Lecture 2:

The Invisible Hand: Laws of Demand

and Supply
 Intended Learning Outcomes
At the end of this session you will be able to:
Explain how a market reconciles demand and supply
through price adjustment.
Examine the principal factors that shift supply and
demand curves.
Develop the concepts of elasticity.
To ponder upon

Do we use economics everyday?

What was the price of the first product you bought

today?
Who decided on this price?
What if you did not have enough money to make the
purchase?
Where from now?

Demand and
Supply and its Market Government
its
determinants equilibrium set prices
determinants
Demand
Demand defined
Demand is the various amounts of a
product that consumers are willing to
purchase at each of a series of possible
prices during a specified period of time.
Demand shows the quantities of a product
that will be purchased at various possible
prices, other things equal.
 Demand
Demand schedule

P Qd Demand can be easily shown in table

form.
R50 2
It reveals the relationship between
40 3
the various prices of the product and
30 4 the quantity of the product a
particular consumer would be willing
20 5
and able to purchase at each of these
10 6 prices.
Demand

Law of demand
Ceteris paribus, as price falls, the quantity
demanded rises, and as price rises, the
quantity demanded falls: there is a
negative/inverse relationship between
quantity demanded and price.
 Why the inverse relationship?
Consistent with common sense
Diminishing marginal utility
Less satisfaction (utility) for successive unit of the product consumed
Because of DMU, consumers will buy additional units only if the price of
those units is progressively reduced
Income and substitution effect
Income effect: lower price increases the purchasing power of a buyers
money income, enabling the buyer to purchase more of the product than
before
Substitution effect: lower-price buyers have then incentive to substitute
what is now a less expensive product for similar products that are now
relatively more expensive
Demand
Demand curve
P

Individual 60

demand
50
for meat
P Qd

Price (per /kg)

40
R50 2
30
40 3

30 4 20

20 5 10
D
10 6
0 Q
1 2 3 4 5 6 7 8
Quantity demanded (kg per week)
Market demand
Market demand
By adding the quantities demanded by all
individual consumers at each of the various
possible prices, we get from individual demand
to market demand.
The higher the number of consumers, the
higher the market demand of a specific product
Market demand
 Changes in quantity demanded
What is the first thing that affects your
decision to buy something, not buy it or
how much to buy?

Price the most important determinant of

amount of any product purchased (quantity
demanded).
Changes in price translates in movement up or
down the demand curve.
Changes in quantity demanded (1)
A decrease in price from R5 to R3
increase in quantity demanded
from 4 to 10 units
P (movement along the curve)
6

Price
3

2
D
1

0
2 4 6 8 10 12 14 16 18
Quantity demanded (Qd) Q
Changes in quantity demanded (2)
An increase in price from R3 to R5
decrease in quantity demanded
from 10 to 4 units
P (movement along the curve)
6

Price
3

2
D
1

0
2 4 6 8 10 12 14 16 18
Quantity demanded (Qd) Q
Determinants of demand

Except for price, what other factors affect

your decision to buy a good or not?

Other factors, called determinants of

demand, are assumed to be constant
when a single demand curve is drawn.
When these change, the curve will move
to the right or left.
These factors sometimes called demand
shifters
Determinants of demand
1. Consumers tastes
Changes that make the product more desirable
will increase the demand and vice versa.
Increased demand more will be demanded at
each price, i.e. demand curve shifts rightward.
Examples: introduction of digital cameras greatly
decreased demand for film cameras
Consumer concerns over health hazards of fatty
foods have increased demand for low-calorie
beverages and fresh fruit while decreasing
demand for beef, eggs and whole milk.
Determinants of demand
2. Number of buyers in market
An increase in number of buyers in a market
likely to increase product demand and vice
versa.
Examples: rising number of older persons in
community can increase demand for medical
care, retirement facilities.
Determinants of demand
3. Income of consumers
Normal goods: Products whose
demand varies directly with money
income.
Examples: most products.
Inferior goods: Products whose
demand varies inversely with money
income.
Examples: used clothing, second-hand
cars, no-name brands.
Determinants of demand
4. Price of related goods
Substitute good: Product that can be
used in place of another one.
When the price of the one falls, its
quantity demanded increases the
demand of the other decreases.

