Demand & Supply
Demand & Supply: Shifts and Elasticities
Understanding demand and supply is fundamental to microeconomics. Together they determine market equilibrium — the price and quantity at which goods are traded.
Demand
Demand is the quantity of a good or service consumers are willing and able to buy at a given price in a given time period.
The Law of Demand
There is an inverse relationship between price and quantity demanded (ceteris paribus). This creates a downward-sloping demand curve.
Reasons:
- Income effect: as price falls, real income rises, so consumers buy more
- Substitution effect: as price falls relative to substitutes, consumers switch towards the cheaper good
Shifts in Demand (Conditions of Demand)
A movement along the demand curve is caused by a change in the good's own price. A shift of the entire curve is caused by non-price factors:
| Factor | Shift Right (Increase) | Shift Left (Decrease) |
|---|---|---|
| Income | Rise (normal goods) | Rise (inferior goods) |
| Price of substitutes | Rise | Fall |
| Price of complements | Fall | Rise |
| Tastes/fashion | Favourable | Unfavourable |
| Population | Increase | Decrease |
| Advertising | Successful campaign | — |
| Expectations | Expected future price rise | Expected future price fall |
Supply
Supply is the quantity of a good producers are willing and able to offer for sale at a given price in a given time period.
The Law of Supply
There is a positive relationship between price and quantity supplied (ceteris paribus), creating an upward-sloping supply curve.
Reason: higher prices increase potential profit, incentivising firms to produce more.
Shifts in Supply (Conditions of Supply)
| Factor | Shift Right (Increase) | Shift Left (Decrease) |
|---|---|---|
| Costs of production | Fall (cheaper inputs) | Rise (dearer inputs) |
| Technology | Improvement | — |
| Indirect taxes | Removed/reduced | Imposed/increased |
| Subsidies | Granted/increased | Removed/reduced |
| Number of firms | Entry | Exit |
| Weather/natural events | Favourable | Unfavourable |
Elasticities of Demand and Supply
Price Elasticity of Demand (PED)
PED measures the responsiveness of quantity demanded to a change in price.
Formula: PED = % change in quantity demanded ÷ % change in price
PED is always negative (law of demand) but often expressed as an absolute value.
| PED Value | Description | Example |
|---|---|---|
| > 1 | Elastic (responsive) | Luxury holidays |
| < 1 | Inelastic (unresponsive) | Petrol, insulin |
| = 1 | Unit elastic | — |
| = 0 | Perfectly inelastic | Life-saving drugs (theoretical) |
| = ∞ | Perfectly elastic | Perfect competition |
Determinants of PED:
- Availability of substitutes (more substitutes → more elastic)
- Necessity vs luxury (necessities → inelastic)
- Proportion of income spent (higher proportion → more elastic)
- Time period (longer run → more elastic as consumers adjust)
- Brand loyalty/addiction (stronger → more inelastic)
Significance for firms: If demand is inelastic, a price rise increases total revenue. If elastic, a price cut increases total revenue. This is crucial for pricing strategies.
Income Elasticity of Demand (YED)
YED = % change in quantity demanded ÷ % change in income
| YED | Good Type | Example |
|---|---|---|
| Positive (0 to 1) | Normal (necessity) | Bread, toothpaste |
| Positive (> 1) | Normal (luxury) | Designer clothing, foreign holidays |
| Negative | Inferior | Value-brand food, bus travel |
Significance: Firms selling luxury goods benefit from economic growth but suffer in recessions. Understanding YED helps firms plan product portfolios and anticipate demand shifts during the business cycle.
Cross Elasticity of Demand (XED)
XED = % change in QD of good A ÷ % change in price of good B
| XED | Relationship | Example |
|---|---|---|
| Positive | Substitutes | Coca-Cola and Pepsi |
| Negative | Complements | Printers and ink cartridges |
| Zero | Unrelated | Bread and televisions |
The magnitude indicates the strength of the relationship. A high positive XED means the goods are close substitutes — important for firms assessing competitive threats.
Price Elasticity of Supply (PES)
PES = % change in quantity supplied ÷ % change in price
PES is always positive (law of supply).
Determinants:
- Spare capacity: more spare capacity → higher PES
- Availability of stocks: goods that can be stored have higher PES
- Time period: long run → more elastic (firms can adjust capacity)
- Ease of factor substitution: easier → more elastic
- Barriers to entry: lower barriers → higher PES in long run
Agricultural goods tend to have low PES in the short run (crops take time to grow), explaining price volatility in commodity markets.
Total Revenue and Elasticity
Total revenue (TR) = Price × Quantity
- If PED is elastic (> 1): price cut → TR rises; price rise → TR falls
- If PED is inelastic (< 1): price cut → TR falls; price rise → TR rises
- If PED is unit elastic (= 1): TR is maximised; any price change leaves TR unchanged
Firms use this to set optimal pricing strategies. Governments use PED to predict the revenue impact of indirect taxes.
Evaluation
- Elasticity values change along a straight-line demand curve (elastic at the top, inelastic at the bottom)
- Real-world measurement is difficult — ceteris paribus rarely holds
- Elasticities are estimates and vary by time period, market segment, and context
- Firms may have imperfect knowledge of their own demand curves
- Behavioural factors (habits, brand loyalty, bounded rationality) affect responses to price changes
Exam Tips
- Always state the formula and show workings in calculation questions
- Relate elasticity to total revenue and business/government decisions
- Use real-world examples to demonstrate understanding
- For essays, evaluate whether elasticity values are reliable and constant over time