Debre Tabor University

College of Business and Economics

Department of Economic
Advanced Microeconomics I
Technology
2022G.C
Gashaw Molla
Chapter 2

Technology
 The Standard Theory of the Firm
Introduction
• This is the supply side of economy
• The supply side is viewed as composed of a number of productive
units, or firms. The firm is viewed merely as a “black box,” able
to transform inputs into outputs
• We begin by introducing a firm’s production set, a set that
represents the production activities, or production plans, that are
technologically feasible for the firm.
• The most general way is to think of the firm as having a
production possibility set, Y ⊂ RL, where each vector y = (y1, . . . ,
yl) ∈ Y is a production plan whose components indicate the
amounts of the various inputs and outputs. y ∈ Y so that yi < 0 if
resource i is used up in the production plan, and yi > 0 if resource i
is produced in the production plan.
 Technology
• A technology is a process by w/c inputs are converted to an output.
Technology is typically summarized using a production function
that transforms inputs into a maximal level of output that can be
produced from a given combination of inputs.
The firm produces outputs by using inputs (both measured in
terms of flow amounts per unit time).
• Thus, the simplest and most common way to describe the
technology of a firm is the production function, which is
generally studied in intermediate courses.
e.g: A production function is given by f with values:
q = f(k; l); where k - capital, l for labor and q for output.
The set of inputs and outputs that are possible to produce using
technology f is called a production possibilities set and given
by: Y = f( -k; -l; y ) : y ≤ f(k; l); k ≥0; l ≥ 0.
• The minus signs are supposed to capture that k; l are (net) inputs
while y is an (net) output.
Production sets: Exogenously given technology applies over L
commodities (both inputs and outputs).
Production is the process of transforming inputs into outputs.
• Technological feasibility: the state of technology determines and
restricts what is possible in combining inputs to produce output.
 Measurement of inputs and outputs

• In order to study firm choices (behaviour) we need a convenient way

to summarize the production possibilities of the firm, i.e., which
combinations of inputs and outputs are technologically feasible.
• Inputs and outputs as being measured in terms of flows: a certain
amount per unit of time. Both are commodities.

• This is done, for example, in labour hours per week, capital services
in hours per week, etc, and the production of output in units per
week
 Specifications of technologies

• Suppose the firm has L possible goods to serve as inputs and/or

outputs.
• If a firm uses yiJ units of a good j as an input and produces y0J units of
the good as an output, then the net output of good j is given by yJ = y0J
–yiJ
• If the net output of a good j is positive, then the firm is producing more
of good j than it uses as an input (e.g., as seeds or other forms of
inputs);
• If the net output is negative, then the firm is using more of good j than
it produces.
• We can represent a production plan by a vector y in RL ( set of L-
dimensional real numbers-inputs and outputs) where yJ is negative if
the jth good serves as net input and positive if the jth good serves as a
net output.
e.g: A production vector (plan) is given as y = (y1; ….; yl) ∈ RL where
an output has yj > 0 and an input has yj < 0;
The standard criterion for deciding on a production plan is profit
maximization.
N.B: net output can be negative (input) or positive (output)
The set of all technologically feasible production plans is called the firm's
production possibilities set and will be denoted by Y, a subset of RL.(see
below)
 Specification (Cont’d)
The production possibility set Y  RL is the set of all technologically
feasible production plans. All vectors of inputs and outputs that
are technologically feasible.
It provides a complete description of the technology identified
with the firm.
• A production y  Y is said to be efficient if there is no y'  Y such
that y’k ≥yk for all k and y’h > yh for at least one h.
Specification (Cont’d)
• We will generally assume that such restrictions can be described by
some vector z in RL
– For example, z could be a list of the maximum amount of the
various inputs and outputs that can be produced in the time period
under consideration.

