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he actually buys the quantity OQ (during a given period of time). The
curve DD' joins all those points that are relevant for the consumer. The
abscissa of the curve, for any given price ordinate, indicates the quantity
that the consumer will take at the price.7 The curve abstracts from all the
many other kinds of change that might alter the quantity taken by a con-
sumer, and concentrates on the consumer's response to price changes, other
things being left unchanged.
Although the demand curve, both as a diagrammatic aid and as a con-
ceptual tool, depends on "other things remaining equal," it cannot of course
exist in a vacuum. The demand curve associates with each price of a good
the quantity that a consumer will buy under a given set of conditions with
respect to those "other things." A demand curve is drawn for a consumer
with a definite income, facing a definite subjective value scale of his own.
A change in any of these other things will cause the entire demand curve
to change: the set of quantities of a good that a consumer will buy at differ-
ent prices, under one set of these "other" conditions, being quite different
7 The individual demand curve may be looked at from another, no less important
angle. A point on the demand curve represents the highest price per unit that the
consumer will be prepared to pay (if forced to do so) for a given quantity of the com-
modity.
CONSUMER INCOME ALLOCATION 81


from those relevant to different conditions. A rise in income, for example,
may shift a demand curve to the right (or, for an inferior good, to the left)
and, besides changing its position, will probably also change its shape.
The demand curve of the individual consumer for a single commodity
is thus just one piece in the complex jig-saw puzzle that is made up by the
understanding of the different ways the consumer would allocate his income
in response to different sets of conditions. Its usefulness in analysis, we will
discover, is not so much in explaining the actions of the consumer himself;
these are best understood by attacking the problem of income allocation on
marginal utility lines. The demand curve becomes of value in helping
explain the forces that, in the market, are being exerted by individuals
upon the price of particular goods. And for this reason it becomes fruitful
to concentrate attention on the (admittedly partial) relationship existing
between price and quantity alone.
The shape of the demand curve of the individual is of considerable
theoretical importance. This is especially so when we consider, in the next
chapter, the shape of market demand curves derived from the individual
curves. The question we are faced with is whether any generalizations can
be made concerning the relationship between the quantity a consumer will
buy of a good and its price, which should be valid under all possible assump-
tions regarding relevant "other things." Can we say, for example, that a
lower price for a good will invariably be accompanied by a larger purchase
of it on the part of a consumer”no matter what the particular good may be,
no matter what the income of the consumer may be (that is assumed to be
constant), and no matter what the (constant) prices of other goods are
assumed to be? Or can we at least make some such generalization that
should be valid under a limited but specified range of conditions?
Our marginal utility analysis of consumer income allocation enables
us to provide answers to these questions. We saw that a fall (rise) in the
price of one good, other things being equal, affects a consumer's action in
two ways. First, it alters the relative prices of goods in favor (at the expense)
of this good so that the marginal utility of an additional dollar's worth of
this good is now higher (lower) than that of a dollar's worth of other goods,
at the margin. This moves the consumer to replace expenditure at the
margin on other goods by additional expenditure on a good that has become
cheaper, and vice versa for a good that has become more expensive. This
substitution effect will tend to make a negatively sloping demand curve,
showing that a consumer will buy more of a good as its price falls. This
effect is perfectly general. The second way a fall (rise) in the price of a good
affects the consumer's actions (and thus the shape of his demand curve) re-
sults, as we have seen, from the fact that a change in one price alone, which
leaves all other things "the same," is by that very token the change in price
that at the same time changes the real income of the consumer. A fall (rise)
82 MARKET THEORY AND THE PRICE SYSTEM


