KANENUS COLLEGE

INTRODUCTION TO ECONOMICS

CHAPTER TWO

THEORY OF
DEMAND AND
SUPPLY LECTURE NOTES
Course Instructor: Assefa D.
2022
 PRE-TESTS

•What is demand?
•What is supply?
•What is elasticity?
•What market equilibrium?

2
 1.1. THEORY OF DEMAND

• Demand is one of the forces determining prices

• The purpose of the theory of demand is to
determine the various factors that affect demand
• Demand implies more than a mere desire to
purchase a commodity
• A desire should be backed by purchasing power
(ability to pay)
• So, for a demand both willingness and ability is
necessary
3
 1.1. THEORY OF DEMAND

• Demand refers to various quantities of a commodity

or service that a consumer would willing and able
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.
• Law of demand: states that , price of a commodity
and its quantity demanded are inversely related,
ceteris paribus.
4
 2.1.1 DEMAND SCHEDULE (TABLE), DEMAND
CURVE AND DEMAND FUNCTION

• The FUNCTIONAL 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 can be constructed for any commodity if
the list of prices and quantities purchased at those prices
are known.
Combinations A B C D E
Price per kg 5 4 3 2 1
Quantity demand/week 5 7 9 11 13 5
 2.1.1 DEMAND SCHEDULE (TABLE), DEMAND
CURVE AND DEMAND FUNCTION

b) 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.

6
 2.1.1 DEMAND SCHEDULE (TABLE), DEMAND
CURVE AND DEMAND FUNCTION

c) Demand function is a mathematical relationship

between price and quantity demanded
• A typical demand function is given by: Qd=f(P)
• Where: Qd=quantity demanded and P=price of the
commodity
• 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 b=slope of the function ) 7
2.1.1 DEMAND SCHEDULE (TABLE), DEMAND
CURVE AND DEMAND FUNCTION

• Suppose a demand function for a theater ticket is given

as Q =100−2P .
• If now price changes from Birr 2 to Birr 2.50, its effect will
be a decline in quantity demanded from 96 tickets to 95
tickets. 8
 Market Demand

• 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.
Price Individual demand Market
demand
Consumer-1 Consumer-2 Consumer-3

8 0 0 0 0

5 3 5 1 9

3 5 7 2 14

0 7 9 4 20

9
Market Demand

10
 2.1.2 DETERMINANTS OF DEMAND (Demand
Shifters)

• The demand for a product is influenced by many

factors. Some of these factors are:
• Price of the product
• Taste or preference of consumers
• Income of the consumers
• Price of related goods
• Consumers expectation of income and price
• Number of buyers in the market
11
 2.1.2 DETERMINANTS OF DEMAND

• Change in demand: A change in any of the above

listed factors except the price of the good will
change the demand
• A change in demand will shift the demand curve
from its original location.
• For this reason those factors listed above other
than price are called demand shifters.
• Change in quantity demanded: change in own
price is only a movement along the same demand
curve. 12
2.1.2 DETERMINANTS OF DEMAND

i. Change in number of buyers: Increase in

number of buyers increases quantity demanded
at each price, shifts D curve to the right.
ii. Income:
• Demand for a normal good is positively related to income
– Increase in income causes increase in quantity demanded at
each price, shifts D curve to the right.
• Demand for an inferior good is negatively related to
income.
– An increase in income shifts D curves for inferior goods to
the left. 13
2.1.2 DETERMINANTS OF DEMAND

iii. Prices of Related Goods: Substitutes Vs

Complementary
• Two goods are substitutes if an increase in the price
of one causes an increase in demand for the other.
Example: Coke and Pepsi,
• Shifts the demand curve to the right
• Two goods are complements if an increase in the
price of one causes a fall in demand for the other.
Example: computers and software.
• Shifts the demand curve to the left
14
2.1.2 DETERMINANTS OF DEMAND

iv. Tastes: When the taste of a consumer changes

in favor of a good, her/his demand will increase
and the opposite is true.

v. Consumers Expectations of future income

and price:
• If people expect their incomes to rise, their
current demand for goods may increase now.
• Higher price expectation will increase demand
while a lower future price expectation will
decrease the demand 15 for the good
2.1.3 ELASTICTY OF DEMAND

• Elasticity is a measure of responsiveness of a

dependent variable to changes in an independent
variable
• 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.
16
2.1.3 ELASTICTY OF DEMAND

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 demand can be measured in two
ways:
• 17
Point elasticity and arc elasticity.
 NUMERICAL COEFFICIENTS OF PRICE ELASTICITY
OF DEMAND

Numerical Responsiveness of quantity Terminology

coefficients demanded to changes in price

ed = 0 none Perfectly inelastic

0 < ed < 1 Quantity demanded changes by a smaller Inelastic

percentage than the percentage change in price

ed = 1 Quantity demanded changes by a percentage Unit elastic

equal to the percentage change in price

1 < ed < ∞ Quantity demanded changes by larger Elastic

percentage than the percentage change in price

ed = ∞ Quantity demanded goes to zero or to all that is perfectly elastic

available
18
2.1.3 ELASTICTY OF DEMAND

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.

