Suppose government put a tax on renting capital so that firms need to pay τ fraction...

Suppose government put a tax on renting capital so that firms need to pay τ fraction of their capital rental expenses as a tax to government. Drive first-order conditions for capital and labor by solving firm’s maximization problem. What happens in labor, capital and financial markets in short run and long run? Explain in detail by showing the changes in the relevant markets.

Expert Solution

The government has put a tax on renting capital. This will dis-incentivize them to hire/take renting capital and they would opt for labor more. Hence this tool is used by the government in places where unemployment is hurting the economy.

1st order condition for capital and labor solving firm’s maximization problem will give the result that the firm will hire labor till the time when the Marginal cost of hiring labor plus tax equals the marginal cost of capital. But here we have assumed that the extra cost of substitution is zero and there is no hidden cost.

Note: For reference, short-run are in black pen and the long run is in blue pen.

Rahul Sunny answered 8 months ago

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Suppose government put a tax on renting capital so that firms need to pay τ fraction...

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