<p>CFAI understands that high quality investment advisors and portfolio managers need to have base competency in economic theory in order to value and forecast asset prices.&nbsp; Economics is the study of how people choose to use their resources. It is a branch of knowledge concerned with production, consumption and transfer of wealth. Economics consists of two broad areas of study, namely, macroeconomics and microeconomics. Microeconomics is concerned with how buyers and sellers interact with each other to determine the prices. In this we study the behaviour of individual households and firms to understand how they make decisions to allocate their limited resources.</p>



<p>This reading provides an introduction to the most important concepts in microeconomics related to the principles of demand and supply of goods and services.</p>



<p><strong>Key Concepts:</strong></p>



<ul><li>Demand and supply</li><li>Equilibrium</li><li>Efficient allocation of resources</li><li>Elasticity</li><li>Excess supply and demand</li><li>Consumer and producer surplus</li></ul>

Study Notes for Demand and Supply Analysis

Demand and Supply Analysis

<p>There are two types of markets where factors of production (such as land, labor, and capital) and products are bought and sold. These are:</p>



<ul><li>Factor Market</li><li>Product Market</li></ul>



<h3>Factor Market</h3>



<p>Factor markets allocate the factors of production to the owners of businesses. It’s a place where the factors of production are bought and sold. These factors can be labor, real estate, crude oil or machinery used to produce final goods. In the factor market the labour and land is provided by the consumers to firms and capital goods such as machinery are provided by other firms. Firms are generally the buyers in factor markets.</p>



<h3>Product Market</h3>



<p>This is the place where finished goods and services are bought and sold.&nbsp; Examples include grocery stores, accounting services, liquor, and new car dealers.</p>



<p>The consumers earn income from the factor markets and use this income to purchase goods and services in product markets.</p>



<p>Some companies produce goods that are used as an input in the production of other final products. Such goods are called intermediate goods. For example, some car manufacturers buy engines that are intermediate goods from other producers. Similarly, sugar when sold directly to consumers via a grocery store is a final good. However, when sugar is used by a chocolate manufacturer, it’s an intermediate good.</p>



<h3>Financial Markets</h3>



<p>Apart from factor markets and product market, we also have the financial markets that channel savings from individuals and firms having surplus money to those needing more funds. This is the place where firms raise money through equity and debt.</p>

Types of Markets in Economics

<p>The two fundamental principles in microeconomics are the principles of demand and supply of goods and services. At any point of time, the various goods and services will have a certain demand and supply that will depend on a variety of factors.</p>



<h3>Demand</h3>



<p>Demand refers to the ability and the willingness of consumers to buy certain quantities of goods and services at a given price during a given time period. Demand of a product is affected by many factors such as the cost of production, its price compared to other alternative products, or the income levels of consumers. All these are called the determinants of demands.</p>



<p>For any product, we can calculate the <b>quantity demanded</b> as a function of various factors influencing the demand. The quantity demanded (Qd) is the amount of a good or service consumers are willing &amp; able to purchase during a given period of time.</p>



<p><b>Factors Affecting Quantity Demanded</b></p>



<p>The common factors affecting the quantity demanded are:</p>



<ul><li>Price of good or service <i>(P)</i></li><li>Incomes of consumers <i>(M)</i></li><li>Prices of related goods &amp; services <i>(P<sub>R</sub>)</i></li><li>Expected future price of product <i>(P<sub>e</sub>)</i></li><li>Number of consumers in market <i>(N)</i></li><li>Taste patterns of consumers (Á)</li></ul>



<h3><b>General Demand Equation</b></h3>



<p>The general demand function with the above determinants will be as follows:</p>



<div class="wp-block-image"><figure class="aligncenter"><img src="https://financetrain.com/wp-content/uploads/dq1.gif" alt="Demand Functioin" class="wp-image-12740"/></figure></div>



<p>A simple demand function for product X is presented below:</p>



<div class="wp-block-image"><figure class="aligncenter"><img src="https://financetrain.com/wp-content/uploads/dq2.gif" alt="dq2" class="wp-image-12739"/></figure></div>



<p>Here 500 is a cumulative of all the factors that are not specified above. The quantity demanded is inversely related to price of the products, i.e., if prices fall, the demand will increase. The quantity demanded is positively related to the price of related goods, i.e., if the price of related goods increases, the quantity demanded for product X will increase. The quantity demanded is also positively related to the income of consumers, i.e., if the income is more, the quantity demanded will be more.</p>



