2.

Theories of Demand and Supply

Definitions of Terms
Desire: refers to something that we wish to have regardless of our wants and needs.
Need: refers to something that we must have to fulfill our basic requirements.
Want: refers to something that we desire to have for our better satisfaction.
Demand: refers to the desire for a particular commodity that will be backed by the ability and willingness
to purchase it at certain prices during a specific period.
Therefore, demand refers to
a) the ability and willingness of buyers to purchase different quantities of a good
b) at different prices
c) during a specific time period
For example, we can express part of Mintesenot’s demand for magazines by saying that he is able and
willing to buy 2 magazines a month at Birr 10 per magazine and that he is willing and able to buy 4
magazines a month at Birr 5 per magazine.
Ceteris Paribus: It is a Latin term meaning ‘all other things constant’ or ‘nothing else changes’ or
‘keeping other things remaining constant’.
2.1. Definition and Law of Demand

2.1.1 Definition

Demand refers to the desire and ability of buyers/consumers to purchase/consume a given amount of
goods or services, over a range of prices, over a given period of time. Demand refers to the whole set of
price-quantity combinations, i.e., demand defines the whole set of relationship between price and
quantity.

Quantity Demanded: the specific amount of a commodity that people are willing and able to buy at a
particular price, i.e., the quantity of a good or service that consumers demand at price Birr 1, the quantity
they demand at price Birr 2, etc.

Demand Schedule: a tabular listing that shows the quantity demanded at various prices, ceteris paribus.

The phrase ceteris paribus means other things remain the same.

Table 2.1: Demand schedule of Mr.Bayu for bread

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

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 Demand curve- a graphical representation of demand schedule showing the relationship between the
quantities demanded and its own price, ceteris paribus. It is the relationship showing the various amounts
of a commodity that buyers would be willing and able to purchase at possible alternative prices during a
given time period, all other things remaining constant. 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

0 50 100 150 200 250 Quantity

Y axis = the sacrifices that must be made to obtain a commodity - price

X axis = the quantity demanded per unit of time

2.1.2 Law of Demand

Law of Demand- is a principle stating that as the price of a commodity increases, the fewer consumers
will purchase per unit of time, ceteris paribus. As price increases, the quantity demanded decreases per
unit of time, ceteris paribus. Why?
 Substitution Effect- When a price of a good starts to increase relative to the price of other goods,
then people start to buy less of that good and more of its substitutes.
 Income Effect- When price increases relative to income, people begin to buy less of the good
whose price has increased.
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:
Q = a - bp Where, a is the intercept and -b is the slope (-ve).

2.2. Determinants of Demand

Demand for goods and services are affected by several factors. These include:
i. The price of the good and service (own price)-negative

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 ii. The tastes and preferences of the group demanding the good. -ve or +veEg. Animal fat leads to a
higher risk of heart attacks. This results in low demand for red meat.
iii. The income and wealth of the group. +ve or -ve
Normal goods: An increase in disposable income leads to the increase in demand for these goods.
Inferior goods: An increase in disposable income leads to a decrease in demand for these goods. Can you
give any example of such good?
iv. The Price of related goods and services (i.e. substitute goods. +ve and complements (negative)
v. The size of the group (population).
vi. Expectations about the future (eg. Of higher price)
vii. Others (Changes in the population, weather, length of adjustment period, availability of
substitutes, proportion of the consumer’s budget that a particular good represents, etc.). The less
of a consumers budget a commodity represents, the more inelastic the demand be. For e.g.
Salt….Even if price doubles, the consumption will not be affected very much).
Demand is, therefore, a multivariate function:
Qd= f(P, Po T, S, I, E,Z)
Where: P is output price
Po is the price of other goods and services.
T is the taste of consumers toward the good.
S is the size of the population in the market.
I is the income of consumers.
E is the expectation of consumers about future market conditions.
Z is other factors.
All things that affect demand work through one of these factors. When studying demand all factors that
affect demand, except one, are kept constant (ceteris paribus) and we determine what happens to demand
when the factor under consideration changes.
Why the demand curve is downward sloping?

The two reasons for the negative slope of demand curve are income effect and substitution effect.

