Introduction to Economics
Chapter Two
Demand, Supply and Elasticity
Chapter Two
2. Theory of Demand and Supply
2.1 Introduction
We began the study of economics by stressing the importance of scarcity in determining
society's choice. Recall from chapter one that Economics is concerned with problem of
scarcity. When there is free exchange (no government control and other barriers), prices will
allocate scarce goods and services. Therefore, one of the major objectives of economics is to
analyze the factors that determine the prices and quantities of commodities sold. The
determinants of price and quantity sold (purchased) for analytical purpose are usually
separated into two categories: factors affecting demand for a good and factors affecting
supply of a good. The purpose of this chapter is to explain what demand and supply are and
show how they determine price and quantity sold in markets. Moreover, concepts such as
market equilibrium, elasticity, etc. are introduced.
2.2. The Theory of Demand
2.2.1. Definition of Key Concepts
Demand is a willingness and ability of a consumer to purchase goods and services at specific
price within a set of possible prices at a given period of time.
Law of demand: This is the principle of demand, which states that, other things being
constant, price of a commodity and it quantity demanded are inversely related i.e., as price of
a commodity increases (decreases) quantity demanded for that commodity decreases
(increases), ceteris paribus.
Quantity demanded (Qd) of a commodity is the amounts of the commodity purchased at a
given price level. The inverse relationship between the quantity demand and price of a
commodity can be shown by a demand schedule and a demand curve.
Demand Schedule is a table which shows how much of a good individuals are willing and
able to buy at different price levels during a given period of time (week, month etc).
Table 2.1: Hypothetical Demand Schedule for Teff.
Price of teff (in Birr)
100
150
200
250
300
Qd for teff (in quintals)
40
35
25
15
10
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At each price level consumers buy definite quantity of teff. As price of teff increases from 100
Birr to 300 Birr, quantity demanded for the teff decreases from 40 quintals to 10 quintals.
This demand schedule can also be depicted graphically as a demand curve for teff as follows.
Price of teff
teffteff
300
250
200
150
100
0 10
15
25
35
40
Quantity of teff
Fig. 2.1: Demand curve for teff
Demand curve of a commodity is a curve, which shows the relationship between the quantity
demanded of the commodity at different price levels. In drawing the demand curve we singled
out price of a commodity as the most important factor affecting the quantity demanded of the
commodity and ignored the influences of other factors (hold all other influences constant).
2.2.2. Determinants of Demand
The demand curve shows how a change in commodity's own price will affect the quantity
demanded, but what determine the shape and the position of the curve itself? The shape and
position of the demand curve depends on the following major determinants. That is to say, the
following variables are also important determinants of quantity demanded of a commodity.
However, we treat them separately from own price of a commodity because unlike change in
own price level, change in these variables has quite different effect on the position of the
demand curve itself. All the following variables cause demand curve to change its position
and we call them shift variables of demand curve. As one of the following determinants
changes assuming other things being constant demand curve shifts either to the right or to the
left. A right ward (left ward) shift of the demand curve indicates an increase (a decrease) in
demand.
A. Tastes and Preferences of the Consumers
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Individuals' preferences and tastes for particular commodity differ according to the
satisfaction they get from the commodity. When people change their mind about taste and
preference for a commodity demand for the commodity also changes. For example if
consumers have favorable (unfavorable) taste and preference for a commodity the demand for
commodity increases (decreases), other things being constant.
Tastes and preferences of the individuals towards the consumption of egg increases if it is
announced that consumption of egg is helpful in curing lung Cancer. For example,
advertisement on different goods and services changes tastes and preferences of consumers
and accordingly the demand for these goods and services changes. The following demand
curve depicts the effect of a favorable tastes and preferences of a consumer on raincoat during
rainy season.
Price of
Raincoat
An increase in Demand
A decrA
eadecrease
se in demin
andemand
d (a left (a
waleft
rd sward
hift) shift)
Quantity of raincoat
Fig. 2.2: An individual demand for raincoat
B. The Income of Consumers
Other things being constant, as income of the consumers' increases (decreases) demand for
normal goods increases (decreases), but demand for inferior goods decreases (increases).
C. Prices of Related Goods
If two goods are related, then the change in price of one good affects demand for the other.
