Producer Theory

Econ 2100 Fall 2015

Lecture 9, September 30

Outline
1 Properties of Supply and Prot
2 Hotelling and Shephard Lemmas
3 Cost Minimization
4 Aggregation
 From Last Class
Denition
A production set is a subset Y Rn .

Denition
Given a production set Y Rn , the transformation function F : Y ! R is
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.

A rms objective is to choose an output vector in its production set so as to

maximize prots.
Denition
Given a production set Y Rn , the supply correspondence y : Rn++ ! Rn is:
y (p) = arg max p y :
y 2Y

Denition
Given a production set Y Rn , the prot function : Rn++ ! R is:
(p) = max p y :
y 2Y
 Properties of Supply and Prot Functions

Proposition
Suppose Y is closed and satises 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 dierentiable at p and r (p) = y (p) (Hotellings
Lemma).
if y (p) is dierentiable at p, then Dy (p) = D 2 (p) is symmetric and
positive semidenite with Dy (p)p = 0.
 The Prot Function Is Convex
Proof.
Let p,p 0 2 Rn++ and let the corresponding prot maximizing solutions be y and y 0 .
For any 2 (0; 1) let p = p + (1 ) p 0 and let y be the prot 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 denition of prot 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 denition:
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).
 Hotellings Lemma
if jy (p)j = 1, then is dierentiable at p and r (p) = y (p)
Proof.
Suppose y (p) is the unique solution to max p y subject to F (y ) = 0.
The Envelope Theorem says
>
Dq (x (q); q) = Dq (x; q)jx =x (q);q=q [ (q)] Dq F (x; q)jx =x (q);q=q
In our setting,
(x ; q) = p y ,
F (x ; q) = F (y ), and
(x (q); q) = (p).
Thus, by the envelope theorem:
> >
r (p) = Dp (p y )jy =y (p) [ (p)] Dp F (y )jy =y (p) = y jy =y (p) [ (p)] 0

because p y is linear in p and Dp F (y ) = 0.

Therefore
r (p) = y (p)
as desired.
 Law of Supply
Remark
If y (p) is dierentiable at p, then Dy (p) = D 2 (p) is positive semidenite.

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 prot 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 Prot Function
The previous concepts can be stated using the production function notation.

Denition
Given p 2 R++ and w 2 Rn++ and a production function f : Rn+ ! R+ , the rms
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

Denition
Given p 2 R++ and w 2 Rn++ and a production function f : Rn+ ! R+ , the rms
supply function y : Rn+ ! R is dened by
y (p; w ) = f (x (p; w )) :

Denition
Given p 2 R++ and w 2 Rn++ and a production function f : Rn+ ! R+ , the rms
prot function : R++ Rn++ ! R is dened by
(p; w ) = py (p; w ) w x (p; w ) :
 Factor Demand Properties

Given these denitions, 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) (Hotellings Lemma).

Proof.
Problem 2a,b; Problem Set 5.
 Cost Minimization
Cost Minimizing
Consider the one 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.

Denition
Given w 2 Rn++ and a production function f : Rn+ ! R+ , the rms conditional
factor demand is
x (w ; y ) = arg min fw x subject to f (x) = y g ;

Denition
Given w 2 Rn++ and a production function f : Rn+ ! R+ , the rms cost function
C : Rn++ R+ ! R is dened 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 2c; Problem Set 5. (Hint: use a revealed preferencesargument)

Shephards 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 )
Dierentiating one more time: @C @w i @w i = @w i 0 where the
inequality follows by Question 2c in Problem Set 5.
 Aggregation
Back to our abstract analysis of rms/producers.
Next, we compare the prot maximizing production choices individually made
by rms with those that would be made by a central planner that tries to
maximize the sum of the prots of all rms simultaneously. This compares
centralizeddecision making with decentralizedchoices.
We can show that the planner cannot do better: individual maximizing behavior
cannot be improved upon.
We can also show that any e cientaggregate output level can be achieved
when each rm maximizes its own prots.
Later, we will use these results to prove the two fundamental theorems of
welfare economics.
Roughly, the rst theorem says that a competitive equilibrium cannot be
improved upon by a central planner.
Decentralized choices cannot be improved upon.
Roughly, the second theorem says that any outcome chosen by a central planner
can be achieved in a competitive equilibrium.
Centralized choices can be achieved in a decentralized manner.
 Aggregate Supply and Aggregate Prots
Notation
There are J rms, each with a non empty closed production set Yj satisfying
free disposal.
Denote rm j supply correspondence and prot function by yj and j
respectively.

