Transcript 4-10 Income and Substitution Effects Illustrated: Inferior Goods

MICROECONOMICS: Theory & Applications
Chapter 4 Individual and Market Demand
By Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
9th Edition, copyright 2006
PowerPoint prepared by Della L. Sue,
Marist College
Learning Objectives
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Understand how price changes affect consumption
choices.
Differentiate between the income and substitution
effects associated with a price change on the
consumption of a particular good.
Explain the relation between income and substitution
effects in the case of inferior goods.
Show how individual demand curves are aggregated
to obtain the market demand curve.
(continued)
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Learning Objectives (continued)
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Demonstrate how consumer surplus represents the
net benefit , or gain, served by an individual from
consuming one market basket instead of another.
Investigate the relationship between own-price
elasticity of demand and the price-consumption
curve.
Examine network effects: the extent to which an
individual consumer’s demand for a good is
influenced by other individuals’ purchases.
Overview the basics of demand estimation.
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Price Changes and Consumption
Choices
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Price-consumption curve: a
curve that identifies the
optimal market basket
associated with each
possible price of a good,
holding constant all other
determinants of demand.
The consumer’s demand
curve can be derived from
the price-consumption
curve.
Figure 4.1
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Some Remarks about the Demand
Curve
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The consumer’s level of well-being varies along the demand
curve.
The prices of other goods are held constant among a demand
curve, but the quantities purchased of these other goods can
vary.
At each point on the demand curve, the consumer’s optimality
condition is satisfied:
MRSXO = PX/PO
where “O” refers to “other goods” (composite good).
The demand curve identifies the marginal benefit associated
with various levels of consumption.
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Do Demand Curves Always Slope
Downward?
[Figure 4.2]
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Income and Substitution Effects of
a Price Change
 Income effect – a change in a consumer’s
real purchasing power brought about by a
change in the price of a good
 Substitution effect – an incentive to increase
consumption of a good whose price falls, at
the expense of other, now relatively more
expensive, goods
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Income and Substitution Effects
Illustrated: The Normal-Good Case
[Figure 4.3]
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A Graphical Examination of a TaxPlus-Rebate Program
[Figure 4.4]
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Income and Substitution Effects
Illustrated: Inferior Goods
[Figure 4.5]
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Possibilities for Inferior Goods
 If the substitution effect is larger than the
income effect, then the demand curve will
have a negative slope.
 If the income effect is larger than the
substitution effect, then the demand curve will
have a positive slope. This type of inferior
good is called a Giffen good.
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From Individual to Market Demand
[Figure 4.6]
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Consumer Surplus
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Consumer surplus – the net benefit or gain from
consuming one market basket instead of another
Total benefit – the total value a consumer derives
from a particular amount of a good and thus the
maximum amount the consumer would be willing to
pay for that amount of the good.
Marginal benefit – the incremental value a consumer
derives from consuming an additional unit of a good
and thus the maximum amount the consumer would
pay for that additional unit
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Calculating Consumer Surplus
[Figure 4.8]
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Geometric Calculation of Consumer
Surplus
[Figure 4.9]
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Consumer Surplus and Indifference
Curves
[Figure 4.11]
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Price Elasticity and the PriceConsumption Curve
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[Figure 4.12]
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Network Effects
 Network effects – the extent to which an
individual consumer’s demand for a good is
influenced by other individuals’ purchases
– Bandwagon effect – a positive network effect
– Snob effect – a negative network effect
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The Bandwagon Effect
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It exists whenever the
quantity of a good
demanded by a particular
consumer is greater the
larger the number of other
consumers purchasing the
same good.
The market demand is more
elastic than the individual
demand curves.
Figure 4.13
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The Snob Effect
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It occurs when a
consumer is less willing
to purchase a good the
more widespread its
usage.
The market demand is
more inelastic than the
individual demand
curves.
Figure 4.14
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The Basics of Demand Estimation
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Experimentation
– Limitations:
 difficult to allow only one factor to change, holding the other
factors constant
 may be incorrect to apply the results obtained from the sample
to the entire population
Surveys
– Important to choose a representative sample
– Reliability is dependent on respondents’ truthfulness
Regression analysis (econometrics) – a statistical method that allows
one to estimate the sensitivity of the quantity demanded of a good to
determinants such as price and income
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