Choice of technique
When factor prices are given and constant as they are supposed to be to a firm under theoretically perfect competition and factor proportions are variable, you choose that combination of factors in production which equates the relative prices of factors to their relative marginal productivity.
The object is to minimize cost of a given output. The combination that you choose gives you the technique of production. The prices of factors depend upon their relative degree of scarcity. If labour is more scarce relatively to capital, you choose a relatively capital-intensive technique. If, on the other hand, capital is more scarce than labour, you choose a relatively labour-intensive technique. The production function, together with factor prices, solves the problem of choice of technique. So choice of technique is important.
Let us be clear about the assumption that we are making here. The output is given, and the same given output can be produced by varying proportions of capital and’ labour. You may use a little less of labour and a little more of capital, or you may use a little more of labour and a little less of capital, and yet you will get the same output.
There is, however, one particular proportion which satisfies the minimum cost condition, and it is this proportion that you choose. The technique thus is independent of the scale of production.
Now vary the hypothesis and assume that the volume of capital howsoever it might be measured is given, while labour is variable at constant price. Here the output will vary with every variation in the labour-capital ratio, i.e. with every variation in the technique of production. In what manner? Applying the so-called law of non-proportional returns, one finds that with given capital and varying labour employment, the output goes on increasing up to a point and then declines. Over a range, increasing labour-capital ratio yields increasing returns. But beyond a point, there is too much of labour used with relatively too little of capital and you have the phenomenon of ‘diminishing returns’. Where do you fix your technique in this case? Applying the principle of minimum cost, you choose that technique where the wage rate is equal to the marginal product of labour.
If you make your technique more labour-intensive, although your total output may increase, the wage rate exceeds the marginal product and, therefore, the average labour-cost of output increases. In both these cases the criterion of choosing the technique is the same the criterion of minimum cost, which is the only valid economic criterion. However, whereas in the former case, since the output to be derived is given and the problem of technique is a problem of the substitution of labour for capital, the pertinent equation is the equation between relative factor prices and relative marginal product in the latter case, since the volume of available capital is given, so that capital figures as Ricardian land, the relevant equation is the equation between the price of the variable factor, labour, and its marginal product. So choice of technique is important.
Now, it is this latter hypothesis which forms the basis of recent discussions on the choice of technique. The discussion arose first in the context of the reconstruction of war-devastated economies and then extended to the problem of planned development of underdeveloped economies. These economies have two things in common a plethora of unemployed labour and a limited supply of capital. The aggregate of this capital is composed in varying proportions of foreign aid (Marshall Aid, for example) and internal savings. It is reasonable to assume in the context of these economies that, while the form in which capital is to be used is variable, the volume of capital as such is not. Since, therefore, the form which the given capital is allowed to assume determines the amount of labour that a unit of capital can accommodate at full capacity, the question naturally arises as to how labour-intensive (or capital-intensive) the technique of production should be what, in other words, should be the amount of labour employed per unit of capital with reference to the varying forms that the available capital might be given.
The problem is complicated by the fact that there exists in such economies a plethora of unemployed labour, so that the supply of labour is perfectly elastic as much to the economy as a whole as it is supposed to be to a firm under perfect competition. So choice of technique is important.