Chapter 7

Costs and
Cost
Minimization

1
Chapter Seven Overview

1.
1. What
Whatare
areCosts?
Costs?

2.
2. Long
LongRun
RunCost
CostMinimization
Minimization
•• The
Theconstraint
constraintminimization
minimizationproblem
problem
•• Comparative
Comparativestatics
statics
•• Input
Inputdemands
demands

3.
3. Short
ShortRun
RunCost
CostMinimization
Minimization

2
Chapter Seven
Explicit Costs and Implicit Costs

Explicit
Explicit Costs
Costs –– Costs
Costs that
that involve
involve aa direct
direct
monetary
monetaryoutlay.
outlay.

Implicit
Implicit Costs
Costs –– Costs
Costs that
that do
do not
not involve
involve outlays
outlays
of
ofcash.
cash.

3
Chapter Seven
Opportunity Cost

The
The relevant
relevant concept
concept ofof cost
cost isis
opportunity
opportunity cost:
cost: the
the value
value ofof aa
resource
resourcein
inits
itsbest
bestalternative
alternativeuse.
use.

 The
The only
only alternative
alternative we
we consider
consider isis
the
thebest
bestalternative
alternative

4
Chapter Seven
Economic Costs and Accounting Costs

Economic
Economic Costs
Costs –– Sum
Sum of
of aa firm’s
firm’s explicit
explicit costs
costs
and
andimplicit
implicitCosts.
Costs.

Accounting
AccountingCosts
Costs––Total
Totalof
ofaafirm’s
firm’sexplicit
explicitcosts.
costs.

5
Chapter Seven
 Sunk Costs
Sunk
SunkCosts
Costsare
arecosts
coststhat
thatmust
mustbe
beincurred
incurredno
nomatter
matterwhat
whatthe
the
decision.
decision. These
Thesecosts
costsare
arenot
notpart
partof
ofopportunity
opportunitycosts.
costs.

• It costs $5M to build and has no alternative uses

• $5M is not sunk cost for the decision of whether

or not to build the factory

• $5M is sunk cost for the decision of whether to

operate or shut down the factory

Non-Sunk
Non-SunkCosts
Costsare
arecosts
coststhat
thatmust
mustbe
beincurred
incurredonly
onlyififaaparticular
particular
decision
decisionisismade.
made.
6
Chapter Seven
 Cost Minimization

Cost
Cost minimization
minimizationproblem:
problem: Finding
Findingthe
the input
input combination
combination
that
thatminimizes
minimizesaa firm’s
firm’s total
totalcost
cost of
of producing
producingaa particular
particular
level
levelof
ofoutput.
output.

Cost
Cost minimization
minimizationfirm:
firm: AAfirm
firmthat
thatseeks
seekstotominimize
minimizethe
the
cost
costof
of producing
producingaa given
givenamount
amount ofof output.
output.

Long
Longrun:
run: AAperiod
periodof
oftime
time when
whenthe
thequantities
quantitiesof
of all
allof
of the
the
firm’s
firm’sinput
inputcan
canvary.
vary.

Short
Shortrun:
run: AAperiod
periodof
of time
timewhen
whenat
at least
leastone
oneof
of its
itsinputs’
inputs’
quantities
quantitiesisisfixed.
fixed.

7
Chapter Seven
 Long-Run Cost Minimization

Minimize
Minimizethe
thefirm’s
firm’scosts,
costs, subject
subjectto
toaafirm
firmproducing
producingaagiven
given
amount
amountofof output.
output.

Cost
Cost to
to the
theFirm:
Firm:

TC
TC==Total
TotalCost
Cost
ww==wage
wagerate
rate
LL==Quantity
QuantityofofLabor
Labor
rr== price
priceper
per unit
unitof
of capital
capitalservices
services
KK== Quantity
Quantityofof Capital
Capital

TC  wL  rK
8
Chapter Seven
Isocost Line

The
The setset of
of combinations
combinations of
of labor
labor and
and
capital
capital that
that yield
yield the
the same
same total
total cost
cost for
for
the
the firm.
firm.

