Chapter Two: Theory of Demand and Supply

2.1. Theory of demand

 Demand refers to an effective desire.

 A desire becomes an effective desire or demand only when it is backed by the

following three factors:
 ability to pay for the good desired,
 willingness to pay the price of the good desired, and
 availability of the good itself
 Therefore, Demand indicates the different quantities of a product that buyers are
willing and able to buy at various prices in a given period of time, other things
remain unchanged.
 A demand schedule is a tabular statement that states the different quantities of a
commodity that would be demanded at different prices.
 A demand schedule is either individual demand schedule or market demand schedule.
 Individual demand schedule is a tabular statement which shows the quantity of a
commodity demanded by an individual household at various alternate prices per time
period.
 Example: An individual household demand for orange per week in the following
table.
Price per kg 6 5 4
Quantity demand per week 2 3 4
 Market demand schedule is a tabular statement which shows the different quantities of a
commodity demanded by different households or consumers in a market at various
alternate prices per time period.
 Example: different quantities of mangoes demanded by different consumers at
different prices expressed in the following.
 The quantity demanded is the actual amount of a good or service consumers are willing
to buy at some specific price.
 A demand curve is a graphical representation of the demand schedule.

 It shows the relationship between quantity demanded and price.

 •Demand curves also are of two types: Individual demand curve and Market demand
curve.
 Demand Function: it expresses factors influencing the demand for a commodity in
functional form.
 = f ( , , , Y, T);
 Where and stands for the demand for a commodity X and price of commodity
X, respectively. and refer to the prices of other substitutes and complementary
goods.
 Y represents the income level of the consumers, while T is an indicator of their
tastes and preferences.
 The word f shows the functional relationship between the demand for x and the
other variables P_X , P_Y , P_Z , Y, T.
2.2. The Law of Demand
 Law of demand expresses the functional relationship between the price of a commodity
and its quantity demanded.
 It states that the quantity demanded of a good or service varies inversely with its price.
 In other words, when the price goes up, other things equal, quantity demanded goes down.
Likewise, when the price goes down, quantity demanded goes up holding other things
constant.
 Assumptions of the Law of Demand
 There should be no change in prices of related goods.
 Tastes and preferences of the consumer should remain constant.
 There should be no change in the income of the consumers.
 The size of the population should remain constant.
 Distribution of income and wealth should be equal.
 There should be perfect competition in the market.

 Exceptions to the Law of Demand

 There are some situations when the law of demand does not operate.
 With an increase in price, more quantity of a commodity is purchased and vice-versa.
 In these situations demand curve is upward sloping.
 These are known as exceptions to the law of demand
 Main exceptions are as follows:
 Giffen Goods: is a good for which an increase in the price raises the quantity
demanded.
 Giffen goods are a special category of inferior goods.
 Prestige Goods: Some consumers measure the utility of a commodity entirely by its
price.
 For example diamond is considered as a prestige good in the society, the higher the
price of diamonds, the higher the prestige value of them.
 When the price of diamonds goes up their prestige value will go up and, as a result,
quantity demanded by consumers will rise.
 Expectation of People about the Future: This assumption relates to the changes in the
expectations of the people regarding prices of the commodities in the future.
 For example, if rainfall in any year does not occur in adequate quantity and there
is widespread drought, the expectations of the people will be that the prices
would rise in the future.
 Therefore, even if the prices of food grains are higher at present, they would
demand greater quantities since they will be expecting even higher prices in
future.
 Necessities: There are some commodities which are necessities of life – for example,
food grains, salt, medicines, etc.
 A minimum quantity of these commodities has to be purchased by the consumer
irrespective of their price.
 Why Does the Demand Curve Slope Downwards: Basis of the Law of Demand
 Demand curve normally slopes downwards to the right.
 It is also known as the negative slope of the demand curve, indicating an inverse
relationship between the price of the commodity and its demand.
 There are several reasons for this inverse relationship as given below :

