Chapter 7.1, Problem 4R

To determine

To evaluate: The difference between real income effect and the substitution effect.

Explanation of Solution

The effect on income is the rise in revenue-based product consumption. Typically, this means that consumers will spend more if they undergo an income boost, and if their income declines, they will spend less. The influence does not however decide what type of products customers buy. They can opt to purchase more expensive products in lesser quantities or cheaper goods in greater quantities, based on their situations and priorities.

A customer, for example, may want less spending on clothes, as his income has gone down. The impact on income is indirect when a customer makes spending choices because of factors not relevant to his income. For example, food prices could go up letting the customer with lower income to spend on other items. This can cause her to cut back on eating out, contributing to an indirect impact on her income.

Substitution can occur when a customer replaces products that are inexpensive or reasonably priced with products that are more costly when a financial transition takes place. For instance, a better investment return or on other money benefits may cause a customer to replace the older type of a costly item with a newer one.

For example, if college tuition costs more than school tuition and money is a concern consumers would of course be drawn to public colleges. But a small decrease in the cost of private tuition can suffice to inspire more students to start attending private school.

Economics Concept Introduction

Introduction: The effect on income reflects the influence of increased buying power on demand, while the effect on substitution explains how demand is influenced by changes in relative income and prices. Such principles in economics describe market developments and how they impact patterns in demand for consumer goods and services.