Demand,

Supply and
Elasticity of
Demand
Chapter 4
THE MARKET FORCES OF SUPPLY AND DEMAND

• Supply and Demand are the two words

that economists use most often.
• Supply and Demand are the forces that
make market economies work!
• Modern microeconomics is about supply,
demand, and market equilibrium.
DEMAND

• Quantity Demanded refers to the

amount (quantity) of a good that buyers
are willing and able to purchase at
alternative prices for a given period.
Determinants of Demand

• What factors determine how much of a

product you will buy?
• What factors determine how much you will
really purchase?
1) Product’s Own Price
2) Consumer Income
3) Prices of Related Goods
4) Tastes
5) Expectations
6) Number of Consumers
1) Price

Law of Demand
– The law of demand states that, other
things equal, the quantity demanded of a
good falls when the price of the good rises.
2) Income

• As income increases the demand for

a normal good will increase.
• As income increases the demand for
an inferior good will decrease.
3) Prices of Related Goods

Prices of Related Goods

– When a fall in the price of one good
reduces the demand for another good, the
two goods are called substitutes.
– When a fall in the price of one good
increases the demand for another good,
the two goods are called complements.
4) Others

• Tastes
• Expectations
The Demand Schedule and the Demand Curve

 The demand schedule is a table that

shows the relationship between the price
of the good and the quantity demanded.
 The demand curve is a graph of the
relationship between the price of a good
and the quantity demanded.
 Ceteris Paribus: “Other thing being equal”
Table 1: Leena’s Demand Schedule

Price of Ice-cream Quantity of cones

Cone(Rs) Demanded
0.00 12
5.00 10
8.00 8
9.00 6
10.00 4
10.50 2
12.00 0
Figure 1: Leena’s Demand Curve
Price of
Ice-Cream
Cone
Rs12.00

10.50

10.00

9.00

8.00

5.00

0 2 4 6 8 10 12 Quantity of
Ice-Cream
Cones
Market Demand Schedule

• Market demand is the sum of all individual

demands at each possible price.
• Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
• Assume the ice cream market has two buyers
as follows…
Table 2: Market demand as the Sum of Individual
Demands
Price of Ice-cream
Leena Nitin Market
Cone (Rs)
0.00 12 + 7 = 19
5.00 10 6 16
8.00 8 5 13
9.00 6 4 10
10.00 4 3 7
10.50 2 2 4
12.00 0 1 1
 Figure 2: Shifts in the Demand Curve
Price of
Ice-
Cream
Cone
Increase in
demand

Decrease in
demand

D2
D1

D3
Quantity of
Ice-Cream
Cones
Table 3: The Determinants of Quantity Demanded
Demand Function

A demand function in mathematical terms expresses

the functional relationship between demand for the
product and its various determining variables.
Dx = f ( Px, Ps, Pc, Yd, T,A,N,u)
Where X represents the commodity
Dx is quantity demanded
Px is price of commodity X
Ps and Pc is price of substitute and complementary
goods
Demand Function

Yd is the level of disposable income with the buyers

T is the change in the taste and preferences of the
buyers
A is the advertisement effect measured through the
level of advertising expenditure
N is the changes in population number or number of
buyers
U is incorporated to recognize “other” unspecified/
unknown determinants of the demand for
commodity X
SUPPLY

• Quantity Supplied refers to the amount

(quantity) of a good that sellers are
willing to make available for sale at
alternative prices for a given period.
Determinants of Supply

• What factors determine how much ice

cream you are willing to offer or
produce?
1) Product’s Own Price
2) Input prices
3) Technology
4) Expectations
5) Number of sellers
1) Price

Law of Supply
– The law of supply states that, other things
equal, the quantity supplied of a good rises
when the price of the good rises.
The Supply Schedule and the Supply Curve

 The supply schedule is a table that shows

the relationship between the price of the
good and the quantity supplied.
 The supply curve is a graph of the
relationship between the price of a good
and the quantity supplied.
 Ceteris Paribus: “Other thing being equal”
Table 4: Ben’s Supply Schedule

Price of Ice-cream Quantity of cones

Cone (Rs) Supplied
0.00 0
5.00 0
8.00 1
9.00 2
10.00 3
10.50 4
12.00 5
Figure 3: Ben’s Supply Curve
Price of Ice-
Cream Cone

