Advanced Economic Theory

1364 Pages·11.348 MB·English

by  H. L. Ahuja

ADVANCED
ECONOMIC THEORY
MICROECONOMIC ANALYSIS
H L AHUJA
MA, PhD (DSE)
Formerly, Associate Professor
Department of Economics
Zakir Husain Delhi College
University of Delhi,
Delhi
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First Edition 1970
Subsequent Editions and Reprints 1971, 75, 80, 85, 90, 92, 95, 96, 97, 98, 2000, 2001, 2003, 2004, 2005, 2006
(twice), 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2016, Twenty-first Edition 2017,
Reprint 2017 (Twice), 2018 (Twice), 2019
ISBN : 978-93-5253-332-9 Product Code : H5AET41ECON10ENAU17O
Dedicated to
the memory of my mother
Nihal Bai
with reverence and affection

PREFACE TO THE TWENTY-FIRST EDITION
It gives me immense pleasure to bring out the 21st edition of this popular book. As mentioned
in the previous editions, my efforts have been to incorporate in this book the latest trends and tenden-
cies in microeconomic theory. In keeping with this approach, I have explained the various important
economic concepts and theories such as theory of demand, cost, production, price and output determi-
nation under perfect competition, monopoly and oligopoly in mathematical terms. Further, to enable
the students to understand better the mathematical exposition of the theories, I have added Chapter 5
which explains the Basic Mathematical Concepts and Optimisation Techniques.
In the present revised 21st edition of the book, some significant changes have been made in
some chapters. Among them, mention may be made of the following:
l Chapter 1: The meaning of economic efficiency has been clearly explained distinguishing
between production efficiency, allocative efficiency and distributive efficiency.
l Chapter 7: The concept of utility and its critique by Prof. Amartya Sen has been explained.
l Chapter 8: The Hicksian substitution effect and Slutsky substitution effect have been clearly
distinguished.
l Chapter 17: The attitudes towards risk of different individuals have been explained and the
choice by risk-averter and risk lover under risky and uncertain situations has been shown. It
has been clearly shown why a risk-averter generally buys insurance and a risk lover indulges
in gambling.
l Chapter 28: The chapter explains how economic efficiency is claimed to be achieved under
perfect competition and have shown that even in a perfectly competitive economy, there are
market failures to achieve economic efficiency when there exist externalities, both positive
and negative, public goods and imperfect information. Besides, it has been made clear how
a perfectly competitive economy fails to achieve equity in distribution of goods and services.
l Chapter 65: The Bergson-Samuelson social welfare function has been critically examined
and how it differs from Classical utilitarian social welfare function and Rawl’s social welfare
function which gives the highest weight to the welfare of the poorest people in a society has
been brought out.
l Chapter 67: The impact of imperfect and asymmetric information on individual’s choice has
been explained and the problems of adverse selection and moral hazard under conditions of
imperfect and asymmetric information has been clarified.
With the above changes, I hope the students will find the book more useful for them. The
book is intended to meet the requirements of the students of MA (Economics), MCom, MBA and
related courses, BA (Hons) and candidates preparing for competitive examinations such as IAS,
IES and Public Service Examinations of different States. I shall greatly appreciate the suggestions
for further improvement of the book from fellow teachers. The author can be approached at
[email protected]
H L AHUJA
PREFACE TO THE FIRST EDITION
There have been significant developments in economic theory in recent years, but the tendency
has been to make it more mathematical. Postgraduate and Honours students of Indian universities,
having poor background of mathematics, find it difficult to understand the various theories and con-
cepts involving use of advanced mathematics. Moreover, the matter pertaining to advanced topics
in economic theory is scattered in many economic journals to which most of the students of Indian
universities have no access. I have endeavoured to help them. So, in this book an effort has been made
to discuss the various theories of microeconomics without making use of advanced mathematics. The
merit of this book is that it explains the advanced theories and concepts with the help of geometry
and simple mathematics.
The book is intended to meet the requirements of MA and Honours students of Indian universi-
ties and of candidates who are preparing for IAS, IES and Allied Civil Services competitive exami-
nations, for their paper on advanced economic theory. In this book, I have confined myself only to
microeconomic theory and have covered the theories of demand, production, value and distribution.
