Chapter 2: Theory of Production A.

Production Functions Consider a firm that has the technological feasibility that determines and limits the transformation of inputs x into production possibilities y. Technology converts inputs into m outputs. The production possibility set Y + is the set of all potential alternative production plans y = (y1, y2 , , ym)T whose elements yi represent inputs and outputs of the plan. If yi < 0, the resource is used up in the plan (it is an input); if yi > 0, it represents a new output. If n inputs are used in the plan, we can represent the vector of n inputs xi as x. In a single commodity n economy, the production function f maps + into + . That is, the production function dictates that a maximum of y units of output can be produced with x. n Assume in most cases that the production function f : + + is strictly quasiconcave n on + (there may exist complementary factors of production), continuous, and that f(0) = 0. Figure 1 depicts a Total Production function in a single-output, two input economy. The Law of Diminishing Returns implies a quasiconcave total production function with a finite maximum, negative marginal product (at some minimum production level) in addition to circular isoquants. We will generally ignore upward sloping portions of these isoquants along with the downward sloping portions of total product functions. That is, we will generally assume that the relevant portions of production technologies are monotonic. The set of technologically efficient n transformation functions T: + + where T(y) = 0 exist if and only if y is efficient. The marginal product of input i is the rate at which infinitesimal increases output and may be represented by where f(x) is differentiable. y-level isoquants depict sets of input vectors producing exactly y units of output and, again, are obtained in much the same manner as indifference curves. Y=f(x1, x2) Y2

x2

Y1

x1

Figure 1: 3-Dimensional Production Surface in Two-Input Space

The marginal rate of technical substitution (also called the technical rate of substitution) is:

The marginal rate of technical substitution measures the rate at which one input can be substituted for another while holding output constant. For example, consider a firm that produces a single commodity in the quantity f(x1) with two inputs, x1 and x2. Note that x1 and x2 are factors of production that comprise factor combination x1. In Figure 2, the y-level isoquant f(x1) depicts the varying combinations of x1 and x2 that can be combined to produce exactly y or f(x1) units of the commodity. The marginal rate of technical substitution at some combination of inputs is the slope of the isoquant at that combination on Figure 2.
x2

Slope =MRTS1,2

f(x1) = f(x1, x2)

x1

Figure 2: The Isoquant f(x1) in Two Input Space If we hold production constant at f(x*) and allow x2 to vary as x1 varies in the opposite direction, the marginal rate of technical substitution can be expressed as follows:

The elasticity of substitution also measures how various inputs substitute for each other in the production process. For example, a capital intensive process can substituted for a labor intensive process; capital can substitute for labor in many production technologies. Elasticity of substitution measures the proportional change in input factor proportions due to a proportional change in the marginal rate of technical substitution. Elasticity is independent of the units of measure of the inputs. With two inputs, elasticity of substitution, is computed as follows:

John Hicks [1932] and Joan Robinson [1933] introduced elasticities of substitution to the economics literature. Production Function Examples Cobb-Douglas productions allow for some degree of substitutability among production inputs while Leontief production functions do not. Figures 3 and 4 portray Cobb-Douglas and Leontief (fixed proportion, no-substitution) production functions. Isocost curves (dashed lines) are presented on these figures as well. Note that optimal output solutions will occur at points of tangency between isoquant and isocost curves, or in the case of the Leontief function, a corner solution will result. Hence, excepting cases of corner solutions, marginal rates of technical substitution will equal slopes of isocost curves at optimal production levels. Table 1 presents various characteristics of the Cobb-Douglas and Leontief technologies. Notice on this table that, in the case of the Leontief technology, long-run and short-run production possibilities sets are the same.
x2

Q(Y2) Q(Y2) x1

Figure 3: Cobb-Douglas Production Function in Two-Factor Space

x2

Q(Y2)

Q(Y2)

x1

Figure 4: Leontief Production Function in Two-Factor Space

Technology: Cobb-Douglas
Production Function Producton Possibilities Set Input Requirement Set Isoquant Transformation Function Restricted Production Possibilities Set
Same as Production Possibilities Set

Leontief

Table 1: Cobb-Douglas and Leontief Production Function Technologies1 Convexity with respect to production implies that positive linear combinations of production possibilities with a given output will also produce that output level: If x1 and x2 are both in the Input Requirement Set V(Y), then tx1 + (1-t)x2 is also in Convex Set V(Y) for all 0 t 1. B. Returns to Scale Returns to scale are concerned with how output varies with the use of inputs. For example, how will output change if each of the inputs double? More generally, let t be a scale factor. The elasticity of scale measures proportional output change in y as a function of x and a positive scale factor t of x:

Elasticities are convenient because they are measured as proportions or percentages rather than with unit measures. A scale elasticity equal to one implies constant returns to scale. Increasing and decreasing returns to scale are indicated by scale elasticities greater than or less than one. Thus, the following characterize constant, increasing and decreasing returns to scale for production functions: Constant Returns to Scale: f(tx) = tf(x) for all t 0 Increasing Returns to Scale: f(tx) > tf(x) for all t > 1 Decreasing Returns to Scale: f(tx) < tf(x) for all t > 1
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See Varian [1992], pp. 4-5. Also, Cobb-Douglas production functions were proposed by Cobb and Douglas [1928] due to their attractive mathematical properties rather than any empirical observations or technological conditions that would suggest that they would or should be realistic.

