Theory of Demand and

Supply

Teach a parrot to say “Demand and Supply” and you have an

economist (Campbell R.)
Demand
Demand is defined as the quantity of a good or service that consumers are willing and able to
buy at a given price in a given time period. Each of us has an individual demand for particular
goods and services and the level of demand at each market price reflects the value that
consumers place on a product and their expected satisfaction gained from purchase and
consumption.

Market demand

Market demand is the sum of the individual demand for a product from each consumer in the
market. Graphically, the market demand curved for a particular good is represented by the
horizontal summation of the individual demand curves for that good in the market. If more
people enter the market and they have the ability to pay for items on sale, then demand at each
price level will rise.

Effective demand and willingness to pay

Demand in economics must be effective which means that only when a consumers' desire to
buy a product is backed up by an ability to pay for it does demand actually have an effect on
the market. Consumers must have sufficient purchasing power to have any effect on the
allocation of scarce resources.

The demand for a product X might be strongly linked to the demand for a related product Y –
giving rise to the idea of a derived demand. For example, the demand for steel is strongly linked
to the demand for new vehicles and other manufactured products, so that when an economy
goes into a downturn or recession, so we would expect the demand for steel to decline likewise.
Similarly, the demand for bricks is derived from the demand for the final output of the
construction industry e.g. buildings. When there is a boom in the building industry, so the
market demand for bricks will increase

The Law of Demand

Other factors remaining constant (ceteris paribus) there is an inverse relationship between the
price of a good and demand.
  As prices fall, we see an increase in demand
 If price rises, there will be a decrease in demand.

The ceteris paribus assumption

Understanding ceteris paribus is the key to understanding much of microeconomics. Many

factors can be said to affect demand. Economists assume all factors are held constant (i.e. do not
change) except one – the price of the product itself. A change in a factor being held constant
invalidates the ceteris paribus assumption

The Demand Curve

A demand curve shows the relationship between the price of an item and the quantity
demanded over a period of time. There are two reasons why more is demanded as price falls:

 The Income Effect: There is an income effect when the price of a good falls because the
consumer can maintain current consumption for less expenditure. Provided that the
good is normal, some of the resulting increase in real income is used by consumers to
buy more of this product.
 The Substitution Effect: There is also a substitution effect when the price of a good falls
because the product is now relatively cheaper than an alternative item and so some
consumers switch their spending from the good in competitive demand to this product.
The demand curve is normally drawn as a straight line suggesting a linear relationship
between price and demand but in reality, the demand curve is non-linear. No business has a
perfect idea of what the demand curve for a particular product looks like, they use real-time
evidence from markets to estimate the demand conditions and they accumulated experience of
market conditions gives them an advantage in constructing demand-price relationships.

A change in the price of a good or service causes a movement along the demand curve. A fall
in the price of a good causes an expansion of demand; a rise in price causes a contraction of
demand. Many other factors can affect total demand - when these change, the demand curve
can shift. This is explained below.

Shifts in the Demand Curve

There are two possibilities: either the demand curve shifts to the right or it shifts to the left.
In the diagram below we see two shifts in the demand curve:
  D1 – D3 would be an example of an outward shift of the demand curve (or an increase
in demand). When this happens, more is demanded at each price.
 A movement from D1 – D2 would be termed an inward shift of the demand curve (or
decrease in demand). When this happens, less is demanded at each price.

The demand function

The conditions of demand for a product in a market can be summarized as follows:

D = f (Pn, Pn…Pn-1, Y, T, P, E)

Where:
Pn = Price of the good itself
Pn…Pn-1 = Prices of other goods – e.g. prices of Substitutes and Complements
Y = Consumer incomes – including both the level and distribution of income
T = Tastes and preferences of consumers
P = The level and age-structure of the population
E = Price expectations of consumers for future time periods

 Changing prices of a substitute good

Substitutes are goods in competitive demand and act as replacements for another product.

For example, a rise in the price of Nil mineral water should cause a substitution effect away
from Nil mineral water towards competing brands such as Inyange. Consumers will tend over
time to switch to the cheaper brand or service provider. When it is easy and cheap to switch,
then consumer demand will be sensitive to price changes. However, this switch much depends
on whether consumers have sufficient information about prices for different goods and
services.

 Changing price of a complement

Two complements are said to be in joint demand. Examples include: fish and chips, DVD
players and DVDs, bread and butter. A rise in the price of a complement to Good X should
cause a fall in demand for X. For example an increase in the price of shoes should cause a
decrease in the demand for shoe polish.

Similarly, a fall in the price of a complement to Good Y should cause an increase in demand for
Good Y. For example a reduction in the market price of computers should lead to an increase in
the demand for printers, scanners and software applications.

 Change in the income of consumers

Most of the things we buy are normal goods. When an individual’s income goes up, their
ability to purchase goods and services increases, and this causes an outward shift in the
demand curve. When incomes fall there will be a decrease in the demand for most goods.

