10 : Theory of Demand

Recap from last session

Change in Demand
Supply, Law of Supply
Market Equilibrium
Change in Equilibrium

Prof. Trupti Mishra, School of Management, IIT Bombay

A Shift in Both Supply and Demand

Price of
Ice-Cream
Cone

Large increase
in demand

New
equilibrium

S2
S1

P2
Small
decrease in
supply

P1

D2

Initial equilibrium

D1
0

Q1

Q2

Prof. Trupti Mishra, School of Management, IIT Bombay

Quantity of
Ice-Cream
Cone

A Shift in Both Supply and Demand

Price of
Ice-Cream
Cone

Small increase
in demand

S2

New
equilibrium

S1

P2
Large
decrease in
supply

P1

Initial
equilibrium

D2
D1
0

Q2

Q1

Prof. Trupti Mishra, School of Management, IIT Bombay

Quantity of
Ice-Cream
Cone

Simultaneous Shifts

When demand & supply shift simultaneously

Can predict either the direction in which price changes or
the direction in which quantity changes, but not both
The change in equilibrium price or quantity is said to be
indeterminate when the direction of change depends on
the relative magnitudes by which demand & supply shift
Prof. Trupti Mishra, School of Management, IIT Bombay

What Happens to Price and Quantity when Supply or

Demand Shifts?

Prof. Trupti Mishra, School of Management, IIT Bombay

Session 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.

Prof. Trupti Mishra, School of Management, IIT Bombay

Session Summary
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.
Prof. Trupti Mishra, School of Management, IIT Bombay

Session Summary

The supply curve shows how the quantity of a good

supplied depends upon the price.

According to the law of supply, as the price of a good

rises, the quantity supplied rises.
supply curve slopes upward.

Therefore, the

Prof. Trupti Mishra, School of Management, IIT Bombay

Session Summary

In addition to price, other determinants of how much

producers want to sell include input prices, technology,
expectations, and the number of sellers.

If one of these factors changes, the supply curve shifts.

Prof. Trupti Mishra, School of Management, IIT Bombay

10

Session Summary
Market equilibrium is determined by the intersection of
the supply and demand curves.
At the equilibrium price, the quantity demanded equals
the quantity supplied.
The behavior of buyers and sellers naturally drives
markets toward their equilibrium.

Prof. Trupti Mishra, School of Management, IIT Bombay

11

Elasticity of Demand
From the managerial point of view, the knowledge of the
nature of relationship between
products demand and its determinants is not sufficient. What
is more important is the degree of responsiveness of demand
to changes in its determinants.

Prof. Trupti Mishra, School of Management, IIT Bombay

12

Elasticity of Demand

It allows us to analyze demand with greater precision.

It is a measure of how much buyers and sellers respond to
changes in market conditions
Prof. Trupti Mishra, School of Management, IIT Bombay

13

Elasticity of Demand measures the degree of responsiveness

of the quantity demanded of a commodity to a given change in
any of the determinants of demand.

Prof. Trupti Mishra, School of Management, IIT Bombay

Types of Elasticity of Demand

Price elasticity of Demand

Income Elasticity of Demand

Cross Elasticity of Demand
Prof. Trupti Mishra, School of Management, IIT Bombay

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.
Percentage change in quantity demanded given a percent
change in the price.

Prof. Trupti Mishra, School of Management, IIT Bombay

Price Elasticity of Demand

% Q
% P
P & Q are inversely related by the law of demand so E is
always negative.
E

The larger the absolute value of E, the more sensitive buyers

are to a change in price
Prof. Trupti Mishra, School of Management, IIT Bombay

Degree of Price Elasticity of Demand

Inelastic Demand
Quantity demanded does not respond strongly to price
changes.
Elastic Demand
Quantity demanded responds strongly to changes in price.
Prof. Trupti Mishra, School of Management, IIT Bombay

Degree of Price Elasticity of Demand

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.
Prof. Trupti Mishra, School of Management, IIT Bombay

Degree of Price Elasticity of Demand

Price

Price
D
D

Quantity

Perfectly Elastic
E =

Quantity

Perfectly Inelastic
Ep = 0

Prof. Trupti Mishra, School of Management, IIT Bombay

Inelastic Demand
Price

Demand

E<1

5.00

4.00
1. A 25%
increase in
price

90

100

Quantity

2. Leads to a 10% decrease in quantity demanded.

Prof. Trupti Mishra, School of Management, IIT Bombay

21

Unit Elastic Demand

E=1

Price

Demand

5.00

4.00
1. A 25%
increase in
price

75

100

Quantity

2. Leads to a 25% decrease in quantity demanded.

Prof. Trupti Mishra, School of Management, IIT Bombay

22

Elastic Demand
E>1

Price

Demand

5.00

4.00
1. A 25%
increase in
price

50

100

Quantity

2. Leads to a 50% decrease in quantity demanded.

Prof. Trupti Mishra, School of Management, IIT Bombay

23

The own-price elasticity can be measured between two

points on a demand curve (for arc elasticity) or on a
point ( for point elasticity)

