All else constant, an increase in a firm's cost of debt will most likely:

• A. Increase the firm's demand for labor
• B. Decrease the firm's profitability
• C. Lower the firm's equilibrium output
• D. Have no effect on the firm's production decisions

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the relationship between the firm's cost of debt and its overall costs. An increase in the cost of debt means the firm has to pay more interest on borrowed funds, which raises its total expenses.
2. Step 2: Recognize that higher costs reduce the firm's profitability because profit is calculated as total revenue minus total costs. When costs increase and revenue remains constant, profits decrease.
3. Step 3: Consider how a decrease in profitability affects the firm's production decisions. Lower profitability typically leads the firm to reduce output to avoid losses or to optimize production at a lower scale.
4. Step 4: Analyze the impact on labor demand. Since labor is a variable input, if the firm reduces output, it will likely demand less labor, not more.
5. Step 5: Conclude that the increase in the cost of debt decreases profitability and lowers equilibrium output, which in turn reduces the firm's demand for labor. Therefore, the correct effect is a decrease in the firm's profitability.