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Block # 4: Market Demand and Pricing Decisions

Q # 2. Define the Concepts: (a) price elasticity of demand; (b) cross-elasticity of demand; and (c)
income elasticity of demand. How are these elasticity’s estimated? Explain why it might be
important for a firm to know their values.

Ans:

(a) Price elasticity of demand

A measure of the responsiveness of the quantity demanded of a good to a change in its price. It is
calculated as:

Percentage change∈Quantity Demand

EOD=
Percentage chage ∈Price

Point elasticity of demand

When a price change is very small, there will be little difference between the initial and final
prices and quantities for point on demand curve, the formula for price elasticity of demand can
be written as:

∆q p
Ed = ×
∆p q

Arc elasticity of demand

Arc method of the measurement of elasticity of demand is used when there is a major, or big or
prominent change in quantity demanded as a result of a major change in price of the commodity.
Therefore, such a change on demand curve has clear and separate identity between two points.

For easier calculations, the formula for arc elasticity can be rewritten as:

Q2−Q1 P2+ Q1
Ed = ×
Q2 +Q1 P2−P1

(b) Income elasticity of demand

Income elasticity of demand shows the extent to which a consumer’s demand for a good changes
as a result of a change in his income.

“Income elasticity of demand is the proportionate change in the quantity demand

resulting from a proportionate change in income.”

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Percentage change∈Quantity Demand

IED=
Percentage chage ∈income

For change in income, the income elasticity of demand is,

∆q Y
EY = ×
∆Y q

(C) Cross elasticity of demand

The cross elasticity of demand is the ratio of the percentage change in quantity demanded of one
good to the percentage change in price of another good.

“Cross elasticity of demand is the proportionate change in the quantity demanded of one
commodity resulting from a proportionate change in the price of another commodity.”

Percentage change∈Quantity Demand of X

CED=
Percentage chage∈ Price of Y

For %age change in quantity demand of X due to %age change in price of Y, the cross elasticity
of demand is,

∆ Qx P y
EC = ×
∆ Py Qx

Why it might be important for a firm to know their values.

It is very important for a company to know their value for its various products. Otherwise, it will
not know the ideal price to charge for those products.

If a firm knows that the elasticity of demand for its products is low, for example, it should raise
prices on those products. By doing so, it will increase its profits. If it does not know the price
elasticity of demand for its products, it will not know the best price to charge -- the one that will
bring it the maximum profit.

Note: This question is taken from past papers.

Q # …: (a) What is quantity supplied? Also explain the law of supply.

(b) Supply curve shift due to different variables; identify and explain these variables.

Edited by: Lect. Imran Monus

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(a) Quantity Supplied

The amount of goods or services that are supplied at a given market price. Graphically,
the amount of goods or services supplied lies at any point along the supply curve in a price
versus quantity plane. The rate at which the amount supplied changes in response to changes in
prices is called the price elasticity of supply.

Law of Supply

There is direct relationship between the price of a commodity and its quantity offered fore sale
over a specified period of time.

“When the price of a goods rises, other things remaining the same, its quantity which is offered
for sale increases as and price falls, the amount available for sale decreases.”

This relationship between price and the quantities which suppliers are prepared to offer for sale
is called the law of supply.

Px 4 3 2 1

QxS 100 80 60 40

In the table above, the produce are able and willing to offer for sale 100 units of a commodity at
price of $4. As the price falls, the quantity offered for sale decreases. At price of $1, the quantity
offered for sale is only 40 units.

The market supply data of the commodity x as shown in the supply schedule is now presented
graphically.

In the figure price is plotted on the vertical

axis OY and the quantity supplied on the
horizontal axis OX. The four points d, c, b,
and a show each price quantity combination.
The supply curve SS/ slopes upward from
left to right indicating that less quantity is
offered for sale at lower price and more at
higher prices by the sellers not supply curve
is usually positively sloped.

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Formula for Law of Supply/Supply Function:

Qs = f (Px, Tech, Si, ........)

Here: Px = Price of commodity x, Tech = Technology, Si = Supplies of inputs.

Assumptions of Law of Supply:

(i) Nature of Goods. If the goods are perishable in nature and the seller cannot wait for the rise in price.
Seller may have to offer all of his goods at current market price because he may not take risk of getting
his commodity perished.

(ii) Government Policies. Government may enforce the firms and producers to offer production at
prevailing market price. In such a situation producer may not be able to wait for the rise in price.

