You are on page 1of 6

A NOTE ON CES FUNCTIONS

Drago Bergholt, BI Norwegian Business School 2011

Functions featuring constant elasticity of substitution (CES) are widely used in applied
economics and finance. In this note, I do two things. First, I derive a number of conditions
(such as the optimal demand schedule) when aggregation technology is CES. Second, I
show how the CES function nests some particular functional forms as special cases.

1 P RELIMINARIES
Consider a general CES function:

J
! 1
X 1 1

Y =A j Yj , (1)
j=1
PJ
where A, > 0, j , Yj > 0 j, and j=1 j = 1. In models with monopolistic com-
petition between firms, Y is interpreted as aggregate output and {Yj }Jj=1 as output by
intermediate firms. In turn, the production technology of firms can also have a CES struc-
ture, with each Yj being referred to as an input factor such as labor or capital or land.
Y can also be aggregate demand or consumption, a composite of individual consumer
classes or goods. In open economy macroeconomics, one uses the CES structure to dis-
tinguish between domestically produced goods and imports. The scaling parameter A is
often normalized to 1, but in the context of production theory, it is typically interpreted as
a measure of total factor productivity (which can be stochastic in a time series context).

2 I MPLICATIONS OF CES TECHNOLOGY


What are the implications of assuming a CES technology for aggregation in economic
models? To shed light on this question, we start with a maximization problem. The prob-
lem is to choose the vector {Yj }Jj=1 that maximizes Y subject to some budget constraint
J
X
Pj Yj Z, (2)
j=1

where Z is total money spent. Let us state the Lagrangian (where is the multiplier for
the constraint):

J
! 1 J
!
X 1 1 X
L=A j Yj Pj Yj Z
j=1 j=1
1
1 1 1
The necessary first order condition is A Y j Yj = Pj . This must hold for all

j J , so we can write
 
j Pj
Yj = Yi i, j (3)
i Pi

1
2.1 A NATURAL PRICE INDEX
Next, we derive an exact price index for a unit increase in Y . Plug (3) into the budget
constraint and solve for Yi :
J J
X Yi Pi X
Z= P j Yj = j Pj1
j=1
i j=1
Zi Pi
Yi = PJ 1
j=1 j Pj

Insert this result into Y (now with indexing i):



J
! 1
X 1 1

Y =A i Yi
i=1


J
! 1 1
Zi Pi
1
X

= A i PJ 1

i=1 j=1 j Pj
!1
J J
! 1
X X
= AZ j Pj1 i Pi1
j=1 i=1
1
J
! 1
X
= AZ j Pj1
j=1

Finally, define P as the expenditure needed to buy one unit of Y , i.e. P Z|Y =1 . From
the expression above, it naturally follows that
1
J
! 1
1 X
P = j Pj1 . (4)
A j=1

Thus, P is the natural price index for Y .

2.2 T HE BUDGET CONSTRAINT REVISITED


Next, note that inserting (3) into (2) gives
J
X
Z= P j Yj
j=1
J  
X j Pj
= Pj Yi
j=1
i Pi
Yi
= Pi A1 P 1
i
 
Pi Z
Yi = i . (5)
P A1 P

2
Substitute into (1) and solve for Z. The result is


J   ! 1

1
X 1
Pj Z
Y = A j j 1
= ZP 1 .
j=1
P A P

Thus, Z = P Y , and we can write the budget constraint as


J
X
PY = Pj Yj .
j=1

2.3 T HE OPTIMAL DEMAND SCHEDULE


Finally, substitution of Z = P Y into (5) (which holds i, j J ) gives the optimal
demand for Yj :
 
Pj Y
Yj = j (6)
P A1
One can also get rid of A and end up with

J
! 1
Pj X 1

1

Yj = j  i Yi .

1
 1
PJ 1
i=1 i Pi
i=1

Thus, optimal demand for Yj in (6) is not determined by A, but rather by the price Pj
relative to all other prices, as well as by total factor demand. Equation (6) is widely used
as demand function in theoretical models of optimizing economic behavior.

