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The law of demand states that more is bought at a lower
price than at a higher price
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A market demand curve for a certain product is derived from the horizontal summation of all
individuals demand curves at each and every price of the quantity demanded
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Price

D

P

P1
D
0

Quantity demanded
Q

Q1

A fall in the price from OP to OP1 expands the quantity demanded from OQ to OQ1, whilst a
rise will do the contrary
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For instance,
a rise in the price of good X will lead to a fall in quantity demanded for good X
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For most goods, an increased in real income will lead to an increase in demand
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In fact, there exists
a direct relationship between income and quantity demanded for normal goods
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These are called inferior good, for example,
cheap clothing, cheap foodstuff, black and white TV
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A change in consumer tastes in favour of a good can increase the demand for that
commodity
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Similarly, if a commodity is in
fashion, demand will rise
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Changes in the prices of complements and substitutes:
Demand for a commodity depends much on the price of its complementary goods
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For example, if the price of car falls,
demand for petrol will increase
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Thus, there exists an inverse relationship between demand for a commodity and the price of its
complements
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If the price
of substitutes increases, demand for a commodity will also increase
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This is because people will buy less tea, and therefore,
they will shift to coffee
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An increase in total population would generally lead to an increase in demand
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An increase in
old age people would mean a greater demand for walking sticks, spectacles
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On the other hand, more females in the population
indicate that demand for goods and services consumed by women will rise
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Expectation of future changes in price:
Expectations by consumers of future changes in prices would affect demand
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Incomes could
be redistributed to achieve greater equality of income by taxing the rich and subsidizing the poor
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An increase in
savings would lead to a fall in demand since the individual forgoes present consumption in order to save
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Hence, an increase in rate of interest will
cause demand to fall
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Thus, a rise in the price will
cause quantity demanded to fall, and vice versa
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The movement along
the demand curve is shown as follows:
Price

D
B

P1
A
P
C
P2
D
0

Quantity demanded
Q1

Q

Q2

If price rises from 0P to 0P1, quantity demanded will fall from 0Q to 0Q1, that is, a movement
from A to B along the demand curve
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A shift in the demand curve or a change in demand occurs when quantity demanded changes
only because there are changes in conditions of demand, while the price of the commodity remains
constant
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The shift in the demand curve is shown as follows:
D1
Price

D
increase
D2

decrease

P
D1
D2

D

0

Quantity demanded
Q2

Q

Q1

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ELASTICITY OF DEMAND:
The law of demand, which expresses an inverse relationship between quantity demanded and
price, shows only the direction of demand
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This information is, however,
provided by the concept of elasticity of demand which shows the exact magnitude by which demand will
change if there is a change in its variables
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Price elasticity of demand
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Income elasticity of demand
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Cross elasticity of demand
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In other words, it shows by how much quantity demanded has changed given a
change in price
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OR

Price elasticity of demand = change in quantity demanded *
initial price
change in price
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Demand for most goods is either elastic, inelastic or unitary depending on whether its coefficient
is greater than, less than or equal to one
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Hence, an elastic demand occurs
when the percentage change in quantity demanded is greater than the percentage change in price, and the
coefficient of the elasticity is greater than 1 (PED > 1)
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Hence, an inelastic demand occurs when the
percentage change in quantity demanded is less than the percentage change in price, and the coefficient
of the elasticity is less than 1 (PED < 1)
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The coefficient of elasticity is equal to 1 (PED = 1)
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The coefficient of elasticity is equal to infinity
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The value of the PED is zero (PED = 0)
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It varies according to the level of price
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FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND:
There are various factors which influence the price elasticity of demand
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Nature of commodity:
(a)

Necessities:

The demand for necessities is inelastic because when their prices rise, the

consumers’ demand will fall very slightly
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If their prices fall, demand will increase by a

