MBA512

Dr. Tanova

MARKET FUNDAMENTALS

Every society must find a way to answer the three economic questions: what

to produce, how to produce and for whom to produce.

The problem is that we do not know what and how much exactly people want

to consume. If even we were able to find out an answer to this question, we still have

to make a decision how to use our scarce resources, because they are not enough to

satisfy all our needs. On the other hand, people constantly change their needs.

Therefore, people must find a way to coordinate their economic decisions.

1. Market functions:

a) market prices tell firms what is more profitable to produce and firms direct

their resources to these industries. On the other hand, if prices of some goods

and services cause lower profits and even losses, people withdraw resources

from these industries. This is the allocative function of the market.

b) Since there is always a risk not to be able to sell the goods at a high enough

price, firms are motivated to reduce their costs to minimum and to look for

more efficient technologies. This is the motivating function of the market.

c) Markets distribute goods and services between people according to their

success in the solution of the first two economic problems. This is the

distributive function of the market. If producers have been efficient and have

allocated resources to the industries, most preferred by the society, they have

made good profits and they have improved their welfare.

In summary: Under the market economy the prices tell people what to

produce, how to produce and for whom to produce. Firms study the market and make

decisions. They want to produce goods and services that will provide them with good

profits. Therefore, the first step to learn how markets work is to study what buyers are

willing to buy.

2. The demand for a good

The behavior of buyers is called demand.

In fact, there is demand for all goods and services. If no one wants a good, this

good is not produced at all. However, if prices are higher, people want to buy less; if

prices are lower, people want to buy more. In order to study the demand, we have to

find out how much people are willing to buy at different price levels.

Let’s study the demand for chocolates “Milka”. The first thing that we learn is

that there is not just demand. The demand is always for a particular good. Further, the

demand is always in a particular market. If chocolates “Milka” are five cents cheaper

in Larnaka, George would not go from Limasol to Larnaka to buy chocolates there.

Therefore, we shell study the demand for chocolates “Milka” in a specified market.1

We know that if the price of chocolates is higher, people will be willing to buy less. If

the price is lower, they are willing to buy more. Therefore, in order to present the

demand, we have to build a table with all the quantities of the good that buyers are

willing to buy at different prices. On the schedule on the next page we have such

information.

1 For many goods today the demand is global. For example, the demand for software

and for some information services is studied in the global market. Now we just start

with a simple example and a simple market. In your courses in marketing you will

study in details of studying demand in different markets.

The demand for chocolates is presented by all the quantities and all the prices

on the schedule. In other words, the demand for chocolates is presented by the entire

schedule.

We can now give a second definition of demand.

The Demand for a good – all the quantities of the good buyers are willing and

able to buy at every different price.

Three things are important in this definition:

a) the demand for a good is presented by all the quantities at every price;

b) the demand itself does not tell how much buyers buy, but how much they are

willing to buy depending on the price;

c) the demand for a good is not only a willingness to buy, but an ability to buy,

as well.

The demand schedule is a good instrument to study demand. However, it does not

present all the possible prices and all the quantities demanded, indeed. It is not

possible to build such a table. This is why, we use a better tool to present demand.

This is the demand curve.

We build the demand curve on a graph. On the vertical axis we put the price

(P), and on the horizontal axes we put the quantity demanded. Then we take the

numbers from the demand schedule and draw the demand curve. It is shown on

the graph bellow. (fig. 1).

PD

D

8 12 Q

B

C2.00

1.60

Fig. 1. The Demand for chocolates “Milka”

The Demand curve shows the relationship between the price and quantity

demanded. Every point along the curve indicates the quantity demanded, while the

entire curve presents the demand. If, for example, the price of chocolates falls from

€2.00 to €1.60, the quantity demanded rises from 8 bars to 12 bars. The demand for

chocolates does not change. Only the quantity demanded changes. The first

combination of price and quantity demanded is presented by point B and the second

one – by point C. There is a movement along the demand curve, but there is not any

change in demand. The demand is still the same – presented in the same demand

schedule and by the same demand curve.

The demand curve shows that always, when the price falls, the quantity

demanded increases. Alternatively, when the price increases, the quantity demanded

falls. This relationship holds of course, when all other conditions remain the same.

Now we can articulate the law of demand.

The law of demand states that the decrease in the price of the good raises the

quantity of the good demanded, other factors held equal.