Prof. Trupti Mishra, School of Management, IIT Bombay

24

Measurement of Price Elasticity of Demand

Point Elasticity of Demand

% Q
% P

Q
Q
P
P

100
100

Q
P

P
Q

Prof. Trupti Mishra, School of Management, IIT Bombay

ARC Elasticity of Demand

Q
P

Average P
Average Q

Total Revenue and Price Elasticity of Demand

Price

4.00

P x Q = 400
(revenue)
Demand

100

Prof. Trupti Mishra, School of Management, IIT Bombay

Quantity
27

How Total Revenue Changes When Prices Changes: Inelastic

Demand
Price

3.00

P x Q = 240
(revenue)
1.00

P x Q = 100
(revenue)
0

Demand
80

100

Prof. Trupti Mishra, School of Management, IIT Bombay

Quantity
28

How Total Revenue Changes When Prices Changes: Elastic

Demand
Price

Change in Total Revenue when Price Changes

5.00

4.00

Demand

Revenue = 200

Revenue = 100

20

50

Prof. Trupti Mishra, School of Management, IIT Bombay

Quantity
29

A Linear Demand Curve

Price

Elasticity
is larger
than 1.

7
6

5
4
Elasticity
is smaller
than 1.

3
2
1

10

12

Prof. Trupti Mishra, School of Management, IIT Bombay

14

Quantity
30

Price Elasticity & Total Revenue

Elastic

Unitary elastic

Inelastic

Q-effect dominates

No dominant effect

P-effect dominates

% Q

% P

% Q

% P

% Q

% P

Price
rises

TR falls

No change in TR

TR rises

Price
falls

TR rises

No change in TR

TR falls

Prof. Trupti Mishra, School of Management, IIT Bombay

31

Determinants of Price Elasticity of Demand

Nature of Commodity :
The demand for luxury goods is more price-elastic than the
demand for necessities and comforts.
The demand for necessity goods is price-inelastic.
Comforts have more elastic demand than necessities, and less
elastic demand than luxuries.
Prof. Trupti Mishra, School of Management, IIT Bombay

Determinants of Price Elasticity of Demand

Availability and proximity of Substitutes : The higher the degree

of closeness between the commodity and its substitutes, the
greater the price-elasticity of demand for the commodity.

Prof. Trupti Mishra, School of Management, IIT Bombay

Determinants of Price Elasticity of Demand

Proportion of Income Spent on the Commodity: The larger the
proportion of income spent on a commodity, the greater will be
the elasticity of demand for such commodity, and vice versa.

Prof. Trupti Mishra, School of Management, IIT Bombay

Determinants of Price Elasticity of Demand

Time: The longer the adjustment time, the greater the priceelasticity of demand

Prof. Trupti Mishra, School of Management, IIT Bombay

Determinants of Price Elasticity of Demand

Durability of the Commodity
Items of addiction

Prof. Trupti Mishra, School of Management, IIT Bombay

Income Elasticity of Demand

Income elasticity (EM) measures the responsiveness of quantity
demanded to changes in income, holding the price of the good &
all other demand determinants constant.
EM

% Qd
% M

Qd
M

M
Qd

Prof. Trupti Mishra, School of Management, IIT Bombay

Income Elasticity of Demand

Positive for a normal good
Negative for an inferior good
Zero for a neutral goods

Prof. Trupti Mishra, School of Management, IIT Bombay

Income Elasticity of Demand

If Em > 1, Luxury good
If Em < 1, Necessity Goods
If Em = 1, Semi Luxury goods

Prof. Trupti Mishra, School of Management, IIT Bombay

Cross-Price Elasticity of demand

Cross-price elasticity of demand
(EXY) measures the
responsiveness of quantity demanded of good X to changes in
the price of related good Y, holding the price of good X & all
other demand determinants for good X constant

Prof. Trupti Mishra, School of Management, IIT Bombay

40

Cross-Price Elasticity of demand

E XY

% QX
% PY

QX
PY

PY
QX

Positive when the two goods are substitutes

Negative when the two goods are complements

Prof. Trupti Mishra, School of Management, IIT Bombay

41

Promotional/ Advertising Elasticity of Demand

It measures the response of quantity demanded to change in
the expenditure on advertising and other sales promotion
activities.

Prof. Trupti Mishra, School of Management, IIT Bombay

42

Promotional/ Advertising Elasticity of Demand

Ea = Q/A.A/Q

Q= quantity of goods sold

A= unit of advertising expenditure on goods

Prof. Trupti Mishra, School of Management, IIT Bombay

43

Session References
Managerial Economics; D N Dwivedi, 7th Edition
Managerial economics Christopher R Thomas, S Charles
Maurice and Sumit Sarkar
Managerial economics Geetika, Piyali Ghosh and Purba Roy
Choudhury
Managerial economics- Paul G Keat, Philip K Y Young and
Sreejata Banerjee
Micro Economics : ICFAI University Press
Prof. Trupti Mishra, School of Management, IIT Bombay

44

Numericals
Demand Schedule
Price

Quantity Demanded

3
20
4
15
5
11
6
9
7
7
Compute point price elasticity of demand for decrease in price from Rs 6 to 5.
Compute point price elasticity of Demand for a increase in price from Rs 5 to 6.

45

Price

Quantity Demanded

10

30

11

25

12

21

13

18

The current price is Rs 12 per kg. Compute E using arc method for an
increase in price by one rupee per kg.

Prof. Trupti Mishra, School of Management, IIT Bombay

46