CHAPTER III MICROECONOMICS-I

UNIT THREE
THE THEORY OF PRODUCTION
3.1 Introduction: Definition and basic concepts
Production means creation of utility for sales. Alternatively, production may be defined as the
act of creating those goods/services which have exchange value for sale (not for personal
consumption).In order to get utility from raw materials, first they must be transformed into
output. However, transforming raw materials into final products require factor inputs such as
land, labor, and capital and entrepreneurial ability.
Fixed Vs variable inputs
In economics, inputs can be classified as fixed & variable. Fixed inputs are those inputs whose
quantity can not readily be changed when market conditions indicate that an immediate change
in output is required. In fact no input is ever absolutely fixed, but may be fixed during an
immediate requirement. Buildings; machineries and managerial personnel are examples of fixed
inputs because their quantity cannot be manipulated easily in short time periods.
Variable inputs, on the other hand, are those inputs whose quantity can be changed almost
instantaneously in response to desired changes in output. That is, their quantity can easily be
diminished when the market demand for the product decreases and vice versa. The best example
of variable input is unskilled labor.
Short run vs. long run
In economics, short run refers to that period of time in which the quantity of at least one input is
fixed. For example, if it requires a firm one year to change the quantities of all the inputs, those
time periods below one year are considered as short run. Thus, short run is that time period
which is not sufficient to change the quantities of all inputs, so that at least one input remains
fixed. Long run is that time period (planning horizon) which is sufficient to change the
quantities of all inputs. Thus there is no fixed input in the long -run.

3.2Production in the short run: Production with one variable input

Production with one variable input (while the others are fixed) is obviously a short run
phenomenon because there is no fixed input in the long run.

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Assumption of short run production analysis

In order to simplify the analysis of short run production, the classical economist assumed the
following:
1. Perfect divisibility of inputs and outputs
This assumption implies that factor inputs and outputs are so divisible that one can hire, for
example a fraction of labor, a fraction of manager and we can produce a fraction of output, such
as a fraction of automobile.
2. Limited substitution between inputs
Factor inputs can substitute each other up to a certain point, beyond which they cannot substitute
each other.
3. Constant technology
They assumed that level of technology of production is constant in the short run.
Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor (which is variable
input). Given the assumptions of short run production, the firm can increase output only by
increasing the amount of labor it uses.
Hence, its production function is
Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
3.3 Total product, marginal product and average product
Total product: is the total amount of output that can be produced by efficiently utilizing a
specific combination of labor and capital. The total product curve, thus, represents various levels
of output that can be obtained from efficient utilization of various combinations of the variable
input, and the fixed input. It shows the output produced for different amounts of the variable
input, labor.
Any ways, increasing the variable input (while some other inputs are fixed) can increase the total
product only up to a certain point. Initially, as we combine more and more units of the variable
input with the fixed input output continues to increase. But eventually, increasing the unit of the
variable input may not help output increase. Even as we employ more and more unit of the
variable input beyond the carrying capacity of a fixed input, output may tends to decline.

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Thus increasing the variable input can increase the level of output only up to a certain point,
beyond which the total product tends to fall as more and more of the variable input is utilized.
This tells us what shape a total product curve assumes. The shape of the total variable curve is
nearly S-shape (see fig 2.1 Panel A)
Marginal Product (MP)
The marginal product of variable input is the addition to the total product attributable to the
addition of one unit of the variable input to the production process, other inputs being constant
(fixed). Before deciding whether to hire one more worker, a manager wants to determine how
much this extra worker (L =1) will increase output, q. The change in total output resulting
from using this additional worker (holding other inputs constant) is the marginal product of the
worker. If output changes by q when the number of workers (variable input) changes by ∆L, the
change in output per worker or marginal product of the variable input, denoted as MP L is found
as

MPL =

Thus, MPL measures the slope of the total product curve at a given point. In the short run,
the MP of the variable input first increases reaches its maximum and then tends to decrease
to the extent of being negative. That is, as we continue to combine more and more of the
variable inputs with the fixed input, the marginal product of the variable input increases
initially and then declines.
Average Product (AP)
The AP of an input is the ratio of total output to the number of variable inputs.

