Suppose that Canada wants to subsidize production from capital. Production is given by Y = A * K^α * L^1−α. The market for labor and capital is competitive, and producers do not own capital. The government pays producers a fraction τ for each unit of revenue generated from capital.
1. How does this change the “user cost of capital” arbitrage equation?
2. What is the new rental rate of capital? Write the new rental rate in terms of the rental rate prior to the policy and the amount of the subsidy per unit of output (τ ).
3. What happens to the amount of capital used by producers in response to the new policy?
4. Suppose that, in the long run, the policy does not change the growth rate of capital; and that depreciation and capital’s share of output do not change. What happens to the I/Y ratio?