Lecture Notes On Elasticity of Substitution: Elasticity of A Function of A Single Variable
Lecture Notes On Elasticity of Substitution: Elasticity of A Function of A Single Variable
Lecture Notes On Elasticity of Substitution: Elasticity of A Function of A Single Variable
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same whether quantity is measured in tons or in ounces and the percentage
change in price is the same whether price is measured in dollars, Euros, or
farthings. Thus the price elasticity is a “unit-free” measure. For similar rea-
sons, engineers measure the stretchability of a material by an “elasticity” of
the length of the material with respect to the force exerted on it.
The elasticity of the function f at a point of x can also be thought of as
the slope of a graph that plots ln x on the horizontal axis and ln f (x) on the
vertical axis. That is, suppose that we make the change of variables u = ln x
and v = ln y and we rewrite the equation y = f (x) as ev = f (eu ). Taking
derivatives of both sides of this equation with respect to u and applying the
chain rule, we have
dv
ev = eu f 0 (eu ) (3)
du
and hence
dv eu f 0 (eu ) xf 0 (x)
= = = η(x), (4)
du ev f (x)
where the second equality in Expression 4 is true because eu = x and ev =
dv
f (x). Thus du is the derivative of ln f (x) with respect to ln x. We sometimes
express this by saying that
d ln f (x)
η(x) = . (5)
d ln x
It is interesting to consider the special case where the elasticity of f (x) with
respect to x is a constant, η that does not dependent on x. In this case,
integrating both sides of Equation 5, we have
ln f (x) = η ln x + a (6)
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Elasticity of inverse functions
Another useful fact about elasticities is the following. Suppose that the
function f is either strictly increasing or strictly decreasing. Then there is a
well defined inverse function φ, defined so that such that φ(y) = x if and only
if f (x) = y. It turns out that if η(x) is the elasticity of f (x) with respect to
x, then 1/η(x) is the elasticity of φ(y) with respect to y.
Proof. Note that since the function φ is the inverse of f , we must have
φ (f (x)) = x. Using the chain rule to differentiate both sides of this equation
with respect to x, we see that if y = f (x), then φ0 (y)f 0 (x) = 1 and hence
φ0 (y) = 1/f 0 (x). Therefore when y = f (x), the elasticity of φ(y) with respect
to y is
yφ0 (y) f (x)
= .
φ(y) φ(y)f 0 (x)
But since y = f (x), it must be that φ(y) = x, and so we have
d ln R(p) d ln D(p)
=1+ = 1 + η(p)
d ln p d ln p
where η(p) is the price elasticity of demand. So revenue is an increasing
function of p if η(p) > −1 and a decreasing function of p if η < −1. In the
former case we say demand is inelastic and in the latter case we say demand
is elastic.
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Elasticity of substitution
Now we introduce today’s main event–the elasticity of substitution for a func-
tion of two variables. The elasticity of substitution is most often discussed in
the context of production functions, but is also very useful for describing util-
ity functions. A firm uses two inputs (aka factors of production) to produce
a single output. Total output y is given by a concave, twice differentiable
function y = f (x1 , x2 ). Let fi (x1 , x2 ) denote the partial derivative (marginal
product) of f with respect to xi . While the elasticity of a function of a sin-
gle variable measures the percentage response of a dependent variable to a
percentage change in the independent variable, the elasticity of substitution
between two factor inputs measures the percentage response of the relative
marginal products of the two factors to a percentage change in the ratio of
their quantities.
The elasticity of substitution between any two factors can be defined
for any concave production function of several variables. But for our first
crack at the story it is helpful to consider the case where there are just two
inputs and the production function is homogeneous of some degree k > 0.
We also assume that the production function is differentiable and strictly
quasi-concave.
Fact 1. If f (x1 , x2 ) is homogeneous of some degree k and strictly quasi-
concave, then the ratio of the marginal products of the two factors is deter-
mined by the ratio x1 /x2 and f1 (x1 , x2 )/f2 (x1 , x2 ) is a decreasing function of
x1 /x2 .