The average product of labor first increases with the number of labor (i.e. TP increases faster
than the increase in labor), and eventually it declines.

Graphing the short run production curves

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The following figures shows how the TP, MP and AP of the variable (labor) input vary with the
number of the variable input.

Output

TP3

TP2 TP

TP1

Units of labor (variable input)

L1 L2 L3
APL, MPL

APL

Units of labor (variable input)

L1 L2 L3
MPL

Fig 3.1 Total product, average product and marginal product curves: As the number of the
labor hired increases (capital being fixed), the TP curve first rises, reaches its maximum when L3
amount of labor is employed, beyond which it tends to decline. Assuming that this short run

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production curve represents a certain car manufacturing industry, it implies that L3 numbers of
workers are required to efficiently run the machineries. If the numbers of workers fall below L3,
the machine is not fully operating, resulting in a fall in TP below TP3. On the other hand,
increasing the number of workers above L3 will do nothing for the production process because
only L3 number of workers can efficiently run the machine. Increasing the number of workers
above L3, rather results in lower total product because it results in overcrowded and unfavorable
working environment.
Marginal product curve increases until L 1 number of labor reaches its maximum at L 1, and then it
tends to fall. The MPL is zero at L3 (when the TP is maximal); beyond which its value assumes
zero indicating that each additional worker above L3 tends to create over crowded working
condition and reduces the total product. Thus, in the short run (where some inputs are fixed), the
marginal product of successive units of labor hired increases initially, but not continuously,
resulting in the limit to the total production. Geometrically, the MP curve measures the slope of
the TP. The slope of the TP curve increases (MP increases) up to L1, it decreases from L1 to L3
and it becomes negative beyond L3.
The average product curve increases up to L2, beyond which it continuously declines. The AP
curve can be measured by the slope of rays originating from the origin to a point on the TP
curve. For example, the APL at L2 is the ratio of TP2 to L2. This is identical to the slope of ray
a.
The relationship between AP and MP of the variable input
The relationship between MPL and APL can be stated as follows:
 For all number of workers (Labor) below L2, MPL lies above APL.
 At L2, MPL and APL are equal.
 Beyond L2, MPL lies below the APL
Thus, the MPL curve passes through the maximum of the APL curve from above. This
relationship between APL and MPL can be shown algebraically as follows:
Suppose the production function is given as
TP = f (L), K -being constant
Given the total product function,

And =

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To determine the relationship between APL and MPL, consider the slope of the APL function.

Slope of APL = = = --------

(quotient rule of differentiation)

Slope of APL = - ----------------------------- (note that )

= -

Slope of APL = , because = MPL and = APL

Now – when MPL > APL, Slope of APL is positive (APL rises)
 When MPL = APL, Slope of APL is zero (APL is at its maximum).
 When MPL < APL, Slope of APL is negative (APL falls)
3.4 The law of diminishing marginal returns (LDMR): short –run law
Of production
The LDMR states that as the use of an input increases in equal increments (with other inputs
being fixed), a point will eventually be reached at which the resulting additions to output
decreases. When the labor input is small (and capital is fixed), extra labor adds considerably to
output, often because workers get the chance to specialize in one or few tasks. Eventually,
however, the LDMR operates: when the number of workers increases further, some workers will
inevitably become ineffective and the MPL falls (this happens when the number of workers
exceeds L1 in fig 2.1)
Note that the LDMR operates (MP of successive units of labor decreases) not because highly
qualified laborers are hired first and the least qualified last. Diminishing marginal returns results
from limitations on the use of other fixed inputs (e.g. machinery), not from decline in worker
quality. The LDMR applies to a given production technology (when the level of technology is
fixed). Over time, however, technological improvements in the production process may allow the
entire total product curve shift upward, so that more output can be produced with the same input.

