Topic

Demand
and
Supply
Analysis

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.

Discuss demand analysis;

2.

Discuss supply analysis;

3.

Determine equilibrium price and quantity;

4.

Compute and interpret price elasticity of demand;

5.

Compute and interpret income elasticity;

6.

Compute and interpret cross-price elasticity; and

7.

Identify other useful elasticities.

INTRODUCTION
Because the demand for a firm's goods and services plays such an important and
central role in determining the amount of cash flow which the firm will be able to
generate, and thus, the economic value of the firm, it is essential that we have a
strong and deep understanding of demand and supply concepts. This
understanding permits us as managers, to react to changes or shifts in demand
for our firms goods and services in a manner that maximises profits and
shareholders' wealth. The essential tools for predicting changes in the demand
function include price, income and cross-price elasticities. Thus, demand
analysis, in particular, could easily satisfy two critical managerial objectives
provide the insight necessary for effective management of demand and assist in
forecasting sales and revenue for the firm.

26 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

3.1
3.1.1

DEMAND RELATIONSHIP
What is Demand Analysis?

In general, the demand for a goods or services can be defined as quantities of a

goods or services that people are ready (willing and able) to buy at various prices
within a given time period, with factors other than price, held constant (or
unchanged). An important contributor to the risk of a firm is the sudden shifts
in demand for a product or service due to and as a result of changes in the other
factors such as income level and population size.
Conducting demand analysis serves two managerial objectives:
(a)

Provides the insight necessary for effective management of demand; and

(b)

Assists in forecasting sales and revenues.

The most prominent feature of the demand curve (the simplest form of the
demand relationship) is its downward slope. Price ($/Q) and quantity (Q/time unit)
are negatively related (Figure 3.1). The higher the price, the lower will be the
quantity demanded and vice versa, with other factors constant. In Figure 1,
when the price was RM8, the quantity demanded was 12 units; when the price
dropped to RM 5, the quantity demanded increased to 20 units.

Figure 3.1: The individual demand curve

Basically, there are two economic reasons for the downward slope:
(a)

Income effect As the price of a type of goods declines, the consumer can
purchase more of the goods as his real income is increased.

(b)

Substitution effect As the price declines, the goods become relatively

cheaper.

TOPIC 3 DEMAND AND SUPPLY ANALYSIS

27

Rational consumers are those people who seek to maximise satisfaction. They
will reorganise consumption until the marginal utility (MU) in each goods per
dollar is equal. This is shown in the equation below.
Optimality Condition is MUA/PA = MUB/PB = MUC/PC =
If MU per dollar in A and B differ, the consumer can improve utility by
purchasing more of the one with the higher MU per dollar and less of the other.

3.1.2

Market Demand Curve

The market demand curve is the horizontal sum of the individual demand
curves. In Figure 3.2, there are two consumers in the market. The market demand
curve is the horizontal summation of the two demand curves (panel 3).

Figure 3.2: The market demand curve

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

3.1.3

What is Demand Function?

The Demand Curve, as discussed above, only considers the relationship between
price and quantity; other factors" being constant. The Demand Function
includes all of the factors which significantly influence the quantity demanded,
including the price. A general demand function can be written in the form of a
mathematical expression as shown below:

QD = f (P, Ps, Pc, Y, Pe, A, Ac, TA, X.)

P =
Ps =

Price of the good itself

Price of substitute

28 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

Pc
Y
Pe
A
Ac
TA
X

=
=
=
=
=
=
=

Price of complements
Income
Expected price
Firms advertisement expenditure
Competitors expenditure on advertisement
Taste and preference
Other factors

The expected effects of the various factors (or variables or influences) on the
quantity demanded are as follows:

The price of the goods, P, is negatively related to QD.

The higher the price of substitute goods, Ps, the greater the quantity
demanded of one's own goods. Two goods are substitutes if an increase in the
consumption of one leads to the decline in the consumption of the other; for
example, coffee and tea; butter and margarine.

The higher the price of complementary goods, Pc, the smaller the quantity
demanded. Two goods are complements if an increase in the consumption of
one also leads to an increase in the consumption of the other; for example,
coffee and creamer; bread and butter.

The effect of income on quantity demanded depends on the types of goods

(or service). For normal goods, if income increases, the quantity demanded
will also increase. If income increases but the quantity demanded decreases,
it is called inferior goods.

By now, you should be able to determine the relationships (positive or negative)

between the quantity demanded and other factors such as expected price of
goods, amount of advertisement expenditure by your firm, amount of
advertisement expenditure by your competitor, consumer tastes and preferences,
etc.

