Microeconomics: Effects of Price Changes

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Questions and Answers

What is the outcome when the substitution effect dominates in absolute terms?

The total effect is negative, meaning quantity demanded decreases as price decreases.

How does the income effect behave when it dominates in absolute terms?

When the income effect dominates, the total effect is positive, leading to an increase in quantity demanded as price rises.

What characterizes Giffen goods in relation to the income and substitution effects?

Giffen goods are inferior goods for which the income effect outweighs the substitution effect, resulting in an upward sloping demand curve.

What is the primary conclusion regarding inferior goods and Giffen goods?

<p>All Giffen goods are inferior goods, but not all inferior goods are Giffen goods.</p> Signup and view all the answers

What limitation does the Hicksian Method have in practical applicability?

<p>The Hicksian Method is defective because it does not provide a clear way to determine the change in real income required to maintain the original indifference curve.</p> Signup and view all the answers

What does Slutsky's decomposition explain about the effects of a price change?

<p>Slutsky's decomposition explains how a price change can be broken down into pure substitution and income effects.</p> Signup and view all the answers

How does the demand curve behave for Giffen goods compared to normal goods?

<p>The demand curve for Giffen goods is upward sloping, contrasting with the typical downward-sloping demand curve of normal goods.</p> Signup and view all the answers

What happens to quantity demanded when the price of an inferior good decreases?

<p>For a regular inferior good, quantity demanded typically increases as price decreases, in line with the substitution effect.</p> Signup and view all the answers

How does the Slutsky method address changes in a consumer's real income when the price of good x1 falls?

<p>The Slutsky method maintains the consumer's apparent real income constant to ensure they can purchase the same quantity of x1 as before.</p> Signup and view all the answers

What is the key difference between the Slutsky substitution effect and the Hicksian substitution effect?

<p>The Slutsky substitution effect considers the consumer's increased purchasing power while keeping them at the original level of satisfaction, whereas the Hicksian effect adjusts their consumption to maintain their original utility level after a price change.</p> Signup and view all the answers

In the context of price changes, what does the term 'indifference curve' refer to?

<p>An indifference curve represents a set of combinations of goods x1 and x2 that provide the consumer with the same level of satisfaction.</p> Signup and view all the answers

What role does the 'compensating variation' play in the Slutsky substitution effect?

<p>Compensating variation allows the consumer to account for the price change by adjusting their income to stay on the same indifference curve throughout the substitution effect.</p> Signup and view all the answers

How does an increase in the real income due to a price decrease affect a consumer's consumption choices according to the Hicksian approach?

<p>According to Hicks, the increased real income allows the consumer to buy more of both goods, moving them to a higher indifference curve for greater satisfaction.</p> Signup and view all the answers

What does point p1 represent in the context of the curves intersecting?

<p>Point p1 represents the price level at which an individual's income is just sufficient to attain a given utility level U.</p> Signup and view all the answers

Explain the role of income compensation at prices above p1.

<p>At prices above p1, income compensation is positive, meaning the individual requires additional income to maintain their utility level U.</p> Signup and view all the answers

What is the significance of the negative income compensation at prices below p1?

<p>Negative income compensation at prices below p1 indicates that less income is needed to avoid an increase in utility from a drop in prices.</p> Signup and view all the answers

Define the Total Price Effect in terms of utility maximization.

<p>The Total Price Effect refers to the change in quantity demanded, illustrated by the movement from xa to xb as utility maximization adjusts from point Ea to Eb after a price change.</p> Signup and view all the answers

What does Slutsky's observation about 'real income' imply when prices decrease?

<p>Slutsky's observation implies that if less income is needed at the new prices to buy the original bundle, then 'real income' has effectively increased.</p> Signup and view all the answers

In what situation does Slutsky claim that 'real income' has decreased?

<p>Real income is said to have decreased when more income is required to buy the original bundle at the new prices.</p> Signup and view all the answers

How does the adjustment of income impact the shift in demand according to Slutsky?

<p>The adjustment of income allows the change in demand to be isolated due to relative price changes instead of income changes.</p> Signup and view all the answers

What is the purpose of drawing a line parallel to the new budget line through point Ea?

