Chapter Two

Theory of Demand and Supply

Prepared By; Mahamed A.

By; Mahamed A. 1
 Outline
 Theory of demand
 Law of demand
 Demand schedule (table), demand curve and demand
function
 Determinants of demand
 Elasticity of demand
 Theory of supply
 Law of supply
 Supply schedule, supply curve and supply function
 Determinants of supply
 Elasticity of supply
 Market equilibrium By; Mahamed A. 2
 Theory of demand :. Is related to the economic activities of

consumers-consumption

 Theory of demand analysis various factors that affect demand. Ex.

price

 Demand is the willingness and ability of a consumer to purchase

the commodity at alternative price at given periods

 Demand is not mean desire in which desire should be backed by

purchasing power.

 If a consumer is willing to buy but not able to pay, desire will not be

demand. By; Mahamed A. 3

 Similarly, if the consumer has the ability to pay but not willing to
pay, desire will not be demand.
 For example; the poor willing to buy a car, but has no ability to pay
for it.
On the other hand, the rich able to pay for car, but may not willing to
pay for it.
 So, an individual should have both willingness and ability to pay the
same time. Is called demand
 demand refers to various quantities of a commodity or service that a
consumer willing and able to purchase in a market at various prices
at a given time, given other things unchanged (ceteris paribus).
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 NOTE THAT
 A commodity refers to any good produce for sale in the market

 Demand refers to the relationship b/n the price of commodity and its
quantity demanded (ceteris paribus).
 Quantity demanded is specific quantity which a consumer is willing to
buy at a specific price

 Law of demand
 It is the principle of demand, which states that ,

 as price of a commodity increases (decreases) quantity demanded

for that commodity decreases (increases), ceteris paribus.
 Price of a commodity and its quantity demanded are inversely
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 Demand schedule (table), demand curve and demand function

 The inverse relationship between price of goods and the

quantity of demand can be represented by a table

(schedule) or a curve or an equation (function).

Demand schedule
 Demand schedule is the tabular representation of the

relationship between price and the amount of commodity

purchased.

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 The individual demand schedule represents various
quantities of a commodity, which an individual
consumer purchases at various levels of prices in the
market.

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 Demand curve
 Demand curve is a graphical representation of the
relationship between different quantities of a commodity
demanded by an individual at different prices per time
period.

Price of orange are given OY

Quantity of demanded on OX
Downward slop of dd curve

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 The downward sloping for demand curve indicates the
inverse relationship between price and quantity demanded.

Demand function
 Demand function is a mathematical relationship between
price and quantity demanded, all other things remaining
the same.
 Demand function express as;

Where; → quantity demanded

→ price for the commodity
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Example: Let the demand function be Q = a+ bP;
b= , the change in quantity demanded for the
commodity with respect to the change in price of the
commodity indicates the slope of the demand curve.
From the given individual household demand, if the
price for orange change and decreases from 5 to 4, the
quantity demanded for orange change and increase from 5
to 7, then; b=== -2, the negative slope indicates the
downward demand curve.
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 The demand function express as Q=a-2P, then find a?

since; Q=7 and P=4;

7=a-2(4); a=15
Then, the demand function is Q=15-2P
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

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 The individual and the market demand curve at 3
given price.

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 Individual and market demand function
Suppose the individual demand function of the product is
given by: P=10 - Q /2 and there are about 100 identical
buyers in the market. Then the market demand
function=number of buyers* individual demand function
P= 10 - Q /2 price form change in to demand function
Q /2 =10-P ↔ Q= 20 - 2P
Qm=Qd*No buyers
Qm = (20 – 2P) 100 = 2000-200P
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 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
IV. Price of related goods
V. Consumers expectation of income and price
VI. Number of buyers By;inMahamed
the A.market 14
 Change in demand (Demand Curve)
 Demand changes when there is a change in any
determinant of demand except for the good‘s price causes
the demand curve to shift.
 If buyers choose to purchase more at any price, the
demand curve shifts rightward
 an increase in demand.

 If buyers choose to purchase less at any price, the demand

curve shifts leftward
 a decrease in demand By; Mahamed A. 15
 Change in demand and shift in demand curve

Factors rather than or except the price of the commodity

shifts the demand curve and they are called demand shifter.
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 Change in quantity demanded
 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.
 Downward movement along the demand curve is called
extension of demand, right ward
 i.e. the decrease in price increases the quantity demanded.

