Application of Isocost, Isoquant and Classic Model in the Economy - Lab Report Example

1) Isocost: A line along which, the cost production of combination of two factors is constant. Since these are usually drawn for given prices, which are therefore constant along the line, an isocost line is usually a straight line, with slope equal to the ratio of the (factor) prices. As this can be seen from the definition of isocost lines that these can be made with the combination of the price levels of two or more components or factors of production and results in the straight line because the prices of the factors of production are constant along the given line. An isocost line is a line showing combinations of inputs that would yield the same cost. Therefore, the word isocost implies that the cost of the given factors of production are constant along the certain activity level and thus can be used for the planning and decision making purposes. In the above figure, L denotes the amount of labor utilized by the producer and K denotes the amount of capital utilized by the producer. It is evident from the figure that along the line the cost of both of the factors of production is same and the total cost of production is also shown on the graph for different cost lines. With the help of isocost lines, most economic and cost beneficial decision can be made for getting the desired output. This graph also shows that isocost lines are the straight lines and the only different in them is that they shift up or down the graph showing the same pattern for different activity levels. These isocost lines are parallel because each reflects the same relative resource price. Isoquant Given a production function, an isoquant is "the locus of input combinations that yield the same output level." (Chiang, p. 360) There is an isoquant set for each possible output level. Mathematically the isoquant is a level curve of the production function. Isoquants is a concept relating to the quantity of input required to produce a certain level of output. For a given level of output, there are certain levels of input of production factors that yield the same level of output. If the ratio of two or more of the factors of production is changed then the resulting yield of those input factors can be same for all of the combinations of factors. This implies that the concept of isoquant deals primarily with the cost minimization problems of producers. The above figure shows different levels of labor and capital required to produce a certain output of a particular product and the curve shows that different combinations of input resources can be made to get an output of predetermined rate. This graph compels us to make certain generalizations about the isoquant curves and these are: 1 Isoquants further from the origin represent greater levels of output. 2 Isoquants slope downward. 3 Isoquants never intersect. 4 Isoquants tend to be convex — that is, bowed towards the origin These generalizations about the nature and behavior of isoquant curves tell us how they work and how the information provided by these curves at different output levels can be utilized by the manufacturer or producer of a particular product for minimizing the costs for a given level of output. Through the help of these curves those points can be calculated which achieve the best combination of factors of input to ensure the lowest possible cost required to make a particular product at the desired output level. This is particularly important in the case where one of the many factors of production is in scarcity as compared to others or in terms of prices; one resource is more expensive than others. In these situations, isoquants help to ensure that an appropriate mix of input resources is utilized to make the desired level of output, thus resulting in the optimal use of the scarce or more expensive resource as well as achieving the cost minimization goal and resultantly achieving the optimal profit level at a certain level of output. Useful in Economic Analysis The point of tangency between the isocost line and the isoquant shows the minimum Cost required producing a given output. For the purpose of knowing which is the most suitable and cost minimizing point or pattern for production which will result in the optimal utilization of resources at a particular output level, both of the isocost lines as well as isoquants are brought together and the point where both of these curves meet is considered to be the best option for production mix. The point of intersection of isocost and isoquant curves is the point where isocost line is tangent to the isoquant curve and this is the very point at which given level of output should be produced with the amount of inputs provided by the intersection point. 2) Classical Model Classical model can be defined by:  A model of the economy in which, it is assumed that prices, wages and interest rates are flexible, so that all markets clear. In such an economy factors are fully employed, and the growth of output depends on the growth of available factor supplies. Classical model of economics is the self sustaining model for the utilization and application of resources available to the economy. It is based on the principle that the supply and demand will balance themselves over a period of time to achieve an equilibrium level at which the market will operate and there is no need to regulate the workings of the market. One of the most famous and important concepts this model introduced was the concept of “Laissez Faire” which means “Let it be”. It implies that there should not be any intervention from the governing authority in the market workings and the markets should be set free to find equilibrium for itself. According to the Classical model, there comes a point after verifying various positions of market that factors of production are fully utilized up to the extent of their full potential and the price of the product is set by that appropriate utilization of factors of production. During this period the price of the factors of production will not remain constant whereas it will also look for a stage where the factors and their prices will reach at equilibrium. Classical model states that during the period of time when markets are looking for their equilibrium point, there should be no intervention in the market by government or any other governing authority and the markets should be set free to settle all the matters themselves. Two of the most important factors of production are Capital and Labor at a given level of technology and due to the fact that firms produce the homogeneous products. The total amount of income generated by the economy is represented by the production function of Capital and Labor. With the help of production function economy wide marginal product of labor is calculated, which in turn is used to calculate the real wage rate prevailing in the economy. With the help of production function, economy wide marginal product of capital is also calculated, and so, the real rate of return on physical investment is determined. After determining the marginal productivity of labor and marginal production of capital and with the use of related wage rates and rate of return on physical investments, the assessment of the employment level of the economy is made and the level of outputs that can be achieved by the economy in the long run. If the return on investment is higher in the economy then people will have more propensities towards investing instead of savings. In this scenario more and more employment will generate to satisfy the demand of labor and thus a competitive wage rate will prevail in the economy. Production function is the key, according to the classical model, for the determination of output level to be achieved by the economy. Thus, there are generally three characteristics that the production function must exhibit. (a) The production function is increasing in both labor and capital. (b) The production function exhibits diminishing returns from both labor and capital. (c) Production function exhibits constant returns to scale. This means that if we increase both the labor and capital, then the output should also increase and vice versa. Moreover, it implies that if you add more labor , the amount of output produced should also go up but up to some extent and as you keep adding more and more labor, marginal increase in the output starts decreasing and the effect is addition of resources is not going to effect the level of output significantly. This is true for capital as well. It also states that the returns to scale remain constant, for example, if you double or halve the inputs then the outputs will also get double or halve respectively. Technological advancement has the same effect on the economy. With the increase in productivity, more and more capital is being utilized for creative works and exploration of new fields. More capital is used whereas labor resources are involved in the work that is more productive, result oriented and value added. This model comfortably applies to the technological advancement scenario in which more valued output is generated and the resources are utilized to their fullest. Read More