EA SESSION 4 5th JULY, 2007 PROF. SAMAR K. DATTA 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 The level of utility that can be attained changes as we move along the curve. 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. 4

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) C2 F2 T U2 B When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B. R F1 S C1 A U1 E Total Effect Substitution Effect D The substitution effect,F1E, (from point A to D), changes the relative prices but keeps real income (satisfaction) constant. The income effect, EF2, ( from D to B) keeps relative prices constant but increases purchasing power. Income Effect Food (units per month) O

Income and Substitution Effects: Inferior Good Clothing (units per month) Total Effect Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. B Income Effect U2 R A D Substitution Effect U1 Food (units per month) O F1 E S F2 T

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 But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further. $30 $20 Demand Pure Price Effect Bandwagon Effect Quantity (thousands per month) 20 40 48 60 80 100

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 Demand D2 D4 Price $30,000 Net Effect Snob Effect $15,000 ($ 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 D6 D8 Quantity (thousands per month) 2 4 6 8 14 Pure Price 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)