Economics of Demand & Supply

Economics of Demand & Supply
In every market, there are both buyers and sellers. The buyers' willingness to buy a particular good (at
various prices) is referred to as the buyers' demand for that good. The sellers' willingness to supply a
particular good (at various prices) is referred to as the sellers' supply of that good. Economists use the
term demand to refer to the amount of some good or service consumers are willing and able to purchase
at each price. Demand is based on needs and wants, based on ability to pay. What a buyer pays for a unit
of the specific good or service is called price. The total number of units purchased at that price is called
the quantity demanded.
The price of a commodity is determined by its demand and supply equalisation. However, it is
not the demand of a single buyer or the supply of a single seller which determines the price of a
commodity in the market. It is the demand of all the buyers of a commodity taken together and the
supply made by all the sellers selling that commodity taken together, which determine the price of that
commodity in the market. This is called the equilibrium price. In economic terminology, demand is not
the same as quantity demanded. When economists talk about demand, they mean the relationship
between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve
or a demand schedule.
Meaning of Demand
Demand, in economics, refers to the amount of a commodity which the consumers are prepared to
purchase at a particular price per unit of time. Demand in economics, is therefore, is not the same thing
as desire. You may have a desire to have a car but if you do not have sufficient money with you to
purchase it and even if you have sufficient money with you but are not prepared to spend it on the
purchase of the car, it will merely remain a desire and will not be called demand. Your desire to have a
car will become demand when you have sufficient money with you and are willing to spend the
money on the purchase of the car at the particular price per unit of time. The time may be one hour,
one day, one week, and one month and so on. A want with three attributes - desire to buy, willingness to
pay and ability to pay - becomes effective demand. Only an effective demand figures in economic
analysis and business decisions.
It is meaningless to say that the demand of car in our country is 10,000 because this statement does not
specify the price of car and the unit of time. Even it is not correct when you say that the demand of car in
India is 10,000 when price per car is Rs. 80,000, because it does not refer to the unit of time. The correct
statement would be that the demand for car in India per year is 10,000 at the price of Rs. 80,000 per car.
Even if you have, say, one lakh rupees with you but are not willing to spend the money on the purchase
of a car at the price of Rs. 80,000 per car today, then you cannot say that you have a demand for a car.
Factors Determining the Demand
The demand for a commodity does not remain constant. It keeps on varying with changing conditions.
(i) Household Demand The demand for a commodity by a consumer or a household depends upon the
following factors:
(a) Income: The income of family is a very important factor determining its demand for a
commodity. Other things remaining constant, if the income increases, normally the demand for goods
will increase and vice-versa. With increase in income the demand for superior goods and goods of
comforts and luxuries will increase and the demand for inferior goods will decline. But if the income
declines the demand for superior goods and those of comforts and luxuries will decline.
(b) Price of the commodity: Normally there is an inverse relationship between the price of a
commodity and its demand. Other things remaining constant, if the price of a commodity declines
normally more of it will be purchased and if the price increases, lesser amount of the commodity will be
purchased.

(c) Taste and Preferences of consumers: Taste, fashion and preferences of the consumers also
affect the demand for a commodity. If people have developed a taste or preference for a commodity its
demand will increase but if a commodity has gone out of fashion, its demand will decline.
(d) Price of related goods: The changes in the price of related goods i.e., complementary and
substitute goods also affect the demand for a commodity. Complementary goods are those goods where
one commodity has utility and is demanded only when the second related commodity is also available.
For instance scooter and petrol are complementary goods. If the price of petrol increases, it will reduce
the demand for scooter. Similarly, change in the price of refills will affect the demand for ball-pens.
Substitute’s goods are those where one goods can be used in place of another. For instance, tea and
coffee are close substitutes. One can use tea in place of coffee and vice-versa. If the price of coffee
increases, people will start substituting tea for coffee and therefore the demand for tea will increase even
though there is no change in the price of tea.
(ii) Market Demand: When we take market demand i.e. the total demand for a commodity in the
market, in addition to the above four factors, there are two other factors which also determine the market
demand. These two factors are - the size and composition of the population and distribution of income:
(e) Size and composition of Population: Large and increasing population increases the demand
for various types of goods and vice-versa. Similarly the composition of population i.e., ratios of male-
female, children-adult-old-age people etc., also affect the demand for different types of goods. For
instance, if there are more children, the demand for goods such as toys, baby foods, biscuits etc., will be
more.
(f) Distribution of Income: If there is an unequal distribution of national income and few people
have large income while other have to do with small income, the demand for goods of comforts and
luxuries will be more and that of the goods needed by the majority of people, who are poor, will be
small. If there is an even distribution of income in a country, the demand for luxuries will be less and
that of goods of mass consumption will be more.
The Law of Demand
The law of demand expresses the functional relationship between price and quantity demanded.
According to the law of demand, an inverse relationship exists between the price of a good and the
quantity demanded of that good assuming that all other variables that affect demand are held constant.
As the price of a good goes up, buyers demand less of that good and vice versa. This other things which
are assumed to be constant arc the tastes or preferences of the consumer, the income of the consumer,
and the prices of related goods. The Law of Demand is only a qualitative statement. It tells only the
direction in which the quantity of a commodity will normally change in response to any change in its
price but does not say anything about the quantum or the amount of change in response to change in the
price of a commodity.
Basis of Law of Demand: Why does Demand Curve Slope Downward?
The law of demand operates or demand curves slope downwards due to the following reasons:
(i) Operation of Law of Diminishing Marginal Utility: The Law of Demand is based on the law of
diminishing marginal utility. As the consumer consumes more and more units of a commodity the
marginal utility which he derives from the successive units will keep on diminishing.
(ii) New Consumers: One reason why market demand for any good increases in response to a fall in its
price, is that each fall in its price brings in new consumers for the commodity. When the price of a
commodity is relatively high, only few consumers can afford to buy it. And when the price of a
commodity falls, more consumers would start buying it because some of those who previously could not
afford to buy it may now afford to buy it. This increased number of consumers of a commodity at a
lower price. Thus, when price of a commodity falls, the number of its consumer’s increases and this also
tends to raise the quantity demanded of the commodity in the market.

(iii) Income effect: When price of a commodity falls, the consumer can buy more quantity of the
commodity with his given income. As a result of fall in the price of a commodity, the real income
of the consumer increases. Consequently, his purchasing power increases since he is required to pay less
for the same quantity. On the other, a rise in price will reduce his purchasing power or real income and
therefore he will be able to buy only less amount of the commodity. The increase in real income
encourages the consumer to demand more of goods and services. The change in the demand for a
commodity as a result of the change in real income (due to fall or rise in the price of the commodity)
is called Income Effect of a price change. This is one reason why a consumer buys more of a
commodity whose price falls. Income effect is negative in case of inferior goods. In case the price of
inferior goods falls substantially, consumers’ real income increases and they become relatively richer.
Consequently, they substitute the superior goods for the inferior ones. As a result, the consumption of
inferior goods falls.
(iv) Substitution Effect: When price of a commodity falls, prices of all other related goods (particularly
of substitutes) remaining constant, the goods of latter category become relatively costlier. This
induces the consumer to substitute the commodity whose price has fallen for other commodities which
have now become relatively dearer. For instance a fall in the price of tea will induce consumers to
substitute tea for coffee and therefore the demand for tea will increase but conversely, a rise in the price
of tea will induce consumers to substitute coffee for tea and will reduce the demand for tea. The increase
in demand on account of fall in commodity price is known as Substitution Effect.
(v) Utility-Maximising Behavior: The utility-maximising behavior of the consumer under the condition
of diminishing marginal utility is also responsible for increase in demand for a commodity when
its price falls. As mentioned above, when a person buys a commodity, he exchanges his money
income for the commodity in order to maximise his satisfaction. He continues to buy goods and
services so long as marginal utility of his money (MUm) is less than the marginal utility of the
commodity (MUo). Given the price of a commodity, the consumer adjusts his purchases. so that
MUm= Po= MUo. When price of the commodity falls, (MUm= Po) < MUo, and equilibrium is
disturbed. In order to regain his equilibrium, the consumer will have to reduce the MUo to the
level of MUm. This he can do only by purchasing more of the commodity. Therefore, the consumer
purchases the commodity till MUm=Po=MUo. This is another reason why demand for a commodity
increases when its price decreases.
Exceptions to the Law of Demand
Law of demand is generally believed to be valid in most of the situations. However, some exceptions to
the law of demand have been pointed out as follows –
1. Goods having Prestige Value (Veblen Effect) - According to Veblen, some consumers measure the
utility of a commodity entirely by its price i.e. for them, the greater the price of a commodity, the greater
it’s utility. For example, diamonds are considered as prestige good in the society and for the upper strata
of the society, the higher the price of diamonds, the higher the prestige value of them and therefore the
greater utility or desirability of them. In this case, some consumers will buy less of the diamonds at a
lower price because with the fall in price its prestige value goes down. On the other hand, when price of
diamonds goes up, their prestige value goes up and therefore their utility and desirability. As result, at a
higher price the quantity demanded of diamonds by a consumer will rise. This is called Veblen effect.
Besides diamonds, other goods such mink coats, luxury cars have prestige value ad Veblen effect works
in their case too.
2. Goods which are expected to become scarce or whose prices are expected to rise in future: In case
of goods which are expected to become scarce in future the consumers may buy more of those goods
even at a higher price. Similarly when the price of a good has increased but consumers expect that it will
rise further in future, then they will prefer to buy more of the commodity even at a higher price at

