Inverse demand function, Microeconomics

Inverse Demand Function: If variable factor prices changes, then the isocost line will tilt and consequently, the optimal factor requirement will be different. Suppose the wage rate of labor is allowed to vary. The resulting locus of profit maximizing amount of labor is referred to as the inverse demand function for labor. It measures what the price of labor must be to get certain units of labor, when the level of the other factor is fixed.

2183_Inverse Demand Function.png


• Expansion Path: This line shows how the factor combinations utilized by a firm changes as it expands its level of output. It is the locus of points of tangency between the isoquants and isocost lines.

• Price Factor Curve (PFC): Holding total cost fixed, factor prices are allowed to vary. If e change the price of L and hold the price of K fixed then the isocost will tilt. The locus of optimal factor combination points is known as the price factor cost. Note that this is the long run equivalent of the inverse demand function.

663_Inverse Demand Function1.png

• Effect of Change in the Factor Price: The total effect of a change in the price of a factor can be divided in 2 - the expansion or output effect and the technical substitution effect. The output effect refers to the changes caused due to the alterations in the total cost. Technical substitution effect is the result of the change in the relative price of the factors. This is similar to the effect of changes in the price of a commodity that we mentioned under Slutsky equation.

• Expenditure Elasticity :This measures the percentage change in the factor used in response to the change in the total cost. If this value is greater than 0 then the factor is superior, otherwise it is inferior.

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