Income And Substitution Effects Flashcards
What is responsible for change in the quantity demanded?
Substitution & income effect
What is the substitution effect?
Substitute other goods for good A as the price of A rises
What is the income effect?
As the price of A rises, real income falls and so spends on all goods changes
How to calculate the total effect?
Substitution effect + Income effect
The substitution effect of an own-price increase is..
Always negative or 0, but never positive
The substitution effect of an own-price decrease is…
Always positive or 0, but never negative
What are the 3 types of goods in the income effect?
Normal goods
Inferior goods
Giffen goods
What is the income and substitution effect of an own price increase in normal goods?
Negative
What is the income and substitution effect of an own price decrease in normal goods?
Positive
What is the income and substitution effect of an own price increase in inferior goods?
Income effect positive
Substitition negative
Total effect negative
What is the income and substitution effect of an own price decrease in inferior goods?
Income effect negative
Substitution effect positive
Total effect positive
What is the income and substitution effect of an own price increase in giffen goods?
Income effect positive
Substitution effect negative BUT
Income effect overcompensates negative substitution effect
Consumption goes up
What is the income and substitution effect of an own price decrease in Giffen goods?
Income effect negative
Substitution effect positive BUT
Income effect overcompensates positive substitution effect
Consumption goes down
Draw me all the effects on a normal good, inferior and Giffen good
What is a compensated demand curve?
compensated demand curve shows the quantity of a good which a consumer would buy if income is kept the same but price of good changes
In other words, it isolates the substitution effect by compensating for changes in purchasing power that would result from price changes. This provides insights into how consumers would adjust their consumption patterns purely based on changes in relative prices, without the confounding influence of changes in real income.
What is an uncompensated demand curve?
A standard demand curve which reflects both income and substitution effects
What does a derived compensated demand curve hold?
Holds utility constant as a good’s price changes (hicksian demand curve)
What does the compensated demand curve do?
Eliminates the income effect so price increases always decrease demand and price decreases increase demand
What is an important application of the substitution-income effect decomposition?
Cost of living adjustments
How does cpi try to measure changes in Cost of living ?
Computes average cost of a bundle of widely used goods in a reference or base year.
They compare it to the cost of the same bundle in all subsequent years
Weigh each good by expenditure in the base year
How is the CPI computed with just two goods?
What is the CPI substitution bias?
Compensated demand curves only..
Represent substitution effects
Substitution effects can?
Lead to bias in the CPI
With a perfect substitute in consumption, how many of the goods may be consumed in equilibrium?
ONLY 1 of the 2
In perfect substitutions in consumption, can goods A and B both be inferior goods?
No. . If goods A and B were both inferior goods, it would imply that as consumer incomes rise, the demand for both goods decreases. This contradicts the characteristic of perfect substitutes, where an increase in income should lead consumers to switch entirely to the cheaper option.