Constant returns to scale imply that the production function is homogeneous of degree 1; scaling the inputs of production by a constant leads to the same proportional change in output. Example: Cobb-Douglas Returns to Scale and Marginal Rates of Technical Substitution With Cobb-Douglas production , with one output y and two inputs x1 and x2, the elasticity of scale is calculated as follows:

Thus, with t=1, a+b=1 characterizes constant returns to scale (the technology is homogeneous of degree one), a+b>1 characterizes increasing returns to scale and a+b<1 characterizes decreasing returns to scale. These relations contribute to the usefulness of the Cobb-Douglas functions usefulness as a hypothetical production function. Now, we will return to marginal rate of technical substitution. Marginal rates of technical substitution for Cobb-Douglas production functions when a+b = 1 are found as follows:

The elasticity of substitution function is found as follows. First, rewrite the following from the Cobb-Douglas MRTS:

Differentiate ln (x2/x1) with respect to lnMRTS1,2and recall that equals dln(x2/x1)/dlnMRTS1,2:

C. Profits A neoclassical firm is an institution that manages the transformation of inputs into outputs to realize profits. We define profits to be the difference between revenues R and costs C and assume that firms select activities so as to maximize this difference:

This implies that for each activity level maximizes profits:

, marginal revenue equals marginal cost when the firm

Second order conditions will be negative. The profit function *(p) = max py where y in the profit function represents the vector of inputs (negative values) and outputs of the firms production technology maps specified input or factor prices to the maximum profit levels achievable at those input and output prices. That is, the profit function maps out the maximum profits achievable by the firm based on input and output prices. Consider this restatement of the profit function:

Thus, the profit-maximizing firm seeks to maximize profits * where *(p, w) = pTy wTx where y in the profit function now represents the vector of outputs of the firms production technology and x represents the technologys inputs. The profit function is analogous to the indirect utility function in consumer theory. The competitive firm is a price-taker; that is, price levels are taken to be an exogenous condition. Profits *(p) are maximized as a function of prices; *(p) is the firms profit function. In the short-run, the firm may not have flexibility to be able to vary its production technologies. Suppose, for example, that input 2, x2, were fixed at level z in the short run and that the input price vector were labeled w. The short run profit and short run cost functions would be:

The vector w represents input costs, z, the vector of fixed inputs, and y and -x, the vectors of variable inputs and outputs. In the long run, profits are simply the difference between revenues and costs:

Consider Hotelling's Lemma, which states that if profit functions are differentiable at p and w, then:

This means that differentiating the profit function with respect to output price yields output quantity. Similarly, differentiating the profit function with respect to price of a particular input yields (the negative of) the corresponding input or factor quantity. Hotellings Lemma enables us to obtain supply functions with profit functions without first having to specify production functions. With a single output, the firms objective is to select inputs and a production level to maximize profits:

The firm should continue use each of its inputs xi to produce until its marginal profit with respect to each is zero. This means that the marginal revenue product (the revenue or price of the final unit of production used multiplied by the marginal product of that unit) equals the marginal cost of production with respect to that unit of input:

If, for example, the marginal revenue product of an input exceeded its cost, the firm would use more of that input until they became equal. Thus, the marginal rate of technical substitution for all pairs of inputs will equal the ratios of their prices:

These two conditions are consistent with profit maximization. The profit function has several important characteristics. First, it is non-increasing in w and non-decreasing in p. This means that profits are inversely related to input prices and directly related to output prices. The profit function is homogeneous of degree 1 in (w, p). Thus, for example, if input and output prices both doubled while the production level was held constant, profits would also double. Profits are convex in w and p. This means that profits would actually more than double if both input and output prices doubled because the firm would adjust its production level to maximize profits. Generally, firms will produce more when output prices are high and input prices are low. Finally, profit functions are continuous in w>0 and p > 0.

