ECON 500

ECON 500 Microeconomic Theory

Producer Theory

ECON 500

Producer Theory A theory of how firms coordinate the transformation of inputs into outputs with a goal of maximizing profits in the meantime. Part I Part II Part III Production Functions Cost Functions Profit Maximization

ECON 500

Part I. Production Functions The principal activity of any firm is to turn inputs into outputs. In the theory of producer behavior the relationship between inputs and outputs is formalized by a production function of the form

where q represents the firms output of a particular good during a period, k represents the machine (that is, capital) usage during the period, l represents hours of labor input, m represents raw materials used, and represents the possibility of other variables affecting the production process.

ECON 500

Part I. Production Functions Most of our analysis will involve two inputs k and l, capital and labor respectively

Where q is the maximum amount of a good that can be produced by using alternative combinations of k and l. Since it is possible to produce the same amount of a good using different combinations of capital and labor, it is important to understand their respective contributions to the production process at various levels of utilization.

ECON 500

Part I. Production Functions Marginal Physical Product: The marginal physical product of an input is the additional output that can be produced by employing one more unit of that input while holding all other inputs constant.

Where the use partial derivatives reflect the fact that all other input usage is held constant while the input of interest is being varied.

ECON 500

Part I. Production Functions Diminishing Marginal Productivity: We assume that the marginal physical product of an input depends on how much of that input is used. We also postulate that inputs cannot be added indefinitely to a production process without eventually exhibiting some deterioration in its productivity. Mathematically:

ECON 500

Part I. Production Functions Diminishing Marginal Productivity Changes in the marginal productivity of labor depend not only on how labor input is growing, but also on changes in capital. Therefore, we must also be concerned with MPl / k In most cases, this cross partial derivative is positive indicating that the marginal productivity of an input increasing in the other input. Diminishing marginal productivity of a single input can be offset by the increases in other inputs. The gloomy prediction of Malthus that led economics to be called a dismal science is misplaced.

ECON 500

Part I. Production Functions Average Physical Productivity

APl is easily measured and is of much empirical significance. The relationship between average and marginal physical productivity is also of significance.

When APl is at its maximum, it equals MPl

ECON 500

Part I. Production Functions Isoquants An isoquant shows those combinations of k and l that can produce a given level of output. Mathematically, an isoquant records the set of k and l that satisfies:

ECON 500

Part I. Production Functions

ECON 500

Part I. Production Functions Marginal Rate of Technical Substitution The marginal rate of technical substitution (RTS) shows the rate at which labor can be substituted for capital while holding output constant along an isoquant.

ECON 500

Part I. Production Functions RTS and Marginal Productivities The total differential of the production function is

Along and isoquant, we know that dq=0, therefore

Hence

ECON 500

Part I. Production Functions Diminishing RTS Isoquants naturally have a negative slope but they are also as convex curves. This means along any one of the isoquants, the RTS is diminishing However, it is not possible to derive a diminishing RTS from the assumption of diminishing marginal productivity alone since Marginal Physical Product depends on the level of both inputs and cross productivity effects are present. To show that isoquants are convex, we would like to show that dRTS/dl < 0. Since RTS = fl/fk, we have

ECON 500

Part I. Production Functions Diminishing RTS Because fl and fk are functions of both k and l, we must be careful in taking the derivative of this expression

Using the fact that dk/dl = - fl/fk along an isoquant and Youngs theorem (fkl = flk), we have

ECON 500

Part I. Production Functions Diminishing RTS

Because we have assumed fk > 0, the denominator of this function is positive. Hence the whole fraction will be negative if the numerator is negative. Because fll and fkk are both assumed to be negative, the numerator definitely will be negative if fkl is positive. When we assume a diminishing RTS we are assuming that marginal productivities diminish rapidly enough to compensate for any possible negative cross-productivity effects.

