Cost Minimization and the Cost Function

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1 Cost Minimization and the Cost Function Juan Manuel Puerta October 5, 2009

2 So far we focused on profit maximization, we could look at a different problem, that is the cost minimization problem. This is useful for some reasons: Different look of the supply behavior of competitive firms But also, this way we can model supply behavior of firms that don t face competitive output prices (Pedagogic) We get to use the tools of constrained optimization Cost Minimization Problem: min x wx such that f(x) = y Begin by setting-up the Lagrangian: L(λ, x) = wx λ(f (x) y) Differentiating with respect to x i and λ you get the first order conditions, w i λ f (x ) x i = 0 for i=1,2,...,n f (x ) = y

3 Letting Df (x) denote the gradient of f (x), we can write the n derivative conditions in matrix notation as, w = λdf (x ) Dividing the i th condition by the j th condition we can get the familiar first order condition, w i w j = f (x ) x i f (x ), for i, j = 1, 2,..., n (1) x j 1 This is the standard isocost=slope of the isoquant condition 2 Economic intuition: What would happen if (1) is not an equality?

4 Source: Varian, Microeconomic Analysis, Chapter 4, p. 51.

5 Second Order Conditions In our discussion above, we assume we approach the isoquant from below. Do you see that if your isoquant is such that the isocost approaches it from above there is a problem? Other way of saying this is: if we move along the isocost, we cannot increase output? Indeed, output should remain constant or be reduced. Assume differentiability and take a second-order Taylor approximation of f (x 1 + h 1, x 2 + h 2 ) where h i are small changes in the input factors. Then, f (x 1 + h 1, x 2 + h 2 ) f (x 1, x 2 ) + f (x 1,x 2 ) x 1 h 1 + f (x 1,x 2 ) x 2 h 2 + (1/2)[ 2 f (x 1,x 2 ) h 2 x f (x 1,x 2 ) x 1 x 2 h 1 h f (x 1,x 2 ) h 2 x2 2 2 ]

6 Second Order Conditions Since we assumed a move along the isocost, w 1 h 1 + w 2 h 2 = 0 = λ(f 1 h 1 + f 2 h 2 ) where the last equality follows from using FOC (w i = λf i ) But in order to be at an optimum, f (x 1 + h 1, x 2 + h 2 ) f (x 1, x 2 ) 0, which means that ( h1 h 2 ) ( f 11 f 12 f 21 f 22 ) ( ) h1 0 (2) for f 1 h 1 + f 2 h 2 = 0 Generalizing to the n-factor case, h D 2 f (x)h 0 for all h satisfying wh = 0 Where h = (h 1, h 2,..., h n ) is a quantity vector (a column vector according to our convention) and D 2 f (x) is the Hessian of the production function. Intuitively, FOC imply that the isocost is tangent to the isoquant. SOC imply that a move along the isocost results on a reduction h 2

7 The second order conditions can also be expressed in terms of the Hessian of the Lagrangian D 2 L(λ, x1, x 2 ) = 2 L λ 2 2 L x 1 λ 2 L x 2 λ 2 L λ x 1 2 L x1 2 2 L x 2 x 1 2 L λ x 2 2 L x 1 x 2 2 L x2 2 Computing these derivatives for the case of our Lagrangian function L(λ, x) = wx λ(f (x) y)

8 The resulting is the Bordered Hessian 0 f 1 f 2 D 2 L(λ, x1, x 2 ) = f 1 λf 11 λf 12 f 2 λf 21 λf 22 It turns out that the sufficient conditions stated in (2) are satisfied with strict inequality if and only if the determinant of the bordered hessian is negative. Similarly, if you have n factors, the bordered Hessians for the n-cases should be negative

9 Difficulties For each choice of w and y, there should be an optimum x that minimizes the cost of producing y. This is the Conditional Factor Demand (Cf. factor demands in profit maximization) Similarly, the Cost Function is the function that gives the minimum cost of producing y at the factor prices w. c(w, y) = wx(w, y)

10 As in the profit maximization case, there could be cases in which the first order conditions would not work 1 Technology not representable by a differential production function (e.g. Leontieff) 2 We are assuming interior solution, i.e. that all the inputs are used in a strictly positive amount. Otherwise, we have to modify the conditions according to Kuhn-Tucker, λ f (x ) x i w i 0 with strict equality if x i > 0 3 The third issue concerns the existence of the optimizing bundle. The cost function, unlike the profit function, will always achieve a minimum. This follows from the fact that a continuous function achieves a minimum and a maximum on a compact (close and bounded) set. (more on that on the next slide) 4 The fourth problem is the issue of uniqueness. As we saw, calculus often ensures that a local maximum is achieved. For finding global maxima you have to make extra assumptions, namely V(y) convex.

