D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869 Part A - 1 Indifference Curves - food and clothing only. food f1

fc

c c1

clothing

Indifference curves indicate bungles of goods which are equally preferred, in Ramya's case combinations of food and clothing. Lines of iso-satisfaction. When based on the following assumptions the curves are convex to the origin, curving down to the right - - a diminishing marginal rate of substitution, people are prepared to give up more and more of an increasingly abundant good in exchange for less and less of an increasingly scarce good, as they 'weigh up' value and rank preferences which are described as 'ordinal'; people exercise choice - consistency, curves cannot cross, if bungle 'a' is preferred to 'a1', and if 'a2' and 'a' are equally preferred, then 'a1' cannot be preferred to 'a2'; people are rational - non satiation, more is wanted, satisfaction or utility increases away from the origin reflecting combinations with larger quantities of food and clothing; people are confronted with a scarcity of utility. Any combination of food and clothing will lie on an indifference curve, to cover all possible combinations there will be a family or map of curves. Although all combinations can be ranked and positioned on indifference curves, real choices are constrained. In Ramya's case they will be constrained by her income and the prices of food and clothing. If Ramya's income is to be spent solely on food and clothing and at current prices it is sufficient to purchase either f1 units of food or c1 units of clothing, a 1 D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869 budget constraint, line f1 c1, can be drawn on the indifference map. Combinations below and to the left of this line are feasible purchases within the constraint whilst combination above and to the right of the line are not affordable. To maximise utility Ramya will choose a combination of goods which is both feasible and maximises quantities, that is, a combination which lies on an indifference curve furthest away from the origin. Point 'a' represents such a combination. To buy more units or less units of either food or clothing on the budget line would result in a lower utility. 2 Budget lines for food and clothing food f1

f2

f3

c4 c2 c1 c3 Clothing

(a). Assuming no change in income, at the original prices Ramya could purchase either f1 units of food or c1 units of clothing, giving the budget line f1 c1, and maximum utility at 'a1'. An increase in the price of clothing would result in a new budget line f1 c2. Less clothing available at the increased price, with maximum utility at 'a2'. (b). If the price of food increased and the price of clothing decreased the new budget line would be f2 c3, with maximum utility at 'a3'. (c). If her income reduced and prices remained stable, a new budget line would be parallel to f1 c1 but shifted towards the origin reflecting the lower feasible purchase quantities f3 and c4, with maximum utility at 'a4'. 3. Normal, inferior and Giffen goods. a) Normal b) Inferior food

f2 f1 f1 f2 2 D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869

clothing What happens to Ramya's consumption of food when her income increases or decreases depends on the shapes of her indifference curves. Different shapes indicate different consumption behaviour. a) shows food as a normal good, as income decreases from aa to bb consumption decreases from f1 to f2. b) shows food as an inferior good, as income decreases consumption of food increases from f1 to f2. Normal, inferior and Giffen goods. (food price increase) food

Clothing

What happens to Ramya's consumption of food when prices change can also be analysed using indifference curves. In this case consumption depends on the relative magnitudes of the income and substitution effects. These effects distinguish normal, inferior and Giffen goods. The response to a price rise in food, shifting the budget line from zz to zy, can be split into a substitution effect and income effect. The substitution effect, movement at the same utility to 'a1' from an initial preference bungle 'a', indicates the decreasing preference for food as the price rises and clothing is substituted. Given the assumptions underpinning convex indifference curves, this effect in response to a price rise is always in the same direction, higher prices result in less consumption. However there is also an income effect resulting from the changed level of real disposable income. This is indicated by a shift in the budget line towards the origin from 'a1' to the new zy position. 3 D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869 Depending on the shape of the indifference curves, a lower utility curve could meet the new budget line maximising utility at 'n', 'I' or 'g'. 'n' indicates a normal good, where the substitution effect and the income effect act in the same direction and consumption of food falls. 'i' is an inferior good, where the income effect acts in the opposite direction to the substitution effect but is smaller and consumption still falls. 'g' is a Giffen good, where the income effect is greater than the substitution effect and consumption of food rises as the price rises.

