Income and Substitution Effects

Income and Substitution Effects

Incomeand Substitution Effects

ByStudent Name’s

Incomeand Substitution Effects

Whenthe price of normal commodities is determined by the market, theforces of demand and supply come into play in the determination ofthe market equilibrium1.In the case the automobile companies, the vanadium, GPS systems,steel and cars are normal goods whose market equilibrium aredetermined by the forces of demand and supply. At the same time, theGPS system, steel and windshield are a complementary good, whichmeans that its demand will be influenced by the changes in the priceof cars. This is in addition to the changes in their own demand,prices and supply.

Theimposition of a unit tax on vanadium leads to a proportionateincrease in its price per unit. This is because vanadium is a normalgood, and manufacturers will tend to pass the tax margin to thebuyers. A unit tax imposed on a normal product will be passed to theconsumers by increasing the price in case of market determination ofprice2.The increase in the price of vanadium will in turn leads to adecrease in its demand because consumers reduce the quantity they arebuying at their disposable income. At the same time, vanadium is anormal good, but a necessity in the production of steel, a rawmaterial for cars. Therefore, the supply of vanadium will increase asthe suppliers seek to profit in the market due to their passage ofthe tax margin to the buyers.

Therise in the price of vanadium leads to an increase in the price ofsteel. This is because vanadium is a raw material for steel.Therefore, an increase in the price of vanadium increases the cost ofproduction of steel, which reflects in the price of steel as theproducers will pass the cost to the buyer. The increase in the priceof steel will in turn leads to an increase in the cost of makingcars. As a result of the increase in costs, the price of cars willincrease. The price of vanadium affects the price of the car becauseautomobile manufacturers will pass the same increase in cost to thebuyer in the form of a proportionate price increment.

Therise in the price of cars will lead to a proportionate change in thedemand of cars. The demand of cars will reduce margins in the market.This is because the customers will be limited to buying cars inaccordance with their level of disposable income. Without an increasein income, any increase in the price of a normal good lead to aproportionate increase in the demand of that product3.Therefore, customers will keep reduced the quantity of cars they buy.However, the supply of cars will remain the same, because the pricedoes not affect the profitability of the car manufacturers. Thishappens because the suppliers are able to pass the incremental costto the customers.

Atthe same time the increase in the price of vanadium will lead to aproportionate decrease in the demand for windshields and GPS systems.This is because they are complimentary goods used in the manufactureof the cars. Therefore, a reduction in the demand of the cars willlead to a reduction in the production, thereby reducing the demandfor input goods such as windshields and the GPS systems. A reductionin the demand of windshields and GPS systems leads to a reduction intheir prices, which reduces their supply in the market. This showsthe comprehensive effect of the imposition of a per unit tax onvanadium.


Mankiw,N. (2014). Principlesof Economics.Stamford: Cengage Learning

Frank,R. (2008). Microeconomicsand Behavior,7th Ed.New York: McGraw-Hill.

1 Mankiw, N. (2014). Principles of Economics. Stamford: Cengage Learning

2 Frank, R. (2008). Microeconomics and Behavior, 7th Ed. New York: McGraw-Hill

3 Mankiw, N. (2014). Principles of Economics. Stamford: Cengage Learning