CHAPTER TWO

THEORY OF DEMAND AND SUPPLY

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 THEORY OF DEMAND
Definition: - It refers to the amount of commodity which and
individual buyer is willing and able to buy at a given price and a given
period of time.
• Demand describes the behavior of consumers.
LAW OF DEMAND
• The law of demand states that, other things being equal, at higher
price consumers will purchase less of a commodity, and at a lower
price, consumers will purchase more of it. Or
• A rise in the price of goods leads to a fall in quantity demanded and
vice versa, assuming all other determinants of demand are kept
constant.
• Price and demand are inversely related. 2
 THEORY OF SUPPLY

Definition
• It refers to a various quantities of a commodity which
producers are willing and able to offer for sale at a particular
time and at various corresponding prices.
Law of supply
• The law of supply states that there is a direct relationship
between the price of a commodity and its supply. Or
• Other things being equal the supply of a commodity
increases with an increase in its price and decreases with the
fall in price. 3
 Demand Schedule
A demand schedule is a table which presents the
quantity demanded at different price levels during a
specific time period.
Individual demand schedule: - A tabular statement
which shows a quantity demanded of a commodity by an
individual household at various alternate prices per time
period.
Market demand schedule: - A tabular statement which
shows the different quantities of a commodity
demanded by different households or consumers in a
market at various alternate prices per time period. 4
 Table 1.1 Individual demand schedule
Price (per KG) Quantity Demanded (units)
10 4
15 3
25 1

Table 1.2 Market demand schedule

Price (per X’s Demanded Y’s Demanded Market
KG) (units) (units) Demand (X+Y)
10 4 6 10
15 3 4 7
25 1 2 3
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 Supply schedule
It is a tabular statement that states the different
quantities of a commodity offered for sale at different
prices.
• Individual supply schedule: - A tabular statement
which shows the different quantities of a commodity
offered for sale by an individual firm at different prices
per time period.
• Market supply schedule: - A tabular statement which
shows the sum of the quantities supplied by all the
sellers.
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 Table 1.3 Individual Supply schedule
Price (per KG) Quantity Supplied(units)
5 15
8 20
12 28

Table 1.4 Market Supply schedule

Price X’s Supply Y’s Supply Market Supply
(per KG) (units) (units) (X+Y)
5 15 12 27
8 20 18 38
12 28 25 53
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 Demand Curve
A demand curve conveys the same information as a demand
schedule. But it shows the information graphically rather
than in a tabular form. Demand curves also are of two types.
Individual demand curve: - Refers to a curve which
expresses graphically the relationship between different
quantities of a commodity demanded by an individual at
different prices per time period.
Market demand curve: - Refers to the curve which shows
graphically the relationship between different quantities of a
commodity demanded by different households at different
prices per time period.
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Individual and market demand curves

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 Supply Curve
• It is a graphical statement that states the different
quantities of a commodity offered for sale at
different prices.
• Individual supply curve: - refers to a curve which
expresses graphically the relationship between
different quantities of a commodity supplied by an
individual firm at different prices per time period.
• Market supply cure: - is found by adding up
horizontally the individual supply curves
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 Supply Curves

Fig 1.4 Market supply

Fig 1.3 Individual supply curve
curve

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 Determinants of demand
• Price of the commodity itself.
• Price of related goods.
A. Substitute good
B. Complementary good
• Change in consumer’s income
• Change in consumer taste and preference
• Consumer expectation about future price
• Climate.
• Population and number of households.
• Distribution of income and wealth.
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 Determinants of supply
• Price of the commodity
• Change in Price of related goods.
A. Substitute good
B. Complementary good
• Change in factor prices.
• Objectives of the firm.
• State of technology.
• Cost of production
• Expectation about future price change
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 Elasticity of Demand
• Definition: - It refers to the degree of
responsiveness of quantity demand of a good to a
change in its price, or change in income, or
change in price of related goods.
• Accordingly there are three kinds of demand
elasticity: price elasticity, income elasticity and
cross elasticity.

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 Price elasticity of demand (PED)
• It is the 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= percentage change in quantity
demanded
𝐐 𝟐− 𝐐 Percentage
𝟏 change in the price of
good % ∆ 𝑸𝒅 𝐐𝟏
𝑷𝑬𝑫= = 𝐏 𝟐− 𝐏 𝟏
%∆𝑷
𝐏𝟏 15
• EXAMPLE 1: from the above diagram suppose that the
price of a commodity is Br. 3 and the quantity demanded
at that price is 5 units of a commodity. Now assume that
the price of the commodity rise to Br. 4 and the quantity
demanded falls to 3 units. In terms of the above formula,
the value of Price elasticity of demand will be;
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• EXAMPLE 2: suppose the price of gasoline is Br. 3 and the
quantity demanded at that price is 4 liters. Now assume that
the price of gasoline rises to Br. 4 and the quantity
demanded falls to 3.5 liters. In terms of the above formula,
the value of Price elasticity of demand will be;
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Interpretation of the Value of PED
Price Elasticity of Demand is the percentage change in
quantity demanded resulting from a 1% change in the
price.
Price elasticity of demand is ALWAYS Negative because
of the negative relationship between price and the
quantity demand.
 Interpretation of the first example is (for every 1%
increase in price, Qd decreases by 1.21%)
 The 2nd example’s interpretation is (for every 1%
increase in price, Qd decreases by 0.38%)
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 Determinants of Price elasticity of
demand
• S: # of Substitutes; the more substitutes a good has the
elastic it is and vice versa.
• P: the proportion of consumers’ income the price of a
good represents
• L: Luxury or Necessity; Demand for Luxury good tends to
be more elastic than Necessity
• A: Addictiveness of a good; Addictive goods tend to have
highly inelastic demand
• T: the amount of time; in a short run demand tends to be
less elastic
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 Income elasticity of demand
(YED)
It is the ratio of proportionate change in demand to
proportionate change in income of the consumer.

