Professional Documents
Culture Documents
Firm 1
Firm 1
1.0 Introduction
In this lesson, we begin by a review of the meaning of microeconomics.
Microeconomics is concerned with the behavior of individual economic units and their
interactions. The two types of economic units typically considered are firms and
consumers. The major type of interaction that is usually analyzed is that of market
In studying economic units and their interaction, we will utilize two major analytical
techniques
behavior. In so doing we need to specify the objective of the unit and the
constraints which it faces. For example when we model the behavior of firms, we
will want to describe the objective as profit maximization and the constraints as
budget constraints.
what happens to the economic system when all of the units’ behavior is
economic system when some consumers /firms find their action thwarted.
examination of situations in which no economic unit can further its objectives through
feasible changes in its behaviors, that is, in an economic equilibrium each unit is
1
choosing an action which, given the choices of the other agents, it perceives as optimal,
1.1. Objectives
By the end of this lesson, the learner should be able to:
• Understand the duality aspect between the cost function and the production
function.
2
1.2. Theory of the Firm (Producer)
π = TR − TC
TR = PQ
• Revenue maximization
• Cost minimization
It is assumed that the objective of a firm is to maximize profits but subject to:
(i) Technological constraints, that is, the relationship between inputs and
(ii) Market constraints. This is concerned with the effects of actions of other
that is, price takers in both inputs and outputs. Therefore the focus will
be on technological constraints.
3
1.2.1. The production function
The simplest and most common way to describe the technology of the firm is the
production function. It represents the maximum output that can be produced using a
Mathematically, Q = f ( inputs )
Output Q
Q = f ( Inputs )
Q2
Production
Q1
possibilities
set
X1 X2 Inputs X
Given any sets of inputs say x1 , the maximum possible Q is Q1 , for X 2 is Q2 .The
area below the production function represents the set of feasible production plans or the
where z is real valued, M-dimensional vector containing both inputs used and quantity
produced in a given time period. We would further represent the function as
non-negative outputs.
4
The explicit form of the above equation expresses the vector of outputs as a function of
the vector of inputs, that is y = f ( x ) . If the highest level of output is isolated from the
net-put vector, and expressed as a function of a given set of inputs, it provides the
inputs.
If x ' and x are two vectors of inputs such that, x ' ≥ x then the output produced from
I.e. the output produced from x ' must be at least equal to the output from x
Given the two vectors of inputs above, such that x ' > x then f ( x' ) > f ( x)
where 0 < x < x i.e. the output produced from a superior vector of inputs must be strictly
greater.
V ( y ) = { x : f ( x ) ≥ y}
The input requirement set is a convex set, i.e. it is all the input combinations x capable
of producing at least output level y . This property implies that the law of diminishing
5
X2
V ( y)
y
X1
Alternatively, the property implies that if x 1 and x 2 are both elements of the input
any weighted average of these two input bundles can also produce y .
x1 x2
6
∂ 2y ∂ 2y
∂ x 2 ∂ x1∂ x2
1
x1
H = <0
∂ y ∂ y
2 2
x2
∂ x2∂ x1 ∂ x22
∂y
∂2 y ∂
Where 2 = dx i = ∂MPx i < 0
∂xi
∂xi ∂xi
I.e. The principal diagonal of the Hessian matrix should be negative because the
α α2
e.g. y = Ax1 1 x2 , α 1, α 2 < 1
∂y α −1 α
= α1 A x1 1 x2 2
∂x1
∂2 y
= α1 (α1 − 1) Ax 1α1 −2 x 2α2
∂x12
∂y α α −1
= α2 A x1 1 x2 2
∂x2
∂2 y
= α2 (α2 − 1) Ax1α1 x2α2 −2
∂x22
7
4. (a) Weak Essentiality
It states that without inputs we cannot produce any output i.e. to produce a
i.e. f (0n ) = 0,
If any of the inputs in the input bundle is zero, then output is zero, that is, all
V ( y)
5. The input requirement set is closed and non empty for all positive
means that it is always possible to produce any positive output, i.e. feasibility
8
7. The production function is everywhere continuous and twice differentiable.
0 ≤ x < 1
1 ≤ x < 2
differentiable is; f ( x ) = .
.
n ≤ x < n + 1
It takes the form; f ( x ) = min (α1 x1 , α2 x 2 ,...... αn x n ) i.e., it equates the output level to
If α1 x1 = 10 & α 2 x 2 = 15
Then f ( x ) =10
X2
V ( y)
X1
9
2. Linear production function.
n
f ( x ) = ∑ α i xi = ( α 1 x1 + α 2 x 2 + ... + α n x n ) , α i > 0
i =1
The function assumes that the inputs in production are perfect substitutes.
X2
V ( y)
X1
n
f ( x) = A∏ xih ( x ) g ( x )
i =1
Where;
h( x ) = αi
g ( x) = 0
n
f ( x ) = A∏ xiαi
i =1
i =1,2......
f ( x ) = A x1 1 x2 2 .........
α α
co b bd o u g la sfu n ctio n
10
Where A is an efficiency parameter and measures the level of technical progress and
f ( x ) = A x1 1 x2 2
α α
α −1 α2 x
= α1 A x1 1 x 2
* 1
α1 α 2
Ax x
1 2
= α1 (elasticity)
X2
V ( y)
X1
11
Where: A is an efficiency parameter.
