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BUSINESS ECONOMICS

UNIT II

SUPPLY AND DEMAND

INTRODUCTION

This chapter deals with how the free market Economic systems deals with the allocation of
scarce resources, making choices on what, how and for whom to produce. Thisemphasis is on the
market for goods and services. However, the factor market, which is the market for factors of
production, land, labour, capital and enterprise, with the corresponding rewards, rent, wages,
interest and profit respectively, works in almost a similar way.

A market is where buyers and sellers meet, it does not necessarily mean a geographical location.
What determines what and how much of anything to produce is the price, and price results from
the operation of demand by buyers and supply from sellers.

In a free market, prices, which are basically determined by demand and supply, combine to solve
the problem of resource allocation. Prices act as a signal of what people want to buy, indicating
to producers where their scarce factors will most profitably be utilized.

DEMAND

Individual demand must be differentiated from wants or desires. Demand refers to the
willingness by consumers to own goods, and it must be backed by money, it is therefore,
qualified as effective demand. This is the quantity of a product or service that consumers are
willing and able to buy at a given price. Emphasis is not only willingness, but this must be
supported by the ability to pay. Market demand is the total quantity, which all customers are
willing and able to buy at a particular price.

THE DEMAND SCHEDULE

There is an inverse relationship between the quantity demanded and price, the amounts that a
consumer is willing and able to purchase at various prices at any given time tends to be high at
low prices, and low at high prices.

Below is Mr Banda’s demand schedule for mangoes in the month of November.

Price (K) Quantity demanded (units)

1 000 0
800 3
500 4
300 6

1
2

200 10

DEMAND CURVE

When the data above is plotted into a line graph, a demand curve is produced.

FIG 3: DEMAND CURVE

Price
D

Quantity

A ‘normal’ demand curve slopes downwards from left to right, due to changes in price. A change
in price never shifts the demand curve for any good, it results in a movement along a demand
curve. This is a change in the quantity demanded.

An increase in price from OP to OP1 causes a contraction in demand from OQ to OQ1.

Alternatively, a reduction in price from OP1 to OP results in an extension in the quantity
demanded from OQ1 to OQ.

Contractionin demand Extension in demand

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UTILITY THEORY

The standard shape of a demand curve, downward sloping, explains consumer behaviour with
reference to utility theory. Utility is the satisfaction or the benefit derived from consuming a
good or a service, and total utility is the total satisfaction. The utility theory assumes that
consumers want to maximize the total utility they gain when they buy goods and services, a sign
that they are behaving rationally.

In general, when a consumer buys more of a product, the total utility rises, but the marginal
utility, which is the satisfaction gained from consuming one additional unit of a product,
reduces. For example, if a very thirsty person drinks a glass of water, she will derive a lot of
satisfaction from that, but the second glass of water will be less satisfying, by the time she drinks
the third and fourth glasses of water, there is very little satisfaction derived from drinking water.
This signifies that successive increases in consumption raise total utility but at a diminishing
rate, known as diminishing marginal utility. A person is only prepared to pay less for an extra
unit bought, more demand is at a lower price! This explains the shape of the demand curve, it
slants downwards from left to right, signifying that the lower the price, the higher the quantity
demanded and the higher the price the lower the quantity demanded.

The normal demand curve is also partly explained by the substitution effect, which occurs due
to relative price changes. Changes in the price of goods and services cause consumers to adjust
their demand schedules. If the price of a good falls, there is a substitution effect, consumers buy
more of that good and less of the other goods because of relative price changes. However, there
is also an income effect, as the fall in price increases a consumer’s real income. The consumer is
better off, and can buy more of a product, hence increasing demand as price falls.

A consumer’s spending of a good is in equilibrium where the marginal utility is equal to price.
Therefore the equilibrium for a combination of goods is

Marginal utility of good A =MUB=MUC

Price of good A PB PC

Note that the utility theory has a number of limitations, the important one being that it is
subjective, an individual who does not smoke cannot derive any satisfaction from cigarette
smoking. For some products such as beer, there is no diminishing marginal utility for some
people! In addition, a poor person who is starving can pay dearly for basic foodstuffs, while a
rich person will find this negligible in terms of price and utility.

A CHANGE IN DEMAND

Demand curves shift only if there is a change in the conditions of demand other than price.

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The following are the main influences on demand:

 Household income
An increase in income leads to an increase in the demand for goods and services, known
as ‘normal’ goods. These are expensive, luxurious products. Demand falls when there is
a reduction in income, indicating a positive relationship betweenhousehold incomeand
most goods and services.

