Understanding the fundamental principles of supply and demand, and the concept of elasticity, is crucial for the CPA exam. These concepts form the bedrock of how markets function and how businesses make pricing and production decisions. This module will break down these core microeconomic ideas.

The Law of Demand states that, all other factors being equal, as the price of a good or service increases, the quantity demanded will decrease, and vice versa. This inverse relationship is a fundamental concept in economics.

The Law of Supply states that, all other factors being equal, as the price of a good or service increases, the quantity supplied will increase, and vice versa. This direct relationship is driven by the profit motive of producers.

Market equilibrium occurs at the price where the quantity demanded by consumers equals the quantity supplied by producers. This is the point where the supply and demand curves intersect. At this equilibrium price, there is no surplus or shortage of the good or service.

Factors other than price can cause the entire supply or demand curve to shift. For demand, these include changes in consumer income, tastes and preferences, prices of related goods (substitutes and complements), expectations, and the number of buyers. For supply, these include changes in input prices, technology, expectations, number of sellers, and government policies (taxes and subsidies).

Elasticity measures the responsiveness of one variable to a change in another. In economics, we commonly discuss price elasticity of demand and price elasticity of supply.

PED measures how much the quantity demanded of a good responds to a change in its price. It's calculated as the percentage change in quantity demanded divided by the percentage change in price.

• Elastic Demand (|PED| > 1): A small price change leads to a large change in quantity demanded. Consumers are very responsive.
• Inelastic Demand (|PED| < 1): A price change leads to a proportionally smaller change in quantity demanded. Consumers are not very responsive.
• Unit Elastic Demand (|PED| = 1): The percentage change in quantity demanded equals the percentage change in price.
• Perfectly Elastic Demand (PED = ∞): Any price increase causes quantity demanded to drop to zero.
• Perfectly Inelastic Demand (PED = 0): Quantity demanded does not change regardless of price.

PES measures how much the quantity supplied of a good responds to a change in its price. It's calculated as the percentage change in quantity supplied divided by the percentage change in price.

• Elastic Supply (PES > 1): Producers can easily and quickly increase production in response to price changes.
• Inelastic Supply (PES < 1): Producers cannot easily or quickly change production levels in response to price changes.
• Unit Elastic Supply (PES = 1): The percentage change in quantity supplied equals the percentage change in price.
• Perfectly Elastic Supply (PES = ∞): Producers will supply any amount at a specific price but nothing above or below.
• Perfectly Inelastic Supply (PES = 0): Quantity supplied remains fixed regardless of price.

Several factors influence the elasticity of demand and supply:

For Demand:

• Availability of Substitutes: More substitutes mean higher elasticity.
• Necessity vs. Luxury: Necessities tend to be inelastic; luxuries are elastic.
• Proportion of Income: Goods that take up a large portion of income tend to be more elastic.
• Time Horizon: Demand tends to be more elastic over longer periods.

For Supply:

• Flexibility of Production: Ease of increasing or decreasing output.
• Time Horizon: Supply is generally more elastic in the long run.
• Availability of Inputs: Difficulty in acquiring resources affects supply elasticity.

On the CPA exam, you'll encounter questions that require you to analyze how changes in supply and demand, and understanding elasticity, impact business decisions, pricing strategies, market outcomes, and financial reporting. For instance, understanding elasticity is key to analyzing the impact of price changes on total revenue, a concept vital for management accounting and financial analysis.