Introduction to Economics Lecture Note for students Instructor: Gutema F.

2021

Microeconomics part

Chapter Two: Demand, Supply and Market Equilibrium

2.1. Theory of demand and demand elasticity

2.1.1. Definition and Basic Concepts of Demand
In our day-to-day life we use the word ‘demand’ in a loose sense to mean a desire of a person to purchase
a commodity or service. But in economics it has a specific meaning. Demand implies more than a mere
desire to purchase a commodity. It states that the consumer must be willing and able to purchase the
commodity, which he desires. His desire should be backed by his purchasing power. A poor person is
willing to buy a car; it has no significance, since he has no ability to pay for it. On the other hand, if his
desire to buy the car is backed by the purchasing power then this constitutes demand. Demand, thus, means
the desire of the consumer for a commodity backed by purchasing power. These two factors are essential.
If a consumer is willing to buy but is not able to pay, his desire will not become demand. Similarly, if the
consumer has the ability to pay but is not willing to pay, his desire will not be called demand.

More specifically, demand refers to various quantities of a commodity or service that a consumer would
purchase at a given time in a market at various prices. In deriving the demand of a commodity, it is assumed
that other things such as consumer’s income, tastes, prices of interrelated goods, etc, remain unchanged
(ceteris paribus). The quantity demand of a particular commodity depends on the price of that commodity.

2.1.2 The Law of Demand

Law of demand tells us the functional relationship between the price of a commodity and its quantity
demanded in the market. The law of demand states that all other factor reaming the same, the price of a
good and its quantity demanded have inverse relation, i.e., as price rise quantity demanded falls and vice
versa.

2.1.3 Demand equation, schedule and curve

The relationship between the price of a good and its quantity demanded, all other things reaming the same
can be represented using an equation where quantity demanded will be the dependent variable and price
will be the independent or exogenous variable as given below:-

Dx = f(Px) Where Dx = quantity demanded

Px = price of commodity

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 Introduction to Economics Lecture Note for students Instructor: Gutema F. 2021

The specific function can take any from linear to non-linear functions of various forms. Demand schedule
is a tabular way of representing the relation between price and quantity demand.

A demand schedule can be constructed to any commodity if the list of prices and quantities purchased at
those prices are known. An individual demand schedule is a list of the various quantities of a commodity,
which an individual consumer purchases at various levels of prices in the market. A demand schedule states
the relationship between two variables of price and quantity demanded in a table form.

Demand schedule for oranges

Price per dozen (Birr) Quantity demanded in Kgs

1 15
2 12
3 10
4 7
5 5

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Demand curve: graphical representation of demand

5
Price

D
1
X
0
Quantity demand
5 7 10 12 15

In the above diagram prices of oranges are given on ‘OY’ axis and demand on ‘OX’ axis. When the price
per Kilogram is birr 1 only, 15 kilograms are demanded. If we plot the data as above, you may notice that
if the price falls down demand increases and vice-versa.

2.1.4 Individual and Market demand

An individual’s quantity demanded of any good is the total amount that individual would choose to buy at
a particular price. While, the market quantity demanded of any good is the total amount that all buyers in
the market would decide to buy at a particular price. For example, the demand for ‘teff’ by a single
household living in Bale is an individual demand while the total demand for ‘teff’ in Bale is the market
demand.

Let there are only three individuals in the market having demand curves of Da, Db and Dc. At price of P1,
these three individuals will represent a quantity demand of a1, b1 and c1 respectively. These three people
together will bring Q units of quantity demand in the economy.

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At each level of price, then market quantity demand is the horizontal summation of individual quantity
demands, and hence market demand curve at large is the horizontal summation of individual demand
curves.

2.1.5 Determinant of Demand

The demand for a product is influenced by many factors. Some of these factors are:

I) Price of the product

II) Taste or preference of consumers

III) Income of the consumers

IV) Price of related goods

V) Consumers expectation of income and price

VI) Number of buyers in the market

When we state the law of demand, we kept all the factors to remain constant except the price of the good.

A change in any of the above listed factor except the price of the good will change the demand. While a

change in the price, other factors remain constant will bring change in quantity demanded. A change in

demand will shift the demand curve form its original location for these reason those factors listed from II

to VI are called demand shifters. While a change in own price is only a movement along the same demand

curve

When demand increases, demand curve

shifts up ward ( 1 ) while a decrease in dd
Price
shifts dd curve down wards (2).

D1
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 Introduction to Economics Lecture Note for students Instructor: Gutema F. 2021

D0
D2
Quantity demand

Now let us examine how each factor affect demand

I) Taste or preference: When the taste of a consumer changes in favor of a good, her/his demand will

increase, the opposite change will decrease demand.

II) Income of the consumer : Goods are classified into two depending on how a change in income affects

their demand.

Normal Goods: are goods whose demand increases, as income increase. While inferior goods are those

whose demand is inversely related with income, i.e., as income increases the demand for these goods

decrease.

III) Price of related goods : Related goods are those goods which have some form of relation. Two goods

are said to be related if a change in the price of one good, affect the demand of another good.

There are two forms of relation between goods. These are substitute and complimentary goods.

Substitute goods: are goods which satisfy the same desire of the consumer. Ex. tea and coffee or Pepsi

and coca cola. If two goods are substitutes, then price of one and the demand of the other are directly related.
When price of one good increase demand for the other increase .

Complimentary goods: on the other hand are those which are jointly consumed. Ex. car and fuel or tea

and sugar. If two goods are complements, then price of one and the demand of the other are inversely

related. When price of one good increase demand for the other decrease.

IV) Consumer expectation of income and price: Higher price expectation will increase demand while a

lower future price expectation will decrease the demand for the good.

Higher income expectation will increase demand while a lower future income expectation will decrease the

demand for the good.

V) Number of buyer in the market: Since market demand is the horizontal sum of individual demand, an

increase in the number of buyers will increase demand while a decrease in the number of buyers will

decrease demand.

2.1.6 Elasticity of Demand

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 Introduction to Economics Lecture Note for students Instructor: Gutema F. 2021

In microeconomics elasticity is used as a method to measure the degree of dependent variables

responsiveness to changes in an independent variable. Elasticity has various applications most of them are

interesting and useful in the study of consumption demand.

Elasticity of demand – means responsiveness of demand to the change in variable that affect demand. It

is a measurement of the percentage of responsiveness of a quantity demanded to a percentage change in an

independent variable.

There are as many elasticity of demand as its determinants. The most important of this elasticity are:

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross-price elasticity of demand

1. Price Elasticity of Demand

Price elasticity of demand: It is a measure of the responsiveness of demand to changes in the commodity’s

own price. It can also be expressed as the ratio of a relative change in quantity to a relative change in price.

There are two types of price elasticity values. They are point and arc elasticity.

I) Point Price Elasticity of Demand

This is calculated to find elasticity at a given point. In this method, we take a straight-line demand curve

joining the two axis, and measure the elasticity between two points Q and Q1 which are assumed to be
Y
intimately close to each other.

In the diagram ‘RP’ is the straight-line demand

R
curve, which connects both axis. In the beginning at

Q the price QM, the quantity demanded is OM. Then

Price

N the price changes to Q1M1 and the new quantity

P Q1
demanded will be OM1. The symbol ‘P’ represents
N1
the change in price while the symbol ‘Q’ shows the
Q
X change in quantity demanded. The price elasticity of

O P demand can be determined by the following formula.

M M1

Quantity
The formula for calculating the point price elasticity of demand is:
DEMAND

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Percentage change in the quantity demanded % Qd Q 𝑃0

Point Epd = = = x
Percentage change in the price % p p 𝑄0

Where Epd stands for point price elasticity of demand.

