Economics 50: Intermediate Microeconomics

Summer 2010
Stanford University
Michael Bailey
Lecture 6: Cost Minimization and Cost Curves
Overview
The cost minimization problem (CMP) is for the rm to minimize its cost

w
i
x
i
subject to a pro-
duction constraint f(x
1
; :::; x
n
) = y
The CMP is solved by the conditional factor demand functions
The CMP is mathematically equivalent to the expenditure minimization problem
The cost function gives the lowest cost attainble given the prices and target output
The output expansion path is the set of conditional factor demands for all values of output
Using Shephards Lemma, the conditional factor demands can be derived from the cost function, and
sometimes can be used to recover the production function
A prot maximizing rm is a cost minimizing rm, and the rms supply function solves max py C(y)
A rm has economies of scale if average costs are decreasing in output,
@AC(y)
@y
< 0: A rm has
diseconomies of scale if average costs are increasing in output,
@AC(y)
@y
> 0
Economies of Scale == Increasing Returns to Scale
Neither == Constant Returns to Scale
Diseconomies of Scale == Decreasing Returns to Scale
The long-run cost is always less than the short-run cost. The long-run cost function is tangent to the
short-run cost function at the point when the short-run rm is constrained at the optimal long-run
level of inputs
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Cost Minimization
Suppose that instead of maximizing prots, the rm set a target level of output, y; and produced that level
of output in the cheapest way possible. The objective function of such a rm would be given by:
min

w
i
x
i
s.t. f(x
1
; :::; x
n
) = y
and is known as the cost minimization problem (sometimes referred to as the CMP). Notice the similarity
between this problem and the expenditure minimization problem that has min

p
i
x
i
s.t. u(x
1
; :::; x
n
) = u
as an objective function. In fact, the two problems are identical if we just relabel p = w, u() = f(); and
y = u:
Remark 1 The cost minimization problem and the expenditure minimization problem are identical (just
with dierent labels). The prot maximization problem is dierent from the utility maximization problem
because the rm is unconstrained.
Recall that the EMP has an optimality condition
px
py
=
MUx
MUy
. Hence, the optimality condition for the
cost minimization problem is
MP
L
MP
K
=
w
r
, or the ratio of marginal products must equal the ratio of input
prices. We would get the same result by solving the lagrangian for the problem:
L =

w
i
x
i
(f(x
1
; :::; x
n
) y)
which has rst order conditions:
@L
@x
i
= w
i

@f(x
1
; :::; x
n
)
x
i
= 0
== =
w
i
@f(x1;:::;xn)
xi
=
w
i
MP
xi
for all i
has an analogous interpretation to that of the EMP; if we relax the constraint by one unit, i.e. increase
target output, y; by one unit, the rm will have to increase its costs by
wi
MPx
i
to achieve this new level of
output. If we set two rst order conditions equal to each other, we would get:
=
w
i
MP
xi
=
w
j
MP
xj
==
w
i
w
j
=
MP
xi
MP
xj
Hence to solve the CMP, set
wi
wj
=
MPx
i
MPx
j
; and then substitute into the constraint f(x
1
; :::; x
n
) = y:
We could derive the same result graphically. If the isoquant is xed, the rm would minimize cost by
2
getting to the lowest iso-cost line (the budget line for the rm

