Resource

Price per Unit of Resource

Resources Required

Technique 1

Technique 2

Technique 3

Units

Units

Units

Land

$2

2

2

3

Labor

$4

3

2

1

Capital

$3

1

2

3

Entrepreneurial Ability

$5

1

1

1

Problem:

Suppose there are three techniques for producing 1 wool blanket, as shown in the table above.

1. With the resource prices shown, which production technique will the firm use? Why?
2. Suppose the firm can sell blankets for $26 each. Will the firm be profitable?
3. Assume a new technique, call it Technique 4, is developed that economizes on the relatively expensive labor. It requires 2 units of land, 1 unit of labor, 3 units of capital, and 1 unit of entrepreneurial ability. Will the firm adopt this new technique?
4. Suppose the firm's cost of capital rises to $5, all other values being the same. Which technique will the firm now choose?

Answer:

1. The firm will choose technique 2. Its land cost is $2x2 = $4, its labor cost is $4x2 = $8, its capital cost is $3x2 = $6, and the cost of its entrepreneurial ability is $5x1 = $5, for a total cost of $4 + $8 + $6 + $5 = $23. By comparison, each of the other techniques have a total cost of $24.
2. Yes—If each blanket sells for $26 and can be produced at a total cost of $23, the firm will make $3 profit on each one.
3. Yes—The cost of producing a blanket would fall to $2x2 + $4x1 + $3x3 + $5x1 = $22. This is $1 cheaper than its current production technique.
4. Technique 1 is now cheapest, with a total cost of $26. By contrast, Techniques 2, 3 and 4 now cost $27, $30, and $28, respectively.