Friday 13th January 2023

Unit 2: Explaining the Consumer Choice Theory

In economics the theory of consumer behaviour refers to the analysis of the concept of
marginal utility. What then is the meaning of the term “utility”? Used in context of
economics, the term “utility” may be defined as the amount of satisfaction to be derived or
enjoyed from a commodity or service at a particular time. The utility of bread is the
satisfaction to be obtained from consuming bread at a particular moment of time. There are
two points to note:

(1). In the first place, the utility of a commodity has nothing to do with its usefulness; it may
or may not be useful, though it must yield satisfaction. Nor has utility any ethical
connotation. If we want something, whether it is good or bad for us, it possesses utility for
us. And so the ordinary meaning of the word must therefore be put aside.

(2).The second point to be stressed is its applicability to something at a particular time. A

commodity does not possess a specific amount of utility. To a hungry person bread will have
great utility, whereas for a person who has just had lunch, bread for the moment may
possess no utility at all. If a hungry person is given a good meal, bread will also cease or stop
for a time, to have utility for him. Utility therefore depends on the individual’s own
subjective estimate of the amount of satisfaction to be obtained from something. Thus
there is no such thing as intrinsic value, for the same commodity has at the same time
different utilities for different people, and even for the same person the utility of a thing is
not constant, but differs at different times and in different circumstances.

Having looked at the meaning of “utility” in a little detail, what then is meant in economics
by the term “margin”? The marginal unit of anything is the last to be added to or the first to
be taken away from a supply. If a student already possesses three books on economics and
is thinking of buying a fourth one, this fourth book might be considered to be his “marginal”
volume. Whether he buys it or not will depend on whether he thinks that the additional
benefit to be obtained from this fourth book is worth the price he will have to pay for it i.e.
he considers its marginal worth to him.

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It is always marginal considerations that determine whether a person will add to his existing
stock of a commodity. The marginal significance of any commodity, therefore, depends on
how much of it is already possessed. If a student already possesses a number of books on
economics the marginal significance to him of books on economics is likely to be low; if he
has only one book on economics the marginal significance of such books may be high.

Diminishing Marginal Utility:

The marginal utility of a product will thus be the amount of satisfaction to be obtained
from the possession of a little bit more of it, or, alternatively, the loss of satisfaction due
to giving up the smallest possible amount of it. The student with only one book on his
subject has a high marginal utility for such books. When he acquires a second book
marginal utility falls, and after acquiring a third, marginal utility falls again. With each
additional book he obtains, the marginal utility of such books for him successively declines.
Eventually a time will arrive when their marginal utility will be so low that an additional
volume will have no utility at all for him. The marginal utility of a commodity therefore
declines as one’s supply of it increases until satiety is reached.

As a hungry person consumes more and more food, the marginal utility of food gradually
declines for him. It is therefore the marginal utility of a thing, and not its total utility, that is
important economically, for a person’s demand for anything depends on the marginal utility
of the commodity to him. Marginal utility can be applied to money, its marginal utility being
the satisfaction to be obtained from the expenditure of one more unit of it. The Law of
Diminishing Marginal utility is a general law of life, as it applies to everything.

Since utility is the strength of the satisfaction to be obtained from a thing, it cannot be
measured, assume, however, for the moment that the utility of tea for Mrs Banda can be
measured in units of utility as per table hereunder:

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 Marginal Utility

500gms of Tea Bags Total Utility (units of utility) Marginal Utility (units of utility)
1 60 60
2 102 42
3 132 30
4 156 24
5 176 20
6 191 15
7 201 10
8 208 7

The table shows that for Mrs Banda the marginal utility of the first 500gms of tea bag stands
at “60 units of utility”. After purchasing 500gms tea bags its marginal utility falls to 42, and
with each subsequent purchases the marginal utility of the commodity falls until her 8 th
500gms tea bag its marginal utility has declined to 7 units of utility. Each additional purchase
has less utility than the preceding one, showing that as one’s stock increases marginal utility
declines.

Consumer’s Surplus:

Refers to the satisfaction derived from enjoying the use of a product whose price is below
the customer’s expected and prepared expenditure.

Let us assume that a new book is published at K21.00. Those people who considered that
the amount of satisfaction they will derive from it is not to be worth this price will obviously
not buy it. Of those who buy a copy some would have been willing to pay more than K21.00.
Thus a person who would have been prepared to pay K30.00 for the book can be considered
to have obtained a consumer’s surplus of K9.00 worth of satisfaction.

