CHAPTER-TWO

THEORY OF DEMAND AND SUPPLY

• What is a Market?
• A market is an institution or an established arrangement or place or mechanism, which brings
together buyers (demanders) and sellers (suppliers) of particular goods or services.
 Thus, market model deals with the following theories.

• Theory of demand

• Theory of supply

• Theory of equilibrium.

• Theory of elasticity

• Market structure
Demand in economics is defined as a schedule, which shows the various
amounts of a product which consumers are willing and able to purchase at
each specific price in a series of possible prices during some specified period
of time in a specified market.

• It shows the quantities of a product which will be demanded at various

prices, all other things being equal (ceteris paribus assumption).
Demand schedule is a tabular presentation of the demand for a commodity.

Demand Curve It is a graphic representation of preferences for a particular

good.
The Law of Demand:

• Keeping all other factors being constant (ceteris paribus), as price falls, the
corresponding quantity demanded rises

• The market (aggregate) demand is driven by summing up the demand of

all persons participating In the market for that particular product.
 Factors Influencing Demand
Generally, there are two determinants.

1. Own-price determinant/demand mover-the price of the product

2. Non- Own-price determinants/demand shifters
 Preference/tastes of consumers
 Money income of consumers
 Price of related goods
 Number of consumers
 Consumer expectation w.r.t. future price and income
Culture, religion and government policy.
These determinants of demand are also called demand shifters.
Change in demand: Demand for different goods changes overtime. Change
in demand is the total change in the quantity data of the demand schedule
having price constant.
Change in quantity demanded: This is movement along the original
demand curve.
Price, P

Price, P
B

A
D3
D2 D1
D1
0 Quantity demanded 0 Quantity demanded

a. A change in demand (a shift in b. A change in quantity

the demand curve) demanded
Supply of a commodity can be defined as the quantity that producers are
willing and able to offer for sale in a given time period at citrus paribus.

The Supply Schedule: It is a tabular presentation of the supply for a product.

The Supply Curve:The supply curve is simply the graphic representation of

the supply schedule or the concept of supply.S
Price (Birr/quintal)

Quantity of wheat supplied (quintal/week)

Law of Supply:

Other things being equal, the higher the price of a good, the greater is the
quantity supplied, i.e. price and quantity supplied is directly related.

An individual supply curve represents the price-quantity combinations for a

single seller (or firm)

The market supply is simply the horizontal sum of the individual supply
curves.
 Factors Influencing Supply:
Change in price of inputs (factors of production)

Change in the level of technology

Change in the price of other goods within the producer’s production plan

Change in the level of taxes and subsidies

Number of Suppliers

Nature, especially weather and pests

Expectation
• Change in Supply
• Change in supply is a total change in the location of the supply curve. The
change or shift in supply could be an increase or a decrease
• Change in quantity supplied
• This is movement from one point to another point on a stable supply curve
(the original supply curve)
S2
C
P3

S3
P1
A

P1 P2
B

S1
q2 q1 q3 Qs
0
0 q2 q1 q3 Qs
Market Equilibrium Determination

In any market one of the following three conditions may exist:

Excess demand (shortage): a condition in which quantity demanded is greater

than quantity supplied.

Excess supply (surplus): a condition in which quantity supplied is greater than

quantity demanded at the current price

Equilibrium or balances-where the quantity demanded and quantity supplied

are equal at the current prices.
Price (Birr/qt)

PE E

0 QE Quantity of wheat (qt/wk)

Equilibrium Price

• It is the price at which the wishes of buyers and sellers coincide. The price
that exists when the quantity demanded equals the quantity supplied in a
given market for specific time period.

• Equilibrium Quantity

• It is the quantity that corresponds the equilibrium price

• The quantity at which the amount of the good buyers are willing to buy
equals the amount sellers are willing to sell, and both equal the amount
actually bought and sold.
Disequilibria Price: A price other than equilibrium price. A price at which
quantity demanded does not equal quantity supplied. A state of either surplus or
shortage is in a market
Effects of change in Demand and Supply on the Equilibrium State

Equilibrium price and quantity are determined by supply and demand. Any time either
demand or supply or change, equilibrium price and quantity change. There are different
cases where this occurs.

Case I. Change in Demand Supply being Constant

Increase in demand, supply being constant

Decrease in demand, supply being constant

Case II. Change in supply assuming that demand is constant

Increase in supply, demand being constant

Decrease in supply, demand being constant

 Cont’d

Case III. When both demand and supply change (combined effect)

a. Supply and demand change in opposite direction (in equal or unequal magnitude of
change)

When demand increases but supply decreases

When demand decreases but supply increases

b. Supply and demand change in the same direction (in equal or unequal magnitude
of change)

I. Both demand and supply increase

ii. Both demand and supply decrease

Limitation of the Market as a Resource Allocator

• Demise of competition: competition, the control mechanism of the system,

tends to decline overtime.

