Revision: Part 2 (Demand, Supply, Elasticity and

Government Intervention)

By Mr John Fallo Khanye

UKZN INSPIRING GREATNESS

An increase in the price of bottled water:
a) increases the supply of bottled water.
b) decreases the supply of bottled water.
c) increases the demand for bottled water.
d) increases the quantity supplied of bottled water.
e) increases the quantity demand for bottled water.
 Demand
The Law of Demand
• The law of demand states: Other things remaining the same, the higher the price of a
good, the smaller is the quantity demanded; and the lower the price of a good, the
greater is the quantity demanded
Why does a higher price reduce the quantity demanded? For two reasons:
1. Substitution Effect
• When the price of a good rises, other things remaining the same, its relative price – its
opportunity cost – rises
• Although each good is unique, it has substitutes – other goods that can be used in its
place
2. Income Effect
• When a price rises and all other influences on buying plans remain unchanged, the
price rises relative to people’s incomes
• So faced with a higher price and an unchanged income, people cannot afford to buy all
the things they previously bought
 Supply
The Law of Supply:
• The law of supply states that, Other things remaining the same, the
higher the price of a good, the greater is the quantity supplied: and
the lower the price of a good, the smaller is the quantity supplied.
Why does a higher price increase the quantity supplied?
• It is because marginal cost increases. As the quantity produced of any
good increases, the marginal cost of producing the good increases.
 One reason why the quantity demanded of a good tends to decline as its price increases is that:

a) the increase in price shifts the demand curve to the left.

b) the supply curve is upward sloping.
c) at higher prices, suppliers are willing to supply more.
d) people’s purchasing power declines.
e) the increase in price shifts the demand curve to the left.
If technology lowers the cost in producing computers,
what will happen to the equilibrium price and quantity
of computers?
a) Both the equilibrium price and quantity will increase.
b) Both the equilibrium price and quantity will decrease.
c) The equilibrium price will decrease and the equilibrium quantity will
increase.
d) The equilibrium price will increase and the equilibrium quantity will
decrease.
e) The equilibrium price and quantity will remain unchanged.
Individual supply

Individual 60
supply S1 S2
of computers 50

Price (kg per week)

40

30

20

10

0
1 2 3 4 5 6 7 8
Quantity supplied (kg per week) Q
SUPPLY

 We illustrate a change in supply as a shift of the supply curve

Table 3.2 The Supply for Chomp Bars (Summary)

The Law Of Supply

Decreases If: Increases If:

• the price of Chop bar falls • The price of Chomp bar rises

Changes in Supply

• the price of a factor of production used to • the price of a factor of production used to
produce Chomp bars rises produce Chomp bars falls

• the price of a substitute in production rises • the price of a substitute in production falls
• the price of a complement in production falls • the price of a complement in production rises
• the expected future price of a Chomp bar rises • the expected future price of a Chomp bar falls
• the number of suppliers of bars decreases • the number of suppliers of bars increases
• a technology change decreases Chomp bar • a technology change increases Chomp bar
production production
• a natural event decreases Chomp bar production • a natural event increases Chomp bar production
 Which of the following will definitely occur when there
is a decrease in the supply of and an increase in the
demand for wireless headphones?
a) An increase in equilibrium price.
b) A decrease in equilibrium price.
c) An increase in equilibrium quantity.
d) A decrease in equilibrium quantity.
e) Both equilibrium price and quantity will decrease
Which one of the following will definitely cause an increase in the equilibrium price?

A decrease in both demand and supply.

B. An increase in both demand and supply.
C. A decrease in demand combined with an increase in supply.
D. An increase in demand combined with a decrease in supply.
E. Not clear because not enough information is given.
If there is an excess supply of a good in a perfectly competitive market, the excess can be
eliminated by:

a) an increase in supply.
b) government raising the price.
c) a decrease in the market price of a good.
d) a decrease in quantity demanded.
e) government giving firms a subsidy to increase production
Market Equilibrium
For a normal good, when price increases which of the following is
likely to happen?

a) The income and substitution effect will both decrease the quantity
demanded
b) The income and substitution effect will both increase the quantity
demanded and quantity supplied.
c) The substitution effect will increase the quantity demanded while
income effect will decrease the quantity demanded.
d) The substitution effect will decrease the quantity demanded while
the income effect will increase the quantity demanded.
e) The income effect will not affect the quantity demanded, but the
substitution effect will reduce the quantity demanded.
 DEMAND

