TOPIC 2

DEMAND AND SUPPLY

LEARNING OBJECTIVES

❑To understand the concepts of demand and supply.

❑Discuss the factors that lead to shifts in the demand/supply
curves.
❑Knowledge on the Law of Demand and Law of Supply and
their exceptions.
❑Differentiation of the Demand/Supply Schedule and
Demand/supply Curve.
❑Explain how prices and output are determined in product
markets through the interaction of demand and supply.
❑Elasticity of demand/supply and its practical applications

2
DEMAND
DEMAND

• Is defined as the willingness and ability of a consumer to

purchase(pay for) a certain amount of goods and services at
various prices during some specific period.
• Demand is always at price, without it it is meaningless to say that
demand is this much.
• Demonstrated by demand schedule and demand curve
• Demand schedule is the list/table that shows different quantities
of goods and services which a consumer is willing and able to
purchase at a different prices during a specified period of time.

4
DEMAND SCHEDULE

Price per kg Quantity

(Tsh) demanded (per
week)
500 10
400 20
300 30
200 40
100 50
QUANTITY DEMANDED

• Quantity demanded is the amount (number of

units) of a product that a household would buy
in a given time period if it could buy all it
wanted at the current market price.
DEMAND IN OUTPUT MARKETS

ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS • A demand schedule is a
QUANTITY table showing how much of a
PRICE DEMANDED given product a household
(PER (CALLS PER
CALL) MONTH) would be willing to buy at
$ 0 30 different prices.
0.50 25
3.50 7 • Demand curves are usually
7.00 3
10.00 1 derived from demand
15.00 0
schedules.
DEMAND CURVE

• Is a graphical depiction/representation of the

relationship between price and quantity of goods
and services that a consumer is willing and able
to purchase.
• Demand curve usually slopes downward from left
to right .
THE DEMAND CURVE
ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS
QUANTITY • The demand curve is a
PRICE DEMANDED
(PER (CALLS PER graph illustrating how much
CALL) MONTH)
$ 0 30 of a given product a
0.50 25
3.50 7 household would be willing
7.00 3
10.00 1 to buy at different prices.
15.00 0

• Is the graphical
representation of the
demand schedule.
Qty = 2 − P
Qdd = 7 − 3P

DEMAND
Qdd = 10 −
1
2
P FUNCTION
DD = 3 − 8 P

• Is a mathematical expression of the relationship

between price and the quantity of goods and services
that a consumer is willing and able to purchase.
• Demand is always at prices
• The following are some examples of demand
functions with different slopes
DEMAND

Price Quantity demanded

per unit per week

a 5 10
b 4 20
c 3 35
d 2 55
e 1 80

11
GRAPHING DEMAND
P D1
a
5

b
4
Price ($ per unit)

c
3

d
2

e
1
D1

0 10 20 30 40 50 60 70 80 Q
Quantity demanded (units per week)

12
LAW OF DEMAND

• The Law states that “Ceteris paribus (other

things remain constant) as price falls, the quantity
demanded rise and as price increases the quantity
demanded fall for most type of goods and
services”
• Note:This is true for normal goods, inferior goods etc.
but not for all types of goods, example for Giffen and
luxurious goods demand law is violated.
THE LAW OF DEMAND
• The law of demand states that
there is a negative, or inverse,
relationship between price and the
quantity of a good demanded and
its price.

• This means that

demand curves slope
downward.
LAW OF DEMAND (CONT.)

Based on:
1. Income effect
2. Substitution effect
3. Diminishing marginal utility

15
WHY DOES THE LAW OF
DEMAND
16 OCCUR?
1. The Substitution Effect
• If the price goes up for a product,
consumer buy less of that product and
more of another substitute product
(and vice versa)
2. The Income Effect
• If the price goes down for a product, the
purchasing power increases for consumers -
allowing them to purchase more.
WHY DOES THE LAW OF DEMAND
OCCUR?
17

3. Law of Diminishing Marginal Utility

• Utility = Satisfaction
• We buy goods because we get utility
from them
• The law of diminishing marginal utility
states that as you consume anything,
the additional satisfaction that you will
receive will eventually start to decrease
• In other words, the more you buy of
ANY GOOD the less satisfaction you
get from each new unit consumed.
INCOME EFFECT

• At a lower price, consumers can buy more of a

product without giving up other goods
• A decline in price increases the purchasing power
of money/real income

18
SUBSTITUTION EFFECT

• At a lower price, consumers have the incentive

to substitute the cheaper good for similar goods
that are now relatively more expensive

19
DIMINISHING MARGINAL UTILITY

• States that successive units of a given

product yield less and less extra
satisfaction
• Therefore, consumers will only buy more
of a good if its price is reduced

20
EXCEPTIONS OF LAW OF DEMAND

• Generally the amount demanded of a good increases with a

decrease in price of the good and vice versa. In some cases,
however, this may not be true. There are certain goods which
do not follow this law.
These exceptions include
❑Giffen goods
❑Prestigious goods(Veblen goods)
❑Speculation
❑Ignorance about quality
❑Emergencies
❑Change in Fashion.
EXCEPTIONS OF LAW OF
DEMAND
GIFFEN GOODS

