3. If a firm uses only capital and labour, show why the cost minimising combination of inputs sets:
MPK = PK
This task is intended to assess your knowledge of conventional microeconomic principles (part of LO1). The word count is deliberately tight in order to force you to prioritise the most important arguments/explanations in your answers. Providing clear and concise explanations of the most important aspects will lead to good marks. Your answers should be written in an academic style.
Diagrams are essential. It is impossible to produce a good answer to these questions without using a well-chosen, and well-drawn, diagram. Do not simply present a diagram without carefully explaining it in the text. Use diagrams to save words and explain them to illustrate your answer.
Cost minimization is the process or goal of incurring the least possibleopportunity cost in the pursuit of a given activity. Cost minimization is comparable to other objectives, including utility maximization and profit maximization. This goal, however, is generally used when circumstances constrain a decision. For example, a government agency has been assigned the task of building a bridge. It must now do so at the lowest cost possible.
For a firm with N productive inputs, cost minimization requires that: MP(1)/P(1)=MP(2)/P(2)=… MP(n)/P(n). This equation tells us that, to minimize cost, the additional output per dollar spent to employ one additional unit of each input must be the same.
For cost minimization and profit maximization, a firm must employ inputs in quantities such that: MRP(1)/P(1)=MRP(2)/P(2)=…=MRP(n)/P(n)=1. MRP is short for marginal revenue product, which equals to “MR*MC”.