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ECON 5000 Production Theory Spring 2010

Reading (1) on Io!uant"Iocot ana#yi (capita# #a$or u$titution)


Source%
www.oup.com/uk/orc/bin/9780199286416/01student/interactive/lipsey_etra_c!06/pa"e_
04/!tm
Isoquants and the conditions for cost minimization
Finding the efficient way of producing any output requires finding the least-cost input
combination. To do this when both inputs are variable, prices of inputs need to be known.
Suppose that capital is priced at ! per unit and labour at ". #e can now draw what
is called an isocost line, which shows all of the combinations of the two inputs that can
be purchased for a given outlay. Four such lines are shown in Figure $.%. For given factor
prices, the parallel isocost lines reflect alternative levels of spending on inputs. The higher
the spending, the further from the origin is the isocost line. &ote that the isocost line is
similar to the budget line which shows all the combinations of two goods that can be
bought with a given income.
Figure $.% Isocost lines
An isocost line shows alternative factor combinations that can be purchased for
a given outlay.
The graph shows the four isocost lines that result when labour costs " a unit and
capital ! a unit and e'penditure is held constant at "(, (!, %$, and !)
respectively. The line labelled TC * "( represents all combinations of the two factors
that the firm could buy for "(. +oint a represents ( units of K and ! units of L.
,n Figure $.! the isoquant and isocost maps are brought together. - careful study of that
figure reveals the following important results. ,f the isoquant cuts the isocost line, it is
possible to move along the isoquant and reach a lower level of cost. #here the isoquant
is tangent to the isocost line, however, a movement in either direction along the isoquant
is a movement to a higher level of cost. Thus.
The least-cost method of producing any given output is shown graphically by
the point of tangency between the relevant isoquant and an isocost line.
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Figure $.! The determination of the least-cost method of output
Least-cost methods are represented by points of tangency, such as A, between
isoquant and isocost lines.
The isoquant map of Figure /.( and the isocost map of Figure /.% are brought together
here. 0onsider point A. ,t is on the $-unit isoquant and the (! isocost line. Thus, it is
possible to achieve an output of $ units for a total cost of (!. There are, however,
other ways to achieve this output. For e'ample, at point B, $ units are produced, but at a
total cost of !).
&ow consider moving along the isocost line, say from point A to point C. -lthough costs
are held constant, output falls from $ to ! units.
+oint A thus shows both the least-cost method of producing $ units of output and the
ma'imum output that can be produced for an outlay of (!. 1oving along the isoquant
from point A in either direction clearly increases cost.
&otice that point A in Figure $.! indicates not only the lowest level of cost for $ units of
output but also the highest output for (! of cost. This illustrates the general
proposition that we find the same solution if we set out either to minimi2e the cost of
producing a given output or to ma'imi2e the output that can be produced for a given
cost. 3ne problem is said to be a dual of the other.
The absolute value of the slope of the isocost line is given by the ratio of the prices of the
two inputs. The slope of the isoquant is given by the ratio of their marginal products.
45oth statements refer to absolute values.6 #hen the firm reaches its least-cost position,
it has equated the price ratio 4which is given to it by the market prices6 with the ratio of
marginal products 4which it can ad7ust by varying the proportions in which it hires the
inputs6. ,n symbols,
#e have now derived this result by use of the isoquant analysis of the firm8s decisions.
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