o The substitution effect is found by the distance a. X-X1 c. Xi-X2. d. E-E The
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o The substitution effect is found by the distance a. X-X1 c. Xi-X2. d. E-E The income effect is found by the distance a. Xi-X3. b. X3-X2. c. Xi-X2. d. E-E 10. 11 If the original equilibrium was E' and the new equilibrium was E, then the substitution effect would be a. Xi-Xi b. X2-X3. c. X2-Xi d. none of the above because the substitution effect would have to be measured on the indifference curve with E Quaality Figure 4-3 12. For a demand curve to be upward sloping a. the income effect must be larger than the substitution effect and the good must be a no good b. the income and substitution effects must be the same size. c. the good must be an inferior good and the income effect must be larger than the substi effect d. the good must have a strong bandwagon effect.Explanation / Answer
9. (a) X1-X3
Substitution effect gives change in quantity demanded due to change in price holding income constant. It is the difference between the original bundle and the bundle which we get by drawing line parallel to the budget line after price change, which is tangent to original indifference curve to keep the utility level same.
10. (b) X3-X2
Income effect gives change in purchasing power due to change in price. When price increases then purchasing power of income decreases and hence quantity demanded decreases.
11. (d) none of the above because the substitution effect would have to be measured on the indifference curve with E’.
12. (c) the good must be an inferior good and the income effect must be larger than substitution effect.
For demand curve to be upward sloping the quantity demand must increase with increase in price which requires that good must be inferior.
The substitution effect is negative for all goods but income effect is positive for inferior good with respect to price change. So for demand curve to be upward sloping the positive income effect must dominate the negative substitution effect so that overall price change is positive. Positive price change means both price and quantity will move in same direction.
14. (c) All Giffen goods are inferior goods but not all inferior goods are Giffen goods.
Inferior good have positive income effect with respect to price change (positive implies that quantity and price move in same direction when price change) which means when price decrease and income increases their quantity demanded decreases. Giffen goods are part of inferior good they also have positive income effect.
In case of inferior good substitution effect (which is always negative) dominates the income effect (which is positive). In case of Giffen good which is a special case of inferior good the income effect (which is positive) dominates the substitution effect (which is always negative).
15.(b) Horizontally
This is because by adding horizontally we add up the quantity demand which is shown on X-axis, for given level of price and we hence get the market demand curve.
16. (c) APC
Consumer surplus is given by area below the demand curve and above the price line.
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