Consumer and Producer Theory
Although Intermediate Microeconomics is not a prerequisite for Intermediate Macroeconomics, modern
Intermediate Macroeconomics borrows heavily from standards in the theory of the consumer and producer.
In particular, students must have a basic understanding of a budget constraint, utility maximization, and
profit maximization. Any standard Principles of Microeconomics text book covers these ideas at a basic
level. We will review the most important information here.
1. CONSUMPTION THEORY: THEORY OF THE CONSUMER
We assume there are two goods X and Y with givens prices Px and Py. The consumer has income I. The
consumers budget constraint in a simple world simply describes possible expenditure now, or in some
fixed period of time (e.g. this week). But there is no past and no future, hence no savings, no debt, no
1
bequests, etc.
1.1 THE BUDGET CONSTRAINT
Imagine you have I = $500 and must decide on how many X = apples and Y = shoes to buy, where Px =
2/pound Py = 10. The budget constraint is
Budget Constraint : I XPx YPx
X Expenditure : XPx 0 X 0
Y Expenditure : YPy 0 Y 0
For example
500 X 2 Y 10
The constraint implies a budget line:
I P
Y X x
Py Py
Maximum number of Y units affordable I / Py
Maximum number of X units affordable I/Px
Slope Market Tradeoff Px / Py
which can be plotted on a Euclidean X,Y-plane:
1
The two goods can be anything. In the future (but not in this document) we will assume X is simply a consumption good, and Y is
leisure time. The less Y one has the more time spent working so the more X. In this scenario the price of consumption is 1, and the
price of leisure is the wage that would have been earned if the person worked.
Y
I/Py
Budget Line, or Budget Fronti er. All bundles {X,Y} on
the line cost I, like point A, and therefore exhaust all
A
income. All points outside, like B, cannot be afforded;
all points inside imply not all income is spent, e.g. C.
C
I/Px X
For example
Y = shoes
500/10 = 50
500/2 = 250 X = apples
Notice the budget line articulates consumption possibilities: all points on or inside the line are possible; all
outside are not.
1.2 INCOME SHIFTS
As income increases or decreases, consumption possibilities increase or decrease for any price level. If
income increases to $1000 then
Y = shoes
1000/10 = 100
500/10 = 50
I = 1000
I = 500
500/2 = 250 1000/2 = 500 X = apples
1.3 PRICE SHIFTS
As the price of a good increases or deceases the market tradeoff changes: the budget line slope changes and
therefore consumption possibilities change. If I = 500 and the price of X increases to 4 then
Y = shoes
500/10 = 50
Px = 2
Px = 4
500/4 = 125 500/2 = 250 X = apples
1.4 UTILITY
We assume individuals gain some sort of utility, or personal welfare, when they consumer goods. We
assume more consumption leads to more personal welfare, but there are decreasing marginal returns. For
example, if you are very hungry the first apple gives you a lot of satisfaction, the second gives you less
satisfaction since you are no longer very hungry, etc.
The utility function is written as U(X,Y). For example, the Cobb-Douglas utility function is
U (X , Y ) X Y 0 , 1 1
The parameters and are preference parameters that reflect a consumers overall predisposition toward
a good. Here, if Frank has = 3/4 and Susan has = 2/3, Frank will literally prefer X more than Susan,
holding everything else constant (i.e. ceteris parabus). If Frank and Susan were otherwise identical (i.e.
same income level), Frank would consume more X then Susan.
In Susans case if = 2/3 and = 1/3, then
U ( X , Y ) X 2 / 3Y 1 / 3
Marginal utility, or MU, denotes the change in utility when the consumption level is changed. We do this
for infinitesimal changes, hence MU is the partial derivative of U(X,Y):
MU x U ( X , Y ) MU y U ( X , Y )
X
Y
Recall more is better, but there are decreasing marginal returns. This implies we must have
MU x U ( X , Y ) 0 and MU x gets smaller as X increase
X
MU y U ( X , Y ) 0 and MU y gets smaller as Y increase
Y
1.5 COBB-DOUGLAS UTILITY FUNCTION
Recall Susans preference structure for X = apples and Y = shoes is
U ( X , Y ) X 2 / 3Y 1 / 3
The marginal utility functions are
1/ 3
2 2 2 Y
MU x U ( X , Y ) X 2 / 31Y 1 / 3 X 1 / 3Y 1 / 3
X 3 3 3 X
2 /3
1 1 1 X
MU y U ( X , Y ) X 2 / 3Y 1 / 31 X 2 / 3Y 2 / 3
Y 3 3 3 Y
Clearly
1/ 3
2 Y
MU x 0 and MU x as X
3 X
2/ 3
1 X
MU y 0 and MU y as Y
3 Y
So, the Cobb-Douglas utility function satisfies our basic requirements about people.
