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Course Name: Microeconomics

Chapter note
Prepared by SM Nahidul Islam
Dept. of Finance & Banking
Islamic University, Kushtia.
Chapter 2: Demand and Supply analysis
Questions at a glance:
1.
2.
3.
4.

What do you mean by demand? state the law of demand


What is Demand Schedule and demand curve?
Describe Market demand.
Describe the factors or determinants of demand curve or Factors that cause shift in the
demand curve.
5. Why does demand curve slop downward from left to the right.
6. Define supply & state the low of supply
7. Describe the factors or determinants of supply curve or Factors that cause shift in the supply
curve.
8. Describe the shifts in both demand and supply
9. Explain why a situation of excess demand will result in an increase in the market price. Why
will a situation of excess supply result in a decrease in the market price?
10. Define elasticity & elasticity of demand & Why Economists Use Elasticity
11. Define price elasticity of demand & state the different types of elasticity of demand
12. Factors influencing the price elasticity of demand
13. Describe the income elasticity of demand
14. Define cross price elasticity of demand & what does the sign of the cross-price elasticity of
demand between two goods tell us about the nature of the relationship between those goods?
15. What are the differences between elastic demand and inelastic demand?
16. Explain why the price elasticity of demand varies along a linear demand curve.
17. Describe the Arc elasticity measure.
18. Describe the price elasticity of supply & what factors affect the elasticity of supply?
19. What do you mean by perfectly elastic supply and perfectly inelastic supply?
20. Explain why a good with a positive price elasticity of demand must violate the law of demand.

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

1. What do you mean by demand? state the law of demand


Answer: The demand for a good or service is defined to be the relationship that exists between the price
of the good and the quantity demanded in a given time period, ceteris paribus. Everybody has a lot of
desires. All desires are not demand. Any desire may change into demand after completion the basic three
conditions.
Desire
Ability to pay
Willingness to pay
In addition to above tree conditions other factor are necessary to define the concept of demand whose are:
Price
Place
Period
In absence of any above condition desire may not be a demand.
In the economy over a period of time other things (taste, habit, income, prices of complement,
population, rate of interest on higher purchase etc) remain constant if price increase of good X, demand
decreases, if price decreases demand increases of good X. This inverse relationship shows the law of
demand.

2. What is Demand Schedule and demand curve?


Answer: Tabular representation of the relationship between price and demand is called demand schedule.
It indicates that when Price of goods X increases than Demand decreases and when Price decreases than
Demand of goods X increases.

Figure: Demand Schedule


Demand Curve is the graphical representation of demand schedule. The demand curve simply
shows how the quantity purchased varies with the variation in price.

Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

3. Describe Market demand.


Answer: The market demand consists of the total quantity demanded by each individual in the market.
Conceptually, the market demand curve is formed by computing the horizontal summation of the
individual demand curves for all consumers. The following diagram illustrates a simple case in which
there are only two consumers, Person A and Person B. Notice that the total quantity demanded in the
market is just the sum of the quantities demanded by each individual. In this diagram, Person A wished to
buy 10 of this commodity and person B wishes to buy 15 units when the price is $3. Thus, at a price of $3,
the total quantity demanded in the market is 25 (=10+15) units of this commodity.

4. Describe the factors or determinants of demand curve or Factors that cause shift in the
demand curve.
Answer: The factors that cause shift in the demand curve are given below:
1. Price of goods: price is the most important determinate for changing demand of goods. If price
increase the demand falls but if the price decrease then the demand increase.

Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
2. The price of related goods: Goods may be related in consumption as either
Substitute goods
Complementary goods
Substitute goods: A rise in the price of substitute goods increases the demand for the other goods and
shifting the demand curve to the right. For an example is coffee and tea.

Above the diagram illustrates the effect of an increase in the price of coffee. A higher price of
coffee reduces the quantity of coffee demanded, but increases the demand for tea.
Complementary goods: A rise in the price of complementary goods decreases the demand for other
goods and shifting the demand curve to the left. For an example is DVDs and DVD players.

