Microeconomics 1

Production

Instructor: Andrés Salamanca

Krugman, Economics, 6e, © 2021
2020 Worth Publishers
Production
Production is a process by which some goods,
denominated inputs, are transformed into another
good, called output.
• As we have seen, in the rational consumer theory
there are two fundamental elements:
– The alternatives set (i.e., consumption set)
– An appropriate ordering of the alternatives (i.e.,
preferences).
• In this chapter, we will define the production set,
which is the producer’s alternatives set.

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Production Possibilities
A production plan is a specification of the quantities of
inputs required to produce a certain quantity of output.
• The firm’s production possibilities are given by the
set of all possible production plans that the firm can
perform.
– This set is called the production set.
– This set determines the production technology of
the firm.

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Production Set
Consider an economy where a number 𝐿𝐿 of inputs are
required to produce an output.
• A production plan is a 𝐿𝐿-tuple 𝑧𝑧1 , 𝑧𝑧2 , … , 𝑧𝑧𝐿𝐿 , 𝑥𝑥 ∈ ℝ𝐿𝐿+1
+
– The first 𝐿𝐿 components, 𝑧𝑧1 , 𝑧𝑧2 , … , 𝑧𝑧𝐿𝐿 , denote the
amounts of inputs.
– The 𝐿𝐿-th component, 𝑥𝑥, denotes the quantity of
output that can be correspondingly produced.
• The set of all production plan available to the firm is
called production set and will be denoted 𝑌𝑌 ⊆ ℝ𝐿𝐿+1 + .

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Production Set
Properties
We will consider a series of properties that a production
set may satisfy:
• Possibility of inaction. This property says that 0 ∈ 𝑌𝑌.
That is, the firm can choose to do nothing.
• Closedness. The production set is closed, i.e., it
contains its boundary.
• Convexity. The production set is convex. It is
possible to combine production plans in different
proportions.
• Free disposal:
– Plans that produce less with the same amount of
inputs are feasible.
– Plans that produce the same output with more inputs
are feasible.
– If 𝑦𝑦 ∈ 𝑌𝑌, any plan to theKrugman,
right and below is2020 feasible.
Economics, 6e, © 2021 Worth Publishers
Production Set
Properties
𝑥𝑥 𝑥𝑥

• Not closed • Closed

𝑌𝑌 • No free disposal
• Free disposal
𝑧𝑧 • Convex 𝑧𝑧 • Convex
𝑌𝑌 • No inaction • Inaction

𝑥𝑥 𝑥𝑥

• Closed • Closed
• Free disposal • Free disposal
𝑧𝑧 • Not Convex 𝑧𝑧 • Convex
𝑌𝑌 • Inaction 𝑌𝑌 • No inaction

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Returns to Scale
The following properties measure the change in output
from a proportionate increase in all inputs.
• The production set 𝑌𝑌 exhibits non-increasing returns
to scale if for all 𝑦𝑦 ∈ 𝑌𝑌 and 0 ≤ 𝜆𝜆 ≤ 1, we have that
𝜆𝜆𝑦𝑦 ∈ 𝑌𝑌.
𝑥𝑥 𝑥𝑥

𝑦𝑦
𝜆𝜆𝑦𝑦 𝑦𝑦
𝜆𝜆𝑦𝑦

𝑧𝑧 𝑧𝑧
𝑌𝑌 𝑌𝑌

Krugman, Economics, 6e, © 2021

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Returns to Scale

Lemma
If 𝑌𝑌 is convex and allows inaction, then 𝑌𝑌 has non-
increasing returns to scale.
– Proof. Since 𝑌𝑌 allows inaction, then 0 ∈ 𝑌𝑌. Take
𝑦𝑦 ∈ 𝑌𝑌 and 𝜆𝜆 ∈ [0,1). Because 𝑌𝑌 is convex, then
𝜆𝜆𝑦𝑦 = 1 − 𝜆𝜆 0 + 𝜆𝜆𝑦𝑦 ∈ 𝑌𝑌

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Returns to Scale
• The production set 𝑌𝑌 exhibits non-decreasing returns
to scale if for all 𝑦𝑦 ∈ 𝑌𝑌 and 𝜆𝜆 ≥ 1, we have that 𝜆𝜆𝑦𝑦 ∈
𝑌𝑌.
𝑥𝑥 𝑥𝑥
𝜆𝜆𝑦𝑦

𝑦𝑦

𝑦𝑦 𝜆𝜆𝑦𝑦
𝑧𝑧 𝑧𝑧
𝑌𝑌 𝑌𝑌

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Returns to Scale
• The production set 𝑌𝑌 exhibits constant returns to
scale if for all 𝑦𝑦 ∈ 𝑌𝑌 and 𝜆𝜆 ≥0, we have that 𝜆𝜆𝑦𝑦 ∈ 𝑌𝑌.
– That is, the productivity is independent of the
production level.
– Constant returns to scale implies inaction.
𝑥𝑥

