Question

Suppose you are the manager of a public utility that supplies electricity to a significant portion of your geographic region. You preside over electrical generation facilities that can produce electricity using either natural gas or oil, or some combination of both. In the past several years, you have been faced with skyrocketing, then plummeting, natural gas prices, and now think you face the possibility of more of the same, coupled with the probability of similar volatility in oil prices. Having been trained in Managerial Economics, you are familiar with production functions, isoquant and isocost analysis, and other tools of microeconomics. How can you use these tools to decide the best path for your company to pursue? What are the pros and cons of using these tools? Provide specific examples of how to go about making the difficult decisions you must make in the near future as well as an overall blueprint of action.

Answer 1

ANSWER:

Actually, it is simple. Isocost and isoquants are the producer's version of the consumer's budget line and indifference curve respectively.

the axes are replaced by factors of production rather than consumer goods. Given the relative costs of say capital and labour, you can draw a series of parallel lines representing different budgets/costs: isocost lines.

Then given the technology available, taking into account diminishing marginal returns, you get isoquants just like you'd get indifference curves with diminishing marginal utility. The isoquant represents the combinations of capital and labour that combine to produce a fixed volume of output.

Equilibrium is a tangential solution where each factor of production is employed such that the ration os marginal (physical) product to the price of the factor are equalised, that is it costs the same to produce one extra unit of output by employing one unit of labour or one unit of capital.

Just as in indifference curve analysis, changes in prices affect the slope of the isocost, and hence the allocation of resources among the two factors.