Chapter Two

Theory of Demand and Supply

Introduction
The purpose of this chapter is to explain what
demand and supply are and show how they
determine equilibrium price and quantity. We
will also show how the concepts of demand
and supply reveal consumers‘ and producers‘
sensitivity to price change.
 2.1 Theory of demand
• Demand is one of the forces determining
prices. The theory of demand is related to the
economic activities of consumers-consumption.
• Demand is defined as willingness and ability
of buyers to buy and use a commodity in a
specific time.
• Demand does not mean only interest or want of
individuals to use a commodity. Rather, it
implicates also the purchasing power to
command on the commodity.
 2.1 Theory of demand
• 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.
 Quantity Demanded
• Quantity demanded is the amount
(number of units) of a product that a
household would buy in a given time
period if it could buy all it wanted at the
current market price.
Symbolically; Qd = Quantity demanded
It 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.
Demand only when it is backed by the
following three factors:
 ability to pay for the good desired,
 willingness to pay the price of the
good desired, and
 availability of the good itself.
 The Law of demand
Law of demand 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.
 The Law of demand
• The law of demand states that the quantity
demanded of a good or service is negatively
related to its price, ceteris paribus. Holding
other things the same, consumers will buy
more of a good or service at a lower price
than at a higher price. As price rises,
consumers will demand a smaller quantity
of a good or service.
The Law of demand
The Law of Demand
• The law of demand
states that there is a
negative, or inverse,
relationship between
price and the quantity of
a good demanded and
its price.
• This means that
demand curves slope
downward.
 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 can be constructed for any commodity if
the list of prices and quantities purchased at those prices
are known. 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.
A demand schedule states the relationship between price
and quantity demanded in a table form.
 Table 2.1 Individual household demand
for orange per week

Combinations A B C D E

Price per kg 5 4 3 2 1

Quantity 5 7 9 11 13
demand/week
 Demand in Output Markets
ANNA'S DEMAND • A demand schedule
SCHEDULE FOR is a table showing
TELEPHONE CALLS
QUANTITY
how much of a given
PRICE DEMANDED product a household
(PER (CALLS PER
CALL) MONTH) would be willing to
$ 0
0.50
30
25 buy at different
3.50
7.00
7
3
prices.
10.00
15.00
1
0
• Demand curves are
usually derived from
demand schedules.
 Demand curve
• 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.
• Demand Curve: it is a graph that shows the
inverse relationship between price and
quantity demanded, and is plotted from the
demand schedule/table.
 Demand curve
Price = P
Y
5 A

B Demand curve
4 C
D

1 E

0 5 7 9 11 13 Qauntity demand = Qd
Figure 2.1: Individual demand curve
In the above diagram prices of oranges
are given on OY‘ y-axis and quantity
demanded on OX x- axis. For example,
when the price per kilogram is birr 1
the quantity demanded is 13 kilograms.
From the above figure you may notice
that as the price declines quantity
demanded increases and vice-versa.
The Demand Curve
ANNA'S DEMAND
SCHEDULE FOR
• The demand curve is
TELEPHONE CALLS a graph illustrating
PRICE
QUANTITY
DEMANDED how much of a given
(PER
CALL)
(CALLS PER
MONTH) product a household
$ 0
0.50
30
25 would be willing to
3.50
7.00
7
3 buy at different prices.
10.00 1
15.00 0
 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) 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 = ∆Qd (e.g. moving from point A to B on figure 2.1 above)
∆P
b = 7 - 5 = -2, where b is the slope of the demand curve
4-5
Qd = 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
Market Demand is the market demand schedule,
curve or function is derived by horizontally
adding the quantity demanded for the product by
all buyers at each price.
Price Individual demand Market
Demand
Consumer 1 Consumer 2 Consumer 3

8 0 0 0 0
5 3 5 1 9
3 5 7 2 14
0 7 9 4 20
 The following graph depicts market demand
curve at price equal to 3

+ + =
3 3 3 3

5 7 2 14

Figure 2.2: Individual and Market demand curve

 Numerical Example
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.
Then the market demand function is given by:
Market demand function = Number of buyers ×
Individual demand function
P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and
Qm = (20 – 2P) 100 = 2000-200P
 Changes in demand:
• A change in demand will shift the
demand curve from its original location.
• 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.
 Changes in demand

