Chapter Two
Theory of Demand
and Supply
1
Demand
 It states that the consumer must be willing
and able to purchase the commodity, which
he/she desires, given
 A particular price that must be paid for the good
 backed by his/her purchasing power
 All other constraints on the household
 It refers to various quantities of goods or service that a
consumer would purchase at a given time in a market at
various prices, given other things unchanged (ceteris
paribus). The quantity demanded of a particular commodity
depends on the price of that commodity.
2
The Law of Demand
 States that when the price of a good rises(falls) and
everything else remains the same, the quantity of
the good demanded will fall(rises).
3
The Demand Schedule, Curve and
the function
 Demand schedule (table)
 A list (price- quantity combination) showing the quantity of
a good that consumers would choose to purchase at
different prices, with all other variables held constant.
Showing the r/s b/n P & Qd in table form. Ex..
Combinations
A
B
C
D
E
Price per kg
5
4
3
2
1
Quantity
demand/week
5
7
9
11
13
4
Demand curve
 It is a graphical representation of the
relationship between different quantities of a
commodity demanded by an individual at
different prices per time period, citrus paribus.
 Demand
function:
is
a
mathematical
relationship between price and quantity
demanded, all other things remaining the
same.
 Qd=f(P)
5
Figure 1: The Demand Curve
Price per
Bottle
When the price is $4.00
per bottle, 40,000 bottles
are demanded (point A).
$4.00
A
B
2.00
At $2.00 per bottle,
60,000 bottles are
demanded (point B).
D
40,000
60,000
Number of Bottles
per Month
6
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…
Price
Individual demand
Consumer-1
Consumer-2
Consumer-3
8
0
0
0
Market
demand
0
5
3
5
1
9
3
5
7
2
14
0
7
9
4
20
We can show graphically, to predict the market demand curve at
price equal to 3, as follows:
7
Cont..
8
Numerical examples:
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.
Find the market demand function? (ans: Q = 2000-200P)
9
Determinants of demand
The demand for a product is influenced by many factors. Some of
these factors are:
• Price of the product
• Taste or preference of consumers
• Income of the consumers (normal vs inferior goods)
• Price of related goods (Substitute vs Complimentary goods)
• Consumers expectation of income and price
• Number of buyers in the market
10
Shift of Demand Versus Movement
Along a Demand Curve
• A change in demand is
not the same as a change
in quantity demanded.
• In this example, a higher
price causes lower
quantity demanded.
• Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
DA to DB.
11
A Change in Demand Versus a Change in
Quantity Demanded
• When demand shifts to
the right, demand
increases. This causes
quantity demanded to be
greater than it was prior to
the shift, for each and
every price level.
12
A Change in Demand Versus a Change in
Quantity Demanded
To summarize:
Change in price of a good or service
leads to
Change in quantity demanded
(Movement along the curve).
Change in income, preferences, or
prices of other goods or services
leads to
Change in demand
(Shift of curve).
13
Example..
Price
Entire demand curve shifts
rightward when:
• income or wealth ↑
• price of substitute ↑
• price of complement ↓
• population ↑
• expected price ↑
• tastes shift toward good
D2
D1
Quantity
14
Elasticity of demand
 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: price elasticity, income elasticity, and
cross elasticity.
15
Price elasticity of demand

16
When there is a big gap in p & Q, we
can use Arc formula as:

Suppose that the price of a commodity is Br. 5 and the quantity demanded at that
price is 100 units of a commodity. Now assume that the price of the commodity
falls to Br. 4 and the quantity demanded rises to 110 units. Find the Ep?
Answer: (-0.42 = ed <1, inelastic)
17
Note that:
• Elasticity of demand is unit free
• Elasticity of demand is usually a negative number because of the law
of demand, with some exceptions.
18
Determinants of PED
 The availability of substitutes: the more substitutes available for a
product, the more elastic will be the price elasticity of demand.
 Time: In the long- run, price elasticity of demand tends to be
elastic. Because, More substitute goods could be produced and
People tend to adjust their consumption pattern
 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.
 The importance of the commodity in the consumers’ budget
 Luxury goods tend to be more elastic, example: gold.
 Necessity goods tend to be less elastic example: Salt.
19
Income Elasticity of Demand

