CHAPTER TWO

THE THEORY OF PRODUCTION

3.1 Concepts of production

Production is the process of conversion of inputs (factors of production) into a consumable
form of goods and services. In this regard, in the production process or activity, firms turn
inputs into Output. This transformation of inputs (factors of production) into output is
defined at a particular time period and at a given technology. By technology we mean the
state of knowledge about the various methods that might be used to transform inputs into
outputs, and it is described by a production function.
Raw materials yield less satisfaction to the consumer by themselves. In order to get more
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. Thus, no production (transforming raw material into
output) can take place without the use of inputs.so there are two types of inputs fixed and
variable inputs.
Fixed vs. variable inputs
In economics, inputs can be classified as fixed & variable. Fixed inputs are those inputs
whose quantity cannot 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. For example, if the demand for Beer shoots up
suddenly in a week, the brewery factories cannot plant additional machinery over a night
to respond to the increased demand. It takes long time to buy new machineries, to plant
them and use for production. Thus, the quantity of machinery is fixed for some times
such as Buildings, machineries and managerial and personnel skills 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.
In our previous example, if the brewery factory had idle machinery before the market
demand shoot up, the factory can easily and immediately respond to the market condition
by hiring laborers.
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 3.2 short run vs. long run

In economics, short run refers to that period of time in which the quantity 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. One thing to be noted here is that short run periods of different firms have
different duration. Some firms can change the quantity of all their inputs within a month
while it takes more than a year to change the quantity of all inputs for another type of
firms. For example, the time required to change the quantities of inputs in an
automobile factory is not equal with that of flour factory. The later takes relatively shorter
time.
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, or all inputs are
variable.
3.3 production 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 .
Assumptions of short run production analysis
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
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 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)

The production function shows different levels of output that the firm can obtain by
efficiently utilizing different units of labor and the fixed capital. In the above short run
production function, the quantity of capital is fixed. Thus output can change only when
the amount of labor used for production changes. Hence, Q is a function of L only in the
short run.
3.4 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 with a fixed input that is capital. Do you think that output can
always be increased by increasing the variable input while there is a fixed input? 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. 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 3.1 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
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the variable input, denoted as MP L is found as
𝑑𝑄 𝑑𝑇𝑃
MPL= 𝑑𝐿 or MPL= 𝑑𝐿

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.
total product TP
APlabour = =
Number of L L
The average product of labor first increases with the number of labor increases (i.e. TP
increases faster than the increase in labor), and eventually it declines.
Graphing the short run production curves
The following figures shows how the TP, MP and AP of the variable (labor) input vary
with the number of the variable input.
From Fig 2.1 below 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 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. 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.

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Fig 2.1 Total product, average product and marginal product curves
The marginal product curve increases until L1 number of labor reaches its maximum at
L1, 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.
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 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.
• 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)

3.5 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 3.1)

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.
3.6 Efficient regions of production in the short run
we are now not in a position to determine the specific number of the variable input
(labor) that the firm should employ because this depends on several other factors than the
productivity of labor such as the price of labor, the structure of input and output markets,
the demand for output, etc. However, it is possible to determine ranges over which the
variable input (labor) be employed.
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 To do best with this, let as refer back to fig 3.1 and divide it into three ranges
called stages of production.
• Stage I range 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 methods;
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.
3.7 long run production; production with two variable inputs
In order to completed our analysis of the short-run production function in which the firm
uses one variable input (labor) and one fixed input (capital). Now we turn to the long run
analysis of production. Remember that long run is a period of time (planning horizon)
which is sufficient for the firm to change the quantity of all 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. So it is necessary to first see what is meant by isoquants and
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their properties.
Isoquants
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, isoquants 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.

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Fig 2.2 isoquant and isoquant map
Properties of an isoquant
Isoquants have most of the same properties as indifference curves. The biggest difference
between them is that output is constant along an isoquant whereas indifference curves hold
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utility constant. Most of the properties of isoquants, results from the word efficient in
its definition.
1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs
that yield the same output, isoquants always have negative slope. Isoquants can never be
horizontal, vertical or upward sloping. If for example, isoquants have to assume zero
slopes (horizontal line) only one point on the isoquant is efficient. Thus, efficiently
requires that isoquants must be negatively sloped. As employment of one factor
increases, the employment of the other factor must decrease to produce the same quantity
efficiently.
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. The more inputs used, more outputs should be obtained if the firm is producing
efficiently. Thus efficiency requires that higher isoquants must denote higher level of
output.
3. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.

