CHAPTER 4 & 5: THE MARKET FORCES OF

DEMAND & ELASTICITY OF DEMAND

1
MARKETS AND COMPETITION
Supply and demand are the two words that
economists use most often.
Supply and demand are the forces that make
market economies work.
Modern microeconomics is about supply,
demand, and market equilibrium.

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What Is a Market?

A market is a group of buyers and sellers of a

particular good or service.

The terms supply and demand refer to the

behavior of people . . . as they interact with one
another in markets.

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What Is a Market?

Buyers determine demand.

Sellers determine supply.

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What Is Competition?

A competitive market is a market in which there

are many buyers and sellers so that each has a
negligible impact on the market price.

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What Is Competition?

Competition: Perfect and Otherwise

Perfect Competition
Products are the same
Numerous buyers and sellers so that each has no
influence over price
Buyers and Sellers are price takers
Monopoly
One seller, and seller controls price

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What Is Competition?

Competition: Perfect and Otherwise

Oligopoly
Few sellers
Not always aggressive competition
Monopolistic Competition
Many sellers
Slightly differentiated products
Each seller may set price for its own product

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DEMAND
Quantity demanded is the amount of a good
that buyers are willing and able to purchase.
Law of Demand
The law of demand states that, other things equal,
the quantity demanded of a good falls when the
price of the good rises.

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Catherines Demand Schedule Locally
grown potatoes

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The Demand Curve: The Relationship
between Price and Quantity Demanded
Demand Schedule
The demand schedule is a table that shows the
relationship between the price of the good and the
quantity demanded.

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Figure 1 Catherines Demand Schedule and Demand Curve

Price of
Potato per bags
$3.00

2.50

1. A decrease
2.00
in price ...

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Potato (bags)
2. ... increases quantity
of cones demanded.
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The Demand Curve: The Relationship
between Price and Quantity Demanded
Demand Curve
The demand curve is a graph of the relationship
between the price of a good and the quantity
demanded.

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Market Demand versus Individual Demand

Market demand refers to the sum of all

individual demands for a particular good or
service.
Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.

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 The Market Demand Curve
When the price is $2.00,
When the price is $2.00, The market demand at
Nicholas willcurve
demand is3 the $2.00 will be 7 bags.
The market
Catherine demand
will demand 4
bags.
horizontal sum
Bags.
of the individual demand curves!
Catherines Demand + Nicholass Demand = Market Demand
Price of Each Price of Each Price of Each
Bag Bag Bag

2.00 2.00 2.00

1.00 1.00 1.00

7 13
4 8 3 5

Quantity of potatoes (bags) Quantity of potatoes (bags) Quantity of potatoes (bags)

When the price is $1.00, When the price is $1.00, The market demand at
Catherine will demand 8 Nicholas will demand 5 $1.00, will be 13 bags.
bags. bags.

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Shifts in the Demand Curve

Change in Quantity Demanded

Movement along the demand curve.
Caused by a change in the price of the product.

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Changes in Quantity Demanded
A tax on sellers of
Price of
potatoes potatoes raises the
(bags)
price of potatoes per
B bag and results in a
$2.0
0
movement along the
demand curve.

1.00 A

D
0 4 8 Quantity of potatoes (bags)
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Shifts in the Demand Curve

Consumer income
Prices of related goods
Tastes
Expectations
Number of buyers

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Shifts in the Demand Curve

Change in Demand
A shift in the demand curve, either to the left or
right.
Caused by any change that alters the quantity
demanded at every price.

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 Figure 3 Shifts in the Demand Curve
Price of
potatoes
(bags)
Increase
in demand

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Quantity of
Potatoes 9bags)
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Shifts in the Demand Curve

Consumer Income
As income increases the demand for a normal good
will increase.
As income increases the demand for an inferior
good will decrease.

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Consumer Income Normal Good

Price of
potatoes
$3.0 An increase
0
2.5 in income...
0 Increase
2.0 in demand
0
1.5
0
1.0
0
0.5
0
D2
D1 Quantity
of
0 1 2 3 4 5 6 7 8 9 10 11 12 potatoes
(bags)
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Consumer Income Inferior Good

Price of
potatoes (bags)
$3.0
0
2.5 An increase
0
2.0
in income...
0 Decrease
1.5 in demand
0
1.0
0
0.5
0
D2 D1 Quantity of
Price of
0 1 2 3 4 5 6 7 8 9 10 11 12 potatoes
(bags)
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Shifts in the Demand Curve

Prices of Related Goods

When a fall in the price of one good reduces the
demand for another good, the two goods are called
substitutes.
When a fall in the price of one good increases the
demand for another good, the two goods are called
complements.

