3: Demand

Question 1

income expansion path

Answer 1

how the optimal bundle changes as income changes

x2 vs. x1 space

Question 2

engel curve

Answer 2

how optimal consumption of one good changes as income changes

m vs. x1 space

Question 3

normal good

Answer 3

as income increases, demand increases

positive engel slope

Question 4

inferior good

Answer 4

as income increases, demand decreases

negative engel slope

Question 5

offer curve

Answer 5

how the optimal bundle changes as price changes
x2 vs. x1 space

Question 6

ordinary good

Answer 6

as price increases, demand decreases

demand curve slopes down

Question 7

giffen good

Answer 7

as price increases, demand increases

demand curve has a positive slope

Question 8

substitutes

Answer 8

demand for one good increases as the price of the other good increases

dx1*/dp2 > 0

Question 9

complements

Answer 9

demand for one good decreases as the price of the other good increases

dx1*/dp2 < 0

Question 10

total price change decomposed into

Answer 10

substitution effect and income effect

effect of PP change and relative price change

Question 11

substitution effect

Answer 11

relative price effect

if the relative price of two goods change, we expect the consumer’s new bundle to include more of the cheaper good at the expense of the more expensive good

Z - X

Question 12

income effect

Answer 12

PP effect
- similar to an income change

if the relative price of a good changes and income stays the same, we expect the consumer’s new bundle to include more of both goods because the consumer is “richer”

Y - Z

Question 13

slutsky decomposition question

Answer 13

what if a consumer faced a budget line with the same slope (prices are the same relative prices) but they can still afford the original bundle?

Question 14

slutsky decomposition

Answer 14

controlling for PP since you can afford original prices but relative prices are different

start with old budget and optimal point x
draw new budget line after price change and new optimal point y
draw hypothetical budget with same slope as new budget which crosses x

Question 15

substitution and income effect in slutsky decomposition

Answer 15

substitution effect must be negative if preferences are monotonic
- when price increases, substitution effect is to consume less
- when price decreases, substitution effect is to consume more

income effect can go either way
- depends on whether the good is normal or inferior
- if the income effect is strong in the opposite direction to the substitution effect, we have a giffen good

Question 16

hicks decomposition question

Answer 16

what if a consumer faced a new price ratio but their optimal choice was on the same indifference curve as before?

start with old budget line and optimal point x
draw new budget line after price change and new optimal point y
draw hypothetical budget line with same slope as the new budget line which is tangent to the old IC

Question 17

slutsky vs. hicks

Answer 17

slutsky is useful since its based on observables and not utility
- decomposed by focusing on affordability of the old bundle after the price change

hicks is useful to measure welfare changes and compensation
- decomposed by focusing on utility of the old bundle after price change
- 2 ICs
- harder to measure in the real world

Question 18

PED

Answer 18

% change in QD / % change in P

the steeper the demand curve, the more inelastic

Question 19

PED equation

Answer 19

• dx1/p1 (p1/x1)

Question 20

PED < 1

Answer 20

inelastic demand

% demand response is smaller than % price change

Question 21

PED > 1

Answer 21

elastic demand

% demand response is bigger than % price change

Question 22

income expansion path for cobb-douglas function

Answer 22

higher weight on good 1 than good 2 on the utility function makes the liner flatter

lower price of good 1 also makes the liner flatter

if p1=p2 and there are equal weights, the consumer always spends half their income no each good
- 45 degree line from origin

Question 23

when is the substitution effect 0?

Answer 23

optimal choice on the hypothetical budget line exactly the same as the optimal choice on the original budget line

Question 24

MRS > p1/p2

Answer 24

there are bundles above that are preferred

willing to give up more than necessary (by price constraint)