CASE: Representation of the isoquants depending on the

returns of scale?
Concept of returns of scale: How much does the firm
produce when the use of inputs is multiplied by t>0? For
example, if inputs are doubled and the production doubles,
returns of scale are constant. If the production multiplies
by more than 2, returns of scale are increasing. If the
production multiplies by less than 2, returns of scale are
decreasing.

So, we can observe that, if returns of scale are constant,

isoquants are equidistant, if returns of scale are increasing,
isoquants are increasingly closer to each other, and, if
returns of scale are decreasing, isoquants are increasingly
distant to each other.
PRODUCTION COSTS
5. THE FIRM´S PROBLEM
The firm is a price taker competitive in the labour and
capital markets, in which the prices are w and r,
respectively. This means that it cannot influence the prices.
(This assumption is reasonable if the labour and capital
markets are large relative to the firm’s output market.)
Let p denote the market price of good Q.

In the product market, if the company is small, variations in

the production decisions hardly have an impact on market
supply, it is price – taker in the product market.
If the company is large relative to the market supply, we
cannot assume it is a price – taker, the firm has market
power.

The firm’s objective is maximizing its profit, the difference

between revenue and costs.
𝑀𝑎𝑥 𝑝. 𝑄 − (𝑤𝐿 + 𝑟𝐾)
𝑠. 𝑡. 𝐹(𝐿, 𝐾) ≤ 𝑄, 𝐿 ≥ 0, 𝐾 ≥ 0, 𝑄 ≥ 0

For now, let us postpone the profit – maximization problem

and let us treat the “internal” problem of the firm taking
the production level as given: 𝑄0 . Then, the intermediate
objective would be minimizing the cost of producing the
level 𝑄0 .

𝑀𝑎𝑥 𝑝. 𝑄0 − 𝑤𝐿 − 𝑟𝐾 → 𝑀𝑎𝑥 − 𝑤𝐿 − 𝑟𝐾 →
𝑀𝑖𝑛 𝑤𝐿 + 𝑟𝐾

So, the firm’s problem is:

𝑀𝑖𝑛 𝑤𝐿 + 𝑟𝐾
𝑠. 𝑡. 𝐹(𝐿, 𝐾) ≤ 𝑄, 𝐿 ≥ 0, 𝐾 ≥ 0

6. COSTS MINIMIZATION
It is an internal objective of the firm and previous to the
profit maximization.
TYPES OF COST CONCEPTS:
Accounting costs: purchase price net of depreciation.
Opportunity costs: value of the best alternative use.
Sunk costs: unrecoverable costs asociated with past
decisions.
From an economic point of view, relevant costs are
opportunity cost, sunk costs are irrelevant in making
optimal decisions.
Example: A firm owns a building that is not being used in
the production process. Accounting cost? Opportunity
cost?

LONG RUN MINIMIZING COST

In the long run, both inputs are variable. Thus, the cost –
minimization problem is:
𝑀𝑖𝑛 𝑤𝐿 + 𝑟𝐾
𝑠. 𝑡. 𝐹(𝐿, 𝐾) ≤ 𝑄
𝐿 ≥ 0, 𝐾 ≥ 0

Solving the problem, we find conditional demand functions

of inputs: they express the optimal quantity of input
needed to produce each amount of output, given the price
of the inputs.
𝐿∗ = 𝐿(𝑤, 𝑟, 𝑄)
𝐾 ∗ = 𝐾(𝑤, 𝑟, 𝑄)

To analyse, in each case, how conditional demands are

obtained, previously we need to define the ISOCOST LINES.
Each isocost line represents all input combinations that cost
the same.
𝐶 = 𝑤𝐿 + 𝑟𝐾

The cost increases when the firm uses a greater quantity of

inputs, that is, if the isocost moves away from the origin.
But the objective of the firm is to minimize the cost, that is,
moving towards the origin.
Convex isoquants: the optimal combination of inputs is in
the point where the isoquant is tangent to the isocost line.

Solution: solving these two conditions.

𝑤
𝑀𝑅𝑇𝑆 =
𝑟

𝑄 = 𝐹 (𝐿, 𝐾)

Example: 𝑄 = 𝐿𝐾

1/2 1/2
𝑄𝑟 𝑄𝑤
𝐿∗ = ( ) 𝐾 ∗ = ( )
𝑤 𝑟
An isoquant shows all the combinations of inputs that allow
to produce the same quantity, which means that inputs can
be substituted. If the price of labour increases, the firm can
choose another combination of inputs that allows it to
produce the same quantity while minimizing the cost.
Producing the same, it moves from combination A to
combination B.