present. Conversely, though the price has fallen but the people expect that it will fall further in future,
they prefer not to buy more of it even at lower price at present and will prefer to wait for the further fall.
3. Giffen goods: The real exception of the law of demands is in case of Giffen goods. the fall in the price
of an inferior good increases the real income of the consumers and therefore they can afford to buy
superior goods. They will start substituting superior good in place of an inferior good and therefore the
demand for the inferior good will decline. Conversely, if the price of an inferior good reduces the real
income of the consumers and they will also increase. The increase in the price of an inferior good
reduces the real income of the consumers and they will be forced to spend more on the inferior good.
After the name of Robert Giffen, all such goods whose demands increase with increase in prices and
whose demands fall with fall in their prices, are called ‘Giffen Goods’. However, it should be noted that
a ‘Giffen Good’ is an inferior good but every inferior good cannot be called a ‘Giffen Good’. There is a
difference between an inferior good and a Giffen good. Only those inferior goods are called Giffen
Goods, in whose case there is a direct price-demand relationship i.e., both price and demand of the
commodity move in the same direction.
Contraction/Extension of Demand & Shift in Demand
[Change in Demand & Change in Quantity Demanded]
A change in the quantity demanded is a movement along the demand curve due to a change in
the price of the good being demanded. On the contrary, a change in demand is represented by a shift of
the demand curve. As a result of this shift, the quantity demanded at all prices will have changed.
When the quantity demanded of a commodity rises due to fall in its price alone, it is called
Extension Of Demand. On the other hand, if the quantity demanded falls due to rise in prices, it is called
Contraction Of Demand. The extension and contraction of demand takes place only due to changes in
the price of the commodity and are represented by the movement on the same downward sloping
demand curve. It should be remembered that extension and contraction in the demand takes place as a
result of changes in the price alone when other determinants of demand remain constant. These other
factors remaining constant means that the demand curve remains the same, that is, it does not change its
position; only the consumer moves downward or upward on it.
Reasons for a Change in Demand (Factors affecting Demand)
1. Changes in the price of related goods: The demand for good X may be changed by increases or
decreases in the prices of other, related goods. These related goods are usually divided into two
categories called Substitutes and Complements. A substitute for good X is any good Y that satisfies
most of the same needs as good X. For example, if good X is butter, a substitute good Y might be
margarine. When two goods X and Y are substitutes, then as the price of the substitute good Y rises, the
demand for good X increases and the demand curve for good X shifts to the right. Conversely, as the
price of the substitute good Y falls, the demand for good X decreases and the demand curve for good X
shifts to the left.
2. Changes in income: The demand for good X may also be affected by changes in the incomes of
buyers. Typically, as incomes rise, the demand for a good will usually increase at all prices and the
demand curve will shift to the right. Similarly, when incomes fall, the demand for a good will decrease
at all prices and the demand curve will shift to the left.
3. Changes in preferences: As peoples' preferences for goods and services change over time,
the demand curve for these goods and services will also shift. For example, as the price of gasoline
has raised, automobile buyers have demanded more fuel‐efficient, “economy” cars and fewer
gas‐guzzling, “luxury” cars. This change in preferences could be illustrated by a shift to the right in the
demand curve for economy cars and a shift to the left in the demand curve for luxury cars.
4. Changes in expectations: Demand curves may also be shifted by changes in expectations. For
example, if buyers expect that they will have a job for many years to come, they will be more willing to
purchase goods such as cars and homes that require payments over a long period of time, and therefore,

the demand curves for these goods will shift to the right. If buyers fear losing their jobs, perhaps because
of a recessionary economic climate, they will demand fewer goods requiring long‐ term payments and
will therefore cause the demand curves for these goods to shift to the left.
Shifts in Demand: Increase and Decrease in Demand
When demand changes due to the factors other than price, there is shift in the whole demand
curve. As mentioned above, apart from price, demand for a commodity is determined by incomes of the
consumers, their tastes and preferences, prices of related goods. Thus, when there is any change in these
factors, it will cause a shift in demand curve. For example, if incomes of the consumers increase, say
due to the hike in their wages and salaries or due to the grant of dearness allowance, they will demand
more of a good & this will cause a shift in the demand curve to the right.
If people expect that price of a commodity is likely to go up in future, they will try to purchase
the commodity, especially a durable one, in the current period which will boost the current demand for
the good and cause a shift in the demand curve to the right. The price of related commodities such as
substitutes and complements can also change the demand for a commodity. For example, if price of
coffee raises, other factors remaining the constant, this will cause the demand for tea, a substitute for
coffee, to increase and its demand curve to shift to the right.
On the other hand if the income of the consumer declines he demands less of goods. This fall in
his demand is called decrease in demand & this will cause a shift in the demand curve to the left.
Though the extension and contraction of demand can be represented on the same demand curve, but the
increase or decrease in demand are represented by the upward or downward shifts in demand curve.
Demand Function
In mathematical language a function is a symbolic statement of relationship between the
dependent and the independent variables. Demand function states the relationship between the demand
for a product (the dependent variable) and its determinants (the independent variables). Let us consider a
very simple case of demand function. Suppose all the determinants of demand for commodity X, other
than its price, remain constant. This is a case of short-run demand function. In case of a short-run
demand function quantity demanded of X, (Dx) depends only on its price (Px). The demand
function can then be stated as ‘demand for commodity X, (Dx) depends on its price (Px)’The same
statement may be symbolically written as Dx= f(Px) In this function Dx is a dependent and Px is an
independent variable. The function reads ‘demand for commodity X (i.e., Dx) is the function of its price
(i.e., Px)’. It implies that a change in Px (the independent variable) causes a change in Dx (the dependent
variable).
The form of demand function depends on the nature of demand-price relationship. The
two most common forms of demand-price relationship are linear and nonlinear. Accordingly, the
demand function may assume a Linear or a nonlinear form. A demand function is said to be linear
when it results in a linear demand curve with a constant slope (ΔPx/ΔDx) throughout the curve.

Dx= a – bPx is a linear demand equation. A demand function is said to be Nonlinear Or Curvilinear
when the slope of the demand curve, (DP/DD) changes all along the curve. Nonlinear demand
function takes the form of a power function.
Defining Elasticity of Demand
The quantity of a commodity demanded per unit of time depends upon various factors such as
the price of a commodity, the money income of the consumer, prices of related goods, the tastes of the
people, etc., etc. Whenever there is a change in any of the variables stated above, it brings about a
change in the quantity of the commodity purchased over a specified period of time. The elasticity of
demand measures the responsiveness of quantity demanded to a change in any one of the above factors
by keeping other factors constant.
The concept of elasticity of demand is a device to measure the responsiveness of the quantity
demanded to changes in any factor that may influence the demand for a commodity.
For analytical purposes and practical decision-making it is often necessary to know the degree of
responsiveness of demand to each of the factors that may be influencing it as well as relative
responsiveness of demand to one factor compared to another factor or a comparison of the relative
responsiveness of demand for different goods to the same factor. The concept of elasticity of demand is
generally used to measure the responsiveness of demand to changes in (a) prices of the goods
themselves, (b) changes in the prices of related goods and (c) changes in the incomes of the consumers.
When the price of a goods falls, its quantity demanded rises and when the price of the goods
rises, its quantity demanded falls. This is generally known as law of demand. This law of demand
indicates only the direction of change in quantity demanded in response to change in price. This does not
tell us by how much or to what extent the quantity demanded of goods will change in response to a
change in its price. This information as to how much or to what extent the quantity demanded of a good
will change as a result of a change in its price is provided by the concept of elasticity of demand. When
the relative responsiveness or sensitiveness of the quantity demanded is measured to changes, in its
price, the elasticity is said to be price elasticity of demand. When the change in demand is the result of
the given change in income, it is named as income elasticity of demand. Sometimes, a change in the
price of one good causes a change in the demand for the other. The elasticity here is called cross
electricity of demand.
Types of Elasticity of Demand:
The concepts of demand elasticities used in business decisions are:
(i) Price-elasticity;
(ii) Cross-elasticity;
(iii) Income-elasticity;
(iv) Advertisement elasticity,
(v) Elasticity of price expectation.
(1) Price Elasticity of Demand:
Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change in
its price. Precisely, it is defined as: "The ratio of proportionate change in the quantity demanded of a
good caused by a given proportionate change in price". Formula: The formula for measuring price
elasticity of demand is:
Symbolically, if we write ‘e’ for elasticity of demand, ‘Q’ and ‘P’ for the original quantity
demanded and the original price respectively and ΔQ and ΔP for absolute changes in quantity and price
respectively, we can write the above formula in the form of the following expression.

