Question

The following equations describe the long-run situation for prices and costs, where the numbers indicate the...

The following equations describe the long-run situation for prices and costs, where the numbers indicate the amounts of labor and land needed to produce a unit of corn and toys.

Pcorn = 80W + 40R

Ptoys = 100W + 30R

a. If the price of corn is initially 200 and the price of toys is initially 200, what are the values for the wage rate W and the rental rate R?

b. The price of corn now increases to 240. The price of toys stays the same. What are the new values for W and R after adjustment to the new long-run situation?

c. What is the change in the real wage (purchasing power of labor income) with respect to each good? Is the real wage higher or lower "on average"? What is the change in the real rental rate (purchasing power of land income) with respect to each good? Is the real rental rate higher or lower "on average"?

d. Is there a magnification effect (i.e., does the percentage real return of the rental rate rise change more than the percentage change in the price of corn)?

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Answer #1

c. If we notice then the wage falls from $1.25 to $0.50. Not just the wage falls but workers also experienced a rise in the price of corn while price of toys kept constant. Hence the purchasing power of workers (real wage rate) falls with respect to both goods.

The case of land owners (rent) is the opposite. After the price rise, the real rental rate increase. Since price of toys are held constant, purchasing power of rent increases with respect to toys. Also, the rate of increase in rentals is higher than rate of price increase in corn, hence the purchasing power of rentals also increases relative to corn.

d. The price of corn increased by (240-200)*100/100 = 40% and rent increased by (5-2.50)*100/2.50 = 100%. Thus there is indeed a magnification effect.

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