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    Substitution effect & income effect (with graphs)

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    Managers are very interested in how a consumer makes a choice among alternatives. In this exercise, we ask you to consider the amount of money you spend purchasing gasoline to operate your automobile for a month and any alternatives available to you assuming your net income available to make those purchases. Also assume gasoline prices for your auto rose 100% during one difficult summer as our time period for the purpose of discussion. Explain, then, the following effects in terms of the income effect, or the substitution effect, or both effects:

    You drove less and purchased less gasoline.
    You ate out less often.
    You spent less to maintain your automobile.
    You took public transportation more often.
    You bought a bicycle.
    You did not take a vacation away from home.
    You bought fewer clothes and made do with more around the home.

    Demonstrate your understanding of the concepts by providing a graph of each effect as a figure.

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    Solution Preview

    The income effect refers to how my spending on a good changes because of a change in my real income, or at least in the portion of my income that I have available to spend on the good. The substitution effect refers to how my spending changes because of a change ...

    Solution Summary

    Using the income and substution effects to explain why my spending habits changed after the price of gasoline increased 100%. Illustrated with graphs.