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ch05 - Chapter 5 The Theory of Demand Solutions to Review...

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Chapter 5 The Theory of Demand Solutions to Review Questions 1. The price consumption curve plots the set of optimal bundles for two goods, say X and Y, by changing the price of one good while holding the price of the other good and income constant. 2. The price consumption curve plots the set of optimal bundles for two goods as the price of one good changes while the price of the other good and income remain constant. The income consumption curve, on the other hand, plots the set of optimal bundles for two goods as the consumer’s income changes while holding the prices of both goods constant. 3. With a normal good, when income increases, consumption of the good will increase. This implies the income elasticity for a normal good will be positive. With an inferior good, when income increases consumption of the good will decrease. This implies the income elasticity for an inferior good will be negative. 4. If indifference curves are bowed in toward the origin and the price of, say, good X falls, consumption of X will always increase; so the substitution effect will always be positive. A decrease in the price of X implies that the slope of the budget line becomes flatter. When indifference curves are bowed in, a direct consequence of this change in relative prices is that any tangency will occur “southeast” of the original bundle along the initial indifference curve. The only way for consumption to fall when price falls is for the income effect to be negative (an inferior good) and for its magnitude to more than offset the substitution effect. In this rare situation, the good is known as a Giffen good. 5. If the consumer purchases only three goods and income increases, it is possible that consumption of all three goods will increase. For example, the consumer might allocate one-third of the increase to each of the three goods. Thus, it is possible for all three goods to be normal. If the consumer purchases only three goods and income increases, it is not possible that consumption of all three goods will decrease. Recall that if consumption falls when income increases the good is inferior. If this were to occur, the consumer would be spending less income than he did prior to the income increase. Thus, it is not possible for all three goods to be inferior. Page 5 - 1
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6. Generally speaking demand curves are downward sloping. Economic theory, however, suggests a special case of an inferior good whose negative income effect is greater than its positive substitution effect. In this event, consumption of the good falls when the price of the good falls. This type of good is known as a Giffen good. While economic theory suggests that such a good could exist, in practice no such good has been confirmed for humans (although the text suggests an experiment on rats where a good was determined to be a Giffen good).
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