The demand curve of a good can be derived with the help of indifference curve analysis. Demand curve illustrates the law of demand i.e., inverse relation between price and quantity demanded of a goods.
Other things being constant, demand curve shows the various quantities of a goods will be purchased by the consumer at different prices. According to indifference curves analysis an individual’s demand curve.
According to indifference curves analysis an individual’s demand curve for a goods is related to the price consumption curve (PCC) for the goods.
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PCC reveals the same information that a demand curve tells us. It means that we can derive an individual’s demand curve for goods from its PCC.
PCC shows consumer’s equilibrium at different prices of goods; say X. Derivation of demand curve is explained.
Point E1 E2 and E3 on the PCC show consumer’s equilibrium at different prices of goods X. Supposing initial price line is AB.
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The consume is in equilibrium on indifference curve IC, at E, point. It means the consumer is willing to buy OQ, of goods X at OA/OB, (slope of AB, price-line). With the fall in price of goods X, price line becomes AB2 and price falls to OA/OB2 (slope of AB2 price line).
As a result of fall in price consumer’s equilibrium shifts to point E2 on indifference curve IC2. Now the consumer purchases OQ2 quantity of goods X at lower price OA/OB2.
Again with the fall in price line becomes OA/OB3 (slope of AB, price line). At this lower price OA/OB3 the consumer is in equilibrium at point E3 and he purchases OQ3 quantity of goods X. Thus, with the fall in price demand of goods X is increasing.
By plotting the above demand schedule in the lower part we get the downed slopping demand curve DD for goods X. This is a demand curve for a normal commodity.
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The slope of the demand curve depends upon the nature of the commodity whether the goods is normal or inferior one.
We know that ‘price effect’ is the composite effect of income effect’ and substitution effect’. The income effect may be negative or positive, it depends upon the nature of the goods.
Thus, the slope of demand curve and relation between price and demand of a goods depends on the nature and strength of ‘income effect’ of change in price. There can be following three situations:
(i) Income effect is positive: Where income effect of change in price is positive then there will be inverse relation between price and demand for a good. This is the case of normal goods.
(ii) Income effect is negative but less than the degree of substitution effect. In this situation also demand curve of the goods will slope downward from left to right. This happens in case of inferior goods. In both the above situations Marshall’s demand theorem applies, though he could not explain the nature of income effect.
(iii) Income effect is negative and its strength (degree) is greater than substitution effect. In this situation demand curve of goods will have a positive slope. This happens in case of Giffen goods (most inferior goods). Marshall considered this situation on exception to his demand theorem as he ignored income effect.