Question

Consider the production process used by Coca-Cola. Coke uses both labor and capital to make its products. Labor is creative. Workers design, manage, predict, forecast, and perhaps assemble. Workers do most of the high-level processes. Capital can be used in the form of computers to do some calculations, machines to transform the raw materials into the products, and buildings to house the production processes.

On a very small scale suppose Coke uses 10 units of capital and 25 units of labor. With this combination suppose the company can produce 5000 products. (Again this is just a small portion of the entire production. We could scale these numbers up to be more representative of the actual production).

Now suppose the price of labor increases. The company wants to replace some labor with capital and continue to produce the same level of output. Explain, using this example, that while the first extra unit of capital might replace a certain number of workers, the second extra unit of capital will necessarily replace a different amount of labor. Will it be more or less labor and why? Use the graph below, along with the concept of isoquants and the MRTS to support your answer. Be sure to clearly explain how the MRTS is represented in your graph. (You do not need to use any specific numbers in your explanation.)

HINT: Here, you are discussing the MRTS of capital for labor not the MRTS of labor for capital

Answer 1

As labor becomes more expensive, firms like Coca-Cola substitute labor with capital, initially replacing many workers with the first additional capital units, but fewer with subsequent ones due to diminishing marginal returns, as explained by the MRTS and depicted on an isoquant graph.

Step-by-step explanation:

When the price of labor increases, firms like Coca-Cola will seek to substitute labor with capital to maintain profitability and production levels. This substitution is guided by the concept of the marginal rate of technical substitution (MRTS), which measures the rate at which a business can replace labor with capital without affecting output. Initially, the first unit of additional capital might replace a significant number of workers due to the high productivity of new machinery or technology. However, as more capital is added, the MRTS indicates that each subsequent unit of capital will typically replace fewer units of labor. This is because the productivity of additional units of capital tends to decrease as more and more capital is used, a principle known as diminishing marginal returns.

In a graph depicting isoquants, which represent combinations of labor and capital that yield the same level of output, the slope of the isoquant curve—the MRTS—tends to become flatter as we move along the curve. This signifies that less labor is replaced by additional units of capital. Thus, with each additional unit of capital, the amount of labor that can be replaced diminishes. Hence, production technologies and the labor-to-capital ratio are strategically chosen based on input costs, which is exemplified by Coca-Cola's different manufacturing approaches in high-wage versus low-wage countries.