Applied Economics for Business

Management
Lecture #10

Lecture Outline
Review
Homework Set #8
Continue Production Theory:
Generalized Production Function

Exam

Generalized Production Function

In the general case of m products and n variable
factors of production, the production function in
implicit form is:

For profit maximization:

Generalized Production Function

We assume that production occurs on this
production frontier called

So to tie in profit maximization subject to this

production frontier, we have the following general
form:

1st order conditions:

m equations

n equations

Generalized Production Function

In the general case there are m + n + 1
equations and m + n + 1 variables, so the system
of equations is solvable.
The first order conditions would determine the
levels of outputs and inputs that maximize profits
while operating on the production frontier.
Of course, the second order conditions (not
shown) should verify the critical values for the
maximum.

 What are the economic relationships which we

can derive from this general case?
Relationship between 2 factors of production.

Relationship between 2 factors of

production
Take inputs j and j+1.

Recall optimal allocation of inputs is where the

isoquant is tangent to the isocost line.

 What are the economic relationships which we

can derive from this general case?
Relationship between 2 factors of production.
Relationship between 2 products

Relationship between 2 products

Take 2 products i and i + 1:

 What are the economic relationships which we

can derive from this general case?
Relationship between 2 factors of production.
Relationship between 2 products
Relationship between a variable factor of
production and a product

Relationship between a variable factor

of production and a product
Take input j and product i.

Multiply both sides by -1.

Profits are maximized where the value of the MPP of

xj is equal to its factor price.

Demand for Nitrogen, Phosphorus and

Potash Fertilizer Nutrients.
A study done by Hoy Carmen from the University
of California at Davis.
Objective of study: To empirically estimate
aggregate state demands for nitrogen,
phosphorus and potash for the Western United
States.

Demand for Nitrogen, Phosphorus and

Potash Fertilizer Nutrients.
Carmens model:
Uses production economic theory, specifically derived
demand theory.
Carmen states in his article:
To derive the input demand function, one forms the profit
function in terms of output price, the production function, and
costs associated with the inputs.
Maximization of profits with respect to the quantity of inputs by
taking the partial derivatives of the profit function with respect to
the inputs, setting the partial derivatives equal to zero and
solving these equations for the quantity of inputs, yields the
input demand functions.

 He chose the Cobb-Douglas form for estimating

fertilizer demand functions:

 Question: Are the derived demand functions

homogeneous of degree zero in prices?
Yes. All prices are deflated by the wholesale price
index.

Regression results for nitrogen fertilizer demand:

 Since the input demand is estimated in CobbDouglas form, the coefficient on PN is the nitrogen
price elasticity of demand for that particular
state.
Which states have elastic nitrogen price
elasticities of demand that are statistically
significant at the 95% confidence level?

 The production processes for commercial

fertilizers are highly energy intensive.
Assume a period of extremely high energy prices
necessitating fertilizer rationing by increasing its
real price.

Given these estimated results for nitrogen demand,

which states would you suspect would have greater
success in reducing nitrogen application?

Application of Production Economic

Theory to Lease Arrangements
There are generally two types of lease
arrangements:
Cash lease
Share lease

Landlords can charge cash rent for the use of the

land by the tenant or elect to have a lease
arrangement in which returns and costs are shared
by the tenant and landlord.
The cash lease simply involves a direct cash
payment from the tenant to the landlord for the use
of the land.

Application of Production Economic

Theory to Lease Arrangements
The tenant decides:
What to grow on the land
How to grow these crops
How to market and sell the crop

The landlord is no longer concerned with the

success or failure of the tenant except that crop
failure might jeopardize the tenants ability to
cover cash rent.

Application of Production Economic

Theory to Lease Arrangements
Tenants on cash rent leases tend to underutilize
inputs that have no immediate effect (such as soil
conservation methods where the benefits occur
over a longer period of time).
Unless there is a guarantee from the landlord of a
longer term arrangement, the tenant chooses not
to make longer term investments or
improvements.

Share Rental Leases

In our standard profit maximization framework, we
have

1st order conditions:

For the first type of share lease arrangement,

consider the following:

assume the lease arrangement whereby the

landlord gets back a share of gross revenues
from the tenant and pays none of the
expenses (costs).

Share Rental Leases

For example: the landlord gets 25% of the crop
and the tenant gets 75% of the crop.
Assume that both the tenant and landlord are profit
maximizers:
landlords profits:
tenants profits:

Share Rental Leases

To maximize profits, the landlord chooses to
maximize output.
(why? because he/she does not pay any of the
costs)

producer (tenant) should produce where MPP = 0

or output is maximized.
Since the landlord doesnt pay any costs, his/her
suggestion to the tenant is to maximize output.

Share Rental Leases

tenant uses less x1 than the profit

maximizing level

Share Rental Losses

Likewise, using x2 such that
tenant would choose to underutilize x2

So the tenant would choose to use less x1 and x2

than what the landlord would choose to use.
Lease arrangements where the landlord receives
a share of the crop but pays none of the costs can
result in conflict between tenant and landlord.
Perhaps a better lease arrangement could be
drawn whereby the landlord and tenant share
both returns and costs.

Share Rental Leases

Suppose the landlord gets k% of the revenue and
pays s% of the cost. Then the tenant gets (1 k)
% of the revenue and pays (1 s)% of the cost.
The values of k and s are negotiated.
The landlords profit function:

The tenants profit function:

1st order conditions for landlord:

1st order conditions for tenant:

1st order conditions for tenant:

Landlord prefers to overutilize inputs (as

compared to the usual profit max usage

so the tenant favor underutilizing inputs than

would be the usual profit max level.
Suppose now that we take the case where

For the landlord:

landlord prefers to underutilize inputs (than
would be the usual profit max level)

 tenant favors overutilizing inputs (than

would be the usual profit max usage)
These cases illustrate that even if the landlord
and tenant share costs and revenue, there is
potential for conflict.
Only if k and s are equal will the landlords and
tenants profit max conditions agree.

 landlord:
Tenant:

Share Rental Leases

So the landlord and tenant would not tend to
overutilize or underutilize input usage.
Note that these actions by tenant and landlord
are not to cheat the other but are consistent
with the perceptions of profit maximization.
This lease illustration comes from David Debertin,
Agricultural Production Functions, 1986 pp. 142
145.