Substitution the product that has the same price
Substitution and Income Effects Paper Substitution and Income Effects Paper Introduction: Substitution and Income effects are part of everyone’s everyday life, without anyone really realizing. The substitution effect takes place on the same indifference curve, while the income effect takes place on a higher or lower indifference curve depending on the change in price (Thomas and Maurice, 2011). For the specific example of the price of gas rising by over 100%, examples that demonstrate the income effect would have a lower indifference curve than the normal one.For the substitution effect the same amount of products are still being consumed, however what changes is that if the price of one goes down then they will probably purchase more of that and less of the other product that has the same price as before (Substitution Effect, 2011). The opposite is true that if the price of a product increases then the consumer will probably buy more of the product that has the same price as before than they did previously because they can’t spend as much money on the product with the increased price (Microeconomics Consumer Behavior: Income and Substitution Effects, 2010; Thomas and Maurice, 2011).
A. Driving Less In this scenario the consumer is decreasing overall consumption by driving their car less so they can therefore consume less gas. In the graph shown below, the purple line indicates the normal amount of driving that the consumer takes part in (Figure 1).
The red line represents the substitution effect that is occurring in this scenario. This effect would indicate that since less gas was being consumed that in turn more driving was taking place, obviously this would not occur.The Income effect would be the dominate effect in the circumstance demonstrating less driving occurring with less gas being consumed (Thomas and Maurice, 2011). Figure 1: Amount of driving B. Eating out less often: To make up for the higher gas prices one effect would be eating out less often. Both the quantity of gas being consumed and the amount of eating out are decreased in this scenario.
For this type of scenario the income effect is dominant. The fact that the prices of gas are higher would put a bigger burden on the consumer and therefore reduce the eating out as well.The substitution effect is not as relevant because it would show that the consuming less gas because it is priced higher so they therefore would be eating out more to make up for it, and realistically this would probably not be the case (Thomas and Maurice, 2011). Figure 2: Eating Out Less Often C.
Spending less on Car Maintenance: In this scenario the consumer is spending less on the maintenance of their car to make up for the increase in gas prices. The purple line in figure 3 shows the initial quantity of maintenance before the increase in gas prices.The red line shows the substitution effect which demonstrates an increase in maintenance with a decrease in gas consumption (Figure 3). So the consumer would be choosing to have more maintenance done and consume less gas. The blue line in figure 3 represents the income effect in this scenario.
Like the above scenario with eating out, the income effect dominates. The amount of maintenance done stays the same however the indifference curve lessens because of the higher price and they consume less gas (Thomas and Maurice, 2011). Figure 3: Car Maintenance D. Using more Public TransportPublic transportation is being used more often since the price of gas has increased. In this scenario, again, the purple line of figure 4 is the initial amount of public transportation that was used. The red line exhibits the substation effect. This substitution effect is the main effect that is occurring in this scenario because the consumer is “substituting” the amount the quantity of gas by using public transportation more often (Thomas and Maurice, 2011).
The consumer still needs the quanitity to stay consistent, and therefore the indifference line stays consistent as well.The blue line shows what the income effect would be however, it does not make sense because this shows that the amount of public transport would stay the same, which probably would not occur (figure 4). Figure 4: Public Transportation E. Buying a bike If a consumer were to buy a bike because of the prices of gas increasing substantially, less gas would be necessary to consume. In the below graph (figure 5), the purple line would indicate the normal amount of other goods that the consumer would use. The substitution effect can be seen in red in figure 5.It shows an increase in consumption of other goods, like buying a bike (Thomas and Maurice, 2011).
Instead of of consuming more gas, the consumer is substituting getting a bike. Consumption gets reduced with the income effect (seen in blue in figure 5). The indifference curve for the income effects would have to lower because the price of gas is higher and therefore the customer wouldn’t be able to purchase as much gas as they typically would (Thomas and Maurice, 2011). Figure 5: Buying a Bike F. Not taking a vacation: With the increase in gas prices, the consumer no longer is going to take a vacation.Therefore there is a fall in consumption in the other good. The purple line in the below graph shows the typical quantity of vacations (Figure 6).
The red line shows the substitution effect. The substitution effect shows an increase in vacations as a result of the decrease in the quantity of gas (Thomas and Maurice, 2011). It doesn’t really make sense for people to be vacationing more often because they are having to consume less gas. The Income effect is the dominating effect in this scenario. It indicates both a reduction in vacation and a reduction in gas consumption.Figure 6: Vacations G.
Buying less clothing By buying less clothing this indicates a reduction in overall consumption, much like not taking a vacation. Again, the purple line represents the normal consumption of clothing by the consumer (Figure 7). The substitution effect, indicated by the red line, demonstrates in increase of clothing in substitution for the decrease in gas consumption (Thomas and Maurice, 2011).
Obviously, once again the Income effect dominates, producing a decrease in gas consumption as well as in clothing (Figure 7).Figure 7: Clothing Bought References Thomas, C. & Maurice, S. (2011). Managerial economics: Foundations of business analysis and strategy (10th ed.
). New York: McGraw-Hill. Substitution Effect.
(2011). In Encyclop? dia Britannica. Retrieved from http://www. britannica. com/EBchecked/topic/571064/substitution-effect Microeconomics Consumer Behavior: Income and Substitution Effects. (2010) Slideshare. Retrieved from http://www.
slideshare. net/salasvelasco/microeconomics-income-and-substitution effects