CHAPTER TWO

THEORY OF DEMAND AND SUPPLY

2.1 THEORY OF DEMAND

The theory of demand is related to the economic activities of consumers-consumption.
Hence, the purpose of the theory of demand is to determine the various factors that affect
demand. In our day-to-day life we use the word “demand” to mean a desire of a person to
purchase a commodity or service. But in economics it has a specific meaning, which is
different from what we use it in our day to day activities. 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/she desires. His/her desire should be backed by
his/her purchasing power. A poor person is willing to buy a car; it has no significance,
since he/she has no ability to pay for it. On the other hand, if his/her 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.
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, given other things
unchanged (ceteris paribus). The quantity demanded of a particular commodity depends
on the price of that commodity.
Demand schedule: a tabular listing that shows the quantity demanded at various prices,
ceteris paribus. The phrase ceteris paribus means other things remain unchanged. So as to
derive the demand schedule of an individual (say Mr. Abebe) what is required is just
asking him what quantity of the good (say bread) he would buy at different prices of the
good, ceteris paribus. Look at the following table for illustration.
Table 2.1: Demand schedule

Price Quantity
0 250
5 200
10 150
15 100
20 50
25 0

Try to draw a curve using price as a vertical axis and quantity as a horizontal axis based
on the figures in the above table. The curve that you tried to draw is called demand curve.

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Demand curve: Is a graphical representation of a demand schedule showing the quantity

demanded at various prices, ceteris paribus. Plotting the price-quantity relationships from
the demand schedule on a two-axis plane derives the demand curve for a good or service
given in figure 2.1 below.
Price
25
20 Demand curve
15
10
5
0 50 100 150 200 250 Quantity
Figure 2.1: The Demand Curve

Law of Demand
The law of demand states that the quantity demanded of a good or service is negatively
related to its price, ceteris paribus. Holding other things the same, consumers will buy
more of a good or service at a lower price than at a higher price. As price rises,
consumers will demand a smaller quantity of a good or service.

Demand Function
Demand function shows the functional relationship between the quantity demanded of a
good and its price, ceteris paribus. It is defined as:
Q = f (P)
The demand function gives quantity demanded as a negative function of price. The most
widely used functional form is a linear demand curve, which is given as:

In a more general case, in which the market consists of n consumers with individual
demand functions for goods X is defined as:
Xi = f (PX)
Where Xi represents the quantity demanded of good X by individual i.

Determinants of demand

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But the above law operates only under the assumption that “other things remain
constant”. The above phrase implies that when we state the law of demand, we assume
the determinants of demand constant, these are
 Tastes and preference remain constant
 The number and price of substitute goods
 The number and price of complementary goods.
 Income of consumer
 Distribution of income.
 Expectations of future price and income changes.
 Advertisement
Shift in the demand curve
The demand curve is drawn on the assumption that other things remain the same. If,
however, the factors assumed constant change, their effect would be shifting the demand
curve. In other words, shift in the demand curve for a good result from changes in one or
more of the factors that affect demand except the price of own good. Increase in demand
is shown by outward shift of the demand curve whereas inward shift of the demand curve
represents decrease in demand.
When the tastes of the people change in favor of bread, it would be reflected by an
increase in demand for bread. At every price, consumers demand a larger amount than
before. This, as shown in Figure 2.4, shifts the demand curve from D to D1. The opposite
would have occurred if tastes change against bread, in which case there would be
decrease in demand, represented by a shift from D to D2. Look at the following figure for
illustration.
P

P1

D D1
D2
0 Q2 Q Q1 Q
Figure 2.4: Shift of the Demand Curve
 An increase in income leads to an increase or a decrease in demand depending on the
nature of the good. Depending on the effect of change in income on their quantity
demanded, there are two types of goods: normal goods and inferior goods. Demand
increases with increase in income if the good is normal. As an example, consider
meat whose demand is directly related with income. On the other hand, inferior good