19
Example: Point Elasticity of Demand

• Assume that a consumer purchases 10 units of a

good when price is Birr 4 and 18 units when price
falls to Birr 2.
a) Compute price elasticity of demand
b) Determine whether it is elastic or inelastic
(-1.6-Elastic)

20
 ELACTICITY OF DEMAND

B. Arc elasticity of demand:

•It is a measure of average elasticity.
•That is, the elasticity at the midpoint of the chord that
connects the two points (A and B) on the demand curve
defined by the initial and new price levels.
•To calculate the arc elasticity, we use the following formula:

21
 ELACTICITY OF DEMAND

Example
•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 point
elasticity will be____________
•.4-Inelastic
22
 Determinants of Price Elasticity of
Demand
• Substitutes: If a good has many close substitutes,
it is generally held that its quantity demanded
would be very responsive to price changes
• Time lag: The longer the period of time
consumers have to adjust, the more elastic the
demand becomes
• Nature of the need that the commodity satisfies:
Generally luxury goods are price elastic and
necessities are price inelastic

23
 Determinants of Price Elasticity of Demand

• The proportion of income spent on the particular

commodity
• Goods like car which take up a large proportion of
income tend to have more elastic demand than goods
like salt which take up only small proportion of income

24
Elasticity

II. Cross Elasticity of Demand:

• The responsiveness of demand
of one good to changes in the price of a
related good – either a substitute or a
complement

% Δ Qd of good t
__________________
Xed =
% Δ Price of good y

25
Elasticity

• Goods which are complements:

• Cross Elasticity will have negative sign (inverse
relationship between the two)
• Goods which are substitutes:
• Cross Elasticity will have a positive sign (positive
relationship between the two)
• 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. Exy=____ (2-sub)
26
Elasticity

• The cross – price elasticity of demand for

substitute goods is positive.
• The cross – price elasticity of demand for
complementary goods is negative.
• The cross – price elasticity of demand for
unrelated goods is zero.

27
Elasticity

III. Income Elasticity of Demand: The responsiveness of

demand to changes in incomes
• Normal Good – demand rises as income rises and vice
versa
• Inferior Good – demand falls as income rises and vice
versa
• A positive sign denotes a normal good
• A negative sign denotes an inferior good

28
Example Income Elasticity

• 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 is____________
• Determine the nature of the good
• 1.5-nor

29
 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 quantity supplied of any good is the amount that sellers
are willing and able to sell.
• Law of supply: the claim that the quantity supplied of a
good rises when the price of the good rises and vice versa,
other things equal
• There is a positive relationship between price and quantity
supplied.

30
2.2.1 Supply schedule, supply curve and
supply function

A. Supply Schedule
•A supply schedule is a tabular statement that
states the different quantities of a commodity
offered for sale at different prices.
Table 2.3: an individual seller’s supply schedule for butter

Price ( birr per kg) 30 25 20 15 10

Quantity supplied kg/week 100 90 80 70 60

31
 2.2.1 Supply schedule, supply curve
and supply function
B. Supply Curve: A supply curve conveys the
same information as a supply schedule.
•But it shows the information graphically rather
than in a tabular form.

32
 2.2.1 Supply schedule, supply curve
and supply function
C. 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.
•The most widely used functional form is the linear
supply curve, which is given as:
Q = c + dP ,The slope of the supply function is d
•Exercise, compute c and d from Table 2.3 and
determine supply function 33
 2.2.3 Market Supply

• Market supply: It is derived by horizontally adding the

quantity supplied of the product by all sellers at each
price.
Table 2.4: Derivation of the market supply of good X

Price Quantity Quantity Quantity Market

per supplied by supplied by supplied supply per
unit seller 1 seller 2 by seller 3 week
5 11 15 8 34
4 10.5 13 7 30.5
3 8 11.5 5.5 25
2 6 8.5 4 18.5
1 4 6 2 12
34
 2.2.3. Determinants of Supply (Supply curve
shifters)
• Change in Quantity Supply-Refers to movement
along a supply curve due to change in price
• Change in Supply-Refers to shift in supply curve
due to changes in other non-price determinants of
supply
• Examples: price of inputs, technology, prices of
related goods, sellers‘ expectation of price of the
product, taxes & subsidies, number of sellers in
the market, weather, etc

