Theory of Demand and Supply

Your Business Purpose - Theory of Demand and Supply

2.1 Theory of Demand

  • Demand is a key force in determining prices.
  • The theory of demand is related to consumer economic activities and consumption.
  • The purpose of the theory of demand is to identify factors affecting demand.
  • Demand is more than just a desire to purchase; it requires willingness and ability to purchase.
  • A consumer's desire does not translate to demand if they are unwilling or unable to pay.
  • Demand refers to the quantities of a commodity consumers will purchase at various prices at a given time, assuming other factors are constant (ceteris paribus).
  • The quantity demanded depends on the price of the commodity.
  • Law of Demand: Price and quantity demanded are inversely related; as price increases (decreases), quantity demanded decreases (increases), ceteris paribus.

2.1.1 Demand Schedule, Demand Curve, and Demand Function

  • The relationship between price and quantity demanded can be represented by a table (schedule), a curve, or an equation.
  • Demand Schedule: A table showing the relationship between price and quantity demanded.
  • Demand Curve: A graphical representation of the relationship between quantity demanded and price.
  • Demand Function: A mathematical relationship between price and quantity demanded, assuming all other factors are constant. A typical demand function is Qd=f(P), where Qd is quantity demanded and P is the price.
  • Example: Demand function: Q = a + Bp

Market Demand

  • Market demand is derived by horizontally adding the quantity demanded by all buyers at each price.
  • Numerical Example: Individual demand function is given by: P=10 - Q /2, assuming there are 100 identical buyers in the market. The market demand function is derived as follows:
    • P= 10 - Q /2
    • Q /2 =10-P
    • Q= 20 - 2P
    • Qm = (20 – 2P) 100
    • = 2000-200P

2.1.2 Determinants of Demand

  • Demand is influenced by several 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
  • When stating the law of demand, all factors except the price are kept constant.
  • Factors other than price are called demand shifters.
  • A change in own price results in a movement along the same demand curve.

Changes in Demand

  • A change in any determinant of demand except price causes the demand curve to shift.
  • If buyers purchase more at any price, the demand curve shifts rightward (increase in demand).
  • If buyers purchase less at any price, the demand curve shifts leftward (decrease in demand).

I. Taste or Preference

  • Demand increases when consumer taste favors a good, and vice versa.

II. Income of the Consumer

  • Goods are classified into normal and inferior goods based on how demand changes with income.
  • Normal Goods: Demand increases as income increases.
  • Inferior Goods: Demand decreases as income increases; these are typically lower-quality goods.

III. Price of Related Goods

  • Goods are related if a change in the price of one affects the demand for the other.
  • Substitute Goods: Satisfy the same desire (e.g., tea and coffee). If two goods are substitutes, the price of one and the demand for the other are directly related.
  • Complimentary Goods: Goods consumed jointly (e.g., car and fuel). If two goods are complements, the price of one and the demand for the other are inversely related.

IV. Consumer Expectation of Income and Price

  • Higher price expectations increase demand, while lower future price expectations decrease demand.

V. Number of Buyers in the Market

  • An increase in buyers increases demand, and vice versa.

2.1.3 Elasticity of Demand

  • Elasticity measures the responsiveness of a dependent variable to changes in an independent variable.
  • Elasticity of Demand: Degree of responsiveness of quantity demanded to changes in price, income, or prices of related goods.
  • Three types of demand elasticity:
    • Price elasticity
    • Income elasticity
    • Cross elasticity

I. Price Elasticity of Demand

  • Measures the degree of responsiveness of demand to price changes.
  • The greater the reaction to price change, the greater the price elasticity.
  • Calculated as the percentage change in quantity demanded divided by the percentage change in price.
  • Demand for necessities may not change even with price changes, while demand for commodities like clothes or fruit changes even with a small change in their price.
  • Price elasticity can be measured in two ways: point and arc elasticity.
A. Point Price Elasticity of Demand
  • Calculated to find elasticity at a specific point using the following formula:
B. Arc Price Elasticity of Demand
  • Uses the midpoints of the old and new values of both price and quantity demanded.
  • Measures elasticity over a segment of the demand curve.
  • Numerical Example: If the price of a commodity is Br. 5 and the quantity demanded is 100 units, and the price falls to Br. 4 and the quantity demanded rises to 110 units, the arc elasticity can be calculated.
  • Elasticity of demand is unit-free as it is a ratio of percentage changes.
  • Elasticity of demand is usually negative due to the law of demand.

