Course 405: Production

Technologies
Surender Kumar
For simplicity, we start with the single output
case. Let y denote output, and x = (x1, , xn) be a
(n1) vector of inputs. The production technology
is the process that transforms the inputs x into
output. It is typically a complex process. This
process can be represented by the production
function (or production frontier) f(x):

f(x) = maxy{y| x and the best available

technology}.
 Properties of the Production Function

Monotonicity and Strict Monotonicity:

If x x, then f x f x (monotonicity)

If x x then f x f x (strict monotonicity)

Quasi-Concavity and Concavity

V y x : f x y is a convex set (qausi-concave)

f x 0 1 x* f x 0 1 f x* for any 0 1
(concave)
 Weakly essential and strictly essential inputs
f 0n 0, where 0n is the null vector (weakly essential)

f x1 , xi1 ,0, xi1 , xn 0 for all xi (strict esstential)

Properties (1a) and (1b) require the production function to be

non-decreasing in inputs, or that the marginal products be
nonnegative.
In essence, these assumptions rule out stage III of the
production process, or imply some kind of assumption of
free-disposal.
One traditional assumption in this regard is that since it is
irrational to operate in stage III, no producer will choose
to operate there. Thus, if we take a dual approach (as
developed above) stage III is irrelevant.
 The set V(y) is closed and nonempty for all y >
0.
f(x) is finite, nonnegative, real valued, and single
valued for all nonnegative and finite x.
Continuity
f(x) is everywhere continuous; and
f(x) is everywhere twice-continuously differentiable.
 Properties (2a) and (2b) revolve around the
notion of isoquants or as redeveloped here
input requirement sets.
The input requirement set is defined as that set
of inputs required to produce at least a given
level of outputs, V(y). Other notation used to
note the same concept are the level set.
Strictly speaking, assumption (2a) implies that we
observe a diminishing rate of technical
substitution, or that the isoquants are negatively
sloping and convex with respect to the origin.
x1

V y

x2
 Assumption (2b) is both a stronger version of
assumption (2a) and an extension. For example, if we
choose both points to be on the same input requirement
set, then the graphical depiction is simply

x1

f x0 1 x0 f x0 1 f x 0

V y

x2
 If we assume that the inputs are on two different
input requirement sets, then

f x 0 1 x* f x 0 f x* f x*

f x
*

f x0 1 x
*

x

0
x x f x
* *

Clearly, letting approach zero yields f(x) approaches

f(x*), however, because of the inequality, the left-
hand side is less than the right hand side. Therefore,
the marginal productivity is non-increasing and, given
a strict inequality, is decreasing.
 As noted by Chambers, this is an example of
the law of diminishing marginal productivity
that is actually assumed.
Chambers offers a similar proof on page 12,
learn it.
The notion of weakly and strictly essential inputs
is apparent.
The assumption of weakly essential inputs says that
you cannot produce something out of nothing.
Maybe a better way to put this is that if you can
produce something without using any scarce
resources, there is not an economic problem.
The assumption of strictly essential inputs is that in
order to produce a positive quantity of outputs, you
must use a positive quantity of all resources.
 Different production functions have different
assumptions on essential inputs. It is clear that
the Cobb-Douglas form is an example of strictly
essential resources.
The remaining assumptions are fairly technical
assumptions for analysis. First, we assume that
the input requirement set is closed and
bounded. This implies that functional values for
the input requirement set exist for all output
levels (this is similar to the lexicographic
preference structure from demand theory).
 Also, it is important that the production
function be finite (bounded) and real-
valued (no imaginary solutions). The
notion that the production function is a
single valued map simply implies that any
combination of inputs implies one and
only one level of output.
Stages of Production

First, consider the simple case of a single input (n = 1) and single

output. Assume that the firm intends to maximize profit
maxx,y{py rx: y f(x)}
where p > 0 denotes output price, and r > 0 denotes input price.

Given p > 0, it follows that the firm would always choose y such
that y = f(x). This is called technical efficiency, where the firm
operates on the production frontier.

Define the stages of production as follows

- stage 1 is the production region where f/x > f(x)/x.
- stage 2 is the production region where f(x)/x f/x 0.
- stage3 is the production region where f/x < 0.
The first-order condition (FOC) for an interior
solution is

p f/x = r
or
f/x = r/p.

