Theory of Demand

and Supply
2.1 Theory of Demand
Demand :-means the desire of the consumer for a
commodity backed by purchasing power(Ability).

:-implies more than a mere desire to purchase.

Quantity demanded :-is the amount of a good that

buyers are willing and able to purchase at various
prices in a given period of time, other things
remaining unchanged (Ceteris Paribus).

Law of demand: States that , price of a commodity and

its quantity demanded are inversely related.
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2.1.1 Demand Representation by Schedule (table), curve &
function
Demand schedule :-
Constructed by list of known prices and quantities
purchased at those prices.
Demand curve :-is a graph illustrating how much of a
given product a household would be willing to buy at
various prices in a given period, ceteris paribus.

Demand function is a mathematical relationship

between price and quantity demanded, all other
things remaining the same.
Qd  f ( P ) is direct demand function
P  f (Qd ) is inverse demand function

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Example: Let the demand function be Q = a+ bp
b=∆Q/∆P
moving from point A to B Slope(b)=(7-5)/(4-5)=-2
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 DD function.

Individual demand for a good or service can be defined

for an individual household.

Market demand is the sum of all the quantities of a good

or service demanded per period by all the households
buying in the market for that good or service.
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Market demand

Quantity Demanded/week Market

Demand/week
Price Mr.A Mr.B Mr.C

6 2 0.5 1.5 4
5 3 1.5 2.5 7
4 4 2 4 10
3 5 3 5 13
2 6 4.5 5.5 16
1 7 6 7 20

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Market demand graphically:
P P P P

3 3 3 3

5 Q 3 Q 5 Q 13 Q

Mr.A’s Mr.B’s Mr.C’s Market

demand demand demand Demand

Example: Suppose the individual demand function given

by=10 - Q /2 and there are about 100 identical buyers in the
market. Then the market demand function?:
P= 10 - Q /2 ↔ Q= 20 - 2P and Qm = (20 – 2P) 100
Q= 2000-200P 7
2.1.2 Determinants of Demand

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 Determinants of Demand … cont’d
3.Prices of related goods & services:
When a fall in the price of one good reduces the
demand for another good, vice versa, the two goods are
called substitutes; E.G Cocacola AND Pepis
When a fall in the price of one good increases the
demand for another good, vice versa, the two goods are
called complements. E.G Car and gasoline
4. Consumer expectations of future income or price;

5. Number of buyers (population size):- increase in the

number of buyers will increase demand
6.Others (religion, weather, …).

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A change in demand is not the same as a change in
quantity demanded;

•A higher price causes lower quantity demanded

and a move along the demand curve;

•Changes in the determinants of demand, other than

price, cause a change in demand, or a shift of the
entire demand curve.

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Change in price of a good or service
leads to Change in quantity demanded
(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to Change in demand
(Shift of the curve).

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Price of
Bread

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
O
Qty of bread

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2.1.3 Elasticity of demand

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Types 0f elasticity

Four basic types are used:

Price elasticity of demand

Income elasticity of demand

Cross elasticity

Price elasticity of supply

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a) Price Elasticity of Demand (PED)
It is the responsiveness of demand to changes in
price;
Where % change in quantity demand is greater than
% change in price – elastic;(E=2.6%)
Example= jewelry ,clothes,televsion,,,etc

Where % change in quantity demand is less than %

change in price – inelastic (E= 0.2%)

Example=basic necessities of life, like salt, food.

Percentage ge in Qty Demanded
Elasticity 
Percentage ge in Pr ice
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 ( X A  X B )/( X A  X B )
Elasticity 
( P A  P B )/( P A  P B ) 17
Note: we’ll take absolute value.

Economists usually refer to the own price elasticity of

demand by its absolute value (ignore the negative
sign).

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. In terms of the above
formula, the value of the arc elasticity will be?
Solution:-
Ed=110-100 / 4-5 =(10/210) /(-1/9)= -3/7
100+110 4+5 18
2.Point Formula for Own PED
Used to find elasticity at a given point

The exact formula for calculating an elasticity at the

point A on the demand curve:

 %Qd 
Elasticity   
 %P 

=
Note: we’ll take absolute value.
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 Special cases of elasticity
Perfectly Elastic Demand
Demand is perfectly
P
elastic when a 1% Perfectly Elastic
Demand (elasticity = )
change in the price
would result in an
infinite change in
quantity demanded.
Q

Perfectly Inelastic Demand

• Demand is perfectly
inelastic when a 1%
change in the price
would result in no
change in quantity
demanded.
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Determinants of Price Elasticity of Demand:
1.The number & closeness of substitutes;
More number more elastic
2.Generality and specificity of goods:
lower elasticity for general . E.g. detergent Vs dd for soap

3.Time horizon/period:
the longer the time the more elastic a good is likely to be.

