Chapter 5 - Individual and Market Demand

Question 1

What is the income effect?

Answer 1

The change in a consumers utility optimising bundle which occurs after a change in consumption.

Question 2

What are normal goods?

Answer 2

Goods for which consumption will rise when income rises.

Question 3

What are inferior goods?

Answer 3

Goods for which consumption will decrease when income rises.

Question 4

What is income elasticity?

Answer 4

The percentage change in the quantity consumed of a good in response to a 1% change in income.

Question 5

How do you calculate income elasticity?

Answer 5

By finding the change in Q divided by the change in income.

Question 6

What will the income elasticity of a normal good look like?

Answer 6

It will be positive and thus greater than 0. If it is between 0 and 1 then the good is a necessity whereas if it is more than one it is a luxury good.

Question 7

What will the income elasticity of an inferior good look like?

Answer 7

It will be negative and thus less than 0.

Question 8

What is the income expansion path?

Answer 8

If for a given set of prices and preferences we were to map out the utility maximising bundle for every budget constraint and join them up then this would give the income expansion path.

Question 9

What does the income expansion path look like when both goods are normal?

Answer 9

It is positively sloped.

Question 10

What does the income expansion path look like when one good is inferior?

Answer 10

It will be negatively sloped.

Question 11

What is an Engel curve?

Answer 11

An Engel curve uses information from the income expansion path and maps the changes in consumption of just one of the goods in relation to changes in income.

Question 12

What is the substitution effect?

Answer 12

If the price of one good changes then consumers will want to buy more of the good which is now relatively cheaper in comparison.

Question 13

What is the income effect?

Answer 13

It is the change in the consumers purchasing power as a result of a change in the price of one good.

Question 14

How is the substitution effect calculated?

Answer 14

The budget constraint will shift outwards to show increased PP for both goods and the point of tangency will still lie on the same indifference curve.

Question 15

How is the income effect calculated?

Answer 15

The budget constraint will rotate outwards to show the greater quantity of the cheaper good that the consumer can now afford.

Question 16

What is the total effect?

Answer 16

The total effect is the combined income and substitution effects after a price change. It is what would happen in the real world.

Question 17

What are the 3 steps for graphing the income, substitution and total effects?

Answer 17

1. Draw a new budget constraint to accommodate the change in the price of one good, the optimal point of this is the income effect.
2. Draw a second line parallel to the new budget constraint but tangent to the original indifference curve, this point will be the substitution effect.
3. Figure out the values for each point.

Question 18

What is the size of the substitution effect dependant on?

Answer 18

It depends on the curvature of the indifference curve, if it is highly curved the effect will be smaller as MRS changes quickly.

Question 19

What is the size of the income effect dependant on?

Answer 19

It depends on how much of the good the consumer was purchasing prior to the price change, if they were purchasing a lot then it will have a greater effect on their budget.

Question 20

What is a Giffen good?

Answer 20

It is a theoretical good for which a fall in price will cause a fall in consumption.

Question 21

What is the market demand?

Answer 21

The market demand is the sum of all the individual demand curves for a good.

Question 22

How is market demand calculated?

Answer 22

Market demand is calculated by adding together each consumer’s demand at a certain price or Qmarket = Qx + Qy….