university of leipzig · production theory overview 1 the production set 2 e¢ ciency 3 exploring...
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Advanced MicroeconomicsProduction theory
Harald Wiese
University of Leipzig
Harald Wiese (University of Leipzig) Advanced Microeconomics 1 / 48
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Part B. Household theory and theory of the �rm
1 The household optimum2 Comparative statics and duality theory3 Production theory4 Cost minimization and pro�t maximization
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Production theoryOverview
1 The production set2 E¢ ciency3 Exploring the production mountain (function)4 Edgeworth box and transformation curve5 Convex production sets and convave production functions
Harald Wiese (University of Leipzig) Advanced Microeconomics 3 / 48
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The vector space of goods and inputs
Set of goods bundles:
R` := f(z1, ..., z`) : zg 2 R, g = 1, ..., `g .
we allow for zg < 0;
goods of a negative amount � input or factors of production;
goods of a positive amount �output or produced goods.
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The vector space of goods and inputs
1z
2z
inaction
outputofunits
inputofunits
2
1
z
z−outputofunits
outputofunits
2
1
z
z
inputofunits
outputofunits
2
1
z
z
−inputofunits
inputofunits
2
1
z
z
−−
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De�nition of a production set
De�nition
A production set Z � R` is the set of input-output combinations suchthat:
Z is nonempty,
Z is closed,
for every bundle of inputs (z1, ..., zm) 2 Rm�, there is a bundle of
outputs (zm+1, ..., z`) 2 R`�m+ such that:0@z1, ..., zm| {z }
inputs
, zm+1, ..., z`| {z }outputs
1A 2 Z
holds;
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De�nition of a production set
De�nition8<:0@zm+1, ..., z`| {z }
outputs
1A 2 R`�m+ :
0@z1, ..., zm| {z }inputs
, zm+1, ..., z`| {z }outputs
1A 2 Z
9=; is
bounded for every input bundle
0@z1, ..., zm| {z }inputs
1A 2 Rm�,
Z does not contain any element z > 0 and
z 2 Z implies �z /2 Z .The elements in Z �production vectors, production plans or input-outputvectors.
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De�nition of a production set
1z
2z
( )21 zz ,
1z 1z−
2z
2z−
( )21 zz �,�
( )21 22 zz ,
lunchfree
( )( )21
21
zz
zz
,ofreversal
,−−Z
inaction
productiondivine
Divine production: Then let us all with one accord sing praises to ourheavenly Lord, who hath made heaven and earth from naught ...Harald Wiese (University of Leipzig) Advanced Microeconomics 8 / 48
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Further axioms
De�nition
A production set Z � R` obeys
the possibility of inaction if 0 2 Z holds,the property of free disposal if z 2 Z and z 0 � z implies z 0 2 Z ,nonincreasing returns to scale if z 2 Z implies kz 2 Z for allk 2 [0, 1],nondecreasing returns to scale if z 2 Z implies kz 2 Z for all k � 1,Z -convexity if Z is convex.
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Further axioms
1z
2z(b)
1z
2z(c)
1z
2z(d)
setupcosts
inaction
Z
Z
Z
( )01,z
( )21 zz ,
Nonincreasing returns to scale are violated in (b) and (c).Harald Wiese (University of Leipzig) Advanced Microeconomics 10 / 48
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Returns to scale
Returns to scale are:
nonincreasing if production can be scaled down;nondecreasing if production can be scaled up.
Z -convexity and possibility of inaction imply nonincreasing returns toscale.
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Production theoryOverview
1 The production set2 E¢ ciency3 Exploring the production mountain (function)4 Edgeworth box and transformation curve5 Convex production sets and convave production functions
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Input e¢ ciency and output e¢ ciencyInput improvement
De�nition
Let Z � R` be a production set. A point
z =
0@z1, ..., zm| {z }inputs
, zm+1, ..., z`| {z }outputs
1Ais not input-e¢ cient if another input-output vector
z =
0@z1, ..., zm| {z }inputs
, zm+1, ..., z`| {z }outputs
1Aexists such that (z1, ..., zm) > (z1, ..., zm) .z �an input improvement over z .
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Input e¢ ciency and output e¢ ciencyOutput improvement
De�nition
Let Z � R` be a production set. A point
z =
0@z1, ..., zm| {z }inputs
, zm+1, ..., z`| {z }outputs
1Ais not output-e¢ cient if another input-output vector
z =
0@z1, ..., zm| {z }inputs
, zm+1, ..., z`| {z }outputs
1Aexists such that (zm+1, ..., z`) > (zm+1, ..., z`) .z �an output improvement over z .
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Input e¢ ciency and output e¢ ciencyImprovement
De�nition
Let Z � R` be a production set. A point
z =
0@z1, ..., zm| {z }inputs
, zm+1, ..., z`| {z }outputs
1Ais not e¢ cient if another input-output vector
z =
0B@ z1, ..., z`| {z }inputs and outputs
1CAexists such that z > z holds.z �an improvement over z .