• A Giffen good describes an inferior good that as the price

increases, demand for the product increases. As an example,
during the Irish Potato Famine of the 19th century, potatoes
were considered a Giffen good.
• Potatoes were the largest staple in the Irish diet, so as the
price rose it had a large impact on income. People responded
by cutting out on luxury goods such as meat and vegetables,
and instead bought more potatoes. Therefore, as the price of
potatoes increased, so did the quantity demanded.
EXCEPTIONS OF LAW OF
DEMAND
• Prestigious goods
• There are certain goods having prestige value. These goods
are mainly consumed by the richer sections of the society f
or the gain of pride and social distinction.
• The consumption of prestigious goods is known as conspic
uous consumption.
• According to Veblen some rich people measure the utility o
f a commodity entirely by price. The greater the price of a c
ommodity, the greater it’s utility.
EXCEPTIONS OF LAW OF
DEMAND
• Expectation of change in the price of
commodity
• If an increase in the price of a commodity causes
households to expect the price of a commodity to
increase further, they may start purchasing a greater
amount of the commodity even at the presently
increased price. Similarly, if the household expects the
price of the commodity to decrease, it may postpone
its purchases.
EXCEPTIONS OF LAW OF
DEMAND

Basic or necessary goods

• The goods which people need no matter how
high the price is are basic or necessary goods.
Medicines covered by insurance are a good
example. An increase or decrease in the price of
such a good does not affect its quantity
demanded
INDIVIDUAL AND MARKET DEMAND

• Market demand is derived by horizontally

summing individual demand curves
• Market demand is derived by adding all the
quantities demanded in a demand schedule which
correspond to their prices

26
Deriving the market demand curve from individual
curves: Figure 3.3
Deriving the market demand curve from individual
curves: Figure 3.3, continued
FROM HOUSEHOLD TO MARKET
DEMAND
• Demand for a good or service can be defined for an
individual household, or for a group of households that
make up a market.

• Market demand is the sum of all the quantities of a good

or service demanded per period by all the households
buying in the market for that good or service.
FROM HOUSEHOLD DEMAND TO
MARKET DEMAND
• Assuming there are only two households in the market, market demand is
derived as follows:
INDIVIDUAL DEMAND AND Figure 5.1
MARKET DEMAND
DETERMINANTS OF HOUSEHOLD
DEMAND
A household’s decision about the quantity of a particular output to demand depends
on:

• The price of the product in question.

• The income available to the household.
• The number of consumer in the market.
• The prices of related products available to the
household.(Complementary, substitute goods)
• The household’s tastes and preferences.
• The household’s expectations about future income,
wealth, and prices.
INCOME AND WEALTH
• Income is the sum of all households wages,
salaries, profits, interest payments, rents, and other
forms of earnings in a given period of time. It is a
flow measure.
• Wealth, or net worth, is the total value of what a
household owns minus what it owes. It is a stock
measure.
RELATED GOODS AND SERVICES
• Normal Goods are goods for which demand goes up when income is
higher and for which demand goes down when income is lower. Or
• These are goods whose demand increases as the consumer’s income
increases and vice versa, these are goods whose demand curve shift
rightward when income of the buyer increases and leftward when
income of the buyer decreases.
Inferior Goods are goods for which demand falls when income rises.
These are goods whose demand decreases as consumer income
increases and vice versa i.e. are those goods whose demand curve shift
leftward when income of the buyer increases and rightward when
income of the buyer decreases.
RELATED GOODS AND SERVICES

• Substitutes are goods that can serve as replacements

for one another; when the price of one increases,
demand for the other goes up. Perfect substitutes are
identical products.
• Complements are goods that “go together”; a decrease
in the price of one results in an increase in demand for
the other, and vice versa. This applies to commodities
like guns and bullets, tea and sugar, motorcars and
gasoline etc
CHANGES IN DEMAND

• This is the shift of a location of demand curve resulting from

changes of other factors influencing demand rather than
price of a commodity
• Caused by changes in one or other of the non-price
determinants of demand.
• Represented as a shift of the demand curve either to the
right or left.

36
SHIFT OF DEMAND VERSUS MOVEMENT ALONG A
DEMAND CURVE

• A change in demand is
not the same as a change
in quantity demanded.
• In this example, a higher
price causes lower
quantity demanded.
• Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
DA to DB.
A CHANGE IN DEMAND VERSUS A CHANGE IN
QUANTITY DEMANDED

• When demand shifts to

the right, demand
increases. This causes
quantity demanded to be
greater than it was prior to
the shift, for each and
every price level.
A CHANGE IN DEMAND VERSUS A CHANGE IN
QUANTITY DEMANDED

To summarize:

Change in price of a good or service

leads to

Change in quantity demanded

(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to

Change in demand
(Shift of curve).
CHANGES IN DEMAND

• Tastes or preferences
• Number of buyers
• Income
• Normal or superior goods—demand varies
directly with income
• Inferior goods—demand varies inversely with
income

40
CHANGES IN DEMAND (CONT.)

• Prices of related goods

• Substitute goods
• Complementary goods

• Expectations
• Seasons/weather

41
INCREASE IN DEMAND
D D2
P5 1

4
Price ($ per unit)

3 Increase in
Demand
2

D2
1
D1

0 10 20 30 40 50 60 70 80
Quantity demanded
Q

42
DECREASE IN DEMAND
P5 D1 Decrease in
Demand
D3
4
Price ($ per unit)

1
D1
D3
0 10 20 30 40 50 60 70 80
Quantity demanded
Q

43
CHANGES IN QUANTITY DEMAND

This refer to either upward or downward

movement along the same demand curve. This is
caused by changes in price of this commodity while
other factors determining demand are
held/assumed constant.
The upward movement is called contraction of
demand while the downward movement is called
extension of demand.
It is represented by movement along the same
demand curve

44
CHANGE IN QUANTITY DEMANDED
VERSUS CHANGE IN DEMAND

Variables that
Affect Quantity Demanded A Change in This Variable . . .
Price Represents a movement along
the demand curve
Income Shifts the demand curve
Prices of related goods Shifts the demand curve
Tastes (new products) Shifts the demand curve
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve
MOVEMENT ALONG A CURVE
P5 D1

