Unit-2

Demand Analysis and Theory of Demand

INTRODUCTION

In managerial economics we are concerned with demand for a commodity faced by the firm.
Demand in fact is regarded as the lifeline of a business enterprises. It is one of the crucial
requirements for the very existence of any business firm or organization. An extent of sales and
profit of the firm depend particularly upon the demand for its product. Demand analysis seeks to
identify and measure the forces that determine sales. In the words of Joel Dean Demand analysis
has the following important business or managerial purposes; forecasting sales manipulating
demand appraising salesman’s performance and fixing their quotas and tracing the trend of the
firms competitive position in the market.

Thus demand analysis is essential for a business firm in the following ways:
1. Demand analysis is required to identify and ensure the forces that determine sales
2. Extent of production and cost allocation depend upon demand analysis.
3. Demand analysis is essential for pricing and inventory holdings
4. Demand analysis helps in sales forecasting and profit planning
5. New product policy and advertisement policy cannot be drawn without the analysis of
demand.
6. Research and development strategy cannot be framed without demand analysis.
7. Demand analysis is the basis of tracing the trend of the firm’s competitive position in the
market.

In nutshell we can say that demand analysis is primarily used for forecasting and promotion of
sales. Production can be better planned if future demands are identified. However demand
forecasting can be analysed in an efficient way only after we have the knowledge of demand
demand function demand distinctions determinants of demand law of demand etc.

II Meaning of Demand

In ordinary language the terms need desire want and demand are used in the same sense. But in
Economics all these terms have different meanings. For instance a sick a child needs a tonic a
peon desires to have a car but such needs and desires do not constitute the demand.

Desire. A desire for anything is not the demand for it. Desire means a conscious longing for a
thing.

A poor man may have a desire to possess a grand bungalow a car and so many other costly
things but he is too poor to purchase them his desire for them will simply remain a desire for he
does not have enough money with him.

Want. Want is that desire which is backed by the ability and willingness to satisfy it. Likewise.
Determinants of Demand or Factors Affecting Demand

The demand for a commodity depends upon many factors as listed below:

1. Price of the Commodity: Basically demand for a commodity depends upon its price. If the
price rises the demand falls and if the price falls the demand rises.

2. Price Expectations: Demand is also influenced by expected changes in prices. If people

anticipate a rise in price in future they buy more now and store the commodities. Then demand
increases. If they expect a fall in price they may postpone their purchases. Then demand
decreases.

3. Price of Related Goods: The demand for a commodity is also influenced by changes in the
price of related goods like substitutes and complementaries. The demand for tea depends not
only on its price but also on the price of its substitute coffee. If the price of coffee falls while that
of tea remains the same the demand for tea falls. Similarly the demand far petrol depends not
only on its own price but also on the price of cars and scooters. Car and petrol being
complementary goods. If price of cars fall demand for petrol will rise irrespective of the price of
petrol. The demand for cement may rise because the price of bricks has come dowm resulting in
increase in demand for bricks and therefore for cement as well.

4. Income of the Consumer: Income levels determine the demand to a great extent. Normally
there is direct relationship between income and demand. In case of normal goods if income rises
demand increases and if income falls demand decreases. On the other hand demand for inferior
goods falls with increase in income and rises with decrease in income.

5. Population: Demand for commodities depends upon the size of population. Increase in
population leads to more demand for all types of goods and decease in population leads to a fall
in demand. Composition of population also affects the demand. Composition refers to the ratio of
males females adults and children and the number of old in the population. If the number of
females exceeds the number of males then the demand for goods required by women falls as
Lipsticks, Bangles, Bindies, Sarees etc will be more. On the other hand if the number of old
persons is more than the demand for spectacles sticks denturies tonic etc will increase.

6. Tastes and Preference: These terms are used in broad sense. They include fashion habit
custom etc. Tastes and preferences f the consumers are influenced by advertisement climate and
new inventions etc. Demand for those goods goes up for which consumers develop taste. On the
other hand demand for a particular good will go down if people have no liking for that.

7. Distribution of Income: Demand is also influenced by the distribution of income in the

society. If income is equitably distributed there will be more demand. If income is not equitably
distributed there will be less demand. In the latter case the rich becomes richer and the poor
becomes poorer and because of the low income of the larger group of the society i.e. for the poor
the demand will also be low.
8. Discoveries: If new substitutes are discovered they may decrease the demand for original
products. Polythene milk bags have deceased the demand for milk bottles. Synthetic fibre has
reduced the demand for cotton cloth.

9. Trade Activity: The level of demand for different goods depend upon the business condition of
the country. If the country is passing through boom when trade is active and brisk the demand for
all commodities tends to rise. But in the days of depression when trade is dull and slow demand
tends to fall.

10. Climate and Weather: Demand for commodities also depend upon the climate of an area and
weather. In cold hilly areas woolens are demanded. During summer demand for umbrellas may
rise in winter ice is not so much demanded.

11. Money Supply: Supply of money determines the purchasing power of money. When money
supply increases people acquire more purchasing power thus increasing the demand for goods
and services. If money supply falls demand for goods also falls.

12. Savings: If people save more they will have less money to spend on goods then demand
decreases. If people save less demand will increase.

13. Reduction in Taxes: Reduction in taxes and duties will allow more persons to enter a
particular market and thus raising the demand for a particular product.

Demand Function

The important factors influencing the demand for a commodity can be briefly expressed in the
following functional relationship known as demand function. In other words demand function is
a comprehensive formulation which specifies the factors that influence demand for the product.

Dx=f(Px, Py, Y,T…etc)

Here Dx means the demand for a commodity x the word f shows the functional relationship
between the demand of x and the other variables i.e Pr which refers to the prices of related goods
or the prices of substitutes and complementary goods y represents the income of the consumer
while T is an indicator of their tastes and preferences. In simple words demand function shows
that the demand for a commodity x depends upon the price of x the prices of other related goods
the income of the consumers and their tastes and preferences.

It thus evident from demand function that demand of a commodity is affected by various factors
i.e. there are numerous determinants of demand. These determinants have already been explained
in Section IV.

Demand Schedule

Demand schedule is a schedule which shows different quantities of a commodity purchased at

different prices. It is a list of prices and quantities. It explains the functional relationship between
price and demand of a commodity. It is T shaped. In one column the different prices of a
commodity and in the other various quantities bought are portrayed.
Demand schedule is of two types:
1. Individual Demand Schedule
2. Market Demand Schedule

1. Individual Demand Schedule: An individual demand schedule is a schedule or a list of various

quantities of a commodity which an individual consumer purchase at different prices in the
market. Individual demand schedule is traced below:-

Table 3.1 Individual Demand Schedule

Price of Milk per kg (in Rs) Quantity Demanded by Mr x (in kg)

5 1
4 2
3 3
2 4
1 5

The above is the demand schedule of Mr x for milk. The demand schedule agrees with the law of
demand. As price falls demand increases. When the price of milk is Rs 5.00 per kg only 1 kg of
milk is demanded but when the price falls to Rs 1.00 per kg 5 kg of milk is demanded.

2. Market Demand Schedule: Market demand schedule is a schedule which represents different
quantities of commodity which all consumers will buy at all possible prices at a given moment of
time. In every market there are many buyers of a commodity. The market demand schedule can
be obtained by adding up all the individual demand schedules. Market demand schedule shows
the different quantities of a commodity purchased by all the consumers collectively at its
different prices. It is the sum total of all individual demand schedule of the commodity at
different prices.

