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Direct to edit Profit
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Maximization
In the 1-input model, profit maximization typically involves tangencies between
isoprofit curves and the production frontier.
In a 2-input model, a production plan
specifies how much x is produced using
labor and capital k. Production plans
therefore lie in 3 dimensions.
The 1-input model is best viewed as a
short run model that holds capital fixed
with the real underlying production
frontier lying in 3 dimensions.
Isoprofit lines then become isoprofit
planes that can be viewed as the firms
indifference curves.
And profit maximization again (typically)
involves tangencies except now in 3
dimensions.
 Click
Short and to edit
Long RunMaster title style
Production Frontiers
Long run production frontiers illustrate the available technology assuming all inputs can
be varied.
Short run production frontiers are derived from long-run frontiers by assuming capital is
fixed at some level and only labor input can be varied.

For different levels of fixed capital, we get

different slices of the long run
production frontier

When graphed as single-input production

frontiers, they then appear as different
frontiers despite being drawn from the
same long run production frontier.

The marginal product of labor is still the

increase in output from hiring one more
labor hour and is thus still measured as
a slope on the short run production
frontier. As capital increases, the
marginal product of labor changes.
 ClickProduction
2 Input to edit Master title style
and Returns to Scale

A second way of slicing a 2-input production frontier is along a ray from the origin.

If the resulting slice is linear, then increasing all inputs by a factor k results in a k-fold
increase in output. Such a production frontier is said to have constant returns to
scale.

Alternatively, the slice may have

diminishing slope, implying that
increasing all inputs by a factor of k
results in less than a k-fold increase in
output. This is called decreasing
returns to scale.

Or, the slice may have increasing

slope, implying that increasing all
inputs by a factor of k results in more
than a k-fold increase in output. This is
called increasing returns to scale.
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 ClicktotoScale
Returns editversus
Master title style
Marginal Product
Returns to scale are seen on slices along rays from the origin because the concept
describes what happens to output when all inputs rise at the same time.

Marginal product is seen on slices that hold

one input fixed because the concept
describes what happens to output when one
input rises all else staying unchanged.

It is logically possible to have diminishing

marginal product (of all inputs)
and increasing returns to scale.

It is also logically possible to have

increasing returns to scale
and increasing marginal product.

Is it possible to have decreasing returns to scale and increasing

marginal product of one input? No
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Isoquants withMaster
2-Input title style
Production

So far, we have looked at two kinds of vertical slices of the 2-input production frontier.

A third way of slicing 2-input production frontiers is horizontally at different levels of

output.

These slices can then be projected

onto 2 dimensions with the height of
the slice indicated as a label on each
curve.
The resulting isoquant map looks similar
to a consumer map of indifference
curves.

But instead of showing combinations of

consumption goods that produce the
same level of utility, an isoquant illustrates
all input bundles that can produce a given
level of output without wasting any input.
 Click to
(Marginal) edit Master
Technical Rates title style
of Substitution
The blue isoquant represents all technologically efficient production plans that involve
100 units of output.
A, for instance, is the production plan (2, 10, 100) the plan that combines 2 labor hours
with 10 units of capital to produce 10 output units. It is a technologically efficient plan
because it lies on the production frontier which means no inputs are wasted.
The slope of the isoquant at A tells us how many units of capital we could substitute for 1
labor hour and maintain production at 100 units of output. This is called the (marginal)
technical rate of substitution (TRS).
If TRS = 3, it means that at A, labor must be
approximately 3 times as productive per unit as
capital because we can replace 3 units of capital
with just 1 unit of labor. Thus MPl A 3MPkA .

And that implies

MPl
TRS
MPk

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 Click to edit Master
Substitutability title style
in Production

Just as we can compare consumer tastes in terms of the degree of substitutability of goods,
so we can compare technologies in terms of the degree of substitutability of inputs.
We will throughout assume that isoquant maps are homothetic with the TRS constant
along any ray from the origin.

But this allows for any degree of substitutability between labor and capital, with
greater substitutability causing flatter isoquants

and less substitutability causing more L-

shaped isoquants.

These rays from the origin are, of course,

the very rays along which we can slice the
production frontier vertically to identify
the technologys returns to scale.
 Click to
Returns toScale
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Master title style
the Isoquant Graph
Consider, for instance, the ray that lies on the 45-degree line.
The vertical slice (of the production frontier) that lies on
this ray has output x on the vertical axis and both inputs on
the horizontal.
A linear shape of this vertical slice then indicates
constant returns to scale.
But the same isoquant map with isoquant labels
changed can give rise to a diminishing slope on the
vertical slice, and thus decreasing returns to scale.
Similarly, other isoquant labels will give us
increasing returns to scale.
Returns to scale are then seen in the
rate at which isoquant labels change
along rays from the origin.
How could you similarly identify
diminishing versus increasing MP?
On horizontal and vertical lines.
 ClickProduction
Homothetic to edit Master titleofstyle
and 2 Types Convexity

For a producer choice set to be convex, any slice of the 3-dimensional set must be convex.
Along rays from the origin (like the 45 degree line), a slice can be convex only if the
technology has decreasing (or constant) returns to scale.
This automatically implies that all marginal
products are diminishing and thus short
run production slices are convex.
Finally, the isoquant map has to have
the convexity property.

