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substitution effect

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Consider a firm where production depends on two inputs: labor and capital, with prices w and r, respectively. Initially, the firm faces market prices of w=6 and r=4. these prices then shift to w=4 and r=2.

a) in which direction with the substitution effect change the firm's employment and capital stock?

b) in which direction will the scale effect change the firm's employment and capital stock?

c) can we say conclusively whether the firm will use more or less labor? more or less capital?

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Assess the substitution effect.

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a. In order to see in what direction will the substitution effect go, we must compare the relative price of labor to capital (or capital to labor, the final answer would be just the same) before and after the price change. The relative price prior to the change was 6/4 = 1.5. This means that labor was 1.5 times more expensive than capital; or ...

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