UNIT 2- MARKET FORCES OF DEMAND AND SUPPLY

 Demand and supply – Definition, Laws of demand and supply, Factors

affecting demand and supply – Shift Vs. Movement of the demand and
supply curve
 Market Equilibrium
 Consumer and producer surplus
 Impact of government intervention on price and quantity, Deadweight loss of
taxation
 Elasticities of demand (Own-price, Cross-price, and Income elasticity) and
supply (Own-price elasticity)
Introduction
 A market is a group of buyers and sellers of a particular good or service.
 The buyers as a group determine the demand for the product, and the
sellers as a group determine the supply of the product.
 A competitive market is a market in which there are many buyers and
many sellers so that each has a negligible impact on the market price.
 Perfectly competitive markets are defined by two primary
characteristics: (1) the goods being offered for sale are all the same,
and (2) the buyers and sellers are so numerous that no single buyer or
seller can influence the market price. Because buyers and sellers in
perfectly competitive markets must accept the price the market
determines, they are said to be price takers.
 Some markets have only one seller, and this seller sets the price. Such a
seller is called a monopoly.
 Some markets fall between the extremes of perfect competition and
monopoly. One such market, called an oligopoly, has a few sellers that do
not always compete aggressively.
 Another type of market is monopolistically competitive; it contains many
sellers, each offering a slightly different product. Because the products
are not exactly the same, each seller has some ability to set the price for
its own product. An example is the software industry.
 The quantity demanded of any good is the amount of
the good that buyers are willing and able to purchase.

Demand
 The demand schedule for an individual specifies the units of a good
or service that the individual is willing and able to purchase at
alternative prices during a given period of time.
 The relationship between price and quantity demanded is inverse:
more units are purchased at lower prices because of a substitution effect
 and an income effect. As a commodity’s price falls, an individual
normally purchases more of this good since he or she is likely to
substitute it for other goods whose price has remained unchanged. Also,
when a commodity’s price falls, the purchasing power of an individual
with a given income increases, allowing for greater purchases of the
commodity.
 When graphed, the inverse relationship between price and quantity
demanded appears as a negatively sloped demand curve.
 A market demand schedule specifies the units of a good or service all
individuals in the market are willing and able to purchase at alternative
prices, i.e., Qd = f (P).

What Determines the quantity of an individual

demands?
 Price-
The quantity demanded falls as the price rises and rises as the price falls,
we say that the quantity demanded is negatively related to the price. This
relationship between price and quantity demanded is true for most goods
in the economy and, in fact, is so pervasive that economists call it the law
of demand.

Law of demand - The claim that, other things equal, the quantity
demanded of a good fall when the price of the good rises.

 Income-
A lower income means that you have less to spend in total, so you would
have to spend less on some—and probably most—goods.

Normal good- If the demand for a good fall when income falls, the good
is called a normal good.

Inferior good- If the demand for a good rise when income falls, the good
is called an inferior good. Example- Bus rides.

 Prices of Related Goods-

Substitute goods- When a fall in the price of one good reduces the
demand for another good, the two goods are called substitutes.
Substitutes are often pairs of goods that are used in place of each other,
such as hot dogs and hamburgers, sweaters and sweatshirts, and movie
tickets and video rentals.
 Complement goods- When a fall in the price of one good raises the
demand for another good, the two goods are called complements.
Complements are often pairs of goods that are used together, such as
gasoline and automobiles, computers and software, and skis and ski lift
tickets.
 Tastes-
The most obvious determinant of your demand is your tastes. If you like
the taste of a good, you buy more of it.

 Expectations-
Your expectations about the future may affect your demand for a good or
service today. For example, if you expect to earn a higher income next
month, you may be more willing to spend some of your current savings.

THE DEMAND SCHEDULE AND THE DEMAND CURVE

 Demand Schedule- A table that shows the relationship between the price
of a good and the quantity demanded.

 Demand Curve- A graph (downward-sloping line) of the relationship

between the price of a good and the quantity demanded.

 Ceteris Paribus- A Latin phrase, translated as “other things being equal,”

used as a reminder that all variables other than the ones being studied are
assumed to be constant.
 Market Demand- The market demand, which is the sum of all the
individual demands for a particular good or service.
Example
Table gives an individual’s demand and the market demand for a commodity.
Column 2 shows one individual’s demand for corn—the bushels of corn that
one individual is willing and able to buy per month at alternative prices. We
find, for example, that the individual buys 3.5 bushels of corn each month when
the price is $5 per bushel. If there are 1,000 individuals in the market, the
market demand for corn is the sum of the quantities the 1,000 individuals will
buy at each price. So for example, 1,000 individuals collectively are willing to
purchase 3,500 bushels of corn each month at $5 per bushel. The market
demand is shown in the last column, which shows the typical relationship
between quantity demanded and price, i.e., more units of a commodity are
demanded at lower prices. The market demand for corn is plotted in Figure
and the curve is labeled D. Note that the demand curve is negatively sloped.
Questions 1
a. Is there a difference between a demand for a good and a need for a
good?
 Demand refers to the willingness and financial ability to buy a
commodity. The existence of a need or a want is a necessary but
insufficient condition for the existence of demand. The need or
want must be backed by financial ability (i.e., ability to pay for a
good) to transform the need into effective demand. Thus, our needs
or wants may be infinite but our demand for each good and service
is limited by our income and wealth and therefore our ability to
pay.
b. What is a demand schedule? A demand curve?
 A demand schedule specifies the quantities of a commodity
demanded at alternative prices during a specified period, holding
constant other variables that may influence demand. A demand
curve is a graphic presentation of a demand schedule.
c. Why is there a negative relationship between quantity demanded and
price?
 The negative slope of the demand curve shows that price and
quantity are inversely related. That is larger quantities are
demanded at lower prices. This confirms to our everyday
experience as consumers and is the result of substitution and
income effects. The substitution effect says that as the price of a
specified commodity falls, we substitute this commodity for similar
commodities whose price are unchanged. For example, when the
price of chicken falls and the price of mutton is unchained,
consumer buys more chicken and less mutton. The income effect
indicates that as the price of a commodity falls, a given money
income has greater purchasing power which allows the consumer
to buy more of this and other commodities.
d. Explain Qd = f (P).
 The quantity demanded of an item depends upon (is a function of)
the price of an item.
Question 2- Suppose there are only 3 individuals in a market area who
demand Brussels sprouts; the demand schedule for each individual appears
in Table.
Price Quantity Quantity Quantity
($ per 1b) demanded by demanded by demanded by
individual 1 individual 2 individual 3
(1b per month) (1b per month) (1b per month)
2.50 2.25 0.75 0.25
2.00 2.50 1.00 0.50
1.50 3.00 1.50 1.00
1.00 4.00 2.25 1.75
0.50 5.50 3.50 2.75