<p>When the quantity demanded is expressed only as a function of the price of the product, it is called a demand function.</p>



<p>Let’s say the price of substitute products is 5 and the income is 50, the above equation can be rewritten as follows:</p>



<div class="wp-block-image"><figure class="aligncenter"><img src="https://financetrain.com/wp-content/uploads/dq3.gif" alt="dq3" class="wp-image-12738"/></figure></div>



<p>Other factors remaining constant, the quantity demanded will be 415 - 1.2P.</p>



<p>Note that quantity is a linear function of price and the quantity is inversely proportional to price. For every $1 increase in price of the product, the quantity demanded will reduce by 1.2 units.</p>



<h3><b>Demand Curve</b></h3>



<p>The information from the demand function can be plotted as a simple graph with quantity demanded on x-axis and price on y-axis. This is called a demand curve.</p>



<p>The equation plotted is the <i>inverse demand function, <b>P = f(Q<sub>d</sub>)</b></i></p>



<p>A point on the demand curve can be interpreted as follows:</p>



<ul><li>Maximum amount of a good that will be purchased for a given price</li><li>Maximum price consumers will pay for a specific amount of the good</li></ul>



<div class="wp-block-image"><figure class="aligncenter"><img src="https://financetrain.com/wp-content/uploads/demand-function.gif" alt="Demand Curve" class="wp-image-12742" title="Demand Curve"/></figure></div>



<p>The demand curve illustrates the law of demand. The law of demand states that when the price of a good rises, and everything else remains the same, the quantity of the good demanded will fall.</p>

Demand Function and Demand Curve

Supply is the ability and willingness of the firms to sell a specific quantity of a good or service at a given price in a given time period. This will depend on many factors such as the cost of machinery, labor cost, price of the product, prices of related products, number of firms producing the product, etc.
<h3><b>Supply Function</b></h3>
When the quantity supplied is expressed only as a function of the price of the product, other factors remaining constant, it is called a supply function. The following is a simple supply function:

<img class="aligncenter size-full wp-image-12754" src="https://financetrain.com/wp-content/uploads/qs.gif" alt="Supply Function" width="129" height="39">

The positive sign indicates that the price and quantity supplied are positively related, i.e., when the price increases, the quantity supplied will also increase. In the above example, for every $1 increase in price, the quantity supplied will increase by 1.5 units.
<h3><b>Supply Curve</b></h3>
The information from the supply function can be plotted as a simple graph with quantity supplied on x-axis and price on y-axis. This is called a supply curve.

The equation plotted is the <i>inverse supply function, <b>P = f(Q<sub>s</sub>)</b></i>

A point on a direct supply curve can be interpreted as follows:
<ul>
 	<li>Maximum amount of a good that will be offered for sale at a given price</li>
 	<li>Minimum price necessary to induce producers to voluntarily offer a particular quantity for sale</li>
</ul>
<p align="center"><img class="aligncenter size-full wp-image-12741" src="https://financetrain.com/wp-content/uploads/supply-function.gif" alt="supply-function" width="453" height="338"></p>
The supply curve illustrates the law of supply. The law of supply states that when the price of a good rises, and everything else remains the same, the quantity of the goods supplied will increase.

Supply Function and Supply Curve

<div>
<h2>Shifts in Demand Curve</h2>
</div>
We learned that the demand function expressed the quantity demanded as a function of price, while the other factors are held constant.

If the price of a good or service changes, and there is no change in the other factors affecting demand such as income levels, and prices of related products, then there will be a movement along the existing demand curve.

This movement along the curve indicates that when prices decrease, consumption increase (demand increases), and when prices increase, consumption decreases.

However, if any of the other factors affecting the quantity demanded also changes, then the complete demand curve will shift to a new level either to the left or to the right. There is a change in the quantity demanded at every price level.

A shift in demand curve to the right indicates that the demand for goods and services has increased due to a change in one of the determinants of demand. For example, the overall income of consumers may have increased or a substitute product may have become expensive.

A shift in demand curve to the left indicates that the demand for goods and services has decreased due to a change in one of the determinants of demand. For example, the overall income of consumers may have decreased, people might have lost jobs or people may be expecting a price fall in the future.

The following chart illustrates both a movement and a shift in demand curve.
<p align="center"><img class="aligncenter size-full wp-image-12750" alt="Shift in Demand Curve" src="https://financetrain.com/wp-content/uploads/demand-shift.gif" width="515" height="253"></p>

<div>
<h2>Shifts in Supply Curve</h2>
</div>
Just like in demand curve we can have movements or shifts in supply curve.

