Question

Hard Times Burt buys only rotgut whiskey and jelly donuts to sustain him. For Burt, rotgut whiskey is an inferior good that exhibits Giffen's paradox, although rotgut whiskey and jelly donuts are Hicksian substitutes in the customary sense. Develop an intuitive explanation to suggest why an increase in the price of rotgut whiskey must cause fewer jelly donuts to be bought. That is, the goods must also be gross complements.

Short answer

Question: Provide an intuitive explanation for why an increase in the price of rotgut whiskey, which Burt experiences Giffen's Paradox with, must lead to a decrease in the quantity of jelly donuts bought, indicating that the goods are also gross complements, even though they are Hicksian substitutes in the usual sense. Answer: When the price of rotgut whiskey increases, Burt buys more whiskey due to Giffen's Paradox, which results in a higher share of his income being spent on whiskey. This effectively "decreases" his spending power, causing him to buy less jelly donuts. Although whiskey and jelly donuts are Hicksian substitutes, the Giffen's Paradox and the strong income effect it creates override the substitution effect, leading to a decrease in the consumption of both goods when the price of whiskey increases. This behavior indicates that the goods are also gross complements.

Step-by-step solution

Understanding Key Concepts

First, let's understand what these key concepts mean: a. Inferior good - A good is called inferior if the demand for the good decreases as the consumers' income increases. b. Giffen's Paradox - It is a phenomenon that occurs when the demand for an inferior good increases as its price increases, contrary to the Law of Demand. c. Hicksian substitutes - Two goods are Hicksian substitutes if the demand for one good increases as the price of the other good increases, holding the utility constant. d. Gross complements - Two goods are gross complements if an increase in the price of one good leads to a decrease in the quantity demanded for both goods.

Analyzing the Increase in Rotgut Whiskey Price

Now, let's analyze what happens when the price of rotgut whiskey increases: 1. Due to Giffen's Paradox, Burt will buy more rotgut whiskey even if its price increases. 2. As Burt's spending on whiskey increases, the relative share of his income spent on whiskey also increases. 3. Since rotgut whiskey is an inferior good, this means that Burt's income has effectively "decreased" (at least in terms of spending power), which might lead to a reduction in the consumption of jelly donuts.

Impact on Jelly Donuts Consumption

Given that rotgut whiskey and jelly donuts are Hicksian substitutes, an increase in the price of whiskey should have led to an increase in the consumption of jelly donuts. However, due to the Giffen's Paradox and the resulting income effect, the consumption of jelly donuts decreases.

Goods as Gross Complements

Since an increase in the price of rotgut whiskey leads to a decrease in the consumption of jelly donuts, we can conclude that these goods are also gross complements. The intuitive explanation for this behavior is that the Giffen's Paradox leads to an income effect that is strong enough to override the substitution effect, causing the demand for both goods to decrease as the price of one increases.