DEMAND AND SUPPLY NOTES
Purpose The theory of demand and supply enables us to understand the
determination of prices and quantities in different markets
For example, why the prices of
agricultural commodities such as tomatoes, apples, mangoes and cabbages
increase and decrease at certain times of the year, why have the prices
of computers, music systems and television sets been steadily declining
over time. An understanding of the working of the price system provides
us with the answers to some of these questions. The price system
provides the basis for determining the prices of factors of production.
Specific Objectives
At the end of this lesson you should be able to:
- Outline the key determinants of demand and supply
- Explain the difference between a movement along a demand and supply
curve and shift of the curve. - Explain the concept of market equilibrium
- Distinguish between maximum and minimum price controls and explain
the consequences of each - Compute equilibrium values in elementary market models.
2.1 Definition of Demand
Demand refers to the quantity of a commodity that consumers are willing
and able to purchase at any given priceover a given period of time. It is important to realize that demand is not the same thing as want, need or desire. Only when want is supported by the ability and willingness to pay the price does it become an effective demand and have an influence on the market price. Hence demand in economics means effective demand. It is different from desire in that it has to be supported by the ability to purchase the product/service. The price of a commodity is most important factor/determinant of demand. All factors affecting demand other than the price are referred to as conditions for demand. While analyzing the relationship between price and quantity of demand economists assume that all factors affecting demand remain constant. An individual demand for a given good can be presented in a form of a demand schedule. A demand schedule is a table showing quantity of a commodity that could be purchased at various prices. The Table 2.1 shows an individuals demand for commodity X
From the table, 65 units of commodity X will be demanded per week if the
price is Kshs 6 per unit. A demand schedule can be represented in the
form of a graph known as a demand curve. Figure 2.1 shows the demand
curve for commodity X. The curve shows graphically the relationship
between quantity demanded and the price of the commodity. A demand curve
has a negative slope. It slopes downwards from left to right showing
that as the price of a commodity falls demand increases. The inverse
relationship between the price of a commodity and the quantity demanded
is what is referred as the law of demand.
This law states that, “ceteris paribus (other things remaining
constant), the lower the price of a commodity the greater the quantity
demanded by the individual and vice versa”.
Exceptions to the Law of Demand
There are some demand curves that slopes upwards from left to right
showing that as the prices of a product rise more is demanded and vice
versa. This type of demand curve is known as regressive, exceptional or
abnormal demand curve and occurs in the following
situations:
- When there is fear of a more drastic price changes in the future.
This will causes consumers to increase there quantity demanded to
avoid paying a higher price in the future. This situation is often
found in the stock exchange where there is often an increase in the
demand of shares of a company if its shares are expected to increase. - In the case of giffen goods. This refers to basic foodstuffs that
constitute a high proportion of the budget of low income families.
When the price of a giffen good rises, the proportion of the total
income of individuals who consumes these giffen goods rises and
since such consumers are worse off in real terms, they can no longer
afford to consume other more expensive commodities like meat and
fruits. To make up for the goods they can no longer afford to buy,
they are more likely to purchase more of basic
foodstuffs; conversely when the price of basic foodstuffs falls.
They become better of in real terms and are likely to buy more or
relatively more expensive foodstuffs and less basic foodstuffs.
Goods of ostentation (Veblen goods). These are commodities whose prices
falls in the upper price ranges and that have a snob appeal. The wealthy
are usually concerned about status. Believing that only goods at high
prices are worth buying and worth the effect of distinguishing them from
other consumers. In the case of such commodities, a firm increasing its
prices may find that the sales of its product increase and at lower
prices less of the commodity may be bought as the commodity is rejected
as being substandard.
Consumers often in making comparisons between similar products with
different prices opt for relatively more expensive product believing it
to be better. As prices increase demand increases this is referred to as
sonob effect. Examples of goods of ostentation are expensive perfume,
jewellery, cars clothes, etc. The demand curve will be positively
slopping as indicated in Figure 2.2.
