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Laws of Returns: The Isoquant-

Isocost Approach | Economics
The various production functions were explained in terms of the traditional
analysis. This article explains them with the help of the isoquant-isocost
approach.The technique involved here is similar to the indifference curve
technique used in consumption theory.

Isoquants:
An isoquant (isoproduct) is a curve on which the various combinations of
labour and capital show the same output. According to Cohen and Cyert,
“An isoproduct curve is a curve along which the maximum achievable rate
of production is constant.” It is also known as a production indifference
curve or a constant product curve. Just as indifference curve shows the
various combinations of any two commodities that give the consumer the
same amount of satisfaction (iso-utility), similarly an isoquant indicates the
various combinations of two factors of production which give the producer
the same level of output per unit of time. Table 24.1 shows a hypothetical
isoquant schedule of a firm producing 100 units of a good.

TABLE 24.1: Isoquant Schedule:

Units of Units of Total Output
Combination Capital Labour (in units)
A 9 5 100
В 6 10 100
С 4 15 100
D 3 20 100
This Table 24.1 is illustrated on Figure 24.1 where labour units are
measured along the X-axis and capital units on the K-axis. The first,
second, third and the fourth combinations are shown as A, S, С and D
respectively. Connect all these points and we have a curve IQ.
This is an isoquant. The firm can produce 100 units of output at point A on
this curve by having a combination of 9 units of capital and 5 units of
labour. Similarly, point В shows a combination of 6 units of capital and 10
units of labour; point C,4 units of capital and’ 15 units of labour; and point
D, a combination of 3 units of capital and 20 units of labour to yield the
same output of 100 units.

An isoquant map shows a number of isoquants representing different

amounts of output. In Figure 24.1, curves IQ, IQ1 and IQ2 show an isoquant
map. Starting from the curve IQ which yields 100 units of product, the curve
IQ1, shows 200 units and the IQ2 curve 300 units of the product which can
be produced with altogether different combinations of the two factors.

Isoquants vs. Indifference Curves:

An isoquant is analogous to an indifference curve in more than one way. In
it, two factors (capital and labour) replace two commodities of consumption.
An isoquant shows equal level of product while an indifference curve shows
equal level of satisfaction at all points. The properties of isoquants, as we
shall study below, are exactly similar to those of indifference curves.
However, there are certain differences between isoquants and indifference
curves.

Firstly, an indifference curve represents satisfaction which cannot be

measured in physical units. In the case of an isoquant the product can be
measured in physical units.
Secondly, on an indifference map one can only say that a higher
indifference curve gives more satisfaction than a lower one, but it cannot be
said how much more or less satisfaction is being derived from one
indifference curve as compared to the other, whereas one can easily tell by
how much output is greater on a higher isoquant in comparison with a
lower isoquant.

In Figure 24.1 output on the curve 1QI is double, and on the IQ2 treble than
on the curve IQ. Lastly, since satisfaction on indifference curves cannot be
measured in physical units, they are given arbitrary numbers 1, 2, 3, 4, etc.
The isoquants have an added advantage over the former because they can
be labelled in physical units, as 100, 200, 300, etc. in Figure 24.1, to
indicate the output level to which each curve corresponds.

Properties of Isoquants:
Isoquants possess certain properties which are similar to those of
indifference curves.

(1) Isoquants are negatively inclined:

If they do not have a negative slope, certain logical absurdities follow. If the
isoquant slopes upward to the right, it implies that both capital and labour
increase but they produce the same output. In Figure 24.2 (A), combination
В on the IQ curve having a larger amount of both capital and labour
(ОС1 +OL1 > ОС + OL) will yield more output than before. Therefore, point
A and В on the IQ curve cannot be of equal product.
ADVERTISEMENTS:

Suppose the isoquant is vertical as shown in Figure 24.2 (B), which implies
a given amount of labour is combined with different units of capital. Since
OL of labour and OC1 of capital will produce a larger amount than produced
by OL of labour and ОС of capital, the isoquant IQ cannot be a constant
product curve.
Take Figure 24.2 (С) where the isoquant is horizontal which means
combining more of labour with the same quantity of capital. Here ОС of
capital and OL1 of labour will produce a larger or smaller amount than
produced by the combination ОС of capital and OL of labour. Therefore, a
horizontal isoquant cannot be an equal product curve.
Thus it is clear that an isoquant must slope downward to the right as shown
in Figure 24.2 (D) where points A and В on the IQ curve are of equal
quantity. As the amount of capital decreases from ОС to OC1 and that of
labour increases from OL to OL1 so that output remains constant.