Above the diagram illustrates the effect of an increase in the price of DVDs. Note that an increase in the
price of DVDs would reduce both the quantity of DVDs demanded and the demand for DVD players.
3. Consumers Income: An increases in income will Increase demand (Shift the curve rightward) for a normal good.
Decrease demand (Shift the curve leftward) for an inferior good.
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
4. Consumers taste, habits and preferences: Consumers preferences tastes and habits change the
demand.
Example: A Consumers habits of taking tea. So then increase the demand of sugar and milk.
5. The number of consumers: Consumers of a country is the main market for the economic
institution. So the number of consumers increase then the demand of goods will increase.
6. Expectations of future prices: An expectation that price will rise or fall in the future shifts the
current demand curve rightward of leftward.

5. Why does demand curve slop downward from left to the right.
Answer: Demand curve slopes downward from left to right for the following reasons:
1. Low of diminishing marginal utility: According to this law the amount of good consumed
increases, the marginal utility of that good tends to diminish for this inverse relationship between
consumption and marginal utility, demand curve slope downward to the right.
2. Law of demand: According to this law if price increases of goods demand decreases, price
decreases demand increases of goods. For this inverse relationship between price and demand,
demand curve slopes downward to the right.
3. Substitute effect: when the prices of a good increased, the consumer will substitute other similar
goods for it. In this cases, the demand of that goods decreases and the demand curve slope
downward.
4. Income effect: A consumer purchases goods and services at various levels of incomes. If the price
of the goods and services increases then the real income of consumer decreases. Also, if the price
decreases then the real income increases. It is called income effect.

6. Define supply & state the low of supply


Answer: Supply is the relationship that exists between the price of a good and the quantity supplied in
a given time period, ceteris paribus. For example - In 2013 UK farmers sold 10 million tones of
potatoes at an average process of $500 per tones from their stock of 15 million tones, thus 10 million
tones was the supply.
In the economy other things (Technology, prices of raw material, Factors of production, tax,
Subsidy, weather, government policy etc) over a period of time remain constant price of good
increases supply increases, price decreases supply also decreases this direct relationship between price
and supply shows the law of supply.

7. Describe the factors or determinants of supply curve or Factors that cause shift in the
supply curve.
Answer: The factors that can cause the supply curve to shift include the followings:
1. The price of resources: An increase in the price of resources reduces the profitability of
producing the good or service. This reduces the quantity that suppliers are willing to offer for sale
at each price. Thus, an increase in the price of labor, raw material, capital, or other resource, will
be expected to result in a leftward shift in supply as illustrated belowIslamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

2. Technology and productivity: Technological improvements and changes that increase the
productivity of labor result in lower production costs and higher profitability. Supply increases in
response to this increase in the profitability of production as illustrated below-

3. The expectations of producers: As in the case of demand, expectations can play an important
role in supply decisions. If, for example, the expected future price of a gasoline rises, refiners may
decide to supply less today so that they can stockpile gas for sale at a later date. Conversely, if the
expected future price of a good falls, current supply will increase as sellers try to sell more today
before the price declines.
4. The number of producers: An increase in the number of producers results in an increase (a
rightward shift) in the market supply curve as illustrated below-

Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
5. The prices of related goods and services: The supply decision for a particular good is affected
not only by the price of the good, but also by the price of other goods and services the firm may
produce. For example, an increase in the price of corn may induce a farmer to reduce the supply of
wheat. In this case, an increase in the price of one product (corn) reduces the supply of another
product (wheat).

8. Describe the shifts in both demand and supply


Answer: Let's examine what happens if demand or supply changes. First, let's consider the effect of an
increase in demand. As the diagram below indicates, an increase in demand results in an increase in the
equilibrium levels of both price and quantity.

A decrease in demand results in a decrease in the equilibrium levels of price and quantity as illustrated
below -

An increase in supply results in a higher equilibrium quantity and a lower equilibrium price.

Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

Equilibrium quantity will fall and equilibrium price will rise if supply falls as illustrated below -

9. Explain why a situation of excess demand will result in an increase in the market price.
Why will a situation of excess supply result in a decrease in the market price?
Answer: Excess demand occurs when price falls below the equilibrium price. In this situation, consumers
are demanding a higher quantity than is being made available by suppliers. This creates pressure for the
price to increase sellers can ask for higher prices and still find buyers, and buyers offer higher prices to
secure the units they want. As the price increases, quantity demanded will fall as quantity supplied
increases returning the market to equilibrium.
Excess supply occurs when price is above the equilibrium price. Suppliers have made available
more units than consumers are willing to purchase at the high price. This creates pressure for the price to
decrease buyers can get away with paying less because sellers are happy to find a buyer at all, and
sellers are willing to sell for less wanting to make sure they find a buyer. As the price decreases, the
quantity demanded will go up while at the same time the quantity supplied will decrease, returning the
market to equilibrium.
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