2.2 The Determinants of Demand
The demand of the product can be considered from the standpoint of
either individual demand or market demand. Demand for any commodity can
be considered from two points of view:
- Individual demand is the amount the individual is willing and able to
buy at a given price and over a given period of time. Factors affecting
individual demand are;
- Price of the product
- Price of other related goods
- Consumer’s income
- Consumer’s tastes and preferences
- Future expectation in price changes
- Advertising
- Other factors such as subsidies, climate change etc.
The price of the product. When deciding whether or not to buy a
particular product, an individual will compare the price of the product
and the amount of utility or satisfaction expected to be received from
the product. If the price is considered worth the anticipated utility
the individual will buy the product and if not will not buy. A decrease
in the price of a product will probably increase individual’s demand for
it since the amount of utility obtained is likely to be worth the lower
price. Conversely a rise in the price of a product will probably result
in a fall in demand, as the amount of utility received is less likely to
be worth the higher price to be paid. An example of this phenomenon is
the hotel industry in Kenya. There is usually an increase in domestic
tourism during the low season when many Kenyans consider the lower hotel
prices to be worth the level of satisfaction they are receiving. During
the high season when the hotel prices are high, many do not consider the
satisfaction they are receiving to be worth.
If the amount a consumer is willing and able to purchase due to change
in the price, a change in the quantity demanded is said to take place.
If on the other hand the amount the consumer is willing and able to
purchase changes because of a change in the price of a given commodity
leads to a change in the quantity demanded will be undertaken later in
utility analysis and indifference curve analysis. The prices of related
goods. The demand for all goods is interrelated in that they are
competing for consumer’s limited income. Two peculiar interrelationships
can be; Substitutes goods such as tea and coffee butter and margarine,
beef and mutton, a bus ride and a matatu ride, a mango and an orange,
CDs and cassettes.
Two goods, X and Y are said to be substitutes if a rise in the price of
one commodity, say Y, leads to a rise in the demand of the other
commodity X. If the price of tea increases consumers will find coffee
relatively cheaper to tea as a result demand for coffee increases.
Substitutes are commodities that can be used in place of other goods.
This phenomenon is illustrated in Figure 2.3. The graph shows the
relationship between the prices of tea over the quantity for coffee. If
the price of tea increases from P1 to P2 the quantity of coffee demanded
increases from Q1 to Q2.
Compliments goods such as shoe and polish, pen and ink cars and petrol,
computers and software, bread and margarine, hamburgers and chips, tapes
and tape recorders. Demand for some commodities can also be affected by
changes in the prices of the complementary if a rise in the price of one
of the goods, say A leads to the fall in the demand of another food, say
B. Complimentary goods are usually jointly demanded in the sense that
the use of one requires or is enhanced by the use of the other. Figure
2.4 illustrates the relationship between complementary goods
graphically. For example if the price of cars is lowered demand for
petrol increases because more cars will be bought/demanded. The curve
shows the relationship between the price and of a car and quantity
demanded for petrol. If the price of cars falls from P2 to P1 the
quantity demanded for petrol increases from Q1 to Q2.
Changes in disposal real income. An individual’s level of income has an
important effect on the level of demand for most products. If income
increases demand for the better quality goods and services increases.
This relationship however, depends on the type of goods and level of
consumers‟ income. The three types of are goods; Normal gods these are
goods whose demand increases as income increases. The demand for normal
goods increases continuously with increase in income. It tends to become
gently as people reach the desired level of satisfaction.
Inferior goods refer to goods for consumers with low income levels such
that as income increases its demand falls. At low level of income, these
individuals will tend to consume large amount of these goods but as
income increases they buy other goods which they consider superior thus
demanding less of the inferior goods. At very low level of income an
inferior good behave like a normal good only to behave inferior as
income increases. Necessities these are goods which consumers cannot do
without such as salt, match boxes among others. Their income demand
curve tends to remain constant other than at the lowest levels of income
as indicated in Figure 2.5
Changes in consumer tastes, preferences and fashion Personal tastes play
an important role in governing the consumer’s demand for certain goods.
