Substitution and Income Effects

Substitution and Income Effects

Business 640: Managerial Economics

Charles Fanning

January 16, 2011

Substitution and Income Effects

As the price of goods rises, many people are being forced to offset consumption costs in order to maximize income. As the price of any good decreases, many consumers will tend to substitute a higher quantity of that good for another good and will tend to substitute higher quantities of other similar goods that are less expensive when the price of a good increases (Thomas & Maurice, 2011, pg. 186). The substitution effect takes place on the same indifference curve, while the income effect takes place on a higher or lower indifference curve, while income effect takes place on a higher or lower indifference curve depending on the change in price (Thomas and Maurice, 2011). Price change is the determining factor, it could either be negative or positive either of which will have an effect on income or substitute effect. Most often the two effects will not be separated.

Substitution effect as defined by Thomas and Maurice (2011), "is the change in the consumption of a good that would result if the consumer remained on the original indifference curve after the price of the good changes" (pg. 187). The authors of the text continued to state that, "The income effect from a price change is the change in the consumption of a good resulting strictly from a price change in purchasing power" (Maurice and Thomas, 2011. pg.188). These definitions are graphically illustrated below and having in mind that one of the things we intend to achieve is to show the different effects.

Normal good.

L

D

A

Q of Y F E

H

T

I S S Z R

Quantity of X

Inferior good

L

A D

Q of Y

F E H

T I

S

S Z R

Qantity of X

Driving Less and Using Less Gasoline

Driving less and purchasing less gasoline is an example of the income effect only as no substitution has occurred. If the price of gasoline increases, there are not many substitutes available to ease this strain and people will tend to drive less, therefore purchasing less gasoline to offset the price increase. By using the minimal amounts of gasoline no other goods are being substituted however more income is available for use toward other goods.

Eating Out Less

Eating out less often can have an effect both income effect and substitution effects. While eating out less will increase the money saved if it is less expensive to cook one's own food at home, this saved money may be then put towards the purchase of gasoline or other goods. If people would eat out less,