1 DEMAND AND SUPPLY

2 Price Elasticity of Demand “ Measures the degree of responsiveness of the quantity demanded of a commodity to changes in its prices, ceteris paribus. It involves a movement along the demand curve in response to price change” Tutorial Notes DEMAND AND SUPPLY

3 Price Elasticity of Demand PED of a Good A = % quantity demanded of good A % in price of good A Tutorial Notes DEMAND AND SUPPLY

4 Price Elasticity of 2 Product/Service In India P Q P0P0 Q2Q2 Q1Q1 D0D0 Price Elasticity of Demand P1P1 D1D1 P Burger Rice

*Revenues is calculated as PXQ 5 DEMAND AND SUPPLY Quantity Demanded For 2 Types of Food Rice Vs Burgers in India P Q P0P0 Q Q D Price Elasticity of Demand (PED) P1P1 D P1P1 Burger Rice 1. For a price inelastic product, rice in this example, a big change in price does not extensively affect the quantity demanded of the product. P Q P0P0 ElasticInelastic 2. For the producer of rice, his lost in revenue, red shade, is lesser than the revenue gained (yellow shade) when price is increased for rice. Q0 Q1 Q0 Rev. Gained Rev. Gained Rev. Lost 3. This however is not the same for the burger that is price elastic in product. Before P Increased, Revenue = P0XQ0 After P increased, Revenue = P1XQ1

66 DEMAND AND SUPPLY Factors that Influence PED Availability of Substitutes -The more substitutes there are the greater the PED ie. the more elastic the PED of the good. The slope of the demand curve would not be very steep. -The less substitutes there is for the product, the steeper the slope of the demand curve. Time - When there is a sudden change in price of say, rice, people cannot react as fast in the short run so they will still have to suffer the increase in prices of rice. This makes the slope of the demand curve steep. But with time, when substitute for rice can be found or perhaps there is a change in taste and preference for rice, the demand curve will become less steep. Proportion of Income Spent on Commodity If you only spend a small portion of your income on the good like say a pen, the change in its price by 10% is not going to make you change your quantity demand for it by much as it is cost very little unlike a car or clothing. So the slope for these items can be steep. D0D0 P Qty D1D1

7 Quizz 1 - Teaser Q1: The world market for Thai rice has been disrupted by protest against the government. Simultaneously, demand for rice has also been dropping owing to the change in taste and preference of the Thai people from rice to Soya Bean. Using a diagram, explain what will happen to the market price and quantity demanded for Thai rice. (5 marks) Answer 1. Draw a demand and supply diagram. 2. On the diagram explain how disruption and population will shifts the demand and supply curves. 3. You must explain the diagrams by saying, “Initially market equilibrium is at (P0,QO). Subsequently owing to a disruption in supply causing the supply curve to shift to the left and population increase shifting the demand curve to the right, this have given rise to a new market equilibirum for Thai rice of (P1,Q1). The market clearing price is now higher (causing quantity demanded to increase less quickly) while the equilibrium quantity demanded may increase or decrease depending on the amount of shift of the demand curve to the right” P1 P0 Q0 Q1 P Q

8 Quizz 2 - Teaser Qn: Cigarettes are addictive and the government intends to curb smoking by increasing the price of cigarettes through a cigarette tax. Using an appropriate diagram, explain how the revenues of cigarette producers are affected after this price increase. (5 marks) P0P0 Q D P1P1 Cigarettes P Q Inelastic Q0 Q1 Rev. Gained Rev. Lost Before P Increased, Revenue = P0XQ0 After P increased, Revenue = P1XQ1 Revenues is calculated as PXQAnswer 1. Define price elasticity of demand. 2. Explain that smoking cigarettes is addictive and is price inelastic in demand.. 3. Draw the diagram on the right. You must explain the diagram. Start by saying “initially the equilibrium price is at P0 and quantity demanded is at Q0. This gives rise to total revenue represented by the red shaded area. After the price has increased, the new total revenue is given by P1XQ1.” 4. Based on the diagram, it can be seen that the total revenue gained (yellow shaded areas) after the price increased is more than total revenue lost (red shaded areas). As such the producer actually benefits with greater total revenues than before as long as his product sold is prices inelastic in demand.

9 Quizz 3 - Teaser The price of corn has been increasing relentlessly ever since the US Department of Transport approved biofuel (made by processing corn) as an alternative fuel to petrol. However, given the fact that many Americans are addicted to petrol, it is unlikely that drivers will switch to bio fuel in the short term. 1.Using demand and supply diagram (s), explain the relationship between corn and bio-fuel. 2.Using a demand and supply diagram(s), explain the relationship between bio fuel and petrol. 3.Using a well labeled diagram, explain what the author means by saying “Americans are addicted to fuel oil”.

10 Quizz 3 (continued) - Teaser Q1. Bio fuel is derived from corn. As such corn is a derived demand good. This can be illustrated by the diagram below. Referring to the diagrams, it can be seen that when there is an increase in demand for bio fuel, this will cause the demand curve for biofuel to shift to the right. Simultaneously, this will also cause a shift of the demand curve to the rigth for corn as well. Bio Fuel Corn

11 Quizz 3 (continued) - Teaser Q2. Petrol and Bio fuel are substitutes. Their relationship can be illustrated by the diagrams below. Referring to the diagrams, it can be seen that when there is an increase in demand for bio fuel, this will cause the demand curve for bio fuel to shift to the right. However, this will cause a shift of the demand curve for petrol to shift to the left as there will be less quantity demanded for petrol as bio fuel and petrol are substitutes for each other. Bio Fuel Petrol

12 Quizz 3 – Continued. Q3. Answer: P0P0 Q D P1P1 Petrol P Q PED<1 Q0 Q1 Q3. “ Adiction” implies that the demand for petrol for Americans is price elastic in demand. When something is price in elastic in demand it would means that the degree of change in quantity demand is not as great as the degree of change in its price This can be seen from the diagram on the right. When there is a change in the price from Po to P1, it is noticed that the change in quantity demanded only incrrease by an amount Q0 to Q1 which is not as great as the degree of change in its price. As such, small change in fuel prices will not immediately cause Americans to switch over to bio fuel.