Income and Substitution Effects and Consumer Welfare: every key term you need (+ practice quiz)
25 flashcard terms for Intermediate Microeconomics Topic 3, written to match the course framework. Study them here, then drill them as interactive flashcards, or test yourself with the 15-question quiz — free, no account needed.
The change in quantity demanded caused purely by the change in relative prices, holding purchasing power constant. It is always weakly negative for an own-price rise because the compensated choice moves away from what became relatively dearer.
Income effect of a price change
The change in demand caused by the shift in real purchasing power when a price moves. Its sign depends on whether the good is normal or inferior, which is why the total price effect can go either way.
Slutsky decomposition
The split of a total price effect into a substitution piece plus an income piece, where purchasing power is held constant by keeping the original bundle just affordable at the new prices.
Hicksian compensation
An alternative way to hold purchasing power constant by keeping the consumer on the original indifference curve rather than able to buy the original bundle. It gives the utility-constant version of the substitution effect.
Compensated demand function
Quantity demanded as a function of prices and a fixed utility level, obtained by minimising expenditure. It isolates substitution behaviour because income is adjusted to neutralise real income changes.
Expenditure function
The minimum spending needed to reach a target utility level at given prices. It is increasing and concave in prices, and its derivative with respect to a price returns compensated demand.
Shephard identity for consumers
The result that differentiating the expenditure function with respect to a price yields the compensated quantity of that good. It converts a cost concept directly into a demand concept.
Law of compensated demand
Compensated demand curves never slope upward, because the substitution effect of an own-price rise is always weakly negative. This is the one demand law that holds without exception.
Normal good
A good whose demand rises with income at constant prices. For normal goods income and substitution effects reinforce each other, so the ordinary demand curve must slope downward.
Inferior good
A good whose demand falls as income rises, typically a cheaper alternative displaced by better options. Its income effect opposes the substitution effect after a price change.
Giffen good
An inferior good so dominant in the budget that the perverse income effect outweighs substitution, producing an upward-sloping ordinary demand curve. It requires both strong inferiority and a large budget share.
Ordinary versus compensated slope
The compensated curve is always steeper in the sense of being less elastic than the ordinary curve for a normal good, because it strips out the reinforcing income response.
Endowment income effect
When a consumer owns a bundle rather than money, a price rise raises the value of what she holds. This extra income channel can make a net seller better off when her own good becomes dearer.
Gross demand
The total quantity of a good a consumer ends up holding, as opposed to the amount traded. In endowment models it is what appears in the budget constraint valued at market prices.
Net demand
The difference between gross demand and the endowment, positive for a buyer and negative for a seller. Comparative statics differ sharply for net buyers and net sellers of the same good.
Labour supply as endowment choice
Treating leisure as a good with the wage as its price and a time endowment as the resource. Working is then simply selling leisure, which is why the wage appears on both sides of the constraint.
Backward-bending labour supply
The case where a wage rise beyond some point reduces hours worked because the income effect on leisure overwhelms the substitution effect that pulls toward more work.
Consumer surplus
The area between the demand curve and the price line, approximating the money value of the gains from trade a buyer enjoys. It is exact only when income effects on the good are negligible.
Compensating variation
The income adjustment that would restore the consumer to her original utility after a price change, measured at the new prices. It answers what payment exactly offsets the harm of a price rise.
Equivalent variation
The income change at original prices that would leave the consumer as well off as the actual price change does. It asks what sum she would accept instead of enduring the price movement.
Ranking of surplus measures
For a normal good and a price rise, equivalent variation exceeds consumer surplus loss which exceeds compensating variation. All three coincide when the good is quasilinear with no income effect.
Deadweight loss from a tax
The surplus destroyed beyond the revenue collected, arising because the tax distorts the relative price and pushes trades that were mutually beneficial out of existence.
Cost of living index reasoning
Comparing the expenditure needed to reach the same standard of living across price regimes. A fixed-basket index overstates inflation because it ignores substitution toward goods that became relatively cheaper.
Revealed preference
Inferring the ranking from observed choices: if an affordable alternative was passed over, the chosen bundle is at least as good. It builds demand theory from data without assuming a utility function.
Weak axiom of revealed preference
If one bundle is chosen when another is affordable, then the second must never be chosen when the first is affordable. Violations are direct evidence of inconsistent choice behaviour.