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Advanced Microeconomics

Topic 5: Production & Cost
Primary Readings: DL – Chapter 2 & JR – Chapter 5
In this lecture, we will present a general framework of production technology. We will focus on what
choices could be made; and the issue of what choices would be made will be deferred to the next
lecture when we look into the firm’s behaviour.

The first part will describe production possibilities in physical terms; while the second part
will recast this description into a cost function framework.
The treatment in this lecture is a bit abstract and quite general. You are required to understand the
relevance of this abstract framework in terms of particular technological processes.
5.1 Production Possibility Sets
There are many ways to describe the technology of a firm, such as, production functions, graphs, or
systems of inequalities. But in mathematical term, these representations can all be expressed as a set.

The firm uses and produces a total of m commodities.
A particular production plan is y in Rm:
 yi > 0 implies that a net amount yi of i-th commodity is produced;
 yj < 0 implies that a net amount –yj of j-th commodity is used;
 y is called a netput vector.

Production possibility set of a firm is a subset Y  Rm. A firm may select any vector y 
Y as its production plan.

Properties of Production Possibility Set
 Closed: If the limit of any converging sequence of vectors in Y is in Y.
 Convex: Convex combinations of its elements remain to be inside.
 Free disposal: If y  Y implies that y’  Y for all y’  y.
 Meaning that: commodities (inputs or outputs) can be thrown away.
Input Requirement Set: V(q) = {z: (-z, q)  Y }

z2

V(q)

Q(q)

1
z1

 An efficient production implies that it is not possible to either unilaterally increase the output(s) or unilaterally decrease the input(s) while still remaining in Y. q’  q}  The isoquant Q(q) is usually the boundary closest to the origin of V(q).  We normally do not require that the production possibility set is convex.  With a single output. q’)  Y  q’  q. (Do you see why?) 5. i. q)  0}. That is. it is possible to describe them in item of single inequality of the form T(y)  0. MRTS and Separable Production Functions 2 . Y = {(-z. (-z.  The netput vector has the form: (-z.e. Efficient Production  A production point y Y is efficient is there is no y’ Y . which leads to another function: q = f(z). which has both the theoretical and empirical appeal. it will rule out "start-up costs" and other sorts of returns to scale.e. If so. q). the input requirement set V(q) is convex if and only if the corresponding production function f(z) is a quasiconcave function. then under certain regularity conditions. y’  y..Isoquant: Q(q) = {z: (-z.  If the technology has a transformation function T. where q is the output. q’)  0}. q): T(-z. Production Functions (Joan Robinson)  For those technologies that have a single output can be described by a production function.2 Production Functions Transformation Function of the Production Possibility Set For most production possibility sets.. f(z) = max{q’: T(-z. we can solve T(-z. i. q)  Y . Proposition: If Y is convex. with y’  y. q) = 0 for all q. This function f is the production function. so is V(q). Y = {y: T(y)  0} A function T that describes Y this way is called a transformation function.  The specification of q = f(z) involves the notion of efficiency since it represents the maximum output level that can be achieved with the input.

the elasticity of substitution between inputs i and j at the point z is defined as d ln( z j / z i ) d ln( z j / z i )  ij (z )   d ln(MRTS ij (z )) d ln( f i (z ) / f j (z ))  d ( z j / zi ) f i (z ) / f j (z ) . …. MRTSij depends on the specification of all inputs. 3 . f ( z ) / z j  Normally. (ij  1)  The basic functional form is m q  f (z )   z i i . the easier substitution between them. the closer the elasticity of substitution is to zero.) is the total differentiation. 1  Special Cases of CES Production Function  Linear Homogeneous Cobb-Douglas Production Function:  Correspond to the case when   0. With a given production function q = f(z). i 1   A proof (for the case of n = 2) is in the Appendix of this note. mzm}. refer to p. For details. MRTS is not independent of the units of measurement. the more difficult substitution between the inputs. the larger it is. the marginal rate of technical substitution (MRTS) between two inputs i and j is defined as follows: f ( z ) / zi MRTSij ( z )  . 1  ij ( z )  i  j. The elasticity of substitution is unitless. (ij  0)  The functional form is q = f(z) = min{1z1. where  i 1 i  1 and  i  0 i. It can be shown that for the above production function. In general. and d(. We can use MRTS to define separable production functions. z j / z i d ( f i (z ) / f j (z )) where fi and fj are the marginal products of inputs i and j. CES Production Function The constant elasticity of substitution (CES) production function has the following form:  q  f (z )   m   1/    z  i 1  i i  m . Elasticity of Substitutions For a production function f(z). The elasticity of substitution is defined as the percentage change in the input proportion (zj/zi) associated with a 1 percent change in the MRTS between the two inputs. which involves regrouping the inputs into several mutually exclusive and exhaustive subsets. Leontief Production Function:  Correspond to the case when   .221 of Jehle & Reny.    MRTS is a local measure of substitutability between two inputs in producing a given level of output..