4 Movement along
Price ($ per unit)

a demand curve
3

Change in
2
quantity demanded

1
D1

0 10 20 30 40 50 60 70 80
Quantity demanded
Q

46
SUPPLY
SUPPLY

• It is the willingness and ability of a seller to offer

a certain amount of goods and services at
different market prices during a specific period of
time.
• the quantity supplied is the amount of a goods or
service that people are willing and able to sell.
SUPPLY SCHEDULE

• It is the list/table which shows different quantities

of goods and services that an individual seller is
willing and able to offer for sell at different
market prices during a specific period of time.
• . For a particular good with all other factors held
constant, a table can be constructed of price and
quantity supplied based on observed data
SUPPLY SCHEDULE

Price (TSHS) Quantity Supplied (KG)

10 100

15 120

20 125

30 140

40 145

50 150
SUPPLY CURVE

• Is the graphical representation of a supply schedule

or is the graphical representation of the relationship
between price and the quantities that an individual
seller is willing and able to offer for sell.
• The supply curve has a positive slope. The positive
slope shows the direct relationship between price
and the quantity supplied
SUPPLY CURVE
LAW OF SUPPLY

• States that, "other things being equal or constant,

as price of a commodity rises, the corresponding
quantity supplied also rises and if price falls, the
quantity supplied falls.”
THE LAW OF SUPPLY

• The law of supply states that

Price of soybeans per bushel ($)

6
5 there is a positive relationship
4 between price and quantity of a
3 good supplied.
2 • This means that supply curves
1 typically have a positive slope.
0
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
DETERMINANTS OF SUPPLY

•Price of that commodity (P)

•Cost of Production (Cp)
•Taxation (Tx)
•Weather (Wht)
•State of Technology (Tech)
•Factor (resource) Price (Fp)
•Seller’s price expectation (E)
•Number of sellers in the market (No.s)
•Infrastructure (Infr)
SUPPLY FUNCTION
INDIVIDUAL SUPPLY VS.
MARKET SUPPLY
• The quantity supplied by an individual producer at
different prices is known as Individual supply
whereas the total quantity supplied by all the
producers together in the given market is known
as Market supply
• Market supply is the total supply for a commodity
that can be calculated by adding the quantity
supplied by all the producers at each price.
FROM INDIVIDUAL SUPPLY
TO MARKET SUPPLY
• The supply of a good or service can be defined for an
individual firm, or for a group of firms that make up a market
or an industry.
• Market supply is the sum of all the quantities of a good or
service supplied per period by all the firms selling in the
market for that good or service.
Deriving the market supply curve from individual
curves
Deriving the market supply curve from individual
curves

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia
INDIVIDUAL SUPPLY VS.
MARKET SUPPLY
• For example, if three person (A, B, and C) supply
milk in the market, the market supply (in litres)
for a given period of time (e.g. a month) will then
be calculated as shown in the table below
MARKET SUPPLY

• As with market demand, market supply is the horizontal

summation of individual firms’ supply curves.
CHANGES IN SUPPLY

• This is the shift of a location of supply curve

resulting from changes of other factors
influencing supply rather than price of a
commodity.
• Supply curve may shift either rightward or
leftward. Shift of a supply curve right to the
original curve signify increase in supply and to the
left in for a decrease.
CHANGE IN SUPPLY

• represented as a shift of the supply curve

• caused by changes in determinants of supply
other than price

64
INCREASE IN SUPPLY
P S1
5 S2

4
Price ($ per unit)

1
S1
S2
0 Q
2 4 6 8 10 12 14 16
Quantity supplied (000/week)

65
DECREASE IN SUPPLY
P S3 S1
5

4
Price ($ per unit)

2 S3

1
S1
0 Q
2 4 6 8 10 12 14 16
Quantity supplied (000/week)

66
Changes in Quantity Supplied

Refers to the movement along the same supply

curve. This is caused by changes in price of this
commodity while other factors which determine
supply are held/assumed constant.
CHANGES IN QUANTITY SUPPLIED

• Caused by changes in price only

• Represented as a movement along a supply curve

68
MOVEMENT ALONG A SUPPLY CURVE
P S1
5

4
Price ($ per unit)

Movement along
2
a supply curve

1
S1
0 Q
2 4 6 8 10 12 14 16
Quantity supplied (000/week)

69
MOVEMENT ALONG A SUPPLY CURVE
P S1
$5

4
Price ($ per unit)

Movement along
2
a supply curve

1
S1
0 Q
2 4 6 8 10 12 14 16
Quantity supplied (000/week)

70
CHANGE IN QUANTITY SUPPLIED
VERSUS CHANGE IN SUPPLY
Variables that
Affect Quantity Supplied A Change in This Variable . . .
Price Represents a movement along
the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
A CHANGE IN SUPPLY VERSUS
A CHANGE IN QUANTITY SUPPLIED

• A change in supply is
not the same as a
change in quantity
supplied.
• In this example, a higher
price causes higher
quantity supplied, and
a move along the
demand curve.
• In this example, changes in determinants of supply, other
than price, cause an increase in supply, or a shift of the
entire supply curve, from SA to SB.
A CHANGE IN SUPPLY VERSUS
A CHANGE IN QUANTITY SUPPLIED

• When supply shifts

to the right, supply
increases. This
causes quantity
supplied to be
greater than it was
prior to the shift, for
each and every price
level.
A CHANGE IN SUPPLY VERSUS
A CHANGE IN QUANTITY SUPPLIED

To summarize:

Change in price of a good or service

leads to

Change in quantity supplied

(Movement along the curve).

