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# The Austrian position on Isoquant-isocost diagrams

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539 Posts
Points 11,275
Consumariat posted on Sun, Nov 4 2012 10:21 AM

In mainstream econ classes, when analysing the impact of relative price changes in Labour and Capital, an Isoquant-Isocost diagram is used.

This shows Labour on the x-axis measured in labour hours, and Capital on the y-axis. The isocost line (in other words the budget available) shows all possible combinations of labour and capital for a given budget, and the isoquant (the curved line) shows how much output it is possible to produce at that particular combination of labour and capital.

Now, Labour is supposedly measured in labour hours. This is all very well, but my question is about how it is possible to measure 'capital' in general. There are many different types of capital ranging from screwdrivers to CNC machines and anything in between. So what unit of measurement to mainstream economists use to measure capital?

I asked my lecturer this, and his answer was that it is usual to measure capital in the value of the capital used, but there seems something wrong with this. After all, isn't the point of the isocost-isoquant diagram that you can analyse changes in the relative prices of the inputs, and how this impacts on output? If Capital is measured in the price of that Capital, then the answer to the question "how much capital can you buy with £300,000 would be... er... £300,000s worth. Well, yeah. Great. And then, changing the price of capital would not change the position of where the isocost line touches the y-axis, and as such it would be impossible to assess how capital price changes affect output.

What do Austrians say about this issue? How to Austrians analyse capital-labour ratios and input-output relations? Do they have a critique of the mainstream use of isocosts and isoquants?
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5,255 Posts
Points 80,815

Jon Irenicus replied on Sun, Nov 4 2012 3:50 PM

Good point, actually. He seems to be confusing the physical limitations of capital goods with the subjective attributes of consumer goods.

Freedom of markets is positively correlated with the degree of evolution in any society...

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3,260 Posts
Points 61,905

Daniel James Sanchez replied on Sun, Nov 4 2012 3:51 PM

"the isoquant (the curved line) shows how much output it is possible to produce at that particular combination of labour and capital. "

Did your teacher tell you that? You have it backward.  The isoquant shows the possible combinations of labour and capital for producing a given output.

"the obligation to justice is founded entirely on the interests of society, which require mutual abstinence from property" -David Hume
• | Post Points: 20
3,260 Posts
Points 61,905

Daniel James Sanchez replied on Sun, Nov 4 2012 4:20 PM

"After all, isn't the point of the isocost-isoquant diagram that you can analyse changes in the relative prices of the inputs, and how this impacts on output?"

Consumariat,

No, the point of the diagram is to illustrate that for any given output (isoquant), the least-cost combination of inputs is the point of tangency on the isocost curve that is closest to the origin, but still touching the given isoquant.

"the obligation to justice is founded entirely on the interests of society, which require mutual abstinence from property" -David Hume
• | Post Points: 20
3,260 Posts
Points 61,905

Daniel James Sanchez replied on Sun, Nov 4 2012 4:27 PM

Alternatively, it can indicate, at a given cost, the maxiumum amount of output (the greatest isoquant touching the given isocost).

"the obligation to justice is founded entirely on the interests of society, which require mutual abstinence from property" -David Hume
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539 Posts
Points 11,275
Consumariat replied on Sun, Nov 4 2012 5:21 PM

The isoquant shows the possible combinations of labour and capital for producing a given output.

Yes, you are correct. I thought that's what I said. My wording was bad I guess.

• | Post Points: 5
3,260 Posts
Points 61,905

Daniel James Sanchez replied on Sun, Nov 4 2012 5:25 PM

All that being said, the iscost-isoquant approach is wrong-headed. The problem with the analysis is that it misunderstands the nature of entrepreneurial decisions. It takes output as given, and portrays profit maximization as simply a matter of achieving that output while minimizing costs.

The entrepreneur's role is not merely to minimize costs,  but to maximize the spread between his costs and income.  And doing that takes much more than high-school level math. It takes successful forecasting of demand for his product.  Based on those forecasts, he must choose both his output and input with the aim of maximizing that spread.

Furthermore, the anlaysis can be misleading.  It represents factor hire prices as simply given to the entrepreneur.  While to a single entrpreneur in a large market, the "prevailing price" may appear as given, it is fundamentally entrepreneurial demand for the factors that determines factor prices.

"the obligation to justice is founded entirely on the interests of society, which require mutual abstinence from property" -David Hume
• | Post Points: 5
539 Posts
Points 11,275
Consumariat replied on Sun, Nov 4 2012 5:30 PM

No, the point of the diagram is to illustrate that for any given output (isoquant), the least-cost combination of inputs is the point of tangency on the isocost curve that is closest to the origin, but still touching the given isoquant.

OK, what I should have said, which I think would have communicated what I meant better, is that if the price of either of the factors changes, then the slope of the isocost will move, and hense the point of tangency will change to a different isoquant. So wouldn't output be affected?

For example:

Say the budget is such that the isocost is N1 on this diagram. Then the cost of labour goes up so that N1 shifts inwards to N2. The possible output that can be achieved is reduced from isoquant i1 to isoquant i2. The point of tangency of N2 and i2 is the cheapest way that this output can be achieved.

Am I understanding it correctly?

• | Post Points: 20
3,260 Posts
Points 61,905

Daniel James Sanchez replied on Sun, Nov 4 2012 5:54 PM

Yes, that sounds right.

In case you missed it, I answer you're original question in the previous post.

"the obligation to justice is founded entirely on the interests of society, which require mutual abstinence from property" -David Hume
• | Post Points: 20
539 Posts
Points 11,275
Consumariat replied on Sat, Nov 24 2012 7:38 PM

Yes, that sounds right.

In case you missed it, I answer you're original question in the previous post.

Thank you for your response. Sorry about the belated reply, I was mulling over your answer for a while but then got distracted by essays and the like.

The entrepreneur's role is not merely to minimize costs,  but to maximize the spread between his costs and income

Could you explain a bit more about this please? How does maximising the spread between costs and income differ from inimising costs? They Sound the same to me.

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