Topic 5 - Consumer Theory in Practice

Question 1

Which demand curves only consider the substitution effect (change in D purely bc good is cheaper)

Answer 1

Hicksian and Slutsky demand curves

marshallian demand considers both income and substitution effect

Question 2

How does the hicksian and slutsky demand curve ensure the income effect is not considered

Answer 2

hicksian: utility is the same after the price changes as it was before the price change (so consumer is no better off despite the lower price)

slutsky: purchasing power is same after the price change as to was before the price change (consumer has just enough to buy the original bundle)

Question 3

Describe the substitution and income effect shown for normal, inferior and giffen goods

Answer 3

Normal good: sub+, income -

inferior and giffen good: sub +, income -

inferior: Sub > income

giffen: Sub < income

Question 4

Slutsky vs hicksian

Answer 4

• hick: utility remains constant, Compensated BC is tangent to original IC
• slutsky: purchasing power remains cons tant, compensated BC passes through original IC

Question 5

Outline the hicksian dual problem

Answer 5

• find the initial bundle (initial price ratio)
  + utility maximisation: highest IC subject to BC
• Find the change in demand due to the substitution effect
  + expenditure minimisation: the least costlt way of achieving original utility at the new price ratio
• find the new bundle (at new price ratio)
  + utility maximisation (now also takes inot account the income effect)

Question 6

What is slutsky substitution

Answer 6

• find the change in income needed to make the original bundle affordable at new price P1’

Question 7

As you change between inferior, giffen and normal goods what happens to each of the demand curves

Answer 7

(Uncompensated) marshallian demand curve changes
- normal/inferior: downward sloping
- giffen: upward sloping

(Compensated) slutsky and hicksian demand curves remain unchanges as they only consider substitution effect, not income effect