Economics 50: Intermediate Microeconomics

Summer 2010
Stanford University
Michael Bailey
Lecture 5: Production Functions and Prot Maximization
Overview
The production function is the highest level of production the rm can produce with a set of inputs
Most realistic production functions are monotonic, convex, and have diminishing returns
When '1 1, 1 is increasing. When '1 < 1, 1 is decreasing
In the short run, at least one factor of production is xed
The technical rate of substitution is the rate at which one input r

can be substituted for another

input r
I
to keep output constant
A production function has
Constant Returns to Scale if )(`r) = `)(r)
Increasing Returns to Scale if )(`r) `)(r)
Decreasing Returns to Scale if )(`r) < `)(r)
The elasticity of substitution o = -K
L
,T1S
L;K
is a measure of the curvature of the isoquant and indicates
how substitutable inputs are for each other. A high o indicates the inputs are good substitutes in the
production process
A prot maximizing rm sets marginal revenue equal to marginal cost
In a perfectly competitive market, the objective function of the prot maximizing rm is max j

)(r)

n
I
r
I
and has a solution given by the optimality condition that the marginal revenue product of the
input equals the input price
The factor demand functions, r

I
(j

, n), are the optimal choice of the inputs as a function of the prices:
r

I
(j

, n) = arg max j

)(r)

n
I
r
I
1
The supply function, j

(j

, n), is the optimal supply as a function of the prices:

j

(j

, n) = )(r

1
(j

, n), ..., r

n
(j

, n))
The prot function, is the maximum prots attainable given prices:
(j

, n) = j

(j

, n)

n
I
r

I
(j

, n)
The weak axiom of prot maximization is that rms choices must yield higher prots than any other
point from its revealed production set
Producer Theory
So far, we have looked at the determinants of consumer demand. Individual demand is derived from con-
sumers optimal choices and market demand is the summation of consumer demand. Now we will turn our
attention to the determinants of supply by analyzing the behavior of producers; we will see that many of the
theories and conclusions of consumer theory have an analog in producer theory. We assume that producers
are prot maximizers. Recall that prots are given by:
Prots = Revenue Costs
= jj c(j)
Just as consumer theory looks at the implications of a model of utility maximizing consumers, producer
theory looks at the implications of a model of prot maximizing producers. There are two major constraints
on the producer: (1) technological constraints and (2) market constraints. Technological constraints dictate
how the
0
j
0
can be produced, or what inputs can be turned into the outputs. Market constraints dictate how
prices and costs are determined in the market. For example, in a perfectly competitive market the rm takes
the output price as given, whereas a monopolist sets the output price. We begin by assuming the rm is in
a perfectly competitive market that takes all output and input prices as given, and look at the technological
constraint side of prot maximization. Later in the course we will introduce dierent market constraints.
Technology
A technology is a way to combine inputs into outputs. For example, suppose that r = (r
1
, ..., r
n
) is a vector
of inputs and j = (j
1
, ..., j
|
) is a vector of outputs. A technology would be represented by some function
2
q(r) = j. The production set is the set of inputs and outputs such that the outputs are technologically
feasible to create with the inputs, or the set of inputs and outputs (r, j) such that there exists a technology
q() such that q(r) = j. We will assume in this class that the rm is only producing one output, j = j
1
.
Figure 1: A production set for a convex technology
Production Function
Because we assume the rm is a maximizer, we only are worried about those technologies that produce more
output, given the inputs, than any other technology. If the rm used a technology that produced less output,
then it would be losing potential revenue.
Denition 1 The production function is the maximum possible output given a vector of inputs, )(r) = j.
Example 2 Examples of production functions, often using labor (1) and capital (1) as inputs, include:
Perfect Complements )(1, 1) = (min(a1, /1))
~
Perfect Substitutes )(1, 1) = (a1 + /1)
~
Cobb Douglas )(1, 1) = 1
o
1
b
Constant Elasticity of Substitution (CES) )(1, 1) = (a1
o
+ /1
o
)

These have the same interpretation as in consumer theory. For example, perfect complements means the
rm will always use inputs in the same ratio a1 = /1. is a term that we call a "technology shifter" because
it increases the amount of output the rm can get for the same amount of inputs.
3
The CES production function is the general form of the rst three production functions depending upon
the value of c. When c = 1, it is equivalent to perfect substitutes. When c 0, the production function
becomes Cobb-Douglas in the limit (take logs and use LHospitals Rule). When c , the production
function becomes perfect complements.
Denition 3 An isoquant is a level curve of the production function, or a set of inputs that will produce the
same amount of output j.
Isoquants are the analog to indierence curves in consumer theory. Note that in producer theory, the
level of production, j, is not arbitrary like utility, it has an actually physical meaning, 3 cars is not the same
thing as 6 cars. Production functions are not just a rank over bundles like a utility function, it literally tells
us how much of an output those inputs can produce given the production function. In consumer theory, we
always set = 1 because the actual level of utility doesnt matter, in producer theory it does and we let
act as a parameter that dictates the level of production we can attain.
Example 4 )(1, 1) = min(1, 1)
0 1 2 3 4 5 6 7 8 9 10
0
1
2
3
4
5
6
7
8
9
10
L
K
Figure 2: Isoquants for the perfect complements production function )(1, 1) = min(1, 1) for production
levels of 3 and 6
Example 5 Cobb Douglas )(1, 1) = 21
1/3
1
2/3
4
0 1 2 3 4 5 6 7 8 9 10
0
1
2
3
4
5
6
7
8
9
10
L
K
Isoquants for the Cobb-Douglas production function )(1, 1) = 21
1/3
1
2/3
with output levels equal to 5 and
10
Axioms of Technology
Axiom 6 A technology is monotonic if it can create at least as much output if an input is increased.
A production function is monotonic if
J}(r)
Jri
_ 0 for all inputs r
I
.
The monotonicity axiom just says that more inputs can only help the rm create more output, or at
worst not decrease output. Similar to consumer theory, monotonicity means that the isoquants cannot be
upward sloping and are not thick.
Axiom 7 A technology is convex if for , 1 Production Set, then ` + (1 `)1 Production Set.
If the technology is convex, the production function is concave: for two input vectors r
1
and r
2
that yield
the same output j, )(r
1
) = )(r
2
) = j, the production function is concave if )(`r
1
+ (1 `)r
2
) _ j.
The convexity assumption means the rm can produce just as much output with the average of two input
bundles then with the bundles themselves. This means that the production function is concave, or always
lies above the line between two points, and the isoquants are convex.
5
Figure 3: This technology is convex: the production set is convex and the production function is concave
Figure 4: A technology that is not convex, the production function is not concave
6
Marginal Product and Average Product
Denition 8 The marginal product of factor r
I
,
J}(r)
Jri
= '1
ri
is the additional output from increasing
factor r
I
on the margin.
The marginal product is the analog to marginal utility, but note that the marginal product has an actual
meaning, the extra output is a physical amount, unlike marginal utility. Notice that the marginal product
is the slope of the production function.
Denition 9 The production function has diminishing returns in factor r
I
if
J
2
}(r)
Jr
2
i
_ 0.
Denition 10 The law of diminishing returns holds if lim
ri!1
J
2
}(r)
Jr
2
i
_ 0 for all inputs r
I
; the marginal
product of all factors eventually are decreasing, holding all other factors constant.
The law of diminishing returns holds if eventually each additional input is less productive, holding all
other inputs constant. Think of a farm plot. The rst worker is very productive and can work the best parts
of the land, whereas the next work is less productive and can still produce output, but not as much as the
rst worker. As more and more workers are added, holding capital equipment and land xed, each additional
worker becomes less productive being relegated to the marginal land and using the worst equipment. If the
law of diminishing returns did not hold, the worlds food supply could be grown in a ower pot.
Denition 11 The average product of factor r
I
,
}(r)
ri
= 1
ri
, is the quantity of output produced per unit of
input r
I
.
The average product is the slope of the line from the origin to the point of interest ((r
I
, )(r)). If the
'1
ri
1
ri
, then 1
ri
must be increasing and if '1
ri
< 1
ri
, then 1
ri
must be decreasing. If you
add terms that are higher (lower) than average to the series, the average of the new series must be higher
(lower).
7
Figure 5: The average product is the slope of the line from the origin to the point on the production function.
The marginal product is the slope of the line tangent to the production function
Figure 6: When '1 1, 1 is increasing. When '1 < 1, 1 is decreasing
8
Short Run versus Long Run
In the short run, at least one input (often referred to as a factor of production), is xed at some level that
cannot be changed. In the long run, all inputs are variable. For example, a rm might have a xed level
of capital corresponding to a factory that it has built. In the long run, it can produce more factories, or
demolish existing factories, so capital is completely unconstrained.
Example 12 Suppose that capital is xed at 1 = 1, then the production function )(1, 1) = 1
1/2
1
1/2
is the short run production function. The long run production function is )(1, 1) = 1
1/2
1
1/2
. The xed
variables are exogenous in the short run.
Technical Rate of Substitution
If the rm used one less unit of capital, 1, how much more labor, 1, would it need to employ so that
production remains the same? If we take the total derivative of the production function (with two inputs, 1
and 1), we would have that:
dj = '1
J
d1 + '1
1
d1
To keep production constant we set dj = 0, and solve:
'1
J
d1 + '1
1
d1 = 0
'1
J
d1 = '1
1
d1

