a. Provide a graph of an isocost line for a company that pays $20 per hour...

a. Provide a graph of an isocost line for a company that pays $20 per hour for its labor, and $15 per hour for its capital.

b. Show and briefly explain the effects on the isocost line on the same graph if the labor costs of the company are decreased to $10 per hour.

c. How would the company adjust its use of labor relative to capital as a result of this change in costs to continue to produce optimally, assuming labor and capital are imperfect substitutes for each other? Explain intuitively and demonstrate on your graph.

Expert Solution

Answer:

(A): An iso-cost line represents the cost constraint a firm faces while making it's production decisions. C(q) is the total cost function. And, the intercepts represent the maximum amounts of labour or capital that could be hired if the firm spent all the money on either of the inputs.

(B): When the price of the labor falls to $10 per hour, the iso-cost line moves outwards on the horizontal intercept while it does not change on the vertical intercept. The new iso-cost line is represented by the red line in the graph below.

(C): A profit maximizing firm will choose input combinations for producing outputs such that the ratio if the marginal productivities of the inputs (MP_L / MP_K) equals the ratio of their prices (P_L / P_K). As the price of labor falls from $20 to $10, initially the price ratio falls while the marginal product ratio remains the same (Thus, MP_L / MP_K > P_L / P_K). Hence, the firm will add more units of labor in its production process while reduce the capital's share in the input to output relation. Thus, the labor input hired will rise from L to L', while capital hired will fall from K to K'. The total output produced will increase (given by the iso-quants) as shown in the diagram:

Rahul Sunny answered 1 year ago

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