DM = DA, + DB, +…. Dn

where DM is the market demand schedule and DM = DA, + DB, +…. Dn are individual demand
schedules. Table 3.2 represents market demand schedule. The schedule is based on the
assumption that there are only two consumer’s Mr x and Mr y of milk in the market. By
summing up there individual demands the market demand schedule has been drawn:

Table 3.2 Market Demand Schedule

Price of milk per kg Demand of Mr x (kg) Demand of Mr y (kg) Market Demand (kg)
(in Rs)
5 1 2 1+2=3
4 2 3 2+3=5
3 3 4 3+4=7
2 4 5 4+5=9
1 5 6 5+6=11
Demand Curve

The graphic representation of demand schedule is a demand curve. Demand curve is a

geometrical representation of what demand schedule represents arithmetically. It is a
diagrammatic presentation of the relation between different quantities of a commodity demanded
at different prices at a given time in the market.

The whole demand curve shows the complete relations between quantity demanded and price. A
single print on a demand curve depicts a single price quantity relation. Demand curve is a
geometric device to express the relation between quantity demanded and price.

Like demand schedule demand curve is also of two types:

1. Individual Demand Curve

2. Market Demand Curve

1. Individual Demand Curve: Individual demand curve is a curve which presents different
quantities of a commodity demanded by a consumer at different prices. Fig 3.9 portrays
individual demand curve. On X-axis is shows quantity demanded and on Y-axis the price. DD is
the demand curve drawn on the basis of our individual demand schedule. Each point on DD
demand curve expresses the relation between price and demand. At a price of milk Rs 5.00 per
kg demand is 1 kg and at a price of Rs 1.00 per kg demand for mil is 5 kg. The demand curve
slops downwards from left to right which means that when price is high demand is low and when
price is low demand is high. Such a slope is called negative slope of the demand curve.

2. Market Demand Curve: It is a curve that depicts the aggregate demand of all the consumers in
the market at different prices. Technically this market demand curve is the lateral summation (to
add together sidewise) of all the individual demand curves concerning homogeneous commodity.
In Fig 3.10 the market demand curve is shown which is based on the market demand schedules
traced in Table 3.2.

A I
5 B e ndiv
mCa idu
4 nd al
price

CuD
3 E
2
1 D
0 1 2 3 4 5
D dFig.3.9 Individual Demand Curve
In Fig 3.10 quantity demanded is shown along X-axis and price on Y-axis. Dx and Dy are the
individual demand curves and Dm is the market demand curve which has been obtained by the
lateral summation of the individual demand curves. Its slope is also negative.

Law of Demand

This law is also known as the first law of purchase. It indicates the functional relationship
between the price of a commodity and its quantity demand in the market. Law of demand states
that other things being equal the demand for a good extends with a fall in price and contracts
with a rise in price. Symbolically law of demand is illustrated as under:

P D
P D

It can further be clarified with the help of the following equation:

Dx = f(Px, Pr, Y, T, U……..)

Herein the shorthand expressions indicate that demand for commodity x i.e. (Dx) is a function (f)
of price of commodity x(Px) while price of related goods (Pr)consumer’s income (Y) and his
tastes (T), (µ) represents other determinants of demand like size of population its composition
distribution of money income weather etc remains constant. Herein by putting bar on Pr Y T and
U it is assumed that these determinants of demand are held constant and a functional relationship
is established between the quantity of demanded of a commodity and its price.

In simple words law of demand explains the inverse relationship between price and demand of a
commodity.

Definition of Law of Demand

Dr Marshall defines it as the law of demand states that amount demanded increases with a fall in
price and diminished with a rise in price.
In the words of Sumelson Law of demand states that people will buy more at lower prices and
buy less at higher prices ceteris paribus or other things remaining the same.
Benham defines the law as Usually a larger quantity of a commodity will be demanded at a
lower price that at a higher price.
In Ferguson’s words According to the law of demand the quantity demanded varies inversely
with the price.

Assumptions of the Law of Demand

While stating the law of demand the phrase other things remaining the same is used. It conceals
the conditions on which the law of demand is based. The main assumption of the law are the
following:

1. No change in the income of the consumer

2. No change in the prices of related goods
3. There should be no expectation of any change in the future prices of the commodity.
4. Consumers tastes preferences and choices remains constant
5. The commodity in question is not of any prestigious value such as diamonds etc
6. No substitutes for the commodity in question are available

Explanation of the Law of Demand

The law of demand can be illustrated with the help of the following demand schedule and
demand curve.

Price of Milk per litre (in Rs) Quantity for Milk (Qtls)
5 10
4 12
3 15
2 20
1 30
This imaginary market demand schedule for milk represents that as the price of milk goes down
from Rs 5.00 per litre to Rs 1.00 per litre the demand for milk goes up from 10 Qtls to 30 Qtls
and when the price of milk goes up its demand comes down. The same fact has been represented
by the demand curve DD in the Fig 3.11 which is based on the hypothetical market schedule of
milk.

8.4 Main points of the Law of Demand

Following are some of the important facts concerning law of demand which should be born in
mind:

1. Inverse Relationship: The law of demand states the inverse relationship between the price and
quantity demanded. It simply affirms that a rise in price would tend to reduce demand and a fall
in price would tend to increase in demand.

2. Qualitative and Not Quantitative: Law of demand makes a qualitative statement only. It
indicates the direction of change in the amount demanded and the law speaks nothing about the
magnitude of the upward and downward swings.

3. No Proportional Relationship: It should be clearly understood that the law of demand does not
establish a proportional relationship between change in price and resultant change in demand.

4. Comparison with the Game of See saw: Demand and price are like the two ends of a sea saw.
When the one end say price goes down and the other one say demand goes up and vice versa.
Thus the law of demand can be compared with the game of see saw.

5. One Sided: Law of demand is one sided. It explains only the effect of change in price on the
demand. It speaks nothing about the effect of change in demand on the price of the commodity.
Causes of the Operation of the Law of Demand
Or
Why does Demand Curve Slope Downwards?

Why does the law of demand apply? Why is the demand curve negatively sloped? There are
some reasons given for the inverse relationship between price and amount demanded in case of
ordinary commodities. These reasons are as follows.

1. Law of Diminishing Marginal Utility: The law of diminishing marginal utility tells us firstly
that as the stock of things increases its marginal utility other things remaining the same
decreases. Secondly we know that the price which a person is willing to offer for a commodity is
equal to its marginal utility to him. Therefore as the quantity offered for sale increases its
marginal utility to be buyer decreases the consequently the price which the buyer is willing to
pay for its successive units goes on diminishing. This is the law of demand.

2. Income Effect: The working of the law of demand can be explained in terms of Income Effect.
A fall in the price of a commodity results in a rise in consumer’s income. He can therefore
purchase more of it. On the contrary a rise in the price of a commodity results in a fall in his real
income. He is therefore forced to purchase less of it. Thus when price falls amount demanded
increases and vice versa represents the operation of the law of demand due to income effect.

3. Substitution Effect: The operation of the law of demand can also be explained in terms of
substitution effect. The fall in the price of a commodity (the prices of its substitutes remaining
constant) makes it more attractive to the consumers who now substitute it for the comparatively
costly substitutes leading to an extension to its demand. This can be attributed to the substitution
effect. Conversely a rise in the price of a commodity (while the prices of its substitutes remain
constant) will make it unattractive to the consumers who will now demand less of it. They will
now use other commodities (whose prices have not risen) in place of the commodity in question.
Consequently there will a contraction in its demand which can be attributed to the substitution
effect. For example with the fall in the price of tea the price of coffee remaining the same tea will
be substituted for coffee and thereby the demand for tea would go up. This is nothing but
application of the law of demand due to substitution in effect.

