Question

Maria 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 is the effect of a change in the relative prices of goods on consumption patterns. the substitution effect refers to the change in the quantity demanded of one commodity with respect to change in the price of its substitute commodity. Here, the substitution effect does not cause her to buy more or less clothing because clothes and food are not substitute goods ie. they cannot be used in place of each other.

2. The income effect is the effect on real income when price changes – it can be positive or negative. Income effect refers to the change in quantity demanded of a commodity due to the change in real income of the buyer. The increase in real income leads to increase in purchasing power of the buyer and decrease in real income results in decrease in purchasing power of the buyer. Here, the income effect cause her to buy more or less clothing as when the price of clothing dcreases, the real income of maria increases which leads to increase in the purchasing power of maria. This results in her buying more clothing.

3. Circumstances under which a price decrease will result in Helen buying (on net) less clothing are:

Giffin goods. These goods are goods that are inferior in comparison to luxury goods. thus, clothing can be a giffin good for helen as when the price decrease, she might buy luxury goods instead of going for these goods.

Veblen goods. There are certain goods that become more valuable as their price increases. as these goods are highly luxury goods as their prices decreases, their value also decreases and are demanded less.

There are times when the price of a product increases and market conditions are such that the product may get more expensive. In such cases, consumers may buy more of these products before the price increases any further. Consequently, when the price drops or may be expected to drop further, consumers might postpone the purchase to avail the benefits of a lower price.

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