Chapter 2

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Production Theory
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2.1. Introduction
• Economic activity considers not only consumption but also
production and trade.
• Production should be interpreted very broadly, however, to
include production of both physical goods – such as rice or
automobiles–and services–such as medical care or financial
services.

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• A firm can be characterized by many factors and aspects such
as sectors, production scale, ownerships, organization
structures, etc.
• But which are most important features for us to study
producer’s behavior in making choices?
• To grasp the most important features in studying producer
behavior and choices in modern producer theory, it is assumed 2
that the key characteristic of a firm in production set.
• Producer’s characteristic together with the behavior
assumption are building blocks in any model of producer
theory.
• The production set represents the set of all technologically
feasible production plans.
• The behavior assumption expresses the guiding principle
the producer uses to make choices.

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• It is generally assumed that the producer seeks to identify
and select a production that is most profitable.

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2.2. Production Technology
• Production is the process of transforming inputs to outputs.
Typically, inputs consist of labor, capital equipment, raw
materials, and intermediate goods purchased from other
firms.
• Outputs consists of finished products or service, or
intermediate goods to be sold to other firms.

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• Often alternative methods are available for producing the
same output, using different combinations of inputs.
• A firm produces outputs from various combinations of inputs.
In order to study firm choices we need a convenient way to
summarize the production possibilities of the firm, i.e., which
combinations of inputs and outputs are technologically
feasible. 4
2. 2.1 Measurement of Inputs and Outputs
• It is usually most satisfactory to think of the inputs and
outputs as being measured in terms of flows: a certain
amount of inputs per period are used to produce a certain
amount of outputs per unit the period at some location.
• It is a good idea to explicitly include the time and location
dimensions in a specification of inputs and outputs.
• The level of detail that we will use in specifying inputs and

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outputs will depend on the problem at hand, but we should
remain aware of the fact that a particular input or output
good can be specified in arbitrarily fine detail.
• However, when discussing technological choices in the
abstract, as we do in this chapter, it is common to omit the
time and location dimensions.
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2.2.2 Specification of Technology
• The fundamental reality firms must contend with in this
process is technological feasibility.
• The state of technology determines and restricts what is
possible in combing inputs to produce outputs, and there
are several way we can represent this constraint.
• The most general way is to think of the firm as having a

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production possibility set.

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 • A production plan is simply a list of net outputs of various
goods.
• We can represent a production plan by a vector y in RL(
production plan) where yj is negative if the jth good serves
as a net input and positive if the jthgood serves as a net
output.
• The set of all technologically feasible production plans is
called the firm’s production possibilities set and will be

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denoted by Y , a subset of RL.
• 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. It can be set as

• Y= { ( Y, -X1, -X2) in R3: Y≤ X1 α X21-α} 7

 • When we study the behavior of a firm in certain economic
environments, we may want to distinguish between
production plans that are “immediately feasible” and those
that are “eventually” feasible.
• We will generally assume that such restrictions can be
described by some vector z in RL.
• The restricted or short-run production possibilities set will
be denoted by Y (z); this consists of all feasible net output

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bundles consistent with the constraint level z.
• The following are some examples of such restrictions.

• Y(Z)= { ( Y, -X1, -X2) in R3: Y≤ X1 α X21-α , X = Z in fixed manner

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• EXAMPLE: Input requirement set
• Suppose a firm produces only one output. In this case we
write the net output bundle as (y,−x) where x is a vector of
inputs that can produce y units of output.
• We can then define a special case of a restricted production
possibilities set, the input requirement set:

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• The input requirement set is the set of all input bundles that
produce at least y units of output.
• Note that the input requirement set, as defined here,
measures inputs as positive numbers rather than negative
numbers as used in the production possibilities set.
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• EXAMPLE: Transformation function
• A production plan y in Y is (technologically) efficient if there is
no y′ in Y such that y′ = y and y′ y; that is,
• a production plan is efficient if there is no way to produce
more output with the same inputs or to produce the same
output with less inputs.
• We often assume that we can describe the set of
technologically efficient production plans by a transformation

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function T: → R where T(y) = 0 if and only if y is efficient.
• Just as a production function picks out the maximum scalar
output as a function of the inputs, the transformation
function picks out the maximal vectors of net outputs.

