Chapter Two: Demand and Supply

2.1. Overview Market Structure

 Economists categorize industries into four distinct market structures:
1. pure competition/ perfectly competitive market
2. pure monopoly
3. monopolistic competition and
4. oligopoly
 These four market models differ in several respects:
 the number of firms in the industry
 whether those firms produce a standardized product or try to differentiate
their products from those of other firms,
 how easy or how difficult it is for firms to enter the industry.

1
2.1.1 Pure competition/perfectly competitive market

 Is a market which involves a very large number of firms producing a

standardized product .

 Although pure competition is relatively rare in the real world (except few
industries which closely approximate pure competition than any other market
structure, for example, markets for agricultural goods, fish products, foreign
exchange, basic metals, and stock shares), this market model is highly
relevant.

 Also, pure competition is a meaningful starting point for any discussion of

price and output determination. Moreover, the operation of a purely
competitive economy provides a standard, or norm, for evaluating the
efficiency of the real-world economy.
2
 Characteristics/Assumption of the Model
 The model of perfect competition was constructed based on the
following assumptions or imaginations.
• Large number of sellers and buyers.
• Standardized/ homogenous products
• A firm is price-taker
• Free entry and exist
• Perfect Knowledge of Market Conditions.
• Absence of government regulation/intervention.

3
 Profit Maximization of a Competitive Firm
 How much a competitive firm should have to produce? A firm operating
in a competitive market has to produce the quantity that maximizes its
profit. In other words, equilibrium occurs when it produces that level of
output which maximizes its profit, given the market price.
 A firm is said to be in equilibrium when it maximizes its profit ().
Profit is defined as
= TR-TC
 Thus, determination of equilibrium of the firm operating in a perfectly
competitive market means determination of the profit maximizing
output since the firm is a price taker.
 Total Revenue (TR)
• Firm generates revenue from the sale of its product and it is the product of price and
quantity of the product sold.
• TR = P*Q where P stands for unit price and Q quantity of the product.
• Since in a competitive market unit price is constant and the firm is a price taker, TR is
a linear function of quantity of output. If the unit price is Birr 5 per unit the TR is
determined as follows
Average Revenue (AR)
 Average revenue is revenue per unit of output.
 In a competitive market Average revenue is equal to unit
price of a commodity and is obtained by dividing TR by
quantity of output (Q).
 AR = TR/Q = P …………….. Why?
• Marginal Revenue: it is the additional amount of
revenue the firm receives by selling one more unit of the
product.

• Thus, in a perfectly competitive market, a firm‘s AR =

MR = P =Df
• Since firms are price taker, they will maximize economic
profit only by adjusting its output.
• In the short run, the firm has fixed plant. Thus, it
can adjust its output only through changes in the
amount of variable resources.
• There are two ways to determine output that
maximum profit or minimum loss.
a) Total Approach (TR-TC approach)
• In this approach, a firm maximizes total profits when
the (positive) d/ce b/n TR & TC is greatest

At Qe vertical distance b/n

TR and TC curves is
maximized.
 So Qe isprofit maximizing
level of output
b) Marginal Approach (MR-MC)
• The firm will maximize profit or minimize loss by
producing output at which marginal revenue equals
marginal cost.
 MR = MC
 Slope of MC is rising or slope of MC > 0
• Second order condition of profit maximization
• Whether the firm in the short- run gets positive or zero
or negative profit depends on the level of ATC at
equilibrium.
i) Economic/positive profit - If the AC is below the market
price at equilibrium, firm earns positive profit equal to
the area b/n ATC curve and the price line up to profit
maximizing output.
ii) Loss - If AC is above price at equilibrium, the
firm earns a negative profit (incurs a loss)
equal to the area b/n AC curve and price line.
iii) Normal or zero profit (break- even point): If AC
is equal to market price at equilibrium, firm gets
zero (normal) profit.
IV) Shutdown point: The firm will continue to
produce irrespective of the existing loss as far as
price is sufficient to cover average variable costs.
• If P > AVC but P< AC, firm minimizes total losses.
• But if P < AVC, firm minimizes total losses by
shutting down. Thus, P = AVC is shutdown point
• Example: Suppose a firm operates in a
perfectly competitive market. Market price of
the product is $10. The firm’s cost function
is:

A) What level of output should the firm produce to

maximize its profit? (MC=MR)
B) Determine level of profit at equilibrium.
C) What minimum price is required by the firm to
stay in the market? (hint: P=min AVC, change in
AVC=0)
 Example 1

 Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 and a TR of

$6,000 at equilibrium.

 Should the firm stop its operation? Why?

