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...

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?

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teachsuccess eNotes educator| Certified Educator

Based on Economics (Tregarthen and Rittenberg), if we spend $1 more on capital, we must spend $1 less on labor.

Since the marginal product of capital is 60, and the price of capital is $6, the marginal benefit of $1 spent on capital is Marginal Product of Capital/ Price of Capital= 60/6= 10.

So, the firm will gain 10 units of output by spending an additional $1 on capital.

Then, we are told that the marginal product of labor is 20 and the price of labor is $2.50. The marginal disadvantage of $1 less spent on labor would be Marginal Product of Labor/ Price of Labor= 20/2.50= 8.

The firm would lose 8 units of output from spending $1 less on labor.

To compare, MPC/P > MPL/P

 60/6 > 20/2.50

So, the company achieves a net gain of 2 units of output if it transfers $1 from labor to capital. It will continue to transfer funds as long as it gains more output from the additional capital than it loses in output by reducing labor. Essentially, the company will increase in output and be capital-intensive for a period of time.

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