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Introduction
 Demand and supply are the most fundamental concepts of
economics and widely applied in a market economy.

 This is one of the most important managerial factors

because it assists the managers in predicting changes in
production and input prices.

 Demand refers to how many (quantity) of a product or

service is required by buyers.

 Supply refers to the amount of good or service a producer

is willing and able to supply.

 Market Equilibrium is where demand and supply

intersect
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 A market is a group of individuals & firms that interact with
each other to buy or sell a particular goods or services
 Market Equilibrium point is determined by the interactions of
supply (sellers) and demand (buyers) 3
 Basis of Demand
 The basic source of demand is the need of individuals.

 Individuals need products and services and they are also

willing to pay a price to acquire those products and
services.

 The firms analyse the needs and create products and

services for them.

 The market for a firm’s product cannot be analysed

without reference to the demand conditions.

 Successful business firms, therefore, spend considerable

time, energy and effort in analysing the demand for
their products. 4
 Basis of Demand
Without a clear understanding of consumers’
behaviour, the firm is handicapped in its attempt
towards profit planning or any other business strategy
planning.

Hence, demand is the crucial requirements for the

existence of any business enterprise.

The decisions which management takes with respect to

production, advertising, cost allocation, pricing, etc., call
for an analysis of demand

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 Demand
 Ordinarily, demand to you would mean your
desire to buy something, but in economic sense it is
something more than a mere desire.

 It is interpreted as your want backed up by your

purchasing power.

 Example: a poor man’s desire for and his willingness

to pay for a car is not demand because he does not
have the necessary ability to pay (purchasing power).

 One can also think of a person who has both the will
and purchasing power to pay for a commodity, yet this is
not demand for that commodity if he does not have
desire to have that commodity.
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 Demand
 Further demand is per unit of time such as per day, per
week etc.

 Moreover, it is meaningless to mention demand without

reference to price.

 Considering all these aspects the term demand can be

defined as:

 The desire, willingness and ability to buy a specific

quantity of a commodity at the prevailing price in
a given period of time.

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 Demand
 Law of demand: The quantity of a commodity demanded
in a given time period increases as its price falls, ceteris
paribus =other things remaining constant

 This is because as the price of a good goes up, so

does the opportunity cost of buying that good.

 Demand schedule: a table showing the quantities of a

good that a consumer is willing and able to buy at the
prevailing price in a given time period.

 Demand Curve: A curve indicating the total quantity of a

good consumers are willing and able to purchase at each
possible price, ceteris paribus

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Demand

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 Determinants of Demand
 Is price the only determinant of demand?
 The demand theory says that the quantity demanded of a
commodity is a function of or depends on not only the
price of a commodity, but also on:
 income of the person,
 price of related goods – both substitutes and complements
tastes of consumer,
price expectation and
 all other factors
 Demand function is a comprehensive formulation which
specifies the factors that influence the demand for the
product. 10
Determinants of Demand

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Determinants of Demand

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 Determinants of Demand
The impact of these determinants on Demand is:

1. Price of the good:

 Price and demand are inversely related.

 Higher the price less is the demand and vice

versa.

 This relationship between price and quantity

corresponds to a movement along a given
demand curve.

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Effect of change in price

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 Income
 Income affects the ability of consumers to purchase a
good
 A change in income shifts the entire demand curve.
 Whether an increase in income shifts the demand curve
to the right or to the left depends on two types of goods:
 Normal good - demand increases (shifts to the right) when
consumer incomes rise.
 As income goes up, consumers buy more of these
goods at any given price.
 Conversely, when consumers suffer a decline in
income, the demand for a normal good will decrease
(shift to the left)
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Inferior good - as income goes up, consumers consume less
of these goods at each price.

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 Price of related goods
 The price of related goods like substitutes and
complementary goods also affect the demand.
 In the case of substitutes, rise in price of one commodity
lead to increase in demand for its substitute.
 E.g, if the price of coke increases, most consumers
will begin to substitute coke for pepsi. As a
consequence, the quantity of pepsi demanded will
tend to increase, and vice versa.
 In the case of complementary goods, fall in the price of
one commodity lead to rise in demand for both the
goods.
 E.g. demand for printers generates demand for ink
cartridges 18
 population
 Size: As the size of population increases, more and
more individuals wish to buy a given product, and this
has the effect of shifting the demand curve to the right.

 Composition: The composition of the population can

also affect the demand for a product.

 An increase in the number of children in 7 –

20 -year-old age bracket will increase the demand
for schools.

 As a greater proportion of the population ages,

the demand for medical services will tend to
increase.
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 ADVERTISING & CONSUMER TASTES
 An increase in advertising shifts the demand curve to
the right, from D1 to D2 .Why?

 Advertising provides consumers with information

about the existence or quality of a product, which in
turn induces more consumers to buy the product. These
types of advertising messages are known as informative
advertising.

 Advertising can influence demand by altering the tastes

of consumers. For example, advertising that promotes
the latest fad in clothing may increase the demand for a
specific fashion item. These types of advertising is
known as persuasive advertising.
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ADVERTISING & CONSUMER TASTES

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 EXPECTATION OF FUTURE PRICE
 If consumers expect the price of automobiles
to be significantly higher next year, the demand for
automobiles today will increase to D2 with quantity
demanded 60,000 unit at the same price level, RM40,000

 Similarly, if the price of automobile is expected

to be lower next year, the quantity demanded will
decrease to 35,000 unit with the price remaining unchanged

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 SUPPLY
 It is true that an economy runs on demand but that
demand has to be fulfilled with corresponding supply
as well.
 Supply is the specific quantity of output that the
producers are willing and able to make available to
consumers at a particular price over a given period of
time.
 A supply schedule is a table which lists the possible
prices for a good and service and the corresponding
quantity supplied.
 Supply Curve: A graphical representation of how
much of a commodity a firm sells at different prices. The
supply curve is upward sloping from left to right. 24
SUPPLY

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 SUPPLY
Law of Supply
 According to the Law of Supply, other things remaining
constant, higher the price of a commodity, higher
will be the quantity supplied and vice versa.

 There is a positive relationship between supply and

price of a commodity.

 Market supply is the summation of all individual

supplies at a given price. The market supply curve is
the horizontal sum of the individual supply curve.

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 Determinants Of Supply
 Price is not the only determinant of supply.

 Variables that affect the position of supply curve are

called supply shifters, and they include:

 the prices of inputs,

 the level of technology,

 the number of firms in the market,

 taxes, and

 producer expectations.
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 Determinants Of Supply
 Whenever one or more of these variables changes,
the position of the entire supply curve shifts. Such a
shift is known as a change in supply.

 The shift from S0 to S2 in the Figure below is

called an increase in supply since producers sell
more output at each given price.

 The shift from S0 to S1 represents a decrease in

supply since producers sell less of the product at
each price.

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 Determinants Of Supply
1. The cost of factors of production: Cost depends on the
price of factors. Increase in factor cost increases the cost
of production, and reduces supply (left ward shift in SS).

2. The state of technology: Use of advanced technology

increases productivity of the organization and increases its
supply (right ward shift in SS).

3. External factors: External factors like weather influence

the supply. If there is a flood, this reduces supply of
various agricultural products (SS shifts to the left).

