Lecture 9/10 - Income and Substitution effects

Question 1

How can we decompose the change in the quantity demanded of a good as its price changes?

Answer 1

We can decompose the change in the quantity demanded of a good into the substitution effect and the income effect

Question 2

What is the substitution effect?

Answer 2

The substitution effect is when a consumer substitutes other goods for good A as the price of A rises

Question 3

What is the income effect?

Answer 3

The income effect is when as the price of good A rises, real income falls and so spend on all goods changes

Question 4

Look at the preferences diagram on slide 5 of lecture 10 and explain which parts of the total effect are the income and substitution effects

Answer 4

See slide 5 of lecture 10

Question 5

What is the total effect of a change in the consumption of a good as price rises made up of?

Answer 5

Total effect = Substitution effect + Income effect

Question 6

For a normal good, what is the income and substitution effect of an own-price increase?

Answer 6

The income and substitution effect of an own-price increase are both negative

Question 7

For a normal good, what is the income and substitution effect of an own-price decrease?

Answer 7

For a normal good the income and substitution effect of an own-price decrease are both positive

Question 8

For an inferior good, what is the income and substitution effect of an own-price increase?

Answer 8

For an inferior good subject to an own-price increase:
- The income effect is positive
- The substitution effect is negative
The total effect is negative

Question 9

For an inferior good, what is the income and substitution effect of an own-price decrease?

Answer 9

For an inferior good subject to an own-price decrease:
- The income effect is negative
- The substitution effect is positive
The total effect is positive

Question 10

What is a Giffen good?

Answer 10

A Giffen good has the following properties:
- When the price of the good increases, the positive income effect overcompensates the negative substitution effect so overall consumption increases
- When the price of the good decreases, the negative income effect overcompensates the positive substitution effect so overall consumption decreases

Question 11

What are some examples of a Giffen good?

Answer 11

• The Irish Potato is the first example of a Giffen good
• Recent research by Jensen and Miller (2008) found that rice is a Giffen good in Hunan, China

Question 12

What do standard demand curves reflect?

Answer 12

Standard demand curves reflect both income and substitution effects. These are also called uncompensated demand curves or Marshallian Demand curves

Question 13

What is a compensated demand curve?

Answer 13

• A compensated demand curve holds utility constant as a good’s price changes
• It eliminates the income effect so price increases always decrease demand and price decreases always increase demand

Question 14

What is a compensated demand curve also called

Answer 14

A Hicksian demand curve

Question 15

What is an uncompensated demand curve also called?

Answer 15

A Marshallian demand curve

Question 16

How do we construct a compensated demand curve?

Answer 16

We construct a compensated demand curve by shifting the budget constraints to remain on the same indifference curve

Question 17

How is a compensated demand curve for normal goods different to regular demand curves for normal goods?

Answer 17

The compensated demand is steeper for normal goods because the income effect has been eliminated