If there is only a change in price, we will have a movement along the existing supply curve. This will change the quantity supplied at the new price level.

However, if one of the determinants of supply changes such as technology, labour cost, taxes, etc., then there will be a change in supply causing a shift in the supply curve. At each price level there will be a new level of quantity supplied creating a new supply curve.

A shift in supply curve to the left indicates that there is a decrease in quantity supplied due to a change in one of the determinants. For example, there could be an increase in labor cost.

A shift in supply curve to the right indicates that there is an increase in quantity supplied due to a change in one of the determinants. For example, there may have been an improvement in technology, or a reduction in taxes.

The following chart illustrates both a movement and a shift in supply curve.

<img class="aligncenter size-full wp-image-12749" alt="Shift in Supply Curve" src="https://financetrain.com/wp-content/uploads/supply-curve-shift.gif" width="517" height="319">

Shifts in Demand and Supply Curves

<h3>Aggregate Demand and Supply Curves</h3>



<p>Suppose the demand function for a product is Q<sub>d</sub> = 415 – 1.2P and there are 1,000 consumers of this product. We can calculate the market demand by aggregating the demand for all the consumers. The aggregate market demand will be calculated as follows:</p>



<p class="has-text-align-center"><strong>Q<sub>d</sub> = 415*1000 – 1.2P*1000 = 415,000 – 1,200P</strong></p>



<p>The inverse demand function will be:</p>



<p class="has-text-align-center"><strong>P = 415,000/1,200 - Q<sub>d</sub>/1200, or</strong></p>



<p class="has-text-align-center"><strong>P = 345.83 – 0.0008 Q<sub>d</sub></strong></p>



<p>-0.0008 is the slope of the aggregate demand curve.</p>



<p>Similarly if the supply function for a product is Qs = 400+1.5P and there are 100 manufacturers of the product, the market supply will be:</p>



<p class="has-text-align-center"><strong>Qs = 40,000+150P</strong></p>



<p>The inverse market supply function will be:</p>



<p class="has-text-align-center"><strong>P = - 266.67 + 0.0067Qs</strong></p>



<p>0.0067 is the slope of the aggregate supply curve.</p>



<h3>Market Equilibrium</h3>



<p>Using the market supply and the market demand curve we can arrive at a price at which the quantity supplied will be equal to the quantity demanded. At this point buyers and sellers will agree on a price and the quantity.&nbsp; This point is called the market equilibrium price and quantity.</p>



<p>The market equilibrium price is the price at which the quantity of a good or service demanded in a given time period equals the supply.</p>



<p>The market equilibrium price will change when the price changes or when one of the determinants of demand and supply change.</p>



<p>The following graph indicates the intersection of a demand and supply curve.  The point of intersection is called the equilibrium point.</p>



<figure class="wp-block-image size-large"><img src="https://financetrain.com/wp-content/uploads/dse.png" alt="" class="wp-image-28147"/></figure>



<h3>Impact of a Curve Shift on Equilibrium</h3>



<p>At equilibrium if the demand curve shifts to the right, both the quantity demanded and the price will increase.&nbsp; If the demand curve shifts to the left, both the quantity demanded and price will fall.</p>



<p>If the supply curve shifts to the right, the supply will increase but the price will fall.&nbsp; If the supply curve shifts to the left, the supply decrease but the price will rise.</p>

Aggregating Demand and Supply Curves and Concept of Equilibrium

Based on the <a title="Demand Function and Demand Curve" href="https://financetrain.com/demand-function-and-demand-curve/">demand</a> and<a title="Supply Function and Supply Curve" href="https://financetrain.com/supply-function-and-supply-curve/"> supply curve</a>, the market forces drive the price to its equilibrium level.

There are two possibilities: 1) Excess Demand or 2) Excess Supply

Excess supply is the situation where the price is above its equilibrium price. The quantity willing supplied by the producers is higher than the quantity demanded by the consumers.

Excess demand is the situation where the price is below its equilibrium price. The quantity supplied is lower than the quantity demanded by the consumers.

The following chart illustrates the excess demand and excess supply.

<img class="aligncenter size-full wp-image-12757" src="https://financetrain.com/wp-content/uploads/excess.gif" alt="Supply and Demand" width="471" height="310">

In each of these situations market forces will interact to drive the prices to its equilibrium level.

When we have higher prices and excess supply, manufacturers will have excess inventories and the competition among manufacturers will put the downward pressure on price as there will be some suppliers who will be willing to supply at lower prices. As prices fall, the consumer demand will increase until it finally settles at the equilibrium price.

