SummaryIn this first LP on production, we examine the decisions that lead to optimal levels of production. This is crucial, as it mirrors the same decisions that we saw consumers making: assigning our limited (and expensive!) resources in the best way possible in order to maintain optimal levels of production.
Isocost lines show combinations of productive inputs which cost the same amount. They are the same concept as budget restrictions when looking at consumer behaviour. Mathematically, they can be expressed as:
rK + wL = C
Where r is the cost of capital and w is the cost of labour. Generally, we think of r as the interest rate the financial markets offer, as capital requires investment. Even if the capital can be paid for using a company’s own resources, r is still equivalent to the opportunity cost of having the money tied up in investments rather than in liquid assets which offer a return (r) by lending it to the markets. The cost of labour (w) is the salary paid to employees per unit of time.
Isocosts are usually represented graphically together with isoquant lines (which are combinations of productive inputs which produce a fixed quantity of outputs). The two have a tangency point, which determines the optimal production (where production is maximised or cost minimised).
Video – Isocosts: