Microeconomics: Demand & Elasticity Fundamentals

TAKEAWAYS:

• Demand is shaped by price, income, and preferences, and is graphically represented by a downward-sloping demand curve.
• Price elasticity of demand measures responsiveness to price changes, with formulas and numerical examples critical for exams.
• Market equilibrium occurs where supply meets demand, and shifts in either curve cause new equilibria.
• Real-world examples like eSewa’s dynamic pricing and Daraz’s discount strategies use these principles daily.
• Understanding elasticity helps businesses optimize revenue (e.g., Ncell’s call tariffs) and governments design tax policies.
• The point elasticity method is a precise tool for calculating elasticity at any point on a demand curve.

1. Introduction to Microeconomics and Demand

Microeconomics studies individual decision-making by households, firms, and markets. Demand is a fundamental concept—it represents how much of a good or service consumers are willing and able to buy at different prices.

Key Definitions

• Demand: The quantity of a good consumers are willing to purchase at various prices, ceteris paribus (all else equal).
• Law of Demand: As price falls, quantity demanded rises, and vice versa (inverse relationship).
• Market Demand: Sum of all individual demands for a good or service.

Demand Schedule vs. Demand Curve

A demand schedule is a table listing prices and quantities demanded, while a demand curve graphs this relationship.

flowchart TD
    A["Price (Rs.)"] --> B["Quantity Demanded (units)"]
    B --> C["Demand Curve (↓ slope)"]

Example: Suppose the price of a smartphone falls from Rs. 30,000 to Rs. 25,000. Consumers may increase purchases from 500 to 700 units/month.

Visual: The demand curve slopes downward, showing higher demand at lower prices.

2. Factors Affecting Demand

Demand is influenced by:

• Price of the good (direct effect).
• Income (normal vs. inferior goods).
• Prices of related goods (substitutes/complements).
• Consumer preferences (trends, advertising).
• Future expectations (e.g., stockpiling before price hikes).
• Number of buyers (market size).

Example: If Ncell reduces call rates (price of substitutes), consumers may switch from NTC, increasing demand for Ncell’s services.

Normal goods (e.g., Daraz premium delivery) increase demand with income. Inferior goods (e.g., generic brands) decrease demand as income rises.

3. Price Elasticity of Demand (PED)

Measures how responsive quantity demanded is to a price change: $$E_d=\frac{\%\text{ change in quantity demanded}}{\%\text{ change in price}}$$

Types of Elasticity

Worked Example (Past Exam Question): A consumer buys 80 units at Rs. 4. When price falls, they buy 100 units. If E_d = -1, find the new price.

Solution:

1. Initial quantity (Q₁) = 80, new quantity (Q₂) = 100.
2. Price change (P₂) = ?
3. Elasticity formula: $$-1=\frac{(100-80)/80}{(P_2-4)/4}⟹-1=\frac{20/80}{(P_2-4)/4}=\frac{0.25}{P_2-4}$$
4. Solve for P₂: $$P_2-4=-0.25⟹P_2=Rs.3.75$$

Real-World Tie: Ncell’s call tariffs often use elasticity—if demand is elastic (e.g., for international calls), lowering prices increases revenue.

Elastic demand (steep curve) reacts strongly to price changes; inelastic demand (flatter curve) does not.

4. Methods of Measuring Elasticity

(a) Arc Elasticity (Midpoint Formula)

$$E_d=\frac{(Q_2-Q_1)/[(Q_2+Q_1)/2]}{(P_2-P_1)/[(P_2+P_1)/2]}$$

(b) Point Elasticity (Instantaneous)

$$E_d=\frac{dQ}{dP}\cdot \frac{P}{Q}$$

Example (Point Elasticity): For a linear demand curve $Q=100-2P$, find elasticity at $P=20$.

1. $dQ/dP=-2$.
2. At $P=20$, $Q=100-2(20)=60$.
3. Elasticity: $$E_d=(-2)\cdot \frac{20}{60}=-0.67⟹\text{Inelastic}$$

5. Market Equilibrium

Equilibrium occurs where supply meets demand, determining price and quantity.

flowchart TD
    A["Demand Curve (↓ slope)"] -->|"Intersection"| B["Equilibrium Price & Quantity"]
    C["Supply Curve (↑ slope)"] --> B
    B --> D["Market Clears: No Surplus/Shortage"]

Example: Suppose Daraz sets a price of Rs. 500 for a book. If demand is 1,000 units and supply is 800 units, there’s a shortage (demand > supply). At Rs. 600, supply exceeds demand (surplus).

6. Shifts in Demand vs. Movement Along Demand Curve

7. In the Real World

1. eSewa’s Dynamic Pricing:

   • Uses elasticity to adjust transaction fees. If demand for eSewa is elastic (e.g., during festivals), they may lower fees to attract more users.
   • How: Monitor transaction volumes; if E_d > 1, reduce fees to increase revenue.

2. Daraz’s Discount Strategies:

   • During sales (e.g., "Daraz Festival"), Daraz offers steep discounts on electronics. If demand is elastic (consumers respond strongly to price drops), they boost sales volume.
   • How: Use past sales data to estimate E_d; apply discounts where demand is most responsive.

3. Ncell’s Call Tariffs:

   • Ncell’s prepaid plans (e.g., "Rs. 100 for 100 minutes") assume inelastic demand for local calls. Even if prices rise slightly, consumers keep using them because alternatives (e.g., WhatsApp) are imperfect substitutes.
   • How: Segment customers by call patterns; apply higher prices to inelastic users.

Worked Example (Real Situation): Suppose Pathao’s surge pricing during peak hours (e.g., 7–9 AM) increases fares from Rs. 100 to Rs. 150. If E_d = -0.5, calculate the % change in quantity demanded.

Solution:

1. E_d = -0.5 = (ΔQ/Q) / (ΔP/P).
2. ΔP/P = (150–100)/100 = 0.5.
3. -0.5 = (ΔQ/Q) / 0.5 → ΔQ/Q = -0.25.
4. Result: Quantity demanded falls by 25% during peak hours.

8. Exam Tip

• Focus on numerical problems: Elasticity questions (like the past exam example) are high-scoring. Master the arc elasticity formula and point elasticity for linear curves.
• Draw curves: Always sketch demand/supply curves with shifts and equilibria. Label axes clearly (price vs. quantity).
• Real-world links: Connect theory to examples (e.g., eSewa’s fees, Daraz’s discounts). Examiners love applied answers.
• Common mistakes:
  • Confusing shifts (non-price factors) with movements (price changes).
  • Forgetting the negative sign in elasticity (demand curves slope downward).
• Time management: Spend 10–15 minutes on each numerical question. Show all steps, even if the final answer seems off.

Past Exam Question Practice: From the following data, compute price elasticity of demand using the arc elasticity method:

Solution:

1. ΔQ = 60 – 50 = 10; Q_avg = (50 + 60)/2 = 55.
2. ΔP = 8 – 10 = -2; P_avg = (10 + 8)/2 = 9.
3. E_d = (10/55) / (-2/9) = -0.818 → Inelastic.

Final Visual Summary