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Lesson Three

Production function Microeconomics

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14 views13 pages

Lesson Three

Production function Microeconomics

Uploaded by

juniorwafula782
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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THE FIRM III: THE COST FUNCTION LECTURE THREE [TRODUCTION In the last two lessons, we learnt that the production function represents the maximum possible output. We now tum to the study of the minimum expenditure of attaining this ‘maximum output. It is the cost function, LECTURE OBJECTIVES @ W By the end of the lesson, the student be able To define the cost function and understand its properties. To derive the cost function. To understand the duality between the cost function and the production function. Itis defined as the minimum cost of producing a given output level during a given period of time. The cost function is expressed as a function of input prices and output ie. C(W,.Y)= min[Wx : X 0 Ww> 0. y>0 It’s not possible to produce a positive output at zero cost. As long as input prices are all strictly positive, the cost of producing a positive output must also be positive 2. Non-decreasing in input prices i.e. if W and w' are two vectors of input prices and that “(w ww, then; Clw, 3. The cost function is non-decreasing in output; ify > y' C(w, ») > Cw, y') ie. increasing output cannot reduce costs. 4, Fixed cost in the long run are zero If the cost function is differentiable in W, then there exists a unique vector of cost minimizing demand given by the first derivative of the cost function with respect to the input price. ie. if x,(w,y) is the unique cost minimizing input demand then, sdb Thisis referred to.as the shepherd's lemma The cost function is concave and continuous in input prices. Le. the Hessian matrix of the cost funetion is negative semi-definite. », w, H= <0 Ph om, a Sey Where ac uy, is the input demand an ec <0is the slope of the demand function which is always negative. 7. The cost function is positively linearly homogenous in input prices. ise. C(Aw,y)=ACGy,y), VA >0 that is, only relative prices matter to economically optimizing agents. As long as input prices vary only proportionately, the cost minimizing choice of inputs will not vary. DERIVATION OF COST FUNCTION. Given the firms production function as y = AL* K'* Let ® be the price of labour and the price of capital. So that the firm’s expression of the cost equation is given as C = wl +rK The firm seeks the minimum cost of producing the level of output? wt Adal K™ i) 2 +7A(l —ae)L* K~ =0. (ii) 20 SO 2 y- ALK = it a (iii) Rewriting equations (i) and (ii) Adal KY" AA(l— a1 )L*K* Dividing two equations AAaLeK™ r —AA(I- a)" K* wa K r I-@L b= "k. (iv) loa w Expansion paths K-@¥*) () ar Substituting equation (v) into equation (ii) L’ and K"is the combination of inputs that minimizes the cost of producing y. They are referred to as the conditional factor demands. The minimum cost of producing is given by DUALITY BETWEEN PRODUCTION FUNCTION AND COST FUNCTION We can use exclusively the cost phenomena to reconstruct and to study the properties of the technology. ie. we can describe the technology entirely in terms of the cost function. The implication here of being able to deseribe the technology using the cost function is that the specification of a well cost function C(w, y) is equivalent to the specification of a well behaved production function f(x) We could therefore say that the cost function is a sufficient statistics for the technology since all the economically relevant information about the technology can be obtained from the cost function. The decision therefore to use either the direct function (production function) or the indirect function (cost function) is a matter of convenience, This is the most important aspect of duality theorem. Given a production function we can obtain the cost function by solving the constrained cost minimization problem as shown abov . We wish now to see how, given a cost function, we could recover the form of the underlying technology i. the production function, Given the cost function; C = kyw*r'™* Using the shepherds lemma, Z = 2 xe a ar L=akyw tr L= oo(*) r SUMMARY In this lesson we have not only defined the minimum cost of producing a given level of input, but we have also learnt of the strong relationship between the cost function and the production. The decision to use either is a matter of convenience. NOTE The cost function is a sufficient statistics for the technology since all the economically relevant information about the technology can be obtained from the cost function, SELF-TEST QUESTIONS Given the following cost function, determine the underlying production function. C(j,»;,») = 10s y> Where 2” is the output and ¥; and ¥, are the prices of two inputs x, and 2 respectively.

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