Chapter 7: Costs and Cost Minimization

•Consumers choose GOODS to minimize

EXPENDITURE.
•This consumption depends upon a
consumer’s UTILITY (U)and the PRICE of
the goods

•Firms choose INPUTS to minimize COSTS

•This output depends upon the firm’s
PRODUCTION (Q) and the PRICE of the
inputs
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Chapter 7: Costs and Cost Minimization
In this chapter we will cover:

7.2 Isocost Lines

7.3 Cost Minimization
7.4 Short-Run Cost Minimization

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One of the goals of a firm is to produce
output at a minimum cost.
This minimization goal can be carried out in
two situations:
1) The long run (where all inputs are variable)
2) The short run (where some inputs are not
variable)
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Suppose that a firm’s owners wish to
minimize costs…

Let the desired output be Q0

Technology: Q = f(L,K)

Owner’s problem: min TC = rK + wL

K,L

Subject to Q0 = f(L,K)
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 From the firm’s cost equation:
TC0 = rK + wL
One can obtain the formula for the ISOCOST LINE:
K = TC0/r – (w/r)L

The isocost line graphically depicts all

combinations of inputs (labour and capital) that
carry the same cost. 5
 K Example: Isocost Lines
Direction of increase
TC2/r in total cost

TC1/r
Slope = -w/r
TC0/r

L
TC0/w TC1/w TC2/w
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 Isocost curves are similar to budget lines,
and the tangency condition of firms is also
similar to the tangency condition of
consumers:

MRTSL,K = -MPL/MPK = -w/r

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 K Example: Cost Minimization

TC2/r

TC1/r
• Cost inefficient point for Q0

Cost minimization point for Q0

TC0/r
• Isoquant Q = Q0

L
TC0/w TC1/w TC2/w 8
1) Tangency Condition
- MPL/MPK = w/r
-gives relationship between L and K
2) Substitute into Production Function
-solves for L and K
3) Calculate Total Cost
4) Conclude
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 Q = 50L1/2K1/2 w = $5 r = $20
MPL = 25K1/2/L1/2 Q0 = 1000
MPK = 25L1/2/K1/2

1) Tangency:
MPL/MPK = w/r
(25K1/2/L1/2)/(25L1/2/K1/2)=w/r
K/L = 5/20
L=4K

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2) Substitution:
1000 = 50L1/2K1/2
1000 = 50(4K)1/2K1/2
1000=100K
K = 10

L = 4K
L = 4(10)
L = 40

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3) Total Cost:
TC0 = rK + wL
TC0 = 20(10) + 5(40)
TC0 = 400

4) Conclude

Cost is minimized at $400 when labour is 40 and

capital is 10.

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 K Example: Interior Solution

400/r
Cost minimization point

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• Isoquant Q = 1000

40 L
400/w 13
 Q = 10L + 2K MP = 10
L
w = $5 MPK = 2
r = $2
Q0 = 200
1) Tangency Condition:
MPL/MPK = w/r
10/2=5/2
10=5????

Tangency condition fails! 14

We can rewrite the tangency condition:
MPL/w = MPK /r
-the productivity per dollar for labour is equal to
the productivity per dollar for capital
-but here:
MPL/w = 10/5 > MPK /r = 2/2
…the “bang for the buck” in labour is ALWAYS
larger than the “bang for the buck” in capital…

So you would only use labor: 15

2) Substitution (K=0) 4) Conclude
Q = 10L + 2K Cost is minimized at
200 = 10L + 2(0) $100 when labour is
20= L 20 and capital is
zero.
3) Total Cost
TC0 = rK + wL
TC0 = 2(0) + 5(20)
TC0 = 100

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 Example: Cost Minimization: Corner Solution
K

Isoquant Q = Q0

• Cost-minimizing L
input combination 17
 Comparative Statistics
•The isocost line depends upon input prices
and desired output

•Any change in input prices or output will

shift the isocost line

•This shift will cause changes in the optimal

choice of inputs
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A change in the relative price of inputs changes
the slope of the isocost line. If MRTSL,K is
decreasing,
An increase in wage:
-decreases the cost minimizing quantity of labour

