ECON 250D1.

Topic 6: FIRMS AND PRODUCTION

October 2014
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 1 / 23
Notes on Conference for Topic 6
For conference on Topic 6 (next week), please try to answer FIVE
questions: (3.4, 4.13, 4.15, 4.16, and 5.3) at the end of the chapter,
pages 203-205.
Do not attempt other questions.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 2 / 23
Ownership and Management
Most rms are privately owned.
Economists assume that the objective of private-owned rms is to
maximize prot.
This is not as simple as it may sound: there is a distinction between
short-run prot and long-run prot.
A rm may want to sacrice short-run prot so as to boost long-run
prot.
However, at our level, we do not deal with this deep question.
We simply assume that in each period, the rm chooses its output
level to maximize the dierence between the its total revenue for the
period and its total cost for the period.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 3 / 23
Inputs and Outputs
We consider only a simple model: the rm produces only one output,
and uses several inputs.
We consider three main types of inputs:
(i) capital services (broadly dened to include land, building, and
equipment),
(ii) labour services, and
(iii) raw materials.
Inputs are also called factors of production.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 4 / 23
Production Functions
Suppose a rm uses two inputs, labour and capital, to produce an
output.
Let q denote the output level, and L and K the quantity of labour
and capital the rm employs.
The production function q = f (L, K) tells us how output varies as
the rm varies its inputs.
It also contains information about the degree of substitutability of the
inputs
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 5 / 23
Short-Run and Long-Run
In the short-run (for example, one year), the rm cannot, or is not
willing to change the quantity of some inputs (for example, the size of
the boiler, or the number of elevators in its factory).
In the long-run, all inputs are variable.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 6 / 23
Short-Run Production Function
We assume that there are two inputs, say capital and labour.
In the short run, capital is a xed input, and labour is the only
variable input.
Thus K is xed at some level K, and the rm can decide on the level
of employment, L.
We dene the marginal product of labour, given K, by
MP
L
=
f (L, K)
L
and the average product of labour, given K, by
AP
L
=
f (L, K)
L
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 7 / 23
Long-Run Production Function
In the long-run, we assume that level of all inputs can be adjusted.
For simplicity, we often consider a model with just two inputs, for
example, capital and labour.
We often assume that the production function takes the
Cobb-Douglas form
q = AL

where 0 < < 1 and 0 < < 1

However, we do not always require that + = 1.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 8 / 23
Long-Run Production Function
A rms capital is often interpreted as the aggregate value of
equipment and buildings that it uses.
for example six hand-held power saws (costing $100 each) may
represent more capital than ten handsaws (costing $40 each)
and two bench power saws (costing $400 each) may represent more
capital than six hand-held power saws.
This raises a deep question: what is the appropriate measure of
capital when equipment and building are heterogeneous?
At the elementary theory level, we abstract from these complications,
and assume that capital is a homogenous input. Similarly, we often
assume labour is a homogeneous input, for simplicity.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 9 / 23
Isoquants
We normally restrict attention to production functions with just two
inputs.
Given a production function, say q = f (L, K), for any xed output
level q > 0, we dene the isoquant for q as the set of points (L, K)
such that f (L, K) = q
In general, the two inputs need not be capital and labour. We can
denote them as x
1
and x
2
, and write q = f (x
1
, x
2
).
Since isoquants in production theory are indierence curves in the
theory of the consumer, we will not dwelve on their properties.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 10 / 23
Isoquants
Figure 1: isoquant maps for a Cobb-Douglas production function.
Other cases:
(i) The two inputs are perfect substitutes (Figure 2): To produce
orange juice, a rm may use a combination of Californian oranges and
South African oranges:
f (x
1
, x
2
) = x
1
+x
2
(ii) The two inputs are perfect complements (Figure 3A): To produce
one hour of gondola ride, a rm need one gondola (for one hour) and
one gondolier (for one hour),
f (x
1
, x
2
) = min fx
1
, x
2
g
Generalize to xed coecient function q = min
n
x
1
a
1
,
x
2
a
2
o
e.g. 1
bicycle frame, 2 bicycle wheels.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 11 / 23
Marginal Rate of Technical Substitution
consumer theory:MRS
12
=
U
1
U
2
In production theory, we analogously dene the marginal rate of
technical substitution between input 1 and input 2 at the point
(x
1
, x
2
) as the slope of the isoquant passing through that point
MRTS
12
=
f
1
f
2
where f
1
and f
2
are the marginal products of inputs 1 and 2
respectively.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 12 / 23
Elasticity of Substitution
Assume diminishing marginal rate of technical substitution.
Let x
1
be masured along the horizontal axis, and x
2
along the vertical
axis.
Then, as we move up along the isoquant (by reducing x
1
and
increasing x
2
), the jMRTS
12
j increases, and the ratio x
2
/x
1
also
increases.
A measure of the degree of substitutablity between inputs 1 and 2
provides the answer to the following question: As the jMRTS
12
j
increases (when we move up along the isoquant), how great is the
increase in the ratio x
2
/x
1
?
If x
2
/x
1
increases a lot, then we say that the two inputs are highly
substitutable.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 13 / 23
Elasticity of Substitution
FIGURE 4 compares two isoquants for producing one unit of two
dierent nal goods, say a manufactured good, denoted by q
m
, and
an agricultural good, denoted by q
a
f (x
1
, x
2
) = q
m
= 1
g(x
1
, x
2
) = q
a
= 1
We assume the two production functions are dierent, and their
isoquants have dierent curvature, though both are convex to the
origin.
Suppose these two isoquants have a common point E, at which the
jMRTS
m
12
j and jMRTS
a
12
j have the same numerical value.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 14 / 23
Elasticity of Substitution
Now let both jMRTS
m
12
j and jMRTS
a
12
j increase by t%.
This is a move from point E to point M along the isoquant
f (x
1
, x
2
) = q
m
= 1, and from point E to point A along the isoquant
g(x
1
, x
2
) = q
a
= 1.
The ratio x
2
/x
1
at point A is greater than that at point M.
We say that x
1
and x
2
are more substitutable in the production of
nal good a than in the production of nal good m.
Roughly speaking, greater substitutability means that curvature of the
isoquant is not too pronounced. A formal denition of the elasticity
of substitution between the two inputs is
jj =
percentage change in x
2
/x
1
percentage change in jMRTS
12
j
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 15 / 23
Elasticity of Substitution
That is
jj =
(x
2
/x
1
)
x
2
/x
1
jMRTS
12
j
jMRTS
12
j
More precisely,
jj =
d(x
2
/x
1
)
x
2
/x
1
djMRTS
12
j
jMRTS
12
j
=
jMRTS
12
j
x
2
/x
1
d(x
2
/x
1
)
djMRTS
12
j
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 16 / 23
Elasticity of Substitution
Cobb-Douglas production function has jj = 1 always.
CES production function
q =

