Chapter Two

Demand and Supply

1.1 Theory of Demand

Law of Demand, Demand Schedule and Demand Curve

Definition of demand
 Demand basically reflects consumers’ attitude and reaction towards a commodity.
 Demand is the amount of a commodity that a consumer would like and is able to purchase
at various given prices in a period of time. Hence, demand for a good or service
constitutes both the desire for and the purchasing power to purchase it.

Quantity demanded
 Quantity demanded refers to the quantity which the consumer is willing and able to buy at
a specific price.

The law of demand

 The law of demand states that, other factors remaining constant, when price of product
increases, quantity demanded of the product decreases and vice versa. Thus, according to
law of demand, there is inverse relationship between price and quantity demanded, other
things remaining the same.

Demand Schedule and Demand Curve

 The law of demand can be illustrated through a demand schedule and a demand curve.
The table and the curve below represents the relationship between the various prices of
an item and the quantity demanded for the good other things remaining constant.
 Demand curve is a curve which represents the relationship between price and quantity
demand of an item and it is down ward sloping curve because of the law of demand. In
other words demand curve is a graphical statement or presentation of quantities of a
good which will be demanded by the consumer at various possible prices at a given
moment of time.
Price Price Qd(quantity
demand)
12
12 10
10
10 20
8
8 30
6
6 40
4
4 50
2 dd
2 60
0 10 20 30 40 50 60 Qd

Fig 1.1 demand curve Table 1.1.demand schedule

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 Market demand curve

We can add or sum up the various quantities demanded by the number of consumers in the
market and by doing so we can obtain the market demand and by representing that
graphically we obtain market demand curve. Thus market demand is horizontal summation of
individuals demand for a product at various price levels. Suppose there are three individual
buyers of a product in the market, individuals A, B &C

Da Db Dc Dd=market demand

p P P P

o Qda o Qdb o Qdc o Qda+ Qdb+ Qdc =Qdd

Example: A market for a commodity consists of three individuals A, B and C whose demand
functions for the commodity are given below. Find out the market demand function.

QA = 40 – 2P

QB = 25.5 - 0.75P

QC = 36.5 – 1.25P

Solution:

QM = QA + QB + QC

QM = (40 – 2P) + (25.5 - 0.75P) + (36.5 – 1.25P)

QM = 102 – 4P

However, note that when individual demand functions are expressed as ‘’ price as functions
of quantity’’, then in order to obtain the market demand, they have to be first converted into
‘quantity as function of price’.

1.1.2. Determinants of demand

The demand for a product is determined of influenced by the following factors.

1. Taste and preference of the consumers

 An important factor which determines demand for a good is the tastes and preferences of
the consumers for it. A good for which consumers tastes and preferences are greater, its
demand would be large and its demand curve will lie at a higher level. People’s tastes and
preferences for various goods often change and as the result there is change in demand for
them. The change in demand for various goods occurs due to change in fashion and the
pressure of advertisements by manufacturing and sellers of different products.
2. Income of consumers

