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Theory of Demand

Demand is defined as the quantity of a commodity that a Consumer is capable of buying and is willing to pay the
given price for it at the given time. The Theory of Demand is a Law that states the relationship between the quantity
demanded of a product and its price, assuming that all the other factors affecting the Demand are constant.
According to the Law of Demand Theory, the quantity demanded of a commodity is inversely related to its price in
the market. Through this article, we will try to comprehend the Theory of derived Demand, the factors affecting
Demand, the Demand curve and the application of Demand Theory.

Factors Affecting Demand

After having discussed the Theory of Demand economics and the Theory of derived Demand, we will now talk
about the various factors affecting the quantity Demanded of a product.

1. Price of the Commodity: As stated in the Law of Demand Theory, the price of a commodity shows an
inverse relationship with its quantity Demanded. As the price of the product falls, its Demand increases.
2. The Number of Consumers: It is directly related to the quantity Demanded of a commodity. The more the
number of Consumers, the more is the Demand for that product.
3. Price of Related Goods: There are two types of related goods: Substitutes and Complementary goods. For
example, for milk, the juice is a substitute whereas biscuits are complementary products. If the prices of
milk fall, the Demand for juice (substitute) will increase and that for biscuits (complementary goods) will
lessen.
4. Income: With the increment in a Consumer’s income, he will become capable of buying more of a
particular commodity, and thereby, his Demand will also rise.
5. Consumer Expectation: If a Consumer expects that the price of a certain commodity will go up in the
future, he will buy more of that product at present, which will lead to a hike in its Demand.
6. Tastes and Preferences: It has a direct relation with the quantity Demanded.

Theory of Demand
7. Demand theory is a principle that emphasizes the relationship between consumer demand and the price for
goods and services within a market. It can also be illustrated as the demand curve, which is downwards
sloping in a horizontal manner, as the price of the good decreases as quantity increases. Vice-versa, where
the price of the good increases as the quantity decreases.
Ultimately, when applying the supply curve together, the equilibrium price shifts accordingly. Essentially,
demand theory highlights the consumer’s perspective, while supply focuses on the business’s point of view.

Understanding Demand Theory

Demand is the quantity of a good or service the consumer is willing to purchase at specific prices during a time
period. The demand for a good at a certain price generally reflects the consumer’s willingness to pay and
expectation for consuming that product. The goods indeed range in price, from necessities to luxuries.

For example, regarding necessities, people need food, healthcare, clothing, entertainment, shelter, and water across
all welfares. The price of the goods tends to be fairly affordable for most individuals. Whereas, designer bags, for
example, tend to be priced at a premium, as such goods are considered wants and are not required to continue to live
a healthy life.

The demand for a good or service is generally driven by two factors – utility and ability to pay for the good or
service.

The two aspects coincide with one another. Demand happens when a good or service yields some level of utility
while being backed by the ability, which ultimately provides satisfaction to the consumer.
Demand aims to convey how bad people wish to purchase specific goods, along with how much is bought based on
their income levels and utility. Based on the satisfaction that the good provides, companies adjust their supply level
accordingly, which changes prices.

For example, if a good is extremely popular and with high utility, companies will first see a scarce supply, shifting
the supply curve and raising prices. However, over time, they will increase production, shifting the supply curve
back to its original position, bringing the price back down.

Types of Demand

1- Individual Demand

2- Market Demand

Individual Demand

The individual demand is the demand of one individual or firm. It represents the quantity of a good that a single
consumer would buy at a specific price point at a specific point in time. While the term is somewhat vague,
individual demand can be represented by the point of view of one person, a single family, or a single household.

Market Demand

Market demand provides the total quantity demanded by all consumers. In other words, it represents the
aggregate of all individual demands. There are two basic types of market demand: primary and selective.
Primary demand is the total demand for all of the brands that represent a given product or service, such
as all phones or all high-end watches. Selective demand is the demand for one particular brand of
product or service, such as the iPhone or a Michele watch.

Kinds of Demand

1. Price demand:

Price demand refers to the different quantities of the commodity or service which consumers will purchase at a

given time and at given prices, assuming other things remaining the same. It is the price demand with which people

are mostly concerned and as such price demand is an important notion in economics. Price demand has inverse

relation with the price. As the price of commodity increases its demand falls and as the price decreases, its demand

rises.

2. Income demand:

Income demand refers to the different quantities of a commodity or service which consumers will buy at different

levels of income, assuming other things remaining constant. Usually the demand for a commodity increases as the

income of a person increases unless the commodity happens to be an inferior product. For example, coarse grain is a

cheap or inferior commodity. The demand for such commodities decreases as the income of a person increases.

Thus, the demand for inferior or cheap goods is inversely related with the income.
3. Cross demand:

When the demand for a commodity depends not on its price but on the price of other related commodities, it is

called cross demand. Here we take closely connected or related goods which are substitutes for one another.

For example, tea and coffee are substitutes for one another. If the price of coffee rises, the consumer will be induced

to buy more of tea and, hence, the demand of tea will increase. Thus in case of substitutes, when the price of one

related commodity rises, the demand of the other related commodity increases and vice-versa.

4. Direct demand:

Commodities or services which satisfy our wants directly are said to have direct demand. For example, all consumer

goods satisfy our wants directly, so they are said to have direct demand.

5. Derived demand or Indirect demand:

Commodities or services demanded for producing goods which satisfy our wants directly are said to have derived

demand. For example, demand for a factor of production (say labor) is a derived demand because labor is demanded

to help in the construction of houses which will directly satisfy consumers’ demand.

Thus, the demand for labor which helps us in making a house in a case of indirect or derived demand. The demand

for labor is called derived demand because its demand is derived from the demand of a house.

6. Joint demand:

In finished products as in case of bread, there is need for so many things—the services of the flour mill, oven, fuel,

etc. The demand for them is called joint demand. Similarly for the construction of a house we require land, labor,

capital, organization and materials like cement, bricks, lime, etc. The demand for them is, thus, called a ‘joint

demand.’

7. Composite demand:

A commodity is said to have a composite demand when its use is made in more than one purpose. For example the

demand for coal is composite demand as coal has many uses—as fuel for a boiler of a factory, for domestic fuel, for

oven for steam-making in railways engine, etc.

Determinates of Demand
Some of the important determinants of demand are as follows,

1] Price of the Product

People use price as a parameter to make decisions if all other factors remain constant or equal. According to the law of
demand, this implies an increase in demand follows a reduction in price and a decrease in demand follows an increase in
the price of similar goods.

The demand curve and the demand schedule help determine the demand quantity at a price level. An elastic demand
implies a robust change quantity accompanied by a change in price. Similarly, an inelastic demand implies that volume
does not change much even when there is a change in price.

