Law Of Demand

What Does Law Of Demand Mean?

A microeconomic law that states that, all other factors being equal, as the price of a good or service
increases, consumer demand for the good or service will decrease and vice versa.

Investopedia explains Law Of Demand

This law summarizes the effect price changes have on consumer behavior. For example, a consumer will
purchase more pizzas if the price of pizza falls. The opposite is true if the price of pizza increases.

elasticity of demand
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Definition

Responsiveness of the demand for a good or service to the increase or decrease in its price. Normally,
sales increase with drop in prices and decrease with rise in prices. As a general rule, appliances, cars,
confectionary and other non-essentials show elasticity of demand whereas most necessities (food,
medicine, basic clothing) show inelasticity of demand (do not sell significantly more or less with
changes in price). See also cross price elasticity of demand.

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Elasticity - 1

In the previous section, supply and demand curves were drawn as straight lines. This
is a simplification, as we are assuming that the rate of change of demand or supply is
the same for all prices in the market.
Many goods have demand curves that look like this.
At some prices, a small change in price may cause a
large change in the quantity demanded.
This shown in the diagram as the movement from Pe to Pe1;
a small change in price which causes an even larger
percentage decrease in quantity demanded (from Qe to Qe1.

Elasticity - 2

At other prices, a large increase in price may see a much

smaller decrease in demand. This shown in the diagram as
the movement from Pe2 to Pe3; a large change in price which
causes a smaller percentage decrease in quantity demanded
(from Qe2 to Qe3.

Elasticity - 3

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The price elasticity of demand refers to the relationship between
changes in price and the subsequent change in quantity demanded.
Economists are very interested in elasticity.

Calculating it will answer important questions like : if price rises by a certain

amount, by how much will demand fall, and total revenue change?

We use the Greek letter ''eta'' or η

To make the model easier to understand, we will continue using straight lines for the
demand and supply curves. What we will now look at is the slope of these curves: are
the curves ''flat'' or ''steep''? Be aware, though, that there is no necessary reason for a
demand or supply curve to be a straight line.
There are three methods that can be used to measure elasticity. The simplest is called
the total outlays method.

Elasticity - The Total Outlays Method - 4

A simple method of measuring the price elasticity of demand is the total

outlays method. This method is only an approximate method of determining
elasticity. The most accurate method is the arc method of elasticity, which will be
outlined later in this section.
The ''total outlays'' method has two steps.
The first is to prepare a total outlay or total revenue table for the good or service
under investigation. The second step is to look at the change in total revenue received
and compare it with the direction of the price change that caused the change in total
revenue.

Elasticity - 5

Total Consider the following table to your left.

Pric Quantit Outlay As price change from $1 per unit to $2 per unit, total outlays
e y (or Total (total revenue) rises from $1,000 to $1,800. Total outlays and
per Demand Revenue price have both risen. Economists say the demand for this
unit ed ) good, in this price range is inelastic, and that the good has price
$ elasticity of less than 1, in this price range.
A given percentage change in price has resulted in

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1.00 1,000 $1,000 a lesser percentage change in quantity demanded. Price has
doubled; that is increased by 100% : (from $1 to $2). However,
2.00 900 $1,800 the quantity demanded has only fallen by 100, on a basedemand
of 900 units.
3.00 800 $2,400
This is a decrease of only 100 / 900 = 11%
4.00 700 $2,800

5.00 600 $3,000

6.00 500 $3,000

7.00 400 $2,800

8.00 300 $2,400

9.00 200 $1,800

Elasticity -
6

Total Consider the table to your left.

Pric Quantit Outlay The owner of the firm producing this good can see that increasing
e y (or Total price will have beneficial effects on total revenue, and on
per Demand Revenu total profits. The increase in price has seen demand fall (this is
unit ed e) the law of demand in action), but despite this, total revenue
$ received will increase.
When price rises from $7 to $8, however, total outlays (total
1.00 1,000 $1,000 revenue) fall from $2,800 to $2,400. Total outlays
havefallen when price has risen. This movement in opposite
2.00 900 $1,800 directions indicates that the demand for this good is elastic (in this
price range). Economists say the good has price elasticity
3.00 800 $2,400 of more than 1. The owner of this firm can see that increasing
price is a bad idea: total revenue received will fall. It is
4.00 700 $2,800 likely profit will fall if prices are increased from $7 to $8.
5.00 600 $3,000

6.00 500 $3,000

7.00 400 $2,800

8.00 300 $2,400

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9.00 200 $1,800

Elasticity - 7

You will note that when price changes from $5 per unit to $6, total
outlays remain the same. This indicates the good has unitary
elasticity (an elasticity of1.00).