Price
1

2 D1
D0

D2
Qauntity

Figure 2.3: Shift in demand curve

When demand increases, demand curve shifts upward (D1)
while a decrease in demand shifts demand curve downwards
(D2).
 2.1.2 Determinants of demand

The demand for a product is influenced by

many factors. Some of these factors are:
I. Price of the product
II. Taste or preference of consumers
III. Income of the consumers
IV. Price of related goods
V. Consumers expectation of income and price
VI. Number of buyers in the market
 Determinants of demand
1. Taste or preference
When the taste of a consumer changes in favour 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, while inferior goods are those whose
demand is inversely related with income.
•
 Determinants of demand
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.
a. Substitute goods are goods which satisfy the
same desire of the consumer.
• For example, tea and coffee or Pepsi and Coca-
Cola Oil and Butter are substitute goods.
 Determinants of demand
• If two goods are substitutes, then price of one
and the demand for the other are directly.
b. Complimentary goods 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.
 Determinants of demand

•
 Determinants of demand
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.
• Expectation: when consumers expect higher price
of goods and service in the future, current demand
for goods and services will go up
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.
 Determinants of demand
• The number of buyers: when the numbers
of buyers are large, the demand for goods
becomes higher and the converse is also true
6. Season: The demand for stationary would
be high during academic periods, and falls
during school vacation. Similarly demand
for overcoats fall during hot and dry season
and increases during rainy and cold seasons.
 2.1.3 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 responsiveness
of a dependent variable to changes in an
independent variable. Accordingly, we have
the concepts of elasticity of demand and
elasticity of supply.
 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.
 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.
 Price Elasticity of Demand
• Price elasticity of demand is a measure of
how much the quantity demanded of a
good responds to a change in the price of
that good.
• It computed as the percentage change in
quantity demanded divided by the
percentage change in price.
 Price Elasticity of Demand
Depending on the magnitude of the change in
price, we have two types of price elasticity of
demand.
a. Point price elasticity of demand
b. Average or arc price elasticity of demand
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.
 Point Price Elasticity of Demand
Point elasticity of demand:- is used to
measure price elasticity of demand when
the change in price is very small or at a
point.
The point price elasticity coefficient (Ep)
can be determined as.
% change in qunatity demand of X
Ed 
% change in price of X
 Point Price Elasticity of Demand
 Q2  Q1  Q P
  x100
 Q1   
Ed 
P2  P1 P Q
( ) x100
P1

Q
P = Represents slope of the demand curve

Suppose the demand function Qd  a  bP

is
Q
P = -b
 Point Price Elasticity of Demand

• Price Elasticity of demand is therefore

Ep = - b x P/Q
• The value of Price elasticity is always a
negative and is unit free
• This because of the inverse relationship
between price and quantity demanded of a
commodity.
 Point Price Elasticity of Demand
Example 1: Suppose that the demand equation is indicated as Q d=
100 - 4P and the price is equal to $10,then Ep = ?
Solution: As the demand function is linear Q/p is constant and
equal to – 4 thus quantity demanded changed by – 4/4 units for
each unit increase in P. First calculate for Q d by substituting
P=$10 in the demand equation
Qd= 100-(4 x10) = Qd= 60
Then the point elasticity at P=$10 is
• EP= Q. P EP = - 4. 10 = - 0.67
p Qd 60
• The result can be expressed as a one percent increase
in price causes a 0.67 percent reduction in quantity
demanded.
 Point Price Elasticity of Demand
Example 2: Suppose that a household demands 50
units of oranges at the price 40 cents per piece. If
the price falls to the price 30 cents per piece, 100
oranges are demanded. What is the elasticity of
demand for Oranges?
Example 3: Consider the following demand curve

• Calculate price elasticity of demand when P= 5

Example 4: What is point elasticity when price is 12
for the demand function p = 60 − 3q?
 2. Arc Price Elasticity Of Demand
• 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 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
• Arc elasticity measures an average elasticity of the
segment AB
• The formula for measuring arc elasticity is given
below.
Ed = Change in quantity demanded ÷ Change in price
Original quantity plus new Original price plus
quantity demanded new price
Symbolically, the formula may be expressed thus:
Ed = Q1 – Q0 ÷ P1 – P0
Q1 + Q0 P 1 + P0
 Arc Price Elasticity of Demand
Here, Qo = Original quantity demanded
Q1 = New quantity demanded
Po = Original price
P1 = New price

