Chapter 8

COST FUNCTIONS

Copyright ©2005 by South-western, a division of Thomson learning. All rights reserved. c

 ¦efinitions of Costs
½ It is important to differentiate between
accounting cost and economic cost
± the accountant¶s view of cost stresses out-
of-pocket expenses, historical costs,
depreciation, and other bookkeeping
entries
± economists focus more on opportunity cost


 ¦efinitions of Costs
½ abor Costs
± to accountants, expenditures on labor are
current expenses and hence costs of
production
± to economists, labor is an explicit cost
½ labor services are contracted at some hourly
wage (©) and it is assumed that this is also
what the labor could earn in alternative
employment

G
 ¦efinitions of Costs
½ Capital Costs
± accountants use the historical price of the
capital and apply some depreciation rule to
determine current costs
± economists refer to the capital¶s original price
as a ³sunk cost´ and instead regard the
implicit cost of the capital to be what
someone else would be willing to pay for its
use
½ we will use  to denote the rental rate for capital
º
 ¦efinitions of Costs
½ Costs of Entrepreneurial Services
± accountants believe that the owner of a firm
is entitled to all profits
½ revenues or losses left over after paying all input
costs
± economists consider the opportunity costs of
time and funds that owners devote to the
operation of their firms
½ part of accounting profits would be considered as
entrepreneurial costs by economists
M
 ÿ onomi Cost
½ The economic cost of any input is the
payment required to keep that input in
its present employment
± the remuneration the input would receive in
its best alternative employment


9 o Simplifying Assumptions
½ There are only two inputs
± homogeneous labor (a), measured in labor-
hours
± homogeneous capital (), measured in
machine-hours
½ entrepreneurial costs are included in capital costs
½ Inputs are hired in perfectly competitive
markets
± firms are price takers in input markets
·
 ÿ onomi Profits
½ Total costs for the firm are given by
total costs =  = ©a ë 
½ Total revenue for the firm is given by
total revenue =
= (,a)
½ Economic profits (9) are equal to
9 = total revenue - total cost
9 =
- ©a - 
9 = (,a) - ©a - 
m
 ÿ onomi Profits
½ Economic profits are a function of the
amount of capital and labor employed
± we could examine how a firm would choose
 and a to maximize profit
½ ³derived demand´ theory of labor and capital
inputs
± for now, we will assume that the firm has
already chosen its output level (
0) and
wants to minimize its costs
Õ
Cost-Minimizing Input Choi es
½ To minimize the cost of producing a
given level of output, a firm should
choose a point on the isoquant at which
the ‘
is equal to the ratio ©/
± it should equate the rate at which can be
traded for a in the productive process to the
rate at which they can be traded in the
marketplace

c
Cost-Minimizing Input Choi es
½
athematically, we seek to minimize
total costs given
= (,a) =
0
½ Setting up the agrangian:
^ = ©a ë  ë VŒ
0 - (,a)]
½ First order conditions are
0^„0a = © - V(0„0a) = 0
0^„0 =  - V(0„0) = 0
0^„0V =
0 - (,a) = 0
cc
Cost-Minimizing Input Choi es
½ ividing the first two conditions we get
  a
å å
 a for 
  

½ The cost-minimizing firm should equate

the ‘
for the two inputs to the ratio of
their prices

c
Cost-Minimizing Input Choi es
½ Cross-multiplying, we get
 a
å
 ©

½ For costs to be minimized, the marginal

productivity per dollar spent should be
the same for all inputs

cG
Cost-Minimizing Input Choi es
½ Note that this equation¶s inverse is also
of interest


V
a 

½ The agrangian multiplier shows how

much in extra costs would be incurred
by increasing the output constraint
slightly
cº
Cost-Minimizing Input Choi es
üiven output
0, we wish to find the least costly
point on the isoquant
 per period
Costs are represented by
1 parallel lines with a slope of -
3 ©/
2

1 < 2 < 3



a per period
cM
Cost-Minimizing Input Choi es
The minimum cost of producing
0 is 2

 per period This occurs at the

tangency between the
1

3
isoquant and the total cost
curve
2

 The optimal choice

 is a*, *

a per period
a c
Contingent ¦emand for Inputs
½ In Chapter 4, we considered an
individual¶s expenditure-minimization
problem
± we used this technique to develop the
compensated demand for a good
½ Can we develop a firm¶s demand for an
input in the same way?