Demand and Supply Curves:

The concept of a market – in examining the price theory we will look in more detail at the
micro-economic level of the individual firm, individual markets and consumers or
households. This means looking at what influences the amount of a product demanded or
supplied and analysing how price and output are determined through the interaction of
demand and supply. In the context of economics demand and supply takes place in a
market place. The question then that arises is what is a market?
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A market can be defined as a place where potential buyers and potential sellers (suppliers)
of goods or services meet for the purpose of exchange.

There are essentially three types of markets in the economy as follows:

(i) Product markets – these could include a street market selling fresh vegetables and
the market for used furniture conducted in the back pages of the local newspaper.

(ii) Commodity markets – these may include the global markets for copper conducted
between mine owners and users or between dealers on the floor of the London or
Shangai Metal Exchange or the New York Commodity Exchange (COMEX).

(iii) Financial markets – these may include stock exchange markets where shares in
companies are traded or money markets where bank trade loans using computer
screens are traded.

Our discussion will be cantered on the product markets involving buyers and sellers of a
product who influence its price.

In economics suppliers and potential suppliers are referred to as firms. The potential
purchasers or buyers of consumer goods are known as households. The price theory is
concerned with how market prices for goods are arrived at through the interaction of
demand and supply. The market structure wherein the pricing mechanism is driven by the
forces of demand and supply is known as Free Competition Market and discussion of this
module will be based on this type of market structure.

The Demand Schedule and the Demand Curve:

The demand schedule refers to the quantity of a product demanded by a customer at

various price levels. The demand curve is therefore a graphic presentation of the
relationship between the quantity demanded of a product and the price levels. The demand
curve of a single consumer or household is derived by estimating how much of the product
the consumer or household would demand at various hypothetical market prices.

Suppose that the following demand schedule shows demand for sugar by one household
over a period of one month:
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Price per kg in kwacha Quantity demanded in kgs

10 9.75

20 8.00

30 6.25

40 4.50

50 2.75

60 1.00

Notice that we show demand falling as price increases. This is what normally happens with
most products. This is because purchasers / buyers have a limited amount of money to
spend and must choose between products that compete for their attention. When the price
of one product rises, it is likely that other products will seem relatively more attractive and
so demand will switch away from the more expensive product to the cheaper alternative.

The Law of Demand – states that as the price of a product falls, other things remaining
equal, the quantity demanded of the product increases.

The demand curve happens to be a straight line. Straight line demand curves are often used
as illustration in economics because it is convenient to draw them this way. However, in
reality, a demand curve is more likely to be a curved line convex to the origin.

The market Demand Curve:

The demand schedule shows how much of a product consumers are willing and able to
purchase / buy at any given price. The position of the demand curve is determined by the
demand conditions, which include consumer’s tastes and preferences and consumer’s
incomes. In the previous example, we have been looking at the demand schedule of a single
household. A market demand curve is a similar curve, but it expresses the expected total
quantity of the product that would be demanded by all consumers together, at any given
price.

The Conditions of Demand:

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Factors Affecting Demand – several factors influence the total market demand for a product.
One of these factors is obviously its price. A demand curve shows how the quantity
demanded will change in response to a change in price provided that all other conditions
affecting demand are unchanged; i.e. that is, provided that there is no change in the prices
of other products, tastes, expectations or the distribution of household income.

(1) Substitute Goods - are goods that are alternatives for each other, so that an increase in
the demand for one is likely to cause a decrease in the demand for another. Switching
demand from one product to another “rival” product is substitution.

(2) Complements – are goods that tend to be bought and used together, so that an increase
in the demand for one is likely to cause an increase in the demand for the other.

Substitutes and complements are goods for which the market demand is inter-connected.

Examples of substitute goods and services are:

 Rival brands of the same commodity, like Coca-Cola and Pepsi-Cola.

 Tea and coffee

 Some different forms of entertainment

Substitution takes place when the price of one product rises relative to a substitute product.
By contrast, complements are connected in the sense that demand for one is likely to lead
to demand for the other.

Examples of complement goods and services:

 Cups and saucers

 Bread and butter

 Motor cars and the components and raw materials that go into their manufacture.

(b) Household incomes - more income will give households more to spend and they will
want to buy more products at existing prices. However, a rise in household income will

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 not increase market demand for all goods and services. The effect of a rise in income on
demand for an individual product will depend on the nature of the product.

Demand and level of income may be related in different ways:

 We might normally expect a rise in household income to lead to an increase in demand

for a product, and products for which demand rises as household income rises are called
normal goods.