much greater percentage, but if their prices rise, consumers will reduce their demand considerably
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Availability of substitutes:
The more close and numerous availability of substitutes a commodity has, the more will be its
price elasticity of demand, that is, demand is price elastic
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Thus, the demand for the commodity will fall by a
greater proportion
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However, demand for a group of commodity as a whole has an inelastic demand
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Proportion of income spent on a commodity:
Commodities on which a very low proportion of income is spent, the demand for the product is
inelastic
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On the other hand, commodities on which a large
proportion of income is spent, the demand is elastic
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Number of uses of a product:
A product, which has several uses, has an elastic demand
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A slight fall in the price of electricity will cause quantity demanded to increase by a
larger extent
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On the
other hand, a product, which has a single use, has an inelastic demand, for example, toothpaste
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Habit:
There are certain goods which people consume because they have developed a habit, for
example, cigarettes for a chain-smoker
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Thus, the demand for these commodities is
inelastic since quantity demanded will change very slightly to a change in price
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Time period:
Demand tends to be more elastic in the long run than in the short run
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For example, if the price of petrol rises,
consumers will find it very difficult to switch from petrol to diesel immediately
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This is because at
a lower price level, consumers can be expected to be already buying as much of the commodity as he
desires
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RELATIONSHIP BETWEEN PRICE AND TOTAL REVENUE DEPENDING
UPON PRICE ELASTICITY OF DEMAND:
 Total Revenue (TR) / Total Expenditure (TE) = Price (P) * Quantity (Q)
Whether total expenditure or total revenue rises, falls or remains constant with a change in price
depends on the price elasticity of demand of the commodity
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Price Elastic:
Let initial price = £20, initial Quantity = 100
Thus, initial TR / TE = 20 * 100 = £2000
When price = £22 (10% increase), Quantity = 75 (25% decrease), then TR = 22 * 75 = £1650
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Thus, there exists an inverse relationship between price and total revenue or total
expenditure when demand is elastic
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Price Inelastic:
Let initial price = £20, initial Quantity = 100
Thus, initial TR / TE = 20 * 100 = £2000
When price = £23 (15% increase), Quantity = 95 (5% decrease), then TR = 23 * 95= £2185
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Thus, there exists an direct relationship between price and total revenue or total
expenditure when demand is inelastic
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Demand is unitary:
When demand is unitary, TR / TE remains the same with a change in price
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Price

D

TR / TE

P
10%
P4
10%

D

0

Quantity
Q

Q4

0

Price

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USEFULNESS OF A KNOWLEDGE OF PRICE ELASTICITY OF DEMAND:
A manufacturer / firm would find his knowledge of price elasticity of demand for his commodity
very useful in adopting pricing policies and taking business decisions
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Thus, if
the firm’s products face an elastic demand, then the businessman would be able to maximise his net
revenue if he lowers the price
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It will be
a mistake to increase the price if demand is elastic since revenue will fall
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If the
producer lowers the price to 0P1, total revenue will increase to the given area B + C (0P1SQ1)
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This can be explained by the fact that an increase in price will bring about a
less than proportionate decrease in quantity demanded
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This can be illustrated as follows:
D
Price
P2

T
G

P

U
E

F
D

0

Quantity
Q2

Q

(Explain the diagram)

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EVALUATION:
However, the firm cannot only rely on the concept of price elasticity of demand to increase
revenue
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They are based on survey
carried out on small sample of consumers
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Moreover, the concept of price elasticity of demand is calculated on the basis of all other factors
affecting demand remain constant
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Besides, the concept of price elasticity of demand is useful for the producer in order to increase
revenue
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Hence, the firm needs to know more about
its costs
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With revenue rising, and costs falling, profits must go up
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If price is lowered, this will also increase
output, and therefore, costs
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Income elasticity of demand is calculated as follows:


Income elasticity of demand = percentage change in quantity demanded
percentage change in income
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initial quantity demanded

The coefficient of income elasticity of demand can be positive or negative depending upon the nature of
the commodity
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The demand for normal goods
increases as income increases, and therefore, the value of the income elasticity of demand is positive
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However, it is important to distinguish between 2 types of normal goods namely luxuries and
necessities
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For a luxury, the value of income elasticity of demand is greater than 1, implying that the percentage
increase in quantity demanded is larger than the percentage increase income
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On the other hand, for a necessity, the value of income elasticity of demand is less
than 1, implying that the percentage increase in quantity demanded is smaller than the percentage
increase income
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However, with inferior goods, as income rises demand falls and the coefficient of income
elasticity of demand is therefore negative
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An exceptional case is that demand will remain constant as income rises
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Consumption
EY = 0
EY = -ve

