Isoquant-isocost analysis can be used to solve short-run production problems as well. Variable inputs are often substitutable for each other, and the firm faces a short-run decision concerning the combination of variable factors (in conjunction with fixed factors) which would minimize cost for a particular output level. A firm may have the choice of hiring either “generalist” labor (who can accomplish a sequence of tasks) or, alternatively, hiring “specialist” labor who can each do only one of the required tasks. Thus these two different types of labor are substitutable in the short run, presuming each can be hired or fired at management’s discretion.
Similarly, labor may be substitutable for raw materials in some production processes. For example, three workers and ten yards of cloth may combine (along with the fixed factors) to produce five shirts per hour. Alternatively, five workers and eight yards of cloth may combine to produce five shirts per hour. The extra labor allows more careful cutting of the cloth so that there is less waste of the material. A further example is the substitutability among different sources of energy. A firm can install
254 Production and Cost Analysis
electric heating to supplement or replace its oil heating system if the cost of oil rises relative to that of electricity.
Example: The “energy crises” of 1974 and 1979 spurred the movement away from petroleum-derived energy and toward alternative energy sources. Oil prices shot up dramatically during 1979, following the turmoil in Iran, and after a short decline, continued their upward thrust when war broke out between Iran and Iraq in September 1980. Heating oil consumption in the winter of 1980-1981 was substantially below projections, however, indicating the shift from petroleum as an energy source to competing energy sources. 5
In terms of Figure 6A-5, where we show fuel oil on the horizontal axis and electrical energy on the vertical axis, suppose that the initial price ratio was such that the isocost line in early 1979 was MN. To produce output level Q 0 , the firm would choose the combination of fuel oil and electrical energy represented by points, or To units of fuel oil and E 0 units of electrical energy. The rise in oil prices is indicated by the shift of the isocost curve to MN'. To maintain its output at level Q 0 , the firm (and households which had the ability to do so) would prefer to substitute away from fuel oil and toward electric energy to point B on isoquant Q 0 . Thus, after the adjustment process, the firm would purchase E\ units of electrical energy and F\ units of fuel oil. In fact, we ob-
FIGURE 6A-5. Response of Cost-Minimizing Firm to a Change in Fuel Oil Costs
served a shift away from petroleum-derived energy and toward a variety of other energy sources, including solar and nuclear energy.