The Market

WHAT IT IS:
A market is a location where buyers and sellers meet to exchange goods and services
at prices determined by the forces of supply and demand.

HOW IT WORKS (EXAMPLE):

A market may be a physical location or a virtual one over a network (for example, the
internet). Here, people who have a specific good or services (the supply) they want to
sell interact with people who wish to buy it (the demand). Prices in a market are
determined by changes in supply and demand. If market demand is steady, an increase
in market supply results in a decline in market prices and vice versa. If market supply is
steady, a rise in demand results in a rise in market prices and vice versa. These
relationships are demonstrated in the following graphs:

Producers advertise goods and services to consumers in a market in order to generate

demand. Also, the term "market" is closely associated with financial assets and
securities prices (for example, the stock market or the bond market).

WHY IT MATTERS:
A market facilitates transactions between buyers and sellers (financial markets) and
producers and consumers (consumer goods and services market). Markets experience
fluctuations and price shifts resulting from changes in supply and demand. These
changes result from fluctuations in many variables including, but not limited to,
consumer preferences and perceptions, the availability of materials, and external
sociopolitical events (for example, wars, government spending, and unemployment).

The concept of a market is any structure that allows buyers and sellers to exchange any
type of goods, services and information. The exchange of goods or services, with or
without money, is a transaction. Market participants consist of all the buyers and sellers
of a good who influence its price, which is a major topic of study of economics and has
given rise to several theories and models concerning the basic market forces of supply
and demand. In our previous subject in Microeconomics, it traditionally focuses on the

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study of market structure and the efficiency of market equilibrium; when the latter (if it
exists) is not efficient, then economists say that a market failure has occurred.

TYPES OF MARKET:
A market is one of the many varieties of systems, institutions, procedures, social
relations and infrastructures whereby parties engage in exchange. While parties may
exchange goods and services by barter, most markets rely on sellers offering their
goods or services (including labor) in exchange for money from buyers. It can be said
that a market is the process by which the prices of goods and services are established.

Markets facilitate trade and enable the distribution and allocation of resources in a
society. Markets allow any trade-able item to be evaluated and priced. A market
sometimes emerges more or less spontaneously or may be constructed deliberately by
human interaction in order to enable the exchange of rights (cf. ownership) of services
and goods. Markets of varying types can spontaneously arise whenever a party has
interest in a good or service that some other party can provide. Hence there can be a
market for cigarettes in correctional facilities, another for chewing gum in a playground,
and yet another for contracts for the future delivery of a commodity. There can be black
markets, where a good is exchanged illegally, for example markets for goods under a
command economy despite pressure to repress them and virtual markets, such
as eBay, in which buyers and sellers do not physically interact during negotiation. A
market can be organized as an auction, as a private electronic market, as a
commodity wholesale market, as a shopping center, as a complex institution such as
a stock market and as an informal discussion between two individuals. Markets vary in
form, scale (volume and geographic reach), location and types of participants as well as
the types of goods and services traded.

 Physical consumer markets

 Food retail markets: farmers' markets, fish markets, wet markets and grocery
stores
 Retail marketplaces: public markets, market squares, Main Streets, High
Streets, bazaars, night markets, shopping strip malls and shopping malls
 Big-box stores: supermarkets, hypermarkets and discount stores
 Ad hoc auction markets: process of buying and selling goods or services by
offering them up for bid, taking bids and then selling the item to the highest
bidder
 Used goods markets such as flea markets
 Temporary markets such as fairs

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 Physical business markets
 Physical wholesale markets: sale of goods or merchandise to retailers; to
industrial, commercial, institutional, or other professional business users or to
other wholesalers and related subordinated services
 Markets for intermediate goods used in production of other goods and services
 Labor markets: where people sell their labor to businesses in exchange for
a wage
 Ad hoc auction markets: process of buying and selling goods or services by
offering them up for bid, taking bids and then selling the item to the highest
bidder
 Temporary markets such as trade fairs

 Non-physical markets
 Media markets (broadcast market): is a region where the population can
receive the same (or similar) television and radio station offerings and may
also include other types of media including newspapers and Internet content
 Internet markets (electronic commerce): trading in products or services using
computer networks, such as the Internet
 Artificial markets created by regulation to exchange rights for derivatives that
have been designed to ameliorate externalities, such as pollution permits