a. From the data in Table, derive a market demand schedule for

Brussels sprouts.
 The market demand schedule ,is obtained by adding the quantities
demanded by all individuals in the market at each price.

Price Quantity Quantity

($ per 1b) demanded by demanded in the
individual 1, 2 market
and 3 (1b per month)
(1b per month)
2.50 2.25+0.75+0.25 3.25
2.00 2.50+1.00+0.50 4.00
1.50 3.00+1.50+1.00 5.50
1.00 4.00+2.25+1.75 8.00
0.50 5.50+3.50+2.75 11.75

b. Plot this market demand schedule and label the curve D1.
 Plot graph

Question 3. Suppose medical research indicates that consumption of

Brussels sprouts prolongs life. Assumed that 4 rather than 3 individuals
now demand Brussels sprouts and that this additional individual has the
same demand schedule as individual 1 in question 2.
a. Present the new market demand schedule for Brussels sprouts.
 Table present the price per pound in column one the quantity
demanded by individual 4 in column 2, market demand in column
3.
 Price Quantity Quantity
($ per 1b) demanded by demanded in the
individual 4 market
(1b per month) (1b per month)
2.50 2.25 5.50
2.00 2.50 6.50
1.50 3.00 8.50
1.00 4.00 12.00
0.50 5.50 17.25

b. Plot this new market demand schedule and label it D2.

 Plot graph
c. What happens to a market demand schedule when more individuals
in a market demand a commodity?
 When more individual in a market area demands a commodity,
market demand schedule shifts outward.

Shifting of a Market Demand Curve

 The market demand for a good or service is influenced not only by
the commodity’s price, but also by the price of other goods and
services, disposable income, wealth, tastes, and the size of the market.
In presenting the market demand for corn, variables other than the
commodity’s price are held constant. This relationship is presented as
Qd = f (Pcorn), ceteris paribus, where ceteris paribus indicates that
variables other than the price of corn are unchanged.
 When one or more of these variables change, there is a change in
demand and therefore a shift of the demand curve. For example, the
market demand curve shifts up and to the right when there is an
increased preference for the commodity, when income increases, and
when the price of a substitute commodity rises and/or the price of a
complementary good declines.
 A common error made by the beginning economics student is failure to
differentiate between a change in demand and a change in quantity
demanded.
 A change in demand refers to a shift of the demand curve because a
variable other than price has changed. Whenever any determinant of
demand changes, other than the good’s price, the demand curve shifts. As
Figure below shows, any change that increases the quantity demanded at
every price shifts the demand curve to the right. Similarly, any change
that reduces the quantity demanded at every price shifts the demand curve
to the left.
 A change in quantity demanded occurs when there is a change in the
commodity’s price, resulting in a movement along an existing
demand curve.
Note- When we graph a demand curve, a change in price does not shift
the curve but represents a movement along it. By contrast, when there is a
change in income, the prices of related goods, tastes, expectations, or the
number of buyers, the quantity demanded at each price changes; this is
represented by a shift in the demand curve.

If warnings on cigarette
packages convince smokers
to smoke less, the demand
curve for cigarettes shifts to
the left. The demand curve
shifts from D1 to D2. At a
price of $2 per pack, the
quantity demanded falls from
20 to 10 cigarettes per day,
as reflected by the shift from
point A to point B.
 If a tax raises the price of
cigarettes, the demand curve
does not shift. Instead, we
observe a movement to a
different point on the
demand curve. When
the price rises from $2 to $4,
the quantity demanded falls
from 20 to 12 cigarettes per
day, as reflected by the
movement from point A to
point C.

Question 4- Explain what happens to the demand curve for air

transportation between New York City and Washington, D.C., as a result
of the following events:
a. The income of households in metropolitan New York and
Washington DC increases 20%.
 Individuals will travel more since they have more disposable income. The
demand for air transportation between NYC and Washington increases;
the demand curve shifts up and to the right.
b. The US government subsidises Amtrak and the cost of a train ticket
between New York City and Washington DC is reduced 50%.
 The cost of an alternative mode of transportation between NYC and
Washington has decreased; thus, more individuals will travel by train
between NYC and Washington. The demand for air transportation
decreases; the demand curve shifts down and to the left.
c. The number of businesses with offices in both New York City and
Washington DC doubles;
 There should be increased business travel between NYC and Washington.
This increased demand for air transportation shifts the demand curve up
and to the right.
d. The price of an airline ticket decreases 20%.
 There is no shift but there is a movement down the existing demand
curve, the lower price for an airline ticket results in an increase in the
number of people travelling by air between NYC and Washington.