 A Shift of the Demand Curve

• If the price of a good remains constant but some other influence on buying plans changes, there is a
change in demand for that good
• We illustrate a change in demand as a shift of the demand curve

Table 3.1 The Demand for Chomp Bars (Summary)

The Law Of Demand

Decreases If: Increases If:

• the price of Chop bar rises • the price of Chomp bar falls

Changes in Demand

• the price of a substitute falls • the price of a substitute rises

• the price of a complement rises • the price of a complement falls
• the expected future price of a Chomp bar falls • the expected future price of a Chomp bar rises
• Income falls* • Income rises*
• Expected future income falls or credit becomes • Expected future income rises or credit becomes
harder to get* easier to get*
• the population decreases • the population increases
If an increase in the price of bacon results in an increase in the quantity of eggs demanded, then you can accurately conclude that:

a) bacon is an inferior good.

b) the cross price elasticity of demand is negative.
c) eggs are a normal good.
d) eggs and bacon are competing goods.
e) the cross price elasticity of demand is positive
The demand for a good increases when the price of a
complement ________ and also increases when the
price of a substitute ________
A. rises; falls.
B. remains the same; falls.
C. rises; rises.
D. falls; rises.
E. falls; falls.
 More Elasticities of Demand

Cross Elasticity of Demand

Cross Elasticity of Demand
The cross elasticity of demand is a
measure of the responsiveness of
demand for a good to a change in the
price of a substitute or a complement,
other things remaining the same.

The cross elasticity equals:

Percentage change in quantity demanded
Percentage change in price of substitute or
complement

%ΔQddA
%ΔPB
If an increase in demand caused no change in the equilibrium price then supply
must be:

a) perfectly price inelastic.

b) price inelastic.
c) price elastic.
d) perfectly price elastic.
e) unitary price elastic
Price and total revenue move in inverse
directions when demand is:

a) price elastic.
b) price inelastic.
c) perfectly price inelastic.
d) unitary price elastic.
e) None of the above
 Price Elasticity of Demand
Total Revenue and Elasticity
• The total revenue from the sale of a good equals the price of the good multiplied by the quantity
sold (TR = P x Q)
• When a price changes, total revenue also changes
• But a rise in price doesn’t always increase total revenue (when all other factors remain the same,
ceteris paribus).

The change in total revenue due to a change in price depends on price elasticity of demand:

o If demand is elastic (>1), total revenue moves in opposite direction from price. A 1% P ↓ , ↑Q
sold by more than 1%, therefore total revenue increases.
o If demand is inelastic (< 1), total revenue moves in same direction as price. A 1% P ↓ , ↑Q
sold by less than 1% and total revenues decreases.
o If demand is unit elastic (= 1), total revenue remains the same as price changes. A 1% P ↓ ,
↑Q sold by 1% and total revenue remains unchanged.
Categorizing Goods by Elasticity
Price elasticity of demand Demand

Between 0 and -1 Inelastic

Equal to 0 Perfectly Inelastic

Absolute Value > 1 Elastic

Equals 1 Unitary Elastic

Approaches minus infinity Perfectly

(infinitely) Elastic
The price elasticity of demand for bottled water in KZN is -2, and the
price elasticity of demand for bottled water in Gauteng is -0.5. In other
words, the demand in KZN is_____ and demand in Gauteng is____.
a) price elastic; price inelastic.
b) price inelastic; price elastic.
c) price elastic; unitary price elastic.
d) price inelastic; perfectly price inelastic.
e) perfectly elastic; perfectly price inelastic
The income elasticity of demand will be:
a) positive for an inferior good.
b) negative for an inferior good.
c) negative for a normal.
d) positive for a Giffen good.
e) None of the above
 More Elasticities of Demand
Income Elasticity of Demand
Income elasticity of demand =
Percentage change in quantity demanded
Percentage change in income

• Income elasticities of demand can be positive or negative and they fall into
three interesting ranges:

• Greater than 1 (normal good, income elastic)

• Positive and less than 1 (normal good, income inelastic)

• Negative (inferior good)