Rs12.00

10.50

10.00

9.00

8.00

5.00

0 1 2 3 4 5 6 8 10 12 Quantity of Ice-
Cream Cones
Market Supply Schedule

• Market supply is the sum of all individual

supplies at each possible price.
• Graphically, individual supply curves are
summed horizontally to obtain the market
demand curve.
• Assume the ice cream market has two
suppliers as follows…
Table 5: Market supply as the Sum of Individual
Supplies
Price of Ice-cream
Ben Nicholas Market
Cone (Rs)
0.00 0 + 0 = 0
5.00 0 0 0
8.00 1 0 1
9.00 2 2 4
10.00 3 4 7
10.50 4 6 10
12.00 5 8 13
Figure 4: Shifts in the Supply Curve
Price of S3
Ice-
Cream S1
Cone S2

Decrease in
supply

Increase in
supply

Quantity of
Ice-Cream
Cones
Table 6: The Determinants of Quantity Supplied
SUPPLY AND DEMAND TOGETHER

• Equilibrium refers to a situation

in which the price has reached
the level where quantity
supplied equals quantity
demanded.
Equilibrium

• Equilibrium Price
– The price that balances quantity supplied and quantity
demanded.
– On a graph, it is the price at which the supply and demand
curves intersect.
• Equilibrium Quantity
– The quantity supplied and the quantity demanded at the
equilibrium price.
– On a graph it is the quantity at which the supply and
demand curves intersect.
Figure 5: The Equilibrium of Supply and Demand

Price of
Ice-
Cream
Cone Supply

Equilibrium price Equilibrium

Rs
10.00

Demand

Equilibrium quantity

0 1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream
Cones
Equilibrium
• Surplus
– When price > equilibrium price, then quantity supplied >
quantity demanded.
• There is excess supply or a surplus.
• Suppliers will lower the price to increase sales, thereby moving
toward equilibrium.
• Shortage
– When price < equilibrium price, then quantity demanded >
the quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many buyers chasing too
few goods, thereby moving toward equilibrium.
Surplus
Shortage
 Three Steps To Analyzing Changes in
Equilibrium

• Decide whether the event shifts the supply or

demand curve (or both).
• Decide whether the curve(s) shift(s) to the left
or to the right.
• Use the supply-and-demand diagram to see how
the shift affects equilibrium price and quantity.
• Example: A Heat Wave
 Figure 6: How an Increase Demand Affects the Equilibrium

Price of Ice-
Cream Cone
1. Hot weather increases the
demand for ice cream…
Supply
Rs 2.50 New equilibrium

Rs 2.00
Initial D2
2. … resulting equilibrium
in a higher
price …

D1

0 1 2 3 4 5 6 7 10 11 Quantity of Ice-
Cream Cone
3. … and a higher quantity
sold.
 Figure 7: How a Decrease Demand Affects the Equilibrium

Price of Ice- S2
Cream Cone
1. An earthquake reduces the
supply of ice cream…
S1
Rs2.50 New equilibrium

Rs 2.00 Initial equilibrium

2. … resulting
in a higher
price …

Demand

0 1 2 3 4 7 10 11 Quantity of Ice-
Cream Cones
3. … and a lower quantity
sold.
 Figure 8 a): A Shift in Both Supply and Demand

Price of Ice-
Large increase in
Cream Cone demand

New
S2
equilibrium S1
P2
Small decrease
in supply

P1 Initial equilibrium D2

D1

0 Q1 Q2 Quantity of Ice-
Cream Cone
 Figure 8 b): A Shift in Both Supply and Demand

Price of Ice- Small increase in

Cream Cone demand
New S2
equilibrium
S1
P2

Large decrease
in supply

P1 Initial equilibrium

D2

D1

0 Q2 Q1 Quantity of Ice-
Cream Cone
Table 7: What Happens to Price and Quantity
when Supply or Demand Shifts
 Calculation of Demand Function
A firm has a certain equilibrium price, when the
demand function is Qd= 100-5P and the
supply Function is Qs=10+5P. If the firm’s
demand function is shifted to Qd= 200-5P,
what would be the difference between the
new equilibrium price and the old equilibrium
price?
 Solution
• At Equilibrium price, Qs=Qd
• 10+5P =100-5P
• 10P=90
• P=9
When firms demand function shifts to Qd= 200-5P,
At Equilibrium Price, Qs=Qd
10+ 5P =200-5P
10P=190
P=19
New Equilibrium price= 19
The difference between new and old equilibrium price is 19-9=10.
 THE ELASTICITY OF DEMAND
• … allows us to analyze supply and demand
with greater precision.
•… is a measure of how much buyers and sellers
respond to changes in market conditions
• Elasticity of demand measures the degree of
responsiveness of the quantity demanded of a
commodity to a given change in any of the
determinants of demand.
 A Variety of Demand Curves
Because the price elasticity of demand measures
how much quantity demanded responds to the
price, it is closely related to the slope of the
demand curve.
 A Variety of Demand Curves