εp 
ΔQ
X
P1  P2  OR

ΔP Q1  Q 2 
Example 1: If price of good X rises from birr 3
to birr 5 and its quantity demand falls from 240
units to 180 units. Calculate the arc price
elasticity of demand.
 Arc Price Elasticity of Demand
Example 2: Suppose that the price of
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. In
terms of the above formula, the value of the
arc elasticity will be
 Solution

Arc Ed = Q1 – Q0 ÷ P1 – P0
Q1 + Q0 P 1 + P0
Arc Ed = 110 – 100 ÷ 4 – 5
110 + 100 4+5
Arc Ed = 10 ÷ - 1 = 1 x 9 = - 3
210 9 21 -1 7
 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.
i) If l E l >1, demand is said to be elastic and the
product is luxury product
ii) If 0 ≤ /E/< 1, demand is inelastic and the
product is necessity
iii) If /E/ = 1, demand is unitary elastic.
iv) If /E/ = 0, demand is said to be perfectly
inelastic.
v) If /E/ = ∞, 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.
i) The availability of substitutes: the more
substitutes available for a product, the more
elastic will be the price elasticity of demand.
ii) 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
iii) 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.
iv) 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.
 2. Income Elasticity of Demand

It is a measure of responsiveness of
demand to change in income.

% change in qunatity demand

EId 
% change in income
EId = %∆Qd = ∆Q . I
%∆I ∆I Q
Is Called Point income elasticity of demand
 Income Elasticity of Demand
• Arc income elasticity is used when relatively
large changes in income are being considered and
is defined as
EY= Q2 - Q1 x Y2 +Y1
Y2 - Y 1 Q2 + Q1
Example1 what is the income elasticity of
automobiles as per capital income increases from,
$10,000 to $11,000? The demand for automobiles
as a function of income per capital is given by the
equation. Q= 50,000 +5(y)
 Solution:
First find Q1 and Q2 by substituting Y1= $10,000 and
Y2= 11,000 in to the demand equation
respectively.
Q1 = 50,000+5(10,000)
= 50,000 + 50,000
• Q1 = 100,000 cars
• Q2 = 50,000+5(11,000)
= 50,000 +55,000
• Q2 = 105,000 cars
 Solution
• Thus EY = 105,000-100,000 x 11,000+10,000
11,000-10,000 105,000+100,000
EY = 0.512
Interpretation: The result can be interpreted as
over the income range $10,000 to 11,000 each 1
percent increase in income causes about 0.51
increase in quantity demanded.
 Income Elasticity of Demand

Point income elasticity of demand:

i) If EId >1, the good is luxury good.
ii) If EId < 1, (and positive), the good is
necessity good.
iii) If EId < 0, (negative), the good is
inferior good.
 3. Cross price Elasticity of Demand

Cross price elasticity of demand Measures

how much the demand for a product is
affected by a change in price of another
good.
It is a percentage change in quantity
demanded of commodity X divided by the
percentage change in price of Y
This can be shown as:
 Cross price Elasticity of Demand

percentage change in quantity demanded good X

ε XY 
percentage change in price of good Y
ΔQ X P1Y  P2y
ε XY   iscalledarccrosspriceofdd
ΔPY Q 1X  Q 2X

Exy = %∆Qx = Qx1 – Qxo . Po is Called Point

%∆Py Py1 - Pyo Qo
 Cross price Elasticity of Demand
I ) The cross – price elasticity of demand for
substitute goods is positive.
ii) The cross – price elasticity of demand for
complementary goods is negative.
iii) The cross – price elasticity of demand for
unrelated goods is zero.
The cross–price elasticity of demand is zero if the
two goods are not related at all
 Cross price Elasticity of Demand
Example: Consider the following data which
shows the changes in quantity demanded of
good X in response to changes in the price of
good Y.
Unit price of Y Quantity demanded
of X
10 1500
15 1000
 Cross price Elasticity of Demand
• Calculate the cross –price elasticity of
demand between the two goods. What
can you say about the two goods?

Exy = %∆Qx = Qx1 – Qxo . Po

%∆Py Py1 - Pyo Qo

Exy = ( 1000 – 1500 } . 10 = - 500 x 10 = - 0.67

15 - 10 1500 5 1500

Therefore, the two goods are complements.

 Exercise
Q1. When price of tea in local café rises from
Br. 10 to 15 per cup, demand for coffee
rises from 3000 cups to 5000 cups a day
despite no change in coffee prices.
A) Determine cross price elasticity.
B) Based on the result, what kind of relation
exists between the two goods?
 Questions
1. Income elasticity of demand for a product is -2 the product is
A. Normal good B. Inferior good C. Necessity good
D. Luxury good
2. Which one of the following is true about cross price elasticity
of demand?
A. Cross Price elasticity of demand for substitute goods is
always negative
B. Cross Price elasticity of demand for Complementary goods is
always positive
C. Cross Price elasticity of demand for unrelated goods is one
D. Cross Price elasticity of demand for substitute goods is
always positive
3. When goods are Substitute
A. An increase in price of one good leads to an
increase in demand for the other
B. An increase in price of one good will reduce the
demand for the other
C. Change in the price of one good has no effect on
the demand another D. None of the above
4. If the demand for good “X” decreases as the level of
consumer’s income decrease then good X should be:
A. Complementary B. Substitute C. Normal
D. Inferior
5. Demand for a commodity increased from 100 units to 120
units as a result of 10% fall in its price. Calculate price
elasticity of demand.
Solution: Given: Q1= 100, Q2 = 120, fall in price = 10%
% change in quantity demanded =
(120 - 100) X100 = 20%
100
% change in price = 10% that is Given
• ЄP = 20% = 2
10% (Point price elasticity of demand)
Demand for the commodity is more than unit-elastic, that is,
1% fall in price cases 2% rise in quantity demanded.
 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.
 Theory of supply
The Supply can be demonstrated by d/t
instruments :
• supply schedule
• supply curve
• supply Function
A supply schedule is a tabular statement
that states the different quantities of a
commodity offered for sale at different
prices.
 Theory of supply
Price ( birr per kg) 30 25 20 15 10

Quantity supplied 100 90 80 70 60

kg/week
Table 2.3: an individual seller’s supply schedule for butter

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 Curve and
the Supply Schedule
• A supply curve is a graph illustrating how
much of a product a firm will supply at
different prices.

Price of soybeans per bushel ($)

6
5
CLARENCE BROWN'S
SUPPLY SCHEDULE
4
FOR SOYBEANS
QUANTITY
3
SUPPLIED
PRICE (THOUSANDS 2
(PER OF BUSHELS
BUSHEL) PER YEAR) 1
$ 2 0
1.75
2.25
10
20
0
3.00 30
4.00 45 0 10 20 30 40 50
5.00 45 Thousands of bushels of soybeans
produced per year
 The Law of Supply
The law of supply The law of supply
6
states that there is a
Price of soybeans per bushel ($)

5 positive relationship
4 between price and
3
quantity of a good
2
1
supplied.
0 • This means that
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
supply curves
typically have a
positive slope.
 Theory of supply
price The supply curve
slopes upward as we go
Supply Curve from the left to the
right. This means, as
the price rises, more is
offered for sale and
Quantity vice-versa.

Figure 2.5 supply curve

• 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.
 Theory of supply
• Market supply: It is derived by horizontally
adding the quantity supplied of the product by
all sellers at each price.
Price per Quantity Quantity Quantity Market
unit supplied by supplied by supplied by supply
seller 1 seller 2 seller 3 per week
5 11 15 8 34
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