9
Chapter Seven
Isocost Line

w = $10/hour
r = $20/hour
TC = $1 million
$1 mil = $10L + $20K
K = $1 mil/20-(10/20)L

Or more generally: TC
K
r  (w / r ) L

10
Chapter Seven
 Isocost Lines
K
Direction
Directionofof
TC2/r increase
increaseinin
TC1/r total
totalcost
cost

TC0/r Slope Combinations of

Slope==-w/r
-w/r labor and capital that
yields the same total
cost for the firm

L
TC0/w TC1/w TC2/w
11
Chapter Seven
Long-Run Cost Minimization
Suppose that a firm’s owners wish to
minimize costs

Let the desired output be Q0

Technology: Q = f(L,K) TCTC==rKrK++wL

wL……
or…
or…
Owner’s problem: min TC = rK + wL KK==TC/r
TC/r––(w/r)L
(w/r)L
• K,L isisthe
theisocost
isocostline
line
• Subject to Q0 = f(L,K)

12
Chapter Seven
Long-Run Cost Minimization
•• Cost
Cost minimization
minimization subject
subject to
to satisfaction
satisfaction of
of the
the
isoquant
isoquantequation:
equation:QQ00==f(L,K)
f(L,K)

•• Note:
Note: analogous
analogous to
to expenditure
expenditure minimization
minimization for
for
the
theconsumer
consumer

Tangency
TangencyCondition:
Condition:

••MRTS
MRTSL,KL,K==-MP
-MPLL/MP
/MPKK==-w/r
-w/r (or)
(or) MP
MPLL/w
/w==MP
MPKK/r
/r

••Constraint:
Constraint:QQ00==f(K,L)
f(K,L)
13
Chapter Seven
Long-Run Cost Minimization

Solution to cost
minimization:

•Point where isoquant

is just tangent to
isocost line (A)
•G – Technically
Inefficient
•E & F – Technically
Efficient but do not
minimize cost
14
Chapter Seven
Long-Run Cost Minimization
Solution to cost minimization:

• Slope of isoquant = slope of isocost line

w MPL w
 MRTS L , K  
r (or) MPK r

• Ratio of marginal products = ratio of input prices

MPL MPK

w r
15
Chapter Seven
 Long-Run Cost Minimization

• At point E MPL w MPL MPK

 (or ) 
MPK r w r
• This implies the firm could
spend an additional dollar
on labor and save more
than a dollar by reducing its
employment of capital and
keep output constant

16
Chapter Seven
 Long-Run Cost Minimization

• At point F MPL w MPL MPK

 (or ) 
MPK r w r
• This implies the firm could
spend an additional dollar
on capital and save more
than a dollar by reducing its
employment of labor and
keep output constant

17
Chapter Seven
Interior Solution

QQ==50L
50L1/2KK1/2
1/2 1/2

MP
MPLL==25L
25L-1/2KK1/2
-1/2 1/2

MP
MPKK==25L
25L1/2KK-1/2
1/2 -1/2

ww==$5$5
rr==$20
$20
QQ00==1000
1000

MPL/MPK = K/L => K/L = 5/20…or…L=4K

1000 = 50L1/2K1/2

K = 10; L = 40

18
Chapter Seven
 Corner Solution
The cost-minimizing input
combination for producing
Q0 units of output occurs at
point A where the firms
uses no capital. At this
corner point the isocost line
is flatter than the isoquant.

MPL w
( )  ( )
MPK r
MPL MPK
 
w r
19
Chapter Seven
Corner Solution
QQ==10L
10L++2K
2K
MP
MPL L==10
10
MP
MPKK==22

ww==$5$5
rr==$2
$2
QQ0 ==200
200
0

MPL/MPK = 10/2 > w/r = 5/2

But… the “bang for the buck” in labor larger than the “bang
for the buck” in capital…

MPL/w = 10/5 > MPK/r = 2/2

K = 0; L = 20

20
Chapter Seven
Comparative Statics

A change in the relative price of inputs changes the

slope of the isocost line.

All else equal, an increase in w must decrease the cost

minimizing quantity of labor and increase the cost
minimizing quantity of capital with diminishing MRTSL,K.

