UNIT 2: THEORY OFDEMAND, SUPPLY AND ELASTICITY

OVERVIEW
This unit aims at developing an understanding of the concept of demand and supply and
elasticity. Students will be able to analyse how elasticity is measured. The importance of
elasticity of demand is as well explained. Also, the concept of market equilibrium is discussed.

LEARNING OUTCOMES
By the end of this unit, you should be able to do the following:
1. Discuss the concept of demand and supply.
2. Identify factors affecting demand and supply.
3. Analyse the concept of elasticity of demand and supply.
4. Discuss factors affecting elasticity of demand and supply.
5. Evaluate the importance of elasticity to management and government
6. Examine the Operation of Markets.
7. Explore the changes in Market Equilibrium.
8. Assess intervention in the Market.

DEMAND
In economics, demand is defined as the willingness and ability to buy a good or service at a
particular price over a given time period. Demand is not the same as wants. This is explained by
the fact that people can desire to have anything. For a desire or willingness to be considered as
demand, it must be backed by the ability to pay and thus it become an effective demand and has
an influence on the market.

The relationship that exists between price and quantity demanded is found to be an inverse one.
Hence, as price increases, normally quantity demanded falls and vice versa. This inverse
relationship that exists between price and quantity demanded can be represented through the
following demand schedule:

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 Price (Rs) Quantity Demanded (per week)
1 90
2 80
3 70
4 40
5 32
Table 1.1: Demand Schedule

If the above information is plotted graphically, the demand curve is obtained as shown below:

A normal demand curve slopes downward from left to right showing the inverse relationship that
exists between price and quantity demanded which is also called as the law of demand.

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Reasons why demand curves slope downward from left to right.
For most products, more will be demanded at lower prices than at higher prices. This link
between price and quantity demanded can be explained as follows:

(1) The income and substitution effects

(2) The Rational Consumer Behaviour
(3) The law of diminishing marginal utility

WARM-UP ACTIVITY
Students are expected to prepare brief notes on the reasons why the demand curves slope
downward from left to right.

EXCEPTIONS TO THE LAW OF DEMAND

As mentioned above, most demand curves slope downwards from left to right because of the law
of demand. There are, however, some unusual demand curves which show that more is being
demanded as price rises. This relationship is shown below where there is a direct link between
price and quantity demanded. Examples are the Veblens goods and Giffen goods

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EXTENSION AND CONTRACTION IN DEMAND (MOVEMENTS ALONG THE SAME
DEMAND CURVE)
Referring to the law of demand, assuming factors affecting demand to remain constant and
allowing only the price of the good to change, more will be demanded at lower prices than at
higher prices. Such an increase or decrease in demand resulting from a change in the price of the
good itself is also termed as extension or a contraction in demand as shown in the diagram
below;

Factors affecting demand or conditions of demand (Shifts in the demand curve)

Holding price constant, an increase in demand due to a change in the factors affecting demand
will shift the demand curve to the right and vice versa.
This can be shown in the diagram below:

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Factors affecting demand are as follows:
 Changes in disposable income
 Changes in the distribution of income
 Changes in the prices of related goods and services
 Changes in taste and fashion
 Advertising
 The availability of credit
 Changes in population size
 Changes in the age structure of population
 Weather

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PRICE ELASTICITY OF DEMAND
Elasticity is concerned with the extent to which demand, responds to a change inprice. The three
types of elasticity of demand measure how the quantity demanded responds to changes in the key
influences on demand; price, price of related products and income.

The price elasticity of demand measures the degree of responsiveness in quantity demanded due
to a change in price, assuming all other things remaining constant. In fact, it measures the rate at
which quantity demanded changes whenever there is a change in price. The formulae which are
commonly used are as follows:

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Where Q and P are original quantity demanded and original price andQ and P are changes in
quantity demanded and changes in price respectively.

The value of the price elasticity of demand is normally negativebecause of the inverse
relationshipbetween price and quantity demanded. However, for simplicity purposes, sign is
ignored.

