CHAPTER TWO

Theory of Demand and Supply

Demand is the desire of the consumer for a commodity backed by purchasing power. It also refers to various
quantities of a commodity or service that a consumer would purchase at a given time in a market at various
prices, ceteris paribus.

The law of demand states that price of a commodity and its quantity demanded are inversely related, ceteris
paribus.

Demand schedule is a list of the various quantities of a commodity which an individual consumer or consumers
purchase at various levels of prices in the market per time period. It is tabular in form.

Demand curve is a graphical representation of the demand schedule.

Demand function is a mathematical relationship between price and quantity demanded, ceteris paribus.

Here are some types of goods:

• Normal goods – Their demand increases as income increases.

• Inferior goods – are forsaken in place of better-quality goods as income increases.
• Related goods – are those where a change in the price of one affects the demand for another.
➢ Substitute goods – satisfy the same desire of the consumer, i.e., they are interchangeable.
➢ Complementary goods – are jointly consumed.
• Giffen goods – are non-luxury products whose demand rises as their prices increase.

Change in demand is the shifting of the demand curve due to a change in any determinant of demand (demand
shifter) except for the good’s price. An increase in demand shifts the demand curve rightwards, while a decrease
shifts it leftwards. But a change in price is only a movement along the same demand curve.

Determinants of Demand

• Price of the product – In general, as price increases, demand decreases.

• Taste or preference – A change of taste in favor of a good increases its demand.
• Income of the consumer – As income increases, the demand for normal goods increases while it decreases
for inferior goods.
• Price of related goods
➢ For substitute goods, the price of one and the demand for the other are directly related.
➢ For complementary goods, the price of one and the demand for the other are inversely related.
• Consumer expectation of income and price – Higher price expectation will increase demand.
• Number of buyers in the market – Since market demand is the horizontal sum of individual demand, an
increase in the number of buyers will increase demand.

Elasticity of Demand

Elasticity is a measure of the responsiveness of a dependent variable to changes in an independent one.

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 price of related goods. Its types are as follows:

• Price elasticity of demand – measures the degree of responsiveness of demand to change in price.
 ➢ Point price elasticity of demand – is the elasticity at a given point.
∆𝑄 𝑃0
𝜀𝑑𝑃 = ·
∆𝑃 𝑄0

➢ Arc price elasticity of demand – measures a portion of the demand curve between two points.
𝑄1 − 𝑄0 𝑃1 − 𝑃0
𝜀𝑑𝑃 = ÷
𝑄1 + 𝑄0 𝑃1 + 𝑃0

𝜀𝑑𝑃 = price elasticity of demand 𝑃1 = new price

𝑄0 = original quantity demanded ∆𝑄 = 𝑄1 − 𝑄0

𝑃0 = original price ∆𝑃 = 𝑃1 − 𝑃0

𝑄1 = new quantity demanded

✓ If 𝜀 > 0, then the product is inferior.

✓ If |𝜀| > 1, demand is said to be elastic and the product is luxury.
✓ If 0 ≤ |𝜀| < 1, demand is inelastic and the product is a necessity.
✓ If |𝜀| = 1, demand is unitary elastic.
✓ If |𝜀| = 0, demand is said to be perfectly inelastic.
✓ If |𝜀| = ∞, demand is said to be perfectly elastic.

Determinants of 𝜀𝑑𝑃

i) The availability of substitutes – increases elasticity.

ii) Time – [in the long-run] increases elasticity since more substitute goods could be produced.
iii) The proportion of income consumers spend for a product – increases elasticity.
iv) The importance of the commodity in the consumers’ budget (whether it’s a luxury or necessity)

• Income elasticity of demand – measures the degree of responsiveness of demand to change in income.
∆𝑄 𝐼0
𝜀𝑑𝐼 = ·
∆𝐼 𝑄0

✓ If 𝜀𝑑𝐼 > 1, the good is a luxury.

✓ If 0 < 𝜀𝑑𝐼 < 1, the good is a necessity.
✓ If 𝜀𝑑𝐼 < 0, the good is inferior.
• Cross price elasticity of demand – measures how much the demand for a product is affected by a change
in price of another good.
𝑄𝑥1 − 𝑄𝑥0 𝑃𝑦0
𝜀𝑥𝑦 = ·
𝑃𝑦1 − 𝑃𝑦0 𝑄𝑥0

✓ 𝜀𝑥𝑦 > 0 for substitute goods.

✓ 𝜀𝑥𝑦 < 0 for complementary goods.
✓ 𝜀𝑥𝑦 = 0 for unrelated goods.

Supply indicates various quantities of a product that sellers (producers) are willing and able to provide at different
prices in a given time period, ceteris paribus.
The law of supply states that, ceteris paribus, as price of a product increases, quantity supplied of the product
increases. It tells us there is a positive relationship between the two.

Supply schedule is a tabular statement that states the different quantities of a commodity offered for sale at
different prices.

Supply curve conveys the same information as a supply schedule but graphically.

Supply function establishes a mathematical relationship between the quantities supplied and the corresponding
prices, ceteris paribus.

Determinants of Supply

• Price (cost) of inputs – As it increases, it causes a decrease in supply.

• Technological advancement – increases supply and shifts the supply curve outwards.
• Change in weather condition – may boost or hinder production and supply depending on its favorability.
• Prices of related goods
• Sellers’ expectation of price of the product
• Taxes and subsidies
• Number of sellers in the market

Elasticity of Supply

It’s the degree of responsiveness of the supply to change in price. It can be calculated as follows:
∆𝑄 𝑃0
𝜀𝑠 = ·
∆𝑃 𝑄0

✓ If the supply is perfectly inelastic, it’ll be represented by a vertical supply curve.

✓ If the supply is perfectly elastic, it’ll be represented by a horizontal supply curve.

Market Equilibrium

It occurs when market demand equals market supply.

Any price greater than the equilibrium price leads to market surplus, and below it leads to shortage.

When demand increases and supply remains constant, the equilibrium price also increases.

When supply increases and demand remains constant, the equilibrium price declines.

Whenever both demand and supply increase, the quantity of the product will increase indefinitely, but:

✓ if the increase in demand is more than the increase in supply, then the price goes up.
✓ if the increase in supply is more than the increase in demand, then the price falls.
✓ if the increase in demand and supply is the same, then the price remains the same.

Whenever both demand and supply decline, the quantity of the product will decrease, but:

✓ if the decrease in demand is more than the decrease in supply, then the price falls.
✓ if the decrease in supply is more than the decrease in demand, then the price rises.
✓ if the decrease in demand and supply is the same, then the price remains the same.