Chapter 5 - Individual and market demand Flashcards
- Define the income effect. What variables do we hold constant in order to isolate the income effect?
- The income effect describes the change in a consumer’s consumption choice given a change in the purchasing power of the consumer’s income. In describing this change, we hold the goods’ prices fixed
- What are the differences between normal goods, inferior goods, and luxury goods?
- We characterize a good as normal when consumption of the good rises with income. Luxury goods are a class of normal goods whose income elasticity is greater than 1.
In contrast to normal goods, the consumption of an inferior good decreases when income rises.
(A good can be normal at low income values, but inferior at high income values)
- Both the income expansion path and the Engel curve show the effect of income on consumption choices. When might you choose to use the income expansion path? When might the Engel curve be more useful?
- The income expansion path connects the optimal bundles of two goods for one consumer, while the Engel curve shows the relationship between the quantity of a good consumed and a consumer’s income. While both the Engel curve and the income expansion path contain the same information, the income expansion path allows us to understand how two goods’ relative quantities change with income. The Engel curve isolates the impact of income changes on the consumption of a single good
- Describe how we can derive a consumer’s demand curve from his indifference curves. Why would we expect the demand curve to slope downward?
- Holding the consumer’s income constant, we can draw his demand curve by connecting the utilitymaximizing quantities of a good at different prices of the good. When the price of a good increases, the consumer’s demand for the good decreases, creating a downward-sloping demand curve.
- Name at least three factors that can shift an individual’s demand curve for pizza. Also describe the effect each factor has on demand (e.g., does it rise or fall?).
- The demand for pizza will shift in response to changes in the consumer’s income or preferences, as well as the price of other goods. Three possibilities of shifts in the demand for pizza are listed below:
a. Increase in the consumer’s income:
If pizza is a normal good, then an increase in the consumer’s income will shift out his demand for pizza.
b. Decrease in the consumer’s relative preference for pizza: If the consumer’s relative preference for pizza decreases-say, he starts preferring the substitute good, Chinese take-out-then his demand for pizza will shift in.
c. Increase in the price of another good: If the price of a good such as Chinese take-out increases, then the consumer’s demand for pizza will shift out. If the price of a complement of a good-like the beverage the consumer prefers to have with his pizza-increases, then the consumer’s demand for pizza will shift in
- Define the substitution effect. How does it relate to the income effect?
- Both the income and substitution effects stem from a change in the prices of two goods. While the substitution effect is the change in a consumer’s consumption choices that results from a change in the relative prices of the two goods, the income effect describes the change resulting from the consumer’s purchasing power.
Finally, remember that the total effect of a price change (for either good) on quantity consumed depends on the relative size of the substitution and income effects. If the price of one good falls, the quantities of both goods consumed may rise, or consumption of one good may rise and consumption of the other good may decline. But the quantities consumed of both goods cannot both decline, because this would mean the consumer would not be on her budget constraint.
- How do income and substitution effects differ between normal and inferior goods?
- The direction of the substitution effect is the same for both normal and inferior goods, but the income effect differs between the two types of goods.
Substitution effects involve comparisons of bundles that lie on the same indifference curve.
If the good’s relative price falls, the substitution effect causes the consumer to want more of it.
If the good’s relative price rises, the substitution effect causes the consumer to want less of it
Income effects involve comparisons of bundles that lie on two different indifference curves.
If a normal good’s price decreases, the change in consumption due to the income effect is an increase in consumption of the good. If an inferior good’s price decreases, the change in consumption due to the income effect is a decrease in consumption of the good.
- What are complements and substitutes?
- A complement is a good that is purchased and used in combination with another good. A substitute is a good that can be used in place of another good.
- When the cross-price elasticity of demand is positive, are the two goods complements or substitutes? What type of goods have a negative cross-price elasticity?
- When the price of a good’s substitute rises, the demand for the good increases, meaning substitutes have a positive cross-price elasticity of demand. Complements have a negative cross-price elasticity of demand; when the price of a good’s complement rises, the demand for the good decreases.
- What can the shape of the indifference curve tell us about two goods?
- The shape of the indifference curve reveals information about the degree of two goods’ substitutability. The less curved the indifference curve, the more substitutable the two goods are.
- How does the market demand relate to individual demand curves?
- The market demand is the horizontal sum of all individuals’ demand curves for a good
- Why will a market demand curve always be at least as flat as a given individual demand curve and why will a market demand curve never be to the left of any individual demand curve?
- For a given change in price, the change in quantity demanded by the market as a whole must be at least as great as the change in quantity demanded by an individual consumer. As a result, the market demand curve must be at least as flat as an individual’s demand curve.
A market demand curve will never be to the left of any individual demand curve, because all consumers combined must consume at least as much of a good at a given price as any single consumer does
What is the income expansion path and what does the slope mean?
Income expansion path - a curve that connects a consumer’s optimal bundles at each income level
When both goods are normal goods, the income expansion path will be positively sloped because consumption of both goods rises when income does
If the slope of the expansion path is negative, then the quantity consumed of one of the goods falls with income while the other rises
The one whose quantity falls is an inferior good
What is the Engel curve and what does the slope mean?
Engel curve - a curve that shows the relationship between the quantity of a good consumed and a consumer’s income
Positive slope - normal good at that income level
Negative slope - inferior good at that income
How do changes in the prices of substitutes or complements shift the demand curve?
Outward demand shift if price of substitute rises or price of complement falls.
Inward demand shift if price of substitute falls or price of complement rises.
