Revised The input requirement set for y, V(y), is the set of inputs x sufficient to

Lecture 2, Technology and profit maximization produce y. Formally,

Varian 1 and 2 (Gravelle & Rees ch 7).

Describing technologies
The firm’s production decisions can be represented as a “netput” vector
y = {y1, y2, ... , yn} where yi > 0 means that yi is an output for the firm,
i.e. it produces more of i than it uses. Negative elements are inputs.
Varian also uses the notation -xj if j is an input ( -xj = yj < 0) so that we
can talk about the input quantity as a positive number. Note that an
increased use of the input j reduces the yj element in the netput vector. Input combinations x that yield the same (maximum) level of output, y,
define an isoquant,
The set of technologically feasible production plans is called the
production possibility set and is denoted Y. Cobb-Douglas example

If we only have one output the production function f(x) describes the
maximum level of output that can be obtained for a given vector of
inputs x. It constitutes the border of the production possibility set.

Specific properties of technologies

The technical rate of substitution between two inputs is simply the slope
of Q(y) and can be obtained by totally differentiating f(x) = y.

In the case of several outputs the production set can be described by a Thus the technical rate of substitution TRS between two inputs is simply
transformation function T(y) such that T(y) = 0 only if the production the ratio of the marginal products of the inputs in question. While
plan is efficient. The set of efficient production plans is called the marginal products are not required to be positive in general it is assumed
transformation frontier. that there is always one input with a positive marginal product.
Elasticity of substitution
The elasticity of substitution tells us how much the ratio of inputs,
change with a change in the TRS, along the isoquant. If the isoquant is
very curved then a considerable change in the slope will only be
associated with a minor change in the ratio of inputs.
Homogeneous and homothetic functions
Let us now examine two classes of production functions with the
convenient property that the TRSs are independent of the scale of
production, namely homogeneous functions and homothetic functions.
This means that a proportional change of all inputs starting from any
point on a certain isoquant will lead to the same change in output.
Let s be the factor by which inputs are changed and let y = f(sx).
A function is homogeneous of degree t if
To assume that a function is homothetic is a weaker assumption than to
assume homogeneity but it still preserves the central property.
A function g(x) is homothetic if g(x) = F(f(x)) where
! f(x) is linearly homogenous and
! F'> 0.
The elasticity of scale measures the proportionate change in output in
response to a proportionate change in the scale of production.
If E = 1 production exhibits constant returns to scale (CRS). If E < 1the
returns to scale are decreasing and if E > 1they are increasing.
! The elasticity of scale of a homogeneous function of degree t is t.
! The partial derivatives, the marginal products, are homogeneous
of degree t-1:
! A linear homogenous function (t = 1) has CRS for all x and have
marginal products that are independent of scale.
! The slopes of the isoquants of homogeneous production functions
are independent of scale.
! Assuming that a production function is homothetic does not
impose restrictions on scale elasticity (except it being positive) but
implies that the slopes of the isoquants are independent of scale.
If f(x) is homogeneous of degree t then it follows that
This is known as Euler’s theorem.1 If t = 1 and the input price equals the
marginal product this implies that the firm breaks even.
1
Combining the following observations yields the theorem
Example: Consider a Cobb-Douglas production function, Profit maximization on a competitive market
The profit maximization problem for a firm facing given prices is
choose inputs and outputs, or “netputs” to maximize

This technology is homogeneous of degree a + b. The returns to scale is

constant if a + b = 1, increasing if a + b > 1 and decreasing if a + b < 1.

The maximum profit that can be obtained with a technologically feasible

production plan for a given price vector p is given by the profit function,

Thus the TRS only depends on the relative proportion of the inputs. or if the firm produces only one output
Using that

where p denotes output price and w is a vector of input prices.

we can more easily derive the elasticity of substitution. From the TRS The first-order condition for profit maximization in the latter case is
expression we have that

i.e. the marginal revenue product should equal the marginal cost which
and thus implies that the marginal product must equal the slope of the isoprofit
line in the relevant input output plane. In the one input - one output case
we can illustrate this as follows
The SOC for this case is simply The same conclusion can also be drawn from observing that profit
maximization requires that if yt maximizes profits at pt then it must be
the case that

The FOC describes the profit maximizing firm’s behavior. If the

economic environment changes, for instance a change in the price of the
input or the output, then the firm will adapt its choice of x so that the
FOC is met. Thus by differentiating the FOC with respect to the
parameter we can derive the comparative static effect on the firm’s
behavior, i.e. its choice of x.
where yk can be any other feasible choice. If ys is optimal at prices ps
then - ps(yk - ys) $ 0. Combining this with the above inequality and
letting k = s in the first case and k = t in the second yields,

This property generalizes to the multi input case. Differentiation of the

FOC in the two input case yields

In that case the matrix of Mxi/Mwj terms (Dx(w)) showing how a firm will
adjust its demand for inputs when the prices of inputs change - the
substitution matrix - turns out to be equal to the inverse of the fij matrix,
the Hessian.

The SOC requires the Hessian, which is a symmetric matrix, to be

negative definite and then its inverse must also be negative definite.
Thus the diagonal elements of Dx(w), Mxi/Mwi, must be negative which
means that the demand for an input decreases in its price.