CHAPTER 2. Introduction to Economics ppt

08/02/2024 www.dagimfetene7@gmail.com 1
CHAPTER TWO
THEORY OF DEMAND AND SUPPLY
P. by Dagim F.
DEPARTMENT OF ECONOMICS, MIZAN-TEPI UNIVERSITY

Introduction
Demand is one of the forces determining prices.
The theory of demand is related to the economic
activities of consumers consumption.
Hence, the purpose of the theory of demand is to
determine the various factors that affect demand.

Demand implies more than a mere desire to purchase a
commodity.
 It states that the consumer must be willing and able to
purchase the commodity, which he/she desires.
His/her desire should be backed by his/her purchasing
power.
A poor person is willing to buy a car; it has no
significance, since he/she has no ability to pay for it.
On the other hand, if his/her desire to buy the car is
backed by the purchasing power then this constitutes
demand.

Demand, thus, means the desire of the
consumer for a commodity backed by
purchasing power.
These two factors are essential.
If a consumer is willing to buy but is not able to
pay, his/her desire will not become demand.
Similarly, if the consumer has the ability to pay
but is not willing to pay, his/her desire will not
be called demand

 More specifically, demand refers to various quantities of a
commodity 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.
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
The relationship that exists between price and the
amount of a commodity purchased can be
represented by a table (schedule) or a curve or an
equation.
Demand schedule: states the relationship between
price and quantity demanded in a table form.
 An individual demand schedule is a list of the
various quantities of a commodity, which an
individual consumer purchases at various levels of
prices in the market.

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)
Where:- Qd : is quantity demanded and
P: is price of the commodity, in our
case price of orange.

Example: Let the demand function be
Q = a+ bP
b =∆ /∆
𝑄 𝑃
(e.g. moving from point A to B on figure 2.1 above)
b =7-5 / 4-5 = - 2
where b is the slope of the demand curve
Q = a-2P
to find a, substitute price either at point A or B.
7= a-2(4),
a = 15
Therefore, Q=15-2P is the demand function for orange in the above
numerical example.

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.

Exercise
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.
i. Derive the market demand function

2.1.2. 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
 Price of related goods
 Consumers expectation of income and price
 Number of buyers in the market

 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.
Changes 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.
If buyers choose to purchase more at any price, the demand curve
shifts rightward an increase in demand.
If buyers choose to purchase less at any price, the demand curve
shifts leftward a decrease in demand.

Now let us examine how each factor affect demand.
1. Taste or preference: When the taste of a consumer changes in
favor of a good, her/his demand will increase and the opposite is
true.
2. Income of the consumer: Goods are classified into two categories
depending on how a change in income affects their demand.
These are normal goods and inferior goods.
 Normal Goods are goods whose demand increases as income
increase.
 Inferior goods are those whose demand is inversely related with
income .

3. Price of related goods: Two goods are said to be
related if a change in the price of one good affects the
demand for another good. There are two types of related
goods.
These are substitute and complimentary goods.
Substitute goods are goods which satisfy the same
desire of the consumer.
For example, tea and coffee or Pepsi and Coca-Cola are
substitute goods.
If two goods are substitutes, then price of one and the
demand for the other are directly related.

Complimentary goods, on the other hand, are
those goods which are jointly consumed.
For example, car and fuel or tea and sugar are
considered as compliments.
If two goods are complements, then price of
one and the demand for the other are inversely
related

4. 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.
5. Number of buyer in the market: 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

2.1.3. Elasticity of demand
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

1. Price Elasticity of Demand
Price elasticity of demand: means degree of responsiveness of
demand to 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.
 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.
 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. The price elasticity of demand can be
determined by the following formula.

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.

In arc price elasticity of demand, the mid-points
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.
 An arc is a portion of a curve line, hence, a
portion or segment of a demand curve.

Arc price elasticity of demand= ep =

Note that:
 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.
1. If   1, demand is said to be elastic and the product is
luxury product
2. If 0 

 1, demand is inelastic and the product is necessity
3. If  1, demand is unitary elastic.
4. If  0, demand is said to be perfectly inelastic.
5. If  , demand is said to be perfectly elastic.

Determinants of price Elasticity of Demand
The following factors make price elasticity of demand elastic
or inelastic other than changes in the price of the product.
1. The availability of substitutes: the more substitutes
available for a product, the more elastic will be the price
elasticity of demand
2. 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.

3. 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.
4. 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.

Exercise
1. Suppose the price of the commodity falls from Birr 5 to Birr
4 and quantity demanded increases from 100 units to 150
units. i. Calculate elasticity of demand by using the point
method
2. Consider a market for music CDs. When the price of CDs is
birr 20 per unit, consumers by 6 units per year. When the
price rises to birr 24 per unit consumers buy 4 CDs per year.
i. Find price elasticity of demand for CDs using arc
method.
3. At Birr 5 per unit, a consumer buys 40 units of a commodity
and the price elasticity of his demand is 2.
i. How much will he buy if the price reduces to Birr
4 per unit?

ii. Income Elasticity of Demand
It is a measure of responsiveness of demand to
change in income.
= =
Point income elasticity of demand:
1. If 1, the good is luxury good.
2. If 1( and positive), the good is necessity good,
3. If  0,(negative), the good is inferior good

iii. Cross price Elasticity of Demand
Measures how much the demand for a product is affected by a change in
price of another good.
1. The cross – price elasticity of demand for substitute goods is positive.
2. The cross – price elasticity of demand for complementary goods is
negative.
3. The cross – price elasticity of demand for unrelated goods is zero.