– The restricted or short-run production possibilities set will be

denoted by Y(z);

– this consists of all feasible net output bundles consistent with the
constraint level z.
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production plans such that y is in Y where y is fixed at y-bar)

– Note that Y(z) is a subset of Y, since it consists of all production plans that are
feasible-which means that they are in Y-and that also satisfy some additional
E.g. 1. Input requirement set (A special feature of a
technology)
• Suppose a firm produces only one output.
• In this case we write the net output bundle as (y, -x) where x is a vector of inputs.
• We can then define a special case of a restricted production possibilities set, the
input requirement set (restricted in the sense that the quantity of output y is
given and is only feasible in the long run):

• The input requirement set is the set of all input bundles that produce at least y
units of output.
• Note that the input requirement set, as defined here, measures inputs as positive
numbers rather than negative numbers as used in the production possibilities set.
Fig: Input requirement set
 Specification (Cont’d)
E.g 2: lsoquant
In the above case we can also define an isoquant

We define also the isoquant to be the set all input bundles that allow
the firm to produce exactly y
E.g. 3: Short-run production possibilities set
Suppose a firm produces some output from labor and some kind of
machine which we will refer to as "capital.”
• Production plans then look like (y, -1, -k) where y is the level of
output.
 We imagine that labor can be varied immediately but that capital is fixed
at the level k in the short run. Then

is an example of a short-run production possibilities set.

 E.g. 4: Production function
The production set is by far the most general way to characterize the firm’s
technology b/c it allows for multiple inputs and multiple outputs. However,
for the
case in which the firm produces only a single output from many inputs, it is
more convenient to describe the firm’s technology in terms of production
function.
It identifies the maximum output associated with a given level of output. In the
case of only one output, define the production function f (x):

For a firm with only a single output y (and inputs -x), defined as
f (x) ≡ max y such that (y, -x) ∈ Y .
Y = {(y, -x) f: y(x)
≤ f=(x)}, in R : y free
{y assuming Y}.disposal
The production function, f, is therefore a mapping from R L+ → R+ with a
generic element y = f(x). (f : RL + → R+ ).
Specification (Cont’d)
• E.g 5: Transformation function

• Any function F : RL → R with

F (y) ≤ 0 ⇔ y ∈ Y ; and
F (y) = 0 ⇔ y is a boundary point of Y. Can be interpreted as the
amount of technical progress required to make y
feasible
The set {y : F (y) = 0} is the production possibilities frontier
(transformation frontier)

• A production plan y in Y is (technologically) efficient if there is no

y' in Y such that y' > y and y' # y; that is, a production plan is
efficient if there is no way to produce more output with the same
inputs or to produce the same output with less inputs.
We often assume that we can describe the set of technologically
efficient production plans by a transformation function F : Rn  R
(R is maximal vector of efficient output among RN) where F(y) = 0 if
and only if y is efficient.
Just as a production function picks out the maximum scalar
output as a function of the inputs, the transformation function
picks out the maximal vectors of net outputs
E.g: Cobb-Douglas technology
• Let a be a parameter such that 0 < a < 1. Then the Cobb-Douglas technology is
defined:
E.g: Leontief technology (perfect complements or fixed proportion technology)
Figure: Panel A depicts the general shape of a isoquant curve, and
panel B depicts the general shape of a perfect complement
(Leontief) technology
E.g: (CES production function)

Let for
 Activity analysis
• The most straightforward way of describing production sets or input
requirement sets is simply to list the feasible production plans.
• For example, suppose that we can produce an output good using factor inputs 1
and 2. There are two different activities or techniques by which this
production can take place:
• Technique A: one unit of factor 1 and two units of factor 2 produces one unit
of output.
• Technique B: two units of factor 1 and one unit of factor 2 produces one unit
of output.
• Let the output be good 1, and the factors be goods 2 and 3. Then we can
represent the production possibilities implied by these two activities by the
production set

or the input requirement set

 Activity analysis (cont’d)

• This input requirement set is depicted in Figure 1.2A.

 Properties of the Production Function
1. Monotonic technologies
 Let us continue to examine the two-activity example introduced in the last section.
Suppose that we had an input vector (3,2). Is this sufficient to produce one unit of
output?
We may argue that since we could dispose of 2 units of factor 1 and be left with (1,2), it
would indeed be possible to produce 1 unit of output from the inputs (3,2).

