Question

microeconomics

2.) Production, Costs and Industry Structure Firms normally seek the combination of inputs that offers the least costly way to produce any given output. Is it possible for a firm to produce the same quantity of output in a variety of ways by substituting more of one input for less of another? If so, why would firms do so and how in doing so would firms engage in this economic behavior? Give one example of this economic behavior that illustrates how you would operationalize this economic behavior (assuming you act as a firm) in preparing to market yourself to your future employers.

Answer 1

The objective of any firm is profit maximization. Profit maximization also is the dual problem of cost minimization, that is, both the problems have the same objective and thus yield the same results. Suppose, the firm uses two inputs – Labour (L)and Capital(K) in the production process. The price of capital is r and that of labor is w. It is possible for the firm to attain the same level of output using different input combinations. The locus of all such combinations gives the isoquant curve. Substitution of inputs depends on the degree of substitutability of inputs. That is given by the Marginal rate of technical substitution (MRTS). It gives the rate which one factor must decrease while increasing the other factor so that the amount of output remains constant. MRTS is given by –

MRTS = dL/dK = MP_L/ MP_k

So, the rate of substitution of factors will depend on the marginal productivity of the respective factors. A MRTS = 4 means the firm gives up 4 units of capital in exchange of 1unit of labor and still produces the same amount of output.

The firm may substitute inputs to optimize the use of inputs. If the MP of one input is higher than the other, it is rational to employ more of those inputs. Also, if the price of one input increases say w increase, the profit of firms decreases. So, to optimize, the firm hires less labor and substitute it with capital to produce the same output. SO, this is how the firm engages in this economic behavior.

Suppose I have two skillsets – A and B which I can market and invest in. Let the price for the skill set A be P_A in the market and the price of skill set B be P_B. If, P_A > P_B, and the Marginal productivity A is higher than B, I will invest more in developing skillset A, so that my elasticity of substitution decrease.