 Law of diminishing marginal utility: According to this law, if a consumer increases

the consumption of a commodity in a given time period, the utility from
consumption of each successive unit goes on diminishing.
 Income effect: When the price of a commodity falls (rises), a consumer can buy
more (less) of the commodity with the same amount, indicating an increase in his
real income.
 Substitution effect: When the price of a commodity falls, it becomes relatively cheaper
than its substitutes.
 So people who are consuming the other goods would now start consuming the
commodity whose price has fallen, and as a result, its demand increases.
 This increase in demand is called the substitution effect of price change.
 Change in the number of consumers: A fall in the price of a commodity increases the
number of households who demand it in the market and a rise in the price of commodity
reduces this number.
 Different uses of a commodity: At a lower price, a commodity will be in high demand for
being put to different uses.
 For example, electricity could be used for various purposes like lighting lamps,
heating rooms and operating TV, refrigerator, air conditioners etc.
 Determinants of Demand
 An individual’s demand for a commodity is determined by a number of factors.
Some of these important factors are as follows:
 Price of the Commodity (-vely)

 Income of the Consumer (+vely)

 Prices of Related Goods

• Related goods may be of two types: Substitute goods, and complementary goods.

 Tastes and Preferences

 Future Expectation of Changes in the Price

  Climate
 Population and Number of Households
 Distribution of Income and Wealth
 Demand mainly depends upon three factors, namely
 Price of the commodity;
 Income of the consumer, and
 Price of related goods.
 On the basis of the above three factors, demand can be classified into three types:
I. Price Demand,
II. Income Demand, and
III.Cross Demand.
 Price Demand: Price demand indicates, other things being equal, the relationship
between the price of a commodity and its quantity demanded.
= f ()
Where = Demand for commodity X; = Price of commodity X.
  There is inverse relationship between price of a commodity and its demand.
 In other words, when price of a commodity falls, its demand rises, and when
price of a commodity rises, its demand fails.
 Income Demand: Income demand indicates, other things being equal, the
relationship between the income of consumer and demand for a commodity.
= f ()
 Generally, the demand for a commodity changes in the same direction as
change in income, with a higher level of income leading to a larger
demand, and with a smaller income resulting in a fall in demand.
 However, an increase in income does not always and invariably lead to an
increase in the demand for all the commodities.
 Thus, it is the nature of the commodity on which its demand depends.
 On the basis of nature, goods can be classified into two types:
Normal Goods (Superior Goods): refer to those goods whose income effect
is positive – i.e., all other factors remaining the same, as income increases,
demand also increases and vice-versa. For example, cheese, butter,
chocolates, biscuits, etc.
Inferior Goods: refer to those goods whose income effect is negative – i.e.,
all other factors remaining the same, as income increases, demand decreases
and vice-versa.
 Cross Demand: Cross demand indicates, other things being equal, the relationship
between the price of a commodity and demand for related goods (substitute goods or
complementary goods).
= f ()
Where, = Demand for commodity X, = Price of commodity Y.
 Movement along a demand curve or change in quantity demand)
 Other things being equal, if the quantity demanded increases or decreases due to fall
or rise in the price of a commodity alone, it is known as movement along a demand
curve or change in quantity demanded.
 Here the movement is – either upward or downward – along the same demand curve.
Change in quantity demanded occurs due to change only in the price of the
commodity itself.
 Downward movement along the demand curve is called extension of demand, while
the upward movement as contraction of demand.
 Shift in the demand curve or change in demand
 If more or less of a commodity is demanded, at the same price, due to change in
factors other than the price of the commodity concerned (such as change in income,
or taste or prices of other related goods, etc.), it is called shift in the demand curve or
change in demand.
 In this situation, there is an either rightward shift or leftward shift in the demand
curve itself.
 Here the rightward shift in the demand curve indicates increase in demand while the
leftward shift indicates decrease in demand
2.3. Theory of Supply
 Supply of a commodity refers to various quantities of it which producers are willing
and able to offer for sale at a particular time at various corresponding prices.
 Note that supply shows a relationship between quantities supplied and price of
a commodity,
 Whereas quantity supplied refers to a specific quantity which a producer is
willing to sell at a specific price.
 A supply schedule is a tabular statement that states the different quantities of a
commodity offered for sale at different prices.
 A supply schedule is either individual supply schedule or market supply schedule.
  Individual supply schedule is a tabular statement which shows the different quantities
of a commodity offered for sale by an individual firm at different prices per time
period.
 Market supply schedule is a tabular statement which shows the sum of the quantities
supplied by all the sellers.
 A supply curve is a graph showing the relationship between the price of a good and the
quantity of the good supplied over a given period of time.
 Supply function: mathematical representation of factors influencing the supply of a
commodity.
 = f ( , , , B, Z);
 Where and stands for the supply for a commodity X and price of commodity X, respectively.
shows price of related (goods of other substitutes and complementary goods).
 refer to the prices of factors of production. B represents objectives of firm and Z refers to other
relevant factors.
 2.4. The Law of Supply
 The Law of supply expresses the functional relationship between the price of a
commodity and its quantity supplied.
 The law of supply states that there is a direct relationship between the price of a
commodity and its supply.
 In other words, other things being equal, the supply of a commodity increases
with an increase in its price and, the inverse is true ( decreases with the fall in
price.
 Assumptions of the Law of Supply
 There should be no change in the prices of related goods.
 There should be no change in the prices of factors of production.
  There should be no change in the goals of the firm.
 There should be no change in the state of technology.
 The income of the buyers and sellers should remain constant.
 Exceptions to the Law of Supply
 There are some situations when the law of supply does not operate. With an increase
in price, less of a commodity is supplied and vice-versa. These are known as
exceptions to the law of supply.
 The main exceptions are as follows:
 Future Expectations About Change in Prices
 Agricultural Products
 Perishable Commodities
 Etc.
 Why does the Supply Curve Slope Upwards: Basis of the Law of Supply

