Chapter Two: Theory of the firm

Contents to be covered:
 Production
 Returns to Scale and Varying Proportions
 Cost
 Duality in Production and Cost
 The Competitive Firm
 Profit Maximization
 The Profit Function

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Economics 1
 Introduction
• The second important actor on the microeconomic
stage is the individual firm.
• We begin this chapter with aspects of production and
cost that are common to all firms.
• Then we consider the behaviour of perfectly
competitive firms.

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Economics 2
 Introduction
• At its simplest, a firm is an entity created by individuals
for some purpose.
• This entity will typically acquire inputs and combine
them to produce output.
• Inputs are purchased on input markets and these
expenditures are the firm’s costs.
• Output is sold on product markets and the firm earns
revenue from these sales.
• Why would someone go to the considerable bother of
creating a firm in the first place, and what guides such a
person in the myriad decisions that must be made in the
course of the firm’s activities?
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 Introduction
• Profit maximisation is the most common answer an
economist will give, and it is an eminently reasonable one.
• Profit – the difference between revenue the firm earns from
selling its output and expenditure it makes buying its inputs
– is income to owners of the firm.
• All decisions on acquiring and combining inputs, and on
marketing output, must serve the goal of maximising profit.
• Like the hypothesis of utility maximisation for consumers,
profit maximisation is the single most robust and
compelling assumption we can make as we begin to
examine and ultimately predict firm behaviour.
• In any choice the firm must make, we therefore will always
suppose its decision is guided by the objective of profit
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maximisation.
Economics 4
 2.1 Production
• Production is the process of transforming inputs into outputs.
• The fundamental reality firms must contend with in this process
is technological feasibility.
• The state of technology determines and restricts what is
possible in combining inputs to produce output, and there are
several ways we can represent this constraint.
• Suppose the firm has n possible goods to serve as inputs and/or
outputs.
• If a firm uses units of a good j as an input and produces of the
good as an output, then the net output of good j is given by .
• If the net output of a good j is positive, then the firm is
producing more of good j than it uses as an input; if the net
output is negative, then the firm is using more of good j than it
produces.
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 2.1 Production
• A production plan is simply a list of net outputs of various
goods.
• We can represent a production plan by a vector y in where
is negative if the good serves as a net input and positive if
the good serves as a net output.
• The set of all technologically feasible production plans is
called the firm's production possibilities set and will be
denoted by Y, a subset of .
• The set Y is supposed to describe all patterns of inputs and
outputs that are technologically feasible. It gives us a
complete description of the technological possibilities
facing the firm.

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 2.1 Production
• The production possibility set is by far the most general
way to characterise the firm’s technology because it allows
for multiple inputs and multiple outputs.
• Often, however, we will want to consider firms producing
only a single product from many inputs.
• For that, it is more convenient to describe the firm’s
technology in terms of a production function.
• When there is only one output produced by many inputs, we
shall denote the amount of output by y, and the amount of
input i by , so that with n inputs, the entire vector of inputs
is denoted by

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 2.1 Production
• Of course, the input vector as well as the amount of output
must be non-negative, so we require x ≥ 0, and y ≥ 0.
• A production function simply describes for each vector of
inputs the amount of output that can be produced.
• The production function, f , is therefore a mapping from
into .
• When we write y = f (x), we mean that y units of output (and
no more) can be produced using the input vector x.
•

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 2.1 Production

• Continuity of f ensures that small changes in the vector of

inputs lead to small changes in the amount of output
produced.
• We require f to be strictly increasing to ensure that employing
strictly more of every input results in strictly more output.
• The strict quasiconcavity of f is assumed largely for reasons
of simplicity.
• When the production function is differentiable, its partial
derivative, ∂f (x)/∂xi, is called the marginal product of input
Department of the rate at which output changes per additional
i and gives
Economics
unit of input i employed. 9
 2.1 Production
• For any fixed level of output, y, the set of input vectors
producing y units of output is called the y-level isoquant.
• An isoquant is then just a level set of f .
• We shall denote this set by Q(y). That is,
Q(y) ≡ {x ≥ 0 | f (x) = y}.
• For an input vector x, the isoquant through x is the set of
input vectors producing the same output as x, namely, Q(f
(x))
• An analogue to the marginal rate of substitution in
consumer theory is the marginal rate of technical
substitution (MRTS) in producer theory.
• This measures the rate at which one input can be substituted
for another without changing the amount of output
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produced.
Economics 10
 2.1 Production
Figure: An isoquant
Map for the case of
two inputs (k, l).