 Monopoly Market

 Pure monopoly is a market structure in which one firm

is the sole seller of a product or service (for example, a
local electric utility).
 Since the entry of additional firms is blocked, one firm
constitutes the entire industry. Thus, it is at the opposite
extreme from perfect competition.
The main characteristics of this market structure
include:
1. Single seller: A pure or absolute monopoly is a one firm
industry. The firm and the industry are synonymous.
2. No close substitutes: monopolist‘s product is unique in
that there are no good or close substitutes
3. Price maker: the monopolist can change product price
by changing quantity of the product supplied.
4. Blocked entry: there are barriers ( economic, legal,
technological etc.) for competitors to enter the industry.
In case of pure monopoly, entry is totally blocked.
 Sources of monopoly
• Barriers to entry are sources of monopoly power. The
major sources of barriers to entry are:
i) Legal restriction: Some monopolies are created by law in
public interest in both public and private sectors.
• Eg. postal service, telegraph, telephone services, radio and
TV services, generation and electricity, rail ways, airlines
etc… are public utility sectors /monopolies.
ii) Control over key raw materials: Some firms acquire
monopoly power from their traditional control over certain
scarce and key raw materials
• Eg. Aluminum Company of America had monopolized
aluminum industry b/s it had acquired control over almost all
sources of bauxite supply;
• Such monopolies are often called raw material monopolies
 Sources of monopoly...
iii) Efficiency: a primary and technical reason for growth of
monopolies is economies of scale.
• The most efficient plant (probably large size firm,) which
produces at minimum cost, can eliminate competitors by
curbing down its price for short period & can acquire
monopoly power.
• This is are known as natural monopolies.
iv) Patent rights: Patent rights are granted by the government to a
firm to produce commodity of specified quality and character
• Such monopolies are called patent monopolies.
V) Exclusive knowledge of production technique.
Vi) Government Franchise and License
Franchise is a promise by the government for a firm to
prohibit the establishment of another firm
 Monopolistically competitive market
• In reality there are very few monopolists
because there are very few commodities for
which close substitutes do not exist.
• Similarly, very few commodities are entirely
homogeneous (identical) to make perfect
competition assumption realistic.
• It is market organization in which there are
relatively many firms selling differentiated
products.
• It is the blend of competition and monopoly.
 Monopolistically competitive market
• The competitive element arises from the existence of
– large number of firms and
– no barrier to entry or exit.
• The monopoly element results from
– differentiated products, i.e. similar but not identical
products.
• A seller of a differentiated product has limited
monopoly power over customers who prefer his
product to others.
• His monopoly is limited because his product has
close substitutes
 Monopolistically competitive market...
• This market is characterized by:
(i) Differentiated product: the product produced by many
sellers is similar but not identical in the eyes of the buyers.
• Eg. style, brand name, in quality, or others
ii) Many sellers and buyers but their number is not as large as
that of the perfectly competitive market.
(iii) Easy entry and exit: there is no barrier for entry and
exit
(iv) Existence of non-price competition: Economic rivals
take the form of non-price competition in terms of
product quality, advertisement, brand name, service to
customers, etc.
• Many retail trade activities such as clothing, shoes, soap,
etc are in this type of market structure.
Product differentiation: A strategy that firms use to achieve
market power.
 * process of making a product unique from other product

Two types of product differentiation

a. Real product differentiation: products differ in terms of their

inheritance characteristics such as inputs used, location etc.

E.g. Shampoo with and without conditioner

25
b. Fancied (spurious) product differentiation: products
are the same but producers convince customers as
their product is different
• It is psychological differentiation, not real

• It is only advertisement, difference in packing, design,

brand name and other sales promotion activities
E.g. Collegate and Aquafrish teeth brush
 Oligopoly market
It characterized by:
i) Few dominant firms: number of firms is small enough
that each firm recognizes actions of other firms
– firms are mutually interdependent
ii) Entry barrier: The barriers may include economies of
scale, legal, control of strategic inputs, etc.
iii) Products may be homogenous or differentiated.
– If the product is homogeneous, we have a pure oligopoly.
– If the product is differentiated, it is differentiated oligopoly.
IV) Interdependence of firms in decision making
V) Firms have some power to set price
• A special type of oligopoly in which there are only
two firms in the market is known as duopoly.
• A beer industry in Ethiopia is a good example of
oligopoly market structure.
• Automobile industry, which produces different cars
and aerospace industry producing different
airplanes are also an example of oligopoly industry
• Each of the major beer producers takes in to
account the reaction of others when they
formulate their price and output policies
Causes of Oligopoly
Economies of scale: Average cost of production reach minimum
only when the output produced in large amount by a few firms.
Barriers to entry: Barrier may be technological, skill, cost, size of
the market in relation to economies of scale , patent right, licensing
and marketing quota.
Collusion (merger of small firms): Small firms collide to get
market power and overcome their competitor’s pressure and then
to set higher price and restricts output supply that maximizes their
profit.
29
Types of Oligopoly

