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Lecture Notes 3

The document discusses the minimization of production costs given labor and capital inputs, defining total cost as TC(q) = min wl + rk, subject to the production function f(k, l) ≥ q. It introduces input demand functions and optimal solutions characterized by the marginal product ratios, while also addressing corner solutions and the impact of price changes on input employment. An example using a Cobb-Douglas technology illustrates the derivation of cost functions, average costs, and marginal costs, highlighting the distinction between fixed and variable costs.

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13 views1 page

Lecture Notes 3

The document discusses the minimization of production costs given labor and capital inputs, defining total cost as TC(q) = min wl + rk, subject to the production function f(k, l) ≥ q. It introduces input demand functions and optimal solutions characterized by the marginal product ratios, while also addressing corner solutions and the impact of price changes on input employment. An example using a Cobb-Douglas technology illustrates the derivation of cost functions, average costs, and marginal costs, highlighting the distinction between fixed and variable costs.

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menocarehonestly
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© © All Rights Reserved
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30 3.

2 Costs

Consider now a problem of minimizing the costs of producing output q given


technology f . Assume that price of a unit of labor is w (e.g. hourly wage of unskilled
worker) while renting price of capital is r. The total (minimum) cost of producing q
is hence:

T C(q) = min wl + rk,


k,l≥0
s.t. f (k, l) ≥ q.

The solutions to this minimization problem are called input demand functions and
are denoted by l∗ (q, w, r), k ∗ (q, w, r). For quasiconcave and differentiable f , optimal
(and interior) solution to this problem is characterized by:

M Pk M Pl
= ,
r w
or equivalently: M RT Sk,l = wr , hence the rate at which the firm wants to exchange
inputs along the isoquant must be equal to the rate at which the market can exchange
both inputs3 . For corner solutions the condition may not hold. However, since there
are only two inputs considered in the optimization problem, there are only two corner
solutions, which need to be verified, i.e. (k = 0, l > 0) or (k > 0, l = 0). Hence, one
need to compare the costs of wl with rk such that q = f (0, l) = f (k, 0).
If the ratio of prices changes, typically firms’ change their input employment. We
can analyze this by observing how the optimal l∗ (q, w, r), k ∗ (q, w, r) vary with prices.
Consider the following example.

Example 3.5 (Cost function for a Cobb-Douglas technology) Let prices w, r


2
be given and consider f (k, l) = k .5 l.5 . Solving q = k .5 l.5 for k gives isoquant k = ql .
2
Putting that to the optimization problem T C(q) = minl≥0 wl + r ql , where the first
2
order condition for interior optimal l∗ is w = r (lq∗ )2 and hence l∗ (q, w, r) = q wr ,
p

that is decreasing in w, increasing in r, and linear in q. The total costs function is


√
hence T C(q) = 2q rw.
T C(q)
Having derived the cost function we define average costs as AC = q and
4T C(q) T C(q+δ)−T C(q) T C(q+δ)−T C(q)
marginal costs M C = 4q= =
(q+δ)−q ,
for small increase
δ
0
δ in production, or simply M C(q) = T C (q) for differentiable total costs function. If
some part of the total costs does not change with q (i.e. F C = T C(0)), we call this
a fixed costs and write T C(q) = F C + V C(q) or AC(q) = FqC + V C(q) q . Notice that
fixed costs can be either sunk or not. Can you think of some examples?
3 Recall
the condition for optimal consumption bundle in the consumer choice problem, discussed
in chapter 2.2. Again, the similarity of the two conditions will be important in the general equilibrium
analysis.

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