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Advanced Microeconomic Theory
Chapter 4: Production Theory
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Outline
⢠Production sets and production functions⢠Profit maximization and cost minimization⢠Cost functions⢠Aggregate supply⢠Efficiency (1st and 2nd FTWE)
Advanced Microeconomic Theory 2
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Production Sets and Production Functions
Advanced Microeconomic Theory 3
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Production Sets
⢠Let us define a production vector (or plan)ðŠðŠ = (ðŠðŠ1, ðŠðŠ2, ⊠, ðŠðŠð¿ð¿) â âð¿ð¿
â If, for instance, ðŠðŠ2 > 0, then the firm is producing positive units of good 2 (i.e., good 2 is an output).
â If, instead, ðŠðŠ2 < 0, then the firms is producing negative units of good 2 (i.e., good 2 is an input).
⢠Production plans that are technologically feasible are represented in the production set ðð.
ðð = ðŠðŠ â âð¿ð¿: ð¹ð¹(ðŠðŠ) †0where ð¹ð¹(ðŠðŠ) is the transformation function.
Advanced Microeconomic Theory 4
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Production Sets⢠ð¹ð¹(ðŠðŠ) can also be
understood as a production function.
⢠Firm uses units of ðŠðŠ1 as an input in order to produce units of ðŠðŠ2 as an output.
⢠Boundary of the production function is any production plan ðŠðŠsuch that ð¹ð¹ ðŠðŠ = 0.â Also referred to as the
transformation frontier.Advanced Microeconomic Theory 5
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Production Sets
⢠For any production plan ï¿œðŠðŠ on the production frontier, such that ð¹ð¹ ï¿œðŠðŠ = 0 , we can totally differentiate ð¹ð¹ ï¿œðŠðŠ as follows
ððð¹ð¹ ï¿œðŠðŠðððŠðŠðð
ðððŠðŠðð +ððð¹ð¹ ï¿œðŠðŠ
ðððŠðŠðððððŠðŠðð = 0
solving
ðððŠðŠðððððŠðŠðð
= âððð¹ð¹ ï¿œðŠðŠðððŠðŠðð
ððð¹ð¹ ï¿œðŠðŠðððŠðŠðð
, where ððð¹ð¹ ï¿œðŠðŠðððŠðŠðð
ððð¹ð¹ ï¿œðŠðŠðððŠðŠðð
= ðððððððð,ðð ï¿œðŠðŠ
â ðððððððð,ðð ï¿œðŠðŠ measures how much the (net) output ððcan increase if the firm decreases the (net) output of good ðð by one marginal unit.
Advanced Microeconomic Theory 6
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Production Sets
⢠What if we denote input and outputs with different letters?
ðð = (ðð1, ðð2, ⊠, ðððð) ⥠0 outputsð§ð§ = (ð§ð§1, ð§ð§2, ⊠, ð§ð§ð¿ð¿âðð) ⥠0 inputs
where ð¿ð¿ ⥠ðð.
⢠In this case, inputs are transformed into outputs by the production function, ðð(ð§ð§1, ð§ð§2, ⊠, ð§ð§ð¿ð¿âðð), i.e., ðð: âð¿ð¿âðð â âðð.
Advanced Microeconomic Theory 7
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Production Sets
⢠Example: When ðð = 1 (one single output), the production set ðð can be described as
ðð = (âð§ð§1, âð§ð§2, ⊠, âð§ð§ð¿ð¿â1, ðð):ðð †ðð(ð§ð§1, ð§ð§2, ⊠, ð§ð§ð¿ð¿â1)
⢠Holding the output level fixed, ðððð = 0, totally differentiate production function
ðððð ð§ð§ððð§ð§ðð
ððð§ð§ðð +ðððð ð§ð§
ððð§ð§ððððð§ð§ðð = 0
Advanced Microeconomic Theory 8
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Production Sets
⢠Example (continued): and rearranging
ððð§ð§ððððð§ð§ðð
= âðððð ï¿œð§ð§ððð§ð§ðð
ðððð ï¿œð§ð§ððð§ð§ðð
, where ðððð ï¿œð§ð§ððð§ð§ðð
ðððð ï¿œð§ð§ððð§ð§ðð
= ðððððððð ð§ð§
⢠ðððððððð ð§ð§ measures the additional amount of input ðð that must be used when we marginally decrease the amount of input ðð, and we want to keep output level at ï¿œðð = ðð ð§ð§ .
⢠ðððððððð ð§ð§ in production theory is analogous to the ðððððð in consumer theory, where we keep utility constant, ððð¢ð¢ = 0.
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Production Sets⢠Combinations of (ð§ð§1, ð§ð§2)
that produce the same total output ðð0, i.e., (ð§ð§1, ð§ð§2 : ðð(ð§ð§1, ð§ð§2) = ðð0}
is called isoquant.
⢠The slope of the isoquant at ( ð§ð§1, ð§ð§2) is ðððððððð ð§ð§ .
⢠Remember: â ððððððððrefers to isoquants
(and production function).
â ðððððð refers to the transformation function.
Advanced Microeconomic Theory 10
z2
z1
Isoquant,
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Production Sets
⢠Example: Find theðððððððð ð§ð§ for the Cobb-Douglas production function ðð ð§ð§1, ð§ð§2 = ð§ð§1
ðŒðŒð§ð§2ðœðœ,
where ðŒðŒ, ðœðœ > 0.
⢠The marginal product of input 1 is ðððð ð§ð§1, ð§ð§2
ððð§ð§1= ðŒðŒð§ð§1
ðŒðŒâ1ð§ð§2ðœðœ
and that of input 2 is ðððð ð§ð§1, ð§ð§2
ððð§ð§1= ðœðœð§ð§1
ðŒðŒð§ð§2ðœðœâ1
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Production Sets
⢠Example (continued): Hence, theðððððððð ð§ð§ is
ðððððððð ð§ð§ =ðŒðŒð§ð§1
ðŒðŒâ1ð§ð§2ðœðœ
ðœðœð§ð§1ðŒðŒð§ð§2
ðœðœâ1 =ðŒðŒð§ð§2
ðœðœâ(ðœðœâ1)
ðœðœð§ð§1ðŒðŒâ(ðŒðŒâ1) =
ðŒðŒð§ð§2
ðœðœð§ð§1
⢠For instance, for a particular vector ð§ð§ =ð§ð§1, ð§ð§2 = (2,3), and ðŒðŒ = ðœðœ = 1
2, then
ðððððððð ð§ð§ =32
= 1.5
i.e., the slope of the isoquant evaluated at input vector ð§ð§ = ð§ð§1, ð§ð§2 = (2,3) is â1.5.
Advanced Microeconomic Theory 12
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Properties of Production Sets
1) Y is nonempty: We have inputs and/or outputs.
2) Y is closed: The production set ððincludes its boundary points.
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y2
y1
Y
2 y
Properties of Production Sets
The firm uses amounts of input ðŠðŠ1in order to produce positive amounts of output ðŠðŠ2.
Advanced Microeconomic Theory 14
3) No free lunch: No production with no resources.
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y2
y1
Y
2y Y R+â â©
Properties of Production Sets
The firm produces positive amounts of good 1 and 2 (ðŠðŠ1 > 0and ðŠðŠ2 > 0) without the use of any inputs.
Advanced Microeconomic Theory 15
3) No free lunch: violation
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y2
y1
Y
2y Y R+â â©
Properties of Production Sets
The firm produces positive amounts of good 2 (ðŠðŠ2 > 0) with zero inputs, i.e., ðŠðŠ1 =0 .
Advanced Microeconomic Theory 16
3) No free lunch: violation
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Properties of Production Sets
Firm can choose to be inactive, using no inputs, and obtaining no output as a result (i.e., 0 â ðð).
Advanced Microeconomic Theory 17
4) Possibility of inaction
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Properties of Production Sets
Inaction is still possible when firms face fixed costs (i.e., 0 â ðð).
Advanced Microeconomic Theory 18y2
y2
y1
Y 0 YâSet up non-sunk cost
4) Possibility of inaction
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Properties of Production Sets
Inaction is NOT possible when firms face sunk costs (i.e., 0 â ðð).
Advanced Microeconomic Theory 19
y2
y1
Y0 Yâ
Sunk cost
4) Possibility of inaction
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Properties of Production Sets
5) Free disposal: if ðŠðŠ â ðð and ðŠðŠâ² †ðŠðŠ, then ðŠðŠâ² â ðð. ðŠðŠâ² is less efficient than ðŠðŠ:
â Either it produces the same amount of output with more inputs, or less output using the same inputs.
Then, ðŠðŠâ² also belongs to the firmâs production set. That is, the producer can use more inputs
without the need the reduce his output:â The producer can dispose of (or eliminate) this
additional inputs at no cost.
Advanced Microeconomic Theory 20
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Properties of Production Sets
5) Free disposal (continued)
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Properties of Production Sets
6) Irreversibility Suppose that ðŠðŠ â ðð
and ðŠðŠ â 0. Then, â ðŠðŠ â ðð. âNo way backâ
Advanced Microeconomic Theory 22
y2
Y
y
-y â Yy1
y1
-y1
y2
-y2
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Properties of Production Sets
7) Non-increasing returns to scale: If ðŠðŠ â ðð, then ðŒðŒðŠðŠ â ðð for any ðŒðŒ â 0,1 . That is, any feasible vector can be scaled down.
Advanced Microeconomic Theory 23
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Properties of Production Sets
7) Non-increasing returns to scale The presence of fixed or sunk costs violates
non-increasing returns to scale.
Advanced Microeconomic Theory 24
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Properties of Production Sets
8) Non-decreasing returns to scale: If ðŠðŠ â ðð, then ðŒðŒðŠðŠ â ðð for any ðŒðŒ ⥠1. That is, any feasible vector can be scaled up.
Advanced Microeconomic Theory 25
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Properties of Production Sets
8) Non-decreasing returns to scale The presence of fixed or sunk costs do NOT
violate non-increasing returns to scale.
Advanced Microeconomic Theory 26
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Properties of Production Sets
⢠Returns to scale:â When scaling up/down
a given production plan ðŠðŠ = âðŠðŠ1, ðŠðŠ2 : We connect ðŠðŠ with a ray
from the origin.
Then, the ratio ðŠðŠ2ðŠðŠ1
must be maintained in all points along the ray. Note that the angle of
the ray is exactly this ratio ðŠðŠ2
ðŠðŠ1.
Advanced Microeconomic Theory 27
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y2
y1
Y
y
, 1y ifα α <
, 1y ifα α >
Properties of Production Sets
CRS is non-increasing and non-decreasing.
Advanced Microeconomic Theory 28
9) Constant returns to scale (CRS): If ðŠðŠ â ðð, then ðŒðŒðŠðŠ âðð for any ðŒðŒ ⥠0.
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Properties of Production Sets
⢠Alternative graphical representation of constant returns to scale:â Doubling ðŸðŸ and ð¿ð¿
doubles output (i.e., proportionally increase in output).
Advanced Microeconomic Theory 29
L
K
1
1
2
2
Q=200
Q=100
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Properties of Production Sets
⢠Alternative graphical representation of increasing-returns to scale:â Doubling ðŸðŸ and ð¿ð¿
increases output more than proportionally.
Advanced Microeconomic Theory 30
L
K
1
1
2
2
Q=300
Q=100Q=200
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Properties of Production Sets
⢠Alternative graphical representation of decreasing-returns to scale:â Doubling ðŸðŸ and ð¿ð¿
increases output less than proportionally.
