ECON Module-2 2

Download as pdf or txt
Download as pdf or txt
You are on page 1of 32

CHAPTER 2

SUPPLY AND DEMAND

OVERVIEW
Supply and demand are an economic theory that's used to explain the
relationship between the availability of a commodity and the willingness of consumers
to buy that commodity.

LEARNING OUTCOMES

LESSON 1. DEMAND
A. LEARNING OUTCOMES

At the end of the lesson, you will be able to:


1. Define demand.
2. State and explain the law of demand.
3. Create a demand schedule.
4. Graph demand curve.
5. Determine the determinants of demand.

B. TIME ALLOTMENT

1 session = 1.5 hours (90 minutes)

C. DISCUSSION

DEMAND

In economics means a desire to possess good support by willingness and ability


to pay for it.

If you have the desire to buy a certain commodity, say, a tractor, but do not have
an adequate means to pay for it, it will simply be a wish a desire, or a want, and not a
demand.

1
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
LAW OF DEMAND

The law of demand states that other factors being constant (ceteris peribus),
price, and quantity demand of any good and service are inversely related to each other.
When the price of a product increases, the demand for the same product will fall. The
negative relationship between price and quantity demanded.

The law of demand explains consumer choice behavior when the price changes.
In the market, assuming other factors affecting the demand are constant, when the
price of good rises, it leads to a fall in the demand for that good. This is the natural
consumer choice behavior. This happens because a consumer hesitates to spend more
for the good, fearing going out of cash.

The diagram at the side, shows


the demand curve which is
downward sloping. When the
price of the commodity
increases from price p3 to p2,
its quantity demand comes
down from Q3 to Q2 and then
to Q3 and vice versa.

DEMAND SCHEDULE

In economics, a demand schedule is a table that shows the quantity demanded


of a good or service at different price levels. A demand schedule can be graphed as a
continuous demand curve on a chart where the Y-axis represents the price, and the X-
axis represents the quantity.

Individual demand

2
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Refers to the demand for a good or a service by an individual (or a household).
Individual demand comes from the interaction of an individual's desires with the
quantities of goods and services that he or she can afford. By desires, we mean the likes
and dislikes of an individual.

Market Demand

In economics, a market demand schedule is a tabulation of the quantity of a


good that all consumers in a market will purchase at a given price. At any given price,
the corresponding value on the demand schedule is the sum of all consumers’
quantities demanded at that price.

3
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Change in Quantity Demanded vs Change in Demand

A change in quantity demanded refers to a movement along a fixed demand curve --


that's caused by a change in price. A change in demand refers to a shift in the demand
curve -- that's caused by one of the shifters: income, preferences, changes in the price
of related goods and so on.

Note:

A change in demand occurs when the demand curve shifts left or right due to a
determinant of demand.

A change in quantity demanded occurs when there is a movement along the


demand curve itself due to a price change.

4
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
DETERMINANTS OF DEMAND

Determinants of demand are factors that either positively or negatively affect


the demand for a good or service in the market.

The determinants of demand are the non-price determinants of demand.

The determinants of demand are:

1. Consumer taste
2. Number of buyers in the market
3. Consumer income
4. Price of related goods
5. Consumer expectations

Increase/ decrease of demand for a good or service.

5
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
➢ Consumer taste: if consumers like a particular good or service more than
before, the demand curve will shift to the right.

➢ The number of buyers in the market: if the number of buyers in the


market increase, the demand will increase.

➢ Consumer income: if consumers' income increases in the market, the


demand will increase for normal goods.
Inferior goods. Goods for which demand tends to fall when income rises.

➢ Price of related goods:

Substitute good. Goods that can serve as replacements for one another, when
the price of one increase, demand for the other increases.

Complementary goods. Goods that “go together”; a decrease in an increase


in demand for the other and vice versa.
An increase in the price of a substitute good will increase the demand for a
good. A decrease in the price of a complementary good will also increase the
demand for a good.
➢ Consumer expectations: consumer expectations of higher prices in the
future will increase demand today.

6
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
LESSON 2. SUPPLY
A. LEARNING OUTCOMES

At the end of the lesson, you can:


1. Define supply.
2. State and explain the law of supply.
3. Create supply schedule.
4. Graph supply curve.
5. Determine the determinants of supply.

