Microeconomics I

UNIT ONE: Introduction

1.1. Foundations of economics

The world is endowed with various resources. Some are free and others are available with cost.
Economics concerns itself with the latter type of resources. Economic resources are available in
limited quantity. The problem, therefore, is finding the best way of allocating these scarce
resources.
Definition: Economics is the social science that deals with the choices that individuals,
businesses, governments, and entire societies make as they cope with scarcity and the incentives
that influence and reconcile their choices.
The study of economics is often divided into microeconomics and macroeconomics.
Microeconomics looks at the interactions of producers and consumers in individual
markets−say, the market for shoes−and the interactions between different markets−say, the
market for coffee and the market for tea.
Macroeconomics studies the behavior of economy-wide measures such as the Gross National
Product−the value of final output that the economy produces in a given time period−as
well as categories that cut across many markets, such as total employment in manufacturing
industries or total exports.

It is also studies how individuals & nations make choices about how to use scarce resources to
fill their needs & wants. It is a social science concerned with production, distribution, exchange
& consumption of goods & services.

Economics is a way of thinking, a way of weighing the cost & benefits of actions & policies in
every fact of life.

Economics: deals with the allocation of scarce resources among alternatives to satisfy human
wants.

A resource is anything that people can use to make or obtain what they need or want. you may be
asking yourself at this point how economics will help you, a student. Also you may be
wondering how scarce resource is a problem of for a nation like the united-states that has such
abundant resources.
Economics can help you to understand both costs and, benefits, help you to make better
decisions. Because economics examine facts in order to make choices, it can teach you some
Page 1 of 23
basic skills for making decisions. Being able to make reason, we informed decisions will be
important to you as an employee, employer, and entrepreneur, consume, saver, investor or
citizen.
Scarcity means that people don’t & can’t have enough income, time or resources to satisfy their
every desire. What you can buy with your income as student is limited by the amount of income
you have. In this case your income is the scarce resource.

Microeconomics attempts to explain some of the most important and social problems of the day.

Microeconomics studies for: - environmental pollution, monopoly, discrimination, labor unions,

wages, & leasers, crime & punishment, taxation & subsidies, individual price, profit margins,
rental changes.

Microeconomics focuses attention on two broad categories of economic unit house-holds

business firms, & it examines the operation of two types of markets: the market for goods &
services, & the market for economic resources.

Households own the labor, the capital, the land & the natural resources that business firms
require to produce the goods & services households want.

Business firms pay to household’s wages, salaries, interest, rents & so on for the services &
resources that households provide.

Households then use the income that they receive from business firms to purchase the goods &
services produced by business firms. The incomes of households are the production costs of
business firms. The expenditures of households are the receipt of business firms. The so called
circular flow of economic activity is complete.

Fig. Circular Flow model

Page 2 of 23
Microeconomic theory:
Microeconomic theory examines how a consumer spends his or her income to maximize
satisfaction. How a firm combines resources to minimize production costs & maximize profits,
how a particular form of market structure perfect competition, monopoly, monopolistic
competition & oligopoly arises & how much each affects the well-being of society, how the
pricing & employment of resources or inputs are determined, & how government can increase
the well-being of society by taxes & subsidies. Microeconomic theory studies the economic
behavior of individual decision making units such as individual consumers, resource owners, and
business firms.
Human Wants: Refers to all the goods, services & the conditions of life that individual desire.
That is, human wants refers to the quality, variety & quantity of goods we want. Human wants
vary, of course, among different people, over different periods of time, & in different locations.
However, human wants always seem to be greater than the goods & services available to satisfy
those wants.

The sum total of all human wants is insatiable or can never be fully satisfied.
Resources: are inputs, the factors or means of producing the goods & services we want.
Economic Resources can be classified broadly in to:-
1. Land (Natural resources):- fertility of the soil, the climate, forests, mineral deposits
2. Labor (human resources);- human effort b/n physical and mental to produce desires goods &
services.
3. Capital is all the “produced” means of production such as the machinery, factories
equipment, tools, inventories, drainage & irrigation on agricultural land, & the transportation
& communication networks. All of these greatly facilitate the production of other goods &
services. Money is not capital because money, as such, produces nothing but simply
facilitates the exchange of goods & services.