c·
Contingent ¦emand for Inputs
½ In the present case, cost minimization
leads to a demand for capital and labor
that is contingent on the level of output
being produced
½ The demand for an input is a derived
demand
± it is based on the level of the firm¶s output

cm
 9he Firm¶s ÿ
pansion Path
½ The firm can determine the cost-
minimizing combinations of  and a for
every level of output
½ If input costs remain constant for all
amounts of  and a the firm may
demand, we can trace the locus of cost-
minimizing choices
± called the firm¶s expansion path
cÕ
 9he Firm¶s ÿ
pansion Path
The expansion path is the locus of cost-
minimizing tangencies
 per period The curve shows
how inputs increase
ÿ
as output increases

1

0

00
a per period

 9he Firm¶s ÿ
pansion Path
½ The expansion path does not have to be
a straight line
± the use of some inputs may increase faster
than others as output expands
½ depends on the shape of the isoquants
½ The expansion path does not have to be
upward sloping
± if the use of an input falls as output expands,
that input is an inferior input
c
 Cost Minimization
½ Suppose that the production function is
Cobb-ouglas:

= ÿa
½ The agrangian expression for cost
minimization of producing
0 is
^ =  ë ©a ë V(
0 -  ÿ a )


 Cost Minimization
½ The first-order conditions for a minimum
are
0^„0 =  - Vÿ ÿ-1a = 0
0^„0a = © - V  ÿa -1 =0
0^„0V =
0 -  ÿ a = 0

G
 Cost Minimization
½ ividing the first equation by the second
gives us

 c
  a  
å
c 
å å‘


 a
a

½ This production function is homothetic

± the ‘
depends only on the ratio of the two
inputs
± the expansion path is a straight line
º
 Cost Minimization
½ Suppose that the production function is
CES:

= ( † ë a †)/†
½ The agrangian expression for cost
minimization of producing
0 is
^ =  ë ©a ë VŒ
0 - ( † ë a †)/†]

M
 Cost Minimization
½ The first-order conditions for a minimum
are
0^„0 =  - V(/†)(† ë a†)(-†)/†(†)†-1 = 0
0^„0a = © - V(/†)(† ë a†)(-†)/†(†)a†-1 = 0
0^„0V =
0 - ( † ë a †)/† = 0


 Cost Minimization
½ ividing the first equation by the second
gives us
´

     




  a a

½ This production function is also

homothetic

·
 9otal Cost Fun tion
½ The total cost function shows that for
any set of input costs and for any output
level, the minimum cost incurred by the
firm is
 = (,©,
)
½ As output (
) increases, total costs
increase

m
 Average Cost Fun tion
½ The average cost function () is found
by computing total costs per unit of
output
( )
average cost å  ( )å

Õ
 Marginal Cost Fun tion
½ The marginal cost function () is
found by computing the change in total
costs for a change in output produced
0
£

   
£
0

G
 üraphi al Analysis of
9otal Costs
½ Suppose that 1 units of capital and a1
units of labor input are required to
produce one unit of output
(
=1) = 1 ë ©a1
½ To produce J units of output (assuming
constant returns to scale)
(
=J) = J1 ë ©Ja1 = J(1 ë ©a1)
(
=J) = J * (
=1)
Gc
 üraphi al Analysis of
9otal Costs
Total With constant returns to scale, total costs
costs are proportional to output
 = 


Both  and
 will be
constant

Output
G
 üraphi al Analysis of
9otal Costs
½ Suppose instead that total costs start
out as concave and then becomes
convex as output increases
± one possible explanation for this is that
there is a third factor of production that is
fixed as capital and labor usage expands
± total costs begin rising rapidly after
diminishing returns set in
GG
 üraphi al Analysis of
9otal Costs
Total 
costs

Total costs rise

dramatically as
output increases
after diminishing
returns set in

Output
Gº
 üraphi al Analysis of
9otal Costs
Average
and  is the slope of the  curve
marginal
costs 
If > ,

 must be
falling

If < ,
min 
 must be
rising
Output
GM
 Shifts in Cost Curves
½ The cost curves are drawn under the
assumption that input prices and the
level of technology are held constant
± any change in these factors will cause the
cost curves to shift

G
 Some Illustrative Cost
Fun tions
½ Suppose we have a fixed proportions
technology such that

= (,a) = min(,a)
½ roduction will occur at the vertex of the
-shaped isoquants (
= a)
(©,,
) =  ë ©a = (
/) ë ©(
/)





£ å   Ë
 d G·
 Some Illustrative Cost
Fun tions
½ Suppose we have a Cobb-ouglas
technology such that

