Chapter II theory of demand and supp.pdf
- 1. Chapter II Theory of Demand and Supply Addis Ababa University 18-Nov-24
- 2. 2.1 Theory of Demand • The theory of demand is related to the economic activities of consumers-i.e., act of 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.
- 3. Cont’d… • 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. Effective demand = ability to pay + willingness to pay+ availability
- 4. Cont’d… • Law of demand: This is the principle of demand, which states that, for ordinary goods, the price of a commodity and its quantity demanded are inversely related, i.e., as the price of a commodity increases (decreases) quantity demanded for that commodity decreases (increases), ceteris paribus. • Why? Some reasons • Price Effect: When the price of a commodity decreases, new consumers can afford it, leading to increased demand. • Income Effect: When a commodity’s price falls, a consumer’s real income increases, which encourages consumers to buy more of the commodity.
- 5. Cont’d… • Substitution Effect: A change in the price of a commodity affects its substitutes. When a commodity’s price falls, consumers may choose it over substitutes, leading to increased demand. • Note: the law of demand does not hold for special type of goods called Veblen goods. • Goods purchased for conspicuous consumption; people gain satisfaction from being seen to consume expensive products by other people 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. • Demand schedule: is the relationship between price and quantity demanded in a table form.
- 6. Cont’d… Table 2.1: Individual household demand for orange per week • 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. A B C D E Price (Per Kg) 5 4 3 2 1 Qd (Per Week) 5 7 9 11 13
- 7. Cont’d… Downward sloping curve • Customarily, price is drawn on the vertical axis. • Note that the actual demand curve is not straight line, i.e., slope is not constant along with the line.
- 8. Cont’d… • 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 … … … … … 𝑏𝑒ℎ𝑎𝑣𝑖𝑜𝑢𝑟𝑎𝑙 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 𝑄𝑑 = 𝑎 − 𝑏𝑃 … … … . … … … … 𝑙𝑖𝑛𝑒𝑎𝑟 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 Where b = ∆Q ∆P , which is the slope of the demand curve. • For instance, if we move from point A to point B on figure 2.1, then 𝑏 = ∆𝑄 ∆𝑃 = 7 − 5 4 − 5 = 2 −1 = −2 𝑄𝑑 = 𝑎 − 2𝑃 and to find a at point B, 7 = 𝑎 − 2 4 = 15
- 9. Cont’d… • 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. Table 2.2: Individual and market demand for a commodity Prices Individual Demands Market Demand Consumer 1 Consumer 2 Consumer 3 8 0 0 2 2 5 3 5 4 12 3 5 7 6 18 0 7 9 8 24
- 10. Cont’d… • The following graph depicts market demand curve at price equal to three.
- 11. Cont’d… • Example: Suppose the individual demand function of a product is given by: 𝐏 = 𝟏𝟎 − 𝑸𝒊 /𝟐 and there are about 100 identical buyers in the market. Then the market demand function is given by: P = 10 − Q 2 ⇒ Q 2 = 10 − P ⟹ Q = 20 − 2P • Market Demand Function = Number of buyers * Individual Demand function • QM = 20 – 2P 100 • QM = 2000 − 200P • Thus, Market Demand Function is 𝑄𝑚 = 2000 − 200p
- 12. Cont’d… 2.1.2 Determinants of Demand • The demand for a product is influenced by many factors. Some of these factors include: • Price of the product itself: The price of a commodity is the most important factor which affects the demand for a commodity. • Other things remain the same, if the price increases, the quantity demanded decreases, and vice-versa
- 13. Cont’d… • 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. 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.
- 14. Cont’d… • Income of the Consumer: i) Normal Goods… 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.
- 15. Cont’d… • Prices of Related Goods: Changes in the prices of related goods also affect the demand for a commodity. • There are three possible relationships between products. Substitutes, complements, or unrelated. i) Substitute Goods: 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, etc. ii) Complementary Goods: are those goods that are used together/jointly to satisfy a given want. If two goods are complementary, 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, printers and ink cartridges, tea and sugar are complements of each other.
- 16. 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. • 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. • Higher expected income will increase the demand for a normal good.
- 17. Cont’d… • 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. • 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 price Demand.
