The main aim of a producer is to continue production activities with least costs. For this purpose, he combines different factors of production in such a way that the costs incurred for hiring their services are minimum. He continues his efforts in this regard until he arrives at the least cost combination of factors.
In order to arrive at the least cost combination, the producer follows the principle of equi-marginal returns or the principle of substitution. He makes a comparison between the marginal productivity of different factors. He substitutes that factor whose marginal productivity is greater in the place of lower marginal productivity factors. He may substitute labour in the place of machinery or machinery in the place of labour. For example, he engages 5 units of capital + 2 units of labourers or 2 units of capital+ 7 units of labourers for producing 100 units of output. Here he substitutes labour for machinery or machinery for labour for getting the estimated output. This is possible under marginal conditions.
The substitution of one factor in place of another depends on two elements namely 1) Marginal productivity, (2) prices of the factors. So the produce, while substituting the factors compares the marginal productivity. Let us suppose that marginal productivity of factor ‘A’ and its price are greater than the marginal productivity and price of factor ‘B’. So he will substitute A in place of B. He follows this, principle of substitution until the marginal productivity and price of the factors are equal.
Thus, he arrives at the least cost combination. He does not like to change this combination because he can’t attain equilibrium either before or after this Combination. It is only at combination, the producer will be in equilibrium.
Least Cost Combination Equation :
The least cost combination or optimum factor combination or producers equilibrium is shown by an equation as follows:
MP of Factor A/Price of factor A = MP of Factor B/Price of factor B = MP of Factor C/Price of factor C [where MP is Marginal Productivity]
The above equation explains that a producer substitutes the factor’s A, B and C until their marginal productivity become equal. Here production costs will be minimum. Such a combination of factors is known as optimum factor combination. The optimum factor combination determines how factors of production are allotted between different firms and industries.
Limitations of Principle Of Least Cost Combination:
There are certain limitations to the principle of least cost combination.
1) All the factors of production are not perfectly divisible. Substitution of factors is not possible in the case of such factors.
2) It is not possible to estimate correctly the marginal productivity of every factor of production.
3) The producer has to determine not only the optimum combination of factors but also the optimum returns to scale. So it becomes a difficult task for him to arrive at a least cost combinations of factors.
This law is also known as the Principle of Substitution or Equi-marginal Returns on production or Optimum Factor Combination.