0

Income

USEFULNESS OF A KNOWLEDGE OF INCOME ELASTICITY OF DEMAND:
A knowledge of income elasticity of demand is useful to a manufacturer as it helps him to plan
his sales and allocate resources more efficiently in order to maximise profits should there be any change
in consumer’s income
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If the country experiences economic growth, national income will rise, and this rise in income
will be shared among most households
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Hence, the producer will be well advised to allocate resources in the
production of those commodities for which income elasticity of demand is positive
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Thus, these producers will have to restructure their businesses by shifting to normal
goods
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For instance, with commodities for which income elasticity of demand is inelastic, although demand
may rise with income, it might not rise faster
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On the other hand, a downturn in national income may well mean a rapid decline in the demand
for positive income elasticities
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EVALUATION:
 The concept could not reveal accurate information – based on a sample of consumers
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CROSS ELASTICITY OF DEMAND:
Cross elasticity of demand measures the degree of responsiveness of quantity demanded of one
commodity to a change in the price of another commodity
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If the tow goods are substitutes, then the value
of cross elasticity of demand is positive as changes in price of the commodity will lead to changes in
quantity demanded of another commodity in the same direction
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The value of cross elasticity of demand may vary from - ∞ to + ∞
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USEFULNESS OF A KNOWLEDGE OF CROSS ELASTICITY OF DEMAND:
The concept of cross elasticity of demand becomes more relevant in determining price structure
in an oligopolistic market situation where few firms compete with each other
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The concept of cross elasticity of demand allows the producer to identify whether his product is a
complement or a substitute which is produced by other firms
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If the cross elasticity of demand is positive, it means that a cut in price by a rival business will
significantly reduce the firm’s sales
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However, to avoid price wars, the producer could use other policies such as better services,
personalised service and aggressive advertisement
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If the price of its complements rises, it is not advisable for
the producer to increase production
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 Demand changes due to changes in other factors too
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The law of supply states that there is a direct relationship between price and quantity supplied
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In other words, the
higher the price of the product, the more the firm will supply because more is the profit
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Thus, the supply curve is an
upward sloping curve from left to right
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The price of the good itself:
Changes in the price of the commodity will lead to changes in quantity supplied of that
commodity
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This is because good X is now more profitable and producers supply more of it
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Weather / climatic conditions:
The supply of agricultural products is affected by changes in weather conditions
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On the other hand, an unfavourable season which results in a poor harvest may
cause quantity supplied to fall
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Technical progress:
Technical progress means improvements in the performance of machines, labour, production
methods, management control and quality
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For instance, increase in wages paid to workers increases the cost
of production and reduces the profits of firms
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If the government wants firms to produce more, it may
give them a subsidy which will lower their costs, boost their profits and increase supply
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Note: Indirect taxes increase cost pf production and cause supply to fall (shift to the left), whereas
subsidies reduce cost of production and cause supply to rise (shift to the right)
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In fact, when
a supply curve is drawn, only the price of the product is allowed to vary, while the conditions of supply
do not change
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The supply curve can shift either to the right or to
the left, depending upon the changes in the conditions of demand
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No information is revealed as to how much or to what extent will
supply change to a change in price
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Price elasticity of supply measures the degree of responsiveness of quantity supplied to a change
in the price of the commodity
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OR

Price elasticity of supply = change in quantity supplied *
initial price
change in price
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Supply for most goods is either elastic, inelastic or unitary depending on whether its coefficient
is greater than, less than or equal to one
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Any straight line supply curve that meets the vertical axis (Price axis) will be elastic and its value

is greater than 1
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Q

A straight line supply curve that meets the horizontal axis (Quantity axis) will be inelastic and its

value is less than 1
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Q2

Any straight line supply curves passing through the origin whatever the slopes have unitary price

elasticity of supply and its value is equal to 1
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Perfectly inelastic supply curve – value of price elasticity of supply is zero
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Perfectly elastic supply curve - The coefficient of elasticity is equal to infinity
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Price
P