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3.5 Efficient Region of Production in the short-run

It is possible to determine ranges over which the variable input (labor) be employed.
To do best with this, let’s refer back to fig 2.1 and divide it into three ranges called stages of
production.
 Stage I – ranges from the origin to the point of equality of the APL and MPL.
 Stage II – starts from the point of equality of MPL and APL and ends at a point where
MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.
Now, which stage of production is efficient and preferable?
To answer the question, let us follow elimination method.
Obviously, a firm should not operate in stage III because in this stage additional units of variable
input are contributing negatively to the total product (MP of the variable input is negative)
because of overcrowded working environment i.e., the fixed input is over utilized.
Stage I is also not an efficient region of production though the MP of variable input is positive.
The reason is that the variable input (the number of workers) is too small to efficiently run the
fixed input; so that the fixed input is underutilized (not efficiently utilized)
Thus, the efficient region of production is stage II. At this stage additional inputs are contributing
positively to the total product and MP of successive units of variable input is declining
(indicating that the fixed input is being optimally used). Hence, the efficient region of production
is over that range of employment of variable input where the marginal product of the variable
input is declining but positive.

3.6 Long run Production: Production with two variable inputs

For the sake of simplicity, assume that the firm uses two inputs (labor and capital) and both are
variable. The firm can now produce its output in a variety of ways by combining different
amounts of labor and capital. With both factors variable, a firm can usually produce a given level
of output by using a great deal of labor and very little capital or a great deal of capital and very
little labor or moderate amount of both. In this section, we will see how a firm can choose among
combinations of labor and capital that generate the same output. To do so, we make the use of
isoquant.

Isoquants

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An isoquant is a curve that shows all possible efficient combinations of inputs that can yield
equal level of output. If both labor and capital are variable inputs, the production function will
have the following form.
Q = f (L, K)
Given this production function, the equation of an isoquant, where output is held constant at q is
q = f (L, K)
Thus, isoquant show the flexibility that firms have when making production decision: they can
usually obtain a particular output (q) by substituting one input for the other.
Isoquant maps: when a number of Isoquants are combined in a single graph, we call the graph
an isoquant map. An isoquant map is another way of describing a production function. Each
isoquant represents a different level of output and the level of out puts increases as we move up
and to the right. The following figure shows Isoquants and isoquant map.

Capital

q3

2 q2
1 q1
1
Labor
1 3 6

Fig 3.2 Isoquant and isoquant map. Isoquants show the fact that long run production process is
very flexible. A firm can produce q1 level of output by using either 3 capital and 1 labor or 2
capital and 3 labor or 1 capital and 6 labor or any other combination of labor and labor on the
curve. The set of isoquant curves q1 q2 & q3 are called isoquant map.

Properties of isoquant

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1. Isoquants slope down ward. Because isoquant denote efficient combination of inputs that
yield the same output, isoquant always have negative slope. Isoquants can never be horizontal,
vertical or upward sloping.
2. The further an isoquant lays away from the origin, the greater the level of output it denotes.
Higher Isoquants (Isoquants further from the origin) denote higher combination of inputs.
3. Isoquants do not cross each other. This is because such intersections are inconsistent with the
definition of Isoquants.
4. They are convex to the origin.

Shape of isoquant
Isoquants can have different shapes (curvature) depending on the degree to which factor inputs
can substitute each other.
1-Linear Isoquants
Isoquants would be linear when labor and capital are perfect substitutes for each other. In this
case the slope of an isoquant is constant. As a result, the same output can be produced with only
capital or only labor or an infinite combination of both.
Graphically,

K
Fig.3.6 linear isoquant. Capital
And labor can perfectly substitute
10 each other so that the same
Output (q=100) can be produced
by using either 10k or 8K and
12L or 15L or an infinite
8 Combinations of both inputs.
q=100
L
12 15

