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Suppose that Capital (K) and Labour (L) are perfect substitutes. Initially wage (w) rates are equal...

Suppose that Capital (K) and Labour (L) are perfect substitutes. Initially wage (w) rates are equal to the rental rate on K (r), this means that the firm is indifferent between choosing K and L. Suppose now that wage rate goes up. What happens to demand for L? What are the substitution and scale effects?

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Answer #1

It is given that Capital (K) and Labor (L) are perfect substitutes. Moreover, initially, the rental rate of K (r) and wage rate (w) of L were the same.

Now, it is given that the wage rate has increased. Usually there are two effects (1) Scale Effect that comes from the change in purchasing power of producer when price of K or L changes, and (2) Substitution Effect that comes from the change in the relative price ratio of K and L. However, since K and L are perfect substitutes so there will not be any scale effect.

The total effect of an increase in the wage rate will be the substitution effect in which producers will use only K.

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