THEORY OF THE FIRM 1

1.0 Introduction
In this lesson, we begin by a review of the meaning of microeconomics.

Microeconomics is concerned with the behavior of individual economic units and their

interactions. The two types of economic units typically considered are firms and

consumers. The major type of interaction that is usually analyzed is that of market

interaction. These concepts will be the primary focus.

In studying economic units and their interaction, we will utilize two major analytical

techniques

1. Optimization: - we will model the behavior of economic units as optimizing

behavior. In so doing we need to specify the objective of the unit and the

constraints which it faces. For example when we model the behavior of firms, we

will want to describe the objective as profit maximization and the constraints as

technological and market constraints. When we model the behavior of consumers,

we will describe the objective as utility maximization and the constraints as

budget constraints.

2. Equilibrium analysis:-at its broadest level it can be viewed as the analysis of

what happens to the economic system when all of the units’ behavior is

compatible. Thus we will typically not be concerned with the analysis of an

economic system when some consumers /firms find their action thwarted.

If we accept the model of optimizing behavior and restrict ourselves to the

examination of equilibrium states, then the focus of microeconomics becomes the

examination of situations in which no economic unit can further its objectives through

feasible changes in its behaviors, that is, in an economic equilibrium each unit is

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choosing an action which, given the choices of the other agents, it perceives as optimal,

and the resulting behavior of the system as a whole is feasible.

1.1. Objectives
By the end of this lesson, the learner should be able to:

• Distinguish between production function and an input requirement set.

• Understand the properties and the types of production functions.

• Understand the cost function and its properties.

• Understand the duality aspect between the cost function and the production

function.

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1.2. Theory of the Firm (Producer)

A firm is a decision making unit/entity which through process of production converts

inputs into outputs. The producer is assumed to be motivated by the objective of

maximizing profits where:

Profit= Gross revenue-Expenditure

π = TR − TC

TR = PQ

Where P is the output price and Q is the output

Other objectives of the firm include:

• Revenue maximization

• Cost minimization

• Market share maximization

It is assumed that the objective of a firm is to maximize profits but subject to:

(i) Technological constraints, that is, the relationship between inputs and

outputs. This relationship shows all the conceivable combinations of

inputs where output is assumed to be continuously divisible.

(ii) Market constraints. This is concerned with the effects of actions of other

agents on the firm. However, the firms are assumed to be competitive,

that is, price takers in both inputs and outputs. Therefore the focus will

be on technological constraints.

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1.2.1. The production function
The simplest and most common way to describe the technology of the firm is the

production function. It represents the maximum output that can be produced using a

given set of inputs.

Mathematically, Q = f ( inputs )

Output Q

Q = f ( Inputs )
Q2
Production
Q1
possibilities
set

X1 X2 Inputs X

Given any sets of inputs say x1 , the maximum possible Q is Q1 , for X 2 is Q2 .The

area below the production function represents the set of feasible production plans or the

production possibilities set. We assume that there exists a general function f ( z ) = 0

where z is real valued, M-dimensional vector containing both inputs used and quantity
produced in a given time period. We would further represent the function as

f ( z1 , z 2 ,..., −z 6 ,−z 7 ) where a positive sign represents an output and a negative

represents inputs. Such a function is referred to as the Net-put vector.

To avoid confusion, the equation can be re-written as; f ( y , x ) = 0 where x is an

N-dimensional vector of non-negative inputs and y is an (M-N) dimensional vector of

non-negative outputs.

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The explicit form of the above equation expresses the vector of outputs as a function of

the vector of inputs, that is y = f ( x ) . If the highest level of output is isolated from the

net-put vector, and expressed as a function of a given set of inputs, it provides the

production y i = f ( x ) where y i is a unique level of output and x is a given set of

inputs.

1.2.2. Properties of the production function:

1. Monotonicity

(i) Weak monotonicity

If x ' and x are two vectors of inputs such that, x ' ≥ x then the output produced from

x ' and x is such that f ( x ' ) ≥ f ( x ) where 0 < x < x

I.e. the output produced from x ' must be at least equal to the output from x

(ii) Strong monotonicity

Given the two vectors of inputs above, such that x ' > x then f ( x' ) > f ( x)

where 0 < x < x i.e. the output produced from a superior vector of inputs must be strictly

greater.

