THE FIRM 2

2.0. Introduction
In the first lesson, we learnt that the production function represents the maximum

possible output. We now turn to the study of the minimum expenditure of attaining this

maximum output. It is the cost function.

2.1. Objectives
• To define the cost function and understand its properties.

• To learn how to derive the cost function.

• To learn the duality between the cost function and the production function.

2.2. The Cost Function

It is 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

i.e. C (Wi , Y ) = min [WX : X ∈ V ( y ) ]

Where W is a vector of strictly positive input prices.

X is a vector of strictly positive inputs and,

WX = [W1 X 1 + W2 X 2 + ... + Wn X n ]

The cost function depends on technology since the only constraint to the minimization

problem expressed above is that X must be capable of producing at least output y .

2.2.1. Properties of a Cost Function

1. Non-negativity property i.e. C ( wi y ) > 0 ∀w > 0 , y > 0

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 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 ≥ w' , then; C ( w, y ) ≥ C ( w' y )

3. The cost function is non-decreasing in output; if y ≥ y ' C ( w, y ) ≥ C ( w, y ') i.e.

increasing output cannot reduce costs.

4. Fixed cost in the long run are zero

5. 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.

i.e. if xi ( w, y ) is the unique cost minimizing input demand then,

∂C ( wi , y )
xi ( w, y ) = This is referred to as the shepherd ' s lemma
∂wi

6. The cost function is concave and continuous in input prices. I.e. the Hessian matrix of

the cost function is negative semi-definite.

w1 w2

2
  ∂ 2c ∂ 2c 
w1
 ∂ w1 ∂ w1∂ w2 
2
H =
2  <0

∂ c ∂ c 2
w2
2

 ∂ w2∂ w1 ∂ w2 
Where

∂C
is the input demand and
∂wi

∂2C
< 0 is the slope of the demand function which is always negative.
∂wi2

7. The cost function is positively linearly homogenous in input prices.

i.e. C ( λw, y ) = λC ( w, y ), ∀λ > 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.

2.2.2. Derivation of cost function.

Given the firms production function as y = AL α K 1−α

Let w be the price of labour and r 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 y .

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 min C = wL + rK
s.t
y = AL α K 1−α

θ = wL + rK − λ( y − AL α K 1−α )
∂θ
= w + λAαLα−1 K 1−α = 0.......... .( i )
∂L
∂θ
= r + λA(1 −α) Lα K −α = 0.......... ...( ii )
∂K
∂θ
= y − AL α K 1−α = 0.......... ...( iii )
∂λ

Rewriting equations (i) and (ii)

w = −λAαLα−1 K 1−α
r = −λA(1 −α) Lα K −α

Dividing two equations

w − λAαLα −1 K 1−α
=
r − λA(1 − α ) Lα K −α

w α K
=
r 1− α L
α r 
L= K . . . . . .(.i.v.).
1− α w 
 E x p a n ps iaot nh s
1− α w
K= L. . . . . .(.v.). .
α r 

Substituting equation (v) into equation (iii)

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 1 − α w 
y = ALα  L
 α r 
1−α 1−α
1 −α   w 
y = ALα L1−α    
 α  r
L= y
1−α 1−α
1 −α   w 
A   
 α  r
L= y
w1−α
r 1−α
r 1−α
L = y 1−α
w
1−α
r 1
L* = y  1−α
w 1 − α 
A 
 α 
α
w 1
K = y 
*
α
r   α 
A 
1 −α 

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 y is given by

C = wL * + rK *
1−α α
1 r  1 w
C =w 1−α
y  +r α
y 
1 −α  w  α  r 
A  A 
 α  1 −α 
1 1
= 1−α
yr 1−α w α + α
yw α r 1−α
1 −α   α 
A  A 
 α  1 −α 
 
 
1 1
= yw α r 1−α  + 
 1 −α 1−α  α 
α 
 A  A  

  α  1 −α   
C = kyw α r 1−α

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2.2.3 Duality between production function and cost function
We can use exclusively the cost phenomena to reconstruct and to study the properties

of the technology. i.e. we can describe the technology entirely in terms of the cost

function.

The implication here of being able to describe 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 above. We wish now to see how, given

a cost function, we could recover the form of the underlying technology i.e. the

production function.

Given the cost function; C = kyw α r 1−α

∂C ∂C
Using the shepherds lemma, L = K =
∂w ∂r

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 L =αkyw α−1 1−α
r
α−1
w 
L =αky  
r 
α−1
w  L
  =
r  αky
1
w  L α−1
=
αky 

r  

K = (1 −α) kyw α r −α
α
w
K = (1 −α) ky  
r 
α
w K
  =
r  (1 −α)ky
1
w  K α
=
 (1 −α) ky 

r  

1 1
 L α−1  K α

 αky 
 =
 (1 −α) ky 

   

Raising both sides by α(α −1)

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 1 1
α ( α −1) α ( α −1)
 L α −1  K α
  =  
 αky   (1 − α ) ky 
α α −1
 L   K 
  =  
 αky   (1 − α ) ky 
Lα K α −1
=
(αk ) α y α [ (1 − α ) k ]α −1 y α −1
Lα [ (1 − α ) k ] y α −1 K α −1 (αk ) y α
α −1 α
=
K α −1 y α −1 K α −1 y α −1
Lα [ (1 − α ) k ]
α −1
K 1−α
y α −α −1 =
(αk ) α
if
[ (1 − α ) k ]α −1 =A
(αk ) α
y = ALα K 1−α

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.

Question

Given the following cost function, determine the underlying production function.

1 2
y is the output and w1 and w2 are the prices of two
C ( w1 , w2 , y ) = 10 w w y , where
3
1
3
2

inputs x1 and x2 respectively.

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Activity

( )
1
Suppose that f ( x , x ) = x  + x   . What is the associated cost function?
1 2 1 2

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.

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