Suppose a firm employs only capital and labor as inputs. Explain how the firm should allocate its inputs in order to maximize profits in a perfectly competitive market.

What will be an ideal response?


To maximize profits, the firm should allocate the two inputs so that the marginal revenue product (MRP) of each of the two inputs equals its input price, i.e., the MRP of capital equals the price of capital (cost per unit of service), and the MRP of labor equals the price of labor (wage rates).