Question

a) If a firm is employing inputs X1 and X2 such that (MPX1/MPX2) > (w1/w2), where...

a) If a firm is employing inputs X1 and X2 such that (MPX1/MPX2) > (w1/w2), where w1 and w2 are the prices of X1 and X2, respectively. Is the firm behaving optimally? Why or why not? Show this situation on a graph.

b) What should the firm do? Why?

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Answer #1

If the current input combination results in (MPX1/MPX2) > (w1/w2), it implies that the firm is using too much of factor X2 and too little of X1 so that the marginal product of X1 per dollar is more than that of X2. Equimarginal principle is not satisfied,.

This also suggests that MRTS > Price ratio so Isoquant is steeper than budget constraint. It should therefore use more X1 and reduce its usage of X2.

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