• T(Y, -X1, -X2 ) = Y - X1 α X21-α

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• Let us see different numeric examples
• Let us see different numeric examples as PPS, IRS,
IQF, SRPPS, TF and CDTF

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• See example from exercise book page 28

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2.2.3 Common Properties of Production Sets
• Although the production possibility sets of different
processes can differ widely in structure, many technologies
share certain general properties. Thus,
• Some important properties are defined below:
POSSIBILITY OF INACTION: 0 ∈ Y .
• Possibility of inaction means that no action on production is a

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possible production plan.
Closeness: Y is closed.
• The possibility set Y is closed means that, whenever a
sequence of production plans yi, i = 1, 2, . . . , are in Y and yi
→ y, then the limit production plan y is also in Y .
• It guarantees that points on the boundary of Y are feasible.
• Note that Y is closed implies that the input requirement set V 16
(y) is a closed set for all y ≥ 0.
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• Convexity of Y means that, if all goods are divisible, it is often
reasonable to assume that two production plans y and y′ can 17
be scaled downward and combined.
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2.2.4 Returns to Scale
• Suppose that we are using some vector of inputs x to produce some
output y and we decide to scale all inputs up or down by some amount t
greater than or equal to 0.
• What will happen to the level of output? The notions of returns to scale
can be used to answer this question.
• Returns to scale refer to how output responds when all inputs are varied
in the same proportion so that they consider long run production
processes.

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• There are three possibilities: technology exhibits (1) constant returns to
scale; (2) decreasing returns to scale, and (3) increasing returns to scale.
• Formally, we have (GLOBAL) RETURNS TO SCALE. A production function
f(x) is said to exhibits :

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• Constant returns to scale (CRS) means that doubling inputs
exactly double outputs, which is often a reasonable
assumption to make about technologies.
• Decreasing returns to scale means that doubling inputs are
less than doubling outputs.
• Increasing returns to scale means that doubling inputs are
more than doubling outputs.

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• See example from exercise book page 30

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2.2.5 The Marginal Rate of Technical Substitution
• Suppose that technology is summarized by a smooth
production function and that we are producing at a particular
point .
• Suppose that we want to increase a small amount of input 1
and decrease some amount of input 2 so as to maintain a
constant level of output.
• How can we determine this marginal rate of technical

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substitution(MRTS) between these two factors? The way is
the same as for deriving the marginal rate of substitution of
an indifference curve. Differentiating production function
when output keeps constant, we have

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• See the whole processes of derivation
page 31.

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2.2.6 The Elasticity of Substitution
• The marginal rate of technical substitution measures the slope
of an isoquant. The elasticity of substitution measures the
curvature of an isoquant.
• More specifically, the elasticity of substitution measures the
percentage change in the factor ratio divided by the
percentage change in the MRTS, with output being held fixed.
• If we let Δ(x2/x1) be the change in the factor ratio and ΔMRTS

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be the change in the technical rate of substitution,
• we can express this as

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• This is a relatively natural measure of curvature: it asks how
the ratio of factor inputs changes as the slope of the
isoquant changes.
• If a small change in slope gives us a large change in the
factor input ratio, the isoquant is relatively flat which means
that the elasticity of substitution is large.
• In practice we think of the percent change as being very
small and take the limit of this expression as Δ goes to zero.
• Hence, the expression for σ becomes

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• (The absolute value sign in the denominator is to convert
the MRTS to a positive number so that the logarithm makes
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sense.)
• See the whole processes of derivation and from
page 33 or next example:

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• See the whole processes of derivation from page
34-35 and 36-38.