To say that a producer choice set is convex

is then to say that is has decreasing
returns to scale and its isoquants have
convex upper contour sets.

Increasing returns to scale make the producer

choice set non-convex even though the
isoquant map may still be convex.
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 Click to Maps
Indifference edit Master title style
versus Isoquant Maps

Despite the many technical similarities between consumer

indifference maps and producer isoquants, there are important
differences:
1. These are representations of tastes for consumers and
constraints for producers.
2. The numerical values attached to them are objectively
measurable and thus inherently meaningful for producers
but not for consumers.
3. This is why we take vertical slices in the producer case but
NOT in the consumer case.
4. This is also why the concept of marginal utility of a good is
not emphasized in consumer theory but marginal product
of an input is.
 ClicktotoDirect
Back edit Profit
Master title style
Maximization
The tangency that occurs at the profit maximizing production plan in the 1-input model
has a specific and intuitive economic interpretation. At the tangency, pMPl w.
In a 2-input model, this tangency will
happen in 3 dimensions.
can now be thought of
Isoprofit planes
as sheets that will touch the 3-
dimensional production frontier at the
profit maximizing production plan.
And this tangency is a tangency in
every direction which means the
short-run profit maximization condition
pMPl w must still hold (although it
might lie on a different vertical slice as
capital is adjusted in the long run).
But the same tangency holds along the
slice with labor held fixed and so

pMPl w and pMPk r Go to

Math
2-StepClick
ProfittoMaximization
edit Masterusing
title Cost
styleCurves

In the 1-input model, we showed how to split profit

maximization into two steps:
Step 1: Derive AC and MC
Step 2: Set x where p = MC as long as p AC
Step 1 is the cost minimization part of profit
maximization. In the 1-input model, it simply implies
not wasting inputs.
But in the 2-input model, producing an output level x
at the lowest possible cost involves more than not
wasting inputs.
This is because there are now many ways many
combinations of capital and labor to produce the
output level x without wasting inputs.
 Click toCost-Minimizing
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For instance, all input bundles on this isoquant will produce
100 units of x without wasting inputs all represent
technologically efficient ways of producing 100 units .
When w =20 and r =10, a budget or isocost of $300 is
sufficient to reach production plans on this isoquant.
But a production plan is not economically efficient unless its
inputs are the least-cost way of reaching the output level.
For every output quantity, there is usually one such
economically efficient input bundle where
w
TRS
r
And when technology is homothetic, the economically
Constant
Returns to Scale efficient input bundles lie on the same ray from the origin.

For each output level, we can then read off the cost of
production assuming the firm cost-minimizes.
From the (total) cost curve, we can derive the marginal
and average cost curves exactly as in the 1-input case.
Click to edit Master
Supply Curvetitle style
Suppose A is the cost-minimizing input bundle to produce 10 units of
output. With homothetic technologies, this implies all cost-minimizing
input bundles lie on the same ray.
From A, we can calculate the cost (A)and average
cost (A) of producing 10 units of output (given
DRS
input prices w =20 and r =10).
IRS And repeating this for all other output quantities,
we get the (total) cost and average cost curves.
The slope of the (total) cost curve becomes
the marginal cost curve.

And just as in
the 1-input case,
the supply curve
is the MC curve
that lies above AC.

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Profit Click to edit Master
Maximization title style
with Increasing Returns
If the production process had increasing returns to scale throughout, then AC would
always fall.
And the only way AC can fall is for MC to lie below AC.
Since the total cost is the sum of all marginal costs, it is equal to the shaded area.
Suppose AC and MC converge to the dotted horizontal line. Then:

1. Profit is negative for any price at or below p* unless the firm

Corner produces nothing; and
Solutions 2. Profit is infinite for any price above p* if the firm produces
infinite output.
But increasing returns to scale throughout is an
assumption incompatible with price-taking
behavior.
We will return to this
in our discussion of
natural monopolies.
 Bringing
Click toCost Minimization
edit and style
Master title Profit
Maximization Together

A producer that only minimizes costs has to pay no attention to

output prices only input prices (w,r) matter for determining the
least cost way of producing different levels of output.
implies

A profit-maximizing producer also thinks about output price.

does not imply

(unless p=MC)
 Click to edit
Multi-Input Master title
Production style
Functions

A production function with inputs labor and capital simply takes the form

and tells us that output x f (l ,k) can be produced with the input bundle (l ,k) .

It gives rise to the producer choice set

that specifies the production plans that are feasible under the
technology represented by the production function f.

Production functions are mathematically similar to utility functions: In fact, we can

think of a utility function as a production function in which consumer goods are inputs
and utility is the output.

Our focus will be on homothetic production processes and we will return to

functional forms like the Cobb-Douglas and CES functions.
 Click to edit
TRSMaster
and MPtitle style

The (marginal) technical rate of substitution (TRS) is for the production function what
the marginal rate of substitution (MRS) is for the utility function.
u x1
Recall that MRS . By the same sequence of steps, we then get
u x 2
f l
TRS .
f k

The marginal product of labor is the change in output from a

marginal change in labor input (all else equal); and the
product of capital is the change in output from a
marginal
marginal change in capital (all else equal). Thus
f f
MPl and MPk .
l k
Combining these, we get

f l MPl
TRS .
f k MPk Back to
Graphs
 ClickConvexity
to edit Master title
in Productionstyle

Our notion of convexity (of upper contour sets) from consumer theory simply says that
averages are better than extremes or, in terms of producer theory, average input
bundles result in greater output than extremes.
A function is defined as quasiconcave if and only if implies
min f x1A , x 2A , f x1B , x 2B f x1A (1 )x1B , x 2A (1 )x 2B
which is exactly what our previous notion of convexity (of upper contour sets) says.

The set of points underneath a function is convex if the function is concave. A

function is defined to be concave if and only if

f x1A , x2A (1 ) f x1B , x2B f x1A (1 )x1B , x2A (1 )x2B .

does not imply

Convexity of the producer choice set implies convexity of upper contour sets;
BUT convexity of upper contour sets does NOT imply convexity of producer
choice sets.
 ClickConvexity
to edit Master title style
in Production

Convexity of the producer choice set implies convexity of upper contour sets;
BUT convexity of upper contour sets does NOT imply convexity of producer
choice sets.
2 2
1 1
f (l ,k) l k
3 3
is quasiconcave
f (l ,k) l k
3 3
is concave
(but not concave)

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Graphs
 Click to edit Master
Homogeneous title
Functions andstyle
RTS

The concept of returns to scale is most easily presented for homogeneous functions
where a function f is homogeneous of degree k if and only if

f (tl ,tk) t k f (l ,k).

k > 1 implies Increasing Returns to Scale
k = 1 implies Constant Returns to Scale

k < 1 implies Decreasing Returns to Scale

The Cobb-Douglas production function, for instance, is f (l ,k) Al k .

+ > 1 implies Increasing Returns to Scale

+ = 1 implies Constant
Returns to Scale
+ < 1 implies Decreasing Returns to Scale
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Graphs
 Click toProduct
Marginal edit Master title style
and Returns to Scale
f (l ,k) Al k
The Cobb-Douglas functions offers an easy way to explore the relationship between
marginal product and returns to scale.
+ > 1 implies
Increasing Returns to Scale

2 2 MPk Al k 1
f (l ,k) l 3 k 3

MPk
( 1)Al k 2
k
MPk
1 implies 0
k
Diminishing MP
4 4
f (l ,k) l 3
k 3
MPk
1 implies 0
k
Back to Increasing MP
Graphs

Click toProfit
edit Maximization
Master title style

1-Input Model: 2-Input Model:

This can be written as

The first order conditions are:

or simply
 Click to
Profit edit MasterAntitle
Maximization: style
Example

This is a Cobb-Douglas production function with exponents summing to less than 1. It

therefore has decreasing returns to scale giving rise to a fully convex producer choice set.
As a result, we know that the first order conditions are necessary and sufficient for us to
identify the profit maximizing production plan.

The constrained profit maximization problem

can be solved using the Lagrange method, or it can be solved by substituting the
constraint into the objective function.

The latter turns the problem into the unconstrained maximization problem
 Click to
Profit edit MasterAntitle
Maximization: style
Example

First Order Conditions:

8 p 5 3 2 3
k l
r

labor demand

capital
demand

16384
profit function output supply

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Graphs
2-StepClick
ProfittoMaximizing
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via title
Cost style
Minimizing

First order conditions:

Notice that, aside from notation, cost minimizing is identical to the expenditure
minimization portion of the consumer duality picture.
 AnClick to edit
Example Master title style
Continued:
STEP 1: Minimize Cost

First Order Conditions:

Same input
demand and output
supply functions as
under direct profit
maximization

STEP 2: Set
Output
 Click to edit Master
Completing Producertitle style
Duality

Hotellings Shephard
Lemma s Lemma