(2) An Isoquant lying above and to the right of another represents a higher
output level. In Figure 24.3 combination В on IQ1 curve shows larger output
than point A on the curve IQ. The combination of ОС of capital and OL of
labour yields 100 units of product while OC1 of capital and OL1 of labour
produce 200 units. Therefore, the isoquant IQ1 which lies above and to the
right of the isoquant IQ, represents a larger output level.

(3) No two isoquants can intersect each other. The absurd conclusion that
follows when two isoquants cut each other is explained with the aid of
Figure 24.4. On the isoquant IQ, combination A =B. And on the isoquant
IQ1 combination R=S. But combination S is preferred to combination B,
being on the higher portion of isoquant IQ1. On the other hand, combination
A is preferred to R, the former being on the higher portion of the isoquant
IQ. To put it algebraically, it means that S> В and R< A. But this is logically
absurd because S combination is as productive as R and A combination
produces as much as B. Therefore, the same combination cannot both be
less and more productive at the same time. Hence two isoquants cannot
intersect each other.

(4) Isoquants need not be parallel because the rate of substitution between
two factors is not necessarily the same in all the isoquant schedules.
(5) In between two isoquants there can be a number of isoquants showing
various levels of output which the combinations of the two factors can yield.
In fact, in between the units of output 100, 200, 300, etc. represented on
isoquants there can be innumerable isoquants showing 120, 150, 175,235,
or any other higher or lower unit.
(6) Units of output shown on isoquants are arbitrary. The various units of
output such as 100, 200, 300, etc., shown in an isoquant map are arbitrary.
Any units of output such as 5, 10, 15, 20 or 1000, 2000, 3000, or any other
units can he taken.
(7) No isoquant can touch either axis. If an isoquant touches X-axis, it
would mean that the product is being produced with the help of labour
alone without using capital at all. This is a logical absurdity for OL units of
labour alone are incapable of producing anything. Similarly, ОС units of
capital alone cannot produce anything without the use of labour. Therefore
IQ and lQ1 cannot be isoquants, as shown in Figure 24.5.

(8) Each isoquant is convex to the origin:

As more units of labour are employed to produce 100 units of the product,
lesser and lesser units of capital are used. This is because the marginal
rate of substitution between two factors diminishes. In Figure 24.6, in order
to produce 100 units of the product, as the producer moves along the
isoquant from combination A to В and to С and D, he gives up smaller and
smaller units of capital for additional units of labour. To maintain the same
output of 100 units, BR less of capital and relatively RC more of labour is
used.
If he were producing this output with the combination D, he would be
employing CT less of capital and relatively TD more of labour. Thus the
isoquants are convex to the origin due to diminishing marginal rate of
substitution. This fact becomes clear from successively smaller triangles
below the IQ curve ∆ ASB > ∆BRC > ∆ CTD.

(9) Each isoquant is oval-shaped:

It is elliptical which means that at some point it begins to recede from each
axis. This shape is a consequence Labour of fact that if a producer uses
more of capital or more of labour or more Fig. 24.6 of both than is
necessary, the total product will eventually decline.

The firm will produce only in those segments of the isoquants which are
convex to the origin and lie between the ridge lines.

This is the economic region of production. In Figure 24.7, oval-shaped

isoquants are shown. Curves OA and OB are the ridge lines and in
between them economically feasible units of capital and labour can be
employed to produce 100, 200, 300 and 400 units of the product. For
example, ОТ units of labour and ST units of the capital can produce 100
units of the product, but the same output can be obtained by using the
same quantity of labour ОТ and less quantity of capital VT.

Thus only an unwise entrepreneur will produce in the dotted region of the
isoquant 100. The dotted segments of an isoquant are the waste- bearing
segments. They form the uneconomic regions of production. In the upper
dotted portion, more capital and in the lower dotted portion more labour
than necessary is employed. Hence GH, JK, LM, and NP segments of the
elliptical curves are the iso- quants.

