1.

2: DEMAND AND SUPPLY

Demand

SECTION ONE

Demand is defined as the ability and willingness of producers to buy

a good or service at a certain price. There are several types of
Demand:

Effective Demand: This is Demand that is backed by the money to

buy the good or service.
Composite Demand: This is Demand for a good or service for two or
more reasons. (e.g. Demand for oil, which is used for transportation
and also for electricity).
Derived Demand: This is Demand for a good or service caused by
demand for another good or service. (e.g. Demand for Labour,
caused by demand for producing a good).
Joint Demand: This is Demand for a good or service caused by
demand for another good or service that is sold alongside it. (e.g.
Demand for laptops will cause demand for the laptop charger as
well, which is sold alongside it).
The Law of Demand states that Demand varies such that it is
inversely proportional to price. This means that for any increase in
price, the Quantity Demanded will fall. To explain this, we have to
understand the Income Effect and the Substitution Effect:

Types of Demand

Law of Demand

According to the Income Effect, if the price of a good falls, the

individual will have more disposable income and will therefore
demand more of the good. Therefore, there is an extension along the
Demand Curve. Similarly, if the price of a good rises, then the
individual will have less disposable income and demand less, so the
demand curve contracts.
According to the Substitution Effect, if the price of a good falls, then
it becomes cheaper than other alternatives and substitutes. This
causes demand for the good to increase and the demand curve
extends. Similarly, if the price rises the individual will have less
disposable income and demand less, so the demand curve contracts.
REMEMBER: Contractions and Extensions along the Demand Curve
are just shifts in the curve based on price, not shifts in the entire
curve outwards.
The Demand Curve, when plotting Quantity against Price, is a
downward sloping curve. There are some exceptions to the Law of
Demand:

Veblen Goods: These are goods that are luxuries. Usually, as the
price of luxuries increases, people feel that it is better. Because the
rich mostly buy these, they may want to buy a luxury the more
expensive it is to show off their wealth. However, once the price hits
the snob value, demand begins to fall as the price increases. This is
because they feel that the good is no longer worth the cost its being
sold for.
Giffen Goods: In a Giffen Good, the Income Effect outweighs the
Substitute Effect. When incomes fall, individuals will demand more
of necessities and inferior goods. For example, they may buy rice

Special Cases

(which is a staple of the diet in some countries), as its price rises

because they know it is a necessity and have to buy it be it at any
price.
Speculative Demand: Often people demand a good or service
because they feel that its price will increase in the future. This is
caused because they seek to sell it in the future at a higher price and
profit from it. This is common in the stock market, where people
buy shares, see the stock price go up and continue to buy them
believing that its price will keep going up (and therefore its value) so
it can be sold in the future.
There are several factors that affect Demand:
Disposable Income: If
there is an increase in
the disposable income
available, the demand
for the good increases.
If there is a fall in
disposable income
available, the demand
for the good decreases.
The Prices of other
goods and services: To
understand this, we
will use the example of
bread and butter. These are complementary goods, meaning that
they go well together and are therefore often bought together. If the
price of bread rises, even though the price of butter is unchanged,
the demand for bread has decreased (contracted along the curve),
causing the demand for butter to decrease (the demand curve shifts
to the left). If the price of bread decreases, demand for butter will
increase because the demand for bread has also increased.
Changes in tastes, habits and fashion: If a good becomes more
fashionable, people may want to buy it more and as a result,
demand increases. However, if all of a sudden, consumers dont
want the good or service, demand for it will decrease.
Population factors: If the population increases, demand increases
because there are more people to buy the good or service. If the
population decreases demand will also decrease because there are
fewer people to buy the good or service. However, if the population
structure is such that there are more young people, demand for
goods that the young would want would increase. If there is an
ageing population, then the demand for goods and services the aged
need will increase.
Optimism in the economy: If the economy is doing well and people
think it will continue to grow they will want more goods and
services because they know they will keep their job and would want
to improve their life. However, if the economy enters a recession
and people fear losing their jobs, they will save and demand will fall.

