Chapter two

Demand, supply and market equilibrium

Compiled by: Aleboy Mesfin

 2.1 Theory of demand and demand elasticity
• What is demand?
• Is what you desire to purchase your demand?
• In loose sense we use demand to mean desire of a
person to purchase a product.
• But, it has a specific meaning in economics
• Demand is a desire backed by
 Ability to pay
 Willingness to pay
 And availability of a product
• Hence, demand for a good or service constitutes
both the desire for and the purchasing power to
purchase it.
• Thus demand refers to the various quantity of
G&S that a consumer is willing and able to
purchase in market at various price level.
• In deriving the demand of a commodity, it is
assumed that other things such as
consumer’s income, tastes, prices of interrelated
goods, etc, remain unchanged (ceteris paribus).
• The specific quantity which the consumers buy
at a particular price is called quantity demanded.
• Law of demand tells us the functional
relationship between the price of a commodity
and its quantity demanded in the market.
• The law of demand states that all other factor
remaining the same, the price of a good and its
quantity demanded have inverse relation, i.e.,
as price rise quantity demanded falls and vice
versa.
• Demand equation, schedule and curve
• Demand equation – other things remain
constant, It shows the inverse relationship b/n
quantity demanded(Qd) and Price(P).
• Qd is dependent variable and P independent
• i.e; Qd = a-bp
• E.g : Qd = 12- 0.5P …..is demand equation.
• Demand schedule- shows the negative
relationship b/n Qd and P in table form. We
can have two demand schedules
• Individual demand schedule
• Market demand schedule
• Individual demand schedule- shows various
quantity of G&S that individual house hold
would purchase at various price level.
Price X’s Demand

10 7

15 4.5

22 1

• Market demand schedule- various quantities

demanded by different house holds at different
price level.
Price X’ s Demand Y’s Demand Market Demand X + Y

10 7 6 13

15 4.5 4 8.5

22 1 2 3
• Demand curve – is graphical representation of
the relation between price and quantity
demand and,
• It is down ward sloping curve because of the
law of demand.
• shows the information graphically rather than in a tabular form
• Demand curves also are of two types Individual demand
curve and Market demand curve.
• 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.
• Numerical Example: 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. Then the market
demand. function is given by:
P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and
Qm = (20 – 2P) 100 = 2000-200P
• 2.2 Determinants of demand
• In stating the law of demand, we kept all the other
factors to remain constant except price of the product.
• A change in the price of a good only, will bring
change in quantity demanded.
• that is, movement along the same demand curve( up
or dawn movement ).
• E.g movement from point A to B in graph below.
• A change in any factors other than price of the good
will cause change in demand.
• A change in demand will shift the demand curve
from its original location.
• E.g movement from point A to C in graph below.
• Demand for a product is influenced by;
• A) Price of the product
• B) Price of related good (substitute and complementary good)
• C) Income ( normal or inferior goods)
• D) Consumers price and income expectations
• E) Test and preference
• F) Number of buyers
•
• B) Price of related goods
• Goods are 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.
• Complimentary goods 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.
• C) income of the consumer
• Normal Goods are goods whose demand increases as income
increase.
• inferior goods are those whose demand is inversely related
with income.
• classification of goods into normal and inferior is subjective.
• D) test and preference
• When the taste of a consumer changes in favor of a good,
her/his demand will increase and the opposite is true.
• E) price and income expectation
• Higher income and price expectations increase current demand
• F) number of buyers
• an increase in the number of buyers will increase demand
while a decrease in the number of buyers will decrease
demand.
 2.3 Elasticity of demand
• It is Responsiveness or sensitivity of demand to
change of any determinant
• There are as many elasticity of demand as its
determinants. The most important of these elasticity
are:
• 1. Price elasticity of demand
• 2. Income elasticity of demand
• 3. Cross-price elasticity of demand
1. Price elasticity demand- meaning
• It is a measure of the responsiveness of demand to
changes in the commodity’s own price
• Expressed as ratio of percentage change in Qd to
• E.P =
• E.P = % ∆Qd/ % ∆P = *

• If the percentages are known quantities, then the numerical size

of Ep can be easily calculated.
• E.g. when price of a commodity falls from birr 24 to birr 12
quantity demanded increased from 18 unit to 54 unit. calculate
EP?
• e.p = % ∆Qd ÷ %∆P
• % ∆Qd = 54-18 = 200% and %∆P = 12-24 = -50%
18 24
• E.p = 200%/ 50% = -4
• Interpretation: For a 1% fall in price, there is 4% increment in
quantity demanded. OR alternatively
• Ep = Qd/Q1 1 = * = -4
• Price elasticity of demand is a unit less and negative number.
B) Measuring the value price elasticity of demand

• I) Point Price Elasticity of Demand

• measures the elasticity between two points of
DD curve
• which are assumed to be intimately close to
each other.
÷
• =
=
• II) Arc price elasticity of demand
• In this method the midpoints between price
and quantity demanded are used.
• It is applicable even if we have big gap b/n
initial and final price and quantity demand.
• C) Ranges of Price elasticity of Demand
• The price elasticity value falls b/n zero and infinity.
• Elastic demand
• When Ep > 1
• Occurs when %∆Qd > %∆p
• E.x; if price elasticity is -2 then / -2 / =2 > 1.
Therefore, this is elastic demand
• Inelastic demand
• When Ep < 1
• Occurs when %∆Qd < %∆p
• E.x;if price elasticity is -0.7 then / -0.7 / =0.7 < 1.
Therefore, this is inelastic demand.
• Unitary elastic demand
• This is when numerical value of price
elasticity of demand is equal to one.
• Perfectly elastic demand
• Ep =
• Small price change brings extra large change
in quantity demand.
•
• Perfectly inelastic demand
• Ep=0
• In this case even substantial changes in the price will
not bring about any change in demand.
• The demand in this case is insensitive or not
responsive to changes in price.
• On the demand curve elasticity of demand will
be elastic for the higher region,
• unitary elastic around the mid point and,
• in-elastic in the lower region as shown by the
following graph.
D) 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.
– People tend to adjust their consumption pattern.
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 elastic example: Salt
V) number of uses of commodity – commodity with multiple use
tends to be inelastic.
E) Elasticity and total revenue
• If price is elastic, TR(p*q) moves in opposite
direction to price
• If price is elastic, TR(p*q) moves in same
direction to price.
2. Income Elasticity of demand
• The responsiveness of demand to changes in income is termed
as income elasticity of demand
• It is expressed as the proportionate change in the quantity
demanded resulting from a proportionate change in income.
• For normal goods income elasticity is positive and negative
for inferior goods.
 3. Cross Price Elasticity of Demand
• It is the responsiveness of demand to change in the price of
other commodities.
• It can also be defined as the proportionate change in the
quantity demanded of X resulting from a proportionate change
in the price of Y.

• Complementary goods have negative cross elasticity and

substitute goods have positive cross elasticity.
 2.2. Theory of supply and Supply elasticity

• A supply curve shows the minimum prices at which

someone is willing to sell various amounts of a good
or service.
• Supply indicates various quantity of a commodity
that a seller is willing and able to offer for sale at
different price level.
• In deriving the supply of a commodity, it is assumed
that other things such as
• resource price, technology, prices of related goods and
all other factors remain unchanged (ceteris paribus).
 2.3 Law of supply
• Shows functional relationship between the price
of a commodity and its quantity supplied in the
market.
• states that all other factor remaining the same,
the price of a good and its quantity supplied
have direct relation, i.e., as price rise quantity
supplied also rises and vice versa .
• The relationship b/n price and supply can be
represented using equation, curve and schedule
• A supply equation briefly expresses the
functional relationship between price and
quantity supply.
• E.g QS = 20 + 0.75p where Qs is quantity
supplied and p is price.
• A supply schedule is a tabular statement that
shows the different quantities of a commodity
offered for sale at different prices.
• Example;
• Supply curve- a curve that shows quantity of
G&S that a seller could offer to Market at
different price.
• It is positively sloped.
 2.4 Determinants of Supply
• The supply of a product is influenced by many factors. Some of these factors are:
• I) Price of the product price and quantity supply are inversely related.
• II) Resource price( input price)
• resource price directly affect the cost of the firm and hence its profit.
• Therefore, an increase in resource price is likely to decrease supply
• III) Technology
• Technological advancement will increase the supply of the good.
• IV) Price of related goods (substitute and complimentary )

• Substitute goods – goods that can be produced by similar producer . For example

