Chap II Theory of Demand and Supply PDF
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This document provides an overview of the theory of demand and supply in economics. It explains the relationship between price and quantity demanded and supplied. The document also examines determinants of demand and supply, including factors such as price, income, and consumer preferences.
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Chapter Two: Theory of Demand and Supply 2.1 Theory of Demand The theory of demand is related to the economic activities of consumers-consumption. The purpose of the theory of demand is to determine the various factors that affect demand. What is Demand in Economics? In economi...
Chapter Two: Theory of Demand and Supply 2.1 Theory of Demand The theory of demand is related to the economic activities of consumers-consumption. The purpose of the theory of demand is to determine the various factors that affect demand. What is Demand in Economics? In economics the word “Demand” refers to the amount of commodity which an individual buyer is willing and able to buy at a given price and during a given period of time. Thus, demand is different from a mere desire. Human wants are unlimited, and therefore, desires are many. But only a desire that is backed up by the capacity to pay the price for the commodity and the willingness to buy it, is termed as a demand. We may say demand refers to an effective desire/wish. Demand = ability to pay + willingness to pay + availability of the good Law of Demand: This is the principle of demand, which states that, price of a commodity and its quantity demanded are inversely related i.e., as price of a commodity increases ( d e c re ase s) q uant i t y d e m and e d f o r t hat c o m m o d i t y decreases (increases), ceteris paribus. 2.1.1 Demand schedule (table), demand curve and demand function These are three ways of representing the relationship that exists between price and the am ount of a com m odity purchased. A) A demand schedule: is the relationship between price and quantity demanded in a table form. Table 2.1: Individual household demand for orange per week A B C D E Price (Per KG) 5 4 3 2 1 QD(Per Week) 5 7 9 11 13 B) Demand curve: is a graphical representation of the relationship between different quantities of a commodity demanded by an individual at different prices per time period. Market Demand: The market demand schedule, curve or function is derived by horizontally adding the quantity demanded for the product by all buyers at each price. Example: Table 2.2: Individual and market demand for a commodity Prices Individual Demands Market Demand Consumer Consumer Consumer 1 2 3 8 0 0 2 2 5 3 5 4 12 3 5 7 6 18 0 7 9 8 24 The following graph depicts market demand curve at price equal to three. 2.1.2 Determinants of Demand The demand for a product is inf luenced by many factors. Some of these factors include: A) Price of the product itself: The price of a commodity is the most important factor which affects the demand for a commodity. Other things remaining the same, if price increases, quantity demanded decreases, and if price decreases, quantity demanded increases(Law of Demand). B) Income of the Consumer: Income of the consumer is also an important factor affecting the demand for a commodity. Generally, when income increases, demand also increases, and when income decreases, demand also decreases. This is true in the case of normal goods. However, in the case of inferior goods, with an increase in income their demand decreases and vice-versa. On the basis of nature, goods can be classified into two types: i) Normal Goods (Superior Goods): refer to those goods whose income effect is positive – i.e., all other factors remaining the same, as income increases, demand also increases and vice-versa. For example: Cheese, Butter, Chocolates, Biscuits, etc. ii) Inferior Goods: Inferior goods refer to those goods whose income effect is negative – i.e., all other factors remaining the same, as income increases, demand decreases and vice-versa. In general, inferior goods are poor quality goods with relatively lower price and buyers of such goods are expected to shift to better quality goods as their income increases. For example: Some Chinese shoes, coarse cloth, leftover food etc. C) Prices of Related Goods: Changes in the prices of related goods also affect the demand for a commodity. Related goods may be of two types: i) Substitute Goods: are those goods which can be used in place of each other to satisfy a given want. That is why they are also called competitive goods. For example, Coffee and tea, Pepsi and Coca-Cola, pens and pencils, butter and oil, etc. i i ) C o m p l e m e n t a r y G o o d s : a re t h o s e g o o d s w h i c h a re u s e d tog e the r/ j oi ntl y to sati sf y a g i v e n want. I f two g ood s are complementary goods, a decline in the price of one would indirectly change the demand for the other commodity and vice-versa. For example, cars and petrol/fuel, pen and ink, tea and sugar are complements of each other. D) Tastes and Preferences: If a consumer is accustomed to certain commodities, he will demand that commodity and this leads to increase in the demand for that commodity. When the taste of a consumer changes in favor of a good, her/his demand will increase and the opposite is true. E) Consumer expectation of income and price Higher price expectation will increase demand while a lower future price expectation will decrease the demand for the good. F) Number of buyer in the market(Population) and family size An increase in the number of buyers will increase demand while a decrease in the number of buyers will decrease demand. G) Climate/Weather: The demand for a commodity is also affected by climate. For example, demand for woolen clothes (heaters) increases in cold seasons. On the other hand demand for coolers, cotton clothes etc., increases in hot seasons. Generally, demand mainly depends upon three factors, namely. Price of the commodity; Income of the consumer, and Price of related