Cost

Minimization
 Cost Minimization
 A firm is a cost-minimizer if it
produces any given output level y  0
at smallest possible total cost.
 c(y) denotes the firm’s smallest
possible total cost for producing y
units of output.
 c(y) is the firm’s total cost function.
 Cost Minimization
 When the firm faces given input
prices w = (w1,w2,…,wn) the total cost
function will be written as
c(w1,…,wn,y).
The Cost-Minimization Problem
 Consider a firm using two inputs to make
one output.
 The production function is
y = f(x1,x2).
 Take the output level y  0 as given.
 Given the input prices w1 and w2, the cost
of an input bundle (x1,x2) is w1x1 +
w2x2.
The Cost-Minimization Problem
 For given w1, w2 and y, the firm’s
cost-minimization problem is to
solve min w 1x1  w 2x 2
x1 , x 2  0
subject to f ( x1 , x 2 )  y .
The Cost-Minimization Problem
 The levels x1*(w1,w2,y) and x2*(w1,w2,y)
in the least-costly input bundle are the
firm’s conditional demands for inputs
1 and 2.
 The (smallest possible) total cost for
producing y output units is therefore
*
c( w 1 , w 2 , y )  w 1x1 ( w 1 , w 2 , y )
*
 w 2x 2 ( w 1 , w 2 , y ).
 Conditional Input Demands
 Given w1, w2 and y, how is the least
costly input bundle located?
 And how is the total cost function
computed?
 Iso-cost Lines
 A curve that contains all of the input
bundles that cost the same amount
is an iso-cost curve.
 E.g., given w1 and w2, the $100 iso-
cost line has the equation
w 1x1  w 2x 2  100.
 Iso-cost Lines
 Generally, given w1 and w2, the
equation of the $c iso-cost line is
w 1x1  w 2x 2  c
i.e.
w1 c
x2   x1  .
w2 w2
 Slope is - w1/w2.
 Iso-cost Lines
x2

c”  w1x1+w2x2

c’  w1x1+w2x2

c’ < c”

x1
 Iso-cost Lines
x2 Slopes = -w1/w2.

c”  w1x1+w2x2

c’  w1x1+w2x2

c’ < c”

x1
 The y’-Output Unit Isoquant
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

f(x1,x2)  y’
x1
The Cost-Minimization Problem
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

f(x1,x2)  y’
x1
The Cost-Minimization Problem
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

f(x1,x2)  y’
x1
The Cost-Minimization Problem
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

f(x1,x2)  y’
x1
The Cost-Minimization Problem
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

x2*
f(x1,x2)  y’
x1* x1
The Cost-Minimization Problem
At an interior cost-min input bundle:
x2 * *
(a) f ( x1 , x 2 )  y 

x2*
f(x1,x2)  y’
x1* x1
The Cost-Minimization Problem
At an interior cost-min input bundle:
x2 * *
(a) f ( x1 , x 2 )  y  and
(b) slope of isocost = slope of
isoquant

x2*
f(x1,x2)  y’
x1* x1
The Cost-Minimization Problem
At an interior cost-min input bundle:
x2 * *
(a) f ( x1 , x 2 )  y  and
(b) slope of isocost = slope of
isoquant; i.e.
w1 MP1
  TRS   at ( x*1 , x*2 ).
w2 MP2
x2*
f(x1,x2)  y’
x1* x1
 A Cobb-Douglas Example of
Cost Minimization
 A firm’s Cobb-Douglas production
function is
y  f ( x1 , x 2 )  x11/ 3x 22/ 3 .
 Input prices are w1 and w2.
 What are the firm’s conditional input
demand functions?
 A Cobb-Douglas Example of
Cost Minimization
At the input bundle (x1*,x2*) which minimizes
the cost of producing y output units:
(a) y  ( x*1 )1/ 3 ( x*2 ) 2/ 3 and

(b) * 2/ 3 * 2 / 3
w1  y /  x1 (1 / 3)( x1 ) (x2 )
  
w2  y /  x2 ( 2 / 3)( x*1 )1/ 3 ( x*2 ) 1/ 3
*
x2
 .
*
2x1
 A Cobb-Douglas Example of
Cost Minimization
w x*
* 1/ 3 * 2/ 3 1  2 .
(a) y  ( x1 ) ( x 2 ) (b)
w 2 2x*1
 A Cobb-Douglas Example of
Cost Minimization
w x*
* 1/ 3 * 2/ 3 1  2 .
(a) y  ( x1 ) ( x 2 ) (b)
w 2 2x*1
* 2w 1 *
From (b), x 2  x1 .
w2
 A Cobb-Douglas Example of
Cost Minimization
w x*
* 1/ 3 * 2/ 3 1  2 .
(a) y  ( x1 ) ( x 2 ) (b)
w 2 2x*1
* 2w 1 *
From (b), x 2  x1 .
w2
Now substitute into (a) to get
2/ 3
* 1/ 3  2w 1 * 
y  ( x1 )  x1 
 w2 
 A Cobb-Douglas Example of
Cost Minimization
w x*
* 1/ 3 * 2/ 3 1  2 .
(a) y  ( x1 ) ( x 2 ) (b)
w 2 2x*1
* 2w 1 *
From (b), x 2  x1 .
w2
Now substitute into (a) to get
2/ 3 2/ 3
* 1/ 3  2w 1 *   2w 1  *
y  ( x1 )  x1    x1 .
 w2   w2 
 A Cobb-Douglas Example of
Cost Minimization
w x*
* 1/ 3 * 2/ 3 1  2 .
(a) y  ( x1 ) ( x 2 ) (b)
w 2 2x*1
* 2w 1 *
From (b), x 2  x1 .
w2
Now substitute into (a) to get
2/ 3 2/ 3
* 1/ 3  2w 1 *   2w 1  *
y  ( x1 )  x1    x1 .
 w2   w2 
2/ 3
*  w2 
So x1    y is the firm’s conditional
 2w 1  demand for input 1.
 A Cobb-Douglas Example of
Cost Minimization 2/ 3
* 2w 1 * *  w2 
Since x 2  x1 and x1    y
w2  2w 1 
2/ 3 1/ 3
* 2w 1  w 2   2w 1 
x2    y  y
w 2  2w 1   w2 
is the firm’s conditional demand for input 2.
 A Cobb-Douglas Example of
Cost Minimization
So the cheapest input bundle yielding y
output units is