If such free disposal is allowed, it is reasonable to argue that if x  V (y) and x’ ≥ x then
x’  V (y).
Thus, the input requirement sets should be monotonic in the following sense
MONOTONICITY. If x is in V(y) and x' > x, then x' is in V(y).

Or If x  x, then f  x  f  x  (monotonicity)

• If we assume monotonicity, then the input requirement sets depicted in the above
Figure become the sets depicted the following
Fig:
N.B: Monotonicity: f is a nondecreasing function of inputs
2. Convex technologies

Fig:
 Convex technologies (cont’d)
 A similar condition may (or may not) be imposed on the production
set Y: if y; y’  Y then ty + (1 - t)y’  Y for every 0 ≤ t ≤ 1, or Y is a
convex set.
 The convexity of Y implies the convexity of V(y).

 The convexity of V(y) implies that the f (x) is quasi-concave.

set
By definition of f (x) means: tf (x) + (1 - t)f (x0) ≤ f (tx + (1 - t)x’)
for every 0 ≤ t ≤ 1, the definition of a concave f (x).
 3. Regular technologies
• REGULARITY: V ( y ) = x : y ≤ f(x) is a closed, nonempty set for
all y ≥ 0.
• The assumption that V ( y ) is nonempty requires that there is some
conceivable way to produce any given level of output.
– This is simply to avoid qualifying statements by phrases like
"assuming that y can be produced.”
 The possibility set Y is closed means that, whenever a sequence of
production plans yi, i = 1; 2; : : : ; are in Y and yi y, then the limit
production plan y is also in Y . It guarantees that points on the
boundary of Y are feasible. Note that Y is closed implies
that the input requirement set V (y) is a closed set for all y ‚ 0.
 Roughly speaking, the input requirement set must "include its own
boundary (closed).”
Parametric Representation of Technology
(Read Varian from page 10)
 The technical rate of substitution

when xl changes by a small amount.

• which can be solved for

dx2 f / x1

dx1 f / x2
• In the n-dimensional case, the technical rate of substitution is the
slope of an isoquant surface, measured in a particular direction
 The elasticity of substitution (ES)
 TRS measures the slope of an iso-quant.
 Elasticity of substitution measures the curvature of an iso-quant. With
output being held fixed, it is calculated as

 ( x 2 / x1)
  x 2 / x1
TRS
TRS

 It asks how the ratio of factor inputs changes as the slope of the
isoquant changes.
– If a small change in slope gives us a large change in the factor input ratio,
the isoquant is relatively flat which means that the elasticity of
substitution is large.
• In practice we think of the percent change as being very small and take
the limit of this expression as D goes to zero.
• Hence, the expression for  (sigma) becomes

• It is often convenient to calculate  using the logarithmic derivative.

• In general, if y = g(x), the elasticity of y with respect to x refers to the
percentage change in y induced by a (small) percentage change in x.
• That is,

• Provided that x and y are positive, this derivative can be written as:
.
Assignnment
1. Check ES for Linear, CES and Fixed proportion production
technologies
2. The Cobb-Douglas production function is

3. Draw the iso-quant

Reading Assignment
1. Choice under Uncertainty
2. Aggregating across Goods and Consumers.
 RETURNS TO SCALE
• Measure how output responds to changes in the amounts of different
inputs.

• Suppose that we are using some vector of inputs x to produce some

output y and we decide to scale all inputs up or down by some amount
t > 0. What will happen to the level of output?

