Question

1. Suppose the marginal product of labor is 8 and the marginal product of capital is 2. The wage rate is $4 and the price of capital is $2. a. Is the firm using the cost minimizing combination of inputs? b. How do you know? c. If you do not believe that the firm is using the cost minimizing combination of inputs, should the firm increase or decrease capital (and why)?

Answer 1

Question 1

(a)

The firm is not using the cost minimizing combination of inputs.

(b)

A firm is said to be using cost-minimizing combination of inputs when following condition is fulfilled -

MP_L/P_L = MP_K/P_K

in given case,

MP_L/P_L = 8/4 = 2

MP_K/P_K = 2/2 = 1

As MP_L/P_L is not equal to the MP_K/P_K, firm is not using the cost-minimizing combination of inputs.

(c)

In given case,

MP_L/P_L > MP_K/P_K

So, firm should increase the labor and decrease the capital. This will decrease the MP_L and would increase the MP_K. This should be done untill the ratio gets equal.

Thus, the firm should decrease capital.