UNIT 2

Demand, supply and market equilibrium

 Demand, supply and market equilibrium
• By the end of this chapter you should be able to:
● Understand what is meant by the ‘market’.

● Define demand and supply.

● Explain the factors that influence demand and supply.

● Understand the difference between a movement along and a shift in the demand and
supply curve.

● Derive a market demand curve and a market supply curve.

● Explain what is meant by ‘market equilibrium’.

 THE MARKET
The market for a product is not a particular place but rather any situation in which
the buyer and seller of a product communicate with each other for the purpose of
exchange.

The collective actions of the buyers in the market determine the market demand
for a particular product while the collective actions of the sellers determine the
market supply.
 DEMAND

• Demand is an economic principle referring to a consumer's desire to

purchase goods and services and willingness to pay a price for a specific

good or service. Holding all other factors constant, an increase in the price

of a good or service will decrease the quantity demanded, and vice versa

• Market Demand:The total demand for a good or service by all consumers

at a particular price over a particular period of time.

 Effective demand

$4.8 million — Koenigsegg CCXR Trevita

Effective demand means there has to be the willingness and ability to buy a product.
The Law of Demand

• The law of demand says that quantity demanded varies inversely with
price, other things constant. Thus, the higher the price, the smaller
the quantity demanded; the lower the price, the greater the quantity
demanded.
 Fig: The Demand Curve for Apple

Price

8 14 20 26 32

Quantity Demanded Per Day

 The Demand Schedule and Demand Curve
Fig: The Demand Curve for Apple
Table: The Demand Schedule for Apple
Price per Quantity 15
Apple (Rs) Demanded
per Day
12

Price of Apple
15 8
9
12 14
9 20 6

6 26
3
3 32

8 14 20 26 32

Quantity Demanded Per Day

Factors Determining Demand For Products
The demand for a product, for example DAIRY MILK Chocolate,
depends upon a number of factors, namely:

a) Change in the price of the product

b) Change in the price of all the other ‘related’ products in the economy;

c) Change in the level of household income

d) Change in the tastes of the consumer
e) Advertising
 1. Changes in the price of the product

Fig: The Demand Curve for Apple

Table: The Demand Schedule for Apple
Price per Quantity 15
Apple (Rs) Demanded
per Day
12
Expansion

Price of Apple
15 8
9
12 14
Contraction
9 20 6

6 26
3
3 32

8 14 20 26 32

Quantity Demanded Per Day

 2. Change in the level of household income

Goods are classified into two broad category,

The impact on demand caused by an increase in income
depending on how demand responds to
change in money income

Normal Goods
The demand for normal goods increase as
money income increase
• Demand curve D1 then, for a normal good, an
increase in income will lead to the demand curve
pivoting from D1 to D2
Inferior Goods
• The demand for inferior goods decrease as
money income increase Cheaper car, inter-
city bus services
• For an inferior good, however, an increase in income
will result in the demand curve pivoting from D1 to
D3.
 3. A change in the price of other related products
Substitute Product
Two goods are considered substitute if an increase in the price of one shifts
the demand for the other rightward and, conversely, if a decrease in the
price of one shift demand for the other leftward.

• For Example
• If the product in question was a substitute product for chocolate, such as
crisps, and its price rose relative to that of chocolate, then the demand for
chocolate bars would increase at every price.
Cont…

Complementary Product

When two considered complements if an increase in the price of one decreases the
demand for the other downward.

For example,

An increase in the price of pizza shifts the demand curve for Coke leftward.

the demand for one good (printers) generates demand for the other (ink
cartridges).

Cars and Petrol

 4.Taste
• A change in tastes will bring about an increase or a decrease in the
quantity of a product demanded.

• It may be the case that the tastes of the chocolate-buying public will
change away from chocolate in the future and less chocolate will be
demanded
5. Advertising

• Advertising is important in influencing the level of demand for a

product.

