Explain the theoretical principles of production to explain ....

Explain the theoretical principles of production to explain the relative
substitution of one input for another occurring as a result of the increased price
of labour.

Answer. The production theory deals with quantitative relationships, i.e., technical and
technological relations, between inputs, especially labour and capital, and between
output and input.
The Laws of production
This law states the relationship between output and input. The traditional theory studies
the marginal input-output relationships under short run and long run. In the short run,
input – output relations are studied with one variable input, other inputs held constant>
the laws of production under these conditions are called ‘The laws of variable
proportions’. In the long run input-output relations are studies assuming all the inputs to
be variable. The long run relations are studies under ‘Laws of return to scale’.
Input Prices - Substitution Effect
Input prices do not remain constant. When input prices change, it changes the least
cost input-combination and also the level of output, given the total cost. If all the input
prices change in the same proportion, the relative prices of inputs remain unaffected.
But, when the prices change at different rates in the same direction, or change at
different rates in opposite direction or price o only one input changes while the price of
the other input remains constant, the relative prices of the inputs change. A change in
relative input-output prices changes both input-output-combination and the level of
output.
The change in the input-output combination results from the substitution effect of
change in relative prices of inputs. A change in relative prices of inputs implies that
some input has become cheaper in relation to the other. The cost minimizing firms,
therefore, substitute relatively cheaper input for the costlier one. This is known as
substitution effect of change in the relative input prices.
Substitution effect = Price effect – Budget effect
If the price of one input, say labour, increases, the firm will adjust the input mix by
substitution capital for labour. If the price of labour declines, thus making labour
relatively less expensive, labour will be substituted for capital. In general, if the relative
prices of inputs change, managers will respond by substituting the input that has
become relatively less expensive for the input that has become relatively more
expensive.
The isoquant – isocost framework can be used to demonstrate this principle. Let us
suppose the firm is currently operating at point a where 100 units of output are
produced using the resource combination (K = 10, L = 2). This is an efficient resource
mix because the 100 unit isoquant is tangent to the isocost line CC. If the firm’s goal is
to maximize production subject to a cost constraint (i.e., the firm is limited to resource
combinations on a given isocost function).
If the price of labour falls while the price of capital remains unchanged (i.e., labour has
become relatively less expensive), the isocost pivots to the right from CC to the isocost
CC1. The reduction in the price of labour means that the firm is able to increase the
rate of production. Hence the firm moves from point a to point b, which is a new
efficient resource combination. That is, the new isocost is tangent to the 120 –unit
isoquant at point b. Now 9 units of capital and 6 units of labour are employed/. At point
a, the efficient ratio of capital to labour was 5 : 1. Now the efficient ratio of two inputs is
3: 2. The reduction in the price of labour has caused the firm to substitute that relatively
less expensive input for capital.