CHAPTER TWO

THEORY OF DEMAND AND SUPPLY

P. by Dagim F.

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 Introduction
Demand is one of the forces determining prices.
 The theory of demand is related to the economic
activities of consumers consumption.
 Hence, the purpose of the theory of demand is to
determine the various factors that affect demand.

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 Demand implies more than a mere desire to purchase a
commodity.
 It states that the consumer must be willing and able to
purchase the commodity, which he/she desires.
 His/her desire should be backed by his/her purchasing
power.
 A poor person is willing to buy a car; it has no
significance, since he/she has no ability to pay for it.
 On the other hand, if his/her desire to buy the car is
backed by the purchasing power then this constitutes
demand

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Demand, thus, means the desire of the consumer
for a commodity backed by purchasing power.
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.
Similarly, if the consumer has the ability to pay
but is not willing to pay, his/her desire will not be
called demand

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 More specifically, 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

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 2.1.1 Demand schedule (table),
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: states the relationship between price
and quantity demanded in a table form.
 An individual demand schedule is a list of the
various quantities of a commodity, which an
individual consumer purchases at various levels of
prices in the market.

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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.

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Example: Let the demand function be
Q = a+ bP
b =∆𝑄/∆𝑃
(e.g. moving from point A to B on figure 2.1 above)
b =7-5 / 4-5 = - 2
where b is the slope of the demand curve
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 demand function for orange in

the above numerical example.

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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.

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 Exercise
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.
i. Derive the market demand function

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 2.1.2. Determinants of demand

The demand for a product is influenced by many

factors. Some of these factors are:
 Price of the product
 Taste or preference of consumers
 Income of the consumers
 Price of related goods
 Consumers expectation of income and price
 Number of buyers in the market

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 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.

Changes in demand: a change in any determinant of

demand except for the good‘s price causes the demand
curve to shift. We call this a change in demand.
 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.

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 Now let us examine how each factor affect demand.

1. 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.

2. 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.
 Inferior goods are those whose demand is inversely related
with income .

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3. 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.

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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

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4. 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.

5. 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

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 2.1.3. Elasticity of demand
Elasticity: is a measure of responsiveness of a dependent
variable to changes in an independent variable.

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:

1. Price elasticity
2. Income elasticity, and
3. Cross elasticity

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 1. 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.

 It is a measure of how much the quantity demanded of a good

responds to a change in the price of that good, computed as the
percentage change in quantity demanded divided by the
percentage change in price.
 Price elasticity demand can be measured in two ways. These
are point and arc elasticity.

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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.

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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.
 We may possess demand schedules in which there are big
gaps in price as well as the quantity demanded.
 In such cases, there is an alternative method known as arc
method of elasticity measurement.

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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.

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 %ΔQ
Arc price elasticity of demand= ep =
%ΔP

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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.
 If the price elasticity of demand is positive the product is
inferior.

1. If   1, demand is said to be elastic and the product is

luxury product
2. If 0    1, demand is inelastic and the product is
necessity
3. If   1, demand is unitary elastic.
4. If   0, demand is said to be perfectly inelastic.
5. If   , demand is said to be perfectly elastic.

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 Determinants of price Elasticity of Demand

The following factors make price elasticity of demand

elastic or inelastic other than changes in the price of the
product.
1. The availability of substitutes: the more substitutes
available for a product, the more elastic will be the
price elasticity of demand
2. 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.

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3. 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.
4. 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.

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 ii. Income Elasticity of Demand

It is a measure of responsiveness of demand to change

in income.
%ΔQ
 =
𝑰

%Δ𝑰
Point income elasticity of demand:
1. If 𝑰 1, the good is luxury good.
2. If 𝑰 1( and positive), the good is necessity
good,
3. If 𝑰  0,(negative), the good is inferior good

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 iii. Cross price Elasticity of Demand
Measures how much the demand for a product is affected by a
change in price of another good.

1. The cross – price elasticity of demand for substitute goods is

positive.
2. The cross – price elasticity of demand for complementary
goods is negative.
3. The cross – price elasticity of demand for unrelated goods is
zero.

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 Exercise
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

i. Calculate the cross-price elasticity of demand between

the two goods. What can you say about the two goods?

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 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, 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.

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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

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A supply curve conveys the same information as
a supply schedule. But it shows the information
graphically rather than in a tabular form.

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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.

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 2.2.2. Determinants of supply
Apart from the change in price which causes a
change in quantity demanded, the supply of a
particular product is determined by:
1. price of inputs ( cost of inputs)
2. Technology
3. prices of related goods
4. sellers‘ expectation of price of the product
5. taxes & subsidies
6. number of sellers in the market
7. weather, etc.

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 2.2.3 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

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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.
Thus, the formula for measuring price
elasticity of supply is:

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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.

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 2.3. Market equilibrium
Having seen the demand and supply side of
the market, now let‘s bring demand and
supply together so as to see how the market
price of a product is determined.
Market equilibrium occurs when market
demand equals market supply.

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 In the above graph, any price greater than P will lead to
market surplus.
 As the price of the commodity increases, consumers
demand less of the product.
 On the other hand, as the price of increases, producers
supply more of the good.
 Therefore, if price increases to P1 the market will have a
surplus of HJ.
 If the price decreases to P2 buyers demand to buy more
and suppliers prefer to decrease their supply leading to
shortage in the market which is equal to GF.

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 Exercise
Given market demand: Qd= 100-2P, and market
supply: P =( Qs /2) + 10
1. Calculate the market equilibrium price and
quantity
2. Determine, whether there is surplus or
shortage at P= 25 and P= 35.

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Effects of shift in demand and supply on
equilibrium

 Given demand and supply the equilibrium price and

quantity are stable.
 However, when these market forces change what will
happen to the equilibrium price and quantity?
 Changes in demand and supply bring about changes
in the equilibrium price level and the equilibrium
quantity.

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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.

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 DD and SS curves intersect at point E and the quantity
demanded and supplied is OM at OP equilibrium price.
 Given the supply, if the demand increases the demand curve
will shift upward to the right. Due to a change in demand,
the demand curve D1D1 intersects SS supply curve at point
E1.
 The equilibrium price increases from OP to OP1 and the
equilibrium quantity from OM to OM1.
 On the other hand, if demand falls, the demand curve shifts
downwards to the left. Due to a change in demand, the
curve D2D2 intersects the supply curve SS at point E2.
 The equilibrium price decreases from OP to OP2 and the
equilibrium quantity decreases from OM to OM2.
 Supply being given, a decrease in demand reduces both the
equilibrium price and the quantity and vice versa.

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2. 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.
 SS and DD intersect at point E, where supply and
demand are equal at OM quantity at OP
equilibrium price. Given the demand, if the
supply increases, the supply curve shifts to the
(S1S1).

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The new supply curve, which intersects DD
curve at E1, reduces the equilibrium m price
from OP to OP1 and increases the equilibrium
quantity from OM to OM1.
On the contrary, when the supply falls, the
supply curve moves to the left (S2S2) and
intersects the DD curve at point E2 raising the
equilibrium price from OP to OP2 and reducing
the equilibrium quantity from OM to OM2.

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3. 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.

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When demand and supply decline, the quantity
decreases. But the change in price will depend
upon the relative fall in demand and supply.
When the fall in demand is more than the fall
in supply, the price will decrease.
On the other hand, when the fall in supply is
more than the fall in demand, the price will
rise.
 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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