Question

According to data from the U.S. Department of Energy, the average retail price of regular gasoline rose from $\mathrm{\$}1.16$ in 1990 to $\mathrm{\$}3.24$ in $2012,$ a $180\mathrm{\%}$ increase. a. Other things equal, describe the effect of this price increase on the quantity of gasoline demanded. In your explanation, make use of the utility- maximizing principle of marginal analysis and describe income and substitution effects. In fact, however, other things were not equal. Over the same time period, the prices of other goods and services rose as well. According to data from the Bureau of Labor Statistics, the overall price of a bundle of goods and services consumed by an average consumer rose by 75\%. b. Taking into account the rise in the price of gasoline and in overall prices, other things equal, describe the effect on the quantity of gasoline demanded. However, this is not the end of the story. Between 1990 and 2012 , the typical consumer's nominal income increased, too: the U.S. Census Bureau reports that U.S. median household nominal income rose from $\mathrm{\$}29,943$ in 1990 to $\mathrm{\$}51,017$ in $2012,$ an increase of $70\mathrm{\%}$. c. Taking into account the rise in the price of gasoline, in overall prices, and in consumers' incomes, describe the effect on the quantity of gasoline demanded.

Short answer

Question: Describe the final effect on the quantity of gasoline demanded, considering the increase in gasoline prices, the rise in overall prices, and the increase in consumers' incomes from 1990 to 2012. Answer: The final effect on the quantity of gasoline demanded depends on the income elasticity of gasoline demand and the magnitude of the income, substitution, and price effects. If gasoline demand has a positive income elasticity, the increase in consumer income could offset the negative effects of higher gasoline prices. If gasoline demand has a negative income elasticity, the increase in consumer income would lead to a further decrease in the quantity of gasoline demanded.

Step-by-step solution

a. Effect of the price increase on gasoline demand

When the price of gasoline increases, consumers are likely to consume less gasoline due to the law of demand, which states that when the price of a good increases, the quantity demanded decreases, ceteris paribus. The utility-maximizing principle of marginal analysis states that consumers should continue consuming a good until its marginal benefit equals its marginal cost. In this case, when the price of gasoline increases, the marginal cost of gasoline increases. To maximize utility, consumers may consume less gasoline, and the quantity demanded of gasoline may decrease. Furthermore, there are two different effects at work with this change in price - the substitution effect and the income effect. The substitution effect represents the change in consumption due to changes in relative prices of goods, and the income effect represents the change in consumption due to a change in real purchasing power (income). When the price of gasoline increases, consumers may substitute other modes of transportation (e.g., public transit, carpooling, or walking), decreasing the quantity demanded for gasoline (substitution effect). The higher price of gasoline also means that consumers' purchasing power is lowered; as a result, they may cut back on gasoline consumption (income effect).

b. Effect on gasoline demand considering rising prices of other goods and services

Taking into account the rise in the prices of other goods and services, we need to evaluate the overall impact on consumers' purchasing power. If the overall prices for a bundle of goods and services increased by 75%, it means that the relative price of gasoline has increased more than the overall price level, as gasoline prices rose by 180%. However, since not only the price of gasoline has increased but also the price of other goods and services have increased, it might reduce the substitution effect compared to when the price of gasoline had risen in isolation. Despite the reduced substitution effect, the overall higher price of gasoline would still lead to a decrease in the quantity of gasoline demanded due to the income effect.

c. Final effect on gasoline demand, considering price increases and a rise in income

Now we consider the change in consumers' incomes, which increased by 70% from 1990 to 2012. This rise in income could potentially offset the negative effect of increased gasoline prices on the quantity demanded, depending on the income elasticity of gasoline demand. If gasoline demand has a positive income elasticity, it means that the quantity demanded will increase as income increases (i.e., it's a normal good). In this case, the increase in consumer income might lead to an increase in the quantity of gasoline demanded, partially or completely offsetting the negative effects of higher gasoline prices. However, if gasoline demand has a negative income elasticity, it means that the quantity demanded will decrease as income increases (i.e., it's an inferior good). In this case, the increase in consumer income would lead to a further decrease in the quantity of gasoline demanded. Overall, the effect of the price increase in gasoline, the rise in overall prices, and the increase in consumers' incomes on the quantity of gasoline demanded is not straightforward and depends on the income elasticity of gasoline demand and the magnitude of the income, substitution, and price effects.

Key concepts

Marginal Analysis and Its Role in Gasoline Demand

Marginal analysis is a crucial concept in economics, helping consumers and firms determine the allocation of resources to maximize satisfaction or profits. When it comes to individual consumers, this involves making consumption decisions based on the utility-maximizing principle.
This principle suggests that consumption should continue up to the point where the marginal benefit of a good equals its marginal cost.
In the context of gasoline, as its price rises, so does its marginal cost. At this higher cost, the additional benefit of each extra unit of gasoline reduces relative to its price.
To optimize utility, consumers buy less gasoline, thereby decreasing the quantity demanded.

Marginal analysis not only shows why demand decreases when prices rise but also bridges the understanding between economic decisions and real-life changes in spending behavior.
Consumers, aiming to stay within their budgets while trying not to compromise on their utility, often switch to alternatives or reduce consumption to maintain equilibrium between costs and benefits. This adaptation to changing prices is a natural outcome of applying marginal analysis.

Understanding the Substitution Effect in Demand

The substitution effect is a powerful force in consumer behavior, particularly when prices change.
When the price of gasoline increases, consumers often look for more affordable alternatives as a response to change in relative prices.

Substitution is more likely to occur when substitutes are readily available. For instance, if public transportation services are efficient and not costly, people might prefer buses or trains over driving themselves.
Besides, carpooling does not only reduce the individual costs but can also be a socially conscious alternative.

This effect causes consumers to consume less of the product experiencing price increase, while they consume more of the substituted product.
In the scenario of gasoline prices increasing, the substitution effect may not only reduce demand for gasoline but could promote the use of bicycles, walking, or even opting for energy-efficient vehicles.
The decision to substitute is driven by the intent to fulfill needs while minimizing costs amidst rising prices, thus significantly reshaping demand dynamics.

The Role of Income Effect in Consumer Demand

The income effect explores how a change in a consumer's real income, or purchasing power, impacts their buying behavior.
When the price of gasoline rises, but incomes remain the same, individuals experience reduced real purchasing power because they need to spend more of their income on gasoline, leaving less for other products.

This diminished purchasing power can lead them to cut back not only on gasoline but potentially on other goods and services as well.
Conversely, if an individual's income increases, it could counterbalance the higher cost of gasoline as they can afford to maintain or even increase their consumption.
The strength of this effect depends on whether the good in question is deemed a normal or inferior good.

For gasoline, often considered a normal good, an increase in income may lead people to buy more despite price hikes. But if income growth is less than the rise in gasoline prices, the real income effect still drives a reduction in quantity demanded.
Understanding the income effect helps illuminate how broader economic factors, like salary changes over time, intertwine with everyday consumer choices in response to price fluctuations.