Income And Substitution Effects

Question 1

What is responsible for change in the quantity demanded?

Answer 1

Substitution & income effect

Question 2

What is the substitution effect?

Answer 2

Substitute other goods for good A as the price of A rises

Question 3

What is the income effect?

Answer 3

As the price of A rises, real income falls and so spends on all goods changes

Question 4

How to calculate the total effect?

Answer 4

Substitution effect + Income effect

Question 5

The substitution effect of an own-price increase is..

Answer 5

Always negative or 0, but never positive

Question 6

The substitution effect of an own-price decrease is…

Answer 6

Always positive or 0, but never negative

Question 7

What are the 3 types of goods in the income effect?

Answer 7

Normal goods
Inferior goods
Giffen goods

Question 8

What is the income and substitution effect of an own price increase in normal goods?

Answer 8

Negative

Question 9

What is the income and substitution effect of an own price decrease in normal goods?

Answer 9

Positive

Question 10

What is the income and substitution effect of an own price increase in inferior goods?

Answer 10

Income effect positive
Substitition negative
Total effect negative

Question 11

What is the income and substitution effect of an own price decrease in inferior goods?

Answer 11

Income effect negative
Substitution effect positive
Total effect positive

Question 12

What is the income and substitution effect of an own price increase in giffen goods?

Answer 12

Income effect positive
Substitution effect negative BUT
Income effect overcompensates negative substitution effect
Consumption goes up

Question 13

What is the income and substitution effect of an own price decrease in Giffen goods?

Answer 13

Income effect negative
Substitution effect positive BUT
Income effect overcompensates positive substitution effect
Consumption goes down

Question 14

Draw me all the effects on a normal good, inferior and Giffen good

Question 15

What is a compensated demand curve?

Answer 15

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.

Question 16

What is an uncompensated demand curve?

Answer 16

A standard demand curve which reflects both income and substitution effects

Question 17

What does a derived compensated demand curve hold?

Answer 17

Holds utility constant as a good’s price changes (hicksian demand curve)

Question 18

What does the compensated demand curve do?

Answer 18

Eliminates the income effect so price increases always decrease demand and price decreases increase demand

Question 19

What is an important application of the substitution-income effect decomposition?

Answer 19

Cost of living adjustments

Question 20

How does cpi try to measure changes in Cost of living ?

Answer 20

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

Question 21

How is the CPI computed with just two goods?

Question 22

What is the CPI substitution bias?

Question 23

Compensated demand curves only..

Answer 23

Represent substitution effects

Question 24

Substitution effects can?

Answer 24

Lead to bias in the CPI

Question 25

With a perfect substitute in consumption, how many of the goods may be consumed in equilibrium?

Answer 25

ONLY 1 of the 2

Question 26

In perfect substitutions in consumption, can goods A and B both be inferior goods?

Answer 26

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.