w
i
x
i
= I is called an iso-cost line and is
the set of inputs that have the same cost) given it must produce on its isoquant. The minimum would be
where the iso-cost is tangent to the isoquant. The slope of the iso-cost is
wi
wj
and the slope of the isoquant
is TRS
xi;xj
=
MPx
i
MPx
j
, hence the tangency condition yields the same optimality condition:
wi
wj
=
MPx
i
MPx
j
:
0 1 2 3 4 5 6 7 8 9 10
0
1
2
3
4
5
6
7
8
9
10
L
K
Figure 1: The lowest iso-cost curve the rm can attain will be tangent to the given isoquant
Recall that the rms rst order conditions for prot maximization are p
y
MP
xi
= w
i
; the input price is
equal to the marginal revenue product. Taking the ratio of this condtion for two inputs:
p
y
MP
xi
p
y
MP
xj
=
w
i
w
j
==
MP
xi
MP
xj
=
w
i
w
j
which is the same optimality condition for the cost-minimizing rm. So the prot maximizing factor
demands satisfy the optimality condition for cost-minimization. Hence a prot maximizing rm produces
at a level that minimizes cost. Given the prot maximizing rm is maximizing revenue minus cost, it will
produce output in a way such that costs are as low as possible. The cost minimizing rm is not necessarily
a prot maximizer, it depends upon whether the constraint y is chosen in a prot maximizing way. Well
discuss this in more detail later.
Conditional Factor Demand and the Cost Function
Just as the EMP requires convexity and monotonicity for the Lagrangian Method to work, so does the CMP.
Before solving the CMP, we must check that the production function is concave and monotone. Because the
EMP and CMP are mathematically identical, you can review the problems we solved for the EMP and the
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answer to the CMP will be the same.
Example 2 f(L; K) = min(L; K)

; nd the level of inputs that produce y units of output at the lowest cost.
What is the cost of producing y in the cheapest way possible?
Note that the solution is where L = K: If L ,= K; then money is being spent on an input that is not
contributing to creating output.
L = K
== min(L; K)

= L

= K

Substituting this into the production constraint:

L

= K

= y
== L
C
(w; r; y) = K
C
(w; r; y) = y
1

The cost of producing y is:

Cost = C(w; r; y) = wL +rK
= wy
1

+ry
1

= (w +r)y
1

Denition 3 The cost minimization problem is solved by the conditional factor demands:
x
C
i
(w; y) = arg min

w
i
x
i
s.t. f(x
1
; :::; x
n
) = y
The conditional factor demands are the cheapest input bundle that can produce y given the production
function at the nput prices.
Denition 4 The cost function is the minimum cost of producing y given prices:
C(w; y) =

w
i
x
C
i
(w; y)
Just like in the EMP, the factor demands are homogenous of degree r = 0 in input prices (only depend
upon relative prices, slope of iso-cost line) and the cost function is homogenous of degree r = 1 in input
prices.
Example 5 f(L; K) = 4LK; prices are (w; r); nd the factor demand functions and the cost function.
4
f(L; K) is monotone in both inputs and is strictly concave. The optimality condition is:
MP
L
MP
K
=
4K
4L
=
K
L
=
w
r
== K =
w
r
L
== 4L
_
w
r
L
_
= y (subbing into production constraint)
== L
2
=
y
4
r
w
== L
C
(w; r; y) =
1
2
_
y
r
w
== K
C
(w; r; y) =
w
r
L =
1
2
_
y
w
r
C(w; r; y) = wL
C
(w; r; y) +rK
C
(w; r; y)
=
w
2
_
y
r
w
+
r
2
_
y
w
r
=
1
2
_
ywr +
1
2
_
ywr
=
_
ywr
Just like compensated demand, the conditional factor demand must slope downward. If the input price
of an input increases, the rm will substitute away from that input to produce y:
Figure 2: The conditional factor demands are downward sloping
5
Output Expansion Path
Denition 6 The output expansion path (OEC) is the set of conditional input demands for all values of
y R holding input prices constant.
The OEC is analogous to the ICC in consumer theory. The ICC is derived by increasing income and
plotting the optimal demands. The OEC is derived by expanding output and plotting the conditional input
demands. For the ICC, the budget line is expands outward, whereas for the OEC, the isoquants expand
outward. If the output expansion path slopes downward over some range, then one of the inputs is an inferior
input, meaning the rm would use less of that input to reach a higher level of output.
Figure 3: The output expansion path is the set of conditional factor demands for all levels of output
Example 7 f(L; K) = min(aL; bK)

