Answer to Question #88903 in Economics for apikali veibataki

Question #88903

Consider a firm for which production depends on two normal inputs, labour and capital, with prices w and r, respectively. Initially the firm faces market prices of w = 6 and r = 4. The price of capital (r) then shifts to r = 6 while w remains the same. Use isocost-isoquant analysis to show and explain the following.
A. In which direction will 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 labour and more or less capital?

Expert's answer

A. The substitution effect will increase the firm’s employment and decrease capital stock

B. The scale effect will increase the firm’s employment and will not change capital stock.

C. So, we can we say conclusively that the firm will use more labour and less capital.