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STUDY SESSION 5
THE MARKET DEMAND CURVE
5.0 INTRODUCTION
Demand is a model of consumer behavior. It attempts to identify the factors that influence the choices
that are made by consumer. In Neoclassical microeconomics, the objective of the consumer is to
maximize the utility that can be derive given their preferences, income, the prices of related goods
and the price of the good for which the demand function is derived. An individual’s demand function
can be thought of as a series of equilibrium or optimal conditions that result as the price of a good
changes. This session deals with both the individual and market demand curve as well discuss the
various factors that influence demand, types and characteristics of demand curves and movement
along and shifts in demand curve.
5.1 INDIVIDUAL VERSUS MARKET DEMAND CURVE
Demand for a product refers to the amount of it which will be bought per unit of time at a particular
price. Demand is equal to desire plus ability to pay plus will to spend. Demand = Desire + ability to
pay + will to spend. Ability to pay: money/purchasing power
Individual demand curves are demand curves for a single economic actor. This actor could be an
individual, a household, or a firm (where the firm may be a for-profit, a non-governmental non-
profit, or a governmental agency).
The market demand curve aggregates (or adds up) the demand curves for a number of economic actors.
For instance, the market household demand curve for a good in a town is obtained by adding up the
demand curves for all the households in the town. The market demand curve for steel in the
automobile industry is obtained by adding up the demand curves for steel for all firms in the
automobile industry.
Note that market demand (which is the aggregate across all economic actors of their demand for a
particular good) is distinct from aggregate demand. Aggregate demand is a controversial
macroeconomic notion that is part of Keynesian theory and roughly describes the total demand in the
economy across all goods. Some schools of economics dispute whether the notion of aggregate
demand makes sense even at a theoretical level, because demand for one good is expressed in relation
to other goods. None of this discussion of demand curves touches upon aggregate demand.
Qualitative distinctions: Here individual could mean individual, household, or firm, any single
economic actor.
A lot of interesting and quirky phenomena may be obtained at the level of individual demand curves
but may become less visible (due to smoothing and averaging out) at the aggregate level because of the
canceling out or smoothing out effects. Some examples are discussed below:
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For items where purchase quantities are discrete, individual demand curves are by nature
discontinuous, while aggregate demand curves are likely to be continuous given sufficient
heterogeneity among individuals. Note that individual demand quantities could be fractional
even with discrete purchase quantities -- for instance, my weekly number of loaves of bread
purchased could be 3.5, if I purchase a loaf of bread every second day.
Individual demand curves are more likely to exhibit sharp discontinuities for other
reasons: Individuals may use threshold prices and reference prices to determine which item to
purchase and how much. For instance, if, for me, A and B are equivalent goods (i.e., they are
perfect substitute goods for each other), then I buy none of A when its price exceeds that of
B, but I shift my entire consumption to A when its price drops below that of B. The price of B
is thus a point of discontinuity in the demand curve for
. In the aggregate, the heterogeneity of individuals ensures that they do not all perceive the
same pairs of goods as perfect substitutes, and hence these jumps are less likely to occur.
Various violations of the law of demand (the assertion that demand curves slope
downwards), both rational and irrational, are more likely to be seen at the individual level
than at the aggregate level: For instance, the Giffen good phenomenon and the Veblen good
phenomenon may play an important role in the consumption behavior of one individual or
household, but because of differing incomes and differing tastes and preferences that lead
individuals to value substitutes differently, the phenomena would not apply to all economic
actors. Since an aggregate Giffen good phenomenon depends on the phenomenon affecting a
large number of individuals, aggregate Giffen good phenomena may be much rarer than
individual Giffen good phenomena. The same holds for various forms of mild irrationality and
idiosyncratic behaviour.
The market demand for a given commodity is the horizontal summation of the demands of the
individual consumers. In other words, the quantity demanded in the market at each price in the sum of
the individual demands of all consumers at that price.
Figure 5.1
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Complimentary Goods: If two goods are used together to satisfy a want, they are said to be
complimentary goods. For example: tea and sugar, automobiles and petrol, pens and ink.
A fall in price of a commodity raises the demand for its complimentary goods. For example,
the demand for petrol increases when prices of automobiles fall. It means with fall in price of
ink, the demand for pens raises.
Demand for a commodity is inversely related with price of its complimentary goods.
