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

This is because the scenario described is related to the substitution effect, where a change in the relative price of an input leads to a substitution towards the relatively cheaper input. The idea of derived demand is related to the demand for an input which is derived from the demand for the output it helps produce. The law of diminishing returns refers to the decline in marginal productivity of an input as more units are added. The output effect is related to a change in the price of output affecting the quantity of inputs used to produce it.

A Firm Will Employ More of an Input Whose Relative