DEMAND, SUPPLY AND

ELASTICITY
Overview

I. Market Demand Curve III. Market Equilibrium

 The Demand Function IV. Price Restrictions
 Determinants of Demand
 Consumer Surplus
V. Comparative Statics

II. Market Supply Curve

 The Supply Function
 Supply Shifters
 Producer Surplus
 Market Demand Curve
 Shows the amount of a good that will be purchased
at alternative prices.
 Law of Demand
 The demand curve is downward sloping.

Price

D
Quantity
Determinants of Demand
 Income
 Prices of substitutes
 Prices of complements
 Advertising
 Population
 Consumer expectations
The Demand Function
 An equation representing the demand curve
Qxd = f(Px , PY , M, H,)

 Qxd = quantity demand of good X.

 Px = price of good X.

 PY = price of a substitute good Y.

 M = income.

 H = any other variable affecting demand

Change in Quantity Demanded
Price
A to B: Increase in quantity demanded

A
10

B
6

D0
4 7 Quantity
Change in Demand
Price D0 to D1: Increase in Demand

6
D1

D0
7 13 Quantity
Market Supply Curve
 The supply curve shows the amount of a good that
will be produced at different prices.
 Law of Supply
 The supply curve is upward sloping

Price
S0

Quantity
Supply Shifters
 Input prices
 Technology or government regulations
 Number of firms
 Substitutes in production
 Taxes
 Producer expectations
The Supply Function
 An equation representing the supply curve:
QxS = f(Px , PR ,W, H,)

 QxS = quantity supplied of good X.

 Px = price of good X.

 PR = price of a related good

 W = price of inputs (e.g., wages)

 H = other variable affecting supply

Change in Quantity Supplied
Price A to B: Increase in quantity supplied

S0
B
20

A
10

5 10 Quantity
Change in Supply
S0 to S1: Increase in supply
Price

S0

S1

5 7 Quantity
Market Equilibrium
 Balancing supply and demand
 QxS = Qxd

 Steady-state
If price is too low…
Price S

7
6

Shortage D
12 - 6 = 6
6 12 Quantity
If price is too high…
Surplus
Price 14 - 6 =
S
8
9

8
7

6 8 14 Quantity
Price Restrictions

 Price Ceilings
 The maximum legal price that can be charged
 Price Floors
 The minimum legal price that can be charged.
Impact of a Price Ceiling
Price S

PF

P*

Ceiling
Price
Shortage D

Q* Quantity
Qs Qd
Impact of a Price Floor
Price Surplus S
PF

P*

Qd Q* QS Quantity
Summary
 Use supply and demand analysis to
 clarifythe “big picture” (the general impact of a
current event on equilibrium prices and quantities)
 organize an action plan (needed changes in
production, inventories, raw materials, human
resources, marketing plans, etc.)
PRICE, INCOME
AND CROSS ELASTICITY
Elasticity – the concept
 The responsiveness of one variable to changes in
another
 When price rises, what happens
to demand?
 Demand falls
 BUT!
 How much does demand fall?
Elasticity – the concept
 If price rises by 10% - what happens to demand?
 We know demand will fall
 By more than 10%?
 By less than 10%?
 Elasticity measures the extent to which demand
will change
Elasticity
 4 basic types used:
 Price elasticity of demand
 Price elasticity of supply
 Income elasticity of demand
 Cross elasticity
Elasticity
 Price Elasticity of Demand
 The responsiveness of demand
to changes in price
 Where % change in demand
is greater than % change in price – elastic
 Where % change in demand is less than % change in
price - inelastic
 Elasticity

The Formula:
% Change in Quantity Demanded
___________________________
Ped =
% Change in Price

If answer is between 0 and -1: the relationship is inelastic

If the answer is between -1 and infinity: the relationship is elastic

PED has – sign in front of it; because as price rises

demand falls and vice-versa (inverse relationship between
price and demand)
Elasticity
Price (Rs.)
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.

Quantity Demanded
 Elasticity
Price
Total revenue is of
price x
The importance elasticity
quantity sold. In this
is the information it
example, TR = Rs.5 x on
provides on the effect
100,000 = Rs.500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
Rs
.5

Total Revenue

100 Quantity Demanded (000s)

 Elasticity
Price
If the firm decides to
decrease price to (say)
Rs.3, the degree of price
elasticity of the demand
curve would determine the
extent of the increase in
demand and the change
Rs therefore in total revenue.
.5

Rs.
3

Total Revenue
D
100 140 Quantity Demanded (000s)
Elasticity
Price (Rs.)
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
5 Total Revenue would fall

D
5 6
Quantity Demanded
 Elasticity
Price (Rs.)
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10

7
D

5 Quantity Demanded 20
Elasticity
 If demand is price  If demand is price
elastic: inelastic:
 Increasing price would  Increasing price would
reduce TR (%Δ Qd > increase TR
% Δ P) (%Δ Qd < % Δ P)
 Reducing price would  Reducing price would
increase TR reduce TR (%Δ Qd <
(%Δ Qd > % Δ P) % Δ P)
 Factors Affecting Price Elasticity of Demand