• Successful advertising of a product will shift the demand curve to the

right although successful advertising of a substitute product by a
competitor will shift the demand curve for the product in question to
the left.
 The derivation of market demand
The market demand curve is the total amount that consumers demand
at a particular price over a given period of time.

The market demand curve is derived from summing the individual

demand curves horizontally

Qd= f(p)= q1 + q 2+ q3+ q4 ………………………qn

 “Sell for less, and
the world will beat a
path to your door.”
 Supply
The supply of a product is the quantity of the product that firms are
willing and able to put onto the market at a particular price over a
particular period of time.
 The Supply Schedule and Supply Curve
Fig: The supply Curve for Apple
Table: The Supply Schedule for Apple
Price per Quantity 15
Apple (Rs) Supplied
per Day
12

Price of Apple
15 32
9
12 26
9 20 6

6 14
3
3 8

0 8 14 20 26 32

Quantity Supplied Per Day

The factors which influence the quantity supplied are:

1. A change in the price of the product

2. A change in the price of other products

3. A rise in the price of the factors of production;

4. A change in the state of technology.

5. All the other factors which might influence the quantity supplied.
Factors influencing supply

• (a) A change in the price of the product.

Increase in price more profitable to produce and thus incentive to

supply more

Other factor which influence the shift in the supply curve are
follows.
 (b) A change in the price of other products.
Fig: The supply Curve for Apple

• Condition: Substitute goods 15

• Substitutes in production
9
are other products which
could be produced with 6
similar resources to those
used in producing
3
(c) A rise in the price of the factors of production.
Fig: The supply Curve for Apple

15

3
 (d) A change in the state of technology

Fig: The supply Curve for Apple

15

• Case of Apple Phone 9

• Imac 6
• Itunes
• App store 3
(e) All other factors which might influence
the quantity supplied Fig: The supply Curve for Apple

• weather conditions 15

• Government policy

3
MARKET EQUILIBRIUM
Equilibrium is the state in which market supply and
demand balance each other, and as a result, prices
become stable. Generally, an over-supply of goods or
Table: The Market Equilibrium services causes prices to go down, which results in
Quantity Quantity higher demand. The balancing effect of supply and
Price per Demanded Supplied demand results in a state of equilibrium
Apple (Rs) Per Day Per Day
3 32 8
6 26 14
9 20 20 It is now possible to bring them together to see how
12 14 26 they interact to determine the equilibrium price and
quantity
15 8 32
 Fig: The Demand Curve for Apple Fig: The supply Curve for Apple

15 15

12 12
Price of Apple

Price of Apple
9 9

6 6

3 3

8 14 20 26 32 0 8 14 20 26 32 32

Quantity Demanded Per Day Quantity Supplied Per Day

 Fig: Market Curve for Apple
Supply
15

12
Price of Apple

9 Equilibrium

Demand

0 8 14 20 26 32 32

Quantity Demanded and supplied

Per Day
Changes in the equilibrium market price
Changes in either demand or supply cause changes in market
equilibrium. ... Similarly, the increase or decrease in supply, the
demand curve remaining constant, would have an impact on
equilibrium price and quantity. Both supply and demand for goods may
change simultaneously causing a change in market equilibrium.
 Fig: Shift in the Demand Curve
s1
Demand curve D and supply curve
D Supply S intersect at point c to yield the ini­
15 tial equilibrium price of Rs 9 and
the initial equilibrium quantity of
12 20
c
9
Price

0 8 14 20 24 30

Quantity
 Fig: Shift in the Demand Curve

D’
Now suppose that one of the
D Supply
determinants of demand
15
g
changes in a way that increases
12 demand, shifting the demand
9
c curve to the right from D to D'.

