A rational producer always attempts to attain largest volume of output from a specified factor expenditure outlay on factors like such factors are joined in an optimal or most proficient manner. The producer maximizes his profits and generates a given level of output with least combination of factors. This extent of cost combination of factors will be optimum for him.
Figure: Producers’ Equilibrium
In the above figure, E is the point of equilibrium, where isoquant IQ2 is tangential to isocost line at AB. Provided budget line AB, points ‘P’, ‘N’ and ‘F’ are beyond the reach of the producer and points ‘R’ and ‘S’ on isoquant IQ1 provide less output than the output at the point of equilibrium ‘E’ that is on IQ2. The amount spent on combinations R, E, and S is similar as all the three points lie on identical isocost line. However the output generated at point E is higher as E lies on higher isoquant. Given the isocost line and the sequence of isoquants (i.e., isoquant-map), a producer will select that level of output, where a given isocost line is tangential to the highest probable isoquant.
Therefore the producer is in equilibrium at point E where the isoquant is tangential to the isocost line. At this position, the slopes of isoquant and isocost line are equivalent. Therefore at equilibrium point the marginal rate of technical replacement is equivalent to the price ratio of factors. Therefore, the circumstance for producer’s equilibrium is
MRTSxy = PX/PY
At this point of equilibrium, the combination E (that is, OL of labor and OQ of capital) is termed as least cost.
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