I am deeply indebted to Dr K K Dewett, formerly Head of Economics Department, Punjab Uni-
versity, and Dr J D Varma, former Professor and Head, Department of Economics, Punjab University,
Chandigarh, who have been my teachers as well as colleagues, for inspiring me to write this book.
I am also grateful to my wife Prem Ahuja, teacher in Cambridge School, without whose generous
cooperation and help, this book would not have been possible.
Suggestions for making improvements in the book from fellow teachers are most welcome.
January 26, 1970 H L AHUJA
Disclaimer : While the authors of this book have made every effort to avoid any mistake or omission and have used their
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S. Chand does not give any representation or warranty with respect to the accuracy or completeness of the contents of this
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or reader of this publication or not, in respect of anything and everything forming part of the contents of this publication.
S. Chand shall not be responsible for any errors, omissions or damages arising out of the use of the information contained in
this publication.
Further, the appearance of the personal name, location, place and incidence, if any; in the illustrations used herein is purely
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CONTENTS
PART – I
SCOPE AND METHODOLOGY OF ECONOMICS
1. Nature and Scope of Economic Theory 3–30
The Economic Problem: Scarcity and Choice. The Scope of Economic Theory and
Basic Economic Problems. The Problem of Allocation of Resources. Choice of a
Production Method. The Problem of Distribution of National Product. The Problem of
Economic Efficiency. The Problem of Full Employment of Resources. The Problem of
Economic Growth. Problem of Scarcity vs. Problem of Affluence. Critical Evaluation
of Robbin’s Definition of Economics, Positive Economics, Normative Economics
and Welfare Economics. Production Possibility Curve: A Basic Tool of Economics.
Economic Growth and Shift in Production Possibility Curve. Production Possibility
Frontier and the Law of Increasing Opportunity Cost. Production Possibility Curve
and Basic Economic Questions.
2. Micro and Macro-Economics 31–43
Microeconomics. Importance and Uses of Microeconomics. Macroeconomics
distinguished from Microeconomics. Why a Separate Study of Macroeconomics.
Interdependence between Micro and Macroeconomics.
3. Methodology of Economics 44–55
Nature of Scientific Theory. Derivation of Economic Theories and Nature of Economic
Reasoning. Deductive Method. Merits and Demerits of Deductive Method. The
Inductive Method. Conclusion: Integration of Two Methods. Role of Assumptions in
Economic Theory: Friedman’s View. The Concept of Equilibrium: Partial Equilibrium
Analysis; General Equilibrium Analysis. Model Building in Economics. Endogenous
and Exogenous Variables in Economic Models.
4. Methodology of Economics: Economic Statics and Dynamics 56–67
Nature of Economic Statics. Static Analysis and Functional Relationships. Micro-
Statics and Macro-Statics. Assumptions of Static Analysis. Relevance of Static
Analysis. Comparative Statics. Economic Dynamics. Endogenous Changes and
Dynamic Analysis. Hicks’ Definition of Economic Dynamics. Expectations and
Dynamics. Need and Significance of Economic Dynamics.
5. Basic Mathematical Concepts and Optimisation Techniques 68–94
Introduction. Functions: Linear and Power Functions-Slopes of Functions.
Optimisation Techniques: Differential Calculus. The Concept of a Derivative. Rules of
Differentiation. Differentiation of Functions with Two or More than Two Independent
Variables. Applications of Differential Calculus (Derivatives) to Optimisation
Problems: Use in Profit Maximisation; Minimisation Problem. Multivariate
Optimisation. Constrained Optimisation. Lagrange Multiplier Technique.
PART – II
DEMAND ANALYSIS AND THEORY OF CONSUMER’S CHOICE
6. Demand and Demand Function 97–114
Significance of Demand Function. Individual Demand. Demand Function. Law of
Demand. Reasons for the Law of Demand: Why does Demand Curve Slope Downward?
Market Demand Function. Inverse demand function. Relationship between Demand
Function and Demand Curve. Factors Determining Demand. Demand for Durable
Goods. Derived Demand. Network Externalities: Bandwagon Effect and Snob Effect.
7. Consumer’s Behaviour: Cardinal Utility Analysis 115–133
Introduction. The Concept of Utility. Amartya Sen's Critique of the Concept of
Utility. Law of Diminishing Marginal Utility; Consumer’s Equilibrium: Principle of
Equi-marginal Utility. Derivation of Demand Curve and Law of Demand. Critical
Evaluation of Marshall’s Cardinal Utility Analysis.