3.1.4

Changes in Quantity Demanded and Changes in

Demand

Changes in price result in changes in the quantity demanded. This implies a

movement along a demand curve. As shown in Figure 3.3, the movement is from
one point to another along the same demand curve such as DD.
Changes in non-price determinants result in changes in demand. This is shown
as a shift in the entire demand curve, say, from DD to D1D1 if it results in an
increase in demand or to D2D2 if there is a decrease in demand.

TOPIC 3 DEMAND AND SUPPLY ANALYSIS

Figure 3.3: Shifts in demand

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

SELF-CHECK 3.1
1.

What is demand analysis and what are the objectives of studying

demand analysis?

2.

What is demand function and what are the factors affecting the
quantity demanded?

3.

Discuss the relationship between quantity demanded and each of

the factors identified in (2).

4.

Show the differences between changes in quantity demanded

and changes in demand.

29

30 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

3.2

MARKET SUPPLY

The supply of a particular goods or service is defined as quantities of a particular

goods or service that people or firms are ready to sell at various prices within a
given time period, with other factors besides price, being held constant.

Figure 3.4: Individual supply curve

The supply curve usually slopes upward, i.e. the higher the price, the greater the
quantity of goods or services an individual is willing to sell, holding constant all
other factors affecting supply. Non-price determinants of supply include:
(a)

Costs and technology

(b)

Prices of other goods or services offered by the seller

(c)

Future expectations

(d)

Number of sellers

(e)

Weather conditions

Similar to market demand, the market supply curve is the horizontal summation
of all the individual supply curves.
Changes in price result in changes in the quantity supplied. This implies a
movement along the supply curve. On the other hand, changes in non-price
determinants result in changes in supply. This is shown as a shift in the supply
curve.

TOPIC 3 DEMAND AND SUPPLY ANALYSIS

3.3

31

MARKET EQUILIBRIUM

We are now able to combine supply with demand into a complete analysis of the
market where price and quantity are determined (Figure 3.5).

Figure 3.5: Market equilibrium

From Figure 3.5, it is clear that both the supply and demand curves determine
market equilibrium price and quantity:

Equilibrium price: The price that equates the quantity demanded with the
quantity supplied.

Equilibrium quantity: The amount that people are willing to buy and sellers
are willing to offer at the equilibrium price level.

More often than not, due to the dynamic nature of the economy, equilibrium
price and quantity are not easily attainable or sustainable. There are always
shortages and surpluses; however, prices will always tend to move towards
equilibrium.

Shortage: A market situation in which the quantity demanded exceeds the

quantity supplied. A shortage occurs at a price below the equilibrium level.

Surplus: A market situation in which the quantity supplied exceeds the

quantity demanded. A surplus occurs at a price above the equilibrium
level.

32 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

3.4

ECONOMIC CONCEPT OF ELASTICITY

Elasticity is a measure of the sensitivity of one variable to another or, more

precisely, the percentage change in one variable relative to a percentage change
in another.
Percentage change in A
Coefficent of Elasticity =
Percentage change in B

3.4.1

Price Elasticity of Demand

The slope of the demand curve gives some indications of how sensitive the
quantity demanded is to price. But slopes are quite different, using different
units of measure. Economists therefore, developed the concept of elasticity which
is completely independent of the units of measurement.

Price elasticity of demand, ED, is the percentage change in quantity demanded

divided by the percentage change in its price, other things being equal (ceteris
paribus). It is the percentage change in the quantity demanded caused by a one
percent change in price.
ED = % Quantity
% Price
There are two methods of computing elasticity arc elasticity and point
elasticity. We use arc elasticity when we have two points on a demand curve and
we use point elasticity if we have a demand curve in an equation form.

Arc Price Elasticity is used to calculate price elasticity between two prices.
Since we do not want the calculation to be altered by the direction of the
price movement, we use the "average" quantity (QAVE) and the "average"
price (PAVE).
ED = %Q = Q/QAVE = (Q2-Ql)/(Q1+Q2)/2 = (Q2-Q1)/Q1+Q2)
%P P/PAVE
(P2 - P1)/(P1+P2)/2
(P2 - Pl)/(P1+P2)
Example of Arc Price Elasticity:
Given:
Q = 1000 when the price is $10
Q= 1200 when the price is reduced to $6

TOPIC 3 DEMAND AND SUPPLY ANALYSIS

33

Arc price elasticity

ED = (+200/1100)/(-4/8) = - 0.3636
The answer is a number. The elasticity is 0.3636. The negative in front of the
number indicates that quantity is inversely related to price. A 1% increase in
price reduces the quantity demanded by 0.36%.