d1
d1
=
'1
J
'1
1
Thus to keep production constant, the rate at which we would substitute the two inputs to keep production
constant is
11
L
11
K
which is minus the slope of the isoquant
J1
JJ
. We call this the technical rate of substitution
1
:
Denition 13 The Technical Rate of Substitution of input r
I
for input r

, T1o
ri,rj
=
11x
i
11x
j
, is the rate at
which input r

can be substituted for input r

I
to keep output constant.
Notice that if we have
JT1Sx
i
;x
j
Jri
_ 0, then the technology is convex.
Example 14 )(1, 1) = 21
1/3
1
2/3
T1o
J,1
=
'1
J
'1
1
=
2(1,3)1
2/3
1
2/3
2(2,3)1
1/3
1
1/3
=
1
2
1
1
1
Technically, this is the marginal technical rate of substitution, MTRS; which only considers innitesimal changes. The
Technical Rate of Substitution considers discrete changes
K
L
:
9
Returns to Scale
Denition 15 A production function has
Constant Returns to Scale if )(`r) = `)(r)
Increasing Returns to Scale if )(`r) `)(r)
Decreasing Returns to Scale if )(`r) < `)(r)
Notice that the denition of constant returns to scale is equivalent to homogeneity of degree 1. If the
production function is homogenous of degree r 1, then it will satisfy increasing returns to scale, and if it
is homogenous of degree r < 1, it will satisfy decreasing returns to scale.
Remark 16 If a production function has increasing returns to scale, it will lie above the j = r
1
line in the
one-input case (above the

