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AS Chapter 2: The price system and the micro economy
 Market:
It is the exchange of goods/services or the factors of production (resources). The exchange of
goods/services is called the product market while the exchange of production is called the
factor market.
 Free market
The market for a good/service is said to be a free market if its price and quantity traded is
determined by the free interaction of the forces of market demand and supply. In a free market
the government has no role in determining the prices and quantities of the goods/services.
The free market forces are market demand and market supply which are also referred to as
the invisible hands.
 Demand
It is the quantity of any good/commodity that the buyers are able and willing to buy at various
prices over a period of time, ceteris paribus.
Example: When the price of good x is $10 per unit, its quantity bought by the consumers is 50
units per week. So, demand for good x is 50 units per week.
Demand for a good arises only when the consumers have the ability and willingness to pay for
the good. A consumer’s want to have something without the ability and willingness to pay for it
is not demand; it is a mere wish or desire. A consumer’s wish/desire to have something
becomes his demand if he has the ability and willingness to pay for it. So, an effective demand
is a consumer’s desire to have something that is supported by his ability and willingness to pay
for it.
Table: Demand Schedule
Price of Good X
Quantity demanded
($ per unit)
(Units per week)
10
2
9
3
8
4
7
5
6
6
5
7
4
8
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Fig : Demand curve
 Individual and market demand:
Individual demand is the quantity of a good bought/demanded by an individual buyer at
various prices over a period of time.
Example: If at the price of $10 per unit, the market demand for good x is 50 units/ week and
the quantity demanded by buyer A is 20% of the total market demand then, individual demand
for good x is 10 units/ week.
Market demand
Market demand is the sum of the quantities of a good demanded by all the individual buyers of
the good at various prices over a period of time. It is derived by horizontally adding up or
aggregating the individual demand.
Price of good x
($ per unit)
10
9
8
7
6
5
Table: Individual and market demand schedule
Quantity Demanded (units per week)
Buyer A
Buyer B
Buyer C
Market Demand
1
2
3
6
2
3
4
9
3
4
5
12
4
5
6
15
5
6
7
18
6
7
8
21
Fig: Individual demand curve
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In the above diagram, DD is an individual demand curve. It is negatively sloped (sloping
downward from left to right). This shows that there exists an inverse relationship between the
price of a good and its quantity demanded by an individual buyer. That is, when the price of a
good rises, its quantity demanded by an individual buyer decreases and vice versa.
Fig: Derivation of market demand curve
 Factors affecting demand: Determinants of demand
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
Price of the given good









Taste of the consumers
Prices of related goods (substitutes and complements)
Income of consumers
Number of buyers/ users of the good
Expectation of price and income change
Seasonal change
Government policy
Culture and tradition
Advertisement
Price of the given good [dx= f (Px)]
All other factors being unchanged, when the price of a good rises, its quantity demanded decreases and
vice versa.
Fig: the demand curve
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Total Expenditure (TE) = Price x Qty. demanded
Example, when price=OP, Quantity demanded=OQ
So, TE =OP x OQ
=OPaQ
If P=8 and Qd=12 then,
TE = 8 X12=96
Non-price factors/ determinants of demand
 Taste of consumers/fashion
Demand for a good rises if it is in fashion or preferred by the consumers while its demand decreases if it
goes out of fashion.
 Income of consumers
To analyse the effect of change in consumer’s income on the demand for the good, we classify the
goods as superior or normal goods and inferior goods.
In case of superior or normal goods, as consumers’ income increases, their demand increases and vice
versa.
Fig: Demand for superior/normal goods
In case of inferior goods, an increase in consumers’ income reduces their demand and vice versa.
Fig: Demand for inferior goods
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
Prices of related goods [dx= f(py)]
To analyse the effect of change in price of related goods on the demand for a good, we
classify the goods as substitutes and complements.
In case of substitutes, an increase in the price of one good raises the demand for another good
and vice versa. For example, an increase in price of Pepsi raises the demand for coke and vice
versa
Fig: Alternative demand
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In case of complements, an increase in price of one good reduces the demand for another good
and vice versa. For example, an increase in price of petrol reduces the demand for motorbikes
and vice versa.
Fig: Joint demand
 Number of buyers/ users of the good
An increase in the number of buyers or users of the good increases the demand for the good
and vice versa. For example, an increase in the number of students studying
A Level economics will increase the demand for economics text book and vice versa.
 Expectation of price and income change
If the consumers expect the price of a good to rise in the near future its demand will increase as
the consumers will rush to buy the good and hold in stock before the price rises. While if the
consumers expect the price of the good to fall in the near future, its demand will decrease as
the consumer will postpone their purchase and wait for the price to fall.
Similarly, expectation of income change also affects the demand for the goods. If an economy is
experiencing economic growth, consumers can expect a rise in employment and income. This
will increase the consumer confidence and hence they will consume more. On the other hand,
if the economy is experiencing recession, there will be an atmosphere of pessimism as
employment and income is expected to fall. Thus, there will be lack of consumer confidence
and the demand for goods decreases.
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 Seasonal change
Demand for the goods changes with the change in season/weather. For example, demand for
cold drinks increases in the summer season while their demand decreases in the winter season.
 Culture and tradition
Demand for the goods is also affected by the culture and tradition followed by the people.
For example, demand for fruits, flowers, sweets, dairy products etc. increases during the festive
season.
 Government policy
Demand for a good is also affected by government policy. For example, government policy of
increase in direct taxes (income tax) reduces the disposable income of the consumers which in
turn, reduces the demand for the good. On the other hand, cut in income tax raises the
demand for the good.
 Advertisement
An effective advertisement provides information to the consumers about the good and attracts
the consumers towards the good. This increases the demand for the good.
 ‘Change in quantity demanded’ and ‘change in demand’: movement along
and shift in demand curve
Change in quantity demanded is caused by a change in the price of the good itself, all other
factors remaining unchanged. Change in quantity demanded cause a movement along the
demand curve. An increase in the price of the good reduces the quantity demanded and causes
a leftward movement along the demand curve. This is technically referred to as “contraction of
demand”. On the other hand, a fall in the price of good increases its quantity demanded and
causes a rightward movement along the demand curve. This is referred to as an “expansion of
demand”.
Fig: Change in quantity demanded: movement along the demand curve
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Change in demand is caused by the change in one or all the non-price determinants of demand,
price of the good being unchanged. Change in demand causes a shift in the demand curve. An
increase in demand causes the rightward shift while a decrease in demand causes a leftward
shift in the demand curve. For example, price of economics textbook being unchanged, if there
is an increase in the number of students studying economics; demand for economics textbook
will increase. This will cause the demand curve to shift rightward.
Fig: Change in demand: shift in demand curve
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 Law of demand
The law of demand states that all other things being unchanged; there exist an inverse
relationship between the price of good and its quantity demanded. That is when the price of a
good rises, its quantity demanded decreases and vice versa.
Fig: the demand curve
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 Exceptions of law of demand
 Giffen Goods
Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods are goods that
are inferior in comparison to luxury goods. However, the unique characteristic of Giffen goods
is that as its price increases, the demand also increases. And this feature is what makes it an
exception to the law of demand.
 Veblen Goods
Veblen Goods is a concept that is named after the economist Thorstein Veblen, who introduced
the theory of “conspicuous consumption“. According to Veblen, there are certain goods that
become more valuable as their price increases. If a product is expensive, then its value and
utility are perceived to be more, and hence the demand for that product increases.
And this happens mostly with precious metals and stones such as gold and diamonds and luxury
cars such as Rolls-Royce. As the price of these goods increases, their demand also increases
because these products then become a status symbol.
 The expectation of Price Change
There are times when the price of a product increases and market conditions are such that the
product may get more expensive. In such cases, consumers may buy more of these products
before the price increases any further. Consequently, when the price drops or may be expected
to drop further, consumers might postpone the purchase to avail the benefits of a lower price.
There are also times when consumers may buy and store commodities due to a fear of
shortage. Therefore, even if the price of a product increases, its associated demand may also
increase as the product may be taken off the shelf or it might cease to exist in the market.
 Necessary Goods and Services
Another exception to the law of demand is necessary or basic goods. People will continue to
buy necessities such as medicines or basic staples such as sugar or salt even if the price
increases. The prices of these products do not affect their associated demand.
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 Change in Income
Sometimes the demand for a product may change according to the change in income. If a
household’s income increases, they may purchase more products irrespective of the increase in
their price, thereby increasing the demand for the product. Similarly, they might postpone
buying a product even if its price reduces if their income has reduced. Hence, change in a
consumer’s income pattern may also be an exception to the law of demand.
 Reasons for an inverse relationship between the price of a good and its
quantity demanded