All else equal, an increase in r must decrease the cost

minimizing quantity of capital and increase the cost
minimizing quantity of labor.
21
Chapter Seven
Change in Relative Prices of Inputs

• Price of capital r = 1
• Quantity of output Q0 is
constant.
• When price of labor w =
1 the isocost line is C1,
optimal point A
• When price of labor w =
2 isocost line is C2,
optimal point B

22
Chapter Seven
 Some Key Definitions

An
Anincrease
increasein
inQQ00moves
movesthe
theisoquant
isoquantNortheast.
Northeast.

•• Expansion
Expansion Path:
Path: AA line
line that
that connects
connects the
the cost-minimizing
cost-minimizing input
input
combinations
combinations asas the
the quantity
quantity ofof output,
output, Q,
Q, varies,
varies, holding
holding input
input
prices
pricesconstant.
constant.
•• Normal
Normal Inputs:
Inputs: An
An input
input whose
whose cost-minimizing
cost-minimizing quantity
quantity
increases
increasesas
asthe
thefirm
firmproduces
producesmore
moreoutput.
output.
•• Inferior Input: An
Inferior Input: An input
input whose
whose cost-minimizing
cost-minimizing quantity
quantity
decreases
decreasesas asthe
the firm
firm produces
produces more
moreoutput.
output.

23
Chapter Seven
 An Expansion Path

As output increases, the cost minimization path

moves from point A to B to C when inputs are
normal

24
Chapter Seven
 An Expansion Path

As output increases, the cost minimization path

moves from point A to B to C when labor is an
inferior input

25
Chapter Seven
Input Demand

Definition: A function that shows how the

firm’s cost-minimizing quantity of input
varies with the price of that input.

Labor demand curve: Shows how the firm’s cost-

minimizing quantity of labor varies with the price of
labor.

Capital demand curve: Shows how the firm’s cost-

minimizing quantity of capital varies with the price of
capital.
26
Chapter Seven
Input Demand Functions

27
Chapter Seven
Input Demand

• For a fixed
quantity, as price
of labor increases
from $1 to $2, firm
moves along its
labor demand
curve from A to B.
Increase in output
shifts the demand
curve.

28
Chapter Seven
Price Elasticity of Demand for Inputs

• Percentage change in the cost-minimizing quantity of labor

with respect to a 1% change in the price of labor.
L w
 L,w 
w L
• Percentage change in the cost-minimizing quantity of capital
with respect to a 1% change in the price of capital.

K r
 K ,r 
r K
29
Chapter Seven
Price Elasticity of Demand for Inputs

30
Chapter Seven
Short-Run Cost Minimization

Total Variable Costs – the sum of total expenditures on

variable inputs, such as labor and materials, at the short-
run cost-minimizing input combination

Total Fixed Costs – the cost of fixed inputs; it does not

vary with output

• Variable and nonsunk

• Fixed and nonsunk
• Fixed and sunk

31
Chapter Seven
Short-Run Cost Minimization

One fixed Input - CapitalK

• Short run combination
is point F
• If the firm were free to
adjust all of its inputs,
the cost-minimizing
combination is at Point
A

32
Chapter Seven
Short-Run Cost Minimization

• Long run-all variables

are variable and the
expansion path is from A
–B–C
• Short run-some
variables are fixed
(capital)-the expansion
path is from D –E –F

33
Chapter Seven
Short-Run Cost Minimization

• Short run: One input is fixed, capital K .

Firm can vary the other input, labor. SO
demand for labor will be independent of
price.

• Short run demand for labor will also depend

on quantity produced. As quantity
increased, labor used increases holding
capital fixed.
34
Chapter Seven
Short-Run Cost Minimization

Q  50 LK  1000 • Capital is fixed K

2
Q
L
2500 K

35
Chapter Seven
Short-Run Cost Minimization

• More than one variable input – analysis similar

to long-run cost minimization
• 3 inputs – labor (L), capital ( ), raw materials
K
(M)
w
 MRTS L , M 
m

MPL w

MPM m

36
Chapter Seven