 A supply curve normally slopes upwards to the right.

 It is also known as the positive slope of the supply curve, indicating a direct
relationship between the price of the commodity and its supply.
 There are several reasons for this direct relationship, as given below:

 Expectations of Profit: If prices are high, profit expectation increases with the
result that producers increase their output or production; and the inverse is true.
 Change in Stock
 Entry and Exit of Firms: If, due to rising prices there are high profits, new firms
enter into the market and add to the supply of the commodity; and the inverse is
true.
 Determinants of Supply
 Supply of a commodity is determined by a number of factors. Some of these
important factors are as follows:
 Price of the Commodity (+vely)

 Changes in Factor Prices (-vely)

 Price of Related Goods

 Objectives of the Firm

 State of Technology

 Other Factors (fiscal policy, etc.)

 Movement along a supply curve vs shift in supply curve
 Being equal, if the quantity supplied increases or decreases due to rise or fall in the
prices of the commodity alone, it is known as movement along a supply curve.
 Supply curve move either upwards or downwards.

 Upward movement along the supply curve is extension of supply (that is, more
quantity supplied at a higher prices).
 Downward movement is contraction of supply (that is, less quantity supplied at a
lower prices).
 Shift in the supply curve (or change in supply): If more or less quantity of a commodity
is supplied at every alternative price due to changes in factors other than the price of the
commodity.
 Supply curve shift due if the one of the factors that affect supply changes.
o Changes in input prices
o Changes in the prices of related goods or services
o Changes in technology
o Changes in expectations
o Changes in the number of producers
2.5. Market Equilibrium
 The word equilibrium means a state of balance.
 Market Equilibrium: In the context of price determination, equilibrium refers to a
situation in which the quantity demanded of a commodity equals the quantity supplied
of the commodity.
 It refers to the balance between opposite forces of demand and supply and is
termed as market equilibrium.
 Equilibrium Price: The price at which the quantity demanded of a commodity equals
quantity supplied is known as ‘equilibrium price’. consumers are willing to purchase
 The equilibrium price is the price at which the the same quantity of a commodity
which producers are willing to sell.
 Equilibrium Quantity: The amount that is bought and sold at equilibrium price is
called the ‘equilibrium quantity’.
 Example: the imaginary market’s demand/supply schedule of oranges at
different prices.
 Example: Given market demand: Qd= 100-2P, and

