Presentation on theme: "EA SESSION 4 5th JULY, 2007 PROF. SAMAR K. DATTA"— Presentation transcript:
1 EA SESSION 4 5th JULY, 2007 PROF. SAMAR K. DATTA DEMAND THEORY -IIIEA SESSION 45th JULY, 2007PROF. SAMAR K. DATTA
2 Overview of Session 4 Substitution and income effects Giffen goods Digression on derivation of market demand curve from individual demand curvesNetwork 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 EffectEven with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.
7 Income and Substitution Effects: Normal Good Clothing(units permonth)C2F2TU2BWhen the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.RF1SC1AU1ETotal EffectSubstitutionEffectDThe substitution effect,F1E,(from point A to D), changes therelative prices but keeps real income(satisfaction) constant.The income effect, EF2,( from D to B) keeps relativeprices constant butincreases purchasing power.Income EffectFood (unitsper month)O
8 Income and Substitution Effects: Inferior Good Clothing(units permonth)Total EffectSince food is aninferior good, theincome effect isnegative. However,the substitution effectis larger than theincome effect.BIncome EffectU2RADSubstitutionEffectU1Food (unitsper month)OF1ESF2T
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($ perunit)D20D40D60D80D100But as more people buythe good, it becomesstylish to own it andthe quantity demandedincreases further.$30$20DemandPure PriceEffectBandwagonEffectQuantity(thousands per month)2040486080100
14 Snob EffectIf 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 $15,000 ($ perunit)The demand is less elastic andas a snob good its value is greatlyreduced if more people ownit. Sales decrease as a result.Examples: Rolex watches and longlines at the ski lift.Demand$30,000Net EffectSnob Effect$15,000D2D4D6D8Quantity (thousandsper month)246814Pure 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. jewelleryThey 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)