Factors, determining demand

Now we shell find out which are those factors that are held equal along the

demand curve. In other words – which are the factors that can change the entire

demand?

a) buyers income

Let’s assume that the income of buyers increases. If, for example, our demand

schedule presents the demand for chocolates at the cafeteria in the university, and all

students have more money to spend, than before, they will be willing to buy more

chocolates at every price level. The previous demand schedule will not present the

current demand for chocolates. We have to study the demand again and to build a new

demand schedule. It might look like the one below.

The New Demand schedule

P (€) QA1 2,5 13B1 2 16C1 1,6 20D1 1,5 23E1 1,4 30F1 1,3 36G1 1,2 44H1 1,1 58I1 1 108

If we compare this schedule to the first one, at every price of the chocolates,

we have greater quantities. Let’s build the new demand curve on the same graph. (fig.

2.)

PD

D

8 12 Q

D1

D1

Fig. 2. The increase in the demand for chocolates “Milka”

We can see that the new demand curve is located to the right. The new

demand for chocolates is greater. We say that the demand has increased and the

demand curve has shifted to the right.

If buyers’ income falls, the demand for chocolates will fall, too and the demand curve

will shift to the left.

b) the prices of other goods

Let’s assume now, that students’ income does not change, but the price of

chocolates “Lindt” falls significantly. Probably, some of the buyers of “Milka” will

shift their demand to the other brand – “Lindt”, because they consider it to be a

substitute for “Milka”. The demand for “Milka” will fall. At every price buyers will

be willing to buy lower quantities. The demand curve for “Milka” will shift leftwards.

(fig. 3)

P D

D

Q

D1

D1

Fig. 3. The decrease in the demand for chocolates “Milka”

If the price of a substitute good decreases, the demand for chocolates “Milka”

falls. Alternatively, if the price of the substitute good (chocolates “Lindt”) increases,

some of the buyers of “Lindt” will reduce their purchases of “Lindt” and increase

their purchases of “Milka”. The demand for “Milka” will increase because of the

increase in the price of the substitute.

The demand for a good depends not only on the prices of substitutes, but on

the prices of complementary goods, as well. For example, cigarettes and lighters are

complementary goods. If the price of cigarettes increases significantly, some smokers

might give up smoking. The quantity demanded of cigarettes will fall. (This is the law

of demand). This will affect the demand for lighters. Since cigarettes are a

complementary good for the lighters, the demand for lighters will fall even though

their price has not changed.

c) buyers expectations

Let’s take the demand for the US dollars. If the potential buyers of the US dollars

expect the US dollars to increase in price, many of them will prefer to buy dollars

now. This means that the entire demand schedule for the US dollars will be different.

At every price level, buyers will be willing to buy more US dollars and the demand

curve, indicating this demand will shift to the right. The demand for the US dollars

will increase. The demand curve for the US dollars will shift rightwards.

d) buyers’ taste and preferences

Let’s take the market for coca cola. During the last years many people who used

to buy coca cola were convinced that it was unhealthy and they changed their taste

and preferences. They prefer now natural juices. The demand for coca cola has

decreased. The demand for juices has increased, because of the change in taste and

preferences.

e) the size of the market

In Summer Limasol is full of tourists. The number of buyers increases and the

demand for hotel services rises. In November, some hotels will close because the

number of tourists falls and the demand for these services falls too.

d) institutions

Institutions are the rules of economic decision making. Taxes are such a rule. If

the government raises income taxes, people will have less money to spend and the

demand for many goods will decrease.

3. The Supply of a good

Supply is the behavior of sellers. As opposed to the buyers, sellers are happy if

they can sell at a higher price. Alternatively, if the price of the good is falling, sellers

cannot make much money on it and they are willing to sell less.

The relationship between the price and the quantity supplied is positive. The greater

the price, the greater the quantity supplied. It is presented on the supply schedule

below.

S

S

Q

We can use the supply schedule to draw the supply curve. (fig. 4).

Fig. 4. The supply curve for chocolates “Milka”

The supply of chocolates is presented by all the quantities and all the prices on

the schedule. In other words, the supply of chocolates is presented by the entire

schedule and by the entire supply curve.

We can now give a second definition of supply.

The Supply of a good – all the quantities of the good seller are willing and

able to sell at every different price.