 There are two groups of oligopoly

Non collusive oligopoly and Collusive Oligopoly

 Non collusive oligopoly: is a condition in which firms

operate independently

• Yet each firm makes some expectation (assumption) about

the reaction of its rivalry in response to its action or observe

the decision of its rivalry while setting profit maximizing

level of output and price

30
 Collusive Oligopoly: Firms get together to make open and formal
agreement in setting prices and output to maximizes the total profit
of the industry as in the case of cartel
 And implicit cooperation of firms in the industry without actually
making explicitly agreement with one an other as in the case of price
leader.
 Firms enter in to collusive agreement in order to
– increasing profit,
– decreasing uncertainties
– create better opportunity to prevent other’s entry to the industry
31
Summary of types of market structures
 Theory of Demand
• Demand: Demand is more than desire.
• It states consumer’s willingness and ability to
purchase a commodity
• More specifically, 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).
• Law of demand: price of a commodity and its
quantity demanded are inversely related (ceteris
paribus)
 Demand...
• The r/ship b/n price and amount of a commodity
purchased can be represented by a demand schedule
(table) or a demand curve or an equation.
individual demand schedule

De individual demand curve

 Demand...
• Demand function is a mathematical r/ship b/n
price and quantity demanded (ceteris paribus)
• A typical demand function is given by: Qd=f(P)
where Qd is quantity demanded and P is price of commodity,
• Example: Let the demand function be Q = a+ bP
• B is slope of the demand curve and can be
denoted as b=∆Qd/∆P
• Taking any move from one point to the next, we
can find value of b or the slope (taking move from A to B)
• ; So, Qd= a-2P
 Demand...
• To find value of ‘a’ substitute P with respective Qd
at any point in the demand schedule or curve
• At point B, 7=a-2(4) and a is equal to 15.
• Hence, the demand function becomes Qd= 15-2P
• Market Demand: is derived by adding quantity
demanded for the product by all buyers at each
price.
Individual and market demand
 Individual and market demand...
• Numerical Example: Suppose individual demand
function of a product is given by: P=10 - Q /2 and
there are about 100 identical buyers in the
market.
• Then to find the market demand function first
write the demand function Qd as a function of P
• Qd=20-2P
• Then, multiply individual demand function by
total buyers
• Qm=100(20-2P)
• Then, the market demand (Qm) is Qm=2000-200P
 Individual vs. Market Demand…
• Example: - Suppose the demand of a typical
consumer is Qd= 20 -3P and that there are 200
identical consumers in the market for corn. What is
the market demand?
• Soln QM = 200 X Qd
= 200 (20-3P)
QM = 4,000 – 600P
• Q1. Suppose there are 100 identical consumers in
Kutcha butter market, and the inverse demand of a
typical consumer is given as P = 20 - 1/5.Qd. Find
the market demand function for Kutcha butter
market. [Ans. Q = 10,000-500P].
 Individual vs. Market Demand…
Exercise
• Suppose there are 500 consumers in Adama banana
market and they are grouped in three categories as
follows
– 150 consumers have identical demand function Q1 =
9-1/2P;
– 100 have identical demand equation of Q2 = 4 - 1/5P,
– 250 consumers have the same demand equation of the form
Q3 = 8 - P.
Find the aggregate demand for Adama Banana Market [Ans.
Qm= 3750 – 345P]
• [Hint: First find the demand equation of each group and then add
the three equations together to find the market demand.]
 Determinants of demand
• Factors affecting demand for a commodity include:
• The price of the commodity X (own price (Px)),
• The money income of the consumer (M),
- For normal good (+)
- For inferior good (-)
• The price of other goods,
- Price of substitute goods Ps (+)
- Price of complement goods Pc (-)
• Taste & preference of the consumer
• Number of buyers in the market,
• Future expectations of prices, income, and availability of the
commodity
• Weather condition (W), Etc.
 Movements Vs Shift of the Demand Curve

A . A change in Quantity demanded

 It designates the movement from one point to another point –

from one price quantity combination to another

 The cause of such movement is a change in the own price.