𝜆𝜆𝑦𝑦 𝜆𝜆𝑦𝑦
𝑦𝑦

𝑧𝑧
𝑌𝑌

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Efficient Production
A production plan 𝑦𝑦 ∈ 𝑌𝑌 is said to be efficient if
• There is no other feasible production plan 𝑦𝑦 ′ producing
more output with the same amount of inputs.
• There is no other feasible production plan 𝑦𝑦 ′ producing
the same output with fewer inputs.
𝑥𝑥
• 𝑦𝑦� is not efficient: it uses the
𝑦𝑦 same inputs as 𝑦𝑦, but
𝑦𝑦�
produces less output.
𝑦𝑦�
𝑧𝑧 • 𝑦𝑦� is not efficient: it produces
𝑌𝑌 the same output as 𝑦𝑦, but
uses more inputs.

• Where are located all efficient plan?

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Efficient Production
“Efficient” Frontier
The frontier of the production set corresponds to all
production plans that produce the highest possible
output for a given amount of inputs.
• All efficient plans are contained in the frontier of the
production set.
• Not all plans in the frontier are efficient.
𝑥𝑥
𝑦𝑦� • 𝑦𝑦 is efficient.
𝑦𝑦
• 𝑦𝑦� lies on the frontier but is
not efficient (it produces the
𝑧𝑧 same output as 𝑦𝑦 but uses
𝑌𝑌 more inputs).

Krugman, Economics, 6e, © 2021

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Efficient Production
“Efficient” Frontier

Lemma
If 𝑌𝑌 is strictly convex, then the set of all efficient
production plans coincides with the frontier of the
production set.

Krugman, Economics, 6e, © 2021

2020 Worth Publishers
Production Function
A production set can be described through a
production function 𝑓𝑓: ℝ𝐿𝐿+ → ℝ, which specifies the
maximum level of product 𝑥𝑥 that can be produced
using the vector of inputs 𝑧𝑧 = 𝑧𝑧1 , 𝑧𝑧2 , … , 𝑧𝑧𝐿𝐿 ≥ 0.
• Assuming free disposal, the production set
associated to 𝑓𝑓 is
𝑥𝑥
𝑌𝑌𝑓𝑓 = 𝑧𝑧, 𝑥𝑥 |𝑥𝑥 ≤ 𝑓𝑓 𝑧𝑧 , 𝑧𝑧 ≥ 0
𝒇𝒇(𝒛𝒛)

– 𝑌𝑌 is the hypograph of 𝑓𝑓; that is,

𝑧𝑧
the area under the graph of 𝑓𝑓.
𝑌𝑌
– The graph of 𝑓𝑓 outlines the
frontier of 𝑌𝑌.
Krugman, Economics, 6e, © 2021
2020 Worth Publishers
Production Function
Properties of the Production Set
The following results relate the properties of the
production function to the characteristics of its
corresponding production set.
• 𝑌𝑌𝑓𝑓 is closed if and only if 𝑓𝑓 is continuous.
• 𝑌𝑌𝑓𝑓 satisfies inaction if and only if 𝑓𝑓 0 = 0.
• 𝑌𝑌𝑓𝑓 is (resp. strictly) convex if and only if 𝑓𝑓 is (resp.
strictly) concave.

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Production Function
Returns to Scale
• 𝑌𝑌𝑓𝑓 exhibits constant returns to scale if and only
if 𝑓𝑓 𝜆𝜆𝑧𝑧 = 𝜆𝜆𝑓𝑓 𝑧𝑧 for all 𝜆𝜆 ≥ 0 and all 𝑧𝑧 ∈ ℝ𝐿𝐿+ .
• 𝑌𝑌𝑓𝑓 exhibits non-decreasing returns to scale if and
only if 𝑓𝑓 𝜆𝜆𝑧𝑧 ≥ 𝜆𝜆𝑓𝑓 𝑧𝑧 for all 𝜆𝜆 ≥1 and all 𝑧𝑧 ∈ ℝ𝐿𝐿+ .
• 𝑌𝑌𝑓𝑓 exhibits non-increasing returns to scale if and only
if 𝑓𝑓 𝜆𝜆𝑧𝑧 ≤ 𝜆𝜆𝑓𝑓 𝑧𝑧 for all 𝜆𝜆 ≥1 and all 𝑧𝑧 ∈ ℝ𝐿𝐿+ .

