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Concept
Isocost
Summary
In economics, an isocost line shows all combinations of inputs which cost the same total amount. Although similar to the budget constraint in consumer theory, the use of the isocost line pertains to cost-minimization in production, as opposed to utility-maximization. For the two production inputs labour and capital, with fixed unit costs of the inputs, the equation of the isocost line is
where w represents the wage rate of labour, r represents the rental rate of capital, K is the amount of capital used, L is the amount of labour used, and C is the total cost of acquiring those quantities of the two inputs.
The absolute value of the slope of the isocost line, with capital plotted vertically and labour plotted horizontally, equals the ratio of unit costs of labour and capital. The slope is:
The isocost line is combined with the isoquant map to determine the optimal production point at any given level of output. Specifically, the point of tangency between any isoquant and an isocost line gives the lowest-cost combination of inputs that can produce the level of output associated with that isoquant. Equivalently, it gives the maximum level of output that can be produced for a given total cost of inputs. A line joining tangency points of isoquants and isocosts (with input prices held constant) is called the expansion path.
Conditional factor demands
The cost-minimization problem of the firm is to choose an input bundle (K,L) feasible for the output level y that costs as little as possible. A cost-minimizing input bundle is a point on the isoquant for the given y that is on the lowest possible isocost line. Put differently, a cost-minimizing input bundle must satisfy two conditions:
it is on the y-isoquant
no other point on the y-isoquant is on a lower isocost line.
If the y-isoquant is smooth and convex to the origin and the cost-minimizing bundle involves a positive amount of each input, then at a cost-minimizing input bundle an isocost line is tangent to the y-isoquant.
Official source
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