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**THE PRODUCTION FUNCTION + MARGINAL + AVERAGE PRODUCTS
**

**The Production Function simply shows the TECHNICALLY POSSIBLE outcomes of a given combination of inputs.
**

y

In the form: Y = f(x1, ..., xn)

It does NOT consider the availability of those inputs, the affordability of those inputs. It simply shows the process of transformation from input output. The MARGINAL PRODUCT of an input is the change in output cause by an incremental change in the amount of the input:

y y

dY/dx1 = MPx1 We assume: MP is NON ² NEGATIVE, and is DIMINISHING.

**The AVERAGE PRODUCT of an input is the amount of output per unit of input:
**

y

Y/x1 = APx1

ISOQUANTS + MRTS

Basically indifference curves for producers, with caveats. An Isoquant describes the different combinations of inputs that will result in a constant level of output.

y

F(K,L) = Y* would describe an Isoquant at the level Y* of output, for example.

Isoquants are strictly convex and they do not cross. HOWEVER: Isoquants are a CARDINAL measure, whilst Indifference curves are ORDINAL. The slope of an Isoquant shows the Marginal Rate of Technical Substitution; i.e., the rate at which you would have to substitute two inputs to retain the same level of output. You can derive the MRTS thusly:

y y y

Y = F(K,L) dY = MPK. dK + MPL. dL = 0 - dK / dL = MPL / MPK = MRTS of L for K Any trade off implied by the MRTS is due to the Ratio of two inputs, NOT the scale of output. This suggests that all Isoquants are radial expansions of one another.

**Production functions are HOMOTHETIC:
**

y y

RETURNS TO SCALE

How output changes due to JOINT CHANGES IN INPUTS. Decreasing Returns To Scale: If output rises proportionally less than the rise in inputs. Isoquants will be spaced far apart.

y

F(tK, yL) < t F(K,L)

Constant Returns To Scale: If output rises proportionally the same as the rise in inputs. Isoquants will be evenly spaced.

y

F(tK, yL) = t F(K,L)

Increasing Returns To Scale: If output rises proportionally more than the rise in inputs. Isoquants will be bunched together.

y y y y y

F(tK, tL) > t F(K,L) DRS: Homogenous of degree < 1 in inputs CRS: Homogenous of degree 1 in inputs IRS: Homogenous of degree > 1 in inputs. Note that if a function is homogenous of degree ¶k·, it·s derivatives are homogenous of degree ¶k-1·.

HOMOGENEITY:

ELASTICITIES

Output Elasticity: Responsiveness of output to a change in input output due to a percentage change in input:

Percentage change in

I Y , xi

Elasticity of Substitution: How easy is it to substitute two inputs? How quickly does the MRTS diminish? Assume two inputs, Capital and Labour. The elasticity of substitution of capital for labour is given by the proportionate change in K / L relative to the change in the MRTS, shown below: k k k

W % (MRTS K , L % ( MPL

xY xi ! xxi Y

MPK

A high value of indicates that MRTS doesn¶t change much relative to K/L and the Isoquant is relatively FLAT. A Low value indicates that MRTS does change much relative to K/L and the Isoquant is relatively SHARP. will always be > 0, and can change ALONG an Isoquant or ACROSS the scale of production.

%(

l

%(

l

x ln

x ln MPL

l

MPK

**EXAMPLES OF ELASTICITY OF SUBSTITUTION
**

**For a linear function,
**

y y

= Infinite =0

Denominator is 0. Numerator is 0 as firm will always produce along the ray at which K / L is constant.

**For a Fixed Proportions function, For a Cobb Douglass function,
**

y y

=1

Simple to show it¶s true. In addition, a Cobb Douglass production function can exhibit any degree of returns to scale ± simply sum the indices of the inputs If they sum to 1, it is CRS, below 1 is DRS, above 1 is IRS.

**For a CES function,
**

y y y

= Any value

A CES function is a more general production than the three above (as noted in the consumer theory slides). The production form of the function is:

Y = [Kp + Lp]

/p

**Direct application of this yields the result that:
**

= 1 / (1 ± p)

**THE COST MINIMISATION PROBLEM
**

**Analogous to the Expenditure Minimisation problem in consumer theory.
**

The firm·s budget constraint can be graphically expressed via an ISOCOST line. y Want to find the Isocost line that is TANGENTIAL to the Isoquant at the desired level of output.

y

**To do this, identify the Objective Function as:
**

y y

Min r1x1 + r2x2 + ... + rnxn Y* = F(x1, x2, ..., xn)

And identify the Constraint as: Once done, simply apply traditional Lagrangian methodology to receive the optimal quantities and therefore the minimum price. Also, it transpires that

y y

MRTS (xi for xj) = MPI / MPJ = ri / rj In other words, the Marginal Rate of Technical Substitution between two inputs is equal to the ratio of their prices.

