
dQ
= MR = MR 
dQ
So, from (1) and (2),
MR = MC1 = MC2 = MR1 = MR2
SOC :
d 2TR d 2TC
* 
dQ2 dQ2
d 2TR d 2TC
* 
dQ2 dQ2
 NTA-UGC-NET | Cartels
Profit Maximisation Problem of a Cartel:
Maximise  Joint = 1 +  2
Given: P = f (Q1 + Q2 ), Q = Q1 + Q2 , C1 = f (Q 1) and C2 = f (Q2 )
where, 1 = TR1 − TC1 and 1 = TR2 − TC2
Maximise  Joint = 1 +  2 = TR1 − TC1 + TR2 − TC2
Total market MRJoint = MR1 = MR2 → irrespective of which machine is used, additional revenue from
extra unit will fetch same revenue as the price is same for both the firms.
FOC :
d Joint dTR1 dTC1 = 0  dTR1 dTC1 = dTR   MR = MR = MR  ...(1)
* = − = Joint 1 2
dQ1 dQ1 dQ1 dQ1 dQ1 dQ
d Joint dTR2 dTC2 = 0  dTR2 dTC2 = dTR   MR = MR = MR  ... (2)
* = − = Joint 1 2
dQ2 dQ2 dQ2 dQ2 dQ2 dQ
So, from (1) and (2),
MR = MC1 = MC2 = MR1 = MR2
SOC :
2
d 2TR d TC
*  1
dQ2 dQ12
2
d 2TR d TC
2 
* 2
2
dQ dQ2
 NTA-UGC-NET | Cartels
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists' costs
are C1 = 5X1 and C2 = 0.5X22.
Ascertain Stackelberg solution when A is sophisticated leader
Ascertain Stackelberg solution when B is sophisticated leader
Ascertain profit maximization condition under cartel
 NTA-UGC-NET | Cartels
Example:-1: Assume that in a duopoly market the demand function is P = 100 - 0·5(X1 + X2) and the duopolists' costs
are C1 = 5X1 and C2 = 0.5X22.
Ascertain Stackelberg solution when A is sophisticated leader
Ascertain Stackelberg solution when B is sophisticated leader
Ascertain profit maximization condition under cartel
 NTA-UGC-NET | Cartels
Case-A: Joint Profit Maximisation- Problems
The main reasons why industry profits may not be maximized.
• Mistakes in the estimation of market demand. Usually the elasticity of market demand is
underestimated. Each firm believes that the e of its own demand curve is high due to the
existence of perfect (or almost perfect) substitutes made by competitors, while the industry
demand is much less elastic.

• Mistakes in the estimation of MC. The estimation of the market MC, from the
summation of individual costs, may involve mistakes, due to incomplete knowledge
of the individual MC curves at all levels of output.

• Slow process of cartel negotiations. Cartel agreements take a long time to negotiate
due to the differences in size, costs, and markets of the individual firms.
• Stickiness' of the negotiated price. Once the agreement about price is reached, its
level tends to remain unchanged over long periods, even if market conditions are
changing. This price inflexibility (stickiness) is due to the time-consuming process
of cartel negotiations and the difficulties and uncertainties about the bargaining of
cartel members.
 NTA-UGC-NET | Cartels
Case-B: Market Sharing
• More popular

• Here the firms agree to share the market but at the same time maintain a
considerable degree of freedom regarding product differentiation, selling activities
and other business decisions.

• There are two basic methods of sharing the market:

• (1) Non-price competition and
• (2) Quota system
 NTA-UGC-NET | Cartels
Case-B: Market Sharing

1) Non-price competition:
• In this form of a ‘loose’ cartel, the member firms agree on a common price, at
which each of them can sell any quantity demanded.

• The price is set by the process of bargaining, with the low-cost firms pressing for a
lower price and the high-cost ones for a higher price.

• The agreed price must be such as to allow some profits to all the members.

• The firms agree not to sell at a price below that decided by the cartel, but they are
free to vary the style of their product and/or their selling activities. In other words,
firms compete on a non-price basis.
 NTA-UGC-NET | Cartels
Case-B: Market Sharing

1) Quota System:
• It is an agreement on the quantity that each member may sell at the
agreed price(s), if the costs are identical, then the firms share the
market equally among themselves.

• If costs differ, then the share of the market is decided by bargaining.

• The final quota of each firm depends on the level of it’s cost as well
as on it’s bargaining skill.

• Most often adopted criteria for determining quotas are ‘past-period

sales’ and ‘productive capacity’.
• Another popular method of determining quota is that of geographical
sharing of the market.
 NTA-UGC-NET | Mergers
Mergers

• If firms in an oligopolistic industry cannot form a cartel or accept leadership, then

they have another way out that will save them from any price war. That is
• to eliminate rivalry through merger.

• A Merger is the consolidation of two or more independent firms into a single

firm.

• There are three kinds of mergers:

1) Horizontal: A Horizontal merger combines two firms that produce the same product in
the same geographic market. Since the two are competitors, a merger reduces the number
of firms in the market. A merger occurring between companies in the same industry.
Horizontal merger is a business consolidation that occurs between firms who operate in
the same space, often as competitors offering the same good or service. Horizontal
mergers are common in industries with fewer firms, as competition tends to be higher and
the synergies and potential gains in market share are much greater for merging firms in
such an industry.
 NTA-UGC-NET | Mergers
Mergers
1) Vertical: A Vertical merger combines two firms that previously had an actual or potential customer-supplier
relationship. A merger between two companies producing different goods or services for one specific finished product.
A vertical merger occurs when two or more firms, operating at different levels within an industry's supply chain, merge
operations. Most often the logic behind the merger is to increase synergies created by merging firms that would be more
efficient operating as one.
• That is, the product of one firm is used as an input of the other. The most important motive of vertical merger is the
security in the input markets, output markets or both.
• When an acquiring firm merges with a firm that distributes it’s products through it’s outlets then it is a Downstream
Integration, and this is done to obtain security in the output market.
• If the acquiring firm merges with an input-supplying firm, thenit is called an Upstream Integration and designed to
obtain security in the input markets.
 NTA-UGC-NET | Mergers
Mergers

Conglomerate: A merger between firms that are involved in totally unrelated business activities. There are two
types of conglomerate mergers: pure and mixed. Pure conglomerate mergers involve firms with nothing in
common, while mixed conglomerate mergers involve firms that are looking for product extensions or market
extensions. A conglomerate merger is neither horizontal nor vertical. These mergers have three motives:
extending the market, expanding the product line and pure investment. The Walt Disney Company merged with
the American Broadcasting Company (ABC) in 1995
NTA-UGC-NET | Price Leadership
Price Leadership Oligopoly Market Structure
It is a co-ordinated behaviour of oligopolists, where in one firm sets the price
and the others follow it.

This enables them to avoid uncertainty about the rival’s reactions and the
follower still prefer to follow the leader even at the cost of profit maximising
position.

There can explicit agreement or informal and unsaid trust. However, most often
it remains informal, that is tacit collusion. And this is more popular than cartels,
as in cartels, firms must adhere to the rules, but in price leadership model, they
have the freedom in selling activities.

In case of homogenous product & concentration of firms in one locality→

Identical prices
BUT
If products are differentiated, then prices will be different, but there will be
similarity in their price change movements.
NTA-UGC-NET | Price Leadership
Price Leadership Oligopoly Market Structure- FORMS
• Price leadership by a low-cost firm
• Price leadership by a large firm Given by Fellner
• Barometric Price leadership

Price Leadership Model of Low-Cost Price Leader

• Assume that there are two firms producing homogenous product but at
DIFFERENT Costs and are sold at the same price.
• They can have equal or unequal market shares (presumed or decided by
agreement).

• The unequal cost structures are being reflected by the different cost curves of
the two firms.
 NTA-UGC-NET | Price Leadership
Price Leadership Model of Low-Cost Price Leader
Equal Market Share
• In both the figures, firm A is having the low cost structures. So,
firm A is a Price Leader here and will charge PA (MRA = MCA).
• In the figure (right), both agree to share the market equally, so the
MR curves are equal, as they faced the same demand curve.
• But in the figure (below), the share of market is unequal, & that is
why, MRA is different from MRB

Unequal Market Share

 NTA-UGC-NET | Price Leadership
Price Leadership Model of Low-Cost Price Leader
Equal Market Share
• Price charged by follower Firm B is PA, which clearly is not the
profit maximising price (as at Price PA, B’s MRB  MCB). For B,
higher profits can be earned by producing lower output Xbe and
selling it at higher price PB. But it follows Firm A to avoid price war.
• Firm A is maximising its profits, at PA price and sells XA output.
• Firm B, supplies 0XB (below) and 0X1 (right)

Unequal Market Share

 NTA-UGC-NET | Price Leadership
Price Leadership Model of Low-Cost Price Leader
Equal Market Share
• Important to note that there must be formal or informal agreement of
market share between A and B, else, B even though follows the Price
set by A, but produces lesser than 0XB or 0X1.
• If B produces lesser than 0XB or 0X1, then A would be forced to
deviate from its profit maximisation condition.
• Hence, the follower must be tied by a quota-share agreement (formal
or informal), else leader may
reach non-profit maximisation
situation.

Unequal Market Share

 NTA-UGC-NET | Price Leadership
Steps to Solve for Equilibrium Condition:
1) Identify the firm with the lower cost function.
2) Set up the profit function of the lower cost firm with the assumption that the rival firm will also produce
the same amount of output as produced by the lower cost firm and maximise the profit of the latter (lower
cost firm)
3) The profit function will be a function of quantity of the lower cost firm only.
4) Solve for one variable case and equate the first derivatives to zero
5) Using the quantity of the lower cost firm so ascertain, calculate the price. This will be the price at which
the rival firm will also sell; however, it might happen that it may not be the profit maximization situation
for the rival firm.
 NTA-UGC-NET | Price Leadership
Example:-2: Assume that in a duopoly market the demand function is P = 105 - 2·5(X1 + X2) and the duopolists' costs
are C1 = 5X1 and C2 = 15X2.
Ascertain equilibrium quantity, price and profit of the low cost firm
Ascertain equilibrium quantity, price and profit of the rival firm (higher cost firm)
Check whether the equilibrium price and profit of the rival firm is not the profit maximization condition
 NTA-UGC-NET | Price Leadership
Example:-2: Assume that in a duopoly market the demand function is P = 105 - 2·5(X1 + X2) and the duopolists' costs
are C1 = 5X1 and C2 = 15X2.
Ascertain equilibrium quantity, price and profit of the low cost firm
Ascertain equilibrium quantity, price and profit of the rival firm (higher cost firm)
Check whether the equilibrium price and profit of the rival firm is not the profit maximization condition
 NTA-UGC-NET | Price Leadership
Price Leadership Model of Dominant-Firm Price Leader
• In this case, there is a dominant firm which enjoys the greater share of total market and there are a few smaller
firms, which cater to the remaining market.
• The dominant firm knows the market demand curve (DD) and MC curves of smaller firms, which if added
horizontally, to derive the total supply by all the smaller firms at a given price. Accordingly, the large firm can
supply the uncaptured market (by the smaller firms). This implies that at price P2, smaller firms will supply P2A
and leader will supply AD2 output. Similarly at P and P3.

At equilibrium Price OP1, the entire market

supply is by the small firms and leader’s supply
is 0. But for all prices below OP1, leader’s
supply rises.
If the price is below P3, then the market demand
becomes the leader’s demand curve (as no
smaller firms will supply at price less than P3.

Unequal Market Share

 NTA-UGC-NET | Price Leadership
Price Leadership Model of Dominant-Firm Price Leader
• In the figure (right), market demand curve of large firm has been derived considering the supply curves of smaller
firms. The large firm will set price at OP, where MR = MC and its output is Ox. This Ox = BC (in figure left).
• Do note that it is only the large firm that is maximising its profits, the smaller firms are price-takers & they may or
may not maximise their profits.
• Here also, the large firm should ensure that the small firms are not only following the price set by the large firm
but also producing the required quantity say PB at OP or P2A at OP2, else the large firm will push to a non-profit
maximising situation.
 NTA-UGC-NET | Price Leadership
Example-3: Market Demand curve is D = 50 – 0.3 P and sum of all MC curves of small firms is S = 0.2P. The total cost
function of the dominant firm is given as C = 2Q. Calculate the Qs of the dominant firm and that of the smaller firms and
the market price.
NTA-UGC-NET | Price Leadership
Barometric Price Leadership Model

• In this model, all firms has either formally or informally agreed to

follow the price changes initiated by a firm which is considered to have
a goodwill or long standing in the market. It is a general consensus that
this firm has a good knowledge of the market and indeed regarded as
barometer (in fact the market leader). This firm may or may not be the
low cost firm or large firm, but has a strong goodwill in the market.

• On the basis of a formal or informal tacit agreement, the other firms in

the industry accept such a firm as the leader and follow it in making
price changes for the product.
 NTA-UGC-NET | Price Leadership

Q-1: A cartel aims at maximising

(1) individual profits (2) industry profits
(3) share of output of members (4) goodwill of the members

Q-2: Which among the following is/are true for a Cartel ?

I. It aims at maximising of individual firm’s profit.
II. It decides the total output in the industry to which Cartel represents .
III. It does not fix the price at which members sell their output.
Answer from the code below :
(1) All are true. (2) I and II are true.
(3) Only II is true. (4) Only I and III are true.
 NTA-UGC-NET | Price Leadership
Q-3: Match the items in List – I with items in List – II :
List – I List – II
(a) Technical Monopoly (1) Gold and Silver
(b) Global Market (2) Cartel
(c) Legal Monopoly (3) Coca Cola
(d) Oligopoly (4) Patent Rights
Codes :
(a) (b) (c) (d)
(A ) (3) (1) (4) (2)
(B) (3) (2) (1) (4)
(C) (4) (3) (1) (2)
(D) (4) (1) (2) (3)

Q-4: Barometric price leadership implies leadership of:

a) low cost firm
b) high cost firm
c) most experienced firm
d) least experience
 NTA-UGC-NET | Price Leadership
Q-5: Which of the following factors does not stall the entry of other firms in an Oligopolistic industry:
a) huge advertising expenditure incurred by existing firms
b) economies of scale
c) technology
d) increased in demand

Q-6) In Stackelberg model of duopoly, if both sellers act as followers, we then have:
a) Cornout solution
b) A price war between sellers
c) A situation of disequilibrium
d) Collusion between sellers
Lecture-19: Factor Pricing
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Theory of Factor Pricing
Determination of Factor Demand and Equilibrium Factor Employment with One
Variable Factor- Perfect Competition
Supply Curve of the Variable Factor
 Theory of Factor Pricing: PC & Single Variable
Determination of Factor Demand and Equilibrium Factor Employment with
One Variable Factor- Perfect Competition
Supply Curve of the Variable Factor
Assumptions. A good ‘X’ is assumed to be produced and sold in a perfectly
competitive market. The firm is a profit maximiser combining (for simplicity
purposes only two factors of production) labour (L) and capital (K) to produce its
output. Further capital is assumed to be constant in the short run. Hence its
production function is given by, X = F (L,K bar) The firm, hence, uses the single
variable factor of production, L, which is also assumed to be sold in a perfectly
competitive market with several buyers and sellers. The supply curve of this variable
factor of production SL is perfectly elastic at the ongoing price w.

Since the firm is a price taker, it will sell all its output of good X at a fixed price PX.
Thus the firm’s revenue function is given by TR = PxX = Px f (L, Kbar)--------------
(1)
Workings
 Theory of Factor Pricing: PC & Single Variable
Determination of Factor Demand and Equilibrium Factor Employment with
One Variable Factor- Perfect Competition
Supply Curve of the Variable Factor
The total cost function of the firm is equal to the sum of the total variable and total
fixed costs, i.e., TC = wL + TC (2)
The firm being a profit maximiser would want to maximize profits

= TR − TC = Pxf (L, K ) − (wL + TFC) − − − −3

d dX
= Px − w = 0 − − − − − − − − − − − − − −4
dL dL
The first term is slope of production function or MPL. So, the equilibrium
condition is
dX
Px = w or VMPL = w − − − − − − − − − − − − − −5
dL
 Theory of Factor Pricing: PC & Single Variable
Demand curve of Single Variable
Determination of Factor Demand and Equilibrium Factor Employment with One
Variable Factor-Perfect Competition

VMPL is the value of marginal product of labour or simply put it is the value of the
additional unit of output produced by hiring an additional unit of labour. This curve is
the demand curve for labour and slopes downwards due to the assumption of
diminishing returns to the variable factor, labour in this case.

Thus according to equation (5) the profit maximizing competitive firm would continue
to hire labour as long as the value of output produced by it is more than the addition to
the cost of hiring it i.e. the wage rate.

If VMPL > w --> firm should hire more labour

If VMPL < w --> firm should fire labour
Theory of Factor Pricing: PC & Several Variables
Determination of Factor Demand and Equilibrium Factor Employment with
Several Variable Factors-Perfect Competition

With several variable factors of production, the VMP curve no longer is the demand
curve for the factor. This is because when several variable factors are being used
simultaneously, the change in the price of one factor would lead to a change in the
employment of not only the said factor but of the other variable factors as well. This in
turn would shift the marginal product of the factor in question whose price originally
changed.
Theory of Factor Pricing: PC & Several Variables
Determination of Factor Demand and Equilibrium Factor
Employment with Several Variable Factors-Perfect Competition
Theory of Factor Pricing: PC & Several Variables
Determination of Factor Demand and Equilibrium Factor
Employment with Several Variable Factors-Perfect
Competition

With the original price of labour, w1, L1 units of labour are hired. This
is determined from the point e1 where VMPL1 is equal to w1. With a
fall in the wage rate to w2 if the VMP of labour were to remain constant
at VMPL1 the employment of labour would increase to L12 given by
the equilibrium point e12. However the fall in the wage rate leads to a
change in the employment of all the variable factors. For instance with
labour becoming cheaper it makes sense for the profit maximizing firm
to hire and club more capital in the form of machinery with cheaper
labour. This in turn increases the marginal product of labour and shifts
the VMPcurve of labour. In the given figure the VMPL curve shifts
from VMPL1 to VMPL2 and the labour employed increases to L2
which is greater than L12. Similarly a further fall in the wage rate
would shift the VMP curve of labour to VMPL3 and the labour
employment would further increase to L3. Thus the demand curve of a
variable factor when several factors are variable is not it’s VMP but
infact is the locus of points of the shifting VMP curves obtained due to
the change in its marginal product. In the figure this is the curve marked
DL
Theory of Factor Pricing: Monopoly & Single Variables
Determination of Factor Demand and Equilibrium Factor Employment with
Single Variable Factors (Monopoly)
A firm being the sole seller of some product is a monopoly in the output market. But
it may or may not necessarily be a monopoly in the input market. In case it competes
with several other firms in hiring the input then it is a competitor in the factor market
despite being a monopolist in the output market. The monopolist bases his decision
about hiring the input depending on whether hiring of an additional unit of the factor
as long as it adds more to its revenue than its costs. In the case of a perfectly
competitive firm, its demand curve was based on its value of marginal product or
VMP. The VMP is the value of the additional output produced by hiring another unit
of the factor input. The monopolist unlike aperfectly competitive firm faces a
downward sloping demand curve in its output market. More units of the output can be
sold by lowering the price. Thus another unit of the output sold does not increase the
revenue by the price which in any case is no longer uniform under monopoly. The
addition to revenue of selling another unit of output is the marginal revenue or MR.
Hence, for a monopolist the addition to the revenue of hiring another unit of the
factor input is the marginal revenue product or MRP of the factor input. The MRP
measures the contribution of hiring an additional unit of the factor input to the
revenue of the firm. The MRP of the factor input is the product of the marginal
product and the marginal revenue. Thus for monopolist the MRP of the factor input is
its demand curve for that input.
Theory of Factor Pricing: Monopoly & Single Variables
Determination of Factor Demand and Equilibrium Factor Employment with
Single Variable Factors (Monopoly)
Derivation
Assume that a firm that is a monopolist in the output market uses a single variable
factor of production-labour, which is sold in a competitive market. Thus the demand
curve for the product X of the firm would be downward sloping and
Px = f (X) --------(6) with f’ < 0.
Total Revenue of the firm is TR = PxX ---- (7)
And MR = Px + XdPx/dX------ (8) dTR 
MRPl = =  Px + X dPx  dX − − − (9)
dl dX dL
 
As labour is the only variable factor in SR, so production function is
dX
( )
X = f L, K & MPl =
dL
Equating (9), MRPl = MRx.MPl
In the above figure the VMPL is the demand curve of the factor input-labour under a
perfectly competitive market structure. The MRPL is the demand curve of the factor
input-labour under a monopoly. The MRPL curve lies below the VMPL curve because
the marginal revenue for the monopolist is always below the price at each level of
output. Thus the MRPL curve slopes downwards because the marginal product of
labour declines with greater employment of labour
Workings
Theory of Factor Pricing: PC & Monopoly
Theory of Factor Pricing: Monopoly & Several Variables

Determination of Factor Demand and Equilibrium Factor Employment with

Single Variable Factors (Monopoly)

Profit Maximisation Condition

 =TR − TC = PxX − (wL + TFC)
d 
=  PxX + X dPx  dX − w = 0
dL dX dL
 
MRPl = w − − − − −(10)
In the figure, the supply curve of labour is the horizontal line SL as labour is assumed
to be traded in a perfectly competitive market. The demand curve for labour of the
monopolist is the MRPL and the monopolist would hire LM units of labour at the
ongoing wage rate of w. For wage rates higher than w the monopolist would cut down
on labour since the addition to the costs of labour would be greater than the MRPL.
Similarly for wage rates lower than w the monopolist would hire more labour as the
additional costs of labour would be smaller than the MRPL.
Theory of Factor Pricing: Monopoly & Several Variables
Determination of Factor Demand and Equilibrium Factor Employment with
Several Variable Factors (Monopoly)

Just as in the case of perfect competition with several variable factors of production,
the VMP curve is no longer the demand curve for the factor, under monopoly too with
several variable inputs; the MRP curve is no longer the demand curve for the factor.
The reasoning and analysis is similar to the one under perfect competition. The
demand curve of a variable factor under monopoly when several factors are variable is
the locus of points of the shifting MRP curves obtained due to the change in its
marginal product.
Monopolistic & Single Variable
Determination of Factor Demand and Equilibrium Factor
Employment with Single Variable Factors (Monopolistic)

When firms have monopoly power the factor input is paid a price
that equals its MRP which is smaller than its VMP. More precisely
at equilibrium for the monopolistic firm,

MRPL = MRx MPL = w

The equilibrium condition for the perfectly competitive firm is
VMPL = PxMPL = w

Under Perfect competition, Px = MRx and so

MRPL = VMPL = w

Thus, under perfect competition profit maximizing behavior implies

that factors are paid a price equal to the value of the marginal
product but under monopoly factors are paid a price equal to its
marginal revenue product.

