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Isoquant and Isocost
Isoquant and Isocost
and Product
Substitution
Isoquant
Isoquantmeans
meansequal
equalquantity
quantity
Output
Outputisis
identical
identicalalong
along
an
anisoquant
isoquant
Two
Twoinputs
inputs
Slope of an Isoquant
The slope of an isoquant is referred to as the
Marginal Rate of Technical Substitution, or
MRTS. The value of the MRTS in our example
is given by:
Slope of an Isoquant
The slope of an isoquant is referred to as the
Marginal Rate of Technical Substitution, or
MRTS. The value of the MRTS in our example
is given by:
MRTS
MRTS
here
hereisis
-41=
-41=-4
-4
What
What isis the
the slope
slope over
over
range
range B?
B?
What
What isis the
the slope
slope over
over
range
range B?
B?
MRTS
MRTS
here
hereisis
-11=
-11=-1
-1
What
What isis the
the slope
slope over
over
range
range C?
C?
What
What isis the
the slope
slope over
over
range
range C?
C?
MRTS
MRTS
here
hereisis
-.51=
-.51=-.5
-.5
Recall MRTS = dK / dL
MRS = dK / dL
Recall MRTS = dK / dL
MRTS = dK / dL
dK
MPL
dL
MPK
isoquant
Recall MRTS = dK / dL
MRTS = dK / dL
dK
MPL
MRTS
dL
MPK
isoquant
Firm
Firmcan
canafford
afford10
10units
unitsof
of
capital
capitalat
ataarental
rentalrate
rateof
of$100
$100
for
foraabudget
budgetof
of$1,000
$1,000
10
100
Labor
Firm
Firmcan
canafford
afford10
10units
unitsof
of
capital
capitalat
ataarental
rentalrate
rateof
of$100
$100
for
foraabudget
budgetof
of$1,000
$1,000
10
Firm
Firmcan
canafford
afford100
100units
unitsof
of
labor
laborat
ataawage
wagerate
rateof
of$10
$10for
for
aabudget
budgetof
of$1,000
$1,000
100
Labor
dK
PL
dL
PK
Line
LineAB
ABrepresents
represents
the
theoriginal
originaliso-cost
iso-cost
line
linefor
forcapital
capitaland
and
labor
labor
Change in wage rate
The
Theiso-cost
iso-costline
linewould
wouldshift
shiftout
out
to
toline
lineEF
EFififthe
thefirms
firmsavailable
available
budget
budgetdoubled
doubled(or
(orcosts
costsfell
fellin
in
half)
half)or
orback
backto
toline
lineCD
CDififthe
the
available
availablebudget
budgethalved
halved(or
(orcosts
costs
doubled.
doubled.
Change in wage rate
IfIfwage
wagerates
ratesfell
fellin
inhalf,
half,
the
theline
linewould
wouldshift
shiftout
outto
to
AF.
AF.The
Theiso-cost
iso-costline
linewould
would
shift
shiftin
into
toline
lineAD
ADififwage
wage
rates
ratesdoubled
doubled
The
Theiso-cost
iso-costline
linewould
would
shift
shiftout
outto
toline
lineBE
BEififrental
rental
rate
ratefell
fellin
inhalf
halfwhile
whilethe
the
line
linewould
wouldshift
shiftin
into
toline
line
BC
BCififthe
therental
rentalrate
ratefor
for
capital
capitaldoubled
doubled
Slope
Slope of
of an
an
isoquant
isoquant
Slope
Slope of
of isoisocost
cost line
line
MP
MPLL per
per dollar
dollar
spent
spent on
on labor
labor
MP
MPkk per
per dollar
dollar
spent
spent on
on capital
capital
MP
MPLL per
per dollar
dollar
spent
spent on
on labor
labor
MP
MPkk per
per dollar
dollar
spent
spent on
on capital
capital
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
Iso-cost
Iso-costline
linefor
for$1,000.
$1,000.
Its
Itsslope
slopereflects
reflectsprice
priceof
of
labor
laborand
andcapital.
capital.
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
We
Wecan
can determine
determine
this
this graphically
graphicallyby
by
observing
observing where
where
these
these two
two curves
curves
are
aretangent.
tangent.
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
We
Wecan
canshift
shiftthe
theoriginal
original
iso-cost
iso-costline
linefrom
fromAB
ABout
out
in
inaaparallel
parallelfashion
fashionto
to
A*B*
A*B*(which
(whichleaves
leavesprices
prices
unchanged)
unchanged)which
whichjust
just
touches
touchesthe
theisoquant
isoquantat
atG
G
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
At
Atthe
thepoint
pointof
oftangency,
tangency,we
weknow
knowthat:
that:
slope
slopeof
ofisoquant
isoquant==slope
slopeof
ofiso-cost
iso-costline,
line,or
or
MPP
MPPCAPITAL = - (wage rate rental rate)
MPPLABOR
LABOR MPPCAPITAL = - (wage rate rental rate)
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
At
Atthe
thepoint
pointof
oftangency,
tangency,therefore,
therefore,the
theMPP
MPPper
per
dollar
dollarspent
spenton
onlabor
laborisisequal
equalto
tothe
theMPP
MPPper
per
dollar
dollarspent
spenton
oncapital!!!
capital!!! See
Seeequation
equation(8.5)
(8.5)on
on
page
page181,
181,which
whichisisanalogous
analogousto
toequation
equation(4.2)
(4.2)
back
backon
onpage
page76
76for
forconsumers.
consumers.
dK
MPL
PL
MRTS
dL
MPK
PK
100
O
Units of labour (L)
MPL PL
MPK PK
MPL MPK
PL
PK
100
O
Units of labour (L)
MPL MPK
PL
PK
Intuition is that money spent on each factor
should, at the margin, yield the same
additional output
Suppose not
MPL MPK
PL
PK
Suppose
MPL MPK
PL
PK
Then extra output per 1 spent on labour greater than extra output per 1 spent on
Capital
So switch resources from Capital to Labour
MPPL?