Change in costs, input prices, technology, or prices of

related goods and services
leads to

Change in supply
(Shift of curve).
MARKET EQUILIBRIUM

• Occurs when the buying decisions of households and the

selling decisions of producers are equated
• Determines the equilibrium price and equilibrium
quantity bought and sold in the market

75
MARKET EQUILIBRIUM (CONT.)
P
5 S
Price ($ per unit)
4

Equilibrium price
3

1
D
0 2 4 6 7 8 10 12 14 16 18 Q
Units of X (000/week)

76
MARKET EQUILIBRIUM

• Only in equilibrium is quantity

supplied equal to quantity
demanded.

• At any price level

other than P0, the
wishes of buyers
and sellers do not
coincide.
MARKET DISEQUILIBRIA

• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds quantity
supplied at the current price.
• When quantity demanded
exceeds quantity
supplied, price tends to
rise until equilibrium is
restored.
MARKET DISEQUILIBRIA

• Excess supply, or surplus, is

the condition that exists when
quantity supplied exceeds
quantity demanded at the
current price.

• When quantity supplied

exceeds quantity
demanded, price tends to
fall until equilibrium is
restored.
MARKET EQUILIBRIUM (CONT.)
P
5
surplus
S
Price ($ per unit)
4

Equilibrium price
3

1
D
0 2 4 6 7 8 10 12 14 16 18 Q
Units of X (000/week)

80
MARKET EQUILIBRIUM (CONT.)
P
5
surplus
S
Price ($ per unit)
4

Equilibrium price
3

shortage
1
D
0 2 4 6 7 8 10 12 14 16 18 Q
Units of X (000/week)

81
SHORTAGE (EXCESS DEMAND)

• Occurs when the quantity demanded exceeds the

quantity supplied at the current price
• Competition amongst buyers eventually bids up
the price until equilibrium is reached

82
SURPLUS (EXCESS SUPPLY)

• Occurs when the quantity supplied exceeds the

quantity demanded at the current price
• Competition amongst producers eventually
causes the price to decline until equilibrium is
reached

83
CHANGES IN DEMAND AND SUPPLY

• Changes or shifts will disrupt the equilibrium

• The market will adjust until once again an
equilibrium is reached
• The equilibrium price and quantity traded will
change

84
DEMAND OR SUPPLY CHANGE

• Increase in D: P increases; Q decreases

• Decrease in D: P decreases; Q increases
• Increase in S: P decreases; Q increases
• Decrease in S: P increases; Q decreases

85
INCREASE IN DEMAND
P D1 D2
S
Equilibrium
price & quantity
rise

D2
D1
0 Q

86
DECREASE IN DEMAND
P D2 D1
S
Equilibrium
price & quantity
fall

D1
D2
0 Q

87
INCREASE IN SUPPLY
P S1
D1
S2

Equilibrium
price falls & quantity
rises

S1
D1
S2
0 Q

88
DECREASE IN SUPPLY
P S2
D1
S1

Equilibrium
price rises & quantity
falls

S2
S1 D1
0 Q

89
BOTH DEMAND & SUPPLY INCREASE
P D1 D2 S1 Quantity will increase
but price change will
S2 be in determinant

S1
D2
D1
S2
0 Q

90
Both Demand & Supply change

• Demand increases and supply increases;

Q must rise but P??
• Demand increases and supply decreases;
P must rise but Q??
• Demand decreases and supply increases;
P must fall but Q??
• Demand decreases and supply decreases;
Q must fall but P??

91
BOTH DEMAND & SUPPLY CHANGE

• The overall change in the indeterminate side of the

market, i.e. P or Q depends on the relative shifts in DD
and SS.

92
INCREASES IN DEMAND AND
SUPPLY

• Higher demand leads to higher • Higher supply leads to lower

equilibrium price and higher equilibrium price and higher
equilibrium quantity. equilibrium quantity.
DECREASES IN DEMAND AND
SUPPLY

• Lower demand leads to lower • Lower supply leads to higher

price and lower quantity price and lower quantity
exchanged. exchanged.
RELATIVE MAGNITUDES OF
CHANGE

• The relative magnitudes of change in supply and

demand determine the outcome of market equilibrium.
RELATIVE MAGNITUDES OF
CHANGE

• When supply and demand both increase, quantity

will increase, but price may go up or down.
DEMAND, MARGINAL BENEFIT,
AND CONSUMER SURPLUS
Consumer surplus
Consumer surplus is the value of a good minus the
price paid for it, summed over the quantity bought.
• It is measured by the area under the demand curve and
above the price paid, up to the quantity bought.
• Figure 5.2 on the next slide shows the consumer surplus
for pizza for an individual consumer.
DEMAND AND CONSUMER Figure 5.2
SURPLUS
SUPPLY, MARGINAL COST, AND
PRODUCER SURPLUS
• Supply, cost, and minimum supply price
• The cost of one more unit of a good or service is its
marginal cost, which we can measure as minimum price that
a firm is willing to accept.
• A supply curve of a good or service shows the quantity
supplied at each price.
• A supply curve is a marginal cost curve.
COST, PRICE, AND PRODUCER
SURPLUS
• Producer surplus
• Producer surplus is the price of a good minus the
marginal cost of producing it, summed over the quantity
sold.
• Producer surplus is measured by the area below the
price and above the supply curve, up to the quantity sold.
• Figure 5.4 on the next slide shows the producer surplus
for pizza for an individual producer.
SUPPLY AND PRODUCER SURPLUSFigure 5.4
IS THE COMPETITIVE MARKET
EFFICIENT?
• Efficiency of competitive equilibrium
• A competitive market creates an efficient allocation of
resources at equilibrium.
• In equilibrium, the quantity demanded equals the quantity
supplied.
AN EFFICIENT MARKET FOR PIZZA
Price (dollars per pizza) Figure 5.5(a)

Consumer S
25 surplus

20
Equilibrium
15

10

5 Producer
Equilibrium D
surplus quantity

0 5 10 15 20
Quantity (thousands of pizzas per day)
IS THE COMPETITIVE MARKET
EFFICIENT?
• At the equilibrium quantity, marginal benefit equals
marginal cost, so the quantity is the efficient quantity.
• The sum of consumer and producer surplus is maximized
at this efficient level of output.
IS THE COMPETITIVE MARKET
EFFICIENT?
• Underproduction and overproduction
• Obstacles to efficiency lead to underproduction or
overproduction and create a deadweight loss.