• CRS: A technology exhibits constant returns to scale if any of the

following are satisfied:
(1) y in Y implies t y is in Y , for all t > 0; (using Production
possibilities set)
(2) x in V ( y ) implies t x is in V ( t y ) for all t > 0; (using input
requirement set)
(3) f ( t x ) = t f ( x ) for all t > 0; i.e., the production function f ( x )
is homogeneous of degree 1 (using production function)
• IRS: A technology exhibits increasing returns to scale if f (tx) > t f
(x) for all t > 1.
• DRS: A technology exhibits decreasing returns to scale if f (tx) < t f
(x) for all t > 1.
– The most natural case of decreasing returns to scale is the case
where we are unable to replicate some inputs.
– Thus, we should expect that restricted production possibility sets
would typically exhibit decreasing returns to scale.
– is due to the presence of some fixed input
• Finally, let us note that the various kinds of returns to scale defined
above are global in nature.
• However, many technologies exhibit increasing, constant, and
decreasing returns over only certain ranges of output. Thus in many
circumstances a local measure of returns to scale is useful.
• The elasticity of scale measures the percent increase in output due to
a one percent increase in all inputs that is, due to an increase in the
scale of operations
• Let y = f (x) be the production function. Let t be a positive scalar, and
consider the function y(t) = f (tx).
• If t = 1, we have the current scale of operation;
• if t > 1, we are scaling all inputs up by t; and
• if t < 1, we are scaling all inputs down by t.
• The elasticity of scale at the point x is given by

evaluated at t = I. Rearranging this expression, we have

• Note that we must evaluate the expression at t = 1 to calculate the
elasticity of scale at the point x.

• We say that the technology exhibits locally increasing, constant, or

decreasing returns to scale as e(x) is greater, equal, or less than 1
2.11 Homogeneous and homothetic technologies
• f (x) is homogeneous of degree k if f (tx) = tk f (x) for all t > 0

The two most important "degrees" in economics are the zeroth and first
degree .
A zero-degree homogeneous function is one for which f (tx) = f(x), and a
first-degree homogeneous function is one for which f(tx) = t f ( x) .
•A function g : R  R is said to be a positive monotonic
transformation if g is a strictly increasing function; that is, a function
for which x > y implies that g(x) > g(y). (The "positive" is usually
implied by the context.)
•A homothetic function is a monotonic transformation of a function that
is homogeneous of degree 1.
• In other words, f (x) is homothetic iff it can be written as f ( x ) =
g(h(x)) where h(.) is homogeneous of degree 1 and g ( . ) is a
monotonic function. See the following figure for a geometric
interpretation.
.
 Homogeneous and homothetic functions are of interest due to the
simple ways that their isoquants vary as the level of output varies.

• In the case of a homogeneous function, the isoquants are all just

"blown up" versions of a single isoquant. If f(x) is homogeneous of
degree 1, then if x and x' can produce y units of output it follows that
tx and tx' can produce ty units of output, as depicted above

• A homothetic function has almost the same property: if x and x'

produce the same level of output, then tx and tx' can produce the same
level of output-but it won't necessarily be t times as much as the
original output.
 Homogeneous and homothetic technologies are of interest since they
put specific restrictions on how the technical rate of substitution
changes as the scale of production changes ( i.e. independent of the
scale of production)
– It follows that the ratio of any two derivatives is homogeneous of
degree zero, which is the result we seek
• E.g.: The CES production function
• The CES production function has the form

– It is easy to verify that the CES function exhibits CRS. The CES function
contains several other well-known production functions as special cases,
depending on the value of the parameter .
– These are described below and illustrated in Figure below
• In our discussion, it is convenient to set the parameters a 1 = a2 = 1
By direct calculation of a simple CES production function, we can get

The closer ρ is to unity, the larger is σ; when ρ is equal to 1, σ is

infinite and the production function is linear.

This means that as  approaches - , a CES isoquant looks

like an isoquant associated with the Leontief technology.
It will probably not surprise you to discover that the CES
production function has a constant elasticity of substitution.
PROFIT MAXIMIZATION
• The behavior of a competitive firm: a price taker on both output and
input markets.
• Profit maximization is the overriding objective of the firm.
• The firm must decide both what level of output to produce and how
much of which factors to use to produce it.
• The firm will choose that level of output and that combination of
factors that solve the following problem:

where f (x) is a production function.

We can replace the inequality in the constraint by an equality, b/c the
production function is strictly increasing.
Since y = f (x), we can rewrite the maximization problem in terms of a
choice over the input vector alone as:

FOC:

The left hand term is referred to as the marginal revenue product of

input i. It gives the rate at which revenue increases per additional
unit of input i employed.
 At the optimum, MRP must equal the cost per unit of input i,
namely, wi.
 We can use the previous FOCs to get the following equality b/n ratios:

i.e. the MRTS b/n any two inputs is equated to the ratio of their prices.