 While the upward movement as contraction of demand, i.e.

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the increase in price decreases the quantity demanded.
 Change in quantity demanded due to the
change in price

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 Some of these important factors are as follows:

 tastes or preference

 When the taste of a consumer changes in favor of a good,

demand will increase and vise-versa.

 Income of the consumer

 Goods are classified as normal goods and inferior goods

depending on how a change in income affects their demand.

 the classification Based on subjective nature

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 Normal (superior)goods and inferior foods

 Normal goods are goods whose demand increases as income

increase,

 Income of consumer demand positive related to normal goods

 while inferior goods are good whose demand decrease as

income increase.

 whose demand is inversely related with income.

 In general, inferior goods are poor quality goods with relatively

lower price and buyers of such goods are expected to shift to

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better quality goods as their income increases.
Income expenditure for normal and inferior goods

Income expenditure for inferior

Income expenditure for
normal goods Qd increase goods Qd decrease
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 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.
 Related goods classified as substitute and complimentary goods.
 Substitute goods are goods which satisfy the same desire of the
consumer.
 a goods that can used the place of another

For example, tea and coffee or Pepsi and Coca-Cola are substitute
goods.

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 If two goods are substitutes, then price of one and the demand for

the other are directly related.

 If the price of coffee increase . Demand for tea increase

 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.

 If the price of car increase. demanded for fuel decrease

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 Consumer expectation of income and price

 Higher income and price expectation will increase demand in these

time.

 while a lower future income and price expectation will decrease the

demand for the good in these time.

Number of buyer in the market

 Since market demand is the horizontal sum of individual demand

 an increase in the number of buyers will increase demand

 while a decrease in the number of buyers will decrease demand.

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 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 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.

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 1. Price Elasticity of Demand
 Price elasticity of demand means degree of responsiveness

of demand to change in price.

 It is sensitive demand it own price

 It indicate how consumer react 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 goods.
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 Price elasticity of demand can be measured in two ways

point and arc elasticity.

Point Price Elasticity of Demand

 Point price elasticity of demand calculated elasticity at a

given point.

 The price elasticity of demand can be express and

determined as;

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Point price elasticity of demand

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Point price elasticity of demand
 RP is the straight line demand curve
with connect both axis
Measure elasticity b/n two goods Q0
and Q1
 in the First at the price ON and
quantity OM,
then price change to ON1 and
quantity demanded also change to
OM1

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Example 1, price unit of a commodity increase from birr 5
to birr 6. as a result. The demand decreases from 100 units
to 80 units. Calculate price elasticity of demand
Solution: Give Q1=100,Q2=80, P1=5 and P2=6
2.Demand for a commodity increased from 100 units to
120 units as a result of 10% fall in its price. then calculate
price elasticity of demand.
Give:Q1=100,Q2=120 fall in price =10%
3.At Birr 5 per unit, a consumer buys 40 units of a
commodity and the price elasticity of his demand is 2. How
much will he buy if the price reduces to Birr 4 per unit?
Solution: Given: P1 = 5, Q1 = 40, eP = 2, P2 = 4 and Q2 =
?
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 Arc price elasticity of demand

 It measures a portion or a segment of the demand curve

between the two points.

 In arc price elasticity of demand, the midpoints of the old

and the new values of both price and quantity demanded

are used.

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It simplified as;

Ed=

Here, Qo = Original quantity demanded

Q1 = New quantity demanded

Po = Original price

P1 = New price

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Example: Consider a market for music CDs. When the
price of CDs is birr 20 per unit, consumers by 6 units
per year.
When the price rises to birr 24 per unit consumers buy
4 CDs per year. Find price elasticity of demand for
CDs using arc method.
Solution: Given: P1 = Birr 20, P2 = Birr 24, Q1 = 6,
Q2 = 4

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 Note that:

 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

inferior. Types of price elasticity of demand

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Demand curve showing different types of price elasticity

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 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. By; Mahamed A. 39

 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.

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 2. Income Elasticity of Demand
 It is a measure of responsiveness of demand to change in income.

