The scale effect suggests that as wages increase, the cost of producing output increases, leading to a decrease in a firm's demand for labor. Conversely, the substitution effect suggests that as wages increase, firms have an incentive to substitute capital for labor, leading to a decrease in a firm's demand for labor. Therefore, the scale and substitution effects move in opposite directions, and the firm's demand for labor decreases.

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When Wages Increase

Question 17

Multiple Choice

When wages increase,

A) the scale and substitution effects counteract each other and the firm's demand for labor remains the same.
B) the scale and substitution effects move in the same direction and the firm's demand for labor decreases.
C) the scale and substitution effects move in the same direction and the firm's demand for labor increases.
D) the scale and substitution effects move in opposite directions and the firm's demand for labor decreases.
E) the scale and substitution effects move in opposite directions and the firm's demand for labor increases.

Correct Answer: