DOCSLIB.ORG

The Empirical Estimation of Substitution Terms from Demand Analysis

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
The Empirical Estimation of Substitution Terms from Demand Analysis Iowa State University Capstones, Theses and Retrospective Theses and Dissertations Dissertations 1968 The mpire ical estimation of substitution terms from demand analysis Joseph Salim Fuleihan Iowa State University Follow this and additional works at: https://lib.dr.iastate.edu/rtd Part of the Economic Theory Commons Recommended Citation Fuleihan, Joseph Salim, "The mpe irical estimation of substitution terms from demand analysis " (1968). Retrospective Theses and Dissertations. 3548. https://lib.dr.iastate.edu/rtd/3548 This Dissertation is brought to you for free and open access by the Iowa State University Capstones, Theses and Dissertations at Iowa State University Digital Repository. It has been accepted for inclusion in Retrospective Theses and Dissertations by an authorized administrator of Iowa State University Digital Repository. For more information, please contact [email protected]. This dissertation has been 69-9859 microfihned exactly as received FULEIHAN, Joseph Salim, 1935- THE EMPIRICAL ESTIMATION OF SUBSTITUTION TERMS FROM DEMAND ANALYSIS. Iowa State University, Ph.D., 1968 Economics, theory University Microfilms, Inc., Ann Arbor, Michigan THE EMPIRICAL ESTIMATION OF SUBSTITUTION TERMS FROM DEMAND ANALYSIS Joseph Sallm Fulelhan A Dissertation Submitted to the Graduate Faculty In Partial Fulfillment of The Requirements for the Degree of DOCTOR OF PHILOSOPHY Major Subjects Economics Approved : Signature was redacted for privacy. In Chaise of mjor Work Signature was redacted for privacy. Head of Major Department Signature was redacted for privacy. raduate College Iowa State University Ames, Iowa 1968 11 TABLE OP CONTENTS Page INTRODUCTION 1 THEORETICAL DISCUSSION 2 Classical Demand Theory 2 Substitution terms 5 Properties of substitution terms 11 Importance and implications 13 Modern Demand Theory 17 Geometric interpretation of substitution effects 22 EMIRICAL ESTIMATION OF SUBSTITUTION TERMS FROM UNCONSTRAINED DEMAND EQUATIONS 26 Procedure 26 Estimating structural equations 26 Estimating substitution terms 33 Results ^9 Beef and pork 50 Beef, pork, and broilers 62 Beef, pork, broilers, and mutton 6? Red meat end poultry meat 76 Eggs 80 Eggs and cheese 83 Eggs, cheese, and breakfast cereals 90 Margarine and butter 95 ill i^age Selected vegetables 100 Coffee 104 Pood, pleasure goods, durables and others 105 Summary of results 108 ESTIMATING DEMAND FUNCTIONS BY LINEAR PROGRAMMING 118 Statement of the Problem 118 The use of linear programming in regression analysis 119 Results 136 Beef and pork 137 Beef, pork, and broilers 139 Beef, pork, broilers, and mutton 1^5 Red meat and poultry meat 152 Eggs and cheese 155 Eggs, cheese, and cereals I60 ESTIMATING DEMAND FUNCTIONS BY QUADRATIC PROGRAMMING I70 Statement of the Problem 170 Results 174 Beef and pork 17^ Red meat and poultry meat 175 SUMMARY AND CONCLUSIONS 177 BIBLIOGRAPHY I8I ACKNOWLEDGEMENTS 186 APPENDIX 187 1 INTRODUCTION Economists have always been Interested in the degree of substltutability In consumption that exists between various commodities. They have even devised measures to estimate sub­ stltutability, such as the cross elasticity of demand. The concept of substitution effects (or substitution terms), Is fairly recent. It was developed by the Russian economist Eugene Slutsky (35). Other economists who followed him developed the concept further and expounded its mathemati­ cal properties. Today, substitution terms play a key role in modern demand theory. Strange as it may seem, no economist, with the recent exception of Barten (2), has attempted to verify or refute the theoretical characteristics attributed to substitution terms. The empirical testing of the Slutsky conditions is one of the objectives of this dissertation. After the more important properties have been tested and verified, methods of estimating demand functions of substitute commodities satisfying the Slutsky conditions will be discussed. Specifically, demand functions will be estimated by applying both linear and quad­ ratic programming techniques, subject to inequality constraints which preserve these Important properties of substitution terms which have been verified by empirical evidence. 