Question

The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services. b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same. c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same.

Short answer

The law of demand applies to gasoline as higher prices lead to lower quantities demanded. The substitution effect leads people to use alternatives like public transport or biking. The income effect results in reduced purchasing power and decreased overall gasoline consumption.

Step-by-step solution

Explain the Law of Demand for Gasoline

The law of demand states that, all else being equal, as the price of a good or service increases, the quantity demanded decreases. This applies to gasoline because when the price of gasoline rises, consumers will generally buy less of it. This decrease in quantity demanded can happen because consumers will either reduce their usage or seek alternatives.

Substitution Effect on Gasoline Purchases

The substitution effect occurs when consumers replace a more expensive good with a less expensive alternative. When the price of gasoline rises, people may seek alternatives to gasoline for transportation. Examples include carpooling, using public transportation like buses or trains, biking, or even walking for shorter distances.

Income Effect on Gasoline Purchases

The income effect happens when a change in the price of a good affects the purchasing power of a consumer's income. When gasoline prices rise, the purchasing power of consumers' incomes effectively decreases, making them feel 'poorer.' This could lead people to cut back on gasoline consumption and other non-essential expenditures. Some might opt for smaller, more fuel-efficient cars or reduce non-essential travel.

Key concepts

substitution effect

When the price of gasoline rises, people naturally look for cheaper alternatives. This is known as the substitution effect. It basically means replacing a more expensive item with a cheaper one to save money.
For example, if gasoline gets too pricey, you might:

• Share a ride with friends (carpooling)
• Start using buses, subways, or trains
• Ride a bike or walk for shorter trips
• Consider electric or hybrid vehicles

All these actions are ways consumers adjust their behavior to avoid higher costs.

income effect

The income effect comes into play when the price of gasoline increases. Your purchasing power decreases, meaning your money doesn't go as far.
Suppose gasoline prices rise sharply. You will feel like you have less money to spend overall. This could lead to cutting back on gasoline and other optional expenses. For example:

• Skipping weekend drives
• Choosing a smaller, fuel-efficient car
• Avoiding non-essential travel

The idea is that higher gas prices make you feel 'poorer,' pushing you to spend less.

quantity demanded

The law of demand states that as the price of a good or service increases, the quantity demanded decreases. This is true for gasoline, just like any other good.
When gas prices go up, you might buy less of it. You could:

• Cut down on unnecessary trips
• Use gas more efficiently
• Switch to other forms of transport

Essentially, you reduce what you buy because it costs more. The relationship between price and quantity demanded is inversely proportional – higher price leads to less quantity demanded.

purchasing power

Purchasing power refers to what you can buy with your money. If gas prices rise, your purchasing power drops. You might feel poorer because you can't buy as much with the same amount of money as before.
When gas gets expensive, you may notice things like:

• Having less money for other fun activities
• Needing to budget more carefully
• Finding ways to make your money go further

Simply put, higher gas prices shrink your budget and leave you with less for other things.