Substitute Goods: Those goods which can be used in place of one another are called
substitute goods. For example: tea and coffee, scooter and motorcycle, etc.
The existence of alternative goods (substitutes) to satisfy a given demand divides the total
demand among the many different goods. The larger the number of substitutes, smaller will
be the demand for anyone of them. For example, with an increase in the price of coffee, the
demand for its substitute (tea) increases.
Demand for commodity is directly related to the price of its substitute.
A fall in price of a commodity results in lowered demand for its substitute, and an increase in
the price of a commodity results in increase in the demand of its substitute.
Income of Consumers (I)
QdN f (I ) (5.2)
The demand for goods also depends upon the income of consumers. With an increase in income, the
consumer's purchasing power increases, because he is in now in a position to buy more goods.
Consequently, the consumer's demand for goods increases.
There are three types of goods for each of which the effect of income differs:
Normal Goods: Increase in income has a +ve effect on the demand for goods.
Generally, income of the people is directly related to their demand. That is when "I" goes up,
demand for Normal goods goes up and when "I" falls, demand also falls. example: laptop, etc.
Thus there is a direct relationship between income and demand of normal goods.
Necessity Goods: For certain goods called necessities, demand is not related to income.
Salt, petrol, and LPG are considered necessity goods.
Demand for salt does not increase with the increase in income and does not decrease with the
decrease in income. It means that it is irrespective of income.
Inferior Goods: Goods are said to be inferior goods if its demand falls with increase
in income of the consumer. Thus there is an inverse relationship between income and demand
of inferior goods.
Taste and preference of consumers (T)
QdN f (T ) (5.3)
Demand for a commodity depends upon the taste and preferences of a consumer. A change in taste
and preferences affects the level of demand for various goods. Consumer's preferences may change
because of changes in fashion, habits, and so on.
Expectations about future prices (E)
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QdN f (E) (5.4)
Future prices of goods also affect their demand particularly for consumer durable goods. Since
purchase of durables can be postponed or preponed more easily than those of non-durables.
If for some reason consumers expect prices of certain goods to rise in near future, they tend to demand
more for it, in the present even at increasing prices.
On the other hand, if they expect prices to fall in the near future, they will demand less of it in
the present.
Other factors (O)
QdN f (O) (5.5)
Size and regional distribution of population: A rise in population leads to an increase in the
number of consumers. As a result demand, increases.
The greater the number of consumers, the greater the market demand for a commodity.
Therefore, demand for a commodity is directly related to the size of the population. Regional
distribution of a population also affects the demand.
Composition of population:
If there are more children, demand for goods like toys, biscuits, sweets, etc will
increase.
Similarly, if there are more old people, the demand for goods like glasses, canes,
hearing aids, medicines, dentures and so on will increase.
Predominance of young people in the population will raise demand for goods like mobile
phones, clothes, hair gels and other related products.
Distribution of income: Equitable distribution of income leads to increase in demand
and unequal distribution of income leads to decrease in demand.
Weather and climatic conditions: Changes in weather conditions also influence demand
for a product. For example, a sudden rainfall on a hot summer day brings down the demand for
ice cream and cold drinks.
Taxation: Higher taxes imposed on a commodity will lower the demand for that
commodity, and vice versa.
Technical progress (inventions and innovations): It leads to production of new
attractive quality products at fair prices. Latest LCD, 3G, etc.
Advertisement effects: Preferences of customers can be affected by advertisement and
publicity, leading to greater demand for a product.
Law of Demand
Also known as "first law of purchase", explains the inverse relationship between price and demand.
Price α 1⁄Demand
Statement of Law of Demand: "Other things being equal (constant), as price of commodity falls,
demand extends that is demand rises and as price increases, demand contracts i.e. demand decreases."
Assumptions
QdN f (P ) cet. par
N
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ceteris paribus: other factors being constant
1. Price of related commodity (PR) must remain constant.
2. Income of household (I) must remain constant.
3. Taste and preferences (T) must remain constant.
4. Composition and size of population must remain constant.
5. Distribution of income should remain constant.
6. Taxation policy, National factors, Technology, etc., should remain unchanged.
7. There should not be any future expectations about change in the price.
Explanations
The law can be explained scientifically using multiplicative model as,
Let the average individual hypothetical demand function be: QdN =
(6 - PN)cet. par
Let the number of households in the market for commodity be = 100
Then the market demand law under multiplicative model will be: QdN =
100 (6 - PN)cet. par
QdN = 600 -100PN
As price increases from ₦10 to ₦50, QdN contracts from 500 units to 100 units and vice-versa. Thus
the schedule expresses negative/inverse relationship between price & quantity demanded. From the
table it is clear that individual consumer demanding more at lower prices and less at higher prices.
