Cost minimisation

Dr Bibhas Saha
Two-step procedure

 We can break down profit maximisation as a two-

step procedure.
 First, find the minimum cost to produce a given
output (y)
 And then find the output that gives maximum
profit.

 This two-step procedure helps us develop a framework that

can be used for any market (perfect competition, monopoly
etc.) we want to consider.
Thinking about cost
 Certain costs vary with output (VARIABLE) [Predominantly input
costs]

 And certain costs don’t (FIXED) change with respect to output.

 Set-up costs, advertising cost, contractual obligations, temporary
availability constraints on certain inputs ( machinery, rare raw
materials, workers of specialised skills)
 Nature of production: Up to 300 passengers a plane is a fixed cost.
[minimum capacity issue]

 Fixed costs, quasi-fixed costs, sunk costs (variety of fixed costs)

 [Note certain costs that appear to be fixed with respect to output,
can vary with respect to time. Tenancy lease is an example.]
FIXED COSTS AND SUNK COSTS
 Some costs are are called sunk costs if they cannot be recovered
if the firm exits

 Contractual obligations: with a guarantee of minimum number of

hours of work, non-refundable tickets, tenancy agreements
 Selling of a firm’s physical assets: only partial value may be
recovered.

 If some costs are fixed only with respect to output, but can be
fully recovered at the time of exit then it is called a quasi-fixed
cost or non-sunk fixed costs.
 Example: An aeroplane remains fixed with respect to number of
passengers (up to a point), but the aeroplane can be sold off or
leased out if the airlines wants to exit/shut down.
Some simplifications

 1) All fixed costs are due to time constraint on availing

certain inputs: [SHORT RUN problems]
 Examples:
 Labour in labour shortage countries,
 capital in developing countries

 2) If there is enough time all costs can be freely

adjusted
 IN THE LONG RUN ALL COSTS ARE VARIABLE; there are
no fixed or sunk costs.

 3) Short run: All fixed costs are also sunk cost.

Analysis of cost minimisation

 Minimise 𝐶 = 𝑤1 𝑥1 + 𝑤2 𝑥2

 Subject to 𝑓 𝑥1 , 𝑥2 = 𝑦 [Hold output fixed at some

specific value]

 Question: What is the minimum cost of producing y?

 Short run: one input, say 𝑥2 is fixed

 Long run: both inputs are freely chosen.
The Leontief technology
(one of the simplest case)
 Minimise 𝐶 = 𝑤1 𝑥1 + 𝑤2 𝑥2 s.t. 𝑦 = min 𝑎𝑥1 , 𝑏𝑥2

 Short run: 𝑥2 = 𝑥2

𝑦
 Short-run choice of x1: 𝑥1 =
𝑎
 [Note it does not depend on input price]

𝑦
 Short-run cost function: 𝐶𝑆 = 𝑤1 + 𝑤2 𝑥2
𝑎
𝑤1 𝑤1 𝑥2
 𝑀𝐶 = , 𝐴𝐶 = + 𝑤2
𝑎 𝑎 𝑦
Cost: Perfect Complements

x2 y0 Iso-cost line: 𝐶 = 𝑤1 𝑥1 + 𝑤2 𝑥2

𝑥ҧ2

Lowest possible cost,

but possible only
𝑦0 in the long run
y0
𝑏

𝑦0 x1
𝑎
𝑦0
Short run: 𝐶𝑆 = 𝑤1 + 𝑤2 𝑥2
𝑎
𝑦 𝑦 When y is given at y0
Long run: C= 𝑤1 𝑎0 + 𝑤2 𝑏0
Cost: Perfect Complements (moving
to a higher y (namely y1)

x2 y1

𝑥ҧ2

𝑦1
y1
𝑏

𝑦1 x1
𝑎
𝑦1
Short run: 𝐶𝑆 = 𝑤1 + 𝑤2 𝑥2
𝑎
𝑦 𝑦
When y is given at y1
Long run: C= 𝑤1 𝑎1 + 𝑤2 𝑏1
Some important properties of the
cost function

 1) Short-run cost is never smaller than the long-run cost.

 2) Both short- and long-run cost functions are increasing functions of

𝑦, 𝑤1 , 𝑤2 .

 3) If w1 and w2 are doubled, then cost will also be doubled. [Cost

functions are homogeneous of degree 1 in (𝑤1 , 𝑤2 ).

 4) Derivative of C with respect to wi, gives the conditional input

𝜕𝐶(𝑦,𝑤1 ,𝑤2 )
demand function xi. [Shephard’s Lemma: = 𝑥𝑖 (𝑦, 𝑤1 , 𝑤2 )]
𝜕𝑤𝑖
But….