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Example:1. Suppose a consumer has money income of
Birr 1000 and he purchases 4 kg of wheat. If his
money income goes up to Birr 1200, he is now
prepared to buy 5 kg of wheat. His income elasticity
of demand can be found using point method
2. Suppose a consumer started consuming 12 kg of
butter when his income increased to Birr 2000 –
which he used to consume only 8 kg when his income
was Birr 1600. The consumer's income elasticity of
demand can be found using arc method

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43
44
 Cross price Elasticity of Demand
 Measures how much the demand for a product is affected by a
change in price of another good.

i) The cross – price elasticity of demand for substitute goods is

positive.
ii) The cross – price elasticity of demand for complementary goods
is negative.
iii) The cross – price elasticity of demand for unrelated goods is
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zero.
 Theory of supply
 Theory of supply analysis various factors that affect supply.

 Supply refers to the willingness and ability of the sellers

(producers) to provide various quantities of a product at

different prices in a given period of time, other things

remaining unchanged.

 Quantity supplied refers to the amount of a commodity in

which the sellers (producers) are willing and able to provide

at different prices in a given period

By; Mahamed A. of time at ceteris paribus.
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 The law of supply states that, as price of a product increase, quantity

supplied of the product increases, and as price decreases, quantity

supplied decreases at ceteris paribus.

Supply schedule, supply curve and supply function

 The relationship that exists between price and the amount of a

commodity supplied can be represented by a table (schedule) or a

curve or an equation (function).

Supply schedule

 A supply schedule is a tabular statement that states the different

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quantities of a commodity offered for sale at different prices.
 an individual seller’s supply schedule for butter

SUPPLY curve
 It is the graphical representation of the relationship
between price of the commodity and its quantity
supplied.

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 supply curve represented as;

Supply function
 It is a mathematical relationship between price and quantity supplied,

all other things remaining the same.

 The supply of a commodity can be briefly expressed in the functional

relationship as:

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

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 Market supply
 The market supply schedule, curve or function is derived
by horizontally adding the quantity supplied for the
product by all sellers at each price.
Individual and market supply schedule for the product

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Individual and market supply curve for the product

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 Suppose the individual supply function of the product is
given by: P=10 +2S and there are about 100 identical
sellers in the market. Then the market supply function is
given by:
P=10 +2S ↔ 2S =P-10 ↔ S= 1/2P-5 ↔ S= -5+1/2p
Sm = (-5+1/2p) 100 = -500+50P
where; S, the individual supply function
Sm, the market supply function

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 Determinants of supply
 Apart from the change in price which causes a change in quantity
supplied, 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

VII. weather, etc.

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i) 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 which is represented by a leftward shift of the supply
curve.
 Likewise, a decrease in input price causes an increase in
supply and represents a rightward shift in supply curve.
ii) Effect of change in Technology
 Technological advancement enables a firm to produce and
supply more in the market and causes to shifts the supply
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curve outward.
iii) 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.
 For example, other things remain unchanged, good
weather condition boosts the supply of agricultural
products and causes to shifts the supply curve of a given
agricultural product outward.

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iv) prices of related goods
 An increase in the price of other related goods induces
the firms to produce more of those other goods, leading to
a reduction in the supply of the goods whose price has
remained unchanged.
v) sellers‘ expectation of price of the product
 If sellers expect the price the product increase in the
future, the supply of the product decrease, why because,
the seller wants to supply and sell at higher price in the
future. By; Mahamed A. 56
vi) taxes & subsidies
 The reduction of taxes lay on the firm causes the firm
become more profitable and initiates the firm produce
more and increases the supply of the product.
 The subsidies also initiate the firms production and the
firm produce more and increases the supply of the product.
vii) number of sellers in the market
 Large number of seller in the market causes the
competition between the seller and decreases selling price
and results decreases theBy;supply
Mahamed A. of the product. 57
 Elasticity of supply
 It is the degree of responsiveness of supply to change in
price.
 It defined as the percentage change in quantity supplied
due the percentage change in price.
 The price elasticity of supply can be measured using point
and arc elasticity methods.
 The point price elasticity of supply is the ratio of
proportionate change in quantity supplied of a commodity
to a given proportionateBy;change
Mahamed A.
in its price. 58
 price elasticity of supply can be express;

 price elasticity of supply can be elastic, inelastic,

unitary elastic, perfectly elastic or perfectly inelastic.