 Scarcity and Opportunity Cost

A society’s resources consist of natural endowments such as land, forests, and minerals;
human resources, both mental and physical; and manufactured aids to production such as tools,
machinery, and buildings. Such resources are called factors of production in economics,
because they are used to produce output that people desire. These outputs could be goods or
services. Goods are tangible (e.g., shoes, bread), and services are intangible (e.g., education,
entertainment). The quantity of factors of production and the goods and services they help
produce is not infinite. The existing resources are inadequate to satisfy the unlimited desires of
people. Wants are insatiable, because no matter how much people have, they always want more
of them. Since not all wants can be satisfied, individuals have to pick and choose among the
possibilities open to them. Every society is faced with the same problems of Scarcity and choice.

Page 3 of 23
Scarcity forces individuals to economize on their use of resources. Every decision to produce
or to consume something means that we must forego producing or consuming something
else. The cost of engaging in certain activity, say, going to cinema, includes cost of the ti ticket
and the value of what is given up in order to participate in that activity. The time spent watching
movie could have been spent in other activities, such as work. You are therefore giving up the
opportunityy of working in order to watch movie.
movie. The value of this foregone opportunity is called
opportunity cost.

Definition: opportunity cost is the value of the next best opportunity given up in order
to enjoy a particular good or service.
ser

Scarcity: Economic resources are that they are scarce or limited in supply rather than unlimited.
Free resources & free goods are those of which the quantity supplied exceeds the quantity
demanded at zero prices.
Society can only satisfy some wants rather than all wants, thus, every society faces scarcity. If
human wants were limited or resources unlimited, there would be no scarcity & there would be
no need to study economics.

 Production possibilities
ABDE is a production possibilities frontier or or transformation curve. It shows the alternative
combinations of food & clothing that the economy can produce by fully utilizing all the
resources at its disposal with the best technology available to it.
A point such as G above the frontiers can be reached
reached only with growth. A point such as H inside
the frontiers is inefficient.
Starting at point such as B on the frontier, the nation can produce an additional 3 units of food
only by giving up 4 units of clothing (the movement from point
point B to D) because re
resources are
scarce.

Fig. Production possibility curve (PPC or PPF)

Page 4 of 23
Macroeconomics: Studies total or aggregate level of output and national income & the level of
national employment, consumption, investment & prices for the economy viewed as a whole.

Functions of Economic System/Fundamental questions of Economics

All societies must have somehow determine

1. What to produce? Refers to which goods & services to produce & in what quantities to
produce them.
2. How to produce refers to: to the way in which resources or inputs are organized to produce
the goods & services that consumers want.
3. For whom to produce: deals with the way that the output is distributed among the members
of the society.
4. How to provide for the growth of the system. Although governments can affect the rate of
economic growth with tax incentives, & with incentives for research, education and
training. The price system is also important.
 Though capital accumulation, technological improvements, and increase how to
increase a given quantity of commodity over time.
 Some people (speculators) will buy some wheat soon after harvest (when the price is
low) & sell it later (before the next harvest (when the price is higher. The available
wheat is thus rational though out the year.
5. The quantity & quality (productivity) of labor, a nation grows over time.
6. The quantity & quality (productivity) of labor, a nation grows over time.

Page 5 of 23
 UNIT TWO: BASIC DEMAND AND SUPPLY

2.1. Market analysis

A market is the network of communications between individual & firms for the
purpose of buying & selling goods & services.

A market can, but need not, be a specific place or location where buyers & sellers
actually come face to face for the purpose of transacting their business.

There is a market for each goods, service or resource bought & sold on the economy.

Some of the markets are local, some are regional and others are national or
international in character.

Perfectly competitive market & one in which no buyers & sellers can affect the price of
the product, all units of the products are homogeneous or identical, resources are
mobile and knowledge of the market is perfect.

A market demand schedule is a table showing the quantity of a commodity that

consumers are willing & able to purchase over a given period of time. At each price of
the commodity, while holding constant all other relevant economic variables on which
demands depends (the ceteris Paribas assumption).

Market demand curve D shows that the lower hamburger price, greater quantities are
demanded this is reflected on the negative slope of the demand curve & is referred to
as the “law of demand”.
The lower prices, greater quantities of hamburgers are demanded. This is true for most
Page 6 of 23
commodities.

Lower commodity prices will also bring more consumers on to the market.

The inverse price – quantity relationship (indicating that a grater quantity of the
commodity is demanded at lower prices & smaller quantity at higher prices) is called
the law of demand.

The price per unit of the commodity is usually measured along the vertical axis, while
the quantity demanded of the commodity per unit of time is measured along the
horizontal axis.

