The Substitution Effect and the Income Effect in Microeconomics - Assignment Example

Question 1:- Utility is basically a hypothetical unit that is derived to ascertain the level of satisfaction that is derived from the consumption of a good. Now, Utility maximization is the instance whereby the satisfaction of the customers is maximized at their respective levels of consumptions of the good. Now, this maximization can only be achieved if people have to pay for the good the price that they feel is pertinent and which most importantly, the customers are willing to pay. Now, we introduce the concept of a budget constraint. A Budget constraint is basically representative of that optimal combination of goods that a consumer can purchase given current prices and the customer’s respective income. Now, when we put these two conditions together, we arrive at a condition whereby at any given level of prices and income, the level of consumption of a good is at the exact price that the customer is willing and able to pay for that good and at that point utility of consumption is maximized i.e. the greatest level of satisfaction can be realized at a given set of prices and income which inherently is the level of product demanded at that given price and quantity. All of these points put together become the demand curve of the good; therefore, we can say that the demand curve for a commodity can be derived from utility maximization subject to a budget constraint. 1 The Substitution Effect: This effect is caused by that reaction of consumers with respect to the change in the price of a good in the quantity demanded of the good that arises due to the consumer altering between two closely substitutable good. For example, let’s assume there are two good X and Y, when the price of X would fall, the price of Y would become larger in comparison to X, and people would be more interested in the cheaper good X now that it is cheaper. This decision is based on the law of marginal returns i.e. good X can give the consumer the same satisfaction as good Y but at a lower cost, and the fact that market equilibrium is not being preserved by the consumer at this point in time. Now, in the case where the price of good X falls, its market marginal utility is on the rise, and the best strategy to cash in on this is to buy more units of good X. This sees a fall in the demand of Y which encapsulated the entire concept of substitution effect.2 Source: http://upload.wikimedia.org/wikipedia/en/thumb/a/aa/Hicks_Substitution_effect.svg/405px-Hicks_Substitution_effect.svg.png The Income Effect: The change in price on quantity demanded due largely to the fact that consumers will better off (or worse off) due to the change in price of the good, arising from the consumer becoming better or worse off as a result of the price change. The declining prices of good X leads to a boom in the real income of the consumer and as both of these goods are normal goods.3 Source: http://upload.wikimedia.org/wikipedia/en/thumb/a/a3/Found_demand.svg/414px-Found_demand.svg.png Now, in the instance of a price change and for a normal good, the income effect and the substitution effect will both be geared towards the same direction. As with any hike in prices, the increased priced will reduce the quantity demanded for that good. Now, we take the example to of an inferior good, which we want to determine as to whether it obeys the law of demand i.e. the demand of a Giffen good is downward sloping. Now, for an inferior good, the substitution effect and the income effect are both directed towards opposite directions. However, the substitution effect is much larger than the income effect for these inferior goods; therefore, a decrease in price leads to a fall in demand. In the instance of a change in price of an inferior good, the change in quantity demanded will be equal to the summation of the substitution effect and the income effect. Therefore, we can safely assume that even inferior goods follow the laws of demand. So, we have determined that a normal good and an inferior good both have downward sloping demand curves, hence, they are said to follow the law of demand. Despite this, there are still some examples of some goods that are in complete opposition to the law of demand i.e. their demand curves are upward sloping.4 Question 2: The situation whereby the entity purchasing a commodity and the entity selling that commodity do not have the same type or level of information with regards to the commodity that is being transferred is known as Information asymmetry. Figure 10 is an illustration of this phenomenon. DU and DI represent the two different scenarios that the demands of the good vis-à-vis the consumer can take place i.e. the case with the absence and the case with the presence of perfect information with regards to the commodity. This is why the sub-scripts U are attached to the labels of the demand curves as they determine consumer’s ‘uninformed’ i.e. U and ‘informed’ demands. Now, the actual amount of the commodity that is being traded is given by the notation YU on our graphical representation and as can be witnessed from the graph; this quantity is larger than the quantity YI which represents the amount of the commodity in question that is being traded in the case of perfect information on the part of the purchasers.So, as we can see from the graph, the area demarcated by puBApI on the graphy determines th increased augmentation in producer’s surplus due to the “over-compensation’ on the part of the consumers. Due to this same phenomenon i.e. “over-compensation”, the producer’s surplus increased by the amount demarcated on the graph by the area puBApI. Therefore, the overall loss in the surplus of the consumers is given by: ApIE – (OpUBYU-OECYU) = ApIE – (pUEF – FBC) = ApIpUF+ FBC. Therefore, we can see that the net loss that the society faces in lieu of the phenomenon of “over-compensation” is determined mathematically by the loss to the consumers less the gain to the producer and this is given by = ApIpUF + (AFB+ABC) – (ApIpUF + AFB) =ABC. In the instance whereby the consumers of a commodity overestimate the quality of said commodity due a lack of persistent and accurate information being made available to them, then the producers of these commodities are not motivated enough to divulge these necessary pieces of information which lie at the crux of the over-valuation of the commodities. This is because producer surplus may drop in the case of accurate information being made available to the consumers. The above analysis can also be applicable in the instance whereby lack of necessary information may cause consumers to undervalue the commodity i.e. ‘under-consumption’. In this case, the producers of these goods would have the incentive to provide the necessary set of information whereby consumers would begin to increase the value they attach to these goods. An analysis, identical to that above, would apply if, due to lack of information, consumers underestimated quality so that there was ‘under-consumption’. Now, however, producers would have an incentive to provide information since accurate information would now lead to a higher surplus for the producer. Now, the effectiveness of a strategy for information-gathering depends upon: The variability of the quality of the product Level and regularity of purchase The holistic price of the good and possible side effects of use Exploration costs5 Question 3: The long-run average cost curve indicates the per unit cost of producing a good or service in the long run in instance where all the input factors are varying whereas the short run average total cost looks at the cost of production in the case where some input factors are constant. Now these cost are U-shaped because they are indicative of the economies of scale when the curve is downward sloping and diseconomies of scale when the curve is upward sloping. Therefore, in the upward sloping section of the curve the marginal cost of producing one more unit is larger than the previous, hence, the total cost is increasing and hence, increasing the scale of production will increase overall level of costs. In comparison, in the downward sloping section of the graph, the marginal cost of producing an extra unit is less than producing the previous unit, therefore, total costs would decrease in the instance of increasing the scale of production and hence the firm would enjoy economies of scale as described earlier.6 Now, the important thing to understand is the notion of increasing or decreasing returns to scale. In increasing returns to scale, the output produced when the input factors are processed is greater in proportion than the expected output from the same level of inputs before these inputs are processed. This inherently means the actual output is greater than the expected output for a given level of inputs. Now, in the case of increasing returns to scale, the effect of increasing input factors should be greater than the proportionate increase that was expected and the increase would be less than the proportionate increase in the case of decreasing returns to scale. A pertinent example for this concept is the Cobb-Douglas production function which usually takes the form: Q = a*(X1) b*(X2) c Now, if the sum of b and c in the function becomes greater than one, than the product enjoys increasing returns to scale. In the case where the sum is less than one, then the production function suffers from decreasing returns to scale and the production function is said to have constant returns to scale in the case where the sum is exactly equal to one. Short run Average Total Cost Source: http://upload.wikimedia.org/wikipedia/commons/9/9a/Costcurve_-_Av_Total_Cost.PNG Long run Average Total Cost Source: http://upload.wikimedia.org/wikipedia/commons/2/2f/Costcurve_-_Long-Run_Av_Cost.PNG Question 4(A): A Public good is any good or service that is identified by the key characteristics of non-rivalry and the inability to be excluded from the market. Therefore, none of the firms in the market has any incentive to produce a public good and hence, it is never provided by the actions of the free but rather but the state or government. A public good is for the use of everyone present in the society and it has no specific ownership rights. Question 4(B): The basic reason why the production of public goods is impossible is due to the presence of free-riders. A free-rider problem is the scenario whereby a good purchased by some one else in the society is being consumed by people who are present in the society but are not the owner of that good. Therefore, any efficient production of public goods is hampered by its illegal use by people who only aim to use these goods but in no way act to preserve or restore them to their original conditions. Question 4(C): The optimal level of the provision of a public good can be determined very simply by conducting a cost benefit analysis and finding the equilibrium point where both the costs and the benefits and equal. The benefits of the provision of a public good have already been identified whereas the costs of such a provision would include lack of ownership or accountability, loss in market realization due to inability to produce this good on the free market etc. Question 4(D): Pareto efficiency is known as the concept where all possible market adjustments have been made after which any changes in the market will result in the gain of one party only at the expense of another i.e. the market now becomes a zero-sum gain where somebody’s gain is somebody else’s loss. It is Pareto inefficient to exclude anyone from consuming a public good once it is provided because primarily the public good is for the use of everyone so preventing some from using will leave someone worse off, hence, that point would be Pareto inefficient. Secondly, in the instance that somebody is prevented from using a public and subsequently that person uses it, then that benefit will be at the expense of someone else, creating Pareto inefficiency.7 Read More