2. Input- output isoquant

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It is also called Leontief isoquant. This assumes strict complementarities or zero substitutability
of factors of production. In this case, it is impossible to make any substitution among inputs.
Each level of output requires a specific combination of labor and capital: Additional output
cannot be obtained unless more capital and labor are added in specific proportions. As a result,
the Isoquants are L-shaped. See following figure.

q3

q2
K2

q1
K1

L
L1 L2
Fig. 2.7 L-shaped isoquant. When Isoquants are L-shaped, there is only one efficient way of
producing a given level of output: Only one combination of labor and capital can be used to
produce a given level of output. To produce q1 level of output there is only one efficient
combination of labor and capital (L1 and K1). Output cannot be increased by keeping one factor
(say labor) constant and increasing the other (capital). To increase output (say from q1 to q2)
both factor inputs should be increased by equal proportion.
3. Kinked Isoquants
This assumes limited substitution between inputs. Inputs can substitute each other only at some
points. Thus, the isoquant is kinked and there are only a few alternative combinations of inputs to
produce a given level of output. These Isoquants are also called linear programming Isoquants or
activity analysis Isoquants. See the figure below.

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12 A

7
B
5
C
3
D

1 3 5 9
L
Fig. 3.8 kinked isoquant in this case labor and capital can substitute each other only at some
point at the kink (A, B, C, and D). Thus, there are only four alternative processes of producing
q=100 output.
4. Smooth, convex Isoquants
This shape of isoquant assumes continuous substitution of capital and labor over a certain range,
beyond which factors cannot substitute each other. Basically, kinked Isoquants are more realistic:
There is often limited (not infinite) method of producing a given level of output. However,
traditional economic theory mostly adopted the continuous isoquant because they are
mathematically simple to handle by the simple rule of calculus, and they are approximation of
the more realistic isoquant (the kinked Isoquants). From now on we use the smooth and convex
Isoquants to analyze the long run production.

3.7 The slope of an isoquant: marginal rate of technical

Substitution (MRTS)
The slope of an isoquant (-K/L) indicates how the quantity of one input can be traded off
against the quantity of the other, while output is held constant. The absolute value of the slope
of an isoquant is called marginal rate of technical substitution (MRTS). The MRTS shows the
amount by which the quantity of one input can be reduced when one extra unit of another input is
used, so that output remains constant. MRTS of labor for capital, denoted as MRTS L, K shows the
amount by which the input of capital can be reduced when one extra unit of labor is used, so that
output remains constant.

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MRTS L,K decreases as the firm continues to substitute labor for capital (or as more of labor is
used). In fig.2.9 to increase the amount of labor from 1 to 2, the firm reduces 4 units of capital
(K=4), to increase labor from 2 to 3, the firm reduce 2 unit of capital (K=2), and so on.
Hence, the firm reduces lower and lower number of capital for the successive one unit of labor.
The reason is that when the number of capital is large and that of labor is low, the productivity of
capital is relatively lower and that of labor is higher (due to the law of diminishing marginal
returns). Thus, at this point relatively large amount of capital is required to replace one unit of
labor (or one unit of labor can replace relatively large amount of capital). As the employment of
labor increases and that of capital decreases (as we move down ward along the isoquant), quite
the reverse will happen. That is, productivity of capital increases and that of labor decreases.
Hence, the amount of capital that needs to be reduced increase when one extra labor is used
decreases. The fact that the slope of an isoquant is decreasing makes an isoquant convex to the
origin.
MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal products of
factors. That is,

This can be shown algebraically as follows:

Let the production function is given as:

q= f (L, K) Where q- is output

L- is unit of labor employed
K-is the amount of capital employed.

