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## Optimal choice of factors in perfectly competitive factor markets

# Cost minimizing choice of inputs

AP.MICRO:

PRD‑4 (EU)

, PRD‑4.C (LO)

, PRD‑4.C.1 (EK)

, PRD‑4.C.2 (EK)

, PRD‑4.C.3 (EK)

, PRD‑4.C.4 (EK)

## Video transcript

- [Instructor] We are
now going to continue our discussion of factor markets. And we're going to go beyond just thinking about labor as a factor. In fact, in this video,
we're going to start thinking about capital as well, which we know is another one
of the factors of production. But just as a little bit of review, we've already thought about
it from a firms perspective on what is the rational
amount of labor to hire based on the marginal
revenue product of labor and based on the marginal
factor cost of labor. So, in the horizontal axis,
we have the quantity of labor hired by the firm. And in the vertical axis,
you have the wage rate, wage rate, which you could
view as the price of labor. And we've seen this multiple times. You are likely to have a downward sloping marginal revenue product curve, MRP. And I'm going to be very specific that this one is the marginal
revenue product of labor. And then we have the
marginal factor cost curve. And if we're assuming that this firm is in a competitive, perfectly
competitive labor market, well, they're just going to have to pay whatever the wage is in the market. And so, that's why we have
a horizontal line there, so that's the marginal
factor cost of labor. And we've talked about multiple times that it's rational for
the firm to keep hiring as long as the marginal
revenue product of labor, as long as the incremental revenue that the firm gets for
each of those people or each of those units
of labor that they hire is higher than the incremental cost of each of those units of labor. And so, it'll keep hiring until
these two lines intersect. And so, it would be rational for it to hire that quantity of labor. I'll do this is the labor for the firm, and I'll put a little star over here, so that quantity of labor. And we can draw an
analogous thing for capital. So, this is how a firm
thinks about that input, how it thinks about labor. But we could also do
something similar for capital. Or we could do it for land as well. But hopefully, so this
is going to be the firm, the firm as you think about capital. And we'll see that they
have analogous axes. The horizontal axis right over here is going to be the quantity not of labor, but the quantity of capital. And then the vertical
axis, the price of capital, you could view that as the rent rate, rent rate, if you're thinking about maybe you're renting some type of machinery. And so, you will have your marginal revenue product of capital. We could still imagine that
you have diminishing returns, so that's why it's downward sloping, so marginal revenue product. And we typically use a K for capital, just so we don't get the C
confused with other things. And then we have our marginal factor cost, which is really just, and
we'll assume, once again, that this is a perfectly
competitive capital market, so you just have to pay
whatever the market rate for renting that capital is. And so, that would be the marginal factor cost of the capital. And so, once again, it makes sense to keep bringing on more
and more and more capital as long as the incremental
revenue that you get from each of those extra units of capital is higher than the cost of each of those extra units of capital. And so, here, it would
be rational for the firm, if we're just looking at the dimension of capital to product this much. So, this would be, actually, let me, this would be the capital,
the quantity of capital for the firm to employ. Now, an interesting question that might've already crossed your minds are, is that firms have a
certain amount of resources that they are going to think about, well, how much do I put in labor versus how much do I put into capital. So, they don't just think
about these dimensions of how much inputs of
these factors they want, they have to think about
them relative to each other. And to help us think through this, let's say that we are at
a certain level of output. So, let's say that our output right now, I don't know, our current output, our current output is, I'm just going to make up something, 1,000 units per day. And at our current output, we know what the marginal product of labor and the marginal product of capital is. Let's say that we know that
our marginal product of labor at this output, remember it changes, as we have different output and we bring on more
labor or more capital, so our marginal product of
labor at that level is 90 units. So, another way to think about it, for every incremental
unit of labor we bring on, we're going to be able to
produce 90 more units of output, so this is, and then let's
say that the price of labor, which is the wage rate, is equal to $10, $10 per unit of labor. So, let me call this output units, output units. And let's say that the
marginal product of capital, let me do this in a different color, the marginal product of capital right now is 80 output units, output units. So, every unit of this factor of capital, we are able to produce an
incremental 80 output units. And let's say that the price of capital, which would be the rent, is equal to $5, $5 per input unit of the factor. So, right at this moment, if
I have an incremental dollar, would it be more rational
for me to add more labor, or would it be more rational
for me to add more capital? Pause this video and see
if you can figure that out. Well, to think about which
one is more rational, you just have to think about which one do I get more of a bang for my buck. So, per dollar, how many
output units do I get when I put a dollar into labor versus, per dollar, how
many output units do I get when I put that dollar into capital? So, let's do it first for labor. So, if you want your bang
for the buck, so to speak, you would just take your marginal, let me do this in a different color, if you want your bang for buck, you would just take your
marginal product of labor, so your output, and
divide it by the price. So, this is gonna tell
you output per dollar. And so, in this situation,
it's 90 output units, we could say widgets for a
general term for output units, output units, over $10, over $10. And so, this is going to be equal to nine output units per dollar. So, this is equal to nine output units per dollar. So, that's our measure
of our bang for our buck when we put an incremental
buck into labor. Now, what about for capital? Well, our marginal product of capital divided by the price of capital, right at this moment, remember it changes depending on our output level
and different combinations, is going to be equal to 80 output units divided by $5, which is equal to 16 output units per dollar. So, which one would I get
a better bang for my buck? Well, right at this moment, I'm getting a better bang for my buck from investing in capital. Every extra dollar I put,
I get 16 output units. So, it'd be rational for this firm that wants to maximize its
profit and reduce its cost, if it has an extra dollar to invest, it would put it into capital. And so, maybe it puts it into capital, and then it gets a little bit more output. And then the marginal product of capital is likely to go down. And so, you could imagine, at some point, these things might be equal, and then the firm might be
indifferent between the two. And then maybe, at some point,
if they kept adding capital, then maybe you get a better bang for your buck from the labor. In general, a firm would wanna keep investing in one or the other until these two things
are equal to each other. So, big picture, you would
look at the marginal product of the factor divided by
the price of the factor, and then you'd compare that
to the marginal product of the other factors divided by the price of those other factors. And whichever one has the
best bang for the buck, that's where it would be
rational to invest in. And then you have, in some ways, your, one way is a very efficient combination, is if you get to that point
that you're indifferent, when the marginal product
divided by the prices of the various factors
are equal to each other. So, for example, if I were to tell you that we are at a different
point of production, let me cordon this off, so if we're at a different
level of production, where our marginal product of labor is equal to, I'll call it 10 widgets, this saves time, and let's say that the price
of labor is equal to $5, and let's say that the price
of capital is equal to $10, what would have to be the
marginal product of capital for me to be indifferent
between labor and capital? Pause this video and
try to figure that out. Well, in order for me to be
indifferent right over here, that means that my
marginal product of labor divided by price of labor needs to be equal to my
marginal product of capital divided by my price of capital. And so, I would have 10 over five would have to be equal to my marginal product of capital over 10. So, 10 over five, this is
two widgets per dollar. And so, if I want two
widgets per dollar over here, this has got to be equal to 20. So, at this point, I'm
indifferent between producing, between bringing on more
capital versus labor, because in either case,
every dollar I bring on, if the marginal product of capital is 20, then I'm able to get
two widgets per dollar of investing in either factor.