2] Income of the Consumers

Rising incomes lead to a rise in the number of goods demanded by consumers. Similarly, a drop in income is
accompanied by reduced consumption levels. This relationship between income and demand is not linear in nature.
Marginal utility determines the proportion of change in the demand levels.

3] Prices of related goods or services

 Complementary products – An increase in the price of one product will cause a decrease in the quantity
demanded of a complementary product. Example: Rise in the price of bread will reduce the demand for butter.
This arises because the products are complementary in nature.

 Substitute Product – An increase in the price of one product will cause an increase in the demand for a substitute
product. Example: Rise in price of tea will increase the demand for coffee and decrease the demand for tea.

4] Consumer Expectations

Expectations of a higher income or expecting an increase in prices of goods will lead to an increase the quantity
demanded. Similarly, expectations of a reduced income or a lowering in prices of goods will decrease the quantity
demanded.

5] Number of Buyers in the Market

The number of buyers has a major effect on the total or net demand. As the number increases, the demand rises.
Furthermore, this is true irrespective of changes in the price of commodities.

Meaning of Demand:
In traditional economics it is often assumed that the only factor that affects the quantity of a good or service
purchased is its price.

But economists, while stressing the importance of price, also recognise that a host of factors determine the quantity
of a goods or service demanded by consumers during a given period. But, in order to keep the analysis simple,
economists lay stress on the more important influencing forces and ignore those that have little or no effect.

In this context, one may note that demand implies something more than a need or want. In economics, demand does
not just refer to the desire (willingness) to buy a commodity. For example, the desire to buy Maruti cars is universal.
But such desire carries no significance unless they are backed up by purchasing power (i.e., capacity to pay).
Thus, in addition to a need or want, an individual must have purchasing power in order to satisfy that need or want.
Thus demand for a commodity refers to the quantity of the commodity consumers are willing to buy (at each of the
several prices at a particular time or under given conditions) and ready to pay for.

As a general rule, economists assume that the quantity of a good or service that individuals are willing and
able to purchase during a fixed period of time depends upon five major variables:
(1) The price of the good itself,

2) The income of the buyers,

(3) The prices of related goods and services,

(4) The expected price of the good in future periods, and

(5) The tastes of the consumers.

Consumers are desirous and capable of buying more of a good the lower the price of the good, when the other
variables are held constant (i.e., the ceteris paribus). This important relation is called the law of demand.

The market demand schedule may be expressed in tabular form, and it can be graphed. When a demand schedule is
graphed, it is often called a demand curve.

Laws of Demand:
The inverse relationship between the price of a good and the quantity of it demanded is observed in reality with such
regularity that it is known as the law of demand. This observed regularity means that the law of demand is an
empirical (statistical) law. An algebraic expression of the relationship between price and quantity demanded is
known as a demand function.

The law of demand holds because, when the price of a good increases, consumers tend to buy less of it and more of
other goods. The converse is also true. In the event of a fall in the price of a good, consumers tend to buy more of
that good in place of other goods that are now relatively more expensive.

Next we may look at income changes. If we hold the other variables constant, an increase in income can cause the
quantity demanded of a commodity either to increase or to decrease. If an increase (a decrease) in income causes
quantity demanded to increase (decrease) we refer to such a commodity as a ‘normal’ good, that is, in which case
income and sales vary directly.
However, there are commodities the quantities demanded of which may fall when income rises, other variables held
constant. These types of commodities are known as ‘inferior’ goods.

Commodities are related in consumption in either of two ways: as substitutes or complements. In general, goods are
substitutes if one good can be used in the place of the other; an example might be Maruti cars and Fiat cars. If two
goods are substitutes, an increase in the price of one good will increase the quantity purchased of the other (holding
the price of the good under consideration constant).

If the price of Maruti Car rises while the price of Fiat car remains constant, we would expect consumers to purchase
more Fiat cars. A fall in the price of a substitute good will reduce the quantity purchased of the other good.

For example, if the price of tea falls, we would expect the quantity of coffee purchased to fall, given a constant price
of coffee. Goods are said to be complementary if they are used in conjunction with each other.

Examples might be tennis racket and tennis ball or cars and petroleum. An increase in the price of either of the
complementary goods will lead to fall in the quantity demanded of the other goods, the price of the other good held
constant.

However, all commodities are not necessarily either substitutes or complements in consumption. Various
commodities are essentially independent. For example, one cannot expect the price of butter to significantly
influence the sales of shoes. Thus, we can treat these commodities as independent and ignore the price of butter
when evaluating the demand for shoes.

Expectations of consumers also influence the quantity demanded of a commodity. To be more specific, consumers’
expectations about the future price of the commodity can change their current purchases.

If consumers expect the price to be higher in a future period, sales would probably tend to rise in the current period.
On the contrary, expectations of a price drop in the future would cause some purchases to be postponed; thus sales in
the current period will fall.

Finally, a change in taste or preferences can change the quantity demanded of a commodity, the other variables held
constant. Clearly, changes in taste and preferences could either increase or decrease sales of a product such as
readymade garments.

Since it is difficult to measure taste, economists normally take this variable as constant. However, this factor is very
important in understanding the effects of advertising, which shifts demand from one product to another.
We can express the function describing the quantity that consumers are willing and able to purchase during a
particular time period as:

The Demand Function:

The demand function shows the relation between the quantity demanded of a commodity by the consumers and the
price of the product. These functions are probably the most important tools used by economists. While many
variables determine the quantity consumers wish to purchase in a market, the price of the commodity is perhaps the
most important one.

In this context, we may distinguish between individual demand and market demand. The former refers to the
quantity of a good that an individual stands ready to buy at each of several prices, at a particular time, under given
conditions.

The latter consists of the total quantity of a good that would be bought in the aggregate by individuals and firms, at
each of the various prices, at a fixed point of time. The demand schedules may be graphed or shown in a tabular
form. When a demand schedule is graphed, it is called the demand curve.

following definition of a demand function:

A demand function is a list of prices and the corresponding quantities that individuals are willing and able to buy at
a fixed point of time. We may note at the outset that demand is a function (or schedule), not a specific quantity. It is
formally defined as a schedule of the total quantities of a commodity or service that will be purchased at various
prices at a particular point of time.

Hence when we refer to the demand for meat or the demand for motors cars in India, we are considering the
amounts that consumers are willing and able to purchases at various prices.
The word ‘demand’ is a broad concept referring to the entire schedule of quantities and prices. But the term
‘quantity demanded’ refers to a single point on the demand schedule or curve. It shows the maximum quantity
demanded at a particular price.

