The Firm and Technology Prot Maximization

Microeconomic Theory: Lecture 3

Production, Costs and the Firm

Parikshit Ghosh

Delhi School of Economics

Summer Semester, 2014

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

The Firm

The Firm
I Often a very large organization with thousands of workers.
I Starting assumption: objective is to maximize prots.
I Obvious exceptions: public sector organizations, non-prots,
vanity projects (sports teams).
I Inside the rm: a command economy. Outside the rm: a
market economy. What determines the boundary (Coase)?
I The joint stock company: separation of ownership and
management/labour. Gives rise to agency problems: do
managers have the incentive to maximize prots?
I Dynamic and strategic issues: there may be trade-os
between prot maximization in the short run and the long run.

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Technology

The Production Function

I The rm produces one output (y ) using n inputs
x = (x1 , x2 , . . . , xn ).
I The input-output relationship is captured in the production
function: y = f (x), where f (.) is continuous, strictly
increasing and (strictly) quasiconcave, with f (0) = 0.
I An isoquant is a set of input vectors that produce the same
output:
Q (y ) = fx 0jf (x) = y g
I Monotonicity and quasiconcavity of f (.) implies isoquants are
convex to the origin and higher isoquants represent higher
output.

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Technology

The Production Function: Characteristics

I Returns to scale:
I Constant Returns to Scale (CRS) if f (x) = f (x).
I Decreasing Returns to Scale (DRS) if f (x) < f (x).
I Increasing Returns to Scale (IRS) if f (x) > f (x).
I The production function is homogeneous of degree k if

f (x) = k f (x) for any x 0

I There is CRS, DRS, IRS if k =, <, > 1.

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Optimization

Prot Maximization
I A perfectly competitive market is a market where there are
a large number of buyers and sellers. Each agent takes the
prices as given, and assumes he will be able to buy/sell any
quantity he wants at these prices.
I The rm faces some input price p and a vector of output
prices, w = (w1 , w2 , . . . , wn ).
I The prot maximization problem:
max py wx subject to y f (x)
y ,x

I Becomes an unconstrained problem after incorporating the

(binding) constraint into the objective function:
max pf (x) wx
x

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Optimization

Two-Step Solutions: the Cost Function

I Break up the problem into two parts.
I Find the least costly way of producing any output level y :

c (w, y ) = min wx subject to f (x) = y

x

I Using this information, nd the most protable output level:

max py c (w, y )
y

I The cost min problem is the dual of the consumers problem.

I The cost function is the expenditure function.
I The conditional input demand functions, x(w, y ), are
Hicksian demand functions.

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Optimization

Cost Functions of Homogeneous Production Functions

Theorem
Suppose f (x) is homogeneous of degree k. Then the cost and
conditional input demand functions are multiplicatively separable in
y and w, and are given by
1
c (w, y ) = c (w, 1).y k
1
x(w, y ) = x(w, 1).y k

I The cost function is linear/convex/concave if returns to scale

is constant/decreasing/increasing.
I Marginal cost is constant/increasing/decreasing if the cost
function is linear/convex/concave.
Parikshit Ghosh Delhi School of Economics
Production, Costs and the Firm
The Firm and Technology Prot Maximization

Optimization

Proof of the Theorem

I The cost function can be rewritten as:

c (w, y ) = min wx subject to f (x) = y

x
1 1
1
= y k min w y k x subject to y f (x) = 1
x
1 1 1
= y k min w y k x subject to f y k x =1
x
1
= y k min wz subject to f (z) = 1
z
1
= c (w, 1).y k

I Similar proof for conditional input demand functions.

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Optimization

Returns to Scale and Competition

I First-order condition:
c (w, y )
p=
y
I Second-order condition:
2 c (w, y )
0
y 2
I For IRS technology, the second-order condition cannot be
satised anywhere! y is either 0 or . Not compatible with
perfect competition. IRS typically leads to natural monopolies.
I For CRS technology, the optimum is 0, [0, ] , when
p <, =, > c (w, 1). Optimum output can be indeterminate.
Parikshit Ghosh Delhi School of Economics
Production, Costs and the Firm
The Firm and Technology Prot Maximization

Optimization

Returns to Scale and Competition

I The prot function of the rm is the value function of the
prot-max problem:
(p, w) = max pf (x) wx
x
I First-order condition:
f (x )
p = wi
xi |{z}
| {z }
Marginal revenue product = price of input
I Second order condition: the Hessian matrix of f (.) must be
negative semi-denite (i.e. locally concave) at x .
I The choice functions x(p, w) are the (unconditional) input
demand functions. y (p, w) = supply function.
Parikshit Ghosh Delhi School of Economics
Production, Costs and the Firm
The Firm and Technology Prot Maximization

Functional Properties

Properties of the Prot Function

I Increasing in p (higher prot for every input choice).
I Decreasing in wi (lower prot for every input choice).
I Homogeneous of degree 1 in (p, w) (when input and output
prices are scaled up, relative prots remain unchanged).
I Convex in (p, w).
I Hotellings Lemma (using envelope theorem):

(p, w)
= y (p, w)
p
(p, w)
= xi (p, w)
wi

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Functional Properties

Convexity of the Prot Function: Proof

I Suppose optimal input-output choices are
I (y 1 , x1 ) at prices (p 1 , w1 ).
I (y 2 , x2 ) at prices (p 2 , w2 ).
I (y , x) at prices (p, w), where
(p, w) = (p 1 , w1 ) + (1 )(p 2 , w2 ).
I By denition of prot maximization:

p 1 x1 w1 x1 p1 x w1 x

p 2 x2 w2 x2 p2 x w2 x
I Taking weighted averages:

(p 1 , w1 ) + (1 ) (p 2 , w 2 ) (p, w)

Parikshit Ghosh Delhi School of Economics

Production, Costs and the Firm
The Firm and Technology Prot Maximization

Functional Properties

Implications of Convex Prot Function

I The Hessian matrix of (p, w) is symmetric, positive
semi-denite:
2 2 3 2 3
2 2 y y y
2
6 2 2
p pw 1 pw n
2 7 6
p w 1 w n
7
6 7 6 x1 x1 x1
7
6 w p w 12 w 1 w n 7 6 7
H = 6 1.
p w 1 w n
7 = .. ..
6 .. .. 7 6 7
4 . 5 4 . . 5
2 2 2 xn xn xn
w n p w n w 1 w n2 p w 1 w n

I All principal minors are non-negative ) diagonal elements are

non-negative.
I The supply function y (p, w) is increasing in output price:
y (p,w)
p 0.
I The input demand functions, x(p, w), are decreasing in own
x (p,w)
price, iw i 0.
Parikshit Ghosh Delhi School of Economics
Production, Costs and the Firm