Determinants of Price Elasticity of Demand

  • Availability of substitutes: More substitutes lead to more elastic demand.
  • Time: Demand tends to be more elastic in the long run due to more substitutes and adjusted consumption patterns.
  • Proportion of income spent: Smaller proportion leads to less price elasticity.
  • The importance of the commodity in the consumers’ budget:
    • Luxury goods tend to be more elastic.
    • Necessity goods tend to be less elastic.

II. Income Elasticity of Demand

  • Measures the responsiveness of demand to changes in income.
  • Point income elasticity of demand formula:
    \varepsilon = \frac{\%\Delta Qd}{\%\Delta I} = \frac{\Delta Q}{\Delta I} * \frac{I}{Q}
  • If \varepsilon > 1 , the good is a luxury good.
  • If \varepsilon < 1 (and positive), the good is a necessity good.
  • If \varepsilon < 0 , the good is an inferior good.

III. Cross-Price Elasticity of Demand

  • Measures how much the demand for a product is affected by a change in the price of another good.
  • Example: Data showing changes in quantity demanded of good X in response to changes in the price of good Y. Calculate the cross-price elasticity to determine the relationship between the two goods.

2.2 Theory of Supply

  • Supply indicates the quantities of a product that sellers are willing and able to provide at different prices in a given period, ceteris paribus.
  • Law of Supply: As the price of a product increases, the quantity supplied increases, and vice versa, ceteris paribus. Shows a positive relationship between price and quantity supplied.

2.2.1 Supply Schedule, Supply Curve, and Supply Function

  • Supply Schedule: A table stating the different quantities of a commodity offered for sale at different prices.
  • Supply Curve: A graphical representation of the supply schedule.
  • Supply Function: A mathematical representation, S = f(P), where S is quantity supplied and P is the price.

Market Supply

  • Derived by horizontally adding the quantity supplied by all sellers at each price.

2.2.2 Determinants of Supply

  • Supply is determined by:
    • Price of inputs (cost of inputs)
    • Technology
    • Prices of related goods
    • Sellers' expectation of the product's price
    • Taxes and subsidies
    • Number of sellers in the market
    • Weather

I. Effect of Change in Input Price on Supply

  • An increase in input prices decreases supply, shifting the supply curve leftward.

II. Effect of Change in Technology

  • Technological advancement increases supply, shifting the supply curve outward.

III. Effect of Change in Weather Conditions

  • Weather impacts the supply of agricultural products significantly.

2.2.3 Elasticity of Supply

  • Measures the responsiveness of supply to changes in price.
  • It is the percentage change in quantity supplied divided by the percentage change in price.
  • 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.
  • 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

  • Market equilibrium occurs when market demand equals market supply.
  • At point 'E' market demand equals market supply (equilibrium point).
  • P is the market equilibrium (market clearing) price.
  • M is the market equilibrium (market clearing) quantity.

Numerical 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) Qa(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
    • Qa( at P=35) = 100-2(35) = 30 and Qs (at p = 35) = 2(35)-20 = 50, a surplus of 20 units

Effects of Shift in Demand and Supply on Equilibrium

  • Given demand and supply, the equilibrium price and quantity are stable.
  • Changes in demand and supply alter the equilibrium price level and quantity.

I ) When Demand Changes and Supply Remains Constant

  • Factors like changes in income, tastes, and prices of related goods shift demand.

II. When Supply Changes and Demand Remains Constant

  • Changes in technical knowledge and factor prices shift supply.

III) Effects of Combined Changes in Demand and Supply

  • When both demand and supply increase, the quantity increases definitely.
    • If demand increases more than supply, the price rises.
    • If supply increases more than demand, the price falls.
    • If demand and supply increase equally, the price remains the same.
  • When demand and supply decline, the quantity decreases.
    • If demand falls more than supply, the price decreases.
    • If supply falls more than demand, the price rises.
    • If demand and supply decline equally, the price remains the same, but the quantity decreases.