ECON 500

Part I. Production Functions Returns to Scale If the production function is given by q = f (k,l) and if all inputs are multiplied by the same positive constant t (where t > 1), then we classify the returns to scale of the production function by

ECON 500

Part I. Production Functions Constant Returns to Scale CRS production functions are homogenous of degree 1:

Derivatives of a CRS function are homogenous of degree 0:

And CRS functions are homothetic

ECON 500

Part I. Production Functions Elasticity of Substitution If the RTS does not change for changes in k/l, we say that substitution is easy because the ratio of the marginal productivities of the two inputs does not change as the input mix changes. Alternatively, if the RTS changes rapidly for small changes in k/l, we would say that substitution is difficult because minor variations in the input mix will have a substantial effect on the inputs relative productivities. A scale-free measure of this responsiveness is

ECON 500

Part I. Production Functions

ECON 500

ECON 500

Part II. Cost Functions Accounting Costs vs. Economics Costs

Accountants emphasize out-of-pocket expenses, historical costs, depreciation, and other bookkeeping entries. Economists on the other hand define cost by the size of the payment necessary to keep the resource in its present employment, or alternatively, by the remuneration that input would earn in its next best use. Labor costs = hourly wage = w Capital costs = rental rate of capital = v Cost of entrepreneurial services = forgone earnings

ECON 500

Part II. Cost Functions Cost Minimization The firm seeks to minimize total costs given q = f (k, l) = q0.

First order conditions for this constrained minimum are

ECON 500

Part II. Cost Functions In order to minimize costs, the firm should choose inputs such that the rate at which k can be traded for l in production to the rate at which they can be traded in the marketplace.

Alternatively, the firm should chose inputs such that the marginal productivity per dollar spent should be the same for all inputs.

ECON 500

Part II. Cost Functions

ECON 500

Part II. Cost Functions

ECON 500

Part II. Cost Functions Total Cost Function

Average Cost Function

Marginal Cost Function

ECON 500

Part II. Cost Functions CRS Production Function and its Costs

ECON 500

Part II. Cost Functions Cubic Cost Function

ECON 500

Part II. Cost Functions Properties of Cost Functions

Non-decreasing in v, w, and q Homogenous of degree 1 in input prices Concave in input prices

ECON 500

Part II. Cost Functions

ECON 500

Part II. Cost Functions Contingent Demand for Inputs and Shephards Lemma Shephards lemma claims that C/w = l Suppose that the price of labor (w) were to increase slightly. Costs would rise by approximately the amount of labor l that the firm was currently hiring. Along the pseudo cost function all inputs are held constant, so an increase in the wage increases costs in direct proportion to the amount of labor used. Because the true cost function is tangent to the pseudo-function at the current wage, its slope (that is, its partial derivative) also will show the current amount of labor input demanded.

ECON 500

Part II. Cost Functions Contingent Demand for Inputs and Shephards Lemma

ECON 500

Part II. Cost Functions Short run vs. Long run In the short run, the firm is able to alter only its labor input while capital input is fixed at some level k1.

With this formulation, payments to capital attain a fixed cost nature in the short run and do not vary with the amount produced. Short run cost function becomes:

ECON 500

Part II. Cost Functions Short run vs. Long run In the short run, to change output, firms are forced to use input combinations that are non-optimal. Unavailability of input substitution prevents the firm from finding the input mix where RTS equals the ratio of input prices. Hence, in the short run, costs are not necessarily minimized.

ECON 500

Part II. Cost Functions

ECON 500

Part II. Cost Functions Long-run total costs are always less than short-run total costs, except at that output level for which the assumed fixed capital input is at the appropriate level to ensure long-run cost minimization. Therefore, long-run total cost curves constitute an envelope of their respective short-run curves. A family of short run cost curves can be obtained by varying the capital level in Long run cost curve can be recovered by combining the above SC with

ECON 500

Part II. Cost Functions

ECON 500

Part II. Cost Functions

ECON 500

Part III. Profit Maximization A profit-maximizing firm chooses both its inputs and its outputs with the sole goal of achieving maximum economic profits. That is, the firm seeks to make the difference between its total revenues and its total economic costs as large as possible. This holistic approach that treats the firm as a single decision-making unit and sweeps away all the complicated behavioral issues about the relationships (contractual or implicit) among input providers. The profit maximizing assumption has a long history in economic literature. It is plausible because firm owners may indeed seek to make their asset as valuable as possible and because competitive markets may punish firms that do not maximize profits. The assumption also yields interesting theoretical results that can explain actual firms decisions.