Isoquants record the

alternative
combinations of
inputs that can be
used to produce a
given level of
output.
The slope of these curves shows the rate at which l can be
substituted for k while keeping output constant.
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 2.1 Production
• Formally, the marginal rate of technical substitution
of input j for input i when the current input vector is
x, denoted MRTSij(x), is defined as the ratio of
marginal products.

• In the two-input case, as depicted in the figure, is the

absolute value of the slope of the isoquant through at
the point .

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 2.1 Production

Figure: The
marginal rate of
technical
Substitution.

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 2.1 Production

• The elasticity of substitution (σ) provides a measure of

how easy it is to substitute one input for another in
production.
• the elasticity of substitution can never be negative, so σij
≥ 0.
• In general, the closer it is to zero, the more ‘difficult’ is
substitution
Department of between the inputs; the larger it is, the ‘easier’
is substitution between them
Economics 14
 2.1 Production

• In (a), the isoquant is linear and there is perfect substitutability

between the inputs. There, σ is infinite.
• In (c), the two inputs are productive only in fixed proportions with
one another – substitution between them is effectively impossible,
and σ is zero.
• In (b), we have illustrated an intermediate case where σ is neither
zero nor infinite, and the isoquants are neither straight lines nor right
angles indicating
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Economics 15
 2.1 Production
• Example : Given the following production function

• Calculate the elasticity of substitution?

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 2.1 Production
• To calculate the elasticity of substitution, σ, note first that the marginal
rate of technical substitution at an arbitrary point ( is

• Hence, in this example the ratio of the two inputs alone determines
MRTS, regardless of the quantity of output produced.
• Consequently, setting ,

• Hence, which is a constant.

• This explains the initials CES, which stand for constant elasticity of
substitution.
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 2.1 Production
• With the CES form, the degree of substitutability between
inputs is always the same, regardless of the level of output
or input proportions.
• It is therefore a somewhat restrictive characterisation of the
technology.
• On the other hand, different values of the parameter ρ, and
so different values of the parameter σ, can be used to
represent technologies with vastly different (though
everywhere constant) substitutability between inputs.
• The closer ρ is to unity, the larger is σ; when ρ is equal to 1,
σ is infinite and the production function is linear.

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2.1.1 Returns to Scale and Varying
Proportions
• We frequently want to know how output responds as the amounts of
different inputs are varied.
• For instance, in the short run, the period of time in which at least
one input is fixed, output can be varied only by changing the
amounts of some inputs but not others.
• As amounts of the variable inputs are changed, the proportions in
which fixed and variable inputs are used are also changed.
• ‘Returns to variable proportions’ refer to how output responds in
this situation.
• In the long run, the firm is free to vary all inputs, and classifying
production functions by their ‘returns to scale’ is one way of
describing how output responds in this situation. Specifically,
returns to scale refer to how output responds when all inputs are
varied in the same proportion, i.e., when the entire ‘scale’ of
operation
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Economics 19
2.1.1 Returns to Scale and Varying
Proportions
• In the two-input case, the
distinction between these two
attributes of the production
function is best grasped
graphically.

• Returns to varying proportions concern how output behaves as we move

through the isoquant map along the horizontal at , keeping constant and
varying the amount of .
• Returns to scale have to do with how output behaves as we move through
the isoquant map along a ray such as OA, where the levels of and are
changed simultaneously, always staying in the proportion / = α.
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2.1.1 Returns to Scale and Varying
Proportions
• Elementary measures of returns to varying proportions
include the marginal product, MPi(x) ≡ fi(x), and the average
product, APi(x) ≡ f (x)/xi, of each input.
• The output elasticity of input i, measuring the percentage
response of output to a 1 per cent change in input i, is given
by
μi(x) ≡ fi(x)xi/f (x) = MPi(x)/APi(x).

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2.1.1 Returns to Scale and Varying
Proportions
• A production function is said to have constant, increasing, or
decreasing returns to scale according to the following
definitions.
1. Constant returns to scale if f (tx) = tf (x) for all t > 0 and all
x;
2. Increasing returns to scale if f (tx) > tf (x) for all t > 1 and
all x;
3. Decreasing returns to scale if f (tx) < tf (x) for all t > 1 and
all x.