D’
3

0 8 14 20 24 30
 Fig: Shift in the Demand Curve

D’
D Supply
15
g
12 The amount demanded at the initial price of
c Rs 9 is 30 lakhs, which exceeds the amount
9
supplied of 20 by 10 pizzas
6

D’
3

0 8 14 20 24 30
 Fig: Shift in the Demand Curve

D’
D Supply
15
g
12
Competition among consumers for
c
9 the limited quantity supplied puts
upward pressure on the price.
6

D’
3

0 8 14 20 24 30
 Fig: Shift in the Demand Curve

D’
D Supply
15 As the price increases, the quantity
g demanded decreases along the new demand
12 curve D', and the quantity supplied increases
c along the existing supply curve S until the two
9
quantities are equal once again at equilibrium
6
point g

D’
3

0 8 14 20 24 30
 Fig: Shift in the Demand Curve

D’
D Supply
15 The new equilibrium price is
g Rs 12, and the new
12 equilibrium quantity is 24
c
9 pizzas per week
6

D’
3

0 8 14 20 24 30
 Shifts of the supply curve
D Supply

we begin with demand curve D and supply

c curve S intersecting at point c to yield an

9
equilibrium price of Rs 9 and an equilibrium
quantity of 20 lakh pizzas per week

0 8 14 20 24 30
 D S
S’
Suppose one of the determinants of
supply changes, increasing supply
from S to S'. Changes that could shift
the supply curve rightward
c
9

6 The amount supplied at the initial price

of $9 increases from 20 lakhs to 30 lakhs,
so producers now supply 10 million more
pizzas than consumers demand
S S’ D

0 8 14 20 24 30
 D Supply
Pizza makers compete to sell the surplus by lowering
the price. As the price falls, the quan­tity supplied
declines along the new supply curve and the quantity
c demanded increases along the existing demand curve
9
d until a new equilibrium point d is established
6

The new equilibrium price is Rs 6, and the

D new equilibrium quantity is 26 million pizzas
0
per week
8 14 20 26 30
Thus, given a downward-sloping demand curve, a
rightward shift of the supply curve decreases
price but increases quantity, and a leftward shift
increases price but decreases quantity.
KEY POINTS
• The market refers to any situation
that allows buyers and sellers to obtain information for the purpose of
exchange.
• The market demand for a product is
• the total amount which consumers demand at a particular price over a
particular period of time.
• Effective demand means
there is an ability and willingness to buy a particular product.
• Ceteris paribus is all important when studying demand and supply
and it refers to
all other things of relevance remaining the same or other things being equal.
 Cont..
● The market supply of a product refers
to the total quantity that firms are willing and able to put onto a market at a particular
price over a particular period of time.
● Equilibrium price relates to
the price at which the quantity demanded equals the quantity supplied.
1 Which of the following could shift the demand curve for the Hyundai Creta car to the right?
a) An increase in income
b) A reduction in the population
c) A decrease in the price of the Nissan Terrano , a substitute
d) An increase in the price of the Hyundai Creta
e) An increase in the price of fuel, a complement

2 The price of a product will increase if:

a) demand for the product increases
b) supply of the product increases
c) the price of a complement increases
d) if there is a surplus of the product
e) none of the above.
3 A good can be seen as inferior if:
a) a reduction in the price of the good leads to an increase in the quantity of that good consumers wish to purchase
b) an increase in income leads to an increase in the demand for the good
c) the good is seen as being of low quality
d) an increase in income leads to a reduction in the demand for the good
e) an increase in the price of the good leads to a reduction in the quantity of the good consumers wish to purchase.
 True/false questions

1. A market is defined as a situation in which buyers and sellers communicate for the purpose of exchange.

2. The change in the price of a product will lead to a movement along the demand curve for that product.

3. If an increase in income results in a reduction in the quantity demanded then the good in question is said to be

an inferior good.

4. The market demand curve for a product is derived from the vertical summation of individual consumers’

demand curves.

5. Equilibrium quantity is the quantity bought and sold at the equilibrium price.
 Elasticity
By the end of this chapter you will be able to:

● Understand the concept of elasticity of demand and supply.

● Identify the factors affecting price, income and cross elasticity of demand and

price elasticity of supply.

● Explain the relationship between price elasticity of demand and total revenue.

● Understand the importance of elasticity.

● Apply the concept of elasticity to various situations.