When we have lower prices and excess demand, there will shortage of goods, putting an upward pressure on the price as there will be more buyers chasing the available goods. As price increases the suppliers will start producing more but the demand from buyers will decrease. This will drive the price and quantity to its equilibrium level.

<b>Calculating Excess Supply and Demand</b>

Let’s say we have the following demand and supply functions:

Q<sub>d</sub> = 415,000 – 1,200P

Qs = 40,000+150P

The equilibrium price can be calculated by equating the two functions and solving for P

415,000 – 1,200P = 40,000+150P

P = 375,000/1350 = 277.78

We will have excess supply when price is above 277.78 and excess demand when price is below 277.78.

At this price the quantity demanded and supplied is 81,667.

At P=300, the quantity supplied will be = 40,000+150*300 = 85,000. The excess supply is 85,000 – 81,667 = 3,333

At P = 200, the quantity demanded is = 415,000 – 1,200*200 = 175,000. The excess demand is 175,000 – 81,667 = 93,333.

Excess Demand and Excess Supply

<p>When the demand and quantity deviate from their equilibrium levels, the market forces will interact with each other to bring the price and quantity back to its equilibrium level. As long as this is possible the equilibrium is labelled as stable.</p>



<p>The equilibrium will be stable as long as the supply curve cuts through the demand curve from above, irrespective of whether the supply curve slopes upwards or downwards. The equilibrium will be stable in both the situations below:</p>



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/equilibrium-1-1024x395.png" alt="" class="wp-image-28159"/></figure></div>



<p>However, there are some situations where the equilibrium is unstable. For example, when the slope of the supply curve is less than the demand curve or when the supply function is non-linear.</p>



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/equilibrium-2-1024x393.png" alt="" class="wp-image-28160"/></figure></div>

Stable and Unstable Equilibrium

The equilibrium price for a product can also be determined using an auction where potential buyers place competitive bids for the product and the winner is determined though a pre-specified mechanism. There are different types of auctions:

<b>English Auction: </b>An English auction is an ascending sequential bid auction. The bidders observe the bids of others and decide whether or not to increase the bid. The bid price keeps increasing as more buyers bid for a higher value. The item is sold to the person that first offers the highest bidder. In general, such auctions are called ascending price auctions.<b></b>

<b>First-price, Sealed Bid Auction</b>: In this type of auction, all the bidders simultaneously submit bids on pieces of paper. The item is sold to the highest bidder. Each bid is sealed and bidders do not know the bids of other players.<b></b>

<b>Second-price, Sealed Bid Auction:</b> In this type of auction, the same bidding process as a first price sealed bid auction is followed. The winder is the highest bidder. However, the high bidder pays the amount bid by the second highest bidder.<b></b>

<b>Dutch Auction: </b>A Dutch auction is the descending price auction. The auctioneer begins with a high asking price. The bid amount decreases until one bidder is willing to pay the quoted price.<b></b>

The auctions can be distinguished as <b>common value auctions</b> and <b>private value auctions</b>. In common value auctions, the true value of the item is the same for all bidders, for example, timber. In private value auctions, there is no true value of the item and each bidder puts the value for himself, for example, art and collectibles. Bidders know their own valuation of the item, but not other bidders’ valuations. Bidders’ valuations also do not depend on the bids of others.

In Dutch auctions, if there are many units for sale, each bidder will specify the price and the quantity he will accept at that price in the bid. At that price, the given quantity of the item will be sold to the bidder. The subsequent bids will be of lower price as price keeps descending. Sometime a modified Dutch auction process will be used, where all winning bidders will pay the same price.

<em>Many <a href="https://financetrain.com/four-methods-of-distributing-government-securities/">Government Securities are issued via auctions</a>.</em>

Types of Auctions

The central governments use one of the following four methods to distribute a new issue of securities:

<strong>Regular calendar auction / Dutch style auction</strong>

In this type of auction, there is a regular auction cycle. The winning bidders are allocated securities at yield (price) they bid. This is also called multiple-price method.

<strong>Regular calendar auction / Minimum-price offering system</strong>

This is also a regular auction but all the winning bidders are awarded securities at highest yield accepted by government (stop-out yield). This is also called single price method. For example, if the highest yield is 6.55%, and you had bid 6.52% you will be awarded securities at 6.55%. In the dutch style auction, you would have been awarded the securities at 6.52% (your bid). US government bonds are issued using this method.

