If the price of labor increases relative to the price of capital, and as a result the quantity of capital hired increases, the output effect of the price increase is greater than the substitution effect.

Question

Quizplus · Accepted Answer

When the price of labor increases relative to the price of capital, firms are likely to substitute labor with capital, leading to an increase in the quantity of capital hired. This change is primarily driven by the substitution effect, where capital is substituted for labor because it becomes relatively cheaper. The output effect refers to the change in the quantity of output produced as a result of the change in input prices and quantities. If the quantity of capital hired increases due to the substitution of capital for labor, it does not necessarily mean the output effect is greater; it indicates the substitution effect is dominating the firm's decision to adjust its input mix.

If the Price of Labor Increases Relative to the Price