MANAGERIAL ECONOMICS
Week 6 - Significance Of Elasticity of Demand
Masood Alam Student Id: 716103
Week 6 - LAQ's
Explain the concept of the optimal combination of inputs in production. How do
firms determine the most cost-effective mix of labor and capital to maximize
output?
The Concept of the Optimal Combination of Inputs in Production
In economics, the optimal combination of inputs (also known as the least-cost
combination or efficient input mix) refers to the specific quantities of inputs—such
as labor (L) and capital (K)—that a firm should use to produce a given level of
output at the lowest possible cost. This concept is central to production theory
and assumes that firms aim to maximize profits by minimizing costs while achieving
their production targets. It balances the trade-offs between different inputs,
considering their productivity and prices.
Key Concepts
Isoquant: A curve that shows all the different combinations of inputs (e.g., labor
and capital) that produce the same total output.
Isocost Line: A line that shows all possible combinations of inputs that a firm can
afford for a given total cost.
Marginal Rate of Technical Substitution (MRTS): The rate at which one input can
be substituted for another while maintaining the same level of output. It's the
absolute value of the slope of the isoquant.
Marginal Product: The additional output gained from using one more unit of an
input.
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Isoquant Curves
An isoquant curve is a curve that shows various combinations of two factors of
production that a firm can use in order to get the same total output.
The term isoquant is derived from the Greek word ‘iso" which means equal, and
‘quant’ which means quantity. That is why the isoquant curve is also called an
equal pro Assumptions
The following assumptions are made while drawing the isoquant curves. duct
curve or a production indifference curve.
• Technology remains constant.
• A firm uses two factors of production, i.e., labour and capital.
• Both factors of production are variable.
• Both factors of production can be substituted.
• Both factors of production are not perfect substitutes
• All units of each factor of production are of equal quality.
• The law of diminishing marginal returns is applicable for each factor of
production.
Isoquant Curves: Key Concepts
Inputs
Primary Inputs:
❖ Capital (K): Man-made resources like machinery, tools, buildings.
❖ Labour (L): Human effort measured in work hours or number of workers.
Other Inputs (in real-world scenarios):
❖ Land, energy, technology, raw materials.
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Output
Total Physical Product (TPP):
❖ Fixed level of output represented by each isoquant.
❖ Example: An isoquant for 500 units means every input combination on that
curve yields exactly 500 units.
Efficiency
Technical Efficiency Principle:
❖ Firms aim to produce a given output using the least possible input.
❖ Isoquants
Data Example Let’s assume the following table which shows different
combinations of capital (K) and labour (L) to produce the same total output or
total physical product (TPP) of 500 unit
Capital (K) Labour (L) Total Physical Product (TPP)
100 50 500
80 70 500
60 95 500
40 130 500
20 180 500
❖ Each row represents a different input combination that achieves the
same output level.
❖ As capital decreases, more labour is required to maintain the same
output — demonstrating input substitutability.
❖ This reflects the concept of an isoquant curve, which is analogous to an
indifference curve in consumer theory.
Graph of an Isoquant
The following graph shows an isoquant curve for TPP of 500 units and is made by
using data in the above table. On the horizontal axis (X-axis), we have taken the
quantity of capital (K), while on the vertical axis (Y-axis), the quantity of labour (L)
is taken. The graph of isoquant is a downward sloping curve which is convex to
the origin.
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Marginal Rate of Technical Substitution (MRTS)
The marginal rate of technical substitution (MRTS) is the number of units of labour
that must be sacrificed in order to increase capital by one unit to get the same
total output. It is also called the marginal rate of factor substitution.
The MRTS formula is given below.
The diminishing MRTS is also shown in the following diagram.
A graph of isoquant curve illustrating diminishing marginal rate of technical
substitution.
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The calculations of the marginal rate of substitution (MRTS) are shown in the table
below.
Combination Capital (K) Labour (L) MRTS (ΔL/ΔK)
A 1 10 –
B 2 5 5/1=5
C 3 2 3/1=3
D 4 1 1/1=1
Explanation of Decreasing MRTS
From A to B (MRTS = 5)
• 1 unit of capital replaces 5 units of labour.
• Labour is abundant and less productive; capital is scarce and highly productive.
• High MRTS reflects the high marginal productivity of capital.
From C to D (MRTS = 1)
• 1 unit of capital replaces only 1 unit of labour.
• Capital has increased and its marginal productivity has declined.
• Labour is now scarce and more productive.
Underlying Principle: Diminishing Marginal Returns
• As more capital is used, its marginal contribution to output falls.
• This leads to a decline in MRTS because each additional unit of capital
substitutes for fewer units of labour.
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Shape of Isoquant Curve
• MRTS = slope of isoquant.
• A diminishing MRTS implies a convex isoquant (bowed inward toward origin).
• Convexity reflects the increasing difficulty of substituting capital for labour as
capital becomes more abundant.
How Firms Determine the Optimal Input Mix
Identify Production Goals: The firm first decides on the desired output level.
Construct the Isoquant: The firm maps out the various combinations of labor and
capital that can produce this specific output level.
Determine Input Prices: The firm identifies the costs of labor (wages) and capital
(rental rates).
Draw the Isocost Line: The firm draws the isocost line(s) that represent the total
cost of purchasing these inputs.
Find the Tangency Point: The optimal input combination occurs at the point where
an isoquant is tangent to the lowest possible isocost line.
Apply the Marginal Product Rule: The firm aims for the point where the ratio of
marginal products of the inputs equals the ratio of their prices (MPL/MPK = w/r).
This ensures that the last dollar spent on labor yields the same amount of
additional output as the last dollar spent on capital.
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Example
If a firm is using a certain combination of labor and capital, and the last dollar
spent on labor produces more output than the last dollar spent on capital, the
firm should shift its spending towards labor, increasing it and decreasing its capital
use. This adjustment continues until the marginal product per dollar spent is equal
for both labor and capital, at which point the firm has found its cost-minimizing
input combination.
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