THEORY OF DEMAND AND SUPPLY

Theory of Demand
The Market
 A place where buyers and sellers meet to decide on prices. A market may have a physical address or
location or it may exist nominally in computers.
 Mbare Musika has a physical location
Demand
 The amount of goods and services consumers are willing to buy at a given price, in a given period
ceteris paribus.
Ceteris Paribus
 It means all things being equal.
 It is used to hold other factors constant.
Effective Demand
 Refers to the willingness and ability to purchase a product.
 This form of demand is one that’s most important to economists.
Demand Schedule
 Shows the relationship between price and quantity demanded at that price.
P 5 10 15 20 25
Q 100 80 60 40 29
 A demand schedule can be shown on a graph called the demand curve.
Demand Curve
 It is a locus points showing combinations of prices of goods and quantities bought at that price.
 It can be derived using the demand schedule.

Factors affecting demand

Price
 It results in changes in quantity demanded.
 The law of demand states that an increase in the price of a good will lead to a decrease in quantity
demanded ceteris paribus.
 The diagram above shows the demand curve for a particular good.

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 An increase in the price of the good from P5 – P4 will lead to a decrease in quantity demanded from
Q5 – Q4.
 On the other hand a decrease in price from P1-P2 will increase quantity demanded from Q1 – Q2.
 Changes in prices leads to changes in quantity demand
Changes in Quantity Demanded

 Movement from point A to B is called a change in quantity demanded.

Change in Demand
 It is a shift of the entire demand curve.
 It is caused by changes in any of the determinants of demand other than the price of the good.

 A shift of the demand curve from D1 – D2 is called an increase in demand.

 A decrease in demand is shown by a shift of the demand curve from D2 – D1.
Other Factors Affecting Demand
Price of Other Goods
 The demand for goods is affected by changes in the market conditions of other goods.
 A good may be related to others in 2 ways:
a) It can be a substitute.
b) It can be a compliment.

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Substitutes
 These are goods that compete for consumption.
 If the price of a good goes up, the demand for its substitute increases.
 Pork and beef are examples of substitutes.
 If the price of beef increases the demand for pork also increases.
Relationships between substitutes
Price of beef

P0

P0

Q0 Q1 Quantity of pork
 If the price of beef increases demand for pork will increase from Q0 – Q1 this causes the demand
curve of pork to shift from D0 –D1.
Price S

P0
P1

D1
D0
Q0 Q1 Quantity

 There is positive relationship between price and demand for substitutes.

Compliments
 These are goods that are consumed together.
 They are said to have joint demand.
 If the price of a good decreases, the demand for a compliment increases
 Cars and petrol are examples of compliments.
 If the price of cars decrease, the demand for petrol increases.

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 THEORY OF DEMAND AND SUPPLY

Price of Cars

P0

P1

Q0 Q1 Quantity of Petrol
 If the price of cars decrease from P0 to P1 demand for petrol will decrease from Q0 to Q1.
 The result is a shift of the demand curve of petrol from D0 to D1
Price S

P0
P1

D1
D0
Q0 Q1 Quantity
Taste and Fashion
 Consumer tastes are significant on the market.
 A change in demand occurs when tastes move towards or away from a good e.g. social changes may
require more women in public and increase the demand cinemas.
Number of Consumers (Population)
 Changes in population lead to changes in demand.
 An increase in population increases the demand of all goods.
 The demand for a particular good may increase due to changes in the population of a particular age
group e.g. an increase in the population of people between the ages of 12 and 18 increases the
demand of calculators.
Income
 Income is the means by which households acquire goods and services for consumption.
 The effect of changes in income on demand is dependent on the type of good.
 There are basically 3 types of economic goods:
a) Normal goods
b) Inferior goods.
c) Giffen goods.

