Question

Suppose labor and capital are substitute resources, and the price of capital decreases.

A. What happens to the demand for labor and capital?

B. Do the producers produce more or less of the final good?

C. Now suppose labor and capital are complement resources, and the price of capital decreases. Do the producers produce more, less, or the same amount of the final good?

I understand the answer to part A but I am unsure about B and C. Please explain your answers thoroughly.

Answer 1

A) When price of a good decreases, its demand increases. As price of capital decreases, demand for capital will increase. And, labor and capital are substitutes, so, if price of capital is cheaper then they will hire only capital. Demand for labor will reduce to zero.

B) They will produce same amount, only their input combination will change because the budget of production remains same.

C) Now, if they are complements, then with decrease in price of capital, demand for both labor and capital have to increase, otherwise capital would be wasted because they must be used together. So, demand for both would increase. When they increase the quantity of both of their inputs, then their output would increase. So, they would be producing more of the final good.