1

Miscellaneous Notes on Production Economics

Compiled by Peter F. Orazem
September 9, 2010
I. Implications of convex isoquants
Two input case
, along an isoquant
0 along an isoquant
Slope of the isoquant = , , MRTS is the marginal rate of technical
substitution

A convex shape requires that inputs have diminishing marginal productivity, the necessary
assumption for downward sloping derived demand for factor inputs. This requires that as we
move down an isoquant toward more x1 and less x2, f1 falls and f2 increases, and so 0.

x2

Slope =

x1

,
Note that ; and by Young’s theorem,
,

?
2 0 (I.1)

If term in brackets < 0, then 0 implying convex isoquants and diminishing marginal rate
of technical substitution.

Diminishing MRTS is consistent with stage 2 of production in 1 input case.

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II. Elasticities of substitution

is a measure of substitutability, but it is sensitive to units of the inputs.

Example: Cobb-Douglas

K measured in horsepower or dollars changes slope, as does L measured in hours, weeks, …

Sensitivity to units makes interpretation impossible

Need unit free measure of substitution.

Following RGD Allen (1938), John Hicks (1932)

%∆ , %∆ ,
, %∆
%∆

, · · · ·

?
· 0 (II.1)

This is symmetric and unit free

If 2 0, then , 0 which implies that x1 and x2 are substitutes if

indifferences are convex.

With two inputs, diminishing returns, and either cost minimization or profit maximization, the
two inputs have to be substitutes. With more than two inputs, complements are possible but at
least one pair of inputs has to be substitutes as shown below.
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III. Generalization of the elasticity of substitution

The general form of the elasticity of substitution

| |
· (III.1)
| |

Where |Fij| is the i,j cofactor of F, the Hessian matrix of the production function

Estimating the elasticity of substitution using the primal is complicated because it requires both
first and second order derivatives of the unknown production function to estimate the elements of
the matrix F.

0 f1 f2 …. fn
f1 f11 f12 …. f1n
F= f2 f12 f22 …. f2n
.
.
fn f1n f2n …. fnn

Special case of constant returns to scale (CRS)

The general form of the elasticity of substitution is unwieldy, and so we often impose restrictions
that simplify the form.

Output elasticities sum to 1

1 which means that
(III.2)

With constant returns, each factor is paid its marginal contribution to production. To see this,
multiply both sides by output price p

Total revenue pq is equal to each factor’s marginal revenue product (equal to input price at
optimum) times the amount of the input.

Using (III.2), we can define factor shares without knowing input or output prices by

/
(III.3)
/

And so with constant returns to scale, factor shares equal the ratio of the output elasticity to the
scale elasticity.
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The imposition of constant returns to scale simplifies the estimation of the elements of F
somewhat, although it is difficult to demonstrate that without using a particular specification
which we will demonstrate with the translog production function below. From the general form
above, we can write the CRS form of the elasticity of substitution as

| |
·
| |

Which does not simplify much. However, in the two input form, we can show some substantial
simplifications.

· (III.4)

This can be further simplified by imposing the restrictions implied by which

implies
0 0
0 0

Inserting these into the denominator of the second term in (III.4), we have

Placing this into the CRS form of the elasticity of substitution, we have

· (III.5)

IV. Translog Production Function

To estimate the elements of matrix F, we need first and second partials of the production
function. The translog is a second-order approximation to an unknown production function q =
f(x1, x2, …, xn)

ln ∑ ∑ ∑ (IV.1)

First derivatives of (IV.1) will yield output elasticities

∑ (IV.2)

So
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Second derivatives of (IV.1) are of the form

Rearranging:

And so

· ·

Similarly

· 1

If you wish, you can populate the Hessian matrix of the production function, F, using the
estimated first and second partial derivatives of f(•) and compute the elasticities of substitution

The CRS form of the translog production function imposes the restriction that the output
elasticities must add up to 1. Inspection of (IV.2) reveals that the restrictions implied by CRS
are

∑ 1; ∑ 0 . We can also impose symmetry so that . Often the

restriction improve the precision of the estimates by reducing collinearity among the first- and
second-order terms and reducing the number of parameters to be estimated.
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V. Generalized Cost Minimization

Assume the firm wants to produce a level of output the firm is a price taker in input markets.
The firms objective is to choose inputs x1 through xn so as to minimize the cost of producing .

