THE ELEMENTARY PRICE THEORY: DEMAND AND SUPPLY

LECTURE TWO

LECTURE OBJECTIVES

By the end of the lecture, the learner should be able to:

 Define demand and supply.

 Determine the factors affecting demand and supply.

 Define the laws of demand and supply

 Distinguish the concept of movement along and shift of the demand and
supply curves.

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 DEMAND

Demand is defined as, the amount of a commodity people are willing and able to buy at all
possible prices and in a given time.

There is a difference between demand and wants, in that demand are human desires that are
fully backed by the ability to pay. On the other hand, wants are human needs that are not
backed by ability to pay.

FACTORS THAT INFLUENCE QUALTITY DEMANDED

 Price of the commodity itself

 Price of other commodities which are related to the good in question (be they substitute
or complementary) (Py)
 Consumer income (y)
 Consumer taste and preference for the good (T)
 Advertisement
 Consumer expectation about future prices (E)
 Size of population and its composition (N)
 Credit availability (C )
 Other factors (Z)

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 Using a functional notation we come up with the following demand function

D x  f px , py , y,T, A, E, N,C, Z  .......................... 1


This simply states that the individual demand for good X is a function of all the factors listed
in the brackets.

i) The price of the commodity itself

In order to analyze the effects of price on quantity demanded of the commodity, we
hold all other factors fixed. the relationship between price and demand can be
explained by the help of the law of demand. According to Alfred Marshall this law is
defined as, “other things being equal, with a fall in price, the demand for the
commodity is extended (increases), and with a rise in the price, the demand is
contracted (decreased)”

This law can be explained with the help of a demand schedule and diagram.

Demand Schedule: is a tabular representation of the quantity demand of a good at

given price level and at a given point in time.

Demand diagrams on the other hand is a graphical representation of the content of

the demand schedule.

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 Demand schedule

Price in Kshs Quantity demanded

25 1
20 2
15 3
10 5
5 7

From this demand schedule, a demand curve can be plotted as shown below.

Price

25
*
20
* Demand curve
15
*
10
*
5
*
01234 56 7Quantity
Demanded

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 In the above diagram it is seen that the demand curve slopes downwards from left to
right showing that at higher prices less is demanded and at low prices more is
demanded. We can thus say that for normal demand curve, less is demanded at
higher prices and more is demanded at low prices.

REASONS FOR THE DOWNWARD SLOPING DEMAND CURVE.

i) Lowering prices brings in new buyers who were not able to buy at the previous price.
ii) Reduction of price may coax out some extra purchases by each of the initial
consumers of the goods, while a rise in price may lead to less purchases. Naturally,
consumers will try to substitute the commodity with another cheaper one.
Note also that a fall in price implies a rise in real income, hence the ability to
purchase more of the same good.

iii) Whenever a commodity becomes expensive its consumption normally will be left for
only very important uses. For instance a consumer may opt to use electricity lighting
only, and not for cooking if its prices sky rocket. The vice versa is also true.
EXCEPTION TO THE LAW OF DEMAND

There exists cause where demand may slope upwards instead of downwards from left to
right.

(i) In the case of Giffen goods:- Giffen goods (named after the economist Sir Robert
Giffen) are very inferior goods for which demand increase as price rises and decrease
as price falls. This applies to poor communities.. e.g. In Asia people’s stable food is
rice. If price of rice was to fall, consumers may reduce their demand for rice or
consume the same amount of rice and use their extra money saved as a result of fall in
price to purchase some more nutritional food. If price increase of rice, then they
would only consume the rice.
Q
0 19
p
(ii) Veblen good (goods of ostentation)
Goods associated with the rich, luxury goods such as jewellery, luxurious vehicles etc.
the value of such goods (quality) is measured by how much expensive it is. For such
goods, the higher the price, the higher will be the demand.

Q
0
p

(iii) Fear of future rise in price

fear of future rise in price makes consumers buy more quantities of different goods
even at higher prices than before because they know that if they dent buy more now,
they will have to pay much higher prices in future.

