INTRODUCTION TO ECONOMICS (Econ-1012)

By: Milkessa August, 2021

Lecture-
2

Theory of Demand
and Supply
2.1 Theory of Demand
Demand is one of the forces determining prices.
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.
Hence the two essential factors to say demand are willingness
and ability.
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
It also 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)or
constant
Quantity demanded refers to a specific quantity which a consumer
is willing to buy at a specific price
Demand refers to the whole set of price-quantity combinations,
while quantity demanded is the amount consumers want to buy at a
particular price.
Law of Demand

 Law of demand: states that , price of a

commodity and its quantity demanded are
inversely related, since other factors constant
 It states that as price of a commodity increases
(decreases),quantity demanded for that commodity
decreases (increases), ceteris paribus.
The Law of Demand • The law of demand states that
there is a negative, or inverse,
relationship between price and the
quantity of a good demanded and
its price, other things being remain
constant

• This means that demand curves

slope downward.
Cont.…
Law of demand depends on the basic assumption of other things
being equal (ceteris paribus).
By other things being equal or ceteris paribus mean that factors
other than price which affect the demand for a commodity is fixed
For example, prices of related goods, tastes and preferences of
consumer, income of the consumer, population, etc.
For the law to operate correctly, there should be no change in any of
these determinants.
Assumptions of Law of DD
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

Why Does 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,
indicating an inverse relationship between the price of the
commodity and its demand.
There are several reasons for this inverse relationship/ the reason
for down ward sloping of DC:
Law of diminishing marginal utility
Income effect
Substitution effect
Customer effect
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.

 A demand schedule states the relationship between price and quantity demanded in a
table form. See fig.2.1
P ($) qd

$2.00 5

$1.50 7

$1.00 15
 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. Look at fig 2.2
 Demand Function: is a mathematical relationship between
price and quantity demanded, all other things remaining the
same
 A demand function is a causal relationship between a
dependent variable (i.e., quantity demanded) and various
independent variables (i.e., factors which are believed to
influence quantity demanded)
 Q = f(P)

Where Q= quantity and P = price of a good.

Example Qd = 2 – 4P
Cont.…
 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.

 Market Demand: The market demand schedule, curve or function is

derived by horizontally adding the Qtydd for the product by all buyers at
each price.

 Market demand is horizontal summation of individual demands of all

consumers for that particular good
Cont.…

•Numerical 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 given by:

P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and Qm = (20 – 2P) 100 = 2000-200P

2.1.2 Factors that affect the demand for a goods and services or Determinants of dd
are:

1. The price of the good or services /Own price/price of the

products
2. The tastes and preference of the group demanding the good
3. The size of the group (population size)
4. The income and wealth of the consumers
5. The prices of other/related goods and services
6. Expectations about future prices or income
2.1.3 Change in Qd(movement along the dd curve) Vs Change in
Dd(Shift in the demand curve)
A) Movement along the demand curve( Change in Qd)
A Change in own price is causes only a movement along the
same demand curve.
Movement along the demand curve refers to that change in
the quantity demanded of a good because of changes in the
prices of that good while other factors affecting demand
remaining the same or ceteris paribus.
B) Shift in the demand curve(Change in Dd curve)
A shift in the demand curve for a good result from changes in
one or more of the factors that affect demand except the price of
own good.
Cont.…..

• A change in demand is not the same

as a change in quantity demanded.

• In this example, a higher price

causes lower quantity demanded.

• Changes in determinants of
demand, other than price, cause a
change in demand, or a shift of the
entire demand curve, from DA to
DB.
Cont.…

To summarize:
Change in price of a good or service
leads to

Change in quantity demanded

(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to

Change in demand
(Shift of curve).
Cont.…
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.

Now let us examine how each factor affect demand.

•I. Taste or preference

•When the taste of a consumer changes in favors of a good, her/his demand will increase
and the opposite is true.
II. Income of the consumer
Goods are classified into two categories depending on how a change in income
affects their demand. These are:

 Normal Goods: are goods whose demand increases as income increase, while

 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. These are Substitute goods and Complimentary goods.
ↈSubstitute 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 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.

