EconS 501 - Microeconomic Theory I

Recitation #5 - Production Theory-I1

Exercise 1
1. Exercise 5.B.2 (MWG): Suppose that f ( ) is the production function associated
with a single-output technology, and let Y be the production set of this technology.
Show that Y satis…es constant returns to scale if and only if f ( ) is homogeneous of
degree one.

Suppose …rst that a production set Y exhibits constant returns to scale (see …gure
L 1
below). Let z 2 R+ and > 0. Then ( z; f (z)) 2 Y . By constant returns
to scale, ( z; f (z)) 2 Y . Hence f (z) f ( z).

Figure 1. Constant returns to scale.

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By applying this inequality to z in place of z and in place of , we obtain

1 1
f ( z) f ( z) = f (z) ; or f ( z) f (z)

Hence f ( z) = f (z). The homogeneity of degree one is thus obtained.

Suppose conversely that f ( ) is homogeneous of degree one. Let ( z; q) 2 Y and
0, then q f (z) and hence q f (z) = f ( z). Since ( z; f ( z)) 2 Y ,
we obtain ( z; q) 2 Y . The constant returns to scale is thus obtained.
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Felix Munoz-Garcia, School of Economic Sciences, Washington State University, 103G Hulbert Hall,
Pullman, WA. Tel. 509-335-8402. Email: [email protected].

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Exercise 2
2. Exercise 5.B.3 (MWG): Show that for a single-output technology, the production
set Y is a convex if and only if the production function f (z) is concave.

In order to prove this “if and only if statement”we need to show …rst that: if the
production set Y is convex, then the production function f (z) is concave. And
second, we need to show the converse: that if the production function f (z) is
concave then the set Y must be convex.
First, suppose that Y is convex. Let z; z 0 2 RL+ 1
and 2 [0; 1] ; then ( z; f (z)) 2
Y and ( z 0 ; f (z 0 )) 2 Y . By the convexity,

( ( z + (1 ) z) ; f (z) + (1 ) f (z)) 2 Y .

Thus, f (z) + (1 ) f (z) f ( z + (1 ) z). Hence f (z) is concave.

Figure 2. Decreasing returns to scale.

Let us now suppose that f (z) is concave. Let (q; z) 2 Y; (q 0 ; z 0 ) 2 Y , and

2 [0; 1], then q f (z) and q 0 f (z 0 ). Hence

q + (1 ) q0 f (z) + (1 ) f (z 0 )

By concavity,
f (z) + (1 ) f (z 0 ) f ( z + (1 ) z0)
Thus
q + (1 ) q0 f ( z + (1 ) z0)
Hence

( ( z + (1 ) z 0 ) ; q + (1 ) q0) = ( z; q) + (1 ) ( z0; q0) 2 Y

Therefore Y is convex.

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 Finally, note that if, in contrast, the production function f (z) is convex in z (i.e.,
the production process exhibits increasing returns to scale), the production set Y
would be that in …gure 3.

Figure 3. Increasing returns to scale.

Exercise 3
3. Given a CES (Constant Elasticity of Substitution) production function:
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q = f (z1 ; z2 ) = A [ z1 + (1 )z2 ] , where A > 0 and 0 < <1

Calculate the Marginal Rate of Technical Substitution (MRTS) and the Elasticity of
z2
d ln z1
Substitution ( ), where d ln M RT S
.

(a) Is it an homogeneous production function?

(b) Show, using MRTS and , that:
1. when ! 1 the CES production function represents the Leontief produc-
tion function;
2. when = 1 the CES production function represents a perfect substitutes
technology; and
3. when = 0 the CES production function represent a Cobb-Douglas technol-
ogy.

Solution:

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a) We can calculate the MRTS between the two factors as:
1
1 1 1
@q A [ z1 + (1 )z2 ] z1 z1 1
@z1
M RT S12 = @q
= 1
= 1
1 1 1 (1 )z2
@z2 A [ z1 + (1 )z2 ] (1 )z2

Using the de…nition of the Elasticity of Substitution we have:

d ln (z2 =z1 ) d ln (z2 =z1 )

= =
d ln M RT S d ln @q=@z 1
@q=@z2

to …nd this expression we can use the expression of the MRTS we just found:
1
z2
M RT S =
(1 ) z1

and using a logarithmic transformation

z2
ln(M RT S) = ln + (1 ) ln
1 z1

solving for ln(z2 =z1 ) we have:

z2 1
ln = ln(M RT S) ln
z1 1 1

thus,
z2
d ln z1 1
= =
d ln M RT S 1
As we can observe, the elasticity of substitution, , is a constant value for any pro-
duction process and any output value. This is the reason for the name of the CES
function.

