April 29 - Substitute Resources

Last time we looked at the determinants of resource demand.  For the most part they are pretty simple and intuitive.  However, we did not get to the last of the determinants. 

We handled complimentary resources.  This was pretty simple, since it just makes sense that if you are going to get more or less of one resource, you would also get more or less of a complimentary resource. 

Now we need to look at substitute resources. 

This one gets a bit tricky, because it ends up looking at two effects caused by one change in price.

At first it seems pretty straightforward.  After all if the price of substitute resource A goes down you will want to buy more of A.  Once you buy more of A, you will want less of B, right?

The answer is yes, but also maybe no.  This is because we have to look at two affects caused by the change in price.

These two changes are called the Substitution Effect and the Output Effect.  Then we can put those two together and we call it the Net Effect. 

The Substitution Effect is what we described above.  It is the idea that when the price of Resource A goes down, we will substitute A for B and our demand for Resource B will go down.  And of course is the price of resource A goes up our demand for Resource B will go up.

This is effectively the exact same thing we looked at when we talked about substitute goods in the product market.  But there is a second effect, the Output Effect.

Let's say you had a business that needed both A and B to operate.  Some jobs can be done only with Resource A.  Some jobs can only be done with Resource B.  And some jobs can be done with either resource A or B.  Obviously for the 3 set of jobs, you will choose A or B depending on which one is cheaper overall.  (That's the substitution effect.)

When the price of Resource A went down you got more A's and less B's.  And when you switched from B to A that switch will save you money.  If you are big operation, that switch might save you a lot of money.  What can you do with that money you've saved? 

You will likely use that excess of money to increase production.  If you increase production you will now need more of every resource you use.  Because some jobs can only be done with Resource B, you will need to get more B's to do that resource. 

This is the Output effect.  By saving money with the substitution effect, you can increase output. 

The substitution effect means less of Resource B.
The output effect means more of Resource B.

When we add together the substitution and output effect we get the Net Effect.

If the substitution effect is having a bigger impact we will overall have less B's.  But if the output effect is having a bigger impact we will overall actually increase our use of B's.

Here is a power point that goes into detail on these interplay of these two effects.  Please feel free to ask questions about it.  I'll admit it can make you scratch your head.

The Substitution, Output and Net Effects

Don't forget that there will be a Zoom meeting at 10:00 tomorrow if you have questions.