 For some products, there is an inverse relationship between household income and
demand. Demand is high only when household income is low. Goods, whose demand
decreases when income is high, are known as ‘inferior’ goods. Examples are black and
white television sets, cheap wine, some vegetables etc.

 The price of other goods

`This can either be substitute or competitive goods, those goods that are interchangeable,
are competing with each other. Examples are margarine is a substitute for butter, and tea
is a substitute for coffee.Different brands of tea, coffee and different cellular phone
service
providers like Celtel, Telecel and Zamtel are very close substitutesof each other!

 For substitute goods, a change in the price of one good causes a change in the demand for
the other good. Suppose there is an increase in the price of butter, the demand for
margarine is likely to increase as consumers will switch to margarine, which will appear
relatively cheaper.

 The other goods can also be complementary goods or those goods that are jointly
demanded such as cars and fuel, or cell phones and sim cards.

 For complementary goods, a change in the price of one good also causes a change in the
demand for the other good, however, an increase in the price of motor vehicles causes a
reduction in the demand for fuel.

 There is an increase in demand for herbal medicines because of the complexities of the
H.I.V A.I.D.S. scourge.

 Population
An increase in population creates a larger market for goods andservices, demand
increases
and vice versa.

 Price expectations
Expectations of future price increases in a commodity results in an increase in demand,
the
idea is to purchase a lot of goods at the current ‘low’ price and ‘beat’ future price
increases.

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 A change in demand is a shift in the whole demand curve either to the right or to the left,
indicating an increase or a decrease in demand respectively.

Price D2
D1 D

Quantity

In the diagram above, a decrease in demand shifts the demand curve to the left from DD to D1D1
and an increase in demand would shift the demand curve to the right from DD to D2D2

SUPPLY

Supply must be differentiated from production, which is the total value of goods in stock. Supply
is the amounts of a good producer are willing and able to sell at a given price.

THE SUPPLY SCHEDULE

There is a positive relationship between the quantity supplied and price. The amounts that
producers or sellers are willing and able to sell at various prices at any given time tend to be high
at high prices, and low at low prices.

Below is MsChanda’s supply schedule in the month of November.

Price (K) Quantity supplied (units)

1 000 0
800 3
500 4
300 6
200 10
SUPPLY CURVE

When the data above is plotted into a line graph, a supply curve is produced.

Price S

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Quantity

A ‘normal’ supply curve slopes upwards from left to right, an indication that at high prices,
supply is high, while at low prices, supply is also low. A change in price never shifts the supply
curve for any good, it results in a movement along a supply curve. This is a change in the
quantity supplied.

An increase in price from OP to OP1 results in an extension in supply from OQ to OQ1.

Alternatively, a reduction in price from OP1 to OP results in a contraction in the quantity
supplied from OQ1 to OQ.

Price

P1
P

P P1

0
Q Q1 Quantity Q1 Q

A CHANGE IN SUPPLY

The supply curve shifts only if there is a change in the conditions of supply either than price. If
supply conditions change, a different supply curve must be drawn, unlike a change in the
quantity supplied due to price changes,

The following are the main influences on supply:

- Cost of production
A rise in costs generally decreases the amount of a commodity being supplied to the
market, since firms cannot continue in business for long if they are failing to cover the
costs of production. Low costs encourage production and therefore increases the supply
of goods and services.

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- Technological changes
Improvements in technology lead to more efficient production a method that reduce
production cost per unit and therefore increases supply. Obsolete technological has the
opposite effect.

- Weather conditions
For agricultural goods, natural disasters like floods, droughts or favorable weather
conditions can reduce or increase the supply respectively.

- Prices of other goods

The goods can be either substitute goods or those that are jointly supplied.

- Suppose it is easy to shift resources into the production of other goods, then an increase
in the producer price of one maize would lead to an increase in the production and supply
of maize, and a decrease in the production and supply of groundnuts.

- An increase in the price of a good such as beef, would lead to an increase in its supply. In
addition, the supply of leather would also increase.

- Government policy, such as taxes and subsidies

Taxes are treated as costs, subsidies are benefits to a firm. An increase in taxes reduces
supply, while a reduction in taxes tends to increase the supply.

A subsidy is when the government pays part of the costs in order to encourage the
production of goods. Increased production increases supply.

- Other factors
Industrial and political unrest in the form of work stoppage, strikes, fire, wars, riots etc,
can lead to a reduction in supply.

- A change in supply is a shift in the whole supply curve either to the right or to the left,
an
indication of an increase or a decrease in supply respectively.

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In the diagram below, a decrease in supply shifts the supply curve to the left from SS to S 1S1 and
an increase in supply shifts the supply curve to the right from SS to S2S2.

