Microeconomics

Topic 2: Income and substitution effects

In terms of economics, the income effect portrays the effect of the increased purchasing power on consumption. In microeconomics, the effect of income is the alteration in demand for a commodity or service caused by a change in a buyer’s buying capacity that results from a change in real income. In simple words, it can be said that the fluctuation in the income of a consumer leads to a change in the buying behavior as well as the buying process of the buyer. In case a consumer earns more, then he or she can afford a lot of commodities at once. Whereas in case the consumer earns limited money, he or she will not be able to consume a higher level of commodities. The changes that occurred by the income effect can be the cause of an increment in wages, salaries, etc. or because the current income is freed up by an increase or decrease in the price of a good that money is being expensed on. In the case of the inferior goods, the effect of income level controls the effect of substitution and makes the buyers buy more of a commodity and less of substitute goods at the time of the increment of prices.

On the other side, the effect of substitutes is the change in the demand for a good or service because of an alteration of the relative price of the good than that of the other substitute goods. As an example, in the case of the increment in the price of a commodity, the commodity turns to be more expensive relative compared to the other goods in the market. Therefore, it makes the consumer switch their preferences from good commodities to their substitutes. In simple words, it can be said that if substitute goods of better commodities are sold at a reasonable price as compared to the original one or if the price of a commodity rises to a higher level, the consumers will prefer to consume goods from the substitute market. Hence, the substitute of a commodity has a higher effect on the overall market structure (corporatefinanceinstitute.com, 2020).  There is a truth in inverse when the income decreases. Therefore, the substitution in the direction of purchasing items with less price has a generally negative result on the retailers because it means lower profits. Such effects also indicate a small number of options for the consumer. It is a fact that the retailers who sell items with lesser prices on a general basis typically take advantage of the substitution effect.

Figure 1: An Increase in the Price of x

Source: (Notes)

In the given figure, the consumer earns less in the sense that bundles in the shaded area are no longer available. In the graph, there is an increment in the price of x, which can be identified with the budget line. Therefore, the increment is between B1 and B2, and hence there will a change in the demand for the commodities accordingly (Www2.econ.iastate.edu, 2020).

Figure 2: Income and Substitution effects

Source: (Econpage.com, 2020)

Topic 4: Backward bending labor supply curve

In economics, the supply curve refers to a graphic demonstration of the correspondence between the cost of the commodity and the number of goods and services supplied for an expected period. As per the elaboration of the supply curve in-depth, it can be said that the price will become visible on the left vertical axis, whereas the number of items supplied will become visible on the horizontal axis. In most of the cases in the supply curve, as there is an increment in the price of a commodity, the number of items supplied will also increase. Hence, it can be said that the quantity supplied and the price of the commodity has a parallel relationship with each other. However, the upgrading technology that boosts up the efficiency lowers the labor cost, which also increases the price of a commodity (britannica.com, 2020). The supply curves can reflect whether the commodity will be experiencing an increase or decrease in the price depending on the demand, and vice versa. In general, the supply curve will have a movement upward starting from left to right. This movement indicates the law of supply, which states that if the goods price is increased, then the quantity of the supplied will also increase (Pettinger, 2020).

In the field of economics, a backward-bending supply curve of labor, also known as backward-bending labor supply curve, refers to a graphical tool indicating circumstances in which as real wages enlarge ahead of an assured level, people will surrogate spare time (time that is not paid) for the work time that is payable and therefore higher wages causes a decrease in the labor supply and so less labor-timing being offered for sale. Generally, a supply curve indicates an enhancement in supply as an increase in the wage rate. Therefore it slopes from left to right.

Figure 3: Backward bending labor supply curve

Source: (Notes)

As per the explanation for the provided note, it can be said that, as there is an increase in the wages, the wage line, which is originated at M, becomes steeper, and the optional position alters from A to B to C, as the wage upgrades from W1 to W2 to W3. On the other side, the lower part indicates the sum total of labor supplied at the different rates of wage that are (a, b, and c) on the supply curve denoted by S corresponding to the optional positions A, B, and C. The focus of optional points in the provided figure in the notes creates the supply curve below.

Therefore, in terms of the backward bending supply curve, there is an increase in the W, which is an increase in labor supply at a low rate of wage, however, declining at the higher rate of wage. As per the fact that there is a decrease in the labor supply, there will be an increase in the demand for leisure, where W is the price of leisure.

