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Chapter 7: Problem 6

Suppose the economy takes a downturn, and that labor costs fall by 50 percent and are expected to stay at that level for a long time. Show graphically how this change in the relative price of labor and capital affects the firm's expansion path.

Short Answer

Expert verified
A decrease in labor cost will shift the expansion path to become steeper, signifying an increased employment of labor relative to capital at each level of output. This is visually represented by an upward pivoting of the expansion path over time.

Step by step solution

01

Understand the Problem Context

Firstly, one should acknowledge an economic downturn, which reduces the labor costs by half, and this situation is anticipated to persist indefinitely. When labor becomes cheaper, it becomes more efficient to employ labor than capital, which changes the firm's expansion path and production decisions.
02

Recreate the Initial Graph

Start with a graph that represents the initial condition, where the cost of labor and capital are equivalent, rendering an isoquant straight down the middle of the graph. The isoquant, which represents different combinations of labor and capital that produce the same level of output, should be tangential to the lowest isocost line (depicting choices of capital and labor combinations at a given cost).
03

Depict Economical Downturn

Since labor costs fall by fifty percent, readjust the isocost line, as it can now be obtained at half the previous cost. Rotate the isocost line counterclockwise around the capital axis. It will intercept the vertical axis further up since more labor can be hired for the same cost.
04

Draw the New Expansion Path

The new expansion path should be drawn to reflect the lower cost of labor. It will slope upwards and become steeper than the original path, since more labor will be used for the same level of output. It should be drawn such that it is tangential to all isoquants, representing the optimal choice of capital and labor at each level of output.

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Most popular questions from this chapter

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