The related goods are either" substitute or "complementary" to each other in consumption.
When price of its substitute good (Injera) increases (decreases), demand for the commodity
(Bread) increases (decreases), ceteris paribus. As price of its complementary good (Fuel)
increases (decreases) demand for that commodity (Car) decreases (increases), ceteris paribus.
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D. Number of Consumers
An increase in a number of consumers causes an increase in demand for commodities given
that consumers have ability to pay for. For example, Addis Ababa with the total population of
3 million people buys commodities 3 times than the population of Nazareth with 1 million
people.
2.2.3. Change in Quantity Demanded and Change in Demand
The law of demand states that, ceteris paribus, price and quantity demanded of a commodity
are inversely related. The demand curve is derived under the assumption of Ceteris Paribus
i.e., other determinants of demand except own price are held constant. Thus, the demand
curve shows how quantity demanded of a commodity varies when the price of the commodity
changes. In this case we observe change in quantity demanded simply because of change in
the price of a commodity, and the demand curve remained unchanged (not shifted).
Thus, if we vary only price of a commodity and hold other determinants of demand (income,
taste and preference, prices of related goods, expectation, number of consumers) constant, the
demand curve does not shift. In this case as price varies we are moving along the same
demand curve and we call this movement change in quantity demanded. The following graph
shows change in quantity demanded from Q1 to Q2 or from Q2 to Q1 due to change in price of
the commodity from P1 to P2 or from P2 to P1 respectively, ceteris paribus.
Price
A
P1
Fig. 2.4: Change in quantity demanded (movement
B
along the same demand)
P2
P3
C
0
Q1
Q2
Q3
Quantity
If the price of a commodity (own price) remains constant and one or more of those other
factors affecting demand (e.g., income, taste and preference, prices of other goods,
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expectation and number of consumers) change, then the demand curve shifts from its position
either to the right or to the left. Thus, when the demand curve changes its position we call it
change in demand (shift in demand).
Price
D1
D0
D2
Fig. 2.5: Change in demand (shift in demand curve)
P0
D1
D0
D2
0
Quantities
When demand curve shifts from D0 to D2 we say increase in demand, i.e., shift of the demand
curve to the right. When demand curve shifts from D0 to D1 (shift of demand curve to the left)
we say decrease in demand. Increase in demand (shift from D0 to D2) is caused due to:
increase in consumers' income for normal goods, favorable taste and preference for a
commodity, expectation of higher price in the future, increase in the price of substitute goods,
decrease in price of complementary goods and others, ceteris paribus the reverse is also true.
Therefore, when we say increase (decrease) in demand we mean shift of the demand curve to
the right (left). When we say increase (decrease) in quantity demanded we mean downward
(upward) movement along the same demand curve.
Note that an increase (decrease) in demand also implies purchasing of more (less) of goods at
each price level. Thus, change in demand necessarily implies change in quantity demanded,
but change in quantity demanded does not necessarily imply change in demand. Change in
own price causes movement along the same demand curve without causing shift of the
demand curve while change in other factors affecting demand cause shift in the demand
curve.
2.2.4. Individual and Market Demand Curve
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Individual demand curve is defined as amount of goods that a single consumer is willing
and able to buy at different price levels over certain time period. Market Demand Curve is
the total amount of goods that all consumers are willing and able to buy at each price level
over certain time period.
Table 2.2: Demand for wheat by three individual consumers over the last five months
Price per
Quintal
(1)
300
260
220
180
140
100
60
Abebe's
Demand
(2)
0
2
4
6
8
10
12
Bekele's
Demand
(3)
3
6
9
12
15
18
21
Almaz's
Demand
(4)
5
10
15
20
25
30
35
Total (market)
Demand
5 = 2+3+4
8
18
28
38
48
58
68
From this table we can see that market demand is the horizontal summation of the demand of
those three consumers, which can be shown as individuals and market demand curve as
follows.
300
260
+
=
220
180
140
100
60
0 2 4 6 8 10 12
3 6 9 12 15 18 21
3 8 13 18 23 28 33
ig.
2.6: Individual and Market Demand Curves: Quantity of wheat
2.3. The Theory of Supply
2.3.1. Definitions
Supply refers to the willingness and ability of producers to produce goods and services and
make available for sale in the market at a given price level within a set of possible prices over
certain period of time (e.g., week, month, year, etc).
