2.4.2. Deriving a Demand Curve from Indifference Curves and Budget Constraints

Consider an individual consuming bananas (X1) and mangoes (X2), whose income is M and market prices of X1 and X2 are P1 and P2 respectively. Figure (a) depicts her consumption equilibrium at point C, where she buys X1* and X2* quantities of bananas and mangoes respectively. In panel (b) of figure 2.14, we plot P1 against X1 which is the first point on the demand curve for X1.

This portion introduces the scenario of an individual consumer making choices between two goods: bananas and mangoes. The point C on the graph represents where the consumer maximizes her satisfaction (utility) based on her budget and the prices of the goods. The quantities of each good purchased at this equilibrium are referred to as X1* for bananas and X2* for mangoes. This sets the framework for understanding how demand for bananas is influenced by price.

Imagine someone trying to budget their monthly grocery shopping. If they have a fixed income (M), they have to decide how many bananas and mangoes they can buy without exceeding their budget. The point C is like finding that perfect balance where they get maximum satisfaction from their groceries.

Suppose the price of X1 drops to P1 with P2 and M remaining constant. The budget set in panel (a) expands and new consumption equilibrium is on a higher indifference curve at point D, where she buys more of bananas (X1 > X1*). Thus, demand for bananas increases as its price drops.

Here, we see the effect of a price change on demand. When the price of bananas (X1) drops, the consumer can afford more bananas while still having the same budget, allowing her to reach a new equilibrium at point D on a higher indifference curve. This signifies that the quantity of bananas demanded increases as the price decreases, demonstrating the law of demand.

Think of a sale at your favorite grocery store. If bananas were originally $1 each and suddenly go on sale for$0.50, you'd likely buy more bananas than before, as you can get more for your money. This shows how a drop in price can lead to an increase in demand.

Likewise, the price of bananas can be dropped further to P1**, resulting in further increase in consumption of bananas to X1**. P1** plotted against X1** gives us the third point on the demand curve. Therefore, we observe that a drop in price of bananas results in an increase in quantity of bananas purchased by an individual who maximizes his utility.

Continuing from the previous point, if the price of bananas decreases further to a new point P1**, the consumer buys even more bananas (X1**). Plotting this point also on the demand graph allows us to visualize how the demand curve shifts downward to the right, confirming that lower prices lead to higher demand. This showcases the consistent negative slope of demand curves.

Imagine a situation where a new vendor starts selling bananas for even less than before. Just like a consumer might buy more bananas at $0.50 rather than$1.00, if they find them for $0.25, they would likely buy even more, representing an expansion of demand.

The negative slope of the demand curve can also be explained in terms of the two effects, namely, substitution effect and income effect that come into play when the price of a commodity changes.

When the price of bananas decreases, two main effects come into play that influence demand: the substitution effect and the income effect. The substitution effect occurs as consumers switch from more expensive goods (like mangoes) to cheaper ones (bananas). The income effect arises because lower prices effectively increase the consumer’s purchasing power, allowing them to buy more of both goods.

Think about how, if bananas get cheaper and you also have some extra money to spend, you might buy more bananas instead of mangoes (substitution effect) and still have some cash left for extra snacks or treats (income effect). This combination explains why you choose to buy more bananas.

Law of Demand: Law of Demand states that other things being equal, there is a negative relation between demand for a commodity and its price. In other words, when price of the commodity increases, demand for it falls and when price of the commodity decreases, demand for it rises, other factors remaining the same.

The Law of Demand illustrates the fundamental principle in economics that, with all other factors held constant, there is an inverse relationship between price and quantity demanded. This means that as prices rise, consumers tend to buy less of a good, while lower prices tend to spur an increase in purchasing.

Imagine a simple scenario: if the price of a concert ticket goes up significantly, fewer people are likely to buy those tickets. Conversely, if the tickets become much cheaper, more people will likely decide to go to the concert. This simple rule exemplifies the Law of Demand.

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