a farmer may have the option of producing either maize or Chat on her plot of

land. A rise in the price of Chat will encourage the farmer to use her limited

resource for producing more chat and hence the supply of maize (food) will be

decreased.
• Complimentary goods, on the other hand are those which are produced
together.
• i.e., as we go for the production of a good another product is also
produced in the same line of production. For example if the price of meat
increases, the supply of animal skins will also increase suppliers of meat
try to increase their supply because of the higher price for meat, they
slaughter more animals making more skins available in the market.
• V) Price expectation of the supplier
• when suppliers expect higher price in the future they tend to decrease the
supply of their product now in order to sale it at higher expected price in
the future.
• VI) Tax and Subsidy
• An increase in tax rate is likely to decrease supply since the supplier faces
higher cost of production. On the other hand, provision of subsidy
encourages the suppliers to increase their supply.
• VII) Number of sellers in the market
• an increase in the number of sellers will increase supply while a decrease
in the number of sellers will decrease supply.
 2.5 Price Elasticity of Supply
• It is the degree of responsiveness of the supply
to change in price.
• Defined as the percentage change in quantity
supplied divided by the percentage change in
price.
• Supply can also be elastic, inelastic unitary
elastic, perfectly elastic and perfectly inelastic.
• 2.6 Market Equilibrium and its Determination
• Market equilibrium is states of the market in
which market forces of demand and supply are in
balance
• It occurs when Qd = Qs
• the market price and the amount of the good
exchanged tend to be stable.
• At equilibrium, both buyer and saler are willing
to trade.
• Buyers in the market follow the law of
demand.
• The sellers follow the law of supply.
• Thus, demand and supply move in opposite
directions.
• the price at which demand and supply are
equal is the equilibrium price
• Equilibrium quantity is the quantity supplied
and the quantity demanded at equilibrium
price.
• If the price is more or less than the equilibrium price,
the equilibrium output is disturbed.
• But ultimately the quantity demanded and the
quantity supplied will be balanced at some
equilibrium price.
• The effect of a shortage in a free market is
always to increase the price.
• Once the equilibrium price is determined,
there is no change from this price as this
satisfies both the consumers and the producers.
• If, at any time, the price is more or less than
Birr 5 the forces of demand and supply will
adjust it back to Birr 5.
• The effect of a surplus in a free market is
always to reduce the price.
• The above schedule can also be shown using
DD and SS curves.

• Example; if demand and supply equations are

given in form of
– Qd = 100-2p and Qs = -20+4p
• Attempt the following questions
– A. What is the equilibrium price and quantity
– B. Show the equilibrium diagrammatically
– C. If price of the good is fixed at p=25,will there be
shortage or surplus how large it is?
– solution
A. at equilibrium Qd = QS

……. equilibrium price

• To find equilibrium quantity substitute the
equilibrium price in either Qd or Qs
• Qd= 100-2(20) = 60…….equilibrium quantity
• B) b and c left for you?
 2.3.2. Effects of Shift in Demand and Supply on Equilibrium

• Given demand and supply the equilibrium price

and quantity are stable.
• However, when these market forces change what
will happen to the equilibrium price and quantity?
• Changes in demand and supply bring about
changes in the equilibrium price level and the
equilibrium quantity.
• I) Effects of Changes in Demand supply remain
constant.
• When
• When
 price
•• .. SS • movement from D0 to D1 is increase in

ep1 • ........................
.
E1
•
demand
This increase in demand increases Ep0 to

.. ......................
.........................
E0 EP1and Eq0 to Eq1
ep0
.................
......
• movement from D0 to D2 is decrease in
E2
.
.................
................
ep2 demand
D1 • This decrease in demand reduces Ep0 to
D0 EP2and Eq0 to Eq2
D2 •
Quantity
Eq2 Eq0 Eq1

II) Effects of Changes in supply demand remaining constant

• When • movement from s0 to s1 is decrease in
• When supply
Price s1 s0 • This decrease in supply increases Ep0
s2 to EP1andreduce Eq0 to Eq1
• movement from s0 to s2 is increase in
EP1 supply
..
......................

……………
EP0 • This increase in supply reduces Ep0
.....................

………………………
Ep2 to EP2and increase Eq0 to Eq2
•
................

……………………………….
DD
Eq1 Eq0 Eq2 quantity
III) Effects of Combined Changes in Demand and Supply

• When both demand and supply increases, the

quantity of the product will increase
definitely.
• 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.
• The demand and supply might change in
opposite directions.
• Given an increase in demand and decrease in
supply,
• equilibrium price will rise definitely.
• if the increase in demand is greater than the
decrease in supply the equilibrium price and
quantity will rise.
• However, if the decrease in supply is greater
than the increase in demand while price rise,
equilibrium quantity will fall.
Exercise:

1. Given market demand Qd = 50 - P, and market supply P = Qs + 5

A) Find the market equilibrium price and quantity?

B) Calculate and interpret price elasticity of demand at the equilibrium point.

2. When price of tea in local café rises from Br. 10 to 15 per cup, demand for coffee

rises from 3000 cups to 5000 cups a day despite no change in coffee prices.

A) Determine cross price elasticity.

B) what kind of relation exists between the two goods?

3. Distinguish between these terms

A. Normal goods and inferior goods

B. Complementary goods and substitute goods

C. Market demand and individual demand

D. Individual supply and market supply

E. Excess demand and excess supply