Supply and demand is perhaps one of the most fundamental concepts of economics and it is the

backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired
by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price;
the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price. The correlation
between price and how much of a good or service is supplied to the market is known as the supply
relationship. Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlie the forces behind the allocation of resources.
In market economy theories, demand and supply theory will allocate resources in the most efficient way
possible. How? Let us take a closer look at the law of demand and the law of supply.

A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good, the less
people will demand that good. In other words, the higher the price, the lower the quantity demanded. The
amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so
does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product
that will force them to forgo the consumption of something else they value more. The chart below shows
that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between
quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will
be P1, and so on. The demand relationship curve illustrates the negative relationship between price and
quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower
the price, the more the good will be in demand (C).

B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price.
But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher
the price, the higher the quantity supplied. Producers supply more at a higher price because selling a
higher quantity at a higher price increases revenue.
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between
quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2,
and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough:
Economics.)

Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to
supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is
important to try and determine whether a price change that is caused by demand will be temporary or
permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season;
suppliers may simply accommodate demand by using their production equipment more intensively. If,
however, there is a climate change, and the population will need umbrellas year-round, the change in
demand and price will be expected to be long term; suppliers will have to change their equipment and
production facilities in order to meet the long-term levels of demand.

C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show how supply and
demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because the record company's
previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs
were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten
CDs are demanded by 20 people, the price will subsequently rise because, according to the demand
relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more
CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity
supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because
the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their
CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten
CDs. The lower price will then make the CD more available to people who had previously decided that
the opportunity cost of buying the CD at $20 was too high.

D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the
economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because
the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus,
everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given
price, suppliers are selling all the goods that they have produced and consumers are getting all the goods
that they are demanding.
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which
indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will
be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.

E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative
inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however,
the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is
greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to
produce more goods, which they hope to sell to increase profits, but those consuming the goods will find
the product less attractive and purchase less because the price is too high.

2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too
many consumers want the good while producers are not making enough of it.
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are
too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers
have to compete with one other to buy the good at this price, the demand will push the price up, making
suppliers want to supply more and bringing the price closer to its equilibrium.

F. Shifts vs. Movement

For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very
different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in
both price and quantity demanded from one point to another on the curve. The movement implies that the
demand relationship remains consistent. Therefore, a movement along the demand curve will occur when
the price of the good changes and the quantity demanded changes in accordance to the original demand
relationship. In other words, a movement occurs when a change in the quantity demanded is caused only
by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve means that the supply
relationship remains consistent. Therefore, a movement along the supply curve will occur when the price
of the good changes and the quantity supplied changes in accordance to the original supply relationship.
In other words, a movement occurs when a change in quantity supplied is caused only by a change in
price, and vice versa.
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even
though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of
beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the
demand curve imply that the original demand relationship has changed, meaning that quantity demand is
affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer
suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2,
then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply
curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by
a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused
a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.
Law of Supply and Demand: Basic
Economics http://www.investopedia.com/university/economics/economics3.asp#ixzz4uWH81nSq

What is 'Demand Elasticity'

Demand elasticity refers to how sensitive the demand for a good is to changes in other economic
variables, such as the prices and consumer income. Demand elasticity is calculated by taking the percent
change in quantity of a good demanded and dividing it by a percent change in another economic variable.
A higher demand elasticity for a particular economic variable means that consumers are more responsive
to changes in this variable, such as price or income.
Demand elasticity measures a change in demand for a good when another economic factor changes.
Demand elasticity helps firms model the potential change in demand due to changes in price of the good,
the effect of changes in prices of other goods and many other important market factors. A grasp of
demand elasticity guides firms toward more optimal competitive behavior and allows them to make more
precise forecasts of their production needs. If the demand for a particular good is more elastic in response
to changes in other factors, companies must be more cautions with raising prices for their goods.
Types of Demand Elasticities
One common type of demand elasticity is the price elasticity of demand, which is calculated by dividing
the percent change in quantity demanded of a good by the percent change in its price. Firms collect data
on price changes and how consumers respond to such changes and later calibrate their prices accordingly
to maximize their profits. Another type of demand elasticity is cross-elasticity of demand, which is
calculated by taking the percent change in quantity demanded for a good and dividing it by percent
change of the price for another good. This type of elasticity indicates how demand for a good reacts to
price changes of other goods.

Interpretation and Example of Demand Elasticity

Demand elasticity is typically measured in absolute terms, meaning its sign is ignored. If demand
elasticity is greater than 1, it is called elastic, meaning it reacts proportionately higher to changes in other
economic factors. Inelastic demand means that the demand elasticity is less than 1, and the demand reacts
proportionately lower to changes in another variable. When a change in demand is proportionately the
same as that for another variable, the demand elasticity is called unit elastic.
Suppose that a company calculated that the demand for soda product increases from 100 to 110 bottles as
a result of the price decrease from $2 to $1.50 per bottle. The price elasticity of demand is calculated by
taking a 10% increase in demand (10 bottles change divided by initial demand of 100 bottles) and
dividing it by a 25% price decrease, producing a value of 0.4. This indicates that lowering soda prices will
result in a relatively small uptick in demand, because the price elasticity of demand for soda is inelastic.
Also, an increase in total revenue will be smaller in this case compared to more elastic demand for soda.

