Economics of Input

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:

MRTS = Capital Labor

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 = Capital Labor

If output remains unchanged along an isoquant,
the loss in output from decreasing labor must be
identical to the gain in output from adding capital.

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

Units of capital (K)

MRS = dK / dL

Loss of Output if reduce

K = - MPKdK
Gain of Output if increase
L = MPLdL
Along an Isoquant dQ=0
so - MPKdK = MPLdL
isoquant

Units of labour (L)

Recall MRTS = dK / dL

Units of capital (K)

MRTS = dK / dL

Along an Isoquant dQ=0

so - MPKdK = MPLdL

dK
MPL

dL
MPK
isoquant

Units of labour (L)

Recall MRTS = dK / dL

Units of capital (K)

MRTS = dK / dL

Along an Isoquant dQ=0

so - MPKdK = MPLdL

dK
MPL
MRTS

dL
MPK
isoquant

Units of labour (L)

Introducing Input Prices

Plotting the Iso-Cost Line

Capital

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

Plotting the Iso-Cost Line

Capital

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

Slope of an Iso-cost Line

The slope of an iso-cost in our example is given by:

Slope = - (wage rate rental rate)

or the negative of the ratio of the price of the two
Inputs.
($10 use of labor) + ($100 use of capital)=$1,000

What about the slope of an isocost line?

Units of capital (K)

Reduction in cost if reduce

K = - PKdK
Rise in cost if increase
L = PLdL
Along an isocost line
-PKdK = PLdL

Units of labour (L)

Units of capital (K)

What about the slope of an isocost line?

Along an isocost line

- PK dK = PL dL

dK
PL

dL
PK

Units of labour (L)

Original iso-cost line

Change in budget or both costs

Line
LineAB
ABrepresents
represents
the
theoriginal
originaliso-cost
iso-cost
line
linefor
forcapital
capitaland
and
labor
labor
Change in wage rate

Change in rental rate

Original iso-cost line

Change in budget or both costs

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

Change in rental rate

Original iso-cost line

Change in wage rate

Change in budget or both costs

Change in rental 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

Original iso-cost line

Change in wage rate

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

Change in budget or both costs

Change in rental rate

Least Cost Combination

of Inputs

Least Cost Decision Rule

The least cost combination of two inputs (labor and
capital in our example) occurs where the slope of the
iso-cost list is tangent to the isoquant:
MPLABOR MPCAPITAL = - (wage rate rental rate)

Slope
Slope of
of an
an
isoquant
isoquant

Slope
Slope of
of isoisocost
cost line
line

Least Cost Decision Rule

The least cost combination of labor and capital in out
example also occurs where:
MPLABOR wage rate = MPCAPITAL rental rate

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 Cost Decision Rule

This
decision
rule holds
a larger
The
least
cost combination
of labor for
and capital
in out
example
alsoof
occurs
where:as well
number
inputs
MPLABOR wage rate = MPCAPITAL rental rate

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 Cost Combination

of Inputs to Produce a
Specific Level of Output

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.

In equilibrium slope of Isoquant = Slope of isocost

Units of capital (K)

dK
MPL
PL
MRTS

dL
MPK
PK

100

O
Units of labour (L)

In equilibrium slope of Isoquant = Slope of isocost

Units of capital (K)

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

(Principle of Diminishing Marginal Returns)

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

The Linear Production Function

Suppose that the production function is
q = f(k,l) = ak + bl

This production function exhibits constant

returns to scale
f(tk,tl) = atk + btl = t(ak + bl) = tf(k,l)

All isoquants are straight lines

RTS is constant
45

The Linear Production Function

Capital and labor are perfect substitutes
RTS is constant as k/l changes

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

Capital and labor must always be used

in a fixed ratio
the firm will always operate along a ray
where k/l is constant

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

Cobb-Douglas Production Function

Suppose that the production function is
q = f(k,l) = Akalb A,a,b > 0

This production function can exhibit any returns

to scale
f(tk,tl) = A(tk)a(tl)b = Ata+b kalb = ta+bf(k,l)
if a + b = 1 constant returns to scale
if a + b > 1 increasing returns to scale
if a + b < 1 decreasing returns to scale
49

Cobb-Douglas Production Function

The Cobb-Douglas production function is
linear in logarithms
ln q = ln A + a ln k + b ln l
a is the elasticity of output with respect to k
b is the elasticity of output with respect to l

50

The Cobb-Douglas Producti

Paul Douglas

Capital Income = MPK K =

Y

CobbDouglas Production Function

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

A is a parameter that measures the productivity

of the available technology. (Total Factor Productivity)

CobbDouglas Production Function

CobbDouglas
CobbDouglas Production
Production Function:
Function:
1-1-
YY== FF(K,
L)
=
A
K
(K, L) = A K LL
Differentiating,
Differentiating, we
we get
get the
the Marginal
Marginal product
product of
of labor:
labor:

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

Properties of the CobbDouglas Production Fu

(1) Consider the CobbDouglas production function:

MPL = (1- )Y/L .(i)

MPK = Y/ K(ii)
Equation (i) tells us that marginal product of
the labour is proportional to output per worker
(average productivity of worker).
Similarly, equation (ii) states that marginal
product of the capital is proportional to the
output per unit of capital (average productivity
of capital).
In conclusion, Marginal productivity of a
factor is proportional to its average

Properties of the CobbDouglas Production Fu

(2) The CobbDouglas production function has constant
returns to scale. That is, if capital and labor are
increased by the same proportion, then output
increases by the same proportion as well.

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.

However, in the real world, often

restrictions or constraints
are placed upon values of the independent
variables.
These problems are referred to as
constrained optima or constrained optimization.

Constrained Optimization

Graphically, the difference between the free opt

and the constrained optima can be shown as:
Constrained
maximum
Constraint

Free
maximu
m

Constrain
ed
maximum

Free
maximu
m

Constrai
nt

The free optima occurs at the peak of the

surface.
If we specify a specific relationship between
variables
and
(a constraint) then the
search for an optimum is restricted to a slice of
the surface. The constrained maximum occurs at
the peak of the slice.

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