Demand and Supply theory

 Upon completion of this unit you will be able to:

 Show how demand and supply can be expressed in words, numbers,
graphs and equations.
 Define the law of demand and the law of supply and the concept of
elasticity.
 Distinguish between a movement along a demand/supply curve and
the shift of a demand/supply curve.
 Identify the determinants of individual demand and individual
supply, market demand and market supply and elasticity.
 Explain how the equilibrium price and quantity are determined in
the market.
 Identify the function of prices and elasticity in a market.
 Explain the relationship between price elasticities and total revenue.
 The Concept of a Market

What is a Market:
A market is a set of arrangements through which buyers and sellers exchange
goods and services.

The interaction between buyers and sellers determines:

 Quantity of goods or services produced.
 Price at which these are bought and sold
In a Market economy (Capitalist/Free market economy), price of goods is
determined by the interaction of demand and supply.

The behaviour of buyers (consumer) is captured by the concept of demand and the
behaviour of the seller (producers) is captured by the concept of supply.

Price
A price is what buyers and sellers regard as the value of a product or service
and is determined on markets by the interaction of demand and supply.
 Demand Analysis

Demand: Describes the quantity of a good buyers wish to purchase at every possible price, at a
particular moment in time or a relationship between price and quantity demanded in a given time
period, ceteris paribus.

Market demand: Obtained by adding the relevant individual demands horizontally, using schedules
or graphs. It is the horizontal summation of individual consumer demand curves.

Market demand curve is important for:

Business; It helps to define production schedules so as to meet demand expectations.

Consumer; Have an interest in the nature of the market demand curve because it have a major
effect on market price of goods or service.
Policymakers; Have an interest in market demand, both from a commodity policy perspective and
from macroeconomic growth perspective.

Demand schedule: Is a table that displays price and quantities demanded.

Demand Curve: Shows the maximum amount an individual is willing to pay for an additional unit of
a good.
Figure 1:From a Demand schedule to a Demand Curve

A Demand Schedule $6.00

A Demand Curve

Price per DVD rentals 5.00

Price per DVDs (in dollars)

cassette demanded per
week 4.00 E

A $0.50 9 3.50 B G
3.00 D
B 1.00 8 Demand for
C
C 2.00 6 2.00 DVDs
D 3.00 4 1.00
F
A
E 4.00 2 .50
0
1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of DVDs demanded (per week)
 Law of Demand

The law of demand states that more of a good will be demanded when the price is
lower and less of a good will be demanded when the price is higher, other things
equal.

Change in quantity demanded:

When the price of a good changes it will cause a change in the
quantity demanded and graphically it is shown as a movement along
the demand curve.
Changes in demand:
Exogenous variables are factors that cause shifts of the demand curve.
A change in anything besides the price will shift the entire demand
curve.
 FIGURE 2: A Demand Curve

Law of Demand consumers

demand more of a good the
p,N$ per kg

p
lower its price, holding constant
all other factors that influence
consumption

4.30
3.30
2.30

0 200 220 240 286

Q, Million kg of ostrich meat
per year
 Figure 3:Change in Quantity Demanded

$2 B
Price (per unit)

Change in quantity demanded

(a movement along the curve)

A
$1

D1
0
100 200
Quantity demanded (per unit of time)
 Figure 4: Shift in Demand

Change in demand
(a shift of the curve)
$2
Price (per unit)

B A
$1

D0

D1
100 200 250
Quantity demanded (per unit of time)
 Individual and Market Demand Curves

 A market demand curve is the horizontal sum of all

individual demand curves.
 This is determined by adding the individual demand curves of
all the demanders.
 Figure 5: From Individual Demands
to a Market Demand Curve

(1) (2) (3) (2) (3) $4.00

Price per Alice’s Bruce’s Cathy’s Market G
cassette demand demand demand demand 3.50

Price per cassette (in dollars)

