David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

I 0.1 The firm's demand for factors in the long run
expensive capital, use labour-intensive techniques. Workers with scythes and shovels do the jobs done by
combine harvesters and bulldozers in the UK.
A higher wage makes the firm substitute capital for labour in making a given output. But it also raises the
total cost of producing any output. Firms still use some labour, for which they now pay more than before.
With higher marginal costs, but unchanged demand and marginal revenue curves, the firm chooses to
make less output.
Thus a rise in the price of one factor not merely changes factor intensity at a given output, but also changes
the profit-maximizing level of output. Studying consumer decisions in Chapter 5, we saw that a change in
the price of a good has both a substitution effect and an income effect. The substitution effect reflects the
change in relative prices of different goods and the income effect reflects changes in real income as a result
of the price change. The demand for production inputs works in exactly the same way.
There is a pure substitution effect at a given level of output. A higher relative price oflabour compared with
capital leads firms to substitute capital for labour. But there is also an output effect, the analogue of the
income effect in consumer demand theory. By raising the marginal cost of producing output, a rise in the
price of labour leads to a lower output.
In the long run a rise in the wage will reduce the quantity oflabour demanded. The substitution effect leads
to less demand for labour and each output, and the output effect reduces the demand for all inputs.
A rise in the wage also affects the long-run demand for capital and other inputs. At any particular output,
the firm substitutes capital for labour. However, with lower output it needs less capital input. The overall effect
could go either way. The easier it is to substitute capital for labour, the more likely is the substitution effect
to dominate. Firms will substitute a lot of capital for labour. The quantity of capital demanded will rise.
The demand for factors of production is a derived demand. It depends on demand for the firm's output.
The output demand curve affects the output effect on the demand for inputs when an input price changes.
In Figure 10.l at the original wage, the long-run marginal cost curve LMC of output is LMC0. A rise in the
wage shifts this up to LMC1• The original profit-maximizing point is A. If the firm faces a horizontal
demand curve DD, output falls from Q0 to Q1. With the less elastic demand curve D'D', the firm still begins
at A where LMC0 equals MR, the marginal revenue curve corresponding to D'D'. Now the shift to LMC1
leads to a much smaller fall in output. The new output is Q2 and the firm is at C.
GI
Po D "*----i--llf--
MR'
D'
A wage increase will have a substitution effect
leading firms to substitute relatively more
capital-intensive techniques. Nevertheless, total
costs and marginal costs of producing output
will be greater than before. Facing the horizontal
demand curve DD, a shift from LMC0 to LMC1 will
lead the firm to move from A to B and output will
fall from Q0 to Q1. This tends to reduce the
demand for all factors of production. Facing the
demand curve D'D' and corresponding marginal
revenue curve MR', the upward shift from LMC0 to
LMC1 leads the firm to move from A to Cat which
marginal cost and marginal revenue are again
equal. The output effect reduces output only from
00 to 02.
Figure 10.1
The output effect of o woge increase
225