Price theory & applications

Demand , supply & market

equilibrium
 MARKETS
• Includes the interplay among all the relevant
buyers and Sellers involved in the exchange
of something, good, service etc or
• Process through which products that are fairly
similar are bought and sold
• Examples: BSE, foreign exchange market,
vegetable market
• Markets are important because they
represent mechanism most societies use to
facilitate production, distribution &
transactions of all kinds
 Tools of Analysis
• Equilibrium Analysis
• Optimization
 Overview of Equilibrium
Analysis (price
determination)
• In a free Market economy, price of a
product/service is determined by demand &
supply situation in that market
• Market for a product will be at equilibrium
when producers bring to the market exactly
what consumers want to take out of the
market at that price.
• Equilibrium is a market situation where
there is no inherent tendency for change
• The market is at equilibrium when quantity
demanded is equal to quantity supplied
 Demand/Buying Side
• Demand for a good refers to the various
quantities of that good per unit of time that
purchasers will take off the market at all
possible alternative prices, ceteris paribus
• Willing to buy – the product must satisfy a
need or want
• Able to buy – purchasers must have the
purchasing power to buy what they are willing
to buy for there to be effective demand
• Quantity that purchasers will take off the
market will be affected by a number of factors
• These factors are referred to as
determinants of demand
 Determinants of Demand
• Price of the good (P)
• Consumers’ tastes & Preferences (T)
• No. of consumers under consideration (Pn)
• Consumers’ income (I)
• Prices of related goods (Pr)
• Credit Availability (Ca)
• Consumers’ expectations regarding future
prices of the product (E)
• Past levels of demand (Qt-1 )
• Number of goods available to consumers (R)
• Q = f(P, T, Pn, I, Pr, R, Ca, E, Qt-1 )
 Demand schedules &
• Curves
Demand theory singles out the relationship between
possible alternative prices of the product & the
quantities of it that purchasers will take off the
market per time period
• Thus determinants 2 through 9 are held constant -
ceteris paribus

• Demand theory conjectures quantity to be inversely

related to price (law of demand)
• Some exceptions may occur in which quantity taken
varies directly with price, but these must be few
• A demand schedule lists different quantities of
commodity that consumers will take opposite the
various prices of the good per period
• Demand curve is the demand schedule plotted on an
ordinary graph, Q = f(P) or P = f(Q)
• By convention quantity demanded is measured on the
horizontal axis & price on the vertical axis
 Demand schedule and Curve
• d d d
contd…
P = a – bQ or Q = a/b – (1/b) P
d

• Qd = 50 – 1Pd
• The downward slope reflects the law of demand –
people buy more of a product, service etc, as its
price falls. Why?
• Causality – changes in price cause changes in
quantity demanded & not the other way round
• A time-based relationship – it’s quantity demanded
per period of time, e.g., day, week, year etc
• Derive a Demand schedule and plot the Demand
curve for an individual consumer
Demand Schedule (individual)
Price per KG Quantity per week
50 0
45 5
40 10
35 15
30 20
25 25
20 30
15 35
10 40
5 45
0 50

Demand Curve

60
50
40
30
20
u
n
la
e P
ric

10
0
0 10 20 30 40 50 60
quantity per week

Demand Curve
Demand Schedule (market)
Quantity per week Summary
price per kgThato Tebogo Tshepho Total qty demanded
price per per
kg week
50 0 0 0 0 50
45 5 2 1 8 45
40 10 5 3 18 40
35 15 8 5 28 35
30 20 11 7 38 30
25 25 14 9 48 25
20 30 17 11 58 20
15 35 20 13 68 15
10 40 23 15 78 10
5 45 26 17 88 5
0 50 29 19 98 0

Market denad curve

60
50
40
30
20
u
p
n
la
e P
ric

10
0
0 20 40 60 80 100 120
quantity per week
 Derivation of Market
demand
• Market demand is the sum of all
individual demand for a particular
p good or service p
r p
r
i r
i
c i
c
e c
e
e

