Demand Supply Analysis

PART II
Topics
• Supply and Demand

• The Market Mechanism

• Changes in Market Equilibrium

• Elasticities of Supply and Demand

• Short-Run versus Long-Run Elasticities,
• Revenue and Elasticity
• Income and Cross price elasticity

• Effects of Government Intervention

• Ceilings and floors – direct intervention

• Taxes and subsidies

2
Case Studies

• Can good news for farming be bad news for farmers?;

• Why did OPEC fail to keep the price of oil high?

• Elasticity has a role to play!!

3
Elasticity

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 ELASTICITY OF DEMAND
Price Elasticity of Demand
● price elasticity of demand Percentage change in quantity
demanded of a good resulting from a 1-percent change in its
price.
Slope co-eff= absolute
change in Q/ absolute • An increase in price of ice creams from
change in P Rs. 20 to Rs. 22 reduces the quantity
demanded from 50 litres to 44 litres.
• slope = -6/2 = -3 (absolute change)
Elasticity = % change in Q/
% change in P • Elasticity= -12/10 = -1.2 (percentage
change)
• Values it can take
• Larger values of price elasticity implies
demand is more price sensitive
 ELASTICITIES OF SUPPLY AND DEMAND

Point versus Arc Elasticities

● point elasticity of demand Price elasticity at a particular point on

the demand curve.

Arc Elasticity of Demand

● arc elasticity of demand Price elasticity calculated over a range of

prices.

● Elasticity of demand may be equal to, less than or greater than 1.

Point Elasticity from a Demand Equation
Q = 400 – 8P
At P = 50, Q = 0.
At P = 0, Q = 400.
At P =25, Q= 200. what is the elasticity?
|Elasticity| = |e|= 8*25/200 = 1.

At P = 10, e =?
At P = 40, e =?

Practise: If demand function is: Q = 100-4P. Find elasticity at P = 20.

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 ELASTICITY OF DEMAND
Linear Demand Curve

The price elasticity of demand

depends not only on the slope
of the demand curve but also
on the price and quantity.

The elasticity, therefore,

varies along the curve as price
and quantity change. Slope is
constant for this linear
demand curve.

The elasticity becomes

smaller as we move down the
curve.
 ELASTICITY OF DEMAND : infinitely elastic

(a) Infinitely Elastic Demand

For a horizontal demand

curve, ΔQ/ΔP is infinite.
Because a tiny change in
price leads to an
enormous change in
demand, the elasticity of
demand is infinite.

● infinitely elastic demand Principle that consumers will buy as

much of a good as they can get at a single price, but for any higher
price the quantity demanded drops to zero, while for any lower price
the quantity demanded increases without limit.
 ELASTICITY OF DEMAND : Perfectly inelastic

(b) Completely Inelastic Demand

For a vertical demand

curve, ΔQ/ΔP is zero.
Because the quantity
demanded is the same no
matter what the price, the
elasticity of demand is
zero.

● completely inelastic demand Principle that consumers

will buy a fixed quantity of a good regardless of its price.
 Determinants of Elasticity
•Elasticity more as greater no. of substitutes available
(sugar vs. salt)

•Elasticity more as substitutes are more close

(tea-coffee vs. juice-tea)

•A commodity has closer substitutes more narrowly it is

defined (brand vs. product, or apple juice-mango juice vs.
juice-coffee)

•In longer run, availability of substitutes might be more –

hence more elastic in the long run
 SHORT-RUN VERSUS LONG-RUN ELASTICITIES
In the short run, an Gasoline: Short-Run and
increase in price has only a Long-Run Demand Curves
small effect on the quantity
of gasoline demanded.
Motorists may drive less,
but they will not change
the kinds of cars they are
driving overnight.

In the longer run, however,

because they will shift to
smaller and more
fuel-efficient cars, the
effect of the price increase
will be larger. Demand,
therefore, is more elastic
in the long run than in the
short run.
 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand and durability

(Automobiles: Short-Run and

Long-Run Demand Curves
The opposite is true for
automobile demand. If price
increases, consumers initially
defer buying new cars; thus
annual quantity demanded falls
sharply.

