Tuesday 22nd July 2024

Unit 3: Explaining the Consumer Choice Theory

Demand and Supply Curves:
The concept of a market – in examining the price theory we
will look in more detail at the micro-economic level of the
individual firm, individual markets and consumers or
households. This means looking at what influences the amount
of a product demanded or supplied and analysing how price
and output are determined through the interaction of
demand and supply. In the context of economics demand and
supply takes place in a market place. The question then that
arises is what is a market?
A market can be defined as a place where potential buyers
and potential sellers (suppliers) of goods or services meet for
the purpose of exchange.
In economics suppliers and potential suppliers are referred to
as firms. The potential purchasers or buyers of consumer
goods are known as households. The price theory is
concerned with how market prices for goods are arrived at
through the interaction of demand and supply. The market
structure wherein the pricing mechanism is driven by the
forces of demand and supply is known as Free Competition
Market and discussion of this module will be based on this
type of market structure.
The Demand Schedule and the Demand Curve:
The demand schedule refers to the quantity of a product
demanded by a customer at various price levels. The demand
curve is therefore a graphic presentation of the relationship
between the quantity demanded of a product and the price
levels. The demand curve of a single consumer or household is
derived by estimating how much of the product the consumer
or household would demand at various hypothetical market
prices.
Suppose that the following demand schedule shows demand for sugar
by one household over a period of one month:

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Price per kg in kwacha Quantity demanded in
kgs
10 9.75

20 8.00

30 6.25

40 4.50

50 2.75

60 1.00

Notice that we show demand falling as price increases. This

is what normally happens with most products. This is because
purchasers / buyers have a limited amount of money to spend
and must choose between products that compete for their
attention. When the price of one product rises, it is likely that
other products will seem relatively more attractive and so
demand will switch away from the more expensive product to
the cheaper alternative.
The Law of Demand – states that as the price of a product
falls, other things remaining equal, the quantity demanded of
the product increases.
The demand curve happens to be a straight line. Straight line
demand curves are often used as illustration in economics
because it is convenient to draw them this way. However, in
reality, a demand curve is more likely to be a curved line
convex to the origin.
The market Demand Curve:
The demand schedule shows how much of a product consumers
are willing and able to purchase / buy at any given price. The
position of the demand curve is determined by the demand
conditions, which include consumer’s tastes and preferences
and consumer’s incomes. In the previous example, we have
been looking at the demand schedule of a single household. A
market demand curve is a similar curve, but it expresses the
expected total quantity of the product that would be
demanded by all consumers together, at any given price.
The Conditions of Demand:
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Factors Affecting Demand – several factors influence the total
market demand for a product. One of these factors is obviously
its price. A demand curve shows how the quantity demanded
will change in response to a change in price provided that all
other conditions affecting demand are unchanged; i.e.
that is, provided that there is no change in the prices of other
products, tastes, expectations or the distribution of household
income.
(1) Substitute Goods - are goods that are alternatives for
each other, so that an increase in the demand for one is
likely to cause a decrease in the demand for another.
Switching demand from one product to another “rival”
product is substitution.
(2) Complements – are goods that tend to be bought and
used together, so that an increase in the demand for one is
likely to cause an increase in the demand for the other.
Substitutes and complements are goods for which the
market demand is inter-connected.
Examples of substitute goods and services are:
 Rival brands of the same commodity, like Coca-Cola and
Pepsi-Cola.
 Tea and coffee
 Some different forms of entertainment
Substitution takes place when the price of one product rises
relative to a substitute product. By contrast, complements are
connected in the sense that demand for one is likely to lead to
demand for the other.
Examples of complement goods and services:
 Cups and saucers
 Bread and butter
 Motor cars and the components and raw materials that go
into their manufacture.

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(b) Household incomes - more income will give households
more to spend and they will want to buy more products at
existing prices. However, a rise in household income will not
increase market demand for all goods and services. The
effect of a rise in income on demand for an individual
product will depend on the nature of the product.
Demand and level of income may be related in different ways:
 We might normally expect a rise in household income to lead
to an increase in demand for a product, and products for
which demand rises as household income rises are called
normal goods.
 Demand may rise with income up to a certain point but then
fall as income rises beyond that point. Products that whose
demand eventually falls as income rises are called inferior
products, examples might include public transport or cheap
clothing. The reason for falling demand is that as incomes
rise, customers can afford to switch demand to superior
products.
(c) Demand, fashion and expectations – a change in
fashion or tastes will also alter the demand for a product. For
example, if it becomes fashionable for blue clothing to be
worn then expenditure on blue clothing will increase. Tastes
can be affected by advertisers and suppliers trying to
“create” demand for their products.
If consumers believe that prices will rise or that shortages will
occur, they may attempt to stock up on the product before
these changes occur. Again, this could lead to increases in
demand despite the price of the product remaining unchanged.
(d) Marginal Utility – utility refers to the level of
satisfaction that a consumer derives from consuming a
product or service. Marginal utility is concerned with the
extra satisfaction that a person gains from consuming one
additional unit of a particular product or service. Some
businesses use the concept of marginal utility to help them
determine how many units of an item a consumer will
purchase.

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 Marginal utility is said to be positive when consumption of
an extra unit of a product results in an increase in overall
satisfaction. If, other hand, consumption of an additional unit
of a product reduces a consumer’s overall satisfaction, then
marginal utility is said to be negative.
(e) Shifts of the demand curve – so far, we have been
looking at the way a change in price affects the quantity
demanded, depicted as a movement along the demand
curve. However, when there is a change in the conditions
of demand, the quantity demanded will change even if the
price remains constant. In this case, there will be a different
price and quantity demand schedule and so a different
demand curve. This change is called a shift of the demand
curve.
The difference between a change in demand and a shift of the
demand curve is of fundamental importance:
(i) Movements along a demand curve (contractions or
expansions) for a product are caused solely by changes
in its price.
(ii) Variations in the conditions of demand create shifts
in the demand curve –
 A rise in household income including a reduction in
direct taxes,
 A rise in the price of substitutes
 A fall in the price of complements
 A change in tastes towards this product
 An expected rise in the price of the product
 An increase in population
An outward shift in the demand curve but conversely a fall in
demand at each price level would be represented by a shift in
the opposite direction, a shift to the original demand curve.
Such a shift may be caused by the opposite of the conditions of
demand shown above.
The supply Schedule:
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The supply concept – supply refers to the quantity of a product
that existing suppliers would want to produce for the market at
a given price. As with demand, supply relates to a period of
time – for example, we might refer to an annual rate of supply
or to a monthly rate.
The quantity of a product supplied to a market varies up or
down for two reasons as follows:
(i) Existing suppliers may increase or reduce their output
quantities
(ii) Firms may stop production altogether and leave the
market or new firms may enter the market and start to
produce the product.
If the quantity that firms want to produce at a given price
exceeds the quantity that households / consumers would want,
there will be an excess of supply, with firms competing to win
what sales and demand there is. Over-supply and competition
would then be expected to result in price-competitiveness and
a fall in prices.
As with demand, a distinction needs to be made:
(i) An individual firm’s supply schedule is the quantity of the
product that the individual firm would want to supply to
the market at any given price.
(ii) Market supply is the total quantity of the product that
all firms in the market would want to supply at a given
price.
The Supply Curve:
A supply schedule and supply curve can be created both for an
individual supplier and for all firms (Market Supply Curve)
which produce the product.
A supply curve is constructed in a similar manner to a demand
curve (from a schedule of quantities supplied at different
prices) but it shows the quantity suppliers are willing to
produce at different price levels. It is an upward sloping
curve from left to right, because greater quantities will be
supplied at higher prices.
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We usually assume that suppliers aim to maximise their
profits and the upward slope of the supply curve reflects this
desire to make profit (i.e. they are prepared to supply more of
a product the higher the price that customers will pay for it). It
is also important to bear in mind that under the Free
Competition Market Structure, which we have indicated
that discussion of this module will be based, a single supplier is
assumed to be a price-taker. In other words, a single supplier
cannot influence the price at which his products are being sold
in the market. But rather he takes the price that is determined
by the forces of demand and supply i.e. the market price or
market clearing price as this price is also known as.
The Law of Supply states that as price of a product rises,
other things remaining constant, the quantity supplied of a
product will increase.
Factors Influencing the Supply Quantity:
The quantity supplied of a product depends, as you might
expect, on prices and costs. More specifically, it depends on
the following factors:
(i) The costs of producing the product – these include raw
materials costs which ultimately depend on the prices of
factors of production (wages, interest rates, land rents and
profit expectations).
(ii) The prices of other products – when a supplier can
switch readily from supplying one product to another, the
products concerned are substitutes in supply. An
increase in the price of one such product would make the
supply of another product whose price does not rise less
attractive to suppliers. When a production process has two
or more distinct and separate outputs, the products
produced are known as goods in joint supply or
complements in production. Goods in joint supply
include, for example, meat and hides. If the price of beef
rises, more will be supplied and there will be an
accompanying increase in the supply of cow hides.
(iii) The application of indirect taxes and subsidies will
affect prices. If the government apply an indirect tax on
the producer, such as per litre of fuel oil, then the
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 producer will treat this as a cost rise and raise their
price. Alternatively, if the government contributes a
subsidy, say a sum of money per education course sold,
then the producer will reduce their prices to get a bigger
number of sales and so attract more units of the subsidy.
(iv) Expectations of price changes – if a supplier expects
the price of a product to rise, he is likely to try to reduce
supply while the price is lower so that he can supply more
of his product or service once the price is higher.
(v) Changes in technology – technological developments
which reduce costs of production (and increase
productivity) will raise the quantity of supply of a product
at a given price.
(vi) Other factors – such as changes in the weather (for
example, in the case of agricultural products), natural
disasters or industrial disruption.
The supply curve shows how the quantity supplied will change
in response to a change in price. If supply conditions alter, a
different supply curve must be drawn. In other words, a change
in price will cause a change in supply along the supply
curve. A change in other supply conditions will cause a shift in
the supply curve itself.
This distinction between a movement along the supply curve
and a shift in the supply curve is just as important as the
similar distinction relating to the demand curve.
Shifts of the Market Supply Curve:
The market supply curve is the aggregate of all the supply
curves of individual firms in the market. A shift of the market
supply curve occurs when supply conditions (other than the
price of the product itself) change. A rightward (or downward)
shift of the curve shows an expansion of supply and may be
caused by the factors below:
(i) A fall in the cost of factors of production, for example, a
reduction in the cost of raw material inputs.
(ii) A fall in the price of other products. The production of
other products becomes relatively less attractive as their
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 price falls. Firms are therefore likely to shift resources
away from the products whose price is falling and into the
production of higher priced products that offer increased
profits. We therefore expect that (ceteris paribus), the
supply of one product will rise as the prices of other
products fall and vice versa.
(iii) Technological progress which reduces unit costs and also
increases production capabilities.
(iv) Improvements in productivity or more efficient use of
existing factors of production which again will reduce unit
cost.
A shift of the supply curve is the result of changes in costs,
either in absolute terms or relative to the costs of other
products.
Conversely, we might see a left or upward shift in the supply
curve if the cost of supply increases. This would mean that at
the existing price, a firm’s output will decrease and less will be
supplied. An upward (leftward) shift in supply could be caused
by:
(i) An increase in the cost of factors of production e.g. a rise
in wages and salaries, which are the costs of labour.
(ii) A rise in the price of other products which would make
them relatively more attractive to the producer.
(iii) An increase in indirect taxes or a reduction in a subsidy,
which would make supply at existing prices less profitable.
The Equilibrium Price:
People only have a limited income and they must decide what
to buy with the money they have. The prices of the products
they want will affect their buying decisions. The firms ‘output
decisions will be influenced by both demand and supply
considerations.
(i) Market demand conditions influence the price that a firm
will get for its output. Prices act as signals to producers
and changes in prices should stimulate a response from a
firm to change its production quantities.
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(ii) Supply is influenced by production costs and profits. The
objective of maximising profits provides the incentive for
firms to respond to changes in price or cost by changing
their production quantities.
(iii) Because demand is potentially greater than supply the
scarce supply must be rationed-out between the buyers.
This is done by the price rising until only the keenest
buyers can afford it.
In summary, the three functions of price are signalling,
rewarding and rationing.
The price mechanism and the equilibrium price
The price mechanism brings demand and supply into
equilibrium and the equilibrium price for a product is the
price at which the volume demanded by consumers and the
volume that firms would be willing to supply is the same. This
is also known as the market clearing price, since at this price
there will be neither surplus nor shortage in the market.
The way demand and supply interact to determine the
equilibrium price can be illustrated by drawing the market
demand curve and the market supply curve on the same
graph.
At price P1, suppliers want to produce a greater quantity than
the market demands, meaning that there is excess supply,
equal to the distance AB. Suppliers would react as the stock of
unsold products accumulates:
 They would cut down the current level of production in order
to sell unwanted inventories
 They would also reduce prices in order to encourage sales.
The opposite will happen at price P2 where there is an excess
of demand over supply shown by the distance CD. Supply and
price would increase. Faced with an excess of demand,
manufacturers could raise their prices. This would make
supplying the product more profitable and supply would
increase.