We generally specify consumer demand in any of the three ways: as a schedule, a graph, or a function. A typical
market demand schedule is shown in Table 6.1. This table shows the list of prices and the corresponding quantities
that the consumers demand per unit of time (say, a day or a week).

Quite often it is more convenient to work with the graph of a demand schedule, called a demand curve, rather than
with the schedule itself. Figure 6.1 shows the demand curve which is a graphical representation of the demand
schedule presented in Table 6.1. Each price-quantity combination — (Rs. 6, 2,000), (Rs. 5, 3,000), and so on — is
plotted. The locus of such points (each one showing a particular combination of p and q) DD’ is the demand curve.

The demand curve indicates the quantity of the good consumers are willing and able to buy at a fixed point of time
at alternative prices, i.e., at every price from Rs. 6 to Re. 1. Since price and quantity demanded are inversely related,
the curve slopes downward.
Indeed, all market demand curves (which are arrived at by adding up demand curves of individual consumers) are
downward sloping because of the law of demand. Individuals purchase less when price rises. Furthermore, as price
increases, some individuals do not purchase anything at all, again causing the quantity demanded at each price to
fall.

Alternatively, we can express demand as a function

Qx = ƒ(Px)
In this function, the other variables (income, and so on) are held constant. The quantity demanded of a commodity is
a function of the price of the good, holding constant the other (proximate) determinants of demand.

Substitution and Income Effects of a Price Change:

When the price of a good falls and price of other goods are unchanged, buyers in a market respond under the
influence of two different (separate) effects.

Firstly, consumers may substitute other goods by the good whose price has fallen.

Secondly, consumers are able to buy greater quantities of this good (and of other relatively more expensive goods)
with the same income, which is equivalent to an increase in real income.

These two effects of a lower price are called, respectively, the substitution effect and the income effect. The effects
are normally reinforcing since both tend to encourage consumers to buy a larger quantity when price falls. There are
also substitution and income effects of a rise in price, but, of course, the effects normally encourage consumers to
buy less, not more, when the price is raised.

Let us consider a rise in the market price of wheat. The higher price of wheat will effect consumers in two ways.

Firstly, consumers experience the substitution effect since some will substitute rice and other products for wheat
products that are now comparatively more expensive.

Secondly, consumers experience an income effect since they are relatively poorer as the result of an equivalent de-
crease in real income or purchasing power.

Consumers may buy less of many goods, including wheat products. The two effects normally go hand in hand,
which simply means that each one encourages consumers to buy a lesser quantity of wheat products when the price
of wheat rises.
Exceptions to the Empirical Law of Demand:
There are certain exceptions to the Law of Demand. Firstly, we observe that, in some cases, consumers buy more
when price is high than when it is low. In fact, when consumers lack complete knowledge of a product, they take
price as the index of quality such as costly watches or nasal spray or car wax. However, this is not a true exception
to the Law of Demand.

Another possible exception occurs in case of items having snob appeal. Jewellery and costly dresses, for instance,
are often purchased because they are expensive. Buyers of such goods derive psychic satisfaction from the fact that
they cannot be afforded by people with lower incomes to whom the buyers wish to be superior.

There are, however, goods that have unusual income effects. The substitution effect is always negative, implying
that “when the price of a good rises relative to other goods that satisfy more or less the same needs or desires, the
relatively low- priced good is substituted for the relatively higher-price goods”.

By contrast, income effect may be negative or positive and may reinforce or be in conflict with the substitution
effect depending on the nature of the commodity under consideration.

When an increase in income leads to increased consumption of a good, it is called a normal (superior) good. Most
commodities that we consume in real life fall in this category. On the other hand when an increase in the income of
buyers leads to a fall in the consumption of a good it is called an inferior good. Inferior goods are those that have a
preferred but more expensive substitute.

As income rises, consumers can afford more of the expensive substitutes. For example, white bread may be
preferred to ordinary bread, cigarettes to bidis or costly soaps and perfumes to low priced ones.

Income effect is positive in case of normal goods and negative in case of inferior goods. True exceptions to the law
of demand will materialize only if the negative income effect of an inferior good outweighs the substitution effect
(which is always negative). This condition is unlikely to be fulfilled in the real world. At present there is no such
example. Hence it is a rare exception to the Law of Demand.

The reason for this is easy to find. It is quite unlikely for a fall in the price of a good to increase consumer’s real
income (or purchasing power) substantially or for an increase to reduce real income drastically.

For instance, if one representative consumer had an annual income of Rs. 50,000 and found that the price of a
package of shaving blades purchased once a week had fallen from Rs. 1 to 50 p., the saving of Rs. 26 per year is
certainly the equivalent of an increase in the real income. But the increase is very slight.
Moreover, the effect of the ‘marginal’ increase in his real income from a change in price of a single good would be
small, if not negligible. Thus, it would seem that “the change in real income from most relevant price changes in
the case of inferior goods makes it most unlikely that the income effect from a change in the price of an
inferior good would out-weight the substitution effect and thus cause a demand curve to slope upward”.
However, such cases are possible in theory at least. In 19th century, Sir Robert Giffen of Britain noted, for example,
that “by far bread was the cheapest food in the diets of the poorest labouring families in England. When the price of
bread rose, he pointed out, it so drained the resources of these poor families that they were forced to curtail their
meager consumption of meat and the more expensive ‘farinaceous’ foods. Bread was still the cheapest food that they
could get and would like. So to replace the calories lost from meat, they consumed more and not less bread even
after the rise in the price of bread”.

This phenomenon illustrates a perverse demand relation and is popularly known as Giffen’s Paradox.

Shifts in Demand:
From our earlier discussion we know that price is not the sole determinant of the amount of the commodity
consumers wish to purchase. Obviously, the amount of carrot or number of motor cars consumers wish to purchase
during a given period depends on other variables, including income, the price of related goods and so on.

In other words, changes in these other variables could cause changes in the quantity demanded at each price, i.e.,
they change (shift) the demand curve to a new position. We refer to these other variables as the determinants of
demand since they determine exactly where the demand function will be located.

As we noted earlier when we plot a demand curve like the one in Figure 6.1, we make the assumption that all other
things remain unchanged during the period under consideration.

The other things are:

(1) Buyers incomes (and the pattern of income distribution among buyers),

(2) The prices of related goods (i.e., substitutes and complements),

(3) Price expectations, and

(4) Tastes.

Change in any other variable will cause change in demand. Demand is said to increase or decrease only if one (or
more) of the determinants of demand changes. For example, if incomes of consumers increase and they wish to buy
a larger quantity of a good at each price than they did before, the demand for the good is said to have increased.
That is, consumers demand more at each price in the list of prices. If the change in income causes consumers to
demand less of the good than before at each price then demand is said to have decreased. This happens in case of
inferior goods.