differentiate with respect to xi. we have sy = Σxifi where fi ≡δf/δxi. m }. To see this.  The easiest way of proving this result is to check the corresponding MRTS ij of CES production function as   . Suppose that we introduce another "new input" and measured by z0. a1 am It is clear from the function specification that a Leontief technology uses inputs in fixed proportion. Elasticity of Scale  The elasticity of scale is a local measure of returns to scale. defined at a point. Increasing returns to scale if f(tz) > t f(z) for all t > 1 and all z. which lead to specific isoquants that are unique to Leontief technology.  input factor price vector: w  R+m. Constant returns to scale if f(tz) = t f(z) for all t > 1 and all z. Now define a new production function: F(z0. greater than.   The most natural case of decreasing returns to “scale” is the case where we are unable to replicate some inputs. In fact. 5. z) that results from setting z0 = 1. Returns to Scale  A production function f(z) has the property of (globally) 1. which implies that there is a single fixed formula for production. specifies the instantaneous percentage change in output as a result of 1 percent increase in all inputs: m  (z )  lim t 1  d ln( f (tz ))  d ln(t )  f (z ) z i 1 i i f (z ) We say that returns to scale are locally constant. 3. It is easy to see that F exhibits constant returns to scale. 2. . input vector: z  R+m. or less than one. Another function form for the Leontief production function is as follows: q  f (z )  min{  z z1 ... it can always be assumed that decreasing returns to scale is due to the presence of some fixed input. To show this. the original decreasing returns technology f(z) can be thought as a restriction of the constant returns technology F(z0. A production function homogenous of degree s. or decreasing when (x) is equal to. increasing. let f(z) be a production function with decreasing returns to scale. It.3 The Cost Function Basic Settings:  output vector: q  R+n. evaluated at k=1. the marginal product of each factor is homogenous of degree s-1. Decreasing returns to scale if f(tz) < t f(z) for all t > 1 and all z. differentiation with respect to k. Constant Returns to Scale and the Marginal Productivity Theory of Distribution From the definition of a homogenous production function. z) = z0 f(z/z0).  Recall that for the given output vector q. the input requirement set is defined as 4 . In this sense.

which leads to the geographical illustration of the cost minimization (tangency condition) indicated as below. ) = wz .t. then c(w. q) = wz(w. q  0. q) = min wz s.t. q)  Y }  Cost Function. f(z)  q If z(w. q)   The solution z(w. z2) = q (Isoquant) Factor 1 (z1) 5 . m. z  V(q) defined for all w  0.q)  w  f ( z*) (FOC for some interior solution z*)  wi f ( z*) / z i   MRTS ij w2 f (z*) / z j i . j  1. since it is conditional on the level of output q. then c(w. (f(z) .  If there is a single output and the production technology is fully represented by the production function q = f(z). The cost function of a firm is the function c(w. Calculus Analysis of Cost Minimization Consider the following cost-minimizing problem: c(w. which at this point is arbitrary and so may or may not be profit-maximizing. q) = min wz s.t. The inequality constraint can usually be replaced by the equality. Factor 2 (z2) C = w1 z1 + w2 z2 (Isocost) f(z1. q) is referred to as the firm's conditional input demand functions (also known as conditional factor demand functions). q) solves this minimization problem. q) = min wz s.  . f(z) = q Then the corresponding Lagrange function is L(z.V(q) = {z: (-z.