4. Tax and subsidy: Increase in government subsidies

results in more production and higher supply (right ward
shift in SS). 30
 Determinants Of Supply
5. Transport: Better transport facilities will increase the
supply (causes right ward shift).
6. Price: If the prices are high, the sellers are willing to
supply more goods to increase their profit (causes a
movement along the same supply curve than causing
shifts).
7. Price of other goods: If the price of other goods is
more than ‘X’ then the supply of ‘X’ will be
increased (right ward shift in supply).
 If price of tea increases, supply of coffee will increase
 If the price of meat increases, the supply of skin will
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increase
 Price theory answers the question of interaction of
demand and supply to determine price in a competitive
market.
Shortage of Goods
 Price at point B; consumers wish to purchase Q1 units of
the good.
 Price at point A; producers willing to produce only Q0
units.
 Thus, when the price is PL, there is a shortage of the
good to satisfy consumers willing to purchase it at that
price.
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Surplus of Goods
 Suppose price is at higher level, PH to point F on market
demand curve: consumers wish to purchase Q0 units of
good.
 The price PH corresponds to point G on the market supply
curve; producers willing to produce Q1.
 Thus, when the price is PH, there is a surplus of good;
firms are producing more than they can sell at a price of
PH

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Demand equal Supply
 When a shortage exists, there is a tendency for the price
to rise.
 As the price rises from PL to Pe, producers have an
incentive to expand output from QO to Qe.
 But when the price rises at Pe, consumers are willing to
purchase less good at Qe.
 At this price, quantity demanded equals quantity
supplied.
 A competitive price, Pe, is called equilibrium price, and
the corresponding quantity, Qe, is called the equilibrium
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quantity for the competitive market.
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Thus, the interaction of supply and demand determines
market equilibrium at point E, where there is neither a
shortage nor a surplus of the good.

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Elasticity is the measure of responsiveness.

It is the ratio of the percent change in one variable to

the percent change in another variable.

The key thing to understand is that we use elasticity

when we want to see how one thing changes when we
change something else.

How does demand for a good change when we change

its price? How does the demand for a good change when
the price of a substitute good changes?

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 Elasticity
A manager should also be able to determine the magnitude of
the changes and provide detailed quantitative answers to
questions, such as:
How much do we have to cut our price to achieve 3% sales
growth?
If we cut price by 5%, how many more units will be sold?
How much will our revenues & cash flows change as a
result of the price cut?
How much will our sales change if rivals cut their prices
by 2% OR household real income decline by 6%
The tool used to determine the magnitude of these changes is
called elasticity analysis.
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TYPES OF ELASTICITY OF DEMAND

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

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Price Elasticity of Demand

The response of the consumers to a change in the

price of a commodity or

 it is the responsiveness of quantity demanded due

to changes in price .

 It is measured by dividing the percentage change in

quantity demanded by the percentage change in price.

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Example 1: If the quantity demanded for a good increases
15% in response to a 10% increase in price, the price
elasticity of demand would be

Example 2: Quantity demanded is 20 units at a price of

Birr 500. When there is a fall in price to Birr 400 it results
in a rise in demand to 32 units. Therefore the change in
quantity demanded is 12 units resulting from the change in
price of Birr 100.
The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3

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 Ranges/degrees/types of Price Elasticity of Demand
Relatively Elastic Demand (Ed >1) a small percentage
change in price leading to a larger change in Quantity
demanded. (10%/5%)

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Perfectly Elastic Demand (Ed = ∞) a small change in
price will change the quantity demanded by an infinite
amount.

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Relatively Inelastic Demand (Ed < 1) a change in price
leads to a smaller percentage change in quantity demanded
(5%/6%)

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Perfectly Inelastic Demand (Ed = 0) the quantity
demanded does not change regardless of the percentage
change in price (0/5%).

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Unit Elasticity of Demand (Ed =1) the percentage
change in quantity demanded is the same as the
percentage change in price that caused it (5%/5%)
The demand curve will be known by gentle slope