2 THEORETICAL DISCUSSION Classical Demand Theory^ The classical theory of consumer behavior assumes that the consumer derives utility from the commodities he consumes. Utility, u, is a function of the amounts of various commodities Xi,,,.,Xn consumed. The utility function is assumed to be cardinal and to have first- and second-order partial deriva­ tives. If u represents the consumer's utility function, then (1.1) u = u (X^,,,,,X^), The consumer is faced with a fixed budget or money income M, and given commodity prices P^, or n (1.2) M = 2 P.X. 1 = 1 n. •1=1 ^ ^ The consumer is assumed to maximize u, subject to the Income or budget constraint. In other words, he maximizes the expression n (1.3) F = u (X^ X^) - X (M P^X^) where X is a Lagrange multiplier. First-order conditions for utility maximization require that the partial derivatives of the Lagrangean expression F ^A detailed discussion of demand theory Is found in Allen (1), Hicks (21), Kuenne (2?) and Samuelson (33). 3 with respect to the quantity of each of the n commoclltiers, unci with respect to k, be equal to zero. This yields (n + l) equations in (n + 1) variables (n X*s and X), The last equation guarantees that the budget constraint is met, (1-4) = izib - & *1 = 0 = - A ?! # 1 J" 9 = -§x; - t pR = 0 = "n - ^ Pn ^ p n where Ui = , the marginal utility of . Transposing the second term of the first n equations to the right-hand side, and dividing the 1^^ by the equation gives u/ P, u. P. where u^ and Uj are the familiar marginal utilities. Accord­ ing to classical economists, marginal utility, as well as total utility, may be measured cardinally. The result (1.5) states that in equilibrium, the ratio of the marginal utilities of any two commodities should equal their price ratio. 4 (1.5) can also be expressed as U.6, 2^ = = = ^1 ^2 ^n-1 ^n which are Marshall's results that in equilibrium the ratio of marginal utility to price should be equal for all commodities. These (n-l) equations and the budget constraint equation pro­ vide (n) equations for determining the quantities To guarantee that utility is a maximum, second-order con­ ditions must hold. In other words, not only should du = 0, but also d 2u < 0, or n (1.7) du = Z u, dX. = 0 i=l ^ ^ P n n (1.8) d^u = Z Z u, ,d X, d X, < 0 J=1 1=1 ^ J where u^^^ is the second partial derivative of u. It can be seen that u^^ is symmetrical with respect to both i and j, i.e., Uj^j = Uj^. (1,8) is a quadratic form subject to a linear side-relation. For (1.8) to be negative definite, the deter­ minants 5 (1.9) 0 u. u. u. u. u. Ur f » » » f ###U.n U U Ui 12 Ui U12 u^3 Ui 12''" '^in u ^2 ^21 22 ^22 ^2] ^2 "^21 "22'' "^2n ^3 "31 U32 ^n %1 ^n2""%n must be alternatively positive and negative. The last determinant shall be denoted by U, which is the determinant of the first and second partial derivatives of u, and shall be used to denote the cof actors of u^ and in U respectively. Substitution terms Demand functions can be derived from the analysis of utility maximization. More specifically, they are obtained by solving the first-order equilibrium conditions for the un­ knowns , The consumer's demand functions for commodities in terms of prices and income are given by the first-order equi­ librium conditions (1.4), or Ui = X Pj n Z P,X, = M. 1=1 ^ ^ 6 To get the change In demand when income varies, prices constant, we differentiate these equations with respect to income; to get the effect of a price change on demand, we differentiate with respect to price. First consider the effect of an increase in Income M, prices remaining unchanged. For the sake of clarity, write the first-order equilibrium conditions as (1.10) + PgXg +...+ P^X^ = M - + u^ = 0 - XPg + Ug = 0 Upon differentiating these equations with respect to M, we get (1.11) ()X^ ^n mr = ^ - ^1 Tm ^ ^1 ^ ""12 TiT + o>X ^^1 o" %2 aXn . - Fn ITw + ^nl "SIT + %2 TIT + %n TT" = ° By rearrangement, the first elements of the last n equa­ tions can be expressed as P^(- -j-^), ^2^' f • °O 9' p ^n^ " . Such a rearrangement enables us to express the matrix of coefficients in the equations in symmetric form, since ^ij' *ji' 7 ZPhlis system contains (n+l) equations In (n+l) variables* A ^4 X— "5^)f and. the n variables ^ ^ , The equations can be <) X. j \ :solved, for the variables "5"]^ and for the variable ( - -y-^) as a VbyMprod-uct , SoLving the equations by Cramer's rule gives (Cl .12,) 0 ,P. 1 ^2 !