For example, preferring to consume imported commodities despite them
being extremely expensive. Prevailing fashions are an important
determinant of tastes. The demand for clothing for example, particularly
is susceptible to changes in fashion.
Level of advertising is also an important determinant of demand. In
highly competitive markets, a successful advertising campaign will
increase the demand of a particular product while at the same time
decreasing the demand for competing products. Increase in advertising
will increase demand in the following ways;
- it helps inform about the product of a firm
- Can introduce new products to the market.
- Induce individuals to frequently use the product/service
Factors affecting advertising policies
- cost of advertising
- mode of advertising
- impact of advertising on the demand of the product
- The target group (old, young)
- number of competitors and quality of their products
- The market share of the firm and the degree of competition
- Future expectations in price changes
- Government policies and taxes
- Appropriate time to make advertisements
- Cultural background
- Language
The availability of credit consumers. This factor especially affects the
demand for durable consumer goods which are often purchased on credit.
For example a decrease in availability of credit or the introduction of
more stringent credit terms is likely to lead to a reduction in the
demand of some durable consumer goods. The government policy The
government may influence the demand of a given commodity through
legislation. For example making it mandatory for everyone to wear
seatbelts. The consumers inevitably get to purchase more seatbelts as a
result. Subsidies it’s the opposite of taxation. When the government
grants subsidies prices
of goods falls leading to increase in demand and vice versa. Climate
change demand of various goods varies depending on weather. For instance
there is high demand for woolen clothes during rainy reasons
- Market factors affecting individual demand
It’s a horizontal demand sum of the demands for individual consumers. It
refers to quantity demanded in the market at each price by individual
consumers. For this reason all the factors affecting individual demand
will affect market demand. The market demand for a commodity can be
derived graphically as in Figure 2.6.
Where P1, P2 and P3 are individual prices Q1, Q2 and Q3 are individual
quanties demanded. Pmk is the market price qmk is market quantity demanded.
Other factors affecting market demand
Change in population market demand is influenced by the size of the
population, the composition of the population in terms of age sex as
well as geographical distributions. Distribution of income more evenly
distribution of income may increase demand for
normal goods while at the same time it may lower the demand for luxuries.
2.3 Movement Along and Shift in Demand Curve
Demand is a multi- variant function in the sense that it is influenced
by so many factors such as the price of the commodity, the price of
other related commodities, consumer incomes etc. The price of the
commodity is the most important determinant of demand and its
relationship with the quantity demanded give rise to a demand curve.
Movement along demand curve is demonstrated by a change in the price of
a good as shown in Figure 2.7 by movement from one point to another on
the same demand curve.
A change in price of a good from P1 to P2 causes a movement from point A
to B along the demand curve. This movement along demand curve shows a
change in quantity demanded which is an increase or a fall in the
quantity demanded. A shift in the demand curve is caused as a result of
a change in any factor affecting demand other than price such as changes
in consumer income tastes and preferences. For this reason all other
factors affecting demand other than price of the product are also
referred to as shifting factors as illustrated in Figure 2.8 Any change
in the shifting factors will cause changes in demand (an increase or a
fall in demand). A shift to the right (dd to d1d1) shows an increase in
demand while a shift from (dd to d2d2) shows a decrease in demand.
Terms used in demand
- Joint demand it is the demand whereby two commodities are always
demanded together. One good cannot be demanded in the absence of the
other such as car and petrol. - Competitive/rival goods it is the demand for goods which are
substitutes such tea and coffee. - Derived demand where goods are demanded in order to provide goods
such as cotton is required to produce cotton wool - Composite demand (several uses) where some goods are used for
different purposes such as steel for cars machine etc
2.4 Definition of Supply
Individual supply refers to the quantity of a given commodity that a
producer is willing and able to sell at a given price over a specific
time period. Market supply refers to horizontal summation of individuals
producers/firms supply in the market. The supply schedule and the supply
curve demonstrate the relationship between market prices and quantities
that suppliers are willing to offer for sale. Supply differs from
“existing stock” or the amount available because it is concerned with
amounts actually brought to the market. The basic law of supply states
that, “a greater quantity will be supplied at a higher price than at a
lower price”. An individual producer’s supply schedule shows alternative
quantities of a given commodity that a producer is willing and able to
sell various alternative prices for that commodity ceteris paribus
(other things remaining constant).
