Firm Theory and Duality

EC115 - Methods of Economic Analysis
Spring Term, Lecture 9

Constrained Maximisation III:
Firms Theory and Duality
Renshaw - Chapter 16
University of Essex - Department of Economics
Week 24
Domenico Tabasso (University of Essex - Department of Economics) Lecture 9 - Spring Term Week 24 1 / 39
Introduction
In the last lectures we have focused on how to maximize a
utility function under a budget constraint.
We have outlined two methods:
Total Dierentiation ( MRS and Budget Constraint)
Direct Substitution.
The next (and nal!) question that we want to answer in
this course are:
Is there any other method for nding a max under a
constraint?
How about the theory of rms?.
Introduction - 2
With respect to the rst question, the answer is:
Yes!, There is third method and it is called the Lagrange
method.
We will study this technique next week as last topic of the
course.
Today we will focus on the second question: how do rms
behave under a constraint?.
Firms Behaviour
Dierently from consumer theory, in which the aim is
always the maximization of the utility under the budget
constraint, for the rms the aim can be dierent. In
particular we will distinguish between:
1
Maximization of the prots or of the output?
2
Maximization or minimization of the costs?
Firms Behaviour
Dierently from consumer theory, in which the aim is
always the maximization of the utility under the budget
constraint, for the rms the aim can be dierent. In
particular we will distinguish between:
1
Maximization of the prots or of the output?
2
Maximization or minimization of the costs?
Maximization of the Prots
In the most standard case, the aim of the rm is the
maximization of the prots. This case is rather easy to
handle.
the maximization of the prots, in fact, implies the
maximization of the Total Revenues minus the Total Costs,
under the constraint of a certain production level.
But this problem can be simply written as:
max
K,L
(K, L) = p f (K, L) wL rK
where p is the price of the good sold by the rm, f (K, L) is
the production function, w is the wage paid to the workers
and r the cost of capital.
Maximization of the Prots
Evidently the prot function already contains the constraint
in itself, so the maximization is straightforward and follows
the usual steps:
1
Obtain the rst order conditions;
2
Solve the FOCs and obtain the critical values of K and
L, respectively K
and L
;
3
Check the critical values satisfy the second order
conditions for a max.
Maximization of the Output
Sometimes a rm can aim at maximizing the output and
not the prots (think about a rm which is owned by the
state).
In this case the problem becomes:
max
K,L
Q = f (K, L)
s.t. TC = rK + wL.
The objective function is the production function;
The constraint is given by the total cost function (TC).
This maximization problem can be solved following the two
methods studied with respect to the consumer theory. In
particular, by using the total dierential approach we aim
at building up the following system:
Slope of the Isoquant ( MRTS) = Slope of the Isocost

Equation of the total Cost Function
where the similarities with the consumers theory are
evident.
So given the following problem:
max
K,L
Q = f (K, L) ;
s.t. TC = wL + rK.
where TC is just a number, by xing the output at a certain
constant level Q
0
and using total dierentiation we have
dQ
0
=
Q
K
dK +
Q
L
dL.
Since dQ
0
= 0 the last equation can be rewritten as
Q
K
dK +
Q
L
dL = 0
which we can rearrange to obtain:
dK
dL
=
Q/L
Q/K
where
dK
dL
is dened as the Marginal Rate of Technical
Substitution (or Marginal Rate of Substitution in
production) which tells us the amount of capital that can
be released when the one more unit of labour is employed
and the output is constant.
So our system is given by:
dK
dL
Q/L
Q/K
=
w
r
TC=wL+rK
and by solving the system we can nd K
, L
.
Maximization of the Output - Example
A rms production function is given by Q = K
1/3
L
1/3
.
Find K
, L
, Q
given TC = 2000 and w = r = 1.

