Chapter 2: Demand, Supply, and Elasticity

2.1 Markets and Resource Allocation Market Structure

2.2 Demand and the Demand Curve Individual Demand and Market Demand Movements Along a Demand Curve Demand Shifters

2.3 Supply and the Supply Curve Individual Supply and Market Supply Movements Along a Supply Curve Supply Shifters

2.4 Measuring the Responsiveness of Demand to Price: ElasticityPrice Elasticity of Demand

Point Arc

Relationship to Total Spending (Total Revenue) Constant Elasticity Demand Curve Income Elasticity

2.5 Supply Elasticity

This chapter introduces and applies three basic components of economic analysis:

demand, supply, and elasticity. Each of these is, indeed, a separate topic. As we see below,

demand reflects the behavior of many individuals, each of whom buys a sufficiently small part of

the market quantity that her or his decision about how much to buy of the good under

consideration has no impact on its price. Likewise, supply reflects the behavior of many

individuals, each of whom sells a sufficiently small part of the market that her or his decision

about how much to buy of the good under consideration has no impact on its price. Finally,

demand (and supply) elasticity helps us understand how buyers (and sellers) of a good respond to

a change in its price. .

ach of the demand and supply represents a model that depicts reality more or less well.

All models fail to replicate reality completely. The important question is not whether a model is

"realistic" or even "right" but whether it is more useful than alternative models. The models

developed in this chapter have proved useful over the many decades economists have been

applying them to real world phenomena.

One assumption above warrants attention before looking at the uses of demand and

supply. Throughout this chapter, reference is made to the quantity of a good and to its price. No

attention is paid to the nature of that goodits "quality," its durability, its color, its taste, etc.

Also, no reference is made to individuals who meet to buy or sell the good. We proceed this way

because the model developed herein is strictly appropriate for a good like wheat that can be

purchased by specification. Every unit of the good is the same, buyers and sellers know all about

the good, and accordingly they need not meet to discuss any details. This representation is close

to descriptive of the wheat market, but not for the used car or labor markets. Even so, much can

be gained by ignoring the details of individual transactions. This is especially true in the labor

market. Even though real transactions involve personal contact and every job is in some ways

unique, many important aspects of the labor market can be analyzed within the framework

developed in this and the next chapter (Chapter 3).

2. 1. 1 Markets and Resource Allocation

The analysis of markets is the main component of microeconomic analysis because the

vast majority of actions regarding which goods and services we produce and consume are

influenced and coordinated by markets. Large components of our economy, such as schooling

and highways, are directed via political processes. Even so, these pale in comparison to the

number of commodities, ranging from entertainment to housing and food, that we obtain through

markets. Accordingly, it is essential to gain an understanding of how the market system works.

This understanding depends on our understanding of the building blocks, demand and supply.

We put the two together in chapter 3.

2. 1. 2 Market Structure

How the building blocks fit together depends on the structure of markets. Economists

identify four general structure types for product markets: perfect competition, perfect monopoly,

oligopoly, and monopolistic competition. In each of these four, the building blocks fit together in

somewhat different ways.

Perfect competition is the market structure in which demand, supply, and market

equilibrium provide the whole story. This chapter and Chapter x develop the logic of this market

structure. As noted earlier, in perfect competition each seller (and each buyer) is too small to

influence the market price appreciably. Each one is a price taker rather than a price maker. The

demand curve, as developed below, exists only when all buyers are price takers; the supply curve

likewise exists only when all sellers are price takers. For other market structures the supply curve

does not exist. Rather, analysts look at the firm's (or firms') cost structure and, coupled with

information about the demand curve, deduce the nature of the market's behavior.

Monopoly (Chapter 9) is the simplest of all market structures. A single firm faces a

demand curve (some times more than one demand curve) for its product. The firm uses the

information in the demand curve to determine what price (or prices) to charge and what quantity

to produce.1

Oligopoly (Chapter 10) is the most complicated of all market structures. A few firms face

a market demand for their product. Complicating the issue, however, is that the demand for the

product of each of the firms is not related to market demand in any direct way. Rather, the

relationship depends on how each firm reacts to the other firms' behavior. This interdependence

induces strategic behavior, which rules out precise statements about the performance of

oligopolistic markets. Analysis is limited to deriving insights about their performance in various

sets of circumstances.