 Income effect: When the price of a commodity falls, a consumer can buy more of the
commodity with the same amount, indicating an increase in his real income.
 Substitution effect: When the price of a commodity falls, it becomes relatively cheaper than
its substitutes. So people who are consuming the other goods would now start consuming the
commodity whose price has fallen, and as a result, its demand increases. This increase in
demand is called the substitution effect of price change.
Exceptional cases to the Law of Demand

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There are some situations when the law of demand does not operate. With an increase in price, more
quantity of a commodity is purchased and vice versa. In these situations demand curve is upward sloping.
These are known as exceptions to the law of demand. The main exceptions are as follows:

a) Giffen Goods

As the Law of Demand states, if the price of a commodity increases, the demand for that commodity
should decrease. However, sometimes exceptions do arise. Giffen goods are not any specific kind of
commodities. They may be essential commodities, much cheaper than their substitutes, which are
consumed by poor households who spend a large part of their income consuming them. If prices of such
goods increase (while the price of its substitutes remain constant), their demand increases instead of
decreasing. Sometimes, people may buy more of a good when the prices are high. This phenomenon that
does not obey the law of demand is known as Giffen's Paradox (named after the economist Robert
Giffen).

b) Prestigious Goods (or Luxury Goods)

The law of demand does not apply to certain commodities that serve as "status symbols," enhance social
prestige, display possession of wealth and richness, or confer a higher social status on the consumer.

Examples: Diamonds, gold, precious stones, and antiques are purchased by rich people to maintain high
prestige in the society without caring for the high price of these goods.

2.3. Definition and Law of Supply

Supply refers to the quantity of goods offered for sale at a particular time or a particular place at
alternative prices. Supply defines the whole set of price-quantity relationship. It shows the quantities that
producers are willing and able to supply at alternative prices, ceteris paribus.
Supply schedule: is a tabular listing that shows quantity supplied at various prices, ceteris paribus. Look
at the table below.
Table: Supply Schedule
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 below).

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 P Supply curve
25
20
15
10
5

0 10 20 30 40 50 Q
Figure: Supply Curve
The Law of Supply
The supply curve shows the relationship between the quantity supplied of a good and its price. Therefore,
in order to see what happens when the price of the good under considerations changes, everything but the
price of the good must be held constant. Given these conditions, the law of supply states that the quantity
supplied of a good or service is usually a positive function of price, ceteris paribus.
2.4. 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/firms (S).
5. Expectations (E).
6. Others (Weather, Price of other commodities that use the same or similar set (bundle) of inputs:
Eg. Land to use for Corn or Wheat..If E(profit) from corn is greater than E(profit) from Wheat,
we expect the supply of corn to increase, Producer Expectations of price change).
Everything that affects supply works through one of these determinants. Supply function is, then, defined
as
Qs = f (P, T, Pf, S, E, Z)

2.5. Market Equilibrium Approaches

In a free market system output price as well as the level of output in a market are determined by the forces
of demand and supply. The condition of equality of demand and supply is called equilibrium.
Demand is a negative function of price while supply is a positive function of price. Coexistence of buyers
and sellers in a given market implies that if there is to be any exchange, there must be a price at which the

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quantity that sellers are willing and able to sell must be equal to the quantity that buyers are willing and
able to buy.
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. Additionally, a market that is not at the equilibrium position moves toward that
point. 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).

Table: Supply of and Demand for Coffee

Price per Kg Kg supplied Kg demanded Difference
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 )
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
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: Market Equilibrium
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.

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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. Quantities bought and
quantities sold are always equal. But at equilibrium the quantity that suppliers wish to sell is exactly equal
to the quantity demanders wish to purchase, i.e., 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. If demand is
given as Qd  a  bP and supply is given as Qs  c  dP , the equilibrium condition is

Supply = Demand
a  bP  c  dP
Example: Suppose the demand and supply functions in a particular market are given as:

Qd  100  2 P

Qs  10  4 P
At equilibrium Qd = Qs
100  2P  10  4P
Rearranging 6P  90
The equilibrium Price is, therefore, P = 15.
The equilibrium quantity is obtained by substitution.