(iii) Alternative Products. If a number of alternative products are available in the market and customers
tend to buy those products to fulfill their needs, the producer will have to shift to transform his resources
to the production of those products.

(iv) Squeeze in Profit. Production costs like raw materials, labor costs, overhead costs and selling and
administration may increase along with the increase in price. Such situations may not allow producer to
offer his products at a particular increased price.

Limitations/Exceptions of Law of Supply:

Exceptions that affect law of supply may include:

(i) Ability to move stock.

(ii) Legislation restricting quantity.

(iii) External factors that influence your industry.

(b) Different variables that causes shift in supply curve

There are four important variables as under:

(i) Technology changes.

Technology helps a producer to minimize his cost of production.

(ii) Resource supplies.

The producer also has to pay for other resources such as raw materials and labor. if his money is
short on supplying a certain number of products because of an increase in resource supplies,
then he has to reduce his supply.

(iii) Tax/ Subsidy.

A producer aims to maximize his profit, but an increase in tax will only increase his expenses,
decreasing his capacity to buy resource supplies and forcing him to reduce his supply.

(iv) Price of other goods produced.

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A producer may not only produce on product but other products as well. A producer's money is
limited and if he increases his supply in one product, he would have to decrease his supply in the
other product, no unless his sales increase.

Note: This question is taken from past papers.

Q # …: (a) Explain the price theory and price mechanism?

(b) What is the relationship between quantity demanded and price of a product? Explain
the shifts in the demand curve with examples?

Ans: (a) Price Theory

Price is the quantity of payment or compensation given by one party to another in return
for goods or services.

Economic theory asserts that in a free market economy the market price reflects
interaction between supply and demand: the price is set so as to equate the quantity being
supplied and that being demanded. In turn these quantities are determined by the marginal utility
of the asset to different buyers and to different sellers. In reality, the price may be distorted by
other factors, such as tax and other government regulations.

When a commodity is for sale at multiple locations, the Law of one price is generally
believed to hold. This essentially states that the cost difference between the locations cannot be
greater than that representing shipping, taxes, other distribution costs etc. In the case of the
majority of consumer goods and services, the distribution costs are quite a high proportion of the
overall price, so the law may not be very useful. In practice it may well make economic sense to
offer a product or service for sale at a higher price in a wealthy area than in a deprived area as
the marginal utility of the asset for purchasers will be higher in the former.

Price Mechanism
Price mechanism is an economic term that refers to the buyers and sellers who negotiate prices
of goods or services depending on demand and supply. A price mechanism or market-based
mechanism refers to a wide variety of ways to match up buyers and sellers through price
rationing.

An example of a price mechanism uses announced bid and ask prices. Generally speaking, when
two parties wish to engage in a trade, the purchaser will announce a price he is willing to pay
(the bid price) and seller will announce a price he is willing to accept (the ask price).

(b) Relationship between Quantity demand and price

The law of demand states that, if all other factors remain equal, the higher the price of a good,
the less people will demand that good. In other words, the higher the price, the lower the quantity
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demanded. The amount of a good that buyers purchase at a higher price is less because as the
price of a good goes up, so does the opportunity cost of buying that good. As a result, people will
naturally avoid buying a product that will force them to forgo the consumption of something else
they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between quantities demanded (Q) and price (P). So, at point A, the quantity demanded will be
Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative
relationship between price and quantity demanded. The higher the price of a good the lower the
quantity demanded (A), and the lower the price, the more the good will be in demand (C).

Shift in demand curve

The shift of a demand curve takes place when there is a change in any non-price
determinant of demand, resulting in a new demand curve. Non-price determinants of demand are
those things that will cause demand to change even if prices remain the same—in other words,
the things whose changes might cause a consumer to buy more or less of a good even if the
good's own price remained unchanged. Some of the more important factors are the prices of
related goods (both substitutes and complements), income, population, and expectations.
However, demand is the willingness and ability of a consumer to purchase a good under the
prevailing circumstances; so, any circumstance that affects the consumer's willingness or ability
to buy the good or service in question can be a non-price determinant of demand.
Demand shifters
i. Changes in disposable income
ii. Changes in tastes and preferences
iii. Changes in expectations.
iv. Changes in the prices of related goods (substitutes and complements)
v. Population size and composition

Edited by: Lect. Imran Monus