CHAPTER TWO

2.THEORY OF DEMAND AND SUPPLY

2.1 Theory of Demand

What do you mean by demand?

Demand refers to the quantities consumers are willing and able to buy at
various prices.

 the desire and ability to consume certain quantities at certain prices.

the various quantities of a good or service that people will be and able to

purchase at various prices during a period of time.

Demand implies both the desire to purchase and ability to pay for the good.
Demand Function

Demand for a commodity is determined by several factors.

the price of the commodity,
income,
prices of related commodities,
tastes and preferences,
advertisement, and expectations etc.

Thus, individual‘s demand for a commodity can be

expressed in the following general functional form,
Qx d = f (Px, I, Pr , T, A, E) where,

Qx d = Quantity demanded of commodity ‘‘x”;

Px = Price of commodity x;
I = Income of the individual consumer;
Pr = Price of related commodities;
T = Tastes and preferences of individual consumer;
A = Advertisement expenditure;
E = Expectations
 Thus, we can write the demand function as:
Qx d = f (Px)
Law of Demand

expresses the functional relationship between price and quantity

demanded.

According to the law of demand, other things being equal, if the price of
the commodity falls the quantity demanded of it will rise and if the price
of the commodity rises, its quantity demanded will decline.

Thus, there is an inverse relationship between price and quantity

demanded, other things remaining the same.

The other things which are assumed to be constant are tastes and
preferences of the consumer, the income of the consumer, prices of
related commodities etc.
The law of demand can be illustrated through a
demand schedule and through demand curve.

Demand schedule shows various quantities of good or

service that people will buy at various possible prices
during some specified period, while holding constant all
other relevant economic variables on which demand
depends.

A demand schedule is presented below.

Price Quantity Demanded
10 20
8 40
6 60
4 80
2 100
We can convert the demand schedule into demand curve by
graphically plotting the various price quantity combinations, as shown
below.
Thus, the demand curve is a graph showing the various
quantities of a good or service that the people will be
willing and able to buy at various possible prices.

Demand curve slopes downwards from left to the right.

The downward sloping demand curve is in accordance
with the law of demand, which describes inverse price-
quantity demanded relationship.

The various points on the demand curve represents

alternative price -quantity combinations.
The Market Demand
To explain the market behaviour, we need to know the
total demand of all individuals.
gives the alternative amounts of the commodity
demanded at various prices by all individuals in the
market during a period of time.
To obtain the market demand, we sum the quantities
demanded by each individual at a particular price to
obtain the total quantity demanded at that price.
The market demand for a commodity depends on the
all the factors that determine the individual‘s demand.
In addition, it also depends on the number of buyers of
the commodity in the market.
Individual Individual Market
A B Demand

Price Quantity Price Quantity Price Quantity

Demanded Demande Demanded
d
8 2 8 2 8 4
6 4 6 4 6 8
4 8 4 6 4 14
At price Rs 8, individual A will buy 2 units and individual B will
also buy 2 units. The total quantity demanded at Rs 8 is therefore 4
units.

This is shown in the market demand schedule.

Similarly, the total quantity demanded in the market at Rs 6 is 8
units and 14 units are demanded at Rs 4 in the market.

It can be seen that the market demand schedule is the sum of the
demands of the individual consumers in the market.

A graph of this market demand schedule is called the market

demand curve. The market demand curve is shown below
Reasons for law of Demand
Let us analyse the reasons for the inverse relationship between price and
quantity demanded. This is due to both income effect and substitution effect.

 When the price of the commodity falls, the consumer can buy
more quantity of the commodity with his given income.

The increase in real income induces the consumer to buy more of

the commodity. This is called the income effect of the change in
price of the commodity.

This is the reason why a consumer buys more of a commodity

whose price falls.

Similarly, an increase in the price of the commodity results in the

reduction of real income of the consumer. Hence, the consumer buys
less of a commodity whose price rises.
Again, when price of the commodity falls, it becomes relatively
cheaper than other commodities.

