Question

 

1.

What is a Giffen good and what is a Veblen good? What are price and income elasticity of demand of a Giffen good and a Veblen good?

2.

Explain how a firm in a perfect competition market decides the optimal quantity of production.

Answer 1

1. A Giffen good is a low income, non-luxury product that defies standard economic and consumer demand theory. Demand for Giffen goods rises when the price rises and falls when the price falls. In econometrics, this results in an upward-sloping demand curve, contrary to the fundamental laws of demand which create a downward sloping demand curve.

Examples of Giffen goods can include bread, rice, and wheat. These goods are commonly essentials with few near-dimensional substitutes at the same price levels.

A Veblen good is a good for which demand increases as the price increases, because of its exclusive nature and appeal as a status symbol. A Veblen good has an upward-sloping demand curve, which runs counter to the typical downward-sloping curve. However, a Veblen good is generally a high-quality, coveted product, in contrast to a Giffen good, which is an inferior product that does not have easily available substitutes.

• A Giffen good is a good satisfying the following equivalent conditions: Its price-elasticity of demand is positive even though the value people place on it does not change with changes in price. It is an inferior good for which the demand increases with increase in its price, because buyers shift more of their consumption to it from superior, costly substitutes in order to compensate for the extra cost. As a giffen good is an inferior good, the income effect will be larger than the negative value from the substitution effect. A giffen good faces an upward sloping demand curve because the income effect dominates the substitution effect, meaning that quantity demanded increases as price rises. In other words, there is an inverse relationship between real income and the demand for the good in question. If real incomes rise, the demand for an inferior good will fall. If real incomes fall (in a recession, for instance), the demand for an inferior good will rise.
• A Veblen good is a good satisfying the following in a certain price range and for certain buyers: The price-elasticity of demand for the good is positive, because an increase in price leads to an increase in the desirability of possessing the good.. A Veblen good is a superior goods with a prestige value so high that a price decline would lower demand. The income elasticity of a superior good is above one by definition, because it raises the expenditure share as income rises.

2. As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases at a constant rate determined by the given market price. Profits will be highest or losses will be smallest for a perfectly competitive firm at the quantity of output where total revenues exceed total costs by the greatest amount, or where total revenues fall short of total costs by the smallest amount.

A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand why this is so, consider a different way of writing out the basic definition of profit:

Profit Total revenue − Total cost

= (Price)(Quantityproduced) − (Averagecost)(Quantityproduced)

Since a perfectly competitive firm must accept the price for its output as determined by the product’s market demand and supply, it cannot choose the price it charges. This is already determined in the profit equation, and so the perfectly competitive firm can sell any number of units at exactly the same price. It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm’s total revenue, total costs, and ultimately, level of profits.

A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. If you increase the number of units sold at a given price, then total revenue will increase. If the price of the product increases for every unit sold, then total revenue also increases. As an example of how a perfectly competitive firm decides what quantity to produce.

A higher price would mean that total revenue would be higher for every quantity sold. A lower price would mean that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses. But a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest.