Microeconomics I Note for 2nd year Economics Students

Chapter Three: Theory of Production

Introduction
In simple words, production refers to the process of transferring inputs into outputs. An input (factor of
production) is a good or service that goes into the production of another good or service. In other words,
an input is simply anything, which the firm buys for use in its production process. Inputs include labor,
land, capital and entrepreneurial talent. The end products of the production process are outputs which
could be tangible (goods) or intangible (services).
Simple examples of production:
- A furniture-producing firm combines workers' labor time, machineries, his organizational skills and
various raw materials like wood, metal, etc. to produce sofas for sale to its customers.
- A high school uses teachers, books, educational materials (aids), classrooms, the available technology
(like plasma tv), etc. to provide educational services to students.
The theory of production explains and formalizes the nature of relationships between factors (inputs) used
and output. As you might have noticed, the production process does not necessarily involve physical
conversion of raw materials into tangible goods. Besides teachers, lawyers, doctors, social workers,
consultants, hairdressers, etc are all engaged in producing intangible goods.
To an economist production means the creation of utility for sales. Alternatively, production may be
defined as the act of creating those goods/services, which have exchange value for sale (not for personal
consumption).Raw materials yield less satisfaction to the consumer by themselves. In order to get 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, capital and entrepreneurial ability.
Thus, no production (transforming raw material into outputs) can take place without the use of other
inputs.
4.1. Production function
Production function is a technical relationship between inputs and outputs. It shows the maximum
output that can be produced with a fixed amount of inputs and the existing technology. A production
function may take the form of an algebraic equation, table or graph.
A general equation for production function could for instance be described as:
Q = f(X 1 , X 2 , X 3 ,..., X n )
where Q is the maximum output produced; and
X1, X2, X3,…, Xn are different types of inputs.
To illustrate, suppose a wheat-producing firm uses labor (L), capital (K), Lund (S) and Entrepreneurship
(E). Other inputs such as seeds, fertilizers, insecticides, and the like may be included in one of these large
groups of factors of production. The production function for wheat may then be expressed as:
Quantity of Wheat = f(L, K, S, E)
Note that we must assume that the production of Q tons of wheat is realized in the most efficient way
possible. If it, for instance, is possible to produce 20 tons of wheat using a certain combination of L, K, S
and E, it is also possible to produce only 19 tons with the same combination. Therefore, the second
technology has to be abandoned, as it is not efficient (it is wasting resources that could be used for the
production of one more ton).
In sum, production functions describe what is technically feasible when the firm operates efficiently: that
is, when the firm uses each combination of inputs as effectively as possible.
 Classification of inputs
Normally, firms employ inputs whose amount does not change for some time and others whose quantity
varies according to the amount of production (output). One can hence categorize inputs as fixed and
variable.

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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 sometimes such as a weak. Buildings, plot of land and machineries 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 vise versa. The best example of variable input
includes unskilled labor and raw materials.
 Production period
Depending on the nature of economic adjustment in a firm to changing economic environment, the
production period is divided into short-run and long -run.
The short run refers to a period of time in which the quantity of at least one input remains fixed while
others are variable .Put it differently, one or more factors of production cannot be changed. In this case,
the firm can alter its level of output by increasing or decreasing the use of variable inputs. A firm’s
capital, for example, usually requires time to change – a new factory must be planned and built,
machinery and other equipment must be ordered and delivered, all of which can take a given time period.
The long run, on the other hand, is the amount of time needed to make all inputs variable. Here the
period is long enough to allow changes in the level of all inputs. I.e. all inputs are variable and there is no
fixed input.
Here , it should be noted that short run doesn’t refer to relatively short period of time like a year or less
than a year , and long run doesn’t mean to period of time greater than a year than or 10 years . They
rather refer to the nature of economic adjustment in the firm to changing economic environment.
Note that the supply of fixed inputs in the short-run is inelastic while the supply of variable inputs in the
short-run is elastic.
The Short-run Production Function: Production with one variable input
The majority of production decisions of firms are made in the short-run in which the quantity of at least
one factor of production changes with output. Hence, the short-run production function shows the
relationship between the maximum product and the level of the variable input. In more general
expression, a short-run production could take the following form, for Q output and X 1 variable input
quantities:
Q = f(X 1 )
Imagine, for example, that you are managing a clothing plant. You have a fixed amount of equipment, but
you can hire more labor or less to sew and to run the machines. You have to decide how much labor to
hire and how much clothing to produce. To make the decision, you will need to know how the amount of
output Q increases (if at all), as the input of labor L increases. Therefore, the short-run production
function of cloth could be expressed as:
Quantity of Cloth = f (Labor)
Here, the short-run level of cloth produced is supposed to depend on labor, the only variable input. Since
other factors are assumed to be fixed in the short-term, we do not include them in the production function.
This, however, does not mean that they are not used in the production process.
 Total, Average and Marginal Products
The contribution that variable input makes to the production process can be described in terms of the
total, average and marginal product.
 Total Product (TP)
It refers to the total output (say cloth) produced by a given amount of a variable input (say labor) keeping
the quantity of other inputs fixed (say machines). In almost all real world production processes, TP in the
short-run follows a certain trend: it initially increases at an increasing rate, then increases at a decreasing

