Prot Function

Cost minimization

Exercises of Microeconomics

Prot Function and Cost Minimization (Ch. 3-4 Varian)

Fabio Tramontana (University of Pavia)
slides available at: http://tramontana.altervista.org/teaching.html

PhD in Economics at L.A.S.E.R.

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Exercises Micro

Prot Function
Cost minimization

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Exercise 3.1 (a)

A competitive prot-maximizing rm has a prot function

(w , w ) = (w ) + (w ). The price of the output is normalized
to be 1.
(a) What do we know about the rst and second derivatives of the
functions (w )?
1

Remember that the prot function must be nonincreasing in input

prices and convex, so:
i0 (wi ) 0

and

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i00 (wi ) 0 .

Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
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Exercise

3.1
3.2
3.3
3.4
3.5

Exercise 3.1 (b)

(b) If x (w , w ) is the factor demand function for factor i , what is

the sign of x / w ?
i

Given that in the prot function the two inputs appears in an

additive form, one factor does not inuence the optimum value of
the other, so:
xi / wj = 0.

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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
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Exercise

3.1
3.2
3.3
3.4
3.5

Exercise 3.1 (c)

(c) Let f (x , x ) be the production function that generated the

prot function of this form. What can we say about the form of
this production function? (Hint: look at the rst order conditions.)
1

We have seen that the demand for a factor only depends on its
price. So, the marginal product of each factor must only be a
function of the amount of the factor itself. It follows that:

f (x , x
1

) = g1 (x1 ) + g2 (x2 ).

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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Exercise 3.2

Consider the technology described by y = 0 for x 1 and y = ln x

for x > 1. Calculate the prot function for this technology.
Note that we are looking for an expression in which prots does
only depend on prices:
(p , w )

in other words we need the demand function x (p , w ) and the supply

function y (p , w ).

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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Solution

Demand function and supply function come from the rst order
condition:
from which we have that:

p /x = w ,

x (p, w ) = p/w and y (p, w ) = ln(p/w )

that gives us the prot function:
(p , w ) = py (p , w ) wx (p , w ) = p ln(p /w ) p

but given that the rm may always choice x = 0 to avoid negative
prots, we have:
(p , w ) = max {p ln(p /w ) p , 0} .
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercises Micro

Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

3.1
3.2
3.3
3.4
3.5

Exercise 3.3

Given the production function f (x , x ) = a ln x + a ln x ,

calculate the prot-maximizing demand and supply functions, and
the prot function. For simplicity assume an interior solution.
Assume that a > 0.
1

If we denoted by w and w the factors' prices and p the output

price, we have the following rst-order conditions:
1

p
w
x
p
a w
x
a

=0

=0

that can be solved for the factor demand functions.

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Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

3.1
3.2
3.3
3.4
3.5

Solution

We have:

p
w
p
x =a
w
x

= a1

that inserted in the objective function give us the prot function:

p
(p , w , w ) = p a ln a
w
"

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p
+ a ln a
w
2

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a1 a2

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

3.1
3.2
3.3
3.4
3.5

Exercise 3.4

Given the production function f (x , x ) = x 1 x 2 , calculate the

prot maximizing demand and supply functions, and the prot
function. Assume a > 0. What restrictions must a and a satisy?
1

Once again we must calculate the rst-order conditions:

pa x
pa x
1

a1

1
a2

1
1

x
x

2
2
2
1

w1 = 0
w2 = 0

and solve them for the factor demands.

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Exercise
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Prot Function
Cost minimization

3.1
3.2
3.3
3.4
3.5

Solution

From the rst f.o.c. we have that:

w
pa

2 =

! a1

1a1
a2

and by using it in the second f.o.c. we obtain:

pa

w
pa

! a1

a2 1

1a1
a2

w2 = 0

from which, after some algebra, we have the demand function of

the rst factor:
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Prot Function
Cost minimization

3.1
3.2
3.3
3.4
3.5

Solution

w
pa

2
a2

(a2 1)(a1 +a2 1)

w
pa

a2
1 +a2 1

!a

Note that in order to be meaningful (that is, inputs are normal

goods), we must have:
a +a < 1
1

that is decreasing returns to scale.

The other input demand function and the prot function are now
easily obtainable.
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

3.1
3.2
3.3
3.4
3.5

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

3.1
3.2
3.3
3.4
3.5

Exercise 3.5

Given the production function f (x , x ) = min {x , x } , calculate

the prot maximizing demand and supply functions, and the prot
function. What restrictions must a satisy?
a

The important note to start the exercise is that the rm will never
use dierent amounts of inputs to produce a certain level of output.
In fact, if not the rm may reduce the amount of the input that is
more used and still produce the same level of output. So we can
assume that:

= x2

and the production function becomes:

f (x , x
1

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) = x1a
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Exercise
Exercise
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Prot Function
Cost minimization

3.1
3.2
3.3
3.4
3.5

Solution

The objective function is the following:

px

a
1

w1 x1 w2 x2

from which we have the f.o.c.:

pax

(w 1 + w 2 ) = 0

and the demand function:

+ w2

(a1)

pa

that is meaningful provided that a < 1.