2. The input requirement set.

V ( y ) = { x : f ( x ) ≥ y}

The input requirement set is a convex set, i.e. it is all the input combinations x capable

of producing at least output level y . This property implies that the law of diminishing

marginal rate of technical substitution holds.

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 X2

V ( y)

y
X1

Alternatively, the property implies that if x 1 and x 2 are both elements of the input

requirement set V ( y ) , then their convex combination x 3 given by

x 3 = Qx 1 + (1 − Q ) x 2 where 0 < Q < 1

Is also an element of the V ( y ) . I.e. x 3 is also capable of producing y .

Further more, convexity of V ( y ) implies that if x 1 and x 2 can produce y , then

any weighted average of these two input bundles can also produce y .

3. The production function is concave

The boardered Hessian matrix is negative semi-definite. A boardered Hessian matrix is a

matrix of the second order derivatives. Given a production function y = f ( x1 , x 2 ) then

the Hessian matrix is;

x1 x2

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  ∂ 2y ∂ 2y 
 ∂ x 2 ∂ x1∂ x2 
 1 
x1
H = <0

∂ y ∂ y 
2 2
x2

 ∂ x2∂ x1 ∂ x22 

 ∂y 
∂2 y ∂ 
Where 2 =  dx i  = ∂MPx i < 0
∂xi
∂xi ∂xi

I.e. The principal diagonal of the Hessian matrix should be negative because the

production function must obey the law of diminishing returns.

α α2
e.g. y = Ax1 1 x2 , α 1, α 2 < 1

∂y α −1 α
= α1 A x1 1 x2 2
∂x1

∂2 y
= α1 (α1 − 1) Ax 1α1 −2 x 2α2
∂x12

∂y α α −1
= α2 A x1 1 x2 2
∂x2

∂2 y
= α2 (α2 − 1) Ax1α1 x2α2 −2
∂x22

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4. (a) Weak Essentiality

It states that without inputs we cannot produce any output i.e. to produce a

positive output, we need at least one input.

i.e. f (0n ) = 0,

Where 0 n is a null vector.

(b) Strict essentiality (No free lunch)

If any of the inputs in the input bundle is zero, then output is zero, that is, all

inputs are essential.

f ( x1 , x2 ,... xi −1 ,0, xi +1 ,... xn ) = 0

e.g. given the function y = α1 x1 + α 2 x 2 , if one input is zero say x1 = 0 , there is

an output y = α 2 x 2 . However, given a multiplicative function such as y = x1α 1 x 2α 2 ,

then if one input is zero, output is also zero.

V ( y)

5. The input requirement set is closed and non empty for all positive

values of y , i.e. the boundary of V ( y ) is included in the set. Non-emptiness

means that it is always possible to produce any positive output, i.e. feasibility

assumption. Closed-ness is required so as to avoid the possibility of having

“holes” in the boundary of V ( y )

6. The production function f ( x ) is finite, non-negative, real single valued with

non-negative and finite inputs x .

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7. The production function is everywhere continuous and twice differentiable.

An example of a technology that is neither continuous nor everywhere

0 ≤ x < 1 
1 ≤ x < 2 

 

differentiable is; f ( x ) = . 
. 
 

n ≤ x < n + 1


1.2.3. Types of production function

1. The fixed proportion production function (Max Leontief).

It takes the form; f ( x ) = min (α1 x1 , α2 x 2 ,...... αn x n ) i.e., it equates the output level to

the smallest possible value of αi xi

For example f ( x ) = min (α 1 x1 , α 2 x 2 )

If α1 x1 = 10 & α 2 x 2 = 15

Then f ( x ) =10

This function assumes that inputs are complements in production.

The input requirement set is L shaped as show below

X2

V ( y)

X1
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2. Linear production function.

