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

(1) The substitution effect of a price fall is always positive because the shape of the indifference curve is convex to the origin. So, when the price of cloths decreases, Helen will buy it more as it is cheaper than substitutes.  Hence, the substitution effect of a fall in price always results in an increase in the quantity demanded.

(2) The income effect is basically how the consumption of the goods changes based on income. So, consumers will spend more money if there is an increase in income. So, a decrease in price is equivalent to an increase in the income of the consumer. So, Helen will buy more clothes in case the price decreases.

(3) If there is a decrease in price, and Helen still buys fewer clothes, it can be because the clothes are an inferior good. In the case of inferior goods, even if the price decreases, the demand is less. This is because the quality of the goods is not good and hence people do not prefer to buy it.

There is another scenario. If the price decreases, but Helen has an expectation that the price would fall further due to any sale that is supposed to happen, she might not buy at that time and think of buying it later. Hence, in this case also, a decrease in price will result in Helen buying less clothes,