Module 2
Demand and Supply Analysis
The Price Mechanism
Demand and Supply decisions by
consumers and producers are
transmitted to each other through their
effect on prices or price mechanism
Prices respond to shortages and
surpluses
Demand and Supply are the two
components to understand Price
Mechanism
Demand
Relationship between price and
quantity demanded at a given price
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
The demand curve is a relationship
between the quantity demanded and
its price
Holding all else constant –
quality is constant
consumers’ incomes are unchanged
the prices of other goods are unchanged
Consumer tastes are unchanged, etc.
Demand
A demand schedule is a table
showing how much of a given
product a household would be
willing to buy at different prices.
Demand curves are usually derived
from demand schedules.
Demand
P ◼ The demand curve is
A
P1 a graph illustrating
how much of a given
B
P2 product a household
would buy at different
Q1 Q2 prices.
Q
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
• Demand curves slope downward.
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 household’s amount of accumulated
wealth.
• The prices of related products available to
the household.
• The household’s tastes and preferences.
• The household’s expectations about future
prices.
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
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).
Types of Goods
Normal Goods are goods for
which demand goes up when
income increases and for which
demand goes down when income
decreases.
Inferior Goods are goods for
which demand falls when income
rises.- public transport, non
branded clothes, second hand
stuff…
Types of Goods
Substitutes are goods that can
serve as replacements for one
another; when the price of one
increases, demand for the other
goes up.
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.
The Impact of a Change in
Income
• Higher income • Higher income
decreases the increases the
demand for an demand for a
inferior good normal good
The Impact of a Change in the
Price of Related Goods
• Demand for complement good
(ketchup) shifts left
• Demand for substitute good
(chicken) shifts right
• Price of hamburger
• rises
Quantity of
hamburger demanded
falls
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:
Elasticity – the concept
The responsiveness of one variable to
changes in another
When price rises, what happens to
demand? -- Demand falls BUT! How much
does demand fall?
If price rises by 10% - what happens to
demand? It decreases by more than 10%?
Or by less than 10%? Or equal to 10%?
It is the extent to which demand will
change in response to change in price
Types of Elasticity
Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity of demand
Price elasticity of demand
Price elasticity of demand is defined as:
◼ the % change in the quantity of a good demanded
resulting from a one % change in its price
◼ the price elasticity of demand is negative,
for convenience we will take the absolute value
Price Elasticity of Demand
◼ The responsiveness of demand to
changes in price
◼ Where % change in demand is greater
than % change in price – elastic
◼ Where % change in demand is less than
% change in price - inelastic
Price Elasticity- Three
particular Case
Elastic Demand
◼ price elasticity is greater than one
Because the % change in quantity sold exceeds the %
change in prices, change in quantities dominates
Inelastic Demand
◼ price elasticity is less than one
Because the % change in prices exceeds the % change
in quantities, change in prices dominates
Unit elastic Demand
◼ price elasticity equals one (dividing line case)
% change in price = % change in quantity sold
Price Elasticity of Demand
Perfectly Inelastic Perfectly Elastic Unitary Elastic
Relationship between demand slope
and elasticity
PRICE Perfectly inelastic
Perfectly elastic
Relatively Elastic
Demand
Relatively Inelastic Demand
Quantity
Elastic and Inelastic Demand
Examples of Price Elasticity
Good Price elasticity
Inelastic demand
Eggs 0.1
Bread 0.4
Stationery 0.5
Petrol 0.5
Elastic demand
Housing 1.2
Restaurant meals 2.3
Airline travel 2.4
Foreign travel 4.1
Determinants of Price
elasticity of demand
The number and closeness of
substitute goods
Proportion of income spent on the
good
The time period
Types of Goods
Normal Goods are goods for
which demand goes up when
income increases and for which
demand goes down when income
decreases.
Inferior Goods are goods for
which demand falls when income
rises.- public transport, non
branded clothes, second hand
stuff…
Income Elasticity of Demand
Income Elasticity of Demand:
◼ The responsiveness of demand to
changes in incomes
Yed = % change in demand
% change in income
Income Elasticity of
Demand:
Normal Good – demand rises as
income rises and vice versa
Inferior Good – demand falls as
income rises and vice versa
Look out for the sign…!
A positive sign (+) denotes a normal
good
◼ Necessity Good: <1
◼ Luxury Good: >1
A negative sign (-) denotes an
inferior good
Look for the signs!
◼NORMAL GOODS
LUXURY
+ +
GOODS
BETWEEN 0 & 1 GREATER THAN 1
+0.5 +0.9 + 0.1 +2 +5 +27
◼INFERIOR GOODS
- CAN BE A DECIMAL OR A VALUE
GREATER THAN 1
Question: Divide the following
products on the basis of type
of good and elasticity
Yed = - 0.6
Yed = + 0.4
Yed = + 1.6
Yed = - 2.1
Types of Goods
Substitutes are goods that can
serve as replacements for one
another; when the price of one
increases, demand for the other
goes up.
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.
Cross Elasticity
The responsiveness of demand
of one good to changes in the price of
a related good – either a substitute or
a complement
% Δ Qd of good A
__________________
Xed =
% Δ Price of good B
Cross Elasticity
Goods which are complements:
◼ Cross Elasticity will have negative sign
(inverse relationship between the two)
Goods which are substitutes:
◼ Cross Elasticity will have a positive sign
(positive relationship between the two)
Supply
• Relationship between price and
quantity supplied at a given price
• A supply schedule is a table showing
how much of a product firms will
supply at different prices.
• Quantity supplied represents the
number of units of a product that a
firm would be willing and able to offer
for sale at a particular price during a
given time period.
The Supply Curve and
the Supply Schedule
• A supply curve is a graph illustrating
how much of a product a firm will supply
at different prices.
6
Price of soybeans per bushel ($)
5
4
3
2
1
0
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
The Law of Supply
The law of
6
Price of soybeans per bushel ($)
5
supply states
4 that there is a
3 positive
2 relationship
1 between price
0 and quantity of a
0 10 20 30 40 50
Thousands of bushels of soybeans good supplied.
produced per year
This means that
supply curves
typically have a
positive slope.
Determinants of Supply
• The price of the good or service.
• The cost of producing the good, which in
turn depends on:
• The price of required inputs (labor,
capital, and land),
• The technologies that can be used to
produce the product,
• Government policies (Tax and
Subsidies)
• The profit of related products.
• Nature, random shocks and other
unpredictable events
• Expectations of future prices
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
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).
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.
Market Supply
As with market demand, market
supply is the horizontal summation of
individual firms’ supply curves.
Price Elasticity of Supply
◼ The responsiveness of supply to changes in
price
◼ If Pes is inelastic - it will be difficult for
suppliers to react swiftly to changes in price
◼ If Pes is elastic – supply can react quickly to
changes in price
% Δ Quantity Supplied
____________________
Pes =
% Δ Price
Examples of Price
Supply Elasticities
When the price of DaVinci paintings increases
by 1% the quantity supplied doesn’t change
at all, so the quantity supplied of DaVinci
paintings is completely insensitive to the
price.
◼ Price elasticity of supply is 0.
When the price of egg increases by 1% the
quantity supplied increases by 5%, so egg
supply is very price sensitive.
◼ Price elasticity of supply is 5.
Market Equilibrium
The operation of the market
depends on the interaction
between buyers and sellers.
An equilibrium is the
condition that exists when
quantity supplied and
quantity demanded are
equal.
At equilibrium, there is no
tendency for the market
price to change.
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.
Increases in Demand and
Supply
Higher demand leads Higher supply leads
to higher equilibrium to lower equilibrium
price and higher price and higher
equilibrium quantity. equilibrium quantity.
Decreases in Demand and
Supply
Lower demand Lower supply leads
leads to lower price to higher price and
and lower quantity lower quantity
exchanged. exchanged.
Thank You
9/15/2025 54