4 8 20 cake 4 10 cake 4 12 cake

 Consumer surplus (CS)
• CS is a monetary measure of the extent to which
buyers benefit from a transaction – it is a measure of
consumers’ well-being
• It is important for purposes of evaluating potential
government programmes
• We use demand curves to measure consumer surplus
• Recall that height of the demand curve at any given
quantity measures the most the consumer is willing to
pay for an extra unit of the good – willingness to pay.
• That amount less the market price is the surplus he
gets from consuming the last unit or
• The area below the demand curve & above the price
measures consumer surplus in a market
 Consumer Surplus
p p
r r
i (a) i
A (b)
A c1
c
1 e5
e Market demand Consumer
14
surplus

3 B C 3 B C

1 12 cake
2 3 12 cake
 Consumer surplus
• Panel (a): the most the consumer is willing to pay
for:
• 1st unit of cake is P14. Since cake costs only P3/unit,
he obtains a surplus of P11 (P14-P3) from the
purchase of the 1st unit of cake per week
• 2nd unit of cake is P13. His surplus from the
purchase of that unit will be smaller (P13-P3) only
P10
• Continuing as above & the adding the surpluses we
get total CS of the consumer
• For any other perfectly divisible good we can use
panel (b) to derive the CS, which is given by the
area ABC – CS from consuming 12 units/wk.
 Loss/gain in consumer
surplus
• If price of cake is increased from
P3/unit to p4/unit resulting in 11
units/wk of cake consumed, how will
that affect well being of consumers? It
will fall by the area BCED
• If government reduces the price of
cake from P4/unit to P3/unit, what will
be the new CS? ADE
 p
p r
r i A
i A c
c Initial CS
e
e
Loss in CS CS to new consumers
4D E 4 B additional CS C
3B C 3 D Initial consumers E

11 12 11 12 cake
cake
 Change in Demand Vs Change
in quantity demanded
Price per kg

Movement along demand curve

Shift in demand curve

Initial demand curve
25 New demand curve

20

0
10 20 Quantity per week
Change in Demand vs Change
in qty demanded
• A movement along a given demand curve
represents a change in quantity
demanded from a change in price of the
good itself, ceteris paribus
• When any of the circumstances held
constant in the definition of demand curve
are changed, the demand curve itself will
shift (change in demand)
– Take for example an increase in wages &
salaries (Income), consumers will be willing to
purchase more at any given price
– The same reasoning applies in the case of No. of
consumers and other determinants
 Determinants of demand
• Consumers’ tastes (preferences) – a change
in consumer tastes that makes the product
more desirable means more of it will be bought
at each price
• No. of buyers – an increase in the number of
buyers in the market increases product demand
• Income – for most products (normal/superior
goods) , a rise in income causes an increase in
demand. For inferior goods, an increase in
income reduces their demand
 Determinants of demand
• contd
Prices of related goods – a change in the
price of a related good may increase or
decrease the demand for a product,
depending on whether it is a substitute or
compliment
• Substitute good – is a good that can be
used in the place of another good. An
increase in the price of a substitute
increases the demand for the other good.
• Complimentary good – is a good that is
used together with another good. An
increase in the price of a complimentary
good reduces demand for the other.
 Supply side
• Supply of a good is defined as the various quantities of
that good that sellers will place on the market at all
possible prices, ceteris paribus
• Quantities of a good that suppliers will put in the market
will depend on a No. of factors
• Such factors include, Price of the good (P)
• Set of prices of resources used in producing the good (Pf)
• Range of production techniques available (K)
• Size, structure & nature of industry (Ms)
• Government policy (Taxes and subsidies (Ts))
• Therefore Qs = f(P, Pf, K, Ms, Ts)
 Supply schedule & Curve
• Supply schedule lists different quantities per unit of
time of the good that suppliers are willing to put in
the market, ceteris paribus
• Supply curve is supply schedule plotted on a graph &
is usually upward sloping to the right
• For the supply curve, Pf, Ts and K are held constant,
I.e. Qs = f(P) or Ps = f(Qs)
• Example: Qs = Ps – 10 or Ps = Qs + 10
• From the equation above, derive the supply schedule
and plot the supply curve (Do it on the board)
• The law of supply states that as price rises the
quantity supplied rises; as price falls quantity
supplied falls. Why?
 Supply schedule & curve
Supply schedule Supply curve
Price/trip trips per
week price/trip
A 10 0 Supply
B 15 5 40 curve
C 20 10
D 25 15 30
E 30 20 20
F 35 25
G 40 30
10
H 45 35
0 10 20 40
30 trips/wk
I 50 40
 Producer surplus (PS)
• PS is a monetary measure of the extent to which
sellers benefit from a transaction – it is a measure of
producers’ well-being
• It is important for purposes of evaluating potential
government programmes
• We use supply curves to measure producer surplus
• Recall that height of the supply curve at any given
quantity measures the least the producer is willing
to accept for an extra unit – willingness to accept.
• The market price less that amount is the surplus he
gets from supplying the last unit or
• The area above the supply curve & below the price
measures producer surplus in a market
 Consumer Surplus
p p
r r
i (a) i (b)
c c1
e e5
1
Market supply
producer surplus