Income effect:
Consumer’s money income being unchanged when there is an increase in the price of a good, real
income (purchasing power) of the consumer decreases. That is, the consumer can buy lower quantity of
the good using the given money income when the price of the good rises. Hence the quantity demanded
of a good falls when its price rises and vice versa.
Let, M= $100
Px= $10/ unit
So, $100/$10= 10 units
Now, M1=$100
Px1=$20/ unit
So, M1/Px1= $100/$20= 5 units
 Substitution effect:
When the price of a good rises, it becomes relatively expensive. So the consumers substitute the
expensive good with the cheaper ones. Hence, the quantity demanded of a good falls when its price
rises and vice versa. For example when the price of Pepsi increases its quantity demanded decreases
because the consumers switch to coke which is now relatively cheaper. It is always the case that the
consumers substitute towards the cheaper products.
 Law of diminishing marginal utility:
According to this law, as the quantity of a good consumed by a consumer increases, the utility
(satisfaction) derived from the successive units (marginal utility) decreases. So, a rational consumer will
not consume the successive units of the good at the same price. He will consume the successive units of
the good only if the price decreases. Hence, the quantity consumed/demanded of a good increases only
when its price decreases.
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Table: Marginal utility derived from a good and the price paid by a consumer
Quantity of good x
Marginal utility
Price paid / value assigned
consumed
( utils/units)
by consumers (in $)
1
8
40
2
6
30
3
4
20
4
2
10
 Types of demand

Direct demand
Demand for the finished products that directly satisfy the human wants is called direct demand.

Indirect or derived demand
Demand for factors of production / resources such as land, labour, capital etc. is called derived demand
as they are demanded for the production of finished goods or services.

Alternative demand
Demand for substitutes is called alternative demand.

Joint demand
Demand for two or more goods to satisfy a single want is called joint demand. For example, demand for
pen, ink and paper to write something.

Composite demand
Demand for a single good to satisfy multiple wants is called composite demand. For example, demand
for electricity for cooking, heating, lighting, cleaning etc.
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 Supply
Supply is the quantity of a good/ commodity that the sellers are able and willing to offer for sale at
various prices over a period of time, ceteris paribus.
Example: When the price of good x is $10 per unit, the sellers are able and willing to sell 50 units per
week. So, supply of good x is 50 units per week.
 Individual and market supply
Individual supply is the quantity of a good that an individual seller of the good is able and willing to sell
at various prices over a period of time, ceteris paribus.
Example: If at the price of good X is $10 per unit, the market supply of good x is 100 units/ week and the
quantity supplied by seller A is 20% of the total market supply then, quantity of good x supplied by seller
A is 20 units/ week.
 Market supply
Market supply is the sum of the quantities of a good supplied by all the individual sellers of the good at
various prices over a period of time. It is derived by horizontally adding up or aggregating the individual
supply.
Price of good x
($ per unit)
2
4
6
8
10
12
Table: Individual and market supply schedule
Quantity Supplied (units per week)
Seller A
Seller B
Seller C
1
2
3
2
3
4
3
4
5
4
5
6
5
6
7
6
7
8
Fig: Individual supply curve
Market Supply
6
9
12
15
18
21
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Fig: Derivation of market supply curve
 Factors affecting / determinants of supply

Price of the given good






Prices of resources
Prices of related goods
Technology
Government policy (taxes and subsidies)
Expectation of price change
Number of sellers
Price of the given good [Sx = f(Px)]
All other things being unchanged, an increase in the price of the given good raises the quantity supplied
of the good and vice versa.
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Fig: the supply curve
Non- price determinants of supply
 Prices of resources
An increase in the prices of resources (FOP) increases the costs of production and reduces the supply of
the goods and vice versa.
 Prices of related goods
In case the goods are in joint supply, an increase in the price of one good raises the supply of another
good and vice versa. For example, an increase in price of goose meat increases the supply of feathers
and vice versa.
 Technology
An improvement in the state of technology increases the supply of the good as the improved technology
enables the firms to produce higher quantity of the goods at lower costs.
 Government policy
An imposition of indirect taxes on the production of goods increases the costs of production and
reduces the supply of the goods and vice versa.
On the other hand, if the government provides subsidies to the producers, the costs of producing the
goods decreases and hence supply increases.
 Expectation of price change
If the sellers expect the prices of the goods to rise in the near future supply will decrease as the sellers
will hold the goods in stock to sell them at higher prices in the future. On the other hand, if the sellers
expect the prices to fall in the near future, supply will increase as the consumers will rush to sell the
goods at the current prices.
 Number of sellers [Sx=f(Ns)]
If the number or sellers of the good increases, supply of the goods will increase and vice versa.
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 Change in quantity supplied and change in supply: Movement along and
shift in supply curve
‘Change in quantity supplied’ is caused by the change in the price of the good itself, all other
factors/determinants remaining unchanged. An increase in the price of a good raises its quantity
supplied and causes a rightward movement along the supply curve. This is technically referred to as
‘expansion of supply’. While a fall in the price of the good reduces its quantity supplied and causes a
leftward movement along the supply curve. This is technically referred to as ‘contraction of supply’.
Fig: Change in quantity supplied
‘Change in supply’ is caused by the change in the non-price determinants of supply, price of the good
being unchanged. For example, price of the good being unchanged, if the number of sellers of the good
increases, its supply will increase. Change in supply causes a shift in supply curve. An increase in supply
causes a rightward shift while a decrease in supply causes a leftward shift in the supply curve.
Fig: Change in supply
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 The law of supply
The law of supply states that, all other factors being unchanged there exists a direct relationship
between the price of a good and its quantity supplied. That is, when the price of a good rises, its
quantity supplied increases and vice versa.
Fig: the supply curve
In the above figure,
When price is OP quantity supplied is OQ. So,
Total Revenue (TR) = Price x quantity sold
= OP x OQ
= OPa Q
 Reasons for a direct relationship between the price of a good
and its quantity supplied

