Unit-2

Theory of Demand and Supply

 Overview of Unit-2
• Theory of Demand: Meaning of Demand and Determinants
of demand- Demand function, Law of demand, expansion
and contraction of demand, increase and decrease in
demand, Importance of law of demand, Exceptions to law
of demand.
• Elasticity of Demand
• Theory of Supply: Meaning of supply, Determinants of
supply, Law of supply and its determinants, Expansion and
Contraction of Supply, Increase and decrease in supply.
• Theory of Consumer Behavior: Consumer Surplus Law of
Diminishing Marginal Utility
 Demand
Demand is an economic principle that describes a consumer's desire
and willingness to pay a price for a specific good or service.

Demand means the ability and willingness to buy a specific

quantity of a commodity at the prevailing price in a given period of
time.

Therefore, demand for a commodity implies the desire to acquire it,

willingness and the ability to pay for it. 
 Demand Analysis
• Demand –
Desire + ability to pay + willingness to pay

Demand is relative term –

Price
Time
Place
 3 Aspects of Demand
1. It is the quantity desired at a given price.

2. It is the demand at a price during a given time.

3. It is the quantity demanded per unit of time.

 Determinants of demand
• Price
• Income
• Prices of related goods
• Taste, preference and fashion
• Government policy
• Custom and tradition
• Advertisement
 The Price of the Commodity
• The price of a commodity is the primary
determinant of the amount of the commodity the
consumer will buy at any time.
• Other things remaining the same, the higher the
price charge a for a commodity, the less the amount
of it a consumer will be willing to buy. The converse
is also true. The lower its market price, the larger
the number of units that will be demanded.
• At any particular price of a commodity an individual
consumer will buy a definite quantity of it.
 The amount of such purchase depends on
two things
(a) The utility received, and
(b) The price paid.

A consumer will always compare the benefits received from a com­modity

with the sacrifice made before deciding on its purchase.
While the receipt of a commodity gives utility to a consumer, the con­
sumer has to make some sacrifice in terms of price paid. Thus, when
the price of a commodity falls, the consumer is required to make less
sacrifice. So, he will buy more of the commodity. On the other hand,
when the price of a commodity rises, the consumer is required to make
more sacrifice and so less of its will be purchased. Thus, the primary
determinant of the amount of a commodity a consumer will buy is its
price.
 The Income of the Buyer
• The next important determinant of an individual’s demand for a
commodity is his level of income. A rise in his money income, all
other things remaining the same, is likely to increase his ability to
buy. So, it will induce him to purchase a large quantity of each
broad class of commodities and services such as food, clothing,
shelter, entertainment and so on.
• This means that, an increase in money income may cause a
person to travel more frequently and in upper classes and may
increase his demand for better accommodation. On the other
hand, a fall in money income causes a general fall in the demand
for goods and services which a consumer normally purchases. So,
with a change in the money income of a buyer the demand for
commodities and services consumed by him is likely to change.
 The Prices of Related Goods (i.e.,
Substitutes and Complements
The quantity demanded of a commodity is also determined by the prices of related goods. Thus,
the demand for tea depends not only on its own price but also on the price of coffee, the price
of sugar, the price of milk, etc. If the consumption of one commodity leads to a fall in the
consumption of another commodity, they are called substitutes.

For example, the consumption of coffee is at the cost of tea. If the price of a substitute, such as coffee,
increases, the demand for tea will rise, because tea is now relatively cheap and coffee is now relatively
expensive (although nothing has happened to the absolute price of tea). In this case, the demand for tea
changes in the same direction as the price of its substitute, viz., and coffee.

On the other hand, if the consumption of a commodity requires the consumption of another
commodity they are called complements. Such commodities are jointly demanded. If the price
of a complement, such as sugar, increases the demand for tea is likely to fall, because each cup
of tea will now cost more.

The same thing is true of motor car and petrol. A rise in the price of petrol will lead to a fall in the demand
for motor cars. The same thing is true of bread and butter. Thus, in such cases the demand for a
commodity changes in the opposite direction with a change in the prices of its complements.
 Tastes and Preferences of the Buyer

• An individual’s demand for a commodity also largely depends

on his taste and preference for a commodity. A person with a
taste for fashionable articles, like modern furniture, imported
garments, costly perfumes, etc., will have a strong demand for
these. But, these things may not have much appeal to a poor
person with limited purchasing power.
• With the change in tastes and preferences the demand for a
commodity of an individual consumer is likely to change. For
example, an individual may gradually develop a taste for coffee
in which case his demand for tea will fall. Similarly, an individual
may prefer for journey by train to journey by bus or a football
match to a cricket match.
 Other Factors

There are various other factors which are also likely

to affect an individual’s consumer demand for a
commodity. Since these are external to and
beyond the control of an individual, these are
normally called environmental factors.
– Government policy
– Custom and tradition
– Advertisement
– standard of living of the neighbors and friends
– his social position and status and so on.
 Four other factors may and often do affect
the demand for a good.
These are called non-economic factors and are the following:
(a) Demographic and sociological factors: Such factors include age, gender, marital status
,health, the level of education, social status, place of residence (urban or rural) as also
moral and religious values. The last set of factors may be influenced by family, peer group or
political allegiance.
(b) Psychological factors: Here, we include all the factors, inherited or acquired, that affect
the personality of an individual and his taste and preference. We also include such factors
as fads and fashions.
(c) Random variables: Such factors include the weather, earthquakes, diseases, etc. These
also include such unsystematic events as strikes, revo­lution, war, riots, etc.
(d) Government action: The demand for a number of commodities may be affected by
government action. Examples are: rules compelling the wearing of helmets, statutory
warning on cigarette smoking, regulations on the emissions from car exhausts, etc.
The permis­sion given to people by the Central and State Governments to use ball-point pens
in writing answer-scripts in examinations, in signing cheques and various legal documents
has raised the market demand for ball-point pens and a corresponding fall in the demand
for fountain pens.
 Law of Demand
• The law of demand describes the relationship
between the quantity demanded and the price
of a product.
• It states that the demand for a product
decreases with increase in its price and vice
versa, while other factors are at constant.
• Therefore, there is an inverse relationship
between the price and quantity demanded of a
product.
Therefore, demand is a function of price and can be expressed as:
D = f(P)
Where
D= Demand
P= Price
f = Functional Relationship
In the law of demand, other factors of demand (except price) should be kept
constant as the demand is subject to various influences.
If all the factors would be allowed to vary at the same time, this may counteract
the law.
The law of demand can be understood with the help of certain concepts, such
as
•demand schedule
•demand curve and
•demand function
 Demand Function
• The demand function is a mathematical expression
of the relation­ship between the quantity of goods
or services that is demanded and changes in a
number of economic factors, such as its own price,
the prices of substitutes and complementary goods,
income, credit terms the level of advertising, etc.
• The quantity demanded is the dependent variable
the other factors and independent variables.
The quantity of a commodity that is demanded
by an individual household is affected by five
main variables:
The price of the commodity
The prices of other commodities
The income of the household
Various ‘sociological’ factors and
The tastes and preferences of the household.
The relationship between the quantity demanded and the
variables listed in previous slides can be expressed in the form
of equation called a demand function.

qdn = f(Pn, P1, P2, …., Pn-1, Y, S)

