LE COMBINATION oF FACTORS (PRODUCER’S EQUILIBRIUM) gintroduction Recall chapter 9 wherein we discussed about the production function/curve involving two variable inputs known as isoquants, showing technical relationship between inputs and output. It shows ll possible combination of factors that can be used to produce the same quantity of output. Thus, an isoquant shows a given level of output with different combinations of two inputs. In other an igoquant curve reveals that a producer can produce a given level of output through /e ways. We also discussed about the negative slope of all words, application of two inputs in many alternativ isoquant curve and the law of diminishing marginal rate of substitution. Now, in this chapter we sh discuss the producer's equilibrium using isoquant curve. We know that the prime objective of @ producer is to achieve maximum profit. However, the cbjective of profit maximisation by the producers is not unconstrained. With the production function of two variables, a producer is constrained to choose the quantity of different inputs given their market prices and expenditure on inputs, Le. the cost. So before attempting to the producer's equilibrium, let us highlight about the budget constraint for the producerin the form of isocost line. §lsocost Line An isocost line is that line which shows the various combination of factors that will result in the same level of total cost. It refers to those different combinations of two factors that a firm can obtain at the same cost. Just as there are various isoquant curves, there are various isocost lines corresponding to a different level of total output. Isocost line may be defined as the line which shows different possible combinations of two factors that the producer can afford to buy given his total expenditure to be incurred on these factors and price of the factors.262 Microeconomics Let us illustrate the concept of isocost line with the help of Table 1 and Fig. 1. Suppose the Producer's budget for the purchase of labour and capital is fixed at 7100. Further suppose that a unit of labour costs the producer 710, while a unit of capital %20. Table 1. Alternative Factor Combinations Total Expenditure Labour (P,) = ¢ 10 Capital (Px) = © 20 100 10 | o 100, 0o 5 10 4 3 +400 2 4 The producer has the following options: spending all the money on the purchase of ts0-cost Line labour, he can hire 10 units of labour (322 = 10} CaLPiekP, 10 Sope = PP, Gi spending all the money on the capital, he may buy 5 units of capital 200 -5 20 (ii) spending the money on both labour and capital, he can choose between various possible combinations of labour and capital such as (4, 3), 2,4), ete. Fig. 1 In Fig. 2, labour is represented on X-axis and capital on Y-axis. The points A, B, C and D show the different combinations of two factors, capital and labour, which can be purchased by spending 100. Point A indicates 5 units of capital and no unit of labour. While point D represents 10 units of labour and no unit of capital. Point B indicates 4 units of capital and 2 units of labour. Likewise point C represents 3 units of capital and 4 units of labour. The slope of isocost line is the ratio of input prices. For Slope of isocost line shows factor any isocost line indicating labour on the X-axis and capital on _ price ratio (P:/P,), while the level of the Y-axis, slope will be as follows. isocost line indicates budget con- Price of Labour _ RL straint of the producer. Higher Price of Capital Py isocost line shows higher budget Note that the price of labour is expressed in terms of Allocated to the production of a units of capital and the price of capital is expressed in terms commodity. of units of labour. @ Producer’s Equilibrium The producer's equilibrium refers to the situation in which a producer maximises his profits. In other words, the producer is producing given amount of output with least cost combination of factors. The least cost combination of factors is also called optimum combination of the factors. Optimum or least cost combination is that combination at which either Slope of Isocost Line =vy ‘ —————__—_¢ —_** zee es a 263 sd combination of Factors (Producer's Equilibrium) “ (g the output derived from a given level of inputs is maximum, or fy the cost of producing a given output is minimum sre situation of produce’s equilibrium or optimum [—¥ n of factors is explained with the help of Fig. 2. mse 0 reicet wan to produce pens (100 pens) sem rota expenditure of ZLS00. He requires two | vz, labour and capital to produce this output. The |F i, ce of labour is *50 per unit and that of capital