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TOPIC 3: DEMAND AND SUPPLY

THEORY OF DEMAND AND DEMAND CURVE

- The fundamental objective of demand theory is to identify and analyse the basic determinants of consumer
needs and wants.
- Such knowledge provides the back ground needed to make pricing decisions, forecast sales, and formulates
marketing strategies.
INDIVIDUAL DEMAND AND MARKET DEMAND
INDIVIDUAL DEMAND
Definition
 Is that quantity of a commodity that an individual is willing and able to buy during a given time period.
 An individual’s demand curve for goods shows the relationship between the quantity demanded by the
individual and the market price, ceteris paribus.

MARKET DEMAND
Definition
 Market: The market for a product is the area in which buyers and sellers come into contact with each other
in order to exchange the product.
 Market demand: The market demand for a product is the sum of the demands of individual consumers in
the relevant market.
Demand analysis deals with the whole range of planning by the firm including; manpower utilisation, production
planning, inventory management, investment decisions, cost budgeting, purchase plan, market research, pricing
decisions, advertising budget, profit planning e.t.c.- all these call for a detailed analysis of demand.
THE LAW OF DEMAND (PRICE DEMAND RELATIONSHIP)
 Demand for a commodity during a given period of time depends upon so many factors including the price
of the commodity.
 The relationship between price and demand can be explained by the help of the ”Law of demand”
 The law states that ‘’other things being equal, with fall in price, the demand for the commodity is
extended (increases), and with a rise in the price, the demand is contracted (decreases)’’.

Price demand relationship can be represented in a form of a schedule, graph or algebraic equation.

Example: Schedule and graph illustrating the Law of demand.

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Demand schedule
Price Demand
(Ksh) (Ksh) Demand Curve
50 10 70 D
45 20 60
40 30 50

Price
35 40 40
30 50 30
25 60 20 D D
20 70 10
10 20 30 40 50 60 70
Quantity (per time period)
Assumptions of the Law of Demand
The following is assumed to remain constant (Ceteris paribus) or the same by the law:
1. Income of the consumer.
2. Taste and preferences of individual.
3. Price of substitute commodities.
4. Further expected changes.

Exceptions of the law of demand

1. Veblen goods (conspicuous good). Veblen goods are groups of commodities for which people’s
preference for buying them increases as direct function of their price, as greater price confers greater status.
Hence, the law does not apply where marginal utility of any commodity goes to increase when more and
more units of that commodity are consumed e.g. Some high-status goods, such as Diamond, designer hand
bags, rare paintings and luxury cars etc. are good examples. Prestige is directly associated with the price of
the good. The higher the price, the greater the status or prestige of the buyer in the society and vice versa.
2. Giffen goods - AGiffen good is one which people consume more of as price rises, violating the law of
demand. ( N/B. In normal situations, as the price of such a good rises, the substitution effect causes people
to purchase less of it and more of substitute goods). In the Giffen good situation, cheaper close substitutes
are not available. Because of the lack of substitutes, the income effect dominates, leading people to buy
more of the good, even as its price rises. Example of giffen goods are inferior quality staple foods, whose
demand is driven by poverty that makes their purchasers unable to afford superior foodstuffs. As the price
of the cheap staple rises, they can no longer afford to supplement their diet with better foods, and must
consume more of the staple food.

As Mr. Robert.Giffen pointed out, a rise in the price of bread makes so large a drain on the resources of
the poorer labouring families and raises so much the marginal utility of money to them, that they are forced
to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the
cheapest food which they can get and will take, they consume more, and not less of it.

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DEMAND FUNCTION (Demand Determinant)

The demand function for a good is the relationship between the various amount of the commodity that management
be bought and the determinants of those amounts in a given market and in a given period of time. Thus, the factors
on which demand for a commodity depends (determinants of demand) are:-
a. The price of the commodity.
b. The prices of related goods (substitutes or compliments).
c. The income of the consumers,
d. The tastes and preferences of the consumers and,
e. The expectations about the future prices of the commodity.

