Question

Economists claim that to derive the market demand curve, one should take the horizontal sum of the individual demand curves. If this is so, how can the horizontal demand curves to the many small perfect competitors, figure 1, sum to the downward-slope demand curve, figure 2, which represents the entire market demand?

Short answer

In a perfectly competitive market, individual demand curves are horizontal, meaning consumers can purchase any quantity at the market price without affecting it. To derive the market demand curve, we sum these individual demand curves horizontally by adding quantities demanded by all consumers at each price level. This results in a downward-sloping market demand curve, as a lower price leads to more consumers purchasing the good, increasing overall market quantity demanded. The apparent contradiction between the horizontal demand curve of an individual and the downward-sloping market demand curve arises from the difference in market power at individual and market levels. The horizontal individual demand curve reflects the small market power held by individuals, while the market demand curve captures the responsiveness of the entire market to price changes.

Step-by-step solution

Understanding Individual Demand Curves

An individual demand curve represents the relationship between the quantity demanded of a good by a single consumer and the price of that good. In a perfectly competitive market, each consumer faces a horizontal demand curve, meaning that they can purchase as much of the good as they desire at the market price.

Summing Individual Demand Curves Horizontally

To find the market demand curve, we need to add the individual demand curves horizontally. This means that at each price level, we sum the quantities demanded by all consumers. To visualize this, imagine stacking the individual demand curves on top of each other and then adding the quantities demanded at each price level.

Visualizing the Downward-Sloping Market Demand Curve

When we sum the individual demand curves horizontally, we obtain a downward-sloping market demand curve. The reason for this downward slope is that as the price of the good decreases, more consumers are willing to purchase the good, which increases the overall quantity demanded in the market. Conversely, as the price increases, fewer consumers are willing to purchase the good, resulting in a lower quantity demanded in the market.

Explaining the Difference between Horizontal and Downward-Sloping Demand Curves

The individual demand curves in a perfectly competitive market are horizontal because each consumer can buy as much of the good as they want at the market price without influencing the price. The market price is determined by the intersection of the market demand and market supply curves. However, when we aggregate the individual demand curves to create the market demand curve, we observe a downward slope as the overall quantity demanded in the market responds to changes in price.

Reconciling the Horizontal Demand Curve of Perfect Competitors with the Market Demand Curve

The key to understanding the apparent contradiction between the horizontal demand curve of a perfectly competitive individual and the downward-sloping market demand curve lies in the difference between the individual and market levels. The horizontal individual demand curve reflects the small amount of market power held by each individual in the market, while the downward-sloping market demand curve captures the overall responsiveness of the entire market to price changes. In conclusion, when summing the individual horizontal demand curves of a perfectly competitive market, we obtain a downward-sloping market demand curve. The reason for this downward slope is that as the price decreases, more consumers are willing to participate in the market, leading to an increase in the quantity demanded overall. The individual horizontal demand curves represent each competitor's limited market power, while the market demand curve represents the total market responsiveness to price changes.

Key concepts

Individual Demand Curves

Imagine a single consumer in a market, deciding how much of a product to purchase at different prices. This is where the concept of an individual demand curve comes into play. It's a graphical representation that shows the relationship between the quantity of a product that the consumer is willing to buy and the price of that product. Typically, individuals are likely to buy more of something when prices are low and less when prices are high. This relationship usually results in a demand curve that is downward-sloping for an individual.

However, in a perfectly competitive market, every consumer faces the same price, which is determined by the market as a whole. This can lead to horizontal individual demand curves for price-taking consumers, because they can purchase any quantity at the given market price without affecting that price. It's crucial to understand the behavior of individual consumers to later grasp how these curves combine to form the market demand curve.

Perfect Competition

When economists refer to perfect competition, they describe a market structure characterized by a high number of sellers and buyers, homogeneity of products, and ease of entry and exit. In such a market, no single buyer or seller has the power to influence the market price of goods and services. Buyers and sellers are known as 'price takers' because they must accept the prevailing market price. In a perfectly competitive market, the individual demand curve that a seller faces is horizontal at the market-determined price, illustrating the concept that the seller can sell any amount of good at this price.

The idealization of perfect competition can help us understand broader economic principles, such as resource allocation efficiency and the effects of market forces on price and production.

Price Elasticity of Demand

Price elasticity of demand is a measure that captures how much the quantity demanded of a good changes as its price changes. This concept is crucial because it tells us how sensitive consumers are to price changes. If the demand is elastic, even a small price increase could lead to a significant drop in the quantity demanded. Conversely, if demand is inelastic, changes in price have little to no effect on the quantity consumers want to buy.

To calculate the price elasticity of demand, we use the formula: \( E_d = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}} \). The market demand curve's slope relies heavily on this elasticity. Understanding elasticity helps businesses and policymakers predict how a change in price can impact total revenue and expenditure.

Horizontal Sum of Demand Curves

The market demand curve is created by adding up, or summing horizontally, the quantity demanded by all individual consumers at each price point. This is not as simple as just adding up all the individual quantities demanded—instead, it's about determining the combined quantity that all consumers will purchase at each possible price. If we lay all the individual demand curves side by side and sum the quantities demanded at each price level, the resulting curve will typically slope downward. This depicts the market demand.

The horizontal summation process acknowledges that even if each consumer's quantity demanded doesn't change with price (a horizontal line), the market as a whole adds more buyers as the price decreases, thus increasing the total quantity demanded—the essence of why the aggregated market demand curve slopes downward.

Downward-Sloping Demand

Downward-sloping demand is a fundamental principle in economics, which states that, generally, as the price of a good or service decreases, the quantity demanded increases, and vice versa. This concept is visualized as a downward-sloping curve on a graph where price is on the vertical axis and quantity demanded is on the horizontal axis.

This behavior results from the law of diminishing marginal utility, which suggests that as consumers purchase more of a good, the additional satisfaction from each extra unit tends to decrease, so they are only willing to buy additional quantities at lower prices. Importantly, the market demand curve's downward slope comes from the aggregation of individual demand curves and represents a broader market phenomenon that higher prices deter consumption and lower prices encourage it.