Because the conditional input demands are just the set of kink points, aL = bK; the output expansion
path is just the line from the origin through the kink points, i.e the line K =
a
b
L:
Example 8 f(L; K) = (aL +bK)

The rm will use either labor or capital exclusively in production, so the OEC is either the x-axis (if
labor is cheaper) or the y-axis (if capital is cheaper). If they are equally expensive, the OEC is every positive
combination of (L; K):
Shephards Lemma
Shephards Lemma holds for the CMP as well as the EMP and allows us to derive the conditional input
demands from the cost function.
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Proposition 9 Shephards Lemma:
@C(w; y)
@w
i
= x
C
i
(w; y)
Example 10 C(w; r; y) =
_
ywr; given the cost function, derive the conditional factor demands.
@C(w; r; y)
@w
=
1
2
_
yrw
1=2
=
1
2
_
y
r
w
= L
C
(w; r; y)
@C(w; r; y)
@r
=
1
2
_
ywr
1=2
=
1
2
_
y
w
r
= K
C
(w; r; y)
Recovering the Production Function
We can use Shephards Lemma to recover the production function from the cost function. Shephards Lemma
gives us a system of equations in prices, output, and factor demand. By factoring out input prices, we are
left with a function of just factors and output which can be solved for the production function.
Example 11 C(w; r; y) =
_
ywr; solve for the production function that gives rise to this cost function.
By Shephards Lemma we have L
C
(w; r; y) =
1
2
_
y
r
w
and K
C
(w; r; y) =
1
2
_
y
w
r
: Solving both of these
functions so that they are a function of input prices:
L
C
(w; r; y) =
1
2
_
y
r
w
==
2L
_
y
=
_
r
w
K
C
(w; r; y) =
1
2
_
y
w
r
==
_
y
2K
=
_
r
w
We can combine these into an equation that is only a function of inputs and output and solve for the
production function:
2L
_
y
=
_
y
2K
y = 4LK
7
Relationship Between Prot Maximization and Cost Minimization
A prot maximizing rm is also a cost minimizer. This implies that the factor demand functions and the
conditional factor demand functions coincide at the level of output that maximizes prots, which is given by
the supply function:
x

i
(p
y
; w) = x
C
i
(w; y

(p
y
; w))
Another implication is that the prot maximization problem can be recast in terms of the cost function.
Maximizing prots is equivalent to maximizing the following objective function:
max
y
p
y
y C(w; r; y)
Hence the supply function solves:
y

(p
y
; w) = arg max p
y
y C(w; r; y)
and the prot function can be written as:
(p
y
; w) = p
y
y

(p
y
; w) C(w; r; y

(p
y
; w))
This is equivalent to a 2 stage maximization process: (1) nd the cheapest way of producing output, i.e.
nd the cost function C(w; r; y) (2) maximize prots = revenue costs = p
y
y C(w; r; y): Intuitively, if the
rm sets the target level of output as the prot maximizing one, and then produces it in the cheapest way
possible, prots will be maximized.
Example 12 f(L; K) = min(L; K)

; nd the cost function and use it to recover the supply function, the
prot function, and the factor demand for labor.
We found that the cost function is (w+r)y
1

and the conditional input demands are y

1

: We can nd the
8
prot function and supply function by maximizing the objective function:
max
y
p
y
y C(w; r; y)
= p
y
y (w +r)y
1

= y (w +r)y
1

(normalize p
y
= 1)
== 1 =
1

(w +r)y
1

(FOC)
== y
1

=

(w +r)
== y =
_

(w +r)
_

1
=
_
(w +r)

_

1
= y

(p
y
; w; r)
p
y
y

(p
y
; w) C(w; r; y

(p
y
; w))
=
_
(w +r)

_

1
(w +r)
_
(w +r)

_ 1
1
=
_
(w +r)

_ 1
1
_
(w +r)

(w +r)
_
= (p
y
; w; r)
L
C
(w; y

(p
y
; w; r)) =
_
_
(w +r)

