L9 - Income and Subsitution

Question 1

What is the Income-Consumption curve?

Answer 1

The combinations of preferences (done via the interior solution)

-To show how consumption varies with income

(DIAGRAM IN NOTES)

Question 2

What happens to the Income-Consumption Curve when there is an inferior good?

Answer 2

Inferior Good:
Where demand decreases with increase in income

• When one good is normal and the other is Inferior, the curve is downward sloping

(DIAGRAM IN NOTES)

Question 3

What is the Engel curve?

Answer 3

• How household expenditure on a particular good or service varies with household income
• Done in similar way to income-consumption curve

(DIAGRAM IN NOTES)

Question 4

What is the Price-Consumption Curve?

Answer 4

Shows how consumption varies with price

DIAGRAM IN NOTES

Question 5

How to derive the demand-curve from Price-Consumption Curve

Answer 5

Derive the demand curve off the aggregation of points making up the price-consumption curve.

(DIAGRAM IN NOTES)

Question 6

What is the Income Effect?

Answer 6

People feel poorer.

Cannot buy as much with their fixed income.

Question 7

What is the Substitution Effect?

Answer 7

People change their consumption.

They buy similar but rival products or they spend their money on other products.

Question 8

What does the graph look like with a price increase for Good X (Substitution Effect)? (PRICE CONSUMPTION CURVE)

Answer 8

• An increase in the price of good X changes the budget constraint from B1 to B2
• The optimal choice changes from a to c.

(DIAGRAM IN NOTES)

Question 9

What does the graph look like with a price increase for Good X (Income Effect)? (PRICE CONSUMPTION CURVE)

Answer 9

• An increase in the price of good X changes the budget constraint from B1 to B2
• The optimal choice changes from a to c.

(DIAGRAM IN NOTES)

Question 10

How do the Income and Substitution Effects operate for normal and inferior goods?

Answer 10

• For normal goods, the income and substitution effect work in the same direction
• For inferior goods, they work in opposite directions

Question 11

Considering the income and substitution effects what does the graph look like for inferior goods?

Answer 11

• A higher price makes the consumer poorer, and this increases quantity demanded of inferior good (relative to b)

DIAGRAM IN NOTES

Question 12

Considering the income and substitution effects what does the graph look like for Giffen goods?

Answer 12

A Giffengood is a special kind of inferior good. The income and substitution effects work in opposite directions, and the income effect dominates

The price of good X rises but consumption of good X increases as well

DIAGRAM IN NOTES