B. TIME ALLOTMENT

1 session = 1.5 hours (90 minutes)

C. DISCUSSION

SUPPLY

Supply is the amount of a resource that firms, producers, laborers, providers


of financial assets, or other economic agents are willing and able to provide to the
marketplace or to an individual.

Supply is defined as the quantity of goods or services that suppliers are willing
and able to provide to customers.

LAW OF SUPPLY

The law of supply states that other factors remaining constant, price and
quantity supplied of a good are directly related to each other.

In other words, when the price paid by buyers for a good rise, then suppliers
increase the supply of that good in the market.

7
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Description: Law of supply depicts the producer behavior at the time of changes in
the prices of goods and services. When the price of a good rises, the supplier increases
the supply in order to earn a profit because of higher prices.

The above diagram shows the supply curve that is upward sloping (positive relation
between the price and the quantity supplied). When the price of the good was at P3,
suppliers were supplying Q3 quantity. As the price starts rising, the quantity supplied
also starts rising.

Supply Schedule
In economics, a demand schedule is a table that shows the quantity
demanded of a good or service at different price levels. A demand schedule can be
graphed as a continuous demand curve on a chart where the Y-axis represents the
price and the X-axis represents the quantity.
A supply schedule shows how much of the product firms will sell at alternative
prices.

Individual supply and market supply


Individual supply is the supply of an individual producer at each price whereas market
supply of the individual supply schedules of all producers in the industry.

8
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Change in Quantity Supplied vs Change in Supply

A change in supply refers to a shift in the entire supply curve, which can happen due
to factors such as changes in production costs or taxes. A change in quantity supplied,
on the other hand, refers to movement along the curve due to changes in price.

9
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Determinants of Supply

Refer to factors that can change or affect how readily a manufacturer is


able to deliver a certain good or service. Determinants of supply may include a
price or non-price variables. These factors impact the supply of commodities in
a positive or negative manner.

1. Prices of resources/inputs/factors or raw materials/Technology


When goods require less inputs (material, money, etc.), they are cheaper to
make, so the supply increases.

2. Taxes and subsidies


If the government imposes regulations, such as increasing taxes, supply will
be reduced. If the government pays the producers in the form of subsidies,
then the supply may increase.
If the government subsidizes the goods more heavily, supply will increase.
If the government increases taxation, supply will decrease.

3. Prices of other goods

10
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
If a similar good is at a higher price AND makes you more profit, the supply
of the original good would fall while the supply of the similar good rises.

Imagine that a firm produces laptops, but also produces alternative goods
like cell phones and televisions. If the prices of cell phones and televisions
go up, then the firm will increase the supply of other goods and decrease the
supply of laptops. This will occur since the firm will want to take advantage
of the higher prices of cell phones and televisions to increase its profit.

4. Producer expectations
If the expected price of a good is greater than the current price, suppliers
will hold back their goods so that they can sell them later at higher prices.
This results in a drop of CURRENT supply.

Usually in the case of manufacturing, if producers expect the price of a


good to increase in the future, producers will increase their supply today.

5. Number of sellers in the market


When more people are making a good, the supply increases. The same would
happen with inferior goods, for more people may make it which results in a
rise of supply.

6. Technology
When a technology makes it cheaper or easier to produce a good, you can
make more. Therefore, the amount of that good that can be produced
increases, and the supply rises.

11
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
LESSON 3. MARKET EQUILIBRIUM
A. LEARNING OUTCOMES

At the end of the lesson, you can:


1. Define market equilibrium.
2. Explain the impact of a change in demand or supply on equilibrium price
and quantity.

B. TIME ALLOTMENT

1 session = 1.5 hours (90 minutes)

C. DISCUSSION

MARKET EQUILIBRIUM

Market equilibrium is a market state where the supply in the market is equal to the
demand in the market. The equilibrium price is the price of a good or service when the
supply of it is equal to the demand for it in the market.

Shortage and Surplus

Excess Demand: the quantity demanded is


greater than the quantity supplied at the given
price. This is also called a shortage.

Excess Supply: the quantity demanded is less


than the quantity supplied at the given price.
This is also called a surplus.