A supply curve show the relationship between the price of the commodity
and the quantity supplied. The relationship is a direct one as the
supply curve slopes upwards from left to right. The direct relationship
is a graphical representation of the law of supply which states that
other things remaining constant a greater quantity will be supplied at
higher prices and vice versa.
Determinants of Supply
The supply of a good is influenced by the following factors
- price of the commodity in the market
- the price of other related goods
- cost of production
- state of technology
- objective of the firm
- future expectations of price changes
- climate
- government policy and taxes
Price of the good as the price of a given commodity say X rises, with
the costs and the prices of all other goods remaining unchanged, the
production of commodity X becomes more profitable. The existing firms
are therefore likely to expand their profit and new firms are to be
attracted into the industry. It should be noted however, that not just
the current rise but also expectations concerning the future increases
prices may motivate producers. The total supply of goods is expected to
increase as the prices rise. Prices of other related goods changes in
the prices of other commodities may affect the supply of a commodity
whose price does not change.
Substitutes; two goods X and Y are said to be substitutes in production
if the supply of good X is inversely/negatively related to the price of
Y. For instance barley and wheat or tea and coffee. If a firm producing
both tea and coffee notices that the price of tea is rising may decide
to allocate more resources to tea at the expense of coffee. The supply
of coffee will therefore fall as the price of tea increases. However,
the movement of resource from one use to the other is dependent on the
mobility of factors of production.
Complimentary goods; two goods X and Y are said to be compliments if an
increase in the price of X causes an increase in the supply of Y such as
a vehicle and petrol. Jointly supplied goods; two goods X and Y are said
to be jointly supplied if an increase in the price of X causes an
increase in the price of Y such as petrol and paraffin. If the demand
for petrol increases the supply of petrol will rise and at the same time
the supply of paraffin will increase.
N/B The extent to which firms can move from one industry to another in
search of higher profits depends on occupational and geographical
mobility of the factors of production.
Prices of factors of production as the prices of factors of production
used intensively by producers of a certain commodity rise, so do the
firm costs. This will cause the supply to fall since some firms will
eventually leave the industry. Similarly, if the price of one factor of
production, say land, increases, some firms may move out of the
production of land intensive products into the production of goods that
are intensive in other factors of production which are relatively
cheaper. Finally other less efficient firms will make losses and
eventually leave the market.
The state of technology is a society’s pool of knowledge concerning
industrial activities and its improvements. Technological improvements
or progress such as improvements in machine performance, management and
organization or an improvement in quality of raw materials leads to
lower costs through increased productivity and increases the profit
margin in every unit sold. This leads to increase in supply.
Future expectations of price change Supply of a good is not only
influenced by the current prices but future expected price as well. For
example, if the price of a good is expected to rise the firm may decide
to reduce the amount of supply in the current period. This is to enable
them pile stock which they can offer for sale when prices increase in
the future. This is known as hoarding. Government policies through tax
imposition on goods increases the cost of production hence decline in
production and supply Through subsidies -a grant to citizens of a
country which lowers the cost of production hence encourages production
and increases in supply.
Through price control can either by price minimization where prices are
fixed above equilibrium encouraging producers to produce more hence
increase in supply. It may be undertaken through price maximization
where prices are fixed below equilibrium discouraging production hence
decline in supply. Though quotas where the government puts restriction
or limit production of various goods which leads to decline in supply.
Weather /climate the supply of agricultural products is considerably
affected by changes in weather conditions. Output in agriculture is
subject to variations in weather from year to the next. An excellent
growing season associated with favorable weather conditions will result
in a bumper harvest leading to an increase in supply. An unfavorable
season that results in a poor harvest may be viewed as an increase in
the average costs of production because a given expenditure on inputs
yields a lower input than it would in a good/ favorable season. A bad
harvest is represented by a leftward shift of the supply curve.
