ISOCOST LINE
WHAT IS ISOCOST LINE
An isocost line is a graphical representation of various combinations of two factors (labor and capital)
which the firm can afford or purchase with a given amount of capital. It is an important tool for
determining what combination of factor-inputs the firm will choose for the production process.
Mathemathically, an isocost line can be expressed as
C= wL+rK
Where
C= cost of production
P= Price of labor cost
L= Units of labor
r=price of capital
K= units of capital
In the given diagram, x-axis represents units of labor and y-axis represents units of capital. Isocost
line in the figure represents 50 units of labor and 40 units of capital.If we join points A and B, we get
isocost line for 200. The straight line which joins points A and B will pass through all combinations of
labor and capital which the firm can buy with the outlay of 200. This way an isocost line is also known
as price line or outlay line. It is a counterpart of budget line of indifferent curve analysis. The slope of
isocost line is equal to the ratio of price of factor inputs.
Slope of AB= price of labor/price of capital
This slope remains the same throughout the isocost line.
SHIFTS IN ISOCOST LINE
An isocost line may shift due to two reasons:
- Change in total outlay made by the firm.
- Change in price of a factor input.
When the firm decides to increase the total money to be spent on the purchase of inputs while prices
of inputs remain the same, the producer becomes able to afford such combination of inputs which
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were initially unattainable to him. This causes isocost line to shift to a new position higher than the
initial line.
In the given figure AB is the initial isocost line. When the firm increased its total outlay the isocost
line shifts rightwards which shows higher units of capital and labor. Likewise, if the firm reduces its
total outlay, the isocost line shifts leftwards. Since we assume that no changes are made in the prices
of either of the inputs the slope will remain the same for all budget line.
Let us suppose that a firm has a total outlay of 200 and AB is initial isocost line. If the price of labor is
decreased the producer is able to purchase more units of labor at the same outlay. The assumption is
capital is constant so the position of price line is changed in the x-axis but unchanged in y-axis.
Isoquant and isocosts
An isoquant shows all combination of factors that produce a certain output
An isocost show all combinations of factors that cost the same amount.
Isocosts and isoquants can show the optimal combination of factors of production to
produce the maximum output at minimum cost.
Definition isoquant
An isoquant shows all the combination of two factors that produce a given output
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In this diagram, the isoquant shows all the combinations of labour and capital that can produce a
total output (Total Physical Product TPP) of 4,000. In the above isoquant, this could be
20 capital and 18 labour or (more capital intensive)
9 capital and 35 labour. (more labour intensive
An isoquant is usually shaped convex to the origin because of the law of Marginal Rate of Technical
Substitution (MRTS) which means there are diminishing returns from using more of one factor of
production.
Marginal rate of factor substitution
Which is 11/17
MRS= Difference in K/Difference in L
If 2 units of capital could be replaced with one-factor labour, the MRS would be 2.
Diminishing marginal rate of substitution
If the firm employs 2 L and 40 K. Then employing one extra worker can enable it to save 10K. This is
quite an efficient saving. However, at a combination of 9 Labour, employing an extra worker enables
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a saving of only 2 capital. Therefore, the more that workers are employed, there is diminishing rate
at which you can substitute the other factor.
In this example, initially, the cost of labour and capital is both £5,000. (e.g. 60L = 60 x £5,000
= £300,000)
However, if Labour cost rises to £10,000, then the isocost shifts to the left. Now, to keep cost
at £300,000, a firm could only employ 30 workers (30 x £10,000)
The slope of an isocost is, therefore, Pι / Pκ
