11 Demand and Price Changes

Question 1

How do we find the optimal point of consumption?

Answer 1

Question 2

What are the marginal utilities?

The MRS condition? The budget constraint?

Solve for x₁ and x₂.

Answer 2

Question 3

4 steps to finding the optimal point of consumption

Answer 3

Question 4

Answer 4

Question 5

Answer 5

Question 6

Answer 6

Question 7

Answer 7

Question 8

Answer 8

Question 9

Answer 9

Question 10

Define normal goods

Answer 10

Positive income elasticity

Question 11

Define inferior goods

Answer 11

Negative income elasticity

Question 12

Define necessities

Answer 12

Positive income elasticity between zero and one

Question 13

Define luxury goods

Answer 13

Positive income elasticity greater than one

Question 14

Define ordinary goods

Answer 14

Negative own-price elasticity

Question 15

Define giffen goods

Answer 15

Positive own-price elasticity

Question 16

Define price elastic

Answer 16

Own-price elasticity between -1 and -∞

Question 17

Define price inelastic

Answer 17

Own-price elasticity between 0 and -1

Question 18

Define complements

Answer 18

Negative cross-price elasticity

Question 19

Define substitutes

Answer 19

Positive cross-price elasticity

Question 20

When price changes, what are the two effects on the budget constraint?

Answer 20

1. Change in relative prices of the good (change in slope) → substitution effect
2. Change in the consumer’s purchasing power (area) → income effect

Question 21

Suppose a relative price change of good 1, how do we show the substitution effect? + diagram

Answer 21

Holding utility constant, the budget constraint changes slope.

This changes the point at which the MRS = slope.

The change in quantity demanded is the substitution effect.

Question 22

Train ticket to Weston-super-Mare

Answer 22

Question 23

Suppose a change in budget, how do we show the income effect? + diagram

Answer 23

Holding relative prices constant at their new level, it shifts inwards/outwards.

This changes the quantity at which MRS = slope, the combination of goods does not.

The change in quantity demanded is the substitution effect.

Question 24

Total effect (income + substitution) written algebraically

Answer 24

Question 25

What is the substitution effect always?

Answer 25

As it shows the change in demand as its price changes (holding the utility number constant), the value is always weakly negative (or zero).

This is due to the convexity and downward-sloping characteristics of indifference curves generated by well-behaved preferences.

Question 26

For a normal good, what are the signs of each effect and of total effect? Implication.

Answer 26

Question 27

For an inferior good, what are the signs of each effect and of total effect?

Answer 27

Question 28

What is the Slutsky equation? (own-price)

Answer 28

For derivative-sized changes the approximation disappears.

Question 29

What is the Slutsky equation? (cross-price) + implication

Answer 29

Question 30

What is the Slutsky equation with endowment?

Answer 30

Depending on whether or not the consumer is a net demander or supplier of good 1, this final term can be positive or negative.