12
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Example: Qd = 16- 2P Qs = 2+5P

Answer: Qd= Qs at a given Price

Solution: 16-2P = 2+5P


16-2 = 5P +2P
14 = 17P
14/7 = 7P/7
2=P

Substitute P:

Qd = 16-2P
= 16- 2( 2) = 16- 4= 12

Qs = 2+ 5P
= 2 + 5( 2) = 2 + 10 = 12

CHANGES IN EQUILIBRIUM
Changes in the equilibrium price occur when either demand or supply, or both, shift
or move.

NOTE:
An increase in demand, all other things unchanged, will cause the equilibrium
price to rise; quantity supplied will increase. A decrease in demand will cause the
equilibrium price to fall; quantity supplied will decrease.

An increase in supply, all other things unchanged, will cause the equilibrium
price to fall; quantity demanded will increase. A decrease in supply will cause the
equilibrium price to rise; the quantity demanded will decrease.

A decrease in demand An increase in Demand

13
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Decrease in supply Increase in supply

Increase in Demand and Increase in Supply

GRAPHS TO REVIEWED

14
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
15
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
LESSON 4. DEMAND AND SUPPLY APPLICATIONS
A. LEARNING OUTCOMES

At the end of the lesson, you can:


1. Apply the principles of demand and supply in real-life situation.
2. Give example of the application of demand and supply.

B. TIME ALLOTMENT

1 session = 1.5 hours (60 minutes)

C. DISCUSSION

DEMAND AND SUPPLY APPLICATIONS

The market system, also called the price system, performs two important and
closely related functions. First, it provides an automatic mechanism for distributing
scarce goods and services. That it serves as a price rationing device for allocating
goods and services to consumers when the quality demanded exceeds the quantity
supplied. Second, the price system ultimately determines bot the allocations f
resources among producers and the final mix of output.

What is Price Rationing?

It is a method of rationing that allocates limited quantities of goods and


services using markets and prices mostly in a free enterprise economy.

Price rationing works like this. If the quantity of a given commodity becomes
increasingly limited, then the price rises. Only the buyers most willing and able to buy
the commodity, and pay the higher prices, obtain the good. The limited quantity is
automatically rationed to the highest bidder.

Back in history, rationing began on 8th January 1940 during the second world
war when bacon, butter and sugar were rationed. By 1942 many other kinds of stuff,
including meat, cheese and cooking fat were also on the ration.

16
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
In the banking sector, credit rationing is used to limit the supply of loans to
consumers.

Currently, the world is experienced a pandemic commonly known as


coronavirus that has shuttered down almost all economies and as such essential goods
such as masks, sanitizers and food are being rationed in many countries by
governments so as to enable their proper distribution.

Conclusively, price rationing provides governments with a way to constrain


demand, and regulate supply and cap prices, but does not totally neutralize the laws of
supply and demand. Black markets often spring out when rationing is in effect. These
allow people to trade rationed goods they may not want for one they do.

A black market, underground economy, or shadow economy is a


clandestine market or series of transactions that has some aspect of illegality or is
characterized by noncompliance with an institutional set of rules. If the rule defines
the set of goods and services whose production and distribution are prohibited by law,
non-compliance with the rule constitutes a black-market trade since the transaction
itself is illegal. Parties engaging in the production or distribution of prohibited goods
and services are members of the illegal economy.

17
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Laws enacted by the government to regulate prices are called price controls. Price
controls come in two flavors. A price ceiling keeps a price from rising above a certain
level—the “ceiling”. A price floor keeps a price from falling below a certain level—the
“floor”.

Price Ceiling

A price ceiling is the mandated maximum amount a seller is allowed to charge


for a product or service. Usually set by law, price ceilings are typically applied to
staples such as food and energy products when such goods become unaffordable to
regular consumers.

A price ceiling can be defined as the price that has been set by the government
below the equilibrium price and cannot be soared up above that.

Price ceilings are typically imposed on consumer staples, like food, gas, or
medicine, often after a crisis or event sends costs skyrocketing.

18
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
The following are some common examples of price ceilings.

