Handout 7 (Consumer Theory – Income and Substitution Effects) with Solutions

Handout 7 Consumer Theory – Income and Substitution Effects This handout contains exercises of - Consumer Theory (Engel Curve, Substitution and Income Effect) Things you should know - How to draw the graphs and find the substitution and income effect when price changes? - How to analyze the income characteristic of each good? Exercises Question 1 (Practice Quiz) You need two large, clear graphs (one for each question) for this quiz, and short explanations. Please present quantity of good X along the horizontal axis in each graph, mark all intercepts and mark income, substitution and price effect on your graphs. 1. True or false: If good X is a normal good, after a decrease in price for good X from PX1 to PX2, we expect to see an income effect that reinforces the substitution effect for a larger price effect. Assume that consumer has income, I, and the price for good Y is PY. 2. True or false: If good X is a Giffen good, after a decrease in price for good X from PX1 to PX2, we expect to see an income effect that reinforces the substitution effect for a larger price effect. Assume that consumer has income, I, and the price for good Y is PY. Question 2 (Engel Curve) Assume that there are only two goods, X and Y. Argue intuitively (without calculus or math) that it is not possible for both goods to be simultaneously inferior goods. (Hint: “More is preferred to less.”) Question 3 (Substitution and Income Effect) The diagram above exhibits the scenario when price of good X increases. We can conclude that the substitution effect causes the consumption of good X to [ increase / decrease ], and the consumption of good Y to [ increase / decrease]. Furthermore, we can conclude that good X is [ a normal / an inferior / neither normal nor inferior] good, and good Y is [ a normal / an inferior / neither normal nor inferior ] good. 1 Question 4 (Income and Consumption – Graphical Question) The diagram above exhibits an increase in the price of good Y. The price effect is exhibited by the movement from point __________ to point __________. The substitution effect is exhibited by the movement from point __________ to point __________. The income effect is exhibited by the movement from point __________ to point __________. When price of good Y increases, the substitution effect causes the [ increase / decrease ] in the consumption of good Y, and the consumption of good X [ increases / decreases ]. The income effect causes the [ increase / decrease ] in the consumption of good Y, and the consumption of good X to [ increase / decrease ]. Therefore, good Y is [ a normal / an inferior ] good and good X is [ a normal / an inferior ] good. Question 5 (Determining the Hypothetical Budget Line) The following concludes the information regarding the prices and consumption bundles from the price, substitution and income effects. X* PX PY Y* Point Income E1 $5 $5 $100 10 (Original Prices) E’ 7 12 (Hypothetical Budget Line) E2 $10 $5 $100 5 (New Prices) 1. Fill in the blanks in the table above. Using the information, draw a diagram exhibiting the decomposition of substitution and income effect when price of good X changes. 2. Write down the equation for the hypothetical budget line. 3. The substitution effect causes the consumption of good X to [ increase / decrease ] by _______ units and the consumption of good Y to [ increase / decrease ] by _______ units. The income effect causes the consumption of good X to [ increase / decrease ] by _______ 2 units and the consumption of good Y to [ increase / decrease ] by _______ units. Thus, good X is [ a normal / an inferior ] good, and good Y is [ a normal / an inferior ] good. 3