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The forces of supply and demand push a market to its
equilibrium price and quantity. Note the following key points:
(i) If there is no change in conditions of supply or demand,
the equilibrium price will prevail in the market and will
remain stable.
(ii) If the price is not at the equilibrium the market is in
disequilibrium and supply and demand will push prices
towards the equilibrium price.
(iii) In any market there will only be one equilibrium position
where the market is cleared.
(iv) Shifts in the supply curve or demand curve will change the
equilibrium price (and the quantity traded).
The competitive market process results in an equilibrium
price which is the price at which market supply and market
demand quantities are in balance. In any market, the
equilibrium price will change if market demand or supply
conditions change.

Elasticity of Demand and Supply:

The Price elasticity of Demand – elasticity in general refers
to the relationship between two variables. Price elasticity of
demand explains the relationship between change in quantity
demanded and changes in price. If prices went up by 10%,
would the quantity demanded fall by the same percentage?
Price Elasticity of Demand (PED) indicates or measures the
responsiveness in the quantity demanded of a product to
changes in its price.
The coefficient of PED is measured as: % Change in Quantity
Demanded
% Change in Price
Since demand usually increases when the price falls, and
decreases when the price rises, elasticity has a negative
value. However, it is usual to ignore the minus sign and just
describe the absolute value of the coefficient.
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If we are measuring responsiveness of demand to a large
change in price, we can measure elasticity between two points
on the demand curve and the resulting measure is called the
Arc Elasticity of Demand (Arc PED). We calculate the Arc
Elasticity of Demand from the percentage change in quantity
relative to average quantity for the relevant range of output
and from the percentage price change relative to the average
of the corresponding price range.
Arc PED =Q2 – Q1 / P2 –P1
(Q2+Q1)/2 (P2+P1)/2
Worked example of calculating Arc PED:
The price of a product is K1,200 per unit and annual demand is
800,000 units. Market research indicates that an increase in
price of K100 per unit will result in a fall in annual demand of
70,000 units. What is the price elasticity of demand measuring
the responsiveness of demand over this range of price
increase?
Solution:
Firstly we need to determine the values of Quantities and
Prices as follows:
 Q1 =800,000 and Q2 = (800,000 – 70,000) = 730,000
i.e. resulting from a fall of 70,000 units from the initial units
of 800,000.
 P1=1,200 and P2 = (1,200+100) = 1,300 i.e. resulting from
an increase of price by 100 from the initial 1,200.
Arc PED = Q2 – Q1 / P2 – P1
(Q2+Q1)/2 (p2+P1)/2
= 730,000 – 800,000 / 1,300 – 1,200
(730,000+800,000)/2 (1,300+1,200)/2
= 70,000 / 100
765,000 1,250
= 0.0915 / 0.08
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Arc PED = 1.14
The demand for this product over the range of annual demand
of 730,000 to 800,000 units is elastic because the price
elasticity of demand is greater than 1.

