Economics of Input

Substitution
Prepared by:
Escol, Leah M.
Labus, Julien Grace S.
Subade, Rona Grace A.
• A business can alter the
combination of capital and labor
used

• Farming operations have become

much more capital intensive
during post-World War II period.
• In the short run, we determine the
least-cost combination of labor and
variable capital inputs, given the
business’s existing fixed resources
and technology.
• Because all inputs are variable in the
long run, the business will also have
an interest in the optimal expansion
path of labor and all capital overtime.
Concept and Measurement of
Isoquants
• A curve that reflects the combination
of two inputs that result in a particular
level of output is called isoquant
curve.

• Along any isoquant, an infinite number

of combinations of labor and capital
that result in the same level of output
are depicted.
• As the quantity of labor increases,
less capital is necessary to
produce a given level of output,
vice versa.
Let:
X1=capital
X2=labor
Rate of Technical Substitution
Marginal Rate of Technical
Substitution

• "The rate at which one factor can

be substituted for another while
holding the level of output
constant".
Rate of Technical Substitution

∆ 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝑴𝑷𝑷𝒍𝒂𝒃𝒐𝒓
=
∆ 𝒍𝒂𝒃𝒐𝒓 𝑴𝑷𝑷𝒄𝒂𝒑𝒊𝒕𝒂𝒍

• in which MPPcapital and MPPlabor

represent the marginal physical
products for capital and labor, and Δ
represents the change in a variable.
Rate of Technical Substitution
• A decline in the MRTS along an
isoquant is called a diminishing
marginal rate of technical
substitution.

– When labor increases, its marginal

physical product falls.

– When capital decreases, its marginal

physical product rises.
Isoquants at the Extreme
The Iso-cost Line

• The relationship between the

combination of wage rate for labor
and rental rate for capital for a given
level of total cost is referred to as an
iso-cost line.
• Suppose Frank Farmer has $1,000 available
daily to finance a business’s production costs.
The wage rate for labor is $10 per hour, and
the rental rate for capital is $100 per day. The
business’s daily budget constraint is?

($10 x use of labor) + ($100 x use of capital) = $1,000

• Frank’s choice of how much capital and labor

to employ must be no more than $1,000.
The Iso-cost Line

𝒘𝒂𝒈𝒆 𝒓𝒂𝒕𝒆
𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝑰𝑳 = −
𝒓𝒆𝒏𝒕𝒂𝒍 𝒓𝒂𝒕𝒆

• The iso-cost line plays a key role in

determining the least-cost combination of
input use.
Nature of Iso-cost Line
Nature of Iso-cost Line
Least Cost Combination of
Inputs
Least cost decision rule

The least cost combination of two inputs occurs

where the slope of the iso-cost line is tangent to the
isoquant curve:
𝑀𝑃𝑃𝑙𝑎𝑏𝑜𝑟 𝑤𝑎𝑔𝑒 𝑟𝑎𝑡𝑒
=
𝑀𝑃𝑃𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑛𝑡𝑎𝑙 𝑟𝑎𝑡𝑒

Slope of an Slope of iso-cost

isoquant line
Least cost decision rule

𝑀𝑃𝑃𝑙𝑎𝑏𝑜𝑟 𝑀𝑃𝑃𝑐𝑎𝑝𝑖𝑡𝑎𝑙
=
𝑤𝑎𝑔𝑒 𝑟𝑎𝑡𝑒 𝑟𝑒𝑛𝑡𝑎𝑙 𝑟𝑎𝑡𝑒
Marginal physical product per dollar spent on labor
equals the marginal physical product per dollar spent
on capital.
Thus, a firm should allocate its expenditures on
inputs so the marginal benefits per dollar are spent
on competing equally.
Least cost use of inputs
for a given output
Short-run least-cost input use
• Lowest possible cost of producing a given
level output
• Technology and input prices are assumed to
be known and constant
• Any additional capital is rented (variable cost)
through a short-term leasing arrangement
rater than owned (fixed cost)
 The least-cost choice of input use
is given by the point where the iso-
cost curve is tangent to the
isoquant for the desired level of
output.
Capital