Objectives of the firm a business may pursue several objectives such as
sales maximization, market leadership, quality leadership, survival,
profit maximization, social responsibility. Firms with sales
maximization as an objective aim at supplying greater quantities of its
product than a firm aiming at profit maximization where the later
supplies less quantities but at a higher price in order to maximize the
profit. Incidence of strikes lead to a reduction in supply of a product.
The supply of manufactured goods is particularly likely to be affected
by industrial disputes because of generally stronger unions in the
industrial sector.
Market supply
The market supply curve represents the alternative amount of a good
supplied per period of time at various alternative prices by all the
producers of goods in the market. The market supply of goods therefore
will be influenced by all the factors that determine individual producer
supply and all the number of producers of goods in the market. This
concept is illustrated in Figure 2.10 It therefore follows that the
market supply curve will have a gently slope than individual supply
curves. Figure 2.10 Derivation of market supply curve
2.5 Movement Along and Shift in Supply Curve
The relationship between price of a commodity and quantity supplied give
rise to a supply curve. Any changes in the price of a good causes change
in the quantity supplied. This can be traced by the movement along
supply curve as shown in Figure 2.11 The movement from point A to B is
caused by changes in price from P1 to P2 which bring fourth the movement
along the supply curve.
A shift of supply curve is caused by a change in any other factors
affecting supply other than the price of the goods. This shift indicates
changes in supply as a result of e.g. advances in technology which makes
it cheaper to produce goods and services and therefore their supply will
increase. Similarly incase of increase in cost of production will lead
to a fall in quantity supplies as shown in Figure 2.12. A shift to the
right from S1S1 to S3S3 shows a fall in supply.
2.6 The Concept of Equilibrium in Economics
Equilibrium in economics refers to a situation in which the forces
determine the behavior of variables are in balance and therefore exert
no pressure on these variables to change. In equilibrium the actions of
all economic agents are mutually consistent. Market
equilibrium occurs when the quantity of a commodity demanded in the
market per unit equals the quantity of the commodity supplied to the
market over the same period of time. Geometrically, equilibrium occurs
at the intersection point of the commodity’s
market demand and market supply curve. The price and quantity at the
equilibrium are known as the equilibrium price and equilibrium quantity
respectively. The price Pe is also referred to as market clearing point.
At this equilibrium point the amount that producers are wiling and able
to supply in the market is just equal to the amount that consumers are
wiling and able to demand. Both consumers and producers are satisfied
and there is no pressure on prices to change and thus the market for
goods is said to be at equilibrium. This is illustrated in Figure 2.13
Equilibrium point
Equilibrium can be defined as a state of rest or balance in which no
economic forces are being generated to change the situation. These
economic forces are excess demand and supply and are illustrated in
Figure 2.14. At P1, the quantity demanded by consumers is
Q1 units but producers are willing to supply at price a quantity of Q2
units. Therefore there is an excess supply equal to (Q2 –Q1). Excess
supply refers to a situation where quantity demanded is less than
quantity supplied at prevailing market price. Producers
may therefore react to the excess supply by lowering prices of their
products so as to sale the unsold stocks. Excess supply is referred to
as a buyer’s market since suppliers may be obliged to lower their prices
in order to dispose of excess output a situation which is
favorable to buyers. Excess supply represents an economic force that
exerts downward pressure on prices. At P2 the quantity demanded is Q2
but producers are wiling to supply Q1 units of goods. Therefore, there
will be excess demand equal to (Q2-Q1). This
situation of excess demand is referred to as sellers market because
competition among buyers will force up the price due to the existing
shortage Excess supply is a situation where quantity demanded is greater
than quantity supplied at prevailing market prices.
In this case, the price of goods will rise because of competition among
buyers. Excess demand represents an economic force on prices which
exerts upward pressure. Prices P1 and P2 are disequilibrium prices and
market is said to be at disequilibrium. Therefore, the
general rule for equilibrium is that demand should equal supply
represented by Qe and Pe.
2.6.1 Mathematics Derivation of Equilibrium
2.6.2. Types of Equilibrium
The are three types of equilibrium; stable, unstable and neutral.
