AGRODEP Technical Note TN-02

November 2012

Functional Forms Commonly Used in CGE Models

Fabienne Femenia

1
Contents
1 Demand functions 3
1.1 Generalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Cobb-Douglas . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 Constant Elasticity of Substitution . . . . . . . . . . . . . . . 7
1.4 Linear Expenditure System-Cobb Douglas . . . . . . . . . . . 8
1.5 Linear Expenditure System - Constant Elasticity of Substitution 9
1.6 Almost Ideal Demand System . . . . . . . . . . . . . . . . . . 11
1.7 Linearized Almost Ideal Demand System . . . . . . . . . . . . 12
1.8 Normalized Quadratic Expenditure System . . . . . . . . . . . 14
1.9 An Implicit Direct Additive Demand System . . . . . . . . . . 16
1.10 Degrees of freedom . . . . . . . . . . . . . . . . . . . . . . . . 20

2 Production functions 22
2.1 Generalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.2 Leontief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.3 Cobb-Douglas . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.4 CES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.5 CET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

1
Abstract
This technical note presents a review of the functional forms commonly used
to represent demand and production in Computable General Equilibrium
(CGE) models. The general properties of demand and production functions
are described. The note also includes the detailed derivation of some specific
functions.

2
1 Demand functions
1.1 Generalities
Demand functions
Marshallian demand functions
Marshallian demand functions are derived from the maximization of direct
utility U (q1 , ..., qn ) under budget constraint:

maxP U (q1 , ..., qn )
s.t. i pi qi = R
where qi and pi represent the demand and price respectively of good i, R
is the household’s income, and U (q1 , ..., qn ) is the utility function. These
demands are also called uncompensated, as opposed to the compensated
Hicksian demand functions described bellow.
Marshallian demands are thus functions of prices and income: qi (p1 , p2 , ..., pn , R).
From this we can find the indirect utility function V (p1 , ..., pn , R) which
corresponds to the utility level obtained for a given income and set of prices.
V (p1 , ..., pn , R) = U (q1 , ..., qn ) = U (q1 (p1 , ..., pn , R) , ..., qn (p1 , ..., pn , R))

Hicksian demand functions

Hicksian demand functions are derived from the minimization of expenditure
under a utility constraint:

min i pi qiH
P
s.t.U (q1 , ..., qn ) = u
Hicksian demands are also called compensated, since the utility level is held
contant. They are thus functions of prices and utility: qiH (p1 , p2 , ..., pn , u).
From this we can find the expenditure function e which gives the minimum
budget required to obtain a given utility level for a given set of prices.
X
e (p1 , ..., pn , u) = pi qiH (p1 , ..., pn , u)
i
It is also worth noting that:

qiH (p1 , p2 , ..., pn , V (p1 , ..., pn , R)) = qi (p1 , p2 , ..., pn , R)

In the same way:

qi (p1 , p2 , ..., pn , e (p1 , ..., pn , u)) = qiH (p1 , p2 , ..., pn , u)

3
Elasticities
Uncompensated price elasticities
The uncompensated price elasticities measure the evolution of demand with
prices, the level of income being constant.
The own price elasticity measures the evolution of one good’s demand
with its own price:

∂qi pi
i =
∂pi qi
The cross price elasticity measures the evolution of one good’s demand
with the price of another good:

∂qi pj
ij =
∂pj qi

Income elasticities
The income elasticity measures the evolution of demand with income:

∂qi R
ηi =
∂R qi

Compensated price elasticities

The compensated (Hicksian) price elasticities measure the evolution of de-
mand with prices, the level of utility being constant.
Own price elasticity:
∂qiH pi
H
i =
∂pi qiH
Cross price elasiticity:
∂qiH pj
H
ij =
∂pj qiH
The Allen substitution elasticity is defined as:
H
ij
σij =
wj
p q
Where wj is the budget share of good j, that is, wj = Pj j
i pi qi

