Module No.

and Title MODULE 1 Supply and Demand Analysis

INTRODUCTION:
LEARNING
An analysis OUTCOMES Elasticity
of demand and supply necessitatesof Demand
a subsequent study of their
responsiveness or elasticity with respect toand Supply
changes in their determinants. The
discussions on this lesson focus of their elasticises with respect to price and income.
For every elasticity topic discussed, the measurements=s are first presented followed
by the analysis and interpretations.

ABSTRACTION:

Price elasticity of demand - the degree of responsiveness of quantity demanded to a

change in price is measured by dividing the percentage change in quantity demanded
by the percentage change in price.

Three Cases of Elasticity

Elastic – the percentage change in quantity demanded is obviously higher than
the percentage change in price and the elasticity coefficient is greater than 1.
Inelastic – if the quantity demanded registers a percentage change in quantity
demanded less the percentage in price, the elasticity coefficient is less than 1.
Unitary- quantity demanded change in the same proportion as the change in
price; the elasticity coefficient is equal to 1.
Measures of Price Elasticity of Demand
Arc Elasticity – the coefficient of the price elasticity of demand between two
points along the demand curve.
Epa= ΔP / ΔP / ____ΔP___
(Q1 + Q2) + 2 (P1 + P2) + 2

Point Elasticity – the elasticity at point along the demand curve.

- it is more exact than that of arc elasticity.

Epp = ΔQ
__Q__
ΔP
P

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Commodities and Their Elasticises
The more essential a good is to the consumer, the more inelastic will be the
demand for the good. The less of a necessity a good is, the more elastic is the demand
for it.
Goods have Elasticities < 1 Goods have Elasticities > 1
Infant’s Milk Branded Bags
Electricity Chocolates
Medicine Gadgets
Salt Imported shoes
Sugar Perfumes
Rice Luxurious dresses

An increase in price will benefit the producer if demand is inelastic because

this will cause an increase in his total revenue. On the other hand, if the demand is
elastic, an increase in price may not benefit the producer.
The increase in price has resulted in a significant decrease in demand
consequently causing the total revenue to decrease but a decrease in price may
ultimately benefit the seller if the demand is elastic.
However, if demand is unitary elastic, neither an increase nor a decrease in
price will affect the seller’s total revenue.
Substitution Effect - is the decrease in sales for a product that can be attributed to
consumers switching to cheaper alternatives when its price rises. As prices
increase for a good, we start to think of other products or choices that can
satisfy us at a relatively lower price. Given our budget has stayed the same, we
must continually find ways to meet our needs as prices increase around us.
Example:
When the price of your favorite shampoo goes up a dollar, you decide to try a
cheaper brand. Your demand and many other people's demand for the cheaper
shampoo have now increased as a result of the price increase of your favorite
shampoo.
A decrease in price would increase earnings if demand were price elastic
enough to stretch Qd (quantity demand) and revenue in order to offset the increase in
cost with more quantity produced. Likewise, an increase in price due to higher
production cost or cost of business would increase earnings if demand were price
inelastic enough to stretch price and revenue in order to offset the said increase in
cost. The price inelasticity of demand to maximize revenue and earnings is also true
even without a change in cost.

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 Increasing Qd without changing price highlights the effect of decreasing price
and increasing Qd with a very elastic demand on revenue and earnings. Conversely,
increasing price without changing Qd highlights the effect of increasing price and
decreasing Qd with a very inelastic demand on revenue and earnings. Thus, revenue
increase as price decreases when the increase in Qd offsets the decrease in price with
an elasticity coefficient of more than one (elastic). The opposite is true when price
increases with an inelastic demand.

Price Increase Price Decrease

Elastic Decrease Increase

Inelastic Increase Decrease

Income Elasticity of Demand

The coefficient of income elasticity of demand measures a product’s
percentage change in demand as a ratio of the percentage change in income which
caused the shift in the demand curve.
EY is given as: ΔD ΔD
__D__ or __D__ Y
ΔY ΔY D
Y
Or % ΔD
% ΔY

where ΔD represents the change in demand and ΔY the change in income.