r
I
= j hyperplane in the multi-input case). Similarly, it will lie on or below the
j = r line if it has constant or decreasing returns to scale respectively.
Example 17 )(1, 1) = 1
o
1
b
)(`1, `1) = (`1)
o
(`1)
b
= `
o+b
1
o
1
b
= `
o+b
)(1, 1)
== homogenous degree r = a + /
10
Figure 7: Three production functions that have increasing, constant, and decreasing returns to scale
Elasticity of Substitution
A measure of how substitutable two inputs are in a production process would be very useful. The technical
rate of substitution tells us how substitutable two inputs are at a certain point, but it does not inform us of
how substitutable the two goods are along the entire isoquant. If the rm varies the ratio of inputs greatly
for a change in the T1o between the inputs, then the inputs must be very substitutable for each other.
Conversely, if the T1o is changing, but the rm is not changing the input ratios, then the goods must be
complementary, otherwise they would prot from the changing T1o by changing the input ratio.
The curvature of the isoquant measures how much the input ratio changes for a change in the T1o. If
the isoquant is very curved, then the goods are very complementary because a large changes in the T1o
(slope of the isoquant) leads to small changes in the input ratio (slope of curve from origin to the point). If
the isoquant is nearly linear, small changes in the T1o would lead to large changes of the input ratio; the
inputs are very substitutable. One measure of the curvature of the isoquant, and thus the substitutability is
the elasticity of substitution.
Denition 18 The elasticity of substitution between inputs 1 and 1, o = -K
L
,T1S
L;K
, is the percentage
change in the input ratio
1
J
per percentage change in the T1o
J,1
.
The larger the elasticity of substitution, the more substitutable the inputs are in the production process.
11
Alternative ways of writing the elasticity of substitution are:
o = -K
L
,T1S
L;K
=
%
1
J
%T1o
J,1
=
0
1
J
0T1o
J,1
T1o
J,1
1
J
=
0 ln(
1
J
)
0 lnT1o
J,1
=
1
JT1S
L;K
J
K
L
K
L
T1S
L;K
Example 19 Perfect Substitutes )(1, 1) = a1 + /1
Because the isoquant is linear, the T1o
J,1
does not change along the curve, while the
1
J
ratio does
change, so o = .
Example 20 Perfect Complements )(1, 1) = min(a1, /1)
This isoquant has a slope equal to innity at the points where /1 a1, 0 when /1 < a1, and undened
when a1 = /1. Consider a point where a1 = /1, in a neighborhood around the point (for small changes
around the point), the T1o changes by an innite amount (from 0 to or from to 0), whereas the ratio
of inputs
1
J
changes very little, so o = 0. At the other points, the T1o does not change in a neighborhood
around the point so o = .
Example 21 )(1, 1) = 1
o
1
b
T1o
J,1
=
1
1
a
/
0T1o
J,1
0
1
J
=
a
/
1
J
T1o
J,1
=
/
a
== -K
L
,T1S
L;K
=
1
JT1S
L;K
J
K
L
K
L
T1S
L;K
= 1
12
Figure 8: o measures how responsive
1
J
is to a changing T1o
Prot Maximization
We can write the rms prots as a function of output, :
Prots() = Revenues() Costs()
The rm is a prot maximizer, so on the margin the additional prots from an additional unit of output
must be 0, otherwise it would produce more:
0Prots(j)
0j
=
0Revenues(j)
0j
. .
Marginal Revenue

0Costs(j)
0j
. .
Marginal Cost
= 0
This is equivalent to saying the rm would set marginal revenue equal to marginal cost. We will derive
this condition for various market conditions that change the marginal revenue and marginal cost.
Suppose the rm is in a perfectly competitive environment such that it takes the output price and all
input prices as given. It can buy as many inputs as it wants, and produce as much output as it wants,
without aecting the price (a rm that can alter the output price would be a monopolist or oligopolist, a
13
rm that can aect the input price is a monopsonist). In terms of notation:
j = output
r = (r
1,
..., r
n
) = vector of inputs
)(r) = j technology constraint (production function)
j

= price of output
n = (n
1
, ..., n
n
) = vector of input prices
We can write the rms prots in the perfect competition case as:
prots = (j

, n) (j, r)
= j

j n
1
r
1
... n
n
r
n
j

)(r)

n
I
r
I
The objective function of the rm is:
max
r
j

)(r)

n
I
r
I
which has the rst order conditions:
j

0)(r)
0r
I
n
I
= 0 for all i
Which tells us that j

'1
ri
= n
I
at the optimum. We call j

'1
ri
the value of the marginal product, or
the marginal revenue product of r
I
('11
ri
). At the optimum, the value of the marginal product must be
equal to the input price for all inputs. If this were not true, then the rm could increase prots by using more
or less of that input. The second order condition (if there is one input r
1
) is that j

J
2
}(r)
Jr
2
1
_ 0, or
J
2
}(r)
Jr
2
1
_ 0..
If the production function has diminishing returns in the input, then the optimum is a maximum.
Example 22 )(1, 1) = 1
o
1
b
, output price is j

, and input prices are n and r for 1 and 1 respectively.

