Bus 640 Managerial Economics Week 3 Assignment 2

Lawanda Peterson

Substitution and Income Effects

BUS 640 Managerial Economics

Instructor: Thomas Bradley

August 8, 2012

Price changes affect buyers’ decisions to purchase (SparkNotes.com). When this happens it is called income effect. Price increases makes consumers feel as though they are poorer or inferior than they were before, even though the amount of their check did not change. This tends to lead to less spending. When prices decrease, consumers tend to feel as though they are wealthier and this leads them to spend more (Para 1). Consumers spending habits adjust according to the increase or decrease of prices.

When the consumption of a good changes and that change would results if the consumer stayed on the original indifference curve after the price of the good changes, this is called a substitution effect. With this effect, consumers move to a higher or lower indifference curve. This is done according to the direction of the price change. The substitution effect happens along the original indifference curve and is the difference between the total effect of the price change and the substitution effect (Thomas & Maurice, 2011, p. 198).

Price changes income effect is the change in the consumption of a good that results from the change in purchasing power alone. This tends to affect consumers decisions to purchase when more than one good is being purchased. For instance, a pack of gum could at one time be purchased at 45 cents. Now that same pack of game has gone up to 85 cents. So instead of being able to purchase two packs for the dollar, the consumer can now only purchase one. This tends to make the consumer feel poorer than they felt three years prior because the prices went up, but their paycheck stayed the same. With that being said, the income effect basically changes the consumers absorption patterns because of the change in their purchasing power. This can also happen by income increases, currency fluctuations and price changes....