Cost Minimization A Graphical Approach

A graphical solution boils down to determining the right way to combine information
about the firms costs and the firms production function. We have represented a firms
costs graphically using isocost lines. Isocost lines, however, dont convey any information
about how much the firm can produce with a set of inputs. They only indicate how much
each set of inputs costs. To represent the production function, we use isoquants. These
tell us, for a given production function, how much capital and labor it takes to produce a
fixed amount of output.
Before we work through a specific example, lets think about the logic of the firms
cost-minimization problem. The firms objective is to minimize costs subject to the
constraint that it has to produce a particular quantity of output, . The
cost-minimization part means the firm wants to be on an isocost line that is as close to
the origin as possible, because isocost lines closer to the origin correspond to lower levels
of expenditure. The output constraint means that the firm has to somehow end up on the
isoquant that corresponds to . Therefore, the firms best choice is to be on the isocost
line that is as close to the origin as possible but still provides enough capital and labor to
allow the firm to produce .
Figure 6.10 shows the isoquant for the firms desired output quantity . The firm
wants to produce this quantity at minimum cost. How much capital and labor should it
hire to do so? Suppose the firm is considering the level inputs shown at point A, which is
on isocost line C
A
. That point is on the Q = isoquant, so the firm will produce the
desired level of output. However, there are many other input combinations on the
isoquant that are below and to the left of C
A
. These all would allow the firm to produce
but at lower cost than input mix A. Only one input combination exists that is on the
isoquant but for which there are no other input combinations that would allow the
firm to produce the same quantity at lower cost. That combination is at point B, on
isocost C
B
. There are input combinations that involve lower costs than B for example,
any combination on isocost line C
C
but these input levels are all too small to allow the
firm to produce .
Point B has a special property. It is the point of tangency of the isocost line C
B
to
isoquant. In other words, when the total costs of producing a given quantity are
minimized, the isocost line is tangent to the isoquant.
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The end-of-chapter appendix uses
calculus to solve the firms
cost-minimization problem.
With this tangency property, we once again see a similarity to optimal consumer
behavior, which was also identified by a point of tangency. The parallels are particularly
strong if we think about the expenditure-minimization interpretation of consumer
behavior, where the consumer wants to choose a bundle of goods that minimizes the
total expenditure required to achieve a given level of utility. Here, the firm wants to
choose a set of inputs that minimizes the total cost of producing a given quantity of
output.
Another important feature of the tangency result is that by definition, the isocost line
and isoquant have the same slope at a tangency point. We know what these slopes are
from our earlier discussion. The slope of the isocost line is the negative of the relative
price of the inputs, W/R. For the isoquant, the slope is the negative of the marginal rate
of technical substitution (MRTS
LK
), which is equal to the ratio of MP
L
to MP
K
. The
tangency therefore implies that at the combination of inputs that minimizes the cost of
producing a given quantity of output (like point B), the ratio of input prices equals the
MRTS:
This condition has an important economic interpretation that might be easier to see if we
rearrange the condition as follows:
The way weve written it, each side of this equation is the ratio of an inputs marginal
product to its price (capital on the left, labor on the right). One way to interpret these
ratios is that they measure the marginal product per dollar spent on each input, or the
inputs bang for the buck. Alternatively, we can think of each of these ratios as the
firms marginal benefit-to-cost ratio of hiring an input.
Why does cost minimization imply that each inputs benefit-to-cost ratio is equal?
Suppose the firm was producing an input bundle where this wasnt true. For example, if
, the firms benefit-to-cost ratio for capital is higher than for labor. This
would mean that the firm could replace some of its labor with capital while keeping its
output quantity the same but reducing its total costs. Or if it wanted to, the firm could
substitute capital for labor in a way that kept its total costs constant but raised its output.
These options are possible because capitals marginal product per dollar is higher than
labors. If the sign of the inequality were reversed so , the firm could
reduce the costs of producing its current quantity (or raise its production without
increasing costs) by substituting labor for capital. Thats because, in this case, the
marginal product per dollar spent is higher for labor. Only when the benefit-to-cost
ratios of all the firms inputs are the same is the firm unable to reduce the cost of
producing its current quantity by changing its input levels.
Again, this logic parallels that from the consumers optimal consumption choice in
Chapter 4. The optimality condition for the consumers expenditure-minimization
problem was that the marginal rate of substitution between goods equals the goods price
ratio. Here, the analog to the MRS is the MRTS (the former being a ratio of marginal
utilities, the latter a ratio of marginal products), and the price ratio is now the input price
ratio. There is one place where the parallel between consumers and firms does not hold.
The budget constraint, which plays a big role in the consumers utility-maximization
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problem, doesnt really have a parallel in the firms production problem. As we discuss in
later chapters, firms desires to maximize their profits lead to a particular quantity of
output they want to produce. If for some reason they dont have enough resources to pay
for the inputs necessary to produce this quantity, then someone should always be willing
to lend them the difference, because the lender and the firm can split the extra profits
that result from producing the profit-maximizing output, making both parties better off.
This outcome means that with well-functioning capital markets, firms should never be
limited to a fixed amount of total expenditure on inputs in the same way a consumer is
constrained to spend no more than her income. Thats the idea embodied in our
Assumption 9.
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