Aggregation Problem of Market Demand | Goods

In this article we will discuss about the aggregation problem of market demand, explained with the help of a diagram. 

The aggregation of individual demand curves for a good to obtain its market demand curve by means of horizontal summation of the individual curves would pose no problems if the individual demand curves are independent.

But, if these curves are not independent, for example, if individual B’s purchases depend on A’s purchases, either because B is jealous of A and tries to keep up with A in consumption or because B’s income depends in some way on A’s purchase, then it cannot simply take the horizontal summation of the individual curves to obtain the market demand curve.

For, now observe how a shift in the demand curve of one individual affects the demand curves of others, would have an aggregation problem. The most convenient solution to this problem is to assume away the problem.

Actually, most pure theory proceeds on the assumption that the individual demand curves are independent and their formal axiom here is that consumers’ preferences are selfish.

By this axiom, it is assumed that a particular consumer’s preferences are not influenced by the consumption levels of others, and the consumers do not judge quality by price, i.e., it is not that the consumers buy more at higher prices because a higher price indicates a higher quality.

However, simple observations and introspections suggest that this axiom is severely restrictive. The axioms, in general, involve oversimplification, but the axiom of selfishness implies a substantial departure from reality.

Therefore, what happens to the theory of consumer behaviour if the selfishness axiom is relaxed.

First, it may be assumed that an individual purchases goods in order to behave like other members of his social group. If their demand for a good increases, so will his, since he wishes to identify with them. This effect is known as the bandwagon effect.

The effect with the help of Fig. 1.8, where D_X is the market demand curve for a good X under the axiom of selfishness, or under the absence of interdependencies. Along this demand curve, at the point A, the market demand for the good is q, at the price p₁ and if price falls from p₁ to p₂, move from the point A₁ to A₂, and the market demand for the good would increase from q₁ to q₂.

This is because a large section of the existing customers, if not all of them, will want to purchase more of the good now that its price has fallen. Besides, some new but selfish buyers would enter the market to have the good at a lower price.

However, if there is the bandwagon effect, a large number of new customers driven by the desire to keep up with the Joneses will enter the market, and the demand for the good at the price of p₂ will exceed q₂.

If the demand for the good becomes q₃ > q₂, then the market demand curve would be the curve D_X passing through A₁ (p₁, q₁) and A₃ (p₂, q₃). This market demand curve, D_X, would be more flat and more elastic than the original curve, viz., D_X. So the bandwagon effect makes the market demand curve more elastic.

A second case of violation of selfishness axiom occurs if the consumer attempts to make himself different from other members of his social group by purchasing the commodities which they do not purchase, and, conversely, by reducing the purchase of the goods which they purchase, i.e., if the consumer behaves like a snob.

The effect of such be­haviour of the consumer is known as the snob effect, this effect can be illustrated with the help of Fig. 1.9.

Here the market demand curve when the snob effect did not exist is D_X. Along this demand curve, the market demand for the good is q₁ at the price p₁—this is at the point A₁, and if the price falls to p₂, the market demand would rise to q₂, i.e., move from the point A₁ to the point A₂ along the curve D_X.

However, if some of the buyers of the good behaved like snobs, then demand at the price p₂ would not have increased to q₂, it would have been somewhat less, say, q₃ (q₃ < q₂). Therefore, if the snob effect exists, the demand curve would not pass through A₁ and A₂, it would pass through the points A₁ (p₁, q₁) and A₃ (p₂, q₃). Since q₃ < q₂, the snob effect makes the demand curve more steep and less elastic.

Lastly, a case of consumer’s lack of independence where he judges the quality of a good by its price. The effect upon the market demand for the good that is obtained here is known as the Veblen effect after the economist Thorstein Veblen.

The Veblen effect can be illustrated with the help of Fig. 1.10. In this figure, the curve D_X is the market demand curve that would be obtained as the horizontal summation of the individual demand curves, i.e., if the axiom of selfishness prevailed.

At the point A₁ on this demand curve, the price-demand combination is (p₁q₁), and if price comes down from p₁ to p₂, then at the point A₂, demand would increase from q₁ to q₂. But if there is Veblen effect, the fall in the price from p₁ to p₂ would induce some of the consumers to think that the quality of the good has worsened and they will reduce their quantities purchased of X.

Because of this, demand for the good at the price of p₂ will not be equal to q₂, but it would be somewhat less; let us suppose it would be q₃. Therefore, the market demand curve, instead of being D_X, would be D_X which would pass through the points A₁ and A₃ and it would be steeper than D_X, but downward sloping. Therefore, the Veblen effect, generally, makes the demand curve less elastic.

A stronger Veblen effect may, of course, make the market demand curve positively sloped, i.e., it would generate an exception to the law of demand.

In Fig. 1.10, this case would be obtained, if, as price falls from p₁ to p₂, some of the consumers may think so strongly of a quality fall that the quantity demanded would be as small as q₄ so that by joining the points A₁ and A₄,  a positively sloped demand curve, viz., D_X.

If the consumers’ choices and buying plans are interdependent, the true market demand curve would diverge from the horizontal summation of the individual demand curves.

However, the extent of such divergence would depend on the strength of the bandwagon, snob and Veblen effects and on the number of individuals subject to such effects. Note here that the market is composed of a large number of independent buyers. Therefore, it is most likely that all the three effects may work together along with the normal consumer behaviour.