But since MRx < Px for the monopolist this implies that MRPL <
VMPL which leads to monopolistic exploitation demonstrated in the
following figure.
Monopolistic & Single Variable
Determination of Factor Demand and Equilibrium Factor
Employment with Single Variable Factors (Monopolistic)

In the above figure given the perfectly elastic supply curve of labour
SLat the wage rate w the perfectly competitive firm would hire LPC
units of labour where w = VMPL. The monopolistic firm would
however LM units of labour where w = MRPL. Hence the
employment of labour is lower under monopoly. Further at LM the
VMPL is equal to w1> w= MRPL. This reflects monopolistic
exploitation equal to eeM or ww1 as the price paid to the factor input
under monopoly is smaller than the value of the marginal product.
This monopolistic exploitation is a loss to the society as the value to
consumers of the additional output produced by hiring another
labour unit is greater than the wage rate being paid to it by the
monopolist.
 Monopsonist & Single Variable
Determination of Factor Demand and Equilibrium Factor Employment with Single Variable Factors
(Monopsonist)

A market in which there is a single buyer of the factor input is referred to as a monopsony. Monopsony may exist due to
the highly specialized nature of the factor input or due to factors like geographical immobility of the factor input. A
monopsony implies that the given firm is the only purchaser of the factor input. Being the only purchaser of the factor
input the monopsonist faces the market supply curve of the input which is upward sloping. The monopsonist enjoys market
power in the factor market just like a monopolist enjoys market power in the goods market. The upward sloping supply
curve of the factor input implies that the monopsonist would have to increase the factor price to hire more units of the
given factor. Clearly in this case the marginal cost of hiring another unit of the factor would not be equal to the factor
price but the addition to the total cost of hiring all units of the factor at the new price.
For instance consider a firm that is the sole recruiter of a specialized kind of labour. Further assume that the firm hires
fifteen units of labour at a wage rate of Rs. 1000. If the firm now wants to hire another worker it would have to increase
the wage rate to Rs. 1200. Thus the cost of hiring the sixteenth worker would not simply be Rs. 1200 but would in fact be
4200 (i.e. 16*1200-15*1000).
Monopsonist & Single Variable
Determination of Factor Demand and Equilibrium Factor Employment
with Single Variable Factors (Monopsonist)

Thus there is a difference between the average expenditure (the same factor
price being paid to all units of the factor) incurred by the monopsonist and
its marginal expenditure (the increase in the expenses due to higher cost of
hiring another unit of the factor). The latter curve is steeper compared to the
former. In the present case, we assume, that the firm is the single buyer of
labour its only variable factor and uses this labour to produce a good ‘X’
sold in a monopoly market. Since the firm is assumed to enjoy monopoly
power in the output market; hence, the demand curve for labour is the
MRPL. The supply curve of labour however is not perfectly elastic but is
upward sloping since the monopsonist would have to pay higher wages to
hire more workers.

The supply curve of labour, SL, is also the average expenditure (AE)
curve of the monopsonist since it pays the same uniform wage to each unit
of labour. The monopsonist however bases his decision to hire labour on
the marginal expenditure (ME) curve. As shown in the figure the ME
curve lies above the SL or the AE curve. This is because when the wage is
increased to hire more units of labour, all units of labour receive the higher
wages.
Monopsonist & Single Variable
Determination of Factor Demand and Equilibrium Factor Employment
with Single Variable Factors (Monopsonist)

The monopsonist is a profit maximiser and thus would hire labour so as to

maximize his profits.
The total revenue, TR, as is the previous case, is equal to PxX.
The total cost, TC, is equal to w(L)L + TFC

Earlier since the wage rate was constant the total cost of labour was wL.
However with the firm being a monopsonist in the labour market, it can
hire more workers only by increasing the wage rate of all workers. Thus the
total expense (TE) on labour is equal to w(L)L.

The firm’s profit function now is equal to:

Profit Maximisation Condition Hence for monopsony the
=TR − TC = PxX − (w ( L ) L + TFC) equilibrium condition is:
d   dw(L)  MRPL = MEL
=  PxX + X dPx  dX −  w(L) + =0
dL dX dL dL 
   
 dw(L) 
MRPl = w(L) + = MEL
 dL 
 
Bilateral Monopolists
 Bilateral Monopolists

The difference EH between marginal revenue product NE

and the wage rate NH is due to the existence of
monopsony in the labour market and has, therefore, been
called by Joan Robinson as monopsonistic exploitation.
But the difference FE between the value of the marginal
product (VMP) which is equal to NF and the marginal
revenue product (MRP) which is equal to NE is due to
existence of monopoly in the product market.
The worker get FE amount less than his value of the
marginal product because of the fact of monopoly in the
product market and has, therefore, been designated as ‘
monopolistic exploitation” by Joan Robinson. Under
monopsony-monopoly market situation, the worker is
subjected to double exploitation; because of monopoly he
gets less than value of its marginal product and because of
monopsony he gets less than his marginal revenue
product.
 Questions
Questions
1. For an equilibrium in the labour market which of the following condition is
necessary
A. MPL = per capita output
B. MPL= Output
C. MPL= Wage
D. MPL= wage per worker
 Questions
Questions
1. For an equilibrium in the labour market which of the following condition is
necessary
A. MPL = per capita output
B. MPL= Output
C. MPL= Wage
D. MPL= wage per worker

Solution
Any event that changes the supply or demand for labor must change the equilibrium
wage and the value of the marginal product by the same amount because these must
always be equal. Therefore, MPL should be equal to Real wage.
 Questions
Questions
Question-2: If a rise in the marginal product of labour leads to a shift in demand
outward then
A. Wages rise
B. Wages fall
C. Wages remain unaffected
D. Wages may rise or fall
 Questions
Questions
Question-2: If a rise in the marginal product of labour leads to a shift in demand
outward then
A. Wages rise
B. Wages fall
C. Wages remain unaffected
D. Wages may rise or fall

Solution: The marginal product of labor (MPL) is the change in output that results
from employing an added unit of labor. As the MPL increases say because of an
improvement in technology then the demand curve shifts outward. More labour will be
hired and their wages also increase.
 Questions

Q-3: The difference between the value of marginal product and the marginal revenue
product arises only if:
A. Average revenue is not equal to marginal revenue.
B. Average cost is not equal to marginal cost.
C. Total revenue is not equal to total cost.
D. Average cost is not equal to average revenue.

Q-4: If the producer pays the price for each of the inputs that is used is equal to its
value of Marginal product, then which one of the following does he earn ?
(1) Zero supernormal profit
(2) Monopoly profit
(3) Positive supernormal profit
(4) Negative supernormal profit
 Questions

Q-5: The firms are competitive and profit maximizing the demand curve for labour is determined by:
(A) The opportunity cost of workers’ time
(B) The value of marginal product of labour
(C) Offsetting income and substitution effect
(D) The value of marginal product of capital

Q-6: Which one of the following curves will respond the supply curve of labour ?
(A) Marginal product curve of labour
(B) Marginal revenue product curve of labour
(C) Value of marginal product curve of labour
(D) Average product curve of labour
 Questions

Q-7: In imperfect factor and product markets, labour exploitation is represented by:
1. When ARP > Average wage
2. When ARP > MArginal wage
3. When ARP < MRP
4. When ARP < Marginal wage
Codes:
A) 4 and 3
B) 1 and 4
C) 1 and 3
D) 1 and 2
Lecture-20: Theories of Rent &
Profit
Unit-1: Microeconomics
NTA-UGC-NET
1
Economics (Paper-2)

2
 Three Versions of Theory of Rent
Ricardian Theory Modern Theory [J.S.Mill]
• Further developed by Jevons, Pareto,
• Rent appears due to limited supply of land – Marshall, Joan Robinson.
known as Scarcity Rent • Rent = Actual Earning-Transfer Earning
• Rent appears due to difference in fertility and • When we transfer one factor from one
hence difference in productive capacity of land – use to another, we have to sacrifice the
known as Differential Rent income earned by it from its earlier use.
• Scarcity Rent exists only in LR, when the land • Sacrifice of earning is called transfer earning.
is scarce. • Concept of Transfer Earning was given by
• Rent is not a part of cost of production Prof. Benham
Marshallian Theory
• Marshall introduced and developed a new concept of rent what is known as quasi-
rent to show element of rent in the incomes of man-made appliances and capital
goods.
• Marshall defines quasi-rent (or near-rent) as “the short-run earnings of machines (or
3
 appliances of production made by men) minus the short-run cost of keeping it in
running order.”
• Thus quasi- rent is the surplus of short-run cost of maintaining them.
• It is 0 in LR

4
 RICARDIAN THEORY OF RENT

He defined rent as “that portion of the produce of the earth which is paid to the landlord
for the use of the original and indestructible powers of the soil.” In his theory, rent is
nothing but the producer’s surplus or differential gain and it is found in land only.

Ricardo points out that rent can appear because of two reasons:
i) Rent appears due to limited supply of land – known as Scarcity Rent

ii) Rent appears due to difference in fertility and hence difference in productive capacity of land
– known as Differential Rent

5
 RICARDIAN THEORY OF RENT

ASSUMPTIONS
1. Rent is the return of original and indestructible powers of soil.
2. Supply of land is fixed from the stand point of society.
3. Law of diminishing product operates on the productivity of land.
4. Since land is a gift of nature production cost of land is zero.
5. Land has no alternative use.
6. There exists perfect competition in the market of land.
7. There exists perfect competition in the product market.
6
8. Rent is not a part of cost of prodn and so does not determine the
price of corn. Rather price of corn determines rent.

7
 RICARDIAN THEORY OF RENT- SCARCITY RENT

Ricardian theory, rent emerges as surplus over cost of production (labour and capital cost).

The Ricardian concept of scarcity rent is based on following assumptions:

(1) There is an island with finite size of land. All plots of the land are homogenous in quality.
(2) It is assumed that only one crop will be cultivated in all the plots.
(3) All plots are assumed to be owned by large number of absentee landlords. That is, no
landlord will farm the land himself.
(4) There is perfect competition among the landlords.
(5) Assume that the world market for the crop is also perfectly competitive. The supply
decision from our imaginary island has least impact on the market price of the crop. Therefore each and
every farmer is a price taker.

8
Since, land market is perfectly competitive, no rent will arise until all plots of the land are used. The price of
corn will be equal to the minimum average cost. In the below figure, we show the scarcity rent measuring
output along the horizontal axis and price of corn along the vertical axis.

9
RICARDIAN THEORY OF RENT- SCARCITY RENT

10
 RICARDIAN THEORY OF RENT- SCARCITY RENT
Suppose that a farmer is initially in equilibrium at point L and corresponding
level of output is OM0. At point L the price level equals to OP0 minimum long
run average cost of production. Now suppose demand for corn increases due to
growth of population. The price of corn will rise temporarily and it will exceed
minimum average cost. There will be super normal profit which will attract more
new farmers for cultivation. This will lead to increase in production and fall in
price. This will be continued until all the plots of land are exhausted. After the
cultivation of all plots of the land if population continues to grow, the demand
for corn will increase further and there will be a permanent rise of price.
Suppose the new price level will be OP1 which is higher than minimum average
cost. This increment of price is permanent as there will be no idle land for
cultivation so that increase in production will reduce the price back to its original
level. At higher price level OP1 each farmer will increase output by equating
long run marginal cost to this price level. The new equilibrium point will be at

11
point H and at this point the farmer will produce OM1 level of output. When the
price is permanently settled at OP1, the vertical distance from point H to point E
on the LAC curve measures the rent per unit of land. That is, total HEFP1
amount of rent will be paid by the farmer. The rent is generated here, due to the
scarcity of homogenous land. This rent is, therefore, called scarcity rent.

12
 RICARDIAN THEORY OF RENT- DIFFERENTIAL RENT

Differential rent arises when quality of plot varies across the land. If one plot is relatively more fertile than the
other plot, the average cost of production will be lower in the first one. When price rises over the average
minimum cost of production in less fertile land, a surplus will be generated in the more fertile land and this
surplus is called differential rent.

13
14
RICARDIAN THEORY OF RENT- DIFFERENTIAL RENT

15
 RICARDIAN THEORY OF RENT- DIFFERENTIAL RENT

The important point to be noted about the classical (Ricardian) theory of rent is that rent
does not form a part of the cost of production. As seen above, rent on land is the earnings
over and above the cost of production. As rent does not enter into cost of production, it
therefore does not determine price.

Price of corn (or produce of the land) must be equal to the minimum average cost of
production of the marginal land, but the marginal land earns no rent. It is thus clear that in
Ricardian Theory, rent is not price determining. In fact, in this theory rent is price
determined, that is, it is price of corn which determines rent, and not other way around. To
quote Ricardo, “Corn is not high because a rent is paid, but a rent is paid because corn is
high.”

16
 Theory of Economic Rent

Theory of Economic Rent

• The economic rent is an amount of payment received by the supplier of a factor input in excess of the minimum
amount required to retain the factor in its present employment.

• The transfer earning or price is the payment or price which is necessary to keep a unit of factor in a certain use or
industry.

• Economic rent is the excess payment to an input over its transfer earning or opportunity cost.

Economic rent is a surplus income — excess of total payments to a factor of production (land, labour or capital) over
and above its minimum supply price or opportunity cost (i.e., what is required to bring the particular factor into
production). The opportunity cost is known as Transfer Earning.

Gross rent is the rent which is paid for the services of land and the capital invested on it.
Gross rent consists of:
(1) Economic rent: (payment made for the use of land)
(2) Interest on capital invested (for improvement of land)
17
(3) Reward for risk (taken by landlord in investing his capital)

18
 Economic Rent: When SS is Perfectly Inelastic
• The determination of economic rent in these three different situations are plotted in figure- (a)-(c).

• If the market supply of an input is fixed or perfectly inelastic, demand alone determines the input price and all of the
payment made to the input is rent.

• The supply curve parallel to vertical axis shows that the supply of factor input is perfectly inelastic and as a result of
this there is no opportunity cost or transfer earning. Thus the factor earns only economic rent O Y0EP0.

19
20
 Economic Rent: When SS is Moderately Elastic
• If the market supply of an input is positively sloped or moderately elastic, the area above the supply curve and below
the price of input shows the rent. The supply curve of factor input is moderately elastic.

• For each corresponding unit of input used the minimum earning(transfer earning) or reservation price required to
supply this factor is represented by the straight line drawn from the supply curve to the horizontal axis.

• For OY0 level of output the transfer earning will be the area OAFY0. However the market equilibrium price is OP0.
Therefore, the economic rent represented by the area AP0 F is obtained by deducting the transfer earning from the total
earning (i.e. OP0 FY0 - OAFY0).

21
 Economic Rent: When SS is Perfectly Elastic
• When the supply curve is perfectly elastic, there will be no rent, the entire income will be transfer earning and the
factor doesn’t earn economic rent as the entire area below the market equilibrium price and the area below the supply
curve is same. That is, the entire earning shown by the area OP0GY0 is transfer earning and there is no surplus earning
over transfer earning.

22
 Rent v/s Economic Rent
• It is > 0 in LR
Rent by Ricardo
• Rent of land, according to Ricardo and his
followers, is a differential gain or a
producer’s surplus.

• It arises on account of its absolutely fixed

supply even in the long run.

• It is the surplus above the cost and it

continues to exist even in the long run as
the supply of land, being a gift of nature, is
fixed for all the time to come.

• It is peculiar to land only.

23
 • The earnings of land are rent proper, but the short-
Quasi-Rent by Marshall
run net earnings of machines and of man-made
• Marshall introduced and developed a
appliances of production are quasi-rent.
new concept ofrent what is known as
quasi-rent to show element of rent in
• It is = 0 in LR
the incomes of man-made appliances
and capital goods.

• Marshall defines quasi-rent (or near-

rent) as “the short-run earnings of
machines (or appliances of
production made by men) minus the
short-run cost ofkeeping it in running
order.”

• Thus quasi- rent is the surplus of short-run

cost of
maintaining them.
24
 Quasi Rent: Introduced by Marshall
• Marshall introduced the concept of quasi-rent.

• It is the earning on capital equipment.

• It rises due to the inelastic supply of capital equipment in the short run.

• Unlike supply of land, the supply of capital equipment is not permanently fixed or perfectly inelastic; it varies in the
long run. That is, in the long run the supply of capital equipment becomes elastic.

• According to Marshall this type of earning is defined as quasi-rent rather than the concept of rent defined earlier
sections.

• It is a surplus earning enjoyed by the owner of capital in the short run due to an increase in demand for it and will be
completely wiped out when supply will increase in response to the increase in demand.

• Quasi-rent or Marshallian rent is a temporary economic rent like returns to a supplier/owner. Alfred Marshall was the
first to observe quasi-rents.
25
 Quasi Rent: Introduced by Marshall

• Quasi-rent differs from pure economic rent in that it is a temporary phenomenon. It can arise from the barriers to entry
that potential competitors face in the short run, such as the granting of patents or other legal protections for intellectual
property by governments.

• It can also arise due to entrepreneurial responses to market fluctuation, or due to a lack of real capital to meet near-term
increases in demand. In the longer term, however, the opportunity to profit will generate new capital and the quasi-rent
will be competed away.

• Quasi-rent refers to that additional income which is similar to rent. According to David Ricardo, rent arises on account
of fixed supply of land. But he recognizes other factors which are found in fixed supply in the short term. The
additional income earned by these factors in the short-period is similar to rent

26
 Quasi Rent: Introduced by Marshall
• The quasi-rent can also be defined as revenue generated in the short run less the short run variable cost.

• For instance, assume that a firm hires a machine on contract, and pays a constant amount per period.

• This kind of payment is fixed and not considered as a variable cost for the firm.

• If the entrepreneur has only one fixed factor, his total revenue net of the total variable cost is a quasi-rent
earned by the machine.

• This quasi-rent may be higher than, equal to or lower than the fixed rental of the machine.

27
 Quasi Rent: In Short Run
• Suppose at price OP0, the average revenue or demand
for product intersects the marginal cost at F and
corresponding output is OY0. We draw a vertical line
from F to Y0.

• The line FY0 cuts the AVC curve at point G. The area
of the rectangle FGHP0 measures the difference
between total revenue and total variable cost or quasi-
rent in the short run.

• The surplus earning defined by the area FGHP0 is

greater than the total fixed cost.

• This implies that in this case quasi-rent of the machine

is greater than fixed cost or fixed rental of the machine.
28
 Quasi Rent: In Long Run
• In the long run when a large number of new firms enter, the supply
of machines will increase and there will be an expansion of output.
This will lead to fall in price of product. Price falls from OP0 to
OP1.

• At price OP1, the average revenue curve is tangent with curve

shown by point E. That indicates that at price OP1 the fixed rental
cost of capital equals to the quasi-rent. This is shown by the area of
rectangle EIJP1.

29
 Quasi Rent: In Long Run
• Suppose that the demand further declines and price falls to OP2 at
which price equals to minimum of AVC .

• At price OP2 level, average revenue earned from the capital

equipment equals to the minimum of average variable cost shown by
the point K and the quasi-rent is completely eroded away.

• In this case quasi-rent is zero, but the rental cost of capital still exists
and as before equals to total fixed cost.

• If the price falls further (suppose price falls below the shut-down
point), firm will stop production. Therefore, quasi-rent cannot be
negative.

30
 Theories of Profits

1. Walker’s Theory of Profit: Profit as Rent of Ability

2. Clark’s Theory of Profit: Profit as Reward for Dynamic Entrepreneurship
3. Hawley’s Risk Theory of Profit: Profit as Reward for Risk- Bearing
4. Knight’s Theory of Profit: Profit as a Return to Uncertainty Bearing
5. Schumpeter’s Innovation Theory of Profit: Profit as Reward for Innovations
6. Modern Theory or Perfect Competition or Demand & Supply Theory of Profit
7. Monopoly Power Theory of Profit

31
 Theories of Profits

What is Profit?

• The meaning and source of ‘profit’ have always been a controversy.

• “The word ‘profit’ has different meanings to businessmen, accountants, tax collectors,
workers and economists...” For example, ‘profit to a layman means all incomes that go to the
capitalist class’.
• To an accountant, profit means the excess of revenue over all paid-out costs including both
manufacturing and overhead expenses. For all accounting purposes, businessmen also use
accountants’ definition of profit

32
 Theories of Profits

Concept of Pure Profit

• Economists’ concept of profit is of ‘pure profit’.

•
• It is also called ‘economic profit’ or ‘just profit’.

• ‘Pure profit’ is a return over and above opportunity cost i.e., the payment that would be
“necessary to draw forth the factors of production from their most remunerative alternative
employment.

• Pure profit may thus be defined as “a residual left over after all contractual costs have been
met, including the transfer costs of management, insurable risks, depreciation, and payments
to shareholders sufficient to maintain investment at its current level
33
 Theories of Profits

Concept of Net Profit

• Pure profit equals Net profit less opportunity costs of management, insurable risk,
depreciation of capital, necessary minimum payments to shareholders than can prevent them
from withdrawing their capital from its current use.

• Thus, the pure profit, so defined, may not be necessarily positive for a single firm in a
single year; rather there may be negative profit (i.e., loss)

34
 Risk Theory of Profit

• This theory is associated with American economist Hawley. According to him profit is the reward for risk-
taking in business. Risk-taking is supposed to be the most important function of an entrepreneur. Every
production that is undertaken in anticipation of demand involves risk. According to Drucker there are four
kinds of risk. They are replacement, obsolescence, risk proper and uncertainty.

• The first two are calculated and therefore they are insured. But the other two are unknown and unforeseen
risks. It is for bearing such risk profit is paid to entrepreneur. No entrepreneur will be willing to undertake
risks if he gets only the normal return.

• Therefore the reward for risk-taking must be higher than the actual value of the risk. If the entrepreneur does
not receive the reward, he will not be prepared to undertake the risk. Thus higher the risk greater is the
possibility of profit. F.B. Hawley, who believed that those who have the risk taking ability in the dynamic
production have a sound claim on the reward, called as profit. Simply, profit is the price that society pays to
assume the business risk

35
• According to Hawley the entrepreneur can avoid certain risks for a fixed payment to the insurance company.
But he cannot get rid of all risks by means of insurance. If he does so he is not an entrepreneur and would
earn only wages of management and not profit.

