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Date Submitted: 06/26/2011 12:13 PM
The Effects of the Income and Substitution Effects on Gasoline Prices
March 14, 2011
The Effects of the Income and Substitution Effects on Gasoline Prices
Gasoline prices are increasing at a steady rate. Last summer gas prices rose by 100%. In any given month, the cost of gas for me to go back and forth to work is approximately $240. If I include weekend recreational time, I add another estimated $120. With a 100% increase in gas, the price increases to $480 with a possibility of an additional weekend cost of $240. This is quite a significant amount of money and my income has not changed, therefore to afford gasoline, sacrifices need to be made.
As prices began to increase, there were several alternatives to think about rather than driving. For example, I could drive less and therefore purchase less gasoline; I could eat out less often; spend less to maintain my automobile; take public transportation more often; buy a bicycle; not take a vacation that requires a lot of driving; or spend less on clothing. It is evident that something has to change in order to afford the significant increase in gasoline. The substitution effect is the “change in the consumption of a good that would result if the consumer remained on the original indifference curve after the price of the good changes” (Thomas and Maurice, 2011, p.186). If I decide to substitute X for Y, Y being gasoline, I may spend less on gas than I would if I did not substitute good X for gasoline.
For example, eating out less often requires eating in, which in turn requires additional groceries. I will then be substituting good X (additional groceries) for good Y (gasoline). This will allow me to maximize my utility with the reduced budget constraint. The graphic below shows the effect of a price increase for good Y or in this case, gasoline. If the price of gas increases, the budget constraint will pivot from BC2 to BC1. Notice that because the price of X does not change, I can still buy...