Chapter Two: Theory of Demand and Supply

Chapter objectives, after covering this chapter,

you will be able to:

Explain the concept of demand and the factors

affecting it;

Explain the concept supply and the determinants

of supply;

Explain the elasticity of demand and supply

Explain how the market reaches equilibrium

condition,

Describe the possible factors that could cause a

change in equilibrium
2.1. Theory of Demand
Theory of demand is related to the economic
activities of consumers-consumption.

Hence, its aim is to determine the various factors

that affect demand.

Is demand, desire and wants are similar? Why cant

we purchase all what we needs or desire to have?

Demand implies more than a mere desire to

purchase a commodity

It state 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
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The demand for a particular good is defined as the
quantity of a good that consumers are willing and able
to buy in a specific time period.

The law of demand says that demand for a particular

product will increase as the price reduces.

This is because consumers can afford to buy more if

prices are lower.

Conversely, the higher the price, the less people will

demand.

This is because the opportunity cost of purchasing a

particular good increase with the price.
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Determinants of demand
A. Price: the quantity demanded falls as the price
rises and rises as the price falls, thus quantity
demanded is negatively related to the price.

Other things equal, when the price of a good rises,

the quantity demanded of the good falls.

Income of consumer: Income is based on two types of

goods. That is normal and inferior goods.

If the income of an consumer increase, the demand

for normal good is increase For examples
dorowot,

While If the income of a consumer decrease, the

4
demand for inferior good decrease. Shiro wot
C. Prices of Related Goods: The effect of price
related to goods also two types goods.

That is substitution and complementary goods and

services.

Substitutes are often pairs of goods that are used in

place of each other.

When a fall in the price of one good reduces the

demand for another good, the two goods are called
substitutes.

If two goods Substitutes, an increase in the price of

one lead to an increase in the demand for the other 5
Suppose that the price of Pepsi falls. The law of demand
says that you will buy more Pepsi and less coca cola.

Complements are often pairs of goods that are used

together, such as computers and software.

When a fall in the price of one good raise the demand

for another good, the two goods are called
complements.

If two goods are complements, an increase in the price

of one lead to a decrease in the demand for the other.

Now suppose that the price of sugar falls. The law of

demand, you will buy more sugar and you will buy more 6
D. Tastes: The most obvious determinant of your
demand is your tastes. If you like banana, you buy
more of it.

•Economists normally do not try to explain people’s

tastes because tastes are based on historical and
psychological forces

E. Expectations: Your expectations about the future

may affect your demand for a good or service today.

•For example, if you expect to earn a higher income

next month, you may be more willing to spend some of
your current savings.

•As another example, if you expect the price of banana

to fall tomorrow, you may be less willing to buy a
banana at today’s price. 7
The individuals demand schedule and
curve
A demand schedule, a table that shows the relationship
between the price of a good and the quantity demanded.

The following table shows how many quantity Abebe

buys each month at different prices of a good.

Price 0 10 20 30 40 50
Quantit 250 200 150 100 50 0
Demand
y curve is the graphical that shows the
relationship between the price of a good and the quantity
demanded.

By convention, the price of good is on the vertical axis,

and the quantity of good demanded is on the horizontal
axis 8
• It is downward-sloping line rela/ting price and Qd
indicating inverse rships b/n price and Qd, ceteris
paribus.

• Ceteris paribus is a Latin phrase, translated as “other

things being equal

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10
Movements along vs shifts in the demand
curve
• Whenever any determinant of demand changes, other
than the good’s price, the demand curve shifts.

Variables that affect A change in this variable

quantity demanded ...

Price Represents a movement

along the demand curve

Income Shifts the demand curve

Price of related goods Shifts the demand curve
Tastes Shifts the demand curve
Expectation Shifts the demand curve
Number of buyers Shifts the demand curve11
Theory of Supply
The quantity supplied of any good or service is the
amount that sellers are willing and able to produce
and sell.

