Constrained Cost Minimisation

Cost minimization is a basic rule used by producers to determine what

mix of labor and capital produces output at lowest cost. In other words,
what the most cost effective method of delivering goods and services
would be while maintaining a desired level of quality.
Cost Minimisation rule;

Cost is minimized at the levels of capital and labor such that the marginal
product labor divided by the wage (w) is equal to the marginal product of
capital divided by the rental price of capital (r).

Cost minimization analysis ;

It compares the cost of two similar interventions to ascertain which is less
expensive. Cost minimization analysis, however, suffers from the problem that
it often compares two different interventions that may initially seem similar
but are not.
The cost minimization problem is constrained optimization. The firm wishes
to minimize the cost of producing certain level of output, but it is constrained
by its technological possibilities, as summarised by the production function.
Consequently, we will obtain Lagrange multiplier as part of the answer. The
Lagrange multiplier, is the shadow value of the constraint. In this case tells
us the increase in the firms cost that would arise if we expand output just a
little bit. This quantity is known as marginal cost.
Optimal choice: -
Firms seek to minimise cost subject to the constraint that they produce y units
of output. That is, the firms cost minimisation problem, (CMP), is given
by;
Min k,l wl+rk
s.t. f(k, l) = y
l0 k0
In the CMP parameters are given by factor prices, w and r, and the target level
of output, y. If we were given values for these parameters we could
obtain the actual quantities demanded. Since we are using arbitrary
quantities, our solution will be quantities of l and k as functions of factor
prices and target output levels:
l* (r, w, y ) and k* ( r, w, y)
This set of demand functions is known as conditional or derived demand
functions. Notice that conditional demand functions are functions of
target output y. This means that as we vary the relative factor cost, the
firms optimal quantities will always be on the same isoquant.

Conditional or derived demand

Conditional demand functions are the solution to the firms cost minimization
problem:
l* (w, r, y) and k*(w, r, y)
Properties of conditional demand functions;
Conditional demands are homogeneous of degree in prices
The solution is characterized by no excess production

Cost Function: -
If we take the conditional demand functions and plug them into the objective
function we obtain the firms cost function. This function tells us the minimum
money outlay necessary to achieve production y, given factor prices.
C(w, r, y)= wl*(w, r, y 0+ rk*(w, r, y)
Properties of the cost function
The cost function is homogeneous of degree 1 in prices.
The cost function is increasing by y
The cost function is non decreasing in w and r
The cost function is concave in w and r
The Langrage Multiplier: -
Let us now consider the interpretation of the Langrage multiplier, . Consider
the cost function.
C (w, r, y)
And let us find the extra cost that the firm must pay if it wishes to increase its
target output, y by a tiny amount. Mathematically speaking, we are looking for

dC (w, r ,y)/dy

If we use the definition of the cost function and compute its derivative
with respect to target output, we obtain:
 dC (y)/dy= w dl*(y)/dy+ r dk*(y)/dy,

where we have supressed w and r as arguments of the cost function and

of the conditional demand functions. If we recall the first order
conditions with respect to l and k :
[l] : w =*f1
[k] : r=*fk
And use them to substitute the for prices we obtain:
dC (y)/dy= * (f1 dl* (y0/dy + fk dk* (y)/dy)

Now, we totally differentiate the feasibility condition with respect to y :

F1 dl* (y)/dy+ fk dk*(y)/dy =1,

Which establishes that

dC (w, r, y)/dy=
Consequently, we can interpret as the firms marginal cost. This is the dollar
price of one additional unit of output. Notice that we have essentially proven
the envelope theorem while carrying out the above discussion.