compares to the cost of an additional unit of labour. If the two sides of
Equation 8-2 are the same, then the firm cannot make any substitutions
between labour and capital to reduce costs (if output is held constant).
However, with the marginal products and factor prices used in the
example above, the left side of the equation equals 2 but the right side
equals 5; the last unit of capital is twice as productive as the last unit of
labour but it is five times more expensive. It will thus pay the firm to
switch to a method of production that uses less capital and more labour.
Only when the ratio of marginal products is exactly equal to the ratio of
factor prices is the firm using the cost-minimizing production method.
Profit-maximizing firms adjust the quantities of factors they use to the market prices of the
factors.The Principle of Substitution
The preceding discussion suggests that profit-maximizing (and therefore
cost-minimizing) firms will react to changes in factor prices by changing
their methods of production. This is referred to as the principle of
substitution.
Suppose the firm’s use of capital and labour currently satisfies Equation
- Then consider a decrease in the price of capital while the price of
labour remains unchanged. The least-cost method of producing any
output will now use less labour and more capital than was required to
produce the same output before the factor prices changed.