 The case of fixed coefficient technology is a special

case.

 Since it does not allow substitution between inputs, the

conditional input demand is insensitive to input prices.

 So let us move on to the imperfect substitute input

story and take a Cobb-Douglas example.
Graphical approach

 Let us first see what we can learn from graphs

Short-Run & Long-Run Total Costs

y 
Output fixed at 𝑦 ′
x2 Input x2 is fixed at 𝑥2′′
y 

y𝑦′
S
𝑥2 ′′
Lowest possible cost,
L but possible only
x𝑥22 ′ in the long run (Here TRS=w1/w2)

𝑥1
x𝑥11 ′ x1
 Output expansion paths
(consider increase in output)
𝑦 ′′′
x2
Long-run
y′′
output
expansion
path
𝑦′
TRS= w1/w2
′′′
𝑥2
Short-run
x2′′ output
x𝑥22′ expansion
path

x𝑥11′ x𝑥11′′ 𝑥1 ′′′ x1

 What we learn from the graph

1. Short run cost is greater than long-run cost at all y except

at one point where they are equal. At this specific point,
the fixed input happens to be optimal in the long run, like
y’’ in the graph.

2. As output is increased how the cost will increase depends on

• Returns to factor of the variable input in the short-run case, and
• Returns to scale in the long-run case.
 If input price changes
w1/w2
x2 increases

Higher w1/w2
ratio

x2/x1 ratio increase

A
𝑦′

x1
 What we learn from the graph

3. Two inputs are gross substitutes. If w1 increases x2 must rise,

and if w2 rises x1 must rise.

4. If w1 and w2 are increased by the same rate →

conditional input demands do not change.
But the total cost will increase by the same rate.
 What we learn from the graph

3. Two inputs are gross substitutes. If w1 increases x2 must rise,

and if w2 rises x1 must rise.

4. If w1 and w2 are increased by the same rate →

conditional input demands do not change.
But the total cost will increase by the same rate.

5. Long-run AC curve is an envelope of short-run AC curves.

 LAC graph
LAC, SAC

SAC1 LAC
SAC3

SAC2

MES

y
Local IRS
Local DRS
Local CRS
LAC: Envelope of SACs

 Reason:
 (i) At some y, SAC=LAC
 (ii) At all other y, SAC>LAC
 (iii) When LAC=SAC, (local) returns to scale = local
returns to factor
 (iv) When they are tangent they both must be increasing
or both must be decreasing, or both must be constant
(as at their minimum point).
Algebra of short-run cost
minimisation

 Suppose 𝑦 = 𝐴𝑥1𝑎 𝑥2𝑏 . Let us assume y is fixed and x2 is

fixed: (𝑥2 = 𝑥2 ).

 Since y is x2 are both fixed, there is only one value of x1

to choose.
 Conditional (on y) input demand
1/𝑎
𝑎
𝑦 𝑦
𝑥1 = ⇒ 𝑥1 =
𝐴𝑥2𝑏 𝐴𝑥2𝑏

1/𝑎
𝑦
 Cost function: 𝐶𝑆 = 𝑤1 𝑥1 + 𝑤2 𝑥2 = 𝑤1 + 𝑤2 𝑥2
𝐴𝑥2𝑏

VC FC
Short-run AVC and AFC

1/𝑎
𝑦
 Cost function: 𝐶𝑆 = 𝑤1 𝑥1 + 𝑤2 𝑥2 = 𝑤1 + 𝑤2 𝑥2
𝐴𝑥2𝑏

1/𝑎 1−𝑎
𝑉𝐶 1
 AVC(Average variable cost): = 𝑤1 𝑦 𝑎
𝑦 𝐴𝑥2𝑏

𝐹𝐶 𝑥2
 AFC (Average fixed cost) = 𝑦
= 𝑤2 𝑦
Example

1/3 1/3
 Recall our example 𝑦 = 6𝑥1 𝑥2

 Here a=b=1/3 and A=6, but keep 𝑥2 = 𝑥2

 Therefore, the short-run input demand function is 𝑥1 =

1/𝑎
𝑦
𝐴𝑥2𝑏

𝑦3 𝑦3
 𝑥1 = =
63 𝑥2 216𝑥2
1/𝑎
𝑦 𝑦3
 𝐶𝑆 = 𝑤1 𝑏 + 𝑤2 𝑥2 = 𝑤1 + 𝑤2 𝑥2
𝑥2 216𝑥2
Directly deriving the long-run cost
function
1 1
 Minimise ℒ = 𝑤1 𝑥1 + 𝑤2 𝑥2 − 𝜇[6𝑥1 𝑥2 − 𝑦] 3 3

