Substitution Effect of Capital Subsidy

Steps:

• Subsidies reduce the effective price of capital equipment.
• Labor and capital are substitutes, so firms respond by using more of the cheaper capital.
• Increased capital use raises its quantity demanded and employed.
• Substitution away from labor lowers its quantity demanded and employed.

Why A is correct:

• Per the substitution effect in microeconomics, a lower relative price of capital prompts firms to replace labor with more capital, increasing capital quantity and decreasing labor quantity.

Why the others are wrong:

• B: Reverses the substitution; applies if labor were subsidized instead.
• C: Subsidy lowers capital cost, so its quantity rises, not falls.
• D: Assumes complements, but substitutes mean one input displaces the other.

Final answer: A