In the longer run, however, old

cars wear out and must be
replaced; thus annual quantity
demanded picks up. Demand,
therefore, is less elastic in the
long run than in the short run.
Exercise 1
• Q.1 A consumer purchases 80 units of a commodity when its
price is Re. 1 / unit and purchases 48 units when its price is Rs
2/unit. What is the Arc price elasticity of demand?
• Q.2 Suppose price of a good falls from Rs 10 to Rs 8 per unit. As a
result, its quantity demanded increases from 80 units to 100
units. What is the price elasticity (Arc) of demand?
• Q3. Calculate price elasticity of demand curve, P=100-5Q at each
of the following price and quantity levels:
• P=90, Q=2
• P=50, Q=10
• P=5, Q=19:
• Q4. Suppose the price elasticity of demand for gasoline is 0.2 in
the short run and 0.7 in the long run. If the price of gasoline rises
by 28 percent, what effect on quantity demanded will this have in
the short run? In the long run?
 Exercise 1
5. Suppose the demand for a product is given as Q = 10 -2P.
a. Can you find out for which price, elasticity is 1?
b. For which price elasticity is >1?
c. For which price elasticity is <1?
6. A firm would like to know on which segment of the demand
curve it is currently operating (elastic or inelastic). It is now
charging a price of Rs. 3000. The demand function is:

(hint: Find out the price at which the elasticity of demand is equal to unity )
7. Cigarette price is raised by 25%. If |ep|= 1.3, what will be the
impact on quantity sold?
8. Studies in the United States indicate that price elasticity of
demand for cigarettes is 0.4. If a pack of cigarettes currently costs
$2 and the government want to reduce smoking by 20 percent, by
how much should it increase the price?

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Elasticity and Revenue
P dQ/dP=-6
A (infinite)
2
C (|e|=3) infinity
1.5
E (|e|=1)
1

F (|e|=0.33)
0.5
(|e|=1)
B (|e|=0)
Q
3 6 9 12
When p falls, Q rises – but how much?
At C point elasticity = -6*1.5/3 = -3. or |e|=3

As price is reduced along the demand curve, till the mid point
elasticity is greater than 1. After mid point elasticity is less than 1.

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 Elasticity and Revenue
P dQ/dP=-6
A (infinite)
2
C (|e|=3)
1.5
E (|e|=1)
1

F (|e|=0.33)
0.5
(|e|=1)
B (|e|=0)
Q
3 6 9 12
Lesson: To have an increase in revenue,
• reduce price if you have e>1, i.e. you are on the upper part of
the demand curve [ total revenue will increase (P , Q ) ]

• raise price if you have e<1, i.e. you are on the lower part of the
demand curve [total rev will increase (P , Q ) ]
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Exercise 2 : Applications and Caselet

Q1. From the demand schedule below calculate price elasticity of

demand and total revenue
Quantity
Price Demanded
10 20
8 30
6 35
4 40

Q2. (think before your speak!) Your company currently sells

50 kgs of salt and decided to increase the price from Rs.10 to Rs.12.
If |ep|= 0.10, how much will sales & revenue change?

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 Exercise 2 : Applications and Caselet
Q3 At current p, |ep|= 0.8,
i. the current price is on which part of the dd curve?
ii. If you want to raise your total revenue should you raise or
reduce price?
iii. Will you move upward or downward along dd curve?
Q4 Suppose a seller of a textile cloth wants to lower the price of its
cloth from Rs 150 per metre to Rs 142.5 per metre. If its present
sales are 2000 metres / Month and further it is estimated that its
elasticity of demand for the product equals - 0.7 .
a) Would his total revenue increase as a result of his decision to
lower the price.
b) Calculate the exact magnitude of its new total revenue.