What is Elasticity?

Elasticity is an economic concept used to measure the change in the

aggregate quantity demanded for a good or service in relation to price
movements of that good or service.

A product is considered to be elastic if the quantity demand of the

product changes drastically when its price increases or decreases.
Types of Elasticity
• In this section we are going to discuss how the demand and supply
respond to the above changes are important and can be measured by
the use of a concept known as elasticity.

a) Price Elasticity of Demand

b) Income Elasticity of Demand

c) Cross Elasticity of Demand

d) Price Elasticity of Supply.

 PRICE ELASTICITY OF DEMAND (PED)
What is price elasticity of demand?

To measure how the demand for a good responds to a change in its own
price by using the concept of price elasticity of demand (PED).
When you raise the price of most items, people will
buy less of them.
For example, when one airline raises its price, air
passengers may switch to a rival airline.

When you reduce the price of most items, people will

buy more of them.
For example, when supermarkets make special offers
with reduced prices, they expect a sharp increase in
corresponding sales.
The relationship between price and quantity
demanded is measured by 'price elasticity of
demand' (PED). This is calculated as:change
in sales/% change in price
 
where:
Q = the original quantity
P = the original price
ΔQ = the change in quantity
ΔP = the change in price

Demand is said to be elastic if e >1, inelastic if e <1, and unitary elastic if e =1.
 
Numerical value Terminology Description
Whatever the % change in price
0
Perfectly Inelastic Demand no change in quantity
 
demanded
A given % change in price leads
0 < PED < 1 Relatively Inelastic Demand
to a smaller % change in
   
quantity demanded
A given % change in price leads
1 Unit elastic demand
to exactly the same % change in
   
quantity demanded
A given % change in price leads
1 < PED < ∞ Relatively Elastic Demand
to a larger % change in quantity
   
demanded

An infinitely small % change in

∞ (infinity) Perfectly Elastic Demand price leads to an infinitely large
    % change in quantity demanded
 
Perfectly Inelastic Perfectly Elastic Unit Elastic
Demand is infinite at a price P0

30

20

10
Why does a firm want to know PED?
Sales forecasting
The firm can forecast the impact of a change in price on its sales volume, and
sales revenue (total revenue, TR).

For example, if PED for a product is (-) 2, a 10% reduction in price (say, from
Rs. 10 to Rs. 9) will lead to a 20% increase in sales (say from 1000 to 1200). In
this case, revenue will rise from Rs. 10,000 to Rs. 10,800.
Pricing Policy

Knowing PED helps the firm decide whether to raise or

lower price, or whether to price discriminate.
Price discrimination is a policy of charging consumers
different prices for the same product.
If demand is elastic, revenue is gained by reducing price,
but if demand is inelastic, revenue is gained by raising
price.
Determinants of PED
There are several reasons why consumers may respond elastically or in
elastically to a price change, including
1. The number and ‘closeness’ of substitutes
2. The degree of necessity of the good
3. Whether the good is habit forming
4. The proportion of consumer income which is spent on the good
5. Whether consumers are loyal to the brand
6. Life cycle of product
 For Example

Price of Quantity
Point
X of X
A 8 0
B 7 1000
C 6 2000
D 5 3000
F 4 4000
G 3 5000
H 2 6000
L 1 7000
M 0 8000
EXAMPLE 1
Given the market demand schedule in above table and market demand
curve in above Fig. 3-1, we can find e for a movement from point B to
point D and from D to B, as follows

P =7
Q= 1000
Example

For the market demand schedule in Table find the price elasticity of demand for a movement from point B to
point D, from point’ D to point B, and (b) Do the same for points D and G.

