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Economics of Inputinput combinations
Prepared By: Milan Padariya
Topics of DiscussionConcept of isoquant curveConcept of an iso-cost lineLeast-cost use of inputs
2
Physical Relationships
3
Use of Multiple Inputs
This lecture will refer to situations where we have multiple variable inputsLabor, machinery rental, fertilizer application,
pesticide application, etc.
4
Use of Multiple InputsOur general single input production function
looked like the following: Output = f(labor | capital, land, energy, etc)
Lets extend this to a two input production function Output = f(labor, capital | land, energy, etc)
Variable Input Fixed Inputs
Fixed InputsVariable Inputs
5
Use of Multiple InputsOutput (i.e. Corn Yield)
250
Nitrogen Fert.
Phos. Fert.
6
Use of Multiple InputsIf we take a slice at a level of
output we obtain what is referred as an isoquantSimilar to the indifference
curve we covered when we reviewed consumer theory
Shows collection of multiple inputs that generates a particular output level
There is one isoquant for each output level
250
Output isidentical alongan isoquant and different across isoquants
Isoquant means “equal quantity”Isoquant means “equal quantity”
Two inputs
Slope of an IsoquantThe slope of an isoquant is referred to as
the Marginal Rate of Technical Substitution (MRTS) The value of the MRTS in our example is given
by: MRTS = Capital ÷ Labor Provides a quantitative measure of the
changes in input use as one moves along a particular isoquant
Slope of an IsoquantThe slope of an isoquant is the
Marginal Rate of Technical Substitution (MRTS) Output remains unchanged along an
isoquant The ↓ in output from decreasing labor
must be identical to the ↑ in output from adding capital as you move along an isoquant
Labor
CapitalQ=Q*
L*
K*
MRTS here is– 4 ÷ 1 = – 4
MRTS here is– 4 ÷ 1 = – 4
What is the slope overrange B?
MRTS here is–1 ÷ 1 = –1
MRTS here is–1 ÷ 1 = –1
What is the slope overrange C?What is the slope overrange C?
MRTS here is–.5 ÷ 1 = –.5
MRTS here is–.5 ÷ 1 = –.5
Slope of an IsoquantSince the MRTS is the slope of the
isoquant, the MRTS typically changes as you move along a particular isoquantMRTS becomes less negative as shown
above as you move down an isoquant
Introducing Input Prices
Plotting the Iso-Cost LineLets assume we have the following
Wage Rate is $10/hour Capital Rental Rate is $100/hour
What are the combinations of Labor and Capital that can be purchased for $1000 Lets introduce the Iso-Cost Line
Plotting the Iso-Cost Line
Labor
Capital
10
100
Firm can afford 100 hour of labor at a wage rate of $10/hour for a budget of $1,000
Firm can afford 100 hour of labor at a wage rate of $10/hour for a budget of $1,000
Firm can afford 10 hours ofcapital at a rental rate of $100/hr with a budget of $1,000
Firm can afford 10 hours ofcapital at a rental rate of $100/hr with a budget of $1,000
Combination of Capital and Labor costing $1,000 Referred to as the $1,000 Iso-Cost
Line
Plotting the Iso-Cost LineHow can we define the equation of this iso-
cost line? Given a $1000 total cost we have:
$1000 = PK x Capital + PL x Labor → Capital =
(1000÷PK) – (PL÷ PK) x Labor→The slope of an iso-cost in our example is
given by:Slope = –PL ÷ PK
(i.e., the negative of the ratio of the price of the two inputs)
Plotting the Iso-Cost Line
Labor
Capital
20
200
10
5
10050
Doubling of Cost
Note: Parallel cost linesgiven constant prices
Original Cost Line
2,000÷PK
500 ÷ PK
Halving of Cost
500 ÷ PL 2000 ÷ PL
Plotting the Iso-Cost Line
Labor
Capital
10
10050 200
$1,000 Iso-Cost Line
Iso-Cost Slope = – PK ÷ PL
PL = $5PL = $10
PL = $20
Plotting the Iso-Cost Line
Labor
Capital
10
10050 200
$1,000 Iso-Cost Line
Iso-Cost Slope = – PK ÷ PL
20
5
PK = $200
PK = $100
PK = $50
Least Cost Combinationof Inputs
Least Cost Input Combination
Labor
CapitalTVC are predefined Iso-Cost Lines
TVC*
TVC**
TVC***
TVC*** > TVC** > TVC*
A
B
C
Pt. C: Combination of inputs that cannot produce Q*
Pt. A: Combination of inputs that have the highest of the two costs of producing Q*
Pt. B: Least cost combination of inputs to produce Q*
Q*
Least Cost Decision RuleThe least cost combination of two inputs
(i.e., labor and capital) to produce a certain output level Occurs where the iso-cost line is tangent to
the isoquant Lowest possible cost for producing that level
of output represented by that isoquant This tangency point implies the slope of the
isoquant = the slope of that iso-cost curve at that combination of inputs
Least Cost Decision RuleWhen the slope of the iso-cost = slope of the
isoquant and the iso-cost is just tangent to the isoquant
–MPPK ÷ MPPL = – (PK ÷ PL)
We can rearrange this equality to the following
Isoquant Slope
Isoquant Slope
Iso-cost Line SlopeIso-cost
Line Slope
Least Cost Decision Rule
=
L K
L k
MPP MPP
P P
MPP per dollar spent on labor
MPP per dollar spent on labor
MPP per dollar spent on capitalMPP per dollar spent on capital
Least Cost Decision Rule
3 51 2 4
1 2 3 4 5
MPP MPPMPP MPP MPP
P P P P P
The above decision rule holds for all variable inputs• For example, with 5 inputs we would have the
following
MPP1 per $ spent on Input 1
MPP1 per $ spent on Input 1 = MPP2 per $ spent
on Input 2
MPP2 per $ spent on Input 2 = …… =MPP5 per $ spent
on Input 5
MPP5 per $ spent on Input 5=
Least Cost Input Choice for 100 Units of OutputLeast Cost Input Choice for 100 Units of Output
7
60
Point G represents 7 hrs of capital and 60 hrs of labor
Wage rate is $10/hr and rental rate is $100/hr
→ at G cost is $1,300 = (100×7) + (10×60)
7
60
G represents a total cost of $1,300 every input combination on the iso-cost line costs $1,300
With $10 wage rate → B* represent 130 units of labor: $1,300$10 = 130
G represents a total cost of $1,300 every input combination on the iso-cost line costs $1,300
With $10 wage rate → B* represent 130 units of labor: $1,300$10 = 130
130
Least Cost Input Choice for 100 Units of OutputLeast Cost Input Choice for 100 Units of Output
130
Capital rental rate is $100/hr → A* represents 13 hrs of capital,
$1,300 $100 = 13
Capital rental rate is $100/hr → A* represents 13 hrs of capital,
$1,300 $100 = 1313
Least Cost Input Choice for 100 Units of OutputLeast Cost Input Choice for 100 Units of Output