Last week, I posted about the incentive effects of a fuel price change, noting that:
When the price of petrol went up on 1 July this year, it created an incentive for people to consume less petrol.
Now that I've covered the consumer choice model (or the constrained optimisation model for the consumer) in my ECONS101 class, it's time to revisit what happens when the price of fuel goes up, from the perspective of a fuel consumer. I'm not going to go through the basics of the consumer choice model here though, as I did that in this post about kūmara prices last year, so refer to that for the basic setup of the model.
The consumer choice model for the fuel consumer is shown below. The consumer can choose to buy a bundle of goods that includes some quantity of fuel (measured along the x-axis) and some quantity of 'all other goods' (AOG; measured along the y-axis). The starting point for our consumer is shown in black. The straight line that runs from M/Pa to M/Px0 is the consumer's budget constraint when the price of fuel is low (Px0). The consumer is trying to get to the highest possible indifference curve, which is the indifference curve I0. The consumer buys the bundle of goods E0, which contains X0 fuel.
Once the price of fuel goes up (to Px1), the budget constraint pivots inwards (shown by the red budget constraint, which runs from M/Pa to M/Px1). The consumer can no longer buy the bundle of goods E0, because it lies outside the consumer's budget constraint (it is outside the consumer's feasible set). Now, the highest possible indifference curve that the consumer can reach is the red indifference curve I1. The consumer buys the bundle of goods E1, which contains X1 fuel.
So, this model shows that when the price of fuel increases (from Px0 to Px1), the consumer decreases the amount of fuel that they buy (from X0 to X1). That is the Law of Demand, which is one of the most robust findings in economics. And it is clear that the consumer choice model demonstrates the same incentive effect of the fuel price increase that I discussed in my post about fuel prices last week.
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