Price S1
S
S2

S1
S
S2

Quantity

PRICE DETERMINATION

The equilibrium market price is the price at which consumers want to buy equals the price at
which producers want to sell.

Consumers and producers both act rationally. Consumers want to maximize their utility and
therefore want to purchase goods as cheaply as possible, while producers also act rationally and
aim at profit maximization, they charge high prices. The equilibrium market price therefore is
determined by the interaction of the market forces of demand and supply. The point where the
demand and supply curves intersect is the compromise price, both consumers and producers are
satisfied at this point.

Consumers are willing and able to purchase OQ quantities at price OP, while Producers are also
willing and able to supply OQ quantities at price OP, as shown in the diagram below.

Price D S

S D

O
Q Quantity

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At the equilibrium price, there are neither surpluses nor shortages. The price is stable unless
there are changes in either supply or demand conditions listed above under changes in demand
and supply.

Note that the marginal utility of consumers vary, with some consumers willing and able to pay
for a product than the prevailing market price, since they are paying less, there is a consumer
surplus.
A producer surplus also arises when some suppliers are willing to sale at less than the prevailing
market price, since they are selling at a higher price there is a producer surplus.

Price

Consumer
surplus

Producer
surplus

Quantity

PRICE CHANGES

Shifts in the supply or demand curves will change the equilibrium price and quantity traded.

If for example, there is a large increase in consumer’s income, the demand curve will shift to the
right from DD to D1D1 signifying an increase in the demand for goods and services. The new
equilibrium price is OP1 and the quantity traded also increases to OQ1.

Price D1
S
D

P1

D1
S
D

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O Q Q1 Quantity
DISEQUILIBRIUM IN THE MARKET

The market system is considered to be the best way of allocating scarce Economic resources,
because prices act as signals to producers. An increase in the price of product X, is a signal to
producers to transfer resources to the production of product X and vice versa.

The objective of maximizing profits provides the incentive for firms to respond to changes in
price.

The system is self-adjusting. If the price is above the equilibrium at OP1, there is excess supply,
surpluses. At this high price, producers are encouraged to supply more, but the quantity
demanded at this high price is less. This causes a downward pressure of cutting down production
to eliminate the surplus and reducing the price to encourage demand.

At prices below the equilibrium at OP2, there is excess demand, shortages. Producers supply few
quantities at low prices while more consumers are willing and able to purchase products at low
prices. Excess demand causes an upward pressure on price resulting in a rise in price and output.

Price D S
Excess supply
P1

P2
Excess demand
S D

O
Q Quantity

GOVERNMENT INTERVENTION

Price regulation and government policy of taxation and subsidy interfere with the working of the
free market system.

MAXIMUM PRICE (PRICE CEILING)

If the government thinks that the price determined by the market forces of supply and demand
for a product or service is high, the government might decide to set a maximum price, that is the
price should not go beyond the amount stipulated by the government.

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Maximum prices are normally set to encourage the consumption of goods and services,
considered to be essential, and therefore should be affordable to everyone.

This has the same effect as the price being below the equilibrium, at OP2 in the diagram above.
The result is excess demand, shortages. There is no self-adjustment as this is government policy;
queues, black markets and tie in sales become common whenever there are shortages.

The government may attempt to ration the few commodities, or subsidize consumers.

Price D S

S D

O
Q1 Q Q2
Quantity

Maximum price OM, at this price OQ, quantities are supplied while OQ 2 quantities are
demanded, the result is a shortage.

MINIMUM PRICE (PRICE FLOOR)

This is set in order to protect producers. If the government feels that the price set by the market
forces of supply and demand is too low for producers to earn a decent standard of living them a
minimum price is set. This meaning that the goods should not be sold below the amount
stipulated by the government.

This has the same effect as the price being above the equilibrium at OP.

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Price D S

D
O
Q1 Q Q2 Quantity

Minimum price is OM, quantity supplied is OQ2 while the quantity demanded at this high price is
only OQ1. The result is excess supply, surplus amounts that have to be sold at low prices
“dumped” in poor countries.
The surplus can also be stored away, but this is at a cost.

Government intervention in relation to taxation and subsidy is explained in detail in the

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ELASTICITY
INTRODUCTION

The law of demand states that an increase in price causes a decrease in the quantity demanded,
while a decrease in price causes an increase in the quantity demanded.
Elasticity measures the degree of responsiveness or sensitivity of demand to a change in price.

If a small change in price causes a big change in the quantity demanded then demand is elastic.
However, if a big change in price causes only a small change in the quantity demanded, then it is
inelastic.

