CHAPTER TWO

THEORY OF DEMAND AND SUPPLY

Theory of demand
 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.
Demand, thus, means the desire of the consumer for a
commodity backed by purchasing power.
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).

Law of demand: states that , price of a commodity

and its quantity demanded are inversely related
 Demand schedule (table), demand curve and
demand function

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.

A demand schedule states the relationship

between price and quantity demanded in a table
form
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.
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.
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.
• Now let us examine how each factor affect demand.
• 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, while inferior goods are those
whose demand is inversely related with income.
• 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.
• 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.
• 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.
• 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 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: 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.
• 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 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.
• Demand for commodities like clothes, fruit etc. changes when
there is even a small change in their price, whereas

• Demand for commodities which are basic necessities of life,

like salt, food grains etc., may not change even if price changes,
or it may change, but not in proportion to the change in price.

• Price elasticity demand can be measured in two ways.

• These are point and arc elasticity.

• In this method, we take a straight-line demand
curve joining the two axes, and
• measure the elasticity between two points Qo
and Q1 which are assumed to be intimately close
to each other.
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.
• 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.
• Market supply: It is derived by horizontally adding
the quantity supplied of the product by all sellers
at each price.
• iii) Effect of change in weather condition
• A change in weather condition will have an impact on the
supply of a number of products, especially agricultural
products.
• For example, other things remain unchanged, good
weather
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.
• 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
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.
• 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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