Theory of Consumer Behaviour QA Test (1) Subjective Test Question 1 ( 1.0 marks) Define the law of demand.

Question 2 ( 1.0 marks) What will happen when the prices of both goods along with a consumers income are halved? Question 3 ( 1.0 marks) What is the slope of the demand curve for Giffen goods? Question 4 ( 1.0 marks) Define market demand. Question 5 ( 1.0 marks) What do you understand by Marginal Rate of Substitution? Question 6 ( 3.0 marks) Assume that a consumers income is Rs 40 and the prices of good 1 and good 2 are Rs 8 and Rs 5 respectively. (i) (ii) How much of good 2 will be consumed if the consumer spends all her income on it? (ii) Write down the equation for the budget line. (iii) What will happen to the budget line when the income of a consumer is doubled, keeping the prices of both goods constant? (1+1+1)

(iii)

Question 7 ( 3.0 marks) Explain the difference between a normal good and an inferior good with examples. Question 8 ( 4.0 marks) What are the three factors that lead to a shift in the demand curve? Question 9 ( 4.0 marks) Consider the demand for a good. At a price of Rs 4, the demand for the good is 25 units. Suppose the price of the good increases to Rs 5. As a result, the demand for the good falls to 20 units. What is the price elasticity? Question 10 ( 6.0 marks) (i) (ii) (iii) What do you understand by elasticity of demand? (ii) State the four reasons that affect elasticity of demand for a good. (iii) Also draw figures for the following situations: (a) when the demand is perfectly inelastic and (b) when the demand is perfectly elastic. (1+4+1)

(iv)

ANSWERS Question 1 ( 1.0 marks) Define the law of demand. Solution: According to the law of demand, a consumers demand shares an inverse relationship with the price of a good and vice-versa, ceteris paribus. In other words, if the income, price of related goods and the consumers tastes and preferences remain unchanged, then the demand of the good moves in the direction opposite to the direction in which the price of that good moves.

Question 2 ( 1.0 marks) What will happen when the prices of both goods along with a consumers income are halved? Solution: When the prices of both goods along with the consumers income are halved, the horizontal intercept, the vertical intercept and the slope will not change. The new budget line will be the same as the old budget line. Question 3 ( 1.0 marks) What is the slope of the demand curve for Giffen goods? Solution: Giffen goods are those goods whose demand shares a positive relationship with their prices. Thus, the slope of the demand curve for Giffen goods is positive. Question 4 ( 1.0 marks) Define market demand. Solution: The market demand for a good at a particular price is the sum total of the demands of all the consumers in the market. If there are only two consumers in the market, then graphically, it can be represented as the horizontal summation of the two demand curves of the consumers at different prices.

Where Q* = Q1 + Q at price P Q** = Q2 + Q at price P Question 5 ( 1.0 marks) What do you understand by Marginal Rate of Substitution? Solution: The rate at which the consumer is ready to substitute good 1 for good 2 is called the Marginal Rate of Substitution. In other words, it represents how much of good 2 the consumer is ready to give up in order to gain one extra unit of good 1. It is given by:

Question 6 ( 3.0 marks) Assume that a consumers income is Rs 40 and the prices of good 1 and good 2 are Rs 8 and Rs 5 respectively. (i) (ii) How much of good 2 will be consumed if the consumer spends all her income on it? Write down the equation for the budget line.

(iii)
Solution: M = Rs 40 P1 = Rs 8 P2 = Rs 5

What will happen to the budget line when the income of a consumer is doubled, keeping the prices of both goods constant? (1+1+1)

(i) Amount of good 2 consumed is the vertical intercept of the budget line. That is,

8 units Hence, 8 units of good 2 will be consumed. (ii) Equation of the budget line: P1 x1 + P2 x2 = M Or, 8x1 + 5x2 = 40 (iii) If a consumers income is doubled, then this will lead to a parallel, rightward and outward shift of the original budget line.