This. 6. . for the case of two inputs. strictly increasing and unbounded above in y. with     i   i 1 Cost function for CES Technology: q = (az1 + bz2)1/. q )  q  1/  i /   m .wage). a1 am Its cost function is given by: c(w. then c(w.4 Conditional Input Demand Functions 6 . 2.  1 Cost function for Leontief Technology: q  f (z )  min{ z z1 . Examples:  Cost function for the Cobb-Douglas technology: q = K1/2 L1/2. w2 . 5. we can derive the cost function given by:   w  c( w1 . Zero when q = 0. by using the first-order Lagrangian conditions. General Properties of Cost Functions  If the production function f is continuous and strictly increasing. Continuous on its domain 3. w2 . Increasing in w. with r   (   1). q )  2q w1 w2  For the general Cobb-Douglas production function: m q  f (z )   z i i . where K is the capital (with a unit price of w1 .rental) and L is the labor (with a unit price of w2 . the isoquant must lie above the isocost line. 4. i 1 The corresponding cost function is given by: c (w . q) is 1. 5. leads to that the bordered Hessian matrix of the Lagrangian. For any all w > 0. Homogenous of degree one in w. q) = q wa. Then the corresponding cost function is c ( w1 . m }.  2L 2L 2L    2  z1 z1z 2 z1    f  f 12  f1  11  2L 2L 2L    H     f   f  f    21 22 2 2  z 2 z1 z 2 z 2     f 1  f 2 0  2 2   2L   L  L  2   z1 z1   has a negative determinant. Concave in w. q )  q   1    a    wi   i 1   i m r  w    2    b   r 1/ r .The above figure indicates that there is also a second-order condition that must be checked. namely.

q) = wz(w. Shephard's lemma implies that the cost function is a non-decreasing function of input prices. q) is the firm's conditional input demand function. zv the vector of variable inputs. Let zf be the vector of fixed inputs.  Short-run cost function is then given by: sc(w. q. wf). q )   f ( z ) f ( z ) T 0 1      I    0  This result is in fact associated with comparative statics of the conditional input demand functions with respect to the input prices. Assume that c(w. q ))  0 I   2 f ( z ( w . q )   I     ( w . q )    0       From this. in term of matrices. q ))  0. In this case. q. We can express the long-run cost function in terms of the short-run cost function 7 . some of the inputs are fixed. q ))z (w . zf)/q In the long-run.. the solution z(w. the firm must optimize in the choice of zf. q..  It is easy to see that the conditional input demand functions are homogeneous of degree 0. n. Note: 5. q )        ( w . become:    2 f ( z )    f ( z )   f ( z ) T 0   z ( w ..  The short-run conditional input demand functions: zv(w. q ))  0 which.   This result is a direct application of Envelope Theorem. q) be the firm's conditional input demand function. zf)/q  Short-run average variable cost (SAVC) = SVC/q  Short-run average fixed cost (SAFC) = FC/q  Short-run marginal cost (SMC) = sc(w. all production factors are variable.  Shephard's Lemma: (The derivative property) Let z(w.. q).5 Short-Run & Long-Run Costs Recall that the cost function can be expressed as the value of conditional input demands: c(w. We also break the vector of input prices w = (wv. q ))  f (z ( w . q. zf) + wf zf  SVC + FC = STC   Other derived cost concepts are  Short-run average cost (SAC) = sc(w. q ). and c ( w. q) by taking the inverse of the bordered Hessain matrix:   2 f ( z )  z ( w . q ))z ( w . w  f ( z ( w . Applying the usual argument. wi i  1. q )) ( w . we can solve for the substitution matrix z(w.  In short-run. q )  z i ( w. zf) = wv zv(w. q) is differentiable at w with w > 0. z(w. zf). q ))  q. q. Differentiating these identities with respect to w we will have the following: f (z ( w . q) must satisfy the first-order conditions: f ( z (w .For the given cost minimization problem.