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Application Exercise 2

Q6 The in charge of a toll bridge that costs nothing to operate estimates

the demand for bridge crossings Q (in hundreds) given by: P = 15 –
1/2Q.
• Draw the demand curve for bridge crossings.
• Currently the toll is Rs. 7. Would the toll bridge revenue increase
or decrease if he wants to raise the toll further, from 7? What does
your answer tell you about the elasticity of demand?
Q7 For which of the following pairs of goods would you expect to have
more elastic demand and why?
a. Required textbooks or novels
b. Metro rides in the next 3 months or metro rides in the next 3 years
c. Water or cola
d. Volkswagen Polo or automobile industry in general
e. Salt or Sugar

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Application Exercise 2

• Q8. Suppose that 50 candy bars are demanded at a particular

price. If the price of candy bars rises by 4 percent, the number of
candy bars demanded falls to 46 candy bars. Calculate price
elasticity and was the decision to increase price correct?
• Q9. Knowing that the demand for wheat is inelastic, if all
farmers voluntarily ploughed 10 percent less of their wheat crop,
then their total revenue would ______________.

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ELASTICITY OF SUPPLY

● price elasticity of supply Percentage change in quantity

supplied resulting from a 1-percent change in price.

● Relates to the supply curve/ equation

● Price Elasticity of Supply = % change in quantity

supplied/ % change in price
● This is always positive

● Elastic supply (horizontal) and inelastic supply (vertical)

● https://www.youtube.com/watch?v=sSeByVLztJg

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 ELASTICITIES OF SUPPLY AND DEMAND

During recent decades, changes in the wheat market had

major implications for both American farmers and U.S.
agricultural policy.

To understand what happened, let’s examine the behavior of supply and

demand beginning in 1981.

By setting the quantity supplied equal to the quantity demanded, we can

determine the market-clearing price of wheat for 1981:
 ELASTICITIES OF SUPPLY AND DEMAND

Substituting into the supply curve equation, we get

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

We can likewise calculate the price elasticity of supply:

Because these supply and demand curves are linear, the price
elasticities will vary as we move along the curves.

Later the elasticities changed with changes in new eqm prices

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Other Elasticities of Demand

•Income elasticity – normal or inferior good

•Cross price elasticity – substitutes or complements
•Advertising elasticity – effect on sales/ revenue

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OTHER ELASTICITIES OF DEMAND
●income elasticity of demand Percentage change in the
quantity demanded resulting from a 1-percent change in
income.
EI = % change in Q/% change in I or

●Income elasticity can be positive or negative –

implications
●If it is positive, it can be greater or less than 1

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Income Elasticity

Elasticity > 0 implies normal good

Elasticity > 1 implies luxury,

0 to 1 implies necessity

Elasticity < 0 implies inferior

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Cross Price Elasticity

● cross-price elasticity of demand Percentage change in the

quantity demanded of one good resulting from a 1-percent change in
the price of another. Positive sign implies substitute and negative
sign implies complementary goods.
εYX = ∂QY/QY ÷ ∂PX/PX
= % change in Q of Y (coffee)/% change in P of X (tea)

• Positive cross price elasticity implies x and y are substitutes

• Negative cross price elasticity implies x and y are complements

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 Application Exercise 3
Q1 Suppose, between the two goods x and y, we get the following
information:
Income elas. of x = 2.33, income elas. of y = -0.25, price
elasticity of x = 1.75 and cross price elasticity of x on y =
0.09.
a. what kind of good is x? b. what kind of good is y?
c. what’s the relationship between x and y?
Q2 Price elasticity of demand for good X is 2. Income elasticity of
good X is 1.2. If income rises by 5% and also, price rises by 2%,
what will be the impact on the demand for X?

Q3 In India, in every large city, the public transport system runs

a deficit. Do you think, by increasing fares, the deficit can be
reduced?

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Exercise 3
Q4 The demand equation of X is:
Qx = 4000 - 12.5 Px - 3.5 Py -0.75I, where I is income and Py is
price of another good.
What is the relation between goods X and Y? What type of good is
good X?