4
Useful identities
Slutsky equation
The Slutsky equation decomposes the (uncompensated) price effect into two
components: a substitution effect and an income effect. Namely, if the price
of good j increases, the real income of the consumer decreases which induces
a decrease in the demand for good i (income effect for normal goods), but
as the price of good i relative to the price of good j decreases, the decrease
in demand for good i may be attenuated (substitution effect for substituable
goods). We thus have:

ij
ij = H
ij − wj ηi ⇔ σij = + ηi
wj

Shephard’s lemma
The Shephard’s lemma states that the demand for a particular good i for a
given level of utility u and given prices p, equals the partial derivative of the
expenditure function with respect to the price of the good:

∂e (p, u)
qiH (p, u) =
∂pi
This is easliy demonstrated by differentiating both sides of the equality:

X
e (p1 , ..., pn , u) = pi qiH (p1 , ..., pn , u)
i

Roy’s identity
The Roy’s identity relates the Marshallian demand function to the partial
derivatives of the indirect utility function:

∂V (p,R)
∂pi
qi (p, R) = − ∂V (p,R)
∂R

1.2 Cobb-Douglas
Demand function
The Cobb-Douglas demand function is derived from the following utility max-
imization program:

5
 Q α
max U = j qj j

P
s.t. j pj qj = R
P
With i αi = 1

!
α
Y X
L= qj j − λ pj qj − R
j j

Q α
∂L αi j qj j
=0= − λpi
∂qi qi
∂L X
=0= p j qj − R
∂λ j

Q α
αi j qj j
λ= , ∀i
pi qi
αj pi qi
⇒ pj q j = , ∀i, j
αi
X pi qi X
R= pj q j = αj
j
αi j
Rαi
⇒ qi =
pi

Elasticities
∂qi pi Rαi pi qi pi
i = =− 2 =− = −1
∂pi qi pi qi pi qi

∂qi pj
ij = = 0∀i 6= j
∂pj qi

∂qi R αi R αi Rpi
ηi = = = =1
∂R qi pi q i pi αi R

ij
σij = + ηi = 1
wj

6
1.3 Constant Elasticity of Substitution
Demand function
The Constant Elasticity of Substitution (CES) demand function is derived
from the following utility maximization program:


P  1
1− σ1 1− σ1

max U = i α i q i
 s.t. P p q = R
i i i

! 1 !
1
1− σ
1− σ1
X X
L= αi qi −λ pi qi − R
i i

1
! σ−1
∂L −1
X σ−1
= 0 = αi qi σ αj qjσ
− λpi
∂qi j

∂L X
=0= p j qj − R
∂λ j

1
− σ1
! σ−1
αi q i X σ−1
λ= αj qj σ
, ∀i
pi j

 σ
αj pi
⇒ qj = qi , ∀i, j
αi pj

 σ X
X pi
R= pj q j = qi αjσ pj1−σ
j
αi j

αiσ R
⇒ qi =
pσi j αjσ p1−σ
P
j

7
Elasticities
 
σ−1 σ 1−σ
pi  −αiσ Rσpi − αi2σ R (1
P
∂qi pi j α j pj − σ)  αiσ (σ − 1)
i = =  2  = −σ+
pσ−1
P σ 1−σ
∂pi qi qi j α j pj
 P
pσi j αjσ p1−σ
j
i

∂qi pj pj q j
ij = = (σ − 1) , ∀i 6= j
∂pj qi R

∂qi R ασ R
ηi = = σ P i σ 1−σ = 1
∂R qi pi j α j pj qi

ij
σij = + ηi = (σ − 1) + 1 = σ
wj
pj qj pj αj R
Where the second equation follows from noting that wj = R
= R pσ
P 1−σ =
j k αk pk
αj pj1−σ
P 1−σ , ∀j.
k αk p k

1.4 Linear Expenditure System-Cobb Douglas

Demand function
The Linear Expenditure System (LES)- Cobb-Douglas demand function is
derived from the Stone-Geary utility maximization program:

U = i (qi − qmini )αi

 Q
maxP
s.t. i pi qi = R
P
With i αi = 1 ; qmini being the minimal consumption quantities.

