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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 firms 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

Isoquant: Q(q) = {z: (-z, q) Y , (-z, q) Y q q, q q}

The isoquant Q(q) is usually the boundary closest to the origin of V(q).

Proposition: If Y is convex, so is V(q).

We normally do not require that the production possibility set is convex. If so, it will rule
out "start-up costs" and other sorts of returns to scale. (Do you see why?)

5.2 Production Functions

Transformation Function of the Production Possibility Set


For most production possibility sets, it is possible to describe them in item of single inequality of the
form T(y) 0. That is,
Y = {y: T(y) 0}
A function T that describes Y this way is called a transformation function.

Efficient Production

A production point y Y is efficient is there is no y Y , y y, with y y.


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.

Production Functions (Joan Robinson)

For those technologies that have a single output can be described by a production function, which
has both the theoretical and empirical appeal.
The netput vector has the form: (-z, q), where q is the output.

If the technology has a transformation function T, i.e., Y = {(-z, q): T(-z, q) 0}, then under
certain regularity conditions, we can solve T(-z, q) = 0 for all q, which leads to another function: q
= f(z). This function f is the production 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, i.e.,
f(z) = max{q: T(-z, q) 0}.

With a single output, the input requirement set V(q) is convex if and only if the corresponding
production function f(z) is a quasiconcave function.

MRTS and Separable Production Functions

With a given production function q = f(z), the marginal rate of technical substitution
(MRTS) between two inputs i and j is defined as follows:
f ( z ) / zi
MRTSij ( z )
.
f ( z ) / z j

Normally, MRTSij depends on the specification of all inputs. We can use MRTS to define separable
production functions, which involves regrouping the inputs into several mutually exclusive and
exhaustive subsets. For details, refer to p.221 of Jehle & Reny.

Elasticity of Substitutions
For a production function f(z), 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 )

,
z j / z i d ( f i (z ) / f j (z ))
where fi and fj are the marginal products of inputs i and j, and d(.) is the total differentiation.

MRTS is a local measure of substitutability between two inputs in producing a given level
of output. MRTS is not independent of the units of measurement.
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. The
elasticity of substitution is unitless.
In general, the closer the elasticity of substitution is to zero, the more difficult substitution
between the inputs; the larger it is, the easier substitution between them.

CES Production Function


The constant elasticity of substitution (CES) production function has the following form:

q f (z )

1/

z
i 1

i i

, where

i 1

1 and i 0 i.

It can be shown that for the above production function,


1
ij ( z )
i j.
1

Special Cases of CES Production Function

Linear Homogeneous Cobb-Douglas Production Function:


Correspond to the case when 0. (ij 1)
The basic functional form is
m

q f (z ) z i i .
i 1

A proof (for the case of n = 2) is in the Appendix of this note.

Leontief Production Function:


Correspond to the case when - . (ij 0)
The functional form is
q = f(z) = min{1z1, , mzm}.

The easiest way of proving this result is to check the corresponding MRTS ij of CES
production function as - , which lead to specific isoquants that are unique to
Leontief technology.
Another function form for the Leontief production function is as follows:

q f (z ) min{

z
z1
, , m }.
a1
am

It is clear from the function specification that a Leontief technology uses inputs in fixed
proportion, which implies that there is a single fixed formula for production.

Returns to Scale

A production function f(z) has the property of (globally)


1. Constant returns to scale if f(tz) = t f(z) for all t > 1 and all z.
2. Increasing returns to scale if f(tz) > t f(z) for all t > 1 and all z.
3. Decreasing returns to scale if f(tz) < t f(z) for all t > 1 and all z.

The most natural case of decreasing returns to scale is the case where we are unable to
replicate some inputs. In fact, it can always be assumed that decreasing returns to scale is due
to the presence of some fixed input.
To see this, let f(z) be a production function with decreasing returns to scale. Suppose that we
introduce another "new input" and measured by z0. Now define a new production function:
F(z0, z) = z0 f(z/z0).
It is easy to see that F exhibits constant returns to scale. In this sense, the original decreasing
returns technology f(z) can be thought as a restriction of the constant returns technology F(z0,
z) that results from setting z0 = 1.

Elasticity of Scale

The elasticity of scale is a local measure of returns to scale. It, defined at a point, 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

f (z )

We say that returns to scale are locally constant, increasing, or decreasing when (x) is equal to,
greater than, or less than one.

