According to data from the U.S. Department of Energy, the average retail price of regular gasoline rose from \(\$ 1.16\) in 1990 to \(\$ 3.24\) in \(2012,\) a $180 \%$ increase. a. Other things equal, describe the effect of this price increase on the quantity of gasoline demanded. In your explanation, make use of the utility- maximizing principle of marginal analysis and describe income and substitution effects. In fact, however, other things were not equal. Over the same time period, the prices of other goods and services rose as well. According to data from the Bureau of Labor Statistics, the overall price of a bundle of goods and services consumed by an average consumer rose by 75\%. b. Taking into account the rise in the price of gasoline and in overall prices, other things equal, describe the effect on the quantity of gasoline demanded. However, this is not the end of the story. Between 1990 and 2012 , the typical consumer's nominal income increased, too: the U.S. Census Bureau reports that U.S. median household nominal income rose from \(\$ 29,943\) in 1990 to \(\$ 51,017\) in \(2012,\) an increase of \(70 \%\). c. Taking into account the rise in the price of gasoline, in overall prices, and in consumers' incomes, describe the effect on the quantity of gasoline demanded.

Step by step solution

01

a. Effect of the price increase on gasoline demand

When the price of gasoline increases, consumers are likely to consume less gasoline due to the law of demand, which states that when the price of a good increases, the quantity demanded decreases, ceteris paribus. The utility-maximizing principle of marginal analysis states that consumers should continue consuming a good until its marginal benefit equals its marginal cost. In this case, when the price of gasoline increases, the marginal cost of gasoline increases. To maximize utility, consumers may consume less gasoline, and the quantity demanded of gasoline may decrease. Furthermore, there are two different effects at work with this change in price - the substitution effect and the income effect. The substitution effect represents the change in consumption due to changes in relative prices of goods, and the income effect represents the change in consumption due to a change in real purchasing power (income). When the price of gasoline increases, consumers may substitute other modes of transportation (e.g., public transit, carpooling, or walking), decreasing the quantity demanded for gasoline (substitution effect). The higher price of gasoline also means that consumers' purchasing power is lowered; as a result, they may cut back on gasoline consumption (income effect).

02

b. Effect on gasoline demand considering rising prices of other goods and services

Taking into account the rise in the prices of other goods and services, we need to evaluate the overall impact on consumers' purchasing power. If the overall prices for a bundle of goods and services increased by 75%, it means that the relative price of gasoline has increased more than the overall price level, as gasoline prices rose by 180%. However, since not only the price of gasoline has increased but also the price of other goods and services have increased, it might reduce the substitution effect compared to when the price of gasoline had risen in isolation. Despite the reduced substitution effect, the overall higher price of gasoline would still lead to a decrease in the quantity of gasoline demanded due to the income effect.

03

c. Final effect on gasoline demand, considering price increases and a rise in income

Now we consider the change in consumers' incomes, which increased by 70% from 1990 to 2012. This rise in income could potentially offset the negative effect of increased gasoline prices on the quantity demanded, depending on the income elasticity of gasoline demand. If gasoline demand has a positive income elasticity, it means that the quantity demanded will increase as income increases (i.e., it's a normal good). In this case, the increase in consumer income might lead to an increase in the quantity of gasoline demanded, partially or completely offsetting the negative effects of higher gasoline prices. However, if gasoline demand has a negative income elasticity, it means that the quantity demanded will decrease as income increases (i.e., it's an inferior good). In this case, the increase in consumer income would lead to a further decrease in the quantity of gasoline demanded. Overall, the effect of the price increase in gasoline, the rise in overall prices, and the increase in consumers' incomes on the quantity of gasoline demanded is not straightforward and depends on the income elasticity of gasoline demand and the magnitude of the income, substitution, and price effects.

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