Chapter -3

3 Comparative static analysis

After successfully completing this chapter, students should be able to:

 Appreciate the importance of comparative statics in economics
 Understand differentiation and its application to comparative statics
 Analyze Comparative Statics of General function model
 Identify the limitations of comparative static analysis

Introduction
Incomparative statics, we simply compare the initial (or pre- change) equilibrium state with the
final (or post change ) equilibrium state by disregarding the process of adjustment of the
variables over times. Thus comparative statics is essentially concerned with finding the rate of
change of the equilibrium value of a choice(endogenous) variable with respect to a change in a
particular parameter (exogenous) variable.
Here one has to be clear that the problem under consideration is essentially one of finding a rate
of change in which is supported as mathematical concept of derivative in use.

Student activity- what happens to the quantity demanded of a good when the price of related
goods or income changes?
In general, the logical simulation of the testing of theories in economics is called the theory of
comparative statics.

3.1. Differentiation and its application to comparative static Analysis

Let R(x) = total revenue function
C(x)= total cost function
t(x)= per unit tax (beyond the control of the firm )
Max : x  Rx  Cx  tx
Find the first order condition. We all know that the necessary condition for profit maximization
stipulates that marginal revenue should be equal to marginal cost.(MR=MC)
x  Rx  C x  t  0  1
S.O.C x  0 
 Rx  Cx  0  2
Now , the profit maximizing level of output for the firm depends upon the tax rate(an exogenous
variable).
i.e. X  X * t    3
substituting (3) in (1):
   
R x * t   C  x * t   t  0

  dxdt   dxdt
* *
 R  x * .  C  x * . 1  0


dx *
dt
  
R  x *  C  x *  1  
dx * 1
  0
dt  
R  x  C  x *
*
 
Output X will decline as the tax rate the firm faces increases. Thus, a prediction about changes in
the choice variable, i.e. marginal adjustment of output, when the parameter facing the decision
maker changes is easily derived, this is the goal of comparative statics.
Example-2 x   p.x  cx
F.O.C: x  p  cx  1
S.O.C x  cx  0  cx  0  2

X  X *  p    3
Substituting (3) into (1).
 
p  c x *  p   0


dp
dp
 
 c x *
dx *
dp
0
dx *

1
dp cx 
0

This means that if the output price to a competitive firm is raised, output level is increased. i.e.
the supply function is upward sloping.
Market model
Consider one commodity market model.
D : Q  a  bp, a, b  0 
S : Q  c  dpc, d  0 
At equilibrium Qd  Qs

With solutions:
ac
P* 
bd
ad  bc
Q* 
bd
What would happen to the equilibrium P&Q, if one or more of the parameters changes?

 p
p *
1 
1
0
 0
a b  d c bd
p *  a  c 


 0
 p 
a  c  0
b  d 2
b d b d  2

Q Q
 
a  a S  b S
a

D
P D

P*  P P *  P 

National Income model

Consider the following simple national income model:
y  c  I 0  G0

C     Y  T ,   0,0    1
T    y, r  0,0    1
Where,   non – income tax revenue
y  income tax revenue
  income tax rate.
-Endogenous variable = Y, C, & T
- Exogenous variable = I0 & G0
-Exogenous parameters =  ,  ,  .and .
The model can be solved for y* as:
    I 0  G0
y*  , this is the reduced form of the above national income model.
1    
From this equation income value, we can have six comparative static derivatives as we have six
exogenous variables.
y * 1
1.  0
G0 1    

y * 
2.  0
 1    

y *  y *
3.  0
 1    

3.2. Comparative Statics of General function model

In the comparative static problems considered before, equilibrium values of endogenous
variables of the model could be explicitly expressed in terms of the exogenous variables;
accordingly, the technique of simple partial differentiation was all we need to obtain the desired
comparative static information.
However, when a model contains functions expressed in general form, explicit solutions are not
available. In such cases, a new technique must be employed that makes use of such concepts as
implicit function rule to find the comparative static derivatives directly from the given general
function model.
Example :- Consider a market model:
D D
Qd  D p1 y 0 ,  0, 0
p y 0
s
Qs  s p , 0
p
At equilibrium D( P, y0 )  S ( P)  D( P, y0 )  S ( P)  0
Where , p= endogenous
Y0=exogenous.
We know that every equation price is a function of income. i.e. p  p *  y 0  . Therefore, the

equilibrium condition can be taken to be an identify in the equilibrium solution.

   
 D p * , y0  s p *  0
 F p , y   0
*
0

 The comparative static analysis of this model will therefore be concerned with how a change
in y0 will affect the equilibrium position of the model.
i.e.i) what is the effect of a change in Y0 on p* ?
F

dp *
y 0  D y 0
  0
dy 0 F p *
D * s

p () p * ()

Thus, increase y  P* or the other way.

i) what is the effect of a change in Y0 on Q * ?
At equation , Q * =Qd=Qs
We can write ,
 
Q *  S P * , and .P  P *  y 0 

dQ * ds dp
  *. 0
dy 0 dp dy 0
Thus, the comparative static results convey the proposition that an up –ward shift of the
demand curve ( due to a rise in income) will result in a higher equilibrium price as well as a
higher equilibrium quantity.

S0
P1   y 
P0  P
D1

Q0* Q1 D0
Q

3.3. Limitations of comparative static analysis

Comparative static is helpful in finding out how a disequilibrating change in a parameter
will affect the equation state of a model. However, by its very nature, comparative statics
has the following limitations.
1) Ignores the process of adjustment from the old equilibrium to the new one.
2) Neglects the time element (length of time ) involved in the adjustment process from one
to another equilibrium
3) Assumes that a new equilibrium can be defined and attained after a disequilibrating
change in a parameter, i.e. disregards the possibility that the new equilibrium may not
be attained ever because of the inherent instability of the model all these limitation are
addressed by dynamic analysis which will be dealt in the next chapter.