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Introduction to Economics ECO401

Lesson 4.4

BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED................)

Normal Goods and Giffen Good:

A normal good is one whose consumption increases when income increases, while inferior

good is one whose consumption decreases with increase in income.

A Giffen good is a sub-category of inferior goods; its consumption increases when it's price

increases. This is because of its very strong income effect.

Both normal and inferior goods have downward sloping demand curves.

The Income Consumption Curve (ICC) and Price Consumption Curve (PPC):

The income consumption curve (ICC) can be used to derive the Engel Curve, which shows the

relationship between income and quantity demanded.

The price consumption curve (PCC) traces out the optimal choice of consumption at different

prices. The PCC can be used to derive the demand curve, which shows the relationship

between price & quantity demanded.

When the price of one good change, two things happen:

· One the purchasing power of consumer changes i.e., the budget line shifts (leads to

income effect).

· Secondly, the slope of budget line changes due to a change in the relative price ratio

(leads to substitution effect).

The substitution effect of a price rise is always negative, while the income effect of a price

rise on the consumption of a normal good is negative. The income effect for an inferior good

is positive. The income effect of a Giffen good is so positive that it offsets the negative

substitution effect, therefore.

Limitation of Indifference Approach:

The indifference curves approach has the following limitations:

a. Indifference curve analysis is only possible for 2 or at best for 3 goods.

b. It is almost impossible to practically derive indifference curves.

c. The consumer may not always behave rationally.

d. The consumer may not always realize the level of utility (ex-post) from consumption,

that she originally expected (ex-ante).

e. Indifference curve analysis can not help when one of the goods (X or Y) is a durable

good.

Introduction to Economics ECO401

END OF UNIT 4 - EXERCISES

Do you ever purchase things irrationally? If so, what are they and why is your

behaviour irrational?

A good example is things you purchase impulsively, when in fact you do have time to reflect

on whether you really want them. It is not a question of ignorance but a lack of care. Your

behaviour is irrational because the marginal benefit of a bit of extra care would exceed the

marginal effort involved.

Imagine that you are going out for the evening with a group of friends. How would you

decide where to go? Would this decision-making process be described as `rational'

behaviour?

You would probably discuss it and try to reach a consensus view. The benefits to you (and to

other group members) would probably be maximized in this way. Whether these benefits

would be seen as purely `selfish' on the part of the members of the group, or whether people

have more genuinely unselfish approach, will depend on the individuals involved.

If you buy something in the shop on the corner when you know that the same item

could have been bought more cheaply two miles up the road from the wholesale

market, is your behaviour irrational? Explain.

Not necessarily. If you could not have anticipated wanting the item and if it would cost you

time and effort and maybe money (e.g. petrol) to go to the wholesale market, then your

behaviour is rational. Your behaviour a few days previously would have be irrational, however,

if, when making out your weekly shopping list for the wholesale market, a moment's thought

could have saved you having to make the subsequent trip to the shop on the corner.

Are there any goods or services where consumers do not experience diminishing

marginal utility?

Virtually none, if the time period is short enough. If, however, we are referring to a long time

period, such as a year, then initially as more of an item is consumed people may start `getting

more of a taste for it' and thus experience increasing marginal utility. But even with such

items, eventually, as consumption increases, diminishing marginal utility will be experienced.

If Ammaar were to consume more and more crisps, would his total utility ever (a) fall to

zero; (b) become negative? Explain.

Yes, both. If he went on eating more and more, eventually he would feel more dissatisfied

than if he had never eaten any in the first place. He might actually be physically sick!

Complete this table to the level of consumption at which total utility (TU) is at a maximum,

given the utility function TU = Q + 60Q 4Q2.

4Q2

60Q

120

104

180

144

240

176

300

100

200

360

144

216

420

196

224

480

256

224

Derive the MU function from the following TU function:

Introduction to Economics ECO401

TU = 200Q 25Q² + Q³

From this MU function, draw up a table (like the one above) up to the level of Q where MU

becomes negative. Graph these figures.

