APPENDIX TO CHAPTER 7

PRODUCTION, COST THEORY, AND DECISIONS OF THE

FIRM

I. APPENDIX OVERVIEW

This appendix extends one of the topics from Chapter 7: How does the firm choose the least-cost input
combination to use in the production process? In the chapter, you learned that the least-cost combination of
inputs will be characterized by the least-cost rule, which means that the ratio of an input’s marginal product to
its price will be equal for all inputs used in the production process. That is, the productivity of the last dollar
spent on each input will be equal for all inputs.
If we limit the number of inputs to two (e.g., labor and land), the production function can be illustrated,
with labor on the X axis and land on the Y axis, by a series of equal-output lines, or isoquants. Each of these
lines represents all of the combinations of labor and land that can be used to produce a particular level of output.
On the same diagram, we may also easily draw any number of equal-cost lines, or isocosts. Each of these lines
represents all of the combinations of labor and land that cost the same amount of money. Taken in
combination, these two sets of curves will succinctly describe the process of cost minimization.

II. LEARNING OBJECTIVES

After you have read the appendix to Chapter 7 in your text and completed the exercises in this Study Guide
appendix, you should be able to:
1. Define and illustrate (a) an equal-cost line and (b) an equal-product line.
2. Draw sets of equal-cost lines and equal-product lines, and describe the process of moving from one
curve to the next.
3. Explain why the minimum-cost combination of inputs is found at the point of tangency between an
equal-cost line and the equal-product line for a particular output level.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.
A B
__ Equal-product curves 1. MPx / MPy, where x and y are two inputs used in a production process.
__ Equal-cost curves 2. Indicate all the different combinations of two inputs that yield the same
quantity of output.
__ Substitution ratio 3. MPx / MPy = Px / Py, where x and y are two inputs used in a production
process.
__ Least-cost 4. Indicate all the different combinations of two inputs that cost the same
tangency amount of money.

IV. SUMMARY AND APPENDIX OUTLINE

This section summarizes the key concepts from the chapter appendix.
1. Production functions define relationships between inputs and outputs. They operate something like recipes
by describing minimum input requirements, processes, and output expectations.
2. The law of diminishing marginal productivity, as you learned in Chapter 6, states that as you add variable
inputs to a fixed input base, eventually the marginal product of the variable input will fall. This is illustrated in
Table 7A-1 of the text. As you move across a given land row, you are adding workers to a fixed amount of land
and you can see that the marginal product of labor falls.
3. Given input prices and a production function, it is possible to find the least-cost input combination for a
particular output level by summing the total cost for each input.
4. In order to illustrate the process of finding the least-cost input combination for a particular output level,
economists have developed two sets of curves. Equal-product curves indicate all the different combinations of
two inputs that can be used to produce a particular level of output. Equal-cost curves indicate all the different
combinations of two inputs that cost the same amount of money, given fixed input prices.
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5. Once the firm has determined its optimal level of output and identified the associated equal-product curve,
the least-cost combination of inputs will be found where this equal-product curve is tangent to the lowest equal-
cost curve. This means that the slope of the equal-product curve is equal to the slope of the equal-cost curve,
given the definition of a tangency; i.e., MPx / MPy = Px / Py , where x and y are two inputs used in the
production process. Note that this expression can be easily rewritten as MPx / Px = MPy / Py , and the
illustration yields the same interpretation that was made verbally in Chapter 7, namely, that the productivity of
the last dollar’s worth of each input must be equal at the least-cost combination of inputs.

