Compare and explain the significance of the substitution and output effects as they apply to resource pricing. What relationship, if any, do they bear to the income and substitution effects discussed in connection with product demand?

Question

What will be an ideal response?

Answer 1

In both cases the effects apply to the relationship of the product or resource to its substitutes. In the case of resource pricing, if the price of a substitute resource declines, this will cause a decrease in the demand for the original resource as producers hire more of the substitute. However, there may be an offsetting output effect, as lower costs mean that the producer will find it profitable to produce and sell a larger output that may require more employment of all resources including the one that was originally displaced.
In the case of the income and substitution effects discussed with regard to product demand, they tend to reinforce one another in the case of a normal good. If the price of a substitute product declines, it will cause a decrease in the demand for the original product because buyers will buy more of the now lower-priced substitute in place of the original product. However, buyers will also find that they have more income left to spend since their costs have declined and this may cause them to buy more of everything.