What values of 1 yield the highest prot?
14
max j

1
o
1
b
n1 r1
== aj

1
o1
1
b
= n
== 1
o1
=
n
aj

1
b
== 1 =
_
n
aj

1
b
_ 1
a1
= 1

(j

, n, r)
Factor Demand, Supply, and Prot
The factor demand functions, r

I
(j

, n), are the optimal choice of the inputs as a function of the prices:
r

I
(j

, n) = arg max j

)(r)

n
I
r
I
The supply function, j

(j

, n), is the optimal supply as a function of the prices:

j

(j

, n) = )(r

1
(j

, n), ..., r

n
(j

, n))
The prot function, is the maximum prots attainable given prices:
(j

, n) = j

(j

, n)

n
I
r

I
(j

, n)
Example 23 )(1, 1) = 1
o
1
b
We found the factor demand function
_
u
oy1
b
_ 1
a1
= 1

(j

, n, r). The supply and prot function are

given by:
j

(j

, n) = )(r

1
(j

, n), ..., r

n
(j

, n))
=
_
n
aj

1
b
_ a
a1
1
b
(j

, n) = j

(j

, n)

n
I
r

I
(j

, n)
= j

_
n
aj

1
b
_ a
a1
1
b
n
_
n
aj

1
b
_ 1
a1
r1
15
Graphical Solution
We can nd the prot maximizing solution graphically in the one output, one input case. Let prots equal:
= j

j nr
== j =

j

+
n
j

r
This is called an iso-prot line, a set of input combinations that yield the same prots. It has y-intercept
t
y
and slope
u
y
. We can recast the prot maximization problem as "get to the highest iso-prot line given
j = )(r)." It is apparent that for an interior solution, the highest iso-prot line will be tangent to the
production function, otherwise there is an even higher iso-prot line that intersects the production function.
At the tangency, the slope of the iso-prot equals the slope of the production function, or '1
r
=
u
y
==
n = '11
r
, which is the solution we found with calculus.
The maximizing condition n = '11
r
does not necessarily hold at a corner solution. It could be the
highest attainable prots is 0 where no inputs are used. In the multiple input case, the solution might be
to use only one of the inputs, or to set some input to 0. We can amend our maximization problem to take
care of non-negativity constraints similar to the consumer demand problem. Given a monotone and concave
production set, if the factor demand is negative r

I
< 0 for some values of the prices, then set r

I
= 0 for
those values of the prices.
0 1 2 3 4 5 6 7 8 9 10
0
10
20
30
x
y
Figure 9: The prot maximizing rm will try to attain the highest iso-prot line given j = )(r). The highest
iso-prot line is tangent to the production function at an interior solution.
16
0 1 2 3 4 5 6 7 8 9 10
0
10
20
30
L
y
Figure 10: The highest iso-prot line attainable has 0 prots (corner solution)
Examples of Prot Maximization
Example 24 )(1, 1) =
_
1, prices (j

