Choosing the Cheapest Mix of Inputs

How firms decide how much labour and capital to use, why they substitute machines for workers when wages rise, and what this means for different countries.

A firm can often produce the same output using different combinations of inputs. A textile factory could use many workers with simple machines, or fewer workers with advanced machines. How does it decide?

Different ways to make the same output

Economists describe combinations of inputs that produce the same output with an isoquant, meaning “equal quantity”. Along an isoquant, a firm can substitute capital for labour, or labour for capital, while producing the same amount.

Cost minimisation

Firms aim to produce their chosen output at the lowest cost. The best mix depends on input prices:

If wages are low and machines expensive, firms use more workers and fewer machines.
If wages are high and machines cheap, firms use more machines and fewer workers.

At the cost-minimising mix, the extra output from the last rupee spent on labour equals the extra output from the last rupee spent on capital. If one input gives more output per rupee, the firm shifts toward it.

Why production looks different across countries

This explains why the same product is often made differently in different countries:

In countries with low wages, factories may use more labour-intensive methods, such as manual sewing or hand assembly.
In high-wage countries, factories use more automation.

Economists call a country’s relative abundance of labour or capital its factor endowments, and these shape both production methods and trade patterns.

Responding to price changes

When wages rise, firms substitute toward machines. This is one reason China’s factories have automated rapidly as wages rose. When machines become cheaper, as with robots and software, firms also shift toward capital.

Two ways to harvest

In one country, labour is cheap, so farms hire many workers to harvest by hand. In another, wages are high, so farms buy combine harvesters. Both produce grain; each chooses the mix of inputs that is cheapest given local prices.

Thinking the most advanced technology is always the most efficient

The best technology depends on input prices. In a low-wage country, labour-intensive methods may be cheaper and create more jobs, even if more automated methods are available.

Key takeaways

Firms can produce the same output with different mixes of labour and capital.
They choose the mix that minimises cost given input prices.
Low-wage countries tend to use labour-intensive methods; high-wage countries automate more.
Rising wages or cheaper machines lead firms to substitute toward capital.