Suppose capital is readily substitutable for labor and that the price of capital falls. We can conclude that the
A) substitution effect will tend to reduce the demand for labor.
B) output effect will tend to reduce the demand for labor.
C) demand for labor will necessarily decline.
D) demand for labor will necessarily increase.

Question

Quizplus · Accepted Answer

When the price of capital falls, firms tend to substitute capital for labor, which decreases the demand for labor due to the substitution effect. This is because firms will find it cheaper to use capital instead of labor. However, the output effect could potentially increase the demand for labor if firms are able to produce more output with the cheaper capital, but this effect is uncertain and depends on the specific production function. Therefore, A is the best answer as it highlights the substitution effect's dominant impact on decreasing the demand for labor.

Suppose Capital Is Readily Substitutable for Labor and That the Price