Microeconomics: Production, Cost Minimisation, Profit Maximisation
Microeconomics: Production, Cost Minimisation, Profit Maximisation
Microeconomics: Production, Cost Minimisation, Profit Maximisation
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