 Financial markets
Financial markets facilitate the exchange of liquid assets. Most investors prefer
investing in two markets:
 The stock markets, for the exchange of shares in corporations
 The bond markets

 Unauthorized and illegal markets

 Grey markets (parallel markets): is the trade of a commodity through
distribution channels which, while legal, are unofficial, unauthorized, or
unintended by the original manufacturer
 markets in illegal goods such as the market for illicit drugs, illegal
arms, infringing products, cigarettes sold to minors or untaxed cigarettes (in
some jurisdictions), or the private sale of unpasteurized goat milk

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There are also:
 Currency markets are used to trade one currency for another, and are often
used for speculation on currency exchange rates
 The money market is the name for the global market for lending and borrowing
 Futures markets, where contracts are exchanged regarding the future delivery
of goods are often an outgrowth of general commodity markets
 Prediction markets are a type of speculative market in which the goods
exchanged are futures on the occurrence of certain events; they apply the
market dynamics to facilitate information aggregation

MECHANISMS OF MARKETS:
In economics, a market that runs under laissez-faire policies (or an economic system in
which transactions between private parties are free from government intervention such
as regulation, privileges, tariffs and subsidies) is called a free market, it is "free" from
the government, in the sense that the government makes no attempt to intervene
through taxes, subsidies, minimum wages, price ceilings and so on. However, market
prices may be distorted by a seller or sellers with monopoly power( monopoly exists
when a specific person or enterprise is the only supplier of a particular commodity, this
contrasts with a monopsony), or a buyer with monopsony power( a market structure in
which only one buyer interacts with many would-be sellers of a particular product). Such
price distortions can have an adverse effect on market participant's welfare and reduce
the efficiency of market outcomes. The relative level of organization and negotiating
power of buyers and sellers also markedly affects the functioning of the market.

Markets are a system and systems have structure. The structure of a well-functioning
market is defined by the theory of perfect competition. Well-functioning markets of the
real world are never perfect, but basic structural characteristics can be approximated for
real world markets, for example:

 Many small buyers and sellers

 Buyers and sellers have equal access to information

 Products are comparable

Markets where price negotiations meet equilibrium, but the equilibrium is
not efficient are said to experience market failure. Market failures are often associated
with time-inconsistent preferences, information asymmetries, non-perfectly competitive
markets, principal–agent problems, externalities, or public goods. There exists a popular
thought, especially among economists, that free markets would have a structure of
a competition. The logic behind this thought is that market failures are thought to be
caused by other exogenic systems (exogenous change is one that comes from outside
the model and is unexplained by the model), and after removing those exogenic

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systems ("freeing" the markets) the free markets could run without market failures. For a
market to be competitive there must be more than a single buyer or seller. It has been
suggested that two people may trade, but it takes at least three persons to have a
market, so that there is competition in at least one of its two sides. However, competitive
markets—as understood in formal economic theory—rely on much larger numbers of
both buyers and sellers.
In market economies, there are a variety of different market systems that exist,
depending on the industry and the companies within that industry. It is important for
small business owners to understand what type of market system they are operating in
when making pricing and production decisions, or when determining whether to enter or
leave a particular industry.

Different Types of Market Systems:

 Perfect Competition
Perfect competition is a market system characterized by many different buyers and
sellers. In the classic theoretical definition of perfect competition, there are an infinite
number of buyers and sellers. With so many market players, it is impossible for any
one participant to alter the prevailing price in the market. If they attempt to do so,
buyers and sellers have infinite alternatives to pursue. In a perfectly competitive
market, the forces of supply and demand determine the amount of goods and
services produced as well as market prices set by the companies in the market.
Perfect competition assumes the environment or climate cooperates with the
buildings within it. The perfectly competitive market structure is a theoretically ideal
market; there is free entry and exit, so many companies move into the market and
easily exit when it’s not profitable. With so many competitors, the influence of one
company or buyer is relatively small and does not affect the market as a whole.
Buyers and sellers are referred to as price takers rather than price influencers. The
products within the market are seen as homogenous, there is little difference
between them. Not only the products are identical, information regarding product
quality and price is perfectly and openly given to the public. The model assumes
each producer is operating at the lowest possible cost to achieve the greatest
possible output. The perfect competition model is difficult to find in operation. There
are few agricultural and craft markets that may fit the theory. This model is primarily
a reference point from which economists compare the other market structures.

