Demand, Supply and Elasticity

Demand

Demand is the quantity of a good that buyers are willing and able to buy at each price in a given period. The law of demand says that, other things remaining the same (ceteris paribus), quantity demanded falls when price rises and rises when price falls. The demand curve therefore slopes downward.

Determinants of demand other than the good's own price:

• Income of consumers
• Prices of related goods (substitutes and complements)
• Tastes and preferences
• Expectations about future prices
• Number of buyers

Supply

Supply is the quantity that sellers are willing and able to sell at each price. The law of supply says quantity supplied rises when price rises, so the supply curve slopes upward. Determinants other than own price are input costs, technology, taxes and subsidies, prices of other goods the firm could produce, weather and the number of sellers.

Movement versus shift

Better technology or cheaper inputs shift supply to the right. Higher income shifts the demand for a normal good to the right.

Market equilibrium

Equilibrium is the price at which quantity demanded equals quantity supplied.

• Price above equilibrium: surplus (excess supply), which pushes price down.
• Price below equilibrium: shortage (excess demand), which pushes price up.

Worked example. Qd = 100 - 2P and Qs = 20 + 2P. Setting Qd = Qs gives 100 - 2P = 20 + 2P, so 4P = 80 and P = 20. Quantity is 100 - 40 = 60.

When demand increases and supply is unchanged, both equilibrium price and quantity rise. When supply increases and demand is unchanged, price falls and quantity rises.

Elasticity

Price elasticity of demand (PED) = percentage change in quantity demanded divided by percentage change in price. It is negative by the law of demand, so the absolute value is usually quoted.

Percentage method example. Price rises from Rs 20 to Rs 25 (25 percent) and quantity falls from 100 to 80 units (20 percent). PED = 20 / 25 = 0.8, so demand is inelastic.

Midpoint (arc) method. Use the average of the two prices and the average of the two quantities as the base. If price falls from Rs 12 to Rs 8 and quantity rises from 40 to 60, the quantity change is 20 / 50 = 40 percent and the price change is 4 / 10 = 40 percent, so elasticity is 1. Total revenue is Rs 480 at both prices, which confirms unitary elasticity.

Income elasticity of demand = percentage change in quantity demanded divided by percentage change in income.

• Positive: normal good (above 1 is a luxury, between 0 and 1 a necessity)
• Negative: inferior good

Cross elasticity of demand = percentage change in quantity demanded of good X divided by percentage change in price of good Y.

• Positive: substitutes (tea and coffee)
• Negative: complements (vehicles and petrol)
• Zero: unrelated goods

Price elasticity of supply = percentage change in quantity supplied divided by percentage change in price. It is positive and tends to be larger in the long run.

Exam pointers

• A change in own price causes a movement along the curve; any other factor shifts the curve.
• Surplus occurs above the equilibrium price, shortage below it.
• Inelastic demand: price and total revenue move in the same direction. Elastic demand: they move in opposite directions.
• The sign matters for income elasticity (negative means inferior) and cross elasticity (positive means substitutes, negative means complements).
• In numerical questions check whether the simple percentage method or the midpoint method is asked for, because they give different answers.
• To find equilibrium from equations, set Qd equal to Qs and solve for P first.