CHAPTER TWO

THEORY OF DEMAND AND SUPPLY

1
2.1 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).
In defining demand, we have to consider:
 Ability to pay for the good

 Willingness to pay the price of the good

 Availability of the good

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 i.e., as price of a commodity increases (decreases) quantity
demanded for that commodity decreases (increases), ceteris paribus.

2
• 2.1.1 Demand schedule (table), demand curve and demand function

• Demand schedule (table): is a tabular presentation of the relationship between

price and quantity a commodity that consumers are able and willing to buy at each
specific price.

• Table 2.1 Individual household demand for orange per week

Combinations A B C D E

Price per KG 5 4 3 2 1

Quantity 5 7 9 11 13
demanded/week

• Demand curve: is a graphical representation of the relationship between different

quantities of a commodity demanded by an individual at different prices per time
3
period.
4
• 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)

• Where Qd is quantity demanded and P is price of the commodity, in our case price of
orange.

• Example: Let the demand function be Q = a + bP

(E.g. moving from point A to B on figure 2.1 above)

, where b is the slope of the demand curve

Q = a - 2P, to find a, substitute price either at point A or B.

7= a-2(4), a = 15

• Therefore, Q=15-2P is the demand function for orange in the above numerical example.
5
• 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.

• Table 2.2: Individual and market demand for a commodity

6
• The following graph depicts market demand curve at price equal to 3

• Figure 2.2: Individual and Market demand curve 7

•Numerical Example 1: 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

Qm = 2000-200P

•Numerical Illustration 2: Assume the following three equations represent

the demand for individual A, B and C respectively, who are the only buyers of
orange in the market. QdA = 40-2P; QdB= 10-0.4P; QdC= 20-2P;
8
suppose now that the market price of a kilogram of orange is Birr 10.
 a) Calculate the Qd of each individual.

b) Calculate the market demand for orange.

•Solution:

a) QdA = 40-2*10= 20 Kg; QdB= 10-0.4*10= 6Kg; and QdC = 20-2*10= 0Kg.

b) The market demand for orange is the sum of the quantity demand by A, B and C.
Therefore, QdM = 20Kg+6 Kg+ 0Kg= 26 Kg.

You can also alternatively calculate the market demand after deriving the market
demand equation.
The market demand equation can be derived simply by taking the horizontal
summation of the three equation as follows; Qd M= QdA +QdB+QdC= (40-2P) + (10-
0.4P) + (20-2P) By taking similar terms together; QdM= (40+10+20)-(2P+0.4P+2P)=
70-4.4P Now you can calculate the market demand for orange by just substituting the
price in the equation . 9
 2.1.2 Determinants of demand
•The demand for a product is influenced by many factors. Some of these factors are:
I. Price of the product
II. Taste or preference of consumers
III. Income of the consumers (Normal vs Inferior goods)
IV. Price of related goods (Substitute vs Complementary goods)
V. Consumers expectation of income and price
VI. Number of buyers in the market
•Changes 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.

10
11
•Changes in Quantity Demanded:

A change in the price, other factors remain constant, will bring change in
quantity demanded.
A change in own price is only a movement along the same demand
curve.

12
•2.1.3 Elasticity of demand
•It 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.

•i. Price Elasticity of Demand

Price elasticity of demand means degree of responsiveness of

demand to change in price.
The greater the reaction the greater will be the elasticity, and the
lesser the reaction, the smaller will be the elasticity. 13
•Price elasticity of demand can be measured in two ways:

a. Point Price Elasticity of Demand

•It is used when price change is very small

•Is measured at particular point on a demand curve/ measure the elasticity between

two points A and B which are assumed to be intimately close to each other.

14
•Numerical illustration:

15
 b. Arc price elasticity of demand
•It is used when change in price is large.
•It measures a portion of the demand curve between the two points.

Numerical example: Suppose the price of a commodity is Br. 5 and the

quantity demanded at that price is 100 units of a commodity. Now assume
the price of the commodity falls to Br. 4 and the quantity demanded rises to
110 units. The value of the arc elasticity will be: 16
NOTE:
 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 /Ped/ > 1, demand is said to be elastic and the product is luxury

If 0 £ /Ped/ <1, demand is inelastic and the product is necessity

If /Ped/ = 1, demand is unitary elastic.

