Prerequisites Almost essential Firm Optimisation Useful but optional

Prerequisites Almost essential Firm: Optimisation Useful, but optional Firm: Demand Supply THE MULTI-OUTPUT FIRM MICROECONOMICS Principles and Analysis Frank Cowell April 2018 Frank Cowell: Multi-Output Firm 1

Introduction § This presentation focuses on analysis of firm producing more than one good • modelling issues • production function • profit maximisation § For the single-output firm, some things are obvious: • the direction of production • returns to scale • marginal products § But what of multi-product processes? § Some rethinking required. . . ? • nature of inputs and outputs? • tradeoffs between outputs? • counterpart to cost function? April 2018 Frank Cowell: Multi-Output Firm 2

Overview The Multi-Output Firm Net outputs A fundamental concept Production possibilities Profit maximisation April 2018 Frank Cowell: Multi-Output Firm 3

Multi-product firm: issues § “Direction” of production • Need a more general notation § Ambiguity of some commodities • Is paper an input or an output? § Aggregation over processes • How do we add firm 1’s inputs and firm 2’s outputs? April 2018 Frank Cowell: Multi-Output Firm 4

Net output § Net output, written as qi • if positive denotes the amount of good i produced as output • if negative denotes the amount of good i used up as output § Key concept • treat outputs and inputs symmetrically • offers a representation that is consistent § Provides consistency • in aggregation • in “direction” of production We just need some reinterpretation April 2018 Frank Cowell: Multi-Output Firm 5

Approaches to outputs and inputs NET OUTPUTS OUTPUT INPUTS q 1 z 1 q 2 z 2 . . . qn-1 zm qn §Left-hand boxes: approach using “net outputs” §Bottom-left: how the two are related §Bottom-right: simple sign convention q q 1 –z 1 q 2 –z 2. . . =. . . qn-1 –zm qn +q April 2018 §Right-hand boxes: standard “accounting” approach Outputs: + net additions to the stock of a good Inputs: reductions in the stock of a good Frank Cowell: Multi-Output Firm 6

Aggregation § Consider an industry with two firms • Let qif be net output for firm f of good i, f = 1, 2 • Let qi be net output for whole industry of good i § How is total related to quantities for individual firms? • Just add up • qi = qi 1 + qi 2 § Example 1: both firms produce i as output • qi 1 = 100, qi 2 = 100 • qi = 200 § Example 2: both firms use i as input • qi 1 = − 100, qi 2 = − 100 • qi = − 200 § Example 3: firm 1 produces i that is used by firm 2 as input • qi 1 = 100, qi 2 = − 100 • qi = 0 April 2018 Frank Cowell: Multi-Output Firm 7

Net output: summary § Sign convention is common sense § If i is an output • addition to overall supply of i • so sign is positive § If i is an input • net reduction in overall supply of i • so sign is negative § If i is a pure intermediate good • no change in overall supply of i • so assign it a zero in aggregate April 2018 Frank Cowell: Multi-Output Firm 8

Overview The Multi-Output Firm Net outputs A production function with many outputs, many inputs… Production possibilities Profit maximisation April 2018 Frank Cowell: Multi-Output Firm 9

Rewriting the production function… § Reconsider single-output firm example given earlier • goods 1, …, m are inputs • good m+1 is output • n=m+1 § Conventional way of writing feasibility condition: • q f (z 1, z 2, . . , zm ) • where f is the production function § Express this in net-output notation and rearrange: • qn f (−q 1, −q 2, . . , −qn-1 ) • qn − f (−q 1, −q 2, . . , −qn-1 ) 0 § Rewrite this relationship as • F (q 1, q 2, . . , qn-1, qn ) 0 • where F is the implicit production function § Properties of F are implied by those of f April 2018 Frank Cowell: Multi-Output Firm 10

The production function F § Recall equivalence for single output firm: • qn − f (−q 1, −q 2, . . , −qn-1 ) 0 • F (q 1, q 2, . . , qn-1, qn ) 0 § So, for this case: • F is increasing in q 1, q 2, . . , qn • if f is homogeneous of degree 1, F is homogeneous of degree 0 • if f is differentiable so is F • for any i, j = 1, 2, …, n − 1, MRTSij = Fj(q)/Fi(q) § It makes sense to generalise these… April 2018 Frank Cowell: Multi-Output Firm 11

The production function F (more) § For a vector q of net outputs • q is feasible if F(q) 0 • q is technically efficient if F(q) = 0 • q is infeasible if F(q) > 0 § For all feasible q: • F(q) is increasing in q 1, q 2, . . , qn • if there is CRTS then F is homogeneous of degree 0 • if f is differentiable so is F • for inputs i, j, MRTSij = Fj(q)/Fi(q) • for outputs i, j, marginal rate of transformation of i into j is MRTij = Fj(q)/Fi(q) § Illustrate the last concept using the transformation curve April 2018 Frank Cowell: Multi-Output Firm 12

