Theory of Demand and Supply for CA Foundation
Why people buy more when prices fall, how strongly they react, and how sellers respond to price: the base of all market analysis.
Business EconomicsPaper 414 MCQs3 lessons3 flashcards3 memory tricks
Practise Theory of Demand and Supply free
What you'll learn
- Demand and the law of demand
State the law of demand, list what shifts demand, and tell a movement along the curve from a shift. - Elasticity of demand
Calculate price, income and cross elasticity and use the total expenditure method. - Supply and elasticity of supply
State the law of supply and identify its determinants and elasticity.
Key formulas
| Price elasticity | Ed = % change in quantity demanded ÷ % change in price |
|---|---|
| Arc elasticity | Ed = [ΔQ ÷ (Q₁+Q₂)/2] ÷ [ΔP ÷ (P₁+P₂)/2] |
| Income elasticity | Ey = % change in quantity ÷ % change in income |
| Cross elasticity | Exy = % change in quantity of X ÷ % change in price of Y |
Concepts explained
Movement along vs shift of the demand curve
A change in the good's own price moves buyers along the same demand curve; a change in anything else shifts the whole curve.
What it means
- Movement along the curve: expansion (price falls, more bought) or contraction (price rises, less bought).
- Shift of the curve: increase (shift right) or decrease (shift left) in demand, caused by income, prices of related goods, tastes, expectations or population.
- Examiners test the words: 'expansion/contraction' for movements, 'increase/decrease' for shifts.
- Notebook price rises from ₹20 to ₹25
- Purchases fall from 10 to 8
Answer: Contraction of demand (movement up the curve)
- Pocket money rises, more pens bought at the same price
Answer: Increase in demand (rightward shift)
Related terms
- Change in quantity demanded: movement along the curve
- Change in demand: shift of the curve
Exam tip: If the question mentions only the good's own price, it's a movement. Anything else: a shift.
Price elasticity of demand
Price elasticity of demand = % change in quantity demanded ÷ % change in price. It tells you how strongly buyers react to a price change.
What it means
- Ed > 1 elastic, Ed < 1 inelastic, Ed = 1 unitary, Ed = 0 perfectly inelastic (vertical curve), Ed = ∞ perfectly elastic (horizontal curve).
- Total expenditure method: price rise → spending rises if inelastic, falls if elastic, stays the same if unitary.
- Arc elasticity uses the midpoints of the two prices and quantities, so the answer doesn't depend on direction.
- Price ₹10 → ₹12 (20% rise)
- Quantity 100 → 90 (10% fall)
- Ed = 10 ÷ 20
Answer: 0.5 (inelastic); revenue rises from ₹1,000 to ₹1,080
- Price rises 10%
- Quantity falls 20%
Answer: Ed = 2 (elastic)
Related terms
- Income elasticity: response to income changes
- Cross elasticity: response to the price of another good
Exam tip: Ignore the minus sign when classifying elasticity. And quantity always goes on top.
Substitutes, complements and cross elasticity
Substitutes are used in place of each other (tea, coffee); complements are used together (car, petrol). Cross elasticity is positive for substitutes and negative for complements.
What it means
- Price of a substitute rises → demand for the other good rises (shift right).
- Price of a complement rises → demand for the other good falls (shift left).
- Cross elasticity = % change in quantity of X ÷ % change in price of Y. Zero means the goods are unrelated.
- Tea price falls
- Coffee drinkers switch to tea
Answer: Coffee demand decreases (shift left)
- Petrol price rises
- Fewer people buy cars
Answer: Car demand decreases; cross elasticity negative
Related terms
- Perfect substitutes: cross elasticity tends to infinity
- Joint demand: another name for demand for complements
Exam tip: Remember the signs: substitutes same direction (+), complements opposite (−).
Exceptions to the law of demand
In a few cases, people buy more as the price rises: Giffen goods, Veblen (status) goods, expected further price rises and emergencies.
What it means
- Giffen good: an inferior staple bought by poor households; a price rise cuts real income so much that they buy more of it (strong negative income effect).
- Veblen good: bought to show status; a higher price makes it more desirable.
- Expectations: if prices are expected to rise further, people buy more now.
- Emergencies and necessities: during shortages, people buy regardless of price.
- Coarse grain price rises
- Poor family can no longer afford pulses
- It buys even more coarse grain
Answer: Demand rises with price: Giffen paradox
Related terms
- Inferior good: income elasticity negative
- Income and substitution effects: the two parts of a price change's effect on demand
Exam tip: Every Giffen good is inferior, but not every inferior good is a Giffen good.
Income elasticity: normal, inferior and luxury goods
Income elasticity = % change in quantity demanded ÷ % change in income. Its sign and size classify goods.
What it means
- Negative: inferior good (demand falls as income rises).
- Between 0 and 1: necessity (normal good).
- Greater than 1: luxury (normal good).
- Income rises 10%
- Demand for air travel rises 25%
Answer: Ey = 2.5 (luxury)
- Income rises 10%
- Demand for coarse grain falls 5%
Answer: Ey = −0.5 (inferior)
Related terms
- Engel curve: shows how demand changes with income
Exam tip: A rise in income shifts demand right for normal goods and left for inferior goods.
Memory tricks
Own Price, Income, prices of Related goods, Tastes, Expectations, Population. Own price moves along the curve; the rest shift it.
Inelastic demand: raising price raises revenue. Elastic demand: cutting price raises revenue. Unitary: revenue unchanged.
Substitutes (tea, coffee): positive cross elasticity. Complements (car, petrol): negative.
Try 3 CA Foundation-style questions
Q1. A straight-line supply curve passing through the origin has a price elasticity of supply equal to
- 1 at every point
- 0
- infinity
- more than 1 at every point
Show answer
Answer: (1) 1 at every point
For any straight-line supply curve through the origin, Es = 1 at every point, whatever its slope.
Q2. Arc elasticity of demand is calculated using
- only the original price and quantity
- the average (midpoint) of the two prices and of the two quantities
- only the new price and quantity
- the slope of the demand curve alone
Show answer
Answer: (2) the average (midpoint) of the two prices and of the two quantities
Arc elasticity = [ΔQ ÷ (Q₁ + Q₂)/2] ÷ [ΔP ÷ (P₁ + P₂)/2], so the answer is the same whether price rises or falls.
Q3. The law of demand states that, other things remaining the same, the quantity demanded of a good
- falls when its price rises
- rises when its price rises
- does not depend on its price
- rises only when income rises
Show answer
Answer: (1) falls when its price rises
Ceteris paribus, price and quantity demanded move in opposite directions, so the demand curve slopes downwards.
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