INTRODUCTION ECONOMICS
AMU
College of Business and Economics
Department of Economics
by
Zigale Y.(MSc.)
12/22/2024 1
CHAPTER TWO
THEORY DEMAND AND SUPPLY
2.1 THEORY OF DEMAND
Are demand and want similar? Why?
Why can’t we purchase all that we need or we desire to have?
The words demand, desire and want are often
interchangeably used to express what an individual needs
and what he/she would like to acquire.
However, in economics, the term demand has a specific
meaning.
Cont’d …
Demand refers to the amount of commodity which an individual
buyer is willing and able to buy at a given price and during a given
period of time.
As such demand is different from a mere desire. Human wants are
unlimited, and therefore, desires are many. demand refers to an
effective desire.
A desire becomes an effective desire or demand only the
following three factors fulfill:
ability to pay for the good desired
willingness to pay the price of the good desired
availability of the good itself 3
Cont’d …
Demand for a commodity is the amount of it that a consumer is
willing to buy at various given prices and a given moment of time.
A commodity refers to any good produced for sale in the market.
Demand and quantity demanded are two different concepts;
Demand refers to the relationship between the price of a
commodity and its quantity demanded, other things being
same.
Quantity demanded refers to a specific quantity which a
consumer is willing to buy at a specific price.
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Law of Demand
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Assumptions of the Law of Demand
Law of demand depends on the basic assumption of
other things being equal (ceteris paribus).
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Demand Schedule (table)
Demand schedule refers to a tabular representation of the
relationship between price and quantity demanded.
Demand schedules are of two types:
A).Individual Demand schedules :is a tabular statement which
shows the quantity of a commodity demanded by an individual
household at various alternate prices per time period.
7
Cont’d …
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.
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Demand Curve
A demand curve conveys the same information as a demand schedule.
But it shows the information graphically rather than in a tabular form.
Demand curves also are of two types:
1) Individual demand :The curve which expresses
graphically the relationship between different quantities of a
commodity demanded by an individual at different prices per
time period.
2) Market demand curve :The curve which express graphically
the relationship between different quantities of a commodity
demanded by different households or consumers at different
prices per time period.
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Cont’d …
10
Cont’d …
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Why the Demand Curve Slope Downwards?
Demand curve normally slopes downwards to the right.
It is also known as the negative slope of the demand curve,
It indicating an inverse relationship between the price of the
commodity and its demand.
Demand function
The functional relationship between the demand for a commodity
(say X) and the factors influencing it.
Dx= f (Px) or
Dx= f (Px, Py, Pz, Y, T)
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Cont’d …
Example :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?
2.1.2 Determinants of demand
The demand for a product is influenced by many factors;
a) Price of the product/ Commodity
b) Taste or preference of consumers
c) Income of the consumers: income effect can be see in form of
normal goods(+) and inferior goods(negative)
13
Cont’d …
D).Prices of Related Goods: Changes in the prices of related goods
also affect the demand for a commodity.
Related goods may be of two types:
Substitute Goods(+): Substitute goods are those goods which can be
used in place of each other to satisfy a given want.
Also called competitive goods. Coffee and tea, pens and pencils, butter
and oil, etc.,
Complementary Goods: are those goods which are used together to
satisfy a given want. For example, cars and fuel, ten and suger.
Complements are two goods for which an increase in the price of one
lead to a decrease in the demand for the other.
Cont’d …
e).Tastes and Preferences : If a consumer is accustomed to
certain commodities, he will demand that commodity.
f).Future Expectation of Changes in the Price
g).Climate:
h).Population and Number of Households. etc.----
What Difference between Movement along a Demand
Curve (or change in quantity demanded) and Shift in the
Demand Curve (or change in demand)?
15
Cont’d …
Movement along a demand curve or change in quantity
demanded .
Change in quantity demanded occurs due to change only in the price
of the commodity itself . (Other things being equal ).
the movement is – either upward or downward – along the same
demand curve.
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.
In this situation, there is an either rightward shift or leftward shift in
the demand curve itself.
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Change in quantity demanded .
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Change in demand
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Cont’d …
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.
Giffen Goods:
Prestige Goods; diamond
Necessities: food grains, salt, medicines, etc. 19
2.2 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.
the term supply is often misused with the term ‘stock’.
Stock is the total volume of a commodity produced during a
period less the quantity already sold out.
Note that supply shows a relationship between quantity 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.
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Law of Supply
Statement of the Law
The law of supply states that there is a direct relationship
between the price of a commodity and its supply.
Or
Other things being equal, the supply of a commodity increases
with an increase in its price and decreases with the fall in price.
