Chapter Two:

Theory of Demand and

Supply
Contents
2.1. Theory of Demand
2.1.1. Demand function, demand schedule and demand
curve
2.1.2. Determinants of Demand
2.1.3. Elasticity of Demand
2.2. Theory of Supply
2.2.1. Supply function, supply schedule and supply
curve
2.2.2. Determinants of supply
2.2.3. Elasticity of supply
2.3. Market equilibrium
2.1 Theory of Demand
The theory of demand is related to the
economic activities of consumers-consumption.
The purpose of the theory of demand is to
determine the various factors that affect
demand.

What is demand in Economics?

 In economics the word “Demand” has a specific
meaning, which is different from what we use it
in our day to day activities.
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.
 2.1 Theory of…cont
Thus, demand is different from a mere desire.
Human wants are unlimited, and therefore, desires are
many. But only a desire that is backed up by the capacity
to pay the price for the commodity and the willingness
to buy it, is termed as a demand.

We may say demand refers to an effective desire/wish.

Demand = ability to pay + willingness to pay +

availability of the good

 Law of demand: This is the principle of demand, which

states that, price of a commodity and its quantity
demanded are inversely related i.e., as price of a
commodity increases (decreases) quantity demanded for
that commodity decreases (increases), ceteris paribus.
2.1.1 Demand schedule (table), demand curve and
demand function
These are three ways of representing the relationship
that exists between price and the amount of a commodity
purchased.

A) A demand schedule: is the relationship between price

and quantity demanded in a table form.

Table 2.1: Individual household demand for orange per

week

A B C D E
Price (Per KG) 5 4 3 2 1
QD(Per Week) 5 7 9 11 13
 2.1.1 Demand… cont

B) 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.
 2.1.1 Demand…cont
C) Demand function: is a mathematical relationship
between price and quantity demanded, all other things
remaining the same.
 A typical demand function is given by:
𝑸𝑫 = 𝒇(𝒑)
 Example: Let the demand function be 𝑸𝑫 = 𝒂 + 𝒃𝑷
∆𝑸
Where 𝒃 = , which is the slope of the demand
∆𝑷
curve.
For instance, if we move from point A to point B on
figure 2.1 or Table 2.1, then,
∆𝑸 𝟕−𝟓 𝟐
𝒃= = = =-2
∆𝑷 𝟒−𝟓 −𝟏
Thus, 𝑸𝑫 = 𝒂 − 𝟐𝑷
To find a, lets substitute for 𝑄𝐷 and P at pint A or B.
7= 𝒂 − 𝟐(𝟒); a = 𝟕 + 𝟖 = 𝟏𝟓
𝑸𝑫 = 𝟏𝟓 − 𝟐𝑷 ∶ The individual demand function
2.1.1 Demand…cont

Market Demand: The market demand schedule, curve

or function is derived by horizontally adding the
quantity demanded for the product by all buyers at
each price.
Example:
Table 2.2: Individual and market demand for a
commodity

Prices Individual Demands Market

Demand
Consumer 1 Consumer 2 Consumer 3
8 0 0 0 0
5 3 5 4 9
3 5 7 6 14
0 7 9 8 20
 2.1.1 Demand…cont

The following graph depicts market demand curve at price equal to three.
2.1.1 Demand…cont

Market Demand Function:

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:
𝑄
𝑃 = 10 −
2
𝑄
= 10 − 𝑃
2
𝑄 = 20 − 2𝑃
Market Demand Function = Number of buyers *
Individual Demand function
𝑄𝑀 = 20 – 2𝑃 100
𝑄𝑀 = 2000 − 200𝑃
Thus, 𝑸𝒎 = 𝟐𝟎𝟎𝟎 − 𝟐𝟎𝟎𝒑: Market Demand Function
2.1.2 Determinants of demand
 The demand for a product is influenced by many
factors. Some of these factors include:

A) Price of the product itself: The price of a

commodity is the most important factor which affects
the demand for a commodity.
 Other things remaining the same, if price increases,
quantity demanded decreases, and if price decreases,
quantity demanded increases(Law of Demand).

