Income and Substitution Effects

Income and Substitution Effects - price would cause you to...

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Income and Substitution Effects Income and Substitution Effects Changes in price can affect buyers' purchasing decisions; this effect is called the income effect. Increases in price, while they don't affect the amount of your paycheck, make you feel poorer than you were before, and so you buy less. Decreases in price make you feel richer, and so you may feel like buying more. What if we're looking at two goods at once? For instance, a fast food chain sells hamburgers and hot dogs. If the price of hamburgers goes up, but the price of hot dogs stays the same, you might be more inclined to buy a hot dog. This tendency to change your purchase based on changes in relative price is called the substitution effect. When the price of hamburgers goes up, it makes hamburgers relatively expensive and hot dogs relatively cheap, which influences you to buy fewer hamburgers and more hot dogs than you usually would. Likewise, a decrease in hamburger
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Unformatted text preview: price would cause you to eat more hamburgers and fewer hot dogs, according to the substitution effect. The income effect also affects buying decisions when there are two (or more) goods. When the price of hamburgers goes up, it makes you feel relatively poorer, so your tendency might be to buy fewer of both hamburgers and hot dogs. If you look at the combined results of the income effect and the substitution effect, the total effect is a little unclear. According to the income effect, an increase in the price of hamburgers decreases consumption of both hamburgers and hot dogs. According to the substitution effect, however, hamburger consumption drops, but hot dog consumption rises. Thus, while it is clear what happens to hamburger consumption, since both effects tend to cause a decrease, we cannot be sure what happens to hot dog consumption, since there is both an increase (substitution effect) and a decrease (income effect)....
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