Normally e is negative because of negative relationship between price and quantity given other things.
The value of e ranges from 0 to ∞. The shape of the demand curve will vary depending on value of e.
1. In the extreme case when there is no change in the quantity demanded in response to a price
change, elasticity of demand is said to be equal to zero or demand is described as ‘perfectly inelastic’.
The demand curve is vertical as shown in next diagram (a).
2. On the other hand, when there is an infinite change in quantity demanded due to a change in price,
elasticity of demand is said to be equal to infinity or demand for the good is described as ‘perfectly
elastic’. The demand curve is horizontal as shown in diagram next (b).
3. If the percentage change in quantity demanded is equal to the percentage change in price, elasticity
of demand is said to be equal to be equal to one or demand for the good in question is described as of
‘unit elasticity’. The demand curve is rectangular hyperbola as shown in diagram (c).
4. If the percentage change in quantity demanded is greater than the percentage change in price,
elasticity of demand is said to be greater than one or demand for the good in question is described as
‘elastic’. The curve is flatter as shown in diagram (d).
5. If the percentage change in quantity demanded is less than the percentage change in price, elasticity
of demand is said to be less one or demand for the good in question is described as ‘inelastic’. The curve
is steeper as shown in diagram (e).
PED on a linear demand curve will fall continuously as the curve slopes downwards, moving from left
to right. PED = 1 at the midpoint of a linear demand curve.

PED and Revenue
There is a precise mathematical connection between PED and a firm’s revenue.
When TR is at a maximum, MR = zero, and PED = 1.
Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel out the Qs to get P.
A curve plotting AR (=P) against Q is also a firm’s demand curve.
TR increases, reaches a peak and decreases.
Measurement of Price Elasticity of Demand
There are three different methods of measuring elasticity of demand, namely-
 Total Outlay Method,
 Point Method
 Arc Elasticity.
The price elasticity can be measured (a) either between the two points on a demand curve (called arc
elasticity) or on a point (called point elasticity).
Arc Elasticity: The measure of elasticity of demand between any two finite points on a demand curve is
known as the Arc elasticity.
Point Elasticity: The concept of point elasticity is also useful in measuring the elasticity where change
in price and quantity combinations is infinitesimally small. Point elasticity is the elasticity of demand at
a finite point on a linear demand curve.

Major Observations are as follows -
A. In case of a straight line demand curve (so that ∆Q/∆P = dQ/dP throughout) value of
elasticity (e = dQ / dP. P/Q) will normally vary from one point to another (because of the variations in
the value of the ratio P/Q) except in the following two cases:
(a) When ∆Q/∆P = dQ/dP = zero, i.e., in case of a vertical demand curve along which
quantity demanded does not vary at all in response to price changes. The elasticity of demand will be
zero (i.e. dQ/dP ×P/Q = zero) at all points. Such a demand curve is described as ‘perfectly inelastic’. It is
vertical and runs parallel to the Y axis as shows in the diagram (A).
(b) When ∆Q / ∆P = dQ/dP (infinity), i.e., in a case in which an infinite amount of a
commodity is bought at a certain price and nothing at all at any slightly higher price. Such a demand
curve will be horizontal and parallel to the X axis in the diagram (B).
B. In case of a non-linear demand curve, in addition to the variations in the value of the ratio
P/Q, the value of the ratio ∆Q / ∆P will also be different for a relatively large (finite) change in P and for
an infinitesimally small change in P. Therefore, in case of a non-linear demand curve value of elasticity
will normally vary from one point to another except when dQ/dP. P/Q always equals 1.
A demand curve with unit elasticity at all points is of the shape of a rectangular hyperbola as shown in
the diagram (C). It is the peculiar property of a rectangular hyperbola that the areas of all the rectangles
subtended through different points on it are all equal. Thus, in the diagram (c) above the rectangles
ABCO-EFHO-JKLO, etc represent the total outlays. All these outlays are equal when the elasticity of
demand is unity at all points along the demand curve.
The Total Outlay Method
According to the total outlay method, instead of comparing the percentage change in quantity demanded
with the percentage change in price, we simply compare the total outlay of consumers on the commodity
after the price change with their original outlay and make following qualitative statements about the
value of elasticity:
1. If the total outlay of consumers on the commodity after the price change (i.e.Q1× P1) is greater than
the original outlay (Q0× P0) in case of a fall in price (and less than the original outlay in case of rise in
price), elasticity of demand is said to be greater than one or demand is described as ‘ELASTIC’.

2. If the total outlay of consumers remains the same even after a rise or fall in price (i.e.Q1×P1= Q0×
P0) elasticity of demand is said to equal one or demand is described as of ‘UNIT ELASTICITY’
3. If the total outlay of consumers after the price change is less than the original outlay in case of a fall
in price (Q1× P1< Q0× P0) and greater than the original outlay in case of a rise in price (Q1× P1>
Q0×P0) or the changes in the price and total outlay move in the same direction, elasticity of demand is
said to be less than one or demand is described as ‘INELASTIC’.
The outlay method enables us only to know whether elasticity of demand is greater than, less
than or equal to one. This method does not give us the exact value of elasticity except in the unit
elasticity case. The following two methods enable us to calculate the exact value of elasticity of demand.
The Graphical Method of Measuring Elasticity (Point Elasticity)
Actually this method is only a graphical version of the ‘Percentage change method. For measuring
elasticity at any point on a downward sloping straight-line demand curve which meets the two axis, we
can devise a rule of thumb and say that value of elasticity at any point on a downward sloping straight-
line demand curve which meets the two axis is equal to the lower segment divided by the upper segment
of the demand curve.
‘ARC’ Elasticity
Arc elasticity is a measure of the average responsiveness of quantity demanded, Q to the relatively
large (finite) changes in price, P (or average responsiveness to price change exhibited by a
demand curve over a finite stretch). For measuring arc elasticity, instead of picking up any
particular P and the Q associated with it for the ratio P/Q, it is customary to fix P = (P0+P1)/2 (i.e.,
the average of the two end values P0i.e, original price and P1 i.e., changed price and similarly to fix
Q = (Q0 + Q1)/2 (i.e., average of the two end values Q0 i.e., the original quantity and Q1 i.e., changed
quantity. Hence Arc Elasticity is defined by the following expression:
Suppose, due to a fall in the price of a commodity from Rs. 10 to 8 per unit the quantity demanded
of it increases from 1000 units to 1500 units. According to the example P0= 10, P1= 8, Q0= 1500,
∆Q (i.e., Q1 – Q0) = 500 and ∆P (i.e. P1 – P0) = 2.
MEASURING POINT ELASTICITY ON A NON-LINEAR DEMAND CURVE
In order to measure elasticity at any point on a non-linear demand curve, we draw a straight-line tangent
to it at that point meeting the two axes at T and R. The value of elasticity on the straight line tangent at
the point of tangency is also the value of elasticity on the non linear demand curve at that point. For
example, in the diagram DD1is a non-linear demand curve and TR has been drawn tangent to it at P.
The value of elasticity at P on DD1 is given by the fraction PR/PT.