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 The effect change in income of a consumer on his/her demand depends on the nature of
the product. For some products an increase in consumer’s income causes an increase in
demand, and decrease in income causes a decrease in demand. Those goods whose
demand changes directly with demand are called normal goods. Example Milk, Leather
shoes…etc.
 On the other hand, there are some products whose demand Decreases as consumer’s
income increases, and whose demand increases as a consumer’s income decreases. Such
goods are called Inferior goods. Example: cabbage, bus rides, ‘shero wot’… etc.
3. Changes in the price of related goods:
 The demand for a good is also affected by the prices of other goods, especially
those which are related to it as substitutes or complements. We call two goods
are substitute if they are alternative to each other, or are alternatively consumed.
E.g. Tea and coffee. If X and Y are substitutes an increase in the price of good Y
leads to an increase in demand of good X and vice versa. Alternatively goods
are said to be Complements if they are to be used together. E.g. Car and
petroleum, Sugar and tea … etc. If X and Y are complements, an increase in the
price of good X leads to decrease in the demand for good Y.
4. Number of consumers in the market
 An increase in a number of consumers causes an increase in demand for
commodities given that consumers have ability to pay for. If the number of
buyers in the market increases the demand for a product will increase as market
demand is the summation of individual’s demand and the vice versa also holds
true. Number of consumers in a market may increase due to many factors like
migration, population growth, and if sellers find new markets for their products.
5. Consumers’ expectations with regard to future price and income
 If due to some reason, consumers expect that in the near future prices of the
goods would rise, then in the present they would demand greater quantities of
the goods so that in the future they should not have to pay higher prices.
Similarly, when the consumers hope that in the future they will have good
income, then in the present they will spend greater part of their income with the
result that their present demand for goods will increase.
6. Income distribution
 If distribution of income is more equal, then the propensity to consume of the
society as a whole will be relatively high which means greater demand for
goods. But the change in the distribution of income in the society would affect
the demand for various goods differently. If progressive taxes are levied on the
rich people and the money so collected is spent on providing employment to the
poor people, the distribution of income would become more equal and with this
there would be a transfer of purchasing power from the rich to the poor. As a
result of this, the demand for those goods will increase which are generally
purchased by the poor because the purchasing power of the poor people has
increased and, on the other hand, the demand for those goods will decline which
are consumed by the rich on whom progressive taxes have been levied.

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 Note that: when demand changes due to the factors other than price, there is shift in the
whole demand curve.

1.1.3 Elasticity of demand

Law of demand indicates only the direction of change in quantity demanded in response to a
change in price. This does not tell us by how much or to what extent the quantity demanded
of a good will change in response to change in its price. This information as to how much or
to what extent the quantity demanded of a good will change as a result of a change in its price
is provided by the concept of elasticity of demand. The concept of elasticity of demand refers
to the degree of responsiveness of quantity demanded of a good to a change in its price,
consumer’s income and prices of related goods. Accordingly, there are three concepts of
demand elasticity:

I. Price elasticity of demand

II. Income elasticity of demand
III. Cross elasticity of demand

I. Price elasticity of Demand

It indicates the degree of responsiveness of quantity demanded of a good to the change in its
price, other factors such as income, price of related commodities that determine demand are
held constant. And mathematically can be calculated as:
𝑝𝑒𝑟𝑐𝑒𝑛𝑎𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
Price elasticity of demand (ep) =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

Ep = %∆Qd/%∆P

%Qd (Q1  Qo ) / Qo * 100

EP   where, Ep = price elasticity of demand
%P ( P1  Po) / Po * 100
(Q1  Qo ) * Po
 Qd = change in quantity demanded
( P1  Po) * Qo

(Q1  Qo ) Po
 * P = change in price
( P1  Po) Qo
NB :  Ep  Ed

Ep = ∆Qd/∆P * Po/Qo
This formula is known as point price elasticity of demand

We also use another formula to determine price elasticity of demand if the change in price is
substantially large. This is called Arc price elasticity of demand or mid-point elasticity of

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demand. And measures the average responsiveness of quantity demanded between two points
on the demand curve to change in price other things remaining constant. Mathematically,

%𝜟𝑸𝒅
Ep= %𝜟𝑷

𝑄1−𝑄0 𝑃1−𝑃0
= (𝑄1+𝑄0 ) ∗ 100% (𝑃1+𝑃0 )*100%

𝑄1−𝑄0 𝑃1+𝑃0 𝑄1−𝑄0 𝑃1+𝑃0

= ( 𝑄1+𝑄0 )* (𝑃1−𝑃0) = ( 𝑃1−𝑃0 )*(𝑄1+𝑄0)

𝛥𝑄𝑑 𝑃1+𝑃0
Ep = ( 𝛥𝑃 ) ∗)*(𝑄1+𝑄0)

NB: - when the change in price is quite large, say more than 5 percent, and also when we
want to measure elasticity between two points then accurate measure of price elasticity of
demand can be obtained by taking the average of original price and subsequent price as well
as average of the original quantity and subsequent quantity as the basis of measurement of
percentage changes in price and quantity. Moreover

 Ep is unit free because it is a ratio of percentage change

 Ep is usually a negative number because of the law of demand i.e. negative relationship
between price and quantity demand. So we can take the absolute value of /Ep/.