1.6 UTILITY MAXIMIZATION - OPTIMAL CONSUMPTION CHOICE
We assume people choose their consumption bundles by maximization the utility they obtain from
consumption, subject to their budget constraint:
max U ( X , Y ) s.t. I XPx YPy
x, y
* *
The following skips several steps simply to present the solution. The utility maximizing bundle {X , Y }
must satisfy two conditions. First, it must be affordable and therefore satisfy the budget constraint:
I X * Px Y *Py
Second, it must satisfy the optimality condition:
MU x Px
MU y Py
* *
With these two equations we solve for {X , Y }.
1.7. COBB-DOUGLAS REVISITED
Suppose Susan has income I = 500, the price of X = apples is 2, the price of Y = shoes is 10, and her utility
function is
U ( X , Y ) X 2 / 3Y 1 / 3
Then her optimal consumption choice solves
Budget Constraint : 500 X * 2 Y *10
MU x Px
Optimality Condition :
MU y Py
Use the marginal formulas above to solve:
1/ 3
2 Y
MU x 3 X Y
2 / 3 2
MU y 1 X X
3 Y
The optimality condition implies
Y 2 1
2 Y X
X 10 10
Use the budget constraint to get
Y 50 .2 X .1 X X 50 / .3 500 / 3 166 .67
Y .1 X .1 167 16.67
The Optimal Bundle X * , Y *
166.67, 16.67
Double check affordability:
XPx YPy 166.67 2 16.67 10 333 .33 166.67 500
So, the optimal bundle does indeed cost exactly the persons income.
1.8 COBB-DOUGLAS AGAIN: DEMAND FUNCTION
We can solve for the optimal consumption of X and Y as functions of income I and prices P. We use
Budget Constraint : I X *Px Y * Py
MU x Px
Optimality Condition :
MU y Py
Solve
MU x Y P 1
2 x YPy XPx
MU y X Py 2
Use the budget constraint to get
1 3
I X *Px Y * Py X * Px X *Px X *Px
2 2
2 I
X*
3 Px
So, quantity demanded of X is decreasing in price, and increasing in income (i.e. it is a normal good). For
I = 500 and 1000 we have
Demand Functions: X(I,P)
30
Quantity Demanded X
25
20
15
10
X(1000,P)
5 X(500,P)
0
1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191
Price X(500,P)
X(1000,P)
2. PRODUCER THEORY: THEORY OF THE FIRM
By comparison the theory of the firm is fairly transparent. The firm uses inputs, or factors of production
(e.g. L = labor, K = capital; but also human capital, land, energy, etc), to generate output Y. The
relationships between inputs and output is the production function, which itself must imply some level or
state of technology. In this class we write
Y AF (K , L )
were F is the production function, and A denotes total factor productivity. We use A to capture an
abstract sense of technology: a more technologically advanced nation will be able to produce more goods
with the same number of labor and capital inputs as comparatively less advanced nations.
We assume increasing marginal product: more inputs must generate more output. The Marginal Product
of Labor and Capital are
MPL A F ( K , L) MPK A F ( K , L)
L
K
We also assume decreasing marginal returns: more input leads to more output, but at a decreasing rate:
MPL as L MPK as K
2.1 COBB-DOUGLAS PRODUCTION FUNCTION
The Cobb-Douglas function was investigated as a likely expression of output inputs translate to output by
Paul Douglas and Charles Cobb in (1928). Since then economists used the functional form for utility.
*
Consider a short-run production problem: capital is fixed at K = 1 and
F (L ) F (1, L) AL2 / 5
This means the short-run marginal product of labor is
2A 1
MPL AL2 / 5
L 5 L3 / 5
which is positive, and decreasing in L.