3 B C 3 B C

A A
1 12 cake
2 3 12 cake
 Loss/gain in producer
surplus
• If price of cake is increased from
P3/unit to p4/unit resulting in 13
units/wk of cake supplied, how will that
affect well being of producers? It will
increase by the area BCED
• If government reduces the price of
cake from P3/unit to P2/unit, what will
be the new PS?
 Consumer Surplus
p p
r r
i (a) i (b)
c c1
e e5
1 Market supply
producer surplus
D E
3 B C 3 B C

A A
1 12 cake
2 3 12 cake
 Change in Supply vs Change
in qty supplied
• A change in the price of the good
will occasion a movement along the
supply curve, this is change in
quantity supplied
Price per trip

S0 S1
A change in any of the factors
held constant will result in a shift
in the entire supply curve from S0
20 b to S1 – change in supply

15 a
10
0 5 10 trips per day
 Change in supply
• If costs of factor input increase,
Quantity supplied at any given price
will fall. For instance we may have
Qs=Ps-15 as the new supply function
(Use board)
Price per Trips per week
trip
B1 15 0 (5)
C2 20 5 (10)
D3 25 10 (15)
E4 30 15 (20)
F5 35 20 (25)
G6 40 25 (30)
H7 45 30 (35)
I8 50 35 (40)
 Market price Determination
• If the demand & supply curves of any given good
are placed on a single diagram, then forces that
determine its market price will be highlighted
• Demand curve highlights what consumers are
willing to do
• Supply curve shows what sellers are willing to do
• Consumers’ demand is assumed to be independent
of the activities of suppliers
• Sellers’ supply is assumed to be independent of
consumers’ activities
• Equilibrium – a situation of balance – where there
is no inherent tendency to change. It occurs when
the plans of consumers match those of producers.
 Market Price Determination
Price per kg