Isocost Curves:
Having studied the nature of isoquants which represent the output
possibilities of a firm from a given combination of two inputs, we pass on to
the prices of the inputs as represented on the isoquant map by the isocost
curves. These curves are also known as outlay lines, price lines, input-price
lines, factor-cost lines, constant-outlay lines, etc. Each isocost curve
represents the different combinations of two inputs that a firm can buy for a
given sum of money at the given price of each input.

Figure, 24.8 (A) shows three isocost curves AB, CD and EF, each
represents a total outlay of 50, 75 and 100 respectively. The firm can hire
ОС of capital or OD of labour with Rs. 75. ОС is 2/3 of OD which means
that the price of a unit of labour is 1½ times less than that of a unit of
capital. The line CD represents the price ratio of capital and labour. Prices
of factors remaining the same, if the total outlay is raised, the isocost curve
will shift upward to the right as EF parallel to CD, and if the total outlay is
reduced it will shift downwards to the left as AB. The isocosts are straight
lines because factor prices remain the same whatever the outlay of the firm
on the two factors. The isocost curves represent the locus of all
combinations of the two input factors which result in the same total cost. If
the unit cost of labour (L) is w and the unit cost of capital (C) is r, then the
total cost: TC = wL + rC. The slope of the isocost line is the ratio of prices
of labour and capital i.e., w/r.

The point where the isocost line is tangent to an isoquant represents the
least cost combination of the two factors for producing a given output. If all
points of tangency like LMN are joined by a line, it is known as an output-
factor curve or least-outlay curve or the expansion path of a firm. Salvatore
defines expansion path as “the locus of points of producer’s equilibrium
resulting from changes in total outlays while keeping factor prices
constant.” It shows how the proportions of the two factors used might be
changed as the firm expands.

For example, in Figure 24.8 (A) the proportions of capital and labour used
to produce 200 (IQ1) units of the product are different from the proportions
of these factors used to produce 300 (IQ2) units or 100 (OQ) units at the
lowest cost.

Like the price-income line in the indifference curve analysis, a relative

cheapening of one of the factors to that of another will extend the isocost
line to the right. If one of the factors becomes relatively dearer, the isocost
line will contract inward to the left. Given the price of capital, if the price of
labour falls, the isocost line EF in Panel (B) will extend to the right as EG
and if the price of labour rises, the isocost line EF will contract inward to the
left as EH. if the equilibrium points L, M, and N are joined by a line, it is
called the price-factor curve.

The Principle of Marginal Rate of Technical

Substitution:
The principle of marginal rate of technical substitution (MRTS or MRS) is
based on the production function where two factors can be substituted in
variable proportions in such a way as to produce a constant level of output.

The marginal rate of technical substitution between two factors С (capital)

and L (labour), MRTSLC is the rate at which L can be substituted for С in
the production of good X without changing the quantity of output. As we
move along an isoquant downward to the right, each point on it represents
the substitution of labour for capital.
MRTS is the loss of certain units of capital which will just be compensated
for by additional units of labour at that point. In other words, the marginal
rate of technical substitution of labour for capital is the slope or gradient of
the isoquant at a point. Accordingly, slope = MRTSLC = – ∆ С/A L. This can
be understood with the aid of the isoquant schedule, in Table 24.2.
TABLE 24.2: Isoquant Schedule:
CombinationLabour Capital MRTSLC Output
1 5 9 __ 100
2 10 6 3:5 100
3 15 4 2:5 100
4 20 3 L;5 100
The above table shows that in the second combination to keep output
constant at 100 units, the reduction of 3 units of capital requires the
addition of 5 units of labour, MRTSLC = 3:5. In the third combination, the
loss of 2 units of capital is compensated for by 5 more units of labour, and
so on.
In Figure 24.9 at point B, the marginal rate of technical substitution is
AS/SB, at point G, it is BT/TG and at H, it is GR/ RH.

The isoquant AH reveals that as the units of labour are successively

increased into the factor-combination to produce 100 units of good X, the
reduction in the units of capital becomes smaller and smaller. It means that
the marginal rate of technical substitution is diminishing. This concept of
the diminishing marginal rate of technical substitution (DMRTS) is parallel
to the principle of diminishing marginal rate of substitution in the
indifference curve technique.