Thus, in any discussion of the principles of supply and demand it is customary to distinguish between:
(1) Changes in quantity demanded of a commodity due to a change in its own price, and

(2) Changes (shifts) in demand due to changes in one or more of the determinants of demand (e.g., income).

Figure 6.2 might make this difference clear.

In Figure 6.2, the original demand curve is given by D0D’0. Given this demand curve, at a price of Rs. 12 the
quantity demanded by all consumers is 2,100 units. If price falls from Rs. 12 to Rs. 8, the quantity demanded will
increase to 2,500 units. Changes in quantity demanded are caused only by changes in the price of the product itself
and are reflected in movements along the same demand curve.
Now, starting from the same demand curve D0D’0, we may consider a change in demand. Let us suppose that income
falls and the commodity under consideration is a normal good. Consumers will now demand less of the commodity
at each price. The demand for the product will fall as is illustrated by the leftward shift of the demand curve from
D0D’0 to D1D’1 in Figure 6.2.
At each price, quantity demanded is less than before, e.g., at a price of Rs. 12 per unit the quantity demanded is now
1,000 units. In this example, the fall in the amount consumers are willing and able to purchase (from 2,500 to 1,000
at a price of Rs. 12 per unit) is the result of a change in demand.

By contrast, an increase in demand would be as illustrated by the rightward shift of the demand curve from D0D’0 to
D2D’2 in Figure 6.2.
In either case, changes in demand are caused by changes in one or more of the determinants of demand (income,
prices of related goods, price expectations, and taste). Changes in demand are shown in shifts of the demand curve,
either to the right (for an increase in demand) or the left (for a decrease in demand).

We may now have a more specific look at the effect of changes in the various determinants of demand, starting with
income. We have just noted that an increase in income causes consumers to demand more of the good at every price,
provided the good is a normal good. If the good is inferior, consumers will demand less of the good at every price
after an increase in income.

Thus, an increase in income increases the demand (shifts the curve rightward) for a normal good but decreases the
demand (shifts the curve leftward) for an inferior good. The converse is also true; a decrease in income will decrease
(increase) the demand for a normal (an inferior) good.

If goods A and B are substitutes, an increase in the price of good B will cause an increase in the demand for A. For
example, if the price of Fiat Car increases by Rs. 5,000, we would expect consumers to demand more Ambassador
cars for each relevant price. If two goods are substitutes, an increase (decrease) in the price of one will cause the
demand for the other to increase (decrease).

On the contrary, if two goods are complements, an increase in the price of one good will decrease the demand for
the other. For example, since bread and butter and usually consumed together, they may be treated as complements.

If the price of butter rises, consumers are likely to demand less bread at each price, because the good used with
bread is now more expensive. In case of two complementary goods the price of one good rises (falls), we would
expect the demand for the other to decrease (increase).

Consumer demand is also affected by price expectations, i.e., expectations regarding future prices. Thus when the
price of a good is expected to increase (decrease) in the future, the demand for the good in the current period will
increase (decrease).

For example, widespread consumer expectation that prices of VCRs will fall in near future will cause some
consumers to postpone purchasing a VCR and, therefore, cause a decrease in the current demand for VCRs.

It is extremely difficult to quantify tastes. We can only say that if something causes consumer’s tastes to change
toward (away from) a particular good, the demand for that good will increase (decrease). For example, if consumers
gradually develop a taste for coffee the market demand for tea will fall.
In Table 6.2, we summaries the effects of selected changes on the market demand for a good say, x. The basic point
to note is that the demand schedule or curve for good x is not changed or shifted by a change in its own price. The
demand curve for good x is changed or shifted in response to change in any variable other than a change in its own
price.

Demand Schedule
A demand schedule is a tabular arrangement of different prices of a product or service and its quantity at various
prices during a specific period. Examining the price and quantity demanded momentum in the table will reveal if
demand is elastic or inelastic.
Plotting the data in the table on a graph depicts the demand curve, representing the connection between price and
quantity desired. It frequently represents the law of demand, which asserts that demand rises when prices fall and
vice versa if all other factors influencing demand stay constant.

The demand schedule in economics shows the correlation between price and demand. For elastic goods,
the quantity demanded changes as the price changes, and the price and demand move in different directions at a
significant pace. Compared to elastic goods, the change in demand in response to the price change will be gradual
for inelastic goods. In the case of perfectly inelastic demand, the quantity sought does not vary in response to price
changes; it remains constant.
The core of the schedule is two columns. The first column represents an asset’s different prices, like the values
during a whole year and the second column represents the quantity demanded corresponding to the listed prices.
Altogether, the table presents a list of price and demand pairs disclosing the quantity preference in the market at a
different price level. It is categorized into two types; Individual demand schedule representing the quantities
demanded by a single entity at different prices, and market demand schedule representing the preferences of
multiple entities or the total market.

Practical Example

Let’s look into a demand schedule example to understand how it works.

Corey works as a manager for a car rental firm in the United States. He wants to see the link between the price of car
rental services and how much they sell. According to the schedule, when they provided a car rental package for $5
per day, 610 customers took advantage of the service. However, he did find that increasing the price reduces the
number of people who use the service. Only 460 individuals will purchase if the service costs $10, and 270 if the
company charges $20. Customers will explore alternatives if they perceive it as pricey, may be overpriced, and
unappealing.

The following table shows the changes in price and demand:

Market Demand Schedule

Price ( $) Quantity Demanded
(Units)
5.00 610
10.00 460
15.00 350
20.00 270
25.00 220
30.00 180
35.00 150

These prices can be put into perspective using a demand curve: The Y-axis will represent the price, while the X-
axis will represent the demand.
Note: Demand curve draw here

After visualizing the data, Corey can see that it’s not good to increase the price or continue the business after a
certain point. Otherwise, he can use the information he organized to determine the best price. In the end, his decision
will be based on which option is more profitable while still retaining enough demand. He will try to maximize the
value of the service without losing the clients.

Demand and Supply Schedule

As the name signifies, the supply schedule portrays data in a table revealing how the supply of a product or service
moves with changes in the price, unlike the demand schedule depicting the relationship between demand and price.
Generally, a supply schedule indicates a positive correlation between price and supply. In contrast, a demand and
price table reveals the inverse correlation between price and demand. Thus, it is easy to derive an upward
sloping supply curve from the supply schedule. In the same way, the demand schedule yields a downward sloping
demand curve.
A supply schedule shows how much a supplier can offer to the market at a specific price. The larger the production
establishment is, the lower the price will be. When significant factors like the cost of inputs remain constant, large-
scale production essentially makes the products cheaper to produce, so producers can sell them on the market for a
lower value and beat competitors.

