The focus of this chapter is on the firm. The chapter examines the theory of production or how firms organize production i. Production theory is extended to deal with two variable inputs by the introduction of isoquants. From the theory of production where only one or two inputs are variable, we proceed to examine cases in which all inputs are variable. While going through this analysis students may feel it is a revision of the indifference curve and the budget line.

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In this diagram, the isoquant shows all the combinations of labour and capital that can produce a total output Total Physical Product TPP of 4, In the above isoquant, this could be. An isoquant is usually shaped concave because of the law of diminishing returns.

With fixed capital employing extra workers gives a declining increase in the marginal product MP. The marginal rate of substitution is the amount of one factor e. K that can be replaced by one factor e. If 2 units of capital could be replaced with one-factor labour, the MRS would be 2. If the firm employs 2 L and 40 K. Then employing one extra worker can enable it to save 10K. This is quite an efficient saving. The firm only has to pay one extra worker but can save the cost of However, at a combination of 9 Labour, employing an extra worker enables a saving of only 2 capital.

Therefore, the more that workers are employed, there is a diminishing rate at which you can substitute the other factor. There comes a point, where employing more workers barely saves any capital at all. As one moves down the isoquant, output remains the same. Therefore the output gained from employing more labour must equal the output lost from employing more capital. In the short-term, a firm faces a trade-off along one particular isoquant.

But, in the long-term, a firm can invest in increasing capital stock and produce at a higher output for the same quantity of labour. To maximise profits, a firm will wish to produce at the point of the highest possible isoquant and minimum possible isocost. In this example, we have one isocost and three isoquants. Another way of seeking to maximise profits is to target an output of say 4,00 and then find the isocost with the lowest possible cost.

An isoquant shows all combination of factors that produce a certain output An isocost show all combinations of factors that cost the same amount. Isocosts and isoquants can show the optimal combination of factors of production to produce the maximum output at minimum cost. Definition isoquant An isoquant shows all the combination of two factors that produce a given output In this diagram, the isoquant shows all the combinations of labour and capital that can produce a total output Total Physical Product TPP of 4, In the above isoquant, this could be 20 capital and 18 labour or more capital intensive 9 capital and 35 labour.

With fixed capital employing extra workers gives a declining increase in the marginal product MP Marginal rate of factor substitution The marginal rate of substitution is the amount of one factor e. If 2 units of capital could be replaced with one-factor labour, the MRS would be 2 Diminishing marginal rate of substitution If the firm employs 2 L and 40 K. For example I1 may show the combinations of capital and labour that can produce 4, TPP. I2 may show the combinations of capital and labour that can produce 5, TPP.

I5 is a higher output than I4 In the short-term, a firm faces a trade-off along one particular isoquant. Isocost An isocost shows all the combination of factors that cost the same to employ.

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## Isoquant and isocosts

In this diagram, the isoquant shows all the combinations of labour and capital that can produce a total output Total Physical Product TPP of 4, In the above isoquant, this could be. An isoquant is usually shaped concave because of the law of diminishing returns. With fixed capital employing extra workers gives a declining increase in the marginal product MP. The marginal rate of substitution is the amount of one factor e.

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## Isocost-isoquant analysis

In economics an isocost line shows all combinations of inputs which cost the same total amount. For the two production inputs labour and capital, with fixed unit costs of the inputs, the equation of the isocost line is. The absolute value of the slope of the isocost line, with capital plotted vertically and labour plotted horizontally, equals the ratio of unit costs of labour and capital. The slope is:. The isocost line is combined with the isoquant map to determine the optimal production point at any given level of output. Specifically, the point of tangency between any isoquant and an isocost line gives the lowest-cost combination of inputs that can produce the level of output associated with that isoquant. Equivalently, it gives the maximum level of output that can be produced for a given total cost of inputs.

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