Advanced Microeconomic Theory 31
L
K
1
1
2
2
Q=200
Q=100Q=150
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Properties of Production Sets
⢠Example: Let us check returns to scale in the Cobb-Douglas production function ðð ð§ð§1, ð§ð§2 = ð§ð§1
ðŒðŒð§ð§2ðœðœ.
Increasing all arguments by a common factor ðð, we obtain
ðð ð§ð§1, ð§ð§2 = (ððð§ð§1)ðŒðŒ(ððð§ð§2)ðœðœ= ðððŒðŒ+ðœðœð§ð§1ðŒðŒð§ð§2
ðœðœ
â When ðŒðŒ + ðœðœ = 1, we have constant returns to scale;â When ðŒðŒ + ðœðœ > 1, we have increasing returns to scale;â When ðŒðŒ + ðœðœ < 1, we have decreasing returns to scale.
Advanced Microeconomic Theory 32
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Properties of Production Sets
⢠Returns to scale in different US industries (Source: Hsieh, 1995):
Advanced Microeconomic Theory 33
Industry ðŒðŒ + ðœðœDecreasing returns Tobacco 0.51
Food 0.91
Constant returns Apparel and textile 1.01Furniture 1.02Electronics 1.02
Increasing returns Paper products 1.09Petroleum and coal 1.18Primary metal 1.24
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Properties of Production Sets
Homogeneity of the Production Function Returns to Scale
ðŸðŸ = 1 Constant ReturnsðŸðŸ > 1 Increasing ReturnsðŸðŸ < 1 Decreasing Returns
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Properties of Production Sets
⢠The linear production function exhibits CRS as increasing all inputs by a common factor ð¡ð¡yields
ðð ð¡ð¡ðð, ð¡ð¡ðð = ððð¡ð¡ðð + ððð¡ð¡ðð = ð¡ð¡ ðððð + ððððâ¡ ð¡ð¡ðð(ðð, ðð)
⢠The fixed proportion production function ðð ðð, ðð = min{ðððð, ðððð} also exhibits CRS as
ðð ð¡ð¡ðð, ð¡ð¡ðð = min ððð¡ð¡ðð, ððð¡ð¡ðð = ð¡ð¡ ï¿œ min ðððð, ððððâ¡ ð¡ð¡ðð(ðð, ðð)
Advanced Microeconomic Theory 35
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Properties of Production Sets
⢠Increasing/decreasing returns to scale can be incorporated into a production function ðð(ðð, ðð)exhibiting CRS by using a transformation function ð¹ð¹(ï¿œ)
ð¹ð¹ ðð, ðð = ðð(ðð, ðð) ðŸðŸ, where ðŸðŸ > 0
⢠Indeed, increasing all arguments by a common factor ð¡ð¡, yields
ð¹ð¹ ð¡ð¡ðð, ð¡ð¡ðð = ðð(ð¡ð¡ðð, ð¡ð¡ðð) ðŸðŸ = ð¡ð¡ ï¿œ ðð(ðð, ðð)by CRS of ðð(ï¿œ) ðŸðŸ
= ð¡ð¡ðŸðŸ ï¿œ ðð ðð, ðð ðŸðŸ
ð¹ð¹ ðð,ðð= ð¡ð¡ðŸðŸ ï¿œ ð¹ð¹ ðð, ðð
Advanced Microeconomic Theory 36
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Properties of Production Sets
⢠Hence, â if ðŸðŸ > 1, the transformed production function
ð¹ð¹ ðð, ðð exhibits increasing returns to scale;â if ðŸðŸ < 1, the transformed production function
ð¹ð¹ ðð, ðð exhibits decreasing returns to scale;
Advanced Microeconomic Theory 37
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Properties of Production Sets
⢠Scale elasticity: an alternative measure of returns to scale.â It measures the percent increase in output due to
a 1% increase in the amounts of all inputs
ðððð,ð¡ð¡ =ðððð(ð¡ð¡ðð, ð¡ð¡ðð)
ððð¡ð¡ï¿œ
ð¡ð¡ðð(ðð, ðð)
where ð¡ð¡ denotes the common increase in all inputs.â Practice: Show that, if a function exhibits CRS,
then it has a scale elasticity of ðððð,ð¡ð¡=1.Advanced Microeconomic Theory 38
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Properties of Production Sets
10) Additivity (or free entry): If ðŠðŠ â ðð and ðŠðŠâ² âðð, then ðŠðŠ + ðŠðŠâ² â ðð. Interpretation: one plant produces ðŠðŠ, while
another plant enters the market producing ðŠðŠâ². Then, the aggregate production ðŠðŠ +ðŠðŠâ² is feasible.
Advanced Microeconomic Theory 39
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y2
y1
y(1 ) 'y y Yα α+ â â
(1 ) 'y yα α+ â
y'
y'
Properties of Production Sets
11) Convexity: If ðŠðŠ, ðŠðŠâ² â ðð and ðŒðŒ â 0,1 , then ðŒðŒðŠðŠ + (1 â ðŒðŒ)ðŠðŠâ²â ðð.
Advanced Microeconomic Theory 40
Intuition: âbalancedâ input-output combinations are more productive than âunbalancedâ ones.
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y2
y1
Y
y
yαy'
(1 ) 'y y Yα α+ â â
Properties of Production Sets
11) Convexity: violation
Advanced Microeconomic Theory 41
Note: The convexity of the production set maintains a close relationship with the concavity of the production function.
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Properties of Production Sets
11) Convexity With fixed costs, convexity is NOT necessarily satisfied; With sunk costs, convexity is satisfied.
Advanced Microeconomic Theory 42
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Diminishing MRTS
⢠The slope of the firmâs isoquants is
ðððððððððð,ðð = â ðððððððð
, where ðððððððððð,ðð = ðððððððð
⢠Differentiating ðððððððððð,ðð with respect to labor yields
ðððððððððððð,ðð
ðððð=
ðððð ðððððð + ðððððð ï¿œ ðððððððð â ðððð ðððððð + ðððððð ï¿œ ðððð
ðððððððð
2
Advanced Microeconomic Theory 43
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Diminishing MRTS
⢠Using the fact that ðððððððð
= â ðððððððð
along an
isoquant and Youngâs theorem ðððððð = ðððððð,
ðððððððððððð,ðð
ðððð=
ðððð ðððððð â ðððððð ï¿œ ðððððððð
â ðððð ðððððð â ðððððð ï¿œ ðððððððð
ðððð2
=ðððððððððð â ðððððððððð â ðððððððððð + ðððððð ï¿œ ðððð
2
ðððððððð
2
Advanced Microeconomic Theory 44
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Diminishing MRTS
⢠Multiplying numerator and denominator by ðððð
ðððððððððððð,ðð
ðððð=
ï¿œðððð2
+âðððððð
â
+ ï¿œðððððð
âï¿œðððð
2+
â 2ðððððððð
+ï¿œðððððð
â or+
ðððð3
⢠Thus,
â If ðððððð > 0 (i.e., â ðð â¹ â ðððððð), then ðððððððððððð,ðððððð
< 0
â If ðððððð < 0, then we have
ðððð2ðððððð + ðððððððððð
2 >< 2ðððððððððððððð â¹
ðððððððððððð,ðð
ðððð<> 0
Advanced Microeconomic Theory 45
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Diminishing MRTS
Advanced Microeconomic Theory 46
ðððððð > 0 (â ðð â¹ â ðððððð), or ðððððð < 0 (â ðð â¹ â ðððððð) but small â in ðððððð
ðððððð < 0 (â ðð â¹ ââ ðððððð)
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Diminishing MRTS
⢠Example: Let us check if the production function ðð ðð, ðð = 600ðð2ðð2 â ðð3ðð3 yields convex isoquants. â Marginal products:
ðððððð = ðððð = 1,200ðð2ðð â 3ðð3ðð2 > 0 iff ðððð < 400ðððððð = ðððð = 1,200ðððð2 â 3ðð2ðð3 > 0 iff ðððð < 400
â Decreasing marginal productivity:ðððððððð
ðððð= ðððððð = 1,200ðð2 â 6ðð3ðð < 0 iff ðððð > 200
ðððððððððððð
= ðððððð = 1,200ðð2 â 6ðððð3 < 0 iff ðððð > 200Advanced Microeconomic Theory 47
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Diminishing MRTS
⢠Example (continued):â Is 200 < ðððð < 400 then sufficient condition for
diminishing ðððððððð? No! We need ðððððð > 0 too in order to guarantee diminishing
ðððððððððð,ðð.
â Check the sign of ðððððð:ðððððð = ðððððð = 2,400ðððð â 9ðð2ðð2 > 0 iff ðððð < 266
Advanced Microeconomic Theory 48
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Diminishing MRTS
⢠Example (continued):â Alternatively, we can represent the above
conditions by solving for ðð in the above inequalities:
ðððððð > 0 iff ðð < 400ðð
ðððððððððððð
< 0 iff ðð > 200ðð
ðððððð > 0 iff ðð < 400ðð
ðððððððððððð
< 0 iff ðð > 200ðð
and
ðððððð > 0 iff ðð < 266ðð
Advanced Microeconomic Theory 49
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Diminishing MRTS
⢠Example (continued):
â Hence, 200ðð
< ðð < 266ðð
guarantees positive but diminishing marginal products and, in addition, a diminishing ðððððððð.
â Figure: ðð = 200ðð
is a curve decreasing in ðð, never
crossing either axes. Similarly for ðð = 266ðð
.
Advanced Microeconomic Theory 50
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Constant Returns to Scale
⢠If production function ðð(ðð, ðð) exhibits CRS, then increasing all inputs by a common factor ð¡ð¡ yields
ðð ðð, ðð = ð¡ð¡ðð ðð, ðð
⢠Hence, ðð(ðð, ðð) is homogenous of degree 1, thus implying that its first-order derivatives
ðððð ðð, ðð and ðððð ðð, ððare homogenous of degree zero.
Advanced Microeconomic Theory 51
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Constant Returns to Scale
⢠Therefore,
ðððððð =ðððð(ðð, ðð)
ðððð=
ðððð(ð¡ð¡ðð, ð¡ð¡ðð)ðððð
= ðððð ðð, ðð = ðððð ð¡ð¡ðð, ð¡ð¡ðð⢠Setting ð¡ð¡ = 1
ðð, we obtain
ðððððð = ðððð ðð, ðð = ðððð1ðð
ðð,ðððð
= ðððððððð
, 1
⢠Hence, ðððððð only depends on the ratio ðððð, but not
on the absolute levels of ðð and ðð that firm uses.⢠A similar argument applies to ðððððð.
Advanced Microeconomic Theory 52
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Constant Returns to Scale
⢠Thus, ðððððððð = ððððððððððððonly depends on the
ratio of capital to labor.
⢠The slope of a firmâs isoquants coincides at any point along a ray from the origin.
⢠Firmâs production function is, hence, homothetic.
Advanced Microeconomic Theory 53
L
K
q=4q=3
q=2
Same MRTSl,k
Ray from the origin
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Elasticity of Substitution
Advanced Microeconomic Theory 54
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Elasticity of Substitution
⢠Elasticity of substitution (ðð) measures the proportionate change in the ðð/ðð ratio relative to the proportionate change in the ðððððððððð,ððalong an isoquant:
ðð =%â(ðð/ðð)%âðððððððð
=ðð(ðð/ðð)ðððððððððð
ï¿œðððððððð
ðð/ðð=
ððln(ðð/ðð)ððln(ðððððððð)
where ðð > 0 since ratio ðð/ðð and ðððððððð move in the same direction.