The subject matter of this unit is basic to the understanding of economics. The theories of demand
and supply are the building blocks of how the economic system at large operates.

2.2. Theory of Demand

Definition: demand refers to the desire and ability to consume certain quantities at certain
prices.
Distinction between demand and quantity demanded of a good or service: Demand refers to the
whole set of price-quantity combinations, i.e., demand defines the whole set of relationship
between price and quantity. Quantity demanded, on the other hand, is the amount consumers
want to buy at a particular price, i.e., the quantity of a good or service that consumers demand at
price Birr 1, the quantity they demand at price Birr 2 etc.
The law of demand states that there is inverse relationship between quantity demand and price of
the commodity other factors like consumer’s income, price of other goods, consumer’s taste &
preferences & expected price being constant. As a result the demand curve slopes downward. We
can depict this relationship using a demand schedule & a demand curve.

A. The demand schedule:-It is a tabular presentation of a series of prices of a commodity and the
corresponding quantities demanded. A hypothetical demand schedule is given in table 2.1 below.
As it is illustrated in the table, the demand for shoes (Qs) increases as its price (Ps) decreases for
instance at price 150 per shoes, only 1000 shirts are demanded per month. When price decreases
to 100 birr, the demand for shoes increases to 1300 and when price falls further to 75 birr,
demand increases to 1500 shoes and so on.
Table 2.1 Demand schedule for shoes
Ps 0 5 10 15 20 25
Qs 250 200 150 100 50 0

Page 7 of 23
 B. The demand curve:-It is a graphical
presentation of the law of demand. The demand curve can be obtained by plotting the demand
schedule. When the data given in demand schedule is presented graphically as it is shown in fig
2.1, we get the demand curve .The curve DD’ in fig 2.1 below depicts the law of demand. It
slopes downward to the right and has negative slope. The negative slope of the demand cove
DD’ shows the inverse relationship between the prices of shoes and its quantity demanded. In
other words the demand for shoes increases with the decrease in price and decreases with the
increase in price.

 Determinants of demand
Although as stated above, price is the most important determinant of the quantity demanded, there
are also various factors which determine (affect) it. These determinants are:-.
1. Price of substituted and complementary goods
The demand for a commodity depends also on the levels of the price of its substitute and
complementary good. Two commodities are said to be substitute for each other if changes in the
price of one affects the demand for the other in the same direction. In other words, if a rise in price of
x good increases the demand for y and vise verse. Eg. Tea & coffee, Pepsi and coca. A commodity is
deemed to be a complement of another when it complements the use of the other. In other words
when the use of any two goods goes together so that their demand changes (increases or decreases)
simultaneously they are treated as complements. For example gun &gun powder, camera & film,
petroleum & vehicle.

Page 8 of 23
2. Consumer’s income
The consumer’s income is also the basic determinant of the quantity demanded of a product.
That is why the people with higher disposable income spend larger amount on goods & services
than those with lower income .But since consumer’s income-demand analysis depends on the
type of the good; we look this income -demand analysis with related to different categories of
goods.

A. Inferior goods:-Are goods which are given low value / class/ by the society .The demand for
such goods may initially increases with the increase in income up to a certain limit. But it
decreases when income increases beyond that limit.

B. Normal goods:-Technically normal goods are those goods which are demanded in increase
quantities as consumer’s income increases. Normal goods are divided into luxuries and
necessities.
i. Essential consumer goods / basic goods/:-Are goods which are essentially consumed by
almost all parts of the society. E.g. food grains, vegetable oils ,sugar etc .The quantity demand of
such goods increases with the increase in consumer’s income only up to a certain limit/ citrus
paribus/.
ii. Prestige or luxury goods: -Are goods which are mostly consumed by the rich section of
society .E.g. Costly cosmetics, jewelry and luxury cars. Demand for such goods arises only
beyond a certain level of consumer’s income.

3. Consumer’s future in come

Consumer’s future income has positive relationship with demand. That means if the consumer
expects future income, he consumes more today and vice versa.

Page 9 of 23
4. Consumer’s expected price: -- It has also positive relationship with demand. That is if
consumer expected price of goods increases in the future, his today’s consumption /demand/ for
that good increases & vice versa.

5. Consumers taste & preferences: - It also plays an important role in determining the demand
for a product. Taste & preferences generally depend on the social customs, religious values
attached to a commodity, habits of the people and general life style of the society.

