Show Carefully How A Market Demand Curve Can Be Derived From Individuals? Indifference Maps And Budg Essay, Research Paper

I will split the answer to this

question into four distinct parts.

Firstly I will show how indifference curves and budget constraints can

be used to construct an individual?s demand curve for a product. Secondly, I will describe and explain the

characteristics of the demand curves for normal, inferior and Giffen

goods. Thirdly I will show how

individual?s demand curves can be combined to form a market demand curve for a

product. Finally I will discuss how a

market demand curve can be estimated. Indifference curves graphically

connect bundles of goods. The consumer

is indifferent about the goods on the indifference curve. Any of the goods on the indifference curve

present the consumer with the same amount of utility. We do not quantify this utility, but instead use representation

theorem to rank levels of utility.

Budget lines are autonomous of taste and preferences and show

combinations of goods that the consumer can afford to buy with a fixed

level of income. The two curves combine

and the point where the indifference curve is tangent to the budget line

depicts the optimal choice between the goods (point A below). At this point the consumer is maximising his

utility, whilst not over or under spending in relation to his budget. By using comparative statics and

ceteris paribus we can see what effect a change in price will have upon the

optimal choice, and thus upon demand.

So, if we hold constant the level of income and the price of good 2, as

well as assuming that tastes and preferences have not changed, then we can

clearly see the effect of a price rise.

By raising the price of good 1 we flatten the budget line. As we can see from the diagram below the

price rise has pivoted the budget line to the left. Consequently a new optimal choice point is shown. We can see graphically that the increase in

price has lessened the demand for good 1.

If we continue raising the price, and marking the optimal choice points,

we can create a price offer curve.

A price offer curve simply depicts the optimal choice points as the

price changes (see diagram below). By

using the information from the price offer curve we can create the demand

curve. The demand curve is the plot of the demand function. The demand function is in this case

x1(p1,p2,m), or demand is equal to the function of the price of good 1, the

price of good 2 and money income. By

looking at the price offer curve we can see the quantity demand of good 1 at

different prices. We know this is the

demand function because we keep price 2 and money income fixed. As we see from the diagram below the demand

curve is usually negative, or downward sloping. For ordinary goods as price increases demand

decreases. So the change in quantity

demanded divided by the change in price will always lead to a negative number. However not all goods are

ordinary. As you increase the price of

some goods their demand increases, or the change in quantity demand divided by

the change in price leads to a positive number. These goods are known as giffen goods. We see from indifference curve analysis that

the price decrease causes a decrease in demand for good 1 (assuming that money

income is fixed and price 2 is unchanged).

The change in quantity demanded can be split up into substitution and

income effects. In the case of the

Giffen good the income effect causes a large reduction in demand, which

outweighs the substitution effect that increases demand (see diagram below).

The income effect simply measures the change in demand due to the change in

purchasing power (change in real income due a price change). But why is the income effect so large for a

Giffen good? By reducing the price of

good 1 purchasing power is increased, whilst money income is kept

constant. In the case of the Giffen

good the consumer uses the extra purchasing power to decrease his consumption

of good 1 by increasing his consumption of good 2! The price change also changes purchasing power, which in turn

changes demand. By joining up the optimal choice

points on the indifference map we see a different price offer curve to that of

an ordinary good. By plotting the

prices of good 1 at these optimal choice points and the quantity demand of

these goods at these prices we again draw a demand curve. However the demand curve for a Giffen good

is upward sloping (as seen in the above diagram). Inferior goods are goods whose

demand will increase upon a decrease in income, and whose demand will decrease

upon a rise in income. By increasing

income and shifting the budget lines to the right, we see that the optimal

choice point show a decrease in consumption of good 1 (assuming ceteris

paribus). By mapping the optimal choice

points for different levels of income we create an income offer curve. We then extrapolate the information from an

income offer curve and plot an Engel Curve.

Engel curves simply measure the demand for goods as a function of

income. As we see below an increase in

income causes a decrease in consumption for inferior goods, thus the Engel

curve is negatively sloped. However for

normal goods an increase in income causes an increase in consumption, thus

creating a positively sloped Engel curve. We know that price changes affect

purchasing power. A prices decrease causes real income to increase, and as in a

Giffen good, causing an income effect. The income effect for a price decrease

in this case causes negative income effect or a fall in demand. However inferior goods also have positive

substitution effects. When the price

decreases the change in the relative price causes consumers to switch over to

good 1. If the substitution effect

outweighs the income effect then the good is inferior (a price decrease still

causes a rise in demand), but if the income effect outweighs the substitution

effect then the good is a Giffen good. If plot the demand curves from

the price offer curves we see that it is only the Giffen good that produces an

upward sloping demand curve (price function demand curves), whereas normal and

inferior goods produce downward slopping demand curves (price function demand

curves). An inferior good may have an

inelastic curve as it is less responsive to price movements as a result of the

opposing income and substitution effects. An individual?s demand curve for

a good depends on prices and his income, but a market demand curve depends on

the same prices and distributions of all individual?s income. However it is more convenient to see

aggregate demand as a demand curve based on the same prices as an individual?s

demand curve with the sum of all individual?s income. Geometrically we simply add up

all individuals? demand curves horizontally.

We have to be careful not to add up linear demand functions (for example

20 ? p + 10 ?2p) as they are not technically linear demand functions. This concept is explained graphically below. In short it is very difficult to

estimate demand functions, but there are ways that it can be attempted. A simple way would be to interview

consumers. However how do we know that

consumers are honest? Will they make

snap judgements? To avoid these

artificial market situations could be created in consumer clinics. A group of people are given money to spend

on a set of goods. The moderator could

then change the price and view the effect on demand. This kind of strategy can be revealing, but does not supply the

necessary quantitative information required for a more precise estimation of

the demand function. A more expensive

and complex approach is known as the direct market approach. If a company waned to know the effect of

advertising upon the demand for a product they could change the level of

advertising in three different areas and examine the consequent changes in

demand. However this approach does not

counter the problem of other variables affecting demand. It is also costly and time consuming. However it could be used to cross check a

more statistical approach. The standard statistical approach

utilises historical data and attempts to extrapolate demand functions. In its

most simplistic form it is possible to extrapolate a demand function using such

methods as squared deviation and maximum likelihood. However making assumptions about the effect on the demand

function resulting from a change in one variable can be disastrous. There are many variables that affect demand;

so thinking that the change in demand is related only to the change in

advertising is overly simplistic. To

see the demand changes caused by a change in one variable is difficult,

especially if the demand function includes a simultaneous function. For example, the demand function of a good

may include income, education and advertising.

However income and education may be linked, thus there are at least two

relationships in this function. Unless

it is possible to separate these relationships then statistical analysis is

impossible. However if we know that on

variable affects one equation and not the other we can isolate the equations by

using data from the unique variable and watching demand rise or fall, thus

attributing the change to only one of the relationships. Even with this isolation of variables it is

still extremely difficult to estimate demand.

I must therefore conclude that it is almost impossible to estimate

demand accurately, but that is partly due to the inherent hypothetical nature

of the demand function. As economists

we must accept these difficulties and find ways to work around them.