 Availability of substitutes
 The better & more numerous the substitutes for a good,
the more elastic is demand
 Percentage of consumer’s budget
 The greater the percentage of the consumer’s budget
spent on the good, the more elastic is demand
 Time period of adjustment
 The longer the time period consumers have to adjust to
price changes, the more elastic is demand
 Calculating Price Elasticity of Demand
6-34

 Price elasticity can be calculated by multiplying the

slope of demand (Q/P) times the ratio of price
to quantity (P/Q)

Q
 100
%Q Q Q P
E   
%P P P Q
 100
P
 Calculating Price Elasticity of Demand
 Price elasticity can be measured at an interval (or
arc) along demand, or at a specific point on the
demand curve
 If the price change is relatively small, a point
calculation is suitable
 If the price change spans a sizable arc along the
demand curve, the interval calculation provides a
better measure
 Computation of Elasticity Over an Interval

 When calculating price elasticity of demand over

an interval of demand, use the interval or arc
elasticity formula

Q Average P
E 
P Average Q
 Computation of Elasticity at a Point
 When calculating price elasticity at a point on
demand, multiply the slope of demand (Q/P),
computed at the point of measure, times the ratio
P/Q, using the values of P and Q at the point of
measure
 Method of measuring point elasticity depends on
whether demand is linear or curvilinear
 Marginal Revenue
6-39

 Marginal revenue (MR) is the change in total

revenue per unit change in output
 Since MR measures the rate of change in total
revenue as quantity changes, MR is the slope
of the total revenue (TR) curve

TR
MR 
Q
 Demand & Marginal Revenue
6-40

Unit sales (Q) Price TR = P  Q MR = TR/Q

0 $4.50 $ 0 --

1 4.00 $4.00 $4.00

2 3.50 $7.00 $3.00
3 3.10 $9.30 $2.30
4 2.80 $11.20 $1.90
5 2.40 $12.00 $0.80
6 2.00 $12.00 $0
7 1.50 $10.50 $-1.50
6-41
Demand, MR, & TR (Figure 6.4)

Panel A Panel B
 MR, TR, & Price Elasticity
6-42

Marginal Price elasticity

Total revenue
revenue of demand
MR > 0 TR increases as Elastic
Elastic
Q increases (E> 1) 1)
(E>
(P decreases)
MR = 0 Unitelastic
Unit elastic
TR is maximized
(E=
(E= 1) 1)
MR < 0 TR decreases as Inelastic
Inelastic
Q increases (P (E< 1)
decreases)
(E< 1)
 Marginal Revenue & Price Elasticity
6-43

 For all demand & marginal revenue curves, the

relation between marginal revenue, price, &
elasticity can be expressed as

 1
MR  P 1  
 E
Elasticity
 Income Elasticity of Demand:
 The responsiveness of demand
to changes in incomes
 Normal Good – demand rises
as income rises and vice versa
 Inferior Good – demand falls
as income rises and vice versa
Elasticity

 Income Elasticity of Demand:

 A positive sign denotes a normal good

 A negative sign denotes an inferior good
Elasticity
 For example:
 Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of
3% would lead to demand falling
by 1.8%
 Yed = + 0.4: Good is a normal good but inelastic –
a rise in incomes of 3% would lead to demand rising
by 1.2%
 Yed = + 1.6: Good is a normal good and elastic –
a rise in incomes of 3% would lead to demand rising
by 4.8%
 Yed = - 2.1: Good is an inferior good and elastic –
a rise in incomes of 3% would lead to a fall in demand of 6.3%
Elasticity

 Cross Elasticity:
 The responsiveness of demand
of one good to changes in the price of a related
good – either
a substitute or a complement

% Δ Qd of good t
__________________
Xed =
% Δ Price of good y
Elasticity
 Goods which are complements:
 Cross Elasticity will have negative sign (inverse
relationship between the two)
 Goods which are substitutes:
 Cross Elasticity will have a positive sign (positive
relationship between the two)
Elasticity

 Price Elasticity of Supply:

 The responsiveness of supply to changes
in price
 If Pes is inelastic - it will be difficult for suppliers to react
swiftly to changes in price
 If Pes is elastic – supply can react quickly to changes in
price
% Δ Quantity Supplied
____________________
Pes =
% Δ Price
Determinants of Elasticity
 Time period – the longer the time under consideration the
more elastic a good is likely to be
 Number and closeness of substitutes –
the greater the number of substitutes,
the more elastic
 The proportion of income taken up by the product – the
smaller the proportion the more inelastic
 Luxury or Necessity - for example,
addictive drugs
Importance of Elasticity
 Relationship between changes
in price and total revenue
 Importance in determining
what goods to tax (tax revenue)
 Importance in analysing time lags in production
 Influences the behaviour of a firm