Question

6. Substitution effect due to a relative change in input price Аа аа Suppose a firm is initially producing 100 units of output at point B, where the purple line (diamond symbols) labeled Isocosti lies tangent to isoquant IQ (Q = 100). Suppose that initially the wage is $10 and the rental rate of capital is $10. CAPITAL Isocosta 1919-1001 socost1 10 LABOR Now, suppose that the wage changes to . shifting the isocost curve from Isocosti to Isocost2. The new economically efficient way of producing 100 units of output is given by the input bundle at point

TRUE OR FALSE: As a result of the increase in wage, the firms supply curve will only change if its subsituties towards capital at each level of output.

Answer 1

Budget at w = 10 and r = 10 = 6*10 = $60.

Now wage changes to w’: such that 60/w’ = 2.

Wage changes to w’ = $30.

Economically efficient way to produce 100 units of output at new wage rate and the given capital cost is where the IQ = 100 is tangent to the isocost line with new slope = w’/r. This happens at point A, where more of capital is used in the production of output.

	Initial Wage	New wage
Total cost of producing bundle B	=r*K + q*L =10*3 + 10*3 =$60	=r*K + w’*L = 10*3 + 30*3 = $120
Total cost of producing using the new bundle	= 10*6 + 10*1 = $70	= 10*6 + 30*1 = $90

The supply curve is given by the marginal cost curve above the minimum point of Avergae cost curve. Thus the new supply curve is given by marginal curve above point W. Thus the correct option is (b).

False. The marginal curve or the supply curve changes when the price of either labour (wage) or the capital (r) change.