<p>Drawing a line parallel to the new budget line through point Ea helps visualize the adjusted income level required to maintain utility at new prices.</p> Signup and view all the answers

What does the utility function U = v(p1,p2,m) represent in consumer theory?

<p>It represents a consumer's preferences based on the prices of two goods (p1 and p2) and their income (m).</p> Signup and view all the answers

How does the Hicksian demand differ from the Marshallian demand?

<p>Hicksian demand represents compensated demand that isolates substitution effects, while Marshallian demand reflects both income and substitution effects.</p> Signup and view all the answers

Explain why Hicksian demand curves cannot be upward-sloping.

<p>Hicksian demand curves cannot be upward-sloping because the substitution effect must be negative; if the price of a good increases, its quantity demanded decreases.</p> Signup and view all the answers

What is the income effect and how does it relate to the price change in utility maximization?

<p>The income effect reflects the change in consumption resulting from a change in real income due to price changes; it shows how much demand shifts when a consumer's purchasing power changes.</p> Signup and view all the answers

What defines the difference between uncompensated demand and compensated demand in terms of responsiveness to price changes?

<p>Uncompensated demand is more responsive to price changes because it includes both income and substitution effects, whereas compensated demand only includes substitution effects.</p> Signup and view all the answers

Describe the total price effect when the price of good 1 increases.

<p>The total price effect consists of a movement from point Ea to Eb, reflecting both the substitution effect (from Ea to Ec) and the income effect (from Ec to Eb).</p> Signup and view all the answers

In terms of demand curves, what does the gap between the Hicksian and Marshallian curves indicate?

<p>The gap indicates the income effect, demonstrating how much quantity demanded changes due to variations in real income resulting from price changes.</p> Signup and view all the answers

When analyzing the movement from point Ea to point Ec on an indifference curve, what does this movement represent?

<p>This movement represents the substitution effect, as it indicates a change in quantity demanded solely due to a change in the relative price of good 1.</p> Signup and view all the answers

What is the primary difference between Marshallian demand and Hicksian demand?

<p>Marshallian demand focuses on consumption variation with prices and income, while Hicksian demand is concerned with consumption variation with prices and utility.</p> Signup and view all the answers

Explain how the budget constraint is affected by an increase in income in the context of Marshallian demand.

<p>An increase in income shifts the budget constraint outward in a parallel manner, allowing for greater consumption options.</p> Signup and view all the answers

How do you determine whether a good is normal or inferior based on changes in income?

<p>If both goods x1 and x2 increase as income rises, they are normal goods; if x1 decreases as income rises, it is an inferior good.</p> Signup and view all the answers

What are the two effects that occur when the price of a good changes?

<p>The two effects are the substitution effect, which holds income constant, and the income effect, which holds relative prices constant.</p> Signup and view all the answers

What does the term 'm' represent in the equation for Marshallian demand?

<p>'m' represents income in the context of the Marshallian demand equation.</p> Signup and view all the answers

What does it imply if the change in consumption of good 1 is decreasing in income?

<p>If the change in consumption of good 1 is decreasing in income, it indicates that good 1 is an inferior good.</p> Signup and view all the answers

Why does the optimal marginal rate of substitution (MRS) remain constant as a worker's utility increases?

<p>The optimal MRS remains constant because as the worker moves to higher utility levels, the relative prices do not change.</p> Signup and view all the answers

How can the change in consumption due to a shift in income from m to m' be computed?

<p>It can be computed using the formula Δx1 = x1(p1, p2, m') - x1(p1, p2, m).</p> Signup and view all the answers

Explain the concept of Slutsky's substitution effect.

<p>The Slutsky substitution effect describes how a change in the price of a good alters the quantity demanded while holding utility constant, separating the price change into a substitution effect and an income effect.</p> Signup and view all the answers

What is the relationship between the changes in money income and the demand for good x1?

<p>Changes in money income directly influence the demand for good x1 as they affect the consumer's ability to purchase goods at given prices.</p> Signup and view all the answers

How does the equation ∆x1 = ∆xm + ∆xs demonstrate the impact of price and income changes on demand?

