SESSION

2
DEMAND, SUPPLY, PRICE AND
ELASTICITY
PLOTTING THE DEMAND CURVE
• Consider all of the possible renters of the apartments and ask each of them
the maximum amount that he or she would be willing to pay to rent one of
the apartments.

• If there is only one person who is willing to pay $500 a month to rent an
apartment, then if the price for apartments were $500 a month, exactly one
apartment would be rented

• At price of $490, exactly two apartments would be rented: one to the

$500 person and one to the $490 person.

• Between $ 491-499, only one continues to be rented

• Economists call a person’s maximum willingness to pay for something that

person’s reservation price.

• The reservation price is the highest price that a given person will accept
and still purchase the good
DEMAND CURVE
QD = QD(P) • The demand curve, labeled D, shows how the quantity
of a good demanded by consumers depends on its
price.
• The demand curve is downward sloping; holding
other things equal, consumers will want to purchase
more of a good as its price goes down.
• The quantity demanded may also depend on other
variables, such as income, the weather, and the prices
of other goods.
• For most products, the quantity demanded increases
when income rises.
• A higher income level shifts the demand curve to the
right (from D to D′).
SUPPLY CURVE
• The supply curve, labeled S in the figure, shows
how the quantity of a good offered for sale changes
as the price of the good changes.
• The supply curve is upward sloping: The higher the
price, the more firms are able and willing to
produce and sell.
• If production costs fall, firms can produce the same
quantity at a lower price or a larger quantity at the
same price.
• The supply curve then shifts to the right (from S to
S′).
•Is Supply = Stock?

•No, Supply measures the quantity offered for sale

 EXCEPTIONS
Exceptions to law of demand Exceptions to law of supply
• Giffen goods: these are those inferior goods on which the • The law of supply does not always apply to agricultural
consumer spends a large part of his income and the demand for goods as their production sometimes depends on climatic
which falls with a fall in their price conditions
• Commodities which are used as status symbols: Some expensive
• In case of perishable goods, like vegetables, fruits, etc.,
commodities like diamonds, air conditioned cars, etc., are used as
sellers will be ready to sell more even if the prices are
status symbols to display one’s wealth
falling.
• Speculative activities
• Rare, artistic and precious articles are also outside the scope
• Emergency: At times of war, famine etc. consumers have an of law of supply. For example, supply of rare paintings
abnormal behaviour cannot be increased, even if their prices are increased.
• Quality-price relationship: some people assume that expensive
• Future expectations and scope for hoarding
goods are of a higher quality then the low priced goods
 DETERMINANTS OF DEMAND AND
SUPPLY
• The quantity that producers are willing to sell • Change in own price causes
depends not only on the price they receive but
movement along D
also on their production costs, including wages,
interest charges, and the costs of raw materials. • Changes in all other variables cause
P2 shifts of D
• When production costs decrease, output increases
no matter what the market price happens to be.
• An increase in price of a substitute
The entire supply curve thus shifts to the right. P1
causes an increase in demand (D to
• Economists often use the phrase change in supply D’ )
to refer to shifts in the supply curve, while
reserving the phrase change in the quantity • An increase in price of a complement
supplied to apply to movements along the causes a decrease in demand
supply curve.
• An increase in income causes an
• The market demand function for a good depends
increase in demand for normal
on own price, prices of related goods, per-capita
income, population size etc goods, and a decrease in demand for
Q2 Q1 Q’2 Q’1 inferior goods
 SUBSTITUTES, COMPLEMENTS, NORMAL &
INFERIOR GOODS
• A pair of goods are substitutes / complements in consumption if the increase in price of one of the goods
causes the demand for the other to rise / fall
– ‘competitors’ produce substitutes, while ‘complementors’ produce complements

• For a consumer, a good is a normal / inferior good if its demand rises / falls as income rises
– for any ‘good’ that comes in different quality levels, the lower-quality products will tend to be inferior
goods, and the higher-quality products will tend to be normal goods
– what is a normal good for one ‘poor’ person can be an inferior good for another ‘rich’ person

• A product can have multiple substitutes, some of which are normal goods and others inferior; a product can
have multiple complements, some of which are normal goods and others inferior
MARKET EQUILIBRIUM
• The market clears at price P0 and quantity Q0.
• At the higher price P1, a surplus develops, so price
falls.
• At the lower price P2, there is a shortage, so price
is bid up.
• equilibrium (or market clearing) price that
equates the quantity supplied to the quantity
demanded.
• Possible when if a market is at least roughly
competitive.
• By this we mean that both sellers and buyers
should have little market power—i.e., little ability
individually to affect the market price.
MARKET EQUILIBRIUM

• In this example, rightward shifts of the supply and demand

curves lead to a slightly higher price and a much larger
quantity.