If A = 1 in 1980 and A = 2 in 2000, the marginal product of labor is
2A 1 2 1 1
MPL 3/ 5
A 1 then MPL 0.046588
5 L 5 363 / 5
2 2 1
A 2 then MPL 0.093177
5 363 / 5
Cobb-Douglas: F(L) = A*L^(2/5)
14
12
MPL = .093 Y in 2000
10
Output Y
8
6 MP L = .047
Y = 1980
4
2
0
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96
Labor Input L F(L): A = 1
F(L): A = 2
Marginal Product of Labor
0.6
0.5
Marginal Product
0.4
0.3
0.2
MP L = .093 0.1
MP L = .047
0.0
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96
Labor Input L M PL: A = 1
M PL: A = 2
We can imagine the product is a table: one new unit of labor (e.g. one person working one more hour) can
produce 1/20th of a table in 1980, but 1/11th of a table in 2000.
2.2 PROFIT MAXIMIZATION: OPTIMAL OUTPUT
The firm solves the following profit maximization problem. We assume the firm is small, hence a price-
taker: price is simply given. The firm also takes the market wage w as given. In the short-run only labor-
inputs are adjusted to optimize profit, and capital is held fixed (e.g. it is relatively easy to hire more labor
inputs; but expanding production by adding an assembly line takes months or years to prepare for). This is
the problem with the Classical Model: there is only a short-run, and no capital accumulation such that the
economy can grow.
Profit as a function of labor inputs, denoted (L), is
Profit Revenues - Cost
( L) P AF(K * ,L)-wL
The profit maximization problem is
max ( L ) P A F(K * ,L)-wL
L
The first order condition is
( L) 0 P A F(K* ,L)-w 0
L L
P MPL w
Value of Marginal Product labor cost
Thus, the firm uses labor to the point where the cost of an additional hour, w, is exactly off-set by the
market value of that additional unit of labor: PMP L.
Notice PMP L denotes the Labor Demand function, based on the what it costs to employ labor. Since we
assume diminishing marginal returns, the demand for labor is
DL = PMP L
So, what shifts the demand for labor? First, a high price: ceteris paribus an in increase in price makes
production more profitable, hence output will be expanded which requires more labor inputs at whatever
the wage is. Second, more productive labor: if people can produce output faster2 this represents a de facto
savings to the firm. This lower cost implies greater profits, hence output expands and again the demand for
labor increases.
For example, an increase in the price implies more labor is demanded at every wage:
P' > P
w = 10
DL = P'MP L
DL = PMP L
L = 25 L = 35 L
2.3 EXAMPLE
If the market wage and price are w = 20 and P = 50, then the firm uses labor until
50 MPL 20 MPL 2 / 5 .4
Since the price is so high, the value of labor is high. Recall that the Marginal Product of Labor decreases as
labor units are added (diminishing marginal returns). So the resulting tiny 2/5 implies a large number of
labor units: valuable labor = employ a lot of labor.
2.4 EXAMPLE
Fix capital at K = 1, and assume w = 10, P = 50, and
Y A F( L) AF (1, L) 2 L2 / 5
Then the profit maximization problem reduces
P MPL w
2 1
50
2 3 / 5 10 4 5 / 3 L L 10.07937
5 L
The firms profit maximizing level of labor is 10.08 units (e.g. individuals/day, hours, etc., whatever the
units are). The resulting level of output and profit are
2
That is, fewer labor hours are required to produce one unit: think of car manufacturing in 1960 versus 2000.
Y A F ( L* ) 2 10.079372 / 5 5.039671
50 5.039671 - 10 10.07937 151.1898
Notice we can represent and plot profit as a function of labor:
( L) 50 2 L3 / 5 10 L
Output and Profit
200 12
Profit = 151.2
150
10
100
50 8
Output
Profit
0
6 Output Y = 5.04
-50
-100 4
-150
2
-200
-250 0
1 6 11 1 2 2 3 3 4 4 51 5 6 6 71
Labor Input L Pro fit (L) Y(L)
Optimal L = 10.08
The Demand for Labor in this case is
2 1 1
50 MPL 50 2 3 / 5 40 3 / 5
5L L
which looks like
Demand for Labor
45
40
Value of Marginal Product
35
30
P*MPL =
25
20
15
10
5
0
1 6 11 16 2 1 2 6 3 1 3 6 4 1 4 6 51 56 6 1 6 6 71 76 8 1 8 6 9 1 9 6
Labor Input L
