Demand Flashcards
What is the market demand curve?
The horizontal addition of individual demand curves, sum of the individual demand curves
Define income effect.
The change in a consumer’s consumption choices that result from a change in the purchasing power of the consumer’s income
What happens to the demand curve and indifference curve when a consumer’s income rises and both goods are normal?
Both shift to the right
Define a normal good.
A good for which consumption rises when income rises
Define an inferior good.
A good for which consumption decreases when income rises
What happens to the demand curve and indifference curve when a consumers income rises and one good is inferior?
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
Define the income expansion path.
A curve that connects a consumer’s optimal bundles at each income level
Draw the income expansion path on a graph.
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How do you get the income expansion path?
Increase the income slightly and shift the curve the demand and indifference curves. Then connect all the optimal bundles
Define substitution effect.
The change in a consumers consumption choices that result from a change in the relative prices of two goods
If the price of a good falls what happens in the buying power of the income?
It rises
Why is the substitution effect always negative?
As a good becomes more expensive consumers consume less of it and more of the other good
Define the total effect.
The total change (Substitution effect + income effect) in a consumers optimal consumption bundle as a result of a price change
What is the formula for total effect?
Total effect = Substitution effect + Income effect
What does the sign of the total effect depend on?
Whether the income effect is positive, or negative and greater than the substitution effect
What is income effect the change in?
The change in quantity consumed given a change in income
Why is the total effect a combination of the substitution and income effect?
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
What is the name of the two methods we can use to isolate the two effects in the total effect?
- ) The Hicks method
2. ) The Slutsky method
How does the Hicks method isolate the two different effects?
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
What represents the substitution effect in the Hicks method?
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
Show the income and substitution effect on a graph using the Hicks method for normal goods.
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What represents the income effect in the Hicks method ?
The change in quantity from the pivoted position on the initial indifference curve to the new optimal bundle
Show the income and substitution effect on a graph using the Hicks method for inferior goods.
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Show the income and substitution effect on a graph using the Hicks method for giffen goods.
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What is the relative sizes of the substitution and income effect for giffen goods?
The income effect is negative and larger than the substitution effect
Define giffen good.
A good for which price and quantity are positively correlated
Why are income and substation effects important?
They can be used to explain the policy effects in tax
How does the Slutsky method isolate the two effects?
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
Whats the main difference between the the Hick’s method and the Slutsky method?
In the Hicks method we move then pivot where as in the slutksy method we pivot then move
What determines the size of the substitution effect?
The curvature of the indifference curve
What determines the size of the income effect?
The quantity of each hood the consumer purchases before the price change