•„ 1-1 i+1 n pi 0 "ll "l2 »ln ^11 ^1,1-1 *1,1+1 *ln •^2 "l2 "22 "2n ^2 *12 *2,1-1 ° *2,1+1 *2n "in "2n l^n *ln *n,i-l ° *n,i+l *nn u Because 3j = ^ in (1,10), we can write (1,12) as (1.13) u.. d.X. u, u u n 0 h. hdL 1 u dM X \ '"'X \ • • • k i+1 ...X h .X *11 *l2'''*in \ *11''"*1,1-1 ° *l,l+l''*ln u. 0 A *21 *22'''*2n *21•••*2.1-1 *2,1+1^•*2n w# vO • • w# •• # 0 • # «• U* # u u.n n 1" *nl *n2 unn *nl'''*n,l-l *n,i+l***nn M Hence àx u "5M • 7 ° i "i or dX U, ,2 U (1-14) tm" = r • r = ^ û" Since the equilibrium conditions say nothing about the ax, sign of "57î~ could be positive or negative.
Load more

Recommended publications
  • Substitution and Income Effect
    Intermediate Microeconomic Theory: ECON 251:21 Substitution and Income Effect Alternative to Utility Maximization We have examined how individuals maximize their welfare by maximizing their utility. Diagrammatically, it is like moderating the individual’s indifference curve until it is just tangent to the budget constraint. The individual’s choice thus selected gives us a demand for the goods in terms of their price, and income. We call such a demand function a Marhsallian Demand function. In general mathematical form, letting x be the quantity of a good demanded, we write the Marshallian Demand as x M ≡ x M (p, y) . Thinking about the process, we can reverse the intuition about how individuals maximize their utility. Consider the following, what if we fix the utility value at the above level, but instead vary the budget constraint? Would we attain the same choices? Well, we should, the demand thus achieved is however in terms of prices and utility, and not income. We call such a demand function, a Hicksian Demand, x H ≡ x H (p,u). This method means that the individual’s problem is instead framed as minimizing expenditure subject to a particular level of utility. Let’s examine briefly how the problem is framed, min p1 x1 + p2 x2 subject to u(x1 ,x2 ) = u We refer to this problem as expenditure minimization. We will however not consider this, safe to note that this problem generates a parallel demand function which we refer to as Hicksian Demand, also commonly referred to as the Compensated Demand. Decomposition of Changes in Choices induced by Price Change Let’s us examine the decomposition of a change in consumer choice as a result of a price change, something we have talked about earlier.
    [Show full text]
  • Principles of Economics1 3
    Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Principles of Economics1 3. Scarcity, work, and choice Giuseppe Vittucci Marzetti2 SCOR Department of Sociology and Social Research University of Milano-Bicocca A.Y. 2018-19 1These slides are based on the material made available under Creative Commons BY-NC-ND © 4.0 by the CORE Project , https://www.core-econ.org/. 2Department of Sociology and Social Research, University of Milano-Bicocca, Via Bicocca degli Arcimboldi 8, 20126, Milan, E-mail: [email protected] Giuseppe Vittucci Marzetti Principles of Economics 1/26 Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Layout 1 Income and working hours across time and countries 2 Scarcity and choice: key concepts Production function, average productivity and marginal productivity Preferences and indifference curves Opportunity cost Feasible frontier 3 Decision-making under scarcity Constrained choices and optimal decision making Labor choice Income effect and substitution effect Effect of technological change on labor choices 4 Concluding remarks and summary Concluding remarks Summary Giuseppe Vittucci Marzetti Principles of Economics 2/26 Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Income and free time across countries Figure: Annual hours of free time per worker and income (2013) Giuseppe Vittucci Marzetti Principles of Economics 3/26 Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Income and working hours across time and countries Figure: Annual hours of work and income (18702000) Living standards have greatly increased since 1870.