Qd  100  2(15)  70  Qs
Market equilibrium condition is determined by the interaction of demand and supply forces. This means,
any change on one of the two or on both will affect the equilibrium condition. Now, let us discuss how
the equilibrium condition is affected by changes in demand or in supply or in both.

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2.6. Elasticity of Demand and Supply
The determinants of demand and supply may change for a host of reasons. In studying the effects of
factors that affect demand and supply, we are interested not only in the direction of change but also in the
magnitude of the change. With regard to price, the slope of the demand and supply functions could be
considered.

Slope = dQ/dP,

Where, dQ is the change in quantity and dP is the change in price.

Slope measures by how much output changes for a very small (say a unit) change in price. In this sense,
slope is a measure of responsiveness but it presents some problems. The most important one is that the
slopes of demand or supply functions depend on the units in which price and quantity are measured.
Output could be measured in units, kilograms, litres, gallons etc while price is measured in currency units
such as Birr, Dollars etc. Therefore, slope measures certain kg per Birr, some liters per Dollar etc. This, in
turn, creates problem of comparison where responsiveness is measured in different units. It is not possible
to compare responsiveness measured as X kg/Birr with one measured as Y pounds/Dollar.

Rather than specify units all the time, it is convenient to consider a unit free measure of responsiveness
for this purpose, thus, a measure known as elasticity is often used.

Definition: Elasticity is a measure of the sensitivity or responsiveness of quantity demanded or quantity

supplied to changes in price (or other factors).

Elasticity 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

%Y %Y %Y

1  , 2  , ……….., n 
%X 1 %X 2 %X n

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.

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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.

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.

Percentage change in quantity demanded


Percentage change in price

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

Rearranging

Q P
 
P Q

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:

P
  slope 
Q

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.

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.

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Demand curves can be classified according to their elasticity’s. Demand is elastic when the elasticity is
greater than 1, so that quantity moves proportionately more than the price. Demand is inelastic when the
elasticity is less than 1, so that quantity moves proportionately less than the price. If the elasticity is
exactly 1, so that quantity moves the same amount proportionately as price. In the extreme case of zero
elasticity, demand is perfectly inelastic, and the demand curve is vertical. In this case, regardless of the
price, the quantity demanded stays the same. At the opposite extreme, demand is perfectly elastic. This
occurs as the price elasticity of demand approaches infinity and the demand curve becomes horizontal,
reflecting the fact that very small changes in the price lead to huge changes in the quantity demanded.

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.

18  10
Percentage change in quantity demanded is  100  80% and,
10

24
Percentage change in price is  100  50%
4

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 80%
Elasticity, therefore, is given as    1.6
 50%

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.

Example

Again, assume that a consumer purchases 10 units of a good when price is Birr 4 and 14 units when price
falls to Birr 2. Compute price elasticity of demand.

14  10
Percentage change in quantity demanded is  100  40% and
10

24
Percentage change in price is  100  50%
4

40%
Price elasticity of demand is    0.8
 50%

This implies that a one percent fall in price causes a 0.8 percent rise in quantity demanded. Since
elasticity is less than one, therefore, demand is said to be inelastic.

If, however, a given percentage change in price causes a proportionate percentage change in quantity
demanded the elasticity coefficient will be -1; and hence demand is referred to as unitary elastic.

Example

Assume now a consumer purchases 10 units of a good when price is Birr 4 and 15 units when price falls
to Birr 2. Compute price elasticity of demand.

15  10
Percentage change in quantity demanded is  100  50%
10

24
Percentage change in price is  100  50%
4

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 50%
Price elasticity of demand is, therefore,    1
50%

With most demand curves, the elasticity coefficient varies along the curve. In this regard, a good example
is a linear demand curve. The coefficients of elasticity of such demand curves range from perfectly elastic
(at the intercept of y-axis) to perfectly inelastic (at the x-axis intercept).

Consider a linear demand function of the form, Q = a – bP, depicted in the figure below. The slope of this
demand curve is a constant -b.

