L9 - Income and Substitution

Question 1

How do you create the Income-Consumption curve?

Answer 1

• By creating a Budget constraint and its corresponding indifference curve
• Then by increasing income the budget constraint shift to the right and has its own respective indifferent curve
• By connecting each point of where the Indifference curve it tangential to it Budget Constraint you get the Income-Consumption curve
• The income–consumption curve shows how consumption varies with income

Question 2

What does the Income-Consumption Curve look like with an Inferior good?

Answer 2

- When one good is an
inferior good (x-axis normal good is on the y-axis), the income consumption curve is downward sloping
- because as the budget constraint increased due to income less of the inferior good is bought

Question 3

How can indifference curves be linked to the Engel Curve?

Answer 3

• As the income-consumption curve is created from different budget curves signifying a increase in income
• This can then be related to the relationship between income and consumption of a good
• As plotting on a graph Income on the y-axis and Quantity of a good on the x-axis you can plot the increase in consumption based off the indifference curves and budget constraints
• by connecting these points you get the Engel curve
• The slope of the Engel curve is linked to the income elasticity of demand

Question 4

How do you create the Price-consumption curve?

Answer 4

• by decreasing the price of say good x we can plot the new budget constraints and their respective indifference curves as it pivots out
• by connecting the tangential points of the indifference curves and their respective budget constraints we get the Price-Consumption curve
• The price–consumption curve shows how consumption varies with price

Question 5

How can we relate indifference curves to PED?

Answer 5

• by creating the Price-Consumption curve we can illustrate the relationship between price and consumption of a good
• By the plotting the Price of good X against the Quantity demanded of good X we can use the curve to plot the respective prices and the quantity demand of that goods
• by connecting the points we get the consumer’s demand curve
• this can then be used to derive the market demand curve

Question 6

What is the Income Effect?

Answer 6

INCOME EFFECT

• People feel poorer:
• They cannot buy as much with their fixed income

Question 7

What is the Substitution Effect?

Answer 7

SUBSTITUTION EFFECT
- People change their consumption:
- They buy similar but rival products or they spend their money on other
products

Question 8

How do the Substitution Effect come into play with an increase in the price of good X?

Answer 8

• if there is a increase in the price of a good plot the corresponding budget constraint and indifference curve
• If the consumer could keep utility constant, what would she choose given the new prices?
• Draw a line parallel to the new budget constraint until it is tangent to the original indifference curve
• The difference between the original Unit of good X demand and this value is the Substitution Effect

Question 9

How does the Income Effect come into play with an increase in the price of good X?

Answer 9

• if there is a increase in the price of a good plot the corresponding budget constraint and indifference curve
  -How much income is needed to return the
  consumer to the original indifference curve?
  -Draw a line parallel to the new budget constraint until it is tangent to the original indifference curve
• The difference between the this unit of good X demanded and the one after the change in price is the Income effect?

Question 10

How does the Income and Substitution effect differ from normal to Inferior goods?

Answer 10

For normal goods, the income and substitution effect work in the same direction For inferior goods, they work in opposite directions

• Here the substitution effect dominates
• This occurs because A higher price makes the consumer poorer, and this increases quantity demanded of inferior good (relative to b)

Question 11

How does the Income and Substitution effect differ for Giffen goods?

Answer 11

A Giffen good is a special kind of inferior good. The income and substitution effects work in opposite directions, and the income effect dominates
- This happens as even though the price of good X has risen the consumption of it has increased aswell