The Firm: Basics

MICROECONOMICS
Principles and Analysis
Frank Cowell
October 2011
Overview...
The setting
Input require-
ment sets
Returns to scale
Marginal
products
The Firm: Basics
The environment
for the basic
model of the firm.
Isoquants
The basics of production...
Some of the elements needed for an analysis of the
firm
Technical efficiency
Returns to scale
Convexity
Substitutability
Marginal products
This is in the context of a single-output firm...
...and assuming a competitive environment.
First we need the building blocks of a model...
Notation
Quantities
z
i


amount of input i
z = (z
1
, z
2
, ..., z
m
)
input vector
amount of output
q
Prices

price of input i
w = (w
1
, w
2
, ..., w
m
)
Input-price vector
price of output
p
For next
presentation
w
i

Feasible production
The basic relationship between
output and inputs:
q s | (z
1
, z
2
, ...., z
m
)
This can be written more compactly
as:
q s | (z)
single-output, multiple-input
production relation
| gives the maximum amount of
output that can be produced from a
given list of inputs
Note that we use s and not
= in the relation. Why?
Consider the meaning of |
Vector of inputs
The production
function
distinguish two
important cases...
Technical efficiency
The case where
production is technically
efficient
The case where
production is
(technically) inefficient
Case 1:
q = | (z)
Case 2:
q < | (z)
Intuition: if the combination (z,q) is inefficient you can
throw away some inputs and still produce the same output
z
2

q >|

(z)
Boundary points are feasible
and efficient
The function |
q
0
The production function
Interior points are feasible
but inefficient
Infeasible points
q <|

(z)
q =|

(z)
We need to
examine its
structure in
detail.
Overview...
The setting
Input require-
ment sets
Returns to scale
Marginal
products
The Firm: Basics
The structure of
the production
function.
Isoquants
The input requirement set
remember, we must
have q s | (z)
Pick a particular output level q
Find a feasible input vector z

Repeat to find all such vectors
Yields the input-requirement set
Z(q) := {z: | (z) > q}
The set of input
vectors that meet the
technical feasibility
condition for output q...
The shape of Z depends on the
assumptions made about production...
We will look at four cases.
First, the
standard case.
z
1

z
2

The input requirement set
Feasible but inefficient
Feasible and technically
efficient
Infeasible points.
Z(q)
q < |

(z)
q = |

(z)
q > |

(z)
z
1

z
2

Case 1: Z smooth, strictly convex
Pick two boundary points
Draw the line between them
Intermediate points lie in the
interior of Z.
A combination of two
techniques may produce
more output.
What if we changed
some of the assumptions?
z'
z
Z(q)
q< |

(z)
q = |

(z")
q = |

(z')
Note important role of
convexity.
Case 2: Z Convex (but not strictly)
z
1

z
2

A combination of
feasible techniques is
also feasible
Z(q)
z'
z
Pick two boundary points
Draw the line between them
Intermediate points lie in Z
(perhaps on the boundary).
Case 3: Z smooth but not convex
z
1

z
2

in this region there is an
indivisibility
J oin two points across the
dent
Z(q)
Take an intermediate point
Highlight zone where this can
occur.
This point is
infeasible

z
1

z
2

Case 4: Z convex but not smooth

Slope of the boundary is
undefined at this point.
q = |

(z)
z
1

z
2

z
1

z
2

z
1

z
2

z
1

z
2

Summary: 4 possibilities for Z
Only one
efficient point
and not
smooth. But
not perverse.
Problems:
the "dent"
represents an
indivisibility
Standard case,
but strong
assumptions
about
divisibility and
smoothness
Almost
conventional:
mixtures may
be just as
good as single
techniques
Overview...
The setting
Input require-
ment sets
Returns to scale
Marginal
products
The Firm: Basics
Contours of the
production
function.
Isoquants
Isoquants
Pick a particular output level q
Find the input requirement set Z(q)
The isoquant is the boundary of Z:
{ z : |