3.00 F
A $.0.50 9 6 1 16 E
B 1.00 8 5 1 14 2.50
D
C 1.50 7 4 0 11 2.00
D 2.00 6 3 0 9 C
1.50
E 2.50 5 2 0 7 B
F 3.00 4 1 0 5 1.00
A
G 3.50 3 0 0 3 0.50
H 4.00 2 0 0 2 Cathy Bruce Alice Market demand
0
2 4 6 8 10 12 14 16
Quantity of cassettes demanded per week

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

 Determinants of Demand

Number of potential buyers

Income

Tastes

Expectations
Prices of related goods
 The effect of price of related goods

 Substitute goods: an increase in the price of one results in an increase

in the demand for the other.
 Complementary goods: An increase in the price of one results in a
decrease in the demand for the other.
 The Demand Function
 The processed ostrich meat demand function is:

Q = D(p, pc, pb, Y)

 where Q is the quantity of ostrich meat demanded

 p is the price of ostrich meat (dollars per kg)
 pc is the price of chicken (dollars per kg)
 pb is the price of beef (dollars per kg)
 Y is the income of consumers (thousand dollars)
From the Demand Function to the Demand Curve
 Estimated demand function for ostrich:

Q = 171−20p + 20pc+ 3pb + 2Y

 Using the values pc = 4, pb = 3.33 and Y =

12.5, we have
Q = 286−20p

 which is the linear demand function for ostrich

meat.
Figure 6: From the Demand Function to the Demand Curve

Q = 286−20p If p = 0, then Q = 286

If p decreases by $1 (to
p, N$ per kg

14.30
N$2.30) then,Q =
240

In general,
DQ = -20Dp
= slope Dp
4.30
3.30
2.30

0 200 220 240 286

Q , Million kg of ostrich meat
 2. Demand Elasticity and Related
coefficients
Elasticity of demand
Price elasticity of demand is a measure of the sensitivity or responsiveness of
quantity demanded as a result of price changes.

Calculation of Price Elasticity

Percentage change in the quantity demanded

Ed = -------------------------------------------------------
Percentage change in the price

We can write this relationship as a formula:

DQ
Q
Ed = - --------- or - DQ/Q x DP/P or - DQ/ DP x P/Q
DP
P
Note: - DQ Is the slope of the demand curve.
DP
The formula above is used to calculate point elasticity on the demand curve.
To calculate elasticity using two points on the demand curve we use
the following formula (Arc elasticity):

DQ
(Q1 + Q2)
Ed = ------------
DP
(P1 + P2)
Sensitivity of Quantity Demanded to
Price (cont.)
 Along linear demand curve with a function of:

Q = a − bp

 Where -b is the slope or

DQ
−b =
Dp
 the elasticity of demand is

DQ p p
= = −b (3.3)
Dp Q Q
 Interpretation of Elasticities:
The five categories of price elasticity of
demand
We can distinguish between five different categories
of price elasticity of demand. They are as follows:
 Perfectly inelastic demand (Ed = 0)
 Relatively inelastic demand (Ed < 1)
 Unit elastic demand (Ed = 1)
 Relatively elastic demand (Ed > 1)
 Perfectly elastic demand (Ed = )
Figure 7: Perfectly inelastic demand
 If demand is perfectly
inelastic a change in price
causes no change in
quantity demanded.
 Buyers are completely
insensitive to price
changes because they
cannot do without the
product:
 Examples of goods
that could have a
perfectly elastic
demand are:
 Medicine when a person’s
life is in danger like
insulin for a diabetic.
Figure 8: Relatively inelastic demand
If demand is relatively
inelastic, the percentage
change in quantity demanded
is smaller than the percentage
change in price.
Examples of such goods
are:
• Goods with no good
substitutes such as electricity
and petrol.
•Necessities such as bread and
milk.
•Low priced goods such as salt,
pencils and matches
Figure 9: Unit elastic demand

