MAIN TITLE

CHAPTER
Two
YOUR
Theory of Demand and
Supply BUSINESS
NAME
• YOUR BUSINESS PURPOSE
 2.1 Theory of demand
1. Are demand and want similar? Why?
2. Why can’t we purchase all that we need or we desire to have?
3. Can we say that, with a decrease in the price of a commodity, a
consumer normally buys more of it? Why?
4. Explain why demand curves always slope downwards from left
to right. Are there any exceptions to this?
• Demand is one of the forces determining prices.
• The theory of demand is related to the economic activities
of consumers-consumption.
• The purpose of the theory of demand is to determine the
various factors that affect demand.
• Demand implies more than a mere desire to purchase a
commodity.
• Demand states that the consumer must be willing and able to
purchase the commodity, which he/she desires.
• These two essential factors are.
 If a consumer is willing to buy but is not able to pay, his/her
desire will not become demand.
 Similarly, if the consumer has the ability to pay but is not
willing to pay, his/her desire will not be called 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.
• Law of demand: This is the principle of demand, which
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.
 2.1.1 Demand Schedule (table), Demand
curve and Demand Function
• The relationship that exists between price and the quantity
demand can be represented by a table (schedule) or a curve
or an equation.
• 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 5 7 9 11 13
demand/week
Table 2.1 Individual household demand for orange per week
• Demand curve is a graphical representation of the
relationship between different quantities of demanded by
an individual at different prices per time period.
• 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
 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.
• The following graph depicts market demand curve at price
equal to 3
• 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
• Qm = (20 – 2P) 100
• = 2000-200P
 2.1.2 Determinants of Demand
• The demand for a product is influenced by many factors.
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 in the market
• Note. When we state the law of demand, we kept all the
factors to remain constant except the price of the good.
• Those factors listed above except price are called demand
shifters. A change in own price is only a movement along the
same demand curve
 Changes in demand
• Changes in demand: a change in any determinant of
demand—except 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.
I. Taste or preference
• When the taste of a consumer changes in favor of a good,
her/his demand will increase and the opposite is true.
II. 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.
• In general, inferior goods are poor quality goods with
relatively lower price and buyers of such goods are expected
to shift to better quality goods as their income increases.
III. 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.
 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.
IV. 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.
V. 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.
 2.1.3 Elasticity of Demand
• Elasticity is a measure of responsiveness of a dependent
variable to changes in an independent variable.
• Accordingly, we have the concepts of elasticity of demand
and elasticity of supply.
 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
 Cross elasticity
 I. Price Elasticity of Demand
• Price elasticity of demand means degree of responsiveness
of demand to change in price.
• It indicates how consumers react to changes in price.
• The greater the reaction the greater will be the elasticity,
and the lesser the reaction, the smaller will be the elasticity.
• Computed as the percentage change in quantity demanded
divided by the percentage change in price.
• Demand for commodities like clothes, fruit etc. changes
when there is even a small change in their price.
• Demand for commodities which are basic necessities of life,
like salt, food grains etc., may not change even if price
changes
• Price elasticity demand can be measured in two ways. These
are point and arc elasticity.
A. Point Price Elasticity of Demand
• This is calculated to find elasticity at a given point. The
price elasticity of demand can be determined by the
following formula.
 B. Arc price 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.
 An arc is a portion of a curve line, hence, a portion or
segment of a demand curve.
• A numerical example to illustrate arc elasticity. 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. In terms of the
above formula, the value of the arc elasticity will be
• 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.
Determinants of price Elasticity of Demand
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 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.
 ii. Income Elasticity of Demand
• It is a measure of responsiveness of demand to change in
income
 iii. Cross price Elasticity of Demand
• Measures how much the demand for a product is affected by
a change in price of another good.
• 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.
• Calculate the cross –price elasticity of demand between the
two goods. What can you say about the two goods?
 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, as price of a product
increase, quantity supplied of the product increases, and as
price decreases, quantity supplied decreases, ceteris paribus.
• 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 of a commodity offered for sale at
different prices.
• A supply curve conveys the same information as a supply
schedule. But it shows the information graphically rather
than in a tabular form.

• Supply function is mathematical representation

• S = f(P), where S is quantity supplied and P is price of the
commodity
• Market supply: It is derived by horizontally
adding the quantity supplied of the product
by all sellers at each price.
 2.2.2 Determinants of Supply
• 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.
 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.
II ) Effect of change in Technology
• Technological advancement enables a firm to produce and
supply more in the market. This shifts the supply 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
 2.2.3 Elasticity of supply
• It is the degree of responsiveness of the supply to change in
price.
• It is the percentage change in quantity supplied divided by
the percentage change in price.
• The point price elasticity of supply can be calculated as the
ratio of proportionate change in quantity supplied of a
commodity to a given proportionate change in its price.
• Like elasticity of demand, 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 or less elastic when a great change in price
induces only a slight change in supply.
 If the supply is perfectly inelastic, it will be represented by a
vertical line shown as below.
 If supply is perfectly elastic it will be represented by a
horizontal straight line as in second diagram.
 2.3 Market Equilibrium
• Market equilibrium occurs when market demand equals
market supply.
 Numerical example:
• Given market demand: Qd= 100-2P, and market supply:
P =( Qs /2) + 10
• a) Calculate the market equilibrium price and quantity
• b) Determine, whether there is surplus or shortage at P= 25
and P= 35.
 Effects of shift in demand and supply on
equilibrium

• Given demand and supply the equilibrium price and

quantity are stable.

• 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
• Factors such as changes in income, tastes, and prices of
related goods will lead to a change in demand. The figure
below shows the effects of a change in demand and the
resultant equilibrium price and quantity.
 ii. When supply changes and demand
remains constant
• Changes in supply are brought by changes in technical
knowledge and factor prices. The following graph explains
the effects of changes in supply.
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.
I. If an increase in demand is more than an increase in
supply, then the price goes up.
II. If an increase in supply is more than an increase in
demand, the price falls.
III.If the increase in demand and supply is same, then the
price remains the same.
 When demand and supply decline, the quantity decreases.
But the change in price will depend upon the relative fall in
demand and supply.
I. When the fall in demand is more than the fall in supply,
the price will decrease.
II. when the fall in supply is more than the fall in demand,
the price will rise.
III. If both demand and supply decline in the same ratio,
there is no change in the equilibrium price, but the
quantity decreases.
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