Question

In: Economics

In each of the following cases identify whether the change is an income effect, a substitution...

In each of the following cases identify whether the change is an income effect, a substitution effect, or both. Explain briefly, and draw a graph depicting the change, making sure to label axes and lines.

1) Heather has received a bonus of $500 in her job.

2) Hala is choosing consumption and savings from her current income. The interest rate on her savings increased from 5% to 10%.

3) Henry spends all his income on electronics and food. The price of electronics just went up from $200 to $300.

4) Hugo receives Social Security benefits. This week, the price of food went up, but his Social Security benefits adjusted with the price increase so that he can still achieve the same level of utility as before the price change.

Expert Solution

To answer each of these options, we need to first understand what an income effect and substitution effect is:

The income effect is the change in consumption patterns due to the change in purchasing power. This can occur from income increases, price changes, or even currency fluctuations.

Substitution Effect: The substitution effect is the change in consumption patterns due to a change in the relative prices of goods.

Now let's take each of the case:

1) Heather has received a bonus of $500 in her job. If there is an increase in income at high level we can say that the quantity demanded will increase for the products Change in because of Both - Income as well as Substitution Effect

(Graph # 1 to be referred)

From the question we understand that the income increases for Heather (from I1 to I2) which increases the consumption of both the products however the ration in which increase in consumption happens cannot be only attributed to income effect, it have some element of substitution effect too. Consumers have the tendency to replace, or substitute, luxury items with cheaper alternatives when income decreases or prices increase. Conversely, the same consumers tend to substitute low-cost alternatives with higher-priced goods when income increases or as the price of luxury goods decreases. So while the Quantity increases from Qo to Q2, the increase in quantity from Qo to Q1 is attributed to substitution effect and from Q1 to Q2 is attributed to income effect.

2) Hala is choosing consumption and savings from her current income. The interest rate on her savings increased from 5% to 10%. Change in because of Both - Income as well as Substitution Effect

(Graph # 2 to be referred)

Although higher interest rates means that Hala will use less money for consumption and do more savings, Higher interest rates make saving more attractive than spending, reducing Hala's spending (substitution effect) but at the same time Higher interest rates increase income from saving. Therefore, this gives her more income to spend, and spending may rise (income effect)

3) Henry spends all his income on electronics and food. The price of electronics just went up from $200 to $300. Change is a Substitution Effect

(Graph # 3 to be referred)

This is a pure case of substitution effect where there will be a change in consumption patterns due to a change in the relative prices of goods. Here price of electronics went up which will reduce its consumption from A0 to A1 and increase the consumption of Food from Q0 to Q1

4) Hugo receives Social Security benefits. This week, the price of food went up, but his Social Security benefits adjusted with the price increase so that he can still achieve the same level of utility as before the price change. Change in because of Both - Income as well as Substitution Effect

(Graph # 4 to be referred)

Although higher Social security means that Hugo will have more money for consumption, Higher benefits increase the spending(income effect) but at the same time price of food went up. Therefore, this Hugo spend extra money to subside the increase of prices (substitution effect) Please note the questions mentions that his Social Security benefits adjusted with the price increase so that he can still achieve the same level of utility as before the price change, that doesn't imply he will use the same quantity of Food and Electronics, his consumption of food will comparatively go down (from Q1 to Q2) which will be replaced with electronic whose consumption will go up (from Ao to A1) because of substitution effect.

Rahul Sunny answered 2 years ago

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