Chapter One: Theory of Consumer Behavior and Demand

2.1.1. Definition of Demand

Demand: is simply a statement of a buyer’s plans, or intentions, with respect to the purchase of a
product.

 The definition involves willingness and ability to buy because willingness alone without the
necessary birr will be a nominal (not real or not actual) demand.

 Willingness to buy must be backed up by the ability to acquire the good demand to be effective.

2.2.2. Law of Demand

Law of demand: All else equal/cetris paribus, as price falls, the quantity demanded rises, and as
price rises, the corresponding quantity demanded falls. In short, there is a negative or inverse
relationship b/n price and quantity demanded.

 If the relationship between price and quantity demanded of a product is to be established, the
effects of other determinant factors should remain constant.

 This is what we mean by cetirus paribus, a Latin word to means other things or variable remain
constant.
 2.2.3. Determinants of Demand

 The basic determinants/factors that may affect the demand for a commodity include:

 The price of the commodity X(own price (Px)),

 The money income of the consumer (M),

-For normal good (+)

- For inferior good (-)

 The price of other goods,

- The price of substitute goods (+)

- Price of complement goods Pc (-)

 Taste & preference of the consumer (T),

 Number of buyers/ population served in the market (POP),

 Future expectations of prices, income, and availability of the commodity (E)

2.2.4. Demand Function, Schedule and Curve

Demand function .

• specifies the relationship between the quantity demanded of acommodity (Qd) that he/she is
willing and able to buy and the price level and other determinants of demand.

• In mathematical form, we can express it as follows:

Qd = f{ Px, M, Ps, Pc, T, POP, E,...}
• For example: 𝑄𝑑1 = 8 − 4𝑝1
𝑄𝑑2 = 80 − 25𝑝2
Demand Schedule : schedule that show the relationship between price and quantity demand

Price/Kg of Teff (in Birr) 15 10 5

Quantity demanded per month (in Kg) 1000 1200 1400
Demand Curve: curve shows the r/ship between quantity demand and price.

Demand curve for Teff,

, Br per kg

15
10
5
0 1000 1200 1400
Q, Teff In Kg
 2.2.5. Exceptional cases for the law of demand not to work

a. Status goods: These goods show the social status of the individual in the society. So,
even if the price of those Luxury goods is increasing due to the desire of the individual
to have high social status or to be considered as rich, the demand for those goods
increases.

b. Giffen goods: named after the economist Sir Robert Giffen who has

• discovered them for the first time. Increase in prices of such goods is considered as
increase in qualities and people tend to consume more of them at higher prices.

C. Uncertain future events: if consumers are expecting that there will be increase in the
price of the good in the near future, then they choose to guard themselves against additional
costs by buying now

d. Judging quality by price: people usually resort to the irrational conclusion that price
always follows the footsteps of quality.
 2.2. 6. Movements Vs Shift of the Demand Curve
A . Change in Quantity demanded

 It designates the movement from one point to another point – from one price quantity
combination to another

 The cause of such movement is a change in the own price.

B. Change in Demand

 The cause of such change is a change in non own price determinants.

 graphically, shift in the location of the demand curve is called a change in demand.
A. A Change Quantity b. A Change in Demand
 2.2.7. Individual vs. Market Demand

 We can find market demand curve by adding all individuals demand curve
horizontally. Assume there are only two households in the market, market demand
is derived as follows.

Price per House hold A demand House hold B Total or market demand
unit demand
3 Br 4 units 6 units 10 Units
4Br 3 units 4 units 7units
 To find the market demand function:

• First write the demand function of representative consumer in terms of quantity

demand

• Second multiply it by the number of identical consumers in the market.

 Example: - Suppose the demand of representative consumer is 𝑄𝑑 = 20 −

3𝑝 and that there are 200 identical consumers in the market for corn.

• What is the market demand?

• 𝑄𝑚 = 200 ∗ 𝑄𝑑

• Soln: 𝑄𝑚 = 200 ∗ 𝑄𝑑 = 200 (20-3P)

 2.2.8. Elasticity of Demand

 It is a measurement of responsiveness, or sensitivity, of consumers to a

change in one of the factors that affect demand (like price, income, price of
other goods…) .

 There are many elasticity of demand. The most common types of elasticity
of demand are of the following:-

a. Price elasticity

b. Income elasticity of demand

c. cross-price elasticity of demand.

 a. Price Elasticity of Demand

 It is a measure of responsiveness, or sensitivity, of consumers (i.e. their quantity

demanded) to a change in the price of a product, other factors being the same.

• The price elasticity of demand always has a negative value, this shows, the fact that the
relationship between price of a good and quantity demanded is inversely related to
each other.

