Lecture 9: Firm Problem

Advanced Microeconomics I

Yosuke YASUDA
Osaka University, Department of Economics
yasuda@econ.osaka-u.ac.jp

November 4, 2014

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Production

Consumer theory imposes a strong structure on the choice sets

(budget sets) but few constraints on the preferences or utility
function. In contrast, classic producer theory assigns the producer
a highly structured target function (profit function) but fewer
constraints on the choice sets (technology or production functions).

Production is the process of transforming inputs into outputs.

Let 1, ..., k be commodities. The producer’s choice will be
made from subsets of the “grand set,” k-dimensional
Euclidean space.
A vector z in this space is interpreted as a production
combination; positive components in z are interpreted as
outputs and negative components as inputs.
(Note P
that the firm’s profit can be expressed as
pz = ki=1 pi zi where p ∈ Rk++ is a vector of prices.)

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Technology
Definition 1
A producer’s choice set is called a technology (or production
possibility set), Z ⊂ Rk , which specifies the production
constraints.

The following restrictions are usually placed on the technology Z:

1 0 ∈ Z: Producer can remain “idle.”

2 There is no z ∈ Z ∩ Rk+ besides the vector 0:
No production with no resources.
3 If z ∈ Z and z0 ≤ z, then z0 ∈ Z: Free disposal.
4 Z is a convex set: Decreasing return to scale.
5 Z is a closed set.
 
Rm Check each restriction by drawing a figure with k = 2.
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Production Function (1)
Suppose that a commodity (denoted by 0) is produced from other
commodities 1, ..., n, that is, for all z ∈ Z, z0 ≥ 0 and zi ≤ 0 for
i = 1, 2, ..., n.
Another way to describe the firm’s technological constraints is a
production function, f : Rn+ → R+ , which specifies, for any
positive vector of inputs x ∈ Rn+ , the maximum amount of
commodity 0 that can be produced:

f (x) = max{y|(−x, y) ∈ Z}.

Theorem 2
When a function f satisfies the assumptions of (i) f (0) = 0, (ii)
increasing, (iii) continuity, and (iv) concavity, then Z(f ) satisfies
the above assumptions 1-5, where Z(f ) is defined as

Z(f ) = {(−x, y)| y ≤ y 0 and x ≥ x0 for some y 0 = f (x0 )}.

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Production Function (2)
 
Q A production function f (x) is said to be
 
1 Constant returns to scale (homogeneous of degree 1):

if f (tx) = tf (x) for all t > 0 and all x.

2 Increasing returns to scale:

if f (tx) > tf (x) for all t > 1 and all x.

3 Decreasing returns to scale:

if f (tx) < tf (x) for all t > 1 and all x.

Theorem 3
Suppose that the production function f (x) satisfies (i) f (0) = 0,
(ii) increasing, (iii) continuity, and (iv’) quasi-concavity, and
constant returns to scale. Then it is a (iv) concave function.
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Cost function (1)
Let w = (w1 , ..., wn ) ≥ 0 be a vector of prevailing market prices at
which the firm can buy inputs (x1 , ..., xn ).
Definition 4
The cost function is the minimum-value function of the following
cost minimization problem,

c(w, y) =: minn wx s.t. f (x) ≥ y.

x∈R+

Mathematically speaking, the cost function is identical to the

expenditure function.

e(p, u) =: minn px s.t. u(x) ≥ u.

x∈R+

So, the properties that the expenditure function e(·) possesses also
hold for the cost function c(·).
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Cost function (2)
Theorem 5
If f is continuous, strictly increasing and f (0) = 0, then the cost
function c(w, y) : Rn+1
+ → R+ is
1 Zero when y = 0.
2 Continuous on its domain.
3 For all w 0, strictly increasing and unbounded above in y.
4 Increasing in w.
5 Homogeneous of degree one in w.
6 Concave in w.
Moreover, if f is strictly quasi-concave we have
7 Shephard’s lemma: c(w, y) is differentiable in w at (w0 , y 0 )
whenever w 0, and

∂c(w0 , y 0 )
= xi (w0 , y 0 ), i = 1, ..., n.
∂wi
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Firm’s Objectives

We assume the goal of the firm (producer) is to maximize profits.