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The Price elasticity of demand depends on the following
factors:
1. Nature of the commodity: The demand for necessities is
inelastic because the demand does not change much with a
change in price. But the demand for luxuries is elastic in
nature.
2. Range of substitutes: The commodity which has more
number of substitutes has relatively elastic demand. A
commodity with fewer substitutes has relatively inelastic
demand.
3. Income level: People with high incomes are less affected
by price changes than people with low incomes.
4. Time: In the short run demand will be less elastic but in
the long run the demand for commodities are more elastic.48
5. Proportion of income spent on the commodity: When a
small part of income is spent on the commodity, the price
change does not affect the demand therefore the demand is
inelastic in nature
6. Urgency of demand / postponement of purchase: The
demand for certain commodities are highly inelastic because
you cannot postpone its purchase. For example medicines for
any sickness should be purchased and consumed immediately.
7. Durability of a commodity: If the commodity is durable then
it is used it for a long period. Therefore elasticity of demand is
high. Price changes highly influences the demand for durables
in the market.
8. Purchase frequency of a product/ recurrence of demand:
The demand for frequently purchased goods are highly
elastic than rarely purchased goods. 49
Income Elasticity
Income elasticity of demand measures the responsiveness of
quantity demanded to a change in income.
It is measured by dividing the percentage change in
quantity demanded by the percentage change in income.

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The following are the various types of income elasticity:

Zero Income Elasticity: The increase in income of the

individual does not make any difference in the demand for
that commodity (EM = 0)

Negative Income Elasticity: The increase in the income

of consumers leads to less purchase of those goods (EM <
0).

Unitary Income Elasticity: The change in income leads

to the same percentage of change in the demand for the
good ( EM = 1).
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 Income Elasticity of Demand
Income Elasticity is Greater than 1: The change in
income increases the demand for that commodity more
than the change in the income (EM > 1).

 Income Elasticity is Less than 1: The change in

income increases the demand for the commodity but at a
lesser percentage than the change in the Income (EM < 1).

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 Elasticity Of Demand
Cross Elasticity of Demand
The quantity demanded of a particular commodity varies
according to the price of other commodities.
Cross elasticity measures the responsiveness of the quantity
demanded of a commodity due to changes in the price of
another commodity.
 For example, the demand for tea increases when the price of
coffee goes up. Here the cross elasticity of demand for tea is
high.
If two goods are substitutes then they will have a positive
cross elasticity of demand.
In other words if two goods are complementary to each
other then negative cross elasticity may arise. 53
 Cross Elasticity of Demand
The responsiveness of the quantity of one commodity
demanded to a change in the price of another good is
calculated with the following formula.

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 Elasticity of supply
Elasticity of supply of a commodity is defined as
the responsiveness of a quantity supplied to a unit
change in price of that commodity

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 Elasticity of Supply
Kinds of Elasticity of Supply
Perfectly inelastic: If there is no response in supply to a
change in price.(Es = 0)
Inelastic supply: The proportionate change in supply is
less than the change in price (Es <1 but >0)
Unitary elastic: The percentage change in quantity
supplied equals the change in price (Es=1)
Elastic: The change in quantity supplied is more than the
change in price (Es>1 but < ∞)
Perfectly elastic: Suppliers are willing to supply any
amount at a given price (Es=∞) 56
 Elasticity of Supply
Factors Influencing Elasticity Of Supply
1. Nature of the commodity: If the commodity is
perishable in nature then the elasticity of supply will be
less. Durable goods have high elasticity of supply.

2. Time period: If the operational time period is short then

supply is inelastic. When the production process period
is longer the elasticity of supply will be relatively elastic.

3. Size of the firm and number of products: If the firm is

a large scale industry and has more variety of
products then it can easily transfer the resources.
Therefore supply of such products is highly elastic.
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 Elasticity of Supply
4. Scale of production: Small scale producer’s supply is
inelastic in nature compared to the large producers.

5. Natural factors: Natural calamities can affect the

production of agricultural products so they are relatively
inelastic.

 Apart from the above mentioned factors

 future expectations of the market,

 natural resources of the country and

 government controls can also play a role in

determining supply of a good.
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 Useful for the managers
The concept of elasticity is useful for the managers for the following
decision making activities

1. In production i.e. in deciding the quantity of goods to be

produced

2. Price fixation i.e. in fixing the prices not only on the cost basis
but also on the basis of prices of related goods.

3. In distribution i.e. to decide as to where, when, and how much etc.

4. In international trade i.e. what to export, where to export

5. In foreign exchange

6. For nationalizing an industry

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7. In public finance