Chapter Seven

Q1. Explain the least cost rule for a firm’s use of inputs?

Least Cost Rule:

Production at least cost requires the ratio of labor’s marginal product to its price equals the
ratio of capital’s marginal product to its price. The amounts of labor and capital employed must
be adjusted, all the while keeping output constant, until this condition is achieved.

Labor per unit cost is 3 and capital per unit cost is 5

Units MUL MPc MUL/PL MUc/Pc

1 48 80 16 16
2 42 70 14 14
3 36 60 12 12
4 30 50 10 10
5 24 40 8 8
6 18 30 6 6
7 12 20 4 4
8 6 10 2 2

The price of labor is $10 and the price (rent) on capital is $20. The marginal product of labor is
30 and the marginal product of capital is 60.

MPL/PL=MPC/PC. 30/10=60/20. 3=3

The marginal product of the last input of labor was 30 units produced and laborer was paid
$10. So for each $1 spent we received 3 units produced, 30/10 = 3 and
The marginal product of the last input of capital was 60 units produced and the rent was $20.
So for each $1 spent we received 3 units produced, 60/20 = 3

Q2. What does U-shaped average cost curve show? Explain the reasons which rise to give this
shape in the short run as well as long run?

Initially average costs fall. But when marginal cost is above the average cost, then average cost
starts to rise.

Short Run Average Cost Curve:

  The fixed cost of a firm remains the same. Only changes the variable costs such as raw
material, labor etc.

 The fixed cost distributed over the output is expanded. Therefore, the average cost
begins to fall. When a firm fully utilizes its plant size the average cost is at minimum. If a
firm increases its output with the same fixed plant, then the average cost begins to rise
sharply.

Long Run Average Cost Curve:

 In the long run average cost curve everything can be changed.

 The average costs are high at low level of output because of rising the average fixed
costs and average variable costs.
 But, the average costs are fall sharply at increasing level of output because of declining
the average fixed costs and average variable costs.

Q4. Explain why in the short run a firms marginal cost initially falls and rises?
Due to the law of diminishing returns and U- shaped average cost curve the marginal cost
initially falls and rises.

1. When MC is less than AC, MC curve remains below AC curve, the AC falls.
2. When MC comes equal to AC, AC becomes constant. AC is the short run average cost
curve having U-shape. MC passes from the minimum points of AC through the points B.
3. When MC is higher than AC, MC curve rises above the AC curve.

***Q. a) Explain on what basis you would choose inputs to produce a given level of output
at least cost assuming that the prices of inputs are fixed?
Production at least cost requires the ratio of labor’s marginal product to its price equals the
ratio of capital’s marginal product to its price. The amounts of labor and capital employed must
be adjusted, all the while keeping output constant, until this condition is achieved.

The price of labor is $10 and the price (rent) on capital is $20. The marginal product of labor is
30 and the marginal product of capital is 60. MPL/PL=MPC/PC. 30/10=60/20. 3=3

The marginal product of the last input of labor was 30 units produced and laborer was paid
$10. So for each $1 spent we received 3 units produced, 30/10 = 3 and
The marginal product of the last input of capital was 60 units produced and the rent was $20.
So for each $1 spent we received 3 units produced, 60/20 = 3

Units MUL MPc MUL/PL MUc/Pc

1 48 80 16 16
2 42 70 14 14
3 36 60 12 12
4 30 50 10 10
5 24 40 8 8
6 18 30 6 6
7 12 20 4 4
8 6 10 2 2

b) How would you change your choice if the price of one inputs fall while the prices of all
other inputs remain the same?

Rule of substitution: If the price of one factor falls while all other factor prices remain the
same, firms will profit by substituting the cheaper factor for the other factors until the marginal
products per dollar are equal for all inputs.

Let’s take the case of labor. A fall in the price of labor will raise the ratio MPL/PL above MP/P
ratio for other inputs. Raising employment of L lowers the MPL by the law of diminishing
returns and therefore lowers MPL/PL. Lower price and MP of labor then brings the marginal
product per dollar for labor back into equality with that ratio for other factors.