Chapter 6: Problem 2

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 a rise in the price of rotgut must cause fewer jelly donuts to be bought. That is, the goods must also be gross complements.

Short Answer

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Question: Explain how a rise in the price of rotgut whiskey, a Giffen good, could lead to a decrease in the consumption of jelly donuts, revealing the goods as gross complements. Answer: When the price of rotgut whiskey increases, due to Giffen's Paradox, Burt consumes more whiskey despite the price increase. Since Burt has limited income, he must spend a larger portion of his budget on the now more expensive whiskey, even though it's an inferior good. As a result, he has less money left for the purchase of jelly donuts. Although jelly donuts and rotgut whiskey are Hicksian substitutes, the behavior of Giffen's Paradox takes precedence in this situation, forcing Burt to consume fewer jelly donuts to accommodate the increase in rotgut whiskey consumption. Thus, rotgut whiskey and jelly donuts are considered gross complements in this scenario.

Step by step solution

Understand Giffen's Paradox

A Giffen good is an inferior good, which means that as a consumer's income increases, the demand for the good decreases. Giffen's Paradox occurs when the price of a Giffen good rises, which leads to an increase in its demand instead of a decrease, as theory predicts for normal goods. This paradox is quite rare and only appears in specific circumstances, like our case of rotgut whiskey for Burt.

Understand Hicksian Substitutes

Hicksian substitutes are two goods that, when the price of one increases, the other good can be consumed as a replacement by the consumer in order to maintain the same level of utility (satisfaction). In our exercise, rotgut whiskey and jelly donuts are Hicksian substitutes, meaning that if the price of one of them rises, Burt is expected to consume more of the other to maintain his satisfaction.

Understand Gross Complements

Gross complements are goods for which an increase in the price of one good leads to a decrease in the consumption of the other good. This is the opposite of gross substitutes, where an increase in the price of one good leads to an increase in consumption of the other good. In our scenario, we need to show an intuitive explanation to suggest that rotgut whiskey and jelly donuts are gross complements.

The Effect of a Rise in the Price of Rotgut Whiskey - Intuition

When the price of rotgut whiskey (the Giffen good in this scenario) increases, Burt, who is constrained by his limited income, would be expected to increase the consumption of jelly donuts, as they are Hicksian substitutes. However, due to Giffen's Paradox, Burt would actually consume more rotgut whiskey despite the price increase. Since Burt has limited income, he must allocate a higher portion of his budget to purchase the now more expensive rotgut whiskey, which was already an inferior good.

Reasoning for Fewer Jelly Donuts to be Bought

As Burt now spends more money on rotgut whiskey due to Giffen's Paradox and has a limited budget, he would have less money left to allocate for the purchase of jelly donuts. Even though jelly donuts and rotgut whiskey are Hicksian substitutes, the behavior of Giffen's Paradox takes precedence in this scenario, forcing Burt to consume fewer jelly donuts in order to accommodate the increase in rotgut whiskey consumption. This shows that, in this particular situation, rotgut whiskey and jelly donuts are gross complements.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Inferior Good

An inferior good is a type of product that individuals consume more of when their income decreases, and vice versa. Unlike normal goods, where demand increases as the consumer's income rises, inferior goods have a reverse relationship with income. For example, in the provided exercise, rotgut whiskey is considered an inferior good for Burt. As strange as it might seem, there are situations where the demand for such goods increases even when prices go up, which leads us to the anomaly known as Giffen's Paradox.

Considering Burt's predicament, if his income were to rise, we might expect him to purchase less rotgut whiskey in favor of a higher quality alternative. However, a hike in price of rotgut whiskey leads Burt to consume more due to its unique status as a Giffen good, hence demonstrating the paradox.

Hicksian Substitutes

The idea of Hicksian substitutes relates to how consumers make choices to retain a consistent level of satisfaction, or utility, despite changes in the market. When the price of a good increases, a consumer will typically look for a substitute product that provides similar satisfaction. It's akin to opting for an off-brand cereal when your favorite brand gets too pricey—you still start your day with a satisfying breakfast, but at a lower cost.

In Burt's case, rotgut whiskey and jelly donuts are considered Hicksian substitutes. This means that if the cost of whiskey went up in a regular market scenario, Burt would be expected to consume more jelly donuts to maintain his utility. However, due to the peculiarity of Giffen's Paradox, this typical substitution effect does not occur.

Gross Complements

Unlike substitutes, gross complements are products that are typically purchased together, such that an increase in the price of one leads to a decrease in the consumption of the other. Think of printers and ink cartridges; if printers become more expensive, people might buy fewer ink cartridges because they're less likely to purchase the printer in the first place.

In our exercise, Burt's alcoholic beverage and sweet treat initially seem like unlikely partners for this concept. However, due to the limited budget and the Giffen's Paradox effect on rotgut whiskey, Burt ends up buying fewer jelly donuts when the price of whiskey rises. Hence, paradoxically, they behave as gross complements in this scenario.

Utility

Utility is a measure of satisfaction or happiness that a consumer derives from consuming goods and services. Think of it as a way to score how much joy you get from eating your favorite ice cream or using the latest smartphone. Economists use this concept to understand consumer choices: the products that give us higher utility are the ones we're more likely to buy.

For Burt, his utility is derived from consuming a balance of rotgut whiskey and jelly donuts. His choice to consume more whiskey, even as the price increases due to the Giffen's Paradox, is because the utility or satisfaction he gains from whiskey outweighs the satisfaction he would get from the donuts or other goods within his limited budget.

Consumer Demand

The concept of consumer demand reflects the desire and ability of consumers to purchase goods and services at different prices. It's the backbone of market economics: if there's a demand for it, the market will supply it. However, consumer demand is not a static force; it can be molded by income levels, tastes and preferences, and price changes.

In the context of our exercise, Burt's demand for rotgut whiskey, even when its price increases, is an unusual display of consumer demand informed by Giffen's Paradox. His limited budget restrains his ability to purchase other goods, causing his demand for jelly donuts to decline, even though they are initially Hicksian substitutes.