This induces the consumer to substitute the commodity whose price

has fallen for other commodities which have now become relatively
dearer.

This change in quantity demanded resulting from substituting one

commodity for another is referred to as substitution effect of the price
change.

As a result of this substitution effect, the quantity demanded of the

commodity whose price has fallen rises.

Apart from the income effect and substitution effect, there is an

additional reason why the market demand curve for a commodity
slopes downwards.
Determinants of Demand
(1) Income: The demand depends up on income of the people.
The greater the income of the people, the greater will be their demand
for goods and services.
If their income increases, people will tend to buy more goods and
services than they did before the increase in income.
(2) Prices of related goods: Goods and services may be related to each
other in two ways; they may be substitutes or they may be complements.
Example: tea and coffee, beef and chicken. Two goods are said to be
complementary if they are used together.
(3) Taste and Preferences: The quantity of a commodity that people will
buy will be affected by the taste and preferences.
(4) Expectations: The expectations of the consumers regarding the price in
the future will affect present purchases of goods and services.
(5) Number of buyers in the market: The quantity of the commodity that
people will buy depends on the number buyers in the market for that
particular commodity. The greater the number of buyers of a good, the
greater the market demand for it.
 2.2 Nature of Supply
supply refers to what firms actually are willing and able to
produce and offer for sell at alternative prices.
Supply refers to the various quantities of a good or service that
sellers will be able to offer for sale at various prices during a
period of time.
It shows how price of a good or service is related to the quantity
which the sellers are willing and able to make available in the
market.
Supply Function Like demand, supply also depends on many
things.
In general, quantity supplied of a product is expected to depend
on own price, prices of related products, prices of inputs, state of
technology, expectations, number of producers (sellers) in the
market etc.
QX S = f (Px, Pr , Pi , T, E, N)
Where., QX S = Quantity supplied of commodity x
 Px = Price of the commodity x
Pr = Prices of related products
Pi = Prices of inputs
T = State of technology
E = Expectations
N = Number of producers in the market
Thus we can write the supply function as
QX S = f (Px)
That is, quantity supplied of commodity x is a function of its own
price, other determinants are assumed to remain constant.
Law of Supply
The functional relationship between price and quantity supplied is
called the law of supply.
According to the law of supply, as the price of the commodity falls, the
quantity supplied decreases or alternatively, as the price of the
commodity rises the quantity supplied increases, other things being
equal.
Therefore, there is a direct relationship between of the commodity and
quantity supplied.
The law of supply can be illustrated through a supply schedule and
supply curve.
Supply schedule is a table that shows various quantities of a good or
service that sellers are willing and able to offer for sale at various
possible prices during some specified period. A supply schedule is
presented below
Price Quantity Supplied
5 40
10 60
15 80
20 100
25 120
* Supply schedule shows that as price rises, a greater quantity is offered
for sale. By plotting the information contained in the supply schedule
on a graph we can derive the supply curve as shown below.
Why there is a direct relationship between price and quantity
supplied?

The main reason is that higher prices serve as an incentive for sellers to
offer greater quantity for sale.

The sellers or producers can be induced to produce and offer a greater

quantity for sale by higher prices.

It is assumed that sellers or producers aim to maximise profit from the
production and sale of the commodity.

The higher the prices of the commodity, other things being equal, the
greater the potential gain producers can expect from producing and
supplying it in the market.

Moreover, increases in price may invite new suppliers in the market.

Determinants of Supply
(1) Prices of related products Goods can be substitutes or complements
in production. Goods are substitutes in production if they are
produced as alternatives to each other. Example: rice and vegetables
(as farmer can produce one or the other on the same piece of land).
(2) Pricesof inputs An increase in the production cost will results in a
reduction in the supply of the product.
(3) Technology Overtime, knowledge and production technologies change
and it will affect the supply of the product. A technological change that
decreases cost will increase profits earned at any given price.
(4) Expectations If producers expect prices to rise in the future, now they
might begin to expand their productive capacity and thus increase their
present output levels.
(5) Number of Producers : Obviously, the number of sellers in the
market will have some effect on the total market supply.
 Market Equilibrium

 The operation of the market depends on the interaction

between buyers and sellers.