1. New Buyers: When the price of a commodity falls the demand for that increases two fold
(1) the existing buyers buy more (2) new buyers also start purchasing it because with the
fall in the price the commodity will come within the rach of lower income group people.

2. Different Uses: Many goods have several uses some of which are more important than
others. If the price of the commodity is high its use will be restricted to the most
important purpose. The demand of the commodity will therefore be small but when the
price declines the consumer will use it in less important uses also. Consequently the
demand for the commodity will rise.

3. Benham’s Explanation: Benham has explained the law of demand by using the concept of
consumers equilibrium. We know that with a given income and price a consumer attains
equilibrium by equalising the marginal utility and price of the good he purchases. If the
price of a good falls it disturbs his equilibrium position. He may again attain equilibrium
 by purchasing more of that good. Thus a fall in price leads to higher demand and vice
versa.

Exceptions to the Law of Demand

There are certain exceptions to the law of demand. It means that under certain circumstances
consumes buy more when the price of a commodity rises and less when the price falls. In such
cases the demand curve slopes upward from left to right i.e. demand curve have a positive slope
as is shown in Fig. 3.12. Many causes can be attributed to an upward sloping demand curve.

1. Ignorance: When the consumer haunted by the phobia that high price goods are always
superior in quality. It may not be true. Superior/deceptive packing and high price deceive the
people. They may purchase more because of this price situation. The producers of cosmetics
goods like face creams powders lipsticks etc have experienced such a behavior in the market.
This can be called as Ignorance effect.

2. Speculative Effect: When the price of a commodity goes up people may buy larger quantity
than before if they anticipate or speculate a further rise in its price. On the other hand when the
price falls people may not react immediately and may still purchase the same quantity as before
waiting for another fall in the price. In both the cases the law of demand fails to operate. This is
known as speculative effect.

3.The Giffen’a Paradox: A fall in the price of inferior goods (Giffen Goods) tends to reduce its
demand and a rise in its price tends to extend its demand. The phenomenon was first observed by
Sir Robert Giffen popularly known as Giffen’s paradox. He observed that the working class
families of UK were compelled to curtail their consumption of meat in order to be able to spend
more on bread Mr Giffen British ecomoist observed that rise in the price of bread caused the low
laid British workers to buy more bread and not less. These workers lived mainly on the diet of
bread when price rose as they had to spend more for a given quantity of bread they could not buy
as much meat as before. Bread still being comparatively cheaper was substituted for meat even at
its high price.

4. Fear of Shortage: The people may buy more of a commodity even at higher prices when they
fear of a shortage of that commodity in near future. This is contrary to the law of demand. It may
happen during times of war and inflation and mostly in the case of goods which fall in the
category of necessities of life like sugar kerosene oil etc then the tendency to hoard or stock
piling these commodities all the more will be great.

5. Prestigious Goods: This is explained by Veblen. If consumers measure the desirability of a

good entirely by its price and not by its use then they buy more of a good at high price and less
of a good at low price. Diamond Jewellary and big cars etc are such prestigious goods. In their
case demand relates to consumer who use them as status symbol. As their prices go up and
become costlier rich people think it is more prestigious to have them. So they purchase more. On
the other hand when their prices fall sharply they buy less as they are no more prestigious goods.
This is known as Veblem’s effect or also as demonstration effect.
6. Conspicuous Necessities: Another exception occurs in use of such commodities as due to their
constant use have become necessities of life. For example in spite of the fact that the prices of
television sets refrigerators washing machines cooking gas scooters etc have been continuously
rising their demand does not show any tendency to fall. More or less same tendency can be
observed in case of most of other commodities that can be terms as Upper Sector Goods.

Importance of the Law of Demand

The following is the importance of the law of demand:

1. Useful for the seller or Manufacturer: It is useful for the seller or the manufacturer. While
fixing price for his commodity seller or the manufacturer is faced with the problem like how
much would his sales fall off if he raises the price of his product? Or how much would his sales
expand if lowers the prices to a given extent.

2. Price Determination: A monopolist gets the help of the law of demand in fixing his price. He
is able to know how much amount demanded for his commodity shall up or down with change in
prices.

3. To the Finance Minister: The law of demand is very useful to the Finance Minister of the
State. The minister in search of revenue has to take into account the demand schedule for a
commodity which he is going to tax. If increasing the rate of taxation of a commodity reduces its
sale to a large extent it will not be a good policy to tax this commodity. Only such commodities
should be taxed as have relatively inelastic demand.

4. To Farmers: How far shall a good or bad crop effect the economic condition of the farmer can
be known from the law of demand. If there is a good crop and demand for it remains the same
price will definitely go down. The farmer will not have much benefit from a good crop under
such situation.

Changes in Demand

Demand does not remain fixed. It however changes. The changes in demand can be of following
two types:

1. Extension and Contraction of Demand or Movement Along Demand Curve

2. Increase and Decrease in Demand or Shifts in Demand Curve

In ordinary language extension of demand increase in demand have the same meaning. Similarly
contraction of demand and decrease in demand have the same meaning but in economics there is
lot of difference in them. This is made clear as under:

A shift in demand means at the same price, consumers wish to buy more. A movement along the
demand curve occurs following a change in price.

Movement along the demand curve

A change in price causes a movement along the demand curve. It can either be contraction (less
demand) or expansion/extension. (more demand)

Contraction in demand. An increase in price from $12 to $16 causes a movement along the demand
curve, and quantity demand falls from 80 to 60. We say this is a contraction in demand
Expansion in demand. A fall in price from $16 to $12 leads to an expansion (increase) in demand.
As price falls, there is a movement along the demand curve and more is bought.
A change in price doesn’t shift the demand curve – we merely move from one point of the demand
curve to another.

Shift in the Demand Curve

A shift in the demand curve occurs when the whole demand curve moves to the right or left. For
example, an increase in income would mean people can afford to buy more widgets even at the same
price.

The demand curve could shift to the right for the following reasons:

 The good became more popular (e.g. fashion changes or successful advertising campaign)
 The price of a substitute good increased.
 The price of a complement good decreased.
 A rise in incomes (assuming the good is a normal good, with positive YED)
 Seasonal factors.
 Elasticity of Demand

INTRODUCTION

Law of demand states that there is an inverse relationship between the price and quality
demanded of a commodity. The law explains that when price falls demand extends and when
price rises demand contracts. The law of demand thus explains the direction of change in
demand for a commodity as a result of change in its price. But by our common experience we
see that there is no quantitative uniformity in the behavior of various goods regarding changes in
their prices in their demand but in case of other goods like salt the quantity demanded is little
affected by the fluctuation in its price. The law of demand thus does not explain the degree of
change in demand. It does not explain how much the quantum of demand will change to a given
change in price. In managerial economics the management needs to know more i.e it must have
information regarding the magnitude of the impact of each factor in the quantity demanded. In
order to measure the extent of change in demand Prof Marshall developed the concept of
elasticity of demand in his famous book Principles of Economics. Though the concept of
elasticity of demand is generally associated with the name of Prof Marshall yet this idea was
evolved much earlier by economists like Cournot and J.S. Mill.

Meaning of elasticity of Demand

Elasticity of demand measures the degree of change in demand of a commodity in response to a

change in the price of the commodity or change in the income of the consumer or change in the
prices of related goods. In the words of Dooley. The elasticity of demand measures the
responsiveness of the quantity demanded of a good to change in its price price of other goods
and changes in consumer’s income.

This is the general definition of the term elasticity of demand.