The absolute value of the coefficient of income elasticity is also a measure of
how responsive demand is to change in income. As income increases, the coefficient
of:
> 1 means demand is elastic and the good is superior;
< 1 means demand is inelastic and the good is inferior; and
= 1 means demand is unitary and the good is normal
A study of income elasticity for food was made by Ernesrt Engel and
according to him, when income increases, the percentage that is spent for food tends
to decease. The resulting coefficient is less than one because food is a necessity.
When income increases, the increase goes mostly to the purchase of luxury items,
education, travel and leisure.

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 If elasticity is equal to 1, the share of the product in the allocation of the
incremental or additional income is equal to its share in the allocation of the total
income thus, maintaining the product’s importance in the overall consumption basket.
An analysis of income analysis figure is shown below:
Income Degree of Demand Type of Good
Elasticity
2 Elastic Normal luxury
1.5 Elastic Normal Luxury
.75 Inelastic Normal- Necessity
.50 Inelastic Normal- Necessity
.30 Inelastic Inferior
.22 Inelastic Inferior

Consumption Line – is upward sloping from the point of origin of the graph.
As income increases, some products gain importance (superior goods) while
some do otherwise (inferior goods) in the consumption basket. Moreover, superior
goods are eventually become inferior as income continues to increase to give way to
new superior goods.
The theory of diminishing utility is the cornerstone of the concept of income
elasticity of demand. The shift in consumption from inferior goods to superior goods
as increases as implies that the marginal utility of the latter is greater than that of the
former. Marginal spending shifts to those commodity items with higher marginal
utilities due to the relative scarcity, thus, making them superior as substitute to
inferior goods, However, these commodity items will eventually lose their superiority
as income continues to increase due to the law of diminishing marginal utility and
their individual elasticity will decrease are most to zero. This is the point of
maximum satisfaction and incremental spending shifts instead to the consumption of
new and relative scarce goods.
Cross elasticity of demand - a measure of the extent to which the demand for a good
changes when the price of a substitute or complement changes, other things remaining
the same

Cross elasticity of demand :

= Percentage change in quantity demanded of a good
Percentage change in the price of one of its substitutes or complements

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Example: Suppose that when the price of a burger falls by 10 percent, the quantity of
pizza demanded decreases by 5 percent.
Cross elasticity of demand = -5% /-10% = 0.5
The cross elasticity of demand for a substitute is positive.
• A fall in the price of a substitute brings a decrease in the quantity
demanded of the good.
• The quantity demanded of a good and the price of its substitute change
in the same direction.
The cross elasticity of demand for a complement is negative.
● A fall in the price of a complement brings an increase in the quantity
demanded of the good.
● The quantity demanded of a good and the price of one of its
complements change in opposite directions.
So pizzas and burgers are substitutes and cross elasticity is positive. However, pizzas
and soda are complements and so cross elasticity is negative.
Price Elasticity of Supply:
The coefficient of price elasticity of supply measures the percentage change in
the quantity supplied of a commodity compared to a percentage change in the price od
such a commodity.
The difficult or ease of increasing or decreasing the supply of goods
determines its elasticity. Goods which are relatively easy to manufacture tend to have
elastic supplies; whereas goods which are difficult to produce have inelastic supplies.
Just as in the demand curve, the supply curve is elastic if es is >1, inelastic, if curve is
< 1 and unitary elastic when es =1. Normally, the coefficient of es is positive, because
of the direct relationship between price and quantity supplied.
Three Elasticity of Supply Curve
Relatively Elastic - a change in price results in a significant change in
quantity supplied.
Relatively Inelastic - a change in price results in a slight change in quantity
supplied.
Perfectly Inelastic – at a given price, quantity supplied may change infinitely.
Perfectly Elastic – at a given price, quantity supplied remains constant or (Qs
is equal to zero)

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 Exercise 1
Direction: Comment on the sizes and signs of the following elasticities.