Down
MPPK?
Up
MPL MPK
PL
PK
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
This
Thistherefore
thereforerepresents
represents
the
thecheapest
cheapestcombination
combinationof
of
capital
capitaland
andlabor
laborto
toproduce
produce
100
100units
unitsof
ofoutput
output
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
IfIfIItold
toldyou
youthe
thevalue
valueof
ofCC11
and
andLL11and
andasked
askedyou
youfor
for
the
thevalue
valueof
ofA*
A*and
andB*,
B*,
how
howwould
wouldyou
youfind
findthem?
them?
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
IfIfIItold
toldyou
youthat
thatpoint
pointG
G
represents
represents77units
unitsof
ofcapital
capital
and
and60
60units
unitsof
oflabor,
labor,and
and
that
thatthe
thewage
wagerate
rateisis$10
$10
and
andthe
therental
rentalrate
rateisis$100,
$100,
then
thenat
atpoint
pointG
Gwe
wemust
mustbe
be
spending
spending$1,300,
$1,300,or:
or:
$1007+$1060=$1,300
$1007+$1060=$1,300
60
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
IfIfpoint
pointG
Grepresents
representsaatotal
total
cost
costof
of$1,300,
$1,300,we
weknow
knowthat
that
every
everypoint
pointon
onthis
thisiso-cost
iso-cost
line
linealso
alsorepresents
represents$1,300.
$1,300.
IfIfthe
thewage
wagerate
rateisis$10,
$10,then
then
point
pointB*
B*must
mustrepresent
represent130
130
units
unitsof
oflabor,
labor,or:
or:
$1,300$10
$1,300$10==130
130
60
130
Least
LeastCost
CostInput
InputChoice
Choicefor
for100
100Units
Units
And
Andthe
therental
rentalrate
rateisis$100,
$100,
then
thenpoint
pointA*
A*must
must
represents
represents13
13units
unitsof
of
capital,
capital,or:
or:
13
$1,300
$1,300$100
$100==13
13
60
130
Production Function
The firms production function for a
particular good (q) shows the maximum
amount of the good that can be produced
using alternative combinations of capital
(k) and labor (l)
q = f (k,l)
42
Returns to Scale
If the production function is given by q = f(k,l)
and all inputs are multiplied by the same
positive constant (t >1), then
43
Returns to Scale
It is possible for a production function to
exhibit constant returns to scale for some
levels of input usage and increasing or
decreasing returns for other levels
economists refer to the degree of returns to
scale with the implicit notion that only a fairly
narrow range of variation in input usage and
the related level of output is being considered
44
k per period
slope = -b/a
q1
q2
q3
l per period
46
Fixed Proportions
Suppose that the production function is
q = min (ak,bl) a,b > 0
47
Fixed Proportions
No substitution between labor and capital is
possible
k/l is fixed at b/a
k per period
q3
q3/a
q2
q1
q3/b
l per period
48
50
Paul Douglas
Cobb-Douglas
Production Function
Capital
Capital Income
Income == MPK
MPK KK== YY
Labor
LaborIncome
Income == MPL
MPL LL== (1(1- )
) YY
is a constant and measures capital and labors
share of income.
Cobb
Cobb showed
showed that
that the
the function
function with
with this
this
property
property is:
is:
11-
FF (K,
(K, L)
L) == AAKK LL
MPL
MPL== (1(1- )
)AAKK LL
Multiply
Multiplyand
and Divide
Divide right
right hand
hand side
side by
by L.
L.Then,
Then,
1-
1-
MPL
MPL== (1(1- )
) [A
[AKK LL ]] LL// LL== (1(1- )
) [A
[AKK LL ]] // LL
Average
MPL
Labour
MPL== (1(1- )
) YY// LL
Productivit
Similarly,
Similarly,The
The Marginal
Marginal product
product of
of capital
capital is:
is:y
Average
-1
1
MPK
Capital
MPK == A
AK
K-1LL1or,
or, MPK
MPK == Y/K
Y/K
Proof:
Consider the Cobb-Douglas Production
function:
F (K, L) = A K L1-
F(zK,zL) = A(zK) (zL)1-
F(zK,zL) = Az Kz1- L1-
1-
1-
F(zK,zL) = Az z K L
+1-
1-
F(zK,zL) = Az
K L
1-
1-
F(zK,zL) = Az K L
= zA K L
= zF(K,L)
= zY
Constrained Optimization
So far we have discussed optimizing
functions without placing restrictions
upon the values that the independent
variables can assume. Such problems
are often referred to as free maxima
and minima or free optima.
Constrained Optimization
Free
maximu
m
Constrain
ed
maximum
Free
maximu
m
Constrai
nt
Constrained Optimization
Since economists deal with the allocation of
scarce resources among alternative uses, the
concept of constraints or restrictions is
important.
There are two approaches to solving
constrained optima problems:
(i)
Substitution method
(ii)
Lagrange multipliers