 The supply is elastic when a small change in price leads

to great change in supply.

 The supply is inelastic or less elastic when a great

change in price induces only a slight change in supply.

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 The supply is perfectly inelastic, means that, quantity
supplied doesn’t affected by change in price, i.e. even if
the price change, the quantity supplied doesn’t change.
 Supply is perfectly elastic, means that, even if the price
doesn’t change, the quantity supplied change
continuously.

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 Market equilibrium
 It is the equilibrium in which the market price and
market quantity of the product determined under the
equality of demand and supply of the product.

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 As shown in the graph, any price greater than ‘P’ will lead to market
surplus.
 As the price of the commodity increases, consumers demand less of the
product.
 On the other hand, as the price of the commodity increases, producers
supply more of the good.
 Therefore, if price increases to P1, the market will have a surplus of HJ.
 If the price decreases to P2, buyers buy to demand 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
a) Calculate the market equilibrium price and quantity
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b) Determine, whether there is surplus or shortage at P= 25 and P= 35.
 Effects of shift in demand and supply on
equilibrium
 Changes in demand and supply bring about changes in the
equilibrium price level and the equilibrium quantity.

i) when demand changes and supply remains constant

 Changes in income, tastes, and prices of related goods will
lead to a change in demand.
 In the given supply; if the demand increases, the demand
curve will shift upward to the right.
 Whereas; demand falls, the demand curve shifts downwards
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 The effect of change in demand on market equilibrium under constant
supply.

 Demand and supply curves intersect at point ‘E’ and the quantity
demanded and supplied is ‘OM’ at ‘OP’ equilibrium price.
 With the given supply; the increase in demand shifts the demand curve to
the right and intersect the supply curve at ‘E1’ , the equilibrium price
increases to ‘OP1’ and also the equilibrium quantity increases to ‘OM1.
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 With the given supply; the decrease in demand shifts the
demand curve to the left and intersect the supply curve at
‘E2’ , the equilibrium price decreases to‘OP2’ and also
the equilibrium quantity decreases to‘OM2.’
 Supply being given, a decrease in demand reduces both
the equilibrium price and the quantity and vice versa.
ii. When supply changes and demand remains constant
 Changes in supply are brought by changes in
determinant of supply especially factor (input) price.
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 In the given demand; the increases in supply shifts the
supply curve to right (downward).
 Whereas; the decreases in supply shifts the supply curve
to left (upward).
The effect of change in supply on market equilibrium
with constant demand

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 Supply and demand curves intersect at point ‘E’ and the
quantity supplied and demanded is ‘OM’ at ‘OP’ equilibrium
price.
 With the given demand; the increase in supply shifts the
supply curve to the right and intersect the demand curve at
‘E1’ , the equilibrium price reduces to ‘OP1’ and the
equilibrium quantity increases to ‘OM1.’
 With the given demand; the decrease in supply shifts the
supply curve to the left and intersect the demand curve at ‘E2’
, the equilibrium price increase to ‘OP2’ and the equilibrium
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quantity decreases to ‘OM2.’
 iii) Effects of combined changes in demand and supply
 When both demand and supply increase, the quantity of the
product will increase definitely.
 But it is not certain whether the price will rise or fall, it depends
on the relative increase in demand and supply.
1. If an increase in demand is more than an increase in supply, then
the price goes up.
2. On the other hand, if an increase in supply is more than an
increase in demand, the price falls.
3. If the increase in demand and supply is same, then the price
remains the same. By; Mahamed A. 68
 Effect of simultaneous change in demand and supply on
equilibrium price and quantity (both demand and supply
increase)

Increase in Increase in Increase in

demand is demand demand and
greater than smaller than increase in
increase in increase in supply are
supply supply
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equal 69
 When demand and supply decline, the quantity decreases.
 But, the change in price will depend upon the relative fall
in demand and supply.
1. When the fall in demand is more than the fall in supply,
the price will decrease.
2. When the fall in supply is more than the fall in demand,
the price will rise.
3. If both demand and supply decline in the same ratio, there
is no change in the equilibrium price.
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 Effect of simultaneous change in demand and supply on
equilibrium price and quantity (both demand and supply
decrease)

Decrease in Decrease in Decrease in

demand is greater demand is smaller demand and
than decrease in than decrease in decrease in supply
supply supply are equal
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