Conventionally, however, when price and quantity behave in the normal manner (i.e., move in opposite
directions in accordance with the law of demand) elasticity coefficient is taken to be a positive fraction
and in the abnormal case (when price and quantity move in the same direction) elasticity coefficient is
taken to be a negative fraction.
Factors Determining Elasticity Of Demand For Different Goods
(i) Availability of Close Substitutes: One of the most important factors determining elasticity of
demand for a good is the availability of close substitutes. Some commodities like tooth paste, shaving
blades, soaps, shoe polish, etc., have a number of quite close substitutes (i.e., different brands). If the
price of a particular brand of tooth paste (say, Forhan’s) change, price of other brands of tooth paste
remaining constant; it is likely to cause substantial substitution-a fall in price leading consumers to buy
more of it and a rise in the price leading consumers to buy more of the other brands. Therefore, elasticity
of demand for a good which has several close substitutes is bound to be high. On the other hand,
elasticity of demand for goods which have few or no satisfactory substitutes is bound to be inelastic.
Salt, for example, has hardly any substitute for it. Therefore, elasticity of demand for salt is inelastic.
(ii) Character of the commodity: Elasticity of demand depends also upon the character of the
good-whether it is considered a necessity or a luxury by the consumers. The demand for necessities of
life is usually inelastic while the demand for luxuries tends to be highly elastic. The demand for a staple
food is likely to be insensitive to price changes because when its price rises a consumer has no
alternative but to continue buying it. On the other hand, luxury goods can be easily dispensed with when
their prices are high. Therefore, demand for necessities of life is usually inelastic while the demand for
luxuries is highly elastic.
(iii) Level of Price: At very high and at low prices elasticity of demand is usually very low. If
the price of a commodity is very high or very low a slight change in it will not affect its demand
significantly. Pencils, for example, which are already selling at low prices, will not be purchased in
larger quantities if prices fall still lower. On the other hand, slight fall in the price of cars, for example,
will not bring them within the reach of average consumers. Cars will still be purchased only by the rich
who, in any case, buy them whether the price is somewhat higher or lower. Therefore, elasticity of
demand is usually low at very high and at very low prices.
(iv) Importance of the commodity in the consumer’s budget (i.e., the proportion of income
spent on the commodity): When a commodity claims only a small fraction of a consumer’s income, he
makes no great effort to look for substitutes when its price rises. For example, one normally spends a
very small amount of money on goods like match boxes, salt, shoe polish, newspapers, etc. When the
price of such a good rises it will not affect the consumer’s budget significantly and consequently he is
not inclined to change its consumption very much. The demand for such a good is bound to be relatively
inelastic. On the other hand, when a good claims a fairly large fraction of a consumer’s income, as for
instance with most groceries, a rise in price will affect the consumer’s budget significantly. This will
compel him to look for some cheaper substitute and somehow cut down his expenditure on the
commodity in question. Therefore, the demand for a good on which a consumer speeds a large
proportion of his income is likely to be relatively more elastic as compared to other goods on which a
consumer spends a small amount.
(v) The possibility of new customers entering the market: When the price of a commodity is
high only the relatively rich people can afford to buy it. But as the price gradually falls, it becomes
accessible to new customers who could not afford to but it when price was high. Thus, with each fall in
price more and more new customers are induces to buy the commodity. Hence a fall in price which
induces consumers in several income-groups to buy will result in a considerable elasticity of demand.
(vi) Possibility of postponing purchases: The elasticity of demand for a good also depends on
whether or not its purchases can be postponed if the situation so demands. The demand for consumer
durables such as furniture, refrigerators, television sets and less essential items can usually be postponed

for better time in future. The demand for a good the purchase of which can be easily deferred to future is
likely to be more elastic as compared to the demand for a good the purchase of which cannot be
postponed. For this reason the demand for commodities such as medicines, education, necessities of life,
etc. is usually very inelastic.
(vii) The period of time under consideration: In the event of a rise in price of a good a
consumer’s real income is reduced and he is compelled to readjust his consumption pattern. He does so
by changing his consumption habits and by finding cheaper substitutes. Since it takes time to find
suitable substitutes and to change one’s consumption habits, elasticity of demand for any good will tend
to greater the longer the period of time allowed for these adjustments. Elasticity of demand for a good
will tend to be lowering shorter the period of time under consideration.
(2) Income Elasticity of Demand:
When there is a change in the level of income of a consumer, there is a change in the quantity demanded
of a good, other factors remaining the same. The degree of change or responsiveness of quantity
demanded of a good to a change in the income of a consumer is called income elasticity of demand.
Income elasticity of demand can be defined as: "The ratio of percentage change in the quantity of a
good purchased, per unit of time to a percentage change in the income of a consumer". The formula
for measuring the income elasticity of demand is
When the income of a person increases, his demand for goods also changes depending upon whether the
good is a normal good or an inferior good. For normal goods, the value of elasticity is greater than zero
but less than one. Goods with an income elasticity of less than 1 are called inferior goods.
(3) Cross Elasticity of Demand
The concept of Cross Elasticity Of Demand is used for measuring the responsiveness of quantity
demanded of a good to changes in the price of related goods. Cross elasticity of demand is defined as:
"The percentage change in the demand of one good as a result of the percentage change in the price of
another good". The formula for measuring, cross, elasticity of demand is:
Exy = % Change in Quantity Demanded of Good X
% Change in Price of Good Y
Types and Example:
(i) Substitute Goods. When two goods are substitute of each other, such as coke and Pepsi, an increase in
the price of one good will lead to an increase in demand for the other good. The numerical value of cross
elasticity of demand of goods is positive.

(ii) Complementary Goods. However, in case of complementary goods such as car and petrol, cricket
bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the demand for the
balls (say by 6%). The cross elasticity of demand which are complementary to each other is, therefore,
negative.
(iii) Unrelated Goods. The two goods which are unrelated to each other, say apples and pens, if the price
of apple rises in the market, it is unlikely to result in a change in quantity demanded of pens. The
elasticity is zero of unrelated goods.
Cross-Elasticity
Some Interesting Elasticity Theorems
1. Value of point elasticity varies from zero to infinity along a downward1 sloping straight line demand
curve.
2. Elasticity at different points along two (or more) parallel (i.e., having the same slope) demand curves.
A) Of the two (or more) parallel demand curves, the one farther from the origin is less elastic at
each price than the one closer to the origin.
B) The one farther from origin is more elastic at each level of demand than the one closer to the
origin.
C) Have the same elasticity at points lying along a straight line drawn from the origin.
3. Value of elasticity of downward sloping straight-line demand curves originating from the same point
on the price axis - (i) Are iso elastic at each price.
(ii) The flatter is more elastic at each level of demand than the steeper one.
4. Downward sloping straight-line demand curves meeting the quantity axis at the same point have the
same elasticity at each level of demand.
5. Of the two (or more) intersecting straight-line demand curves the flatter one is more elastic at the
point of intersection, than the steeper one.
Joint Demand and Composite Demand:
When two or more goods are jointly demanded at the same time to satisfy a single want it is called joint
or complementary demand. Joint demand refers to the relationship between two or more commodities or
services when they are demanded together. There is joint demand for cars and petrol, pens and ink, tea
and sugar, etc. Jointly demanded goods are complementary. A rise in the price of one leads to a fall in
the demand for the other and vice-versa. For example, a rise in the price of care will bring a fall in their
demand together with the demand for petrol and lower its price, if the supply of petrol remains
unchanged.
On the contrary, a fall in the price of cars, as a result of a fall in the cost of production of cars, will
increase their demand and therefore increase the demand for petrol and raise its price, if available
supplies of petrol are unchanged. A commodity is said to have composite demand when it can be put to

several alternative uses. This is not only peculiar to commodities like leather, steel, coal, paper, etc. but
also to factors of production like land, labour and capital. For example, coal is demanded by railways,
by factories, by households, etc. There is competition among the different uses of a commodity in com-
posite demand. Hence, each use of the commodity is the rival of the other uses. So it is also called rival
demand. Any change in the demand for a commodity by a user will affect the supply of the other users
which will change their prices.
The importance of cross-elasticity to the firm
In competitive markets firms should be aware of how a change in a rival’s price will affect demand for
their own goods. A high value of cross-elasticity implies strong interdependence between firms and this
could influence a firm’s pricing strategy, as when one supplier is unwilling to embark upon a price cut in
case this leads to retaliatory price cuts from its competitors. Firms also often produce a range of
products, many of which compete with each other, as in the case of cigarette or detergent manufacturers.
In such
Advertising elasticity
A measure of the effect of a change in advertising upon the sales of a given good.
The value should always be positive. If Ea< 1, i.e. inelastic, proportionally large amounts of
expenditure would be needed to increase demand. In such circumstances the firm might seek
alternative ways of increasing demand. The most successful advertising campaigns are those with
the highest elasticity. We would also generally expect to observe eventual diminishing returns to
advertising, i.e. as expenditure on a given advert increases, the percentage increase in generated
demand will eventually decline. We may also have a cross-advertising elasticity. This measures the
influence of a change in advertising expenditure on good A upon the demand for good B. The value
could be positive or negative depending upon the relationship between the goods, i.e. positive for
complements and negative for substitutes.
The Elasticities of Demand for Exports and Imports