Income Degree of Demand Elasticity Nature of Good

Elasticity
Elasti Inelastic Unitary Superior Inferior Normal
c

1.8

-1.2

-.93

.05

Exercise 2
Direction: State the effect of the following on the total revenue of the seller
(Increase, Decrease, Same)
1. Increase price of imported chocolates __________
2. Decrease price of rice __________
3. Decrease price of sugar __________
4. Total revenue is constant __________
5. Increase price of electricity __________
6. Increase price of Huawei phones __________
7. Total revenue is increasing at a fast rate __________
8. Decrease price of Nestogen 3 __________
9. Increase price of soft drinks __________
10. Decrease price of soft drinks __________

MODULE ASSESSMENT

A. Write the letter of the correct answer on the line before each number.
_____ 1. Another term used for “equilibrium”
a. deflation c. growth
b. static d. None of the above
_____ 2. The economic problem that refers to the nature of goods and services the economy
should produce ______.

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 a. what to produce c. how much to produce
b. how to produce d. for whom to produce
_____ 3. Goods that are required for man’s survival.
a. essential goods c. Created wants
b. luxuries d. All of the above
_____ 4. Which of the following is NOT classified as natural resource?
a. land c. minerals
b. capital d. forest
_____ 5. Microeconomics theory studies the economic behavior of______.
a. a consumer c. a business firm
b. a resource owner d. all of the above
_____ 6. If the cost of production of pork increases, supply will ______.
a. increase c. remain constant
b. decrease d. vary
_____ 7. An increase in the price of a commodity when demand is inelastic causes total
revenue of the producer to ______.
a. increase c. remain constant
b. decrease d. vary
_____ 8. If the income elasticity of demand is greater than one, the good is ______.
a. essential c. an inferior good
b. a luxury d. a superior good
_____ 9. If the cost of producing a goof decreases, the ______.
a. supply curve will shift to the right
b. supply curve will shift to the left
c. demand curve will shift to the right
d. none of the above
_____ 10.Which of the statement is true?
a. The supply of inputs used affects the supply of a good.
b. The lower the price of a good, the smaller the quantity that will be offered
by the supplier
c. The lower the price of a good, the bigger the quantity that will be
demanded by the buyer
d. All of the above are true.

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 B. On the line below each number, write T if the statement is correct and F if incorrect.
(2 points each)
_____ 1. In the law of demand, the price and quantity demanded move in opposite direction.
_____ 2. Complementary goods are used together.
_____ 3.Microenomics looks at the decisions of economy as a whole.
_____ 4. Shifts in of the demand and supply curves alone or at the same time can cause a
change in the equilibrium point.
_____ 5. Traditional economic system is best describe as a free enterprise.
_____ 6.Microeconomics is the study of individuals and business decisions.
_____ 7. In the law of supply, the price and quantity supplied of a good are indirect related to
each other .
_____ 8. How to produce is a question that refers to the market to which the producers are
willing to sell.
_____ 9.Accordinf to Engel, as income increases, the increase mostly goes to luxury items,
travel, and leisure.
_____10. There is two points in the graph where demand is exactly equal to supply and this is
what we call equilibrium.
_____11.Superior goods are products that gain importance as income increase.
_____12. Any point on the supply curve cannot reflects the quantity that will be supplied at a
given price.
_____13.Inferior goods are purchase more at higher income levels.
_____14. Macroeconomics also focuses on unemployment and inflation.
_____15. Combining the demand and supply curves will show the point of market
equilibrium.

SUMMARY

Economics studies how prices of land, labor and

capital are determined, and how these prices are used to
allocate scarce resources. Economics is classified into
positive and negative economics.
Human wants, use of resources and technique of
production are the three elements of human economic
activity. Logic, statistic and the mathematics are the tools
of economics.

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 Macroeconomics treats the economic system as a whole rather that individual
economic units of which it are composed. Microeconomics concerned primarily with the
market activities on individual economic units.
Traditional economic system, command economic system and market system are the
three types of economic system.
Market is a mechanism through which buyers and sellers interact in order to determine
the price and quantity of a good or a services; its mechanics is best describe by the law of
demand and supply.
Law of demand – as price increases, the quantity demanded of the product decreases,
but as price decrease, the quantity purchased increase.
Law of supply - as price increases, the quantity supplied of the product tend to increase,
but as price decrease, the quantity supplied decreases.

The responsiveness of quantity demanded to changes in price is measured by price

elasticity of demand (PED). It tells us how much the quantity demanded of a good or
service will change when its price changes.