Consider the above figure 2.3

This figure shows that the firm can produce at either output level (20 or 50) with the
same combination of labor and capital (L* and K*). The firm must be producing
inefficiently if it produces q = 20, because it could produce q = 50 by the same
combination of labor and capital (L* and K*). Thus, efficiency requires that isoquants do

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 not cross each other.
4. Isoquants must be thin. If isoquants are thick, some points on the isoquant will
become inefficient. Consider the following isoquant.

Fig.2.4: Iso quants can never be thick. Points A and B are on the same iso quant. But point A
denotes higher amount of capital and the same amount of labor as point B. Hence point A
denotes inefficient combination of inputs and thus it lies out of the iso quant. The iso-quant
should be thin if point A is to be excluded.
3.6 Shape of isoquants
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 iso quant is constant. As a result, the same output can be produced
with only capital or only labor or an infinite combination of both. Fig.2.5 lies below linear
isoquant. Capital and labor can perfectly substitute 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
combinations of both inputs.

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 fig 2.5 linear iso quant
2. Input output isoquant
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

Fig 2.6 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

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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.

Fig. 2.7. 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 or convex isoquant
This shape of isoquant assumes continuous substitution of capital and labor over a certain
range. Basically, convex, isoquants are more realistic. Traditional economic theory mostly
adopted the continuous isoquants because they are mathematically simple to handle by the
simple rule of calculus, and they are approximation of the more realistic isoquants (the
convex isoquants). From now on we use the smooth and convex isoquants to analyze the
long run production.

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Fig: 2.8 the smooth and convex isoquant. This type of isoquant is the limiting case of the
kinked isoquant when the number kink is infinite. The slope of the iso quant decrease as
we move from the top (left) to the right (bottom) along the isoquant. This indicates that the
amount by which the quantity of one input (capital) can be reduced when one extra unit
of another inputs (labor) is used (so that output remains constant) decreases as more of the
latter input (labor) is used.
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. This is
analogues to the marginal rate of substitution (MRS) in consumer theory. MRTS L,K

decreases as the firm continues to substitute labor for capital (or as more of labor is used).
In fig.3.8 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 use of successive one

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unit of labor. This is because of;
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. 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,
Δ𝑘 𝑀𝑃𝐿
MRTSL,K=-Δ𝐿 =𝑀𝑃𝐾

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 q .
q = f (L, K) = q
Total differential of q measures the total change in q that happens as a result of a
simultaneous change in L and K.
i.e, dq = q .dL + q .dk = d q
L k

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

q q
So, .dL + dk = 0
L k

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 𝜕𝑞
But =mpl and
𝜕𝑙
𝜕𝑞
=mpk
𝜕𝑘

Thus, the above equation can be written as:

MPL. dL + MPK.dk = 0
MPL − dK
 =
MPk dL
Therefore, the slope of an isoquant can be given as the ratio of marginal products of
inputs.
3.8 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 ratio is the higher the capital intensity but
the lower the capital-labor ratio is the higher labor intensity of the process.

Fig 2.9 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,
𝑜𝑘1
which equals =K1/L1
𝑜𝑙1

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Similarly, factor intensity of process B is given by K2/L2
𝒌𝟏 𝒌𝟐
Since > , process A is more capital intensive than process B or B is more labor intensive
𝒍𝟏 𝒍𝟐

than A. The upper part of the isoquant includes more capital intensive processes and the
lower part, labor intensive techniques.
3.9 The efficient region of production: long run
In principle the marginal product of a factor may assume any value, positive, zero or
negative. However, the basic production theory concentrates only on the efficient part of
the production function, i.e. over the range of output over which the marginal product of
factors is positive and declining. In the short run production function efficient region of
MPL
production prevails in stage two (stage II), where MPL >O, but <0
L

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Similarly, efficient region of production in the long run prevails when the marginal product
of all variable inputs is positive but decreasing. Graphically this can be represented by the
negatively slopped part of an isoquant. The locus of points of isoquants where the marginal
products of factors are zero form the ridge lines. The upper ridge line implies that the MP of
capital is zero. MPk is negative for all points above the upper ridge line and positive for
points below the ridge line. The lower ridge line implies that the MPL is zero. For all points
below the lower ridge line the MPL is negative and positive for points above the line.
Production techniques are technically efficient inside the ridge lines symbolically; in the long
run efficient production region can be illustrated as:
𝜕𝑚𝑝𝑙
MPL.>0 But <0
𝜕𝑙
𝜕𝑚𝑝𝑘
MPK>0 But <0
𝜕𝑘

Graphically, efficient region of production is shown as follow

Fig 2.10 : Thus efficient region of production is defined by the range of isoquants over
which they are convex to the origin.
3.11 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. 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

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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.
Now let’s have a deep examination of law of returns to scale.
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* = tX0, we say that there is

constant returns to scale, this implies the increasing of output is equal the
increasing of an input.
• 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,
this implies the proportionate increasing of an output is less than the increasing
input.
• If X* increases more than proportionally with the increase in the factors (by a
more than t proportion), we have increasing returns to scale; this implies the
proportionate increasing of output is less than that of input.
Causes of increasing returns to scale
Technical 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
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output beyond optimum, the top management personnel will be overburdened and the
productivity of additional unit of the variable inputs decline eventually. E.g., doubling
fishing fleet may not double fish catch.