What is the law of supply? The law of supply says

that suppliers will produce more of a good if it sells at
higher prices.

This makes sense, as higher prices mean increased

revenue.

Suppliers are willing to deliver more products and

services where they are paid more for doing so.

Determinants of supply
Price of a goods: The price of product is one
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determinant of the quantity supplied.
Cont....
When the price of product is high, selling product is
profitable, and so the quantity supplied is large.

As a seller of product, you work long hours, buy

many banana machines, and hire many workers,
vice versa.

 Input Prices: price of inputs are major costs to the

firms.

 When the price of one or more of these inputs

rises, producing product is less profitable.

If input prices rise substantially, you might shut

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down your firm and supply no product at all.
Cont....
Thus, the supply of a good is negatively related
to the price of the inputs used to make the good.

Technology: The technology for turning the

inputs into product is yet another determinant of
supply.

The invention of the mechanized product

machine, for example, reduced the amount of
labor necessary to make product.

By reducing firms’ costs, the advance in

technology raised the supply of product.

Feb. 04, 2010 14

Cont...
Future Expectations: It is the future expectation
about income and price level.

The amount of product you supply today may

depend on your expectations of the future.

Changes in weather condition: It will have

positive or negative on the of numbers of products
especially agricultural products.

For example goods weather condition boosts the

supply of agricultural products.

Activity: Discuss how supply is affected by the

changes in prices of related goods, government
intervention(taxes and subsidies), sellers
expectations of futures price of the product, and
the number of sellers in the market?
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The Supply Schedule, Curve and Function

Feb. 04, 2010 16

Movements along versus shifts in the
demand curve
Whenever any determinant of demand changes, other
than the good’s price, the demand curve shifts.
•
Variables that affect A change in this variable . .
Qs .
Price of a goods Movement along the supply
curve
Inputs price Shifts the supply curve
Price of related Shifts the supply curve
goods
Tastes Shifts the supply curve
Future Expectation Shifts the supply curve
17
Market equilibrium
Market equilibrium is a price-quantity combination that
results from the interaction of the supply and the demand
curve.

At equilibrium price equate quantity demanded and

quantity supplied.

The equilibrium has the property that once the market

settles on that point it stays there unless either supply or
demand shifts.

Additionally, a market that is not at the equilibrium position

moves toward that point.

Like demand and supply the r/ship b/n price and quantity in
market equilibrium also shows using schedule, curve and
func.
Cont...
Consider the following demand and supply of coffee in
a given market given by the following table.
Price per Kg Kg demanded Difference
Kg supplied per month
per
month
Br 1.00 2 10 thousand 8 thousand excess Qd
thousand
Br 2.00 4 8 thousand 4 thousand excess Qd
thousand
Br 3.00 6 6 thousand Equilibrium (no
thousand excess)
Br 4.00 8 4 thousand 4 thousand excess Qs
thousand
Br 5.00 10 2 thousand 8. thousand excess
thousand Qs 19
Cont....
Excess demand causes an upward pressure on
price. Thus, price converges to the equilibrium
price.

Excess supply causes a downward pressure on

price. Thus, price follows a path towards the
equilibrium.

Once equilibrium is reached at the point of equality

of the demand and supply curve, it remains there
as long as demand and supply remain unchanged

Demand and supply curve......

20
Numerical Approach to Equilibrium (functional form)
Cont....
At the equilibrium position, the demand function is
exactly equal to the supply function.

If demand is given as Qd = a – bp and Qs = c+dp.

The equilibrium condition is Supply = Demand.

Example 3: Suppose the demand and supply in a

particular market are given as: Qd = 100 – 2P and
Qs = 10 +4p

[Link] the equilibrium price and quantity and graph

your result?
b. If equilibrium price is reduce by half, calculate Qs
and Qd at this new price and compare it with
equilibrium
[Link] equilibrium price is rise by half, calculate Qs and
Qd at this new price and compare it with equilibrium 21
Effects of Change in Demand
When the ceteris paribus (price of other goods,
income, taste, etc.) change, there will be a shift in
the demand curve.

