Question

By using the indifference curve analysis, derive the demand curve in the case of: (a) Normal good. (b) Inferior good and Giffen good.

Short answer

Answer: In deriving the demand curve using indifference curve analysis, the income effect and the substitution effect play an essential role. For normal goods, both the income and substitution effects lead to a decrease in the good's consumption when its price increases, resulting in a negatively sloped demand curve. For inferior goods, the income and substitution effects work in opposite directions, leading to a negatively sloped demand curve if substitution effect dominates, but a positively sloped demand curve in case of a Giffen good when the income effect is stronger than the substitution effect.

Step-by-step solution

(Normal Good)

A normal good is a good for which the quantity demanded increases with an increase in income and decreases with a decrease in income, keeping the price constant. This positive relationship between income and quantity demanded is indicative of a positive income effect on a normal good. To break down the indifference curve analysis for a normal good, follow these steps: 1. Assume the consumer is initially at an equilibrium point where they're indifferent between two bundles of goods (x and y). 2. Increase the price of the normal good x, which will lead to a new budget constraint and a new tangent on the indifference curve. 3. Observe that the new equilibrium point involves the consumer consuming less of good x and possibly more of good y due to the substitution effect. 4. Observe that the new equilibrium point also involves the consumer consuming less of good x because of the income effect, as the real income level has effectively decreased. 5. Since both income and substitution effects lead to a decrease in the consumption of good x, the demand for a normal good decreases with an increase in its price, forming a negatively sloped demand curve.

(Inferior Good and Giffen Good)

An inferior good is a good for which the quantity demanded decreases with an increase in income and increases with a decrease in income, keeping the price constant. This negative relationship between income and quantity demanded is an indication of a negative income effect on an inferior good. A Giffen good is a special case of an inferior good, where the negative income effect is so strong that it outweighs the substitution effect, causing the demand curve to slope upward. To break down the indifference curve analysis for inferior and Giffen goods, follow these steps: 1. Assume the consumer is initially at an equilibrium point where they're indifferent between two bundles of goods (x and y). Let x be the inferior good. 2. Increase the price of the inferior good x, which will lead to a new budget constraint and a new tangent on the indifference curve. 3. Observe that the new equilibrium point involves the consumer consuming less of good x and possibly more of good y due to the substitution effect. 4. Observe that the new equilibrium point also involves the consumer consuming more of good x because of the income effect, as the real income level has effectively decreased. 5. Now, assess the net effect of income and substitution effects on good x: a. If the substitution effect is stronger than the income effect, the demand for the inferior good decreases with an increase in its price, forming a negatively sloped demand curve. b. If the income effect is stronger than the substitution effect (Giffen good), the demand for the good increases with an increase in its price, forming a positively sloped demand curve.