36
 Risk Theory of Profit

• Hawley’s risk theory of profit is based on the notion that the businessman would expect adequate
compensation in excess of the actuarial value, i.e., premium on calculable risk, for assuming the risk.
Every entrepreneur strives to gain in excess of wages of the management for bearing the business risk.

• The major reason behind the Hawley’s opinion that profit should be maintained over and above
the actuarial risk is that the assumption of risk is annoying; it leads to trouble, anxiety, and
disutility among the businessman of several kinds.

• Thus, assuming risk grants entrepreneur a claim to a reward above the actuarial business risk.

• According to Hawley, the profit consists of two parts: One representing the compensation for
the actuarial loss suffered due to several classes of risks assumed by the entrepreneur; Second
part represents the inducement to bear the consequences due to the exposure to risk in the
entrepreneurial adventures.
37
 Risk Theory of Profit

• Hawley’s risk theory of profit is based on the assumption that profits arise from the factor ownership, as
long as the ownership involves risk.

• Hawley believed that an entrepreneur must assume risks to qualify for the additional rewards (profit).

• On the contrary, if he avoids the risk by insuring against it, then he would cease to be an entrepreneur and
would not be entitled to profits. Thus, it can be concluded that it is the uninsured risk from which the
profit arises and until the product is sold an entrepreneur’s amount of reward cannot be determined.

• It is definite that no entrepreneur will like to undertake risks if he gets only the normal return.
Therefore, the reward for risk-taking must be higher than the actual value of the risk.

• Thus, it can be concluded that it is the uninsured risk from which the profit arises and until the
product is sold an entrepreneur’s amount of reward cannot be determined. Hence, in Hawley’s
38
opinion, the profit is a residue and therefore his theory is also called a Residual Theory of
Profit.

39
 Uncertainty Bearing Theory of Profit

• This theory was propounded by an American economist Prof. Frank H. Knight. This theory, starts on the
foundation of Hawley’s risk bearing theory. Knight agrees with Hawley that profit is a reward for risk-taking.
There are two types of risks viz. foreseeable risk and unforeseeable risk. According to Knight unforeseeable
risk is called uncertainty beaming.

• Knight, regards profit as the reward for bearing non-insurable risks and uncertainties. He distinguishes
between insurable and non-insurable risks. Certain risks are measurable, the probability of their occurrence
can be statistically calculated. The risks of fire, theft, flood and death by accident are insurable. These risks are
borne by the insurance company.

• The premium paid for insurance is included in the cost of production. According to Knight these foreseen risks
are not genuine economic risks eligible for any remuneration of profit. In other words insurable risk does not
give rise to profit.

40
 Uncertainty Bearing Theory of Profit
• According to Knight profit is due to non-insurable risk or unforeseeable risk.
• Non- insurable risks
• (a) Competitive risk: Some new firms enter into the market unexpectedly. The existing firms may have to
face serious competition from them. This will inevitably lower down the profit of the firms.

• (b) Technical risk: This risk arises from the possibility of machinery becoming obsolete due to the discovery
of new processes. The existing firm may not be in a position to adopt these changes into its organization, and
hence suffer losses.

• (c) Risk of government intervention: The government, in course of time, interferes into the affairs of the
industry such as price control, tax policy, import and export restrictions, etc., which might reduce the profits of
the firm.

• (d) Cyclical risk: This risk emerges from business cycles. Due to business recession or depression,
consumer’s purchasing power is reduced, consequently demand for the product of the firm also falls.
41
• (e) Risk of demand: This is generated by a shift or change of demand in the market.

42
 Uncertainty Bearing Theory of Profit

• Prof. Knight calls these risks as ‘uncertainties’ and ‘it is uncertainties in this sense which explains profit in
the proper use of the term’. These risks cannot be foreseen and measured, they become non- insurable and the
uncertainties have to be borne by the entrepreneur. According to this theory there is a direct relationship
between profit and uncertainty bearing.

• Greater the uncertainty bearing the higher the level of profit. Uncertainty beaming has become so important
in business enterprise in modern days, it has come to be considered as a separate factor of production. Like
other factors it has a supply price and entrepreneurs undertake uncertainty bearing in the expectation of
earning certain level of profit. Profit is thus the reward for assuming uncertainty.

• In the modern days production has to take place In advance of consumption. The producers have to face their
rival producers and the future is uncertain and unknown. These are uncertainties. Some entrepreneurs are able
to see it more clearly than others and therefore able to earn profit.

43
 Rent Theory of Profits
[Propounded by Walker, based upon ideas of Senior and Mill]
• Mill said that the extra gains which any producer obtains through superior talents for business or superior
business arrangements are very much of a kind similar to rent.
• Walker said Profits are of the same genus as rent”. He said that profit is the rent which is earned by the
superior entrepreneur over their counterparts who are of less efficient.

• Walker’s Theory of Profit, also called as a Rent Theory of profit was propounded by F.A. Walker, who
believed that profit is regarded as a rent of differential ability that an entrepreneur may possess over the
others.

• Walker has said that Profit is the rent of ability. He has made a comparative study between different grades of
land and entrepreneur’s different abilities. Entrepreneurs of superior ability earn Profits just as superior land
earns rent.

44
 Rent Theory of Profits
[Propounded by Walker, based upon ideas of Senior and Mill]
• So, there exists a similarity between rent and profit. Rent- a reward for the use of land while Profit - reward
for entreprener skills.

• As different land pieces are different in fertility, similarly, entrepreneurs differ in skills.

• Like rent of a land is determined as MP of superior land – MP of infertile land; similarly Profits are
determined by MP of superior entrepreneurs – MP of marginal entrepreneurs.

• So, the fertile land has excess rent similarly superior entrepreneur earns excess profit and marginal
entrepreneur earns 0 profits. They sell their products at cost price and earns 0 profits. He is as good as a wage
earner.

• Like rent, profit also does not enter into price. Profit is thus a surplus.

45
 Rent Theory of Profits
[Propounded by Walker, based upon ideas of Senior and Mill]

• The walker’s theory of profit is based on the assumption that a state of perfect competition prevails,
wherein all the firms are presumed to attain the same managerial ability.

• Each firm would draw wages for management ability, which in the Walker’s view do not form a part of the
pure profit. The wages of management are regarded as ordinary wages.

• Thus, under the perfect completion scenario, there will be no pure profit and each firm will earn the
management wages, known as normal profit.

46
 Schumpeter’s Innovation Theory of Profits

• This theory was propounded by Schumpeter. This theory is similar to that of Clark’s theory, where he has
mentioned about five changes (Changes in the size of the population, Changes in the supply of capital,
Changes in production techniques, Changes in the forms of industrial organisation, and Changes in human
wants.),

• Schumpeter explains the change caused by innovations in the production process. According to this theory
profit is the reward for innovations. He used the term innovation in a sense wider than Clark.

• Innovation refers to all those changes, in the production process with an objective of reducing the cost of
commodity so as to create gap between the existing price of the commodity and its new cost. Innovation may
take any shape like introduction of a new technique or a new plant, a change in the internal structure or
organizational set up of the firm or change in the quality of raw material, a new form of energy, better method
of salesmanship, etc.

47
 Schumpeter’s Innovation Theory of Profits

• Schumpeter makes a distinction between invention and innovation.

• Innovation is brought about mainly for reducing the cost of production and it is cost reducing agent. Profit is
the reward for this strategic role. Any new measure or policy adopted by an entrepreneur to reduce his cost
of production or to increase the demand for his product is an innovation.

• Innovations are not possible by all entrepreneurs. Only exceptional entrepreneurs can innovate as they are
capable of tapping new resources, technical knowledge and reduce the cost of production. Thus the main
motive for introducing innovation is the desire to earn profit. Profit is therefore the cause of innovation.

48
 Schumpeter’s Innovation Theory of Profits

• Thus innovations can be divided into two categories.

• First types of innovations are those which reduce cost of production. In this first type of innovations are
included the introduction of a new machinery, new and cheaper technique or process of production,
exploitation of a new source of raw materials, a new and better method of orgainising the firm, etc.

• Second types of innovations are those which increase the demand for the product. In this category are included
the introduction of a new product, a new variety or design of the product, a new and superior method of
advertisement, discovery of new markets etc. If an innovation proves successful, that is, if it achieves its aim
of either reducing the cost of production or increasing the demand for a product, it will give rise to profits.

• Profits emerge because due to successful innovations either cost falls below the prevailing price of the product
or the entrepreneur is able to sell more and at a better price than before.

49
 Schumpeter’s Innovation Theory of Profits

• Innovation is of two types:

• (i) Product innovations, and (ii) Market innovations.

• Product innovations affect the cost and quality of the product while market innovations include discovery and
exploitation of new market, introducing new variety of products and product improvement, modes of
advertising and sales propaganda etc.

• It has been said that any form of innovation leads to a Profit. It is called as innovational profit. This Profit is
uncertain and unpredictable. It is temporary in nature.

50
 Schumpeter’s Innovation Theory of Profits

• Profits are of temporary nature. The pioneer who innovates earns abnormal profit for a short period. Soon
other entrepreneurs, “swarm in clusters”, compete for profit in the same manner. The pioneer will make
another innovation. In a dynamic world innovation in one field may induce other innovations in related
fields.
• The emergence of motor car industry may in turn stimulate new investments in the construction of highways,
rubber, tyresm and petroleum products. Profits are thus causes and effects of innovation. The interest of
profit leads entrepreneur to innovate and innovation leads to profit. Thus profit has a tendency to appear,
disappear and reappear.
• Profits are caused by innovation and disappear by imitation. Innovational profit is thus, never permanent, in
the opinion of Schumpeter. Therefore it is different from other incomes, such as rent, wages and interest.
These are regular and permanent incomes arising under all circumstances. Profit on the other hand is a
temporary surplus resulting from innovation.
• Prof. Schumpeter also explained his views on the functions of the entrepreneur. The entrepreneur organizes
51
the business and combines the various factors of production. But this is not his real function and this will not
yield him profit. The real function of the entrepreneur is to introduce innovations in business. It is
innovations which yield him profit.

52
 Dynamic Theory of Profits
[Profit = Price – Cost of Production]
• Propounded by J.B. Clark in 1900. He said that profit is the result of progressive change in an organized
society.

• This progressive change can happen only in a dynamic state.

• He divided the whole economy into organized and unorganized sector.

• Organised sector is divided into – static and dynamic state.

• Further, Prof. Clark was of this opinion that in a stationary state having static economic conditions of demand
and supply, there can be no real or pure profit as a surplus.

53
 Dynamic Theory of Profits
[Profit = Price – Cost of Production]

• Organised sector is divided into – static and dynamic state.

Static Dynamic
• 1) Changes in the size of the population, Stagnant
• 2) Changes in the supply of capital, No Change
• 3) Changes in production techniques, No time element
• 4) Changes in the forms of industrial organisation, and No uncertainty
• 5) Changes in human wants. Price = COP [0EP]
So no profit, as no risk

• The entrepreneur would get wages for his labour and interest on his capital. If the price of the commodity is
higher than the cost of production, competition would reduce the price again to the level of the cost of
production so that profit is eliminated.
54
 Dynamic Theory of Profits
[Profit = Price – Cost of Production]
• These dynamic changes affect the demand and supply of commodities which leads to emergence of profit.

• When at sometime, any single firm introduces new product or production technique then it reduces the cost
of production and thereby, it increases in profit. Such type is possible only in case of invention.

55
 Monopoly Theory of Profit

• Definition: Another source of a pure profit (over and above the normal profit) is said to be a Monopoly,
characterized by a single seller without any close substitute.

• Monopoly Theory of Profit posit that the firms enjoying the monopoly power restricts the output and charge
higher prices for its products and services, than under perfect completion.

• So far, all the theories of profit have been propounded on the premise of perfect competition.

• But theoretically, the perfect market condition is perceived as a non-existent or very rare phenomena.

• Thus, an extreme to the perfect competition is the monopoly market structure wherein the firms under monopoly
can decide on the level of output and can charge a higher price for its products.

• Firms with monopoly power restrict output and charge higher prices than under perfect competition. This causes
above-normal profits to be earned by the monopolistic firms.
56
• Joan Robinson, E.H. Chamberlin, M. Kalecki associated super-normal profits with monopoly power enjoyed by
some firms. Because of strong barriers to the entry of new firms, monopoly firms can continue to earn economic
profits even in the long run.

57
 Monopoly Theory of Profit
• According to the monopoly theory of profit, an entrepreneur can earn a pure profit (or monopoly profit) and
can sustain earning that profit a longer time period by using his monopoly powers, which are:
• a) Power to control the supply and price of products.
• b) Power to prevent the entry of a new competitor into the market by price cutting.
• c) In certain situations, a monopoly power to control or regulate certain input markets.

• Thus, a firm under monopoly can use any of these powers to earn a pure profit. Thus, monopoly serve as an
important source to make a pure profit.

• The Monopolies exists, especially in the government sectors such as production and supply of water,
electricity, energy, etc. or come under the existence by the government sanction and are under the control and
regulation of the government.

58
 Modern Theory of Profit
Modern Theory or Perfect Competition or Demand & Supply Theory of Profit

• Modern theory defines the entrepreneur as a business enterprise itself and ‘Profits’ as his
net income.
• It regards profits as the reward of an entrepreneur.

• Profits are determined by the demand for and supply of entrepreneur.

• The point at which the demand curve cuts the supply curve of an entrepreneur the profit
will be determined.

• It is the point of equilibrium where an entrepreneur earns normal profit. It is also called
opportunity cost of the entrepreneur.
59
 Modern Theory of Profit
Modern Theory or Perfect Competition or Demand & Supply Theory of Profit

• Profits are determined by the demand for and supply of entrepreneur.

• The demand for an entrepreneur depends on its marginal revenue productivity (MRP), which is = profit rate.
• MRP and demand for entrepreneur are shown on OY axis and OX asix.
• There is negative relationship between the demand for entrepreneur and the MRP as shown by MRP curve.

Demand For Entrepreneurs

depends upon:

• Level of industrial development,

• Level of uncertainty,
• Scale of production
• Marginal revenue productivity of entrepreneurship
60
[Most important]

61
 Modern Theory of Profit
Modern Theory or Perfect Competition or Demand & Supply Theory of Profit

Supply of Entrepreneurs
depends upon:

• Capital availability [Most important]

• Level of managerial and technical skills
• Number of entrepreneurs
• Level of Society
62
• The larger the availability of capital, the larger is
• the supply of entrepreneur’s capital.

63
 Modern Theory of Profit
Modern Theory or Perfect Competition or Demand & Supply Theory of Profit

64
 Modern Theory of Profit
Modern Theory or Perfect Competition or Demand & Supply Theory of Profit
• Under Imprefect Competition profit will be determined as:
• Profit and price are shown on OY-axis and demand and supply of
entrepreneur on OX-axis respectively. E is the point of equilibrium
where the DD intersects the SS curve.

• OQ is the demand for the supply of entrepreneur. OP is the profit.

The firm will earn supernormal profit during short run and long run
under imperfect competition because the goods are sold at more
than its average cost (AC) which means average revenue (AR or
Price) is greater than its average cost (AR/P>AC).

• There is monopoly, element under this type of market structure and

the entrepreneur will be benefited and will earn more than the
normal profit as shown by the shaded area PSE
65
 Marginal Productivity Theory of Profit [Marshall]
Profit = MP of Entrepreneur

• “Profit is equal to the marginal productivity of the entrepreneur.

• Profit is the reward of an entrepreneur which is determined by its marginal revenue productivity.
• Higher the marginal productivity, higher are the profits and lower the marginal revenue
productivity, the lower are the profits of an entrepreneur.

• Edgeworth, Chapman, Stigler and Stonier and Hague have explained the determination of profit on
the basis of marginal productivity of an entrepreneur as other factors of production are rewarded on
the basis of their marginal productivities.

• Demand for an entrepreneur is based on its marginal productivity curve, whereas, its supply
depends upon the opportunity cost or transfer earning of an entrepreneur.
66
• Marginal productivity means an addition to total productivity when an additional unit of a factor of
• production is employed. We can determine the entrepreneurial ability by employing an additional
unit of entrepreneur or withdrawing it.

67
 Marginal Productivity Theory of Profit [Marshall]
Marginal Productivity Theory of Profit [Marshall]
Profit = MP of Entrepreneur

• MRP is the demand curve for entrepreneur and SS is the

supply curve of entrepreneur. Both the curves cut each
other at L point where the OE is the supply and demand for
entrepreneurs.
• OS is the profit level which is equal to transfer earnings of
entrepreneurs. In the long run under perfect competition
this level of profit (normal profit) will remain as it is. But
during short period an entrepreneur may earn abnormal
profit as well.
• When the supply of entrepreneurs is OE1, the entrepreneur
68
is earning abnormal profit equal to SS1 out of OS profit.
This abnormal profit will disappear in the long run when
new firms will enter the industry under perfect competition
and there will be normal profit only.

69
 Marginal Productivity Theory of Profit [Marshall]
Profit = MP of Entrepreneur

• This theory is based on unrealistic assumptions of homogeneity of entrepreneurs in an industry. As

entrepreneurs’ efficiency differ, therefore it is not possible that there will be one marginal revenue
productivity curve for all entrepreneurs. So Profit cannot be same.

• This theory fails to determine profit accurately: Because efficiency of entrepreneurs differs,
systems and methods of doing work differ, therefore. Profit cannot be calculated accurately.

• The concept of marginal revenue productivity of entrepreneurship is a meaningless concept:

Because unlike other factors, there can be only one entrepreneur in a firm.

• It is one sided theory: This theory takes into account only the demand for entrepreneurs and do not
take into account the supply or availability of entrepreneurs.
70
• This is a static theory: Where all entrepreneurs earn only normal profits, they have not considered
that the world is dynamic also where some entrepreneurs can earn more than normal profits.

71
72
Lecture-21: Product Exhaustion Theorem,
Social Welfare Function and Social
Optimality
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
The Beginning of Product Exhaustion Theorem
The Beginning of Product Exhaustion Theorem
NTA-UGC-NET | Product Exhaustion Theorem
The Euler’s Theorem and Product Exhaustion Problem

• We know that each factor is paid as per their marginal product in the production
process. That is, each unit of labour will get MPl as wage and MPk is rent.

• This implies that Value of Product = wL + rK

• If each factor is rewarded equal to its marginal product, the total product should
be disposed of without any surplus or deficit. The problem of proving that the
total production will be just exhausted if all factors are paid rewards equal to their
marginal products has been called “Adding- up Problem” or Product
Exhaustion Problem.

• The way this proposition is solved has been called the adding-up problem Wick-
steed in the Coordination of the Laws of Distribution demonstrated with the
help of Euler’s Theorem (developed by Leonhard Euler) that payment in
accordance with marginal productivity to each factor exactly exhausts the total
product.
NTA-UGC-NET | Product Exhaustion Theorem
The Euler’s Theorem and Product Exhaustion Problem

Q = (MPl) L + (MPk) K

where Q is total output, MP is marginal product, L is labour and K is capital. To find

out the value of output, multiply through P (price).
PxQ = (MPL x P) L + (MPK x P) K
(MPL x P) = VMP, and (MPK x P) = VMPK
PQ = VMPL + VMPK
Where VMP, is the value of marginal product of labour and VMPc is the value of
marginal product of capital.
NTA-UGC-NET | Product Exhaustion Theorem
Wicksteed’s Solution of Product Exhaustion Problem with Euler’s Theorem
• Philip Wicksteed was one of the first economists who posed this problem and
provided a solution for it.

• Wicksteed applied a mathematical proposition called Euler’s Theorem to prove

that the total product will be just exhausted if all the factors are paid equal to their
marginal products.

• Let Q stand for the total output of the product, a stands for the factor labour and b
stands for the factor capital and c stands for land. Assuming that there are only
three factors employed for production. Then, the adding up problem implies that,

• Q = MPa x a + MPa x b +MPc x c

• That is, the marginal product of factor a multiplied by the amount of factor a plus
the marginal product of factor b multiplied by the amount of factor b plus the
marginal product of factor c multiplied by the amount of factor c equals the total
product of the firm. Marginal products of various factors can be expressed as
partial derivatives.
 NTA-UGC-NET | Product Exhaustion Theorem
Wicksteed’s Solution of Product Exhaustion Problem with Euler’s Theorem
• Thus, the marginal product of labour (i.e. factor a) can be expressed as ∂W/∂a,
and the marginal product of capital (factor b) as ∂W/∂b, and the marginal product
of land (factor c) as ∂W/∂c, then for the adding-up problem (i.e. product
exhaustion problem) to be fulfilled, the following equation must hold good:
Q = MPa x a + MPa x b +MPc x c

Euler’s Theorem states that if production function is a homogenous function of

the first degree, that is, if in Q =f (a, b, c) for any increase in the variables a, b
and c by the amount n, the output Q also increases by n, then Q will be equal to
the total sum of the partial derivatives of production function with respect to
various factors multiplied by the amounts of the factors respectively.
NTA-UGC-NET | Product Exhaustion Theorem
Wicksteed’s Solution of Product Exhaustion Problem with Euler’s Theorem
• The homogeneous function of the first degree or linear homogeneous function is
written in the following form:
nQ = f(na, nb, nc)
• Now, according to Euler’s theorem, for this linear homogeneous function:

• Thus, if production function is homogeneous of the first degree, then according to

Euler’s theorem the total product is:

Where Q represents the total product and ∂W/∂a, ∂W/∂b, ∂W/∂c are partial
derivatives of the production function and therefore represent the marginal products
of labour, capital, and land respectively. It follows therefore that if production
function is homogeneous of the first degree (that is, where there are constant returns
to scale), then, according to Euler’s Theorem, if the various factors a, b and c are
paid rewards equal to their marginal products, the total product will be just
exhausted, with no surplus or deficit.
NTA-UGC-NET | Product Exhaustion Theorem
Wicksteed’s Solution of Product Exhaustion Problem with Euler’s Theorem
• We thus see that Euler’s Theorem is able to explain product exhaustion when
production function is homogenous of the first degree.

• In this way, Wicksteed assuming constant returns to scale and applying Euler’s
Theorem, proved the adding-up problem, that is, demonstrated that if all factors
are paid equal to their marginal products, the total product will be just exactly
exhausted.
Importance of Product Exhaustion Theorem:
Euler’s theorem plays an important role in the theory of distribution. The total
product is produced by combining different factors of production. The question that
arises is how the total output should be distributed among the factors of production?
If the production function is homogeneous of degree one, then Eular’s theorem can
solve this question. It provides the solution to the producer’s long-run problem of
allocation of total product to each factor and the distribution of the total outlay
among the different inputs.
The theorem also suggests how a firm should employ the various inputs. It tells us
that the firm should employ its inputs to that extent at which the reward to the factor
equals its marginal revenue product.
NTA-UGC-NET | Product Exhaustion Theorem
Critique of Euler’s Theorem and Wicksteed’s Solution:
• Wicksteed’s solution was critcized by Walras, Barone, Edgeworth and Pareto. It
was asserted by these writers that production function was not homogeneous of
the first degree, that is; returns to scale are not constant in the actual world. Thus
Edgeworth satirically commented on Wicksteed’s solution, “There is
magnificence in this generalisation which recalls the youth of philosophy. Justice
is a perfect cube, said the ancient sage; and rational conduct is a homogeneous
function, adds the modern savant”.