Proof. If f is homogeneous of degree k, then the partial derivatives of f are
homogeneous of degree k − 1.2 Therefore
x1
f1 (x1 , x2 ) = xk−1
2 f 1 , 1
x2
and
x1
f2 (x1 , x2 ) = xk−1
2 f 2 , 1 .
x2
It follows that
f1 (x1 , x2 ) xk−1 x1
2 f 1 x2 , 1
= k−1 x (8)
f2 (x1 , x2 ) x2 f2 x12 , 1
2
To prove this, note that if f is homogeneous of degree k, then f (λx) = λk f (x).
Differentiate both sides of this equation with respect to xi and arrange terms to show that
fi (λx) = λk−1 fi (x).
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x1
f1 x
,1
= 2 . (9)
f2 xx12 , 1
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As we remarked in our earlier discussion, the elasticity of an inverse func-
tion is just the inverse of the elasticity of a function. The function g defined
in Equation 10 is the inverse of the function h defined in Equation 11 and so
where
x1 w1
=h
x2 w2
it must be that the elasticity σ(x1 /x2 ) of the function g satisfies the equations
f1 (x1 ,x2 )
1 d ln f2 (x1 ,x2 )
=− (13)
σ(w1 /w2 ) d ln xx12
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Fact 2. The function as in Equation 14 has a constant elasticity of substi-
tution
1
σ= .
1−ρ
The function in Equation 15 has constant elasticity of substitution 1.
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with respect to wi . Cost minimization requires that the ratio of marginal
products is equal to the ratio of prices, so
f1 (x(w, y)) w1
= . (17)
f2 (x(w, y)) w2
c2 (w, 1) x2 (w, 1)
= . (18)
c1 (w, 1) x1 (w, 1)
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Noting that ln(x2 /x1 ) = − ln(x1 /x2 ), we can write this as:
! !
x2 1 f1 (x1 , x2 ) 1 λ2
ln = ln + ln
x1 1−ρ f2 (x1 , x2 ) 1−ρ λ1
! !
f1 (x1 , x2 ) λ2
= σ ln + σ ln , (23)
f2 (x1 , x2 ) λ1
We have seen that a function of this form has elasticity of substitution 1/(1−
r). We have shown that the elasticity of substitution of c must also equal 1/σ
where σ is the elasticity of substitution of the original production function.
Therefore
1 1
= . (25)
σ 1−r
We can solve for r in terms of the parameter ρ of the original production
function. From Equation 25 it follows that σ = 1 − r and hence
1 ρ
r =1−σ =1− = .
1−ρ ρ−1
We still have a bit more work to do. How are the constants a1 and a2 in
the cost function related to the coefficients in the production function? One
way to find this out is as follows. At the wage rates, w1 = λ1 and w2 = λ2 ,
the cheapest way to produce 1 unit is to set
x1 (λ1 , λ2 ) = x2 (λ1 , λ2 ) = 1
and the cost of producing one units is c(λ1 , λ2 ) = λ1 + λ2 = 1. (To see this,
note that when one unit of each factor is used, the ratio of marginal products
is equal to λ1 /λ2 and total output is equal to λ1 + λ2 = 1.)
Thus, we know that
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Calculating derivatives, we have
!r−1
c1 (λ1 , λ2 ) a1 λ1
= (27)
c2 (λ1 , λ2 ) a2 λ2
c1 (λ1 , λ2 ) x1 (λ1 , λ2 )
= =1 (28)
c2 (λ1 , λ2 ) x2 (λ1 , λ2 )
then the cost of producing one unit of output is given by the function
1/r
c(w1 , w2 , 1) = λ11−r w1r + λ21−r w2r (30)
where
ρ
r= .
