ECON5210 Lecture 5: Production

Rui Tang, HKUST

Email: ruitang@ust.hk
Office hour: Tuesday 4-5 p.m.
Roadmap

Producer Theory

Production Economy and Equilibrium

Efficiency and Welfare

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Cost Minimization

Consider a firm who can produce good n + 1 based on n goods.

The production function of the firm is given by F : R+n → R+ .
n
When the prices of the n goods are given by p ∈ R++ , the cost function
F
c (p, y ) for producing y units of good n + 1 is given by

c F (p, y ) = min
n :F (x)=y
p · x.
x∈R+

The associated firm’s demand x F (p, y ) ⊆ R+n that solves the minimization
problem, i.e.,
x F (p, y ) = arg min
n
p · x,
x∈R+ :F (x)=y

if exists, is called the conditional factor demand.

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Remark 1. We say that c F (p, y ) is well-defined if x F (p, y ) is not empty, that is,
there is x ∗ such that F (x ∗ ) = y and p · x ∗ ≤ p · x for all x with F (x) = y .
Remark 2. When we say x F (p, y ) is a function, we essentially mean that
|x F (p, y )| = 1.

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Proposition
Suppose for y > 0, {x : F (x) = y } is not empty. If F is continuous, then x F (p, y )
is not empty and c F (p, y ) is well-defined. In addition, if F is monotone and
strictly quasiconcave, then x F (p, y ) is a function of p.

Proof.
Since F is continuous, A = {x : F (x) = y } is a closed subset of R+n .
However, A might not be compact (bounded), how should we apply the
Weierstrass theorem?
Pick an arbitrary x ∗ ∈ A.
Consider the set B = {x : p · x ≤ p · x ∗ }, which is closed and bounded.
Consider the intersection A ∩ B, it is compact.
Since the function g (x) = p · x is continuous, g (x) achieves its minimum in
A ∩ B. The bundles that achieve the minimum are x F (p, y ). c F (p, y ) is thus
also well-defined.

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Proof Continued.
Now suppose that F is monotone and strictly quasiconcave.
If there exist distinct x, x 0 ∈ x F (p, y ), then for t ∈ (0, 1),

F (tx + (1 − t)x 0 ) > F (x) = F (x 0 ) = y .

Let x 00 = tx + (1 − t)x 0 . Note that x 00 6= 0. We have F (x 00 ) > y and

p · x 00 = c F (p, y ) > 0.
By continuity and monotonicity, F (0) ≤ y .
If F (0) = y , we have a contradiction since c F (p, y ) > 0.
If F (0) < y , then F (x 00 ) > y implies that F (tx 00 ) = y for some t ∈ (0, 1)
(intermediate value theorem). Obviously, p · tx 00 < p · x = c F (p, y ),
contradiction.

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More on Continuity

The continuity of c F (p, y ) with respect to p is not directly related to the

continuity of F , since we are doing the cost minimization for a linear function
p · x. As long as {x : F (x) = y } is closed, we can show the continuity of
c F (p, y ).

The continuity of x F (p, y ) with respect to p is ensured by the continuity of F .

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Proposition (Monotonicity)
If both c F (p, y ) and c F (p 0 , y ) are well-defined, then

p ≥ p 0 ⇒ c F (p, y ) ≥ c F (p 0 , y ),

p  p 0 and c F (p, y ) > 0 ⇒ c F (p, y ) > c F (p 0 , y ).

Note that no restriction is imposed on the function F .

If p ≥ p 0 , consider x ∈ x F (p, y ), we have F (x) = y and

p · x = c F (p, y ) ≥ p 0 · x ≥ c F (p 0 , y ).

If p  p 0 and c F (p, y ) > 0, consider x ∈ x F (p, y ), we have x 6= 0, and

p · x = c F (p, y ) > p 0 · x ≥ c F (p 0 , y ).