- 18. Cont’d… • Note the distinction between change in demand and change in quantity demanded, • A change in any determinant of demand—except for the good‘s own price – causes the demand curve to shift. We call this a change in demand. • This is reflected in a shift in the demand curve from its original location. • A change in own price of the product, other factors remain constant, will bring a change in the quantity demanded. • This is shown as a movement on 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.
- 19. Cont’d…
- 20. 2.1.2 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 the responsiveness of a dependent variable to changes in one of the determinants. • The elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to a change in its price, 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.
- 21. Cont’d… A. Price Elasticity of Demand (𝜀𝑑 𝑝 ) • 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 vice-versa.
- 22. Cont’d… • Price elasticity demand can be measured in two ways. These are point and arc elasticity. • Point price elasticity of demand: This is calculated to find elasticity at a given point, and given as 𝜀𝑑 𝑝 = %Δ𝑄𝑑 %Δ𝑃 = 𝑄1 − 𝑄0 𝑄0 𝑥100 𝑃1 − 𝑃0 𝑃0 𝑥100 = 𝑄1 − 𝑄0 𝑃1 − 𝑃0 . 𝑃0 𝑄0 = Δ𝑄 Δ𝑃 . 𝑃0 𝑄0 • Alternatively, if we are given initial price ad quantity of a demand equation, elasticity is computed 𝜀𝑑 𝑝 = 𝑑𝑄 𝑑𝑃 . 𝑃 𝑄
- 23. Cont’d… • In this method, we take a straight-line demand curve joining the two axes and measure the elasticity between two points Q1 and Q0 which are assumed to be intimately close to each other. • Suppose the price of the commodity falls from Birr 5 to Birr 4 and the quantity demanded increases from 100 units to 150 units. Given this, Compute the point price elasticity of demand? 𝑄1−𝑄0 𝑃1−𝑃0 * 𝑃0 𝑄0 = 150−100 4−5 * 5 100 = 250 100 = | − 2.5| • This implies that, at price = Birr 5, if price decreases by 1%, quantity demand increases by 2.5%.
- 24. Cont’d… Note: It should be remembered that the point elasticity of demand on a straight line is different at every point.
- 25. Cont’d… • 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 (infinitesimal) 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.
- 26. Cont’d… • 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. ↋𝑑 𝑎 = 𝛥𝑄𝑑 𝑄1+𝑄0 / 𝛥𝑃 𝑃1+𝑃0 = 𝑄1−𝑄0 𝑃1−𝑃0 . 𝑃1+𝑃0 𝑄1+𝑄0 • In the previous examplae, ↋𝑑 𝑎 = ∆𝑸 ∆𝑷 * 𝑷𝟏+𝑷𝟎 𝑸𝟏+𝑸𝟎 = 150−100 4−5 * 4+5 150+100 = 45 −25 = −9 5 = |-1.8|
- 27. Cont’d… • The arc elasticity formula is used if the price change is relatively large. • It is a more accurate measure of elasticity than the point elasticity method. • 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 Veblen good (prestige good).
- 28. Cont’d… • Range of values of price elasticity of demand (PED) in theory • The possible range of values for PED can, in theory, go from zero to infinity. • Practically, however, the actual PED values for a product will lie in between these two extreme theoretical values. • Five interpretations • If |εd p | > 1, demand is said to be elastic and the product is luxury product. • If , 0 < |εd p | < 1, demand is inelastic and the product is necessity. • If|εd p | = 1, demand is unitary elastic. • If|εd p | = 0, demand is said to be perfectly inelastic (vertical demand curve). • If|εd p | = ∞, demand is said to be perfectly elastic (horizontal demand curve).
- 29. Cont’d… • What are the determinants of PED? • Different products will have different values of PED. • For example, the demand for a restaurant meal may have a PED value of 3, i.e., the demand is elastic, whereas the demand for petrol may have a PED value of 0.4, which is inelastic. There are a number of determinants. 1. The number and closeness of substitutes • The more substitutes there are for a product, the more elastic the demand will be for it. • Also, the closer the substitutes available, the more elastic the demand will be.
- 30. Cont’d… 2. The necessity of the product and how widely the product is defined • Food is a necessary product. Thus we would expect the demand for it to be very inelastic. • However, if we define food more narrowly and consider meat, we would expect the demand to be less inelastic, since there are many alternatives. • Once again, if we then define meat more narrowly and consider chicken, pork, lamb, and beef, we could once again reasonably assume that the demand for each would be relatively elastic. • It is worth remembering that for many goods, necessity will change from consumer to consumer, since different people have different tastes and necessity is often a subjective view.
