Deriving Market Demand from Individual Demand

Question 1

How do you draw a demand curve from an individual consumer’s indifference curve/budget constraint diagram?

Answer 1

1. Identify points of maximised utility.
2. Choose a good to make a demand curve for.
3. Copy the quantities down from the IC/budget diagram for that good.
4. Draw a demand curve through the points ​

Question 2

How do you show the effects of an increase in income on demand? (for one consumer, from an IC/budget diagram)

Answer 2

• An increase in income shifts the budget constraint straight out
• Remember in the indifference curve diagram the price is fixed, it only looks at two goods quantities
• Once again take the quantities at the utility maximising points for the consumer of your chosen good and copy down into a demand curve diagram

You will find that the demand curve shifts outwards (right) and price stays the same.

This makes logical sense since the consumer is increasing their consumption due to an increase in their income, nothing else.

Question 3

What is an Engel curve?

Answer 3

The Engel Curve shows changes in consumption with income.

Question 4

What are the 2 effects of a price change?

Answer 4

1. Makes a good relatively more/less expensive (substitution effect)
2. Effectively changes the real income of the consumer (income effect)

Question 5

In detail, what is the substitution effect?

and

How do you isolate the effect?

Answer 5

This is where a good feels cheaper/more expensive relative to other goods, due to a price change.

The effect can be isolated by allowing the change in price but compensate (or take away if its a price decrease) the consumer so that their income is the same.

Question 6

In detail, what is the Income effect?

and

How do you isolate the effect?

Answer 6

The income effect is the change in the quantity of a good a consumer demands because of a change in income, holding prices constant.

The easiest way to think about this is that if you always bought a good, then the price of that good went down, you effectively have increased income.

The income effect can be isolated by allowing the consumers income to increase/decrease, whilst keeping price the same (shift budget constraint without changing slope).

Question 7

What is the Slutsky Equation?

Answer 7

TE = SE + IE

Total effect = Substitution effect + Income effect

Question 8

If the price falls, what are the substitution, income, and total effects?

Answer 8

Question 9

If the price rises, what are the substitution, income, and total effects?

Answer 9

Question 10

How do you derive the market demand curve from consumer’s demand curves?

Answer 10

To find market demand curve, add up consumers demand curves horizontally.

D= d1+d2

In this example:

At P=2 they total 2 units together

At p=1 they total 10 units together