PRICE ELASTICITY OF DEMAND (PED)

It is measured by the formula: % change in quantity demanded

% change in price

There is an inverse relationship between price and quantity, as such the sign is negative.
Note that the sign is always ignored when interpreting the elasticity value.

CATEGORIES OF PRICE ELASTICITY OF DEMAND

There are five categories of PED, namely:-

Perfectly or completely inelastic demand

When a change in price has no effect at all on the quantity demanded, PED when measured is
equal to zero. This is an extreme situation, the closest it can be liked to is medicines. Consumers
purchase exactly the same quantities whatever the price is, whether it is high at OP or low at OP1,
the quantity remains OQ.

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Price D

P1

O
Q Quantity

Inelastic demand

This is when elastic is relatively or fairly inelastic, a big change in price results in only a small
change in the quantity demanded and the conclusion is that demand is inelastic. Price changes by
a big margin, from OP to OP1, but the demand reduces by a very small amount, from OQ to
OQ1. PED when measured is greater than zero, but less than one.

Inelastic demand applies to necessities such as mealie meal, sugar, salt, and addictive products
such as cigarettes, beer, drugs.
Price
D
P1

D
O Q1 Q Quantity

Unitary elasticity of demand

This is a hypothetical scenario, based on the assumption that if demand changes by a certain
percentage, then the quantity demanded should also change by exactly the same percentage.
When measured, elasticity is equal to one exactly.

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Price D

P1

D
O Q1 Q Quantity

Perfectly or completely elastic demand

This is another theoretical structure, it is important because a perfectly competitive market

structure model is based on it.

At the compromise price of OP, demand is infinite, but a small change in price would cause
demand to reduce to zero.

PRICE

P D

QUANTITY

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Elastic demand
Demand is relatively or fairly elastic when a small change in price results in a big change in the
quantity demanded, a sign that consumers are able to respond to changes in prices.

Therefore goods and services that can easily be substituted, those that are mere luxuries and are
expensive (normal) goods are the ones which have an elastic demand.

When measured, the value would be greater than one but less than infinity.

Price
D

P1
P
D

O Q1 Q Quantity

CALCULATING PRICE ELASTICITY OF DEMAND

The calculation is done in two ways

(a) Point Elasticity of Demand

Under point elasticity, the elasticity is calculated at a certain point on the demand curve.

Example1

The price of a product was K4000 and the annual demand was 2000 units when the price was
reduced to k3000, the annual demand increased to 4000 units.

Calculate the price elasticity of demand for the price changes given.

PED Formula = % change in quantity demanded = Q2 - Q1 ÷ P2 –P1

% change in price Q1 P1

= Q2 - Q1 × P1
Q1 P2 –P1

where Q2 = 4000
Q1 = 2000
P2 = 3000

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P1 = 4000
= 4000 – 2000 x 100
2000
___________________
3000 – 4000 x 100
4000

= 2000 x 4000 = -4_

2000 -1000 Demand is elastic

Example 2

The price of a commodity was initially K10, 000 and 150 units were bought per day. When the
price fell to K5, 000 the units being bought increased to 200 per day. What is the price elasticity
of demand for the price changes given?

PED Formula = % change in quantity demanded = Q2 - Q1 ÷ P2 –P1

% change in price Q1 P1

= Q2 - Q1 × P1
Q1 P2 –P1

where Q2 = 200
Q1 = 150
P2 = 5000
P1 = 10000

200 - 150 x 100 50

150 150
= _____ = 50 x 10 000 = 10
150 -5 000 -15

5 000 – 10 000 x 100 -5000

10,000 10000

= -2 = - 0.67
3
Demand is inelastic

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Example 3

From the following data

Price quantity bought

(K’000) ( units)
1.75 125
2.0 100

Calculate PED

At price K1.75
% Change in quantity 25 x 100 = 20%
125

% Change in Price -0.25 x 100 = -14.2857%

1.75

PED Formula = % change in quantity demanded

% change in price

= 20% = -1.4 Demand is elastic

-14.2857%

(b) Arc elasticity of demand

The elasticity is calculated over a range of values or an arc.

Example 1

The annual demand for a product is 1,800,000 at K2, 600 per unit and demand reduces to
1,500,000 when the price increases to K3, 000 per unit. What is the elasticity of demand over
this price range?