Give an example of
substitute goods
Determinants of demand
4. Price of related goods (cont.)
Complementary good: Product that is used
together with another one.
When the price of one falls, its quantity demanded increases
the demand for the other also increases.

Unrelated goods
Independent goods; price change in one has little or no effect on
demand for other.

Give an example of
complementary goods
Determinants of demand
5. Consumer expectations
A newly formed expectation of higher future
prices may cause consumers to buy now in
order to beat the anticipated price rises, thus
increasing current demand and vice versa.
6. Population growth
Especially for necessary goods such as food, the
higher the population, the higher the demand
will be.
Changes in demand (1)
Studies have proven that cool drink A is particularly
beneficial for your health. What will happen to its demand?
Increase in demand
P (movement of curve to the right)
6

4
Price

2
D2
D1
1

0
2 4 6 8 10 12 14 16 18
Quantity demanded Q
Changes in demand (2)
The marginal tax rate on individuals is increased by 10 percentage
points. What will happen with the demand for new motor cars?
Decrease in demand (movement of curve to the left)

P 6

Price 3

2
D1
1
D2
0
2 4 6 8 10 12 14 16 18
Quantity demanded Q
Complement goods
The price of coffee decreased from R4 to R3
The quantity demanded of coffee increased from 4 to 8 units
Coffee and sugar are complement goods
The demand for sugar increased
P 6
P 6

5
5

4
4

3
3

2
2 D2
D1
1
1 D1

0 Q
0 Q
2 4 6 8 10 12 14 16 18 2 4 6 8 10 12 14 16 18

Coffee Sugar
Substitute goods
The price of Cola-type A decreased from R4 to R3
The quantity demanded of Cola-type A increased from 4 to 8 units
Cola-type A and B are substitute goods
The demand for Cola-type B decreased
P 6
P 6

5
5

4
4

3
3

2
2 D1
D1
1
1 D2

0 Q
0 Q
2 4 6 8 10 12 14 16 18 2 4 6 8 10 12 14 16 18

Cola-type A Cola-type B
Supply
Supply defined
Supply is the various amounts of a product that
producers are willing to make available for sale
at each of a series of possible prices during a
specified period of time.
Supply
Supply schedule

P Qs Supply can be easily shown in table

form
R50 6
It reveals the relationship between
40 5
the various prices of the product and
30 4 the quantity of the product a
particular supplier would be willing
20 3
and able to supply at each of these
10 2 prices.
Supply
Law of supply

Ceteris paribus, as price falls, the quantity

supplied falls too, and as price rises, the
quantity supplied increases: there is a
positive/direct relationship between
quantity supplied and price.
Why the positive relationship?
A. Revenue implications: to a supplier, price represent
revenue, which serves as an incentive to produce and sell a
product. The higher the price, the greater this incentive and
the greater the quantity supplied
Why the positive relationship?
B. Marginal Cost: beyond some quantity of production,
manufactures usually encounter increasing marginal cost
(the added cost of producing one more unit of output).

Certain productive resources (firms plant and machinery)

cannot be expanded quickly, so the firm uses more of
other resources, such as labour, to produce more output.
Why the positive relationship?
But as labour becomes more abundant relative to fixed plant
and equiptment, the additional workers have relatively less
space and access to equipment. As a result, each added
worker produces less added output, and the marginal cost of
successive units of output rises accordingly.
The firm will not produce the more costly units unless it
receives a higher price for them.
Individual supply

Individual 60
supply S1
of meat 50

Price (kg per week)

P Qs 40
R50 6
30
40 5

30 4 20

20 3 10

10 2
0
1 2 3 4 5 6 7 8
Quantity supplied (kg per week) Q
Determinants of supply
Except for price, what other factors affect a
producers decision to sell a good or how
much of the good they can supply?

1. Resource prices
Higher resources prices raise production costs, and
assuming a particular product price, squeeze profits.
Reduction in profits reduces incentive for firms to
supply output at each product price.
Conversely when resource price fall, firms supply
greater output at each product price
 Determinants of supply
2. Technology
Improvements in technology enable firms to produce units of
output with fewer sources and hence lower production costs
and increase supply. E.g. tech advances in producing flat panel
computer monitors lower cost more of such monitors.
3. Taxes and subsidies
Businesses treat taxes as costs
Increase in tax will increase production costs and reduce
supply
Subsidies (taxes in reverse) lower production costs and
increase supply
Determinants of supply
4. Prices of other goods
Firms that produce a particular good can sometimes use
their plant and equipment to produce alternative goods
(substitution in production).
e.g. Same plant producing soccer ball, rugby balls and
volley balls
Higher prices of rugby and volley falls may entice soccer
ball producers to switch production to those other goods in
order to increase profits
This substitution in production results in decline in supply
of soccer balls.
Convers holds
 Determinants of supply
5. Producer expectations
Changes in expectations about the future price of a product may affect the
producers current willingness to supply the product.
Difficult to generalize about how new expectation of higher prices affects
present supply of a product.
E.g. farmers anticipating a higher maize price in the future might withhold
some of their current maize harvest from the market.
In manufacturing industries, newly formed expectations that price will
increase may induce firms to add another shift of workers or to expand
their production facilities, causing current supply to increase.
 Determinants of supply
6. Number of sellers
Ceteris paribus, the larger the number of suppliers, the greater the market
supply and vice versa.
Changes in supply (1)
The government has implemented a decrease in
taxes on the production of apples
What will happen to the supply of apples?
Increase in supply (movement of curve to the right)
P 6

5 S1

S2
4

Price
3

0
2 4 6 8 10 12 14 16 18
Quantity supplied Q
Changes in supply (2)
An agreement with the employees in the production of
software resulted in an increase in their wages.
What will happen to the supply of software?
Decrease in supply (movement of curve to the left)
P 6 S2

5 S1

Price
3

0
2 4 6 8 10 12 14 16 18
Quantity supplied Q
Changes in quantity supplied (1)
An increase in price from R2 to R3
increase in quantity supplied
from 6 to 10 units
P (movement along the curve)
6
S1
5

Price
3

0
2 4 6 8 10 12 14 16 18
Quantity supplied Q
Changes in quantity supplied (2)
A decrease in price from R3 to R2
decrease in quantity supplied
from 10 to 6 units
P (movement along the curve)
6
S1
5

Price
3

0
2 4 6 8 10 12 14 16 18
Quantity supplied Q
Market equilibrium

Equilibrium price

The price where the intentions of buyers

and sellers match.

Equilibrium quantity

The quantity demanded equals quantity

supplied at the equilibrium price.
Market equilibrium
200 buyers & 200 sellers
Market Market
demand 60 supply
200 buyers S 200 sellers
P Qd 50
P Qs

R50 400 R50 1200

40
40 600 E 40 1000

Price
30 800 30 30 800

20 1000 20 600
20
10 1200 10 400

10 D

0 2 4 6 8 10 12 14 16 18
Meat per kg (hundreds per week)
Market equilibrium
200 buyers & 200 sellers
Market Market
demand 60 supply
200 buyers S 200 sellers
P Qd 400 kg P Qs
50
surplus
R50 400 R50 1200
40
40 600 E 40 1000

30 800 Price 30 30 800

20 1000 20 600
20
10 1200 10 400

10 D

0 2 4 6 8 10 12 14 16 18
Meat per kg (hundreds per week)
Market equilibrium
200 buyers & 200 sellers
Market Market
demand 60 supply
200 buyers S 200 sellers
P Qd 50 P Qs
R50 400 R50 1200
40
40 600 E 40 1000

30 800 Price 30 30 800

20 1000 20 600
20
10 1200 10 400

10 400 kg D
shortage
0 2 4 6 8 10 12 14 16 18
Meat per kg (hundreds per week)
Market equilibrium

Rationing function of prices

The ability of the competitive forces of supply

and demand to establish a price at which
selling and buying decisions are consistent.

Efficient allocation

Productive efficiency: the production of any

particular good in the least costly way.
Allocative efficiency: the production of a
particular mix of goods most highly valued by
society.
 Changes in supply, demand and equilibrium
Q: What effects will changes in demand or supply have on
equilibrium price and quantity?
Changes in demand (1)
The price of toothbrushes decreases
What will happen to equilibrium P and Q of toothpaste?
Increase in demand
P and Q

60
S
50
E

Price of toothpaste
40
E
30

20
D

10 D

0 2 4 6 8 10 12 14 16 18
Toothpaste units
Changes in demand (2)
With the recession, the income of the consumers fell.
What will happen to equilibrium P and Q of cars?
Decrease in demand
P and Q

60
S
50
E

Price of cars
40
E
30

20
D

10 D

0 2 4 6 8 10 12 14 16 18
Cars
Changes in supply (1)
The price of ingredients for baking bread has decreased.
What will happen to equilibrium P and Q of bread?
Increase in supply
P and Q

60
S
S
50

40
Price E

30
E

20

10 D

0 2 4 6 8 10 12 14 16 18
Bread per kg (hundreds per week)
Changes in supply (2)
The price of plastic has increased.
What will happen to equilibrium P and Q of plastic toys?
Decrease in supply
P and Q

60
S
S
50 E

40
Price E

30

20

10 D

0 2 4 6 8 10 12 14 16 18
Plastic toys (hundreds)
 Demand and Supply
(Market for shoes) The price of leather increase.
Income of consumers increase as well
What will happen to the equilibrium P and Q of the market for shoes?
Decrease in Supply = Increase in Demand
P en Q ?
60
S
S
50
E
40
E

Price
30

20 D

10 D

0 2 4 6 8 10 12 14 16 18
Shoes (hundreds)
 in Demand and Supply
Decrease in Supply< Increase in Demand
P and Q ?

60
S
S
50

40
E
Price
30 E

20 D

10 D

0 2 4 6 8 10 12 14 16 18
Plastic Toys (hundreds)
Summary

Demand Supply Price Quantity

Increases Increases Uncertain Increases

Increases Decreases Increases Uncertain

Decreases Increases Decreases Uncertain

Decreases Decreases Uncertain Decreases

Market equilibrium
Price ceilings on fuel

60
S
50

40
E
Price
30
R20 price ceiling
20

400 tons D
10
shortage

0 2 4 6 8 10 12 14 16 18

Fuel (tons)
Government-set prices

Rationing problem

Since an unregulated shortage does not lead to an

equitable distribution of a product, the
government must establish some formal system for
rationing it to consumers (ration coupons?)

Black markets

Buyers are willing to pay more than the ceiling

price. So, the product is illegally bought and sold at
prices higher than the legal ones.
Government-set prices
Rent controls
Goal: to protect low income families from escalating rents
caused by perceived housing shortages.
Demand: as rents are below equilibrium, more families are
willing to consume rental housing
Supply: price controls make it less attractive to landlords to
offer housing on the rental market.
Low rents make it unprofitable for owners to repair or
renovate rental units
Rent controls distort market signals and resources are
misallocated; too few resources are allocated to rental
housing, and too many to alternative uses.
Market equilibrium
Price floors on minimum wage

60
400 workers S
Surplus
50

R40 price floor

40
Wages E
30

20

10 D

0 2 4 6 8 10 12 14 16 18

Number of workers
Concept of Elasticity
Price elasticity of demand

Consumers buy more of a product when its

price decreases and vice versa.

How much more or less will they buy?

 We need a tool to measure the
responsiveness of quantity demanded
to changes in price and to help suppliers
in decision-making

Price elasticity of demand

Price elasticity of demand

Price elasticity of demand: Measuring

responsiveness (sensitivity) of consumers to
price changes

Modest changes in P cause very large changes in

Qd Relatively elastic

Substantial changes in P cause small changes in

Qd Relatively inelastic
Price elasticity of demand (2): Point elasticity
It measures the responsiveness
of quantity demanded (Qd)
to a change in the price (P) of the good or
service.
Negative due to
law of demand
(absolute value
(Q1- Q0)
x 100
Q0
Ed =
(P1- P0)
x 100
P1
Price elasticity of demand (3): midpoint or arc
Using averages
Midpoint formula: it averages the two prices
and the two quantities as the reference
points to compute percentages:

(Q1- Q0)
In a
test/exam,
x 100
use the (Q0+Q1)/2
midpoint Ed =
formula ONLY (P1- P0)
if it is
specified
x 100
(P0+P1)/2
Price elasticity of demand (4)
Why use percentages?
The use of absolute values will arbitrarily
affect our impression of buyer
responsiveness
By using %, we can correctly compare
consumer responsiveness among various
products
Elimination of the minus sign
The relationship between price and
quantity demanded is mainly negative.
Price elasticity of demand (5)
Calculate the price elasticity of demand if
the quantity demanded of product A
decreased by 4% as a result of an
increase in price by 2%.

%Q 0.04
Ed = = 0.02 =2
%P
If the price elasticity of demand
of a holiday package is ed=2 (>1)
What does this mean?
Elastic demand

That is when %Q > %P

Price elasticity of demand (6)
Calculate the price elasticity of demand if
the quantity demanded of product A
increased by 1% as a result of a decrease
in price by 2%.

%Q 0.01
Ed = = 0.02 = 0.5
%P
If the price elasticity of demand
of bread is ed=0.1 (<1)
What does this mean?
Inelastic demand

That is when %Q < %P

Price elasticity of demand (7)
Calculate the price elasticity of demand if
the quantity demanded of product A
increased by 2% as a result of a decrease
in price by 2%.

%Q 0.02
Ed = = 0.02 =1
%P

Ed=1 Unit elasticity

%Q = %P
Price elasticity of demand (8)
The quantity demanded for product A
decreases from 6 to 3 when the price
increases from R5 to R10. Calculate the
elasticity of demand.

%Q (3-6)/6 -0.5
Ed = = (R10-R5)/R5
= 1 = -0.5
%P

Ed=-0.5 Inelastic demand

%Q < %P
Price elasticity of demand (9)
Elastic D1 vs. inelastic D2 demand
D2
P D1: %Q > %P

D2: %Q < %P

A C
P0
D
P1
B

D1

Q
0 Q0 Q1 Q2 Q3
Price Elasticity of Demand1(0)
(Critical Elasticities)

D2
P
Ed > 1 Ed < 1
Elastic demand Inelastic Demand

A C
P0
D Ed = 1
P1 Unitary Elastic
B

D1

Q
0 Q0 Q1 Q2 Q3
Price elasticity of demand (11)
Extreme cases
Perfectly inelastic demand
P
D1
%Q=0
Ed = 0

0
Q
Price elasticity of demand (12)
Extreme cases
Perfectly elastic demand
P

%P=0
Ed =

D2

0
Q
 Total-Revenue Test

TR=P x Q
The importance of elasticity for firms related to the effect
of price changes on total revenue and thus on profits
Useful for firms to know by how much they can change the
price of their product without losing any revenue in sales or
evening gaining some revenues in sales.
The TR test considers how elasticities of demand larger
than one, smaller than one and equal to one will influence
TR of the firm in response to a change in the price of their
product.
 The total-revenue test

Total revenue = Price (P) of product times quantity

demanded (Qd)
Elastic demand

P TR1= P1 x Q1
=2x10=20
TR2=P2 x Q2
R3
=1x40=40

a
2

Revenue loss
b
1
D1
Revenue gain

0 10 20 30 40 Q
The total-revenue test (2)
Total revenue = Price (P) of product times quantity
demanded (Qd)
Inelastic demand
P
R4 c
TR1= P1 x Q1
=4x10=40
TR2=P2 x Q2
3
= 1x20=20

2
Revenue loss

1 d
Revenue gain
D1
0 10 20 30 40 Q
 The total-revenue test (3)
Total revenue = Price (P) of product times quantity
demanded (Qd)
Unit elastic demand
P
R4 TR1= P1 x Q1
=3x10=30
TR2=P2 x Q2
3 e =1x30=30

2
Revenue loss
f
1 D1
Revenue gain

0 10 20 30 40 Q
The total-revenue test (4)
Total revenue = Price (P) of product times quantity
demanded (Qd)

Inelastic
%Q<%P changes in P, direct changes in TR
Elastic
%Q>%P changes in Q, direct changes in TR
Unit elastic
%Q=%P TR remains the same
Elasticity on a linear demand curve
Price elasticity of demand for chocolate bars as
measured by the elasticity coefficient and the
total-revenue test
(1) (2) (3) (4) (5)
Total quantity of Price per bar Elasticity Total revenue Total-revenue
chocolate bars coefficient (Ed) (1) X (2) test
demanded (Midpoint
per week, thousands formula)

1 8 R8,000
2
]7 5.00
14,000
] Elastic

3
]6 2.60
18,000
] Elastic

4
]5 1.57
20,000
] Elastic

5
]4 1.00
20,000
] Unit-elastic

6
]3 0.64
18,000
] Inelastic

7
]2 0.38
14,000
] Inelastic

8
]1 0.20
8,000
] Inelastic
Price elasticity and the TR curve
Price elasticity and the TR curve (2)

R8 a Elastic
7 Ed > 1
b

Price (Rand)
6
c Unit-elastic
5
4
d Ed = 1
e
3 Inelastic
f
2 g Ed < 1
1 h D
0 1 2 3 4 5 6 7 8
Quantity demanded (thousands)
20 Elastic
18
Ed > 1

(Thousands of Rand)
16

Total Revenue
14
12 Unit-elastic
10 Ed = 1
8
6
4
TR Inelastic
2 Ed < 1
0 1 2 3 4 5 6 7 8
Quantity demanded (thousands)
Price elasticity and the TR curve (3)

Impact on TR of a:
Absolute value
of elasticity Demand is Description
Price Price
coefficient
increase decrease
Ed>1 Elastic or %Q>%P TR TR
relatively
elastic
Ed=1 Unit or unitary %Q=%P TR=0 TR=0
elastic
Ed<1 Inelastic or %Q<%P TR TR
relatively
inelastic
 Determinants of Ed
1. Substitutability
The larger the number of substitute goods available, the
greater the Ed, ceteris paribus. E.g various brands of chocolate
Ed depends on how narrowly the product is defined.
2. Proportion of income
The higher the price of a good relative to consumers
incomes, the greater Ed, ceteris paribus.
3. Luxuries versus necessities
The more a good is considered to be a luxury rather than a
necessity, the greater is the Ed.
4. Time
Product demand is more elastic the longer the time period
under consideration.
Consumers need time to adjust to price changes.
Product durability
Luxury Necessity
goods? goods?
Car
Medication

Fuel
Sweets
 Applications of Ed
Large crop yields
Highly inelastic demand (0.2-0.25)
It means:
Farmers: large crop yields may be undesirable
Policy makers: achieving the goal of higher total farm income
requires that farm output be restricted.
Excise taxes
A higher tax on a product with elastic demand will
bring in less tax revenue
Government targets products with inelastic demand
(alcohol, fuel, cigarettes, etc.)
Price elasticity of supply

Producers supply more of a product when its

price increases and vice versa.

How much more or less will they sell?

 We need a tool to measure the
responsiveness of quantity supplied
to changes in price and to help suppliers
in decision-making

Price elasticity of supply

Price elasticity of supply (2)

Price elasticity of supply: Measuring responsiveness

(sensitivity) of producers to price changes.

Modest changes in P cause very large changes in Qs Relatively

elastic

Substantial changes in P cause small changes in Qs Relatively

inelastic
 Price elasticity of supply (3)
It measures the responsiveness
of quantity supplied (Qs)
to a change in the price (P) of the good or service.

Positive due to the

relationship between
Qs and P
 Price elasticity of supply (3)
The degree of price elasticity of supply depends on how easily and
quickly producers can shift resources between alternative uses.

The easier and more readily producers can shift resources between
alternative uses, the greater the price elasticity of supply.

The longer the time, the greater the resource shiftability.

Economist distinguish among the immediate market period, the short

run and the long run.
Price elasticity of supply (4)
Immediate market period:
Not enough time to shift resources
e.g. truck load of tomatoes as entire seasons output
Perfectly inelastic Es = 0
P

Sm

Greatest Pm
price
impact P0 D2

D1

Q0 Q
Price elasticity of supply (5)
Short-run period:
Resources not easily shifted to alternative uses
Nb: increase in demand is met by an increase in quantity
Inelastic supply Es < 1
P

Ss

Lower Ps
price
impact P0 D2

D1

Q0 Qs Q
Price elasticity of supply (6)
Long-run period:
Resources easily shifted to alternative uses

Relatively elastic Es > 1

P

Sl

Least
Pl
price
impact P0 D2

D1

Q0 Ql Q
Applications of Es
Volatile gold prices
Main sources of fluctuations in gold prices are shifts in
demand and highly inelastic supply
Gold production is costly and time consuming.
Physical availability of gold is limited.
Therefore, increases in gold prices do not elicit
substantial increases in Qs.
Supply of gold is inelastic
Applications of Es
Antiques and reproductions
High prices of antiques: strong demand and
limited, highly inelastic supply.
Genuine antiques cannot be reproduced (specific
amount exists).
Higher demand, while inelastic supply prices
have been boosted.
Faux antiques and reproductions do not have
highly inelastic supply.
Cross-elasticity of demand
Cross-elasticity of demand measures how sensitive consumer
purchases of one product (say X) are to a change in the price
of some other product (say Y).

Percentage change in quantity

demanded of product X
Exy =
Percentage change in price
of product Y
Cross-elasticity of demand (2)
Substitute goods (e.g. two different types of cool drinks)
price of Y Qd of Y Qd of X
Numerator > 0 and Denominator > 0
Exy> 0

Percentage change in quantity

demanded of product X
Exy =
Percentage change in price
of product Y
Cross-elasticity of demand (3)
Complementary goods
price of Y Qd of Y Qd of X
Numerator < 0 and Denominator > 0
Exy< 0

Percentage change in quantity

demanded of product X
Exy =
Percentage change in price
of product Y
Cross-elasticity of demand (4)
Independent goods (e.g. peanuts and peaches)
price of Y Qd of Y Qd of X = 0
Numerator = 0 and Denominator > 0
Exy= 0

Percentage change in quantity

demanded of product X
Exy =
Percentage change in price
of product Y
Cross-elasticity of demand (5)
The decrease in the price of CD players from R750
to R400 resulted in an increase in the sales of CDs
from 300 to 900.

Calculate and interpret the cross elasticity.

Exy= -0.2333<0 Complementary

Income elasticity of demand
Income elasticity of demand measures the degree to which
consumers respond to a change in their incomes by buying
more or less of a particular good.

Percentage change in quantity

demanded of product X
Ei =
Percentage change in income
 Income elasticity of demand (2)
Normal goods
income Qd of X
Numerator > 0 and Denominator > 0
Ei > 0

Percentage change in quantity

demanded of product X
Ei =
Percentage change in income
 Income elasticity of demand (3)
Inferior goods
income Qd of X
Numerator < 0 and Denominator > 0
Ei < 0

Percentage change in quantity

demanded of product X
Ei =
Percentage change in income
Income elasticity of demand (4)
Mr X bought more burgers (up from 10 to 15 units)
when he got a salary increase of R500 (from R1500
to R2000).

Calculate and interpret the income elasticity.

Exy= 1.5 >0 Normal good

Consumer surplus

The benefit surplus received by a consumer or

consumers in a market is called consumer surplus.

It is the difference between the maximum price a

consumer is willing to pay for a product and the
actual price.

Consumers gain greater utility in rand terms from

their purchases than the amount of their
expenditures (product price x quantity)
Consumer surplus (2)

Consumer
surplus

Price (per bag)

Equilibrium
price = R8
P1

D
Q1
Quantity (bags)
Producer surplus

The benefit surplus received by a producer or producers in a

market is called producer surplus.

It is the difference between the actual price a producer

receives and the minimum acceptable price.

Sellers collectively receive a producer surplus in most

markets because most sellers are willing to accept a lower-
than-equilibrium price if that is required to sell the
product.
Producer surplus (2)

Producer S
Surplus

Price (per bag)

Equilibrium
Price = R8
P1

Q1
Quantity (bags)
Consumer and producer surplus

CS and prices are

inversely related
S
Consumer
surplus PS and prices are
positively related
Price (per bag)
Equilibrium
price = R8
P1

Producer
surplus
D
Q1
Quantity (bags)
Consumer and producer surplus (2)

Productive
efficiency
S
Consumer
surplus
Price (per bag)
Equilibrium
price = R8
P1

Producer
surplus
D
Q1
Quantity (bags)
Consumer and producer surplus (3)

Allocative
efficiency
S
Consumer
surplus
Price (per bag)
Equilibrium
price = R8
P1

Producer
surplus
D
Q1
Quantity (bags)
Efficiency revisited

Efficiency losses are the reductions of combined CS and PS

associated with underproduction or overproduction of a
product.
Efficiency revisited (2)
Quantities higher or lower than the efficient
quantity Q1 create efficiency losses

bde:
underproducti
on at level Q2
bfg:
overproduction
at level Q3
 Intended Learning Outcomes (Recap)
At the end of this session you will be able to:
Explain how a market reconciles demand and supply
through price adjustment.
Examine the principal factors that shift supply and
demand curves.
Develop the concepts of elasticity.

Class: Check whether those have been covered and your

understanding. If required we go back and revisit the
material.