Substitution and Income Effects ? Abstract This paper examines the effects of gasoline price increase over the period of a summer. It looks at the income effect and substitution effect of different scenarios to determine how the author should best make up the difference in cost based on the same income. Seven scenarios are examined; driving less, eating out less, less spent on maintenance, public transportation, bicycle, no vacation and fewer extra expenses. Using graphs to demonstrate the income effect and substitution effect, it is easier to see which is the best solution.
Substitution and Income Effects Substitution and income effects are a part of everyday life. This paper examines the substitution and income effects of gasoline prices. The author currently spends $120 on gasoline per month, 4 weeks. Assuming that there is a price increase of 100% during one summer, then the cost of those 3 months for gasoline to drive the same amount would be $240 per month, or $720 for the summer, 12 weeks. The automobile driven gets 30 miles per gallon of gasoline.
During the spring gasoline cost $3. 0 per gallon and during the summer gasoline costs rose to $6. 00 per gallon. Thomas and Maurice 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 (2011, p 186-187). Using either the substitution effect or the income effect, there are a number of ways to evaluate 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. Drive less
If the author were to drive less during the summer months, then they would be able to save money. This would fall under the 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” (p. 188). For instance, the author normally drives to work, 50 miles a day 5 days a week, to the store 5 miles 2 days a week, and into town to spend time with friends 40 miles 3 times a week. Cut backs can be made by car pooling and meeting friends closer to home and thus cutting distance by 20 percent.
Appendix A1 shows this effect. Eat out less The substitution effect can be seen if the author chooses to eat out less during the summer to be able to afford gasoline. The substitution effect is “the change in consumption of a good that would result if the consumer remained on the same indifference curve after the price of the good changed” (p 187). For instance, if the author normally spends $80 a week eating out $5 dollar meals and changes to eating out half as much, $40 dollars a week, there is a $40 dollar savings.
Appendix A2 demonstrates these savings. Less maintenance on automobile Another option for saving money to afford the increase in gasoline prices would be to spend less money on overall maintenance for the car. This would be an income effect. If the author normally spends $500 prior to the summer on maintenance to get the belts checked, tires rotated, oil change, and the air conditioning unit checked, they could select a smaller maintenance package. The package could be $100 to get an oil change and the air conditioning checked.
There is a $400 savings that can be applied towards the gasoline price increase. Public transportation Substituting public transportation to driving a personal vehicle could be a huge cost savings for the author. The cost of the city transportation is only $1 per trip. There would also be an income effect cost savings due to having less, if any automobile maintenance. The cost for driving for one month over the summer would be $240, where as if the author takes 4 trips per day for a month (30 days), then it would cost the same as a regular month of driving, $120.
Bicycle Purchasing a bicycle would cost money upfront, $100, however there wouldn’t be nearly as much up keep or the need to purchase gasoline. A bicycle could be used to travel short distances, thus substituting for the car in some instances. The bicycle wouldn’t be able to substitute in as many instances as public transportation, however would still show some savings. The author would still be paying for gasoline to drive to and from work, approximately half of the gasoline budget, however, would save half by riding a bicycle the other half of the time.
Thus, saving $120 a month. The total including the purchase of the bicycle would be $260 for the increased price, however, it would still be more than in the spring by $100. Vacation The author takes a vacation every summer by driving to the desired location. This causes increase in the amount of gasoline used, thus the amount spent on gasoline the week of vacation. If the author does not take vacation, then they would save money on gasoline and the cost of the vacation it’s self. They would also need less maintenance on the automobile.
This would be both an income effect and a substitution effect. Other purchases Along with passing on vacation, the author could also shop less for clothing and cut back on the amount of money spent on groceries. Substituting clothing already owned and non-name brand foods would help to save money that could go towards paying for the higher gasoline prices. Conclusion There are changes that can be made to make up for the increase in gasoline prices. Some are income effects, some substitution effects, and others still are a combination of both.
These effects can be seen in other examples, outside of gasoline prices. Canada is showing a 12 percentage point decline in the low income rate associated with market income effects (Picot, Lu, and Hou, 2010, p 13). In Tokyo there is a great example of the substitution effect. According to an article in Economics Week, “Recently several researchers have succeeded in producing expectation driven cycles by balancing the tension between the wealth effect and the substitution effect stemming from the higher expected future productivity” (2010, p 30).
The usage of both income and substitution effects cross from topics and across the globe. It is a great way to evaluate, in this paper, the best way to be able to afford the increase in gasoline prices and what sacrifices being made would create the best outcome. Overall, it can be seen that when the price of gas increases the substitution effect and the income effect both fall. ? Appendix A A1 Income Effect A2 Substitution Effect ? References Macroeconomics; New Data From I.
Fujiwara et al Illuminate Research in Macroeconomics. (2010, May). Economics Week, 30. Retrieved June 14, 2010, from ABI/INFORM Global. Maurice, S. & Thomas, C. (2011). Managerial economics (10th ed. ). New York, NY: McGraw- Hill. Picot, G. , Lu, Y. , & Hou, F.. (2010). Immigrant Low-Income Rates: The Role of Market Income and Government Transfers. Perspectives on Labour and Income, 22(1), 13-21, 26-27. Retrieved June 14, 2010, from CBCA Complete.
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