Chapter Two

Theory of Demand and Supply

 Introduction
Forward our understanding on two very powerful tools, theory of demand
and theory of supply.
Explain what demand and supply are and show how they determine
equilibrium price and quantity.
Show how the concepts of demand and supply reveal consumers‘ and
producers‘ sensitivity to price change.
 Chapter objectives

After covering this chapter, you will be able to:

 understand the concept of demand and the factors affecting it;
explain the supply side of a market and the determinants of supply;
understand how the market reaches equilibrium condition
explain the elasticity of demand and supply
Theory of demand
 Theory of demand

Demand is one of the forces determining prices.

In our day-to-day life we use the word demand in a loose sense to mean a
desire/wish/want of a person to purchase a commodity or service.
But in economics demand implies more than a mere desire to purchase a
commodity.
the consumer must be willing and able to purchase the commodity,
which he/she desires.
Cont’d
 Cont’d

These two factors are essential.

If a consumer is willing to buy but is not able to pay, his/her desire will not

become demand.

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.

 Cont’d

The quantity demanded of a particular commodity depends on the price of

that commodity.
Law of demand: is the principle of demand, which states that , price of a
commodity and its quantity demanded are inversely related
Demand schedule, demand curve and demand function
The relationship that exists between price and the amount of a commodity
purchased 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.
 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.
 Demand function

It 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.
 Cont’d

Example: Let the demand function be

(e.g. moving from point A to B on figure 2.1 above)

where b is the slope of the demand curve and a is intercept.

, and to find the intercept (a), substitute price either at point A or B. Example
at Point B, Q=7 and P=4, Therefore;

= a=7+8, a = 15
Therefore, Q=15-2P is the demand function for orange in the above
numerical example.
 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.
Cont’d
 Cont’d

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 and
 there fore, Qm = (20 – 2P) 100 = 2000-200P
 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 in the market

A change in any of the above listed factors except the price of the good will change the
demand, while a change in the price, other factors remain constant will bring change in
quantity demanded.
 Cont’d

A change in demand will shift the demand curve from its original location.
For this reason those factors listed above other than price are called demand shifters.
A change in own price is only a movement along the same demand curve.
I. Taste or preference

When the taste of a consumer changes in favour of a good, her/his demand

will increase and the opposite is true.
 II. INCOME OF THE CONSUMER

Normal Goods are goods whose demand increases as income increase

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.

• However, the classification of goods into normal and inferior is subjective and
it is usually dependent on the socio-economic development of the nation.
 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.
 Cont’d

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

other are directly related.

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.

 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

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
 ELASTICITY OF DEMAND

Elasticity measure the responsiveness or sensitivity of consumers or

seller to changes in price or other variables.
In economics, the concept of elasticity is used to analyze the quantitative
relationship between price and quantity purchased or sold.
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.
 Cont’d

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.
i. Price Elasticity of Demand
Price elasticity of demand means degree of responsiveness of demand to
change in price.
 Cont’d

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.
Price elasticity of 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

The main drawback of the point elasticity method is that

it is applicable only when we have information about even the slight
changes in the price and the quantity demanded of the commodity.
But in practice, we do not acquire such information about minute changes.

In such cases, there is an alternative method known as arc method of

elasticity measurement.
 Cont’d

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.
Fore example: the measure of elasticity between point R and R1 on the demand curve is the
measure of arc elasticity.
Cont’d
Cont’d
 Cont’d

Note that:

• 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.

i) If  1, demand is said to be elastic and the product is luxury product

ii) If 0   1, demand is inelastic and the product is necessity

iii) If  1, demand is unitary elastic.

iv) If   0, demand is said to be perfectly inelastic.

v) If   , demand is said to be perfectly elastic.

 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.
 Cont’d

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.

 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, ceteris paribus, as price of a product
increase, quantity supplied of the product increases, and as price
decreases, quantity supplied decreases.
 It tells us there is a positive relationship between price and quantity supplied.
 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.

Cont’d
 Cont’d

• The supply of a commodity can be briefly expressed in the following

functional relationship:

• 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.
Cont’d
 DETERMINANTS OF SUPPLY

the supply of a particular product is determined by:

i) price of inputs ( cost of inputs)

ii) technology
iii) sellers‘ expectation of price of the product
iv) taxes & subsidies
v) number of sellers in the market
vi) weather, etc.
Cont‘d
 ELASTICITY OF SUPPLY

It is the degree of responsiveness of the supply to change in price.

It may be defined as the percentage change in quantity supplied divided by the
percentage change in price.
As the case with price elasticity of demand, we can measure the price elasticity of
supply using point and arc elasticity methods.
However, a simple and most commonly used method is point method.

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.
Cont’d
Cont’d
Cont’d
 EFFECTS OF SHIFT IN DEMAND AND SUPPLY ON EQUILIBRIUM
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. DD is the demand curve and SS is the supply curve .
Cont’d
 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. If an
increase in demand is more than an increase in supply, then the price goes up.
 On the other hand, if an increase in supply is more than an increase in
demand, the price falls but the quantity increases.
 If the increase in demand and supply is same, then the price remains the same.

The reverse true for the condition both supply and demand decrease.
END OF THE CHAPTER

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