Question

1. Consider a firm in the long run. Initially the firm faces a wage of $8 to hire labor and rent of $10 to rent capital. Suppose the wage then increase to $10.

a. Describe what will happen to the isocost and isoquant curves due to the wage increase.

The total effect of the wage change can be separated into two effects.

b. In which direction will the substitution effect change the firm’s employment and capital stock?

c. In which direction will the scale effect change the firm’s employment and capital stock?

d. Can we say conclusively whether the firm will use more or less labor? More or less capital?

Answer 1

a) intially the isocost pivots through the initial isoquant, then the final isoquant lies parallel to the pivoted line.

b) substitution effect will lead to decrease in labor demanded and increase in capital employed.

c) Scale effect or income effect will lead to decrease in both capital and labor demanded.

d) we can say conclusively that less labor will be hired because both scale and substitution effect go in the same direction. But we cannot say anything about capital. If substitution effect dominates more capital will be hired and if scale effect dominates less capital will be hired.

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