Solution:
MRTS? =
Q/L
Q/K
So:
MRTS =
1
3
K
1/3
L
2/3
1
3
K
2/3
L
1/3
=
K
L
Maximization of the Output - Example
Setting the system we have:
K
L
=
w
r
2000=wL+rK
which we can solve easily and obtain
K
= 1000, L
= 1000 which imply Q
= 100.
Cost Minimization
In the theory of rm we may also encounter a dierent
problem: A rm wants to reach a given output trying to
minimize the costs.
Formally, the problem can be rewritten as:
min
K,L
TC = wL + rK ;
s.t.Q = f (K, L)
and can be interpreted as the complementary problem to
those studied so far. In particular now TC is unknown,
while Q = Q
0
is given and equal to a constant.
Cost Minimization
How can we nd the optimal K
, L
that satisfy our

minimization problem?
Y
TC1
TC*
Optimum
TC0
y*
X
0
x*
0
Cost Minimization
Well, rst of all we can notice that at the optimum two
condition are satised:
Slope of the Isoquant ( MRTS) = Slope of the Isocost (Again!)

Equation of the Production Function (the constraint!)
So the system looks very similar to the one of the
maximization problem. Is the solution going to be similar
as well?
Cost Minimization - Example
In order to understand our problem lets start with an
example.
A rm wants to nd the cost minimizing combination of
capital and labour for producing Q = 100 given that
w = r = 1. The rm has the following production
function:Q = K
1/3
L
1/3
.
The slope of the Total Cost function is simply given by
w
r
= 1 while the MRTS can be obtained through total
dierentiation of the Production Constraint and is again
equal to
K
L
Cost Minimization - Example
So the system is
K
L
= 1
100 = K
1/3
L
1/3
From the rst equation we obtain K = L which substituted
in the second equation implies
100 = K
2/3
=K = 100
3/2
=K
= 1000
and given that K = L =L
= 1000
Summary of results
Problem:
max
K,L
Q = K
1/3
L
1/3
s.t. 2000 = K + L
Solution:K
= 1000, L
= 1000 and Q
= 100
Problem:
min
K,L
TC = K + L
s.t. 100 = K
1/3
L
1/3
Solution:K
= 1000, L
= 1000 and TC
= 2000
Summary of results
Problem:
max
K,L
Q = K
1/3
L
1/3
s.t. 2000 = K + L
Solution:K
= 1000, L
= 1000 and Q
= 100
Problem:
min
K,L
TC = K + L
s.t. 100 = K
1/3
L
1/3
Solution:K
= 1000, L
= 1000 and TC
= 2000
Duality
So the two problems lead to the same solution. Is this
just a coincidence???
Of course no!
Can we obtain something similar with respect to
consumers theory?
Duality
Of course no!
consumers theory?
Duality
Of course no!
consumers theory?
Duality
Consider the following standard problem for a consumer:
max
x,y
U(x, y) = x
s.t.m = p
x
x + p
y
y
We have studied this problem several times and we know
that in order to solve it we have to nd the solution for the
following system:
MRS=
p
x
P
y
m = p
x
x + p
y
y
Duality
Y
Optimum
U1
y*
U*
X
0
U0
x* x
Duality
We know that in this case MRS =
y
x
and last week we
saw that the solution is given by:
x
=
m
( + )p
x
y
=
m
( + )p
y
Note that x
and y
are functions themselves! They are

functions of m, p
x
, p
y
.
Duality
So for any dierent combination of m, p
x
, p
y
well observe
dierent values of x and y that satisfy the maximization
problem.
We dene:
x = x(m, p
x
, p
y
)
y = y(m, p
x
, p
y
)
as the Marshallian demand functions of x and y, or simply
the demand functions.
Duality
Remember that we started from a Cobb-Douglas utility
function. More generally we could have started from:
U = U(x, y)
But now we know that x is going to be x = x(m, p
x
, p
y
)
and y is going to be y = y(m, p
x
, p
y
), so that our utility
function can be expressed as:
U = U(x(m, p
x
, p
y
), y(m, p
x
, p
y
)) = V(m, p
x
, p
y
)
We call V = V(m, p
x
, p
y
) the Indirect Utility Function
Duality
So in our previous example:
U(x, y) = x
and we obtained:
x =
m
( + )p
x
y =
m
( + )p
y
So the indirect utility function is:
V = V(m, p
x
, p
y
) =
m
( + )p
x
m
( + )p
y
Applying Duality to Consumer Theory
Consider now the following problem for a consumer:
min
x,y
p
x
x + p
y
y
s.t. U
0
= f (x, y) = x
What is the minimum expenditure the consumer must