1. Rent Ceilings
Some areas have rent ceilings to protect renters from rapidly climbing
rates on residences. Such rent controls are a frequently cited example of the
ineffectiveness of price controls in general and price ceilings in particular.
In the late 1940s, rent controls were widely implemented in New York
City and throughout New York State. In the aftermath of World War II,
homecoming veterans were flocking and establishing families—and rent rates
for apartments were skyrocketing, as a major housing shortage ensued. The
original post-war rent control applied only to specific types of buildings.
However, it continued in a somewhat less restricted form, called rent
stabilization, into the 1970s.
The aim was to help maintain an adequate supply of affordable housing
in the cities. However, the actual effect, critics say, has been to reduce the
overall supply of available residential rental units in New York City, which in
turn has led to even higher prices in the market.

2. Food and Fuel Price Caps


Some governments may cap the prices of essential goods, such as food
and fuel, in order to ensure access to these essential goods and prevent
profiteering. For example, following the Russian invasion of Ukraine, the

19
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
German government pledged to cap energy prices due to the shortage of
Russian natural gas.

3. Cost Caps for Prescription Drugs and Laboratory Tests


In the United States, there is a strong incentive by medical equipment
and drug manufacturers to raise prices, knowing that the increased cost will
most likely fall on taxpayers or insurance companies. In order to prevent
further price rises, president Biden signed the Inflation Reduction Act,
which includes price caps on the negotiated prices of certain drugs.

4. Rideshares
As popularity of Uber and other rideshare services proliferated, these
rideshare services could charge much higher fares during peak hours. This price
variability concerned India, and the Karnataka government decided to
implement the price per kilometer Uber and other rideshares could charge. In
the long-run, the government noted that even though more passengers
demonstrated interest in using rideshare services, passengers often needed to
wait longer to get an Uber because fewer drivers were incentivized.

5. Salary Cap
Popular in professional sports, price ceilings may relate to the maximum
amount a single employee may receive in compensation. Consider the
agreement between the National Basketball Association and the National
Basketball Players Association. The collective bargaining agreement between
the two associations outlines a number of situations where a player is eligible
to receive a maximum salary. Below is a snipped for newer players in the league
with less than seven years of service.

Way to Resolve Price Ceiling Shortage

The shortages created by price ceilings can be resolved in many ways without
increasing the price. Following are the ways that can be used to resolve shortages:

20
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
• First come first serve: This is the most common way of resolving the
shortage, wherein, the person who comes first gets to buy the product.

• A common example of this is the people standing in line at the counter of a


cinema hall to buy the tickets to a movie.

• Lottery: It is a type of lucky draw, where one lucky person who picks, the right
numbers is allowed to make the purchase. The lottery system could be a way to
dole out a product that is facing a shortage.

• For example, some chargers may use this system to determine the persons who
could buy the limited tickets to a special game of football.

• Sellers’ selection: Another way of resolving the shortage due to price ceiling
is allowing sellers to select the buyers to whom they want to sell their products.

• For example, many landlords select renters to rent based on certain criteria
(such as preference for the married couple and without pets).

• Choice of government: On many occasions it is left to the government to


make the selection of buyers.

• For example, to deal with the shortage of gasoline in 1979, the California
government allowed the sale of gasoline to those who had license plates of their
vehicles ending in an odd number on the odd days of the month.

Price Floor

A price floor is said to exist when the price is set above the equilibrium price
and is not allowed to fall. It is used by the government to prevent the prices from hitting
a bottom low.

21
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
A price floor is the lowest legal price that can be paid in markets for goods and
services, labor, or financial capital. Perhaps the best-known example of a price floor is
the minimum wage, which is based on the normative view that someone working full
time ought to be able to afford a basic standard of living.

Price floors are sometimes called “price supports,” because they support a
price by preventing it from falling below a certain level. Around the world, many
countries have passed laws to create agricultural price supports. Farm prices and thus
farm incomes fluctuate, sometimes widely. So even if, on average, farm incomes are
adequate, some years they can be quite low. The purpose of price supports is to prevent
these swings.

The most common way price supports work is that the government enters the
market and buys up the product, adding to demand to keep prices higher than they
otherwise would be.

Way to Resolve Price Floor Shortage

There are some problems due to the surplus (quantity in demand is lesser than
the quantity in supply) created through the price floor. If the surplus exists in the

22
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
market for a long period, the price floor begins to fall below the price of equilibrium,
which can result in market failure. Thus, the government is required to intervene to
avoid the occurrence of surplus. Some of the measures that can be adopted by the
government to deal with the surplus are:

• Purchase of all surplus goods: A way to deal with the surplus is the purchase
of all the surplus goods by the government. The surplus can be sold to other
countries. For example, the US government had bought all the surplus grain in
the US and sold it to Africa.