 Demand may rise with income up to a certain point but then fall as income rises beyond
that point. Products that whose demand eventually falls as income rises are called
inferior products, examples might include public transport or cheap clothing. The reason
for falling demand is that as incomes rise, customers can afford to switch demand to
superior products.

(c) Demand, fashion and expectations – a change in fashion or tastes will also alter the
demand for a product. For example, if it becomes fashionable for blue clothing to be
worn then expenditure on blue clothing will increase. Tastes can be affected by
advertisers and suppliers trying to “create” demand for their products.

If consumers believe that prices will rise or that shortages will occur, they may attempt to
stock up on the product before these changes occur. Again, this could lead to increases in
demand despite the price of the product remaining unchanged.

(d) Marginal Utility – utility refers to the level of satisfaction that a consumer derives from
consuming a product or service. Marginal utility is concerned with the extra satisfaction
that a person gains from consuming one additional unit of a particular product or
service. Some businesses use the concept of marginal utility to help them determine
how many units of an item a consumer will purchase.

Marginal utility is said to be positive when consumption of an extra unit of a product

results in an increase in overall satisfaction. If, other hand, consumption of an additional
unit of a product reduces a consumer’s overall satisfaction, then marginal utility is said
to be negative.

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(e) Shifts of the demand curve – so far, we have been looking at the way a change in price
affects the quantity demanded, depicted as a movement along the demand curve.
However, when there is a change in the conditions of demand, the quantity demanded
will change even if the price remains constant. In this case, there will be a different price
and quantity demand schedule and so a different demand curve. This change is called a
shift of the demand curve.

The difference between a change in demand and a shift of the demand curve is of
fundamental importance:

(i) Movements along a demand curve (contractions or expansions) for a product are
caused solely by changes in its price.

(ii) Variations in the conditions of demand create shifts in the demand curve –

 A rise in household income including a reduction in direct taxes,

 A rise in the price of substitutes

 A fall in the price of complements

 A change in tastes towards this product

 An expected rise in the price of the product

 An increase in population

An outward shift in the demand curve but conversely a fall in demand at each price level
would be represented by a shift in the opposite direction, a shift to the original demand
curve. Such a shift may be caused by the opposite of the conditions of demand shown
above.

The supply Schedule:

The supply concept – supply refers to the quantity of a product that existing suppliers would
want to produce for the market at a given price. As with demand, supply relates to a period
of time – for example, we might refer to an annual rate of supply or to a monthly rate.

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The quantity of a product supplied to a market varies up or down for two reasons as follows:

(i) Existing suppliers may increase or reduce their output quantities

(ii) Firms may stop production altogether and leave the market or new firms may enter
the market and start to produce the product.

If the quantity that firms want to produce at a given price exceeds the quantity that
households / consumers would want, there will be an excess of supply, with firms
competing to win what sales and demand there is. Over-supply and competition would then
be expected to result in price-competitiveness and a fall in prices.

As with demand, a distinction needs to be made:

(i) An individual firm’s supply schedule is the quantity of the product that the individual
firm would want to supply to the market at any given price.

(ii) Market supply is the total quantity of the product that all firms in the market would
want to supply at a given price.

The Supply Curve:

A supply schedule and supply curve can be created both for an individual supplier and for
all firms (Market Supply Curve) which produce the product.

A supply curve is constructed in a similar manner to a demand curve (from a schedule of

quantities supplied at different prices) but it shows the quantity suppliers are willing to
produce at different price levels. It is an upward sloping curve from left to right, because
greater quantities will be supplied at higher prices.

We usually assume that suppliers aim to maximise their profits and the upward slope of the
supply curve reflects this desire to make profit (i.e. they are prepared to supply more of a
product the higher the price that customers will pay for it). It is also important to bear in
mind that under the Free Competition Market Structure, which we have indicated that
discussion of this module will be based, a single supplier is assumed to be a price-taker. In
other words, a single supplier cannot influence the price at which his products are being

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sold in the market. But rather he takes the price that is determined by the forces of demand
and supply i.e. the market price or market clearing price as this price is also known as.

The Law of Supply states that as price of a product rises, other things remaining constant,
the quantity supplied of a product will increase.

Factors Influencing the Supply Quantity:

The quantity supplied of a product depends, as you might expect, on prices and costs. More
specifically, it depends on the following factors:

(i) The costs of producing the product – these include raw materials costs which
ultimately depend on the prices of factors of production (wages, interest rates, land
rents and profit expectations).