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is a good whose demand decreases with increase in income. If, for example, you
decrease your consumption of ‘shiro wet’ as your income increases in order to shift to
say meat, then ‘shiro wet’ is going to an inferior good for you.
The price of related goods and services also has effect on demand depending on the
nature of the other goods. There are two classes of such goods:
 Substitute goods- such goods are substitute to one another. As a result, an increase in
the price of such related goods lead to increase in demand for the other good. Consider
Pepsi Cola and Coca Cola. If the price of Coca Cola increases consumers will shift from
the consumption of Coca Cola to Pepsi Cola. This implies increase in the price of Coca
Cola results in the increase of the demand for Pepsi Cola.
 Complementary goods- these are goods that are jointly consumed. As a result, a rise in
the price of one such good results in decline in demand of the other good. Consider the
case of sugar and coffee. Coffee is consumed together with sugar. Thus, increase in the
price of sugar causes decline in demand for coffee.
Future expectations of price and income also have influence on demand. Suppose
consumers expect prices to fall in the future. In this case they reduce current consumption
hoping to buy more of the good when price falls in the future. If, on the other hand, they
expect prices to rise in the future, they will consume more of the goods at present so as to
avoid buying the good at a higher price in the future.
Similarly, change in expectation about the future income influences the decision of
consumers. If consumers expect their income to increase in the future, they would
increase their current consumption through current borrowing. On the other hand, if they
expect income to decrease in the future they will reduce current consumption.

ELASTICITY OF DEMAND
Definition: Elasticity of demand is a measure of the sensitivity or responsiveness of
quantity demanded to changes in price (or other factors). It measures the way one
variable (dependent variable) responds to changes in other variables (independent
variables). We express the dependent variable (Y) as a function of the independent
variables (Xi) as in the following function:

Y = f(X1, X2, X3,…, Xn)

In this function, Y is given as a function of n variables. As any one of these variables (Xi)
changes, there will be consequent change in the value of Y.
The formula to determine the responsiveness of Y to changes in the Xi can be expressed as

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………..,

This formula states that elasticity is the percentage change in the dependent variable
divided by the percentage change in the particular independent variable whose effect is
being examined. Now, let us look at the elasticity of demand.
Elasticity of Demand
In examining demand, it would be interesting to measure how quantity demanded
responds to changes in price and changes in other factors that affect demand such as price
of other goods and income.
Depending on the variables involved, three measures of elasticity of demand could be
considered:
 Price elasticity of demand: measures the responsiveness of quantity
demanded to changes in output price, ceteris paribus.
 Cross elasticity of demand: measures the responsiveness of quantity
demanded to changes in the price of other goods, ceteris paribus.
 Income elasticity of demand: measures the responsiveness of quantity
demanded to changes in consumers’ income, ceteris paribus.
1. Price Elasticity of Demand
The price elasticity of demand (): is defined to be the percentage change in quantity
demanded divided by the percentage change in price.

, where Q is change in quantity and P is change in price.

Rearranging

The sign of the elasticity of demand is generally negative, since demand curves
invariably have a negative slope. Accordingly price elasticity of demand can be stated as:

In elasticity, we consider the absolute value of the coefficients. The negative sign in front
of an elasticity coefficient indicates only that the relationship between price and quantity
demanded is negative. A demand with –2 elasticity coefficient is said to be ‘more elastic’
than the one with –1.
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If a good has an elasticity of demand greater than 1 in absolute value, it is said to have an
elastic demand. Such values imply that a given percentage fall in price causes more than
proportionate rise in price.
Example
Assume that a consumer purchases 10 units of a good when price is Birr 4 and 18 units
when price falls to Birr 2. Compute price elasticity of demand.
Percentage change in quantity demanded is and,

Percentage change in price is

Elasticity, therefore, is given as

This implies that for one percent fall in price quantity demanded rises by 1.6 percent.
Here, since E is greater than one, demand is said to be elastic. If the elasticity is less than
1 in absolute value, on the other hand, it would be the case of inelastic demand. This
indicates that a given percentage fall in price causes a less than proportionate rise in
quantity demanded.

2. Cross Elasticity of Demand

The responsiveness of quantity demanded for one commodity to the changes in the prices
of other commodities, ceteris paribus, is called cross elasticity of demand. It is denoted
as:

In this case, the demand function is modified in such a way it includes the prices of
related goods.
QX = f (PX, PY)
The cross elasticity formula is given as:

Where QX is the quantity demanded of good X and PY is the price of good Y.

 The cross elasticity of demand coefficient may take different values depending on the
type of relationship between the two goods. The cross elasticity demand coefficient is
equal to zero for unrelated the two goods. In this case, any increase or decrease in
price of one of the two goods has no effect on the quantity demanded of the other
good.