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2.3 Profit Maximization
• 2.3.1 Producer Behavior
• A basic hypothesis on individual firm behavior in the
producer theory is that a firm will always choose a most
profitable production plan from the production set.
• We will derive input demand and output supply functions by
considering a model of profit-maximizing behavior coupled

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with a description of underlying production constraints.
• Economic profit is defined to be the difference between the
revenue a firm receives and the costs that it incurs.
• It is important to understand that all (explicit and implicit)
costs must be included in the calculation of profit.
• Both revenues and costs of a firm depend on the actions
taken by the firm. 33
• We can write revenue as a function of the level of operations
of some n actions, R(a1, ..., an), and costs as a function of
these same n activity levels, C(a1, ..., an), where actions can
be in term of employment level of inputs or output level of
production or prices of outputs if the firm has a market power
to set up the prices.
• A basic assumption of most economic analysis of firm
behavior is that a firm acts so as to maximize its profits; that

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is, a firm chooses actions (a1, ..., an) so as to maximize R(a1,
..., an)−C(a1, ..., an).
• The profit maximization problem facing the firm can be then
written as

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• The intuition behind these conditions should be
clear:
• if marginal revenue were greater than marginal cost, it would
pay to increase the level of the activity;
• if marginal revenue were less than marginal cost, it would
pay to decrease the level of the activity.
• In general, revenue is composed of two parts: how much a

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firm sells of various outputs times the price of each output.
• Costs are also composed of two parts: how much a firm uses
of each input times the price of each input.

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2.3.2 Producer’s Optimal Choice
• Let p be a vector of prices for inputs and outputs of the firm.
The profit maximization problem of the firm can be stated
π(p) = max py such that y is in Y.----------------3.1
• Note that since outputs are measured as positive numbers
and inputs are measured as negative numbers, the objective
function for this problem is profits: revenues minus costs.

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• The function π(p), which gives us the maximum profits as a
function of the prices, is called the profit function of the firm.
• There are several useful variants of the profit function:
• Case 1. Short-run maximization problem. In this case, we
might define the short-run profit function, also known as the
restricted profit function:
π(p, z) = max py such that y is in Y (z). 36
• Case 2. If the firm produces only one output, the profit
function can be written as π(p,w) = max pf(x) − wx
• where p is now the (scalar) price of output, w is the vector of
factor prices, and the inputs are measured by the
(nonnegative) vector x = (x1, ..., xn).
• The value of y that solves the profit problem (3.1) is in general
not unique.
• When there is such a unique production plan, the production

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plan is called the net output function or net supply function,
• the corresponding input part is called the producer’s input
demand function and the corresponding output vector is
called the producer’s output supply function.

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2.3.3 Producer’s First-Order Conditions
• Profit-maximizing behavior can be characterized by calculus
when the technology can be described by a differentiable
production function.
• For example, the first-order conditions for the single output
profit maximization problem with interior solution are

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• The first-order conditions state that the “marginal value of
product of each factor must be equal to its price,” i.e.,
marginal revenue equals marginal cost at the profiting
maximizing production plan.
• This first-order condition can also be exhibited graphically in
next slide
• Consider the production possibilities set depicted in Figure
3.3. In this two-dimensional case, profits are given by

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• Π = py−wx.
• The level sets of this function for fixed p and w are straight
lines which can be represented as functions of the form:
• y = Π/p+(w/p)x.
• Here the slope of the iso-profit line gives the wage measured
in units of output, and the vertical intercept gives us profits
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measured in units of output.
• The point of maximal profits the production function must
lie below its tangent line at x∗; i.e., it must be “locally
concave.” and it should be

• It can be presented in graph

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2.3.4 Sufficiency of Producer’s First-Order Condition
• The second-order condition for profit maximization is that
the matrix of second derivatives of the production function
must be negative semi-definite at the optimal point;
• that is, the second-order condition requires that the Hessian
matrix must satisfy the condition that hD2f(x∗)h′ less than
or equal to 0 for all vectors h.

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• Geometrically, the requirement that the Hessian matrix is
negative semi-definite means that the production function
must be locally concave in the neighborhood of an optimal
choice.
• Formerly, we have the following proposition.