!
Y αi
X
L= (qi − qmini ) − λ pi qi − R
i i

∂L αi Y
=0= (qj − qminj )αj − λpi
∂qi qi − qmini j

∂L X
=0= p j qj − R
∂λ j

8
 αi Y
λ= (qj − qminj )αj , ∀i
pi (qi − qmini ) j

α j pi
⇒ qj = qminj + (qi − qmini ) , ∀i, j
α i pj

X X pi X
R= pj q j = pj qminj + (qi − qmini ) αj
j j
αi j

!
αi X
⇒ qi = qmini + R− pj qminj
pi j

Elasticities
! !
∂qi pi pi αi X αi qmini
i = =− R− pj qminj + qmini = (1 − αi )−1
∂pi qi qi p2i j
pi qi

∂qi pj αi pj qminj
ij = =− , ∀i 6= j
∂pj qi pi qi

∂qi R R
ηi = = αi
∂R qi pi qi

 
ij αi qminj
σij = + ηi = 1−
wj wi qj

1.5 Linear Expenditure System - Constant Elasticity

of Substitution
Demand function
The LES-CES demand function is derived from the following utility maxi-
mization program:

( σ
P 1 σ−1
 σ−1
max U = i αi (qi − qmini )
σ σ
P
s.t. i pi qi = R

9
 σ
! σ−1 !
X 1 σ−1 X
L= αi (qi − qmini )
σ σ −λ p i qi − R
i i

1
! σ−1
∂L 1 1 X 1 σ−1
= 0 = αiσ (qi − qmini )− σ αj (qj − qminj )
σ σ − λpi
∂qi j

∂L X
=0= p j qj − R
∂λ j

1 1
1
! σ−1
α σ (qi − qmini )− σ X 1 σ−1
λ= i αj (qj − qminj )
σ σ , ∀i
pi j

αj pσi
⇒ qj = qminj + (qi − qmini ) , ∀i, j
αi pσj

X X pσi X αj
R= pj q j = pj qminj + (qi − qmini )
j j
αi j pσ−1
j

 P 
αi R − j pj qminj
⇒ qi = qmini +
pσi j αj p1−σ
P
j

Elasticities
  P  
αi p1−σ R− j pj qminj
i = − P i 1−σ qi + σ  − qi + qmini 
q i j α j pj pi

αi pj (qj − σ (qj − qminj ))

ij = − , ∀i, j
qi pσi k αk pk1−σ
P

∂qi R R (qi − qmini )

ηi = =  
∂R qi P
qi R − j pj qminj

ij σR (qi − qmini ) (qj − qminj )

σij = + ηi = P
wj qi qj (R − k pk qmink )

10
1.6 Almost Ideal Demand System
Demand function
The Almost Ideal Demand System (AIDS), proposed by Deaton and Muell-
bauer (1980) is a flexible functional is the sense that it has enough parameters
to be regarded as a reasonable approximation to whatever the true unknown
function might be.
The consumers’ preferences on which the AIDS is based, are assumed to
belong to the Price Independant Generalized linear Log (PIGLOG) class of
preferences and are represented via the expenditure function:

X 1 XX Y β
ln (e (p, u)) = α0 + αk ln pk + γ∗kj ln pk ln pj + uβ0 pkk (1)
k
2 k j k
P P P P
Where i αi = 1, j γ∗kj = j γ∗jk = j βj = 0
As e (p, u) = i pi qi , we know that ∂e(p,u)
P
∂pi
= qi , which leads to:

pi ∂e (p, u) pi qi
= (2)
e (p, u) ∂pi e (p, u)
pi qi pi ∂(p,u) ∂ ln(e(p,u))
Recognizing that wi = e(p,u) and that e(p,u)∂p i
= ∂ ln pi
, using equality
(2) and logarithmic differentiation of (1) leads to:
X Y
wi = αi + γij ln pj + βi uβ0 pβkk
j k