.
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 quantity supplied is specific quantity of product
that sellers want to sell over a specified period of time at
Law of supply
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
Cont..
2.2.1 Supply schedule, supply curve and supply function

price quantity
 Supply schedule: is a tabular listing, 1 2
which shows quantity supplied at 5 10
various prices, ceteris paribus.
8 15
There exists a positive relation 13 25
between quantity and price 20 35
 Supply Curve: is a graphical price
representation of a supply
S
schedule showing the
quantity supplied at various
prices, ceteris paribus

qty

•Supply function shows the mathematical relation between quantity and

price. It has is a positive relation.
Example : Qs = 2 + 4P
Factors affecting the supply of a good or service include:

1 The price of the good

1. The level of technology
2. The price of factors of production/ Input price
3. The number of suppliers
4. Price expectations
5. Taxes & subsidies
6. prices of related goods
7. Number of sellers in the market
8. weather, etc.
A Change in Quantity Supply Versus a Change in Supplied

• A change in supply is not the

same as a change in quantity
supplied.
• In this example, a higher price
causes higher quantity supplied,
and a move along the demand
curve.
• In this example, changes in determinants of supply, other than
price, cause an increase in supply, or a shift of the entire supply
curve, from SA to SB.
Cont..

To summarize:
Change in price of a good or service
leads to

Change in quantity supplied

(Movement along the curve).

Change in costs, input prices, technology, or prices of

related goods and services
leads to

Change in supply
(Shift of curve).
2.3 Market Equilibrium
 An equilibrium is the condition that exists when quantity supplied and
quantity demanded are equal
 Is point where buyers and seller reach the compromise and settle down the
price of the commodity.
At Mkt eqlb point price of quantity demanded is equal to price of the
quantity supplied, and market quantity DD equal to market quantity
SS
Market equilibrium occurs where the demand curve and supply curve
intersect
Market equilibrium determines market output and price
• At equilibrium, there is no tendency for the market price to change.
Market Equilibrium ( Qd= Qs)
• Only in equilibrium is quantity
supplied equal to quantity
demanded.

• At any price level other than P0,

the wishes of buyers and sellers do
not match/coincide.
Market Disequilibria(Qd>Qs)

• (From b to d )Excess demand, or

shortage, is the condition that exists
when quantity demanded exceeds
quantity supplied at the current price.

• When quantity demanded exceeds

quantity supplied, price tends to
rise until equilibrium is restored.
Market Disequilibria (Qs>Qd)
• (From b to d) Excess supply, or
surplus, is the condition that exists
when quantity supplied exceeds
quantity demanded at the current
price.

• When quantity supplied exceeds

quantity demanded, price tends to
fall until equilibrium is restored.
Effects of shift in demand and supply on equilibrium:-
Increases in Demand and Supply

• Higher demand leads to higher • Higher supply leads to lower

equilibrium price and higher equilibrium price and higher
equilibrium quantity. equilibrium quantity.
Decreases in Demand and Supply

• Lower demand leads to • Lower supply leads to higher

lower price and lower price and lower quantity
quantity exchanged. exchanged.
Relative Magnitudes of Change

• When supply and demand both increase, quantity will increase,

but price may go up or down.
GENERALLY, the effects of shift in demand and supply on equilibrium

S constant, increases in D leads to increase Q* and P*

 S constant, decreases in D leads to decrease Q* and P*
 D constant, increase in S leads to increase Q* but decrease P*
 D constant, decrease in S leads to decrease Q* but increase P*
 If the increments of DD and SS is equal, price is constant and Q*
increase
 When supply and demand both increase, quantity will increase,
but price undetermined ( may go up or down), because it based on the
relative increments of the demand and supply;
1) If
2) If
Cont..
3) If D > S, P &Qty decrease
4) If D < S then P is increasing, but Qty decreases
5) If D = S, then price remain constants ,but Qty
decrease
2.4. Elasticity