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Production theoryOverview
1 The production set2 E¢ ciency3 Exploring the production mountain (function)4 Edgeworth box and transformation curve5 Convex production sets and convave production functions
Harald Wiese (University of Leipzig) Advanced Microeconomics 16 / 48
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Production function and isoquant
De�nition
Let Z � R` be a production set. A function f : R`�1+ ! R+ de�ned by
f (x1, ..., x`�1) = max fy 2 R+ : (�x1, ...,�x`�1, y) 2 Zg .
�the production function for y .
ProblemFind the production functions for the production set
Z =�(z1, z2) 2 R2 j z2 � � (z1)2 if z1 � 0 and z2 � �
12z1 if z1 < 0
�
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Production function and isoquant
De�nition
Let f be a production function on R`�1+ .
Bx :=nx 2 R`�1
+ : f (x) � f (x)o
�the better set Bx of x ;
Wx :=nx 2 R`�1
+ : f (x) � f (x)o
�the worse set Wx of x ;
Ix := Bx \Wx =nx 2 R`�1
+ : f (x) = f (x)o
� x�s isoquant Ix .
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Production function and isoquant
inputefficientpoint
inputinefficientpoint
4
7
2x
1x
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Production function and isoquantIndi¤erence curves vs isoquants
De�nitionA production function f obeys:
weak monotonicity i¤ x > x 0 implies f (x) � f (x 0) ,strict monotonicity i¤ x > x 0 implies f (x) > f (x 0), and
local non-satiation at x 0 i¤ a bundle x with f (x) > f (x 0) can befound in every ε-ball with center x 0.
Cardinality of production functions vs ordinality of preferences!
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Factor variations
Partial factor variation: We change one factor only and keep theother factors constant.
Proportional factor variation: We change all the factors while keepingproportions constant.
Isoquant factor variation: We change the factors so as to keep outputconstant.
Isoclinic factor variation: We change the factors so as to keep themarginal rate of technical substitution constant.
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Partial and proportional factor variations
proportionalfactor variation
partialfactor variation
2x
1x
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Isoquant and isoclinic factor variation
isoclinicfactor variation
isoquantfactor variation
2x
1x
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Partial factor variation
The marginal productivity of factor i :
MPi :=∂f∂xi.
Average productivity of factor i :
APi :=f (xi )xi
.
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Partial factor variationExercises
ProblemSuggest a de�nition of production elasticity. Do you see how theproduction elasticity depends on the marginal and the averageproductivity?
ProblemCalculate factor 1�s production elasticity for the Cobb-Douglas productionfunction f given by f (x1, x2) = xa1 x
b2 , a, b � 0.
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Marginal something equals average something
LemmaLet f : R ! R be any di¤erentiable (production) function )dfdx
��x=0 =
f (x )x
���x=0
if f (0) = 0 holds.
Not di¢ cult to show.
ExamplesAverage product equals marginal product for the �rst �very small� unit,price equals marginal revenue for the �rst �very small� unit.
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Marginal something equals average something
LemmaLet f : R ! R be any di¤erentiable (production) function. Assume x > 0)
dfdx>f (x)x
, d f (x )xdx
> 0.
Problem
Provide a proof by applying the quotient rule of di¤erentiation to d f (x )xdx .
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Marginal something equals average somethingSummary
If the marginal productivity is above the average productivity, theaverage productivity increases.
If the marginal productivity equals the average productivity, theaverage productivity is constant.
This holds for:�marginal revenue and average revenue (price),�marginal cost and average cost and�marginal pro�t and average pro�t.
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Proportional factor variation: returns to scale
De�nitionProportional factor variation:
(x1, ..., x`) 7! t (x1, ..., x`) = (tx1, ..., tx`) .
with
x �the factors of production and
t �scalar.
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Proportional factor variation: returns to scale
De�nition
A production function f : R`+ ! R+ is characterized
by constant returns to scale if
f (tx) = tf (x) for all t � 0;
by increasing returns to scale if
f (tx) � tf (x) for all t � 1;
by decreasing returns to scale if
f (tx) � tf (x) for all t � 1
hold for all x 2 R`+, respectively.
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Returns to scaleScale elasticity
De�nition
Let f : R`+ ! R+ be a production function. The scale elasticity at
x = (x1, ..., x`) is:
εy ,t =
df (tx )f (tx )dtt
������t=1
=df (tx)dt
tf (tx)
����t=1
.
LemmaWe have
increasing returns to scale at x 2 R`+ i¤ εy ,t � 1 holds,
decreasing returns to scale at x 2 R`+ in case of εy ,t � 1 and
constant returns to scale at x 2 R`+ i¤ εy ,t = 1 is true.
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Returns to scaleScale elasticity
ProblemCalculate the scale elasticity for the Cobb-Douglas production function fgiven by f (x1, x2) = xa1 x
b2 , a, b � 0.