Demand is unit elastic if the

percentage change in quantity
demanded equals the percentage
change in price.
Figure 10:Relatively elastic demand
Demand is relatively elastic if
the percentage change in
quantity demanded is greater
than the percentage change in
price.
Figure 11:Perfectly elastic demand
•The demand curve is parallel to
the quantity axis and this
represents the other extreme on
the demand side, perfectly
elastic demand.
•At the price of N$25 an infinite
quantity is demanded.
•At any other price nothing is
demanded.
•We say in this case that price
elasticity of demand is equal to
infinity.
Examples:
Goods that are perfectly elastic
in demand have perfect
substitutes. In theory, the
consumer can switch easily to
another product if the price
changes. This demand curve is
very important in the theory of
perfect competition.
Elasticity Along a Demand Curve
 The elasticity of demand varies along most
demand curves.
 Along a downward-sloping linear demand curve the
elasticity of demand is a more negative number the
higher the price is.
Figure 12: Linear demand curves

 On a linear or straight line

demand curve the
elasticity of demand varies
over the length of the
curve. But the slope of a
linear demand curve is
constant.
 Above the midpoint of the
curve price elasticity of
demand is greater than 1
(elastic).
 At the midpoint price
elasticity of demand is
equal to 1 (unit elastic).
 Below the midpoint price
elasticity of demand is less
than 1 (inelastic).
Figure 13:Illustration of Elasticity Along the OSTRICH
MEAT Demand Curve
Q = 286 -20p
p, $ per kg

Perfectly elastic
14.30
11.44
Elastic  < –1 57.2
11.44
 = –4

= 7.15
Unitary:  = -1
Inelastic 0 >  > –1

3.30
 = –0.3 Perfectly
inelastic

0 57.2 143 220 a = 286

Q, Million kg of pork per year
 Price elasticity of demand
and total revenue
 Suppose a seller wants to increase the price of his product
to increase the firm’s revenue.
 We know that if the price rises, the quantity demanded will
fall and the business can lose money.
 The question is now, what should a firm do to increase its
revenue?
 Price elasticity of demand can be used to determine how
the total revenue of a business will change when the price of
a product changes.
 A firm’s total revenue can be calculated using the following
formula:
 Total revenue = price x quantity (TR = P x Q)
 A business can apply the following principles when decisions about
price changes have to be made:
 Inelastic demand (Ed < 1): If demand is inelastic an increase in
price will increase total revenue. The higher price will cause a
decrease in the quantity demanded, but the percentage change in
quantity demanded is less than the percentage change in price.
 Unit elastic demand (Ed = 1): If demand is unit elastic, sellers
should leave the price unchanged because they cannot increase total
revenue by increasing or decreasing the price of the product. In both
cases the percentage change in the price will be offset by a
corresponding percentage change in the quantity demanded. Total
revenue will therefore remain unchanged.
 Elastic demand (Ed > 1): If demand is elastic a decrease in price
will increase total revenue. The percentage change in quantity
demanded is greater than the percentage change in Price.
 Determinants of price elasticity of demand

The following factors may influence price elasticity of demand:

a) Availability of substitutes: Products with good substitutes will have a more
elastic demand. If the price of the product increases, consumers can switch to the
substitutes. If there are few substitutes, demand tends to be inelastic.
c) Complementary goods: Complements are used jointly with other goods, such as
petrol in a car and sugar in tea, coffee and many other foods. The demand for these
goods tends to be inelastic.
d) Necessity or luxury: If the product is a necessity such as basic foods, petrol and
electricity, will continue to buy the product when prices increase, although we may
buy slightly less than before. We can therefore say the demand for necessities is
inelastic. The demand for luxury goods tend to be more elastic as we may feel we
can get by without the products and there may be a substantial decrease in the
quantity demanded if the price increases.
e) Proportion of income spent on the product: The demand for goods on which
we spend a large proportion of our income such as houses and cars tends to be more
elastic. The demand for goods on which we spend a small fraction of our income,
tends to be more inelastic.
 The time period: Demand will be more elastic in the
long run because consumers will have time to adjust to
price changes. In the short run demand tend to be
inelastic.
 Habit-forming products: If the product is habit-
forming such as cigarettes, the demand is more likely to
be inelastic as buyers will be insensitive to price changes
and will continue to smoke in spite of the price.
 Durability of the Product: The demand for durable
goods such as furniture or appliances, tend to be more
elastic as consumers may decide to keep the old products
a little longer. If goods are non-durable such as food and
cleaning materials, the demand will be more inelastic
because these goods can be used only once.
 Income and elasticity of demand

