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Short Answer Questions

The document discusses consumer welfare and demand analysis. It provides definitions for key concepts like the law of demand, Slutsky equation, consumer surplus, compensating and equivalent variations, and Giffen goods. It also uses diagrams to explain how changes in prices can impact consumer demand curves and welfare through substitution and income effects. For example, it shows how an increase in the price of a normal good leads to a decrease in quantity demanded due to both substitution and reinforcing income effects.

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68 views

Short Answer Questions

The document discusses consumer welfare and demand analysis. It provides definitions for key concepts like the law of demand, Slutsky equation, consumer surplus, compensating and equivalent variations, and Giffen goods. It also uses diagrams to explain how changes in prices can impact consumer demand curves and welfare through substitution and income effects. For example, it shows how an increase in the price of a normal good leads to a decrease in quantity demanded due to both substitution and reinforcing income effects.

Uploaded by

mustafa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter 4: Price changes and consumer welfare

Short Answer Questions

1. What is the law of demand and its implication?

Answer: The law of demand states that when the price of a commodity increase,
holding other things constant, and the quantity demanded of that commodity
decreases. The implication of the law of demand is the negative relationship between
price and the quantity demanded and hence downward-sloping demand curve

2. State and briefly explain the Slutsky equation.

Answer: The Slutsky equation shows the decomposition of the effect of a price
change on quantity demanded into an income effect and a substitution effect. It can
be expressed as:

⎛ ∆x ⎞
where ⎜ ⎟ denotes the substitution effect which must be negative as long as the
⎝ ∆p ⎠ comp
∆x
indifference curve exhibit a diminishing marginal rate of substitution and − x1 ×
∆I
denotes the income effect.

3. Define the concept of consumer surplus and graphically explain your answer.

Answer: The consumer surplus (also referred to as Marshallian consumer surplus) is


the difference between what a consumer is willing to pay and what he has to pay
which can be represented by the area under the demand curve and above the going
price.
4. Briefly distinguish between the meaning of compensating and equivalent
variations.

Answer: Compensating variation is the amount of money by which an individual


would need to be compensated for after the price increase in order to remain at this
initial level of utility. Equivalent variation is the amount of money that you have to
take away from the individual to lower his level of utility as much as the price
increase does.

5. What is a Giffen good?

Answer: A Giffen good is a good that its quantity demanded increases with price and
hence has an upward sloping demand curve.

For the next four questions assume an economy in which John can spend his
budgets (£M) on purchasing two goods X and Y. Use an appropriate diagram to
explain your answer:

6. John initial chooses his consumption bundle between X and Y, in such a way
so that he maximises his utility function. Now suppose that the price of good
X suddenly rises. Assuming that both goods are normal, draw an appropriate
diagram showing the income and substitution effects of this price change.

Answer: When the price of good X increases, John’s budget line change from B1 to
B2. The total effect of a price increase on quantity demanded which is the movement
from X1 to X2 can be decomposed into an income effect and a substitution effect. The
substitution effect decreases the quantity demanded for good X from X1 to Xc and the
income effect decreases the quantity demanded for good X from Xc to X2.. Since both
goods are normal, the two effects reinforce each other.
7. How would your answer to question 6 change, if good X is an inferior good?

Answer: If good X is an inferior good, then the income effect increases the quantity
demanded for good X from X’c to X’2. However, the result satisfies the law of demand
since the substitution effect (the movement from X’1 to X’c ) is more powerful that the
income effect. So, the total effect of a price increase is the reduction in quantity
demanded for good X, the movement from X’1 to X’2.

8. Derive diagrammatically the equivalent variation of the price increase.

Answer:
9. Show how this price increase in good X has now affected John’s consumer
surplus.

Answer: Assuming that John has a smooth demand curve. At the p1, his consumer
surplus equals to area A+B. When the price of good X increases to p2, his consumer
surplus equals to area B. So, his welfare decreases by area A.

10. Explain the difference between the ordinary demand curve and the
compensated demand curve.

Answer: The ordinary demand curve shows the relationship between price and
quantity demanded holding money income constant. In contrast, the compensated
demand curve shows the relationship between price and quantity demanded holding
real income (or utility) constant. The ordinary demand curve shows both income
effect and substitution effect, whereas the compensated demand curve shows the
substitution effect.

Essay questions

1. Explain how the use of trade quotas can reduce consumer welfare.

Brief answer: A trade quota is a restriction on the quantity of some commodity that
can be imported into the country. As a consequence of the quota, the price of the
commodity increases. The loss of consumer surplus associated with a price increase is
the area behind the demand curve between the two prices, which is represented by
area F+G in the figure below. (The reader should also discuss about quota rent and the
deadweight loss.)
2. Using an appropriate diagram, discuss how the use of a price subsidy on a
good of your choice (examined against “all other goods”) could affect the
equilibrium consumption bundle and consumers welfare.

Brief answer: (The example of the full discussion on a price subsidy can be viewed
from chapter 2, p 109-112.)

3. Can demand curves be used to measure welfare changes? Fully explain your
answer.

Brief answer: Recall that the demand curve shows the relationship between price and
quantity demanded, holding other thing including money income constant. But with a
constant money income, the value that an individual outs on an additional unit of a
good may depend on the amount that he/she has already spent on previous units of
good. So, the vertical distance up to the demand curve may not exactly measure the
consumer’s marginal valuation of the associated unit of output. An exact marginal
valuation schedule must eliminate the income effects that are embodied in the demand
curve. (The reader may also mention the compensated demand curve.)

4. Using the aid of appropriate diagrams, explain what the compensated demand
curve is and how it can be graphically derived.

Brief answer: The compensated demand curve is the schedule that shows how the
quantity demanded varies with price, assuming that as price changes consumers are
compensated with enough income to keep them at their initial utility level. The figure
below shows how to derive the compensated demand curve. (The reader should also
explain how to derive it.)
5. “Every Giffen good must be an inferior good”. Discuss.

Brief answer: Recall that the demand curve for a Giffen good is upward sloping.
Since the substitution effect always leads to a decrease in quantity demanded when
price increases, the only way for the demand curve to slope upwards is for the
substitution effect to be dominated by a positive income effect of a price increase.
When a decrease in income leads to an increase in consumption, the good is inferior
by definition. (The reader may also discuss that a commodity may be inferior but not
be a Giffen good.)

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