Monopolistic Competition (chapter 11). Monopolistically competitive markets occur

where many firms sell quite similar products and in which entry of new firms is relatively easy.

In these markets, we combine the analysis of monopolistic markets with the condition that entry

occurs as long as it is profitable in order to determine relevant aspects of market behavior.

 

2. 2 Demand and the Demand Curve

Before proceeding to employ the concepts of demand and supply, we must specify just

what the terms mean for the purposes of analysis. Economists use these two terms in a precise

way. This section addresses the meaning of "demand." "Supply" is addressed in the following

section. Economists view demand as being based on consumers' response to incentives. Chapter

4 develops a rather detailed model of demand. For now we define a demand function as a

relationship that shows the quantity that buyers are willing and able to purchase of a good or

service at each of a set of values taken by specific variables. For example, the market demand for

Good X might be:

QX = f(PX, PY, PZ, I, N), (2.1)

where QX is the quantity demanded per time period of Good X; PX, PY, and PZ are prices of Goods

X, Y, and Z; I is income, and N is the number of potential buyers in a the market.

Among these variables, PX warrants special attention. This attention is not because the

good's own price is necessarily the most important single determinant of the quantity demanded.

Rather, we accord the "own price" special attention for two reasons. First, for virtually any good,

its own price has at least some influence on that good's consumption. The other factors affecting

demand can vary from one good to another. A more compelling reason for paying special

attention to price is that it influences both sides of the market: The price simultaneously affects

the actions of buyers and sellers. Indeed, it coordinates the actions of the two otherwise unrelated

groups.

For these reasons, we rephrase the demand function above in terms of the demand curve:

QX = f(PX | PY, PZ, I, N). (2.2)

Read this function as follows: the quantity of Good X is determined by the price of Good X,

holding constant the prices of Good Y and Good Z, the income level, and the number of potential

consumers. More generally the demand curve is defined as follows:

The market demand curve is the quantity of a good that buyers are willing and able to purchase at each of a set of prices, holding other things constant.

Figure 2.1 shows one such demand curve. This demand curve shows the quantity

demanded at each price between zero and $300. Some of the price/quantity pairs also appear in

the table to the left of the graph. This graph obeys the law of demand, that an inverse relationship

exists between the price of a good and the quantity that buyers are willing and able to purchase,

other things equal. This law is an empirical regularity; theory does not dictate that demand

curves slope downward, though it suggests that this is the most common state of affairs.

Figure 2.1 A Demand Curve

2. 2. 1 Individual Demand and Market Demand

Individuals rather than groups make decisions and take actions, including reacting to

price changes. Therefore, the market demand curve must be derived from individual demand

curves. Figure 2.2 shows how the market demand curve relates to individual demand curves. We

consider just two individuals, Chris and Blair, and examine how their individual demand curves

determine the market demand curve.

Figure 2.2 Individual and Market Demand Curves

At prices above $3.00 Chris chooses not to consume this good. At lower prices Chris is more

responsive to price than Blair is, increasing the number of units purchased by 4 per $1 price

decrease, in contrast to Blair's two-unit change per dollar. To calculate market demand requires

simple summation of the individuals' quantities at each possible price. In this case, the market

demand curve "kinks" at $3.00, where Chris enters the market; at higher prices the market

demand is the same as Blair's demand. The nature of the summation process does not depend on

the number of individual buyers. In most markets, of course, the number is quite large.

2. 2. 2 Movements along a Demand Curve

The definition of a demand curve divides the factors that affect the amount of a good that

a person (or group) buys into two categories: the good's price and all others. When the "all

others" remain unchanged, the location of the demand curve remains the same. That is, the

quantity purchased at each price remains the same. In this case, the only thing that changes the

amount that people are willing and able to consume is the good's own price. Economists refer to

quantity changes induced by price changes as changes in the quantity demanded, as distinct from

changes in demand, which are addressed in the section 2.2.3. Figure 2.3 illustrates a change in

the quantity demanded of the good under consideration. The price changes from $150 to $180.

