Chapter Two Theory of Demand and

Supply

 Introduction
 The purpose of this chapter is to
explain what demand and supply are
and show how they determine
equilibrium price and quantity. We will
also show how the concepts of demand
and supply reveal consumers‘ and
producers‘ sensitivity to price change.
 Chapter objectives

 After covering this chapter, you will be able to:
 understand the concept of demand and the
factors affecting it;
 explain the supply side of a market and the
determinants of supply;
 understand how the market reaches
equilibrium condition, and the possible factors
that could cause a change in equilibrium and
 explain the elasticity of demand and supply
 2.1 Theory of
demand

 Demand is one of the forces
determining prices.
 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.
 Demand, means the desire of the
consumer for a commodity backed by
purchasing power.
 cont.

 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
 2.1.1 Demand schedule (table), demand
curve and demand function

 The relationship that exists between price and
the amount of a commodity purchased can be
represented by a table (schedule) or a curve or
an equation.
 A demand schedule states the relationship
between price and quantity demanded in a table
form.
 Demand curve


 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.

 Demand function

 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
 b= (e.g. moving from point A to B on figure 2.1
above)
 cont.
 b=

, where b is the slope of the
demand curve
 Q = a-2P, to find a, substitute price
either at point A or B.
 7= a-2(4), a = 15
 Therefore, Q=15-2P is the demand
function for orange in the above
numerical example.
 2.1.2 Determinants 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
 Changes in demand:



those factors listed above other than price are
called demand shifters. A change in own price is
only a movement along the same demand curve.
 Determinants of 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
 Normal Goods are goods whose demand
increases as income increase, while inferior
goods are those whose demand is inversely
related with income.
 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
 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.
 If two goods are substitutes, then price of
one and the demand for the other are
directly related.
 cont.

 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 decrease in the number of buyers
will decrease demand.
 2.1.3 Elasticity of demand

 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.
 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,
 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.
 Price elasticity of demand is a measure of how
much the quantity demanded of a good
responds to a change in the price of that
good, computed as the percentage change in
a. Point Price Elasticity of
Demand

b. Arc price elasticity of
demand

 cont.

 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
 cont.
 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.
cont.

 Determinants of price
Elasticity of Demand

 i) The 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.
 cont.

 iii) The 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) The importance of the
commodity in the consumers’
budget :
 Luxury goods →tend to be more elastic,
example: gold.
 Necessity goods→ tend to be less
 ii. Income Elasticity of
Demand


It is a measure of responsiveness of
demand to change in income.

 iii. Cross price Elasticity of
Demand


Measures how much the demand for a
product is affected by a change in price
of another good.
 cont.

 i) The cross – price elasticity of demand
for substitute goods is positive.

 ii) The cross – price elasticity of demand

for complementary goods is negative.

 iii) The cross – price elasticity of

demand for unrelated goods is zero.
cont.

 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
 2.2.1 Supply schedule, supply curve
and supply function

 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.
 2.2.2 Determinants of supply

 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.
i) Effect of change in input price on
supply of a product

 An increase in the price of inputs
such as labour, raw materials,
capital, etc causes a decrease in
the supply of the product which
is represented by a leftward shift
of the supply curve. Likewise, a
decrease in input price causes
an increase in supply.
 ii) Effect of change in
Technology

 Technological advancement
enables a firm to produce
and supply more in the
market. This shifts the
supply curve outward.
 iii) Effect of change in
weather condition

 A change in weather condition will
have an impact on the supply of a
number of products, especially
agricultural products. For example,
other things remain unchanged, good
weather condition boosts the supply
of agricultural products. This shifts the
supply curve of a given agricultural
product outward. Bad weather
 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.
 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.
 Cont.


 Like elasticity of demand, price elasticity of

supply can be elastic, inelastic, unitary
elastic, perfectly elastic or perfectly inelastic.
 Cont.

 The supply is elastic when a small change on
price leads to 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.
 If supply is perfectly elastic it will be
represented by a horizontal straight line as in
second diagram.
Perfectly inelastic and perfectly
elastic supply curves

 2.3 Market
equilibrium

 Market equilibrium occurs when market
demand equals market supply.
 Cont.

 In the above graph, any price greater than P will
lead to market surplus. As the price of the
commodity increases, consumers demand less of
the product. On the other hand, as the price of
increases, producers supply more of the good.
Therefore,
 if price increases to P1 the market will have a
surplus of HJ.
 If the price decreases to P2 buyers demand to buy
more and suppliers prefer to decrease their supply
leading to shortage in the market which is equal to
GF.
 Cont.

 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.
 Cont.

 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
i) when demand changes and supply
remains constant

ii. When supply changes and
demand remains constant

III) Effects of combined changes
in demand and supply

 When both demand and supply increase, the
quantity of the product will increase
definitely. But it is not certain whether the
price will rise or fall. If an increase in
demand is more than an increase in supply,
then the price goes up.
 On the other hand, if an increase in supply is
more than an increase in demand, the price
falls but the quantity increases. If the
increase in demand and supply is same,
then the price remains the same.
 CONT.


When demand and supply decline, the
quantity decreases. But the change in price
will depend upon the relative fall in demand
and supply. When the fall in demand is more
than the fall in supply, the price will
decrease.
 On the other hand, when the fall in supply is
more than the fall in demand, the price will
rise. If both demand and supply decline in
the same ratio, there is no change in the
equilibrium price, but the quantity