Question

To answer these questions use the neoclassical model.. For simplicity assume (as Mankiw does) that labor supply is perfectly inelastic with respect to real wage and that private savings does not depend upon the real interest rate.

1. The Labor Market Suppose that an earthquake destroys part of the capital stock. Predict what will happen to

(1) total production,

(2) the real rental rate of capital, and

(3) the real wage.

For simplicity, assume that the size of the population is unaffected.

Answer 1

When the capital is stock is reduced and the population of worker is not changed, then capital per worker will fall. This indicates that the marginal productivity of capital will increase. As capital becomes more productive there will be an increase in the demand for capital and a decrease in the demand for labour.

This will reduce the real wage rate and increase the real rental rate of capital as a result. Total production may or may not change depending upon the number of workers and amount of capital the nation has.