Quantity of
Point Price of X
X

A 6 0
B 5 20000
C 4 40000
D 3 60000
F 2 80000
G 1 100000
H 0 120000
 INCOME ELASTICITY OF DEMAND
(YED)

income elasticity of demand (YED) measures how

the demand for a product responds to a change in
income.
 𝛥 𝑄 ∕ 𝑄 𝛥𝑄 𝑌
ⅇ=− =− ⋅
𝛥𝑌 ∕ 𝑌 𝛥𝑌 𝑄
where:
Q = the original quantity
Y = the original income
ΔQ = the change in quantity
ΔY = the change in income
The coefficient of income elasticity of demand (eM)
measures the percentage change in the amount of a
commodity purchased per unit time (DQ/Q) resulting from
a given percentage change in a consumer’s income (DY/Y).
 Types of income elasticity of demand

Income elasticity of demand

Can you explain why the inferior product might experience an increase
in demand for a fall in income (+/− = −) over certain ranges of income?
CROSS ELASTICITY OF DEMAND (CED)

Cross elasticity of demand (CED) refers to the

response of demand for one product to the
change in the price of another product.
 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏𝒕𝒉𝒆 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒐𝒇 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝒐𝒇 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 𝑨
𝑷𝑬𝑫=
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 𝑩

This can be rewritten as:

𝐂 𝐄𝐃=− ¿ ¿
where:
QA = the original quantity of product A
PB = the original price of product B
ΔQA = the change in the quantity of Product of A
ΔPB = the change in the price of product B
 (3)
Price of Good B
Quantity Demanded of good A
In situation (1) relates to
substitutes product, as the
price of B increases the
quantity demanded of A
increases. The cross
elasticity of demand is
therefore positive (+/+).
Situation (3) relates to
(1) two products which are
totally unrelated. If, for
example, the price of
soap increased it is
unlikely to result in a
change in the quantity of
ballpoint pens
(2) demanded.
Situation (2) relates to
complementary products, in that as
the price of product B rises (for
example petrol), the quantity
demanded of product A demanded
decreases (for example cars) (-/+ = -)
1. Find the cross elasticity of demand between tea (X) and coffee (Y)
and between tea (X) and lemons (Z)?
Answer
 Price Elasticity of Supply
Price Elasticity of Supply (PES) refers to the responsiveness of supply of
a product to a change in its own price. PES refers to movement along
the supply curve, i.e. expansion/contraction of supply
 Price Elasticity of Supply

where:
Qs= the original supply
P = the original price
ΔQs= the change in supply
ΔP = the change in price
 Perfectly Inelastic Unit Elasticity Infinity Elasticity

In the case of Fig a the supply
curve S1 is perfectly inelastic,
as the price rice there is no
change in the quantity
supplied
In the case of Fig b the supply curve
s2 is unit elastic (=1). Any given
percentage Change in the price
leads to exactly the same
percentage change in the quantity
supplied
In case of Fig c the
supply curve S3 Is
perfectly elastic with a
numerical value equal
to infinity
Factors Determining Price Elasticity of
Supply
(a) The existence of spare capacity
Non-availability of spare capacity (perfectly inelastic)
Availability of spare capacity( elastic)

(b) The availability of stocks

Accumulated a large quantity of unsold stocks or inventories (Supply will tend to be more elastic)

(c) Mobility of the factors of production

Reallocate of its resources from one type of production to another, then the supply for that
product will tend to be more elastic.

(d) The time period

Supply is likely to be more elastic in the long run time period
Question & Answer
The concept used to reveal the responsiveness of demand for a product to a change in the price of that product is
termed:
a) price elasticity of supply
b) price elasticity of demand
c) cross elasticity of demand
d) income elasticity of demand
e) none of the above.

If a small percentage drop in the price of a good leads to a large percentage increase in the quantity of that good demanded
then:
a) demand is inelastic
b) demand is elastic
c) demand is unit elasticity
d) demand is perfectly inelastic
e) demand is perfectly elastic.
If a 10% increase in price leads to a 4% reduction in the quantity of a good demanded
then the price elasticity of demand is:
a) - 0.4
b) - 0.6
c) - 2.5
d) - 4.0
e) -10.0

If a demand curve is horizontal it indicates that:

a) income elasticity of demand is zero
b) price elasticity of demand is infinity
c) price elasticity of demand is zero
d) price elasticity of demand is between zero and one
e) none of the above.
The price of Good Y increases by 8% and the demand for Good X increases by 10%,
calculate the cross-price elasticity of demand (CPED) of Good X with respect to Good Y,
and comment on the relationship between the two goods.

