Budget Constraints and income changes

Question 1

Equation of budget constraint

Answer 1

q2= -p1/p2 x q1 + Y/p2

Question 2

What is the slope of a budget constraint

Answer 2

Marginal rate of transformation (MRT), it measures the opportunity cost of consuming one pizza in terms of burritos. -p1/P2

Question 3

What must be true for a point to give optimal utility given the budget constraint

Answer 3

MRS=MRT so u1/p1=u2/p2

Question 4

How are interior solutions for maximising utility found?

Answer 4

Substitution method or langrangian method

Question 5

When can corner solutions occur?

Answer 5

When the utility functions indifference curve hits the axis. Usually happens with perfect substitutes or quasilinear

Question 6

What happens to an individual’s consumption of a good when that good’s price changes?

Answer 6

They re-optimise, their behaviour changes but their preferences don’t

Question 7

How can a demand curve be derived for a good using price?

Answer 7

Lower and increase the price of the good and find what quantity of the good the consumer consumes using a price consumption curve and then plot this

Question 8

How can demand curves be derived for a good using income?

Answer 8

Alter income and find changes in consumption, plot an Engel curve and then turn this into demand curves

Question 9

Normal good

Answer 9

If Income increases so does consumption

Question 10

Inferior good

Answer 10

If income increases, demand decreases

Question 11

How do we find market demand when we have consumers’ demand

Answer 11

Find their demand functions and add them then turn it into inverse demand

Question 12

What two parts can we decompose the total change in quantity demanded of a good into?

Answer 12

Substitution effect and income effect

Question 13

Substitution effect

Answer 13

Substitute other goods for good A as price of A rises

Question 14

Income effect

Answer 14

As the price of A rises, real income falls and so spending on all goods decreases

Question 15

How do we find the substitution effect after an increase in price of good one?

Answer 15

We increase the consumers income until their utility is back to its original level. The difference in quantity between this point e* and the original point e1 is equal to the substitution effect

Question 16

How do we find the income effect after an increase in the price of good one?

Answer 16

We give the consumer their original income with the new price and find the new maximised utility e2. The difference between this point and e* is the income effect.

Question 17

Substitution, income and total effect of an increase in price of a normal good?

Answer 17

Sub -ve
In -ve
Total -ve

Question 18

Substitution, income and total effect of a decrease in price of a normal good?

Answer 18

Sub +ve
In +ve
Total +ve

Question 19

Substitution, income and total effect of an increase in price of an inferior good?

Answer 19

Sub -ve
In +ve
Total -ve

Question 20

Substitution, income and total effect of a decrease in price of an inferior good?

Answer 20

Sub +ve
In -ve
Total +ve

Question 21

Substitution, income and total effect of an increase in price of a giffen good?

Answer 21

Sub -ve
In +ve
Total +ve

Question 22

Substitution, income and total effect of a decrease in price of a giffen good?

Answer 22

Sub +ve
In -ve
Total -ve

Question 23

What are compensated demand curves?

Answer 23

It is a demand curve that holds utility constant as a goods price changes. This eliminates the income effect so price increases always decrease demand

Question 24

How do you construct the compensated demand curve?

Answer 24

By shifting budget constraints to remain on the same indifference curve.

Question 25

Is compensated demand curve steeper or shallower than the uncompensated demand curve?

Answer 25

It is steeper for normal goods because the income effect has been eliminated

Question 26

Why do we use the compensated demand curve?

Answer 26

Substitution effects cause a bias in the consumer price index (CPI)

Question 27

Compensating variation

Answer 27

Refers to the amount of money we have to pay someone after a price change to bring them back to their original utility level

Question 28

How do you work out the compensating variation?

Answer 28

Original utility maximising point is e1, after price increase point is e2. The same as with the income and substitution effect, we increase the co summers income until they are on their original utility function again. The increase in income is the compensating variation

Question 29

Equivalent variation

Answer 29

Given a consumers choice before a price increase, how much Monday would we have to gage away from that consumer to reduce their utility by as much as the price increase

Question 30

Who do we work out the equivalent variation

Answer 30

Start at original point e1, the consumption point changes to e2 after the price change. We move the old budget constraint parallel to the new utility function. The vertical difference between the two budget constraints is the equivalent variation.

Question 31

Are the compensating abs equivalent variations the same?

Answer 31

Usually they are different because
CV- how much money is required to compensate the consumer given the new prices
EV- how much money needs to be taken away from the consumer given old prices

Question 32

Why must the government consider the equivalent variation when setting subsidies?

Answer 32

The cost of the subsidy must be greater than the equivalent variation

Question 33

Why are subsidies inefficient?

Answer 33

The subsidy cost is greater than the equivalent variation do costs > benefits so direct income transfer to consumers would be cheaper

Question 34

Consumer surplus

Answer 34

It is an alternative welfare measure to compensating and equivalent variation in income. It is the difference between the price paid and what the consumer is willing to pay for it

Question 35

What is the problem with using consumer surplus

Answer 35

It is approximate since it ignores the income effect

Question 36

Marginal valuation argument

Answer 36

Assumes that utility from consuming good one doesn’t depend on how much money is left for good two. This is usually a good assumption if good one only accounts for a very small share of total expenditure.

Question 37

What could make consumer surplus more accurate

Answer 37

If we used the compensated demand curve then consumer surplus would be exact. However, we use the uncompensated curve because sometimes income effects are difficult to measure