• To avoid possible confusion caused by the negative value of elasticity, economists by

convention have agreed to ignore the negative sign, in most literature the price
elasticity of demand is presented with positive value.

 There are two approaches to calculate elasticity.

a. Point price elasticity of demand

b. Arc price elasticity of demand.

a. Point elasticity of demand:- is used to measure price elasticity of demand
when the change in price is very small or at a point. Thus, price elasticity
of demand is measured as a percentage change in quantity demanded
resulting from a percentage change in price.

ΔQ Δ𝑃 ΔQ 𝑃
εP= / ⟹ εd= ∗
𝑄 𝑃 ΔP 𝑄

𝑑𝑄 𝑃
OR εd= *
𝑑𝑃 𝑄

Ex1. A 5% fall in the price of a good leads to a 20% rise in the quantity
demanded.

• Determine the elasticity and comment on its value.

Ex2. With an 8% rise in the price of a commodity, the quantities demanded falls
from 10 to 2 units. Determines the price elasticity of demand.
Example 3 :Suppose that a household demands 50 units of oranges at
the price 40 cents per piece. If the price falls to the price 30 cents
per piece, 100 oranges are demanded. What is the elasticity of
demand for Oranges? Interpret it.

Example 4: Consider the following demand and supply equation= 20-

0.5 Q and P = 16+0.5Q. Using this information determine price
elasticity of demand at the equilibrium point and interpret the result!
• First we need to determine the value of price and quantity at
equilibrium.
16 + 0.5Q = 20-0-5Q.
Q = 4 and P = 18
𝑑𝑄 𝑃 18
εd= 𝑑𝑃 ∗ 𝑄= -2 4
= −9
 Interpretation: If the price of a good increases by 1 percent,
quantity demanded will fall by 9 percent. Similarly if the price
falls by 1%, quantity demanded will increase by 9%.
 Arc Elasticity of Demand: Arc Elasticity measurement is used when the change in price

is relatively large. That is, it measures elasticity between to points. It is an estimation of

an average elasticity of an arc.

• Arc elasticity of demand is determined as:-

ΔQ 𝑃1 + 𝑃2
εd= ∗
ΔP 𝑄1 + 𝑄2

• Example: The price of sugar was 6 birr per kilo. Due to unfavorable harvest in sugarcane

the price has raised to 8 birr per kilo. Because of this price change the quantity purchased

falls from 16 million quintals to 14 million quintals of sugar. What is the arc price

elasticity of demand for sugar?

14−16 6+8
• Solution: εd= ∗
8−6 16+14

• If the price of sugar increases or decreases by 1%, quantity demanded of sugar decreases

or increases by 0.466% respectively.

Elasticity Description, Implication and Demand curve
• εP > 1- Elastic- % ΔQ>%ΔP Flatter
• εP= 1 -Unitary elastic- % ΔQ=%ΔP
• 0 <εP < 1 -Inelastic -% ΔQ<%ΔP Steeper
• εP= = 0 -Perfectly inelastic -% ΔQ= 0 Vertical
εP= =∞- Perfectly elastic- % ΔQ= ∞ horizontal
major determinants of price elasticity of demand
a. Availability of close substitutes
 The more and better substitutes that exist for a good, the more elastic its demand.
b. The nature of a commodity
 The items that a consumer can use may be either necessary or luxury
C. The proportion of income consumers spends on the commodity: Demand for
those goods on which a consumer spends very small proportion of his income will be inelastic. But
demand for those goods on which a consumer spends the largest proportion of his income will be
elastic.

d. The length of time allowed (available) to adjust to change in price.

 The longer the time allowed for adjustment, the higher would be its elasticity because the
consumer can find more substitutes for the product in the long run
b. Cross Price Elasticity of Demand

 Demand for a good is also affected by the change in the price of related goods.

 Consumers also respond for the change in the price of related goods by either cutting their
consumption or by increasing their consumption.

Δ𝑄𝑥 Δ𝑃𝑦 Δ𝑄𝑥 𝑃𝑦

 Point: εX,Y= / ⟹ εP= ∗
𝑄𝑥 𝑃𝑦 Δ𝑃𝑦 𝑄𝑥

Δ𝑄𝑥 𝑃1𝑦 +𝑃2𝑦

 Arch:εX,Y= ∗
Δ𝑃𝑦 𝑄1𝑥 +𝑄2𝑥

 Example:1

 Due to unknown reason the price of beef meat increased from 40 birr per kilo to 80 birr per kilo.
As a result of this change the quantity demanded of chicken increase from 30 thousand per
month to 50 thousand.

 Determine the cross price elasticity of demand between beef and chicken and interpret the result

 Determine the nature of their relationship?

• The cross price elasticity can have zero, positive and negative value.

