Summary Derivation of the Demand Curve

Humanities Sciences

Course: Econ 1: Principles of Economics

In this lesson, we are going to derive the demand curve, that downward sloping line that
shows you how, in a market, the quantity demanded declines as the price increases.

This is actually the first in a series of lessons that enables us to think about how markets work,
whether sellers and buyers and as an equilibrium.

The first part, we are going to actually, as I say, derive the demand curve and to do that we are
going to look at the behavior of consumers and the buyers in the market.

Then after we do that, we are going to derive the supply curve, which will focus on firms rather
than consumers, the producers in the market, which would be the sellers.

Then finally, once we derive the demand curve and the supply curve, we are going to think
about equilibrium and efficiency where the buyers and sellers come together in the market.

In addition, we will see why markets work well and, and when they do not.

So remember the demand curve, as I say, is this downward sloping line between the price and
the quantity demanded.

In addition, it is something that's the basic part of the supply and demand model.

But now we want to see, really look at the consumers that underlie that demand curve, the
people that underlie the demand curve and really see why the demand curve has the shape it
has, why it's downward sloping and when it tends to shift.

Now to do this, we are going to follow the following approach.

First, we want to, as I say, start with an individual consumer.

You could imagine it might be you, might be me, and could be anyone.
Moreover, based on that individual's behavior, we are going to derive that person's demand
curve, and then from the demand curve, we are going to consider many such consumers who
are in the market, and any such individuals in the market.

Moreover, get the market demand curve. Again, by adding up demand curve for many such
individuals will get the market demand curve.

However, let us start with the individual.

To get to the individuals demand curve, we are going to apply that general economic principle
that people make purposeful choices with limited resources that is the mantra that we have
emphasized as a general principle of economics.

When it is applied to the demand curve, we want to think about consumers.

Therefore, we want to apply this principle to the behaviors of consumers.

In this case, the people, will not be maximizing their utility, we will call it, subject to a budget
constraint.

Therefore, purposeful choice becomes maximizing utility, which we will describe in a minute.

In addition, the limited resources is going to reflect the fact they have a budget constraint,
which means they only have certain amount that they can spend in a particular period.

So let us go with this.

Utility, for an economist, is simply a numerical indicator of people's preferences.

When this numerical indicator is higher, for a particular bundle of goods or a certain number
of, of apples and grapes, or pears and oranges.

When it is higher, then that person prefers that bundle.

If it is lower, then the other one, they do not prefer that bundle.

Therefore, the, the higher level of utility compared to another bundle represents preference
for that bundle.

You like, certain number of items A.

More than the certain number of items, B.

And the utility of A is higher than the utility of B.

That is the concept.

Now to make this work, I want to use an example and I want to imagine that you or someone
else is a consumer deciding how many pounds of grapes to buy, in the, in the supermarket or
how many pounds of bananas to buy in the supermarket.

And so on the horizontal axis of this box I'm labeling first the pounds of bananas.
One, two, three, four, five, and on the vertical, we are labeling the pounds of grapes one, two
three, four, five.

Then inside the box, inside this matrix, we are representing utility that this consumer gets from
these various bundles or combinations of bananas and grapes.

Therefore, for example if, the consumer has one pounds of bananas one pound of bananas or
one pound of grapes that is a utility of 16 by our assumption.

We made up these numbers to illustrate it.

For two pounds of grapes and one pound of banana, utility is 20 so, obviously, the consumer
prefers two grapes, two pounds of grapes to one pound of grapes.

In addition, as you go up, the vertical line there, 16, 20, 23, 25, 26, you see that that is
increasing.

In addition, that means that there is more utility with more pounds of grapes and therefore
the consumer prefers that.

If you notice as you go up this column, the increments, gets smaller.

So from 16 to 20 is four.

From 20 to 23 is three, from 23 to 25 is 2, from 25 to 26 is 1.

Those increments sometimes called marginal utility, decline the more grapes you have.