11 More on why existence of a solution would not be a problem in the cost minimization case? Because we are minimizing a continuous function on a close and bounded set. To see this, wx is certainly continuous and V(y) is closed by assumption (regularity assumption). Boundedness could be proved easily. Assume an arbitrary x, then the minimal cost bundle must have a lower cost, wx wx. But then we can restrict to a subset {x in V(y):wx wx }, which is bounded so long w 0

12 Some Examples of Cost Minimization Cobb Douglas with 2 inputs, f (x 1, x 2 ) = Ax a 1 xb 2. CES, f (x 1, x 2 ) = (x ρ 1 + xρ 2 )1/ρ. Homework! Leontieff, f (x 1, x 2 ) = min{ax 1, bx 2 }. Linear, f (x 1, x 2 ) = ax 1 + bx 2. Illustration of the Kuhn-Tucker conditions.

13 2-input case In the usual fashion, the conditional factor demand function imply the following identities, f (x(w,y)) y w λdf(x(w,y) 0 For the simpler 1-output, 2-input case, FOC imply f (x 1 (w 1, w 2, y), x 2 (w 1, w 2, y)) y w 1 λ f (x 1(w 1,w 2,y),x 2 (w 1,w 2,y)) x 1 0 w 2 λ f (x 1(w 1,w 2,y),x 2 (w 1,w 2,y)) x 2 0

14 As we did with the FOC of the profit maximization problem, we can differentiate these identities with respect to the parameters, e.g. w 1 f x 1 x 1 w 1 + f x 2 x 2 w λ[ 2 f x 1 x1 2 w λ[ 2 f x 1 x 2 x 1 w f x2 2 2 f x 1 x 2 x 2 w 1 ] f x 1 x 2 w 1 ] f x 2 Which can be written in matrix form as, λ 0 f 1 f 2 w f 1 λf 11 λf 21 1 x 1 w 1 f 2 λf 12 λf 22 x 2 w 1 λ w 1 0 λ w Note that the matrix on the left is precisely the Bordered Hessian

15 Recall the Cramer s Rule, we can use it to solve for x i / w 1 x 1 w 1 = 0 0 f 2 f 1 1 λf 21 f 2 0 λf 22 0 f 1 f 2 f 1 λf 11 λf 21 f 2 λf 12 λf 22 Solving the determinant on the top, and letting H denote the lower determinant x 1 w 1 = f 2 2 H < 0 In order to satisfy SOC, H < 0, which means that the conditional factor demand has a negative slope.

16 Similarly, you can use Cramer s rule to solve for x 2 x 2 w 1 = 0 f 1 0 f 1 λf 11 1 f 2 λf f 1 f 2 f 1 λf 11 λf 21 f 2 λf 12 λf 22 w 1, Carrying out the calculations, x 2 w 1 = f 2f 1 H > 0 Similarly, you can differentiate the identities above with respect to w 2 to get 0 f 1 f 2 f 1 λf 11 λf 21 f 2 λf 12 λf 22 λ w 2 x 1 w 2 x 2 w

17 And using the Cramer s rule again, you can obtain x 2 w 1 = f 1f 2 H > 0 Compare the expressions for x 1 w 2 and x 2 w 1. You will notice that as in the case of the factor demand functions, there is a symmetry effect. In the 2-factor case, x i w j substitutes. > 0, means that factors are always Of course, this analysis is readily extended to the n-factor case. As in the case of the profit maximization problem, it is better to use matrix notation.

18 n-input case The first order conditions for cost minimization are 1 f (x(w)) y w λdf (x(w)) 0 Differentiating these identities with respect to w, Df (x(w))dx(w) = 0 I λd 2 f (x(w))dx(w) Df (x(w))dλ(w) = 0 Rearranging this expression, ( ) ( ) 0 Df (x(w)) Dλ(w) Df (x(w)) λd 2 f (x(w)) Dx(w) = ( ) 0 I 1 We omitted y as an argument as it is fixed.