Q5 The Management of the Ironny Steel Company estimated the

following elasticities of demand for a special type of steel: |ep | = 2,
eI = 1, exy = 1.5, where X is steel and Y refers to aluminium. Next
year, the firm is planning to increase the price of steel by 6 per
cent. The Management forecasts that income will grow by 4 per
cent and price of aluminium will fall by 2 per cent next year. If the
sales of steel this year is 1200 tons, how much steel does the
company expect to sell next year?

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Exercise 3 continued…..
Q6 Suppose the demand curve for a product is given by
Q=10-2P+Pr, where P is the price of the product and Pr is the price
of a related good. The price of the related good is Rs20.
• a. Suppose P=Rs10. What is the price elasticity of demand? What
is the cross price elasticity of demand. Are the goods substitute or
complement?
• b. Suppose the price of the good, P, is now Rs 5. What is the price
elasticity of demand? What is the cross price elasticity of demand?
Q7 Suppose the demand function for a product is given by
Q=300-2P+4I, where I is average income measured in thousand of
dollars. The supply curve is Q=3P-50.
a. If I=25, find the market clearing price and quantity for the
product
b. Let I=50. What is the income elasticity of demand. Comment on
the type of elasticity.

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Exercise 3 continued…..

Q8. Suppose the cross price elasticity of demand between goods X

and Y is 4. How much would the price of good Y have to change in
order to increase the consumption of good X by 20 percent?
Q9. Suppose the own price elasticity of demand for good X is -3, its
income elasticity is 1, its advertising elasticity is 2, and the cross
price elasticity of between it and good Y is -4. Determine how much
the consumption of this good will change if:
a. The price of the good X decreases by 5 percent
b. The price of good Y increases by 8 percent
c. Advertising decreases by 4 percent
d. Income increases by 4 percent

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Exercise 3 continued…..
•

33
Exercise 3 continued…..

Q12. Vijay Dairy is selling flavoured milk and buttermilk in packets

of 150 ml. The dairy sells 2000 packets of flavoured milk and 100
packets of butter milk every day. The former is priced at Rs.6 and
the latter at Rs. 4. A market survey estimates the cross elasticity
(bothways) at 1.8 and the own price elasticity to be -1.3. The dairy
is contemplating a 10% reduction in the price of flavoured milk.
Should it go ahead with the price reduction? Show your working.

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Do It Yourself
Q1 The South Beach Café recently reduced appetizer prices from $12 to $10 for
afternoon “early bird” customers and enjoyed a resulting increase in sales from
90 to 150 orders per day. Beverage sales also increased from 300 to 600 units
per day.
• Calculate the price elasticity of demand for appetizers.
• Calculate the cross-price elasticity of demand between beverage sales and
appetizer prices.
• Holding all else equal, would you expect an additional appetizer price
decrease to $8 to cause both appetizer and beverage revenues to rise?
Explain.
Ans: 4, -6, yes
Q2 Income Elasticity for Selected Commodities in the US as estimated by
Houthakker
and Taylor (1970)
Restaurant Meals 1.61
Furniture 2.60
Dental Service 0.38
Motor Cars 1.03
Petrol & Oil 0.55
Comment on the nature of the goods
Ans: >1 means normal and luxury, <1 but positive, means normal and necessity
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Imposition of a Tax
• Tax per unit of price or quantity
• Suppose in free market condition a seller is selling his commodity
at Rs 6 per unit. He sells 100 units.
• Now a per unit tax is imposed, say, Rs. 2 per unit of output
• What will the supplier do? Will he supply the same amount?
• He will supply less as his net price is now Rs 6-2 = 4 per unit!!
• Maybe, he will supply 80 units at Rs 6 now!
• This happens at all levels of prices, i.e. he will sell less at r=each
price level
• Hence the outcome will be like a leftward shift of the supply
curve!!
• This is how the authorities influence the behaviour of sellers!
Market price and quantities are then determined by new ss curve
and the original demand curve – no direct intervention!!