This states that the marginal physical product (MPP =

f/x) is equal the input/output price ratio (r/p). Since
r/p > 0, it follows that the profit maximizing firm
would never want to operate where MPP = f/x < 0.
Thus, the firm would never choose to be in stage 3.
Assuming that the firm has always the option to do
nothing (and thus to obtain a zero profit), the profit
maximizing firm would never choose a production plan
such that

pf(x) rx < 0, or r/p > f(x)/x.

But r/p = f/x from (FOC).

It follows that the firm would never choose f/x > f(x)/x,
i.e. it would never choose to be in stage 1.
Substitution Effects
Consider the two input case, where x = (x1, x2). The associated
production function is
y = f(x1, x2).
Assuming that f is increasing in x2, the production function can
be implicitly solved for x2, yielding
x2 = g(x1, y).
Graphing x2 as a function of x1 for a given output y gives an
isoquant. The slope of an isoquant is x2/x1 = g/x1. It can be
obtained by differentiating y = f(x1, g(x1, y)) with respect to x1,
yielding
0 = f/x1 + (f/x2)(g/x1),
or
g/x1 = -f1/f2 = MRS12,
where fi = f/xi, i = 1, 2, and f1/f2 = the marginal rate of
substitution between x1 and x2 (MRS12).
The Shape of an Isoquant
Assume that the production function is quasi-concave (note: a
concave function is also quasi-concave). Then, by (strong)
quasi-concavity of f(x1, x2), we have
(u1 u2) 11 12 1 < 0, subject to [f1 f2] u1
f f u
= 0,
f12 f 22 u 2 u2
(u1 u2) 0, where fij = 2f/xixj, i, j = 1,2
It means that the isoquants are strictly convex to the origin, or
equivalently that the feasible technology is convex in (x1, x2).
u1
Note that [f1 f2] = 0 implies that u2 = -(f1/f2) u1. It follows
u2

that the above expression can be alternatively written as

u1[f11 (f1/f2)f12 + f12(-f1/f2) + (f1/f2)2f22] u1 < 0, for all u1 0,

or
[f11 f22 2 f12 f1 f2) + f22 f12]/f22 < 0.
The Allen Elasticity of Substitution (AES)

From the Cost Function

The cost function C(r, y) is given by
C(r, y) = rxc = minx{rx: y = f(x)},
where xc = xc(r, y) denotes the (n1) vector of cost minimizing
input demand functions.
Let the associated Lagrangean be L(x, l, r, y) = rx + l [y-
f(x)]. The first-order conditions (FOC) for cost minimization
are
L/x = r - l f/x = 0,
L/l = y f(x) = 0.
The second-order condition (SOC) are satisfied under the
(strong) quasi-concavity of f(x).
Definition: The Allen elasticity of substitution (AES)
between inputs xi and xj is

2C C
sij = , i, j = 1, , n,
ri r j (C / ri )(C / r j )

or, using Shephards lemma (C/r = xc),

x ic C
sij = r x c x c , i, j = 1, , n.
j i j

The Allen elasticity of substitution (AES) sij measures the

response of the i-th input demand to a change in the j-th input
price, holding output y constant (i.e., moving along an isoquant)
and other input prices constant.
Note: We know that xc/r is a (nn) symmetric, negative
semi-definite matrix. It follows that the (nn) matrix of Allen
elasticities of substitution s =

s11 s1n
.

s n1 . s nn

is also symmetric, negative semi-definite. This implies that

sij = sji for all i, j = 1, ..., n, and sii 0.

Definition: Two inputs i and j are said to be substitutes

(complements) if sij > 0 (< 0).

Given C > 0 and xc > 0, this means that inputs i and j are
substitutes complements if xic/rj = xjc/ri > 0 (< 0).
Note: In the two input case (n = 2), we have x1c/r1
0. Also, by homogeneity of degree zero of xc(r, y)
in r, we have
(x1c/r1) r1 + (x1c/r2) r2 = 0. (Euler equation)
It follows that
(x1c/r2) = - (x1c/r1)(r1/r2) 0 (since x1c/r1
0).
Thus, in the two input case, inputs can only be
substitutes. In other words, it takes at least three
inputs before input complementarity can arise.
Note: The AES can also be written as
sij = C (xic/rj)/(xicxjc)
= C [(xic/rj)(rj/xic)]/(rjxjc)
= (ln xic/ln rj)/wj,
where wj = rjxjc/C is the j-th cost share,
or equivalently,
ln xic/ln rj = sij wj,
for all i, j = 1, ..., n. This states that the price elasticity of
the cost minimizing input demand function (ln xic/ln rj) is
equal to the corresponding Allen elasticity of substitution (sij)
times the budget share (wj).
 From the Production Function
We have sij = C(xic/rj)/(xicxjc). Differentiating the FOC of the
cost minimization problem yields the following comparative
static results
lf xx f x ' x c / r I n
f
x 0 l / r 0

where fx = f/x = a (1n) vector and fxx = 2f/x2 = a (nn)

matrix. Multiplying this expression by (1/l) yields
f xx f x ' x c / r I n
f l
0 ( l / r ) / l 0
(1 / )
x
It follows that 1
f xx f x ' I n I n
xc/r = (1/l) f = (1/l) H-1
x 0 0 0
f xx f x '
where H = f 0
x
This can be written as
H cij
xic/rj = (1/l) , for all i, j = 1, ..., n,
det( H )

where Hijc is the cofactor of fij in H. The AES can then be written as
H cij
sij = [C/(xicxjc)] (1/l)
det( H )
H ijc
= [( nk1 rk xkc)/(xicxjc)] (1/l)
det( H )

or, using the (FOC), rk/l = fi, (where fi = f/xi)

c
n
sij = k 1f k x k
H ij
det( H )
, for all i, j = 1, ..., n.
xi x j

This is the general formula to evaluate the AES from the production
function.
Note: In the two input case (n = 2), we have
H12c = f1 f2,
and
det(H) = -[f12 f22 + f22 f11 - 2 f1 f2 f12] > 0 (from the
(SOC)).
It follows that the formula for the AES in the two input case is

f1x1 f 2 x 2 f1f 2
s12 = f12 f 22 f 22 f11 2f1f 2 f12
x 1x 2

Note: Why is the AES called an "elasticity"? To see that,

consider the two input case (n = 2). While moving along a
given isoquant (i.e., while holding output y constant), consider
the change in the input ratio (x1/x2) due to a change in (f1/f2).
This move along an isoquant can be done by changing x1, and
letting x2 adjust according to x2 = g(x1, y)
 1 x1 g
2
x 2 x 2 x1
-(x1/x2)/(f1/f2) = -
f11 f1f 21 f12 f1f 22 g
2 2
f2 f2 f2 f 2 x1

or, using g/x1 = -f1/f2,

2 2 2
f x f1x1
1
f2 x 2
-(x1/x2)/(f1/f2) = -
1
f23f11f 2
2 f 22 f1
2
2f12 f1f 2
Thus, the negative of the elasticity of (x1/x2) with respect to
(f1/f2) is
-ln(x1/x2)/ln(f1/f2) = -[(x1/x2)/(f1/f2)][(f1/f2)/(x1/x2)]

f2 x 2 f1x1
1 f1
f 2 x 22 f2
=- 1
f2
f f 2 f 22 f12 2f12 f1f 2
3 11 2 x1
x2
 f1x1 f 2 x 2 f1f 2
=- x 1x 2 f12 f 22 f 22 f11 2f1f 2 f12

which the formula for the AES derived above. This shows that the
AES s12 can be interpreted as the negative of the elasticity of
the input ratio (x1/x2) with respect to a change in (f1/f2)
obtained by moving along an isoquant. Thus, the AES is an
elasticity measure of relative input change along an isoquant.
This provides the following intuitive interpretation for the
AES. Consider a move along an isoquant. If the isoquant is
"kinked", then the input ratio x1/x2 changes little as the slope of the
isoquant (as measured by f1/f2) changes, implying a low elasticity
of substitution. Alternatively, if the isoquant is "flat", then the
input ratio x1/x2 changes a lot as the slope of the isoquant (as
measured by f1/f2) changes, implying a high elasticity of
substitution. This illustrates that the AES is an elasticity measure
of the shape of isoquants.
From the Profit Function

Profit maximizing behavior is given by

(p, r) = maxx{p f(x) - r'x}
= maxx,y{p y - r'x: y = f(x)}
= maxy {p y - minx{r'x: y = f(x)}}
= maxy {p y - C(r, y)}, where C(r, y) = minx{r'x: y = f(x)}
is the cost function.