B. A Change in Demand

 The cause of such change is a change in non own price determinants.

 graphically, shift in the location of the demand curve is called a

change in demand.
A. A Change Quantity Demand b. A Change in Demand
 2.2.5. Exceptional cases for the law of demand not to work

a. Status goods: These goods show the social status of the individual in the

society. So, even if the price of those Luxury goods is increasing the demand

for those goods increases.

b. Giffen goods: named after the economist Sir Robert Giffen who has

•discovered them for the first time. Increase in prices of such goods is

considered as increase in qualities and people tend to consume more of them

at higher prices.

C. Uncertain future events: if consumers are expecting that there will be

increase in the price of the good in the near future, then they choose to guard

themselves against additional costs by buying now

d. Judging quality by price: people usually resort to the irrational conclusion

that price always follows the footsteps of quality.

 Determinants of demand...
• Now let us examine how each factor affect demand.
a) 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.
b) Income of the consumer
• Goods are classified based on how a change in
income affects their demand
• Normal Goods are goods whose demand increases as
income increase,
• Inferior goods are those whose demand is inversely
related with income (buyers shift to better quality
goods as their income increases)
 Determinants of demand...
C) 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.
• Substitute goods: price of one and the demand
for the other are directly related. E.g tea &
coffee, pepsi & coca
• Complimentary goods : price of one and
demand for the other are inversely related. E.g ,
tea & sugar, car & fuel
 Determinants of demand...
d) Consumer expectation of income and price
• Higher price expectation will increase demand
for goods and the opposite is true
e) 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
• And decrease in the number of buyers in the
market will decrease demand.
 Elasticity of demand
• Elasticity is a measure of responsiveness or
sensitivity of dependent variable to changes in an
independent variables (
• Elasticity of demand refers to degree of
responsiveness of quantity demanded of a good to
a change in its own price, income, price of related
goods.
• Accordingly, there are three kinds of demand
elasticity:
• price elasticity
• Cross price elasticity
• income elasticity
 Price Elasticity of Demand
• Price elasticity indicates how consumers react to
changes in price
• Demand for commodities like clothes, fruit etc.
changes when there is even a small change in their
price, whereas demand for commodities which are
basic necessities of life, like salt, food grains etc.,
may not change or shows smaller change even if
price changes
• Price elasticity of demand can be measured in two
ways:
• Point elasticity and
• Arc elasticity
 Price Elasticity of Demand...
1. Point Price Elasticity of Demand
• It is calculated to find elasticity at a given point which are
assumed to be intimately close to each other.

• Point elasticity of demand on a straight line is different at

every point
2) Arc price elasticity of demand
• Arc Elasticity measurement is used when the
change in price is relatively large. It measures
elasticity b/n to points. It is an estimation of an
average elasticity of an arc.
• The main drawback of point elasticity method
is that it requires information about slight
changes in price and quantity demanded of a
commodity.
• It measures a portion or a segment of demand
curve between two points.
• An arc is a portion or segment of demand curve
• Its formula is given as:

• Or

• Suppose that price of a commodity is Br. 5 and quantity

demanded at that price is 100 units. Assume price of the
commodity falls to Br. 4 and quantity demanded rises to 110 units.
• Value of the arc elasticity will be:

•Elasticity of demand is negative number b/s of the law of

demand.
•If the price elasticity of demand is positive the product is
inferior.
• Example: The price of sugar was 6 birr per kilo. Due to

unfavorable harvest in sugarcane the price has raised to 8

birr per kilo. Because of this price change the quantity

purchased falls from 16 million quintals to 14 million quintals

of sugar. What is the arc price elasticity of demand for

sugar?

• Solution:

• If the price of sugar increases or decreases by 1%, quantity

demanded of sugar decreases or increases by 0.466%

respectively.
 Elasticity Description, Implication and Demand curve

• > 1- Elastic- % ΔQ>%ΔP Flatter

• 1 -Unitary elastic- % ΔQ=%ΔP

• 0 < < 1 -Inelastic -% ΔQ<%ΔP Steeper

• = 0 -Perfectly inelastic -% ΔQ= 0 Vertical

• =∞- Perfectly elastic- % ΔQ= ∞ horizontal

 Determinants of price Elasticity of Demand
• The availability of substitutes: availability of more
substitutes results in greater elasticity
• 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.
• Proportion of income consumers spend for a product:-
the smaller the proportion of income spent for a good,
the less price elastic will be.
• Types /nature of commodity. The importance of the
commodity in the consumers’ budget : Luxury goods
tends to be more elastic, example: gold. Necessity
goods tends to be less elastic eg: Salt.
 Cross price Elasticity of Demand
• Measures responsiveness of demand for price
change of other product

