Microeconomics Technology Lecture

Advanced Microeconomics
Ivan Etzo
University of Cagliari
ietzo@unica.it
Dottorato in Scienze Economiche e Aziendali, XXXIII ciclo
Ivan Etzo (UNICA) Lecture 1: Technolgy 1 / 61

Overview
1 Firms behavior and technology

2 Production Plan and Technology set
3 Isoquants
4 Marginal (Physical) Products
5 Returns-to-Scale
6 The technical rate of substitution (TRS)
7 The elasticity of substitution
8 The Constant Elasticity of Substitution (CES) production function
9 Well-Behaved Technologies

Firms behavior and technological constraints
The firms behavior is expressed by the choices made by the firms

Choices are not free, there are some constraints coming from:
Customers (Demand);
Competitors (Market structure);
Nature (Technology);

Technology
At the moment the firm makes the production decisions it faces some
technological constraints
The technology describes the feasible ways to produce the outputs
from inputs at a certain point in time ( t ).
Inputs or factors of production: land, labor, capital, raw materials
(e.g. energy)
Often, different technologies will produce the same product
Usually capital and labor are considered as the two main broad
categories of inputs

Defining capital
Capital goods (or Physical capital): inputs which are themselves

an output (i.e. they have been produced too).
Financial capital: the amount of money which is required to start (or
maintain) a business.

The production set
Technological constraints imply that a given amount of output can

be produced only with certain combination of inputs.
The production set represents all combinations of inputs and
outputs that are technologically feasible.
Which technology is best?
How do we compare technologies?

Input bundles
xi denotes the amount used of input i ( i.e. the level of input i).
An input bundle is a vector of the input levels; (x1 , x2 , · · · , xn ).
E.g. (x1 , x2 , x3 , , · · · , xn ) = (6, 0, 9, · · · , 3).

Production Functions
y denotes the output level.

The technology’s production function states the maximum amount
of output possible from an input bundle.
y = f (x1 , · · · xn )
Inputs and outputs are usually measured in flow units (i.e., hours
worked per week, machines hours per week → units of output per
week)
yt = f (x1t , · · · xnt )

Production Functions
One input, one output

Technology Sets
A production plan is an input bundle and an output level;

(x1 , · · · , xn , y ).
A production plan is feasible if
y ≤ f (x1 , · · · xn )
The collection of all feasible production plans is the technology set.

Technology Set

Technology Set

Technologies with Multiple Inputs
What does a technology look like when there is more than one input?
The two input case:
Input levels are x1 and x2 .
Output level is y .
Suppose the production function is
1/3 1/3
y = f (x1 , x2 ) = 2x1 x2

E.g. the maximal output level possible from the input bundle
(x1 , x2 ) = (1, 8) is
y = f (x1 , x2 ) = 2 × 11/3 × 81/3 = 2 × 1 × 2 = 4


The y output unit isoquant is the set of all input bundles that yield
exactly the same output level y .

Isoquants with Two Variable Inputs
Isoquants can be graphed by adding an output level axis and

displaying each isoquant at the height of the isoquants output level.

More isoquants tell us more about the technology.

More isoquants tell us more about the technology.

The complete collection of isoquants is the isoquant map.

The isoquant map is equivalent to the production function – each is
the other.
E.g.
1/3 1/3
y = f (x1 , x2 ) = 2x1 x2















Stop

Cobb-Douglas Technologies
A Cobb-Douglas production function is of the form
y = Ax1a1 x2a2 ·, · · · · xnan
E.g.
1/3 1/3
y = x1 x2
with n = 2, A = 1, a1 = 1/3, a2 = 1/3

Cobb-Douglas Technologies

Fixed-Proportions Technologies
A fixed-proportions production function is of the form
y = min{a1 x1 , a2 x2 , · · · an xn }
E.g.
y = min{x1 , 2x2 }
with n = 2, A = 1, a1 = 1, a2 = 2

Fixed-Proportions Technologies
y = min{x1 , 2x2 }

Perfect-Substitutes Technologies
A perfect-substitutes production function is of the form
y = a1 x1 + a2 x2 + · · · + an xn
E.g.
y = x1 + 3x2
with n = 2, a1 = 1, a2 = 3

Perfect-Substitutes Technologies
y = x1 + 3x2

Marginal (Physical) Products
The marginal product of input i is the rate-of-change of the output

level as the level of input i changes, holding all other input levels fixed.
∂y
MPi =
∂xi
The marginal product of input i is diminishing if it becomes smaller

as the level of input i increases. That is, if
∂2

∂MPi ∂ ∂y
= = <0
∂xi ∂xi ∂xi ∂xi2
Remember the law of diminishing marginal product.

