Wednesday, July 08, 2009

Income and Substitution Effects Explain Changes in Burrito Consumption



I took many economics courses, and yet it wasn’t until I experienced a change in my own personal finances that I really understood the nature of the income and substitution effects. The technical definitions are as follows: the income effect explains spending responses to effective changes in income level; the substitution effect explains spending responses to changes in the relative price of one good to another.

Only when my parents stopped paying for my groceries did the technical definitions sink in. Back when groceries were “free,” I often faced the following decision: Do I make lunch at home at no personal monetary cost, or do I go out and spend $6 on a burrito? The answer depended on a number of factors, such as (1) how badly I wanted a burrito (my current preference for burritos vs. homemade food); (2) how much money I recently made and spent (my budget constraint); and (3) what I could do if I wasn't preparing food (the opportunity cost of making lunch).

Having to pay for my own groceries altered this decision-making process in two ways. First, the former trade-off between a $6 burrito and the homemade lunch with ingredients paid for by my parents became the choice between a $6 burrito and a homemade lunch that costs me $3 in groceries. Although the price of eating out remained the same, it became relatively less expensive. The explicit cost of getting a burrito is now only $3 more than that of making a sandwich ($6 burrito, $3 sandwich); before it was $6 more ($6 burrito, $0 sandwich). I might now be more likely to choose the burrito than before. In doing so, I would be substituting the burrito for the homemade lunch due to the reduction in the relative price of a burrito. Whether or not I actually choose to do this, however, would depend on the strength of the income effect.

Now that I allocate a substantial portion of my monthly income to buying groceries, I have less money for all other purchases. Among those purchases are burritos, so by adding another item to my budget, the income available for burritos effectively declined. If burritos are normal goods, this negative income effect may lead to a decrease in my burrito consumption.

Which effect dominates? In my case, probably the income effect, but in general—it depends. Given that my budget didn’t encompass a lot of luxury purchases to begin with, dining out was a big part of the non-essential purchases I cut back on to make room in my budget for groceries. I adapted my schedule so that I could go home for lunch more often, and I started buying groceries conducive to paper-bag lunches.

Discussion Questions

1. Suppose your parents decide to stop paying for your textbooks (assuming they paid for them in the first place). What is the expected effect on your food consumption as a whole? Is this an example of the income effect, the substitution effect, or both?

2. In addition to the income and substitution effects changing my spending behavior, paying for my own groceries made me internalize the cost of groceries. How might this affect my overall consumption of food? In terms of economic efficiency, is internalization a good or a bad thing?

3. What are some factors that might affect the opportunity cost of homemade lunches? How would changes in the opportunity cost affect the strength of the income effect vs. the substitution effect?

4. Consider what would happen if you didn’t plan ahead and face the choice between spending half an hour to walk home and prepare lunch or spend $6 to buy lunch. Which effect is likely to dominate if your hourly wage is $7.25? $13? How does this relate to the concept of opportunity cost?

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