Given the ff profit max. problem

.
 The optimal choice of output, y* ≡ y(p,w), is called the firm’s output supply
function, and the optimal choice of inputs, x* ≡ x(p,w), gives the vector of firm
input demand functions.
The profit function
 The profit function is a useful tool for studying these supply and demand
functions.
The firm’s profit function depends only on input and output prices and is defined
as the maximum-value function,
 Properties of the profit function

• Moreover, under the additional assumption that f(.) is strictly concave

(Hotelling’s lemma),

i.e. output supply & input demands can be obtained directly by simple
differentiation
 Property count…
• Note that convexity says profit at average prices is less than or
equal to the average of the profits at the two prices
• Note Convexity means profit increases at an increasing rate when
output price increases.
• As shown in the fig initially, price is p* and the firm uses the
production plan (y*,x*). Suppose price of output increases. If the
firm continues to use the old production plan, i.e., no increase in
output (the resulting profit function is given by the straight line,
which is called passive profit function). But if the firm increases
output in response to output price increase, the profit function
becomes convex.
 Properties of output SS and input DD functions
• Suppose that f(.) is a strictly concave satisfying all its properties and
its associated profit function, π(p, y), is at least twice continuously
differentiable. Then, for all p > 0 and w≫ 0, it is well defined:
1. Homogeneity of degree zero:
y(tp, tw) = y(p,w) for all t > 0,
xi(tp, tw) = xi(p,w) for all t > 0 and i = 1, . . . , n.
This means that if we multiply all of the prices by some t>0 , the
vector of factor inputs that maximizes profits will not change.
• It follows that firms supply of output will not change
2. Own-price effects:
Some commentaries

Homogeneity of output ss & input dd follows from Hotelling’s lemma and

homogeneity of the profit function.
Output supply is increasing in product price and input demands are
decreasing in their own input price.
Profit-maximizing behavior can be characterized by calculus.
• For example, the first-order conditions for the single output profit maximization
problem are
 This condition simply says that the value of the marginal product of each
factor must be equal to its price.
 Using vector notation, we can also write these conditions as

pD f (x*) = w.

Here

is the gradient of f : the vector of partial derivatives of f with respect to

each of its arguments.
 (Cont’d)

• This FOC can also be exhibited graphically.

– In this two-dimensional case, profits are given by  = py - wx.
– The level sets of this function for fixed p and w are straight lines
(Isoprofit lines) which can be represented as functions of the
form:
y =  /p +(w/p)x.
– Here the slope of the line (w/p) gives the wage measured in
units of output, and the vertical intercept gives us profits
measured in units of output.( /p)
• By inspection it can be seen that such an optimal point can be
characterized by the tangency condition

• In this two-dimensional case it is easy to see the appropriate SOC for

profit maximization,
SOC in the multiple-input case.
• In this case the SOC for profit maximization is that the matrix of
second derivatives of the production function must be negative semi-
definite at the optimal point; that is, it requires that the Hessian matrix

• The Hessian matrix is negative semi-definite means that the

production function must be locally concave in the neighbourhood of
an optimal choice.
Difficulties(read Varian)
• For each vector of prices (p, w) there will in general be some
optimal choice of factors x*.
• The function that gives us the optimal choice of inputs as a function
of the prices is called the factor demand function of the firm.
– This function is denoted by x(p, w).
• It follows, the function y(p, w) = f(x(p, w)) is called the supply
function of the firm.

We will often assume that these functions are well-defined and nicely
behaved, but it is worthwhile considering problems that may arise
if they aren't.
Ex. If Leontief technology, no interior solutions, if there is no π max
plan (i.e. when p>w) and even when a profit-maximizing
production plan exists, it may not be unique.
The Envelope theorem (generalizes Hotelling’s
Lemma)
• The derivative property of the profit function is a special case of
a more general result known as the envelope theorem
• Consider an arbitrary maximization problem where the objective
function depends on some parameter a:

• The function M(a) gives the maximized value of the objective

function as a function of the parameter a.
• In the case of the profit function a would be some price, x would
be some factor demand, and M(a) would be the maximized
value of profits as a function of the price.
• Let x(a) be the value of x that solves the maximization problem.
• Then we can also write M(a) = f (x(a), a). This simply says that the optimized
value of the function is equal to the function evaluated at the optimizing choice.
• It is often of interest to know how M(a) changes as a changes. The envelope
theorem tells us the answer:

• The proof of the envelope theorem is given in Chapter 27, page 491
• Let's see how the envelope theorem works in the case of a simple
one-input, one-output profit maximization problem.
• The profit maximization problem is

Where, the a in the envelope theorem is p or w, and M(a) is (p,w).