(ii) The prices of other products – when a supplier can switch readily from supplying
one product to another, the products concerned are substitutes in supply. An
increase in the price of one such product would make the supply of another product
whose price does not rise less attractive to suppliers. When a production process has
two or more distinct and separate outputs, the products produced are known as
goods in joint supply or complements in production. Goods in joint supply include,
for example, meat and hides. If the price of beef rises, more will be supplied and
there will be an accompanying increase in the supply of cow hides.

(iii) The application of indirect taxes and subsidies will affect prices. If the government
apply an indirect tax on the producer, such as per litre of fuel oil, then the producer
will treat this as a cost rise and raise their price. Alternatively, if the government
contributes a subsidy, say a sum of money per education course sold, then the
producer will reduce their prices to get a bigger number of sales and so attract more
units of the subsidy.

(iv) Expectations of price changes – if a supplier expects the price of a product to rise,
he is likely to try to reduce supply while the price is lower so that he can supply more
of his product or service once the price is higher.

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(v) Changes in technology – technological developments which reduce costs of
production (and increase productivity) will raise the quantity of supply of a product
at a given price.

(vi) Other factors – such as changes in the weather (for example, in the case of
agricultural products), natural disasters or industrial disruption.

The supply curve shows how the quantity supplied will change in response to a change in
price. If supply conditions alter, a different supply curve must be drawn. In other words, a
change in price will cause a change in supply along the supply curve. A change in other
supply conditions will cause a shift in the supply curve itself.

This distinction between a movement along the supply curve and a shift in the supply curve
is just as important as the similar distinction relating to the demand curve.

Shifts of the Market Supply Curve:

The market supply curve is the aggregate of all the supply curves of individual firms in the
market. A shift of the market supply curve occurs when supply conditions (other than the
price of the product itself) change. A rightward (or downward) shift of the curve shows an
expansion of supply and may be caused by the factors below:

(i) A fall in the cost of factors of production, for example, a reduction in the cost of raw
material inputs.

(ii) A fall in the price of other products. The production of other products becomes
relatively less attractive as their price falls. Firms are therefore likely to shift
resources away from the products whose price is falling and into the production of
higher priced products that offer increased profits. We therefore expect that (ceteris
paribus), the supply of one product will rise as the prices of other products fall and
vice versa.

(iii) Technological progress which reduces unit costs and also increases production
capabilities.

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(iv) Improvements in productivity or more efficient use of existing factors of production
which again will reduce unit cost.

A shift of the supply curve is the result of changes in costs, either in absolute terms or
relative to the costs of other products.

Conversely, we might see a left or upward shift in the supply curve if the cost of supply
increases. This would mean that at the existing price, a firm’s output will decrease and less
will be supplied. An upward (leftward) shift in supply could be caused by:

(i) An increase in the cost of factors of production e.g. a rise in wages and salaries,
which are the costs of labour.

(ii) A rise in the price of other products which would make them relatively more
attractive to the producer.

(iii) An increase in indirect taxes or a reduction in a subsidy, which would make supply at
existing prices less profitable.

The Equilibrium Price:

People only have a limited income and they must decide what to buy with the money they
have. The prices of the products they want will affect their buying decisions. The firms
‘output decisions will be influenced by both demand and supply considerations.

(i) Market demand conditions influence the price that a firm will get for its output.
Prices act as signals to producers and changes in prices should stimulate a response
from a firm to change its production quantities.

(ii) Supply is influenced by production costs and profits. The objective of maximising
profits provides the incentive for firms to respond to changes in price or cost by
changing their production quantities.

(iii) Because demand is potentially greater than supply the scarce supply must be
rationed-out between the buyers. This is done by the price rising until only the
keenest buyers can afford it.

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In summary, the three functions of price are signalling, rewarding and rationing.

The price mechanism and the equilibrium price

The price mechanism brings demand and supply into equilibrium and the equilibrium price
for a product is the price at which the volume demanded by consumers and the volume that
firms would be willing to supply is the same. This is also known as the market clearing price,
since at this price there will be neither surplus nor shortage in the market.

The way demand and supply interact to determine the equilibrium price can be illustrated
by drawing the market demand curve and the market supply curve on the same graph.

At price P1, suppliers want to produce a greater quantity than the market demands,
meaning that there is excess supply, equal to the distance AB. Suppliers would react as the
stock of unsold products accumulates:

 They would cut down the current level of production in order to sell unwanted
inventories

 They would also reduce prices in order to encourage sales.

The opposite will happen at price P2 where there is an excess of demand over supply shown
by the distance CD. Supply and price would increase. Faced with an excess of demand,
manufacturers could raise their prices. This would make supplying the product more
profitable and supply would increase.