Exy > 0 Exy <0 Exy = 0

substitutes complements unrelated

Note: Larger positive cross elasticity coefficient

shows greater substitutability, cetris paribus
The larger negative cross elasticity coefficient,
shows greater the complementarity, cetris paribus
 Cross price Elasticity of Demand...
• Eg: Consider the following data which shows the
changes QdX in response to changes in PY
Unit price of Y Quantity demanded of X
10 1500
15 1000

• Cross price elasticity of demand is:

Hence, the two goods are complement

 Income Elasticity of Demand
• It measures responsiveness of demand to
change in income

Ed < 0 (-ve) E d > 0 (+ ve)

Normal
Inferior 0< Ed < 1 Ed > 1
Necessity Luxury
 Theory of supply
• Supply indicates various quantities of a product that
sellers are willing and able to provide at different
prices in a given period of time, ceteris paribus
• Law of supply: ceteris paribus, as price of a product
increase, quantity supplied increases, and vice versa
• There is a positive r/ship b/n price and quantity
supplied.
• Supply schedule: shows different quantities of a
commodity offered at different prices in a table form
• Supply curve: conveys the same information but in
a curve
• Supply function: conveys the same information in
mathematical form
 Theory of supply...
• Market supply: is derived by horizontally adding
quantity supplied of the product by all sellers at
each price.
 Determinants of supply
– price of the product itself
– price of inputs ( cost of inputs)
– technology
– prices of related goods
– sellers‘ expectation of price of the product
– taxes & subsidies
– number of sellers in the market
– weather, etc.
 Determinants of supply
• Input price: 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 and the opposite is true.
• Technology: Technological advancement shifts
the supply curve outward
• weather: weather condition affect supply of
products, especially agricultural products.
 Elasticity of supply
• It is the degree of responsiveness of the
supply to change in price.
• 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.
• The formula for point price elasticity of supply
is:
 Elasticity of supply
• If Es >1, supply is elastic;
• if Es < 1, then supply is inelastic;
• If Es = 1, then supply is unitary elastic.
• If Es= 0, supply is perfectly inelastic;
• If Es = ∞, then supply is perfectly elastic.
 Market equilibrium
• Market equilibrium occurs when market demand
equals market supply.

 P is the market equilibrium (market clearing) price.

 M is the market equilibrium (market clearing) quantity.
 Market equilibrium...
• 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
• 30 = P and 40 = Q
b) Qd (at P = 25) = 100-2(25)=50 and Q (at P = 25) = 2(25) -20 =30
• Therefore, there is a shortage of: 50 -30 =20 units

• Qd ( at =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
• Changes in Demand: - Keeping supply constant,
increases (decreases) in demand will lead to rise
(fall) in both equilibrium P and Qd
• Change in Supply:-Keeping demand constant,
increases (decreases) in supply leads to lower
(higher) P and higher (lower) Qd
 Effects of shift in demand and supply …
• Complex cases: - this is a case when both supply and
demand change. In this case, the effect is combination/
net of the individual effects.
(i) Supply increase, Demand Decrease: - Both changed
decrease price, so the net result is a price drop greater
than that resulting from either change alone.
• The direction of the change in quantity depends on the
relative sizes of the changes in supply and demand.
• If the increase in supply is larger than the decrease in
demand, the equilibrium quantity will increase.
• If the decrease in demand is larger than the increase in
supply, equilibrium quantity will decrease
 Effects of shift in demand and supply …
• (ii) Supply Decrease, Demand Increase: - A
decrease in supply and an increase in demand both
increase Price. So net effect is higher price
• But their effect on equilibrium quantity depends
on relative sizes of changes in supply and
demand.
• If the decrease in supply is larger than the increase
in demand, equilibrium quantity will decrease.
• In contrast, if the increase in demand is greater
than the decrease in supply, the equilibrium
quantity will in increase.
 Effects of shift in demand and supply …
iii) Supply Increase, Demand Increase: - A supply increase
drops equilibrium price, while demand increase boosts it.
• Net effect is a raise in equilibrium quantity.
• The effect on equilibrium price depends on relative sizes
of changes in supply and demand.
• If the increase in supply is greater than the increase in
demand, the equilibrium price will fall. If the opposite
holds, equilibrium price will rise.
• The effect on equilibrium quantity is certain:
• Therefore, the equilibrium quantity will increase by an
amount greater than that caused by either change alone.
 Effects of shift in demand and supply …
(IV) Supply Decrease, Demand Decrease: -
If the decrease in supply is greater than the
decrease in demand, equilibrium price will
rise if the reverse is true, equilibrium price
will fall.
Decreases in supply and demand each
reduces equilibrium quantity, so net effect is
fall in quantity