    [Show full text]
  • What Impact Does Scarcity Have on the Production, Distribution, and Consumption of Goods and Services?
    Curriculum: 2009 Pequea Valley SD Curriculum PEQUEA VALLEY SD Course: Social Studies 12 Date: May 25, 2010 ET Topic: Foundations of Economics Days: 10 Subject(s): Grade(s): Key Learning: The exchange of goods and services provides choices through which people can fill their basic needs and wants. Unit Essential Question(s): What impact does scarcity have on the production, distribution, and consumption of goods and services? Concept: Concept: Concept: Scarcity Factors of Production Opportunity Cost 6.2.12.A, 6.5.12.D, 6.5.12.F 6.3.12.E 6.3.12.E, 6.3.12.B Lesson Essential Question(s): Lesson Essential Question(s): Lesson Essential Question(s): What is the problem of scarcity? (A) What are the four factors of production? (A) How does opportunity cost affect my life? (A) (A) What role do you play in the circular flow of economic activity? (ET) What choices do I make in my individual spending habits and what are the opportunity costs? (ET) Vocabulary: Vocabulary: Vocabulary: scarcity, economics, need, want, land, labor, capital, entrepreneurship, factor trade-offs, opportunity cost, production markets, product markets, economic growth possibility frontier, economic models, cost benefit analysis Concept: Concept: Concept: Economic Systems Economic and Social Goals Free Enterprise 6.1.12.A, 6.2.12.A 6.2.12.I, 6.2.12.A, 6.2.12.B, 6.1.12.A, 6.4.12.B 6.2.12.I Lesson Essential Question(s): Lesson Essential Question(s): Lesson Essential Question(s): Which ecoomic system offers you the most What is the most and least important of the To what extent
    [Show full text]
  • AP Macroeconomics: Vocabulary 1. Aggregate Spending (GDP)
    AP Macroeconomics: Vocabulary 1. Aggregate Spending (GDP): The sum of all spending from four sectors of the economy. GDP = C+I+G+Xn 2. Aggregate Income (AI) :The sum of all income earned by suppliers of resources in the economy. AI=GDP 3. Nominal GDP: the value of current production at the current prices 4. Real GDP: the value of current production, but using prices from a fixed point in time 5. Base year: the year that serves as a reference point for constructing a price index and comparing real values over time. 6. Price index: a measure of the average level of prices in a market basket for a given year, when compared to the prices in a reference (or base) year. 7. Market Basket: a collection of goods and services used to represent what is consumed in the economy 8. GDP price deflator: the price index that measures the average price level of the goods and services that make up GDP. 9. Real rate of interest: the percentage increase in purchasing power that a borrower pays a lender. 10. Expected (anticipated) inflation: the inflation expected in a future time period. This expected inflation is added to the real interest rate to compensate for lost purchasing power. 11. Nominal rate of interest: the percentage increase in money that the borrower pays the lender and is equal to the real rate plus the expected inflation. 12. Business cycle: the periodic rise and fall (in four phases) of economic activity 13. Expansion: a period where real GDP is growing. 14. Peak: the top of a business cycle where an expansion has ended.