100 units
of
output

0 B

Labor
 The iso-cost line from AB shifts in
a parallel fashion to A*B* (which
leaves prices unchanged) which
A*
touches the isoquant at G
Capital

A G
C1

100 units
of
output

0 L1 B B*

Labor
 This therefore represents the cheapest
combination of capital and labor to
A* produce 100 units of output
Capital

G
C1

100 units
of
output

0 L1 B*

Labor
Effects of input price
changes
 Assume the initial wage rate and cost of
A
capital results in the iso-cost line AB
Capital

G
C1

100 units
of
output

0 L1 B

Labor
 Wage rate decline means that the
A
firm can now afford B* instead of B
Capital

G
C1

100 units
of
output

0 L1 B B*

Labor
 The new point of tangency occurs
A
at H instead of G. DE represents a
D parallel shift of line AB* to a point of
Capital

tangency with the desired isoquant

G
C1
H

100 units
of
output

0 L1 B E

Labor
 As a consequence, the firm would
A
desire to use more labor and less
capital
Capital

G
C1
H
C2
100 units
of
output

0 L1 L2 B B*

Labor
Least cost use of inputs
for a given budget
 The least-cost choice of input use
for a given budget is found by
plotting the iso-cost line associated
with this budget and observing the
point of tangency with the highest
M possible isoquant
Capital

125 units
C3 P

100 units

75 units

0 L3 N

Labor
 In this case, the firm can afford to
produce only 75 units of output
using C3 units of capital and L3
units of labor at point P
M
Capital

125 units
C3 P

100 units

75 units

0 L3 N

Labor
 The firm’s budget is not large
enough to operate at 100 or 125
units

M
Capital

125 units
C3 P

100 units

75 units

0 L3 N

Labor Firm is not spending available

budget here
Long-Run Expansion of
Input Use
Long Run
• In the long run, a business has time to
expand the size of its operations, and
all costs become variable.
Long Run Average Cost
• The long run average cost (LAC) curve
reflects points of tangency with a series of
short run average total cost (SAC) curves.
The point on the LAC where the following
holds is the long run equilibrium position
(QLR) of the firm:
𝑆𝐴𝐶 = 𝐿𝐴𝐶 = 𝑃𝐿𝑅
Where MC represents the marginal cost and QLR
represents the long run price, respectively.
 The LAC curve represents an
envelope of a series of short-
run average costs
Cost per unit

LAC

Output
 Size A is the smallest, with costs represented
by SACA. Size B is larger and can operate at
lower costs and curve SACB is much lower.
SACA Size C is still larger but curve SACC has a
Cost per unit

higher cost structure than B.

SACB
SACC

LAC

A B C
Output
The Long-Run Planning Curve

- The Long-Run Average Cost Curve

ILLUSTRATES/INDICATES:
1. How varying a business size will affect
its economic efficiency
2. Minimum per unit cost at which any
output level can be produced
The Long-Run Planning Curve

- The Long-Run Average Cost Curve

ILLUSTRATES/INDICATES:
1. How varying a business size will affect
its economic efficiency
2. Minimum per unit cost at which any
output level can be produced
What causes LAC curve’s
behaviour?
Returns to Size:

1. Increasing Returns to Size

2. Constant Returns to Size
3. Decreasing Returns to Size
1. Increasing Returns to Size
- Increase in output is more than
proportional to the increase in input
use

As firm’s operations increases, firm’s

management can switch from using the
minimum-sized piece of equipment to
larger, more efficient equipment.
2. Constant Returns to Size

Increase in output is exactly

proportional to an increase in input
use
3. Decreasing Returns to Size
Increase in output is less than
proportional to the increase in input
use

The managerial skills needed to

coordinate efforts and resources
usually do not increase
proportionately with the size of the
operations.
Economics of a Business
Expansion
Capital Variable in the
Long Run
Expansion Path through
Isoquants