Firms, Production Possibility Sets, and Pro…t

Maximization

Econ 2100, Fall 2019

Lecture 1, 21 October

Outline
1 Logistics
2 Production Sets and Production Functions
3 Pro…ts Maximization, Supply Correspondence, and Pro…t Function
 Logistics
Instructor: Luca Rigotti
O¢ ce: WWPH 4115, email: luca at pitt.edu
O¢ ce Hours: Monday 3pm-5pm, or by appointment (send me an email)

Teaching Assistant: Nicolas Pastrian Contador

O¢ ce: WWPH 4901, email: [email protected]
O¢ ce Hours: Tuesdday 3-5pm.

Class Time and Location

Monday & Wednesday, 10:30am to 11:45am in WWPH 4940
Recitation Times
Fridayday , 2pm to 3:15am, in WWPH 4940.

Class Webpage http://www.pitt.edu/~luca/ECON2100/

Announcements
None Today
 Logistics
Handouts: For each class, I will post an handout that you can use to take notes
(either print and bring to class, or use computer).

Useful textbooks: Kreps, Microeconomic Foundations I: Choice and Competitive

Markets, Princeton University Press
Mas-Collel, Whinston and Green: Microeconomic Theory.
Other useful textbooks by Varian, Jehle and Reny, older Kreps.
The best book: Gerard Debreu: Theory of Value.

Grading
Luca’s Half: Problem set 10%, Exam 90%
Final Exam, 2 hours long, date TBA

Problem Sets
Weekly, some questions appear during class.
DO NOT look for answers... These are for you to learn what you can and
cannot do; we can help you get better only if we know your limits.
Working in teams strongly encouraged, but turn in problem sets individually.
Start working on exercises on your own, and then get together to discuss.
Typically, a Problem Set will be due at the beginning of each Monday class.
 Luca’s Goals for Micro Theory Sequence

Learn and understand the microeconomic theory every academic economist

needs to know.
Stimulate interest in micro theory as a …eld (some of you may want to become
theorists).
Enable you to read papers that use theory, and go to research seminars.
We will cover the following standard topics:
…rms: production, pro…t maximization, aggregation;
general equilibrium theory: consumers and …rms in competitive markets,
Walrasian equilibrium, First and Second Welfare Theorems, existence of
equilibrium, uniqueness of equilibrium, markets with uncertainty and time,
Arrow-Debreu economies.
In the Spring, Professor Richard van Weelden will cover game theory and
information economics.
Questions? This will be fun: let’s go!
 Producers and Production Sets
Producers are pro…t maximizing …rms that buy inputs and use them to produce and
then sell outputs.

The plural is important because most …rms produce more than one good.

The standard undergraduate textbook description focuses on one ouput and a

few inputs (two in most cases).
In that framework, production is described by a function that takes inputs as
the domain and output(s) as the range.
Here we focus on a more general and abstract version of production.

De…nition
A production set is a subset Y Rn .

y = (y1 ; :::; yN ) denotes production (input-output) vectors.

A production vector has outputs as non-negative numbers and inputs as
non-positive numbers: yi 0 when i is an input, and yi 0 if i is an output.
What is p y in this notation?
 Production Set Properties

De…nition
Y Rn satis…es:
no free lunch if Y \ Rn+ f0n g;
possibility of inaction if 0n 2 Y ;
free disposal if y 2 Y implies y 0 2 Y for all y 0 y;
irreversibility if y 2 Y and y 6= 0n imply y2
= Y;
nonincreasing returns to scale if y 2 Y implies y 2 Y for all 2 [0; 1];
nondecreasing returns to scale if y 2 Y implies y 2 Y for all 1;
constant returns to scale if y 2 Y implies y 2 Y for all 0;
0 0
additivity if y ; y 2 Y imply y + y 2 Y ;
convexity if Y is convex;
Y is a convex cone if for any y ; y 0 2 Y and ; 0, y + y 0 2 Y .

Draw Pictures.
 Production Set Properties Are Related

Some of these properties are related to each other.

Exercise
Y satis…es additivity and nonincreasing returns if and only if it is a convex cone.

Exercise
For any convex Y Rn such that 0n 2 Y , there is a convex Y 0 Rn+1 that
satis…es constant returns such that Y = fy 2 Rn : (y ; 1) 2 Rn+1 g.
 Production Functions
Let y 2 Rm n
+ denote outputs while x 2 R+ represent inputs; if the two are related by
n m
a function f : R+ ! R+ , we write y = f (x) to say that y units of outputs are
produced using x amount of the inputs.

When m = 1, this is the familiar one output many inputs production function.
Production sets and the familiar production function are related.

Exercise
Suppose the …rm’s production set is generated by a production function
f : Rn+ ! Rm n
+ , where R+ represents its n inputs and R+ represents its m outputs.
Let
Y = f( x; y ) 2 Rn Rm
+ :y f (x)g:
Prove the following:
1 Y satis…es no free lunch, possibility of inaction, free disposal, and irreversibility.
2 Suppose m = 1. Y satis…es constant returns to scale if and only if f is
homogeneous of degree one, i.e. f ( x) = f (x) for all 0.
3 Suppose m = 1. Y satis…es convexity if and only if f is concave.
 Transformation Function
We can describe production sets using a function.

De…nition
Given a production set Y Rn , the transformation function F : Y ! R is de…ned
by
Y = fy 2 Y : F (y ) 0 and F (y ) = 0 if and only if y is on the boundary of Y g ;
the transformation frontier is
fy 2 Rn : F (y ) = 0g

De…nition
Given a di¤erentiable transformation function F and a point on its transformation
frontier y , the marginal rate of transformation for goods i and j is given by
@F (y )
@yi
MRTi ;j = @F (y )
@yj

Since F (y ) = 0 we have
@F (y ) @F (y )
dyi + dyj = 0
@yi @yj
MRT is the slope of the transformation frontier at y .
 Pro…t Maximization

Pro…t Maximizing Assumption

The …rm’s objective is to choose a production vector on the trasformation frontier
as to maximize pro…ts given prices p 2 Rn++ :
max p y
y 2Y
or equivalently
max p y subject to F (y ) 0

Does this distinguish between revenues and costs? How?

Using the single output production function:
max pf (x) w x
x 0

here p 2 R++ is the price of output and w 2 Rl++ is the price of inputs.
 First Order Conditions For Pro…t Maximization

max p y subject to F (y ) = 0

Pro…t Maximizing
The FOC are
@F (y )
pi = for each i or p = rF (y ) in matrix form
@yi |{z} | {z }
1 n 1 n
Therefore
@F (y )
1 @yi
= for each i
pi
the marginal product per dollar spent or received is equal across all goods.
Using this formula for i and j:
@F (y )
@yi pi
@F (y )
= MRTi ;j = for each i; j
pj
@yj

the Marginal Rate of Transformation equals the price ratio.

 Supply Correspondence and Pro…t Functions
De…nition
Given a production set Y Rn , the supply correspondence y : Rn++ ! Rn is:
y (p) = arg max p y :
y 2Y

Tracks the optimal choice as prices change (similar to Walrasian demand).

De…nition
Given a production set Y Rn , the pro…t function : Rn++ ! R is:
(p) = max p y :
y 2Y

Tracks maximized pro…ts as prices change (similar to indirect utility function).

Proposition
If Y satis…es non decreasing returns to scale either (p) 0 or (p) = +1.

Proof.
Question 2, Problem Set 1.
 Properties of Supply and Pro…t Functions

Proposition
Suppose Y is closed and satis…es free disposal. Then:
( p) = (p) for all > 0;
is convex in p;
y ( p) = y (p) for all > 0;
if Y is convex, then y (p) is convex;
if jy (p)j = 1, then is di¤erentiable at p and r (p) = y (p) (Hotelling’s
Lemma).
if y (p) is di¤erentiable at p, then Dy (p) = D 2 (p) is symmetric and
positive semide…nite with Dy (p)p = 0.
 The Pro…t Function Is Convex
Proof.
Let p,p 0 2 Rn++ and let the corresponding pro…t maximizing solutions be y and y 0 .
For any 2 (0; 1) let p = p + (1 ) p 0 and let y be the pro…t maximizing
output vector when prices are p.
By “revealed preferences”
p y p y and p0 y 0 p0 y
why?
multiply these inequalities by and 1
p y p y and (1 ) p0 y 0 (1 ) p0 y
summing up
p y + (1 ) p0 y 0 [ p + (1 ) p0] y
using the de…nition of pro…t function:
(p) + (1 ) (p 0 ) ( p + (1 ) p0)
proving convexity of (p).
 The Supply Correspondence Is Convex

