Marginal Decision Rule in Factor Mix

A firm can vary its factor mix at any level of total cost. The marginal decision rule says that a firm will shift spending among factors as long as the marginal benefit of such a shift exceeds the marginal cost. The marginal benefit of $1 spent on capital is the marginal product of capital divided by its price. The cost of spending $1 less on capital is the output lost from cutting back $1 worth of labor.

Questions

• What is the marginal benefit of $1 spent on capital?
• What is the cost of spending $1 less on capital?
• How does the marginal decision rule determine the optimal factor mix?

Answers

• The marginal benefit of $1 spent on capital is the marginal product of capital divided by its price.
• The cost of spending $1 less on capital is the output lost from cutting back $1 worth of labor.
• The marginal decision rule determines the optimal factor mix by comparing the marginal benefit of spending $1 on one factor to the marginal cost of spending $1 less on another factor.