Week 7 - Consumer theory II: Indifference curves and labour supply

Question 1

Explain Substitution and Income effect when the price of a normal good increases

Answer 1

Consumers purchase less of the good:
1. Substitution effect - the good is more expensive relative to other goods, they substitute relatively cheaper goods
2. Income effect - the proportion of income spent on each unit of the good has increased, so real income (purchasing power) has decreased

Question 2

What is a Giffen good

Answer 2

An inferior good, for which quantity demanded increases as price increases as the income effect outweighs the substitution effect

Question 3

How does a per-unit tax on a single good x, and a lump sum tax on income, impact the budget constraint (formulas)

Answer 3

tax on good X: M = (Px + t)X + PyY

tax on income: M - T = PxX + PyY

Question 4

What are 2 effects of a wage rise, considering the labour-leisure choice

Answer 4

1. Positive income effect - more income, no change to opportunity cost
2. Negative substitution effect - higher opportunity cost of leisure