• Control of production by the government: Another way to control the


surplus is the government’s control over the production. The government can
offer rights of production to some of the selected suppliers. If the government
gives out the rights for production to some suppliers (selected on a specific
criterion) or compensates them for not making any additional supply, then the
unnecessary production of goods can be eliminated.

• Sponsorship of consumption: The government can also sponsor the buyers


by paying a part of the cost. This would help the buyers to buy more of the
surplus.

Supply and Demand and Market Efficiency

Supply and demand curves help explain the way that markets and market prices
work to allocate scarce resources. Recall that when we try to understand “how the
system works,” we are doing “positive economics”.

Supply and demand curves can also be used to illustrate the idea of market
efficiency, an important aspect of “normative economics”.

Consumer surplus. The difference between the maximum amount a person is


willing to pay for a good and its current market price.

Producer surplus. The difference between the current market price


At free market equilibrium with competitive markets, the sum of consumer
surplus and producer surplus is maximized.

The total loss of producer and consumer surplus from underproduction or


overproduction is referred to as deadweight loss.

23
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
When producers overproduce or underproduce, resources are misallocated. This
causes the market to be out of equilibrium and creates a deadweight loss. Deadweight
loss is the inefficiency in the market due to overproduction or underproduction of
goods and services, causing a reduction in the total economic surplus.

24
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
LESSON 5. ELASTICITY

A. LEARNING OUTCOMES

At the end of the lesson, you can:


1. Explain the concept of elasticity; and
2. Express and calculate price elasticity of demand.
3. Discuss the factors that determine the price elasticity of demand.
4. Describe the cross-price elasticity of demand and how it may be used to
indicate whether two goods are substitutes or complements.
5. Explain the income elasticity of demand.

B. TIME ALLOTMENT

1 session = 1.5 hours (90 minutes)

C. DISCUSSION

ELASTICITY
Elasticity refers to the measure of the responsiveness of quantity demanded or
quantity supplied to one of its determinants. Goods that are elastic see their demand
respond rapidly to changes in factors like price or supply. Inelastic goods, on the other
hand, retain their demand even when prices rise sharply (e.g., gasoline or food).

Price elasticity of demand.

The ratio of the percentage of change in


quantity demanded to the percentage of
change in price; measures the
responsiveness of quantity demanded to
change in price.

Formula: Arc vs Point Elasticity

Where: Q = Quantity
P = Price

25
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Midpoint Formula for Elasticity

• To erase the natural bias according to base point, we calculate the elasticity of
demand using the Midpoint Formula given by:

Degrees of Elasticity of Demand

Shape of
Type of
Ed Type of Ed Description Demand
Good
Curve
No change in Qty
Perfectly Essential of Vertical
Ed = 0 demanded due to change in
Inelastic life Straight Line
price

% change in demand < % Necessities Downward


0 < Ed < 1 Inelastic
change in price of life sloping steeper

Unitary % change in demand = % Normal Rectangular


Ed = 1
Elastic change in price goods hyperbola

% change in demand > % Downward


1 < Ed <∞ Elastic Luxuries
change in price sloping flatter

Perfectly Infinite change in demand Imaginary


Ed = ∞ Horizontal
Elastic without any change in price (Under PC)

26
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
The price elasticity of supply is a measure of how sensitive the quantity supplied
of a good is to changes in price. It is calculated as the percentage change in quantity
supplied divided by the percentage change in price.

Supply could be inelastic for the following reasons

• Firms operating close to full capacity.


• Firms have low levels of stocks, therefore there are no surplus goods to sell.
• In the short term, capital is fixed in the short run e.g. firms do not have time to
build a bigger factory.
• If it is difficult to employ factors of production, e.g. if highly skilled labour is
needed
• With agricultural products, supply is inelastic in the short run, because it takes
at least six months to grow new crops. In September the farmer cannot
suddenly produce more potatoes if the price goes up.