Types of price elasticity of demand:

Elasticity Description Implications

>1 Elastic %∆Qd > %∆P

=1 Unitary %∆Qd = %∆P

<1 Inelastic %∆Qd < %∆P

The main reason for differences in elasticity of demand is the possibility of substitution i.e.
the presence or absence of competing substitutes. The greater the ease with which substitutes
can be found for a commodity or with which it can be substituted for other commodities, the
greater will be the price elasticity of demand of that commodity. The demand for salt is
inelastic since it satisfies a basic human want and no substitutes for it are available. People
would consume almost the quantity of salt whether it become slightly cheaper or dearer than
before.

Perfectly elastic and perfectly inelastic: in perfectly inelastic whatever the price, quantity
demanded of the commodity remains unchanged. An approximate example of perfectly
inelastic demand is the demand of acute diabetic patient for insulin. Because he/she has to get
the prescribed doze of insulin per week whatever its price. In perfectly elastic demand the
horizontal demand curve for a product implies that a small reduction in price would cause the

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 buyers to increase the quantity demanded from zero to all they could obtain. On the other
hand, a small rise in price of the product will cause the buyers to switch completely away
from the product so that its quantity demanded falls to zero. The perfectly elastic demand
curve found for the product of an individual firm working under perfect competition.
Products of different firms working under perfect competition are completely identical. If any
perfectly competitive firm raises the price of its product, it would lose all its customers who
would switch over to other firms and if it reduces its price somewhat it would get all the
customers to buy the product from it.

p p dd

ep = 

dd ep = 0

Q Q

a) Perfectly elastic dd curve b) Perfectly Inelastic dd curve

II. Cross elasticity of demand

Degree of responsiveness of demand for one good in response to the change in prices of
another good represents the cross elasticity of demand of one good for the other.

We can measure the responsiveness or sensitivity in the quantity purchased of commodity X

as a result of a change in the price of commodity Y by the cross elasticity of demand (Exy).
This is given by:
Coefficient of cross elasticity =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑋
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑌
Qx PY0
Exy = . --------------------------- point formula
PY Qx 0

Qx  Py  Py 2 
Exy = .  1  --------------------------- Arc Formula
PY  1
Qx  Q 2 

1. Substitute goods, Exy >0.

2. Complement goods, Exy < 0

3. Unrelated goods ,Exy = 0,

II. Income Elasticity (E1)

Income elasticity of demand shows the degree of responsiveness of quantity demanded of a
good to a small change in the income of consumers. And this is measured by:

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 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
Income elasticity =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

…….. Point income elasticity of demand

……Arc income elasticity of demand formula

The result for income elasticity can be:

 If income elasticity of demand for a product is greater than one, that good is luxury good.
 If income elasticity of demand for a product is less than one but positive, that good is said
to be necessary good.
 For inferior goods, income elasticity of demand is always negative.

Example: Consider a local car dealership that gathers data on changes in demand and
consumer income for its cars for a particular year. When the average real income of its
customers fell from $50,000 to $40,000, the demand for its cars plummeted from 10,000 to
5,000 units sold, all other things unchanged. The income elasticity of demand is calculated by
taking a negative 50% change in demand, a drop of 5,000 divided by the initial demand of
10,000 cars, and dividing it by a 20% change in real income, the $10,000 change in income
divided by the initial value of $50,000. This produces an elasticity of 2.5.

1.2 Theory of Supply

The quantity of a product that firms are ready and able to provide to the market represents the
supply of a product. The more someone is willing to pay for a good, the more interested is a
seller in supplying it. What is important in the discussion of supply curves is the ease with
which production can be expanded to a large scale.
Law of Supply:
When price of a commodity rises, the quantity supplied of it in the market increases, and
when the price of a commodity falls, its quantity supply decreases, other factors determining
supply remaining the same.
Supply schedule and curve: the supply schedule and supply curve reflect the law of supply.

Price Qd(quantity supply)

12 SS 12 60
10
10 50
8
6 8 40
4 6 30
2
4 20

10 20 30 40 50 6 2 10

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 Determinants of supply

Factors Determining the Supply of a Product: the effect of changes in price of a product
on the quantity supplied of it is depicted and explained by movement along a given
supply schedule or curve, the effect of other factors is represented by the changes or
shifts of the entire supply schedule or supply curve. Thus when these other factors
change, they cause a shift in the entire supply curve. The factors other than price
which determine price are the following:-

a) Production technology: if there occurs an improvement in production technology used

by the firm, the unit cost of production declines and consequently the firms would
supply more than before at the given price.
b) Price of factors: with higher unit cost of production, less would be supplied than
before at various given prices.
c) Prices of other products: any change in the prices of other products would influence
the supply of a product by causing substitution of one product for another.
d) Objective of the firm: if the firms aim to maximize sales or revenue rather than profits,
the production of the product produced by them and hence its supply in the market
would be larger.
e) Number of producers (or firms): if the number of firms producing a product increases,
the market supply of the product will increases causing a rightward shift in the supply
curve.
f) Future price expectations: if sellers expect the prices to rise in future, they would
reduce supply of a product in the market at would instead hoard the commodity.
g) Taxes and subsides: if an excise duty or sales tax is levied on a product, the firms will
supply the same amount of it at a higher price or less quantity of it at the same price.
This implies that imposition of a sales tax or excise duty causes a leftward shift in the
supply curve.
Elasticity of Supply

The concept of elasticity of supply is a relative measure of the responsiveness of quantity

supplied of a commodity to the changes in its prices.
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
Elasticity of supply =
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒𝑠

∆𝑞 𝑝
es = ∗
∆𝑝 𝑞

However for an accurate measure of elasticity of supply midpoint method should be used.
Using midpoint formula, elasticity of supply can be measured as:

∆𝑞 𝑝1+𝑝2
es = ∗
∆𝑝 𝑞1+𝑞2

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 Like elasticity of demand, price elasticity of supply is divided in to three ranges.
I. When Es > 1, the supply is said to be elastic
II. When 0 < Es < 1, the supply is said to be inelastic
III. When Es = 1, the supply is said to be unitary.

1.2 Equilibrium determination

Definition: a market is said to be in equilibrium when demand for a commodity is equal to its
supply. Market equilibrium is the result of an interaction of demand and supply curves that
determines price- quantity equilibrium. The price at which quantity demanded equals quantity
supplied is called equilibrium price.

At equilibrium, the market is expected to be stable, which is to mean equality of demand and
supply. At price of PE, the quantity supplied and quantity demanded is the same and equal to
QE. All suppliers have respective demand for their product and vice versa.

However, if price is taken up of equality (like P0), the quantity supplied will become larger
than the quantity demanded (S0>D0). At this level of price, the amount that consumers are
ready to supply to the market is clearly greater than the amount demanded. At this level of
price, some of the suppliers will lose a respective demand to their product. They will compete
with each other to win a demand for their product. Such a competition will lower the price of
the product till point E is attained.

On the other hand, if price is taken below PE, where consumer’s quantity demand is to be
greater than quantity supplied, consumers not suppliers will compete with each other. The
bid-up process by the buyers to get a supply will take the price up.

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