DEMAND SUPPLY AND ELASTICITY

Definitions Needed for This Topic:

1. Demand: is the quantity that consumers are willing and able to purchase
at different price levels during a given time period, ceteris paribus.
2. The Law of Demand states that an inverse relationship exists between the
price of good and the quantity demanded of the good, ceteris paribus.
3. Supply: is the quantity that producers are willing and able to produce and
sell at different price levels during a given time period, ceteris paribus.
4. The Law of Supply states that a direct relationship exists between the
prices of a good and the quantity supplied of that good, ceteris paribus.
5. The Price Elasticity of Demand measures the degree of responsiveness of
the quantity demanded of an item to a given change in the price of that
item itself, ceteris paribus.
6. The Price Elasticity of Supply measures the degree of responsiveness of
the quantity supplied of a good to a given change in the price of the good
itself, ceteris paribus.
7. The Income Elasticity of Demand measures the degree of responsiveness
of the demand of a good to a given change in the income level, ceteris
paribus.
8. The Cross Elasticity of Demand measure the degree of responsiveness of
the demand of a good to a given change in the price of another good,
ceteris paribus.
Factors of Demand:
1. Expectation of future prices
i. If consumers expect prices to rise in the future, they buy
more now.
ii. If consumers expect prices to fall in the future, they postpone
purchase now.
2. Government Policy (Tax/subsidies/campaigns)
i. Tax Government discourages consumption, increase price
of goods so as to decrease demand.
ii. Subsidies Government encourages consumption,
decreases price of goods so as to increase demand.
iii. Campaign
3. Income
i. The higher the income level, the greater is the demand for
normal goods.
4. Price of Related Goods (Joint/Competitive/Derived)
i. Joint Demand Goods that are complements Increase in
demand for tennis rackets leads to an increase in demand for
tennis balls.
ii. Competitive Demand Goods that are substitutes
Increase in demand for Coca-Cola leads to a decrease in
demand for Pepsi
iii. Derived Demand Refers to the demand of a factor of
production for an item whereby increase in demand for
jewellery leads to an increase in derived demand for gold.
5. Tastes and Preferences
i. These will change from time to time due to influence from
advertisements/campaigns.
6. Population

DEMAND SUPPLY AND ELASTICITY

i. Size Increase in size of population increases the number of
consumers and demand increases.
ii. Composition Increase in composition of elderly in the
population increases the demand for healthcare services.
7. Seasonal Factors
i. Based on weather, climate, season or festivals.
1. Valentines Day sees a greater demand for roses and
chocolates.
Supply
Factors of Supply:
1. Cost of Production
a. The greater the cost of production, the lower is the supply.
2. Government Policy (tax/subsidies/regulations)
a. Tax (direct/indirect) increases the cost of production and decreases
supply.
b. Subsidies decrease cost of production and increase supply.
c. Regulations
3. Expectation of future prices
a. If producers expect prices to rise in the future, they decrease supply
now.
b. If producers expect prices to fall in the future, they increase supply
now.
4. Technology
a. Better technology enhances production and increases supply/
5. Price of related goods (joint/competitive supply)
a. Joint supply : goods produced together
i. E.g. beef and leather; increase in supply of beef leads to an
increase in the supply of leather.
b. Competitive supply
1. Goods produced at the expense of each other
increases the supply of food, leading to a decrease in
the supply of biofuel.
6. Number of sellers
a. The greater the number of sellers, the greater is the supply
7. Wars/natural disasters
a. When there are wars or natural disasters in the producing country,
the supply decreases.
8. Seasonal goods
a. Goods are only in supply when they are in season especially
agricultural goods
Price Elasticity of Demand
Magnitude
1. Price-inelastic demand A change in price leads to a less than
proportionate change in the quantity demanded.
2. Price-elastic demand A change in price leads to a more than
proportionate change in quantity demanded.
3. Perfectly price-inelastic demand A change in price leads to no change in
the quantity demanded.

DEMAND SUPPLY AND ELASTICITY

4. Unitary price-elastic demand A change in price leads to an equal
proportionate change in the quantity demanded.
5. Perfectly price-elastic demand A change in price leads to an infinite
change in the quantity demanded.
Factors
1. Habitually consumed goods (e.g. cigarettes/drugs)
a. The demand for this item is price inelastic.
2. Proportion of income spent on goods
a. The greater the proportion of the income spent, the greater is the
price elasticity of demand.
3. Nature of good (necessity/luxury)
a. Necessity The demand is price-inelastic
b. Luxury The demand is price-elastic
4. Time spent under consideration
a. The demand is price inelastic in the short-term.
b. The demand is price elastic in the long-term longer time to find
substitutes or change consumption patterns
5. Availability and closeness of substitutes
a. The greater the available of substitutes and/or greater the closeness
of substitutes to the item in demand, the more price elastic is the
demand of that item.
Applications
1. Pricing strategies
a. When the demand for the item is price inelastic firms can
increase price in order to earn a higher total revenue.
b. When the demand for the item is price elastic firms can decrease
the price in order to earn a higher total revenue.
2. Marketing strategies
a. Create brand loyalty and reduce substitutes the demand for
goods becomes more price inelastic firms can increase the price
in order to earn a higher total revenue.
3. Government taxation (indirect tax)
a. Tax goods in which the demand is price inelastic (e.g. cigarettes,
alcohol) results in increase of total tax revenue for the government.
Price Elasticity of Supply
Magnitude
1. Price inelastic supply: The change in price leads to a less than
proportionate change in the quantity supplied.
2. Price elastic supply: The change in price leads to a more than
proportionate change in the quantity supplied.
3. Perfectly price inelastic supply: The change in price leads to no change in
the quantity supplied.
4. Unitary price elastic supply: The change in price leads to an equal
proportionate change in the quantity supplied.
5. Perfectly price elastic supply: The change in price leads to an infinite
change in the quantity supplied.
Factors

DEMAND SUPPLY AND ELASTICITY

1. Availability of spare capacity
a. When there is availability of spare capacity, producers can
increase/decrease production in a short time. This means that the
supply of the good is more price elastic.
2. Level of stocks
a. The greater the ease of storing unsold stock producers can
respond to rise/fall in the demand quickly the supply is more
price elastic.
3. Production period e.g. gestation period
a. The shorter the time, the more price elastic is the supply.
b. The longer the time taken, the more price inelastic is the supply
agriculture).
4. Factor mobility e.g. geographical or occupational
a. The higher the mobility, the more price elastic is the supply.
5. Degree of barriers to entry
a. The greater the ease to enter the market (low barriers to entry)
the more sellers the more price elastic is the supply.
Application
1. Incidence of tax
a. Markets in which the supply of goods is price inelastic producers
are less responsive to changes in cost of production producers
bear more tax.
Income Elasticity of Demand
Magnitude
1. Inferior goods: the greater the income level, the lower is demand.
2. Necessities: The change in income level leads to a les sthan proportionate
change in the demand.
3. Luxury goods: The change in income level leads to a more than
proportionate change in demand.
4. Zero income elasticity: The change in income level leads to no change in
the demand.
5. Unitary price elastic supply: The change in income level leads to an equal
proportionate change in the demand.
Factors
1. Degree of necessity
a. The more basic the item is, the lower the income elasticity of the
demand.
2. Level of income
a. The increase in the level of income greater purchasing power
demand better goods.
Application
1. For producers
a. Production plan If income levels rise, producers produce more
necessities/luxuries.
b. Location Different income elasticity of the demand Different
shop locations to sell different type of goods.
2. For the government

DEMAND SUPPLY AND ELASTICITY

a. Estimate effects of taxation impact of taxes.
Cross elasticity of Demand
Magnitude
1. Substitutes: when the price of good Y increases, the demand of good X
increases.
2. Perfect substitutes: When the price of good Y increases, the demand of
good X increases exponentially.
3. Complements: When the price of good Y increases, the demand of good X
decreases.
4. Unrelated: Change in the price of good Y leads to no change in the
demand of good X.
Factors
1.

Closeness of substitutes/complements
a. The greater the closeness of substitutes or complements, the
greater is the cross elasticity of demand.
2. Time spent under consideration
a. The longer time spent under consideration, the more time
consumers have to find substitutes greater cross elasticity of
demand.
Applications
1. Pricing policy
a. Rival consciousness close substitutes = close rivals.
b. It indicates the effect of changes in the price of substitutes/
complements on their goods plan sales/promotions.
2. Marketing strategies
a. Bundle sales for goods that are complements increase in total
revenue
b. Lower prices of goods that have close substitutes increase in
total revenue.
c. Make products less substitutable using product differentiation
increase in total revenue.