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Law of Supply states that other things being equal the quantity supplied of a commodity
varies directly with the price of that commodity i.e. quantity supplied increases (decreases) as
price of the commodity increases (decreases), ceteris paribus.
Supply Schedule is a table which shows how much of a good individuals are willing and able
to produce and make available for sale in the market at different price levels during a given
period of time (week, month etc)
Quantity Supplied is the amount of commodity that producer supplies to the market at a
given price level. The direct (positive) relationship between price of a commodity and
quantity supplied can be shown using either the supply schedule or the supply curve.
Table 2.3 An individual supply schedule of coffee
Price of coffee Quantity
supplied
(Birr)
for coffee ( k. g)
70
700
60
600
50
500
40
400
30
300
20
200
10
100
Supply curve of a commodity is a curve, which shows the relationship between the quantities
supplied of the commodity at different price levels. In drawing the supply curve we singled
out price of a commodity as the most important factor affecting the quantity supplied of the
commodity and ignored the influences of other factors (hold all other influences constant).
S
Price
70
60
50
40
30
20
10
0
100 200 300 400 500 600 700
Fig. 2.7: The Supply Curve
Quantity
As price of a commodity increases from 10 Birr to 70 Birr then quantity supplied increases
from 100 to 700. Supply curve is derived under the assumption that other factors that can
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affect quantity supplied are hold constant and only price of a commodity is allowed to vary.
Quantity supplied of a commodity and its price is positively related i.e. as price increases
quantity supply also increases.
2.3.2. Determinants of Supply
Firms are interested in supplying of commodities in order to get profit. Thus, they supply
more goods when price is high relative to cost of production and supply less when production
cost is high relative to price. Price of a commodity is not the only determinant of quantity
supplied of the commodity. There are a number of other factors. These are:
A. Prices of Production Substitutes
Production substitutes are goods, which a producer tends to substitute for one another when
their price changes. If price of a good increases other things remain, constant, producers
decrease the production of its substitute because production of the good is more profitable
than production of its substitute. For example, if price of wheat increases in the market in
relation to price of teff a farmer allocates large part of its land to wheat production instead of
teff production.
B. Prices of factor inputs
Other things being constant, an increase (decrease) in the price of factors of production causes
an increase (decrease) in cost of production. As cost of production increases (decreases) profit
- margin decreases (increases) and therefore amount supplied to the market decreases
(increases). Thus, increase (decrease) in price of factor inputs causes quantity supplied to fall
(rise) of course under the assumption of other things being constant.
Price of Commodity
S2
S0
S1
A decrease in supply
An increase in
supply
Quantity of a commodity
Fig, 2.8 Shift of supply curve
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C. Technological State of production
The development of the new method of production or the invention of efficient machines may
make possible a big expansion of output at a lower cost and so causes supply to increase. i.e.
improvement in technology causes supply to increase and absolute technology causes supply
to decrease.
D. Number of Producers
As number of firms producing a good increase, more and more goods will be supplied.
2.3.3. Change in Quantity Supplied and Change in Supply
Change in quantity supplied refers to the movement along the some supply curve and it is
caused by a change in commodity's price. In this case only price of a commodity is allowed
to vary and other determinants of supply (e.g. Price of production substitute, prices of factor
inputs, technological state, taxes and subsidies, no of producer, expectation of producers and
weather etc,) are held constant.
Price
P3
S
P2
P1
Fig. 2.9 Change in quantity supplied
B
(movement along the same supply curve)
A
Quantity
0
Q1 Q 2 Q3
As price increases from P1 to P2, quantity supplied also increases from Q1 to Q2, i.e., we call
this increase in quantity supplied and as price decreases from p3 to p2 quantity supplied also
decreases from Q3 to Q2.
Change in supply refers to the shift of the supply curve. If we fix price of a commodity (own
price) constant and vary any of those other factors affecting supply (e.g. Prices of production
substitute and inputs, technological state, tax and subsidy, no of producers, producers'
expectation and weather) then the supply curve changes its position, i.e., the supply curve
shifts.