Formula for Price Elasticity of Demand:

PED=%Change in Quantity Demanded%Change in Price\text{PED} = \frac{\% \text{Change in
Quantity Demanded}}{\% \text{Change in Price}}

Where:

 % Change in Quantity Demanded is the percentage change in the quantity

consumers want to buy.
 % Change in Price is the percentage change in the price of the good or service.

Types of Price Elasticity of Demand:

1. Elastic Demand: When PED > 1, the demand is said to be elastic. This means
consumers are very responsive to price changes. A small change in price leads to a
large change in quantity demanded.
o Example: If the price of a popular brand of smartphones decreases by 10%,
and the quantity demanded increases by 20%, the demand is elastic.
2. Inelastic Demand: When PED < 1, the demand is inelastic. This means consumers
are less responsive to price changes. A price change leads to a small change in
quantity demanded.
o Example: If the price of salt increases by 10%, but the quantity demanded
decreases by only 2%, the demand for salt is inelastic.
3. Unitary Elastic Demand: When PED = 1, the percentage change in quantity
demanded is exactly equal to the percentage change in price.
o Example: If the price of a product increases by 5%, and the quantity
demanded decreases by exactly 5%, the demand is unitary elastic.

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Example:

Consider the case of coffee in a local café:

 If the price of a cup of coffee rises by 10%, and as a result, the quantity demanded
falls by 5%, then the demand is inelastic (since the percentage change in quantity
demanded is smaller than the percentage change in price).
 If, instead, the price of coffee rises by 10%, and the quantity demanded falls by 20%,
then the demand is elastic, as consumers are more sensitive to the price change.

Conclusion:

Price elasticity of demand is crucial for businesses and policymakers because it helps
them understand how changes in price will impact sales and revenues.

Price elasticity of demand (PED) measures how much the quantity demanded of a
good changes when its price changes. In other words, it shows how sensitive
consumers are to price changes.

Simple Explanation:

 If a price increase causes a large drop in the quantity demanded, the product is said
to be elastic.
 If a price increase causes only a small drop in the quantity demanded, the product
is said to be inelastic.

Example:

Imagine you love a certain type of soda, and it's sold for $1 per can. Now, the price of
the soda increases to $1.50.

 Elastic Demand Example: If you suddenly decide to buy fewer cans of soda
because the price went up (say you now buy 30% fewer cans), then the
demand for the soda is elastic. This means you are sensitive to price changes.
 Inelastic Demand Example: If you still buy almost the same amount of soda,
even though the price went up by 50%, then the demand is inelastic. This
means you're not very sensitive to price changes because soda is something
you really like or need.

Key Point:

 Elastic demand: Consumers change their behavior a lot when prices change.
 Inelastic demand: Consumers don't change their behavior much when prices
change.

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A real-world example of price elasticity of demand can be seen with gasoline
(petrol):

Example: Gasoline (Petrol)

 Situation: Imagine the price of gasoline increases from $3.00 per gallon to $3.50 per
gallon (a 17% price increase).
 Response: People still need gasoline to drive their cars, so even though the price has
gone up, many drivers will continue to buy roughly the same amount of gasoline.
They might drive less or look for ways to save, but their overall demand doesn't drop
dramatically.

Why is this an example of inelastic demand?

 Gasoline is a necessity for many people, especially those who live in areas without
good public transportation options. Because there are few immediate substitutes
and people still need it to commute, the quantity demanded doesn’t decrease much,
even with a price increase. This is why the demand for gasoline is inelastic—the
percentage change in quantity demanded is smaller than the percentage change in
price.

Contrast Example: Luxury Goods

Now, consider a luxury item like designer handbags:

 Situation: If the price of a high-end designer handbag increases by 20%, the quantity
demanded might drop significantly. Many people might decide they can live without
the handbag, or they might choose a cheaper option.

Why is this an example of elastic demand?

 The demand for luxury items is often elastic because people are more sensitive to
price changes. When the price rises, many consumers will choose to forgo the
purchase or switch to a less expensive alternative.

Summary:

 Gasoline: Inelastic demand (people still need it even when prices rise).
 Designer handbags: Elastic demand (fewer people buy them when prices increase).

