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Producer Behavior

Theory of Producer Behavior

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The fundamental relation guiding producer

behavior is the production function

the production function is the relationship
between inputs of labor and capital and the
amount of production

the causal order is from inputs to output

The cost function is obtained by using the cost

minimization principle under the condition of

constant production levels

Cont
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combining the cost function and sales function,

the profit function is defined as the difference

between sales and cost functions.
Optimal output is determined by applying the
profit maximization principle to the profit
function
Therefore, cost minimization is a necessary
condition for profit maximization.

Cont
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The production function

q = f(x1, x2, , xm)

where q is the amount of production and x1, x2, ,
xm are factor inputs necessary for production.
Factors of production are land, labor, and

capital.

Cont
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The definition of the cost equation is:

C = irixi
where C is cost and ri is the unit cost for the i-th
factor input
The cost minimization hypothesis stipulates that
a firm chooses a combination of factor inputs so
as to minimize costs under the condition of
constant production levels and fixed factor input
prices

Cont
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To get the optimal amount of factor inputs under

the condition of constant levels of production,

the Lagrange multiplier method is utilized.
The evaluation function is:
V = irixi + (q f(x1 x2, , xm))
first-order conditions for cost minimization are:

V/xi = ri f/xi = 0
V/ = q0 f(x , x , , x ) = 0

Cont
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From the first equation, we get:

1/ = (f/xi)/ri
This is called the law of equal marginal products

per unit cost of input (or the least-cost rule).

Using FOC, factor demand functions are
obtained as:
xi = g(r1, r2, , rm | q0 )
where q0 is a parameter

Cont
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Substituting xi in cost equation, the cost

function is obtained as the function of factor

input prices of r1, r2, , rm and constant
quantity of q0:
C = i rixi = h(r1, r2, , rm | q0 )

This is the cost function satisfied by cost

minimization under the condition of constant

production levels.

Cont
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When we change the levels of production while

keeping the least-cost rule, the cost function

changed to
C = H(r1, r2, , rm, q)

This is the cost function in which the variables

are factor input prices and quantity produced.

Cont
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By applying the profit maximization principle, the

optimal production level of the firm can be

determined.
The profit function is:
= pq C(q)

where is profit and p is the market price

Differentiating both sides by q and setting d/dq
as zero, we get

Cont
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d/dq = p + q(dp/dq) dC/dq = 0

The solution of the quantity of q satisfies the

optimal production level with maximum profit.

This equation is the same as the MR (marginal
revenue) = MC (marginal cost) condition:

MR = p(1 + (q/p)dp/dq) = dC/dq = MC

When dp/dq is equal to zero, the market becomes a

competitive market, and the equilibrium condition of

the competitive market becomes p = dC/ dq, where
market price is equal to marginal cost.

Cont
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There are three issues to bear in mind here about

producer behavior:
(1) the profit maximization hypothesis;

(2) the difference between short-run and long-

run

(3) the plausibility of the linear homogeneity of the

production function

Cont
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It is important to bear in mind, however, that

economic analysis extends beyond the scope of

individual firms and managers. It is true that
firms may have different strategies and
priorities, but a common goal is profit
maximization.
Profit maximization is also treated as an
analytical principle. When corporate behavior is
explained sufficiently through the profitmaximizing principle, then the principle is
relevant even if firms in the real world dont
focus solely on profit maximization.

Cont
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We usually think that the short-run is a short

period of time, say one day, one week, or at most

one year, and that the long-run is a long period,
say five years, ten years or one hundred years.
Short-run in microeconomics refers to the
period when capital stocks are constant. That
is, the capital stock in the production function
is treated as being constant.
Long-run in microeconomics is defined as the
period during which the amount of capital
stock varies and a firm must consider the
optimal investment behavior.

Cont
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In macroeconomics, the terms short-run and

long-run have different meanings.

The short-run is the period when the process of
price adjustment continues, and
the long-run is the period when price
adjustments are completed.
it is important to bear in mind that the two terms
are defined differently in microeconomics and
macroeconomics.

Cont
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Linear Homogeneity of the production function

Example

there is a factory that produces 10 units per month

using 10 laborers and 10 units of capital. When
building a new factory that has the same amount of
laborers and capital as the existing factory, we
might assume that 10 units of output will be
produced in the new factory. This illustrates the
concept of linear homogeneity: when all the factor
inputs are doubled, the amount of production also
doubles.

Models of Producer Behavior

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In the case of competitive markets for labor and

capital, the behavioral principle for firms is to

determine the amount of labor and capital
needed so as to minimize the cost of labor and
capital while maintaining a constant level of
production
In terms of the goods and services market, firms
determine the amount of production that will
maximize profits.
Cost minimization is a necessary condition for
profit maximization

Cont
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CobbDouglas production function

Q = AK1N2
where Q is quantity of output, N is labor input,
and K is capital input, and A, 1, and 2 are
parameters to be estimated.
To estimate A, 1, and 2 there are two
methods.
The first is to estimate the production function directly
The second is to derive the parameters of the production
function from estimates of the cost function.