• Inelastic Demand
– Quantity demanded does not respond strongly
to price changes.
– Price elasticity of demand is less than one.
• Elastic Demand
– Quantity demanded responds strongly to
changes in price.
– Price elasticity of demand is greater than one.
 A Variety of Demand Curves

• Perfectly Inelastic
– Quantity demanded does not respond to price
changes.
• Perfectly Elastic
– Quantity demanded changes infinitely with any
change in price.
• Unit Elastic
– Quantity demanded changes by the same
percentage as the price.
 Figure 1 a): Perfectly Inelastic Demand
Price
Demand E=0

Rs 5

Rs 4
1. An increase in
price…

0 100 Quantity

2. …leaves the quantity demanded unchanged.

 Figure 1 b): Relatively Inelastic Demand
Price
Demand E<1

Rs 5.

Rs. 4.
1. A 22%
increase in
price…

0 90 100 Quantity

2. … Leads to a 11% decrease in quantity demanded.

 Figure 1 c): Unit Elastic Demand
Price E=1
Demand

$5.00

$4.00
1. A 22%
increase in
price…

0 80 100 Quantity

2. … Leads to a 22% decrease in quantity demanded.

 Figure 1 d):Relatively Elastic Demand
Price E>1
Demand

$5.00

$4.00
1. A 22%
increase in
price…

0 50 100 Quantity

2. … Leads to a 67% decrease in quantity demanded.

 Figure 5-1 e): Perfectly Elastic Demand
Price E=

1. At any price above $4, quantity demanded

is zero.

$4.00 Demand
2. At exactly $4, consumers will buy any quantity.

3. At any price below $4, quantity demanded is infinite.

0
Quantity
 Methods of Measuring Elasticity
• Price elasticity of demand is a measure of how
much the quantity demanded of a good
responds to a change in the price of that good.

• Price elasticity of demand is the percentage

change in quantity demanded given a percent
change in the price.
 Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as the

percentage change in the quantity demanded
divided by the percentage change in price.

ep Percentage change in quantity demanded

=
Percentage change in price
 The Price Elasticity of Demand and Its
Determinants
• Availability of Close Substitutes: Price elasticity
of demand of a brand of a product would be
quite high, given availability of other substitute
brands.
• Necessities versus Luxuries: Necessities are
relatively price inelastic. Eg perishable
commodities like eatables. while luxuries are
relatively price elastic. Eg: Consumer electronic
appliances.
 The Price Elasticity of Demand and Its
Determinants
• Alternative Uses of Commodity: If a
commodity can be put to more than one use,
it would be relatively price elastic. For Eg:
Electricity, water etc.
• On the other hand commodities which have
only one use, demand for such goods would
be relatively price inelastic. For Eg: calculator,
salt or life saving drugs etc.
 The Price Elasticity of Demand and Its
Determinants
• Time: Demand for commodities is usually
more price elastic in the long run. Eg: A shift
from petrol driven automobiles to GNG driven
ones.
Demand for commodities is usually more price
inelastic in the short run.
 The Price Elasticity of Demand and Its
Determinants
• Items of Addiction: Items of intoxication and
addition are relatively inelastic. Eg Cigarettes,
Liquor etc.
 The Price Elasticity of Demand and Its
Determinants

• Demand tends to be more elastic:

– the larger the number of close substitutes.
– if the good is a luxury.
– the more narrowly defined the market.
– the longer the time period.
 Methods of Measuring Elasticity
• Income elasticity of demand measures how much the
quantity demanded of a good responds to a change in
consumers’ income.
• It is computed as the percentage change in the
quantity demanded divided by the percentage change
in income.
P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e
 Methods of Measuring Elasticity

• Types of Goods
– Normal Goods
– Inferior Goods
• Higher income raises the quantity demanded
for normal goods but lowers the quantity
demanded for inferior goods.
 Methods of Measuring Elasticity

• Cross-Price elasticity of demand measures how

much the quantity demanded of a good responds
to a change in the price of another good.