To determine if price has an effect on demand, we use the concept of price elasticity
of demand (PED), which measures the responsiveness of quantity demanded to a
change in price. Here's how we can identify and evaluate the effect of price on
demand:

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1. Price Elasticity of Demand (PED) Calculation

The most direct way to know if price affects demand is to calculate the price
elasticity of demand using the formula:

PED=% Change in Quantity Demanded% Change in Price\text{PED} = \frac{\%\ \text{Change

in Quantity Demanded}}{\%\ \text{Change in Price}}

 If PED > 1, demand is elastic, meaning that price changes significantly affect quantity
demanded.
 If PED = 1, demand is unit elastic, meaning price changes lead to proportional
changes in quantity demanded.
 If PED < 1, demand is inelastic, meaning that price changes have little effect on
quantity demanded.

A high PED (greater than 1) indicates that demand is sensitive to price changes, while
a low PED (less than 1) suggests that demand is relatively insensitive to price
changes.

2. Observation of Past Data or Market Trends

 Price Changes and Demand Responses: By analyzing historical data, you can observe
how demand responds to price changes. For example, if a company raises the price
of a product and the demand significantly drops, it suggests that price has a
significant effect on demand (indicating elastic demand).
 Experimentation or A/B Testing: Some businesses use experimentation to measure
how changes in price affect demand. For example, a company might slightly raise or
lower the price of a product and track how that influences sales.

3. Changes in Consumer Behavior

 Substitute Availability: If a price change leads consumers to switch to a substitute

product, it indicates that price has a significant effect on demand. For instance, if the
price of butter increases and people start buying margarine instead, it shows price
sensitivity.
 Changes in Purchase Quantity: In some cases, you might observe changes in the
quantity demanded as prices change. If people buy much less of a product when the
price increases, it shows that price affects demand.

4. Using Demand Curves

 Demand Curve Shifts: A demand curve represents the relationship between price
and quantity demanded. If the price changes and the quantity demanded moves
along the curve (without shifting the entire curve), we can conclude that price is
affecting demand.
o If the price change results in a shift in the demand curve, it may indicate
that other factors (like consumer income, preferences, or advertising) are
also influencing demand, and price alone is not the only factor at play.

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5. Market Research and Surveys

 Consumer Surveys: Businesses or researchers often conduct surveys to gauge how

consumers would respond to price changes. Asking consumers how likely they are to
purchase a product if the price increases or decreases helps estimate price
sensitivity.
 Market Research: Understanding consumer preferences, income levels, and
competition can provide insights into how price might affect demand. For example,
in markets where there are many substitutes, price changes are more likely to affect
demand.

6. Empirical Evidence from Studies

 Economists and businesses often conduct empirical studies to understand how price
changes impact demand in specific industries or for particular goods. These studies
typically involve observing actual consumer behavior in response to price changes
and can offer detailed insights.

7. Examples of How Price Affects Demand

 Elastic Demand Example: If a clothing brand increases the price of a t-shirt, and as a
result, consumers buy significantly fewer t-shirts, we know that price has a strong
effect on demand.
 Inelastic Demand Example: If the price of gasoline increases, but people still buy
roughly the same amount because they need it for commuting, then we know that
price changes have a limited effect on demand in this case.

8. Key Factors Influencing Price Sensitivity

Several factors determine how sensitive demand is to price changes:

 Availability of Substitutes: If substitutes are readily available, demand is more likely

to be elastic (i.e., more sensitive to price changes).
 Necessity vs. Luxury: Necessities (like basic food or medicine) tend to have inelastic
demand, while luxury goods are more likely to have elastic demand.
 Proportion of Income: The greater the share of income spent on a product, the
more elastic its demand is likely to be.
 Time Frame: As discussed, demand becomes more elastic in the long run as
consumers have more time to adjust their behavior.

Conclusion:

To know if price affects demand, you can look at the price elasticity of demand
(PED), analyze consumer behavior in response to price changes, observe historical
data, conduct market research, or simply look for shifts in demand when price
changes. In general, price changes do affect demand, but the degree of the effect
depends on the nature of the good and market conditions.

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