Question

Consider a firm who sells its products competitively at a price p = $90 per unit and whose production depends on two normal inputs, labour and capital, with prices wand r respectively. Suppose the price of the firm’s product decreases to p = $85 per unit, but the input prices w and r do not change. Which of the following is true about the resulting substitution and scale effects?

A.The substitution effect induces the firm to hire more labour while the scale effect works in the

opposite direction.

B.The scale effect induces the firm to hire more labour while the substitution effect works in the

opposite direction.

C.The scale effect induces the firm to hire less labour, but there is no substitution effect.

D.The substitution effect induces the firm to hire less labour, but there is no scale effect.

E.There will be no scale effect and no substitution effect.

Answer 1

As the input prices of capital and labour are kept constant then there will be no substitution effect. But due to fall in prices may be due to decreasing average cost due to an increase in the production volume gives rise to scale effect. I am going with C because there is no substitution effect and scale effect induces the firm to hire less labour and more capital which will be beneficial for the further production process.