<strong>Ad hoc auction&nbsp; </strong>

Ad hoc auctions are announced by the government when the market conditions are favourable. Typically, the amount and maturity of issue are announced only at the time of the auction. Ad hoc auctions provide increased flexibility to raise funds, and also lessens the volatility which is high in regular auctions.

<strong>Tap system</strong>

Tap system is where the additional bonds of previously outstanding issues are auctioned. The government will periodically announce about these bonds.

Four Methods of Distributing Government Securities

<p>Typically, consumers value the goods they purchase by an amount that exceeds the purchase price of the goods.</p>



<p><strong>Consumer surplus</strong> is the difference between what the consumer has to pay for a good and the amount he/she is willing to pay. It is the area under the demand curve &amp; above the price.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/consumer-surplus.png" alt="" class="wp-image-28165" width="573" height="426"/></figure></div>



<p><strong>Producer surplus</strong> is the difference between what the producer receives for the good and the amount he/she must receive to be willing to provide the good. It is the area above the supply curve &amp; below the price.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/producer-surplus.png" alt="" class="wp-image-28166" width="568" height="429"/></figure></div>



<p>Total social welfare is the sum of consumer surplus and producer surplus.&nbsp;</p>



<p>Both the consumers and the producers want to maximize their surplus leading to efficient allocation of resources to produce the product which maximizes the total benefit to the society.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/surplus-1.png" alt="" class="wp-image-28167" width="569" height="444"/></figure></div>



<p>At any other point other than the equilibrium, the total surplus will be less than this. For example, at quantity Q1 and price P1, consumer surplus is the red area &amp; producer surplus is the green area. The total surplus is less than the area under the equilibrium price.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/surplus-2.png" alt="" class="wp-image-28168" width="583" height="448"/></figure></div>



<p>Let’s analyze the above graph. Assume the quantity produced was cut to Qf leading to a price of Pf. If we compare this to the consumer and producer surplice in case of equilibrium price, we will notice the following:</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/surplus-3.png" alt="" class="wp-image-28169" width="549" height="418"/></figure></div>



<ul><li>Consumers lost area U and V</li><li>Producers lost area W but gained area U.</li><li>Put together both consumers and producers lost area V and W. This area is called the deadweight loss. This is the deadweight economic loss due to inefficiency.</li></ul>



<p>Deadweight loss occurs when the quantity supplied does not maximize the sum of consumer and producer surplus. Deadweight loss can occur due to overproduction or underproduction.</p>

Consumer and Producer Surplus

<p>A government can impose various restrictions that will lead to an imbalance in the quantity and price equilibrium resulting in a deadweight loss.</p>



<p>These interventions include:</p>



<ul><li>Price ceilings and price floors</li><li>Taxes and trade restrictions</li><li>Minimum wages</li><li>Subsidies and Quotas</li></ul>



<h3>Price Ceilings</h3>



<p>A price ceiling is the highest price at which it is legal to trade a particular good or service.</p>



<p>Assume that the demand and supply of housing determines the equilibrium rent of $550 a month and the equilibrium quantity of 4,000 units of housing.</p>



<p>The following graph shows the efficient housing market with maximum consumer and producer surplus.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/price-ceiling.png" alt="" class="wp-image-28172" width="548" height="496"/></figure></div>



<p>Suppose the government imposes a rent ceiling of $400 per month which is below the equilibrium price. As a result the following changes happen.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/price-ceiling-2.png" alt="" class="wp-image-28173" width="596" height="490"/></figure></div>



<ol type="1"><li>Rent ceiling restricts quantity supplied. Supplied quantity is 3000 and quantity demanded is 6000. Shortage of 3000 units.</li><li>Rent ceiling creates a black market. Some people will be willing to pay $625 per month for a house.</li><li>Resources get used in costly search activity including both time and cost.</li><li>A dead weight loss arises.</li></ol>



<h3>Price Floor</h3>



<p>A price floor makes it illegal to pay a price lower than a specified level. An example of price floor is minimum wage.</p>



<p>Let’s say the equilibrium wage rate per hour is $5 at the equilibrium quantity of 5000 workers.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/price-floor-1-1.png" alt="" class="wp-image-28175" width="550" height="454"/></figure></div>



<p>Minimum wage is imposed at $7 per hour. The graph will change as follows:</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/price-floor-2.png" alt="" class="wp-image-28176" width="512" height="386"/></figure></div>