Note to Students: Refer to STANLAKE, F.G. & GRANT, S.J., 2000. Stanlake’s Introductory
Economics (7th Revised Edition), Pearson Education Limited; Chapter 9 as from page 76 for
Types of Elasticity of Demand

INCOME ELASTICITY OF DEMAND

Income elasticity of demand is concerned with the association between changes in income and
changes in demand. This relationship is known as the income elasticity of demand. It is
measured by the following formula:

The value of the income elasticity of demand can be both positive and negative. If it is positive,
then, the product is said to be a normal good. If the value of the income elasticity of demand is
negative, then, the product is said to be an inferior good. The value of income elasticity of
demand ranges from 0 to ∞.

If the value of income elasticity of demand lies between 0 and 1, that is, 0 < YED < 1, then
demand is said to be relatively income inelastic.

If the value of income elasticity of demand lies between 1 and ∞, that is, 1 <YED <∞, then,
demand is said to be relatively income elastic.

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CROSS ELASTICITY OF DEMAND
The cross elasticity of demand measures the rate at which the quantity demanded of a good
changes when there is a change in the price of some other goods. Formulae to calculate cross
elasticity of demand are as follows:

The coefficient of the cross elasticity of demand can either be zero, positive or negative.
 If it is zero, then, the two goods are said to be unrelated.

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  If the two goods are related, then, they can either be two substitutes or two complements.

If the value of the cross elasticity of demand is positive, then, the two goods are said to be
substitutes to each other. On the contrary, if the value of the cross elasticity of demand is
negative, then, the two goods are said to be complements to each other, that is, jointly demanded
or complementary goods.

The PED can also be calculated by using the point price elasticity of demand formula as follows:

In this formula, ∂Q/∂P is the partial derivative of the quantity demanded taken with respect to the
good’s price, P0 is a specific price for the good, and Q0 is the quantity demanded associated with
the price P0.

To determine the point price elasticity of demand the following steps need to be undertaken:
1. Take the partial derivative of Q with respect to P, ∂Q/∂P.
2. Determine P0 divided by Q0.
3. Multiply the partial derivative

In order to maximise profits, knowledge about how much each additional unit sold adds to
revenue is as well important, hence, or in other words, calculation of the marginal revenue. If the
point price elasticity of demand, η, is known the following formula can be used to quickly
determine marginal revenue, MR, for any given price.

Similarly, point elasticities for the income elasticity of demand, cross-price elasticity of demand,
and advertising elasticity of demand can be calculated by using the following formulas:

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 The point income elasticity of demand:

In this formula, ∂Q/∂I is the partial derivative of the quantity taken with respect to income, I
is the specific income level, and Q is the quantity purchased at the income level I.

 The point cross-price elasticity of demand:

In this formula, ∂Qx/∂Py is the partial derivative of good x’s quantity taken with respect to
good y’s price, Py is a specific price for good y, and Qx is the quantity of good x purchased
given the price Py.

 The point advertising elasticity of demand:

In this formula, ∂Q/∂A is the partial derivative of the quantity demanded taken with respect
to advertising expenditures, A is the specific amount spent on advertising, and Q is the
quantity purchased.

Factors affecting Elasticity of Demand:

o Nature of the good
o Existence of substitutes
o Time period
o Cheap and expensive goods
o Existence of strong habits and preferences
o Percentage of income spent on the good
o Individual and collective goods
o Marketing strategies adopted by firms

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IMPORTANCE OF PED FOR MANAGEMENT
PED can help managers to take pricing decisions. For instance if PED is inelastic, managers can
go for an increase in price. However, if PED is elastic meaning that there are many substitutes
for the good, managers cannot increase price.

PED can also be useful to take decisions on shifting tax burden on consumers.
PED are also useful to decide on marketing strategies.

Importance of YED for Management

YED are useful for managers to decide in which line of business to enter or even to decide on
whether to contract or expand a particular business with respect to the economic environment
prevailing in the country.

ACTIVITY 1
1) Clearly explain the meaning of the income and substitution effect.

2) Discuss how the law of equi marginal utility explains the inverse relationship between
demand and price.

3) Using diagrams clearly explain the relationship between own-price elasticity, marginal
revenue and total revenue.

4) Explain the meaning of Veblens goods and Giffen goods.

5) The equation below shows the demand for good X drawn from a sample of households.

