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Chp5Review - AP/ECON3240 Review Material for chapter 5 A...

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AP/ECON3240: Review Material for chapter 5 A. Required Reading: Textbook (BGLR) pp. 151-169 B. Answers to End-of-Chapter Review Questions Review questions 1-3 on page 181. 1. This is an interior solution where the isoquant is tangent to the isocost line. The marginal rate of technical substitution between labour and capital is equal to the ratio of their prices. Any other point in the diagram is either unattainable for the firm, or is sub-optimal, meaning that the firm can make higher profits by a substitution of one input for another. The firm's expansion path is the locus of points (capital/labour combinations) that the firm chooses as it expands production. Do not confuse it with the labour demand curve, which is in employment-wage space. The expansion path is always in labour-capital space, which is just like the isocost and the isoquant curves. Normally, we would expect the expansion path to be positively sloped - as output expands, the firm hires more labour. It need not be a straight line, however, and in general it is not. 2. For an inferior factor of production, as the level of output increases (decreases), the quantity demanded of the factor falls (increases), all other factors held constant. How would the firm's demand for labour be altered if labour were an inferior factor of production? The scale effect of a wage decrease would be negative (production increases, so the quantity demanded of labour decreases for an inferior factor), but the substitution effect would be positive, working in the direction of an increase in the quantity demanded of labour. The quantity demanded of labour would still increase. The labour demand curve still has a negative slope. Note than in this case, the two effects work in opposing directions. 3. This statement is false. See the end of the section entitled ‘the demand for labour in the short run’. The theory of labour demand assumes that labour is homogenous in quality. The negative relationship is due to a negative scale effect and a negative substitution of a wage change on the quantity demanded of labour. C. End-of-Chapter PROBLEMS PROBLEMS No. 1, 2, 3, 4, 5 on Page 182. Suggested Answers 1. a) Given that the production function is Q = 2L 1/2 , we can derive the function for the marginal product of labour, which is the derivative of that function with respect to labour input: 1/L 1/2 . The next step is to derive the function for the marginal revenue product of labour. Assuming that the product market is perfectly competitive, the MRP = VMP = Price*marginal product of labour, which works out to: 10/L 1/2 (given a wage of $10.00). Since the firm’s demand curve for labour is the same as its MRP curve (provided 1
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that we are below the firm’s average revenue product curve), it follows that the expression for the demand curve is W = 10/L 1/2 . Solving for L, we have L = 100/W 2 . Note that there is a negative relationship between L and W, as there should be.
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