Percentage change
in quantity demanded
Cross elasticity of demand =
Percentage change
in the price of
good 2.
 Methods of Measuring Elasticity
• Promotional and Advertising Elasticity of Demand:
Advertising elasticity of demand can be defined as
the degree of change in the quantity demanded
of a product to a given change in the expenditure
of the advertisements and other promotional
activities. Some of the factors affecting this type
of elasticity are type of product, stage of the
product, reactions of competitors of the firm to its
advertising campaigns
 Methods of Measuring Elasticity
• •P••e•rc• e••n•ta• g••e• c• h• a• n• g• e

•• •i•n• q• u• a••n••ti•t•y• d• e•m• a• n• d• e d

• • • Ea
• • • =
• •P••e•rc• e••n•ta• g••e• c• h• a• n• g• e
• in the advertising
•
expenditure
 Methods of Measuring Elasticity
• Arc Elasticity of demand : measures elasticity
at the midpoint of an arc between any two
points on a demand curve. It is also known as
the midpoint method. By this method,
elasticity is defined as:
 The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

The midpoint formula is preferable when

calculating the price elasticity of demand
because it gives the same answer regardless of
the direction of the change.
(Q2 - Q1) /Q1
Price elasticity of demand =
(P2 - P1) /P1
 Computing the Price Elasticity of Demand

Percentage change in quatity demanded

Price elasticity of demand 
Percentage change in price
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and
the amount you buy falls from 10 to 8 cones then your elasticity of demand
would be calculated as:

(10  8 )
 100
10 20 percent
 2
( 2.20  2.00 )
 100 10 percent
2.00
 Computing the Price Elasticity of Demand
(100- 50)
Price (100  50)/2
ED 
(4.00- 5.00)
(4.00 5.00)/2
$5
4 Demand
67 percent
  -3
- 22 percent

Demand is price elastic

0 50 100 Quantity
 Total Revenue and the Price Elasticity of
Demand

• Total revenue is the amount paid by buyers

and received by sellers of a good.
• Computed as the price of the good times the
quantity sold.

TR = P x Q
 Figure 2: Total Revenue
Price

$4.00

P x Q = $400
(revenue)
Demand

0 100 Quantity
 Elasticity and Total Revenue: Inelastic
Demand

Price Price …leads to an increase in total

An increase in price from $1 revenue from$100 to $240
to $3...

$3

Revenue = $240
$1 Demand Demand
Revenue = $100
0 100 Quantity 0 80 Quantity
Elasticity and Total Revenue

With an inelastic demand

curve, an increase in price leads
to a decrease in quantity that is
proportionately smaller. Thus,
total revenue increases.
 Elasticity and Total Revenue: Elastic Demand

Price Price …leads to a decrease in total

An increase in price from $4 revenue from$200 to $100
to $5...

$5
$4

Demand Demand
Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity
 Elasticity and Total Revenue: Inelastic
Demand

Price Price …leads to an increase in total

An increase in price from $1 revenue from$100 to $240
to $3...

$3

Revenue = $240
$1 Demand Demand
Revenue = $100
0 100 Quantity 0 80 Quantity
Elasticity and Total Revenue

With an elastic demand curve, an

increase in the price leads to a
decrease in quantity demanded
that is proportionately larger.
Thus, total revenue decreases.
 Usefulness of price elasticity
Firms can use price elasticity of demand (PED)
estimates to predict:
a) The effect of a change in price on the total
revenue & expenditure on a product.
b) The likely price volatility in a market following
unexpected changes in supply – this is
important for commodity producers who may
suffer big price movements from time to time.
 Usefulness of price elasticity
This is where a monopoly supplier decides to
charge different prices for the same product to
different segments of the market e.g. peak
and off peak rail travel or yield management
by many of our domestic and international
airlines.
 Calculation of Price Elasticity

Ep= Q2-Q1/ Q1
P2-P1/P1
Where
Q1= original quantity demanded,
Q2= new quantity demanded,
P1= original price level,
P2= new price level.
 Calculation of Price Elasticity
Suppose quantity demanded of coconut is
initially 800 units at a price of Rs 10 and
increases to 1000 units when price falls to Rs
8. Calculate price elasticity of demand.
Solution:
Ep= Q2- Q1/Q1
P2-P1/P1
 Calculation of Price Elasticity
Putting the respective values we get:

Ep= 200/2 = -1.25

800/10

Since the value of ep > 1 it is said that demand

for coconut is relatively elastic.
 Calculation of Cross Elasticity
2. Consider two goods X and Y. There was no
change in the price of X, but its demand
increased from 5500 units to 6000 units. On
analysis it was found that price of another
commodity Y has decreased from 250 to 225.
Find out the cross elasticity between X and Y
and relationship between the two goods.
 Calculation of Cross Elasticity
Solution:
Ec=Q2- Q1/Q1
P2-P1/P1
Ec= 6000-5500/5500 = 0.82
250-225/225
Since elasticity is positive, it can be concluded
that X and Y are substitutes.
THANK YOU

THE END