Figure 8A-5 The Effects of a Change in Factor Prices on Costs and
Factor Proportions
basic principle that the decision makers (consumers or producers) face
market prices beyond their control and so adjust quantities (consumption
or factor inputs) until they are achieving their objective (utility
maximization or cost minimization).
The Principle of Substitution
Suppose with technology unchanged (that is, for a given isoquant map),
the price of one factor changes. In particular, suppose with the price of
capital unchanged at $4 per unit, the price of labour rises from $1 to $4
per unit. Originally, the cost-minimizing factor combination for producing
6 units of output was 12 units of labour and 3 units of capital. Total cost
was $24. To produce that same output in the same way would now cost
$60 at the new factor prices. Figure 8A-5 shows why this production
method is no longer the cost-minimizing one. The slope of the isocost
line has changed, which makes it efficient to substitute the now relatively
cheaper capital for the relatively more expensive labour. The change in
slope of the isocost line illustrates the principle of substitution.