 Envelope theorem (cont’d)

• According to the envelope theorem, the derivative of (p, w) with respect to p

is simply the partial derivative of the objective function, evaluated at the optimal
choice:

This is simply the profit-maximizing supply of the firm at prices (p, w).

Similarly,

which is the profit-maximizing net supply of the factor.

 Comparative statics using the profit function

• We have just seen that the net supply functions (output supply function
and input demand functions) are the derivatives of the profit function.
• It is of interest to see what the properties of the profit function imply
about the properties of the net supply functions.
– First, the profit function is a monotonic function of the prices.
Hence, the partial derivative of (p) w.r.t price i will be negative if
good i is an input and positive if good i is an output.
– Second, the profit function is homo(1)in the prices. It follows that
the partial derivatives of the profit function ( supply & demand
functions) must be homogeneous of degree 0.
Scaling all prices by a positive factor t won't change the optimal
choice of the firm, and thus profits will scale by the same factor t.
– Third, the profit function is a convex function of p. Hence, the
Hessian matrix-must be a positive semi-definite.
But the matrix of second derivatives of the profit function is just
the matrix of first derivatives of the net supply functions.
• In the two-good case, for example, we have

• The matrix on the right is just the substitution matrix-how

the net supply of good i changes as the price of good j
changes.
• This must be a symmetric, positive semi-definite matrix,
i.e. the effect of a change in the price of input i on the use
of input j is exactly the same as the effect of change in the
price of input j on the use of input i
 – Thus all diagonal elements must be positive. An increased
output price is thus met by increased output.
– If yi is an input (yi=-x) which implies that input demand
decreases in input price.
• The fact that the net supply functions are the derivatives of the
profit function gives us a handy way to move b/n properties of
the profit function and properties of the net supply functions.
• Many propositions about profit-maximizing behaviour become
much easier to derive by using this relationship
COST MINIMIZATION
 Cost Minimization

• In this part we will study the behaviour of a cost-minimizing firm.

• This is of interest for two reasons:
– first it gives us another way to look at the supply behavior of a
firm facing competitive output markets, and
– second, the cost function allows us to model the production
behavior of firms that don't face competitive output markets.
 Cost Minimization and Cost Functions
• A profit maximizing firm necessarily chooses cost-minimizing production plan.
Assume that firms are perfectly competitive on their input markets and face fixed
input prices.
w = (w1, . . . ,wn) ≥ 0 be a vector of prevailing market prices at which the firm
can buy inputs x = (x1, . . . , xn).
Consider the problem of finding a cost-minimizing way to produce a given level
of output:

Thus by using Lagrangian we can analyze this contrained optimization as follows

 Cost minimization

Differentiate w.r.t. each of the choice variables, x i, and the Lagrange

multiplier, .
FOCs characterizing an interior solution x* are

B/c wi > 0, i = 1, . . . , n, dividing the preceding ith equation by the jth

yields

This implies that in cost minimization MRTS b/n any two inputs is
equal to the ratio of their prices.
• The solution depends on the parameters w and y.
 We can write x*≡ x(w, y) to denote the vector of inputs minimizing the cost of
producing y units of output at the input prices w.
 The solution x(w, y) is referred to as the firm’s conditional input demand, b/c
it is conditional on the level of output y.
 With two inputs, an interior solution corresponds to a point of tangency b/n the
y-level isoquant & an iso-cost line of the form
wx = α for some α > 0.
If x1(w, y) & x2(w, y) are solutions, then c(w, y) = w1x1(w, y) + w2x2(w, y).