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Price
Decrease in supply
S1 S0
Demand, Supply and Elasticity
S2
Increase in supply
Po
0
Q1
Q0
Q2
Quantity
Fig. 2.10: Change in Supply (Shift in the supply curve)
If the supply curve shifts from So to S2 (shift of the curve to the right), we call it increase in
supply. If the supply curve shifts from So to S1 (shift of the curve to the left), we call it a
decrease in supply. Increase in supply, i.e., shift of the supply curve to the right is caused by
the following factors: decrease in price of production substitute, decrease in prices of inputs,
improvement in technology, increase in subsidy, decrease in tax, increase in number of
producers, expectation of lower price in the future, good weather and others, ceteris paribus.
The supply curve shifts to the left (decrease in supply) when the above factors change in
opposite direction.
NB. As supply curve shifts, quantity supplied also changes therefore change in supply
necessarily implies change in quantity supplied. However, change in quantity supplied does
not necessarily imply change in supply, because change in quantity supplied can be observed
by moving along the same supply curve (without shift in supply curve).
2.3.4. Individual and Market Supply Curve
Individual Supply Curve shows us the quantity that a single producer is willing and able to
supply at each price level over certain period of time.
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Table 2.4: A hypothetical supply schedule for the production of wheat by three individual
producers over the last seven months
Price of wheat
(Birr)
(1)
300
260
220
180
140
100
60
Kebede's supply
of wheat (k.g)
(2)
7
6
5
4
3
2
1
Balcha's supply
of wheat (k.g)
(3)
26
22
18
14
10
6
2
Birke's supply
of wheat (k.g)
(4)
35
30
25
20
15
10
5
Market supply
of wheat (k.g)
[5 = 2 + 3 + 4]
68
58
48
38
28
18
8
Exercise: Draw supply curves for the above supply schedules
Market Supply Curve shows the total amount of particular commodity supplied by all
producers at each price level, i.e., market supply curve is the horizontal summation of
individuals.
2.4. Market Equilibrium
Market can be considered as a mechanism or structure that facilitates exchange of goods and
services among different economic units (e.g., firm, government, etc). Market does not
necessarily refer to certain geographical area. It can exist wherever there is a contact between
buyers and sellers without any spatial dimension attached to it. At that equilibrium, price and
quantity remain. If some changes occur to shift either the supply curve or the demand curve,
then the market equilibrium point also changes.
Now the question is, what determines the price level on which both consumers and producers
agree on, i.e., the equilibrium? The operation of the forces of supply and demand provides
answer to this question. At any price level above the equilibrium price, quantity supplied is
greater than quantity demanded. At that price level producers plan to supply more and more
of the goods in order to get more profit. However, consumers plan to buy less and less as
goods are too costly to them. Therefore, there will be an excess supply (surplus). In order to
get rid of this excess supply there will be completion among producers to decrease price. This
decrease in price encourages consumers to demand more and more of the goods.
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Thus, producers continue to decrease their prices and consumers continue to buy more until
the excess supply is eliminated or until the equilibrium point is reached at point E. At any
price below the equilibrium price level, quantity demanded is greater than quantity supplied.
At that price level, producers plan to supply less and less of the goods. However, consumers
plan to buy more and more as they feel goods are relatively cheap. Thus, there is an excess
demand (shortage of goods) and this creates competition among consumers to get these scarce
goods by increasing price. This increase in price encourages producers to supply more and
more. Thus, consumers continue to bid up price and producers continue to supply more and
more until the excess demand is eliminated or the equilibrium price is reached again at point
E. Graphically the market equilibrium
(i.e., equilibrium price which is 180 birr and
equilibrium quantity which is 38 quintals) can b shown as follows:
Excess supply or
shortage of demand
Price
G
Fig. 2.13 Market equilibrium
E
180
Excess demand
or
F
shortage of supply
D
Quantity
38
At point E supply and demand curve intersect each other and therefore quantity supplied is
equal to quantity demanded hence market equilibrium is attained at point E.
2.5. Effects of Change in Demand or Supply on the Market Equilibrium
Strictly speaking market equilibrium is achieved under the assumption of perfectly
competitive market, in which all factors affecting supply and demand except the price of a
commodity are assumed to be constant. When one of the factors varies and others held
constant, then the market equilibrium point also changes. This situation can be shown by the
following graph.