Part B - Introduction. When grappling with the immense complexities of the real world, economists are forced to simplify their models to enable analysis. While this can provide illuminating insights into understanding, such models are risky as policy determinants. In reality the 'ceteris paribus' assumption, essential to all simplified models, is always invalid. Variables are not independent and not controllable. Neo-classical demand theory. An important insight of neo-classical theory is the downward sloping demand curve, 'a useful device which enables economists to predict the behaviour of consumers in response to price changes' [1]. Underpinned by indifference curve analysis it provides a robust explanation for the 'sovereignty' of consumers in markets when confronted with choice. The key to understanding the neo-classical demand curve is that it indicates only price effects at the margin, changes in any other exogenous factor shifts the curve. Neo-classical supply & demand price s s1

exogenous 4 D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869 - income - substitutes p1 - technology - social factors p2 - etc etc d - everything but price!

q1 q2 quantity

Cartier's introduction of 'a less expensive collection of watches' shifting the supply to 's1' could be based on neo-classical theory and a strategy of reducing prices 'p1' to 'p2' to increase sales 'q1' to 'q2'. The jewellery trade sceptics insist this strategy will not increase sales but will 'devalue the old Cartier name' suggesting other factors apart from price might be involved. Problems with neo-classical demand theory. The assumptions of decreasing marginal rate of substitution, preference ranking, non satiation and consistency can all be shown be anomalous in certain real situations. Some of these weaknesses are exemplified in Cartier's activities, which appear to undermine consumer 'sovereignty' and support the idea of a consumer 'dependent' on marketing manipulation? Both Veblen and Bourdieu suggested consumer behaviour was much more complex and subtle than a simple response to price, casting doubt on the neo- classical consumer maximising utility in the face of budget constraints. Alternative theories. Veblen's approach focused on 'conspicuous consumption' as consumers aspired to belong to a higher social class, ostentatiously emulating others in an attempt to 'keep up with the Jones's'. The economic significance of this was the suggestion that this type of consumption was 'wasteful'. More recently J K Galbraith has written a popular exposition of this belief [2]. Bourdieu extended the idea to encompass aspirations for 'distinctiveness' as a means to higher status. Individuality was the route to gaining esteem and respect from fellow group members. These ideas fit well with the Cartier marketing strategy of encouraging jewellery sales as status symbols satisfying a desire to belong to a group or seek esteem. If perceived value is associated with price, marginal rates of substitution may not diminish when price increases. The 'grand old Cartier name' may have been established by price induced scarcity. Furthermore Cartier's propensity to keep sales figures under wraps and 'be as secretive as a Swiss Bank' may owe something to maintaining this image of scarcity. Exclusivity seems to support these ideas of status seeking. 5 D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869 Furthermore, ranking may not possible in situations of 'necessity', a staving girl will find it difficult to rank bread and potatoes. But ranking can also be difficult when demonstrable benefits are absent. Cartier's jewellery maybe indistinguishable from competitors. Their differentiation strategy appeared to depend more on fashionable endorsements of celebrities and 'private commission still represents a sizeable chunk of Cartier's sales, enhancing the brand's prestige'. This is pure Veblen, the desire to join an elite group and adopt its identity symbols. Another neo-classical assumption, non satiation, cannot apply when value disappears and there are gluts that price reductions cannot clear. Selling refrigerators to Eskimos is an oft quoted example. But Cartier's approach to selling jewellery to the 'nouveaux riche' had little to do with practical benefit and more to do with aspirations. Perhaps 'nouveaux rich' Eskimos do have refrigerators to indicate membership of a 'Veblen' group or attain 'Bourdieu' status? Wedgewood went as far as to suggest a business strategy where 'fashion is infinitely superior to merit', although he was less than clear about a definition of merit. Consistency over time is also often fragile as people learn and experiment, and fashion and tastes change. Cartier was well aware of the Italian competition 'now challenging France's dominance in fashion'. Fashion and taste change as perceived association with groups or status change. Problems with institutional theory. Veblen and Bourdieu are disingenuous with their institutional approach when proposed as an alternative to neo-classical theory. Aristotle centuries previously understood the complexity of human behaviour. He identified 'feelings of recognition and affiliation that link every human being, including common bodily appetites and pleasures, fear of losing resources, association and fellowship, respect for one's own worth and the planning of one's own life's project'. Maslow has more recently [3] produced a theory of human behaviour based on a hierarchy of successively satisfied needs which mirror Aristotle's thoughts. Basic needs are physiological (food, shelter, sex), followed by a concern for their security against the vicissitudes of life, then social desire to belong to a group become important, and later a need for esteem, respect and recognition from the group, finally leading to an ultimate motivational concern with self- fulfilment. Veblen's conspicuous consumption is akin to the social activity of Maslow level three and Bourdieu's distinctiveness is Maslow level four. The utility which consumers maximise is complex indeed. It would appear all behaviour is more generally explained as part of a continuum as people struggle to find perceived value in excess of cost in a scarce environment.