The formula for price elasticity of demand is given as

dQ P
 
dP Q

P
 slope 
Q

Exercise: Plot the graphs of perfectly inelastic and perfectly elastic supply curves.
Exercise: Find the price elasticity of demand and supply of wheat for the year 1981 at the equilibrium
price and quantity.

Approaches to Elasticity Measurement

There are two main approaches to elasticity computation: the arc elasticity and point elasticity. If we are
measuring the elasticity between points, we are actually calculating the average elasticity over the space
between the points. This is called arc elasticity.

Q
(Q  Q2 ) / 2 Q P1  P2
Elasticity between two points:  1  
P P Q1  Q2
( P1  P2 ) / 2

P1 a

P2 b
D
0 Q1 Q2 Q
Figure: Arc Elasticity

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Suppose you wish to measure price elasticity of demand as price falls from P1 and P2. In this case you are,
in a way, measuring the average elasticity between point a and point b.

When measuring the responsiveness of quantity demanded to changes in price at a particular point on a
curve, you are actually measuring point elasticity.

Elasticity at a point is measured by assuming infinitesimally small changes in price and quantity
demanded. When dealing with the concept of arc elasticity, however, we are working with sizable,
discrete changes.

Elasticity at a particular point:

Q P
 
P Q
P

P1 a

D
0 Q1 Q

Figure: Point Elasticity

Price elasticity of demand at a particular point, such as point a, can be obtained by multiplying the slope
of the demand curve at that point by the corresponding price/output ratio.

P
  slope 
Q

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:

Percentage change in quantity demanded of one commodity (X)

 XY 
Percentage change in the price of another commodity (Y)

In this case (where the demand of a given good does not depend solely on its price), the demand function
is modified in such a way it includes the prices of related goods.

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 QX = f(PX, PY)

The cross elasticity formula is given as:

Q X PY
 XY   ’
PY Q X

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. If cross elasticity demand coefficient is equal to zero, it would mean the two
goods under consideration are unrelated. 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.

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.

Definition: 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 has a positive sign it indicates that a rise in the price of one of
the two goods results in rise in the quantity demanded of the other good. As a result the two goods are
substitutes. If, however, the cross elasticity of demand coefficient has a negative sign, it reflects that a
rise in the price of one of the goods results in decline in the demand for the other indicating that the goods
are complements.

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 complementarity, depending on the sign.

Example

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.

Q X PY
 XY  
PY Q X

50 5
 XY   2
5 25

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The two goods, therefore, are substitute products.

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.

Percentage change in quantity demanded

I 
Percentage change in income

Q I
I  
I Q

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

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.

Definition: 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.

For normal goods, the same designation for the elasticity coefficients that is used for price elasticity of
demand can be used. If the coefficient is greater than one, I>1, the good is income elastic, whereas if
I <1, the good is said to be income inelastic.

Example

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:

Q I
I  
I Q

30 1000
I    1.5
200 100

The consumer’s demand is income elastic.

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Goods with high positive income elasticity are considered as luxury goods. Necessities in contrast have
low income elasticity. It is important to note at this point that there is no clear cut range of the income
elasticity of demand coefficient for distinguishing between necessities and luxury goods.

Definition: Luxury goods are normal goods for which quantity demanded changes by a very high
magnitude for a given change in income. Necessities are normal goods whose quantity demanded changes
by a smaller percentage for any given change in income.

Elasticity of Supply

Dear colleague, as we did for demand, let us now discuss the responsiveness of quantity supplied to
changes in its price.

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:

Percentage change in quantity supplied

S 
Percentage change in price

Q s P
s  
P Q s

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. But there are exceptions in which the supply curve is either vertical or horizontal. If the
supply curve is verticalthe quantity supplied does not change as price changesthen elasticity is zero.
This is the case in the very short run where it is difficult to produce more of a good regardless of what
happens to price. Similarly, a horizontal supply curve has an infinitely high elasticity of supply: a small
drop in price would reduce the quantity producers are willing to supply from an indefinitely large amount
to zero. Between these extremes the elasticity of supply varies with the shape of the supply curve.

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Example

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.

Q s P 20 20
s   s    0.8 , the supply of the firm is price inelastic.
P Q s 5 100

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