, n)
max
J
j

_
1 n1
== j

1
2
1
1/2
= n
== 1
1/2
=
j

2n
== 1

(j

, n) =
_
j

2n
_
2
== j

(j

, n) =
_
j

2n
_
== (j

, n) = j

_
j

2n
_
n
_
j

2n
_
2
=
j
2

2n
Example 25 )(1, 1) = 501 21
2
, prices (j

, n)
17
max
J
j

_
501 21
2
_
n1 r1
== 50j

4j

1 = n
== 4j

1 = 50j

n
== 1

(j

, n) = max
_
0,
50
4

n
4j

_
== j

(j

, n) =
_
j

2n
_
== (j

, n) = j

_
j

2n
_
n
_
j

2n
_
2
=
j
2

2n
The factor demand will be equal to 0 when
50
4

u
4y
_ 0, or 50j

_ n. We need to be careful about this

corner solution when calculating supply and prot:
j

(j

, n) = max
_
0, 50
_
50
4

n
4j

_
2
_
50
4

n
4j

_
2
_
(j

, n) = max
_
0, j

_
50
_
50
4

n
4j

_
2
_
50
4

n
4j

_
2
_
n
_
50
4

n
4j

_
_
Example 26 )(1, 1) =
_
1 + 1, prices (j

, n, r)
max
J,1
j

_
1 + 1 n1 r1
The FOCs for this problem yield: j

1
2
(1+1)
1/2
= n = r, which does not hold unless n = r. Notice that
if r n, the rm will not want to use 1 as it contributes the same to production as 1 but is more expensive;
the two inputs are perfect substitutes. In that case, the rm sets 1 = 0, and resolves max
J,1
j

_
1 n1
which is the same problem as (24). If n < r, then 1 = 0 and 1 has the same solution as (24). When n = r,
the rm is indierent about using either input.
1

(j

, n, r), 1

(j

, n, r) =
_
_
y
2u
_
2
, 0
_
if n < r
_
a
_
y
2u
_
2
, (1 a)
_
y
2:
_
2
_
for some a [0, 1] if n = r
_
0,
_
y
2:
_
2
_
if n r
18
j

(j

, n, r) =
_
y
2u
_
if n < r
_
y
2u
_
=
_
y
2:
_
if n = r
_
y
2:
_
if n r
(j

, n, r) =

2
y
2u
if n < r
_

2
y
2u
_
=
_

2
y
2:
_
if n = r

2
y
2:
if n r
Example 27 )(1, 1) = 1 + 1, prices (j

, n, r)
max
J,1
j

(1 + 1) n1 r1
= 1(j

n) + 1(j

r)
Notice that if j

n, the rm can always increase prots by increasing 1, and similarly if j

r, the
rm can always increase prots by increasing 1. If the condition holds with <, the rm would always lose
prot and would never use that input. If the condition holds with =, the rm is indierent between using
any amount of the input.
1

(j

, n, r) =
if j

n
[0, ) if j

= n
0 if j

< n
1

(j

, n, r) =
if j

r
[0, ) if j

= r
0 if j

< r
The supply will either be 0 or and the prot function will either be 0 or .
An important result that this example demonstrates is that a production function with CRTS or IRTS
will have = 0 or . To see this, suppose that the rm had CRTS had = j)(1, 1) n1 r1 = a 0.
If the producer scaled all inputs up by the same amount, the new prot would be:
j)(`1, `1) n`1 r`1
= j`)(1, 1) n`1 r`1
= `(j)(1, 1) n1 r1)
= `
19
So the producer would set ` = and earn innite prots. This would only fail if = 0.
Example 28 )(1, 1) = (11)
1/3
, prices (j

, n, r)
max
J,1
j

(11)
1/3
n1 r1 ==
j

1
3
1
2/3
1
1/3
= n
j

1
3
1
1/3
1
2/3
= r
==
j

1
3
1
2/3
1
1/3
j

1
3
1
1/3
1
2/3
=
n
r
==
1
1
=
n
r
== 1 =
n
r
1
== j

1
3
1
2/3
_
n
r
1
_
1/3
= n subbing back into FOC
== 1
1/3
=
3n
j

_
n
r
_
1/3
=
3
j

_
rn
2
_
1/3
== 1 =
_
3
j

_
3
_
rn
2
_
1
== 1

(j

, n, r) =
_
j

3
_
3
_
1
rn
2
_
== 1

(j

, n, r) =
n
r
1

=
n
r
_
j

3
_
3
_
1
rn
2
_
=
_
j

3
_
3
_
1
r
2
n
_
== j

(j

, n, r) = (1

)
1/3
=
_
_
j

3
_
6
_
1
r
3
n
3
__
1/3
=
_
j

3
_
2
1
rn
== (j

, n, r) = j

(j

, n, r) n1

(j

, n, r) r1

(j

, n, r)
= j

_
j

3
_
2
1
rn
n
_
j

3
_
3
_
1
rn
2
_
r
_
j

3
_
3
_
1
r
2
n
_
= 3
_
j

3
_
3
1
rn
2
_
j

3
_
3
_
1
rn
_
=
_
j

3
_
3
1
rn
20
Hotellings Lemma
Proposition 29 Hotellings Lemma
0(j

, n)
0j

= j

(j

, n)
0(j

, n)
0n
= r

I
(j

, n)
Hotellings Lemma is, like Shephards Lemma, an application of the envelope theorem. We expect a
change in j

to aect the prot function, (j

, n) = j

(j

, n)

n
I
r

I
(j

, n), in two ways: (1) directly

via
J(y,u)
Jy
(2) indirectly via
J(y,u)
J

Jy
and
J(y,u)
Jr

i
Jr

i
Jy
. The change in price will aect prots, but it will
also aect the supply and factor demands which in turn aect prots. But notice that the rst derivative
in the indirect channels,
J(y,u)
J

and
J(y,u)
Jr

i
, have to equal 0 since they are at the optimum. This is
the crux of the envelope theorem, when taking derivatives at optimal values, the indirect channels drop out.
Looking at (j

, n) = j

(j

, n)

n
I
r

I
(j

, n), if we ignore how a change in j

aects j

and r

I
it is
clear that
J(y,u)
Jy
= j

(j

, n) and
J(y,u)
Ju
= r

I
(j

, n).
Example 30 )(1, 1) = (11)
1/3
, (j

, n, r) =
_
y
3
_
3
_
1
:u
_
0(j

, n)
0j

= 3
_
j
2

3
3
_
_
1
rn
_
=
_
j

3
_
2
_
1
rn
_
= j

(j

, n, r)
0(j

, n)
0n
=
_
j

3
_
3
_
1
rn
2
_
= 1

(j

, n, r)
Revealed Protability and the WAPM
Suppose we are given a rms input-output choices, is there any way we can tell whether the rm is a prot
maximizer? Assuming the rms technology is constant, the rms input-output choices reveal points on the
rms production function. If the rm is a prot maximizer, then the rms choices in each period must
yield higher prots then any other point on its production function. This is the basis for the weak axiom of
prot maximization (WAPM). Suppose that the rm chooses output j
I
= )(r
I
) in period i using inputs r
I
when prices are (j
I

, n
I
) and thus makes prot
I
= j
I

j
I
n
I
r
I
(n
I
r
I
=

n

n
I

r
I

).
Denition 31 The rms input-output choices are consistent with the weak axiom of prot maximization if
its choices in each period are more protable then its choices in all other periods.

|
= j
|

j
|
n
|
r
|
_ j
|

j
s
n
|
r
s
for all periods t and :
21
It is much easier to check for violations of WAPM (we say "WAPM" and not "the WAPM") than of
WARP because it is sucient to nd one period where the rm could have made higher prots by choosing
another periods input-output combination to nd a violation. Intuitively, WAPM tells us that if the rm
could have made higher prots by choosing another point in its observed production set (all observed choices
are in the production set), then the rm is not a prot maximizer.
Figure 11: The rms choices are consistent with WAPM, prots in each period would be lower if the rm
chose the other periods input-output bundle
22
Figure 12: This rms choices violate WAPM. In each period, the rm could make higher prots by choosing
the input-output bundle of the other period. If the rm is a prot maximizer, then technology must have
changed
Example 32 Suppose that we observe the rms choices (one output, one input) in three periods according
to the table below:
(j
I
, 1
I
) (j
I

, n
I
)
Period 1 (2,1) (1,1)
Period 2 (5,4) (2,1)
Period 3 (10,8) (4,3)
We can calculate the prot in each period and how much prot the rm would have made having chosen
the other points on its observed production set:
Prot (j
1
, 1
1
) (j
2
, 1
2
) (j
3
, 1
3
)
(j
1

