Question

A typical firm's cost minimisation rule requires that the output of the last dollar spent on...

A typical firm's cost minimisation rule requires that the output of the last dollar spent on labour MPL/w must be equal to the output of the last dollar spent on capital MPk/r.

a) What does it mean if MPL/w is less than MPk/r?

b) What does this imply for the firm's cost minimisation behaviour?

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Answer #1

(a)

If MPL /w is less than MPK/r, this implies than capital has a higher marginal product per dollar compared to labor. This means the the firm should reduce its labor input and increase its capital output, as each extra input of capital would bring more output at lesser cost. The company should do this till the marginal products per dollar are equal for the two.

(b)

This means that the firm is not minimizing its cost and is employing more labor than it should and is employing lesser capital than it should. The the firm should substitute capital for labor, as each extra input of capital would bring more output at lesser cost. The company should do this till the marginal products per dollar are equal for the two. This will lead to the cost being minimized.

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