Given this production function, the equation of a specific isoquant can be obtained by equating
the production function with a given level of output, say .
= f (L, K) =
Total differential of measures the total change in that happens as a result of a simultaneous
change in L and K. i.e.,

But since is constant, d is zero (d =0)

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So,

(But, and )

Thus, the above equation can be written as:

MPL. dL + MPK.dk = 0

Therefore, the slope of an isoquant can be given as the ratio of marginal products of inputs.
Elasticity of substitution
MRTS as a measure of the degree of substitutability of factors has a serious defect. It depends on
the units of measurement of factors. A better measure of the ease of factor substitution is
provided by the elasticity of substitution, δ. The elasticity of substitution is defined as

The elasticity of substitution is a pure number independent of the units of measurement of K and
L, since the numerator and the denominator are measured in the same units and be cancelled.
Factor intensity
A process of production can be labor intensive or capital intensive or neutral process. A process
of production is called labor intensive if it uses many labors and relatively few capitals. If it uses
many capitals and relatively few labor it is called capital intensive technology. On the other
hand, if the process uses equal proportion of both it is called neutral technology. The factor
intensity of any process is measured by the slope of the line through the origin representing the
particular process. Thus, the factor intensity is the capital-labor ratio. The higher the capital-labor

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ratio is the higher the capital intensity but the lower the capital-labor ratio is the higher labor
intensity of the process.

Capital

A
K1

B
K2 X

Labor
O
L1 L2
Fig 3.10 Process A uses k1 and L1 units of labor and capital to produce x amount of output. The
factor intensity of this process can be measured by the slope of OA, which equals AL1/OL1 =

Similarly, factor intensity of process B is given by

Since process A is more capital intensive than process B or B is more labor intensive

than A. The upper part of the isoquant includes more capital intensive processes and the lower
part, labor intensive techniques.
Now let’s illustrate the above concepts with the most popular and applicable form of production
function, Cobb-Douglas production function
The Cobb- Douglas production function is of the form

From this production function

1. MPL =

= b0 b1

= b1.APL

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MPK =

= b2 b2.APK

2. Marginal rate of technical substitution

(MRT SLK) =

3. The elasticity of substitution

4. Factor intensity is measured by the ratio b1/b2. The higher the ratio, the more labor intensive

the technique. Similarly, the lower the ratio ,the more capital intensive the technique.

5. The efficiency of production. This is measured by the coefficient b0. Obviously it is clear that
if two firms have the same K, L, b1 and b2 and still produce different quantities of output, the
difference could be due to the superior organization and entrepreneurship of one of the firms,
which results in different efficiencies. The more efficient firm will have a larger b0 than the less
efficient one.

3.8 The long run law of production: The law of returns to scale
The laws of production describe the technically possible ways of increasing the level of
production.

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Output may increase in various ways. In the long run output can be increased by changing all
factors of production. This long run analysis of production is called Law of returns to scale.
In the short run output may be increased by using more of the variable factor, while capital (and
possibly other factors as well) are kept constant. The expansion of output with one factor (at
least) constant is described by the law of variable proportion or the law of (eventually)
diminishing returns of the variable factor.

3.9 Laws of returns to scale: long run analysis of production

In the long run all inputs are variable. Expansion of output may be achieved by varying all
factors of production by the same proportion or by different proportions.
The traditional theory of production concentrates on the first case, i.e. the study of output as all
inputs change by the same proportion. The term returns to scale refers to the change in output as
all factors change by the same proportion. Suppose initially the production function is
X0 = f (L, K)
If we increase all factors by the same proportion t, we clearly obtain a new level of output X*
where,
X* = f (tL, tK)
 If X* increases by the same proportion t or if X* = tX 0, we say that there is constant
returns to scale.
 If X* increases less than proportionally with the increase in the factors (or if X*
increases by a proportion less than t), we have decreasing returns to scale.
 If X* increases more than proportionally with the increase in the factors (by a more
than t proportion), we have increasing returns to scale.

