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T. W. G. Hs. Lo Kon Ting Memorial College
F.6: Economics (2004-2005)
Worksheet 4 on Chapter 4: Consumer Demand (2): The Indifference Curve Approach
Marking Scheme
1. The Giffen paradox is a theoretical possibility in which the income effect of a change in
price overpowers the positive substitution effect, resulting in an increase in quantity demanded
for a Giffen goods (whose quantity demanded is negatively related to income) when its price
increases, vice versa. Therefore, the demand curve, if exists, for a Giffen good was upward
sloping showing a positive relationship between its quantity demanded and its price.
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Whenever there is a change in the price of a good, ceteris paribus, income effect and (real)
income effect occur. By definition, substitution effect (of a price change) refers to the change in
consumption that would occur if the relative price of the two goods under consideration changes,
but the consumer is held on his or her original indifference curves (ICs). And the income effect
(of a price change) is the change in consumption that would occur if the real income of the
consumer changes, the relative price of the two goods being held constant.
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In the diagram on the left, BL is the original budget line while
BL’ is the new one after a decrease in the price of good X.
Point A is the original equilibrium and point C is the new
equilibrium if real income is held constant (via shifting the new
budget line back to tangent the original IC, IC1 at point C). The
decreased price of good X makes it relatively cheaper and
hence raises its quantity demanded (from X1 to X2) as we
substitute more good X for Y. Because of the convexity of the
ICs, the demand curve so derived must be negatively sloped,
hence Giffen good is impossible.
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On the contrary, point E is the equilibrium if only money income is held constant. If it is the
money income that is kept constant, both the income and substitution effects are included for
the analysis of a price change. As good is priced less, our real income is enhanced and,
however, leading to a fall in the demand for good X for it is a Giffen good. Under the extreme
case that the negative income effect (from C to E) is so
significant that it overrides the negative substitution effect
(from A to C), Giffen good will then be a possibility as its
quantity falls when its price is increased. It is therefore quite
clear from the diagram that Giffen paradox exists if only
money income is held constant.
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2. As implied by the postulate of substitution, every good is substitutable at the margin with
another good. Besides, it is always preferable to have the amount of any one good increased.
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Accordingly, if the amount of one good is increased, the amount of the other good must be then
reduced for utility level to be constant. Thus an indifference curve must be downward sloping.
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Moreover, the degree of convexity of the indifference curve depends on the substitutability of
goods X and Y. For perfect substitutes, the indifference curve will be a downward sloping
straight line.
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