Question 5.
 a. What causes the market demand for a commodity to increase (i.e.,
causes the market demand curve to shift up and to the right)?
 Market demand for a commodity increases (the demand curve shift up
and to the right) when (1.) The number of individuals buying the
commodity increases (which would occur as a result of population
growth) (2.) Consumer preference for the commodity increases (increased
concern about w weight would induce more people to drink diet soda).
(3.) Consumers income rise (occurs during an economic expansion). (4.)
The price of a substitute commodity increases (more potatoes are
demanded when the price of rice increases). (5.) The price of the
complementary commodity falls (individual purchasing more fuel
efficient cars when gasoline price rises). An increase in demand means
that more units of the commodity demanded per unit of time.
b. What causes market demand to decrease(that is causes the market
demand curve to shift down and to the left)?
 Market demand decreases (market demand curve shift down and to the
left) when (1.) the number of individuals buying the commodity
decreases, (2.) consumer’s preference for the commodity decreases, (3.)
consumers income fall, (4.) The price of a substitute commodity
decreases. (5.) The price of complementary commodity rises.
A decrease in demand means that at each price, individuals demand fewer
units of the commodity per unit of time.
c. Distinguish between an increase in the quantity demanded and then
increase in demand.
 An increase in quantity demanded indicates that there is a decrease in
price and therefore a movement down a given demand curve, while
holding constant other variables that influence demand. An increase in
demand refers to a shift to the right by the entire demand curve and
indicates that at each price, individuals are willing to purchase more units
of the commodity per unit of time.
d. Distinguish between a decrease in the quantity demanded and a
decrease in demand.
 A decrease in quantity demanded indicates an increase in price and
therefore a movement up a given demand curve, while holding constant
variables other than price. A decrease in demand refers to a shift to the
left by the demand curve and indicates that less of the commodities
purchased at each price per unit of time.

Multiple Choice Questions

Question 6. A demand schedule shows the relationship between the quantity
demanded of a commodity over a given period of time and
a. the price of the commodity
b. the test of the consumers
c. the income of the consumers
d. the price of related commodities

Question 7. More of a commodity will be purchased at lower prices because

a. consumers substitute this commodity for others whose price has not
changed
b. at lower prices consumers can purchase more of this commodity with a
given money income
c. more consumers will buy the commodity at lower prices than at higher
prices,
d. all the above.

Supply
 A supply schedule specifies the units of a good or service that a producer
is willing to supply (Qs) at alternative prices over a given period of time,
i.e, Qs = f (P).
 The quantity supplied of any good or service is the amount that sellers
are willing and able to sell.
 The supply curve normally has a positive (upward) slope, indicating that
the producer must receive a higher price for increased output due to the
principle of increasing costs.
 A market supply curve is derived by summing the units each individual
producer is willing to supply at alternative prices.

What Determines the quantity of an individual Supplies?

Price
The quantity supplied rises as the price rises and falls as the price falls, we say
that the quantity supplied is positively related to the price of the good. This
relationship between price and quantity supplied is called the law of supply:

law of supply- The claim that, other things equal, the quantity supplied of a
good rise when the price of the good rises.

Prices of related goods –

If prices of other goods increases, they become relative more profitable to
produce and sell, than the goods in question. It implies that for example, if the
price of wheat increases the farmers may shift lands to wheat production and go
away from producing paddy.
Input Prices
When the price of one or more of inputs rises, producing goods are less
profitable, and the firm supplies less goods. If input prices rise substantially,
one might shut down the firm. Thus, the
supply of a good is negatively related to the price of the inputs used to make the
good.

Technology
By reducing firms’ costs, the advance in technology raised the supply of ice
cream.

Expectations
Supply depends on the expectations about the future. For example, if you expect
the price of a good to rise in the future, you will put some of your current
production into storage and supply less to the market today.

Govt policy
Production of goods may be subject to imposition of taxes, excise duty, etc.
these increases the price of goods. Subsidies, on the other hand, reduce the cost
of production and provide incentive to the firm to increase supply.

THE SUPPLY SCHEDULE AND THE SUPPLY CURVE

Supply schedule-
A table that shows the relationship between the price of a good and the quantity
supplied.

supply curve-
A graph of the relationship between the price of a good and the quantity
supplied.
 The supply curve shows how the
quantity supplied of the good
changes as its price varies. Because
a higher price
increases the quantity supplied,
the supply curve slopes upward.

Market Supply-
 market supply is the sum of the supplies of all sellers.

The quantity supplied in a market is

the sum of the quantities supplied
by all the sellers.

 The market supply curve is found by adding horizontally the individual

supply curves. At a price of $2, Ben supplies 3 ice-cream cones, and
Jerry supplies 4 ice-cream cones. The quantity supplied in the market at
this price is 7 cones.
  Market supply depends on all those factors that influence the supply of
individual sellers, such as the prices of inputs used to produce the good,
the available technology, and expectations. In addition, the supply in a
market depends on the number of sellers.

SHIFTS IN THE SUPPLY CURVE

 The market supply curve shifts when the number and/or size of
producers’ changes, factor prices (wages, interest, and/or rent paid to
economic resources) change, the cost of materials changes,
technological progress occurs, and/or the government subsidizes or
taxes output.
 The market supply curve shifts down and to the right with more
producers entering the market, decreases in factor or materials
prices, improvement in technology, and government subsidization.
 A change in supply thereby denotes a shift of the supply curve.
 A change in quantity supplied indicates a change in the commodity’s
price and therefore a movement along an existing supply curve.
 Whenever there is a change in any determinant of supply, other than
the good’s price, the supply curve shifts.
 Any change that raises quantity supplied at every price shifts the
supply curve to the right. Similarly, any change that reduces the
quantity supplied at every price shifts the
supply curve to the left. SHIFTS IN THE SUPPLY CURVE.
Any change that raises the
quantity that sellers wish to
produce at a given price
shifts the supply curve to
the right. Any change that
lowers the quantity that
sellers wish to produce at a
given price shifts the supply
curve to the left.

 A change in the price represents a movement along the supply curve,

whereas a change in one of the other variables shifts the supply curve.
Movement along the supply curve
• If the supply of a commodity changes due to change in its own price,
other factors remaining constant it is known as Change in Quantity
Supplied.
• Here when price changes, movement occurs along the supply curve.
• If the price increases from P2 to
PI, the movement happens along
the supply curve from point A to B.
This is called expansion
• If the price decreases from P1 to
P2, the movement happens along
the supply curve from point B to A.
This is called contraction

Questions 8-
a. What is supplies schedule? A supply curve?
b. What is the usual shape of a supply curve? Why?
Supply curve is usually positively sloped, that is its slopes upward to the
right. Producers normally are willing to supply additional units of a
commodity at higher prices since higher production cost are associated
with producing larger quantities in the short run. Although the supply is
normally positively sloped, a supply curve can be vertical. When vertical
the same quantity supplied regardless of its price. This occurs when the
period of analysis is so short that more of the community cannot be
produced or when, as in case of original works of art, the quantity supply
is fixed forever.
c. Explain Qs = f(p).