(The user of the spreadsheet can choose any other price). In response to this price change, the

quantity demanded changes from 30 units at a price of $150 to 24 units at a price $180. We

observe a movement upward along the (unchanged) demand curve.

Figure 2.3 Movement Along a Demand Curve

2. 2. 3 Demand Shifters

While price is central to the analysis of what determines the quantity of the good that

buyers choose to purchase, it is not the whole story. The income level, prices of related goods, or

any of a host of other factors can change. These changes affect the quantity that buyers are

willing and able to purchase at each of the prices listed on the demand curve. Thus, any of these

changes renders the initial demand curve obsolete, causing it to be replaced by a new curve. In

the terminology of economics, demand has changed. Figure 2.4 illustrates that a changed

demand (in this case a demand increase) will result in a new quantity demanded at each possible

price. In particular, at the price of $150, the quantity demanded increases from 30 units per time

period to 50 units per time period.

Figure 2.4. A Change in Demand

Figure 2.5 focuses attention on the factors that can shift the demand curve. To be concrete,

the illustration takes into account three such factors:

the price of a substitute,

the price of a complement, and

the income of the consumer.

When the price of a substitute for Good X changes, the demand for Good X changes in the

same direction.2 For example, if the price of Pepsi Cola were to rise to $1.00 per can from $0.50

per can, (at least some) people would buy more Coke at each possible price of Coke. The

demand for Coke would increase. When the price of a complement changes, demand for Good X

changes in the opposite direction. If the price of tires for SUVs (Sport Utility Vehicles) doubles,

then (at least some) consumers would purchase another style of vehicle. The demand for SUVs

would shift to the left. Finally, income affects the demand for most goods. More often than not, a

changed income shifts the demand curve in the same direction.

Figure 2.5 shows the effect of a changed price of the substitute good from $100 to $115. The

$15 increase in the substitute good's price causes the demand for Good X to shift rightward by 12

units. The other two factors can be examined separately with the result that increasing the

complement's price shifts the demand to the left and increasing income shifts it to the right. Of

course, any combination of these changes can be examined.

Figure 2.5.Demand Shifters

2. 3 Supply and the Supply Curve

The logic of the supply curve parallels that of the demand curve. The quantity of a good

that sellers provide depends on the good's price, on technology, on input prices, and on any of a

number of factors that are peculiar to the good under consideration. For our purposes, price is the

variable of most interest. This section sketches the relationship between price and quantity,

following the preceding analysis of demand.

2. 3. 1 Individual Supply and Market Supply

As with demand, the market supply derives from the individual supply decisions of many

sellers. For purposes of illustration we again limit the number to two price-taking sellers, Terry

and Lee. Figure 2.6 shows Terry's and Lee's supply curves and the implied market supply curve.

Each individual supply curve shows how the seller reacts to price. In each case, the higher price

induces additional output. This need not be true for all individual sellers, but seems likely for at

least some. Chapter 8 develops the logic of the supply by the individual seller.

Figure 2.6 Individual and Market Supply

2. 3. 2 Movements Along a Supply Curve

Again, as with demand, we distinguish between movements along a specific supply curve

and a change in demand. The former results from a change in the product's price while all other

factors are held constant. When any of those other factors change, the entire supply curve shifts.

That is, the original supply curve is supplanted by a new one.

Figure 2.6 illustrates movements along supply curvesin this case the two individual

supply curves and the market supply curve. At a price of $2.00, the individual quantities of 5 and

8 are supplied for a market quantity of 13 units. The higher price calls for more output from each

of the two sellers and, therefore, a larger quantity at the market level.

2.3.3 Supply Shifters

The market supply curve is subject to shifts, as is the market demand curve. Some

important supply shifters are these: the prices of inputs used to produce the good, the number of

potential sellers, and technology. An increased input price implies that sellers must be paid more

to produce a given quantity or, equivalently, that at a given price the quantity supplied decreases.

