Lecture II-Session One

Theory of Demand and Supply

By:

Amsalu B. (MSc.)

Lecturer, Department of Economics

Wolkite University

Email: [email protected]

Wolkite , Ethiopia
 Theory of Demand (DD)
 DD denotes 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).
 Ceteris paribus is a Latin term meaning “other things being
equal”. Otherwise it becomes difficult to establish the effect of
one factor on anther (if other things change).
 Because, human wants are unlimited, and therefore, desires
are many, that is why demand is an effective desire of the
consumer.
 Cont’d
 A desire becomes an effective desire or demand only when it is backed by
the following three factors:
 Ability to pay for the good desired,
 Willingness to buy the price of the good desired, and
 Availability of the good itself
 Note that;
 If a consumer is willing to buy but is not able to pay, his/her desire will
not become DD.
 If the consumer has the ability to pay but is not willing to pay, his/her
desire will not be called DD.
 Quantity Demanded: The quantity demanded is the actual amount of
a good or service consumers are willing to buy at some specific price.
 Cont’d
 Law of DD: The states that , price of a commodity and its quantity DD are
inversely related. That is when the price of a commodity increases (decreases)
quantity DD for that commodity decreases (increases), ceteris paribus.

 The law od demand describes in terms:

 Table (DD schedule): a tabular statement which shows the quantity of a
commodity demanded by an individual household at various alternate
prices
 Graph (Demand curve): is a graph of the relationship between the quantity
demanded of a good and its price.
 Equation: a mathematical relationship between price and quantity
demanded, all other things remaining the same.
 Q = a – bP, where b is the slope of the demand curve
 Demand Function
 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)

The Dependent variable is the quantity demanded.
The Independent variable is the good’s own price.

• Example: Let the demand function be; Q = a + bP , where b is the

slope of the demand curve (e.g. moving from point A to B on figure 2.1
below).

• Therefore, Q = a -2P , and at point B, we can find Q

Demand Schedule and Demand Curve
 Cont’d
 Market demand: curve or function is derived by horizontally adding
the quantity demanded for the product by all buyers at each price.
 Example: different quantities of mangoes demanded by different
consumers at different prices expressed in the following.
Cont’d
 Determinants of Demand

 An individual’s demand for a commodity is determined by a

number of factors.

 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

 Change in Quantity Demand
 A change in price, other factors remain constant will bring change in quantity
demanded. A change in own price is only a movement along the same
demand curve. A change in any determinant of DD except for the good‘s price
causes the DD curve to shift.
 Shift In Demand Curve
 A change in any factors except the price of the good will change the DD.
 A change in DD will shift the DD curve from its original location. For this reason
those factors other than price are called DD shifters.
 A change in own price is only a movement along the same demand curve.
 Cont’d
 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
 Income of the Consumer: The nature of the commodity on which its
demand depends.
 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.
 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.
 Cont’d
 Price of related goods: Two goods are said to be related if a change in
the price of one good affects the DD for another good.
 Substitute goods: are 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.
 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 DD
for the other are directly related.
 Cont’d
 Complimentary goods: Those goods which are used together to
satisfy a given want.
 If two goods are complements, then price of one and the demand
for the other are inversely related.
 Example, car and fuel or tea and sugar
 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.
 Number of buyer in the market: An increase in the number of
buyers will increase demand while a decrease in the number of buyers
will decrease demand.
 Elasticity of Demand
 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 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.
 Three kinds of demand elasticity
1. Price elasticity
2. Income elasticity, and
3. Cross elasticity.
 Cont’d
1. Point Price Elasticity of Demand: Price elasticity of demand refers
to the responsiveness of the quantity demanded of a good to a change
in its price. This is calculated to find elasticity at a given point. The
price elasticity of demand can be determined by the following
formula.

2. 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.
 Cont’d
• Example: 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.
a) Find price elasticity of demand for CDs using arc method.
 Range of Elasticity's on a Linear DD Curve
• Note that:
• Elasticity of DD is unit free because it is a ratio of percentage change.
• Elasticity of DD is usually a negative because of the law of demand.
• If the price elasticity of DD is positive the product is inferior.
• If   1, DD is said to be elastic (more sensitive to a price change) and the
product is luxury product
• If 0    1, DD is inelastic (less sensitive to a price change) and the product is
necessity
• If   1, DD is unitary elastic. (%change in Qd equals to %change in price)
• If   0, DD is said to be perfectly inelastic. (Change price very small in the
denominator)
• If   , DD is said to be perfectly elastic. (Change quantity very small in the
nominator)
 Determinants of Price Elasticity of DD
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 and 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.
 Income Elasticity of DD
 Income elasticity of demand refers to the sensitiveness of the quantity
demanded to a change in income.
 It is a measure of responsiveness of demand to change in income.

• Point income elasticity of demand:

i) If dI 1, the good is luxury good.
ii) If dI 1( and positive), the good is necessity good,
iii) If dI  0,(negative), the good is inferior good.
 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. His income elasticity of demand
can be found as follows.
 Cont’d
• Example: Suppose a consumer started consuming 12 kg of butter when
his income increased to Birr 2000 – which he used to consume only 8
kg when his income was Birr 1600. The consumer's income elasticity of
demand can be found using arc method as follows.
 Cross Price Elasticity of Demand
• Cross elasticity of demand means the degree of responsiveness of the
demand of a good to a change in the price of a related good, which may
be either a substitute for it or a complementary with it.

 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.
 Cont’d
• Example: Calculate the cross price elasticity of demand between the
two goods. What can you say about the two goods?

• Solution

• Therefore, the two goods are complements.

 THANKS!!!

The End of Session One!!

THANKS!!!