income+effects+and+substitution+effects

Income Effects and Substitution Effects Andrew McCashland

The two key items to this topic tie into **Theory of Consumer Choice**. So to understand the key elements below we need to get a understanding of what budget constraints are and how they effect these items. A budget contraint explains what a consumer can purchase is determined from their income. The slope of the budget constraint measures the rate at which you can trade one good for another, and the prices of the two goods. This slope is called the Marginal Rate of Subsitution(MRS). Budget constraints are determined by both the income of the consumers and prices of the products they are looking to buy.

__**Substitution Effects**__ are the movements along a given indifference curve that results from a change in the relative prices of goods, holding real income constant.

For a substition effect we have an example graph below. When we change the price but leave income alone the budget curve shifts but the shift rotates out not parallel. On this graph we will change the price of the goods but leave income alone.In the graph they are showing an example of a decrease in price because the curve is shifting from BC1 to BC2.This example of a higher price shows that we are lowering our real income. In a substition effect the buyer will substitute away from the good that is becoming more expensive. Because since the price of say good X is going up then they will trade off and buy more of good.

Graph from Wikipedia Site


 * __Income Effects__** are the movement from one indifference curve to another that results from the change in real income caused by a price change.

By looking at the graph below we see that when changing the price we will show a paralllel shift in the budget curve. If we were to increase income we would see the budget curve shift from BC2 to BC3. Becauses we would have more income. If we were to lower income we would shift the curve from BC2 to BC1.

Graph is fromWikipedia Site

When determing the total effect on consumer behavior. We must use both the substitution and income effect to determine what changes will take place. We need to look at the effects due to the change in the price of a good and also from the change in the income of the consumer. By using these to measures we can determine both to help show us the real effect on the consumer and to find the maximum consumer satisfaction from his or her purchases. When the consumer reaches consumer equillbrium they will get the best quantity of the two goods that their income will allow.

From the articles I have read and the website I have seen we have income and substitution effects every day in our lives. If we are at the store buying groceries or if we are going out to eat. We always have to make choices based upon what the prices are and what we can afford through our current income. That is why consumers are always try to find the best price because they are wanting to get more out of their income by stretching it as far was it will go. Many consumers that has a lower income will be more inclined to look for prices or deals that create better consumer satisfaction for them. For everyone their maximum consumer satisfaction is different then the next person. But by looking more into these two effects we can determine what drives consumers toward these objectives.

1. What is the formula to compute MRS a.= Px/Py b. Py/Px c. -P/Px The Answer is a because it is the Price of goody X of Price of good y

2, If you have two products such Water and Pop and the price of Pop rose dramatically you would stop buying as much pop and buy more water. This is an example of what effect? a.Substition b. Income c. No Effect d. Example that include both Substitution and Income

The answer is Substitution because the Water and Pop are substitutes and their was no change in income.

3. In a Income Effect situation if you are given a gift certifcate for $20 dollars what would that do to the indifference curve? a. It would shift it out to the right horziontally 20 then continue down the same slope b. Shift the curve to the left by 20 c. No effect to the indifference curve

a. It would shift the curve out to the right and horizontially because their is a increase in income which allow more money to buy more of the goods

4. How would a consumers indifference curve shift in a income effect graph if he/she gets a promotion at work? a. No effect b. Shift the curve to the left c. Shift to the right.

Answer: C It would shift the curve out to the right

5. What are examples of products that would be complements in a substion effect graph a. Coke and Pepsi b.Water and Pop c. Beer and Pizza d. A and C e. A, B and C.

Answer is D both A and C are examples of products that are substitutes.

References: Baye, Michael R., Mangerial Economics and Business Strategy, Fifth Edition pg. 133-134

http://en.wikipedia.org/wiki/Consumer_theory

http://www.sparknotes.com/economics/micro/supplydemand/demand/section2.rhtml

http://www.basiceconomics.info/theory-of-consumer-choice.php

http://encarta.msn.com/dictionary_561546698/consumer_equilibrium.html