_

1
_1

=
_
(w +r)

_ 1
1
= L

(p
y
; w; r)
Cost Curves
Because a prot-maximizing rm is a cost-minimizing rm, the cost functions of the rm inform us about
optimal rm behavior. By breaking down the rms cost function into its various components, we will be
able to draw insight about rm supply and general rm behavior in the short and long run. First, some
denitions:
Denition 13 Econonomic cost includes the opportunity cost of a decision, whereas accounting cost includes
only the numerical cost of the decision.
For example, suppose that the rm purchases a pile of lumbar for $100,000, and now has to decide whether
to use it in production, or resell it. The accounting cost of the lumbar is $100,000, what the rm paid for it.
The economic cost is the opportunity cost, or the next best use of that lumbar, which would be the amount
for which the rm could sell the lumbar. Economic costs are decision specic and thus always take into
account what you are giving up by making a decision. If the rm could resell the lumbar for $80,000, then
9
the economic cost of using the lumbar in production would be $80,000. If the cost of the lumbar went up to
$110,000, then the economic cost of using the lumbar would go up to $110,000, whereas the accounting cost
is always stuck at $100,000.
Notice that the economic cost is the same as the input price, as the input price changes, the opportunity
cost of using that input changes. In this class, all our costs include economic costs. If a rm has a machine,
the rental rate, r; is the value the rm could get by renting the machine to another rm. The wage of the
owner, which is often not included in accounting costs because the owner does not "pay" himself, would be
included in economic costs as the wages the owner would earn working at the next best rm. In a competitive
market, it is not uncommon for the rm to earn 0 economic prot. What accountants would refer to as
positive prot, is often just the unadjusted return to capital and owners for not including in economic costs.
Denition 14 Fixed costs are the costs incurred by the rm in the short run due to its xed factors of
production. There are no xed costs in the long run because no factor of production is xed. For example, if
capital is xed at K = K; and the rental rate of capital is r; then the xed costs of the rm in the short run
are rK:
Denition 15 Quasi-xed costs are those costs that are incurred if the rm produces, but are not dependent
upon the level of output. For example, if the rm has costs for opening the factory that do not depend upon
the output of the factory, those would be quasi-xed costs.
Denition 16 Variable costs are those costs that vary with the amount of output produced and are equal to
0 when output is 0:
Denition 17 Sunk costs are those costs that are non-recoverable. For example, if the rm buys a machine
for $100,000, and can resell it for $80,000, then $20,000 of the cost of the machine is sunk. Sunk costs do
not alter the decisions of the rm since they are lost no matter what the rm does. Notice that xed costs
do not necessarily equal to sunk costs, like in the previous example.
Suppose that input prices are not changing, we can treat them as exogenous variables and write the cost
function as C(w; y) = C(y): Notice that Cost is the sum of xed and variable costs:
C(y) = Fixed Costs + Variable Costs
= FC +V C(y)
10
The average cost is the average per-unit cost of producing output y :