Fig: The solution to the firm’s cost-minimization problem (α < α’ )

 The cost function

Because f is strictly increasing, the constraint will always be binding

at a solution. The cost minimization problem is then equivalent to
 Example: Suppose the firm’s technology is given the following form,
the conditional input demands & the cost function can be derived.
The cost-minimization problem is

The first-order Lagrangian conditions reduce to the two conditions

 Properties of the cost function
• If f is continuous and strictly increasing, then c(w, y) is
1. Zero when y = 0,
2. Continuous on its domain,
3. For all w ≫ 0, strictly increasing and unbounded above in y,
4. Concave & Increasing in w,
5. Homogeneous of degree one in w,
Moreover, if f is strictly quasi-concave, we have
7. Shephard’s lemma: c(w, y) is differentiable in w at (w0, y0)
whenever w0 ≫0, and

Shephard’s lemma states that the change in cost induced by a change in the price
of an input equals the demand for that input, i.e., the direct effect of the price
change
Example: Consider a cost function in the form, c(w, y) =
From Shephard’s lemma, the conditional input demands are
obtained by differentiating w.r.t input prices:

The proportions in w/c a firm will use its inputs depend only on
relative input prices, and are independent of the level of output.
Input share: the proportion of total expenditure spent by the firm on
input i.
si≡ wixi(w, y)/c(w, y)
The input shares are always constant for the Cobb-Douglas cost
function: s1= α, and s2= β.

Properties of conditional input demands

• Ceteris paribus,
1. x(w, y) is homogeneous of degree zero in w, increasing input
prices by the same amount doesn’t alter the firm’s demand for
inputs at all
2. The substitution matrix, defined and denoted.
 Long-run and short-run costs
• In the long-run, the firm can freely choose the amount of every input
it uses in choosing its production plan to minimize cost. While, in
the short run, the firm does not have this.
• Consequently, a firm’s costs in the s/run differ from its costs in the
l/run.
1. The short-run, or restricted, cost function
The fixed inputs enter as parameters rather than as choice variables in
s/run costs.
• For a given level of output, l/run costs can never be greater than s/run
costs.
In the l/run, it will use input combinations B, C, & D, and be able to
achieve l/run costs of c(y1), c(y2), and c(y3), respectively.
• Note sc(y1) and sc(y3) are strictly greater than c(y1) and c(y3),
respectively, and sc(y2) = c(y2).
Solving for a cost function - an example

 The minimal cost required to produce a certain output level y at given

prices p can be obtained by substituting the optimal bundle back into the
cost expression.
 This gives us the cost function for the technology.



 The first-order conditions are

Example (ontinued)
 Short run and long run cost

 In the s/run, some of the factors of production are fixed.

 Then the short-run cost function can be written as
 Short run and long run cost (cont’d)

 L/run and s/run are of course relative concepts.

o Which factors are considered variable and which are fixed depends on
the particular problem being analyzed.
o You must first consider over what time period you wish to analyze the
firm's behavior and then ask what factors can the firm adjust during
that time period.
 Short run and long run cost (cont’d)

e.g: CRS & the cost function (how costs & inputs are related)

 If the production function exhibits CRS, then the cost function should exhibit
costs that are linear in the level of output:
o if you want to produce twice as much output it will cost you twice as
much.

o If the technology exhibits CRS, then the average cost, the average
variable cost, and the marginal cost functions are all the same.

B/c CRS implies all factors are variable and AC =AVC and this
equals the constant MC
 The geometry of costs
(How different costs change when output increases)

 Since we have taken factor prices to be fued, costs depend only on the level
of output of a firm.
 The TC curve is always assumed to be monotonic in output: the more you
produce, the more it costs.

 The AC curve, however, can increase or decrease with output, depending on

whether TCs rise more than or less than linearly.

 It is often thought that, at least in the s/run, is the case where AC curve first
decreases and then increases b/c SAC = AVC+AFC, where AFC
continuously decreases with output while AVC initially decreases if there is
some initial region of economies of scale.

