Consumer Theory 6

Question 1

Key insights

Answer 1

The level of utility that the consumer obtains changes as we move along the demand curve. At every point along the demand curve, the consumer is maximising their utility. The lower the price of the product, the higher level of total utility the consumer gets. On the other hand, with lower prices, the marginal utility from the good goes down as they are consuming more of the good. This implies the MRS must be decreasing, which should make sense as the relative price was going down

Question 2

What happens when the price of a good changes relative to another

Answer 2

One good becomes relatively more expensive, and the other relatively less and the total purchasing power of a consumer’s income changes

Question 3

Consumer responses to price changes

Answer 3

The substitution effect is the change in a consumers consumption choices, resulting from a change in a relative price of goods. It is always negative- when the price of one good relative to another increases, consumption of the former falls and vice versa. The income effect is the change in a consumer’s consumption choices that results from a change in the consumer’s income, holding relative prices constant. It can be negative or positive- depending on whether the goods are normal or inferior goods. The total effect of a change in a price is the sum of the substitution and income effect- the observed change in consumption of a good after a price change e.g. A to B to C

Question 4

Why clothing demand first falls then rises

Answer 4

As the price of food decreases, the budget constraint pivots outward (from BC1 to BC3), increasing the set of affordable bundles. At point A to B- food is cheaper > sub away from clothing so (-). However real income increases > demand for both goods rise so (+). At point B to C- Food becomes even cheaper, but income effect becomes larger. In conclusion demand for clothing first falls due to substitution then rises due to stronger income effect.

Question 5

Intuitive decomposition: Hicks vs Slutsky

Answer 5

When the price of a good changes, 2 things happen at once- the relative price of goods changes; this alters the trade off the consumer faces and the purchasing power (real income) of the consumer also changes. Economists separate these 2 effects to understand behaviour more clearly. Hicks decomposition holds the consumers utility constant- keeps them on the same indifference curves. Slutsky decomposition holds the consumer’s purchasing power constant in terms of their original bundle.

Question 6

Hicks decomposition: Holding utility constant

Answer 6

The goal is to isolate the substitution effect by holding the consumer’s utility level constant. This is done by shifting the new budget line until it becomes tangent to the original indifference curves. This requires a reduction in income to remove any income effect from the analysis. The resulting shift in consumption represents the substitution effect only. Visually, the new budget line is parallel to the post price change budget line, but touches the initial indifference curves. The movement along the original indifference curve captures how choices respond to price changes, assuming no change in satisfaction.

Question 7

Slutsky decomposition: Holding purchasing power constant

Answer 7

Slutsky’s method isolates the substitution effect by holding purchasing power constant. This is done by shifting the new budget line so that it passes through the original consumption bundle. The consumer is now at a different point (on a different indifference curve), but can still afford the same original bundle. As a result, any movement away from this point reflects the substitution effect only- not income effect. This approach shows how relative prices change behaviour while maintaining ability to buy the same bundle as before

Question 8

Normal goods

Answer 8

When income increases, demand for the good also increases. These goods have a positive income effect

Question 9

Inferior goods

Answer 9

When income increases, demand for the good decreases. The income effect is negative, but usually smaller than the substitution effect

Question 10

Giffen goods

Answer 10

A rare case of an inferior good where the negative income effect dominates the substitution effect. As a result, demand for the good rises when its price rises

Question 11

Interpreting income in price changes

Answer 11

When analysing how consumers respond to price change, we often refer to the income effect. In this context, income doesn’t not mean a change in actual earnings or wages. Instead it refers to a change in purchasing power- how much a consumer can afford giver fixed nominal income and new prices e.g. a fall in the price of food increases the consumer’s purchasing power, even if income stays the same.