CHAPTER 5 COST FUNCTION

The cost function measures the minimum cost of producing a given level of output for some
fixed factor prices, also summarizes the information about the technological choices available
to the firm and turns out the behavior of the ost function that can tell us a lot about the nature
of the technology of the firm.

5.1. Average and marginal costs

Consider the cost function expressed as the value of the conditional factor demands.

Just says that the minimum cost of producing y units of output is the cost of the cheapest way
to produce y.

In the short run the factors of production are fixed at predetermined levels. Let xf be the
vector of fixed factors xv the vector of variable factors and break up w into w=(wv, wf). The
short run conditional factor demand functions will generally depend on xf, so we write them as
xv(w, y, xf). So it can be written like this:

The term wvxv(w, y, xf) is called short run variable cost (SVC) and the term wfxf is the fixed
cost (FC). These are various cost derived cost concepts:

We can express the long run function in terms of the short run cost function. Lets xf(w, y) be
the optimal choice o the fixed factors and let xv(w, y) = xv(w, y, xf(w, y)) be the long-run
optimal choice of the variable factors. Then the long-run cost function can be written as:

We can also have similar concepts defined above:

5.2. The geometry of costs.

In the short run the cost function has two components: fixed costs and variable costs. We can
write the short run average cost as:

We can consider the short run fixed factors such as machines, buildings and other type of
capital equipment and variable costs are associated with the output changes.

Lets us now consider the curve of marginal cost. It has a relationship with average cost. Let y*
denote the point of minimum average cost; then to the left of y* average costs are declining so
that for y≤y*

Taking the derivative gives:

This inequity says that the marginal cost is less than average cost to the left of the left of the
minimum average cost point. A similar analysis shows that.

Since both hold inequities in y* we have:

5.3. Long-run and short run cost curves.

There is a relationship between long and short run cost curves. Let us write the long run cost
function as d(y)=c(y, z(y)). Here we have omitted the factor prices since they are assumed to
be fixed and let z(y9 be cost minimizing demand for a single fixed factor.

Let y¨be some level of outpu and z*=z(y*) be associated long run demand fo the fixed factor.

This is just as geometric restatement of the envelope theorem. The slope of the long run cost
curve at y* is:

But since z* is the optimal choice of the fixed factors at the output level y* we must have:

Thsu long run marginal costs at y* short run costs at (y*, z*). Finally, we note the long and shor
run cost curves are tangent.
5.4. Factor prices and cost functions

Properties of the cost function.

1. Nondrecreasing w. if w’ ≥w, then c(w’, y) ≥ c(w, y)

The most important note is the concavity property of the function similarly to the profit
function. Suppose the price of the factor 1 changes from w1* to w1. If we just behave
passively and continue to use x* our costs will be C=w1x1 + ∑(t=2) wi*xi* The minimal cost of
production c(w, y) must be less than this passive cost function . Both curves coincide in w1.
5.5 Envelope theorem for constrained optimization

Consider a constrained maximization problem of the form

In this case of the function g(x1, x2, a) = w1x1+w2x2, h(x1, x2, a) = f(x1, x2) –y and a could be
one of the prices. Constructing the Lagrangian.

FOC:

Turn to determine the maximum value form

The envelope theorem gives a formula for the derivative of the value function with the
parameter in the maximization problem.
Then the theorem asserts that:

5.6. Comparative statics using the cost function

Considering the properties we have found some restrictions too using several methods:

1. The cost function is nondecreasing in factor prices. Follow: δc(w, y)/dwi=xi(w, y)≥0
2. The cost function is homogeneous of degree 1 in w. Therefore, the derivatives of the
cost function, the factor demands, are homogeneous of degree 0 in w.
3. The cost function is concave in w.
 The cross price effects are symmetric.

 The own price effects are nonpositive. This follows since δc(w, y)/dwi=xi(w,
y)≤0 where the last inequity comes from the fact that the diagonal terms of a
negative semidefinite matrix must be nonpositive.
 The vecotor of changes in factor demands moves opposite the vector of
changes in factor prices. That is, dw dx≤0