Economic Theory of Supply
Concept of Supply
In economics, supply is the amount of something that firms, consumers, laborers, providers of
financial assets, or other economic agents are willing to provide to the marketplace. In the goods
market, supply is the amount of a product per unit of time that producers are willing to sell at various
given prices when all other factors are held constant. In the labor market, the supply of labor is the
amount of time per week, month, or year that individuals are willing to spend working, as a function of
the wage rate. In the financial markets, the money supply is the amount of highly liquid assets available
in the money market, which is either determined or influenced by a country's monetary authority. Supply
refers to the schedule of the quantities of a good that the firms are able and willing to offer for sale at
various prices.
Two things are worth mentioning about the concept of supply. First, supply is a flow concept,
that is, it refers to the amount of a commodity that the firms produce and offer for sale in the market per
period of time, say a week, a month or a year. Without specifying the time period, supply of a
commodity has a little meaning. Second, the quantity supplied at a commodity which the producers plan
to produce and sell at a price is not necessarily the same as the quantity actually sold. Sometimes the
quantity which the firms are willing to produce and sell at a price is greater than the quantity demanded,
so the quantity actually bought and sold is less than the quantity supplied.
Supply should be distinguished from the Quantity Supplied. Whereas ‘supply’ of a commodity is
the entire schedule of the quantities of a commodity offered for sale at all possible prices during a given
period of time while the ‘quantity supplied’ refers to the quantity of a commodity which the firms are
able and willing to sell at a particular price of the commodity. Thus the term ‘supply’ refers to the entire
supply curve where the term ‘quantity supplied’ refers to a point on a given supply curve.
Individual Supply: Refers to quantity of a commodity that an individual firm is willing and able
to offer for sale at a certain price during a given period of time.
Market supply: It is the sum total of quantity supplied of a commodity by all sellers or all firms in
the market at a certain price and in a given period of time.
Law of Supply
In contrast to the inverse relationship between the quantity demanded and the changes in price, the
quantity supplied of a commodity generally varies directly with price. That is, the higher the price, the
larger is the quantity supplied of a commodity.
Supply Function: The supply function is the mathematical expression of the relationship between
supply and those factors that affect the willingness and ability of a supplier to offer goods for sale. By
convention economists graph the dependent variable (quantity) on the horizontal axis and the
independent variable (price) on the vertical axis. The inverse supply equation is the equation written
with the vertical-axis variable isolated on the left side, P = f (Q)
Supply curve: Refers to the graphical representation of supply schedule which represents various
quantities of a commodity that a producer is willing to supply at different during given period of
time. The curve is generally positively sloped. The curve depicts the relationship between two variables
only; price and quantity supplied. All other factors affecting supply are held constant.
Supply Schedule: Refers to a tabular presentation which shows various quantities of a commodity that
a producer is willing to supply at different prices, during a given period of time.
Why doesSupplyCurveGenerallySlopeUpward?
In the real world that price of a product and quantity supplied of it by firms producing it is positively
related to each other, that is, at a higher price more is supplied and vice versa, other things remaining the
same. Firms are driven by profit motive. The higher price of a product, given the cost per unit of output,

makes it profitable to expand output and provides greater incentive for the firm offer more quantity of
product for sale and supply of a commodity in the market, other things remaining the same. To produce
more of a product, firms have to devote more resources to its production. When production of a product
is expanded by using more resources, diminishing returns to variable factors occur. Due to the
diminishing returns average and marginal costs of production increase. Therefore, at higher additional
cost of producing more units of output; it is profitable to produce more units of output only at a higher
price so as to cover the rise in additional cost per unit. It is due to this positive relationship between price
of a commodity and its quantity supplied that the supply curve of a commodity slopes upward to right.
There are three main reasons why supply curves are drawn as sloping upwards from left to right
giving a positive relationship between the market price and quantity supplied:
1. The Profit Motive: When the market price rises following an increase in demand, it becomes
more profitable for businesses to increase their output
2. Production and Costs: When output expands, a firm's production costs tend to rise, therefore a
higher price is needed to cover these extra costs of production. This may be due to the effects of
diminishing returns as more factor inputs are added to production.
3. New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in total supply.
Shifts in Supply Curve: Increase and Decrease in Supply
The supply of a commodity in economics means the entire schedule or curve depicting the
positive/direct relationship between price and quantity supplied of the commodity, given the other
factors influencing supply are unchanged. These other factors are the state of technology, prices of
inputs (resources), prices of other related commodities, etc. It is the change in these factors other
than price that cause a shift in the supply curve. For example, when prices of inputs such as labour and
raw materials used for the production of a commodity decline, this will result in lowering the cost of
production which will induce the producers to produce and make available a greater quantity of the
commodity in the market at each price.
The Increase in Supply meaning the rise in quantity supplied at each price of the commodity
due to (a) the reduction in prices of inputs & (b) progress in technology used for production of
commodity increases productivity and reduces cost per unit will cause the supply curve to shift to the
right. On the other hand, Decrease in Supply means the reduction in quantity supplied at each price of
the commodity and as a result of decrease in supply the supply curve shifts to the left. The decrease in
supply occurs (a) when the rise in prices of factors (inputs) used for the production of a commodity leads
to higher cost per unit of output which causes a reduction in quantity supplied at each price & Similarly
(b) the imposition of an excise duty or sales tax on a commodity means that each quantity will now be
supplied at a higher price than before so as to cover the excise duty or sales tax per unit. (c) Another
important factor causing a decrease in supply of a commodity is the rise in prices of other commodities
using the same factors. For example if the price of wheat rises sharply, it will become more profitable
for the farmers to grow it. This will induce the farmers to reduce the cultivated area under other crops,
say sugarcane, and devote it to the production of wheat. This will lead to the decrease in supply of
sugarcane whose supply curve will shift to the left.
Suppliers are frequently able to switch their production processes from one type of good to
another. Farmers, for example, might decide to grow less wheat and more corn on the same land if the
price of corn rises relative to the price of wheat. In this case, the supply curve for wheat would shift to
the left, as a consequence of the higher price for corn.
The prices of the raw materials or inputs used to produce a good also cause the supply curve to
shift. An increase in the prices of a good's inputs will raise costs to suppliers and cause suppliers to
supply less of that good at all prices. Therefore, an increase in the prices of a good's inputs leads to a
leftward shift of the supply curve for that good. A decrease in the prices of a good's inputs reduces costs

and allows suppliers to supply more of that good at all prices. Therefore, a decrease in the prices of a
good's inputs leads to a rightward shift of the supply curve for that good.
Advances in technology often have the effect of lowering the costs of production, allowing
suppliers to supply more goods at all prices. For example, the development of pesticides has reduced the
amount of damage done to certain crops and therefore has reduced the cost of farming. The result has
been an increase in the supply of these crops at all prices, which can be represented by a shift to the right
in the supply curves for these crops.
Movements versus shifts: Movements along the curve occur only if there is a change in quantity
supplied caused by a change in the good's own price. A shift in the supply curve, referred to as a change
in supply, occurs only if a non-price determinant of supply changes. For example, if the price of an
ingredient used to produce the good, a related good, were to increase, the supply curve would shift left.
Factors Determining Supply
(a) Production Technology- If there occurs an improvement in production technology used by the firm,
its production efficiency increases which reduce the unit cost of production and consequently the firms
would supply more than before at the given price & thereby causing the entire supply curve would shift
to the right.
(b) Price of Inputs - Changes in prices of factors or inputs used in production also cause a change in
cost of production and consequently bring about a change in supply. For example, if either wages of
labour increase or prices of raw materials and fuel go up, the unit cost of production will rise. With
higher unit cost of production, it will be profitable to produce less and therefore less would be supplied
or offered for sale than before at various given prices. This implies that supply curve would shift to the
left.
(c) Prices of Related Products - When we draw a supply curve we assume that the prices of other
products remain unchanged. Now, any change in the prices of other products would influence the supply
of a product by causing substitution of one product for another. For example, if the market price of X
rises, it will lead to the reduction in the production and supply of Y by the farmers as the farmers would
withdraw land and other resources from the production of Y and devote them to the production of X.
This will cause decrease in the supply of Y and a leftward shift in the supply curve of Y.
(d) Number of Producers (or firms) - If the number of firms producing a product increases, the market
supply of the product will increase causing a rightward shift in the supply curve. When, in the short run,
firms in an industry arc making large profits, the new firms enter the industry in the long run and
consequently the total production and supply of the product of the industry increases. On the other hand,
due to losses in the short run if some firms leave the industry in the long run, the supply of its product
will decline.
(e) Future Price Expectations - The supply of a commodity in the market at any time is also determined
by sellers' expectations of future prices. If, as happens during inflationary periods, sellers expect the
prices to rise in future, they would reduce current supply of a product in the market and would instead
hoard the commodity. The hoarding of huge quantities of goods by traders is an important factor in
reducing their supplies in the market and thus causing further rise in their prices.
(f) Taxes and Subsidies- Taxes and subsidies also influence the supply of a product. If an excise dutyor
sales tax is levied on a product, the firms will supply the same amount of it at a higher price or less
quantity of it at the same price. This is because excise duty on a commodity is included in price by the
sellers and passes it on the buyers.
Elasticity of Supply
Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a given change in
price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market

conditions, especially to price changes. It is given by the percentage change in the quantity supplied of
a commodity divided by the percentage change in price.
Coefficient of price elasticity of supply, ε = % change in quantity Supplied/ % change in price
ε = [ΔQ/ ΔP]. P/ Q
Since quantity supplied and price move in the same direction, supply curves normally have
positive slope. Therefore, supply elasticity is normally positive. It will be anything between zero and
infinity (0< ε <∞).
Degrees of Supply Elasticity
When the supply curve is upward sloping, the elasticity of supply will be anything between zero and
infinity. On the basis of the value of the coefficient of elasticity of supply we can classify it
into the following five categories: (i) Perfectly inelastic supply, (ii) Inelastic supply, (iii) Unitary
elastic supply , (iv) Elastic supply, (v) Perfectly elastic supply.
(1) Perfectly Inelastic Supply
When the quantity supplied of a commodity does not change at all in response to the change in price,
elasticity of supply is said to be perfectly inelastic. This is the case of zero elasticity (ε = o) and
the supply curve will be vertical straight line, as shown below.
(2) Inelastic Supply
If the percentage change in quantity supplied is smaller than the percentage change in price, supply is
said to be inelastic. The value of the coefficient of supply will be greater than zero but less than unity
(0<ε<1). If a linear supply curve crosses or cuts the horizontal (quantity) axis, supply is
inelastic, as shown below
(3) Unitary Elastic Supply
If the percentage change in quantity supplied is equal to percentage change in price, supply is said to be
unitary elastic. The value of coefficient of elasticity will be equal to one (ε =1) when supply is unitary
elastic. If linear supply curve passes through the origin, supply is unitary elastic regardless of its scope.
This is illustrated below.