Table 2.4: Derivation of the market supply of good X

 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:
i) price of inputs ( cost of inputs)
ii) technology
iii) prices of related goods
iv) sellers‘ expectation of price of the
product
v) taxes & subsidies
vi) number of sellers in the market
vii) weather, etc.
 Determinants of supply
1. Effect of change in input price on supply of a
product
• An increase in the price of inputs such as labour,
raw materials, capital, etc causes a decrease in
the supply of the product which is represented
by a leftward shift of the supply curve.
• Likewise, a decrease in input price causes an
increase in supply.
2. Effect of change in Technology
• Technological advancement enables a firm to
produce and supply more in the market. This
shifts the supply curve outward.
 Determinants of supply
3. Effect of change in weather condition
• A change in weather condition will have an
impact on the supply of a number of
products, especially agricultural products.
For example, other things remain
unchanged, good weather condition boosts
the supply of agricultural products. This
shifts the supply curve of a given
agricultural product outward. Bad weather
condition will have the opposite impact.
 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
 Elasticity of supply
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:
 Elasticity of supply

% change in qunatity sup ply

ES 
% change in price
ES = ∆Qs ÷ ∆P = = ∆Qs X P
Q P ∆P Q

Like elasticity of demand, price elasticity of

supply can be elastic, inelastic, unitary elastic,
perfectly elastic or perfectly inelastic.
Example 1: Suppose an increase in price of a ball pen from
Birr 4 to Birr 5 results in increase in quantity supplied of
pens from 1,000 to 1,500 units. Then find price elasticity of
supply using the Arc method.
• Solution: Given: Q1 = 1000, Q2 = 1500, P 1= 4, P2 = 5
• ΔQ = 1, 500 – 1,000 = 500, ΔP = 5 – 4 = 1
If price increases by 1%, quantity supplied increases by 2%.
Example 2: A local producer of edible oil reduced its quantity
supplied from 10,000 liters to 8,000 liters per month in
response to price fall of oil from Birr 25 to Birr 20. Then
find price elasticity of supply using the Arc method.
Solution: Price elasticity of supply using arc method can be
found as follows
Example 3: The quantity supplied of a commodity
at a price of Birr 8 per unit is 400 units. Its price
elasticity of supply is 2. Calculate the price at
which its quantity supplied is 600 units.
Solution: Given: es= 2, P1 = 8, Q1 = 400, Q2= 600,
• ΔQ = 600 – 400 = 200, P2 = ?
2P2 – 16 = 4 ⇒ 2P2 = 20 ⇒ P2 = 10
The quantity supplied will be 600 units at a price
of 10 Birr per unit.
 2.3 Market equilibrium
Market equilibrium refers to a situation
in which quantity demanded of a
commodity equals the quantity
supplied of a commodity.
Market equilibrium occurs when market
demand equals market supply.
 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.
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.
 Market equilibrium
Price At point E market
demand equals
D S market supply
H J (equilibrium point) P
P1 E is the market
equilibrium (market
p2 clearing) price.
S G F D M is the market
M Q equilibrium (market
clearing) quantity.
Figure 2.7: market equilibrium
 Market equilibrium
• 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.
 Market equilibrium
• 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.
 Market equilibrium
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
 Market equilibrium
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
50-30 = 20 units
 EXERCISE
1. Given market demand Qd = 50 - P, and market
supply P = Qs + 5
A) Find the market equilibrium price and quantity?
B) What would be the state of the market if market
price was fixed at Birr 25 per unit?
C) Calculate and interpret price elasticity of
demand at the equilibrium point.
d. Calculate and interpret price elasticity of Supply
at the equilibrium point.
 EXERCISE
2. When price of tea in local café rises from Br.
10 to 15 per cup, demand for coffee rises
from 3000 cups to 5000 cups a day despite no
change in coffee prices.
A) Determine cross price elasticity.
B) Based on the result, what kind of relation
exists between the two good
3. The demand and supply functions that a firm faces are given by:
Qd = 40 – 2P Qs = 10 + P, Then Calculate
a. The equilibrium price
b. The equilibrium quantity
c. How much (surplus/shortage)would there be if price is fixed at
birr 6
d. How much (surplus/shortage)would there be if price is fixed at
birr 12
e. Calculate the total revenue of the sellers at equilibrium point
(Hint TR = P x Q)
f. Calculate and interpret price elasticity of demand at the
equilibrium point.
g. Calculate and interpret price elasticity of supply at the
equilibrium point.
4. Suppose market demand is given as
Qd = a – bp and market supply is given as
Qs = c +dp, and then find the following:
a. Equilibrium price
b. Equilibrium quantity
c. Price elasticity of demand at equilibrium
d. Price elasticity of supply at equilibrium
Any question?