Question

In: Economics

In 2016 Obama’s administration presented a budget plan. It proposed an increase in defense spending by...

In 2016 Obama’s administration presented a budget plan. It proposed an increase in defense spending by $54 billion (more than a 10% raise):

Let’s suppose that a new corporate tax plan includes investment breaks that stimulate firms to invest in physical capital. Can you asses the consequences of the establishment of investment tax breaks on productivity of capital (MPK), productivity of labor (MPL) and investment? use all equations and graphs.

Solutions

Expert Solution

Increase in defense is considered to be the public expenditure. The new corporate tax which include investement breaks that increase the incentives for the firms to invest more in the physical capital. If we go step by step on impact of investment breaks on MPK and MPL we have to first understand the law of diminishing marginal returns which states that after some optimal level of capacity is reached, adding an additional factor of production will actually result in smaller increases in output assuming the state of technology to be constant. Only one input should be variable. keeping other inputs constant. This law does not apply to cases when all the inputs vary proportionately. In that case, the returns to scale comes to the rescue.

In simpler words, the total productivity, for a given state of technology, is bound to increase with an increase in the quantity of a variable input. However, as the quantity of the inputs keeps on increasing, the marginal product rises to a maximum, then starts to decline and eventually becomes negative. If the labor is keeping fixed , and we keep on increasing the capital , the marginal productivity of the capital will increase and reach to it maximum at the optimal level and after the optimal point of capital , MPK will start falling. MP curve of factors of production is an inverted U shaped. Assuming , the technology is fixed and the labor is assumed to be constant , The new tax will incentivse the firm to employ more capital and the cost of procuring the capital and investment in capital is less , they will employ ,more capital which will increase the MPK till it reaches to the new optimum and then MPK will be maximum at optimal capital and then MPK will start falling . MPL will remain constant.

For competivite market equibirium , optimum quantity of factors of production will be at the point where

marginal cost of capital = mariginal product of capital...............(1)

marginal cost of labour = mariginal prodictivity of labor. ..................(2)

Since , labor is constant at l1*, after new tax regime, cost of capital will come down
at intial level of capital K1*, MPK>MC (marginal cost of capital) , firms have incentive to increase capital qunatity till some new opitimal level let say K*2, MPK will incraese till point K*2, after K*2 MPK will start falling and will become negative also if firm keep on increasing capital.


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