IF1105 Microeconomics
Tutorial Topic 3 Consumer Demand
Tutorial Essay Question
Define normal, inferior, and Giffen goods. Using diagrams, explain how indifference
curve analysis can be used to distinguish the effects of price changes on normal,
inferior, and Giffen goods. Assess the importance of differentiating between these
types of goods for businesses and government policy.
[I recommend you practice writing your response in an essay style, as this will help
prepare you for the exam and also improve your ability to explain your reasoning
verbally.
The aim is to teach you how to approach these types of questions using economics.
Use full sentences to show your understanding and to develop well-structured
arguments — this is also a valuable transferable skill for future employment.
In the tutorial, the tutor will guide you through the answer verbally.
Guided solutions (rather than full model answers) will be available on Moodle.]
[note: The exam version would be simpler:
“Define normal, inferior, and Giffen goods. With the aid of diagrams, explain the
difference in how their demand responds to changes in price. Use examples to support
your answer.”]
Guide to answering question
Introduction
Briefly introduce consumer choice: indifference curves (preferences) + budget line
(income and prices).
State that goods can be classified as normal, inferior, or Giffen, depending on how
demand responds to income and price changes.
Definitions
Normal good: Demand increases as income rises (positive income effect).
Inferior good: Demand decreases as income rises (negative income effect).
Giffen good: Rare type of inferior good where a price rise increases demand because
the negative income effect outweighs the substitution effect.
Analysis with Diagrams
1. Price changes for normal goods
Diagram: Budget line pivots inward after a price rise.
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Substitution effect: consumer moves along IC → less of the good (price rise makes it
relatively more expensive).
Income effect (for normal goods): reduces consumption further.
Total effect = fall in demand (Law of Demand holds).
Example: restaurant meals, branded clothing.
2. Price changes for inferior goods
Diagram: Same budget line pivot as price rises.
Substitution effect: demand falls.
Income effect: negative → pushes consumption up.
But substitution effect dominates → overall demand still falls (Law of Demand still
holds).
Example: bus travel, instant noodles.
3. Price changes for Giffen goods
Diagram: Budget line pivot again.
Substitution effect: demand falls.
Income effect: strongly negative (good takes a large share of budget).
Income effect dominates → overall demand rises after a price increase (violates Law
of Demand).
Example: rice in rural China (Jensen & Miller, 2008), maize in Africa.
Students should clearly label substitution and income effects on diagrams to
distinguish the three cases.
Evaluation: Why differentiation matters
Policy
Governments need to predict how poor households respond to income support,
subsidies, or food price changes.
Example: maize subsidies in Africa prevent nutrition collapse; transport subsidies help
poorer households.
Business strategy
Firms must know whether their product is aspirational (normal) or budget fallback
(inferior).
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Helps anticipate demand shifts as consumer incomes rise (e.g. students upgrading
from budget supermarkets to higher-end brands).
Economic development & forecasting
In developing economies, staple foods may show Giffen-like behaviour.
As incomes grow, spending patterns shift (Engel’s law: falling share of income on
food).
Useful for long-term forecasting of market opportunities.
Critical perspective
True Giffen goods are rare.
Consumer behaviour is influenced by advertising, habits, and social norms beyond
income/price effects.
Indifference curve analysis is elegant but stylised.
Conclusion
Normal, inferior, and Giffen goods differ in how they respond to income and price
changes.
Indifference curve analysis provides a rigorous way of separating substitution and
income effects.
For businesses and policymakers, recognising these distinctions is vital for pricing,
welfare policy, and anticipating demand shifts — though in reality, Giffen goods are
exceptional, and consumer behaviour is more complex.
Income and su stitution effects: normal good
Income effect of
the price rise
Effect on
Substitution effect
consumption
of the price rise
g of Good
Units of good
2
h
I2
2 a
2
Income Substitution Units of Good
effect effect
3
Income and su stitution effects: Giffen good
Effect on
g consumption
2 of Good
Units of good
I
h
a
2 I2
2
Substitution effect Units of Good
Income effect
4
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Questions
*Q . Outline different types of asymmetric information and explain the difference
between adverse selection and moral hazard.
Guided answer:
Types of asymmetric information
Hidden characteristics: one party knows more about product quality before a
transaction (e.g. sellers know the true quality of goods; buyers don’t).
Hidden action (moral hazard): after a contract is signed, one party can take actions
unobservable to the other (e.g. insured drivers taking more risks).
Hidden intention: one party conceals their motives (e.g. fraud/scams online). – not
covered in the lecture
Adverse selection vs moral hazard
Adverse selection: arises before the transaction when hidden characteristics lead low-
quality goods driving out high-quality goods (Akerlof’s “lemons” problem).