19 Assuming a regular optimum so that the Hessian is non-degenerate. Then pre-multiplying each side by the inverse of the Bordered Hessian we obtain, ) ( ) 1 ( ) 0 ( Dλ(w) Dx(w) = 0 Df (x(w)) Df (x(w)) λd 2 f (x(w)) From this expression, it follows that, since the hessian is symmetric, the cross-price effects are symmetric. Also, It can be shown that the substitution matrix is negative semi-definite. I

20 The cost function The cost function tells us the minimum cost of producing a level of output given certain input prices. The cost function can be expressed in terms of the conditional factor demands we talked about earlier c(w,y) wx(w,y) Properties of the cost function. As with the profit function, there are a number of properties that follow from cost minimization. These are: 1 Nondecreasing in w. If w w, then c(w, y) c(w, y) 2 Homogeneous of degree 1 in w. c(tw, y) = tc(w, y) for y>0. 3 Concave in w. c(tw + (1 t)w ) tc(w) + (1 t)c(w ) for t [0, 1] 4 Continuous in w. c(w, y) is a continuous function of w, for w 0

21 Proof : Non-decreasing Homogeneous of Degree 1 Concave Continuous Intuition for concavity of the cost function

22 Proof : Non-decreasing Homogeneous of Degree 1 Concave Continuous Intuition for concavity of the cost function

23 Proof : Non-decreasing Homogeneous of Degree 1 Concave Continuous Intuition for concavity of the cost function

24 Proof : Non-decreasing Homogeneous of Degree 1 Concave Continuous Intuition for concavity of the cost function

25 Proof : Non-decreasing Homogeneous of Degree 1 Concave Continuous Intuition for concavity of the cost function

26 Shepard s Lemma Shepard s Lemma: Let x i (w, y) be the firm s conditional factor demand for input i. Then if the cost function is differentiable at (w, y), and w i > 0 for i = 1, 2, 3,..., n then, x i (w, y) = c(w,y) w i for i = 1, 2,..., n Proof In general there are 4 approaches to proof and understand Shepard s Lemma 1 Differentiate de identity and use FOC (Problem set 2) 2 Use the Envelope theorem directly (see next section) 3 A geometric argument 4 A economic argument. At the optimum x, a small change in factor prices has a direct and an indirect effect. The indirect effect occurs through re-optimization of x but this is negligible in the optimum. So we are left with the direct effect alone, and this is just equal to x.

27 Envelope theorem for constrained optimization Shepard s lemma is another application of the envelope theorem, this time for constrained optimization. Consider the following constrained maximization problem M(a) = max x1,x 2 g(x 1.x 2, a) such that h(x 1, x 2, a) = 0 Setting up the lagrangian for this problem and obtaining FOC, g x 1 λ h x 1 = 0 g x 2 λ h x 2 = 0 h(x 1, x 2, a) = 0 From these conditions, you obtain the optimal choice functions, x 1 (a), x 2 (a) obtaining the following identity M(a) g(x 1 (a), x 2 (a))

28 Envelope theorem for constrained optimization The envelope theorem says that dm(a) is equal to dm(a) da = g(x 1,x 2,a) a x=x(a) λ h(x 1,x 2,a) a x=x(a) In the case of cost minimization, the envelope theorem implies c(x,w) w i da = L w i = x i xi =x i (w,y) = x i (w, y) c(x,y) y = L y = λ The second implication follows also from the envelope theorem and just means that (at the optimum), the lagrange multiplier of the minimization cost is exactly the marginal cost.

29 Comparative statics using the cost function Shepard s lemma relates the cost function with the conditional factor demands. From the properties of the first, we can infer some properties for the latter. 1 From the cost function being non decreasing in factor prices follows that conditional factor demands are positive. c(w,y) w i = x i (w, y) 0 2 From c(w, y) being HD1, it follows that x i (w, y) are HD0 3 From the concavity of c(w, y) if follows that its hessian is negative semi-definite. From Shepard s lemma it follows that the substitution matrix for the conditional factor demands is equal to the Hessian of the cost function. Thus, 1 The cross price effects are symmetric. x i / w j = 2 c/ w i w j = 2 c/ w j w i = x j / w i 2 Own price effects are non-positive ( x i / w i = 2 c/ w 2 i 0 3 The vectors of own factor demands moves opposite to the vector of changes of factor prices. dwdx 0

