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Total Revenue – Total Cost = π. Costs are dependent upon technology relationships between
inputs in production.
Production Function
Q = f(L,K) the amount obtainable from different amounts of input.
Q=Output, L= Labor, K=Capital
The marginal product of labor declines with labor, but it increases with capital. MPl as a
measure of labor productivity depends upon the tools available for labor. Holding the amount of
labor constant, giving it more tools raises productivity and MPl. On the other hand, if we hold
the amount of tools constant and increase the amount of labor, then the less the amount of tool
per unit labor, resulting in a decrease in labor productivity.
> 0 MPI,
Isoquant Convex shape of the
Isoquant is due to
the Law of
Diminishing
Q0 Marginal Returns. ∂
MPl / ∂L <0.
Q0
L - labor
Profit maximization requires Cost Minimization
Isocost Line - all combinations of L and K which cost the same. Isocost derived from total
cost function.
Total Cost = (w * L) + (r * K); where w=wage rate, L=Labor, r=rental rate K=capital.
Rewriting this in terms of the variable K allows us to plot into our input space
diagram, K= (TC/r) – (w/r) L. This is the isocost curve whose properties are: the further
from the origin (out to the North East) the greater the total cost, and w/r, its slope in the wage
rental ratio, or the relative price of labor in terms of capital. With regards to the latter, the
steeper the isocost the more expensive labor is relative to capital. Of course the converse also
holds, the flatter the cheaper labor is relative to capital.
K*
Q0
L* L - labor
The least cost input bundle lies on the isocost line tangent to the Isoquant. In other words the slopes of the two
are equal: -MPL/MPK = -w/r. Cross multiplying
leads to MPL/w = MPK/r, which is interpreted as
that the output per $ spent is equal across all inputs.
If this were not the case then the firm could
substitute the cheaper input for the more expensive
and thus lower costs.
A change in the price of an input, either labor or capital, will change the wage rental ratio and
consequently change the slope of the isocost curve. For example, if wages decrease, the isocost
line becomes flatter. Now the cost minimizing firm will need to seek a new set of inputs as a
result of the price change. Seeking the new tangency between the isoquant and the new isocost
the firm will substitute labor for capital until their slopes are equal moving from L1, K1 down
and to the right to L2, K2.
K - capital
K1
K2
w(1)/r Q0
w(2)/r
L1 L2 L - labor