V. HELPFUL HINTS

1. Production functions are not as mysterious as they may seem. Take a look at a boxed cake mix, or the
directions for assembling a gas grill: They list raw materials, or pieces, that must be used in a production
process, and they provide some directions that, when followed, will yield a finished product. In some sense, the
functions that we refer to in this chapter have the same properties.
2. You may have trouble understanding why the slope of an equal-product line must be -MPL/MPK, when
labor is the X axis variable and capital is the Y axis variable. Here is a rough explanation: The slope of a line is
often referred to as “rise over run,” i.e., the change in the Y axis variable over the change in the X axis variable
between two points. Suppose that when capital is reduced by 1 tiny unit, labor must be increased by 2 tiny units
in order to hold output fixed and stay on the equal-product line. That would make the slope of the equal-
product line -1/2 because at this point a unit of capital is twice as productive as a unit of labor; it takes 2 units of
labor to make up for the output lost when 1 unit of capital is taken away. When capital was reduced, output
fell—by an amount dictated by MPK. The amount of labor needed to make up that output loss was dictated by
MPL.
3. The tangency solution is a generally useful concept in economic analysis. The slope of the equal-product
line represents the rate at which one input can be substituted for another depending on how productive each
input is at the margin. The slope of the equal-cost line represents the rate at which one input can be substituted
for another given market prices. Thus, the slope of the equal-product line—the ratio of the marginal
productivities—is determined by the productivity of the inputs with this particular production function, while
the slope of the equal-cost line—the ratio of input prices—is determined by market forces that are most often
out of the firm’s control.

VI. MULTIPLE CHOICE QUESTIONS

Choose the best answer from the options available.

1. An equal-cost line describes the various:
a. quantities of output that a firm will produce at alternative output prices.
b. quantities of two inputs that would cost the same amount as the prices of the inputs change.
c. combinations of two inputs that a firm could purchase for a given level of expenditure.
d. combinations of two inputs that a firm could employ to produce some given quantity of output.
e. combinations of inputs that bring equal utility to the firm.
2. Which alternative in question 1 correctly describes an equal-product line?
a. quantities of output that a firm will produce at alternative output prices.
b. quantities of two inputs that would cost the same amount as the prices of the inputs change.
c. combinations of two inputs that a firm could purchase for a given level of expenditure.
d. combinations of two inputs that a firm could employ to produce some given quantity of output.
e. combinations of inputs that bring equal utility to the firm.
3. Each and every point on an equal-product curve stands for a different:
a. combination of two inputs, all of which can be purchased at the same total expense.
b. quantity of output, all of which cost the same to produce.
c. combination of inputs, all of which can be employed to produce the same level of output.
d. production function, all of which use the same combinations of inputs.
e. combination of outputs, all of which can be purchased at the same total expense.
4. A diagram showing a set of equal-product curves illustrates the firm’s:
a. total cost function.
b. minimum cost level of output.
c. profit-maximizing level of output.
d. production function.
e. utility function.
5. The slope of an equal-cost line is a measure of the:
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a. ratio of the price of the factor on the vertical axis to the price of the factor on the horizontal axis.
b. ratio of the price of the factor on the horizontal axis to the price of the factor on the vertical axis.
c. various outputs which may be produced at a given cost.
d. total cost of producing a given output.
e. marginal productivity of one of the factors.
6. Consider Firm X’s production function. It uses 2 workers and 1 unit of capital to produce 10 units of
output. Additional workers, or additional units of capital, are not useful unless the inputs are obtained in the
above ratio. Firm X will have equal-product curves that are:
a. straight lines.
b. L-shaped.
c. curved, and convex to the origin.
d. curved, and concave to the origin.
e. any of the above.
Use Figure 7A-1 to answer questions 7 through 9.