in one price can only leave the consumer with more (less) than sufficient
money income than is required, at the new price, to buy the old bundle of
purchases. This income effect, of course, is likely to be extremely small
in the case of a moderate price change for a commodity that occupies a
relatively minor place in the budget. Moreover, the income effect of a fall
in price of a good that is not "inferior" tends, we have seen, to increase the
quantity purchased. The negative slope of the demand curve that we
found to be associated with the substitution effect is thus reinforced by the
income effect.
Even for inferior goods the negative income effect may still leave the
demand curve sloping downward to the right. Since this effect may in the
real world be expected to be very small, where it exists it is likely that a fall
in price of even an inferior good will increase the quantity that a consumer
will buy. The theoretical possibility does exist, of course, that a fall in
price of a good may have so strong a negative income effect as to make a
demand curve with a positive slope, representing the case where a man will
buy more of a good when its price is higher. This constitutes the so-called
"Giffen-paradox."

SOME REMARKS ON EXPECTATIONS
The analysis of this chapter has been almost purely formal in character,
and this has enabled us to group together under "tastes and preferences," a
host of factors that have a bearing on the way a consumer will allocate his
income, and on the shape of his demand curve for a particular commodity
or service. Several further remarks are necessary in this regard, in order to
prevent possible misunderstanding of the scope of the tools of demand
analysis, due to the simplicity of the framework that we have been using.
Demand analysis is concerned with the way the consumer acts in spend-
ing his income. Our analysis has been static in the sense that we have
assumed a given scale of values and worked out the consequences for con-
sumer behavior of changes in income and prices in the light of the given
scale of preferences. We discussed the consequences upon consumer actions
of a formal change in his relative preferences, from one value scale to a
different one. This procedure, valid in itself, must not lead us to believe
that we have not taken into account the fact that acting human beings are
forward looking; that they act on the basis of expectations, anticipations,
and uncertainty; and, of course that, in consequence, they frequently make
"mistakes." In the course of time, human beings "learn by their mistakes"
and constantly revise their assessment of future requirements and their
interpretations of current market events. All this must certainly be kept
in mind and lies very close indeed to the core of the possibility of a science
of human action.
CONSUMER INCOME ALLOCATION 83


For the purposes of demand analysis, these aspects of action are under-
stood as reflected in the tastes and preferences of the moment under con-
sideration; they are implicit in the marginal utilities associated by consum-
ers with given quantities of specified goods and services. The marginal
utility of an air conditioner depends, for a consumer at the start of summer,
on his guess of the heat expected in the coming months. The demand curve
for air conditioners for this consumer will reflect all his guesses in this re-
spect. It will reflect, perhaps, his guess as to the degree of discomfort to be
expected in the various rooms of his home; it will reflect, perhaps, his guess
how an air conditioner in one room will help to lessen or increase the dis-
comfort in adjoining rooms.8 No matter what uncertainties enter into his
choice, his scale of values will still reflect the law of diminishing utility-
utility, of course, itself reflecting the expectations and estimates of the con-
sumer. The psychology of choice in the face of risk and uncertainty would
certainly help in making concrete statements about the actual choices made.
For the formal analysis of "static" demand this is unnecessary.
These considerations must be kept in mind when the tools of demand
analysis are applied to the real (dynamic) world. A rise in price for a
particular commodity, for example, may bring about a revision by a con-
sumer of his estimates of future prices, and therefore of the significance of
additional current purchases of the good. This must be interpreted as a
shift in consumer "tastes." It would be inadvisable to apply a demand
curve that has reference to one set of expectations, to a different set. The
recognition of the limitations of the demand curve is of importance in ex-
ploiting its appropriate usefulness and in pointing to the directions where
more refined analysis is called for.