ECON 500

Part III. Profit Maximization Marginalism and Profit Maximization Firms perform the conceptual experiment of adjusting those variables that can be controlled until it is impossible to increase profits further. This involves, say, looking at the incremental, or marginal, profit obtainable from producing one more unit of output. As long as this incremental profit is positive, the extra output will be produced. When the incremental profit of an activity becomes zero, the firm has pushed output far enough, and it would not be profitable to go further.

ECON 500

Part III. Profit Maximization Firms choose the level of output that maximizes

The first order condition for a maximum is

In order to maximize economic profits, the firm should choose that output for which marginal revenue is equal to marginal cost

ECON 500

Part III. Profit Maximization MR=MC condition is only a necessary condition for maximum profits. The second order condition that requires marginal profit to be decreasing at the optimal level of output must also hold for sufficiency.

ECON 500

Part III. Profit Maximization

ECON 500

Part III. Profit Maximization Marginal Revenue If the firm can sell all it wishes without having any effect on market price, the market price will indeed be the extra revenue obtained from selling one more unit. Total revenue will be linear in output, marginal and average revenue will be equal to price. However, a firm may not always be able to sell all it wants at the prevailing market price. If it faces a downward-sloping demand curve for its product, the revenue obtained from selling one more unit will be less than the price of that unit because, in order to get consumers to take the extra unit, the price of all other units must be lowered. Marginal revenue be below price for any quantity q>1.

ECON 500

Part III. Profit Maximization Marginal Revenue

If price does not change as quantity increases dp/dq = 0, marginal revenue will be equal to price. In this case we say that the firm is a price taker because its output decisions do not influence the price it receives. On the other hand, if price falls as quantity increases dp/dq < 0, marginal revenue will be less than price.

ECON 500

Part III. Profit Maximization

ECON 500

Part III. Profit Maximization Marginal Revenue and Elasticity

ECON 500

Part III. Profit Maximization Price Marginal Cost Markup Using the MR elasticity relationship and equating MR to MC

The more elastic demand becomes, the lower the markup over MC

ECON 500

Part III. Profit Maximization Supply Decision of a Price Taking Firm If a firm is sufficiently small such that its output choice has no market on the market price, the marginal revenue becomes equal to the market price. The profit maximizing level of output q* can be found by P = MR = MC As long as at this level of output average variable cost is below the market price, the firm would continue to operate in the short run. The short run supply curve for a price taking firm is the positively sloped segment of the firms short-run marginal cost above the point of minimum average variable cost.

ECON 500

Part III. Profit Maximization

ECON 500

Part III. Profit Maximization Cobb Douglas Example

ECON 500

Part III. Profit Maximization

I - The supply curve is positively sloped - increases in P cause the firm to produce more because it is willing to incur a higher marginal cost II - The supply curve is shifted to the left by increases in the wage rate, III - The supply curve is shifted outward by increases in capital input IV - The rental rate of capital, v, is irrelevant to short-run supply decisions

ECON 500

Part III. Profit Maximization Profit Functions We can represent the firms (maximized) profits as depending only on the prices that the firm faces by a profit function of the form

With the properties: I Homogenous of degree 0 II Non-increasing in input prices III Non-decreasing in output price IV Convex in output prices

ECON 500

Part III. Profit Maximization Cobb Douglas Example

ECON 500

Part III. Profit Maximization Input Demand

ECON 500

Part III. Profit Maximization Comparative Statics for Input Demand Single Input

ECON 500

Part III. Profit Maximization Comparative Statics for Input Demand Two Inputs

ECON 500

Part III. Profit Maximization

ECON 500