 An equilibrium is the condition that exists when quantity

supplied and quantity demanded are equal.

 At equilibrium, there is no tendency for the market price

to change.
 The operation of the market depends on the interaction between
buyers and sellers.
 An equilibrium is the condition that exists when quantity
supplied and quantity demanded are equal.
 At equilibrium, there is no tendency for the market price to
change.
 Only in equilibrium is quantity supplied equal to quantity
demanded.
 At any price level other than P0, the wishes of buyers and sellers
do not coincide.
 Market Disequilibria
 Excess demand, or shortage, is the condition that exists when
quantity demanded exceeds quantity supplied at the current price.
 When quantity demanded exceeds quantity supplied, price tends to
rise until equilibrium is restored.
 Excess supply, or surplus, is the condition that exists when quantity
supplied exceeds quantity demanded at the current price.
 When quantity supplied exceeds quantity demanded, price tends to
fall until equilibrium is restored.
 Increases in Demand and Supply

• Higher demand leads to higher • Higher supply leads to lower

equilibrium price and higher equilibrium price and higher
equilibrium quantity. equilibrium quantity.
 Decreases in Demand and Supply

• Lower demand leads to lower • Lower supply leads to

price and lower quantity higher price and lower
exchanged. quantity exchanged.
 Elasticity of Demand

The law of demand tells us that consumers will respond to

a decline in a products price by buying more of that product.

But how much more of it will they purchase?

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.
It is the responsiveness of consumer’s Qd of a given
product to change in factors affecting demand. e.g own
price, income of consumer, price of other goods …
Commonly, there are three kinds of demand elasticity:
price elasticity, income elasticity, and cross elasticity.
I. Price Elasticity of Demand: -it is a measure of
responsiveness, or sensitivity, of consumers to a
change in the price of a product, other factors being
the same.
We measure the degree of price elasticity or inelasticity
of demand with the coefficient Ed, defined as
  % Change in Quantity Demand
Ed = % Change in Price
We know from the downward sloping demand curve that
price and quantity demanded are inversely related. Thus, the
price elasticity coefficient of demand, Ed, will always be a
negative number.

Therefore, we usually ignore the minus sign and simply

present the absolute value of the elasticity coefficient to
avoid an ambiguity which might arise.

It can be confusing to say that an Ed of -4 is greater than

one of -3. This possible confusion is avoided when we say an
Ed of 4 reveals greater elasticity than one of 3.
For some products consumers are highly responsive to price
changes; modest price changes lead to very large changes in
the quantity purchased.

For other products, consumers are quite unresponsive to

price changes; substantial price changes result only in small
changes in the amount purchased.

In extreme cases, demand for a few products is totally

unresponsive while for others it is perfectly responsive.

How can we interpret the price elasticity of demand for

products?
 A.Elastic Demand
 demand is said to be elastic if a specific percentage change in
price results in a larger percentage change in quantity
demanded.

 Then Ed will be greater than 1(|Ed|>1).

 Example: if a 3% decline in price results in a 9% increase in
quantity demanded, then demand is elastic and Ed= 0.09/ 0.03 =
3> 1.

 The demand curve in this case is drawn flatter.

