When wages increase, the net effect on the level of capital used depends on the relative magnitudes of the factor substitution and output effects.

Question

Quizplus · Accepted Answer

When wages increase, firms may substitute labor for capital to reduce costs, which is the factor substitution effect. However, the output may also increase in response to higher wages, leading to a greater demand for capital, which is the output effect. The net effect on the level of capital used will depend on the relative magnitudes of these two effects.

When Wages Increase, the Net Effect on the Level of Capital