10. Define elasticity & elasticity of demand & Why Economists Use Elasticity
Answer: Elasticity is a measure of the degree of sensitivity (or responsiveness) of one variable to changes
in another variable. In other words, it is the measurement of the percentage change in one variable that
results from a 1% change in another variable.
Elasticity of demand means the responsiveness demand due to the change in price, income and
price of others good.
Economists use elasticity for the following reasons
a. An elasticity is a unit-free measure.
b. By comparing markets using elasticities it does not matter how we measure the price or the
quantity in the two markets.
c. Elasticities allow economists to quantify the differences among markets without standardizing the
units of measurement

11. Define price elasticity of demand & state the different types of elasticity of demand
Answer: Price elasticity of demand is the measure of sensitivity of quantity demanded to a change in the
price of a good. Notice that price elasticity of demand will always be expressed as positive number (since
the absolute value of a negative number is always positive). The price elasticity of demand, defined as:
price elasticity of demand (Ed) =
Different types of price elasticity of demand are given below:
Value of price elasticity
of demand
0
between 0 and -1
-1
between 1 and
-

Classification

Meaning

Perfectly inelastic demand

Quantity demanded is completely insensitive to


price.
Quantity demanded is relatively insensitive to
price.
Percentage increase in quantity demanded is
equal to percentage decrease in price.
Quantity demanded is relatively sensitive to
price.
Any increase in price results in quantity
demanded decreasing to zero, and any decrease
in price results in quantity demanded increasing
to infinity.

Inelastic demand
Unitary elastic demand
Elastic demand
Perfectly elastic demand

12. Factors influencing the price elasticity of demand


Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Answer: The price elasticity of demand for a particular demand curve is influenced by the following
factors:
1. Availability of substitutes: the greater the number of substitute products, the greater the elasticity.
2. Degree of necessity or luxury: luxury products tend to have greater elasticity than necessities.
Some products that initially have a low degree of necessity are habit forming and can become
necessities to some consumers.
3. Proportion of income required by the item: products requiring a larger portion of the
consumers income tend to have greater elasticity.
4. Time period considered: elasticity tends to be greater over the long run because consumers have
more time to adjust their behavior to price changes.
5. Permanent or temporary price change: a one-day sale will result in a different response than a
permanent price decrease of the same magnitude.
6. Price points: decreasing the price from $2.00 to $1.99 may result in greater increase in quantity
demanded than decreasing it from $1.99 to $1.98.

13. Describe the income elasticity of demand


Answer: The elasticity of demand with respect to a consumers income is called the income elasticity.
The income elasticity of demand, defined as:

a. When the income elasticity of demand is positive (normal good), consumers increase their
purchases of the good as their incomes rise (e.g. automobiles, clothing).
b. When the income elasticity of demand is greater than 1 (luxury good), consumers increase their
purchases of the good more than proportionate to the income increase (e.g. ski vacations).
c. When the income elasticity of demand is negative (inferior good), consumers reduce their
purchases of the good as their incomes rise (e.g. potatoes).
For example:

Yed = - 0.6: Good is an inferior good but inelastic a rise in income of 3% would lead to demand
falling by 1.8%.
Yed = + 0.4: Good is a normal good but inelastic a rise in incomes of 3% would lead to
demand rising by 1.2%.
Yed = + 1.6: Good is a normal good and elastic a rise in incomes of 3% would lead to demand
rising by 4.8% .
Yed = - 2.1: Good is in inferior good and elastic a rise in incomes of 3% would lead to a fall in
demand of 6.3%

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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

14. Define cross price elasticity of demand & what does the sign of the cross-price elasticity
of demand between two goods tell us about the nature of the relationship between those
goods?
Answer: The cross-price elasticity of demand is a measure of the responsiveness of a change in the price
of a good to a change in the price of some other good. The cross-price elasticity of demand between the
goods j and k can be expressed as:

Notice that this cross-price elasticity measure does not have an absolute value sign around it. In fact, it
can be positive or negative.
When the cross-price elasticity is positive we have
% QA
0
% PB

QA

PB

Either a) both
and
increased or b) they both decreased. Since they are moving in the same
direction, the product must be substitutes. Take coffee and tea for example; if the price of tea increases,
the quantity of coffee demanded will increase.

