Question

Assume that the marginal product of labor (MPL) = 10. And the marginal product of capital (MPK = 6. Assume also that the price of labor (PL) = 4 and the price of capital (PK) = 2. Do you agree or disagree that the firm should substitute capital for labor? Explain why with a narrative explanation and a graph.

Answer 1

Ans.
For cost minimizing level of output, the marginal product per dollar spent must be equal for all the inputs, so,

MPK/Pk = MPL/Pl

Here, MPK/Pk = 6/2 = 3

And MPK/ Pl = 10/4 = 2.5

So, it will be benficial for the firm to substitute capital for labour to maximize its output at given cost. This is because the marginal product per dollar is higher for capital. So, for each dollar spent, more output will be produced when using capital.

Also, as the marginal product of capital anf labour are constant here, so, the process of substituting capital in place of labour will go on till demand for labour is 0 and all the output is beinv made by the capital.

The marginal rate of technical substitution = MRTS = MPL/MPK = 10/6 = 1.6666

Thus, the slope of the isoquant curve, MRTS, is constant, so, isoquant curve will be downward sloping straight line and as the slope of the isocost line is Pl/Pk = 4/2 = 2, the isocost line will be steeper than the isoquant. As shown.

* Please don’t forget to hit the thumbs up button, if you find the answer helpful.