Individual and Market Demand 5

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In Chapter 4, we learned the basics of how consumers make choices: Preferences (embodied in the consumer’s utility function and its associated indifference curves) and income and market prices (both embodied in the consumer’s budget constraint) combine to pin down the consumer’s utility-maximizing bundle of goods. Variations in preferences are reflected in the shapes of indifference curves, and variations in income and prices are reflected in the location and slope of the budget constraint.

Now that we’ve built our consumer choice framework, we can show how it forms the basis of the demand curves in Chapter 2 and Chapter 3. We’ll see exactly where demand curves come from, when they shift, and how to add up individual consumers’ demands to get market demand curves.

Because demand is half the story in any market, knowing what determines and drives consumer demand is crucial to understanding a number of issues, including:

why shifts in tastes affect prices,
the benefits that products offer consumers,
what happens to purchase patterns as consumers (or even entire countries) become wealthier,
how changes in the price of one good affect the demand for other goods, and
what factors determine consumers’ responses to price changes.

5.1 How Income Changes Affect an Individual’s Consumption Choices

5.2 How Price Changes Affect Consumption Choices

5.3 Decomposing Consumer Responses to Price Changes into Income and Substitution Effects

5.4 The Impact of Changes in Another Good’s Price: Substitutes and Complements

5.5 Combining Individual Demand Curves to Obtain the Market Demand Curve

5.6 Conclusion

We start this chapter by looking at what happens to a consumer’s choices when prices stay fixed and his income goes up or down. This analysis involves finding the consumer’s optimal bundle not just once for a particular income level (as we did in Chapter 4), but over and over for every possible amount of income.

Next, we determine how a consumer’s chosen bundle changes as the price of one good in the bundle changes, holding constant income and the price of the other good. This analysis involves finding the consumer’s optimal bundle not just once, but for every possible price of the good in the bundle. By analyzing how the quantity desired of a good changes as the price of that good changes (holding everything else constant), we can map out an individual consumer’s demand curve for that good. We’ll see that consumers’ responses to price changes have two components: the change in relative prices caused by the price change and the change in the purchasing power of the consumer’s income caused by the price change.

We then see how changes in the price of other goods affect the consumer’s decision about how much of a particular good to consume. This effect can increase or decrease the quantity of a good demanded, depending on whether one good is a substitute for the other or if the two goods are consumed together.

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After we explore all these features of an individual’s choices, we show how total market demand responds to the same changes. Once this is done, we’ll have a full understanding of what determines the market demand that we took as given in Chapter 2 and Chapter 3.