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rate, reaches a maximum point but eventually falls with a rise in the quantity of the variable input. That is,
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 tend 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 product curve is
nearly S-shape (see fig 16).
 Average Product (AP)
The average product of an input is the level of output that each unit of input produces, on the average. It
tells us the main contribution of each variable input in the total product. Mathematically, AP is the total
product divided by the amount of variable input used to produce that product. The average product of
labor (APL), for instance, is given by:
Total Product TP
APL = =
Total Labor L
Like that of TP, APL first increases, gets its maximum value and eventually falls continuously afterwards.
 Marginal Product (MP)
We may, at times, be interested in knowing the extra output brought about by the extra employment of a
variable input. In terms of labor, we may ask “how much has the last laborer added to total product?”
These issues are explained by the marginal concept.
Marginal product is the extra or additional output obtained when one extra unit of a variable input is
entered into production while other factors remain fixed. Simply, marginal product is a change in the
amount of total product divided by a change in the amount of variable input used. For instance, the
marginal product of labor (MPL) is given by:
Change in Total Product TP Q
MPL = = =
Change in Labor L L
The last term in this equation (read as the partial derivative of Q with respect to L) is applied when a
continuous production function (i.e. An algebraic equation) is given for output Q.
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.
Tabular and Graphical representation of the short run product curves

Table 1 contains the total product (TP) and other product types for various amounts of labor units (e.g.
number of workers) and a constant amount of capital (e.g. 5 machineries). The values in column 3 of the
table show total output. If you carefully have a look at the values of the TP, they initially increase at an
increasing rate as labor units rise from 0 to 4. TP still increases but at a decreasing rate when labor units
are between 4 and 8. The maximum total output of 119 units is realized by combining 8 units of labor and
5 units of capital at the cheaply available technology. This could be interpreted as the total output
maximizing level of labor employment is 8. Finally, the total product begins to decline when the amount
of the variable input exceeds 8 units.

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Table 1: Production with One Variable Input

Amount of Amount of Total Product Average Product Marginal Product Stage of

Labor, L Capital, K TP (Q) AP(=TP/L) MP(=ΔTP/ΔL) Production
0 5 0 - -
1 5 10 10 10
2 5 32 16 22 Stage I
3 5 63 21 31
4 5 84 21 21
5 5 100 20 16 Stage II
6 5 111 18.5 11
7 5 119 17 8
8 5 119 14.9 0
9 5 117 13 -2
Stage III
10 5 110 11 -7
We can see that the behavior of AP is almost similar to that of TP. Like that of TP, APL first increases up
to 4 labor units, gets its maximum value of 21 output units at the 4th labor unit and eventually falls
continuously afterwards.
We observe an almost similar behavior for MPL as APL and TP. Hence, MPL first rises up to the 3rd labor
unit, gets its maximum value of 31 output units for the 3rd labor unit and eventually falls afterwards. MPL
becomes zero when the total product gets its maximum. This means that the last factor of production adds
nothing to total output. Further employment of labor beyond the zero MPL point even makes it negative
implying that total production is falling from its maximum value. In our illustration, this happens after the
employment of 8 units of labor. Workers hired after 8th laborer contribute negatively. These phenomena
can also be depicted in graph as shown in figure 1 below.
Figure 1: Total, Average and Marginal Product Curves