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1. Effects of Change in Demand when Supply Remains Unchanged
D0
D1
S
Price
P1
e1
e0
P0
Quantit
Fig. 2.14 Effects of an increase in Demand when Supply Remains Unchanged
Q1
Q0
An increase in demand (shift of the demand curve from D0 to D1), supplies being unchanged,
causes equilibrium point to change from e0 to e1. In this case the new equilibrium point (point
e1) is attained both at a higher price and quantity than the initial equilibrium (point e0).
A decrease in demand (shift of the demand curve from D1 to D0) and supply remains constant
causes attainment of the equilibrium at a lower point. i.e., equilibrium point decrease from
point e1 to e and therefore equilibrium quantity decreases from Q1 to Q0 and equilibrium
price decreases from P1 to P0.
2. Effects of Change in Supply when Demand Remains Unchanged
D0
S0
S1
Price
P0
e
P1
e1
D0
0
Q0
Q1
Quantity
Fig. 2.15 Effects of an increase in supply when demand remains unchanged
An increase in supply (shift of supply curve from S0 to S1) assuming demand not to change
causes equilibrium point to change from point e to e1. As a result equilibrium price decreases
from P0 to P1 and equilibrium quantity sold or bought increases from Q0 to Q1, i.e., the new
equilibrium is attained at a lower price but higher quantity than before and vice versa.
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3. Effect of simultaneous change in DD and SS on equilibrium price and quantity
If both demand and supply increase simultaneously, then the equilibrium quantity increases
but equilibrium price may increase, decrease or remain unchanged depending on the relative
magnitude of the percentage change in demand and supply. There are three cases.
(1) If demand increases by more proportion than the supply, the new equilibrium (e1) is
attained at both higher equilibrium price and quantity than before. Thus, the new
equilibrium quantity (Q1) is greater than the previous equilibrium quantity (Q0) and
the new equilibrium price (P1) is also greater than the previous equilibrium price (P0).
D1
S0 S1
D0
Price
P1
e1
P0
eo
Q0
Q1
Quantity
Fig. 2.17 Effects of increase in demand by more proportion than supply increase.
(2) If supply increases by more proportion than demand, then the new equilibrium (e1) is
attained at a higher equilibrium quantity (Q1) than previous quantity (Q0) but at a
lower equilibrium price (P1) than the previous price (P0).
S0
D0 D1
S1
Price
P0
e0
P1
e1
Quantity
Q0
Q1
Fig. 2.18 Effects of increase in supply by more proportion than demand increase.
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(3) If both demand and supply increases by an equal proportion the new equilibrium
quantity is attained at a higher level then the initial equilibrium quantity. But
equilibrium price remains unchanged.
Price
D0
P0
D1
e0
S0
S1
E1
Q0
Q1
Quantity
Fig. 2.19 Effects of increase in supply and demand by equal proportion.
So far we discussed the relationship between price and quantity demanded in terms of demand
schedule and demand curve. As well, we have seen the relationship between price of a
commodity and quantity supplied in terms of supply schedule and supply curve. Our demand
and supply curves helped us in explaining basic concepts in demand and supply analysis such
as market equilibrium, change in demand, change in quantity demand, change in supply,
change in quantity supply, etc. The supply schedule (curve) or demand schedule (curve) can
also be represented by supply equation or demand equation respectively and can be used to
explain those basic demand and supply concepts we mentioned above.
E.g. if the demand and supply curve equation of a commodity are given by:
𝑄 𝑑 = 250 - 50P and
𝑄 𝑠 = 25 + 25P, respectively, where 𝑄 𝑑 , 𝑄 𝑠 and P are quantity
demanded, quantity supplied and price respectively. The equilibrium price and quantity will
be:
𝑄 𝑑 = Qs at market equilibrium, so
250 - 50P = 25 + 25P
250 - 25 = 25P + 50P
225 = 75P
P=3
𝑄 𝑑 = 250 - 50(3) = 100 = 𝑄 𝑠
Thus, equilibrium price and quantity is 3 and 100 units respectively.
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2.6. Elasticities
The concept of elasticity is widely used in Economics. By elasticity we mean the
responsiveness of dependent variable when the independent variables changes by 1 percent.
