Microeconomics: Production, Cost Minimisation, Profit Maximisation

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MICROECONOMICS:

PRODUCTION, COST
MINIMISATION, PROFIT
MAXIMISATION
THE PRODUCTION FUNCTION +
MARGINAL + AVERAGE PRODUCTS
 The Production Function simply shows the TECHNICALLY
POSSIBLE outcomes of a given combination of inputs.
 In the form: Y = f(x1, ..., xn)
 It does NOT consider the availability of those inputs, the
affordability of those inputs. It simply shows the process of
transformation from input  output.
 The MARGINAL PRODUCT of an input is the change in
output cause by an incremental change in the amount of the
input:
 dY/dx1 = MPx1
 We assume: MP is NON – NEGATIVE, and is DIMINISHING.
 The AVERAGE PRODUCT of an input is the amount of
output per unit of input:
 Y/x1 = APx1
ISOQUANTS + MRTS
 Basically indifference curves for producers, with caveats.
 An Isoquant describes the different combinations of inputs that will
result in a constant level of output.
 F(K,L) = Y* would describe an Isoquant at the level Y* of output, for example.
 Isoquants are strictly convex and they do not cross.
 HOWEVER: Isoquants are a CARDINAL measure, whilst
Indifference curves are ORDINAL.
 The slope of an Isoquant shows the Marginal Rate of Technical
Substitution; i.e., the rate at which you would have to substitute two
inputs to retain the same level of output.
 You can derive the MRTS thusly:
 Y = F(K,L)
 dY = MPK. dK + MPL. dL = 0
 - dK / dL = MPL / MPK = MRTS of L for K
 Production functions are HOMOTHETIC:
 Any trade off implied by the MRTS is due to the Ratio of two inputs, NOT the
scale of output.
 This suggests that all Isoquants are radial expansions of one another.
RETURNS TO SCALE
 How output changes due to JOINT CHANGES IN INPUTS.
 Decreasing Returns To Scale: If output rises proportionally less than the rise in
inputs.
 Isoquants will be spaced far apart.
 F(tK, yL) < t F(K,L)
 Constant Returns To Scale: If output rises proportionally the same as the rise in
inputs.
 Isoquants will be evenly spaced.
 F(tK, yL) = t F(K,L)
 Increasing Returns To Scale: If output rises proportionally more than the rise in
inputs.
 Isoquants will be bunched together.
 F(tK, tL) > t F(K,L)
 HOMOGENEITY:
 DRS: Homogenous of degree < 1 in inputs
 CRS: Homogenous of degree 1 in inputs
 IRS: Homogenous of degree > 1 in inputs.
 Note that if a function is homogenous of degree ‘k’, it’s derivatives are homogenous
of degree ‘k-1’.
ELASTICITIES
 Output Elasticity:
 Responsiveness of output to a change in input  Percentage change in output
due to a percentage change in input:
Y xi
 Y , xi  
 Elasticity of Substitution: xi Y
 How easy is it to substitute two inputs? How quickly does the MRTS diminish?
 Assume two inputs, Capital and Labour.
 The elasticity of substitution of capital for labour is given by the proportionate
change in K / L relative to the change in the MRTS, shown below:


 l
% k

% k l
 l
 ln k
 A high value of σ indicates%that
MRTSMRTS
K ,L
K/L and the Isoquant is relatively FLAT.
%  
doesn’t
MPL change
MPK

