02.

MARKET FORCES AND ELASTICITY

[ SUMMARIZED NOTE ]

Demand
In a certain period of time, when other factors remain constant, the various quantities
consumers are ready to buy at various prices of a good is called as demand.

Determinants of individual and market demand can be listed as below.

▪ Price of the concerned goods(P)

▪ Price of the related goods(Pn)
▪ Consumer Income( Y)
▪ Consumers’ Taste (T)
▪ Future expectations (Ex)
▪ Number of buyers and the composition (N)
▪ Other factors (O)

Law of demand

In a certain period of time, when other factors affecting demand remains constant the inverse
relationship between price and the quantity demand of goods, is called the law of demand.

Demand Equation The common equation of a liner demand curve which slopes
downward can be stated as below,

Qd = a – bp
▪ Qd = Quantity demanded(dependent variable)
▪ a = Quantity demanded at zero price
∆𝑸𝒅
▪ b = Variance of the slope of the demand curve b = ∆𝑷
▪ P = Price of the concerned goods(independent variable)

Reasons for the Law of Demand

The reasons for the inverse relationship between price and quantity demanded are given
below.

When other factors remain constant including the price of

Substitution effect substitute goods, due to increase or decrease of the price of
concerned good, the change of the quantity demand of the
concerned good as a result of increase or decrease in relative price of the good is known as
substitution effect.

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When the price of the good concerned increases the good becomes relatively expensive and
thus consumers switch to cheaper substitutes which results in a decrease in quantity
demanded of the good concerned and vice versa.

When other factors remain constant including the nominal income of

Income effect consumers, changes of the quantity demanded according to the changes
of real income is called income effect.

When the price of a good concerned increases the real income/purchasing power of
consumers decrease resulting in a decrease in quantity demand and vice versa.
Exceptions to the law of demand are given below.

• Giffen goods
• Demonstrative goods

There is a positive relationship that exists between price of

these goods and the quantity demand as the quantity
demanded increases when the price increases and the
quantity demanded decreases when the price decreases.
Because of this demand curve slopes upwards.

When the price of demonstrative goods increase the

quantity demanded increases to show the artificial status
of the buyer.

Example: Increase the demand for expensive vehicles and diamonds to show-off.

Classification of goods based on the income and substitution effect of a price change

Price Effect of a Normal Good

Change in Price Substitution Effect Income Effect Price Effect
Decrease in Price Negative (ΔQd+) Positive (ΔQd+) Negative (ΔQd+)
Increase in Price Negative (ΔQd-) Positive (ΔQd-) Negative (ΔQd-)
Price Effect of an Inferior Good
Change in Price Substitution Effect Income Effect Price Effect
Decrease in Price Negative (ΔQd+) Negative (ΔQd-) Negative (ΔQd+)
Increase in Price Negative (ΔQd-) Negative (ΔQd+) Negative (ΔQd-)
Price Effect of a Giffen Good
Change in Price Substitution Effect Income Effect Price Effect
Decrease in Price Negative (ΔQd+) Negative (ΔQd-) Positive (ΔQd-)
Increase in Price Negative (ΔQd-) Negative (ΔQd+) Positive (ΔQd+)

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 Change in Quantity Demanded When all other factors affecting demand remain
constant, except the price of the concerned goods,
changes of the quantity demanded in response to the increase or decrease of the price of the
considering good is called changes of quantity demanded.

When other factors are constant, if the price of the concerned good is increased the quantity
demanded decreases and the point on the demand curve moves upward along the demand
curve. This situation is defined as a contraction in demand.

When other factors are constant, if the price of the concerned good decrease the quantity
demanded increases and the point on the demand curve moves downward along the demand
curve. This situation is defined as an expansion in demand.

Change in Demand When the price of the concerned goods remains constant, change of
demand according to the change of other factors is known as change
in demand.

Increase of demand as a response to the changes of other factors of demand while the price
of the concerned goods remains constant is called an increase in demand and the demand
curve shifts to the right.

Decrease of demand as a response to the changes of other factors of demand while the price
of the concerned goods remains constant is called a decrease in demand and the demand
curve shifts to the left.

The difference
between change in
quantity demand
and change in
demand can be
shown by the
diagram below.

Reasons for an increase in demand/ a Reasons for an decrease in demand/ a

rightwards shift of the demand curve leftwards shift of the demand curve
Increase of the price of substitute goods Decrease of the price of substitute goods
Decrease of the price of complementary Increase of the price of complementary
goods goods
Increase of the consumer income Decrease of the consumer income
Increase of the consumer taste Decrease of the preferences of consumers
Expect that the price will increase in the Expect that the price will decrease in the
future future
Increase of the number of buyers Decrease of the number of buyers

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Elasticity of Demand
Price Elasticity of Demand

Measure the percentage change of quantity demanded in response to the percentage change
of price is identified as price elasticity of demand.