Elasticity is a measure of the sensitivity or responsiveness of quantity

demanded or quantity supplied to changes in price (or other factors)
It is convenient to consider a unit free measure of responsiveness is
called elasticity
In economics, the concept of elasticity is very crucial and is used to
analyze the quantitative relationship between price and quantity
purchased or sold.
Accordingly, we have the concepts of elasticity of demand and
elasticity of supply.
2.4.1. Elasticity 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.
Types of Elasticity of D; are 3

1) PRICE ELASTICITY OF DEMAND

2) CROSS ELASTICITY OF DEMAND

3) INCOME ELASTICITY OF DEMAND

1)Price elasticity of demand/Own price elasticity of dd:

It is the degree of responsiveness of

quantity demanded of a commodity due to
change in price, other things remaining
the same.
Or price elasticity of demand is the
percentage change in quantity demanded
due to certain percentage change in price
Measurement of elasticity:-are two ways;
Point method of elasticity measurement is measured for
a single point on the demand or supply curve
 Arc method of elasticity measurement is measured for
two points along the demand or supply curve
Ed is generally negative, since demand curves have a
negative slope. But we consider the absolute value of the
coefficients
mathematical expression for point method;

Ed = % change in Qd
% change in P
Where,
EP = Price elasticity of demand
q = Original quantity demanded
∆q = Change in quantity
demanded p = Original
price
∆p = Change in price
mathematical expression for Arc method;
Practical Example
Suppose that price of a commodity falls down from Rs.10 to Rs.9
per unit. Due to this, quantity demanded of the commodity
increased from 100 units to 120 units.

What is the price elasticity of demand?

Solution: Elasticity of demand is usually a negative number
because of the law of demand
Give that,
p= initial price= Rs.10
q= initial quantity demanded= 100 units
∆p=change in price=Rs. (9-10) = Rs.-1
∆q=change in quantity demanded= (120-100) units = 20 units

The quantity demanded

increases by 2% due to fall in
price by Rs.1.
Types or degrees /range of price elasticity of demand
1. Perfectly Elastic Demand (EP = ∞), Demand changes
infinitely
2. Perfectly Inelastic Demand (EP = 0), Change in price does
not affect demand at all
3. Elastic/Relatively Elastic Demand (EP> 1), If %∆q > %∆p,
4.Inelastic/Relatively Inelastic Demand (Ep< 1 ),If %∆q < %∆p, E
D

between 0 and 1

5. Unitary Elastic Demand ( Ep = 1),If %∆q = %∆p

Determinants of price Elasticity of Demand
The availability of substitutes: the more substitutes product
is the more elastic.
 Time: In the long- run, price elasticity of demand tends to be
elastic. Because: More substitute goods could be produced and
People tend to adjust their consumption pattern.
 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.
 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
2) Cross-Price Elasticity of D
 Cross-price elasticity: A measure of the responsiveness of
the demand for a good to changes in the price of a related
good
 It is the percentage change in the quantity demanded of
one good divided by the percentage change in the price of a
related good.
 The cross-price elasticity is positive whenever goods are
substitutes, negative whenever goods are complements.
And zero if goods unrelated goods/independent
Mathematically

Exy= % Change in Quantity of X

% Change in Price of Y

==
3) Income elasticity of D
Income elasticity of demand is the ratio of proportionate change in
demand to proportionate change in income
 It is a percentage change in demand divided by the percentage
change in income
 Inferior goods have Negative income elasticity
 Normal goods have Positive income elasticity
 Normal goods with income inelastic, where elasticity between 0 and 1 is
Necessities goods
 Normal goods with income elastic, Elasticity > 1 is Luxuries goods
Income elasticity of demand

% change in quantity demanded

EI  % change in
income
Q / Q Q I
 
I / I I
Q
THANK YOU
END
OF
CH- 2 GALATOOMAA