PED Formula = Percentage change in quantity demanded

Percentage change in price

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Q2 - Q1 x 100 Where Q2 = 1 800 00

Q1 + Q2 Q1 = 150 0000
___ 2______________ P2 = 2600
___ _______________________ P1 = 3000

P2 - P1 x 100
P1 + P2
2

18 00000 – 15 00 000 x100

1500000 + 18 00 000

2 600 – 3 000

3 000 +2 600 x 100

2

300,000
1650 000

= 300,000 x 2800 = -1.27

-400 1650 000 -400 demand is elastic
2800

Example 2
From the following data

Price Quantity bought

K’000 000 units
10 15
5 20

Calculate PED

Change in quantity -5 x 100 = -28.57%

17.5

Change in price -5 x 100 = 66.67%

7.5

PED = -28.57% = - 0.43

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66.67% demand is inelastic

PRICE ELASTICITY ALONG THE DEMAND CURVE

The five categories of price elasticity of demand can be shown on one demand curve. Demand
curves generally slope downwards from left to right, and elasticity varies along the length of a
demand curve. The ranges of price elasticity of demand at different points along a demand curve
are illustrated below.

Price
PED = ∞

PED>1

PED = 1 (mid-point of the line)

PED<1

PED = 0
Quantity
0

Along the top half of the line, PED is greater than 1. We say that demand is elastic. Along the
bottom half of the line, PED is less than 1 and we say that demand is inelastic. Exactly halfway
along the line, PED = 1; demand is of ‘unitary elasticity’.

The arithmetic accuracy can be examined by studying the demand schedule for beans shown
below:

Price Quantity
(K’000) (kilograms)

10 0
9 10
8 20
7 30
6 40
5 50
4 60
3 70
2 80

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1 90
0 100
If the price is lowered from 8 to 7, PED is 10/20  1/8 = 10/20 x 8/1 = 4.
Demand is therefore, elastic.

If price is lowered from 4 to 3, PED is 10/60  ¼ = 10/60 x 4/1 = 2/3 = 0.66.

Demand is therefore, inelastic

At higher price ranges, demand is elastic. At lower price ranges, demand is inelastic.

At the point where demand is changing from elastic to inelastic demand, demand is unitary. If
price is lowered from 5 to 4, PED is 10/50  1/5 = 10/50 x 5/1 = 1.

Note that it is wrongly assumed that when calculating elasticity values, either an increase or a
decrease in price calculations, given the same values, have the same elasticity coefficient. It is
also wrongly assumed that two demand curves with the same shape will have the same elasticity
coefficient, and yet the slope and position of the demand curve determine the numerical value of
elasticity. In general, a big change in price causes only a small change in the quantity
demanded, resulting in an inelastic demand curve if the demand curve is steep, further from the
origin, and vice versa.

POSITIVE PRICE ELASTICITIES OF DEMAND OR EXCEPTIONAL

DEMANDCURVES

If the quantity demanded of certain goods falls as an individual’s income reduces, then the goods
are said to be inferior goods. It is assumed that a person substitutes better quality alternatives,
for example substituting a black and white television for a colour, flat plasma television set, from
buying mixed cut beef to a high quality expensive steak.

The quantity demanded for a good may also increase when the price increases if the product is a
status maxi miser! Ostentatious goods such as gold and diamond jewels, private jets, etc., are
more desirable to some consumers when the price is high, when the price falls, the products
become common and are no longer desirable to those people.

If consumers anticipate future price increases whenever the price of a product increases, they
are likely to buy more to ‘beat’ inflation in the short term.

FACTORS DETERMINING PRICE ELASTICITY OF DEMAND

Elasticity of demand depends on the consumer’s ability to increase or reduce the quantities being
purchased when there is a change in price. This depends on the following:

 Availability of substitutes
Substitutes have a very big impact on elasticity, if there are close substitutes available,
then an increase in the price of a good, will enable consumers to react, and demand will

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be elastic. However, the demand for a unique product is likely to have an inelastic
demand.

 Income
This is when a commodity constitutes a small proportion of an individual’s income, a
cheap product such as a razor blade, a rubber and pencil or a box of matches, items
costing K100 or so would still be affordable even if there is a 100% percent increase in
price. In contrast, the demand for luxurious expensive products is likely to be elastic. A 10%
increase in the price of a product costing K2 million would make consumers responsive
to changes in demand.

 Necessities
The demand for commodities such as mealie meal, salt, sugar, milk etc is likely to be
stable and inelastic.

 Additive or habit forming products

Consumers who are addicted to products such as beer, cigarettes, drugs etc feel that they
cannot function properly without them. To them, the products are ‘necessities’, and
therefore their demand is stable and inelastic.

 Time period
It takes time to adapt to changes in price. Consumers are likely to cling to a certain
lifestyle until reality sets in and they are forced to adjust their spending habits. As such
demand is more likely to be elastic in the long run rather than in the short run.