- Stable equilibrium If there is a force that distracts market
equilibrium then there will adjustment that brings back the prices and
quantity demand to the initial equilibrium. This is well explained in
the previous section. - Unstable equilibrium equilibrium is said to be equilibrium if there
is divergence from the equilibrium set by forces which push the prices
further away from the equilibrium prices. For example, in case of a
giffen good which assumes a demand curve which is positive as indicated
in Figure 2.15
At P1 there is excess demand and this will exert an upward pressure on
the prevailing market thus push it further away from the equilibrium. At
p2 there is excess demand and this will exert an upward pressure on the
prevailing market prices thus pushing it further away from the
equilibrium. This type of equilibrium is known as knife edge
equilibrium. A small in price will send the system further away from the
equilibrium.
- Neutral equilibrium occurs when initial equilibrium is disturbed and
forces of disturbances leads to a new equilibrium point. It may occur
due to a shift of either demand or supply or through the effect of taxes.
The effect of a shift of demand and supply on market equilibrium.
Shift in demand
Increase in demand. Consider Figure 2.16 which illustrates the effect of
an increase on demand on market equilibrium. An increase in demand is
represented by a shift of the demand curve from d1d1 to d2d2. The
immediate effect will be shortage and this will force prices to rise
leading to increase in quantity supplied until equilibrium is
reestablished at Pe. Fall in demand Consider Figure 2.17 which
illustrates the effect of a fall in demand on the market equilibrium.
A fall in demand is represented by a shift of demand curve to the left
from d1d1 to d2d2. The immediate effect will be a surplus and this will
force the producers to lower the price in an attempt to get rid of
excess stock. This fall in price will led to decline in quantity
supplied until a new equilibrium is established at Pe1; Qe1
Shift in supply
Increase in supply Consider Figure 2.18 which illustrates the effect of
an increase of supply on the market equilibrium. An increase in supply
is represented by a shift of supply curve to the right from S1S1 to
S2S2. The immediate effect will be surplus and this will force the
producer to lower their prices in order to get rid of excess stock. This
fall will lead to an increase in quantity demanded until a new
equilibrium is established at Pe.
2.7 What Is Price Control ?
This refers to a deliberate action by the government to artificially
impose through legislation the prices of certain goods and services.
Such imposed prices are referred to as flat prices. These flat prices
may be a maximum or a minimum price. A maximum price refers to that
price above which a good or a service cannot be sold. A minimum price
refers to that price below which a good/service cannot be sold. The
government may find it necessary to control the prices of certain
good/service because:
- Cheapness It may be objective of the government to keep price of
certain goods and services at a level at which they can be afforded
by most people hence protecting the consumer being exploited by
producers - Maintenance of income. The government may want to keep the income of
certain producers at a higher level than that which would be
supplied by market forces demand and supply. Thus the government is
able to maintain the low income producers in the market. - Price stability if there is a wide variation in the price of product
year to year the government may wish to iron out these variations
for the interests of both producers and consumers. This price
control will act as one of the methods to curb inflation.
Advantages of price control
- Protects consumers, especially the low income consumers from price
increases by producers. - Ensures that producers have a reasonable income which is subject to
inflation - Contributes to industrial peace especially if they constitute part
of the comprehensive income policy and a maximum price is fixed on
some basic goods. - It may be associated with a decrease in price and an increase in
output such as the case of a monopolist overcharging for its
products and is forced to lower prices. In this case the monopolist
may accompany the fall in price with an increase in
output in order to compensate for loss in revenue. - It may be used as one of the several counters of inflation.
2.8 Define Elasticity of Demand
It can be defined as the ratio of the relative change of a dependent
variable to changes in another independent variable. Elasticity can be
analyzed in terms of demand and supply. It can also be defined as a
measure of responsiveness of quantity demanded of a good in
to changes in income or prices of other related goods. There are three
types of elasticity; price elasticity of demand, cross elasticity of
demand and income elasticity of demand. Price elasticity of demand it’s
the measure of responsiveness of the quantity demanded of
a commodity to changes in its own price. It is also referred to as own
price elasticity. It abbreviated as PED/ED. It is calculated as follows
2.8.1 Types of elasticity
There are five types of elasticity of demand.