, n
1
)
1
= j
1

j
1
n
1
1
1
= $1 j
1

j
2
n
1
1
2
= $1 j
1

j
3
n
1
1
3
= $2
(j
2

, n
2
) j
2

j
1
n
2
1
1
= $3
2
= j
2

j
2
n
2
1
2
= $6 j
2

j
3
n
2
1
3
= $12
(j
3

, n
3
) j
3

j
1
n
3
1
1
= $5 j
3

j
2
n
3
1
2
= $8
3
= j
3

j
3
n
3
1
3
= $16
These choices are not consistent with WAPM because in each period the rm could have made higher
prots by choosing (j
3
, 1
3
) = (10, 8).
Graphically, WAPM requires that the iso-prot line through each periods choice must be higher than the
iso-prot line through all other periods choices (holding prices constant for the period under consideration).
23
Implications of WAPM
Suppose that we observe the rm for two periods: (j
I
, 1
I
) for i = 1, 2, when prices are (j
I

, n
I
) for i = 1, 2.
WAPM requires:

1
= j
1

j
1
n
1
r
1
_ j
1

j
2
n
1
r
2
(1)

2
= j
2

j
2
n
2
r
2
_ j
2

j
1
n
2
r
1
(2)
Multiplying (2) by 1 yields:
n
2
r
1
j
2

j
1
_ n
2
r
2
j
2

j
2
(3)
Adding (1) and (3):
j
1

j
1
j
2

j
1
+ n
2
r
1
n
1
r
1
_ j
1

j
2
j
2

j
2
+ n
2
r
2
n
1
r
2
jj
1
+ nr
1
_ jj
2
+ nr
2
jj
2
jj
1
+ nr
1
nr
2
_ 0
jj nr _ 0
where j = (j
2

j
1

) and n = (n
2
n
1
). If n = 0, then jj _ 0. This inequality implies that
the change in the output must be opposite in sign to the change in the output price. If the price of output
falls, output must increase (at least weakly). If j = 0, then nr _ 0, which implies that the change
in factor demand must be the same sign as the change in its price; if the wage increases, the demand for
labor must fall (at least weakly).
WAPM implies that the supply function must be upward sloping, and factor demands must be downward
sloping. It is surprising that such powerful results (that we struggled to nd in consumer theory) fell out of
the simple principle of WAPM for 2 periods in such a parsimonious equation.
Properties of Factor Demand, Supply, and Prot
1. Factor demand functions are downward sloping
0r

I
(j

, n)
0n
I
_ 0
WAPM implies that nr _ 0.
24
2. The supply function is upward sloping
0j

(j

, n)
0j

_ 0
WAPM implies that jj _ 0.
3. Factor demand functions are homogenous of degree r = 0
r

I
(`j

, `n) = r

I
(j

, n)
The slope of the iso-prot line does not change if all prices and wages change by the same amount (slope
of iso-prot is
u
y
). We found earlier that the optimal input choice would yield a tangency between the
production function and the iso-prot line; if the slope of the iso-prot line does not change, then the
tangency condition does not change, and the optimal inputs do not change. The iso-prot lines will all
shift, however, so the prot level does change.
4. The supply function is homogenous of degree r = 0
j

(`j

, `n) = j

(j

, n)
This falls out from factor demands being homogenous of degree r = 0 : j

(`j

, `n) = )(r

(`j

, `n)) =
)(r

(j

, n)) = j

(j

, n).
5. The prot function is increasing in the output price, and decreasing in input prices
0(j

, n)
0j

_ 0
0(j

, n)
0n
I
_ 0
If this did not hold, then the rm must not be maximizing its prots as a prot-maximizing rm would
respond to an output price increase by increasing output (at least weakly), and an input price increase
by decreasing use of that input (at least weakly).
6. The prot function is homogenous of degree r = 1
(`j

, `n) = `(j

, n)
This falls right out from the condition that factor demands and the supply function are homogenous
of degree 0 : (`j

, `n) = `j

(`j

, `n)

`nr

I
(`j

, `n) = `(j

(j

, n)

nr

I
(j

, n)) =
25
`(j

, n). This is a very intuitive result, if all prices change by the same amount, all iso-prot lines will
have the same slope, but their y-intercepts
t
y
(i.e. level of prot) shift by a factor of `; the iso-prot
line that is now tangent to the production function is the one that is consistent with prots equal to
`.
26