MU = dTU/dQ = 200 50Q + 3Q²

3Q2

200

50Q

200

153

200

100

112

200

150

200

250

200

300

108

200

350

147

180

160

140

120

100

-2 0

If a good were free, why would total consumer surplus equal total utility? What would be

the level of marginal utility?

Because there would be no expenditure. At the point of maximum consumer surplus, marginal

utility would be equal to zero, since if P = 0, and MU = P, then MU = 0.

Why do we get less consumer surplus from goods where our demand is relatively

elastic?

Because we would not be prepared to pay such a high price for them. If price went up, we

would more readily switch to alternative products.

How would marginal utility and market demand be affected by a rise in the price of a

complementary good?

Marginal utility and market demand would fall (shift to the left). The rise in the price of the

complement would cause less of it to be consumed. This would therefore reduce the marginal

Introduction to Economics ECO401

utility of the other good. For example, if the price of lettuce goes up and as a result we consume

less lettuce, the marginal utility of mayonnaise will fall.

The diagram illustrates a person's MU curves of water and diamonds. Assume that

diamonds are more expensive than water. Show how the MU of diamonds will be greater

than the MU of water. Show also how the TU of diamonds will be less than the TU of

water.

MU, P

MU water

MU diamonds

Define `risk' and `uncertainty'.

Risk: when an outcome may or may not occur, but its probability of occurring is known.

Uncertainty: when an outcome may or may not occur and its probability of occurring is not

known.

Give some examples of gambling (or risk taking in general) where the odds are (a)

unfavorable; (b) fair; (c) favourable.

a. Betting on the horses; firms launching a new product in a market that is already virtually

saturated and where the firm does not bother to advertise.

b. Gambling on a private game of cards which is a game of pure chance; deciding which of

two alternative brands to buy when they both cost the same and you have no idea which

you will like the best.

c. The buying and selling of shares on the stock exchange by dealers who are skilled in

predicting share price movements; not taking an umbrella when the forecast is that it will

not rain (weather forecasts are right more often than they are wrong!); an employer

taking on a new manager who has excellent references from previous employers.

(Note that in the cases of (a) and (c) the actual odds may not be known, only that they are

unfavorable or favourable.)

Which game would you be more willing to play, a 60:40 chance of gaining or losing Rs10

000, or a 40:60 chance of gaining or losing Re1? Explain why.

Most people would probably prefer the 40:60 chance of gaining or losing Re1. The reason is

that, given the diminishing marginal utility of income, the benefit of gaining Rs10 000 may be

considerably less than the costs of losing Rs10 000, and this may be more than enough to deter

people, despite the fact that the chances of winning are 60:40.

Do you think that this provides a moral argument for redistributing income from the rich

to the poor? Does it prove that income should be so redistributed?

Introduction to Economics ECO401

Arguments like this are frequently used to justify redistributing income and form part of people's

moral code. Most people would argue that the rich ought to pay more in taxes than the poor and

that the poor ought to receive more state benefits than the rich. The argument is frequently

expressed in terms of a pound being worth more to a poor person than a rich person. It does

not prove that income should be so redistributed, however, unless you argue (a) that the

government ought to increase total utility in society and (b) that it is possible to compare the

utility gained by poor people with that lost by rich people something that is virtually impossible

to do.

What details does an insurance company require to know before it will insure a person to

drive a car?

Age; sex; occupation; accident record; number of years that a license has been held; traffic law

violations and convictions; model and value of the car; age of the car; details of other drivers of

the car.

How will the following reduce moral hazard?

a. A no-claims bonus.

b. The driver having to pay the first so many rupees of any claim (called "excess").

c. Offering lower premiums to those less likely to claim (e.g. if a house has a burglar alarm,

it is less likely to be burgled and therefore the insurance premiums for its contents TV,

VCR, etc. can be reduced by the insurance company).