Supply curve
ve
cur
nd
ma

50 Excess supply
De

a b
35
e
30
c d
25
10 Excess demand

15 20 25 Quantity per week

 Some explanations
• At a price of P10 (intercept) or lower, the
price is so low that none of the good will
be supplied.
• On the demand, at a price of P50
(intercept) or higher, the price is so high
that none of the good will be consumed.
• For every P1 increase in price, qty
consumed fall by 1 kg per week (slope
of demand curve)
• Similarly, for every P1 increase in the
price, qty supplied increases by 1 kg per
week (slope of supply curve)
 Market price
• At determination
price of P35, producers will bring 25 kg of
beef/wk to the market
• Consumers will buy only 15 kg of beef/wk
• Suppliers bring to mkt more than consumers can
take off the mkt, there will be disequilibrium with
excess supply – (a surplus (25-15)) of 10
• Suppliers will cut prices to dispose off their
surpluses
• As price goes down so will be the goods brought to
the market
• On the other hand, as price falls qty taken off the
mkt by consumers will increase
• Eventually price will drop to P30/kg & consumers
will be willing to take exactly the amount that
sellers want to place on the market at that price –
This is equilibrium price
• Assume the starting point was a price of P25 and do
the equilibrium analysis.
 Changes in demand
• What happens to the equilibrium
price & qty exchanged of a good
when its demand changes, say
coz of changes in income?supply
Price per kg

e2
35
e1
30 b

Excess D2
demand D1
0
20 25 30 kg per wk
Changes in Demand contd..
• Demand curve shifts from D1 to D2
• At the initial price of P30, suppliers supply
20kg/wk, but consumers are willing & able
to buy 30kg/wk
• Consumers will bid against each other,
thus pushing up the price
• But as price increases, consumers will
demand less & less of the beef.
• On the other side producers will produce
more beef as its price rises
• The bidding & increase in qty supplied will
continue until a new equilibrium is reached
at e2
 Changes in Supply
• What happens to the equilibrium
price & qty exchanged of a good
when its supply changes, say coz
of increases in wage level?
S2
S1
Price per kg

e2
35
e1
30

Excess Demand curve

demand
0 10 15 20 kg per week
 Changes in Demand &
supply
• An increase in demand alone leads to an increase in
both equil price & qty (D : P , Q )
• A decrease in demand alone leads to a decrease in
both equil price & qty (D : P , Q )
• An increase in supply alone leads to an increase in
equil qty & fall in equil price (S : P , Q )
• A decrease in supply alone leads to an increase in
equil price & fall in equil qty (S : P , Q )
• What happens if both supply & demand
increase/decrease together?
 Surplus & shortage
• A surplus is an excess of quantity supplied
over quantity demanded. When there is
surplus, sellers cannot sell the quantities they
desire to supply.
• A shortage is an excess of quantity
demanded over quantity supplied. When there
is a shortage buyers cannot purchase the
quantities they desire
• An equilibrium is a situation in which there
are no inherent forces that produce change
 Prices as a rationing
•
mechanism
Price variations act as a signal in
response to changes in demand or
supply or both
• It directs resources to where they are
needed the most
 Algebra of Demand-Supply
Analysis
• Qd = 50 – P: demand
• Qs = P – 10: supply
• Or Pd = Ps
• To find Equilibrium we
equate Demand to
• 50 – Qd = 10 + Qs
Supply, I.e Qd = Qs
• 40 = Qd + Qs, but Qs =
• 50 – P = P – 10 & solve
for P Qd = Q*, so
• 2P = 60
• P* = 30 • 40 = 2Q*
• Insert P* = 30 into either • Q* = 20
Qs or Qd to get Q*
• Qd=50-30 = 20 = Qs = Q* • Insert Q* into either Ps
or Pd to get P*
• P* = Pd =50-20=Ps=30
 Generalization
• Demand: Pd = a – bQd, a,b>0
• Supply: Ps = c + dQs, c,d>0
• Equil: Qs = Qd or Ps = Pd
• a - bQd = c + dQs
• Qd = Qs = Q
• a – c = bQ + dQ
• a – c = (a + d)Q*

a −c
Q* =
b +d
 Generalization contd…
P =a −bQd
 a −c 
P =a −b 
b +d 
a (b +d ) −b(a −c )
P* =
b +d
ab +da −ab +bc
P* =
b +d
da +bc
P* =
b +d
 Public Policy Issues
• Microeconomic models above can help
illuminate public policy issues
• Price floors – governments intervene in mkts
to raise prices of particular goods or resources,
minimum wage (to protect unskilled labour
from exploitation), sorghum price (to protect
incomes of farmers)
• Price ceilings – to keep prices of certain
goods at less than certain prices, ex. Rent
controls, interest rates, petrol prices,
food prices in Zim!
• Do these policies always help their intended
beneficiaries?
 Price ceiling (max. fare)
Price per trip

