Demand, supply and elasticity

Demand and supply

• Demand falls as price rises (law of demand). Shifts are caused by income, prices of related goods (substitutes, complements), tastes, population and expectations.
• Supply rises with price. Shifts are caused by costs of production, technology, weather (important for agriculture), taxes and subsidies.
• Equilibrium is where demand equals supply; excess demand pushes price up and excess supply pushes it down.

Elasticities

• Price elasticity of demand (PED) = %ΔQd ÷ %ΔP. Elastic if |PED| > 1; inelastic if < 1.

- Determinants: availability of substitutes, proportion of income, necessity vs luxury, time period.

- Revenue: if demand is elastic, a price cut raises total revenue; if inelastic, a price rise raises revenue.

• Income elasticity of demand (YED) = %ΔQd ÷ %ΔY: positive for normal goods (luxuries > 1), negative for inferior goods.
• Cross elasticity (XED) = %ΔQd of A ÷ %ΔP of B: positive for substitutes, negative for complements.
• Price elasticity of supply (PES) = %ΔQs ÷ %ΔP, depending on time, spare capacity and stocks.

Consumer and producer surplus

Consumer surplus is the difference between what consumers are willing to pay and what they pay; producer surplus is the difference between price received and the minimum acceptable price.

Check yourself

1. A 10% rise in income raises demand for a good by 25%. Find YED and classify the good.
2. What sign does cross elasticity have for complements?
3. Why is demand for fuel price inelastic in the short run?