Average Cost = AC(y) =
C(y)
y
=
FC
y
+
V C(y)
y
The marginal cost is the cost of producing the marginal unit of output:
Marginal Cost = MC(y) =
@C(y)
@y
=
@FC
@y
+
@V C(y)
@y
=
@V C(y)
@y
Notice that if we integrate marginal cost (take the area under the marginal cost curve), we get variable
cost:
_
MC(y) =
_
@V C(y)
@y
= V C(y)
== C(y) = FC +
_
y
0
MC(y)
Example 18 Suppose we wrote the short-run cost function generically as C(y) = wL(y) +rK: What is the
marginal cost of production?
MC(y) = w
@L(y)
@y
=
w
@y
@L(y)
=
w
MP
L
Intuitively, the marginal cost of production is the wage (the cost of increasing the amount of labor) times
by the amount of labor needed to produce one more unit (
1
MP
):
Example 19 C(y) = y
3
+ 7: What are the xed costs of production? The variable costs? What are the
marginal and average costs of production?
FC = 7
V C(y) = y
3
AC(y) =
y
3
+ 7
y
= y
2
+
7
y
MC(y) = 3y
2
Remark 20 If the marginal cost is above the average cost, the average cost is increasing. If the marginal
11
0 1 2 3 4 5
0
10
20
30
y
Cost
Figure 4: Graph of FC = 7; V C(y) = y
3
; and C(y) = y
3
+ 7: The dierence between cost and variable cost
is the xed cost
cost is below the average cost, the average cost is decreasing. The marginal cost goes through the minimum
of the average cost.
12
0 1 2 3 4 5
0
10
20
30
y
Cost
Figure 5: Graph of
FC
y
=
7
y
; AV C(y) = y
2
; and AC(y) = y
2
+
7
y
: Notice that average xed costs are always
falling, average variable costs are always increasing, and average costs are decreasing and then increasing
0 1 2 3 4 5
0
2
4
6
8
10
12
14
y
Cost
Figure 6: Graph of AC(y) =
y
3
+7
y
and MC(y) = 3y
2
13
Returns to Scale and Cost Functions
If a rm operates with a constant returns to scale technology, then the lowest cost of producing units of
output, is C(1) where C(1) is the lowest cost of producing 1 unit of output. This is because the rm can
just scale up its cost minimizing inputs that produced one of output in the cheapest way and achieve an
output on the same scale. If a rm has constant returns to scale, we can write its average cost and marginal
cost as:
AC(y) =
C(y)
y
=
C(1)y
y
= C(1)
MC(Y ) =
@C(y)
@y
=
@(C(1)y)
@y
= C(1)
If a rm has CRTS, its marginal cost and average cost are equal to each other and are constant.
Example 21 A rm has a production function f(L; K) = (LK)
1
2
; what is its average and marginal cost
when all input prices are equal to one?
The cheapest way this rm can produce one of output is by using one unit of labor and unit of capital,
thus C(1) = 1 + 1 = 2: Since the production function has CRTS, we know that AC = MC = 2: If we
had solved for the cost function explicity from the CMP, we would get that C(w; r; y) = 2y
_
wr = 2y; and
MC = AC = 2:
Economies of Scale
An important question is how do average costs change as output changes, or how do costs change as the rm
"scales up". A rm whose costs per unit are falling as scale is increasing is said to have economies of scale.
Denition 22 A rm has economies of scale if average costs are decreasing in output,
@AC(y)
@y
< 0: A rm
has diseconomies of scale if average costs are increasing in output,
@AC(y)
@y
> 0:
Economies of Scale == Increasing Returns to Scale
Neither == Constant Returns to Scale
Diseconomies of Scale == Decreasing Returns to Scale
To see why this relationship between returns to scale and economies of scale holds, suppose that the rm
doubled its inputs. This change would double its costs (