It takes the form,

n
f ( x ) = ∑ α i xi = ( α 1 x1 + α 2 x 2 + ... + α n x n ) , α i > 0
i =1

The function assumes that the inputs in production are perfect substitutes.

The input requirement set is linear as shown below.

X2

V ( y)

X1

3. Generalized power function:

It takes the form

n
f ( x) = A∏ xih ( x ) g ( x )
i =1

Where;

h( x ) = αi
g ( x) = 0

n
f ( x ) = A∏ xiαi
i =1

i =1,2......

f ( x ) = A x1 1 x2 2 .........
α α
co b bd o u g la sfu n ctio n

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 Where A is an efficiency parameter and measures the level of technical progress and

α1 and α2 are input elasticities of the output or factor shares i.e.

f ( x ) = A x1 1 x2 2
α α

α −1 α2 x
= α1 A x1 1 x 2
* 1
α1 α 2
Ax x
1 2

= α1 (elasticity)

. The input requirement set is shown in the graph below.

X2

V ( y)

X1

The inputs are imperfect substitutes in production.

4. Constant elasticity of substitution (C.E.S.) production function.

It takes the form:

f ( x ) = A(α 1 x1−  + (1 − α 1 ) x2−  )

v
−


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 Where: A is an efficiency parameter.

 is substitution parameter, i.e. it measures the ease with which two

inputs can be substituted.

α is distribution parameter. It shows how the two inputs are distributed over

the production of one unit of output.

V is the degree of the homogeneity of the production function. It is a

measure of returns to scale.

1.2.4. The MRTS Vs Elasticity of substitutes (δ ) .

MRTS shows the rate at which input xi can be substituted for another input x j while

output remains constant, i.e. it’s the adjustment of xi which is necessary to preserve

output after x j changes.

∂f
∂xi
MRTS ij = −
∂f
∂x j

∂f
Where; = MPi = f i
∂xi

∂f
= MP j = f j
∂x j

So that;

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 fi
MRTS ij =−
fj

As a measure of degree of substitutability between inputs, MRTS suffers from a serious

defect, i.e. The value depends on the units of measurements of the input involved in

production.

A superior measure in this regard is the elasticity of substitution (δ ) . It’s defined as the

proportionate change in the input ratio divided by the proportionate rate of change in

MRTS.

x 
∂ i 
 x  MRTS
=   ×
% change in input ratio j
δ=
% change in MRTS ∂MRTS  xi 
 
 xj 
 

Or,

fi f j
δ=
Qf ij

Example of a Cobb Douglas function

Q = AL α K β

∆Q
fL = = αALα−1 K β
∆L

∆Q
fk = = βALα K β −1
∆K

fl αALα−1 K β
=
fK βALα K β −1

α K
MRTS = ×
LK
β L

K β
= × MRTS
L α
LK

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 K 
∂ 
L =β
∂MRTS α

αK
β MRTS β βL
δ= × = × =1
α K α K
L L

Or

fL fK αALα −1 K β × βALα K β −1
δ= = =1
Qf LK β αALα −1 K β −1 × ALα K β

Example of a linear production function

Q = αL + βK

fL =α
fK = β
fL α
MRTS = =
fK β

fL fK αβ
δ= = =∞
Qf LK 0 × ( αL + βK )

Example of a fixed proportion production function

Q = min (αL, βK )
if αL < βK

Then Q = αL

f L =α
f K =0
f LK = 0

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 fL fK α ×0
δ= = =0
Qf LK 0 × αL

The elasticity of substitution for the CES.