The forces of supply and demand push a market to its equilibrium price and quantity. Note
the following key points:

(i) If there is no change in conditions of supply or demand, the equilibrium price will
prevail in the market and will remain stable.

(ii) If the price is not at the equilibrium the market is in disequilibrium and supply and
demand will push prices towards the equilibrium price.

(iii) In any market there will only be one equilibrium position where the market is
cleared.
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(iv) Shifts in the supply curve or demand curve will change the equilibrium price (and the
quantity traded).

The competitive market process results in an equilibrium price which is the price at which
market supply and market demand quantities are in balance. In any market, the
equilibrium price will change if market demand or supply conditions change.

Elasticity of Demand and Supply:

The Price elasticity of Demand – elasticity in general refers to the relationship between two
variables. Price elasticity of demand explains the relationship between change in quantity
demanded and changes in price. If prices went up by 10%, would the quantity demanded
fall by the same percentage?

Price Elasticity of Demand (PED) indicates or measures the responsiveness in the quantity
demanded of a product to changes in its price.

The coefficient of PED is measured as: % Change in Quantity Demanded

% Change in Price

Since demand usually increases when the price falls, and decreases when the price rises,
elasticity has a negative value. However, it is usual to ignore the minus sign and just
describe the absolute value of the coefficient.

If we are measuring responsiveness of demand to a large change in price, we can measure

elasticity between two points on the demand curve and the resulting measure is called the
Arc Elasticity of Demand (Arc PED). We calculate the Arc Elasticity of Demand from the
percentage change in quantity relative to average quantity for the relevant range of output
and from the percentage price change relative to the average of the corresponding price
range.

Arc PED = Q2 – Q1 / P2 –P1

(Q2+Q1)/2 (P2+P1)/2

Worked example of calculating Arc PED:

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The price of a product is K1,200 per unit and annual demand is 800,000 units. Market
research indicates that an increase in price of K100 per unit will result in a fall in annual
demand of 70,000 units. What is the price elasticity of demand measuring the
responsiveness of demand over this range of price increase?

Solution:

Firstly we need to determine the values of Quantities and Prices as follows:

 Q1 =800,000 and Q2 = (800,000 – 70,000) = 730,000 i.e. resulting from a fall of 70,000
units from the initial units of 800,000.

 P1 =1,200 and P2 = (1,200+100) = 1,300 i.e. resulting from an increase of price by 100
from the initial 1,200.

Arc PED = Q2 – Q1 / P2 – P1

(Q2+Q1)/2 (p2+P1)/2

= 730,000 – 800,000 / 1,300 – 1,200

(730,000+800,000)/2 (1,300+1,200)/2

= 70,000 / 100

765,000 1,250

= 0.0915 / 0.08

Arc PED = 1.14

The demand for this product over the range of annual demand of 730,000 to 800,000 units
is elastic because the price elasticity of demand is greater than 1.

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Point Elasticity of Demand:

If we wish to measure the responsiveness of demand at one particular point in the demand
curve, we can calculate a Point Elasticity of Demand without averaging quantity and price
over a range. In doing so, it is convenient to assume that the demand curve is a straight line
unless told otherwise.

Worked example of calculating Point Elasticity of Demand (PED):

The price of a product is K1,200 per unit and annual demand is 800,000 units. Market
research indicates that an increase in price of K100 per unit will result in a fall in annual
demand for the product of 70,000 units. Calculate the elasticity of demand at the current
price of K1,200.

Solution:

Firstly we need to determine the values of the Quantities and Prices as follows:

 Q1 = 800,000 and Q2 = (800,000 – 70,000) = 730,000 i.e. resulting from a fall in annual
demand by 70,000 units from 800,000 units.

 P1 = 1,200 and P2 = (1,200+100) = 1,300 i.e. resulting from an increase of price by 100
from 1,200.

At the current price of K1,200, annual demand is 800,000 units for a price rise of 100.

Point Elasticity of Demand (PED) = Q2+Q1 / P2+P1

Q1 P1

PED = 730,000 – 800,000 / 1,300 – 1,200

800,000 1,200

= 70,000 / 100

800,000 1,200

= 0.08750 / 0.0833

Point PED= 1.05

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The price elasticity of demand at this point is 1.05. Demand is elastic at this point because
the elasticity is greater than 1.

Elastic and Inelastic Demand:

The value of demand elasticity may be anything from zero to infinity:

 Demand is elastic if the absolute value is greater than 1

 Demand is inelastic if the absolute value is less than I

Consider what this means if there is an increase in price. Where demand is elastic, demand
falls by a larger percentage than the rise in price. Where demand is inelastic, the quantity
demanded falls by a small percentage than the rise in price.