- Perfectly elastic demand. Demand is said to be perfectly elastic
when the consumers are willing to buy an amount of a commodity at a
given price, but non at a slightly higher price. - Elastic demand. Demand is said to be price elastic when a charge in
price causes more than proportionate change in quantity demanded. - Unity elastic demand. Demand is said to unit elastic if changes in
price cause proportionate change in quantity demanded. If price
increase quantity falls in the same proportion and vice versa. - Inelastic demand. Demand is said to be price inelastic if changes in
price causes less than proportionate change in quantity demanded. If
prices increases the quantity falls in less proportion and if the
prices falls the quantity demanded increases in less proportion ED < 1 - Perfectly inelastic demand. Demand is said to be perfectly price
inelastic if changes in price has no effect on the quantity demand
(ED= 0).
Factors affecting price elasticity of demand
- Substitutability. If a substitute is available in the relevant price
range, quantity demanded will be elastic. The demand for a
particular brand of cigarettes maybe considered being elastic
because if there is existence of other brands that are close
substitutes. However, the total demand for cigarettes may be
inelastic because there are no close substitutes for cigarette. It
can hence be said that the greater the number of substitutes for a
given commodity, the greater will be its price
elasticity of demand. - The proportion of a consumer’s income spent on the commodity. If
this proportion is very small as in the case of match boxes , the
quantity demanded will tend to be inelastic. On the other hand if
this proportion is relatively large as for example in the case of
meat, demand will tend to be elastic. This implies that the greater
the proportion of income which the price of the product represents,
the greater price elasticity of demand will end to be. - The extent to which the product is habit forming. Habit forming
products like cigarettes or alcohol have a low price elasticity of
demand. In the case of in addiction to, say drugs, the price
elasticity of demand is likely to be even lower. - The number of uses of a commodity. The greater the number of uses of
the commodity, the greater the price of elasticity. The elasticity
of alluminium for example is likely to be much greater than of
butter because butter is mainly used as food while alluminium has
hundreds of uses such as electrical wiring and appliances. - The length of adjustments. The longer the period allowed for
adjustment in the quantity demanded as a commodity the greater its
price elasticity is likely to be. This is because it usually takes
some time for new prices to be known and for consumers to make the
actual switch. Consumers adjust buying habits slowly. - The level of prices. If the ruling price is at the upper end of the
demand curve, quantity demanded is likely to be more elastic than if
it was towards the lower end. This is always true for a negatively
sloped straight line demand curve. - Necessities and luxuries Demand for luxury is likely to be price
elastic while the demand for necessities is generally price
inelastic. However, this depends with availability of close substitutes. - Width/size of the market the wide definition of the market of a
good, the lower is the price elasticity of demand. Thus for wide
markets demand will tend to be price inelastic while for a small
market demand will tend to be price elastic. - Time demand for most goods and services tend to be more elastic in
the long run as compared to the short run period. This is because
consumers will take some time to respond to price changes. For
instance, if the price of petrol falls relative
to diesel, it will take long for motorists to respond because they
are locked in existing investment in diesel engines. - Durability of the commodity durable goods have low elasticity of
demand or they are price elastic while perishable goods are price
inelastic.
Importance of price elasticity of demand/economic application of the
concept of elasticity
- The consumer needs knowledge of elasticity when spending income
where more income is spent on goods whose elasticity of demand is
inelastic and vice versa. - The government imposes taxes with inelastic demand and vice versa.
Devaluation when a country devalues or lowers the value of its
currency. The currency is made cheaper relative to other currencies.
This makes a country’s exports cheaper for foreigners. Its import
expensive for the residents. For a country to benefit by increasing
exports, the elasticity of demand must be high. - Business/producers They use elasticity of demand on deciding on
whether to charge high or lower prices or even deciding on
commodities to bring to the market especially those which are price
inelastic.
