The owner of Instant Printing, a firm that prints business cards, tells you that as a result of an increase in the wage rate of printer operators he has reduced the amount of output he produces and the amount of capital he uses. How would you respond to this?
A) You should tell him that this doesn't make any economic sense because according to the factor substitution effect he should have substituted toward capital and away from labor.
B) This seems logical, because the output effect of a factor price increase would cause a firm to demand less of all inputs, not just the input whose price increased.
C) You should tell him that instead of reducing output and the demand for all factors of production, he should increase output and the demand for all factors of production so that he can meet the higher labor costs by generating more revenue.
D) You tell him that capital must be an inferior input, because he reduced his use of capital when the price of labor increased.

Question

Quizplus · Accepted Answer

This is a reasonable response, as the output effect of a factor price increase would cause a firm to demand less of all inputs, not just the input whose price increased. The substitution effect, which would lead the firm to substitute toward capital and away from labor, may not be strong enough to outweigh the output effect in this case.

The Owner of Instant Printing, a Firm That Prints Business