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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.
Production possibility set of a firm is a subset Y Rm. A firm may select any vector y
Y as its production plan.
z2
V(q)
Q(q)
1
z1
The isoquant Q(q) is usually the boundary closest to the origin of 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?)
Efficient Production
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.
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.
q f (z )
1/
z
i 1
i i
, where
i 1
1 and i 0 i.
q f (z ) z i i .
i 1
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
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.
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.
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)
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
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
q f (z ) min{
z
z1
, , m }.
a1
am
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.
It is easy to see that the conditional input demand functions are homogeneous of degree 0.
Note:
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
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
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*
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
(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