B) Income of the Consumer: Income of the consumer is

also an important factor affecting the demand for a
commodity. Generally, when income increases, demand
also increases, and when income decreases, demand also
decreases. This is true in the case of normal goods.
However, in the case of inferior goods, with an increase
in income their demand decreases and vice-versa.
2.1.2 Determinants…cont
On the basis of nature, goods can be classified into two
types:
i) 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.
ii) Inferior Goods: 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. 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.
For example: Some Chinese shoes, coarse
cloth, leftover food etc.
2.1.2 Determinants…cont
C) 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:

i) Substitute Goods: are those goods which can be used in

place of each other to satisfy a given want. That is why
they are also called competitive goods.
 For example, Coffee and tea, Pepsi and Coca-Cola, pens
and pencils, butter and oil, etc.

ii) Complementary Goods: are those goods which are used

together/jointly to satisfy a given want. If two goods are
complementary goods, a decline in the price of one would
directly change the demand for the other commodity and
vice-versa.
 For example, cars and petrol/fuel, pen and ink, tea and
sugar are complements of each other.
2.1.2 Determinants…cont

D) Tastes and Preferences: If a consumer is accustomed

to certain commodities, he will demand that commodity and
this leads to increase in the demand for that commodity.

 When the taste of a consumer changes in favor of a

good, her/his demand will increase and the opposite is
true.

E) Consumer expectation of income and price

 Higher price expectation will increase demand while a

lower future price expectation will decrease the demand
for the good.
2.1.2 Determinants…cont
F) Number of buyer in the market(Population) and
family size

 Since market demand is the horizontal sum of

individual demand, an increase in the number of
buyers will increase demand while a decrease in the
number of buyers will decrease demand.

G) Climate/Weather: The demand for a commodity

is also affected by climate.

For example, demand for woolen clothes increases

in cold seasons. On the other hand demand for
coolers, cotton clothes etc., increases in hot
seasons.
 2.1.2 Determinants…cont

Generally, 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.

Change in Demand
 a change in any
determinant of
demand—except for
the good‘s price
causes the demand
curve to shift. We
call this a change in
demand.
 2.1.2 Determinants…cont
 When we state the law of demand, we kept all the
factors to remain constant except the price of the
good under consideration.
 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.
 A change in own price is only a movement along the
same demand curve.
 Thus, a change in demand is observed by a shift in
the demand curve, while a change in quantity
demanded is expressed by a movement in the
demand curve.
2.1.3 Elasticity of demand
 In economics, the concept of elasticity is very crucial
and is used to analyze the quantitative relationship
between price and quantity purchased or sold.
 Elasticity is a measure of responsiveness of a
dependent variable to changes in an independent
variable.

 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.

 Commonly, there are three kinds of demand elasticity:

1) price elasticity,
2) income elasticity, and
3) cross elasticity.
 2.1.3 Elasticity…cont
i) Price Elasticity of Demand
 Price elasticity of demand: refers to the degree of
responsiveness of demand to change in price.
 It is a measure of how much the quantity demanded of a
good responds to a change in the price of that good,
computed as the percentage change in quantity
demanded divided by the percentage change in price.
 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.
 Demand for commodities like clothes, fruit etc. changes
when there is even a small change in their price, whereas
demand for commodities which are basic necessities of
life, like salt, food grains etc., may not change even if
price changes, or it may change, but not in proportion to
the change in price.
 2.1.3 Elasticity…cont
 Price elasticity demand can be measured in two ways.
These are point and arc elasticity.
A) Point Price Elasticity of Demand
 This is calculated to find elasticity at a given point,
and given as:
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %∆𝑄𝐷
=
𝑝
𝑒𝑑 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 %∆𝑃
𝑄2 −𝑄1
∗100% 𝑄2 −𝑄1 𝑃1 ∆𝑸 𝑷𝟏
= * = *
𝒑 𝑄1
𝒆𝒅 = 𝑃2 −𝑃1
∗100% 𝑃2 −𝑃1 𝑄1 ∆𝑷 𝑸𝟏
𝑃1
 In this method, we take a straight-line demand curve
joining the two axes, and measure the elasticity
between two points Q2 and Q1 which are assumed to be
intimately close to each other.
 Example: Suppose the price of the commodity falls
from Birr 5 to Birr 4 and quantity demanded increases
from 100 units to 150 units. Given this, Compute point
price elasticity of demand.
2.1.3 Elasticity…cont
𝑄2 −𝑄1 𝑃1 150−100 5 250
 Solution: * = * = = -2.5
𝑃2 −𝑃1 𝑄1 4−5 100 100
 This implies that, at price = Birr 5, if price decreases
by 1%, quantity demand increases by 2.5%.
 2.1.3 Elasticity…cont
NOTE: It should be remembered that the point elasticity
of demand on a straight line is different at every point.