Where
qdn is the quantity that the household demands of some
commodity, say, n
pn is its price
p1 … pn-1 are the prices of all other commodities
Y is the income of the household and
S is various sociological factors, such as the number of children in
the family, its place of residence (big city, small town, village).
If we make the ceteris paribus assumption, i.e.,
if we assume that all except one of the variable
on the right hand side of the demand function is
held constant the function may be expressed as:
Qdn = f(Pn)
We now allow the only variable, pn, to change
and we may consider how the quantity
demanded qdn changes.
 Demand Schedule
Demand schedule refers to a tabular
representation of the relationship between price
and quantity demanded. It demonstrates the
quantity of a product demanded by an individual or
a group of individuals at specified price and time.
Demand schedule can be categorized into two
types
– Individual Demand Schedule
– Market Demand Schedule
 Individual Demand Schedule
Refers to a tabular representation of quantity of
products demanded by an individual at different
prices and time.
The individual demand schedule of product a
purchased by Mr. Rohit
 Characteristics of individual demand
schedule
a. Demonstrates the effect of changing price on
the buying behavior of customers rather than
change in the demand for a product
b. Expresses the disparity in demand with the
difference in the product’s price
c. Represents that at higher prices the quantity
demanded reduces and vice versa
 Market Demand Schedule
Shows a tabular representation of quantity demanded in
aggregate by individuals at different prices and time. Therefore,
it demonstrates the demand of a product in the market at
different prices. The market demand schedule can be derived by
aggregating the individual demand schedules.
Market demand schedule also demonstrates an inverse relation
between the quantity demanded and price of a product.
The market demand schedule prepared through the individual
demand schedule of three individuals:
 Demand Curve
Demand curve shows a graphical representation
of demand schedule. It can be made by plotting
price and quantity demanded on a graph. In
demand curve, price is represented on Y-axis,
while quantity demanded is represented on X-
axis on the graph.
R.G Lipsey has defined demand curve as “the
curve which shows the relationship between the
price of a commodity and the amount of that
commodity the consumer wishes to purchase is
called Demand Curve.”
Demand curve can be of two types
– Individual demand curve and
– Market demand curve
• Individual demand curve is the graphical
representation of individual demand schedule,
while market demand curve is the
representation of market demand schedule.
 Individual demand curve
points a, b, c, d, and e demonstrates the relationship between
price and quantity demanded at different price levels. By joining
these points, we have obtained a curve, DD, which is termed as
the individual demand curve. The slope of an individual demand
curve is downward from left to right that indicates the inverse
relationship of demand with price.
 Market demand curve
• The market demand curve also represents an
inverse relationship between the quantity
demanded and price of a product.
 Assumptions of Law of Demand
The law of demand studies the change in demand
with relation to change in price.
In other words, the law of demand studies the
effect of price on demand of a product, while
keeping other determinants of demand at constant.
The assumptions underlying the law of demand
are:
• Assumes that the consumer’s income remains
same.
• The preferences of consumer remain same
• The fashion does not show any changes
• No change in the age structure, size, and sex ratio of population.
This is because if population size increases, then the number of
buyers increases, which, in turn, affect the demand for a product
directly.
• Restricts the innovation and new varieties of products in the
market, which can affect the demand for the existing product.
• Restricts changes in the distribution of income.
• No changes in fiscal policies of the government of a nation,
which reduces the effect of taxation on the demand of product.
Apart from the afore mentioned points, the law of demand
assumes that the world is static and people consume products in
the market at a fixed rate and price.
These assumptions are not valid in the dynamic world.
 Exception to the law of demand
• Giffen Goods
• Prestigious goods
• Buyers illusions
• Necessary goods
• Brand loyalty
 Exception to Law of Demand
The law of demand states that the increase in the price
of a product would decrease the demand for that
product and vice versa.
However, there are certain exceptions that with a fall in
price, the demand also falls and there is an increase in
demand with increase in price. This situation is
paradoxical in nature and regarded as exception to the
law of demand.
In simple words, exception to law of demand refers to
conditions where the law of demand is not applicable.
In case of exceptions, demand curve shows an upward
slope and referred as exceptional demand curve.
 Giffen Paradox
Refer to one of the major criticism of law of demand.
Giffin Paradox was given by Sir Robert Giffen, who
classified goods into two types, inferior goods and
superior goods, generally called Giffen goods.
The inferior goods are those whose demand decreases
with increase in consumer’s income, such as cheap
potatoes and vegetable ghee.
These goods are of low quality; therefore, the demand
for these goods decreases with increase in consumer’s
income. In addition, if the price of these goods increases,
then the demand for these goods increases assuming
that the high price good would be of good quality
 Necessity Goods
Refer to goods that are considered as essential
for consumer.
The demand of necessity goods does not
increase or decrease with increase or decrease
in their prices.
For example, salt is a necessity good whose
consumption cannot be increased in case its
price decreases.
In such a scenario, the law of demand is not
applicable.
 Prestige Goods

Refers to goods that are perceived as a status

symbol, such as diamond.
The demand for these goods remains same in
case of increase or decrease in their price.
In such a case, the law of demand is not
applicable.
 Speculation

Refers to an assumption of consumers about the

change in prices of a product in future.
If the price of a product is expected to rise in
future, then the demand for the product
increases in the present situation.
However, this is against the law of demand.
 Psychologically Bias Customers

Refer to one of the important exceptions to the

law of demand.
Different customers have different perceptions
about the price of a product.
Some customers have perceptions that low price
means bad quality of a particular product, which
is not true in all cases.
Therefore, if there is a fall in the price of a
product, then the demand for that product
decreases automatically.
 Brand Loyalty

Refers to the preference of a consumer towards

a particular brand.
Consumers do not prefer to change a brand with
increase in the price of that brand.
For example, if a consumer prefers, to wear
Levi’s jeans, he would continue to purchase it,
irrespective of increase in its price.
In such a situation, the law of demand cannot be
applied.
 Emergency Situations

