Review Questions

1. Define the income effect. What variables do we hold constant in order to isolate the income effect?

   The income effect describes the change in a consumer’s consumption choice given a change in the purchasing power of the consumer’s income. In describing this change, we hold the goods’ prices fixed.

2. What are the differences between normal goods, inferior goods, and luxury goods?

   We characterize a good as normal when consumption of the good rises with income. Luxury goods are a class of normal goods whose income elasticity is greater than 1. In contrast to normal goods, the consumption of an inferior good decreases when income rises.

3. Both the income expansion path and the Engel curve show the effect of income on consumption choices. When might you choose to use the income expansion path? When might the Engel curve be more useful?

   The income expansion path connects the optimal bundles of two goods for one consumer, while the Engel curve shows the relationship between the quantity of a good consumed and a consumer’s income. While both the Engel curve and the income expansion path contain the same information, the income expansion path allows us to understand how two goods’ relative quantities change with income. The Engel curve isolates the impact of income changes on the consumption of a single good.

4. Describe how we can derive a consumer’s demand curve from his indifference curves. Why would we expect the demand curve to slope downward?

   Holding the consumer’s income constant, we can draw his demand curve by connecting the utility-maximizing quantities of a good at different prices of the good. When the price of a good increases, the consumer’s demand for the good decreases, creating a downward-sloping demand curve.

5. Name at least three factors that can shift an individual’s demand curve for pizza. Also describe the effect each factor has on demand (e.g., does it rise or fall?).

   The demand for pizza will shift in response to changes in the consumer’s income or preferences, as well as the price of other goods. Three possibilities of shifts in the demand for pizza are listed below:
   a. Increase in the consumer’s income: If pizza is a normal good, then an increase in the consumer’s income will shift out his demand for pizza.
   b. Decrease in the consumer’s relative preference for pizza: If the consumer’s relative preference for pizza decreases—say, he starts preferring the substitute good, Chinese take-out—then his demand for pizza will shift in.
   c. Increase in the price of another good: If the price of a good such as Chinese take-out increases, then the consumer’s demand for pizza will shift out. If the price of a complement of a good—like the beverage the consumer prefers to have with his pizza—increases, then the consumer’s demand for pizza will shift in.

6. Define the substitution effect. How does it relate to the income effect?

   Both the income and substitution effects stem from a change in the prices of two goods. While the substitution effect is the change in a consumer’s consumption choices that results from a change in the relative prices of the two goods, the income effect describes the change resulting from the consumer’s purchasing power.

7. Describe how to decompose the consumer’s response to price changes into the substitution and income effects.

   We can isolate income and substitution effects using three basic steps. Take a consumer with initial utility-maximizing bundle A.
   a. A change in the goods’ prices rotates the budget constraint. The new optimal bundle (B) is at the tangency of the new budget constraint to a new indifference curve.
   b. The line that is parallel to the new budget constraint but tangent to the original indifference curve gives you point A'. The substitution effect is the movement from A to A'.
   c. The income effect is the movement from A' to the new optimal bundle B.

8. How do income and substitution effects differ between normal and inferior goods?

   The direction of the substitution effect is the same for both normal and inferior goods, but the income effect differs between the two types of goods. If a normal good’s price decreases, the change in consumption due to the income effect is an increase in consumption of the good. If an inferior good’s price decreases, the change in consumption due to the income effect is a decrease in consumption of the good.

9. What is a Giffen good?

   A Giffen good is a good for which price and quantity demanded are positively related. In other words, if the price of the good decreases, the consumer demands less—not more—of the good.

10. What are complements and substitutes?

    A complement is a good that is purchased and used in combination with another good. A substitute is a good that can be used in place of another good.

11. When the cross-price elasticity of demand is positive, are the two goods complements or substitutes? What type of goods have a negative cross-price elasticity?

    When the price of a good’s substitute rises, the demand for the good increases, meaning substitutes have a positive cross-price elasticity of demand. Complements have a negative cross-price elasticity of demand; when the price of a good’s complement rises, the demand for the good decreases.

12. What can the shape of the indifference curve tell us about two goods?

    The shape of the indifference curve reveals information about the degree of two goods’ substitutability. The less curved the indifference curve, the more substitutable the two goods are.

13. How does the market demand relate to individual demand curves?

    The market demand is the horizontal sum of all individuals’ demand curves for a good.

14. Why will a market demand curve always be at least as flat as a given individual demand curve?

    For a given change in price, the change in quantity demanded by the market as a whole must be at least as great as the change in quantity demanded by an individual consumer. As a result, the market demand curve must be at least as flat as an individual’s demand curve.