Matthew Sumption- Economics Essay 2

Why do demand curves for most commodities slope downwards?

To start to address this question, some definitions are in order. In a broad sense, commodity is a word used to denote goods and services. In a more specific sense, commodities are those goods that cannot be differentiated in quality between different producers, and for which there are generally many producers in the market. Examples of commodities in this sense would be wheat, or iron ore. In this essay I shall be using the term in its broad sense to explain why the demand curves for most goods and services slope downwards. It is easily observed that for different prices of a good x1, different quantities will be consumed by a consumer. One way of displaying this information would be to note down in a table how the quantity of x1 demanded (that is, the amount the consumer is willing and able to consume) changes with the price p1 changes. To see the correlation without interfering factors, we must hold income, and the prices of other goods to be constant. This table would be called a demand schedule, however, even if this table became very long, it would not cover all the price intervals for which there was a change in quantity of x1 demanded by the consumer. Therefore economists find it extremely useful to construct a demand curve which does show the changes in quantity demanded of a good x1 vary with variations in price p1. If we plot this function with price on the vertical axis and quantity demanded on the horizontal axis, we find that the demand curve for most commodities slopes downwards, that is, there is an inverse relationship between the quantity demanded and price for the vast majority of commodities. How can we explain this? Firstly we should investigate why consumers desire different quantities of the same commodity at different times. This can be explained by the concept of utility, which is the satisfaction a consumer derives from consuming a commodity. In explaining the behaviour of consumers, the assumption is made that consumers choose the commodities that they most prefer out of those they can afford. In this way, under several assumptions, we see that consumers make decisions that give them the greatest utility. How do we link this with the downward sloping demand curve? Through the concept of marginal utility, which means the additional utility derived from consuming an additional unity of a commodity. A key concept in economics is how the marginal utility a consumer derives changes with the overall quantity of a good consumed. Using an example of the service of paying to visit Christ Church, for additional tours the consumer will derive some additional satisfaction or utility (the pleasures of seeing Tom Quad in the morning light, or students confidently striding about the cloisters of the Cathedral, and less confidently striding into the library, are not to be underestimated). Nevertheless, as the consumer engages in more tours, the additional utility gained from each additional tour will decrease. We could explain this in a number of ways, in the tour example, the same information being given by tour guides, a familiarity of

Matthew Sumption- Economics Essay 2

the views and architecture, the same rules having to be followed etc. all contributing to the satisfaction the consumer derives from each additional tour decreasing. The overall utility of the consumer may well increase, but at a slower and slower rate. This is the law of diminishing marginal utility, which, just to reiterate, states that, as the amount of a good consumed increases, the marginal utility of that good tends to decline. Linking this to demand curves, we know that consumers face a budget constraint, as their chosen commodities cannot exceed their income in price. To bring me maximum utility, a sensible rule would be to arrange my consumption so that the last pound spent on a good is exactly the same as the marginal utility of the last pound spent on any other good. This can be seen to be the case as if any one good gave me less marginal utility per pound spent, I would reduce my consumption of that good until the marginal utility gained would be back to the common level, and vice versa, as this will bring me the maximum satisfaction. Expressing the principle above algebraically, MUgood1/P1 = MUgood2/P2 = MUgoodn/Pn = MU per unit of income()

To see how this principle affects the slope of the demand curve, let us hold the marginal utility per unit of income constant for a consumer. If the price of good1 falls, then good1 will have a higher MU/ than the other goods. To maximise utility, the consumer will therefore increase their consumption of good1, until, by the law of diminishing marginal utility, the MU/ of good1 is once again equal to that of other goods. Hence a fall in price leads to an increase in quantity demanded, and we have a downward sloping demand curve. The above explanation of why demand curves slope downwards for most commodities has been the historic view. However this view has been supplemented by analysis using indifference curves; this analysis strives to break down the movements along the demand curve into specific effects which affect the choices of consumers. One effect of a price change of one good, is that its relative price compared to other goods on the market changes as well. This means the trade-off the consumer makes has altered with respect to the previous situation, as now the rate of exchange between goods in the market has also altered. If the price of quiche increases, and the price of pizza remains the same, then a consumer has to give up (or substitute) more pizza in order to purchase quiche. We can say that the opportunity cost of buying quiche has increased, we call this effect the substitution effect. The other main effect is that if the price of quiche increases, the purchasing power of the consumer decreases, as they need to expend a greater proportion of their income to buy the same quantity of quiche, every pound will buy less quiche, we call this the income effect.

