Substitution and Income Effects - Research Paper Example

The objective of this paper is to analyze the fluctuations over the purchase behaviors of individuals with relation to the ‘income effect’ and the ‘substitute effect’ when the gasoline prices go high. Theoretical Perspective From a theoretical perspective, the substitute effect essentially refers to the effect over the purchase decisions which take place as a result of the changes in terms of price of the commodities. When the price of a particular commodity increases, the individuals tend to purchase the substitutes of that commodity which would cost them less than the earlier one.

One of the major impacts is on the purchasing power of the individuals which seems to be lower when the price of the commodities rises. This can be regarded as a consequential effect to the fact that the fixed budget is less flexible than the prices changes of the commodities which, in turn, tend to determine the consumption capacity of that particular individual or household. In this context, though the budget of the consumer does not alter, the increase on the prices tends to present a circumstance as if the individual has lowered his/her budget with similar consequences to a decrease in the income of the individual.

Therefore, the individual responds according to the fluctuation in the purchasing power which is termed as the income effect (Samuelson, 1980). This particular relationship between the budget, substitute and price changes can be apparently witnessed from the diagram represented below: Source: (Iowa State University, 2012) As can be witnessed from the above diagram, q1 and q2 represent the original product and the substitute products respectively. The graph represents that for purchasing 18 units of product q1 and q2, the individual has to spend 8 units and 4 units respectively increasing the probability to consume q2, provided all other factors such as quality are assured (Iowa State University, 2012).

Discussion The discussion henceforth will address the critical situation over a year when the prices of gasoline have been assumed to increase by 100%. 1. You drove less and purchased less gasoline The reduction in the driving distance is expected to result in a lesser consumption of gasoline. Over a year, with the speedy hikes in the gasoline prices, i.e. by 100%, it becomes quite likely that a budget constraint shall be witnessed. Consequently, as substitute of gasoline, especially in the case of automobiles that are quite constricted, an apparent occurrence of income effect is bound to take place.

It is in this context that by reducing the driving distances, the expenditure in terms of gasoline can also be reduced substantially mitigating the constraint of lowered budget due to rapid price increases. 2. You ate out less often In this situation, the consumer responds to the increase in gasoline prices by avoiding gasoline consumption needed to travel with the purpose of having food outside. In this context, the reaction of avoiding travel for outdoor fooding can be regarded as a result of income effect.

It is in this context that by avoiding extra gasoline consumption for such luxurious or rather such recreational causes, savings can be augmented proportionately and, likewise, the budget flow can be made flexible by a certain extent. 3. You spent less to