-increases the cost minimizing quantity of capital

An increase in rent
-decreases the cost minimizing quantity of capital
-increases the cost minimizing quantity of labour.
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K Example: Change in Relative Prices of Inputs

Cost minimizing input combination w=2, r=1

• Cost minimizing input combination, w=1, r=1

Isoquant Q = Q0
•

0 L
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Originally, MicroCorp faced input prices of $10 for
both labor and capital. MicroCorp has a contract
with its parent company, Econosoft, to produce 100
units a day through the production function:
Q=2(LK)1/2
MPL=(K/L)1/2 MPK=(L/K)1/2

If the price of labour increased to $40, calculate the

effect on capital and labour.
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Originally : Q  2 KL
MPL w
 Q  2 KK
MPK r
100  2 K
K / L 10
 50  K
L / K 10
KL 50  L 22
After Change : Q  2 KL
MPL w
 Q  2 4 LL
MPK r
100  4 L
K / L 40
 25  L
L / K 10
K  4L 100  K 23
If the price of labour quadruples
from $10 to $40…
Labour will be cut in half, from 50 to 25

Capital will double, from 50 to 100

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An increase in Q0 moves the isoquant Northeast.

The cost minimizing input combinations, as Q 0

varies, trace out the expansion path

If the cost minimizing quantities of labor and

capital rise as output rises, labor and capital are
normal inputs

If the cost minimizing quantity of an input

decreases as the firm produces more output, 25
the input is called an inferior input
 K Example: An Expansion Path

TC2/r

TC1/r Expansion path, normal inputs

TC0/r •
• Isoquant Q = Q0

L
TC0/w TC1/w TC2/w 26
 K Example: An Expansion Path

TC2/r
Expansion path, labour is inferior
TC1/r •

L
TC1/w TC2/w 27
Originally, MicroCorp faced input prices of $10 for
both labor and capital. MicroCorp has a contract
with its parent company, Econosoft, to produce 100
units a day through the production function:
Q=2(LK)1/2
MPL=(K/L)1/2 MPK=(L/K)1/2

If Econosoft demanded 200 units, how would labour

and capital change?
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Tangency : Q  2 KL
MPL w
 Q  2 KK
MPK r
200  2 K
K / L 10
 100  K
L / K 10
KL 100  L 29
If the output required doubled from
100 to 200..
Labour will double, from 50 to 100

Capital will double, from 50 to 100

(Constant Returns to Scale)
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 Input Demand Functions
•The demand curve for INPUTS is a
schedule of amount of input demanded at
each given price level (Also known as
FACTOR DEMAND)
•This demand curve is derived from each
individual firm minimizing costs:
Definition: The cost minimizing quantities of
labor and capital for various levels of Q, w and r
are the input demand functions.
L = L*(Q,w,r)
K = K*(Q,w,r) 31
K
Example: Labour Demand Function
•
• When input prices (wage
W3/r
•
W2/r
Q = Q0
W1/r
and rent, etc) change, the
firm maximizes using
different combinations of
0 L inputs.
w
As the price of inputs goes
up, the firm uses LESS of
• that input, as seen in the
input demand curve
•
• L*(Q0,w,r)

L1 L2 L3 L 32
K

•
• A change in the quantity
• • Q = Q0 produced will shift the
• • Q = Q1
isoquant curve.