If the percentages are known quantities, then the numerical size of E can be easily calculated

II) Arc price elasticity of demand

The main drawback of the point method is that it is applicable only when we possess information about

even the slight changes in the price and the quantity demanded of the commodity. But in practice, we do

not possess such information about minute changes. We may possess demand schedules in which there are

big gaps in price as well as the quantity demanded. In such cases, therefore is an alternative method known

as arc method of elasticity measurement. In this method the midpoints between the old and the new data in

the case of both price and quantity demanded are used. It studies a portion or a segment of the demand

curve between the two points. An arc is a portion of a curve line, hence, a portion or segment of a demand

curve. The formula for measuring arc elasticity is given below.

Change in quantity demanded Change in price

Ed = 
Orginal quantity plus new Original price plus
quantity demand new price after change
Symbolically, the formula may be expressed thus:

Q  Q1 P  P1

Q  Q1 P  P1
Ed = Here, Q = Original Quantity demanded
Q1 = New quantity after change in price
P = Original price before change
P1 = New price after change
We can take a numerical example to illustrate arc elasticity. Suppose that the price of a commodity in Br.

5 and the quantity demanded at that price is 100 units of a commodity. Now assume that the price of the

commodity falls to Br. 4 and the quantity demanded rises to 110 units. In terms of the above formula, arc

elasticity, then, will be

Coefiecient or Ranges of Price elasticity of Demand

The price elasticity value can be categorized into five ranges. These are

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 Introduction to Economics Lecture Note for students Instructor: Gutema F. 2021

Elastic demand: This is when numerical value of price elasticity of demand is greater than one. For

example: if price elasticity is -2 then / -2 / =2 > 1. Therefore, this is elastic demand.

For demand to be elastic a given change in price should lead to a more than proportionate change in quantity

demanded.

Inelastic demand: This is when numerical value of price elasticity of demand is less than one. For example:

if price elasticity is -0.7 then / -0.7 / =0.7 < 1. Therefore, this is inelastic demand. For demand to be elastic

a given change in price should lead to a less than proportionate change in quantity demanded.

Unitary elastic demand: This is when numerical value of price elasticity of demand is equal to one.For

example: if price elasticity is -1 then / -1 / =1 = 1. Therefore, this is unitary elastic demand. For demand to

be elastic a given change in price should lead to an equal proportionate change in quantity demanded.

Perfectly elastic demand: It is a situation where the slightest rise in price causes the quantity demanded of
Y
the commodity to fall to zero. Similarly, the slightest fall in price causes an infinite increase in the quantity

demanded of the commodity. This type of cases are exceedingly rare in the world. It can be shown with the

help of a diagram. Demand curve will be a horizontal straight line.

PRICE

O Quantity X

 In this case even substantial changes in the price will

Perfectly inelastic demand not bring about any change in demand. The demand in
Y
D this case is insensitive or not responsive to changes in
PRICE

price. The elasticity of demand in this case is zero. Like

perfectly elastic demand, cases of perfectly inelastic
demand are also rare in real life. It can be shown with
the help of a diagram. In this case, the demand curve
Ep= 0
will be a vertically straight line.
O D
Quantity X

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 Introduction to Economics Lecture Note for students Instructor: Gutema F. 2021

2. Income Elasticity of Demand

The responsiveness of demand to changes in income is termed as income elasticity of demand. It can also

be expressed as the proportionate change in the quantity demanded resulting from a proportionate change

in income.

Percentage change in quantity demanded

Ey =
Percentage change in income

Symbolically, we may write

Ey = D  Y
D Y

For normal goods income elasticity is positive. Some of the writers have used income elasticity in order to

classify goods into “luxuries” and “: necessities”. A commodity is considered to be a luxury if its income

elasticity is greater than unity. A commodity is necessity is its income elasticity is small.

3. Cross Price Elasticity of Demand

It is the responsiveness of demand to change in the price of other commodities. It can also be defined as the

proportionate change in the quantity demanded of X resulting from a proportionate change in the price of

Y.

