avillagrasa 1st year IBE - 3rd Term Microeconomics I

XIII. Cost minimization

Index
Cost minimization ............................................................................................................. 2
Conditional factor demand ........................................................................................... 2
Isocost curve ..................................................................................................................... 3
Returns to scale ................................................................................................................ 4
Computations ................................................................................................................... 5
Steps to minimize the cost ........................................................................................... 5
In the short run ............................................................................................................. 6
Fixed costs ........................................................................................................................ 7
Quasi-fixed costs........................................................................................................... 7
Sunk costs ..................................................................................................................... 7
Summary ........................................................................................................................... 8

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avillagrasa 1st year IBE - 3rd Term Microeconomics I

Cost minimization
It consists in finding the cheapest way to produce a certain amount of output. If we’re
maximizing profits we have to be minimizing the costs.

We will distinguish between fixed and variable costs. Fixed costs are those that we
have regardless of how much we produce, while variable costs depend on the
production. Fixed costs in short term are called sunk costs because they are not
recoverable.

The profit function is: , where is the total cost. In

the s/r, where x2 is fixed, the variable cost is and the fixed cost is .

The cost is minimized when the tangency condition (slope of the production function is
equal to the slope of the isocost) is fulfilled:

Conditional factor demand

Is the equation determining the optimal amount of factor (x*) given an output level (y).
The optimal is the minimum we have to pay to produce y:

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avillagrasa 1st year IBE - 3rd Term Microeconomics I

Isocost curve
It is the cost curve fuction but isolating one on the factors:
, with slope and the vertical interception with the axis in .

The isocosts contain all the bundles that cost the same. The objective when we’re
maximizing is to find the lowest isocost line that our production function is touching.
This is why we will use the tangency condition to find the optimal point. Of course, if
our production function wasn’t convex, the solution would be in the extreme, just as in
consumer theory.

In the short run, as some factor is fixed, the cost of it becomes fixed (sunk) cost. In the
long run all costs are variable: they depend on the production. To minimize the costs
we will do it with Lagrange or substitution.

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The production function is also called Isoquant

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avillagrasa 1st year IBE - 3rd Term Microeconomics I

Returns to scale
In theory, the more we produce the less average cost we have, as the fixed cost is
distributed between more and more units, but it actually depends on the type of
function we have:

Constant: if you double input the output doubles too. It means also that the costs will
double and the production will double too, so the profit will double. The average cost
is constant.

Increasing: if you double the inputs, the production will more than double. It means
also that the costs will double but, as the production will more than double, the profits
will more than double too. The average cost decreases.

Decreasing: it is the opposite of increasing returns to scale. If you double the inputs,
production will less than double. It means also that the costs will double but, as the
production will be less than double, the profits will be less than double too. The
average cost increases.

Some production functions have regions with different returns to scale.

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avillagrasa 1st year IBE - 3rd Term Microeconomics I

Computations

Steps to minimize the cost

1. Find the cost function:
2. Find the conditional demand functions applying the tangency condition,
isolating and substituting in the production function:
3. Write the cost function for and :

4. State the profit function: and find the maximum of

the profit function deriving respect y to get the optimal production.

Example:
The production function of a firm is

1. Find the cost function:

2. Find L* and K*:
i. Compute the partial derivative of L 

ii. Compute the partial derivative of L 

iii. Sate the tangency condition and isolate L:

iv. Put L in the production function (Y) and isolate K:

v. Find L* in terms of y, w and r:

3. Find the cost function in terms of w,r and y:

4. Maximize profits given the cost you found:

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avillagrasa 1st year IBE - 3rd Term Microeconomics I

In the short run

In the short run the minimization problem is: 2

The conditional factor demand of x2 is fixed ( ), but the demand of x1 depends

on the price of both inputs, the quantity of x2 and the output ( ).

In the short run the cost function has fixed ( ) and variable costs:
.

Note that the conditional demand on factors depends on the prices of the
inputs and the output, while the factor demand (obtained maximizing the
profit) depends on the prices of the inputs and the price of the product in
the market.

2
Use lagrange to solve it

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avillagrasa 1st year IBE - 3rd Term Microeconomics I

Fixed costs
Fixed costs are costs that you have to pay regardless of how much you produce, for
example the rent.

Quasi-fixed costs
Quasi-fixed costs are kind of a fixed cost, but they only have to be paid when you
produce. For example water, electricity, etc.

It might be that you have to pay it only after a threshold. For example you pay a fixed
fee for telephone (even if you don’t use it one month) but if you consume more than X
you have to pay more that month.

In the long run we don’t have fixed costs, but we might have quasi-fixed costs.

Sunk costs
They are a kind of fixed cost. It is a cost that is not recoverable.

For example, if you buy paint for your office it is a fixed cost and a sunk cost because
you will never recover the cost of the paint. However, if you buy furniture for your
company this is a fixed cost and not a sunk cost because you can sell it afterwards,
although there might be a sunk cost if the selling price is less than the acquisition price.
The rent is also a sunk cost because you will never get that money back.

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avillagrasa 1st year IBE - 3rd Term Microeconomics I

Summary
 The cost function C(w1,w2,y) that we find applying the tangency condition
(TRS=w1/w2) measures the minimum cost we can achieve to produce a certain
level of output (y).
 Isocosts represent the cost function (isolating one of the factors) and it is
composed by all the bundles with the same cost. The objective is to reach the
lowest one.
 The average costs are related to the returns to scale because depending on the
type of returns the average costs will grow at one rate or another.
 Sunk costs are a type of fixed cost that is not recoverable.