This can represented graphically as follows:
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X and Y axis respectively represent quantity demanded and price. Demand curve slopes downward
from left to right.
Demand curve is a curve derived by joining various points showing the quantity demanded and the
price of a product and it indicates consumers behavior i.e. an individual consumer demands more at
lower price and less at higher price.
Thus, it indicates there is inverse relationship between price and quantity demanded cet. par. Thus the
law is verified.
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that given price. It is a graphic representation of a demand schedule. The demand curve for all
consumers together follows from the demand curve of every individual consumer: the individual
demands at each price are added together.
Demand curves are used to estimate behaviors in competitive markets, and are often combined with
supply curves to estimate the equilibrium price (the price at which sellers together are willing to sell
the same amount as buyers together are willing to buy, also known as market clearing price) and the
equilibrium quantity (the amount of that good or service that will be produced and bought without
surplus/excess supply or shortage/excess demand) of that market. In a monopolistic market, the demand
curve facing the monopolist is simply the market demand curve.
The demand curve for a good is defined with the following in the background:
i. The specific good.
ii. A unit for measuring the quantity of that.
iii. A unit for measuring price.
iv. A convention on whether sales taxes are included in the stated price.
v. A certain set of economic actors who are the potential buyers of that good.
vi. A time frame within which the demand is measured.
vii. An economic backdrop that includes all the determinants of demand other than the unit price of
that good.
i. The vertical axis is the price axis, measuring the price per unit of the commodity.
ii. The horizontal axis is the quantity axis, measuring the quantity of the good demanded in total
by all the economic actors chosen above.
Here, quantity demanded by an economic actor refers to the quantity that that economic actor is
ready, willing, and able to buy.
Note that the demand curve makes sense only ceteris paribus -- all other determinants of
demand being kept constant.
The term demand is used for the entire price-quantity relationship depicted pictorially by the demand
curve.
Figure 5.3: Demand curve for fixed total budget: reciprocal relationship between price and quantity
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Here, the individual or household spends a fixed amount of money on the commodity
regardless of its price. Thus, the quantity purchased is inversely proportional to the unit price,
i.e., the demand curve equation is given by:
q b (5.6)
p
where b is the total budget amount that the household spends. Here are some properties of such a
demand curve:
q b (5.7)
p pt
where pt 0 is the transaction cost (which we assume as a cost per unit quantity purchased).
This variant avoids the problem of infinities at one end: as the price falls to 0, quantity
demanded goes to b / pt . In particular, for small transaction costs, this quantity demanded is
extremely high.
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Yet another variant involves two kinds of transaction costs: a transaction cost per unit, and a
transaction cost that is constant for all nonzero amounts purchased and 0 if nothing is
purchased. If we denote these two transaction costs as pt (per unit) and p f (fixed) then:
b pf
q (5.8)
p pt
Yet another variant is where there is a minimum quantity that can be demanded if any nonzero
quantity is demanded, which we call qmin . In this case, we first use the formula to determine
quantity demanded. If the quantity demanded is less than qmin , we replace it by 0.
The graph of the demand curve uses the inverse demand function in which price is expressed as a
function of quantity. The standard form of the demand equation can be converted to the inverse
equation by solving for P or P = a/b - Q/b.
More plainly, in the equation P = a + bQ, "a" is the intercept where quantity demanded is zero (where
the demand curve intercepts the Y axis), "b" is the slope of the demand curve, "Q" is quantity and "P"
is price.
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Here, the demand curve is a straight line and is given by an equation of the form:
q p
=1, for p p0, q = 0 for p p0, (5.10)
q0 p0
Here, q0 is the quantity purchased at zero price and p0 is the minimum price needed for the
quantity purchased to drop to 0. Some features of this demand curve are:
Figure 5.5: Demand curve with a region of high price elasticity in between
In the demand curve shown above, at a unit price of about 3, the demand curve is at its most
elastic. For a very small variation in price around this point, demand goes from 2 units to 4
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units. For prices greater than or less than 3, the price elasticity is considerably less. The high price
elasticity at a price of 3 may arise because that is the price of a close substitute.
a Pb
Q (5.11)
where b is the constant price elasticity ( see the next session on the discussion of the concept of
elasticity)
The picture given above shows two different demand curves for the same good. A change in some
exogenous parameter that is one of the determinants of demand may lead to an expansion from the
inner (blue) demand curve to the outer (purple) demand curve.