3.11 Technological process and production function

Technological improvement (progress) makes factors of production more productive or it
makes production system more efficient; so that the firm will get higher output from the
same combinations of labor and capital than before.
Graphically, this can be shown by upward movement of the total product curve
(indicating higher output level can be achieved from the same input) and down ward
movement of isoquant denoting lower combinations of factors of production can produce
equal level of output. See the figures.

Fig 2.11 technological progress shifts the TP curve up ward &the isoquant down ward
3.12 Equilibrium of the firm: Choice of optimal combination of factors of
production,
In our previous discussion we have said that 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 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.

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 Technical efficiency takes in to account the physical quantity of inputs whereas
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 (𝜋), 𝜋 = 𝑅 − 𝐶

Where 𝜋 -Profit, R-revenue and C-is cost outlay.

2. The price of the product is given and it is equal to Px.

3. The prices of inputs are given (constant).Price of a unit of labor is w and that of capital
is r.
Now before we go to the discussion of optimal input combination (or economically
efficient combination), we need to know the isocost line, because optimal input is defined
by the tangency of the isoquant and isocost line.
Isocost line
Isocost lines have most of the same properties as that of budget lines, 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 C amount of cost out lay (budget) and prices of labor and capital
are w and r respectively. The equation of the firm’s isocost line is given as:

C=wL+ rk where, L and K are quantities of labor and capital respectively.

Given the cost outlay C, the maximum amounts of capital and labor that the firm can

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 𝐶 𝑐
Purchase are equal to 𝑟 and 𝑤 respectively. The straight line that connects these points

is the iso-cost line. See the following figure:

Fig: 2.12 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. Under we will discuss the two situations.
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 output, 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
w MPL
iso cost line ( ) is equal to the slope of the isoquant ( ).
r MPK

The condition of equilibrium under this case is therefor:

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𝑤 𝑀𝑃𝐿 𝑀𝑃𝐿 𝑀𝑃𝐾
= or = this is the first order (necessary) condition.
𝑟 𝑀𝑃𝐾 𝑊 𝑟

The second order (sufficient) condition is that isoquant must be convex to the origin.
See the follwing figure;

Fig: 2.13 the optimal combination of inputs ( L1 and K1 ) is defined by the tangency of the iso-
cost line (AB) and the highest possible isoquant ( X 2 ), at point E. At this point the slope of iso-
cost line ( w/r ) is equal to the slope of isoquant X ( MPL/MPK ).The second order condition
is also satisfied by the convexity of the isoquant.
But if isoquant is concave to the origin the point of tangency of the iso cost line and the
isoquant does not define the equilibrium combination of factor inputs. With a concave isoquant,
we have a corner solution. Refer the figure below; Fig: 2.14 Concave isoquant results in corner
solution. The point of tangency between the isoquant and the iso-cost line does not satisfy the
second order condition as the isoquant is concave. The same level of output(X=100Kg) can be
produced with a lower cost out lay at point A. see the figure;

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Fig 2.14 concave iso quant
Mathematical derivation of the equilibrium condition
The problem can be stated as,
Maximize X=f(L,K)……………………….Objective function
Subject to C= WL+rk………………………constraint function
Or C-wL+rk=0
We use the lagrangian method to solve the problem.
The lagrangian equation is written as:
∅ =X-( C)
𝜕∅ 𝜕∅ 𝜕∅
Then we find , and 𝜕𝜆 and set all of them equal to zero to solve for Land K.
𝜕𝐿 𝜕𝐾
That is;

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 Solving these equations simultaneously, we obtain the equilibrium condition.

MPL/w=MPK/r or
MPL/MPK=w/r
Numerical Example
Suppose the production function of a firm is given as;
X= 2L0.5 K0.5 prices of labor and capital are given as $ 6 and $ 12 respectively, and the firm has a
constant cost out lay of $ 800.Find the combination of labor and capital that maximizes the
firm’s output and the maximum output.
Case -2: Minimization of cost for a given level of output
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. At the point of tangency, the slope of the isoquant
and isocost lines is identical.
𝑚𝑝𝑙 𝑤
That is =
𝑚𝑝𝑘 𝑟

Numerical example
Suppose a certain contractor wants to minimize cost 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 L0.5K0.5. 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.

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