There are two ways of calculating the price elasticity of demand.

• Point price elasticity of demand

• Arc price elasticity of demand

Point PED
Percentage Δ in Qd ΔQd P
PED = PED = x
Percentage Δ in P ΔP Qd

Arc PED

Measure the relative percentage change in quantity demanded to a large percentage change
in price between two certain points on the demand curve is defined as arc price elasticity of
demand.

AED = ΔQd x P1 + P2
ΔP Q1 + Q2
TYPES OF PED

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Slope of the Demand curve and PED

PED can be calculated by ratio of the absolute change in quantity demanded to absolute
∆𝑄
change in price of the concerned good or the variance of the slope of the demand curve ( ∆𝑃 )
𝑃
multiplied by the ratio between quantity demanded and price (𝑄).

ΔQd P
PED = x
ΔP Qd

P
PED = 𝑏 x
Qd

Determinants of PED

1. Nature of the concerned good.

▪ Essential – Inelastic
▪ Luxury - Elastic
2. Number of substitutes available to a good and its closeness.
▪ Many close substitutes – Elastic
▪ Distant substitutes - Inelastic
3. Percentage of the income spent on the good.
▪ Large percentage – Elastic
▪ Small percentage - Inelastic
4. The alternative uses of goods
▪ Many uses – Inelastic
▪ Less uses - Elastic
5. The time taken to adjust to the price change.
▪ Short run | Immediately – Inelastic
▪ Long run | With time - Elastic

PED and Producer

Revenue/Consumer Expenditure

There is a relationship that exists

between price elasticity of demand and
consumer expenditure/producer
revenue. It can be presented by a graph
as below.

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Cross Elasticity of Demand [CED / XED]

The changes of the price of one product affects the change in the demand for other goods.
When other factors affecting demand is held constant the responsiveness of Quantity
demand of the concerned good to a change in price of another good can be termed as Cross
Elasticity of Demand.

The cross price elasticity of demand can be calculated by using the following formulas.

Percentage change in demand (X)

XED =
Percentage change in price (Y)

∆𝑄𝑑𝑥 𝑃𝑦
XED = 𝑋
∆𝑃𝑦 𝑄𝑑𝑥

Based on the XED the relationship between the two goods could be identified

▪ XED > 0 [Positive] – Substitutes

o XED > 1 – Close substitutes
o XED < 1 – Distant substitutes [more market power]
▪ XED = 0 – Unrelated products
▪ XED < 0 [Negative] – Complimentary goods

Income Elasticity of Demand [YED]

The change of demand for each good with a change in income differ at various situations.
When other factors affecting demand remain constant the responsiveness of the percentage
change in demand to a percentage change in income is known as income elasticity of demand.

Income elasticity of demand can be measured by using the following formula.

percentage change in demand

YEd =
Percentage change in income

∆𝑄𝑑 𝑌
YEd = 𝑋
∆𝑦 𝑄𝑑

Based on the YED the type of the good could be identified

▪ YED > 0 [Positive] – Normal good

o YED > 1 – Luxury good
o YED < 1 – Essential good
▪ YED < 0 [Negative] – Inferior good

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Supply
At a certain period of time the various quantities that the producers are willing and able to
supply, at alternative prices is called supply in economics.

The determinants of market supply can be listed as follows.

▪ Price of concerned good (P)

▪ Price of inputs (C)
▪ Technology (T)
▪ Prices of related goods (Pn)
▪ Expectations of producers (Ex)
▪ Government Policies (G)
▪ Other factors (O)
▪ Number of producers (N)

Law of Supply

The law of supply is the positive relationship that exists between price of the concerned good
and the quantity supplied when other determinants of supply remain constant at a certain
period of time.

Supply Equation

- Qs = Quantity supplied (dependent variable)

Qs = a +bp - a = Horizontal intercept (Quantity supplied in price zero)

∆𝑄𝑠
- b = slope of the supply curve
∆𝑃
- P= Price of concerned good

Reasons for the Law of Supply/ upward sloping supply curve

1. Profit Motive:
The basic aim of producers, while supplying a commodity, is to secure maximum profits.
When price of a commodity increases, without any change in costs, it raises their profits. So,
producers increase the supply of the commodity by increasing the production. On the other
hand, with fall in prices, supply also decreases as profit margin decreases at low prices.