Questions 9- Table presents the supply schedule of the 3 producers of

potatoes for a market area.
Price Quantity Quantity Quantity
($ per bu) supplied by supplied by supplied by
producer 1 producer 2 producer 3
(bu per month) (bu per month) (bu per month)
5 37.5 22.5 17.5
4 35.0 20.5 15.0
3 30.0 15.0 10.0
2 20.0 10.0 5.0
1 5.0 2.5 0.0
 a. Derive market supply schedule for potatoes.
b. Plot this market supply schedule and label the curve S.

Questions 10- What happens to the airline industry market supply as a result
of the following event
a. there is an increase in the price of oil
with an increasing the price of oil the cost of providing air transportation
increases, the market supply schedule shifts up and to the left.
b. airline workers demand and receive 20% increase in their wage
higher wage contracts cause an increase in the per unit cost of suppling
air transportation, the market supply schedule shifts up and to the left.
c. Pratt and Whitney develop an airplane engine which is 50% more fuel
efficient.
With more fuel-efficient engines, the cost of providing air transportation
decreases, the market supply curve shifts down and to the right.
d. Us manufacturer of airplanes are subsidised by the U.S government.
The US government subsidy lowers the cost of airplanes in the airline
industry, reducing their cost of providing air transportation; the market
supply curve shifts down and to the right.

Equilibrium
 Equilibrium occurs at the intersection of the market
supply and market demand curves. At this
intersection, quantity demanded equals quantity
supplied, i.e., the quantity that individuals are
willing to purchase exactly equals the quantity
producers are willing to supply.

THE EQUILIBRIUMOF SUPPLY

AND DEMAND. The
equilibrium is found where
the supply and demand
curves intersect. At the
equilibrium price, the
quantity supplied equals
the quantity
demanded. Here the
equilibrium price is $2: At
this price, 7 icecream
cones are supplied, and 7
ice-cream cones are
demanded.
 Equilibrium- A situation in which supply and demand
have been brought into balance.
 The price at which these two curves cross is called the
equilibrium price, and the quantity is called the
equilibrium quantity.
 At the equilibrium price, the quantity of the good that
buyers are willing and able to buy exactly balances the
quantity that sellers are willing and able to sell.
 The equilibrium price is sometimes called the market-
clearing price because, at this price, everyone in the
market has been satisfied: Buyers have bought all they
want to buy, and sellers have sold all they want to sell.
 A surplus exists at prices higher than the equilibrium
price since the quantity demanded falls short of the
quantity supplied.

surplus
a situation in which quantity
supplied is greater than
quantity demanded.

Suppliers try to increase

sales by cutting the price
of a cone, and this moves
the price toward its
equilibrium level.

The price adjustment moves

the market toward the
equilibrium of supply and
demand.

 The situation where the quantity supplied is greater than

the quantity demanded is called excess supply in the
market.
 The situation where the quantity demanded is greater
than the quantity supplied is called excess demand in
the market.
 prices lower than the equilibrium price, there is a
shortage of output since quantity demanded exceeds
quantity supplied.
 shortage
a situation in which quantity
demanded is greater than
quantity supplied.

With too many buyers chasing

too few goods, suppliers can
take
advantage of the shortage by
raising the price.

the price adjustment moves

the market toward the
equilibrium of supply and
demand.

 Once achieved, the equilibrium price and quantity persist

until there is a change in demand and/or supply.
Questions 11- Market demand and market supply schedules for wheat appear
in Table.

Price Qd Qs
(S per bu) (million bu per (million bu per month)
month)
5 2.25 3.75

4 2.50 3.50

3 3.00 3.00

2 4.00 2.00

1 5.50 0.50

(a) What is the relationship of quantity demanded and quantity supplied at

prices per bushel of $5, $4, $3, $2, and $1? Is there a market surplus
or shortage at these prices?
When the price of wheat is $5 per bushel, 2.25 million bushels per month
are demanded and 3.75 bushels are supplied. There is a wheat surplus
since quantity supplied is greater than quantity demanded. At a $4 price,
the quantity of wheat demanded is 2.5 million bushels per month, while
the quantity of wheat supplied is 3.5 million, giving a I million bushel
surplus. The quantity of wheat supplied and demanded is 3 million
bushels when the price of wheat is $3 per bushel, and there is neither a
surplus nor a shortage of wheat. When the price of wheat is $2 or $1,
 there is a shortage of wheat production since the quantity of wheat
demanded exceeds that which is being supplied.

(b) What effect does a surplus of wheat have upon the price of wheat?
There is downward pressure on the price of wheat when a surplus exists.
In order to sell this excess production, producers must lower price to
induce consumers to purchase the excess production.

(c) What effect does a shortage of wheat have upon the price of wheat?
When a shortage exists, there is upward pressure on the price of wheat
since consumers want to buy more wheat than is being supplied. Higher
wheat prices induce consumers to substitute other grains for wheat. and
eventually there is a balancing of quantity supplied and quantity
demanded.

Questions 12- Suppose the market demand for Good X is given by the
equation Qd = 1000-20P, and market supply is given by the equation Qs = 500
+ 30P.

(a) Find quantity demanded and quantity supplied when the price of Good
X is $12. Is there a surplus or shortage in the production of Good X?
What should happen to the price of Good X?
Quantity demanded is found by letting P equal $12 in the demand
equation Qd = 1000-20P. Thus, Qd= 1000-20(12); quantity demanded is
760. Quantity supplied is 860 when price is $12 [Qs = 500+30(12);
Qs = 860]. There is a surplus of production since 860 units
are supplied while 760 units are demanded when the price
per unit is $12. There is therefore downward pressure on
the $12 price for Good X.

