Methods of production will change if the relative prices of factors change. Relatively more of
the cheaper factor and relatively less of the more expensive factor will be used.The principle of substitution plays a central role in resource allocation
because it relates to the way in which individual firms respond to changes
in relative factor prices that are caused by the changing relative scarcities
of factors in the economy as a whole. Individual firms are motivated to
use less of factors that become scarcer to the economy and more of
factors that become more plentiful. Here are four examples of the
principle of substitution in action.
In recent decades, advances in information and communications
technology (ICT), and massive declines in the price of ICT capital, have
changed many everyday activities, including banking. Banks used to
employ thousands of tellers to handle deposits and withdrawals at
hundreds of branches across Canada. But now most retail bank
transactions are done at automated teller machines (ATMs) or over the
Internet by computer or smartphone. Banks have followed the principle
of substitution by substituting away from labour and toward ICT capital
as the price of the latter has declined.
The principle of substitution can also explain why methods of producing
the same product often differ across countries. In Canada, where labour is
generally highly skilled and expensive, farmers use advanced machinery
to economize on labour. In many developing countries, however, where
labour is abundant and capital is scarce, a much less mechanized method
of production is appropriate. The Western engineer who believes that