1. EA SESSION 4 5th JULY, 2007 PROF. SAMAR K. DATTA
DEMAND THEORY -III
EA SESSION 4
5th JULY, 2007
PROF. SAMAR K. DATTA

2. Overview of Session 4 Substitution and income effects Giffen goods
Digression on derivation of market demand curve from individual demand curves
Network externalities etc.

3. 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

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.

5. 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.

6. Income and Substitution Effects
Income Effect
Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

7. 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

8. 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

9. 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.

10. Marshallian Uncompensated Vs. Hicksian Compensated Demand Curve

11. 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.

12. 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).

13. 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

14. 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.

15. 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

16. 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

17. Veblen Effect (not a part of the prescribed reading; only for interested students)