(b) Find the equilibrium price for Good X by equating Qd and Qs.
The equilibrium price for Good X is found by equating Qd,
and Qs.
Qd = Qs
1000-20P =500+30P
50P = 500
P = $10
(c) Prove that the price found in part (b) is an equilibrium price.
At equilibrium, the quantity demanded must equal the
quantity supplied. Substituting the $10 equilibrium price
into the market demand and market supply equations, we
find that quantity supplied and quantity demanded each
 equals 800 units. [Qd=1000-20(10); Qd=800. Qs = 500+
30(10); Qs=800.]

Equilibrium when market demand and/or market supply

curve shift
 Equilibrium price and/or equilibrium quantity change
when the market demand and/or market supply
curves shift.
 Equilibrium price and equilibrium quantity both rise when
there is an increase in market demand with no
change in the market supply curve.

HOW AN INCREASE IN DEMAND

AFFECTS THE EQUILIBRIUM.
An event that raises quantity
demanded at any given price
shifts the demand curve to the
right. The equilibrium price and
the equilibrium quantity both
rise.
Here, an abnormally hot summer
causes buyers to demand more
ice cream. The demand curve
shifts from D1 to D2, which
causes the equilibrium price to
rise from $2.00 to $2.50 and the
equilibrium quantity to rise
from 7 to 10 cones.

 Equilibrium price increases while equilibrium quantity

decreases when market supply decreases and
demand is unchanged.
 HOW A DECREASE IN SUPPLY
AFFECTS THE EQUILIBRIUM.
An event that reduces quantity
supplied at any given price shifts
the supply curve to the left. The
equilibrium price rises, and the
equilibrium quantity falls.

Here, an earthquake causes sellers

to
supply less ice cream. The supply
curve shifts from S1 to S2, which
causes the equilibrium price to rise
from $2.00 to $2.50 and the
equilibrium quantity to fall from 7 to
4 cones.

 An increase in both market demand and market

supply - shift to the right by both supply and demand
curves- results in a higher equilibrium quantity; the
change in equilibrium price is indeterminate,
however, when the magnitude of the demand and
supply shift is unspecified.
 When demand increases substantially while supply falls just a little,
the equilibrium quantity also rises.
 The
equilibriu
m price
rises from
P1 to P2,
and the
equilibriu
m quantity
rises
from Q1 to
Q2 .

 When supply falls substantially while demand rises just a little, the
equilibrium quantity falls.
The equilibrium
price rises
from P1 to P2,
but the
equilibrium
quantity falls
from Q1 to Q2.
Question 13-
Suppose the market supply and demand curves for Good A are initially S and
D in Fig.; equilibrium price is $3 and equilibrium quantity is 280.

(a) When the price of a substitute good increases 20%, the demand for
Good A shifts up and to the right, from D to D'. After the demand shift
what is the relationship between quantity demanded and quantity
supplied at the initial $3 equilibrium price? What must happen to the
price of Good A in a market economy?
Quantity demanded for market schedule D' is 330 when the price is $3,
while market supply is 280. There is a shortage of Good A at the initial
$3 equilibrium price which puts upward pressure on the price of Good A.

(b) What is the new equilibrium price and quantity for Good A after the
increase in demand?
 The new equilibrium price for market demand curve D' and market
supply curve S is $4; the equilibrium quantity is now 290.

(c) What happens to a commodity's equilibrium price and quantity when

there is an increase in demand, ceteris paribus?
Holding other variable constant, equilibrium price increases when there
is an increase in demand. Equilibrium quantity also increases as long as
the market supply curve is not vertical.

ELASTICITY

 Elasticity, a measure of how much buyers and sellers respond to changes

in market conditions, allows us to analyze supply and demand with
greater precision.
 We noted that buyers usually demand more of a good when its price is
lower, when their incomes are higher, when the prices of substitutes for
the good are higher, or when the prices of complements of the good are
lower.
 The discussion of demand was qualitative, not quantitative. That is, we
discussed the direction in which the quantity demanded moves, but not
the size of the change.
 To measure how much demand responds to changes in its determinants,
economists use the concept of elasticity.
 Elasticity is a measure of the responsiveness of quantity demanded or
quantity supplied to one of its determinants.

THE PRICE ELASTICITY OF DEMAND AND ITS DETERMINANTS

 Price elasticity of demand- a measure of how much the quantity

demanded of a good respond to a change in the price of that good,
computed as the percentage change in quantity demanded divided by the
percentage change in price.
 Demand for a good is said to be elastic if the quantity demanded responds
substantially to changes in the price.
 Demand is said to be inelastic if the quantity demanded responds only
slightly to changes in the price.
What determines whether the demand for a good is elastic or inelastic?
Necessities versus Luxuries
 Necessities tend to have inelastic demands, whereas luxuries have elastic
demands. When the price of a visit to the doctor rises, people will not
dramatically alter the number of times they go to the doctor, although
they might go somewhat less often. By contrast, when the price of
sailboats rises, the quantity of sailboats demanded falls substantially. The
reason is that most people view doctor visits as a necessity and sailboats
as a luxury.
Availability of Close Substitutes
 Goods with close substitutes tend to have more elastic demand because it
is easier for consumers to switch from that good to others. For example,
butter and margarine are easily substitutable. A small increase in the price
of butter, assuming the price of margarine is held fixed, causes the
quantity of butter sold to fall by a large amount. By contrast, because
eggs are a food without a close substitute, the demand for eggs is
probably less elastic than the demand for butter.
Definition of the Market
 Narrowly defined markets tend to have more elastic demand than broadly
defined markets, because it is easier to find close substitutes for narrowly
defined goods. For example, food, a broad category, has a fairly inelastic
demand because there are no good substitutes for food. Ice cream, a more
narrow category, has a more elastic demand because it is easy to
substitute other desserts for ice cream. Vanilla ice cream, a very narrow
category, has a very elastic demand because other flavors of ice cream are
almost perfect substitutes for vanilla.
Time Horizon
 Goods tend to have more elastic demand over longer time horizons.
When the price of gasoline rises, the quantity of gasoline demanded falls
only slightly in the first few months. Over time, however, people buy
more fuel-efficient cars, switch to public transportation, and move closer
to where they work. Within several years, the quantity of gasoline
demanded falls substantially.