For a unit price of 2, the inner demand curve indicates a quantity of 1 unit demanded, while the outer
demand curve indicates a quantity of 1 unit demanded.
Similarly, to achieve a quantity demanded of 3 units, a unit price of 2/3 is needed with the inner
demand curve, but a unit price of 4/3 is needed with the outer demand curve.
Curve characteristics
Slope or first derivative
The slope (or rate of change) of the demand curve is inversely related of what is termed the price-
elasticity of demand. The price-elasticity measures the total change in quantity demanded per unit
change in price, made dimensionless by dividing by the quantity-price ratio. In other
words, at a price p and quantity q , the price-elasticity of demand is:
dq / dp
q/ p (5.12)
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The slope in mathematical jargon would be:
dp
dq (5.13)
Sign of slope
Typically, the price-elasticity of demand is negative, which is equivalent to saying that the slope of
the demand curve is negative, or the demand curve is downward-sloping. In other words, ceteris
paribus:
A decrease in the price per unit leads to an increase in the total quantity demanded.
An increase in the price per unit leads to a decrease in the total quantity demanded. This is
termed the law of demand. There are two broad explanations for the law of demand:
Concavity of the utility functions of individuals and households: the marginal utility of an
individual or household per unit of a good decreases with the amount already purchased. Also,
the income effect and the substitution effect. Further information: Law of demand for
individual buyers follows from diminishing marginal utility
Heterogeneity in households, i.e., differences in the reservation prices across
households. Further information: Law of demand for multiple buyers follows from differences
in reservation prices
A demand curve that violates the law of demand is termed an exceptional demand curve. One source
of exception to the law of demand is Veblen goods, whose demand is related to conspicuous
consumption. Other goods that appear to violate the law of demand (though they do not directly
violate it) are Giffen goods and certain kinds of goods where there is inadequate information about
quality and a higher price may be taken as a signal of higher quality.
In general, there are certain price ranges where the price-elasticity of demand is particularly high.
These, in general, tend to be the price ranges where the substitution effect operates most strongly, i.e.,
the price ranges where there could be significant changes in the extent to which to substitute towards
and away from substitutes. Alternatively, these are the price ranges where the reservation prices of
many households are clustered.
In general below these price ranges, quantity demanded for the good is high, but largely price-
inelastic, while above these price ranges, quantity demanded for the good is low, but again largely
price-inelastic.
In this model of some critical price ranges, the sign of the second derivative is not constant.
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In general, the behavior of the second derivative depends on the following:
In a free market, suppliers are expected to vary their price until demand equals supply. In other words,
demand moves along the demand curve until the price reaches the market price. Movements along a
demand curve happen only when the price of the good changes. When a non-price determinant of
demand changes the curve shifts. These "other variables" are part of the demand function. They are
"merely lumped into intercept term of a simple linear demand function." Thus a change in a non-
price determinant of demand is reflected in a change in the x-intercept causing the curve to shift along
the x axis.
Any particular price corresponds to a point on the demand curve: the price coordinate of the point is
that price, while the quantity coordinate is the quantity demanded at the price. Changes in price, while
keeping other factors constant, is termed movement along the demand curve. Decreasing price with
time is termed riding down the demand curve (also called price skimming) while increasing
price with time is termed riding up the demand curve.
Discreteness of amounts
If a commodity is sold in whole units, and these are valuable for a consumer, then the individual
demand curve can hardly be approximated by a continuous curve. It is a set function of the price,
defined by a price above which no unit is bought, a price range for which one is bought, etc.
Units of measurement
If the local currency is dollars, for example, then the units of measurement of the variable "price"
are "dollars per unit of the good" and the units of measurement of "quantity" are "units of the good per
time (e.g., per week or per year). Thus quantity demanded is a flow variable. Price elasticity of
demand (PED)
PED is a measure of the sensitivity of the quantity variable, Q, to changes in the price variable, P.