4.The nature of the need (Luxury Vs Necessity

good): example: addictive drugs, salt, ... .; &
5.The proportion of income spent on the particular
commodity: -
Smaller income proportion, then the more inelastic & vice
versa.
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b) Cross-Price Elasticity of Demand (CPED)
Is responsiveness of demand of one good to changes
in the price of a related good – either a substitute or a
complement,
 %Q x  • Goods which are:
E X,Y   complements: – Cross Elasticity
 %P  will have negative sign (inverse
 y 
relationship b/n the two).
 ΔQ x   Py 
E X, Y    • Goods which are substitutes:
 ΔP Q  – Cross Elasticity will have a
 y  x 
positive sign (positive
relationship b/n the two).
• For unrelated goods: – Cross
Elasticity is zero
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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
Therefore, the two goods are complements

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c) Income Elasticity of Demand (YED)
Is the responsiveness of demand to changes in incomes

 %Qd   ΔQ d  Y
Ey      ( )
 Q
 %Y   ΔY  d
Point income elasticity of demand:

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II. THEORY OF SUPPLY
Supply indicates the various quantities of a
product that sellers (producers) are willing and
able to provide at each of a series of possible
prices in a given period of time, other things
remain unchanged;
The law of supply there is a positive relationship
between price and quantity supplied.
At ceteris paribus, as P↑ quantity supplied will ↑.
A supply schedule is a table showing how much of
a given product a firm would be willing to sell at
different prices in a given period of time.
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Supply… cont’d

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 Mr.X’s supply schedule and supply curve

Price of Quantity of
Bread Bread supplied Price of
Bread Supply curve
$3.00
$0.00 0 cones
0.50 0 2.50 1. An increase
in price
1.00 1 2.00
1.50 2
2.00 3 1.50
2. increases quantity
2.50 4 1.00 of bread supplied.
3.00 5
0.50

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Bread

Hypothetical SS schedule: Quantity of SS increase as Price rises

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Individual Vs Market supply
Quantity supplied/week Market
supply/week
Price Seller A Seller B Seller C

6 9 7 8 24
5 7.5 6 6 19.5
4 6 5 5 16
3 4.5 4 4.5 13
2 3 3 3 9
1 1.5 2 2.5 6

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Market supply graphically:

P P P
P

3 3 3 3

Q
4.5 Q 4 Q 4.5 Q 13
Seller A Seller B Market
Seller C
supply

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Determinants of Supply
The supply of a product is determined by:

Price of the product;

Input prices(cost of inputs); (Inverse)

Technology;(Direct)

Taxes and subsidies; and

Weather (Good weather more supply)

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Shift of supply Vs movement along a supply curve
Change in price of a good or
service leads to Change
in quantity supplied
(Movement along the
curve).

Change in costs, input

prices, technology,
leads to change in
supply
(Shift of curve).

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d) Price Elasticity of Supply(PES)
It is the responsiveness of supply to changes in
price
If PES is inelastic - it will be difficult for suppliers
to react quickly to Δges in price
If PES is elastic – supply can react quickly to Δges
in price
%  in Quantity Supplied
PES 
%  in Pr ice
If PES > 1, Supply is elastic;
If PES = 1, Supply is unit elastic;
If PES < 1, Supply is inelastic.
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Examples: of Own Price Supply Elasticities
When the price of Davinci paintings increases
by 1% the quantity supplied doesn’t change
at all, so the quantity supplied of Davinci
paintings is completely insensitive to the
price.
Price elasticity of supply is 0.

When the price of beef increases by 1% the

quantity supplied increases by 5%, so beef
supply is very price sensitive.
Price elasticity of supply is 5.
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Perfectly Elastic Supply

Price
Perfectly Elastic Supply
(elasticity = )

Quantity

Perfectly Inelastic Supply

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III. MARKET EQUILIBRIUM
An equilibrium is the condition that exists when
quantity supplied and quantity demanded are
equal;

The operation of the market depends on the

interaction between buyers and sellers;

At equilibrium, there is no tendency for the market

price to change.
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Mkt Equilibrium … cont’d

Demand Schedule Supply Schedule

At $2.00, the quantity demanded is equal

to the quantity supplied!
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 Mkt Equilibrium … cont’d

Price of
Ice-Cream
Cones Supply
$3.00

2.50 Equilibrium
price Equilibrium
2.00

1.50
1.00
Equilibrium Demand
0.50 quantity

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

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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
Solution
A)At equilibrium Qd=Qs
100-2p=2p-20= 4p=120= P=30 and Q=40
B) At P=25
Qs=30 Qd=50
shortage of 20 units

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 Markets Not in Equilibrium
1. Excess Supply (Surplus)
Excess supply, or surplus, is the condition
that exists when quantity supplied exceeds
quantity demanded at the current price.
When price exceeds equilibrium price,
then Qss>Qd
There is excess supply or a surplus;
Suppliers will lower the price to increase sales,
there by moving toward equilibrium;

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Price of
(a) Excess Supply
Ice-Cream
cone Supply
Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of Ice-Cream
Quantity Quantity cones
demanded supplied
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 2.Excess Demand
Shortage
When price is less than equilibrium price,
then Qdd>Qss
There is excess demand or a shortage;
 Suppliers will raise the price due to too many
buyers chasing too few goods, thereby moving
toward equilibrium;
Excess demand, or shortage, is the condition
that exists when quantity demanded exceeds
quantity supplied at the current price.
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 (b) Excess Demand
Price of
Ice-Cream
Supply
cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of Ice-Cream
Quantity Quantity cones
supplied demanded
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 Price of
Ice-Cream 1. Hot weather increases the
Cone demand for ice cream . . .

Supply

$2.50 New equilibrium

2.00
2. . . .
Resulting in a Initial
higher equilibrium
price . . . D

0 7 10 Quantity of
Ice-Cream Cones
3 . . . and a higher
quantity sold 44
 Price of
Ice-Cream 1. An increase in the price of
Cone sugar reduces the supply of
ice-cream. . .
S2
S1

$2.50 New equilibrium

2.00 Initial equilibrium

2. . . . resulting
in a higher
price of ice
cream . . . Demand

0 4 7 Quantity of
3. . . . and a lower Ice-Cream Cones
quantity sold. 45
When both Supply and Demand Shift

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