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

Ans 1 : The substitution effect is always negative thatnis when price of clothing decreases, it becomes relatively cheaper and Helen would substitute clothing in place of food, in this way negative substitution effect cause her to buy more of clothing.

Ans 2. It depends

Thed in price of clothing will increase the real income of Helen, so if clothing is a normal good then it will have positive income effect and income effect will cause her to buy more of clothing. But if clothing is an interior good to her then negative income effect will cause her to buy less of clothing.

Ans. 3 A decrease in price of clothing will cause her to buy less of clothing only in the case when clothing is a giffin good for Helen, that is the case when negative income effect cause her to buy less of clothing and it dominantes the substitution effect.