Source: Practice MCQs for Exam 1, Texas A&M University
Tags: income effect, substitution effect, normal good, inferior good, Giffen good, consumer surplus, price consumption curve, demand curve derivation, income consumption curve, Slutsky decomposition
When the price of a good changes, the consumer's response can be split into a substitution effect (the change due to the new relative price, holding utility constant) and an income effect (the change due to the shift in purchasing power). For normal goods the two effects reinforce each other. For inferior goods they work in opposite directions. A Giffen good is the rare case where the income effect dominates the substitution effect for an inferior good, producing an upward-sloping demand curve. Consumer surplus measures the difference between what a consumer is willing to pay and what they do pay.
Substitution effect
The change in quantity demanded that results from a change in relative prices, holding utility constant. Found by comparing the original optimum to the point on the original indifference curve at the new price ratio.
Income effect
The change in quantity demanded that results from the change in purchasing power after a price change, holding relative prices at the new level. Found by comparing the hypothetical bundle (on the original indifference curve at the new prices) to the final optimum on the new budget line.
Normal good
A good for which quantity demanded increases when income rises. The income effect and substitution effect work in the same direction when price changes. The income-consumption curve slopes upward. The demand curve slopes downward.
Inferior good
A good for which quantity demanded decreases when income rises. The income effect works against the substitution effect. The income elasticity of demand is negative.
Inferior good with downward-sloping demand
For most inferior goods, the substitution effect still dominates the income effect, so the demand curve slopes downward. The price elasticity of demand is negative (downward slope), and the income elasticity is also negative.
Giffen good
A special subset of inferior goods where the income effect is so strong that it dominates the substitution effect. The result is an upward-sloping demand curve: a price increase causes an increase in quantity demanded. A Giffen good must be inferior; it is not the same as all inferior goods.
Income-consumption curve (ICC)
The curve tracing optimal bundles as income changes, with prices held constant. For normal goods, the ICC slopes upward (more of both goods as income rises).
Consumer surplus
The difference between what a consumer is willing to pay for a unit of a good and what they actually pay. Graphically, it is the area between the demand curve and the price line.
Compare the equilibrium on the original indifference curve at the original prices to the equilibrium on the same indifference curve at the new prices. This isolates the effect of the change in relative prices, holding utility constant.
In practice, you draw a hypothetical budget line that is parallel to the new budget line but tangent to the original indifference curve. The movement from the original bundle to the tangency on this hypothetical line is the substitution effect.
Compare the equilibrium on the hypothetical budget line (same indifference curve, new prices) to the actual new equilibrium on the new budget line. This captures the effect of the change in purchasing power.
The exam answer: the income effect is found by comparing equilibrium quantities on the new budget line and a hypothetical budget line that is a parallel shift back to the original indifference curve at the new price ratio.
When the price of a normal good falls:
Substitution effect: buy more of it (it is now relatively cheaper).
Income effect: buy more of it (real income has risen, and it is a normal good, so demand goes up with income).
Both push quantity up. The demand curve slopes downward.
When the price of an inferior good falls:
Substitution effect: buy more of it (relatively cheaper).
Income effect: buy less of it (real income has risen, but this good is inferior, so demand falls with income).
The substitution effect usually dominates, so the demand curve still slopes downward.
Price elasticity is negative; income elasticity is also negative.
A Giffen good is the case where the income effect is so large that it overwhelms the substitution effect for an inferior good:
Price falls, substitution effect says buy more, but the income effect (buy less) is larger.
Net result: quantity demanded falls when price falls, so the demand curve slopes upward.
A Giffen good is always inferior, but not all inferior goods are Giffen.
For a linear inverse demand curve p = a - bq, consumer surplus at price P is the triangular area above the price line and below the demand curve.
Worked example: Leo's inverse demand: p = 100 - q.
At P = 20: Q = 80. Consumer surplus = 0.5 × 80 × (100 - 20) = 0.5 × 80 × 80 = 3200.
At P = 40: Q = 60. Consumer surplus = 0.5 × 60 × (100 - 40) = 0.5 × 60 × 60 = 1800.
Change in consumer surplus = 1800 - 3200 = -1400.
Consumer surplus decreases by 1400 when price rises from 20 to 40.
Consumer surplus (linear demand):
CS = 0.5 × Q × (P_max - P)
Where P_max is the price intercept (where Q = 0) and P is the market price.
Decomposition of total effect:
Total effect = Substitution effect + Income effect
For normal goods: both effects have the same sign.
For inferior goods: the effects have opposite signs.
For Giffen goods: the income effect dominates and reverses the total effect.
⚠️ The income effect is found by comparing the new budget line to a hypothetical budget line that is parallel to the new one but tangent to the original indifference curve. This wording appears on exams almost verbatim.
⚠️ A Giffen good is a subset of inferior goods where the income effect dominates the substitution effect. It is not the case that all inferior goods are Giffen, and it is not the case that the substitution effect dominates (that would just be a regular inferior good).
⚠️ For an inferior good with a downward-sloping demand curve: price elasticity is negative, income elasticity is negative. Both negative.
⚠️ For a normal good: the demand curve always slopes downward, the ICC slopes upward, and the income and substitution effects go in the same direction. "All of the above" is correct when all three are listed.
⚠️ Consumer surplus = willingness to pay minus price actually paid. This is the textbook definition of consumer surplus, not producer surplus, not cost-benefit analysis, not net utility.
⚠️ When computing the change in consumer surplus, calculate CS at the old price and at the new price separately, then subtract.
Q: For a normal good, what can we say about the demand curve, the income-consumption curve, and the direction of income and substitution effects?
A: The demand curve slopes downward, the ICC slopes upward, and the income and substitution effects go in the same direction. All three statements hold.
Q: For an inferior good with a downward-sloping demand curve, what are the signs of price elasticity and income elasticity?
A: Both are negative. Price elasticity is negative (downward slope). Income elasticity is negative (inferior good).
Q: How do you find the income effect of a price change?
A: Compare the equilibrium quantities on the new budget line and a hypothetical budget line that is parallel to the new budget line but shifted back to the original indifference curve.
Q: What is a Giffen good?
A: A special subset of inferior goods in which the income effect dominates the substitution effect. The demand curve slopes upward.
Q: Leo's inverse demand for wine is p = 100 - q. Price changes from $20 to $40. How does consumer surplus change?
A: It decreases by $1,400. CS at $20 = 0.5(80)(80) = 3,200. CS at $40 = 0.5(60)(60) = 1,800. Change = 1,800 - 3,200 = -1,400.
Q: The difference between willingness to pay and the actual price paid is called what?
A: Consumer surplus.
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