The existence of such goods and factors explain why under exceptional case the
demand curve may be positively sloped as below.
1.1 SUBTOPIC 1

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The existence of such goods and factors explain why under exceptional case the demand
curve may be positively sloped as below.

Price of
commodity

D Demand Curve for

0 Quantity

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CONCEPT OF MOVEMENT ALONG DEMAND CURVE AND SHIFT OF DEMAND
CURVE.

A movement along a given demand curve is coursed by change in the price of the
commodity. An upwards movement is caused by an increase in prices while a downwards
movement is caused by a fall in prices. This can be shown as below.

Price of

p2 a

p1 b
D

0 Q1 Q2 Quantity
A movement from b to a is caused by a (rise) change in price prom p1 to p2 and a
movement form a to b is caused by a fall in prices from p2 to p1 .

Note: as price falls from p2 to p1 , quantity demanded rises from Q1 to Q2 .

A shift of the demand curve is caused by change in other factors influencing demand
other than price of the commodity. The impact of these other factors shall be observed
later.
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 A shift of the demand curve can either be to the right or left depending on the direction on
which a change has taken place. A shift to the right shows an increase in demand while a
shift to the left shows a decline in demand.

Price of

Increase
Decrease
D1
D
D2

0 Quantity

In the diagram above D

represents an increase in demand while D2 D2 represents a
1
decline in demand.
D
1

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 OTHER FACTORS THAT INFLUENCE DEMAND

2) price of other commodities which are related to the good in question:

There are three possible relations between the demand of one commodity and the price of
other commodity.

A fall in price of one commodity may lower the quantity demanded of good x, the two
commodities x and y, are said to be substitutes.

When prices of one commodity fall, the household buys more of it and less of
commodities that are substitutes for it.

Example:

a. Butter and Margarine

b. Sukuma wiki and Cabbage
c. Beef and Fish
If a fall in price of one commodity raises the quantity demanded of another commodity the
two are said to be complements.

When the price of one commodity falls, more of it is consumed and more of those
commodities that are complementary to it are consumed also. Example, motor cars and
petrol, butter and bread etc.

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 Price of Price of

p0 p0

p1 p1

Q1 Q0 Quantity Q0 Q1 Quantity

i ii

Graph 1: curve sloped upwards indicating that as price of a substitute falls, the quantity
demanded of good x falls. So good y, and x, are substitutes.

Graph 2: curve slopes downwards, indicating that when the price of a complement falls there
is a rise in the quantity of good x demanded.

3) Consumer income
We would expect a rise in income to be associated with a rise in the quantity of a good
demanded. Goods obeying this rule are called normal goods. In some cases a change in
income might leave the quantity demanded completely unaffected. This will be the case
with goods for which desire is completely satisfied after a level of income is obtained.

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Example: if one used to eat salt, the consumption of it will not change even though his
income rises, unless his income is very low.

Incase of other commodities, rise of income beyond a certain level may lead to a fall in
the quantity that the household demand. If the demand for a commodity falls as income
rises, the good is called inferior good.

The relation between income and quantity demanded can be shown by the use of Engels
curve
Income Y

0 Quantity

The curve shows the relationship between income and demand, holding other factors
constant. Engel curve for normal good slopes upwards, implying that as income rises,
quantity demanded will also increase. Incase of inferior good, if Y increases Q decreases.
In this case the Engels curve will slope downwards from left to right.

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 DISTINCTION BETWEEN GIFFEN GOOD AND INFERIOR GOOD

Giffen good; relates to behavior of quantity demanded in relation to price.

Inferior good: relates to behavior of quantity demanded in relation to income.

4) Consumers tastes and preferences

When the tastes for a commodity are favorable, consumers will prefer more of that
commodity to other commodities thereby increasing the demand for the commodity.

For example, in the beauty, would the taste of women have moved towards colored hair
products such as pony tail or dyeing of hair. So the demand of such products would hike.