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Production Function
Returns to Scale
A production function 𝑓𝑓 is called homogeneous if
𝑓𝑓 𝜆𝜆𝑧𝑧 = 𝜆𝜆𝑟𝑟 𝑓𝑓 𝑧𝑧 ,
where 𝑟𝑟 is called the degree of homogeneity.
• If 𝑟𝑟 > 1and 𝜆𝜆 > 1, then 𝑓𝑓 𝜆𝜆𝑧𝑧 = 𝜆𝜆𝑟𝑟 𝑓𝑓 𝑧𝑧 > 𝜆𝜆𝑓𝑓 𝑧𝑧 .
– A production function that is homogeneous of
degree greater than 1 generates non-decreasing
returns to scale.
• If 𝑟𝑟 < 1and 𝜆𝜆 > 1, then 𝑓𝑓 𝜆𝜆𝑧𝑧 = 𝜆𝜆𝑟𝑟 𝑓𝑓 𝑧𝑧 < 𝜆𝜆𝑓𝑓 𝑧𝑧 .
– A production function that is homogeneous of
degree lower than 1 generates non-increasing
returns to scale.
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Production Function
Returns to Scale
• If 𝑟𝑟 = 1and 𝜆𝜆 ≥ 0, then 𝑓𝑓 𝜆𝜆𝑧𝑧 = 𝜆𝜆𝑟𝑟 𝑓𝑓 𝑧𝑧 = 𝜆𝜆𝑓𝑓 𝑧𝑧 .
– A production function that is homogeneous of
degree 1 generates constant returns to scale.

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Production Function
Scale Elasticity
Assume the production function 𝑓𝑓 is differentiable. The
scale elasticity (at 𝑧𝑧), denoted 𝜀𝜀 𝑧𝑧 , is defined as
𝑑𝑑𝑓𝑓 𝜆𝜆𝑧𝑧 𝜆𝜆
𝜀𝜀 𝑧𝑧 = �
𝑑𝑑𝑑𝑑 𝑓𝑓 𝜆𝜆𝑧𝑧 𝜆𝜆=1
• The scale elasticity measures the percentage
change in output due to (infinitesimal) variations in
the production scale.
• The production set associated to 𝑓𝑓 exhibits:
– Constant returns to scale (at 𝑧𝑧) if 𝜀𝜀 𝑧𝑧 = 1.
– Non-decreasing returns to scale (at 𝑧𝑧) if 𝜀𝜀 𝑧𝑧 > 1.
– Non-increasing returns to scale (at 𝑧𝑧) if 𝜀𝜀 𝑧𝑧 < 1.
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Production Function
Scale Elasticity
Consider the following production function
𝛼𝛼 𝛽𝛽
𝑓𝑓 𝑧𝑧1 , 𝑧𝑧2 = 𝑧𝑧1 𝑧𝑧2 ,
where 𝛼𝛼, 𝛽𝛽 > 0.
𝛼𝛼+𝛽𝛽 𝛼𝛼 𝛽𝛽
• Notice that 𝑓𝑓 𝜆𝜆𝑧𝑧1 , 𝜆𝜆𝑧𝑧2 = 𝜆𝜆 = 𝜆𝜆𝛼𝛼+𝛽𝛽 𝑓𝑓 𝑧𝑧1 , 𝑧𝑧2 .
𝑧𝑧1 𝑧𝑧2
– Constant returns to scale if 𝛼𝛼 + 𝛽𝛽 = 1
– Non-decreasing returns to scale if 𝛼𝛼 + 𝛽𝛽 > 1
– Non-increasing returns to scale if 𝛼𝛼 + 𝛽𝛽 < 1
• Therefore,
𝑑𝑑𝑓𝑓 𝜆𝜆𝑧𝑧1 , 𝜆𝜆𝑧𝑧2 𝑑𝑑𝜆𝜆𝛼𝛼+𝛽𝛽 𝑓𝑓 𝑧𝑧1 , 𝑧𝑧2
= = 𝛼𝛼 + 𝛽𝛽 𝜆𝜆𝛼𝛼+𝛽𝛽−1 𝑓𝑓 𝑧𝑧1 , 𝑧𝑧2
𝑑𝑑𝜆𝜆 𝑑𝑑𝜆𝜆
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Production Function
Scale Elasticity
Hence, the scale elasticity is:

𝑑𝑑𝑓𝑓 𝜆𝜆𝑧𝑧 𝜆𝜆
𝜀𝜀 𝑧𝑧 = �
𝑑𝑑𝑑𝑑 𝑓𝑓 𝜆𝜆𝑧𝑧 𝜆𝜆=1
𝛼𝛼+𝛽𝛽−1
𝜆𝜆
= 𝛼𝛼 + 𝛽𝛽 𝜆𝜆 𝑓𝑓 𝑧𝑧1 , 𝑧𝑧2 𝛼𝛼+𝛽𝛽
�
𝜆𝜆 𝑓𝑓 𝑧𝑧1 , 𝑧𝑧2 𝜆𝜆=1
= 𝛼𝛼 + 𝛽𝛽

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