Demand, supply, elasticity — CFA L1 Econ

Demand slopes down (lower price → more buyers); supply slopes up (higher price → more producers). Equilibrium where they cross. Elasticity measures responsiveness — % change in quantity per % change in price.

Foundation

Price elasticity of demand: |%ΔQ| / |%ΔP| • Elastic (>1): luxuries, substitutes available • Inelastic (<1): necessities, no substitutes • Unit-elastic (=1): proportional changes Indian context: • Salt: highly inelastic (everyone needs) • Cigarettes: inelastic (addiction) • International travel: highly elastic • Branded clothing: relatively elastic

Deep Dive

Cross-elasticity: % change demand for X / % change price of Y • Substitutes: positive cross-elasticity (Pepsi-Coke) • Complements: negative cross-elasticity (printers-cartridges) Income elasticity: • Luxuries: > 1 • Inferior goods: < 0 • Necessities: 0-1 Elasticity changes over time: • Petrol: inelastic short-term (commute), elastic long-term (efficient cars, EVs) • Pricing decisions hinge on this

Advanced

Surplus analysis: • Consumer surplus: willingness to pay − price • Producer surplus: price − marginal cost • Total surplus measures market efficiency Government intervention: • Price floors (minimum wages, agri MSPs) • Price ceilings (rent control) • Taxes (GST, sin taxes) • Each creates deadweight loss Indian agri MSP: support farmers but creates incentives for over-production of supported crops; fiscal cost. Classic CFA exam case.

Regulatory references

CFA Institute curriculum
Indian RBI economic surveys
Reserve Bank of India publications

Common mistakes & pitfalls

Forgetting elasticity changes over time.
Confusing income elasticity with own-price elasticity.
Surface-level demand-supply analysis without considering substitution.

Frequently asked

Why is gold demand inelastic in India?

Cultural attachment + monetary store. Marriages, festivals, savings habit. Demand barely falls with price increases. Different from elastic luxury goods.

How does elasticity affect tax revenue?

Inelastic demand: tax increases revenue (people still buy). Elastic demand: tax may reduce revenue (quantity falls more than price gain).

Practice questions

Click each question to reveal the answer and explanation.

Q 1

Elastic demand:

(a)|elasticity| < 1
(b)|elasticity| > 1
(c)|elasticity| = 0
(d)|elasticity| = 1

Correct: (b) |elasticity| > 1

Elastic = > 1. Quantity changes more than price. Substitutes available.

Q 2

Income elasticity for inferior goods:

(a)Positive
(b)Negative
(c)Zero
(d)Greater than 1

Correct: (b) Negative

Inferior goods: as income rises, demand falls. E.g., generic substitute when income rises, switch to branded.

Q 3

Indian gold demand is approximately:

(a)Highly elastic
(b)Inelastic (cultural + monetary)
(c)Perfectly elastic
(d)Random

Correct: (b) Inelastic (cultural + monetary)

Indian gold demand: inelastic. Cultural attachment + savings habit. Demand barely falls with price.

Q 4

Cross-elasticity for substitutes:

(a)Negative
(b)Positive
(c)Zero
(d)Always 1

Correct: (b) Positive

Substitutes: positive cross-elasticity. As price of one rises, demand for the other rises.

Q 5

Long-run elasticity vs short-run for petrol:

(a)Same
(b)Long-run more elastic (people switch to efficient cars/EVs)
(c)Short-run more elastic
(d)Always inelastic

Correct: (b) Long-run more elastic (people switch to efficient cars/EVs)

Long-run: people switch to efficient transport, EVs. Short-run: stuck with current cars. Demand more elastic long-run.

Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.