Consumer Theory - Own Price Effects and Consumer Welfare

Question 1

What is the Substitution Effect Graphically?

Answer 1

It is the change in demand holding other prices and utility constant.
Purely impact of change in relative prices

Question 2

How do you find the Substitution Effect?

Answer 2

Found by shifting the new budget line onto the original Indifference Curve
(SEE IN GRAPH)

Question 3

What is a particular element of the Substitution Effect?

Answer 3

Always negative as long as the budget constraint is linear and the Indif Curve strictly convex to the origin

Question 4

What is the Income Effect graphically?

Answer 4

It is the change in demand resulting from the associated change in real income or purchasing power

Question 5

How do you find the Income Effect?

Answer 5

Found from the remaining effect on demand. Results from what’s effectively reduction in real income

(SEE IN GRAPH)

Question 6

What are some of the elements of the Income Effect?

Answer 6

• Can be positive or negative

- If good is inferior then the income effect can be positive

Question 7

What is the Slutsky Equation?

Answer 7

A way to calculate total effect on welfare loss/gain

Question 8

How do you calculate the Slutsky Equation with derivatives?

Answer 8

dpi / dpq = dqi/ dpi (Holding U constant) + dqi/dm dm/dqi

SEE NOTES FOR BETTER VIEW

Question 9

How do you calculate the Slutsky equation in terms of elasticities?

Answer 9

ε = ε* - ηθ

Where:
ε = Total Price Effect (Own Price Elasticity)
ε* = Substitution Price Elasticity
ηθ = Income Elasticity
θ = Budget Share = How much of my income do i allocate to this good

Question 10

What is the first implication of the Slutsky Equation?

Answer 10

1. ε* must always be negative
   i. e In Substitution effect any price increase must reduce own demand of the good

Therefore, ε must always be positive when η is negative

θ must always be positive since you cannot go negative budget allocation on a good

• Income elasticity being negative is normal with a normal good
• Own price elasticity must be negative
  i. e If P goes up then D must go down (Law of Demand)

Question 11

What is the second implication of the Slutsky Equation?

Answer 11

Income effect for Good i is negligible if good i has income elasticity close to 0 (low η)

Income elasticity small when is small

Question 12

What is the difference between an ordinary and a compensated demand curve?

Answer 12

• Ordinary Demand curves take into account substitution and income effect
• Compensated take only sub effect into account

Question 13

What is a Compensated Demand Curve?

Answer 13

Displays how demand changes following change in price holding utility constant

Question 14

Why is it more accurate to use Compensated Demand Curves instead of Ordinary Demand Curves?

Answer 14

As with the Slutsky equation:
Size of income effect depends on how much consumer spends on that good

• This dependency makes using ordinary demand curves inexact

Question 15

How do we draw a compensated and a ordinary demand curve if there is a normal good?

Answer 15

SEE GRAPH AND NOTES

Question 16

How do we draw a compensated and a ordinary demand curve if there is an inferior good?

Answer 16

SEE GRAPH AND NOTES

Question 17

What are the 3 ways of measuring changes in Consumer Welfare?

Answer 17

1. Consumer Surplus
2. Compensating Variation
3. Equivalent Variation

Question 18

How can you measure consumer welfare with Consumer Surplus?

Answer 18

Can be calculated by the area under the demand curve but also above market price, for the quantity purchased.

Finding out area of the shapes of welfare lost

SEE EXAMPLE IN NOTES

Question 19

What is the Compensating Variation? (CV)

Answer 19

Change in income that the consumer would need to restore his/her original utility

Question 20

How do you calculate the Compensating Variation?

Answer 20

Need to find the income to restore the consumer back to his original indif curve.
Done via shifting Budget Constraint 2 tangent to Indif Curve 1

We price Y = 1 so whatever it comes out to is the amount of income needed

The gap between the new line and the new budget constraint is the CV. So whatever the gap is the monetary amount needed to restore original utility

(SEE EXAMPLE OF PRICE INCREASE IN NOTES)

Question 21

What is the Equivalent Variation? (EV)

Answer 21

How much money would I need to take off you to reduce your utility in a parallel way to the effect of the price increase

Question 22

How do you calculate the Equivalent Variation?

Answer 22

By shifting the original B.C (BC1) to be tangent to the new lower Indif Curve (IC1)

• Shift labelled as EV which Py = 1, then equal to reduction in income needed to lower utility by same amount as price increase

(SEE EXAMPLE OF PRICE INCREASE IN NOTES)

Question 23

What are the Pro’s and Con’s of Consumer Surplus?

Answer 23

Pro’s:
- Easy to calculate using simple estimate of demand function using price and demand data

Con’s

• Uses Ordinary demand curve
• Which uses income effect
• Lose accuracy

However, inaccuracy from using ordinary Demand Curve minimal when income effects are small (Small when η or θ are low)

Question 24

What are the comparisons between the 3 measures of Consumer Welfare?

Answer 24

• 3 Measures give dif values for change in consumer welfare (for normal good):
  EV< CS < CV
• CV looks at new prices
• EV looks at old prices