If the price of labor falls relative to the price of capital, and as a result the quantity of capital employed decreases, then it can be concluded that
A)the substitution effect is greater than the output effect.
B)the output effect is greater than the substitution effect.
C)the income effect is greater than the output effect.
D)labor cannot be easily substituted for capital.

Question

Quizplus · Accepted Answer

When the price of labor falls relative to the price of capital, firms are more likely to substitute labor for capital because labor becomes cheaper. If the quantity of capital employed decreases as a result, it indicates that the substitution effect (the change in the quantity of capital and labor used due to the relative price change) dominates any output effect (the change in production levels due to the change in overall cost of production). This means firms are substituting labor for capital rather than increasing overall production enough to use more of both inputs.

If the Price of Labor Falls Relative to the Price