Returns-to-Scale
Marginal products describe the change in output level as a single

input level changes.
Returns-to-scale describes how the output level changes as all input
levels change in direct proportion (e.g. all input levels doubled, or
halved).

Returns-to-Scale
Constant returns-to-scale
The technology described by the production function f (x) exhibits
constant returns-to-scale if, for any input bundle (x1 , · · · xn ),
f (kx1 , kx2 , · · · kxn ) = kf (x1 , x2 , · · · xn )
i.e. the production function f (x) is homogeneous of degree 1.

E.g. (k = 2) doubling all input levels doubles the output level.
Increasing returns-to-scale
f (kx1 , kx2 , · · · kxn ) > kf (x1 , x2 , · · · xn )
Decreasing returns-to-scale
f (kx1 , kx2 , · · · kxn ) < kf (x1 , x2 , · · · xn )
Returns-to-Scale
A single technology can ’locally’ exhibit different returns-to-scale.

Examples of Returns-to-Scale
Perfect-Substitutes production function
y = a1 x1 + a2 x2 + · · · + an xn
y = a1 (kx1 ) + a2 (kx2 ) + · · · + an (kxn )
= k (a1 x1 + a2 x2 + · · · + an xn )
= ky
⇒ Constant RtS

Perfect-Complements production function
y = min{a1 x1 , a2 x2 , · · · an xn }
min{a1 (kx1 ) , a2 (kx2 ) , · · · an (kxn )}
k (min{a1 x1 , a2 x2 , · · · an xn })
⇒ Constant RtS

Cobb-Douglas production
y = x1a1 x2a2 · · · xnan
(kx1 )a1 (kx2 )a2 · · · (kxn )an
= k a1 +··· +an
y
Thus:
if Pni=1 ai = 1 ⇒ Constant RtS
P
if Pni=1 ai > 1 ⇒ Increasing RtS
if ni=1 ai < 1 ⇒ Decreasing RtS

Return to Scale and Marginal Product
A technology can exhibit increasing returns-to-scale even if all of its

marginal products are diminishing.
Why?
E.g.
2/3 2/3
y = x1 x2
∂y 2 −1/3 2/3
MPx1 = = x1 x2
∂x1 3
∂MP1 1 2 −4/3 2/3
= − x1 x2 < 0
∂x1 33
MPx2 = MPx1 < 0

4
RtS: a1 + a2 = 3 > 0 ⇒ Increasing RtS

Return to Scale and Marginal Product
A marginal product is the rate-of-change of output as one input level

increases, holding all other input levels fixed.
Marginal product diminishes because the other input levels are fixed,
so the increasing inputs units have each less and less of other inputs
with which to work.
Therefore, diminishing marginal product is a short run concept
RtS imply that all inputs vary, thus it refers to the long run

The technical rate of substitution (TRS)
Assume y = f (x1 , x2 ) and that the firm is producing y ∗ = f (x1∗ , x2∗ )

At what rate can a firm substitute one input for another without
changing its output level?
Using total differential of function f (x1 , x2 )
∂f ∂f
dy = dx1 + dx2
∂x1 ∂x2
impose
dy = 0
∂f ∂f
dx1 + dx2 = 0
∂x1 ∂x2
dx2 ∂f /∂x1
=−
dx1 ∂f /∂x2

Example: The Cobb-Douglas technology
Consider f (x1 , x2 ) = x1α x21−α
∂f /∂x1 α x2
TRS = − =−
∂f /∂x2 1 − α x1

The elasticity of substitution
The elasticity of substitution measures the curvature of an isoquant.