w
i
2x
i
= 2

w
i
x
i
): If the rm has CRTS, it
will end up producing exactly twice as much output, so average costs are constant. If it has IRTS, it will
more than double its output, and so average costs per unit must decrease. Similarly, if it has DRTS costs
per unit must increase.
14
An alternative way of determining economies of scale is to look at the elasticity of cost with respect to
output:
"
C;y
=
%C(y)
%y
=
@C(y)
y
y
C(y)
= MC(y)
1
AC(y)
If MC(y) > AC(y); AC(y) must be increasing, and if MC(y) < AC(y); AC(y) must be decreasing.
Therefore:
Economies of Scale == "
C;y
< 1
Neither == "
C;y
= 1
Diseconomies of Scale == "
C;y
> 1
Example 23 C(y) = y
3
+ 7; AC(y) = y
2
+
7
y
@AC(y)
@y
= 2y 7y
2
@AC(y)
@y
< 0 ==
2y < 7y
2
== y
3
<
7
2
The rm has economies of scale when y <
_
7
2
_1
3
; and diseconomies of scale otherwise.
0 1 2 3 4 5
0
2
4
6
8
10
12
14
y
Cost
Figure 7: The rm has economies of scale until y =
_
7
2
_1
3
Economists tend to characterize rms as initially having economies of scale, and then reverting to disec-
onomies of scale. For small amounts of input, the rm can benet greatly from specialization in production,
15
but eventually those benets and other constraints means the rm faces decreasing returns to scale.
Short-run versus Long-run Cost
The short-run cost is always larger than the long-run cost, except at the output when the factors that are
xed in the short run are optimal for the long-run problem. It should be intuitive that the rm can always
achieve a lower cost in the long run because it can freely choose all the inputs of production whereas in the
short run some factors of production are xed.
Figure 8: The short-run cost conditional factor demands (black) when capital is xed always lie on a higher
iso-cost then the long-run conditional factor demands (red). At the level of output when the xed level of
input is optimal in the long-run, the short-run and long-run costs coincide
16
Figure 9: The short-run cost is always higher than the long-run cost, except at the level of output when the
xed factor is the optimal long-run choice
The long-run cost curve will thus lie below every short-run cost curve (where the set of short run cost
curves is the set of curves C(y; K) for all values of the xed input K) and be equal to each short run cost
curve at the level of output such that the xed level of output for that short-run curve is the optimal level ot
the input in the long-run problem. Thereofre, the long-run curve is just the lower envelope of the short-run
curves. The short-run average cost and long-run average cost curves thus have the same relationship. as the
short and long-run cost curves.
The long-run marginal cost goes through the minimum of the long-run average cost curve. Each short-run
marginal cost curve intersects the long-run marginal cost at the output when the short-run average cost is
tangent to the long-run average cost.
17
Figure 10: Short-run and long-run average cost
Figure 11: The long-run cost is tangent to every short-run cost curve, and is thus the lower envelope of all
the short-run cost curves
18
Figure 12: Each short-run marginal cost curve goes through the minimum of short-run average cost. The
rm operates on the marginal cost curve for the short-run average cost that is tangent to the long-run average
cost
Figure 13: The long-run average cost curve goes through the minimum of the long-run average cost, and is
equal to the short-run marginal cost where the short-run and long-run average cost curves are tangent
19
20
Example 24 C(y; K) = K +
y
2
K
To nd the long-run cost function, we nd the level of the xed factor K such that rm achieves the
lowest cost:
min
K
K +
y
2
K
== 1 y
2
K
2
= 0
== K = y
== C(y) = y +
y
2
y
= 2y
0 1 2 3 4 5
0
1
2
3
4
5
y
Cost
Figure 14: Long-run cost and a set of short-run cost functions
AC(y) = 2
AC(y; K) =
K
y
+
y
K
Example 25 f(L; K) = 4LK; nd the short-run and long-run cost function.
21
0 1 2 3 4 5
0
1
2
3
4
5
y
Cost
Figure 15: Long-run average cost and a set of short-run average cost functions
Notice that the short-run factor demand for L has to satisfy the output constraint:
4LK = y
== L
C
(y; K) =
y
4K
== C(y; K) = wL +rK
= w
y
4K
+rK
To nd the long-run cost function, we nd the value of the xed factor that minimizes the short-run cost
function:
min
K
w
y
4K
+rK
==
wy
4
K
2
+r = 0
== K
2
=
wy
4r
== K =
1
2
_
wy
r
== C(y) = w
y
4
1
2
_
wy
r
+r
1
2
_
wy
r
=
1
2
_
wyr +
1
2
_
wyr
=
_
wyr
22
0 10 20 30 40 50
0
1
2
3
4
5
6
7
8
9
10
y
Cost
Figure 16: Long-run cost and a set of short-run cost functions when w = r = 1
AC(y) =
_
wr
y
AC(y; K) =
w
4K
+
rK
y
0 10 20 30 40 50
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
y
Cost
Figure 17: Long-run average cost and a set of short-run average cost functions when w = r = 1
23