b) To verify that it is an homogeneous production function, we increase all inputs by :

1 1
f ( z1 ; z2 ) = A [ ( z1 ) + (1 ) ( z2 ) ] = A [ (z1 ) + (1 ) (z2 ) ]

and rearranging
1
f ( z1 ; z2 ) = A [ (z1 ) + (1 ) (z2 ) ] = f (z1 ; z2 )

then the function is homogeneous of degree one.

c) Now we analyze what happens for di¤erent values of parameter :

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 z1 1
i) When ! 1: From part (a) we have M RT S12 = (1 )z2 1 , the limit of MRTS
when ! 1 is
1 1
z1 z2
lim M RT S12 = lim 1 =
! 1 ! 1 (1 )z2 (1 ) z1

As we can see, if z2 > z1 the MRTS goes to 1 (indicating a vertical segment

of the isoquant) if z2 < z1 the MRTS goes to zero (indicating a ‡at segment of
the isoquant). These values of the MRTS are the same of the Leontief or Fixed
Proportions production function.
ii) When = 1: In this case the production function becomes

q = f (z1 ; z2 ) = A z1 + A(1 )z2

this production function is a perfect substitutes inputs technology (or = 1

,
which is constant in z1 and z2 ).
iii) When ! 0: The MRTS is

z2
M RT S = ;
(1 ) z1
In the extreme case where = 0; the elasticity of substitution = 1 1 becomes
= 1, thus coinciding with the elasticity of substitution of a Cobb-Douglas
production function.

Exercise 4
4. Assume a standard technology represented by the production function q = f (z1 ; z2 ),
show:

(a) If the function represents always Constant Returns to Scale (CRS) , it is true
that marginal productivity of the factors are constant along the same production
process?
(b) What if the degree of the production function is di¤erent from one?

Solution:

a) If the production function has CRS, then the function is homogeneous of degree one,
thus, the marginal productivity of the factors (…rst derivatives of the production func-
tion) are also homogeneous, but one degree less than the original function (degree
zero).
f1 ( z1 ; z2 ) = 0 f1 (z1 ; z2 ) = f1 (z1 ; z2 )
0
f2 ( z1 ; z2 ) = f2 (z1 ; z2 ) = f2 (z1 ; z2 )

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 Since a ray from the origin increases both inputs by a common factor , the input
ratio zz21 remains constant in all points along the ray. In addition, the above result
indicates that the marginal product of every input is constant along a given ray (i.e.,
for production plans using the same ratio of inputs zz12 ). Note that since the marginal
product of every input is constant along a given ratio of input combinations zz12 , then
we must have that the ratio of marginal products ff21 (z
(z1 ; z2 )
1 ; z2 )
is also constant along a given
ray zz21 . Finally, since
f1 (z1 ; z2 )
= M RT S(z1 ; z2 )
f2 (z1 ; z2 )
z1
then the MRTS between inputs 1 and 2 is constant along a given ray z2
. Therefore,
the production function is homothetic.

b) If the production function is homogeneous of degree k 6= 1, then by Euler’s theorem we

know that the marginal product of every input is homogeneous of degree k 1. That
is2
k 1
f1 ( z1 ; z2 ) = f1 (z1 ; z2 ) for the marginal product of input 1, and
k 1
f2 ( z1 ; z2 ) = f2 (z1 ; z2 ) for the marginal product of input 2

In this case, the marginal product of every input is not constant along a given ray zz12 (in
which we increase both z1 and z2 keeping their proportion zz12 unmodi…ed). However,
the production function is still homothetic since:
k 1
f1 (z1 ; z2 ) f1 (z1 ; z2 )
M RT S( z1 ; z2 ) = k 1
= = M RT S(z1 ; z2 )
f2 (z1 ; z2 ) f2 (z1 ; z2 )

Exercise 5
5. Obtain the conditional factor demand functions, z(w; q), the cost function, c(w; q),
supply correspondence, q(w; p), and pro…t function, (w; p), for the technology: q =
z1 z2 with ; 0.