• They pointed out that production function is such that it yields a U- shaped long-
run average cost curve. The U-shape of the long-run average cost curve implies
that up to a point increasing returns to scale occur and after it diminishing returns
to scale are obtained.
• In case a firm is still working under increasing returns to scale, then if all factors
are paid equal to their marginal products, the total factor rewards would exceed
the total product. On the other hand, if a firm is working under diminishing
returns to scale, and if all factors are paid equal to their marginal products the
total factor rewards would not fully exhaust the total product and will therefore
leave a surplus. (Contd.)
NTA-UGC-NET | Product Exhaustion Theorem
Wicksell, Walras and Barone’s Solution of Production Exhaustion Problem:
• After Wicksteed, Wicksell, Walras and Barone, each independently, advanced
more satisfactory solution to the problem that marginally determined factor
rewards would just exhaust the total product. These authors assumed that the
typical production function was not homogeneous of the first degree, but was such
that yielded U-shaped long-run average cost curve.

• They pointed out that in the long-run under perfect competition the firm was in
equilibrium at the minimum point of the long-run average cost curve. At the
minimum point of the long-run average cost curve, the returns to sc ale are
momentarily constant, that is, returns to scale are constant within the range of
small variations of output.

• Thus the condition required for the marginally determined rewards to exhaust the
total product, that is the operation of constant returns to scale, was fulfilled at the
minimum point of the long-run average cost curve, where a perfectly competitive
firm is in long-run equilibrium. Thus in the case of perfectly long-run equilibrium,
Euler Theorem can be applied and if the factors are paid rewards equal to their
marginal products, the total product would be just exactly exhausted.
NTA-UGC-NET | Product Exhaustion Theorem
Hicks-Samuelson’s Solution to the Product Exhaustion Problem:
• After Wicksell, Walras and Barone, J.R. Hicks and P. A. Samuelson
provided more satisfactory- solution to the problem of product
exhaustion problem. The basic point to note in their solution is that it is
the market conditions of perfect competition with its important feature of
zero economic profits in the long run and not the first degree-
homogeneous production function that ensures that if factors are paid
rewards equal to their marginal products, total value product would be
just exhausted.

• In a perfectly competitive market structure, firms make neither economic

profit nor make losses. Thus the solution of product exhaustion problem
in case of the firms working in competitive factor markets where factors
are paid equal to their marginal products, the existence of perfect
competition in the product markets will ensure zero economic profits in
the long run. Consider Figure where a perfectly competitive firm is in
long- run equilibrium at the minimum point of the long-run average cost
curve LAC producing level of output OQ at price OP.
NTA-UGC-NET | Product Exhaustion Theorem
Hicks-Samuelson’s Solution to the Product Exhaustion Problem:
• The total value product produced by the firm in this long-run equilibrium
is equal to the area OPEQ. Since price OP is equal to average cost (AC)
at this long-run equilibrium output with zero pure profits, total value
product (PQ) will be equal to the total cost (TC). Thus

• In long-run competitive equilibrium:

Total Value Product (P.Q.) = w.L+K.r. …(1)

• Now marginal productivity theory of distribution requires that

w =VMPL=P.MPPL …(2)
r = VMPK= P. MPPK …(3)
Where w and r are prices of labour and capital respectively and MPPL and
MPPK are marginal physical products of labour and capital respectively and
P is the price of the product.

Substituting the values of w and r into equation (1) we have

P.Q = L. (P. MPPL) + K. (P. MPPK)

NTA-UGC-NET | Product Exhaustion Theorem

Total Value Product (P.Q.) = w.L+K.r. …(1)

Now marginal productivity theory of distribution requires that
w =VMPL=P.MPPL …(2)
r = VMPK= P. MPPK …(3)
Where w and r are prices of labour and capital respectively and MPPL and
MPPK are marginal physical products of labour and capital respectively and
P is the price of the product.

Substituting the values of w and r into equation (1) we have

P.Q = L. (VMPL) + K. (VMPK)
or
P.Q = L. (P. MPPL) + K. (P. MPPK)
Dividing both sides by P we have
Q = L.MPPL + K. MPPK
• That is, if labour and capital are paid equal to their marginal physical
products, total output will be just exhausted.
NTA-UGC-NET | Product Exhaustion Theorem
Hicks-Samuelson’s Solution to the Product Exhaustion Problem:
P.Q = L. (P. MPPL) + K. (P. MPPK)
Dividing both sides by P we have
Q = L.MPPL + K. MPPK
• That is, if labour and capital are paid equal to their marginal physical
products, total output will be just exhausted.
NTA-UGC-NET | Product Exhaustion Theorem
Comparison!
It is important to note that in contrast to the solutions of Wicksteed and of
Wicksell, Walras and Barone, the solution furnished by Hicks and
Samuelson proves the product exhaustion theorem without assuming
constant returns to scale (i.e. first-degree-homogeneous production function)
and without using Euler theorem. They prove it by just assuming conditions
of perfect market structure.

The merit of the Hicks-Samuleson solution is that it highlights when

conditions of perfect competitive market do not hold, that is, when there is
either monopoly or imperfect competition in the product market or
monopsony or imperfect competition in the factor market, the hired factors
do not get rewards equal to the value of their marginal products and are
therefore exploited by the entrepreneurs who may enjoy large economic
profits.
 NTA-UGC-NET | Product Exhaustion Theorem

2. Select the correct statement of Adding up Theorem.

(A) If income generated by the given output produced during the given period is
distributed according to average productivity of all factors, total income will be
exhausted.
(B) Total income derived from the output will be exhausted if all factors are paid
according to their marginal productivity.
(C) Total income derived from the output will be exhausted if all factors are paid at
the same rate.
(D) Total income will be exhausted if all factor rewards are proportional to
commodity prices.
 NTA-UGC-NET | Product Exhaustion Theorem

2. Select the correct statement of Adding up Theorem.

(A) If income generated by the given output produced during the given period is
distributed according to average productivity of all factors, total income will be
exhausted.
(B) Total income derived from the output will be exhausted if all factors are paid
according to their marginal productivity.
(C) Total income derived from the output will be exhausted if all factors are paid at
the same rate.
(D) Total income will be exhausted if all factor rewards are proportional to
commodity prices.
Answer: (B)
 NTA-UGC-NET | Product Exhaustion Theorem

27. What is not correct regarding assumptions of adding-up problem ?

(1) Constant returns to scale
(2) Applicable in the short-run
(3) Perfect competition
(4) Risk-free static economy
 NTA-UGC-NET | Product Exhaustion Theorem

27. What is not correct regarding assumptions of adding-up problem ?

(1) Constant returns to scale
(2) Applicable in the short-run
(3) Perfect competition
(4) Risk-free static economy

Answer: (B)
 NTA-UGC-NET | Social Welfare Function
Social Welfare Function- The Introduction
• It includes the concept of value judgements in analyzing the welfare issues.
• A value judgement is the conceptions or ethical beliefs of people about they think to be good or
bad or they think is bad for the economy or society as whole perspective.
• It is based on ethical, political, philosophical and religious beliefs and not scientific logic or
law.
• These are recommendations and totally normative in nature. Like honesty is the best policy,
poors should not be taxed.
• Jeremy Rothenberg- The Measurement of Social Welfare, 1961 included some value
judgements used in Welfare Economics. Prof. S. K. Nath mentioned about value-judgements in
pareto Optimality Conditions in his title- A Reappraisal of Welfare Economics, 1969. IMD
Little written about value judgement in his book- A critique of Welfare Economics, 1957.
• Abram Bergson was the first one to introduce the idea of a social welfare function in his article-
A Reformation of Certain Aspects of Welfare Economics, 1938.
• The Classical Welfare function was introduced by Bentham, Pigou and Marshall and termed as
Benthamite Welfare Function, which states social welfare as a sum of cardinal utilities obtained
by all the member of the society. W = U1 + U2 +U3+ ….+ Un
• Society aims at maximizing this utility function given income is so distributed that MU of
Income for all members of the society. Thus, as per Classicals, social welfare is maximized
only with equal distribution of Income.
• Another Social Welfare function was introduced by John Rawls.
 NTA-UGC-NET | Social Welfare Function
Social Welfare Function- The Introduction
• Rawls mentioned that if people are risk averse, then
W (U1, U2, U3 ,. ............U ,) = min (Ul, U2, U3, ............... Un)
• This implies that social welfare of resource allocation depends only on the worst of
individual, that is, the person with minimum utility.
• SWF by Bergson-Samuelson is W = W (U1, U2, U3,… UH)
Where, h = 1, 2, ........ H, where H are the number of households in the society.
• In other words, U1, U2,.., UH represents the ordinal utility indices of different individuals or
households in the society.
• The ordinal utility index of an individual depends upon the goods and services she
consumes and the magnitude and kind of work she does and the amount of leisure she enjoys.
• This theory can be understood with the help of GUPF→ every point on this curve is a
Pareto Optimal Allocation and hence, no point is preferable to another.
 NTA-UGC-NET | Social Welfare Function
Social Welfare Function- The Introduction
• Rawls mentioned that if people are risk averse, then
W (U1, U2, U3 ,. ............U ,) = min (Ul, U2, U3, ............... Un)
• This implies that social welfare of resource allocation depends only on the worst of
individual, that is, the person with minimum utility.
• SWF by Bergson-Samuelson is W = W (U1, U2, U3,… UH)
Where, h = 1, 2, ........ H, where H are the number of households in the society.
• In other words, U1, U2,.., UH represents the ordinal utility indices of different individuals or
households in the society.
• The ordinal utility index of an individual depends upon the goods and services she
consumes and the magnitude and kind of work she does and the amount of leisure she enjoys.
• This theory can be understood with the help of GUPF→ every point on this curve is a
Pareto Optimal Allocation and hence, no point is preferable to another.

Grand utility possibility frontier (G-G-) is the envelope cover to the utility possibility
frontiers at pareto optimum points of production and exchange. The grand utility
possibility frontier indicates that no reorganization of the production-exchange
process is possible that makes someone better off without, at the same time,
marking someone else worse off. To determine the pareto optimum point in
production and exchange at which social welfare is maximum, we need a social
welfare function.
 NTA-UGC-NET | Social Welfare Function
• The shape of SIC inherits the idea of fairness and equity. Social Welfare Function- The Introduction
• Point S is the point of equilibrium, where UA*, UB* is the point on GUPF.
• This is social optimum determined by tangency of SIS and GUPF.
NTA-UGC-NET | Social Welfare Function
Social Welfare Function- The Introduction
 NTA-UGC-NET | Social Welfare Function
Social Welfare Function- The Introduction
W =  HhU h Benthamite or Utilitarian SWF is a linear sum of weighted utilities
h=1 Thus, as stipulated by Jeremy Bentham and the Utilitarians, this one
maximises the (weighted) sum of individual utilities and
yields linear social indifference curves
NTA-UGC-NET | Social Welfare Function
Social Welfare Function- The Introduction
Bergson-Samuelson SWF states the conditions for "social justice", as that, MRSAB is
equal to the ratio of MRS of A and B.
In other words, this implies that the allocation of goods is done in such a manner so as to
have the utility distribution compatible with the "worthiness" of the individuals according
to the social welfare function.
Thus, social welfare is a function of the levels of utility of members in the society.
W = Y1 + Y2 + …. + Yn
where
W is social welfare and Yx is the income of each of the xth individual in a
society. In this case, maximising the social welfare function means maximising
the total income of the people in the society, without regard to how incomes are
,distributed in the society.

Rawlsian Welfare Function

W = Min (Y1, Y2,,,,…..Yn)→ Social welfare of the society is taken to be related
to the income of poorest person in society.

These two social welfare functions express very different views about how a
society would need to be organised in order to maximise welfare
NTA-UGC-NET | Social Welfare Function
Theory of Second Best
It refers to what is the optimal policy when the true optimum (the first best) is
unavailable due to constraints on policy choice.
We know that in case of externalities and public goods, all MCs or Pareto Optimality
are not fulfilled.
Lipsey and Lancaster (who introduced TSB) asserted that the second best solution will
not lead to an increase in social welfare.
Example- monopoly is producing in a market. Govt, takes step to make it market
competition, as doing this, social welfare will increase. But this overlooks the idea,
that there might be some markets where monopoly can’t be removed and there Pareto
Optimality conditions cannot be satisfied. In such case, TSB states that this will not
enhance social welfare.
NTA-UGC-NET | Social Welfare Function
Theory of Second Best
PP' is the production possibility curve and all points on the
curve are Pareto efficient.
Lipsey and Lancaster, mentioned it is sometimes better to
move inside PP' to achieve a higher level of social welfare in
case all marginal conditions are not satisfied.

These social welfare curves represent combinations of two

products X and Y, which yield the same level of social
welfare.

Further, the higher the level of social welfare curve denotes

higher
level of welfare. It will be seen from the figure that point H at
which social welfare curve is tangent to PP' shows maximum
social welfare point satisfying all the marginal conditions of
Pareto optimality.
NTA-UGC-NET | Social Welfare Function
Theory of Second Best
Now, suppose due to the existence of monopoly in the
markets of the two goods, X and Y, the socially best point H
is unattainable. Further, suppose that under such
circumstances, combinations lying on the line CC' are
attainable. Suppose the economy is at present at point L on
the attainable line CC'. If Pareto optimality is to be achieved,
we can move from a point L, which is inside PP’ to point A
or B which are also on the attainable line CC'. However, as
will be seen from the figure, moving to point A or B on PP'
would put us in a lower welfare curve W1 If instead from
point L, we move the point E, which is inside PP' and is
therefore Pareto inefficient and yields a higher level of
welfare as indicated by Wz. Thus, the theory of second best
asserts that when one of the marginal conditions of Pareto
optimality is not satisfied due to some or other reasons, it
may be better to violate other marginal conditions of Pareto
optimality to achieve maximum possible social welfare.
Lecture-22: Concept of Pareto Optimality,
Conditions of Pareto Efficiency, First &
Second Welfare Theorems
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
NTA-UGC-NET | Welfare Economics
 NTA-UGC-NET | Chronology
Chronological Order of Welfare Economics
• Pareto Optimality Conditions- Vilfredo Pareto: Manual of Political Economy”, 1906
• Pigouvian Analysis- A.C.Pigou: The Economics of Welfare, 1920
• Kaldor-Hicks Compensation Criterion- Welfare Propositions of Economics and Interpersonal
Comparison of Utility', 1939
• Scitovsky Reversals and Double Criteria [Tibor Scitovsky]- “A Note on Welfare Propositions
in Economics”, 1941
• Little Criterion- IMD Little “A Critique of Welfare Economics”, 1949
• Samuelson’s Criteria: Evaluation of Real National Income”, 1950
• William Gorman’s (aka Terence Gorman) Intransitivity Problem: "The Intransitivity of Certain Criteria
Used in Welfare Economics", 1955
 NTA-UGC-NET | Pigouvian Analysis
Pigouvian Analysis- Economics of Welfare 1932
In the words of Pigou, ‘a situation in which each several sort of resource is allocated in such a way that the last unit of it
in any one use yields a physical product of the same money value as the last unit of it in any other use' is one of ideal
allocation, irrespective of the distribution of money incomes. Therefore, according to Pigou, such an allocation is properly
called the ideal allocation with respect to the existing distribution of money income.’ It is based upon Law of
Equimarginal Principle.
• To begin with Pigou assumed that there is some resource allocation problem in the economy and this inefficient
allocation can be sought out and can be made efficient by channelizing the real factors of production to their best
possible uses.
• So, the crux is how can be the existing real factors of production can be rearranged, so that the total value of the output
is maximized.
 NTA-UGC-NET | Pigouvian Analysis
Pigouvian Analysis: Assumptions
• Every person tries to maximise his/her satisfaction from the amount spent on different goods and services.
• One can compare level of satisfaction in both manner- interpersonally and intrapersonally.
• Law of Diminishing Marginal Utility of income is applicable. This implies that as income rises, the marginal utility of
income falls. As a result of this, rich people utility falls and that of poor people rises, provided the income distribution
is equal and there is some mechanism available for transfer of income from rich to poor.
• Equal ability to achieve contentment→ It means that different people derive the same satisfaction out of the same real
income.
 NTA-UGC-NET | Pigouvian Analysis
Two Pigouvian Welfare Conditions: Based upon the dual criterion, Pigou stated the following two welfare conditions,
which if fulfilled can lead to the improvement in economic welfare
✓ Welfare is said to increase when NI Increases: With the given tastes and preferences and income distribution, an
increase in NI represents an increase in welfare.
✓ Distribution of NI should be equal for welfare maximisation: If NI is constant, transfer of income from the rich to the
poor would enhance welfare. This is based upon- Equal Capacity for satisfaction and Diminishing MU of Income. He
mentioned that since rich having more money will have less MU of Income, so if there is a transfer of income from
rich to poor (whose MU of Income is very high), so the social welfare of the whole economy will raise.
 NTA-UGC-NET | Pareto Optimality
The Concept of Pareto Optimality
• Pareto mentioned that social welfare is the sum total of welfare of the individual members of the society. It rules out
any interpersonal comparison of welfare and rejects the cardinality of assumption and accepts ordinality of utility.
• Pareto Optimum is defined as a situation where it is not possible to make any one better off without making someone
worse off by reallocation of resources. In other words, when a pareto optimum point has been reached, then from there
is not possible to increase someone’s welfare without reducing the welfare of the other person.
• Pareto Optimum can be explained with the help of Pareto Criterion for welfare judgement.
• Pareto improvement: If at a particular situation due to any reallocation of resources if it is possible that someone’s
welfare can be increased without reducing other’s welfare, then that particular situation (older point) is called pareto
inferior and the new point that can be reached is called pareto superior and the overall journey is called pareto
improvement. In short, pareto improvement is a movement from pareto inferior to a pareto superior point.
• Pareto Optimum situation is also termed as a situation of efficient allocation of resources (inputs or outputs).
• This can be explained with the help of the Utility Possibility Curve.
 NTA-UGC-NET | Pareto Optimality
Due to policy change movement from point A to D, A to C and A to B are pareto
improvement.
• A → D, Consumer-1 utility same, C-2 increases
• A → B, C-1 utility increases, C-2 same
• A → C, utility of both C-1 and C-2 rises
But we can’t compare whether movement from A→ E or A → F is pareto improvement. In
these cases, pareto criteria fails to measure any increase or decrease in welfare.

Pareto efficiency - We say we have satisfied Pareto efficiency when there are no
opportunities for Pareto improvements. We say allocation/arrangement X is Pareto superior
to Y if all individuals are at least as happy with X as with Y, and at least one individual is
happier
 NTA-UGC-NET | Pareto Optimality
Assumptions:
• Each individual has his/her own ordinal utility function and possesses a definite amount
of each product and factor.
• Production function of every firm and the state of technology is given and remains
constant.
• Goods are perfectly divisible.
• A producer tries to produce a given output with the least-cost combination of factors.
• Every individual wants to maximise his/her satisfaction.
• Every individual purchases some quantity of all goods.
• All factors of production are perfectly mobile.
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-1: Pareto Optimality in the Allocation of
Goods among Consumers / Efficiency in Exchange / Exchange
Optimum / Consumption Efficiency
Basic Terminologies in Pareto’s Theory
Mind Map of Pareto Criteria
Mind Map of Pareto Criteria
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-1: Pareto Optimality in the Allocation of
Goods among Consumers / Efficiency in Exchange / Exchange
Optimum / Consumption Efficiency
• Initial point is E, where Consumer A is consuming Xa and Ya
goods with utility as Ua & consumer B consuming Xb and Yb
goods with Utility as Ub. This is Pareto inferior allocation as due to
some reallocation A’s utility can be increased without making B
worse off and similarly for B, while keeping A on his original level
of satisfaction.
• Consider the point D. A is on initial IC, but B has reached a higher
IC.
• So point D is Pareto Optimal and is Pareto Superior to E. But
remember in this case, we can’t compare Point C to either D or to
E, indeed C is not Pareto-Comparable to E and D.
• Contract curve connects all the pareto optimal allocations.
• Conditions to achieve Consumption Efficiency
1. Allocation has to be pareto-optimal
2. Must lie on contract curve
3. MRS between two goods must be same among all the
consumers. MRS A = MRSB
XY XY
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-1: Pareto Optimality in the Allocation of
Goods among Consumers / Efficiency in Exchange / Exchange
Optimum / Consumption Efficiency
Contract Curve: It is the locus of all such points, where the IC of two
consumers are tangents. All points on Contract Curve are Pareto
optimal, so there is no unique point of Pareto Optimal Solution. Indeed,
there exists an infinite number of pareto optimal solutions. It is not
possible to compare point D and C on the contract curve. When we
move from point D to C, we can see that utility of A rises, while that of
B falls. Thus, on the basis of Pareto Criterion, it is not possible to say
whether the movement from D to C or from C to D is desirable or not.
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-1: Pareto Optimality in the Allocation of
Goods among Consumers / Efficiency in Exchange / Exchange
Optimum / Consumption Efficiency
Contract Curve: It is the locus of all such points, where the IC of two
consumers are tangents. All points on Contract Curve are Pareto
optimal, so there is no unique point of Pareto Optimal Solution. Indeed,
there exists an infinite number of pareto optimal solutions. It is not
possible to compare point D and C on the contract curve. When we
move from point D to C, we can see that utility of A rises, while that of
B falls. Thus, on the basis of Pareto Criterion, it is not possible to say
whether the movement from D to C or from C to D is desirable or not.

