Cost-minimization analysis is an overview of what it is.
Cost minimization is a rule used by producers to determine what mix of labor and capital will produce the lowest cost output.What is the most cost-effective way of delivering goods and services while maintaining a desired level of quality?
Understanding why cost minimization is important and how it works is an essential financial strategy.
In the long run, a producer has a lot of flexibility over all aspects of production, such as how many workers to hire, how big of a factory to have, what technology to use, and so on.A producer can change the amount of capital and labor it uses over time.
Capital and labor are inputs in the long-run production function.q is the quantity of output that is created.
There are a number of ways in which a certain amount of output can be created.If you want to make sweaters for your business, you can either hire people or buy knitting needles or machines.
The first process uses a small quantity of capital and a large amount of labor, whereas the second process is "capital intensive".You can choose a process that is between the 2 extremes.
How can a company decide what mix of capital and labor to use when there are so many different ways to produce a given amount of output?Companies want to choose the combination that produces the most output at the lowest cost.
One option would be to map out all of the combinations of labor and capital that would yield the desired quantity of output, calculate the cost of each option, and then choose the option with the lowest cost.This is not feasible in some cases.
There is a simple condition that companies can use to determine if their mix of capital and labor is cost minimizing.
At the levels of capital and labor, the marginal product of labor divided by the wage is the same as the capital product.
When the additional output per dollar spent on each of the inputs is the same, you can think of cost being minimized and production being most efficient.You get the same "bang for your buck" from each input.This formula can be used to apply to production processes that have more than 2 inputs.
To understand why this rule works, we need to consider a situation that is not cost minimizing.
There is a production scenario where the marginal product of labor divided by the wage is greater than that of capital.