• Deadweight loss
• The decrease in consumer and producer surplus that
results from an inefficient allocation of resources
UNDERPRODUCTION
Price (dollars per pizza) Figure 5.6(a)

Deadweight S
25
loss

20

15
Efficient
10 output

If output is
5
reduced to D
5,000
0 5 10 15 20
Quantity (thousands of pizzas per day)
OVERPRODUCTION
Price (dollars per pizza) Figure 5.6(b)

S
25

20
Deadweight
15 loss

10

5 If output
D
is increased to
15,000 pizzas
0 5 10 15 20
Quantity (thousands of pizzas per day)
PRICE CONTROLS

Price controls are legal restrictions on how high or low

a market price may go. OR Is the state control on fixing
the prices of different commodities
REASONS FOR PRICE CONTROLS
(i) To protect the interests of consumers and
producers
(ii) To check the inflation and enable the poor
individuals to live a reasonable standard of living
PRICE CONTROLS

(iii) When market forces are not functioning

smoothly and prices are raised by some traders
unnecessarily
(iv) To encourage the production of import
substitutes and improve the balance of payments
Price controls are of two forms:
Price ceiling.
Price floor.
PRICE CEILING

• Is the maximum price at which above it the

commodity must not be sold. When prices are set
artificially below the market-clearing level, the
controlled price is a ceiling above which it is not
allowed to rise. A price ceiling would result in excess
demand or shortage.
• Because of these ceilings, we are faced with a shortage.
• The shortage will lead to inefficiencies:
PRICE CONTROLS: PRICE CEILINGS

• Equilibrium • Price ceiling

S Price D S
Price D

4 4

3 3
Price
Ceiling
2 2

Shortage

100 200 Quantity of 800 Quantity of

100 200
icecreams icecreams
PRICE CEILING

• Let’s take a look at the different possible

inefficiencies:
1. Inefficient Allocation to Consumers
2. Wasted Resources
3. Inefficiently Low Quality
4. Black Markets
PRICE CEILINGS(INEFFICIENCY)

Inefficient Allocation to Consumers

• Price ceilings can lead to inefficiency in the form
of inefficient allocation to consumers:
people who really want the good and are willing
to pay a high price don’t get it, and those who are
not so interested in the good and are only willing
to pay a low price do get it.
• Example: rent control. In such case people get the
appartment usually through luck or personal
connections.
PRICE CEILING (INEFFICIENCY)

Wasted Resources
• Price ceilings typically lead to inefficiency in the
form of wasted resources: people spend money,
time and expend effort in order to deal with the
shortages caused by the price ceiling.
• You waste a lot of time looking for a good (e.g. an
appartment) in case of shortage, the time has it’s
value! You can work or just rest, do something
better than look for a good you’ can’t find.
PRICE CEILING (INEFFICENCY)

Inefficiently Low Quality

• Price ceilings often lead to inefficiency in that the goods
being offered are of inefficiently low quality
• In case of rent controls, the landlords will not improve
the conditions of the appartments, there is no incentive
since the rental fee is low but the main reason is that
since there is a shortage, people are willing to rent the
apartment as it is, even in bad condition!
PRICE CEILING (INEFFICIENCY)

Black Markets
• A black market is a market in which goods or
services are bought and sold illegally—either because it
is illegal to sell them at all or because the prices
charged are legally prohibited by a price ceiling.
• If someone for example bribes (gives extra money) to
the apartment owners he will get the apartment, but
the honest people that don’t break the law will never
find one this way!
PRICE FLOOR

• Is the minimum price at which below it the

commodity must not be sold. When prices are set
artificially above the market-clearing level, the
supported price is a floor below which it is not
allowed to fall.
• A price floor would result in excess supply or
surplus.
PRICE CONTROLS: PRICE FLOORS

• Equilibrium • Price floor

Surplus
Price D S Price D S

4 4

3 3
Price
2 Ceiling
2

100 200 Quantity of Quantity of

100 200 600
icecreams icecreams
PRICE CONTROLS: PRICE FLOORS

Why a Price Floor Causes Inefficiency

• Inefficient Allocation of Sales Among Sellers
Price floors lead to inefficient allocation of
sales among sellers: those who would be
willing to sell the good at the lowest price are
not always those who actually manage to sell it.
Example: Farm Subsidies.
• Wasted Resources
Like a price ceiling, a price floor generates
inefficiency by wasting resources.
PRICE FLOORS

Inefficiently High Quality and Quantity

Price floors often lead to inefficiency in that goods of

inefficiently high quality are offered: sellers offer high-
quality goods at a high price, even though buyers would
prefer a lower quality at a lower price.