Three things are important in this definition:

a) the supply of a good is presented by all the quantities at every price;

b) the supply itself does not tell how much sellers sell, but how much they are

willing to sell depending on the price;

c) the supply of a good is not only a willingness to sell, but an ability to sell, as

well.

The supply curve is a picture of the law of supply.

P

S

S

S1

S1

Q

The law of supply states that the increase in the price of the good raises the

quantity of the good supplied, other factors held equal.

Factors, determining supply

a) sellers’ expectations

Expectations are a powerful factor affecting supply. If potential sellers of the US

dollars expect an increase in the price of the dollar, they will be willing to sell less

today and more in the future. This means that at every particular price of the US

dollar, quantities supplied will be less. On the graph it will be presented by a new

supply curve, which will be located closer to the origin of the coordinate system.

(fig. 5).

Fig. 5. A leftward shift in the supply curve. A fall in supply

As we can see on figure 5, the supply curve shifts to the left. The supply of the US

dollars falls.

b) cost of production

With the increase in the price of gasoline, transportation services become more

costly. Transportation firms will be willing to sell the same quantities of

transportation services, at a higher price which should compensate for the higher

P

S

S

S1

S1

Q

price of gasoline. The supply of these services will fall. The supply curve will shift

to the left.

c) technological changes

Technological progress reduces the cost of production. Firms can produce the same

quantities of the goods at a lower cost, or (which is the same), they can produce

more at the same cost. This means that the new supply curve, presenting such a

change, will be located to the right from the supply curve before the technological

changes. (fig. 6).

Fig. 6. An increase in supply

d) the size of the market.

The increase in the number of sellers raises supply and the supply curve shifts to

the right.

e) institutions

If the government would raise the taxes on production, the cost of production will

increase. Thus, the supply curve shifts to the left. Supply falls. A reduction in the

tax rates raises supply and the supply curve shifts rightwards.

P

S

D

E

Q

4. Market Equilibrium

One does not need going to school to realize that buyers are willing to buy more at

lower prices, while sellers are willing to sell more only at higher prices. Economists

just articulate these uniformities of buyers’ and sellers’ motivation and derive the law

of demand and the law of supply.

The concepts of supply and demand present motivation and behavior of buyers

and sellers.

Demand is presented by the demand schedule and the demand curve.

Supply is presented by the supply schedule and the supply curve.

When we analyze supply and demand we can realize that they indicate entirely

different attitudes of sellers and buyers. Sellers want to sell for more, and buyers want

to buy for less. However, there is one only price, at which quantity demanded equals

quantity supplied at the same price. In our example with the market for chocolates

Milka, it is the price of €1.20. At this price, buyers want to buy exactly the same

quantity of chocolates, that sellers want to sell = 36 bars of chocolates. This situation

is market equilibrium. (Fig. 7)

Fig. 7. Market equilibrium.

P

Qe

P

Pe

SD

E

Q

a surplusqs > qd

a shortageqd > qs

qsqeqd

The market comes at equilibrium when quantity demanded = quantity

supplied at the same price. The price, at which the market is in equilibrium, is

equilibrium price, and the quantity is equilibrium quantity.

Market equilibrium is unique. At any price above ₤1.20 buyers want to buy less,

but sellers want to sell more. At any price below ₤1.20, buyers want to buy more, but

sellers want to sell less. Only at the equilibrium price, all sellers find buyers for all

their quantity supplied and all buyers find as much as they are willing to buy at this

price. No one is motivated to change anything.

Any change in the price will lead to a worst situation and there will be unsatisfied

buyers or sellers. If the price is greater than the equilibrium price, Qs > Qd and this

will produce a surplus. If the price is lower than the equilibrium price Qs < Qd and

this will produce a shortage. (Fig. 8).

Fig. 8. A surplus and a shortage

The Dynamics of Market Equilibrium

Shortages can occur always when demand rises, or when supply falls. (You know the

factors, affecting supply and demand and you can think of examples). If, for instance,

P

Pe

buyers’ income would increase, they will be willing to buy more at any price and the

demand will increase. The demand curve will shift rightwards and the equilibrium

will be destroyed. At the equilibrium price, buyers will be willing to buy more:

Qd>Qs. The shortage will push the price upwards. According to the law of supply,

quantity supplied will increase – as the price rises, sellers are willing to sell more.

According to the law of demand, quantity demanded will fall – as the price rises,

buyers are willing to buy less. Thus, the shortage will be cleared and the market will

come to a new equilibrium at a higher equilibrium price and greater equilibrium

quantity. Economists say, that the market clears the shortage and the equilibrium

price is a market clearing price. Market equilibrium is restored. (Fig. 9)

Fig. 9. Restoration of market equilibrium after a shortage

Surpluses can occur always when supply rises, or when demand falls. Then, at the

equilibrium price Qs > Qd. The surplus will push the price down and the surplus will

be cleared at a new, lower, equilibrium price. (Fig. 10).

P

Q

D

S

E

D’

Pe

QeQd

P’

Q’

E’

Fig. 10. Restoration of market equilibrium after a surplus

Price ceiling

If government would decide that the equilibrium price is too high, it might set

a price ceiling – a maximum price, at which the good could legally be sold. When

this price is below the equilibrium price, the shortage created cannot be cleared by

price increase, because it is illegal. This permanent shortage will create a black

market. (fig 11).

Fig. 11. The black market clears the shortage

P

Q

DS

EPe

Qe

S’

Qs

E’

P

Q

D

S

Pe

Qe

Pc

Qs Qd

shortage

Pb.m.

Shortage = (Qd-Qs) x Pc

Profits of the blackmarketeers =(Pb.m. – Pc) x Qs

Black marketeers will buy all the quantity supplied at the ceiling price and will

illegally sell it at the highest possible price, which buyers will be willing to pay

for this quantity. This price is greater, that the equilibrium price. Therefore,

government intervention in price determination would not reduce prices, but

would create more disturbances.

5. Arbitrage and speculation

There are many cases, when different markets of the same good can produce

different equilibrium prices. For instance, the market in Oz (a hypothetical

country) sets the equilibrium price for widgets at a very high level, while the

market for widgets in Zo (another hypothetical country) comes to equilibrium at a

lower price. If widgets can easily be traded between these two countries, buyers

from Oz will go to Zo to buy at a lower price (the demand in Oz will fall and the

demand in Zo will increase), and sellers from Zo will shift part of their supplies to

Oz (the supply in Zo will fall and the supply in Oz will increase). Theses shifts in

supply and demand will persist until prices in both countries become equal. (Fig.

12a) and 12 b)

Fig. 12 a) Different prices of widgets in Oz and in Zo

P

Q

Oz widget market

DS

P1Oz

QOz

P

Q

Zo widget market

D

S

PZo

QZo

Demand shifts to Zo marketSupply shifts to Oz market

Shifts in Supply and Demand until price differences are eliminated(exports)(imports)

E1Oz

E1Zo

Fig. 12 b) Arbitrage and the establishment of one equal prices

The process of price equalization is arbitrage. People, who take the risk to

perform it are speculators. They perform the most important function in the

market economy, because markets balance the forces of supply and demand

thanks to speculators’ actions.

Arbitrage took place in Cyprus after the accession to the European Union.

Prices of many goods were lower in Cyprus, than in the other countries in the

European Union. Speculators from the EU shifted their demand to Cyprus market

in order to buy at a lower price and then sell in the EU market at a higher price.

Sellers from Cyprus shifted their supply to the EU market, too, in order to sell at

higher prices. As a result, equilibrium prices in Cyprus increased. The impact on

the EU market was not significant and prices did not fall there, because the

European market was much larger than Cyprus market.

P

Q

Oz widget market

DS

P1Oz

Q1Oz

P

Q

Zo widget market

D

S

P1Zo

Q1Zo

Pa

E1Oz

E1Zo

E2E2

Quantifying market responses – elasticity

1. Price elasticity of demand

If you ask a shop owner whether he is interested in studying the law of demand in

order to make more money, he will probably tell you, that one does not need

reading books to intuitively understand, that if he reduces the price, he will sell

more. The problem, however, occurs if price reduction is not compensated for by

enough increase in the quantity sold. If, for example, he reduces the price of

carrots by 50%, but buyers increase purchases of carrots by only 20%, his

revenues, will actually fall. Let’s assume, that he used to sell 100 kilos of carrots

at a price ₤1. Now, he has reduced the price to ₤0.50. His buyers raised their

purchases by 20% and now they are buying 120 kilos. Before, his total revenues

(TR) = ₤1 x 100 = ₤100. Now his TR = ₤0.50 x 120 = ₤60. It seems, that his

buyers were not sensitive enough to the price reduction and price reduction was a

failure. If he had raised the price by 50% up to ₤1.50 and his buyers would have

reduced the quantity demanded by 20% to approximately 80 kilos, his TR = ₤1.50

x 80 = ₤120.

