Question

13. Consider the specific-factors model and use the following information to answer the questions below: Manufacturing: Sales revenue = PM · QM = 150 Payments to labor = W · LM = 100 Payments to capital = RK · K = 50 Percentage change in price = 0% Agriculture: Sales revenue = PA · QA = 150 Payments to labor = W · LA = 50 Payments to land = RT · T = 100 Percentage change in price = 20% Holding the price of manufacturing constant, suppose the price of agricultural good increases by 20% and the increase in wage is 10%.

a. What is the impact of the increase in the price of agricultural good on the rental for land and the rental for capital?

b. Explain what has happened to the real rental on land and the real rental on capital. In other words, based on your answer in a) above, why would the rental rate on land and capital change in this way?

c. If, instead of the situation considered above, the price of manufacturing was to fall by 20%, would landowners or capital owners be better off? Explain how the decrease in the price of manufacturing would affect labor income? Explain.

Answer 1

a).

Consider the given “factor specific model”. So, there are two sectors “agriculture sector” and “manufacturing sector”. So, “K” is used as a specific factor in manufacturing sector and “T” is used as a specific factor in agricultural sector. Now, “RK” and “RT” are the “rental payment of K” and “rental payment of T” respectively. So, “RK = Pm*MPK” and “RT = Pa*MPT”. Now, under the full employment assumption “MPK” and “MPT” are constant. Now, if “Pa” increases by “20%” and “Pm” remain same, => “RT” also increases by “20%” and “RK” remains constant.

So, the “rental payment for K” remains same and “rental payment for T” increases by “20%”.

b).

So, as we can see that “RT” increases and “RK” remains constant as before. So, the only reason is the full employment assumption. So, under the full employment assumption “MP” are constant, => the “R” will only change because of the change of “P”. So, here “Pa” increases, => “RT” increases and “Pm” remains same, => “RK” also remains same.

c).

Now, let’s assume that “Pm” decreases by “20%” and “Pa” remains same, => here “MPK” and “MPT” are constant, => “RK” decreases and “RT” remains same, => “capital owners” will worse off and “land owners” will neither better off nor worse off.

Now, as “Pm” decreases, => “W” also decreases, => under the full employment assumption the “labor income” is given by, “W*Lm+W*La = W*(Lm+La)”, where “Lm+La” is fixed, => as “W” decreases, => the total labor income also decreases. So, as “Pm” decreases implied the workers are worse off.