• A production function has constant returns if it is a (positive)

linear homogeneous function.
• Every homogeneous production function of degree greater
Department of one must have increasing (decreasing) returns.
(less) than
Economics 22
 Important Points to Note:
• If all but one of the inputs are held constant, a relationship
between the single variable input and output can be derived.
• The marginal physical productivity is the change in output
resulting from a one-unit increase in the use of the input
assumed to decline as use of the input increases.
• The entire production function can be illustrated by an
isoquant map. The slope of an isoquant is the marginal rate of
technical substitution (MRTS). It shows how one input can be
substituted for another while holding output constant. It is the
ratio of the marginal physical productivities of the two inputs.

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 Important Points to Note:
• Isoquants are usually assumed to be convex they obey the
assumption of a diminishing MRTS.
• The elasticity of substitution () provides a measure of how
easy it is to substitute one input for another in production. A
high  implies nearly straight isoquants a low  implies that
isoquants are nearly L-shaped.
• The returns to scale exhibited by a production function record
how output responds to proportionate increases in all inputs.
• If output increases proportionately with input use, there are
constant returns to scale. If there are greater than
proportionate increases in output, there are increasing returns
to scale, whereas if there are less than proportionate increases
in output, there are decreasing returns to scale.
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 2.2 Cost
• The firm’s cost of output is precisely the expenditure it must
make to acquire the inputs used to produce that output.
• In general, the technology will permit every level of output to
be produced by a variety of input vectors, and all such
possibilities can be summarised by the level sets of the
production function.
• The firm must decide, therefore, which of the possible
production plans it will use.
• If the objective of the firm is to maximise profits, it will
necessarily choose the least costly, or cost-minimising,
production plan for every level of output.
• We will assume throughout that firms are perfectly
competitive on their input markets and that therefore they
Department of input prices.
face fixed
Economics 25
 2.2 Cost
• Let be a vector of prevailing market prices at which the firm
can buy inputs .
• Because the firm is a profit maximiser, it will choose to
produce some level of output while using that input vector
requiring the smallest money outlay.
• One can speak therefore of ‘the’ cost of output y – it will be
the cost at prices w of the least costly vector of inputs capable
of producing y.

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 2.2 Cost

The cost-minimisation problem is equivalent to

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 2.2 Cost
• Let x∗ denote a solution. Thus, by Lagrange’s theorem,
there is a λ∗ ∈ R such that

• We may divide the preceding ith equation by the jth to obtain

• Thus, cost minimisation implies that the marginal rate of

technical substitution between any two inputs is equal to the
ratio of their prices.

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 2.2 Cost
• We can write x∗ ≡ x(w, y) to denote the vector of inputs
minimising the cost of producing y units of output at the input
prices w.
• The solution x(w, y) is referred to as the firm’s conditional
input demand, because it is conditional on the level of
output y, which at this point is arbitrary and so may or may
not be profit maximising.
• The solution to the cost-minimisation problem is illustrated in
the following figure.
• With two inputs, an interior solution corresponds to a point of
tangency between the y-level isoquant and an isocost line of
the form w · x = α for some α > 0.
• If x1(w, y) and x2(w, y) are solutions, then c(w, y) = w1x1(w, y)
Department of y).
+ w2x2(w,
Economics 29
 2.2 Cost

Figure: The solution to

the firm’s cost-
minimisation problem.
In the figure, α < α’.

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 2.2 Cost
• EXAMPLE: Suppose the firm’s technology is the two-input
CES form. Its cost minimisation problem is then;

• The first-order Lagrangian conditions reduce to the two

conditions

• Solving for x1 in the first equation, substituting in equation

two, and rearranging gives

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 2.2 Cost
• Solving this for x2 and performing similar calculations to
solve for x1, we obtain the conditional input demands:

• To obtain the cost function, we substitute the above solutions

back into the objective function for the minimisation
problem. Doing that yields

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 Properties of the Cost Function
1. Zero when y = 0,
2. Continuous on its domain,
3. Increasing in w,
4. Homogeneous of degree one in w,
5. Concave in w.
6. Shephard’s lemma: c(w, y) is differentiable in w at (w0,
y0), and

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 2.2 Cost
• Example: Consider a cost function with the Cobb-Douglas form, .
• The conditional input demands are obtained by differentiating with
respect to input prices. Thus,

• This tells us that the proportions in which a firm with this cost function
will use its inputs depend only on relative input prices and are
completely independent of the level or scale of output.