Law of diminishing returns
Diminishing return, also called law of diminishing returns or principle of diminishing marginal
productivity is and economic law stating that if one input in the production of a commodity is increased
while all other inputs are held fixed, a point will eventually reached at which additions of the input yield
progressively smaller, or diminishing, increases in output.
In the classic example of the law, a farmer who owns a given acre of land will find that a certain number
of labourers will yield the maximum output per worker. If he hires more workers, the combination of
land and labour would be less efficient because the proportional increase in the overall output would be
less than the expansion of the labour force. The output per worker would therefore fall. This rule holds
in any process of production unless the technique of production also changes.
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
Incentive of higher profit
If the product cost is given, a higher price means greater profits and thus an incentive to
increase the quantity supplied. Hence, price and quantity supplied are directly related.
 Putting demand and supply altogether: Market in equilibrium and
disequilibrium
Equilibrium is a situation of balance where at least under present circumstances there is no tendency for
change to occur. The market for a product reaches a state of equilibrium when the market demand for
the product becomes equal to the market supply and the demand curve intersects the supply curve. The
price established at the state of market equilibrium is called the equilibrium price (market clearing price)
and the quantity traded (demanded and supplied) is called the equilibrium quantity.
Table: Equilibrium in a free market
Price of PCs($)
2000
1800
1600
1400
1200
1000
800
Quantity demanded of PCs per
day
1000
2000
3000
4000
5000
6000
7000
Quantity supplied of PCs per
day
7000
6000
5000
4000
3000
2000
1000
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Fig: Equilibrium in a free market
 Change in market equilibrium
The market equilibrium changes if there is any change in the market forces of demand and
supply of a good. For example, supply of the good being unchanged if the demand for the good
increases, then the excess demand will cause the equilibrium price to rise.
Fig: Effect of increase in demand on equilibrium price
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Fig: Effect of fall in demand on equilibrium price
Fig: Effect of change in demand on equilibrium price
Fig: Effect of increase in supply on equilibrium price
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Fig: Effect of decrease in price on equilibrium price
Fig: Effect of change in supply on equilibrium price
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Fig: Effect of change in demand and supply on market equilibrium
Note: If the market demand and market supply of the good falls by the same proportion, the
equilibrium price will remain unchanged while the equilibrium quantity decreases.
Fig: Effect of change in demand and supply on market equilibrium
Note: If the supply of the good decreases by an equal proportion as an increase in demand then the
equilibrium quantity will remain unchanged while the equilibrium price increases.
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Fig: Effect of change in demand and supply on market equilibrium
Note: If the demand for a good increases by a higher proportion than an increase in supply then the
excess demand will cause the equilibrium price as well as the equilibrium quantity to rise.
 Typical demand function/ Linear demand curve equation
A typical demand function is given by:
Qd = a – bP
Where,
Qd =Quantity demanded
a = autonomous demand or the quantity demanded if the price were zero (demand
independent of price)
b = change in quantity demanded resulting from a change in price or the inverse of slope of the
𝛥𝑄𝑑
demand curve ( 𝛥𝑝 ). The value of b is always negative because of an inverse relationship
between the price of a good and its quantity demanded.
P= price of the good.
For example, let us take the demand for pizza in a small town in a single day. The demand
function for pizza can be expressed as:
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Qd = 600 – 50P
In the above demand function the value of ‘a’ variable is 600.This is the autonomous demand as
it represents the number of pizzas demanded irrespective of the price. That is, even if the price
is zero, 600 pizzas would be demanded in the town. This value of ‘a’ variable will change if there
is any change in the factors affecting demand for pizza. For instance, if the income of
consumers rises, demand for pizza will increase and the value of ‘a’ variable will increase. This
will cause the demand curve to shift rightward. While a fall in the value of ‘a’ variable will cause
the demand curve to shift to the left.
The value of ‘b’ variable in the demand function is 50 which is the inverse of slope of the
demand curve. It says that if the price of pizza changes (rises or falls) by $1, its quantity
demanded will change (fall or rise) by 50 units. A change in the value of b variable will cause the
slope/steepness of the demand curve to change.
In the above demand function, when the price is zero, 600 pizzas are demanded. This gives us
the x-intercept, the point where the demand curve meets the x- axis. It can also be called the
Q-intercept for demand because quantity demanded is always measured along the x-axis. So
for demand function, Q-intercept for demand is 600.
Let us now assume that the price of pizza is $10. At this price, the quantity demanded is:
Qd =600 – 50(10) = 100
So, at the price of $10, only 100 units of pizza are demanded. According to the law of demand,
a fall in price should increase the quantity demanded of pizza. To test this let us assume that
the price of pizza falls to $8 then,
Qd = 600 – 50(8) = 200
Thus we see that when the price of pizza falls to $8, quantity demanded of pizza increases from
100 units to 200 units. For every $1 fall in price, 50 additional units of pizza are demanded/
sold. This means that the price coefficient of 50 determines the responsiveness of consumers to
the change in price. At lower prices, more pizzas are demanded. For example, at $4 quantity
demanded is:
Qd =600 – 50(4) = 400
Note:
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The ‘a’ variable in the demand function is the autonomous demand or the quantity demanded
when the price is zero. It changes with the change in the determinants of demand. Meanwhile,
the variable ‘b’ demonstrates the law of demand, which says that there is an inverse