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• See the derivation process from page 39-40
• From The given CDPF , derive
• Input price function
• The factor demand function
• The supply function and The profit function

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2.3.5 Properties of Net Supply Functions
• In this section, we show that the net supply functions are the
solutions to the profit maximization problem that in fact
have imposed certain restrictions on the behavior of the
demand and supply functions.

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2.4 Profit Function
• Given any production set Y , we have seen how to
calculate the profit function, π(p), which gives us
the maximum profit attainable at prices p.
• The profit function possesses several important
properties that follow directly from its definition.

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• These properties are very useful for analyzing profit-
maximizing behavior.
2.4.1 Properties of the Profit Function
• The properties given below follow solely from the
assumption of profit maximization.
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2.4.2 Deriving Net Supply Functions from Profit
Function
• If we are given the net supply function y(p), it is easy
to calculate the profit function.
• We just substitute into the definition of profits to
find π(p) = py(p).
• Suppose that instead we are given the profit

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function and are asked to find the net supply
functions.
• How can that be done? It turns out that there is a
very simple way to solve this problem: just
differentiate the profit function.
• The proof that this works is the content of the next
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proposition.
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• This expression says that the derivative of π with respect to a
is given by the partial derivative of f with respect to pi,
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holding x fixed at the optimal choice.
• See another example s for profit maximization
page 41-42.

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2.5 Cost Minimization
• An important implication of the firm choosing a profit-
maximizing production plan is that there is no way to produce
the same amounts of outputs at a lower total input cost.
• Thus, cost minimization is a necessary condition for profit
maximization.
• This observation motives us to an independent study of the

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firm’s cost minimization.
• The problem is of interest for several reasons.
• First, it leads us to a number of results and constructions that
are technically very useful.
• Second, as long as the firm is a price taker in its input market,
the results flowing from the cost minimization continue to be
valid whether or not the output market is competitive and so 54
whether or not the firm takes the output price as given as.
• Third, when the production set exhibits non decreasing
returns to scale, the cost function and optimizing vectors of
the cost minimization problem, which keep the levels of
outputs fixed, are better behaved than the profit function.

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2.5.1 First-Order Conditions of Cost Minimization

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• This first-order condition can also be represented graphically.
In Figure 3.6, the curved lines represent iso-quants and the
straight lines represent constant cost curves.
• When y is fixed, the problem of the firm is to find a cost-
minimizing point on a given iso-quant.
• It is clear that such a point will be characterized by the
tangency condition that the slope of the constant cost curve
must be equal to the slope of the iso-quant.

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 2.5.2 Sufficiency of First-Order Conditions for Cost
Minimization
• like consumer’s constrained optimization problem, the above
first-order conditions are merely necessary conditions for a
local optimum. However,
• these necessary first order conditions are in fact sufficient
for a global optimum when a production function is quasi-

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concave, which is formerly stated in the following
proposition.

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• For each choice of w and y there will be some choice of x∗
that minimizes the cost of producing y units of output.
• We will call the function that gives us this optimal choice the
conditional input demand function and write it as x(w, y).
• Note that conditional factor demands depend on the level of
output produced as well as on the factor prices.
• The cost function is the minimal cost at the factor prices w

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and output level y; that is. c(w, y) = wx(w, y).
• Now let us different examples by using different derivations:
• Please considers your exercise book examples with its
procedure page 41.

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• Needs correction for the two CID function from
exercise book page 43-48.

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• See example in exercise book from page 49-54

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• See exercise book from page 55.

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2.6 Cost Functions
• The cost function measures the minimum cost of producing a
given level of output for some fixed factor prices.
• As such it summarizes information about the technological
choices available to the firms.
• It turns out that the behavior of the cost function can tell us a
lot about the nature of the firm’s technology.

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• In the following we will first investigate the behavior of the
cost function c(w, y) with respect to its price and quantity
arguments.
• We then define a few related functions, namely the average
and the marginal cost functions.