This tendency of diminishing marginal substitutability of factors is apparent

from Table 24.2 and Figure 24.9. The MRTSLC continues to decline from
3:5 to 1:5 whereas in the Figure 24.9 the vertical lines below the triangles
on the isoquant become smaller and smaller as we move downward so that
GR < ВТ < AS. Thus, the marginal rate of technical substitution diminishes
as labour is substituted for capital. It means that the isoquant must be
convex to the origin at every point.
The Law of Variable Proportions:
The behaviour of the law of variable proportions or of the short-run
production function when one factor is constant and the other variable can
also be explained in terms of the isoquant analysis. Suppose capital is a
fixed factor and labour is a variable factor. In Figure 24.10., OA and OB are
the ridge lines and it is in between them that economically feasible units of
labour and capital can be employed to produce 100, 200, 300, 400 and 500
units of output.

It implies that in these portions of the isoquants, the marginal product of

labour and capital is positive. On the other hand, where these ridge lines
cut the isoquants, the marginal product of the inputs is zero. For instance,
at point H the marginal product of capital is zero, and at point L the
marginal product of labour is zero. The portion of the isoquant that lies
outside the ridge lines, the marginal product of that factor is negative. For
instance, the marginal product of capital is negative at G and that of labour
at R.

The law of variable proportions says that, given the technique of

production, the application of mote and more units of a variable factor, say
labour, to a fixed factor, say capital, will, until a certain point is reached,
yield more than proportional increases in output, and thereafter less than
proportional increases in output.

Since the law refers to increases in output, it relates to the marginal

product. To explain the law, capital is taken as a fixed factor and labour as
a variable factor. The isoquants show different levels of output in the figure.
ОС is the fixed quantity of capital which therefore forms a horizontal line
CD. As we move from С to D towards the right on this line, the different
points show the effects of the combinations of successively increasing
quantities of labour with fixed quantity of capital ОС.

To begin with, as we move from С to G to H, it shows the first stage of

increasing marginal returns of the law of variable proportions. When CG
labour is employed with ОС capital, output is 100. To produce 200 units of
output, labour is increased by GH while the amount of capital is fixed at
ОС.

The output has doubled but the amount of labour employed has not
increased proportionately. It may be observed that GH < CG, which means
that smaller additions to the labour force have led to equal increment in
output. Thus С to H is the first stage of the law of variable proportions in
which the marginal product increases because output per unit of labour
increases as more output is produced.

The second stage of the law of variable proportions is the portion of the
isoquants which lies in between the two ridge lines О A and OB. It is the
stage of diminishing marginal returns between points H and L. As more
labour is employed, output increases less than proportionately to the
increase in the labour employed. To raise output to 300 units from 200
units, HJ labour is employed. Further, JK quantity of labour is required to
raise output from 300 to 400 and KL of labour to raise output from 400 to
500.

So, to increase output by 100 units successively, more and more units of
the variable factor (labour) are required to be applied along with the fixed
factor (capital) , that is KL>JK>HJ. It implies that the marginal product of
labour continues to decline with the employment of larger quantities to it.
Thus as we more from point H to K, the effect of increasing the units of
labour is that output per unit of labour diminishes as more output is
produced. This is known as the stage of diminishing returns.

If labour is employed further, we are outside the lower ridge line OB and
enter the third stage of the law of variable proportions. In this region which
lies beyond the ridge line OB there is too much of the variable factor
(labour) in relation to the fixed factor (capital). Labour is thus being
overworked and its marginal product is negative. In other words when the
quantity of labour is increased by LR and RS, the output declines from 500
to 400 and to 300. This is the stage of negative marginal returns.

We arrive at the conclusion that a firm will find it profitable to produce only
in the second stage of the law of variable proportions for it will be
uneconomical to produce in the regions to the left or right of the ridge lines
which form the first stage and the third stage of the law respectively.

The Laws of Returns to Scale:

The laws of returns to scale can also be explained in terms of the isoquant
approach. The laws of returns to scale refer to the effects of a change in
the scale of factors (inputs) upon output in the long-run when the
combinations of factors are changed in some proportion. If by increasing
two factors, say labour and capital, in the same proportion, output
increases in exactly the same proportion, there are constant returns to
scale. If in order to secure equal increases in output, both factors are
increased in larger proportionate units, there are decreasing returns to
scale. If in order to get equal increases in output, both factors are increased
in smaller proportionate units, there are increasing returns to scale.
The returns to scale can be shown diagrammatically on an expansion path
“by the distance between successive ‘multiple-level-of-output’ isoquants,
that is, isoquants that show levels of output which are multiples of some
base level of output, e.g., 100, 200, 300, etc.”

Increasing Returns to Scale:

Figure 24.11 shows the case of increasing returns to scale where to get
equal increases in output, lesser proportionate increases in both factors,
labour and capital, are required.

It follows that in the figure:

100 units of output require 3C +3L

200 units of output require 5C + 5L

300 units of output require 6C + 6L

So that along the expansion path OR, OA > AB > BC. In this case, the
production function is homogeneous of degree greater than one.

The increasing returns to scale are attributed to the existence of

indivisibilities in machines, management, labour, finance, etc. Some items
of equipment or some activities have a minimum size and cannot be
divided into smaller units. When a business unit expands, the returns to
scale increase because the indivisible factors are employed to their full
capacity.
Increasing returns to scale also result from specialisation and division of
labour. When the scale of the firm expands there is wide scope for
specialisation and division of labour. Work can be divided into small tasks
and workers can be concentrated to narrower range of processes. For this,
specialized equipment can be installed. Thus with specialization, efficiency
increases and increasing returns to scale follow.

Further, as the firm expands, it enjoys internal economies of production. It

may be able to install better machines, sell its products more easily, borrow
money cheaply, procure the services of more efficient manager and
workers, etc. All these economies help in increasing the returns to scale
more than proportionately.

Not only this, a firm also enjoys increasing returns to scale due to external
economies. When the industry itself expands to meet the increased ‘long-
run demand for its product, external economies appear which are shared
by all the firms in the industry. When a large number of firms are
concentrated at one place, skilled labour, credit and transport facilities are
easily available. Subsidiary industries crop up to help the main industry.
Trade journals, research and training centres appear which help in
increasing the productive efficiency of the firms. Thus these external
economies are also the cause of increasing returns to scale.

Decreasing Returns to Scale:

Figure 24.12 shows the case of decreasing returns where to get equal
increases in output, larger proportionate increases in both labour and
capital are required.
It follows that:
100 units of output require 2C + 2L

200 units of output require 5C + 5L

300 units of output require 9C + 9L

So that along the expansion path OR, OG < GH < HK.

In this case, the production function is homogeneous of degree less than

one.

Returns to scale may start diminishing due to the following factors.

Indivisible factors may become inefficient and less productive. The firm
experiences internal diseconomies. Business may become unwieldy and
produce problems of supervision and coordination. Large management
creates difficulties of control and rigidities. To these internal diseconomies
are added external diseconomies of scale. These arise from higher factor
prices or from diminishing productivities of the factors.

As the industry continues to expand the demand for skilled labour, land,
capital, etc. rises. There being perfect competition, intensive bidding raises
wages, rent and interest. Prices of raw materials also go up. Transport and
marketing difficulties emerge. All these factors tend to raise costs and the
expansion of the firms leads to diminishing returns to scale so that doubling
the scale would not lead to doubling the output.

Constant Returns to Scale:

Figure 24.13 shows the case of constant returns to scale. Where the
distance between the isoquants 100, 200 and 300 along the expansion
path OR is the same, i.e., OD = DE = EF. It means that if units of both
factors, labour and capital, are doubled, the output is doubled. To treble
output, units of both factors are trebled.

It follows that:
100 units of output require 1 (2C + 2L) = 2C + 2L

200 units of output require 2(2C + 2L) = 4C + 4L

300 units of output require 3(2C + 2L) = 6C + 6L

The returns to scale are constant when internal economies enjoyed by a

firm are neutralised by internal diseconomies so that output increases in
the same proportion. Another reason is the balancing of external
economies and external diseconomies. Constant returns to scale also
result when factors of production are perfectly divisible, substitutable,
homogeneous and their supplies are perfectly elastic at given prices.
That is why, in the case of constant returns to scale, the production function
is homogeneous of degree one.
Relation between Returns to Scale and Returns to a
Factor (Law of Returns to Scale and Law of
Diminishing Returns):
Returns to a factor and returns to scale are two important laws of
production. Both laws explain the relation between inputs and output. Both
laws have three stages of increasing, decreasing and constant returns.
Even then, there are fundamental differences between the two laws.