∆(x2 /x1 )
x2 /x1
σ= ∆TRS
TRS
It measures the percentage change in the factor ratio divided by the

percentage change in TRS.
Using logarithmic derivative
dlny
=
dlnx

The elasticity of substitution
Example: The Cobb-Douglas technology
Consider f (x1 , x2 ) = x1α x21−α

we know that
α x2
TRS = −
1 − α x1
x2 1−α
→ =− TRS
x1 α
taking logs and deriving with respect to | TRS |
x2 1−α
ln = ln + ln | TRS |
x1 α
dln (x2 /x1 )
σ =1
dln | TRS |

The CES production function
The Constant Elasticity of Substitution has the following form

1
y = [a1 x1ρ + a2 x2ρ ] ρ
the CES exhibits constant returns to scale

It contains other production functions as a special cases
1 If ρ = 1 ⇒ Perfect-substitutes production function
2 If ρ = 0 ⇒ Cobb-Douglas production function
3 If ∞ = − ⇒ Fixed-proportion production function

1 ρ = 1 ⇒ y = a1 x1 + a2 x2
2 ρ = 0 Consider the TRS of the CES produciton function
ρ−1
a1 x1
TRS = −
a2 x2
when ρ → 0 then the TRS tends to the following limit

a1 x 1
TRS = −
a2 x 2
that is, the TRS of the Cobb-Douglas production function (i.e. the
isoquant is the same).
3 ρ = ∞ then the TRS of the CES
TRS=0 if x2 > x1 ; TRS = ∞ if x1 > x2
i.e. Just as the TRS of the Fixed-proportion production function.

Proof: the CES has a constant elasticity of substitution
We need to compute the elasticity of substitution σ
From the TRS of the CES (where, for simplicity, a1 = a2 = 1)
ρ−1
x1
TRS = −
x2
x2 1
=| TRS | 1−ρ
x1
taking logs
x2 1
ln = ln | TRS |
x1 1−ρ
and applying the definition of σ using the log derivative
dln(x2 /x1 ) 1
σ= =
dln | TRS | 1−ρ
.
Well-Behaved Technologies
A well-behaved technology is
monotonic
convex.

Monotonicity
Monotonicity: More of any input generates more output.

Convexity
Convexity: If the input bundles x and x both provide y units of

output then the mixture tx + (1 − t)x provides at least y units of
output, for any 0 < t < 1.
Convexity implies that the | TRS | decreases as x1 increases.


Microeconomics Technology Lecture

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Advanced Microeconomics

Ivan Etzo (UNICA) Lecture 1: Technolgy 1 / 61

1 Firms behavior and technology

Ivan Etzo (UNICA) Lecture 1: Technolgy 2 / 61

The firms behavior is expressed by the choices made by the firms

Ivan Etzo (UNICA) Lecture 1: Technolgy 3 / 61

Ivan Etzo (UNICA) Lecture 1: Technolgy 4 / 61

Capital goods (or Physical capital): inputs which are themselves

Ivan Etzo (UNICA) Lecture 1: Technolgy 5 / 61

Technological constraints imply that a given amount of output can

Ivan Etzo (UNICA) Lecture 1: Technolgy 6 / 61

Ivan Etzo (UNICA) Lecture 1: Technolgy 7 / 61

y denotes the output level.

Ivan Etzo (UNICA) Lecture 1: Technolgy 8 / 61

Ivan Etzo (UNICA) Lecture 1: Technolgy 9 / 61

A production plan is an input bundle and an output level;

The collection of all feasible production plans is the technology set.

Ivan Etzo (UNICA) Lecture 1: Technolgy 10 / 61

Ivan Etzo (UNICA) Lecture 1: Technolgy 11 / 61

Ivan Etzo (UNICA) Lecture 1: Technolgy 12 / 61

Ivan Etzo (UNICA) Lecture 1: Technolgy 13 / 61

y = f (x1 , x2 ) = 2 × 11/3 × 81/3 = 2 × 1 × 2 = 4

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Isoquants can be graphed by adding an output level axis and

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The complete collection of isoquants is the isoquant map.

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Ivan Etzo (UNICA) Lecture 1: Technolgy 35 / 61

A Cobb-Douglas production function is of the form

y = Ax1a1 x2a2 ·, · · · · xnan

Ivan Etzo (UNICA) Lecture 1: Technolgy 36 / 61

Ivan Etzo (UNICA) Lecture 1: Technolgy 37 / 61

A fixed-proportions production function is of the form

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Ivan Etzo (UNICA) Lecture 1: Technolgy 39 / 61

A perfect-substitutes production function is of the form

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Ivan Etzo (UNICA) Lecture 1: Technolgy 41 / 61

The marginal product of input i is the rate-of-change of the output

The marginal product of input i is diminishing if it becomes smaller

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Marginal products describe the change in output level as a single

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f (kx1 , kx2 , · · · kxn ) = kf (x1 , x2 , · · · xn )