Price Elasticity Of Demand

Price elasticity of demand is a measure of the relationship between a change in the quantity demanded of
a particular good and a change in its price. Price elasticity of demand is a term in economics often used
when discussing price sensitivity. The formula for calculating price elasticity of demand is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

If a small change in price is accompanied by a large change in quantity demanded, the product is said to
be elastic (or responsive to price changes). Conversely, a product is inelastic if a large change in price is
accompanied by a small amount of change in quantity demanded.
Price elasticity of demand measures the responsiveness of demand to changes in price for a particular
good. If the price elasticity of demand is equal to 0, demand is perfectly inelastic (i.e., demand does not
change when price changes). Values between zero and one indicate that demand is inelastic (this occurs
when the percent change in demand is less than the percent change in price). When price elasticity of
demand equals one, demand is unit elastic (the percent change in demand is equal to the percent change in
price). Finally, if the value is greater than one, demand is perfectly elastic (demand is affected to a greater
degree by changes in price).
For example, if the quantity demanded for a good increases 15% in response to a 10% decrease in price,
the price elasticity of demand would be 15% / 10% = 1.5. The degree to which the quantity demanded
for a good changes in response to a change in price can be influenced by a number of factors. Factors
include the number of close substitutes (demand is more elastic if there are close substitutes) and whether
the good is a necessity or luxury (necessities tend to have inelastic demand while luxuries are more
elastic).
Businesses evaluate price elasticity of demand for various products to help predict the impact of a pricing
on product sales. Typically, businesses charge higher prices if demand for the product is price inelastic.

Income Elasticity Of Demand

01::27
Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a
change in real income of consumers who buy this good, keeping all other things constant. The formula for
calculating income elasticity of demand is the percent change in quantity demanded divided by the
percent change in income. With income elasticity of demand, you can tell if a particular good represents a
necessity or a luxury.
Income elasticity of demand measures the responsiveness of demand for a particular good to changes in
consumer income. The higher the income elasticity of demand in absolute terms for a particular good, the
bigger consumers' response in their purchasing habits, if their real income changes. Businesses typically
evaluate income elasticity of demand for their products to help predict the impact of a business cycle on
product sales.

Calculation of Income Elasticity of Demand

Consider a local car dealership that gathers data on changes in demand and consumer income for its cars
for a particular year. When the average real income of its customers fell from $50,000 to $40,000, the
demand for its cars plummeted from 10,000 to 5,000 units sold, all other things unchanged. The income
elasticity of demand is calculated by taking a negative 50% change in demand, a drop of 5,000 divided by
the initial demand of 10,000 cars, and dividing it by a 20% change in real income, the $10,000 change in
income divided by the initial value of $50,000. This produces an elasticity of 2.5, which indicates local
customers are particularly sensitive to changes in their income when it comes to buying cars.

Interpretation of Income Elasticity of Demand

Depending on the values of the income elasticity of demand, goods can be broadly categorized as inferior
goods 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 less of inferior goods. A typical example of
such type of product is margarine, which is much cheaper than butter.
Luxury goods represent normal goods associated with income elasticities of demand greater than one.
Consumers will buy proportionately more of a particular good compared to a percentage change in their
income. Consumer discretionary products such as premium cars, boats and jewelry represent luxury
products that tend to be very sensitive to changes in consumer income. When a business cycle turns
downward, demand for consumer discretionary goods tends to drop as workers become unemployed.

Elastic
Elastic is an economic term meant to describe a change in the behavior of buyers and sellers in response
to a price change for a good or service. How the demand for the good or service reacts in response to a
change in price determines its elasticity or inelasticity. The elasticity of a good or service can vary
according to the amount of close substitutes, its relative cost and the amount of time that has elapsed since
the price change occurred.
Companies that operate in very fierce and competitive industries provide goods or services that are very
elastic because these companies tend to be price takers. When a good or service is elastic, it means sellers
and buyers quickly adjust their demand for that good or service when the price changes. The opposite of
elastic is inelastic. When a good or service is inelastic, sellers and buyers are not as likely to adjust their
demand for a good or service when its price changes.

The Significance of Elasticity

Elasticity is an important economic trend to study, particularly for sellers of goods or services because it
gives them an idea of how much of a good or service buyers consume when the price changes. When a
good is elastic, a change in price quickly results in a change in the quantity demanded. When a good is
inelastic, there is little change to the quantity demanded if the price of the good changes. The change that
is observed for an elastic good is an increase in demand when the price decreases and a decrease in
demand when the price increases.
For consumers, elasticity also communicates important information. If the market price of a good goes
down for an elastic good, firms likely reduce the amount of good or service they are willing to supply. If
the market price goes up, firms likely increase the amount of good they are willing to sell. This is
important for consumers who need a good and are concerned with potential scarcity.
Examples
Generally, goods that are elastic are either unnecessary goods or services or goods or services with
competitors offering readily available substitute goods and services. The airline industry is very elastic
because there is a lot of competition. If one airline decides to increase the price of its fares, consumers can
use another airline, and the airline that increased its fares will see demand for its services decrease.

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