Returns to scale and homogeneity of production function

Suppose we increase both factors of the function X 0=f (L, K) by the same proportion‘t’, and we
get the new level of output X = f (tL, tK)
If t can be factored out (that is, may be taken out of the brackets as a common factors), then the
new level of output X* can be expressed as a function of t (to any power V) and the initial level
of output, and the production function is said to be homogeneous.
X* = t f (LK) or X* = t X0

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If t cannot be factored out, the production function is non-homogeneous. Thus, a homogeneous

function is a function such that if each of the input is multiplied by t, then t can be completely
factored out of the function. The power V of t is called degree of homogeneity of the function
and is measure of returns to scale.
If V=1, we have constant returns to scale. This production function is sometimes called linear
homogeneous.
If V<1, decreasing return to scale prevails
If V>1, increasing return to scale prevails
For a Cobb-Douglas production function
X = b0Lb1 Kb2, V = b1 +b2 and it is a measure of returns to scale.
Proof: Let L and K increase by t. The new level of output is
X* = b0 (tL) b1 (tk) b2
X* = b0 tb1 lb1 tb2kb2
X* = b0Lb1Kb2 tb1+b2
X* = X (t b1+b2)
Thus V = b1+b2
For a homogeneous production function the returns to scale may be represented graphically in an
easy way.
Causes of increasing returns to scale
Technical and /or managerial indivisibility. Mostly, processes of production can be doubled but
it may not be possible to half them. When the production system expands, workers will
specialize in one extreme and their productivity increases.
Causes of decreasing returns to scale
The most common causes are ‘diminishing returns to management’. If we expand the output
beyond optimum, the top management personnel will be over burdened and the productivity of
additional unit of the variable inputs decline eventually.
3.10 Equilibrium of the firm: Choice of optimal combination of factors of
production
An isoquant denotes efficient combination of labor and capital required to produce a given level
of output. But, this does not mean that the monetary cost of producing a given level of output is
constant along an isoquant. That is, though different combinations of labor and capital on a given

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isoquant yield the same level of output, the cost of these different combinations of labor and
capital could differ because the prices of the inputs can differ. Thus, isoquant shows only
technically efficient combinations of inputs, not economically efficient combinations. Technical
efficiency takes in to account the physical quantity of inputs where as economic efficiency goes
beyond technical efficiency and seeks to find the least cost (in monetary terms) combination of
inputs among the various technically efficient combinations. Hence, technical efficiency is a
necessary condition, but not a sufficient condition for economic efficiency. To determine the
economically efficient input combinations we need to have the prices of inputs.
To determine the economically efficient input combination, the following simplifying
assumptions hold true:
Assumptions
1. The goal of the firm is maximization of profit ( ) where
Where -Profit, R-revenue and C-is cost outlay.
2. The price of the product is given and it is equal to .
3. The prices of inputs are given (constant).Price of a unit of labor is and that of capital is
.
Isocost line
An isocost line is the locus points denoting all combination of factors that a firm can purchase
with a given monetary outlay, given prices of factors.
Suppose the firm has amount of cost out lay (budget) and prices of labor and capital are and
respectively. The equation of the firm’s isocost line is given as:
are quantities of capital and labor?
respectively.
Given the cost outlay , the maximum amounts of capital and labor that the firm can purchase
are equal to and respectively. The straight line that connects these points is the iso-cost
line. See the following figure:

Capital

C/r

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Iso cost
line

Labor
C/w
Fig: 3.18 the iso cost line: shows different combinations of labor and capital that the firm can
buy given the cost out lay and prices of the inputs.

Now we are in a position to determine the firm’s optimal in put combination. However, the
problem of determining optimal input combination (economic efficiency) takes two forms.
Sometimes, situations may happen when a firm has a constant cost outlay and seek to maximize
its output, given this constant and cost out lay and prices of inputs. Still, there are also situations
when the goal of the firm is to produce a predetermined (given) level of output with the least
possible cost.
Case1: Maximization of output subject to cost constraint
Suppose a firm having a fixed cost out lay (money budget) which is shown by its iso-cost line.
Here, the firm is in equilibrium when it produces the maximum possible out put, given the cost
outlay and prices of input. The equilibrium point (economically efficient combination) is
graphically defined by the tangency of the firm’s iso-cost line (showing the budget constraint)

with the highest possible isoquant. At this point, the slope of the iso cost line ( ) is equal to the

slope of the isoquant ( ).