Advanced Microeconomic Theory 55
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Elasticity of Substitution
⢠Bothðððððððð and ðð/ððwill change as we move from point ðŽðŽ to point ðµðµ.
⢠ðð is the ratio of these changes.
⢠ðð measures the curvature of the isoquant.
Advanced Microeconomic Theory 56
L
K
(k/l)B
(k/l)A
A
B
MRTSA
MRTSB
0q q=
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Elasticity of Substitution
⢠If we define the elasticity of substitution between two inputs to be proportionate change in the ratio of the two inputs to the proportionate change in ðððððððð, we need to hold:â output constant (so we move along the same
isoquant), and â the levels of other inputs constant (in case we
have more than two inputs). For instance, we fix the amount of other inputs, such as land.
Advanced Microeconomic Theory 57
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Elasticity of Substitution
⢠High elasticity of substitution (ðð): â ðððððððð does not
change substantially relative to ðð/ðð.
â Isoquant is relatively flat.
Advanced Microeconomic Theory 58
L
K
(k/l)B
(k/l)A
A
B
MRTSA
MRTSB
0q q=
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Elasticity of Substitution
⢠Low elasticity of substitution (ðð): â ðððððððð changes
substantially relative to ðð/ðð.
â Isoquant is relatively sharply curved.
Advanced Microeconomic Theory 59
L
K
(k/l)B
(k/l)A
A
B
MRTSA
MRTSB
0q q=
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Elasticity of Substitution: Linear Production Function
⢠Suppose that the production function isðð = ðð ðð, ðð = ðððð + ðððð
⢠This production function exhibits constant returns to scale
ðð ð¡ð¡ðð, ð¡ð¡ðð = ððð¡ð¡ðð + ððð¡ð¡ðð = ð¡ð¡ ðððð + ðððð= ð¡ð¡ðð(ðð, ðð)
⢠Solving for ðð in ðð, we get ðð = ðð ðð,ðððð
â ðððð
ðð. â All isoquants are straight linesâ ðð and ðð are perfect substitutes
Advanced Microeconomic Theory 60
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Elasticity of Substitution: Linear Production Function
⢠ðððððððð (slope of the isoquant) is constant as ðð/ðð changes.
ðð =%â(ðð/ðð)%âðððððððð
0
= â
⢠This production function satisfies homotheticity.
Advanced Microeconomic Theory 61
q3q2q1
Slope=-b/a
K
L
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Elasticity of Substitution:Fixed Proportions Production Function⢠Suppose that the production function is
ðð = min ðððð, ðððð ðð, ðð > 0⢠Capital and labor must always be used in a fixed
ratioâ No substitution between ðð and ððâ The firm will always operate along a ray where ðð/ðð is
constant (i.e., at the kink!).
⢠Because ðð/ðð is constant (ðð/ðð),
ðð =%â(ðð/ðð)%âðððððððð
â
= 0
Advanced Microeconomic Theory 62
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Elasticity of Substitution:Fixed Proportions Production Function⢠ðððððððð = â for ðð
before the kink of the isoquant.
⢠ðððððððð = 0 for ðð after the kink.
⢠This production function also satisfies homotheticity.
Advanced Microeconomic Theory 63
q3
q2
q1
q3/b
q3/a
K
L
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Elasticity of Substitution:Cobb-Douglas Production Function
⢠Suppose that the production function isðð = ðð ðð, ðð = ðŽðŽðððððððð where ðŽðŽ, ðð, ðð > 0
⢠This production function can exhibit any returns to scale
ðð ð¡ð¡ðð, ð¡ð¡ðð = ðŽðŽ(ð¡ð¡ðð)ðð(ð¡ð¡ðð)ðð= ðŽðŽð¡ð¡ðð+ðððððððððð
= ð¡ð¡ðð+ðððð(ðð, ðð)â If ðð + ðð = 1 â¹ constant returns to scaleâ If ðð + ðð > 1 â¹ increasing returns to scaleâ If ðð + ðð < 1 â¹ decreasing returns to scale
Advanced Microeconomic Theory 64
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Elasticity of Substitution:Cobb-Douglas Production Function
⢠The Cobb-Douglass production function is linear in logarithms
ln ðð = ln ðŽðŽ + ðð ln ðð + ðð ln ðð
â ðð is the elasticity of output with respect to ðð
ðððð,ðð =ððln(ðð)ððln(ðð)
â ðð is the elasticity of output with respect to ðð
ðððð,ðð =ððln(ðð)ððln(ðð)
Advanced Microeconomic Theory 65
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Elasticity of Substitution:Cobb-Douglas Production Function
⢠The elasticity of substitution (ðð) for the Cobb-Douglas production function:â First,
ðððððððð =ðððððð
ðððððð=
ðððððððððððððððð
=ðððŽðŽððððððððâ1
ðððŽðŽððððâ1ðððð =ðððð
ï¿œðððð
â Hence,
ln(ðððððððð) = lnðððð
+ lnðððð
Advanced Microeconomic Theory 66
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Elasticity of Substitution:Cobb-Douglas Production Function
â Solving for ln ðððð
,
lnðððð
= ln ðððððððð â lnðððð
â Therefore, the elasticity of substitution between ððand ðð is
ðð =ðð ln ðð
ðððð ln ðððððððð
= 1
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Elasticity of Substitution:CES Production Function
⢠Suppose that the production function isðð = ðð ðð, ðð = ðððð + ðððð ðŸðŸ/ðð
where ðð †1, ðð â 0, ðŸðŸ > 0â ðŸðŸ = 1 â¹ constant returns to scaleâ ðŸðŸ > 1 â¹ increasing returns to scaleâ ðŸðŸ < 1 â¹ decreasing returns to scale
⢠Alternative representation of the CES function
ðð ðð, ðð = ððððððâ1
ðð + ððððððâ1
ðð
ððâ1ðð
where ðð is the elasticity of substitution.Advanced Microeconomic Theory 68
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Elasticity of Substitution:CES Production Function
⢠The elasticity of substitution (ðð) for the CES production function:â First,
ðððððððð =ðððððð
ðððððð=
ðððððððððððððððð
=
ðŸðŸðð ðððð + ðððð
ðŸðŸððâ1 ððððððâ1
ðŸðŸðð ðððð + ðððð
ðŸðŸððâ1 ððððððâ1
=ðððð
ððâ1
=ðððð
1âðð
Advanced Microeconomic Theory 69
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Elasticity of Substitution:CES Production Function
â Hence,
ln(ðððððððð) = ðð â 1 lnðððð
â Solving for ln ðððð
,
lnðððð
=1
ðð â 1ln ðððððððð
â Therefore, the elasticity of substitution between ððand ðð is
ðð =ðð ln ðð
ðððð ln ðððððððð
=1
ðð â 1Advanced Microeconomic Theory 70
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Elasticity of Substitution:CES Production Function
⢠Elasticity of Substitution in German Industries (Source: Kemfert, 1998):
Advanced Microeconomic Theory 71
Industry ððFood 0.66Iron 0.50Chemicals 0.37Motor Vehicles 0.10
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Elasticity of Substitution
⢠The elasticity of substitution ððbetween ðð and ðð is decreasing in scale (i.e., as ðð increases).â ðð0 and ðð1 have very
high ððâ ðð5 and ðð6 have very
low ðð
Advanced Microeconomic Theory 72
L
K
q3
q2q1q0
q4
q5
q6
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Elasticity of Substitution
⢠The elasticity of substitution ððbetween ðð and ðð is increasing in scale (i.e., as ðð increases).â ðð0 and ðð1 have very
low ððâ ðð2 and ðð3 have very
high ðð
Advanced Microeconomic Theory 73
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Profit Maximization
Advanced Microeconomic Theory 74
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Profit Maximization
⢠Assumptions:â Firms are price takers: the production plans of an
individual firm do not alter price levels ðð =ðð1, ðð2, ⊠, ððð¿ð¿ â« 0.
â The production set satisfies: non-emptiness, closedness, and free-disposal.
⢠Profit maximization problem (PMP):max
ðŠðŠðð ï¿œ ðŠðŠ
s.t. ðŠðŠ â ðð, or alternatively, ð¹ð¹(ðŠðŠ) †0Advanced Microeconomic Theory 75
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Profit Maximization
⢠Profit function ðð(ðð) associates to every ðð the highest amount of profits (i.e., ðð(ðð) is the value function of the PMP)
ðð ðð = maxðŠðŠ
ðð ï¿œ ðŠðŠ: ðŠðŠ â ðð⢠And the supply correspondence ðŠðŠ(ðð) is the
argmax of the PMP, ðŠðŠ ðð = ðŠðŠ â ðð: ðð ï¿œ ðŠðŠ = ðð ðð
where positive components in the vector ðŠðŠ ðð is output supplied by the firm to the market, while negative components are inputs in its production process.
Advanced Microeconomic Theory 76
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Profit Maximization
⢠Isoprofit line:combinations of inputs and output for which the firm obtains a given level of profits.
⢠Note thatðð0 = ðð2ðŠðŠ2 â ðð1ðŠðŠ1
Solving for ðŠðŠ2
ðŠðŠ2 =ï¿œðð0
ðð2intercept
ï¿œâ
ðð1
ðð2ðŠðŠ1
slopeAdvanced Microeconomic Theory 77
y2
y1
( )F yâ
{ }: ( ) 0y y F y= â€
1,2 ( )slope MRT y= â
Increasing profit
y(p) Supply correspondence
2 2 1 1 ''p y p y Ïâ =
2 2 1 1 'p y p y Ïâ =
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Profit Maximization
⢠We can rewrite the PMP asmax
ðŠðŠâ€ð¹ð¹(ðŠðŠ)ðð ï¿œ ðŠðŠ
with associated Lagrangian
ð¿ð¿ = ðð ï¿œ ðŠðŠ â ððð¹ð¹(ðŠðŠ)
Advanced Microeconomic Theory 78
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Profit Maximization
â Taking FOCs with respect to every ðŠðŠðð, we obtain
ðððð â ððððð¹ð¹(ðŠðŠâ)
ðððŠðŠðð†0
where ð¹ð¹(ðŠðŠâ) is evaluated at the optimum, i.e., ð¹ð¹ ðŠðŠâ = ð¹ð¹(ðŠðŠ(ðð)) .
â For interior solutions, ðððð = ðð ððð¹ð¹(ðŠðŠâ)ðððŠðŠðð
, or in matrix notation
ðð = ððð»ð»ðŠðŠð¹ð¹(ðŠðŠâ)that is, the price vector and the gradient vector are proportional.
Advanced Microeconomic Theory 79
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Profit Maximization
â Solving for ðð, we obtain
ðð = ððððððð¹ð¹(ðŠðŠâ)
ðððŠðŠðð
for every good ðð â¹ ððððððð¹ð¹(ðŠðŠâ)
ðððŠðŠðð
= ððððððð¹ð¹(ðŠðŠâ)
ðððŠðŠðð
which can also be expressed as
ðððððððð
=ððð¹ð¹(ðŠðŠâ)
ðððŠðŠððððð¹ð¹(ðŠðŠâ)
ðððŠðŠðð
(= ðððððððð,ðð(ðŠðŠâ))
â Graphically, the slope of the transformation frontier (at the profit maximization production plan ðŠðŠâ), ðððððððð,ðð(ðŠðŠâ), coincides with the price ratio, ðððð
ðððð.