much 
relative to
ln MPL
MPK

 A Low value indicates that MRTS does change much relative to K/L and
the Isoquant is relatively SHARP.
 σ will always be > 0, and can change ALONG an Isoquant or ACROSS
the scale of production.
EXAMPLES OF ELASTICITY OF
SUBSTITUTION
 For a linear function, σ = Infinite
 Denominator is 0.
 For a Fixed Proportions function, σ = 0
 Numerator is 0 as firm will always produce along the ray at which
K / L is constant.
 For a Cobb Douglass function, σ = 1
 Simple to show it’s true.
 In addition, a Cobb Douglass production function can exhibit any
degree of returns to scale – simply sum the indices of the inputs
 If they sum to 1, it is CRS, below 1 is DRS, above 1 is IRS.
 For a CES function, σ = Any value
 A CES function is a more general production than the three
above (as noted in the consumer theory slides).
 The production form of the function is:
 Y = [Kp + Lp]γ/p
 Direct application of this yields the result that:
 σ = 1 / (1 – p)
THE COST MINIMISATION PROBLEM
 Analogous to the Expenditure Minimisation problem in consumer theory.
 The firm’s budget constraint can be graphically expressed via an ISOCOST line.
 Want to find the Isocost line that is TANGENTIAL to the Isoquant at the desired level
of output.
 To do this, identify the Objective Function as:
 Min r1x1 + r2x2 + ... + rnxn
 And identify the Constraint as:
 Y* = F(x1, x2, ..., xn)
 Once done, simply apply traditional Lagrangian methodology to receive the
optimal quantities and therefore the minimum price.
 Also, it transpires that
 MRTS (xi for xj) = MPI / MPJ = ri / rj
 In other words, the Marginal Rate of Technical Substitution between two inputs is
equal to the ratio of their prices.
 Assumption is that the price of output is irrelevant.
 In addition, you can use Expansion Paths to graphically show the locus of cost –
minimising points for a firm.
 They do NOT have to be straight lines.
 They may bend backward – if an input is used less as the scale of production rises,
it is an inferior input.
THE COST FUNCTION
 Using the optimal quantity of inputs, given by the cost – minimisation
problem, we can express Total Cost as:
 TC = r1x1*+r2x2* + ... + rnxn*
 Total Cost is the minimum level of expenditure required to reach a certain
production level, Y*.
 The cost function behaves differently depending on the returns to scale
exhibited by the production function.
 If DRS, the TC function increases more than linearly with respect to output
 If IRS the TC function increases less than linearly with respect to output.
 If CRS the TC function increases linearly with respect to output.
 Marginal Cost is the cost of an extra unit of output, and the MC function
can be given by taking the derivative of the TC function:
 MC = d(TC)/dY
 Graphically, it is the gradient of the tangent to the TC curve.
 Average Cost is the cost per unit of output and can be derived by
dividing TC by output:
 AC = TC / Y
 Graphically, it is the gradient of the line from the origin to a point on the TC
curve.
MC + AC Price

 MC and AC have a MC
relationship as shown to the
side.
 MC will intersect AC at
AC’s minimum point: AC
 The MINIMUM
EFFICIENT SCALE.
 We can also conclude that if
AC is rising, MC must be
rising too – but not vice
versa.
 If AC is falling, MC < AC.
Q* Quantity
THE COST FUNCTION
 Properties:
 Homogenous of Degree 1 in inputs:
 A rise in all prices of inputs will lead to a proportionally equal rise
in expenditure.
 The same can be said for MC and AC
 Cost functions are non decreasing in output and prices of
inputs.
 If costs do decrease due to a RISE in any of the variables, then it
must’ve been the case that the firm wasn’t operating at the minimum
cost initially.
 Cost Functions are concave in input prices:
 If the price of any input rose or fell, the actual cost would be below
the cost if input mix didn’t change.
 Graphically, this can be shown by a concave cost function with a
straight line tangential (and therefore above) to it. The straight line
is the cost function if input prices didn’t change. The x – axis would
be the quantity of one of the inputs
ELASTICITY OF SUBSTITUTION
 Different to the previous Elasticity of Substitution we saw.
 This version shows by how much a change in input prices causes a
change in input usage.
 In order to do this, we see how the ratio of input usage (K / L) changes
in response to a change in the ratio of input prices (r / w), whilst holding

   ln  K 
output constant.
% K
L  L
%  r   ln  r 
sK , L 
w w
 This can be expanded to many inputs, simply replace ‘K’ and ‘L’ with
the inputs and ‘r’ and ‘w’ with the respective payments to those inputs.
 Large values of ‘s’ suggest that the firm substantially alters it’s
input mix with a change of prices.
 In addition, the EXTENT to which a rise in input prices raises TC
depends on:
 Importance of input in production
 Substitutability of inputs
CONTINGENT DEMAND
 Demand for inputs is a DERIVED demand.
 It is derived from two main sources:
 The Cost – Minimisation problem:
 Gives the demand of inputs for a given QUANTITY of output.
 The Profit – Maximisation problem.
 Gives the demand of inputs for a given PRICE of output.
 Derived factor demands are not directly observable. To
calculate it for the cost-minimisation problem:
 USE SHEPHARD’S LEMMA  differentiate the cost function with
respect to the payment of the input in question to get the derived
input demand:
C (r , w, Y )
K (r , w, Y ) 
r
 You can then use this to calculate the elasticity of substitution
straight from the cost function – just replace ‘K’ with the partial
derivative of the cost function with respect to K etc.
SHORT-RUN AND LONG-RUN
DIFFERENCES
 The short run:
 Characterised by at least one factor of production being fixed.
 The long run:
 Characterised by no fixed factors.
 The cost minimisation problem in the short run is the same as
in the long run, except one or more of the factors is held
constant.
 With at least 2 factors not being constant, solve as you would
normally.
 With only 1 variable factor, derive the demand function for that
input, and thus find the Short – Run Total Cost function:
 SRTC: w.[L*(w, r, Y)] + r.[Kfixed] = variable costs + fixed costs
 In addition, the firm won’t be able to work at the optimal
point of production in the short run.
ISOQUANTS AND ISOCOSTS
K
 In the SHORT RUN, at least one
factor is fixed.
 Consider a firm expanding from a £350
production of 20 units to 40 units,
shown by the two different
Isoquants.
 Ideally, the new mix of inputs would £300
be K2 and L2 at a cost of £300.
 However, if we fix CAPITAL in the K2
short run at the level of K1, we see
to produce 40 units the firm has to
employ L3 labour – an inefficient K1
level. Q=40
 It also has to operate on a higher Q=20
Isocost line - £350 rather than £300.
 The MRTS is not equal to the ratio
of input prices. £150
L1 L2 L3 L
SHORT RUN + LONG RUN
 Short run costs are always above or equal to long run costs.
 Diagrammatically, the Long Run AC curve is simply an
‘envelope’ of Short Run AC curves.
 The same can be said for the Long Run Total Cost function – the SR
TC functions will all exhibit a CUBIC pattern – diminishing returns
set in at higher output, so they rise quickly.
 The lowest point on the Long Run AC curve (the MES) had the
property that:
 Min LR AC = min SR AC = SR MC = LR MC

