Marshall’s Partial Equilibrium Analysis

• In partial equilibrium approach to the pricing, we seek to explain the price

determination of commodity, keeping the prices of other commodities
constant and also assuming that the various commodities are not
interdependent.
• Thus in Marshallian explanation of pricing under perfect competition,
demand function for a commodity is drawn with the assumption that
prices of other commodities, tastes and incomes of the consumers
remain constant.
• Similarly, supply curve of commodity is constructed by assuming that
prices of other commodities, prices of resources or factors and
production function remain the same.
• Then Marshall’s partial equilibrium analysis seeks to explain the price
determination of a single commodity through the intersection of
demand and supply curves, with prices of other goods, resource
prices etc., remaining the same.
• Prices of other goods, resource prices, incomes, etc., are the data of
the system which are taken as given to explain the determination of
price-output equilibrium of a single commodity.
• Given the assumption of ceteris paribus it explains the
determination of a price of a goods, say X,
independently of the prices of all other goods. With the
change in the data, new demand and supply curves will
be formed and, corresponding to these, new price of
the commodity will be determined.
• Thus partial equilibrium analysis of price determination
also studies how the equilibrium price changes as a
result of change in the data.
• But given the independent data the partial equilibrium
analysis explains only the price determination of a
commodity in isolation and does not analyse how the
prices of various goods are interdependent and inter-
related and how they are simultaneously determined.
• It should be noted that partial equilibrium analysis is
based on the assumption that the changes in a single
sector do not significantly affect the rest of the sectors.
Thus, in partial equilibrium analysis, if the price of a
good changes, it will not affect the demand for other
goods.
• Prof. Lipsey rightly writes: “All partial
equilibrium analyses are based on
the assumption of ceteris paribus.
Strictly interpreted, the assumption
is that all other things in the
economy are unaffected by any
changes in the sector under
consideration (say sector A).
• This assumption is always violated to
some extent, for anything that
happens in one sector must cause
changes in some other sectors.
• What matters is that the changes
induced throughout the rest of the
economy are sufficiently small and
diffuse so that the effect they in turn
have on the sector A can be safely
ignored”.
 Marshallian Approach to Price Determination
• Marshall prices are determined
in a static framework keeping
other things constant.
• Marshall asked "what
determines the price" and
answered that Qd and Qs
determine the price. Thus he
uses supply and demand curves
for price determination and
assumes perfect competition.
 We can arrive at Marshal stability of an equilibrium by disturbing the quantity. Let
initial equilibrium be (P0, Q0). Let us disturb it to produce Q1. But at Q1, the price
offered by consumers is much less than the price demanded by suppliers.
 Suppliers are disappointed and they produce less in the next cycle such that the price
demanded is same as price offered in the last cycle. Hence it is Marshal stable
 In figure 1, e1 is Marshal unstable. In figure 2, e1 is Marshal unstable, e2 is Marshal
stable and e3 is Marshal unstable. In figure 3, e1 is Marshal unstable and e2 is @
equilibrium @ P < P2 and Marshal stable for P > P2.
 Walras General Equilibrium Analysis
• In general equilibrium analysis, put forward by French Economist Walras
the price of a good is not explained to be determined independently of
the prices of other goods.
• Since the changes in price of good X affect the prices and quantities
demanded of other goods and in turn the changes in prices and quantities
of other goods will affect the quantity demanded of the good X, the
general equilibrium approach explains the simultaneous determination of
prices of all goods and factors.
• As stated above, partial equilibrium approach assumes that the effect of
the change in price of a good A” will be so diffused in the rest of the
economy (i.e., over all other goods) so as to have negligible effect on the
prices and quantities of other individual goods.
• Therefore, where the effect of a change in the price of a good on the prices and
quantities of some other goods is significant, as is there in the case of inter-
related goods, that is, substitutes and complementary goods, the partial
equilibrium approach cannot be validly applied in such cases and therefore there
is need for applying general equilibrium analysis which should explain the mutual
and simultaneous determination of their prices and quantities.