is €75 |S fit He can either hire 30 units of labour and no Tor 20 units of capital and no labour. He would like qntinatio Producers Equilibrium capita : sak ave an optimum combination of both the factors. The timum combination is indicated by point E using 10 5 10 15 20 25 30 35 ras of capital and 15 units of labour (#10 x75 + x15 x LABOUR Fig. 2 50 = £1,500). At point E, isoquant curve IQs tangent to ‘AB. The producer has the option of moving upward or downward from E al long the oint M or N of isoquant curve IQ, he would find thus exceeding his fixed level of if he moves towards point R or Son for less output (50 e maximum output derived from a given level of expenditure on |. The producer will be in equilibrium only at point E. jsocost line ioquant curve 1Q or isocost line AB. Ifhe moves top fimself on a higher isocost line CD paying out more and expenditure for the same output (100 pens). On the other hand, the lower isoquant curve IQ; he will find himself paying the same amount (1,500) pens), Thus, point E indicates th labour and capital @ Conditions of Least Cost Combination The following are the conditions of optimum combination of factors (least cost combination) or producer's equilibrium. (i At the point of equilibrium, the isocost tangency, the slope of both isoquant ans isocost line is the ratio of the prices of the inputs. TI of the marginal products of the inputs. It is also called the marginal substitution. (id) At point of tangency, ie, E in Fig. 2 the isoquant curve is convex to the origin or MRTSi is diminishing. We can thus state the conditions of optimum combination of factors as follows: () Slope of Isoquant = Slope of isocost Line AK _MPR LR line must be tangent to isoquant. At the point of 1d isocost line should be equal. The slope of the hé slope of the isoquant curveis the ratio | rate of technical Tangency between isoquant curve and isocost line indicates maximisation of output with the given level of inputs implying least cost combination of inputs. (i) At point of tangency, isoquant is convex or MRTS,«is diminishing.264 Microeconomics © Principle of Substitution According to the principle of substitution, with the change in price of factors of production, the method of production also changes: relatively cheaper factor is substituted for the other factor or More of the relatively cheaper factor is used and less of the other. Accordingly, allocation of resources among different uses in production process is influenced by the relative prices of factors of production, Mlustration Let us assume that a producer wants to produce 100 pens. Also assume that in equilibrium (satisfying the least cost or profit maximising condition) 10 units of capital and 15 units of labour are employed; total expenditure is 21,500, given price of capital as 75 per unit and price of labour as 50 per unit, The information is summarised as under: Output ipa Price “Total Expenditure (et) Q kK L Pic Pu 4100 40 18 a 50 150 +780 = 1,500 Now, suppose the price of labour (P.) increases from 50 to 275 per unit. Accordingly, to Produce the same level of output (and by keeping the same combination of inputs) the situation will change as under: Output Inputs Price Total Expenditure (2) Q K L Pr BL 100 40 15 75 5 750 +1,125 = 1,875 Thus, if input combination is not changed, the cost of production rises from %1,500 to €1,875 even when the level of output is the same. Fig. 3 illustrates this situation: If least cost combination of inputs is to be achieved, the producer must substitute capital for labour. Because, when price of labour rises, other things remaining constant, capital obviously becomes relatively cheaper. Earlier, Hg spre ratio was Lr) aos z 78 it is 52, implying that capital is cheaper in relation to labour (Compared to the earlier situation). the same ‘combination of factor is employed, it would cost 21,875 = (75 * 10+ 75x18), ‘Thus, 100 units of pens at new prices, with old combination of factors costs 1,875, while earlier it would cost @ 1,500. 