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Table 1 Variables That Influence Buyers

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Elasticity . . .

allows us to analyze supply and demand

with greater precision.

is a measure of how much buyers and sellers

respond to changes in market conditions

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THE ELASTICITY OF DEMAND
The price elasticity of demand is a measure of
how much the quantity demanded of a good
responds to a change in the price of that good.
When we talk about elasticity, that responsiveness
is always measured in percentage terms.
Specifically, the price elasticity of demand is the
percentage change in quantity demanded due to a
percentage change in the price.

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The Price Elasticity of Demand and Its
Determinants
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon

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The Price Elasticity of Demand and Its
Determinants
Demand tends to be more elastic:
the larger the number of close substitutes.
if the good is a luxury.
the more narrowly defined the market.
the longer the time period.

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Computing the Price Elasticity of Demand

price elasticity of demand is computed as the

percentage change in the quantity demanded
divided by the percentage change in price.

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

Price elasticity of demand greater than 1: ELASTIC

Price elasticity of demand less than 1: INELASTIC

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The Variety of Demand Curves

Inelastic Demand
Quantity demanded does not respond strongly to
price changes.
Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to changes in
price.
Price elasticity of demand is greater than one.

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Price Elasticity Between Two Points

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Computing the Price Elasticity of Demand

Example: If the price of bag of potatoes

increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 bags, then your
elasticity of demand would be calculated as:
P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e
(10 8)
100
10 20%
ED 2 Demand is price elastic.
(2.20 2.00)
100 10%
2.00 Interpretation: All things being equal, a
1% change in price will result in a 2%
change in quantity

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The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities

The midpoint formula is preferable when

calculating the price elasticity of demand
because it gives the same answer regardless of
the direction of the price change.
(Q2 Q1 ) / [(Q2 Q1 )]
Price elasticity of demand =
( P2 P1 ) / [( P2 P1 )]

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The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities

Example: If the price of bag of potatoes

increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 bags, then your
elasticity of demand, using the midpoint
formula, would be calculated as:
(8 10) Demand is price elastic.
(8 10) 2 /18 Interpretation: All things
ED 2.32
(2.20 2.00) 0.2 / 4.2 being equal, a 1% change
(2.20 2.0) in price will result in a
2.32% change in quantity

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Given the demand curve for bags of corn used by Iowa
Ranchers (as animal feed), calculate the price elasticity of
demand for Corn by ranchers in Iowa when price per bag
increase from $4 to $5.
(50 100)
(50 100)
ED
Price (5.00 4.00)
(5.00 4.00)
$5 -0.33
ED 3
4 0.11
Demand
Demand is price elastic.
Interpretation: All things being
equal, a 1% change in price will
result in a 3% change in quantity
0 50 100 Quantity

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CLASS QUIZ: Percentage Changes and
Elasticities

Example: If the price of a bag of grain increase

by 22% and the number of bags bought falls by
68%, then the price elasticity of demand, using
the elasticity formula, would be?
Interpretation?
Demand is price elastic.
Interpretation: All things
%changeinquantity 68% being equal, a 1% change
ED 3
%changeinprice 22% in price will result in a 3%
change in quantity

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The Variety of Demand Curves

Perfectly Inelastic
Quantity demanded does not respond to price
changes.
Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.
Unit Elastic
Quantity demanded changes by the same percentage
as the price.

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The Variety of Demand Curves, Elasticity
& Slopes
Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related to the
slope of the demand curve.
But it is not the same thing as the slope!
Steep sloping demand curve is more inelastic than flat
sloped curve
Flat sloping curve is more elastic than steep sloping
curves
Example: ???

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Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

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Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

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Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

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Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

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Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.

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Total Revenue and the Price Elasticity of
Demand
Total revenue is the amount paid by buyers and
received by sellers of a good.
Computed as the price of the good times the quantity
sold.

TR P Q

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 Figure 2 Total Revenue
Price

When the price is $4, consumers

will demand 100 units, and spend
$400 on this good.

