Substitution and Income Effects - Essay Example

Substitution effect pertains to the substitution that a consumer resorts to by substituting one product for other owing to the change in the relative prices of the two products (Pass, Lowes & Davies, 1993). Usually the shrinking in the price of a commodity is accompanied by an enhanced demand for it. A fraction of this increased demand occurs owing to the substitution effect. For instance, a fall in the price of gasoline, considering that the price of some alternate fuels like ethanol or LPG remains the same will make gasoline more attractive to me, thereby inducing me to substitute gasoline for the relatively more expensive fuel options.

My choice of fuel for my auto also depends on the income impact effect by the change in the price of a fuel option. For instance, a fall in the price of gasoline will make me purchase more of it owing to a rise in my real income (Pass, Lowes & Davies, 1993). If my budget for auto fuel is $100 and say the price of gasoline is $10 per gallon, I can purchase 10 gallons of gasoline. Now, if the price of gasoline falls to $5 per gallon, I can buy 20 gallons of gasoline from the same budgetary allocation of $100 or in other words I can buy 10 gallons of gasoline for $50.

Hence, I am left with an extra $50 to spend on purchasing more of gasoline or other goods I need. It is the substitution effect combined with income effect that explain as to why demand curves are mostly downward sloping. For instance, I can explain the substitution effect and income effect for a price increase in gasoline (X) on my fuel purchasing preferences by the below given graph. An increase in the price of gasoline causes my budget line for fuel to shift from B1 to B2. Suppose that my auto could run on both gasoline (X) and ethanol (Y).

So I change my fuel consumption from the bundle of gasoline and ethanol represented by A to the bundle of gasoline and ethanol represented by B. This shift from A to B is indicative of the total effect of the change in the price of gasoline. This fall in the amount purchased of gasoline from X1 to X2 occurs owing to two reasons. First it is the substitution effect because gasoline is now costlier than ethanol. Second it’s the income effect because my real budge