Matthew Sumption- Economics Essay 2

To see how the income effect and the substitution effect reinforce each other in most cases, so that demand curves for most commodities slope downwards, let us consider an example.

Let us now consider the situation where the price for quiche has fallen, and the price of pizza has remained constant. To consider the substitution effect, we must analyse how the change in relative prices alters the consumers behaviour. Here, the consumer is compensated in income to m, as this will allow them to consume the same bundle of goods as they began with (point A), however the change in relative prices means that the gradient of the budget line decreases, as the gradient of the line is given by -pquiche/ppizza, this is shown by the dark grey budget line. Purchasing power remains constant, so the new optimum bundle for the consumer to consume is where this budget line meets the new indifference curve at B, thus the increase in quiche demanded from A to B is entirely due to the new choices the consumer makes due to the relative price change, so the increase in demand due to the substitution effect. To consider the impact the income effect makes, let us readjust income m to m, but keep the relative prices constant, this is shown by the shift from the dark grey budget constraint to the black budget constraint. The purchasing power of the consumer increases as price of quiche decreases, so we see a parallel shift in the budget constraint outwards, with the new optimum bundle being at point C, the intersection of the indifference curve with the budget constraint. Thus the change in quantity of quiche demanded due to the change in purchasing power while relative prices remained constant, and hence solely associated with the income effect, is the change in quantity from B to C, shown by the arrow below the diagram.

Matthew Sumption- Economics Essay 2

To express the effects algebraically: x1s=x1(p1,m) (p1, m) Substitution effect x1n=x1(p1,m) (p1, m) Income Effect. Thus the total change in quantity demanded can be simplified to the addition of these two effects, as in our diagram we saw that the total change in quantity of quiche demanded (A to C) was the sum of the change due to the income effect and the change due to the substitution effect: x1=x1(p1,m) (p1, m) or in terms of the effects x1= xs+ xn We can briefly summarise the implications of the equation (the slutsky equation) as follows. The substitution is negative, as the change in demand associated with the substitution effect is opposite the change in price. This can be seen as bundle A was preferred to all bundles on the original budget line, therefore with the compensated budget line, bundle A still must be preferred to all those bundles to the left of it on the new dark grey budget line, as these were all available previously but were not chosen. Hence the new amount demanded must be at least as much as was demanded before, as shown by the preferences the consumer has shown, hence the new bundle (B) must be to the right of point A. Since this is the case then a decrease in price must always result in an increase in demand due to the substitution effect. For most goods, with a decrease in price the income effect there will be an increase in quantity demanded due to increased purchasing power, and consumers generally desiring more of whatever product they are choosing. Overall for decreasing price in most markets, we will see this process occurring. If, then we composed a demand schedule, and then worked out and plotted a demand function from the information in the schedule, we would see a downward sloping demand curve for the good when income, and the prices of other goods is held constant. However there are certain products called inferior goods, which consumers tend to demand less of as their purchasing power increases with fixed relative prices. Examples of these are own-brand supermarket goods, or public transportation. Hence it is not always the case that the income effect and the substitution effect will reinforce each other. Sometimes with inferior goods they will counteract each other, with the observed change in demand determined by the individual indifference curves of the consumer. In certain extreme circumstances, for example the demand for staple foods like rice in rural China, the amount demanded will increase as price rises. These goods are known as Giffen goods, however they are exceptions to our general rule of downward sloping demand curves, and rarely observed. It is still safe to say that for normal commodities, the demand for which increases as income increases, the demand curve will tend to slope downwards. Broadly, this can be understood in terms of marginal utility per unit currency spent, but specifically in terms of the way the income effect and the substitution effect reinforce each other for most normal goods, leading to a downward sloping demand curve.

Matthew Sumption- Economics Essay 2