$4

P Q = $400
P
(revenue) Demand

0 100 Quantity

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Elasticity and Total Revenue along a
Linear Demand Curve
With an inelastic demand curve, an increase in
price leads to a decrease in quantity that is
proportionately smaller. Thus, total revenue
increases.

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 Figure 3 How Total Revenue Changes When Price Changes:
Inelastic Demand

Price Price
An Increase in price from $1 leads to an Increase in
to $3 total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity

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Elasticity and Total Revenue along a Linear Demand
Curve

With an elastic demand curve, an increase in

the price leads to a decrease in quantity
demanded that is proportionately larger.
Thus, total revenue decreases.

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 Figure 3 How Total Revenue Changes When Price Changes:
Elastic Demand

Price Price

An Increase in price from $4 leads to an decrease in

to $5 total revenue from $200 to
$100

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

Note that with each price increase, the Law of Demand still holds an
increase in price leads to a decrease in the quantity demanded. It is the
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Elasticity of a Linear Demand Curve

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Figure 4 Elasticity of a Linear Demand Curve
Demand is elastic; When price increases from
Price demand is responsive$4
to to $5, TR declines from
changes in price. $24 to $20.
$7 Elasticity is > 1 in this range.
6

4
Elasticity is is<inelastic;
Demand 1 in this range.
demand is
3
not very responsive to changes
2 When price increases from
in price.
$2 to $3, TR increases from
1 $20 to $24.

0 2 4 6 8 10 12 14
Quantity

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Other Demand Elasticities

Income Elasticity of Demand

Income elasticity of demand measures how much
the quantity demanded of a good responds to a
change in consumers income.
It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.

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 Other Demand Elasticities

Computing Income Elasticity

P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e

Remember, all elasticities are

measured by dividing one
percentage change by another

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Other Demand Elasticities

Income Elasticity
Types of Goods
Normal Goods EI > 0
Inferior Goods EI <0

Higher income raises the quantity demanded for

normal goods but lowers the quantity demanded for
inferior goods.

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Other Demand Elasticities : Necessities
vs. luxury Goods
Income Elasticity
Goods consumers regard as necessities tend to be
income inelastic
Examples include food, fuel, clothing, utilities, and
medical services.
Goods consumers regard as luxuries tend to be
income elastic.
Examples include sports cars, furs, and expensive foods.

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Example

Quantity demanded for beef increased from 3lb

to 5 lb as Kofis income increased from
$10,000 to $20,000 per year.
Calculate the income elasticity of demand for beef.
Interpreted your answer.

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Other Demand Elasticities

Cross-price elasticity of demand

A measure of how much the quantity demanded of one good
responds to a change in the price of another good.
Ccomputed as the percentage change in quantity demanded of
the first good divided by the percentage change in the price of
the second good
%change in quantity demanded of good 1
Cross - price elasticity of demand
%change in price of good 2

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 If Exy > 0 substitutes
Price of good x and quantity of good y are
positively related

If Exy < 0 complements

Price of good x and quantity of good y are negatively related

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Example

As price of peanut butter increased from 2$ to

$4 per jar, the quantity demanded for jelly
reduced from 3 jars to 2 jars.
What is the cross price elasticity of peanut butter
and jelly?
Interpret your answer

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 Summary

Economists use the model of supply and

demand to analyze competitive markets.
In a competitive market, there are many buyers
and sellers, each of whom has little or no
influence on the market price.

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 Summary

The demand curve shows how the quantity of

a good depends upon the price.
According to the law of demand, as the price of a good
falls, the quantity demanded rises. Therefore, the demand
curve slopes downward.
In addition to price, other determinants of how much
consumers want to buy include income, the prices of
complements and substitutes, tastes, expectations, and the
number of buyers.
If one of these factors changes, the demand curve shifts.

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 Summary

Price elasticity of demand measures how much

the quantity demanded responds to changes in
the price.
Price elasticity of demand is calculated as the
percentage change in quantity demanded
divided by the percentage change in price.
If a demand curve is elastic, total revenue falls
when the price rises.
If it is inelastic, total revenue rises as the price rises.

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 Summary

The income elasticity of demand measures

how much the quantity demanded responds to
changes in consumers income.
The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.

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