Supply curve
ve
cur
nd
ma

50
De

20
e
15
c d
12
10 shortage

15 20 25 trips per day

 Price floor (min. wage)
Price per hour

Supply curve
ve
cur
nd
ma

50 surplus
De

a b
20
e
15
12
10

15 20 25 Labor hours per day

 The elasticity of demand
• Have so far dealt with the direction of change in
demand, and the direction of its impact on prices
and quantity demanded.
• Now we look at the magnitude of its impact
• Elasticity is a numerical measure of the
responsiveness of quantity demanded or quantity
supplied to one of its determinants
• Price elasticity of demand measures how much the
quantity demanded responds to a change in price.
• Demand for a good is said to be elastic if the
quantity demanded responds more than
proportionately to changes in the price
• demand is said to be inelastic if the quantity
demanded responds only slightly to changes in the
price
 Price elasticity of demand
• Measures the sensitivity of quantity demanded to changes in own
price.
• Defined as %change in qty demanded resulting from 1% change in
price
– Varies from one point to another along a single demand curve,
i.e., from one price range to another, why?
– Price elasticity for same good may vary from market to market,
why?
• Why should we care about elasticity of demand? Later!
• Why use percentages: absolute changes may bias our perception
of the responsiveness depending on the units used. Example: P1
change & changes in grams
• Percentages also permit comparison of sensitivities to changes in
prices of different products. Example: response to P1 change of
houses & matches
 Computing price elasticity of
demand
Point elasticity – measured at a single point on the curve
Arc elasticity – measured between two points on the curve
% change in quantity demanded of product X
PED (ε d ) =
% change in price of product X
change in quantity demanded of X change in price of X
εd = ÷
original quantity demanded of X original price of X
• Problem! A price decrease and increase between two points
along a given demand curve gives different percentage
changes (draw demand curve & elasticity coefficients when
moving from A to B & from B to A)
– Example: a price change from P1 to P2 is 100%, but a change from P2
to P1 is 50%. Similarly, a qty change from 10 to 20 is 100%, but from
20 to 10 is 50%
– Which of these changes should we use in the calculation of elasticity?
– Elasticity should be the same whether price falls or rises
 price elasticity of demand
(midpoint formula)
• This problem is solved by using the
midpoint formula, where

(Q2 − Q1 ) /[(Q2 + Q1 ) / 2]
εd =
( P2 − P1 ) /[( P2 + P1 ) / 2]
• Examples: when P1 =2, Q1=10; when
P2=1, Q2=40; calculate price elasticity
of demand using midpoint formula.
 Price elasticity & demand
•
curves
Demand is elastic when the elasticity is greater than 1, so
that quantity moves proportionately more than price.
Example: a 3% decline in price of lunch results in a 5%
increase in the quantity demanded
• Demand is inelastic when the elasticity is less than 1, so
that quantity moves proportionately less than price:
Example: a 3% decline in price of lunch results in a 1%
increase in quantity demanded
• Demand is unit elastic when elasticity equals to 1, so
that quantity moves the same amount proportionately to
price: E.g., a 3% fall in price results in a 3% increase in
quantity demanded
• The flatter the demand curve through a point, the
greater the price elasticity of demand
• The steeper the demand curve through a point, the
smaller the price elasticity of demand
 Price elasticity & demand
curves
• For a vertical demand curve,
demand is said to be perfectly
inelastic. Quantity demanded stays
the same irrespective of the price
• Demand is perfectly elastic for a
horizontal demand curve. This
implies that very small changes in
the price lead to huge changes in
quantity demanded.
 Determinants of PED
• Range & attractiveness of substitutes – the
greater the number & closer the substitutes,
the higher the PED
– Quality & accessibility of info on substitutes
– Degree to which product is a necessity
– Addictive properties of product; brand image
• Relative expense of the product – the larger
the proportion of income that the price
represents, the larger the PED, why?
• Time – In the short run PED is less sensitive
(coz of habits, patterns, etc)
 Price elasticity & total revenue
test
Price per Cans of Elasticity TR(PxQ) TR test
can (P) coke (Q) coefficient

