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Transcript:
In this video, we will be discussing the Cost Minimizing Input Combination
Production requires multiple inputs, and firms must decide what combination of inputs to use to produce their output. In this lesson, we will be looking at how firms decide the optimal combination of factors for producing the desired level of output.
Firms can choose from two main input combinations to produce a given level of output. The first is called a capital intensive operation and requires greater investment in forms of capital and very little labor. The second is called a labor intensive operation and requires lots labor but very little capital investment. Many other combinations of labor and capital can be utilized to get to the same amount of product produced using different amounts of inputs. Inputs can either be substitutes or complements.
A substitute is when a rise in the price of one good makes consumers more willing to buy the other good. Meanwhile, when two goods are consumed together they are considered as complements.
The concepts of substitutes and complements are also applicable to a firm’s purchase of inputs. Just as the price of related goods affects consumer’s purchasing decisions, the price of other inputs can affect a firm's decision about how much of an input it will use.
Because several alternate input combinations can be made, the firm will select the cost minimizing input combination. This requires evaluating the cost of each combination and selecting the one that minimized cost of production.
EXAMPLE
In this example, both Option A and Option B give you the same amount of product but use different amounts of labor and capital to do so. In order to choose the most efficient combination, the firm must compare the total cost of capital and labor for both options. The combination which is less expensive is the one that minimizes cost in this case.
Because there can be a very large number of possible combinations, it is much more practical to use marginal analysis to find the cost minimizing level of output or the cost minimization rule. Firms want to receive the highest possible marginal product for each dollar spent on inputs. To do this, firms adjust their their combination of inputs until the marginal product per dollar is equal for all inputs. This is the cost minimization rule. When the inputs are labor and capital, this amounts to equating Marginal Product of Labor per dollar spent on wages to the Marginal Product of Capital per dollar spent to rent capital.