Returns to a factor relate to the short period production function when one
factor is varied keeping the other factor fixed in order to have more output,
the marginal returns of the variable factor diminish. On the other hand,
returns to scale relate to the long period production function when a firm
changes its scale of production by changing one or more of its factors.

We discuss the relation between the returns to a factor (law of diminishing

returns) and returns to scale (law of returns to scale) on the assumptions
that:

(1) There are only two factors of production, labour and capital.

(2) Labour is the variable factor and capital is the fixed factor.

(3) Both factors are variable in returns to scale.

(4) The production function is homogeneous.

Given these assumptions, we first explain the relation between constant

return to scale and returns to a variable factor in terms of Figure 24.14
where OS is the expansion path which shows constant returns to scale
because the difference between the two isoquants 100 and 200 on the
expansion path is equal i.e., OM = MN. To produce 100 units, the firm uses
ОС + OL quantities of capital and labour and to double the output to 200
units, double the quantities of labour and capital are required so that ОС1+
OL2 lead to this output level at point N. Thus there are constant returns to
scale because OM = MN.

To prove that returns to the variable factor, labour, diminish, we take ОС of

capital as the fixed factor, represented by the CC, line. Keeping С as
constant, if the amount of labour is doubled by LL2, we reach point К which
lies on a lower isoquant 150 than the isoquant 200. By keeping С constant,
Ц if the output is to be doubled from 100 to 200 units, then L3units о of
labour will be required. But L3 > L2. Thus by doubling the units of labour
with constant C2, the output less than doubles. It is 150 units at point К
instead of 200 units at point P. This shows that the marginal returns of the
variable factor, labour, have diminished.
As pointed out by Stonier and Hague, “So, if production function were
always homogeneous of the first degree and if returns to scale were always
constant, marginal physical productivity (returns) would always fall.”

The relation between diminishing returns to scale and return to a variable

factor is explained with the help of Figure 24.15 where OS is the expansion
path which depicts diminishing returns to scale because the segment
MN>OM. It means that in order to double the output from 100 to 200, more
than double the amounts of both factors are required.

Alternatively, if both factors are doubled to OC2+ OL2 they lead to the lower
output level isoquant 175 at point R than the isoquant 200 which shows
diminishing returns to scale. If С is kept constant and the amount of
variable factor, labour, is doubled by LL2 we reach point К which lies on a
still lower level of output represented by the isoquant 140. This proves that
the marginal returns (or physical productivity) of the variable factor, labour,
have diminished.
3. Now we take the relation between increasing returns to scale and returns
to a variable factor. This is explained in terms of Figure 24.16 (A) and (B).
In Panel (A), the expansion path OS depicts increasing returns to scale
because the segment OM > MN. It means that in order to double the output
from 100 to 200, less than double the amounts of both factors will be
required. If С is kept constant and the amount of variable factor, labour, is
doubled by LL2 the level of output is reached at point K which shows
diminishing marginal returns as represented by the lower isoquant 160 than
the isoquant 200 when returns to scale are increasing.
In case the returns to scale are increasing strongly, that is, they are highly
positive they will offset the diminishing marginal returns of the variable
factor, labour. Such a situation leads to increasing marginal returns. This is
explained in Panel (B) of Figure 24.16 where on the expansion path OS,
the segment OM > MN, thereby showing increasing returns to scale. When
the amount of the variable factor, labour, is doubled by LL2 while keeping С
as constant, we reach the output level K represented by the isoquant 250
which is at a higher level than the isoquant 200. This shows that the
marginal returns of the variable factor, labour, have increased even when
there are increasing returns to scale.

Conclusion:
It can be concluded from the above analysis that under a homogeneous
production function when a fixed factor is combined with a variable factor,
the marginal returns of the variable factor diminish when there are
constant, diminishing and increasing returns to scale. However, if there are
strong increasing returns to scale, the marginal returns of the variable
factor increase instead of diminishing.

Choice of Optimal Factor Combination or Least Cost

Combination of Factors or Producer’s Equilibrium:
A profit maximisation firm faces two choices of optimal combination of
factors (inputs): First, to minimise its cost for a given output; and second, to
maximise its output for a given cost. Thus the least cost combination of
factors refers to a firm producing the largest volume of output from a given
cost and producing a given level of output with the minimum cost when the
factors are combined in an optimum manner. We study these cases
separately.