 
Q Why is the producer’s goal “profit maximization”?
 
(Only) Profit maximizing firms would survive in the long-run
under competitive pressure.
Profit maximization is the single most robust and compelling
assumption. (JR, pp.125)
Just for mathematical convenience? (Rubinstein, Lecture 7)

 
Ex Alternative plausible(?) targets:

Increase market share subject to not incurring a loss.

Increase salaries with less regard for the level of profits.

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Cost minimization (1)
If the object of the firm is to maximize profits, it will necessarily
choose the least costly production plan for every level of output.
(Note this must be true for all profit-maximizing firms, whether
monopolists, perfect competitors, or anything between.)

min wx s.t. f (x) ≥ y.

x∈Rn
+

Assuming x∗  0 and solve this problem by Lagrange’s method.

(Note f (x) = y must be satisfied at the optimal solution.)

L = wx − λ(f (x) − y).

∂L ∂f (x∗ )
= wi − λ = 0 for i = 1, ..., n.
∂xi ∂xi
∂L
= f (x) − y = 0.
∂λ

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Cost minimization (2)

From the first order conditions, we obtain

∂f (x∗ )
∂xi wi
∂f (x∗ )
= for any i, j.
wj
∂xj

Cost minimization implies that the marginal rate of technical

substitution (MRTS) between any two inputs is equal to the
ratio of their prices.
Definition 6
The solution x(w, y) is referred to as the firm’s conditional
(contingent) input demand, because it is conditional on the level
of output y, which at this point is arbitrary and so may or may not
be a profit maximizing.

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Profit Maximization (1)
Suppose the competitive firm can sell each unit of output at the
market price, p. There are two different ways to solve the firm’s
profit maximization problem.

One-step procedure:

max py − wx s.t. f (x) ≥ y

x∈Rn
+

which is equivalent to (since f (x) = y must hold)

P M 1 : maxn pf (x) − wx.

x∈R+

Two-step procedure:

P M 2 : max py − c(w, y).

y≥0

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Profit Maximization (2)
 
1 2
Rm It can be shown that the P M and P M are equivalent.
Assuming x∗  0, P M 1 is just an unconstrained problem with
“multiple” variables. So we can solve it by just taking partial
derivatives.
∂[pf (x) − wx] ∂f (x∗ )
=p − wi = 0 for i = 1, ..., n.
∂xi ∂xi

From the first order conditions, we obtain

∂f (x∗ )
∂xi wi
∂f (x∗ )
= for any i, j.
wj
∂xj

This is precisely the same as the condition for cost minimization

input choice. It therefore confirms our earlier intuition that profit
maximization “requires” cost minimization in production.
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Profit Maximization (3)
Definition 7
The optimal choice of inputs x∗ = x(p, w) gives the vector of
input demand functions. (Note these input demands are no
longer “conditional” since they are independent of output.)

Assuming y ∗ > 0, P M 2 is just an unconstrained problem with

“one” variable:
d[py − c(w, y)] dc(w, y ∗ )
=p− = 0.
dy dy
Therefore, output is chosen so that “price equals marginal cost”.
Definition 8
The optimal choice of output y ∗ = y(p, w) is called the firm’s
(output) supply function. The maximum-value function, denoted
by π(p, w), is called the profit function.

π(p, w) =: maxn pf (x) − wx.

x∈R+ 13 / 14
Profit Maximization (4)
Theorem 9
Suppose f is continuous, strictly increasing, strictly quasi-concave,
and f (0) = 0. Then, for p ≥ 0 and w ≥ 0, π(p, w), where
well-defined, is continuous and
1 Increasing in p.
2 Decreasing in w.
3 Homogeneous of degree one in (p, w).
4 Convex in (p, w).
5 Differentiable in (p, w)  0. Moreover, ( Hotelling’s
lemma),

∂π(p, w) ∂π(p, w)
= y(p, w) and − = xi (p, w), i = 1, ..., n.
∂p ∂wi
 
Rm Note that profit maximization problem is mathematically not
identical to utility maximization problem.
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