Suppose that the wage rate (w0) is the only relevant cost of labour (i.e. there are no quasi-fixed costs). Also assume that all workers and jobs are homogeneous. Suppose a firm produces a single output food using two inputs, labour N and capital K. The quantity of output is given by the technology Q=F(K,N). These two inputs are imperfect substitutes (i.e. the isoquants have the standard convex shape). The rental price of capital is r0. The firm is both perfectly competitive in the output and input markets.

To stimulate investment, the government now offers a subsidy which effectively brings the price of capital down to r1long-run, will the quantity of labour demanded by the firm increase, decrease. or stay the same? Provide a detailed analysis for each of these 2 cases:

A) The demand for the output is perfectly inelastic

B) The demand for the output is somewhat elastic and slopes downward.

Draw isocost-isoquant diagrams. Denote the initial equilibrium by E0 (before the capital price change). Denote the new, long-run equilibrium allocation of labour and capital by E1. Indicate each step of your analysis on your diagram and explain in words these steps.