Denitions
agg
The aggregate supply correspondence y (p) is the sum of all rmssupply
correspondences: 8 9
agg
<XJ =
y (p) = yj : yj 2 yj (p) ;
: ;
j =1
agg
the aggregate prot function (p) is the sum of all rmsprot functions:
J
X
agg
(p) = j (p):
j =1

agg
y (p) is what results from individual prot maximization given p.
 Centralized Supply and Centralized Prots
Denition
The aggregate production set Y is the sum of the rmsproduction sets:
8 9
<X n =
Y = yj : yj 2 Yj :
: ;
j =1

No individual rm has access to points in Y , but if a central planner tells each

rm what to do, and rms do as they are told, then anything in Y can be
produced.
Denitions
cent
The centralized supply correspondence y (p) is dened as
cent
y (p) = arg max p y ;
y 2Y
cent
the centralized prot function (p) is dened as
cent
(p) = max p y :
y 2Y

cent
y (p) is what results from centralized prot maximization given p.
 Individual and Joint Prot Maximization
Proposition
The following hold:
cent agg
1 Aggregate supply equals centralized supply: y (p) = y (p);
cent agg
2 Aggregate prot equal centralized prot: (p) = (p).

In words: given a price vector:

any production vector that maximizes individual prots also maximizes
centralized prots;
viceversa, any production vector that maximizes centralized prots also
maximizes individual prots.
therefore, aggregate prots are the same as centralized prots.
Prot maximizing rms individually choose the same output that would be
chosen by a central planner that controls their production choices and
maximizes joint prots.
There is no benet, in terms of prots, to centralized decision making.
 Individual and Joint Supply and Prots
Proof.
cent agg
First, show that y (p) y (p) by contradiction.
cent P
Suppose y 2 y (p). Since y 2 Y , there exist yj 2 Yj such that y = j yj .
Suppose that some particular yk 2
= yk (p).
Then p yk0 > p yk for some yk0 2 Yk .
P P cent
Then j 6=k yj + yk0 2 Y and p ( j 6=k yj + yk0 ) > p y = (p).
cent
But this contradicts the fact that y (p) is centralized supply.
agg
So we conclude that each yj 2 yj (p), i.e. y 2 y (p).
agg cent
Next, show that y (p) y (p) also by contradiction.
P cent
Select yj 2 yj (p) for each j, and suppose yj 2
= y (p).
P P
Thus, there exist yj0 2 Yj such that p ( j yj0 ) > p ( j yj ).
This implies there exists at least one k such that p yk0 > p yk .
But since yk0 2 Yk , this contradicts the fact that yk (p) is individual supply.
agg cent
Therefore y (p) y (p).
cent agg cent cent agg agg
Finally, since y (p) = y (p): (p) = p y (p) and (p) = p y (p)
cent agg
Hence, (p) = (p) as desired.
 Aggregate Choices Are E cient
Denition
A production vector y 2 Y is e cient if there exists no y 0 2 Y such that y 0 y
and y 0 6= y .

E ciency means there is no waste. This has nothing to do with prices.

Proposition
cent
If y 2 y (p), then y is e cient.

An output vector that maximizes joint prots is e cient.

Proof.
cent
Suppose not: y 2 y (p) but it is not e cient;
Hence 9y 0 2 Y such that y 0 6= y and y 0 y .
Thus, p y 0 > p y and therefore y does not maximize aggregate prots. This is
a contradiction.

Remark
Using the earlier Proposition, we conclude output that maximizes rms
individual prots yields aggregate production that is also e cient.
 E cient Production Maximizes Centralized Prot

Proposition
Assume Y is convex. If y^ 2 Y is e cient, then there exists p 2 Rn+ n f0n g such
cent
that y^ 2 y (p).

