Assume the price of capital falls relative to the price of labor and, as a result, the demand for labor increases. Therefore,
A) capital is very highly substitutable for labor.
B) the output effect is greater than the substitution effect.
C) the income effect is greater than the output effect.
D) the substitution effect is greater than the output effect.

Question

Quizplus · Accepted Answer

When the price of capital falls relative to the price of labor, firms are more likely to employ labor instead of capital in their production processes. In this case, the demand for labor is likely to increase, leading to both substitution and output effects. The substitution effect occurs as it becomes cheaper to hire labor than capital, and the firm substitutes labor for capital. The output effect occurs as the reduction in the price of capital leads to an increase in the demand for all inputs, including labor, which increases total output. However, since the price of labor increases with increased demand, the income effect is less likely to be greater than the output effect. Instead, the output effect is likely to be greater than the substitution effect. Therefore, option B is the correct answer. Option A is incorrect because it assumes that capital is a perfect substitute for labor. However, in most cases, capital and labor are complementary inputs. Option C is incorrect because it assumes that the income effect is greater than the output effect, which is unlikely to be the case. Option D is incorrect because it assumes that the substitution effect is greater than the output effect, which is also unlikely to be the case.

Assume the Price of Capital Falls Relative to the Price