• In general, changes in price and quantity depend on the

amount by which each curve shifts and the shape of each
curve.
DEMAND ELASTICITY
• Own price elasticity of demand (how many percentage points does demand for a good fall if own price rises by one
percent?) :

• If the absolute value of εP is > 1, then demand is said to be elastic

– when demand is ‘elastic’, any small increase in price will lead to a fall in sales revenue

• If the absolute value of εP is < 1, then demand is inelastic

– when demand is ‘inelastic’, any small increase in price will lead to higher sales revenue

Product/sales managers should gather demand-elasticity information to determine profitability of a price change
DEMAND ELASTICITY
demand curve slope = -1/2 The magnitude of demand elasticity
demand is elastic above B : | εP| > 1 depends on:
price rise leads to fall in sales revenue •the nature of the good – necessity
demand is inelastic below B : | εP | < 1 vs. luxury good
εP=-3
price rise => ↑ sales revenue •the availability of substitutes
goods/brands
•the time-horizon: short-run demand
B Therefore, elasticity numbers should
be interpreted to provide ‘local is generally more inelastic than
εP=-(1/3)
information’ around actual trading long-run demand, but for specific
patterns consumer durables, demand can be
more elastic in short-run as
consumers can postpone purchase
OTHER ELASTICITIES
•Cross-price elasticity of demand for good X with respect to the price of good Y :

•εXY is positive / negative if X and Y are substitutes / complements in consumption [εXY need not equal εYX]

•Magnitudes of positive cross-price elasticites are used to determine market boundaries

•For the affluent, income elasticity is positive for a normal good (like air travel) and negative for an inferior
good (like train travel)
SHORT RUN VS LONG RUN
ELASTICITIES
•In the short run, an increase in price has only a
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.
 SUPPLY ELASTICITY
• Individual firm supply depends on revenue and cost conditions: on sales price (positively), on input prices (negatively), on
inventories(positively), and on ‘other factors’ like technological changes

• The market supply is an aggregation of individual supply

Example: Annual gasoline supply in the US in 2001:

QS(gallons) = 0.7PGas + 0.3Reserves - 0.7PCrude - 0.5PNatural Gas

Sales-price change induces movement along the market supply curve, all other changes induce movement of the curve

•Own-price supply elasticity is a positive number given upward sloping supply curve; supply generally
more inelastic in the short-run
 THE MARKET FOR WHEAT

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.
Supply: QS = 1800 + 240P
Demand: QD = 3550 − 266P
By setting the quantity supplied equal to the quantity demanded, we can determine the
market-clearing price of wheat for 1981:
QS = QD
1800 + 240P = 3550 − 266P
506P = 1750
P = $3.46 per bushel
Substituting into the supply curve equation, we get
Q = 1800 + (240)(3.46) = 2630 million bushels
 THE MARKET FOR WHEAT

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.
ELASTICITY AND TOTAL REVENUE
 ELASTICITY AND TOTAL REVENUE
• As we move up the demand curve from point A to point I, demand becomes increasingly elastic.

• At point E, where demand is unitary elastic, total revenue is maximized.

• At points to the northwest of E, demand is elastic and total revenue decreases as price increases.

• At points to the southeast of E, demand is inelastic and total revenue increases when price increases.

• This relationship among the changes in price, elasticity, and total revenue is called the total revenue test.

• Demand is perfectly elastic if the own price elasticity of demand is infinite in absolute value. Demand is perfectly
inelastic if the own price elasticity of demand is zero.

• Factors Affecting the Own Price Elasticity – Available substitutes, Time, Expenditure share

• Price Elasticity affects the equilibrium condition of the market