When the price of a good or service changes, it always has two effects on the consumer, the first is the effect on the consumer’s income and the second is the effect on other products. Whichever way it is being looked at these two effects are standard for as long as there is a change in price. Price change is the determining factor, it could either be positive or negative, and either ways there will always be an income effect or a substitute effect. Most times, we do not usually separate these two effects. One of the main purposes of this paper is to significantly the defense in both effects (Barwell, R., Thomas, R., & Turnbull, K. 2007).
The substitution effect is the change in the quantity of those commodities consumed when the budget constraint reflects the new relative prices, but keeps the agent on the original indifference curve. It reflects the change in real income that results from a price change. Graphically, when a price change occurs, the budget line shifts accordingly with the change in real income. If the income decreases, the budget line shifts to the left. Income effect is the change in the demand of a good or service, induced by a change in the consumers’ discretionary income (Hamilton, J., Blinder, A., & Kilian, L. 2009).
Any increase or decrease in price correspondingly decreases or increases consumers discretionary income which, in turn, causes a lower or higher demand for the same or some other good or service. For example, if a consumer spends one-half of his or her income on bread alone, a fifty-percent decrease in the price of bread will increase the free money available to him or her by the same amount which he or she can spend in buying more bread or something else (Barwell, R., Thomas, R., & Turnbull, K. 2007).
Substitution and income effects – a part of everyday life
This essay examines the substitution and income effects of gasoline prices during the summer month. Say the author currently spends $1200 on gasoline per month that is four weeks. Assuming that there is a price increase of 100% during the summer season then the cost of those three months for gasoline to drive the same amount would be $2400 per month, or $7200 for the summer that is weeks. The automobile driven gets 30 miles per gallon of gasoline. During the spring gasoline cost $30.00 per gallon and during the summer gasoline costs rose to $60.00 per gallon.
Thomas, C. & Maurice, S. (2011) state that “when the price of a good increases, consumers are worse off” and in this instance, the increase in gasoline prices makes it necessary to adjust the monthly budget. Using either the substitution effect or the income effect, there are a many ways to assess how to afford gasoline. Some sacrifices will have to be made, but budgeting accordingly and making sacrifices allows for the author to afford the increase in gasoline prices (Barwell, R., Thomas, R., & Turnbull, K. 2007).
This essay examines the effects of gasoline price increase over the summer season. It assesses the income effect and substitution effect of different situations to establish how the author should best make up the difference in cost based on the same level of income. Seven scenarios are examined; driving less and purchasing less gasoline, eating out less often, less spent on maintenance, public transportation, bicycle, no vacation and fewer extra expenses.
(Thomas, C. & Maurice, S. 2011)
Firstly, if the author drove less and purchased less gasoline during the summer month: This would be an income effect, or the change in the consumption of a good resulting strictly from a change in purchasing power after the price of a good changes because the change in price lowered his/her real income, he/she have spent more money on less gasoline for less driving, and therefore no surplus money is left that could be spent on any other thing (Hamilton, J., Blinder, A., & Kilian, L.. 2009).
Secondly, the author ate out less often: This would have both income and substitution effects because there were two goods involved. In first place, the price of gasoline that has increased during the summer season and secondly, the price of eating out which did not change, but because the price of gasoline has risen, the author’s real income is affected which in turn affect eating out. This explains the substitute effect of eating at home over eating out (Barwell, R., Thomas, R., & Turnbull, K. (2007). The income effect is definite because the lesser the author eat out means he/she cooks more at home which in turn mean extra money, it adds a higher percentage of the cost of a meal goes towards gasoline.
Thirdly, the author spent less to maintain his/her automobile. The effect would be similar to the second one that is both the income and substitution effect. The price of maintaining his/her automobile did not change, but because the price of gasoline improved, his/her real income is affected and having paid more for gasoline, he has a little to spend on auto maintenance (Hamilton, J., Blinder, A., & Kilian, L. 2009).
This next effect is both substitution and income effect. The price of gasoline improved and since private vehicle will require consumption of gasoline and paying more, driving has to ease and the surrogate offer was to travel by public transportation more often as the price of public transport is still the same (Barwell, R., Thomas, R., & Turnbull, K. 2007). But because the price of gasoline has improved which affect his/her real income, he has to choose inferior commodity (Thomas, C. & Maurice S. 2011).
The choice of buying a bicycle
Buying a bicycle has both substitution and income effect. Increase in the price of gasoline has affect on real income hence making the author to go for an inferior product (buying a bicycle). Income and substitute effects exist. Barwell, R., Thomas, R., & Turnbull, K. (2007) says “A rise in energy prices might influence the level of demand by affecting consumer spending. The rise in prices of energy will have a propensity to compress the purchasing power of labor income through a decrease in the real expenditure wage. If the increase in energy prices is assumed to be lasting, then households should expect that the decline in their purchasing power will also be lasting.”
Because of the fall in real income due to the rise in price of gasoline, I could not afford a real vacation. Vacation was brought home instead of the usual conventional away vacation. This is a case of both income and substitute effect. According to Hamilton, J., Blinder, A., & Kilian, L. (2009). “A consumer who fails to reduce the quantity purchased of an item by as much in percentage terms as its price goes up will find that the item comes to consume an ever-larger fraction of her budget. If her price elasticity were constant at less than unity, an arbitrarily large price increase would ultimately bring her to a point where 100 percent of her budget was going to energy, in which case ignoring the price would no longer be possible.”
The last scenario of buying fewer cloths and making due with more around the home: One issue is standard the increase in the price of gasoline has affected real income. This has income effect. There was no news of high prices of cloths, but since the real income has dropped all other stuff that will be bought like cloths will be affected, fewer funds will be available for all the other goods. Davies, S. (2011) argues “It is important to recognize that while the income-share of one is increasing, it is necessarily decreasing for the other.” Since real income has affected less buying of new cloths, it explains the rationale for vacating at home in one of the above effects.
In conclusion, change in a relative price of commodities has two effects on consumer’s consumption bundle. Income effect is deliberate when prices increase and the consumer cannot afford other goods even when their prices are not affected. Also the higher price of commodities forces consumers to substitute for cheaper and substandard commodities (Hamilton, J., Blinder, A., & Kilian, L. 2009).