Assumption is that the price of output is irrelevant. In addition, you can use Expansion Paths to graphically show the locus of cost ² minimising points for a firm.

y y

They do NOT have to be straight lines. They may bend backward ² if an input is used less as the scale of production rises, it is an inferior input.

**THE COST FUNCTION
**

Using the optimal quantity of inputs, given by the cost ² minimisation problem, we can express Total Cost as:

y y

TC = r1x1*+r2x2* + ... + rnxn* Total Cost is the minimum level of expenditure required to reach a certain production level, Y*.

**The cost function behaves differently depending on the returns to scale exhibited by the production function.
**

y y y

If DRS, the TC function increases more than linearly with respect to output If IRS the TC function increases less than linearly with respect to output. If CRS the TC function increases linearly with respect to output.

Marginal Cost is the cost of an extra unit of output, and the MC function can be given by taking the derivative of the TC function:

y y

MC = d(TC)/dY Graphically, it is the gradient of the tangent to the TC curve.

**Average Cost is the cost per unit of output and can be derived by dividing TC by output:
**

y y

AC = TC / Y Graphically, it is the gradient of the line from the origin to a point on the TC curve.

MC + AC

Price MC

**MC and AC have a relationship as shown to the side. MC will intersect AC at AC·s minimum point:
**

y

AC

The MINIMUM EFFICIENT SCALE.

We can also conclude that if AC is rising, MC must be rising too ² but not vice versa. If AC is falling, MC < AC.

Q*

Quantity

**THE COST FUNCTION
**

**Properties: Homogenous of Degree 1 in inputs:
**

A rise in all prices of inputs will lead to a proportionally equal rise in expenditure. y The same can be said for MC and AC

y

**Cost functions are non decreasing in output and prices of inputs.
**

y

If costs do decrease due to a RISE in any of the variables, then it must·ve been the case that the firm wasn·t operating at the minimum cost initially.

**Cost Functions are concave in input prices:
**

If the price of any input rose or fell, the actual cost would be below the cost if input mix didn·t change. y Graphically, this can be shown by a concave cost function with a straight line tangential (and therefore above) to it. The straight line is the cost function if input prices didn·t change. The x ² axis would be the quantity of one of the inputs

y

ELASTICITY OF SUBSTITUTION

Different to the previous Elasticity of Substitution we saw. This version shows by how much a change in input prices causes a change in input usage. In order to do this, we see how the ratio of input usage (K / L) changes in response to a change in the ratio of input prices (r / w), whilst holding output constant.

%( K

sK ,L

L r %( w

x ln K

L r x ln w

This can be expanded to many inputs, simply replace ¶K· and ¶L· with the inputs and ¶r· and ¶w· with the respective payments to those inputs. Large values of ¶s· suggest that the firm substantially alters it·s input mix with a change of prices. In addition, the EXTENT to which a rise in input prices raises TC depends on:

y y

Importance of input in production Substitutability of inputs

CONTINGENT DEMAND

**Demand for inputs is a DERIVED demand. It is derived from two main sources:
**

y y

**The Cost ² Minimisation problem:
**

Gives the demand of inputs for a given QUANTITY of output. Gives the demand of inputs for a given PRICE of output.

**The Profit ² Maximisation problem.
**

**Derived factor demands are not directly observable. To calculate it for the cost-minimisation problem:
**

y

USE SHEPHARD·S LEMMA differentiate the cost function with respect to the payment of the input in question to get the derived input demand:

xC (r , w, Y ) K (r , w, Y ) ! xr

y

You can then use this to calculate the elasticity of substitution straight from the cost function ² just replace ¶K· with the partial derivative of the cost function with respect to K etc.

**SHORT-RUN AND LONG-RUN DIFFERENCES
**

**The short run:
**

y

Characterised by at least one factor of production being fixed. Characterised by no fixed factors.

**The long run:
**

y

The cost minimisation problem in the short run is the same as in the long run, except one or more of the factors is held constant.

With at least 2 factors not being constant, solve as you would normally. y With only 1 variable factor, derive the demand function for that input, and thus find the Short ² Run Total Cost function:

y

SRTC: w.[L*(w, r, Y)] + r.[Kfixed] = variable costs + fixed costs

In addition, the firm won·t be able to work at the optimal point of production in the short run.

