CHAPTER 5 (test 1) Flashcards
What is the income effect? Equation for it?
The income effect is the change in a consumer’s consumption choices that results from a change in the consumer’s income (or purchasing power), holding relative prices constant
change in Q / change in I
What are normal goods and inferior goods?
Normal - higher income is associated with rising consumption (ex. vacations and basketball tickets)
Inferior - higher income is associated with falling consumption
What in income elasticity? Equation?
Income elasticity describes the response of demand to changing income > the % change in quantity consumed associated with a % change in income
> if goods are very elastic than demand will change a LOT with a change in income
Eid = (change in Q/Q) / (change in I/I)
What’s important about the relation between income elasticity of demand and the income effect?
Their signs (if their positive or negative) is the same!
How can the income effect (or Eid) tell us what type of good it is?
If the income effect (change in Q/change in I) is greater than 0 (positive), the good is a normal good
necessity = income elasticity between 0 and 1
luxury = income elasticity greater than 1
If the income effect (change in Q/change in I)) is less than 0 (negative), the good is an inferior good
What are necessity goods and luxury goods?
necessity goods = normal goods for which income elasticity is between 0 and 1
luxury goods = normal goods for which income elasticity is greater than 1
What is the income expansion path and 4 of its rules/characteristics
Curve that connects a consumer’s optimal bundles at each income level
- only two goods can be represented
- when both goods are normal goods, the path is positively sloped
- if the slope of the income path is negative, one of the goods is an inferior good
- income levels can’t be directly observed on the curve because both axes represent quantities of goods
What is an Engel curve?
It is the more common way of describing the consumption-income relationship
- shows the relationship between quantity of a good consumed and a consumer’s income
- if the Engel curve has a positive slope, the good is a normal good at that income level
- if the Engel curve has a negative slope, the good is an inferior good at that income level
When consumer’s _____, _______, or the ________ change, the demand curve will shift
preferences, income, or the prices of other goods
What 2 things happen when the price of a good changes relative to another?
- one good becomes relatively more expensive, and the other relatively less
- the total purchasing power of a consumer’s income changes
What is the Substitution effect? what kind of relationship is this
And again, what is the income effect?
Substitution effect: Refers to the change in a consumer’s consumption choices that results from a change in the relative prices of two goods
*this relationship is always negative > when the price of one good relative to another increases, consumption of the first good falls, and vice versa
OR
price of x goes down, consume more x and less y (again a negative relationship)
Income effect: Refers to the change in a consumer’s consumption choices that results from a change in the purchasing power of the consumer’s income
*this relationship can be positive or negative (depending on inferior or normal goods)
ex. price of x falls, purchasing pwr increases, increased consumption of both x and y when both goods are normal
*but if y was inferior, than consumption of y would decrease
What is the TOTAL effect of a change in price?
The observed change in consumption of a good after the price change > more specifically, the sum of the substitution and income effects
Total effect = substitution effect + income effect
What does it mean to isolate the substitution effect and isolate the income effect? which one should we isolate first?
*isolate substitution effect first
Isolating substitution effect: determining the bundle of goods that would have been chosen at the new price while maintaining utility experienced before the price change
Isolating the income effect: the change in quantities demanded due to the changes in the consumer’s purchasing power after the change in prices
How do we isolate the substitution effect and then the income effect graphically?
- Draw the new budget constraint after the price change and find the new optimal bundle (B)
- Draw an imaginary line that is parallel to the 2nd budget constraint (after the price change) and tangent to the original indifference curve
- this new tangency point is A’ - Substitution effect is A’ - A
- Income effect is B - A’
How does the Curvature of the indifference curves affect the size of the substitution effect?
When an indifference curve is relatively straight –> the 2 goods are relatively substitutable
* the substitution effect would be larger along a straighter indifference curve because they are more substitutable
And on a curvier indifference curve the substitution effect will be smaller because they aren’t as substitutable
(should be pretty obvious)
How does the quantity consumed before a price change affect the Income effect?
The income effect increases with the amount spent on a good before a price change (because we’re assuming we’re buying the same amount for this one)
ex.
- buy 10 waters each week at $2 = total of $20
- price drops to $1 = total $10
*bigger income effect than if you were buying only 1 water to begin with
Explain how the substitution and income effects will act when our bundle includes an inferior good and a normal good
(ex. ramen and steak, price of ramen decreases)
- Price of ramen noodles decreases
- substitution effect is positive - increase Q ramen - The relative price of steak has increased
- substitution effect is negative - decrease Q steak - Relative income has increased
- income effect positive for steak (normal good) and negative for ramen (inferior good)
*the income effect dominates the substitution effect for steak
*the substitution effect dominates the income effect for ramen noodles
*ultimately we end up buying more of both goods
What are giffen goods?
Goods for which a fall in price leads the consumer to want less of the good
- they are inferior goods, but the income effect outweighs the substitution effect (therefore consumption goes down even when price goes down)
- when the price of a giffen good drops, the substitution effect (which acts to increase demand) is smaller than the income effect
*results in an upward sloping demand curve
If the price of one good rising leads to increased consumption of a second good, what are these goods to each other?
if the price of one good rising leads to decreased consumption of a second good, what are these goods to each other?
they are substitutes
they are complements
How do we find the market demand curve from the individual demand curves?
The market demand curve is found by summing horizontally the individual demand curves
> the market quantity demanded at each price is the sum of the individual quantities demanded at each price > the price points on the vertical y axis will not change! it’s just the quantities that we’re adding up
What is the choke price?
The choke price is the highest price that a consumer is willing to buy at > chokes off the demand > demand will be zero after this > it is the y-intercept of the individual demand
- the choke price can kink off the demand curve > the kink will be at the lower choke price, and then from that point on until the y-intercept, the other consumers demand curve becomes the rest of the market demand curve
** textbook explanation: If the price is so high that only one consumer wants any of the good, the individual demand curve for that consumer will lie directly on top of the market demand curve at that price → the consumer is the market at that point
What will the market demand curve always be in comparison to the individual demand curves
the market demand will always be flatter and will never be to the left of the individual demand curves
How do you find a consumer’s choke price?
You take their demand curve equation, and set the quantity as 0 > that will give you the choke price