Limitations

While these demand and price representations are a handy guide, they have a few limitations. For instance, the law
of demand focuses on price and demand. However, several other factors may cause changes in the demand, like
weather patterns, supply issues, and even sudden societal changes such as a pandemic. For example, amid the Covid
19 outbreak, airlines’ demand and supply historical data are drastically different. As a result, a demand schedule
and demand curve based on past information is no longer applicable for future estimates to manage airline pricing.

Other factors may impact the consumers directly, too. They can include people’s level of income, personal tastes,
preference for luxury goods, the impact of advertising, age, etc. Therefore, if these factors are at play, the whole
demand curve may shift, causing economists to calculate everything again because of the new circumstances.
Elasticity of Demand and its measurement

Elasticity of Demand, or Demand Elasticity, is the measure of change in quantity demanded of a product in

response to a change in any of the market variables, like price, income etc. It measures the shift in demand

when other economic factors change.

In other words, the elasticity of demand is the percentage change in quantity demanded divided by the

percentage change in another economic variable.

The demand for a commodity is affected by different economic variables:

1. Price of the commodity

2. Price of related commodities

3. Income level of consumers

3 Types of Elasticity of Demand

On the basis of different factors affecting the quantity demanded for a product, elasticity of demand is categorized

into mainly three categories: Price Elasticity of Demand (PED), Cross Elasticity of Demand (XED), and Income

Elasticity of Demand (YED).

Let us look at them in detail and their examples.

1. Price Elasticity of Demand (PED)

Any change in the price of a commodity, whether it’s a decrease or increase, affects the quantity demanded for a

product. For example, when there is a rise in the prices of ceiling fans, the quantity demanded goes down.

This measure of responsiveness of quantity demanded when there is a change in price is termed as the Price

Elasticity of Demand (PED).

The mathematical formula given to calculate the Price Elasticity of Demand is:
PED = % Change in Quantity Demanded % / Change in Price

The result obtained from this formula determines the intensity of the effect of price change on the quantity

demanded for a commodity.

2. Income Elasticity of Demand (YED)

The income levels of consumers play an important role in the quantity demanded for a product. This can be

understood by looking at the difference in goods sold in the rural markets versus the goods sold in metro cities.

The Income Elasticity of Demand, also represented by YED, refers to the sensitivity of quantity demanded for a

certain good to a change in real income (the income earned by an individual after accounting for inflation) of the

consumers who buy this good, keeping all other things constant.

Speaking of inflation, you can also take a look at our blog on what is inflation.

The formula given to calculate the Income Elasticity of Demand is given as:

YED = % Change in Quantity Demanded% / Change in Income

The result obtained from this formula helps to determine whether a good is a necessity good or a luxury good.

3. Cross Elasticity of Demand (XED)

In a market where there is an oligopoly, multiple players compete. Thus, the quantity demanded for a product does

not only depend on itself but rather, there is an effect even when prices of other goods change.
Cross Elasticity of Demand, also represented as XED, is an economic concept that measures the sensitiveness of

quantity demanded of one good (X) when there is a change in the price of another good (Y), and that’s why it is also

referred to as Cross-Price Elasticity of Demand.

The formula given to calculate the Cross Elasticity of Demand is given as:

XED = (% Change in Quantity Demanded for one good (X)%) / (Change in Price of another Good (Y))

The result obtained for a substitute good would always come out to be positive as whenever there is a rise in the

price of a good, the demand for its substitute rises. Whereas, the result will be negative for a complementary good.

These three types of Elasticity of Demand measure the sensitivity of quantity demanded to a change in the price of

the good, income of consumers buying the good, and the price of another good.

Apart from these three types, we have some other types of Elasticity of Demand which we would look at now.

Also, take a sneak peek at our blog on 5 key elements of financial analysis

5 other types of Elasticity of Demand

The effect of change in economic variables is not always the same on the quantity demanded for a product.

The demand for a product can be elastic, inelastic, or unitary, depending on the rate of change in the demand with

respect to the change in the price of a product.

On the basis of the amount of fluctuation shown in the quantity demanded of a good, it is termed

as ‘elastic’, ‘inelastic’, and ‘unitary’.

 An elastic demand is one that shows a larger fluctuation in the quantity demanded of a product, in response to even

a little change in another economic variable. For example, if there is a hike of $0.5 in the price of a cup of coffee,

there are very high chances of a steep decline in the quantity demanded.
 An inelastic demand is one that shows a very little fluctuation in the quantity demanded with respect to a change in

another economic variable. An example of this can be petrol or diesel.

 Unitary elasticity is one in which the fluctuation in one variable and quantity demanded is equal.

We can further classify these elastic and inelastic types of demand into five categories.

Demand Curves

1. Perfectly Elastic Demand

When there is a sharp rise or fall due to a change in the price of the commodity, it is said to be perfectly elastic

demand.

In perfectly elastic demand, even a small rise in price can result in a fall in demand of the good to zero, whereas a

small decline in the price can increase the demand to infinity.

However, perfectly elastic demand is a total theoretical concept and doesn’t find a real application, unless the market

is perfectly competitive and the product is homogenous.

The degree of elasticity of demand helps to define the slope and shape of the demand curve. Therefore, we can

determine the elasticity of demand by looking at the slope of the demand curve.

A Flatter curve will represent a higher elastic demand. Thus, the slope of the demand curve for a perfectly elastic

demand is horizontal.
2. Perfectly Inelastic Demand

A perfectly inelastic demand is the one in which there is no change measured against a price change.

Like perfectly elastic demand, the concept of perfectly inelastic is also a theoretical concept and doesn’t find a

practical application. However, the demand for necessity goods can be the closest example of perfectly inelastic

demand.

The numerical value obtained from the PED formula comes out as zero for a perfectly inelastic demand.

The demand curve for a perfectly inelastic demand is a vertical line i.e. the slope of the curve is zero.

3. Relatively Elastic Demand

Relatively elastic demand refers to the demand when the proportionate change in the demand is greater than the

proportionate change in the price of the good. The numerical value of relatively elastic demand ranges between one

to infinity.

In relatively elastic demand, if the price of a good increases by 25% then the demand for the product will necessarily

fall by more than 25%.

Unlike the aforementioned types of demand, relatively elastic demand has a practical application as many goods

respond in the same manner when there is a price change.

The demand curve of relatively elastic demand is gradually sloping.

Demand Curves

4. Relatively Inelastic Demand

In a relatively inelastic demand, the proportionate change in the quantity demanded for a product is always less than

the proportionate change in the price.

For example, if the price of a good goes down by 10%, the proportionate change in its demand will not go beyond

9.9..%, if it reaches 10% then it would be called unitary elastic demand.