Business -people who use economics in decision making is interested in knowing the
responsiveness of the dependent variable (say quantity demanded or quantity supplied) to the
change in any one of the independent variable (say price). In economics, elasticities that are
quite important for the decision making of both consumers and producers are Elasticity of
demand and Elasticity of supply
2.6.1 Elasticity of Demand
Elasticity of demand is defined as a measure of the degree of responsiveness of quantity
demanded (consumers) to the change of determinants of demand. There are three major types
of elasticity of demand:
 Price elasticity of demand
 Income elasticity of demand
 Cross-price elasticity of demand
2.6.1.1. Price Elasticity of Demand
Price elasticity of demand (𝑒𝑑𝑝 ) is also "called elasticity of demand". It is a concept that
measures by how much percent will quantity demanded changes when its price changes by
certain percent, i.e.,
edP
Percentage change in quantity demanded
=
Percentage change in price
%Δ 𝑄
𝑄2−𝑄
1 𝑋100
𝑄1
𝑃2−𝑃
1 𝑋100
𝑃1
=
=
%Δ 𝑃
∆𝑄 𝑑
𝑃
=
𝑋 𝑑
∆𝑃
𝑄
Even though calculation of price - elasticity of demand yields negative value because of the
inverse relationship between quantity demanded and price, for convenience we consider a
positive value in terms of its "absolute value".
The Five Categories of Price Elasticity of Demand
Depending on its magnitude, elasticity of demand can be categorized as follows:
1. Perfectly inelastic demand:: in this case coefficient price elasticity of demand (𝑒𝑑𝑝 ) is zero,
i.e., if demand for the commodity is perfectly inelastic, change in price of the commodity does
not affect quantity demanded and the demand curve is vertical.
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2. Inelastic Demand:: in this case percentage change in quantity demanded is less than
percentage change in price. eg . a change of price by 10%, which caused quantity, demanded
to change only by 5%. Here the value of demand elasticity lies between 0 and 1, i.e. 0 < 𝑒𝑑𝑝 <
1. Graphically it can be shown as follows.
3. Elastic Demand:: When percentage change in quantity demand is greater than percentage
change in price, it is said to be elastic demand. eg change in quantity demand by 10% which
was caused by 5% change in price.
4. Unitary Price Elasticity:: here percentage change in price is equal to percentage in quantity
demanded. e.g. As demand changes by 10% price also changes by 10%.
5. Perfectly Elastic demand:: The percentage change in price is zero but percentage change
in quantity demanded is high. Here elasticity of demand is infinite, 𝑒𝑑𝑝 = 
Linear demand curve and price elasticity of demand
Graphically, elasticity of demand for a straight-line demand curve can be shown as follows:
𝑒𝑑𝑝 = 
Price
D
𝑒𝑑𝑝
>1
𝑒𝑑𝑝 =1
M
𝑒𝑑𝑝 =0
𝑒𝑑𝑝 <1
0
Quantity
Fig.2.20 Demand curve showing price elasticity
Point M is the midpoint of straight-line demand curve. Above the mid point M to the left of M
demand is elastic (i.e., 𝑒𝑑𝑝 > 1). At the midpoint demand is unitary elastic with 𝑒𝑑𝑝 = 1. Below
the midpoint to the left of M demand is in elastic with 𝑒𝑑𝑝 <1.
∆𝑄𝑑
𝑑
Arc Price elasticity (𝑒𝑥𝑦
)=
∆𝑃
𝑃 +𝑃
𝑋 𝑑2 1𝑑
𝑄 +𝑄
2
1
Factors Affecting Price Elasticity of Demand
Elasticity of demand depends on a number of things. Some of them are:
a. Availability and Number of Substitute:: - if a commodity has many substitutes, a change in
price of one substitute will affect quantity demanded of the other substitute highly. The larger
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Chapter Two
Demand, Supply and Elasticity
the number of good substitute products available, the grater the elasticity of demand i.e., a
commodity with many substitutes has larger price elasticity (purposes)
b. Number of Alternative Uses of a Commodity:: If a commodity has many alternative uses it
has high price elasticity of demand, i.e., the higher is the number of alternative uses of a
commodity, the higher is its price elasticity.
c. The Nature of a Commodity (i.e. whether it is luxury or necessity)
If a commodity is a necessity-good, then its, 𝑒𝑑𝑝 is low (inelastic demand) because whatever
price level is, consumers buy almost fixed quantity of this good. If a commodity is nonessential or luxury then it has high price elasticity, because for this commodity a consumer
has an alternative to postpone consumption if price increases, as it is not so essential for daily
activity.
d. Other factors such as size of percentage share of commodity's expenditure in total
expenditure of a consumer, time horizon of consumption, durability of a good, etc can also
affect price elasticity of demand (how? Explain it by yourself).