This goes in the opposite direction of the previous result: if we have an

e cient output vector, there are prices that make this vector the solution to
the joint prot maximization problem.
Also, since joint prot maximization and individual prot maximization are the
same, if a production vector is e cient, there are prices that make the rm
level pieces of this vector the solution to each rms individual prot
maximization problem.
Anything e cient can be achieved by decentralized choices of prot
maximizing rms, if one chooses the rightprices.
 Separating Hyperplane Theorem

To prove the previous proposition, we need the following result.

Theorem (Separating Hyperplane Theorem)

If A; B Rn are convex and disjoint, then there exist a p 2 Rn n f0n g and a k 2 R
such that
p a k for all a 2 A
and
p b k for all b 2 B

Given two disjoint convex sets, there is an hyperplane that goes between them,
and the two sets lie on opoosite half spaces.
 E cient Production Maximizes Centralized
cent
Prot
If y^ 2 Y (convex) is e cient, 9p 2 R+n n f0n g s.t. y^ 2 y (p) = arg maxy 2Y p y .

Proof.
Suppose y^ 2 Y is e cient. Let Py^ = fy 2 Rn : yi > y^i for all i = 1; :::; ng.
Since y^ is e cient, Py^ \ Y = ;.
Verify that Py^ is convex (Question 6, Problem Set 5).
By the Separating Hyperplane Theorem, 9p 2 Rn n f0n g and 9k 2 R such that
p y k for all y 2 Y and p b k for all b 2 Py^
Clearly, pi 0 for all i = 1; :::; n.
if pi < 0, then select x 2 Py^ with xi su ciently large such that p x < k.
Choose a sequence b1 ; b2 ; : : : 2 Py^ such that bn ! y^ .
The set fz 2 Rn : p z kg is closed and
bn 2 Py^ fz 2 Rn : p z kg; therefore p y^ k:
But for all y 2 Y , p y k by separation, hence k p y^ k
cent
Therefore p y^ = k, and y^ 2 y (p).
 E cient Production Is Prot Maximizing

The last result is one building block of the Second Fundamental Theorem of
Welfare Economics.

Firms in the Second Fundamental Theorem of Welfare Economics

For every e cient production vector, there exists some price vector that makes
that production vector a prot-maximizing choice for the planner and a prot
maximizing choice for the individual rms.
Only one assumption is needed: convexity of production sets.

The complete version includes consumers, and a notion of e ciency that

includes their preferences.
 Econ 2100 Fall 2015

Problem Set 5
Due 5 October, Monday, at the beginning of class
1. Show that GARP is equivalent to the following: If xj %I xk then not xk I
xj .

2. Suppose f(xj ; pj ; wj )gN

k=1 is a nite set of demand data. Prove that if there exists a locally nonsatiated
utility function which rationalizes the data, then the data satisfy the Generalized Axiom of Revealed
Preference.

3. Consider the following data set of four demand observations for two commodities.

x p w
1 (3; 9) (3; 3) 36
2 (12; 1) (1; 8) 20
3 (4; 2) (2; 3) 14
4 (1; 1) (4; 4) 8

Find %R , R
, %I , and I
for these observations. Check that the data satisfy GARP.

4. Prove that if Y satises non decreasing returns to scale either (p) 0 or (p) = +1.

5. Given p 2 R++ , w 2 Rn++ , and a production function f : Rn+ ! R+ , prove the following:

(a) the rms prot function (p; w) is convex in (p; w);

@y (p;w)
(b) the rms supply function 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. @wi
0) (Hotellings Lemma).
(c) The rms cost function C(w; y) is concave in w (Hint: use a revealed preferencesargument).

6. Derive cost function C (w; y) and conditional factor demand x (w; y), and then use them to determine
the prot function (w) and the supply function/correspondence y (w) for each of the following single
output production functions (remember to draw pictures).

(a) f (x1 ; x2 ) = x1 x2 .
(b) f (x1 ; x2 ) = x1 + x2 .
(c) f (x1 ; x2 ) = min fx1 ; x2 g.
1
(d) f (x1 ; x2 ) = (x1 + x2 ) with 1.

7. Suppose the aggregate production set Y is convex and y 2 Y is e cient. Show that the set

Py = fx 2 Rn : xi > yi for all ig

is convex.