35
 2.2.3. Determinants of Supply

A. Change in input price

• An increase in the price of inputs such as labor, 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.
B. Technology
• Technological advancement enables a firm to produce and
supply more in the market.
• This shifts the supply curve outward (right ward).
36
 2.2.3. Determinants of Supply
D. Number of sellers
• An increase in the number of sellers increases the quantity supplied
at each price, shifts S curve to the right.
E. Expectation
• Example: Events in the Middle East lead to expectations of higher oil
prices.
• In response, owners of gas stations reduce supply now, save some inventory
to sell later at the higher price.
• S curve shifts left.
F. Weather: change in weather condition affect supply of certain
commodities, for example, agricultural products
G. Tax and subsidy
37
 2.2.4. 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:

38
 2.2.4. Elasticity of supply
• Example: Elasticity of Supply
• 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.
• Price Elasticity of Supply: _____
• .8 (inelastic)

39
 2.2.4. Elasticity of supply
• Like elasticity of demand, price elasticity of supply can be:
• Elastic- when a small change on price leads to great
change in supply (1<Es< ∞)
• Inelastic- when a great change in price induces only a
slight change in supply (0<Es< 1)
• Unitary elastic-when when both price and supply change
proportionally (Es=1)
• Perfectly elastic- it will be represented by a horizontal
straight line.(Es=∞)
• Perfectly inelastic-it will be represented by a vertical line
(Es=0) 40
 2.2.3 Market equilibrium: Demand and
Supply together
• 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.
• Equilibrium: the condition of equality of demand
and supply
• 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
41
2.2.3 Market equilibrium

42
 Market Disequilibrium: Surplus and
Shortage
Surplus
•In the above graph, any price greater than P (such as at P1)
will lead to market surplus.
•Because: Consumers demand less of the product and
Producers supply more of the good.
•The market will have a surplus of HJ
•Facing a surplus, sellers try to increase sales by cutting price
• This causes Qd to increase and Qs to fall, which reduces the surplus
•Prices continue to fall until market reaches at equilibrium (P).

43
 Market Disequilibrium: Surplus and
Shortage
Shortage
•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.
•Facing a shortage, sellers raise the price, causing
Qd to fall and Qs to rise, which reduces the
shortage.
•Prices continue to rise until market reaches
equilibrium (P)
44
Numerical Example: Equilibrium

• Suppose the demand and supply functions in a

particular market are given as: Qd =100 − 2P and
Qs =10 + 4P, respectively
a. Calculate the market equilibrium price and
quantity
b. Determine, whether there is surplus or shortage
at P=10 and P= 20.

45
 EFFECTS OF SHIFT IN DEMAND AND
SUPPLY ON EQUILIBRIUM
• When there is change in demand and supply what
will happen to the equilibrium price and quantity?
• Demand changes due to factors such as:
changes in
• Taste or preference of consumers,
• Income of the consumers,
• Price of related goods, etc
• On the other hand changes in factors (such as
price of inputs, technology, weather condition,
etc,) cause change in supply
46
A. When demand changes and supply remains
constant
•If demand increases the
demand curve will shift upward
to the right to D1D1.
• The equilibrium price increases
from OP to OP1 and the
equilibrium quantity from OM to
OM1
•If demand falls, the demand
curve shifts downwards to the
left to D2D2
• The equilibrium price decreases
from OP to OP2 and the
equilibrium quantity decreases
from OM to OM2 47
B. When supply changes and demand
remains constant
•If the supply increases, the
supply curve shifts to the right
(S1S1)
• Reduces the equilibrium price
from OP to OP1 and increases
the equilibrium quantity from OM
to OM1.
•When the supply falls, the
supply curve moves to the left
(S2S2)
• Raising the equilibrium price from
OP to OP2 and reducing the
equilibrium quantity from OM to
OM2. 48
C. 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.
• If an increase in supply is more than an increase in
demand, the price falls.
• If the increase in demand and supply is same, then the
price remains the same. 49
C. Effects of combined changes in
demand and supply
• WHEN BOTH 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.
• 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 decreases.
50
C. Effects of combined changes in
demand and supply
• Exercise: What would happen to equilibrium
price and quantity when both demand and
supply change simultaneously but in an
opposite direction?

51