(vii)
8. Indifference Curve Analysis of Demand 134–185
Consumer Preferences. Indifference Curve Approach. What are Indifference Curves?
Marginal Rate of Substitution. Properties of Indifference Curves. Some Non-normal Cases
of Indifference Curves: Goods, Bads and Neuters. Budget Line or Budget Constraint.
Consumer’s Equilibrium: Maximising Satisfaction. Consumer’s Equilibrium: Corner
Solutions. Income Effect: Income Consumption Curve. Income Consumption Curve
and Engel Curve. Substitution Effect. Price Effect: Price Consumption Curve. Breaking
Up Price Effect into Income and Substitution Effects. Price-Demand Relationship:
Deriving Law of Demand. Derivation of Individual’s Demand Curve from Indifference
Curve Analysis. Questions and Problems for Review.
Appendix A to Chapter 8: Slutsky Substitution Effect 186–190
Slutsky Substitution Effect and Cost Difference: Slutsky Substitution Effect for a
Decline in Price; Slutsky Substitution Effect for a Rise in Price. A Numerical Example.
Appendix B to Chapter 8: Mathematical Treatment of the Theory of Consumer’s
Choice 191–198
Mathematical Derivation of Conditions for Consumer’s Equilibrium: Lagrangian
Method. Optimum Values of the Goods. Derivation of Demand Function. Slutsky
Equation: Decomposing Price Effect.
9. Demand for Complementary and Substitute Goods 199–207
Edgeworth-Pareto Definition of Complementary and Substitute Goods. Hicksian
Explanation of Complementary and Substitute Goods. Compensated Demand Curve.
Relationship between Compensated and Ordinary Demand Curves. Measurement of
Consumer Surplus with Ordinary and Compensated Demand Curves.
10. Marshallian Cardinal Utility Analysis vs. Indifference Curve Analysis 208–221
Similarity between the Two Analyses. Superiority of Indifference Curve Analysis. Is
Indifference Curve Analysis “Old Wine in a New Bottle” ? A Critique of Indifference
Curve Analysis Limitations of Maximising Behaviour.
11. Applications and Uses of Indifference Curve 222–244
Exchange between Two Individuals: Gain from Trade. Subsidies to Consumers:
Price Subsidy vs. Lump Sum Income Grant. Rationing and Indifference Curve
Analysis. Rationing of both the Commodities. Income-Leisure Choice. Need for
Higher Overtime Wage Rate. Wage Offer Curve and the Supply of Labour. Income
Effect and Substitution Effect of the Change in Wage Rate. Backward-Bending Supply
Curve of Labour. Food Stamp Programmer: In-Kind Food Subsidy. Welfare Effects
of Direct and Indirect Taxes. Economic Theory of Index Numbers: Assessing Changes
in Standards of Living. Conclusion.
12. Revealed Preference Theory of Demand 245–262
Behaviouristic Approach to Demand Analysis. Preference Hypothesis and Strong
Ordering. Deriving Demand Theorem from Revealed Preference Hypothesis. Critical
Appraisal of Revealed Preference Theory. Derivation of Indifference Curves through
Revealed Preference Approach. Convexity of Indifference Curve and Revealed
Preference Approach.
13. Hicks’ Logical Ordering Theory of Demand 263–278
Need for Revision of Demand Theory. Preference Hypothesis and Logic of Ordering
Strong and Weak Orderings Distinguished. Hicks’ Criticism of the Logic of Strong
Ordering. The Logic of Weak Ordering. The Direct Consistency Test. Derivation of Law
of Demand through Logical Weak Ordering Approach: Deriving Law of Demand by
the Method of Compensating Variation. Deriving Law of Demand by Cost Difference
Method. Inferior Goods, Giffen Goods and Law of Demand. Appraisal of Hicksian
Weak Logical Ordering Theory of Demand.