Advanced Microeconomic Theory 80
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Profit Maximization
⢠Are there PMPs with no supply correspondence ðŠðŠ ðð , i.e., there is no well defined profit maximizing vector?â Yes.
⢠Example: ðð = ðð ð§ð§ = ð§ð§ (i.e., every unit of input ð§ð§ is transformed into a unit of output ðð)
Advanced Microeconomic Theory 81
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Profit Maximization: Single Output
⢠Production function, ðð = ðð ð§ð§ , produces a single output from a vector ð§ð§ of inputs.
maxð§ð§â¥0
ðððð ð§ð§ â ð€ð€ð§ð§
⢠The first-order conditions are
ðð ðððð(ðŠðŠâ)ððð§ð§ðð
†ð€ð€ðð or ðð ï¿œ ððððð§ð§ðð †ð€ð€ðð
⢠For interior solutions, the market value of the marginal product obtained form using additional units of this input ðð, ðð ðððð(ðŠðŠâ)
ððð§ð§ðð, must coincide with
the price of this input, ð€ð€ðð.Advanced Microeconomic Theory 82
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Profit Maximization: Single Output⢠Note that for any two input, this implies
ðð = ð€ð€ðððððð(ðŠðŠâ)
ððð§ð§ðð
for every good ðð
Hence,
ð€ð€ððð€ð€ðð
=ðððð(ð§ð§â)
ððð§ð§ðððððð(ð§ð§â)
ððð§ð§ðð
=ððððð§ð§ððððððð§ð§ðð
(= ððððððððð§ð§ðð,ð§ð§ðð(ð§ð§â))
or ððððð§ð§ðð
ð€ð€ð§ð§ðð
=ððððð§ð§ðð
ð€ð€ð§ð§ððIntuition: Marginal productivity per dollar spent on input ð§ð§ðð is equal to that spent on input ð§ð§ðð.
Advanced Microeconomic Theory 83
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Profit Maximization⢠Example : Are there PMPs with no supply correspondence
ðŠðŠ(ðð), i.e., there is no well defined profit maximizing vector? â Yes.
⢠If the input price ððð§ð§ satisfies ððð§ð§ ⥠ðð, then ðð = 0 and ðð ðð = 0.
⢠If the input price ððð§ð§ satisfies ððð§ð§ < ðð, then ðð = +â and ðð ðð = +â. â In this case, the supply correspondence is not well defined,
since you can always increase input usage, thus increasing profits.
â Exception: if input usage is constrained in the interval 0, ð§ð§ , then ðŠðŠ ðð is at the corner solution ðŠðŠ ðð = ð§ð§, thus implying that the PMP is well defined.
Advanced Microeconomic Theory 84
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Profit Maximization
⢠Example (continued):
Advanced Microeconomic Theory 85
q=f(z)
zz
Increasing profit
f(z)=q q=f(z)
z
Increasing profit
f(z)=q
y(p)=0
If ððð§ð§ < ðð, the firm can âðð and âðð.
If ððð§ð§ > ðð, the firm chooses ðð =ðŠðŠ ðð = 0 with ðð ðð = 0.
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Profit Maximization: Single Output
⢠When are these FOCs also sufficient? â When the production set ðð is convex! Letâs see.
⢠Isocost line for the firm isð€ð€1ð§ð§1 + ð€ð€2ð§ð§2 = ðð
⢠Solving for ð§ð§2
ð§ð§2 =ï¿œ
ððð€ð€2
interceptï¿œâ
ð€ð€1
ð€ð€2slope
ð§ð§1
Advanced Microeconomic Theory 86
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Profit Maximization: Single Output
Advanced Microeconomic Theory 87
â The FOCs (necessary) of ðððððððð = ð€ð€1
ð€ð€2are
also sufficient.
⢠Convex production set
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Profit Maximization: Single Output
â the FOCs are NOT sufficient for a combination of (ð§ð§1, ð§ð§2)that maximize profits.
â the profit-maximizing vector (ð§ð§1
â, ð§ð§2â) is at a
corner solution, where the firm uses ð§ð§2 alone.
Advanced Microeconomic Theory 88
⢠Non-convex production set
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Profit Maximization: Single Output
Advanced Microeconomic Theory 89
⢠Example: Cobb-Douglas production function⢠On your own:
â Solve PMP (differentiating with respect to ð§ð§1and ð§ð§2.â Find optimal input usage ð§ð§1(ð€ð€, ðð) and ð§ð§2(ð€ð€, ðð).
⢠These are referred to as âconditional factor demand correspondencesâ
â Plug them into the production function to obtain the value function, i.e., the output that arises when the firm uses its profit-maximizing input combination.
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Properties of Profit Function
⢠Assume that the production set ðð is closed and satisfies the free disposal property.1) Homog(1) in prices
ðð ðððð = ðððð ðð Increasing the prices of all inputs and outputs by a
common factor ðð produces a proportional increase in the firmâs profits.
ðð ðð = ðððð â ð€ð€1ð§ð§1 â ⯠â ð€ð€ððð§ð§ððScaling all prices by a common factor, we obtain
ðð ðððð = ðððððð â ððð€ð€1ð§ð§1 â ⯠â ððð€ð€ððð§ð§ðð= ðð ðððð â ð€ð€1ð§ð§1 â ⯠â ð€ð€ððð§ð§ðð = ðððð ðð
Advanced Microeconomic Theory 90
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Properties of Profit Function
2) Convex in output prices Intuition: the firm
obtains more profits from balanced input-output combinations, than from unbalanced combinations.
Advanced Microeconomic Theory 91
z
y(p)
y(pâ)
( )y p
Y
q
q=f(z)
Price vector Production plan Profits
ðð ðŠðŠ(ðð) ðð ððððâ² ðŠðŠ(ððâ²) ðð ððâ²
ᅵᅵð ðŠðŠ(ᅵᅵð) ðð ᅵᅵð = ðŒðŒðð ðð + 1 â ðŒðŒ ðð ððâ²
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Properties of Profit Function
3) If the production set ðð is convex, then ðð = ðŠðŠ â âð¿ð¿: ðð ï¿œ ðŠðŠ †ðð ðð for all ðð â« 0 Intuition: the production set ðð can be
represented by this âdualâ set. This dual set specifies that, for any given
prices ðð, all production vectors ðŠðŠ generate less profits ðð ï¿œ ðŠðŠ, than the optimal production plan ðŠðŠ(ðð) in the profit function ðð ðð = ðð ï¿œ ðŠðŠ(ðð).
Advanced Microeconomic Theory 92
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Properties of Profit Function⢠All production plans
ð§ð§, ðð below the isoprofit line yield a lower profit level:
ðððð â ð€ð€ð§ð§ †ðð ðð⢠The isoprofit line ðð ðð =
ðððð â ð€ð€ð§ð§ can be expressed as
ðð =ðððð
+ð€ð€ðð
ð§ð§
â If ð€ð€ðð
is constant â¹ ðð ï¿œis convex.
â What if it is not constant? Letâs see next. Advanced Microeconomic Theory 93
z
y(p)
Y
q
q=f(z)
p q w zÏ = â â â
{ }2 : ( )y p q w z pÏâ â â â â€
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Properties of Profit Functiona) Input prices are a function of input usage, i.e., ð€ð€ =
ðð(ð§ð§), where ððâ²(ð§ð§) â 0. Then, eitheri. ððâ² ð§ð§ < 0, and the firm gets a price discount per unit of
input from suppliers when ordering large amounts of inputs (e.g., loans)
ii. ððâ² ð§ð§ > 0, and the firm has to pay more per unit of input when ordering large amounts of inputs (e.g., scarce qualified labor)
b) Output prices are a function of production , i.e., ðð =ðð(ðð), where ððâ²(ðð) â 0. Then, eitheri. ððâ²(ðð) < 0, and the firm offers price discounts to its
customers.ii. ððâ²(ðð) > 0, and the firm applies price surcharges to its
customers.Advanced Microeconomic Theory 94
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Properties of Profit Function
⢠If ððâ² ð§ð§ < 0, then we have strictly convexisoprofit curves.
⢠If ððâ² ð§ð§ > 0, then we have strictly concaveisoprofit curves.
⢠If ððâ² ð§ð§ = 0, then we have straightisoprofit curves.
Advanced Microeconomic Theory 95
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Remarks on Profit Function
⢠Remark 1: the profit function is a value function, measuring firm profits only for the profit-maximizing vector ðŠðŠâ.
⢠Remark 2: the profit function can be understood as a support function.â Take negative of the production set ðð, i.e., âððâ Then, the support function of âðð set is
ððâðð ðð = minðŠðŠ
ðð ï¿œ âðŠðŠ : ðŠðŠ â ðð
That is, take the profits resulting form all production vectors ðŠðŠ â ðð, ðð ï¿œ ðŠðŠ, then take the negative of all these profits, ðð ï¿œ âðŠðŠ , and then choose the smallest one.
Advanced Microeconomic Theory 96
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Remarks on Profit Function
â Of course, this is the same as maximizing the (positive) value of the profits resulting from all production vector ðŠðŠ â ðð, ðð ï¿œ ðŠðŠ.
â Therefore, the profit function, ðð(ðð), is the support of the negative production set, âðð,
ðð ðð = ððâðð ðð
Advanced Microeconomic Theory 97
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Remarks on Profit Function
â Alternatively, the argmax of any objective functionðŠðŠ1
â = arg maxðŠðŠ
ðð(ð¥ð¥)
coincides with the argmin of the negative of this objective functionðŠðŠ2
â = arg maxðŠðŠ
âðð(ð¥ð¥)
where ðŠðŠ1â = ðŠðŠ2
â.
Advanced Microeconomic Theory 98
y2
y1
y(p)
y(pâ)
{ }: ( )y p y pÏâ â€
{ }: ' ( ')y p y pÏâ â€
( )q f z=
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y2
y1
y(p),straight segment of Y
{ }: ( )y p y pÏâ =
Properties of Supply Correspondence
â ðð has a flat surfaceâ ðŠðŠ(ðð) is NOT single
valued.
Advanced Microeconomic Theory 99
1) If ðð is weakly convex, then ðŠðŠ(ðð) is a convex set for all ðð.
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y2
y1
Unique y(p)
{ }: ( )y p y pÏâ =
( )q f z=
Properties of Supply Correspondence
1) (continued) If ðð is strictly convex, then ðŠðŠ(ðð) is single-valued (if nonempty).
Advanced Microeconomic Theory 100
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Properties of Supply Correspondence
2) Hotellingâs Lemma: If ðŠðŠ(ᅵᅵð) consists of a single point, then ðð(ï¿œ) is differentiable at ᅵᅵð. Moreover, ð»ð»ðððð ᅵᅵð = ðŠðŠ(ᅵᅵð).
â This is an application of the duality theorem from consumer theory.
⢠If ðŠðŠ(ï¿œ) is a function differentiable at ᅵᅵð, then ð·ð·ðððŠðŠ(ᅵᅵð) = ð·ð·ðð
2ðð ᅵᅵð is a symmetric and positive semidefinite matrix, with ð·ð·ðððð ᅵᅵð ᅵᅵð = 0. This is a direct consequence of the law of supply.
