Questions for Review with Answers
Chapter 8. Demand Theory I. The Demand Curve. Consumer Behaviour
I. Basics
Chapter 8 – Question 1
1) Give two definitions of the terms demand and quantity demanded.
* Demand stands for (1) the whole demand curve and (2) the quantities of a commodity that consumers would be able and willing to buy at any possible price.
Quantity demanded stands for (1) a particular point on the demand curve and (2) a quantity of a commodity that consumers are willing and able to buy at a particular price.
Chapter 8 – Question 2
Explain the difference between a change in quantity demanded and a change in demand.
* A change in quantity demanded is a response to price changes; it is illustrated by a movement along the demand curve. A change in demand is a response to a change in exogenous variables such as incomes or tastes; it is illustrated by a shift of the demand curve.
Chapter 8 – Question 3
What does the law of demand postulate?
* It stipulates that quantity demanded rises as price declines.
Chapter 8 – Question 4
Is a shift of the demand curve to the right an increase or a decline in demand?
* An increase.
Chapter 8 – Question 5
What is market demand?
* It is demand for an industry's homogenous product in a specified region, for instance, the international market for Jaguar XJ cars.
Chapter 8 – Question 6
Draw your demand curve for digital cameras.
* If you are not interested in digital cameras, you have no demand curve. If you are interested, you need a homogenous product to draw a demand curve. That means, as there is a very large variety of digital cameras, you must first make a decision on the quality requirements that your camera must fulfil. You then must make a second decision on the amount that you are able and willing to spend on such a camera. This gives you one point on a diagram, but one point is not a curve. Perhaps you would consider buying two cameras, if prices declined. This gives you a second point.
Chapter 8 – Question 7
Write down the formula for the propensity to consume.
* Consumption/income.
II. Demand for What?
Chapter 8 – Question 8
Define the following terms and give an example of each:
A. Durables
B. Non-durables
C. Services
D. Substitutes
E. Complements
F. Inferior goods
G. Giffen goods
H. Necessities
I. Luxuries
* A. Durables are household appliances and consumer electronics. They are supposed to last a long time; normally one consumer possesses only one of them. Examples are washing machines and TV sets.
* B. Non-durables include foodstuffs, beverages, tobacco, detergents, and, surprisingly, clothing. They are single-use goods.
* C. Services are services. They use manufactures but do not produce them. Examples are transport, banking, movies.
* D. Substitutes are clearly distinct products like tea and coffee that satisfy similar desires.
* E. Complements such as cars and petrol are necessarily bought together.
* F. Inferior goods are goods that have superior substitutes. Junk food can be replaced by better food, bus tickets by a car.
* G. Giffen goods are foodstuffs like rice, potatoes or bread when they form the major staple of poor people's diets.
* H. Necessities. The best definition of necessities was provided by Adam Smith: "By necessaries I understand not only the kind of commodities which are indispensably necessary for the support of life, but whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without."
* I. Luxuries. The purchase of luxuries can best be defined as conspicuous consumption They are bought to convey a message; you would not take them to a lonely island.
Chapter 8 – Question 9
What are normal goods?
* Goods that fulfil two conditions: (1) They obey the law of demand. (2) Demand for them rises as incomes rise.
Chapter 8 – Question 10
Explain what happens to demand for an inferior good when incomes rise.
* Demand declines; the demand curve shifts to the left. Remember that changes in exogenous variables always lead to shifts of the curves. The reason for the shift to the left is obvious: Higher incomes enable people to substitute better goods for inferior goods.
III. Consumer Behaviour
Chapter 8 – Question 11
Please name some goods whose demand is affected by conspicuous consumption.
* Clothing, consumer electronics, housing, cars, leisure activities.
Chapter 8 – Question 12
Name some goods whose demand is not affected by conspicuous consumption.
* Well, conspicuous means highly visible and noticeable. Purchases of goods whose consumption is invisible or can be hidden do therefore not fall into the category conspicuous consumption. Examples are insurance, everything in the homes of people who never invite guests, meals without guests. The firms supplying such goods are faced with very stiff competition as consumer decisions are primarily determined by price.
Chapter 8 – Question 13
Please distinguish the direct and indirect influences that consumer purchases have on each other.
* The direct influence stands for a tendency to buy things that other people have bought or would like to buy. The indirect influence is the change in prices that other people's purchases have on the price of commodities that you would like to buy.
IV. Why the Demand Curve Slopes Downwards from Left to Right
Chapter 8 – Question 14
What is the income effect?
* The income effect occurs when your purchasing power changes because the price of a commodity that you regularly buy has changed.
Chapter 8 – Question 15
And the substitution effect?
* The substitution effect occurs when you substitute a cheaper commodity for a more expensive commodity that you used to buy.
Chapter 8 – Question 16
Why is diminishing marginal utility the best explanation for the slope of the demand curve?
* Consumers want marginal utility and price to be equal. Since marginal utility diminishes with every additional unit, prices must be lowered if sellers want consumers to buy additional units.
Chapter 8 – Question 17
Write down the equation to express the equimarginal principle.
* Marginal utility of commodity X/Price of commodity X = Marginal utility of commodity Y/Price of commodity Y.
Chapter 8 – Question 18
What does a rational consumer do when the price of one of the commodities in his bundle has been raised?
* He increases purchases of the now cheaper commodity and lowers purchases of the now more expensive commodity until the equimarginal principle holds again.
Chapter 8 – Question 19
Commodity A and B cost $3each. The marginal utility you get from the last A is 5; the marginal utility you get from the last B is 3. What do you do to optimise your bundle?
* The equimarginal principle states that MU/P must be proportional for both goods. This is not the case in our example. MU/P of A (5/3) is greater than MU/P (3/3) of B. You should therefore buy more of A.
Chapter 8 – Question 20
Explain how the consumers of inferior goods and Giffen goods respond to changes in price and income.
* The behaviour of inferior and Giffen goods is diametrically opposed to that of normal goods. When prices rise, consumers buy more of them. When prices fall, they buy less of them. When incomes rise, consumers buy less of them. When incomes decline, they buy more of them.
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