Percentage change in the quantity demanded of X

Exy =
Percentage change in the price of Com mod ity Y

Cross elasticity may vary from minus infinity to plus infinity. Complementary goods will have negative

cross elastic ties and substitute goods will have positive cross elasticity. The main determinant of the cross

elasticity is the nature of the commodities relative to their uses. It two commodities can satisfy equally well

the same need, the cross elasticity is high and vice-versa.

2.2. Theory of supply and Supply elasticity
In this discussion, we will explain what supply is and what factors influence it. In addition, elasticity of
supply will be dealt.
2.2.1. Definition and Basic Concepts of Supply
If the price goes up, the producer will offer more for sale. But, if the price goes down, he will be unwilling
to sell and will offer less to sell. Hence, supply varies with a change in price and supply is always made at
a price. Just as demand implies willingness and ability to pay, "Supply implies willingness and ability to
deliver the goods.

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More specifically, supply refers to various quantities of a commodity or service that a producer would
supply at a given time in a market at various prices. In deriving the supply of a commodity, it is assumed
that other things such as resource price, technology, prices of related goods and all other factors remain
unchanged (ceteris paribus). The quantity supplied of a particular commodity depends on the price of that
commodity. The relationship that exists between price and the amount of a commodity supplied can be
represented either by an equation or a table (schedule) or a curve.

2.2.2 The Law of supply

Law of supply tells us the functional relationship between the price of a commodity and its quantity supplied
in the market. The law of supply states that all other factor reaming the same, the price of a good and its
quantity supplied have direct relation, i.e., as price rise quantity supplied also rises and vice versa . Why
do you think there is a direct relation between price and quantity supplied of goods?

2.2.3 Supply equation, schedule and curve

The relationship between the price of a good and its quantity supplied, all other things reaming the same
can be represented using an equation where quantity supplied will be the dependent variable and price will
be the exogenous variable as given below.

Sx = f(Px)

Where Sx = quantity supply

Px = price of the commodity

The specific function can take any form from linear to non-linear functions of various forms. Supply
schedule is a tabular way of representing the relation between price and quantity supplied. A supply
schedule can be constructed to any commodity if the list of prices and quantities supplied at those prices
are known. An individual supply schedule is a list of the various quantities of a commodity which an
individual producer supplies at various levels of prices in the market. A supply schedule states the
relationship between two variables of price and quantity supplied in a table form.
The following table shows a hypothetical supply schedule for mangoes.

Table: Supply schedule

Price per kgs (In Birr). Quantity (in Kgs)

5 400
4 300
3 200

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2 100
1 50
In the above schedule you may notice that as price falls, fewer mangos are offered for sales and as price
rises, the seller is prepared to sell more of them. The simple explanation here is that the higher the price of
commodity, the greater are the profits that can be earned and thus, the greater the incentive to produce and
offer the commodity for sale.

Y Supply curves In this diagram the quantities of mangoes

5
are measured along OX axis and prices

along OY axis. The supply curve SS slopes

upward as we go from the left to the right.

4
Price

4 2031 100 200 300 400 X

50

Quantity
This means that as the prices rises, more is offered for sale and vice-versa. This supply curve is related to
the cost structure of the firm.

2.2.4 Individual and Market Supply

An individual’s quantity supplied of any good is the total amount that individual would choose to sale at a
particular price. While, the market quantity supplied of any good is the total amount that all producers in
the market would decide to sale at a particular price.

For example, the supply of mangoes by a supper in a market is an individual supply while the total mango
offered by all suppliers in the market is the market supply of mangos.

