Unit 2: Market Forces

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Laws of Demand and Supply, Determinants of Demand/Supply

The Law of Demand

The Law of Demand states that, ceteris paribus (all other factors being equal), as the price of a good increases, the quantity demanded for that good decreases, and vice versa.

This shows an inverse relationship between price and quantity demanded, which is why the demand curve slopes downwards from left to right.

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Determinants of Demand (Factors that Shift the Demand Curve)

A change in price causes a movement along the demand curve. A change in any other determinant causes a shift of the entire curve (Increase = shift right; Decrease = shift left).

• Income of the Consumer:
  • Normal Goods: Income increases → Demand increases (shifts right).
  • Inferior Goods: Income increases → Demand decreases (shifts left).
• Prices of Related Goods:
  • Substitutes: Goods used in place of each other (e.Opening-line. Coke & Pepsi). Price of Coke increases → Demand for Pepsi increases (shifts right).
  • Complements: Goods used together (e.g., Car & Petrol). Price of Car increases → Demand for Petrol decreases (shifts left).
• Tastes and Preferences: If a good becomes more fashionable, its demand increases.
• Future Expectations: If you expect the price to rise in the future, your demand today will increase.
• Number of Buyers (Market Size): More buyers in the market lead to higher market demand.

The Law of Supply

The Law of Supply states that, ceteris paribus, as the price of a good increases, the quantity supplied of that good also increases, and vice versa.

This shows a direct relationship between price and quantity supplied, which is why the supply curve slopes upwards from left to right. (Higher prices give producers a greater incentive to produce more).

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Determinants of Supply (Factors that Shift the Supply Curve)

A change in price causes a movement along the supply curve. A change in any other determinant causes a shift of the entire curve (Increase = shift right; Decrease = shift left).

• Input Prices (Cost of Production): Cost of raw materials or labor increases → Supply decreases (shifts left).
• Technology: Improved technology makes production cheaper/faster → Supply increases (shifts right).
• Government Policies:
  • Taxes: A tax on production increases costs → Supply decreases.
  • Subsidies: A subsidy reduces costs → Supply increases.
• Future Expectations: If producers expect prices to rise in the future, they may decrease supply today (to sell more later).
• Number of Sellers: More firms entering the market → Supply increases.

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Exceptions to Law of Demand, Market Demand, and Market Supply

Exceptions to the Law of Demand

In some rare cases, a rise in price leads to a rise in quantity demanded. This results in an upward-sloping demand curve. These exceptions are:

1. Giffen Goods: These are highly inferior goods (like a basic staple food in a very poor community). If the price of this good (e.g., cheap rice) rises, poor consumers may not be able to afford more expensive foods (like meat or vegetables). So, they cut back on the expensive foods and buy more of the cheap rice to survive. Here, the (negative) income effect is stronger than the substitution effect.
2. Veblen Goods (Conspicuous Consumption): These are luxury goods or status symbols (e.g., diamonds, luxury cars, designer bags). For these goods, a higher price makes them more desirable as a status symbol, so demand increases.
3. Expectation of Future Price Rise: If consumers expect the price of a good to rise even further in the future, a price rise today may lead them to buy more now to "stock up."
4. Emergencies: In times of war, famine, or natural disasters, people may buy more of a good even at a higher price out of fear of non-availability.

Market Demand

Market Demand is the total quantity of a good or service that all consumers in a market are willing and able to buy at various prices. It is derived by the horizontal summation of all individual demand curves.

Example: If at $5, Consumer A demands 2 units and Consumer B demands 3 units, the market demand at $5 is 2 + 3 = 5 units.

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Market Supply

Market Supply is the total quantity of a good or service that all producers in a market are willing and able to sell at various prices. It is derived by the horizontal summation of all individual firms' supply curves.

Example: If at $10, Firm X supplies 50 units and Firm Y supplies 60 units, the market supply at $10 is 50 + 60 = 110 units.

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Market Equilibrium

What is Equilibrium?

Market Equilibrium is a situation where the market "clears." It is the point where the quantity demanded (Qd) by consumers equals the quantity supplied (Qs) by producers.

• The price at which this occurs is the Equilibrium Price (P*).
• The quantity at which this occurs is the Equilibrium Quantity (Q*).

Graphically, this is the point where the demand curve and the supply curve intersect.

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Market Disequilibrium

1. Excess Supply (Surplus):
   • Occurs when the market price is above the equilibrium price (P > P*).
   • Quantity supplied is greater than quantity demanded (Qs > Qd).
   • Producers cannot sell all they want at this high price, so they will lower the price to attract buyers, moving the market back towards equilibrium.
2. Excess Demand (Shortage):
   • Occurs when the market price is below the equilibrium price (P < P*).
   • Quantity demanded is greater than quantity supplied (Qd > Qs).
   • Too many buyers are chasing too few goods. This allows producers to raise the price, moving the market back towards equilibrium.

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Elasticity of Demand: Meaning, Types, and Measurement

Meaning of Elasticity of Demand

Elasticity of Demand measures the responsiveness or sensitivity of the quantity demanded of a good to a change in one of its determinants. While the law of demand tells us the direction of the change (if P increases, Qd decreases), elasticity tells us how much Qd changes.

