Consumers are faced with choice whenever they make purchases. The idea of choice is basic in the study of microeconomics and is dependent on several factors; the amount of money available to make purchases and the prices of goods and services. It is usually a normal practice for consumers to make more purchases of a commodity if the prices fall. This scenario or effect can be split into two; the income effect and the substitution effect.
Any change in the price of one commodity will typically result in either an income effect or a substitution effect. The income effect takes place when other things held constant, consumers are left with more money in their pockets after buying the same quantity of goods at a price that is lower. The more income that a consumer is left with can then be used to make more purchases of the same product, such that the total amount of goods purchased goes up.
On the other hand, a substitution effect occurs when a rise in the price of one commodity leads to an increase in the demand for another commodity. According to Thomas & Maurice (2011), substitute goods are those whose cross-price elasticity of demand is positive. When two commodities are close substitutes (the cross-price elasticity is high), producers of these goods are deemed to be in the same industry.
As explained earlier, the income effect occurs when there are changes in the bundles purchased by consumers that result from changes in real incomes. In the example provided, the income has not changed. However, the costs have changed considerably, and the increase in costs of goods and services, in essence, decrease the quantity that can be purchased at any period (Thomas & Maurice, 2011). Therefore, in this case, real income has decreased.
Driving less and purchasing less gasoline
In this case, when a consumer drives less distance it implies that the ultimate gasoline consumption would have been reduced. The distance covered by the consumers, when driving, is directly proportional to the gasoline consumed. This is a distinct scenario of an income effect. The purchase of gasoline depends entirely on the amount of income that is available for consumer’s disposal. Ideally, as there is less money available for the consumer’s use, the substitution effect cannot be relevant. The dominance of the income effect will be demonstrated in this scenario, as the consumer will only choose to drive less when he or she has a limited income; therefore, consuming less gasoline.
Ate out less often
In this case, it demonstrates both the income and substitution effect. However, the Income effect is definite while the substitution effect is plausible or not definite. In order to make the decision on whether to eat in the restaurant or cook at home, the consumer needs to focus on his or her financial ability. In this case, the relative prices between eating out and cooking one’s own food may have changed. The eating out cost may have increased by a certain percentage as compared to the cost of buying raw food and gas.
Spending less to maintain automobile
In this scenario, the income effect will be definite. The consumer has limited finances for his or her disposal. As there is an increase in the overall cost of vehicle maintenance, and the consumer has limited finances, the consumer will reduce his expenditure on maintenance for the automobile. From the graph below, an increase in the cost of maintenance of the automobile will shift the income curve to the left. For instance, under normal consideration, the consumption of commodity X (expenditure on an automobile) will shift from X1 to X0. This, in turn, will reduce the consumption of the commodity at the same proportion as the increase in prices.
Taking public transport more often
Here, both the substitution and income effects are definite. Public transport is not a normal good, but rather an inferior commodity. An inferior commodity is the one for which the income effect is negative—an increase in real income necessitates a decrease in its consumption (Thomas & Maurice, 2011). Sometimes, it is weaker or lower than the positive substitution effect. From the figure below, it is clear that any decrease in income will increase the consumption of an inferior commodity, in this case, public transport. In addition, there is a change in the relative cost associated with, either taking public transport or using private means. When making a decision to use public transport more often, it is clear that private transport has become expensive—either due to an increase in fuel cost or the price of vehicles. Therefore, the consumer can substitute private transport with a public one; a substitution effect.
Buying a bicycle
A bicycle is an inferior commodity. Its purchase is necessitated by both income effect and the substitution effect. Concerning the income effect, the consumer’s decrease in income will increase the consumption of the inferior commodity. Consequently, substitution effect will be felt when the consumer prefers purchasing bicycle to be his or her means of transport rather than purchasing a vehicle. This is implied by the income constraint of the consumer. The decisions to forego public transport for private transport—purchase of bicycle—were due to the increase in cost of public transports. This effect is illustrated in the diagram above.
Taking a vacation away from home
Vacation is a luxury commodity. Its consumption is affected by both the income effect and substitution effect. As such, an increase in an individual income will increase the consumption and/or demand for the luxury commodity. In this scenario, taking a vacation away from home implies an increase in income. However, the consumer may substitute a cheaper vacation, which is not so far away from his home, with an expensive one. In addition, the consumer can substitute working extra hours, which does not characterize consumption but is an opportunity cost, with taking a vacation.
Bought fewer clothes and made due with more around the home
This is typically an income effect. The assumption made, in this scenario, is that the purchase of commodities is done on similar commodities. The clothes to be purchased are similar; therefore, there is no substitution effect. In order to purchase few clothes, the real income of an individual would have substantially reduced. This is in contrary to the case where the disposable income for the consumer is high. The consumer cannot afford to purchase many new clothes; thus, spending most of the time around the home. However, in the case where there is increased income, the consumer will have a higher purchasing power and will purchase more clothes that are new.
Thomas, C. & Maurice, S. (2011). Managerial economics: Foundations of business analysis and strategy (10th Ed.). New York: McGraw-Hill.