Cont
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In estimating the cost function, we use the

cost minimization principle to include market

conditions.
The assumption of cost minimization is that the
firm determines the combination of labor and
capital inputs needed to minimize the cost given
a constant level of quantity produced.
Therefore, a constant amount of quantity (Q0),
wages (w), and interest rates (r) are treated as
exogenous variables.

Cont
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The definition of cost is

C = wN + rK
We can define cost minimization behavior under
constant levels of production in mathematical
form as:
V = wN + rK + (Q0 AK1 N2 )
To get optimal conditions for N, K, and , we

derive the first-order condition for minimization

through the following equations

Cont
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V/N = w 2 AK1 N2 = 0
V/K = r 1 AK1 N2 = 0
=0
V/ = Q0 AK1 N2
By solving, we get

wN/2 = rK/1
This is the law of equal marginal productivity
per dollar for the CobbDouglas production
function

Cont
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Labor and capital demand functions can be

obtained as:

N=(1/A)1/(1+2)+(1/2)-1/(1+2)+(w/r)-1/(1+2)+Q01/(1+2)
K=(1/A)1/(1+2)+(1/2)2/(1+2)+(w/r)2/(1+2)+Q01/(1+2)
Estimating the equations by the regression

method yields the estimates of the Cobb Douglas

production function

Cont
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The causal order is from w, r, and Q0 to N and K.

The causal order is different for the production

and cost functions.

We will now specify the cost function and
estimate its parameters.
In the case of variable levels of production, we
use the following equations:
N = constant1(w/r)-1/(1+2)Q01/(1+2)
K = constant2(w/r)2/(1+2)Q01/(1+2)

Cont
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Taking the logarithms for both sides of equations

n = log(constant1) 1/(1 + 2) log(w/r) + 1/(1 + 2)q

k = log(constant2) + 2/(1 + 2) log(w/r) + 1/(1 + 2)q
Therefore, when

1/(1 + 2) = K0,
1/(1 + 2) = K1, and
2/(1 + 2) = K2,
we get 1 = K1/K0 and 2 = K2/K0.
The structural parameters 1 and 2 are estimated in
the case of variable levels of production.

Cont
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When using the CobbDouglas production function,

the cost function is written as:

C = [(1/A)(1/2)(w/r)]-1/(1+2) [(1/2)(w/r)-1 w + (1/2)(w/r)2 r] Q01/(1+2)
It is a highly nonlinear function including A, 1,

2, and wage and interest rates.

To estimate the equation, linear approximation
is necessary, as it is difficult to estimate equation
in the nonlinear form to get the estimates of A,
1, 2.

Cont
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Generally, to estimate the cost function, we

specify it as a function of the wage rate, capital

costs, and quantity, and then estimate it directly.
First, we specify the production function in
general as:
Q = f(N, K)
The cost function
C = Nw + Kr

Cont
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Under the condition of cost minimization, capital

demand and labor demand functions are derived

as the function of wage, capital costs and
quantity as:
K = K (w, r, Q)
N = N (w, r, Q

Adding these to the cost definition, we get

C = Nw + Kr = C(w, r, Q)
Thus, cost is a function of wages, unit capital cost
and quantity produced. This is the general cost
function.

Generating Data - Monte Carlo Method

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CobbDouglas type production function

Q = AK1N2
Lets consider the following estimating equation

qi = + 1ki + 2ni + i
Which is the logarithmic transformation of
production function

Cont
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The definition of cost is

C = wN + rK
We can define cost minimization behavior under
constant levels of production in mathematical
form as:
V = wN + rK + (Q0 AK1 N2 )
To get optimal conditions for N, K, and , we

derive the first-order condition for minimization

through the following equations

Cont
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V/N = w 2 AK1 N2 = 0
V/K = r 1 AK1 N2 = 0
=0
V/ = Q0 AK1 N2
By solving, we get

wN/2 = rK/1

Cont
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Labor and capital demand functions can be

obtained as:
N=(1/A)1/(1+2)+(1/2)-1/(1+2)+(w/r)-1/(1+2)+Q01/(1+2)
K=(1/A)1/(1+2)+(1/2)2/(1+2)+(w/r)2/(1+2)+Q01/(1+2)

Taking the logarithms for both sides of equations

k = 1/(1 + 2) logA + 2/(1 + 2) log(1/2) +

2/(1 + 2) log(w/r) + 1/(1 + 2) q + e1
n = 1/(1 + 2) logA 1/(1 + 2) log(1/2) 1/(1 + 2) log(w/r) + 1/(1 + 2) q + e2

Cont
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Generate the following virtual data set

n=500
2 = 0.8
1 = 0.2,
= 1,
q ~ N(12, 32)
log(r/w) ~ N(0, 22)
k ~ N(12, 32)
n ~ N(12, 0.62)
2 ~ N(0, 12), 3 ~ N(0, 12)
1 ~ N(0, 22),
r ~ Uniform Distribution (0.01, 0.2)

Exercise I
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Estimate the labor demand function, the capital

demand function and the production function

k = B0 + B1 log(r/w) + B2q +
n = A0 + A1 log(r/w) + A2q +
qi = + 1ki + 2ni + i

Test the hypothesis