 Market demand
An individual’s demand for a product is the quantity of the good that the consumer would buy at
various prices. The market demand is the total quantity which all the consumers of a commodity
are willing and able to buy at a given price per time unit other things remaining constant. In other
words, the market demand for the commodity is the sum of the individual’s demand at a given
price .For instance, suppose there are three consumers A and B of commodity X. When the
individual demand schedules plotted graphically and summed up horizontally it gives the market
demand curve. Consider the demand schedules of the two individuals and the market indicated in the
following table:
Price 0 1 2 3 4 5
Demand Schedule of A Quantity 50 40 30 20 10 0
Demand Schedule of B Quantity 30 20 25 20 15 10
Market Demand Quantity 80 60 55 40 25 10

The market demand curves are similarly obtained from simple horizontal summation of individual
demand curves as given below:

Page 10 of 23
  Demand Function
Demand function shows the functional relationship between the quantity demanded of a good
and its price, ceteris paribus. It is defined as: Q = f(P)
The demand function gives quantity demanded as a negative function of price. The most widely
used functional form is a linear demand curve, which is given as: Q = a – Bp

 Movement along the Demand Curve

Movement along the demand curve refers to that change in the quantity demanded of a good
because of changes in the prices of that good while other factors affecting demand (such as price
of other goods, income etc.) remaining the same (unchanged).

The consumer buys larger quantities at lower prices and lower quantities at higher prices.
Therefore, such movements take the consumer from one point on the demand curve to another point
on the same demand curve. In the Figure, reduction of price from P1 to P2 increases quantity
demanded from Q1 to Q2. This represents what is called change in quantity demanded.

 Shift in the demand curve

When the demand curve changes its position keeping its shape we call it a shift in demand curve.
Shift in the demand curve for a good result from changes in one or more of the factors that affect
demand except the price of own good. Increase in demand is shown by outward shift of the
demand curve whereas inward shift of the demand curve represents decrease in demand.

When the tastes of the people change in favor of bread, it would be reflected by an increase in
demand for bread. At every price, consumers demand a larger amount than before. This, as
shown in Figure 2.4, shifts the demand curve from D to D1. The opposite would have occurred if
tastes change against bread, in which case there would be decrease in demand, represented by a
shift from D to D2. Look at the figure for illustration.

Page 11 of 23
An increase in the size of the population has an effect of shifting the demand curve from D to
D1. Suppose the government reduces the minimum driving age from 18 to17. Following this
reduction, the population of driving age increases. This, in turn, will have the effect of increasing
the demand for cars. Decrease in the size of population, on the other hand, shifts the demand
curve from D to D2. This would be the case if the minimum driving age were, for example,
raised to 20.

An increase in income leads to an increase or a decrease in demand depending on the nature of the
good. Demand increases with increase in income if the good is normal. (Eg. Meat). If the good is
inferior good, demand decreases with increase in income (eg. Shiro wet).

The price of related goods and services also has effect on demand depending on the nature of the
other goods. An increase in the price of substitute goods leads to increase in demand for the other
good (eg. Pepsi cola and Coca cola). A rise in the price of a complementary good results in decline in
demand of the other good. Consider the case of sugar and coffee. Coffee is consumed together with
sugar. Thus, increase in the price of sugar causes decline in demand for coffee. The converse is true
for decrease in the price of sugar.

Expectations also have influence on demand. If individuals expect prices to change in the future for
any reason, they may take action that they otherwise might postpone. Suppose consumers expect
prices to fall in the future. In this case they reduce current consumption hoping to buy more of the
good when price falls in the future. If, on the other hand, they expect prices to rise in the future, they
will consume more of the goods at present so as to avoid buying the good at a higher price in the
future. Similarly, change in expectation about the future income influences the decision of
consumers. If consumers expect their income to increase in the future, they would increase their
current consumption through current borrowing. On the other hand, if they expect income to decrease
in the future they will reduce current consumption.

Page 12 of 23
2.3. Theory of Supply
Definition: supply refers to the quantity of goods offered for sale at a particular time or a
particular place at alternative prices. Supply defines the whole set of price-quantity relationship.
It shows the quantities that producers are willing and able to supply at alternative prices, ceteris
paribus. It is different from quantity supplied, which represents the actual quantity that producers
supply at each price.
Supply schedule: is a tabular listing that shows quantity supplied at various prices, ceteris
paribus. Look at the table below.
Table: Supply Schedule
Price 5 10 15 20 25
Quantity 10 20 30 40 50

Supply curve: is a graphical representation of a supply schedule showing the quantity supplied at
various prices, ceteris paribus (see the figure below). The supply of goods or services is affected by
several factors. The factors that influence supply include: the price of the good (P)., the level of
technology (T), the price of factors of production (Pf), the number of suppliers (S), expectations (E),
and others (Z).

