Question

In an attempt to stimulate production and employment (L) in industry X, suppose that Party A in Congress proposes a policy that significantly and permanently reduces the cost of capital (K) to that industry. Some lawmakers in Party B oppose the policy arguing that while it might increase production, it will certainly not increase employment, in fact, it will reduce employment in industry X.

Discuss the conditions under which Party A’s predictions are more likely to be realized.

Answer 1

Firms are expected to hire labor and capital using an optimal input mix rule where MPL/w = MPK/r where MPL is marginal product of labor. MPK is marginal product of capital, w is the wage rate and r is the capital cost/capital rent

Now if r or capital cost is reduced, we expect that more labor is hired and employment is increased only when MPL/w > MPK/r. This is possible only when the firms were previously facing a condition MPL/w > MPK/r and reduction in capital cost does not alter this condition.

If the firms were facing either MPL/w = MPK/r or MPL/w < MPK/r, and then the capital cost is reduced, we see that first condition MPL/w = MPK/r, becomes MPL/w < MPK/r and second condtion, MPL/w < MPK/r, remains the same. Hence employment can increase only when before the change the firms were facing MPL/w > MPK/r and the fall in capital cost does not alter these condition.