Or the seller offers more quantity than is demanded and we

are left with a surplus
ELASTICITY OF
DEMAND
THE CONCEPT OF ELASTICITY

• Elasticity is a measure of the responsiveness of

one variable to another.
• In general, elasticity measures the responsiveness
of one variable to changes in another variable.
• The term elasticity is the measure of extent
relationship between two related variables
• The greater the elasticity, the greater the
responsiveness.
THE CONCEPT OF ELASTICITY

The term elasticity is the measure of extent

relationship between two related variables
For example in economics we have elasticity of
demand, elasticity of supply, elasticity of output,
elasticity of labour e.t.c
ELASTICITY OF DEMAND

• Is the measure of degree of responsiveness

on the change in the quantity demanded due
to change in the factors that influence/ affect
that change (i.e. own price of good, price of
related goods, consumer’s income).
• By studying the elasticity of demand we will
want to how demand responds when one of
the factors which determine demand change
ELASTICITY OF DEMAND

• Specifically we will want to know how demand

responds when there is a change in either price
of the same commodity (P), or consumer’s
income (Y) or price of other related goods (Pr).
Hence we have;
• (i) Price elasticity of demand
• (ii) Income elasticity of demand
• (iii) Cross elasticity of demand
PRICE ELASTICITY OF
DEMAND
• Is the measure of degree responsiveness on the
quantity demanded of a good or services due to
the change in price i.e. ( own price of that good).
• Price Elasticity of Demand for a good or
service is defined the percentage change in the
quantity demanded, (Q), that results from the
percentage change in its price, at a particular
point on the demand curve.
PRICE ELASTICITY OF DEMAND

𝑑𝑄
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 ൗ𝑄𝑋 100
• 𝜀𝑝 = = − 𝑑𝑃ൗ
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑃𝑋 100

• OR
𝑑𝑄
𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 ൗ 𝑑𝑄 𝑃
• 𝜀𝑝 = = − 𝑑𝑃ൗ𝑄 = − 𝑑𝑃 𝑋 𝑄
𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑃

• Furthermore, for a linear demand function in the

form of Q= a-bp
PRICE ELASTICITY OF DEMAND

𝑑𝑄 𝑝 𝑝
• 𝜀𝑝 = 𝑋 =
𝑑𝑝 𝑄
-b𝑄

• Hence, for the linear demand function for beef, Q =

286-20p, at the point where p= tsh 3.30 and Q= 220,
the elasticity of demand is
𝑃 3.30
• 𝜀𝑝 = b = -20 X = - 0.3
𝑄 220

• The above formula represents the so called

Point Elasticity of Demand
PRICE ELASTICITY OF DEMAND

• MID POINT formula or ARC ELASTICITY formula.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑

• 𝐸𝑝 = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
𝑑𝑄
(𝑄 +𝑄2 )ൗ 𝑋 100
[ 1 2] 𝑑𝑄 (𝑃 +𝑃 )
𝑑𝑃 = 𝑋 1 2
𝑑𝑃 (𝑄1 +𝑄2 )
(𝑃 +𝑃2 )ൗ 𝑋 100
[ 1 2]

• This is merely used when you want to find out the arc
elasticity of demand. The midpoint formula is preferable when
calculating the price elasticity of demand because it gives the
same answer regardless of the direction of the change.
PRICE ELASTICITY OF DEMAND

• For example: At a price of 3,quantinty

demanded of a good is 6 while at a price of 4
quantity demanded is 4, What is the price
elasticity of demand for this good. Or
• What is the price elasticity of demand at
point A (i.e. when P= 4 and Q= 4)? Or “What
is the price elasticity of demand at point B
(i.e. when P=3 and q =6)?
PRICE ELASTICITY OF DEMAND

• Applying the formula,

𝑑𝑄 (𝑃 +𝑃 ) 2 (4+3)
• 𝜀𝑝 = 𝑑𝑃 𝑋 (𝑄1 +𝑄2 ) = 1 𝑋 (4+6) = 1.4
1 2

• Interpretation of elasticity
• If price elasticity of demand (Ep) = 2.5 then it means
1% reduction in price will result in 2.5% increase in
the quantity demanded
COMPUTING THE PRICE
ELASTICITY OF DEMAND
(Q2 − Q1 )/[(Q 2 + Q1 )/2]
Price Elasticity of Demand =
(P2 − P1 )/[(P2 + P1 )/2]
Example: If the price of an ice cream cone increases from $2.00 to
$2.20 and the amount you buy falls from 10 to 8 cones the your
elasticity of demand, using the midpoint formula, would be
calculated as:

(10 − 8)
(10 + 8) / 2 22 percent
= = 2.32
(2.20 − 2.00) 9.5 percent
(2.00 + 2.20) / 2
PRICE ELASTICITY OF DEMAND

• The price elasticity of demand is not constant along

the demand curve/ line; it normally changes along the
demand curve or demand straight line. Here under is
the numerical example showing how elasticity changes
along the linear demand:
• This is because, the slope is the ratio of the change in
the two variables, whereas the elasticity is the ratio of
the percentage changes in the two variables
PRICE ELASTICITY OF DEMAND

• Point on the curve Price of Good

• (Tsh.) Quantity of Good (Kg)
• A 6 2000
• B 8 1500
• C 10 1000
• D 12 500
• Homework: Calculate price elasticity of demand on each of
the points.
TERMS USED IN ELASTICITY
OF DEMAND
Elastic Demand
Demand is said to be elastic if obtained result (i.e.
elasticity) is greater than 1,
Percentage change in quantity demand is greater than
percentage change in price.
Price elasticity of demand is greater than one.
This indicates that a small change in price causes a big
change in quantity demanded (for normal and luxury
goods.
ELASTIC DEMAND
- ELASTICITY IS GREATER THAN 1
Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
ELASTIC DEMAND

Comes from one or more of these factors:

1. The availability of substitute goods (S)
2. Percentage of your income that a good or
service requires (I)
3. If the good or service is a necessity or a
luxury (N)
INELASTIC DEMAND

