(continued from previous question) Another councilman suggests that – instead of
ID: 1250292 • Letter: #
Question
(continued from previous question)
Another councilman suggests that – instead of imposing a tax on pollution discharges – the town should
offer firms a subsidy per unit of pollution that they do not discharge into the river.
5. Suppose that each firm in the industry minimizes the cost of producing a given level of output.
· How would such a subsidy affect the relative wage rate? Explain.
· How would such a subsidy affect the optimal combination of capital and labor that
each firm uses to produce output? Explain.
· Illustrate your answer to the previous question with isoquants and isocosts.
Explanation / Answer
You have to think of this in a kind of weird way. Subsidies are always equivalent to taxes. In this case, it's as if the town were giving firms a big wad of cash if they were to use zero capital. For each unit of capital that they use, the cash is reduced. It's implicitly a tax on using capital. There's this extra cost of using capital -- the lost subsidy. Once more, this causes capital to become more expensive relative to labor, so the relative wage decreases. The income and scale effects are just the same as with a tax: capital use goes down, while labor depends on which effect dominates. The shape of the isoquant curves stays the same, and isocost curves pivot in exactly the same way that they did with the tax.
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