COST FUNCTIONS

The Firms Expansion Path

The firm can determine the costminimizing combinations of k and l for
every level of output: q= (l*, k*)
If input prices remain constant for all
amounts of k and l, we can trace the
locus of cost-minimizing choices
called the firms expansion path
2

The Firms Expansion Path

The expansion path is the locus of costminimizing combinations if k and l for each level
of output
k per period
The curve shows
how inputs increase
E
as output increases

q1
q0
q00

l per period

The Firms Expansion Path

The expansion path does not have to be
a straight line (k/l ratio may change)
the use of some inputs may increase faster
than others as output expands
depends on the shape of the isoquants

The expansion path does not have to be

upward sloping
if the use of an input falls as output expands,
that input is an inferior input
4

Homothetic Production Functions

Suppose that the production function is
Cobb-Douglas:
q = kl

The Lagrangian expression for cost

minimization of producing q0 is
L = vk + wl + (q0 - k l )
5

Homothetic Production Functions

The first-order conditions for a minimum
are
L/k = v - k -1l = 0
L/l = w - k l -1 = 0
L/ = q0 - k l = 0


1
w
lv

R
T
S
l

Homothetic Production Functions

Dividing the first equation by the second
gives us

This production function is homothetic

the RTS depends on the ratio of the two
inputs; RTS changes as k/l changes
the expansion path is a straight line

Homothetic Production Functions

Suppose that the production function is
CES:
q = (k + l )/

The Lagrangian function for cost

minimization of producing q0 is
L = vk + wl + [q0 - (k + l )/]
8

Homothetic Production Functions

The first-order conditions for a minimum
are
L/k = v - (/)(k + l)(-)/()k-1 = 0
L/l = w - (/)(k + l)(-)/()l-1 = 0
L/ = q0 - (k + l )/ = 0

Homothetic Production Functions

Dividing the first equation by the second
gives us
w l

v k

k

l

k

l

1/

This production function is also

homothetic

10

Total Cost Function

The total cost function shows the
minimum costs that must be incurred to
achieve any output level (at a given set
of input prices)
C = C(v,w,q)

As output (q) increases, total costs

increase
11

C
(
v
,
w
q
)
avergcostA
C
(v,w
q)

Average Cost Function

The average cost function (AC) is found

by computing total costs per unit of
output

12


C
(
v
,
w
q
)
m
arginlcostM
C
(v,w
q)
Marginal Cost Function

The marginal cost function (MC) is

found by computing the change in total
costs for a change in output produced

13

Graphical Analysis of
Total Costs
Suppose that k1 units of capital and l1 units
of labor input are required to produce one
unit of output
C(q=1) = vk1 + wl1

To produce m units of output (assuming

constant returns to scale)
C(q=m) = vmk1 + wml1 = m(vk1 + wl1)
C(q=m) = m C(q=1)

14

Graphical Analysis of
Total
Costs
With constant returns to scale, total
Total
costs

costs
are proportional to output

AC = MC

Both AC and
MC will be
constant
Output
15

Graphical Analysis of
Total Costs
Suppose instead that total costs start
out as concave and then becomes
convex as output increases
one possible explanation for this is that
there is a third factor of production that is
fixed as capital and labor usage expands
total costs begin rising rapidly after
diminishing returns set in
16

Graphical Analysis of
Total Costs
Total
costs

Total costs rise

dramatically as
output increases
after diminishing
returns set in
Output
17

Average
and
marginal
costs

Graphical Analysis of
Total Costs
MC is the slope of the C curve
MC
AC

min AC

If MC < AC,
AC must be
falling
If MC >AC,
AC must be
rising

Output
18

v
w
C
(w
,vq)ab

Some Illustrative Cost

Functions

Suppose we have a fixed proportions PF such

that
q = f(k,l) = min(ak,bl)

Production will occur at the vertex of the Lshaped isoquants (q = ak = bl and k*/l*=a/b)
C(w,v,q) = vk + wl = v(q/a) + w(q/b)

19

k
kv

lw
v

Some Illustrative Cost

Functions

Suppose we have a Cobb-Douglas case

such that
q = f(k,l) = k l

Cost minimization requires that

20


lkq
q
v
w
w
v

1/1

/
/
/

Some Illustrative Cost

Functions
If we substitute into the production
function and solve for l, we will get