Point Elasticity of Demand:

If we wish to measure the responsiveness of demand at one
particular point in the demand curve, we can calculate a
Point Elasticity of Demand without averaging quantity and
price over a range. In doing so, it is convenient to assume that
the demand curve is a straight line unless told otherwise.
Worked example of calculating Point Elasticity of Demand
(PED):
The price of a product is K1,200 per unit and annual demand is
800,000 units. Market research indicates that an increase in
price of K100 per unit will result in a fall in annual demand for
the product of 70,000 units. Calculate the elasticity of demand
at the current price of K1,200.
Solution:
Firstly we need to determine the values of the Quantities and
Prices as follows:
 Q1 = 800,000 and Q2 = (800,000 – 70,000) = 730,000 i.e.
resulting from a fall in annual demand by 70,000 units from
800,000 units.
 P1 = 1,200 and P2 = (1,200+100) = 1,300 i.e. resulting from
an increase of price by 100 from 1,200.
At the current price of K1,200, annual demand is 800,000 units
for a price rise of 100.
Point Elasticity of Demand (PED) = Q2+Q1 / P2+P1
Q1 P1
PED = 730,000 – 800,000 / 1,300 – 1,200
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 800,000 1,200
= 70,000 / 100
800,000 1,200
= 0.08750 / 0.0833
Point PED= 1.05
The price elasticity of demand at this point is 1.05. Demand is
elastic at this point because the elasticity is greater than 1.

Elastic and Inelastic Demand:

The value of demand elasticity may be anything from zero to
infinity:
 Demand is elastic if the absolute value is greater than 1
 Demand is inelastic if the absolute value is less than I
Consider what this means if there is an increase in price.
Where demand is elastic, demand falls by a larger
percentage than the rise in price. Where demand is inelastic,
the quantity demanded falls by a small percentage than the
rise in price.
Price elasticity varies along the demand curve:
Generally, demand curves slope downwards. Consumers are
willing to buy more at lower than higher prices. Except in
certain special cases, elasticity will vary in value along the
length of a demand curve.
At higher prices on a straight line demand curve (at the top of
the demand curve), small percentage price reduction can
bring larger percentage increase in quantity demanded. This
means that demand is elastic over these ranges.
At lower prices on a straight line demand curve (the bottom of
the demand curve), large percentage price reductions can
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bring small percentage increases in quantity. This means that
demand is inelastic over these ranges.
Special Values of Price Elasticity of Demand:
There are three special values of price elasticity of demand: 0,
1 and infinity.
(i) Demand is perfectly elastic: n=0 (infinitely elastic).
Consumers will want to buy an infinite amount, but only
up to a particular price level. Any price increase above this
level will reduce demand to zero. In this case, the demand
curve is a horizontal straight line.
(ii) Demand is perfectly inelastic: n=0. There is no change
in quantity demanded, regardless of the change in price.
In this case, the demand curve is a vertical straight
line.
(iii) Unit elasticity of demand: n=0. Total revenue for
suppliers (which is the same as total spending on the
product by households), does not change regardless of
how the price changes. The demand curve of a product
whose price elasticity of demand is 1 over its entire range
is a rectangular hyperbola.
The Significance of Price Elasticity of Demand:
The price elasticity of demand is relevant to total spending on
a product or service. Total expenditure is a matter of
interest to both suppliers, to whom sales revenue accrues
and to government who may receive a portion of total
expenditure in the form of taxation.
(i) When demand is elastic, an increase in price will result
in a greater than proportional fall in the total quantity
demanded and total expenditure will fall.
(ii) When demand is inelastic, an increase in price will
result in a fall in quantity demanded, but the fall in
quantity demanded will be less than proportional to the
rise in price so total expenditure will rise.
(iii) With unity elasticity, expenditure will stay constant
regardless of a change in price.
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Information on Price Elasticity of Demand:
Information on price elasticity of demand indicates how
consumers can be expected to respond to different prices.
Business people can make use of information on how
consumers will react to pricing decisions as it is possible to
trace the effect of different prices on total revenue and profits.
Information on price elasticities of demand will be useful to a
business which needs to know the price decrease necessary
to clear a surplus (excess supply) or the price increase
necessary to eliminate a shortage (excess demand). Elasticity
is also useful, more generally, for a firm if it is considering
changing the price of a product or service and considering the
impact this change will have on revenues.
Government policy makers can also use the information about
elasticity, for example, when making decisions about indirect
taxation. Products with low (inelastic) price elasticity of
demand such as cigarettes and alcohol tend to be useful
targets for taxation since by increasing taxes on these, total
revenue can be increased. If demand for cigarettes was price
elastic, increases in taxation would be counter-productive as
they would result in lower government revenue.
Elasticity and Total Revenue:
The concept of elasticity is an important decision making tool to
both the private business enterprises, particularly those
involved in manufacturing and also to the government as it
considers the application of taxation on the various products in
an economy. It is important that decision makers understand
that different products face different types of price elasticity of
demand in the market. In order to appreciate the impact of this
concept, let us take the following practical examples:
Suppose that there are two products, A and B. Product A
currently sells for K5,000 per unit and demand at this price is
1,700 units. If the price fell to K4,600 per unit demand would
increase to 2,000 units.
Product B currently sells for K8,000 per unit and demand at this
price is 9,500 units. If the price fell to K7,500 per unit, demand
would increase to 10,000 units.

