Substitution and Income Effect

Running Head: SUBSTITUTION AND INCOME EFFECTS 1

Substitution and Income Effects

BUS 640: Managerial Economics

August 22, 2011

SUBSTITUTION AND INCOME EFFECTS 2

Substitution and Income Effects

This paper will discuss substitution and income effects while considering the price of gasoline used to operate your automobile in any month. There will be discussions utilizing the substitution effect, the income effect or both effects. It is based on the indifference curve and the understanding of how these effects will alter the outcomes of demand.

If you drove less and purchased less gasoline in any month there would be variables to consider. By increasing choices the consumer can utilize the substitution effect to view the changes in the consumer’s income (Thomas, 2011). For instance, if there is a parallel shift by forcing a new budget line, the amount of money spent on gas will decrease. This would not be due to the price falling but due to the amount of income spent being less. This principle is based the change in the consumption of a good after a change in its price, when the consumer is forced by a change in money income to consume at some point on the original indifference curve (Thomas, 2011). It is important to remember that as income changes or the amount spent on gas, the budget line will shift. There would definitely be a shift here because the price of gas goes up 100% during the summer months. This would lower the amount spent on the gas to drive around.

If you drove less and purchased less gasoline in any month and utilized the income effect there would be a change in the consumption of a good (Thomas, 2011). This change would be that the consumer would change the direction of the indifference curve and the income effect would be the difference between the total effects of the price change (Thomas, 2011). The point of the indifference curve is to maximize utility. When looking at price the budget line...