Exercise
Consider the following data which shows the changes in quantity
demanded of good X in response to changes in the price of good Y.
i. Calculate the cross-price elasticity of demand between the two
goods. What can you say about the two goods?
Unit price of Y Quantity demanded of X
10 1500
15 1000

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.
It tells us there is a positive relationship between price and
quantity supplied.

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

A supply curve conveys the same information
as a supply schedule. But it shows the
information graphically rather than in a tabular
form.

The supply 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.
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:
1. price of inputs ( cost of inputs)
2. Technology
3. prices of related goods
4. sellers‘ expectation of price of the product
5. taxes & subsidies
6. number of sellers in the market
7. weather, 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

The point price elasticity of supply can be
calculated as the ratio of proportionate change
in quantity supplied of a commodity to a given
proportionate change in its price.
Thus, the formula for measuring price
elasticity of supply is:

Like elasticity of demand, price elasticity of supply can be
elastic, inelastic, unitary elastic, perfectly elastic or
perfectly inelastic.
 The supply is elastic when a small change on price
leads to great change in supply.
 It is inelastic or less elastic when a great change in
price induces only a slight change in supply.
 If the supply is perfectly inelastic, it will be represented
by a vertical line shown as below.
 If supply is perfectly elastic it will be represented by a
horizontal straight line as in second diagram.

2.3. Market equilibrium
Having seen the demand and supply side of
the market, now let‘s bring demand and
supply together so as to see how the market
price of a product is determined.
Market equilibrium occurs when market
demand equals market supply.

 In the above graph, any price greater than P will lead to market
surplus.
 As the price of the commodity increases, consumers demand
less of the product.
 On the other hand, as the price of increases, producers supply
more of the good.
 Therefore, if price increases to P1 the market will have a surplus
of HJ.
 If the price decreases to P2 buyers demand to buy more and
suppliers prefer to decrease their supply leading to shortage in
the market which is equal to GF.

Exercise
1. Given market demand: Qd= 100-2P, and market
supply: P =( Qs /2) + 10
i. Calculate the market equilibrium price and quantity
ii. Determine, whether there is surplus or shortage at P= 25 and
P= 35.
iii. Draw the graph
2. Let there be 5000 identical buyers of a commodity X in a market with
an individual demand function of Qd = 8 – P, and 1000 identical sellers
of commodity X with an individual supply function of Qs = 20 P,
i. Formulate the market demand and market supply functions for the
commodity X.
ii. Calculating the equilibrium price and equilibrium quantity.
iii. Determine, whether there is surplus or shortage at P= 1 and P= 2.
iv. Draw the graph

Effects of shift in demand and supply on equilibrium
 Given demand and supply the equilibrium price and
quantity are stable.
 However, when these market forces change what will
happen to the equilibrium price and quantity?
 Changes in demand and supply bring about changes
in the equilibrium price level and the equilibrium
quantity.

1. when demand changes and supply remains
constant
 Factors such as changes in income, tastes, and prices
of related goods will lead to a change in demand.
 The figure below shows the effects of a change in
demand and the resultant equilibrium price and
quantity.
 DD is the demand curve and SS is the supply curve.

 DD and SS curves intersect at point E and the quantity demanded
and supplied is OM at OP equilibrium price.
 Given the supply, if the demand increases the demand curve will
shift upward to the right. Due to a change in demand, the demand
curve D1D1 intersects SS supply curve at point E1.
 The equilibrium price increases from OP to OP1 and the equilibrium
quantity from OM to OM1.
 On the other hand, if demand falls, the demand curve shifts
downwards to the left. Due to a change in demand, the curve D2D2
intersects the supply curve SS at point E2.
 The equilibrium price decreases from OP to OP2 and the
equilibrium quantity decreases from OM to OM2.
 Supply being given, a decrease in demand reduces both the
equilibrium price and the quantity and vice versa.

2. When supply changes and demand remains
constant
Changes in supply are brought by changes in
technical knowledge and factor prices.
The following graph explains the effects of
changes in supply.
 SS and DD intersect at point E, where supply and
demand are equal at OM quantity at OP
equilibrium price. Given the demand, if the supply
increases, the supply curve shifts to the (S1S1).

The new supply curve, which intersects DD
curve at E1, reduces the equilibrium m price
from OP to OP1 and increases the equilibrium
quantity from OM to OM1.
On the contrary, when the supply falls, the
supply curve moves to the left (S2S2) and
intersects the DD curve at point E2 raising the
equilibrium price from OP to OP2 and reducing
the equilibrium quantity from OM to OM2.

3. 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.
 If an increase in demand is more than an increase in
supply, then the price goes up.
 On the other hand, if an increase in supply is more
than an increase in demand, the price falls but the
quantity increases. If the increase in demand
and supply is same, then the price remains the same.

When demand and supply decline, the quantity
decreases. But the change in price will depend
upon the relative fall in demand and supply. When
the fall in demand is more than the fall in supply, the
price will decrease.
On the other hand, when the fall in supply is more
than the fall in demand, the price will rise.
 If both demand and supply decline in the same ratio,
there is no change in the equilibrium price, but the
quantity decreases.

THANK
YOU !!
THANK YOU!!

CHAPTER 2. Introduction to Economics ppt

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