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In each of these cases, and using the “point” method,
calculate:
(a) The price elasticity of demand (PED) for the given price
changes
(b) The effect on total revenue if demand is met in full at both
the “old” and “new prices”, of the change in price.
Solution:
(a) Product A:
Firstly we need to determine the values of Quantities and
Prices as follows:
 At current price of K5,000 Q1=1,700 and Q2=2,000 i.e.
resulting from an increase to 2,000 units.
 P1=5,000 and P2=4,600 i.e. resulting from a fall in price to
4,600.
Point PED = Q2 – Q1 / P2 – P2
Q1 P1
Point PED = 2,000 – 1,700 / 4,600 – 5,000
1,700 5,000
= 300 / 400
1,700 5,000
= 0.1765 / 0.08
Point PED = 2.2
Demand is elastic and a fall in price should result in a large
increase in quantity demanded such that total revenue will
increase / rise.
Revenue Analysis: in order to prove that total revenue will
increase given that the PED is elastic, we undertake the
following calculations:
Revenue at “old price” of K5,000 (5,000 x 1,700 units)
=K8,500,000

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Revenue at “new price” of K4,600 (4,600 x 2,000 units) =
K9,200,000
Increase in Total Revenue: =K700,000

(b) Product B:
Firstly we need to determine the values of Quantities and Prices
as follows:
 At current price of K8,000 Q1=9,500 and Q2=10,000 i.e.
resulting from an increase to 10,000 units.
 P1=8,000 and P2=7,500 i.e. resulting from a fall in price to
7,500.

Point ED = Q2 –Q1 / P2 – P1
Q1 P1
= 10,000 – 9,500 / 7,500 -8,000
9,500 8,000
= 500 / 500
9,500 8,000
= 0.0526 / 0.0625
Point PED = 0.84
Demand is inelastic and a fall in price should result in only a
relatively small increase in quantity demanded such that total
revenue will decrease / fall.

