A firm will employ more of an input whose relative price has fallen and, conversely, will use less of an input whose relative price has risen. Thus, a fall in the price of capital will increase the relative price of labor and thereby reduce the demand for labor. This describes the
A)output effect.
B)substitution effect.
C)idea of derived demand.
D)law of diminishing returns.

Question

Quizplus · Accepted Answer

The substitution effect describes how the change in the price of an input affects the firm's choice between different inputs. When the price of capital falls, it becomes cheaper relative to labor, leading firms to substitute labor with capital, hence reducing the demand for labor.

A Firm Will Employ More of an Input Whose Relative