So the margin of utility we call the change in utility as you consume more grapes, declines as
you consume more grapes.

You can look at the utility of bananas just looking in the horizontal direction.

Let us say, so for example, let us look at, I assume you have one pound of grapes and you are
considering different pounds of bananas.

You get 16 for one pound of bananas.

24 for 2, up to 31 for five pounds of bananas along

with that one pound of grape over in the lower right hand entry.

And then if you go up any of

the columns it's increasing utility for pounds of grapes

and if you go to the right to any of the rows, that increasing utility for bananas.

So that's our example of utility and we're gonna use this to derive the demand curve for this
consumer, any consumer that is considering decisions about grapes and bananas.

Now we wanna consider the constraint, that the consumer faces.

The limited, limitations on the resources.

So we'll start by assuming that a consumer has $8 to spend on grapes or bananas.

And we'll also assume to get started that the price of grapes Is a dollar per pound, and the
price of bananas is a dollar per pound.

Now in this same kind of framework, we can describe

how much it costs to buy various pounds of grapes and bananas.

So, for example, one pound of banana, one pound of grapes costs

two dollars, that's in the lower right hand column of the table.

If you get a five pounds of bananas and five pounds

of grapes, that's in the upper right-hand part of the call.

And that would cost $10, that's in upper right there of this box.

And all the other points in between are simply the price

grapes times the number of pounds of grapes purchased times, plus

the price of bananas times the number of pounds of bananas

purchased, and that gives you the various entries in the table.

Now in addition, what this table shows, is the things that you can't afford.

With $8, you can't afford to get the numbers

that are labeled in red, those, that's too high.

$9 is greater than $8 it's not possible.

So you can't consume five pounds of grapes and four pounds of bananas.

You certainly can't consume five pounds of grapes and five pounds of

bananas, those are off limits, they are outside of the budget constraint.

So, now what we wanna do is consider how the consumer decides how many pounds

of grapes and bananas to buy at different prices for grapes or, or bananas.

You can imagine having a higher price of grapes.

So, take this table and now assumes that the price of grapes is $2 rather than $1.

$1, as in the previous table, the price of bananas is the same, exactly $1.

Budget constraint is still $8, and now in this table I've made

the red items the things that they, the consumer can no longer buy.

So, for example if the, with the price of grapes of

$2 and you buy four pounds of grapes that's $8 right there,

pound of banana would be another dollar, that'd take you to

$9, and in the entry that's in red in that particular table.

So, so in this particular case, you, if you, like, you can't

get that number, that's the four from the, from the one, that's.

Cost $9 you only have $8 you could get that if the price

of grapes was one dollar but now it's $2, so, it's, it's off limits.

Okay, so now what we wanna do is examine what happens to the consumers

decision when the price of grapes goes from one dollar to two dollar, dollars.

So now let's take that utility measure we had which this.

Box shows.

Just a repeat of the box we looked at a few minutes.

That gives you utility for different pounds of bananas and grapes.

This is utility box.

Now, with the price of grapes $1 pound and $8 to spend, we could not get to those levels that
are now in red.

Because they cost more than $8 as in the $9 and $10 entries so their now off limits in terms of
this consumer there outside the budget constraint the black lines are inside the budget
constraint the consumer can afford those, and so now we have an answer to our problem how
many grapes.

How many pounds of grapes, how many pounds of bananas will this consumer consume when
the price of grapes is $1.

In addition, the answer is four.

Four pounds of grapes and four pounds of bananas.

Because if you look closely at the table, that's the highest level of utility, 39, this consumer can
get with $8 when the price is a dollar for a pound of grapes and bananas.

Okay, so that is our first prediction.

Now what we wanna do is say, what if the price of grapes goes up, what's that gonna do to the
decision?

We now have the budget constraint again, put it in play.

I've now made the items red, which are no longer affordable.

For this consumer because now the price of grapes is $2, and so that $8 doesn't go as far as it
did.
There's more entries that are red, made in red, because they're not affordable in this case.