Important Point
Not only we fail to compare two points on the contract curve
say like D and C, we also fail to compare point E and C. We
can’t say whether the welfare will improve or deteriorate if
move from point E to C. Moving from E to C, utility of A
increases, while utility of B reduces. Thus, it should be noted
that a movement from a point off the contract curve to a
point on the contract curve can’t be evaluated on the basis
of Pareto Criterion.
A
MRS XY = MRSBXY
NTA-UGC-NET | Pareto Optimality

GATE 2021
 NTA-UGC-NET | Pareto Optimality
Pareto Superiority: All points on the contract curve are Pareto Efficient or Optimal. Are all points on the contract curve
Pareto Suprerior to the initial distribution point? No, they are not.
The set of points that are Pareto superior to D are called the Lens. These are shown as the orange shaded area in the diagram
below. They are the points (distributions of goods) at which both traders would be at least as well off, and one trader better
off. Therefore, they also represent the points to which the traders would move voluntarily.
The Core is the set of points that are both Pareto superior and Pareto efficient; it is the locus of Pareto optimal points within
the lens shaped area that is bounded by the indifference curves passing through the initial allocation D. At any place on the
core the MRS of two traders is the same, i.e. there are no more mutual gains from trade available. Where on the core they
end up will depend upon the relative bargaining skills of the individual traders.
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-2: Pareto Optimality in the Production Sector / Efficiency in Production (Production Efficiency)
• Initial point is G, where two firms are producing output X and Y with full utilisation of resource. But this is a Pareto
Inefficient point, as we can increase the efficiency with the same level of resources.
• MP MP
Moving to Point F, we make a more efficient allocation, such that, MRTS KL
X
= MPL = MRTSYKL = MP L
K K
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-2: Pareto Optimality in the Production Sector / Efficiency in Production (Production Efficiency)
• Initial point is G, where two firms are producing output X and Y with full utilisation of resource. But this is a Pareto
Inefficient point, as we can increase the efficiency with the same level of resources.
• MP MP
Moving to Point F, we make a more efficient allocation, such that, MRTS KL
X
= MPL = MRTSYKL = MP L
K K

i. Optimum Allocation of Factors: There are fixed

quantities of two factors (inputs) which are to be distributed
between the two firms. Both the firms use these two factors
to produce the same goods. Optimum allocation of factor
inputs is said to happen when the MRTS between the two
factors is the same for the two firms using both to produce a
given product. If there exists any inequality, then it will be
possible to produce more of the good by a firm without
producing less of the good by other firm. Thus, optimum
allocation of factors can be satisfied when both the firms
are on the contract curve.

X = MPL Y = MPL
MRTS KL MP = MRTS KL MP
K K
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-2: Pareto Optimality in the Production Sector / Efficiency in Production (Production Efficiency)
ii. Optimum Degree of Specialization: This is related to the determination of optimum output of each product to be
produced by each firm. If we assume that each firm produces the same two products then the optimum degree of
specialization is achieved when the Marginal Rate of Transformation between the two Goods is same for both the
firms. If the Marginal Rate of Transformation is not equal, then it would be possible to increase the output of one
product without reducing the output of the other product. Marginal Rate of Transformation or Marginal Rate of
Product Transformation between two goods is the rate at which one good must be sacrificed to obtain more of the
other good without varying the input used. Thus if MRT or MRPT between two goods is not the same for the two
firms, it would always be possible to increase the combined output of both the goods on at-least one of them. This can
be interpreted that under PC, each firm maximises profit by equating P = MC = min AC

MRPTFirm−1 =  Y   MCX  = MRPT  Y   MCX 

X  =  MC  Firm−2 = X  =  MC 
Firm−1  Y  Firm−1 Firm−2  Y  Firm−2
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-2: Pareto Optimality in the Production Sector / Efficiency in Production (Production Efficiency)
iii. Optimum factor utilization: This condition states that the marginal rate of transformation between any factor and
any product must be the same for any pair of firms using the factor and producing the product. It means that the
marginal productivity of any factor in producing a particular product must be the same for all the firms. If the
marginal productivity of factor to produce a given product is low, the total product would increase by transferring
some units of the factor to the high productivity firm.
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-3: General Pareto Optimality/ Product Mix Efficiency
• It states that the marginal rate of substitution between two goods for any
consumer be equal to the marginal rate of product transformation between
those goods.
• The marginal utility of good X with respect to Y equals the marginal cost of
good X with respect to Y.

• There are infinite numbers of allocations along a contract curve from F to OA

representing different tangencies.
• It incorporates consumption efficiency and production efficiency. It implies
that what the consumers are willing to consume so to maximise their
respective utilities should be produced by the firms that will simultaneously
maximise their level of profits
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-3: General Pareto Optimality/ Product Mix Efficiency
• It states that the marginal rate of substitution between two goods for any
consumer be equal to the marginal rate of product transformation between
those goods.
• The marginal utility of good X with respect to Y equals the marginal cost of
good X with respect to Y. We can take the help of "community indifference
curve" (CIC) or the "Scitovsky indifference curve" (SIC) [Tibor Scitovsky].
CIC is a set of output combinations that yield the same "aggregate utility”
different slopes of the CICc and CICD curves at point F, are captured by
examining the price lines tangent to CICc (with slope -(px/py)-C which is
also tangent to the MRSs of the agents at point C) and CICD( with slope -
(px/py) D which is also tangent to the MRSs at point D).
• There are infinite numbers of allocations along a contract curve from F to OA
representing different tangencies.
• It incorporates consumption efficiency and production efficiency. It implies
that what the consumers are willing to consume so to maximise their
respective utilities should be produced by the firms that will simultaneously
maximise their level of profits
 NTA-UGC-NET | Pareto Optimality
Marginal Condition-3: General Pareto Optimality/ Product Mix Efficiency
A MU Ax B MU B x Px
MRS xy = = MRS xy = = → Consumption Efficiency ...(1)
A B
MU y MU y Py
MPX MPY w = MCX → Production Efficiency ... 2
MRPTxy = MRTS X L,K =MPXL = MRTS L,K = MPLY = r MC
Y
( )
K K Y

So, from (1) and (2), Product Mix Efficiency is attained when:
A MU A x B MU B x X MPX Y MPY
MRS xy = = MRS xy =
MU B y = MRTS L,K = MPX = MRTS L,K = MPY
L L
MU A y
K K

Px w MCX
MRS A xy = MRS B xy = = MRPTxy = =
Py r MCY
In the above expression, it has been assumed Perfect Competition, if we drop this, then the whole expression becomes:
MRS Axy = MRS B xy = MRPTxy
 NTA-UGC-NET | Pareto Optimality- SOC
Second Order Conditions and Sufficient Conditions to ensure Max Welfare:
The marginal conditions of Pareto Optimality are only the FOC or Necessary Conditions. The SOC are fulfilled when all:
i. All indifference curves are convex shaped
ii. All isoquants are convex shaped
iii. PPC or UPF is concave shaped
 NTA-UGC-NET | Pareto Optimality- SOC
Second Order Conditions and Sufficient Conditions to ensure Max Welfare:
The marginal conditions of Pareto Optimality are only the FOC or Necessary Conditions. The SOC are fulfilled when all:
i. All indifference curves are convex shaped
ii. All isoquants are convex shaped
iii. PPC or UPF is concave shaped
It should be noted that even if the FOC and SOC are fulfilled, then also it does not guarantee that largest possible welfare has
been attained. It can be possible that the fulfillment of FOC and SOC may indicate attainment of local max welfare and not
the global max. To attain the global max, certain different conditions are required to be fulfilled. These are termed as total
conditions as laid down by Hicks. The total conditions state that if the welfare is to be maximized, then it must be impossible
to increase welfare by producing a product not otherwise produced or by using a factor that is not used otherwise.
Thus, welfare will be max iff Marginal Conditions (i.e. FOC and SOC) and Total Conditions are fulfilled. But that max
welfare may or may not be unique. There may be more than one optimum situation. We know that Pareto Optimum situation
assumes a given level of income distribution, thus, as income distribution changes, Pareto Optimum situation also changes.
 NTA-UGC-NET | Pareto Optimality- SOC
Perfect Competition and Pareto Optimality Conditions:
We have analysed that all the FOC conditions are fulfilled under perfect competition in the above section, which leads to the
following expression.
Px
MRS xy = MRS xy =
A B = MRPTxy = w = MCX
Py r MCY

Perfect competition represents a welfare optimum in a narrow sense.

i. This is due to the reason that perfect competition does not guarantee that the SOC will be fulfilled.
ii. Due to presence of externalities, perfect competition may not lead us to max welfare position.
iii. Perfect competition does not ensure optimum distribution of income. It means that if the distribution of income is not
optimum, then even if perfect competition situations prevail, it does not guarantee optimum welfare.
Thus, perfect competition though necessary is not sufficient for Pareto Optimality
 NTA-UGC-NET | Pareto Optimality- SOC
First Fundamental Theorem of Welfare Economics: An equilibrium achieved by a competitive market will be Pareto
efficient. The first states that in economic equilibrium, a set of complete markets, with complete information, and in perfect
competition, will be Pareto optimal (in the sense that no further exchange would make one person better off without making
another worse off). The requirements for perfect competition are these:
• There are no externalities and each actor has perfect information.
• Firms and consumers take prices as given (no economic actor or group of actors has market power).
The theorem is sometimes seen as an analytical confirmation of Adam Smith's "invisible hand" principle, namely that
competitive markets ensure an efficient allocation of resources. However, there is no guarantee that the Pareto optimal
market outcome is socially desirable, as there are many possible Pareto efficient allocations of resources differing in their
desirability (e.g. one person may own everything and everyone else nothing)
Definitions:
i) x is the allocation of goods to all traders in the economy - x is a matrix with two dimensions: quantity of good and
amount allocated to each trader
ii) p is a vector of prices for each good
First Fundamental Theorem of Welfare Economics. If all traders have monotonic selfish utility functions, and if (x,p)
is a competitive equilibrium, then x is in the core, and is therefore Pareto optimal as well.
 NTA-UGC-NET | Pareto Optimality- SOC
Implications of First Fundamental Theorem:
• A private market that is competitive will result in Pareto efficiency - all gains from trade will be exhausted.
• A competitive market is a benchmark by which policy-makers can judge actual market outcomes.
• This theorem assumes that there are no market imperfections such as monopoly, externalities and public goods

The First and Second Welfare Theorems were proved graphically by Abba Lerner (1934) and mathematically by
Harold Hotelling (1938), Oskar Lange (1942) and Maurice Allais.
 NTA-UGC-NET | Pareto Optimality- SOC
Second Fundamental Theorem of Welfare Economics
The second theorem of welfare economics has certain advantages over first theorem of welfare economics. It explains that if
all consumers have convex preferences and all firms have convex production possibility sets then Pareto efficient allocation
can be achieved. The equilibrium of a complete set of competitive markets are suitable for redistribution of initial
endowments.
The second theorem states that any Pareto optimum can be supported as a competitive equilibrium for some initial set of
endowments. The implication is that any desired Pareto optimal outcome can be supported; Pareto efficiency can be achieved
with any redistribution of initial wealth. However, attempts to correct the distribution may introduce distortions, and so full
optimality may not be attainable with redistribution
There exists a vector of bank balance transfers (T1, T2, ...,Tn) and a price vector p = (p1, p2, ...,pm) such that y and p are a
competitive equilibrium given the transfers.

The Second Welfare Theorem: Any Pareto-optimal allocation fulfills the three conditions. Thus, assuming differentiability,
we can place price lines with slope px/py between the indifference curves so that MRSAxy = px/py = MRSBxy . Further, we
can place the same price line with the same slope between the CIC and the PPF so that MRSAxy = px/py MRPTxy are on the
PPF (by production efficiency), and then we can place a factor price line with slope r/w between the isoquants of the
production Edgeworth-Bowley box so that MRTSXKL = MRTSYKL
 NTA-UGC-NET | Pareto Optimality- SOC
Difference between First and Second Welfare Theorems
• The main difference between first and second fundamental theory is all about economic efficiency and
distribution of the initial wealth(endowment).
• On first theory believe on perfect competition and situation which does not exist in real world situation to
bring about pareto optimum, where its difficulties comes on suitability to society(welfare) because such
situation doesn’t prevent one from owning everything leaving vacuum to the rest.
• Second theorem complemented the weakness of the first, it began where first theorem ended. As it states,
after suitable distribution of initial endowment, pareto efficiency can be archived at any level under a perfect
situation.
 NTA-UGC-NET | Pareto Optimality- SOC
Difference between First and Second Welfare Theorems
The Second Theorem states that any allocation that is pareto efficient (so that society would not find another
allocation that is unanimously better) can be the outcome of an anonymous market, provided that the initial
endowment is chosen in a certain way. One way in which the endowment may be chosen is by redistributing
consumption claims across individuals via lump-sum transfers.
This theorem was wrongly believed to imply that socialist economies could obtain Pareto-efficient outcomes by
redistributing initial resources and introducing (restrictive) markets. These ideas were held by Oskar Lange and
others in a school of thought called 'market socialism'. The problem is that the only way in which redistribution
may occur is via lump-sum transfers, which severely restricts the ability to accomplish other desirable social
outcomes (like fairness or equality).
 NTA-UGC-NET | PYQs
Q-1: Starting with the earliest, arrange the following authors in the chronological order of
their contribution to welfare economics :
(i) J. Bentham
(ii) Y. Pareto
(iii) M. Marshall
(iv) J. Hicks
Code :
(A) (iii), (ii), (iv), (i) (B ) (i), (iii), (ii), (iv)
(C) (iv), (i), (iii), (ii) (D) (ii), (iv), (i), (iii)

Q-2: Pareto optimum implies

(A) A resource allocation for which a Pareto improvement is possible.
(B) A resource allocation in which social improvement is possible.
(C) A resource allocation for which atleast one is better off and no body is worse off.
(D) A resource allocation for which there are no Pareto improvements.
 NTA-UGC-NET | PYQs
Q-3: The locus of Pareto Optimality in Production and Consumption is given by
(A) The Social Welfare Function
(B. The Utility Possibility Curve
(C) The Transformation Curve
(D) The Grand Utility Possibility Curve

Q-4: The condition of Pareto Optimality holds correct under

(A ) Perfect Competition
(B) Monopolistic Competition
(C) Oligopoly
(D) Monopoly

Q-5: The statement that, “no one can be made better off without making someone worse off”
describes which of the following ?
(1) Pareto Optimum (2) Nash Equilibrium
(3) Low level Equilibrium Trap (4) Cournot’s Equilibrium
 NTA-UGC-NET | PYQs
Q-6: Which of the following statements about Pareto Optimum are correct ?
(a) It changes with changes in the distribution of income
(b) At the Pareto optimum, MRS in consumption=MRT in production
(c) It is not unique
(d) It is obtained under perfect competition
Code :
(1) (a), (c) and (d) (2) (b) and (c)
(3 ) (a), (b) and (d) (4) (a) and (b)

Q-7:
 NTA-UGC-NET | PYQs
Q-8: The statement that, "no one can be made better off without making someone worse off describes which of the
following?
A. Pareto Optimum
B. Nash Equilibrium
C. Low level Equilibrium Trap
D. Cournot's Equilibrium

Q-9: Pareto optimality in production is gained in which of the following conditions?

 NTA-UGC-NET | PYQs

Q-10: Assertion (A): Pareto optimality criterion cannot be used alone to measure welfare level of the people.
Reason (R): The concept Pareto optimality fails in case of externalities, public goods and missing markets.

A. Both (A) and (R) are true and (R) is the correct explanation of (A).
B. Both (A) and (R) are true and (R) is not the correct explanation of (A)
C. (A) is true, (R) is false.
D. (R) is true, (A) is false.
 Lecture-23: Kaldor-Hicks Compensation
Criteria, Scitovsky Double Criterion, Williams
Gorman Intransitivity Issue
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
Recall the concerned segment from Pareto Optimality Criterion!
Important Point
Not only we fail to compare two points on the contract curve say like D and C, we also fail to compare point E and C.
We can’t say whether the welfare will improve or deteriorate if move from point E to C. Moving from E to C, utility
of A increases, while utility of B reduces. Thus, it should be noted that a movement from a point off the contract
curve to a point on the contract curve can’t be evaluated on the basis of Pareto Criterion.
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
Recall the concerned segment from Pareto Optimality Criterion!
Important Point
Not only we fail to compare two points on the contract curve say like D and C, we also fail to compare point E and C.
We can’t say whether the welfare will improve or deteriorate if move from point E to C. Moving from E to C, utility
of A increases, while utility of B reduces. Thus, it should be noted that a movement from a point off the contract
curve to a point on the contract curve can’t be evaluated on the basis of Pareto Criterion.
In the Pareto Criterion, total welfare increases if the utility of one
consumer increases but the utility of the second consumer is not
falling. Thus, in the above figure, we can’t say whether the total
social welfare increases or not when we move along the contract
curve i.e. we can’t compare the following movements:
• E→C
• D → C or C → D
Another limitation of Pareto Criterion was that it ignored the
interpersonal utility comparison.
Both these limitations of Pareto Criterion can be overcome by
resorting Kaldor-Hicks-Scitovsky compensation criterion.
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
In this criterion, the problems of production and exchange are separated from the problem of distribution.
Kaldor was the first person to devise a compensation principle which states that a change is an improvement if those who
gain evaluate their gains at a higher amount than the value which the losers set upon their losses. In simple words, a
situation B is socially preferrable to situation A, if those who gain from B can compensated the losers and still be at a better
position than their original position before the rearrangement i.e. situation A. In such a case, the total society welfare
increases when we move from situation A to situation B.
This concept of welfare is potential or hypothetical welfare and not the actual welfare.
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
In this criterion, the problems of production and exchange are separated from the problem of distribution.
Kaldor was the first person to devise a compensation principle which states that a change is an improvement if those who
gain evaluate their gains at a higher amount than the value which the losers set upon their losses. In simple words, a
situation B is socially preferrable to situation A, if those who gain from B can compensated the losers and still be at a better
position than their original position before the rearrangement i.e. situation A. In such a case, the total society welfare
increases when we move from situation A to situation B.
This concept of welfare is potential or hypothetical welfare and not the actual welfare.
As per Hicks, he used the concept of bribery as against to compensation by the winners (by Kaldor). He mentioned that an
allocation would be preferable to another, if the losers fail to bribe enough to the gainers from not undertaking the change.
He mentioned that situation B is socially preferrable to situation A if the losers at situation B cannot profitably bribe the
gainers and/or the gainers did not accept the bribe and undertake the rearrangement from situation A to situation B.
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
The curve DE represents the utility possibility curve, which indicates the locus of Pareto
Optimality in Production and Consumption. Let P be a point inside the UPC. Due to some
policy change, the two individuals move from point P to point on UPF. Due to this, the
utility of first individual increases while that of the other has reduced. Hence, using Pareto
Criterion, we could not say that movement from P to Q has led to increase in total utility or
welfare.
Let’s now follow K-H criterion. We have moved from point P to Q, now due to some
rearrangement if the individuals can move from Q towards to the right of P say at R, S, or T,
then due to such redistribution of the goods, utility of one increases while that of the other’s
is either increasing (like at T) or remaining same (like at R and S). Thus, the movement from
P to Q is desirable because from Q we can reach the point R or S or T using redistribution
which indicates higher total utility than initial point P.
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
K-H Criterion using Edgeworth Box
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
K-H Criterion using Edgeworth Box
• Initial point is E and we want to move to C.
• A is getting to higher IC at C and B loses as it reaches a lower
IC. But as per Pareto Optimality condition, this is not
possible, because it is a pareto inefficient move, as B is worse
off and A is better off.
• But as K-H, it is possible. If A can pay a portion of his gains
to B, so much that B retains his old utility level at E, then it is
possible.
• Let say A pays Xc-Xf amount of good X to B. With this, B
moves to a higher IC, which is actually his older IC and he is
enjoying the same utility level. On other hand, A is still better
off, as he is at higher IC compared to point E and making a
net gain of OXe – (Oxc – Oxf) + amount of good Y gained.
• Thus, as per Kaldor, we can compare the two Pareto
Incomparable points through HYPOTHETICAL
COMPENSATION TEST.
• Thus, an allocation is preferable to another, if it is possible to
hypothetically redistribute goods so that a Pareto
Improvement Occurs.
 NTA-UGC-NET | Kaldor Hicks Compensation Principle
Important Point!
Using K-H criterion, we have overcome one of the limitations of Pareto Optimality Criterion, whereby we can’t
compare point F and C, i.e. points on contract curve. But still Pareto sub-optimal points can’t be compared with
Pareto optimal points (with K-H theory). That is to say that we still can’t compare point E to C
 Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
• He pointed out an important limitation of K-H criterion which led to contradictory results.
• He mentioned that if at some instance- situation B is shown to be an improvement over another situation A by K-H
criterion, then it should be possible to show A as an improvement over B situation basis upon the same criterion.
 Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
• He pointed out an important limitation of K-H criterion which led to contradictory results.
• He mentioned that if at some instance- situation B is shown to be an improvement over another situation A by K-H
criterion, then it should be possible to show A as an improvement over B situation basis upon the same criterion.
• According to K-H test, the movement from P to Q is desirable as by redistribution we can move from Q to S, which is
north-east to P. Through redistribution the gainers can compensate the losers and can remain better off. Hence, the
movement from P to Q represents an improvement in social welfare as per K-H criteria.
• Now, consider the reverse movement from Q to P.
BY redistribution at P, we can reach the point R which is pareto superior
to Q. This means that the movement from Q to P also represents an
increase in social welfare. And the return movement from Q to P also
represents an increase in social welfare. This is paradox, if the two
utility possibility curves intersects and if the intersection point lies in
between the two points as we have discussed
 Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
• In order to avoid this contradiction, Scitovsky suggested a double criterion which requires fulfilment of the original K-
H test plus the non-fulfillment of reversal test.
• In other words, a movement from P to Q is an improvement only when it is an improvement on the basic of K-H
criterion and a change back from Q to P is not desirable according to same criteria.
• In other words, Scitovsky double test will be satisfied if the gainers can profitably bribe the losers into accepting the
change and the losers cannot profitably bribe the gainers into rejecting it.
 Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
Scitovsky Reversals and Double Criteria [Tibor Scitovsky]
• The double criteria Is satisfied if the two UPCs passing
through P and Q donot intersects at all or if the two points P
and Q lie either to the left or to the right of the point of
intersection of the UPFs.
• Suppose we move from P to Q. The UPF through Q pass
through the north-east of P. Through redistribution at Q, it is
possible to reach the point which is pareto-superior to P.
Hence, the movement from P to Q indicates an increase in
welfare. Now consider the return movement from Q to P.
The UPF through P passes through the south-west of Q.
This means that it si not possible to redistribute at P and
reach a point which is Pareto Superior to Q.
• This means that the movement from P to Q represents an
increase in welfare and the return movement from Q to P
does not indicate an increase in social welfare. Hence
Scitovsky doubtle criterion is satisfied and it can be said that
the movement from P to Q represents an increase in social
welfare.
 William Gorman’s Intransitivity Problem
William Gorman’s Intransitivity Problem
• He mentioned that Scitovsky double criteria even if rules out
the paradox, but it can’t rule the case of intransitive chains.
• He criticized Scitovsky’s double criterion in the manner that
the double criterion can avoid contradictory results only when
the choice is to be made from two positions. It does not help
A
if the choice of a position is to be made from among more
than two possible positions.
• G is preferred to allocation D, allocation D is preferred to B
allocation F but allocation F is not preferred to allocation G.
• We have three PPFs (PPFD, PPFF and PPFG) and three CICs
corresponding to the Pareto-optimal allocations on each PPF
• D is superior to F by the Scitovsky double criteria because D
is better than F by both the Kaldor and Hicks criteria (notice
that CICD does not intersect PPFF while CICF intersects
PPFD).
 William Gorman’s Intransitivity Problem
William Gorman’s Intransitivity Problem
• As noted, by the double criteria, D is preferred to F. By the
same double criteria, G is preferred to D (as CICD intersects
PPFG but CICG does not intersect PPFD).
• But G and D do not fulfill the double criteria (as CICF
intersects PPFG and CICG intersects PPFF. Thus, by the
A
Scitovsky double criteria, G is preferred to D, D is preferred
to F but G is not preferred to F. Thus although the Scitovsky
double criteria rules out ranking reversals (note that
B
although G is not preferred to F, F is also not preferred to G
- they are merely incomparable), the ranking is intransitive.
• Consider G, > D, D > F, but F is not > G
• Thus intranstitive
 Little’s Criterion
Little’s Criterion:
Dr. Little has developed a reaction against the compensation criteria proposed by Kaldor, Hicks and Scitovsky. Little
asserts that neither the Kaldor-Hicks test nor the Scitovsky double test, either alone or together, can possibly be taken as a
criterion of welfare.
Little’s criterion stated that “An economic change constitutes social improvement:
(a) if the resulting redistribution is no worse than the old and
(b) if it is impossible to make the community as well off in the initial position as it would be after the change.
 Samuelson’s Criterion
Samuelson’s Criteria
• He further pointed out a fundamental problem in Scitovsky’s criteria. He mentioned that the Scitovsky’s criterion is
satisfied if the UPC in one situation lies abut the UPC of the other situation in the neighbourhood of both the actual and
observed points.
• Samuelson stated that what is required for consistent results is that the new UPC after the change should be always
must lie outside the old UPC. This implies that every welfare position attainable before the change must be attainable
after the change together with at least one position which was not attainable before. This is termed as Samuelson
Criterion.
•
 Samuelson’s Criterion
Samuelson’s Criteria
• He argues that G is preferred to D, if all hypothetical
redistribution from G will achieve utility allocations
that are superior to some hypothetical redistributions
from situation D and that no hypothetical redistribution
from situation D will yield utility allocations that are
unattainable through any hypothetical redistributions
from situation G.
• In other words, the utility space lies everywhere above
UPFD. In production space, it requires that PPFG
intersects the interiors of CICD and the interior of any
other CIC tangent to PPFD. Clearly, this will often
require that PPFG lies everywhere above PPFD.
• Naturally, if we deal exclusively with PPFs of this type,
neither Scitovsky reversals nor Gorman intransitivities
arise. But it also obviously highly restrictive as it rules
out quite reasonable situations. Thus, in this sense, the
Samuelson criterion is far more restrictive than the
Kaldor, Hicks or Scitovsky double criteria.
 NTA-UGC-NET | Pareto Optimality- SOC
First Fundamental Theorem of Welfare Economics: An equilibrium achieved by a competitive market will be Pareto
efficient. The first states that in economic equilibrium, a set of complete markets, with complete information, and in perfect
competition, will be Pareto optimal (in the sense that no further exchange would make one person better off without making
another worse off). The requirements for perfect competition are these:
• There are no externalities and each actor has perfect information.
• Firms and consumers take prices as given (no economic actor or group of actors has market power).
The theorem is sometimes seen as an analytical confirmation of Adam Smith's "invisible hand" principle, namely that
competitive markets ensure an efficient allocation of resources. However, there is no guarantee that the Pareto optimal
market outcome is socially desirable, as there are many possible Pareto efficient allocations of resources differing in their
desirability (e.g. one person may own everything and everyone else nothing)
Definitions:
i) x is the allocation of goods to all traders in the economy - x is a matrix with two dimensions: quantity of good and
amount allocated to each trader
ii) p is a vector of prices for each good
First Fundamental Theorem of Welfare Economics. If all traders have monotonic selfish utility functions, and if (x,p)
is a competitive equilibrium, then x is in the core, and is therefore Pareto optimal as well.
 NTA-UGC-NET | Pareto Optimality- SOC
Implications of First Fundamental Theorem:
• A private market that is competitive will result in Pareto efficiency - all gains from trade will be exhausted.
• A competitive market is a benchmark by which policy-makers can judge actual market outcomes.
• This theorem assumes that there are no market imperfections such as monopoly, externalities and public goods

