Essay Sample on Income and Substitution Effects, Market Structures, and Output Decisions

Income and Substitution Effects

An employee's decision on how much time to spend working and how much to spend on leisure is influenced by the utility drawn out of work and the income he receives from leisure. The explanation for this can be made using the substitution and income effects. The substitution effect is depicted by the part of the supply curve that slopes upwards. With an increase in the wage rate, employees will be more willing to put more of their time into work, substituting more for leisure, given that the opportunity cost (the value of the alternative forgone) is higher with an increased wage rate. With a rise in the real wage rate, however, employees can earn a higher amount of income for the same number of working hours. The increase will trigger an increase in demand for leisure. Hence, workers will supply less labor, as they prefer spending the increased income on leisure, a phenomenon called the income effect (Önder & Alkan, 2019).

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The prices of lattes will be affected by the income effect in the sense that when employees demand more leisure instead of work, there will be fewer lattes produced; hence the demand for the same will rise, triggering an increase in the price for lattes. The substitution effect, however, will trigger increased demand for work and production of lattes. Hence there will be an increased supply leading to reduced lattes (Önder & Alkan, 2019).

If a drought occurs in the coffee production areas, there will be a general decrease in coffee beans supply, as production will go down. With the demand remaining the same, the equilibrium quantity and price for lattes will rise (Önder & Alkan, 2019).

Output Decisions under the Four Market Structures

In a perfectly competitive market, the local coffee market is influenced only by the market supply and demand mechanism. The decision is factored in the profit equation; hence such a market will sell any amount at the same price. The output decisions for coffee in an oligopoly are indeterminate and rely on how much the industry firms depend on each other; the products are also not well-defined. The demand and supply mechanism, however, affects the prices (Dean et al., 2020).

Under monopolistic competition, a firm will decide on its individual policy, the rivals' reactions notwithstanding. The seller will be at an equilibrium where marginal cost and marginal revenue are equal. The seller will increase output as long as marginal revenue is greater than marginal cost and vice versa. Product differentiation also exists in this market (Dean et al., 2020). A monopolist market has only one producer among many consumers. Monopolies lack competition and substitutes. Therefore, a producer determines the amount to supply and the price to charge, as consumers have no options. The average revenue will also be less than the marginal revenue, given that average revenue falls with increased output (Dean et al., 2020).

Summary

Both the substitution and income effects influence an employee's decision on how much time to be spent working and how much to be spent on leisure. When wage rates increase, employees will be more willing to put more of their time into work, while a rise in the real wage rate will see workers supply less labor, as they prefer spending the increased income on leisure. When employees demand more leisure, less production occurs, which increases both demand and prices. Increased demand for work, however, increases the supply hence a reduction in prices. A calamity such as drought will decrease the demand for the agricultural product, but demand will remain the same; hence the equilibrium quantity and price for lattes both rise.

Output and price decisions in a perfectly competitive market are lowest compared to other markets but are characterized by increasing returns to scale and demand elasticity. In monopolistic competition, oligopoly, and monopoly, product differentiation allows the players to charge higher prices. The monopolists, however, will deal at the point where marginal cost and marginal revenue are equal.

References

Dean, E., Elardo, J., Green, M., Wilson, B., & Berger, S. (2020). Monopolistic Competition. Principles of Economics: Scarcity and Social Provisioning (2nd Ed.).

Önder, K., & Alkan, H. I. (2019). An Investigation of Income and Substitution Effects On Female Labor Supply through a Chain Analysis: The Service Sector Case Specific to the Tr51 Region. Uluslararasi Yönetim Iktisat ve Isletme Dergisi, 15(1), 14-29.