<p>This equation illustrates that the total change in demand for good x1 can be decomposed into the income effect (∆xm) and the substitution effect (∆xs), showing their combined influence.</p> Signup and view all the answers

Define inferior goods in the context of the Slutsky equation.

<p>Inferior goods are those for which demand decreases as consumer income increases, leading to a negative relationship between income changes and the quantity demanded.</p> Signup and view all the answers

What does the change in demand for x1 due to a change in its own price holding M constant imply?

<p>It implies that changes in the price of x1 cause direct adjustments in the quantity demanded, reflecting the price elasticity of the good.</p> Signup and view all the answers

How can the Slutsky method be applied to analyze demand for x1?

<p>The Slutsky method can be applied by separating the overall effect of price changes into the substitution and income effects, allowing for a clearer analysis of consumer behavior.</p> Signup and view all the answers

What effect does an increase in the price of good x1 have on its quantity demanded, all else being equal?

<p>An increase in the price of good x1 typically leads to a decrease in its quantity demanded, illustrating the law of demand.</p> Signup and view all the answers

Explain the significance of holding the prices of x2 constant while examining changes in x1.

<p>Holding the price of x2 constant allows us to isolate the effects of price changes on x1 without confounding variables, leading to a more accurate analysis of its demand.</p> Signup and view all the answers

What is the importance of the equation ∆M = x1∆p2 in the context of Slutsky's analysis?

<p>The equation highlights the relationship between the change in money income needed to maintain consumption of the original bundle and the price of x2, emphasizing income adjustments based on price variations.</p> Signup and view all the answers

Flashcards

Marshallian Demand

Describes how consumption changes with prices and income. It's represented by the equation x(p1, ..., pn, m), where x is the quantity demanded, p is the price, and m is income.

Hicksian Demand

Describes how consumption changes with prices and utility. It's represented by the equation h(p1, ..., pn, u), where h is the quantity demanded, p is the price, and u is utility.

Normal Good

A good whose demand increases when income increases, indicating that consumers buy more of it as they get richer.

Inferior Good

A good whose demand decreases when income increases, implying that consumers buy less of it as they get richer.

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Substitution Effect

The effect of a change in price, holding income constant, on the quantity demanded of a good. It measures how much consumers substitute one good for another due to a price change.

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Income Effect

The effect of a change in income, holding relative prices constant, on the quantity demanded of a good. It measures how much consumers change their purchasing behavior due to a change in their buying power.

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Income Effect on Demand

The change in consumption due to a change in income. It's calculated as the difference between the quantity demanded at the new income level and the quantity demanded at the original income level.

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Price Effect on Demand

The change in consumption caused by a change in the price of a good. It's calculated as the difference between the quantity demanded at the new price and the quantity demanded at the original price.

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Total Price Effect

The total change in quantity demanded due to a price change, encompassing both the substitution and income effects.

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Slutsky Compensation Line

The line that is parallel to the new budget line and passes through the initial utility level, used to isolate the substitution effect.

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Indifference curve

A curve representing all combinations of goods that provide a consumer with the same level of satisfaction, i.e., utility.

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Demand curve

A curve showing the relationship between the price of a good and the quantity demanded, holding other factors constant.

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Why Hicksian demand curves cannot slope upwards?

Hicksian demand curves cannot slope upwards because consumers will always choose to consume less of a good if its price increases, given that their utility remains constant. This shows how consumers react to price changes while staying at the same level of satisfaction.

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Hicksian vs Uncompensated demand curve responsiveness

For a normal good, the Hicksian demand curve is less responsive to price changes than uncompensated demand, because it reflects only the substitution effect. The uncompensated demand curve, on the other hand, reflects both substitution and income effects.

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The gap between Hicksian and uncompensated demand

The difference between the Uncompensated demand curve and the Hicksian demand curve reflects the income effect, which is the change in consumption due to changes in purchasing power.

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Price increase impact on consumer behavior

In response to a price increase, a consumer will move to a new utility-maximizing point on a lower indifference curve. This new point reflects the combined impact of the substitution and income effects.

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Price Effect

The change in the quantity demanded of a good due to a change in its own price, holding income and the price of other goods constant.