 Monopoly
A monopoly is the exact opposite form of market system as perfect competition. In a
pure monopoly, there is only one producer of a particular good or service, and
generally no reasonable substitute. In such a market system, the monopolist is able
to charge whatever price they wish due to the absence of competition, but their
overall revenue will be limited by the ability or willingness of customers to pay their
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price. Monopolies and perfectly competitive markets sit at either end of market
structure extremes. However, both minimize cost and maximize profit. Where there
are many competitors in a perfect competition, in monopolistic markets there’s just
one supplier. High barriers to entry into this market leave a “mono-” or lone company
standing so there is no price competition. The supplier is the price-maker, setting a
price that maximizes profits. There are naturally occurring monopolies and those
created through legislation, such as state-legislated liquor stores. However, several
companies have been criticized as breaking antitrust laws including:
 Microsoft
 Major League Sports

 Oligopoly
An oligopoly is similar in many ways to a monopoly. The primary difference is that
rather than having only one producer of a good or service, there are a handful of
producers, or at least a handful of producers that make up a dominant majority of the
production in the market system. While oligopolists do not have the same pricing
power as monopolists, it is possible, without diligent government regulation that
oligopolists will collude with one another to set prices in the same way a monopolist
would. Not all companies aim to sit as the sole building in a city. Oligopolies have
companies that collude, or work together, to limit competition and dominate a market
or industry. The companies in these market structures can be large or small;
however, the most powerful firms often have patents, finance, physical resources
and control over raw materials that create barriers to entry for new firms. Since this
market structure discourages true competition, the producers are able to set prices,
but the market is price sensitive. If the prices are too high, buyers will migrate to the
market’s product substitutes.
 There are pure oligopolies with homogenous products, like the gasoline industry.
 Some firms function in differentiated oligopolies; selling products with small
differences, like fast food or air transportation.

 Monopolistic Competition
Monopolistic competition is a type of market system combining elements of a
monopoly and perfect competition. Like a perfectly competitive market system, there
are numerous competitors in the market. The difference is that each competitor is
sufficiently differentiated from the others that some can charge greater prices than a
perfectly competitive firm. An example of monopolistic competition is the market for
music. While there are many artists, each artist is different and is not perfectly
substitutable with another artist. Unlike perfect competition, monopolistic competition
does not assume lowest possible cost production. That slight difference in definition
leaves room for huge differences in how the companies operate in the market.

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 Companies in a monopolistic competition structure sell very similar products with
small differences they use as the basis of their marketing and advertising. This is
completely different from the perfectly competitive market structure which excludes
advertising. Consider bath soap — they are all pretty much the same as far as what
makes it soap and its use, but small differences like fragrance, shape, added oils or
color are used in advertising and in setting price. In monopolistic competition
producers are price maximizers. When the profits are attractive, producers freely
enter the market. The slight differences between the products also create imperfect
information regarding quality and price. Monopolistic competition markets are a
hybrid of two extremes, the perfectly competitive market and monopoly. Examples of
monopolistic competition markets are:
 service and repair markets
 Beauty salons and spas.
 Tutoring companies.

 Monopsony
Market systems are not only differentiated according to the number of suppliers in
the market. They may also be differentiated according to the number of buyers.
Whereas a perfectly competitive market theoretically has an infinite number of
buyers and sellers, a monopsony has only one buyer for a particular good or service,
giving that buyer significant power in determining the price of the products produced.

The Demand

Demand for Goods and Services

Economists use the term demand to refer to the amount of some good or service
consumers are willing and able to purchase at each price. Demand is based on needs
and wants—a consumer may be able to differentiate between a need and a want, but
from an economist’s perspective they are the same thing. Demand is also based on
ability to pay. If you cannot pay for it, you have no effective demand. What a buyer pays
for a unit of the specific good or service is called price. The total number of units
purchased at that price is called the quantity demanded. A rise in price of a good or
service almost always decreases the quantity demanded of that good or service.
Conversely, a fall in price will increase the quantity demanded. When the price of a

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gallon of gasoline goes up, for example, people look for ways to reduce their
consumption by combining several errands, commuting by carpool or mass transit, or
taking weekend or vacation trips closer to home. Economists call this inverse
relationship between price and quantity demanded the law of demand. The law of
demand assumes that all other variables that affect demand (to be explained in the next
module) are held constant.