 * *
x1 ( w 1 , w 2 , y ), x 2 ( w 1 , w 2 , y ) 
  w  2/ 3  2w  1/ 3 
  2  y,  1
 y .
  2w 1   w 2  
 
Conditional Input Demand Curves
Fixed w1 and w2.

y
y
y
 Conditional Input Demand Curves
y
Fixed w1 and w2.

y

y x*2 ( y ) x*2

y
x*2 ( y ) y y
y
x*1 ( y ) x*1 ( y ) x*1
 Conditional Input Demand Curves
y
Fixed w1 and w2.

y
y

y x*2 ( y ) x*2
x*2 ( y )

x*2 ( y )
y y
x*2 ( y ) y y
y
x*1 ( y ) x*1 ( y ) x*1
x*1 ( y ) x*1 ( y )
 Conditional Input Demand Curves
y
Fixed w1 and w2.
y
y
y

y x*2 ( y ) x*2 ( y ) x*2

*
x*2 ( y ) x 2 ( y )
y
x*2 ( y )
y y
x*2 ( y ) y y
y
x*1 ( y ) x*1 ( y ) x*1 ( y ) x*1 ( y ) x*1
x*1 ( y ) x*1 ( y )
 Conditional Input Demand Curves
y
Fixed w1 and w2.
y
y
output
y
expansion
path y x*2 ( y ) x*2 ( y ) x*2
*
x*2 ( y ) x 2 ( y )
y
x*2 ( y )
y y
x*2 ( y ) y y
y
x*1 ( y ) x*1 ( y ) x*1 ( y ) x*1 ( y ) x*1
x*1 ( y ) x*1 ( y )
 Conditional Input Demand Curves
y Cond. demand
Fixed w1 and w2. for
y input 2
y
output
y
expansion
path y x*2 ( y ) x*2 ( y ) x*2
*
x*2 ( y ) x 2 ( y )
y Cond.
x*2 ( y ) demand
y y
x*2 ( y ) y for
y
y input 1
x*1 ( y ) x*1 ( y ) x*1 ( y ) x*1 ( y ) x*1
*
x*1 ( y ) x1 ( y )
 A Cobb-Douglas Example of
Cost Minimization
For the production function
y  f ( x1 , x 2 )  x11 / 3 x 22 / 3
the cheapest input bundle yielding y output
units is
 x*1 ( w 1 , w 2 , y ), x*2 ( w 1 , w 2 , y ) 
  w  2/ 3  2w  1/ 3 
  2  y,  1
 y .
  2w 1   w 2  
 
 A Cobb-Douglas Example of
Cost Minimization
So the firm’s total cost function is
c( w 1 , w 2 , y )  w 1x*1 ( w 1 , w 2 , y )  w 2x*2 ( w 1 , w 2 , y )
 A Cobb-Douglas Example of
Cost Minimization
So the firm’s total cost function is
* *
c( w 1 , w 2 , y )  w 1x1 ( w 1 , w 2 , y )  w 2x 2 ( w 1 , w 2 , y )
2/ 3 1/ 3
 w2   2w 1 
 w1   y  w2  y
 2w 1   w2 
 A Cobb-Douglas Example of
Cost Minimization
So the firm’s total cost function is
c( w 1 , w 2 , y )  w 1x*1 ( w 1 , w 2 , y )  w 2x*2 ( w 1 , w 2 , y )
2/ 3 1/ 3
 w2   2w 1 
 w1   y  w2  y
 2w 1   w2 
2/ 3
 1
  w 11/ 3 w 22/ 3 y  21/ 3 w 11/ 3 w 22/ 3 y
 2
 A Cobb-Douglas Example of
Cost Minimization
So the firm’s total cost function is
c( w 1 , w 2 , y )  w 1x*1 ( w 1 , w 2 , y )  w 2x*2 ( w 1 , w 2 , y )
2/ 3 1/ 3
 w2   2w 1 
 w1   y  w2  y
 2w 1   w2 
2/ 3
 1
  w 11/ 3 w 22/ 3 y  21/ 3 w 11/ 3 w 22/ 3 y
 2
2 1/ 3
 w 1w 2 
 3  y.
 4 