sc(q*. z*)  0. q) = wv zv(w.  Let zf(w. which comes from the envelope theorem: dc(q*) dsc (q*.e. q) be the optimal choice of the fixed inputs. for all levels of output. note that if the long-run and short-run cost curves are tangent. the long-run average cost curve is the lower envelope of the short-run cost curves. zf(w. z*) sc ( q*. Then.  The short-run cost will equal to the long-run cost at the output q = q*. z*) = sc(q*. let z* = z(q*) is the associated (optimal) long-run demand for the fixed input.Relationship Between Short-run & Long-Run Costs For ease of presentation.in the following way. we will have two derived long-run cost concepts:  Long-run average cost (LAC) = c(w. z*).  Similarly. Then the long-run cost function is given by: c(w. i. z Finally. q)/q  Long-run marginal cost (LMC) = c(w. c(q. z*)     .z*) q* q 8 . q.  For a given output q*. which implies that   sc ( q*. This implies that the long-run and the short-run cost curves must be tangent at q*.. z(q*)) = c(q*). The geometric illustration of the above result is as follows: AC SAC LAC AC(q*. q. the long-run and short-run average cost curves must also be tangent. c(q) = sc(q. z(q)).  The above result follows from the following argument. Then it is clear that  The short-run cost. q) = sc(w. q) = zv(w. and let zv(w. we drop the argument of w (the fixed input prices) assume a single fix input z. must be least as large as the long-run cost. z ( q*) sc (q*. dq dq q z dq q since z* is the optimal choice of the fixed input at the output level q*. q)). z(q)). q)). q)/q Proposition (Cost Envelope) . q) + wf zf (w. In other word. sc(q. z*) dz ( q*) sc (q*. zf(w.

" American Economic Review. North Holland. Since ( (z1) + (1. 882-888. North Holland. vol. C. E. To find the limit of this nature. W. 225-250. 2. vol. we have to find the limit of the logarithm of f: ln(z1  (1   ) z 2 ) lim ln f ( z1 . North Holland. (1975) “Applications of Duality Theory. Arrow and M. D. the proof is similar. Additional References: Arrow. R.” in Handbook of Mathematical Economics. and R. and R. M. Nadiri. ed. W. (1962) "Production Functions with Constant Elasticities of Substitution.  0 For the general case. Kendricks. vol. W. z 2 )  lim  0  0  [ (ln z1 ) z1  (1   )(ln z 2 ) z 2 ] [z1  (1   ) z 2 ]  0 1   (ln z1 )  (1   )(ln z 2 )  ln[ z1  z 12 ]  lim (Here we have used two results from Calculus: (1) the formula for the derivative of ax: d(ax)/dx = (ln a) (ax). ed. 79. J. K. (1970) Theory of Cost and Production Functions. we have lim f ( z1 . Amsterdam. Amsterdam. 79. (1982) “Producer’s Theory. vol. Chenery. 43. W. (1982) “Duality Approaches to Microeconomic Theory." The Review of Economic Studies. z 2 )  z1  (1   ) z 2  1/  We need to work out the limit of f as   0. D. 9 . E. Diewert. Arrow and M. H. J. vol.” in Handbook of Mathematical Economics.) (z2) )  1 as   0." Journal of Political Economy. vol. M. Intriligator and D. Princeton: Princeton University Press. K. Uzawa. Amsterdam. and (2) L'Hopital's Rule. I. Minhas. Solow (1961) "Capital-Labor Substitution and Economic Efficiency..Technical Appendix of Topic 5 Derivation of Cobb-Douglas Production Function from CES Form It suffices to consider the case for n = 2. R. the limiting problem of f as   0 becomes an indeterminate form of 0. M. J. Intriligator. 29. Blackorby. z 2 )  z1 z 12 . B. Diewert.) Therefore. Intriligator. Note that  q  f ( z1 . E. 2. ed. 481-507. D. Shephard. K. (1971) "An Application of the Shephard Duality Theorem: A Generalized Leontief Production Function.” in Frontiers of Quantitative Economics. 291-299. Russell (1989) "Will the Real Elasticity of Substitution Please Stand Up? (A Comparison of the Allen/Uzawa and Morishima Elasticities). H. A. Diewert." The Review of Economics and Statistics.