The First and Second Welfare Theorems were proved graphically by Abba Lerner (1934) and mathematically by
Harold Hotelling (1938), Oskar Lange (1942) and Maurice Allais.
 NTA-UGC-NET | Pareto Optimality- SOC
Second Fundamental Theorem of Welfare Economics
The second theorem of welfare economics has certain advantages over first theorem of welfare economics. It explains that if
all consumers have convex preferences and all firms have convex production possibility sets then Pareto efficient allocation
can be achieved. The equilibrium of a complete set of competitive markets are suitable for redistribution of initial
endowments.
The second theorem states that any Pareto optimum can be supported as a competitive equilibrium for some initial set of
endowments. The implication is that any desired Pareto optimal outcome can be supported; Pareto efficiency can be achieved
with any redistribution of initial wealth. However, attempts to correct the distribution may introduce distortions, and so full
optimality may not be attainable with redistribution
There exists a vector of bank balance transfers (T1, T2, ...,Tn) and a price vector p = (p1, p2, ...,pm) such that y and p are a
competitive equilibrium given the transfers.

The Second Welfare Theorem: Any Pareto-optimal allocation fulfills the three conditions. Thus, assuming differentiability,
we can place price lines with slope px/py between the indifference curves so that MRSAxy = px/py = MRSBxy . Further, we
can place the same price line with the same slope between the CIC and the PPF so that MRSAxy = px/py MRPTxy are on the
PPF (by production efficiency), and then we can place a factor price line with slope r/w between the isoquants of the
production Edgeworth-Bowley box so that MRTSXKL = MRTSYKL
 NTA-UGC-NET | Pareto Optimality- SOC
Difference between First and Second Welfare Theorems
• The main difference between first and second fundamental theory is all about economic efficiency and
distribution of the initial wealth(endowment).
• On first theory believe on perfect competition and situation which does not exist in real world situation to
bring about pareto optimum, where its difficulties comes on suitability to society(welfare) because such
situation doesn’t prevent one from owning everything leaving vacuum to the rest.
• Second theorem complemented the weakness of the first, it began where first theorem ended. As it states,
after suitable distribution of initial endowment, pareto efficiency can be archived at any level under a perfect
situation.
 NTA-UGC-NET | Pareto Optimality- SOC
Difference between First and Second Welfare Theorems
The Second Theorem states that any allocation that is pareto efficient (so that society would not find another
allocation that is unanimously better) can be the outcome of an anonymous market, provided that the initial
endowment is chosen in a certain way. One way in which the endowment may be chosen is by redistributing
consumption claims across individuals via lump-sum transfers.
This theorem was wrongly believed to imply that socialist economies could obtain Pareto-efficient outcomes by
redistributing initial resources and introducing (restrictive) markets. These ideas were held by Oskar Lange and
others in a school of thought called 'market socialism'. The problem is that the only way in which redistribution
may occur is via lump-sum transfers, which severely restricts the ability to accomplish other desirable social
outcomes (like fairness or equality).
Lecture-24: Concept of Decision-Making
under Uncertainty & Risk Analysis
Unit-1: Microeconomics

NTA-UGC-NET
Economics (Paper-2)
 Concept of Decision-Making Environment
• Let’s distinguish between Certainty, Risk and Uncertainty. The difference is drawn on the basis of
the degree of knowledge or information possessed by the decision-maker.
• Certainty is a state in which the decision-maker possesses complete and perfect knowledge
regarding the impact of all of the available alternatives
• Risk and Uncertainty→ Lack of certainty
• Risk is a state in which the decision maker has only imperfect knowledge and incomplete
information but is still able to assign probability estimates to the possible outcomes of a decision.
• By estimates, we means subjective judgements or mathematically derive from probability
distribution
• Uncertainty is a state in which decision maker does not have even the information to make
subjective probability assessments
• As per Frank Knight (first one to distinct between risk and uncertainty:
• Also, risk can be measured or countable but uncertainty can’t be quantifiable
Concept of Decision-Making Environment
• There are two approaches to estimate the probabilities of decisions
✓ Priori (Deductive): Maker can derive probability estimates without carrying out any
real world experiment or analysis. For example tossing a coin, where, the prob. Of
each outcome is pre-determined.
✓ Posterior (Inductive) based upon statistical analysis of data: This method is based on
past experience, which forms the assumptions and acts as true representative to future.
For example, an insurance company knows that it is very unlikely that a 25 years lad
will die his natural death
• Uncertainty does not seem to suggest that the decision-maker does not have any
knowledge. Instead it implies that there is no logical or consistent approach to
assignment of probabilities to the possible outcomes
 Concept of Decision-Making Environment
Decision making under Different Conditions
There are four conditions under which decisions are taken:
A) Certainty B) Risk C) Uncertainty D) Conflict

A. Decision making under Certainty: Certainty implies a situation in which the decision maker knows without any doubt
what will happen. For example, suppose there is a consumer who is consuming two goods, say bread and butter. He is a
rational consumer and aims at maximisation of his/her utility. Given the prices, tastes and preference, s/he can use
differential calculus to ascertain utility maximising quantities of both the goods.

B. Decision making under Risk: Risk implies a situation when the probabilities of occurrence of different events are
unknown. In case of risk, we have incomplete or some information (from past experiences) about the events and risks
associated with each alternatives, the likelihood and consequences of each alternative and likelihood of success. It is this
likelihood or probability of each of the options that a manager needs to take into account and apply experience,
expertise, and gut feeling to the process of decision-making.
 Concept of Decision-Making Environment
Decision making under Different Conditions
There are four conditions under which decisions are taken:
A) Certainty B) Risk C) Uncertainty D) Conflict

C. Decision making under Uncertainty: In decision making under pure uncertainty, the decision maker has no knowledge
regarding any of the states of nature outcomes, and/or it is costly to obtain the needed information. In such cases, the
decision making depends merely on the decision maker's personality type. Thus, in case of uncertainty, it is not possible
to determine the probabilities of different events. In this case, it is generally assumed that the decision maker at least
knows the different events but the associated probabilities is not known to him.
D. Decision making under Conflict: Conflict implies a situation when the decision maker has an opponent who will
always act to harm the decision maker. The occurrence of an event depends upon the reaction of the opponent. While in
cases of risk and uncertainty, the opponent is silent, whereas, in case of conflict, the opponent is active. Each opponent
does not know what strategy will be adopted by the rival. This kind of problem can be solved using Game Theory.
NTA-UGC-NET | Decision Making- Uncertainty
Concept of Decision-Making Environment under Uncertainty
Four major criteria that are based on pay-off matrix
1. Maximin (Wald)
2. Maximax
3. Hurwicz Alpha Index
4. Minimax Regret (Savage)
5. Laplace Criterion
 NTA-UGC-NET | Decision Making- Uncertainty
Maximin (Wald)/ Criterion of Pessimism
Maximin implies the • It is based on the belief that nature is unkind and that the decision-maker
maximisation of minimum payoff. therefore should determine the worst possible outcome for each of the
The pessimistic decision-maker actions and select the one yielding the best of the worst (maximin) results.
locates the minimum payoff for That is, the decision-maker should choose the best of the worst.
each possible course of action.
• Let there be a situation in which a decision-maker has three possible alternatives
The maximum of these minimum A , A and A , where the outcome of each of them can be affected by the
payoffs is identified and the 1 2 3
occurrence of any one of the four possible events S1, S2, S3 and S4. The monetary
corresponding course of action is
selected payoffs of each combination of Ai and Sj are given in the following table:
 NTA-UGC-NET | Decision Making- Uncertainty
Maximin (Wald)/ Criterion of Pessimism
Maximin implies the • It is based on the belief that nature is unkind and that the decision-maker
maximisation of minimum payoff. therefore should determine the worst possible outcome for each of the
The pessimistic decision-maker actions and select the one yielding the best of the worst (maximin) results.
locates the minimum payoff for That is, the decision-maker should choose the best of the worst.
each possible course of action.
• Let there be a situation in which a decision-maker has three possible alternatives
The maximum of these minimum A , A and A , where the outcome of each of them can be affected by the
payoffs is identified and the 1 2 3
occurrence of any one of the four possible events S1, S2, S3 and S4. The monetary
corresponding course of action is
selected payoffs of each combination of Ai and Sj are given in the following table:
 NTA-UGC-NET | Decision Making- Uncertainty
Maximin (Wald)/ Criterion of Pessimism
Maximin implies the • It is based on the belief that nature is unkind and that the decision-maker
maximisation of minimum payoff. therefore should determine the worst possible outcome for each of the
The pessimistic decision-maker actions and select the one yielding the best of the worst (maximin) results.
locates the minimum payoff for That is, the decision-maker should choose the best of the worst.
each possible course of action.
• Let there be a situation in which a decision-maker has three possible alternatives
The maximum of these minimum A , A and A , where the outcome of each of them can be affected by the
payoffs is identified and the 1 2 3
occurrence of any one of the four possible events S1, S2, S3 and S4. The monetary
corresponding course of action is
selected payoffs of each combination of Ai and Sj are given in the following table:

Solution: Since 17 is maximum out of the minimum payoffs, the optimal action is
A2.
 NTA-UGC-NET | Decision Making- Uncertainty
Maximax Criterion / Criterion of Optimism
Maximax implies the • This criterion, also known as the criterion of optimism, is used when the
maximisation of maximum decision-maker is optimistic about future.
payoff. The optimistic decision-
maker locates the maximum
payoff for each possible course of
action. The maximum of these
payoffs is identified and the
corresponding course of action is
selected.
 NTA-UGC-NET | Decision Making- Uncertainty
Maximax Criterion / Criterion of Optimism
Maximax implies the • This criterion, also known as the criterion of optimism, is used when the
maximisation of maximum decision-maker is optimistic about future.
payoff. The optimistic decision-
maker locates the maximum
payoff for each possible course of
action. The maximum of these
payoffs is identified and the
corresponding course of action is
selected.

Solution: The optimal course of action in the above example, based on this
criterion, is A3.
 NTA-UGC-NET | Decision Making- Uncertainty
Regret Criterion/Minimax Criteria
Regret is defined as the difference • This criterion focuses upon the regret that the decision-maker might have
between the best payoff we could from selecting a particular course of action. This difference, which
have realised, had he knew which measures the magnitude of the loss incurred by not selecting the best
state of nature was going to occur alternative, is also known as opportunity loss or the opportunity cost.
and the realised payoff.
• The regret criterion is based upon the minimax principle, i.e., the decision-
maker tries to minimise the maximum regret. Thus, the decision-maker
selects the maximum regret for each of the actions and out of these the
action which corresponds to the minimum regret is regarded as optimal.
 NTA-UGC-NET | Decision Making- Uncertainty
Regret Criterion / Minimax Criteria
Regret is defined as the difference • This criterion focuses upon the regret that the decision-maker might have
between the best payoff we could from selecting a particular course of action. This difference, which
have realised, had he knew which measures the magnitude of the loss incurred by not selecting the best
state of nature was going to occur alternative, is also known as opportunity loss or the opportunity cost.
and the realised payoff.
• The regret criterion is based upon the minimax principle, i.e., the decision-
maker tries to minimise the maximum regret. Thus, the decision-maker
selects the maximum regret for each of the actions and out of these the
action which corresponds to the minimum regret is regarded as optimal.

The regret corresponding to the course of action is A3 is minimum.

Hence, A3 is optimal.
NTA-UGC-NET | Decision Making- Uncertainty
Hurwicz Criterion
• The maximax and the maximin criteria, assumes that the decision-maker is either optimistic or
pessimistic.
• A more realistic approach would, be to consider the degree or index of
optimism or pessimism of the decision-maker in the process of decision-making.
• If ‘a’, is a constant lying between 0 and 1, denotes the degree of optimism, then the degree of
pessimism will be 1 - a.
• Then a weighted average of the maximum and minimum payoffs of an action, with a and 1 -
a as respective weights, is computed.
• The action with highest average is regarded as optimal.
• We note that a nearer to unity indicates that the decision-maker is optimistic while a value
nearer to zero indicates that he is pessimistic. If a = 0.5, the decision maker is said to be
neutralist.
• We apply this criterion to the payoff matrix. Assume that the index of optimism a = 0.7.
NTA-UGC-NET | Decision Making- Uncertainty
Hurwicz Criterion
• The maximax and the maximin criteria, assumes that the decision-maker is either optimistic or
pessimistic.
• A more realistic approach would, be to consider the degree or index of
optimism or pessimism of the decision-maker in the process of decision-making.
• If ‘a’, is a constant lying between 0 and 1, denotes the degree of optimism, then the degree of
pessimism will be 1 - a.
• Then a weighted average of the maximum and minimum payoffs of an action, with a and 1 -
a as respective weights, is computed.
• The action with highest average is regarded as optimal.
• We note that a nearer to unity indicates that the decision-maker is optimistic while a value
nearer to zero indicates that he is pessimistic. If a = 0.5, the decision maker is said to be
neutralist.
• We apply this criterion to the payoff matrix. Assume that the index of optimism a = 0.7.

Since the average for A3 is

maximum, it is optimal
NTA-UGC-NET | Decision Making- Uncertainty
Laplace Criterion
• This criterion is used when we have absence of any knowledge about the probabilities of
occurrence of various states of nature.

• As per this criterion, we assume that all of them are equally likely to occur. So, if there are n
states of nature, each can be assigned a probability of occurrence = 1/n.

• Using these probabilities, we compute the expected payoff for each course of action and the
action with maximum expected value is regarded as optimal
 Risk Analysis & Uncertainty Choices
Uncertainty Choices
• When we need to make choices for future and those choices are subject to happening of some events which are
uncertain.
• Income level fluctuates, price may undergo revisions, health conditions may get worsen, etc. because of all these,
there always exists a risk that our assumptions and plans and choices made for future may not materialise.

Expected Value:
The expected value associated with an uncertain situation is a weighted average of the payoffs or values associated with
all possible outcomes. The probabilities of each outcome are used as weights. Thus the expected value measures the
central tendency—the payoff or value that we would expect on average.
Suppose a coin is tossed once. If head turns up, then it is regarded as a success which will yield the gambler Rs 40, if tail
turns up, then it is regarded as a failure and the gambler is penalized by paying Rs 20.
Expected value = Prob (success) (Rs 40) + Prob (failure) (Rs 20)
= (1/2) (Rs40) + (1/2) (-Rs20) = 10
NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Q-1 GATE 2021
 Risk Analysis & Uncertainty Choices
Variability:
Variability is the extent to which the possible outcomes of an uncertain situation differ. To see why variability is
important, suppose you are choosing between two part-time summer sales jobs that have the same expected income (Rs
1500).
• The first job is based entirely on commission—the income earned depends on how much you sell. There are two
equally likely payoffs for this job: Rs 2000 for a successful sales effort and Rs 1000 for one that is less successful.
• The second job is salaried. It is very likely (.99 probability) that you will earn $1510, but there is a .01 probability
that the company will go out of business, in which case you would earn only $510 in severance pay.
 Risk Analysis & Uncertainty Choices
Variability:
Variability is the extent to which the possible outcomes of an uncertain situation differ. To see why variability is
important, suppose you are choosing between two part-time summer sales jobs that have the same expected income (Rs
1500).
• The first job is based entirely on commission—the income earned depends on how much you sell. There are two
equally likely payoffs for this job: Rs 2000 for a successful sales effort and Rs 1000 for one that is less successful.
• The second job is salaried. It is very likely (.99 probability) that you will earn $1510, but there is a .01 probability
that the company will go out of business, in which case you would earn only $510 in severance pay.
For Job 1, expected income is 0.5(Rs 2000) + 0.5(Rs 1000) = Rs 1500;
for Job 2, it is 0.99(Rs 1510) + .01(Rs 510) = Rs 1500. However, the variability of the possible payoffs is different.
 Risk Analysis & Uncertainty Choices
Variability:
Variability is the extent to which the possible outcomes of an uncertain situation differ. To see why variability is
important, suppose you are choosing between two part-time summer sales jobs that have the same expected income (Rs
1500).
• The first job is based entirely on commission—the income earned depends on how much you sell. There are two
equally likely payoffs for this job: Rs 2000 for a successful sales effort and Rs 1000 for one that is less successful.
• The second job is salaried. It is very likely (.99 probability) that you will earn $1510, but there is a .01 probability
that the company will go out of business, in which case you would earn only $510 in severance pay.
For Job 1, expected income is 0.5(Rs 2000) + 0.5(Rs 1000) = Rs 1500;
for Job 2, it is 0.99(Rs 1510) + .01(Rs 510) = Rs 1500. However, the variability of the possible payoffs is different.

We measure variability by recognizing that large differences between actual and expected payoffs (whether positive or
negative) imply greater risk. We call these differences as deviations.
 Risk Analysis & Uncertainty Choices
We measure variability by calculating the standard deviation: the square root of the average of the squares of the
deviations of the payoffs associated with each outcome from their expected values.
 Risk Analysis & Uncertainty Choices
We measure variability by calculating the standard deviation: the square root of the average of the squares of the
deviations of the payoffs associated with each outcome from their expected values.