Advanced Microeconomic Theory 101
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Properties of Supply Correspondence
â Since ð·ð·ðððð ᅵᅵð ᅵᅵð = 0, ð·ð·ðð ðŠðŠ(ᅵᅵð) must satisfy:Own substitution effects (main diagonal
elements in ð·ð·ðððŠðŠ(ᅵᅵð)) are non-negative, i.e.,ðððŠðŠðð(ðð)
ðððððð⥠0 for all ðð
Cross substitution effects (off diagonal elements in ð·ð·ðððŠðŠ(ᅵᅵð)) are symmetric, i.e.,
ðððŠðŠðð(ðð)ðððððð
= ðððŠðŠðð(ðð)ðððððð
for all ðð and ðð
Advanced Microeconomic Theory 102
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Properties of Supply Correspondence
⢠ðððŠðŠðð(ðð)ðððððð
⥠0 , which
implies that quantities and prices move in the same direction, (ðð â ððâ²)(ðŠðŠ â ðŠðŠâ²) ⥠0â The law of supply holds!
Advanced Microeconomic Theory 103
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Properties of Supply Correspondence
⢠Since there is no budget constraint, there is no wealth compensation requirement (as opposed to Demand theory).â This implies that there no income effects, only
substitution effects.
⢠Alternatively, from a revealed preference argument, the law of supply can be expressed as
ðð â ððâ² ðŠðŠ â ðŠðŠâ² =ðððŠðŠ â ðððŠðŠâ² + ððâ²ðŠðŠâ² â ððâ²ðŠðŠ ⥠0
where ðŠðŠ â ðŠðŠ(ðð) and ðŠðŠ â ðŠðŠ(ððâ²).Advanced Microeconomic Theory 104
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Cost Minimization
Advanced Microeconomic Theory 105
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Cost Minimization
⢠We focus on the single output case, where â ð§ð§ is the input vectorâ ðð(ð§ð§) is the production functionâ ðð are the units of the (single) outputâ ð€ð€ â« 0 is the vector of input prices
⢠The cost minimization problem (CMP) isminð§ð§â¥0
ð€ð€ ï¿œ ð§ð§s. t. ðð(ð§ð§) ⥠ðð
Advanced Microeconomic Theory 106
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Cost Minimization
⢠The optimal vector of input (or factor) choices is ð§ð§(ð€ð€, ðð), and is known as the conditional factor demand correspondence.â If single-valued, ð§ð§ ð€ð€, ðð is a function (not a
correspondence)â Why âconditionalâ? Because it represents the
firmâs demand for inputs, conditional on reaching output level ðð.
⢠The value function of this CMP ðð ð€ð€, ðð is the cost function.
Advanced Microeconomic Theory 107
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Cost Minimization
Advanced Microeconomic Theory 108
z1
z2
1
2
wslopew
= â
Cost minimization
Isoquant f(z)=q
{ }: ( , )z w z c w qâ = { }: ( , )z w z c w qâ >
( , )z w q
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Cost Minimization⢠Graphically,
â For a given isoquant ðð ð§ð§ = ðð, choose the isocost line associated with the lowest cost ð€ð€ ï¿œ ð§ð§.
â The tangency point is ð§ð§ ð€ð€, ðð .â The isocost line associated with that combination of
inputs isð§ð§: ð€ð€ ï¿œ ð§ð§ = ðð ð€ð€, ðð
where the cost function ðð ð€ð€, ðð represents the lowest cost of producing output level ðð when input prices are ð€ð€.
â Other isocost lines are associated with either: ⢠output levels higher than ðð (with costs exceeding ðð ð€ð€, ðð ),
or ⢠output levels lower than ðð (with costs below ðð ð€ð€, ðð ).
Advanced Microeconomic Theory 109
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Cost Minimization
⢠The Lagrangian of the CMP isâ ð§ð§; ðð = ð€ð€ð§ð§ + ðð[ðð â ðð ð§ð§ ]
⢠Differentiating with respect to ð§ð§ðð
ð€ð€ðð â ðð ðððð(ð§ð§â)ððð§ð§ðð
⥠0
(= 0 if interior solution, ð§ð§ððâ)
or in matrix notationð€ð€ â ððð»ð»ðð(ð§ð§â) ⥠0
Advanced Microeconomic Theory 110
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Cost Minimization
⢠From the above FOCs,
ð€ð€ðððððð(ð§ð§â)
ððð§ð§ðð
= ðð â¹ð€ð€ðð
ð€ð€ðð=
ðððð ð§ð§â
ððð§ð§ðððððð ð§ð§â
ððð§ð§ðð
(= ðððððððð(ð§ð§â))
⢠Alternatively,ðððð ð§ð§â
ððð§ð§ððð€ð€ðð
=
ðððð ð§ð§â
ððð§ð§ððð€ð€ðð
at the cost-minimizing input combination, the marginal product per dollar spent on input ðð must be equal that of input ðð.
Advanced Microeconomic Theory 111
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z1
z2Cost-minimizing, z(w,q)
{ }: ( , )z w z c w qâ =z
Isoprofit line{ }Ë Ë: , where ( , )z w z c c c w qâ = >
Cost Minimization⢠Sufficiency: If the
production set is convex, then the FOCs are also sufficient.
⢠A non-convex production set: â The input combinations
satisfying the FOCs are NOT a cost-minimizing input combination ð§ð§(ð€ð€, ðð).
â The cost-minimizing combination of inputs ð§ð§(ð€ð€, ðð) occurs at the corner.
Advanced Microeconomic Theory 112
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Cost Minimization
⢠Lagrange multiplier: ðð can be interpreted as the cost increase that the firm experiences when it needs to produce a higher level ðð.â Recall that, generally, the Lagrange multiplier
represents the variation in the objective function that we obtain if we relax the constraint (e.g., wealth in UMP, utility level we must reach in the EMP).
⢠Therefore, ðð is the marginal cost of production: the marginal increase in the firmâs costs form producing additional units.
Advanced Microeconomic Theory 113
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Cost Minimization: SE and OE Effects
⢠Comparative statics of ð§ð§(ð€ð€, ðð): Let us analyze the effects of an input price change. Consider two inputs, e.g., labor and capital. When the price of labor, ð€ð€, falls, two effects occur:â Substitution effect: if output is held constant,
there will be a tendency for the firm to substitute ðð for ðð.
â Output effect: a reduction in firmâs costs allows it to produce larger amounts of output (i.e., higher isoquant), which entails the use of more units of ððfor ðð.
Advanced Microeconomic Theory 114
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Cost Minimization: SE and OE Effects
⢠Substitution effect:â ð§ð§0(ð€ð€, ðð) solves CMP at
the initial prices.â â in wages â¹ isocost
line pivots outwards.â To reach ðð, push the
new isocost inwards in a parallel fashion.
â ð§ð§1(ð€ð€, ðð) solves CMP at the new input prices (for output level ðð).
â At ð§ð§1(ð€ð€, ðð), firm uses more ðð and less ðð.
Advanced Microeconomic Theory 115
K
Lwâ 1st step
2nd stepz0(w,q)
z1(w,q)f(z)=q, isoquant
Substitution effect
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Cost Minimization: SE and OE Effects
⢠Substitution effect (SE):â increase in labor
demand from ð¿ð¿ðŽðŽ to ð¿ð¿ðµðµ. â same output as before
the input price change.⢠Output effect (OE):
â increase in labor demand from ð¿ð¿ðµðµ to ð¿ð¿ð¶ð¶.
â output level increases, total cost is the same as before the input price change.
Advanced Microeconomic Theory 116
K
Lwâ (1st step)
(2nd st
ep)
A
f(z)=q0, isoquant
BC3
rd step
KA
KBKC
LA LB LC
0
TCw 1
TCw
f(z)=q1, where q1>q0
SE OETE
TCr
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Cost Minimization: Own-Price Effect
⢠We have two concepts of demand for any inputâ the conditional demand for labor, ðððð(ðð, ð€ð€, ðð) ðððð(ðð, ð€ð€, ðð) solves the CMP
â the unconditional demand for labor, ðð(ðð, ðð, ð€ð€) ðð(ðð, ðð, ð€ð€) solves the PMP
⢠At the profit-maximizing level of output, i.e., ðð(ðð, ðð, ð€ð€), the two must coincide
ðð ðð, ðð, ð€ð€ = ðððð ðð, ð€ð€, ðð = ðððð(ðð, ð€ð€, ðð(ðð, ðð, ð€ð€))Advanced Microeconomic Theory 117
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Cost Minimization: Own-Price Effect
⢠Differentiating with respect to ð€ð€ yields
ðððð ðð, ðð, ð€ð€ððð€ð€
=ðððððð ðð, ð€ð€, ðð
ððð€ð€ðððð (â)
+ðððððð(ðð, ð€ð€, ðð)
ðððð
(+)
ᅵᅵððððððð€ð€
(â)
ðððð (â)ðððð (â)
Advanced Microeconomic Theory 118
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Cost Minimization: Own-Price Effect
⢠Since ðððð > ðððð, the unconditional labor demand is flatter than the conditional labor demand.
⢠Both ðððð and ðððð are negative.â Giffen paradox from
consumer theory cannot arise in production theory.
Advanced Microeconomic Theory 119
w
z
A
B C
SE OETE
lc(v,w,q1) lc(v,w,q2)
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Cost Minimization: Cross-Price Effect
⢠No definite statement can be made about cross-price (CP) effects.â A fall in the wage will lead the firm to substitute away
from capital.â The output effect will cause more capital to be
demanded as the firm expands production.
ðððð ðð, ðð, ð€ð€ððð€ð€
ð¶ð¶ðð ðððð + or (â)
=ðððððð ðð, ð€ð€, ðð
ððð€ð€ð¶ð¶ðð ðððð (+)
+ðððððð(ðð, ð€ð€, ðð)
ðððð
(+)
ᅵᅵððððððð€ð€
(â)
ð¶ð¶ðð ðððð (â)Advanced Microeconomic Theory 120
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Cost Minimization: Cross-Price Effect
⢠The + cross-price OE completely offsets the â cross-price SE, leading to a positive cross-price TE.
Advanced Microeconomic Theory 121
w
K
wâ
A
B C
SEOE
TE
w
w1
1( , , )ck r w q 2( , , )ck r w q
( , , )k p r w
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Cost Minimization: Cross-Price Effect
⢠The + cross-price OE only partially offsets the â cross-price SE, leading to a negative cross-price TE.
Advanced Microeconomic Theory 122
w
K
wâ
A
BC
SEOE
TE
w
w1
1( , , )ck r w q
2( , , )ck r w q
( , , )k p r w
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Properties of Cost Function
⢠Assume that the production set ðð is closed and satisfies the free disposal property.1) ðð(ð€ð€, ðð) is Homog(1) in ð€ð€ That is, increasing all input prices by a common
factor ðð yields a proportional increase in the minimal costs of production:
ðð ððð€ð€, ðð = ðððð(ð€ð€, ðð)
since ðð(ð€ð€, ðð) represents the minimal cost of producing a given output ðð at input prices ð€ð€.
Advanced Microeconomic Theory 123
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Properties of Cost Function
An increase in all input prices (w1, w2) by the same proportion λ,produces a parallel downward shift in the firm's isocost line.
Advanced Microeconomic Theory 124
z1
z2
f(z)=q
( , )z w q
2 2
( , ) ( , )c w q c w qw w
λλ
=
1 1
( , ) ( , )c w q c w qw w
λλ
=1
( , )c w qwλ
2
( , )c w qwλ
2wâ
1wâ
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z1
z2
f(z)=q1
1( , )z w q
f(z)=q0
0( , )z w q
1
1
( , )c w qw
0
1
( , )c w qw
0
2
( , )c w qw
1
2
( , )c w qw
Properties of Cost Function
Producing higher output levels implies a weakly higher minimal cost of production
If ðð1 > ðð0, then it must be
ðð(ð€ð€, ðð1) > ðð(ð€ð€, ðð0)
Advanced Microeconomic Theory 125
2) ðð(ð€ð€, ðð) is non-decreasing in ðð.