Moral hazard: arises after the transaction when hidden actions change behaviour (e.g.
firms posting fake reviews after customers have purchased).
*Q2. Will consumers always face greater uncertainty over quality when purchasing
goods on line rather than visiting the high street? Discuss your answer making
reference to some specific examples.
Guided answer:
Arguments why uncertainty is greater online
No physical inspection: buyers can’t touch/see goods before purchase (e.g. clothing,
electronics).
Delivery/returns risk: longer waits, hassle in refunds (e.g. eBay sellers vs high-street
shop).
Fraud risk: scams/fake sellers more common online.
Arguments why uncertainty is not always greater
Reviews & ratings: online platforms provide collective information (Amazon star
ratings).
Wider information access: online consumers can compare multiple sellers instantly
(e.g. Trustpilot, ouTube reviews).
Some goods low inspection value: for standardised goods (USB sticks, books), online
quality is clear.
High street uncertainty: not all stores allow product testing (e.g. cosmetics hygiene
seals, pre-packed food).
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Conclusion: Uncertainty can be higher online, but not universally — depends on
product type (experience vs search goods) and platform safeguards.
*Q . Using demand and supply diagrams, explain how a market for high-quality
versions of a good might suffer a price collapse if there is asymmetric information.
Using price elasticity of supply, explain the circumstances when the market is more
likely to experience a price collapse.
[Hint: how does asymmetric information affect the position of the demand curve]
Guided answer:
Market collapse means high-quality sellers leave the market entirely.
This happens if the equilibrium price falls below their reservation price (the minimum
needed to cover costs of producing quality).
The key variable is price, not output.
Diagram:
Draw a normal demand curve for high-quality goods and a supply curve for high-quality
goods.
Then show how asymmetric information shifts the demand curve downwards (to an
“average willingness to pay” curve).
At this new lower demand, the equilibrium price is below the reservation
price/minimum price of high-quality sellers → they exit the market → collapse.
Market may “unravels” to only low-quality goods (market failure).
e
e
e2
e2
D2
O e2 e
The blue demand curve shows demand for a high-quality good when buyers know its
quality.
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The green supply curve shows high-quality producers’ costs.
Equilibrium E : high-quality traded at a higher price.
With asymmetric information, buyers only pay based on average expected quality →
demand shifts down to the red dashed curve.
New equilibrium E2: lower price.
If this price falls below the reservation price of high-quality producers, they exit →
potential market collapse.
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Role of price elasticity of supply
Diagram
inelastic
elastic
e
e
e2
e2
e
e
D2
O e2 e e
If supply of high-quality goods is inelastic (costly to produce), high-quality sellers need
high prices. Market collapse more likely. [students have not covered production costs
yet]
If supply elastic (easier to adjust costs), sellers may stay even at lower average prices.
Market collapse less likely.
With elastic supply, the fall in demand causes a smaller drop in price → high-quality
producers may still stay in the market.
With inelastic supply, the same fall in demand causes a much bigger drop in price →
price may fall below the minimum acceptable price → market collapse more likely.
It highlights that market unraveling depends not just on demand, but also on supply
elasticity.
Q4. Discuss some of the benefits and costs for a firm of purchasing and posting fake
reviews.
Guided answer:
Benefits of fake reviews (from firm’s perspective)
Boosts sales and revenue by creating artificial trust.
Low cost compared with genuine quality improvements.
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Can damage rivals if -star reviews posted on competitors.
Costs of fake reviews
Reputation risk if exposed (loss of consumer trust).
Legal/regulatory risk: Competition and Markets Authority banning fake reviews.
Platform sanctions: Amazon/eBay may suspend accounts.
Market-wide cost: if fake reviews become widespread, overall value of reviews falls →
destroys long-term trust.
Evaluation: Short-term gain vs long-term damage. Rational firms may be tempted, but
repeated interactions and regulation should deter behaviour.
Second Participation Question (only covered if time permits)
Is it reasonable to assume that people seek to equate the marginal utility/price ratios
of the goods that they purchase, if (a) they have never heard of ‘utility’, let alone
‘marginal utility’; (b) marginal utility cannot be measured in any absolute way?
Guided answer
es.
Even though people may have never heard of marginal utility, when they seek to get
‘value for money’ from their purchases they are, in effect, weighing up the benefit they
expect to get from each item against the price they are having to pay.
Even though marginal utility cannot be measured in an absolute way, people still have
a pretty good idea of whether an item is worth to them the price they are having to pay.
They do not have to estimate how much utility they expect to get from that item, but
merely whether it is worth spending their money on it, rather than spending it on
something else.