It is clear from this definition that elasticity of demand can be mainly of three types:

1. Price Elasticity of Demand

2. Income Elasticity of Demand
3. Cross Elasticity of Demand

III Price elasticity of Demand

The variation in demand in response to a variation in price is called the price elasticity of
demand. Price elastic of demand is the rate at which quantity bought changes as a result of
change in the price of the commodity other things being equal. Modern economists define
elasticity of demand in a mathematical manner as in the words of Prof Lipsey Price elasticity of
demand may be defined as the ratio of the percentage change in demand to the percentage
change in price it may be written as
 PE= Percentage change in amount demanded/Percentage change in price

Definitions

According to Dr Marshall Elasticity of demand may be defined as the percentage change in the
quantity demanded divided by the percentage change in the price.

In the words of Boulding Price elasticity of demand measures the responsiveness of the quantity
demanded to the change in price.

According to Antol Murad elasticity of demand is the ratio of relative change in quantity to
relative change in price.

In the words of Stonier and Hague Elasticity of demand is a technical term used by the
economists to describe the degreeof resonsivness of demand of a commodity to a change in its
price.

Degrees of Price Elasticity of Demand

A change in demand is not always equal to the change in price. A small change in price may lead
a great change in demand. In such case demand is said to be elastic. If on the other hand even a
big change in price is followed by a small change in demand it is said to be a case of inelastic
demand. According to Dr Marshall The elasticity of demand is great or small according as the
amount demanded increases much or little with a fall in price and diminishes much or little for a
given rise in price. There are five degrees of price elasticity of demand.

1. Perfectly Elastic Demand

2. Perfectly Inelastic Demand
3. Unitary Elastic Demand
4. More Elastic Demand
5. Less Elastic Demand

1. Perfectly Elastic Demand: It refers to that situation in which a small change in price will
cause an infinitely large change in demand. In this case a small fall in price lead to an
unlimited extension of demand. It is illustrated in Fig 4.1.

In this diagram demand curve DD represents the perfectly elastic demand curve which is
horizontal straight line parallel to x-axis. It indicates that if price rises a little more than OP
the demand will contract to zero. At the prevailing price OP a consumer can buy OQ OQ1 or
OQ2 or as much units as he desire. In this case demand is perfectly elastic or E=00. Such
cases are only hypothetical and not real.
 Y

PD E D
price

2
1
O Q Q Q X
Demand
Fig. 4.1 Perfectly Elastic Demand

2. Perfectly Inelastic Demand: It refers to that situation in which there is absolutely no change in
demand as a result of change in price. The demand remains the same irrespective of the price.
Fig 4.2 shows perfectly inelastic demand. DD demand curve which is vertical straight line
parallel to y-axis. It indicates that when price is OP demand is OQ when price changes either to
OP1 or OP2 demand remains the same i.e. OQ. Thus change in price causes no change in demand.
In this case elasticity of demand is said to be zero or E=0. This is also a purely imaginary case.

Y D
P
price

P
P
D
O Q X
Demand
Fig. 4.2 Perfectly Inelastic Demand

3. Unitary Elastic Demand: It refers to a situation where demand changes in exact proportion to
the changes in price. If the price becomes double the demand falls by half and if price falls by
half demand becomes double. This will also mean that the total outlay will be the same even at
the changed prices. Fig 4.3 shows unitary elastic demand. DD demand curve which is a semi
horizontal or semi vertical. This type of demand curve is called rectangular Hyperbola. The area
of different rectangles drawn from different parts on this curve are always equal.
It indicates that change in demand OQ1 is equal to the change in price PP1 (DP=DQ). In this case
elasticity of demand is equal to unity or E=1. The demand for the articles of comforts is unitary
elastic.

Fig. 4.3 Unitary Elastic Demand

4. More Elastic Demand: It refers to a situation in which change in demand is more than the
proportionate change in price. The demand for the articles of Luxury in general is said to be
highly elastic. The demand curve of this type is flatter and more horizontal it tends to be
somewhat parallel to the base but possess a certain degree of steepness. As is shown in Fig 4.4
DD demand curve represents more elastic demand. It indicates when price falls by PP1 demand
extends by QQ1. That is quantity price falls by PP1 demand extends by QQ1. That is quantity
demanded changes relatively more than change in price. In this case elasticity is said to be
greater than unity of E > 1.

Fig. 4.4 More Elastic Demand

 6. Less Elastic Demand: It refers to a situation in which the change in demand is less than
proportionate change in price. The demand for articles of necessity is of this type. The
demand curve in such cases tends to be vertical though it possesses a sharp steep. In Fig
4.5 DD demand curve represents less elastic demand. It indicates that when price falls by
PP1 demand extends by QQ1. That is quantity demanded changes relatively less than the
change in price. In this case elasticity of demand is said to be less than unity or E < 1.

Fig. 4.5 Less Elastic Demand

All these five degrees of price elasticity of demand can be portrayed in one single diagram
below:
In the Fig 4.6. Demand curve ab is perfectly elastic E=∞
Demand curve cd is perfectly inelastic E=0
Demand curve ef is unitary elastic E=1
Demand curve gh is more elastic E > 1
Demand curve lj is less elastic E<1
The various degrees of the elasticity of demand are also shown in Fig 4.7
Fig. 4.6 Various Degrees of Elasticity of Demand

IV Measurement of Price Elasticity of Demand

The measurement of elasticity of demand is to know whether price elasticity of demand (i)
Unitary or (ii) Greater than unity or (iii) Less than Unity. There are four main methods of the
measurement of price elasticity of demand.

1. Total Expenditure Method

2. Percentage of Proportionate Method
3. Point Method
4. Arc Method Graphic Method
5. Revenue Method

1. Total Expenditure Method or Total Outlay Method

This method of measuring elasticity of demand was evolved by Dr Marshall. This is also known
as the unity method. According to this method there can be three measures of elasticity of
demand.

1. Greater than unity

2. Equal to unity
3. Less than unity

1. Greater than unity. When the total expenditure increases with a fall in price and decreases with
a rise in price elasticity is said to be greater than unity or E>1.

2. Equal to unity: When the total expenditure remains the same whether the price rises or falls
elasticity is said to be equal to unity or E=1

3. Less than unity: When the total expenditure decreases with a fall in price and increases with a
rise in price elasticity is said to be less than unity or E<1

Measurement of elasticity of demand by total outlay method can also be explained with the help
of the following table:

Total 4.1 Total Expenditure Method

Case Price Demand Total Description Elasticity of
expenditure demand
I 10 1 10 P TE E>1
9 2 18 P TE
8 3 24
7 4 28
II 6 5 30 P No E =1
5 6 30 P in TE
III 4 7 28 P TE E<1
3 8 24 P TE
2 9 18
1 10 10

In this schedule Case I indicates elasticity of demand as greater than unity because the total
expenditure increases from Rs 10 to Rs 7 and total expenditure decreases from Rs 28 to Rs 10
when price rises from Rs 7 to Rs 10.

Case II indicates elasticity of demand as equal to one or unity because the total expenditure spent
remains the same i.e. Rs 30 when price changes from Rs 6 to Rs 5 or from Rs 5 to Rs 6.

Case III indicates price elastic of demand as less than unity because the total expenditure
decreases from Rs 28 to Rs 10 when price falls from Rs 4 to Rs 1 and total expenditure increases
from Rs 10 to Rs 24 when the price rises from Rs 1 to Rs 4.

Diagram: Total outlay method of measuring price elastic of demand can also be illustrated with
the help of a fig. 4.8.

In this Fig 4.8 total expenditure is shown along x-axis and price on y-axis. Line ABCD
represents total expenditure line. AB part of TE line represents price elastic of demand greater
than unity because on this portion total expenditure increases with a fall in price and decreases
with a rise in price.