Point Price Elasticity When the demand curve is known, the price
elasticity at each point on the curve is called the point price elasticity. The
point price elasticity is:

ED = (Q/P)(P/Q)
Example of Point Price Elasticity:
Given a demand equation Q = 500 - 5P, find the price elasticity at a point
where price = 30.
Point price elasticity ED = - 5(30/500) = - 0.43
A 1% increase in price reduces the quantity demanded by 0.43%.
(a)

Categories of Elasticity
Elasticity coefficients range from zero to infinity. In general, they can be
divided into five categories. The categories for price elasticity of demand (in
absolute values) are shown below.
Range

Description

ED = 1
ED < 1
ED > 1
ED =

unit elastic
inelastic
elastic
perfectly elastic
perfectly inelastic

ED = 0

It should be noted that elasticity coefficients along a linear demand curve

are different at various points (Figure 3.6).

34 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

Figure 3.6: Elasticity along a Linear Demand Curve.

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.
Educational Publishing.

(b)

Factors Affecting Price Elasticities

Elasticity coefficients vary across different goods and services. Some of the
factors affecting elasticity are as follows:
(i)

Availability and Closeness of Substitutes The greater the number of

substitute goods available to consumers, the more price elastic the
goods.

(ii)

Percentage of Budget The demand for high-priced goods tends to be

more elastic than the demand for inexpensive items, as they typically
take up a large portion of one's budget.

(iii) Durable Goods The demand for durable goods tends to be more
price elastic than the demand for non-durable goods.
(iv) Time Frame The demand for many products tends to become more
elastic over longer time periods. Lets say right now, tickets for a
round trip to Paris leaving tomorrow are offered at RM30. A few
managerial economics students would immediately start packing to
go! But if the offer says that you can leave any time within the next six
months, it becomes almost irresistible.

TOPIC 3 DEMAND AND SUPPLY ANALYSIS

(v)
(c)

35

Luxury Goods vs. Necessities Luxury items tend to be more elastic

than necessity items.

Price Elasticity and Total Revenue

Imagine that you have a firm which produces a particular product. Should
you increase the price of the product because you want to increase the total
revenue of your firm? The answer is not necessarily. There is a
relationship between the price elasticity of demand and the revenue
received (see Figure 3.7):

If price decreases and, in percentage terms, quantity rises more than

the price dropped, then the total revenue will increase.

If price decreases and, in percentage terms, quantity rises less than the
price dropped, then the total revenue will decrease.

Figure 3.7: Total revenue and price elasticities

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

36 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

SELF-CHECK 3.2
1.

Show how you calculate price elasticity.

2.

What is the relationship between price elasticity and revenue?

3.

Identify and discuss the factors which determine the price

elasticity of demand.

3.4.2

Income Elasticity

Income elasticity (EY) is the percentage change in the quantity demanded divided
by the percentage change in income.

Arc Income Elasticity, where Y is the income:

EY = %Q = Q/QAVE = (Q2 - Ql)/(Q1 - Q2)/2 = (Q2 - Q1)/Q1+Q2)
%Y Y/YAVE (Y2 - Y1)/(Y1+Y2)/2
(Y2 - Yl)/(Y1+Y2)
Example of arc income elasticity:
Suppose food expenditures (a proxy measure of all food in Ringgit) for families
with an income of RM20,000 is RM5,200; and food expenditure rises to RM6,760
for families earning RM30,000. Find the income elasticity of food.
EY = %Q / %Y =

(6760 5200/(5200 + 6760)/2

(30,000 20,000/(30,000 + 20,000)/2

= (1560/5980) x (10,000/25,000) = 0.652

With a 1% increase in income, food purchases rise by 0.652%.
Point Income Elasticity Provides a measure of this responsiveness of quantity to
income at a specific point on a demand function, where Q/Y = the partial
derivative of quantity with respect to income.
EY = (Q/Y)(Y/Q).

TOPIC 3 DEMAND AND SUPPLY ANALYSIS

37

Example of point income elasticity:

Suppose the demand function is Q = 10 - 2P + 3Y, find the income and price
elasticities when price of P = 2 and income Y = 10.
When P = 2 and Y = 10, Q = 10 - 2(2) + 3(10) = 36
EY = (Q/Y)( Y/Q) = 3( 10/ 36) = 0.833
ED = (Q/P)(P/Q) = -2(2/ 36) = - 0.111
A 1% increase in income will increase the quantity of food demanded by 0.833%.
Categories of Income Elasticity
If EY > 0, then it is a normal or income superior goods.
Some goods are luxuries: EY > 1 with a high-income elasticity.
Some goods are necessities: EY < 1 with a low-income elasticity.
In this case, increase in income leads to an increase in the quantity demanded.
If EY is negative, it is an inferior goods. Here, an increase in income leads to a
decrease in the quantity demanded. This happens in the case of rice, where there
is a tendency for people with higher income to consume less rice since they can
afford to eat more meat and vegetables.