QA

PB

When the cross-price elasticity is negative,


and
are moving in the opposite direction,
implying the products are complements. Take coffee and cream for example; if the price of cream
increases, the quantity of coffee demanded will decrease.

15. What are the differences between elastic demand and inelastic demand?
Answer: The main differences between an elastic demand and an inelastic demand have been
explained in details as follows:
Topics
Definition

Curve
Related
Found

Coefficient

Elastic Demand
Inelastic Demand
When a small change in price brings When a big change in price brings about less
about more than proportionate than proportionate change in demand, it is
change in demand, it is known as the known as inelastic demand.
elastic demand.
The demand curve is flatter
The demand curve is steeper
Luxuries and comforts have elastic Necessary items can be termed as inelastic
demand.
demand
Perfectly elasticity of demand is not Perfectly inelasticity of demand is seen in the
practical, while relative elasticity is demand of necessary goods, while relative
seen I case of moderately priced inelasticity is seen in case of very expensive
goods.
goods.
The coefficient of elasticity of The coefficient of elasticity of demand is less
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Example

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
demand is greater than 1, than it than 1, than it Ed<1.
Ed>1
Example of elastic demand are color Example of inelastic demand are salt, rice,
T.V. sets prestige goods, etc.
food grains, etc.

16. Explain why the price elasticity of demand varies along a linear demand curve.
Answer: we can note that elasticity declines continuously along a linear demand curve. The top
portion of the demand curve will be highly elastic and the bottom is highly inelastic. In between,
elasticity gradually becomes smaller as price declines and quantity rises. At some point, demand
changes from being elastic to inelastic. The point at which that occurs, of course, is the point at which
demand is unit elastic. This relationship is illustrated in the diagram below.

17. Describe the Arc elasticity measure.


Answer: Arc elasticity measure means when elasticity is calculated between two points on the same
demand curve. Suppose that we wish to measure the elasticity of demand in the interval between a
price of $4 and a price of $5. In this case, if we start at $4 and increase to $5, price has increased by
25%. If we start at $5 and move to $4, however, price has fallen by 20%. Which percentage change
should be used to represent a change between $4 and $5? Under this approach, the price elasticity
formula becomes:

Where,

Islamic University, Kushtia

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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the
from $3 to $5. The arc elasticity measure is given by:

price rises

In this interval, demand is inelastic (since Ed < 1).

18. Describe the price elasticity of supply & what factors affect the elasticity of supply?

Answer: The price elasticity of supply is the measure of the responsiveness in quantity supplied to a
change in price for a specific good. The price elasticity of supply is defined as:

Factors affecting the elasticity of supply:


1. Time: In the short run firms will only be able to increase input of labour to increase supply of
commodities may not be able to increase the supply in response to the price change but the supply
change will be little because other factors of production may not be increased in the same
proportion and may limit the supply. However, in the long run a firm will increase the input of all
factors of production and thus the supply becomes more price elastic.
2. Availability of resources: If the economy already using most of its scarce resources then firms
will find it difficult to employ more and so output will not be able to rise. The supply of most of
goods and services will therefore be price inelastic.
3. Number of producers: More producers mean that the output can be increased more easily. Thus
supply is more elastic.

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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
4. Ease of storing stocks: If goods can be stocked with ease and have a long shelf life, the supply
will be elastic, otherwise inelastic.
5. Increase in cost of production as compared to output: In cases where there is a significant
increase in cost of production when output is increased, supply is inelastic. This is because
suppliers will have to have to do a significant investment in order to increase the output. It will
take time and some suppliers may be hesitant in doing so.
6. Improvement in Technology: In industries where there is a rapid improvement in technology, the
PES of such goods will be more elastic as compared to industries where there is not much
improvement in technology.
7. Stock of finished goods: In industries where there are high inventories/stocks of finished goods,
the suppliers can easily supply more as the price rises. Thus, the PES for these goods will be
elastic.

19. What do you mean by perfectly elastic supply and perfectly inelastic supply?
Answer: A perfectly elastic supply curve is horizontal (as illustrated in the diagram below). The supply
curve facing a single buyer in a market in which there are a very large number of buyers and sellers is
likely to appear to be perfectly elastic (or close to this, anyway). This will occur when each buyer is a
"price-taker" who has no effect on the market price.