BC part of TE line represents unitary elasticity (E=1). It points out that on this segment total
expenditure remains constant either with fall or rise in the price. CD part of the TE line
represents less than unitary elasticity of demand (E<1). It signifies that total expenditure
decreases with a fall in price and increases with a rise in price.

Defect: The main weakness of total expenditure method is that it does not assist us to measure
elasticity in terms of numerical numbers. It simply classifies price demand into elastic inelastic
or unitary elastic demands.
2. Percentage Method or Proportionate Method or Flux Method

The second method of measuring price elasticity of demand is the percentage or proportionate
method. This method was propounded by Dr. Flux. Hence it is also known as Flux’s Method. It
measures elasticity of demand by using mathematics it is therefore also known as Mathematical
method. According to this method the elasticity of demand can be measured with the help of the
following formula.

PE=Percentage change in Demand/Percentage change in Price

Or

PE=Proportionate change in Demand/ Proportionate change in Price

Symbolically it can be written as

PE=∆Q/∆P x P/Q PE=∆Q/Q/∆P/P or Change in Quantity Demanded/Original Demand

Change in Price/Original Price

Or
Q1-Q/ P1-P/P where ∆(Delta) stands for change, DQ (Q1-Q)=Change in quantity demanded
Q=Original Demand
∆P= (P1-P) Change in price
P= Original price
Example. Measurement of price elasticity of demand by propionate method can be explained by
an example-suppose price of sugar is Rs 11 per kg and demand is 100 kg. When price of sugar
rises to Rs 10.50 demand contract to 95 kg

In this example elasticity of demand will be

Price of sugar per kg Demand in kg

Rs 10 100
Rs11 80

Here P=10 P1=11

∆P= (P1-P); 11-10= 1Rs
Q=100 Q1=80
∆Q= (Q1-Q) = 80-100 = -20 kg
PE= ∆Q/Q x P/∆P = -20/100x 10/1 = -2

We ignore (-) minus sign. It explains inverse relationship between price and demand. Here
elastic of demand is greater than unity.

The co-efficient of price elasticity of demand is always negative because when price changes
demand moves in the opposite direction. It is however customary to disregard the minus (-) sign.
Proportionate method is used when changes in price and demand are every small.

3. Point Method

This method suggested by Dr Marshall is used to find out the elasticity of demand at a particular
point on a demand curve. Point method for measuring price elasticity of demand is also known
as Geometrical Method. When there are infinitely small changes in price and demand then
demand elasticity is computed at a single point on a demand curve which is known as point
elasticity. According to this method point elasticity can be measured with the help of the
following formula.

E at point = Lower Sector of Demand Curve/Upper Sector of Demand Curve

If (i) Lower Sector > Upper Sector; E>1
(ii) Lower Sector = Upper Sector; E=1
(iii) Lower Sector < Upper Sector; E<1 with the help of this formula price elasticity of demand
can be measured on two types of demand curves-

(a) In case of Linear Demand Curve

(b) In case of Non linear or Curvi-Linear Demand Curve

(a) In case of Linear Demand Curve: In Fig 4.9 AB is a straight line demand curve. We have to
measure the elasticity the elasticity of point P on this demand curve. At point P elasticity of
demand will be equal to PB or the lower segment of the demand line PA divided by upper
segment of the demand line.

To illustrate the same point let us assume AB to represent 4 cm. then at the middle point of AB,
PB will be equal to 2 cm and PA will also be equal to 2 cm.
E at point P = PB/PA=2cm/2cm=1
Fig. 4.9 Point Method

Fig. 4.10 Elasticity at Different Points on demand curve

4. Arc Method

The point method of measuring price elasticity of demand is useful only when there are minute
changes in prices and quantities demanded whereas Arc method is very useful when the changes
in price and demand are very large. In this method we make use of the mid points between the
old and the new figures in the case of both price and demand. This method of measurement is
known as Arc elasticity. Arc signifies a segment of curve between the two points. The area
between P and P1 on the demand curve DD in Fig 4.12 is an arc which measures elasticity over
certain range of rice and quantities. The concept of Arc elasticity was given by Dalton at first. It
was further developed by Watson and Lerner. According to Watson. Arc elasticity is the
elasticity at the mid point of an arc of a demand curve. In the words of Leftwitch, When
elasticity is computed between two separate points on a curve the concept is called are elasticity.
Arc elasticity of demand can be calculated with the help of the following formula-

E=Q1-Q2/Q1+Q2 ÷ P1-P2/P1+P2 or Original quantity-New quantity/original quantity + new quantity/Original

Price – New Price/Original Price + New Price

Or
E= Change in Quantity demanded/original quantity+ New quantity

÷ Change in Price/Original Price + New Price

E= ∆Q/ Q1 + Q2 ÷ ∆P/ P1 + P2

Fig. 4.12 Arc on demand curve

Where Q1 = Original quantity

Q2 = New quantity
P1 = Original price , P2 = New Price
∆ = (Delta) = Change
∆Q=Change in demand
∆P =Change in price

Example. A numerical example can be given to illustrate the are elasticity of demand. Suppose
the price of a commodity is Rs 10 and the quantity demanded at this price is 100 units. If the
price falls to Rs 8 and the quantity demanded increased to 140 units. Arc elasticity then will be

E= 100-140/100+140 + 10-8/10+8
= -40/240+2/18
=-40/240 x 18/2 = -1.5

(Minus is ignored as it only represents the inverse relationship between price and quantity)

5. Revenue Method

Price elasticity of demand can also be measured with the help of average and marginal revenue
as per the following formula.

E=A/A-M

E is price elasticity of demand, A is average revenue which is found by dividing total revenue by
the number of units sold AR is thus price per unit of output. AR curve is also called demand
curve of the firm M is marginal revenue which is defined as the change in TR by selling an
additional unit of output.

If by using this formula E=1 price elasticity of demand is unity if it is greater than one price
elasticity is greater than one. Similarly if MR=0 price elasticity of demand is one. If MR is
positive price elasticity of demand is greater than one and if MR in negative price elasticity of
demand is less than one.

Factors Determining of Price Elasticity of Demand

Elasticity of demand for any commodity is determined or influenced by a number of factors

which are discussed as under-

1. Nature of the Commodity: The elasticity of demand for any commodity depends upon the
category to which it belong i.e whether it is necessity comfort or luxury. The demand for
necessities of life or conventional necessities is generally less elastic. For example the demand
for necessities like food salt medicines etc does not change much with the rise or fall in their
prices. Similar is the case with conventional necessities which are required at the time of
marriages death ceremonies etc.

The demand for necessities of efficiency such as milk eggs butter etc and for comforts like
coolers fans transistor etc is moderately elastic because with the rise or fall in their prices the
demand for them decreases or increases moderately. On the other hand the demand for luxuries
like ACs, Gold and Diamond Jewellery Cellular Phone Artistic Furniture Perfumes costly cars
etc is more elastic because with a small change in their prices there is a large change in their
demand.

2. Substitute: commodities having substitutes have more elastic demand. Because with the
change in the price of one commodity the demand for its substitutes is immediately affected. For
example if the price of coffee rises the demand for coffee will decrease and that for tea will
increase and vice versa. But the demand for commodities having no good substitutes like
cigarette liquor and uniform dress etc is inelastic.

3. Variety of Uses: The demand for goods having variety of uses such as milk coal electricity etc
is more elastic. For example coal is used for cooking heating and power generation in factories in
locomotive etc. If the price of coal falls its demand will increase from all quarters. On the other
hand a rise in its price will bring a considerable decrease in its demand for less important uses.

4. Postponement of the Use: Commodities whose consumption can be deferred have an elastic
demand. For example if demand for constructing houses can be deferred then demand for
building material such as bricks cement steel timber etc will become elastic. On the other hand
goods whose demand cannot be postpone e.g. demand for meals when hungry or for drink when
feeling thirsty having inelastic demand.