And now of the non-red entries and non-red levels of utility, we see the highest is 34, and I've
made that in blue, so you can see it.

So, if you think about this, we have a prediction that when the price of grapes went from $1 to
$2 per pound, the consumption of grapes went from 4 to 2.

That is just the demand curve we have been looking for, derived now from this basic principle
of maximizing utility, subject to this budget constraint.

In addition, we can graph this, using the same points and a picture, so that is what this does
now.

You take the price on the vertical axis, and the quantity demanded on the horizontal axis, and
the points we're plotting now, are the ones that we just got from those, from that
maximization of utility problem.

So again to repeat, we found that when the price of grapes is $1, which is marked on the
vertical axis as one, the quantity demand of the grapes was two pounds, and that's shown in
the horizontal axis.

And that's that black dot, and then when they raise the price of grapes to $2, we've found, that
the quantity demanded of grapes goes down to two.

Those are the two black dots, I've connected them with a line to illustrate it's a downward
sloping demand curve.

We could think of other possibilities, but that's it.

That's the demand curve for grapes.

Now we also wanna think about other aspects of this.

And when you do that, it's very important to think about two things that happen when we
raise the price of grapes in this example.

One was called the income effect, and one was the substitution effect.

Very important, concept in economics.

The income effect, led to reduction in the amount of grapes consumed.

Because effectively, the consumer had less real income to spend.

The $2 grapes are more expensive, so you had less to spend, so

the, that would tend to make you wanna consume fewer grapes and fewer bananas.

In addition, there was a substitution effect, because grapes were now relatively more
expensive compared to bananas.

Went from basically the same price, a dollar for a pound of each, and now the price of grapes
rose, so it's twice as much, $2 compared to a pound in the case of bananas.

So the consumer substituted away from bananas.

And in this case decided that the higher price was going to be resulting in fewer grapes
consumed, so for substituted in

and basically got fewer grapes as a result.

So that's the income and substitution effect.

Now let's go back, and finally see about shifts in the curve.

That's the same, budget constraint we started with,

a dollar for grapes, dollar for bananas, a

total $8 to spend, and that's what's the

red lines are off limits, outside the budget constraint.

Now if in fact, and this is a change, we now change it to suppose that

there were, there's only $5, is the budget constraint, so we change that 5 to 8.

Prices are still the same.

A dollar for grapes, a dollar for bananas.

And now, because there's less to spend,

there's less available to spend, there's fewer possibilities.

So now, all the red things, are higher than $5.

Not higher than $8, higher than $5.

So those are gonna be off limits.

And we can't consume those.

So now we wanna say, what's gonna be the

maximum level of utility achieved with this new budget constraint?

And here's what it is.

So I'm taking that utility table, and now I'm making red all the items that are not available in
the sense that it's outside the budget constraint.

You can get to those utility numbers, they require too much money.

And of the remaining non-red items, I've made 32, be the highest possible utility level that's
left over.

Higher than any other non-red items.

And that suggests that two pounds of grapes and three pounds of bananas will be

consumed as the consumer has less to spend, and it's moved from $8 to $5.

And we can graph this, as well and we'll show you a shift in the demand curve.

So what's happened here, is we took the original demand curve.

Which represented a budget constraint with $8, that's the line over to

the right, and when the budget constraint is now moved from $8 to $5, we've seen

the number of grapes consumed, quantity demanded has gone from either from 2 to 4 at the
bottom end there, or from 2 to 1 in the upper end.

So from 4 to 2, or 2 to 1, but they're both shifts in the demand curve, and that occurred
because of the change in the budget constraint less money to spend, less income to spend,
and therefore the demand curve has shifted.

Therefore, in summary, we have derived the demand curve.

We have shown how higher prices reduce the quantity demanded based on utility
maximization ideas.

In addition, we have shown how the demand curve shifts when income changes, based on the
very sound principles of economics.

Now we are going to consider in the next lesson, yet another way to derive the demand curve,
which has even greater applicability.