Note that the average of the squared deviations under Job 1 is given by .5(Rs 250,000) + .5(Rs 250,000) = Rs 250,000.
The standard deviation is therefore equal to the square root of Rs 250,000, or Rs 500. Likewise, the probability-weighted
average of the squared deviations under Job 2 is .99(Rs 100) + .01(Rs 980,100) = Rs 9900
The standard deviation is the square root of Rs 9900, or Rs 99.50. Thus the second job is much less risky than the first;
the standard deviation of the incomes is much lower. The concept of standard deviation applies equally well when there
are many outcomes rather than just two. Suppose, for example, that the first summer job yields incomes ranging from Rs
1000 to Rs 2000 in increments of Rs 100 that are all equally likely. The second job yields incomes from Rs 1300 to Rs
1700 that are also equally likely.
 Risk Analysis & Uncertainty Choices

New Case: The two jobs can now be described as follows:

Job 1: Expected Income : Rs 1600 Standard Deviation Rs 500
Job 2: Expected Income: Rs 1500 Standard Deviation Rs 99.50
Job 1 offers a higher expected income but is much riskier than Job 2. Which job is preferred depends on the individual.
While an aggressive entrepreneur who doesn’t mind taking risks might choose Job 1, with the higher expected income
and higher standard deviation, a more conservative person might choose the second job.
 NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Behaviour Under Uncertainty: (3 observations of people behaviour)
• They do not want to play actuarially fair games
• They won’t necessarily play actuarially favourable games
• They would not pay large amounts of money to play gambles with huge upside potentials

Example- C and P play a game of tossing a coin only once. If head turns up, then C would pay Re 1 to P
and vice-versa, P would pay Re 1 to C if tail turns up.
For C, X1 (head) -> -1 (lost to P) | X2 (tail) -> +1 (wins)
For P, X1 (head) -> -1 (lost to C) | X2 (tail) -> +1 (wins)
Expected Value of this game is
1 1
1 1
X1 + X 2 = (1) + (−1) = 0
2 2 2 2
 NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Uncertainty Choices
Example- C and P play a game of tossing a coin only once. If head turns up, then C would pay Re 1 to P
and vice-versa, P would pay Re 1 to C if tail turns up.
For C, X1 (head) -> -1 (lost to P) | X2 (tail) -> +1 (wins)
For P, X1 (head) -> -1 (lost to C) | X2 (tail) -> +1 (wins)
Expected Value of this game is 1 1 1 1
X1 + X2 = (1) + (−1) = 0
2 2 2 2
Now, suppose that X1 = 10 & X2= 1,
1 1 1 1

X +
 
X = (10) + (−1) = 4.50
1 2
2 2 2 2
When this game is played large number of times, then P would be a definite gainer. Indeed he can use
some of his gains to attract C to play this game. But, she might decline this offer, as he has to undertake a
lot of risks.

This is called an actuarially fair game, which was formalised by St. Petersburg Paradox, which mentions
that people often avoid playing games with bigger risk even if the game is a fair game.
NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Solution to St. Petersburg Paradox
It is argued that people attached negative 'utility value' to expected 'monetary
value'. Because:
Utility  𝑙𝑒𝑠𝑠 𝑟𝑎𝑝𝑖𝑑𝑙𝑦 𝑡ℎ𝑎𝑛 𝑚𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑖𝑧𝑒𝑠 𝑎𝑛𝑑 the utility
value of the game will fall short of its monetary value.
vNM Expected Utility Theory [von Neumann and Morgenstern]

Where, U is vNM utility function | u is Bernoulli utility function | P is the

probability | L is the list of lottery
NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Expected Utility Theory & Risk Aversion
Usually, people don’t like risk. So, we are concerned with how much a consumer
would be willing to pat to avoid a fair bet (it is a lottery whose expected pay off
Is equal to 0). That means, one either lose money or gain by playing such games.
We are trying to measure the aversion to such type of risks.
With the help of Jensen’s Inequality, we can study the nature of the curve drawn
for vNM Expected Utility function.
NTA-UGC-NET | Risk Analysis & Uncertainty Choices
 NTA-UG C-NET | Risk Analysis & Uncertainty Choices

• Risk averse: Condition of preferring

a certain income to a risky income
with the same expected value
• Risk neutral: Condition of being
indifferent between a certain income
and an uncertain income with the
same expected value.
• Risk loving: Condition of preferring
a risky income to a certain income
with the same expected value.
 NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Example-1: Let an individual faces a gamble with the following choices. He wins Rs 100 with 80% chance else wins Rs 36
with 20% chance. His utility function is given as:
U (I ) = I, where, I represents income
Calculate:
• Expected Value of the Game or Expected Income EV
• Expected Utility E(U)
• Utility of Expected Value U(EV)
• Certainty Equivalents
• Risk Premium
 NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Example-1: Let an individual faces a gamble with the following choices. He wins Rs 100 with 80% chance else wins Rs 36
with 20% chance. His utility function is given as:
U (I ) = I, where, I represents income
Calculate:
• Expected Value of the Game or Expected Income EV
• Expected Utility E(U)
• Utility of Expected Value U(EV)
• Certainty Equivalents
• Risk Premium
 NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Example-2: Let an individual has devised a coin in such that 70% it will turn out to be head and 30% times it will turn out to be
tail. He invites you to play a gamble such that for every head, he will pay you Rs 100 and for every tail it is nothing that you
lose. Consider your utility function as:
U (I ) = I, where, I represents income
Calculate:
• Expected Value of the Game or Expected Income EV
• Expected Utility E(U)
• Utility of Expected Value U(EV)
• Certainty Equivalents
• Risk Premium
 NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Example-2: Let an individual has devised a coin in such that 70% it will turn out to be head and 30% times it will turn out to be
tail. He invites you to play a gamble such that for every head, he will pay you Rs 100 and for every tail it is nothing that you
lose. Consider your utility function as:
U (I ) = I, where, I represents income
Calculate:
• Expected Value of the Game or Expected Income EV
• Expected Utility E(U)
• Utility of Expected Value U(EV)
• Certainty Equivalents
• Risk Premium
 NTA-UGC-NET | Standard Deviation

Part (a) applies to a person who is highly risk averse: An increase in this individual’s standard deviation
of income requires a large increase in expected income if he or she is to remain equally well off. Part (b)
applies to a person who is only slightly risk averse: An increase in the standard deviation of income
requires only a small increase in expected income if he or she is to remain equally well off.
NTA-UGC-NET | Standard Deviation
 Arrow-Pratt Coefficient of Risk Aversion
Arrow-Pratt Coefficient of Risk Aversion
The measure of absolute risk aversion is given by :
U ''(M )
ra (x, u) = −
U '(M )
 Arrow-Pratt Coefficient of Risk Aversion

Absolute v/s Relative Risk-aversion

In simple terms, what we are measuring above is the actual dollar amount an individual will choose to hold in
risky assets, given a certain wealth level w. For this reason, the measure described above is referred to as a
measure of absolute risk-aversion.

If we want to measure the percentage of wealth held in risky assets, for a given wealth level w, we simply
multiply the Arrow-pratt measure of absolute risk-aversion by the wealth w, to get a measure of relative risk-
aversion, i.e.:

The Arrow-Pratt measure of relative risk-aversion is = -[w * u"(w)]/u'(w).

 Arrow-Pratt Coefficient of Risk Aversion

We can also classify the type of risk-aversion within these two main categories.
How Absolute Risk-Aversion Changes with Wealth
Type of Risk-Aversion Description Example of Bernoulli Function
As wealth increases, hold fewer
Increasing absolute risk-aversion w-cw2
dollars in risky assets
As wealth increases, hold the same
Constant absolute risk-aversion -e-cw
dollar amount in risky assets
As wealth increases, hold more
Decreasing absolute risk-aversion ln(w)
dollars in risky assets
How Relative Risk-Aversion Changes with Wealth
Type of Risk-Aversion Description Example of Bernoulli Function
As wealth increases, hold a smaller
Increasing relative risk-aversion w - cw2
percentage of wealth in risky assets
As wealth increases, hold the same
Constant relative risk-aversion ln(w)
percentage of wealth in risky assets
As wealth increases, hold a larger
Decreasing relative risk-aversion -e2w-1/2
percentage of wealth in risky assets
NTA-UGC-NET | Risk Analysis & Uncertainty Choices
Q-2 GATE 2020
Lecture-25: Types of Games, Prisoner's
Dilemma- Pure Strategy
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Game Theory
Game Theory
• Developed by Prof. John Von Neumann and Oscar Morgenstern in 1928

• Game theory is a body of knowledge that deals with making decisions when
two or more rational and intelligent opponents are involved under situations
of conflict and competition.
• The approach of game theory is to seek to determine a rival’s most profitable
counter- strategy to one’s own best moves. It helps in determining the best
course of action for a firm in view of the expected counter moves from the
competitors.
 NTA-UGC-NET | Game Theory
Assumptions

• There are finite number of competitors.

• There is conflict of interests between them.
• Each player has available with him finite courses of action.
• Players know all possible available choices but does not know which one is
going to be chosen.
• Players simultaneously select their respective courses of action.
• The payoff is fixed and determined in advance.
• Players have to make individual decisions without direct communication.
 NTA-UGC-NET | Game Theory
Classification of Games

• Two-Person Game – A game with 2 number of players.

• N-Person Game – A game with N number of players, where >2.

• Zero-Sum Game – A game in which sum of amounts won by all winners is

equal to sum of amounts lost by all losers.

• Non-Zero Sum Game – A game in which the sum of gains and losses is not
equal.

• Pure-Strategy Game – A game in which the best strategy for each player is
to play one strategy throughout the game.

• Mixed-Strategy Game – A game in which each player employs different

strategies at different times in the game.
 NTA-UGC-NET | GAME THEORY

Player-Y

Y1 Y2

Player- X
X1 (50,50) (75, 25)

X2 (25,75) (50,50)
 NTA-UGC-NET | GAME THEORY

Player-B

Y1 Y2
Moving Horizontal [For B]
Player- A
X1 (50,50) (75, 25) Fix A & move → & locate
bigger no. for B [second
X2 (25,75) (50,50) figure]
Go down, & repeat 1
Moving Vertical [For A]
1) Now, Fix B & move  &
locate bigger no. for A [first
figure]
2) Go right, and repeat 2

Nash
Equilibrium
 NTA-UGC-NET | Nash Equilibrium

B B
Left Right Left Right
A A
Top 8, 7 4, 6 Top 9, 9 2, 10
Bottom 6, 4 7, 8 Bottom 10, 0 1, 1

B B
Left Right Left Right
A A
Top 6, 8 5, 7 Top 8,6 5, 5
Bottom 8, 7 4, 9 Bottom 4, 5 6, 3

B
Left Right
A
Top -1, -1 -3, 0
Bottom 0, -3 -2, -2
 Nash Equilibrium & Dominant Strategy

B B
Left Right Left Right
A A
Top 8, 7 4, 6 Top 9, 9 2, 10
Bottom 6, 4 7, 8 Bottom 10, 0 1, 1

B B
Left Right Left Right
A A
Top 6, 8 5, 7 Top 8,6 5, 5
Bottom 8, 7 4, 9 Bottom 4, 5 6, 3

B
Left Right
A
Top -1, -1 -3, 0
Bottom 0, -3 -2, -2
 NTA-UGC-NET | Game Theory
Elements
Player-Y
• Pay off - It is the outcome of playing a game. It is the net gain, the strategy
Y1 Y2 brings to the firm for any given counter-strategy of the competitor. The net
Player- X
X1 (50,50) (75, 25) gain is measured in terms of the objective of the firm i.e., increase in profits,
X2 (25,75) (50,50)
etc.

• Pay-off Matrix – It is the table showing outcomes or pay-offs of different

strategies of the game. E.g., pay-off matrix of a two-person zero sum game.

• Rule of dominance: A strategy is called dominant if each pay-off in the

strategy is superior to each corresponding pay-off matrix

• Optimal strategy: A course of action or plan which puts the player in the
most preferred position irrespective if the strategy of his competitors, is called
an optimal strategy. Any deviation from this strategy results in a decreased
pay-off for the player.

• Value of the game: it is the expected pay –off of the play when all the
players of the game follow their optimal strategies. The game is called fair if
the value of the game is zero and unfair if it is non-zero.
 NTA-UGC-NET | Game Theory
Prisoner’s Dilemma
B

Confess Deny In order to understand prisoners’ dilemma let us suppose that there are 2 persons,
A A & B who are partners in match fixing. The CBI arrests them and lodges them
Confess (5,5) (2, 10)
in separate jails with no possibility of communication between them. They are
Deny (10,2) (0, 0)
being interrogated separated by CBI officials with. Following conditions are
disclosed to them:
• If you confess your involvement in match fixing, you will get a 5 year
imprisonment.
• If you deny your involvement and your partner denies too, you will be set
free for lack of evidence.
• If one of you confesses and turns approver, and other does not, then one who
confesses gets a 2 year imprisonment, and the other one gets 10 year
imprisonment.
Both persons have 2 options:
• To confess
• Not to confess.
But both have a common objective to minimize the period of imprisonment.
Thus, following pay-off matrix is derived
 NTA-UGC-NET | Game Theory
Prisoner’s Dilemma

• Thus, according to conditions there are many options available to them, one
being they both confess and get 5 year imprisonment as they do not know
what the other one will say. But the best they could achieve under given
situations is, they both deny and set free. This situation as a whole is called
prisoners’ dilemma.

B
Confess Deny
A
Confess (5,5) (2, 10)
Deny (10,2) (0, 0)
 NTA-UGC-NET | Game Theory
Methods of Solving 2-Person Zero-Sum Games

• In a two person game if saddle point exists it is solved using pure strategies
but in case of no saddle point, mixed strategies decide the results.

• For no saddle point, we try to reduce the size of game using dominance
rules.

• If size of game could be reduce to 2*2, we solve by assuming A’s strategies

as (p,1-p) and B as (q,1-q) and find values of p, q and value of game.

• In case of mixed strategy, if pay-off matrix is 2*n or 2*m, graphical method

is used.

• For m*n rectangular game when either m or n or both are greater than or
equal to 3, linear programming approach is used.
NTA-UGC-NET | Game Theory
Types of Strategies

A. Pure Strategy. It is the predetermined course of action to be

employed by the player. The players knew it in advance. It is
usually represented by a number with which the course of action
is associated.
B. Mixed Strategy In mixed strategy the player decides his course
of action in accordance with some fixed probability distribution.
Probability are associated with each course of action and the
selection is done as per these probabilities. In mixed strategy the
opponent can not be sure of the course of action to be taken on
any particular occasion.

Decision of a Game: In Game theory, best strategy for each player is

determined on the basis of some rule. Since both the players are
expected to be rational in their approach this is known as the criteria of
optimality. Each player lists the possible outcomes from his action and
selects the best action to achieve his objectives. This criteria of
optimality is expressed as Maximin for the maximising player and
Minimax for the minimising player.
 NTA-UGC-NET | Game Theory
B

B1 B2 Min

A A1 9 2
Find Row Minimum
A2 8 6

A3 6 4
Find Column Maximum
Col Max Ascertain Maxi Min
Ascertain Mini Max
Value of Game, where,
Maximin = MiniMax

Saddle Point
or
Optimum Point
or
Equilibrium
 NTA-UGC-NET | Game Theory
Solution of Pure Strategy Games
B

B1 B2 Min • In case of Pure Strategy game, maximizing player arrives at optimal

A A1 9 2 strategy on the basis of maximin criterion and minimizing player’s
1) Find Row Minimum
A2 8 6 strategy is based on minimax criterion. The game is solved when
A3 6 4
maximin value equals minimax val ue.2)ThisFind
value is the Maximum
Column value of game.

Col Max • 3) Ascertain

Suppose that player A starts the game knowing Maxi
fully well thatMin
whatever
strategy he adopts B will select that particular counter strategy which will
4) Ascertain Mini Max
minimise the payoff to A. If A selects the strategy Al then B will select B2
so that A may get minimum gain. Similarly5) if A chooses
Value A2 than
of Game, B will
where,
adopt the strategy of B2. Naturally A would like to maximise his maximin
gain which is just the largest of row minima,Maximin = MiniMax
which is called 'maximin
strategy'. Similarly B will minimise h is minimum loss which is called
Saddle Point
'minimax strategy’. Observe that in the above example,or the maximum if row
minima and minimum of column maxima are equal. Optimum Point
or
• Maxi [Min.] = Mini [Max] Equilibrium

• The strategies followed by both the p1ayersarecalled ‘optimum strategy’.

 NTA-UGC-NET | Game Theory
Games with Pure Strategies
B

B1 B2 Min • It is smallest value in its row and the largest value in its column. It is the
A A1 9 2 2 equilibrium point.
A2 8 6 6

A3 6 4 4
Steps to find out Saddle Point
• Select the minimum value of each row
9 6
Col Max
• Select the maximum value of each column
Minimax = Maximin = 6 = V • The value with both minimum and maximum value (intersection) is the
saddle point.

• In case there are more than one Saddle point there exist as many optimum
points or solutions of the game. There mayor may not be the saddle point in
the game. When there is no saddle point we have to use algebraic methods
for working out the solutions concerning the game problem.

• The value of game may be +ve or -ve.

• The value of game may be zero which means 'fair game'.

NTA-UGC-NET | Game Theory
Principle of Dominance

• It states that if the strategy of a player dominates over the other strategy
in all condition, the later strategy can be ignored because it will not affect
the solution in any way. A strategy dominates over other only if it is
preferable over other in all conditions.

Rules
• If all the elements in a row of a pay-off matrix are less than or equal to
the corresponding elements of other row then the player A will never
choose that strategy. So, former strategy is dominated by latter strategy.

• If all elements in a column in a pay-off matrix are greater than or equal to

the corresponding elements of other column then B will never choose that
column or former strategy is dominated by latter strategy.

• A Pure Strategy may be dominated if it is inferior to average of two or

more other pure strategies.
 NTA-UGC-NET | Game Theory
Identify the nature of the game and Locate the saddle point
B Row
Min
15 12
A
5 14
Col
Max
 NTA-UGC-NET | Game Theory
Identify the nature of the game and Locate the saddle point
B B B Row Diff erence
Difference Prob
AA Min 12
1515 12 14-5=9 P1= 9/12 = 3/4
15 5 12
5 14 14 15-12=3 P2= 3/12=1/4
A
Difference5
Difference 14
12
ColD ifference
14-12=2 15-5=10 12
Max Q1= 2/12 Q2= 10/12
Prob
=1/6 = 5/16
 NTA-UGC-NET | Game Theory
Identify the nature of the game and Locate the saddle point
B B B Row Diff erence
Difference Prob
AA Min 12
1515 12 14-5=9 P1= 9/12 = 3/4
15 5 12
5 14 14 15-12=3 P2= 3/12=1/4
A
Difference5
Difference 14
12
ColD ifference
14-12=2 15-5=10 12
Max Q1= 2/12 Q2= 10/12
Prob
=1/6 = 5/16
NTA-UGC-NET | Game Theory
Question-1: Under non-cooperative games, it is:
• Essential to understand one’s opponent’s point of view
• Not essential to understand one’s opponent’s point of view
• Essential to understand one’s opponent’s point of view and to deduce the
likely responses accordingly
• Essential to understand one’s opponent’s likely responses

Question-2: Consider the matrix of pay-offs for two firms “X” and “Y”.
What should be the strategies of firm X and Y?
a. Firm Y should advertise and X should not
b. Firm X should advertise and Y should not
c. Both X and Y should advertise.
d. None should advertise
 NTA-UGC-NET | Game Theory
Question-3:
 NTA-UGC-NET | Game Theory
Question-4: Consider the following matrix which describes the respective strategies and the
corresponding pay-offs of firms A and B operating in a duopoly:

Which of the following statement(s) is/are true for the above game? Select the correct
answer from the codes given below:
a. Firm A has no dominant strategy.
b. Firm B has a dominant strategy.
c. The game has a Nash equilibrium.
d. Neither Firm A nor Firm B has a dominant strategy.
Code:
A. (a), (c)
B. (b), (c)
C. (d) Only
D. (a), (b) and (c)
 NTA-UGC-NET | Game Theory
Question-4: IIFT PhD Entrance
2019
 NTA-UGC-NET | Game Theory
Question-4: IIFT PhD Entrance
2019
 NTA-UGC-NET | GAME THEORY
Q-4: Firm A increase its advertisement and firm B responds by increasing its
advertisement if profits of both firms increase. them firms A and B are engaged in?
a) zero-sum game
b) positive- sum game
c) negative sum game
d) behaviour which cannot be understood in terms of game
NTA-UGC-NET | GAME THEORY
 NTA-UGC-NET | Kal ki Class

Identify the nature of the game and Locate the saddle point
H M L
H. 60,60 36,70 36,35
M. 70,36 50,50 30,35
L. 35,36 35,30 25,25
 NTA-UGC-NET | Kal ki Class

Identify the nature of the game and Locate the saddle point
H M L
H. 60,60 36,70 36,35
M. 70,36 50,50 30,35
L. 35,36 35,30 25,25
Lecture-26: Game Theory- Dominant and
Mixed Strategy
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
NTA-UGC-NET | Mixed Strategy Game Theory

[This is a knowledge enhancement session. Basic learners can ignore

this on their own discretion. Questions from this segment has not been
asked in last 17 years since 2004]
NTA-UGC-NET | Discussed in Yesterday’s Session
Identify the nature of the game and Locate the saddle point
H M L
H. 60,60 36,70 36,35
M. 70,36 50,50 30,35
L. 35,36 35,30 25,25
 NTA-UGC-NET | Mixed Strategy Game Theory

Mixed Strategy Games

We know that in pure strategy games, each player is making one choice and adheres to that strategy
throughout the game. However, in mixed strategy method, each player is allowed to randomise those
strategies to assign probabilities to each choice and to pursue those choices according to the probabilities so
attached.
Unlike pure strategy games, under Mixed Strategy games, it is non-random and each of the two players can
have mixed strategies. In other words, each player can have a mix of probabilities associated with each
strategies. In pure strategy games, we have the probabilities of events as either 0 or 1, but in Mixed Strategy
we have 0.33, 0.66 or 0.25, 0.50 and 0.25 likewise.
 NTA-UGC-NET | Mixed Strategy Game Theory
Identify the nature of the game and Locate the equilibrium using Mixed Strategy
Player-2
L R

q 1-q
Player-1
Top p 3, 2 0, 0

Bottom 1-p 0, 0 2, 3
 NTA-UGC-NET | Mixed Strategy Game Theory

STEP-1: Assign probability to each strategy for each player

 NTA-UGC-NET | Mixed Strategy Game Theory

STEP-2: Calculate probability of each outcome of the game

 NTA-UGC-NET | Mixed Strategy Game Theory

STEP-3: Calculate each player’s expected payoffs from each strategy

 NTA-UGC-NET | Mixed Strategy Game Theory

STEP-4: Ascertaining Best Response Function of each player

 NTA-UGC-NET | Mixed Strategy Game Theory

STEP-4: Ascertaining Best Response Function of each player

 NTA-UGC-NET | Mixed Strategy Game Theory

STEP-4: Ascertaining Best Response Function of each player

Lecture-27: Asymmetric Information Adverse
Selection and Moral Hazard
Unit-1: Microeconomics
NTA-UGC-NET
Economics (Paper-2)
 NTA-UGC-NET | Arrow’s Impossibility Theorem

Arrow’s Impossibility Theorem

• Kenneth Arrow mentioned it is a difficult task to construct a single social welfare function that would reflect all
individuals’ preferences, as it difficult to aggregate the individual preferences.
• He proved that it is impossible that social ordering will reflect individual ordering by all members of the society.
• For example, individuals ordering depends upon → individual commodities consumed + consumption of
collective goods such as parks, municipalities goods, etc.
• Individual’s welfare is function of both- individual goods + collective goods (i.e. consumption of other
individuals).
• Arrow’s Impossibility Theorem states that a ranked-voting electoral system cannot reach a community-wide
ranked preference by converting individuals’ preferences while meeting all the conditions of a fair voting system.
• The conditions for a reasonably fair voting electoral system include non-dictatorship, unrestricted domain,
independence of irrelevant alternatives, social ordering, and Pareto efficiency.
• The theorem does not cover cardinal-voting electoral systems.
NTA-UGC-NET | Arrow’s Impossibility Theorem
Features of SCF as per Arrow’s Impossibility Theorem

1. Unrestrictive Domain or Universality:- SCF should depict complete societal

preferences order from every possible set of individual preference orders. This
implies, convexity (complete) and transitivity. Complete means whether, A > B, A <
B or A B. By transitivity means A  B, B  C, then A  C.

