Lesson 7

Question 1

What are the two fundamental effects of a price change?

Answer 1

The Substitution Effect and the Income Effect.

Question 2

What does the Substitution Effect capture?

Answer 2

The change in demand due only to the change in relative prices, holding the consumer’s utility constant.

Question 3

What does the Income Effect capture?

Answer 3

The change in demand due to the change in purchasing power caused by the price change, holding relative prices constant at the new level.

Question 4

What is the Total Effect of a price change?

Answer 4

The sum of the Substitution Effect and the Income Effect: Total Change in Demand = Substitution Effect + Income Effect.

Question 5

How is the Substitution Effect shown graphically?

Answer 5

By pivoting the budget line around the original indifference curve to reflect the new prices, but adjusting income (creating a “phantom” budget line) to keep utility constant.

Question 6

How is the Income Effect shown graphically?

Answer 6

By shifting the “phantom” budget line outwards or inwards to the final budget line, showing the change in consumption from the change in purchasing power alone.

Question 7

What is the Slutsky Identity?

Answer 7

The mathematical formula that decomposes the total effect of a price change into the substitution and income effects.

Question 8

In the Slutsky equation, what is held constant for the Substitution Effect?

Answer 8

The consumer’s utility is held constant.

Question 9

In the Slutsky equation, what is held constant for the Income Effect?

Answer 9

The new relative prices are held constant, and we analyze the change due to the shift in real income.

Question 10

What is another name for the demand function used to calculate the substitution effect?

Answer 10

The Compensated Demand function (Hicksian demand), because the consumer’s income is “compensated” to keep their utility unchanged.

Question 11

For a Normal Good, how do the substitution and income effects work together?

Answer 11

They work in the same direction. A price decrease leads to a positive substitution effect and a positive income effect, both increasing demand.

Question 12

For an Inferior Good, how do the substitution and income effects relate?

Answer 12

They work in opposite directions. The substitution effect is positive (like always), but the income effect is negative (as income increases, demand for the inferior good falls).

Question 13

What is the defining characteristic of a Giffen Good?

Answer 13

It is a special type of inferior good where the income effect is so strong and negative that it outweighs the substitution effect. This causes the Total Effect to violate the Law of Demand.

Question 14

For a Giffen Good, what happens when its price decreases?

Answer 14

The total quantity demanded decreases. The positive substitution effect is smaller than the large negative income effect.

Question 15

What does the Law of Demand state?

Answer 15

For most goods, when the price increases, the quantity demanded decreases, and vice-versa.

Question 16

Which type of good is an exception to the Law of Demand?

Answer 16

A Giffen Good.

Question 17

How does the Slutsky equation explain the violation of the Law of Demand for Giffen goods?

Answer 17

The Law of Demand is violated when the positive substitution effect is overpowered by a sufficiently large negative income effect, which only happens with inferior Giffen goods.

Question 18

What is the Hicks Substitution Effect?

Answer 18

The method of decomposing the price change by creating a “phantom” budget line that is parallel to the final budget line but tangent to the initial indifference curve, thereby holding utility constant.

Question 19

In the Hicks method, what is the goal of the “phantom” budget line?

Answer 19

To isolate the pure change in consumption due to the new relative prices, with the consumer’s “real income” (utility) held constant.