α is distribution parameter. It shows how the two inputs are distributed over
output remains constant, i.e. it’s the adjustment of xi which is necessary to preserve
∂f
∂xi
MRTS ij = −
∂f
∂x j
∂f
Where; = MPi = f i
∂xi
∂f
= MP j = f j
∂x j
So that;
12
fi
MRTS ij =−
fj
defect, i.e. The value depends on the units of measurements of the input involved in
production.
A superior measure in this regard is the elasticity of substitution (δ ) . It’s defined as the
proportionate change in the input ratio divided by the proportionate rate of change in
MRTS.
x
∂ i
x MRTS
= ×
% change in input ratio j
δ=
% change in MRTS ∂MRTS xi
xj
Or,
fi f j
δ=
Qf ij
Q = AL α K β
∆Q
fL = = αALα−1 K β
∆L
∆Q
fk = = βALα K β −1
∆K
fl αALα−1 K β
=
fK βALα K β −1
α K
MRTS = ×
LK
β L
K β
= × MRTS
L α
LK
13
K
∂
L =β
∂MRTS α
αK
β MRTS β βL
δ= × = × =1
α K α K
L L
Or
fL fK αALα −1 K β × βALα K β −1
δ= = =1
Qf LK β αALα −1 K β −1 × ALα K β
Q = αL + βK
fL =α
fK = β
fL α
MRTS = =
fK β
fL fK αβ
δ= = =∞
Qf LK 0 × ( αL + βK )
Q = min (αL, βK )
if αL < βK
Then Q = αL
f L =α
f K =0
f LK = 0
14
fL fK α ×0
δ= = =0
Qf LK 0 × αL
15
( )
1
−
Q = A αL− + βK −
∆Q
( )
1
1 − −1
fL = = − A αL− + βK − × −αL−−1
∆L
( )
1
1 − −1
f L = − A αL− + βK − × −βL−−1
α L−−1 α K +1
MRTS = =
β K −−1 β L+1
+1
α K
MRTS =
βL
+1
K β
= × MRTS
L α
1
K β +1 1
= ( MRTS ) +1
L α
K
∂ 1
L = β +1 × 1 ( MRTS 1
) +1−1
∂( MRTS ) α +1
K
∂
MRTS
δ= ×
L
∂( MRTS ) K
L
1
β +1 1 1 MRTS
= × ( MRTS ) +1−1 ×
α +1 1
β +1 1
( MRTS ) +1
α
1
=
+1
Under different assumptions about , the C.E.S can collapse into any of the specific
forms of production functions e.g. if = 0 , then δ =1, which resembles the Cobb
Douglas production function and hence the two factors of production are imperfect
substitutes. That is, C.E.S will manifest itself as a Cobb Douglas function.
If = −1 , then δ =∞ and the factors are assumed to be perfect substitutes. The C.E.S
16
If = ∞ and δ =0 and the factors are assumed to be complements. The C.E.S manifests
Illustration
( )
1
Q = A αL− + (1 − α ) K −
−
( )
1
Q
= αL− + (1 − α ) K −
−
A
Q = (αL− + (1 − α ) K − )
1 −
A
Dividing through by −
− e −1
Q
∂Q = α L−−1∂L + (1 − α ) K −−1∂K ............ *
A
Suppose = 0
−1
Q
∂Q = αL−1∂L + (1 −α) K −1∂K
A
∂Q α∂L (1 −α)∂K
= +
AQ L K
1 ∂Q ∂L ∂K
+(1 −α) ∫
A∫ Q
=α∫
L K
17
ln Q
= α ln L + (1 − α ) ln K
A
ln Q
= ln Lα + ln K (1−α )
A
= ln ( Lα K 1−α )
ln Q
A
Q
= Lα K 1−α
A
Q = ALα K 1−α (Cobb Douglas function )
Suppose = −1
−1
Q
∂Q =αL−1∂L +(1 −α) K −1∂K
A
1
∂Q = α∂L + (1 −α ) ∂K
A
1
∂Q = α∫ ∂L + (1 −α) ∫ ∂K
A∫
1
Q = αL + (1 − α ) K
A
Where A = 1
18
Alternative
f ( x)
The rule states that if lim = 0, ∞ then we take the same limit but on the
x →0 g ( x)
f ' ( x)
differentiated function i.e. lim
x →0 g' ( x)
( )
1
Q
= αL− + (1 − α ) K −
−
A
ln = ln (αL− + (1 −α ) K − )
Q
A
ln
[
Q − ln αL− + (1 −α ) K −
=
]
A
Let
[
M ( e ) = − ln αL− + (1 − α ) K − ]
N ( e) =
Q M ( e)
lim
→0 A
=
N ( e)
=0
Hence
N ' () = 1
−1α ln L− + −1(1 − α ) K − ln K
M ' ( ) =
αL−e + (1 − α ) K −
19
M ' ( ) α ln L + (1 − α ) ln K
Taking lim =
→0 N ' ( ) 1
Q
ln = ln Lα + ln K (1−α )
A
= ln ( Lα + K ( 1−α ) )
Q
ln
A
Q = ALα K 1−α ( Cobb Douglas function )
Activity
You are provided with the following production function where y the output is and x
function?
Question
20
Note
A production function represents the maximum possible output from any given set of
inputs.
Summary
In this lesson, we have defined and learnt the properties of a production function. We
have also learnt the different types of production functions and how under certain
assumptions, the CES type may give rise to any other specific production function.
21
22