A similar method will yield

21

C
(v,w
q)B
vk(
w
l)qB
vw

1
//

//
/

Some Illustrative Cost

Functions

Now we can derive total costs as

where

which is a constant that involves only

the parameters and

22

/
1)()/
C
(v,w
qC
)(,vk)w
lq1/(v/1w
Some Illustrative Cost
Functions

Suppose we have a CES PF such that

q = f(k,l) = (k + l )/

To derive the total cost, we would use

the same method and eventually get

23

Properties of Cost Functions

Homogeneity
cost functions are all homogeneous of degree
one in the input prices
C(tw,tv,q) = t.C(w,v,q)
cost minimization requires that the ratio of input
prices be set equal to RTS, a doubling of all input
prices will not change the levels of inputs
purchased, but will double the C
Pure inflation will not change a firms input
decisions but will shift the cost curves up
24

Properties of Cost Functions

Nondecreasing in q, v, and w
cost functions are derived from a costminimization process
any decline in costs from an increase in one of
the functions arguments would lead to a
contradiction

25

Properties of Cost Functions

Concave in input prices
costs will be lower when a firm adjust input
mix appropriately in response to changes
in input prices than the costs in the
situation when input mix remains constant
Concavity of CF implies that the firm chooses
the optimal input mix
Linear CF implies that the firm keeps the input
mix constant when input price changes
26

Concavity of Cost Function

At w1, the firms costs are C(v,w1,q1)

Costs

If the firm continues to

buy the same input mix
as w changes, its cost
function would be Cpseudo

Cpseudo
C(v,w,q1)

C(v,w1,q1)

Since the firms input mix

will change, actual costs
will be less than Cpseudo
such as C(v,w,q1)
w1

27

Properties of Cost Functions

Some of these properties carry over to
average and marginal costs
homogeneity
effects of v, w, and q are ambiguous

28

kl w
v

Input Substitution

A change in the price of an input will

cause the firm to alter its input mix
We wish to see how k/l changes in
response to a change in w/v, while
holding q constant

29

(sw

k/vl)w
/kvln(w
k/vl)
Input Substitution

Putting this in proportional terms as

gives an alternative definition of the

elasticity of substitution

in the two-input case, s must be nonnegative

large values of s indicate that firms change
their input mix or k/l ratio significantly if relative
prices of inputs change
30

Shifts in Cost Curves

The cost curves are drawn under the
assumption that input prices and the
level of technology are held constant
any change in these factors will cause the
cost curves to shift

31

Size of Shifts in Costs Curves

The increase in costs will be largely
determined by the relative significance
of the input (whose price increased) in
the production process
If firms can easily substitute another
input for the one whose price increased,
there may be little increase in costs
32

Technical Progress
Improvements in technology also reduce
cost for each level output
Suppose that total costs (with constant
returns to scale) without technical change
are
C0 = C0(q,v,w) = qC0(v,w,1)

33

Technical Progress
After technical change the same inputs that
produced one unit of output in period zero will
produce A(t) units in period t
Ct(v,w,A(t)) = A(t)Ct(v,w,1)
Ct(v,w,1) = C0(v,w,1)/A(t)

Total costs are given by

Ct(v,w,q) = qCt(v,w,1) = qC0(v,w,1)/A(t)
C0(v,w,q)/A(t)

=
34

C
(v,w
qC
)vB
,w
vkq(
w
lvk)qw
vl2qvw
B
w

1
//

//
/

0.5

Shifting the Cobb-Douglas

Cost Function
The Cobb-Douglas cost function is
where

If we assume = = 0.5, the total cost

curve is :

35

C
(3,12q)3612q

Shifting the Cobb-Douglas

Cost Function
If v = 3 and w = 12, the relationship is
C = 480 to produce q =40
AC = C/q = 12
MC = C/q = 12

36

C
(3,27q)281q

Shifting the Cobb-Douglas

Cost Function
If v = 3 and w = 27, the relationship is
C = 720 to produce q =40
AC = C/q = 18
MC = C/q = 18

37

Contingent Demand for Inputs

Earlier, we considered an individuals
expenditure-minimization problem
we used this technique to develop the
demand for a good

Can we develop a firms demand for an

input in the same way?

