Income+and+substitution+effects+in+demand,+insurance,+and+labor+markets.

=**__The Income and Substitution Effects__**=

Changes in price can affect buyers' purchasing decisions. This effect is called the income effect. Increases in price, while they don't affect the amount of your paycheck, make you feel poorer than you were before, and so you buy less. Decreases in price make you feel richer, and so you may feel like buying more. The tendency to change your purchase based on changes in relative price is called the substitution effect. A classic example of this is with hot dogs and hamburgers. If the price of hamburgers goes up, but the price of hot dogs stays the same, you might be more inclined to buy a hot dog. When the price of hamburgers goes up, it makes hamburgers relatively expensive and hot dogs relatively cheap, which influences you to buy fewer hamburgers and more hot dogs than you usually would. Likewise, a decrease in hamburger price would cause you to eat more hamburgers and fewer hot dogs, according to the substitution effect.

The income effect is conceptually used to derive a demand curve that slopes down. People have the tendency to increase their comsumption of normal goods as income increases. If people considered a medical exam as a normal good, then an increase in income would enable them to get the medical exam easier than before the income increase. A good is considered inferior when the demand falls as income increases. If a public health center is considered an inferior good, people may decide to go to a specialist or private physician as their income increased. If two medical services are substitutes, an increase in the price of one of the substitutes would cause people to consume more of the cheaper medical substitute.

//References:// Santerre, Rexford E. and Nuen, Steven P. __Health Economics: Theories, Insights, and Industry Studies.__ Thompson South-Western. 2007. Pgs. 97-99, 561, 569.

A) Buy the same. B) Buy less. C) Buy none. D) Buy more. E) None of the above. (Answer: D)
 * Question**- What would consumers do with normal goods if their income increased?

=**__Total Effect__**=

If you look at the combined results of the income effect and the substitution effect, the total effect is a little unclear. According to the income effect, an increase in the price of hamburgers decreases consumption of both hamburgers and hot dogs. According to the substitution effect, however, hamburger consumption drops, but hot dog consumption rises. It is clear what happens to hamburger consumption, since both effects tend to cause a decrease, we cannot be sure what happens to hot dog consumption, since there is both an increase, substitution effect, and a decrease, income effect. Another factor influencing demand is one that marketers and advertisers are always trying to understand and target which is buyers' preferences. What do people like? When and how do they like it?

=**__Goods__**=

Income and substitution effects change demand differently with different types of goods. The past example with the hot dogs and hamburgers were dealing with normal goods. However, inferior goods change in different ways. If an increase in your income causes you to buy less of a good, that good is called an inferior good. The income effects on the inferior goods can be shown by thinking of a college student. College students usually choose cheap food because their income is low, however, when they graduate and have a higher level of income, they don’t choose to buy the cheaper foods.

=**__Labor Market__**=

This income and substitution effect can also affect the labor market. However, you must think of leisure (time not working) as a good that can be bought by foregone wages (the money you would have earned if you were working). The substitution effect means that given an increase in the price of leisure you are likely to demand less leisure, and therefore more work. In other words, you will substitute work for leisure. The income effect means that you are now better off as a result of working a given number hours, which, assuming leisure is a normal good, will lead you to demand more leisure and work less.

=**__Questions:__**=

1. According to the substitution effect, a decrease in hamburger price would: A) cause you to purchase more hot dog buns B) cause you to purchase more hot dogs and hamburgers C) cause you to eat more hot dogs D) cause you to eat more hamburgers (Answer: D)

2. T/F Income and substitution effects are the same for all types of goods. (Answer: False)

3. Fill the blank: You choose an inferior good if your income _. (Answer: Decreased)

4. Given an increase in the price of leisure you are likely to demand A) less work B) more leisure C) less leisure, D) neither more work or less leisure-no change (Answer: C)