 The relationship between changes in consumers income

and quantity of an item purchased is called an Engel
curve.
 As income increases more or less of a commodity may be
bought.
 Normal good: Consumers buy more of it as income increases.
 Inferior good: Consumers buy less of it as income increases.
 Different Engel curve exists for each commodity and for
each individual.
 Income Elasticity of demand: Measure the
responsiveness of quantity of a good purchased with
changes in changes in income, holding all other factors
constant.
 Figure 14: Engel Curve for Food

Quantity
Food
Purchased

E.g. Using food as an illustration.

The quantity of purchased increases
as income rises, but a decreasing
rate. Thus, the proportion of income
spent for food decreases as income
increases.

1 2 3 4 5 6 7 8 9 10 11 12
Weekly Income in 000’s
 Figure 15: Engel Curve for Clothing

Other items such as clothing can be

Quantity characterized by an Engel curve
represented in this figure. The
Clothing steepening curve shows that the
Purchased quantity of clothing purchased
changes substantially as money
income rises.

1 2 3 4 5 6 7 8 9 10 11 12
Weekly Income in 000’s
 Sensitivity of Quantity Demanded to
Income
 Formally, DQ
%DQ Q DQ Y
x= = =
%DY DY DY Q
Y

 where Y stands for income.

 Example
 If a 1% increase in income results in a 3% increase in quantity demanded, the income
elasticity of demand is x = 3%/1% = 3.
 Formula to calculate arc income elasticity:
EI =
DQ
Q1 + Q 2

x =
DY
Y1 + Y 2
Sensitivity of Quantity Demanded to
Income: Example
 The estimated demand function for ostrich
meat is:
Q = 171 – 20p + 20pC + 3pB + 2Y
 where p is the price of Ostrich, pb is the price of
chicken, pb is the price of beef and Y is the income (in
thousands of dollars).
 Question: what would be the income elasticity of
demand for ostrich if Q = 220 and Y = 12.5
 Answer:
 Since DQ = 2, then x =
DQ Y Y  12.5 
= 2 = 2   0.114
DY DY Q Q  220 
 Calculating income elasticity of demand

 The arc income elasticity coefficient can be calculated from the Engels function.
Suppose that income rise from N$200 to N$400, determine the arc income income
elasticity of demand.
 EI = (10 – 30)/ (10+30) = 20/40 =2/4 X 6/2 = 1.5
(200-400)/(200+400) 200/600
 EI= 1.5 Means that a 1% ↑ in income results in a 1.5% ↑ in the Q of steak purchased.
 Income elasticity of demand is important in determining the impact of income
changes on the purchases of farm food items. “The income elasticity for food in the
aggregate, as well as for many individual food products, is thought to ↓ as income ↑.
 Therefore, income elasticity will change over various income levels and be positive or
negative.
 Positive income elasticity indicate normal goods
 Negative income elasticity indicate inferior goods. (EI < 0)
 Luxury Good:
 A luxury good is a specific type of normal good and is sometimes classified differently.
 It is a good that behaves like a normal good, but as income rises, a higher percentage of total income is spent
on the good (it has a high income elasticity). Examples include jewelry, fashionable clothing, and fine alcohols.
 Luxury goods have EI greater than 1. (EI >= 1)
 Necessities are Normal Goods but 0 < EI < 1
 Exercise 1

 Consider the following market condition

The quantity of goods sold in week one = 20
Income earned per week one = N$ 100

Quantity of goods sold in week two = 50

Income per week two = N$ 300
1. Determine the point income elasticity of demand for
the goods
2. Use same scenario to determine the Arc income
elasticity of demand for the goods
 Cross price elasticity of demand