D. Costs In the short-run, the production technologies of most firms will have some combination of fixed and variable costs. Figure 5 depicts fixed costs (FC), variable costs (VC) and total costs (TC) as functions of production levels, Y. The vertical sum of fixed and variable costs equals total costs: TC = FC + VC. In the long run, all costs might be regarded as being variable.
Costs TC VC

FC Y

Figure 5: Total Costs, Fixed Costs and Variable Costs as a Function of Output Average costs are costs per unit of output. Figure 6 depicts average fixed costs (AFC), average variable costs (AVC) and Average costs (AC) as functions of production levels, Y. These costs are averaged as per unit of production. The vertical sum of average fixed and average variable costs equals average costs: AC = AFC + AVC.

Average Costs AC AVC

AFC

Figure 6: Average Costs, Average Fixed Costs and Average Variable Costs Marginal cost is the cost of an additional unit of production. While marginal costs may decline over lower levels of production, they must increase at higher levels of production. Consider Figure 7 with linear marginal and average variable cost functions.
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Costs MC AC

AVC

Figure 7: Marginal, Average Variable Costs and Average Costs Short run average cost curves must be tangent to the long run average cost curve, because firm adjustment abilities imply that short term costs must be higher than long term costs. As firms adjust their production levels, their long term costs must be less than their costs in the short run, given their ability to adjust inputs and technologies. The long run average cost curve is the lower envelope of the short run average cost curves.
Average Costs Short Run Average Cost Curves

Long Run Average Cost Curve Y

Figure 8: Average Costs, Average Fixed Costs and Average Variable Costs Cost Minimization The firm seeks to minimize its costs at any level of production: Min wTx s.t.: f(x) = y

This leads to the following Lagrangian and first order conditions: L(, x) = wTx - (f(x) y) w = f(x*) This means that for any i and j:

Thus, costs are minimized when relative factor costs (the economic rates of substitution, the rate at which factors can be substituted for one another without changing costs) equal ratios of technical substitution (rates at which factors can be substituted for one another without changing output) for all i and j. From this cost minimizing equality, we obtain the condition that at the optimal production level, the isocost curve will be tangent to an isoquant at output y. Second order conditions for a 2-factor technology are as follows:

E. The Supply Function Let the vector represent the prices of a single output and various inputs and assume that there exists some optimal combination of inputs x* that results in the factor demand function x(p, w). This factor demand function represents the producers demand for inputs x given price levels p for the output and w for the input, consistent with profit maximization. The supply function for the firm is a function of the factor demand function y(p, w) = f(x(p, w)). The supply function provides profit-maximizing output levels at varying price levels for the firms output. The supply function maps the output quantities producers are willing and able to supply at each price during a specific period. As the price rises, the quantity supplied tends to rise. This relationship is called the Law of Supply. Factor demand functions and output supply functions are homogeneous of degree zero in p and w. This means that scaling up output prices and input prices by some constant t will not affect output levels:

In fact, if input demand functions are not homogeneous of degree zero in input and output prices, the firm has selected an output level that does not maximize profits. Cobb-Douglas Profit Factor Demand and Supply Functions
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The Cobb-Douglas profit as a function of output for a single input, single output firm is as follows:

The first order condition with respect to the input x is:

The factor demand function is obtained from the first order condition is:

Note that the exponent is negative. This means that x is directly related to p and inversely related to w, as one would expect. Also recall that the supply function is a function of the factor demand function:

This means that the profit function is simply the sum of the output price multiplied by the supply function minus the input price multiplied by the factor demand function:

We rearrange terms to obtain the profit function as follows:

In the long run, the firm will supply nothing if the output price is less than the average cost of production (which includes both fixed and variable costs. If the output price exceeds the minimum average cost level for the firm, the supply curve is that part of the marginal cost curve that exceeds average costs. Figures 9 and 10 depict the long run supply curve with a linear (9) and non linear (10) marginal cost functions.

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P Costs

LRS AC

MC

AVC

Figure 9: Long Run Linear Supply Curve

P Costs LRS AC

AVC

MC

Figure 10: Long Run Supply Curve In the short run, the firm lacks the ability to shut down quickly if it is losing money. The firm will continue to operate as long as it can recoup its variable costs. Hence, in the short run, the firm will supply nothing if the output price is less than the average variable cost of production. If the output price exceeds the minimum average variable cost level for the firm, the supply curve is that part of the marginal cost curve that exceeds average variable costs. Figure 11 depicts the short run supply curve with a non linear marginal cost function.

