Isoquant

Isoquant and isocosts
 An isoquant shows all combination of factors that produce a certain output

 An isocost show all combinations of factors that cost the same amount.
 Isocosts and isoquants can show the optimal combination of factors of
production to produce the maximum output at minimum cost.
Definition isoquant
An isoquant shows all the combination of two factors that produce a given output
In this diagram, the isoquant shows all the combinations of labour and capital
that can produce a total output (Total Physical Product TPP) of 4,000. In the
above isoquant, this could be
 20 capital and 18 labour or (more capital intensive)
 9 capital and 35 labour. (more labour intensive
An isoquant is usually shaped concave because of the law of diminishing returns.
With fixed capital employing extra workers gives a declining increase in the
marginal product (MP)
Marginal rate of factor substitution

The marginal rate of substitution is the amount of one factor (e.g. K) that can be
replaced by one factor (e.g. L). If 2 units of capital could be replaced with one-
factor labour, the MRS would be 2
Diminishing marginal rate of substitution
If the firm employs 2 L and 40 K. Then employing one extra worker can enable it
to save 10K. This is quite an efficient saving. The firm only has to pay one extra
worker but can save the cost of 40.
However, at a combination of 9 Labour, employing an extra worker enables a

saving of only 2 capital. Therefore, the more that workers are employed, there is
a diminishing rate at which you can substitute the other factor. There comes a
point, where employing more workers barely saves any capital at all. This is
when diminishing returns of labour is very high – workers effectively get in each
other’s way.
As one moves down the isoquant, output remains the same. Therefore the output
gained from employing more labour must equal the output lost from employing
more capital.
MPP (L) x ΔL = MPP (K) x ΔK

This equation gives us
Isoquant map
An isoquant map shows different levels of output. For example
 I1 may show the combinations of capital and labour that can produce
4,000 TPP.
 I2 may show the combinations of capital and labour that can produce
5,000 TPP.
 I5 is a higher output than I4
In the short-term, a firm faces a trade-off along one particular isoquant. But, in
the long-term, a firm can invest in increasing capital stock and produce at a
higher output for the same quantity of labour.
Isocost
An isocost shows all the combination of factors that cost the same to employ.
In this example, a unit of labour and capital cost £6,666 each.
 If we employ 30K and 30L, the total cost will be £200,000 + £200,000
 If we employ 10 K and 50L, the total cost will be £66,666 +£333,333 =
£400,000
Change in labour costs
 In this example, initially, the cost of labour and capital is both £5,000. (e.g.
60L = 60 x £5,000 = £300,000)
 However, if Labour cost rises to £10,000, then the isocost shifts to the left.
Now, to keep cost at £300,000, a firm could only employ 30 workers (30 x
£10,000)
 The slope of an isocost is therefore Pι / Pκ
Profit maximisation
To maximise profits, a firm will wish to produce at the point of the highest
possible isoquant and minimum possible isocost
In this example, we have one isocost and three isoquants. With the isocost of
£400,000 the maximum output a firm can manage would be a TPP of 4,000. If it
produced at say 13 K and 48 Labour, it would only be able to produce a TPP of
3,500.
A total TPP of 4,500 is currently not possible without increasing costs beyond
£400,000
Profit maximisation – the least cost method of production

Another way of seeking to maximise profits is to target an output of say 4,00 and
then find the isocost with the lowest possible cost. In this case, the isocost which
touches the tangential point of the TPP is a TC of £400,000.
Where Px and Py denote prices of goods X and Y respectively and M
stands for money income. The above budget-line equation (8.1)
implies that, given the money income of the consumer and prices of
the two goods, every combination lying on the budget line will cost the
same amount of money and can therefore be purchased with the given
income. The budget line can be defined as a set of combinations of two
commodities that can be purchased if whole of a given income is spent
on them and its slope is equal to the negative of the price ratio.
Thus, the two determinants of the budget line are:
(a) The prices of goods, and
(b) The consumer’s income to be spent on the goods.
Slope of the Budget Line and Prices of two Goods:

It is also important to remember that the slope of the budget line is
equal to the ratio of the prices of two goods. This can be proved with
the aid of Fig. 8.14. Suppose the given income of the consumer is M
and the given prices of goods X and Y are Px and Py respectively. The
slope of the budget line BL is OB/OL. We intend to prove that slope
OB/OL is equal to the ratio of the price of goods X and Y.
The quantity of good X purchased if whole of the given income M is
spent on it is OL.
Now, the quantity of good Y purchased if whole of the given income M

is spent on it is OB.
It is thus proved that the slope of the budget line BL represents the
ratio of the prices of two goods.
Understanding Consumer’s Equilibrium by Indifference

