Economics 190/290 Lecture 12

Transportation Economics:
Production and Costs I
Demand and Supply
Chapters from Essays textbook:

Q
0
P
P
0
Q

Supply (Chapter 3)
Pricing (Chapter 4)
Demand (Chap. 2)
How to obtain supply?
1)What is the production technology?
2)Therefore, what are production costs?
3)Given demand, what will the firm (or
government) choose to supply?
We will focus here on production and
costs.
Production function:
) x ( f ) x ,..., x ( f y
n 1
= =
Given inputs x=(x
1
,x
2
,,x
n
), write output
y as,

Properties:
Increasing:

Quasi-concave:

if and

then
0 x / f > c c
) x ( f ) x ( f
1 0
=
) x ( f ) x ) 1 ( x ( f
0 1 0
> +
1 0 s s
Production Function
Illustrate with iso-quants:
f(x)=y
0
x
0
+(1-)x
1
x
0
x
1
X
2
X
1
f(x)=y
1
>y
0
Returns to Scale
Suppose that there is one input x, and,



o=1 constant returns to scale
doubling all inputs will just double output
o>1 Increasing returns to scale
doubling all inputs more than doubles output
o<1 decreasing returns to scale.
doubling all inputs will less than double output
o
= = x ) x ( f y
Input prices
Prices for inputs x
i
are w
i

E.g. labor wage
Capital rental price
Fuel cost of oil;
Total costs are,

=
=
n
1 i
i i
x w C
The firms problem:

=
n
1 i
i i
x w min
subject to f(x) > y
A

B

C

x
2
x
1
Slope=-w
1
/w
2
f(x)=y

The firms problem (contd):
Point A is the lowest cost method of
producing y
B and C are more expensive to get y
Write solution as cost function:

with:
- input demands
) w , y ( x w ) w , y ( C
n
1 i
i i

=
=
) w , y ( x
i
Change in Price:
Suppose price falls from w
1
to w
1
:
f(x)=y
B

A

x
2
x
1
Slope = -w
1
/w
2
Slope = -w
1
'/w
2
Change in Price (contd):
Fall in w
1
will increase demand for x
1
,
and reduce demand for x
2
, moving from
A to B.

- pure substitution effect 0
w
x
i
i
<
c
c
Demand Curve
This gives us downward sloping demand:
D
w
i
X
i
Derivative of costs:



Because

(substitution effects all cancel out)

Thus, the derivative of costs w.r.t. factor
prices equals factor demands
) w , y ( x
w
x
w ) w , y ( x
w
C
i
n
1 j i
j
j i
i
=
c
c
+ =
c
c

=
0
w
x
w
n
1 j i
j
j
=
c
c

=
Returns to Scale:
If,

then,

o=1 doubling output will double costs;
o>1 Increasing returns to scale.
doubling output will less than double costs;
o<1 Decreasing returns to scale.
doubling output will more than double costs.

w y ) w , y ( C
/ 1 o
=
o
= = x ) x ( f y
Average costs:
Hold the (single) input price w fixed:
Define average costs,




E.g. Total costs =$100, y=5, so AC=$20

, wy
y
w y
y
) w , y ( C
AC
1
/ 1
o
o
o
= = =
Marginal costs
Hold the (single) input price w fixed:
Define marginal costs,




E.g. Total costs=$100 when y=5, $115 when y=6
So marginal costs are $15.
o
o
o
=
c
c
=
1
y
w
y
) w , y ( C
MC
Returns to Scale:



so,


which is a measure of returns to scale!

, wy AC
1
o
o
=
o
o
o
=
1
wy
1
MC
,
MC y
Costs Total
MC
AC

= o =
Constant Returns to Scale:
|
$
o=1
y
AC=MC
Constant returns
Increasing Returns to Scale:
$
y
AC

MC
Increasing
returns
o>1
Decreasing Returns to Scale:
o<1
(Say,
o=1/2)
$
MC



AC
Decreasing
returns
y
Eg: Cobb-Douglas Production Function

Notice that doubling both x
1
and x
2 :




So,
constant returns to scale
increasing returns to scale
decreasing returns to scale
0 , , x x ) x ( f y
2
1
> | o = =
| o
) x ( f 2 ) x 2 ( ) x 2 ( ) x 2 ( f
2 1
| + o | o
= =
1 = | + o
1 > | + o
1 < | + o
Cobb-Douglas Cost Function

Use a Lagrangian,


Find first-order condition w.r.t x
1
, x
2
:
y x x subject to x w x w min
2
1 2 2 1
1
> +
| o
) x x - (y x w x w L
2
1 2 2 1
1
| o
+ + =
) x ( f x w 0 x / ) x ( f w
x
L
1 1 1
1
1
o = = o =
c
c
) x ( f x w 0 x / ) x ( f w
x
L
2 2 2
2
2
| = = | =
c
c
Cobb-Douglas Cost Function (contd)
From these two conditions, we solve for,


We can solve for from the FOC,





) x ( f ) ( x w x w
2 2 1
1
| + o = +
, ) x ( f x w
1 1
o o o o o
o =
| | | | |
| = ) x ( f x w
2 2
| + o | o | + o | o
| o = ) x ( f ) ( ) x ( f ) w w (
2
1
Cobb-Douglas Cost Function (contd)
Solving for , costs then are,





where,

is a constant.
) w w ( Ay ) ( ) x ( f ) (
2 1
1
| + o
|
| + o
o
| + o
| + o = | + o =
2 2 1
1
2 1
x w x w ) w , w , y ( C + =
) ( A
| + o
|

| + o
o

| o =
Returns to Scale:
First write the log of costs as:



Differentiating this w.r.t. y, we see that,



measures the returns to scale!
2 1
w ln w ln y ln
1
B C ln
|
|
.
|

\
|
| + o
|
+
|
|
.
|

\
|
| + o
o
+
|
|
.
|

\
|
| + o
+ =
) (
y ln
C ln
) y / C ( y
Costs
MC
AC
1
| + o =
|
|
.
|

\
|
c
c
=
c c
=

Cobb-Douglas Input Demands:
Demands for inputs are obtained by
differentiating costs:





| + o
|
| + o
o
| + o
o =
c
c
=
2
1
1
1
1
2 1 1
w w Ay
w
C
) w , w , y ( x
| + o
|
| + o
o
| + o
| =
c
c
=
1
2 1
1
2
2 1 2
w w Ay
w
C
) w , w , y ( x
Costs Shares:
Comparing x
1
and x
2
with total costs:


we see that,


which are constant!
| + o
o
=
C
x w
1 1
| + o
|
=
C
x w
2 2
) w w ( Ay ) ( C
2 1
1
| + o
|
| + o
o
| + o
| + o =
Elasticity of Substitution
For the Cobb-Douglas function:



So the elasticity of substitution is,



This may not be a good description of actual
substitution between inputs! So consider..
1
) w / w ln(
) x / x ln(
2 1
2 1
=
c
c

1
2
2
1
w
w
x
x
|
o
=
Translog Cost Function
Many outputs (joint prod.)
And inputs

= =
= = = =
= =
+
+ +
+ + =
m
1 i
n
1 j
j i ij
m
1 i
n
1 j
j i ij
m
1 i
n
1 j
j i ij
n
1 i
i i
m
1 i
i i 0
w ln y ln g
w ln w ln b
2
1
y ln y ln a
2
1
w ln b y ln a a ) w , y ( C ln
) y , , y ( y
m 1
=
) w , , w ( w
n 1
=
Translog Cost Function (contd)
Note that the first line is just Cobb-Douglas,
(in logs, with multiple inputs and outputs):




The extra terms on the second and third
lines allow for more general substitution
between inputs and outputs.


= =
+ + =
n
1 i
i i
m
1 i
i i 0
w ln b y ln a a ) w , y ( C ln
Translog Cost Shares:
Differentiating the cost function,



so that,


this allows for a wide pattern of substitution
between inputs.
j
m
1 i
ij
n
1 j
j ij i
i i
i
y ln g w ln b b
C
w x
w ln
C ln

= =
+ + = =
c
c
0 b
w ln w ln
C ln
ij
j i
2
= =
c c
c
Returns to Scale:



so if a
ij
=0, then,


is a measure of returns to scale!

1
i
i
y ln / C ln
) y / C ( y
Costs
MC
AC

|
|
.
|

\
|
c c =
c c
=

1
i
i
a
MC
AC

|
|
.
|

\
|
=