Suppose that there is a decline in the cost of a unit of capital. In the long ru

Question

Suppose that there is a decline in the cost of a unit of capital. In the long run:

a.) What will be the substitution effect of this change on use of capital and labor, and why?How would this be shown on an isoquant diagram? (a diagram isnt needed, just an explanation.)

b.) What will be the scale effect of this change on use of capital and labor and why? How would this be shown on an isoquant diagram? ( a diagram isnt needed here either.)

c.)What will be the net or total effect of this decline in the cost of capital on the use of capital and labor?

Explanation / Answer

The labor demand curve is given by VMPE = MR x MPE. As demand for the firm’s output increases, its marginal revenue also increases. Thus, an increase in demand for the firm’s output shifts the labor demand curve to the right. To determine how an increase in the price of capital changes the demand for labor, suppose initially that the firm is producing 200 units of output at point P in the figure. The increase in the price of capital (assuming capital is a normal input) increases the marginal costs of the firm and will reduce the profitmaximizing level of output to say 100 units. The increase in the price of capital also flattens the isocost curve, moving the firm to point R. The move from point P to point R can be decomposed into a substitution effect (P to Q) which reduces the demand for capital, but increases the demand for labor, and a scale effect (Q to R) which reduces the demand for both labor and capital. The direction of the shift in the demand curve for labor, therefore, will depend on which effect is stronger: the scale effect or the substitution effect.

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