 As TPL increases at increasing rate, MPL

Increases
 As TPL increases at decreasing rate, MPL
decreases but remains positive
 As TPL decreases, MPL will be negative
 As TPL reaches its maximum, MPL will be zero.
 When MPL> APL, APL increases
 When MPL= APL, APL is at its maximum
 When MPL< APL, APL decreases

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As the number of the labor hired increases (capital being fixed), the TP curve first rises, reaches its
maximum when 8 amounts of labor are employed, beyond which it tends to decline. Assuming that this
short run production curve represents a certain cloth manufacturing firm, it implies that 8 numbers of
workers are required to efficiently run the machineries. If the numbers of workers fall below 8, the
machine is not fully operating, resulting in a fall in TP below 119. On the other hand, increasing the
number of workers above 8 will do nothing for the production process because only 8 numbers of workers
can efficiently run the machine. Increasing the number of workers above 8, rather results in a lower total
product because it results in overcrowded and unfavorable working environment.
Marginal product curve increases until 3 amounts of laborer are employed and then it tends to fall. The
MPL is zero at 8 amount of labor (when the TP is maximal); beyond which its value assumes zero
indicating that each additional worker above 8 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 3 amounts of labor units, it decreases from 3 to 8 and it becomes negative
beyond 8.
The average product curve increases up to labor unit of 4, 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 4 is the ratio of 84 level of output to 4 labor units. This is identical to the slope of ray
a.
Relationship between Average Product and Marginal Product
From the previous discussions and figurative presentations, we can notice specific relationships between
APL and MPL.
If we just have a close look at Table 7 and Figure 16, particularly at APL and MPL, we easily come up
with the following:
 When MPL > APL, APL keeps on increasing. This is what you observe in the entire area labeled as
stage I.
 When MPL = APL, APL is already at its maximum. One can locate this at the point where MPL and
APL intersect (end of stage I and beginning of stage II).
 When MPL < APL, APL keeps on decreasing. You see such a scenario in what we labeled as stages
II and III.
A simpler way to understand the relationship between average and marginal product is to think of it in
terms of grades. Suppose you took only two courses so far and your average score for the two courses is
90 (=APL). If your score for an additional (marginal) course is 93 (=MP L>APL), your new average will be
91. But, had your additional (marginal) score been 87 (=MPL<APL), your new average would be 89. Thus,
your marginal score pushes up or down your average product depending on whether the marginal score is
above or below the average respectively. The same relationship holds true for APL and MPL.
As we know, in addition to tables and graphs, equations are important tools in economics to understand
relationships.
Numerical Illustration:
Suppose that the short-run production function for cut-flower by a certain Ethiopian firm is given by:
Q = 4KL - 0.6K 2 - 0.1L2
WhereQ – represents the annual quantity of cut-flower produced.
K – annual capital input; suppose K=5.
L – annual labor input.
A) Determine the average product of labor (APL) function.
B) At what level of labor does the total output of cut-flower reach the maximum?
C) What will be the maximum achievable amount of cut-flower production?

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Solution:
A)
Q 4KL - 0.6K 2 - 0.1L2 0.6K 2 15 20L - 15 - 0.1L2
APL = = = 4K - - 0.1L = 20 - - 0.1L =
L L L L L
Q
B) We know that when total product (Q) is maximum, MP will be zero. And MPL = .
L
That is, partially differentiating1 Q with respect only to L and equating it to zero:
Q (4KL - 0.6K 2 - 0.1L2 )
MPL = = = 4K - 0.2L = 0
L L
20
 20 - 0.2L = 0  L = = 100
0.2
(Q – cut-flower level of output will be the maximum if the firm employs 100 units of labor.)

