Appendix to Chapter 7 Production and Cost Theory Mathematical

Treatment
Cost Minimization
Production Function F(K,L) describes maximum output that can be produced
for every possible combination of inputs K (capital) and L (labor)
Examples:
Or

F(K,L) = K2L
F(K,L) = 10K + 5L
F(K,L) = (KL)0.5
q = K 2L
q = 10K + 5L
q = (KL)0.5

Marginal product of capital (holding labor constant) MPK= F ( K , L) / K

Marginal product of labor (holding capital constant) MPL= F ( K , L) / L
Assume positive MP
MPK> 0
MPL> 0
and diminishing marginal returns (diminishing MP)

MPK / K 0
MPL / L 0

Marginal Rate of Technical Substitution (MRTSLK)

Recall:
1. isoquant represents all input combinations that give the same level of
output, say q*. The isoquant is given by
F(K,L) = q*
2. Marginal rate of technical substitution of L for K (MRTS LK) is slope of the
isoquant (-dK/dL)
Exercise: Given the production function q = (KL)0.5, find the MRTS when q= q*.
Is the isoquant convex?
On a given isoquant, as inputs are changed, the output level remains the
same. Therefore, total change in output due to a change in K and L is
zero:

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dq*

q
q
dK
dL MPK dK MPL dL 0
K
L

Therefore,

MPL
dK

MRTS LK
MPK
dL
(A.7.1)
Exercise: Given the production function q = (KL) 0.5, show that MPL/MPK = MRTS
for any value of q.
Problem of Minimizing Cost
Competitive firms decision problem is:
Minimize C = wL + rK
subject to the constraint
F(K,L) = Q0
Where
Q0 = a fixed level of output
C = cost of producing Q0
w (wage) = price of labor
r = price of capital
Use Lagrange method to find optimum L, K and .
Lagrangian: = wL + rK [F(K,L) Q0]
Minimizing conditions:

F
r
r MPK 0
K
K

F
w
w MPL 0
L
L

F ( K , L ) Q0 0

From first two conditions:

MPK MPL

r
w
(A.7.2)

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To minimize cost, equate ratio of marginal product of each factor to its price.

Exercise: Suppose F(K,L) = K2L; Q0 = 20; r = 50; w = 10

a) Form the Lagrangian function (K, L, ) and the three conditions
for minimizing the firms cost C subject to the constraint that
F(K,L) = Q0
b) Solve for the firms cost-minimizing input combination (K*, L*)
Isocost line shows all combinations of labor and capital that can be
purchased for a given total cost C*
Rewrite the cost function C* = wL + rK as

C* w
L
r
r
w
r = slope of isocost line

where
Rewriting (A.7.2) as

MPL w

MPK r
Given (A.7.1),
MRTS = w/r.
The slope of the isoquant (-MRTS) equals the slope of the isocost (-w/r) at the
cost-minimizing point. The isoquant is tangent to the isocost at this point.
Exercise: Confirm that the isoquant is tangent to the isocost for the above
example.
Marginal Cost of Production ()
Lagrange multiplier from first two conditions:

Where

r
w

MPK MPL

r
r
K

r
MPK F / K
F

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measures additional input cost of producing an additional unit of output by
increasing capital;

w
w
L

w
MPL F / L
F

measures additional input cost of producing an additional unit of output by

increasing labor; and
= marginal cost of production
measures how much cost increases if output increased by one unit.
Duality in Production and Cost Theory
Producers choice choosing lowest isocost line tangent to a given isoquant
Another view of producers choice choosing highest isoquant touching a
given isocost line
=> duality existence of two perspectives of production theory
Can use Lagrangian method to solve problem:
Maximize F(K,L)
Subject to the constraint that
wL + rK = C0
Solution will yield the same conditions as above (see P&R, page 258).
Cobb-Douglas Cost and Production Functions
The Cobb-Douglas production function:

F(K,L) = AKL

where A, and are constants

Marginal Product of K and L:

MPK [ F ( K , L)] / K AK 1L
MPL [ F ( K , L] / L AK L 1
Assume 0 < < 1, 0 < < 1 => decreasing marginal products of labor and
capital:
Returns to Scale
Doubling inputs:

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F * ( K , L) A(2 K ) (2 L) A2 K L 2 F ( K , L)
If

+=1
+>1
+<1

constant returns to scale

increasing returns to scale
decreasing returns to scale

Minimizing Cost
The Lagrangian for the Cobb-Douglas Production Function is

wL rK ( AK L q 0 )
This can be solved to yield the cost minimizing quantities of capital and labor
(see p. 276-277 of P&R):

w
K *

r
L*

q0

q0
A

Notes:
If w rises relative to r, the firm will use more capital instead of labor
If A increases (say with technological change), both K* and L* will
decrease.
Total cost function to produce output Q with a Cobb-Douglas production
function is derived by substituting above equations for K and L into cost
equation C = wL + rK:

Cw

q
A

And finally, if + = 1, then the cost function becomes:

C w r

1
q
A

Notes:
If + = 1, costs increase proportionately with output (no economies
of scale)

If + > 1, economies of scale; If + < 1, diseconomies of scale

Assignment for Next Class:

Prepare to discuss the following exercises:
From P&R, chapter 6, Exercise 8; chapter 7, Exercise 8
From P&R, chapter 7 Mathematical Annex: Exercises 1- 4a