But, you notice that the percentage decrease in quantity demanded is not equal to the
percentage increase in price. Confirm this yourself : price has risen from $5 to $6 : (a
20% rise) and quantity demanded has fallen from 600 to 500 units : a 17% fall.
What's happening here? The differences in percentage change highlight that the total
outlays method is only an approximate measure of elasticity.

Total Revenue - A Graphical Example - 8

Let's imagine we operate a small

canteen in a school.
I might say to you ''increasing the price of a
can of Brand ''X'' soft drink from $1.00 per
can to $1.40 per can is not a good idea. Our
customers will buy Brand ''Y'' instead.''

''At the moment, we are selling 200 cans per day of Brand ''X'', at $1.00 per can. We
are generating $1.00 per can x 200 cans = $200 per day in revenue from sales of
Brand ''X''. I believe that we will only sell 120 cans per day if we increase the price of
Brand ''X'' to $1.40 per can; resulting in a daily revenue of $1.40 per can x 120 cans =
$168.''

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''The revenue we gain from increasing the price per can ($0.40 x 120 = $48) will not
be enough to offset the revenue we will lose from the decrease in thequantity of cans
we sell ($1.00 x 80 = $80).''
I show you my reasoning, on a Supply and Demand diagram (shown above). Implicit
in my reasoning is my belief that Brand ''X'' has a close substitute in Brand ''Y'', and
that Brand ''X'' is price elastic.

Elasticity - 9

You, however, are more in touch with

teenage trends and fashion than I
am.
You reply ''Brand ''X'' is really popular at
the moment. I believe we can increase the
price to $1.40 per can. We will lose very
few sales''.

You show me your analysis (shown above) of the market for brand ''X''. An increase
in price to $1.40 per can will only cause a loss of 10 cans in sales per day. The
revenue gain from the increase in price ($0.40 x 190 cans = $76) will more than
compensate for the revenue loss caused the decrease in quantitysold ($1.00 x 10 =
$10)
You have correctly noticed that Brand ''X'' is price inelastic, and that an increase in
price will generate more net revenue.

Inelastic Demand - 10

If a given change in price causes

a smaller proportionate change in quantity
demanded, then the demand for the good or service
is said to be inelastic.

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 In the diagram to your left, Po, the initial price is 65 cents per
litre, and P1, the new price, is 75 cents per litre; a 10 cent per
litre increase.

The percentage change in price is 10 cents per litre / 65 cents per litre = a 15%
increase.
Qo, the initial quantity demanded is 20,000 litres; Q1, the new quantity demanded, is
19,500 litres. The change in quantity demanded is 500 litres, on an initial demand
level of 20,000 litres = a 2.5% decrease.
The price elasticity of demand for petrol is defined as the percentage change in
quantity demanded divided by the percentage change in price. (Ignore any minus
signs). In this example, the price elasticity of petrol is 2.5% / 15% = 0.167.
Goods with price elasticities less than 1.0 are called inelastic

Elasticity - 11

Demand for petrol is inelastic : petrol has no close substitute.

Motorists can reduce their usage of their car, and perhaps drive
fewer kilometres, but they can not fill their ''tank'' with water!

Motorists can convert their cars to run on liquified petroleum gas (which is
considerably cheaper than petrol), but the conversion cost is high. Petrol does have a
substitute; but LPG is not a close substitute.
Governments like to tax goods with inelastic demand curves. The diagram illustrates
the effect of a 10 cents per litre tax; a shift of the Supply Curve from S toS1. Petrol
station owners will notice a small fall in sales; but the effect on their profits is small.
Governments do not like to be accused of driving small business out of business!
Other goods with high levels of taxation include alcohol and cigarettes: both very
inelastic.

