Why does (almost) every demand curve move downwards from left to right for a normal good?

 

Demand curves are made up of points at which the quantity consumed of a good or service by a consumer is balanced against its price. This usually reflects a situation in which consumers will pay less given a greater quantity of a good on sale, and more when there is a lower quantity around.

Explaining how these points arise is therefore different from explaining the causes of demand—which are, broadly, income, fashion taste and preference, and the price and availability of substitute and complementary products. It is also different from explaining the slope of the demand curve, which is a matter of elasticity (and which can be affected by non-price hedonic factors such as effective advertising, or addiction.)

There are two convincing theories of why the points which make up a demand curve arise. One is based on the theory of marginal utility. The second is based on the idea of consumer indifference. Marginal utility theory holds that a consumer will look to the usefulness derived from the purchase of the last item bought, rather than the average or the memory of the first. This will generally mean, because usefulness diminishes as greater quantities of anything are acquired, that people will pay less for things that they have a lot of compared to things of which they have very little.

The theory of marginal utility is elegant and easy to grasp and to explain. One major problem with it, however, is that any objective and comparative measure of utility, let alone marginal utility, is very difficult to separate from price. Economists who accept the marginal utility theory are therefore in a tautological position The tautology is that, in marginal utility theory, the prices people will pay reflect the utility they get from a purchase, which is measured by the prices they will pay. If looked at in this fashion, the proposition is absurd.

Indifference curve analysis attempts to avoid the problem by assessing goods and services as part of the general ‘basket’ of purchase which people make to maximise their happiness. In this theory, individuals will, under the constraint of their budget, choose that combination of goods and services which maintains the same level of content. Cardinal utility in that regard reflects the overall level of happiness consumers seek, regardless of the specific combination involved—the combinations they are indifferent to. Ordinal utility reflects their preference for one thing over another, so that they might buy one expensive thing and then other things, or more of the first thing if it is cheaper and less of the others.

Indifference curves therefore assume that rational individuals either prefer one combination to another or are indifferent. The individuals are consistent in their choices. They prefer more of a good thing and less of a bad thing if they can make that choice.

On this basis, curves can be constructed that show all possible combinations that reflect these choices. The curve slopes downwards for particular goods because at a high price, people will want fewer of them in their basket, and, as the price declines, will want more, but at a lower and lower rate of substitution for other goods as they ‘fill up’ on the good.

 This is another way of saying that they will sacrifice less and less of something else for the good. Individuals will never simply buy the one good and abandon all others—curve will never be flat—but it will reflect a lower and lower value on the more abundant good and its place in the basket.

 Indifference curve analysis therefore assumes the importance of the marginal rate of substitution as well as of indifference to combinations so long as overall happiness is maximised. This MRS, however, is why the curve is convex.

Next, economists create budget lines, showing the quantity of a good that can be bought at different prices given its price. When these are plotted against different indifference curves, a set of points can be identified known as the price-consumption line. The reason for different indifference curves is that, though there is overall equality, there could be different levels of utility from different levels of particular goods.

When the income of a person is held constant, and the basket is reduced to two goods, the price consumption line can be used to show the points at which different levels of indifference plot onto different budgets, leading to a downward sloping demand curve.

This is a somewhat complicated explanation., Economics being economics, other ways of explaining the same relationship are sometimes adopted. One points to the income and substitution effects. If a good takes up more and more of a person’s disposable income, they will buy less of it (but that which they do buy will still contribute to their overall happiness.) Equally, if it rises in price, they will have a greater rate of substitution for it, and they will buy more of other things. The income and substitution effects thus explain why people buy more things according to their budgets and indifference when the price is low, and less when the price is high, and thus explain the downward sloping demand curve from another point of view.

The fact that indifference curves link two goods on an income and substitution basis leads to the theoretical possibility of a Giffen Good. This refers to a situation in which people with a budget constraint are buying an expensive and a cheaper good. The cheaper good gets more expensive, but this means that people buy more not less of it because the overall effect on their income makes substituting the more expensive good for the cheaper one impossible.

 So, meat and potatoes are both bought; potatoes, which are cheaper, rise in price, but the rise means that buying meat will wipe out the capacity to buy potatoes, so people dump meat and buy more potatoes. They therefore end up with more of what they don’t really want because the income effect has outweighed the substitution effect. As with Veblen goods, there is an upward sloping demand curve in which price rises lead to more demand, given the lack of near-substitutes. Giffen goods are a particular problem during famines and stagflation, but should not be confused with simple substitute goods since the key point about them is that demand increases when price increases. This is for very different reasons from Veblen goods-–luxury goods in conspicuous consumption—even though the effect is the same.