Topic 5: Producer equilibrium

In the field of microeconomics, equilibrium is said to be a state of rest when there are no requirements of any change. In this context, a producer who is also recognized as a firm is said to be in equilibrium, when it has no leaning to spread out or to contract its output. Therefore, the state either reflects a higher number of profits or a lesser number of losses. In general, the producer equilibrium is illustrated in terms of marginal revenue (MR) and the marginal cost (MC) (toppr.com, 2020). Therefore, the profit is increased, or there is an increase in the producer’s equilibrium when there is satisfaction between two conditions that are as follows:

• MR= MC
• There is an increment in MC or MC exceeds MR beyond the point of equilibrium output.

Figure 4: Producer’s Equilibrium

Source: (economicsdiscussion.net, 2020)

In the given table, the MR is equal to MC in two of the situations, i.e., (a) when there is a production of 2 units (b) when there is a production of 10 units. In this case, when there is a production of 2 units, MC is declining, whereas when there is a production of 10 units, MC is increasing. Therefore, a producer will increase his equilibrium only when MC is increasing.

Generally, the producer’s equilibrium of the asset value utilized for production has a limit. Therefore, the producer should make proper use of such a mixture of inputs as it would offer him with utmost output and profits. The most favorable level of production, are often known as producer’s equilibrium. Hence, it is attained when the maximum output is derived from the least amount of cost (economicsdiscussion.net, 2020).

The understandings of the producer’s equilibrium, there should be an illustration of isoquant curves and iso-cost lines.

Isoquant Curves: The concept of the isoquant curve indicates several mixtures of inputs, which produce the same level of output. The producer can choose any of these combinations available to him because their outputs are always the same. Therefore, it can also be called equal-product curves or production indifference curves. The isoquant curves are partly similar to the indifference curves, as they are pessimistically sloping and convex in shape.

Iso-Cost Lines:

Conversely, the concept of iso-cost indicates a mixture of two factors that is purchasable with dissimilar expenditures. It indicates how money can be expensed on two different factors to produce the greatest production in simpler words.

Production Equilibrium:

As illustrated above regarding the isoquant curves, the explanation reflects the input combinations that are needed to be involved in the production process at a certain level. On the other hand, the concept of iso-cost lines helps in identifying combinations of two factors in which the outlays are to be invested in constructing an output. Therefore, a mixture of these two factors leads to an optimum level of production, which is also called the producer’s equilibrium.

With the use of this equilibrium, a producer or manufacturer can identify various mixtures to augment output. The producer will also be able to use the information to identify the costs that use similar inputs and consequently create maximum profit.

References

britannica.com, 2020. Supply Curve | Definition, Graph, & Facts. [online] Encyclopedia Britannica. Available at: <https://www.britannica.com/topic/supply-curve> [Accessed 10 November 2020].

corporatefinanceinstitute.com, 2020. Substitution Effect – Definition, Practical Example, And Graphical Illustration. [online] Corporate Finance Institute. Available at: <https://corporatefinanceinstitute.com/resources/knowledge/economics/substitution-effect/#:~:text=What%20is%20the%20Substitution%20Effect,other%20goods%20in%20the%20market> [Accessed 10 November 2020].

economicsdiscussion.net, 2020. Producer’S Equilibrium: MR-MC Approach, Perfect Competition And Diagrams. [online] Economics Discussion. Available at: <https://www.economicsdiscussion.net/producers-equilibrium/producers-equilibrium-mr-mc-approach-perfect-competition-and-diagrams/31080> [Accessed 10 November 2020].

Econpage.com, 2020. Substitution And Income Effects. [online] Econpage.com. Available at: <http://www.econpage.com/301/handouts/IC_applications/sandi_effects.htm> [Accessed 10 November 2020].

Pettinger, T., 2020. Backward Bending Supply Curve – Economics Help. [online] Economics Help. Available at: <https://www.economicshelp.org/blog/glossary/backward-bending-supply/> [Accessed 10 November 2020].

toppr.com, 2020. [online] Available at: <https://www.toppr.com/guides/business-economics/laws-of-production/producers-equilibrium/> [Accessed 10 November 2020].

Www2.econ.iastate.edu, 2020. [online] Www2.econ.iastate.edu. Available at: <http://www2.econ.iastate.edu/classes/econ101/hallam/Income_Substitution.pdf> [Accessed 10 November 2020].