The demand function may be expressed symbolically as

Qd = f (P, Pr, Y, T, E, O)
Where
Qd = Quantity demanded for a commodity.
P = Price of the commodity.
Pr = Prices for related goods.
Y = Income of the consumer.
T = Taste & preferences of the consumer.
E = Expectations about the future prices.
O = other factors – e.g. size and regional distribution of population, Composition of population, distribution of
income.

Distinction between extension and contraction of demand, and rise and fall in demand. Extension and
contraction of demand
- The changes in demand due to the changes in price are called extension and contraction of demand.
- Extension of demand is an increase in demand due to fall in price.
- Contraction of demand is a decrease in demand due to rise in price level.
- In extension and contraction of demand, the demand curve remains the same but demand points shifts from
one place to another. The two situations are known as changes in quantity demanded.

Demand Schedule
Price Demand
(Ksh) (Units)
3 10
2 15 Extension
3 10 Contraction
4 5

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Y
4 R2

3 R
Price

2 R

X
0 5 10 15
Demand
Rise and Fall
Rise and fall in demand may occur due to change in any factor other than price.
Rise in demand occurs when other price remaining the same, demand increases or at a higher price, demand
remains the same.
Fall in demand occurs when either price remaining the same, demand decreases or at a lower price, demand
remains the same.
In case of rise and fall in demand, demand curve shifts from one place to another place. When demand rises, the
demand curve shifts from left to right upward. In case of fall in demand, demand curve shifts from right to left
downward. These two situations are known as change in demand.
Illustration of the above situations.

D2 D1
Rise in demand Rise in demand
D
Price Demand 4 In
(Kshs) (Units) ec
3 10 3 on D1
Price

o
3 15 m D2
3 10 2 ic D
s
4 10 5 10 15
an
Demand
d
co D
Y nsD2
Fall in demand u
Price Demand 4 mD1
(Kshs) (Units) er
th
3 10 3 eo
3 5 ry
,a D
3 10 2 D1 D2
G
2 10 0 iff 5 10 15 X
en
go
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Demand

Factors of change in demand

1. Change in price – lead to extension or contraction of demand.
2. Change in fashion and tastes.
3. Change in income – Increase in income increases demand and vise versa.
4. Changes in prices of substitute commodities e.g. if price of coffee increases, demand for tea may increase.
5. Change in population - Increase in population increases demand and vice versa.
6. change in wealth distribution – when wealth is more equally distributed demand for goods and service will
tend to rise and vice versa.
7. Economic conditions – when there will be economic prosperity in the country demand will tend of be greater.

INTER – RELATED DEMANDS

1. Joint demand – two or more goods are demanded together- also called complimentary demand e.g. motor cars
& petrol, tea leaves, sugar & milk etc.
2. Competitive demand – refers to demand of substitute goods – demand of one will inversely affect the demand
of the other e.g. tea & coffee etc.
3. Composite demand – refers to demand of goods used for different purposes. The total demand for such goods
for all uses in known as composite demand for steel used to manufacture motor cars, machines, building etc.
4. Derived demand – refers to demand of goods used to produce some other goods e.g. cotton is required to
produce cloth, demand for cotton is a derived demand as a result of increased demand of cloth.

SUPPLY
In economics supply means quantity of any commodity which is offered for sale at any specific price in a given
period.

Supply is always related to price - without the reference of price, supply cannot be determined. The relationship
supply and price is called the Law of supply.

The law of supply may be defined in the following words:-

“Other things remaining the same when price rises supply increases and when price falls, supply decreases”

This can be explained with the help of the following schedule and curve.
Supply schedule
Supply Schedule

Price Supply
(Shs ) (units)

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20 10
25 20
30 30
35 40
40 50
45 60
50 70
Supply Curve

Assumptions of law of supply

The law supply applies when certain conditions are fulfilled:-

It is assumed that the following factors do not change.