Refers to a condition for which the law of

demand is not applicable.
In emergencies, such as war flood, earthquake,
and famine, the availability of goods become
scarce and uncertain.
Therefore, in such situations, consumer.’ prefer
to store a large quantity of goods, regardless of
their prices.
 Importance of Law of Demand
(i) Determination of price. The study of law of demand is helpful for a trader to fix the
price of a commodity. He knows how much demand will fall by increase in price to a
particular level and how much it will rise by decrease in price of the commodity.
(i) The schedule of market demand can provide the information about total market demand at
different prices. It helps the management in deciding whether how much increase or decrease
in the price of commodity is desirable.

(ii) Importance to Finance Minister. The study of this law is of great advantage to the
finance minister. If by raising the tax the price increases to such an extend than the
demand is reduced considerably. And then it is of no use to raise the tax, because
revenue will almost remain the same. The tax will be levied at a higher rate only on those
goods whose demand is not likely to fall substantially with the increase in price.
 
(iii) Importance to the Farmers. Goods or bad crop affects the economic condition of the
farmers. If a goods crop fails to increase the demand, the price of the crop will fall heavily.
The farmer will have no advantage of the good crop and vice-versa.
 
 Changes in Demand
• In economics the terms change in quantity demanded
and change in demand are two different concepts.
• Change in quantity demanded refers to change in the
quantity purchased due to increase or decrease in the
price of a product.
• In such a case, it is incorrect to say increase or decrease
in demand rather it is increase or decrease in the
quantity demanded.
• On the other hand, change in demand refers to increase
or decrease in demand of a product due to various
determinants of demand, while keeping price at
constant.
 Changes in Demand
• Changes in quantity demanded can be
measured by the movement of demand curve,
while changes in demand are measured by
shifts in demand curve.
• The terms, change in quantity demanded
refers to expansion or contraction of demand,
while change in demand means increase or
decrease in demand.
Expansion and Contraction of Demand
• The variations in the quantities demanded of a product with
change in its price, while other factors are at constant, are
termed as expansion or contraction of demand. Expansion of
demand refers to the period when quantity demanded is more
because of the fall in prices of a product. However, contraction
of demand takes place when the quantity demanded is less due
to rise in the price o a product.
• For example, consumers would reduce the consumption of milk
in case the prices of milk increases and vice versa. Expansion
and contraction are represented by the movement along the
same demand curve. Movement from one point to another in a
downward direction shows the expansion of demand, while an
upward movement demonstrates the contraction of demand.
 Expansion and contraction of demand

When the price changes

from OP to OP1 and
demand moves from OQ to
OQ1, it shows the
expansion of demand.
However, the movement of
price from OP to OP2 and
movement of demand from
OQ to OQ2 show the
contraction of demand.
Increase and Decrease in Demand
Increase and decrease in demand are referred to
change in demand due to changes in various
other factors such as change in income,
distribution of income, change in consumer’s
tastes and preferences, change in the price of
related goods, while Price factor is kept constant
Increase in demand refers to the rise in demand
of a product at a given price.
On the other hand, decrease in demand refers to the
fall in demand of a product at a given price. For
example, essential goods, such as salt would be
consumed in equal quantity, irrespective of increase
or decrease in its price. Therefore, increase in
demand implies that there is an increase in demand
for a product at any price. Similarly, decrease in
demand can also be referred as same quantity
demanded at lower price, as the quantity demanded
at higher price.
Increase and decrease in demand is represented
as the shift in demand curve. In the graphical
representation of demand curve, the shifting of
demand is demonstrated as the movement from
one demand curve to another demand curve. In
case of increase in demand, the demand curve
shifts to right, while in case of decrease in
demand, it shifts to left of the original demand
curve.
 • the movement from DD to
• the movement from DD to
D2D2 shows the decrease
D1D1 shows the increase in
demand with price at constant
in demand with price at
(OP). However, the quantity constant (OP). However,
has also increased from OQ to the quantity has also
OQ1 decreased from OQ to OQ2.
 Elasticity
• Elasticity is a measure of responsiveness of
one variable to another variable.
• Can involve any two variables.
• An elastic relationship is responsive.
• An inelastic relationship is unresponsive.
 Types of Elasticity of demand
• Price Elasticity of demand
• Income elasticity of demand
• Cross Elasticity of demand
• Promotional Elasticity of demand
 Definition Of Price Elasticity Of Demand