14. Elasticity of Demand 279–321
Various Concepts of Demand Elasticity. Price Elasticity of Demand. Perfectly
Inelastic and Perfectly Elastic Demand. Measurement of Price Elasticity. Finding Price
Elasticity from a Demand Function. Price Elasticity of Demand and Changes in Total
Expenditure. Measurement of Price Elasticity of Demand at a Point on a Demand
(viii)
Curve. Comparing Price Elasticity at a given Price on the Two Demand Curves with
Different Slopes. Determinants of Price Elasticity of Demand. Cross Elasticity of
Demand. Income Elasticity of Demand. Measuring Income Elasticity at a Point
on an Engel Curve. Engel Curve and Income Elasticity: Necessities, Luxuries and
Inferior Goods. Sum of Income Elasticities, Budget Constraint and Expenditure. The
Elasticity of Substitution. Relationship between Price Elasticity, Income Elasticity and
Substitution Elasticity.
15. Consumer Surplus 322–342
Meaning of Consumer Surplus. Marshall’s Measure of Consumer Surplus. Consumer
Surplus and Changes in Price. Measurement of Consumer’s Surplus through Indifference
Curves. Hicksian Four Concepts of Consumer Surplus: Price-Compensating Variation;
Price-Equivalent Variation; Quantity Compensating Variation; Quantity Equivalent
Variation. Critical Evaluation of the Concept of Consumer’s Surplus. Applications
of Consumer Surplus: Water-Diamond Paradox, Evaluating Loss of Benefit from Tax;
Evaluating Gain from a Subsidy; Use of Consumer Surplus in Cost-Benefit Analysis.
Numerical Problems on Consumer’s Surplus.
16. Attribute Approach to Consumer’s Behaviour 343–351
Attribute or Characteristics Approach: Introduction. Indifference Curves of Attributes.
The Budget Constraint and the Efficiency Frontier. Maximising Satisfaction from
Attributes. Equilibrium with a Mixed Bundle of Products. Attribute Approach and
the Price Effect. Attribute Approach and Law of Demand. Pricing a Product Out of
the Market. Introduction of a New Product. An Evaluation of the Attribute Approach
to Consumer Theory.
17. Individual Choice Under Risk and Uncertainty 352–378
Introduction. The Concept of Risk. St. Petersburg Paradox and Bernoulli’s Hypothesis.
Utility Theory and Attitude Toward Risk: Risk Averter. Choice of a Risk Averter Under
Conditions of Risk and Uncertainty. Risk Lover. Risk Neutral. Risk Aversion and Fair
Bets. Risk Aversion and Insurance. Risk Preference and Gambling: Why Do Some
Individuals Gamble? An Application: Farmer’s Gambling Against Nature. Friedman-
Savage Hypothesis. Measuring Risk: Probability of an Outcome: Expected Value.
Risk-Return Trade off and Choice of a Portfolio. Decision Making Under Risk when
Investment Projects differ in their Expected Values: Some Numerical Problems.
Appendix to Chapter 17: Neumann-Morgenstern Method of Constructing Utility
Index under Risky Conditions 379–381
PART – III
THEORY OF PRODUCTION AND COST ANALYSIS
18. Theory of Production: Returns to a Variable Factor 385–407
Introduction. Production Function. Production Function with One Variable Factor:
Total, Average and Marginal Physical Products. Output Elasticity of an Input. Law of
Variable Proportions: Three Stages of Production. The Stage of Operation. Causes
of Initial Increasing Marginal Returns to a Variable Factor. Causes of Diminishing
Marginal Returns. Causes of Negative Marginal Returns. General Applicability of
the Law of Diminishing Returns.
19. Production Function with Two Variable Inputs 408–456
Isoquants. Marginal Rate of Technical Substitution. General Properties of Isoquants.
Isoquants of Perfect Substitutes and Complements. Fixed Proportion and Variable
Proportion Production Functions. Linear Homogeneous Production Function. Cobb-
Douglas Production Function. Cobb-Douglas Production Function and Returns to
Scale. Elasticity of Technical Substitution (Between Factors). The Economic Region
of Production. Production Function and Technological Change. Returns to Scale—
Changes in Scale and Factor Proportions. Constant Returns to Scale. Divisibility of
Factors/Constant Returns to Proportionality and Scale. Increasing Returns to Scale.
Decreasing Returns to Scale. Varying Returns to Scale in a Single Production Function.
Returns to Scale and Marginal Returns to a Variable Factor. Important Production
Functions Exhibiting Constant Returns to Scale. Constant Elasticity of Substitution
(ix)