 Measures how sensitive DEMAND for a commodity is to

changes in the price of a substitute or compliment
commodity
 Arc cross price elasticity of demand for commodity X with respect to
a small change in the price of commodity Y can be illustrated with
the following algebraic expression:

Exy = ∆Qx/ (Qx1+Qx2)

∆Py/ (Py1 +Py2)

Point cross price elasticity:

Exy = ∆Qx/Qx
∆Py/Py
 Cross price elasticity of demand

 If cross price elasticity coefficient is:

 Positive = The two commodities as substitute. Exy > 0
 Negative = The two commodities are complementary. Exy < 0
 Zero (0)= Independent commodities. Exy = 0
 The cross price elasticity of pork with respect to the price of beef is around +1.5. Meaning,
Q of pork purchased will ↑0.15% for each 1% ↑ in the price of beef, ceteris paribus.
 Example
The Cross-Price Elasticity of Pork and Beef would be calculated as:
Exy, Pork, Beef = D QPork / % D Pbeef

INTERPRETATION:
If the; Exy, Pork, Beef = + .65

Then for every 1% increase in the price of beef, the Qd of pork would
increase .65%. We also would know that pork and beef are substitutes
 Applicability of Demand Elasticity

 Applicable to Policy makers

 Applicable to farmers
 Applicable to consumers
 Applicable to input manufacturers
 Applicable to food processors and trade firms

 NB: Do read more on your own about the

importance of Elasticity of demand
SUPPLY – refers to the willingness and ability to sell.
QUANTITY SUPPLIED (Qs) – amount supplied at a particular
price for a given period
LAW OF SUPPLY
P, Qs - When price goes up, quantity supplied goes up
P, Qs - When price goes down, quantity supplied goes down
Positive relationship, directly proportional, Why?
Producers/sellers want bigger prices because they want bigger
profits.
CHANGE IN QUANTITY SUPPLIED

PRICE QTY.
SUPPLIED
1 10

2 40
3 70
4 140
 CHANGE IN SUPPLY
results from a change in
one of the NON-PRICE
Price S2 determinants of supply
S1
Causes a shift in the
position of the supply curve
P1

Q2 Q1 Quantity
 CHANGE IN SUPPLY NON-PRICE DETERMINANTS
OF SUPPLY (Causes of shift in
SUPPLY CURVE)

Price technology
S2
S1 cost of production
number of sellers
P1 Prices of other goods
price expectations
taxes and subsidies

Q2 Q1 Quantity
 Change in supply is not equal to a change in
quantity supplied (s  Qs)

Price S2
S1

P1

Q2 Q1 Quantity
LAW OF SUPPLY AND DEMAND
When supply is greater than demand, price
decreases.
When demand is greater than supply, price
increases.
When supply is equal to demand, price
remains constant. This is equilibrium price.
MARKET CONDITION (Qs-Qd)
1. SURPLUS - Qs > Qd
2. SHORTAGE - Qd > Qs
3. EQUILIBRIUM - Qs = Qd
PRICE QTY.
DEMANDED
QTY.
SUPPLIED

1 55 10
2 40 30
3 25 40
4 18 50
5 10 60

What is the Pe? Qe?

 Supply Elasticity

Is the percentage change in quantity supplied associated with a

percentage change in price. Es = % D Q / % D P

Point elasticity of supply

Es = D Q X P
DP Q
Arc Elasticity of Supply
DQ
(Q1 + Q2)
Es = ------------
DP
(P1 + P2)
 This is the elasticity of an average between two points.
 Interpreting Elasticity of Supply

If
Es > 1  elastic supply
Es =   Perfectly elastic supply
Es < 1  inelastic supply
Es = 0  Perfectly inelastic supply
Es = 1  unitary elastic supply
 Application of Supply Elasticity

 Elastic Products
Products that can be easily produced in the short
run or where producers can easily adjust
production or bring output to market in a short
time have the highest supply elasticity.
 Inelastic Products
Products such as fruit, livestock, tea, cocoa etc.
where it is difficult for producer to produce for the
market in the short run.
END OF UNIT 3

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