This task is best understood in terms of what is called the , i. Just as an indifference curve shows the various combinations of any two commodities that give the consumer the same amount of satisfaction iso-utility , similarly an isoquant indicates the various combinations of two factors of production which give the producer the same level of output per unit of time. It states the amount of product that can be obtained from each and every combination of factors. It is obvious that many more isoquants, in principle an number, could also be drawn. The straight line labelled v 2, called the v 2-isocost line, shows all the combinations of input that can be purchased for a specified variable cost, v 2. The theory involves some of the most fundamental principles of economics.
In decreasing-cost industries, average cost declines as the rate of output grows, at least until the plant is large enough to supply an appreciable fraction of its market. At any one time an established firm with an existing plant will make its short-run decisions by comparing the ruling price of its commodity with cost curves corresponding to that plant. It represents a combination of short-run and long-run adjustments to a slight increase in the rate of output. In the graph, goldsmith-hours per month are plotted horizontally and the number of feet of gold wire used per month vertically. These result from balancing the fixed costs entailed by any plant against the short-run costs of producing in that plant. Add Remove The manager of a public supplying electricity to a significant portion of a geographic region presides over an electrical generation facilities that can produce electricity using either natural gas or oil, or some combination of both.
If the price is so high that the firm is operating on the rising leg of its short-run cost curve, its marginal costs will be high—higher than its average costs—and it will be enjoying operating profits, as shown in Figure 3. This, also, is a fundamental theorem of income distribution and one of the most significant theorems in economics. It is now possible to derive the relationship between product prices and factor prices, which is the basis of the theory of income distribution. The straight lines are isocost and the curves are isoquants. In the diagram, if feet of gold wire are indicated by x 1 and goldsmith-hours by x 2, then the marginal rate of substitution is shown by the steepness the negative of the slope of the isoquant; and it will be seen that it diminishes steadily as x 2 increases because it becomes harder and harder to economize on the use of gold simply by taking more care. As an example, the same level of output could be achieved by a company when capital inputs increase, but labor inputs decrease.
Minimization of short-run The production function However much of a commodity a business firm produces, it endeavours to produce it as cheaply as possible. These are especially damaging to the theory of long-run profit maximization. The first layer includes decisions about methods of producing a given quantity of the output in a plant of given size and equipment. The marginal products are closely related to the marginal rates of substitution previously defined. Thus, since the slope of an isoquant is given by the marginal rate of substitution, any firm trying to produce as cheaply as possible will always purchase or hire factors in quantities such that the marginal rate of substitution will equal the ratio of their prices. People are either idle much of the time or shifting, expensively, from job to job.
Similarly point В shows a combination of 6 units of capital and 10 units of labour; point C, 4 units of capital and 15 units of labour; and point D, a combination of 3 units of capital and 20 units of labour to yield the same output of 100 units. To restate it briefly: factors of production are paid in proportion to their marginal products. Here according to the budget and the financial position of the firm the producer can switch between the alternative production systems. Automobile and steel manufacturing are leading examples. In each technique there is no possibility of substituting one input for another, but various mixes of the two techniques may be used by the firm. Property 1: An isoquant curve slopes downward, or is negatively sloped.
Linear isoquants This liner isoquant is drawn if there is a perfect substitutability in the inputs of production. At any higher market price, the firm will produce the quantity for which marginal cost equals that price. This curve is of fundamental importance for economic analysis, for together with the for the product it determines the market price of the commodity and the amount that will be produced and purchased. And for isoquants, Marginal rate of substitution can be defined as the the rate at which one factor must be added to compensate for the loss of another factor, to keep output constant Marginal rate of substitution is the slope of the isoquant curve. Long-run cost curves Cost curves appropriate for long-run analysis are more varied in shape than short-run cost curves and fall into three broad classes. The isoquant curve assists firms in making adjustments to inputs to maximize outputs, and thus profits.
Here, y denotes the quantity of output. The firm can produce 100 units of output at point A on this curve by having a combination of 9 units of capital and 5 units of labour. Overtime may be incurred, outmoded equipment and inexperienced hands may be called into use, there may not be time to take machinery off the line for routine maintenance; or minor breakdowns and delays may disrupt schedules seriously because of inadequate slack and reserves. It has already been shown that the marginal rate of substitution also equals the ratio of the prices of the factors, and it therefore follows that the prices or wages of the factors are proportional to their marginal products. This means that the same level of production only occurs when increasing units of input are offset with lesser units of another input factor. The second layer, including the determination of the most profitable quantities of products to produce in any given plant, deals with what is called short-run profit maximization.
Different factors are needed to produce goods. Gas and oil are perfect substitutes here. The theory of production decisions in the short run, as just outlined, leads to two conclusions of fundamental importance throughout the field of economics about the responses of business firms to the market prices of the commodities they produce and the factors of production they buy or hire: 1 the firm will produce the quantity of its product for which the marginal cost is equal to the market price and 2 it will purchase or hire factors of production in such quantities that the price of the commodity produced multiplied by the marginal product of the factor will be equal to the cost of a unit of the factor. The firm is also presumed to use m fixed factors, or factors like fixed machinery, salaried staff, etc. The firm will then consider whether it could increase its profits by enlarging its plant. If they run slowly, then a relatively large amount of labor is used together with a relatively small amount of raw material. The short-run supply curve for a product—that is, the total amount that all the firms producing it will produce in response to any market price—follows immediately, and is seen to be the sum of the short-run supply curves or marginal cost curves, except when the price is below the bottoms of the average variable cost curves for some firms of all the firms in the industry.
Its logic can be perceived directly. One pitfall must, however, be noted. This is possible in the above figure. Without much difficulty it could be extended to cover firms that produce more than one product, as almost all firms do. Only the simplest aspects of the theory were described above. On still another level, critics of the theory maintain that businessmen are not always concerned with maximizing profits or minimizing costs. This diagram is a graphic display of the relationships expressed in the production function.