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Elastic Demand - 12

If a given change in price causes

a larger proportionate change in quantity
demanded, then the demand for the good or service
is said to be elastic.
In the diagram to your left, the price of Moo iced coffee
drink has risen from $1.50 to $1.70 per 500 ml container.
Sales at your local corner store of ''Moo'' fall from 500
containers per week to 300 containers per week.

Calculate the percentage increase in price, and the percentage decrease in quantity
sold. Calculate the price elasticity of ''Moo''.

Summary and Solutions - 13

The price elasticity of demand for a product is defined as the

percentage change in quantity demanded divided by the percentage
change in price. (Ignore any minus signs).

Goods with price elasticities greater than 1.0 are called elastic
(By the way, the answer is 3.0. )
A fall in sales of 200 containers per week, on initial sales of 500 containers per week
is a 40% decrease. A 20 cent increase in price per container, on a base price of $1.50,
is a 13.3% increase in price. 40% / 13.3% = 3.0

Perfectly Elastic Demand - 14

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 A good with a perfectly flat demand curve has a
price elasticity of demand of infinity.
This would mean that a small change in price would lead to
an infinitely large increase in Demand.
In perfectly competitive markets (such as, say, coal), if you
can charge slightly less than your competitors, and still make
a profit, you will find your customers will attempt to buy as
much as you can produce.

Perfectly Inelastic Demand -

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To have a situation where the Demand curve is a vertical line

is to think of a good where a certain quantity is demanded,
regardless of the price.
Heroin would be the closest ''real life'' example of such a
good. Addicts will pay anything for their ''fix''.

The Arc Elasticity of

Demand - 16

The arc elasticity of demand refers to the relationship between

changes in price and the subsequent change in quantity demanded.
Qo is the
initial
quantity
demand
ed.

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 Q1 is the
new
quantity
demanded
.
Po is the
initial
price.
P1 is the
new
price.

The arc elasticity formula is used if the change in price is relatively large. It is more
accurate a measure of elasticity than simple ''price elasticity''.
If the arc or price elasticity of demand is greater than 1, demand is said to be elastic.
The demand curve has a ''flat'' appearance.
If the arc or price elasticity of demand is less than 1, demand is said to be inelastic.
The demand curve has a ''steep'' appearance.

Calculating Elasticity - 17

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 Consider the market for music CDs.
When the price of CDs is $30 per unit,
consumers buy 6 per year. When the
price falls to $20 per unit, consumers
buy 12 per year.

Remember, we ignore the minus sign when

calculating price elasticity.
When the price of CDs falls from $30 to $20,
and the quantity sold increases from 6 per year
to 12 per year, the price elasticity of demand
is 1.67: CDs are price elastic over this price
range.
What about a further reduction in price? Will this also
lead to even greater revenues for firms?

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Calculating Elasticity - 18

The demand for CDs is price inelastic over the

$20 to $10 price range, because the calculated
elasticity isless than 1.

Calculating Elasticity - 19

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 Revenue is the price per unit sold
multiplied by the quantity of units
sold in a period of time.
When a good or service is priced within
its elastic region, it definitely worthwhile
for firms to lower prices. ''You may make
less profit per item, but you'll make more
than enough extra sales to cover this loss of
profit. In fact, you will make more profit
overall.''
However, when a firm sells at a price
associated with unit elasticity, its revenue
is at a maximum.
The firm may lower prices even further, but
the increase in quantity sold will not be
great enough to increase profits. In fact,
profits will fall.
We show this in the total revenue curve
(shown above). There is a price per unit
that maximises profit!

Factors Effecting the Elasticity of

Demand - 20

Good with close substitutes tend to have elastic demand curves.

The demand for good ''A'' is ''price sensitive'' to changes in the price
of good ''B'', because they both satisfy the same want. The demand
for one brand of butter will vary, if another brand is put on ''special''
at your local supermarket.