2.6.1.2 Income Elasticity of Demand
Income elasticity of demand measures percentage change in quantity demanded due to certain
percentage change in income of the consumer (Y).
Percentage change in quantity demanded
edy =
Percentage change in income
%Δ𝑄
𝑄2−𝑄
1 𝑋100
𝑄1
𝑌2−𝑌
1 𝑋100
𝑌1
∆𝑄 𝑑
𝑌
=
𝑋 𝑑
∆𝑌
𝑄
=
=
%Δ𝑌
If income elasticity of demand for certain good is positive, then the good is said to be normal
good. If income elasticity of a commodity is negative, then the good is inferior good.
∆𝑄 𝑑
Arc Income Elasticity (edxy ) =
∆𝑌
𝑌 +𝑌
𝑋 𝑑2 1𝑑
𝑄 +𝑄
2
1
2.6.1.3 Cross Price Elasticity of Demand
Cross price elasticity is used to measure the percentage change in quantity demanded of a
commodity, (say X) due to percentage change in price of the other commodity, (say Y).
Percentage change in quantity demandedof good X
edxy =
Percentage change in price of good y
%Δ𝑄
𝑥
𝑄𝑥
2 −𝑄1 𝑋100
𝑥
𝑄1
𝑦
𝑦
𝑃2 −𝑃1
𝑦 𝑋100
𝑃1
=
=
%Δ𝑌
∆𝑄 𝑑
𝑃𝑦
𝑦
𝑥
= 𝑥 𝑋 𝑦𝑑
∆𝑃
𝑄
Where Qdx is change in quantity demand of good x, ∆𝑃𝑦 Is change in price of good y
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Introduction to Economics
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Demand, Supply and Elasticity
𝑑
𝑒𝑥𝑦
is point cross price elasticity
If goods are related in consumption they are either a substitute or a complementary to each
other. Cross price elasticity can be positive, negative or zero. For a substitute goods cross
price elasticity is positive. For complementary goods cross price elasticity is negative. If
goods have no relation their cross price elasticity of demand is zero.
Table 2.5 Demand schedule for good X and Y
Points
A
B
C
Px
2
4
5
Py
3
5
6
Qx
18
12
10
Qy
13
9
4
𝑑
Cross - elasticity of demand for commodity X i.e. 𝑒𝑥𝑦
as we move from A to B is given by
∆𝑄𝑥𝑑
edxy =
∆𝑃𝑦
∆𝑄𝑥𝑑
edxy =
∆𝑃𝑦
𝑃𝑦
𝑋 𝑦𝑑=
𝑄
12−
12−18
𝑃𝑦
18−
18−12
𝑥
𝑋 𝑦𝑑=
𝑄
𝑥
5−3
3−5
3
−6
3
𝑋 = 𝑋 =
18 2
18
5
−6
5
𝑋 = 𝑋 =
12 2
12
−1
2
−5
4
for movement from A to B
for movement from B to A
2
1
∆Qd
x Py +Py
𝑑
Arc cross - price elasticity (𝑒𝑥𝑦 ) =
∆Py Q2x +Q1x
.
2.6.2 Elasticity of Supply (Reading Assignment)
2.7. Application of Elasticity
The concept of demand elasticity is useful for business-people. If a producer wants to sell
more of his commodity by reducing price then the demand curve for his product must have
elastic demand. If demand for the product is elastic, an increase in price results decrease in
revenue as small percentage change in price causes large decrease in quantity sold.
If a producer faces an inelastic demand curve for his product he can increase his revenue by
increasing price because under this case large percentage increase in price causes little
percentage decrease in quantity demanded. If a producer faces inelastic demand curve, then it
cannot increase its revenue by decreasing price. If demand is unitary, change in price does not
affect total revenue. In this case there is no need of decreasing or increasing price, as it does
not affect total revenue of the producer.
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