• The change in the quantity demanded of a

product due to a change in its price is known
as Price elasticity of demand. Thus, the
sensitiveness or responsiveness of demand to
change in price is as called elasticity of
demand
 Price Elasticity of demand

According to Alfred Marshall: "Elasticity Of

demand May be Defined as The percentage
Change in quantity Demanded to the
Percentage Change In price."
 Kinds Of Price Elasticity Of Demand
1) Perfectly elastic demand
2) Relatively elastic demand
3) Elasticity of demand equal to unity
4) Relatively inelastic demand
5) Perfectly inelastic demand
 Perfectly elastic demand

Perfectly elastic
When the
P demand curve demand for a
R product changes
I –increases or
D D
C
decreases even
E
when there is no
change in price,
it is known as
perfect elastic
0 x
demand.
 Relatively elastic demand
y
When the
P Relatively elastic proportionate
R demand curve
D
change in
I
demand is more
C
than the
E
D
proportionate
changes in price,
it is known as
0 x
relatively elastic
demand
demand.
Elasticity of demand equal to unity

When the
y
D
proportionate
P
change in
R
demand is equal
I Elasticity of
C
demand equal to proportionate
to utility curve changes in price,
E
D
it is known as
unitary elastic
0 demand
x demand
 Relatively inelastic demand
Y
D When the
Relatively inelastic
demand curve
proportionate
change in demand
P
is less than the
R proportionate
I changes in price, it
C is known as
E relatively inelastic
demand
D

O X
demand
Perfectly inelastic demand
Y
D
When a change in
price, howsover
Perfectly inelastic
P demand curve large, change no
R changes in quantity
demand, it is known
I
as perfectly inelastic
C
demand
E

0 D X
demand
ALL KINDS OF DEMAND CAN BE SHOWN
IN ONE DIAGRAM AS FOLLOW
Y

WHERE
P D1) Perfectly elastic
R demand
D
I D1 D2)Relatively elastic

C demand
D2 D3)Elasticity of demand
E
D3
equal to utility
D4
D4)Relatively inelastic
0 D5 X demand
DEMAND D5)Perfectly inelastic
demand
 Look at the Extremes
• Perfectly Elastic D • Perfectly Inelastic D
Ep infinite
P P
D
Ep 0
D

Q
Q
Measurement Of Price Elasticity Of
Demand
There are main methods like
1. Percentage method or proportionate
method
2. Total outlay method or total revenue
method
3. Geometric method or point method
4. Arc elasticity of demand
 Factors Affecting Price Elasticity Of Demand
• Nature of the Commodity
• Availability of Substitutes
• Variety of uses of commodity
• Postponement
• Influence of habits
• Proportion of Income spent on a commodity
• Range of prices
• Income Groups
• Elements of time
• Pattern of income distribution
1. Nature of the commodity: The demand for necessities is
inelastic because the demand does not change much with a
change in price. But the demand for luxuries is elastic in nature.
2. Extent of use: A commodity having a variety of uses has a
comparatively elastic demand.
3. Range of substitutes: The commodity which has more number
of substitutes has relatively elastic demand. A commodity with
fewer substitutes has relatively inelastic demand.
4. Income level: People with high incomes are less affected by
price changes than people with low incomes.
5. Proportion of income spent on the commodity: When a small
part of income is spent on the commodity, the price change
does not affect the demand therefore the demand is inelastic in
nature.
6. Urgency of demand / postponement of purchase: The demand
for certain commodities are highly inelastic because you
cannot postpone its purchase. For example medicines for any
sickness should be purchased and consumed immediately.
7. Durability of a commodity: If the commodity is durable then it
is used it for a long period. Therefore elasticity of demand is
high. Price changes highly influences the demand for durables
in the market.
8. Purchase frequency of a product/ recurrence of demand: The
demand for frequently purchased goods are highly elastic than
rarely purchased goods.
9. Time: In the short run demand will be less elastic but in the
long run the demand for commodities are more elastic .
 Practical Importance of the
Concept of Price Elasticity Of
Demand
Practical Importance of the Concept of Price
Elasticity Of Demand
• The concept is helpful in taking Business
Decisions
• Importance of the concept in formatting Tax
Policy of the government
• For determining the rewards of the Factors of
Production
• To determine the Terms of Trades Between
the Two Countries
 Practical Importance of the Concept of Price
Elasticity Of Demand
• Determination of Rates of Foreign Exchange
• For Nationalization of Certain Industries
• In economic Analysis ,the concept of price
elasticity of demand helps in explaining the
irony of poverty in the midst of plenty.
Income Elasticity Of Demand
 Income Elasticity of Demand