30 Comparative statics using the cost function Shepard s lemma relates the cost function with the conditional factor demands. From the properties of the first, we can infer some properties for the latter. 1 From the cost function being non decreasing in factor prices follows that conditional factor demands are positive. c(w,y) w i = x i (w, y) 0 2 From c(w, y) being HD1, it follows that x i (w, y) are HD0 3 From the concavity of c(w, y) if follows that its hessian is negative semi-definite. From Shepard s lemma it follows that the substitution matrix for the conditional factor demands is equal to the Hessian of the cost function. Thus, 1 The cross price effects are symmetric. x i / w j = 2 c/ w i w j = 2 c/ w j w i = x j / w i 2 Own price effects are non-positive ( x i / w i = 2 c/ w 2 i 0 3 The vectors of own factor demands moves opposite to the vector of changes of factor prices. dwdx 0

31 Comparative statics using the cost function Shepard s lemma relates the cost function with the conditional factor demands. From the properties of the first, we can infer some properties for the latter. 1 From the cost function being non decreasing in factor prices follows that conditional factor demands are positive. c(w,y) w i = x i (w, y) 0 2 From c(w, y) being HD1, it follows that x i (w, y) are HD0 3 From the concavity of c(w, y) if follows that its hessian is negative semi-definite. From Shepard s lemma it follows that the substitution matrix for the conditional factor demands is equal to the Hessian of the cost function. Thus, 1 The cross price effects are symmetric. x i / w j = 2 c/ w i w j = 2 c/ w j w i = x j / w i 2 Own price effects are non-positive ( x i / w i = 2 c/ w 2 i 0 3 The vectors of own factor demands moves opposite to the vector of changes of factor prices. dwdx 0

32 Comparative statics using the cost function Shepard s lemma relates the cost function with the conditional factor demands. From the properties of the first, we can infer some properties for the latter. 1 From the cost function being non decreasing in factor prices follows that conditional factor demands are positive. c(w,y) w i = x i (w, y) 0 2 From c(w, y) being HD1, it follows that x i (w, y) are HD0 3 From the concavity of c(w, y) if follows that its hessian is negative semi-definite. From Shepard s lemma it follows that the substitution matrix for the conditional factor demands is equal to the Hessian of the cost function. Thus, 1 The cross price effects are symmetric. x i / w j = 2 c/ w i w j = 2 c/ w j w i = x j / w i 2 Own price effects are non-positive ( x i / w i = 2 c/ w 2 i 0 3 The vectors of own factor demands moves opposite to the vector of changes of factor prices. dwdx 0

33 Average and Marginal Costs Cost Function:c(w, y) wx(w, y) Let s break up the w in fixed w f and variable inputs w v, w = (w f, w v ). Fixed inputs enter optimization as constants. Short-run Cost Function:c(w, y, x f ) = w v x v (w, y, x f ) + w f x f Short-run Average Cost: SAC = c(w,y,x f) y Short-run Average Variable Cost: SAVC = wvxv(w,y,x f) y Short-run Average Fixed Cost: SAFC = w fx f y Short-run Marginal Cost: c(w,y,x f) y Long-run Average Cost: LAC = c(w,y) y Long-run Marginal Cost: LMC = c(w,y) y

34 The total cost function is usually assumed to be monotonic, the more we produce, the higher the costs The average cost could be increasing/decreasing with output. We generally assume it achieves a minimum. The economic rationale is given by: 1 Average variable cost could be decreasing in some range. Eventually, it would become increasing 2 Even if they are increasing all the way, average fixed costs are decreasing. The minimum of the average cost function is called the minimal efficient scale Marginal cost curve cuts SAC and SAVC from the bottom at the minimum

35 Constant Returns to Scale: If the production function exhibits constant returns to scale, the cost function may be written as c(w, y) = yc(w, 1) Proof: Assume x solves the cost minimization problem for (1, w) but yx does not the problem for (y, w). Then there is x that minimizes costs for production level y and w, and it is different than x. This implies that wx < wx for all x in V(y) and f (x ) = y. But then, CRS implies that f (x /y) = 1, so x /y V(1) and wx y < w x for all x V(1). We found a input vector x that is feasible at (w,1) and it is cheapest way of producing it. This means that x is not cost-minimizing. From this proof follows that c(w, y) = wx(w, y) = wyx(w, 1) = ywx(w, 1) = yc(w, 1).

36 For the first unit produced, marginal cost equals average cost Long run cost is always lower than short run cost Short run marginal cost should be equal to the long run marginal costs at the optimum (application of the envelope theorem). If c(y) c(y, z(y) and let z be an optimal choice given y Differentiation with respect to y yields, dc(y,z(y )) dy = c(y,z ) y + c(y,z ) z z(y ) y = c(y,z ) y Where the last inequality follows from FOC of the minimization problem with respect to z ( c(y,z ) z = 0)

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