Introduction to Economics –ECO401 VU

Lesson 15

PRODUCER BEHAVIOR: PRODUCTION SIDE ANALYSIS (CONTINUED)

ISOQUANT
An Isoquant represents different combinations of factors of production that a firm can employ
to produce the same level of output. Isoquant can be used to illustrate the concepts of returns
to scale and returns to factor.

Capital

Isoquant
curve

Labor
Isoquant Map:
Like an indifference map, an Isoquant map consists of parallel isoquants that do not intersect.
The higher the output level the further to the right an Isoquant will be.

MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)

The slope of an Isoquant is called marginal rate of technical substitution (MRTS). It is
analogous to the term marginal rate of substitution (MRS) in consumer analysis. MRTS is the
amount of one factor, e.g. capital, that can be replaced by a one unit increase in the other
factor e.g. labor, if output is to be held constant.
The principle of diminishing MRTS is related to the law of diminishing returns. As one moves
down along an Isoquant drawn in K-L space, increasing amounts of labor are used relative to
capital. Now, given diminishing returns, the MPP of labor will fall relative to the MPP of capital.
MRTS = ∆ K
∆L

∆ K. MPPK = ∆L. MPPL

Rearranging

∆ K = MPPL
∆ L MPPK

Also MRTS = ∆ K = MRTS

∆L

MRTS = MPPL
MPPK
Isoquant can be used to illustrate the concepts of returns to scale and returns to factor.

© Copyright Virtual University of Pakistan 1

Introduction to Economics –ECO401 VU

a. Constant returns to scale: equally spaced isoquants;

b. Increasing returns to scale: isoquants become closer and closer to each other;
c. Decreasing returns to scale: isoquants become further and further apart from each
other.
d. Diminishing returns to factors can be illustrated by keeping one of the inputs constant
(say capital). Here if there are constant returns to scale, ever-increasing increments of
labor will be required to produce equal increments to output.

ISOCOST OR BUDGET LINE

The concept of isocost is similar to the budget line developed in indifference curve analysis. It
is a line, which captures all the different combinations of inputs that the firm can afford to hire.
a. If price of both inputs increases, the isocost line shifts inwards.
b. If price of one input increases, it pivots out.
c. The slope of isocost is PL/PK.
The Isoquant-isocost combination can help answer:
a. What is the least cost way of producing a particular level of output?
b. What the highest level of output the firm can produce given a certain budget.

OPTIMAL COMBINATION OF FACTORS

In either case, the optimal factor combination obtains at the point of tangency between the
relevant iso-cost and Isoquant. At this point:

MRTS = MPPL = PL
MPPK PK

Capital At point R, Isoquant

curve is tangent to the
budget line (Isocost).
This is the optimal
combination of factors
R of production.

Labor
SUNK COST
In economics and in business decision-making, sunk costs are costs that have already been
incurred and which cannot be recovered to any significant degree. Sunk costs are sometimes
contrasted with variable costs, which are the costs that will change due to the proposed course
of action. In microeconomic theory, only variable costs are relevant to a decision. Economics
proposes that a rational actor does not let sunk costs influence one's decisions, because doing
so would not be assessing a decision exclusively on its own merits. It is important to note that
the decision-maker may make rational decisions according to their own incentives; these

© Copyright Virtual University of Pakistan 2

Introduction to Economics –ECO401 VU

incentives may dictate different decisions than would be dictated by efficiency or profitability,
and this is considered an incentive problem and distinct from a sunk cost problem.

© Copyright Virtual University of Pakistan 3