2.2.5 Determinant of Supply

The supply of a product is influenced by many factors. Some of these factors are:
I) Price of the product
II) Resource price
III) Technology
IV) Price of related goods
V) Price expectation of the supplier
VI) Tax and Subsidy

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VII) Number of sellers in the market

A change in any of the above listed factor except the price of the good will change the supply. While a
change in the price, if the other factors remain constant will bring change in quantity supplied. A change in
supply will shift the supply curve form its original location for these reason those factors listed from II to
VII are called supply shifters. While a change in own price is only a movement along the same supply
curve.
Changes in supply is the result of a change in any determinant of supply —except for the good’s price and
it will bring a shift in the supply curve. We call this a change in supply. If suppliers choose to supply more
at any price, the supply curve shifts down ward—an increase in supply. If suppliers choose to supply less
at any price, the supply curve shifts up ward a decrease in supply.

S2
S0 S1
Price
When supply increases, supply curve
2
shifts down ward (1) while a decrease
2
in supply shifts supply curve up wards.
1 (2)

Quantity

Now let us examine how each factor affect supply.

I) Resource price
Resource price is one of the most important factors that influence supply. Since resource price directly
affect the cost of the firm and hence its profit. Therefore, an increase in resource price is likely to decrease
supply since the profit of the firm declines with the higher resource prices and vice versa.
II) Technology
Technology is another factor which influences the supply of a good. Technological advancement will
increase the supply of the good.
III) Price of related goods
Goods may have some relations in production. This relation, like in the demand side, can be either
substitutability or complimentarily. Substitute goods in production involve two goods competing for the
given resource of the supplier. For example a farmer may have the option of producing either maize or Chat

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on her plot of land. A rise in the price of Chat will encourage the farmer to use her limited resource for
producing more chat and hence the supply of maize (food) will be decreased.
Complimentary goods, on the other hand are those which are produced together i.e., as we go for the
production of a good another product is also produced in the same line of production. For example if the
price of meat increases, the supply of animal skins will also increase. This is because as the suppliers of
meat try to increase their supply because of the higher price for meat, they slaughter more animals making
more skins available in the market.
IV) Suppliers expectation of price
In general, when suppliers expect higher price in the future they tend to decrease the supply of their product
now in order to sale it at higher expected price in the future.
V) Tax and subsidy
Tax and subsidies also affect the supply of a good.
An increase in tax rate is likely to decrease supply since the supplier faces higher cost of production. On
the other hand, provision of subsidy encourages the suppliers to increase their supply.
VI) Number of sellers in the market
Since market supply is the horizontal sum of individual supply, an increase in the number of sellers will
increase supply while a decrease in the number of sellers will decrease supply.
2.2.6 Price Elasticity of Supply

It is the degree of responsiveness of the supply to change in price. It may be defined as the percentage
change in quantity supplied divided by the percentage change in price. Elasticity of supply can be measured
with the help of the following formula.

Q P
Es = Change in amount supplied  Change in price = 
Q P

Original amount supplied Original price

Where 'Q' refers o the quantity supplied and 'p' to the price and  represents change. The supply is elastic
when with a small change on price there is great change in supply. It is inelastic or less elastic when a great
change in price induces only a slight change in supply. If the supply is perfectly inelastic, it will be
represented by a vertical line shown as below.

Like demand price elasticity of supply can be elastic, inelastic, unitary elastic, perfectly elastic or perfectly
inelastic Infinite elasticity
Y Perfectly inelastic
or zero elasticity Y perfection elastic
Price

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P S
Price

X Supply X
O O
Supply

The above chart represents zero elasticity in which the quantity supplied does not change as price changes.
If supply is perfectly elastic it will be represented by a horizontal straight line as in second diagram. At 'OP'
price the supply elasticity is infinite because nothing at all is supplied at the lower prices. Producers would
supply any quantity demanded at the price. (Note: Different issues of elasticity of supply can be dealt like
the elasticity of demand).