The condition of equilibrium under this case is, thus:

This is the first order (necessary) condition. The second order (sufficient) condition is that
isoquant must be convex to the origin. See the following figure:

Capital

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Q3
K1 E

Q2
Q1

L1 B Labor
Fig: 3.19 the optimal combination of inputs ( ) is defined by the tangency of the iso-cost
line (AB) and the highest possible isoquant ( ), at point E. At this point the slope of iso-cost

line ( ) is equal to the slope of isoquant ( ).The second order condition is also satisfied
by the convexity of the isoquant.
Mathematical derivation of the equilibrium condition

The problem can be stated as:

Maximize
Subject to

We use the lagrangian method to solve the problem.

The lagrangian equation is written as:

Then we find and set all of them equal to zero to solve for
That is,

And,

Solving these equations simultaneously, we obtain the equilibrium condition

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The second order condition (the convexity of isoquant) would be insured when:

Numerical Example
Suppose the production function of a firm is given as prices of labor and capital
are given as $ 5 and $ 10 respectively, and the firm has a constant cost out lay of $ 600.Find the
combination of labor and capital that maximizes the firm’s out put and the maximum out put.

Solution
The condition of equilibrium is

Thus, the equilibrium exists when,

The constraint equation is:

Solving equation (1) and (2) would give us the optimal combination of L and K.

L=60 units and K=30 units.

Thus, the firm should use 60 units of labor and 30 units of capital to maximize its production
(out put). (Check the second order condition).
The maximum output can be found by substituting 60 and 30 for L and K in the production
process.
Case -2: Minimization of cost for a given level of output

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In this case, consider an entrepreneur (a firm) who wants to produce a given output (for example
a bridge or a building or x tones of a commodity) with minimum cost outlay. That is, we have a
single isoquant which denotes the desired level of output, but there are a set of isocost lines
which denotes the different cost outlays. Higher isocost lines denote higher production costs. The
production costs of a desired level of output will therefore be minimized when the isoquant line
is tangent to the lowest possible isocost line (see fig) At the point of tangency, the slope

of the isoquant and isocost lines are identical. That is

Capital

c
a
E
K1
Q

b d f
L1
Labor

Fig: 3.21 the equilibrium combination of factors is K1 and L1 amounts of capital and labor
respectively. Lower isocost lines such as ‘ab’ are economically desirable but un attainable given
the desired level of output. So point E shows the least cost combination of labor and capital to
produce X amount of output.
Now let us see the mathematical derivation of the equilibrium condition. As mentioned earlier,
we minimize the cost of producing a given level of output.
Thus, the problem can be stated as:
Minimize C = f (q) = WL + rK ---------------------------------------- (Objective function)
Subject to q = f (L, K) ------------------------------------------------ (Constraint function)

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Or f (L, K) – q = 0
We use the LaGrange an method to obtain the equilibrium condition. Accordingly, the LaGrange
an function will be:

The condition of equilibrium will be obtained by finding and then solving them

simultaneous after equating each to zero.

That is

Thus, the equilibrium condition is

Rearranging the above condition, we obtain

This condition is only a necessary condition.

The sufficient condition is that the isoquant must be convex to the origin. That is

Numerical example:

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Suppose a certain contractor wants to maximize  from building one bridge. The contractor uses
both labor and capital, and efficient combinations of Labor and capital that are sufficient to make

a bridge is by the function 0.25 L K . If the prices of labor (w) and capital (r) are $ 5 and $ 10

respectively.
Find the least cost combination of L and K, and the minimum cost.
Solution:

The contractor wants to build one bridge. Thus, the constraint equation can be written as 0.25 L

=1

MPL = 0.125 L K

MPK = 0.125 L K

The equilibrium condition is

Substituting L = 2K in the constraint equation we obtain

0.125 (2K) K =1

0.125 . K=1

K=

L = 2K 

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Therefore, efficient combination (least cost combination) of L and K are and

respectively.

The least cost is C = 5 + =$

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