Constant Returns to Scale and the Marginal Productivity Theory of Distribution


From the definition of a homogenous production function, differentiation with respect to k, evaluated at
k=1, we have sy = xifi where fi f/xi.
A production function homogenous of degree s, the marginal product of each factor is homogenous of
degree s-1. To show this, differentiate with respect to xi.
5.3 The Cost Function
Basic Settings:
output vector: q R+n;; input vector: z R+m;
input factor price vector: w R+m;
Recall that for the given output vector q, the input requirement set is defined as

V(q) = {z: (-z, q) Y }

Cost Function. The cost function of a firm is the function


c(w, q) = min wz
s.t. z V(q)
defined for all w 0, q 0.

If there is a single output and the production technology is fully represented by the production
function q = f(z), then
c(w, q) = min wz
s.t. f(z) q
If z(w, q) solves this minimization problem, then
c(w, q) = wz(w, q)

The solution z(w, q) is referred to as the firm's conditional input demand functions (also
known as conditional factor demand functions), since it is conditional on the level of
output q, which at this point is arbitrary and so may or may not be profit-maximizing.
The inequality constraint can usually be replaced by the equality.

Calculus Analysis of Cost Minimization


Consider the following cost-minimizing problem:
c(w, q) = min wz
s.t. f(z) = q
Then the corresponding Lagrange function is
L(z, ) = wz - (f(z) - 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, , m.

which leads to the geographical illustration of the cost minimization (tangency condition) indicated as
below.
Factor 2 (z2)

C = w1 z1 + w2 z2 (Isocost)

f(z1, z2) = q (Isoquant)

Factor 1 (z1)

The above figure indicates that there is also a second-order condition that must be checked, namely, the
isoquant must lie above the isocost line. This, for the case of two inputs, leads to that the bordered
Hessian matrix of the Lagrangian,

2L 2L
2L

2
z1 z1z 2 z1 f
f 12 f1
11
2L 2L 2L

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.
Examples:
Cost function for the Cobb-Douglas technology: q = K1/2 L1/2, where K is the capital (with
a unit price of w1 - rental) and L is the labor (with a unit price of w2 - wage). Then the
corresponding cost function is
c ( w1 , w2 ; q ) 2q w1 w2
For the general Cobb-Douglas production function:
m

q f (z ) z i i .
i 1

The corresponding cost function is given by:

c (w , q ) q

1/

i /

, with i

i 1

Cost function for CES Technology: q = (az1 + bz2)1/, by using the first-order Lagrangian
conditions, we can derive the cost function given by:

w
c( w1 , w2 ; q ) q 1
a

wi

i 1 i
m

w
2
b
r

1/ r

, with r

( 1).
1

Cost function for Leontief Technology:

q f (z ) min{

z
z1
, , m }.
a1
am

Its cost function is given by: c(w, q) = q wa.


General Properties of Cost Functions

If the production function f is continuous and strictly increasing, then c(w, q) is


1. Zero when q = 0.
2. Continuous on its domain
3. For any all w > 0, strictly increasing and unbounded above in y.
4. Increasing in w.
5. Homogenous of degree one in w.
6. Concave in w.

5.4 Conditional Input Demand Functions

For the given cost minimization problem, the solution z(w, q) is the firm's conditional input demand
function. Applying the usual argument, z(w, q) must satisfy the first-order conditions:
f ( z (w , q )) q,

w f ( z ( w , q )) 0.
Differentiating these identities with respect to w we will have the following:
f (z ( w , q ))z ( w , q )) 0

I 2 f ( z ( w , q ))z (w , q )) f (z ( w , q )) ( w , q )) 0
which, in term of matrices, become:

2 f ( z )

f ( z )

f ( z ) T
0

z ( w , q )
I

( w , q ) 0

From this, we can solve for the substitution matrix z(w, q) by taking the inverse of the bordered
Hessain matrix:
2 f ( z )
z ( w , q )


( w , q )
f ( z )

f ( z ) T
0

I

0

This result is in fact associated with comparative statics of the conditional input demand functions
with respect to the input prices.

Shephard's Lemma: (The derivative property) Let z(w, q) be the firm's conditional input demand
function. Assume that c(w, q) is differentiable at w with w > 0, and

c ( w, q )
z i ( w, q ),
wi

i 1,..., n.

This result is a direct application of Envelope Theorem.


Shephard's lemma implies that the cost function is a non-decreasing function of input
prices.

It is easy to see that the conditional input demand functions are homogeneous of degree 0.

Note:

5.5 Short-Run & Long-Run Costs


Recall that the cost function can be expressed as the value of conditional input demands:
c(w, q) = wz(w, q).

