Describe how the firm should adjust its mix of capital and labor?

Suppose a firm finds that the marginal product of capital is 60 and the marginal product of labor is 20. If the price of capital is $6 and the price of labor is $2.50, describe how the firm should adjust its mix of capital and labor? What will be the result?

To determine how a firm should adjust its mix of capital and labor, we can use the concept of marginal productivity and the relative prices of capital and labor. In this scenario, the firm has the following information:

Marginal Product of Capital (MPC) = 60

Marginal Product of Labor (MPL) = 20

Price of Capital (PK) = $6 per unit

Price of Labor (PL) = $2.50 per unit

The firm should aim to allocate its resources (capital and labor) in such a way that the marginal productivity per dollar spent on each resource is equal. This condition is known as profit maximization in a competitive market.

To do this, we calculate the marginal productivity per dollar spent for both capital and labor:

• For capital (MPK/PK): MPK/PK = 60/6 = 10
• For labor (MPL/PL): MPL/PL = 20/2.50 = 8

Comparing these two ratios, we can see that the marginal productivity per dollar spent on capital (10) is greater than that of labor (8). This means that the firm is getting more output for each dollar spent on capital than it is on labor.

To maximize profits, the firm should reallocate resources from labor to capital until the marginal productivity per dollar spent on both resources is equal. In other words, the firm should increase its use of capital and reduce its use of labor.

As the firm adjusts its mix of capital and labor in this way, the following results are likely:

1. The firm's production output will increase because it is allocating resources more efficiently.
2. Total production costs may change depending on how much labor is reduced and capital is increased. If the firm reduces labor (which is cheaper) and increases capital (which is more expensive), total production costs may go up or down, depending on the magnitude of the changes.
3. Profits are likely to increase if the reallocation of resources results in a more efficient production process.

In the real world, there may be practical constraints and limitations on how quickly a firm can adjust its mix of capital and labor, such as contractual agreements, lead times for ordering capital equipment, and the availability of skilled labor. Additionally, the firm should continually monitor and adjust its resource allocation to respond to changing market conditions and costs.

Reference

McAfee, R. P., Lewis, T. R., & Dale, D. D. (2014). Introduction to Economic Analysis.

Rittenberg, L. & Tregarthen, T. (2009). Principles of Economics. Flat World Knowledge.