20
Cross price Elasticity of Demand
 Measures how much the demand for a product is
affected by a change in price of another good.
21
Numerical example:
• The cross – price elasticity of demand for substitute goods is positive.
• The cross – price elasticity of demand for complementary goods is negative.
• The cross – price elasticity of demand for unrelated goods is zero.
Unit price of Y
Quantity demanded of X
10
1500
15
1000
Given the above table, Calculate the cross –price elasticity of demand
between the two goods. What can you say about the two goods?
22
Theory of Supply
 It 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, given
 A particular price for the good
 All other constraints on the firm
 Ability and willingness matters
23
The Law of Supply
 States that when the price of a good rises and everything
else remains the same, the quantity of the good supplied
will rise, other things remain constant.
24
Supply in Output Markets
CLARENCE BROWN'S
SUPPLY SCHEDULE
FOR SOYBEANS
QUANTITY
SUPPLIED
PRICE
(THOUSANDS
(PER
OF BUSHELS
BUSHEL)
PER YEAR)
$
2
0
1.75
10
2.25
20
3.00
30
4.00
45
5.00
45
• A supply schedule is a table showing
how much of a product firms will
supply at different prices.
• Quantity supplied represents the
number of units of a product that a
firm would be willing and able to
offer for sale at a particular price
during a given time period.
25
The Supply Curve
CLARENCE BROWN'S
SUPPLY SCHEDULE
FOR SOYBEANS
QUANTITY
SUPPLIED
PRICE
(THOUSANDS
(PER
OF BUSHELS
BUSHEL)
PER YEAR)
$
2
0
1.75
10
2.25
20
3.00
30
4.00
45
5.00
45
Price of soybeans per bushel ($)
• A supply curve is a graph illustrating how much
of a product a firm will supply at different prices.
6
5
4
3
2
1
0
0
10
20
30
40
Thousands of bushels of soybeans
produced per year
50
26
Price of soybeans per bushel ($)
The Law of Supply
6
5
4
3
2
1
0
0
 The law of supply
states that there is a
positive relationship
between price and
quantity of a good
supplied.
10
20
30
40
50  This means that
Thousands of bushels of soybeans
produced per year
supply curves
typically have a
positive slope.
27
The Supply function
 It shows the following functional relationship: QS = f(P), where S
is quantity supplied and P is price of the commodity.
 Market supply: It is derived by horizontally adding the quantity
supplied of the product by all sellers at each price. Example…
Price per Quantity
supplied by
unit
seller 1
5
11
Quantity supplied Quantity
supplied by
by seller 2
seller 3
15
8
Market supply
per week
4
10.5
13
7
30.5
3
8
11.5
5.5
25
2
6
8.5
4
18.5
1
4
6
2
12
34
28
Determinants of supply
The supply of a particular product is determined by:
 price of inputs (cost of inputs)
 Technology
 prices of related goods
 sellers‘ expectation of price of the product
 taxes & subsidies
 number of sellers in the market
 weather, etc.
29
Factors That Shift the Supply Curve
 Input prices
 A fall (rise) in the price of an input causes an
increase (decrease) in supply, shifting the supply
curve to the right (left)
 Price of Related Goods
 When the price of an alternate good rises (falls), the
supply curve for the good in question shifts leftward
(rightward)
 Technology
 Cost-saving technological advances increase the
supply of a good, shifting the supply curve to the
right
30
Factors That Shift the Supply Curve
 Number of Firms
 An increase (decrease) in the number of
sellers—with no other changes—shifts
the supply curve to the right (left)
 Expected Price
 An expectation of a future price increase
(decrease) shifts the current supply
curve to the left (right)
31
Factors That Shift the Supply Curve
 Changes in weather
 Favorable weather
 Increases crop yields
 Causes a rightward shift of the supply curve for that
crop
 Unfavorable weather
 Destroys crops
 Shrinks yields
 Shifts the supply curve leftward
 Other unfavorable natural events may effect all
firms in an area
 Causing a leftward shift in the supply curve
32
A Change in Supply Versus
a Change in Quantity Supplied
Change in price of a good or service
leads to
Change in quantity supplied
(Movement along the curve).
Change in costs, input prices, technology, or prices of
related goods and services
leads to
Change in supply
(Shift of curve).
33
Market Equilibrium
 The operation of the market depends on the
interaction between buyers and sellers.
 An equilibrium is the condition that exists
when quantity supplied and quantity demanded
are equal.
 At equilibrium, there is no tendency for the
market price to change.
34
Market Equilibrium
 Only in equilibrium
is quantity supplied
equal to quantity
demanded.
• At any price level
other than P0, the
wishes of buyers and
sellers do not coincide.
35
Numerical examples
 Given market demand:
Qd= 100-2P, and market
supply: P =(0.5Q) + 10
 Calculate the market
equilibrium P & Q
 Determine, whether there
is surplus or shortage at
P= 25 and P= 35.
Answer:
 P* = 30, and Q* = 40
 There is shortage at
p=25, and surplus at
p=35
36
Effect of shift in Demand and Supply
on equilibrium
 Higher demand leads
to higher equilibrium
price and higher
equilibrium quantity.
 Higher supply leads
to lower equilibrium
price and higher 37
equilibrium quantity.
Decreases in Demand and Supply
 Lower demand
leads to lower price
and lower quantity
exchanged.
 Lower supply leads
to higher price and
lower quantity
38
exchanged.
Relative Magnitudes of Change
• The relative magnitudes of change in supply and
demand determine the outcome of market equilibrium.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
39
Relative Magnitudes of Change
• When supply and demand both increase, quantity will
increase, but price may go up or down.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
40
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, citrus paribus.
 We can use a simple and most commonly used method of point
method to compute the Es:
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The end …..
What is next….
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