COST
MINIMIZATION
SUBHRA
K.
BHATTACHARYA
FALL
2015
SNU
Produc>on:
Inputs
and
Outputs
• Firm
uses
the
available
technology
to
convert
(factors
of
produc>on)
into
OUTPUTS.
• The
inputs
are
the
factors
of
produc>on,
that
goes
into
the
produc>on
process,
oRen
classified
into
broad
categories
Capital,
Labor
and
Raw
Materials..
• Output
is
the
outcome
of
the
produc>on
process.
Produc>on
Process
• We
assume
there
are
broadly
two
categories
of
input
in
the
produc>on
process,
Labor
(L)
and
Capital
(K).
Also,
for
the
>me
being,
lets
focus
on
Long
Run,
when
both
the
factors
are
variable.
• The
produc>on
func>on
is
given
by:
Q=F(L,
K),
which
gives
the
maximum
level
of
output
that
can
be
produced
from
the
given
set
of
inputs.
The
produc>on
set
is:
Q
<=
F(L,
K).
Produc>on
Func>on
and
Set
ISOQUANTS
• Def:
An
isoquant
is
a
locus
of
combina>ons
of
all
the
inputs
in
a
produc>on
process
that
produces
same
level
of
output.
• Given
the
produc>on
func>on
Q=F(L,
K),
the
equa>on
of
isoquant
is
given
by
level
sets
of
the
produc>on
func>on,
F(L,
K)=
a
constant.
• Slope
of
the
isoquant
is
termed
Marginal
Rate
of
Technical
Subs>tu>on
(MRTS).
MRTS
• The
MRTS
gives
the
rate
of
exchange
between
both
the
inputs
so
that
total
output
remains
the
same.
• Illustra>on:
Reducing
one
unit
of
labor
reduces
the
output
by
MPL.
Now
adding
a
unit
of
capital
adds
MPK
amount
of
total
output.
The
number
of
capital
that
would
exactly
match
the
loss
of
labor
is
given
by
MPL/MPK,
which
is
termed
as
MRTS.
• Remember:
Marginal
Product
is
defined
as
the
increase
in
total
produc>on
due
to
increase
in
a
factor
of
produc>on
by
one
unit.
Proper>es
of
Isoquants
• Monotonic:
Increasing
at
least
one
of
the
inputs
should
enable
you
to
produce
at
least
what
you
were
producing
before.
• Convex
Technology:
you
have
two
ways
to
produce
y
units
of
output,
(x1,
x2)
and
(z1,
z2),
then
their
weighted
average
will
produce
at
least
y
units
of
output.
• Diminishing
MRTS
Objec>ve
• The
objec>ve
of
a
firm,
usually,
is
to
maximize
profit.
Profit
is
defined
as
the
difference
between
total
revenue
and
total
cost.
• Total
revenue
=
P
.
Total
Output.
• Profit
=
P.
Q
–
C
(Q)
• Total
Cost
is
the
total
opportunity
cost
of
all
the
factors
used
in
the
produc>on
process.
Assuming
there
are
two
factors
of
produc>on,
Labor
(L),
and
Capital
(K),
and
their
prices
are
fixed
at
w
and
r
respec>vely,
then
total
cost
is
(wL
+
rK).
Cost
Minimiza>on
• One
way
to
achieve
the
objec>ve
of
profit
maximiza>on
is
to
minimize
the
cost
of
produc>on.
• The
Problem
is
to
find
the
combina>on
of
both
the
factors
of
produc>on,
L
and
K,
such
that
a
given
amount
of
output
can
be
produced
in
a
least
costly
way.
• We
are
assuming
that
both
the
factors
are
freely
variable
in
this
process.
Cost
Minimiza>on:
The
Problem
• Minimize
wL
+
rK
subject
to
F(L,
K)=Q.
• Constraint
in
this
problem
is
the
given
level
of
output,
so
we
first
draw
the
isoquant
that
shows
all
the
input
combina>ons
that
produces
Q.
• Next,
we
find
the
cheapest
possible
one
from
amongst
all
those
feasible
combina>ons
that
produce
the
desired
output
level
Q.
Iso-‐Cost
Lines
• All
the
combina>ons
of
inputs
that
have
some
given
level
of
cost,
wL
+
rK
=
C,
which
can
be
rearranged:
K
=
C/r−
(w/r)
L.
• This
is
a
straight
line
with
a
slope
of
−(w/r)
and
a
ver>cal
intercept
of
C/r.
Every
point
on
an
isocost
curve
has
the
same
cost,
C,
and
higher
isocost
lines
are
associated
with
higher
costs.
• Find
the
point
on
the
isoquant
that
has
the
lowest
possible
isocost
line
associated
with
it.
Cost
Minimiza>on
Equilibrium
• At
the
cost
minimizing
point,
isocost
line
is
tangent
to
isoquant,
which
means
the
slope
of
those
two
curves
are
the
same.
• MRTS
(MPL/MPK)
=
Factor
Price
Ra>o
(w/r),
which
can
be
rewrifen
as
w/MPL=r/MPK.
The
last
unit
of
output
produced
using
either
of
the
factors
of
produc>on
costs
exactly
the
same,
so
that
it
is
impossible
to
reshuffle
and
reduce
cost.
Cost
Func>on
• The
choices
of
inputs
that
yield
minimal
costs
for
the
firm
will
in
general
depend
on
the
input
prices
and
the
level
of
output.
• L(w,
r,
Q)
and
K(w,
r,
Q).
These
are
called
the
condi>onal
factor
demand
func>ons,
or
derived
factor
demands.
• The
solu>on
to
this
cost-‐minimiza>on
problem—
the
minimum
costs
necessary
to
achieve
the
desired
level
of
output,
is
termed
Cost
Func>on,
C(w,
r,
Q).
A
Worked
Out
Example
• Produc>on:
Q
=
K^{1/2}L^{1/2}
• Cost:
wL
+
rK
=
C
• Op>mality:
MRTS
=
K/L
=
w/r
• Op>mal
K
=
(w/r)
L
• Subs>tute
that
into
the
constraint:
Q
=
L^{1/2}
(w/r)^{1/2}
L^{1/2}
=
L
(w/r)^{1/2}
• Condi>onal
factor
Demand:
L
=
Q
(r/w)^{1/2};
• K
=
Q
(w/r)^{1/2}
• Cost
wL
+
rK
