Question

By using the indifference curve analysis, derive the demand curve in the case of: (a) Normal good. (b) Inferior good and Giffen good.

Short answer

Answer: In deriving the demand curve using indifference curve analysis, the income effect and the substitution effect play an essential role. For normal goods, both the income and substitution effects lead to a decrease in the good's consumption when its price increases, resulting in a negatively sloped demand curve. For inferior goods, the income and substitution effects work in opposite directions, leading to a negatively sloped demand curve if substitution effect dominates, but a positively sloped demand curve in case of a Giffen good when the income effect is stronger than the substitution effect.

Step-by-step solution

(Normal Good)

A normal good is a good for which the quantity demanded increases with an increase in income and decreases with a decrease in income, keeping the price constant. This positive relationship between income and quantity demanded is indicative of a positive income effect on a normal good. To break down the indifference curve analysis for a normal good, follow these steps: 1. Assume the consumer is initially at an equilibrium point where they're indifferent between two bundles of goods (x and y). 2. Increase the price of the normal good x, which will lead to a new budget constraint and a new tangent on the indifference curve. 3. Observe that the new equilibrium point involves the consumer consuming less of good x and possibly more of good y due to the substitution effect. 4. Observe that the new equilibrium point also involves the consumer consuming less of good x because of the income effect, as the real income level has effectively decreased. 5. Since both income and substitution effects lead to a decrease in the consumption of good x, the demand for a normal good decreases with an increase in its price, forming a negatively sloped demand curve.

(Inferior Good and Giffen Good)

An inferior good is a good for which the quantity demanded decreases with an increase in income and increases with a decrease in income, keeping the price constant. This negative relationship between income and quantity demanded is an indication of a negative income effect on an inferior good. A Giffen good is a special case of an inferior good, where the negative income effect is so strong that it outweighs the substitution effect, causing the demand curve to slope upward. To break down the indifference curve analysis for inferior and Giffen goods, follow these steps: 1. Assume the consumer is initially at an equilibrium point where they're indifferent between two bundles of goods (x and y). Let x be the inferior good. 2. Increase the price of the inferior good x, which will lead to a new budget constraint and a new tangent on the indifference curve. 3. Observe that the new equilibrium point involves the consumer consuming less of good x and possibly more of good y due to the substitution effect. 4. Observe that the new equilibrium point also involves the consumer consuming more of good x because of the income effect, as the real income level has effectively decreased. 5. Now, assess the net effect of income and substitution effects on good x: a. If the substitution effect is stronger than the income effect, the demand for the inferior good decreases with an increase in its price, forming a negatively sloped demand curve. b. If the income effect is stronger than the substitution effect (Giffen good), the demand for the good increases with an increase in its price, forming a positively sloped demand curve.

Key concepts

Demand Curve

The demand curve is a graphical representation that shows the relationship between the price of a good and the quantity demanded by consumers. It typically slopes downward from left to right. This shape indicates that as the price of a good decreases, the quantity demanded generally increases, and vice versa.
However, variations in demand curves can occur based on different types of goods, such as normal, inferior, or Giffen goods. Key characteristics of a demand curve include:

• Price axis and quantity axis: The vertical axis (usually the y-axis) represents price, while the horizontal axis (x-axis) represents quantity.
• Downward slope: For most goods, the demand curve slopes downward, following the law of demand.
• Shifts vs. movement along the curve: A change in price causes movement along the curve, whereas other factors, like income changes or consumer preferences, can shift the curve left or right.

Understanding demand curves helps in predicting how changes in market conditions affect consumer behavior.

Normal Good

A normal good is one where the demand increases as consumer income rises. The opposite is also true - when income falls, the demand for a normal good decreases. This relationship between income and demand leads to a positive income effect. For normal goods, the indifference curve analysis reveals that:

• When the price of a normal good rises, the budget constraint shifts, causing consumers to buy less of the good.
• The substitution effect makes consumers buy less of the good because they switch to cheaper alternatives.
• The income effect also reduces demand because higher prices lower the consumer's purchasing power.

As both effects reduce consumption of the good when its price rises, the demand curve for a normal good is typically downward sloping. This showcase of consumer behavior is vital in market analysis.

Inferior Good

Inferior goods have a unique relationship with consumer income. As income decreases, the demand for these goods increases, and when income increases, the demand decreases. This negative income effect sets inferior goods apart. Looking at the indifference curve analysis:

• Increasing the price leads to fewer purchases through the substitution effect, as consumers turn to alternative goods.
• The income effect can increase demand by incentivizing consumers to revert to these cheaper options as their effective income lowers.
• If the substitution effect outweighs the income effect, the demand curve remains negatively sloped.

However, understanding the balance of effects is crucial in analyzing consumer choices for inferior goods, as they often defy the typical rules of demand.

Giffen Good

Giffen goods are a special case of inferior goods. They exhibit an unusual demand curve that slopes upwards, meaning demand rises as prices increase. This defies the general expectation where higher prices reduce quantity demanded. Decomposing this phenomenon involves:

• The income effect is significantly strong, overtaking the substitution effect. As prices rise, the strong negative income effect compels consumers to buy more of the good to maintain basic sustenance.
• This leads to a positively sloped demand curve, a rarity in economic analysis.

Giffen goods highlight extreme cases of consumer behavior and are important for recognizing exceptions to the typical laws of demand. They require unique consideration in economic studies and planning.