Examkin

Question

Difficulty: MediumIncome and Substitution Effects on Demand

Suppose the market price of a normal commodity increases. The substitution effect causes a consumer to purchase 55 fewer units of the commodity. If the total price effect results in an overall reduction of 99 units in quantity demanded, what is the specific impact of the income effect on the quantity demanded of the commodity?

  1. A decrease of 44 unitsAnswer
  2. B
    An increase of 44 units
  3. C
    A decrease of 1414 units
  4. D
    An increase of 1414 units

Answer

A decrease of 44 units
The total price effect equals the sum of the substitution effect and the income effect. Given a total price effect of a 99-unit reduction and a substitution effect of a 55-unit reduction, the income effect must account for the remaining 44-unit reduction (−9=−5+(−4)-9 = -5 + (-4)). For a normal good, a price increase lowers real income, leading the consumer to buy less of the good.

Step-by-Step Solution

1
State the fundamental relationship decomposing total price effect into substitution and income effects.
Total Price Effect = Substitution Effect + Income Effect
According to consumer choice theory, any price change decomposes into a relative price adjustment (substitution effect) and a purchasing power adjustment (income effect).
2
Substitute the known values into the decomposition equation, assigning negative values to decreases in quantity demanded.
−9 units=−5 units+Income Effect-9\text{ units} = -5\text{ units} + \text{Income Effect}
Both total price effect and substitution effect represent reductions in quantity demanded due to the price increase of a normal good.
3
Solve for the income effect.
Income Effect=−9−(−5)=−4 units\text{Income Effect} = -9 - (-5) = -4\text{ units}
A result of −4-4 units indicates that the real income reduction from the higher price causes the consumer to further reduce consumption of the normal good by 44 units.

Key Concept

Decomposition of Total Price Effect for Normal Goods
Estimated Time:1m 0s
Rate this question

Topics

Income and Substitution Effects on Demand

More questions from this topic