AnsExam1_S08 - ECO 311: Intermediate Macroeconomics...

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ECO 311: Intermediate Macroeconomics Professor: Constantine Alexandrakis Answers to Exam 1; Spring 2008 You have 55 minutes to complete this exam. Please put all your answers in the blue book, and store away any cell phones, notes, books, and other material. Allocate your time wisely. Good luck! I. (30 pts.) According to the neoclassical theory of distribution, the division of GDP among the factors of production depends on the price of each factor, which is determined in the market for that factor. Suppose that only two factors are needed for production, capital and labor, so that ( 29 L K F Y , = . Suppose also that the supply of each factor is fixed, so that K K = and L L = . a. (10 pts.) Draw two graphs, one representing the market for labor and the other representing the market for capital, and show the equilibrium price of each factor. b. (10 pts.) Explain why the demand for each factor is downward sloping, which means that when the price of each factor drops firms hire more of that factor. Ans. The demand for each factor slopes downward because of the law of diminishing marginal returns, which states that, holding the other factors constant, each additional unit of the factor is less productive than the previous one (or in other words that the marginal product of each factor drops as the quantity of that factor used increases). Because firms hire only those units that can produce more or at least as much as the price firms have to pay for that factor, when the price of the factor is high the firms hire only the first few units that are very productive. When the price of the factor drops, it becomes worthwhile for firms to hire additional units of that factor even though they may be less productive. Hence, the quantity demanded of the factor increases as its price falls, so we end up with a downward-sloping demand curve. w/p R/p Ls Ks Kd = MPK Ld = MPL (w/p) eq (R/p) eq
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c. (10 pts.) Suppose that technological change is continuously raising the productivity of workers. Shift the appropriate curve in the labor market and explain what will happen to the market (equilibrium) real wage over time. Ans. If workers are becoming more productive the labor demand curve, which is also the Marginal Product of Labor curve will keep shifting right (increase). This shift represents that since workers have become more productive firms will be willing to hire more at each given real wage (the quantity indicated as L 1 ). But since there are
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AnsExam1_S08 - ECO 311: Intermediate Macroeconomics...

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