• Demand is said to be inelastic if result obtained

(i.e. elasticity) is 0>𝜀𝑝 < − 1, which indicates
that big change in price causes a slight change in
quantity demanded (for necessary goods)
Percentage change in price is greater than
percentage change in quantity demand.
Price elasticity of demand is less than one
INELASTIC DEMAND
- ELASTICITY IS LESS THAN 1
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
UNITARY DEMAND

• Demand is said to be unitary or equal to

a unit if the coefficient of price elasticity
is equal to 1, this indicate that
proportionate change in price causes the
same proportionate change in quantity
demanded.
UNIT ELASTIC DEMAND
- ELASTICITY EQUALS 1
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
PERFECT INELASTIC DEMAND

• Demand is said to be perfect inelastic if the

coefficient of price elasticity is equal to 0, this
indicate that proportionate change in price causes no
change in quantity demanded.
• For example necessity goods, Demand curve in this
case is vertical. The change in price is the force pulling
at demand; if the quantity demanded does not change
in response to this pulling; the demand curve is
perfectly inelastic
PERFECTLY INELASTIC DEMAND
- ELASTICITY EQUALS 0
Price Demand

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
PERFECT ELASTIC DEMAND

• Demand is said to be perfect elastic if

the coefficient of price elasticity is
infinite, this indicate that different
quantities are purchased with zero change
in price of the same commodity.
Here demand curve is horizontal.
PERFECTLY ELASTIC DEMAND
- ELASTICITY EQUALS INFINITY
Price
1. At any price
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite.
INCOME ELASTICITY OF DEMAND
INCOME ELASTICITY OF
DEMAND
• Is the degree of responsiveness of change in
quantity demand as a result of change in
consumer’s income.
• It measures the percentage change in quantity
demanded per unit of time resulting from a
given percentage change in a consumer’s
income.
INCOME ELASTICITY OF
DEMAND

• its formula,

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑

• = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒
𝑑𝑄 𝑑𝑄
ൗ𝑄𝑋 100 ൗ𝑄 𝑑𝑄 𝑚
𝑑𝑚Τ 𝑋 100 = 𝑑𝑚Τ = 𝑋
𝑚 𝑚 𝑑𝑚 𝑄
COMPUTING INCOME ELASTICITY

Percentage Change
Income Elasticity = in Quantity Demanded
of Demand Percentage Change
in Income
INCOME ELASTICITY
- TYPES OF GOODS -
Normal Goods
Income Elasticity is positive.
Inferior Goods
Income Elasticity is negative.
Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior goods.
INCOME ELASTICITY OF
DEMAND
• Interpretations.
• When coefficient of income elasticity of demand is
negative, particular good is said to be an inferior
good, i.e. ϵy< 0, implies less of it is demanded as
income rises.
• When coefficient of income elasticity of demanded is
positive then particular good is said to be a normal
good, i.e. ϵy ≥0 implies that, as much or more of it is
demanded as income rises
INCOME ELASTICITY OF
DEMAND
• when coefficient of income elasticity of
demand is positive and greater than 1,
a particular normal good is a luxury. On
the other hand, if the quantity demanded
rises less than or in proportion to
income (0≤ ϵ y ≥ 1) it is a necessary
good
CROSS ELASTICITY OF
DEMAND (EXY)
• Is the degree of responsiveness of change in
quantity demanded due to change in the price
of other related goods.
• Cross-price elasticity of demand measures
percentage change in the amount of
commodity X purchased per unit of time
resulting from a given percentage change in
price of commodity Y
CROSS ELASTICITY OF
DEMAND (EXY)
• Formula,

• 𝐸𝑥𝑦 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑓𝑜𝑟 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑋
• =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌
𝑑𝑄𝑥
ൗ𝑄𝑥𝑋 100
𝑑𝑃𝑦
൘𝑃 𝑦 𝑋 100
CROSS ELASTICITY OF
DEMAND
• If two commodities are substitute to each other,
then the coefficient of cross elasticity of demand
will be positive i.e Exy > 0
• If the two goods are complementary to each other,
then the coefficient of Exy will be negative i.e. Exy
<0
• when two commodities are not related
coefficient of cross elasticity of demand will be
equal to zero.
CROSS PRICE ELASTICITY OF
DEMAND
• Elasticity measure that looks at the impact a
change in the price of one good has on the
demand of another good.
• % change in demand Q1/% change in price of
Q2.
• Positive-Substitutes
• Negative-Complements.
APPLICATIONS (OR USES) OF
PRICE ELASTICITY OF DEMAND

• Price Discrimination.
• A monopolist may adopt a price
discrimination policy when realise that there
is difference in elasticity among consumers or
different sub-markets. Consumers or sub
market whose demand is inelastic can be
charged a higher price than those with more
elastic demand.
APPLICATIONS (OR USES) OF
PRICE ELASTICITY
• Factor pricing.
• The factors having price-inelastic demand can
obtain a higher price than those with elastic
demand. Workers producing products having
inelastic demand can easily get their wages raised
• Taxation policy.
• Government can easily raise tax revenues by
taxing commodities which are price-inelastic.
APPLICATIONS (OR USES) OF
PRICE ELASTICITY
• Shifting of tax burden.
• It is possible for a businessman/producer to
shift a commodity tax in case of inelastic
demand to his consumers. But if the demand
is elastic, he will have to bear the tax burden
himself, otherwise demand for his goods will
go down sharply.
FACTORS AFFECTING
ELASTICITY
Is there a Substitute?
• If there are a few substitutes
for a good, then even when its
price rises greatly, you might
still buy it.
• If the lack of substitutes can
make demand inelastic, a wide
choice of substitute goods can
make demand elastic.
DETERMINANTS OF
PRICE ELASTICITY OF DEMAND
Necessities versus Luxuries
Availability of Close Substitutes
Definition of the Market
Time Horizon
Proportion of income spent on
commodity
Durability of a commodity.
Urgency of Demand
DETERMINANTS OF PRICE
ELASTICITY OF DEMAND

• Demand tends to be more inelastic

• If the good is a necessity.
• If the time period is shorter.
• The smaller the number of close
substitutes.
• The more broadly defined the market.
What percentage of income
is the good or service?
• how much of your budget
you spend on a good.
• Spend alot = Elastic
• Spend a little = Inelastic
Is the good a necessities or a
luxury?
• Is the good necessary for
survival?
DETERMINANTS OF
PRICE ELASTICITY OF DEMAND

Demand tends to be more elastic :

if the good is a luxury.

the longer the time period.
the larger the number of close substitutes.
the more narrowly defined the market.
TOTAL REVENUE

Elasticity is important to the study of economics

because elasticity helps us measure how consumers
respond to price changes for different products.