<ol type="1"><li>The minimum wage restricts the quantity demanded by the firms. At $7 per hour, only 3000 jobs are available.</li><li>People will find it hard to find jobs, and some people will be willing to take a job at lower rate. Someone will be ready to take a job at $3 per hour also. Illegal wage rates will range from $3 to below $7.</li><li>The firms’ surplus and the workers’ surplus shrinks.</li><li>A deadweight loss arises.</li><li>Other resources are used up in job search activity.</li></ol>



<h3><strong>Taxes</strong></h3>



<p>Taxes will increase the equilibrium price and decrease the equilibrium quantity, creating a deadweight loss.</p>



<h3><strong>Production Quotas</strong></h3>



<p>A production quota is an upper limit to the quantity of a good that may be produced in a specified time period.</p>



<p>With a production quota, the quantity decreases, the consumer surplus shrinks, the producer surplus expands, and a dead weight loss arises.</p>



<h3><strong>Subsidies</strong></h3>



<p>Subsidies are payments made by governments to producers such as farmers. Subsidies lower the prices paid by buyers and increase the prices received by sellers. With a subsidy, the quantity increases, and a dead weight loss arises due to overproduction.&nbsp;</p>

Effects of Government Regulation on Demand and Supply

<p>Price elasticity of demand is the most common form of elasticity. It measures the change in quantity demanded caused by a change in the price of the good. It’s calculated as a ratio of change in quantity demanded to change in price.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/price-elasticity-demand.png" alt="" class="wp-image-28179" width="436" height="93"/></figure></div>



<ul><li>It measures the movement along the demand curve.</li><li>It’s always negative and but expressed as an absolute value.</li><li>Demand is said to be elastic when quantity demanded changes in response to change in price. If the quantity demanded is not very responsive to price change, it is said to be inelastic.</li><li>A value greater than 1 indicates elasticity. % change in quantity demanded is greater than % change in price. A value between 0 and 1 indicates inelasticity. % change in quantity demanded is less than % change in price.</li></ul>



<p>The following two graphs depict perfectly elastic and perfectly inelastic demand.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/price-elasticity-graph.png" alt="" class="wp-image-28180" width="520" height="295"/></figure></div>



<p>A perfectly inelastic demand means that the demand for the good remains the same irrespective of a change in price. This means that the consumers have no alternative to purchasing the good. An example is a lifesaving drug for which people will be willing to pay any price. A change in price wouldn’t cause a change in quantity demanded.</p>



<p>When price elasticity is -1 it’s called unitary elasticity. This is the price/quantity combination that maximizes the total revenue (price * quantity).</p>

Price Elasticity of Demand

<p>Income elasticity of demand is the responsiveness of quantity demanded to changes in income. The income elasticity of demand depends on the types of goods.</p>



<ul><li><strong>Normal goods:</strong> The demand increases with the increase in income. Elasticity has a positive sign (e &gt; 0). If income elasticity of demand of a good is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good.</li><li><strong>Inferior goods: </strong>The demand decreases with increase in income. Elasticity has a negative sign (e &lt; 0)</li></ul>



<p>If the income elasticity is zero, a change in income doesn’t affect the demand for good. Such goods are called sticky goods.</p>



<p>Note that what constitutes an inferior product for people in some income range may be a normal product for people in a lower income group.</p>



<p><strong>Examples:</strong></p>



<p>Income elasticity = 0.4. It’s a normal good and demand is inelastic. A rise in incomes of 3% would lead to demand rising by 1.2%.</p>



<p>Income elasticity = 0.6. It’s an inferior good and demand is inelastic. A rise in income of 3% would lead to demand falling by 1.8%.</p>

Income Elasticity of Demand

<p>Cross price elasticity of demand refers to the responsiveness of demand of one good to changes in the price of a related good (either a substitute or a complementary product).</p>



<figure class="wp-block-image size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/cross-price-elasticity.png" alt="" class="wp-image-28185" width="221" height="113"/></figure>



<p>The above equation calculates the price elasticity of demand for good y for a change in price of good x.</p>



<p>For complementary products, cross price elasticity will have negative sign, signifying an inverse relationship between the two. So, when the price of a complementary product rises, the demand for the product itself decreases.</p>



<p>For a substitute, cross price elasticity will have a positive sign, signifying a positive relationship between the two. So, when the price of a substitute product rises, the demand for the product itself increases.</p>

Cross Price Elasticity of Demand

This quiz is a part of the CFA Level 1 reading 'Topics in Demand and Supply Analysis'. 

Demand and Supply

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