 SRAC
 SRAC = Av. Variable Costs + Av. Fixed Costs
 SRMC
 SRMC = d(SRTC)/dY = d(VC)/dY + d(FC)/dY = dVC/dY
 Slope of the SRTC function AND the VC functions.
PROFIT MAXIMISATION
 Now we have seen how firms minimise costs for a given level of output, let us
consider how the firm decides the level of output itself.
 Model a firm as acting in order to maximise economic profits – the difference
between total revenue streams and the total economic cost incurred.
 If so, we can directly derive the profit maximizing decision from the PROFIT
FUNCTION:
 Π = TR(Q) – TC(Q)
 Maximising conditions mean that marginal profit is to be set to zero (derivative
take w.r.t Q):
 Π’ = MR – MC = 0
 MR = MC
 It must also be the case that the second derivative is negative, hence we have
found a maximum, not a minimum. By solving for this condition, we can derive
the optimal Quantity to be produced.
 We then substitute this figure back into the profit function to calculate the
maximum level of profit.
 We can graphically show the profit maximising condition as the quantity which
yields the greatest distance between the TR and TC curves – this occurs when
the tangents are equal; i.e., MR =MC.
PROFIT MAXIMISATION
 We can also use the profit function to
derive the firm’s SUPPLY function and
DEMAND function for inputs!
 A simple application of the envelope theorem  ( P, r , w)
is shown to the right; this application is called  Q( P, r , w)

Hotelling’s Lemma:
You can derive the demand functions
P
normally by solving the profit Max problem
 ( P, r , w)
 Differentiate profit function w.r.t the factor
of production you want the demand function   K ( P, r , w)
of, then rearrange. r
 Important to note that these demand functions
are unconditional:  ( P, r , w)
 They allow the firm to change output.   L( P, r , w)
 The Properties of profit functions are:
 Homogenous of degree 1 in all prices.
w
 Non decreasing in output price.
 Non increasing in input prices.
 Convex in output prices (that the average of
two profits at two different output prices is
greater or equal to the profit using the average
of those two prices): Intuitive sense due to
firms being able to make better decisions using
each of the two prices, rather than just the
average of the prices.
SUBSTITUTION + OUTPUT EFFECTS
 Two things will happen if the price of an input L
falls: Y’
 There will be a change in the input mix of
production to take advantage of the fall in
price (a movement ALONG the Isoquant
curve) Y
 There will be more products sold due to the
fall in costs which are passed on via lower
prices (a SHIFT of the Isoquant).
 The first effect is the SUBSTITUTION
EFFECT.
 The second effect is the OUTPUT EFFECT.
 These effects are shown in the diagram to the
side. L
 The price of capital falls: L’’
 The Isocost line then TILTS due to a change
in the ratio of input prices.
 This means that the product mix changes and
more Capital is used.
 However, the fall in prices means that MC
falls, which, with fixed prices, means output
also rises.
 Output rises  higher Isoquant, yet different
product mix.
K K’ K’’ K
SUBSTITUTION + OUTPUT EFFECTS
 We can use a very similar analysis to that of Slutsky to
measure the substitution + output effects incurred by a
price change.
 In order to do this, recall that we can derive the:
 CONDITIONAL input demand function, using Shephard’s
lemma.
 UNCONDITIONAL input demand function, using
Hotelling’s lemma.
 The decomposition is therefore (for example, a change in
the wage rate) thus:
L( P, r , w) LC (r , w, Q) LC (r , w, Q) Q( P, r , w)
  
w w Q w
Total effect Substitution effect Output effect

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