• Inherent income inequalities, inability to register collective wants, and the

presence of external benefits and costs prevent the market system from
producing that collection of goods most wanted by society.

• The competitive market system does not guarantee full employment or price
level stability.
The Concept of Elasticity

Elasticity is a general concept that can be used to quantify the response in one
variable when another variable changes. It denotes the responsiveness of one
variable to changes in another. It is a measure of the responsiveness of a
market to a stimulus (change in a variable).

• There are various types of elasticities but here we confined ourselves to two
types only.

• Elasticity of demand

• Elasticity of supply
 Most commonly, three types of elasticities of demand are computed:

Own-price elasticity of demand

Cross-price elasticity of demand

Income-elasticity of demand

• In each case, the measure will be defined as the ratio of the proportionate
change in the quantity demanded for a particular good to the proportionate
change in a specified determinant of demand (price or income or price of
related goods or services).
Own-price elasticity of demand: measures how sensitive or responsive
consumers are to a change in the price of the commodity under consideration
other factors held constant.

• It is the percent of change in the quantity of a good demanded that is induced

by a one percent change in price.

• It is the relative responsiveness of quantity demanded to changes in

commodity price; in other words, price elasticity is the proportional change in
quantity demanded divided by the proportional change in price.
• Mathematically, the formula to calculate own-price elasticity of demand (Edp),
or simply called elasticity of demand, is given as follows:

Edp = Percentage change in quantity demanded

Percentage change in price
Edp = Q / Qi = % Q
P /Pi %P
Where,  Q = Change in quantity demanded
 P = Change in price
Qi = Initial quantity
Pi = Initial price
• This formula is called point-elasticity formula
• The own-price elasticity will be non-positive (showing the fact that price and
quantity are inversely related) but the convention among economists is to
ignore the sign and to simply consider the absolute value of the elasticity
coefficient. Its numerical value varies from zero to infinity.

• However, the point elasticity formula has problems in applying it for large
changes (even for changes from zero to any positive figure). Therefore, the
mid-point (arc elasticity) formula is used.
• Mid- point formula

Edp = Change in quantity  Change in price

Average of quantities Average of prices

Edp = Q  P
(Qi + Qf)/2 (Pi + Pf)/2

Where, Q = Change in quantity demanded

P = Change in price
Qi = Initial quantity Qf = Quantity final
Pi = Initial price Pf = Price final
There are three categories of price elasticity of demand based on the size of the elasticity
coefficient:

1. Elastic 2. Inelastic 3. Unitary elastic

• Elastic: (Edp > 1). Quantity changes by a larger percentage than price, i.e. it occurs
when some percent change in price results in a large percentage change in quantity

• Inelastic demand: (Edp < 1). When a decline in prices brings a smaller percentage
increase in quantity, i.e. quantity changes by a smaller percentage than price.
Consumers are less responsive to a price change.

• Unitary elastic: (Edp = 1). This is the intermediate case. In this situation quantity
changes by the same percentage as price, i.e. both changes in the same proportion.
• There are also two extreme cases:

a). Perfectly inelastic: quantity demanded does not change as price changes.
Quantity demanded is completely unresponsive to changes in price. Own-price
elasticity of demand (Edp) is zero. The demand curve in this case is a vertical line.

b). Perfectly elastic: consumers will purchase all they can at a particular price but
none of the product at a higher price (Edp =). Here a slight change in price
corresponds to an infinitely large change in quantity. Quantity demanded is
extremely responsive to even very small changes in price (from buying something
to buying nothing). The demand curve in this case is a horizontal line.
Cross-Price Elasticity of Demand
• It measures the relative responsiveness of quantity demanded of a given commodity to

changes in the price of a related commodity. In other words, it is the proportional change in
the quantity demanded of good X divided by the proportional change in the price of good Y.

Edx = Proportionate change in the quantity demanded of good X

Proportionate change in the price of good Y

• Where, good X and good Y are related goods.

Edx = Qx   Py

(Qx1 + Qx2)/2 (Py1 + Py2)/2

• Where, Qx = Change in quantity demanded of good X

Py = Change in price good Y

Qx1= Initial quantity of good X Qx2 = Final quantity of good X

Py1 = Initial price of good Y Py2 = Final price of good Y

• The sign and the magnitude of cross-price elasticity coefficient have meanings.
The sign of cross-elasticity is negative if goods X and Y are complements (Edx <
0) and positive (Edx >0) if X and Y are substitutes. The larger the magnitude of
the Edx, the higher is the degree of substitution or complementarities between the
two goods.
Income- elasticity of demand

• It relates changes in the quantity demanded to changes in income. It

measures the degree of responsiveness of the quantity demanded of a
product to changes in income.

