If a large decrease in rent leads to a firm cutting back on the labor it uses,

Question

Quizplus · Accepted Answer

When the rent decreases, the firm's cost of production decreases. This creates a substitution effect where the firm substitutes capital for labor since capital becomes relatively cheaper compared to labor. However, if the firm reduces labor, its output might decrease due to lower labor inputs. This effect is called the output effect. Therefore, the substitution effect and the output effect are both present when there is a decrease in rent. But if the substitution effect outweighs the output effect, the firm will reduce labor inputs and vice versa. In this case, a large decrease in rent is likely to lead to a significant reduction in the cost of capital and thus, the substitution effect will be stronger, leading to a cut back on labor used by the firm. Hence, option B is the correct answer.

If a Large Decrease in Rent Leads to a Firm