• This coefficient tells us nature of relationship between two goods

εX,Y > 𝟎 εX,Y < 𝟎 εX,Y = 𝟎
substitutes Complements Independent(unrelated)

c. Income Elasticity of Demand (εI )

measures the responsiveness of demand of a particular commodity to changes in income of
the consumer.
ΔQ 𝐼 ΔQ 𝐼 +𝐼
Point: εI= ∗ Arch:εI= ∗ 1 2
ΔI 𝑄 ΔI 𝑄1 +𝑄2

Example: Use the information given in the table below to determine: -

a. Income elasticity of demand of the two goods
b. Interpret the result and determine the nature of these goods.
Year Income Per Year Consumption Per year
Commodity X Commodity Y
1996 1500 500 units 1000 units
1997 2500 1500 units 500 units

εI < 𝟎 εI > 𝟎
Inferior Normal
0< EY < 1 EY >= 1
Necessity Luxury
c. Income Elasticity of Demand (εI)
 measures the responsiveness of demand of a particular commodity to changes in income
of the consumer.
ΔQ 𝐼
Point: εI= ∗
ΔI 𝑄

ΔQ 𝐼1 +𝐼2
Arch:εI= ∗
ΔI 𝑄1 +𝑄2

• Example: Use the information given in the table below to determine: -

a. Income elasticity of demand of the two goods
b. Interpret the result and determine the nature of these goods.

Year Income Per Year Consumption Per year

Commodity X Commodity Y
1996 1500 500 units 1000 units
1997 2500 1500 units 500 units
 2.2. supply

2.2.1 Definition

 It is a schedule or curve showing the amounts of a product a firm is

willing and able to produce and make available for sale at each of a

series of possible prices during a specific period, cetris paribus.

2.2.2. The law of supply

 states that all other things being equal, the quantity supplied of

goods & services varies directly with their prices. As price rises, the

corresponding quantity supplied rises; as price falls, the quantity

supplied falls.
2.2.3 .Determinants of supply

 The basic determinants of supply are

a. own price (Px )

b. Non own price

i. Price of related goods (Pr)

ii. rise of factor of production (Pf)

iii. state of production technology(T)

iv. number of suppliers serving the market (N)

v. taxes and subsidies (Ts),

vi. Expectations about future prices (E); etc.

vii. Weather
 2.2.4. Supply function, Schedule and Curve
 Supply function shows the mathematical relationship between quantity of the
commodity that a producer is willing (and able) to supply and its dominant factors.
It is written as follows:
Q s= f (Px, Pr, Pf, N,T ,Ts, E, w …)
 Example .
𝑄𝑆1=7𝑃1-4
𝑄𝑆2=-100+75𝑃2
 Supply Schedule: Is a table showing the relationship between market price and the
quantity supplied per period of time, Ceteris paribus. Consider the following supply
schedule for meat.
Price per unit (in $) 1 2 3 4
Quantity supplied (in tones) 10 20 30 40

Supply Curve: When we plot each pair of values from the supply schedule in table
above on a graph and join the resulting points we get the producer's supply curve.
 2.2.5. Movement vs. shift of the supply curve

Change in quantity supply

 as price of a good changes the quantity supply changes, while other things being constant. . This
causes movement along the (same) supply curve. We call this kind of movement along the supply
curve "change in quantity supplied.”.

 For example, movement from A to B, C to D to A, etc.

Change in supply

 This kind of change refers to a shift in the position of the supply curve caused by a change in
other factors.

 The price of the factors, increase in sales tax, decline in the number of supplies, etc will increase
the cost of production and hence shift the supply curve to the left.

change in quantity supply Change in supply

2.2.6. Individual Firm vs. Market supply curve

 A Individual supply curve is a supply curve for that particular

individual firm.

 A market supply curve is the sum of all firms’ supply curves or

it is the horizontal summation of individual firms’ supply curves.

Parts (SA), (SB), and (SC) show the supply curves for firms A, B, and C,
respectively.
The market supply curve (S), is the sum of the firms’ supply curves.
 Example 1 . Suppose there are 120 sellers of sweet potatoes in a market
and the sellers have similar supply function of the form Qs = 20p - 5.
What is the market supply? What is the quantity supplied in the market
when price is Br.4?

 Solution: 𝑄𝑚 = 𝑄𝑆 x 120= 120 (20p - 5)

𝑄𝑚 = 1440p – 600

𝑄𝑚 (p=4) = 1440 (4) – 600 =5760 – 600 = 5160 units

 Example 2. What is the market supply of 100 identical suppliers if the

supply function of a typical suppliers is Qs = 3p - 2 ?

 Example 3. If the supply function of a representative supplier in a market

of 50 similar Suppliers of jeans is P= 0.1Qs + 0.5, then What is the market
supply function? What is the quantity supplied in the market if the price is
Br 100?
2.2.7. Elasticity of supply

 Elasticity of supply is the measurement of responsiveness of

quantity supplied when one of the supply determinants (price)
changes.

 To determine elasticity of supply we can use both point as well

as arc elasticity approach depending upon the magnitude of
change in the price of a commodity.
a. Point price elasticity of supply
ΔQ 𝑃
εs= ∗
ΔP 𝑄
b. Arc price elasticity of supply.
ΔQ 𝑃1 + 𝑃2
εs= ∗
ΔP 𝑄1 + 𝑄2
As in the case of price elasticity of demand, the price elasticity of supply
may vary from zero to infinity.

εs Name Interpretation

<1 Relatively inelastic • When the quantity of a good supplied changes

little for a larger changes in its price, supply is
said to be inelastic .

=1 Unitary elastic • When the quantity of a good supplied changed by

the same amount as the change in price, supply is
called unitary elastic supply with the coefficient of
elasticity,

>1 Relatively Elastic • When the quantity of a good supplied changed by

a greater amount than the change in its price,
supply is elastic.

=∞ Perfectly elastic • If supply is perfectly elastic, the coefficient of

elasticity of supply,

=0 Perfectly inelastic • It means there is no effect of price change on

quantity supplied.
 2.8. Market Equilibrium

2.8.1 Definition

 An equilibrium is the condition that exists when quantity supplied and quantity demanded are
equal.

 At equilibrium, there is no tendency for the market price to change.

 The price levels at which the market reaches equilibrium is called the market clearing/equilibrium
price, and the corresponding quantity is called the equilibrium quantity

Price • Only in equilibrium is quantity supplied equal to

of
produc
t Supply quantity demanded.
PE Equilibrium
• At any price level other than PE, the wishes of
Demand buyers and sellers do not coincide.

• It is possible to derive the market clearing price

QE Quantity
and quantity using mathematical approach
 Example 1. If the market demand and supply functions are given as Qd = 80 – 3P and
Qs = 9P -40 respectively.
 Then, what is the market clearing price and the corresponding quantity?
Solution :Equate Qd = Qs to get the equilibrium price
 Qd = Qs
 80 – 3p = 9p-40 substitute for Qd and Qs
 120 = 12p rearrange p* = 10 birr
 To get the equilibrium quantity (Q*), substitute this price in to either of
the functions.
• Qd = 80 – 3 (10)
• Q* = 50 units
 Therefore, the market clears when price is Br. 10 and both the quantity
demanded and supplied are 50 units.
 Example 2 If the inverse demand and supply functions for the market of
ball point pen is given as follows P = 2 – 0.1 Qd and P = 1/5 Qs – 1.
 Then, find the equilibrium price of a unit of ball point pen.
 How many ball point pens will be sold and bought at equilibrium?
 Soln : First of all change the inverse functions in to direct demand and
supply functions.
 P = 2 - 0.1Qd multiply by 10
 10p = 20 - Qd, rearrange
Qd = 20 - 10p
P = 1/5 Q5-1 multiply by 5
 5P = Q5 – 5 rearrange
Qs = 5P + 5
 Now, we equate the two functions and obtain the market clearing price as follows.
Qd = Qs ; substitute
 20 – 10P = 5P + 5 collect like terms
 10P + 5P = 20-5
15P = 15
P* = 1 birr
 Substitute this price in to either of the functions to obtain the equilibrium
quantity.
Qs = Qd = 20 – 10P = 20 – 10 (1)
Q* = 10 pens
2.8.2. Change in Equilibrium Price and Quantity

• Change in market DD, SS or both affects equilibrium

Price and quantity
A) Only Demand shifts
• Demand  P*  and Q* 

• Demand  P*  and Q* 
SS1
P

P*

DD2
DD0 DD1
Q* Q
 B) only supply shifts
• Supply  P*  and Q*
• Supply  P* and Q* 

SS0
SS1
P
SS2
P*

DD1

Q* Q
 C) Both demand and supply change
C1) Both demand and supply increase
• Demand  P*  and Q* 
• Supply   P*  and Q* 
------------------------------------------
• Net effect P* indeterminate and Q*
C2) Both demand and Supply decrease
• Demand   P*  and Q* 
• Supply   P*  and Q* 
----------------------------------------
• Net effect P* indeterminate and Q*
C3) Demand increases and supply decreases
 Demand  P*  and Q* 
 Supply   P*  and Q* 
------------------------------------------
 Net effect P*  and Q* indeterminate
C4) Demand decreases and Supply increase
 Demand  P*  and Q* 
 Supply   P*  and Q* 
----------------------------------------
 Net effect P* and Q* indeterminate