PRICE ELASTICITY OF SUPPLY (PES)

Price elasticity of supply is analogous to price elasticity of demand, it measures the

responsiveness of supply to changes in price. That is the extent to which producers increase
production and therefore the quantity which they take to the market as a result of a rise in price.
PES is measured by the formula: % change in quantity supplied
% Change in price

There is a direct relationship between price and quantity supplied.

CATEGORIES OF PRICE ELASTICITY OF SUPPLY

As with elasticity of demand, there are five categories of elasticity of supply.

Perfectly or completely inelastic supply

A change in price has no effect at all on the quantity supplied to the market. The same quantity is
supplied regardless of a price change, from 0P to 0P1 or vice versa.

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Elasticity is equal to zero.

Price S

P1

O Q Quantity

Inelastic supply

This is when elastic is relatively or fairly inelastic, a big change in price results in only a small
change in the quantity supplied. A large increase in price results in only a small increase in the
quantity produced and therefore supplied to the market. The conclusion is that supply is inelastic.
Price changes by a big margin, from OP to OP1, but supply increases by a very small amount,
from OQ to OQ1. PES when measured is greater than zero, but less than one.

Price S

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P1

O Q Q1 Quantity

Unitary elasticity of supply

This is a hypothetical, it is based on the assumption that if price changes by a certain percentage,
then the quantity supplied should also change by exactly the same percentage. When measured,
elasticity is equal to one exactly.
Price S

P1

O Q Q1 Quantity

Perfectly or completely elastic supply

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This is another theoretical structure. At price OP, supply is infinite, producer will supply any
amount, but a small change (reduction) in price would cause supply to reduce to zero.
Absolutely nothing is supplied to the market even at the smallest decrease in price
Price

P S

O Quantity

Elastic supply

Supply is relatively or fairly elastic when a small change in price results in a big change in the
quantity supplied, a sign that producers are able to respond to changes in prices. A small increase
in price is able to induce a large increase in the quantity produced and supplied to the market and
vice versa.

When measured, the value would be greater than one but less than infinity.

Price

S
P1
P
S

O Q1 Q1 Quantity

FACTORS INFLUENCING PRICE ELASTICITY OF SUPPLY

Elasticity of supply depends on the producer’s ability to increase or reduce the quantities being
supplied to the market when there is a change in price. This depends on the following:

 Time period
This is one of the major factors affecting PES. Supply is likely to be more inelastic in the
short run than in the long run generally because existing stock levels may be low, or it
may take some time for producers to purchase more capital equipment in order to
increase production, if they are already operating at full capacity.

 Availability of factors of production

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In order to respond to an increase in price, a firm should consider the existing stock
levels, do they have enough to increase supply? What is the shelf life of what is in stock,
etc? Are the necessary raw materials and labour easily available in order to increase
production? What about the existence of other factors of production like fixed capital
equipment if the firm is already operating at full capacity?

 Number of firms and entry barriers can also affect the price elasticity of supply.

THE SIGNIFICANCE OF PRICE ELASTICITY

WHEN DEMAND OR SUPPLY CHANGES

In the previous chapter, the explanation on why prices change is given as due to a change in
either supply or demand conditions. In practice, while any change in demand or supply alters the
equilibrium price and output, the effects will vary due to the differences in the elasticities
involved!
If demand is inelastic, a shift in supply will cause a large change in the price but only a small
change in the quantity traded, and vice versa.

a) INELASTIC DEMAND

S
Price
S1

P D

P1 D1

0 Q Q1 Quantity

b) ELASTIC DEMAND
S
Price
S1

P D

P1 D1

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0 Q Q1 Quantity

In the same general way, the effects of a shift in demand depend on the elasticities of the supply
involved. Where supply is inelastic, a shift in demand causes a large change in the equilibrium
price but only a small change in the equilibrium output, and vice versa.

a) INELASTIC SUPPLY b) ELASTIC SUPPLY

Price D1 Price D1

D D
P1 P1
P
P

0 Q Q1 Quantity 0 Q Q1 Quantity

In extreme cases, where demand or supply is perfectly inelastic or elastic, a change in supply or
demand does not change the equilibrium position at all.

a) PERFECTLY INELASTIC DEMAND b) PERFECTLY ELASTIC SUPPLY

Price
S1 Price
D1
D
P1 S

0 Q Quantity 0 Q Q1 Quantity

Under a), a change in supply causes the equilibrium price to change but the equilibrium output
does not change. Under b) a change in demand causes the equilibrium output to change but the
price does not change.

Note that an understanding of this first section is very crucial as sections 2, 3 and 4 below
are more or less a repetition and an extension of this concept.