5 10 15 20 25 30 35 x LABOUR z Fig. 3 With the increase in price of . labour, the isocost line pivots (or rotates) inwards. At new price, and with the given 71,500, now only 20 units of labour can be employed if all of 1,500 are spent on labour (see Fig. 3).GS -_ F|T=_E Combination of Factors (Producer's Equilibrium) cd ps Coot qhe least ae ee ow must change. How much labour and capital should now be aged so tat total XP liture is minimised? Of course, the extent to which capital can be used in ce of labour depends on the marginal rate of technical substitution between labour and ca ital. masttaes a hypothetical situation: e rrtally we started with a situation when 100 pens are grosuced using 10 units of capital and 15 units of labour, fen P= 5O per unit and Px = 75 per unit. E is the initial of equilibrium (Fig. 4). Total expenditure involved is sito (15 * 50) + (10 + 75) = 1,500. We have also shown, em ation (Fig. 4) that after P, rises to 75 per unit (Pk vapaining constant) total expenditure wil rise to &1,875 if tucer sticks to the initial combination of labour and capital (20K and 151). However, prudence demands that the cer now substitutes capital for labour, because (after prrising to 75 per unit, capital becomes relatively cheaper (even when its price remains constant). Of course, the extent tp wich K can be substituted for L depends on marginal rate of technical substitution between Land K. Technically, a situation may warrant to use 13K and 10L. tpobtain the same level of output, as indicated in Fig. 4 If such a situation happens, the producer may decide to continue to produce 100 pens, but now spending (13 * 75) + (10 x 75) = 21,725 only {stead of €1,850 when, after P, rises, Kis not substituted for ). Briefly, factor substitutability (when reative factor price changes) allows same level of output with lesser expenditure. The same 100 units of pens can now be produced by using 10 units of labour and 13 units of capita, Although, both capital and labour now cost €75, but capitals relatively efficient than labour. Therefore, now more capital and less labour is used. The minimum production cost with new combination such that 100 units of pens can be produced is thus: (13 x 875 + 10 x 875) = @1,725 @ Mathematical Derivation of the Conditions of Producer's Equilibrium Given there are two variable inputs, Le, labour (L) and capital (K) with the producer, the total cost forthe producer is the sum of labour cost (total labour multiplied by labour price) and capital cost (total capital multiplied by capital price). Thus, Total Cost = LP, + KPk Fig. 4 Total revenue for the producer isthe total output produced multiplied by the prices of output. Let, producer produces one product with quantity ’Q’ and price of the product in P then, Total Revenue = PQ Profit (n) of the producer is obviously the difference between total revenue and total cost. Thatis, n= TR-TC = PQ- LPL KPx.a? 266 Mictoeconornieg We know that, Q = f(l, K) Thus, n= P f(L, K) ~ LP, - KPx The above equation indicates that profit is a function of labour and capital employed by the producer. As stated, a producer maximises its profit under two conditions, ie, when it produces maximum output from a given level of inputs or when it minimises cost to produce given level of output. Accordingly, there are two approaches of producer's equilibrium, that is, output maximisation and cost minimisation. (i) Output Maximisation In involves maximisation of output subject to cost constraint. It is already explained that a producer will attain equilibrium when the given isocost line is tangent to the highest attainable isoquant curve. At that point the slope of the isoquant is equal to the slope of the isocost line, We know that the slope of isoquant in the ratio of marginal productivities of two factors and the slope of isocost line is equal to the price ratio of two factors. Hence, at producer's equilibrium: Ratio of P. " marginal productivities of two tacors( ME equal to price ratio of two factors (R./P,).. That is, , , rate MP Pe Let us derive the same condition with the help of simple derivative. We have to maximise Q=f(L, K) subject to LP, + KPk = C Forming Lagrangian function, we have; Qt =Q-NC-LR, -KR,) Taking partial derivatives of Q* with respect to K, L 8 2 and setting them as zero: 20* 22_ap 20 OK OK 2Q* _c_ip —kR, =0 on From equations (j) and (ii MR -aR =0- an Combination of Factors (Producer's Equil st 008t COF (Producer's Equilibrium) 287 MRP => MRTS=P . = Slope of Isoquant = Slope of isocost line. {§) Cost Minimisation A producer can also achieve least cost combination of factors when it minimises cost for roducing a given level of output. In order to minimise the cost of any given level of output, the firm should produce at that point on isoquant for which marginal rate of technical substitution is equal to Mie ane | the ratio of input prices. That is, i B MIRTS, = Mote MR To derive the conditions of equilibrium, we have to minimise C=LR, +KP, subject to output constraint: Q=fLK) =Q Forming lagrangian function we have; CF =LP, + KR, -01Q -f(LK)] ‘The first order condition of cost minimisation is that the first order partial derivatives must be equal to zero. That is, act &Q : p12 . aeiieor ta 0 w= il) w= Gi) From equation (i) & (i) MRTS =h % = Slope of isoquant = Slope of isocost line.Microeconomic 268 . @ Expansion Path With an increase in the financial resources of a firm it would like to increase its output: Quantity of output can increase only if with an increase in the financial resources of the firm, there is no increase in the cost of the factors. The level of total output Tang Bil Expeneton Poth of a firm increases with increase in its financial resources. Which of the optimum combinations of factors will be used by the firm at different levels of output is indicated by expansion path. Expansion path refers to the locus of all such points that shows least cost combination of factors corresponding to different levels of output. In other words, expansion path traces the movement of the firm from one optimum combination of the factors to the other optimum combination of the factors. (1) Long Run Expansion Path: In the long run all Fig. 5 factors are variable. Accordingly, both Land K can be varied. Assuming both are increased in some constant ratio, expansion path of the firm will be indicated by a straight line from the origin as OP in Fig. 5. Increasing both Land Kin constant ratio, the firm is shifting from optimum Check Figs. 5 & 6 closely point E to the higher optimum E; and still higher E,, indicating 100,200 and 300 units ofrespective U7 Bothy and K are varied in @ output. Thus, expansion path (OP)is thelocus co tane ratio, HR is the short-run of all points of optimum combinations of L Sransion path when only L increases and K corresponding to different levels of ond K is constant. output. (2) Short Run Expansion Path: In the short run, one factor capital (K), is fixed. Accordingly expansion is possible only through greater [Ypghoa run expansion path, as diferent application of the other factor, viz, labour (L), from long run expansion path implying that firm can expand its output, only by moving horizontally from point H (Fig. 6). When both K and L are variable, the optimum expansion path is indicated by OP. But, when K is constant (during the short period) the expansion path becomes HR, showing constant K = OH. Only point E indicates tangency between isoquant and isocost line during the short period which coincides with long period optimality. Points along the line HR (and other than E) indicate short period optimality (given the constraint of constant capital, K). These points are way apart from E; and E owing to the constraint of constancy of capital. OP is the long run expansion path. CAPITAL, LABOUR Fig. 6wy “ : ano _qcost Combination of Factors (Producer's Equiv) 269 sve Expansion Path and Efficient Input Usage Functions Using the expansion path, the efficient levels of L and K can be expressed as functions of Q, Pi, «We know that the expansion pathis the locus of Land K combinations for which the marginal *reoftechnical substitution equals the (constant) input/price rato, Thus, the expansion path can be expressed as: K* = K* (LU Py Py) -@ here K* and L* are the efficient levels of input usage for producing various levels of output, | a fixed input prices P and Px. The expansion path in expression (j) is obtained from condition of Jeetcost combination that is, by solving algebraically for K"in terms ofL*, Pi and Px For each value aft in @) there is a single value of K*. Mir Mp, PB B From the expansion path, itis possible to express the optimal levels of input usage as functions of Q given the fixed input prices P. and Pr. =U @PuPO -w) kr =k" (@ Pu Pod ~ (ii) To derive the efficient input-usage functions (j) and (i), substitute the values of labour and capital (17K), which solve the system of first-order necessary conditions for the cost-minimization problem in expression. Q-fL, KY) =0 — To find L* (@ Px Pe), substitute the expansion path equation (9 into (jv) and solve for L* in terms of @, P; and Px. To find K* ; PL Px), substitute the expression L* G Px Py) into the expansion path equation () to get K* (@; Pt Pi). The efficient input functions, which are derived from the expansion path, are used to derive the long-run cost functions for a firm. 41. Least cost combination of factors occurs only where what is technically optimal coincides with what is economically viable. Explain how. 2. Short run expansion path of a firm is indicated by a horizontal straight line starting from the Yaxis, while long run expansion path shoots from the origin. Explain the statement, using suitable diagrams. 3. Explain the two approaches of producer's equilibrium. 4. Write a short note on least cost combination of factors.