Managerial Economics

In so many cases the production does not depend upon just on

labor, rather it depends upon labor, capital and land etc. As in textile
industry, there is a cotton firm; making thread not only depends on just
raw material but also the land, workers and capital. It is a challenge for
the firm to arrange these factor of production in balance way.

In such case, according to Marginal Productivity theory ‘A firm will be

in equilibrium when it employs different factors in such a way that
ratio of MP of such factors and their prices become equal.’

LPL + KPK + NPN = C

Where

L = Units of labor

PL = Price of labor

K = Units of capital

PK = Price of capital

N = Units of Land

PN = Price of land

C = Budget of the firm

MPL /PL = MPK /PK = MPN/PN

MPL = Marginal Productivity of labor

MPK = Marginal Productivity of capital

MPN = Marginal Productivity of Land

If the cost of firm is 8 thousand and the price of labor is 2000 and the
price of capital is 1000. How the firm can manage units of labor and
capital?

No Units of MPL Units of MPK

labor Capital
1 1 20000 1 7000
2 2 16000 2 6000
3 3 12000 3 5000
4 4 8000 4 4000
5 5 4000 5 3000

If firm take 2 units of labor and 4 units of capital then there would be
balance between the factor of production and cost.

LPL + KPK = C

2(2000) + 4(1000) = 8000

As it is shown in the table the MP of 2nd labor is 16 and price of labor is

2000. On the MP of 4th capital is 4000 and price of capital is 1000.

MPL /PL = MPK /PK

16000/2000 = 8 which is not equal to 4000/1000 = 4

It shows that if firm employs 2 units of labor and 4 units of capital. Its
budget is fully spent but the ratios of MPs and the prices of factors are
not equalized. It does not represent the optimality and the firm will
have to change the pair of labor and capital.
LPL + KPK = C

3(2000) + 2(1000) = 8000

MPL /PL = MPK /PK

12000/2000 = 6000/1000

6=6

All this shows that in this situation not only the entire budget of the
firm is spent, but the ratio of MP and prices of factors have also been
equalized. If the firm purchases 3 units of labor and 2 units of capital,
the firm will attain equilibrium. Such combination represents an
optimal level of combination of factors in the firm.

Conclusion:

From the above discussion it is concluded that it is necessary for the

firm that it should compare MP of the factor with the price of the factor
and they should be equal. If they are not equal, the firm will go on
substituting the factors until they are equalized. This is the reason that
such approach to firm’s equilibrium is also known as Law of
Substitution in Production.