Final answer:
An increase in the capital stock increases the real wage and increases employment. This is due to higher labour productivity resulting from better or more capital, leading to increased demand for labour which pushes wages and employment upwards. The substitution and income effects influence labour supply, but the increased demand for labour often outweighs the income effect in this scenario.
Step-by-step explanation:
Holding other factors constant, an increase in the capital stock increases the real wage and increases employment. When a firm's capital stock increases, this typically leads to higher labour productivity as workers have more or better tools, machinery, or technology at their disposal. According to economic theory, an increase in labour productivity can lead to a rise in the demand for labour because more productive workers are more valuable to firms. As the demand for labour rises, the equilibrium quantity of labour and the real wage rate also tend to increase.
The labour supply decision is affected by changes in the real wage due to the substitution effect and the income effect. An increase in real wages encourages workers to work more as the opportunity cost of leisure increases; this is the substitution effect. Concurrently, the income effect suggests that higher real wages allow individuals to maintain the same standard of living while working less, which could lead to a decrease in the quantity of labour supplied. However, in the context of an increase in capital stock, the demand for labour increases, often outweighing the income effect and increasing wages and employment.
The increase in the capital stock is related to the production possibilities of the firm. If a firm adopts new technologies or increases its capital stock, it can choose production methods that require less labour but enhance overall productivity. Higher productivity can justify higher wages and can encourage firms to employ more workers to maximize the use of their capital enhancements, thus increasing employment.