Price effects on demand

Question 1

Explain the substitution and income effects of a price increase in shelter

Answer 1

• Price increase causes an inwards pivot of IC as can buy less shelter for same income
• Substitution effect shown by movement along original indifference curve from point A to C on hypothetic budget line, less shelter consumed due to higher price
• Income effect shown by a parallel shift inwards from hypothetical budget line to point D on lower indifference curve

Question 2

Explain income and substitution effects for an inferior good such as a hamburger

Answer 2

• An increase in the price would cause a pivot about the Y axis inwards as less hamburgers for same income
• Substitutiom effect shown by movement along Current IC from point A to point C with less burgers consumed, point c tangential to hypothetical budget constraint parallel to new BC
• Income effect shown by inward shift of B’ to B1 where consumption of burger actually increases which slightly offsets the sub effect

Question 3

What is the demand curve for a giffen good like

Answer 3

Upward sloping, as prices rise, demand rises

Question 4

What is the income and substitution effect for perfect complements

Answer 4

• They have right angle ICs
• No substitution effect
• Purely income effect

Question 5

Explain income and substitution effects for perfect substitutes

Answer 5

• If price of a good x rises, BC pivots inwards about x point
• To maintain same utility at new price, new BC is B’ and consumer moves from point A (all coffee) to point C (all tea)
• All the price effect is substitution effect

Question 6

How do you generate a market demand curve

Answer 6

Through a horizontal summation of all individual demand curves

Question 7

Elasticity of demand equation

Answer 7

% change in Q/ %change in P

Question 8

How does elasticity change along a straight line demand curve

Answer 8

Question 9

What are the determinants of PED

Answer 9

• Budget share
• Substitution options
• Time
• Definition of the good, more narrowly defined= more elastic

Question 10

How can a reduction in price increase total revenue

Answer 10

If PED is inelastic so absolute value is less than 1

Question 11

Income elasticity equation

Answer 11

% change in Q/ % change in Y

Question 12

What happens to demand for a luxury good when income rises

Answer 12

It increases

Question 13

What is the XED for a substitute

Answer 13

Positive

Question 14

XED for complement

Answer 14

Negative