x

1
+x

1/
where 6= 0, < < 1
its has jj =
1
1
Limiting cases: jj ! : perfect substitutes, jj ! 0: perfect
complements.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 17 / 23
Returns to Scale
A production function q = f (x
1
, x
2
) is said to display constant
returns to scale if and only if the following property holds: Given any
input combination (x
1
, x
2
) that results in an output level q (i.e.,
q = f (x
1
, x
2
)), scaling up that input combination by a factor > 1
(or scaling down that input combination by a factor 0 < < 1) will
result in a new output level equal to q.
Loosely speaking, the constant returns to scale property means that if
a rm doubles (or triples) all its inputs, its output will be doubled (or
tripled).
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 18 / 23
Homogeneity of degree 1
A more concise denition: A production function f (x
1
, x
2
), dened
for all (x
1
, x
2
) (0, 0), displays constant returns to scale if and only
if f (x
1
, x
2
) = f (x
1
, x
2
) for all > 0.
This corresponds to the mathematical denition of homogeneity of
degree t .
Denition M1 (Homogeneity of degree h) A function f (x
1
, x
2
)
dened for all (x
1
, x
2
) (0, 0), is said to be homogeneous of degree
h if and only if f (x
1
, x
2
) =
h
f (x
1
, x
2
) for all > 0, where h is a
constant, independent of .
The concept of constant returns to scale is equivalent to the concept of
homogeneity of degree 1.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 19 / 23
Example
Example: The Cobb-Douglas production function q = A(x
1
)

(x
2
)

where A > 0, 0 < < 1 and 0 < < 1 is homogeneous of degree

+ .
Short proof:
f (x
1
, x
2
) = A(x
1
)

(x
2
)

=
+
A(x
1
)

(x
2
)

=
+
f (x
1
, x
2
).
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 20 / 23
Homogeneity of degree greater than 1
If a rms production function is homogeneous of degree 2, then,
when it doubles all the inputs, (i.e., = 2) then the output is
quadrupled, i.e. q = 2
2
q = 4q, and when it triples all the inputs, i.e.,
= 3), then the output is nine times bigger than before, i.e.
q = 3
2
q = 9q.
Homogeneity of degree h > 1 therefore implies increasing returns to
scale.
(Similarly, if the degree of homogeneity of a production function is
positive but less than 1, we say that the the production function
displays decreasing returns to scale)
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 21 / 23
Increasing Returns to Scale
Increasing returns to scale is more general than that of homogeneity
of degree h > 1.
Denition D2 (Increasing Returns to Scale)
A production function q = f (x
1
, x
2
) is said to display increasing returns to
scale if and only if the following property holds: Given any input
combination (x
1
, x
2
) that results in an output level q (i.e.,
q = f (x
1
, x
2
)), if the rm scales up that input combination by a factor
> 1 it will obtain in a new output level greater than q.
Loosely speaking, a rms production function shows increasing returns to
scale if the doubling all inputs results in more than in an output level that
is greater than two times the previous output level.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 22 / 23
Decreasing Returns to Scale
Denition D3 (Decreasing Returns to Scale)
A production function q = f (x
1
, x
2
) is said to display decreasing returns to
scale if and only if the following property holds: Given any input
combination (x
1
, x
2
) that results in an output level q (i.e.,
q = f (x
1
, x
2
)), if the rm scales up that input combination by a factor
> 1 it will obtain in a new output level smaller than q.
(Prof. N.V. Long) Topic 6: Firms and Production October 2014 23 / 23
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