2.3. Market Equilibrium

Market equilibrium is states of the market in which market forces of demand and supply are in balance and
as a result the market price and the amount of the good exchanged tend to be stable. The buyers and sellers
in the market bargain about goods and services. They agree to purchase and sell goods and services at a
certain price. In this manner the price is determined by the interaction of buyers and sellers. In other words,
demand and supply determine prices. Buyers in the market follow the law of demand. The Law of demand
reveals that when the price falls the demand increases and when the price raises the demand decreases. The
sellers follow the law of supply. According to this law, when the price rises the supply is increased and
when the price falls the supply is decreased. Thus, demand and supply move in opposite directions. Price
is determined by the interaction of demand and supply and the price at which demand and supply are equal
is known as the equilibrium price. Equilibrium quantity is the quantity supplied and the quantity demanded
at equilibrium price. If the price is more or less than the equilibrium price, the equilibrium output is
disturbed. But ultimately the quantity demanded and the quantity supplied will be balanced at some
equilibrium price.

We can explain this process of equilibrium adjustment with the help of schedule and figure. In the following
table the quantity demanded and supplied is shown.

Table 2.1: Quantity demanded and Supplied (in kgs)

Price
(Birr) Demand Supply Shortage (-) or Surplus (+)

2 200 50 -150 (↓)

3 150 75 -75 (↓)

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4 130 100 -30 (↓)

5 110 110 0
6 90 120 +30 (↑)
7 80 130 +50 (↑)

When the price of mango is Birr 2 per Kg., the demand for them will be 200 kgs but the quantity supplied
will be 50 Kg. At this price of Birr two the market will have a shortage of 150 kg and this will not make
the market stable. The effect of a shortage in a free market is always to increase the price. If the price rises
to Birr 3 the supply increases to 75 Kgs, whereas the demand falls to 150 Kg. This higher price has reduced
but has not eliminated the shortage so price has to decrease further. If the price is again raised, the supply
will increase to 100Kg, and the demand will be further reduced to 130Kg. Again, when the price goes up
to Birr 5 per Kg., the quantity demanded or supplied will be 110 Kg. At a price of Birr 5 per Kg, the buyers
are ready to purchase 110 Kgs and the sellers are ready to offer 110Kgs. This is the equilibrium price and
the quantity supplied at this price is called the equilibrium quantity, i.e., 110 Kgs. Once the equilibrium
price is determined, there is no change from this price as this satisfies both the consumers and the producers.
If, at any time, the price is more or less than Birr 5 the forces of demand and supply will adjust it back to
Birr 5. For instance, if the price increases to Birr 6 the quantity demanded will decrease, but the quantity
supplied will increase. At Birr 6, the demand will be 90 Kgs and the supply will be 120Kgs. When the
supply is greater than the demand, the seller has to reduce the price to Birr 5. As a result, the supply will
fall to 110 Kg. and demand will also increase to 110 Kgs. Thus, the equilibrium price is re-established. On
the contrary, if the price decreases to Birr 4 the demand will increase to 130 Kgs and the supply will fall to
100Kgs. Here supply will be less than the demand. Decreased supply and an increased demand will lead to
a rise in the price to Birr 5- where the demand and supply will be in equilibrium. In this manner the
equilibrium will be maintained again.

In the Figure below DD is the demand curve and SS is the supply curve. These two curves intersect each
other at point E. The point, at which demand and supply curve intersect is called the equilibrium point. OP
is the equilibrium price at which OM, the equilibrium quantity is demanded and supplied. If demand is less
than supply, every seller will try to sell his quantity of the product first by reducing the price a little. Sellers
compete among themselves to bring down the price to the equilibrium level. Thus demand and supply
determine the equilibrium price. Once it is established, any disturbance from this equilibrium level will be
restored by the forces of demand and supply.

Graghical Illustration

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Price D
S

(P1) 6 H J
5
(P) E
4
G F
3 D
(P2) S
2

0 Quantity
110
X
M
If the demand and supply functions are given in equation form as below
Xd = 100-2P and Xs = -20+2P
Attempt the following questions.
A) What is the equilibrium price and quantity?
B) Show the equilibrium diagrammatically.
C) If the price of the good is fixed at P=25, will there be a shortage or a surplus? How large is it?

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