Supply and prot functions come out easily.
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Exercise 4.3

A rm has two plants with cost functions c (y ) = y /2 and

c (y ) = y . What is the cost function for the rm?
1

2
1

The right way to calculate how much the rm should produce with
each plant, consists in equating the marginal costs, obtaining:

=1

which means that if the rm is producing one unit of output with
the rst plant, it is indierent to produce a little bit more with one
plant or the other one.
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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Solution

Note that the marginal costs of the second plant are xed and equal
to 1, while the marginal costs of the rst plant are lower (resp.
higher) than 1 if the production is lower (resp. higher) than 1.
Putting together these facts you have the cost function:

y /2
if y < 1
y 1/2 if y > 1 ,
where y 1/2 is obtained considering y = y + y that is
y = y y = y 1.
c (y ) =

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Exercises Micro

Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

4.3
4.4
4.6
4.7
4.8

Exercise 4.4

A rm has two plants. One plant produces output according to the
production function x x . The other plant has a production
function x x . What is the cost function for this technology?
a
1

b
1

This case is similar to the EXAMPLE in the text. So, let us

proceed similarly.
The cost minimization problem for the rst plant is the following:

c (w , y ) = min
w x +w x
1, 2
such that x x = y
x

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a
1

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Exercise
Exercise
Exercise
Exercise
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Prot Function
Cost minimization

4.3
4.4
4.6
4.7
4.8

Solution

We can take the constraint, solve it for x and rewrite the

minimization problem as follows:
2

minw x + w y 1a x
1

x1

a
1
a

from which we obtain the f.o.c.:

w y 1a x 1a = 0

1a
that permit us to obtain the conditional demand for factor 1:
1

x (w , w , y ) =
1

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a w
1a w

1a

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Exercise
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Prot Function
Cost minimization

4.3
4.4
4.6
4.7
4.8

Solution

The conditional demand for the second input is similar:

x (w , w , y ) =
2

a w
1a w

a

so the cost function is:

c (w , w , y )
1

= hw1 x1 (w1 , w2 , y ) + w2 xi2 (w1 , w2 , y )

1a

a a 1a
+ 1a a
= 1a a
w1 w2 y

so the cost function is of the form c (y ) = A(a, w , w )y and

mutatis mutandis for the second plant we have
c (y ) = B (b, w , w )y .
1

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Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Solution

Given that the marginal costs are xed, the rm will always use the
plant with lower marginal costs.
That is:

c (y ) = min {A, B } y .

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Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

4.3
4.4
4.6
4.7
4.8

Exercise 4.6

A rm has two plants with cost functions c (y ) = 4 y and

c (y ) = 2y . What is its cost of producing an output y ?
1

If you calculate and equate the marginal costs, obtain:

MC (y
1

) = MC2 (y2 )

4y2 = y1
1

and by using y = y + y :
1

4
5

1
5

so the rm produces more with technology 2... how is it possible?

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Prot Function
Cost minimization

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Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Solution

It is explainable by proving that we obtained a constrained

MAXIMUM and not minimum.
In fact, the cost function is concave and not convex. You can also
look at the second-order conditions.
The minimum is a corner solution, that is
The rm will produce all output at the cheaper plant:

c (y ) = 2 y .

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Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

4.3
4.4
4.6
4.7
4.8

Exercise 4.7

The following table shows two observations on factor demand

x , x , factor prices w , w , and output y for a rm. Is the behavior
depicted in this table consistent with cost-minimizing behavior?
Obs y w w x x
A 100 2 1 10 20
B 110 1 2 14 10
1

According to the WACM (Weak Axiom of Cost Minimization) we

must have that:
The cost of the observed choice of inputs is no greater than the
cost of any any other level of inputs that would produce at least as
much output.
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Prot Function
Cost minimization

Exercise
Exercise
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Exercise

4.3
4.4
4.6
4.7
4.8

Solution

In our case to produce 100 units of output it costs 40

(10 2 + 20 1) while
to produce 110 units of output it costs 34 (14 1 + 2 10)
The data violate WACM

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Prot Function
Cost minimization

Exercise
Exercise
Exercise
Exercise
Exercise

4.3
4.4
4.6
4.7
4.8

Outline
1

Prot Function
Exercise 3.1
Exercise 3.2
Exercise 3.3
Exercise 3.4
Exercise 3.5
Cost minimization
Exercise 4.3
Exercise 4.4
Exercise 4.6
Exercise 4.7
Exercise 4.8
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Exercise
Exercise
Exercise
Exercise
Exercise

Prot Function
Cost minimization

4.3
4.4
4.6
4.7
4.8

Exercise 4.8

A rm has a production function y = x x . If the minimum cost of

production at w = w = 1 is equal to 4, what is y equal to?
1

The minimization problem is the following:

min x + x
1

s .t . x x
1

=y

and by using the constraint you obtain:

min x + y /x
1

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Exercise
Exercise
Exercise
Exercise
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Prot Function
Cost minimization

4.3
4.4
4.6
4.7
4.8

Solution

from which the f.o.c.:

We have that:

y =4=x

+ x2 = 2

and nally:

y =4

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