relationship between the price of a good and its quantity demanded by consumers. According
to the above demand function, as the price of pizza falls from $10 to $0, the quantity
demanded of pizza rises from 100units to 600 units. So, it is possible to construct both a
demand schedule and demand curve from this demand function.
Table: Linear demand schedule for pizza (a = 600)
Price of pizza (p)/ $
10
9
8
7
6
5
4
3
2
1
0
Quantity demanded per
day(Qd)
100
150
200
250
300
350
400
450
500
550
600
Fig: Linear demand curve for pizza (a=600)
Exercise 1: Using the demand schedule given below, answer the following questions:
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Price of PCs($)
2000
1800
1600
1400
1200
1000
800
Quantity demanded of
PCs
per week
1000
2000
3000
4000
5000
6000
7000
1. How many PCs per week are people willing and able to buy if the price is $1100?
2. What price will persuade people to buy 1350 PCs per week?
Soln-1:
Finding ‘a’ variable
Taking the price range $1800 to $1600
b=
∆𝑄𝑑
∆𝑝
=
1000
200
=5
Qd= a – bp
2000= a – 5(1800)
a=11000
So, at price of $1100, the quantity of PCs that the people are able and willing to buy per week
is,
Qd = 11000 – 5 (1100)
Qd= 5500
 Typical supply function/ linear supply curve equation
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A typical supply function is given by
Qs= C + dP
Where,
QS= Quantity supplied
C = autonomous supply or quantity supplied when price is zero
d= change in quantity supplied caused by the change in the price of the good or inverse of the
∆𝑄𝑠
slope of supply curve ( ∆𝑃 ). The value of d is always positive because of a direct relationship
between the price of a good and its quantity supplied.
P = price of the good
In the above supply function, ‘c’ represents the non-price factors affecting supply and indicates
the quantity supplied when price is zero. Any change in the non-price determinants of supply
will cause the ‘c’ variable to change and the supply curve will shift rightward or leftward. For
example, if the number of firms in the market/ industry increases, then the autonomous level
of supply will increase and the supply curve will shift rightward. The corresponding value of Q s
will increase by the same amount as ‘c’ variable at each price along the supply curve.
The ‘d’ variable is an inverse of the slope of the supply curve or it is the responsiveness of
producers to the change in the price of the good. Any change in the value of d variable will
cause the slope/ steepness of the supply curve to change. For example, if the value of‘d’
variable is 5, then an increase in the price of good by $1 will cause the quantity supplied to
increase by 5 units.
Returning to the market for pizza, let us assume that the supply function of pizza is given by:
Qs = - 200 + 150P
According to the above supply function, if the price were zero, -200 pizzas would be supplied. In
other words, no producers would be able and willing to sell pizzas at a price of zero. To
determine the price at which, producers would begin producing and selling pizzas or to find the
P-intercept/ y-intercept, we set the quantity to zero and solve for P,
0 = -200 + 150P
200=150P
P= 1.33
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At a price of $1.33, producers begin to consider selling pizzas. This is where the supply curve
begins. At any price greater than $1.33, there is a direct relationship between the quantity
supplied and price. For example, if the price of pizza rises to $3 then,
Qs = -200 + 150(3)
=250
If the price rises to $5 then,
QS = -200 + 150(5)
= 550
Now, if the price falls to $4 then,
QS = -200 + 150(4)
= 400
Using the above supply function, it is possible to construct the supply schedule and the supply
curve.
Table: Linear supply schedule for pizza, c = -200
Price of pizza
Quantity supplied
(in $)
per day
10
1300
9
1150
8
1000
7
850
6
700
5
550
4
400
3
250
2
100
1
-50
0
-200
Fig: Linear supply curve, c= -200
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Exercise: Using the supply schedule given below, answer the following questions:
Price of PC($)
Quantity of PCs supplied
per week
800
1000
1000
2000
1200
3000
1400
4000
1600
5000
1800
6000
2000
7000
1. How many PCs per week are companies planning to supply if the price is $1100?
2. What price would persuade companies to supply 1350 PCs?
Soln 1:
d=
∆𝑄𝑠
∆𝑃
=5
Qs= C + dp
2000 = C +5(1000)
C = -3000
So, qty. of PCs that the companies are planning to supply is,
Qs= -3000 + 5(1100)
=2500
Soln. 2:
1350 = -3000 + 5(P)
P = 870
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 Equation of market equilibrium
The equation of market equilibrium is given by:
Qd = Qs
In the example of market for pizza,
Qd = 600 – 50P
Qs = -200 + 150P
To find the equilibrium price, solve for P
600 – 50P = -200 +150P
200P= 800
P =4
To find the equilibrium quantity, plug in the value of P in the demand or supply function
Qd = 600-50P
=600- 50(4)
=400
Qs = -200 + 150(4)
=400
So the equilibrium price is $4 and the equilibrium quantity is 400 units.
32 | P a g e
 Elasticity of demand
It is the responsiveness of consumers to the change in the factors affecting demand like price of
the good, income of consumers, change in prices of related goods etc. It measures to what
extent the demand for the goods changes when there is any change in these factors.
Types of elasticity of demand
 Price elasticity of demand(PED)
 Income elasticity of demand(YED)
 Cross elasticity of demand(XED)
Price elasticity of demand (PED)
It is the measure of change in the quantity demanded of a good caused by any percentage
change in the price of the good, ceteris paribus.
Mathematically,
PED =
=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 ÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑) 𝑥 100
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒)𝑥 100
=
𝜟𝑸𝒅 𝜟𝑷
÷ 𝑷
𝑸𝒅
=
𝜟𝑸𝒅
𝑸𝒅
x
𝑷
𝜟𝑷
=
𝜟𝑸𝒅
𝜟𝑷
x
𝑷
𝑸
Example: 1
Px
Qdx
10(P1) 50(Q1)
20(P2) 40(Q2)
Soln:
33 | P a g e
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
PED =
=
− 𝟐𝟎%
𝟏𝟎𝟎%
= - 0.2 = 0.2˂ 1
Or, PED =
=
𝜟𝑸𝒅
𝜟𝑷
−𝟏𝟎
𝟏𝟎
x
x
𝑷
𝑸
𝟏𝟎
𝟓𝟎
= - 0.2 = 0.2 ˂ 1
Note: The value of PED is always negative because of an inverse relationship between the price of a
good and its quantity demanded but by rule we ignore the negative sign.
Example: 2
Px
20(P1)
25(P2)
PED=
Qdx
50(Q1)
20(Q2)
−𝟔𝟎%
𝟐𝟓%
= - 2.4 = 2.4 ˃1
Interpretation: Since the value of PED is greater than 1, demand for good x is elastic. This means that
quantity demanded changes by a greater percentage than the percentage change in
the price of the good. In the given information, quantity demanded has fallen by 60% in
response to 25% rise in the price of the good.
34 | P a g e
Types of price elasticity of demand

