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COST CONSTRAINT

C= wL + rK (m = p1x1 +p2x2) w: wage rate (including fringe benefits, holidays, PRSI, etc) r: rental rate of capital Rearranging: K=C/r-(w/r)L

COST CONSTRAINT

(-) w/r K C/r C=wL+rK Represents society’s willingness to trade the factors of production

C/w

L

Slope of the isocost = ∆ K/∆L=δK/δ L= (-) w/r

EQUILIBRIUM

K

Y

e

C = wL + rK

L

EQUILIBRIUM

We can either Minimise cost subject to

Y = Y ⇒ C and e

or Maximise output subject to

equilibrium

C = C ⇒ Y and e

equilibrium

EQUILIBRIUM

Lagrangian method

Minimise cost subject to output

L* = wL + rK + λ ( Y − f ( K , L ) )

or Maximise output subject to costs

L* = f ( L, K ) + λ ( C − wL + rL )

Lagrange Method

x

x x

Set up the problem (same as with utility maximisation subject to budget constraint). Find the first order conditions. It is easier to maximise output subject to a cost constraint than to minimise costs subject to an output constraint. The answer will be the same (in essence) either way.

**Example: Cobb-Douglas Equilibrium
**

Derive a demand function for Capital and Labour by maximising output subject to a cost constraint. Let L* be Lagrange, L be labour and K be capital. Set up the problem

L* = AK a L( 1 − a ) + λ ( C − wL − rK )

**Multiply out the part in brackets
**

L* = AK a L( 1− a ) + λC − λwL − λrK

**Cobb-Douglas: Equilibrium
**

Find the First Order Conditions by differentiation with respect to K, L and λ

∂L* = AaK a − 1 L( 1− a ) − λr = 0 ∂K ∂L* = A( 1 − a ) K a L− a − λw = 0 ∂L

∂* L =C −wL −rK =0 ∂ λ

1st FOC

2nd FOC

3rd FOC

**Cobb-Douglas: Equilibrium
**

Rearrange the 1st FOC and the 2nd FOC so that λ is on the left hand side of both equations

AaK a − 1 L( 1 − a ) −λ = r A( 1 − a ) K a L− a −λ = w

1st FOC

2nd FOC

**Cobb-Douglas: Equilibrium
**

We now have two equations both equal to -λ so we can get rid of λ

AaK a − 1 L( 1− a ) A( 1 − a ) K a L− a = r w

(Aside: Notice that we can find Y nested within these equations.)

**Cobb-Douglas: Equilibrium
**

AaK a −1 L( 1− a ) A( 1 − a ) K a L− a = r w AaK a K −1 L( 1− a ) A( 1 − a ) K a L− a L1 = r wL

(1 − a ) aK −1 = wL r

We have multiplied by L/L=1 AaK −1 K a L( 1− a ) A( 1 − a ) K a L1 − a = r wL

**Cobb-Douglas: Equilibrium
**

a (1 − a ) = wL rK

Note: K-1 =1/K

awL rK = (1 − a )

Return to the 3rd FOC and replace rk

**Cobb-Douglas: Equilibrium
**

awL rK = (1 − a )

C − wL − rK = 0

awL wL + =C (1 −a ) a wL1 + =C (1 −a )

**Cobb-Douglas: Equilibrium
**

a wL1 + =C (1 −a )

Simplify again.

wL C = (1 −a ) (1 −a )C L= w

Demand function for Labour

**Cobb-Douglas: Equilibrium
**

a (1 − a ) = wL rK

Rearrange so that wL is on the left hand side Now go back to the 3rd FOC and (1 − a ) replace wl and wL = rK a follow the same procedure as Demand aC before to solve K = for for the demand r capital for Capital

EQUILIBRIUM

Slope of isoquant = Slope of isocost MRTS = (-) w/r or MPL/MPK = (-) w/r

**Aside: General Equilibrium
**

K MRTSA = – w/r

Firm A

L

**Aside: General Equilibrium
**

K MRTSB = – w/r

Firm B

L

**Aside: General Equilibrium
**

MRTSA = – w/r MRTSB = – w/r MRTSA = MRTSB We will return to this later when doing general equilibrium.