PERFECT SUBSTITUTES: Cost is minimized in one corner or

in the entire curve. Red curves represent isoquants and
blue lines represent isocosts.
𝑤 𝑤
𝑀𝑅𝑇𝑆 > 𝑀𝑅𝑇𝑆 <
𝑟 𝑟
 𝑤
If 𝑀𝑅𝑇𝑆 > , the isoquant’s slope (in red) is greater than
𝑟
the isocost´s (in blue). The optimal combination is A and it
only uses labour to produce.
Solution: 𝐾 ∗ = 0; 𝑄 = 𝐹(𝐿, 0) → 𝐿∗ (𝑄)

𝑤
If 𝑀𝑅𝑇𝑆 < , the isoquant’s slope (in red) is lesser than the
𝑟
isocost´s (in blue). The optimal combination is B and it only
uses capital to produce.
Solution: 𝐿∗ = 0; 𝑄 = 𝐹(0, 𝐾) → 𝐾 ∗ (𝑄)

𝑤
If 𝑀𝑅𝑇𝑆 = , the slope of both lines coincides, so any
𝑟
combination of factor that can produce 𝑄0 is optimal-
Solution: 𝐿∗ = 𝛾 ∈ [0, 𝐿𝑚𝑎𝑥 ]
𝑄 = 𝐹(𝛾, 𝐾) → 𝐾 ∗ (𝑄)
Example: 𝑄 = 𝐿 + 2𝐾

𝑤 1
𝑄 𝑠𝑖 <
𝑟 2
𝑤 1
𝐿∗ = 𝛾 𝜖[0, 𝑄 ] 𝑠𝑖 =
𝑟 2
𝑤 1
{ 0 𝑠𝑖 >
𝑟 2
𝑤 1
0 𝑠𝑖 <
𝑟 2
𝑄−𝛾 𝑤 1
𝐾∗ = 𝑠𝑖 =
2 𝑟 2
𝑄 𝑤 1
{ 2 𝑠𝑖 >
𝑟 2
PERFECT COMPLEMENTS: Cost is minimized in the vertex.

Solution: the optimal combination does not depend on the

prices of the inputs.

Example: 𝑄 = 𝑚𝑖𝑛{2𝐿, 3𝐾}

COST MINIMIZATION IN THE SHORT RUN

̅ in the short run, then the
If we assume capital is fixed in 𝐾
cost – minimization problem is:
̅
𝑀𝑖𝑛 𝑤𝐿 + 𝑟𝐾
̅) ≤ 𝑄
𝑠. 𝑡. 𝐹(𝐿, 𝐾
𝐿 ≥ 0, 𝐾 ≥ 0

̅ is the fixed cost (FC).

Then, 𝑟𝐾
The firm cannot choose the optimal combination of inputs
that minimizes cost, since capital is given. The firm chooses
the amount of labour required for each quantity of output.

If we substitute the fixed amount of capital, and solve the

equation for L, the short run conditional labour demand is:
̅) = 𝑄 → 𝐿∗ = 𝐿(𝑄, 𝐾
𝐹 (𝐿, 𝐾 ̅)

Example: 𝑄 = √𝐿𝐾 when K = 36

7. COST FUNCTIONS
TOTAL COST FUNCTION: It is the minimum cost of
production for a given level of output, Q, and input prices
w and r.
Short run: ̅
𝐶 (𝑄, 𝑤, 𝑟 ) = 𝑤. 𝐿∗ (𝑄, 𝑤, 𝑟 ) + 𝑟. 𝐾
The total cost may be decomposed as the sum of the
variable cost (the cost of variable inputs) and the fixed cost
(the cost of the fixed inputs):
̅
𝑉𝐶 = 𝑤. 𝐿∗ (𝑄, 𝑤, 𝑟 ); 𝐹𝐶 = 𝑟. 𝐾 Then, 𝑇𝐶 = 𝑉𝐶 + 𝐹𝐶
Long run: 𝐶 (𝑄, 𝑤, 𝑟 ) = 𝑤. 𝐿∗ (𝑄, 𝑤, 𝑟 ) + 𝑟. 𝐾 ∗ (𝑄, 𝑤, 𝑟 )
All costs are variable. 𝑇𝐶 = 𝑉𝐶
For given input prices, long – run total cost is always lesser
or equal to short – run total cost.

AVERAGE (TOTAL) COST FUNCTION: It measures average

cost of production.
𝐶 (𝑄, 𝑤, 𝑟 )
𝐴𝐶 (𝑄, 𝑤, 𝑟 ) =
Q
In the short run there are variable and fixed inputs, so,
there are variable and fixed costs.
𝑉𝐶 𝐹𝐶
𝐴𝐶 (𝑄, 𝑤, 𝑟 ) = + = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
𝑄 𝑄

In the long run all costs are variable:

𝐴𝑇𝐶 = 𝐴𝑉𝐶

For given input prices, the long – run average cost is lesser
or equal to the short – run average cost.

MARGINAL COST FUNCTION: It measures the cost increase

due to a marginal (infinitesimal) increase of output.
𝜕𝐶 (𝑄, 𝑤, 𝑟 )
𝑀𝐶 (𝑄, 𝑤, 𝑟 ) =
𝜕Q
For given input prices, the long – run marginal cost may be
larger or smaller than the short – run marginal cost.

Example: calculate the total cost, average cost and marginal

cost of a firm whose conditional demands are:
𝑄𝑟 1/2 ∗ 𝑄𝑤 1/2
𝐿∗ =( ) 𝐾 =( )
𝑤 𝑟
when 𝑤 = r = 1.