On the other hand, if buyers would have been more responsive to price changes,

and if they would have raised the quantity demanded not by 20% when price is

reduced by 50%, but, say, they would have been willing to buy two times more

carrots (200 kilos, which is 100% increase), TR would have risen from ₤100 to

₤200.

Therefore, sellers need to know which pricing policy will be more profitable and

this depends on buyers’ sensitivity to price changes.

Buyers’ sensitivity (responsiveness) to price changes is called price elasticity

of demand.

It can be measured by the coefficient of price elasticity of demand:

E = % change in quantity demanded : % change in price

Since quantity falls, when price increases, E is always negative. We will take it in

absolute terms |E| in order to avoid negative numbers.

|E| could be less 1 and then demand is inelastic, i.e. buyers are not quite

sensitive to price changes and price reductions are not compensated for by

increase in quantity demanded enough to raise TR (the first case in our example).

If |E| > 1, demand is elastic and price reduction will lead to san increase in TR.

If |E| = 1, demand is unit elastic.

If E = 0, demand is perfectly inelastic, which means that buyers do not react at

all to price changes and keep buying the same quantities. The demand curve is

vertical.

Another extreme situation can occur, if buyers are that sensitive, that they would

change quantity demanded if even the price does not change. In this case demand

is perfectly elastic. E = ∞

Our next point is to learn how to calculate percentage changes in price and

quantity demanded.

Let’s take our example with the carrots. The seller used to sell Q1 = 100 kilos of

carrots at a price P1 = ₤1. Now he reduced the price and P2 = ₤0.50 and he sells Q2

= 120 kilos. We took the percentage changes approximately just in order to

understand the concept of price elasticity of demand. Now we will calculate the

percentage changes more accurately, according to the rule of calculating

percentage changes.

Percentage change in Q =

Q2−Q 1

(Q 1+Q 2) :2

Percentage change in P =

P 2−P 1

( P 1+P 2) :2

Let’s substitute the numbers for the symbols:

Percentage change in Q =

120−100(120+100 ):2

Percentage change in P =

0 .50−1. 00(1. 00+0. 50 ):2

E =

0 .18−0 .66 = - 0.27

Or in absolute terms |E| = 0.27

The demand for carrots is inelastic.

2. Price elasticity of demand and total revenue

We saw that if the seller of carrots reduces the price, he will make less money.

(₤60 < ₤100). If he raises the price, he will make more money (₤120 > ₤100).

We can conclude that:

if demand is inelastic, price reduction leads to a fall in total revenue, while

price increase leads to an increase in TR.

The opposite holds for price elastic demand.

if demand is elastic, price reduction leads to an increase in total revenue,

while price increase leads to a fall in TR.

If demand is unit elastic, the change in price is compensated by the change in

quantity demanded and TR stays the same.

The table below summarized our conclusions.

3. Factors, affecting price elasticity of demand

Price Elasticity of Demand and Total Revenue

P Q TR

| E| > 1

If the pricerises, TRincreases

If the pricerises, TR

falls

If |E| = 1, TR does not change

| E| < 1

It seems that everyone will want to have inelastic demand. Then if the price

rises, buyers will reduce purchases, but anyway total revenues will increase.

Therefore, the question is how to make demand inelastic? Is it possible?

Which are the factors that make demand inelastic, or elastic?

We will first check whether price elasticity of demand is constant along the

demand curve.

Let’s assume that Mr. Happy sells pizza at €1 a piece. He decides to raise the

price by €1 and now the price is €2. Buyers react to the price change and the

quantity demanded falls from 10 to 9 pieces.

% change in Q = (10-9) : (9+10)/2 = 0.10

% change in P = (1-2) : (2+1)/2 = - 0.67

E =- 0.14

|- 0.14| < 1

The demand for pizza is inelastic and TR increase from €10 (10x 1) to €18

(9x2). Mr. Happy is encouraged to raise the price further. His TR increases. Every

day he raises the price by €1 and the quantity of pizza demanded falls by 1 piece.

