Question

3. After Iraq invaded Kuwait, gasoline prices rose dramatically – up 50 percent. There were many effects of the increased price of gasoline. Explain the following effects in terms of the income effect, substitution effect, or both effects:

a. People drove less and purchased less gas.

b. People ate out less often.

c. People had more tune-ups done on their cars.

d. Bike sales went up.

e. The sale of lottery tickets fell.

f. People took vacations closer to home.

Answer 1

a. People drove less and purchased less gas.

Real income of people gets reduced when oil price rises. This is income effect. Hence, now they drove less.

b. People ate out less often.

real income is get reduced or purchasing power people

c. People had more tune-ups done on their cars.

This is substitution effect.

d. Bike sales went up.

This is substitution effect. Bike is close substitute of car and it is relatively consume less oil. Hence, demand for bike begins to rise.

e. The sale of lottery tickets fell.

This is income effect. Purchasing power of people decreases.

f. People took vacations closer to home.

This is both income effect and substitution effect owing fall in purchasing power of people. Far flung vacation has been substituted.