Revenue Analysis: in order to prove that total revenue will

decrease fall given that the PED is inelastic, we undertake
the following calculations:
Revenue at “old price” of K8,000 (8,000 x 9,500 units)
K76,000,000

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Revenue at “new price” of K7,500 (7,500 x 10,000 units)
K75,000,000
Decrease / Fall in Total Revenue:
(K1,000,000)

Factors Influencing Price Elasticity of Demand for a

Product:

Factors that determine price elasticity of demand (PED) are

similar to the factors other than price that affect the volume of
demand. The PED is really a measure of the strength of these
other influences on demand:

(i) Percentage of income spent on the product – if

expenditure on a product only constitutes a small
proportion of a consumer’s income, then a change in the
price of that product will not have much impact on the
consumer’s overall real income. Therefore, demand for
low price products (such as safety matches) is likely to be
inelastic. By contrast, demand is likely to be elastic for
expensive products.

(ii) Availability of substitutes – the more substitutes these

are for the product, especially close substitutes, the
more elastic the price elasticity of demand for the
product will be. For example, the elasticity of demand for
a particular brand of breakfast cereal will be much greater
than the elasticity of demand for breakfast cereal as a
whole, because the former have both more and also close,
substitutes. A rise in the price of a particular brand of
cereal is likely to result in customers switching their
demand to a rival brand. Availability of substitutes is
probably the most important influence on price elasticity
of demand.

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(iii) Necessity – demand for products which are necessary for
everyday life (for example, basic foodstuffs) tend to be
relatively inelastic while demand for luxury products
tends to be elastic. If a product is a luxury and its price
rises, the rational customer may well decide that he or she
no longer needs that product and so demand for it will
fall. However, if a product is a necessity, the consumer
will have to continue buying it even though its price has
increased.

(iv) The time horizon – if the price of a product is increased,

there might initially be little change in demand because
the customer may not be fully aware of the increase or
may not have found a suitable substitute for the
product. Then, as consumers adjust their buying habits in
response to the price increase, demand might fall
substantially. The time horizon influences elasticity
largely because the longer the period of time which we
consider, the greater the knowledge of substitution
possibilities by consumers and the provision of substitutes
by producers. Therefore, elasticity tends to increase as
the time period increases.

(v) Competitor pricing – if the response of competition to a

price increase by one firm is to keep their prices
unchanged, the firm raising its price is likely to face
elastic demand for its products at higher prices. If the
response of competitors to a reduction in price by one firm
is to match the price reduction themselves, the firm is
likely to face inelastic demand at lower prices. This is a
situation which faces many large firms with one or two
major competitors. We will look at this situation in more
detail later when we consider the characteristics of
oligopolies.

(vi) Habit – products which are habit-forming tend to be

inelastic, because the consumer “needs” the products

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 despite their increase in price. This pattern can be seen
with additive products such as cigarettes.

(vii) Definition market – if a market is narrowly defined (for

example, breakfast cereals) there will be a number of
competing brands and substitute products available so
these brands will be price elastic. If a market is only
broadly defined (for example, food) there will be fewer
generic alternatives and so demand will tend to be
inelastic.

Income Elasticity of Demand:

Income elasticity of demand (YED) measures the

responsiveness in demand for a product or service to changes
in income.

Products for which YED is positive are called normal products;

inferior products have a negative YED.

Income Elasticity of Demand = % Change in Quantity

Demanded

% Change in Income

YED = Q2 – Q1 / Y2 – Y1 Or

Q1 Y1

YED = Q2 – Q1 / Y2 – Y1

(Q2+Q1)/2 (Y2+Y1)/2

Zero Income Elasticity:

A change in income may have no effect on the quantity

demanded, demand remains the same i.e. YED=0

Consumers purchase only what they require, this applies to

Giffen products, necessities like maize, mealie meal etc.

Practical uses of Income Elasticity of Demand:

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Producers use YED in their production plans. When incomes are
rising, firms need to produce more normal products than
inferior products because these are the products that will be
in high demand. On the other hand, when incomes are
reducing, firms need to produce more inferior products than
normal products since these are the products that will be in
high demand.

Similarly, the government must be able to predict its revenue

from taxes. Thus, the tax taken from products with different
income elasticities of demand will respond differently to rises
and falls in national income.

