Understanding Market Forces: Demand, Supply, and Elasticity
Demand
Demand refers to the quantity of a commodity that buyers desire at any given price. Several variables determine demand:
Price of Good
Quantity demanded moves inversely to price. If the price rises, consumption decreases, and vice versa.
Income
Normally, if consumer income increases, consumption of goods also increases (normal goods). However, for some goods (inferior goods), increased income may lead to decreased consumption as consumers switch to higher-quality alternatives.
Prices of Related Goods
This involves substitute goods (e.g., margarine for butter) and complementary goods (e.g., tennis racket and ball). If the price of a substitute rises, demand for the good increases. If the price of a complement rises, demand for the good decreases.
Taste
If a product becomes popular, demand increases; if it loses popularity, demand decreases.
Expectations About the Future
Consumer expectations about future changes (e.g., technology, prices, income) can positively or negatively affect current demand.
The demand curve represents the quantity demanded at each price level. It slopes downward because as price increases, quantity demanded decreases.
Offers
Supply refers to the quantity of a good that vendors offer at a given price level. The following variables determine supply:
Price of Good
Quantity supplied moves in the same direction as price. If the price rises, supply increases, and vice versa.
Prices of Factors
If the price of production factors increases, manufacturing costs rise, reducing profitability. Thus, if factor prices increase, supply decreases, and vice versa.
Technology
Technological improvements reduce manufacturing costs and increase profitability, leading to increased supply.
Expectations
Expectations about future conditions (e.g., price changes, input costs) can positively or negatively affect supply.
Only variations in the product’s price cause movements along the supply curve.
Market: Supply and Demand
The intersection of the supply and demand curves is the equilibrium point, determining market price and quantity. At this point, the quantity buyers want to purchase equals the quantity sellers want to sell.
Elasticity of Demand
Elasticity measures the extent of variation of one variable in response to another. This applies to demand and supply curves to measure quantity changes due to determining variables.
Price Elasticity of Demand
This measures the change in quantity demanded due to a price change. It’s calculated by dividing the percentage change in quantity demanded by the percentage change in price.
Factors Determining Elasticity
Necessity vs. Luxury
Necessary goods have inelastic demand (e.g., bread), while luxury goods have elastic demand.
Availability of Substitutes
Goods with substitutes tend to have more elastic demand (e.g., olive oil vs. sunflower oil).
Time Frame
Demand is more elastic over longer time periods (e.g., gasoline demand may be inelastic in the short term but elastic in the long term).
Income Elasticity
- Top: Income elasticity greater than one (demand increases significantly with income).
- Normal: Positive income elasticity (demand increases with income).
- Lower: Negative income elasticity (demand decreases with income).
Cross Elasticity
- Substitutes: Positive elasticity (increased price of Y leads to increased demand for X).
- Complementary: Negative elasticity (increased price of Y leads to decreased demand for X).
- Independents: Zero cross-elasticity (price change of Y does not affect demand for X).
Offer Price Elasticity
Elasticity is generally higher in the lower area of the curve (idle capacity exists) and lower in the upper area (full production capacity). Supply elasticity depends on the time horizon: short-term supply may be rigid, while long-term supply is more flexible.