Chapter Two

Theory of Demand and Supply

2.1 Theory of demand

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.
Cont….

 His/her desire should be backed by his/her purchasing

power.
 A poor person is willing to buy a car; it has no

significance, since he/she has no ability to pay for it.

 On the other hand, if his/her desire to buy the car is

backed by the purchasing power then this constitutes

demand.
 Demand, thus, means the desire of the consumer for a

commodity backed by purchasing power.

Cont….

 Thequantity demanded of a particular commodity

depends on the price of that commodity.

 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.
 Demand schedule: Table 2.1 Individual household demand
for orange per week

Combinations A B C D E
           
Price per kg 5 4 3 2 1
           
Quantity demand/week 5 7 9 11 13
           

 Demand curve: Figure 2.1: Individual demand curve

 Conti…

 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
Cont…
  

(e.g. moving from point A to B on figure 2.1 above)

 = -2, 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.
Cont…

 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.
Cont…

Table 2.2: Individual and market demand

for a commodity
Individual
Price   demand   Market
  Consumer-1   Consumer-2 Consumer-3 demand
8 0  0 0 0
5 3  5 1 9
3 5  7 2 14
0 7  9 4 20
 Cont….

Price Price Price Price

3 + 3 + 3 = 3
Exercise
 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. Find the market demand
function?
Determinants of demand
Price of the product ( law of Demand)
Taste or preference of consumers
Income of the consumers ( Normal &

inferior good)
Price of related goods ( Substitute &

Complementary good)
Consumers expectation of income and

price
Number of buyers in the market
Cont…
 When we state the law of demand, we kept all the factors
to remain constant except the price of the good.
 A change in any of the above listed factors except the

price of the good will change the demand, while a

change in the price, other factors remain constant will
bring change in quantity demanded.
 For this reason 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.
2.1.3 Elasticity of demand

 In economics, the concept of elasticity is very crucial

and is used to analyze the quantitative relationship
between price and quantity purchased or sold.
 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.

Cont…
 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.

 Demand for commodities like clothes, fruit etc. changes

when there is even a small change in their price,
 whereas demand for commodities which are basic necessities
of life, like salt, food grains etc., may not change even if
price changes, or it may change, but not in proportion to the
change in price.
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.

Where &
 Cont…
  
Thus;
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.
 Assume your daily demand for coffee increases from 4 cups

to 5 cups as the price of a cup of coffee falls from Birr 4 to

Birr 2.
i) Calculate the Ed and interpret the size of Ed
 B. Arc price elasticity of demand
 The main drawback of the point elasticity method is
that it is applicable only when we have information
about even the slight changes in the price and the
quantity demanded of the commodity.
 But in practice, we do not acquire such information
about minute changes. We may possess demand
schedules in which there are big gaps in price as well as
the quantity demanded. In such cases, there is an
alternative method known as arc method of elasticity
measurement.
 Cont…
  
Symbolically;

Here, Qo = Original quantity demanded

Q1 = New quantity demanded
Po = Original price
P1 = New price
Cont…
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. Calculate price elasticity of
demand by using arc method?
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.
Types of price elasticity of demand
1) Elastic demand (|εd|>1 ፡demand is said to be elastic and
the product is luxury product.
It reflects to that situation where the proportionate change
in quantity demanded is much greater than the
proportionate change in price.
 Cont…

2. If Elasticity of demand 0<=|εd|<1 demand is inelastic

and the product is necessity
3. |εd|=1 1, demand is unitary elastic.
4. |εd|=0 demand is said to be perfectly inelastic.
5. |εd|= ∞, demand is said to be perfectly elastic
Determinants of price Elasticity of Demand

The following factors make price elasticity of demand elastic or inelastic

other than changes in the price of the product.

o The availability of substitutes: the more substitutes available for a product,

the more elastic will be the price elasticity of demand.
o 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.
o 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.
o The 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.
 II. Income Elasticity of Demand

It is a measure of responsiveness of demand to change in

income.

 If the good is luxury good.

 
 <1(and positive), the good is necessity good,
 
 <0, (negative), the good is inferior good.
Exercise: When the income of a household rises from Birr
1000 to Birr 1400, the monthly consumption of maize falls
from 50Kg to 40Kg. Calculate income elasticity.
III. Cross price Elasticity of Demand

  
Measures how much the demand for a product is affected
by a change in price of another good.

 If 0, substitute goods
 If , complementary goods
 If , unrelated goods
Exercise
Consider the following data which shows the changes in quantity
demanded of good X in response to changes in the price of good Y.

Unit price of Y Quantity demanded of X

10 1500
15 1000

Calculate the cross –price elasticity of demand between the two

goods. What can you say about the two goods?
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.
Law of supply can be expressed by:
  Supply
 schedule: tabular explanation of the
positive r/s b/n SS & Price
 supply curve: Graphical explanation of the

positive r/s b/n SS & Price

 supply function: Mathematical equation which

shows the positive r/s b/n SS & Price

2.2.2 Determinants of supply

  Price of inputs ( cost of inputs)



 Technology
 
  Prices of related goods


 Sellers‘ expectation of price of the product

 
  Taxes & subsidies


 Number of sellers in the market

 
 Weather, etc.
 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.

Thus, the formula for measuring price elasticity of supply is:
Cont…
 Like elasticity of demand, price elasticity of supply can
be elastic, inelastic, unitary elastic, perfectly elastic or
perfectly inelastic.
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.
Cont…

Price
S      
  Infinite elasticity or  
Perfectly        
  perfectly elastic      
inelastic or      
P     S  
zero elasticity          

Figure 2.6: Perfectly inelastic and perfectly elastic supply curves

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.
Þ This occurs when QS = QD
The price at which these two curves cross is called the
equilibrium price
The quantity at which these two curves cross is called
the equilibrium quantity
Cont…
Market equilibrium

Gizaw G.
35
Cont….
 Shortage (Excess Demand) – a shortage occurs when
the quantity demanded is greater than the quantity
supplied at a particular price.
 Surplus (Excess Supply) – a surplus occurs when the

quantity demanded is less than the quantity supplied at

a particular price.

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Cont…
Exercise 1: From statistical studies, we know that for 1981
the supply curve for wheat was approximately as follows:
Supply: QS = 1800 + 240P
Where price is measured in dollars per bushel and quantities
are in millions of bushels per year. These studies also
indicate that in 1981 the demand curve for wheat was
Demand: QD = 3550 – 266P
Find the market clearing price and equilibrium quantity of
wheat for the year1981.

37
Exercise
Given market demand: Qd= 100-2P, and market supply: P

=( Qs /2) + 10
 
 
a) Calculate the market equilibrium price and quantity
a) Determine, whether there is surplus or shortage at P=
25 and P= 35.
Effects of shift in demand and supply on equilibrium

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

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End of the
Chapter!

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