Figure 7A-1

7. Line GH is an equal-cost line for inputs A and B. A shift of GH to a position such as GJ could be caused
by a(n):
a. decrease in the price of input A with no change in the price of B.
b. increase in the price of both inputs.
c. decrease in the price of input B with no change in the price of A.
d. increase in the price of input B with no change in the price of A.
e. proportionate reduction in the price of both inputs.
8. Suppose that the equal-cost line GH shifts to position MJ (with no change in the total cost). Which
alternative in question 7 would correctly explain this shift?
a. decrease in the price of input A with no change in the price of B.
b. increase in the price of both inputs.
c. decrease in the price of input B with no change in the price of A.
d. increase in the price of input B with no change in the price of A.
e. proportionate reduction in the price of both inputs.
9. Suppose that the equal-cost line GH shifts instead to position KH. Which alternative in question 7 would
correctly explain this shift?
a. decrease in the price of input A with no change in the price of B.
b. increase in the price of both inputs.
c. decrease in the price of input B with no change in the price of A.
d. increase in the price of input B with no change in the price of A.
e. proportionate reduction in the price of both inputs.
10. What do we assume is held constant when an equal-cost line is drawn?
a. Total expenditure on input A.
b. Total expenditure on input B.
c. Quantity of the product produced.
d. Total expenditure on either A or B but not both.
e. Total expenditure on the two inputs combined.
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11. Had question 10 referred to an equal-product rather than an equal-cost line, which alternative in that
question would have been correct?
a. Total expenditure on input A.
b. Total expenditure on input B.
c. Quantity of the product produced.
d. Total expenditure on either A or B but not both.
e. Total expenditure on the two inputs combined.
12. Equal-product lines and equal-cost lines have one property in common: Any point on either of these two
lines is intended to mark some:
a. quantity of finished total output.
b. amount of total cost expressed in dollars.
c. combination of physical quantities of inputs.
d. pair of input prices.
e. amount of total sales revenue in dollars.
13. When the difference between the fixed-proportions (FP) and variable-proportions (VP) cases (with respect
to the use of inputs in production) is illustrated by means of equal-product curves or lines, it shows up as
follows: The equal-product curve is a:
a. straight line in the FP case, but it is a right angle in the VP case.
b. right angle in the FP case, but it is a curved line in the VP case.
c. curved line in the FP case, but it is a right angle in the VP case.
d. right angle in the FP case, but it is a straight line in the VP case.
e. curved line in the FP case, but it is a straight line in the VP case.
14. The points of tangency between equal-product and equal-cost curves are important because they indicate:
a. for any given level of output, the lowest possible equal-cost line that can be reached, i.e., it indicates
minimum cost for that output.
b. for any given level of outlay on factors, the highest possible equal-product line that can be reached,
i.e., it indicates the maximum output that can be obtained for that outlay of money.
c. the maximum-profit output level.
d. the minimum possible level of output that can be attained for any given outlay of money.
e. both a and b.
Figure 7A-2 illustrates a production function involving the employment of inputs X and Y. The two curved
lines are equal-product lines for outputs of 300 and 420 units. AB and CD are equal-cost lines. AB marks a
cost outlay of $36. Please use this information to answer questions 15 through 21.
15. From examination of AB, the price of X must be:
a. $2.50.
b. $4.50.
c. $5.50.
d. $6.00.
e. $8.00.

Figure 7A-2
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16. From examination of AB, the price of Y must be:

a. $2.50.
b. $4.50.
c. $5.50.
d. $6.00.
e. $8.00.
17. The minimum total cost of producing 300 units of output is:
a. $36.
b. $45.
c. $54.
d. $100.
e. $160.
18. The average cost of producing 300 units (given that the firm has chosen the minimum cost combination of
inputs) is:
a. 5 cents per unit.
b. 10 cents per unit.
c. 12 cents per unit.
d. 15 cents per unit.
e. 60 cents per unit.
19. The quantities of X and Y used to produce 300 units of output at minimum cost could be:
a. 2.25 of X and 5 of Y.
b. 4 of X and 3 of Y.
c. 5 of X and 9 of Y.
d. 8 of X and 6 of Y.
e. none of the above.
20. Given the above prices of X and Y, equal-cost line CD must indicate a total outlay of:
a. $36.
b. $45.
c. $54.
d. $100.
e. $160.
21. Suppose that equal-cost line CD (still signifying the same total cost amount as before) shifts to position CE.
This would indicate a(n):
a. decrease in the price of X
b. increase in the price of X
c. decrease in the price of Y.
d. increase in the price of Y.
e. none of the above.
22. Farmer Jones is using labor and land in her production process; she grows corn on her 40 acres of land.
The law of diminishing returns tells us:
a. as she adds workers to her fixed amount of land, eventually the marginal product of land will fall.
b. as she adds workers to her fixed amount of land, eventually the marginal product of labor will fall.
c. that the average product of labor will remain constant in the short run.
d. there are no variable inputs in the short run.
e. as she spends more money on land and labor, marginal product will fall only in the long run.

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in this appendix.

1. Suppose Figure 7A-3 describes a production process in which output is produced using alternative
quantities of labor and capital.
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Figure 7A-3

a. Show in Figure 7A-4 the various capital-labor combinations that will produce an output of 346 units.
Join these points with a smooth curve. Repeat the process for outputs of 490 and 282. For identification, label
the three curves q = 282, q = 346, and q = 490.