 Most luxury goods & comforts have elastic demand.
 B. Inelastic Demand:
 if a given percentage change in price is accompanied by
a relatively smaller change in the quantity of the good
or service, then demand is said to be inelastic.
 E.G if a 10% increase in the price of a product is
accompanied by only a 2% decrease in the quantity
demanded of that product Ed = 0.02/0.1 = 0.2< 1.
 The demand curve in this case is drawn steeper.
 Most of the essential goods or necessities have inelastic
demand. 0< Ed < 1
 C.Unitary Elastic:
 the case separating elastic & inelastic demands
occurs where a percentage change in price & the
accompanying percentage change in quantity
demand are equal.
For example, if , a 6% change in price results in
6% change in quantity demanded, then
 in this case the demand curve is a rectangular
hyperbola.
 D. Perfectly Inelastic:
 this is a situation in w/c the quantity demanded of a
certain product is invariable relative to the change in
the price.
 The coefficient of elasticity, Ed =0.
 This shows that a change in the price of a good or
service does not bring in any change in, what so ever is,
the quantity demanded ( i.e.
 Examples are medicine like demand for insulin,
addicted person’s dd for heroin.
 The demand curve for perfectly inelastic demand is a
vertical line parallel to the price axis.
 E. Perfectly Elastic:
this indicates that one percentage change in price results in
infinite change in quantity demanded.
In this regard, the consumer can buy all possible quantities at the
given price and nothing else at some other prices.
The demand curve for a perfectly elastic demand is a horizontal
line drawn parallel to the quantity axis.
Elasticity Description Implication Demand curve
Ed > 1 Elastic % Flatter
Ed = 1 Unitary elastic % Rectangular Hyperbola

0 <Ed < 1 Inelastic % Steeper

Ed = 0 Perfectly % Vertical
inelastic
Ed =∞ Perfectly elastic % ∞ horizontal
From our definition of elasticity,

We have to distinguish b/n point & arc elasticity's.

Point elasticity:- measures elasticity at a specific point on a
demand curve ,.i.e. consumer responsiveness to price changes.

Arc elasticity refers to price elasticity over a distance on the

demand curve.

In other words, it measures the average responsiveness of

consumer demand to changes in price over a range of extended
prices.
 Determinants of Price Elasticity
The major determinants of price elasticity of demand are:
I. Availability of close substitutes:
 a substitute for a product is one that serves the same
general purpose. E.g. Coca for Pepsi, tea for coffer…
Therefore, the demand for a good that has many close
substitutes is more elastic & the good that has few or no
close substitute is inelastic.
II. The proportion of income consumers spends on the commodity:
The demand for a product on w/c a consumer spends large
percentages of his/her income is likely to be quite elastic.
Other things being equal, the smaller the percentage of
income spent on a product, the less elastic the demand
unless the good is considered as a disposable luxury.
III.The nature of a commodity:
 the items that a consumer can use may be either
necessary or luxury.

 In general, the demand for necessities is inelastic.

 This means that what ever be the changes in prices of
such goods & services, certain quantities will still be
purchased by consumers.
However, if the item is a luxury good, the consumer
may postpone his/her consumption, buy more when its
price decreases or buy less when its price rises.

Hence, demand is elastic for luxury goods.

But, demand is inelastic in the case of addictive goods
or alcoholic drinks.

E.g, if an individual is addicted to cigarettes or

alcoholic drinks, he/she finds it difficult to forgo though
price increases and demand is highly inelastic.
 IV. Price level:
 Assuming that the demand curve for a product is
linear, demand tends to be more elastic at higher
price than at lower prices.

This means moving along a liner demand curve,

elasticity is not the same at every point.

Even though a linear demand curve has constant

slope, its elasticity varies from point to point.
As shown in the above figure, along the down-ward sloping demand
curve, demand is elastic at higher prices, unitary elastic at the mid-
point but becomes less elastic as price declines towards the lower end.

At relatively low prices demand becomes inelastic & approaches zero
as price get lower and lower.

If we want to measure price elasticity at point A, then we have to take

the ratio AC/AB At the upper half of the demand curve Ed will be
greater than unity (Ed> 1) .

The mid-point is unitary elastic. The elasticity coefficient will be less

than unity at the lower end of the demand curve in absolute terms.
 V. Adjustment time:

 In general, demand tends to be more elastic with longest

time b/c the consumer can find more substitutes for the
product in the long run.