The supply curve shifts to the left. The number of potential sellers in a market can be affected by

transportation technology, information technology that allows would-be sellers to learn of market

opportunities, or changes in restrictions on entry into the industry (licensing laws, for example).

In any event, an increase in the number of potential sellers shifts the supply curve to the right.

Finally, improved technology lowers cost and induces increased output at any given price; that

is, it shifts the supply curve to the right.

Figure 2.7 illustrates the shifting of a supply curve, showing the effect of an increased

wage rate. Increasing the wage rate by $5 per unit of labor shifts the supply curve upward by $50

per unit of the product. That is, the wage rate translates into a $50 per unit increase in the cost of

bringing this product to the market at each quantity. Phrased in terms of quantity, this means that

the supply curve shifts leftward by 131/3 units. If the index of technology had increased

(indicating better technology), the supply curve would have shifted downward and to the right.

Likewise, an increase in the number of potential sellers shifts the supply curve downward.

Figure 2.7. Supply Shifters

2.4 Measuring the Responsiveness of Demand to Price: Elasticity

The quantity demanded is inversely related to the product's price. It is important for many

purposes to have a way of describing the size of that relationship. Two measures suggest

themselves, slope and elasticity. Of the two, slope is a much more obvious measure. It is the

number of units that the quantity demanded changes per one-unit change in the price. In Figure

2.5, the slope is (-)0.2. That is, the quantity changes by 1/5 for each $1 change in the price.

Whether this is a large or small change depends, of course, on the units. Without more

information, we cannot determine what a slope of (-)1/5 means. This does not imply that the

slope is not a useful measure of the response to price. It is, especially when those using the

information are aware of what the units mean.

The second measure of price responsiveness is elasticity. The price elasticity of demand

for a good is the percentage change in quantity demanded per one-percent change in price. This

measure is a "pure number"--it has no units. If one says, for example, that the price elasticity of

demand for gasoline is (-)0.25, no more information is required. We know that a one percent

change in the price of gasoline results in a 0.25 percent change in the quantity demanded, in the

opposite direction. In addition to being easily interpreted, elasticity offers another advantage over

slope: elasticity determines whether an increase in a product's price will increase or decrease the

amount that consumers spend on that product.

2.4.1 Price Elasticity of Demand

Following the definition offered above, the price elasticity of demand may be written as

follows:

EP = (100*Q/Q) / (100*P/P), 2.3

where the 's indicate changes. Thus, the denominator is the percentage change in quantity and

the denominator is the percentage change in price. Obviously, the 100's can be dropped for

purposes of calculation, so the equation becomes:

EP = (Q/Q) / (P/P), 2.4

The elasticity may be defined and calculated in either of two ways: at a point or over a

range. The point elasticity is closely related to the slope of the demand curve. Rearranging the

terms of Equation (2.4) yields

EPPOINT = (Q/P)(P/Q). 2.5

Alternatively, the price elasticity may be computed from price and quantity data at any two

points on a demand curve. This is typically referred to as the arc elasticity, which is most often

computed in the following way:

EPARC = (Q/(Q1 + Q2)/2) / (P/(P1 + P2)/2). 2.6

Q1 and Q2 are the two quantities, and P1 and P2 are the respective prices. The changes are Q =

Q2 - Q1 and P = P2 - P1. This method, called the mid-point method, avoids ambiguity introduced

by choosing either P/Q pair (P1/Q1 or P2/Q2) as the bases for computing percentages. Reference to

Figure 2.8 illustrates these computations. At any point on the demand curve, the elasticity is

0.2(P/Q). (We ignore the sign, treating the elasticity as a positive number). Thus when P = $180,

Q = 24, and EPPOINT = 0.2(180/24) = 1.5. At that point on the demand curve, quantity changes by

1.5 percent per one percent change in price. (Roughly, for example, if price rises by 1% to

$181.80, quantity would decrease by 1.5 percent or 0.36 units to 23.64 units.)

Computing the arc elasticity is a bit more involved. Consider the elasticity between the

points on the demand curve corresponding to prices of $180 and $120. Over that range, the

percentage change in quantity is 100*(12/30) = 40%. The percentage change in price is

100*(60/150) = 40%. The elasticity over the range, the arc elasticity, is 40%/40% or 1.0.

