Chapter 3
Demand and Its Application
What is demand
Demand refers to the quantities of a
good that purchasers are willing and
able to buy at various prices per period
of time, other things remaining
constant
Elements of demand
Willingness
Ability
Price
Quantity
Time
Other things being equal
Demand Schedule for Broccoli
Law of demand - A Downward Sloping Demand
Curve. higher the price, lower the demand
Determinants of demand
Price
Price of related good (Substitute &
Complementary)
Income
Tastes and preferences
Other factors (fashion, future expectation,
population, weather, distribution of income,
state of business etc)
Demand function
Dx = f (Px ;Py; Y; T………)
Dx = Demand for X commodity
f = function of ( or depends upon)
Px = Price of X commodity
Pr = Price of related commodity
Y = Consumer’s income
T = Taste of consumer
Why demand curve slopes downwards
Market Demand Curve
Market or aggregate Px Qd1 Qd2 Qd3 Mar
demand for a ket
commodity gives
alternative amounts of 6 9 18 30 57
commodity demanded
by all individuals in the
market 5 10 20 32 62
Exceptions:
Bandwagon effect
4 12 24 36 72
Snob effect
Increase/decrease in demand vz
extension/contraction
Exceptions to law of demand
Inferior goods
Veblen goods – rare goods
Necessities of life
Future expectation regarding price rise
Abnormal conditions as floods, famine etc
Hobbies
Addictions
Supply
Supply refers to the quantities of a
product that suppliers are willing and
able to sell at various prices per unit of
time, other things remaining the same
Supply of Broccoli
Law of Supply - Upward sloping Supply Curve of
Broccoli
Factors affecting supply
Quantity
Product – perishable vz non perishable
Suppliers
Technology
Time period
Storage facilities
Cost of production
Equilibrium in the Broccoli Market
How equilibrium price is set
Price Q Q Surplus/ Pressure on
Demand Supply shortage price
1.2 100,000 400,000 +300,000 downward
1.1 125,000 350,000 +175,000 downward
1.0 150,000 300,000 +150,000 downward
.9 175,000 250,000 +75,000 downward
.8 200,000 200,000 0 equilibrium
.7 225,000 150,000 -75,000 upward
.6 250,000 100,000 -150,000 upward
.5 275,000 50,000 -225,000 upward
Market Adjustment to Equilibrium
Demand, supply and shifts in
equilibrium
Demand Shift
Supply Shift
Effect on equilibrium
E.g. Changes in demand and supply and price of
PCs
Elasticity
“The price elasticity of demand is a measure of how
much the quantity demanded of a good responds
to a change in the price of that good”
Determinants:
Availability of close substitutes
Necessities vs luxuries
Definition of the market
Time horizon
Proportion of Income spent
What is income and cross elasticity
“The income elasticity of demand (e i) = is a measure of
how much the quantity demanded of a good responds to a
change in consumers’ income, computed as the percentage
change in quantity demanded divided by the percentage
change in income.”
“The cross-price elasticity of demand ( e xy) = is a measure
of how much the quantity demanded of one good responds
to a change in the price of another good, computed as the
percentage change in quantity demanded of the first good
divided by the percentage change in the price of the second
good.”
Measures of Elasticity
A. Point Elasticity = (Q2-Q1) / Q1* 100
(P2-P1) / P1 * 100
B. Arc Elasticity =
(Q2-Q1)/[(Q2+Q1)/2] * 100
(P2-P1)/[(P2+P1)/2] * 100
PRICE QUANTITY DEMANDED
$40 250
$30 450
$20 675
$10 825
Price
P1
Inelastic Demand
Elasticity less than 1
P2
D
Q1 Q2 Quantity
D
Price
P1
Perfectly Inelastic Demand
Elasticity equals 0
P2
Q1 = Q2 Quantity
Price
Elastic Demand
Elasticity greater than 1
P1
P2
D
Q1 Q2 Quantity
Price
Perfectly Elastic Demand
Elasticity equals infinity
P1 = P2
D
Q1 Q2 Quantity
Impact of a Price Increase on
Expenditure
Inelastic Rises
Elastic Falls
Unit elastic Constant
PRICE QUANTITY ELASTICITY EXPENDITURE CHANGE IN
OF DEMAND EXPENDITURE
40 250 10,000
2.0 -3,500
30 450 13,500
1.0 0
20 675 13,500
.3 5,250
10 825 8,250
Summary of Relationship Between Price Elasticity of Demand and
Total Revenue
Relation of price elasticity and MR
MR = P ( 1 + 1/Ep)
(Figure continues on next slide)
Relationships Among Total Revenue; Marginal Revenue; Average
Revenue; and Price Elasticity of Demand
+/- +/- +/-
QdX = f(PX, I, PY, T )
QdX/PX 0 if a good is normal
QdX/I 0 if X and Y are substitutes
QdX/PY < 0 if X and Y are complements
Applications of Elasticity
Air fares pricing
Agricultural products
Demand for gasoline in long run
Taxes on Cigarettes
Engel’s law
Maximising revenue
Price discrimination in different markets