5. Range of Prices: Elasticity of demand depends upon the range of prices. At very high and very
low range of prices demand tends to be inelastic. On the other hand at middle range of prices
demand will be elastic because a rise or fall in price will affect the demand of a large number of
persons.
6. Proportion of the Income Spent on a Commodity: Goods on which a consumer spends a very
small proportion of his income have inelastic demand e.g. newspaper toothpaste shaving blades
soap boot polish pen pencil thread needle etc. Rise in their prices does not contract their demand.
On the other hand goods on which consumer spends a large proportion of his income have elastic
demand e.g. clothes desert cooler nutritive food etc. Rise in their prices causes contraction of
their demand.

7. Habits: Demand for these goods is inelastic to which people are habitual like cigarette coffee
etc. Despite rise in their prices people demand such goods in more or less same quantity.

8. Time Factor: Time factor plays an important role in influence the elasticity of demand of a
particular commodity. The shorter the time the lesser will be the elasticity of demand the longer
the time the higher will be the elasticity of demand. It is because many things like discovery of
new substitutes changes in habits consumer adjustments to new products are possible in the long
period.

9. Joint Demand: The demand for jointly demanded goods is inelastic e.g. car and petrol camera
and film bread and jam etc. Even if the price of car decreases when the price of petrol rules high
demand of the second commodity depends upon the elasticity of demand of the major
commodity. If the demand for car is less elastic the demand for petrol will also be less elastic. If
the demand for bread is elastic the demand for jam will also be elastic.

10. Durability of Goods: Elasticity of demand also depends upon durability of the commodity.
When goods are durable like scooter TV set car etc the demand is inelastic because people do not
buy more of these goods when their prices fall.

11. Budget Position: The demand for soap salt matches ink etc and for many other similar goods
are highly inelastic because a typical household spends a small portion of his budget on each of
them. On the other hand things like fridge TV Set VCR etc have more elastic demand.

12. Fashion: The elastic demand for a commodity which is in fashion will be inelastic because it
becomes more or less necessary for a consumer to purchase it.

13. Classes of Buyers: The elasticity of demand for a commodity depends upon the class of
buyers. Commodity consumed ordinarily by wealthy and well to do class of people have inelastic
demand because a little rise or fall in the prices of such commodities does not produce any
appreciable response on the part of the well to do. The commodities which are consumed by the
poor section of the society are of elastic demand as the poor always run after cheaper substitutes.

However some of these factors may act differently with different people at different times. For
example we generally say that the demand for luxuries is more elastic. But what is luxury for a
man may not be a luxury for the other. Car is a luxury for a poor teacher but it is necessity for a
busy doctor. Then it will be inelastic in both the cases. Thus we can say that these factors
determine the elasticity to a great extent and not to the fullest extent.
Income Elasticity of Demand

Meaning of Income Elasticity of Demand: Income elasticity of demand is the rate at which
quantity bought changes as a result of change in the income of the consumer other things being
equal. It shows how the quantity demanded will change when the income of the consumer
changes other things remaining constant.

6.1 Definitions

The demand for a product and consumer’s income are directly related to each other, unlike price-
demand relationship.

“Income elasticity of demand means the ratio of the percentage change in the quantity demanded
to the percentage in income”-Watson.
For example, the demand for a product increases with increase in consumer s income and vice
versa, while keeping other factors of demand at constant. The degree of responsiveness of
demand with respect to change in consumer s income is called income elasticity of demand.
According to Watson, “Income elasticity of demand means the ratio of the percentage change in
the quantity demanded to the percentage in income.”

Measurement of Income Elasticity of Demand:

The income elasticity of demand (ey) can be measured by the following formula:

ey = Percentage change in quantity demanded/Percentage change in income

Percentage change in quantity demanded = New quantity demanded (∆Q)/Original

quantity demanded (Q)

Percentage change in income = New income (∆Y)/original income (Y)

Therefore, the income elasticity of demand can be symbolically represented as:

ey = ∆Q/Q : ∆Y/Y

ey = ∆Q/Q * Y/∆Y

ey = ∆Q/∆Y * Y/Q

Change in demand (∆Q) is the difference between the new demand (Q1) and original demand
(Q).

It can be calculated by the following formula:

∆Q = Q1 – Q

Similarly, change in income is the difference between the new income (Y1) and original income
(Y).

It can be calculated by the following formula:

∆Y = Y1 – Y

The formula for measuring the income elasticity of demand is same as price elasticity of demand.
The only difference in the formula is that in the income elasticity of demand, income (Y) is
substituted as a determinant of demand in place of price (P). Let us understand the concept of
income elasticity of demand with the help of an example.

Suppose the monthly income of an individual increases from Rs. 6,000 (Y) to Rs. 12,000 (Y1).
Now, his demand for clothes increases from 30 units (Q) to 60 units (Q1).

The income elasticity of demand can be calculated as follows:

ey = ∆Q/∆Y * Y/Q

∆Q = Q1 – Q = 60 – 30 = 30 units

∆Y = Y1 – Y = 12000 – 6000 = Rs. 6000

ey = 30/6000 * 6000/30 = 1 (equal to unity)

Types of Income Elasticity of Demand:

Like price elasticity of demand, the degree of responsiveness of demand with change in
consumer’s income is not always the same. The income elasticity of demand is different for
different products.

On the basis of numerical value, income elasticity of demand is classified into three groups,
which are as follows:

i. Positive Income Elasticity of Demand:

Refers to a situation when the demand for a product increases with increase in consumer’s
income and decreases with decrease in consumer’s income. The income elasticity of demand is
positive for normal goods.
It is explained with the help of Figure-12:

In Figure-12, the slope of the curve is upward from left to right, which indicates that the increase
in income causes increase in demand and vice versa. Therefore, in such a case, the elasticity of
demand is positive.

The positive income elasticity of demand can be of three types, which are discussed as follows:

a. Unitary Income Elasticity of Demand:

Implies that positive income elasticity of demand would be unitary when the proportionate
change in the quantity demanded is equal to proportionate change in income. For example, if
income increases by 50% and demand also rises by 50%, then the demand would be called as
unitary income elasticity of demand. In such a case, the numerical value of income elasticity of
demand is equal to one (ey = 1).

b. More than Unitary Income Elasticity of Demand:

Implies that positive income elasticity of demand would be more than unitary when the
proportionate change in the quantity demanded is more than proportionate change in income. For
example, if the income increases by 50% and demand rises by 100%. In such a case, the
numerical value of income elasticity of demand would be more than one (ey>1).

c. Less than Unitary Income Elasticity of Demand:

Implies that positive income elasticity of demand would be less than unitary when the
proportionate change in, the quantity demanded is less than proportionate change in income. For
example, if the income increases by 50% and demand increases only by 25%. In such a case, the
numerical value of income elasticity of demand would be less than one (ey<1).

ii. Negative Income Elasticity of Demand:

Refers to a kind of income elasticity of demand in which the demand for a product decreases
with increase in consumer’s income. The income elasticity of demand is negative for inferior
goods, also known as Giffen goods. For example, if the income of a consumer increases, he
would prefer to purchase wheat instead of millet. In such a case, the millet would be inferior to
wheat for the customer.

Negative income elasticity of demand is shown with the help of Figure-13:

Figure-14 shows that when income increases from Rs. 10 to Rs. 20, then the demand for goods is
remain same, 4 units. In Figure-14, the slope of the curve is parallel to Y-axis (income side),
which indicates that the increase in income causes no effect in demand. Therefore, in such a
case, the elasticity of demand is zero.