(4) Elastic Supply
If the percentage change in quantity supplied is greater than percentage change in price, supply is said to
be elastic. The value of the coefficient of elasticity will be greater than unity when the supply is elastic.
A linear supply curve indicates an elastic supply if it cuts the vertical (price) axis.
(5) Perfectly Elastic Supply
At any given price infinite quantity is supplied, supply is said to be perfectly elastic. The coefficient of
elasticity will be infinity (ε=∞) when supply is perfectly elastic. Perfectly elastic supply curve is
depicted by a horizontal supply curve parallel to quantity axis.
PES = (% Change in Quantity Supplied / % Change in Price)
There are mainly five types of elasticities of supply. They are-
1 – Perfectly elastic supply
2 – Perfectly inelastic supply
3 – Elastic supply
4 – Inelastic supply
5 – Unitary elastic supply.

Determinants of PES
The key considerations are:
1. Spare production capacity: If there is plenty of spare capacity then a business can increase output
without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods
and services is most elastic during a recession, when there is plenty of spare labour and capital resources.
2. Stocks of finished products and components: If stocks of raw materials and finished products are at a
high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when
stocks are low, dwindling supplies force prices higher because of scarcity
3. The ease and cost of factor substitution/mobility: If both capital and labour are occupationally mobile
then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched.
E.g. a printing press which can switch easily between printing magazines and greetings cards. Or falling
prices of cocoa encourage farmers to switch into rubber production
4. Time period and production speed: Supply is more price elastic the longer the time period that a firm
is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed
and is determined mainly by planting decisions made months before, and also climatic conditions, which
affect the production yield. In contrast the supply of milk is price elastic because of a short time span
from cows producing milk and products reaching the market place.
Different Price Elasticity of Supply (PES)
 Perfectly elastic supply: where quantity of supply is infinite at any one price. Supply curve is horizontal
or parallel to x-axis. Any increase in demand can be met without any change in price.
 Perfectly inelastic: where only one quantity can be supplied at all the prices. Supply curve is vertical to x-
axis or parallel to vertical coordinate axis, y-axis. Supply quantity is fixed irrespective of any change in
Price that is unresponsive to price change.
 Elastic supply: If a small change in the price will cause big changes in quantity of supply, supply curve is
somewhat flatter to horizontal axis. Large change in demand can be met without large increase in price.
 Inelastic supply: If a big change in price will result in only a small change in supply. Here the supply
curve is a steep one.
 Unitary elastic supply: If a given percentage of change in price will effect in the same percentage change
in quantity of supply. The supply curve is linear curve coming from the origin.
 When PES > 1, then supply is price elastic
 When PES < 1, then supply is price inelastic
 When PES = 0, supply is perfectly inelastic
 When PES = infinity, supply is perfectly elastic following a change in demand

Methods for measuring price elasticity of supply:
There are three possibilities of Elasticity of Supply:
(a) If a straight line supply curve passes through the point of origin doesn’t matter what it makes
angles, Es at any point is equal to unity.
(b) If a straight line supply curve passes through left side of point of origin and interest X-axis in its
negative range, Es will be greater than one at any point.
(c) If a straight line supply curve passes through right side of point of origin and interest X-axis in its
positive range, Es will be less than one at any point.
Change in Quantity Supplied vs Change in Supply
Marginal costs and short-run supply curve: A firm's short-run supply curve is the marginal cost
curve above the shutdown point i.e the short-run marginal cost curve (SRMC) above the minimum
average variable cost. The portion of the SRMC below the shutdown point is not part of the supply
curve because the firm is not producing any output. The firm's long-run supply curve is that portion of
the long-run marginal cost curve above the minimum of the long run average cost curve.

Elasticity along linear supply curves: The slope of a linear supply curve is constant; the elasticity is
not. If the linear supply curve intersects the price axis then PES will be infinitely elastic at the point of
intersection. The coefficient of elasticity decreases as one move "up" the curve. However, all points on
the supply curve will have a coefficient of elasticity greater than one. If the linear supply curve intersects
the quantity axis then PES will equal zero at the point of intersection and will increase as one move up
the curve; however, all points on the curve will have a coefficient of elasticity less than 1. If the linear
supply curve intersects the origin PES equals one at the point of origin and along the curve.
Supply of Factors of Production: Land, Capital and Labour
Just as a market exists for final goods and services, a market also exists for the factors of
production. The key factors of production are labor, capital, and land. These factors of production must
be hired in their own markets in order to produce the final goods and services. These factors have their
own markets, and their own supply and demand curves. The demand for the factors of production is a
derived demand. The demand for the factors will be based on the demand for the final goods and
services that they are hired to produce. The supply of the factors of production will be based on the
opportunity costs for their use. The prices for the factors of production are known by the names of their
earnings. The price for labor is the wage rate. The price for capital is the interest rate. The price for land
is rent.
From the viewpoint of the nature of supply, factors may be divided into two classes original and
produced factors. Original or primary factors of production are not produced in the industries like Land
and labour. Produced factors are the intermediate physical inputs which are themselves produced in
some industries and are used as inputs or productive factors in other industries for production of other
products, for example capital equipment (i.e. machinery, tools, components etc.), steel, cement,
fertilizers; fuels.
The supply curves of produced inputs (factors) depend upon the changes in marginal cost of
production. So long as marginal cost rises as output is expanded, marginal cost curve slopes upward and
therefore the supply curve of these material inputs slopes upward. However, if the industries producing
certain intermediate physical inputs experience decreasing costs as their outputs expands, their supply
curve will be sloping downward.
Supply of Land: Land and labour are called original or primary factors of production as they are not
produced in the industries. Land is a free gift from nature and therefore its quantity is fixed by nature.
More land cannot be produced in response to greater demand for it. Demand for land is dependent on
demand for final products. If the demand for final products increases then the demand for land will
increase as well. Demand for land is also influenced by rent. The higher the rent the lower the demand
for land. The land is usually rented for a longer period of time. This is disadvantage for the
owner because if the demand for the final products increases the owner wants to increase the
rent. This is impossible because of contract that is fixed. Land, unlike most goods, is durable and is not
removed from the marketplace. Land supply is inelastic; we say that its monopoly in the market,
so it cannot be increased by human activity. If we increase the demand for land, supply will be
the same but the price will be higher.
Whatever the rent, high or low, for the use of land, its supply to the economy as a whole remains
unchanged. In other words, the supply of land to the entire economy does not depend on the price i.e.,
rent for its use. Hence, from the standpoint of the whole economy, the supply of land (which includes
natural resources) is perfectly inelastic. Since supply of land is a free gift from nature and not a
produced factor, cost of production has no relevance for its supply. But the supply of land to a single use
or to a particular industry is not perfectly inelastic. The supply of land to a particular use or industry can
be increased by shifting of land from other uses or industries. By offering attractive rents, the supply of
land for a particular use can be increased by taking it away from other competitive uses. Now, a piece of
land will be supplied to a particular use if at least its transfer earnings are paid to it.

