Question

1.) If L and K are substitutes in production, what happens to the amount of L and K used when the cost of capital falls?

2.) Show (1) graphically

3.) Reproduce your graph from (2), and add a scale effect

Answer 1

1. When there is substitution between labour and capital, it means that labour can be substituted for capital and capital can be substituted for labour. Thus if cost of capital falls, it is possible to substitute labour for capital. This will lead to decline in K/L ratio as quantity of labour used in production increases through substitution.

Thus when the cost of capital increases compared to labour, labour will be substituted for capital since labour and capital are substitutes.