The numerical value of relatively inelastic demand always comes out as less than 1 and the demand curve is rapidly

sloping for such type of demand.

Recommended Read: Microeconomics vs Macroeconomics

5. Unitary Elastic Demand

When the proportionate change in the quantity demanded for a product is equal to the proportionate change in the

price of the commodity, it is said to be unitary elastic demand.

The numerical value for unitary elastic demand is equal to 1. The demand curve for unitary elastic demand is

represented as a rectangular hyperbola.

Conclusion

We can conclude the blog by stating the fact that the demand for a commodity is affected by several factors and the

three main types of elasticity of demand explains the effect of those factors.

To explain the extent of the effect of the economic variables on the quantity demanded, we have 5 other types of

elasticity of demand which are perfectly elastic, perfectly inelastic, relatively elastic, relatively inelastic, and unitary

elastic.
Use of Elasticity of Demand in Business Management Problems
Elasticity of demand refers to the sensitivity of quantity demanded with respect to changes in another outside
factor. There are many types of elasticity of demand. The one most relevant to businesses, however, is the price
elasticity of demand, which measures the change in demand as a result of a change in price. Different products
exhibit different elasticities, which in turn has an influence on a firm's pricing decisions.

The Price Elasticity of Demand

In economics, the demand for a certain good or service is represented by the demand curve. The demand curve is
plotted on a graph with price labeled on the y-axis and quantity labeled on the x-axis. The resulting curve is
downward-sloping; thus, increases in price result in a fall in demand for a given product. Just the amount by
which demand falls with an increase in price is measured by the price elasticity of demand; the price elasticity of
demand is measured by the percentage change in quantity demanded divided by the percentage change in price.

Analyzing the Price Elasticity of Demand

After calculating the price elasticity of demand, one of five results may be obtained. An elasticity equal to one is
said to be unit elastic; that is, any change in price is matched by a change in quantity demanded. An elasticity of
between zero and one is said to be relatively inelastic, when large changes in price cause small changes in
demand. An elasticity equal to zero is said to be perfectly inelastic, when a change in price does not change the
quantity demanded.

A relatively elastic good is where elasticity lies between one and infinity, and a small change in price results in a
relatively large change in demand. The last category is that of a perfectly elastic good, when a minute change of
price results in an infinitely large change in demand.

Applying the Price Elasticity of Demand

The price elasticity of demand for a certain good or service has considerable implications for businesses. If an ice
cream shop, for example, were to increase the price of vanilla ice cream by 10 percent, and if demand fell by 5
percent as a result, management would then know that the price elasticity of demand for that particular good was
elastic. But if they also increased the price of their top-selling flavor, chocolate, by the same amount, and if prices
remained the same, then they would have a relatively inelastic product. Thus, elasticities differ with respect to
variety of product in question. Businesses must therefore make pricing decisions based on these elasticity
assumptions.

Impact on Business Management Problems

Price elasticity of demand affects a business's ability to increase the price of a product. Elastic goods are more
sensitive to increases in price, while inelastic goods are less sensitive. Assuming that there are no costs in
producing the product, businesses would simply increase the price of a product until demand falls. Things
become more complicated, however, after introducing costs.

Demand Forecasting : Significance and methods

An organization faces several internal and external risks, such as high competition, failure of technology, labor
unrest, inflation, recession, and change in government laws.
Therefore, most of the business decisions of an organization are made under the conditions of risk and uncertainty.

An organization can lessen the adverse effects of risks by determining the demand or sales prospects for its products
and services in future. Demand forecasting is a systematic process that involves anticipating the demand for the
product and services of an organization in future under a set of uncontrollable and competitive forces.

Some of the popular definitions of demand forecasting are as follows:

According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a process of finding values for
demand in future time periods.”

In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a specified future period based
on proposed marketing plan and a set of particular uncontrollable and competitive forces.”

Demand forecasting enables an organization to take various business decisions, such as planning the production
process, purchasing raw materials, managing funds, and deciding the price of the product. An organization can
forecast demand by making own estimates called guess estimate or taking the help of specialized consultants or
market research agencies. Let us discuss the significance of demand forecasting in the next section.

Significance of Demand Forecasting:

Demand plays a crucial role in the management of every business. It helps an organization to reduce risks involved
in business activities and make important business decisions. Apart from this, demand forecasting provides an
insight into the organization’s capital investment and expansion decisions.

The significance of demand forecasting is shown in the following points:

i. Fulfilling objectives:
Implies that every business unit starts with certain pre-decided objectives. Demand forecasting helps in fulfilling
these objectives. An organization estimates the current demand for its products and services in the market and move
forward to achieve the set goals.

For example, an organization has set a target of selling 50, 000 units of its products. In such a case, the organization
would perform demand forecasting for its products. If the demand for the organization’s products is low, the
organization would take corrective actions, so that the set objective can be achieved.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For instance, an organization has
forecasted that the demand for its product, which is priced at Rs. 10, would be 10, 00, 00 units. In such a case, the
total expected revenue would be 10* 100000 = Rs. 10, 00, 000. In this way, demand forecasting enables
organizations to prepare their budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing according to the forecasted
demand of products helps in avoiding the wastage of the resources of an organization. This further helps an
organization to hire human resource according to requirement. For example, if an organization expects a rise in the
demand for its products, it may opt for extra labor to fulfill the increased demand.

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the expansion of the business of the organization. If the
expected demand for products is higher, then the organization may plan to expand further. On the other hand, if the
demand for products is expected to fall, the organization may cut down the investment in the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the requirement of raw material,
and ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an organization’s products is less, it may take
corrective actions and improve the level of demand by enhancing the quality of its products or spending more on
advertisements.

vii. Helping Government:

Enables the government to coordinate import and export activities and plan international trade.

The various factors that influence demand forecasting

i. Types of Goods:
Affect the demand forecasting process to a larger extent. Goods can be producer’s goods, consumer goods, or
services. Apart from this, goods can be established and new goods. Established goods are those goods which already
exist in the market, whereas new goods are those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is known only in case of
established goods. On the other hand, it is difficult to forecast demand for the new goods. Therefore, forecasting is
different for different types of goods.
ii. Competition Level:
Influence the process of demand forecasting. In a highly competitive market, demand for products also depend on
the number of competitors existing in the market. Moreover, in a highly competitive market, there is always a risk of
new entrants. In such a case, demand forecasting becomes difficult and challenging.

iii. Price of Goods:

Acts as a major factor that influences the demand forecasting process. The demand forecasts of organizations are
highly affected by change in their pricing policies. In such a scenario, it is difficult to estimate the exact demand of
products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid change in technology, the
existing technology or products may become obsolete. For example, there is a high decline in the demand of floppy
disks with the introduction of compact disks (CDs) and pen drives for saving data in computer. In such a case, it is
difficult to forecast demand for existing products in future.

v. Economic Viewpoint:
Play a crucial role in obtaining demand forecasts. For example, if there is a positive development in an economy,
such as globalization and high level of investment, the demand forecasts of organizations would also be positive.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective only when it is conducted systematically and
scientifically.

