CHAPTER TWO

THEORY OF DEMAND, SUPPLY AND MARKET

EQUILIBRIUM
 2.1. THEORY OF DEMAND AND
SUPPLY
2.1.1. Demand Analysis
Demand

is a willingness and ability of a consumer to

purchase goods and services at specific price
within a set of possible prices at a given period of
time

Law of demand: price of a commodity and its

quantity demanded are inversely related, ceteris
paribus (Price is not the only factor that affects supply of quantity
demanded, however it is the major factor)
 Ceteris paribus means keeping other factors constant.
 Quantity demanded of a commodity is the amount
of the commodity willing to be purchased at a given price
level.

Demand Curve: shows the relationship between the

quantity demanded of the commodity at different price
levels
Demand Curve
Birr
1. A decrease
in price...

Demand Schedule
2. ... increases quantity
demanded.
TWO EFFECTS OF DEMAND
The substitution effect
At higher prices, consumers are more willing
and able to look for substitutes.
The income effect
A decline in the price of a good will give
more purchasing power to the consumer and
he/she can buy more now with the same
amount of income.
 This is the income effect.
 Exceptions to the Law of Demand
 Giffen Goods

 Prestige Goods

 Expectation of People about the Future

 Necessities
 2.1.2 NON- PRICE DETERMINANTS
OF DEMAND
A right ward (left ward) shift of the demand
curve indicates an increase (a decrease) in
demand.
A)Change in Tastes and Preferences
B)Change in income
Increase in income >>> shift rightward for
normal goods and leftward to inferior goods
Normal good: When income rises the demand for
the product will increase & the vice versa is true,
ceteris paribus.(Ex. House, Vehicles, PCs, etc)
Inferior good: When income rises the demand for
the product will decrease, ceteris paribus.
(Ex. Shift from tea & bread to milk & burger consumption)
C) Change in Prices of Related Goods
If two goods are related, then the change in price
of one good affects demand for the other & the
relation could be “substitute” or “complementary”.
Substitutes –If two goods satisfy the same
needs /desires separately. Ex: Pepsi & Coca cola,
Coffee &Tea, etc.
Complements -- if they are used /consumed
jointly to satisfy the needs of the consumer (like,
Sugar and tea, car and petrol, etc).
FACTORS AFFECTING …
D) Change in Number of Buyers
Ex. Everybody wears clothes, the more
people there are the greater demand will be for
clothes.

E) Expectation of Consumers:
Purchases may be postponed or rushed
depending on the expectations of future price
changes
 2.2.4 INDIVIDUAL AND MARKET
DEMAND CURVE

Individual demand curve is the amount of goods

that a single consumer is willing and able to buy at
different price levels over certain time period.

Market demand refers to the sum of all individual

demands for a particular good or service.

Market Demand Curve is a horizontal summation

of individual demand curves.
Price Individual Demand Curves Price
P1
A

B
P2

P3 C
0
Q1 Q2 Q3
Quantity

Fig. Change in quantity demanded (movement

along the same demand)

Pr
Pri
icce
e D
D11 D
D00 D2
D2

P0

D
D11 D
D00 D2
D2
0
0 Qu
Qua
ant
ntit
ity
y

Fi
Fig.
g. 2
2..5.
5. C
Cha
han
nge
ge in
in d
dem
ema
and
nd (
(sh
shi
ift
ft i
inn de
dem
ma
annd
d cu
currve
ve)
)

3
3000
0
2
2660
0 +
+ +
+ =
=
2
2220
0
1
1880
0
1
1440
0
1
1000
0
6
600
0
0 2
2 4
4 6
6 8
8 10
10 1
122 3
3 6
6 9
9 1
122 15
15 1
188 21
21 5
5 10
10 1
155 20
20 2
255 30
30 3
355 8
8 18
18 2
288 38
38 4
488 58
58 6
688