- 31. Cont’d… 3. The proportion of income spent on the good • If a good costs very little and constitutes a very small part of a person’s budget, then a change in price may cause very little change in quantity demanded, i.e., the demand will be quite inelastic. 4. The time period considered • As the price of a product changes, it often takes time for consumers to change their buying and consumption habits. PED thus tends to be more inelastic in the short term and then becomes more elastic, the longer the tie period it is measured over.
- 32. Cont’d… B. Income Elasticity of Demand • It is a measure of how much the demand for a product changes when there a change in the consumer’s income. ↋𝑑 𝐼 = 𝑄1−𝑄0 𝑄1 ∗100% 𝐼1−𝐼0 𝐼0 ∗100% = 𝑄1−𝑄0 𝐼1−𝐼0 * 𝐼0 𝑄0 = ∆𝑄 ∆𝐼 * 𝐼0 𝑄0 • Accordingly, • If ↋𝑑 𝐼 > 1, the good is normal but luxury good. • If 0 < ↋𝑑 𝐼 < 1, the good is a necessity good • If ↋𝑑 𝐼 < 0, (negative), the good is inferior good.
- 33. Cont’d… • 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. • Solution ↋𝑑 𝐼 = 𝑄1−𝑄0 𝐼1−𝐼0 ∗ 𝐼0 𝑄0 = 5−4 1200−1000 * 1000 4 = 1000 400 = 1.25 Thus, a 1 percent increase in income there is a 1.25 percent increase in the demand of the commodity and the commodity is normal(luxury).
- 34. Cont’d… C. 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 𝜀𝑥𝑦 = 𝑄𝑥1−𝑄𝑥0 𝑄𝑥0 ∗100% 𝑃𝑦1−𝑃𝑦0 𝑃𝑦0 ∗100% = 𝑄𝑥1−𝑄𝑥0 𝑃𝑦1−𝑃𝑦0 * 𝑃𝑦0 𝑄𝑋0 = ∆𝑄𝑋 ∆𝑃𝑦 * 𝑃𝑦0 𝑄𝑋0 • According to the values of 𝜀𝑥𝑦, i) If 𝜀𝑥𝑦is positive, the goods are substitute goods. ii) If 𝜀𝑥𝑦is negative, the goods are complementary goods. iii) If 𝜀𝑥𝑦is zero, the goods are unrelated goods.
- 35. Cont’d… • 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: 𝜀𝑥𝑦= 𝑄𝑥1−𝑄𝑥0 𝑃𝑦1−𝑃𝑦0 * 𝑃𝑦0 𝑄𝑋0 = 1000−1500 15−10 * 10 1500 = −500 5 * 1 150 = −0.667 Thus, for a 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.
- 36. 2.2 Theory of Supply • Supply refers to the selling side of the market • It is defined as the quantity of a good or service that producers are willing and able to (produce and) sell at different prices in a give time period. • As does in demand, the important phrase here is “willingness and ability.” • It is not enough for producers to be willing to produce a good or service: they must also be able to produce it, i.e., they must have the financial means to supply the product, the ability to supply. • This is known as effective supply and it is this that is shown on a supply curve.
- 37. Cont’d… • 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 A B C D E Price (Per Kg) 30 25 20 15 10 Qd (Per Week) 100 90 80 70 60
- 38. Cont’d… • A supply curve: conveys the same information as a supply schedule. • But it shows the information graphically rather than in a tabular form.
- 39. Cont’d… • 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. • Market supply: It is derived by horizontally adding the quantity supplied of the product by all sellers at each price.
- 40. Cont’d…
- 41. Cont’d… • Non-price determinants of supply • There are a number of factors that determine supply and lead to an actual shift of the supply curve to either the right or the left. 1. The cost of factors of production • If there is an increase in the cost of a factor of production, such as wages and raw materials in a firm producing textile, which is labour-intensive, then this will increase the firm‘s costs. • This means that they can supply less, shifting the supply curve to the left.