ρ−1
We previously found that r = 1 − σ where σ is the elasticity of sub-
stitution of the production function. Therefore the following result fol-
lows from Equation 30 and the fact that with constant returns to scale,
c(w1 , w2 , y) = c(w1 , w2 , 1)y.
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We can also work backwards. If we know that if there is a CES cost
function with parameter r, then it corresponds to a CES production function
with parameter ρ = r/(1 − r).
So for example if ρ = −1, r = 1/2 and if r = 1/2, ρ = −1.
Remark: We have solved for the cost function if
where r ≤ 1. It is not hard now to find the cost function for the more general
CES function
f (x1 , x2 ) = A (λ1 xρ1 + λ2 xρ2 )k/ρ
where A > 0 and k > 0. Hint: If f is homogeneous of degree 1, how is the
cost function for the production function g such that g(x) = Af (x)k related
to the cost function for f ?
Fact 8. n
X 1/r
ai
ai xri
Y
limr→0 = xi .
i=1
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Proof. To prove this, note that
X 1/r 1 X
ln ai xri = ln ai xri (32)
r
Applying L’Hospital’s rule to the expression on the right, we have
d
ai xri )
P !
1 X (
lim ln ai xri = ln lim dr
d
r→0 r r→0 r
dr
ai xri ln xi
X
= lim
r→0
X
= ai ln xi . (33)
Therefore
1 X
ai xri =
X
lim
ln ai ln xi .
r→0 r
The special case where r = 0 for all i is known as the geometric mean.
Two other interesting limiting cases of means of order r are the limits as
r approaches ∞ and −∞. We have the following result:
Fact 9.
lim Mr (x1 , . . . , xn ) = max{x1 , . . . , xn }
r→∞
and
lim Mr (x1 , . . . , xn ) = min{x1 , . . . , xn }
r→−∞
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Fact 11. If r < s, then unless all of the xi are equal,
Mr (x) < Ms (x).
Immediate consequences of Fact 11 are that for any collection of numbers
that are not all equal, the geometric mean is less than the arithmetic mean
and the harmonic mean is less than the geometric mean.
We have demonstrated the following fact in previous discussions.
Fact 12. The function Mr (x) is a concave function if r ≤ 1 and a convex
function if r ≥ 1.
This result is sometimes known as Minkowski’s inequality.
There are at least four different (equally weighted) generalized means that
are sufficiently commonly used to have common names. The first three listed
below are known as the Pythagoran means. The final one is known as the
root mean square.
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A simple generalization of the means of order r is the weighted mean of
order r. Where a = a1 , . . . , an ) such that ai ≥ 0 for all i and i ai = 1, we
P
Exercises
Exercise 1.
A) Suppose that x1 = x2 = x3 = 4. Find Mr (x1 , x2 , x3 ) for r = 1, r = 0,
and r = −1.
B) Suppose that x1 = 1, x2 = 4 x3 = 16. Find Mr (x1 , x2 , x3 ) for r = 1,
r = 0, and r = −1. Verify that Minkowski’s inequality holds.
Exercise 2. Suppose that a vehicle travels from point A to point B at a
speed of S1 and travels back from point B to point A at a speed of S2 . The
average speed of travel is defined to be the ratio of total distance travelled
to total time spent traveling. Show that the average speed of travel for this
vehicle is the harmonic mean of S1 and S2 . Suppose that a vehicle travels at
speed S1 for two hours and speed S2 for two hours. Show that the average
speed of the vehicle is the arithmetic mean of S1 and S2 .
Exercise 3. Suppose that investment 1 offers a rate of return of r0 in odd
numbered years and r1 in even numbered years. Investment 2 offers a rate
of return r every year. If, after 100 years, the total return from investment
1 is the same as that from investment 2, how is r related to r0 and r1 ?
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References
[1] Kenneth J. Arrow, Hollis B. Chenery, Bagicha S. Minhas, and Robert M.
Solow. Capital-labor substitution and economic efficiency. Review of
Economics and Statistics, 43(3):225–250, August 1961.
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