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Isoquant factor variation: Marginal rate of technicalsubstitution
De�nitionIf the function Iy is di¤erentiable and if the production function ismonotonic,
MRTS =
����dIy (x1)dx1
�����the marginal rate of technical substitution between factor 1 and factor 2(or of factor 2 for factor 1).
LemmaLet f be a di¤erentiable production function )
MRTS (x1) =∂f∂x1∂f∂x2
.
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Marginal rate of technical substitutionPareto Improvement
E¢ ciency requires:
MRTSA!= MRTSB
Example
(3 =)
����dxA2dxA1���� = MRTSA < MRTSB = ����dxB2dxB1
���� (= 5)
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Production theoryOverview
1 The production set2 E¢ ciency3 Exploring the production mountain (function)4 Edgeworth box and transformation curve5 Convex production sets and convave production functions
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Edgeworth box
If inputs are attributable to speci�c outputs:
A
B
Ax1
Ax2
A
B
xx
x
22
2
−=
4
7
5
3
A
B
xx
x
11
1
−=
EF
G
isoquantsfor output B
isoquantsfor output A
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Edgeworth box
4
7
5
3production
lens
A
B
Ax1
Ax2
Bx2
Bx1
isoquantsfor output B
isoquantsfor output A
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Production curve
De�nitionProduction curve � the locus of all the points of tangency between twoisoquants.
7
5
3
9
14
6
A
B
Ax1
Ax2
Bx2
Bx1
productioncurve
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Transformation curve (production-possibility frontier)
Ay
By
96
3
7
5
transformationcurve
14
ProblemUsing a transformation curve, discuss output e¢ ciency.
ProblemProduction curve and transformation curve forx1 = x2 = 100, yA = xA1 + x
A2 and yB =
�xB1� 12�xB2� 12
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Transformation curveMarginal rate of transformation
De�nitionAssume that the transformation curve de�nes a di¤erentiable functionyA 7! yB .
MRT :=����dyBdyA
�����the marginal rate of transformation between good A and good B.
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Production theoryOverview
1 The production set2 E¢ ciency3 Exploring the production mountain (function)4 Edgeworth box and transformation curve5 Convex production sets and convave production functions
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Convexity of the production set and concavity of theproduction function
LemmaLet
Z be a production set where the �rst `� 1 entries are alwaysnonpositive;
f be the production function associated with Z ;
Z obey free disposal.
) Z is convex i¤ the corresponding production function f is concave.
See manuscript.
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Convex production sets versus convex better sets
ExampleConsider the following production function:
f (x , y) = xy .
It obeys strict quasi-concavity (Cobb-Douglas preferences!).
It is not concave:
f (k (0, 0) + (1� k) (1, 1)) = f (1� k, 1� k) = (1� k)2 < 1� k= k � 0+ (1� k) � 1= kf (0, 0) + (1� k) f (1, 1) .
for 0 < k < 1.
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Convex production sets versus convex better setsExercise
ProblemShow that every concave function is quasi-concave.Remember:f : R` ! R is quasi-concave if
f�kx + (1� k) x 0
�� min
�f (x) , f
�x 0��
holds for all x , x 0 2 R` and all k 2 [0, 1] .f : R` ! R is concave if
f�kx + (1� k) x 0
�� kf (x) + (1� k) f
�x 0�
holds for all x , x 0 2 R` and for all k 2 [0, 1].
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Convex production sets versus convex better sets
Lemma
Let f be a continuous production function on R`+ )
f concave
⇓f quasiconcave
f �s isoquantsconcave
f strictlyconcave
⇓f strictlyquasiconcave
⇒
⇒
f �s isoquantsstrictlyconcave
⇒
⇔ f �s bettersets convex
c
⇐f �s bettersetsstrictlyconvex
f �s productionset underfree disposalstrictly convex
⇔ ⇔ f �s productionset underfree disposalconvex
⇓
cf �s bettersets strictlyconvexand localnonsatiation
⇒
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What about concave utility functions?
There are functions that are not concave but still quasi-concave:
Example
Consider the utility functions U and V given by U (x , y) = xy andV (x , y) = x
13 y
13 . We can apply the increasing function τ : R ! R given
by τ (U) = U13 and obtain
(τ � U) (x , y) = τ (U (x , y))
= τ (xy)
= (xy)13
= V (x , y)
U and V represent the same preferences, but
U is neither convex nor concave but quasi-concave;
V is concave ) V is quasi-concave.
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Further exercises
Problem 1Sketch a few isoquants that re�ect decreasing returns to scale.
Problem 2Determine the production set for the production functiony = f (x1, x2) = min fx1, x2g , x1, x2 � 0.
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Further exercises
Problem 3Let f be a homogeneous function of degree λ (i.e., f (tx) = tλ � f (x)).Show
∑i
∂f∂xixi = λtλ�1f (x)
and, for λ = 1, Euler�s theorem,
∑i
∂f∂xixi = f (x) .
Hint: Calculate ∂f (tx )∂t and
∂[tλf (x )]∂t .
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