If the price of labor falls,
A) we can conclude that the demand for capital will always decrease because only the factor substitution effect is relevant.
B) we can conclude that the demand for capital will always increase because only the output effect is relevant.
C) the change in the demand for capital cannot be predicted because the factor substitution effect and output effect work in opposite directions.
D) the demand for capital will be unaffected, because only a change in the price of capital would change the demand for capital.

Question

Quizplus · Accepted Answer

The change in the demand for capital cannot be predicted because the factor substitution effect and output effect work in opposite directions. When the price of labor falls, two effects take place: the output effect and the factor substitution effect. The output effect suggests that with cheaper labor costs, firms will increase their production levels, which will increase the demand for both labor and capital. On the other hand, the factor substitution effect suggests that with cheaper labor costs, firms will reduce their demand for capital and increase their demand for labor. The net effect on the demand for capital cannot be predicted, as it depends on the relative magnitude of these two effects. Hence, option C is the correct choice.

If the Price of Labor Falls