Income and Substitution Effects Substitution

Income and Substitution Effects Substitution and Income Effects Income and substitution effects: An increase in gasoline prices Income and substitution effects: An increase in gasoline prices According to the basic principles of economics, when an individual's income increases, their marginal propensity to consume (MPC) also increases (Income effect, 2010, Investopedia). Quite simply, when an individual has more money, they tend to buy more goods and services, even if they also save a percentage of their income as well.

Assuming that gasoline prices 'at the pump' rise 100%, or double, this will result in a loss of available income to spend on other goods and services. Income is not simply determined by pay raises and pay cuts, but by the availability a consumer has of funds to spend on his or her necessities and luxuries. Gas is a necessary good for most people -- it is what they use to get to work to make a salary.

They must drive to work in a car to pay for their other expenses, including food and housing. The price of gasoline is largely inelastic in terms of available substitutions and demand, although some do exist, depending on the location and needs of the consumer. When a necessary good, such as gas, increases in price, consumers will often try to work more, to maintain their level of income.

If they cannot work more, they will try other ways to conserve funds, such as substituting cheaper goods and services for more expensive goods and services in other areas of their budget. The substitution effect suggests that "households always substitute away from a relative expansive good and consume more of a relative cheap good when prices change" (Zhao 2010).

Households will do their 'best' to avoid using gas, but because of the difficulty inherent in this situation, in many regions of the country, they may cut other parts of their budget instead, focusing on more elastic goods. This might be called the 'Starbucks' effect -- when the price of an inelastic necessity increases and takes up a larger proportion of an individual's budget, he or she will eliminate that extraneous cup of coffee in the morning.

The effects of the income and substitution effects are often depicted as follows: (Source: Schneck, 2010) As income increases, people work less, and as income decreases (because of an increase in a necessary good or service) leisure becomes more expensive. People must work more, or try to make the costs of living cheaper through budget cuts or substitutions. Coping strategy one: You driving less and purchasing less gasoline Driving less and purchasing less gasoline gives an individual 'more income,' without substituting other goods or services.

However, because of the rise in gas prices, an individual would have to drive half as much to simply 'break even.' Coping strategy two: Eating out less Eating out less means more money to spend on other goods and services given that eating at home tends to cost less than eating out, where one is paying for the preparation of food and the services as well as the food costs itself. This is one way the substitution effect is manifest.

But this will not result in a net savings, given the increased price of gasoline. Additionally, food costs overall may increase, given that food costs gas money to ship across the nation. The income effect and the benefits gained from this substitution may be nil. Coping strategy three: Reduced vehicle maintenance Spending less money to maintain one's automobile has an immediate positive income effect.

The individual will have more money to spend, although given the increase in gas prices the money will likely be spent upon gasoline to fuel the automobile. Also, there is the question if the maintenance will result in greater long-term costs in the future, if the car is neglected. Coping strategy four: Taking public transportation Taking public transportation will have a more significant income effect than simply trying to drive less or foregoing vehicle maintenance. This will enable the individual to 'opt out' of the increased gas prices.

This will enable him or her to spend more money on goods and services, but given the fact that other prices are often affected by gas prices, the prices overall in the economy could be higher. The costs of a bus, train, or subway pass would have to be figured in as well, as well as the opportunity cost of being late to work, if the public transportation system is not reliable.

However, if the time spent commuting enables the worker to 'get started' on his or her work on the train or bus, this could result in higher levels of productivity and real income. An additional bonus at work would thus give the individual 'more' income as a result. Coping strategy five: Buying a bicycle Buying a bicycle as a lower-cost substitution would have a similar effect upon the availability of income.

Riding a bicycle does not require gasoline to operate, meaning that the rider has more money to spend on other goods and services. Once again, however, the bike rider must subtract the cost of buying the bicycle and maintaining it from the total 'money saved' by not using a car. Also, if a bike, rather than a car is used at all times, this means that the bike rider must have other means of transportation for longer distances, or in severe, inclimite weather.

It is a substitution, but not a perfect substitution for a car, although it has other potential 'substitution' value of time and money: versus working out at a gym, for example. It could enable other budget costs to be made -- forging an expensive gym membership, for example. But in contrast to a commuter via public transport, a bike rider may have an 'opportunity cost' on his or her job because he or she cannot do work and must spend more time commuting than working.

And finally, like a commuter, a biker must have access to such a substitute good. In some areas of the country, there is no public.