SUMMARY
Marginal utility analysis enables us to explain the way a consumer will
allocate his income. He will act to share expenditure between different
commodities and services so that (having regard to the disutility of careful
deliberation) no further opportunity exists to shift any amount of money
from the margin of expenditure on one good to that of another, without
sacrificing a quantity with higher marginal utility for one of lower marginal
utility. A consumer will act, "exchanging" marginal quantities of one good
for another, so tending towards such an "equilibrium" position.
The content of the "bundle" purchased at this position depends on (a)
the consumer's tastes and preferences, (b) his income, and (c) the market
prices of the various goods. Alteration in any of these sets of data will lead

8 See the Appendix on multi-period planning for an outline of the way current
market decisions depend upon expectations concerning future market conditions.
84 MARKET THEORY AND THE PRICE SYSTEM


the consumer to alter the allocation of his income toward a position in
equilibrium with respect to the new sets of data.
The analysis focuses particular attention on the effects of price changes.
In general, a fall in the price of a (non-inferior) commodity, other things
being equal, results (a) in a tendency for the consumer to purchase more of
the good, as a consequence of the substitution effect of the change in purely
relative prices; and (b) in a tendency for more of the good to be bought as
a consequence of the income effect of the rise in the consumer's purchasing
power (brought about by the fall in the one price). For inferior goods, the
substitution effect is not different, but this may be partly offset (or in excep-
tional cases be more than completely offset) by the negative character of
the income effect.
The demand curve for any good of an individual consumer presents the
relationship between the possible prices of the good and the quantities of it
that he will buy. It assumes given conditions with respect to tastes (includ-
ing expectations), income, and prices of other goods. Insofar as a change
in price can itself affect these other conditions, the demand curve cannot be
used without further refinement.

Suggested Readings
Böhm-Bawerk, E. v., Capital and Interest, Vol. 2, Positive Theory of Capital,
Libertarian Press, South Holland, Illinois, 1959, Bk. 3, Part A.
Marshall, A., Principles of Economics, The Macmillan Co., London, 1936, Bk. 3,
Chs. 1, 2, 3.
Knight, F. H., Risk, Uncertainty and Profit, Reprint, University of London, Lon-
don, 1957, Ch. 3.
Hicks, J. R., Value and Capital, Oxford University Press, New York, 1946, Part I.
Machlup, F., "Professor Hicks' 'Revision of Demand Theory,' " American Economic
Review, March, 1957.
Market Demand



i chapter we will carry forward
N THIS
the analysis of consumer demand from the individual to the market. Each
individual, we found, attempts to allocate his consumption expenditures
among various available goods according to fairly well-defined principles.
There will therefore be in the market, at any one time, a demand for par-
ticular goods and services made up of demands of individuals as determined
by their allocation of expenditures. Analysis of market demand carries us
a significant step nearer a complete understanding of the way prices for
particular goods emerge, and of why prices for particular goods change
relatively to the prices of other goods in the way they do. At the same time
market demand analysis is solidly founded on the theory of individual de-
mand explored in the preceding chapters. It serves, therefore, as one of the
most important links relating market phenomena back to the actions of the
individual participant in the market process.

MARKET DEMAND
In a market, at any one time, a set of prices prevails for the various
goods and services available. In addition, consumers have limited sums of
money available for current expenditure. Each consumer acts to allocate
his current expenditure so as to improve his position as far as possible. The
data of the market, at the same time, describe the opportunities open to
each consumer and outline the limitations of these opportunities. Each
consumer consults his own tastes and preferences in deciding which oppor-
tunities he should grasp. For him, his available expenditure and the prices
of the market place determine his actions according to his own scale of
values.
Looking at the market as a whole, therefore, we see a mass of individ-
85
S6> MARKET THEORY AND THE PRICE SYSTEM


