Question

Be sure you are able to clearly explain long run equilibrium of K and L utilization using isoquant and isocost functions. Be able to isolate and explain the substitution and scale effects resulting from a change in W or C.

Answer 1

In case of convex isoquants the point of long run equilibrium will be where the tangency of the isoquant and the isocost occurs. This will be where we have MRTS=w/r, that is marginal rate of technical substition between capital and labour is equal to the ratio of the factor prices of labour and capital. This is given at the point A in the graph below.Now if there is a decrease in wages then the isocost will shift outwards and so this means the firm moves to a higher isoquant at point B. Now the substitution effect is given by the move along the same isoquant as given below from A to C. The move from C to B is the scale effect. The equilibrium will be at the tangency between the isoquant and the isocost.