Perfectly elastic demand (PED=Ꝏ)
Demand for a good is said to be perfectly elastic if a small proportionate change in its price causes the
quantity demanded to change infinitely or immeasurably. That is a small proportionate fall in price
causes the quantity demanded to increase infinitely while a small proportionate rise in price causes the
quantity demanded to fall to zero.
Example:
Px
Qdx
10
0
9
Ꝏ
Here,
Ꝏ
PED= 𝟏𝟎 %
=Ꝏ
Fig: Perfectly elastic demand
Note:
If the demand for a good is perfectly elastic, any percentage change in the quantity demanded causes
the total revenue or total expenditure to change by equal proportion.

Perfectly inelastic demand / fixed demand/ zero elasticity (PED=0)
35 | P a g e
Demand for a good is said to be perfectly elastic or fixed if any proportionate change in the price doesn’t
have any effect on the quantity demanded. That is, quantity demanded of the good remains fixed or
unchanged even if its price changes by a very high proportion.
Example:
Px
Qdx
10
50
5
50
Here, PED=
𝟎
𝟐𝟓
=0
Fig: Perfectly inelastic demand
Note:
If the demand for a good is perfectly inelastic, any percentage change in price causes the total
revenue or total expenditure to change by equal proportion.
 Unitary elastic demand (PED=1)
Demand for a good is said to be unitary elastic if any proportionate change in its prices causes the
quantity demanded to change by equal proportion. For example, a 10% increase in the price of the good
causes the quantity demanded to fall by 10% and vice versa.
Example:
Px
Qdx
10
100
15
50
Here, PED =
𝟓𝟎
𝟓𝟎
=1
36 | P a g e
Fig: Unitary elastic demand (PED =1)
 Relatively elastic or elastic demand (PED ˃1)
Demand for a good is said to be relatively elastic or elastic if any proportionate change in its price causes
the quantity demanded to change by a relatively greater proportion. For example, demand for a good is
elastic if a 10% rise in its price causes the quantity demanded to fall by more than 10%.
Example:
Px
Qdx
10
100
12
50
Here, PED =
50%
20%
=2.5 ˃1
Fig: Relatively elastic demand (PED˃1)
37 | P a g e
 Relatively inelastic or inelastic demand (PED ˂1)
Demand for a good is said to be relatively inelastic or inelastic if any proportionate change in its price
causes the quantity demanded to change by a relatively smaller proportion. For example, demand for a
good is inelastic if a 10% rise in its price causes the quantity demanded to fall by less than 10%.
Example:
Px
Qdx
10
100
20
50
50%
Here, PED = 100%
=0.5˂1
Fig: Relatively inelastic demand (PED˂1)
Exercise: Calculate and interpret the value of PED from the given information
Px
Qdx
10
100
8
150
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
PED=
50%
= 20%
=2.5˃1
Interpretation:
Since the coefficient of PED is greater than 1, demand for good x is elastic. In the given information
quantity demanded increases by 50% in response to 20% fall in price.
38 | P a g e
Exercise 2: Calculate and interpret the value of PED from the given information
Px
Qdx
10
100
20
80
PED =
Fig: Types of PED and the demand curves
Worked example:
Using the following diagram, D1 represents the demand for cigarettes, D2 represents the demand for
movie tickets and D3 represents the demand for ice-cream. Find out which good has the most elastic
and which good has the most inelastic demand.
39 | P a g e
Soln;
PED for cigarettes=0.21
PED for movie tickets= 1.14
PED for ice cream=3
Demand for cigarettes is most inelastic (least elastic) while demand for ice cream is most elastic.
 Factors affecting price elasticity of demand
 Number of substitutes of a good
Demand for a good with large number of substitutes is elastic while the demand for a good with few or
no substitutes is inelastic.
 Nature of the good
Demand for the goods of basic necessity such as staple food, fuel, salt etc. and habit forming goods such
as cigarettes, tobacco, alcohol etc. is inelastic while the demand for luxuries and comforts is elastic.
 Proportion of consumer’s income spent on the good
Demand for a good will is elastic if the consumers have to spend a good while demand will be inelastic if
the consumers have to spend only a small proportion of their income on the good.
 Postponement of consumption
Demand for a good will is inelastic if the consumption of the good cannot be postponed. For example,
demand for food, medicine etc. is inelastic as their consumption cannot be postponed. While demand
will be elastic if the consumption of the good can be postponed.
 Number of uses of a good
Demand for a good with large number of uses is elastic while demand for a good with a single use is
inelastic.
 Time
Elasticity of demand for a good is also affected by the time gap between the changes in the price of the
good. If the price of good rises and remain high for a long time then, demand will be elastic. This is
because given a long time; the consumers can find and switch to the substitutes. While demand will be
inelastic if the price of a good rises and fall back to the original within a short period of time.
40 | P a g e
 Measuring PED using total outlay (Total Expenditure) method
Total outlay or total expenditure is the total amount of money spent by the consumers on the good at
different prices. Mathematically,
Total outlay or total expenditure = price x quantity demanded
This method measures the PED by comparing the price of the good with the total expenditure made by
the consumers on the good. This method measures the following three types of PED:
 PED equal to unity / Unitary elastic demand (PED=1)
According to the total outlay method, PED is equal to unity if any change in the price of the good
doesn’t have any effect on the total expenditure. That is, total expenditure doesn’t change with the
change in the price of the good.
Example:
Price of
Quantity
Total expenditure
good x
demanded
(P x Q)
3
4
12
4
3
12
Here, PED=
𝟏
𝜟𝑸𝒅
𝜟𝑷
=𝟏 x
x
𝑷
𝑸
𝟑
𝟒
= 0.75 = 1
Fig: PED equal to unity
41 | P a g e
Note: If the value of total expenditure is the same at all the prices of the good, then the demand curve is
said to be a rectangular hyperbola. This means that the areas of the rectangles below the demand curve
will be the same.
Fig: Rectangular hyperbola demand curve
In the above diagram,
When P= $4, Qd= 3 units
So, TR= $4 x 3
=$12(OP1aQ1)
When price falls to $3 per unit, quantity demanded increases to 4 units.
So, TR =$3 x 4
= $12(OPbQ)
 PED greater than unity / elastic demand (PED˃1)
PED is greater than unity if a fall in the price of the good raises the total expenditure and vice versa.
Example:
Price of good x
10
8
Here, PED =
𝜟𝑸𝒅
𝜟𝑷
x
𝑷
𝑸
𝟓
=𝟐 x
𝟏𝟎
𝟓
Quantity
demanded
5
10
= 5 ˃1
Total expenditure
(P x Q)
50
80
42 | P a g e
Fig: PED greater than unity/ elastic demand
 PED less than unity / inelastic demand (PED˂1)
PED is less than unity if a fall in the price of the good reduces the total expenditure and vice versa.
Example:
Price of good x
Quantity
demanded
5
7
10
5
Here, PED =
𝜟𝑸𝒅
𝜟𝑷
x
𝑷
𝑸
=
𝟐
𝟓
x
𝟏𝟎
𝟓
Total expenditure
(P x Q)
50
35
= 0.8 ˂ 1
Fig: PED less than unity/ inelastic demand
43 | P a g e
 Linear demand curve and the coefficient of PED
Price of
good x
Quantity
demanded
1
10
2
3
9
8
4
7
5
6
6
5
7
4
8
9
3
2
10
1
44 | P a g e
 Business relevance of PED: usefulness of PED in business decision making

An understanding of the concept of PED helps us to understand the likely price volatility
following any change in the supply of the goods. This is important for commodity producers who
may suffer big price movements from time to time. For example, demand for a good being
unchanged, if its supply decreases its price will rise; but the extent to which the price rises
depends on the price elasticity of demand. Rise in price following a fall in supply will be higher in
case of inelastic demand than elastic demand.
Fig: Price volatility following a fall in supply

An understanding of the concept of PED helps us to understand how the firm’s total revenue
(TR) changes if there is any change in the price of the given good.
Fig: Effect of change in price on firm’s total revenue
45 | P a g e

Information on the PED can be used by a business as part of a policy of price discrimination
(also known as ‘yield management’). This is where a business decides to charge different prices
for the same product to different segments of the market e.g. peak and off peak rail travel or
prices charged by many of our domestic and international airlines.