Factors that affect

Demand

Supply

SECTION TWO

Supply is defined as the ability and willingness of producers to

produce a good or service at a certain price. The Law of Supply states
that the supply of a good or service will increase for any increase in
price, because as the price per unit increases, the producers will
want to produce more because they can earn greater revenue. There
are several factors that affect Supply:

Factors that affect

Supply

Changes in the costs of the factors of production: If the costs of

production increase, then the producers will find it more expensive
to fund increased production and as a result, they will reduce their
supply.
Changes in the prices and profitability of other goods and services: If
the price of other goods increases, and there is a greater chance of
profit in that sector, firms will instead choose to produce that good
over the good they were otherwise producing. As a result, the
supply of the good they were initially producing will decrease. The
good firms choose to produce more, that goods supply will increase.
Technological Advances: If the technology of producing a good or
service improves such that it becomes more efficient while also being
adequately provisioned and at a fair enough price for producers to
buy, then there will be a greater number of goods produced and the
supply increases.
Business Optimism: If producers are confident the economy will do
better, and therefore that demand for goods and services will
increase, they will produce more. This causes an increase in supply.
Similarly, if they feel the economy will do badly or may enter a
recession, they will decrease their supply.
Subsidies: A subsidy is a grant from the government to cover the
costs of production of a firm. If the government subsidises
production, the supply of the good or service will increase. If the
government cuts subsidies or other benefits, supply wont change or
may actually decrease.
Other factors, such as wars or natural disasters, will decrease the
supply of the goods on the market.

Price Elasticity of Demand

The Price Elasticity of Demand measures the responsiveness of the
quantity demanded to a change in price. It is therefore calculated
using the formula:

Price Elasticity of Demand=

SECTION THREE

Calculating PED

% change in quantity demanded

% change in price

The factors affecting the Price Elasticity of Demand are:

Factors that affect

PED


1. The Number of Substitutes: The more substitutes there are, the
higher the Price Elasticity of Demand. This is because the good is not
absolutely necessary and there are equivalent alternatives.
2. The Period of Time: If there is a longer amount of time that can be
taken to decide whether to buy a good or service, consumers may go
about finding different and cheaper substitutes, therefore the Price
Elasticity of Demand will be higher.
3. The Proportion of Income spent: If the good takes up a higher
proportion of income and is not a necessity, then it is likely going to
be highly Price Elastic.
4. Addictive: If the good, such as tobacco, is highly addictive; then the
Demand will be highly Price Inelastic because at any price, just to get
what they want out of the good or service, they will buy it.
5. Luxury or Necessity: Individuals will probably buy absolute
necessities such as food at any price, because it is what they need for
survival. Therefore, the Demand will be highly Price Inelastic.
However, if the good is a luxury, it is more likely to be Price Elastic.
There are several types of Price Elasticities of Demand:

Unitary Elastic Demand: The Price Elasticity of Demand = -1. Here,

for any change in the Price, there will be the same % change in
Quantity Demanded.
Price Elastic Demand: The % change in Quantity Demanded is
greater than the % change in Price. This means the PED is greater
than -1.
Price Inelastic Demand: The % change in Quantity Demanded is less
than the % change in Price. This means the PED is higher than -1
(i.e. negative value decimal).
Perfectly Inelastic Demand: This means that the % change in
Quantity demanded in 0 for any percentage change in Price (the
demand does not change for any increase in price whatsoever),
therefore the PED is 0.
Perfectly Elastic Demand: This means the % change in Quantity
Demanded is infinite for any % change in price. That means that the
PED is -

Price Elasticity of
Demand graphed

Usefulness of PED

1.

2.
3.
4.
5.

Knowledge of the Price Elasticity of Demand can be helpful in many

ways:
It helps firms estimate their total revenue: As you go down the
Demand Curve and prices fall, if the demand is price inelastic, then
there will be little change in the Total Revenue. However, if the
Demand is less sloped, then at first the revenues rise, and then the
revenues will fall.
It helps consumers understand the impact of an increase in prices on
the general output of the company.
It helps the government understand the incidence of a tax, because
when the demand is price inelastic, the consumer pays more and
when the demand is more price elastic, the producers pay more.
It is useful to economists who are monitoring trends in prices, so
that they can understand what the effect of shocks in the supply of a
good or service will have on the demand for a good or service.
It helps firms in what is called surge pricing. For some firms, such
as the taxi industry, the demand is more inelastic at certain times. In
rush hour time, the demand is more price inelastic. As a result, taxi
firms can increase the price at this timing (surge pricing) during
timings such as the rush hour.

Price Elasticity of Supply

SECTION FOUR

The Price Elasticity of Supply measures the responsiveness of supply

to a change in Price. It is calculated using the formula below:
% change in quantity supplied
Price Elasticity of Supply=
% change in price

Calculating PED

There are several factors that affect the Price Elasticity of Supply
1. Time: If the time required to produce a good or service is high, then
the Price Elasticity of Supply will be lower. If the time required to
produce a good or service is lower, then the Price Elasticity of Supply
will be much higher.
2. Availability of Resources: If there is an adequate supply of resources
for producing a good or service, then the goods supply will be price
elastic. However, if there is a limited availability of resource then the
supply is price elastic.
3. Ease of Storage: If the good is easy to store, then the goods supply is
price elastic, but if it is difficult to store, then the goods supply is
price inelastic.

