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DEMAND THEORY -III

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.

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DEMAND THEORY -III

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  1. 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 • Thelevel of utilitythat can be attainedchangesas we move along the curve. • Atevery pointon the demand curve, the consumer is maximizing utility bysatisfying the conditionthat the MRS of food for clothing equals the ratio of the prices of food and clothing.

  4. Substitution Effect • Substitution Effect • Thesubstitution effectis the change in an item’s consumption associated with a change in the price of the item, with thelevel of utility held constant. • When the price of an item declines, the substitution effectalways(like the Old Faithful!)leads to an increase in the quantity of the item demanded.

  5. Income Effect • Income Effect • Theincome effectis the change in an item’s consumption brought about by theincrease in purchasing power, with the price of the item held constant. • When a person’s income increases, the quantity demanded for the productmay increase or decrease.

  6. Income and Substitution Effects • Income Effect • Even with inferior goods, the income effect israrely large enoughto outweigh the substitution effect.

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

  8. Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. B U2 Total Effect Income Effect Income and SubstitutionEffects: Inferior Good Clothing (units per month) 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 belarge 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 oflittle 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 goodbecause 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 NetworkExternality: 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 60 80 100 48

  14. Snob Effect • If the network externality isnegative, asnob effectexists(in sharp contrast to positive externality in case of bandwagon effect) • Thesnob effectrefers to thedesire to own exclusive or unique goods. • The quantity demanded of a “snob” good is higher thefewerthe people who own it.

  15. 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 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 forconspicuous consumption– e.g. jewellery • They are subject to the Veblen effect – the higher the price paid, the greater the satisfaction derived. • Veblen effect may causeupward sloping market demand curvein a certain range of prices (where good is considered worthy of conspicuous consumption) • Giffen good may cause an upward sloping demand curve for anindividual at a low price band; Veblen effect may cause an upward slopingmarket demand curve at a high price band

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

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