Assumptions of the Law of Supply
Law of supply depends on the basic assumption, ‘other things being
equal (ceteris paribus)’.
21
Cont’d …
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 . 22
Supply Schedule
A supply schedule is a tabular statement that states the different
quantities of a commodity offered for sale at different prices.
Supply schedules are of two types:
i. .Individual supply schedule.
ii. Market supply schedule.
i. 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.
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Cont’d
ii. Market supply schedule is …statement which shows the
a tabular
sum of the quantities supplied by all the sellers.
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Supply Curve
A supply curve conveys the same information as a supply
schedule. But it shows the information graphically rather than in
a tabular form.
A). Individual supply curve expresses graphically the relationship
between different quantities of a commodity supplied by an
individual firm at different prices per time period.
B).Market supply curve expresses graphically the relationship between
different quantities of a commodity supplied by two or more firm at
different prices per time period.
Cont’d …
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Cont’d …
27
Why the Supply Curve Slope upward?
Supply curve normally slopes upward to the right.
It is also known as the positive slope of the supply curve,
It indicating an direct relationship between the price of the
output and its supply.
Supply function
The functional relationship between the supply for a commodity (say
X) and the factors influencing it.
Sx= f (Px) or
Sx= f (Px, Py, Pf, B, Z)
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Determinants of Supply
Price of the Commodity;
Changes in Factor Prices;
Price of Related Goods:
Objectives of the Firm:
State of Technology and Other Factors:
Exceptions to the Law of Supply
Agricultural Products:
Perishable Commodities:
Good of Auction and others
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Cont’d …
Movement along a Supply curve (or change in Quantity
Supplied)
Other things being equal, if the quantity supplied increases or decreases
due to rise or fall in the prices of the commodity.
affected by the price it self.
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.
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Change in Quantity Supplied)
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Change in Supply
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[Link]
Elasticity is a measure of responsiveness of one variable to
another.
Elasticity is a measure of responsiveness of a dependent
variable to changes in an independent variable.
In economics, the concept of elasticity is very crucial and is
used to analyze the quantitative relationship between price and
quantity purchased or sold.
We have the concepts of elasticity of demand and
elasticity of supply.
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[Link] of demand
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.
There are three kinds of demand elasticity: price elasticity,
income elasticity, and cross elasticity.
1). Price Elasticity of Demand
Price elasticity of demand means degree of responsiveness of
demand to change in price.
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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.
Determinants of Price Elasticity of Demand
The main factors are:
35
Cont’d …
Availability of substitutes: If a commodity has many close
substitutes, its demand is likely to be elastic.
if a good has no or weak substitutes, the demand for it would be
inelastic
Nature of the commodity; the demand for necessities is
inelastic and the demand for luxuries and comforts is elastic.
Price range: Demand for a commodity tends to be inelastic at
very high and very low prices, and elastic within the moderate
range of prices.
36
Cont’d …
Postponement of consumption: Demand for a commodity is
elastic if its consumption can be postponed.
the consumption of food items cannot be postponed. Therefore,
their demand is inelastic.
Time factor: Price elasticity is generally low for short
periods as compared to long periods.
This is for two reasons. Firstly, it takes time for consumers
to adjust their tastes, preferences and habits.
Secondary, new substitutes may be developed in the long
run. 37
Measurement of Price Elasticity of Demand
The measurement of elasticity of demand can be looked at from
two view points.
1).Point Elasticity: When price elasticity of demand is measured
at a point on a demand curve.
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Cont’d …
E.g. Price per unit of a commodity increases from Birr 5
to Birr 10. As a result, the demand decreases from 100
units to 50 units. Calculate price elasticity of demand.
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Cont’d …
2). Arc Elasticity: When elasticity of demand is measured over
a finite range or ‘arc’ of a demand curve.
Arc price elasticity of demand measures price elasticity of
demand between two points.
The arc elasticity formula is used if the change in price is
relatively large.
It is a more accurate measure of elasticity than point elasticity
method.
40
Cont’d …
41
Cont’d …
Example: Consider a market for music CDs. When the price of
CDs is birr 50 per unit, consumers by 10 units per year. When the
price rises to birr 100 per unit consumers buy 4 CDs per year. Find
price elasticity of demand for CDs using arc method.
Remember that we ignore the minus sign when calculating price
elasticity.
price elasticity of demand is a negative number because of
negative slope of the demand curve.
It is a unit-free measure. because it is a ratio of percentage
change.
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Types of Price Elasticities of Demand
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Cont’d …
44
Cont’d …
45
[Link].Income Elasticity of Demand
Income elasticity of demand is the ratio of proportionate change in
demand to proportionate change in income.