    [Show full text]
  • 1 Unit 4. Consumer Choice Learning Objectives to Gain an Understanding of the Basic Postulates Underlying Consumer Choice: U
    Unit 4. Consumer choice Learning objectives to gain an understanding of the basic postulates underlying consumer choice: utility, the law of diminishing marginal utility and utility- maximizing conditions, and their application in consumer decision- making and in explaining the law of demand; by examining the demand side of the product market, to learn how incomes, prices and tastes affect consumer purchases; to understand how to derive an individual’s demand curve; to understand how individual and market demand curves are related; to understand how the income and substitution effects explain the shape of the demand curve. Questions for revision: Opportunity cost; Marginal analysis; Demand schedule, own and cross-price elasticities of demand; Law of demand and Giffen good; Factors of demand: tastes and incomes; Normal and inferior goods. 4.1. Total and marginal utility. Preferences: main assumptions. Indifference curves. Marginal rate of substitution Tastes (preferences) of a consumer reveal, which of the bundles X=(x1, x2) and Y=(y1, y2) is better, or gives higher utility. Utility is a correspondence between the quantities of goods consumed and the level of satisfaction of a person: U(x1,x2). Marginal utility of a good shows an increase in total utility due to infinitesimal increase in consumption of the good, provided that consumption of other goods is kept unchanged. and are marginal utilities of the first and the second good correspondingly. Marginal utility shows the slope of a utility curve (see the figure below). The law of diminishing marginal utility (the first Gossen law) states that each extra unit of a good consumed, holding constant consumption of other goods, adds successively less to utility.
    [Show full text]
  • Scarcity, Work, and Choice ECONOMICS
    Introduction Supply Choices Demand Choices Decision-making under scarcity Income & Substitution Effects Technological change Scarcity, Work, and Choice ECONOMICS Dr. Kumar Aniket UCL Lecture 3 c Dr. Kumar Aniket Introduction Supply Choices Demand Choices Decision-making under scarcity Income & Substitution Effects Technological change CONTEXT Unit 1: Labour is work. Unit 2: Labour is an input in the production of goods and services. Unit 3: New technologies raise the productivity of labour leading to higher per-hour wage. ◦ How would technological progress affect living standards across the world? ◦ How would technological progress affect the individual’s choice between free time and consumption? c Dr. Kumar Aniket Introduction Supply Choices Demand Choices Decision-making under scarcity Income & Substitution Effects Technological change FREE TIME AND LIVING STANDARDS Living standards have greatly increased since 1870 but some countries still work more than others. c Dr. Kumar Aniket Introduction Supply Choices Demand Choices Decision-making under scarcity Income & Substitution Effects Technological change FREE TIME AND LIVING STANDARDS How people across countries choose between consumption and working hours (free time) c Dr. Kumar Aniket Introduction Supply Choices Demand Choices Decision-making under scarcity Income & Substitution Effects Technological change EXAMPLE:GRADES AND STUDY HOURS What is the production function of grade? Student choose how many hours to study Grade increases if number of hours studied increases. Grade increase with better environment. Source: Plant et. al. (Contemporary Educational Psychology, 2005). c Dr. Kumar Aniket Introduction Supply Choices Demand Choices Decision-making under scarcity Income & Substitution Effects Technological change PRODUCTION FUNCTION Production functions: inputs (hours) ! outputs (grade) c Dr.
    [Show full text]
  • Rebound Effects
    Rebound Effects Prepared for the New Palgrave Dictionary of Economics Kenneth Gillingham Yale University November 11, 2014 Abstract In environmental and energy economics, rebound effects may influence the energy savings from improvements in energy efficiency. When the energy efficiency of a product or service improves, it becomes less expensive to use, income is freed-up for use on other goods and services, markets re-equilibrate, and there may even be induced innovation. These effects typically reduce the direct energy savings from energy efficiency improvements, but lead to improved social welfare as long as there are not sufficiently large externality costs. There is strong empirical evidence that rebound effects exist, yet estimates of the different effects range widely depending on context and location. Keywords Energy efficiency; climate policy; take-back effect; backfire; emissions; welfare; greenhouse gases; derived demand 1 Introduction Energy efficiency policies are among the most common environmental policies around the world. Holding consumer, producer, and market responses constant, an increase in energy efficiency for an energy-using durable good, such as a vehicle or refrigerator, will unambiguously save energy. Rebound effects are consumer, producer, and market responses to an increase in energy efficiency that typically reduce the energy savings that would have occurred had these responses been held constant. The use of the term “rebound” is intuitive: the responses lead to a rebounding of energy use back towards the energy use prior to the energy efficiency improvement. For this reason rebound effects are sometimes also called “take-back” effects, for some of the energy savings are “taken-back” by the responses.
