Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition

Richard B. McKenzie and Dwight R. Lee

Production costs in the short CHAPTER

run and long run 8
Reading 8.1: Choosing the most efficient resource combination,
isoquant and isocost curves
The cost curves developed in chapters 7 and 8 were based on the assumption that the producer
had chosen the most technically efficient, cost-effective combination of resources possible at each
output level. That is, resources were fully employed, were producing as much as possible, and
were used in the lowest-cost combination. The short-run average total cost curve, for example,
was as low as it could be, given the availability and prices of resources.
How does the firm find the most efficient combination of resources? Most products and
output levels can be produced with various combinations of resources. A given quantity of blue
jeans can be produced with a lot of labor and little capital (equipment) or a lot of capital and little
labor. As indicated in Figure R8.1.1, a firm can produce 100 pairs of jeans a day with five
different combinations of labor and machines. Combination a requires seven workers and ten
machines; combination b, five workers and fifteen machines. (To keep output constant, the use of
labor must be reduced when the use of machines is increased. If the use of both were increased,
output would rise.)
Curves like that in figure R8.1.1 are called isoquants. An isoquant curve (from the Greek
and Latin words for “same quantity”) is a curve that shows the various technically efficient
combinations of resources that can be used to produce a given level of output. Different output
levels have different isoquants. The higher the output level, the higher the isoquant curve, as
shown in figure R8.1.2. For example, an output level of 100 pairs of jeans can be produced with
the resource combinations shown on curve IQ1. An output level of 150 pairs of jeans requires
larger resource combinations, shown on curve IQ2.
To understand how the firm determines its most efficient resource combination, we must
remember that it operates under conditions of diminishing marginal returns. The firm will always
produce in the upward-sloping range of its marginal cost curve, and marginal cost increases
because marginal returns decline. Therefore, given a fixed quantity of one resource as more of
another resource is used, the additional output marginal product of that resource must diminish.
Then, as each additional worker is eliminated in figure R8.1.1, the number of machines
added to keep output constant at 100 pairs of jeans must rise – and that is just what happens.
Notice that as the firm moves down curve abcde in figure R8.1.1, using fewer and fewer
workers, the curve flattens out indicating that larger and larger increases in machines are needed
to make up for one fewer worker – or that the marginal product of machines diminishes and the
marginal product of the remaining workers rises.
Suppose, for instance, that the daily wage of labor is $100 and the daily rental for a
sewing machine is $20. With a daily budget of $600, a firm can employ six workers and no
machines or thirty machines and no workers. Or it can combine labor and machinery in various
ways. It can employ four workers at a total expenditure of $400 and add ten machines at a total
expenditure of $200. Curve IC1 in figure R8.1.3 shows the various combinations of workers and
machines the firm could choose. This kind of curve is called an isocost curve.

Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
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An isocost (meaning “same cost”) curve is a curve that shows the various combinations of resources
that can be employed at a given total expenditure (cost) level and given resource prices.
We know, then, that the marginal product of resources differs with their level of use. To
determine exactly which combination of resources should be employed to produce any given
output level, however, we need to know not only the marginal product but also the prices of labor
and capital. The absolute prices of these resources will determine how much can be produced
with any given expenditure. The relative prices will determine the most efficient combination.
There are different isocost curves for different output levels. The higher the output, the
higher the isocost curve. As long as the prices of labor and capital stay the same, however, the
various isocost curves for different output levels will be parallel to one another and will have the
same downward slope.
Using both isoquant and isocost curves, we can determine the most efficient resource
combination for a given expenditure level. Assuming that a firm is on isocost curve IC1 in figure
R8.1.3 (which represents an expenditure of $600 per day), the most technically efficient and
cost-effective combination of labor and capital will be point a, three workers and fifteen
machines. At point a, isocost curve IC2 is tangent to isoquant curve IQ2. The firm is producing as
much as it can – 150 pairs of jeans a day – with an expenditure of $600. If it spent the same
amount but used more labor and less capital, it would move to a lower isoquant and a lower
output level. At point b on curve IC1, for instance, the firm would still spend $600 but its
production level would fall from 150 to 100 pairs of jeans per day.
Of course, with increased expenditures, the firm can move to a higher isocost curve. In
figure R8.1.4, as the firm’s budget expands, its isocost curve shifts outward from IC1 to IC2 to
IC3. At the same time, the firm’s most efficient combination of resources increases from a to b
and then to c. As expenditures on resources rise, we can anticipate that, beyond some point, the
increase in output will not keep pace with the increase in expenditure; at that point, the marginal
cost of a pair of jeans will start to rise.

The bottom line

The most efficient combination of resources to be used in production occurs where the isoquant
is tangent to the budget line.

Review questions
1 Suppose there are technological advancements in the garment industry. What happens to
the isoquant curves in Figure R8.1.2?
2 Suppose the wage rate that must be paid workers increases while the cost of sewing
machines remaisn the same. What happens to the isocost line in figure R8.1.3? What
happens to output? What happens to the employment of workers? What happens to the use
of sewing machines?

Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
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Figure R8.1.1 Single isoquant

A firm can produce 100 pairs of jeans a day using any of the various combinations of labor and
machinery shown on this curve. Because of diminishing marginal returns, more and more
machines must be substituted for each worker who is dropped.

Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
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Figure R8.1.2 Several isoquants

Different output levels will have different isoquants. The higher the output level, the higher the
isoquant.

Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
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Figure R8.1.3 Finding the most efficient combination of resources

Assuming that the daily wage of each worker is $100, and the daily rental on each sewing
machine is $20, an expenditure of $600 per day will buy any combination of resources on isocost
curve IC1. The most cost-effective combination of labor and capital is point a, three workers and
fifteen machines. At that point, the isocost curve is just tangent to isoquant IQ2, meaning that the
firm can product 150 pairs of jeans a day. If the firm chooses any other combination, it will move
to a lower isoquant and a lower output level. At point b (on isoquant IQ1), it will be able to
produce only 100 pairs of jeans a day.

Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
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Figure R8.1.4 The effect of increased expenditures on resources

An increase in the level of expenditures on resources shifts the isocost curve outward from IC1 to
IC2. The firm’s most efficient combination of resources shifts from point a to point c.

Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
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Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010