Ch-2

Theory of Demand and Supply

Theory of Demand
 Demand refers to various quantities of a commodity or
service that a consumer would 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.
 Cont…

• Law of demand 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), demand curve and demand
function

• Demand Schedule: A demand

schedule states the relationship between
price and quantity demanded in a table form.
Combinations A B C D E

Price per kg 5 4 3 2 1

Quantity demand/week 5 7 9 11 13
 Cont..
Demand curve: is a graphical
representation of the relationship
between different quantities of a
commodity demanded by an
individual
Price
at different prices per
time period.

Quantity demand
 Demand Function
• 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), Qd-quantity demand, P-price
• Example: Let the demand function
be
Q = a+ bP, b=ΔQ/ΔP, b<0
 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.
Individual and market demand for a commodity
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
 Cont….

• 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
 Determinants of Demand

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
 Cont…
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.
 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. A change in own price is only a
movement along the same demand curve.
 Cont….
• Changes in demand: a change in any
determinant of demand—except for the
good‘s price- causes the demand curve to
shift.
price

Quantity demand
 Cont…
1. Taste or preference
When the taste of a consumer changes in favour of a
good, her/his demand will increase and the opposite is
true.
2. Income of the consumer
Goods are classified into two categories depending on
how a change in income affects their demand. These
are normal goods and inferior goods.
Normal Goods are goods whose demand increases as
income increase, while inferior goods are those whose
demand is inversely related with income.
 Cont…
3. Price of related goods
 Two goods are said to be related if a change in the
price of one good affects the demand for another
good.
• There are two types of related goods. These are
substitute and complimentary goods.
 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.
 Cont…
Complimentary goods, on the other hand, 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.
 Cont..
4. Consumer expectation of income
and price
• Higher price expectation will increase demand
while a lower future price expectation will
decrease the demand for the good.
5. Number of buyer in the market
 An increase in the number of buyers will
increase demand while a decrease in the
number of buyers will decrease demand
 Cont…
Elasticity 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 ;
 price of product
 Income of consumer
 prices of related goods
 Cont…
1. Price elasticity of demand means degree of responsiveness of
demand to change in price.
 Price elasticity of demand is a measure of how much the
quantity demanded of a good responds to a change in the
price of that good
 It is computed as the percentage change in quantity
demanded divided by the percentage change in price.
 Cont…
Price elasticity demand can be measured in two ways. These are
point and arc elasticity.
a. Point elasticity of demand
This is calculated to find elasticity at a given point.
=%ΔQd/ %ΔP
Ep=*
 Cont..
B. Arc elasticity of Demand :
 In arc price elasticity of demand, the midpoints of the old
and the new values of both price and quantity demanded are
used.
 It measures a portion or a segment of the demand curve
between the two points.
 Cont..

………………………………… ….; or
 Cont….
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.
 Compute elasticity of demand (point elasticity)?
Given: P0= 5, P1=4
Q0=100, Q1=110
*= -0.2
 Compute arc elasticity of demand
*=-0.42
 Cont..
 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. If the price elasticity of demand is
positive the product is giffen good.
 If |Ep| > 1, elastic
 If 0< |Ep| < 1, inelastic
 If |Ep| = 1, unitary elastic
 If |Ep| = 0, perfectly inelastic
 Cont..
 If |Ep| = ∞, perfectly elastic
Determinants of price elasticity of demand
 The availability of substitutes
 Time
 The proportion of income consumers spend for a product
 The importance of the commodity in the consumers’ budget
 Cont..
2. Income Elasticity of Demand :
It is a measure of responsiveness of demand to change in
income.

Point income elasticity of demand:

>0, the good is Normal good
 >=1, luxury good
 , necessity good

, the good is inferior good

 Cont…
3. Cross price Elasticity of Demand
 It Measures how much the demand for a product is affected
by a change in price of another good.

• 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.
 Cont…

Example: 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

=-0.66, the two commodities are complementary 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.
 There is a positive relationship between price and quantity
supplied.
 Cont…
Supply schedule, supply curve and supply function
 A supply schedule: is a tabular statement that states the different
quantities of a commodity offered for sale at different prices.
 A supply curve: it show the relationship between price and quantity
supplied graphically.
price

supply curve

quantity
 Cont…
 Supply function: a mathematical relationship between price
and quantity supply.
Qs=a+b P, b>0
 Market supply: It is derived by horizontally adding the
quantity supplied of the product by all sellers at each price.

Price per Quantity Quantity Quantity Market

unit supplied supplied by supplied supply per
by 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
 Cont…
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.
 Cont…
Effect of change in input price on supply of a product

• An increase in the price of inputs such as labour, raw materials, capital, etc causes a

decrease in the supply of the product.

• A decrease in input price causes an increase in supply.

Effect of change in Technology

• Technological advancement enables a firm to produce and supply more in the

market. This shifts the supply curve outward.

Effect of change in weather condition

•

• A change in weather condition will have an impact on the supply of a

number of products, especially agricultural products

 Elasticity of supply
o It is the degree of responsiveness of the supply to change in
price
o It is the percentage change in quantity supplied divided by
the percentage change in price
o The price elasticity of supply can be measured using point

and arc elasticity methods. However, a simple and most

commonly used method is point method.
 Cont…

 If Es > 1, elastic
 If 0< Es < 1, inelastic
 If Es = 1, unitary elastic
 If Es = 0, perfectly inelastic
 If Es = ∞, perfectly elastic
 Market equilibrium
Market equilibrium occurs when market demand equals market
supply.

SS

P*

DD
Q*
 Cont…
 Any price greater than P* will lead to market surplus.
 Any price less than P* will lead to market shortage.

Example: Given market demand: Qd= 100-2P, and market

supply: P =( Qs /2) + 10

 Calculate the market equilibrium price and quantity

 Determine, whether there is surplus or shortage at P= 25 and
P= 35.
 Cont…
Solution: @ equilbrium ;
Qd= Qs
100-2P= 2P-20
120= 4P
P=30, Q= 40
@ P=25,
Qd= 100-2*25
= 100-50
= 50
Qs= 2*25-20
= 50-20
= 30
Qd> Qs……shortage
 Cont..
@ P=35
Qd= 100-2*35
= 100-70
= 30
Qs= 2*35-20
= 70-20
= 50
Qs > Qd, …..surplus
 Cont…
Effects of shift in demand and supply on equilibrium
i) when demand changes and supply remains constant

P1 B
P* A
P0 C

Q0 Q* Q1
 When demand increase, with constant supply, both price and
quantity increase.
 When demand decrease, with constant supply, both price and
quantity decrease.
 Cont…
ii) When supply changes and demand remains constant
SS2
price SS
C SS1
P2*
A
P*
B
P1*
DD
Q2* Q* Q1* Quantity

• When supply increase, with constant demand, price decrease

& quantity increase.
 When supply decrease, with constant demand, price increase
& quantity decrease.
 Cont….
What will happen on equilibrium price and quantity, when both
demand and supply change?
A. If both demand & supply increase
Case 1: If both demand and supply increase by the same
proportion (percent).
 In this case Quantity (Q*) increase but price become
constant (P*)

P*

Q* Q1*
 Cont….
Case 2: If demand increase by higher proportion (percent)
than supply.
 In this case both equ. Quantity (Q*) and price (p*) increase

P1*
P*

Q* Q1*
 Cont….
Case 3: If demand increase by lower proportion (percent) than
supply.
 In this case equ. Quantity (Q*) increase but price become
constant (P*)

P*
P1*

Q* Q1*
 Cont…
B. What will happen on Q* & P*
when both demand and supply
decrease?