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, how should the firm adjust its...

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, how should the firm adjust its mix of capital and labor? What will be the result?

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The idea in question here is that money in the firm is finite, and therefore the budget must be maximized with what it currently has. Therefore, if you spend an extra dollar on capital, you must spend a dollar less on labor. We want to calculate marginal benefit of each expenditure by dividing marginal product by price.

For capital, Marginal Benefit = 60/6, or 10, and for labor, Marginal benefit = 20/2.5, or 8. Therefore, for each dollar spent on capital, the company gains 10 units of production, and for each dollar spent on labor, the firm gains 8 units of production.

Extrapolating this using the principle in question, if you move a dollar from labor to capital, you will gain 10 units of production but lose 8 at the same time, therefore totaling a net positive of 2 units. Therefore, you will want to move funds to capital until you begin to see diminishing returns from reducing labor.

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First, we can find the firm's marginal benefit per additional dollar that it spends on both factors of...

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