Question

What is the effect of a fall in price of capital on the optimal amount of labor and capital

used in production? Explain your answer using diagram(s), and explain scale and

substitution effect.

Answer 1

Ans

Optimal amount of both will rise. This is because it is profitable to produce more output. Initially the firm is in equilbrium at A where it produces Q1 output. Now when price of capital falls isocost line shifts from PQ to PR. Final equilbrium is at c where firm produces Q2. To break it into substitution and scale effect we draw isocost line St parallel to PR. It reflects new prices but old budget. This line is tangent to Q1 at B. Movement from A to B is substitution effect as it occurs because firm substitutes cheap capital for labour. Movement from B to c is scale effect.