CSS Economics Economics Paper I: Microeconomics and Macroeconomics Syllabus

What is the second-order (stability) condition for consumer equilibrium in indifference analysis?

At the equilibrium point the indifference curve must be convex to the origin (diminishing MRS); the budget line must be tangent to, not cut, the indifference curve.

Define the Income Effect of a price change.

The change in the quantity demanded of a good resulting solely from the change in the consumer's real income (purchasing power) caused by the price change, holding relative prices constant.

Define the Substitution Effect of a price change.

The change in quantity demanded that results purely from the change in relative prices, with real income held constant, causing the consumer to substitute toward the now-cheaper good.

How does the Price Effect relate to the income and substitution effects?

The total price effect is the sum of the substitution effect and the income effect: $$\text{Price Effect} = \text{Substitution Effect} + \text{Income Effect}$$

What is the difference between the Hicksian and Slutsky methods of decomposing the price effect?

The Hicksian method holds real income constant by keeping the consumer on the original indifference curve. The Slutsky method holds real income constant by restoring just enough income to buy the original bundle (compensating variation in purchasing power).

For a normal good, what are the directions of the substitution and income effects when price falls?

Both effects work in the same direction: the substitution effect raises quantity demanded, and the income effect also raises it, so demand definitely increases.

Why does the demand curve for a Giffen good slope upward?

A Giffen good is a strongly inferior good where the negative income effect outweighs the positive substitution effect, so a fall in price reduces quantity demanded, giving a positively sloped demand curve.

State the Law of Demand.

Other things being equal, the quantity demanded of a good rises when its price falls and falls when its price rises, giving an inverse relationship between price and quantity demanded.

Why does the demand curve slope downward? Give the main reasons.

(1) Law of diminishing marginal utility; (2) substitution effect; (3) income effect; (4) arrival of new buyers and multiple uses of the commodity at lower prices.

Distinguish between a change in quantity demanded and a change in demand.

A change in quantity demanded is a movement along the same demand curve caused by a change in the good's own price. A change in demand is a shift of the whole curve caused by a change in a non-price determinant.

List the main determinants of demand (non-price factors).

Consumer income, prices of related goods (substitutes and complements), tastes and preferences, consumer expectations, population/number of buyers, and distribution of income.

Distinguish between substitute goods and complementary goods.

Substitutes can replace one another (tea and coffee); a rise in the price of one raises demand for the other. Complements are consumed together (car and petrol); a rise in the price of one lowers demand for the other.

What are the exceptions to the Law of Demand?

(1) Giffen goods; (2) Veblen/prestige goods (conspicuous consumption); (3) expectations of future price changes; (4) goods of ostentation; and situations of ignorance about quality.

Define Consumer Surplus.

The difference between the maximum price a consumer is willing to pay for a good and the price actually paid: $$\text{Consumer Surplus} = \text{Willingness to Pay} - \text{Actual Price Paid}$$

How is consumer surplus shown on a demand diagram?

It is the area below the demand curve and above the market price line, up to the quantity purchased.

On whose concept is consumer surplus based and on which utility assumption does it rest?

It was developed by Alfred Marshall and rests on the cardinal measurement of utility and the law of diminishing marginal utility.

What is the Revealed Preference Theory and who proposed it?

Proposed by Paul Samuelson, it derives demand from observed consumer behaviour: if a consumer buys bundle A when bundle B was also affordable, A is 'revealed preferred' to B—without needing to measure utility.

State the Weak Axiom of Revealed Preference (WARP).

If bundle A is revealed preferred to bundle B, then B can never be revealed preferred to A; i.e., the consumer chooses consistently and does not contradict an earlier choice.

What advantage does Revealed Preference theory have over indifference curve analysis?

It is based on observable market behaviour rather than introspective psychological assumptions, avoids the need to measure or even rank utility directly, and can derive the downward-sloping demand curve from the strong axiom.

What is Market Demand?

The total quantity of a good that all consumers in a market are willing and able to buy at each price; it is obtained by horizontally summing the individual demand curves.

State the Law of Supply.

Other things being equal, the quantity supplied of a good rises as its price rises and falls as its price falls, giving a direct (positive) relationship between price and quantity supplied.