2. The Law of Increasing Marginal Cost affects the law of supply.

The Law of Increasing Opportunity Cost states that when the production of a particular good
increases the opportunity cost also increases. Producers tend to produce more only if price
increase covers the cost because if they increase the production opportunity cost would also
increase. As the marginal cost increases with output, produces tend to produce more only if
the price of the good increases in a way to cover increasing marginal cost.

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Change in Quantity Supplied

When other factors affecting supply remain

constant a change in price of the considering
good will cause a change in quantity supplied.

When all other determinants remain constant

if the price of goods increases, the quantity
supplied increases. Then the point on the
supply curve moves upward along the curve.

When all other determinants remain constant

if the price of goods decreases, the quantity
supplied decreases, then the point on the supply curve moves downward along the curve.

Change in Supply

Increase or decrease in supply when all other

determinants of supply change while the price
of the goods remains constant, is known as a
change in supply.

The Shift of a supply curve to the left when

other factors affecting supply change with the
price reaming constant is a decrease in supply.
The Shift of a supply curve to the right when
other factors affecting supply change with the
price reaming constant is an increase in supply.

Reasons for a shift of the curve to the right Reasons for a shift of the curve to the left
1. Decrease in the price of related goods. 1. Increase in the price of related goods.
2. Decrease in the price of inputs. 2. Increase in the price of inputs.
3. Development in technology 3. Use of outdated technology
4. Increase in the number of suppliers 4. Decrease in the number of suppliers
5. Cut-off in the government taxes. 5. Increase of the government taxes for
6. Supply of subsidies. suppliers
7. Expectation that the price will reduce in 6. Cut off in the subsidies.
the future. 7. Expectation that price will increase in
the future.

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Price Elasticity of Supply
The responsiveness of quantity supplied to the change in the price of concerned good, when
other determinants remain constant is the price elasticity of supply.
percentage change in quantity supply ΔQs P
Price elasticity of Supply = PES = x
Percentage change in prices ΔP Qs

TYPES OF PES

Supply Equation → Qs = a+bp | Qs = -a+bp | Qs = bp

format

Determinants of PES

1. Factor mobility of production [ability to move factors of production—labor, capital,

or land—out of one production process into another]
▪ Mobile – Elastic
▪ Immobile - Inelastic
2. Nature of the good
▪ Agricultural – Inelastic
▪ Manufactured - Elastic
3. Availability of storage facilities
▪ Can store | Non – perishable – Elastic
▪ Cannot store | Perishable - Inelastic
4. Time taken to (Change) adjust the supply
▪ Short run | Immediately – Inelastic
▪ Long run | With time - Elastic

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Market Equilibrium
Market equilibrium is the situation where the expectations of purchasers and suppliers at a
competitive market equal each other. At that situation, there is no excess demand or excess
supply as quantity demanded equal to quantity supplied and there in no excess demand price
or excess supply price as purchasers’ expected price equals to supplier expected price.
At Equilibrium, Qd = Qs [knowing how to calculate equilibrium price and quantity is a MUST]

Excess demand and Excess Supply

Based on the demand and supply curve, the market
forces drive the price to its equilibrium level.

There are two possibilities: 1) Excess Demand or 2)

Excess Supply

Excess supply is the situation where the price is above

its equilibrium price. The quantity supplied by the
producers is higher than the quantity demanded by
the consumers. [ ES = Qs – Qd ]

Excess demand is the situation where the price is

below its equilibrium price. The quantity supplied is
lower than the quantity demanded by the consumers.
[ Ed = Qd – Qs ]

Consumer Surplus

The difference between the price that the consumer is willing to pay and the price that the
consumer actually pays for the quantity of goods exchanged at the market is called consumer
surplus.

Market equilibrium price is the price which consumer pays for goods and is not the price
consumer is willing to pay. The price that consumer is willing to pay may be higher than that
price. When they expected to pay a higher price,
demand and supply determines a suitable price and
remains as an equilibrium price. This creates a situation
beneficial to consumers.

(Maximum demand price − Eq price)

𝐶. S = x Eq Qty
2

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Producer Surplus

The difference between the minimum price that the suppliers are willing to receive and the
price they actually receive is known as producer surplus.

When we deduct the total variable cost from total revenue of the producer the balance
received is the producer surplus.
(Eq price − Minimum supply price)
𝑃. S = x Eq Qty
2

Economic surplus
Economic surplus refers to two related quantities: consumer surplus and producer surplus.
Economic surplus is calculated by combining the surplus benefit that is experienced by both
consumers and producers in an economic transaction.
Economic surplus = Consumer surplus + Producer Surplus

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