Understanding Demand, Supply and Market Mechanism
Supply curve: Relationship between the quantity of a good that
producers are willing to sell and the price of the good.
• Shows how the quantity of a good offered for sale changes as the
price of the good changes.
• Is upward sloping: The higher the price, the more firms are able
and willing to produce and sell.
• When production costs decrease, output increases no matter
what the market price happens to be. The entire supply curve
thus shifts to the right.
• Change in supply refers to shifts in the supply curve S to S’
• Change in the quantity supplied applies to movements along the
supply curve.
Demand supply curves and market mechanisms work only if a market is at least roughly competitive. Both sellers and buyers should have
little market power—i.e., little ability individually to affect the market price.
Demand curve: Relationship between the quantity of a good that
consumers are willing to buy and the price of the good.
• Shows how the quantity of a good demanded by consumers
depends on its price.
• Is downward sloping; holding other things equal, consumers will
want to purchase more of a good as its price goes down.
• For most products, the quantity demanded increases when
income rises. Higher income normally shifts the demand curve to
the right
• Change in demand refers to shifts in the demand curve D to D’.
• Change in the quantity demanded applies to movements along
the demand curve.
• Goods are substitutes when an increase in the price of one leads
to an increase in the quantity demanded of the other. Example,
copper and aluminum are substitute goods.
• Goods are complements when an increase in the price of one
leads to a decrease in the quantity demanded of the other.
Example, automobiles and gasoline.
Market mechanism: Putting demand and supply curves together
• Demand and Supply curves intersect at equilibrium. At this price
(P0) the quantity supplied and the quantity demanded are just
equal (to Q 0).
• The market mechanism is the tendency in a free market for the
price to change until the market clears—i.e., until the quantity
supplied and the quantity demanded are equal.
• Suppose the price were initially above the market-clearing
level—say, P1. Producers will try to produce and sell more than
consumers are willing to buy. A surplus—a situation in which the
quantity supplied exceeds the quantity demanded—will result.
• To sell this surplus—or at least to prevent it from growing,
producers would begin to lower prices. Eventually, as price fall,
quantity demanded would increase, and quantity supplied would
decrease until the equilibrium price P0 is reached.
• If the price is below the equilibrium, P2, demand will go up, but
supply will be lower, creating a shortage. Consumers will bid for
the goods, and Producers will increase prices in response. Over
time, market will reach a price P0 where demand and supply will
be equal.
Changes in Market Equilibrium
Shift in Supply
• Let us assume that prices of raw material reduce
• This will shift supply curve to the right
• As a result, the market price drops (from P1 to P3), and the total
quantity produced increases (from Q1 to Q3).
• When supply curve shifts to the right, market clears at lower
prices and higher quantities.
• When supply curve shifts to the left, markets clear at higher
prices and lower quantities
When we want to know how much the quantity supplied or demanded will rise or fall. For example,
If price increases by 10 percent, how much will the quantity demanded change?
Shift in Demand Shifts in both Demand and Supply
• Let us assume increase in income. • Assuming both demand and supply curves shift right as a result
of increased income and decrease in cost of production.
• This will shift demand curve to the right
• Price will move from P1 to P2
• A new price and quantity result after demand comes into
equilibrium with supply. We would expect to see consumers pay • As a result, quantity will increase from Q1 toQ2
a higher price, P3, and firms produce a greater quantity, Q3, as a
• When both, demand and supply curves shift to the right,
result of an increase in income.
market clears at higher prices and higher quantities
• When the demand curve shifts to the right, the market clears at
a higher price and a larger quantity.
• When demand curve shifts left, markets clear at lower prices
and lower quantity
How much will it change if income rises by 5 percent?
We use elasticities to answer questions like these.
 Elasticity of Demand
Price elasticity of demand: Percentage change in quantity Linear Demand Curve to calculate Price Elasticity of Demand Special cases
demanded of a good resulting from a 1-percent increase in its price.
• Calculation: Percentage change in quantity demanded over • Graph below assumes an equilibrium price of 2 and quantity of 4, • For a horizontal demand curve, ∆Q/∆P is infinite. Because a tiny
percentage change in price with Price 4 and Quantity 8 as price and quantity points change in price leads to an enormous change in demand, the
elasticity of demand is infinite. It is called infinitely elastic
• Price elasticity at equilibrium will be magnitude of 1
demand.
• The price elasticity of demand is usually a negative number. • Price elasticity at price of 4 is infinity, because at this point
When the price of a good increases, the quantity demanded quantity is 0 and will be not defined • Infinitely Elastic Demand:
usually falls. Principle that consumers will
buy as much of a good as they
• We also refer to the magnitude of the price elasticity—i.e., its
• At quantity 8, price elasticity is zero because price is zero can get at a single price, but
absolute size. For example, if E p = -2, we say that the elasticity is
for any higher price the
2 in magnitude. • Price elasticity at different points along the demand line will be
quantity demanded drops to
different and can be calculated by calculating the slope of
• When the price elasticity is greater than 1 in magnitude, zero, while for any lower price
straight demand line Q=8-2P.
demand is price elastic because the percentage decline in the quantity increases without
quantity demanded is greater than the percentage increase in limit.
price.
Slope 2 can be calculated by • For a vertical demand curve, ∆Q/∆P is zero. Because the
• If the price elasticity is less than 1 in magnitude, demand is said dividing change in price (4-2)=2 quantity demanded is the same no matter what the price, the
to be price inelastic. by change in corresponding elasticity of demand is zero.
• When there are close substitutes, a price increase will cause the quantity (4-0)=4. This means
consumer to buy less of the good and more of the substitute. that for every change in price of • completely inelastic demand:
Demand will then be highly price elastic. 2 units, quantity changes by 4. Principle that consumers will
buy a fixed quantity of a good
• When there are no close substitutes, demand will tend to be regardless of its price.
price inelastic.

