National University of Ireland- Galway
First Semester 2007-08
EC 209: Managerial Economics
Dr. Jacqueline Khorassani
November 23, 2007
Questions & Answers
Question 1
I am a managerial economics student (EC209). I am experiencing some
confusion regarding indifference curves and the substitution effect. In
the 2005 paper, Q.4(e) asks of which good is the most amount consumed and
the answer is that he consumes more pizza because the price of coffee has
risen so much he will substitute it with more pizza.
However in the 2006 paper Q.2 (v) the price of both goods rises by the same
amount. Does this mean the consumer will consume the same amounts of each
as before since the relative price increase is the same? Or does it mean
that he will consume more of the less expensive good as a substitution
effect?
Answer:
When price of good X goes up, it has two effects. (1) Substitution effect has to do with a
change in relative prices and (2) income effect has to do with an overall drop in
purchasing power due to the increase in price of X. If X is a normal good (like coffee),
you would buy less X for two reasons: The substitution effect and the income effect.
How about good Y? Well the substitution effect will make you buy more Y (because it is
relatively cheaper) and the income effect will make you buy less Y (because you have
less purchasing power due to increase in price of X). So the result could be anything. It
will depend on how much price of X went up and how strong is the substitution effect
relative to income effect.
When the price of both goods rises in such a way that the ratio of prices remains constant,
then there is no substitution effect. There is only income effect which will make you buy
less of both goods.
Question 2
I'm really sorry to bother you, but I'm only just after realizing I bought the version of
your book (required for EC209) without the additional chapter on CD. Anyway, I was
just wondering if you could tell me the name of the book the chapter is from so I could
borrow it from the library to photocopy. As far as I'm aware it's a chapter 8 from Frank,
but I can't seem to obtain it from the library without knowing the full details of its title.
Answer:
Sure, it is Microeconomics and Behavior by Robert H. Frank (sixth edition) published by
McGraw-Hill.