Everything that affects supply works through one of these determinants. Supply function is, then,
defined as Qs = f (P, T, Pf, S, E, Z)
The Law of Supply: states that the quantity supplied of a good or service is a positive function of
price, ceteris paribus.

An individual firm’s supply shows the different quantities that the firm would supply at various
prices.

Page 13 of 23
 Market (Industry) Supply:
The market supply curve is obtained by horizontal summation of the individual (firm) supply curves.
This curve represents the sum of the quantities supplied by each firm at different prices. If there are
just two firms in the market, for example, the market supply schedule can be derived from the simple
horizontal summation of the quantity supplied by the two firms at each price.
Table: Supply Schedules
Demand Schedule of A Quantity 0 10 20 30 40
Demand Schedule of B Quantity 0 15 30 45 60
Market Demand Quantity 0 25 50 75 100

Supply Schedule & Supply Curve

A market supply schedule is a table showing the quantity supplied of a commodity at each price
for a given period of time.

It assures that technology, resource prices, and, for agricultural commodities, weather conditions
are held constant (the ceteris paribus assumption).

Higher hamburger prices allow producers to bid resources away from other uses & supply
schedule greater quantities of hamburgers.
The various price-quantity combinations of a supply schedule can be plotted on a graph to obtain
the market supply schedule curve for the commodity.
The positive slope of the supply schedule curve (i.e, its upward to the right inclination reflects
the fact that higher prices must be paid to producers to cover rising marginal, or extra, costs &
thus induce them to supply schedule greater quantities of the commodity.At the price of $ 0.5 per
hamburger, the quantity supplied is 2 million hamburgers per day (point R). If instead the price
in $ 0.75, the quantity supplied is 4 million hamburgers (point N), and so on.

Page 14 of 23
A supply curve also shows the minimum price that the producers must receive to cover their rising
marginal cost & supply schedule each quantity of the commodity.

Market supply schedule for hamburgers

Price per hamburger quantity supplied per day(million hamburgers)

$ 2.00 14

$ 1.50 10

$ 1.00 6

$ 0.75 4

$ 0.50 2

Market supply curve for hamburgers

Marketing supply curve S shows that higher hamburger prices induce producers supply greater
quantities.

 Change in Supply
An improvement in technology, reduction in the price of resources used in the production of the
commodity, and, for agricultural commodities, more favorable weather conditions (i.e. a change in the
ceteris paribus assumptions) would cause the entire supply schedule curve of the commodity to shift to
the right.

The shift to the right from S to S1 is referred to as an increase in SS. On the other hand, a decrease in
supply schedule refers to a left ward shift in the supply curve & must be clearly distinguished from a
decrease in the quantity supplied of the commodity (which is a movement down a supply schedule and
Page 15 of 23
results from a decline in the commodity price). When the supply curve shifts to the right from S to S1
products supply more hamburgers at each price. Thus, at p = $ 1.00 producers supply 12 million
hamburger with s1 instead of only 6 million with S.

Shifts in the Supply Curve

Shifts in the supply curve occur as any one of the ceteris paribus factors (factors kept constant
earlier) is altered. These constitute what is called change in supply (not change in quantity
supplied). Let us now explain how other determents of supply cause a shift in the supply curve.

 Input Prices: A firm’s production costs dictate its supply curve. If a firm produces pencils and
the price of lumber rises, then the firm has no choice but to either cut back on its production of
pencils or raise the price for its pencils. Either option changes the firm’s supply curve. If the cost
of land, labor, or capital increases or decreases; a firm’s supply curve will shift accordingly.
 Producers’ Expectations: Sometimes producers can anticipate a change in the price of raw
materials. When this occurs, the producers’ supply curve shifts accordingly. If an orange producer
is expecting a bad winter, then it may try to harvest more oranges to compensate for a
future shortage. The supply curve for the producer (all other things held constant) will shift to
the right.
 Technology: A change in technology makes production costs less expensive. If a new type of
recyclable oil is invented, how do you think it would affect the supply for oil? The supply curve
for oil would shift to the right, and oil would become cheaper because of a surplus. Technology
improves efficiency, and efficiency allows producers to use their raw materials with lower
opportunity costs.
 Change in the Price of Other Goods: If a supplier made hot dogs and buns and the price of hot
dogs rose as a result of an increase in demand, the supplier could opt to make fewer buns and
more hot dogs. The Number of Suppliers: When more suppliers enter the market, the supply for
that particular good increases (depending on how easy it is to enter the market). When the supply
increases, the supply curve shifts to the right.
Page 16 of 23
 When is a market in equilibrium?
The equilibrium price of a commodity is the price at which the quantity demanded of the commodity
equals the quantity supplied at the market clears. The process by which equilibrium is reached in the
market place can be shown with a table & illustrated graphically. Thus, p = $ 1.00 is the equilibrium
price & Q = 6 million hamburgers per day is the equilibrium quantity. At price above the equilibrium
price, the quantity supplied exceeds the quantity demanded & there is a surplus of the commodity, which
drives the price down.