1) Cost of production
2) Policy of the government
3) Techniques of production
4) Transport and communication system

Extension and contraction of supply and rise and fall in supply

The change in supply due to change in price is known as extension and contraction of supply.
 Extension of supply occurs when supply increases due to rise in price level.
 Contraction of supply occurs when supply decreases due to fall in price level.
Extension and contraction of supply is also known as change in quantity supplied.

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It can be explained by the help of the following schedule and diagram
Extension of supply

Price supply
(Ksh) (units)
3 10
4 15
Contraction of supply
(Ksh) Units
3 10
2 5

Rise and fall in supply

It occurs when supply changes due to change in any factors other than price.
 Rise in supply occurs, when either price remaining the same, supply increases or at a lower price, supply
remains the same.
 Fall in supply occurs, when either price remaining the same, supply decreases or at a higher price, supply
remains the same.
 When supply rises supply curve shifts from left to right downward.
 When supply falls, supply curve shifts from right to left upwards.

It can be explained as under :

Rise in supply Fall in Supply

Factors of change in supply

Rise or fall in supply occurs due to the change in the following factors:-
1) Cost of production

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When cost of production of any commodity rises supply falls and vice versa
2) Climatic situation
If climatic situations remain favourable, agricultural production will increase and as a result of this supply
will rise and vice versa
3) Improvement in the method of production
When new and less expensive methods of production are invented, supply rises and vice versa.
4) Development of means of transport and communication
If means of transport and communication are adequate and developed it will be possible to move
commodities from one place to another. In this case supply will rise and vice versa.
5) Peace and security
During peace and security, supply rises, because production is encouraged and vice versa.
6) Government policy
When restrictions are carried by the government on the movement of the commodities, supply will fall and
when such restrictions are removed supply will rise.

Inter-related supply
1) Joint supply - Is the supply of those goods which have common process of production.. The supply
good is increased or decreased simultaneously.
Examples include – Wool and mutton, form crude oil, different type of petrol
products.
2) Composite supply – Is the supply of goods which are substitute of one another. Their total quantity is
called composite supply.
Examples
1) Supply of mutton , Beef and Chicken
2) Supply of Tee and coffee
3) Supply of cold drinks like cocacola, pepsi etc.
3) Competitive supply
Refers to supply of goods which may use the same factor(s) of production alternatively for example. If
more land is used to produce wheat, then production of maize will decrease.

Explanation of the Law of Supply and Its Exceptions

Law of Supply Meaning

The law of supply describes the practical interaction between the price of a commodity and the quantity offered by
producers for sale. The law of supply is a hypothesis, which claims that at higher prices the willingness of sellers to
make a product available for sale is more while other things being equal. When the price of a product is high, more
producers are interested in producing the products. On the contrary, if the price of a product is low, producers are
less interested in producing the product and hence the offer for sale is low. The concept of law of supply can be
explained with the help of a supply schedule and a supply curve.

Supply Schedule

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Supply schedule represents the relationship between prices and the quantities that the firms are willing to produce
and supply. In other words, at what price, how much quantity a firm wants to produce and supply.

Suppose the following is an individual’s supply schedule of oranges.

Table 1

Price Per Dozen ($) Quantity Supplied (in dozens)

4 3
6 6
8 9
10 12
12 13

The supply curve is a graphical representation of the law of supply. The supply curve has a positive slope, and it
moves upwards to the right. This curve shows that at the price of $6, six dozens will be supplied and at the higher
price $12, a larger quantity of 13 dozens will be supplied.

Market Supply Curve

The summation of supply curves of all the firms in the industry gives us the market supply curve.