Elasticity answers the question of how much the quantity will change in percentage terms for a 1%
change in the price, and is thus important in determining how revenue will change.
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The elasticity of demand indicates how sensitive the demand for a good is to a price change. If the
PED is between zero and 1, demand is said to be inelastic; if PED equals 1, the demand is unitary
elastic; and if the Price elasticity of demand is greater than 1, demand is elastic. A low coefficient
implies that changes in price have little influence on demand. A high elasticity indicates that
consumers will respond to a price rise by buying a lot less of the good and that consumers will
respond to a price cut by buying a lot more...
Effect of Taxes and subsidies on demand curve: A sales tax on the commodity does not directly
change the demand curve, if the price axis in the graph represents the price including tax. Similarly, a
subsidy on the commodity does not directly change the demand curve, if the price axis in the graph
represents the price after deduction of the subsidy.
For some goods, a sales tax is levied on the good, usually either a fixed amount per unit of the good
sold, or as a fixed proportion of the pre-tax price. In case of a sales tax, there are two possible
conventions used when drawing the demand curve:
In one convention, the unit price refers to the pre-tax price. In this case, an increase in the
sales tax leads to a contraction of the demand curve, and a decrease in the sales tax leads to an
expansion of the demand curve.
In the other convention, the unit price refers to the price inclusive of taxes. In this case, a
change in the sales tax has no effect on the demand curve; it affects the supply curve instead.
If the price axis in the graph represents the price before addition of tax and/or subtraction of subsidy
then the demand curve moves inward when a tax is introduced, and outward when a subsidy is
introduced.
Empirical estimation: The demand curve is difficult to estimate because at any given point in time,
we can only get one (quantity, price) pair for the market as a whole. There are, however, ways around
this problem that allow us to make a rough sketch of the demand curve.
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When income increases, the demand curve for normal goods shifts outward as more will be
demanded at all prices, while the demand curve for inferior goods shifts inward due to the increased
attainability of superior substitutes. With respect to related goods, when the price of a good (e.g. a
hamburger) rises, the demand curve for substitute goods (e.g. chicken) shifts out, while the demand
curve for complementary goods (e.g. tomato sauce) shifts in (i.e. there is more demand for substitute
goods as they become more attractive in terms of value for money, while demand for complementary
goods contracts in response to the contraction of quantity demanded of the underlying good).
Demand shifters
Changes in disposable income, the magnitude of the shift also being related to the income
elasticity of demand.
Changes in tastes and preferences - tastes and preferences are assumed to be fixed in the
short-run. This assumption of fixed preferences is a necessary condition for aggregation of
individual demand curves to derive market demand.
Changes in expectations.
Changes in the prices of related goods (substitutes and complements)
Population size and composition
N.B. Whilst variations in the price of the actual product affects the overall quantity
demanded, economists do not consider price to affect the demand curve.
An example of a demand curve shifting. The shift from D1 to D2 means an increase in demand with
consequences for the other variables
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Factors affecting market demand
Market or aggregate demand is the summation of individual demand curves. In addition to the factors
which can affect individual demand there are three factors that can affect market demand (cause the
market demand curve to shift):
a change in the number of consumers,
a change in the distribution of tastes among consumers,
a change in the distribution of income among consumers with different tastes.[6]
Some circumstances which can cause the demand curve to shift in include:
Decrease in price of a substitute
Increase in price of a complement
Decrease in income if good is normal good
Increase in income if good is inferior good
The demand curve changes when one (or more) of the determinants of demand other than price
changes.
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The demand curve may change in shape in a way that moves it inward for some price levels and
outward for other price levels. This may happen in the case of the individual demand curve if the
degree of substitution with another substitute good increases. It may happen for the market demand
curve due to a change in the income distribution.
Demand function is a function that takes as input the unit price and outputs the quantity
demanded. The demand curve is a graphical representation of the demand function, but with a
heterodox choice of axes: the input variable (price) is plotted on the vertical axis and the output
variable (quantity demanded) is plotted on the horizontal axis.
Demand schedule is a discrete version of a demand function. It specifies a (finite) list of unit
price-quantity demanded pairs. Demand schedules may be created observationally.
Graphically, knowing a demand schedule allows us to plot some points on the demand curve,
but the behavior of the parts of the demand curve in between those points is not uniquely
determined. However, we can infer the approximate nature of the demand function and
demand curve from a demand schedule.
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