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Review

Objective: Derive firm’s


Supply curve

Price

Supply
Review:
1. What is a production function?
700 Eu • 2. What is the marginal product of some
input?
3. What is the MRTS?
400 Eu • 4. What are decreasing returns to scale?

0 600 1500 Quantity


Review

How much does it cost the firm to produce q units?

The firm’s cost function specifies the cost to produce q units

Total costs are determined by the production function and the costs of inputs

But there are many different combinations of inputs that can produce q units.
The firm’s problem is to choose the combination of inputs that minimizes costs.
The Cost Function

Example 1. A firm requires a single input to produce output, with production


function f(L)=√L. If the wage is w=$10, how much does it cost to produce 3
units? How much does it cost to produce Q units?

Example 2: A firm needs 2 workers and 1 machine to produce a single unit. The wage is w = 5
and rent is r = 10. What is the cost of producing 10 units? What is the cost function?

Example 3: A firm can produce 1 unit of output with either 2 workers or with 1 machine.
If the wage is w=5 and rent is r = 5. What is the cost of producing 10 units? Derive the
cost function TC(Q)?
The Cost Function

When the firm hires L workers and K units of capital the total cost is:
w = wage rate
L = Quantity of Labor
r = price per unit of capital services
K = Quantity of Capital

The total costs are:

TC  wL  rK
The Cost Function

If are many different combinations of inputs that can produce Q units. The firm’s problem is
to choose the best combination of inputs (that minimizes costs).

The firm’s problem is to choose L and K that solve,

First Order Conditions:

w MPL w MPL MPK


 MRTSL , K  OR  OR 
r MPK r w r
The Cost Function

Definition:
The iso-cost line is the set of combinations of labor and capital that
yield the same total cost for the firm.

Example: The wage is w = $10 per hour and the rent is r = $20 per hour.

The iso-cost line for TC = $1,000 is all the combination L and K such that:

10L + 20K=1,000 or K = 50-0.5L


The Cost Function

The iso-cost lines is K=(TC/r)+(w/r)L


K
TC2/r

TC2
TC1/r

TC0/r TC1

TC0

TC0/w TC1/w TC2/w


L
The Cost Function

The Firm’s problem:


K min wL  rK
TC2/r The isocost line
s.t.F ( K , L)  Q

TC1/r

The isoquant for Q.


TC0/r The firm must choose a point on
the isoquant.

Q
TC0/w TC1/w TC2/w
L
Deriving The Cost Function

Key explanation: How to derive the cost function


The Cost Function

Example: Suppose a firm needs 10 workers and 1 machine to produce a single unit. What is
the production function? The wage is w = 5 and rent is r = 100. What is the cost of
producing 50 units? What is the cost function?

Solution:
The production function F(L,K)= Min[0.1L,K].

To produce 50 units we need 50 machines and 500 workers, and the total cost will be
500*5+50*100=7,500
The Cost Function

Example: Suppose F(K,L)=L + 2K, the wage is w = 1 and rent is r = 1. What is the cost of
producing 1000 units? Derive the cost function TC(Q)?

Do the same if the cost of capital increases to r=4

Solution:
If MPL/w > MPK /r the productivity of a dollar spent on labor is larger than the
productivity of a dollar spent on capital.

If MPL/w < MPK /r the productivity of a dollar spent on labor is smaller than the
productivity of a dollar spent on capital.
Deriving The Cost Function

Example: Suppose F(K,L)= 50L1/2K1/2, the wage is w = $5 and rent is r = $20.


What is the cost of producing 1,000 units? Derive the cost function TC(Q)?

To get the cost of 1,000 units we need to ficure out how many workers and machines to use:
1. Optimality condition: MPL/MPK = w/r or K/L = 5/20
2. Use the production constriant: 50L1/2K1/2=1,000
K = 10; L = 40; And the total cost is 5*40+20*10=400
The Cost Function

At point E MPL  MPK


w r

The firm can increase labor and


decrease capital, and produce for
less.

At point F MPL  MPK


w r

The firm can decrease labor and


increase capital, and produce for
less.
The Cost Function

Example:

As Quantity increases from 1 million to 2


million the cost minimizing input
combination moves from point A to
point B
The Cost Function

What happens when the price of input changes?


Suppose price of capital r = 1 and quantity of output
Q0 is constant. When price of labor w = 1 the isocost
line is C1, optimal point A.
But, when price of labor rises w = 2 isocost line is C2,
optimal point B

Key point: When the price of an input rises,


we use less of that input and more of the
other
- An increase in the wage decreases the optimal
quantity of labor and increases the quantity of
capital.
- An increase in rent decreases the optimal
quantity of capital and increases the quantitty
labor
The Cost Function

Question:
How does the total cost curve shift if the price of all inputs rises by the same
amount?

The price of inputs increases


proportionately by 10%.

1. Cost minimization input stays


same (Why?).
2. TC curve shifts up by the same
10 percent
Fixed and Variable Inputs

Some inputs are fixed and some vary

Total Variable Costs – the costs of variable inputs

Total Fixed Costs – the cost of fixed inputs; does not vary with output

•Fixed costs but not sunk: become zero if no production takes place Q=0
• Fixed and sunk: positive even if Q=0
Fixed and Variable Inputs

Example: Q  50 LK capital fixed at K


2
Q
L* (Q ) 
2500 K
Q2
TC (Q )  w * L (Q )  rK  w *
*
 rK
2500 K
Long Run Cost Curve

Definition
For given input prices:
The average cost function is the long run total cost function divided by output, Q.
ATC(Q) = TC(Q)/Q

The marginal cost function is the rate of change of total cost as output varies
MC(Q) = TC(Q)/Q
Long Run Total Cost

Key points:

When marginal cost is lower than average cost,


average cost is decreasing in quantity.

When marginal cost is greater than average


cost, average cost is increasing in quantity.

When marginal cost equals average cost,


average cost is minimized.
Economies Of Scale

Definitions

We say that a cost function exhibits economies of scale, if the average cost
decreases as output rises, all else equal.

We say that a cost function exhibits diseconomies of scale, if the average cost
increases as output rises, all else equal.

The smallest quantity at which the long run average cost curve attains its
minimum point is called the minimum efficient scale.
Economies Of Scale

Economies of scale, diseconomies of scale, minimum efficient scale.

AC ($/yr) AC(Q)

Q (units/yr)
0 Q* = MES
Economies Of Scale

Why are there economies of Scale?

1. Increase returns to scale- Fixed costs


- More production permits more specialized inputs.

2. Decreasing return to scale- Organizational structure and managerial costs

- Adding software engineers increases communication costs: If there are n engineers, there
are ½n*(n – 1) pairs, so that communication costs rise at the square of the project size
- “The Peter Principle”: Workers move up until they become incompetent
- System slack: it is easier to hide inefficiencies in a large organization than in a small one
Economies Of Scale
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Economies of scale and Returns to scale

- When the production function exhibits decreasing returns to scale, the long
run average cost function exhibits diseconomies of scale.

- When the production function exhibits increasing returns to scale, the long
run average cost function exhibits economies of scale.

- When the production function exhibits constant returns to scale, the long
run average cost function is flat: it neither increases nor decreases with
output.

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