Table 2: Supply Schedule for Two Suppliers and the Market Supply Schedule

Price (in $) Quantity offered by Supplier A Quantity offered by Supplier B Market Supply
4 5 6 5 + 6 = 11
6 7 7 7 + 7 = 14
8 9 8 9 + 8 = 17
10 11 9 11 + 9 = 20
12 13 10 13 + 10 = 23

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In the figure 2 given above, there are three supply curves. It is assumed that there are two sellers in the industry A
and B. SA is the supply curve for A and SB is the supply curve for B. by the lateral summation of these curves we get
the market supply curve.

Exceptions to the Law of Supply

The law of supply states that other things being equal, the supply of a commodity extends with a rise in price and
contracts with a fall in price. There are however a few exceptions to the law of supply.

1. Exceptions of a fall in price

If the firms anticipate that the price of the product will fall further in future, in order to clear their stocks they may
dispose it off at a price that is even lower than the current market price.

2. Sellers who are in need of cash

If the seller is in need of hard cash, he may sell his product at a price which may even be below the market price.

3. When leaving the industry

If the firms want to shut down or close down their business, they may sell their products at a price below their
average cost of production.

4. Agricultural output

In agricultural production, natural and seasonal factors play a dominant role. Due to the influence of these
constraints supply may not be responsive to price changes.

5. Backward sloping supply curve of labor

The rise in the price of a good or service sometimes leads to a fall in its supply. The best example is the supply of
labor. A higher wage rate enables the worker to maintain his existing material standard of living with less work, and
he may prefer extra leisure to more wages. The supply curve in such a situation will be ‘backward sloping’ SS1 as
illustrated in figure 3.

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At WN wage rate, the supply of labor is ON. But beyond NW wage rate the worker will reduce rather than increase
his working hours. At MW1 wage rate the supply of labor is reduced to OM.

Extension and Contraction of Supply

‘Extension’ and ‘contraction’ of supply refer to movements on the same supply curve. If with a rise in price, the
supply rises, it is called an extension of supply; if, with a fall in price, the supply declines it is called a contraction
of supply. The ‘extension’ and ‘contraction’ of supply are illustrated in figure 4. In figure 4, the movement from
point E to E1 on the same supply curve shows an extension of supply and E1 to E shows a contraction of supply.

Increase and Decrease in Supply

‘Increase’ and ‘decrease’ in supply causes shifts in the supply curve. A shift in the supply curve due to a change in
some factor other than the price of the commodity is referred to as a change in supply.

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Supply is said to increase when more is offered in the market without a change in price. Supply is said to decrease
when less is offered in the market without a change in the price of the commodity. In figure 5, at price EM, the
supply is OM. SS is the supply curve before the change. S1S1 shows an increase in supply because at the same price
ME = M1E1 more is offered for sale, i.e., OM1 instead of OM. S2S2 shows the decrease in supply because at the
same price ME = M2E2 less is offered for sale, i.e., OM2 instead Of OM

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THE CONCEPT OF EQUILIBRIUM

Consumers and producers react differently to price changes. Higher prices tend to reduce demand while
encouraging supply, and lower prices increase demand while discouraging supply.
Economic theory suggests that, in a free market there will be a single price which brings demand and supply into
balance, called equilibrium price.

Market clearing

Equilibrium price is also called market clearing price because at this price the exact quantity that producers take to
market will be bought by consumers, and there will be nothing ‘left over’. This is efficient because there is neither
an excess of supply and wasted output, nor a shortage – the market clears efficiently. This is a central feature of the
price mechanism, and one of its significant benefits.
Example

The weekly demand and supply schedule for a brand of soft drink at various prices (between Ksh 30 and 110) is
shown opposite.

QUANTITY
PRICE (£) QUANTITY DEMANDED
SUPPLIED
110 0 1000
100 100 900

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90 200 800
80 300 700
70 400 600
60 500 500
50 600 400
40 700 300
30 800 200

Equilibrium

As can be seen, this market will be in equilibrium at a price of Ksh 60 per soft drink. At this price the demand for
drinks by students equals the supply, and the market will clear. 500 drinks will be offered for sale at Ksh 60 and 500
will be bought - there will be no excess demand or supply at Ksh 60.

