In Production and cost we proposed that firms choose their factors of production in accordance with costminimizing principles. In producing a specific output, firms will choose the least-cost combination of labour and plant size. But how is this choice affected when the price of labour or capital changes? Adjusting to such changes may require a long period of time, because such changes will usually require an adjustment in the optimal amount of capital to use. If one factor becomes more expensive, the firm will likely change the mix of capital and labour away from that factor.
This behaviour is to be seen everywhere, and explains why we have fundamental differences in production techniques in different economies. For example, Canadian farmers face high wages relative to the rental on a harvester, while in South Asia labour is cheap and abundant relative to capital. Consequently harvesting in Canada is capital intensive whereas in Asia it is done with lots of sickle-wielding labour.
In the short run a higher wage increases costs, but the firm is constrained in its choice of inputs by a fixed plant size. In the long run, a wage increase will induce the firm to use relatively more capital than when labour was less expensive in producing a given output. But despite the new choice of inputs, a rise in the cost of any input must increase the total cost of producing any output. This higher cost of production must be reflected in a shift in the supply curve and therefore be reflected in a change in the price of the final good being produced.
Thus a change in the price of any factor has two impacts on firms: in the first place they will substitute away from the factor whose price increases; second, since the cost structure for the whole industry increases, the supply curve in the market for the good must decline – less will be supplied at any output price. With a downward sloping demand, this shift in supply must increase the price of the good and reduce the amount sold. This second effect can be called an output effect.
To conclude: the adjustment responses of firms to changes in input prices are twofold: Firms adjust their combinations of labour and capital in accordance with the prices of each. But increases in input prices result in higher prices for final goods, and these higher prices reduce the demand in the marketplace for the good being produced. Such changes in turn reduce the demand for inputs.
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