In short-run, some of the inputs are fixed. Let zf be the vector of fixed inputs, zv the vector of
variable inputs. We also break the vector of input prices w = (wv, wf).
The short-run conditional input demand functions: zv(w, q, zf).
Short-run cost function is then given by:
sc(w, q, zf) = wv zv(w, q, zf) + wf zf SVC + FC = STC

Other derived cost concepts are


Short-run average cost (SAC) = sc(w, q, 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, q, zf)/q

In the long-run, all production factors are variable. In this case, the firm must optimize in the
choice of zf. We can express the long-run cost function in terms of the short-run cost function

in the following way.


Let zf(w, q) be the optimal choice of the fixed inputs, and let zv(w, q) = zv(w, q, zf(w, q)).
Then the long-run cost function is given by:
c(w, q) = wv zv(w, q) + wf zf (w, q) = sc(w, q, zf(w, q)).

Similarly, we will have two derived long-run cost concepts:


Long-run average cost (LAC) = c(w, q)/q
Long-run marginal cost (LMC) = c(w, q)/q

Proposition (Cost Envelope) - Relationship Between Short-run & Long-Run Costs


For ease of presentation, we drop the argument of w (the fixed input prices) assume a single fix input z.
Then, c(q) = sc(q, z(q)).

For a given output q*, let z* = z(q*) is the associated (optimal) long-run demand for the fixed
input. Then it is clear that
The short-run cost, sc(q, z*), must be least as large as the long-run cost, c(q, z(q)), for all
levels of output.
The short-run cost will equal to the long-run cost at the output q = q*, i.e.,
sc(q*, z*) = sc(q*, z(q*)) = c(q*).
This implies that the long-run and the short-run cost curves must be tangent at q*.
The above result follows from the following argument, which comes from the envelope
theorem:
dc(q*)
dsc (q*, z ( q*) sc (q*, z*) sc ( q*, z*) dz ( q*)
sc (q*, z*)

,
dq
dq
q
z
dq
q
since z* is the optimal choice of the fixed input at the output level q*, which implies that

sc ( q*, z*)
0.
z

Finally, note that if the long-run and short-run cost curves are tangent, the long-run and
short-run average cost curves must also be tangent. In other word, the long-run average
cost curve is the lower envelope of the short-run cost curves.
The geometric illustration of the above result is as follows:
AC
SAC
LAC
AC(q*,z*)

q*

Technical Appendix of Topic 5


Derivation of Cobb-Douglas Production Function from CES Form
It suffices to consider the case for n = 2. Note that

q f ( z1 , z 2 ) z1 (1 ) z 2

1/

We need to work out the limit of f as 0. Since ( (z1) + (1- ) (z2) ) 1 as 0, the limiting
problem of f as 0 becomes an indeterminate form of 0. To find the limit of this nature, we have to
find the limit of the logarithm of f:

ln(z1 (1 ) z 2 )
lim ln f ( z1 , 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); and (2) L'Hopital's Rule.) Therefore, we have

lim f ( z1 , z 2 ) z1 z 12 .
0

For the general case, the proof is similar.


Additional References:
Arrow, K. J., H. Chenery, B. Minhas, and R. M. Solow (1961) "Capital-Labor Substitution and
Economic Efficiency," The Review of Economics and Statistics, vol. 43, 225-250.
Blackorby, C. and R. R. Russell (1989) "Will the Real Elasticity of Substitution Please Stand Up? (A
Comparison of the Allen/Uzawa and Morishima Elasticities)," American Economic Review, vol.
79, 882-888.
Diewert, W. E. (1971) "An Application of the Shephard Duality Theorem: A Generalized Leontief
Production Function," Journal of Political Economy, vol. 79, 481-507.
Diewert, W. E. (1975) Applications of Duality Theory, in Frontiers of Quantitative Economics, ed.
M. D. Intriligator and D. A. Kendricks, North Holland, Amsterdam.
Diewert, W. E. (1982) Duality Approaches to Microeconomic Theory, in Handbook of Mathematical
Economics, vol. 2, ed. K. J. Arrow and M. D. Intriligator, North Holland, Amsterdam.
Nadiri. M. I. (1982) Producers Theory, in Handbook of Mathematical Economics, vol. 2, ed. K. J.
Arrow and M. D. Intriligator, North Holland, Amsterdam.
Shephard, R. W. (1970) Theory of Cost and Production Functions. Princeton: Princeton University
Press.
Uzawa, H. (1962) "Production Functions with Constant Elasticities of Substitution," The Review of
Economic Studies, vol. 29, 291-299.