(z) = q }
Think of the isoquant as
an integral part of the set
Z(q)...
c|(z)
|
i
(z) :=
cz
i .
|
j
(z)

|
i
(z)
If the function | is differentiable at z
then the marginal rate of technical
substitution is the slope at z:
Where appropriate, use
subscript to denote partial
derivatives. So
Gives the rate at which you can trade
off one input against another along the
isoquant, to maintain constant output q
Lets look at
its shape
z
1

z
2

The set Z(q).
Isoquant, input ratio, MRTS
A contour of the function |.
{z: | (z)=q}
An efficient point.
Input ratio describes one
production technique
z
2


z
1

- z
The input ratio
z
2
/ z
1
= constant
Marginal Rate of Technical
Substitution
The isoquant is the
boundary of Z
Increase the MRTS
- z
MRTS
21
=|
1
(z)/|
2
(z)
MRTS
21
: implicit price
of input 1 in terms of 2
Higher price: smaller
relative use of input 1
MRTS and elasticity of substitution
Responsiveness of inputs to MRTS is elasticity of
substitution
log(z
1
/z
2
)
=

log(|
1
/|
2
)
prop change input ratio

prop change in MRTS
A input-ratio A MRTS
=

input-ratio MRTS
z
1

z
2

o =
z
1

z
2

o = 2
Elasticity of substitution
z
1

z
2

structure of the
contour map...
A constant elasticity of
substitution isoquant
Increase the elasticity of
substitution...
Homothetic contours
The isoquants
O

z
1

z
2

Draw any ray through the
origin
Get same MRTS as it cuts
each isoquant.
Contours of a homogeneous function
The isoquants
O

z
1

z
2

Coordinates of input z
Coordinates of scaled up
input tz
O
tz
1

tz
2


z
2


z
1

- tz
- z
q
t
r
q
| (tz) = t
r
| (z)
Overview...
The setting
Input require-
ment sets
Returns to scale
Marginal
products
The Firm: Basics
Changing all
inputs together.
Isoquants
Let's rebuild from the isoquants
The isoquants form a contour map.
If we looked at the parent diagram, what would we see?
Consider returns to scale of the production function.
Examine effect of varying all inputs together:
Focus on the expansion path.
q plotted against proportionate increases in z.
Take three standard cases:
Increasing Returns to Scale
Decreasing Returns to Scale
Constant Returns to Scale
Let's do this for 2 inputs, one output
Case 1: IRTS
z
2

q

0
An increasing returns to
scale function
t>1 implies
|(tz) > t|(z)
Pick an arbitrary point on the
surface
The expansion path
Double inputs
and you more
than double
output
Case 2: DRTS
q
A decreasing returns to
scale function
Pick an arbitrary point on the
surface
The expansion path
z
2


0
t>1 implies
|(tz) < t|(z)
Double inputs
and output
increases by less
than double
Case 3: CRTS
z
2

q
0
A constant returns to scale
function
Pick a point on the surface
The expansion path is a ray

|(tz) = t|(z)
Double inputs
and output
exactly doubles
Relationship to isoquants
z
2

q
0
Take any one of the three
cases (here it is CRTS)
Take a horizontal slice
Project down to get the
isoquant
Repeat to get isoquant map
The isoquant
map is the
projection of the
set of feasible
points
Overview...
The setting
Input require-
ment sets
Returns to scale
Marginal
products
The Firm: Basics
Changing one
input at time.
Isoquants
Marginal products
Measure the marginal change in
output w.r.t. this input
c|(z)
MP
i
= |
i
(z) =
cz
i
.

Pick a technically efficient
input vector
Keep all but one input constant

Remember, this means
a z such that q= |(z)
The marginal product
CRTS production function again
z
2

q
0
Now take a vertical slice
The resulting path for z
2
=
constant
Lets look at
its shape
MP for the CRTS function

z
1

q
|(z)
The feasible set
A section of the
production function
Technically efficient points
Input 1 is essential:
If z
1
= 0 then q = 0

Slope of tangent is the
marginal product of input 1
|
1
(z)
Increase z
1

|
1
(z) falls with z
1
(or
stays constant) if | is
concave
Relationship between q and z
1
z
1

q
z
1

q
z
1

q
z
1

q
Weve just taken the
conventional case
But in general this
curve depends on the
shape of |.
Some other
possibilities for the
relation between
output and one
input
Key concepts
Technical efficiency
Returns to scale
Convexity
MRTS
Marginal product
Review
Review
Review
Review
Review
What next?
Introduce the market
Optimisation problem of the firm
Method of solution
Solution concepts.