uals each attempting to secure definite quantities of different goods and
services according to the market data of the moment and their own individ-
ual scales of value. The result is that for each particular commodity or
service, the market as a whole is bidding definite sums of money for definite
quantities of the good. The determinants of the particular bids made by
the market as a whole for particular goods are of course the very same as
those that guide individuals in their demand for goods, since it is the
aggregate of these actions that constitutes market demand.
As we shall discover in later chapters, the bids made by the market
as a whole play a decisive role in the determination of subsequent market
events. It is the peculiarity of market prices that they emerge as a result
of actions taken at the beckoning of other prices. Analysis of market
demand therefore is directed to help us in understanding its influence on
the emergence of subsequent prices. Considerable assistance in this regard
is afforded by the analysis of the market demand for particular commodities
taken independently, and it is therefore with this aspect of the subject that
this chapter principally deals.
The quantity of any one commodity for which the market as a whole
bids depends, then, on the tastes of the individuals for this and other
commodities, on the incomes of the individuals, and of the prices of this
and other commodities that the individuals believe are the relevant market
prices they are free to bid at. In analyzing the quantities of the specific
good that the market will seek to buy during a given period of time, we
once again focus attention on price as a key determinant. We assume
that consumers' individual incomes are given, that prices of other goods
are given, and that each individual is endowed with a given scale of values
”and we ask how much (per unit of time) the market would seek to buy
of the commodity under consideration at various different prices. This
question can be answered by our analysis of the individual demand for the
particular commodity. At a given price for the commodity, each individual
would seek to buy a particular quantity of it. Summing these quantities
for all individuals gives the quantity that the market as a whole would
seek to buy at this price. Repeating this operation for a series of possible
prices yields the market demand schedule”the list of quantities of the good
that the market will seek to buy at the series of prices. If the individual
demand schedules for participants in the market indicate that each such
participant would seek to purchase a larger quantity of the commodity at
lower than at higher prices, then the market schedule will express this in
the very same way. The market demand schedule is only the aggregate
expression of a series of alternative potential actions of individuals.1
1 There may of course be goods for which a relevant market demand schedule exists
but for which no individual demand schedules are relevant. Stock examples are goods
that are typically consumed in common by a large number of people, such as major-
87
MARKET DEMAND

As we have seen, the analysis of demand for a particular commodity
at different possible prices, but with nothing else permitted to change, means
the analysis of individual behavior when subject to (a) pure changes in
relative prices, together with (b) changes in the purchasing power of in-
come. While the effects of the latter changes, we saw, do not always run
the same way, the effects of pure changes in relative price are, in fact,
invariably to increase the quantity of a commodity that individuals seek
to buy as the price falls. The demand of the market as a whole will there-
fore faithfully reflect these tendencies.

THE MARKET DEMAND CURVE
The graphic representation of the market demand schedule yields the
market demand curve. The curve represents the "lateral summation" of
all the individual demand curves for the commodity under consideration.
Any point on the market demand curve shows by its abscissa the quantity
that the market will seek to buy (during a given period of time) at the
price represented by the ordinate of the point. The length of this abscissa
is found by adding together the abscissae of those points on all the indi-
vidual demand curves with the same price ordinates as the point on the
market demand curve. Suppose, for example, that Figures 6-1 (a), (b), (c)

Price
Price Price

Ap




(a) (b)

Figure 6-1

league baseball, concerts, and so on. For such goods it is hardly useful to talk of in-
dividual consumer demand schedules; the prospective consumers must somehow band
together to buy them”whence the market demand schedule. Tn a market economy
entrepreneurial activity frequently serves prospective consumers of such goods by un-
dertaking the task of organizing production and then selling "tickets of admission." In
any event, the price that the market as a whole is prepared to pay for a given quantity
of such goods is made up of the shares of the total cost various individuals are prepared
to pay for the privilege of admission.
88 MARKET THEORY AND THE PRICE SYSTEM

represent the individual demand curves of a number of market participants
for a commodity. Then points Pa, Ph> Pc indicate that at a given price
OA for the commodity, these participants will seek to buy quantities OBa,
OBh, OBC, respectively. The quantity that will be sought for the market
as a whole at price OA is indicated in Figure 6-2 by the point Pq. This