COMPUTING THE PRICE ELASTICITY OF DEMAND

 Economists compute the price elasticity of demand as the percentage
change in the quantity demanded divided by the percentage change in the
price. That is,

percentagechange ∈the quantity demanded

Price elasticity of demand=
percentage change∈ price
  Example- Suppose that a 10-percent increase in the price of an ice-cream
cone causes the amount of ice cream you buy to fall by 20 percent. We
calculate your elasticity of demand as-

Price elasticity of demand = 20 percent/ 10 percent = 2 reflecting that the

change in the quantity demanded is proportionately twice as large as the
change in the price.
 Because the quantity demanded of a good is negatively related to its
price, the percentage change in quantity will always have the opposite
sign as the percentage change in price. For this reason, price elasticities of
demand are sometimes reported as negative numbers.
 A larger price elasticity implies a greater responsiveness of quantity
demanded to price.

THE MIDPOINT METHOD: A BETTER WAY TO CALCULATE

PERCENTAGE CHANGES AND ELASTICITIES

 The elasticity from point A to point B seems different from the elasticity
from point B to point A.
Point A: Price = $4 Quantity = 120
Point B: Price = $6 Quantity = 80

Going from point A to point B, the price rises by 50 percent, and the
quantity falls by 33 percent, indicating that the price elasticity of
demand is 33/50, or 0.66.
By contrast, going from point B to point A, the price falls by 33 percent,
and the quantity rises by 50 percent, indicating that the price elasticity of
demand is 50/33, or 1.5.

One way to avoid this problem is to use the midpoint method for
calculating elasticities.

The midpoint method computes a percentage change by dividing the

change by the midpoint of the initial and final levels. For instance, $5
is the midpoint of $4 and $6. Therefore, according to the midpoint
method, a change from $4 to $6 is considered a 40 percent rise, because
(6 - 4)/5 *100 = 40. Similarly, a change from $6 to $4 is considered a
40 percent fall.

Because the midpoint method gives the same answer regardless of the
direction of change, it is often used when calculating the price
elasticity of demand between two points.
 In our example, the midpoint between point A and point B is:
Midpoint: Price = $5 Quantity =100

According to the midpoint method, when going from point A to point B,

the price rises by 40 percent, and the quantity falls by 40 percent.
Similarly, when going from point B to point A, the price falls by 40
percent, and the quantity rises by 40 percent. In both directions, the
price elasticity of demand equals 1.

We can express the midpoint method with the following formula for the
price elasticity of demand between two points, denoted (Q1, P1) and (Q2,
P2):
(Q 2−Q1)/[(Q 2+Q 1)/2]
Price elasticity of demand=
(P 2−P 1)/[(P 2+ P 1)/2]

Question- From the hypothetical market demand schedule in table find the
elasticity of market demand between points
a. A and B Price Quantity demanded in the points
market
b. B and E 5 3.5 A
c. E and C 4 4.2 B
3 5.0 E
d. C and F 2 6.0 C
1 7.5 F

Answer- a.
(4.2−3.5)/[(4.2+3.5)/2]
E D=
(4−5)/¿¿

(0.7)/[(7.7)/2]
¿
(−1)/¿ ¿

(0.7)/[3.85 ]
¿
(−1)/[4.5 ]

0.18
¿
−0.22

¿−0.81

¿ 0.81

THE VARIETY OF DEMAND CURVES/ Degrees of Elasticity of Demand

 Demand is elastic when the elasticity is greater than 1, so that quantity
moves proportionately more than the price.
Here, the price has increased by 22 percent which causes 67 percent
decrease in quantity demanded. Hence Ep = (- )67/22= (-)3.04

 Demand is inelastic when the elasticity is less than 1, so that quantity

moves proportionately less than the price.
Here, the price has increased by 22 percent which causes 11 percent
decrease in quantity demanded. Hence Ep = (- )11/22= (-) 0.5

 If the elasticity is exactly 1, so that quantity moves the same amount

proportionately as price, demand is said to have unit elasticity.
Here, the price has increased by 22 percent which causes 22 percent
decrease in quantity demanded. Hence Ep = (-)22/22= (-)1
 The flatter is the demand curve that passes through a given point, the
greater is the price elasticity of demand.
 The steeper is the demand curve that passes through a given point, the
smaller is the price elasticity of demand.
 In the extreme case of a zero elasticity, demand is perfectly inelastic, and
the demand curve is vertical. In this case, regardless of the price, the
quantity demanded stays the same.
Here, the price has increased by 22 percent which causes no change in
quantity demanded. Hence Ep = (-)0/22= 0

 As the elasticity rises, the demand curve gets flatter and flatter.
 At the opposite extreme, demand is perfectly elastic. This occurs as the
price elasticity of demand approaches infinity and the demand curve
becomes horizontal, reflecting the fact that very small changes in the
price lead to huge changes in the quantity demanded.
TOTAL REVENUE AND THE PRICE ELASTICITY OF DEMAND

 Total revenue - The amount paid by buyers and received by sellers of

a good, computed as the price of the good times the quantity sold.

 How does total revenue change as one moves along the demand
curve? The answer depends on the price elasticity of demand.
 With an inelastic demand curve, an increase in the price leads to a
decrease in quantity demanded that is proportionately smaller.
Therefore, total revenue increases.
Here, an increase in the price from $1 to $3 causes the quantity demanded
to fall from 100 to 80, and total revenue rises from $100 to $240.
  With an elastic demand curve, an increase in the price leads to
a decrease in quantity demanded that is proportionately larger.
Therefore, total revenue decreases.
Here, an increase in the price from $4 to $5 causes the quantity
demanded to fall from 50 to 20, so total revenue falls from $200 to
$100.

ELASTICITY AND TOTAL REVENUE ALONG A LINEAR DEMAND

CURVE
 The slope of a linear demand curve is constant, the elasticity is
not. The reason is that the slope is the ratio of changes in the two
variables, whereas the elasticity is the ratio of percentage
changes in the two variables.
  This table shows the demand schedule for the linear demand curve
in Figure and calculates the price elasticity of demand using the
midpoint method.