**ISOQUANTS AND ISOCOSTS
**

K

In the SHORT RUN, at least one factor is fixed. Consider a firm expanding from a production of 20 units to 40 units, shown by the two different Isoquants. Ideally, the new mix of inputs would be K2 and L2 at a cost of £300. However, if we fix CAPITAL in the short run at the level of K1, we see to produce 40 units the firm has to employ L3 labour ² an inefficient level. It also has to operate on a higher Isocost line - £350 rather than £300. The MRTS is not equal to the ratio of input prices.

£350

£300 K2 K1 Q=40 Q=20 £150 L1 L2 L3 L

**SHORT RUN + LONG RUN
**

Short run costs are always above or equal to long run costs. Diagrammatically, the Long Run AC curve is simply an ¶envelope· of Short Run AC curves. The same can be said for the Long Run Total Cost function ² the SR TC functions will all exhibit a CUBIC pattern ² diminishing returns set in at higher output, so they rise quickly. The lowest point on the Long Run AC curve (the MES) had the property that:

y

Min LR AC = min SR AC = SR MC = LR MC

SRAC

y

SRAC = Av. Variable Costs + Av. Fixed Costs SRMC = d(SRTC)/dY = d(VC)/dY + d(FC)/dY = dVC/dY Slope of the SRTC function AND the VC functions.

SRMC

y y

PROFIT MAXIMISATION

Now we have seen how firms minimise costs for a given level of output, let us consider how the firm decides the level of output itself. Model a firm as acting in order to maximise economic profits ² the difference between total revenue streams and the total economic cost incurred. If so, we can directly derive the profit maximizing decision from the PROFIT FUNCTION: = TR(Q) ² TC(Q) Maximising conditions mean that marginal profit is to be set to zero (derivative take w.r.t Q): · = MR ² MC = 0 MR = MC It must also be the case that the second derivative is negative, hence we have found a maximum, not a minimum. By solving for this condition, we can derive the optimal Quantity to be produced. We then substitute this figure back into the profit function to calculate the maximum level of profit. We can graphically show the profit maximising condition as the quantity which yields the greatest distance between the TR and TC curves ² this occurs when the tangents are equal; i.e., MR =MC.

PROFIT MAXIMISATION

We can also use the profit function to derive the firm·s SUPPLY function and DEMAND function for inputs! A simple application of the envelope theorem is shown to the right; this application is called Hotelling·s Lemma: You can derive the demand functions normally by solving the profit Max problem

y

Differentiate profit function w.r.t the factor of production you want the demand function of, then rearrange.

**Important to note that these demand functions are unconditional:
**

y

x4 ( P, r , w) ! Q ( P, r , w) xP x4 ( P, r , w) ! K ( P, r , w) xr x4 ( P, r , w) ! L ( P, r , w) xw

They allow the firm to change output. Homogenous of degree 1 in all prices. Non decreasing in output price. Non increasing in input prices. Convex in output prices (that the average of two profits at two different output prices is greater or equal to the profit using the average of those two prices): Intuitive sense due to firms

**The Properties of profit functions are:
**

y y y y

**SUBSTITUTION + OUTPUT EFFECTS
**

**Two things will happen if the price of an input falls:
**

y

L Y

y

There will be a change in the input mix of production to take advantage of the fall in price (a movement ALONG the Isoquant curve) There will be more products sold due to the fall in costs which are passed on via lower prices (a SHIFT of the Isoquant).

Y·

The first effect is the SUBSTITUTION EFFECT. The second effect is the OUTPUT EFFECT. These effects are shown in the diagram to the side. The price of capital falls:

y y y

L L··

y

The Isocost line then TILTS due to a change in the ratio of input prices. This means that the product mix changes and more Capital is used. However, the fall in prices means that MC falls, which, with fixed prices, means output also rises. Output rises higher Isoquant, yet different product mix.

K

K·

K··

K

**SUBSTITUTION + OUTPUT EFFECTS
**

We can use a very similar analysis to that of Slutsky to measure the substitution + output effects incurred by a price change. In order to do this, recall that we can derive the:

CONDITIONAL input demand function, using Shephard·s lemma. y UNCONDITIONAL input demand function, using Hotelling·s lemma.

y

**The decomposition is therefore (for example, a change in the wage rate) thus: xL( P, r , w) xLC (r , w, Q ) xLC ( r , w, Q) xQ ( P, r , w) xw xQ xw xw
**

Total effect Substitution effect Output effect

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