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

The substitution effect is the tendency for producers to substitute the relatively cheaper input (labor) for the relatively more expensive input (capital). The output effect is the tendency for producers to increase output in response to a decrease in the price of one of the inputs. In this case, the substitution effect is greater than the output effect, because the decrease in the price of labor has led to a decrease in the quantity of capital employed.

If the Price of Labor Falls Relative to the Price