Cost-Minimisation for a Given Output:

In the theory of production, the profit maximisation firm is in equilibrium
when, given the cost-price function, it maximises its profits on the basis of
the least cost combination of factors. For this, it will choose that
combination which minimises its cost of production for a given output. This
will be the optimal combination for it.

Assumptions:
This analysis is based on the following assumptions:

1. There are two factors, labour and capital.

2. All units of labour and capital are homogeneous.

3. The prices of units of labour (w) and that of capital (r) are given and
constant.

4. The cost outlay is given.

5. The firm produces a single product.

6. The price of the product is given and constant.

7. The firm aims at profit maximisation.

8. There is perfect competition in the factor market.

Given these assumptions, the point of least-cost combination of factors for

a given level of output is where the isoquant curve is tangent to an isocost
line. In Figure 24.17, the isocost line GH is tangent to the isoquant 200 at
point M. The firm employs the combination of ОС of capital and OL of
labour to produce 200 units of output at point M with the given cost- outlay
GH. At this point, the firm is minimising its cost for producing 200 units. Any
other combination on the isoquant 200, such as R or T, is on the higher
isocost line KP which shows higher cost of production. The isocost line EF
shows lower cost but output 200 cannot be attained with it. Therefore, the
firm will choose the minimum cost point M which is the least-cost factor
combination for producing 200 units of output. M is thus the optimal
combination for the firm.

The point of tangency between the isocost line and the isoquant is an
important first order condition but not a necessary condition for the
producer’s equilibrium. There are two essential or second order conditions
for the equilibrium of the firm.

1. The first condition is that the slope of the isocost line must equal the
slope of the isoquant curve. The Slope of the isocost line is equal to the
ratio of the price of labour (w) to the price of capital (r) i.e., w/r. The slope of
the isoquant curve is equal to the marginal rate of technical substitution of
labour and capital (MRTSLC) which is, in turn, equal to the ratio of the
marginal product of labour to the marginal product of capital (MPL/MPC).
Thus the equilibrium condition for optimality can be written as:
The second condition is that at the point of tangency, the isoquant curve
must he convex to the origin. In other words, the marginal rate of technical
substitution of labour for capital (MRTSLC) must be diminishing at the point
of tangency for equilibrium to be stable. In Figure 24.18, S cannot be the
point of equilibrium, for the isoquant IQ1, is concave where it is tangent to
the isocost line GH. At point S, the marginal rate of technical substitution
between the two factors increases if move to the right m or left on the curve
lQ1.

Moreover, the same output level can be produced at a lower cost CD or EF

and there will be a corner solution either at C or F. If it decides to produce
at EF cost, it can produce the entire output with only OF labour. If, on the
other hand, it decides to produce at a still lower cost CD, the entire output
can be produced with only ОС capital. Both the situations are
impossibilities because nothing can be produced either with only labour or
only capital. Therefore, the firm can produce the same level of output at
point M where the isoquant curve IQ is convex to the origin and is tangent
to the isocost line GH. The analysis assumes that both the isoquants
represent equal level of output, IQ = IQ1.
Output-Maximisation for a Given Cost:
The firm also maximises its profits by maximising its output, given its cost
outlay and the prices of the two factors. This analysis is based on the same
assumptions, as given above. The conditions for the equilibrium of the firm
are the same, as discussed above.

1. The firm is in equilibrium at point P where the isoquant curve 200 is

tangent to the isocost line CL. At this point, the firm is maximising its output
level of 200 units by employing the optimal combination of OM of capital
and ON of labour, given its cost outlay CL. But it cannot be at points E or F
on the isocost line CL, since both points give a smaller quantity of output,
being on the isoquant 100, than on the isoquant 200. The firm can reach
the optimal factor combination level of maximum output by moving along
the isocost line CL from either point E or F to point P. This movement
involves no extra cost because the firm remains on the same isocost line.
The firm cannot attain a higher level of output such as isoquant 300
because of the cost constraint.

Thus the equilibrium point has to be P with optimal factor combination OM

+ ON. At point P, the slope of the isoquant curve 200 is equal to the slope
of the isocost line CL. It implies that w/r=MPL/MPC=MRTSLC
2. The second condition is that the isoquant curve must be convex to the
origin at the point of tangency with the isocost line, as explained above in

terms of Figure 24.18.