Question

Sven is a poor student who covers most of his dietary needs by eating cheap breakfast cereal, since it contains most of the important vitamins. As the price of cereal increases, he decides to buy even less of other foods and even more breakfast cereal to maintain his intake of important nutrients. This makes breakfast cereal a Giffen good for Sven. Describe in words the substitution effect and the income effect from this increase in the price of cereal. In which direction does each effect move, and why? What does this imply for the slope of Sven's demand curve for cereal?

Short answer

Sven's cereal is a Giffen good where the substitution effect, typically leading to purchasing less of a good as it becomes more expensive in comparison to others, is overshadowed by the income effect, which decreases his real income and increases his reliance on cereal. Consequently, Sven's demand curve for cereal has an upward slope.

Step-by-step solution

Define the Substitution Effect

The substitution effect occurs when consumers react to an increase in a good's price by consuming less of that good and more of other goods. This switch is made because other goods are now relatively cheaper. In Sven's case, typically one would expect him to substitute cereal with a cheaper alternative food.

Explain the Income Effect

The income effect happens when a price increase effectively reduces a consumer's purchasing power, leading them to buy less of a good. For Sven, the income effect means that an increase in the price of cereal reduces his real income, decreasing his overall consumption levels.

Analyze Sven's Behavior

In Sven's situation, the Giffen good behavior signifies that the income effect dominates the substitution effect. Instead of substituting cereal with other goods, Sven buys more cereal when its price increases, sacrificing his purchase of other foods.

Discuss the Demand Curve

For a Giffen good like Sven's cereal, the demand curve will slope upwards rather than downwards. This is because, contrary to the law of demand, Sven purchases more cereal as the price increases due to the strong, dominating income effect.

Key concepts

Substitution Effect

The substitution effect is one of the key principles in understanding consumer behavior when it comes to changes in the price of goods. When the price of a product that a consumer regularly buys goes up, the natural inclination is to look for a less expensive alternative that can replace the more costly item. This is what we call the 'substitution effect'.

For instance, imagine your favorite brand of coffee becomes more expensive; you might decide to switch to a more affordable brand to keep your budget in check. However, in the case of Sven and his breakfast cereal, the expected reaction doesn't occur. Contrary to typical consumer behavior where a substitute would be sought, Sven doubles down on the more expensive cereal. This unusual situation sets the stage for what defines a Giffen good, which defies standard economic predictions.

Income Effect

The income effect delves into how a change in the price of goods affects a consumer's purchasing power. When the price of a commodity increases, a consumer's real income—essentially the basket of goods and services they can afford—effectively diminishes.

In Sven's situation, the rise in cereal price means he can no longer afford the same amount of cereal plus other foods that he could before the price hike. The income effect would generally lead to a decline in the consumption of the pricier item. However, because Sven prioritizes his nutritional intake and has limited food options, he ends up buying more cereal and less of other foods. His reaction underlines the pronounced income effect, which overturns the expected decrease in quantity demanded that would normally accompany a price increase.

Demand Curve

The demand curve is a graphical representation that shows the relationship between the price of a good and the quantity demanded by consumers. Typically, the demand curve slopes downward from left to right, highlighting the inverse relationship between price and quantity demanded—when the price goes up, the quantity demanded goes down, and vice versa.

In the unique case of Giffen goods, however, the demand curve slopes upward. This seemingly paradoxical situation is precisely what we see with Sven and his cereal. As the price of cereal rises, Sven, constrained by his dietary needs and financial resources, buys more cereal instead of less. This counterintuitive behavior results in an upward-sloping demand curve for his breakfast cereal, reflecting the dominance of the income effect over the substitution effect for this particular product.

Price Elasticity of Demand

The price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price. It's typically negative for most goods, indicating that an increase in price results in a decrease in quantity demanded. However, the elasticity can vary in magnitude; some goods are relatively inelastic (less responsive), meaning consumers will not significantly reduce quantity demanded even if the price goes up.

With a Giffen good like the cereal in Sven's scenario, the price elasticity of demand would actually appear positive. As the price of cereal climbs, rather than seeing a drop in quantity demanded, we witness an increase. This counterintuitive response is rare and specific to certain conditions, such as the presence of strong necessity and a lack of close substitutes—conditions that accurately describe Sven's reliance on his nutrition-packed cereal.