# Show carefully how a market demand curve can be derived from individuals' indifference maps and budg

## Show carefully how a market demand curve can be derived from individuals’ indifference maps and budg

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, ...