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Producer’s Equilibrium
with Isoquants
Prof. K.V. Bhanu Murthy
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Introduction

 The producers are always faced with the problem of deciding about
combination of inputs that should be used for producing a commodity.

 A given level of output can be produced by employing various combination of

inputs.

 A rational producer will always choose optimum combination of inputs to

produce a particular given level of output.

 The combination of inputs is optimum if the given quantity of output can be

produced with minimum cost or if the maximum quantity of output can be
produced with a given cost of production.

 This decision of the producers is called as “Producer’s Equilibrium”.

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Isoquant

 An isoquant represents all possible combinations of

labor & capital that can be employed to produce a given
level of output.
 Along an isoquant, the ratio of inputs keeps on changing.
 Itis also known producer’s indifference curve or
production indifference curve because the producer is
indifferent between these combinations of factors.
 Allcombinations lying on the same isoquant produce the
same level of output.
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Derivation of Isoquant
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Production Isoquant

Elasticity of Technical Substitution

Capital

6
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Productive Efficiency
 Productive efficiency is concerned with the optimal
method of producing goods; producing goods at the lowest
cost (lowest real resource cost).
 This can be achieved in two ways
 Keep input use (K+L) constant and maximize output.
 (The Isoquant remains at the same level and it represents
more of output)
 Keep output level same and minimize use of inputs (K+L).
 (The Isoquant level is lowered and output remains same )
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Assumptions
 Fig 1.1 shows that an Isoquant is a locus of all different combinations of two factors
of production K (y)and L (x), such P, Q, R, Sand T can produce 20 units of output.

 An isoquant is based on the following assumptions:

 1. Employment of two factors Labor (L) and Capital (K)

 2. Q=F(K, L) Both K & L are variable (short-run).

 3. Continuous production function

 4. Various Choice of Technique – K/L ratio

 5. Given state of technology (K/L fixed)

 6. The two factors of production are substitutable

 Isoquant Map – A number of isoquants depicting different levels of output are

known as isoquant map.
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Isoquant Map
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Properties of Isoquants

 1. Isoquants are downward sloping

 It can be reasoned that there could be four cases:

 Vertical

 Horizontal

 Ray from the origin

 Downward sloping
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Slope of Isoquant

 1. If it is vertical then it means that the same amount of Labor (X-

Factor)can be combined with any amount of Capital (Y-Factor) to
produce the same amount of Commodity (M).

 Obviously Labor cannot be the fixed factor.

 2. If it is horizontal then there is no substitutability between labor and

capital.

 3. If it is a ray from the origin then it represents a situation where

larger and larger quantities of K and L combine to produce the same
quantity of output. This is impossible.
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Isoquants: Convex to the origin
 This feature of isoquants is based upon the ‘Principle of Diminishing Marginal Rate
of Technical Substitution’. The slope of an isoquant is known as the marginal rate of
technical substitution.

 MRTSLK is defined as the quantity of capital (K) that a firm is needs to substitute with
an additional quantity of labor (L) to produce the same output.

 MRTSLK = ΔK/ ΔL=MPL / MPK

 The MRTs goes on declining as we move down on the isoquant. Hence, MP L falls
and MPK rises, as we substitute labor for capital. The K/L ratio declines
continuously.

 Along downward sloping isoquant, marginal productivity of labor decreases with the
increase in units of labor and simultaneously marginal productivity of capital
increases with the reduction in the units of capital.

 Thus, lesser amount of capital is required to keep the output constant.

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Downward Sloping Isoquant
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Higher isoquant represents a higher
level of output
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Constraint: Iso-Cost Line
 An iso-cost line shows various combination of the two
factors (Capital and Labour) that a firm can employ with a
given amount of money for a given prices of the factors.
 Suppose, a firm has Rs.400 to spend on two factors say
labor (L) and Capital (K). The price of labor is Rs.10 per
unit and that of capital is Rs.40 per unit. This is explained
in figure below.
 If all the budget is spent on labor the producer can employ
40 units of labor. If all the budget is spent on K then he can
employ 10 unit of K.
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+ MRTS
MRTS is the slope of an isoquant and depicts the rate at which one input is substituted for the
other but it does not determine the degree of substitution between these inputs.
Elasticity of technical substitution is the only measure which determines the substitutability of
factors/inputs.
Elasticity of technical substitution is defines as the percentage change in the capital labour ratio
(K/L) divided by the percentage change in the MRTS. Symbolically,

