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After Iraq invaded Kuwait, gasoline prices rose dramatically - up 50 percent
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.
Expert Solution
When people drive less and eat out less often, they are demonstrating the income effect because they are choosing to spend less in response to increasing prices. Having tune-ups is an example of the substitution effect since tune-ups allow a vehicle to operate at peak efficiency and by extension save on gasoline. Choosing to buy and ride bikes is another example of substitution.
Decreases in lottery ticket sales can be attributed to both the income and substitution effect. Lottery tickets are typically sold in gas stations, and customers are choosing to either spend their money on gasoline instead or avoiding the gas station altogether. The same can be said for vacations, People are either choosing to stay closer to home to avoid purchasing gas for extended trips, or have less money to spend on destination travel because disposable income is instead being spent on gas.
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