0 L
w
This will result in a shift in
• the input demand curve.

•
• •
• L*(Q0,w,r)
• L*(Q1,w,r)
L1 L2 L3 L 33
1)Use the tangency condition to find the
relationship between inputs:

MPL/MPK = w/r
K=f(L) or L=f(K)

2) Substitute above into production function

and solve for other variable:
Q=f(L,K), K=f(L) =>L=f(Q)
Q=f(L,K), L=f(K) =>K=f(Q) 34
 Q = 50L1/2K1/2
MPL=25(K/L)1/2, MPK=25(L/K)1/2

1)Tangency Condition:

MPL/MPK = w/r
K/L = w/r
K=(w/r)L
or
L=(r/w)K
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2) Production Function
Q0 = 50L1/2K1/2
Q r
Q0 = 50L1/2[(w/r)L]1/2 Q D
L 
50 w
L*= (Q0/50)(r/w)1/2
or D Q w
Q K 
Q0 = 50 [(r/w)K]1/2K1/2 50 r
K*= (Q0/50)(w/r)1/2
• Labor and capital are both normal inputs
• Labor is a decreasing function of w
• Labor is an increasing function of r 36
•Price elasticity of demand can be calculated
for inputs (Factor markets) similar to outputs:
% QInput
 
% PInPut
L / L
L ,W 
w / w
K / K
K , r 
r / r 37
JonTech produces the not-so-popular J-Pod.

JonTech faces the following situation:

Q*=5(KL)1/2=100
MRTS=K/L.
w=$20 and r=$20

Calculate the Elasticity of Demand for Labour if

wages drop to $5.

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Initially:

MRTS=K/L=w/r
K=20L/20
K=L
Q=5(KL)1/2
100=5K
20=K=L

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After Wage Change:

MRTS=K/L=w/r
K=5L/20
4K=L
Q=5(KL)1/2
100=10K
10=K
40=L
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Price Elasticity of Labour Demand:
L / L
L ,W 
w / w
( 40  20) /( 40  20) / 2
L ,W 
(5  20) /(5  20) / 2)
20 / 30  250
L ,W    0.55
 15 / 12.5 450
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7.4 Short Run Cost Minimization
Cost minimization occurs in the short run when one input
(generally capital) is fixed (K*).
Total variable cost is the amount spent on the variable
input(s) (ie: wL)
-this cost is nonsunk (can be avoided)
Total fixed cost is the amount spent on fixed inputs (ie: rK*)
-if this cost cannot be avoided, it is sunk
-if this cost can be avoided, it is nonsunk
(ie: rent factory to another firm)
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Short Run Cost Minimization
Cost minimization in the short run is easy:

Min TC=wL+rK*
L
s.t. the constraint Q=f(L,K*)
Where K* is fixed.

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Short Run Cost Minimization
Example:
Minimize the cost to build 80 units if Q=2(KL)1/2 and
K=25.
Q=2(KL)1/2
80=2(25L)1/2
80=10(L)1/2
8=(L)1/2
64=L
Notice that price doesn’t matter.
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 K
Short Run Cost Minimization
TC2/r

TC1/r

Long-Run Cost Minimization

• Short-Run Cost Minimization

K*
•
L
TC1/w TC2/w 45
 Short Run Expansion Path
Choosing 1 input in the short run doesn’t depend on
prices, but it does depend on quantity produced.

The short run expansion path shows the increased

demand for labour as quantity produced increases: (next
slide)

The demand for inputs will therefore vary according to

quantity produced. (The demand curve for inputs shifts
when production changes)
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 K Example: Short and Long Run Expansion Paths

TC2/r

TC1/r Long Run Expansion Path

TC0/r
•
K* • • • Short Run Expansion Path
•

L
TC0/w TC1/w TC2/w 47
Short Run and Many Inputs
If the Short-Run Minimization problem has 1 fixed input
and 2 or more variable inputs, it is handled similarly to the
long run situation:

MPInput A MPInput B
 etc.
PInput A PInput B
ie : You feed your workers :
MPL MPFood

w PFood 48
 Chapter 7 Key Concepts
The Isocost line gives all combinations of
inputs that have the same cost
Costs are minimized when the Isocost line
is tangent to the Isoquant
When input costs change, the
minimization point (and minimum cost)
changes
When required output changes, the
minimization point (and minimum cost)
changes
The creates the expansion path
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 Chapter 7 Key Concepts
Individual firm choice drives input demand
As input prices change, input demanded
changes
There are price elasticities of inputs
In the short run, at least one factor is fixed
Short run expansion paths differ from long
run expansion paths

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