PRICE (Ksh) QUANTITY DEMANDED QUANTITY SUPPLIED

110 0 1000
100 100 900
90 200 800
80 300 700
70 400 600

60 500 500
50 600 400
40 700 300

30 800 200

How equilibrium is established

At a price higher than equilibrium, demand will be less than 500, but supply will be more than 500 and there will be
an excess of supply in the short run.

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Graphically, we say that demand contracts inwards along the curve and supply extends outwards along the curve.
Both of these changes are called movements along the demand or supply curve in response to a price change.

Demand contracts because at the higher price, the income effect and substitution effect combine to discourage
demand, and demand extends at lower prices because the income and substitution effect combine to encourage
demand.
Income effect - assume that if money income is fixed, the income effect suggests that, as the price of a good falls,
real income - that is, what consumers can buy with their money income - rises and consumers increase their
demand
Substitution effect - States that as the price of one good falls, it becomes relatively less expensive. Therefore,
assuming other alternative products stay at the same price, at lower prices the good appears cheaper, and
consumers will switch from the expensive alternative to the relatively cheaper one.

Further illustration

If price is below the equilibrium

 If price was below the equilibrium at P2 then demand would be greater than the supply. Therefore there is a
shortage of (Q2 – Q1)
 If there is a shortage, firms will put up prices and supply more. As price rises there will be a movement
along the demand curve and less will be demanded.
 Therefore price will rise to P1 until there is no shortage and supply = demand

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If price is above the equilibrium

 If price was above the equilibrium (e.g. P1), then supply (Q1) would be greater than demand (Q3) and
therefore there is too much supply. There is a surplus.
 Therefore firms would reduce price and supply less. This would encourage more demand and therefore the
surplus will be eliminated. The market equilibrium will be at Q2 and P1.

Changes in equilibrium
Graphically, changes in the underlying factors that affect demand and supply will cause shifts in the position of the
demand or supply curve at every price.
Whenever this happens, the original equilibrium price will no longer equate demand with supply, and price will
adjust to bring about a return to equilibrium.
Changes in equilibrium
For example, if there is a particularly hot summer, students may prefer to drink more soft drinks at all prices, as
indicated in the new demand schedule, QD1 .
PRICE (ksh) QD QD1 QUANTITY SUPPLIED
110 0 200 1000
100 100 300 900

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90 200 400 800

80 300 500 700
70 400 600 600
60 500 700 500
50 600 800 400
40 700 900 300
30 800 1000 200

At the higher level of demand, keeping the price at Ksh 60 would lead to an excess of demand over supply, with
demand at 700 and supply at 500, with an excess of 200. This will act as an incentive for the seller to raise price, to
Ksh 70. Equilibrium will now be re-established at the higher price.

There are four basic causes of a price change:

An increase in demand shifts the demand curve to the right, and raises price and output.
Demand shifts to the right.

Demand shifts to the left

A decrease in demand shifts the demand curve to the left and reduces price and output.

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Supply shifts to the right

An increase in supply shifts the supply curve to the right, which reduces price and increases output.

Supply shifts to the left

A decrease in supply shifts the supply curve to the left, which raises price but reduces output.

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The entry and exit of firms

In a competitive market, firms may enter or leave with little difficulty. Firms may be attracted into a market for a
number of reasons, but particularly because of the expectation of profit. This causes the market supply curve to shift
to the right. Rising prices may provide a sufficient incentive and provide a signal to potential entrants to enter the
market.

There is a chain reaction, starting with an increase in demand, from D to D1. This raises price to P1, which provides
the incentive for existing firms to supply more, from Q to Q1. The higher price also provides the incentive for new
firms to enter, and as they do the supply curve shifts from S to S1.

A market where prices are rising provides the best opportunity for the entrepreneur. Conversely, lower prices
encourage firms to leave the market.

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