Figure 7A-4

b. You can add equal-cost lines to your figure above. Suppose that labor costs $2 per unit and that the
rental cost of capital is $3, and further suppose that the firm has $12 to spend on these two inputs. Use this
information to draw an equal-cost curve. (Hint: You know that your equal-cost curve will be a straight line,
since the slope is constant. So, plot the two axis-intercepts and connect them to get your line; that is, plot the
point representing $12 worth of labor and no capital and the point representing $12 worth of capital and no
labor. Connect these two points with a straight line.)
c. One point on your equal-cost line is 1.5 units of labor and 3 units of capital. The output which this
combination would produce, according to your production function above, is (more than / less than / equal to)
280 units? Explain. ___________________________.
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d. Draw another equal-cost line parallel to the previous one, but this time draw it so that it just touches
your 282 equal product curve at one point. About what combination of inputs will this curve represent? How
much money will the firm spend? _____________________.
2. Suppose a firm uses labor and capital to produce output.
a. If the price of labor is $50 per unit and the price of capital is $75 per unit, what will the firm’s equal-
cost curve look like when it is spending $500? Draw the curve in Figure 7A-5 and label it curve 1.
b. If the price of labor falls to $45 per unit, what happens to the firm’s equal-cost curve? Show the new
curve in Figure 7A-5 and label it curve 2.
c. Return to the specifications for curve 1. If the firm decides to spend $750 instead of $500, what
happens to the firm’s equal-cost curve? Show the new curve in Figure 7A-5 and label it curve 3.

Figure 7A-5

d. Summarize the results of the above changes. What happens to the firm’s options when these types of
changes occur? ___________________________________________________________________________.

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

Figure 7A-6
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1. The Sit Tite Chair Company uses labor and capital to produce wooden kitchen chairs. After carefully
considering their production function, they find that they can produce a single chair using any combination of
labor and capital, as long as they use 4 units of inputs. That is, they can produce a single chair using 4 units of
labor, or 4 units of capital, or 3 units of capital and 1 unit of labor, etc. In Figure 7A-6, show the firm’s equal-
product curves for 1, 2, 3, and 4 chairs.
2. Is the following statement true or false: “A firm’s production function is illustrated by a set of equal-
product curves; these curves alone determine the optimal level of output for the firm, and the optimal input
combination for the firm.”
3. Is the following statement true or false: “A firm will always choose the optimal input combination where
the marginal product of all inputs is zero.” Please explain.
4. Suppose that a firm is producing widgets using capital and labor. The firm finds that it is currently
spending all of its budget, and that the MPL/MPK is greater than PL/PK . What would you tell the firm to do?
Illustrate its current position in Figure 7A-7 using equal-product and equal-cost curves.

Figure 7A-7

IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Review of Key Concepts

2 Equal-product curves
4 Equal-cost curves
1 Substitution ratio
3 Least-cost tangency

VI. Multiple Choice Questions

1. C 2. D 3. C 4. D 5. B 6. B
7. A 8. E 9. D 10. E 11. C 12. C
13. B 14. E 15. B 16. D 17. A 18. C
19. B 20. C 21. B 22. B

VII. Problem Solving

1. a. See Figure 7A-4
b. See Figure 7A-4.
c. More than.
d. Approximately 1.8 units of capital and 2.4 units of labor. The firm will spend approximately $10.20.
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Figure 7A-4

2. a. See Figure 7A-5.

b. See Figure 7A-5.
c. See Figure 7A-5.
d. When prices change, the least-cost curve pivots. When the level of expenditure changes, the curve
shifts parallel. The firm is able to produce more output with the same level of expenditure when the price of
input X falls. (Part b.) The firm is able to produce more output with a greater level of expenditure. (Part c.)

Figure 7A-5

VIII. Discussion Questions

1. See Figure 7A-6.
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Figure 7A-6

2. False. In addition to equal-product curves, a decision maker would also need equal-cost curves to
determine the optimal level of output for the firm.
3. False. The firm will set the ratios of marginal product to the price of each input equal to find the optimal
combination of inputs.
4. Use more labor and less capital. This will allow the firm to increase output while spending the same
amount of money. (See Figure 7A-7.)

Figure 7A-7