S

0

Quantity supplied

Supply curve of more complex shapes:
S
Price

A
B

0

Quantity supplied

The elasticity of supply at any point on the supply curve may be judged by drawing a tangent to
the point of the curve we wish to know about
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If it hits the Horizontal axis, then it is inelastic
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FACTORS INFLUENCING PRICE ELASTICITY OF SUPPLY:
The extent to which supply is elastic or inelastic depends upon the flexibility or mobility of the
factors of production
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Otherwise, supply is inelastic
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Time periods:
The elasticity of supply tends to be greater in the long run than in the short run because it is
easier to increase the amount produced when the firm has more time in which to do it
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This is obvious if one
considers agricultural products
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There is little that farmers can do to supply more agricultural products because it takes time to grow
them
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However, supply is
elastic in the long run since the long run offers opportunities to expand output that are not available
instantaneously
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Availability of resources:
If a firm wishes to expand production, it will need more resources
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Hence, supply of most goods will be inelastic
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This is because any increase in
demand can be easily met by running down the stocks
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Once such industries operate at
full capacity, supply will be inelastic
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This
will be partly influenced by the system of incentives in the economy
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EQUILIBRIUM PRICE AND HOW IT IS SET IN A FREE MARKET:
Equilibrium price refers to a state of rest or a state of balance where there is no tendency either to
expand or to contract
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Since free market implies no government intervention, the price of any commodity in the free
market is determined by the combined forces of demand and supply
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With a downward sloping demand curve and an upward sloping supply curve, equilibrium price
occurs when these two schedules intersect as shown below:
Price
D

S
Surplus

P2
P

P1
S

Shortage

0

D

Quantity
Q

The equilibrium price is 0P and quantity traded is 0Q
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For instance, any prices below the
equilibrium price, say 0P1, there is shortage of goods and market forces will push up the price until
demand is equal supply [Producers expand their supply, while consumers contract their demand]
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However, this equilibrium price is allowed to change due to changes in demand and
supply conditions
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This is
illustrated as follows:

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D1
D

S

P1
P

shortage

D1
S
D
0

Quantity
Q

Q1

Q2

With an increase in demand shifting the demand curve to D1D1, at the prevailing price 0P, there is
a shortage Q2Q which causes an upward pressure on the equilibrium price to 0P1
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Assume no change in demand, an increase in supply due to a fall in cost of production will cause
a fall in equilibrium price but an increase in quantity traded
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This will cause a downward pressure on the equilibrium
price to 0P2
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CONSUMER SURPLUS:
Consumer surplus is the difference between the amount consumers are prepared to pay to obtain
a particular good and the amount they actually pay in the market
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Consumer surplus = Total utility – Total amount spent
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But
at this quantity 0Q, total amount that the consumer is prepared to pay (total utility) is 0ABQ, but actual
total amount spent is 0PBQ
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Consumer surplus may change due to changes in demand and supply conditions
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As a result, consumer surplus rises
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A rise in
supply to S1S1 causes equilibrium price to fall to 0P1 and quantity to rise to 0Q1, thereby, causing a rise
in consumer surplus to KP1B
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It increases because of the
fall in price
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Similarly, a change in demand conditions may also change consumer surplus
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If demand increases and supply is elastic, consumer surplus
may increase because the price will not rise much when demand rises
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Since the increase in
price is less than the increase in demand due to elastic supply, consumer surplus increases
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Besides, the change in consumer surplus depends upon the price elasticity of demand
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Price

D

S

Price

D
S

consumer
surplus

consumer
surplus

P

P

S
S

D

0

Quantity
Q

0

Quantity
Q

When demand for a good is inelastic, consumer surplus is high
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On the other hand, when demand for a good is elastic, consumer surplus is low
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This can be illustrated as follows:

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S

Price

S

consumer surplus
A
P

B

P

B

D

D
S

S

0

Quantity
Q

0

Quantity
Q

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FUNCTIONS OF PRICES IN A MARKET ECONOMY:
In a free market economy, price is determined by the interactions of demand and supply
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It acts as an allocative mechanism, rationing device
and signalling device
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For instance, suppose price of good X increases due to an increase in demand of
good X
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Hence, producers will divert resources from the production of other goods, which are unprofitable, to the
production of good X
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When demand for good X rises to D1D1, the price also
rises to 0P1
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As a result, producers devote 0E1 amount of

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resources in X and 0G1 in the production of other goods
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However,
in the long run supply rises to S1S1
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In other words, price serves to ration the scarce goods
among the people who are demanding them
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Those unable to pay a higher prices
will be eliminated from the market
...

Hence, for price to act as a rationing mechanism, the effect of a rising price must be to reduce the
quantity demanded by some individuals
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A change in price would indicate a change in consumer behaviour, for example, an
increase in price may come about as a result of an increase in demand due to a change in taste
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