 Change in tastes and preferences

Changing tastes and preferences can have a huge effect on demand. Persuasive advertising is
designed to cause a change in tastes and preferences and thereby create an outward shift in
demand.

Exceptions to the law of demand

Does the demand for a product always vary inversely with the price? There are two possible
reasons why more might be demanded even when the price of a good or service is increasing.
We consider these briefly – ostentatious consumption and the effects of speculative demand.
(a) Ostentatious consumption

Some goods are luxurious items where satisfaction comes from knowing both the price of the
good and being able to flaunt consumption of it to other people. The demand for the product is
a direct function of its price. A higher price may also be regarded as a reflection of product
quality and some consumers are prepared to pay this for the “snob value effect”. Examples
might include perfumes, designer clothes, and top of the range cars.

Goods of ostentatious consumption are known as Veblen Goods and they have a high-income
elasticity of demand. That is, demand rises more than proportionately to an increase in income.

(b) Speculative Demand

The demand for a product can also be affected by speculative demand. Here, potential buyers
are interested not just in the satisfaction they may get from consuming the product, but also the
potential rise in market price leading to a capital gain or profit. When prices are rising,
speculative demand may grow, adding to the upward pressure on prices. The speculative
demand for housing and for shares might come into this category and we have also seen, in the
last few years, strong speculative demand for many of the world’s essential commodities.

Supply

Supply is defined as the quantity of a product that a producer/firm/business is willing and able
to supply onto the market at a given price in a given time period.
The basic law of supply is that as the price of a commodity rises, so producers expand their
supply onto the market. A supply curve shows a relationship between price and quantity a firm
is willing and able to sell.
The supply curve

A supply curve is drawn assuming ceteris paribus - i.e. that all factors influencing supply are
being held constant except price. If the price of the good varies, we move along a supply curve.
In the diagram above, as the price rises from P1 to P2 there is an expansion of supply. If the
market price falls from P2 to P1 there would be a contraction of supply in the market.
Businesses are responding to price signals when making their output decisions.

Explaining the Law of Supply

There are three main reasons why supply curves for most products are drawn as sloping
upwards from left to right giving a positive relationship between the market price and quantity
supplied:
1. The profit motive: When the market price rises (for example after an increase in
consumer demand), it becomes more profitable for businesses to increase their output.
Higher prices send signals to firms that they can increase their profits by satisfying
demand in the market.
2. Production and costs: When output expands, a firm’s production costs rise, therefore a
higher price is needed to justify the extra output and cover these extra costs of
production.
3. New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in supply.
Shifts in the Supply Curve
The supply curve can shift position. If the supply curve shifts to the right (from S1 to S2) this is
an increase in supply; more is provided for sale at each price. If the supply curve moves
inwards from S2 to S1, there is a decrease in supply meaning that less will be supplied at each
price, as shown below

Factors affecting supply

 Changes in the costs of production
Lower costs of production mean that a business can supply more at each price. For example a
magazine publishing company might see a reduction in the cost of its imported paper and inks.
Conversely, if the costs of production increase, for example following a rise in the price of raw
materials or a firm having to pay higher wages to its workers, then businesses cannot supply as
much at the same price and this will cause an inward shift of the supply curve.
 Changes in production technology
Production technologies can change quickly and in industries where technological change is
rapid we see increases in supply and lower prices for the consumer.
  Government taxes and subsidies
Government taxes have a tendency of increasing the cost of production. When taxes are
imposed on a good, supply is reduced as producers are constrained by the effect of the taxes.
Subsidy on the other hand reduces the cost of production hence, more can be supplied

 Changes in climate
For commodities such as coffee, oranges and wheat, the effect of climatic conditions can exert a
great influence on market supply. Favorable weather will produce a bumper harvest and will
increase supply. Unfavorable weather conditions will lead to a poorer harvest, lower yields and
therefore a decrease in supply.

 Change in the prices of a substitute in production

A substitute in production is a product that could have been produced using the same
resources. For example, an increase in the price of peas makes peas growing more financially
attractive. The profit motive may cause farmers to grow more peas rather than beans.

 The number of producers in the market and their objectives

The number of sellers (businesses) in an industry affects market supply. When new businesses
enter a market, supply increases causing downward pressure on price.

 Expectations (E): Not just current prices, but also expected future prices affect supply.
An expected rise in future prices for instance motivate producers to produce more
Elasticity of demand and Supply
Price Elasticity of Demand (PED)
Elasticity of demand generally refers to the measure of the responsiveness of the quantity demanded of a
good to changes in the factors affecting demand. The more responsive the quantity demanded to a
change in the factor affecting it, the more elastic it is and vice-versa

Price elasticity of demand (PED) measures the degree of responsiveness of quantity demanded for a
product following a change in its own price.

The formula for calculating the co-efficient of elasticity of demand is:

PED = Proportionate change in the quantity demanded

Proportionate change in price

Or = Percentage change in quantity demanded

Percentage change in price

Since changes in price and quantity nearly always move in opposite directions, economists
usually do not bother to put in the minus sign. We are concerned with the co-efficient or modulus
of elasticity of demand.

Understanding values for price elasticity of demand

 If PED = 0 then demand is said to be perfectly inelastic. This means that demand does not
change at all when the price changes – the demand curve will be vertical
 If PED is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the
percentage change in price), then demand is inelastic. Producers know that the change in
demand will be proportionately smaller than the percentage change in price

 If PED = 1 (i.e. the percentage change in demand is exactly the same as the percentage change
in price), then demand is said to unit elastic. A 15% rise in price would lead to a 15%
contraction in demand leaving total spending by the same at each price level.
 If PED > 1, then demand responds more than proportionately to a change in price i.e. demand is
elastic. For example a 20% increase in the price of a good might lead to a 30% drop in demand.
The price elasticity of demand for this price change is –1.5
Determinants or Price Elasticity of Demand

 Time - In some countries for instance, at peak times, the demand for transport becomes
inelastic – and higher prices are charged by transportation companies who can then
achieve higher revenues and profits

 The number of close substitutes for a good / uniqueness of the product – the more close
substitutes in the market, the more elastic is the demand for a product because consumers can
more easily switch their demand if the price of one product changes relative to others in the
market.

 The cost of switching between different products – there may be significant transactions costs
involved in switching between different goods and services. In this case, demand tends to be
relatively inelastic.

 The degree of necessity or whether the good is a luxury – goods and services deemed by
consumers to be necessities tend to have an inelastic demand whereas luxuries will tend to have
a more elastic demand because consumers can make do without luxuries when their budgets
are stretched.

 The percentage of a consumer’s income allocated to spending on the good – goods and services
that take up a high proportion of a household’s income will tend to have a more elastic demand
than products where large price changes makes little or no difference to someone’s ability to
purchase the product.

 The time period allowed following a price change – demand tends to be more price elastic, the
longer that we allow consumers to respond to a price change by varying their purchasing
decisions. In the short run, the demand may be inelastic, because it takes time for consumers
both to notice and then to respond to price fluctuations

 Whether the good is subject to habitual consumption – when this occurs, the consumer
becomes much less sensitive to the price of the good in question. Examples such as cigarettes
and alcohol and other drugs come into this category

 Peak and off-peak demand - demand tends to be price inelastic at peak times – a feature that
suppliers can take advantage of when setting higher prices. Demand is more elastic at off-peak
times, leading to lower prices for consumers.
Price Elasticity of Supply (PES)
Price elasticity of supply (PES) measures the relationship between change in quantity supplied
and a change in price. If supply is elastic, producers can increase output without a rise in cost
or a time delay. If supply is inelastic, firms find it hard to change production in a given time
period.

The formula for price elasticity of supply is:

Percentage change in quantity supplied divided by the percentage change in price

PES = Proportionate change in the quantity Supplied

Proportionate change in price

= Percentage change in the quantity supplied

Percentage change in price

 When PES > 1, then supply is price elastic

 When PES < 1, then supply is price inelastic
 When PES = 0, supply is perfectly inelastic
 When PES = infinity, supply is perfectly elastic following a change in demand

Factors that Affect Price Elasticity of Supply

(1) Spare production capacity

If there is plenty of spare capacity then a business should be able to increase its output without
a rise in costs and therefore supply will be elastic in response to a change in demand. The
supply of goods and services is often most elastic in a recession, when there is plenty of spare
labour and capital resources available to step up output as the economy recovers.

(2) Stocks of finished products and components

If stocks of raw materials and finished products are at a high level then a firm is able to
respond to a change in demand quickly by supplying these stocks onto the market - supply will
be elastic. Conversely when stocks are low, dwindling supplies force prices higher and unless
stocks can be replenished, supply will be inelastic in response to a change in demand.
(3) The ease and cost of factor substitution

If both capital and labour resources are occupationally mobile then the elasticity of supply for a
product is higher than if capital and labour cannot easily and quickly be switched

(4) Time period involved in the production process

Supply is more price elastic the longer the time period that a firm is allowed to adjust its
production levels. In some agricultural markets for example, the momentary supply is fixed
and is determined mainly by planting decisions made months before, and also climatic
conditions, which affect the overall production yield.

Useful applications of price elasticity of demand and supply

Some relevant issues that directly use elasticity of demand and supply include:

 Taxation: The effects of indirect taxes and subsidies on the level of demand and output
in a market e.g. the effectiveness of the congestion charge in reducing road congestion;
or the impact of higher duties on cigarettes on the demand for tobacco and associated
externality effects
 Changes in the exchange rate: The impact of changes in the exchange rate on the
demand for exports and imports
 Exploiting monopoly power in a market: The extent to which a firm or firms with
monopoly power can raise prices in markets to extract consumer surplus and turn it
into extra profit.
 Government intervention in the market: The effects of the government introducing a
minimum price (price floor) or maximum price (price ceiling) into a market

Elasticity of demand and supply also affects the operation of the price mechanism as a means of
rationing scarce goods and services among competing uses and in determining how producers
respond to the incentive of a higher market price.