With γij = 21 γ∗ij + γ∗ji

Furthermore, (1) implies that:

X 1 XX Y β
ln (e (p, u)) = α0 + αk ln pk + γ∗kj ln pk ln pj + uβ0 pk k
k
2 k j k

!
Y X 1 XX
⇒ uβ0 pβkk = ln (e (p, u))− α0 + αk ln pk + γ∗kj ln pk ln pj
k k
2 k j
The AIDS is thus expressed as:
 
pi q i X R
wi = = αi + γij ln pj + βi ln
R j
P
P P P
With γij = γji , i αi = 1, i βi = 0 and j γij = 0
And P a price index such that: ln P = α0 + k αk ln pk + 21 k j γkj ln pk ln pj
P P P

11
Elasticities
!
∂qi pi γii βi X
i = = −1 + − αi + γji ln pj
∂pi qi wi wi j

!
γij βi X
ij = − αj + γkj ln pk
wi wi k

∂qi R βi
ηi = =1+
∂R qi wi

 
ij γij βi βj R
σij = + ηi = 1 + + ln
wj wi wj wi wj P

1.7 Linearized Almost Ideal Demand System

Demand function
In this linearized version of the AIDS, the non linear price index P is replaced
by the Stone’s price index P ∗ to ease the empirical use of the model. The
equation definig this index P ∗ is given by:

X
ln P ∗ = wk ln pk
k

The demand is thus equal to:

!!
R X X pj qj
qi = αi + γij ln pj + βi ln R − ln pj
pi j j
R

!!
R X X pj q j pi qi
⇒ qi = αi + γij ln pj + βi ln R − ln pj − ln pi
pi j j6=i
R R

!!
R X X pj qj
⇒ qi = αi + γij ln pj + βi ln R − ln pj
(1 + βi ln pi ) pi j j6=i
R

12
Elasticities
!!
∂qi pi 1 + βi ln pi + βi 1 γii βi X ∂qj pi qj pj
i = =− + − ln pj
∂pi qi 1 + βi ln pi 1 + βi ln pi wi wi i6=j
∂pi qj R
!!
1 γii βi X
⇒ i = −1 + −βi + + ji wj ln pj
1 + βi ln pi wi wi j6=i

!
γii βi X
⇒ i = −1 − βi + − wi ln pi + ji wj ln pj
wi wi j

!!
∂qi pj 1 X
ij = = γij − βi wj ln pj + wj + kj wk ln pk
∂pj qi wi (1 + βi ln pi ) k6=i

!
wj βi ln pj 1 γij βi w j βi X
⇒ ij = + − + βi ln pi ij − wk ln pk kj
wi (1 + βi ln pi ) 1 + βi ln pi wi wi wi k

!
γij βi wj βi X
⇒ ij = − − wj ln pj + wk ln pk kj
wi wi wi k

!
∂qi R βi X
ηi = =1+ 1− wj ln pj (ηj − 1)
∂R qi wi (1 + βi ln pi ) i6=j

X
⇒ (ηi − 1) (1 + βi ln pi ) wi = βi +βi wi ln pi (ηi − 1)−βi wj ln pj (ηj − 1)
j

!
βi X
⇒ ηi = 1 + 1 + ln P ∗ − ηj wj ln pj
wi j

!
ij γij βi X
σij = +ηi = 1+ − wj ln pj − wj ln P ∗ + (wk ln pk kj + wj ηk wk ln pk )
wj wj wi wj wi k

!
γij βi pj X
⇒ σij = 1 + − ln ∗ + σkj wk ln pk
wj wi wi P k

13
1.8 Normalized Quadratic Expenditure System
Demand function
We start from the normalized quadratic expenditure function:

