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3.

Production
1

Assumptions

Given a technology, we can transform some of the L commodities into other


commodities. This is summarized by a production vector y = (y1 , ..., yL ) RL .
For instance, (2, 3, 4, 0, 1) R5 is a production vector.
The set of production vectors that are feasible is the production set Y RL .
It is determined by a given technology. This set is described by the transformation function F (y) as follows: Y = {y RL : F (y) 0}. The transformation
frontier is {y RL : F (y) = 0}.
In the case of a single output technology, we use the following notation:
Y = {(z1, ..., zL1, q) : q f (z1, ..., zL1) 0, (z1, ..., zL1) 0}.
We will list some properties of production sets. Note that some of them are
mutually exclusive.
i) Y is nonempty.
ii) Y is closed, y n y, if y n Y , then y Y.
iii) No free lunch. If y Y and y 0, then y = 0.
iv) Possibility of inaction: 0 Y. This is not satisfied if there are sunk costs.
v) Free disposal. If y Y, y 0 y y 0 Y. The absorption of any additional
amounts of inputs without any reduction in output is possible.
vi) Irreversibility. If y Y, y 6= 0, then y
/ Y.
vii) Non-increasing returns to scale: y Y, y Y, [0, 1].
viii) Non-decreasing returns to scale: y Y, y Y, 1.
ix) Constant returns to scale: vii and viii both hold.
In the case of a single output, such as a Cobb-Douglas production function,
if + = 1, then there are CRS. Then, the production function is homogeneous
of degree one.
x) Additivity. y Y, y 0 Y y + y 0 Y, or Y + Y Y. This is related
with the idea of free entry: the aggregate production set satisfies additivity
when free entry is possible: if y and y 0 are possible, then one can set up two
plants that do not interfere with each other and carry out production plans y
and y 0 independently.
xi) Convexity. Y is convex: if y, y 0 Y, [0, 1], then y + (1 )y 0 Y.
With fixed costs, convexity is not satisfied.
xii) Y is a convex cone: y, y 0 Y, , 0, we have that y + y 0 Y.

The PMP and the CMP

Given the production set and a vector of prices p >> 0, the firms optimal
behavior is determined by the solutions to the profit maximization problem and
the cost minimization problem, respectively. Assume that Y is nonempty, closed
and satisfies free disposal. Then, the PMP is

max p y
y

s.t. y

Y, or s.t. F (y) 0

The FOCs of this problem are, at an interior solution,


F (y ) = p
The argmax of this problem is the firms supply correspondence or function
y(p) = {y : p y = (p)}, where (p) = max {p y : y Y } . Hotellings lemma
is (p) = y(p).
The cost minimization problem is
min w z
z0

s.t. f (z) q
and the argmax of this problem is the conditional factor demand correspondence or function z(w, q).
There are some situations where we cannot find any solution to the PMP, for
instance, with a CRS production function f (x) = x and p > w. In this case, the
firm would like to produce an arbitrarily large amount of output, and the profit
function is discontinous in p, w. However, the CMP is meaningful because for
that problem, the level of output is fixed. Note that profit maximization implies
cost minimization, but not the other way round. Furthermore, whenever there is
market power, the profit maximization problem changes, while the minimization
of cost remains valid.
For instance, in the Cobb-Douglas case, if q = f (z1 , z2 ) = z1 z2 , if + > 1,
then there is no solution to the PMP. If + = 1, any level of output yields
zero profits, and if + < 1, the optimal q is zero.
Shepards lemma is w c(w, q) = z(w, q). Finally, the interpretation of the
multiplier in cost minimization problem is the marginal cost of production.
Example 1 The cost function for the Cobb-Douglas technology comes from the
cost minimization problem
min w1 z1 + w2 z2
z0

s.t.

z1 z2

q,

and the first order conditions are:


w1 + z11 z2

0, = 0 if z1 > 0

w2 + z1 z21
(z1 z2 q)

0, = 0 if z2 > 0
=
2

0.

Therefore, at an interior solution,


z11 z2
z1 z21

w1
z2
w1

=
,
w2
z1
w2

where the LHS is the MRTS and the RHS is the ratio of factor prices. This
is analogous to the utility maximization problem where MRS equals the ratio of
prices, and it implies tangency of the isoquant and the isocost curves.
Making use of the constraint, we can obtain the conditional factor demands
z(w, q), since z1 z2 = q. Thus, we have that
z1 = z2

w2
z2+ = q
w1

w1
w2

, z1+ = q

w2
w1

and the cost function is just c(w, q) = w1 z1 (w, q) + w2 z2 (w, q). In our case, it is
c(w, q) = q

1
+

" 
#
  +

+
+
w1+ w2+

This information may be used to construct the firms supply function. In


particular, the sum + determines whether the technology exhibits increasing,
decreasing, or constant returns to scale. In the case of constant returns to scale,
i.e. + = 1, the supply function is determined by the comparison between
the output price and the unit cost c(w, 1). If the former exceeds the latter, it is
optimal to produce an infinite amount. Conversely, if the unit cost exceeds the
price, it is optimal not to produce at all. If the price exactly equals the unit cost,
then any level of output yields zero profits.
Example 2 In the case of a Leontief technology, the cost function cannot be
obtained from the Lagrangian, since the function f (z1 , z2 ) = min{z1 , z2 } is not
differentiable. If the firm is to minimize costs, it will operate at a point where
z1 = z2 = q. Thus,
c(w, q) = q(w1 + w2 )