6 D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869 But Veblen and Boudieu not only oversimplify motivation but in their wake institutional economists also misapply neo-classical demand theory. The downward sloping demand curve has taste, fashion and social factors as exogenous. When fashion changes the demand curve shifts. Cartier's strategies present no problem for neo-classical theory. Derivation of the Veblen demand curve. residual Indifference map price increase of jewellery. income

price Cartier jewellery Demand curves for jewellery.

quantity

Price is not an independent variable but one of the determinants of 'fashion'. Fashion cannot be exogenous in these circumstances, the theory does not collapse but the interpretation changes. If exogenous variables remain exogenous the substitution effect is always robust. More value will always but exchanged at lower cost, providing it remains valuable! Ceteris paribus. The income effect analyses changed circumstances where perceptions of value change. In the above figure, at the new price there is a new set of indifference curves reflecting the changed circumstances. The move of the derived demand from 'a' to 'b' as price changes from 'p1' to 'p2' is not movement along an upward sloping curve but the result of a shift in the curve from 'd' to 'd1'. Evolutionary reality. Daniel Dennett has described human behaviour as an evolutionary phenomena he describes as 'satisficing', choosing the best perceived option available at the time in a specific environment [4]. Once maximising utility is broadened to include the continuum of different hierarchical motivations included in the Maslow/Dennett approach, Cartier's strategy is consistent with neo-classical theory 7 D 319 TMA 01 - 24/3/99 J.P.BIRCHALL PO194869 Reality is not about 'sovereign' individuals nor 'dependency' and manipulation by social institutions, both are parallel manifestations of evolution. Individuals take decisions but they are influenced and constrained by their environment. The two theories are not mutually exclusive. Conclusion . Demand curves shift in addition to movement along them. Demand = f (price), ceteris paribus. But in the real world, Demand = f (price, income, substitutes, complements, social factors, future expectations …. etc. etc... ). A much more complex set of variables. However, all is not lost and with modern computers and powerful statistics, multiple regression can help to separate the effects of these variables, if they can be measured. Unfortunately, reality is even more complex because the variables themselves are not independent. Each one effects all the others and the equations become non-linear with no specific solution. But, again all is not lost, with today's computing power the equations can be iterated and patterns do emerge. Economists are now 'internalising' exogenous variables and gaining new insights into complex real situations. Policy is taking these developments in economic theory into account. For example, New Labour's strategy has moved away from simplistic alleviation of poverty by redistribution towards 'endogenous growth' where other variables like education and technology become relevant. Neo-classical theory is not being rubbished the curve is being shifted ...

[1] Trigg (1964) - D319 Households, OU. [2] Galbraith (1958) – The Affluent Society, Hamish Hamilton. [3] Maslow (1964) - Motivation and Personality, New York, Harper. [4] Dennett (1996) – Darwin's Dangerous Idea, Touchstone.

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