Download Effects of Income Changes

DEMAND THEORY -III
EA SESSION 4
5th JULY, 2007
PROF. SAMAR K. DATTA
Overview of Session 4
• Substitution and income effects
• Giffen goods
• Digression on derivation of
market demand curve from
individual demand curves
• Network externalities etc.
Two Important Properties of
Demand Curves
1.
The level of utility that can be attained
changes as we move along the curve.
2. At every point on the demand curve, the
consumer is maximizing utility by
satisfying the condition that the MRS of
food for clothing equals the ratio of the
prices of food and clothing.
Substitution Effect
• Substitution Effect
– The substitution effect is the change in an
item’s consumption associated with a change in
the price of the item, with the level of utility
held constant.
– When the price of an item declines, the
substitution effect always (like the Old
Faithful!) leads to an increase in the quantity of
the item demanded.
Income Effect
• Income Effect
– The income effect is the change in an
item’s consumption brought about by the
increase in purchasing power, with the
price of the item held constant.
– When a person’s income increases, the
quantity demanded for the product may
increase or decrease.
Income and
Substitution Effects
• Income Effect
– Even with inferior goods, the income
effect is rarely large enough to outweigh
the substitution effect.
Income and Substitution
Effects: Normal Good
Clothing
(units per
month) R
When the price of food falls,
consumption increases by F1F2
as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
A
relative prices but keeps real income
(satisfaction) constant.
C1
D
B
C2
U2
Substitution
Effect
O
F1
Total Effect
The income effect, EF2,
( from D to B) keeps relative
prices constant but
increases purchasing power.
U1
E
S
F2
T
Income Effect
Food (units
per month)
Income and Substitution
Effects: Inferior Good
Clothing
(units per
month) R
Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect.
A
B
U2
D
Substitution
Effect
O
F1
U1
E
Total Effect
S
F2
Income Effect
T
Food (units
per month)
Giffen Good
• A Special Case of Inferior Good:
– The income effect may theoretically be
large enough (to dominate over and
reverse the substitution effect) to
cause the demand curve for a good to
slope upward.
– This rarely occurs and is of little
practical interest.
Marshallian Uncompensated Vs.
Hicksian Compensated Demand Curve
Market Demand
• Two Important Points
1) The market demand will shift to
the right as more consumers enter
the market.
2) Factors that influence the
demands of many consumers will
also affect the market demand.
Bandwagon Effect
• The Bandwagon Effect
– This is the desire to be in style, to have
a good because almost everyone else has
it, or to indulge in a fad.
– This is the major objective of marketing
and advertising campaigns (e.g. toys,
clothing).
Positive Network
Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40 D60 D80 D100
$30
But as more people buy
the good, it becomes
stylish to own it and
the quantity demanded
increases further.
$20
Demand
Pure Price
Effect
Bandwagon
Effect
20
40
48 60
80
100
Quantity
(thousands per month)
Snob Effect
• If the network externality is negative, a
snob effect exists (in sharp contrast to
positive externality in case of bandwagon
effect)
• The snob effect refers to the desire to
own exclusive or unique goods.
• The quantity demanded of a “snob” good is
higher the fewer the people who own it.
Snob Effect
Price
($ per
unit)
The demand is less elastic and
as a snob good its value is greatly
reduced if more people own
it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.
Demand
$30,000
Net Effect
Snob Effect
$15,000
D2
D4
D8
2
4
6
8
Pure Price Effect
D6
Quantity
14
per month)
(thousands
Veblen Effect
(not a part of the prescribed
reading; only for interested students)
• Certain goods are meant for conspicuous
consumption – e.g. jewellery
• They are subject to the Veblen effect – the
higher the price paid, the greater the
satisfaction derived.
• Veblen effect may cause upward sloping market
demand curve in a certain range of prices (where
good is considered worthy of conspicuous
consumption)
• Giffen good may cause an upward sloping demand
curve for an individual at a low price band; Veblen
effect may cause an upward sloping market
demand curve at a high price band
Veblen Effect
(not a part of the
prescribed reading; only for interested students)