This shows that profit maximizing behavior implies cost

minimizing behavior (although the reverse is not necessarily true).
 The first-order condition (FOC) for profit maximization is
p - C/y = 0.
Let x*(r, p) and y*(r, p) denote the profit maximizing input
demand and output supply function, respectively.

It follows that

p = C (r, y*(r, p)).

y
Differentiating this identity with respect to p and r gives
1 = (2C/y2)(y*/p)
and
0 = (2C/yr) + (2C/y2)(y*/r).
But y* = /p from Hotelling's lemma. It follows that
1 = (2C/y2)(2/p2), or (2C/y2) = (2/p2)-1,
and
0 = (2C/yr) + (2C/y2)(2/pr), or (2C/yr) = -
(2C/y2)(2/pr).
Combining these two results yields
(2C/yr) = -(2/p2)-1(2/pr). (B1)

Next, let xc(r, y) be the cost minimizing input demand functions.

Profit maximizing behavior implying cost minimizing behavior
gives the identity
x*(r, p) = xc(r, y*(r, p)).
Differentiating this identity with respect to r yields
x*/r = xc/r + (xc/y)(y*/r).
Using Shephard's lemma (C/r = xc) and Hotelling's lemma
(/r = -x*), we obtain
-2/r2 = 2C/r2 + (C/ry)(/pr)
or, using the transpose of (B1),
-2/r2 = 2C/r2 - (2/rp)(2/p2)-1(/pr),
or
2C/r2 = -2/r2 + (2/rp)(2/p2)-1(/pr) (B2)
Expression (B2) is a "Le Chatelier" result. The convexity of
in prices implies that 2/p2 > 0. It follows that
(2/rp)(2/p2)-1(/pr) is a (nn) positive semi-definite
matrix. Note that the matrix [-2/r2] = x*/r is symmetric,
negative semi-definite, and that the matrix 2C/r2 = xc/r is
also symmetric, negative semi-definite. Then, (B2) states that
the symmetric, negative semi-definite matrix [-2/r2] = x*/r
exceeds the symmetric, negative semi-definite matrix 2C/r2 =
xc/r by a positive semi-definite matrix. This means that the
negative of the profit function -(r, ) is "more concave" in r
than the cost function C(r, ). Equivalently, this means that the
magnitude of the input response to an input price change is
larger under profit maximization than under cost minimization.
This has the more general and intuitive interpretation that
restricting choices (in this case, restricting output to be equal to
y under cost minimization) tends to reduce optimal quantity
adjustments to changing market prices.
Another use of (B2) is in the measurement of the AES
from the profit function. Substituting (B2) into the
definition of the AES from the cost function, and using the
consistency of x* with xc, we obtain

sij = C (2C/rirj)/(xic xjc)

= [ nk 1 rk xk*][-2/rirj + (2/rip)(2/p2)-1(/prj)]/(xi* xj*),

or, using Hotelling's lemma (/ri = -xi*),

sij = -[ r /rk][-2/rirj + (2/rip)(2/p2)-

nk 1 k
1(/pr )]/[(/r )(/r )],
j i j
for all i, j = 1, ..., n. This formula allows the
estimation of the AES solely from knowing the
profit function (p, r).
Output Effects
Definition: The "output elasticities" are defined as
ln(xic)/ln(y) = (xic/y)(y/xic),
where xic is the cost minimizing input demand function for the
i-th input, i = 1, ..., n.

The output elasticities are elasticities of cost minimizing input

demand functions with respect to output, holding input prices
constant. They measure the shape of the "expansion path"
obtained as one moves from one isoquant to another, holding the
marginal rate of substitution constant.

Definition: The i-th input is said to be

- inferior if ln(xic)/ln(y) < 0
- normal if 0 < ln(xic)/ln(y) < 1
- superior if ln(xic)/ln(y) > 1.
Homothetic Technology
The production function is homothetic if f(x) = F(g(x)), where
F/d > 0, and g(x) is linear homogenous in x.

Under the homotheticity of f(x), we have seen that the marginal

rate of substitution MRSij = fi/fj is homogenous of degree zero in
x. This means that the marginal rate of substitution MRSij is
constant along a ray through the origin, i.e. that all isoquants
have basically the "same shape".

Under a homothetic technology, the cost function takes the form

C(r, y) = K(y) H(r).
Proof: We have C(r, y) = r' xc = minx{r'x: subject to y = F(g(x))}.
The associated Lagrangean is L = r'x + l [y - F(g(x))]. The (FOC) are
r' = l (F/g)(g/x).
This yields
C = r'xc = l (F/g)(g/x) xc
= (C/y)(F/g)(g/x) xc, since(C/y) = l from the envelope
theorem.
The linear homogeneity of g(x) gives [(g/x) x] = g, implying that
C = (C/y)(F/g) g,
= (C/y) G(y), where G(y) = [(F/g) g],
or
(C/y)/C = 1/G(y),
or
ln(C)/y = 1/G(y).
Integrating with respect to y gives
ln(C) = ln[H(r)] + ln[K(y)],
where ln[H(r)] is the constant of integration, and ln[K(y)] = [1/G(y)] dy.
This implies that the cost function C(r, y) takes the from
C(r, y) = K(y) H(r).
Q.E.D.
Thus, under a homothetic technology, C(r, y) = K(y) H(r)
implies that
xic = C/ri = K(y) H/ri, (from Shephard's lemma)
or
ln(xic) = ln[K(y)] + ln[H/ri], i = 1, ..., n.
Thus,
ln(xic)/ln(y) = ln[K(y)]/ln(y) = independent of i, for all i
= 1, ..., n.
It follows that, under a homothetic technology, the output
elasticities ln(xic)/ln(y) are the same for all inputs.
Homogenous Technology (= a special case of
homotheticity)
The production function is homogenous of degree k if f(x)
= [g(x)]k, where g(x) is linear homogenous in x.

A homogenous function is always homothetic. Thus, under

a homogenous technology, the marginal rate of substitution
MRSij is also constant along a ray through the origin, i.e.
that all isoquants have basically the "same shape".

Under a homogenous technology of degree k, the cost

function takes the form C(r, y) = y1/k H(r).
Proof: We have C(r, y) = r' xc = minx{r'x: subject to y = g(x)k}.
The associated Lagrangean is L = r'x + l [y - g(x)k]. The (FOC) are
r' = l k gk-1 (g/x).
This yields
C = r'xc = l k gk-1 (g/x) xc
= (C/y) k gk-1 (g/x) xc, since(C/y) = l from the envelope
theorem.
The linear homogeneity of g(x) gives [(g/x) x] = g, implying that
C = (C/y) k gk,
= (C/y) k y, since y = g(x)k,
or
(C/y)(y/C) = 1/k,
or
ln(C)/ln(y) = 1/k.
Integrating with respect to ln(y) gives
ln(C) = ln[H(r)] + (1/k) ln(y),
where ln[H(r)] is the constant of integration. This implies that the cost function
C(r, y) takes the from
C(r, y) = y1/k H(r).
Q.E.D.
Under a homogenous technology of degree k, C(r, y) = y1/k H(r)
implies that
xic = C/ri = y1/k H/ri, (from Shephard's lemma)
or
ln(xic) = (1/k) ln(y) + ln[H/ri], i = 1, ..., n.
Thus,
ln(xic)/ln(y) = 1/k, for all i = 1, ..., n.
It follows that, under a homogenous technology of degree k, the
output elasticities ln(xic)/ln(y) are all equal to (1/k).
This implies that ln(xic)/ln(y) > (=, or <) 1 when k < (=, or >) 1.