For example, if a can of drink costs 0p, you will buy it if it is worth at least 0p to you
at that point in time. ou do not have to estimate whether it is worth 6p, or 47p, or
whatever.
In economic theory it is assumed that people act ‘as if’ they were equating marginal
utility/price ratios. It does not claim to describe the way that people actually make
decision which will be far more informal.
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Online Tutorial Questions
Q . The following table shows the total utility that Eleanor derives from visits to the
cinema per week.
Visits 2 4 5 6 7 8
TU (£) 24 40 50 56 60 62 62 58
MU(£)
(a) Fill in the figures for marginal utility.
Visits 2 4 5 6 7 8
TU (£) 24 40 50 56 60 62 62 58
MU(£) 24 16 10 6 4 2 0 –4
(b) How many visits to the cinema will she make per week if the price of a ticket is:
(i) £8.00
(ii) £5.00
Answer
Using the equi-marginal principle (consume up to the point where MU ≥ P, but stop
once MU < P). So, buy cinema visits until MU < ticket price (P).
Case (i) Price = £8
st visit: MU = 24 ≥ 8 → buy
2nd visit: MU = 6 ≥ 8 → buy
rd visit: MU = 0 ≥ 8 → buy
4th visit: MU = 6 < 8 → stop
Optimal visits = per week.
Case (ii) Price = £5
Compare MU with £5:
st visit: MU = 24 ≥ 5 → buy
2nd visit: MU = 6 ≥ 5 → buy
rd visit: MU = 0 ≥ 5 → buy
4th visit: MU = 6 ≥ 5 → buy
5th visit: MU = 4 < 5 → stop
Optimal visits = 4 per week.
Q2. The following diagram shows the marginal utility (MU) that a consumer gets from
consuming different quantities of a product. Assume that the current market price of
the product is P.
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Marginal utility,
Price (£)
(1)
(2)
(3)
MU
Q Quantity purchased
(a) Why is the optimum consumption point at Q?
Answer
Because MU = P (consumer surplus is maximised)
(b) What area(s) represent(s) total utility at Q?
Answer
1+ 2 (area under MU curve at Q)
(c) What area(s) represent(s) the consumer’s total expenditure at Q?
Answer
2 (= P Q)
(d) What area(s) represent(s) the consumer’s total consumer surplus at Q?
Answer
1 (= total utility – total expenditure)
Q . Imagine that you had £ 0 per month to allocate between two goods, A and B.
Imagine that good A cost £2 per unit and good B cost £ per unit. Imagine also that
the utilities of the two goods are those set out in the table. (Note that the two goods
are not substitutes for each other, so that the consumption of one does not affect the
utility gained from the other.)
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The utility gained by a person from various quantities of two goods: A and B
Good A Good
Units MU TU Units MU TU
per per
(utils) (utils) (utils) (utils)
month month
0 – 0.0 0 – 0.0
1 11.0 11.0 1 8.0 8.0
2 8.0 19.0 2 7.0 15.0
3 6.0 25.0 3 6.5 21.5
4 4.5 29.5 4 5.0 26.5
5 3.0 32.5 5 4.5 31.0
6 4.0 35.0
7 3.5 38.5
8 3.0 41.5
9 2.6 44.1
10 2.3 46.4
(a) What would be the marginal utility ratio (MUa/MUb) for the following
combinations of the two goods: (i) 1A, 8B; (ii) 2A, 6B; (iii) 3A, 4B; (iv) 4A, 2B?
(Each combination would cost £10.)
Answer
(a) (i) 11/3; (ii) 8/4; (iii) 6/5; (iv) 9/14.
(b) Show that where the marginal utility ratio (MUA/MUB) equals the price ratio
(PA/PB) total utility is maximised.
Answer:
(b) PA/PB = 2/ . MUA/MUB = 2/ when consumption is 2A and 6B. With this
combination, total utility is maximised (54 utils).
(c) If the two goods were substitutes for each other why would it not be possible
to construct a table like the one given here?
Answer
(c) Because the consumption of one good would affect the utility of the other.
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Q4. The figure below shows the total utility that Clive, a first-year degree student,
would get from different levels of annual income. Assume at the moment that his
annual income (from an allowance from his parents and some part-time work in a
burger bar) is £4000. Spending this rationally gives him a total utility of 500 ‘utils’.
Assume that he is offered the chance to gamble the whole £4000 on the toss of a coin
at odds of 2: (if he wins, he doubles his money; if he loses, he loses the lot).
800
700
600
500
Utils
400
300
200
100
0
0 2000 4000 6000 8000
Income (£)
(a) If he takes the gamble, what will be his utility this year if he wins?
