Question

If part of a firm’s capital stock is wiped out (perhaps from a natural disaster), what...

  1. If part of a firm’s capital stock is wiped out (perhaps from a natural disaster), what happens to the profit maximizing amount of labor demanded? Using the firm’s one period profit maximization graph to derive labor demand and the equilibrium labor market graph, trace out the effect of a natural disaster in the labor market.
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Answer #1

Considering Capital and Labour as substitutes of each other, when a firm's capital stock is wiped out from a natural disaster then firms tends to increase its labour demand. Profit is maximised when marginal revenue is equal to the Marginal cost of employing a factor of production. As we could see in the graph below E0 is the initial equilibrium where the prices of labour i.e. wage is equal to P0 and quantity demanded is equal to Q0. Now from a natural disaster firm has lost a part of capital stock so the firm will employ more labour. So now the labour demand curve shifts rightwards and E1 is the new equilibrium point where prices have raised up to P1 and the quantity of labour demanded has also increased to Q1.

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