 However, the variable factors required will increase more or less linearly
until we approach some capacity level of output determined by the amounts
of the fixed factors
 The geometry of costs cont...
 When we are near to capacity, we need to use more than a proportional
amount of the variable inputs to increase output.
 Thus, the AVC function should eventually increase as output increases ,
 The level of output at which the AC is minimized is sometimes known as the
minimal efficient scale.
 If there are l/run fixed factors , the appropriate LAC curve should
presumably be U-shaped, for essentially the same reasons given in the short-
run case.
 The geometry of costs cont....

 The Marginal cost curve: What is its relationship to the average cost
curve?
 Let y* denote the point of minimum average cost; then to the left of
y*average costs are declining so that for y y*

 This inequality says that MC<AC to the left of the minimum AC point.
 The geometry of costs cont...

 A similar analysis shows that

 Since both inequalities must hold at y*, we have

that is, marginal costs equal average costs at the point of minimum
average costs.
 Simply by changing the notation in the above argument, we can show that
1. average variable cost curve is decreasing: Marginal cost curve lies
below AVC curve
2. average variable cost curve is increasing: Marginal cost curve lies
above AVC curve
3. average variable cost curve is minimum: AVC = MC
 It is also not hard to show that marginal cost must equal average variable cost
for the first unit of output.
 Long-run and short-run cost curves (comparison of
costs in the two runs)
 In the short run all factors cannot be adjusted in response to a change in
input prices.
 Thus, short run total cost must exceed long run total cost for any output
level. Consequently, the same is also true for average costs.
 Long-run and short-run cost curves…
 The marginal cost curve intersects a U-shaped average cost curve at its
minimum point since,

(derivative of average cost wrt y or slope of AC)

 Note that the long run average cost LAC is tangent to the short run average
cost SAC where SMC = LMC.
 SAC  LAC for all output levels and they coincide when the fixed factor is at
its optimal level (both on LAC and SAC curve).
 At that point the curves must be tangent.
 Moreover, at that point SMC = LMC since the value of adjusting the fixed
factor in response to a small change in output is zero (since it is already
optimal) by the envelope theorem.
 If the technology exhibits constant returns to scale then AC=MC (in the long
run)
 Long-run and short-run cost curves…

Elasticity of scale

 Given a production function f (x) we can consider the local measure of

returns to scale known as the elasticity of scale, defined by

 The technology exhibits locally decreasing, constant, or increasing returns to

scale.
 Given some vector of factor prices we can compute the cost function of the
firm c(w, y).
 Let x* be the cost-minimizing bundle at (w, y). Then we can calculate e(x*)
by the following formula:
 Long-run and short-run cost curves…

Thus, if MC is below AC there is increasing returns to scale and if the

reverse holds there is decreasing returns to scale .
Comparative statics using the cost function
 Duality
 Any concept defined in terms of the properties of the production function has
a "dual" definition in terms of the properties of the cost function and vice
versa.

Duality

 The input requirement set V(y) describes the technology.

 Depending on the relative prices of inputs firms choose different input
bundles along the isoquant. Suppose that we do not know the underlying
technology but can observe the input choices of a cost minimizing firm
for all possible prices.

 Suppose the bundle x is choosen at prices w. Then the set of all input
bundles more expensive than this must include the true input requirement
set.

 Let V*(y) be the set of input bundles that are at least as expensive as the
bundle choosen at w, for all prices w.

 Duality (cont’d)

1. A differentiable function satisfying the properties for cost functions

above is indeed a cost function for some technology.
i. if the original technology is convex and monotonic, then this
cost function can be used to completely reconstruct the original
technology.
ii. If the original tecnology is not convex or nonmonotonic, the
constructed input requirement will be a convexified,
monotonized version of the original set and most importantly,
the constructed technology will have the same cost function as
the original technology
 Duality (cont’d)
2. Functions satisfying the properties of the conditional demand functions –
 (i). homogeneity of degree 0 in prices and
 (ii) that the matrix of partial derivatives with respect to prices is
symmetricand negative semidefinite - can be show to be a conditional
demand function for some technology.
Example: Applying the duality mapping (Going from costs to
technology: See example in Varian, p 87.)
Duality (cont’d)