Conditional factor demand and cost functions with a

Cobb-Douglas production function

EC201 LSE
Margaret Bray
November 19, 2010

1 Introduction
This note is about nding conditional factor demand and rst the long run and then the short run cost
function with a Cobb-Douglas production function f (K; L) = K 1=4 L3=4 . As explained in the notes
on cost functions the long run total cost function is often called simply the cost function. Conditional
factor demand and the cost function in producer theory correspond exactly to compensated demand
and the expenditure function in consumer theory and are found in the same way.

2 Finding conditional factor demand with a Cobb-Douglas pro-

duction function
This explanation was produced by copying and pasting from Consumer Theory Worked Example 2 on
checking for convexity and nonsatiation and the relevant parts of Consumer Theory Worked Example
4 on compensated demand and the expenditure function, and then changing notation.
In the exam a solution without any explanation gets around 50%. To get good marks you must write
out something equivalent to the things in italics below. You can be less wordy, and use abbreviations,
e.g. MRTS for marginal rate of technical substitution.

2.1 Step 1: What problem are you solving?

Conditional factor demand K(v; w; q) and L(v; w; q) is dened as the quantities of K and L that
minimize the cost vK + wL subject to the output constraint f (K; L) q and the nonnegativity
constraints K 0 and L 0.

2.2 Step 2: What is the solution a function of?

conditional factor demand is a function of input prices v and w, and output q.

2.3 Step 3: Check whether increasing one or both inputs increases output
and for convexity.
The condition that increasing one or both inputs increases output is the equivalent for producer theory
of the nonsatiation condition for consumer theory. Here
@f @f
As = 14 K 3=4
L1=4 > 0 and = 34 K 1=4 L 1=4
> 0 increasing one or both inputs increases
@K @L
output.

1
 Rearranging the production equation K 1=4 L3=4 = q to get K as a function of L gives

K = q4 L 3
:

The rst derivative is

@K
= 3q 4 L 4
<0
@L
the second derivative is
@2K
= 12q 4 L 5 > 0
@L2
so as the isoquant considered as a function giving K as a function has a strictly positive (> 0)
second derivative so is convex.
.
As output is an increasing function of inputs and the and convexity condition is satised any point
on the isoquant f (K; L) = q where the isoquant is tangent to an isocost line and satises the
nonnegativity constraints K 0, L 0 minimizes the cost subject to the output and nonnegativity
constraints.

2.4 Step 4: Use the tangency and output conditions.

The output condition is
K 1=4 L3=4 = q
The tangency condition is setting the marginal rate of technical substitution equal to the price ratio, that
is
@f
@L = w :
@f v
@K
As
@f 3 1=4 1=4
= K L
@L 4
@f 1
= K 3=4 L3=4
@K 4
the marginal rate of technical substitution is
@f
3
@L = 4 K 1=4 L 1=4 3K
1 =
@f K 3=4 L3=4 L
4
@K
so the tangency condition is
3K w
=
L v

2.5 Step 5: Draw a diagram based on the tangency and output conditions.
This is gure 1. This gure was drawn with a computer, you are not expected to do this. However the
important point about this diagram is that the isoquants are downward sloping because the nonsatiation
condition is satised and convex because the convexity condition is satised and the isoquants do not
meet the axes. To see why the isoquants do not meet the axes note that f (K; L) = 0 on the axes
where one or both of K and L are zero, and f (K; L) > 0 when K > 0 and L > 0 so no isoquant that
passes through a point where K > 0 and L > 0 can meet either axis.

2
 output condition
K1/4L3/4 = q
K tangency condition
MRTS = 3K = w
L v

0 L

Figure 1: The tangency and output conditions for a Cobb-Douglas production function.

2.6 Step 6: Remind yourself what you nding and what it depends on.
It is not essential to write this out, but you do need to think about it. Refer back to step 2 to remind
yourself that you are nding K and L as functions of v; w and q.