• Suppose, we are contemplating an increase in the price of a

Income Elasticity of Demand: percentage change in the quantity
product from INR 8.00 to INR 10.00 and expect the quantity
demanded, Q, resulting from a
1-percent increase in income I
demanded to fall from 6 units to 4. How should we calculate the • Cross-price elasticity of demand:
price elasticity of demand? In these cases we calculate change percentage change in the quantity
over average price and average quantities over various. This is demanded for a good that results
called Arc elasticity of demand: the elasticity calculated over a from a 1-percent increase in the
price elasticity of supply: percentage change in quantity range of prices. price of another good. Example:
supplied resulting from a 1-percent increase in price. elasticity of demand for butter
• Elasticity in this example will be Change in price: 2, change in
quantity” -2, average price (8+10)/2=9, Average quantity with respect to the price of
This elasticity is usually positive because a higher price gives margarine would be written as:
producers an incentive to increase output. (6+4)/2=5. Therefore elasticity 2/-2*9/5=-1.8
 Elasticity over time
Price elasticity of demand
• Fast moving Consumer Goods like Petrol/Diesel/Soaps, etc.
• Consumer Durables like cars, refrigerators, etc.
Income elasticity of demand
• Fast moving Consumer Goods like Petrol/Diesel/Soaps, etc.
• Consumer Durables like cars, refrigerators, etc.
Price elasticity of Supply
• For most products
• For secondary scrap recycled products
Short-term Long Term
• In the short run, an increase in price has only a small effect on • In the longer run, however, because they will shift to smaller and
the quantity demanded. more fuel-efficient cars or say, less foaming soaps or soapless
baths, the effect of the price increase will be larger.
• People may consume less, but they will not change habits
overnight. • Demand, therefore, is more elastic in the long run
• Demand will be less elastic in short run
• If price increases, consumers initially defer buying new products • In the longer run, however, old products wear out and must
thus annual quantity demanded falls sharply.
• be replaced; thus annual quantity demanded picks up.
• Demand is more elastic in the short run.
• Demand, therefore, is less elastic in the long run
Short-term Long Term
• In the short run, an increase in price has only a small effect on • Income elasticity of demand is larger in the long run
the quantity demanded.
• People may consume less, but they will not change habits
overnight.
• Demand will be less elastic in short run
• Income elasticity of demand is more elastic in the short run. • Less elastic
Short-term Long Term
• Inelastic • Price elastic
• For most products, long-run supply is much more price elastic
than short-run supply because firms face capacity constraints in
the short run and need time to expand capacity by building new
production facilities and hiring workers to staff them.
• Elastic, because temporary supply can be increased by recycling • Inelastic because overall available quantity of scrap will decrease
scrap over time
Calculating Elasticities from a table of data Price (INR) Demand (million) Supply (million)
60 22 14
Consider a competitive market for which the quantities demanded and supplied (per year) at various prices are given at the right: 80 20 16
100 18 18
Q1 Calculate the price elasticity of demand when the price is INR 80 and when the price is INR 100
120 16 20
A1 Price Elasticity of demand formula is: P/QD*∆QD/∆P
When price increases by INR 20, Quantity Demanded decreases by 2 million. So, ∆QD/∆P=-2/20=-0.1
So at Price INR 80:
Elasticity=(80/20)*(-0.1)=-0.4

