Question

Helen spends all her money on food and clothing. When the price of clothing decreases, she ends up buying more clothing. (Note: In the following questions, be clear about the direction of the effect as increasing, decreasing, or ambiguous. And explain completely and explain the possible scenarios)

1. Does the substitution effect cause her to buy more or less clothing? Explain.

2. Does the income effect cause her to buy more or less clothing? Explain.

3. Under what circumstances will a price decrease result in Helen buying (on net) less clothing? Explain.

Answer 1

Answer to the question no. a:

A fall in the price of clothing will cause Helen to buy more clothing. The substitution effect is always negative showing that a fall in the price of a good causes the demand for the product to increase. So, a fall in the price of clothing (irrespective of the fact that the good is normal, giiffen or the inferior) the demand for the product will increase due to the substitution effect.

Answer to the question no. b:

A fall in the price of the good raises the real income of Halen. If the clothing is a kind of normal good (if income increases the demand also increases) then the demand for the clothing (or the purchase of cloths) will increase due to a rise in the real income of Halen. So, without knowing if the clothing is normal or inferior good, we cannot say if the income effect will cause the consumption of cloth or not. The rise in the demand for cloth due to fall in the price may be because of the substitution effect, and the cloth may be an inferior good. So, the answer is ambiguous.

Answer to the question no. c:

The fall in the price of clothing will cause Halen to buy less clothing if and only if the clothing is a giffen good. A giffen good is one demand of which declines with the decrease in the price of the good. The giffen good does not follow the law of demand. Also in case of giffen good the negative income effect (causes the demand to fall with the increase in the real income) is greater than the negative sustitution effect (causes the demand to rise with the fall in the price) and thus net effect is such that the price fall causes the demand to fall.

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