C) Substituting the optimal values of labor (L=100) and capital (K=5) into the original production
function (Q) gives the maximum level of cut-flower production:
Qmax = 4KL - 0.6K 2 - 0.1L2 = 4* 5* 100 - 0.6 * 5 2 - 0.1* 100 2 = 985
3.2. Laws of production
The laws of production describe the technically possible ways of increasing the level of production.
Output may increase in various ways.
Output can be increased by changing all factors of production. Clearly this is possible only in the long
run. Thus the laws of returns to scale refer to the long run analysis of production.
In the short run output may be increased by using more of the variable factor(s), while capital (and
possibly other factors as well) are kept constant. The marginal product of the variable factor(s) will
decline eventually as more and more quantities of this factor are combined with the other constant factors.
The expansion of output with one factor (at least) constant is described by the law of diminishing returns
of the variable factor, which is often referred to as the law of variable proportions.
3.2.1. The Law of Diminishing Marginal Product (LDMP)
The LDMP is the major factor behind the relationship between TP, MP, and AP. It states that as the
number of units of the variable input increases, other inputs held constant, the marginal product of the
variable input declines after a certain point. The law is sometimes called the law of variable proportions.
For instance, as you add more labor to a garden plot of fixed size, the marginal increase in vegetable may
increase. Nonetheless, a point is reached where an increase in the use of the variable input yields
progressively less and less additional (marginal) product. Each additional unit has, on average, fewer
units of the fixed input with which to work.
 The Long-run Production Function: Production with two variable inputs
We have 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. This can be expressed in equation form as:
Q = f(L, K)
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

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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 and isocosts. So it is necessary to first
see what is meant by isoquants and isocosts and their properties.
Numerical Illustration
Suppose a certain small enterprise allocates only 20,000birr for the production of furniture (school
armchairs). The enterprise wants to employ workers (L) whose wage is w=1000 birr and purchase
implements (K) at a price of r=4000 birr. Suppose further that the production function for furniture is
given by
Q = 10L0.5 K 0.5 .
A) Determine the marginal product functions of workers and implements
B) Find
MRTS
L, K and MRTS
K, L .

C) How many workers (L) and implements (K) must be acquired for the small enterprise to produce
the maximum possible number of armchairs.
D) How many armchairs will be produced at the equilibrium of the enterprise?
Solution:
We are given the production function as Q = 10L0.5 K 0.5 and the total cost (TC) function as
TC = wL+ rK  1000L+4000K = 20,000 .
A) Marginal product of a worker (MPL):
Q
MPL = = 0.5(10)L(0.5-1) K 0.5 = 5L-0.5 K 0.5
L
Marginal product of an implement (MPK):
Q
MPK = = 0.5(10)L0.5 K (0.5-1) = 5L0.5 K -0.5
K

MPL 5L-0.5 K 0.5 K

B) MRTS L, K = - = - 0.5 -0.5 =  and
MPK 5L K L
MPK 5L0.5 K -0.5 L
MRTS K, L = - = - -0.5 0.5 = 
MPL 5L K K

C) The optimum of the small enterprise is found at the following point:

w r
MRTSL, K = - or MRTSK, L = - .
r w
If we use the first equality, we have:
w K 1000 1
MRTSL, K = -  - =- = -  L = 4K
r L 4000 4
Substituting this last equation into the TC equation, gives:
1000L + 4000K =20000
1000(4K) + 4000K =20000
8000K =20000
K = 2.5 Hence, L* = 4K = 4(2.5) = 10

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 If the enterprise purchases 2.5 implements and employs 10 workers, it will have the least cost
optimal level of armchair production.
D) At those levels of employments, the least cost amount of armchairs produced will be:
Qmax = 10(L*)0.5(K*)0.5
= 10(10)0.5(2.5)0.5
= 10√25
= 50
3.2.2. Laws of returns to scale: long run analysis of production
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* = tX 0, we say that there is constant returns to

scale.

 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.

 If X* increases more than proportionally with the increase in the factors (by a more than t
proportion), we have increasing returns to scale.
3.3. Choice of optimal combination of factors of production
In this section we shall show the use of the production function in the choice of the optimal combination
of factors by the firm. In part A we will examine two cases in which the firm is faced with a single
decision, namely maximizing output for a given cost and minimizing cost subject to a given output.
Both these decisions comprise cases of constrained profit maximization in a single period.