''Necessities'' tend to have inelastic demand curves. If households see a good as

essential to daily living, demand for the good will be ''price insensitive''. For example,
if the price of milk rose by 50 cents a litre, demand for milk would not change greatly.
All households want milk.
Luxuries on the other hand tend to have elastic demand curves. If soft drinks are put
on ''special'' at your local supermarket, and their price is lowered, demand for them
will rise markedly. Part of this ''necessities'' versus ''luxuries'' distinction is based on
the cost of the item. Many necessities are inexpensive: they have low prices - a loaf of

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bread, a litre of milk, a box of matches, all only cost a very small part of your
available disposable income. An increase in the price of a litre of milk of 50 cents is
still ''small change'' for many consumers, and they will continue to demand milk at the
same levels as they did before the price rise. Luxuries on the other hand can be
very expensive and cost a large part of your available disposable income. You may
decide not to buy that French champagne to celebrate a birthday, if the price rises
from $30 to $32. The price of $30 is already a large enough disincentive.
Some goods are habit forming, or addictive. Cigarettes are a clear example. Once
''hooked'', the average smoker will continue to pay more and more for cigarettes, as
governments increase taxes on tobacco. Very few smokers give up smoking because
of price increases; most give up for health reasons.

Normal and Inferior Goods - 21

All normal goods have positive elasticities of demand; the elasticity of the good is >
1. For some goods (like petrol), the price elasticity of demand will be very close to
zero; but it will be greater than zero - some decrease in demand for petrol will result if
price rises.
Inferior goods have negative elasticities of demand. As income rises, the quantity
demanded actually falls.

Factors Effecting the Elasticity of Supply - 22

Supply curves have ''elasticities''. just as demand curves do. The

major factors effecting the response of firms to changes in price
are expectations of future prices and time.
The Arc Elasticity of Supply
The arc elasticity of supply refers to the relationship between changes in price and
the subsequent change in quantity supplied.
Qo is
the
initial
quantit
y
supplie
d.
Q1 is the
new

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 quantity
supplied
.
Po is the
initial
price.
P1 is the
new
price.

Firms will increase production if they believe market prices for the good or service
they produce will increase in the future, and if they believe such a price rise will be a
permanent change in the market. (There is no incentive to increase production and
stocks, if prices are expected to fall again in the near future).

Elasticity of Supply - 23

Over short periods of time, most goods have an inelastic supply. As

we expand our time frame, goods tend to have more elastic supply.

The shortest period of time economists look at is the market period. In this period,
suppliers can only add to the supply they offer to consumers by using up their stocks.
A retail firm for example, may take deliveries every week from manufacturers. This
weekly arrival of new goods is a flow. Most firms keep a ''buffer'' of goods, in reserve,
in case demand rises unexpectedly. Each week, last week's stock is the first to be sold,
and part of this week's purchases replaces this old stock. In the market period supply
is highly inelastic.
The market period can vary in time. In the fresh vegetable market, an increase in
demand for tomatoes on a Tuesday can see retail firms telephoning suppliers and
getting extra supplies delivered the next day. If you retail imported cars, the market
period could be a month or even more; it takes this long for the cars to be transported
from Japan or Germany or where-ever.

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The short run is the period of time required to to increase production through
employing more labour and raw materials. If the ''pool'' of unemployed skilled labour
is small, firms may not be able to increase production by much at all; supply will tend
to be inelastic. Similarly, if the raw materials needed in production are also in short
supply, then additional production may be difficult to create.

Elasticity of Supply - 24

A firm, in the ''short run'', can not increase its capital stock; the
machinery used in production. A firm may have unutilised
capacity or excess capacity, however. Such a firm can increase
production by using its capital more intensively by having extra
shifts (night shifts, week end shifts, overtime), assuming labour and
materials can be accessed in extra quantities in the same time. If all
the machinery used in production is being fully used, however, the
ability to increase production is limited. A firm in this situation will
find its supply curve inelastic.

In the ''short run'', supply is reasonably elastic; however labour costs may rise per unit
of production if your work force is paid penalty rates for night shifts and weekend
shifts.
In the long run, firms have the time to invest in new capital. In the ''long run'', supply
is at its most elastic, as production can be increased markedly.

Inelastic Supply - 25

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 The diagram to your left indicates a good which has
an inelastic supply curve. It is possible, for example,
to grow tomatoes all year round. To grow tomatoes
in winter requires glass houses, heating, and
supplementary lighting in the right wave lengths, to
compensate for the shorter days and longer nights.
However, it can be done; but at a considerable cost.

The price of tomatoes would have to rise by a considerable amount (to P1 from Po) to
justify the small increase in quantity supplied. (Q1 less Qo).