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Properties of Cost Function
3) If the set ð§ð§ ⥠0: ðð(ð§ð§) ⥠ðð is convex for every ðð, then the production set can be described as
ðð = âð§ð§, ðð : ð€ð€ ï¿œ ð§ð§ ⥠ðð ð€ð€, ððfor every ð€ð€ â« 0
Advanced Microeconomic Theory 126
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Properties of Cost Function Take ðð ð§ð§ = ðð. For input prices ð€ð€ =
(ð€ð€1, ð€ð€2), find ðð(ð€ð€, ðð) by solving CMP.
For input prices ð€ð€â² =(ð€ð€1
â² , ð€ð€2â² ), find ðð(ð€ð€â², ðð) by
solving CMP. The intersection of âmore
costlyâ input combinations ð€ð€ ï¿œ ð§ð§ â¥ðð ð€ð€, ðð , for every input prices ð€ð€ â« 0, describes set ðð ð§ð§ ⥠ðð.
Advanced Microeconomic Theory 127
z1
z2
1
2
wslopewâ
=
f(z)=q0
z(w,q)
z(wâ,q)
1
2
''
wslopewâ
=
{ }: ( , )z w z c w qâ =
{ }: ' ( ', )z w z c w qâ =
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Properties of Conditional Factor Demand Correspondence
That is, increasing input prices by the same factor ðð does not alter the firmâs demand for inputs at all,
ð§ð§ ððð€ð€, ðð = ð§ð§(ð€ð€, ðð)
Advanced Microeconomic Theory 128
z1
z2
z(w,q)=(z1(w,q),z2(w,q))
Isoquant f(z)=q
{ }0 : ( )z f z q⥠â¥
Isocost curve
1
( , )c w qw1
( , )c w qwλ
2
( , )c w qwλ
2
( , )c w qw
1) ð§ð§(ð€ð€, ðð) is Homog(0) in ð€ð€.
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Properties of Conditional Factor Demand Correspondence
2) If the set {}
ð§ð§ â¥0: ðð(ð§ð§) ⥠ðð is strictly convex, then the firm's demand correspondence ð§ð§(ð€ð€, ðð) is single valued.
Advanced Microeconomic Theory 129
z1
z2
Unique z(w,q)
Isoquant f(z)=q
{ }0 : ( )z f z q⥠â¥
Isocost curve
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Properties of Conditional Factor Demand Correspondence
2) (continued) If the set {
}ð§ð§ â¥
0: ðð(ð§ð§) ⥠ðð is weakly convex, then the demand correspondence ð§ð§(ð€ð€, ðð) is not a single-valued, but a convex set.
Advanced Microeconomic Theory 130
z1
z2
Set of z(w,q)
Isoquant f(z)=q
{ }0 : ( )z f z q⥠â¥
Isocost curve
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Properties of Conditional Factor Demand Correspondence
3) Shepardâs lemma: If ð§ð§(ï¿œð€ð€,ðð) consists of a single point, then ðð(ð€ð€, ðð) is differentiable with respect to ð€ð€ at, ï¿œð€ð€, and
ð»ð»ð€ð€ðð ï¿œð€ð€,ðð = ð§ð§(ï¿œð€ð€,ðð)
Advanced Microeconomic Theory 131
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Properties of Conditional Factor Demand Correspondence
4) If ð§ð§(ð€ð€, ðð) is differentiable at ï¿œð€ð€, then ð·ð·ð€ð€
2 ðð ï¿œð€ð€, ðð = ð·ð·ð€ð€ð§ð§ ï¿œð€ð€, ðð is a symmetric and negative semidefinite matrix, with ð·ð·ð€ð€ð§ð§ ï¿œð€ð€, ðð ï¿œ ï¿œð€ð€ = 0. ð·ð·ð€ð€ð§ð§ ï¿œð€ð€, ðð is a matrix representing how the
firmâs demand for every unit responds to changes in the price of such input, or in the price of the other inputs.
Advanced Microeconomic Theory 132
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Properties of Conditional Factor Demand Correspondence
4) (continued) Own substitution effects are non-positive,
ððð§ð§ðð(ð€ð€,ðð)ððð€ð€ðð
†0 for every input ðði.e., if the price of input ðð increases, the firmâs factor demand for this input decreases.
Cross substitution effects are symmetric,ððð§ð§ðð(ð€ð€,ðð)
ððð€ð€ðð= ððð§ð§ðð(ð€ð€,ðð)
ððð€ð€ððfor all inputs ðð and ðð
Advanced Microeconomic Theory 133
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Properties of Production Function
1) If ðð(ð§ð§) is Homog(1) (i.e., if ðð(ð§ð§) exhibits constant returns to scale), then ðð(ð€ð€, ðð) and ð§ð§(ð€ð€, ðð) are Homog(1) in ðð. Intuitively, if ðð(ð§ð§) exhibits CRS, then an
increase in the output level we seek to reach induces an increase of the same proportion in the cost function and in the demand for inputs. That is,
ðð ð€ð€, ðððð = ðððð(ð€ð€, ðð)and
ð§ð§ ð€ð€, ðððð = ððð§ð§(ð€ð€, ðð)Advanced Microeconomic Theory 134
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Properties of Production Function
ðð = 2 implies that demand for inputs doublesð§ð§ ð€ð€, 2ðð = 2ð§ð§(ð€ð€, ðð)
and that minimal costs also double
ðð ð€ð€, 2ðð = 2ðð ð€ð€, ðð
Advanced Microeconomic Theory 135
z1
z2
q=10units
q'=20unitsz(w,q)
z(w,qâ)=2z(w,q)
1
2
1 2λ=2
λ=2
c(w,q)c(w,q')=2c(w,q)
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Properties of Production Function
2) If ðð(ð§ð§) is concave, then ðð(ð€ð€, ðð) is convex function of ðð (i.e., marginal costs are non-decreasing in ðð). More compactly,
ðð2ðð(ð€ð€, ðð)ðððð2 ⥠0
or, in other words, marginal costs ðððð(ð€ð€,ðð)ðððð
are weakly increasing in ðð.Advanced Microeconomic Theory 136
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Properties of Production Function
2) (continued) Firm uses more inputs
when raising output from ðð2 to ðð3 than from ðð1 to ðð2.
Hence,ðð(ð€ð€, ðð3) â ðð(ð€ð€, ðð2) >
ðð(ð€ð€, ðð2) â ðð(ð€ð€, ðð1) This reflects the
convexity of the cost function ðð(ð€ð€, ðð) with respect to ðð.
Advanced Microeconomic Theory 137
z1
z2
q1=10units
q2=20unitsz(w,q1)
c(w,q1) c(w,q2)
z(w,q2)
z(w,q3)
11z
21z
31z
32z
22z
12z
c(w,q3)
q3=30units
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Alternative Representation of PMP
Advanced Microeconomic Theory 138
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Alternative Representation of PMP
⢠Using the cost function ðð(ð€ð€, ðð), we write the PMP as follows
maxððâ¥0
ðððð â ðð(ð€ð€, ðð)
This is useful if we have information about the cost function, but we donât about the production function ðð = ðð ð§ð§ .
Advanced Microeconomic Theory 139
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Alternative Representation of PMP
⢠Let us now solve this alternative PMPmaxððâ¥0
ðððð â ðð(ð€ð€, ðð)
⢠FOCs for ððâ to be profit maximizing are
ðð âðððð(ð€ð€, ððâ)
ðððð†0
and in interior solutions
ðð âðððð ð€ð€, ððâ
ðððð= 0
⢠That is, at the interior optimum ððâ, price equals marginal cost, ðððð ð€ð€,ððâ
ðððð.
Advanced Microeconomic Theory 140
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L
K
q0
q1
c(w,q0) c(w,q1)0cl 1
cl
2ck
1ck
0ck
c(w,q2)
q2
2cl
Expansion path
Firmâs Expansion Path
⢠The curve shows how inputs increase as output increases.
⢠Expansion path is positively sloped.
⢠Both ðð and ðð are normalgoods, i.e.,
ðððððð(ð€ð€,ðð)ðððð
⥠0, ðððððð(ð€ð€,ðð)ðððð
⥠0Advanced Microeconomic Theory 141
⢠The expansion path is the locus of cost-minimizing tangencies. (Analogous to the wealth expansion path in consumer theory)
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Firmâs Expansion Path
⢠If the firmâs expansion path is a straight line:â All inputs must increase at a constant proportion as
firm increases its output.â The firmâs production function exhibits constant
returns to scale and it is, hence, homothetic.â If the expansion path is straight and coincides with the
45-degree line, then the firm increases all inputs by the same proportion as output increases.
⢠The expansion path does not have to be a straight line. â The use of some inputs may increase faster than
others as output expands⢠Depends on the shape of the isoquants.
Advanced Microeconomic Theory 142
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Firmâs Expansion Path
⢠The expansion path does not have to be upward sloping.â If the use of an input falls
as output expands, that input is an inferior input.
⢠ðð is normalðððððð(ð€ð€, ðð)
ðððð⥠0
but ðð is inferior (at higher levels of output)
ðððððð(ð€ð€, ðð)ðððð
< 0Advanced Microeconomic Theory 143
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Firmâs Expansion Path
⢠Are there inferior inputs out there?â We can identify inferior inputs if the list of inputs used
by the firms is relatively disaggregated.â For instance, we can identify following categories:
CEOs, executives, managers, accountants, secretaries, janitors, etc.
â These inputs do not increase at a constant rate as the firm increases output (i.e., expansion path would not be a straight line for all increases in ðð).
â After reaching a certain scale, the firm might buy a powerful computer with which accounting can be done using fewer accountants.
Advanced Microeconomic Theory 144
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Cost and Supply: Single Output
⢠Let us assume a given vector of input prices ï¿œð€ð€ â«0. Then, ðð(ï¿œð€ð€, ðð) can be reduced to ð¶ð¶(ðð). Then, average and marginal costs are
ðŽðŽð¶ð¶ ðð = ð¶ð¶(ðð)ðð
and ððð¶ð¶ = ð¶ð¶â² ðð = ððð¶ð¶(ðð)ðððð
⢠Hence, the FOCs of the PMP can be expressed as
ðð †ð¶ð¶â² ðð , and in interior solutions ðð = ð¶ð¶â² ðð
i.e., all output combinations such that ðð = ð¶ð¶â² ððare the (optimal) supply correspondence of the firm ðð ðð .
Advanced Microeconomic Theory 145
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Cost and Supply: Single Output
⢠We showed that the cost function ðð(ð€ð€, ðð) is homogenous of degree 1 in input prices, ð€ð€.â Can we extend this property to the AC and MC?