In above cases it is assumed that the firm can choose the optimal combination of factors, that it can
employ any amount of any factor in order to maximize its profits. This assumption is valid if the firm is
new, or if the firm is in the long-run. However, an existing firm may be pressurized, due to pressure of
demand, to expand its output in the short-run, when at least one factor, usually capital, is constant.

Assumptions:

1.The goal of the firm is profit maximization – that is, the maximization of the difference
  R  C where П = profits, R = revenue, and C = cost.
2.The price of output is given, Px.
 
3.The prices of factors are given: w is the given wage rate, r is the given price of capital
services (rental price of machinery).
A. Single Decision of the Firm
The problem facing the firm is that of constrained profit maximization, which may take one of
the following forms:

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(a) Maximize profit П, subject to a cost constraint. In this case total cost and prices are given
 
(C, w , r , Px), and the problem may be stated as follows.

Max   R  C
  Px X  C
Clearly maximization of П is achieved in this case if cost C is minimized, given that X and P x are
given constants by the assumption.
(b) Maximize profit П, for a given level of output. For example, a contractor wants to build a bridge
(X is given) with the maximum profit. In this we have
Max   R  C
 
  Px X  C
Clearly maximization of П is achieved in this case is cost C is minimized, given that X and P x
are given constants by assumption.

For a graphical presentation of the equilibrium of the firm (its profit maximizing position) we
will use the isoquant map (fig. 2a) and the isocost-line(s) fig.2b.
For a graphical presentation of the equilibrium of the firm (its profit maximizing position) we
will use the isoquant map (fig. 2a) and the isocost-line(s) fig.2b.

K K

C
w
L
Fig. 2a O B L
Fig. 2b

The slope of an isoquant is

K MPL X / L
- MRS L , K  
L MPK X / K
The isocost line is defined by the cost equation
C  ( r )( K )  ( w)( L)
Where w = wage rate, and r = price of capital services

The isocost line is the locus of all combinations of factors the firm can purchase with a given
monetary cost outlay.

The slope of the isocost line is equal to the ratio of the price of the factors of production. Slope
of isocost line = w/r

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Case 1: Maximization of output subject to a cost constraint (Financial constraint)

Assume (a) A given production function X = f(L,K,v,γ)

and (b) given factor prices w, r, for labor and capital respectively.

The firm is in equilibrium when it maximizes its output given its total cost outlay and the prices
of the factors, w and r.
In fig.3 the maximum level of output the firm can produce, given the cost constraint, is X 2
defined by the tangency of the isocost line, and the highest isoquant. The optimal combination
factors of production is K2 and L2, for prices w and r. Higher levels of output (to the right of e)
are desirable but not attainable due to the cost constraint.

Fig.3 the maximum level of output the

Other points on ABO, below it lie on a lower isoquant than X2. Hence X2 is the maximum
output possible under the above assumptions (of given cost outlay, given production function,
and given factor prices). At the point of tangency (e) the slope of the isocost line (w/r) is equal to the
slope of the isoquant (MPL/MPK). This constitutes the first condition for equilibrium. The second
condition is that the isoquants be convex to the origin. In summary: the conditions for equilibrium of
the firm are:
(a) slope of isoquant = Slope of isocost
w MPL X / L
   MRS L , K
r MPK X / K
(b) The isoquants must be convex to the origin,
 Formal derivation of the equilibrium conditions
The equilibrium conditions may be obtained by applying calculus and solving a constraint maximum
problem which may be stated as follows. The rational entrepreneur seeks the maximization of his output,
given his total-cost outlay and the prices of factors, formally:
Maximize X = f ( L, K )
Subject to C = wL + rK ……….. (cost constraint)
This is a problem of constrained maximum and the above conditions for the equilibrium of firm
may be obtained from its solution.
We can solve this problem by using Lagrangian multipliers. The solution involves the following
steps:

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Rewrite the constraint in the form C  wL  rK  0
Multiply the constraint by a constant λ which is the lagrangian multiplier:
The Lagrangian multipliers are undefined constraints which are used for solving constraint
maxima or minima. Their value is determined simultaneously with the values of the other
unknown (L and K in our example). There will be as many Langrangian multipliers as there are
constraints in the problem.
From the composite function   X   (C  wL  rK )
It can be shown that maximization of the  function implies maximization of the output.
The first condition for the maximization of a function is that its partial derivatives be equal to
zero. The partial derivatives of the above function with respect to L,K, and λ are:
 X
   (w)  0 (1)
L L
 X
   ( r )  0 (2)
k K

 C  wL  rK  0 (3)

solving the first two equations for λ we obtain
X X / L MPL
 w or   
L w w
X X / L MPK
 r or   
K r r
The two equations must be equal then
X / L X / K MPL X / L w
 or  
w r MPK X / K r
This firm is in equilibrium when it equates the ratio of the marginal productivities of factors to
the ratio of their prices. It can be shown that the second-order conditions for equilibrium of the
firm require that the marginal product curves of the two factors have a negative slope.
The slope of the marginal product curve of labor is the second derivative of the production
function:
2 X
Slope of MPL curve =
L2
Similarly for capital
2 X
Slope of MLK curve =
K 2
The second order conditions are
2 X 2 X
 0 and 0
L2 K 2
and
2
  2 X   2 X    2 X 
 2    
2 

 L  K   L K 
These conditions are sufficient for establishing the convexity of the isoquants.

11 AUMiI Note for 2nd year Economics Regular & CEP Students Chapter 3
 Case 2: Minimization of cost for a given level of output
The conditions for equilibrium of the firm are formally the same as in case 1. That is there must
be tangency of the (given) isoquant and the lowest possible isocost curve, and the isoquant must
be convex. However, the problem is conceptually different in the case of cost minimization. The
entrepreneur wants to produce a given output for example, a bridge, a building, or X tons of a
commodity with the minimum cost outlay.
In this case we have a single isoquant (fig.4a) which denotes the desired level of output, but we
have a set of isocost curves (fig. 4b). Curves closer to the origin show a lower total-cost outlay.
The isocost lines are parallel because they are drawn on the assumption of constant prices of
factors: since w and r do not change, all the isocost curves have the same slope w/r.

K
K
K

0 Fig.4a L 0 Fig.4b L 0 L Fig.4c L

Fig. 5 Fig.6 Fig.7

The firm minimizes its costs by employing the combination of K and L determined by the point of
_
tangency of the X isoquant with the lowest isocost line (fig.4c). Points below e are desirable because
_
they show lower cost but are not attainable for output X . Points above e shows higher costs. Hence
point e is the least – cost point, the point denoting the least-cost combination of the factors K and L for
producing X.

Clearly the conditions for equilibrium (least cost) are the same as in case 1, that is equality of the slopes
of the isoquant and the isocost curves, and convexity of the isoquant.

Formally:
Minimise C  f ( X )  wL  rK

Subject to X  f ( L, K )

Rewrite the constraint in the form X  f ( L, K )  0

Pre multiply the constraint by the Langrangian multiplier λ.

  X  f ( L, K )  0

12 AUMiI Note for 2nd year Economics Regular & CEP Students Chapter 3
From the composite function
  C  X  f ( L, K )
or
  wL  rK   X  f ( L, K )

Take the partial derivatives of  with respect to L, K and λ and equal to zero.

  /( L, K ) X
 w  0  w
L L L

  /( L, K ) X
 r   0  r 
K K K


  X  f ( L, K )   0

from the first two equations we obtain

X X
w , r
L K
Dividing through these expressions we find

w X / L
  MRS LK
r X / K

This condition is the same as in case 1 above. The second sufficient conditions, concerning the convexity
of the isoquants, is fulfilled by the assumption of negative slopes of the marginal product of factors as in
case 1, that is

2
2 X 2 X  2 X   2 X    2 X 
 0 , 0 and  2    
2 

L2 K 2  L  K   LK 

13 AUMiI Note for 2nd year Economics Regular & CEP Students Chapter 3