During the past few years , the automobile industry has recieved government support. In the production economy, this support would be modeled as a transfer to the firms. Youve been asked to consider the effects of this policy. Tax revenue is collected through a lump sum tax on consumers.

No Policy: the government collects a lump-sum tax of To=40 and consumes G=40. with no policy the firm pays dividend income of 35 units to the stand-in customer. Under no policy, the representative firm behaves like our standard production economy.

Policy 1. The government is commited to transferring 10 units to firms. The government collects enough tax revenue to consume 40 units and make a lump sum transfer Q=10 to firms. Let T1 be the lump sum tax collected under this policy.

Policy 2: Instead of a lump-sum payout, this policy aims to make the firms more efficient. The proposed policy uses the 10 units to fund investments in productivity. Therefore the firm does not recieve a lump sum transfer. Rather, the firm now has a 5% increase in total factor productivity. The total tax revenue collected is the same as under policy 1 but none is transfered back to either the consumer or firm. Let T2 be the lump sum tax collected under this policy. since there is no transfer G2=T2. Assume that the stand-in consumers dividend income is the same under No policy and Policy 2.

1. For policy 1 write out the firms production function. How would their profit maximizing choice of labor compare to the choice under no policy?

2. How would the profit maximizing choice of labor under policy 2 compare to the choice under No policy?

3. Compare the consumers budget constraint under policy 1 and policy 2. (Hint: I think the easiest way to compare the two budget constraints is to graph them) Explain weather Policy 2 COULD make the consumer better off than policy 1. make sure to address the income and substitution effects.