Explain the output and factor substitution effects of an increase ...

[Mr.Thesaxman]

Explain the output and factor substitution effects of an increase in the price of capital on theDemand for labor by a firm that produces output using both capital and labor.
 
  What will be an ideal response?

Question 2

Refer to Table 4-4. The table above lists the highest prices three consumers, Curly, Moe, and Larry, are willing to pay for a bottle of champagne. If the price of the champagne falls from 24 to 14
 
  A) consumer surplus will increase from 80 to 95.
  B) consumer surplus increases from 32 to 53.
  C) Larry and Moe will receive more consumer surplus than Curly.
  D) Curly will buy four bottles; Moe will buy two bottles, and Larry will buy one bottle.

[Rilsmarie951]

Answer to Question 1

If the price of capital rises, the factor substitution effect suggests that the firm will substitute away from the more expensive input (capital) toward the cheaper input (labor). This means that the demand for labor would increase. However, the increase in the price of capital will also increase the cost of production, leading the firm to produce less. This is the output effect. If the firm produces less, it needs a smaller level of all inputs including labor. This would cause a decrease in the demand for labor. The full effect on the demand for labor depends on the relative sizes of the two effects.

Answer to Question 2

B