Economics Chapter 5 Review Questions

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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?

We can derive a consumer's demand curve by connecting the utility-maximizing quantities of a good at different prices, and the demand curve slopes downward because an increase in price typically results in a decrease in quantity demanded. Signup and view all the answers

Name at least three factors that can shift an individual's demand curve for pizza. Also describe the effect each factor has on demand.

<ol> <li>Increase in consumer's income: Demand for pizza shifts out if it is a normal good. 2. Decrease in preference for pizza: Demand shifts in if preference decreases. 3. Increase in price of another good: Demand shifts out if the price of a substitute increases and shifts in if the price of a complement increases.</li> </ol> Signup and view all the answers

Define the substitution effect. How does it relate to the income effect?

The substitution effect is the change in a consumer's consumption choices that results from a change in the relative prices of two goods, while the income effect describes changes resulting from purchasing power changes. Signup and view all the answers

Describe how to decompose the consumer's response to price changes into the substitution and income effects.

<ol> <li>A price change rotates the budget constraint; 2. Identify the new optimal bundle at the tangency point, and the movement from the original bundle to the new bundle represents the income effect; 3. The substitution effect is the movement along the original indifference curve.</li> </ol> Signup and view all the answers

How do income and substitution effects differ between normal and inferior goods?

The direction of the substitution effect is the same for both, but the income effect differs: for normal goods, consumption increases with a price decrease, while for inferior goods, it may decrease. Signup and view all the answers

Define a Giffen good.

A Giffen good is a good for which price and quantity demanded are positively related; if the price decreases, the quantity demanded decreases. Signup and view all the answers

What are complements and substitutes?

A complement is a good that is purchased and used in combination with another good, while a substitute is a good that can be used in place of another good. Signup and view all the answers

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.