Consumer Behavior-

III
Prof. Ashutosh Tripathi
04th August, 2019
Roadmap: Changes in Consumer Equilibrium
• Income effect and distinction between normal and
inferior goods
• Engel curve
• Price consumption curve and demand curve
• Substitutes and complements
• Substitution and income effects
• Distinction across Normal, Inferior & Giffen goods
• Digression on derivation of market demand curve
from individual demand curves
• Network externalities etc.
 Income Changes, Income Consumption
Curve, and Shift in Demand Curve

Income Changes
An increase in income shifts the
budget line to the right, increasing
consumption along the income-
consumption curve.
Thus, increase in income shifts the
demand curve to the right.
Income Consumption Curve
Clothing
Assume: Pf = $1
(units per
Pc = $2
month)
I = $10, $20, $30

Income-Consumption
Curve
7 D
U3 An increase in income,
with the prices fixed,
5 U2 causes consumers to alter
B their choice of
3 market basket.
A U1

Food (units
4 10 16 per month)
Income Changes & Shifts in the
Demand Curve
Price An increase in income,
of from $10 to $20 to $30,
food with the prices fixed,
shifts the consumer’s
demand curve to the right.

E G H
$1.00

D3
D2
D1

Food (units
4 10 16 per month)
Normal vs. Inferior Good
• Normal Good - The income-
consumption curve has a positive
slope:
• The quantity demanded increases with
income.
• The income elasticity of demand is positive.

• Inferior Good - The income-

consumption curve has a negative
slope:
• The quantity demanded decreases with
income.
• The income elasticity of demand is negative.
 An Inferior Good
Steak 15
(units per Income-Consumption
month) Curve
Both hamburger
and steak behave
C as a normal good,
10 between A and B...
U3

…but hamburger
becomes an inferior
B good when the income
5 consumption curve
bends backward
U2 between B and C.
A
U1
Hamburger
5 10 20 30 (units per month)
 Individual Demand
• Engel Curves
– Engel curves relate the quantity of
good consumed to income.
– If the good is a normal good, the Engel
curve is upward sloping.
– If the good is an inferior good, the
Engel curve is downward sloping.
 Engel Curve
Income
($ per
30
month)
Inferior
Engel curve is
backward bending
20 for inferior goods.

Normal

10

Food (units
0 4 8 12 16 per month)
 Price Consumption Curve
Clothing
The price-consumption
(units per
curve traces out the
month)
utility maximizing
market basket for the
various prices for food.
6 A
Price-Consumption Curve
U1 D
5
B
4 U3

U2

Food (units
4 12 20 per month)
Substitutes and Complements
• Substitutes and Complements
–If the price consumption curve
is downward-sloping, the two
goods are considered
substitutes.
–If the price consumption curve
is upward-sloping, the two
goods are considered
complements.
Individual Demand Curve
Price
of Food
Individual Demand relates
E the quantity of a good that
$2.00
a consumer will buy to the
price of that good.

G
$1.00
Demand Curve
$.50 H

Food (units
4 12 20 per month)
Derivation of Demand Curve from Price
Consumption Curve
Clothing
(units per
month)

Price of
food
Substitutes and Complements again
1. Two goods are considered substitutes if an increase
(decrease) in the price of one leads to an increase
(decrease) in the quantity demanded of the other.
• e.g. movie tickets and video rentals
2. Two goods are considered complements if an increase
(decrease) in the price of one leads to a decrease
(increase) in the quantity demanded of the other.
• e.g. petrol and motor oil
3. Two goods are independent when a change in the price
of one good has no effect on the quantity demanded of
the other.
Two Important Properties of
Demand Curves
1. The level of utility that can be
attained changes as we move along
the curve.
2. 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.
 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.
 Relative Importance of 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
When the price of food falls,
(units per consumption increases by F1F2
month) R as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
C1 A relative prices but keeps real income
(satisfaction) constant.

The income effect, EF2,

( from D to B) keeps relative
D prices constant but
B
C2 increases purchasing power.

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

U2
D

Substitution
Effect U1
Food (units
O F1 E S F2 T per month)
Total Effect
Income Effect
 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.
 Market Demand
• The market demand curve is the horizontal
summation of individual demand curves.
• It indicates the total quantity all consumers would
purchase at each price point.

$ Individual Demand $ Market Demand

Curves Curve
5 Can there be
0 ‘Exchange
40 Entitlement Failure’,
as highlighted by Sen?

D1 D2 DM
1 2 Q 1 2 Q
3
Exchange Entitlement Failure means failure to get sufficient quantity of desired goods in
exchange for sale of goods in hand, when prices of desired goods are too high
 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 D20 D40 D60 D80 D100 But as more people buy
($ per the good, it becomes
unit)
stylish to own it and
the quantity demanded
$30 increases further.

$20

Demand

Pure Price Bandwagon

Effect
Effect
Quantity
20 40 48 60 80 100 (thousands per month)
 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
Price
($ per The demand is less elastic and
unit) Demand as a snob good its value is greatly
reduced if more people own
$30,000 it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.

Net Effect Snob Effect

$15,000

D2
D4
D6
D8
Quantity (thousands
2 4 6 8 14 per month)

Pure Price Effect

 Veblen Effect
• Certain goods are meant for conspicuous
consumption – e.g. jewelry
• 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