At the lower prices, producers supply smaller quantities & consumers demand large quantities until the
equilibrium price of $ 1.00 is reached, at which quantity supplied of 6 million hamburgers per day
equals the quantity demanded & the market clears. On the other hand, at prices below the equilibrium
price, the quantity supplied falls short of the quantity demanded & there is a shortage of the commodity,
which derives the price up.

The intersection of the market demand curve & the market supply curve of hamburgers at point E
defines the equilibrium price of $ 1.00 per hamburger & the equilibrium quantity of 6 million
hamburgers per day. At higher prices, there is an excess supply or surplus of the commodity (the top
shaded area in the fig.). Suppliers then lower prices to sell their excess supplies. The surplus is
eliminated only when suppliers have lowered their price to the equilibrium level.

On the other hand, at below equilibrium prices, the excess demand or shortage (the bottom shaded area
in the fig. drives the price up to the equilibrium level. This results because consumers are unable to
purchase all of the commodity they want at below equilibrium prices & they bid up the price.
Market supply, market demand schedule & equilibrium

Price/hamburger Q ssed/day Q dded/day Shortage(-)or Surplus(+) pressure on

price
down
$ 2.00 14 2 12 ward

$ 1.50 10 4 6

$ 1.00 6 6 0 Equilibrium

$ .75 4 7 -3
$ .50 2 8 -6 upward

The intersection of demand & supply at point E defines the equilibrium price of $ 1.00 /hamburgers & the
equilibrium quantity of 6 million hamburgers/ per day. At price larger than $1.00, the resulting surplus will derive
P down towards equilibrium. At price smaller than $ 1.00, the resulting shortage will drive P upward equilibrium.

Page 17 of 23
Quantity supply = Quantity demand = 6 million hamburgers per day, & the market is in equilibrium
(clears). So both demand supply schedule play a role in determining price. Equilibrium is the condition
which, once achieved, tends to persist in time. That is, as long as demand & supply don’t change, the
equilibrium point remains the same.

Once equilibrium is reached at the point of equality of the demand curve with the supply curve, it
remains there as long as demand and supply remain unchanged.
Numerically: If demand is given as: Qd = a-bP, and Supply is given as Qs = c +dP: then Equilibrium
condition is given as SS=DD, i.e. a-bP = c +dP

The effect of shift in demand or supply on market equilibrium?? Reading Assignment.

2.4. Elasticity of demand and supply

The law of demand and supply states only the nature of relationship between the change in the price of
a commodity and the quantity demanded and supplied respectively the law does not quantity
the Relationship. The quantative relationship is measured by the elasticity of demand and
elasticity of supply.

Definition: Elasticity is a measure of the sensitivity or responsiveness of quantity demanded or

quantity supplied to changes in price (or other factors).
Elasticity measures the way one variable (dependent variable) responds to changes in other
variables (independent variables). We express the dependent variable (Y) as a function of the
independent variables (Xi)as in the following function: Y = f(X1, X2, X3,…, Xn). In this function, is
given as a function of n variables. As any one of these variables (Xi) changes, there will be consequent
change in the value of Y. The formula to determine the responsiveness of Y to changes in the Xi can
be expressed as

% % %
1=% , 2=% ……… =%

Page 18 of 23
 This formula states that elasticity is the percentage change in the dependent variable divided
by the percentage change in the particular independent variable whose effect is being examined.

