Question

How do the substitution and income effects influence purchases? Identify a good or service, such as gasoline, breakfast cereal, shoes, or pizzas. Assume there is an overall increase in the price of the product. What happens to the quantity purchased? What happens to purchases of substitute products or services? What happens as income increases?

Now consider a specific brand of the product or service you identified, such as Shell gasoline, Rice Krispies, Nike shoes, or Domino's pizza. Do you think the substitution effect would be the same if the price of only that brand is raised? What about the income effect?

Answer 1

Whenever there is an increase in the price of a product or an increase in the income of a consumer, substitution effect and income effect are very important to consider. Suppose there is a product such as gasoline and suddenly there is an increase in the price.
An increase in the price would leave the consumer with limited resources to purchase so that the quantity demanded decreases. This is the general behaviour because gasoline is considered to be a normal good. As soon as the price of gasoline is increased two effects are easily seen.
Substitution effect motivates the consumer to buy other goods and purchase less of gasoline because it is expensive and other goods are relatively cheaper. Income effect will measure the change in consumption as a result of change in the real income. When price of gasoline increases there is a decrease in the real income of the consumer as well as the purchasing power. This production in purchasing power will force the consumer to consume fever units of all the goods he is purchasing if all of them are normal goods.
Therefore whenever the price of a normal good increases, substitution effect and income effect move in same direction and encourage consumer to purchase less of gasoline. The final effect is a reduction in the consumption of gasoline.
Similarly when the income of the consumer is increased, the consumer is able to purchase more of gasoline because it is a normal good. The income effect is positive.
In the market where different kinds of varieties of gasoline are available, an increase in the price of a particular type resuls in a larger reduction in consumption because of relative availability of substitutes. The market is therefore defined narrowly and hence the demand is highly elastic. We can say that the substitution effect in this case is larger than in case of a broadly defined market. The income effect is also relatively larger.
In contrast, gasoline as a whole is broadly defined and has a relatively inelastic demand. The quantity demanded is reduced by a very small amount even when the prices increased by a larger amount. Income effect and substitution effect both work in same direction in this case also when there are many substitutes available for a product, but the degree of reduction in the consumption is lower.