WHEN THERE IS A CHANGE IN TOTAL REVENUE

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The calculation of PED is very useful to the business community, as well as the amount being
spent by consumers. If the demand for a good is elastic, then a reduction in price increases total
revenue, and the total amount being spent by consumers. A business selling products that are
very competitive on the market, those with close substitutes, luxuries etc., can advertise small
reductions in prices and discounts in order to woo customers and increase the company’s total
revenue.

Price

P D

P1 D1

0 Q Q1 Quantity

Total revenue is price x quantity, the price reduction results in a more than proportionate increase
in the quantity demanded, this offsets the price reduction. Area 0PDQ is ‘given up’, while area
0P1D1Q1 is what is ‘gained’ when the price is reduced, total revenue increases.

Alternatively, if total revenue falls after a price rise then demand is elastic.

If the demand for a good is inelastic, then an increase in price increases total revenue. A
business selling products that are necessities and addictive products like beer and cigarettes, can
afford to increase prices, and the reduction in the quantity demanded is negligible, as shown
below.
Area 0P1D1Q1 is ‘given up’, while area 0PDQ is what is ‘gained’ when the price is increased,
therefore, total revenue increases.

Price

P D

P1 D1

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0 Q Q1 Quantity

Alternatively, if total revenue falls after a price cut then demand is inelastic.

If total revenue or total expenditure by households remains unchanged whether there is an

increase or reduction in price, then the elasticity of demand is unitary. The areas are equal!

Price

P D

P1 D1

0 Q Q1 Quantity

WHEN AN INDIRECT TAX IS IMPOSED ON A PRODUCT

Imposing an indirect tax on a product is a form of government intervention, like the setting of
maximum and minimum prices. An indirect tax is a tax on expenditure. Such taxes reduce
output, maybe harmful to the domestic industry if it is in a competitive environment and some
foreign firms are not subject to the same tax. Taxes however, can assist in the allocation of
resources when there is a lot of pollution and only polluters are pay through heavy taxes.

The significance of elasticity is in determining how the burden of the tax is to be shared between
the producer and the consumer.

Suppose, a product has unitary elasticities of demand and supply, the market forces determine
the equilibrium price and output. Following the imposition of a tax, some producers transfer their
resources to another product, as this one would be deemed unattractive. Supply reduces, and the
supply curve shifts to the left, to S1. The price paid by consumer’s increases to P1, but the net
amount received by the producer is lower than previously, since he must pay to the government
part of the earning and there is a reduction in output to Q1, due to the tax.
Price D S1

S
P1

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P2

0 Q1 Q Quantity
In the diagram above, the burden of the tax is shared equally between the producer and the
consumer.

In practice, such an equal distribution of the tax burden is unlikely. The burden of the tax
depends on the elasticities of demand and supply involved! If the demand for a good is inelastic,
a firm producing necessities and addictive products like beer and cigarettes can afford to pass
the major burden of the tax on to consumers, price increases to P 1 from P. Producers bear a
small portion of the burden, return falls toP2.

a) INELASTIC DEMAND

S
Price
S1

P1

P2

0 Q Q1 Quantity

b) ELASTIC DEMAND
S
Price
S1

P1
P

P2

0 Q Q1 Quantity

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If the demand for a good is elastic, then a firm dealing in products that are competitive on the
market by having close substitutes, luxuries etc., the burden of the tax is borne mainly by
producers. The price paid by consumers rises slightly to P 1, the return received by suppliers falls
by a big margin, to P2.

a) INELASTIC SUPPLY

S1
Price S

P1
P

P2

0 Q Q1 Quantity

The conclusion as to how the burden is shared is self explanatory from the diagram, the price
paid by consumers rises slightly to P1, the return received by suppliers falls by a big margin, to
P2.

WHEN A SUBSIDY IS GIVEN

A subsidy is the exact opposite of an indirect tax. It is another form of government intervention,
it is when the government makes a payment to producers, and it can bring about artificially low
prices.

Suppose, a product has unitary elasticities of demand and supply, the market forces determine
the equilibrium price and output. When a subsidy is given, production is encouraged. Supply
increases, and the supply curve shifts to the right, to S1. The price paid by consumers reduces to
P2, and this is a benefit to them. There is an increase in output to Q1, and the amount received by
the producer increases.

Price D S

S1
P1

P2

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0 Q Q1 Quantity

The significance of elasticity is in determining how the benefit of the subsidy is to shared
between the producer and the consumer, the benefit will fall more on the consumers if the
product has an inelastic demand and vice versa.

OTHER ELASTICITY MEASURES

INCOME ELASTICITY OF DEMAND (YED)

The elasticity measures are alike, the definition of income elasticity of demand is similar to that
of price elasticity of demand, but price is replaced by income.