Firm’s transformation curve §Goods 1 and 2 are outputs §Green area: feasible outputs §Orange boundary: technically efficient outputs q 2 § Pink line: MRT at qo q° F(q) 0 F 1(q°)/F 2(q°) F(q)=0 q 1 April 2018 Frank Cowell: Multi-Output Firm 13

An example with five goods § § § Goods 1 and 2 are outputs Goods 3, 4, 5 are inputs A linear technology • • § fixed proportions of each input needed for the production of each output: q 1 a 1 i + q 2 a 2 i −qi where aji is a constant i = 3, 4, 5, j = 1, 2 given the sign convention −qi > 0 Take the case where inputs are fixed at some arbitrary values April 2018 Frank Cowell: Multi-Output Firm 14

The three input constraints q 2 § blue: Constraint 3 points satisfying q 1 a 13 + q 2 a 23 −q 3 § brown: Constraint 4 § purple: Constraint 5 points satisfying q 1 a 14 + q 2 a 24 −q 4 § Intersection is the feasible set for the two outputs points satisfying q 1 a 15 + q 2 a 25 −q 5 q 1 April 2018 Frank Cowell: Multi-Output Firm 15

The resulting feasible set q 2 The transformation curve how this responds to changes in available inputs q 1 April 2018 Frank Cowell: Multi-Output Firm 16

q 1 a 13 + q 2 a 23 = §Green area: feasible set as before §Shift blue line: more of input 3 §Shift brown line: less of input 4 −q 3 q −q 3 −d 3 q 2 a 23 = q 2 q 1 a 13 + *Changing quantities of inputs q 1 a 1 + q 4 2 a 24 = −q 4 + dq 4 q 1 April 2018 Frank Cowell: Multi-Output Firm 17

Overview The Multi-Output Firm Net outputs Integrated approach to optimisation Production possibilities Profit maximisation April 2018 Frank Cowell: Multi-Output Firm 18

Profits § The basic concept is (of course) the same • Revenue Costs § But we use the concept of net output • this simplifies the expression • exploits symmetry of inputs and outputs § Consider an “accounting” presentation April 2018 Frank Cowell: Multi-Output Firm 19

Accounting with net outputs § Suppose goods 1, . . . , m are inputs and goods m+1 to n are outputs § 1 st line: Revenue from outputs ( m+1, . . . , n) n å i=m+1 § 2 nd line: Cost of inputs ( 1, . . . , m) pi qi Revenue § Subtract cost from revenue to get profits m å pi [ qi] i=1 – Costs n å pi qi i=1 April 2018 = Profits Frank Cowell: Multi-Output Firm 20

Iso-profit lines. . . §pink-line: net-output vectors for a given P 0 q 2 § higher lines for higher profit levels. g sin rea c in ofit pr p 1 q 1+ p 2 q 2 = constant p 1 q 1+ p 2 q 2 = P 0 use this to represent profit-maximisation q 1` April 2018 Frank Cowell: Multi-Output Firm 21

Profit maximisation: multi-product firm (1) § Green area: Feasible outputs q 2 § pink line: Isoprofit § move isoprofit out to max profit § q*: Profit-maximising output § slope of isoprofit: MRTS * q § Here q 1* > 0 and q 2* > 0 § q* is technically efficient g sin rea c in ofit pr §Slope at q* equals price ratio q 1` April 2018 Frank Cowell: Multi-Output Firm 22

Profit maximisation: multi-product firm (2) § Green area: Feasible outputs § pink line: Isoprofit q 2 § move isoprofit out to max profit § q*: Profit-maximising output § slope of isoprofit: MRTS increasing profit § Here q 1* > 0 but q 2* = 0 § q* is technically efficient §Slope at q* ≤ price ratio April 2018 q* q 1` Frank Cowell: Multi-Output Firm 23

Maximising profits § Problem is to choose q so as to maximise n å pi qi subject to F(q) ≤ 0 i=1 § Lagrangean is n å pi qi l. F (q) i=1 § FOC for an interior maximum is pi l. Fi(q) = 0 April 2018 Frank Cowell: Multi-Output Firm 24

Maximised profits § Introduce the profit function • the solution function for the profit maximisation problem n n P(p) = max å pi qi = å pi qi* {F(q) ≤ 0} i = 1 § Works like other solution functions: • • § i=1 non-decreasing homogeneous of degree 1 continuous convex Take derivative with respect to pi : • Pi(p) = qi* • write qi* as net supply function • qi* = qi(p) April 2018 Frank Cowell: Multi-Output Firm 25

Summary § Three key concepts § Net output • simplifies analysis • key to modelling multi-output firm • easy to rewrite production function in terms of net outputs § Transformation curve • summarises tradeoffs between outputs § Profit function • counterpart of cost function April 2018 Frank Cowell: Multi-Output Firm 26