Question

1. What is an example of the substitution effect?

   1. Workers choose to provide more hours of labor when the wage rate decreases.

   2. Hiring more labor as long as the marginal product of labor is positive.

   3. The firm expands output when production costs fall.

   4. The firm hires more labor when the wage falls because labor has become relatively

      cheaper compared to the price of other factors of production.

Answer 1

Option D

• Substitution effect is an effect caused by the increase in prices that persuades a consumer to consume more of the lower priced goods and less of a higher priced one.
• Substitution effect is not limited only to consumer goods but are also visible in other sectors like demand for labor and capital.
• The above example states that the firm hires more labor when the wages fall because labor has become relatively cheaper compared to the price of other factors of production.