Firms achieve the greatest possible output for a given total cost by operating where the ratios of marginal product to factor price are equal for all factors of production. For a firm that uses labor (L) and capital (K), for example, this requires that MPL/PL= MPK/PK, where MPL and MPK are the marginal products of labor and capital, respectively, and PL and PK are the prices of labor and capital, respectively. Suppose these equalities hold and the price of labor rises. The ratio of the marginal product of labor to its price goes down, and the firm substitutes capital for labor. Similarly, an increase in the price of capital, all other things unchanged, would cause firms to substitute other factors of production for capital. The demand for capital, therefore, would fall.
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