Question

Tammy spends her money on lemonade and iced tea. If the price of lemonade falls, it is as though her income ____________ . a. Increases. b. Decreases. c. Stays the same.

Short answer

a. Increases.

Step-by-step solution

Understand the Concept

This problem relates to the concept of the substitution effect in economics. When the price of a good decreases, a consumer can purchase more of that good with the same amount of money, effectively increasing their purchasing power.

Analyze the Effect of a Price Change

When the price of lemonade falls, Tammy can buy more lemonade without spending extra money. This is similar to having more money or an increase in her income, as she can either consume more lemonade or allocate her savings to buy other items like iced tea.

Determine the Answer

From the analysis, the effect of the lemonade price drop is equivalent to an increase in Tammy's income because her purchasing power has increased. This aligns with choice (a).

Key concepts

Purchasing Power

Purchasing power is a key concept in understanding how much a consumer can buy with a given amount of money. Imagine having a budget or an amount of cash that you can use only for shopping. The amount of goods or services you can buy with that money is your purchasing power. For instance, if you have $10 and lemonade costs $2 per bottle, you can buy 5 bottles. If the price drops to $1 per bottle, your purchasing power effectively increases because you can now buy 10 bottles with the same $10.

In simple terms, when prices decrease, your money can purchase more, thus increasing your purchasing power. It's like getting a mini raise that goes towards buying more products or different products with your unchanged budget.

• If prices increase, your purchasing power decreases because you can buy less with the same amount of money.
• A decrease in prices leads to an increase in purchasing power, which is beneficial for consumers.

Understanding this concept helps explain consumer reactions to price changes.

Price Change

Price change refers to the alteration in the cost of a good or service over time. This change can be either an increase or a decrease, each having different effects on consumers. In our example, when the price of lemonade drops, it's considered a price decrease.

How does a price change impact consumers? Well, when prices go down, consumers often feel like they've gained extra money. This is not literal but rather an effect of their ability to buy more for less. On the flip side, if prices rise, it feels like a part of their income is lost since they'd have to spend more to buy the same quantity as before.

• A key reaction to a price decrease is the substitution effect, where consumers may choose to buy more of the cheaper good or substitute a more expensive good with a cheaper alternative.
• Price increases tend to reduce demand as the good becomes less affordable.

Understanding price changes helps consumers make better purchasing decisions.

Consumer Behavior

Consumer behavior delves into how individuals make decisions to allocate their resources, including money, time, and effort, towards consumption. Several factors influence this, like personal preferences, income, and, importantly, price changes. Let's revisit Tammy: when lemonade becomes cheaper, she might decide to buy more lemonade because she enjoys it.

This behavior showcases the substitution effect, where consumers will alter their usual buying patterns in response to price changes. If lemonade is cheaper, Tammy might buy more of it and less iced tea, especially if she was buying them in comparable quantities earlier.

• When prices decrease, consumers often alter what they buy and in what quantities, showing flexibility in their habits.
• Consumers may also use the saved money from cheaper prices to purchase other goods, reflecting a change in consumption patterns.

By understanding consumer behavior, businesses can predict responses to price changes and adjust their strategies accordingly.