Yes!â For average cost function,
ðŽðŽð¶ð¶ ð¡ð¡ð€ð€, ðð =ð¶ð¶(ð¡ð¡ð€ð€, ðð)
ðð=
ð¡ð¡ ï¿œ ð¶ð¶(ð€ð€, ðð)ðð
= ð¡ð¡ ï¿œ ðŽðŽð¶ð¶ ð¡ð¡ð€ð€, ðð
Advanced Microeconomic Theory 146
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Cost and Supply: Single Output
â For marginal cost function,
ððð¶ð¶ ð¡ð¡ð€ð€, ðð =ððð¶ð¶(ð¡ð¡ð€ð€, ðð)
ðððð=
ð¡ð¡ ï¿œ ððð¶ð¶(ð€ð€, ðð)ðððð
= ð¡ð¡ ï¿œ ððð¶ð¶ ð¡ð¡ð€ð€, ððâ Isnât this result violating Eulerâs theorem? No! The above result states that ðð(ð€ð€, ðð) is homog(1) in
inputs prices, and that ððð¶ð¶ ð€ð€, ðð = ððð¶ð¶(ð€ð€,ðð)ðððð
is also homog(1) in input prices. Eulerâs theorem would say that: If ðð(ð€ð€, ðð) is
homog(1) in inputs prices, then its derivate with respect to input prices, ððð¶ð¶(ð€ð€,ðð)
ððð€ð€, must be homog(0).
Advanced Microeconomic Theory 147
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TC
Total cost
c
output
Graphical Analysis of Total Cost
⢠With constant returns to scale, total costs are proportional to output.
ððð¶ð¶(ðð) = ðð ï¿œ ðð⢠Hence,
ðŽðŽð¶ð¶(ðð) =ððð¶ð¶(ðð)
ðð= ðð
ððð¶ð¶(ðð) =ððððð¶ð¶(ðð)
ðððð= ðð
â¹ ðŽðŽð¶ð¶(ðð) = ððð¶ð¶(ðð)Advanced Microeconomic Theory 148
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Cost and Supply: Single Output
⢠Suppose that TC starts out as concave and then becomes convex as output increases.â TC no longer exhibits constant returns to scale.â One possible explanation for this is that there is a
third factor of production that is fixed as capital and labor usage expands (e.g., entrepreneurial skills).
â TC begins rising rapidly after diminishing returns set in.
Advanced Microeconomic Theory 149
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TCTC(q)
B
q
A
C
0 50
$1,500
ACMC
q0 50
Aâ
Aââ$10
$30
MC(q)
AC(q)
Cost and Supply: Single Output
⢠TC initially grows very rapidly, then becomes relatively flat, and for high production levels increases rapidly again.
⢠MC is the slope of the TC curve.
Advanced Microeconomic Theory 150
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Cost and Supply: Single Output
Advanced Microeconomic Theory 151
ACMC
q
MC(Q)
AC(Q)
min AC
TC becomes flatter
TC becomes steeper
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Cost and Supply: Single Output
Advanced Microeconomic Theory 152
⢠Remark 1: AC=MC at ðð = 0.â Note that we cannot compute
ðŽðŽð¶ð¶ 0 =ððð¶ð¶ 0
0=
00
â We can still apply lâHopitalâs rule
limððâ0
ðŽðŽð¶ð¶(ðð) = limððâ0
ððð¶ð¶(ðð)ðð
= limððâ0
ððððð¶ð¶(ðð)ðððððððððððð
= limððâ0
ððð¶ð¶(ðð)
â Hence, AC=MC at ðð = 0, i.e., AC(0)=MC(0).
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Cost and Supply: Single Output
⢠Remark 2: When MC<AC, the AC curve decreases, and when MC>AC, the AC curve increases.â Intuition: using example of gradesâ If the new exam score raises your average grade, it
must be that such new grade is better than your average grade thus far.
â If, in contrast, the new exam score lowers your average grade, it must be that such new grade is than your average grade thus far.
Advanced Microeconomic Theory 153
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Cost and Supply: Single Output
⢠Remark 3: AC and MC curves cross (AC=MC) at exactly the minimum of the AC curve.â Let us first find the minimum of the AC curve
ðððŽðŽð¶ð¶(ðð)ðððð
=ðð ððð¶ð¶(ðð)
ðððððð
=ðð ððððð¶ð¶(ðð)
ðððð â ððð¶ð¶(ðð) ï¿œ 1
ðð2
=ðð ï¿œ ððð¶ð¶(ðð) â ððð¶ð¶(ðð)
ðð2 = 0
â The output that minimizes AC must satisfy
ðð ï¿œ ððð¶ð¶ ðð â ððð¶ð¶ ðð = 0 â¹ ððð¶ð¶ ðð =ððð¶ð¶ ðð
ððâ ðŽðŽð¶ð¶ ðð
â Hence, ððð¶ð¶ = ðŽðŽð¶ð¶ at the minimum of ðŽðŽð¶ð¶.Advanced Microeconomic Theory 154
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q
-z q
Y
(a) (b) (c)
Ë( )slope AC q=
Ë'( )slope C q=
C(q)
q
p
Câ(q)
AC(q)
q
Heavy trace is supply
locus q(p)q
z
Cost and Supply: Single Output
⢠Decreasing returns to scale:â an increase in the use of inputs produces a less-than-
proportional increase in output. production set is strictly convex TC function is convex MC and AC are increasing
Advanced Microeconomic Theory 155
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q
-z q
Y
(a) (b) (c)
C(q)
q
p
AC(q) = Câ(q)
q(p)
No sales for p < MC(q)
Cost and Supply: Single Output
⢠Constant returns to scale:â an increase in input usage produces a proportional
increase in output. production set is weakly convex linear TC function constant AC and MC functions
Advanced Microeconomic Theory 156
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q
-z q
Y
(a) (b) (c)
C(q)
q
p
q(p)
Câ(q)AC(q)
Cost and Supply: Single Output
⢠Increasing returns to scale: â an increase in input usage can lead to a more-than-
proportional increase in output. production set is non-convex TC curve first increases, then becomes almost flat, and then
increases rapidly again as output is increased further.
Advanced Microeconomic Theory 157
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Cost and Supply: Single Output
⢠Let us analyze the presence of non-convexitiesin the production set ðð arising from:â Fixed set-up costs, ðŸðŸ, that are non-sunk
ð¶ð¶ ðð = ðŸðŸ + ð¶ð¶ð£ð£ ðð
where ð¶ð¶ð£ð£(ðð) denotes variable costs⢠with strictly convex variable costs⢠with linear variable costs
â Fixed set-up costs that are sunk⢠Cost function is convex, and hence FOCs are sufficient
Advanced Microeconomic Theory 158
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Cost and Supply: Single Output
⢠CRS technology and fixed (non-sunk) costs:â If ðð = 0, then ð¶ð¶ ðð = 0, i.e., firm can recover ðŸðŸ if it
shuts down its operation.â MC is constant: ððð¶ð¶ = ð¶ð¶â² ðð = ð¶ð¶ð£ð£
â² ðð = ðð
â AC lies above MC: ðŽðŽð¶ð¶ ðð = ð¶ð¶(ðð)ðð
= ðŸðŸðð
+ ð¶ð¶ð£ð£ ðððð
= ðŸðŸðð
+ ðð
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q
-z q
Y
(a) (b) (c)
C(q)
q
pCv(q)=Câ(q)
AC(q)
q
( )AC q
q(q)
q
Cost and Supply: Single Output⢠DRS technology and fixed (non-sunk) costs:
â MC is positive and increasing in ðð, and hence the slope of the TC curve increases in ðð.
â in the decreasing portion of the AC curve, FC is spread over larger ðð.
â in the increasing portion of the AC curve, larger average VC offsets the lower average FC and, hence, total average cost increases.
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q
-z q
Y
(a) (b) (c)
C(q)
q
pCâ(q)
AC(q)q(p)
K
Cost and Supply: Single Output
⢠DRS technology and sunk costs:â TC curve originates at ðŸðŸ, given that the firm must
incur fixed sunk cost ðŸðŸ even if it chooses ðð = 0.â supply locus considers the entire MC curve and not
only ðð for which MC>AC.
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Short-Run Total Cost
⢠In the short run, the firm generally incurs higher costs than in the long runâ The firm does not have the flexibility of input
choice (fixed inputs).â To vary its output in the short-run, the firm must
use non-optimal input combinationsâ The ðððððððð will not be equal to the ratio of input
prices.
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Short-Run vs Long-Run Total Cost
⢠In the short-run â capital is fixed at ï¿œðŸðŸâ the firm cannot
equate ðððððððð with the ratio of input prices.
⢠In the long-runâ Firm can choose
input vector ðŽðŽ, which is a cost-minimizing input combination.
Advanced Microeconomic Theory 163
A
F
K
L
C(w,Q0)
C(w,Q0)
r
w
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Short-Run vs Long-Run Total Cost
⢠ðð = 1 million unitsâ Firm chooses (ðð1, ðð1)
both in the long run and in the short run when ðð = ðð1.
⢠ðð = 2 million unitsâ Short-run (point B): ðð = ðð1 does not allow
the firm to minimize costs.
â Long-run (point C): firm can choose cost-
minimizing input combination.
Advanced Microeconomic Theory 164
A B
K
L
C
Expansion path
Q=2
Q=10
K1
K2
L1 L2 L2
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Short-Run vs Long-Run Total Cost
⢠The difference between long-run, ððð¶ð¶(ðð), and short-run, ððððð¶ð¶(ðð), total costs when capital is fixed at ðð = ðð1.
Advanced Microeconomic Theory 165
TC
Q0
rK1
A
B
C
1 million 2 million
TC(q)
STC(Q) when k=k1
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Short-Run vs Long-Run Total Cost
⢠The long-run total cost curve ððð¶ð¶(ðð) can be derived by varying the level of ðð.
⢠Short-run total cost curve ððððð¶ð¶(ðð) lies above long-run total cost ððð¶ð¶(ðð).
Advanced Microeconomic Theory 166
TC
q0q 1q 2q
STC(q) where k=k0 STC(q) where k=k1
STC(q) where k=k2
TC(q)
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Short-Run vs Long-Run Total Cost
⢠Summary:â In the long run, the firm can modify the values of
all inputs.â In the short run, in contrast, the firm can only
modify some inputs (e.g., labor, but not capital).
Advanced Microeconomic Theory 167
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Short-Run vs Long-Run Total Cost
⢠Example: Short- and long-run curvesâ In the long run,
ð¶ð¶ ðð = ï¿œð€ð€1ð§ð§1 + ï¿œð€ð€2ð§ð§2
where both input 1 and 2 are variable.
â In the short run, input 2 is fixed at ð§ð§2, and thusð¶ð¶ ðð| ð§ð§2 = ï¿œð€ð€1ð§ð§1 + ï¿œð€ð€2 ð§ð§2
⢠This implies that the only input that the firm can modify is input 1.
⢠The firm chooses ð§ð§1 such that production reaches output level ðð, i.e., ðð(ð§ð§1, ð§ð§2) = ðð.
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Short-Run vs Long-Run Total Cost
⢠Example (continued):â When the demand for input 2 is at its long-run
value, i.e., ð§ð§2(ð€ð€, ðð), then
ð¶ð¶ ðð = ð¶ð¶(ðð|ð§ð§2(ð€ð€, ðð)) for every ððand also
ð¶ð¶â² ðð = ð¶ð¶â²(ðð|ð§ð§2(ð€ð€, ðð)) for every ðði.e., values and slopes of long- and short-run cost functions coincide.
â Long- and short-run curves are tangent at ð§ð§2(ð€ð€, ðð).
Advanced Microeconomic Theory 169
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Short-Run vs Long-Run Total Cost
⢠Example (continued): â Since
ð¶ð¶(ðð) †ð¶ð¶(ðð|ð§ð§2) for any given ð§ð§2,
then the long-run cost curve ð¶ð¶ ðð is the lower envelope of the short-run cost curves, ð¶ð¶(ðð|ð§ð§2).