make to achieve a determine level of utility?
That is, given a utility level u
0
, what is the choice of x
and y such that the consumer reaches this level of
utility at the minimum cost?
Duality
Y
TC1
TC*
Optimum
TC0
y*
X
0
x*
0
Using the tangency condition method we have to solve to
following system
MRS=
p
x
P
y
x
= U
0
where evidently the rst equation is identical to the one we
have with the maximization of the utility problem, whicle
the constraint is now represented by the utility level.
The MRS is still given by MRS =
y
x
so we have:
y
x
=
p
x
p
y
y =

p
x
p
y
x
U
0
= x
U
0
= x
+
p
x
p
y
= U
1
+
0
p
y
p
x

+
; y
= U
1
+
0
p
x
p
y

+
So now x
and y
are functions of p
x
, p
y
, U! In general
we will call:
x = h
x
(p
x
, p
y
, U)
y = h
y
(p
x
, p
y
, U)
the Hicksian (or compensated) demand function for x and
y.
Substituting h
x
and h
y
in our original objective function we
obtain:
E = p
x
h
x
(p
x
, p
y
, U) + p
y
h
y
(p
x
, p
y
, U)
The function E = E(p
x
, p
y
, U) is called the Expenditure
Function.
By construction:
h
x
(p
x
, p
y
, U) =
E
p
x
; h
y
(p
x
, p
y
, U) =
E
p
y
Duality
In equilibrium:
E(p
x
, p
y
, U) = m (1)
This result leads to an important implication known as
duality:
1
Solving eq.(1) for U we obtain an expression for the
indirect utility function
2
Solving V(p
x
, p
y
, E) = U for E gives us the
expenditure function.
Duality - Exercise
Consider the following consumer problem:
max
x,y
U(x, y) = x
1
3
y
1
3
s.t.m = p
x
x + p
y
y
1
Find the indirect utility function;
2
Find the expenditure function;
3
Find the Hicksian demands for x and y
Solution
In order to nd the indirect utility function we rst have to
get the (Marshallian) demands for x and y.
So as usual we have to solve:
MRS=
p
x
P
y
m = p
x
x + p
y
y
In this case:
y
x
=
p
x
P
y
m = p
x
x + p
y
y
Solution
The solution of the system is (prove it yourself!):
x
=
m
2p
x
; y
=
m
2p
y
So, we have just obtained x and y as functions of
(m, p
x
, p
y
). Substituting these in the utility function we
get the indirect utility.
Solution
V = V(m, p
x
, p
y
) =
m
2p
x
1/3
m
2p
y
1/3
=
m
2/3
(2p
x
)
1/3
(2p
y
)
1/3
.
How about the Expenditure function? Well, we have two
ways to get it:
1
Minimize the expenditure under the utility constraint;
2
Use Duality!
Solution
V = V(m, p
x
, p
y
) =
m
2p
x
1/3
m
2p
y
1/3
=
m
2/3
(2p
x
)
1/3
(2p
y
)
1/3
.
How about the Expenditure function? Well, we have two
ways to get it:
1
Minimize the expenditure under the utility constraint;
2
Use Duality!
Solution
Duality implies m = E so we can substitute E instead of m
within the indirect utility function and solve
U = V(E, p
x
, p
y
):
U =
E
2/3
(2p
x
)
1/3
(2p
y
)
1/3
.
Solving this for E we get the expenditure function:
E = 2(p
x
p
y
)
1
2
U
3
2
.
Solution
Finally, given the obtained expression for the Expenditure
Function we can get the Hicksian demand functions with
two simple derivatives:
h
x
=
E
p
x
= (p
x
p
y
)
1
2
U
3
2
;
h
y
=
E
p
y
= (p
x
p
y
)
1
2
U
3
2
;

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EC115 - Methods of Economic Analysis

Spring Term, Lecture 9

Slope of the Isoquant ( MRTS) = Slope of the Isocost

given TC = 2000 and w = r = 1.

= 1000 which imply Q

that satisfy our

Slope of the Isoquant ( MRTS) = Slope of the Isocost (Again!)

are functions themselves! They are

What is the minimum expenditure the consumer must

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