 At points with a low price and high quantity, the demand curve
is inelastic. At points with a high price and low quantity, the
demand curve is elastic.
 When the price is $1, for instance, demand is inelastic, and a price
increase to $2 raises total revenue. When the price is $5, demand is
elastic, and a price increase to $6 reduces total revenue. Between
$3 and $4, demand is exactly unit elastic, and total revenue is the
same at these two prices.

Income elasticity of demand

 A measure of how much the quantity demanded of a good responds to a
change in consumers’ income, computed as the percentage change in
quantity demanded divided by the percentage change in income.

percentage change∈quantity demanded

Income elasticity of demand=
percentage change∈ Income
 Because quantity demanded and income move in the same direction,
normal goods have positive income elasticities.
 Because quantity demanded and income move in opposite directions,
inferior goods have negative income elasticities.
 Necessities, such as food and clothing, tend to have small income
elasticities because consumers, regardless of how low their incomes,
choose to buy some of these goods.
  Luxuries, such as caviar and furs, tend to have large income elasticities
because consumers feel that they can do without these goods altogether if
their income is too low.

The Cross-Price Elasticity of Demand

 A measure of how much the quantity demanded of one good
responds to a change in the price of another good, computed as the
percentage change in quantity demanded of the first good divided by
the percentage change in the price of the second good.

percentage change ∈quantity demanded of good 1

Cross price elasticity of demand=
percentage change∈the price of good 2

 The cross-price elasticity of substitute goods is positive.

 The cross-price elasticity of complement goods is negative.

THE PRICE ELASTICITY OF SUPPLY

 The price elasticity of supply measures how much the

quantity supplied responds to changes in the price.
 Supply of a good is said to be elastic if the quantity
supplied responds substantially to changes in the
price.
 Supply is said to be inelastic if the quantity supplied
responds only slightly to changes in the price.
 Supply is usually more elastic in the long run than in
the short run. Over short periods of time, firms cannot
easily change the size of their factories to make more or
less of a good. Thus, in the short run, the quantity
supplied is not very responsive to the price. By contrast,
over longer periods, firms can build new factories or close
old ones.
 Price elasticity of supply is computed as the percentage
change in the quantity supplied divided by the percentage
change in the price. That is,
percentage change∈the quantity supplied
Price elasticity of supply=
percentage change∈ price

THE VARIETY OF SUPPLY CURVES

 In the extreme case of a zero elasticity, supply is perfectly inelastic, and

the supply curve is vertical. In this case, regardless of the price, the
quantity supplied stays the same.
 Here, the price increased causes no change in quantity supplied. Hence
Ep = 0/22= 0

 Supply is inelastic when the elasticity is less than 1, so that quantity

moves proportionately less than the price.
Here, the price has increased by 22 percent which causes 10 percent
increase in quantity supplied. Hence Ep = 10/22= 0.45

 If the elasticity is exactly 1, so that quantity moves the same amount

proportionately as price, supply is said to have unit elasticity.
Here, the price has increased by 22 percent which causes 22 percent
increase in quantity supplied. Hence Ep = 22/22= 1
 Supply is elastic when the elasticity is greater than 1, so that quantity
moves proportionately more than the price.
Here, the price has increased by 22 percent which causes 67 percent
increase in quantity supplied. Hence Ep = 67/22= 3.04

 At the opposite extreme, supply is perfectly elastic. This occurs as the

price elasticity of supply approaches infinity and the supply curve
becomes horizontal, reflecting the fact that very small changes in the
price lead to huge changes in the quantity supplied.

Impact of government intervention on price and quantity, Deadweight

loss of taxation
 In a free unregulated market system market forces
establish equilibrium price and quantity.
 The market equilibrium may be efficient, but it may
not leave everyone satisfied.
 Those who consider themselves to be losing from the
market outcomes will ask for government to
intervene in the market.
  The government intervention in the market may take
several ways, depending on the circumstances.
 Here we will look at two different cases of direct
government involvement in market:
1. Price controls- Price controls are usually enacted when
policymakers believe that the market price of a good or service is
unfair to buyers or sellers.
2. Tax levied on goods and services- Policymakers
use taxes both to influence market outcomes and to raise revenue
for public purposes.

Price Controls
 Price control: government sets an upper or lower limit (or
both) to the price of goods or services.
 Price controls are enacted by governments because there
is a demand for them from some section of the public.
Either buyer or seller feels that the existing market price is
unfair to them.
 Buyers of any good always want a lower price while sellers
want a higher price, the interests of the two groups
conflict.
 For example, if the Ice Cream Eaters are successful in
their lobbying, the government imposes a legal maximum
on the price at which ice cream can be sold. Because the
price is not allowed to rise above this level, the legislated
maximum is called a price ceiling.
A price ceiling is a legal maximum on the price of a good
or service that sellers can charge to their customers. In
other words market price can be lower but cannot be
higher than the price fixed by government.

 By contrast, if the Ice Cream Makers are successful, the

government imposes a legal minimum on the price.
Because the price cannot fall below this level, the
legislated minimum is called a price floor.
A price floor is a legal minimum on the price of a good or
service that buyers must pay for a product. Market price
can be higher but not below the price set by the
government.
 Let us consider the effects of these policies in turn.

HOW PRICE CEILINGS AFFECT MARKET OUTCOMES

 A price ceiling is a legal maximum on the price of a good
or service that sellers can charge to their customers. In
other words market price can be lower but cannot be
higher than the price fixed by government.

Two outcomes are possible when government imposes a

price ceiling.
The price ceiling is not binding if it is set above the
equilibrium price. It will have no impact on the market.
The price ceiling is binding if it is set below the
equilibrium price. It will lead to shortage in the market as
demand exceeds supply at that price.

A Price Ceiling That Is Not Binding

The government imposes a

price ceiling of $4.
Because the price ceiling is
above the equilibrium
price of $3, the price
ceiling has no effect, and
the market can reach the
equilibrium of supply and
demand. In this
equilibrium, quantity
supplied and quantity
demanded both equal 100
cones.