Significance of Income Elasticity of Demand:

While price elasticity plays a significant role in pricing of a product to maximize the total
revenue of an organization in the short run, income elasticity of demand is important for
production planning and management in the long run.

Following are some of the important uses of income elasticity of demand:

i. Helping in investment decisions:

Refers to one of the major significance of income elasticity of demand. In developing countries,
such as India, the rate of growth of national income is not steady as it is in case of developed
countries. Moreover in developing countries, rise in national income does not result in immediate
increase in the demand for certain goods.

The concept of national income is very important for sellers as it helps them to allocate their
resources in different industries. Generally, sellers prefer to invest in industries where the
demand for goods is more with respect to proportionate change in the income or where the
income elasticity of demand is greater than zero (ey>1).

For example, the demand for durable goods, such as vehicles, furniture, and electrical appliances,
increases in response to increase in the national income. In such industries, sellers earn high
profits when there is increase in national income. On the other hand, industries with low income
elasticity (ey<1), there is a gradual increase in demand for goods, whereas the demand for goods
having negative income elasticity declines when the national incomes grows.

ii. Forecasting demand:

Refers to the fact that income elasticity of demand help in anticipating the demand for goods in
future. If change in income is certain, there would be a major change in the demand for goods.
This is due to the fact that if consumers are aware of change in income, they may change their
tastes and preferences for certain goods.

On the other hand, if the change in income is temporary, there would be a slow change in the
demand. However, the demand for goods in future is also influenced by various factors other
than income.

iii. Categorizing goods:

Implies that income elasticity of demand helps in classifying goods, such as normal goods,
essential goods, or inferior goods. The classification of goods enables sellers to select the goods
to be produced and the quantity of goods to be produced. Apart from this, it also helps sellers to
decide the income group to whom the goods should target.

Cross Elasticity of Demand

It is the ratio of proportionate change in the quantity demanded of Y to a given proportionate

change in the price of the related commodity X.

It is a measure of relative change in the quantity demanded of a commodity due to a change in

the price of its substitute/complement. It can be expressed as:

Cross elasticity may be infinite or zero if the slightest change in the price of X causes a
substantial change in the quantity demanded of Y. It is always the case with goods which have
perfect substitutes for one another. Cross elasticity is zero, if a change in the price of one
commodity will not affect the quantity demanded of the other. In the case of goods which are not
related to each other, cross elasticity of demand is zero.

Definition:

“The cross elasticity of demand is the proportional change in the quantity of X good demanded
resulting from a given relative change in the price of a related good Y” Ferguson

“The cross elasticity of demand is a measure of the responsiveness of purchases of Y to change

in the price of X” Leibafsky

Types of Cross Elasticity of Demand:

1. Positive:

When goods are substitute of each other then cross elasticity of demand is positive. In other
words, when an increase in the price of Y leads to an increase in the demand of X. For instance,
with the increase in price of tea, demand of coffee will increase.
In fig. 21 quantity has been measured on OX-axis and price on OY-axis. At price OP of Y-
commodity, demand of X-commodity is OM. Now as price of Y commodity increases to OP1
demand of X-commodity increases to OM1 Thus, cross elasticity of demand is positive.

2. Negative:
In case of complementary goods, cross elasticity of demand is negative. A proportionate increase
in price of one commodity leads to a proportionate fall in the demand of another commodity
because both are demanded jointly. In fig. 22 quantity has been measured on OX-axis while
price has been measured on OY-axis. When the price of commodity increases from OP to
OP1 quantity demanded falls from OM to OM1. Thus, cross elasticity of demand is negative.

3. Zero:
Cross elasticity of demand is zero when two goods are not related to each other. For instance,
increase in price of car does not effect the demand of cloth. Thus, cross elasticity of demand is
zero. It has been shown in fig. 23.
Therefore, it depends upon substitutability of goods. If substitutability is perfect, cross elasticity
is infinite; if on the other hand, substitutability does not exist, cross elasticity is zero. In the case
of complementary goods like jointly demanded goods cross elasticity is negative. A rise in the
price of one commodity X will mean not only decrease in the quantity of X but also decrease in
the quantity demanded of Y because both are demanded together.

Measurement of Cross Elasticity of Demand:

Cross elasticity of demand can be measured by the following formula:

The Law of Supply

The law of supply reflects the general tendency of the sellers in offering their stock of a
commodity for sale in relation to the varying prices.
It describes seller’s supply behaviour under given conditions. It has been observed that usually
sellers are willing to supply more with a rise in prices.
The law of supply may be written as follows:

“Other things remaining unchanged, the supply of a commodity rises i.e., expands with a rise in
its price and falls i.e., contracts with a fall in its price.
In other-words, it can be said that—”Higher the price higher the supply and lower the price
lower the supply.”
The law thus suggests that the supply varies directly with the change in price. So, a larger
amount is supplied at a higher price that at a lower price in the market.
Explanation of the Law:
This law can be explained with the help of a supply schedule as well as by a supply curve based
on an imaginary figures and data.

This can be shown by diagram as follows:

Here, in this diagram the supply curve SS is sloping upward. It suggests with the supply
schedule, that the market supply tends to expand with the rise in price and vice-versa. Similarly,
the upward slopping curve also depicts a direct co-variation between price and supply.

This law can be shown in this way also.

In the figure above OX axis shows quantity of demand and OY axis shows price. SS1 line is the
line of supply when the price of the commodity is OP then quantity of supply is OQ.

When the price rises from OP to OP2 and then supply also rises from OQ to OQ2. Similarly, if
price is reduced from OP to OP1, then supply will reduce from OQ to OQ1.

By seeing the diagram the conclusion can be drawn that when price rises supply increases and
when the price reduces the supply reduces.

Factors affecting law of supply

Price of the given Commodity:

important factor determining the supply of a commodity is its price. As a general rule, price of a
commodity and its supply are directly related. It means, as price increases, the quantity supplied
of the given commodity also rises and vice-versa. It happens because at higher prices, there are
greater chances of making profit. It induces the firm to offer more for sale in the market.

Supply (S) is a function of price (P) and can be expressed as: S = f (P). The direct relationship
between price and supply, known as ‘Law of Supply’. The following determinants are termed as
‘other factors’ or factors other than price’.

2. Prices of Other Goods:

As resources have alternative uses, the quantity supplied of a commodity depends not only on its
price, but also on the prices of other commodities. Increase in the prices of other goods makes
them more profitable in comparison to the given commodity. As a result, the firm shifts its
limited resources from production of the given commodity to production of other goods. For
example, increase in the price of other good (say, wheat) will induce the farmer to use land for
cultivation of wheat in place of the given commodity (say, rice).
3. Prices of Factors of Production (inputs):

When the amount payable to factors of production and cost of inputs increases, the cost of
production also increases. This decreases the profitability. As a result, seller reduces the supply
of the commodity. On the other hand, decrease in prices of factors of production or inputs,
increases the supply due to fall in cost of production and subsequent rise in profit margin.

To make ice-cream, firms need various inputs like cream, sugar, machine, labour, etc. When
price of one or more of these inputs rises, producing ice-creams will become less profitable and
firms supply fewer ice-creams.

4. State of Technology:

Technological changes influence the supply of a commodity. Advanced and improved

technology reduces the cost of production, which raises the profit margin. It induces the seller to
increase the supply. However, technological degradation or complex and out-dated technology
will increase the cost of production and it will lead to decrease in supply.