P P !
X X 1 j β jk p j p k
e(p, u) = aj p j + bj p j + Pk u
j j
2 j α j pj

With βij = βji

As e(p, u) = R, the indirect utility function can be expressed as:
 P 
R − j aj p j
V (p, R) = P P P 
1 j P k βjk pj pk
j b j p j + 2 αj p j j

Furthermore, applying Shephard’s lemma, allows us to find the Hicksian

demand function:
 
P P P
∂e (p, u) j pj βij 1 αi j k βjk pj pk 
qiH (p, u) = = ai + bi + P − 2  u

∂pi j α j pj 2
P
α p
j j j

Replacing u with the expression for V (p, R) in this equation, we find the
Marsallian demand function:
  P P P 
j pj βij 1 αi j k βjk pj pk
P
R − j aj p j bi + P α j p j − 2 2
( j αj pj )
P
j
qi (p, R) = ai + P P P 
1 j P k βjk pj pk
b p
j j j + 2 αj pj j

Elasticities
  P P P 
j βij pj 1 αi j k βjk pj pk
ai b i + P −2 2
∂qi pi pi  j αj p j ( j αj p j )
P
i = = − P P
β pj p
∂pi qi qi P
bj pj + 1 j P k jk k
j 2 j αj p j

  P
αi j βij pj α2i j k βjk pj pk
P P 
P βii
P
R− j aj p j −2 P 2 + 3
j αj p j ( j αj p j ) ( j αj pj )
P
+ P P
1 j P k βjk pj pk
P
j bj p j + 2 j αj p j
!
(qi − ai )2
− P
R − j α j pj

14
  P  αi
P
βij pj α2i
P P
βjk pj pk

pi R − j aj p j βii − 2 P jαj pj + j k
2
pi (qi − ai ) ( αj p j )
P
j j
⇒ i = − P + P 
R − j aj p j qi α j pj
P 1
P P
j j bj p j + 2 j k βjk pj pk

∂qi pj pj qj (qi − ai )
ij = =− P
∂pj qi qi (R − k ak pk )
 
k (αj βik +αi βjk )pk
P P P
P αi αj k l βkl pk pl
pj (R − k ak pk ) βij − P + 2
k αk p k ( k αk p k )
P
+ P P 1
P P

qi k α k pk k bk p k + 2 k l βkl pk pl

 P P P 
j βij pj 1 αi j k βjk pj pk
R bi + P α j p j − 2
( j αj p j )
P
∂qi R j
ηi = = P P P 
∂R qi 1 j P k βjk pj pk
qi b
j j jp + 2 αj p j j

R (qi − ai )
⇒ ηi =  P 
qi R − j aj p j

 
(αP
j βik +αi βjk )pk
P P P
P k αi αj βkl pk pl
R (R − kak pk ) βij − + 2
k l
ij k αk p k ( k αk p k )
P
σij = +ηi = P P 1
P P

wj qi q j k α k pk k bk p k + 2 k l βkl pk pl

Normalization
A normalization of the NQES parameters is needed in order to avoid indeter-
minancy problems in their estimation (see Diewert and Fox, 2009). Namely,
for a set of reference prices p∗ i :

X
bi p ∗ i = 1
i

X
βij p∗ j = 0
j

15
 X
ai p ∗ i = 0
i

If, as usual in CGE modelling, the reference prices are set to 1, which
eases the calibration of parameters.
Indeed, in that case, at initial point we have:

qi = ai + Rbi

Rβii
i = −bi + P
qi j αj

qj (qi − ai ) Rβij
ij = − + P
qi R q i k αk

Rbi
ηi =
qi

R2 βij
σij = P
qi qj k αk

1.9 An Implicit Direct Additive Demand System

Demand function
Here we start from an implicit directly additive utility function (see Hanoch
(1975) for more detail on implicit additive utility functions):

