Demand

Question 1

What is the market demand curve?

Answer 1

The horizontal addition of individual demand curves, sum of the individual demand curves

Question 2

Define income effect.

Answer 2

The change in a consumer’s consumption choices that result from a change in the purchasing power of the consumer’s income

Question 3

What happens to the demand curve and indifference curve when a consumer’s income rises and both goods are normal?

Answer 3

Both shift to the right

Question 4

Define a normal good.

Answer 4

A good for which consumption rises when income rises

Question 5

Define an inferior good.

Answer 5

A good for which consumption decreases when income rises

Question 6

What happens to the demand curve and indifference curve when a consumers income rises and one good is inferior?

Answer 6

Demand curve shifts to the right, however the indifference curve will not move with it directly but to a different point which means less of one good is consumed

Question 7

Define the income expansion path.

Answer 7

A curve that connects a consumer’s optimal bundles at each income level

Question 8

Draw the income expansion path on a graph.

Answer 8

Picture

Question 9

How do you get the income expansion path?

Answer 9

Increase the income slightly and shift the curve the demand and indifference curves. Then connect all the optimal bundles

Question 10

Define substitution effect.

Answer 10

The change in a consumers consumption choices that result from a change in the relative prices of two goods

Question 11

If the price of a good falls what happens in the buying power of the income?

Answer 11

It rises

Question 12

Why is the substitution effect always negative?

Answer 12

As a good becomes more expensive consumers consume less of it and more of the other good

Question 13

Define the total effect.

Answer 13

The total change (Substitution effect + income effect) in a consumers optimal consumption bundle as a result of a price change

Question 14

What is the formula for total effect?

Answer 14

Total effect = Substitution effect + Income effect

Question 15

What does the sign of the total effect depend on?

Answer 15

Whether the income effect is positive, or negative and greater than the substitution effect

Question 16

What is income effect the change in?

Answer 16

The change in quantity consumed given a change in income

Question 17

Why is the total effect a combination of the substitution and income effect?

Answer 17

When the price of one goods changes relative to the price of the other, consumers will want to buy more of that good because it is relatively cheaper than the other good, also the purchasing power of that good increases so they will also be able to buy more

Question 18

What is the name of the two methods we can use to isolate the two effects in the total effect?

Answer 18

1. ) The Hicks method

2. ) The Slutsky method

Question 19

How does the Hicks method isolate the two different effects?

Answer 19

Decrease the price of X, and draw the two indifference curves and budget constraint line
Draw a line parallel to the new budget line tangential to the old indifference curve
The substitution effect is calculated as the change in quantity demanded holding utility constant
The income effect is the total effect minus the substitutions effect

Question 20

What represents the substitution effect in the Hicks method?

Answer 20

When you draw a new parallel budget line, the pivoting along the initial indifference curve shows the substitution effect. The change in quantity from the original optimal bundle to this one

Question 21

Show the income and substitution effect on a graph using the Hicks method for normal goods.

Answer 21

Picture

Question 22

What represents the income effect in the Hicks method ?

Answer 22

The change in quantity from the pivoted position on the initial indifference curve to the new optimal bundle

Question 23

Show the income and substitution effect on a graph using the Hicks method for inferior goods.

Answer 23

Picture

Question 24

Show the income and substitution effect on a graph using the Hicks method for giffen goods.

Answer 24

Picture

Question 25

What is the relative sizes of the substitution and income effect for giffen goods?

Answer 25

The income effect is negative and larger than the substitution effect

Question 26

Define giffen good.

Answer 26

A good for which price and quantity are positively correlated

Question 27

Why are income and substation effects important?

Answer 27

They can be used to explain the policy effects in tax

Question 28

How does the Slutsky method isolate the two effects?

Answer 28

First we pivot the budget line through the original consumption point
This will give a tangent point with a higher indifference curve showing the substitution effect
Then we move the new indifference curve and budget line upwards (income has increased) to the new optimal bundle showing the income effect

Question 29

Whats the main difference between the the Hick’s method and the Slutsky method?

Answer 29

In the Hicks method we move then pivot where as in the slutksy method we pivot then move

Question 30

What determines the size of the substitution effect?

Answer 30

The curvature of the indifference curve

Question 31

What determines the size of the income effect?

Answer 31

The quantity of each hood the consumer purchases before the price change