CHAPTER TWO

THEORY OF DEMAND AND SUPPLY

2.1 Theory of demand
1. Are demand and want similar? Why?
2. Why can’t we purchase all that we need or we desire to have?
3. Can we say that, with a decrease in the price of a commodity, a
consumer normally buys more of it? Why?
4. Explain why demand curves always slope downwards from left to
right. Are there any exceptions to this?

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 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.

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 Law of demand: This is the principle of demand, which states that , price of
a commodity and its quantity demanded are inversely related i.e., as price of a
commodity increases (decreases) quantity demanded for that commodity
decreases (increases), ceteris paribus.

 2.1.1 Demand schedule, demand curve and demand function

o Demand schedule can be constructed for 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 price and quantity demanded
in a table form.
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 Demand curve is a graphical representation of the relationship
between different quantities of a commodity demanded by an
individual at different prices per time period.

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 Demand function is a mathematical relationship between price
and quantity demanded, all other things remaining the same. A
typical demand function is given by:
Qd = f(P)
 where Qd is quantity demanded and P is price of the commodity, in
our case price of orange.
 Example: Let the demand function be Q = a+ bP

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 Market Demand: The market demand schedule, curve or function
is derived by horizontally adding the quantity demanded for the

product by all buyers at each price.

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 Numerical Example: Suppose the individual demand function of a product
is given by: P=10 - Q /2 and there are about 100 identical buyers in the
market.
 Then the market demand function is given by:

P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and
Qm = (20 – 2P) 100 = 2000-200P

2.1.2 Determinants of demand(TIOES)(TIPNC)

 Taste or preference of consumers

 Income of the consumers

 Price of related goods

Consumers expectation of income and price

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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.

 Changes in demand: a change in any determinant of demand

except for the good‘s price causes the demand curve to shift. We

call this a change in demand.

 If buyers choose to purchase more at any price, the demand curve

shifts rightward an increase in demand.

 If buyers choose to purchase less at any price, the demand curve

shifts leftward a decrease in demand.

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 Now let us examine how each factor affect demand.

I. Taste or preference

 When the taste of a consumer changes in favour of a good, her/his

demand will increase and the opposite is true.

II. Income of the consumer

 Goods are classified into two categories depending on how a change in

income affects their demand.

 These are normal goods and inferior goods.

i. Normal Goods are goods whose demand increases as income increase,

while ii. inferior goods are those whose demand is inversely related with
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income.
 In general, inferior goods are poor quality goods with relatively

lower price and buyers of such goods are expected to shift to

better quality goods as their income increases.

 However, the classification of goods into normal and inferior is

subjective and it is usually dependent on the socio-economic

development of the nation.

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III. Price of related goods
 Two goods are said to be related if a change in the price of one
good affects the demand for another good.
 There are two types of related goods. These are substitute and
complimentary goods.
i. Substitute goods are goods which satisfy the same desire of the
consumer. For example, tea and coffee or Pepsi and Coca-Cola are
substitute goods.

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ii. Complimentary goods, on the other hand, are those goods which are
jointly consumed. For example, car and fuel or tea and sugar are
considered as compliments.
 If two goods are complements, then price of one and the demand

for the other are inversely related.

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.
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
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decrease in the number of buyers will decrease demand.
2.1.3 Elasticity of demand
1. List some goods/commodities you think that increase in their
prices will not significantly decrease their quantity demanded.
2. Can you list some products for which increase in their prices will
significantly decrease/increase their quantity demanded?
 Elasticity is a measure of responsiveness of a dependent variable
to changes in an independent variable.
 Accordingly, we have the concepts of elasticity of demand and
elasticity of supply.

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 Elasticity of demand refers to the degree of responsiveness of
quantity demanded of a good to a change in its price, or change in
income, or change in prices of related goods.
 Commonly, there are three kinds of demand elasticity: price
elasticity, income elasticity, and cross elasticity.

i. Price Elasticity of Demand

 Price elasticity of demand means degree of responsiveness of
demand to change in price. It indicates how consumers react to
changes in price.
 The greater the reaction the greater will be the elasticity, and the
lesser the reaction, the smaller will be the elasticity. 18
 Price elasticity demand can be measured in two ways. These are
point and arc elasticity.
a. Point Price Elasticity of Demand
 This is calculated to find elasticity at a given point. The price
elasticity of demand can be determined by the following formula.

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 In this method, we take a straight-line demand curve joining the two
axes, and measure the elasticity between two points Qo and Q1
which are assumed to be intimately close to each other.

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b. Arc price elasticity of demand
 It measures 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.

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• Here, Qo = Original quantity demanded
Q1 = New quantity demanded
Po = Original price
P1 = New price
 We can take a numerical example to illustrate arc elasticity.
Suppose that the price of a commodity is 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, the value of the arc elasticity will be:

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• Note that:
 Elasticity of demand is unit free because it is a ratio of percentage
change.
 Elasticity of demand is usually a negative number because of the
law of demand.
 If the price elasticity of demand is positive the product is inferior.
i) If   1, demand is said to be elastic and the product is luxury
product
ii) If 0   1, demand is inelastic and the product is necessity
iii) If   1, demand is unitary elastic.
iv) If   0, demand is said to be perfectly inelastic.
v) If   , demand is said to be perfectly elastic.