Note: Under a homogenous technology of degree k, the average cost

function AC(r, y) = C(r, y)/y becomes
AC(r, y) = [y1/k H(r)]/y = y(1-k)/k H(r).
It follows that the average cost function AC(r, y) is
- increasing in y if k < 1
- constant with respect to y if k = 1
- decreasing in y if k > 1.
The Spacing of the Isoquants
Returns to Scale
The concept of "returns to scale" involves measuring the spacing of
the isoquants along a ray through the origin.

Definition: The production technology is said to exhibit

increasing returns to scale (IRTS) at x if f(t x) > t f(x), for
all scalars t > 1,
constant returns to scale (CRTS) at x if f(t x) = t f(x), for
all scalars t > 1,
decreasing returns to scale (DRTS) at x if f(t x) < t f(x),
for all scalars t > 1,
where y = f(x) is the production function.

Note that this definition is global since it applies for all t > 1.
 A local measure: Note that differentiating ln(y) = ln[f(t x)]
with respect to the scalar t (evaluated at t = 1) gives

ln(y)/ln(t) = in1 ln(y)/ln(xi) = n (y/xi)(xi/y)

i 1
Definition: At point x, the scale elasticity (SE) is defined as

SE = in1 ln(y)/ln(xi) = in1 (y/xi)(xi/y).

The scale elasticity provides a local measure of "returns to scale".

More specifically, in the neighborhood of a point x, technology
exhibits
increasing returns to scale (IRTS) if SE > 1,
constant returns to scale (CRTS) if SE = 1,
decreasing returns to scale (DRTS) if SE < 1.

In general, "returns to scale" can vary over different regions of

the production technology.
The case of a homogenous technology: Under a homogenous
technology of degree k, we have y = f(x) = [h(x)]k, where h(x) is
linear homogenous. Then, ln[f(t x)] = k ln[h(t x)], and
ln(y)/ln(t) = k ln(h)/ln(t)

= k in1 ln(h)/ln(xi) = k,

since i 1(h/xi) = 1 from the linear homogeneity of h (Euler

n

equation). It follows that the scale elasticity is

SE = in1ln(y)/ln(xi) = k.

Thus, for homogenous technology, the scale elasticity SE is equal

to the degree of homogeneity k.
Measuring SE from the cost function
Under cost minimizing behavior, we have
SE = in1 (y/xi)(xi/y)
= in1 ri xi/(l y), using the (FOC) to cost minimization (y/xi =
ri/l)
in1 ( ri x i ) / y
= C / y using the envelope theorem (C/y = l).

Note that in1 ri xi/y = AC is the average cost, and C/y = MC

is the marginal cost. It follows that

SE = AC/MC.
This implies that, in the neighborhood of a point x, technology
exhibits
increasing returns to scale (IRTS) if AC/MC > 1, or AC > MC,
constant returns to scale (CRTS) if AC/MC = 1, or AC = MC,
decreasing returns to scale (DRTS) if AC/MC < 1, or AC < MC.
Note: We have
ln(C)/ln(y) = (C/y)/(C/y) = MC/AC.
It implies that MC/AC is the elasticity of the cost C with
respect to output y. This yields
ln(C)/ln(y) = 1/SE,
Thus, the elasticity of cost with respect to output is the
inverse of the scale elasticity. It follows that in the
neighborhood of a point x, technology exhibits
increasing returns to scale (IRTS) if ln(C)/ln(y) < 1,
constant returns to scale (CRTS) if ln(C)/ln(y) = 1,
decreasing returns to scale (DRTS) if ln(C)/ln(y) > 1.
Note: Under free entry and exit, a long-run equilibrium
can exist only under zero profit ( = 0). Indeed, > 0
would stimulate entry, while < 0 would stimulate exit.
Thus, under free entry and exit, a long-run equilibrium
can exist only if all firms produce at a size y
corresponding to (local) CRTS.
Returns to Size
The concept of "returns to size" involves measuring the spacing of
the isoquants along the "expansion path", i.e. moving from one
isoquant to another while keeping the marginal rate of substitution
(MRSij) constant.

Note: Under homothetic technology, the expansion path is a

straight line through the origin. In this case, "returns to scale" and
"returns to size" are equivalent. However, for non-homothetic
technologies, "returns to scale" and "return to size" can differ.
Let AC(r, y) = C(r, y)/y be the average cost function.