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 Summary

• If YED>1, the good is luxury good.

• If YED <1 (and positive), the good is necessity
good,
• If YED < 0 (negative), the good is inferior good.

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Example: Suppose a consumer’s income increases from
100 to 200 birr per week, as a result his/her consumption
of good A increases from 20 units to 40 units per week
therefore, what is the income elasticity of demand.
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• Example 2: Suppose if the consumption of good B
decreases from 20 units to 10 units per week while a
consumer’s income increases from 100 to 200 birr per
week, what will be the income elasticity of demand.
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• So if the good is normal good it will have a positive
relationship with income, and if it is an inferior
good there will be negative relationship between
the income and the consumption

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 Cross elasticity demand (XED)
• Responsiveness in the demand for a commodity to the
change in the prices of its related goods is called cross
elasticity of demand.
• The cross price elasticity is zero for unrelated good;
positive if the goods are substitute and negative for
complementary goods.

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• Example1: Suppose the price of Coca-Cola increased from1$
to 2$, as a result the quantity demanded of Pepsi goes up from
20 to 40 therefore, what is the cross price elasticity of demand
here?
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• Example 2: Assume the price of Petrol increased
from 1$ to 2$, as a result the quantity demanded of
New Cars goes down from 20 to 10 therefore, what is
the cross price elasticity of demand here?
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• Therefore, if the relationship between the price of the
good and the quantity demanded of the other good is
positive, these two good are said to be substitute
goods. But, if they have negative relationship these
goods are complementary goods.

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Types of elasticity of demand

1. Perfectly inelastic demand (ed= 0)

2. Inelastic demand (ed<1)
3. Unit elastic demand (ed=1)
4. Elastic demand= (ed >1)
5. Perfectly elastic demand (ed=ᴔ)

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 Price Elasticity of supply
• It refers to the degree of responsiveness of
quantity supplied of a commodity to a change in
its price.

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 Market Equilibrium
Definition
• Market equilibrium refers to a situation in which the
quantity demanded of a commodity equals the
quantity supplied of the commodity.
• It means a state of balance and it refers to the balance
between the opposite forces of demand and supply.
• The equilibrium quantity and price are determined at
the intersection of demand and supply which is at
point is point E.
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• Equilibrium price:-The price at which the
quantity demanded of a commodity is equal to
quantity supplied.
• Equilibrium quantity: - the amount which is
bought and sold at equilibrium price is called
equilibrium quantity.

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Market Equilibrium Curve

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Example 1:- the demand curve for bottled water is
Qd = 100-6p and the supply curve is Qs = 28+3p.

What is?
a) The equilibrium price
b) The equilibrium Quantity

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 Solution
a) The equilibrium price
At equilibrium Qd=Qs
Thus,
100-6p=28+3p
100-28=6p+3p
72=9p
72/9=p
P=8
Therefore the equilibrium price is 8
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 b)The equilibrium Quantity

Demand equation Supply Equation

Qd=100-6p Qs=28+3p
Qd=100-6(8) As P=8 Qs=28+3(8) As P=8
Qd=100-48 Qs=28+24
Qd=52 Qs=52

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• Sometimes the equations are given in terms of what
the price is equal to, so let’s see at another example
Example 2: the demand curve for bread is given
P=60-1.4Qd and the supply curve is P= -60+1.6Qs
What is?
a) The equilibrium Quantity
b) The equilibrium price
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 Solution
• At equilibrium Qd is equal to Qs, thus we replace Qd and Qs
in both equations with Qe
a) The equilibrium Quantity
At equilibrium Qd=Qs
Thus,
P= 60-1.4Qe
P= -60+1.6Qe
60-1.4Qe = -60+1.6Qe
60+60=1.4Qe+1.6Qe
120=3Qe
120/3 = Qe
40 = Qe 44
 The equilibrium price
Demand equation Supply Equation
P=60-1.4Qd P =-60+1.6Qs
P=60-1.4(40) P=-60+1.6(40)
P=60-56 P=-60+64
P=4 P=4

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