Question 7 ( 3.0 marks) Explain the difference between a normal good and an inferior good with examples. Solution: The demand for a normal good shares a negative relationship with the price of the good but a positive relationship with the consumers income. On the other hand, the demand for an inferior good shares a negative relationship with the price of the good as well as with the income of the consumer. For e.g., the demand for coarse cereals decreases with the increase in the consumers income and decreases with the price- rise of coarse cereals. Question 8 ( 4.0 marks) What are the three factors that lead to a shift in the demand curve? Solution: The three factors that lead to a shift in the demand curve are as follows: (i) Price of related good (Py): The shift in the demand curve is caused by the changes in the price of related goods such as substitute and complementary goods.

(a) Substitute goods: Those goods which are consumed in place of other goods are called substitute goods, such as tea and coffee. The demand curve will shift outwards (inwards) with an increase (decrease) in the price of substitute goods. (b) Complementary goods: Those goods which are consumed together are called complementary goods, such as tea and sugar. The demand curve for a good will shift outwards (inwards) with a decrease (increase) in the price of complementary goods. (ii) Consumers income (M): The demand curve for goods (normal goods) will shift outwards (inwards) with an increase (decrease) in the consumers income. (iii) Tastes and preferences (T): If the tastes and preferences shift in favour of the goods due to change in fashion, practice or climate, the demand curve will shift outwards and vice-versa. Shifts in demand curve may lead to an increase or a decrease in the demand curve. Shifts in demand curve

Question 9 ( 4.0 marks) Consider the demand for a good. At a price of Rs 4, the demand for the good is 25 units. Suppose the price of the good increases to Rs 5. As a result, the demand for the good falls to 20 units. What is the price elasticity? Solution: Initial price of good, P1 = Rs 4 Final price of good, P2 = Rs 5 Change in price, P = P2 P1 =54 =1 Initial quantity of good, Q1 = 25 units Final quantity of good, Q2 = 20 units Change in demand, Q = Q2 Q1 = 20 25 =5

Question 10 ( 6.0 marks) (i) What do you understand by elasticity of demand? (ii) State the four reasons that affect elasticity of demand for a good. (iii) Also draw figures for the following situations:

(a) when the demand is perfectly inelastic and (b) when the demand is perfectly elastic. (1+4+1) Solution: (i) It is the measure of the degree of responsiveness of the demand for a good to the changes in its price. It is defined as the percentage change in the demand for a good divided by the percentage change in its price.

Where Q = Q2 Q1, change in demand P = P2 P1, change in price P1 = Initial price Q1 = Initial quantity (ii) The factors affecting elasticity of demand are as follows: (a) Nature of commodity: The price elasticity of demand depends on the nature of a good. (1) Necessity goods: If a good is a necessity good, such as food, which is essential for life, then this demand does not change much in response to the change in its price. Hence, such goods have an inelastic demand. (2) Luxury goods: If a good is a luxury item, such as an air conditioner, branded garments, etc., then its demand is very responsive to the change in its price. Thus, such goods have elastic demand (|ed|>1). (3) Jointly-demanded goods: The demand for goods that are demanded together (complementary goods), is inelastic. For example, a rise in the price of tea will not reduce its demand if the demand for sugar has not decreased. (b) Substitutes: The demand for a good that has more number of substitutes available will be relatively more elastic and |ed|> 1. On the contrast, if a good has no close substitutes, then it will have an inelastic demand. (c) Several uses: A commodity that can be used for different purposes, will have an elastic demand. If the price of this commodity increases, then it will be used only for important purposes. On the contrast, a good that has limited usage will have an inelastic demand. (d) Consumers income: People with very high or very low income have an inelastic demand as the change in the price of a good will have very low impact on the consumers demand for that good. On the contrary, the middle-income earners will have an elastic demand as their demand is very responsive to the prices of goods. (iii) Perfectly inelastic and perfectly elastic demand curve can be represented as: