Understanding Demand, Supply, and Elasticity in Economics
Demand, Supply, and Elasticity in Economics
Demand – relationship between the quantity of a good that consumers are willing to buy and the price of the good. Qd=Qd(P)
Substitutes – Two goods which satisfy the same need and can replace each other in consumption. For substitutes, an increase in the price of one leads to an increase in the quantity demanded of the other (e.g., Colgate and Blend-a-med toothpaste).
Complements – Two goods which are consumed together. For complements, an increase in the price of one leads to a decrease in the quantity demanded of the other (e.g., car and petrol).
Giffen good is one which people paradoxically consume more of as the price rises, violating the law of demand.
The demand curve shifts to the right (from D to D’) when:
- Consumer income increases
- Price of a substitute increases
- Price of a complement decreases
- The good becomes fashionable
Supply – is a relationship between the price and quantity of output producers are willing to sell at any given price.
The supply curve shifts to the right (supply increases) mainly when:
- Costs of production decrease
- Technology improves
- A subsidy is provided
- Expectations are optimistic
Market Equilibrium
Market equilibrium is a point where the demand curve crosses the supply curve (Qd=Qs).
- Changes in demand and supply will shift the D and S curves and will lead to a new equilibrium price being set.
- Changes in the prices of other products, consumers’ income, their tastes, population size, and so on will shift the D curve.
- Changes in technology, production costs, company taxes, etc., will only shift the S curve.
Consumer Surplus + Producer Surplus = Total welfare
Understanding Elasticity
Elasticity – is a measure of just how much the quantity demanded will be affected by a change in one of these factors.
It measures the responsiveness (in percentage terms) of quantity demanded to a 1% change in different variables that affect demand.
When S lowers (S curve shifts to the left), the market clears at a higher price and a lower quantity.
Price elasticity = equilibrium quantity x price
equilibrium price quantity
A flat demand curve is elastic.
- A steep demand curve is inelastic.
E = Elasticity
- Arc elasticity of demand – price elasticity calculated over a range of prices
- Point price elasticity = 1 x Price / slope quantity
- Arc price elasticity = quantity equilibrium x price average / price equilibrium quantity average
When demand is elastic:
- A price increase will cause a decrease in revenue.
- A price decrease will cause an increase in revenue.
When demand is inelastic:
- A price increase will cause an increase in revenue.
- A price decrease will cause a decrease in revenue.
Income and Cross Elasticity
Income elasticity of demand – measures how quantity demanded (in percentage terms) changes when income changes by 1%.
Income elasticity: quantity equilibrium x income / income equilibrium quantity
Cross elasticity of demand – measures how quantity demanded (in percentage terms) changes when the price of another good (substitute or complement) changes by 1%.
Cross elasticity for good X = equilibrium quantity of X x price of Y / equilibrium price of Y quantity of X
Price elasticity of supply – a measure of the responsiveness of quantity supplied (in percentage terms) to changes in price (in percentage terms).
Price elasticity = equilibrium quantity of supply x price / equilibrium price quantity supplied
Utility and Consumer Choice
Utility – a numerical score representing the satisfaction that a consumer gets from a given market basket. Utility is measured theoretically in utils.
Utility function – a formula that assigns a level of utility to individual bundles of goods.
Marginal rate of substitution (MRS) – the maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good and still get the same level of utility.
MRSxy = MUx/MUy
Marginal utility (MU) – additional satisfaction obtained from consuming one additional unit of a good.
Engel curve – a curve relating the quantity of a good consumed to income.
Income-consumption curve (ICC) – a combination of bundles that maximise consumer utility for various income levels.
Price-consumption curve (PCC) – a combination of bundles that maximise consumer utility as the price of one good changes.
Individual demand curve – a curve showing how the quantity demanded of a good changes depending on its price.
Market demand curve – a curve relating the quantity of a good that all consumers in a market will buy to its price.