A Price Ceiling That Is Binding

The government imposes

a price ceiling of $2.
Because the price ceiling
is below the
equilibrium price of $3,
the market price equals
$2. At this price, 125
cones are demanded and
only 75 are supplied, so
there is a shortage of 50
cones.
HOW PRICE FLOORS AFFECT MARKET OUTCOMES
A price floor is a legal minimum on the price of a good or
service that buyers must pay for a product. Market price
can be higher but not below the price set by the
government.

When the government imposes a price floor again two

outcomes are possible.
The price floor is not binding if it is below the
equilibrium price. It has no effect on the market.
The price floor is binding if it is set above the
equilibrium price it leads to a surplus because demand is
less than supply at that prise.

A Price Floor That Is Not Binding

the government imposes
a price floor of $2.
Because this is below the
equilibrium price of $3,
the price floor has no
effect. The market price
adjusts to balance supply
and demand. At the
equilibrium, quantity
supplied, and quantity
demanded both equal
100 cones.

A Price Floor That Is Binding

 The government imposes
a
price floor of $4, which is
above the equilibrium
price of $3. Therefore, the
market price equals $4.
Because 120 cones are
supplied at this price and
only 80 are demanded,
there is a surplus of 40
cones.

TAXES

• Tax levied on goods and services are called Indirect tax.

• Tax discourages the market activity.
• When a good is taxed, the quantity sold is smaller.
• When tax is levies by the Govt, few questions need
to be addressed:
• Who bears the burden of tax? – Is it the buyer or the
seller.
• If the burden of tax is shared between buyers and
sellers, how the burden is divided?
• Tax incidence – The study of who bears the burden of
taxation is called the tax incidence.
• Taxes results in a change in market equilibrium.
• Buyers pay more and sellers receive less, regardless
of whom the tax is levied on.

HOW TAXES ON BUYERS AFFECT MARKET OUTCOMES

 Suppose, for instance, that our local government passes a
law requiring buyers of ice-cream cones to send $0.50
to the government for each ice-cream cone they buy.
How does this law affect the buyers and sellers of
ice cream?
 Because the tax on buyers makes buying ice cream less
attractive, buyers demand a smaller quantity of ice
cream at every price. As a result, the demand curve
shifts to the left (D1 to D2).
 Because of the $0.50 tax levied on buyers, the effective
price to buyers is now $0.50 higher than the market
price.

 To see the effect of the tax, we compare the old

equilibrium and the new equilibrium.
 The equilibrium quantity falls from 100 to 90 cones.
The price that sellers receive falls from $3.00 to
$2.80.
 Because sellers sell less and buyers buy less in the new
equilibrium, the tax on ice cream reduces the size of
the ice-cream market.
 let’s return to the question of tax incidence: Who
pays the tax? Although buyers send the entire tax
to the government, buyers and sellers share the
burden.
 The price that buyers pay (including the tax) rises
from $3.00 to $3.30. Even though the tax is levied
 on buyers, buyers and sellers share the burden of
the tax.
 Thus, the tax makes sellers worse off. Buyers pay
sellers a lower price ($2.80), but the effective price
including the tax rises from $3.00 before the tax to
$3.30 with the tax ($2.80 + $0.50 = $3.30). Thus,
the tax also makes buyers worse off.
 To sum up,
Taxes discourage market activity. When a good is taxed,
the quantity of the good sold is smaller in the new
equilibrium.
Buyers and sellers share the burden of taxes. In the new
equilibrium, buyers pay more for the good, and sellers
receive less.

HOW TAXES ON SELLERS AFFECT MARKET OUTCOMES

 Suppose the local government passes a law requiring

sellers of ice-cream cones to send $0.50 to the
government for each cone they sell. What are the
effects of this law?

 The tax on sellers raises the cost of selling ice-

cream and leads sellers to supply a smaller quantity
at every price. The supply curve shifts to the left
(S1 to S2) by exactly the size of the tax ($0.50).
 The effective price to sellers—the amount they get
to keep after paying the tax—is $0.50 lower.
  When the market moves from the old to the new
equilibrium, the equilibrium price of ice cream rises
from $3.00 to $3.30, and the equilibrium quantity
falls from 100 to 90 cones. The tax reduces the size
of the ice-cream market.
 Who pays the tax? Once again, buyers and sellers
share the burden of the tax. Because the market
price rises, buyers pay $0.30 more for each cone
than they did before the tax was enacted. Sellers
receive a higher price than they did without the tax,
but the effective price (after paying the tax) falls
from $3.00 to $2.80.
 Taxes on buyers and taxes on sellers are
equivalent. The only difference between taxes on
buyers and taxes on sellers is who sends the money
to the government.

ELASTICITY AND TAX INCIDENCE

 When a good is taxed, buyers and sellers of the

good share the burden of the tax. But how exactly
is the tax burden divided? Only rarely will it be
shared equally. To see how the burden is divided,
consider the impact of taxation in the two markets.
 Figure shows a tax in a market with very elastic
supply and relatively inelastic demand. That is,
sellers are very responsive to the price of the good,
whereas buyers are not very responsive.
 When a tax is imposed on a market with these
elasticities, the price received by sellers does not
fall much, so sellers bear only a small burden.
 By contrast, the price paid by buyers rises
substantially, indicating that buyers bear most of
the burden of the tax.

 Figure shows a tax in a market with relatively

inelastic supply and very elastic demand. In this
case, sellers are not very responsive to the price,
while buyers are very responsive.
 The figure shows that when a tax is imposed, the
price paid by buyers does not rise much, while the
price received by sellers falls substantially. Thus,
sellers bear most of the burden of the tax.
 General lesson- A tax burden falls more heavily on the
side of the market that is less elastic. A small elasticity of
demand means that buyers do not have good alternatives
to consuming this particular good. A small elasticity of
supply means that sellers do not have good alternatives to
producing this particular good. When the good is taxed,
the side of the market with fewer good alternatives cannot
easily leave the market and must, therefore, bear more of
the burden of the tax.