To begin with, producer is in equilibrium at point ‘E’ on isoquant IQ, (Fig. 7.14), given the total outlay. Factor prices are denoted by iso-cost line AB.
Now, when the price of factor ‘X’ falls (price of other factor and total outlay remaining unchanged), the iso-cost line will shift outwards as more of factor ‘X’ can be employed as a result. ‘F’ is the point of producer equilibrium on iso-cost line AC in the new situation.
With further fall in the price of factor ‘X’, the iso-cost line shifts to the position AD. With this iso-cost line, the producer will choose factor combination ‘G’ on isoquant IQ3.
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These alternations in factor combinations as a result of changes in price are known as factor price effect or simply price effect. This effect is partly due to output effect (greater use of an input as higher level of output is produced) and partly due to technical substitution effect (costly input being replaced by a relatively cheaper one depending upon the elasticity of substitution between the two factors, a concept, the discussion of which just follows).
By joining various points of equilibrium like ‘E’, ‘F’ and ‘G’ in Fig. 7.14, we get a curve called price factor curve (PFC). The price factor curve may slope upwards or downwards to the right depending upon whether fall (or rise) in the price of factor ‘X’ causes increased (or decreased) purchase of the factor ‘X’ and decreased (or increased) purchase of factor ‘Y’ in the two cases respectively and vice-versa.
The analysis of the distribution of the two effects, i.e., output effect and technical substitution effect is quite analogous to the distribution of price effect under indifference curve analysis between income and substitution effects.
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In Fig. 7.15, the total effect of a fall in the price of factor ‘X’ is shown by a movement from point ‘E’ to point ‘F’ which has caused a rise in the employment of factor ‘X’ and an uncertain rise in the employment of factor ‘Y’.
If output is held constant at the original level by nullifying the output effect through an appropriate decline in outlay, the producer would reach at point ‘G’. Now, the movement from point ‘E’ to point ‘G’ is called the technical substitution effect, while the movement from point ‘G’ to point ‘F’ is called the output effect.