Proof.
Let p 2 Rn++ and let y ; y 0 2 y (p).
We need to show that if Y is convex then
y + (1 ) y 0 2 y (p) for any 2 (0; 1)
By de…nition:
p y p y for any y 2 Y and p y0 p y for any y 2 Y

multiplying by and 1 we get

p y p y and (1 ) p y0 (1 )p y
Therefore, summing up, we have
p y + (1 ) p y0 [ + (1 )] p y
Rearranging:
p [ y + (1 ) y 0] p y
proving convexity of y (p).
 Law of Supply
Remark
If y (p) is di¤erentiable at p, then Dy (p) = D 2 (p) is positive semide…nite.

Write the Lagrangian

L=p y F (y )
By the Envelope Theorem:
@ (p) @L
= = yi (p)
@pi @pi y =y

Therefore, we have
@ 2 (p) @y (p)
= i 0
@pi @pi

where the inequality follows from convexity of the pro…t function.

This is called the Law of Supply: quantity responds in the same direction as
prices.
Notice that here yi can be either input or output.
What does this mean for outputs?
What does this mean for inputs?
 Factor Demand, Supply, and Pro…t Function
The previous concepts can be stated using the production function notation.

De…nition
Given p 2 R++ and w 2 Rn++ and a production function f : Rn+ ! R+ , the …rm’s
factor demand is
x (p; w ) = arg max fpy w x subject to f (x) = y g = arg max pf (x) w x:
x x

De…nition
Given p 2 R++ and w 2 Rn++ and a production function f : Rn+ ! R+ , the …rm’s
supply y : Rn+ ! R is de…ned by
y (p; w ) = f (x (p; w )) :

De…nition
Given p 2 R++ and w 2 Rn++ and a production function f : Rn+ ! R+ , the …rm’s
pro…t function : R++ Rn++ ! R is de…ned by
(p; w ) = py (p; w ) w x (p; w ) :
 Factor Demand Properties

Given these de…nitions, the following results “translate” the results for output
sets to production functions.

Proposition
Given p 2 R++ and w 2 Rn++ and a production function f : Rn+ ! R+ ,
1 (p; w ) is convex in (p; w ).
@y (p;w )
2 y (p; w ) is non decreasing in p (i.e. @p 0) and x (p; w ) is non
@xi (p;w )
increasing in w (i.e. @w i 0) (Hotelling’s Lemma).

Proof.
Problem 3a,b; Problem Set 1.
 Cost Minimization
Cost Minimizing
Consider the single output case and suppose the …rm wants to deliver a given
output quantity at the lowest possible costs. The …rm solves

min w x subject to f (x) = y

This has no simple equivalent in the output vector notation.

De…nition
Given w 2 Rn++ and a production function f : Rn+ ! R+ , the …rm’s conditional
factor demand is
x (w ; y ) = arg min fw x subject to f (x) = y g ;

De…nition
Given w 2 Rn++ and a production function f : Rn+ ! R+ , the …rm’s cost function
C : Rn++ R+ ! R is de…ned by
C (w ; y ) = w x (w ; y ) :
 Properties of Cost Functions
Proposition
Given a production function f : Rn+ ! R+ , the corresponding cost function C (w ; y )
is concave in w .

Proof.
Question 3c; Problem Set 1. (Hint: use a ‘revealed preferences’argument)

Shephard’s Lemma
Write the Lagrangian
L=w x [f (x) y]
by the Envelope Theorem
@C (w ; y ) @L
= = xi (w ; y )
@wi @wi

Conditional factor demands are downward sloping

2
(w ;y ) @xi (w ;y )
Di¤erentiating one more time: @C @w i @w i = @w i 0 where the
inequality follows concavity of C (w ; y ).
 Next Class

General equilibrium introduction and notation

Pareto optimality