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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

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