Figure 6-2

quantity OQ is made up by adding together OBa> OBh, OBC, and so on for
all the market participants. Thus, the market curve DDq can be thought
of as obtained by "adding together sideways" the individual demand curves
DDa, DDl·, DDC, and so on. (It will be noticed that the quantity axis for
the market demand curve represents a far greater order of magnitude than
the corresponding axes in the individual curves.) It is clear that the shape
of the market demand curve DDq depends completely on the shapes of the
individual curves DDa, DDh, DDC, and so on. The reaction of the market
as a whole to a particular change in price is made up entirely of the
individual reactions.
The market demand curve is a graphic device for presenting compactly
a series of postulated relationships. It can, of course, only tell us what
we have already put into it, but it is nevertheless a highly useful aid in
organizing our thinking about both the determination and effects of price
changes. Two kinds of questions can be answered, at least in principle,
by the organization of our information into the framework of the demand
curve. First, the curve lists the quantities that the market as a whole will
bid for at different given prices. Here price is the independent variable,
with quantity the variable that is made to depend on the prevailing price.
(From this point of view, the demand curve would ordinarily be expected
to have its axes transposed, with quantity measured along the vertical axis.
The prevailing practice however, is the one sanctioned by long economic
usage and is thus well-entrenched.) Second, the curve lists the prices that
MARKET DEMAND 89


given quantities of the commodity can bring if placed on the market.2
Here it is price that we seek to make dependent on the quantity.
It should be emphasized that the demand curve relates quantity to
price in the two ways mentioned, corresponding to two different ways the
term "price" is used in analysis. When we ask what quantity the market
will demand at a given price, we are speaking about a hypothetical or pro-
visional price. As we shall see, the fact that a given quantity will be asked
may in fact be the reason why the provisional price may rise or fall, or why
the hypothetical price cannot in fact become actual. On the other hand,
when we ask what price a given supply will bring on the market, we are
asking about the price that will in fact be realized in the market under
the postulated circumstances.
The use of the demand curve must never mislead us into treating
"price" and "quantity" as being somehow mechanically related, apart from
the actions of individual market participants. Any statement making
quantity bought depend on price asked, or making price determined depend
on quantity offered, must be interpreted as summing up the purposeful
actions of individual human beings in response to definite alternatives
being offered to them or in response to a change in the terms of the available
alternatives.
DEMAND ELASTICITY
The mental tool that is represented by the demand curve attacks the
problem, we have seen, by focusing attention on the influence exerted by
price upon the quantities that will be bought by individuals and by the
market as a whole. This involves the process of mentally "freezing" all the
other factors that have any bearing on the quantity purchased and allowing
the price to vary. Using marginal utility analysis, we were able to make
the generalization that (with the possible exception of certain "inferior"
goods) a fall in price, other things remaining unchanged, is associated with
a greater quantity of goods desired to be purchased. In graphic terms,
this meant that the demand curve slopes downward to the right. It is
useful to further classify demand curves, within the sweep of this gener-
alization, on the basis of their elasticities.
The concept of elasticity, as applied to demand, refers to the degree
of sensitivity to the influence exerted by price that individuals show with
respect to the quantity of a good they seek to buy. A lower price, we
2
This second view of the market demand curve corresponds to the alternative view
of the individual demand curve to which reference was made on p. 80, ftnt. 7. A point
on the market demand curve thus denotes the highest uniform price a given quantity of
the commodity can be sold at in the market without any remainder being left unsold. In
Ch. 7 we will see that this implies that when the quantity has been sold at this price,
all consumers who have failed to buy (even the most eager among them) are not pre-
pared to pay any higher price for additional units.
90 MARKET THEORY AND THE PRICE SYSTEM

found, generally means a larger quantity being purchased. But "larger
quantity" can mean "slightly larger quantity," or "much larger quantity,"
depending on the responsiveness o£ the individuals or group of individuals
to price changes. Demand curves can be ranked in this way as either more
elastic or less elastic. One demand curve is more elastic than a second
if a given change in price exerts a more powerful influence on quantity
purchased in the first than in the second situation. In the diagram, a
decrease in price from p to p' means an increase in quantity purchased

Price


P

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