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Homework answers / question archive / Recent research confirms that the demand for cigarettes is not only price inelastic, but it also indicates smokers with incomes in the lower half of all incomes respond to a given price increase by reducing their purchases by amounts that are more than four times as large as the purchase reductions made by smokers in the upper half of all incomes
Recent research confirms that the demand for cigarettes is not only price inelastic, but it also indicates smokers with incomes in the lower half of all incomes respond to a given price increase by reducing their purchases by amounts that are more than four times as large as the purchase reductions made by smokers in the upper half of all incomes. How can the income and substitution effects of a price change help explain this? Review price elasticity of demand and supply. Price elasticity describes the sensitivity between quantity demanded/supplied and price when a change in price occurs. A relatively lower change in quantity versus a change in price means the product is more price inelastic; a higher relative change in quantity versus a price change indicates more price elastic. Review the substitution effect and income effect dynamics.
Answer:
If a person’s income remains the same and yet prices increase, the end result would be that his capacity to purchase reduces. This is because with the same amount of money, he is now able to purchase lesser quantity of the good or service being offered.
For example, if my earnings were allocated in a manner that I would spend 100$ on buying cigarettes a month which were valued at 10$ a pack, then I would be able to purchase 10 packs in total. However, if the price of the cigarette rises to 20$, I would either have to allocate more funds, or I can now purchase 5 packs only with the given money which I have.
This is what income substitution means. It refers to the reduction in demand because of the decline in real income for a person. Further, I would be tempted to substitute my demand for cigarette by purchasing alternative tobacco products so that even though my consumption remains the same, my budget is not grossly affected.
Even though, the demand for cigarettes is relatively inelastic meaning that the change in price does not reflect too much on the demand as people find it difficult to substitute cigarette or to stop demanding the same, yet after a point of time, people indeed look for substitutes.
Again, for rich people who have a higher gross income, the substitution effect does not come into play as they may be able to raise their budget with a rise in price. However, for those that live on the margins, still being able to purchase the product would be very difficult considering that they find it harder to increase their budgets. They would either have to give up their demand or settle for cheaper alternatives like chewable tobacco products.