Abebe Q
Quua
annti
titty
y o
off w
whhea
eatt

Bekele
Price
P1
A Qtty
B
P2

Price
P3 C
0
Q1 Q2 Q3
Quantity

Fig. Change in quantity demanded (movement

along the same demand)

Price D1 D0 D2

P0

D1 D0 D2
0 Quantity

Fig. 2.5. Change in demand (shift in demand curve)

300
260
220
+ + =
Qtty
180
140
100
60
0 2 4 6 8 10 12 3 6 9 12 15 18 21 5 10 15 20 25 30 35 8 18 28 38 48 58 68

Quantity of wheat

Total

Market Demand Curve

 2.2.4 INDIVIDUAL AND MARKET
DEMAND CURVE
Suppose in the city of Dire Dawa only three people are interested in
purchasing cement. That is, the market for cement in Dire Dawa has only three
consumers – Seid, Helen, and Yonas. Below are given the individual demand
curves of the three consumers, where the quantity is in quintals of cement and the
price is in Birr per quintal.
Seid: Q = 2 – 2P ;Helen: Q = 4 – 3P and Yonas: Q = 5 – 2P

Which of the following statements is true for the total quantity demanded of
cement in Dire Dawa?

a. At a price of $1 per quintal, the total quantity demanded in the market is seven
quintals of cement.
b. If cement was free, the three consumers would demand an infinite amount of
cement.
c. At a price of $2 per quintal, only one quintal of cement would be demanded in
Dire Dawa.
d. At a price of $2 per quintal, nobody demands cement in Dire Dawa.
 2.1.2. SUPPLY ANALYSIS

Supply is the amount of goods and services that

businesses are willing and able to produce at different
prices during a certain period of time.

Law of supply: the quantity supplied of a

commodity varies directly with the price of that
commodity, ceteris paribus.
 Quantity supplied of a commodity is the amount of
commodity that producer supplies to the market at a given
price level.

Supply Curve: shows the relationship between the

quantity supplied of the commodity at different price levels

Birr
1. An
increase
in price ...

2. ... increases quantity of bread supplied.

Supply Schedule
Supply Curve
2.3.2 FACTORS AFFECTING SUPPLY
A) Change in Prices of Factor Inputs
B) Change in technology
C) Taxes and Subsidies
taxes increase costs; subsidies lower costs.
D) Number of Sellers
More or less producers will affect the supply of the
product
E) Expectation of Change in Price
F) Weather
 2.3.4 Individual and Market Supply Curve
30 0
26 0
22 0
Price 18 0 + +
14 0
10 0
60

1 2 3 4 5 6 7 2 10 14 18 22 26 5 10 15 20 25 30 35
Quantity
Individuals Supply Curves

S
300
• Graphically, 260
Price 220
individual 180
supply 140
100
curves are 60
summed y
0 8 18 28 38 48 58 68
horizontally Quantity
Market Supply Curve
to obtain the
market
2.4 MARKET EQUILIBRIUM

Refers to a situation in which the price has

reached the level where quantity supplied
equals quantity demanded.

Equilibrium price: The price that balances

quantity supplied and quantity demanded.

Equilibrium quantity: The quantity supplied and

the quantity demanded at the equilibrium price.
SUPPLY AND DEMAND TOGETHER
Demand Schedule Supply Schedule
Bread price Quantity
Bread price Quantity

At $2.00, the quantity demanded

is equal to the quantity supplied!
 MARKET EQUILIBRIUM

Price of
Bread Supply
Excess Supply

$2.50
Equilibrium Equilibrium
2.00 price

1.50
Excess Demand
Equilibrium Demand
quantity

0 4 7 10 Quantity of Bread
Quantity Quantity
demanded supplied
We can also represent the supply-demand curves
by SS & DD equations.