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 ( )
1
−
Q = A αL− + βK − 

∆Q
( )
1
1 − −1
fL = = − A αL− + βK −  × −αL−−1
∆L 
( )
1
1 − −1
f L = − A αL− + βK −  × −βL−−1

α L−−1 α K +1
MRTS = =
β K −−1 β L+1
+1
α K 
MRTS =  
βL
+1
K  β
  = × MRTS
L α
1
K  β  +1 1
=   ( MRTS ) +1
L α 
K 
∂  1
 L  =  β  +1 × 1 ( MRTS 1
) +1−1
 
∂( MRTS )  α   +1
K 
∂ 
MRTS
δ=   ×
L
∂( MRTS ) K
L
1
 β  +1 1 1 MRTS
=  × ( MRTS ) +1−1 ×
α   +1 1
β  +1 1
  ( MRTS ) +1
α 
1
=
 +1

Under different assumptions about  , the C.E.S can collapse into any of the specific

forms of production functions e.g. if  = 0 , then δ =1, which resembles the Cobb

Douglas production function and hence the two factors of production are imperfect

substitutes. That is, C.E.S will manifest itself as a Cobb Douglas function.

If  = −1 , then δ =∞ and the factors are assumed to be perfect substitutes. The C.E.S

manifests itself as a linear function.

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If  = ∞ and δ =0 and the factors are assumed to be complements. The C.E.S manifests

itself as the fixed proportions production function.

Illustration

Given the CES production function

( )
1
Q = A αL− + (1 − α ) K −
−


( )
1
Q
= αL− + (1 − α ) K −
−

A

Raising both sides by −

Q = (αL− + (1 − α ) K − )
1 −
A

Taking a total derivative of this function.

−e −1
Q
− ∂Q = −αL−−1∂L + −(1 −α) K −−1∂K
A

Dividing through by −

− e −1
Q
∂Q = α L−−1∂L + (1 − α ) K −−1∂K ............ *
A
Suppose  = 0
−1
Q
∂Q = αL−1∂L + (1 −α) K −1∂K
A
∂Q α∂L (1 −α)∂K
= +
AQ L K

Integrating the function back

1 ∂Q ∂L ∂K
+(1 −α) ∫
A∫ Q
=α∫
L K

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 ln Q
= α ln L + (1 − α ) ln K
A
ln Q
= ln Lα + ln K (1−α )
A
= ln ( Lα K 1−α )
ln Q
A
Q
= Lα K 1−α
A
Q = ALα K 1−α (Cobb Douglas function )

From equation * above,

Suppose  = −1
−1
Q
∂Q =αL−1∂L +(1 −α) K −1∂K
A

1
∂Q = α∂L + (1 −α ) ∂K
A

Integrating the function back

1
∂Q = α∫ ∂L + (1 −α) ∫ ∂K
A∫

1
Q = αL + (1 − α ) K
A

Where A = 1

Q = αL + (1 − α ) K ( Linear production function )

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Alternative

The L’hopital’s rule

f ( x)
The rule states that if lim = 0, ∞ then we take the same limit but on the
x →0 g ( x)

f ' ( x)
differentiated function i.e. lim
x →0 g' ( x)

Consider the CES production function

( )
1
Q
= αL−  + (1 − α ) K − 
−

A

Raise both sides by −

−
Q 
  = αL− + (1 − α ) K −
 A

Taking logarithms on both sides

−

ln   = ln (αL− + (1 −α ) K − )
Q 
 A

ln
[
Q − ln αL− + (1 −α ) K −
=
]
A 

Let
[
M ( e ) = − ln αL− + (1 − α ) K − ]
N ( e) = 

Q M ( e)
lim
→0 A
=
N ( e)
=0

Hence
N ' () = 1
−1α ln L− + −1(1 − α ) K − ln K
M ' ( ) =
αL−e + (1 − α ) K −

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 M ' ( ) α ln L + (1 − α ) ln K
Taking lim =
→0 N ' ( ) 1

Q
ln = ln Lα + ln K (1−α )
A
= ln ( Lα + K ( 1−α ) )
Q
ln
A
Q = ALα K 1−α ( Cobb Douglas function )

Activity

You are provided with the following production function where y the output is and x

is the input: y = x a , for what values of a is the production function a legitimate

function?

Hint: check it against all the properties of a production function.

Question

Distinguish between a production function and a production possibilities set.

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Note

A production function represents the maximum possible output from any given set of

inputs.

Summary

In this lesson, we have defined and learnt the properties of a production function. We

have also learnt the different types of production functions and how under certain

assumptions, the CES type may give rise to any other specific production function.

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