Consumer Theory: Optimal Choice

Question 1

If income increases how does demand for an inferior good change?

Answer 1

If income increases demand for an inferior good decreases and if income decreases then demand increases.

Question 2

What is an income expansion path? What is it used to derive ?

Answer 2

It is the path of consumption for one good as income increases. It can be used to derive the engel’s curve where it plots a good against income on the Y axis.

Question 3

What is the income expansion path for good x if it is a perfect substitute for good y and is cheaper than good y ?

Answer 3

Its IEP is wherever the budget line meets the x axis. Therefore the engel curve is diagonal as consumption of x increases with income.

Question 4

If income increases what happens to the demand of a normal good?

Answer 4

This increases the demand for a good and decreases when income decreases.

Question 5

What are homothetic preferences ?

Answer 5

Goods that are purchased in a fixed proportion that is unchanged with income I.e Cobb Douglas function. For instance if income increases consumption of x and y increase in a fixed proportion.

Question 6

How can you tell if an item is a luxury good ?

Answer 6

If the increase in consumption of the good is greater than the increase in income

Question 7

How can you tell if an item is a necessary good?

Answer 7

If the increase in the consumption of the good is lesser than the increase of income

Question 8

What is an ordinary good

Answer 8

When prices of this good decreases, demand for the good increases.

Question 9

What is giffen good ?

Answer 9

When prices of this good increases so too does demand.

Question 10

What is a price offer curve ?

Answer 10

A price offer curve is one that shows the optimal consumption bundle for different levels of income

Question 11

What can a Poc be used to derive ?

Answer 11

Demand function.

Question 12

Describe the substitution effect ?

Answer 12

Good x is cheaper than good y so I will substitute good y for more of good x.

Question 13

Describe the income effect.

Answer 13

Price of good Y has increased so I feel poorer and will consume less of both goods.

Question 14

How do we separate income effect from substitution effect?

Answer 14

We hold purchasing power constant whilst allowing the relative price of x to change.

Question 15

Describe using the substitution and income effects what happens when the price of good x decreases increases.

Answer 15

• If the price of good x falls the substitution effect dictates that the consumer will purchase more of good x and good y will decrease this is shown by the budget line pivoting around the point of the original consumption bundle.
• The income effect then causes this new budget line to shift outwards in a parallel fashion to show that a fall in the price of x means an increase in real income which means the consumer can afford more of both good and y.

Question 16

What happens to the substitution and income effects on a a normal good?

Answer 16

They reinforce each other.

Question 17

What happens to the substitution and income effects on an inferior good x when price increases.

Answer 17

They oppose eachother:

• The income effect says that an increase in price means real income decreases which means the consumption of good x increases.
• The substitution effect says the price of y is now relatively cheaper than good x so the consumption of good x decreases whilst y increases.

Question 18

Under what circumstances does income effect definitely overpower substitution effects?

Answer 18

When a good is a giffen good, this is because income inferiority is too strong .

Question 19

Describe slutsky effects ordinary and inferior goods.

Answer 19

Ordinary good: When price rises substitution and income effects dictates that the demand for the good to fall.
If price falls then income and substitution effects dictates that demand will increase.
Inferior good: When price increases the income effect dictates that demand rises however substitution effects means that demand falls. When price falls income effects dictate that demand for the good falls, however substitution effects dictate that demand increases.