Consider a firm that uses both labor and capital in production. The price of capital is $20 per unit and the wage rate is $10 per hour.
a. Draw the firm’s isocost line assuming a total production cost of $100. How steep is this line (that is, what is its slope)? Be sure to clearly label the axes.
b. Suppose the wage drops to $5 per unit. In which direction does the substitution effect change the firm’s demand for labor and capital? In which direction does the scale effect change the firm’s demand for labor and capital?
c. If the firm chooses its labor and capital combination to minimize its production costs, will the marginal product of labor be higher than, lower than, or equal to the marginal product of capital? Why? (Assume that the price of labor and capital are those given in part b.)