Question

How are upward sloping consumer demand curves explained in terms of income and substitution ratios?

Answer 1

Basically, the law of demand states that other things remaining constant the quantity demanded increases with the decrease in price and quantity demanded decreases with the rise in price. In this case, the demand curve slopes sownward. There are certain exceptions to the law of demand one of them are Giffen paradox or Giffen goods. In this case the demand curve slopes upward. We need to understand the concept of Giffen paradox.

The concept was introduced after Scotush economists Sir Robert Giffen whi believed in different theory rather then the theory of law of demand. He believed quantity demanded will vary directly with the price of the commodity. He illustrated his theory with the example of bread and meat. According to him, if the prices of the bread fell, the demand of bread will also fall.

The upward slope in demand curve occurs because of the giffen paradox. The quantity consumed will rise with the rise in price and quantity consumed decrease with the decrease in price.

INCOME AND SUBSTITUTION EFFECT:-

The income effect would be important when the consumer is spending a huge amount of his income on consumption so that when the prices falls, , a good amount of income is released. In case if the good is inferior in nature the income effect will be negative as well as strong. The fall in price will lead to fall in quantity demanded. A case in which the consumer reduces his consumption level in contrast to the price of the commodity is called giffen paradox. Let us try to understand through example:-

Suppose the price of the commodity x increases that means it will have less consumption because of its rise in price. The consumer would search for some substitute. Let the substitute good be y. Now the consumer had cut down the consumption of y and other goods in order to satisfy the need of good x. That clearly illustrate that irrespective of the fact that the prices of good x rises the consumer are still willing to consume good x. Consumers spend a huge amount of income on the consumption of inferior goods to get maximum satisfaction. Large negative income effect outweighs the substitution effect.

There are three conditions for giffen paradox:-

1.The substitution effect must be small.

2.Good must be inferior in nature with negative income effect.

3.Income ratio must be huge on inferior goods.

If x is an inferior good, substitution effect would be negative and income effect would be positive.

It will cause the upward shift in consumer demand curves.