Chapter 5: Applying Consumer Theory

What is the information we need to draw a demand curve?

By varying one price and holding other prices and income constant, we determine how the quantity demanded changes as the price changes

How to draw the demand curve given indifference curves and budget constraints

The optimal bundles can be drawn down to correspond with the price-quantity combinations

What is the price-consumption curve

the line that goes through the optimal bundles at different prices

An increase in income causes the BC to

shift out

What is the income consumption curve

The income consumption curve shows how a consumer's optimal consumption bundle changes across different income levels

What does the Engel curve represent?

Shows the relationship between income and quantity demanded of a good, holding prices constant

if the Engel curve/ICC is upward-sloping then the good is

a normal good

if the Engel curve/ICC is downward-sloping the good is

an inferior good

What is income elasticity and what does its values represent? ξ

ξ = dQ/dY x Y/Q

ξ > 0 normal good

ξ < 0 inferior good

ξ > 1 luxury good

1 > ξ > 0 Necessity

What tells us the sign of the income elasticity?

The shape of the income-consumption curve for two goods

TRUE or FALSE: It is impossible for both goods to be inferior

TRUE (either both goods are normal or one good is normal and the other is inferior)

Are there cases where income-consumption curves can be backward bending?

Yes, think of the fast food example

(As a person’s income increases, a good can shift from being a normal good to an inferior good)

Increase in price has two effects:

1. Substitution effect

2. Income effect

Substitution effect

change in quantity demanded when the price for a good changes, holding other prices and utility constant.

(consumer substitutes to relatively cheaper goods)

Income effect

Change in quantity demanded due to a change in income, holding prices constant.

(when the price of a good changes, this changes the consumers purchasing power)

When both prices increase/decrease for two goods, how does that affect income?

if both prices on a BC line increase, it acts like a decrease in income (shifting the BC to the left)

if both prices on a BC line decrease, it acts like an increase in income (shifting the BC to the right)

How to calculate total change in Qd

income effect + substitution effect

The substitution effect will ALWAYS be positive for

price decreases

The substitution effect will ALWAYS be negative for

price increases

If a good is normal, the income effect is _____.

positive

If a good is inferior, the income effect is _____.

negative

The substitution effect causes a movement along

an indifference curve

The income effect causes a _____ due to a change in the consumer’s opportunity set.

shift to another indifference curve

True or false: if a good is inferior, the income and substitution effect move in opposite directions.

True

How to tell if a good is a giffen good

when the income effect more than offsets the substitution effect