Question

In each of the following situations, describe the substiIution effect and, if it is significant, the income effect. In which direction does each of these effects move? Why? a. Fid spends a large portion of his income on his children's education. Because tuition fees rise, one of his children has to withdraw from college. b. Homer spends much of his monthly income on home mortgage payments. The interest on his adjustablerate mortgage falls, lowering his mortgage payments, and Homer decides to move to a larger house. c. Pam thinks that Spam is an inferior good. Yet as the price of Spam rises, she decides to buy less of it.

Short answer

a. Fid spends a large portion of his income on his children's education, and tuition fees rise, causing one of his children to withdraw from college. b. Homer spends much of his monthly income on home mortgage payments, and the interest on his adjustable-rate mortgage falls, allowing him to move to a larger house. c. Pam considers Spam an inferior good, and the price of Spam rises, causing her to buy less of it.

Step-by-step solution

Situation a: Fid's children education

For this situation, let's analyze the substitution effect and the income effect. The substitution effect comes into play when the price of tuition increases. As tuition gets more expensive, Fid might consider alternative options for his children's education. For example, Fid may consider enrolling his child in a community college or pursuing vocational training instead of traditional college. The income effect is significant in this case because Fid spends a large portion of his income on education for his children. As the tuition fees rise, Fid is essentially having a decrease in real income because it becomes more expensive to maintain the same level of education. Consequently, Fid has to make his child withdraw from college. The substitution effect moves toward cheaper alternatives, while the income effect moves negatively due to the increased cost of tuition.

Situation b: Homer's mortgage payments

In this case, let's consider the substitution effect and the income effect. The substitution effect comes into play when the interest on Homer's adjustable-rate mortgage falls. As the mortgage payments decrease with the falling interest rate, Homer sees other housing options become relatively more attractive, such as moving to a larger house. The income effect is significant in this case because Homer spends a large portion of his income on mortgage payments. As the interest rate decreases, Homer's real income increases, and he decides to move to a larger house. The substitution effect moves toward more attractive housing options with the lower interest rate, while the income effect experiences a positive direction due to the decreased mortgage payments.

Situation c: Pam and Spam

In this situation, let's address the substitution effect and the income effect. The substitution effect occurs when the price of Spam rises, making it relatively more expensive than other products. As a result, Pam decides to buy less Spam and switch to other alternatives. The income effect might not be significant in this case, as Spam is considered an inferior good. When the price of an inferior good increases, the income effect typically causes people to buy more of it. However, Pam decides to buy less Spam despite viewing it as an inferior good, meaning that the income effect might not have a significant impact on her decision. For this case, the substitution effect moves towards alternative products, while the income effect might not play a significant role in this specific situation.

Key concepts

Substitution Effect

The substitution effect occurs when a change in the price of a good or service causes consumers to replace it with a cheaper alternative. If the price of a product increases, individuals will often seek other products that provide similar satisfaction but at a lower cost.
For example, if tuition fees for education increase significantly, as in Fid's case, a person's incentive to find less costly alternatives grows stronger.
Fid might consider enrolling his children in community colleges or choosing vocational training instead of traditional universities.
The substitution effect usually influences consumers to opt for more affordable options available in the market.
This is why, when prices rise for a good, the quantity demanded for that good often decreases as consumers turn to cheaper substitutes.

• This effect mainly focuses on relative price changes.
• It also happens when the appeal of alternative goods increases due to price differences.

Income Effect

The income effect refers to the change in an individual's purchasing power caused by a change in the price of a good. When the price of a product changes, it effectively alters income availability to buy additional goods or services.
When a price decreases, like with Homer's mortgage payments thanks to lower interest rates, it feels like a boost in real income. This is because Homer can now afford more housing with the same budget.
The opposite occurs when prices increase; similar to the rise in tuition fees faced by Fid, which reduces his effective income.
When a product becomes more expensive, purchasing power diminishes, forcing individuals to cut back or seek alternative goods.

• The income effect is notable in goods where a large portion of income is spent.
• It can lead to a choice between reducing consumption or finding cheaper alternatives.

Inferior Goods

Inferior goods have an interesting demand pattern due to changes in consumers' income. As income decreases, the demand for these goods often increases.
However, this is often not entirely linear with price changes. For example, consider Pam's reaction to the price rise in Spam. Despite Spam being an inferior good, she chooses not to buy it when the price rises.
This goes against the typical expectation that if a consumer's income decreases, they might buy more of an inferior good.
Pam's choice indicates that, even as an inferior good, the substitution effect of looking for alternatives can overpower any income effect.

• Inferior goods are typically those that people opt for when budget constraints tighten.
• As income rises, the demand for these goods generally decreases as better alternatives are within reach.
• Pam's situation reveals real-world complexity beyond textbook definitions.