, ,…,

First order conditions:

0
.
.
.
0

, ,…, 0

For inputs for which equality holds, long-run optimum for any two inputs xi and xj

Firm will set marginal cost of all inputs equal so that

, .

Assume all first order conditions hold with equality. Totally differentiating, we get

0
.
.
.
0
0

Rearranging and applying Young’s theorem

0 -f1 -f2 …. –fn dλ -

-f1 -λf11 -λf12 …. -λf1n dx1 -dw1

-f2 -λf12 -λf22 …. –λf2n dx2 = -dw2

.
.
.
-fn -λf1n -λfn2 …. –λfnn dxn -dwn

H
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The second order condition for cost minimum is that |H| < 0

Using the implicit function rule, |H|≠0 implies that there are well defined reduced form equations
ruling input demand of the form
, , ,…,
, , ,…,
.
.
.
, , ,…,

If there are multiple constraints, the condition for a minimum is sgn|H| =(-1)m where m is the
number of constraints. In two input case, H is

0 -f1 -f2
-f1 -λf11 -λf12 2 <0 for cost minimum
-f2 -λf12 -λf22

But this is the same condition in (I.1) that assures convex isoquants and diminishing MRTS:
stage 2

To get the Hamermesh form (page 35), divide all n equations by λ across both sides of the
equation and multiply both sides by (-1). The equations will have the form:

The matrix form will be

0 f1 f2 …. fn dλ/λ d

f1 f11 f12 …. f1n dx1 dw1/λ

f2 f12 f22 …. f2n dx2 = dw2/λ

.
.
.
fn f1n f2n …. fnn dxn dwn /λ

Multiplying a row by (-1) reverses the sign of the previous determinant. For n+1 equations,
|F| = -[1/(λn )]•|H| if n is even
|F| = [1/(λn )]•|H| if n is odd
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Note the F is the bordered hessian matrix of the production function. A concave production
function requires that sgn(|F|) = (-1)n

VI. Output constant elasticity of factor demand

The output constant elasticity is the input demand along an isoquant. We can relate the elasticity
of substitution to the output constant labor demand elasticity as follows:

Applying Cramer’s rule to the Hamermesh form of the second-order equations (page 35), we
have the cross-price effect defined by

| | | |
| | | |

The first order conditions imply

We can plug these into the general form of the elasticity of substitution (III.1), getting

∑
· ·

∑
· ·

· ;

where kj is the cost share for the jth input, and is the output constant elasticity of the ith input
with respect to the jth input price. Rearranging, we can write the output-constant demand
elasticity as

(VI.1)

If we plug back for σij and kj, we get

| | | |
∑
· · ∑
· ·
| | | |

We can sum all of these output constant demand elasticities as

| | | | | |
∑ ∑ 0 (VI.2)
| | | | | |

The numerators are an example of ‘expansion by alien cofactors’ shown below.

We have shown that the sum of output constant demand elasticities is zero. The cost shares must
be positive. The own demand elasticity σii < 0, and so at least one 0 (ie substitutes). That
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means that in every production process, there must be at least some substitutes. Not all inputs
can be complements for whom 0 because that would violate the condition
∑ ∑ 0

Sidebar: Example of expansion by alien cofactors

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VII. Demonstrating the dual relationship between the cost function and the production
function

From before, we minimized cost subject to a desired output level. With equality of the first order
conditions and a nonzero determinant of the Hessian matrix, we get a system of input demands
, , … , . If we multiply these by their respective input prices, , , … , , we get the cost
of producing output . If we generalize to all output levels, we have a cost function of the form
, , ,…, .

Shepherd’s Lemma

, , ,…, which is the input demand equation

0 is the slope of the input demand equation

is the cross-price effect whose sign is uncertain. 0 means inputs i and j are

substitutes. 0 means that inputs i and j are complements.

Under the dual, the elasticity of substitution can be written

∑
· (VII.1)

Which is much easier to estimate than the elasticity of substitution using the primal (III.1). It
requires only input prices, input quantities, and derivatives of the input demand equation.