Market supply: P = 1/2 Qs+ 10

a) Calculate the market equilibrium price and quantity?
b) Determine, whether surplus or shortage occurs if P= 25?
 Effects of Government Intervention on Market Equilibrium
 Government may intervene in the market in many ways; one of the more prominent
ways is of price control.
 In the interest of consumers and producers, the government executes the policy of
price control by intervening in the market.
 This policy of price-control may have two variants:
 Maximum price
- Competitive prices are so high that they become out of reach for common
consumers, only the rich can purchase and consume the commodity. In such a
situation government comes forward and fixes the maximum price for the
commodity. This process is known as price ceiling.
- Government use price ceiling to protect consumers from conditions that could
make commodities probability expensive; therefore price ceiling is targeted to
protect consumers.
- Price ceiling causes shortages.
 Minimum price.
- Whenever government feels that the competitive price determined by the forces
of demand and supply in a free market is not fair from the producers’ point of
view, government announces a minimum price to protect the interests of the
producers.
- This is also termed as support price or price floor.
- Price floor causes surplus.
2.6. Elasticity Of Demand And Supply
 Elasticity is a measure of responsiveness of one variable to another.
 In economics, elasticity is the measurement of the percentage change of one
economic variable in response to a change in another variable.
 Elasticity of demand- is 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.
 The price elasticity of demand- it measures how much the quantity demanded of a
good changes when its price.
 It indicates how consumers react to changes in price.

 It is the percentage change in quantity demanded divided by the percentage change

in price.
• =
• Measurement of elasticity of demand can be looked at from two view points:
- Point elasticity: When price elasticity of demand is measured at a point on a demand
curve, it is called point elasticity.
 Thus, || = (point price elasticity of demand)
Where, stands for price elasticity of demand,
Q stands for quantity (initial), P stands for price (initial),
∆Q stands for change in quantity, ∆P stands for change in price.
- Arc elasticity: When elasticity of demand is measured over a finite range or ‘arc’ of
a demand curve, it is called arc elasticity of demand.

Example: Let us calculate elasticity of demand by using the point method by taking a
numerical example. Suppose the price of the commodity falls from Birr 5 to Birr 4 and
quantity demanded increases from 100 units to 150 units.

• Find price elasticity of demand using point method

- Answer : || = 2.5 => at price = Birr 5, if price decreases by 1%, quantity demand
increases by 2.5%
 Types of Elasticity of Demand
 Income Elasticity of Demand

 It explains the responsiveness in demand in relation to changes in the income of the

consumer.
 This elasticity explains as to what will be the effect on demand when income of the
consumer changes provided other things (price of the commodity, tastes and
preferences of the consumer, price of related goods etc.) remain constant.
 =
 = (Point income elasticity of demand)
 Note: The income elasticity of demand in the case of normal goods is positive, but in the
case of inferior goods, it is negative.

Example: Suppose a consumer started consuming 12 kg of butter when his income

increased to Birr 2000 – which he used to consume only 8 kg when his income was Birr
1600. The consumer's income elasticity of demand can be found using arc method as

follows. => Answer: = 1.8

 Cross Elasticity of Demand
 It is the responsiveness in the demand for a commodity to the changes in the prices
of its related goods.
 =
 Point cross price elasticity of demand

- Example: Suppose the price of coffee rises from Birr 100 per kg to Birr 120 per
kg. As a result, consumer demand for tea (being a good substitute for coffee)
rises from 20 kg to 30 kg. Cross elasticity of demand for tea.
 Answer: = 2.5 => if price of coffee increases by 1% demand for tea increases by
2.5%.
 Elasticity of Supply
 Price Elasticity of Supply: Price elasticity of supply to change in price, indicates
how sellers react to change in price.
=
 Measurement of Price Elasticity of Supply

 Point Method: The point method of measuring the price elasticity of supply is based on
the definition of elasticity, that is, the ratio of proportionate change in quantity supplied
of a commodity to a given proportionate change in its price.

 =
 Arc method

 Example: Suppose an increase in price of a ball pen from Birr 4 to Birr 5 results in
increase in quantity supplied of pens from 1,000 to 1,500 units. Then find price
elasticity of supply using the point method.
 Answer: ) = 2; if price increase by 1% , quantity supplied increases by 2%.
 Types of Elasticity of Supply

“End of Chapter Two”