Price elasticity varies along the demand curve:

Generally, demand curves slope downwards. Consumers are willing to buy more at lower
than higher prices. Except in certain special cases, elasticity will vary in value along the
length of a demand curve.

At higher prices on a straight line demand curve (at the top of the demand curve), small
percentage price reduction can bring larger percentage increase in quantity demanded. This
means that demand is elastic over these ranges.

At lower prices on a straight line demand curve (the bottom of the demand curve), large
percentage price reductions can bring small percentage increases in quantity. This means
that demand is inelastic over these ranges.

Special Values of Price Elasticity of Demand:

There are three special values of price elasticity of demand: 0, 1 and infinity.

(i) Demand is perfectly elastic: n=0 (infinitely elastic). Consumers will want to buy an
infinite amount, but only up to a particular price level. Any price increase above this
level will reduce demand to zero. In this case, the demand curve is a horizontal
straight line.

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(ii) Demand is perfectly inelastic: n=0. There is no change in quantity demanded,
regardless of the change in price. In this case, the demand curve is a vertical straight
line.

(iii) Unit elasticity of demand: n=0. Total revenue for suppliers (which is the same as
total spending on the product by households), does not change regardless of how
the price changes. The demand curve of a product whose price elasticity of demand
is 1 over its entire range is a rectangular hyperbola.

The Significance of Price Elasticity of Demand:

The price elasticity of demand is relevant to total spending on a product or service. Total
expenditure is a matter of interest to both suppliers, to whom sales revenue accrues and to
government who may receive a portion of total expenditure in the form of taxation.

(i) When demand is elastic, an increase in price will result in a greater than
proportional fall in the total quantity demanded and total expenditure will fall.

(ii) When demand is inelastic, an increase in price will result in a fall in quantity
demanded, but the fall in quantity demanded will be less than proportional to the
rise in price so total expenditure will rise.

(iii) With unity elasticity, expenditure will stay constant regardless of a change in price.

Information on Price Elasticity of Demand:

Information on price elasticity of demand indicates how consumers can be expected to

respond to different prices. Business people can make use of information on how
consumers will react to pricing decisions as it is possible to trace the effect of different
prices on total revenue and profits. Information on price elasticities of demand will be useful
to a business which needs to know the price decrease necessary to clear a surplus (excess
supply) or the price increase necessary to eliminate a shortage (excess demand). Elasticity
is also useful, more generally, for a firm if it is considering changing the price of a product or
service and considering the impact this change will have on revenues.

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Government policy makers can also use the information about elasticity, for example, when
making decisions about indirect taxation. Products with low (inelastic) price elasticity of
demand such as cigarettes and alcohol tend to be useful targets for taxation since by
increasing taxes on these, total revenue can be increased. If demand for cigarettes was
price elastic, increases in taxation would be counter-productive as they would result in
lower government revenue.

Elasticity and Total Revenue:

The concept of elasticity is an important decision making tool to both the private business
enterprises, particularly those involved in manufacturing and also to the government as it
considers the application of taxation on the various products in an economy. It is important
that decision makers understand that different products face different types of price
elasticity of demand in the market. In order to appreciate the impact of this concept, let us
take the following practical examples:

Suppose that there are two products, A and B. Product A currently sells for K5,000 per unit
and demand at this price is 1,700 units. If the price fell to K4,600 per unit demand would
increase to 2,000 units.

Product B currently sells for K8,000 per unit and demand at this price is 9,500 units. If the
price fell to K7,500 per unit, demand would increase to 10,000 units.

In each of these cases, and using the “point” method, calculate:

(a) The price elasticity of demand (PED) for the given price changes

(b) The effect on total revenue if demand is met in full at both the “old” and “new prices”,
of the change in price.

Solution:

(a) Product A:

Firstly we need to determine the values of Quantities and Prices as follows:

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 At current price of K5,000 Q1=1,700 and Q2=2,000 i.e. resulting from an increase to
2,000 units.

 P1=5,000 and P2=4,600 i.e. resulting from a fall in price to 4,600.

Point PED = Q2 – Q1 / P2 – P2

Q1 P1

Point PED = 2,000 – 1,700 / 4,600 – 5,000

1,700 5,000

= 300 / 400

1,700 5,000

= 0.1765 / 0.08

Point PED = 2.2

Demand is elastic and a fall in price should result in a large increase in quantity demanded
such that total revenue will increase / rise.

