Question

A decrease in the price of capital will cause a firm to use more labor: A. regardless of the relative size of the substitution and scale effects. B. under no circumstances. C. if the scale effect is larger than the substitution effect. D. if the substitution effect is larger than the scale effect. E. only in the short run.

Answer 1

Option C.

• A decrease in the price of capital will cause a firm to use more labour if the scale effect is larger than the substitution effect.
• Scale effect occurs when the firms take advantage of lower price of labour and the substitution effect occurs when the firms take advantage of the lower wages.
• The firms have more incentive to use labour intensive production methods Inorder to create more demand on their goods when the price of capital is low.
• The firms do so because the scale effect increases the demand for goods when the price of capital decreases.
• This will increase the demand for workers as firms are ready to hire more labour.