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Slutsky Equation

The equation that decomposes the total change in demand for a good into the substitution effect and the income effect.

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Slutsky Compensating Variation

The change in money income needed to compensate for a price change so that the consumer can afford the same utility level as before the price change.

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Slutsky Compensated Budget Line

The budget constraint after the Slutsky compensating variation in income has been carried out.

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Slutsky Substitution Effect

The change in consumption due to a change in the relative prices of goods, keeping the consumer's real income constant. It measures how much a consumer substitutes one good for another when the price changes.

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Hicksian Compensation

A theoretical concept where a consumer adjusts their spending to maintain the same level of satisfaction (utility) after a price change. It's used to isolate the substitution effect from the income effect.

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Giffen Good

A good for which the income effect opposes the substitution effect. As the price increases, consumers may buy more of the good, violating the Law of Demand. This is because the income effect dominates, leading consumers to consume more of the good despite its higher price.

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Income Effect Dominating

The income effect may be larger than the substitution effect for an inferior good. This can lead to a situation where the quantity demanded increases as the price falls, violating the Law of Demand.

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Substitution Effect Dominating

A good for which the substitution effect dominates the income effect. This leads to a decrease in quantity demanded as the price increases, confirming the Law of Demand.

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Slutsky Decomposition

The method used by economist Slutsky to separate the price effect into substitution and income effects. This method makes a distinction between the 'real' income effect and the 'nominal' income effect.

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Hicksian Method

A method of separating the substitution and income effects by keeping the consumer on the same indifference curve. It relies on observing the change in quantity demanded by adjusting income to keep utility constant.

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Study Notes

Demand Functions

  • Demand functions describe how consumption changes with prices and income.
  • Two key demand functions are Marshallian and Hicksian.

Marshallian Demand

  • Describes how consumption varies with prices and income.
  • Expressed as xᵢ(P₁, ..., Pₙ, m) where xᵢ represents the quantity of good i, Pᵢ are the prices of n goods, and m is the income.
  • Derived by maximizing utility subject to a budget constraint.

Hicksian Demand

  • Describes how consumption varies with prices and utility.
  • Expressed as hᵢ(P₁, ..., Pₙ, u), where hᵢ represents the Hicksian demand, Pᵢ represents the prices of n goods, and u represents the utility.
  • Derived by minimizing expenditure subject to a given utility level.

Changes in Income

  • An increase in income shifts the budget constraint to the right (outward) in a parallel manner.
  • The optimal marginal rate of substitution (MRS) remains constant as the consumer moves to higher utility levels.
  • Normal goods exhibit increasing consumption with higher income.
  • Inferior goods exhibit decreasing consumption with higher income.

Engel Curve

  • Plots the demand for a good (x₁) against income (m).
  • Shows the relationship between consumption and income.

Own Price Effects

  • A change in the price of a good alters the budget constraint's slope.
  • Two main effects are substitution and income.

Substitution Effect

  • Equivalent to a change in relative prices, holding income constant.
  • The consumer buys more of the good whose price has fallen relative to the other goods, holding utility constant

Income Effect

  • Equivalent to a change in income, holding relative prices constant.
  • The consumer buys more of the good whose price has fallen.

Hicksian Method

  • Consumer maximizes utility at a given bundle
  • The total price effect is the change in demand when prices change on an indifference curve
  • The substitution effect is the movement from the original point to a point on the same indifference curve.
  • The income effect is the difference between the total price effect and substitution effect

Slutsky Method

  • Consumer maintains constant real income by changing income.
  • The substitution effect is the change in demand due only to the price change, while holding the real income constant.
  • The income effect is the adjustment in purchasing power that results in the price change.

Slutsky Equation

  • Describes the relationship between the total effect of a price change and its substitution and income components.
  • Used for calculating the change in demand.

Inferior Goods

  • Demand decreases as income increases
  • Substitution and income effects often oppose one another (in contrast with normal goods), therefore the demand curve can slope upward.

Summary of Demand

  • Understanding demand functions (Marshallian and Hicksian) and their underlying principles is crucial for economic analysis.
  • Changes in prices and income significantly affect consumption patterns.
  • The Slutsky and Hicksian methods help isolate these effects.

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