The Effect of A Quota - Perfectly Inelastic Supply - 26

Universities set quotas on some subjects, because of

limitations on resources. The University
actually supplies a fixed number places. It is Year
12 students who demand entry. An increase in
demand for a particular course can occur, from year
to year.
However, an increase in demand for the course simply
means candidates will have to achieve a
higher TER entrance score; the ''price'' of an education.

Elastic Supply - 27

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 The diagram to your left indicates a good which has
an elastic supply curve. An icecream manufacturer
can rapidly increase production, if hot weather is
forecast. Sales are likely to increase by a large
amount.
The demand for icecreams would have to rise by only a
small amount (to P1 from Po) to justify the large increase in
quantity supplied. (Q1 less Qo).

Elasticity of Supply - 28

Elasticity of supply is influenced by a number of factors. These

include :

• the length of the production period.

In the late 1990's, demand for Australia
wines overseas has reached all time
records. Vines take three years to grow to
a point where they yield adequate
amounts of fruit. Increases in demand for
Australian wine has seen prices rise
(from Po to P1), and returns
to existing grape growers are excellent.
Those who wish to buy grapes face a
market where supply can only increase
marginally (from Qo to Q1), in the short
term.

• However, many new stands of vines are being planted, and in a few years,
returns to growers may stabilise, as supply increases. Prices will fall
from P1to P2 as the supply of grapes increases from Q1 to Q2.

Elasticity of Supply - 30

• the level of unutilised capacity.

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 An incecream maker, in Spring, has unutilised
capacity in their factory. They have several
icecream making machines, but are only using one
of them. If warm weather is forecast for next week,
the ice cream manufacturer can rapidly increase
production from Qo to Q1, with only a small increase
in total production costs. The cost of icecream will
rise only marginally from Po to P1.

Cross Elasticity of Demand -

31

The quantity of any good that is demanded

depends on the prices of its substitutes and
its complements.
How much demand for one good is effected by
changes in the price of another, associated good is
measured by the the first good's cross elasticity of
demand

The cross elasticity of of demand for substitutes is a positive number. After all, if the
price of good B rises, then the demand for good A will also rise.
The cross elasticity of demand for complements is negative. If the price of good B
rises, then the quantity of good A demanded will fall.

Income Elasticity of Demand - 32

What happens to the demand for a particular

good as consumers' incomes change?
As you might expect, as income rises, demand
for most, but not all goods will increase as well.

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 For some products, as income rises, demand for the
particular good or service rises even faster than
income. We can see this in the diagram to our left;
the curve moves upward with ever increasing slope.
We say the good or service in question is income
elastic.
Many ''luxury'' goods are income elastic; as we get wealthier,
we tend to buy more expensive clothing, and go on more
overseas holidays.
We do not necessarily buy more shoes for example; we
simply buy more expensive shoes (unless you are Imelda
Marcos, of course).

Income Inelastic Goods - 33

For other products, we note that as income rises, the

quantity demanded also increases, but the increase
in quantity demanded increases at a slower rate
than the increase in income. Products of this type
are income inelastic.
The slope of the curve increases, but the rate of increase
actually falls. (The curve looks like it will reach some kind
of ''maximum'' as income rises).

Products with inelastic income demand include food (but see below) and items like
magazines.
If you produce goods or services which are income inelastic, you will sell more as
people's incomes rise, but the rate of growth of your profitability will eventually fall.

Income Elasticity - 34

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 There are some goods and services,
however, which display a most interesting
feature associated with their income
elasticity.
Initially, as consumer's incomes rise, demand for
these goods also rises. (Although the rate of
increase of demand is less than the rate of increase
in income).

However, when incomes reach a certain level, the demand for these products
actually decreases.
The income elasticity of demand for these products is negative, at certain levels of
income.
In developing countries, as income rises, consumers buy more meat and eat less rice
or wheat products. In China, as incomes have risen, motorcycles have replaced
bicycles.
Goods which have positive income elasticities of demand ( η > 1 ) are
called normal goods.
Goods which have negative income elasticities of demand ( η < 1 ) are
called inferior goods.
(Note : ''inferior'' here means that as incomes rise, the goods in question are replaced
with ''higher quality'' substitutes.)

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