A perfectly inelastic supply curve is vertical (as in the diagram below). The price elasticity of
supply is zero when supply is perfectly inelastic.

Islamic University, Kushtia

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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

20. Explain why a good with a positive price elasticity of demand must violate the law of
demand.
Answer: The law of demand states that, holding other factors fixed, there is an inverse relationship
between price and quantity demanded, i.e. that an increase in price decreases quantity and vice versa. If a
good has a positive price elasticity of demand, it must be that an increase in the price of that good leads to
an increase in the quantity demanded. Therefore, such a good violates the law of demand.

Solutions to Problems
1. A 10 percent increase in the price of automobiles reduces the quantity of automobiles demanded
by 8 percent. What is the price elasticity of demand for automobiles?
Answer:
%Q 8
Q,P

0.80
%P 10
2. A linear demand curve has the equation Q = 50 100P. What is the choke price?
Answer:
Q0

The choke price is the price where

. Using the given demand curve we have


Q 50 100 P
0 50 100 P
100 P 50
P $0.50

3. The demand for beer in Japan is given by the following equation: Qd = 700 2P PN + 0.1I,
where P is the price of beer, PN is the price of nuts, and I is average consumer income.
a. What happens to the demand for beer when the price of nuts goes up? Are beer and nuts
demand substitutes or demand complements?
b. What happens to the demand for beer when average consumer income rises?
c. Graph the demand curve for beer when PN = 100 and I = 10, 000.
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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Answer:
When the price of nuts goes up, the beer quantity demanded falls for all levels of price
(demand shifts left). Beer and nuts are demand complements.

a.

When income rises, quantity demanded increases for all levels of price (demand shifts
rightward).

b.

Now: Qd = 700 2P 100 + 0.1*10,000 = 1,600 2P P = 800 0.5 Qd

c.
P

800

1600

4. Suppose the demand curve in a particular market is given by Q = 5 0.5P.


a) Plot this curve in a graph.
b) At what price will demand be unitary elastic?
Answer:

The inverse demand function is P = 10 2Q

P
10

Demand:
Slope = - 2

Q
5

d.

We know that the value of the price elasticity of demand is given by

for a linear demand function: Q = a bP, then

Q
b
P

Q,P

Q P
P
b
P Q
Q

and

Islamic University, Kushtia

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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Here, b = 1/2. For demand to be unitary elastic it must be that

P
1
P
5 2

12

which implies that P = 5.


5. The demand and supply curves for coffee are given by Qd = 600 2P and Qs = 300 + 4P.
a) Plot the supply and demand curves on a graph and show where the equilibrium occurs.
b) Using algebra, determine the market equilibrium price and quantity of coffee.
Answer:
a
P
300
S
50

D
300

500

600

e.

600 2 P 300 4 P
300 6 P
50 P
Plugging

P 50

Q 500

back into either the supply or demand equation yields

6. Suppose that demand for bagels in the local store is given by equation Qd = 300
- 100P. In this equation, P denotes the price of one bagel in dollars.

a) Fill in the following table:


P

0.10

0.45

0.50

0.55

2.50

Qd

Q,P
b) At what price is demand inelastic?
c) At what price is demand elastic?

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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Answer:
P

0.10

0.45

0.50

0.55

2.50

Qd

290

255

250

245

50

Q,P

0.035

0.176

0.2

0.225

We can find elasticities of demand using the following formula

Q,P

Q d P
P
P
100

d
P Q
300 100 P P 3
.

This demand curve is linear. The inverse demand function is P = 3 1/100 Qd

Observe that for price $1.50 the elasticity of demand is equal to


1.5
Q ,P
1
1.5 3
.
For all prices below $1.50, the demand is inelastic, while for all prices above $1.50, the demand is elastic.
7. Consider a linear demand curve, Q = 350 7P.
a. Derive the inverse demand curve corresponding to this demand curve.
b. What is the choke price?
c. What is the price elasticity of demand at P = 50?
Answer:

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SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

Q 350 7 P
7 P 350 Q
a)

P 50 17 Q
Q0

Q0

b)

The choke price occurs at the point where


. Setting
in the inverse demand equation
P 50
above yields
.
P 50
d. At
, the choke price, the elasticity will approach negative infinity.

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