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 On the other hand, if the goods have a relationship of some sort, this value would be
different from zero. The two goods could be substitutes or complements depending on
whether the cross elasticity coefficient is positive or negative.
 The two goods are said to be substitutes if one good can be consumed in place of the
other. Complementary goods, in contrast, are goods that are consumed together so
that fall in consumption of one implies reduction in consumption of the other.
 If the cross elasticity of demand coefficient positive sign for two substitute goods.
This indicates that a rise in the price of one of the two goods results in rise in the
quantity demanded of the other good.
 If, however, the cross elasticity of demand coefficient has a negative sign, the two
goods are complementary and it reflects that a rise in the price of one of the goods
results in decline in the demand for the other.
 The size (magnitude) of the cross elasticity of demand coefficient shows strength of
the substitution or complementary relationship between the goods under
consideration. i.e., the higher the value of cross elasticity, the stronger will be the
degree of substitutability or complementarily, depending on the sign.
Example 2.15
The quantity demanded of good X before change in the price of good Y was 25 units. As
good Y’s price changes from Birr 5 to Birr 10, the quantity demanded of good X has
increased to 75 units.

The two goods, therefore, are substitute products.

3. Income Elasticity of Demand

Income elasticity of demand is a measure of the responsiveness of quantity demanded to
changes in income assuming all other things, including price, constant.

Where, Q represents output and I represents consumers’ income.

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In measuring income elasticity of demand, the sign of the elasticity coefficient is

important. The sign of the coefficient indicates the nature of the products; whether the
products are normal or inferior.
 Normal goods are goods whose quantity demanded increases with rise in consumers’
income, while inferior goods are those goods whose quantity demanded decreases
with rise in income.
 The income elasticity of normal goods is positive reflecting the positive relationship
between income and quantity demanded. For inferior goods, however, income
elasticity is negative.
 If the coefficient of income elasticity is greater than one, I >1, the good is income
elastic, whereas if I <1, the good is said to be income inelastic.
Example 2.16
When the income of the consumer is Birr 1000, the consumer buys 100 units of a good. If
income increases to Birr 1200, the resulting quantity demanded would be 130 units.
The income elasticity demand of the consumer is given as:

The consumer’s demand is income elastic.

 Goods with high positive income elasticity are considered as luxury goods. These
goods are normal goods for which quantity demanded changes by a very high
magnitude for a given change in income. Necessities in contrast have low income
elasticity. These goods are normal goods whose quantity demanded changes by a
smaller percentage for any given change in income.

2.2 THEORY OF SUPPLY

Definition: supply refers to the quantity of goods offered for sale at a particular time or a
particular place at alternative prices. It shows the quantities that producers are willing and
able to supply at alternative prices, ceteris paribus. It is different from quantity supplied,
which represents the actual quantity that producers supply at each price.
Supply schedule: is a tabular listing that shows quantity supplied at various prices, ceteris
paribus.
Table 2.4: Supply Schedule

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Price 5 10 15 20 25
Quantity 10 20 30 40 50

Supply curve: is a graphical representation of a supply schedule showing the quantity

supplied at various prices, ceteris paribus (see Figure 2.5 below).
P
25 Supply curve
20
15
10
5
0 10 20 30 40 Q

Figure 2.5: Supply Curve

The Law of Supply
The supply curve shows the relationship between the quantity supplied of a good and its
price. Given the conditions, the law of supply states that the quantity supplied of a good
or service is usually a positive function of price, ceteris paribus.
Supply Function
Supply function shows the functional relationship between price and quantity supplied,
ceteris paribus. And it is generally defined as:
Q = f (P)
The most widely used functional form is the linear supply curve, which is given as:
The slope of the supply function is d.
Determinants of Supply
The supply of goods or services is affected by several factors. The factors that influence
supply include:
1. The price of the good (P).
2. The level of technology (T).
3. The price of factors of production (Pf).
4. The number of suppliers (S).
5. Expectations (E).
6. Others (Z)

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Everything that affects supply works through one of these determinants. Supply function
is, then, defined as
Qs = f (P, T, Pf, S, E, Z)
Shifts in the Supply Curve

Shifts in the supply curve occur as any one of the ceteris paribus factors (factors kept
constant earlier) is altered. These constitute what is called change in supply (not change
in quantity supplied).
Suppose a negative technological change will have the negative effect. There will be a
decrease in supply, which is depicted as a leftward shift of the supply curve. This is
shown by shift of the supply curve from S to S2 (see Figure 2.8).
P
S2 S
S1
P2
P1

0 Q2 Q1 Q
Figure 2.8 Shift of the supply curve

Now consider changes in the prices of factors of production. A rise in the price of a
factor of production, ceteris paribus, causes a decrease in supply. This happens because
the producer now will find that the cost of supplying any quantity has increased. We will,
thus, find that after a price rise in the price of a factor of production, less will be supplied
at the old price or the same amount will be supplied only at a higher price.
A change in the number of suppliers similarly will have a predictable effect on supply.
For instance, if the number of beef ranchers declines, the total supply of beef at each
price will be reduced. Thus, the supply curve will shift to the left from S to S2.
Conversely, an increase in the number of ranchers will cause increase in total supply of
beef, and hence, the supply curve to shift to the right from S to S1.
Expectations about future price can have an effect on supply. Assume that ranchers
expect that the price of beef will fall next year because they anticipate a poor harvest,
which would make it more expensive to keep beef on feedlots. Under such expectations,
they would bring more cattle to market now before price falls. If enough farmers follow

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suit, the supply for this year will increase as shown in the figure above, by a rightward
shift of the supply curve.