Ex1. if demand is given by : P = 60 – Q

and supply is given by: P = 10 + 4Q
to find the equilibrium price and quantity, simply
set both equations equal to each other
10 + 4Q = 60 – Q …..> Q= 10, P= 50

Ex.2. D = 100 - 6P,

 S = 28 + 3P
100 - 6P = 28 + 3P
P= 8, Q= 52
 MORE……
 Suppose the demand and supply function for a coke are given
by
 Qd=200-30p

 Qs=20p

 Find equilibrium quantity price of coke?

 Find equilibrium quantity of coke demanded?

 Show it graphically…
 MORE….
 Given the following data find the equilibrium price and
quantity
 P=80-Qd

 P=20+2s
 Suppose there are 100 identical buyers of commodity “X” in a
market with an identical demand function of Qd=10-2px and 200
identical seller of commodity X with and identical supply function
of Qs=0.5p.calculate equilibrium quantity and equilibrium price of
commodity X??
 Example 1: Let there be 5000 identical buyers of a commodity
X in a market with an individual demand function of DX = 8 –
PX, and 1000 identical sellers of commodity X with an
individual supply function of SX = 20 PX, where DX is
quantity demanded, SX is quantity supplied and PX is price of
the commodity X. Calculating the equilibrium price and
equilibrium quantity
 Example 2: Assume in a market individual supply function of a
commodity A is given by SA = 2PA – 3 and individual demand
function is DA = 12 – 4PA.
 There are 200 suppliers of commodity A with identical supply
function and there are 8,000 buyers of the commodity A with
identical demand function. Where; SA is quantity supplied, DA
is quantity demanded and PA is price of commodity A. Find
market equilibrium price and quantity demanded.
EFFECTS OF CHANGES IN DEMAND AND SUPPLY
ON EQUILIBRIUM PRICE AND EQUILIBRIUM
QUANTITY

 I. Effect of Increase in Demand: Under the conditions of

stable supply curve, if there is increase in demand (that is, a
rightward shift of the demand curve), both equilibrium price
and equilibrium quantity increase.
 II. Effect of Decrease in Demand: Under the conditions of
stable supply curve, if there is decrease in demand (i.e., a
leftward shift of the demand curve), both the equilibrium price
 and equilibrium quantity decreases.
 The effect of increase in supply is lower equilibrium
price and larger equilibrium quantity, and the effect of
decrease in supply is higher equilibrium price and
smaller equilibrium quantity.
 When Both Demand and Supply Increase: If both demand
and supply increase (that is, both demand curve and supply
curve shift to the right), the equilibrium quantity would
certainly rise. But the equilibrium price may rise, fall or remain
unchanged. It depends on the comparative increase in demand
and supply.
 a) If the increase in demand is greater than the increase in
supply, the equilibrium price rises. b) If the increase in demand
is smaller than the increase in supply, the equilibrium price
falls.
 c) If the increase in demand and increase in supply are equal,
the equilibrium price remains unchanged.
 When Both Demand and Supply Decrease: If both demand
and supply decrease (that is both demand curve and supply
curve shift to the left), the equilibrium quantity would certainly
fall. But the equilibrium price may rise, fall or remain
unchanged.
 a) If the decrease in demand is greater than the decrease in
supply, the equilibrium price falls. b) If the decrease in demand
is smaller than the decrease in supply, the equilibrium price
rises.
 c) If the decrease in demand and decrease in supply are equal,
the equilibrium price remains unchanged.
 Maximum Price Fixation (Price Ceiling)
 Sometimes the supply of a commodity is so short that it creates
shortages in the market and common consumers are unable to
get the commodity from the market. Competitive prices are so
high that they become out of reach for common consumers,
only the rich can purchase and consume the commodity. In
such a situation government comes forward and fixes the
maximum price for the commodity.
 Minimum Price Fixation (Price Floor)
 Whenever government feels that the competitive price
determined by the forces of demand and supply in a free
market is not fair from the producers‘ point of view,
government announces a minimum price to protect the interests
of the producers. This is also termed as support price or price
floor. It is very common with governments these days to
protect the interests of the farmers.