This series of step-by-step approaches looks at the concepts of supply and demand and the working of the market. The activity will take you through the market process to develop understanding of how markets work in the real world and how so called 'market forces' cause changes in resource allocation.
Please note: to make full use of the activity, your system must have Macromedia Flash Player 6 (or higher) installed - this can be obtained from the Macromedia Web site. Interactive Macromedia Flash resources developed by Biz/ed are designed to work both with and without the use of a mouse and be compatible with as many assistive technologies as possible (further information on our accessibility features is available). If you cannot view the interactive resources for whatever reason a static annotated image will appear instead, if you cannot view the static image it will be replaced by some descriptive text.
The Demand Curve:
The demand curve represents a simple relationship. It tries to demonstrate how many items of a product or service a consumer would LIKE to purchase at different prices. There are two major assumptions made with this simple model.
- Consumers are not only willing but ABLE to buy the item - this is called 'effective demand.'
- It is an expression of preferences and includes a whole range of judgements about 'value'.
At its simplest the relationship suggests that people are willing consume more of a product at lower prices than they are at higher prices. This is described as a negative relationship between demand and price - as one rises the other falls and vice versa. This is fairly logical and should not cause too many difficulties but remember it is an expression of how much of a product someone would LIKE to purchase, not what they ACTUALLY buy.
Diagram 1 represents this basic relationship between the demand for a product or service and the price. Use the slider to see what happens to the demand for this product at different prices. (To move the slider click and drag it with the mouse or highlight the Flash resource by stepping through the sections of this page using the Tab key and then use the Up and Down cursor keys when the relevant slider is highlighted. Nb. if nothing appears below you should make sure your Flash player is up to date.)
Get Interactive:
The diagram shows the amount consumers would like to purchase at a price of £5 (32) What happens in the following cases?
- Price rises to 8
- Price rises to 9
- Price falls to 3
- Price falls to 1
Explain why people may react in the way you have observed.
The demand curves for different products will be different shapes and in different places on the diagram. This is because different products have different 'values' attached to them. Some products are extremely important to us and we would find it difficult to do without them (necessities) whilst other may be nice to have but we can cut them out when forced (luxuries). Of course, both these terms need to be used with care, what is a necessity to one person may be a luxury to another, especially if we are looking at different countries or cultures. Other products have 'substitutes' that can be used instead whilst others are related to other products (complements) and the two items may be bought together at some point for example, CDs and CD players - having one without the other is not of much benefit! The fact that demand curves can be different shapes and in different places on our diagram can affect the nature of the relationship between price and the quantity demanded.
Diagram 2:
Get Interactive:
At a price of 5
- What was the quantity in diagram 1?
- At a price of 5 what is the quantity in diagram 2?
- Compare what happens to the quantity demanded in diagram 2 if price changes by the same amounts as you observed in diagram 1 above.
- Why do you think this might be?
- What types of products might diagrams 1 and 2 represent?
Repeat the exercise above with diagram 3 - what differences do you observe? What conclusions can you draw about the relationship between demand and price and the position and shape of the demand curve? (Note the conclusion will be based on the fact that the scale in each of these examples is the same. Different scales could lead to different results!)
Diagram 3:
Price Elasticity of Demand
This is a very important concept in both economics and business studies. Elasticity measures the responsiveness of one variable to changes in another. In this case we are looking at the responsiveness of demand to changes in price. We have established that demand will fall if price rises and vice versa. Elasticity helps us to measure just how much the demand will fall in relation to a change in the price of a product. For example, if the price of CDs were to rise by 10% would the demand fall by more than 10% or less than 10%?
Price elasticity of demand (PED) is measured by dividing the percentage change in the quantity demanded by the percentage change in the price. The figure we get has no units but PED always has a - sign in front of it. This is to remind us that the relationship between demand and price is an inverse one - as one rises the other falls and vice versa.
The formula
To calculate the PED we use the following formula:
PED = Percentage Change in Quantity Demanded (%ΔQd)/ Percentage Change in Price (%Δ P)
To calculate a percentage change in any data take the amount of the change, divide it by the original figure and multiply by 100. For example, if the price rose from 50p to 75p the percentage change in price would be the change in price (25p) divided by the original price (50p) and divided by 100. The answer is 50%. If the percentage change in the quantity demanded is less than the percentage change in price then demand is said to be inelastic. If the percentage change in demand is greater than the percentage change in price demand is said to be elastic.
Get Interactive:
Using the diagram above, calculate the price elasticity of demand for the following price changes:
- Price rises from 5 to 7
- Price rises from 5 to 9
- Price falls from 5 to 3
- Price falls from 5 to 1
Now use the diagram below and calculate the price elasticity for the following: - what differences do you notice?
- Price rises from 5 to 7
- Price rises from 5 to 9
- Price falls from 5 to 3
PED is important because it gives a firm an indication of the impact of price changes on demand and therefore its total revenue. Total Revenue = Price x Quantity sold. (TR = PxQ) If the price was 5 and demand 42 - and that is what consumers actually purchased - then the TR would be 210.
Get Interactive:
- Using the figures from the last two exercises, calculate the total revenue in each case.
- From your calculations and the work covered so far, write down a relationship between PED and total revenue for different price changes.
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