ELASTICITY OF SUPPLY
As we did for demand, let us now discuss the responsiveness of quantity supplied to
changes in its price.
1. Price elasticity of Supply
Price elasticity of supply measures the responsiveness of the quantity supplied to a
change in the commodity’s price, ceteris paribus. It is defined as:

Where, QS is quantity supplied of a good and P is price.

As with price elasticity of demand, if s = 1, supply is unit elastic. If s > 1, it is elastic;
and if s < 1, it is inelastic.
The coefficients of price elasticity of supply are often positive because normally supply
curves are positively sloped.

Example 2.17
A firm produces 100 units of output and sells each unit for Birr 20 at equilibrium.
Suppose the demand for the firm’s product has increased and caused a rise in price to Birr
25 a unit. After the rise in price the quantity that the firm sells has increased to 120 units.

This implies that the supply of the firm is price inelastic.

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2.3 MARKET EQUILIBRIUM

Definition
Market equilibrium is a price-quantity combination that results from the interaction of the
supply curve and the demand curve such that at the indicated price, the quantity
demanded equals the quantity supplied. The equilibrium has the property that once the
market settles on that point it stays there unless either supply or demand shifts. These two
points can be made clear by considering the graphic representation of equilibrium
discussed below.
Graphic Approach to Equilibrium
To see how equilibrium comes about, consider the following hypothetical demand and
supply of coffee in a given market given by Table 2.7 and its corresponding figure
(Figure 2.9).
At a price of Birr 2.00, suppliers want to supply 4 thousand kg of coffee and demanders
want to purchase 8 thousand kg. The quantity demanded exceeds quantity supplied by
4 thousand kg. This means that some consumers do not get the desired amount at price
Birr 2.00. Some of these consumers will offer more and bid the price up. As the price
rises, the quantity supplied, being a positive function of price will rise and the quantity
demanded, being a negative function of price, will fall. This will continue until the price
reaches Birr 3.00. At Birr 3.00, the amount consumers wish to purchase is exactly equal
to the amount suppliers wish to sell. This is the equilibrium price (market clearing price).
The output which corresponds to the equilibrium price is called the equilibrium quantity.

Table 2.7: Supply of and Demand for Coffee

Price per Kg supplied Kg demanded Difference
Kg per month per month
Br 1.00 2 thousand 10 thousand 8 thousand excess quantity demanded
Br 2.00 4 thousand 8 thousand 4 thousand excess quantity demanded
Br 3.00 6 thousand 6 thousand Equilibrium (no excess or no shortage)
Br 4.00 8 thousand 4 thousand 4 thousand excess quantity supplied
Br 5.00 10 thousand 2 thousand 8 thousand excess quantity supplied

Price/kg
5.00 4 thousand excess supply S

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4.00
3.00
2.00
1.00 4 thousand excess demand D
0 1 2 3 4 5 6 7 8 9 10 Thousand Kg
Figure 2.9 Market Equilibrium
It is important to note that the point representing equilibrium price and equilibrium
quantity is not the same thing as the point where the amount sold equals the amount
bought. The equilibrium represents coincidence of wishes on the part of consumers and
producers.
 Excess demand causes an upward pressure on price. Thus price converges
to the equilibrium price.
 Excess supply causes a downward pressure on price. Thus, price follows a
path towards the equilibrium.
Once equilibrium is reached at the point of equality of the demand curve with the supply
curve, it remains there as long as demand and supply remain unchanged.

Numerical Approach to Equilibrium

At the equilibrium position, the demand function is exactly equal to the supply function.
Supply = Demand
Example
Suppose the demand and supply functions in a particular market are given as:

At equilibrium Qd = Qs

Rearranging

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The equilibrium Price is, therefore, P = 15.

The equilibrium quantity is obtained by substitution.

Exercise 2.3
? Given and , find equilibrium levels of
price
P and quantity.
1

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