5. Government Policy (Taxation Policy):

Increase in taxes raises the cost of production and, thus, reduces the supply, due to lower profit
margin. On the other hand, tax concessions and subsidies increase the supply as they make it
more profitable for the firms to supply goods

6. Goals / Objectives of the firm:

Generally, supply of a commodity increases only at higher prices as it fulfills the objective of
profit maximization. However, with change in trend, some firms are willing to supply more even
at those prices, which do not maximise their profits. The objective of such firms is to capture
extensive markets and to enhance their status and prestige.

7. Transport Conditions:

Refer to the fact that better transport facilities increase the supply of products. Transport is
always a constraint to the supply of products, as the products are not available on time due to
poor transport facilities. Therefore even if the price of a product increases, the supply would not
increase.

8. Natural Conditions:

Implies that climatic conditions directly affect the supply of certain products. For example, the
supply of agricultural products increases when monsoon comes on time. However, the supply of
these products decreases at the time of drought. Some of the crops are climate specific and their
growth purely depends on climatic conditions. For example Kharif crops are well grown at the
time of summer, while Rabi crops are produce well in winter season.

9. More firms.

An increase in the number of producers will cause an increase in supply.

Elasticity of Supply
The law of supply states the direct relationship between the price of a product and quantity supplied of
the product.

In simple words, if the price of a product increases, the quantity supplied for the product also increases.

On the other hand, if there is fall in the price of a product, then the quantity supplied of the product
would also decrease.

“The supply of a commodity is said to be elastic when as a result of a charge in price, the supply changes
sufficiently as a quick response. Contrarily, if there is no change or negligible change in supply or supply
pays no response, it is elastic”-Prof Thomas.

However, it is not a quantitative statement. In practical implications, an organization needs to estimate

the degree of change in the quantity supplied of a product with respect to change in the price of the
product. The degree or extent of change in the quantity supplied of a product in response to change in
the price of the product is known as the elasticity of supply.

According to Prof Thomas, “The supply of a commodity is said to be elastic when as a result of a charge
in price, the supply changes sufficiently as a quick response. Contrarily, if there is no change or negligible
change in supply or supply pays no response, it is elastic.” It can be calculated by dividing the percentage
change in the quantity supplied with percentage change in the price of a product.

The formula for calculating elasticity of supply (eS) is as follows:

eS = Percentage change in quantity supplied/Percentage change in price

Percentage change in quantity supplied = New quantity supplied (∆S)/Original quantity supplied (S)

Percentage change in price = New price (∆P)/Original Price (P)

The symbolic representation of elasticity of supply is as follows:

eS = ∆S/S : ∆P/P

eS = ∆S/S * P/∆P

eS = ∆S/∆P * P/S
Change in quantity supplied (∆S) is the difference between the new quantity supplied (S1) and original
quantity supplied(S).

It can be calculated by the following formula:

∆S = S1 – S

Similarly, change in price is the difference between the new price (P1) and original price (P).

It can be calculated by the following formula:

∆P = P1 – P

Types of Elasticity of Supply:

The degree of change in the quantity supplied with respect to change in the price of a product varies in
different situations.

Following are different types of elasticity of supply:

i. Perfectly Elastic Supply:

Refers to a situation when the quantity supplied completely increases or decreases with respect to
proportionate change in the price of a product. In such a case, the numerical value of elasticity of supply
ranges from zero to infinity (eS = 00)This situation is imaginary as there is no as such product whose
supply is perfectly elastic.

Therefore the situation does not have any practical implication. In such a case, the price remains
constant as the price of a product does not affect the quantity supplied. Let us understand the concept
of perfectly elastic demand with the help of an example.

Prepare a supply curve for the supply schedule of product X and determine the type
of elasticity of supply demonstrated by the supply curve.

Solution:

The supply curve for product X is shown in Figure-15:

Figure-15 shows that the price of product X remains constant at Rs. 100 per kg.
However, the quantity supplied changes from 50,000 Kgs to 90,000 Kgs at the same
price rate. Therefore, the supply of product X is perfectly elastic (eS = 00).

ii. Relatively Elastic Supply:

Refers to a condition when the proportionate change in the quantity supplied is

more than proportionate change in the price of a product. In such a case, the
numerical value of elasticity of supply is greater than one (eS>1) For example, if the
quantity supplied increases by 30% with respect to 10% change in the price of a
product, it is called relatively elastic supply. The concept of relatively elastic supply is
explained with the help of an example.

Example 5:

The quantity supplied and the price of product P is shown in Table-10:

Prepare a supply curve for the supply schedule of product P and determine the type
of elasticity of supply demonstrated by the supply curve.

Solution:

The supply curve for product P is shown in Figure-16:

In Figure-16, when the price of product P is Rs. 50, the quantity supplied is 30,000
Kgs. However, when the price increases to Rs. 51, supply reaches to 35,000.
Similarly, when the price further increases to Rs. 52, the supply reduces to 40,000
Kgs.

This shows that the change in price is only one rupee while the change in supply is
5,000. In other words, the proportionate change in quantity supplied is more than
the proportionate change in the price of product P. Therefore, the supply of product
P is highly elastic (eS>1).

iii. Relatively Inelastic Supply:

Refers to a condition when the proportionate change in the quantity supplied is less
than proportionate change in the price of a product. In such a case, the numerical
value of elasticity of supply is less than one (eS<1). For instance, the elasticity of
supply would be less than unit, if the quantity supplied increases by 20% with
respect to 30% change in the price of a product.

Example-6:

The quantity supplied and the price of product Z is shown in Table-11:

Prepare a supply curve for the supply schedule of product Z and determine the type
of elasticity of supply demonstrated by the supply curve.

Solution:
The supply curve for product Z is shown in Figure-17:

In Figure-17, when the price of product Z is Rs. 50, the quantity supplied is 30,000
Kgs. When price increases to Rs. 55, supply reaches to 31, 000. Similarly, when the
price of product Z increases to Rs. 60, the supply increases to 32,000 Kgs. This
shows that S change in price is five rupees while the change in supply is 1,000. In
other words, the proportionate change in quantity supplied is less than the change in
the price of product Z. Therefore, the supply of product Z is relatively inelastic
(eS<1).

iv. Unit Elastic Supply:

Refers to a situation when the proportionate change in the quantity supplied is equal
to the

Proportionate change in the price of a product. The numerical value of unit elastic
supply is equal to one (eS=1).

Example 7: The quantity supplied and the price of product Y is shown in Table-12:

Prepare a supply curve for the supply schedule of product Y and determine the type
of elasticity of supply demonstrated by the supply curve.

Solution:
The supply curve for product Y is shown in Figure-18:
In Figure-18, when the price of product Y is Rs. 50, the quantity supplied is 30,000
Kgs. When price increases to Rs. 51, supply reaches to 31,000. Similarly, when the
price increases to Rs. 52, the supply increases to 32,000 Kgs. This shows that the
proportionate change in quantity supplied is equal to the change in the price of
product Y. Therefore, the supply of product Y is unit elastic (eS=1).

v. Perfectly Inelastic Supply:

Refers to a situation when the quantity supplied does not change with respect to
proportionate change in price of a product. In such a case, the quantity supplied
remains constant in all the instances of change in price. The numerical value of
elasticity of supply is equal to zero. This situation is imaginary as there is no as such
product whose

Supply is perfectly inelastic. Therefore, this situation does not have any practical
implication.

Example 8:

The quantity supplied and the price of product R is shown in Table-13:

Prepare a supply curve for the supply schedule of product R and determine the type
of elasticity of supply demonstrated by the supply curve.

Solution:
The supply curve for product R is shown in Figure-19:
Figure-19 shows that the supply of product R remains constant at 30,000 Kgs.
However, the price changes from Rs. 50 to Rs. 60 at the same supply rate. Therefore,
the supply of product X is perfectly inelastic (e = 0).