Cross Elasticity of Demand:

Cross elasticity of demand measures the responsiveness or

sensitivity of demand for one product to changes in price of
another product.

XED = % Change in Quantity Demanded of Product A

% Change in Price of Product B

XED = QA2 – QA1 / PB2 –PA1

QA1 PA1

Where suffix A represents product A and suffix B represents

product B.

The XED of substitute products is positive, while that for

complements is negative.

Elasticity of Supply:

The price elasticity of supply measures the responsiveness of

supply to a change in price.

Elasticity of Supply = % Change in Quantity Supplied

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 % Change in Price.

Where the supply of products is fixed whatever price is offered,

for example, in the case of antiques, vintage wines and land,
supply is perfectly inelastic and the elasticity of supply is
zero. The supply curve is a vertical straight line.

Where the supply of products varies proportionately with the

price, elasticity of supply is equal to one and the supply curve
is a straight line passing through the origin. (Note that a
demand curve with unit elasticity along all of its length is not
a straight line but a supply curve with unit elasticity is a
straight line).

Where the producers will supply any amount at a given price

but none at all at slightly lower rice, elasticity of supply is
infinite or perfectly elastic. The supply curve is a
horizontal straight line. Note that a supply curve with unit
elasticity can have many different gradients. The key feature
that identifies unitary elasticity is not the gradient of the curve,
but the fact that it passes through the origin.

Supply is elastic when the percentage change in the amount

producers want to supply is greater than proportional to the
percentage change in price.

Supply is inelastic when the amount producers want to supply

changes by a smaller percentage than the percentage change
in price.

Note, if the supply curve “cuts” across the quantity supplied

axis, supply is inelastic. If the supply curve “cuts” across the
price axis, supply is elastic.

Factors Affecting Elasticity of Supplier:

Elasticity of supply is a measure of firms ‘ability to adjust the

quantity of products they supply. This depends on a number of
constraints some of which are as follows:

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(i) Existence of inventories of finished products – if a
firm has large inventories of finished products then it can
draw on these to increase supply following an increase in
the price of the product in the market. So supply will be
relatively elastic. Perishability or shelf life is important
considerations here though.

(ii) Availability of labour – when unemployment is low it

may be difficult to find worker people with the appropriate
skills.

(iii) Spare capacity – if a firm has spare capacity (e.g.

machinery which is not being fully utilised), it can quickly
and easily increase supply following an increase in
price of products in the market. In this way, spare
capacity is likely to increase elasticity of supply.

(iv) Availability of raw materials and components – the

existence and location of inventories is important just as
they are for finished products.

(v) Barriers to entry – if firms can move into the market

easily and start supplying quickly, elasticity of supply in
that market will be increased.

(vi) The time scale – the elasticity of supply of a product

varies according to the time period over which it is
measured. For analytical purposes, four lengths of time
period may be considered:

(a) The market period – is so short that supplies of the

commodity in question are limited to existing
inventories. In effect, supply is fixed.

(b) The short-run period – is a period long enough for

supplies of the commodity to be altered by increases or
decreases in current capacity, but not long enough
for the factory to be increased in scale. This means that
suppliers can produce larger quantities only if they are

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 already operating at full capacity; they can reduce
output fairly quickly by means of redundancies and
laying-off staff.

(c) The long-run period – is a period sufficiently long

to allow firms ‘capacity to be altered. There is time to
build new factories and machines and time for old ones
to be closed down. New firms can enter the industry in
the long-run.

(d) The secular period – is so long that the underlying

economic factors such as population growth, supplies of
raw materials (such as oil) and the general conditions of
capital supply may alter. The secular period is ignored
by economists except in the theory of economic growth.

In general, supply tends to be more elastic in longer

time periods.

Response to changes in demand:

The price elasticity of supply can be seen, in effect, as a

measure of the readiness with which an industry responds
following a shift in the demand curve.

Summary:

Elasticity of supply measures the responsiveness of the

quantity of a product supplied following a change in the price of
that product. It is a measure of firms ‘ability to adjust the
quantity of products they supply when price changes.

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