Such changes (shifts) in demand result in a shift of

the equilibrium position.

Assume first, there is increase in demand, for any

one reason, represented by an upward (rightward)
shift in the demand curve

Such rise in demand, with supply constant,

creates shortage at the initial equilibrium price,
and the unsatisfied buyers bid up the price.
22
Cont....

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Cont...

24
Effect of changes in supply

25
Cont...

Feb. 04, 2010 26

Cont.....
Therefore, what changes happen to equilibrium
quantity and price due changes in demand and
supply
Change Equilibrium Equilibriu
price m
Demand increase Increase(rises) Increase(ris
(rise) es)
Demand decrease Decrease(falls) Decrease(fa
(fall) lls)
Supply increase Decrease (falls) Increase(ris
(rise ) es)
Supply decrease Increase(rises) Decrease(fa
(fall) lls)
Feb. 04, 2010 27
Elasticity of demand and supply
Elasticity is a measure of the responsiveness of Qd or Qs
to one of their determinants.

It can be categories as elasticity of demand and supply.

2.3.1. Elasticity of Demand

The law of demand indicates only the direction of change

in quantity demanded in response to a change in prices.

This does not tell us by how much or to what extent the

Qd of a good will change in response to a change in its
prices.

Hence, this is known by the concept of elasticity of

demand 28
Cont...
Ed show to the degree of responsiveness of Qd of
a good to a change in its price, price of related
goods or income

[Link]. Types of elasticity of demand

There are three kinds of elasticity of demand;

Price, income and cross elasticity of demand.

Price Elasticity of Demand shows the

responsiveness of Qd of a good to the change in its
price.

It is the most important among the above 29

elasticity of demand.
Cont...
Mathematically, it percentage change in quantity
demanded to percentage changes in price of a goods.
Or

It is calculated by relative change in Qd divided by

relatives change in price.

The value of elasticity(Ed) is always negatives, lies b/n

0 and ∞, we take its absolute value so that Ed will be a
positive and (unit free) coefficient.

Consider the following cases;

If Ed= 1, demands has unit elasticity (unitary elastic).
If Ed> 1, demand is elastic.
If Ed< 1, demands is inelastic.
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If Ed= 0, demand is said to be perfectly inelastic.
Cont...
Perfectly elastic demand (Ed = ∞): It occurs as the
price Ed approaches to infinity & demand curve
becomes horizontal

Elastic demand (1 <Ed<∞): It is a situation where

the proportionate change in Qd is much greater than
the proportionate change in price. For examples Qd
for luxury

Unitary Elasticity of demand (Ed=1): It is a situation

where the proportionate change in Qd is equal to the
proportional change in price.

 Inelastic demand (0<Ed<1) It is a situation where

the proportionate change in Qd is less than the
proportionate change in price. Examples, Qd for food.
31
Cont....
Perfectly inelastic demand (Ed=0): It refers to
that situation where Qd is perfectly independent
of price changes.

In such a case the demand is non-responsive. For

example demand for insulin

Examples: Suppose Soreti super market in reduce

the price of oil from birr 120 to 90 and quantity of
oil demanded is increase from= 80 liters to 100
liters. Then compute the price elasticity of
demand.

Please shows PEd is elastic, inelastic or unitaty

elastic? Interprate the result? 32
Determinants of Price Elasticity of
Demand
 Elasticity of demand varies from commodity to
commodity.

 Availability of substitutes: The closer the

substitute, the greater the elasticity of demand for a
commodity.

 Nature of the commodity: Commodities can be

grouped as luxuries, comforts and necessities.

 Proportion of Income spent: If proportion of

income spent on a commodity is very small, its
demand will be less elastic and vice versa.

 Time factor: it time consumers take to adjust to a

new price: the longer the time taken, the greater the
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elasticity.
Income Elasticity of Demand (EY)
It shows the degree of responsiveness of Qd a good
to a small change in the income of consumers.