 Elasticity of Demand
In examining demand, it would be interesting to measure how quantity demanded responds to changes
in price and changes in other factors that affect demand such as price of other goods and income.
Depending on the variables involved, three measures of elasticity of demand could be considered:

 Price elasticity of demand measures the responsiveness of quantity demanded to

changes in output price, ceteris paribus.
 Cross elasticity of demand measures the responsiveness of quantity demanded to changes in
the price of other goods, ceteris paribus.
 Income elasticity of demand measures the responsiveness of quantity demanded to changes in
consumers’ income, ceteris paribus.
The price elasticity of demand (ε) is defined to be the percentage change in quantity demanded divided
by the percentage change in price.

Percentage change in quantity demanded

=
ℎ

/
= = .
/
The sign of the elasticity of demand is generally negative, since demand curves invariably
have a negative slope. Accordingly price elasticity of demand can be stated as:

= ∗
In elasticity, we consider the absolute value of the coefficients. The negative sign in front of an
elasticity coefficient indicates only that the relationship between price and quantity demanded is
negative. A demand with –2 elasticity coefficient is said to be ‘more elastic’ than the one with -1.

If a good has an elasticity of demand greater than 1 in absolute value, it is said to have an
elastic demand. Such values imply that a given percentage fall in price causes more than proportionate
rise in price.

With most demand curves, the elasticity coefficient varies along the curve. In this regard, a good
example is a linear demand curve. The coefficients of elasticity of such demand curves range from
perfectly elastic (at the intercept of y-axis) to perfectly inelastic (at the x-axis intercept).

Depending on the magnitude (size) of the elasticity coefficient, five types of price elasticity
could be traced along a linear demand curve. Each of these is given in the table below.

Page 19 of 23
 Numerical Responsiveness of quantity demanded to changes in price Terminology
coefficients
e=0 none Perfectly inelastic
0<e<1 Quantity demanded changes by a smaller percentage than the Inelastic
percentage change in price
e=1 Quantity demanded changes by a percentage equal to the Unit elastic
percentage change in price
1<e<∞ Quantity demanded changes by larger percentage than the Elastic
percentage change in price
e=∞ Quantity demanded goes to zero or to all that is available perfectly elastic

 Determinants of Price Elasticity of Demand

Price elasticity of demand depends, in large part, on the number of substitutes a product has. If a
good has many close substitutes, it is generally held that its quantity demanded would be very
responsive to price changes. On the other hand, if there are a few close substitutes for a good, it will
exhibit a quite inelastic demand.

The elasticity coefficients for general groups of commodities will be lower than for specific
commodities. For example, the elasticity of demand for detergent soap will be higher than the
elasticity of demand for soap in general.
Another determinant of elasticity is time. The longer the period of time consumers have to adjust, the
more elastic the demand becomes. This is because there are more opportunities to modify behavior
and substitute different products over a longer time period.

A fourth determinant of price elasticity of demand is the nature of the need that the commodity
satisfies. Generally luxury goods are price elastic and necessities are price inelastic.
The proportion of income spent on the particular commodity also affects price elasticity. Goods like
car which take up a large proportion of income tend to have more elastic demand than goods like salt
which take up only small proportion of income.

 Constant Elasticity Demands

Along a linear demand curve, as shown above, price elasticity of demand ranges between 0 and ∞. In
some exceptional cases, the demand curve may exhibit constant price elasticity throughout. A demand
curve given by a vertical line indicates a case in which the quantity demanded of a good is totally
unresponsive to changes in price. Consequently, the elasticity coefficient is zero. Such demand curve
is called perfectly inelastic demand curve. This is a limiting case, which violates the law of demand.

= . = 0* = 0
If a demand curve is given by a horizontal line, which is also a limiting case, a very small decrease in
Page 20 of 23
 price would cause an infinite quantity of the good to be demanded. If price rises, in contrary,
the quantity of the good falls to zero. Such a curve is referred to as a perfectly elastic demand curve.
 Approaches to Elasticity Measurement

There are two main approaches to elasticity computation: the arc elasticity and point elasticity. If we
are measuring the elasticity between points, we are actually calculating the average elasticity over the
space between the points. This is called arc elasticity.
Elasticity between two points:

/
= = ∗
/

When measuring the responsiveness of quantity demanded to changes in price at a particular point on
a curve, you are actually measuring point elasticity.
Elasticity at a point is measured by assuming infinitesimally small changes in price and
quantity demanded. When dealing with the concept of arc elasticity, however, we are working
with sizable, discrete changes.

