Detailed Notes on Demand, Supply, and Price Elasticity of Demand

Foundation Programme Fundamentals in Economics Lecture 1: Demand & Supply, Price Elasticity of Demand (Part I)

Objectives

  • Review of demand/supply principles
  • Understand the concept of elasticity
  • Compute and interpret the price elasticity of demand (PED)
  • Evaluate the determinants affecting PED

Class Exercises

Market for Playdough

  • Initial Equilibrium: Identified at point e in the demand-supply diagram.
  • Scenario Analysis:
  • Social Stigma: If playing with playdough is seen negatively, demand might decrease (D1 to D2).
  • Supply Disruption: A strike among wheat farmers affects the supply (S0 to S1).
  • Questions:
  • Does social stigma affect demand or supply?
  • How does a farmer's strike impact the market?
  • New Equilibrium must be identified post-changes.

Market for Labubu Dolls

  • Initial Equilibrium: Marked at point e.
  • Impact of Popularity: Lalisa's fans increase demand, shifting it to D1.
  • Production Changes: Pop Mart ramps up supply to meet increased interest.
  • Quality Control Issues: Diminishing excitement reduces demand.
  • Questions: Similar to playdough exercise, aimed at determining the effect of each change on demand/supply and finding new equilibria.

From Demand/Supply to Elasticity

  • Understanding the concept of how demand/supply can indicate changes in quantity but also calculating the extent of such changes is crucial for decision making.
  • Example: A price increase leading to a slight decrease in sales indicates inelastic behavior.

Definition of Elasticity

  • Measures the responsiveness of quantity demanded/supplied to changes in determinants such as:
  • Price of the good
  • Prices of related goods
  • Consumer income

Types of Elasticity

  1. Price Elasticity of Demand (PED)
  2. Cross Elasticity of Demand (XED)
  3. Income Elasticity of Demand (YED)
  4. Price Elasticity of Supply (PES)

Price Elasticity of Demand (PED)

  • What it Measures: Responsiveness of quantity demanded of a good to a change in its price.
  • Formula:
  • PED = %∆ Quantity Demanded / %∆ Price
  • Calculation Example: Given a price drop from $5 to $1 leading quantity demanded to rise from 80 to 120, calculate PED accordingly.

Values of PED

  • Ranges from 0 to ∞ for normal downward sloping demand curves:
  • PE values categorize demand into:
    • Elastic Demand: |PED| > 1
    • Inelastic Demand: |PED| < 1
    • Unit Elastic Demand: |PED| = 1
    • Perfectly Elastic Demand: |PED| = ∞
    • Perfectly Inelastic Demand: PED = 0

Determinants of PED

  1. Number & Closeness of Substitutes
  • More substitutes lead to more elastic demand as consumers can easily switch.
  • Example: Salt vs. salted caramel chocolate—different PED based on availability of substitutes.
  1. Proportion of Income Spent
  • The higher the percentage of income spent on the good, the more elastic the demand.
  • Example Exercise: Compare chewing gums vs. wine in terms of income proportion spent.
  1. Habit Forming Nature
  • Habit-forming goods generally have more inelastic demand as consumers are less responsive to price increases.
  • Case study: Impact of coffee price changes on consumer demand.

Readings

  • Eclectic Economics Source: Sloman, J., Garratt, D., & Guest, J. (2018). Economics. 10th ed. Ch. 2: pp. 34 - 58