Solution: The technology is a Cobb-Douglas production function, then, the conditional

factor demand functions can be calculated as the solution of the costs minimization problem:

min w1 z1 + w2 z2
z1 ;z2

subject to z1 z2 q
2
For instance, a …rm with a production function that is homogeneous of degree k = 2, the …rm experiences
increasing returns to scale. In contrast, a production function homogeneous of degree k = 1=3 implies that
the …rm experiences decreasing returns to scale.

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The next …gure depicts the cost-minimization problem.

Figure 4. Cost-minimization problem.

The …rst order conditions are:

f1 (z) z2 w1
M RT S12 = = =
f2 (z) z1 w2

and q = z1 z2 .
This is a system of two equations and two unknowns (z1 and z2 ) that can be solved for the
conditional factor demand functions h1 and h2 . From the MRTS we have z2 = w 1
w2 1
z , which
we can replace into the constraint as follows

w1 w1
q = z1 z2 = z1 z1 = z1 +
w2 w2

and rearranging
w2
z1 + = q
w1
which allows us to obtain the conditional factor demand correspondence z1 (w; q) for input
1,
=( + )
w2
z1 = h1 (w1 ; w2 ; q) = q 1=( + )
w1
w1
Now replacing z1 = h1 (w1 ; w2 ; q) into z2 = z
w2 1
we obtain the conditional factor demand
correspondence z2 (w; q) for input 2,
=( + )
w1
z2 = h2 (w1 ; w2 ; q) = q 1=( + )
w2

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Using these values we can …nd the cost function as:

C(w; q) = w1 h1 (w1 ; w2 ; q) + w2 h2 (w1 ; w2 ; q)

that is,
=( + ) =( + )
w2 1=( + ) w1
C(w; q) = w1 q + w2 q 1=( + )
w1 w2
| {z } | {z }
h1 (w1 ; w2 ; q) h2 (w1 ; w2 ; q)

+ 1 + 1
= w1 + w2 + q + + w1 + w2 + q +

" #
1 + +
= w1 + w2 + q + +
| {z }
Set to be K

h i 1
Let = ( + )
and K = : We can rewrite the function as:

1
C(w; q) = w11 w2 q + K

since 1 = ( (++) ) = ( + ) .
Pro…t function. In order to …nd the supply correspondence and the pro…t function, we have
to solve the pro…t maximization problem as follows:

max (q) = p q C(w; q)

q 0

max (q) = p q Kq 1=( + )

w11 w2
q

The …rst order conditions are:

@ (q) 1 1
1
=p Kq + w11 w2 (1)
@q +

And the second order derivative must satisfy:

@ 2 (q) 1 1 1
2
= 1 Kq + w11 w2 < 0
@q 2 + +

Note that when ( + ) < 1 the above second order condition is satis…ed. Intuitively, this
condition holds when the function shows decreasing returns to scale. Hence, only under
decreasing returns to scale for this Cobb-Douglas production function we can …nd supply
correspondences that maximize the pro…ts and a supply function that is nondecreasing in
price (satisfying the law of supply). [For a graphical illustration, see the …gures separately

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depicting the case of + < 1, + > 1 and + = 1 below.]

Solving for q from (1) we have:

1 1
1
p Kq + w11 w2 = 0
+
+
+ p 1
q(w; p) =
K w11 w2
and now using this expression we can obtain the unconditional factor demand for factors
z1 and z2 (note that they depend on input and output prices, but are independent on total
output, unlike conditional factor demand correspondences).
=( + )
w2
z1 (w1 ; w2 ; p) = q 1=( + )
w1
" + #1=( + )
=( + )
w2 + p 1
=
w1 K w11 w2

=( + )
w1
z2 (w1 ; w2 ; p) = q 1=( + )
w2
" + #1=( + )
=( + )
w1 + p 1
=
w2 K w11 w2

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And rearranging,
1
=( + )
w2 + p 1
z1 (w1 ; w2 ; p) =
w1 K w11 w2
1
=( + )
w1 + p 1
z2 (w1 ; w2 ; p) =
w2 K w11 w2
Finally, we can calculate the pro…t function (q) = p q w1 z1 w2 z2 as:
+
+ p 1
(q) = p
K w11 w2
1 1
=( + ) =( + )
w2 + p 1 w1 + p 1
w1 w2
w1 K w11 w2 w2 K w11 w2
| {z } | {z }
z1 (w1 ; w2 ; q) z2 (w1 ; w2 ; q)

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