Revenue Analysis: in order to prove that total revenue will increase given that the PED is
elastic, we undertake the following calculations:

Revenue at “old price” of K5,000 (5,000 x 1,700 units) =K8,500,000

Revenue at “new price” of K4,600 (4,600 x 2,000 units) = K9,200,000

Increase in Total Revenue: =K700,000

(b) Product B:

Firstly we need to determine the values of Quantities and Prices as follows:

 At current price of K8,000 Q1=9,500 and Q2=10,000 i.e. resulting from an increase to
10,000 units.

 P1=8,000 and P2=7,500 i.e. resulting from a fall in price to 7,500.

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 Point ED = Q2 –Q1 / P2 – P1

Q1 P1

= 10,000 – 9,500 / 7,500 -8,000

9,500 8,000

= 500 / 500

9,500 8,000

= 0.0526 / 0.0625

Point PED = 0.84

Demand is inelastic and a fall in price should result in only a relatively small increase in
quantity demanded such that total revenue will decrease / fall.

Revenue Analysis: in order to prove that total revenue will decrease fall given that the PED
is inelastic, we undertake the following calculations:

Revenue at “old price” of K8,000 (8,000 x 9,500 units) K76,000,000

Revenue at “new price” of K7,500 (7,500 x 10,000 units) K75,000,000

Decrease / Fall in Total Revenue: (K1,000,000)

Factors Influencing Price Elasticity of Demand for a Product:

Factors that determine price elasticity of demand (PED) are similar to the factors other than
price that affect the volume of demand. The PED is really a measure of the strength of these
other influences on demand:

(i) Percentage of income spent on the product – if expenditure on a product only

constitutes a small proportion of a consumer’s income, then a change in the price of
that product will not have much impact on the consumer’s overall real income.

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 Therefore, demand for low price products (such as safety matches) is likely to be
inelastic. By contrast, demand is likely to be elastic for expensive products.

(ii) Availability of substitutes – the more substitutes these are for the product,
especially close substitutes, the more elastic the price elasticity of demand for the
product will be. For example, the elasticity of demand for a particular brand of
breakfast cereal will be much greater than the elasticity of demand for breakfast
cereal as a whole, because the former have both more and also close, substitutes. A
rise in the price of a particular brand of cereal is likely to result in customers
switching their demand to a rival brand. Availability of substitutes is probably the
most important influence on price elasticity of demand.

(iii) Necessity – demand for products which are necessary for everyday life (for example,
basic foodstuffs) tend to be relatively inelastic while demand for luxury products
tends to be elastic. If a product is a luxury and its price rises, the rational customer
may well decide that he or she no longer needs that product and so demand for it
will fall. However, if a product is a necessity, the consumer will have to continue
buying it even though its price has increased.

(iv) The time horizon – if the price of a product is increased, there might initially be little
change in demand because the customer may not be fully aware of the increase or
may not have found a suitable substitute for the product. Then, as consumers adjust
their buying habits in response to the price increase, demand might fall
substantially. The time horizon influences elasticity largely because the longer the
period of time which we consider, the greater the knowledge of substitution
possibilities by consumers and the provision of substitutes by producers. Therefore,
elasticity tends to increase as the time period increases.

(v) Competitor pricing – if the response of competition to a price increase by one firm is
to keep their prices unchanged, the firm raising its price is likely to face elastic
demand for its products at higher prices. If the response of competitors to a
reduction in price by one firm is to match the price reduction themselves, the firm is
likely to face inelastic demand at lower prices. This is a situation which faces many

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 large firms with one or two major competitors. We will look at this situation in more
detail later when we consider the characteristics of oligopolies.

(vi) Habit – products which are habit-forming tend to be inelastic, because the consumer
“needs” the products despite their increase in price. This pattern can be seen with
additive products such as cigarettes.

(vii) Definition market – if a market is narrowly defined (for example, breakfast cereals)
there will be a number of competing brands and substitute products available so
these brands will be price elastic. If a market is only broadly defined (for example,
food) there will be fewer generic alternatives and so demand will tend to be
inelastic.

Income Elasticity of Demand:

Income elasticity of demand (YED) measures the responsiveness in demand for a product or
service to changes in income.

Products for which YED is positive are called normal products; inferior products have a
negative YED.