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Proposition (1-Homogeneous)
If c F (p, y ) is well-defined, then for any t > 0, c F (tp, y ) = tc F (p, y ).

Since c F (p, y ) is well defined, there exists x ∗ ∈ R+n such that

F (x ∗ ) = y and c F (p, y ) = p · x ∗ ≤ p · x, ∀x with F (x) = y .

Now, consider the price vector tp. Such x ∗ still satisfies:

F (x ∗ ) = y and c F (p, y ) = tp · x ∗ ≤ tp · x, ∀x with F (x) = y .

Hence, c F (tp, y ) = tp · x ∗ = tc F (p, y ).

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Proposition (Concavity)
If c F (p, y ), c F (p 0 , y ), and c F (tp + (1 − t)p 0 , y ) (t ∈ (0, 1)) are well-defined, then

c F (tp + (1 − t)p 0 , y ) ≥ tc F (p, y ) + (1 − t)c F (p 0 , y ).

Consider x ∗ ∈ x F (tp + (1 − t)p 0 , y ). We have F (x ∗ ) = y and

tp · x ∗ + (1 − t)p 0 · x ∗ = c F (tp + (1 − t)p 0 , y ).

Note that

tp · x ∗ ≥ tc F (p, y ) and (1 − t)p 0 · x ∗ ≥ (1 − t)c F (p 0 , y ).

Hence,
c F (tp + (1 − t)p 0 , y ) ≥ tc F (p, y ) + (1 − t)c F (p 0 , y ).

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Proposition (Law of Demand)
If x ∈ x F (p, y ) and x 0 ∈ x F (p 0 , y ) for p 6= p 0 , then

(p − p 0 ) · (x − x 0 ) ≤ 0.

For example: p = (2, 1) and p 0 = (1, 1), then law of demand implies that

x1 − x10 ≤ 0.

Note that
p · x ≤ p · x 0,
p 0 · x 0 ≤ p 0 · x.
Taking sum of the two inequalities leads to law of demand.

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Proposition (Differentiability)
If for an open ball B (p) around p, we have |x F (p 0 , y )| = 1 for all p 0 ∈ B (p), and
x F (p 0 , y ) is continuous on p, then c F (p 0 , y ) is differentiable at p such that

∂c F (p 0 , y )
|p0 =p = xiF (p, y ).
∂pi0

WLOG, let i = 1. Let w  = (, 0, 0, ..., 0) for  > 0.

For  close to 0,
c F (p + w  , y ) − c F (p, y )

(p + w  ) · x F (p + w  , y ) − p · x F (p, y )
=


(p + w  ) · x F (p, y ) − p · x F (p, y )
≤ = x1F (p, y ).


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Proof Continued.
For  close to 0,
c F (p + w  , y ) − c F (p, y )

(p + w  ) · x F (p + w  , y ) − p · x F (p, y )
=


(p + w  ) · x F (p + w  , y ) − p · x F (p + w  , y )
≥ = x1F (p + w  , y ).

Note that x1F (p + w  , y ) converges to x1F (p, y ) as  goes to zero. Hence,

c F (p + w  , y ) − c F (p, y )
lim = x1F (p, y ).
↓0 
Similarly, we can show

c F (p + w  , y ) − c F (p, y )
lim = x1F (p, y ).
↑0 

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Proposition (Differentiability)
If for an open ball B (p) around p, c F (p 0 , y ) is well-defined, and c F (p 0 , y ) is
differentiable at p, then x F (p, y ) is unique, and

∂c F (p 0 , y )
|p0 =p = xiF (p, y ).
∂pi0

Consider any x ∗ ∈ x F (p).

Define function γ(p 0 ) = p 0 · x ∗ − c F (p 0 , y ) ≥ 0. Hence, γ(p 0 ) takes minimum
at p 0 = p.
FOC gives
∂γ(p 0 ) ∂c F (p 0 , y )
0 |p0 =p = xi∗ − |p0 =p = 0.
∂pi ∂pi0

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Constant Return to Scale

F is said to obey constant return to scale (CRS) if F (tx) = tF (x) for any
t > 0.
Claim. If F obeys CRS and c F (p, y ) is well-defined, then

c F (p, y ) = yc F (p, 1).

