DEMAND THEORY -IIIDEMAND THEORY -IIIDEMAND THEORY -IIIDEMAND THEORY -III

EA SESSION 4EA SESSION 4

5th JULY, 20075th JULY, 2007

PROF. SAMAR K. DATTAPROF. 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 SubstitutionEffects: Normal Good

Food (units per month)O

Clothing(units per

month) R

F1 S

C1 A

U1

The income effect, EF2, ( from D to B) keeps relativeprices constant but increases purchasing power.

Income Effect

C2

F2 T

U2

B

When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.

ETotal Effect

SubstitutionEffect

D

The substitution effect,F1E, (from point A to D), changes the relative prices but keeps real income(satisfaction) constant.

Food (units per month)O

R

Clothing(units per

month)

F1 S F2 T

A

U1

E

SubstitutionEffect

D

Total Effect

Since food is an inferior good, theincome effect is

negative. However,the substitution effect

is larger than the income effect.

B

Income Effect

U2

Income and SubstitutionEffects: Inferior Good

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 tothe right as more consumers enter

the market.

2) Factors that influence the demands of many consumers willalso 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).

Demand

Positive NetworkExternality: Bandwagon

Effect

Quantity (thousands per month)

Price($ per

unit)

D20

20 40 60 80 100

D40 D60 D80 D100

Pure PriceEffect

$20

BandwagonEffect

But as more people buythe good, it becomes stylish to own it and

the quantity demandedincreases further.$30

48

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

Quantity (thousandsper month)2 4 6 8

The demand is less elastic and as a snob good its value is greatly

reduced if more people ownit. Sales decrease as a result.

Examples: Rolex watches and long lines at the ski lift.

Price($ per

unit)

D2

$30,000

$15,000

14

D4

D6D8

Demand

Pure Price Effect

Snob EffectNet Effect

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)