5) Advertisement:
As a producer advertises his product, he creates awareness that his products exist, and he
tries to show the superiority of his product over others in the market. If we hold other
factors constant, we expect that an increase in advertisement expenditure will lead to an
increase in demand.

Advertising is

 Informative
 Persuasive on price, availability, performance.

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6) Consumers expectations about future prices:
If consumers expect the price of a commodity to rise in future, they will buy more of the
commodity now and store it. In this case quantity demanded increases. However, should
they expect a fall in price in future they will buy less on the commodity now hoping to
buy more in future after the price has fallen. In this case quantity demanded becomes
less.

7) The size of population and its composition.

The greater the size of population to satisfy, the greater the quantity consumers will be
willing to demand. The fewer the consumer in the market, the less the quantity demanded
will be.

When we talk of composition of population we are talking of the sex proportion and age
group. Certain commodities are manufactured for certain age group and sex. For instance,
cosmetics are meant to be used by women, napkins by infants, shaving cream by men. So
producers consider these factors before deciding how much to produce. Who shall be his
target market?

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 SUPPLY

 Supply as a commodity is defined as the quantity of that commodity sellers are willing to
put in the market at a given price and at a given time.
 Supply should be distinguished from stock, whereas stock is the total quantity of a
commodity which is available at any specific time, supply is that part of stock which is
offered fro sale at any price.
 For example, the supply of oil is not the estimated resources of all the world’s oil fields,
but only that amount which particular price will bring into the market.
 Supply will always change with price changes. This relationship between supply and
price is called the law of supply.
 The Law states that other things remaining constant, when price rises, supply
increases and when price falls, supply decreases.

Supply schedule.

Is defined as table showing quantities sellers are willing to put in the market at all possible
prices. This is shown below.

Price per unit Quantity

1 2
2 4
3 6
4 8
5 10

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From a supply schedule a supply curve can be drawn as shown below.

Price (Kshs)
6

5 *

4 *

3 *

2 *
1 *

0 2 4 6 8 10 Quantity

In the above diagram, it can be seen that the supply curve slopes upwards from left to right
showing that sellers are willing to supply more at higher prices and to supply less at lower
prices. It follows therefore that the supply curve for a normal good slopes upwards from left
to right.

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 Factors that influence supply

1. The price of the commodity

2. Objectives of the firm
3. The technology used
4. The cost of production incurred by producers
5. Taxation policies of the government
6. Weather condition
7. Subsidies
8. Price of competing products
9. Peace and stability
10. Infrastructure

Qs  f  p0 , p1 , tech, O,T ,W , S 




1. The price of commodity
At higher prices products are motivated to produce more thereby increasing the supply of
the commodity under consideration. At lower prices less is supplied because producers
see no reason why they should produce more because profitability will be negatively
affected.

2. Objective of the firm

A firm can have various objectives. For example profit maximization; to maximize profit
will require that more be supplied at higher price. However, some welfare organization
doesn’t follow this law. For example, the supply of drugs; supply of drugs may rise
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3. Technology used
If better methods of production are used, we again expect output to be economically
produced and so the supply of the commodity in question will increase. More can be
supplied at some price because per unit cost of production would be lower than in the
case where worse methods of production are used.

4. Cost of production
Increase in the cost of production will lower quantity supplied because producers will
find it very expensive to increase output. However, with low cost of production more is
likely to be supplied since the producer will find easy and cheaper ways of producing
more of the commodity in question.

5. Taxation policies of the government

The taxation policies of the government also influence quantity supplied because if the
government raises taxes, the cost of production goes up thereby reducing quantity
supplied. Taxes make commodities be more expensive than competing products e.g. East
African breweries has been urging the government to lower taxes on its products so that
they could compete well against the south African Breweries products.

6. Subsidies
When the government subsidizes the production of a given good, the supply of that good
also increases because the cost of production is reduced by the subsidies given.
Government may decide to incur part of the overall cost of production as a way of
motivating production of certain goods which otherwise would have been very expensive
to produce. Why South Africa goods compete effectively against other counties’ goods is
because of support in the form of subsidies the producers receive from South Africa
government.
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7. Weather condition
This commonly affect agricultural produce. When weather condition are good, more is
produced and hence supplied and vice versa.

8. Price of competing products

 For example Kenyan beer Vs South African beer or Aerial soap Vs Omo
 Manufacturers of thee products from Kenya have been complaining of unfair
competition that has been posed by such imported products. Such imported
products have led to the collapse of many local industries. For example,
Mitumba (second hand cloths) whose prices are much lower than locally
produced cloths have led to many textile industries closing down.
 Recall also the closure of Bata Shoes Company of Limuru because of competition
from cheap imported shoes and Jua kali made shoes.
 This is a clear example of how prices of competing products would affect supply.

9. Peace And Security

10. Development of infrastructure particularly transport and communication.

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MOVEMENT ALONG A GIVEN SUPPLY CURVE AND SHIFT OF A SUPPLY CURVE.

A movement along a given supply curve is caused by changes in the prices of the
commodity. An upward movement is caused by an increase in price while a downward
movement is caused by a fall in prices.

Price

p2 d

p1 c

0 Q1 Q2 Quantity
 A movement from C to D is caused by a rise in price from p1 to p2 and a movement
from D to C is caused by a fall in price from p2 to p1 .
 A shift of the supply curve is caused by change in other factors influencing supply other
than price of the commodity. A shift of the supply curve can either be to the right or left
depending on the direction on which a change has taken place. A shift to the right shows
an increase in supply while a shift to the left shows a decline in supply

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 Price
S2
S
S1

Decrease

Increase in supply

0 Quantity

ABNORMAL SUPPLY CURVES

There are cases where the law of supply may fail to be obeyed, and more may be supplied
as prices fall and less as prices rises. A case at hand is the one of target workers. The
supply curve of labor for target workers is a downward sloping curve showing that at
higher wages rates, target workers are willing to work for less hours while at low wage
rates target workers are willing to work are willing to work for more hours. This is
because target workers normally set for themselves a target and after achieving that target
they don’t bother to go ahead with work. This is shown below.

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 Wages

10 *

6
*
4 *

2 *

0 2 4 6 8 10
 Here it is assumed thN
ato.oouft Htaorugrestwwoorkrkeders has set themselves a target of sh. 20 everyday.
At wage rate of sh. 2 per hour. He shall be willing to work for 10 hours in order to get
sh. 20 per day. When the wage rate is increased to sh. 4 per hour, he is willing only to
work for 5 hours in order to sustain his income of sh. 20 per day. As the wage rate is
increased further to sh. 10 per hour he reduces his working hours further to 2 hours only.
This gives us a downwards sloping supply curve of labor. The higher the wage rate, the
lesser will be the labor supplied and vice versa.
 One reason why this would be possible is that as wage rate increases, the laborer is able
to realize his target within a short time and the rest of his time is spent on leisure.

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 Summary

The lecture has captured the concept of demand and supply and the factors affecting them
respectively. It is worth noting that a movement along a given demand or the supply curve is
caused by changes in the prices of the commodity while a shift of the either the demand
supply curve is caused by change in other factors influencing demand or supply other than
price of the commodity

NOTE

 The law of demand is defined as, “other things being equal, with a fall in price, the
demand for the commodity is extended (increases), and with a rise in the price, the
demand is contracted (decreased)”

 The Law of supply states that other things remaining constant, when price rises, supply
increases and when price falls, supply decreases.

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 FURTHER READINGS

 Nicholson, W. (1992): Microeconomic Theory: Basic principles and extensions, 5th edition,
San Diego, Dryden Press

 Koutsoyiannis, A. (1979): Modern Microeconomics, 2nd edition, Macmillan

 Mansfield, E, (1991): Microeconomic theory/applications, 7th edition, New York, Norton

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