Question

Assume that both air travel and travel by car are normal goods and you spend a fixed amount of income on both goods. Suppose that when the price of crude oil goes up by 30%, the price per mile of air travel goes up by 10% and the price per mile traveled by car goes up by 20%. Explain how the increase in the price of crude oil affects air travel and travel by car in terms of the income effect, the substitution effect, and the overall (net) effect.

Answer 1

Increase in the price of oil will lead to decrease in the real income which consequently will lead to buying less of both air travel and car travel.The income effect will negatively affect the consumption of air and car travel as they both are normal goods. We know that demand for normal goods go up with an increase in income and vice versa. Also we can notice that the increase in price of air travel is lower than the increase in price of car travel. This means that air travel will now be preferred more, this is substitution effect. The demand for air travel will go up and car travel will go down. The net effect will be dependent on the magnitude of change in income and substitution effect.