= (,a) =  ÿa
½ Cost minimization requires that



 *
a

 * * aV


Gm
 Some Illustrative Cost
Fun tions
½ If we substitute into the production
function and solve for a, we will get

„
P
„
P P
„
P
„
P
a   


½ A similar method will yield
P„ P
P  
  „



P„ P P„ P

P
GÕ
 Some Illustrative Cost
Fun tions
½ Now we can derive total costs as

P

P P
P

©  
 ©a  
©

where
> 
P


P P
P
P

which is a constant that involves only

the parameters ÿ and
º
 Some Illustrative Cost
Fun tions
½ Suppose we have a CES technology
such that

= (,a) = ( † ë a †)/†
½ To derive the total cost, we would use
the same method and eventually get
/

,© ,  ) 
 ©a  
†/† © †/† ) † )/†

 © 


c
 c ´
 © c ´
c c ´
ºc
Properties of Cost Fun tions
½ omogeneity
± cost functions are all homogeneous of
degree one in the input prices
½ cost minimization requires that the ratio of input
prices be set equal to ‘
, a doubling of all
input prices will not change the levels of inputs
purchased
½ pure, uniform inflation will not change a firm¶s
input decisions but will shift the cost curves up

º
Properties of Cost Fun tions
½ Nondecreasing in
, , and ©
± cost functions are derived from a cost-
minimization process
½ any decline in costs from an increase in one of
the function¶s arguments would lead to a
contradiction

ºG
Properties of Cost Fun tions
½ Concave in input prices
± costs will be lower when a firm faces input
prices that fluctuate around a given level
than when they remain constant at that
level
½ the firm can adapt its input mix to take
advantage of such fluctuations

ºº
 Con avity of Cost Fun tion
At ©1, the firm¶s costs are ©,
1)
Costs
If the firm continues to
buy the same input mix
pseudo as © changes, its cost
function would be 


©
1)

u


 Since the firm¶s input mix

will likely change, actual
costs will be less than

 such as (©
1)

© ºM
Properties of Cost Fun tions
½ Some of these properties carry over to
average and marginal costs
± homogeneity
± effects of , ©, and
are ambiguous

º
 Input Substitution
½ A change in the price of an input will
cause the firm to alter its input mix
½ We wish to see how /a changes in
response to a change in ©/, while
holding
constant



 Ë
a


 Ë

º·
 Input Substitution
½ utting this in proportional terms as
0
a  0 ln
a


0 
a 0 ln 
gives an alternative definition of the
elasticity of substitution
± in the two-input case, must be nonnegative
± large values of indicate that firms change
their input mix significantly if input prices
change
ºm
Partial ÿlasti ity of Substitution
½ The partial elasticity of substitution
between two inputs (0 and 0
) with
prices © and ©
is given by
0( 0 0
) ©
© 0 ln( 0 0
)



0(©
© ) 0 0
0 ln( ©
© )
½

is a more flexible concept than ´
because it allows the firm to alter the
usage of inputs other than 0 and 0

when input prices change
ºÕ
Size of Shifts in Costs Curves
½ The increase in costs will be largely
influenced by the relative significance of
the input in the production process
½ If firms can easily substitute another
input for the one that has risen in price,
there may be little increase in costs

M
 9e hni al Progress
½ Improvements in technology also lower
cost curves
½ Suppose that total costs (with constant
returns to scale) are
0 = 0(
,,©) =
0(,©,1)

Mc
 9e hni al Progress
½ Because the same inputs that produced
one unit of output in period zero will
produce () units in period 
(,©)) = ()(,©,1)= 0(,©,1)
½ Total costs are given by
(,©
 =
(,©,1) =
0(,©,1)/()
= 0(,©,
)/()
M
 Shifting the Cobb-¦ouglas
Cost Fun tion
½ The Cobb-ouglas cost function is

P

© 
 ©a 


P
©P
P

where
> 
P


P P
P
P
½ If we assume ÿ = = 0.5, the total cost
curve is greatly simplified:
0.5 0.5
 ,© ,    © a   ©
MG
 Shifting the Cobb-¦ouglas
Cost Fun tion
½ If  = 3 and © = 12, the relationship is
3,12,
å 2 36 å 12

±  = 480 to produce
=40

±  = /
= 12
± 0/0
= 12

Mº
 Shifting the Cobb-¦ouglas
Cost Fun tion
½ If  = 3 and © = 27, the relationship is
3,27,
å 2 å