An example from the market for gasoline can be shown in the form of a table or a
graph. A table that shows the quantity demanded at each price, such as Table 1, is
called a demand schedule. Price in this case is measured in dollars per gallon of
gasoline. The quantity demanded is measured in millions of gallons over some time
period (for example, per day or per year) and over some geographic area (like a state or
a country). A demand curve shows the relationship between price and quantity
demanded on a graph like Figure 1, with quantity on the horizontal axis and the price
per gallon on the vertical axis. (Note that this is an exception to the normal rule in
mathematics that the independent variable (x) goes on the horizontal axis and the
dependent variable (y) goes on the vertical. Economics is not math.)

The demand schedule shown by Table 1 and the demand curve shown by the graph
in Figure 1 are two ways of describing the same relationship between price and quantity
demanded.

 Price (per  Quantity Demanded (millions of

gallon) gallons)

 $1.00  800

 $1.20  700

 $1.40  600

 $1.60  550

 $1.80  500

 $2.00  460

 $2.20  420

Table 1. Price and Quantity Demanded of Gasoline

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 Figure 1. A Demand Curve for Gasoline. The demand schedule shows that as price
rises, quantity demanded decreases, and vice versa. These points are then graphed,
and the line connecting them is the demand curve (D). The downward slope of the
demand curve again illustrates the law of demand—the inverse relationship between
prices and quantity demanded.

Demand curves will appear somewhat different for each product. They may appear
relatively steep or flat, or they may be straight or curved. Nearly all demand curves
share the fundamental similarity that they slope down from left to right. So demand
curves embody the law of demand: As the price increases, the quantity demanded
decreases, and conversely, as the price decreases, the quantity demanded increases.

Is demand the same as quantity demanded?

In economic terminology, demand is not the same as quantity demanded. When
economists talk about demand, they mean the relationship between a range of prices
and the quantities demanded at those prices, as illustrated by a demand curve or a
demand schedule. When economists talk about quantity demanded, they mean only a
certain point on the demand curve, or one quantity on the demand schedule. In short,
demand refers to the curve and quantity demanded refers to the (specific) point on the
curve.

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 The Supply

Supply of Goods and Services

When economists talk about supply, they mean the amount of some good or service a
producer is willing to supply at each price. Price is what the producer receives for selling
one unit of a good or service. A rise in price almost always leads to an increase in
the quantity supplied of that good or service, while a fall in price will decrease the
quantity supplied. When the price of gasoline rises, for example, it encourages profit-
seeking firms to take several actions: expand exploration for oil reserves; drill for more
oil; invest in more pipelines and oil tankers to bring the oil to plants where it can be
refined into gasoline; build new oil refineries; purchase additional pipelines and trucks to
ship the gasoline to gas stations; and open more gas stations or keep existing gas
stations open longer hours. Economists call this positive relationship between price and
quantity supplied—that a higher price leads to a higher quantity supplied and a lower
price leads to a lower quantity supplied—the law of supply. The law of supply assumes
that all other variables that affect supply (to be explained in the next module) are held
constant.

Is supply the same as quantity supplied?

In economic terminology, supply is not the same as quantity supplied. When economists
refer to supply, they mean the relationship between a range of prices and the quantities
supplied at those prices, a relationship that can be illustrated with a supply curve or a
supply schedule. When economists refer to quantity supplied, they mean only a certain
point on the supply curve, or one quantity on the supply schedule. In short, supply refers
to the curve and quantity supplied refers to the (specific) point on the curve.

Figure 2 examples below illustrates the law of supply, again using the market for
gasoline as an example. Like demand, supply can be illustrated using a table or a

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graph. A supply schedule is a table, like Table 2, that shows the quantity supplied at a
range of different prices. Again, price is measured in dollars per gallon of gasoline and
quantity supplied is measured in millions of gallons. A supply curve is a graphic
illustration of the relationship between price, shown on the vertical axis, and quantity,
shown on the horizontal axis. The supply schedule and the supply curve are just two
different ways of showing the same information. Notice that the horizontal and vertical
axes on the graph for the supply curve are the same as for the demand curve.