Qx= -1500 – 4000 Px + 800 Py + 7.5 I +10A

Where: Qx – represents the quantity demanded for good X;

Px – is the price of good X;
Py – shows the price for good Y; and

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 I – shows household income.
Assuming the initial values to be: Px = $ 1.5; Py = $1.25; and I = $600, A=$400

Calculate and interpret:

i. Price elasticity,
ii. Cross elasticity, and
iii. Income elasticity.

6) Discuss how an understanding of price elasticity of demand, income elasticity of demand

and cross elasticity of demand might be of use to a manufacturing firm.

SUPPLY
Supply is the willingness and ability to sell a good or service. It is not the same as the ‘existing
stock’ or ‘amount available’.

The Supply Curve

According to the law of supply, more is supplied at higher prices. So, the supply curve slopes
upwards from left to right. The diagrams below show a supply schedule and based upon which a
supply curve has been derived:

Price Quantity Supplied (week)

50 250
40 220
30 180
20 120
10 50
Table 1.2: Supply schedule
Supply Curve:

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To supply larger quantities, firms need higher prices in order to cover higher costs.

Movements along a Supply Curve

Movements along a supply curve are referred to as extensions and contractions or as changes in
the quantity supplied.

CHANGES IN SUPPLY
The diagram below illustrates an increase in supply from SS to S1S1. This leads to an increase in
the quantity supplied at any given price.

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The diagram below illustrates a decrease in supply. The supply curve shifts to the left from SS to
S1S1. The effect will be to reduce the quantities supplied at all prices.

Factors Affecting Supply:

 Weather (Climatic conditions)
 Disease
 Technological progress
 Changes in the prices of factors of production (costs of production)
 Changes in the prices of other commodities (Substitutes and complements)
 Indirect taxation and subsidies
 Changes in the number of producers (Entry and exit of producers)
 Unexpected events
 Changes in labour productivity
 Presence of speculation
 Government policy

PRICE ELASTICITY OF SUPPLY

Price elasticity of supply measures the degree of responsiveness in supply as a result of a change
in price. The formula used to measure elasticity of supply is:

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Note to Students: Refer toSTANLAKE, F.G. & GRANT, S.J., 2000. Stanlake’s Introductory
Economics (7th Revised Edition), Pearson Education Limited; Chapter 10 as from page 94.

Factors affecting Price Elasticity of Supply:

 The level of spare capacity in the industry
 The level of employment
 The ability to store the product
 Whether the products are agricultural or manufactured ones (Nature of the good)
 The time it takes to increase capacity (Time Period)
 Market conditions
 Rate of change of technology

EQUILIBRIUM PRICE AND OUTPUT

Price equilibrium is determined at the point where supply and demand are equal. This is the point
where both sellers and buyers are satisfied with the price and quantity.

In the example below equilibrium price is £0.35 and 250 units would be demanded at this
price.

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GOVERNMENT INTERVENTION IN MARKET PRICES
In some markets, the government intervenes and fixes the price of certain goods.

A maximum price or a price ceiling is a price fixed by the government below the equilibrium
price while a minimum price or a price floor is a price fixed above the equilibrium price as
shown on the diagrams below.

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ACTIVITY 2
(a) By using appropriate diagrams, explain and illustrate the impact of a change in the factors
of demand and supply on the equilibrium price and quantity.

(b) Discuss the impact and consequences of

(i) A price ceiling
(ii) A price floor

(c) Discuss the measures the government can adopt to correct the problems caused by a price
ceiling?

SUMMARY
By the end of this unit, students should be able to discuss the concept of demand, supply and
elasticity. Also, the factors affecting demand and supply have been listed in the unit. Students
should have developed an understanding of the determination of prices through price mechanism
and through government intervention.

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REFERENCES
Chapter 3: Elasticity; Oswego State University of New York
[Online] Available at: www.oswego.edu/~edunne/101chapter3.ppt
Accessed on 13 April 2015

SUGGESTED READINGS
 STANLAKE, F.G. & GRANT, S.J., 2000. Stanlake’s Introductory Economics (7th
Revised Edition), Pearson Education Limited.

 MCCONNELL, C., BRUE, S. &FLYNN, S., 2008. Economics (McGraw-Hill Series

Economics; MCMillan/McGraw-Hill Publishing.

 BEGG, D., FISCHER, S. & DORNBUSCH, R., 2008. Economics. Paperback - Apr. 1,
2008.

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