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2.6.1 Properties of Cost Functions
• You may have noticed some similarities here with consumer
theory. These similarities are in fact exact when one compares
the cost function with the expenditure function. Indeed,
consider their definitions.

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• Mathematically, the two optimization problems are identical.
Consequently, for every theorem we proved about
expenditure functions, there is an equivalent theorem for cost
functions.
• We shall state these results here, but we do not need to prove 67
them. Their proofs are identical to those given for the
expenditure function.
• Proposition 2.6.1 [Properties of the Cost Function.]
Suppose the production function f is continuous
and strictly increasing.
• Then the cost function has the following properties:
(1) c(w, y) is non decreasing in w.
(2) c(w, y) is homogeneous of degree 1 in w.

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(3) c(w, y) is concave in w.
(4) c(w, y) is continuous in w, for w > 0.
(5) For all w > 0, c(w, y) is strictly increasing y.

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2.6.2 Properties of Conditional Input Demand
• As solution to the firm’s cost-minimization problem, the
conditional input demand functions possess certain general
properties.
• These are analogous to the properties of Hicksian
compensation demands, so once again it is not necessary to
repeat the proof.

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• Another example cost minimization

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2.6.3 Average and Marginal Costs
• Let us consider the structure of the cost function. Note that
the cost function can always be expressed simply as the value
of the conditional factor demands: c(w, y) ≡ wx(w, y)

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• Let us see different examples and see the exercise
books page 56-58.

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2.6.4 The Geometry of Costs
• Let us first examine the short-run cost curves. In this case, we
will write the cost function simply as c(y), which has two
components: fixed costs and variable costs.
• We can therefore write short-run average cost as

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• In the long run all costs are variable costs and the appropriate
long-run average cost curve should also be U-shaped by the
facts that variable costs usually exhibit increasing returns to
scale at low lever of production and ultimately exhibits 77
decreasing returns to scale.
• It can be explained by graphs

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• Remark : All of the analysis just discussed holds in
both the long and the short run.
• However, if production exhibits constant returns to
scale in the long run, so that the cost function is
linear in the level of output, then average cost,
average variable cost, and marginal cost are all
equal to each other.

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2.6.5 Long-Run and Short-Run Cost Curves
• Let us now consider the relationship between the long-run
cost curves and the short-run cost curves.
• It is clear that the long-run cost curve must never lie above
any short-run cost curve, since the short-run cost
minimization problem is just a constrained version of the long-
run cost minimization problem.
• Let us write the long-run cost function as c(y) = c(y, z(y)).

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• Here we have omitted the factor prices since they are
assumed fixed, and we let z(y) be the cost-minimizing demand
for a single fixed factor.
• Let y∗ be some given level of output, and let z∗ = z(y∗) be the
associated long-run demand for the fixed factor.
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• The short-run cost, c(y, z∗), must be at least as
great as the long-run cost, c(y, z(y)), for all levels of
output, and the short-run cost will equal the long-
run cost at output y∗, so c(y∗, z∗) = c(y∗, z(y∗)).
• Hence, the long and the short-run cost curves
must be tangent at y∗.
• This is just a geometric restatement of the

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envelope theorem. The slope of the long-run cost
curve at y∗ is

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• Finally, we note that if the long- and short-run cost curves
are tangent, the long- and short-run average cost curves
must also be tangent. A typical configuration is illustrated in
Figure 3.8.

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• See examples from exercise book 59-62.

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2.7 Duality in Production
• In the last section we investigated the properties of the cost
function. Given any technology, it is straightforward, at least
in principle, to derive its cost function:
• we simply solve the cost minimization problem.
• In this section we show that this process can be reversed.
Given a cost function we can “solve for” a technology that
could have generated that cost function.

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• This means that the cost function contains essentially the
same information that the production function contains.
• Any concept defined in terms of the properties of the
production function has a “dual” definition in terms of the
properties of the cost function and vice versa.
• This general observation is known as the principle of duality.
• It helps to recover the production function from its cost 85
function
 2.8.1 Recovering a Production Set from a Cost
Function : see page 63-65

• Examples:

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 •The End

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