B) Arc price elasticity of demand

 The main drawback of the point elasticity method is
that it is applicable only when we have information about
even the slight changes in the price and the quantity
demanded of the commodity.
 But in practice, we do not acquire such information about
minute changes. We may possess demand schedules in
which there are big gaps in price as well as the
quantity demanded.
 In such cases, there is an alternative method known as
arc method of elasticity measurement.
 When elasticity of demand is measured over a finite
range or ‘arc’ of a demand curve, it is called arc
elasticity of demand.
2.1.3 Elasticity…cont

 In arc price elasticity of demand, the midpoints of the old and

the new values of both price and quantity demanded are used.
 It measures a portion or a segment of the demand curve between
the two points.
 The formula for measuring arc elasticity is given below.
𝑪𝒉𝒏𝒂𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆
↋𝒂𝒅 = 𝑪𝒉𝒏𝒂𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅
/
𝑺𝒖𝒎 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒂𝒏𝒅 𝒏𝒆𝒘 𝒑𝒓𝒊𝒄𝒆𝒔
𝑺𝒖𝒎 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒂𝒏𝒅 𝒏𝒆𝒘 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅
𝑄2 −𝑄1 𝑃2 −𝑃1 ∆𝑸 𝑷𝟐 +𝑷𝟏
↋𝑎𝑑 = / = *
𝑄2 +𝑄1 𝑃2 +𝑃1 ∆𝑷 𝑸𝟐 +𝑸𝟏
Example: Assuming the previous hypothetical example, compute the
arc elasticity of price demand.
Solution: In terms of the above formula,
∆𝑸 𝑷𝟐 +𝑷𝟏 150−100 4+5 45 −9
𝑎
↋𝑑 = * = * = = = -1.8
∆𝑷 𝑸𝟐 +𝑸𝟏 4−5 150+100 −25 5
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.
 2.1.3 Elasticity…cont

 From Price elasticity of Demand, we can have the

following points
 Elasticity of demand is unit free because it is a
ratio of percentage change.
 Elasticity of demand is usually a negative number
because of the law of demand. If the price
elasticity of demand is positive the product is
inferior/Giffen goods.
 If |↋| > 1 , demand is said to be elastic and the
product is luxury product.
 If , 0 < |↋| < 1, demand is inelastic and the product
is necessity.
 If |↋| = 1, demand is unitary elastic.
 If |↋| = 0, demand is said to be perfectly inelastic.
 If |↋| = ∞, demand is said to be perfectly elastic.
 2.1.3 Elasticity…cont

Determinants of Price Elasticity of Demand

i) The availability of substitutes: the more substitutes available for
a product, the more elastic will be the price elasticity of demand.
ii) Time: In the long- run, price elasticity of demand tends to be
elastic. Because: More substitute goods could be produced. People
tend to adjust their consumption pattern.
iii) 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.
iv) The importance of the commodity in the consumers’ budget :
 Luxury goods: tend to be less elastic. Example: gold.
 Necessity goods: tend to be less elastic. Example: Salt.
V) Number of use of the commodity:
The higher the number of use of the commodity the higher will be the
elasticity. Example: Electricity.
vi) Habits of the consumers: Example: Cigarette Smokers
2.1.3 Elasticity…cont

