Substitution and Income Effects Paper

1 January 2017

Behavior is how consumers allocate their money incomes among goods and services. Each consumer has preferences for certain of the goods and services that are available in the market. Buyers also have a good idea of how much marginal utility they will get from successive units of the various products they might purchase. However, the amount of marginal & total utility that the people will get will be different for every individual in the group because all individuals have different taste and preferences.

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According to Maurice & Thomas (2011) “marginal utility is an additional or incremental utility. Marginal utility is defined as the change in the total utility that results from unit one unit change in consumption of the commodity within a given period of time”(p. 169). There is an assumption that consumers engage in rational behavior. Therefore one can define a consumer as a rational person, who tries to use his or her money income to derive the greatest amount of satisfaction, or utility, from it. Consumers want to get the most for their money or, to maximize their total utility.

Rational behavior also requires that a consumer not spend too much money irrationally by buying tons of items and stock piling them for the future, or starve themselves by buying no food at all. Substitution and Income The income effect describes how consumers react to an increase in purchasing power. For example, if the price of a good they normally buy falls, it leaves them with more money to buy other things. The substitution effect describes how consumers reallocate consumption of goods in response to changes in relative prices.

So if the price of apples increases, a consumer might want more oranges, which seem more appealing now in light of the increased cost of apples. Droving less and purchasing less gasoline In this case we are just talking about one good, gasoline. It became costlier and hence we purchased less gas and travelled less. This can be explained by using the income effect. The effect of a change in the price of one of the goods is generally decomposed into the substitution effect and the income effect.

According to the definition in the article Investopedia (2011), “the income effect is the change in an individual’s or economy’s income and how that change will impact the quantity demanded of a good or service. The relationship between income and the quantity demanded is a positive one, as income increases, so does the quantity of goods and services demanded”(para 1). The substitution effect is the change in the quantity of that good consumed when the budget constraint reflects the new relative prices, but keeps the agent on the original indifference curve.

Price change lowered your real income and hence you bought less gasoline. You cannot buy as much gas as before because of the higher price. With less money for gas, you can save by using your car less. Ate out less often This will involve both income and substitution effects since the price of two goods to take into account. The graph following this question can be used for a number of other parts as I will mention in each part as we go about doing it. In this case we have the price of oil going up while the price of eating out stayed the same.

Say you start at point A on the figure. An increase in the price of oil will change the budge curve from the red line to the green line, since you can now afford less of oil, while you can afford the same quantity of eating outside. Thus you move from A to C. But we break this into two parts. To find that we need to draw a line that is parallel to the new budget line: the green dashed line. That is tangent to the old indifference curve at point B in the figure. This movement explains the substitution effect. One changes consumption from oil to eating out.

But the price change also meant you’re your real income has fallen down. This is shown by a movement from B to C in the figure. That shift is the income effect. Thus the movement from A to B will be the substitution effect: you tend to buy cheaper products; while that from B to C will be income effect: you feel poorer. Thus the consumption of both oil and eating out fell down as the price of gas went up. A B C Second Good Gas Spent less to maintain your automobile. The same theory can be used for this question as well as in the graph.

Even though the price of automobile maintenance didn’t rise, and the substitution effect says you spend more on maintenance the change in real income means you spend less on maintenance too. So in the graph you go from A to B (substitution effect) and from B to C (income effect). Take public transportation more often This can be just explained by using the substitution effect, which is substituting away from a higher priced activity (driving) to a lower priced alternative (public transportation). The price of public transportation didn’t change, and since driving became costly you drove less.

You move from point A to point B on the graph. Bought a bicycle The substitution effect can be used to describe this action as well. This is the same situation as the public transportation. The substitution effect makes biking look better, even if your income was adjusted so that your real income did not change. This is shown by a movement from A to B on the graph. Not taking a vacation away from home Spending less on oil one would expect that one would spend that money on other goods, a movement from A to B on the curve. This is the income effect.

There is not enough left after paying for gas to pay for a vacation. Since the real income has fallen a family can afford to take fewer vacations. This is shown by a movement to C. Thus move from A to C. Bought fewer cloths and made due with more around the home Buying new clothes more often and more expensive clothes is a consequence of the increase in wealth; hence decrease in wealth made me do less of this activity. Clothes still cost the same therefore the graph can be used to describe the substitution and income effect.

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