Good X and Good Y are likely to be quite close substitutes, as an increase in the price of Good Y
has led to a more than proportionate increase in the demand for Good X.
When Peter’s income increases by 10%, his demand for Good A increases by 2%, his demand for Good B increases
by 15% and his demand for Good C decreases by 5%. Calculate and comment on Peter’s income elasticity of
demand for the three goods.

Income elasticity of demand (IED) can be calculated as follows:

Good A is a normal good, since the IED is positive.

Peter’s income elasticity of demand for Good B is:

The price of Good X increases by 5% and the quantity demanded decreases by 10%. Which of the
following statements is FALSE?

A The price elasticity of demand for Good X is – 2.

B Demand for Good X is relatively elastic.

C Good X has a downward-sloping demand curve.

D Good X is likely to have very few substitutes.

The absolute value of the PED is greater than 1, so demand for Good X is elastic, and so
Option B is true.

The PED is negative, indicating that Good X has a downward sloping demand curve.

Therefore
Option C is true.

Demand for Good X is elastic. In other words, as the price of Good X rises, there is a more
than proportionate decrease in demand. This is likely to be partly because consumers are
purchasing cheaper substitutes for Good X.

Therefore Option D is likely to be false, and is the correct answer.

 If the income elasticity of demand for Good X is 1.5, a 4% increase in consumer income will
increase the quantity demanded of Good X by:
A 2.50%
B 2.67%
C 5.50%
D 6.00%

What is the intended effect of an advertising campaign on the demand curve:

A Shift the curve to the left and make it more elastic.
B Shift the curve to the right and make it more elastic.
C Shift the curve to the left and make it more inelastic.
D Shift the curve to the right and make it more inelastic.

Option D. Advertising campaigns generally intend to increase both demand and brand loyalty
for a product. A shift of the curve to the right corresponds to an increase in demand. If the curve
becomes more inelastic i.e steeper, consumers are becoming less price sensitive, in this scenario
probably because of an increase in brand loyalty.
The total revenue from the sale of a good will fall if:
A. price rises and demand for the good is price-elastic.
B. price rises and demand for the good is price-inelastic.
C. consumer income falls and the good is inferior.
D. consumer income rises and the good is a normal good.

Demand for a good is said to be ‘elastic’ when the absolute value of the price elasticity of demand
is greater than one. Option A is therefore correct because the (larger) percentage fall in quantity
will have a greater effect on revenue than the increase in price.

The income elasticity of demand for a normal good:

A must be less than 1.
B must be greater than 1.
C must be positive.
D could be anything

C must be positive
Shadow markets are most likely to be associated with:
A price ceilings which cause excess demand.
B price ceilings which cause excess supply.
C price floors which cause excess demand.
D price floors which cause excess supply.

Option A. Shadow markets tend to develop when there is a shortage. A shortage

occurs when the quantity demanded exceeds the quantity supplied. This occurs if
the price is below the equilibrium price and is not allowed to increase to the
equilibrium price, ie if the government has set a ceiling (or maximum price) below
the equilibrium.
A rise in the price of product Y from Rs 50 to Rs 54 has resulted in the demand for product X increasing from 100 to 104
units per month. The cross elasticity of demand is:
a) 0.2
b) 0.5
c) 1.0
d) 2.0
e) 2.4

If the cross elasticity of demand between two goods X and Y is positive then:
a) the two goods are substitutes
b) the two goods are complements
c) the demand for the two goods is price inelastic
d) the demand for the two goods is price inelastic
e) none of the above.
A 5% increase in income leads to an increase in the quantity demanded from 24 units per week to 27 units per week. The
income elasticity of demand is:
a) 1.0
b) 1.5
c) 2.0
d) 2.5
e) 3.0