Chapter 2 – The Market

Demand

Demand can be defined as the quantity of a product that buyers / customers are willing and able
to buy at a given price. The relationship between price and demand is a negative relationship.
Most people want to buy for the lowest price.

- When prices are high demand will be low

- When prices are low demand will be high

The factors of Demand

Any changes in price results in a movement along the demand curve. There are a number of
other factors that may also have an effect on demand. If any of these factors change, the demand
curve itself will shift.

Income

Price of
Substitutes and
External Shocks
Complementary
Products

Other
factors of
Demand
Tastes, fashion
Demographics
and Customs

Changes in
Advertising
Population

External Shocks

 Natural disasters such as floods, earthquakes

 Government - A change in the law, raising taxes
 An unexpected change of mind by a major customer
 Competition – new competitor enters the market
 Economic Climate – boom and recession
Supply
Supply can be defined as the amount of a product that suppliers/sellers are willing to sell at a
given price. The relationship between price and supply is a positive relationship. Most people
want to sell their products for the highest price.
- When prices are high supply will be high
- When prices are low supply will be low

The factors of Supply

Any changes in price results in a movement along the supply curve. There are a number of other
factors that may also have an effect on supply. If any of these factors change the supply curve
itself will shift.

Changes in
Priduction
Technology

External
The Weather
Shocks
Other
Factors
of Supply

Legislation &
Costs of
Production Government
Policy
Market Equilibrium – Determining Price

By combining supply and demand we can show how market works. The two curves should cross
at one point. This point is called the equilibrium. The equilibrium price is also known as the
market clearing price. This is because the amount supplied in the market is completely bought up
by consumers. There are no buyers left without goods and there are no sellers left with unsold
stock. The market is cleared.

Figure 1 also shows the total revenue or total expenditure at the equilibrium price. Total revenue
is the amount of money generated from the sale of output. It is calculated by multiplying price
and quantity.

Total revenue (TR) = Price (P) × Quantity (Q)

Price Elasticity of Demand (PED)

Price elasticity of demand (PED) measures the change in quantity sold that results from a change
in price.

PED = % change in quantity demanded

% change in price

Or if you don’t like percentages;

PED = Original price X Change in Quantity

Original Quantity Change in Price

P Q

10 500

11 400
P Q

10 500

11 475

P Q

10 500

11 450
There is always an inverse relationship between price and quantity. Therefore the PED
calculation will always be negative. As such the negative sign is ignored. Therefore there are 3
possible outcomes;

 1 Price Inelastic (Change in quantity demanded is less than the change in price)

= 1 Unit Price (Unitary) Elastic (Change in quantity demanded is the same as the change in
price)

 1 Price Elastic (Change in quantity demanded is greater than the change in price)

Factors affecting the Degree of Price Elasticity

 Number and closeness of substitutes- The more substitutes the product has, the more price
elastic it will be.
 Competition for the same product -Some businesses face highly price elastic demand for
their products. This is because they are in very competitive markets, where their product is
either identical (i.e. a perfect substitute) or little different from those produced by other
businesses. Farmers, for example, when selling wheat or potatoes are in this position. If they
push their prices above the market price, they will not be able to sell their crop. Customers
will simply buy elsewhere at the lower market price.
 Luxury or necessity – Luxuries tend to be more price elastic and necessities tend to be more
price inelastic. (unless the luxury in question is a status symbol, in which case cutting the
price may make it say less about your status)
 Proportion of income spent on good – If a box of matches increases in price by 10% most
people will either not notice or not be concerned, sales will hardly change. (Inelastic) On the
other hand if a new car goes up in price by 10%, sales are likely to drop significantly.
(Elastic)
 Time Scale – In the short-term many products and services will be more price inelastic than
in the long-term. Significant increases in the price of fuel leave consumers with little choice
but to keep buying. Over time this will lead to more economical vehicles and the
development of alternative energy sources.
PED & Total Revenue

The effect of changes in price upon total revenue can be seen below; TR = P*Q

For a Price For a Price

Increase Decrease

Demand is PED = -2, PED = -2,

Elastic P= £10- £11(10%), P= £10- £9(10%),

1 D = 500 – 400 (20%) D = 500 – 600 (20%)

Demand is PED = 1, PED = -2,

Unitary Elastic P=£10–£11 (10%), P= £10- £9(10%),

D = 500 – 450 (10%) D = 500 – 550 (10%)

Demand is PED = 0.5, PED = 0.5,

Inelastic P=£10–£11 (10%), P=£10–£9 (10%),

1 D = 500 – 475(5%) D = 500 – 525(5%)

 For a Price For a Price

Increase Decrease

Demand is PED = -2, PED = -2,

Elastic P= £10- £11(10%), P= £10- £9(10%),

1 D = 500 – 400 (20%) D = 500 – 600 (20%)

10*500 = £5,000 10*500 = £5,000

11*400 = £4,400 9*600 = £5,400

Demand is PED = 1, PED = -2,

Unitary Elastic P=£10–£11 (10%), P= £10- £9(10%),

D = 500 – 450(10%) D = 500 – 550 (10%)

10*500 = £5,000 10*500 = £5,000

11*450 = £4,950 9*550 = £4,950

Demand is PED = 0.5, PED = 0.5,

Inelastic P=£10–£11 (10%), P=£10–£9 (10%),

1 D = 500 – 475(5%) D = 500 – 525(5%)

10*500 = £5,000 10*500 = £5,000

11*475 = £5,225 9*525 = £4,725

 Price Value For a Price For a Price
Elasticity of Elasticity Increase Decrease
Demand is
Elastic >1
Demand is
Unitary Elastic =1
Demand is
Inelastic <1

Income Elasticity of Demand (YED)

The demand for a good will change if there is a change in consumer’s income. Income Elasticity
of Demand is a measure of that change. Income elasticity of demand measures the
responsiveness of demand to a change in income.

YED = % change in quantity demanded

% change in income

Or if you don’t like percentages;

YED = Original Income X Change in Quantity

Original Quantity Change in Income

Y Q

16 20

18 25
 Y Q

20 100

25 200

Y Q

25 50

30 40

Y Q

27 60

30 40

The pattern for of demand is likely to change when income changes. It would be reasonable to
assume that consumers will increase their demand for most goods when their income increases.
Goods for which this is the case are called Normal Goods. Normal goods have positive income
elasticity.

However an increase in income will result in a fall in demand for some goods. These goods are
called Inferior Goods. Ex: consumers switch from buses to their own cars when they can afford
to buy their own car. Inferior goods have a negative income elasticity.
Interpretation of the numerical values of income elasticity of demand

The values calculated above show whether demand is income elastic or income inelastic.

● If the value of income elasticity is greater than 1, demand is said to be income elastic. Demand
for product A is income elastic because income elasticity is 2.5. This means that the change in
demand is proportionately greater than the change in income.

● If the value of income elasticity of demand is less than 1, demand is said to be income
inelastic. Demand for product B is income inelastic because income elasticity is 0.5. This means
that the change in demand is proportionately less than the change in income.