Question

Suppose a typical firm uses K and L inputs that have per unit costs of w and c, respectively. Initially, the firm is in LR equilibrium when input prices are w=6 and c=4, then suppose input prices change to w=4 and c=2.

How will the substitution effect impact the firm’s utilization of K and L?

How will the scale effect impact the firm’s utilization of K and L?   

Overall, can we say with any certainty whether the overall utilization of K and L will increase, decrease, or remain the same? Explain.

Do NOT wait until the last minute to answer questions 15–18 because a new labor market report will be released 8:30 am EST on Friday, March 2 and some of these data may no longer be visible on the summary table.

Go to the Bureau of the Labor Statistics ( HYPERLINK "http://www.bls.gov/" http://www.bls.gov/) and examine the data in summary Table A: on the BLS front page, right side column, “Latest Numbers”, Unemployment Rate, click on the icon that looks like a report (not the graph), click on Summary Table A.) Support your answers with data.

Answer 1

Initially firm is in long run equilibrium and we know long run equilibrium is at a point where MRTS=MPL/MPK=W/C

Thus initially MPL/MPK=6/4=3/2

When W/C changes to 4/2=2

MPL/MPK also needa to be equal to 2.

Thus MPL needs to rise and MpK needs to decrease.

MpL will increase only when Labor is decreased because of law of diminishing returns and MPk will decrease only when K is increased. Thus at W=4 and C=2, labor needs fo be decreased and capital needs to be increased in order to achieve new long run equilibrium.