EY may be defined as the ratio of the proportionate

change in the quantity purchased of a good to the
proportionate change in income.

Income elasticity of demand (EY) can be positive,

negative or zero.
If EY is positive, the good is a normal good.
If EY is negative, the good is an inferior good.
If EY is Zero, neither normal nor inferior 34
Cont...
Examples 1: Suppose meat demand in Robe town.
The weekly demand for meat went down from
4,000 kg to 2,500 kg as the level of real income in
the economy decrease from $125 per day to
$75per day

Calculate the EY based on the given information.

Is the good is normal, inferior or neither?

Example 2: Let us assume that recently the

average income level has gone up by 75% that
resulted in extra money which eventually resulted
in an increase in consumption of juice by 25%.

Calculate the income elasticity of demand based

on the given information.
Feb. 04, 2010 35
Cross Elasticity of Demand
The change in the demand for one good in response to
the change in price of another is E Y of one good for the
other

. It is the responsiveness of demand to change in the

price of other commodities.

It is the proportionate change in the Qd of X resulting

from a proportionate change in the price of Y.

Cross elasticity may take positive, negative or zero

value.

When Exy is positive, the two goods are substitutes;

when Exy is negative, the two goods are complementary;
and
 when Exy is zero, the two goods are unrelated. 36
Cont...
Example #1: The Company producing torches and
batteries is want to analyze the E XY of the two related
goods. The demand for torches was 10,000 when the
price of batteries was $10 and the demand rose to
15,000 when the price of batteries was reduced to 8$.

Calculate cross elasticity of demand and interpret the

result

Example #2: The percentage change in the price of

apple juice changed by 18% and the percentage
change in the quantity of demand changed of orange
juice by 12%.

Calculate cross elasticity of demand and interpret the

Feb. 04, 2010 37
result
2.3.2. Elasticity of Supply
[Link]. Price elasticity of supply

•The law of supply states that higher prices raise the

quantity supplied without of explaining the amount.

•Price elasticity of supply is a measure of how much

the quantity supplied of a good respond to a change
in the price of that good,

•It is computed as the percentage change in

quantity supplied divided by the percentage change
in price.

•The price elasticity of supply depends on the

flexibility of sellers to change the amount of the
good they produce.
Feb. 04, 2010 38
Cont...
For example, land has an inelastic supply because
it is almost impossible to produce more of it. its
supply fixed in nature.

In contrast, manufactured goods have elastic

supplies b/c the firms that produce them can run
their factories longer in response to a higher price.

Key determinant of the price elasticity of supply is

the time period being considered.

Supply is usually more elastic in the long run than

in the short run
39
Cont...
Consider the following cases

Supply is perfectly inelastic (Es=0). The Qs is the

same regardless of the price.

Perfectly elastic (Es=∞):This occurs as the price

Es approaches infinity and supply curve become
horizontal

Inelastic supply (0<Es< 1): It a situation where

the proportionate change in Qs is less than the
proportionate change in price.

) Unit elasticity of supply (Es= 1): It a situation

where the proportionate change in Qs is equal to
the proportionate change in price 40
Cont....
Elastic supply (Es> 1): It is a situation where the
proportion change in Qs is much greater than the
proportionate change in price.

 A 33.33% increase in price results 50% increase in

Qs.

. Example 1: Calculate the value of PEs of

commodity. If the percentage change in price of the
commodity is 10% and percentage change in its Qs
is 18%.

Example 2: A firm sells 40 units of commodity X

when its price is 10. At what price it will sell 60 units
of the commodity if its price elasticity of supply is
Feb. 04, 2010 41

0.8.
Cont...
Example 3: If the price of oranges increases by 40% per
kg and its Qs increases from 100 to 125 kgs. Calculate
price elasticity of supply of oranges.

Approaches to Elasticity Measurement

There are two methods of measuring elasticity of

demand

1) Point Elasticity Method

2) arc method

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