Consider an economy that uses two factors of production, capital (K) and labor (
ID: 1150738 • Letter: C
Question
Consider an economy that uses two factors of production, capital (K) and labor (L), to produce two goods, good X and good Y. In the good X sector, the production function is X = 4KX0.5 + 6LX0.5, so that in this sector the marginal productivity of capital is MPKX = 2KX-0.5 and the marginal productivity of labor is MPLX = 3LX-0.5. In the good Y sector, the production function is Y = 2KY0.5 + 4LY0.5, so that in this sector the marginal productivity of capital is MPK = KY-0.5 and the marginal productivity of labor is MPLY = 2LY-0.5. Finally, let the total endowment of capital in this economy be K = 800, the total endowment of labor be L = 1200, the price of good X be PX = 3 and the price of good Y be PY = 6.
Suppose now that the price of good X relative to the price of good Y increases. What will happen to the quantities produced? Are workers better off or are capital owners better off? Explain.
Explanation / Answer
We have the following information
MPKX = 2KX^-0.5 and MPKY = KY^-0.5, Px = 3 and Py = 6. Total capital units KX + KY = 800
Now rental income to capital should be same for both industries
Px * MPKX = Py * MPKY
6KX^-0.5 = 6KY^-0.5
KY/KX = 1 or KY = KX. Hence we have KX + KX = 800 or KX* = 400. This also gives us KY = KX = 400.
Now use the same process to find LX and LY because wage rate should be same for all labor types
Px * MPLX = Py * MPLY
3*3LX^(-0.5) = 6*2LY^(-0.5)
(LY/LX)^0.5 = 4/3 or 9LY = 16LX. Use the fact that LX + LY = 1200 or LX = 1200 - LY
9LY = 16*(1200 - LY)
19200 = 25LY or LY* = 768 and LX* = 432
The results are KY = KX = 400, LY = 768 and LX = 432. We also see that Px * MPLX = Py * MPLY and Px * MPKX = Py * MPKY. If there are no increases in PY, MPLY, MPLX, MPKY, MPKX and PX increases, then wage rate of workers in production of X and rental price of capital engaged in production of X will increase. Since LX is a smaller proportion of total labor than capital, capital owners will be relatively better off from this event.