8 1 8
7 2 5 14 elastic
2.60
6 3 18 elastic
1.57
5 4 20 elastic
4 5 1.00 20 Unit elastic
3 6 0.64 18 inelastic
2 7 0.38 14 inelastic
0.20
1 8 8 inelastic
 Price elasticity along linear
dd curve
• For linear demand curve,
• Elasticity of demand is
– Greater than 1 above the midpoint of curve
– Less than 1 below the midpoint of the curve
– Equals to 1 at the midpoint of the curve
P
Elasticity & Total revenue
Elasticity>1; A price reduction increases total
8
revenue; a price increase reduces it

Elasticity=1; total revenue is at maximum

4
Elasticity<1; A price reduction reduces total
revenue; a price increase increases it

0 2 4 6 8 Q

16

Q
0 2 4 6 8
 Elasticity & Total revenue
• If total revenue changes in the
opposite direction from price,
demand is elastic
• If total revenue changes in the same
direction as price, demand is inelastic
• If total revenue does not change
when price changes, demand is unit
elastic
 Price elasticity & total
Revenue
elasticity Price Price fall
increase
Elastic Total Total revenue
(>1) revenue falls increases
(why?)
Unitary Total Total revenue
(=1) revenue stays the same
stays the
same (why?)

Inelastic Total Total revenue

(<1) revenue falls (why?)
 Determinants of price elasticity of
demand
• Substitutability – the larger the number of substitute
goods that are available, the greater the price elasticity
of demand. The more narrowly defined the product, the
larger the number of substitutes & thus more elastic
• Proportion of income – the higher the price of a good
relative to consumers’ incomes, the greater the price
elasticity of demand. Examples:
• Luxuries vs necessities – the more that a good is
considered to be a “luxury” the greater the price
elasticity of demand.
• Time – product demand is more elastic the longer the
time period under consideration. Consumers need time to
adjust to price changes.
 Price elasticity of supply
• Measures sensitivity of quantity
supplied to changes in price
• Defined as % change in qty supplied
resulting from a 1% change in price
• εs = % change in quantity supplied/
% change in price
ε s = (∆Qs / Qs ) /(∆Ps / Ps )

ε s = [∆Qs /((Qs1 + Qs 2 ) / 2)] /[∆Ps /(( Ps1 + Ps 2 ) / 2)]

 Price elasticity of supply
• Suppose a 2% increase in price of
beef results in a 6% increase in the
supply of beef. Calculate the
εcoefficient
s
of elasticity
• =6%/2%=3; supply is elastic
• Go back to the original supply curve &
compute supply ε s = (∆elasticity
Qs / Qs ) /( ∆P
between
s / Ps )
points
∆Qs = (CQs& −E. Using
2 Q s1 ) = 20 − 10 = 10; Qs1 = 10
∆Ps = ( Ps 2 − Ps1 ) = 30 − 20 = 10; Ps1 = 20
ε s = (∆Qs / Qs1 ) /(∆Ps / Ps1 ) = 1010 ÷ 10 20 = 2
 Price elasticity of supply
• If we compute the elasticity by moving from point E
to C we get:

ε s = (∆Qs / Qs ) /(∆Ps / Ps )
∆Qs = (Qs1 − Qs 2 ) = 10 − 20 = −10; Qs 2 = 20
∆Ps = ( Ps1 − Ps 2 ) = 20 − 30 = −10; Ps 2 = 30
ε s = (∆Qs / Qs 2 ) /(∆Ps / Ps 2 ) = − 10 20 ÷ − 10 30 = 1.5
• But the two should be the same as they
measure elasticity between the same points!!!!
 Price elasticity of supply
(midpoint) formula
• From C to E
∆Qs = (Qs 2 − Qs1 ) = 20 − 10 = 10; (Qs1 + Qs 2 ) / 2 = 15
∆Ps = ( Ps 2 − Ps1 ) = 30 − 20 = 10; ( Ps1 + Ps 2 ) / 2 = 25
ε s = [∆Qs /((Qs1 + Qs 2 ) / 2)] /[∆Ps /(( Ps1 + Ps 2 ) / 2)]
ε s = [10 / 15)] /[10 /(25)] = 1.66
• From E to C
∆Qs = (Qs1 − Qs 2 ) = 10 − 20 = −10; (Qs 2 + Qs1 ) / 2 = 15
∆Ps = ( Ps1 − Ps 2 ) = 20 − 30 = −10; ( Ps 2 + Ps1 ) / 2 = 25
ε s = [∆Qs /((Qs 2 + Qs1 ) / 2)] /[∆Ps /(( Ps 2 + Ps1 ) / 2)]
ε s = [−10 / 15)] /[−10 /(25)] = 1.66
 Determinants of Price elasticity of
supply
• The degree of price elasticity of supply
depends on how easily & quickly producers
can shift resources between alternative uses.
• The easier & more quickly producers can
shift resources between alternative uses, the
greater the price elasticity of supply.
• In the immediate market period supply is
perfectly inelastic because supplier does’t
have time to respond
• The market period is the period that occurs
when the time immediately after a change in
market price is too short for producers to
respond with change in quantity demanded.
 Price elasticity of supply – the short &
long run
• The ease with which firms can accumulate or
reduce stocks of goods – the more easily firms
can do this, the higher the PES
• The short run is a period of time too short to
change plant capacity but long enough to use
fixed plant more or less intensively.
• The price elasticity of supply is greater than in
the case of immediate market period. i.e., an
increase in demand and hence price results in
an increase in supply.
• The long run is a time period long enough for
firms to adjust their plant sizes & for new firms
to enter the industry. So there is a greater
supply response to change in price.
 Income elasticity of dd
• Measures the sensitivity of the amount consumed
to changes in consumers’ money income at any
point on an Engel curve.
• Defined as % change in qty consumed resulting
from a 1% change in consumers’ money income.

ε I = (∆ Q / Q) /(∆ I / I )
% change in quantity demanded of product X
ε xI ) =
% change in money Income
• ε xI can be >, < or = 0
superior
•
If ε xI > 0, the good is normal or
inferior
• If ε xI < 0, the good is a luxury
• If ε xI > 1, the good is a necessity
If 0 < ε xI < 1, the good is
 Cross price elasticity of dd
• Measures responsiveness of qty
demanded of good to changes in price
of another good
• Defined as % change in qty demanded
ofε good x to 1% change in price of good
xy = ( ∆Qx / Qx ) /( ∆Py / Py )
y
If ε xy > 0 the goods are substitutes
If ε xy < 0 the goods are comp lim ents
•
•
 Relevance of Price elasticity of
demand & supply
• Helps understand: price variations in
a market, the impact of changing
prices on consumer spending,
corporate revenues and government
indirect tax receipts
• Helps determine tax incidence
 Relevance of Price elasticity of
demand & supply
• The extent to which a change in supply
will affect the equilibrium price and
quantity traded depends on PED
– The higher the PED, smaller the change
equilibrium price & the larger the change in
equilibrium quantity
– The lower the PED, the larger the change in
equilibrium price and the smaller the
change in equilibrium quantity.
• Do examples on the board