Figure 2. A Supply Curve for Gasoline. The supply schedule is the table that shows
quantity supplied of gasoline at each price. As price rises, quantity supplied also
increases, and vice versa. The supply curve is created by graphing the points from the
supply schedule and then connecting them. The upward slope of the supply curve
illustrates the law of supply—that a higher price leads to a higher quantity supplied, and
vice versa.

Price (per
gallon) Quantity Supplied (millions of gallons)

$1.00 500

$1.20 550

$1.40 600

$1.60 640

$1.80 680

$2.00 700

$2.20 720 11

Table 2. Price and Supply of Gasoline

The shape of supply curves will vary somewhat according to the product: steeper,
flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity:
they slope up from left to right and illustrate the law of supply: as the price rises, say,
from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500
gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.

Market Equilibrium

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Equilibrium—Where Demand and Supply Intersect

Because the graphs for demand and supply curves both have price on the vertical axis
and quantity on the horizontal axis, the demand curve and supply curve for a particular
good or service can appear on the same graph. Together, demand and supply
determine the price and the quantity that will be bought and sold in a market.

Figure 3 illustrates the interaction of demand and supply in the market for gasoline. The
demand curve (D) is identical to Figure 1. The supply curve (S) is identical to Figure
2. Table 3 contains the same information in tabular form.

Figure 3. Demand and Supply for Gasoline. The demand curve (D) and the supply
curve (S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600.
The equilibrium is the only price where quantity demanded is equal to quantity supplied.
At a price above equilibrium like $1.80, quantity supplied exceeds the quantity
demanded, so there is excess supply. At a price below equilibrium such as $1.20,
quantity demanded exceeds quantity supplied, so there is excess demand.
Price (per Quantity demanded (millions of Quantity supplied (millions of
gallon) gallons) gallons)

$1.00 800 500

$1.20 700 550

$1.40 600 600

$1.60 550 640

$1.80 500 680

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 Price (per Quantity demanded (millions of Quantity supplied (millions of
gallon) gallons) gallons)

$2.00 460 700

$2.20 420 720

Table 3. Price, Quantity Demanded, and Quantity Supplied

Remember this: When two lines on a diagram cross, this intersection usually means
something. The point where the supply curve (S) and the demand curve (D) cross,
designated by point E in Figure 3, is called the equilibrium. The equilibrium price is
the only price where the plans of consumers and the plans of producers agree—that is,
where the amount of the product consumers want to buy (quantity demanded) is equal
to the amount producers want to sell (quantity supplied). This common quantity is called
the equilibrium quantity. At any other price, the quantity demanded does not equal the
quantity supplied, so the market is not in equilibrium at that price.

In Figure 3, the equilibrium price is $1.40 per gallon of gasoline and the equilibrium
quantity is 600 million gallons. If you had only the demand and supply schedules, and
not the graph, you could find the equilibrium by looking for the price level on the tables
where the quantity demanded and the quantity supplied are equal.

The word “equilibrium” means “balance.” If a market is at its equilibrium price and
quantity, then it has no reason to move away from that point. However, if a market is not
at equilibrium, then economic pressures arise to move the market toward the
equilibrium price and the equilibrium quantity.

Imagine, for example, that the price of a gallon of gasoline was above the equilibrium
price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. This above-
equilibrium price is illustrated by the dashed horizontal line at the price of $1.80
in Figure 3. At this higher price, the quantity demanded drops from 600 to 500. This
decline in quantity reflects how consumers react to the higher price by finding ways to
use less gasoline.

Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the
600 to 680, as the higher price makes it more profitable for gasoline producers to
expand their output. Now, consider how quantity demanded and quantity supplied is
related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons,
while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price,

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the quantity supplied exceeds the quantity demanded. We call this an excess supply or
a surplus.

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and
at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus
remains unsold, those firms involved in making and selling gasoline are not receiving
enough cash to pay their workers and to cover their expenses. In this situation, some
producers and sellers will want to cut prices, because it is better to sell at a lower price
than not to sell at all. Once some sellers start cutting prices, others will follow to avoid
losing sales. These price reductions in turn will stimulate a higher quantity demanded.
So, if the price is above the equilibrium level, incentives built into the structure of
demand and supply will create pressures for the price to fall toward the equilibrium.

Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the
dashed horizontal line at this price in Figure 3 shows. At this lower price, the quantity
demanded increases from 600 to 700 as drivers take longer trips, spend more minutes
warming up the car in the driveway in wintertime, stop sharing rides to work, and buy
larger cars that get fewer miles to the gallon. However, the below-equilibrium price
reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity
supplied falls from 600 to 550.

When the price is below equilibrium, there is excess demand, or a shortage—that is,
at the given price the quantity demanded, which has been stimulated by the lower price,
now exceeds the quantity supplied, which had been depressed by the lower price. In
this situation, eager gasoline buyers mob the gas stations, only to find many stations
running short of fuel. Oil companies and gas stations recognize that they have an
opportunity to make higher profits by selling what gasoline t2hey have at a higher price.
As a result, the price rises toward the equilibrium level.

Elasticity of Demand and Supply

What is Elasticity?

Elasticity refers to the degree of responsiveness in supply or demand in relation to

changes in price. If a curve is more elastic, then small changes in price will cause large
changes in quantity consumed. If a curve is less elastic, then it will take large changes
in price to effect a change in quantity consumed. Graphically, elasticity can be
represented by the appearance of the supply or demand curve. A more elastic curve will
be horizontal, and a less elastic curve will tilt more vertically. When talking about
elasticity, the term "flat" refers to curves that are horizontal; a "flatter" elastic curve is
closer to perfectly horizontal.

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The Price Elasticity of Demand

Figure 1: Elastic and Inelastic Curves Figure2: Perfectly

Elastic and Perfectly Inelastic Curves

At the extremes, a perfectly elastic curve will be horizontal, and a perfectly inelastic
curve will be vertical. Hint: You can use perfectly inelastic and perfectly elastic curves to
help you remember what inelastic and elastic curves look like: an Inelastic curve is more
vertical, like the letter I. An Elastic curve is flatter, like the horizontal lines in the letter E.

Price elasticity of demand, also called the elasticity of demand, refers to the degree of
responsiveness in demand quantity with respect to price. It is a measure used in
economics to show the responsiveness, or elasticity, of the quantity demanded of a
good or service to a change in its price when nothing but the price changes. More
precisely, it gives the percentage change in quantity demanded in response to a one
percent change in price.

Price elasticities are almost always negative, although analysts tend to ignore the sign
even though this can lead to ambiguity (uncertain or unclear). Only goods which do not
conform to the law of demand, such as Veblen and Giffen goods have a positive PED. A
GIFFEN good shows an increase in demand as the price increases. The good is
typically a staple product Iike wheat, rice, etc. When prices of food rise, the consumer
will stop consuming more “Gourmet” type foods and eat more of the necessary staples
like wheat and rice. Thus we see demand rise as price rises. To properly term a good a
GIFFEN good there are three conditions:
1. the good is of inferior quality (no luxury foods
2. there are few substitute items available;
3. the good is a staple with respect to the buyers income, requiring the buyer to
spend a good % of their income to purchase the GIFFEN good.

Item 3 is dependent on differing incomes of the buyers - so where we cannot term the
item costing a large % of the buyers income, we use the term GIFFEN EFFECT. While

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the VEBLEN EFFECT reflects higher demand for a luxury product specifically after
prices rise. This is a very specific anomaly found with luxury products: as the price of
Hermes bags rose, the demand soared to a point where new bags already have a
waiting list the first day they go on sale. As a student of economics we can see this as
the human need to purchase high quality items before their friends buy them, so they
own something unique.
In general, the demand for a good is said to be inelastic (or relatively inelastic) when the
PED is less than one (in absolute value): that is, changes in price have a relatively small
effect on the quantity of the good demanded. The demand for a good is said to
be elastic (or relatively elastic) when its PED is greater than one.

Revenue is maximized when price is set so that the PED is exactly one. The PED of a
good can also be used to predict the incidence (or "burden") of a tax on that good.
Various research methods are used to determine price elasticity, including test markets,
analysis of historical sales data and conjoint analysis.