This is presented in the table below.

When the price is raised from €5 to €6, the quantity demanded falls from 6 to

5 pieces and TR does not change. The demand is unit elastic. (Calculate it to make

sure!).

K101J92I83H74G65F56D47C38B29A110

QP

If Mr. Happy would raise the price further, he will not be that happy because

his total revenues will fall. The demand will become elastic!

Let’s check it for the price increase from €9 to €10. The quantity of pizza

demanded will fall from 2 to 1 piece.

% change in P = (9- 10) : (9+10)/2 = - 0.10

% change in Q = (2-1) : (2+1)/2 = 0.67

E = 0.67 : - 0.10 = - 670

|-670| > 1

Therefore, price elasticity of demand is not the same along the demand curve.

As we move upwards along the demand curve, price elasticity of demand

increases.

The reason for this is that the price of pizza becomes relatively higher and

buyers spend a larger part of their income on pizza.

The smaller the share of income spent on the good, the lower is the price

elasticity of demand for this good, ceteris paribus.

We identified one of the factors, affecting price elasticity of demand – the

share of buyer’s income spent on this good.

Another factor, determining price elasticity of demand is the availability of

substitutes for the good.

If the good does not have substitutes, the increase in price will not affect

significantly purchases. Such a good is electricity. When its price rises, people try

to consume less, but since they cannot find a substitute for it, the reduction in

quantity demanded is quite small. The demand is inelastic.

If the good has many substitutes, and its price increases, buyers can easily

shift their demand to another good. The quantity demanded will fall significantly.

Demand is elastic.

The availability of substitutes depends on the definition of the market. We

know that the demand for cigarettes is inelastic – price increases do not lead to a

significant reduction in quantity demanded. If, however, sellers of Marlboro

increase the price, many smokers might shift their demand to another brand of

cigarettes, because they might consider it as a substitute for Marlboro. The

demand for Marlboro is more elastic than the demand for cigarettes. The broader

the market definition, the lower is the price elasticity of demand.

Many firms invest in advertisement of their brand name. They want to create

loyal buyers, who will not shift their demand to other brand names if the price of

the good increases. Therefore, buyers’ loyalty is a factor, affecting price elasticity

of demand. The greater this loyalty, the lower is the price elasticity of demand.

Another factor is the time horizon. Immediately after the price of a good

increase, people do not reduce significantly their purchases, because they cannot

change their plans and figure out substitutes so quickly. Over time their reaction to

price increase is stronger and the reduction in quantity demanded is more

significant. The longer the time period, the greater is the price elasticity of

demand.

Price elasticity of demand depends also on traditions in demand and

consumption. For example, milk is a good that people use traditionally and they

do not change significantly their purchases with the changes of its price.

4. Income elasticity of demand

Buyers change purchases not only as a response to the changes in prices, but

also when their income change.

Buyers’ responsiveness to changes in their income is called income elasticity of

demand.

Income elasticity of demand is measured by the coefficient of income

elasticity Ey.

Ey = % change in quantity demanded : % change in buyer’s income

Income elasticity of demand is usually positive.

If Ey > 1 demand is income elastic.

If Ey = 1 demand is income unit elastic.

If 0 < Ey < 1 demand is income inelastic.

If Ey = 0 demand is perfectly inelastic as regard income.

If Ey < 0 income elasticity of demand is negative.

Negative income elasticity of demand is observed when buyers increase their

purchases of a good when their income falls and reduce purchases of this good

when their income rises.

Goods with negative income elasticity of demand are inferior goods. Goods

with positive income elasticity of demand are normal goods.

A typical example of an inferior good are shoe repair services. When income

falls, people would prefer to repair their shoes instead if buying new shoes. When

income increases, they will rather buy new shoes instead of repairing the old ones.

During recessions when unemployment increase and income falls we realize that

people with low skills and no educations are the first to loose their jobs and have

more difficulties to find employment. This is perhaps the reason of their greater

interest to university education. It is observed that during tough economic times,

the demand for higher education increases. Therefore, university education is an

inferior good during recessions. Ordinary cosmetics, like lip stick turn out to be an

inferior good too. When income falls, women often decide that it is easier and

cheaper to buy new lip stick than a new dress. Another explanation could be that

during recessions people invest in their appearance in their efforts to find a job.