±  = 720 to produce
=40

±  = /
= 18
± 0/0
= 18

MM
Contingent ¦emand for Inputs
½ Contingent demand functions for all of
the firms inputs can be derived from the
cost function
± Shephard¶s lemma
½ the contingent demand function for any input is
given by the partial derivative of the total-cost
function with respect to that input¶s price

M
Contingent ¦emand for Inputs
½ Suppose we have a fixed proportions
technology
½ The cost function is





£ å   Ë
 d

M·
Contingent ¦emand for Inputs
½ For this cost function, contingent
demand functions are quite simple:
 

 £


 £ å å



 
 £
a
 £å å
 d

Mm
Contingent ¦emand for Inputs
½ Suppose we have a Cobb-ouglas
technology
½ The cost function is

P

P P
P

©
 ©a 
©

MÕ
Contingent ¦emand for Inputs
½ For this cost function, the derivation is
messier:



P


, ,  
P
P P
P

P
P
P


P  
  

P 



Contingent ¦emand for Inputs

P P P

a 
  
 „

„
 „ P

 P
 „ P
P P  
VVVVVVVVVV VVVVVV  „
 
P 


½ The contingent demands for inputs

depend on both inputs¶ prices

c
 Short-Run ^ong-Run
¦istin tion
½ In the short run, economic actors have
only limited flexibility in their actions
½ Assume that the capital input is held
constant at 1 and the firm is free to
vary only its labor input
½ The production function becomes

= (1,a)

 Short-Run 9otal Costs
½ Short-run total cost for the firm is

 = 1 ë ©a
½ There are two types of short-run costs:
± short-run fixed costs are costs associated
with fixed inputs (1)
± short-run variable costs are costs
associated with variable inputs (©a)

G
 Short-Run 9otal Costs
½ Short-run costs are not minimal costs
for producing the various output levels
± the firm does not have the flexibility of input
choice
± to vary its output in the short run, the firm
must use nonoptimal input combinations
± the ‘
will not be equal to the ratio of
input prices
º
 Short-Run 9otal Costs
 per period
Because capital is fixed at 1,
the firm cannot equate ‘

with the ratio of input prices



2

1

0

a per period
a
a a
M
 Short-Run Marginal and
Average Costs
½ The short-run average total cost (
)
function is

 = total costs/total output =
/

½ The short-run marginal cost (
) function
is

 = change in
/change in output = 0
/0


 Relationship bet een Short-
Run and ^ong-Run Costs

 (2)
Total
 (1)
costs 

 (0) The long-run

curve can
be derived by
varying the
level of 

Output
6 
 ·
 Relationship bet een Short-
Run and ^ong-Run Costs
Costs

 (0)
 (0)  The geometric

 relationship

 (1)
 (1)
between short-
run and long-run
 and  can
also be shown

Output
6 
m
 Relationship bet een Short-
Run and ^ong-Run Costs
½ At the minimum point of the  curve:
± the  curve crosses the  curve
½  =  at this point
± the
 curve is tangent to the  curve
½
 (for this level of ) is minimized at the same
level of output as 
½
 intersects
 also at this point
 =  =
 =

Õ
 Important Points to Note:
½ A firm that wishes to minimize the
economic costs of producing a
particular level of output should
choose that input combination for
which the rate of technical substitution
(‘
) is equal to the ratio of the
inputs¶ rental prices

·
 Important Points to Note:
½ epeated application of this
minimization procedure yields the
firm¶s expansion path
± the expansion path shows how input
usage expands with the level of output
½ it also shows the relationship between output
level and total cost
½ this relationship is summarized by the total
cost function, (,©,
)
·c
 Important Points to Note:
½ The firm¶s average cost ( = /
)
and marginal cost ( = 0/0
) can
be derived directly from the total-cost
function
± if the total cost curve has a general cubic
shape, the  and  curves will be u-
shaped

·
 Important Points to Note:
½ All cost curves are drawn on the
assumption that the input prices are
held constant
± when an input price changes, cost curves
shift to new positions
½ the size of the shifts will be determined by the
overall importance of the input and the
substitution abilities of the firm
± technical progress will also shift cost
curves ·G
 Important Points to Note:
½ Input demand functions can be derived
from the firm¶s total-cost function
through partial differentiation
± these input demands will depend on the
quantity of output the firm chooses to
produce
½ are called ³contingent´ demand functions

·º
 Important Points to Note:
½ In the short run, the firm may not be
able to vary some inputs
± it can then alter its level of production
only by changing the employment of its
variable inputs
± it may have to use nonoptimal, higher-
cost input combinations than it would
choose if it were possible to vary all
inputs
·M