What is Market Equilibrium?

The state where the quantity demanded equals the quantity supplied at the prevailing price ($Q_d = Q_s$), so there is no tendency for price or quantity to change; this defines the equilibrium price and quantity.

What happens in the market when price is above the equilibrium price?

There is excess supply (a surplus): quantity supplied exceeds quantity demanded, which puts downward pressure on price until equilibrium is restored.

What happens in the market when price is below the equilibrium price?

There is excess demand (a shortage): quantity demanded exceeds quantity supplied, which puts upward pressure on price until equilibrium is restored.

Distinguish between static and comparative static analysis.

Static analysis studies a single equilibrium at a point in time without reference to the path of change. Comparative static analysis compares two equilibrium positions (before and after a change in data) without analyzing the transition process.

In comparative statics, how does an increase in demand (supply constant) affect equilibrium?

A rightward shift of the demand curve raises both the equilibrium price and the equilibrium quantity.

In comparative statics, how does an increase in supply (demand constant) affect equilibrium?

A rightward shift of the supply curve lowers the equilibrium price and raises the equilibrium quantity.

Define Price Elasticity of Demand.

The degree of responsiveness of quantity demanded to a change in the good's own price: $$E_p = \frac{\% \Delta Q_d}{\% \Delta P} = \frac{\Delta Q}{\Delta P} \times \frac{P}{Q}$$

Name and define the five categories of price elasticity of demand.

Perfectly elastic ($E_p = \infty$); elastic ($E_p > 1$); unitary elastic ($E_p = 1$); inelastic ($E_p < 1$); perfectly inelastic ($E_p = 0$).

What is the relationship between price elasticity of demand and total revenue?

If demand is elastic ($E_p>1$), a price cut raises total revenue. If inelastic ($E_p<1$), a price cut lowers total revenue. If unitary ($E_p=1$), total revenue is unchanged.

State the formula for the arc (midpoint) method of price elasticity of demand.

$$E_p = \frac{\Delta Q}{\Delta P} \times \frac{P_1 + P_2}{Q_1 + Q_2}$$ It uses the averages of the two prices and quantities to give a single elasticity over a range.

Define Income Elasticity of Demand and state how its sign classifies goods.

$$E_y = \frac{\% \Delta Q_d}{\% \Delta Y}$$ If $E_y > 0$ the good is normal; if $E_y < 0$ it is inferior; if $E_y > 1$ it is a luxury and if $0 < E_y < 1$ it is a necessity.

Define Cross Elasticity of Demand and explain its sign.

$$E_{xy} = \frac{\% \Delta Q_x}{\% \Delta P_y}$$ A positive value indicates substitutes; a negative value indicates complements; zero indicates unrelated goods.

What are the main determinants of price elasticity of demand?

Availability of substitutes, proportion of income spent on the good, whether it is a necessity or luxury, number of uses, the time period considered, and habit formation.

Define Elasticity of Supply.

The responsiveness of quantity supplied to a change in price: $$E_s = \frac{\% \Delta Q_s}{\% \Delta P}$$ It is normally positive because supply rises with price.

What is the geometric (point) method for measuring elasticity on a linear demand curve?

At any point, elasticity equals the lower segment of the demand line divided by the upper segment: $$E_p = \frac{\text{lower segment}}{\text{upper segment}}$$ Elasticity is 1 at the midpoint, >1 above it, and <1 below it.

Why is supply more elastic in the long run than in the short run?

In the long run firms can fully adjust all inputs, vary plant size, and enter or exit the industry, so quantity supplied responds more fully to price changes than in the short run when some factors are fixed.

Distinguish between Partial Equilibrium and General Equilibrium analysis.

Partial equilibrium (Marshall) studies one market in isolation assuming all other markets are unchanged ('ceteris paribus'). General equilibrium (Walras) studies all markets simultaneously, recognizing their interdependence and solving for prices and quantities that clear every market at once.

Who is associated with General Equilibrium theory and what does the Walrasian system require?

Leon Walras is associated with general equilibrium. The Walrasian system requires that all markets—goods and factors—clear simultaneously so that demand equals supply everywhere at a consistent set of equilibrium prices.