Supply of Capital: Capital goods are not used for final consumption, but for production of other goods.
We distinguish financial capital – in the form of money; man-made capital – in the form of machines,
buildings. Financial capital is divided as (a) potentional capital which is savings which can potentionally
be used for loans or purchase of capital goods & (b) real capital – investment. Capital stock is the total
amount of capital. Investment means the addition to capital stock. Social capital is mainly state owned
capital used to produce goods and services that are not usually sold via the market mechanism.
Interest is income from lending capital, revenue for lending capital.
Here also a distinction must be made between real or physical capital i.e., capital goods on the
one hand and financial capital or money capital on the other, since the nature of their supply is quite
different. Capital goods are produced factors as compared to the primary factors like land and labour
which are not produced. Capital goods are produced by firms on the same basis as consumer goods.
Since capital goods are reproducible, the cost of production exercises a significant influence over their
supply.
If the industry producing a capital good is subject to increasing costs, the supply curve of those
capital goods will be upward sloping indicating that more of it will be supplied at a higher price. And if
the industry producing a certain capital good is working under constant cost conditions, the more of that
capital goods will be supplied at the same price and therefore its supply curve will be a horizontal
straight line. However, once the durable capital goods have been produced, their supply is independent
of their cost. But, over a period of time, cost is, no doubt, a determining factor of their supply.
As regards financial capital, the nature of its supply is very complex. The supply of financial
capital depends upon the money supply in the economy, the savings of the people, their willingness to
lend it or buy shares and bonds (i.e. their liquidity preference) and the ability as well as willingness of
the banks to lend money to businessmen. An increase in the rate of interest has an important effect on
the willingness of the people to save more and to accumulate more financial capital. Moreover, increase
in the rate of interest exercises a strong effect in inducing the people to part with the money capital and
lend it to businessmen or buy shares and bonds of companies. In other words, the rise in the rate of
interest induces people to surrender liquidity, and lend it to others.
Supply of Labour: Demand for labour depends on wages, other resources of production, amount of
capital, used technology. Demand for labour also depends on marginal product of labour and marginal
revenue product of labour. Marginal revenue product of labour is wage. The curve of demand is
downwards sloping, because if the labour force increases, wages decrease. The supply of labour can be
viewed as supply of labour (working hours) of an individual, the supply of labour for an industry or
occupation, and supply of labour for the economy as a whole. We begin with the analysis of supply of
labour (working hours) by an individual. Labour supply - depends on:
- Wage in comparison to social benefits
- Population
- A part of population which forms labour force (both the employees and unemployed)
- Average number of working hours a year (number of working days * daily working hours)
- Quality and quantity of work
Curve of labour supply is backwards bending, because from certain point wages are so high that
some people value more free time than higher wage. The reasons of the backward bending supply curve
of labor are: (i) The substitution of leisure for work, (ii) Increase in income which leads to rise in
demand of normal commodities including leisure.
Alternative or opportunity cost of working for a period is the sacrifice of leisure by the individual
for that time period. It should be noted that leisure is a desirable object which provides satisfaction to the
individuals. On the other hand, work provides income to the individual with whom he can buy goods
and services to satisfy his wants. How much leisure an individual will be willing to sacrifice, that is,
how many hours of work he will do depends on the wage rate.

Why a Monopoly Does Not Have a Supply Curve
Although monopoly firms make decisions about what quantity to supply a monopoly does not
have a supply curve. A supply curve tells us the quantity that firms choose to supply at any given price.
This concept makes sense when we are analyzing competitive firms, which are price takers. But a
monopoly firm is a price maker, not a price taker. It is not meaningful to ask what such a firm would
produce at any price because the firm sets the price at the same time it chooses the quantity to supply.
Indeed, the monopolist’s decision about how much to supply is impossible to separate from the
demand curve it faces. The shape of the demand curve determines the shape of the marginal revenue
curve, which in turn determines the monopolist’s profit maximizing quantity. In a competitive market,
supply decisions can be analyzed without knowing the demand curve, but that is not true in a monopoly
market. High barriers to entry such as regulatory hurdles, high capital requirements and technological
advantages prevent competitors from entering the market. The monopolist determines its profit
maximizing price, and then supplies a quantity of goods that allows it to achieve that price. Therefore,
we never talk about a monopoly’s supply curve.
Short-Run Supply Curve [Perfect Competition]
The perfectly competitive firm’s short-run supply curve is a curve showing the relationship between the
price of a product and the quantity supplied in the short run. The individual firm always produces along
its marginal cost curve above its intersection with the average variable cost curve. The perfectly
competitive industry’s short-run supply curve is the horizontal summation of the short-run supply curves
of all firms in the industry.
Three Types of Long-Run Supply Curves [Perfect Competition]
There are three possibilities for a perfectly competitive industry’s long-run supply curve. The perfectly
competitive industry’s long-run supply curve shows the quantities supplied by the industry at different
equilibrium prices after firms complete their entry and exit. The shape of each of these long run supply
curves depends on the response of input prices as new firms enter the industry. The following sections
discuss each of these three cases.
Constant-cost industry: - An industry in which the expansion of industry output by the entry of
new firms has no effect on the individual firm’s cost curve. In a constant-cost industry, input prices
remain constant as new firms enter or exit the industry. Because input prices remain constant, the long-
run supply curve in a perfectly competitive constant-cost industry is perfectly elastic.
Decreasing-cost industry: - An industry in which the expansion of industry output by the entry of
new firms decreases the individual firm’s cost curve (cost curve shifts downward). Input prices fall as
new firms enter a decreasing-cost industry and output expands. As industry output expands, the
individual firm’s average total cost curve declines (shifts downward), and the long-run equilibrium
market price falls. The long-run supply curve in a perfectly competitive decreasing-cost industry is
downward sloping.
Increasing-cost industry: - An industry in which the expansion of industry output by the entry of
new firms increases the individual firm’s cost curve (cost curve shifts upward). In an increasing-cost
industry, input prices rise as new firms enter the industry, and output expands. In an increasing-cost
industry, input prices rise as industry output increases. As a result, the individual firm’s average total
cost curve rises (shifts upward), and the industry long-run supply curve for an increasing-cost industry is
upward sloping.
Comparing the Short-Run and Long-Run Industry Supply Curves
The long-run industry supply curve may slope upward, but it is always flatter more elastic than the short
run industry supply curve. This is because of entry and exit: a higher price attracts new entrants in the
long run, resulting in a rise in industry output and lower price; a fall in price induces existing producer to
exit in the long run, generating a fall in industry output and a rise in price.

Contraction vs Decrease in Supply
Contraction in Supply: A reduction in supply due to a fall in a price of the commodity is termed as
contraction. Contraction results in downward movement on the supply curve
Decrease in Supply: A decrease in supply is defined as a situation when the seller is willing to supply
lesser of quantity at the same price. Decrease in supply results in leftward shift of supply curve because
of Increase in Input Price or taxation rate etc.
Effect of technical progress on the supply of good
The most prominent and sought-after effect of technological advancement is the ability to increase
production. The betterment of technology reduces the cost per unit of production. Advancements in
production mean suppliers can produce more goods at a cheaper cost, thus pushing the supply curve
outward from left to right on the x-axis. This effectively lowers the equilibrium price point, unless
demand for the product increases, or shifts outward left to right, to meet the increased production levels
at the current price point. This leads to firm’s profit maximization and there is increase in the supply.
Technology can make entry into a certain marketplace easier, or more attractive, to other suppliers. As
more suppliers enter a marketplace, this also pushes the supply curve outward, as more goods become
available at the same price point. Changes in technology almost always lead to shift to the RIGHT of
supply curve as a result of technological PROGRESS. Nevertheless, there are exceptions, especially in
medicine. In long term, technology can also lead to a shift to the LEFT of the supply curve as natural
resources are depleted or when new technology replaces old technology and it becomes out-of-date e.g.
conventional film cameras.
Difference between a change in Quantity Supplied and an Increase or Decrease in Supply
(i) A Change in Quantity Supplied: If the quantity supplied is more or less due to the change in
the price of that commodity alone, assuming all other factors which affect the supply of a commodity
mentioned earlier, remains constant, we call it a change in the quantity supplied. When the price of a
ball pen rises from Rs. 1.50 to Rs. 2.00 per ball pen, the supplier supplies 17 ball pens instead of 14 ball
pens. This is called a change in the quantity supplied. This is represented by the downward movement
along the same supply curve.
(ii) Increase or Decrease in Supply for Shifts in the Supply Curve: If the price of a
commodity remains constant but the supply changes due to the changes in any of the other factors
(factors other than price) affecting the supply of a commodity e.g., an innovation, discovery of cheap
raw materials, prices of other goods etc., it is called an increase or a decrease in supply. If as a result of
an innovation, the producers are willing to produce and sell more in the market, it is called an increase in
supply. On the other hand, if as a result of an increase in the prices of factors of production the
producers are willing to produce and sell less, this will be called a decrease in supply.
An increase in the Supply of a commodity is represented by a shift in its supply curve to the right
and a decrease in the supply is represented by a shift to left of the original supply curve, as given in the
following diagram