• Recall demand function is:

Q=f(P,I,Prelated,Tastes,Buyers,Expectations...)
• Change in I causes shift in demand.
• Size of shift depends on income elasticity.
• EI Q/I
• Focus again on point formula.
• Value of EI determines type of good.
 Measurement Of Income Elasticity Of
Demand

Proportionate change in Demand

Income Elasticity Of Demand =
Proportionate change in Income
i.e. ∆q ∆y
Income Elasticity Of Demand = /
Q Y
 Measurement Of Income Elasticity Of
Demand
• Here , ∆q = Change in the quantity demanded.
Q = Original quantity demanded.
∆y = Change in income.
Y = Original income.
• For e.g. ,when Income of the consumer =
2,500/- , he purchases 20 units of X, when
income = 3,000/- he purchases 25 units of X
 Measurement Of Income Elasticity Of
Demand
• Thus
Income Elasticity of Demand
∆q ∆y
= /
Q Y

= (5/20) / (500/2500)
= 1.5
therefore here the IED is 1.5 which is more
than one.
Types Of Income Elasticity Of Demand

• Positive Income elasticity of demand

• Negative Income elasticity of demand
• Zero Income elasticity of demand
 Positive Income elasticity of demand
Y
D

P
A

D
Income

B S
O Quantity Demanded X
Positive Income elasticity of demand

• Income Elasticity Equal to Unity or One

• Income Elasticity Greater Than Unity Or
One
• Income Elasticity Less Than Unity or One
Negative Income elasticity of demand
INCOME

Total Revenue

B S

Quantity Demanded (000s)

Zero Income elasticity of demand
Y
D
Income

O X
D

Quantity Demanded
Factors Affecting Income elasticity Of
Demand
• Income Itself Only.
• Price Of the Commodity
 Importance Of the Concept of Income
Elasticity Of Demand
• In production planning and management
• In forecasting demand when change in
consumers income is expected
• In classifying goods as normal and inferior
• In expansion and contraction of the firm by
the figure of income elasticity of demand
• Markets situations could be studied with the
help of IED
 I
Values for Income Elasticity ( )

• Sign indicates normal or inferior

EI>0 implies normal good.
EI<0 implies inferior good.
• Normal goods may be necessity or luxury.
– If EI>1 then this is luxury (responsive to income).
– If 0<EI<1 then this is necessity (unresponsive to
income).
 Cross Price Elasticity (EXY)

QX=f(PX ,I,PY,Tastes, Buyers,Expectations...)

• Change in PY causes shift in demand for X.
• Size of shift depends on cross-price elasticity.
• EXYQX /PY
• Sign indicates relationship between two goods
 EXY>0 implies goods are substitutes.
EXY<0 implies goods are complements.
 Cross Elasticity of Demand (CED)
• Cross price elasticity (CED) measures the
responsiveness of demand for good X following a
change in the price of good Y (a related good)

• CED = % change in quantity demanded of product A

% change in price of product B

• With cross price elasticity we make an important

distinction between substitute products and
complementary goods and services.
 Cross Elasticity of Demand (CED)
+ = Substitutes
• Substitutes:
– If price of one product increase, the
demand for other substitute goods
increases or vice versa, then The Cross
Elasticity of Demand between the two
substitutes is Positive.

+
Identify some Substitutes
 Cross Elasticity of Demand (CED)
- = Complements
• Complements:
– If price of one product increase, the demand
for other Complementary goods decreases or
vice versa, then The Cross Elasticity of Demand
between the two Complementary is Negative.

-
Identify some Complements
Price of
Good S
Substitutes
Two Weak Substitutes +
Goods S and T are weak
Demand
substitutes
A rise in the price of Good S
P2 leads to a small rise in the
demand for good T
The cross price elasticity of
demand will be positive but the
P1 coefficient of elasticity will be
less than one

tea and coffee

Quantity demanded of
Good T
 Complements
Price of
Good X Demand
-
Two Close Complements

Goods X and Y are close

complements
A fall in the price of good X leads
to a large rise in the demand for P1
good Y
P2
The cross price elasticity of
demand will be negative and the
coefficient of elasticity will be
more than one
Complements are said to be in
JOINT DEMAND

Petrol and petrol car Quantity demanded of

Good Y
 Goods with zero cross-price elasticity of
demand . INDEPENDENT
Price of Demand
Good A
Goods A and B have no
relationship.
A fall in the price of good A leads
P1
to no change in the demand for
good B
Therefore the cross-price
P2
elasticity of demand is zero

P3
Apples and salt!

