Question

The virus has caused governments to tell people that they can not go out or go to work.

Using our model what will this forced drop in L do to?

1. Output

2. MPL?

3. Real Wages?

4. MPK?

5. interest rates?

6. Capacity utilization of capital?

Do you think these predictions from the model are actually happening?

If not why?

model is the production function Y=A•f(K,L)

Answer 1

1. Output would fall. Itis so because L has fallen with K unchaged. And we know that the production function is increasing in L..

2. MPL of the existing emplyees has gone up. It is so because MPL is decreasing in L. Hence if L falls , MPL would rise.

3.If MPL is rising, real wages should rise too. It is so because real wage is the return to labour effort.

4.MPK should fall as there are less workers now per unit of capital. As a result capital is not being used as much as it could have been.

5.Fallen. Because MPK has fallen and the income of the capital is interest earned. Hence, if MPK has fallen, interest rate too must have fallen.

6.Reduced. It is because L has fallen whereas K is unchanged as a result of which firms are sitting with excess capacity. Capital is being underutilised.

No, not all predictions from the model are actually happpening. It is so because here we are not modelling AD and price behaviour. Equilibrium is reached when both AD and AS are looked at together. We cannot comment about the equilibrium values by just looking at the problem from one side.