- 42. Cont’d… 2. The price of related goods- competitive and joint supply • Competitive supply – often producers have a choice as to what they are going to produce, because the factors of production that they control are capable of producing more than one product. • Example, skateboards and roller skates are competing for the factors of production that
- 43. Cont’d… 2. The price of related goods… • Joint supply – when one good is produced, another good is produced at the same time (as a bi-product). • Example, Sugar a d Molasses, petrol and diesel • Thus, if the demand for one good in joint supply increases, then the supply of the other good (s) will also increase.
- 44. Cont’d… 3. Government intervention-indirect taxes and subsidies • Indirect taxes – Taxes on goods and services that are added to the price of the product. • Taxes effectively raise the costs of production to the firms and they have the effect of shifting the supply curve to the left.
- 45. Cont’d… 3. Government intervention… • Subsidies – Payments made by the government to firms that will, in effect, reduce their costs of production. • Hence, more of the product will be supplied at every price.
- 46. Cont’d… 4. Expectations about future prices • Producers make decisions about what to supply based on their expectations of future prices. However, the effect that expectations might have on production decisions might vary. • If market research suggests that demand for a product will fall in the future, then producers will be likely to reduce their supply of the product
- 47. Cont’d… 5. Changes in technology • Improvements in the state of technology in a firm or an industry should lead to an increase in and thus a shift of the supply curve to the right.
- 48. Cont’d… 6. Weather or natural disasters • In markets vulnerable to weather conditions, such as agricultural markets, the weather can have an impact on supply. • Favourable weather could lead to “bumper crops” with increased supply. • On the contrary, poor weather, such as drought, can lead to significant cuts in supply.
- 49. Cont’d… Aside • The non-price determinants listed above are proximate factors. • There are enabling/underlying factors that affect supply of a product, such as • Market access • Infrastructural development, • Political stability • Rule of law etc.
- 50. Cont’d… 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 in the case of 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 the point method. 𝜀𝑠 𝑝 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 = %∆𝑸𝑺 %∆𝑷
- 51. Cont’d… 2.2.3 Elasticity of supply 𝜀𝑆 𝑝 = 𝑄1−𝑄0 𝑄0 ∗100% 𝑃1−𝑃0 𝑃0 ∗100% = 𝑄1−𝑄0 𝑃1−𝑃0 * 𝑃0 𝑄0 = ∆𝑄 ∆𝑃 * 𝑃0 𝑄0 • Given the value of 𝜀𝑆 𝑝 , like elasticity of demand, price elasticity of supply can be elastic, inelastic, unitary elastic, perfectly elastic or perfectly inelastic
- 52. Cont’d… 2.3 Market Equilibrium • Equilibrium is commonly defined as “a state of rest, self- perpetuating in the absence of any outside disturbance”. • Market equilibrium occurs when market demand = market supply. • The price that equates demand and supply is called ‘market- clearing price’ since everything produced in the market will be sold. • The market is in equilibrium, since it will stay like this, in each time period, until there is an outside “disturbance”.
- 53. Cont’d…
- 54. Cont’d… • The equilibrium in this situation is “self-righting” • If price is above, the equilibrium price, supply is greater than demand, i.e., excess supply exists, then price has to decline, • At price below equilibrium price, there will be excess demand, then price has to increase.
- 55. Cont’d… • Example: Given market demand: 𝑸𝒅 = 𝟏𝟎𝟎 − 𝟐𝑷 , and market supply: • 𝑷 = ( 𝑸𝒔 /𝟐) + 𝟏𝟎 a) Calculate the market equilibrium price and quantity b) Determine, whether there is surplus or shortage at P= 25 and P= 35 • Solution: • a) At equilibrium, Qd= 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.
- 56. Cont’d… 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, the supply is given, a decrease in demand reduces both the equilibrium P and Q and vice versa.
- 57. Cont’d… 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.
- 58. Cont’d… 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 the same, then the price remains the same.
- 59. Cont’d… • 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.
- 60. Addendum The price mechanism and its functions • The price mechanism is related to the forces of market demand and supply. • Price has three significant functions in a market 1) The signalling function: Changes in price signals the changing circumstances in the market, thus providing information to consumers and producers. 2) The rationing function: If there is excess demand for a good, its price will be relatively high and the low supply will be rationed to those who are prepared to pay the higher price. 3) The incentive function: Lower prices give consumers an incentive to buy more of a good but producers get an incentive to produce more and sell when prices are high.