Quantity demanded of
Good B
 Importance of Cross Elasticity Of
Demand
• The concept is of very great importance in
changing the price of the products having
substitutes and complementary goods .
• In demand forecasting
• Helps in measuring interdependence of price
of commodity .
• Multiproduct firms use these concept to
measure the effect of change in price of one
product on the demand of their other product
 Importance of CED for businesses
• Firms can use CED estimates to predict:
The impact of a rival’s pricing strategies on demand for their
own products.
• Pricing strategies for complementary goods:
If firms have a reliable estimate for CED they can estimate
the effect, say, of a two-for-one cinema ticket offer on
the demand for popcorn
 Applications of Cross Elasticity
• Higher indirect taxes on goods such as tobacco
– the impact on demand for nicotine patches
and other substitutes
• Rise in the price of natural gas – effect on the
demand for coal used in power generation
 Advertising Elasticity of Demand

• Advertising elasticity of demand is the

measure of the rate of change in demand
due to change in advertising expenditure
• The amount of change in demand of goods
due to advertisement is known as
Advertisement Elasticity of Demand .
 Advertising Elasticity of Demand

Proportionate change in Demand

for product
Advertising Elasticity of Demand =
Proportionate change in Advertising
i.e. expenditure

∆qx ∆a
Advertising Elasticity of Demand =
Q
÷ A
 Relationship Between Advertising
Y Expenditure and Sales
S
Sales

O X
Advertising Expenditure
Factors Affecting Advertising Elasticity
Of Demand
• The stage of the Product’s Market
Development .
• Reaction of market Rival Firms.
• Cumulative Effect of Past Advertisement.
• Influence of Other Factors.
 Importance of the Advertising
Elasticity Of Demand in Business
Decisions
• It is useful in competitive industries.
• Though advertisement shifts the demand
curve to right path but it also increases the
fixed cost of the firm.
 Limitation of Advertising Elasticity of
the Demand
• The impact of advertising on sales is different
under different conditions, even if other
demand determinants are constant.
• Like wise, it is difficult to establish any co-
relationship between advertising expenditure
and volume of sales when there counter
advertisements by rival firm in the market .
The effect on sales depend on what the rivals
are doing.
 The methods used for measuring
elasticity of demand

1. The Percentage Method

2. The Point Method
3. The Arc Method
4. Total Outlay Method.
 The Percentage Method

The price elasticity of demand is measured by its

coefficient (Ep). This coefficient (Ep) measures the
percentage change in the quantity of a commodity
demanded resulting from a given percentage change in
its price.
Thus

Where q refers to quantity demanded p to price and Δ to

change. If EP>1, demand is elastic. If EP< 1, demand is
inelastic, and Ep= 1, demand is unitary elastic.
With this formula, we can compute price elasticities of
demand on the basis of a demand schedule.
Let us first take combinations B and D.
• (i) Suppose the price of commodity X falls from
Rs. 5 per kg. to Rs. 3 per kg. and its quantity
demanded increases from 10 kgs. to 30 kgs.
Then

• ) Let us measure elasticity by moving in the

reverse direction. Suppose the price of Arises
from Rs. 3 per kg. to Rs. 5 per kg. and the
quantity demanded decreases from 30 kgs. to 10
kgs.
Then
• Notice that the value of Ep in example (ii)
differs from that in example (i) depending on
the direction in which we move. This
difference in the elasticities is due to the use
of a different base in computing percentage
changes in each case.
 The Point Method