Income Elasticity of Demand = % Change in Quantity Demanded

% Change in Income

YED = Q2 – Q1 / Y2 – Y1 Or

Q1 Y1

YED = Q2 – Q1 / Y2 – Y1

(Q2+Q1)/2 (Y2+Y1)/2

Zero Income Elasticity:

A change in income may have no effect on the quantity demanded, demand remains the
same i.e. YED=0

Consumers purchase only what they require, this applies to Giffen products, necessities like
maize, mealie meal etc.
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Practical uses of Income Elasticity of Demand:

Producers use YED in their production plans. When incomes are rising, firms need to
produce more normal products than inferior products because these are the products that
will be in high demand. On the other hand, when incomes are reducing, firms need to
produce more inferior products than normal products since these are the products that will
be in high demand.

Similarly, the government must be able to predict its revenue from taxes. Thus, the tax
taken from products with different income elasticities of demand will respond differently to
rises and falls in national income.

Cross Elasticity of Demand:

Cross elasticity of demand measures the responsiveness or sensitivity of demand for one
product to changes in price of another product.

XED = % Change in Quantity Demanded of Product A

% Change in Price of Product B

XED = QA2 – QA1 / PB2 –PA1

QA1 PA1

Where suffix A represents product A and suffix B represents product B.

The XED of substitute products is positive, while that for complements is negative.

Elasticity of Supply:

The price elasticity of supply measures the responsiveness of supply to a change in price.

Elasticity of Supply = % Change in Quantity Supplied

% Change in Price.

Where the supply of products is fixed whatever price is offered, for example, in the case of
antiques, vintage wines and land, supply is perfectly inelastic and the elasticity of supply is
zero. The supply curve is a vertical straight line.

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Where the supply of products varies proportionately with the price, elasticity of supply is
equal to one and the supply curve is a straight line passing through the origin. (Note that a
demand curve with unit elasticity along all of its length is not a straight line but a supply
curve with unit elasticity is a straight line).

Where the producers will supply any amount at a given price but none at all at slightly
lower rice, elasticity of supply is infinite or perfectly elastic. The supply curve is a horizontal
straight line. Note that a supply curve with unit elasticity can have many different gradients.
The key feature that identifies unitary elasticity is not the gradient of the curve, but the fact
that it passes through the origin.

Supply is elastic when the percentage change in the amount producers want to supply is
greater than proportional to the percentage change in price.

Supply is inelastic when the amount producers want to supply changes by a smaller
percentage than the percentage change in price.

Note, if the supply curve “cuts” across the quantity supplied axis, supply is inelastic. If the
supply curve “cuts” across the price axis, supply is elastic.

Factors Affecting Elasticity of Supplier:

Elasticity of supply is a measure of firms ‘ability to adjust the quantity of products they
supply. This depends on a number of constraints some of which are as follows:

(i) Existence of inventories of finished products – if a firm has large inventories of

finished products then it can draw on these to increase supply following an increase
in the price of the product in the market. So supply will be relatively elastic.
Perishability or shelf life is important considerations here though.

(ii) Availability of labour – when unemployment is low it may be difficult to find worker
people with the appropriate skills.

(iii) Spare capacity – if a firm has spare capacity (e.g. machinery which is not being fully
utilised), it can quickly and easily increase supply following an increase in price of

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 products in the market. In this way, spare capacity is likely to increase elasticity of
supply.

(iv) Availability of raw materials and components – the existence and location of
inventories is important just as they are for finished products.

(v) Barriers to entry – if firms can move into the market easily and start supplying
quickly, elasticity of supply in that market will be increased.

(vi) The time scale – the elasticity of supply of a product varies according to the time
period over which it is measured. For analytical purposes, four lengths of time period
may be considered:

(a) The market period – is so short that supplies of the commodity in question are
limited to existing inventories. In effect, supply is fixed.

(b) The short-run period – is a period long enough for supplies of the commodity to
be altered by increases or decreases in current capacity, but not long enough for
the factory to be increased in scale. This means that suppliers can produce larger
quantities only if they are already operating at full capacity; they can reduce
output fairly quickly by means of redundancies and laying-off staff.

(c) The long-run period – is a period sufficiently long to allow firms ‘capacity to be
altered. There is time to build new factories and machines and time for old ones
to be closed down. New firms can enter the industry in the long-run.

(d) The secular period – is so long that the underlying economic factors such as
population growth, supplies of raw materials (such as oil) and the general
conditions of capital supply may alter. The secular period is ignored by
economists except in the theory of economic growth.

In general, supply tends to be more elastic in longer time periods.

Response to changes in demand:

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The price elasticity of supply can be seen, in effect, as a measure of the readiness with which
an industry responds following a shift in the demand curve.

Summary:

Elasticity of supply measures the responsiveness of the quantity of a product supplied

following a change in the price of that product. It is a measure of firms ‘ability to adjust the
quantity of products they supply when price changes.

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