It involves a number of steps, which are shown in Figure-3:

The steps involved in demand forecasting (as shown in Figure-3) are explained as follows:
1. Setting the Objective:
Refers to first and foremost step of the demand forecasting process. An organization needs to clearly state the
purpose of demand forecasting before initiating it.

Setting objective of demand forecasting involves the following:

a. Deciding the time period of forecasting whether an organization should opt for short-term forecasting or long-
term forecasting
b. Deciding whether to forecast the overall demand for a product in the market or only- for the organizations own
products

c. Deciding whether to forecast the demand for the whole market or for the segment of the market

d. Deciding whether to forecast the market share of the organization

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting. Demand can be forecasted for a long period or short
period. In the short run, determinants of demand may not change significantly or may remain constant, whereas in
the long run, there is a significant change in the determinants of demand. Therefore, an organization determines the
time period on the basis of its set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand forecasting process Demand can be forecasted by using
various methods. The method of demand forecasting differs from organization to organization depending on the
purpose of forecasting, time frame, and data requirement and its availability. Selecting the suitable method is
necessary for saving time and cost and ensuring the reliability of the data.

4. Collecting Data:
Requires gathering primary or secondary data. Primary’ data refers to the data that is collected by researchers
through observation, interviews, and questionnaires for a particular research. On the other hand, secondary data
refers to the data that is collected in the past; but can be utilized in the present scenario/research work.

5. Estimating Results:
Involves making an estimate of the forecasted demand for predetermined years. The results should be easily
interpreted and presented in a usable form. The results should be easy to understand by the readers or management
of the organization.

Supply Analysis , Law of Supply

Supply Analysis is a research and analysis done to understand the supply trends and responses to changing market
and production variables. Supply Analysis takes into account the production costs, raw material costs, technology,
labour wages etc. The analysis helps the manufacturers and companies to understand the impact of these variables
on supply and eventually demand.
The goal of demand-supply chain is to make sure that the supply and demand work properly. The demand should be
met and supply should not be more than what expected. There are lot of variables which are considered in demand
analysis and supply analysis.
Importance of Supply Analysis
Supply Analysis helps manufacturers to analyse the impact of production changes, policies on increase or decrease
in supply of finished goods. e.g. newer upcoming technology can help produce more goods in same amount of time.
The analysis can help determine if this new technology should be adopted or not. Also if this technology can help
produce more, is the demand there for more products. What impact will it have on the current labour and how would
be it impact supply in the market.
Another example can be impact of increase in wages in the market on supply. The labour cost would go up and it
will drive the costs of product along with it. If the supply has to be kept constant, the costs would go up and if costs
have to be kept constant the supply would go down hence driving the prices up if the demand is unchanged. These
are some questions which the supply analysis tries to answer.

Supply Analysis Parameters

Some of the key parameter which determine supply are:
1. Product's own price
2. Input prices
3. Technology
4. Expectations of the market
5. Number of producers present
Law of Supply?
The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a good or
service increases, the quantity of goods or services that suppliers offer will increase, and vice versa.

The law of supply says that as the price of an item goes up, suppliers will attempt to maximize their profits by
increasing the number of items for sale.

KEY TAKEAWAYS

 The law of supply says that a higher price will induce producers to supply a higher quantity to the market.
 Because businesses seek to increase revenue, when they expect to receive a higher price for something,
they will produce more of it.
 Supply in a market can be depicted as an upward-sloping supply curve that shows how the quantity
supplied will respond to various prices over a period of time.
 Together with demand, it forms half of the law of supply and demand.
The law of supply summarizes the effect price changes have on producer behavior. For example, a business will
make more video game systems if the price of those systems increases. The opposite is true if the price of video
game systems decreases. The company might supply 1 million systems if the price is $200 each, but if the price
increases to $300, they might supply 1.5 million systems.

To further illustrate this concept, consider how gas prices work. When the price of gasoline rises, it encourages
profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more
pipelines and oil tankers to bring the oil to plants where it can be refined into gasoline; build new oil refineries;
purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep
existing gas stations open longer hours.

The law of supply is so intuitive that you may not even be aware of all the examples around you:

 When college students learn that computer engineering jobs pay more than English professor jobs, the
supply of students with majors in computer engineering will increase.
 When consumers start paying more for cupcakes than for donuts, bakeries will increase their output of
cupcakes and reduce their output of donuts in order to increase their profits.
 When your employer pays time and a half for overtime, the number of hours you are willing to supply for
work increases.

Supply Elasticity

The law of supply states that there is a direct relationship between the quantity supplied and the price of a commodity. To
point out, this is a very qualitative statement. However, markets for different commodities differ in ways we can’t even
imagine. Interestingly, the concept of elasticity of supply handles all this with ease.

Elasticity of Supply

The elasticity of supply establishes a quantitative relationship between the supply of a commodity and it’s price. Hence,
we can express the numeral change in supply with the change in the price of a commodity using the concept of elasticity.
Note that elasticity can also be calculated with respect to the other determinants of supply.

However, the major factor controlling the supply of a commodity is its price. Therefore, we generally talk about the price
elasticity of supply. The price elasticity of supply is the ratio of the percentage change in the price to the percentage
change in quantity supplied of a commodity.
Es= [(Δq/q)×100] ÷ [(Δp/p)×100] = (Δq/q) ÷ (Δp/p)

Δq= The change in quantity supplied

q= The quantity supplied

Δp= The change in price

p= The price

Elasticity from a Supply Curve

Along with the method mentioned above, there are two more ways to calculate the price elasticity of supply, both of
which make use of the supply curve. We can either calculate the elasticity at a specific point on the supply curve, known
as point elasticity or between two prices, known as arc-elasticity.

The formula for calculating the point elasticity of supply is:

Es= (dq/dp)×(p/q)

Here dq/dp is the slope of the supply curve.

The formula for calculating the arc-elasticity of supply is:

Es= [(q1 – q2)/( q1 + q2)] × [( p1 + p2)/(p1 – p2)]

Types of Elasticity of Supply

(Source: economicsonline)

1. Perfectly Inelastic Supply

A service or commodity has a perfectly inelastic supply if a given quantity of it can be supplied whatever might be the
price. The elasticity of supply for such a service or commodity is zero. A perfectly inelastic supply curve is a straight line
parallel to the Y-axis. This is representative of the fact that the supply remains the same irrespective of the price.