If Clive wins, his income doubles from £4,000 to £8,000.
From the utility curve, £8,000 corresponds to 700 utils.
Answer: 700 utils.
(b) If he takes the gamble, what will be his utility this year if he loses?
If he loses, his income falls to £0.
With no income, total utility = 0 utils.
Answer: 0 utils.
(c) What would be Clive’s expected income, if he were to take the gamble?
There is a 50% chance of £8,000 and a 50% chance of £0.
Expected income = (0.5 × £8,000) + (0.5 × £0) = £4,000.
Answer: £4,000 — same as his current certain income.
(£8,000+£0) ÷ 2 = £4,000
(d) What would be his average expected utility from the gamble?
Expected utility = (0.5 × 700) + (0.5 × 0) = 350 utils.
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Answer: 350 utils. (700 + 0) ÷ 2 = 350 utils
(e) Why is it likely that he will not take the gamble, and thus be risk averse?
The certainty of £4,000 gives him 500 utils (from the utility curve).
The gamble has the same expected income (£4,000) but a lower expected utility
(350 utils).
This difference arises from diminishing marginal utility of income:
Extra income at higher levels (going from £4,000 → £8,000) adds less utility than the
loss of income going from £4,000 → £0 takes away.
Therefore, a risk-averse Clive will prefer the certain 500 utils over the risky 350 utils,
even though expected money income is the same.
Answer: He will not take the gamble because expected utility is lower than certain
utility, illustrating risk aversion.
Q5. Match each of the following changes in an indifference diagram to the causes (a)
- (h) of those changes.
(In each case assume ceteris paribus and that units of are measured on the vertical
axis and units of on the horizontal axis.)
(i) The budget line becomes steeper.
(ii) A parallel shift inwards of the budget line.
(iii) A movement along the budget line to a higher indifference curve.
(iv) The indifference curves become steeper.
(v) A movement along the budget line from an old tangency point to a new one.
(a) A change in the optimum level of consumption resulting from a change in tastes.
(b) A shift in tastes towards and away from .
(c) An increase in utility resulting from a change in consumption.
(d) A decrease in the relative price of .
(e) A fall in income.
Answer
(i) → (d)
(ii) → (e)
(iii) → (c)
(iv) → (b)
(v) → (a)
Explanation:
(i) The budget line becomes steeper.
Steeper means price of has risen relative to , or equivalently, price of has fallen
relative to .
Correct match: (d) A decrease in the relative price of .
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(ii) A parallel shift inward of the budget line.
Parallel shift = relative prices unchanged but purchasing power lower.
Correct match: (e) A fall in income.
(iii) A movement along the budget line to a higher indifference curve.
Same budget constraint, but consumer chooses a different point where utility is higher.
Correct match: (c) An increase in utility resulting from a change in consumption.
(iv) The indifference curves become steeper.
Steeper = marginal rate of substitution rises = stronger preference for relative to .
Correct match: (b) A shift in tastes towards and away from .
(v) A movement along the budget line from an old tangency point to a new one.
Budget line hasn’t moved — change must come from preferences/tastes.
Correct match: (a) A change in the optimum level of consumption resulting from a
change in tastes.
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Q6. Mary is an 8-year-old student, who recently bought a used car. Mary is looking
to buy car insurance. Insurance companies compete for her business.
(a) Is there a moral hazard problem in a transaction between Mary and an insurance
company? Explain why or why not.
Answer
There is a moral hazard problem. Once Mary has purchased insurance, she might
change her behaviour by driving less carefully than before.
(b) Is there an adverse selection problem in a transaction between Mary and an
insurance company? Explain why or why not.
Answer
There is an adverse selection problem. Mary has private information about how safe
or how risky a driver she is. The insurance company will attempt screen Mary to
determine her riskiness. In part, the company gets around the adverse selection
problem by charging higher premiums to younger, and hence generally riskier, drivers.
Q7. Ahmed knows that his car is a lemon (faulty car) and offers it for sale. If the used-
car market is working efficiently, will buyers know whether his car is a lemon? Why or
why not?
Answer
If the used car market is working efficiently, then buyers will know that his car is a
lemon. Knowing the car is a lemon, the price is lower than the price of a good car and
Ahmed offers no warranty. If buyers did not know that his car was a lemon, then a
buyer might mistakenly take it for a good car, which would lead the buyer to pay more
than the car’s marginal benefit.
Q8. Some car dealers offer used cars for sale with warranties, and some offer them
without warranties. Describe the equilibrium in the market for used cars (focus on the
price). Is the market likely to be efficient?
Answer
The cars with warranties—the good cars—sell for a higher price than the cars without
warranties—the lemons. The used car market is efficient.
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