• In other words, it measures the responsiveness of consumers to income

changes as the demand curve shifts from one position to another. It is the
proportional change in quantity demanded divided by the proportional
change in income.
 Edy = Percentage change in quantity (%Q)
Percentage in income (%Y)

Edy =  Q  Y
(Qi + Qf)/2 (Yi + Yf)/ 2

• Where, Q = Change in quantity demanded

P = Change in price
Qi = Initial quantity Qf = Quantity final
Yi = Initial income Yf = Income final
• If demand increases when income increases, the income elasticity is a
positive number and such goods are superior or normal goods. (Edy > 0)

• If demand decreases with an increase income, the income elasticity is

negative and such goods are inferior goods. (Edy < 0).

• Income elasticity of demand can be also calculated from expenditure

measures.

Edy = % change in expenditure on good ‘X’

% Change in consumer income

• In the same way as we did for the price elasticity of demand, income
elasticity of demand can be categorized in to three:

• Income elastic: the percentage change in quantity demanded of a good is

greater than the percentage change in income. Edy >1.

• Income inelastic: the percentage change in quantity demanded of a good is

less than the percentage change in income. Edy < 1.

• Income unit elastic: the percentage change in quantity demanded of a good

is equal to the percentage change in income. Edy = 1.
 Determinants of Elasticity of Demand
 Substitutability (the number of substitutes available):

 The number of uses that the good can be put

 The proportion of income spent on a particular product (percentage of one’s

budget spent on the good)
 The extent to which the product is considered as luxury or necessity

 The definition of a product (the degree of commodity aggregation)

 Time

 Habits:
 Elasticity of Supply

• As in the case of demand the elasticity concept is also applicable to measure

the behavioral changes of the supplier in response to the changes in the
determinants.
I. Price Elasticity of Supply

• Price elasticity of supply (ESP) is the measure of responsiveness of

producers in terms of output to changes in the price of their products.

• In other words, it measures the responsiveness of the quantity supplied of a

good to its market price.

• More precisely, the price elasticity of supply measures the percentage change
in quantity supplied in response to a one percent change in the good’s price.
• Esp = Percentage change in quantity supplied of commodity Y

Percentage change in price of Y

Esp = Q  P

(Qi + Qf)/2 (Pi + Pf)/2

• Where, Q = Change in quantity supplied

P = Change in price

Qi = Initial quantity supplied Qf = Quantity supplied final

Pi = Initial price Pf = Price final

• The Esp is a positive figure indicating the direct relationship between price and quantity
supplied. Esp is useful because it tells us the changes in quantify supplied resulting from a
given percent change in price.
• E.g. If Esp is 3, a 5% increase in price will result in a 15% increase in quantity supplied.

• As with the case of price elasticity of demand, depending on the magnitude of the coefficient,
price elasticity of supply can be categorized into three groups (types):

• (I) Elastic -Esp >1, If the percentage rise in quantity supplied is greater than the percentage
rise in price that brought it about. That is, when a change in price causes a more than
proportionate change in quantity supplied.

• (II) Unitary elastic - Esp equal to one. This is that the percentage increase (change) of
quantity supplied is exactly equal to the percentage increase (change) in price.

• (III) Inelastic - Esp < 1. If the percentage rise in quantity supplied is less than the percentage
rise in price that brought it about. That is, quantity changes by a smaller proportion than
price.
• There are also two extreme cases of elasticity of supply:

1. Perfectly elastic (Infinitely elastic)-Where changes in supply occur

without any large change in price being necessary. Where a small change in
price changes quantity supplied by an infinitely large amount. The supply
curve for this case is a horizontal one.

2. Perfectly inelastic: The Esp is equal to zero (Where supply is fixed).

Where a change in price brings no change in quantity supplied. The supply
curve for this case is vertical one. E.g. Out of season demand, entrance ticket
for some game.
• II. Cross-elasticity of supply

• Cross elasticity of supply (Esx) is defined as the percentage change in the supply of one
good in response to a one percent change in the price of alternative product (a product
with in the production possibility of the producer).

Esx = % change in quantity supplied of a good “X”

% Change in price of good “Y”

• Where ‘X’ and ‘Y’ being production alternatives.

• The value of the Esx can be negative or positive. If Esx is negative the two products are
production substitutes. If Esx is positive the two products under consideration are
complements
Determinants of Elasticity of supply
 Time

 The availability of inputs

 Factor mobility

 The extent to which production can be expanded or reduced in an industry

 Natural restriction on the production process

 Risk- taking