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 Determinants of price Elasticity of Demand:(ATIP):
i. Availability of substitutes: the more substitutes available for a
product, the more elastic will be the price elasticity of demand.
ii. Time: In the long- run, price elasticity of demand tends to be
elastic. Because:
 More substitute goods could be produced.
 People tend to adjust their consumption pattern.
iii. proportion of income consumers spend for a product:-the
smaller the proportion of income spent for a good, the less price
elastic will be.
iv. Importance of the commodity in the consumers’ budget :
 Luxury goods  tend to be more elastic, example: gold.
· Necessity goods  tend to be less elastic example: Salt.

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ii. Income Elasticity of Demand
It is a measure of responsiveness of demand to change in income.

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iii. Cross price Elasticity of Demand
• Measures how much the demand for a product is affected by a
change in price of another good.

Example: Consider the following data which shows the changes in

quantity demanded of good X in response to changes in the price of
good Y.
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Therefore, the two goods are complements.

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2.2 Theory of supply
 Supply indicates various quantities of a product that sellers
(producers) are willing and able to provide at different prices in a
given period of time, other things remaining unchanged.
 The law of supply: states that, ceteris paribus, as price of a product
increase, quantity supplied of the product increases, and as price
decreases, quantity supplied decreases.
 It tells us there is a positive relationship between price and quantity
supplied.
2.2.1 Supply schedule, supply curve and supply function
 A supply schedule is a tabular statement that states the different
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 A supply curve conveys the same information as a supply
schedule. But it shows the information graphically rather than in
a tabular form.

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 The supply of a commodity can be briefly expressed in the following
functional relationship:
S = f(P), where S is quantity supplied and P is price of the commodity.
 Market supply: It is derived by horizontally adding the quantity
supplied of the product by all sellers at each price.

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 2.2.2 Determinants of supply(STORE)(PPSTTN)
• Apart from the change in price which causes a change in quantity
demanded, the supply of a particular product is determined by:
i) price of inputs ( cost of inputs)(-)
ii) Technology (+)
iii) prices of related goods(-/+)
iv) sellers‘ expectation of price of the product(-/+)
v) taxes & subsidies (-/+)
vi) number of sellers in the market (+)
vii) weather, etc.(+)
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2.2.3 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.
 As the case with price elasticity of demand, we can measure the
price elasticity of supply using point and arc elasticity methods.
However, a simple and most commonly used method is point
method.
 The point price elasticity of supply can be calculated as the ratio of
proportionate change in quantity supplied of a commodity to a
given proportionate change in its price.
 Thus, the formula for measuring price elasticity of supply is: 35
 Con’t…

 Like elasticity of demand, price elasticity of supply can be elastic,

inelastic, unitary elastic, perfectly elastic or perfectly inelastic.
o The supply is elastic when a small change on price leads to great
change in supply.
o It is inelastic or less elastic when a great change in price induces
only a slight change in supply.
o If the supply is perfectly inelastic, it will be represented by a
vertical line shown as below.
o If supply is perfectly elastic it will be represented by a horizontal
straight line as in second diagram.

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 2.3 Market equilibrium
• Having seen the demand and supply side of the market, now let‘s
bring demand and supply together so as to see how the market
price of a product is determined. Market equilibrium occurs when
market demand equals market supply.

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 Numerical example: Given market demand: Qd= 100-2P, and market supply:
P =( Qs /2) + 10
a) Calculate the market equilibrium price and quantity
b) Determine, whether there is surplus or shortage at P= 25 and P= 35.
Solution:
a) At equilibrium, Qd= Qs
100 – 2P = 2P – 20
4P =120
P*  30, and Q*  40
b) Qd (at P = 25) = 100-2(25) =50 and
Qs (at P = 25 ) = 2(25) -20 =30
• Therefore, there is a shortage of: 50 -30 =20 units
 Qd ( at P=35) = 100-2(35) = 30 and
 Qs (at p = 35) = 2(35)-20 = 50, a surplus of 20 units.

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 2.4 Effects of shift in demand and supply on equilibrium
 Given demand and supply the equilibrium price and quantity are
stable. However, when these market forces change what will happen
to the equilibrium price and quantity? Changes in demand and
supply bring about changes in the equilibrium price level and the
equilibrium quantity.

i) when demand changes and supply remains constant

 Factors such as changes in income, tastes, and prices of related
goods will lead to a change in demand. The figure below shows the
effects of a change in demand and the resultant equilibrium price
and quantity. DD is the demand curve and SS is the supply curve.
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 DD and SS curves intersect at point E and the quantity
demanded and supplied is OM at OP equilibrium price.
 Given the supply, if the demand increases the demand curve will
shift upward to the right. Due to a change in demand, the
demand curve D1D1 intersects SS supply curve at point E1.
 The equilibrium price increases from OP to OP1 and the
equilibrium quantity from OM to OM1. On the other hand, if
demand falls, the demand curve shifts downwards to the left.

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 Due to a change in demand, the curve D2D2 intersects the supply
curve SS at point E2.
 The equilibrium price decreases from OP to OP2 and the
equilibrium quantity decreases from OM to OM2. Supply being
given, a decrease in demand reduces both the equilibrium price
and the quantity and vice versa.

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ii. When supply changes and demand remains constant
 Changes in supply are brought by changes in technical
knowledge and factor prices. The following graph explains the
effects of changes in supply.

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THE END!

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