Income elasticity of demand measures the degree of responsiveness or sensitivity of demand to

changes in income.

The formula = percentage change in quantity demanded

percentage change in income

Categories of income elasticity of demand

Positive Income Elasticity

This is when an increase in income leads to an increase in demand, YED > 0. It applies to
‘normal’ goods such as colour television sets, motor vehicles etc. Most goods have a positive
income elasticity of demand.

Quantity

Income

Negative Income Elasticity

For some goods, an increase in income causes a reduction in demand, YED < 0. Inferior goods,
such as black and white television set, have a negative income elasticity of demand.

Quantity

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Income

Zero income Elasticity

A change in income may have no effect on the quantity demanded, demand remains the same,
YED = 0. Consumers purchase only what they require, this applies to Giffen goods, ‘necessities’
like mealie meal, potatoes etc. Note that with Giffen goods, less is demanded when price falls
because the negative income effect overcomes the positive substitution effect.

Quantity

Income

Factors affecting income elasticity of demand

The size of income elasticity of demand depends on the current standard of living. For example,
the developed countries have a high standard of living, so that when income expands, sales of
consumer durables such as washing machines and cars will rise; sales of basic commodities
(Food, etc) are unlikely to respond significantly to the rise in income (zero income elasticity). In
contrast, developing economies such as Zambia, when income rises, the income elasticity of
demand for basic goods will be higher as a large percentage of the population is unable to afford
basic commodities at its current level of income.

Practical uses of income elasticity of demand

Producers may wish to know the income elasticity of demand for their product, it has an effect
on their businesses. The planned future production may depend on whether incomes are rising or
falling. Income increases during Economic prosperity (Economic boom), businesses sell normal
goods. While during a recession, basic inferior goods are more profitable.

CROSS ELASTICITY OF DEMAND

Cross elasticity of demand measures the sensitivity of demand for one good to changes in the
price of another good. The formula for cross elasticity of demand (XED) is given below.

The formula for cross elasticity of demand

XED = percentage change in quantity demanded of Good A

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percentage change in price of Good B

Categories of cross elasticity of demand

Positive cross elasticity of demand

The XED between butter and margarine is positive, this is because butter and margarine are
substitutes. When the price of butter goes up, demand for margarine rises and demand for butter
falls. In other words, the price of margarine and demand for butter move in the same direction,
therefore XED is positive.

Negative cross elasticity of demand

The XED between complements (goods that are jointly demanded) is negative. Consider cars and
fuel, if the price of cars increases, demand for fuel would fall. Cars and fuel are complementary
goods, so demand for cars is also likely to fall. The price of cars and demand for fuel move in
opposite directions, so the XED of complements is negative.

Zero cross elasticity of demand

This applies to unrelated goods. A change in the price of one good has no effect on the quantity
demanded of the other good.

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UNIT SUMMARY

In a free market economy prices act as a means for consumers to signal to the market what they
wish to buy, and for producers where their scarce Economic would most profitably be utilized.
The price for any good or service is determined by the demand for and the supply of that good or
service.

Changes in demand or supply cause changes in the equilibrium price and quantity
Government intervention, such as the setting of maximum and minimum prices, as well as
taxation and subsidy also disturbs the equilibrium price and quantity.

If maximum prices are imposed, there are shortages or excess demand, and if minimum prices
are imposed, there are surpluses or excess supply.

Indirect taxes lead to an increase in price, while subsidies cause prices to reduce.

Price elasticity of demand and supply measure how much the quantity demanded and supplied
responds to changes in price.

PED/PES are calculated as the percentage change in quantity demanded/supplied divided by the
percentage change in price.

PED/PES are very important in determining the effects of changes in demand and supply,
increases and reductions in total revenue given changes in the prices of goods and services. In
addition, PED/PES are important in determining the effects of changes in government policy
such as taxation and subsidies.

If total revenue increases following a price cut, then demand is elastic. If total revenue falls
after a price cut, then demand is inelastic, and vice versa. If total revenue remains unchanged,
then demand is unitary.

There are a number of factors, which determine the ability of consumers and producers to
respond to changes in price, such as the availability of substitutes, whether a product is a
necessity or it is addictive, as well as the income of consumers.

In most markets, supply is more elastic in the long run than in the short run, it takes time to
transfer resources following a price rise, it also depends on the availability of factors of
production especially raw materials and labour, as well as the ease of entry of new firms into the
market.

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Income elasticity of demand measures how much the quantity demanded responds to changes in
income.

Cross-elasticity of demand measures how the quantity demanded of one good responds to
changes in the price of another good.

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