Advanced Microeconomic Theory 170
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Aggregation in Production
Advanced Microeconomic Theory 171
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Aggregation in Production
⢠Let us analyze under which conditions the âlaw of supplyâ holds at the aggregate level.
⢠An aggregate production function maps aggregate inputs into aggregate outputsâ In other words, it describes the maximum level of
output that can be obtained if the inputs are efficiently used in the production process.
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Aggregation in Production
⢠Consider ðœðœ firms, with production sets ðð1, ðð2, ⊠, ðððœðœ.⢠Each ðððð is non-empty, closed, and satisfies the free
disposal property.⢠Assume also that every supply correspondence ðŠðŠðð(ðð) is
single valued, and differentiable in prices, ðð â« 0.⢠Define the aggregate supply correspondence as the
sum of the individual supply correspondences
ðŠðŠ ðð = ï¿œðð=1
ðœðœðŠðŠðð ðð = ðŠðŠ â âð¿ð¿: ðŠðŠ = ï¿œ
ðð=1
ðœðœðŠðŠðð ðð
where ðŠðŠðð â ðŠðŠðð(ðð) for ðð = 1,2, ⊠, ðœðœ.Advanced Microeconomic Theory 173
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Aggregation in Production
⢠The law of supply is satisfied at the aggregate level.
⢠Two ways to check it:1) Using the derivative of every firmâs supply
correspondence with respect to prices, ð·ð·ðððŠðŠðð ðð .â ð·ð·ðððŠðŠðð ðð is a symmetric positive semidefinite
matrix, for every firm ðð. â Since this property is preserved under
addition, then ð·ð·ðððŠðŠ ðð must also define a symmetric positive semidefinite matrix.
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Aggregation in Production
2) Using a revealed preference argument.â For every firm ðð,
ðð â ððâ² ï¿œ ðŠðŠðð ðð â ðŠðŠðð ððⲠ⥠0
â Adding over ðð,ðð â ððâ² ï¿œ ðŠðŠ ðð â ðŠðŠ ððⲠ⥠0
â This implies that market prices and aggregate supply move in the same direction the law of supply holds at the aggregate level!
Advanced Microeconomic Theory 175
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Aggregation in Production
⢠Is there a ârepresentative producerâ?â Let ðð be the aggregate production set,
ðð = ðð1 + ðð2+. . . +ðððð = ðŠðŠ â âð¿ð¿: ðŠðŠ = ï¿œðð=1
ðœðœðŠðŠðð
for some ðŠðŠðð â ðððð and ðð = 1,2, ⊠, ðœðœ.â Note that ðŠðŠ = âðð=1
ðœðœ ðŠðŠðð , where every ðŠðŠðð is just a feasible production plan of firm ðð, but not necessarily firm ððâs supply correspondence ðŠðŠðð(ðð).
â Let ððâ(ðð) be the profit function for the aggregate production set ðð.
â Let ðŠðŠâ(ðð) be the supply correspondence for the aggregate production set ðð.
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Aggregation in Production
⢠Is there a ârepresentative producerâ?â Then, there exists a representative producer:
⢠Producing an aggregate supply ðŠðŠâ(ðð) that exactly coincides with the sum âðð=1
ðœðœ ðŠðŠðð ðð ; and ⢠Obtaining aggregate profits ððâ(ðð) that exactly coincide with
the sum âðð=1ðœðœ ðððð (ðð).
â Intuition: The aggregate profit obtained by each firm maximizing its profits separately (taking prices as given) is the same as that which would be obtained if all firms were to coordinate their actions (i.e., ðŠðŠððâs) in a joint PMP.
Advanced Microeconomic Theory 177
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Aggregation in Production
⢠Is there a ârepresentative producerâ?â It is a âdecentralizationâ result: to find the solution
of the joint PMP for given prices ðð, it is enough to âlet each individual firm maximize its own profitsâ and add the solutions of their individual PMPs.
â Key: price taking assumption⢠This result does not hold if firms have market power. ⢠Example: oligopoly markets where firms compete in
quantities (a la Cournot).
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Aggregation in Production⢠Firm 1 chooses ðŠðŠ1 given ðð
and ðð1.⢠Firm 2 chooses ðŠðŠ2 given
ðð and ðð2.⢠Jointly, the two firms
would be selecting ðŠðŠ1 +ðŠðŠ2.
⢠The aggregate supply correspondence ðŠðŠ1 + ðŠðŠ2coincides with the supply correspondence that a single firm would select given ðð and ðð = ðŠðŠ1 + ðŠðŠ2.
Advanced Microeconomic Theory 179
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Efficient Production
Advanced Microeconomic Theory 180
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Efficient Production
⢠Efficient production vector: a production vector ðŠðŠ â ðð is efficient if there is no other ðŠðŠâ² â ðð such that ðŠðŠâ² ⥠ðŠðŠ and ðŠðŠâ² â ðŠðŠ. â That is, ðŠðŠ is efficient if there is no other feasible
production vector ðŠðŠâ² producing more output with the same amount of inputs, or alternatively, producing the same output with fewer inputs.
ðŠðŠ is efficient â ðŠðŠ is on the boundary of ðððŠðŠ is efficient â ðŠðŠ is on the boundary of ðð
Advanced Microeconomic Theory 181
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Efficient Production
⢠ðŠðŠâ²â² produces the same output as ðŠðŠ, but uses more inputs.
⢠ðŠðŠâ² uses the same inputs as ðŠðŠ, but produces less output.
⢠ðŠðŠâ²â² and ðŠðŠâ² are inefficient.
⢠ðŠðŠ is efficient â ðŠðŠ lies on the frontier of the production set ðð.
Advanced Microeconomic Theory 182
y
z
Y
y
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y''
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Efficient Production
⢠ðŠðŠ is efficient⢠ðŠðŠâ² is inefficient
â it produces the same output as ðŠðŠ, but uses more inputs.
⢠Hence, ðŠðŠâ² lies on thefrontier of theproduction set ðð â ðŠðŠâ² is efficient.
Advanced Microeconomic Theory 183
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Efficient Production: 1st FTWE
⢠1st Fundamental Theorem of Welfare Economics (FTWE): If ðŠðŠ â ðð is profit-maximizing for some price vector ðð â« 0, then ðŠðŠ must be efficient.Proof: Let us prove the 1st FTWE by contradiction. Suppose that ðŠðŠ â ðð is profit-maximizing
ðð ï¿œ ðŠðŠ ⥠ðð ï¿œ ðŠðŠâ² for all ðŠðŠâ² â ððbut ðŠðŠ is not efficient. That is, there is a ðŠðŠâ² â ðð such that ðŠðŠâ² ⥠ðŠðŠ. If we multiply both sides of ðŠðŠâ² ⥠ðŠðŠ by ðð, we obtain
ðð ï¿œ ðŠðŠâ² ⥠ðð ï¿œ ðŠðŠ, since ðð â« 0But then, ðŠðŠ cannot be profit-maximizing. Contradiction!
Advanced Microeconomic Theory 184
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y
z
Y
y
p
Isoprofit line
y
z
p
y'
y
Efficient Production: 1st FTWE
⢠For the result in 1st FTWE, we do NOT need the production set ðð to be convex.â ðŠðŠ is profit-maximizing â ðŠðŠ lies on a tangency point
Advanced Microeconomic Theory 185
convex production set non-convex production set
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y
z
Y
y
p
Profit maximizingProduction
plans
Efficient Production: 1st FTWE
â Any production plan in the flat segment of ðð can be profit-maximizing if prices are ðð = (0,1).
â But only ðŠðŠ is efficient.â Other profit-maximizing
production plans to the left of ðŠðŠ are NOT efficient.
â Hence, in order to apply 1st FTWE we need ðð â« 0.
Advanced Microeconomic Theory 186
⢠Note: the assumption ðð â« 0 cannot be relaxed to ðð ⥠0.â Take a production set ðð with an upper flat surface.
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Efficient Production: 2nd FTWE
⢠The 2nd FTWE states the converse of the 1st
FTWE: â If a production plan ðŠðŠ is efficient, then it must be
profit-maximizing.
⢠Note that, while it is true for convex production sets, it cannot be true if ðð is non-convex.
Advanced Microeconomic Theory 187
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y
z
p
y'
yy
z
Y
y
p
Isoprofit line
Efficient Production: 2nd FTWE
⢠The 2nd FTWE is restricted to convex production sets.⢠For non-convex production set: If ðŠðŠ is efficient â
ðŠðŠ is profit-maximizing
Advanced Microeconomic Theory 188
convex production set non-convex production set
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Efficient Production: 2nd FTWE
⢠2nd FTWE: If production set ðð is convex, then every efficient production plan ðŠðŠ â ðð is profit-maximizing production plan, for some non-zero price vector ðð ⥠0.Proof: 1) Take an efficient production plan, such as ðŠðŠ on
the boundary of ðð. Define the set of production plans that are strictly more efficient than ðŠðŠ
ðððŠðŠ = ðŠðŠâ² â âð¿ð¿: ðŠðŠâ² â« ðŠðŠ2) Note that ðð â© ðððŠðŠ â â and ðððŠðŠ is convex set.
Advanced Microeconomic Theory 189
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Efficient Production: 2nd FTWEProof (continued): 3) From the Separating
Hyperplane Theorem, there is some ðð â 0such that ðð ï¿œ ðŠðŠâ² ⥠ðð ï¿œ ðŠðŠâ²â², for ðŠðŠâ² â ðððŠðŠ and ðŠðŠâ²â² â ðð.
4) Since ðŠðŠâ² can be made arbitrarily close to ðŠðŠ, we can have ðð ï¿œ ðŠðŠ ⥠ðð ï¿œ ðŠðŠâ²â²for ðŠðŠâ²â² â ðð.
5) Hence, the efficient production plan ðŠðŠ must be profit-maximizing.
Advanced Microeconomic Theory 190
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Isoprofit line
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Py
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Efficient Production: 2nd FTWE
â We just assume that the price vector is not zero for every component, i.e., ðð â (0,0, ⊠, 0).
â Hence, the slope of the isoprofit line can be zero.
â Both ðŠðŠ and ðŠðŠâ² are profit-maximizing, but only ðŠðŠ is efficient.
Advanced Microeconomic Theory 191
y
z
Y
yp
Profit maximizingProduction
plans
y'
⢠Note: we are not imposing ðð â« 0, but ðð ⥠0.
![Page 192: Advanced Microeconomic Theory - Felix Munoz-Garcia · the ððððððin consumer theory, where we keep utility constant, ððð¢ð¢= 0. Advanced Microeconomic Theory](https://reader033.vdocuments.us/reader033/viewer/2022061617/5e2c98b5aa64d919b646dfbd/html5/thumbnails/192.jpg)
Efficient Production: 2nd FTWE
⢠Note: the 2nd FTWE does not allow for input prices to be negative.â Consider the case in which the price of input ðð is
negative, ðððð < 0.â Then, we would have ðð ï¿œ ðŠðŠâ² < ðð ï¿œ ðŠðŠ for some
production plan ðŠðŠâ² that is more efficient than ðŠðŠ, i.e., ðŠðŠâ² â« ðŠðŠ, with ðŠðŠðð
â² â ðŠðŠðð being sufficiently large.â This implies that the firm is essentially âpaidâ for
using further amounts of input ðð.â For this reason, we assume ðð ⥠0.
Advanced Microeconomic Theory 192