Suppose that the quantity of root beer demanded declines from 103000
litres per week to 97000 litres per week as a consequence of a 10%
increase in the price of root beer. The price elasticity of demand is:
a) 1.40
b) 0.60
c) 6.00
d) 1.66
e) 2.00
 Price Elasticity of Demand
Using averages
• Midpoint formula: it averages the two prices and the two quantities as the
reference points to compute percentages:

(Q1- Q0)
x 100
(Q0+Q1)/2
Ed =
(P1- P0)
x 100
(P0+P1)/2
The more time that passes, the:

a) less price elastic is the demand for a product.

b) more price elastic is the demand for a product.
c) fewer the number of available substitutes for a good.
d) smaller the income elasticity of demand for a product.
e) None of the above.
The Factors That Influence the Elasticity of Demand

• The closeness of substitutes

• The closer the substitutes for a good or service, the more
elastic is the demand for it
• The proportion of income spent on the good
• The greater the proportion of income spent on a good, the
more elastic (or less inelastic) is the demand for it
• The time elapsed since the price change
• The longer the time that has elapsed since a price change,
the more elastic is demand
Illegal trading at market prices is best known in economics as a:

a) smuggler’s market.
b) pirate market.
c) command market.
d) monopoly.
e) black market.
 Black Markets

• A black market is an illegal parallel market in which the price exceeds

the legally imposed price ceiling

• The level of a black market rent depends on how tightly the rent
ceiling is enforced

• With loose enforcement, the black market rent is close to the

unregulated rent
An effective price floor results in:

a) quantity demanded greater than quantity supplied.

b) quantity supplied greater than quantity demanded.
c) quantity demanded equal to quantity supplied.
d) demand equal to supply.
e) None of the above.
 Rent ceiling
A Regulated Housing Market
• A price ceiling is a regulation that makes it illegal to charge a price higher than a
specified level

• When a price ceiling is applied to housing markets, it is called a rent ceiling.

• A price ceiling set above the equilibrium price has no effect (= Efficient rent
ceiling)

• A price ceiling below the equilibrium price has powerful effects on a market (=
Inefficient rent ceiling)
 A minimum wage

• A price floor is a regulation that makes it legal to trade at a price lower than a
specified level
• When a price floor is applied to labour markets, it is called a minimum wage.
• If a minimum wage is set below the equilibrium wage, the minimum wage has no
effect (efficient)
• If a minimum wage is set above the equilibrium wage, the minimum wage is in
conflict with market forces and does have some effects on the labour market (=
inefficient)
• The minimum wage frustrates the market mechanism and results in unemployment
– wasted labour resources – and an inefficient amount of job search
In the labour market, when the minimum wage is set above the equilibrium market
wage:

A. the unemployment rate will fall.

B. the unemployment rate will rise.
C. there will be an excess demand for labour at the minimum wage.
D. the quality of the labour force will rise.
E. It will have no effect on the quantity of labour employed.
When the minimum wage is set below the equilibrium market wage,

A. there will be an excess demand for labor at the minimum wage.

B. it will have no effect on the quantity of labor employed.
C. the unemployment rate will rise.
D. the quality of the labor force will rise.
E. the unemployment rate will fall
 Demand
Examine the diagram below of a market for loaves of
bread in South Africa and answer the questions that
follow.
R8
S
R7

Price per loaf

R6.50

E
R6
’

R5

R3 D

0
100 200 300 400 500 600 700 800

Quantity of bread (loafs per week)

Recent increases in the price of food have motivated the government to control
prices of bread. With reference to the loaves bread market, which one of the
following statements is not a consequence of a price ceiling of R5.00 placed on the
price of a loaf of bread?
A. The planned consumption by buyers of loaves of bread corresponds
with the planned production by sellers of loaves of bread.
B. Price no longer performs its normal rationing function, so that other
means of allocating loaves of bread have to be found.
C. There are lower prices for those who can get a loaf of bread.
D. There will be a 100-loaf per week market shortage.
E. The quantity of loaves of bread supplied will fall to 200 loaves per
week.
A price floor of R5.00 placed on the price of
a loaf of bread:
A. restricts the quantity supplied of loaves of bread but not the
quantity demanded.
B. restricts the quantity demanded of loaves of bread but not the
quantity supplied.
C. has no effect on the loaves of bread market, since market forces are
not disturbed.
D. encourages the formation of black markets and search activities.
E. restricts both the quantity demanded and the quantity supplied of
loaves of bread