27
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Inelasticity of Supply

Examples of goods with inelastic supply

• Nuclear reactors – It takes considerable time and expertise to build a new


reactor. If there is high demand, few firms would be able to increase output in
quick time.
• Grapes – Harvest is once a year, so in short-term, supply would be very
inelastic.
• Flood defenses – If there is heavy rainfall and flooding, there would be high
demand for flood defenses. But, to supply barriers against the floods cannot
occur overnight. It will take many months of construction to build.
• During an economic boom when demand for the goods is very high and firm is
running out.

Supply could be elastic for the following reasons

• If there is spare capacity in the factory.


• If there are stocks available.
• In the long run, supply will be more elastic because capital can be varied.
• If it is easy to employ more factors of production.
• If a product can be sold from the internet which increases the scope of
international competition and increases options for supply.

Examples of goods with elastic supply

• Fidget spinners. These goods are relatively easy to make, requiring only basic
raw materials of plastic. Many manufacturing firms could easily adapt
production to increase supply.
• Taxi services. It is relatively easy for people to work as a taxi driver. People can
work part-time and only need a qualified driving license. With mobile apps like
Uber, it has also become easier to fit consumers with a broader range of
options. If price rises, Uber can offer higher wages and encourage more people
to come out to work. There are still some supply constraints on very popular
days. But, mostly, supply is quite elastic.

28
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
• During recession and excess supply. In a recession with a fall in demand, the
firm will have unsold goods and a large stock.

Income Elasticity of Demand

Income elasticity of demand is an economic


measure of how responsive the quantity
demanded for a good or service is to a change
in income. The formula for calculating
income elasticity of demand is the percentage
change in quantity demanded divided by the
percentage change in income.

Formula:

Thus, the formula required under this method is:

29
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Inferior Goods vs. Normal Goods

Depending on the values of the income elasticity of demand, goods can be broadly
categorized as inferior and normal goods. Normal goods have a positive income
elasticity of demand; as incomes rise, more goods are demanded at each price level.

Normal goods whose income elasticity of demand is between zero and one are typically
referred to as necessity goods, which are products and services that consumers will
buy regardless of changes in their income levels. Examples of necessity goods and
services include tobacco products, haircuts, water, and electricity.

As income rises, the proportion of total consumer expenditures on necessity goods


typically declines. Inferior goods have a negative income elasticity of demand; as
consumers' income rises, they buy fewer inferior goods. A typical example of such a
type of product is margarine, which is much cheaper than butter.

Cross Price elasticity

Cross elasticity of demand refers to the


way that changes in the price of one good can
affect the quantity demanded of another
good. This relationship can vary depending
on whether the two goods are substitutes,
complements, or unrelated to each other.

Formula:

30
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Substitute Goods

The cross elasticity of demand for substitute goods is always positive because
the demand for one good increase when the price for the substitute good increases.
For example, if the price of coffee increases, the quantity demanded for tea (a
substitute beverage) increases as consumers switch to a less expensive yet
substitutable alternative. This is reflected in the cross elasticity of the demand formula,
as both the numerator (percentage change in the demand of tea) and denominator (the
price of coffee) show positive increases. Items with a coefficient of 0 are unrelated
items and are goods independent of each other. Items may be weak substitutes, in
which the two products have a positive but low cross elasticity of demand. This is often
the case for different product substitutes, such as tea versus coffee. Items that are
strong substitutes have a higher cross-elasticity of demand. Consider different brands
of tea; a price increase in one company’s green tea has a higher impact on another
company’s green tea demand.

Complementary Goods

Alternatively, the cross elasticity of demand for complementary goods is


negative. As the price for one item increases, an item closely associated with that item
and necessary for its consumption decreases because the demand for the main good
has also dropped.

For example, if the price of coffee increases, the quantity demanded for coffee
stir sticks drops as consumers are drinking less coffee and need to purchase fewer
sticks. In the formula, the numerator (quantity demanded of stir sticks) is negative
and the denominator (the price of coffee) is positive. This results in a negative cross
elasticity.

Usefulness of Cross Elasticity of Demand

Companies utilize the cross elasticity of demand to establish prices to sell their
goods. Products with no substitutes have the ability to be sold at higher prices because
there is no cross-elasticity of demand to consider. However, incremental price changes
to goods with substitutes are analyzed to determine the appropriate level of demand
desired and the associated price of the good.

31
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)
Elasticity and Total Revenue (summary)

32
WPU-QSF-ACAD-82A Rev. 00 (09.15.20)

You might also like