The Cost-Minimization Problem A firm is a cost-minimizer if it produces any given output level y ≥ 0 at smallest possible total cost. x c(y) denotes the firm’s smallest possible total cost for producing y units of output. x c(y) is the firm’s total cost function.

x

**The Cost-Minimization Problem
**

Consider a firm using two inputs to make one output. x The production function is y = f(K,L) x Take the output level y ≥ 0 as given. x Given the input prices r and w, the cost of an input bundle (K,L) is rK + wL.

x

**The Cost-Minimization Problem
**

x

**For given r, w and y, the firm’s costminimization problem is to solve
**

K , L≥ 0

min ( rK +wL )

subject to

f ( K , L) = y

Here we are minimising costs subject to a output constraint. Usually you will not be asked to work this out in detail, as the working out is tedious.

**The Cost-Minimization Problem
**

The levels K*(r,w,y) and L*(r,w,y) in the least-costly input bundle are referred to as the firm’s conditional demands for inputs 1 and 2. x The (smallest possible) total cost for producing y output units is therefore

x

c( r , w , y ) = rK ( r , w , y ) + wL ( r , w , y )

*

*

**Conditional Input Demands
**

Given r, w and y, how is the least costly input bundle located? x And how is the total cost function computed?

x

**A Cobb-Douglas Example of Cost Minimization
**

x

A firm’s Cobb-Douglas production function is 1/ 3 2/ 3

y = f ( K , L) = K

L

**Input prices are r and w. x What are the firm’s conditional input demand functions? K*(r,w,y), L*(r,w,y)
**

x

**A Cobb-Douglas Example of Cost Minimization
**

At the input bundle (K*,L*) which minimizes the cost of producing y output units: * 1/ 3 * 2/ 3 (a) and

y = (K ) (L )

2K * =− * L

(b)

w ∂ y / ∂L (2 / 3)( K * )1/ 3 ( L* ) −1/ 3 − =− =− r ∂ y /∂ K (1 / 3)( K * ) −2 / 3 ( L* ) 2 / 3

**A Cobb-Douglas Example of Cost Minimization
**

(a)

y = ( K ) ( L*)

* 1/ 3

2/ 3

(b)

w 2K * = * r L

**A Cobb-Douglas Example of Cost Minimization
**

(a)

y = ( K ) ( L*)

*

* 1/ 3

2/ 3

(b)

From (b),

2r L = K* w

w 2K * = * r L

**Now substitute into (a) to get
**

y = (K )

* 1/ 3

2r * K w

2/ 3

2/3

2r = w

2/3

K*

So K * = w

2r

y

is the firm’s conditional demand for Capital.

**A Cobb-Douglas Example of Cost Minimization
**

Since

2r L = K* w

*

and

2/ 3

w K = 2r

*

2/ 3

y

2r w L = w 2r

*

y

is the firm’s conditional demand for input 2.

2r L = w

*

1/ 3

y

**A Cobb-Douglas Example of Cost Minimization
**

So the cheapest input bundle yielding y output units is

( K (r , w, y ), L (r , w, y ))

* *

w 2 / 3 2r 1 / 3 = y , y 2r w

**Conditional Input Demand Curves
**

y1 Fixed r and w y2 y3 output expansion path L*(y3) L*(y2) L*(y1) NB K*(y3) K*(y1) K*(y2)

y

Cond. demand for Labour

y3 y2 y1

y L*(y1)

L*(y3) L* L*(y2) Cond. demand for Capital K*(y3) K* K*(y2)

y3 y2 y1

K*(y1)

**Total Price Effect
**

Recall the income and substitution effect of a price change. x We can also apply this technique to find out what happens when the price of a factor of production changes, e.g. wage falls x Substitution and output (or scale ) effects

x

**Total Price Effect
**

K

a Q1 L

**Total Price Effect
**

K Total effect is a to c, more labour is used L1 to L3 c a Y1 L1 L3 L Y2

**Total Price Effect
**

K L1 to L2 is the substitution effect. More labour is being used. c a b L1 L2 Y1 L Y2

**Total Price Effect
**

K L2 to L3 is the output (scale) effect. c a b Y1 L2 L3 L Y2

**Total Price Effect
**

x

What about perfect substitutes and perfect complements? (Homework)

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