In the case of (a) and (b) people will be more careful as they would incur a financial loss if the

event they were insured against occurred (loss of no-claims bonus; paying the first so much of

the claim). In the case of (c) it distinguishes people more accurately according to risk. It

encourages people to move into the category of those less likely to claim (but it does not make

people more careful within a category: e.g. those with burglar alarms may be less inclined to turn

them on if they are well insured!).

If people are generally risk averse, why do so many people around the world take part in

national lotteries?

Because the cost of taking part is so little, that they do not regard it as a sacrifice. They also are

likely to take a `hopeful' view (i.e. not based on the true odds) on their chances of winning. What

is more, the act of taking part itself gives pleasure. Thus the behaviour can still be classed as

`rational': i.e. one where the perceived marginal benefit of the gamble exceeds the marginal cost.

Why are insurance companies unwilling to provide insurance against losses arising from

war or `civil disorder'?

Because the risks are not independent. If family A has its house bombed, it is more likely that

family B will too.

Name some other events where it would be impossible to obtain insurance.

Against losses on the stock market; against crop losses resulting from drought.

Although indifference curves will normally be bowed in toward the origin, on odd

occasions they might not be. What would indifference curves look like in each of the

following cases?

a. X and Y are left shoes and right shoes.

b. X and Y are two brands of the same product, and the consumer cannot tell them

apart.

c. X is a good but Y is a `bad' like household refuse.

a. L-shaped. An additional left shoe will give no extra utility without an additional right shoe

to go with it!

b. Straight lines. The consumer is prepared to go on giving up one unit of one brand

provided that it is replaced by one unit of the other brand.

Introduction to Economics ECO401

c. Upward sloping. If consumers are to be persuaded to put up with more of the `bad', they

must have more of the good to compensate.

What will happen to the budget line if the consumer's income doubles and the price of

both X and Y double?

It will not move. Exactly the same quantities can be purchased as before. Money income has

risen, but real income has remained the same.

The incomeconsumption curve is often drawn as positively sloped at low levels of

income. Why?

Because for those on a low level of income the good is not yet in the category of an inferior

good. Take the case of inexpensive margarine. Those on very low incomes may economise on

their use of it (along with all other products), but as they earn a little more, so they can afford to

spread it a little thicker or use it more frequently (the incomeconsumption curve is positive).

Only when their income rises more substantially do they substitute better quality margarines or

butter.

Illustrate on an indifference diagram the effects of the following: A ceteris paribus (a) rise

in the price of good Y (b) fall in the price of good X.

a. The budget line will pivot inwards from B1 to B2.

b. The budget line would pivot outward on the point where the budget line crosses the

vertical axis. It is likely that the new tangency point with an indifference curve will

represent an increase in the consumption of both goods. The diagram above can be

used to illustrate this. Assume the budget line pivots outwards from B1 to B2. The

optimum consumption point will move from point a to c.

Illustrate the income and substitution effects in the above question.

See the diagram above. In each case the substitution effect is shown by a movement from point

a to point b and the substitution effect is shown by a movement from point b to point c.

Are there any Giffen goods that you consume? If not, could you conceive of any

circumstances in which one or more items of your expenditure would become Giffen

goods?

Good Y

B1a

Good X

Substitution

Good X

Income

(b) Decrease in price of X

(a) Increase in price of Y

Introduction to Economics ECO401

It is unlikely that any of the goods you consume are Giffen goods. One possible

exception may be goods where you have a specific budget for two or more items,

where one item is much cheaper: e.g. fruit bought from a greengrocer (or rehri waala

on the street). If, say, apples are initially much cheaper than bananas, you may be able

to afford some of each. Then you find that apples have gone up in price, but are still

cheaper than bananas. What do you do? By continuing to buy some of each fruit you

may feel that you are not eating enough pieces of fruit to keep you healthy and so you

substitute apples for bananas, thereby purchasing more apples than before (but

probably less pieces of fruit than originally).

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