Definition: The production technology is said to exhibit

increasing returns to size if AC(r, y) is decreasing in output,
constant returns to size if AC(r, y) does not change with output y,
decreasing returns to size if AC(r, y) is increasing in output y.

A local measure: Note that differentiating ln(AC) = ln[C/y] with respect to output y
gives
ln(AC)/ln(y) = (AC/y)(y/AC) = [(C/y)/y - C/(y2)](y/AC)
= [(C/y) - C/y](1/AC)
= [MC - AC]/AC
= sign(MC - AC).
It follows that the technology exhibits
increasing returns to size if (MC - AC) < 0, or AC > MC,
constant returns to size if (MC - AC) = 0, or AC = MC,
decreasing returns to size if (MC - AC) > 0, or AC < MC.
Note that these results are similar to the ones obtained with "returns to scale".
Indeed, we have seen that, when AC = MC, the technology exhibits (at least local)
CRTS, implying that it is (at least locally) linear homogenous, and thus (at least
locally) homothetic.
Note: Assume profit maximization. This implies that
ln(AC)/ln(y) = [(C/y) - C/y](y/C)
= [p y - C]/C, (from the (FOC): p = C/y)
= /C = sign().
It follows that > (=, or <) 0 when the firm produces in a region of
decreasing (constant, or increasing) returns to size. Under free entry
and exit, a long-run equilibrium can exist only if = 0 (since > 0
would stimulate entries and < 0 would stimulate exits). If the
AC(y, ) function has a U-shape, this implies that the long-run
equilibrium for firms is at the point which miny{AC(r, y}. Then, the
long equilibrium price pe is
pe = miny{AC(r, y)}.
In other words, the efficient firm size is the output level that
minimizes AC(, y). At that point,
pe = MC (i.e., marginal cost pricing, from profit maximization)
and
pe = AC (i.e., average cost pricing in long-run equilibrium, with =
0).
Multi-output Technology
So far, we have focused on the single output case (m = 1). All the
arguments presented above can be extended to the multi-output case,
where y is a (m1) output vector, and p is a (m1) output price
vector, m > 1.

- Production function: The implicit joint production function can be

written as f(y, x) = 1, where f(y, x) is increasing in x, decreasing in y,
and concave in (x, y).
This generalizes the single output case (where f(y, x) = fo(x) y +1
= 1 when m = 1, y = fo(x) being the single output production
function).
 - Cost function: C(r, y) = minx{rx: subject to f(y, x) = 1)},
which has for solution xc(r, y), the cost minimizing input demand
functions. The cost function C(r, y) is linear homogeneous,
increasing and concave in r. And it satisfies Shephards lemma:
C/r = xc(r, y).

- Scale elasticity: (when m > 1)

in1 ln( f ) / ln( x i )

SE = -
mj1 ln( f ) / ln( y j )

m ln(C)/ln(y )]
= 1/[ i1 i

This generalizes the single output case (where m = 1 and

ln(f)/ln(y) = -1).
Economies of scope
The concept of economies of scope is relevant only in the multi-
output case where y = (y1, , ym) is a (m1) vector. Let M = {1,
2, , m}be the set of all outputs. Partition the set M into s
mutually exclusive subsets: M = {M1, M2, , Ms}, s m. Let
Yk = {y: such that yj > 0 for j Mk, and yj = 0
for j Mk}
= the k-th product line,
k = 1, , s. It follows that C(r, Yk) is the cost of production for a
firm that specializes in the k-th product line.
 Definitions: The technology exhibits economies of scope if

sk1 C(r, Yk) > C(r, y), where y = sk1Yk.

It exhibits diseconomies of scope if

sk1 C(r, Yk) < C(r, y), where y = sk1 Yk.

And the technology is said to be non-joint if

sk1 C(r, Yk) = C(r, y), where y = sk1 Yk.

Note that economies of scope can motivate the existence of multi-

product firms since they imply that producing more than one product
at a time can reduce production cost. Alternatively, there is no
economic incentive for multi-product firms when the technology
exhibits either non-jointness or diseconomies of scope.