= * = slope*

 Cross Elasticity of Demand

The responsiveness of quantity demanded for one commodity to the changes in the prices of
other commodities, ceteris paribus, is called cross elasticity of demand. It is denoted as:
ℎ ( )
=
ℎ ℎ ℎ ℎ ( )
In this case (where the demand of a given good does not depend solely on its price), the
demand function is modified in such a way it includes the prices of related goods. QX= f(PX, PY)
The cross elasticity formula is given as: = ∗ , Where QX is the quantity demanded of
good X and PY is the price of good Y.

The cross elasticity of demand coefficient may take different values depending on the type of
relationship between the two goods. If cross elasticity demand coefficient is equal to zero, it would
mean the two goods under consideration are unrelated. In this case, any increase or decrease in price of
one of the two goods has no effect on the quantity demanded of the other good.
On the other hand, if the goods have a relationship of some sort, this value would be different from
zero. The two goods could be substitutes or complements depending on whether the cross elasticity
coefficient is positive or negative.

Page 21 of 23
 Definition: two goods are said to be substitutes if one good can be consumed in place of the
other. Complementary goods, in contrast, are goods that are consumed together so that fall in
consumption of one implies reduction in consumption of the other.
If the cross elasticity of demand coefficient has a positive sign it indicates that a rise in the price of one
of the two goods results in rise in the quantity demanded of the other good. As a result the two goods
are substitutes. If, however, the cross elasticity of demand coefficient has a negative sign, it reflects
that a rise in the price of one of the goods results in decline in the demand for the other indicating that
the goods are complements.
The size (magnitude) of the cross elasticity of demand coefficient shows strength of the substitution or
complementary relationship between the goods under consideration. i.e., the higher the value of cross
elasticity, the stronger will be the degree of substitutability or complementarily, depending on the sign.

 Income-Elasticity of Demand
It is the responsiveness of demand to the change in consumer’s income. Income-elasticity of demand
Δ
for a product, say X (i.e. EY) may be defined as EY= ∗ , Where ∆Qx=change in quantity
Δ
demand of x; QX=quantity of X demanded, Y=disposable income and ∆Y=change in disposable
income. For all normal goods income elasticity is positive although the degree of elasticity varies in
accordance
with the nature of commodities while Income-elasticity for inferior goods is negative. The
value of income- elasticity for different categories of goods is stated as follows.
 Necessity goods, income-elasticity less than unite (Ey <1)
 Comfort goods, income elasticity almost equal to unity (Ey =1)
 Luxuries goods , income elasticity greater than unity (Ey >1)
 Inferior goods, income elasticity is negative (Ey <0)

 Price elasticity of Supply

Price elasticity of supply measures the responsiveness of the quantity supplied to a change in the
commodity’s price, ceteris paribus. It is defined as: =

= ∗ , Where, QS is quantity supplied of a good and P is price.

As with price elasticity of demand, if εs= 1, supply is unit elastic. If εs > 1, it is elastic; and if εs < 1, it
is inelastic.
The coefficients of price elasticity of supply are often positive because normally supply curves
are positively sloped. But there are exceptions in which the supply curve is either vertical or
horizontal. If the supply curve is vertical- the quantity supplied does not change as price changes- then
elasticity is zero. This is the case in the very short run where it is difficult to produce more of a good
regardless of what happens to price. Similarly, a horizontal supply curve has an infinitely high
elasticity of supply: a small drop in price would reduce the quantity producers are willing to supply
from an indefinitely large amount to zero. Between these extremes the elasticity of supply varies
Page 22 of 23
 with the shape of the supply curve.

 Determinants of Price Elasticity of Supply

The elasticity of supply depends on:
 How costs behave as output is varied. If the costs of producing a unit of output rise rapidly as
output rises, then the stimulus to expand production in response to rise in price will quickly be
obstructed by increases in costs. In this case, supply will tend to be rather inelastic. If, however,
the costs of producing a unit of output rise only slowly as production increases, a rise in price that
raises profits will bring forth a large increase in quantity supplied before the rise in costs puts a
halt to the expansion of output. In this case, supply will tend to be rather elastic.
 Time involved. Since as the time period increases, the possibility of obtaining new and different
inputs to increase the supply increases, elasticity of supply tends to be more elastic over longer
periods than over shorter periods.
 Excess capacity and unsold stocks. It may be possible to increase supplies if there is a pool of
unemployed labor and unused machinery. Again, if the industry has accumulated a large stock of
unsold goods, supplies can quickly be increased. These mean, it is possible to quickly respond to
an increase in price by increasing quantity supplied and hence, supply becomes more elastic.

Page 23 of 23