 Over longer periods, we also have more time to adjust

our consumption pattern in response to price changes
which also contributes to a more elastic demand.

 Thus, in the short-run demand is inelastic while in the

long-run it is elastic/relatively elastic.
 B. Income Elasticity of Demand
Income Elasticity of Demand: measures the
responsiveness of demand of a particular commodity to
changes in income of the consumer.
It the ratio of the % change in the number of units of a
good consumers demand(change in demand) to the %
change in income, other things being equal.
This coefficient may be positive or negative.
Goods that have positive income elasticity of demand
are called normal goods.

The quantity demand for this goods is positively related

with income.

Where as a negative income elasticity of demand

implies an inverse r/nship b/n income & the quantity of a
good demanded.

Such types of commodities are called inferior goods.

Normal goods may be either necessary or luxury items.
We say a good is necessity good when 0< Em< 1.
But if the income elasticity coefficient is greater than
unity, the commodity is luxury.

Em < 0 Em>0

  Normal
Inferior
0< Em < 1 Em > 1

Necessity Luxury
 C.Cross Elasticity of Demand():-
 it measures the sensitivity of purchase of one goods say
(X) to changes in the price of another good (Y).
 It is the % change in the quantity demanded of
commodity X to the % change in the price of Y.
 This coefficient tells us whether the two goods (X and Y)
are substitutes, complements or independent (unrelated)
 i. Substitute goods:
 If cross elasticity of demand is positive that is, the
quantity demanded of X moves in the same direction as
a change in the price of Y- then X and Y are substitute
goods.
E.g. Kodak film (X) and fuji film (Y).
 An increase in the price of Fuji film causes consumers
to buy more Kodak film.
 In general, the larger the positive cross elasticity
coefficient, the greater the substitutability b/n the two
products, ceteris paribus.
 Could you give other examples of substitute goods?
 ii. Complementary goods:

 When cross elasticity is negative, we know that X and Y

“go together” an increase in the price of one decrease
the demand for the other.

E.g. an increase in the price of sugar will decrease the

amount of tea purchased.

The larger the negative cross elasticity coefficient, the

greater the complementarity b/n the two goods.
 iii. Independent goods:
 A zero or near-zero cross elasticity suggests that the two products are
unrelated or independent goods.
 E.g. the demand for teff and price of Aero plane are unrelated; that is,
we would not expect a change in the price of Aero plane to have any
effect on purchases of teff.

Exy > 0 Exy <0 Exy =0

substitutes Complements Independent

 Elasticity of Supply
Price Elasticity of Supply: - it measures the degree of responsiveness of
suppliers to changes in the price of their product.
It is a coefficient used to measure the sensitivity of
percentage changes
in quantity supplied to a given percentage change in the price of a good,
ceteris paribus.

That is, if Es>1, supply is elastic; if Es < 1, then supply is inelastic; & if
Es = 1, then supply is unitary elastic.
In extreme cases, if Es= 0, supply is perfectly inelastic; & if Es = ∞,
Then supply is perfectly elastic.
Due to the law of supply, price elasticity of supply is never negative.
 * Determinants of the price elasticity of supply

What are the determinants of the price elasticity of supply?

I. Length of production period:
 The main determinant of price elasticity of supply is the
amount of time available to producers for responding to
changes in product price.
Generally, supply is relatively elastic to price changes in
the long-run and relatively inelastic in the short-run.
The reason why supply is elastic in a longer period is
that suppliers might produce good substitutes.
In other words, time for adjustment is important because
most production activities can not be changed in scale
overnight.
 II. Factor substitution:
 If there are greater substitutes of factors of
production, supply is more elastic.
Whenever there is a slight change in the price of
a factor input, it can be substituted for others
making supply quite elastic.
With no substitutes, supply becomes inelastic.
III.  Number of sellers:
 The market supply will be more elastic when
there are large number of firms serving the
market; with less number of firm/sellers supply
becomes inelastic.
THE END