• General equilibrium analysis deals with inter-relationship and inter-dependence
between equilibrium adjustments with each other. General equilibrium exists
when at the going prices, the quantities demanded of each product and each
factor are equal to their respective quantities supplied.
• A change in the demand or supply of any good, or factor would cause changes in
prices and quantities of all other goods and factors and there will begin the
process of adjustment and readjustment in demand, supply and prices of other
goods and factors till the new general equilibrium is established. Indeed, the
general equilibrium analysis is solving a system of simultaneous equations.
• In a general equilibrium system, the quantity demanded of each good is
described by an equation in which its quantity demanded is a function of
prices of all goods. Likewise, in general equilibrium analysis, quantity supplied
of each good is considered to be the function of price of all factors of
production.
• In a general equilibrium system the prices of all goods affect the quantity
demanded of each good. Further, the prices of the all factors affect the
quantity supplied of each good. Besides these crucial equations, there will be
equations determining the price of each of the factors of production. As noted
above, a change in any of the demand or supply equations would cause
changes in all prices and quantities and as a result the system will tend to
move to the new general equilibrium.
• To explain the inter-relationship and interdependence among the prices and
quantities of goods and factors and ultimately to explain the determination of
the relative prices of all goods and factors, the proportion in which different
goods are being produced and different factors are being used for the
production of different goods is the essence of general equilibrium analysis.
 Walrasian Approach to Price Determination

• He determines the entire price

vector i.e. all prices together in
a general equilibrium
framework.
• Walras asked "what determines
the quantity demanded" and his
answer was relative price.
• This can be inferred from law of
equimarginal utilities i.e. a
person consumes till
(MUx/MUy) = (Px/Py).
• He assumes all markets to be
perfectly competitive.
 Assumptions For Solution Of The General
Equilibrium Model
• All markets are perfectly competitive. All factors are
completely mobile. All inputs and outputs are perfectly
divisible. All production functions and demand functions are
continuous and twice differentiable.
• There are no externalities. Closed economy.
• There are constant returns to scale.
Industry
 The Theory of Demand
Cardinal Utility Theory
• Assumptions
1. Rationality: Utility maximizer
consumer.
2. Cardinal Utility: Utility can be
measured in monetary units.
3. Constant Marginal Utility of
Money: This is to make sure
measuring scale doesn't change.
4. Diminishing Marginal Utility: Used
in deriving demand curve.
5. Additive Utility: U(a, b, c) = U(a) +
U(b) + U(c).
Ordinal Utility Theory
• Assumptions
1. Completeness: Consumer can rank
all items.
2. Transitivity: If U(x) > U(y) and U(y)
> U(z) => U(x) > U(z).
3. Non Satiation: The more a good,
the better.
4. Continuity: All goods can be
divided into infinitely small units.
5. Strict Convexity: MRSx,y and
MRSy,x should both decline
throughout the indifference curve.
6. Differentiability: Twice
differentiable.
 Cardinal Utility Theory
• Critique
1. Cardinal Utility: This is extremely
doubtful.
2. Constant Marginal Utility of
Money: Money is a good like
others, so its marginal utility
can't be same.
3. Diminishing Marginal Utility:
This has been established from
'introspection' or psychology.
Ordinal Utility Theory
• Critique
1. Assumption of existence and
convexity of ICs.
2. It is also doubtful if the
consumer can order his
preferences as precisely as the
theory assumes. His orderings
also keep on changing, so at
best, any ordering can be for a
very short run.
3. The concept of Marginal Utility
is still implicit in MRTSx,y.
 Advantages over Cardinal Utility Theory
1. Assumption of cardinality dropped.
2. Assumption of constant marginal utility of money dropped.
3. It breaks down the price effect into substitution effect and income
effect. Thus gives a better understanding of substitutability of goods.