The elasticity of
demand
determines how
a change in price
will affect a firm’s
total revenue or
income.
ELASTICITY AND TOTAL
REVENUE
Total revenue is the amount paid by buyers
and received by sellers of a good.
Computed as the price of the good times
the quantity sold.

TR = P x Q
TOTAL REVENUE AND
ELASTICITY
• Total Revenue (TR) = Price (P) x Quantity (Q)

• If a business firm raises the price it charges will

total revenue go up?
• It depends, because when price increases,
quantity decreases
• While the price increase will raise revenue per
unit, the firm will sell less units.
• The elasticity of demand will determine whether
total revenue goes up or down when price goes
up or down.
Total Revenue = Price x
Price
Quantity
This is shown by the Light
P2 Blue shaded area on the
graph
P1

TR =
PxQ
D

Q2 Q1 Quantity

• When price increases, the firm gains the green area in

revenue...
...but will lose the red area because of the decline in sales.
Let’s draw an inelastic demand curve and
compare the areas gained and lost.
Price Total Revenue = Price x
Quantity
P2
Inelastic Demand: P increase > Q
P1
decrease
TR =
PxQ
D

Q2 Q1 Quantity
• The % increase in P is greater than the % decrease in QD
The revenue gained from the P increase > revenue lost
from the QD decrease.
The green area is greater than the red area
Total revenue increases when price rises for an inelastic goo
Price Total Revenue = Price x
Quantity

P2 Elastic Demand: P increase < Q

P1
decrease
TR =
PxQ D

Q2 Q1 Quantity
• The % increase in P is less than the % decrease in QD
The revenue gained from the P increase < revenue lost
from the QD decrease.
The green area is less than the red area
Total revenue decreases when price rises for an elastic good
ELASTICITY AND TOTAL REVENUE:
SUMMARY
Effect of an Effect of a decrease
Type of Change in quantity increase in price in price on total
demand Value of Ed versus change in price on total revenue revenue
Elastic Greater than Larger percentage Total revenue Total revenue
1.0 change in quantity decreases increases
Inelastic Less than 1.0 Smaller percentage Total revenue Total revenue
change in quantity increases decreases
Unitary Equal to 1.0 Same percentage change Total revenue Total revenue does
elastic in quantity and price does not change not change

• When demand is inelastic, price and total revenues are directly

related. Price increases generate higher revenues.
• When demand is elastic, price and total revenues are indirectly
related. Price increases generate lower revenues.
Checkpoint: Why does a firm need to know whether
demand for its product is elastic or inelastic?
 Knowledge of how the elasticity of demand can affect a
firm’s total revenues helps the firm make pricing
decisions that lead to the greatest revenue.
If a firm knows that the demand for its product
is elastic at the current price, it knows that an
increase in price would reduce total revenue.
If a firm knows that the demand for its product
is inelastic at its current price, it knows that an
increase in price will increase total revenue.
PRICE ELASTICITY OF SUPPLY

• Price elasticity of supply measures the

responsiveness of sellers to changes in
the price of a product.
• If producers are relatively responsive,
supply is elastic.
• If producers are relatively insensitive to
price changes, supply is inelastic.
PRICE ELASTICITY OF SUPPLY

• The price elasticity of supply coefficient

Es is defined as:

percentage change in quantity supplied of X

Es = percentage change in price of X

• To calculate Es, we employ the

midpoint approach to determine the
percentage changes.
PRICE ELASTICITY OF SUPPLY

• If Es < 1, supply is inelastic.

• If Es > 1, supply is elastic.
• If Es = 1, supply is unit-elastic.

• Since price and quantity supplied are

directly related, Es is never negative.
PRICE ELASTICITY OF SUPPLY

• The amount of time it takes producers to shift

resources between alternative uses to alter
production of a good can determine the degree
of price elasticity of supply.
• The easier and more rapid the transfer of
resources, the greater is the price elasticity of
supply.
• The longer a firm has to adjust to a price change,
the greater the elasticity of supply.
PRICE ELASTICITY OF SUPPLY
AND TIME PERIODS
• The market period is a period in which
producers of a product are unable to
change the quantity produced in
response to a change in price.
• During this time period, the supply of a
product is fixed, or supply is perfectly
inelastic.
PRICE ELASTICITY OF SUPPLY
AND TIME PERIODS
• In the short run, producers are able to
change the quantities of some but not all
the resources they employ.
• This time period is too short to change plant
capacity but long enough to use fixed plant
more or less intensively.
• The supply of a product is more elastic than
the market period.
PRICE ELASTICITY OF SUPPLY
AND TIME PERIODS
• In the long run, producers are able to
change all the resources they employ.
• This time period is long enough for firms to
adjust their plant sizes and for new firms to
enter (or existing firms to exit) the industry.
• The supply of a product is more elastic than
in the short run.
PRICE ELASTICITY OF SUPPLY
AND TIME PERIODS