Deriving the market demand curve

The assumptions of economic rationality enable us to conclude that, if the price

of a good falls, other things being equal, the consumer will respond by demanding

more. At worst, the consumer will not respond by demanding less. Hence, the

individual demand curve will be downward-sloping or vertical,

Given that individual demand curves have a negative slope, the market demand curve should also be downward-sloping. This property, however, could be jeopardized by a large shift in income distribution between individuals with different tastes and priorities. Suppose that a society was divided into two groups– book-lovers and food-lovers. Any redistribution of income from book-lovers to food-lovers will have an impact on demand. Hence the demand for books depends not just on price and total income, but on the distribution of income. This potential difficulty must be kept in mind when analysing market demand in the context of changing macroeconomic aggregates.

Elasticities of demand

Elasticity of demand is a shorthand way of characterising the sensitivity of

demand to changes in price, the level of income and other determining variables.

Three types of elasticity are especially relevant to demand analysis: price elasticity

of demand, income elasticity of demand, and cross-price elasticity of

demand. We shall discuss each type in turn.

Price elasticity of demand

A fall in price has two opposing consequences for sales revenue. First, sales

revenue increases because more units are sold to existing customers, and new customers will be tempted to make purchases as a result of the lower price. Secondly,revenue decreases in that the price obtained on the original volume of sales hasfallen. The balance between these two forces determines whether the reduction in price leads to an overall increase or decrease in total sales revenue.

Thus, there is practical value in understanding the interactions between tax rates,

the consumer price, the producer price, sales revenues, and profits. As we saw, an indirect tax can be represented as an inward shift in the supply curve. The incidence of the tax is shared between producers and consumers, and depends on the slope and position of both the demand and the supply curves. In general, the more inelastic the demand for the product, the larger the proportion of the tax shifted forward to consumers, and the smaller the decline in equilibrium quantity. For those reasons, it pays industries affected by indirect taxes to

keep close watch on such matters.