X αi + βi eu 
qi − qmini

ln =1
i
1 + eu Aeu

Where qmini represents the minimal possibleP consumption level P of good i,

and A, αi , βi are parameters, with αi ≥ 0, i αi = 1, βi ≤ 1 and i βi = 1.
The AIDADS (An Implicit Direct Additive Demand System) is derived
from the maximization of utility u, subject to its implicit additivity and to
a budget constraint:

16
 
 maxP u
+βi eu qi −qmini
s.t. i αi1+eu ln Aeu
=1
P
s.t. pi qi = R


! !
X αi + βi eu qi − qmini X
L=u−λ ln −1 −ξ −R
i
1 + eu Aeu pi qi

αi +βi eu
Let’s define φi = 1+eu

    !
∂L ∂u ∂u X ∂φj qj − qminj φi
=0= −λ ln − phij + +ξpi
∂qi ∂qi ∂qi j ∂u Aeu qi − qmini

   
∂L X qj − qminj X qj − qminj
=0=1− φj ln ⇒ φj ln =1
∂λ j
Aeu j
Aeu

   
∂u X ∂φj qj − qminj φi
⇒ ln u
− φj + =0
∂qi j ∂u Ae (qi − qmini )

We thus have:

∂L ∂u ∂u
=0= − ξpi ⇒ = ξpi
∂λ ∂qi ∂qi
And:

∂u φ
=−  i   
∂qi P ∂φ q −qmin
(qi − qmini ) j ∂uj ln j Aeu j − φj

From the two previous equalities we have:

φi
ξ=− P  ∂φj    , ∀i
qj −qminj
pi (qi − qmini ) j ∂u
ln Aeu
− φj

17
 φj pi (qi − qmini )
⇒ qj = qminj + , ∀i, j
φi pj

∂L X
=0= p j qj − R
∂ξ j

X pi (qi − qmini )
⇒R= pj qminj +
j
φi
   
u
P P
φi R − j pj qminj (αi + βi e ) R − j pj qminj
⇒ qi = qmini + = qmini +
pi pi (1 + eu )
We can also derive the the Hicksian AIDADS (An Implicit Direct Additive
Demand System) from the minimization of expenditure, subject the utility
constraint:
 P
min pi qi = R
P αi +βi eu qi −qmini
s.t. i 1+eu ln Aeu = 1
P 
P (αi +βi eu ) qi −qmini


L = i pi qi + λ i (1+eu ) ln Aeu
−1
qi −qmini
P P


= i pi qi + λ i φi ln Aeu
−1
 
∂L φi
= 0 = pi + λ
∂qi qi − γi

pi φj (qi − qmini )
⇒ qj = + qminj , ∀i, j
pj φi
 
∂L X qj − qminj
=0= φj ln −1
∂λ j
Aeu
   
X φj pi
⇒ φj ln + ln = 1 − ln (qi − qmini )
j
pj φi Aeu

 Y φj
H u+1 φi pj
⇒q i = qmini + Ae
pi j
φj

18
Elasticities
! !
∂qi R R1 ∂φi X
ηi = = R− pj qminj + φi
∂R qi qi pi ∂R j

Yet

!
∂φi ∂φi X ∂u ∂qj
=
∂R ∂u j
∂qj ∂R

αi +βi eu
As φi = 1+eu
, we have:

∂φi (βi − αi ) eu
=
∂u (1 + eu )2

So:

!! !
R1 X (βi − αi ) eu X ∂u ∂qj
ηi = R− pj qminj + φi
qi pi j
(1 + eu )2 j
∂qj ∂R

And, as we have seen:

∂u φ
=−  i   
∂qi P ∂φ q −qmin
(qi − qmini ) j ∂uj ln j Aeu j − φj

∂u pi
⇒ = −  
∂qi P
R − j pj qminj e u P
((β − α ) ln (q − qmin )) − 1
(1+eu )2 j j j j j

So, we have:

 
(βi −αi )eu P
  P ∂qj

R  R − j p j qminj u
(1+e ) 2 j p j ∂R
ηi = φi −     
qi pi P
R − j pj qminj e u P
(1+eu )2 j ((βj − αj ) ln (qj − qminj )) − 1