2.4 E LASTICITIES
To understand why the functional form in (1) exhibits CES between any pair Yi , Yj , we
Y
define the elasticity of substitution as the percentage rise in Yji following a one percent
 
Y
rise in the relative price PPji . It is clear from (3) that Yji = ji PPji , so we can write
 
Y
Yji  1
j P i
  = .
Pi i Pj
Pj
   
Y
By dividing by Yji / PPji , a constant elasticity of substitution emerges:
     1
Y Y
Yji / Yji ji PPji
Elasticity of substitution     =  1 =
PPji / PPji j Pi
i Pj

What about the income elasticity? Earlier we defined Z as the income spent on Y . The
income elasticity follows from (5):
 1
Yj /Yj i PPi 1
Elasticity of income =  A 1 P = 1
Z/Z P
i i 1 P A P

3
3 S PECIAL CASES OF THE CES FUNCTION
Next, we show how the CES function nests as special cases some particular functional
forms. Before we start, it is useful to note that equation (1) is equivalent to

J
! 1
X
Y =A j Yj , (7)
j=1

Y
where Yj jj and 1
. Our task is to find an expression for Y when i)
or 1 (linear), ii) 1 or 0 (Cobb-Douglas), and iii) 0 or
(Leontief). For reasons that will be clear below, it is convenient to work with a log
transformation of equation (7):
J
!
1 X F ()
ln (Y ) = ln (A) + ln j Yj = ln (A) + , (8)
j=1
G ()
P 
J
where F () ln j=1 j Y j and G () . Finally, in order to derive the Cobb-
Douglas and Leontief functions we need LHopitals rule:

The LHopitals rule:


Consider two functions F () and G (), which are differentiable on an interval (a, b),
except possibly at a point c (a, b). Suppose limc F () = limc G () = 0 or
F 0 () 0
, limc G 0 () exists, and G () 6= 0 6= c (a, b). Then

F () F 0 ()
lim = lim 0 .
c G () c G ()

j Yj ln(Yj )
PJ
In our case the first derivatives are F 0 () = j=1
PJ and G0 () = 1, implying
j=1 j Yj

PJ  

0
F () Y
j=1 j j ln Yj
= PJ
. (9)
G0 () j=1 j Y j

Next, we consider each of the three special cases of the CES function.

3.1 T HE LINEAR CASE ( 1)


This one is trivial as it follows immediately from equation (7) that
J
X
lim Y = A Yj . (10)
1
j=1

4
3.2 T HE C OBB -D OUGLAS CASE ( 0)
Here we want to evaluate equation (8) when 0. However, the result is
P 
J
ln
j=1 j jY  
0
lim ln (Y ) = ln (A) + lim = ln (A) + .
0 0 0
The last term holds as long as Jj=1 j = 1.1 To proceed, we apply LHopitals rule.
P
Evaluating equation (9) in the limit as 0, we can write (8) as
PJ  

j=1 j Yj ln Yj
lim ln (Y ) = ln (A) + lim PJ
0 0
j=1 j Yj
XJ  
= ln (A) + j ln Yj
j=1
J
!
j
Y
= ln A Yj ,
j=1
or
J
1
Y
lim Y = A QJ j Yj j . (11)
0
j=1 j j=1

This is the widely used Cobb-Douglas function. The scaling parameter A is often nor-
malized so that A QJ 1 j = 1.
j=1 j

3.3 T HE L EONTIEF CASE ( )


When , then equation (8) becomes
P 
J
ln j=1 j Yj



lim ln (Y ) = ln (A) + lim = ln (A) + .

Again, using LHopitals rule, we can write
PJ  

j=1 j Y j ln Yj
lim ln (Y ) = ln (A) + lim PJ
.

j=1 j Yj

j Yj ln(Yj )
PJ
0
j=1

However, a new problem arises because lim PJ = 0
, which can-
j=1 j Yj
2
not be solved
n by multiple o uses of LHopitals rule. In order to proceed, we define
Ym min Y1 , . . . , YJ . Dividing the nominator and denominator by Ym , we get
PJ    
Yj

j=1 j Ym ln Yj
lim ln (Y ) = ln (A) + lim PJ  
Yj
j=1 j Y m

1
PJ
If instead j=1 j > 1 (< 1), then the last term goes to () as 0.
2
Yj will always show up both in the nominator and in the denominator.

5
 n o
= ln (A) + ln min Y1 , . . . , YJ
 n o
= ln A min Y1 , . . . , YJ ,

or
 
Y1 YJ
lim Y = A min ,..., . (12)
1 J

This is the Leontief function.

3.4 F ROM ISOELASTIC UTILITY TO LOG UTILITY


Consider the isoelastic utility function

C 1 1
U= ,
1

with C > 0. Apparently a 00 -issue arises when one evaluates U as 1. In that case


one can define F () C 1 1 and G () 1 . Because F 0 () = C 1 ln (C)


and G0 () = 1, we get

F 0 ()
lim U = lim = ln (C) . (13)
1 1 G0 ()

You might also like