DEMAND AND CONSIDERATIONS OF BUYERS

BY: EDE KENECHUKWU KENNETH edekenechukwuk@gmail.com

The law of demand states that “as the price of goods rise, so less of that commodity will be purchased”. The question, then is seeking special circumstances when this law is broken. In order to find these, we must analyze the two effects of a price change. The substitution effect is concerned with changes in relative prices, while the income effect is concerned with changes in real income or purchasing power.

For a normal good, these two factors act in the same direction. A rise in the price of a commodity increases its price relative to other commodities and causes other goods to be substituted for it. A rise in the price of a commodity also reduces the individual’s real income in as much as he is now unable to purchase the same amount of commodities as before the price rise.

Usually, we expect this reduction in real income to cause a fall in demand. Hence, both the income and substitution effects operate in the same direction causing less of a commodity to be purchased when its price rises. The demand curve for such a commodity therefore slopes downwards as predicted by the law of demand.

For inferior goods, a fall in income is associated with a lager quantity being demanded. So the income effect of a price change is opposite to that of a normal good. Thus the income and substitution effects act in opposing directions. However, the demand curve would still slope downwards while the substitution effect was greater than the income effect. Only when the income effect is greater than substitution effects (and acts in the opposite direction) will the demand curve slope upwards. In this case the commodity is called a “Giffen good”.

This situation is illustrated in the fig 1 below which employs indifference theory for two commodities W and X. Given the individual’s income Y and initial prices P_W and P_X, we may construct his initial budget line FE, reflecting combinations of the two goods he could just afford to purchase if he spent all his income. Note that OF represents the amount of W he could buy if he purchased none of X.

i.e.

                         OF =  Y/PW

                         OE =Y/PX

Given also a set of convex indifference curves, each reflecting combinations of the two goods which yield equal satisfaction, then the highest indifference curve the individual can attain within his fixed budget will be one such as I₂ which just touches the budget line at point G. Here the amount of X purchased is OB, which is his utility maximizing quantity of X demanded at the price P_X, given constant values for Y and P_W.

Now consider the effect of a rise in the price of X to P_X¹. This causes the budget line to rotate inwards to FD. By the same reasoning as above

                        OD =                     

The highest indifference curve he can now attain is I₁, which just touches the new budget line at H, where an amount OC of X is purchased. Since OC exceeds OB, the quantity of X demanded has increased following a rise in its price. The demand curve therefore slopes upwards. As discussed above, this can only occur when the income effect acts in the opposite direction to the substitution effect and is greater in absolute magnitude. To determine the relative sizes of these income and substitution effects we require a third budget line F` D` drawn so as to have the same price ratio (and hence slope) as FD just touching I₂ at point J.

The substitution effect is caused purely by the change in relative prices, the individual being compensated for any change in real income so as to keep him on the same indifference curve I₂. In figure 1, the change in relative prices would cause the individual to move from G to J, hence the quantity of X demanded would fall from OB to OA.

The income effect is found by removing this income compensation, forcing the individual from J to H and increasing the quantity of X demanded from OA to OC. As this effect is greater than the substitution effect the overall impact on demand is positive. Thus, only when the income effect of a price change is greater than the substitution effect and acts in the opposite direction will the demand curve slope upwards.