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Difficulty: MediumIncome and Substitution Effects on Demand

For a Giffen good, when its price decreases, the positive substitution effect on quantity demanded is outweighed by a negative income effect, causing the total quantity demanded to decrease.

Answer: Answer

Answer

The statement is true because for a Giffen good, the negative income effect resulting from a price fall is greater in magnitude than the positive substitution effect, leading to a net reduction in quantity demanded.
The statement accurately reflects the theoretical decomposition of the price effect for a Giffen good: a fall in price enhances real income, generating a negative income effect that exceeds the positive substitution effect, thereby reducing the net quantity demanded.

Step-by-Step Solution

1
Determine the direction of the substitution effect following a price drop.
The substitution effect is always positive when the price of a good falls, incentivizing consumers to buy more of that good relative to others.
Lower relative price drives substitution toward the cheaper commodity regardless of whether the good is normal or inferior.
2
Analyze the income effect of a price reduction for a Giffen good.
A drop in price increases real income. For a strongly inferior good (Giffen good), an increase in real income leads to a decrease in quantity demanded (negative income effect).
Inferior goods exhibit an inverse relationship between real income and quantity demanded.
3
Evaluate the net total price effect (TE=SE+IETE = SE + IE).
For a Giffen good, ∣IE∣>∣SE∣|IE| > |SE|, causing the negative income effect to dominate the positive substitution effect, producing a net decrease in total quantity demanded.
The defining characteristic of a Giffen good is an income effect that overpowers the substitution effect, resulting in an upward-sloping demand curve.

Key Concept

Income and Substitution Effects on Giffen Goods
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Topics

Income and Substitution Effects on Demand

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