38

Contingent Demand for Inputs

The demand for an input is a derived
demand
In the present case, cost minimization
leads to a demand for capital and labor
that is contingent on the level of output
being produced
it is based on the level of the firms output
39

Contingent Demand for Inputs

Contingent demand functions for all of
the firms inputs can be derived from the
cost function
Shephards lemma
the contingent demand function for any input is
given by the partial derivative of the total-cost
function with respect to that inputs price

40

v
w
C
(w
,vq)ab

Contingent Demand for Inputs

Suppose we have a fixed proportions PF:

q (l , k ) min{ al , bk}

The cost function is

41


C
(
v
,
w
q
)
kl(v,w
q)b
a
cc

Contingent Demand for Inputs

For this cost function, demand functions
for l and k are:

42

C
(v,w
q)vkw
lqB
vw

1/

//

Contingent Demand for Inputs

Suppose we have a Cobb-Douglas PF
The cost function is

43

k(v,w
q)

q
B
v
w
vq
B
w

c 1/
/
1

Contingent Demand for Inputs

For this cost function, the demand
function for input k is:

44

l(v,w
q)w

q
B
v
w
w

c 1/
/
1

Contingent Demand for Inputs

The contingent demands for inputs

depend on both inputs prices

45

Short-Run, Long-Run
Distinction
In the short run, economic actors have
only limited flexibility in their choice
Assume that the capital input is held
constant at k1 and the firm is free to
vary only its labor input
The production function becomes
q = f(k1,l)
46

Short-Run Total Costs

Short-run total cost for the firm is
SC = vk1 + wl

There are two types of short-run costs:

short-run fixed costs are costs associated
with fixed inputs (vk1)
short-run variable costs are costs
associated with variable inputs (wl)
47

Efficiency of Short-Run Costs

costs given by short-run CF are not minimal
costs for producing each output level:
C(k1, l, q)
the RTS will not be equal to the ratio of input
prices at each output level
the firm does not have the flexibility of choosing
optimal input mix for each q
to vary its output in the short run, the firm uses
non-optimal input combinations
48

Short-Run Total Costs

k per period

Because capital is fixed at k1,

the firm cannot equate RTS
with the ratio of input prices

k1
q2
q1
q0
l1

l2

l3

l per period
49

Short-Run Marginal and

Average Costs
The short-run average total cost (SAC)
function is
SAC = total costs/total output = SC/q

The short-run marginal cost (SMC)

function is
SMC = change in SC/change in output = SC/q
50

Relationship between ShortRun and Long-Run Costs

SC (k2)

Total
costs

SC (k1)
C

The long-run
C curve can
be derived by
varying the
level of k

SC (k0)

q0

q1

q2

Output
51

Relationship between ShortRun and Long-Run Costs

MC

Costs
SMC (k0)

SAC (k0)
AC
SMC (k1)

q0

q1

SAC (k1)

The geometric
relationship
between shortrun and long-run
AC and MC can
also be shown
Output
52

Relationship between ShortRun and Long-Run Costs

At the minimum point of the AC curve:
the MC curve crosses the AC curve
MC = AC at this point

the SAC curve is tangent to the AC curve

SAC (for this level of k) is minimized at the same
level of output as AC
SMC intersects SAC also at this point

AC = MC = SAC = SMC
53

Important Points to Note:

A firm that wishes to minimize the
economic costs of producing a
particular level of output should
choose that input combination for
which the rate of technical substitution
(RTS) is equal to the ratio of the
inputs rental prices
54

Important Points to Note:

Repeated application of this
minimization procedure yields the
firms expansion path
the expansion path shows how input
usage expands with the level of output
it also shows the relationship between output
level and total cost
this relationship is summarized by the total
cost function, C(v,w,q)
55

Important Points to Note:

The firms average cost (AC = C/q)
and marginal cost (MC = C/q) can
be derived directly from the total-cost
function
if the total cost curve has a general cubic
shape, the AC and MC curves will be ushaped

56

Important Points to Note:

All cost curves are drawn on the
assumption that the input prices are
held constant
when an input price changes, cost curves
shift to new positions
the size of the shifts will be determined by the
overall importance of the input and the
substitution abilities of the firm

technical progress will also shift cost

curves

57

Important Points to Note:

Input demand functions can be
derived from the firms total-cost
function through partial differentiation
these input demands will depend on the
quantity of output the firm chooses to
produce
are called contingent demand functions

58

Important Points to Note:

In the short run, the firm may not be
able to vary some inputs
it can then alter its level of production
only by changing the employment of its
variable inputs
it may have to use nonoptimal, highercost input combinations than it would
choose if it were possible to vary all
inputs
59