If as a result of the change in factors other than the price, the supply of commodity increases, the supply
curve SS will shift to the right and the new supply curve will be S1S1. This shows that even if the price
OP remains constant, the Supply of the commodity has increased from OM to OM1. On the other hand,
if as a result of the changes in factors other than the price, the supply has decreased, the supply curve SS
will shift to the left and the new supply curve will be S2S2. This shows that price remaining constant at
OP; the supply has decreased from OM to OM2.
Determination of Equilibrium Price
The price of a commodity in the market is determined jointly by its demand and supply where its
quantity demanded is equal to its quantity supplied. The term equilibrium means a state of balance; such
a state of balance occurs when consumers are prepared to buy the same quantity as the suppliers are
prepared to offers for sale in the market. It is the equilibrium price which will ultimately prevail in the
market. If at any time the price in the market is above or below the equilibrium, certain forces in the
system will operate to bring the price to the level of the equilibrium price. Let us take an example. The
following table 1.5 shows the market demand schedule and market supply schedule of ball pens i.e, the
different quantities of ball pens demanded and supplied at different prices in the market.
The table shows that as the price is increasing the quantity demanded is falling but the quantity supplied
is increasing. At the price of Rs. 2.50 per ball pen, quantities of ball pens demanded (20) and supplied
(20) are equal. Therefore, price of ball pen in the market will be Rs. 2.50 each. This is also called the
equilibrium price. This can also be explained with the help of the diagram below-
DD is the market demand curve and SS is the market supply curve which shows the quantity of ball pens
demanded and supplied at different prices. Demand and supply curves intersect each other at point. A
showing the equality of demand (OM or 20) and supply (OM or 20) of ball pens. At this point the price
is OP or Rs. 2.50 per ball pen. Therefore, the market price will be Rs. 2.50 (OP) per ball pen. It is not
possible to have the price of ball pen in the market different (less or more) than that of Rs. 2.50 per ball
pen and therefore this is also known as equilibrium price and the quantity demanded and supplied i.e.,
OM is known as equilibrium quantity. Suppose the price in the market is Rs. 3 per ball pen. At this
price, 22 ball pens are supplied but 16 ball pens are demanded. The supply is in excess (22–16 = 6) of

demand. The producers will be left with unsold quantity and will incur losses and therefore they will
reduce the price. The consumers, finding glut of unsold quantity, will be prepared to purchase the
commodity at a lower price. As a result, the price will decline and will ultimately come down to the
equilibrium price. This hypothesis is shown by the arrow indicating a downward pressure to all prices
above Rs. 2.50; On the other hand, let us take the example when the price is Rs. 2.00 per ball pen. At
this price there is an excess demand; demand is for 25 ball pens and its supply is 17. The excess demand
will increase the price. The consumers will offer higher price in order to get the commodity which is in
short supply and the producers will also offer the commodity at higher price. As a result, the price will
start increasing till it becomes equal to the equilibrium price. This is illustrated by the arrow indicating
an upward pressure on all prices below Rs. 2.50 per ball pen. Therefore, if the price is above Rs. 2.50
per ball pen it will fall and if price is below Rs. 2.50, it will rise till it becomes equal to Rs. 2.50. At the
price of Rs. 2.50, the quantity supplied is equal to the quantity demanded and there is no tendency for
the price to change. Therefore, this price is called equilibrium price.
Effects of Shifts in Demand and Supply Curves on Equilibrium Price
Since the price of a commodity is determined by its demand and supply, any change in its demand
or/and supply will therefore affect its price.
(a) Shifts of The Demand Curve and Equilibrium
(i) Leftward shifts of the Demand Curve (Decrease in Demand):Normally, a leftward/downward
shift of the demand curve, given any supply curve, tends to decrease the equilibrium price as well as the
quantity bought and sold as shown in diagram below –
In diagram above as a result of the leftward shift of the demand curve DD to D1D1, price falls from p0 to
p1and the quantity brought and sold falls from q0to q1.However, as shown in the diagrams below –
In part A of the diagram above, as a consequence of a leftward shift of the demand curve DD to D1D1,
price falls from p0 to p1while quantity bought and sold remains constant at q0. In part B on the other
hand, price remains constant at p0 whereas quantity bought and sold decreases from q0 to q1. In part C,
partly the price falls and partly the quantity bought and sold decreases. For a given leftward shift to the

demand curve, the higher the elasticity of the supply curve, the greater the fall in price and lesser the
decrease in the quantity bought and sold and vice versa. In the extreme case of a perfectly inelastic
supply curve (diagram A) the fall in price is the maximum while the quantity bought and sold does not
change at all. On the other hand, in case of a perfectly elastic supply curve, (diagram B) price does not
fall at all and only the quantity bought and sold decreases. In the intermediate case, when supply is
neither perfectly elastic nor perfectly inelastic (i.e., upward rising supply curve in diagram C) the price
falls and the quantity bought and sold decreases.
(ii) Rightward shifts of the Demand Curve (Increase in Demand): Normally, a rightward shiftof
the demand curve, given and supply curve, tends to increase the equilibrium price as well as quantity
bought and sold as shown in the diagram below
In the diagram above, as a result of a rightward shift of the demand curve DD to D1D1, price increases
from p0to p1and quantity increase from q0 to q1. However, for any rightward shift of the demand curve,
move elastic the supply curve, lower will be the increase in price and higher will be the increase in
quantity. In the extreme case of a perfectly elastic supply curve, price does not increase at all and only
the quantity bought and sold increases. On the other hand, when the supply curve is perfectly inelastic,
only the price increases and the quantity remain unchanged. This is shown in the following diagrams
below-
Diagram A shows that when the supply curve is perfectly elastic price remains unchanged at p0 and
quantity increase from q0 to q1. Diagram B on the other hand, shows how quantity remains unchanged
and only price increases from p0 to p, when the supply curve is perfectly inelastic.
(b) Shifts of the Supply Curve and Equilibrium
(i) Leftward shift of the Supply Curve (Decrease in Supply): Normally, given and demand curve,
a leftward shift of the supply curve tends to increase price and reduce quantity bought and sold as shown
in the diagram below – In the diagram below, as a result of a leftward shift of the supply curve from SS
to S1S1, price rises from p0 to p1and quantity decrease from q0 to q1.

.
However, for any given leftward shift of the supply curve, higher the elasticity of demand, lower the
increase in price and greater the reduction in the quantity bought and sold and vice versa. If the demand
curve happens to be perfectly elastic, equilibrium price remains unchanged and only the quantity bought
and sold decreases. On the other hand, if the demand curve is perfectly inelastic, quantity remains
unchanged while price increases. In the intermediate case partly price rises and partly quantity
decreases. Diagrams below demonstrate extreme cases of perfectly inelastic demand curves.
Diagram A, depicts the case of a perfectly elastic demand curve in which case price remains constant at
OP0 but the quantity decreases from Oq0 to Oq1. Diagram B, on the other hand, shows the case of a
perfectly inelastic demand curve in which increases from Op0 to Op1while quantity remains unchanged
at Oq0.
. (ii) Rightward shift of the Supply Curve-Increase in supply: In case of a rightward shift of the supply
curve the results are exactly the opposite of what have been explained above. Normally, a rightward
shift of the supply curve, given any demand curve, tends to lower equilibrium price and to increase the
quantity. However, for a given rightward shift of the supply curve, more elastic the demand curve, lower
is the fall in price and greater is the increase in the quantity bought and sold and vice versa. If the
demand curve is perfectly inelastic, the quantity bought and sold remains unchanged and only the price
falls. On the other hand, if the demand curve happens to be perfectly elastic, price remains unchanged
while quantity increases. These cases are depicted in the following three diagrams –

Incidence Of Commodity Taxes
Taxes on commodities (or indirect taxes) such as sales taxes, excise duties, import and export duties,
etc., are major source of revenue for most government in capitalist economies. What does our price
theory predict about the effects of such taxes on the quantities and prices of taxed goods? Who really
pays the tax-the buyer or the producer?
The immediate effect of a commodity tax is to shift the whole supply curve upward vertically by
the amount of the tax as shown in the diagram below –
In this diagram, consequent upon imposition of a tax equal to p0p2 per unit, the original supply curve SS
shifts to S1S1. The new supply curve S1S1 shows that compared to the pretax position each quantity is
now supplied at a higher price because a part of the price is now taken by the government as tax. The
new supply curve S1S1 intersects the demand curve at new point determining p1 as the price and q1 as the
quantity sold. Thus imposition of a tax on a commodity leads to partly a rise in price and partly to a
reduction in the quantity bought and sold. It should be noted carefully that the price paid by the
purchasers rise by less than the amount of tax (= p0p1) and the net of tax price received by the producers
falls by p0p3. In other words, purchasers pay p0p1 part of tax per unit and the producers pay p0p3 part of
the tax per unit. The term “incidence of a tax” means who actually pays the tax. In the present case the
incidence of the tax is borne by the purchasers and the producers in the ratio of p0p1to p0p3 .
Normally, we would expect the price to rise by less than the amount of the tax when the supply
and demand curves are not perfectly inelastic or elastic. However, as discussed below, depending upon
the relative elasticities of supply and demand curves, the result may be quite different.

Economics of Demand & Supply

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