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P Costs SRS AC

AVC

MC

Figure 11: Short Run Supply Curve

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Exercises 1. In 1590, workers dug pits with spades. Thus, the two inputs for digging pits were workers and spades. Devise appropriate total product curves and isoquant maps for this production process. What type of production function characterizes the pit-digging process? 2. Pencils with red paint on them and pencils with yellow paint on them would be considered by many office workers to be perfect substitutes. What type of production function characterizes the production completed with red and yellow pencils? What would the isoquant mapping look like for this function? 3. Suppose that output for a firm were y = 1000. Now suppose that the firm were to increase its plant and labor force and all other productive resources x by 50%. If output were to increase by 60% to 1600, what would be the firms elasticity of scale, assuming that this elasticity were constant over the range 1000 < y 1600? 4. What is the elasticity of substitution for a two-input Leontief Production function? 5. Consider a Cobb-Douglas production function with a = b = .5. a. What is the total production level for the firm if x1 is 50 and x2 is 100? b. Write the equation for the isoquant consistent with the production level given in part a? c. What is the derivative of the isoquant with respect to x2 consistent with the production technology from part a? (This part requires some calculus.) d. What is the marginal rate of technical substitution between inputs 1 and 2 consistent with the production technology from part a? (This part requires some calculus.) e. What is the elasticity of technical substitution between inputs 1 and 2 consistent with the production technology from part a? f. What is the elasticity of scale for inputs 1 and 2 consistent with the production technology from part a? 6. Consider the production function for a single output, single input firm: f(x) = ln (1+x). Assume that x 0 and the input and output prices are w and 100. a. What is the profit maximization function? b. What is the set of first order conditions for the profit maximization function? c. Write the factor demand function for this output. d. Write the supply function for this output. e. Write the profit function for this output. f. What is the derivative of the profit function with respect to the input price?

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Solutions 1. The diagrams should be consistent with Leontief production functions. This means that each of the isoquants will be shaped like a right angle: (See below). The isoquant mapping will be comprised of right-angle isoquants (placed at constant [finite] distances from one another to reflect integer input units, if we wish to assume that fractional men and fractional spades are useless). See Figure 3 for a total production function. However, if we wish to reflect integer amounts, instead of a surface, dots will represent each of the integer values. (The steps and references to integers are not important to this question for purposes of this class).
x2

Q(Y2)

Q(Y1)

x1

2. The isoquants will be downward sloping lines, with slopes equal to -1. The isoquant mapping will be comprised of these linear isoquants, placed at constant [finite] distances from one another to reflect integer inputs (See the figure below). The total production function will have flat surfaces, linear in each of the inputs with slopes equal to one along each of the two independent variable axes. See Figure 3, but flatten the surfaces so that it appears as a two sides of a pyramid.
x2

Q(Y2)

Q(Y1) x1

3. The firms elasticity of scale would be 1.2:

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The firms elasticity of scale exceeds 1, meaning that it experiences economies of scale at this production level. 4. zero 5.a. TP = = 70.70 b. Remember that the isoquant consists of all possible combinations of two inputs that produce a given output. Our level of output is 70.70. Thus, we want to obtain an isoquant equation that consists of all input combinations that produces an output level of 70.70. We will rewrite our utility equation from part a to accomplish this. 70.70 = = ; Now, we solve this for our vertical coordinate, x2: x2 = 5000/ x1 c. This solution requires a little calculus to find the slope of the isoquant from part b based on the level of input 1 (x1 = 50) from part a: = d. ;

Alternatively, the MRTS can be found with the following Cobb-Douglas specific function where a + b = 1:

e. The elasticity of technical substitution with Cobb-Douglas production functions where (a+b = 1) equals one. f. Calculate with the following: 6.a. max (p, w) = 100 ln (1+x) wx b. 100/(1+x) w = 0 c. Solve part b for x: 100/(1+x) = w; 100/w = 1+x; x = 100/w 1 = x = (100 w)/w d. y = f(x) = ln (1 + x) = ln (1 + 100/w 1) = ln(100/w) e. Profits are = 100 ln (1+x) wx, which equals p multiplied by the supply function minus w multiplied by the factor demand function. Substitute in x to obtain: f. -100/w + 1 which is the derivative of the profit function in part e with respect to w as well as the negative of the factor demand function in part c.

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References Cobb, C.W. and P.H. Douglas [1928] "A Theory of Production", American Economic Review, Vol. 18, pp.139-65. Fonesca, Goncalo L. The History of Economic Thought Website. http://cepa.newschool.edu/het/essays/product/prodcont.htm. Accessed on July 15, 2008. Hicks, John [1932]. The Theory of Wages. 1963 edition, London: Macmillan. Hotelling, Harold [1932]. "Edgeworth's Taxation Paradox and the Nature of Supply and Demand Functions," Journal of Political Economics, pp. 577-616. Robinson, Joan [1933]. The Economics of Imperfect Competition. 1950 reprint, London: Macmillan. Varian, Hal [1992]. Microeconomic Analysis, New York: W.W. Norton and Company.

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