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 2.2 Cost
• Now define the input share, as the proportion of total
expenditure spent by the firm on input i.
• From the above equations, these are always constant and

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 The Short-Run, or Restricted, Cost
• Function
Let the production function be f (z), where .
• Suppose that x is a subvector of variable inputs and is a
subvector of fixed inputs.
• Let and be the associated input prices for the variable and
fixed inputs, respectively. The short-run, or restricted, total
cost function is defined as;

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 The Short-Run, or Restricted, Cost
• Study the definition ofFunction
short-run costs carefully.
• Notice it differs from the definition of generalised or long-run
costs only in that the fixed inputs enter as parameters rather
than as choice variables.
• It should be clear therefore that for a given level of output,
longrun costs, where the firm is free to choose all inputs
optimally, can never be greater than short-run costs, where the
firm may choose some but not all inputs optimally.
• This point is illustrated in the following figure using
isoquants and isocost curves.
• For simplicity we suppose that w1 = 1, so that the horizontal
intercepts measure the indicated costs, and the unnecessary
parameters of the cost functions have been suppressed.
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 The Short-Run, or Restricted, Cost
Function
If in the short run, the firm is stuck
with units of the fixed input, it
must use input combinations A, C,
and E, to produce output levels , ,
and , and incur short-run costs of
sc(y1), sc(y2), and sc(y3),
respectively.
In the long run, when the firm is
free to choose both inputs
optimally, it will use input
combinations B, C, and D, and be
able to achieve long-run costs of
c(y1), c(y2), and c(y3), respectively.
Notice that sc(y1) and sc(y3) are
strictly greater than c(y1) and c(y3),
respectively, and sc(y2) = c(y2).

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 The Short-Run, or Restricted, Cost
• Function
Is the coincidence of long-run and short-run costs at output y2 really
a coincidence? No, not really.
• Why are the two costs equal there? A quick glance at the figure is
enough to see it is because units are exactly the amount of x 2 the firm
would choose to use in the long run to produce y2 at the prevailing
input prices – that units is, in effect, the cost-minimising amount of
the fixed input to produce y2.
• Thus, there can be no difference between long-run and short-run costs
at that level of output.
• Long-run and short-run costs of y1 would coincide if the firm were
stuck with units of the fixed input, and long-run and short-run costs
of y3 would coincide if it were stuck with units of the fixed input.
• Each different level of the fixed input would give rise to a different
short run cost function, yet in each case, short-run and long-run costs
would coincide
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Economics 39
 2.3 Duality in Production and Cost
• Given the obvious structural similarity between the firm’s
cost-minimisation problem and the individual’s expenditure-
minimisation problem, it should come as no surprise that
there is a duality between production and cost just as there is
between utility and expenditure.
• The principles are identical.
• If we begin with a production function and derive its cost
function, we can take that cost function and use it to generate
a production function.
• Moreover, any function with all the properties of a cost
function generates some production function for which it is
the cost function.
• This last fact marks one of the most significant developments
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in modern
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applied work. 40
 2.3 Duality in Production and Cost
• Applied researchers need no longer begin their study of the
firm with detailed knowledge of the technology and with
access to relatively obscure engineering data.
• Instead, they can estimate the firm’s cost function by
employing observable market input prices and levels of
output.
• They can then ‘recover’ the underlying production function
from the estimated cost function.

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 2.3 Duality in Production and Cost
Example: A firm is found to have the following cost function:

• where p1, p2 are the prices of inputs x1 and x2 and y is the

level of output.
A. Calculate the conditional input demand functions of this
firm?
B. Derive from these results the firm’s production function?
C. Demonstrate that the production function and cost function
are ’duals’ by deriving this cost function from the
production function directly?

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 2.3 Duality in Production and Cost

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 2.3 Duality in Production and Cost

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 2.4 The Competitive Firm
• In this section, we examine behaviour when the firm is both a
perfect competitor on input markets and a perfect competitor
on its output market.
• Such a firm is thus a price taker on both output and input
markets.