Types of Elasticity of Demand

There are three main types:

1. Price Elasticity of Demand (PED): Measures responsiveness of Qd to a change in the good's own price.
2. Income Elasticity of Demand (YED): Measures responsiveness of Qd to a change in consumer income.
3. Cross-Price Elasticity of Demand (XED): Measures responsiveness of Qd of Good A to a change in the price of Good B.

1. Price Elasticity of Demand (PED)

This is the most common type. It is calculated as:

PED = (% Change in Quantity Demanded) / (% Change in Price)

Note: PED is (almost) always negative due to the law of demand. However, we usually ignore the negative sign and use the absolute value to describe the degree of elasticity.

Degrees (Types) of Price Elasticity

Type	Value (Absolute)	Meaning	Shape of Demand Curve	Example
Perfectly Inelastic	PED = 0	Qd does not change at all when P changes.	Vertical	Life-saving medicine (e.g., insulin)
Inelastic	0 < PED < 1	% Change in Qd is less than % Change in P. (Insensitive)	Steep	Necessities (e.g., salt, petrol, electricity)
Unitary Elastic	PED = 1	% Change in Qd is exactly equal to % Change in P.	Rectangular Hyperbola	(Theoretical midpoint)
Elastic	1 < PED < ∞	% Change in Qd is greater than % Change in P. (Sensitive)	Flat	Luxuries (e.g., sports cars, foreign holidays)
Perfectly Elastic	PED = ∞ (Infinity)	Any price increase causes Qd to drop to zero.	Horizontal	(Theoretical case of Perfect Competition)

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Measurement of Price Elasticity of Demand

• a) Percentage Method: Uses the main formula: PED = [ (Q2 - Q1) / Q1 ] / [ (P2 - P1) / P1 ]

  Problem: This gives different answers if you move from A to B vs. B to A. To solve this, we use the Mid-point method.

• b) Mid-point (or Arc) Method: This is the most common and accurate method. PED = [ (Q2 - Q1) / ((Q1+Q2)/2) ] / [ (P2 - P1) / ((P1+P2)/2) ]
• c) Total Outlay (Total Expenditure) Method: This method compares Total Expenditure (TE = Price × Quantity) before and after the price change.
  • If P increases and TE increases → Inelastic (P dominant).
  • If P increases and TE decreases → Elastic (Q dominant).
  • If P increases and TE stays the same → Unitary Elastic.
• d) Geometric (Point) Method: Used to find elasticity at a single point on a linear demand curve. PED at a point = (Lower segment of the demand curve) / (Upper segment of the demand curve)

2. Income Elasticity of Demand (YED)

YED = (% Change in Quantity Demanded) / (% Change in Income)

• Normal Goods: YED > 0 (positive). Income rises, demand rises.
  • Luxuries: YED > 1 (Income elastic).
  • Necessities: 0 < YED < 1 (Income inelastic).
• Inferior Goods: YED < 0 (negative). Income rises, demand falls. (e.g., public transport, cheap grains).

3. Cross-Price Elasticity of Demand (XED)

XED = (% Change in Qd of Good X) / (% Change in Price of Good Y)

• Substitutes: XED > 0 (positive). Price of Pepsi (Y) rises, demand for Coke (X) rises.
• Complements: XED < 0 (negative). Price of cars (Y) rises, demand for petrol (X) falls.
• Unrelated Goods: XED = 0. Price of cars (Y) rises, demand for milk (X) stays the same.

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Determinants of Elasticity of Demand

What makes the demand for a good elastic or inelastic? The key factors are:

1. Availability of Close Substitutes: (Most important factor!)
   • Many substitutes (e.g., brands of cereal) → Elastic Demand. (If one price rises, people easily switch).
   • Few substitutes (e.g., salt, petrol) → Inelastic Demand.
2. Nature of the Good (Necessity vs. Luxury):
   • Necessities (e.g., food, electricity) → Inelastic Demand. (You need them regardless of price).
   • Luxuries (e.g., jewelry, vacations) → Elastic Demand. (You can easily cut back if the price rises).
3. Proportion of Income Spent:
   • Small proportion (e.g., a matchbox) → Inelastic Demand. (A 50% price rise is still tiny, so you don't care).
   • Large proportion (e.g., rent, a car) → Elastic Demand. (A small % change has a big impact on your budget).
4. Time Horizon:
   • Short Run → Inelastic Demand. (If petrol prices spike, you still have to drive to work tomorrow).
   • Long Run → Elastic Demand. (Given time, you can buy a more fuel-efficient car, move closer to work, or use public transport).
5. Definition of the Market:
   • Broad market (e.g., "Food") → Inelastic Demand. (No substitutes for food).
   • Narrow market (e.g., "McDonald's burgers") → Elastic Demand. (Many substitutes, like Burger King or KFC).
6. Habit-forming Goods: (e.g., cigarettes, alcohol) → Inelastic Demand due to addiction.