Figure 2.8. Price Elasticity of Demand Along the Demand Curve

2.4.2 Relationship to Total Spending (Total Revenue)

When demand is inelastic, that is when the price elasticity is less than 1.0, then the

quantity demanded falls proportionately less than the price rises. Therefore, an increased price

causes total expenditures on the good to increase. By the same reasoning, an increased quantity

causes expenditures to fall. See the first panel of figure 2.9, which shows a case in which the

elasticity of demand is 0.5. A 20% price change from $90 to $110 causes the quantity to change

in the opposite direction by 10%, from 42 to 38. To see the effect on expenditures, compare the

two rectangles in that panel. Increasing the quantity causes 4 more units to be purchased, adding

$90*4 or $360 to spending. This is the area of the small rectangle at the right. Offsetting this,

however, is the fact that buyers now spend $20 less for each of the 38 units they would have

purchased at the higher price. This reduces spending by $20*38 or $760, the area of the upper

rectangle. Therefore, increasing the quantity (reducing the price) results in lower total spending.

Figure 2.9. Price Elasticity, Price, and Expenditures

Contrast this outcome with that represented in the right panel of Figure 2.9. Here, the two

prices are $190 and $210, with associated quantities of 22 and 18. Over this arc of the demand

curve, a 10 percent change in price is associated with a 20 percent change in quantity. Now

increasing quantity by four units results in a relatively large increase in spending ($190*4 =

$760) compared to the relatively small reduction due to lower spending on the 18 units bought at

the higher price ($20*18 = $360). Now, increasing the quantity (reducing the price) causes

spending to increase. (These two numeric examples come from a spreadsheet that allows the user

to specify an initial price. The sheet, not shown here, provides calculations of percentage

changes, spending levels, and the arc elasticity.)

These two panels of Figure 2.9 illustrate a general principle: Whenever demand is

inelastic, price and spending move in the same direction (quantity and spending move in

opposite directions); and whenever demand is elastic, price and spending move in opposite

directions (quantity and spending move in the same direction). The relationship between quantity

and revenue can be stated more precisely:

S/Q = P(1 - 1/EP). 2.7

The term S/Q is the change in total spending (P*Q) per one-unit change in the

quantity. Refer to the examples in Figure 2.9. In the first panel S/Q = $100*(1 - 1/0.5) =

$100(-1) = -$100. That is, spending decreases by $100 per one-unit change in quantity, or by

$400 over the range considered. In the second panel, in contrast, spending increases: S/Q =

$200*(1 - 1/2) = +$100 per unit, so spending increases by $400.

2.4.3 Constant Elasticity Demand Curve

Preceding material shows that a linear demand curve exhibits different elasticities as one

moves along it; it is elastic at higher prices and inelastic at lower ones. Conversely a demand

curve that exhibits constant elasticity at all points must have different slopes at different prices.

Figure 2.10 shows one such curve. In this case, the curve is slightly inelastic, with a price

elasticity of 0.9. As the figure shows, and as we saw with the linear curve, an inelastic demand

curve implies a direct relationship between price and spending (an inverse relationship between

quantity and spending). In this case, price rises by about 49.6 percent (using the midpoint

formula), while quantity decreases by about 40 percent. Therefore, spending rises with the price

increases.

Figure 2.10. A Constant-Elasticity Demand Curve

No demand curve will exhibit constant price elasticity at all prices. Such a demand curve

would imply that no price could choke off consumption completely. This cannot hold, because

budgets are limited. Even so, the representation can serve as a good approximation over a range

of prices. Also, this type of curve can show how demand curves look when elasticity is very low

and very high. For example, setting the value of Elasticity at 10 results in a curve that is very

nearly horizontal. Likewise, an elasticity of 0.01 results in a demand curve that is nearly vertical

except at quite low prices.