Curve Analysis!
Consumer equilibrium refers to a situation, in which a consumer
derives maximum satisfaction, with no intention to change it and
subject to given prices and his given income. The point of maximum
satisfaction is achieved by studying indifference map and budget line
together.
On an indifference map, higher indifference curve represents a higher

level of satisfaction than any lower indifference curve. So, a consumer
always tries to remain at the highest possible indifference curve,
subject to his budget constraint.
Conditions of Consumer’s Equilibrium:

The consumer’s equilibrium under the indifference curve theory must
meet the following two conditions:
(i) MRSXY = Ratio of prices or PX/PY

Let the two goods be X and Y. The first condition for consumer’s
equilibrium is that
MRSXY = PX/PY
a. If MRSXY > PX/PY, it means that the consumer is willing to pay more
for X than the price prevailing in the market. As a result, the consumer
buys more of X. As a result, MRS falls till it becomes equal to the ratio
of prices and the equilibrium is established.
b. If MRSXY < PX/PY, it means that the consumer is willing to pay less
for X than the price prevailing in the market. It induces the consumer
to buys less of X and more of Y. As a result, MRS rises till it becomes
equal to the ratio of prices and the equilibrium is established.
(ii) MRS continuously falls:

The second condition for consumer’s equilibrium is that MRS must be
diminishing at the point of equilibrium, i.e. the indifference curve
must be convex to the origin at the point of equilibrium. Unless MRS
continuously falls, the equilibrium cannot be established.
Thus, both the conditions need to be fulfilled for a consumer to be in
equilibrium.
In Fig. 2.12, IC1, IC2 and IC3 are the three indifference curves and AB is
the budget line. With the constraint of budget line, the highest
indifference curve, which a consumer can reach, is IC2. The budget line
is tangent to indifference curve IC2 at point ‘E’. This is the point of
consumer equilibrium, where the consumer purchases OM quantity of
commodity ‘X’ and ON quantity of commodity ‘Y.
All other points on the budget line to the left or right of point ‘E’ will
lie on lower indifference curves and thus indicate a lower level of
satisfaction. As budget line can be tangent to one and only one
indifference curve, consumer maximizes his satisfaction at point E,
when both the conditions of consumer’s equilibrium are satisfied:
(i) MRS = Ratio of prices or PX/PY:

At tangency point E, the absolute value of the slope of the indifference
curve (MRS between X and Y) and that of the budget line (price ratio)
are same. Equilibrium cannot be established at any other point as
MRSXY > PX/PY at all points to the left of point E and MRSXY < PX/PY at
all points to the right of point E. So, equilibrium is established at point
E, when MRSXY = PX/PY.
2) MRS is Falling
In Fig. 2.12, IC1, IC2 and IC3 are the three indifference curves and AB is
the budget line. With the constraint of budget line, the highest
indifference curve, which a consumer can reach, is IC2. The budget line
is tangent to indifference curve IC2 at point ‘E’. This is the point of
consumer equilibrium, where the consumer purchases OM quantity of
commodity ‘X’ and ON quantity of commodity ‘Y.
All other points on the budget line to the left or right of point ‘E’ will
lie on lower indifference curves and thus indicate a lower level of
satisfaction. As budget line can be tangent to one and only one
indifference curve, consumer maximizes his satisfaction at point E,
when both the conditions of consumer’s equilibrium are satisfied:
(i) MRS = Ratio of prices or PX/PY:

At tangency point E, the absolute value of the slope of the indifference
curve (MRS between X and Y) and that of the budget line (price ratio)
are same. Equilibrium cannot be established at any other point as
MRSXY > PX/PY at all points to the left of point E and MRSXY < PX/PY at
all points to the right of point E. So, equilibrium is established at point
E, when MRSXY = PX/PY.
2) MRS Falls : IC curve is convex to the origin

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Isoquant and isocosts

 An isoquant shows all combination of factors that produce a certain output

Marginal rate of factor substitution

Diminishing marginal rate of substitution

However, at a combination of 9 Labour, employing an extra worker enables a

MPP (L) x ΔL = MPP (K) x ΔK

An isoquant map shows different levels of output. For example

In this example, a unit of labour and capital cost £6,666 each.

Profit maximisation – the least cost method of production

(b) The consumer’s income to be spent on the goods.

Slope of the Budget Line and Prices of two Goods:

Now, the quantity of good Y purchased if whole of the given income M

Understanding Consumer’s Equilibrium by Indifference

On an indifference map, higher indifference curve represents a higher

Conditions of Consumer’s Equilibrium:

(i) MRSXY = Ratio of prices or PX/PY

(ii) MRS continuously falls:

(i) MRS = Ratio of prices or PX/PY:

(i) MRS = Ratio of prices or PX/PY:

2) MRS Falls : IC curve is convex to the origin

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