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Normal Goods
 These are goods whose consumption and demand increases when income increases.
Relationship between income and quantity demanded of a normal good
Income

Y1

Y0

Q0 Q1 Quantity
 When income increases from Y0 – Y1 the demand for normal good increases from Q0 to Q1. The
result is a shift in the demand curve from D0 to D1.
Income S

Y1
Y0

D1
D0
Q0 Q1 Quantity
Inferior Goods
 These are goods whose demand and consumption decreases as income increases and vice versa.

Income

Y1

Y0

Q1 Q0 Quantity

 An increase in the income from Y0 to Y1 reduces quality demanded from Q0 to Q1.

 Shifting the demand curve inwards from D0 – D1.

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 They are mostly staple foods and basic commodities.

Income S

Y0
Y1

D0
D1
Q0 Q1 Quantity
Expectations
 Consumers tend to take action today for things that will happen tomorrow.
 If consumers think that the price of a good will increase, they tend to demand more of that product
today in order to avoid tomorrow’s inflation.
 If customers expect an increase in income they may also demand more today.
Advertising
 It persuades customers to buy a product thereby increasing the demand for that product.

THEORY OF SUPPLY
Supply
 This is the amount producers are willing to sell.
The Law of Supply
 Quantity supplied increases as price increases ceteris paribus.
Supply Schedule
 Shows the prices of goods and quantity supplied at that price
5 10 15 20 25 P

20 40 60 80 100 Q

Price
 An increase in the price of the good increases the quality supplied.
 Producers find it more profitable to increase the quantity supplied and as a result they devote more
resources towards the production of that good
 Changes in price lead to changes in quantity supplied.an increase in price from P5 to P4 will increase
quantity supplied from Q5 to Q4

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Changes in Quantity Supplied

 Caused by a change in the price of the good.
 The result is movement along the same supply curve

Change in supply
 Changes in supply results in a total shift of the supply curve.
 It’s caused by any other determinant of supply which is not price.

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Other factors affecting supply

Number of Producers
 The greater the number of producers the greater the supply.
Cost of Production
 When the cost of producing goods is cheaper, supply increases.
Changes in Technology
 Improvements in technology mean that more of a good can be produced using the same resources.
 This increases the supply of the product.
Natural Disasters
 Droughts, famines and frost tend to decrease the supply of a good.
Expectations
 It is what producers think will happen in the future.
 If producers expect the price of a good to increase they will supply more of it today and vice versa.
Government Policy
 Affects supply in two ways i.e. taxes and subsidies.
 A subsidy reduces cost of production and this increases supply.
 Taxes on the other hand increases cost of production and reduce supply.

MARKET EQUILIBRIUM
 Occurs when demand is equal to supply. This means that what buyers want to buy is equal to what
sellers are willing to sell.
 This is called market clearing.

Shortage
 Occurs when quantity supplied is less than quantity demanded.
 At price P1 suppliers are willing to supply Q1 and buyers are willing to buy Q2. This results in a
shortage of Q1 – Q2.
 Consumers will start competing over the available resources and bid up prices.
 If prices go up the gap between quantity demanded and quantity supplied is reduced.

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Surplus
 Excess supply is when quantity supplied is greater than quantity demanded.

 The market fails to clear because producers still have unsold stocks.
 Quantity demanded is Q1 and quantity is Q2.
 The surplus is Q1 – Q2 as a result it’s better to reduce price until a new equilibrium is reached.
Changes in demand while bolding supply constant

Price S

P1

P0
P2
D1
D0
D2
Q2 Q0 Q1 Quantity
 Demand is D0 and supply is S.
 The equilibrium price is P0 and quantity Q0.

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 A shift in demand to D1 will cause a shortage, this forces prices up to P2 where a new equilibrium is
reached.
 A decrease in demand from D0 to D2 causes a surplus.
 A surplus will force prices down to P2.
Changes in supply whilst holding demand constant
S2
Price S

S1
P2
P0
P1

D1

Q2 Q0 Q1 Quantity

 An increase in supply shifts the supply curve outwards to S1and forces prices down to P1.
 A decrease in supply causes a shortage and forces prices up to P2.

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