The supply of exclusive items, like the painting of Mona Lisa, falls into this category. Whatever might be the price on
offer, there is no way we can increase its supply.

Browse more Topics under Theory Of Supply

 Meaning And Determinants Of Supply

 Law of Supply

 Equilibrium Price

2. Relatively Less-Elastic Supply

When the change in supply is relatively less when compared to the change in price, we say that the commodity has a
relatively-less elastic supply. In such a case, the price elasticity of supply assumes a value less than 1.

3. Relatively Greater-Elastic Supply

When the change in supply is relatively more when compared to the change in price, we say that the commodity has a
relatively greater-elastic supply. In such a case, the price elasticity of supply assumes a value greater than 1.
4. Unitary Elastic
For a commodity with a unit elasticity of supply, the change in quantity supplied of a commodity is exactly equal to the
change in its price. In other words, the change in both price and supply of the commodity are proportionately equal to
each other. To point out, the elasticity of supply in such a case is equal to one. Further, a unitary elastic supply curve
passes through the origin.

5. Perfectly Elastic supply

A commodity with a perfectly elastic supply has an infinite elasticity. In such a case the supply becomes zero with even a
slight fall in the price and becomes infinite with a slight rise in price. This is indicative of the fact that the suppliers of
such a commodity are willing to supply any quantity of the commodity at a higher price. A perfectly elastic supply curve
is a straight line parallel to the X-axis.

Price of a product under Demand and supply forces

Price is dependent on the interaction between demand and supply components of a market. Demand and supply
represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product
takes place when buyers and sellers can agree upon a price.

This section of the Agriculture Marketing Manual explains price in a competitive market. When imperfect
competition exists, such as with a monopoly or single selling firm, price outcomes may not follow the same general
rules.

Equilibrium price

When a product exchange occurs, the agreed upon price is called an equilibrium price, or a market clearing price.
Graphically, this price occurs at the intersection of demand and supply as presented in Image 1.

In Image 1, both buyers and sellers are willing to exchange the quantity Q at the price P. At this point, supply and
demand are in balance. Price determination depends equally on demand and supply.

Image 1. Figure 1, Graph showing price equilibrium curves

It is truly a balance of the market components. To understand why the balance must occur, examine what happens
when there is no balance, such as when market price is below that shown as P in Image 1.

At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers
would clamour for a product that producers would not be willing to supply; a shortage would exist. In this event,
consumers would choose to pay a higher price in order to get the product they want, while producers would be
encouraged by a higher price to bring more of the product onto the market.

The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were
chosen arbitrarily, the market would be in surplus with too much supply relative to demand. If that were to happen,
producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to
increase their purchases. Only when the price falls would balance be restored.

A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the
part of buyer and seller. Typically, some assumptions about the behaviour of buyers and sellers are made, which add
a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may
not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are
considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to
low, where they can stay in business.

Change in equilibrium price

When either demand or supply shifts, the equilibrium price will change. The section on understanding supply
factors explains why a market component may move. The examples below show what happens to price when supply
or demand shifts occur.

Example 1: Unusually good weather increases output

When a bumper crop develops, supply shifts outward and downward, shown as S2 in Image 2, more product is
available over the full range of prices. With no immediate change in consumers' willingness to buy crops, there is a
movement along the demand curve to a new equilibrium. Consumers will buy more but only at a lower price. How
much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand.

Image 2. Figure 2, Graph showing movement along demand curve

In Image 2, price falls from P1 to P2 if a bumper crop is produced. If the demand curve in this example was more
vertical (more inelastic), the price-quantity adjustments needed to bring about a new equilibrium between demand
and the new supply would be different.

To understand how elasticity of demand affects the size of adjustment in prices and quantities when supply shifts,
try drawing the demand curve (or line) with a slope more vertical than that depicted in Image 2. Then compare the
size of price-quantity changes in this with the first situation. With the same shift in supply, equilibrium change in
price is larger when demand is inelastic than when demand is more elastic.

The opposite is true for quantity. A larger change in quantity will occur when demand is elastic compared with the
quantity change required when demand is inelastic.

Example 2: Consumers lower their preference for beef

A decline in the preference for beef is one of the factors that could shift the demand curve inward or to the left, as
seen in Image 3.

Image 3. Figure 3. Graph showing movement along supply curve

With no immediate change in supply, the effect on price comes from a movement along the supply curve. An inward
shift of demand causes price to fall and also the quantity exchanged to fall. The amount of change in price and
quantity, from one equilibrium to another, is dependent upon the elasticity of supply.

Imagine that supply is almost fixed over the time period being considered. That is, draw a more vertical supply
curve for this shift in demand. When demand shifts from D1 to D2 on a more vertical supply curve (inelastic supply)
almost all the adjustment to a new equilibrium takes place in the change in price.

Price stability

Two forces contribute to the size of a price change: the amount of the shift and the elasticity of demand or supply.
For example, a large shift of the supply curve can have a relatively small effect on price if the corresponding
demand curve is elastic. That would show up in Example 1 above, if the demand curve is drawn flatter (more
elastic).
In fact, the elasticity of demand and supply for many agricultural products are relatively small when compared with
those of many industrial products. This inelasticity of demand has led to problems of price instability in agriculture
when either supply or demand shifts in the short-term.

Price level

The two examples above focus on factors that shift supply or demand in the short-term. However, longer-term forces
are also at work, which shift demand and supply over time. One particular supply shifter is technology. A major
effect of technology in agriculture has been to shift the supply curve rapidly outward by reducing the costs of
production per unit of output.

Technology has had a depressing effect on agricultural prices in the long-term since producers are able to produce
more at a lower cost. At the same time, both population and income have been advancing, which both tend to shift
demand to the right. The net effect is complex, but overall the rapidly shifting supply curve coupled with a slow
moving demand has contributed to low prices in agriculture compared to prices for industrial products.

At various levels of a market, from farm gate to retail, unique supply and demand relationships are likely to exist.
However, prices at different market levels will bear some relationship to each other. For example, if hog prices
decline, it can be expected that retail pork prices will decline as well. This price adjustment is more likely to happen
in the long-term once all participants have had time to adjust their behaviour.

In the short-term, price adjustments may not occur for a variety of reasons. For example, wholesalers may have
long-term contracts that specify the old hog price, or retailers may have advertised or planned a feature to attract
customers.

Summary

Market prices are dependent upon the interaction of demand and supply.

An equilibrium price is a balance of demand and supply factors.

There is a tendency for prices to return to this equilibrium unless some characteristics of demand or supply change.

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