So at Price INR 100:

Elasticity=(100/18)*(-0.1)=-0.56

Q2 Calculate the price elasticity of supply when the price is INR 80 and when the price is INR 100

A2 Price Elasticity of supply formula is: P/QS*∆QS/∆P

When price increases by INR 20, Quantity Supplied increases by 2 million. So, ∆QDS∆P=2/20=0.1
So at Price INR 80:
Elasticity of Supply =(80/16)*(0.1)=0.5

So at Price INR 100:

Elasticity of Supply =(100/18)*(0.1)=0.56

Q3 What will be the equilibrium price? Quantity

A3 At Equilibrium, Demand=Supply
From the table, Demand and Supply are equal 18 million units at price of INR 100, which is the equilibrium price.

Q4 Suppose the government sets a price ceiling of INR 80. Will there be a shortage, and if so, how large will it be?

A3 With a price ceiling of INR 80, the market cannot reach its equilibrium price of INR 100.
At INR 80, consumers would like to buy 20 million, but producers will supply only 16 million. This will result in a shortage of
4 million units.
Calculating Elasticities from a Demand/Supply Curve
Suppose the demand curve for a product is given by Q =10 - 2P + PS, where P is the price of the product and PS is the price of a substitute good. The price of the substitute good is INR 2.00.

Q1 Suppose P =INR 1.00. What is the price elasticity of demand? What is the cross-price elasticity of demand?

A1 Quantity demanded when P=1.00 and PS =2.00 can be found be substituting the values in equation
Q = 10 -2*(1) + 2= 10

Price elasticity of demand : P/QD*∆QD/∆P

Slope ∆QD/∆P is given in the equation as -2 (coefficient of P as slope of the demand curve)
1/10*(-2)=-1/5=-0.2

Cross-price elasticity of demand Ps/QD*∆QD/∆Ps

Slope ∆QD/∆P is given in the equation as 1 (coefficient of Ps as slope of the demand curve)
2/10*(1)=1/5=0.2

Q2 Suppose the price of the good, P, goes to INR 2.00. Now what is the price elasticity of demand? What is the cross-price
elasticity of demand?
A2 Quantity demanded when P=2.00 and PS =2.00 can be found be substituting the values in equation
Q = 10 -2*(2) + 2= 8

Price elasticity of demand : P/QD*∆QD/∆P

Slope ∆QD/∆P is given in the equation as -2 (coefficient of P as slope of the demand curve)
2/8*(-2)=--2/4=-0.5

Cross-price elasticity of demand Ps/QD*∆QD/∆Ps

Slope ∆QD/∆P is given in the equation as 1 (coefficient of Ps as slope of the demand curve)
2/8*(1)=1/4=0.25