An understanding of the concept of PED helps us to understand the effect of imposition of
indirect taxes on the government’s tax revenue. For example, imposition of indirect taxes
generates tax revenue for the government but the amount of tax revenue received by the
government depends on the price elasticity of demand.
Fig: Effect of imposition of indirect taxes on government’s tax revenue
Tax revenue received by imposing indirect taxes on the good that has inelastic demand (Di) = 15 x 90
=1350(P4abP2)
Tax revenue received by imposing indirect taxes on the good that has elastic demand (De)
=15x80=1200(P3cdP1)
Thus, a government receives higher tax revenue by imposing indirect taxes on the good that has
inelastic demand than the good that has elastic demand.
46 | P a g e
 Income elasticity of demand (YED)
It is the measure of change in demand for a good caused by any change in the income of consumers. In
other words, it is the measure of responsiveness of demand for a good to any change in the income of
consumers.
Mathematically,
YED =
=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 ÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑) 𝑥 100
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒)𝑥 100
=
𝜟𝑸 𝜟𝒀
÷ 𝒀
𝑸
=
𝜟𝑸
𝑸
x
𝒀
𝜟𝒀
=
𝜟𝑸
𝜟𝒀
x
𝒀
𝑸
Example:
Income
(in ‘000)
$20
$25
Demand for
good x
50
60
YED =
𝜟𝑸
𝜟𝒀
x
𝒀
𝑸
=
𝟏𝟎
𝟓
x
𝟐𝟎
𝟓𝟎
Demand for
good Z
50
80
= 0.8 ˃ 0
Interpretation: Since the value of YED is greater than 0, good x has positive YED. That is, an increase in
consumer’s income causes the demand for the good x to rise and vice versa. So, good x is a superior
normal good.
47 | P a g e
Types of YED



Positive YED (YED˃0)
Negative YED (YED˂0)
Zero YED (YED=0)
 Positive YED
YED is positive if an increase in consumer’s income raises the demand for the good and vice versa.
YED is positive in case of superior or normal goods.
Example:
Income
(in ‘000)
$20
$10
YED=
=
𝜟𝑸
𝜟𝒀
−𝟐𝟎
−𝟏𝟎
Demand for
good x
50
30
x
x
𝒀
𝑸
𝟐𝟎
𝟓𝟎
=0.8 ˃ 0
Fig: Positive YED
48 | P a g e
 Negative YED
YED is negative if an increase in consumer’s income reduces the demand for the good and vice versa.
YED is negative in case of inferior goods.
Example:
Income
(in ‘000)
$20
$10
YED=
=
𝜟𝑸
𝜟𝒀
𝟐𝟎
−𝟏𝟎
x
x
Demand for
good x
50
70
𝒀
𝑸
𝟐𝟎
𝟓𝟎
= - 1.25 ˂ 0
Fig: Negative YED
 Zero YED
YED is zero if any change in consumer’s income does not affect the demand for the good. YED may be
zero in case of the goods of basic necessity such as rice, salt etc.
Example:
Income
Demand for
(in ‘000)
good x
$20
50
$10
50
YED=0
49 | P a g e
Fig: Zero YED
Note: Higher the value of YED, higher will be the responsiveness of demand to the change in
consumer’s income.
Worked example:
Income (in thousand)
20
30
Demand for good x
50
40
YED for good x =
−𝟏𝟎
𝟏𝟎
x
𝟐𝟎
𝟓𝟎
= - 0.4
YED for good y=
−𝟑𝟎
𝟏𝟎
x
𝟐𝟎
𝟓𝟎
= - 1.2
Demand for good y
50
20
Interpretation: Since the coefficient of YED for good y is greater than the coefficient of YED for good x
(regardless of positive or negative signs) good Y is more responsive to the change in consumers’ income
than good Y.
Exercise: Calculate and interpret the value of YED from the following information.
Income($)
Demand for good X
$200
70
$150
90
50 | P a g e
Business relevance of YED: Usefulness of YED in making business decision
The concept of YED is of significant use in making business decisions. YED may be positive or negative
depending on the types of goods. YED is positive in case of superior or normal goods. This means that
the demand for superior or normal goods increases when there is an increase in consumer’s income and
vice versa. So, the firms should increase the production of normal goods during the period of normal
economic growth. This is because during the period of normal economic growth employment and
income increases causing the demand for superior/normal goods to increase. On the other hand, the
firms should reduce the production of normal goods during the period of recession. This is because
during recession employment and income decreases causing the demand for normal goods to fall.
YED is negative in case of inferior goods. This means that the demand for inferior goods falls during the
period of normal economic growth while their demand increases during the period of recession. So, the
firms should reduce the production of inferior goods during the period of economic growth and increase
their production during the period of recession.
 Cross elasticity of demand (XED)
XED is the measure of change in demand for a good caused by any change in the price of its related
goods (substitutes or complements). In other words, it is the measure of responsiveness of demand for a
good to the change in the prices of its related goods.
Mathematically,
XEDXY =
=
=
=
=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑔𝑜𝑜𝑑 𝑥
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑦
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑔𝑜𝑜𝑑 𝑥 ÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑔𝑜𝑜𝑑 𝑥) 𝑥 100
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑦÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑦)𝑥 100
𝜟𝑸𝒙
𝑸𝒙
𝜟𝑸𝒙
𝑸𝒙
𝜟𝑸𝒙
𝜟𝑷𝒚
𝜟𝑷𝒚
𝑷𝒚
𝑷𝒚
x 𝜟𝑷𝒚
𝑷𝒚
x 𝑸𝒙
÷
Example:
Price of good y
$20
$10
Demand for good x
50
70
51 | P a g e
XEDXY =
=
𝜟𝑸𝒙
𝜟𝑷𝒚
𝟐𝟎
−𝟏𝟎
x
𝑷𝒚
𝑸𝒙
𝟐𝟎
𝟓𝟎
x
= - 0.8˂ 0
Interpretation: Since the XEDxy is negative, good x and y are complements.
Types of XED:



Positive XED (XED ˃ 0)
Negative XED (XED ˂ 0)
Zero XED (XED = 0)
Positive XED (XED ˃ 0)
XED between two goods is positive if an increase in the price of one good raises the demand for another
good and vice versa. XED is positive in case of substitutes like Pepsi and coke, tea and coffee, bus
travel and rail travel etc.
Example:
Price of good y
$20
$10
XEDxy =
=
𝜟𝑸𝒅𝒙
𝜟𝑷𝒚
−𝟐𝟎
−𝟏𝟎
x
x
Demand for good x
50
30
𝑷𝒚
𝑸𝒙
𝟐𝟎
𝟓𝟎
= 0.8 ˃ 0
Fig: Positive XED
52 | P a g e
 Negative XED (XED˂0)
XED between two good is negative if an increase in the price of one good reduces the demand for
another good and vice versa. XED is negative in case of complements like car and petrol, steel and motor
bike etc.
Example:
Price of good y
$20
$10
Demand for good x
50
60
XEDxy = - 0.4 ˂ 0
Fig: Negative XED
 Zero XED (XED=0)
XED between the two goods is zero if the change in price of one good doesn’t affect the demand for
another good. XED is zero in case of unrelated goods like Pepsi and pen.
Example:
Price of good y
$20
$10
XED XY = 0
Demand for good x
50
50
53 | P a g e
Fig: Zero XED
Note: Higher value of XED shows higher degree of relationship between the goods. That is, higher the
value of XED, more closely the goods is related to each other.
Example:
Price of good X
$10
$15
Demand for good Y
50
60
Demand for good Z
50
100
XEDYX = 0.4
XEDZX = 2.0
Interpretation: Since XEDZX ˃ XEDYX, goods X and Z are more closely related than goods X and Y.
Business relevance of XED: Usefulness of XED in business decision making
The concept of XED is of significant use in making business decisions. XED may be positive or negative
depending on the types of relationship between the goods. XED is positive in case of substitutes like
Pepsi and coke. That is, a fall in price of Pepsi reduces the demand for coke and vice versa.
In such a situation, the firms are highly concerned with the pricing strategy of the rival firms. If a rival
firm cuts the price of its product, a firm must respond by cutting the price of its own product. If a firm
fails to respond to the cut in price by the rival firm, its total revenue and profit will fall as the consumers
will switch to the rival product which has now become relatively cheaper. For example, if Pepsi cuts its
price, coke must respond by cutting its price to prevent the fall in its revenue and profit.
54 | P a g e
In case of complements,the firms are concerned with selling a wide range of complements rather than
selling just a single product. An understanding of the concept of XED helps the firms to identify the
relationship between the goods and formulate such a pricing strategy that increases the firm’s total
revenue and profit. For example, if the firms offer discount prices on movie tickets then, the sale of
movie tickets will increase and at the same time the revenue received from parking charges and the sale
of snacks will increase. This will increase the firm’s total revenue and profit.
Exercise:
Calculate and interpret the value of XED between the goods from the given information.
Price of good X
Demand for good y
20
50
25
30
XEDYX =
−20
5
20
50
x
=-1. 6 ˂ 0
Interpretation: Since the value of XEDYX is negative, good x and y are complements. That is, demand for
good Y has decreased in response to an increase in price of good x.
Price elasticity of supply (PES)
It is the measure of responsiveness of quantity supplied of a good to any % change in the price
of the good.
Mathematically,
PES =
=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑) 𝑥 100
(𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒÷𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒)𝑥 100
=
𝜟𝑸𝒔
𝑸𝒔
=
𝜟𝑸𝒔
𝑸𝑺
=
÷
𝜟𝑸𝒔
𝜟𝑷
𝜟𝑷
𝑷
x
x
𝑷
𝜟𝑷
𝑷
𝑸𝒔
55 | P a g e
Example: 1
Px
QSx
10(P1) 50(Q1)
20(P2) 60(Q2)
Soln:
PES =
=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
20%
100%
= 0.2˂1
𝜟𝑸𝒔
𝜟𝑷
Or, PES =
𝟏𝟎
𝟏𝟎
=
x
x
𝑷
𝑸𝒔
𝟏𝟎
𝟓𝟎
= 0.2 ˂ 1
Note: The value of PES is always positive because of a direct relationship between the price of a good
and its quantity supplied.
Example: 2
Px
Qsx
20(P1) 50(Q1)
25(P2) 80(Q2)
PES=
=
𝟑𝟎
𝟓
𝜟𝑸𝒔
𝜟𝑷
x
x
𝑷
𝑸𝒔
𝟐𝟎
𝟓𝟎
=2.4 ˃1
Interpretation:
Since the value of PES is greater than 1, supply of good X is elastic. That is, any % change in price causes
the quantity supplied to change by a relatively higher %. In the given information quantity supplied of
56 | P a g e
good X increases by 60% in response to 25% increase in price. So, supply of good X is elastic (or 1%
increase in price causes the quantity supplied to increase by 2.4%).
Types of price elasticity of supply

Perfectly elastic supply (PES=Ꝏ)
Supply of a good is said to be perfectly elastic if a small percentage change in its price causes the
quantity supplied to change infinitely or immeasurably. That is, a small proportionate rise in price causes
the quantity supplied to increase infinitely while a small proportionate fall in price causes the quantity
supplied to fall to zero.
Example:
Px
QSx
10
0
11
Ꝏ
Here,
PES = Ꝏ
Fig: Perfectly elastic supply
When P=11 and Qs=10
TR1=110
Now, Qs = 20
TR2 =220
Note: If the supply of a good is perfectly elastic any % change in quantity supplied will cause the firm’s
total revenue to change by equal %.
57 | P a g e

Perfectly inelastic supply / fixed supply / zero elasticity (PES=0)
Supply of a good is said to be perfectly inelastic or fixed if any proportionate change in the price doesn’t
have any effect on the quantity supplied. That is, quantity supplied of the good remains fixed or
unchanged even if its price changes by a very high proportion.
Example:
Px
QSx
10
50
5
50
Here, PES = 0
Fig: Perfectly inelastic supply
When P =10, let Qs= 50
TR1 = P x Q = 500
When ‘p’ increases to 15,
TR2=15 x 50 =750
Note: If supply of a good is perfectly inelastic, any % change in the price of the good will cause the firm’s
TR revenue to change by equal %.
 Unitary elastic supply (PES=1)
Supply of a good is said to be unitary elastic if any proportionate change in its prices causes the quantity
supplied to change by equal proportion. For example, a 10% increase in the price of the good causes the
quantity supplied to rise by 10% and vice versa.
Example:
Px
Qsx
10
100
15
150
58 | P a g e
50%
Here, PES = 50%
=1
Fig: Unitary elastic supply (PES =1)
 Relatively elastic or elastic supply (PES ˃1)
Supply of a good is said to be relatively elastic or elastic if any proportionate change in its price causes
the quantity supplied to change by a relatively greater proportion. For example, supply of a good is
elastic if a 10% rise in its price causes the quantity supplied to rise by more than 10%.
Example:
Px
QSx
10
100
12
150
50%
Here, PES = 20%
=2.5 ˃ 1
Fig: Relatively elastic supply (PES˃1)
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 Relatively inelastic or inelastic supply (PES ˂1)
Supply of a good is said to be relatively inelastic or inelastic if any proportionate change in its price
causes the quantity supplied to change by a relatively smaller proportion. For example, supply of a good
is inelastic if a 10% rise in its price causes the quantity supplied to rise by less than 10%.
Example:
Px
QSx
10
100
20
120
20%
Here, PES = 100%
=0.2 ˂ 1
Fig: Relatively inelastic supply (PES˂1)
Exercise 1: Calculate and interpret the value of PES from the given information and draw a supply curve
to illustrate the type of PES.
Px
10
15
QSx
100
120
20%
=
50%
PES=
0.4< 1
60 | P a g e
Interpretation: Since the coefficient of PES is less than 1, supply of good x is inelastic. This means that
quantity supplied changes by a relatively smaller % in response to any % change in price. In the given
information, quantity supplied increases by only 20% in response to 50% increase in price.
Exercise 2: Calculate and interpret the value of PES from the given information and draw a supply curve
to illustrate the type of PES.
Px
10
6
QSx
100
80
 Difference between elastic, inelastic and fixed supply
 Factors affecting price elasticity of supply
 Firm’s ability to store the goods
Supply of the goods is elastic if the firms can store the goods for a long time and vice versa.
For example the supply of manufactured goods is elastic as they are durable in nature and hence can be
stored for a long time. When their prices fall, the firms hold them in stock and wait for the prices to rise.
On the other hand, supply of the goods that are perishable in nature is inelastic as they can’t be stored
for a long time. For example, supply of agricultural products, dairy products, meat, fish etc. is inelastic as
they are perishable in nature and cannot be stored for a long time.
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 Firm’s ability to increase production/ availability of spare capacity
Supply of the goods is elastic if the firms can easily increase the production of goods in response to an
increase in prices. Firm’s ability to increase production depends on the spare/excess capacity available
with the firms. If the firms have spare/excess capacity, they can easily increase production in response
to increased prices of the goods. On the other hand supply is inelastic if the firm’s don’t have spare
capacity and hence cannot increase production in response to the increased prices.
 Factor mobility
Supply is elastic if the factors of production (labor and capital) are mobile and move freely between
uses. In such a case, if the price of good x increases, the firms can switch the resources from the
production of good y to the production of good x and increase its production in response to the
increased price. On the other hand, supply is inelastic if the factors of production are immobile.
 Time
Supply is elastic if the price of a good rises and remains high for a long time. This is because given a long
time; the firms can manage to increase their productive capacity and increase the production of goods
in response to their increased prices. On the other hand, supply is inelastic if the price of a good rises
and falls back to the original within a short period of time.
 Business relevance of PES: Usefulness of PES in making business decisions
An understanding of the concept of PES helps to understand the price volatility following the change in
the demand for the good and how the firms can respond to the change in the price. For example, supply
of the good being unchanged an increase in demand for the good causes its price to rise. The extent to
which the firms can respond to this increased price depends on the price elasticity of supply.
Fig: Price volatility following an increase in demand for the good
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The above diagram shows that if supply of a good is elastic, an increase in its price will lead to a higher
proportionate increase in supply. So, the firms try to make the supply more elastic so that they can
respond to the increased demand for the good. To make the supply of the goods elastic, the firms have
to consider the following:





Invest in spare capacity which can be used if demand rises.
Paying workers overtime to increase production
Using agencies to hire more workers at busy times.
To outsource production to other firms who can meet supply
Improve efficiency and time management techniques to increase supply.
 Consumer and producer surplus
Consumer surplus is the benefit consumers receive when they pay a price below what they are willing to
pay. In other words, it is the difference between the maximum amount the consumers are willing to pay
and the actual amount they pay for the given quantity of a good.
Consumer surplus = Maximum willingness to pay – actual amount paid / market price
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The concept of consumer surplus can be explained using the following example:
Table: Demand and supply schedule: Good X
Price/ $
25
20
15
10
5
Quantity
demanded(Qd) /
millions
5
15
20
25
30
Quantity
supplied(Qs)
/millions
30
25
20
15
5
In the above schedule, the equilibrium price is $15 at which 20 million units of good x are sold. However,
there are many consumers who are willing to pay more than the market price. For example, at price of
$25, consumers demand 5 million units of good x. These consumers will get an extra benefit of $10 at
each unit of good x consumed because the market price of good x is $15 per unit.
In this case, consumer surplus = price the consumers are willing to pay – actual market price
= $25- $15= $10
The following table shows the calculation of consumer surplus:
Price /$
Quantity
Market price/ $
Specific
(Demand
demanded (Qd) /
consumer
price)
millions
surplus
(Demand pricemarket price)
25
5
15
10
20
15
15
5
15
20
15
0
Fig: Consumer surplus
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In the above diagram,
Consumer’s willingness to pay for OQ quantity of good x= OMEQ
Actual amount paid = OPEQ
So, CS = OMEQ – OPEQ
= PME
Numerically,
CS = area of triangle PME
=0.5 X (15 x 20)
=150
Any change in the price of the good causes the consumer surplus to change. An increase in
price reduces the consumer surplus while a fall in price increases the consumer surplus.
In the above diagram, as the price rises from $15 to $ 20, consumer surplus falls to P1ME1 (75)
while if the price falls to $10, consumer surplus increases to 250.
65 | P a g e
Producer surplus
It is the benefit that accrues to the producers in the competitive markets. Producer surplus is
the benefit producers receive when they receive a price above the one at which they were
willing to supply the good. In other words, it is the difference between the actual market price
and the minimum price at which the producers are willing to sell the product.
Mathematically,
Producer surplus = Actual market price – minimum acceptable price
As seen in the demand and supply schedule, even at the lowest price some producers are
willing to produce the product. It might be because they are very efficient. For example, at a
price of $5, they would produce 5 million units of the product. However, for every unit
produced, they would receive $15 as it is the price prevailing in the market. Therefore, they
enjoy a producer surplus of $10($15- $5) per unit.
The following table shows the calculation of producer surplus
Table: Calculating producer surplus
Price
/$(supply
price)
15
10
5
Quantity
supplied(Qs) /
millions
20
15
5
Market price/ $
15
15
15
Fig: Producer Surplus
Producer
surplus
(market pricesupply price)
0
5
10
66 | P a g e
Consumer surplus + producer surplus = community surplus
In this example, community surplus is $300 million. It is shown in the following diagram:
Fig: community surplus
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 Function / role of price in a market economy
In a market economy price acts as an allocative, rationing and signaling mechanism.
As an allocative mechanism, the function of price is to guide the allocation of resources
between alternative uses. In a market economy, the private enterprises are guided by profit
motive. They allocate the scarce resources to produce those goods that yield the maximum
profit. The amount of profit generated form the production of any product depends on the
market price of the product. All other things being unchanged, higher the price of the product,
higher will be the profit and vice versa.
As a rationing mechanism the function of price is to restrict/ reduce quantity demanded of
some goods by some consumers. Price may act as a rationing mechanism with or without the
government intervention in the market. For example, if the firms have limited production
capacity, they may restrict the quantity demanded of their products by keeping their prices
high. At higher prices the quantity demanded of the goods by some consumers is reduced and
thus rationing occurs. This is the reason why the producers of luxurious cars, designer clothes,
exclusive furniture etc. keep the prices of their products high.
The governments may also use the price to ration the quantity demanded of some goods by the
consumers. For example, government imposes indirect taxes on demerit goods like cigarettes,
tobacco, alcohol etc. to restrict the quantity demanded of these products. Imposition of
indirect taxes raises the price of these products and their quantity consumed is reduced. Thus
rationing occurs.
Government may also use minimum pricing (price floor) to reduce the quantity demanded of
some goods. The effective minimum price is set above the equilibrium price. This setting of
minimum price reduces the quantity demanded, although the quantity supplied of the good
increases.
Fig: Effect of minimum price
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As a signaling mechanism, the function of price is to provide signals / information to consumers and
producers to adjust consumption and production with the change in market conditions. For example,
supply of a good being unchanged if its demand increases, the excess demand will put pressure on the
price to rise. This rise in price provides signals to consumers to reduce consumption and to the
producers to increase production.
Fig: role of price as a signaling mechanism
Fig: Role of price as a signaling mechanism in the resource market
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