ii. Income Elasticity of Demand

 It is a measure of responsiveness of quantity
demanded to change in income.
𝑄2 −𝑄1
∗100% 𝑄2 −𝑄1 𝑀1 ∆𝑸 𝑴𝟏
= * = *
𝑄1
↋𝑰𝒅 = 𝑀2 −𝑀1
∗100% 𝑀2 −𝑀1 𝑄1 ∆𝑴 𝑸𝟏
𝑀1
 Accordingly,
 If ↋𝐼𝑑 > 1, the good is luxury good.
 If 1 < ↋𝐼𝑑 < 1, ( and positive), the good is necessity
good
 If ↋𝐼𝑑 < 0, (negative), the good is inferior good.
Example: Suppose a consumer has money income of Birr
1000 and he purchases 4 kg of wheat. If his money
income goes up to Birr 1200, he is now prepared to buy 5
kg of wheat. Compute the point income elasticity of
demand.
2.1.3 Elasticity…cont
Solution:
𝑄 −𝑄 𝑀 5−4 1000 1000
↋𝑰𝒅 = 2 1 * 1 = * = = 1.25, implies for a
𝑀2 −𝑀1 𝑄1 1200−1000 4 400
1 percent increase in income there is a 1.25 percent
increase in the demand of the commodity and the
commodity is normal(luxury).

iii) Cross Elasticity of Demand

 Measures how much the demand for a product is
affected by a change in the price of another
good(related good).
 The formula used to compute cross elasticity is:

𝑄𝑥2 −𝑄𝑥1
∗100% 𝑄𝑥2 −𝑄𝑥1 𝑃𝑦1 ∆𝑸𝑿 𝑷𝒚𝟏
= * = *
𝒙𝒚 𝑄𝑥1
↋𝒅 = 𝑃𝑦2 −𝑃𝑦1
∗100% 𝑃𝑦2 −𝑃𝑦1 𝑄𝑋1 ∆𝑷𝒚 𝑸𝑿𝟏
𝑃𝑦1
 2.1.3 Elasticity…cont
According to the values of ↋𝒅 ,
𝒙𝒚

i) If ↋𝒅 is positive, the goods are substitute goods.

𝒙𝒚

ii) If ↋𝒅 is negative, the goods are complementary goods.

𝒙𝒚

iii) iii) If ↋𝒅 is zero, the goods are unrelated goods.

𝒙𝒚

Example: Suppose that when the price of a good Y increases from 10

birr to 15 birr, then the quantity demanded of a good X has decreased
from 1500 units to 1000 units. Compute the cross price elasticity of
demand.

Solution:
𝑄𝑥2 −𝑄𝑥1 𝑃𝑦1 1000−1500 10 −𝟓𝟎𝟎 𝟏
↋𝒅 = * = * = * = -0.667, implying for a
𝒙𝒚
𝑃𝑦2 −𝑃𝑦1 𝑄𝑋1 15−10 1500 𝟓 𝟏𝟓𝟎
percent increase in the price of a good Y, there is 0.667 percent
decrease in the quantity demanded of price good X. The two good are
complementary.
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 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.
2.2.1 Supply schedule, supply curve and supply function
 A supply schedule is a tabular statement that states the
different quantities of a commodity offered for sale at
different prices.
Table 2.3: an individual seller’s supply schedule for butter
Price ( birr per KG) 30 25 20 15 10
QS(KG/Week) 100 90 80 70 60
 2.2 THEORY OF…cont
 A supply curve: conveys the same information as a
supply schedule. But it shows the information graphically
rather than in a tabular form.

 Supply Function: Mathematical representation. The

supply function of a commodity can be briefly expressed
in the following functional relationship:
S = f(P),
Where S is quantity supplied and P is price of the
commodity.
 2.2 THEORY OF…cont
Market supply: It is derived by horizontally adding
the quantity supplied of the product by all sellers at
each price.
2.2.2 Determinants of supply
 Apart from the change in price which causes a
change in quantity demanded, the supply of a
particular product is determined by:
i) Input Price:
 An increase in the price of inputs such as labour,
raw materials, capital, etc. causes a decrease in
the supply of the product which is represented by
a leftward shift of the supply curve.
Ii) State of Technology
 Technological advancement enables a firm to
produce and supply more in the market. This shifts
the supply curve outward.
iii) Price of Related Goods: An increase in the price
of other, related goods induces the firms to produce
more of those other goods, leading to a reduction in
the supply of the goods whose price has remained
unchanged.
2.2.2 Determinants of…cont
iV) Objectives of the Firm: Beside/apart from to the
primary profit maximization objective, firms could have
such as objectives of maximum sales, maximum
employment, more production, etc. In this case, the
supply will be increasing.
V) Weather condition
 A change in weather condition will have an impact on
the supply of a number of products, especially
agricultural products.
Vi) Sellers‘ expectation of price of the product:
vii) Number of sellers in the market
vii) Taxes & Subsidies (Fiscal Policy)
viii) Other factors: Market access (infrastructural
development), political stability. etc.
2.2.3 Elasticity of supply
 It is the degree of responsiveness of the supply
to change in price. It may be defined as the
percentage change in quantity supplied divided by
the percentage change in price.
 As the case with price elasticity of demand, we can
measure the price elasticity of supply using point
and arc elasticity methods.
 However, a simple and most commonly used method
is point method.
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 %∆𝑸𝑺
=
𝑝
↋𝑠 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 %∆𝑷
𝑄2 −𝑄1
∗100% 𝑄2 −𝑄1 𝑃1 ∆𝑸 𝑷𝟏
= * = *
𝒑 𝑄1
↋𝑺 = 𝑃2 −𝑃1
∗100% 𝑃2 −𝑃1 𝑄1 ∆𝑷 𝑸𝟏
𝑃1
 Given the value of 𝒆𝑺 , like elasticity of demand,
𝒑

price elasticity of supply can be elastic, inelastic,

unitary elastic, perfectly elastic or perfectly
inelastic.
2.3 Market equilibrium Market equilibrium
occurs when market demand = market supply.
Example: Given market demand: 𝑸𝒅 = 𝟏𝟎𝟎 − 𝟐𝑷 , and
market supply: 𝑷 = ( 𝑸𝒔 /𝟐) + 𝟏𝟎
a) Calculate the market equilibrium price and quantity
b) b) Determine, whether there is surplus or shortage at
P= 25 and P= 35
Solution:
a) At equilibrium, Qdv= Qs
100 – 2P = 2P – 20
4P =120
𝑷∗ = 𝟑𝟎 and 𝑸∗ = 𝟒𝟎
b) Qd(at P = 25) = 100-2(25) = 50 and
Qs(at P = 25 ) = 2(25) -20 =30
Therefore, there is a shortage of: 50 - 30 = 20 units
Qd( at P=35) = 100-2(35) = 30 and
Qs (at p = 35) = 2(35)-20 = 50
Therefore, there is a surplus of: 30 – 50 = -20 units.
Effects of shift in demand and supply on
equilibrium
What will happen to the equilibrium price and quantity ?
i) When demand changes and supply remains
constant

 Thus, supply being given, a decrease in demand reduces both

the equilibrium P and Q and vice versa.
ii. When supply changes and demand remains constant

 Thus, give the demand, an increase in supply

reduces the equilibrium P and increases the
equilibrium Q, and vice versa.
III) Effects of combined changes in demand and
supply
 When both demand and supply increase, the quantity
of the product will increase definitely. But it is not
certain whether the price will rise or fall.
 Three Scenarios:
1) If an increase in demand is more than an
increase in supply, then the price goes up.
2) if an increase in supply is more than an increase
in demand, the price falls.
3) If the increase in demand and supply is same,
then the price remains the same.
 Besides, when demand and supply decline, the quantity
decreases.
 But the will depend upon the relative fall in demand
and supply. change in price
 In this case too, there will be three Scenarios:

1) When the fall in demand is more than the fall in

supply, the price will decrease.
2) When the fall in supply is more than the fall in
demand, the price will rise.
3) If both demand and supply decline in the same
ratio, there is no change in the equilibrium price,
but the quantity decreases.

Therefore, when both supply and demand change, the

effect on the equilibrium price depends on the proportion
of change(relative change) in demand and change in supply.
 Assignment
I) The market demand for a product is given as: 𝒑 = 𝟒𝟎 −
𝟏/𝟒𝑸𝒅 and the market supply for the product is given as:
𝟏
𝒑 = 𝑸𝑺 + 𝟒.
𝟓
A) Compute the market clearing price and market
clearing quantity. (4%)
B) What happens to the equilibrium levels of price and
quantity in (A),
i) if both market demand and market supply decline in
the same ratio or proportion. (2%)
ii) if both market demand and market supply increase
in the same ratio or proportion. (2%)
iii)If the decline in market demand is more than the
decline in market supply. (2%)
NB: Properly demonstrate your Answers for questions in
(B) using Graphs.
(Otherwise, will not be evaluated)