SELF-CHECK 3.3
Using the income elasticity coefficient, how do you categorise
goods and services into (a) normal, (b) inferior, (c) luxury and (d)
necessity?

3.4.3

Cross-price Elasticity

Cross-price elasticity, EX, is the percentage change in the quantity demanded for
goods, A, divided by the percentage change in the price of the second goods, B,
with other things being equal (ceteris paribus).
ED = % Quantity of A
% Price of B

38 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

The formula used to compute cross-price elasticity is similar to that of price

elasticity of demand except that the price used in the computation is that of the
second goods.
EX = (QA/PB)(PB/QA)

Substitutes have positive cross-price elasticities, for example, butter and

margarine.

Complements have negative cross-price elasticities, for example, DVD

machines and the rental price of DVDs of blockbuster movies.

When cross-price elasticity is zero or insignificant, the products are not

related.

SELF-CHECK 3.4
Discuss how cross-price elasticity can help you to determine whether
two products are substitutes, complements or unrelated.

ACTIVITY 3.1
Solve the following problems.
1.

Find the point price elasticity, point income elasticity and point
cross-price elasticity when P = 10, Y = 20 and Ps = 9, if the demand
function was estimated to be:
QD = 90 - 8P + 2Y + 2Ps

2.

Is the demand for this product elastic or inelastic? Is it a luxury or a

necessity? Does this product have a close substitute or
complement?

3.

Find the combined effect of the demand elasticities.

(Hint: The combined effect of several changes are additive)

TOPIC 3 DEMAND AND SUPPLY ANALYSIS

39

ACTIVITY 3.2
If you knew the price, income and cross-price elasticities, then you can
forecast the percentage changes in quantity. Find out more about this.

Demand relationships can be represented in the form of a schedule (table),

graph or algebraic function. Each of these methods of presentation provides
insight into the demand concept.

Usually, the demand curve slopes downward, indicating that consumers are
willing to purchase more units of a good or service at lower prices, when
other factors are constant.

Changes in price result in movements along the demand curve, whereas

changes in any of the other variables in the demand function result in shifts
of the entire demand curve.

Some of the factors that cause a shift in the entire demand curve are changes
in the income level of consumers, the price of substitutes and complementary
goods, the level of advertising, competitors advertising expenditures,
population, consumer preferences, time period of adjustment, taxes or
subsidies and price expectation.

The supply of a particular goods or service is defined as quantities of a

particular goods or service that people or firms are ready to sell at various
prices within a given time period, other factors besides price being held
constant.

Equilibrium price is the price that equates the quantity demanded with the
quantity supplied.

Equilibrium quantity is the amount that people are willing to buy and sellers
are willing to offer at the equilibrium price level.

Elasticity refers to the responsiveness of one economic variable to change in

another related variable. Thus, price elasticity of demand refers to the
percentage change in the quantity demanded associated with a percentage
change in price, holding constant the effects of other factors thought to
influence demand.

Demand is said to be relatively price elastic if a given percentage change in

price results in a greater percentage change in the quantity demanded.

40 TOPIC 3 DEMAND AND SUPPLY ANALYSIS

Demand is to be relatively price inelastic if a given percentage change in

price, results in a lesser percentage change in the quantity demanded.

When demand is elastic, an increase in price will result in a decrease in total

revenue and vise-versa. When demand is inelastic, an increase, in price will
result in an increase in total revenue. The same goes in the case if there is a
decrease in price, then thre willbe an increase in total revenue.

Income elasticity of demand refers to the percentage change in the quantity

demanded associated with a percentage change in income, holding constant
the effects of other factors thought to influence demand.

Cross elasticity of demand refers to percentage change in the quantity

demanded of Goods A associated with a percentage change in the price of
Goods B.

An understanding of the magnitude of various elasticity measures for a

product can be very helpful in forecasting demand and formulating
marketing or operations plans.

Arc and point elasticity

Luxury and necessity

Cross-price elasticity

Normal and inferior

Demand

Price elasticity of demand

Elasticity

Substitute and complement

Goods

Supply

Income elasticity

Total revenue