Factors that affect

PED

There are several types of Price Elasticity of Supply:

1. Unitary Elastic Supply: The Price Elasticity of Supply is equal to 1
2. Price Elastic Supply: The Price Elasticity of Supply is greater than 1
(i.e. the Supply changes more in % terms than the Price does in %
terms).

Graphing PED


3. Price Inelastic Supply: The Price Elasticity of Supply is less than 1
(i.e. the Supply changes less in % terms than the Price does in %
terms).

4. Perfectly Inelastic Supply: Supply does not change at all for any
change in Price.
5. Perfectly Elastic Supply: Supply changes infinitely for any change in
Price.
Knowledge of the Price Elasticity of Supply can be very useful in
several ways:
1. The Price Elasticity of Supply can help understand the revenue
changes due to shifts in the Demand Curve. So if the Demand
increases and the Supply is Price Inelastic, the revenue will increase
or stay the same,
2. Price Elasticity of Supply allows firms to try and make arrangements
to change their production strategies to try and make sure the
Supply is more Price Elastic.
3. Price Elasticity of Supply is useful in understanding the incidence of
tax, because if the PES<PED, the incidence of tax is greater on
producers than it is on consumers and when the PES>PED, the
incidence of tax is greater on consumers than it is on producers.

Equilibrium Price
This is the Price set when the Demand for a good or service is equal
to its Supply (i.e. the Price when the two curves intersect). When
Demand increases, the Equilibrium Price increases, and if Demand
decreases the Equilibrium Price decreases. When supply increases,
the Equilibrium Price decreases, and when Supply decreases, the
Equilibrium Price increases.

Usefulness of PES

SECTION FIVE

Though as we have
seen there is an
equilibrium price
set, there exist
demand above the
Equilibrium Price.
This is shown as
the points along
the demand curve
to the left of the
equilibrium Price.
The area between
the demand curve
and the line of the
equilibrium Price shows what is called the Consumer Surplus (the
benefits consumers have with lower prices.) The producers,
similarly, maybe willing to produce at a lower price but the price is
higher than the price they were otherwise willing to produce at. The
area between the point where the supply curve meets the y axis and
the line of equilibrium shows the Producer Surplus. The total area of
the Producer and Consumer Surplus is known simply as Welfare.

Effects of Tax and Subsidy on Market

Supply
A Tax is a Levy placed by
the government. Taxes
placed on the consumption
of a good or service is an
indirect tax. There are two
types of taxes that are in
this section: Specific Tax
and Ad Valorem Tax. A
Specific Tax is a tax of a
certain amount of money,
as against an Ad Valorem
Tax, where the tax is a
percentage. So a Specific
Tax might be a $0.40 tax on

Consumer and
Producer Surplus

SECTION SIX
Tax


chocolate bars, but an Ad Valorem Tax is a 5% tax on a chocolate
bar.
The Graph above shows the Demand and Supply Graph for a
Specific Tax. The Area 1 (above the Equilibrium Price) is the amount
paid by the Consumer. The Area 3 (below the Equilibrium Price) is
the amount paid by the producers. The Quantity Demanded has
fallen and the Price has increased. Area 3 (which is a triangle
between the new equilibrium price with the tax and the vertical
distance to the S curve and the original equilibrium) shows a loss
in efficiency (a Deadweight Loss) caused by the tax. In an Ad
Valorem Tax, the S1 is more price inelastic than the S curve.
In both situations, there is a loss in consumer surplus because the
price has increased so fewer consumers benefit from the price being
higher than the price they were otherwise willing to pay at. There is
also a loss in producer surplus, however there is also a gain because
the price has increased.
A subsidy is a grant
provided by the
government to
producers that cover a
part of the costs of
production. A subsidy
causes a firms costs to
go down and as a
result, the firm will be
able to supply more.
This causes the Supply
curve to shift
outwards. However,
subsidies may also
encourage inefficiency because producers may feel that the
government will always supply them with goods and services. As a
result, the price of the good may fall and supply may increase, but
this has encouraged inefficiency.
The Area 1 shows loss in welfare. Here, there is a decrease in the
Producer Surplus, because the Producers who could produce at a
price initially below the equilibrium price will now see that the
equilibrium price is lower and so they will not benefit.

Subsidy

Define and illustrate Demand and the Demand Curve.

Explain the factors affecting Demand and draw shifts in the Demand Curve.
Define and illustrate Supply and the Supply Curve.
Explain the factors affecting Supply and draw shifts in the Supply Curve.
Draw a graph that shows Equilibrium Price and show how changes in Demand and
Supply changes the Equilibrium Price.
Define, calculate and explain the factors affecting Price Elasticity of Demand and
Supply, and the usefulness of PED and PES
Show how imposing a tax, and subsidies affect Supply and Demand