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Imposition of a Tax
P • Excise tax (per unit of
Ss price or quantity)
• Tax collected from the
sellers (t=0.75)
P’
(1.5)
• SS curve shifts to the left
as at the same price they
P*
(1) will get less, hence
producers reduce the
Dd supply
• Price increases, quantity
Q’ Q* Q
(4) (6) falls
• Consumers now pay 1.5
per unit

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Imposition of a Tax
P • Excise tax (per unit of
Ss price or quantity)
• Tax collected from the
sellers (t=0.75)
P’
(1.5)
• BURDEN of tax can be
shifted to the consumer!!
P*
(1) • Burden on Consumer =
1.5 – 1 =0.5
Dd • Burden on Producer =
0.75 – 0.5 = 0.25
Q’ Q* Q
(4) (6)
Consumers’ burden = 1.5 – 1 = 0.5 out of 0.75 tax
or 2/3 implying 66.6%

Producers’ burden = 0.75 – 0.5 = 0.25 of 0.75 tax

or 0.25/0.75 =1/3 or 33.3% 38
Effect of Tax

•Burden of tax can be related to elasticity of demand and

supply
•Less is the elasticity of demand, higher is the burden
borne by consumers

•Pass-through formulae:
Percentage of tax borne by buyers: es/(es-ed)
Percentage of tax producers bear: -ed/(es-ed)

Example

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Subsidy?

• Application
• Suppose for a good, initial equilibrium price is Rs. 15 and quantity
is 6000. Govt imposes a tax of Rs. 10.5 per unit and so, market
price increases to Rs. 18 and quantity falls to 4500 units. How
much is consumers’ burden? Producers’ burden?
Ans: Consumers’ burden = 18-15 = 3 or 28.6%
Producer’s burden = 10.5 – 3 = 7.5 or 71.2%
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Exercise 4

Q1 “The government is expected to withdraw sugar

export subsidies from the new season beginning October as a sharp
rise in global prices makes it easier for mills to sell the sweetener
on the world market……India, the world's biggest sugar producer
after Brazil, incentivised overseas sales for three years in a row,
helping New Delhi emerge as a significant, stable exporter of the
commodity.” August 17, 2021
https://timesofindia.indiatimes.com/business/india-business/government-likely-to-withdraw-sug
ar-export-subsidies-from-new-season/articleshow/85407496.cms

a. Explain how it helped the country emerge as a stable exporter

of sugar with the subsidy.
b. Is the decision of withdrawing subsidy correct?

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Exercise 4 continued…..
Q2 QD=50 – 2 P + 0.5 PR and Qs = -4 + P. Here PR if the price of a related
good.
• a. What is the equilibrium price and quantity if PR =Rs. 5?
• b. Plot the demand and supply curve and show the equilibrium in the same
plot.
• c. If govt. imposes tax on the related good by Re.1 per unit, then how the
equilibrium will change?

Q3 Suppose the price elasticity of demand for yachts equals -4.04, while the
price elasticity of supply for yachts equals 0.22. If Congress reinstates a luxury
tax on yachts, who will pay more of the tax?

Q4 A firm has following demand and supply function:

Demand: Qd = 13500 – 500P
Supply: Qs = 3000 + 200P
From the above functions, find the equilibrium price.
If the government imposes specific sales tax of Rs. 10, what would be the new
equilibrium price?
Show the same with the help of a diagram and incidence of tax on buyer and
seller

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Topics
• Supply and Demand

• The Market Mechanism

• Changes in Market Equilibrium

• Elasticities of Supply and Demand

• Short-Run versus Long-Run Elasticities,
• Revenue and Elasticity
• Income and Cross price elasticity

• Effects of Government Intervention

• Ceilings and floors – direct intervention

• Taxes and subsidies

43
Reference

• Pindyck and Rubinfeld, Chapter 2 and 4.6

• For tax, Mankiw, chapter 6, as per course outline

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