 FOC-s

1 1
𝜕ℒ 𝑥23 𝑥2 3
 = 𝑤1 − 𝜇2 2 = 0 ⇒ 𝑤1 = 𝜇2 (1)
𝜕𝑥1 𝑥12
𝑥13
1 1
𝜕ℒ 𝑥13 𝑥1 3
 = 𝑤2 − 𝜇2 2 = 0 ⇒ 𝑤2 = 𝜇2 (2)
𝜕𝑥2 𝑥22
𝑥23
1 1 1 1
𝜕ℒ
 3 3
= −[6𝑥1 𝑥2 − 𝑦] = 0 ⇒ 𝑦 = 6𝑥1 𝑥2 3 3
(3)
𝜕𝜇
Solution for the long-run cost
minimisation
 Divide (1) by (2):

𝑥2 𝑤
 = 𝑤1 substitute this into (3)
𝑥1 2

1 1 1 2 1
3 3 𝑤1 3 3 𝑤1 3
 𝑦 = 6𝑥1 𝑥1 ⇒ 𝑦 = 6𝑥1
𝑤2 𝑤2

3
2 1 1 2
3 𝑦 𝑤2 3 𝑦 𝑤2 3
 𝑥1 = 6 𝑤1
⇒ 𝑥1 = 6 𝑤1
Long-run cost function

Conditional (on y) input demands Solution:

1 1
3 3
𝑤2 2 𝑤1 2
𝑥1 = 𝑦 2 and 𝑥2 = 𝑦 2
216 𝑤1 216 𝑤2

Long-run Cost function:

1 1
3 3
𝑤2 2 𝑤1 2
𝐶= 𝑤1 216 𝑤 𝑦 2 + 𝑤2 216 𝑤 𝑦 2
1 2
3
𝑦2
Or 𝐶=2 𝑤1 𝑤2
216
Properties of the conditional input demand
functions and the long-run cost function

 If w1 and w2 are increased by the same rate →

 conditional input demands do not change.
 But the total cost will increase by the same rate.

 Conditional input demands are homogeneous of degree

zero in input prices. But the total cost is homogeneous of
degree 1.

1
 If 𝑦 = 𝐴𝑥1𝑎 𝑥2𝑏 , then 𝐶 = 𝐵𝑦 𝑎+𝑏

 where B is some expression that involves w1 and w2.

 1
Cost curves when 𝐶 = 𝐵𝑦 𝑎+𝑏

C
C
C

y y
y

IRS: a+b>1 CRS: a+b=1 DRS: a+b<1

 1
Average and marginal cost curves when 𝐶 = 𝐵𝑦 𝑎+𝑏
1−𝑎−𝑏 1−𝑎−𝑏
𝐵
; A𝐶 = 𝐵𝑦 𝑎+𝑏 𝑀𝐶 = 𝑦 𝑎+𝑏
𝑎+𝑏

AC, MC
MC, AC MC, AC
MC
AC

MC=AC AC

MC

y y
y

IRS: a+b>1 CRS: a+b=1 DRS: a+b<1

The case of variable returns to scale;
when the long run cost 𝐶 = 𝑎𝑦 3 − 𝑏𝑦 2 + 𝑦 ⇒
𝑀𝐶 = 3𝑎𝑦 2 − 2𝑏𝑦 + 1, 𝐴𝐶 = 𝑎𝑦 2 − 𝑏𝑦 + 1

MC, AC AC
MC

𝑏2
1− 4𝑎
MES (Minimum efficient scale)

𝑏 y
𝑏
3𝑎 2𝑎
Shephard’s Lemma

 Derivative of C with respect to wi, gives the conditional

input demand function xi. [Shephard’s Lemma:
𝜕𝐶(𝑦,𝑤1 ,𝑤2 )
= 𝑥𝑖 (𝑦, 𝑤1 , 𝑤2 )]
𝜕𝑤𝑖

 MC = 𝜇 (the Lagrange multiplier)

EXTRA SLIDES

An alternative way of deriving the long-run cost function

Example

1/3 1/3
 Recall our example 𝑦 = 6𝑥1 𝑥2

 Here a=b=1/3 and A=6, but keep 𝑥2 = 𝑥2

 Therefore, the short-run input demand function is 𝑥1 =

1/𝑎
𝑦
𝐴𝑥2𝑏

𝑦3 𝑦3
 𝑥1 = =
63 𝑥2 216𝑥2
1/𝑎
𝑦 𝑦3
 𝐶𝑆 = 𝑤1 𝑏 + 𝑤2 𝑥2 = 𝑤1 + 𝑤2 𝑥2
𝑥2 216𝑥2
Going from short-run to long-
run cost function
 Minimise the short run cost function with respect to x2 (the fixed
input).
𝑦3
𝐶𝑆 = 𝑤1 + 𝑤2 𝑥2
216𝑥2

