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Practice Problems

Income and Substitution Effects


Problem : Which of the following are complementary goods, and which are substitute goods?

Right and left shoes?
Sweaters and sweatshirts?
Hot dogs and ketchup?
Nickels and dimes?
Ice cream and sorbet?
Chips and salsa?

Complementary goods: Right and left shoes, hot dogs and ketchup, chips and salsa. Substitute goods: Sweaters and sweatshirts, nickels and dimes, ice cream and sorbet.

Problem : If Marianne is grocery shopping for cheese and notices that there is a sale on Swiss cheese, how will that affect her demand for Swiss cheese and Emmenthal cheese?

Her demand for Swiss cheese will increase; it is uncertain how her demand for Emmenthal cheese will be affected, although it will probably decrease, since the substitution effect is usually stronger than the income effect.

Substitution and Income Effects

Problem : Consider the case where Katie gets a raise. How will that affect her consumption of Spam (an inferior good) and steak (a normal good)? What if her income drops? What will happen to her Spam and steak consumption?

Consumption of inferior goods decreases with increases in income; consumption of normal goods increases with increases in income. So when Katie gets a raise, her consumption of Spam will decrease, and her consumption of steak will increase. If she gets a pay cut, the opposite will happen: she will eat more Spam and less steak.

Problem : One of Ruby's favorite cereals, Special K, is on sale at 20% off. How will that affect her buying decision between Special K and Cheerios? What if both are on sale at 20% off?

If only Special K is on sale, Ruby will buy more Special K. We can't be sure how she changes her consumption of Cheerios, although she will probably buy less, since the substitution effect is usually stronger than the income effect.

Income and Substitution Effects if Special K is on Sale

If both brands are on sale, however, there is no substitution effect, since there is no change in the relative prices of the cereals: both prices go down by the same amount, so that their price ratio remains constant. This means that only the income effect will affect Ruby's purchase decision. Thus, since the lower prices make her feel richer, Ruby will buy more of both.

Income and Substitution Effects if Both Cereals are on Sale

Problem : What is the difference between a Giffen good and a normal good?

A Giffen good is a theoretical type of good for which consumption increases with increases in price. Most goods (in the real world) are normal goods: goods for which consumption decreases with increases in price.

Demand Curve for Giffen Goods

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