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Unformatted text preview: be defined in terms of the elasticity of substitution, , as follows: = ___1___ 1+ or, =1-1 THE IMPORTANCE OF The parameter indicates how easily inputs can be substituted among each other along the same isoquant. The higher the value of , the more flexibility there is in the substitution between capital and labour in the production process. For example, = 0 allows no substitution between capital and labour (as in the case of a Liontief fixed-coefficient isoquant). = allows perfect substitution between capital and labour (as in the case of a linear isoquant). A special case of the CES function is when = 0 (or = 1). This gives us the Cobb-Douglas function!!!!!! To see this consider the marginal products of a Cobb-Douglas production function: COBB DOUGLAS MPK = Q K MPL =Q L MRTS = L K CES MPK = / (Q / K)1 + MPL = / (Q / L)1 + MRTS = [L/K]1 + So we can see that there is some relationship between Cobb-Douglas, Liontief, Linear, and CES functions. What values for and do we need to make a CES function into a Cobb-Douglas, Liontief, or a Linear function? 29 Elasticity of Substitution =1 =0 = 0<< Value for =0 = = -1 -1 < < Resulting Function Cobb-Douglas Liontief Linear CES Finally, let's look at these relationships in terms of a graph. Elasticity of Substitution L =0 lower higher = K Geometrically, refers to the curvature of the isoquant such that the higher the value has, the flatter the isoquant is. At the two extremes (as seen in the graph), = 0 implies an L-shaped isoquant with no substitutability between capital and labour while = implies a straight line isoquant with perfect substitutability. Rational Behaviour Consumer Equilibrium A consumer equilibrium is the solution to the consumer's basic problem of selecting the best possible collection of commodities given all of the influencing economic factors. The choice problem is essentially to balance the following two factors: 30 Wants / Preferences What the consumer wants is represented by preferences, utility, and indifference curves. The consumer wants to go as high...
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This note was uploaded on 05/25/2010 for the course ECON 301 taught by Professor Sning during the Spring '10 term at University of Warsaw.

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