Importance of Income Elasticity of Demand
- Business firms- if demand of a commodity is elastic to price, its
possible to revenue by reducing prices. Businesses use specific
information to know which price to increase to eliminate shortages
or which price to reduce to eliminate surpluses. - Government uses elasticity to determine the yield of indirect taxes.
Inelastic commodities are highly taxed. However, if demand of a
commodity is elastic an increase in tax will hinder production - Price elasticity is relevant for a country considering devaluation
as a means of rectifying balance of payment disequilibrium.
Devaluation decreases imports and increases exports. However, this
will depend on demand of import and export elasticities. - It helps to explain price instabilities in the agricultural sector
- Monopolists apply price discrimination by understanding the demand
elasticities. High price is charged to those markets with lower
price elasticity
Factors affecting Income elasticity of demand
- Nature of the need that the commodity covers. For certain goods and
services the percentage of income spent declines as income increases
such as food. - The initial level of income of a country (level of development) TV
sets, refrigerators, motors vehicles are considered as luxuries in
underdeveloped countries while they are considered as necessities in
countries with high per capita income.50 - Time period. The demand for most goods and services will tend to be
income elastic in the long run as compared to short run period. This
is because the consumption pattern adjusts with time and also with
change in income.
Type of price elasticity of supply
- Perfectly elastic supply
- Elastic supply
- Unit elastic supply
- Inelastic supply
- Perfectly inelastic supply.
Factors Affecting Price Elasticity of Supply
- Mobility of factors of production If they are highly mobile then
supply will be price elastic since more factors can be employed
quickly when the prices increase thus increase in supply - The level of employment of resources It refers to the utilization
and allocation of resources. If the factors are fully utilized
supply will be price inelastic due to the fact that all the facts
are occupied and thus can not be mobilized in order to increase
supply. However if they are under employed, supply will be price
elastic. - Production period for product that take short period of time to
produce their supply tend to be price elastic. While thus that take
a longer period will be price inelastic because it will take a while
before the products can reach the market. - Nature of the commodity Price elasticity of supply for perishable
goods tend to be inelastic due to the fact that the goods do not
respond to price fall as they can not be easily stored. On the other
hand supply for durable goods tend to be price elastic since they
can be store when the price falls thus contracting supply. - Risk taking If the entrepreneurs are willing to take risk then
supply of the products will be price elastic. Risk taking will in
return be determined by the prevailing conditions in the economy.
E.g. Political stability, security, government incentives,
infrastructure, etc. - Level of stock If it‟s high supply will be price elastic because if
the price of a good increases more of the good will is supplied from
the stock - Time period Supply for most goods and services will tend to be more
elastic in the long run than in the short run because producer need
more time to reorganize factors of production so that they can
increase supply of the products.
Importance of price elasticity of supply
- If supply of a good is price elastic thus an increase in demand will
benefit both the producer and consumer of products because the
producer will be in apposition to supply relatively more of their
products and consumer will eventually pay a relatively lower price. - If the supply of commodity I price inelastic business may risk
losing revenue when there is a fall in the price of their products.
This is because they will be forced to sell their products at a loss
or a reduced price margin, e.g. In the case of perishable goods,
however in the supply of the goods is price elastic the business
people may store their products when price fall thus contracting
supply e.g. the case of durable goods.
Relationship between total revenue and elasticity
- Elastic demand Increase in price will reduce the total revenue while
a fall in price increase the total revenue - Inelasticity demand Increase in price will reduce the total revenue
while a fall in price causes reduction in total revenue. - Unit demand change in price will leave the price unchanged.
Application of elasticity in economic policy decisions
- Products/services pricing decisions
- Customer spending programmes
- Production decisions
- Government policy orientation -Taxation policy
Evaluation policies
Price control/minimum - Price discrimination
- Shift of the tax burden
Find Other Topics On Micro-Economics Here
INTRODUCTION TO ECONOMICS
DEMAND AND SUPPLY-Micro Economics
THEORY OF CONSUMER
THEORY OF PRODUCTION
TYPES OF MARKET STRUCTURES
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