Consider a case in the figure below where demand is very elastic, that is, when the
curve is almost flat. You can see that if the price changes from $.75 to $1, the quantity
decreases by a lot. There are many possible reasons for this phenomenon. Buyers
might be able to easily substitute away from the good, so that when the price increases,
they have little tolerance for the price change. Maybe the buyers don't want the good
that much, so a small change in price has a large effect on their demand for the good.

Figure 3: Elastic Demand

If demand is very inelastic, then large changes in price won't do very much to the
quantity demanded. For instance, whereas a change of 25 cents reduced quantity by 6
units in the elastic curve in the figure above, in the inelastic curve below, a price jump of
a full dollar reduces the demand by just 2 units. With inelastic curves, it takes a very big
jump in price to change how much demand there is in the graph below. Possible
explanations for this situation could be that the good is an essential good that is not
easily substituted for by other goods. That is, for a good with an inelastic curve,
customers really want or really need the good, and they can't get want that good offers

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from anywhere else. This means that consumers will need to buy the same amount of
the good from week to week, regardless of the price.

Figure 4: Inelastic Demand

Price Elasticity of Supply

Like demand, supply also has varying degrees of responsiveness to price, which we
refer to as price elasticity of supply, or the elasticity of supply. Price elasticity of supply is
a measure used in economics to show the responsiveness, or elasticity, of the quantity
supplied of a good or service to a change in its price. The elasticity is represented in
numerical form, and is defined as the percentage change in the quantity supplied
divided by the percentage change in price.

When the coefficient is less than one, the supply of the good can be described
as inelastic; when the coefficient is greater than one, the supply can be described
as elastic. An elasticity of zero indicates that quantity supplied does not respond to a
price change: it is "fixed" in supply. Such goods often have no labor component or are
not produced, limiting the short run prospects of expansion. If the coefficient is exactly
one, the good is said to be unitary elastic. The quantity of goods supplied can, in the
short term, be different from the amount produced, as manufacturers will have stocks
which they can build up or run down.

Determinants (Causal Factor)

 Availability of raw materials

For example, availability may cap the amount of gold that can be produced in a
country regardless of price. Likewise, the price of Van Gogh paintings is unlikely to
affect their supply.
 Length and complexity of production

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Much depends on the complexity of the production process. Textile production is
relatively simple. The labor is largely unskilled and production facilities are little more
than buildings – no special structures are needed. Thus the PES for textiles is elastic.
On the other hand, the PES for specific types of motor vehicles is relatively inelastic.
Auto manufacture is a multi-stage process that requires specialized equipment, skilled
labor, a large suppliers network and large R&D costs.
 Mobility of factors
If the factors of production are easily available and if a producer producing one good
can switch their resources and put it towards the creation of a product in demand, then
it can be said that the PES is relatively elastic. The inverse applies to this, to make it
relatively inelastic.

 Time to respond
The more time a producer has to respond to price changes the more elastic the supply.
Supply is normally more elastic in the long run than in the short run for produced goods,
since it is generally assumed that in the long run all factors of production can be utilized
to increase supply, whereas in the short run only labor can be increased, and even then,
changes may be prohibitively costly. For example, a cotton farmer cannot immediately
(i.e. in the short run) respond to an increase in the price of soybeans because of the
time it would take to procure the necessary land.
 Inventories
A producer who has a supply of goods or available storage capacity can quickly
increase supply to market.
 Spare/Excess Production Capacity
A producer who has unused capacity can (and will) quickly respond to price changes in
his market assuming that variable factors are readily available. The existence of spare
capacity within a firm would be indicative of more proportionate response in quantity
supplied to changes in price (hence suggesting price elasticity). It indicates that the
producer would be able to utilize spare factor markets (factors of production) at its
disposal and hence respond to changes in demand to match with supply. The greater
the extent of spare production capacity, the quicker suppliers can respond to price
changes and hence the more price elastic the good/service would be.

Various research methods are used to calculate price elasticities in real life, including
analysis of historic sales data, both public and private, and use of present-day surveys
of customers' preferences to build up test markets capable of modeling elasticity such
changes. Alternatively, conjoint analysis (a ranking of users' preferences which can then
be statistically analyzed) may be used.

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