Market demand curve

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For background information, see demand curve

Definition

The market demand curve for a good, service, or commodity is defined with the following backdrop:

  • The specific good, service, or commodity.
  • A unit for measuring the quantity of that commodity.
  • A unit for measuring price.
  • A convention on whether sales taxes are included in the stated price.
  • The market: A certain set of economic actors who are the potential buyers of that commodity.
  • A time frame within which the demand is measured.
  • An economic backdrop that includes all the determinants of demand other than the unit price of that commodity.

The market demand curve is a curve drawn with:

  • The vertical axis is the price axis, measuring the price per unit of the commodity.
  • The horizontal axis is the quantity axis, measuring the quantity of the commodity demanded in total by all the economic actors chosen above.

Obtaining the market demand curve from individual demand curves

The term individual demand curve is used to describe the demand curve for a single economic actor who is part of the market.

The market demand curve is obtained by aggregating (or adding up) the individual demand curves. With the usual way demand curves are drawn, this addition is done horizontally, i.e., for each fixed price (vertical) coordinate, the values of the quantity (horizontal) coordinates for all the economic actors are added.

If we assume that the individual demand curve for each economic actor represents, for each price, the optimal (utility-maximizing) quantity to buy at that price, then the market demand curve represents the optimal quantity for all the economic actors together to buy at that price.

Smoothing out in aggregation

A lot of interesting and quirky phenomena may be obtained at the level of individual demand curves but may become less visible (due to smoothing and averaging out) at the aggregate level because of the canceling out or smoothing out effects. Some examples are discussed below:

  • For items where purchase quantities are discrete, individual demand curves are by nature discontinuous, while aggregate demand curves are likely to be continuous given sufficient heterogeneity among individuals. Note that individual demand quantities could be fractional even with discrete purchase quantities -- for instance, my weekly number of loaves of bread purchased could be if I purchase a loaf of bread every second day.
  • Individual demand curves are more likely to exhibit sharp discontinuities for other reasons: Individuals may use threshold prices and reference prices to determine which item to purchase and how much. For instance, if, for me, and are equivalent goods (i.e., they are perfect substitute goods for each other, then I buy none of when its price exceeds that of , but I shift my entire consumption to when its price drops below that of . The price of is thus a point of discontinuity in the demand curve. In the aggregate, the heterogeneity of individuals ensures that they do not all perceive the same pairs of goods as perfect substitutes, and hence these jumps are less likely to occur.
  • Various violations of the law of demand, both rational and irrational, are more likely to be seen at the individual level than at the aggregate level: For instance, the Giffen good phenomenon and the Veblen good phenomenon may play an important role in the consumption behavior of one individual or household, but because of differing incomes and differing tastes and preferences that lead individuals to value substitutes differently, the phenomena would not apply to all economic actors. Since an aggregate Giffen good phenomenon depends on the phenomenon affecting a large number of individuals, aggregate Giffen good phenomena may be much rarer than individual Giffen good phenomena. The same holds for various forms of mild irrationality and idiosyncratic behavior.

Market size effect

Further information: market size effect

ceteris paribus, if the market expands (i.e., more economic actors join the market), then the market demand curve overall moves outward (i.e., we have an expansion of demand curve). If there is no change in the market supply curve (i.e., more producers do not enter the market) this leads to a situation where the equilibrium quantity increases.

The nature of the effect on market price depends on whether the supply curve is upward-sloping or downward-sloping. Short-run supply curves are generally upward-sloping, so in the short run, an expansion in market size leads to an increase in the market price. Long-run supply curves are often downward-sloping (such industries are termed decreasing cost industries) and in this case, the expansion in the market size leads to a reduction in the market price.

Note that even for goods where the long-run supply curve is upward-sloping, an increase in population may result in a change to the market supply curve as more potential producers enter the market. One example of this is the genius effect. This, however, is conceptually distinct from the market size effect.

Public goods analysis

For public goods (i.e., non-rival goods that are also non-excludable goods) the analogous analysis is done differently. Instead of adding the (analogues of) individual demand curves horizontally, the curves are added vertically. In other words, for a fixed quantity (horizontal) coordinate, the values of the "price" (vertical) coordinates for all the economic actors are added.

The reason for the difference are explained below:

  • Why we do not aggregate quantity: Due to the non-rival good nature, the same quantity of the good can be used by everybody without affecting the quantity accessible to others. Thus, to provide a certain quantity to each economic actor, it suffices to provide the same quantity to all.
  • Why we do aggregate price: We are interested in the total benefit of provision rather than the unit price (which is what market demand curves focus on). This is because, due to the non-excludable good nature, the idea is not to sell the good per unit at a unit price, but rather to determine the total benefit and then compare it against the price.