Question

1. Assume that a competitive economy can be described by a constant-returns-to-scale Cobb-Douglas production function and all factors of production are fully employed. Holding other factors constant, including the quantity of capital and technology, carefully explain how a one-time, 10 percent increase in the quantity of labor as a result of a special immigration policy, will change the following: (12 points)
   1. The level of output produced
   2. The real wage of labor
   3. The real rental price of capital
   4. Labor share of total income

SHOW ALL WORK AND RATIONALE.

Answer 1

a) As due to the diminishing returns to labor theory the output will increase at less than 10% with an increase in input which is labor.

b) The real wage of labor will decrease because the output increases at a decreasing rate so the average productivity of labor which is Y/L will fall which will result in fall in marginal productivity of labor.

c) The rental price of capital will increase as Y/K which is referred to as average productivity of capital is increasing because the output is rising but the capital is not. so Marginal productivity of capital will also increase.

d) Labor share of total income will not change as the parameter on which it depends does not change in the production function