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 2.4.1 Profit Maximisation
• Profit is the difference between revenue from selling output and the cost
of acquiring the factors necessary to produce it.
• The competitive firm can sell each unit of output at the market price, p.
• Its revenues are therefore a simple function of output, R(y) = py.
• Suppose the firm is considering output level y0. If x0 is a feasible
vector of inputs to produce y0, and if w is the vector of factor prices, the
cost of using x0 to produce y is simply w.x0.
• This plan would therefore yield the firm profits of py0 –w.x0.
• There are two things worth noting here. First, output y0 may not be the
best level of output for the firm to produce.
• Second, even if it were the best level of output, input levels x0 may not
be the best way to produce it.
• The firm therefore must make some decisions. It must decide both what
level of output to produce and how much of which factors to use to
produce it.
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 2.4.1 Profit Maximisation
• As usual, we suppose the overriding objective is to maximise
profits.
• The firm therefore will choose that level of output and that
combination of factors that solve the following problem:

• The solutions to this problem tell us how much output the

firm will sell and how much of which inputs it will buy.
• Because y = f (x), we may rewrite the maximisation problem
in terms of a choice over the input vector alone as

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 2.4.1 Profit Maximisation
• Let us assume that this profit-maximisation problem has an
interior solution at the input vector x∗[Hence, the profit-
maximising amount of output produced is y∗ = f (x∗).
• Then the first-order conditions require that the gradient of the
maximand be zero because there are no constraints. That is,

• The term on the left-hand side, the product of the output price
with the marginal product of input i, is often referred to as the
marginal revenue product of input i.
• It gives the rate at which revenue increases per additional unit of
input i employed.
• At the optimum, this must equal the cost per unit of input i,
namely, wi.
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 2.4.1 Profit Maximisation
• Assuming further that all the wi are positive, we may use the
previous first-order conditions to yield the following equality
between ratios:

• or that the MRTS between any two inputs is equated to the ratio of
their prices.
• This is precisely the same as the necessary condition for cost-
minimising input choice.
• Instead of thinking about maximising profits in one step as was done
above, consider the following two-step procedure.
• First, calculate for each possible level of output the (least) cost of
producing it.
• Then choose that output that maximises the difference between the
revenues it generates and its cost.
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 2.4.1 Profit Maximisation
• The first step in this procedure is a familiar one.
• The least cost of producing y units of output is given by the cost
function, c(w, y).
• The second step then amounts to solving the following
maximisation problem:

• If y∗ > 0 is the optimal output, it therefore satisfies the first-

order condition

• Output is chosen so that price equals marginal cost.

• Second-order conditions require that marginal cost be non-
decreasing at the optimum, or that .
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 2.4.1 Profit Maximisation
Figure 3.7. Output
choice for the
competitive firm. Profits
are maximised at y∗,
where price equals
marginal cost, and
marginal cost is non-
decreasing.

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 2.4.2 The Profit Function
• The optimal choice of output, y∗ ≡ y(p,w), is called the firm’s
output supply function, and the optimal choice of inputs, x∗
≡ x(p,w), gives the vector of firm input demand functions.
• The latter are full-fledged demand functions because, unlike
the conditional input demands that depend partly on output,
these input demands achieve the ultimate objective of the
firm; they maximise the firm’s profit.
• The profit function, defined in what follows, is a useful tool
for studying these supply and demand functions.

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 2.4.2 The Profit Function
Properties of the Profit Function
1. Increasing in p,
2. Decreasing in w,
3. Homogeneous of degree one in (p,w),
4. Convex in (p,w),
5. Differentiable in . Moreover,

• Output supply and input demands can be obtained directly by

simple differentiation.

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 2.4.2 The Profit Function
• Example: Consider the problem of maximizing profits for the
production function of the form where > 0.

• The first-order condition is

• Hence, the factor demand function becomes;

• The supply function is given by;

• And the profit function is given by;

•

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 2.4.2 The Profit Function
• Example: Let the production function be the CES form,

• Suppose that β < 1 and that ρ < 1.

• Form the Lagrangian for the profit-maximisation problem, the
first-order conditions reduce to

• Equating equation 1 and 2 together,

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 2.4.2 The Profit Function
• Substituting in the third equation gives

• Substituting these into (E.1) and solving for y gives the supply
function

• From the last two equations, we obtain the input demand

functions,

• To form the profit function, substitute from these last two

equations into the objective function to obtain (r ≡ ρ/(ρ − 1))

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