Income elasticity of demand depends on the share of income spent on the

good. If people spend a very small share of their income on a good, price elasticity

of demand for this good is very low and often close to zero.

Goods with a very low, close to zero, price and income elasticity of demand

are called necessities.

If people spend a large share of their income on a particular good, its income

elasticity of demand tend to be high.

5. Cross price elasticity of demand

Buyers change purchases of some goods as a response to the changes in the

price of some other goods. If, for example, the price of Coca cola increases, but

the price of Pepsi stays the same, many buyers would substitute Pepsi for Coke.

The demand for Pepsi will increase as a response to the change in the price for

Coke. Such a reaction of buyers is called cross-price elasticity of demand.

The responsiveness of buyers of one good to the change in the price of another

good is cross-price elasticity of demand.

Cross price elasticity of demand is measured by the coefficient of cross price

elasticity Eab

Eab = percentage change in quantity demanded of good a : percentage

change in the price of good b.

In the case of Coke and Pepsi, Eab > 0. When the price of Coke rises, the

quantity of Pepsi demanded increases. Therefore, if Eab > 0 the goods are

substitutes.

If Eab < 0, the goods are complements.

If Eab = 0, purchases of good a do not depend on the price of good b. They

are independent.

Firms need to know the cross price elasticity of demand for the goods that they

sell, because this is the way to find out whether these goods have substitutes,

produced by other firms, or not.

6. Price elasticity of supply

Sellers react to the changes in the price of the goods that they sell, as well.

The responsiveness of sellers of a good to the change in its price is called price

elasticity of supply.

Price elasticity of supply is measured by the coefficient of price elasticity of

supply.

E = % change in quantity supplied : % change in price

If E > 1 supply is price elastic.

If E = 1 supply is price unit elastic.

If E < 1 supply is price inelastic.

If E = 0 supply is perfectly inelastic.

If E = ∞ supply is perfectly elastic.

On the graphs below are presented supply curves with different price elasticities

of supply.

7. Factors, affecting price elasticity of supply

a) time horizon

Price elasticity of supply depends heavily on the time horizon. For example,

sellers of kiwi go to the open market with a given amount of kiwi. On the same

day a doctor announces on TV that eating kiwi is very healthy and would prevent

flu. The news drives buyers to the market and the demand for kiwi increases

significantly. Sellers are happy, but at the moment they cannot increase the

quantity supplied. The only thing they can do is to raise the price as a response to

the increase in demand. Supply is perfectly inelastic in the very short run. It is

shown on the graph below.

P

Q

E < 1

E > 1

E = 1

P

Q

E = 1

E = ∞

On the next day sellers can mobilize their families and pick up more kiwi to

take to the market. Their response to the change in price is however not

significant, because the increase in the quantity supplied depends on the scale of

their production. They cannot grow more kiwi at the moment. Supply is inelastic

in the short run. On the next graph we can see price inelastic supply in the short

run.

P

Q

D

D1S

p0

P1

P

Q

D

D1S

p0

P1

S1

For the next year producers can grow more kiwi and then they will be able to

respond fully to the price increase. In the long run supply will be elastic. It is

presented below.

A short run is a period when firms can just partially respond to the changes in

the market, because they have some production factors that are fixed and cannot

be changed at the moment.

A long run is a period when firms can fully respond to the changes in the

market because the can change all the factors of production.

The longer the time period, the higher is the price elasticity of supply.

b) availability of resources

When the price rises, producers are willing to increase the quantity supplied,

but they might have difficulties with finding extra resources in the market. Raw

materials or labor might be in short supply and then the response to the price

increase will be smaller.

The greater the availability of resources in the market, the greater is the price

elasticity of demand.

c) mobility of the production factors

The increase in the price of real estate motivates the developing and construction

companies to build more houses. This means that they will need more

architecturers, more engineers and more workers. However, it takes long time and

P

Q

D

D1S

p0

P1

S1

efforts to become an architecturer or an engineer. Thus, labor is not mobile and

this reduces price elasticity of supply.

d) the level of inventories

When the price of a good increases, sellers can respond to it by using their

inventories – stored raw materials, stored final goods, etc. The greater the level of

inventories, the greater is the price elasticity of supply. However, large levels of

inventories are expensive. The capital stored in inventories does not bring more

money, and at the same time the firm has to pay for the warehouses, electricity,

etc.