2.4.4 Income Elasticity

The quantity of a good that a consumer buys depends on income as well as price. A

useful summary measure of the responsiveness of the quantity demanded to income changes is

the income elasticity of demand. It is calculated much as the price elasticity of demand: the

income elasticity of demand equals the percentage change in quantity demanded per one percent

change in income, other things equal. The income elasticity is calculated as follows:

EI = (Q/Q)/(I/I) 2.8

As with the price elasticity, this computation may be executed at a point or over a range.

Figure 2.11 below shows some quantity-income relationships in which the point price

elasticity is the same at all points. The solid line is downward sloping, representing a good for

which higher income results in reduced consumption; such goods are called inferior goods. Such

goods are rare but in theory can exist. (Along this curve, the income elasticity is -0.1. The

relatively gently-sloped good (dotted with small circles) represents a normal good, one for which

the quantity increases along with increased income. (The income elasticity along this curve is

0.25.) Finally, the more steeply-sloped curve (dotted with small diamonds) is a special case of a

normal good, one for which the percentage change in quantity exceeds the percentage change in

price. In this case, the income elasticity is 1.5, so a 4 percent change in income (for example)

causes the quantity to increase by 6 percent.

Figure 2.11. Income and Quantity Demanded (Price Constant)

An important reason for attention to the income elasticity is that it provides information

on the share of budget allocated to specific goods as incomes change. For those goods whose

income elasticities are below unity, the share of income spent on those goods decreases as

incomes rise. (An example for these goods is food products.) For those with income elasticities

above unity, increased income results in a larger share of the budget being allocated to the goods.

(An example for these goods is expensive vacations (can you think of a better example,

Wilson?.) Figure 2.12 illustrates this relationship. It is from a spreadsheet in which the user

indicates how many units the consumer purchases at the higher of two incomes. The spreadsheet

then calculates the expenditures, share of income spent on the good, and the income elasticity. In

the value selected below, the income elasticity exceeds 1.0, and the share of income spent on the

good increases with the increased income. (The product price of $0.50 is arbitrary and can be

changed. Nothing of importance turns on the price.)

Figure 2.12. An Income Elasticity Calculator

2.5 Elasticity of Supply

Often the responsiveness of the quantity supplied to price changes is as important as that

of quantity demanded. An example, we consider in chapter 3, is the incidence of taxation.

Whether the larger impact of a tax is on buyers or sellers depends critically on the relative

responsiveness of the quantity demanded and the quantity supplied to price changes. As with

demand, the responsiveness may be measured in terms of either slope or elasticity. Again,

elasticity has the advantage of being unit-free, so responsiveness of various products may be

compared.

The computation of elasticity is accomplished the same way with supply as with demand.

As with demand, the price elasticity of supply may be computed at points on a curve or along an

arc. Figure 2.13 shows a supply curve and the point elasticities of supply at various points on the

curve.

Figure 2.13. Supply Elasticities

This supply curve ranges from quite elastic at lower prices to quite inelastic at higher

ones. Arc elasticities are not shown but are easily calculated. Often the analyst need know only

whether the supply curve is elastic or inelastic at a point. For supply this is easily determined.

Draw a line tangent to the curve at the point of interest. If that line intersects the vertical (price)

axis first, then the supply curve is elastic at that point; if it intersects the horizontal (quantity)

axis at that point, then the supply curve is inelastic at that point. (A supply curve that hits the

origin in unitary elastic.)

Because the supply curve slopes upward, the relationship between price and spending as

we move along the curve raises no concern. A higher price induces an increased quantity. Both

add to the result that total spending increases as we move rightward along any supply curve

2.6 Chapter Summary:

This chapter explains demand and supply and the responsiveness of individuals to

changes in a good’s price. Demand reflects the quantity of a good that consumers are willing

and able to by at every price. Likewise, supply reflects the quantity of a good that consumers are

willing and able to by at every price. Finally, demand (and supply) elasticity helps us understand

how demand (and supply) of a good responds to a change in its price.

2.7 Looking Ahead:

Now that we know how demand and supply of a good are determined, we will put the

two together in chapter 3 to analyze how the price of a good is determined in the market. We will

also discuss special applications of demand and supply to taxes and international markets. The

discussion of taxes will build on our understanding of price elasticity of supply and demand.

New Terms