P P ∂q
Furthermore, as R = j p j qj , j pj ∂Rj = 1
Then:

19
 !!
1 βi − αi
ηi = φi −
wi P (1+eu )2
j ((βj − αj ) ln (qj − qminj )) − eu

We also have:

φj ! Y  φj
∂q H i pi
 Y 
H pi 1 φi pj φi φi pj
 i = H
= H − Aeu+1 + Aeu+1
∂pi q i q i pi pi j
φj pi pi j
φj

q H i − qmini pi q H i − qmini
⇒ H i = (φi − 1) = (φi − 1)
qH i wi R

∂q H i pj pj

φi φj
 Y  p k  φk
H u+1 φj
 ij = H
= H Ae , ∀i 6= j
∂pj q i q i pi pj k
φk

φi pj (qj − qminj )
⇒ H ij = , ∀i 6= j
wi R
Therefore:

H ij
 
φi pj (qj − qminj )
σij = =
wj wi R wj

And from Slutsky’s equation,

ij = σij wj − ηi wj

 
φi pj qminj wj  (βi − αi )
⇒ ij = − + P 
wi R wi (1+eu )2
j ((βj − αj ) ln (qj − qminj )) − eu

1.10 Degrees of freedom

20
Demand system Parameters Restrictions Degrees of
on
P parameters freedom
Cobb-Douglas αi α =1 n−1
Pi i 1
LES-CES αi , σ i αi = 1
σ 2n
qmini P P
AIDS α0 , αi , i αi = 1, i βi = 0 2n − 1
+ n(n−1)
P
βi , γij Pi γij ∗= 0, γijP= γji ∗ 2
NQES ai , α i b p = 1, i ai p i = 0 3n − 2
Pi i i∗
bi , βij j βij p j = 0, βij = βji + n(n−1)
2
α
Pi = initialshare
P
AIDADS αi , βi i αi = 1, i βi = 1 3n − 2
σ, qmini 0 ≤ αi , βi ≤ 1

21
2 Production functions
2.1 Generalities
Producers’ decisions can be derived from the maximization of profit (primal
program) or from the minimization of production costs (dual problem). Both
programs lead to the same results in terms of factor demands, of production,
and thus of profit.

Primal program

In the primal program, the optimal production is determined by maximizing

the producer’s profit π (Y, x1 ..., xn ) under technology constraints:
 P
max π (Y, x1 ..., xn ) = P Y − i wi xi
s.t.Y = f (x1 ..., xn )
Y is the quantity produced, P the market price of the product, and xi and
wi respectively the quantity and price of factors used to produce.

Dual program

Here the producer minimizes his cost to produce a given level quantity
Y.
 P
min i wi xi
s.t.Y = f (x1 ..., xn )
The solution of this program is a set of factor demands (x∗1 (wP ∗
1 , ..., wn , Y ) , ..., xn (w1 , ..., wn , Y ))
and, from this we can find the cost function C (Y, w1 , ..., wn ) = i wi x∗i which
gives the minimal cost to produce a given quantity Y .
Form, this we can compute the unit cost: c = YC , and the marginal cost:
∂C
Cm = ∂Y
The primal program described above can thus be rewritten as:

max P Y − C (Y, w1 , ..., wn )

The first order condition of this program is:
∂C
=P
∂Y
Namely, the marginal cost is equal to the market price of the product.

22
2.2 Leontief
n o
xi
The production technology is such that: Y = min αi
.

Factor demands
( P
min i wi xi n o
s.t.Y = min αxii
This optimization program can also be written:
 P
min i wi xi
s.t.gi 6 0, ∀i
xi
With gi = Y − αi
.
 