1
3
𝜕𝐶𝑆 𝑤1 𝑦 3 1 𝑤1 2
FOC: =− + 𝑤2 = 0 Solution: 𝑥2 = 𝑦2
𝜕𝑥2 216 𝑥22 216 𝑤2

𝑦3
Substitute x2 back into the short-run demand for 𝑥1 =
216𝑥2

1
3
𝑦3 𝑤2 2
Solution for x1: 𝑥1 = 1 3 = 𝑦2
𝑤1 2 216 𝑤1
216 × 216 𝑤2
𝑦2

Note the symmetry between x1 and x2.

Long-run cost function

Conditional (on y) input demands Solution:

1 1
3 3
𝑤2 2 𝑤1 2
𝑥1 = 𝑦2 and 𝑥2 = 𝑦2
216 𝑤1 216 𝑤2

Long-run Cost function:

1 1
3 3
𝑤 2 𝑤 2
𝐶= 𝑤1 2162𝑤 𝑦 +
2 𝑤2 2161𝑤 𝑦 2
1 2
3
𝑦2
Or 𝐶=2 𝑤1 𝑤2
216
 Hotelling’s Lemma (recall from
profit maximisation)
𝜕𝜋(𝑝,𝑤1 ,𝑤2 )
 Hotelling’s Lemma: = 𝑦(𝑝, 𝑤1 , 𝑤2 ),
𝜕𝑝

 Differentiate the profit function with respect to p:

𝜕𝜋(𝑝,𝑤1 ,𝑤2 ) 𝜕𝑦 𝜕𝑥1 𝜕𝑦 𝜕𝑥2
 = 𝑦 𝑝, 𝑤1 , 𝑤2 + 𝑝 − 𝑤1 + 𝑝 − 𝑤2
𝜕𝑝 𝜕𝑥1 𝜕𝑤1 𝜕𝑥2 𝜕𝑤2

= 𝑦 𝑝, 𝑣, 𝑤

=0 (by FOC of profit

maximisation)

In the same way you can derive

𝜕𝜋(𝑝,𝑤1 ,𝑤2 ) 𝜕𝜋(𝑝,𝑤1 ,𝑤2 )

= −𝑥1 (𝑝, 𝑤1 , 𝑤2 ) and = −𝑥2 (𝑝, 𝑤1 , 𝑤2 )
𝜕𝑤1 𝜕𝑤2
Shephard’s Lemma

𝜕𝐶(𝑦,𝑤1 ,𝑤2 )
 Shephard’s Lemma: = 𝑥1 (𝑦, 𝑤1 , 𝑤2 ),
𝜕𝑤1
𝜕𝐶(𝑦,𝑤1 ,𝑤2 )
 = 𝑥2 (𝑦, 𝑤1 , 𝑤2 ),
𝜕𝑤2
𝜕𝐶(𝑦,𝑤1 ,𝑤2 )
 = 𝜇∗ (𝑦, 𝑤1 , 𝑤2 )
𝜕𝑦
Proof of Shephard’s Lemma
𝜕𝐶(𝑦,𝑤1 ,𝑤2 )
Shephard’s Lemma: 𝜕𝑤1
= 𝑤1 (𝑦, 𝑤1 , 𝑤2 ),

 Recall: 𝐶(𝑦, 𝑤1 , 𝑤2 ) = 𝑤1 𝑥1∗ + 𝑤2 𝑥2∗ − 𝜇∗ 𝑓 𝑥1∗ , 𝑥2∗ − 𝑦

 By definition, the cost function is an optimal value function
 Differentiate the cost function with respect to y:
𝜕𝐶(𝑦,𝑤1 ,𝑤2 ) ∗ 𝜕𝑓 𝜕𝑥1∗ ∗ 𝜕𝑓 𝜕𝑥2∗ 𝜕𝜇∗

𝜕𝑤1
= 𝑥1 𝑦, 𝑤1 , 𝑤2 + 𝑤1 − 𝜇 𝜕𝑥 𝜕𝑤 + 𝑤2 − 𝜇 𝜕𝑥 𝜕𝑤 − 𝜕𝑤1
1 1 2 1
𝑓 𝑥1∗ , 𝑥2∗ − 𝑦
= 𝑥1 𝑝, 𝑣, 𝑤

Rest of the terms are zero by the first order condition of cost minimisation.

Other parts of the lemma can be proved in the same way.

References

1. Varian 9th edition, Chapter 21, 22