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.