Proof of the Claim. Consider x ∗ ∈ x F (p, y ). p · x ∗ ≤ p · x for all x with

F (x) = y .
Since F (x) = y iff F ( y1 x) = 1, we have p · y1 x ∗ ≤ p · x for all x with
F (x) = 1.
Hence, y1 x ∗ ∈ x F (p, 1) ⇒ c F (p, 1) = y1 c F (p, y ).

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Profit Maximization

Suppose that c F (p, y ) is well-defined for each y ≥ 0.

The firm’s problem is to

max R(y ) − c F (p, y ).

y ≥0

We can consider a more general case to accommodate multi-product firm.

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Production Possibility Set

Suppose that there are in total n goods in the market, including the
ingredients.
We use Y ⊆ R n to denote the production set of the firm.
Consider x ∈ Y such that: xi < 0 for i ∈ I , xj = 0 for j ∈ J, and xk > 0 for
k ∈ K . The interpretation is that the firm can use (−xi )i∈I to produce at
least (xk )k∈K .
Example. Y = {(−x, y ) : x ∈ R n−1 , x ≥ 0, y ≤ F (x)} for the firm that
produces one good.

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Production Possibility Set

Consider the market with five goods: apple, orange, apple juice, orange juice,
mixed juice.
The firm can produce one cup of juice from one fruit; or a cup of mixed juice
from 1/2 apple and 1/2 orange.
Let Y be the production possibility set of the firm. We have

(−1, −1, 1, 1, 0) ∈ Y ,

(−1, −1, 0, 0, 2) ∈ Y ,
(−1, −1, 1, 0.5, 0.5) ∈
/ Y.

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Profit Maximization

In a competitive market, let p  0.

The firm’s problem is to choose

S(p) = arg max p · x.

x∈Y

The firm’s profit is Π(p) = p · x ∗ for some x ∗ ∈ S(p).

S(p) is called the supply correspondence, and Π(p) is called the profit
function.
Note that S(p) might not be well-defined.

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Properties of S(·) and Π(·)

If S(p) is well-defined, then S(tp) is well-defined for t > 0, and

S(p) = S(tp), Π(tp) = tΠ(p).

If Π(p), Π(p 0 ) and Π(tp + (1 − t)p 0 ) are well-defined for t ∈ (0, 1), then

Π(tp + (1 − t)p 0 ) ≤ tΠ(p) + (1 − t)Π(p 0 ).

That is, Π is convex. To see this, note that

Π(tp + (1 − t)p 0 ) = (tp + (1 − t)p 0 ) · x ∗ = tp · x ∗ + (1 − t)p 0 · x ∗

≤ tΠ(p) + (1 − t)Π(p 0 ).

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Law of Supply

Suppose x ∈ S(p) and x 0 ∈ S(p 0 ). We have

(p − p 0 )(x − x 0 ) ≥ 0.

Proof. p · x ≥ p · x 0 and p 0 · x 0 ≥ p 0 · x delivers the result.

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Proposition (Differentiability)
Suppose that Π(·) is well-defined around an open ball of p and differentiable at p,
then S(p) is unique and
∂Π(p 0 )
Si (p) = |p0 =p .
∂pi0

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Production Economy

Nonempty and finite set of agents: A.

Agent’s utility u a : R+n → R and endowment ω a ∈ R+n .
Finite set of firms: F , each firm is denoted f ∈ F .
The production set Y f ⊆ R n , and contains 0.
Each agent owns some share of each firm, s a,f is agent a’s share of firm f :
X
∀f ∈ F , s a,f = 1.
a∈A

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Production Economy

Suppose that the price vector is p  0.