X X xi
L= w i xi + λi Y −
i i
αi

∂L λi
= 0 = wi − ⇒ λi = αi wi
∂xi αi
The complementarity slackness conditions are:

min {λi , gi } = 0, ∀i
Consequently:

wi > 0 ⇒ gi = 0, ∀i

⇒ xi = αi Y

Cost functions
X X
C= w i xi = Y αi wi
i i

C X
c= = αi w i
Y i

X
P = Cm = αi wi
i

23
2.3 Cobb-Douglas
xαi i , with A and αi
Q
The productionPtechnology is such that: Y = A i
paramters, and i αi = 1.

Factor demands
 P
min i wi xQi
s.t.Y = A i xαi i

!
X Y
L= w i xi − λ A xαi i − Y
i i

!
∂L α i Y αj wi x i
= 0 = wi − λ A x ⇒λ= , ∀i
∂xi xi j j αi Y

wi αj
xj = xi , ∀i, j
wj αi

 
wi Y αj αj
Y = Axi
αi j wj

 α
Y αi Y wj j
⇒ xi =
Awi j αj

Cost functions
 α
X 1 Y wj j
C= w i xi = Y
i
A j
αj

 αj
C 1Y wj
c= =
Y A j αj

 αj
∂C 1Y wj
P = Cm = =
∂Y A j αj

24
 We can thus rewrite the demand function of production factors:
αi P Y
xi =
wi
Furthermore:

C = PY

and

c = Cm = P

2.4 CES
1
1− σ1
P  1
1− σ
The production technology is such that: Y = A i α i xi , with A
P
and αi parameters, and i αi = 1.

Factor demands
 P
 min i wi xi
 1
1− σ1 1− σ1
P
 s.t.Y = A i α i xi

σ
 ! σ−1 
X X σ−1
L= wi xi − λ A αi xiσ
−Y
i i

1
 ! σ−1 
∂L − σ1
X σ−1
= 0 = wi − λ Aαi xi α i xiσ 
∂xi i

wi
⇒λ= 1 , ∀i
σ−1  σ−1
− σ1
P
Aαi xi i αi xi
σ

 σ
wi αj
xj = xi , ∀i, j
w j αi

25
 σ
! σ−1
X σ−1
Y =A α i xi σ

σ
!− σ−1
 σ
Y αi X
⇒ xi = αjσ wj1−σ
A wi j

Cost functions
1
! 1−σ
X Y X
C= w i xi = αjσ wj1−σ
i
A j

1
! 1−σ
C 1 X
c= = αjσ wj1−σ
Y A j

1
! 1−σ
1 X
P = Cm = αjσ wj1−σ
A j

We can thus rewrite the demand function of production factors:

 σ
σ σ−1 P
xi = αi A Y
wi

Furthermore:

C = PY

and

c = Cm = P

2.5 CET
σ
P σ+1  σ+1
The production technology is such that: Y = A i α i xiσ
, with A and
P
αi parameters, and i αi = 1.

26
Factor demands
( P
min i wi xi
σ
P σ+1  σ+1
s.t.Y = A i α i xi
σ

σ
 ! σ+1 
X X σ+1
L= wi xi − λ A αi xiσ
−Y
i i

1
 !− σ+1 
∂L 1 X σ+1
= 0 = wi − λ Aαi xiσ α j xj σ 
∂xi j

wi
⇒λ= 1 , ∀i
− σ+1
1 P σ+1
Aαi xi σ
i α i xi σ

 σ
w j αi
xj = xi , ∀i, j
wi αj

σ
! σ+1
X σ+1
Y =A α i xi σ

σ
!− σ+1
 σ
Y wi X
⇒ xi = αj−σ wj1+σ
A αi j

Cost functions
1
! σ+1
X Y X
C= w i xi = αj−σ wj1+σ
i
A j

1
! σ+1
C 1 X
c= = αj−σ wj1+σ
Y A j

27
 1
! σ+1
1 X
P = Cm = αj−σ wj1+σ
A j

We can thus rewrite the demand function of production factors:

 w σ
i
xi = αi−σ A−σ−1 Y
P
Furthermore:

C = PY

and

c = Cm = P

28