    [Show full text]
  • MODULE 1 ECONOMICS REVIEW 1.01 Scarcity, Opportunity Cost, and Incentives 1.02 Factors of Production
    MODULE 1 ECONOMICS REVIEW 1.01 Scarcity, Opportunity Cost, and Incentives 1. What is economics? 2. What does it mean when people say that resources are scarce? 3. What is a shortage? 4. How is a shortage different from scarcity? 5. What is opportunity cost? Provide an example. 6. What is an incentive? Provide an example. 7. Why are incentives and opportunity cost important when you make a decision? 8. What does it mean to “think at the margin?” Provide an example. 1.02 Factors of Production; Comparative Advantage 1. What are resources? 2. Describe the economic term land. 3. Describe the economic term labor. 4. Describe the economic term capital. 5. What is the difference between physical capital and human capital? 6. What is an entrepreneur and why are they important in an economy? 7. What does it mean to specialize? 8. Why should an individual or business specialize? 9. Define the law of comparative advantage. 10. Why would it be beneficial to know one’s comparative advantage? 1.03 Circular Flow Model: Market Interactions 1. Who participates in a market? 2. Describe the factor market? (Who does what? Where? ) 3. Describe the product market? (Who does what? Where? ) 4. Describe physical flow through the market. 5. Describe monetary flow through the market. 6. Why do households and businesses trade with each other? 7. Explain how the government participates in the flow of the market. 8. Describe the role of financial institutions in the flow of the market. 9. Describe the circular flow diagram including the government and institutions.
    [Show full text]
  • Economics 11 Caltech Spring 2010 Definitions
    Economics 11 Caltech Spring 2010 Problem Set 2: solutions Homework Policy Goods for all Study You can study the homework on your own or with a group of fellow students. You should feel free to consult notes, text books and so forth. The quiz will be available Wednesday at 5pm. Following the Honor code, you should find 20 minutes and do the quiz, by yourself and without using any notes. Paper and pen should be all you need. Then turn it in by Thursday 5pm. (drop off in box in front of Baxter 133). It will include one question from each section The answers to the whole homework will be available Friday at 2pm. Definitions Please explain each term in three lines or less Consumer theory Sol: Consumer theory is based on what people like and it tries to explain how people make choices. Utility Sol: Utility refers to the flow of pleasure or happiness that a person enjoys derived as a consequence of a choice. Feasible Set Sol: For given prices and income, the feasible set is given for the set of bundles that are affordable for a consumer. Isoquants Sol: It is the utility contour, and it means equal quantity. Marginal rate of substitution. Sol: Reflects the tradeoff , from the consumer’s perspective, between the goods. Substitution effect. Sol: The substitution effect considers the change in the relative price, with a sufficient change in income to keep the consumer on the same utility. Income effect. Sol: Is the change in consumption when the real income changes. Convex preferences.
    [Show full text]
  • 3 Scarcity, Work and Choice
    Beta September 2015 version 3 SCARCITY, WORK AND CHOICE Shutterstock HOW INDIVIDUALS DO THE BEST THEY CAN, GIVEN THE CONSTRAINTS THEY FACE, AND HOW THEY RESOLVE THE TRADE-OFF BETWEEN EARNINGS AND FREE TIME • Decision-making under scarcity is a common problem because we usually have limited means available to meet our objectives • Economists model these situations: first by defining all of the possible actions • ... then evaluating which of these actions is best, given the objectives • Opportunity cost describes an unavoidable trade-off in the presence of scarcity: satisfying one objective more means satisfying other objectives less • This model can be applied to the question of how much time to spend working, when facing a trade-off between more free time and more income • This model also helps to explain differences in the hours that people work in different countries and also the changes in our hours of work through history See www.core-econ.org for the full interactive version of The Economy by The CORE Project. Guide yourself through key concepts with clickable figures, test your understanding with multiple choice questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements, watch economists explain their work in Economists in Action – and much more. 2 coreecon | Curriculum Open-access Resources in Economics Imagine that you are working in New York, in a job that is paying you $15 an hour for a 40-hour working week: so your earnings are $600 per week. There are 24 hours in a day and 168 hours in a week so, after 40 hours of work, you are left with 128 hours of free time for all your non-work activities, including leisure and sleep.
