Questions and Answers
Define the income effect. What variables do we hold constant in order to isolate the income effect?
The income effect describes the change in a consumer's consumption choice given a change in the purchasing power of the consumer's income. In describing this change, we hold the goods' prices fixed.
What are the differences between normal goods, inferior goods, and luxury goods?
A normal good's consumption rises with income. Luxury goods are a class of normal goods with an income elasticity greater than 1. Consumption of inferior goods decreases when income rises.
When might you choose to use the income expansion path? When might the Engel curve be more useful?
The income expansion path connects optimal bundles of two goods for one consumer, while the Engel curve shows the relationship between the quantity of a good consumed and a consumer's income.
Describe how we can derive a consumer's demand curve from his indifference curves. Why would we expect the demand curve to slope downward?
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Name at least three factors that can shift an individual's demand curve for pizza. Also describe the effect each factor has on demand.
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Define the substitution effect. How does it relate to the income effect?
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Describe how to decompose the consumer's response to price changes into the substitution and income effects.
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How do income and substitution effects differ between normal and inferior goods?
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Define a Giffen good.
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What are complements and substitutes?
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Study Notes
Income Effect
- Represents the change in consumption choices due to a change in purchasing power, with goods' prices held constant.
Types of Goods
- Normal Goods: Consumption increases as income rises.
- Luxurious Goods: A subset of normal goods with income elasticity greater than 1.
- Inferior Goods: Consumption decreases as income increases.
Income Expansion Path vs. Engel Curve
- Income Expansion Path: Connects optimal bundles for two goods; aids in understanding relative quantities as income changes.
- Engel Curve: Shows the relationship between the quantity of a single good consumed and consumer income; isolates the impact of income on one good.
Deriving the Demand Curve
- The demand curve connects utility-maximizing quantities of a good at varying prices, typically slopes downward due to the inverse relationship between price and quantity demanded.
Factors Shifting Demand for Pizza
- Increase in Consumer's Income: Demand for pizza shifts outward if it is a normal good.
- Decrease in Relative Preference: Shift inward if preference decreases (e.g., favoring substitutes).
- Increase in Price of Another Good: Demands shift outward if the price of a substitute rises; inward for complements.
Substitution Effect
- A change in consumption choices resulting from changes in relative prices, distinct from the income effect which deals with purchasing power variations.
Decomposing Price Changes
- Use three steps to isolate income and substitution effects:
- Change in prices rotates the budget constraint, leading to a new optimal bundle.
- Draw a line parallel to the new budget constraint to find the substitution effect.
- Movement from the new tangential point on the original indifference curve represents the income effect.
Income and Substitution Effects in Goods
- The substitution effect is consistent for normal and inferior goods; however, the income effect diverges.
- For normal goods, a decrease in price leads to increased consumption (positive income effect).
- For inferior goods, a decrease in price results in decreased consumption (negative income effect).
Giffen Good
- A unique case where price and quantity demanded are positively related; a decrease in price leads to lower demand.
Complements and Substitutes
- Complements: Goods used together, enhancing each other’s usage.
- Substitutes: Goods that can replace one another in consumption.
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Description
This quiz covers key concepts from Chapter 5 of your economics course, focusing on the income effect and the distinctions between different types of goods. Test your understanding of how purchasing power influences consumer choices and the definitions of normal, inferior, and luxury goods.