2. Non-imposition/ Citizen Sovereignty: It requires that there should be no external

control over a society’s choice. The social welfare function is not to be imposed.
This means that if every person like A over B, then society should also prefer A
over B.

3. Non-Dictatorship: The SCF should not only follow the preference order of an
individual who is influential. That is, society’s preferences should be framed on
collective methods and not by dictatorial methods.

4. Monotonicity: This implies there should be positive association between individual

preferences and social preferences.

5. Independence of Irrelevant Alternatives- It means that the choice made by the

society depends on the orderings of individuals and not upon the ordering of
alternatives outside the environment.
NTA-UGC-NET | Arrow’s Impossibility Theorem

Features of SCF as per Arrow’s Impossibility Theorem

• Majority Rule: He argued for free voting as a democratic procedure for reaching
social choice.

• He mentioned that through majority rule consistent social choices cannot be made
without violating the consistency/transitivity condition.

• His model shows that when there are two alternative social states, then majority rule
can lead to social choice while satisfying all the five conditions.

• But when there are more than 2 alternatives, the majority rule fails to lead to Social
choice without violating atleast one of the 5 conditions. This is what he meant that if
there are two people and they have more than 3 alternatives to chose from, then it is
impossible to design a social choice function satisfying all conditions.
 NTA-UGC-NET | Arrow’s Impossibility Theorem
Arrow’s Impossibility Theorem- The Model
Alternative Social States
People X Y Z • There are 3 members A, B & C in a society and they have 3 alternatives- X, Y & Z.
A 3 2 1
• They have to write 3 to most preferred, 2 to next preferred and 1 to least preferred.
B 1 3 2
C 2 1 3
 NTA-UGC-NET | Arrow’s Impossibility Theorem
Arrow’s Impossibility Theorem- The Model
Alternative Social States
People X Y Z • There are 3 members A, B & C in a society and they have 3 alternatives- X, Y & Z.
A 3 2 1
• They have to write 3 to most preferred, 2 to next preferred and 1 to least preferred.
B 1 3 2
C 2 1 3 • A prefers X > Y, Y > Z, so X > Z A & B prefer Y > Z | A & C prefer X > Y
Thus, majority prefers X > Y and majority
also
• B prefers Y > Z, Z > X, so Y > X prefers Y > Z, hence X > Z (in gross)
But C and B too prefer Z over X,
so that is inconsistent
• C prefers Z > X, X > Y so Z > Y
 NTA-UGC-NET | Arrow’s Impossibility Theorem
Arrow’s Impossibility Theorem- 3 Consequences
Alternative Social States
• Consequence-I: When 2 individuals prefer X over Y, then irrespective of third
People X Y Z alternative (Z), society should prefer X over Y.
A 3 2 1
B 1 3 2 • Consequence-II: If the will of A prevails against the opposition of B, then the will
of A will certainly prevail in case B is different or agrees with A.

• Consequence-III: If A and B have exactly opposite and conflicting interests, then

society will be indifferent between X and Y. [AIT is based on this consequence]

• He mentioned, if A prefers X over Y and B prefers Y over Z, then if the society opts
for X, then A should be a dictator.

• He mentioned that if the decision-making body has at least two members and at least
three options to decide among, then it is impossible to design a social choice function
that satisfies all these conditions at once.

• He, therefore concludes that it is impossible to derive a social ordering of different

conceivable alternative social states on the basis of the individual ordering of those
social states without violating at least one of the value judgments as expressed in the
five conditions of social choices.
NTA-UGC-NET | Rawls- A Theory of Justice (1871)
Rawls- A Theory of Justice (1871)
• His theory is based upon ethics, equity, fair and justice

• He defined Justice in two ways-

✓ Merit Theory- It treats everyone as one deserves. It uses merit to determine just
how a person will be rewarded or punished based upon whether his conduct is
useful or harmful to the society. It reflects utilitarian ethics.

✓ Need Theory- It assumes that individuals should help those members who are
most in need so as to redress their disadvantages. It reflects natural law theory.

• He stated that inequalities in society can only be justified if they produce increased
benefits for the entire society and only if those previously the most disadvantaged
members of society are no worse off as a result of any inequality.

• He mentioned that people resort to max-min decision rule to make their choices.
According to it welfare is maximised when the utility of those society members that
have the least is the greatest. No economic activity will increase social welfare unless
it improves the position of those members who are the worst off.
 NTA-UGC-NET | Rawls- A Theory of Justice (1871)
Rawls- A Theory of Justice (1871)
• Unequal distribution position Q can be chosen only when
the achievable positions of equal distribution of welfare
along the 45 degree line are below point D.
• Equal distribution of welfare lying between D & E are
socially preferred to efficient position Q with unequal
distribution.
• But this would call for sacrificing of some efficiency in
resource allocation
 NTA-UGC-NET | Imperfections

Optimum Welfare- A Myth in Real World full of Imperfections?

• The new & old Welfare Economics showed how welfare can be maximized, but
that’s under Perfect Competition, where, reorganization can take place. In real
life, it is not possible, as there are imperfections, externalities, which lead to
market failure, decreasing costs, uncertainty and non-existent and incomplete
markets.
• Market Failure- A case in which a marker fails to efficiently allocate GAS. This
happens, where-
a. Sub-Optimal Market Structures- Monopoly, Monopsony, Oligopoly,
Oligopsony, Natural Monopoly, Price Discrimination, Price Skimming
b. Lack of Internalization of costs and benefits in prices- Public Goods and
Common Property Resources (Tragedy of the commons, Free Rider
Problem) | Uncertainty- Asymmetrical Information, Adverse Selection,
Moral Hazard, Principle-Agent Problem
 NTA-UGC-NET | Imperfections

Monopoly- Loss of Welfare and Misallocation of Resources MRPT = MPl/MPk

<
• PPC is tangent to SIC at E, where, MRPT = MRSA = MRSa & MRSb
MRSB
• Point E denotes the maximum possible level of social MRPT = MRSa =
welfare. But under monopoly, equilibrium will take place MRSb
at H and not E. Because, monopolist equate MRPT =
(MPL/MPK) to MR Market-1/MR Market-2 & not to
prices of goods, but consumers are equating MRS to prices
of goods.
• Also, as MRSa and MRSb at H > MRPT, consumers
would require higher quantities of X good, but gets low
units of X. So lower welfare.
 NTA-UGC-NET | Imperfections

Natural Monopoly- Loss of Welfare and Misallocation of Resources

• It is a situation where monopoly exists due to fundamental
Price set by Monopolist
cost structure of the industry and this cost is so huge that So, in this case:
restricts the new entrants- e.g. electricity and water • Higher price
supplies. • Lower Output
• Deadweight Loss
• It occurs, when AC is falling over the entire range of
output. It is different from natural LAC, which is U
shaped. Thus, under natural monopoly, the cost curve is
downward sloping.
• If one monopolist, then output produced is Q. If two
producers, then each producing Q/2 and if three, then each
producing Q/3
Price set by
Government
 NTA-UGC-NET | Coase Theorem
Coase Theorem- Ronald Coase
• He mentioned that under PC, private and social cost are equal and
consequently, there will not be a problem of market externalities, which
referred to as Spillover Effects.
• This happens when someone other than the buyer is sharing the benefits or
costs of a product.
• He argued that individuals can bargain to lead to an efficient outcome and
eliminate externalities without government intervention. He mentioned that
the role of government is basically to facilitate bargaining among groups.
• The coase theorem requires that all these conditions are fulfilled, then no
externalities-
✓ Property rights to be well defined
✓ Small no. of people to be involved
✓ Small bargaining costs
 NTA-UGC-NET | Coase Theorem

Coase explains property rights in two theorems:

First Theorem:
Assumptions:
The first theorem is based on the following assumptions:
1. It assumes that the number of contracting parties is very small.
2. The cost of negotiating by the interested parties is also small.
3. There are no transaction costs.
4. There are no income or wealth effects.
5. There is no government interference.
 NTA-UGC-NET | Coase Theorem

Coase explains property rights in two theorems:

First Theorem:
Assumptions:
The first theorem is based on the following assumptions:
1. It assumes that the number of contracting parties is very small.
2. The cost of negotiating by the interested parties is also small.
3. There are no transaction costs.
4. There are no income or wealth effects.
5. There is no government interference.
Let us take Coase’s famous example of only two parties—a cattle raiser and a wheat producing farmer. They are
operating on neighbourhood properties without any fencing. The externality is the damage done by cattle
roaming on the unfenced land of the farmer. As the cattle raiser increases the size of the herd, the damage to the
farmer’s crop increases. According to Coase, property rights should be properly defined and enforced. First, the
farmer has the right that his wheat be not destroyed. Therefore, the cattle raiser will then be forced to pay
damages to the farmer for the crop destroyed.
These will be added to the marginal costs of the cattle- raiser who will reduce the number of cattle to be raised to
a manageable level. Second, if the law is that the cattle raiser has no liability for damage done by his herd to the
farmer’s crop, it will now be advisable for the farmer to bribe the cattle raiser to keep his herd to a minimum
level.
 NTA-UGC-NET | Coase Theorem
Coase Theorem- Ronald Coase
• Example- there is a wheat farmer and cattle raiser
• Initially, the cattle raiser is at point L1, where, his MC intersects with
demand curve = MR = AR. His output is OQ1.. In this case, Marginal
Social Cost is MSCw. And loss of wheat is Ow.
• Now, if the property rights are well defined and there are no transactional
costs or bargaining costs, then the cattle raiser MC would be MC + Ow.
• The optimal solution is now at point L2, where MC + Ow curve cuts the
demand curve and cattle restricted is OQ2.
• Thus, he mentioned that if the property rights are well defined and
transaction costs are 0, then a perfectly competitive market will allocate
resources optimally even under externalities.
 NTA-UGC-NET | Coase Theorem
Coase Theorem- Ronald Coase
• Example- there is a wheat farmer and cattle raiser
• Initially, the cattle raiser is at point L1, where, his MC intersects with
demand curve = MR = AR. His output is OQ1.. In this case, Marginal
Social Cost is MSCw. And loss of wheat is Ow.
• Now, if the property rights are well defined and there are no transactional
costs or bargaining costs, then the cattle raiser MC would be MC + Ow.
• The optimal solution is now at point L2, where MC + Ow curve cuts the
demand curve and cattle restricted is OQ2.
• Thus, he mentioned that if the property rights are well defined and
transaction costs are 0, then a perfectly competitive market will allocate
resources optimally even under externalities.

T = transaction costs, B = gains from the bargain for the party bearing the
transaction costs, G = costs of government intervention, there are 3 possibilities:
• If T < B, a bargain might take place.
• If T > B, a bargain will not occur, but some other regulatory approach might
work.
• If T > G > B, government regulation is likely to occur, and it will be efficient
 NTA-UGC-NET | Coase Theorem
Coase Theorem- Ronald Coase
According to Coase, market failure due to property rights can be
eliminated through private bargaining among the affected parties. He
points out that if property rights are clearly defined and marketable
and transaction costs are zero, a perfectly competitive economy will
allocate resources optimally even under conditions of externalities.
By transaction costs he means costs of negotiating or enforcing a
contract. The existence of differential transaction costs creates
opportunities for one person’s choice to impact on others. It is
property rights that direct and control these choices.

Second Theorem:
On the other hand, if bargaining becomes costly, then property rights matter significantly. In the words of
Coase, “If bargaining is costly and information is imperfect, then liability rules help to achieve optimality and
the party that has the least costly way of dealing with the harmful effects of an externality should be made
responsible for paying the costs associated with the externality.” Thus the second theorem of Coase provides a
natural link between economics and law, offering an efficiency rationale for deciding externality liability rules.
 NTA-UGC-NET | Coase Theorem
Coase Theorem- Ronald Coase
Second Theorem:
Coase has related his second theorem to the problems caused by the sparks emitted by coal and wood-power
steam engines. The problem is that fires sometimes caused by the sparks damage nearby agriculture fields. In
the absence of rules governing compensation for firm’s damages, it creates negative externalities since rail
companies have little incentive to prevent sparks.
On the other hand, rail companies may pay full compensation that may leave property owners with little or no
incentive to protect themselves. Is it better for rail companies to take defensive measures or for farmers to take
defensive measures? Which is done, depends on whether farmers can sue for damages?
The problem of sparks can be solved in the following ways:
(a) Limit the amount of train traffic;
(b) Rail companies should install some type of spark- inhibiting device; or
(c) Farmers should plant their crops several yards further away from the railway tracks.
NTA-UGC-NET | Moral Hazards and Adverse Selection
Problems in Insurance Markets: Factors behind Incomplete Market
• Moral hazards
• Adverse Selection
Moral Hazards
• When people tend to engage in riskier behaviour when they are insured against losses
resulting from their behaviour.
• Example, drivers may take more risks on the road when they know the insurance company
will pay for damages.
• Moral hazard is the name given to the negative behaviour that can arise from an individual
being insured. When an individual, group, or even country, is insured they may take greater
risks than if they are not insured. For example, individuals who take out dental insurance
may follow a less rigorous oral hygiene regime than those who do not.
Situations where moral hazard may exist :
• State provision of free healthcare may encourage poor individual healthcare, such as following a
poor diet, smoking, or excessive alcohol.
• Students who pay for private education may believe that this provides an insurance against
failing exams, and may work less hard than students may in state education.
• Welfare benefits may encourage individuals to rely on the state and not train or retrain if they
become unemployed.
• Banks taking excessive risks because they believe that the RBI or government will help them
out if they run into financial difficulty.
NTA-UGC-NET | Moral Hazards and Adverse Selection
Conditions necessary for moral hazard
1. There is information asymmetry. Where one party holds more information than another.
For example, a firm selling sub-prime loans may know that the people taking out the loan
are liable to default. But, the bank purchasing the mortgage bundle has less information
and assumes that the mortgage will be good.
2. A contract affects the behaviour of two different agents. In some cases, two parties
face different incentives. If you are insured, then you may have less incentive to take care
against risks. For example, if a country knows it will receive a bailout from the IMF, then
it may feel less incentive to reduce debt.

Example: Suppose you have a KTM bike worth Rs 2,00,000.

• If you don’t have insurance, then you will take utmost care of the bike and in such a
situation, there exists 10% chance of your bike getting stolen. Thus, in this case, the
cost of insurance will be around Rs 20,000.
• Now, assume that your bike is insured now. Since you are having insurance, so you
will be more likely to be careless and the chance of bike being getting stolen may rise
to 30%, which 60,000. But the insurance company has insured your bike at Rs 20,000,
so it suffers a loss.
NTA-UGC-NET | Moral Hazards and Adverse Selection
Adverse Selection
• Adverse selection occurs when there is asymmetric (unequal) information
between buyers and sellers. This unequal information distorts the market and
leads to market failure.
• For example, buyers of insurance may have better information than sellers.
Those who want to buy insurance are those most likely to make a claim.
Therefore firms are reluctant to sell insurance.
• Sellers of second-hand goods may have better information about the true
quality of the good than buyers.
• A company selling life insurance will find that people at higher risk of death will be
much more willing to want to buy life insurance. If the insurance company charges an
average price, but only high-risk consumers buy – they will make a loss.
• If a company selling life insurance sells at a high price to take account of the high-
risk people, then young, healthy people will not buy. Because the cost is greater than
their perceived value.
NTA-UGC-NET | Moral Hazards and Adverse Selection
Adverse Selection
• Due to poor information and difficulty selecting customers, there will be a higher overall
price as firms have to take into account relatively higher payouts to high-risk customers
taking out insurance.
• Low-risk customers may not want to buy because it is too expensive for their needs –
leading to a missing market.
• Firms may invest considerable time in identifying which groups of consumers are higher
risk.
NTA-UGC-NET | Moral Hazards and Adverse Selection
Lemon Market
• The lemons problem refers to issues that arise regarding the value of an investment or
product due to asymmetric information possessed by the buyer and the seller.

• Lemons Problem
• The lemons problem was put forward in a research paper, "The Market for 'Lemons':
Quality Uncertainty and the Market Mechanism," written in the late 1960s by George A.
Akerlof, an economist and professor at the University of California, Berkeley. The tag
phrase identifying the problem came from the example of used cars Akerlof used to
illustrate the concept of asymmetric information, as defective used cars are commonly
referred to as lemons.

• The lemons problem exists in the marketplace for both consumer and business products,
and also in the arena of investing, related to the disparity in the perceived value of an
investment between buyers and sellers. The lemons problem is also prevalent in financial
sector areas, including insurance and credit markets. For example, in the realm of corporate
finance, a lender has asymmetrical and less-than-ideal information regarding the actual
creditworthiness of a borrower.
NTA-UGC-NET | Moral Hazards and Adverse Selection
Lemon Market
• Causes and Consequences of the Lemons Problem
• The problem of asymmetrical information arises because buyers and sellers don't have
equal amounts of information required to make an informed decision regarding a
transaction. The seller or holder of a product or service usually knows its true value, or at
least knows whether it is above or below average in quality. Potential buyers, however,
typically do not have this knowledge, since they are not privy to all the information the
seller has.

• Akerlof's original example of the purchase of a used car noted that the potential buyer of a
used car cannot easily ascertain the true value of the vehicle. Therefore, they may be
willing to pay no more than an average price, which they perceive as somewhere between a
bargain price and a premium price. Adopting such a stance may at first appear to offer the
buyer some degree of financial protection from the risk of buying a lemon. Akerlof pointed
out, however, that this stance actually favors the seller, since receiving an average price for
a lemon would still be more than the seller could get if the buyer had the knowledge that
the car was a lemon. Ironically, the lemons problem creates a disadvantage for the seller of
a premium vehicle, since the potential buyer's asymmetric information, and the resulting
fear of getting stuck with a lemon, means that they are not willing to offer a premium price
for a vehicle of superior value.
NTA-UGC-NET | Moral Hazards and Adverse Selection
Lemon Markets
• Warranties and Information
• Akerlof proposed strong warranties as one means of overcoming the lemons problem, as
they can protect a buyer from any negative consequences of buying a lemon. The explosion
of readily available, widespread information disseminated through the internet has also
helped to reduce the problem. Information services such as Carfax and Angie's List help
buyers feel more confident in making a purchase, and they also benefit sellers because they
enable them to command premium prices for genuinely premium products.
NTA-UGC-NET | Principal and Agent Problem (Only in Class Notes
 NTA-UGC-NET | Principal and Agent Problem (Only in Class Notes

• Principal acquires an agent, or proxy, the agent supports the

principal
• A common interest unifies the principal and the agent at the
same time, each is focused on its own self-interest and
acceptable risk
• If the common interest goes away, self-interest exceeds the
common interest, or the level of acceptable risk is too high,
the relationship can decouple.

There are two leading models of asymmetric information.

1. In a hidden action or moral hazard model, the agent’s choice of

action affects the principal, but the principal does not observe the
actions directly.
2. In a hidden type or adverse selection model, the agent’s “type”
remains as private information until after the contract has been
signed.
 NTA-UGC-NET | Principal and Agent Problem (Only in Class Notes

• Principal acquires an agent, or proxy, the agent supports the

principal
• A common interest unifies the principal and the agent at the
same time, each is focused on its own self-interest and
acceptable risk
• If the common interest goes away, self-interest exceeds the
common interest, or the level of acceptable risk is too high,
the relationship can decouple.
Problems that we observe in the principal-agent problems are:

• there is a contract between the principal and the agent;

• information gap exits between the principal and the agent;
• and such a gap has implications for the decision of the
contract they sign.
 NTA-UGC-NET | PYQs
Questions
Which of the following is a lemons problem?
A. Bank charging an average interest rate for all type of borrowers
B. Imported low cost Chinese goods driving out Indian traditional goods
from the Indian market.
C. Profits for banks increasing significantly by charging differential rates
of interest
D. Sri Lankan coffee is high quality and it is being sold at a premium price
compared to Indian coffee.
 NTA-UGC-NET | PYQs
Questions
Which of the following is a lemons problem?
A. Bank charging an average interest rate for all type of borrowers
B. Imported low cost Chinese goods driving out Indian traditional goods
from the Indian market.
C. Profits for banks increasing significantly by charging differential rates
of interest
D. Sri Lankan coffee is high quality and it is being sold at a premium price
compared to Indian coffee.
Ans. B
Solution: The lemons problem arises when sellers know more about the
quality of a good than buyers do, buyers may assume that quality is low,
causing price to fall and only low-quality
goods to be sold. The Chinese sellers make goods with poor quality
materials that are low cost and the buyers in India are unaware of the low
quality. This causes the price of the goods to fall to such an extent that only
cheap Chinese goods are sold in the market while the high quality Indian
goods are driven out from the market.
 NTA-UGC-NET | PYQs
Questions

Which one of the following can be categorized as an example of

adverse selection problem?
A. People having health insurance plan use medical services
higher number of times in a year
B. A person goes for sky diving after purchasing health insurance.
C. A lender is unable to distinguish between high and low risk
borrowers.
D. A good quality second hand car is sold at high price to a buyer.
 NTA-UGC-NET | PYQs
Questions

Which one of the following can be categorized as an example of

adverse selection problem?
A. People having health insurance plan use medical services
higher number of times in a year
B. A person goes for sky diving after purchasing health insurance.
C. A lender is unable to distinguish between high and low risk
borrowers.
D. A good quality second hand car is sold at high price to a buyer.
Ans. C
Solution: Borrowers are more aware of what they are going to do
with the money of the lenders while lenders are unaware of how
their money will be used. So the lenders are unable to distinguish
between high and low risk borrowers leading to the problem of
adverse selection.