    [Show full text]
  • Linking the Substitution and Output Effects Of
    BUSINESS EDUCATION & ACCREDITATION ♦ Volume 6 ♦ Number 1 ♦ 2014 LINKING THE SUBSTITUTION AND OUTPUT EFFECTS OF PRODUCTION TO PROFIT MAXIMIZATION IN THE INTERMEDIATE MICROECONOMICS COURSE Jeffrey Wolcowitz, Case Western Reserve University ABSTRACT In a recent article, Thaver (2013) makes the case for including in intermediate microeconomics textbooks analysis of the substitution and output effects of a firm’s response to a change in the price of an input. In her analysis, Thaver assumes that the firm is constrained by a fixed budget for inputs, making the firm’s substitution and output effects analytically identical to the consumer’s substitution and income effects. Intermediate microeconomics textbooks typically do not assume a fixed budget for inputs when describing a firm’s profit-maximizing behavior. This paper removes the assumption of a fixed budget for inputs and provides a non-calculus presentation of substitution and output effects suitable for the intermediate course. Without this assumption, the substitution and output effects of the change in the price of an input must work in the same direction regardless of whether an input is normal or inferior, and the firm’s input demand curve, unlike a consumer’s demand curve for a good, must slope downward. JEL: A22, D11, D24 KEYWORDS: Substitution Effect, Output Effect, Isoquants, Consumer Theory, Production Theory, Input Demand INTRODUCTION n a recent article in this journal, Thaver (2013) makes the case for including in intermediate microeconomics textbooks and courses analysis of a firm’s response to a change in the price of an I input. In particular, she makes a case for introducing students to the substitution and output effects associated with an input price change in a way analogous to the substitution and income effects associated with a change in the price of a consumer good, emphasizing the similarities between the two.
    [Show full text]
  • 0 Or Ro .. the HISTORY and DEVELOPMENT of CONSUMER's
    0 or ro .. THE HISTORY AND DEVELOPMENT OF CONSUMER'S SURPLUS AND ITS RELEVANCE AS A MEASURE OF WELFARE CHANGE THESIS Presented to the Graduate Council of the North Texas State University in Partial Fulfillment of the Requirements For the Degree of MASTER OF SCIENCE By Richard Murray Anderson, Jr., B. B. A. Denton, Texas August, 1975 Anderson, Richard Murray Jr., The History anadDevelo- M of Consumer's Surplus and Its Relevance as a Measure of Welfare Change, Master of Science (Economics), August, 1975, 118 pages, 20 figures, bibliography, 66 titles. The thesis analyzes the validity of consumer's surplus as a measure of welfare change. The analysis begins by examining the chronological development of the concept. Once an understanding of consumer's surplus is formulated, an evaluation of its use in modern ad hoc problems can be undertaken. Chapter II and III discuss the development of consumer's surplus from Classical economics to its modern reformulations, The concept's application to different problems is discussed in Chapter IV. Chapter V and VI deal with the intergration of consumer's surplus and the compensation principle. The primary conclusion is that the Laspeyres measure, in combination with the compensation test, provides a defini- tive measure of welfare change in a limited situation. TABLE OF CONTENTS LIST OF ILLUSTRATIONS ., ,0 Page 0 0 0 0 00 00 0iv 0 0 0 Chapter I0 INTRODUCTIONIO,, ,0,,0, *,,,,, ,,,, II. THE DEVELOPMENT OF CONSUMER'S SURPLUS, . , * 7 III. MODERN DEVELOPMENT OF CONSUMER'S SURPLUS . 36 IV. MODERN AD HOC APPLICATIONS OF HYPOTHETICAL INCOME VARIATIONS., .,. *.. .. ... 64 V.
    [Show full text]