Question

3) (1 BONUS pt.) Susan grows 100 potatoes each year and all of her income comes from selling them. She spends all of her income each year consuming potatoes and other goods. For Susan, potatoes are a Giffen good, in that if her income is fixed in some way (i.e. ignoring the fact that she sells potatoes and just fixing her income at some value) her consumption of potatoes will rise when their price rises. The price of potatoes falls and she consumes more potatoes. Taking into account the fact that her income actually comes from selling potatoes: You can hand in the assignment anytime before class at my office S705 [put in a plastic file and slip it under the door if the room is closed] (i) explain how the last statement can be consistent with those that precede it. (ii) Illustrate initial choice of Susan, the new choice and decompose the total change in potatoes consumption into the change due to SE and the change due to IE.

Answer 1

A giffen good is a kind of an inferior good. The law of demand is violated in case of giffen goods. The price rise will cause a rise in the quantity demanded and vice versa.

With a certain given price-income situation depicted by the budget line BL₁, the consumer is initially in equilibrium at e1 on indifference curve IC₁. With a fall in price of the good, the consumer shifts to point e2 on indifference curve IC₂. with the fall in price the budget line shifts from BL₁ to BL₂ the consumer reduces his consumption of potatoes from Q1 to Q2.

This is the net effect of the negative income effect which is here equal to QsQ2 which induces the consumer to buy less of potatoes and the substitution effect which is equal Q1Qs which induces the consumer to buy more of the good. Since the negative income effect Q2Qs is greater than the substitution effect Q1Qs, the net effect is the fall in quantity purchased of good X by MN with the fall in its price. Thus, the quantity demanded of a Giffen good varies directly with price. Therefore, if a demand curve showing price-demand relationship of a Giffen good is drawn, it will slope upward.

Page No. Data: Giffen When a Goods decrease in the a giffen Good price of good quantity + of normal LA BL2 0 0 0, 8s BL, Lightity of (tue a, as l-ue) &s - lg - - Substitution offect Income effect