Input Price Changes and Input Demand: Impacts on Costs and Input Demand, Study notes of Microeconomics

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LECTURE 16

INPUT PRICE CHANGES AND INPUT DEMAND

Q^ UESTIONS

,^ I^ SSUES AND

TOPICS TO BE

COVERED

-^ Two firms have the same cost function (at a given set of input prices) andemploy the same number of workers, but have different productiontechnologies.The firms are forced to raise wages due to negotiations with theiremployees.Will their costs be equally affected.If not, which firm’s costs will go up by more?

SKILLS TO BE

M^ ASTERED

-^ You should be able to move isocosts and isoquants in your sleep.

O^ VERVIEW

The relationship between input demand and input prices depends on:!^ The substitutability between the inputs.!^ The sensitivity of the optimal output on the cost of doing business (i.e., tochanges in input prices).^ "^

The sensitivity of the cost function to changes in input prices. " The sensitivity of the demand function to price changes.

!^ The sensitivity of the optimal output on the cost of doing business (i.e., tochanges in input prices).This, in turn, depends on two factors.^ "^

The sensitivity of the cost function to changes in input prices.The ability of a firm to substitute away from the input that is becomingexpensive reduces the sensitivity of the cost function to input pricechanges.

"^ The sensitivity of the demand function to price changes.If demand is relative flat, an increase in the cost of doing businesswould tend to lead to a bigger reduction in optimal output.Higher sensitivity of optimal output to an increase in input costs leads tobigger changes in input demand as input prices change.

In the figure above, the price of capital can increase, leading to a flattening ofthe isocost lines from the dashed to the dashed-and-dotted line.However, this has no effect on the input levels chosen to produce a given output q.

Question:How would a decrease in the price of labor look like in the above graph?In other words, starting from the dashed isocost line, how would I draw anisocost line that would correspond to producing output

q^ when the wage is

lower?

In the figure above, an increase in the price of capital leads the firm (that wantsto maintain output at

q ) to decrease the use of capital (from

to

) and

increase the use of labor (from

to^

Therefore

:^ Substitutability between inputs increases the extent to which a firmthat desires to produce a given output

q^ will move away from an

input whose price increases. This completes our discussion of the “first black bullet.”

If the price of capital goes up form

to

, the cost of producing

q^ units

would need to go up fromto

Now, consider the example in which there is substitutability between the inputs.

Therefore

:^ Substitutability decreases the costs of producing a given level ofoutput

q^ when an input’s price goes up, relatively to when there isno substitutability. The result we have just obtained can be graphically depicted as follows.Consider two firms, A and B, that have the same cost function,

, when

input prices are

and

Firm A has limited substitutability between labor and capital.Firm B has a more flexible production process and thus a greater amount ofsubstitutability between labor and capital.