Or,

Since throughout an isoquant, both K/L and MRTS moves in the same direction,
therefore the value of σ is always positive. Moreover, the value of elasticity of
technical substitution depends on the curvature of the isoquants. It varies
between 0 and ∞, depending on the nature of the production function.
Production function determines the curvature of the various kinds of isoquants.
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Producer’s Equilibrium

III

II
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Equilibrium Condition
 Point above ‘e’ is not desirable as it implies higher total cost. Point below ‘e’ it is feasible though not
desirable as the total budget (total cost) is not being expended. Thus, point e is the least cost combination
point. At the point of equilibrium ‘e’, slope of isoquant and slope of iso-cost line is equal. Thus, the
conditions of producer’s equilibrium are:

 ‘e’= Equilibrium Condition: Slope of isoquant = Slope of iso-cost

 MPL / MPK = MRTSLK (Definition)

 MPL / PL = MPK / PK (Allocative Efficiency)

 MPL / MPK = PL / PK (Transform)

 Since MPL / MPK = MRTSLK (Definition)

 Replace MPL / MPK with MRTSLK

 MRTSLK= PL / PK (Equilibrium)

 Final Condition

 MPL / MPK = MRTSLK = PL / PK

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Optimal Allocation

 MPL / PL = MPK / PK

 This is the condition of optimal allocation or allocative efficiency.

 If more of labor is employed then MPL will fall.

 If more of capital is employed then MPK will fall.

 Therefore, optimally neither more of labor nor more of capital can be

employed.

 This implies optimal combination of L and K for producing a given amount of

output, without increasing the cost.

 Here, the producer is in equilibrium.

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Ridge Lines
+ Ridge Lines
 It is important to note here that, neither an isoquant nor an isoquant map

is technically efficient because the MRTS on an isoquant decreases and

reaches to zero.

 This means that zero MRTS marks a limit to which one input can be substituted for another and
it also determines the minimum quantity of an input required for the production of an output.

 Beyond this point, it becomes important to employ both inputs for the production of the output
(as the substitution between inputs does not take place anymore beyond this point). Such a
point, where MRTS is equal to zero, can be determined by drawing a tangent on the Isoquant
such that it is parallel to both the axes. Here in the above diagram it is shown by the dash lines.
Hence, points a, b, c, d, e, f, g, h are the points where MRTS = 0 and one input cannot be
substituted for another anymore, i.e. the minimum amount of one input required for the
production of the other.

 When we join points a, b, c, d, we get an upper ridge line, OM and when we join points e, f, g,
h then we get a lower ridge line, ON, as shown above. The upper ridge lines shows that the
marginal productivity of capital is zero on OM whereas the lower ridge line shows that the
marginal productivity of labour is zero on ON. The area outside these ridge lines are the
technically inefficient area where production cannot take place.
+ Returns to Scale
 When both the inputs become variable and the change in both the inputs
affect the change in the output and correspondingly the size of the firm
changes, then it is known as the law of returns to scale. It is a long run
phenomenon where the supply of both labor and capital is elastic.
 When both labor and capital are increased proportionately or
simultaneously, then there are possibly three ways in which output can be
increased.
 Output may increase more than proportionately to an increase in inputs
 Output may increase proportionately to an increase in inputs
 Output may increase less than proportionately to an increase in inputs
 Correspondingly, there are three types of returns to scale.
When Output increases more than proportionately to an increase in inputs then
it is known as increasing returns to scale. For example, if labor and capital
both increase by 50% and correspondingly the output increases by more than
50%, then it is known as the increasing returns to scale. Consider figure 4:
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Increasing Returns to Scale

P
N

O
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CRS

O
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Decreasing Returns to scale

M
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Returns to Scale and Returns to Factor

K a<b<c => Decreasing Returns to

Scale

Slope of d> Slope of e> Slope of f> Slope of

g => MRTSLK

d
e f g
4
c
a b 3
2
1

L
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ISOCLINE
 Isocline is a locus along which the MRTS is constant.

 An Expansion Path is also an ISOCLINE.

 Isocline is a straight line is the production function is homogenous.

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Expansion Path