Ei normal goods is positive,(>1 for luxury and 0<Ei<1 for but
necessity). in the case of inferior goods, it is negative.
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Cont’d …
47
Cont’d …
Example: Suppose a consumer has money income of Birr
1000 and he purchases 4 kg of teff. If his money income
goes up to Birr 1200, he is now prepared to buy 5 kg of
teff. His income elasticity of demand?
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.
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[Link].Cross Elasticity of Demand
It is responsiveness in the demand for a commodity to the
changes in the prices of its related goods.
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Cont’d …
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.
Example When the price of a commodity falls from Birr 10
per unit to Birr 9 per unit, its quantity supplied falls by
20%. Calculate its price elasticity of supply?
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[Link] OF SUPPLY
Price elasticity of supply: indicates how sellers react to change in
price. The greater the reaction, the greater will be the elasticity, lesser
the reaction, the smaller will be the elasticity.
Determinants of Price Elasticity of Supply
The main factors are:
51
Cont’d …
Behavior of cost of production: an increase in SS leads to
a large increase in cost of production, the supply would be
relatively inelastic.
Time element: in the short run, supply tends to be relatively
inelastic. But long-run supply tends to be elastic.
Nature of the commodity: the supply of durable products is
relatively elastic. supply of perishable goods like milk and
vegetables is relatively less elastic .
Nature of inputs and others---------
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Measurement of Price Elasticity of Supply
Point Method:
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Types of Elasticity of Supply
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Cont’d …
Example: If price of a commodity falls from Birr 60 per
unit to Birr 58 per unit, its supply decreases from 400 to
300 units. Find out its elasticity of supply.
Example 2; The coefficient of elasticity of supply of a
commodity is 3. A seller supplies 20 units of this
commodity at a price of Birr 8 per unit. How much of this
commodity will the seller supply when price rises by Birr 2
per unit?
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[Link] EQUILIBRIUM
The word equilibrium means a state of balance.
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’.
At equilibrium price, demand and supply are in equilibrium.
Equilibrium Quantity :The amount that is bought and sold at
equilibrium price is called the ‘equilibrium quantity’.
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Market’s demand/supply schedule
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Graphical Presentation of Market Equilibrium
58
Cont’d …
59
Cont’d …
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Effects of changes in Demand and Supply on Equilibrium Price and
Equilibrium Quantity
Now we shall study how a shift either in the demand or in the supply
curve (that is, change in demand or supply) affects equilibrium price
and quantity in the market.
1). Effects of Change in Demand (or Shifts in the Demand Curve) when
Supply Remains Constant.
There can be two situations of change in demand
1).the effect of increase in demand is higher equilibrium price and larger
equilibrium quantity, and
2).The effect of decrease in demand is lower equilibrium price and
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smaller equilibrium quantity.
Effect of Increase in Demand
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Effect of Decrease in Demand
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Cont’d …
2).Effects of Change in Supply (or Shifts in the
Supply Curve) when Demand Remains Constant
1).the effect of increase in supply is lower equilibrium price
and larger equilibrium quantity, and
2). the effect of decrease in supply is higher equilibrium price
and smaller equilibrium quantity
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effect of increase in Supply
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effect of decrease in supply
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Cont’d …
3).Effect of Simultaneous Change in Demand and
Supply (Simultaneous Shifts in Demand and
Supply Curves)
1).When Both Demand and Supply Increase:
If both demand and supply increase (that is, both
demand curve and supply curve shift to the right),
the equilibrium quantity would certainly rise.
But the equilibrium price may rise, fall or remain
unchanged. 67
Cont’d …
It depends on the comparative increase in demand and supply.
A). If the increase in demand is greater than the increase in supply,
the equilibrium price rises.(Fig A)
B). If the increase in demand is smaller than the increase in
supply, the equilibrium price falls. .(Fig B)
C). If the increase in demand and increase in supply are equal, the
equilibrium price remains unchanged. .(Fig C)
68
Cont’d …
69
Cont’d …
2). When Both Demand and Supply Decrease
If both demand and supply decrease the equilibrium quantity
would certainly fall. But the equilibrium price may rise, fall or
remain unchanged.
A). If the decrease in demand is greater than the decrease in
supply, the equilibrium price falls.(Fig A)
B). If the decrease in demand is smaller than the decrease in
supply, the equilibrium price rises.(Fig B)
C). If the decrease in demand and decrease in supply are equal,
the equilibrium price remains unchanged. .(Fig C)
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Cont’d …
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