Proof:
Applying Cramer’s rule to the Hamermesh form of the second-order equations (page 35), we
have the cross-price effect defined by

| | | |
| | | |

We will use that and the result from the first order condition that .
The definition of the elasticity of substitution under the primal (III.1) is

∑ | |
·
| |

∑
·

∑
· _//
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We can derive the output constant elasticity of demand by multiplying and dividing the right-
hand-side by .

∑
· · ·

That means we have the dual version of the primal result (VI.1) derived before

It is much easier to show condition (VI.2), ∑ 0 using the dual.

Subtracting x1 from both sides, we have

Multiplying both sides by w1 and dividing by C, multiply each term by we have

0 · · ·

Using that and ,

0 ∑ ∑ _//
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VII. Estimating the Dual – The Translog Cost Function

n
1 n n
ln C * = V0 + Vy ln Y + ∑ Vi ln Pi + ∑ ∑ γ ij ln Pi ln Pj
i =1 2 i =1 j=1
n
+ ∑ γ iy ln Pi ln Y
i =1

Where Y is output, Pi is price of input i. Notice: γ ij = γ iy = 0 ∀ i, j ⇒ that the cost function (and
production function) are Cobb-Douglas.

To guarantee homogeneity of degree one in the cost function, impose that

∑V i = 1, ∑ γ ij = 0, ∑ γ iy = 0

One could estimate ln C* directly—but there is a problem with multicollinearity given all the 2nd
order terms in the regression. But it is possible to estimate the parameters through the input
demand equations.

Shepherd's Lemma

∂C *
∂C * ∂ ln C * * P ∂C * x i Pi
= x *i = C = i* = * = Ki
∂Pi ∂ ln Pi ∂Pi /Pi C ∂Pi C

so the derivative of ln C* w.r.t. ln Pi yields an equation for factor shares.

n
K i = Vi + ∑ γ ij ln P j + γ iy ln Y
j=1

The same can be done for the other input prices which yields a system of n factor share equations
in factor prices and output.

⎛ 1 ⎞
1) σ ij = ⎜ ⎟ γ +1 (substitution effect)
⎜ K K ⎟ ij
⎝ i j ⎠
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Proof:

⎛ ∂C * ∂Pi ⎞
∂ ⎜⎜ * ⎟⎟
∂ ln C
2 *
⎝ C Pi ⎠
γ ij = =
∂ ln Pi ∂ ln P j ∂P j /P j
⎛ ∂C * Pi ⎞
∂⎜⎜ ⋅ * ⎟⎟
∂P
⎝ i C ⎠
= Pj
∂P j
⎛ ∂ 2 C * Pi ∂C * ⎛ ∂C * Pi ⎞ ⎞
= Pj ⎜ ⋅ − ⎜ ⋅ ⎟⎟
⎜ ∂Pi ∂P j C * ∂Pi ⎜ ∂P C *2 ⎟ ⎟
⎝ ⎝ j ⎠⎠

Pi P j ∂ 2 C * x i x j Pi P j
so γ ij = ⋅ − .
C* ∂Pi ∂P j C *2

Solving for
∂ 2 C*
and multiplying both sides of the resulting equation by
∑x P
i i
,
∂Pi ∂P j xix j

∑x P i i ⎡ C*
⋅⎢
⎛ x P x P ⎞⎤ ⎡ ∂ 2 C * ⎤ ∑ x i Pi
⎜ γ ij + i * i j * j ⎟⎥ = ⎢ ⎥⋅
xix j ⎜ C ⎟⎠⎥⎦ ⎢⎣ ∂Pi ∂P j ⎥⎦ x i x j
⎢⎣ Pi P j ⎝ C

C* C* ⎛ x P x P ⎞
rearranging, ⋅ ⎜ γ ij + i * i j * j ⎟ = σ ij
x i Pi x j P j ⎜ C C ⎟⎠
⎝

⎛ 1 ⎞
σ ij = ⎜ ⎟ γ +1
⎜ K K ⎟ ij
⎝ i j⎠

γ ij
2) η ij = + Kj (cross demand elasticity)
Ki

3) σ ii =
1
2
(
γ ii + K i2 − K i )
Ki

γ ii
4) η ii = + K i −1 (own price elasticity)
Ki