Each firm f will choose bundle x f (p) ∈ Y f to maximize the profit.
The associated profit of firm f is π f (p) ≥ 0.
Each agent a’s wealth is given by
X
p · ωa + s a,f π f (p).
f ∈F

Each agent’s demand is

X
x̄ a (p, p · ω a + s a,f π f (p)).
f ∈F

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Definition
p  0 is a Walrasian equilibrium price if there exists x f ∈ Y f for each f ∈ F and
x a for each a ∈ A, such that

for each firm f , π f = p · x f = max p · x;

x∈Y f

for each agent a, u a (x a ) = maxP u(x);

x∈B(p,p·w a + s a,f π f )
f ∈F

X X X
ωa + xf = x a.
a∈A f ∈F a∈A

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Example
Consider a one-agent economy. There are two goods: orange and orange juice.
There is one firm that produces one cup of orange juice from one orange. The
agent’s endowment is (3, 0), and she owns the firm. The agent’s utility function is

u(x1 , x2 ) = x1 + 2x2 .

We argue that p = (1, 1) is an equilibrium price vector.

The firm can produce (−k, k) for any k > 0 to maximize profit.
The maximized profit is 0. And the agent’s total income is 3. She buys 3
cups of orange juice.
It can be easily verified that k = 3 constitutes an equilibrium.

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Solving for Equilibrium

We can let p1 = 1.
The profit maximization bundle of each firm is a function of p, and so it the
profit.
The demand of each agent is a function of p.
Check market clear condition for the first n − 1 goods.

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Proposition (Efficiency of Production)
Suppose that p  0 is a Walrasian equilibrium price of the production economy,
and suppose that firm f produces x f in the equilibrium. There does not exists
{y f }f ∈F with y f ∈ Y f for each f ∈ F such that
X X
yf > xf .
f ∈F f ∈F

Proof.
Suppose such {y f }f ∈F exists. We have
X X
p· yf > p · xf .
f ∈F f ∈F

∗ ∗
Hence, some firm f ∗ is making strictly more profit with y f than x f ,
contradiction.

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Definition
An allocation {x a }a∈A is feasible if there exists {x f }f ∈F with x f ∈ Y f for each
f ∈ F such that X X X
ωa + xf = x a.
a∈A f ∈F a∈A

It is Pareto optimal if there is no feasible allocation that Pareto dominates it.

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Proposition (First Welfare Theorem)
Suppose each agent’s utility function is monotone. If {x a }a∈A is
the allocation of
the agents in some Walrasian equilibrium {x a }a∈A , {x f }f ∈F , p , then {x a }a∈A is
Pareto optimal.

Proof.
Suppose not, we have a feasible Pareto improvement {x̂ a }a∈A .
It can be easily verified that
X X
p· x̂ a > p · x a.
a∈A a∈A

Since {x̂ a }a∈A is feasible, we know

X X X
x̂ a = ωa + x̂ f
a∈A a∈A f ∈F

for some {x̂ f }f ∈F with x̂ f ∈ Y f for each f ∈ F .

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Proof.
It follows that
X X X X X X
p· x̂ a = p · ωa + p · x̂ f > p · xa = p · ωa + p · xf
a∈A a∈A f ∈F a∈A a∈A f ∈F

X X
⇒p· x̂ f > p · xf ,
f ∈F f ∈F

contradiction.

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Example
Consider a one-agent economy. There are two goods: orange and orange juice.
There is one firm that produces one cup of orange juice from one orange. The
agent’s endowment is (3, 0), and she owns the firm. The agent’s utility function is

u(x1 , x2 ) = x1 + 2x2 .

By the welfare theorem, in any Walrasian equilibrium, the firm has to

produce 3 cups of orange juices.
Fix p1 = 1. The firm must have incentive to produce ⇒ p2 ≥ 1.
p2 > 1 ⇒ no optimal production.
Hence, the only possible equilibrium price vector is p = (1, 1).

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