2.7 Step 7: Write down the equations to be solved.

You have already done this for step 4, so there is no need to write the conditions out unless it is helpful
to you to do so. These are the output condition and the tangency condition:

K 1=4 L3=4 = q (1)

3K w
= (2)
L v

2.8 Step 8: Solve the equations and write down the solution as a function.
You need to solve equations 1 and 2 simultaneously for L and K. The easiest way to do this is to
rearrange equation 1 to get K.
Rearranging the marginal rate of technical substitution to get K in terms of L, w and v gives
wL
K= : (3)
3v
Substituting for K in the production function K 1=4 L3=4 = q gives.
1=4
wL
L3=4 =q
3v

3
which is equivalent to
w 1=4
L =q
3v
so
1=4
3v
L= q:
w
wL
As K = 3v this implies that
w 3=4
K= q:
3v
Thus conditional factor demand is

w 3=4
K (v; w; q) = q (4)
3v
1=4
3v
L (v; w; q) = q: (5)
w

3 The cost function with Cobb-Douglas output

The cost function c (w; v; q) is the minimum the cost needed to get output q at prices w and v, so the
cost function is

c (w; v; q) = wK(v; w; q) + vL(v; w; q)

which given conditional factor demand (equations 4 and 5) is
" #
1=4
w 3=4 3v
c (w; v; q) = v q+w q
3v w
" #
3=4
1 1=4
= +3 v 1=4 w3=4 q:
3

This is the long run total cost function. The long run marginal cost function is
" #
3=4
@c (w; v; q) 1 1=4
= +3 v 1=4 w3=4
@q 3

The long run average cost function is

" #
3=4
c (w; v; q) 1 1=4
= +3 v 1=4 w3=4 :
q 3

In this case the long run marginal and average cost functions are equal to each other and do not depend
on q. This reects the fact that with this Cobb-Douglas production function if m > 0
1=4 3=4
f (mK; mL) = (mK) (mL) = mK 1=4 L3=4 = mf (K; L)

so there are constant returns to scale. Not all Cobb-Douglas production functions display constant
returns to scale. If there are not constant returns to scale the marginal and average long cost functions
are generally dierent from each other and vary with output q.
The cost function I have just derived assumes that all inputs are variable, it is also known as the
long run cost function, or sometimes long run total cost function.

4
4 Short run cost functions
In the short run K is xed so to produce output q it is necessary to have at least an amount of labour
L that satises the production equation K 1=4 L3=4 = q, which implies that
1=3 4=3
L=K q :

With these quantities of capital and labour the total cost of producing output q, that is the short run
total cost function is
s (v; w; K; q) = vK + wL = vK + wK 1=3 q 4=3 :
The short run marginal cost (SRMC) function is

@s (v; w; K; q) 4 1=3 1=3

= wK q
@q 3

and the short run average cost function (SRAC) (sometimes called the short run average total cost
function is
s (v; w; K; q) vK
= + wK 1=3 q 1=3 :
q q
Because capital K is not an opportunity cost in the short run because it cannot be varied it is useful
to divide the short run total cost function into two parts, the xed cost vK and the variable cost
wK 1=3 q 4=3 . Because the xed cost does not depend on q the derivative of short run variable cost
and short run total cost with respect to q are the same; this is short run marginal cost. However short
run average variable cost (SRAVC) here is
1=3 4=3
wK q 1=3 1=3
= wK q :
q
Because there is a xed cost short run average variable cost is less than short run average total cost.
Note that here

5 Supply functions
As with any rm with a constant returns to scale production function the long run marginal and average
cost functions are equal to each other and do not vary with output, so the rms long run supply function
is a horizontal straight line at the level of marginal cost; in this case the level is
The short run supply function is the portion of the short run marginal cost function that is above
the short run average variable cost function. Here
4 1=3 1=3 1=3 1=3
SRM C = wK q > wK q = SRAV C
3
so if the price is strictly positive (> 0) and equal to SRMC it is necessarily greater than SRAVC at the
same level of output. Thus the short run supply function is the short run marginal cost function.