Hicks said that goods are substitute if after adjusting for the change in
real income, a decrease in Px leads to decrease in quantity demanded
for y.
 Demand Curve and Distribution Channels
1. Final Consumers: Some argue that in the long run demand curve should be
flat as demand would be infinitely elastic and consumers will buy only on
basis of price. But this ignores the product differentiation. A consumer
buying an identical product from a trendy store is not irrational.
2. Other manufacturing firms: If the product is an investment good i.e.
machine then it involves substantial sum and brand awareness. So demand
curve will be downward sloping. For intermediate goods, flat curve.
3. Wholesalers: It is argued he will only buy products where his profit margin is
highest or he is price sensitive. But this overemphasizes his ability to control
the final demand and he may buy a low margin product if total profit is
maximized. Hence again demand curve downward sloping.
4. Retailers: If retailers buy for their own brand, then more price conscious and
flat curve. If for end consumers, then downward sloping curve.
 The Theory of Production
• Marginal Revenue and Price Elasticity
To prove: MR = p. (1 - 1/ηd)
Proof 1. We know
total revenue (TR) = price (P) * quantity (q)
=> TR = p.q.
Now differentiating it to get MR,
MR = p + q. (∂p/∂q)
We can write
∂p/∂q = [(∂p/p) / (∂q/q)] . (p/q)
But 1/ηd = - (∂p/p) / (∂q/q)
so => MR = p - 1/ηd . p or MR = p. (1 - 1/ηd).
Production Function
 Homogeneous production function
1. A production function is homogenous when if each input is multiplied by &,
then & can be factored out of the function. The power of & thus factored out
is the degree of homogeneity. Thus Q = A. (K˚å) . (Lˆß) is a homogenous
function of degree (å+ß). If degree of homogeneity is 1 it implies CRS
prevails. 1% change in both K & L together leads to 1% jump in output.
2. If a ƒ is homogenous of degree å then its marginal productivity function will
be homogenous of degree (å-1). This means for CRS functions, MPPL and
MPPK don't change with changing input values i.e. in CRS, MPPL and MPPK
are constant.
3. Homogenous functions of degree 1 satisfy Euler's theorem i.e. Q = L . MPPL +
K . MPPK. This ensures that
(a) Each input is paid the value of its marginal product.
(b) Total output is just exhausted. L.(p.MPPL) + K.(p.MPPK) = p.q. But p.MPPL = w
and p.MPPK = r, this means L.w + K.r = TR. This means in long run, TR = TC or a
firm can only earn normal profits in such a case.
 Productivity Curves
• Given a constant K,
variation of output as a
function of L. Q = ƒ(L)|K0.
Such a curve should
demonstrate law of
diminishing marginal
productivity.
• Also higher the level of K
employed, lower the level
of L needed for a given
output
 Iso-quants & Iso-costs
• MRTSL,K = -(Slope of Iso-quant) = MPPL / MPPK. At equilibrium, MRTSL,K =
w/r. Assumption: Perfect factor markets. 1. If MPPL is -ve => slope of iso-
quant is positive. At such a point, reduction in both L and K will lead to
increase in production. No one would operate on such a point. This defines
the rational zone i.e. a zone where both the marginal products are positive.
• The profit maximizing behavior dictates: π = p.Q - C should me maximized. Q
= ƒ(L,K) and C = a + w.L + r.K. This means ∂π/∂L = 0 and ∂π/∂K = 0. This
means p.MPPL = w and p.MPPK = r are 2 conditions. This actually represents
the point where his MR = MC.
 Long Run Cost Curves
• To get the LR total cost curve, @
every output level q, draw the
SR total cost curves for every K
level. Choose the minimum cost
point. Repeat this process for all
levels of q and get the LR total
cost curve. LTC curve can also be
seen as the envelope of STC
curves.
• To get the LR average cost curve,
just divide the total cost curve
by q. LAC curve can also be seen
as the envelope of SAC curves.
• for LMC curve, take the partial
derivative of LTC wrt q.
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