• Prof. Marshall devised a geometrical method for

measuring elasticity at a point on the demand curve. Let
RS be a straight line demand curve in Figure. 2. If the
price falls from PB ( = OA) to MD ( = OC), the quantity
demanded increases from OB to OD.
Elasticity at point P on the RS demand curve according to
the formula is:
• EP = Δq/Δp x p/q
• Where Δq represents change in quantity demanded, Δp
changes in price level while p and q are initial price and
quantity levels.
With the help of the point method, it is easy to point out
elasticity at any point along a demand curve. Suppose that the
straight line demand curve DC in Figure. 3 is 6 centimeters.
Five points L, M, N, P and Q are taken on this demand curve.
The elasticity of demand at each point can be known with the
help of the above method. Let point N be in the middle of the
demand curve. So elasticity of demand at point.
We arrive at the conclusion that at the mid-point on the demand
curve, the elasticity of demand is unity. Mov­ing up the
demand curve from the mid-point, elasticity be­comes greater.
When the demand curve touches the Y- axis, elasticity is
infinity and any point below the mid-point towards the X’-axis
will show less elastic demand. Elasticity becomes zero when
the demand curve touches the X -axis.
 The Arc Method
• We have studied the measure­ment of elasticity at a point on a
demand curve. But when elasticity is measured between two
points on the same de­mand curve, it is known as arc elasticity.
• In the words of Prof. Baumol, “Arc elasticity is a measure of the
average responsiveness to price change exhibited by a demand
curve over some finite stretch of the curve.”
• Any two points on a demand curve make an arc. The area between
P and M on the DD curve in Figure. 4 is an arc which measures
elasticity over a certain range of price and quantities. On any two
points of a demand curve, the elasticity coefficients are likely to be
different depending upon the method of computation. Consider
the price-quantity combinations P and M as given in Table. 2.
If we move in the reverse direction from M to P,
• Thus the point method of measuring elasticity at two
points on a demand curve gives different elasticity
coefficients because we used a different base in
computing the percentage change in each case.
• To avoid this discrepancy, elasticity for the arc (PM in
Figure 4) is calculated by taking the average of the
two prices [(p1 + p2 )½] and the average of the two
quantities [(q, +q2 )½]. The formula for price
elasticity of demand at the mid-point (C in Figure 4)
of the arc on the demand curve is
• On the basis of this formula, we can measure
arc elasticity of demand when there is a
movement either from point P to M or from M
to P.
• From P to M at point P, p1 =8, q1 = 10, and at
point M, p2 = 6, q2 = 12.
• Applying these values, we get
• Thus whether we move from M to P or P to M on
the arc PM of the DD curve, the formula for arc
elasticity of demand gives the same numerical value.
The closer the two points P and M are, the more
accurate is the measure of elasticity on the basis of
this formula.
• If the two points which form the arc on the demand
curve are so close that they almost merge into each
other, the numerical value of arc elasticity equals
the numerical value of point elasticity.
 The Total Outlay Method:
• Marshall evolved the total outlay, or total
revenue or total ex­penditure method as a
measure of elasticity. By comparing the total
expenditure of a purchaser both before and
after the change in price, it can be known
whether his demand for a good is elastic, unity
or less elastic.
• Total outlay is price multiplied by the quantity
of a good purchased: Total Outlay = Price x
Quantity Demanded. This is explained with the
help of the demand schedule in Table.3.
• i) Elastic Demand:
• Demand is elastic, when with the fall in price the total expenditure increases
and with the rise in price the total expenditure decreases. Table.3 shows that
when the price falls from Rs. 9 to Rs. 8, the total expenditure increases from
Rs. 18 to Rs. 24 and when price rises from Rs. 7 to Rs. 8, the total expenditure
falls from Rs. 28 to Rs. 24. Demand is elastic(Ep > 1) in this case.
• (ii) Unitary Elastic Demand:
• When with the fall or rise in price, the total expenditure remains unchanged,
the elasticity of demand is unity. This is shown in the table when with the fall
in price from Rs. 6 to Rs. 5 or with the rise in price from Rs. 4 to Rs. 5, the total
expenditure remains unchanged at Rs. 30, i.e., Ep = 1.
• (iii) Less Elastic Demand:
• Demand is less elastic if with the fall in price, the total expenditure falls and
with the rise in price the total expenditure rises. In Table 3 when the price falls
from Rs. 3 to Rs. 2, total expenditure falls from Rs. 24 to Rs 18, and when the
price rises from Re. 1 to Rs. 2. the total expenditure also rises from Rs. 10 to Rs.
18. This is the case of inelastic or less elastic demand, Ep < 1.
• Table 4 summarises these relationships
the measurement of elasticity of demand in
terms of the total outlay method is explained
in Fig. 5 where we divide the relationship
between price elasticity of demand and total
expendi­ture into three stages.