Homeworks academic service


Price elasticity or demand marginal utility essay

The income effect The income and substitution effect can also be used to explain why the demand curve slopes downwards.

If we assume that money income is fixed, the income effect suggests that, as the price of a good falls, real income - that is, what consumers can buy with their money income - rises and consumers increase their demand. Therefore, at a lower price, consumers can buy more from the same money income, and, ceteris paribus, demand will rise. Conversely, a rise in price will reduce real income and force consumers to cut back on their demand.

Demand curves

The substitution effect In addition, as the price of one good falls, it becomes relatively less expensive. Therefore, assuming other alternative products stay at the same price, at lower prices the good appears cheaper, and consumers will switch from the expensive alternative to the relatively cheaper one.

  1. So, it is very much on the high side in case of a necessity. We often loosely make the statement that, since we can easily give up the consumption of luxuries, their demand is highly elastic.
  2. Each household will stop purchasing the commodity when marginal utility, i. The substitution effect In addition, as the price of one good falls, it becomes relatively less expensive.
  3. And elasticity of demand is determined not by total utility but by marginal utility over the same range. In the case of a Giffen good, this typical response does not happen as there are no substitutes, and the price rise causes demand to increase.
  4. The second point is that, the shape of the demand curve over the range of price change P0 P3 is irrelevant for determining price elasticity. Thus two points are to be noted here.

It is important to remember that whenever the price of any resource changes it will trigger both an income and a substitution effect.

Exceptions It is possible to identify some exceptions to the normal rules regarding the relationship between price and current demand.

Giffen Goods Giffen goods are those which are consumed in greater quantities when their price rises.

These goods are named after the Scottish economist Sir Robert Giffenwho is credited with identifying them by Alfred Marshall in his highly influential Principles of Economics 1895. In essence, a Giffen good is a staple food, such as bread or rice, which forms are large percentage of the diet of the poorest sections of a society, and for which there are no close substitutes.

  • But, it has no relevance in measuring price elasticity of demand;
  • But, by how much?

From time to time the poor may supplement their diet with higher quality foods, and they may even consume the odd luxury, although their income will be such that they will not be able to save. A rise in the price of such a staple food will not result in a typical substitution effect, given there are no close substitutes.

  • The substitution effect In addition, as the price of one good falls, it becomes relatively less expensive;
  • Suppose, the original price is P0;
  • In the case of a Giffen good, this typical response does not happen as there are no substitutes, and the price rise causes demand to increase.

If the real incomes of the poor increase they would tend to reallocate some of this income to luxuries, and if real incomes decrease they would buy more of the staple good, meaning it is an inferior good. Assuming that the money incomes of the poor are constant in the short run, a rise in price of the staple food will reduce real income and lead to an inverse income effect. However, most inferior goods will have substitutes, hence despite the inverse income effect, a rise in price will trigger a substitution effect, and demand will fall.

Price Elasticity of Demand and Marginal Utility (Relationship)

In the case of a Giffen good, this typical response does not happen as there are no substitutes, and the price rise causes demand to increase. They cannot reduce their consumption of bread, given that their current consumption is the minimum they require, and they cannot find a suitable substitute for their stable food.

Veblen goods Veblen goods are a second possible exception to the general law of demand. These goods are named after the American sociologist, Thorsten Veblenwho, in the early 20th century, identified a 'new' high-spending leisure class. According to Veblen, a rise in the price of high status luxury goods might lead members of this leisure class to increase in their consumption, rather than reduce it.

The purchase of such higher priced goods would confer status on the purchaser - a process which Veblen called conspicuous consumption.