Question

What determines the shape of a demand curve? In your explanation, you must define the income and substitution effect.

Answer 1

A demand curve is a graph that shows how many quantity of goods is demanded at what price. It is a negatively shaped curve due to an inverse relationship between the change in price of a good and its quantity demanded at a particular time. The inverse relationship is due to the law of diminishing marginal utility. The law of diminishing marginal utility states that the satisfaction derived from the consumption of each extra unit of a good consumed keeps on diminishing. This is true for the reason that the consumer is ready to pay a lower price for a higher quantity. As the price of the good rises, the consumer consumes lesser quantity.

Substitution Effect refers to a situation in which when the income of a consumer decreases or the price of a good increases, the consumers replace expensive goods with less expensive goods. When the price of expensive goods decrease or income of the consumer rise, consumers replace the low-cost goods with expensive or luxury items. The substitution effect is not a good situation for the economy as it results in a few choices for producers and consumers.
The demand curve for two goods A and B shows the substitution effect between the two goods, and is concave in shape. An increase in price of one good results in less units of consumption of that good and more units of consumption of the cheaper good. The substitution effect depicts how a change in the relative price of a good impacts the overall consumption pattern and further, the shape of the demand curve. The slope of the demand curve remains the same throughout.

Income effect refers to the change in the quantity demanded of a good or a service, when the purchasing power (real income) of a consumer changes. There can be a change in the buying capacity of a consumer due to an increase/decrease in the real income (wages) of the consumer or an increase/decrease in the spending on a consumer good. The income effect depicts how a change in the purchasing power of a consumer impacts overall consumption and hence, the shape of demand curve.

The consumption patterns of the consumer goods and services can be effected by the changes in the real incomes or relative prices of the goods and services. These are shown by the changes in the substitution and income effects which show the impact of the resulting changes in consumption expenditures on consumer demand curves.