Suppose a firm is currently minimizing costs in the long run with marginal product of labor and marginal product of capital given by K and L, respectively. If the price of capital falls by 50%, the capital-to-labor ratio will:
A) decrease by 50%.
B) double.
C) increase by 50%.
D) increase fivefold.

Question

Quizplus · Accepted Answer

In the long run, the firm will choose the capital-to-labor ratio such that the marginal product per dollar spent on labor is equal to the marginal product per dollar spent on capital. That is:

MP_L / W = MP_K / R

where W is the wage rate, R is the rental rate on capital, MP_L is the marginal product of labor, and MP_K is the marginal product of capital.

If the price of capital falls by 50%, then R is also reduced by 50% (assuming no other changes in factor prices). This implies that the ratio of MP_L to MP_K has to double to maintain the equality in the above equation. Therefore, the capital-to-labor ratio will double.

Suppose a Firm Is Currently Minimizing Costs in the Long