If /Ped/ = 0, demand is said to be perfectly inelastic, vertical line.

If /Ped/ = ¥, demand is said to be perfectly elastic, horizontal line. 17

•Determinants of price Elasticity of Demand

•The following factors make price elasticity of demand elastic or inelastic

other than changes in the price of the product.

•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
18
•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.
ii. Income Elasticity of Demand

19
•Numerical Illustration: When the income of a household rises from Birr
1000 to Birr 1200, the yearly consumption of beer falls from 50 bottles to 30
bottles. Calculate income elasticity demand.
•iii. Cross price Elasticity of Demand
• Measures how much the demand for a product is affected by a change
in price of another good.

20
21
 2.2 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.

 It tells us there is a positive relationship between price and quantity supplied.

• 2.2.1 Supply schedule, supply curve and supply function

• A supply schedule is a tabular statement that states the different quantities

22
of a commodity offered for sale at different prices.
• A supply curve shows the information graphically rather than in
a tabular form.

23
• Supply function is the mathematical representation of the relationship between
price and quantity supplied.

• S = f(P), where S is quantity supplied and P is price of the commodity.

• Solution: Step 1: calculate ‘b’. b = change in Qss /Change in P = (35-10)/

(4-2) = 25/2= 12.5. Step 2: calculate ‘a’. Just take any one of the
coordinates from the table and substitute for Qss and P. Hence, 10= a+
(12.5*2) = a-25⇒ a= 10-25= -15 Therefore, the supply equation can be
24
• Market supply: It is derived by horizontally adding the quantity supplied of
the product by all sellers at each price.

25
• 2.2.2 Determinants of supply

• Apart from the change in price which causes a change in quantity

demanded, the supply of a particular product is determined by:
• i) Price of inputs ( cost of inputs)

• ii) Technology

• iii) Prices of related goods

• iv) Sellers ‘expectation of price of the product

• v) Taxes & subsidies

• vi) Number of sellers in the market

26
 2.2.3 Elasticity of supply
• It is the degree of responsiveness of the supply to change in price.

• Price elasticity of supply can be: elastic, inelastic, unitary elastic, perfectly
elastic or perfectly inelastic.

The supply is elastic when a small change on price leads to great change in
supply.

It is inelastic when a great change in price induces only a slight change in supply.

If supply is perfectly inelastic, it is represented by a vertical line

If supply is perfectly elastic it is represented by a horizontal line. 27

 2.3 Market equilibrium

• Market equilibrium occurs when market demand equals market

supply.

28
 In the above graph, any price greater than P will lead to market surplus.

As the price of the commodity increases, consumers demand less of the

product. And producers supply more of the good. Therefore, if price increases
to P1 the market will have a surplus of HJ.

On the other hand 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.

• Numerical example: Given market demand: Qd= 100-2P, and

• Market supply: P = (Qs /2) + 10 or Qs = 2P - 20

a) Calculate the market equilibrium price and quantity

29
b) Determine, whether there is surplus or shortage at P= 25 and P= 35.
• Solution:

• a) At equilibrium, Qd= Qs
• 100 – 2P = 2P – 20

• 4P =120

• P = 30, and Q = 40

• b) Qd (at P = 25) = 100-2 (25) =50 and Qs (at P = 25) = 2(25) -20 =30.

Therefore, there is a shortage of: 50 -30 =20 units

• Qd (at P=35) = 100-2(35) = 30 and Qs (at p = 35) = 2(35)-20 = 50.

therefore, there is a surplus of 20 units 30

 Effects of shift in demand and supply on
equilibrium price and output

Both equilibrium price and output increase if dd increase (ss constant) and v v.
31
Equilibrium price increase and Equilibrium output decrease if ss decrease (dd
constant) and v v.
32
 Effects of combined changes in demand and
supply
• If demand and supply change in opposite directions, then the change in the
equilibrium price can be determined, but the change in the equilibrium
Output cannot.

• If demand and supply change in the same direction, the change in the
equilibrium output can be determined, but the change in the equilibrium
price cannot.

33