goods. On the basis of the above three factors, demand can be classif ied into three types: i) Price Demand, ii) Income Demand, and iii) Cross Change in Demand a change in any determinant of demand—except for the good‘s price causes the demand curve to shift. We call this a change in demand. When we state the law of demand, we kept all the factors to re m ai n c o nst ant e x c e p t t he p ri c e o f t he g o o d und e r consideration. A change in any of the above listed factors except the price of the good will change the demand, while a change in the price, other factors remain constant will bring change in quantity demanded. A change in demand will shift the demand curve from its original location. For this reason those factors listed above other than price are called demand shifters. A change in own price is only a movement along the same demand curve. Thus, a change in demand is observed by a shift in the demand curve, while a change in quantity demanded is 2.1.3 Elasticity of demand In economics, the concept of elasticity is very crucial and is used to analyze the quantitative relationship between price and quantity purchased or sold. Elasticity is a measure of responsiveness of a dependent variable to changes in an independent variable. Elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to a change in its price, or change in income, or change in prices of related goods. Commonly, there are three kinds of demand elasticity: 1) price elasticity, 2) income elasticity, and 3) cross elasticity. i) Price Elasticity of Demand P ri c e el asti c i ty of d em and : refers to the d eg ree of responsiveness of demand to change in price. It is a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity dem anded div ided by the percentage change in price. It indicates how consumers react to changes in price. The greater the reaction the greater will be the elasticity, and the lesser the reaction, the smaller will be the elasticity. 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 even if price changes, or it may change, but not in proportion to the change in price. NOTE: It should be remembered that the point elasticity of demand on a straight line is different at every point. B) Arc price elasticity of demand The main drawback of the point elasticity method is that it is applicable only when we have information about even the slight changes in the price and the quantity demanded of the commodity. But in practice, we do not acquire such information about minute changes. We may possess demand schedules in which there are big gaps in price as well as the quantity demanded. In such cases, there is an alternative method known as arc method of elasticity measurement. When elasticity of demand is measured over a finite range or ‘arc’ of a demand curve, it is called arc elasticity of demand. Determinants of Price Elasticity of Demand i) The availability of substitutes: the more substitutes available for a product, the more elastic will be the price elasticity of demand. ii) 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. iii) The proportion of income consumers spend for a product:-the smaller the proportion of income spent for a good, the less price elastic will be. iv) The importance of the commodity in the consumers’ budget : Luxury goods: tend to be more elastic. Example: gold. Necessity goods: tend to be less elastic. Example: Salt. V) Number of use of the commodity: The higher the number of use of the commodity the higher will be the elasticity. Example: Electricity. 2.2 THEORY OF SUPPLY Supply indicates various quantities of a product that sellers (producers) are willing and able to provide at different prices in a given period of time, other things remaining unchanged. The Law of Supply: states that, ceteris paribus, as price of a product increase, quantity supplied of the product increases, and as price decreases, quantity supplied decreases. 2.2.1 Supply schedule, supply curve and supply function A supply schedule is a tabular statement that states the different quantities of a commodity offered for sale at different prices. Table 2.3: an individual seller’s supply schedule for butter Price ( birr per KG) 30 25 20 15 10 QS(KG/Week) 100 90 80 70 60 A supply curve: conveys the same information as a supply schedule. But it shows the information graphically rather than in a tabular form. Supply Function: Mathematical representation. The supply function of a commodity can be briefly expressed in the following functional relationship: S = f(P), Market Supply: It is derived by horizontally adding the quantity supplied of the product by all sellers at each price. 2.2.2 Determinants of Supply Apart from the change in price which causes a change in quantity demanded, the supply of a particular product is determined by: i) 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. ii) State of Technology Technological advancement enables a f irm to produce and supply more in the market. This shifts the supply curve outward. iii) Price of Related Goods: An increase in the price of other, related goods induces the f irms to produce more of those other goods, leading to a reduction in the supply of the goods whose iV) Objectives of the Firm: Beside/apart from to the primary prof it maximization objective, f irms could have such as objectives of maximum sales, maximum employment, more production, etc. In this case, the supply will be increasing. V) Weather Condition A change in weather condition will have an impact on the supply of a number of products, especially agricultural products. Vi) Sellers‘ expectation of price of the product vii) Number of sellers in the market vii) Taxes & Subsidies (Fiscal Policy) v i i i ) O t h e r f a c t o rs : M a rk e t a c c e s s ( i n f ra s t ru c t u ra l development), political stability, etc. 2.3 Market Equilibrium Market equilibrium occurs when market demand = market supply. Effects of shift in demand and supply on equilibrium What will happen to the equilibrium price and quantity ? i ) Wh en dem a nd c h a nges a nd s u ppl y rem a i ns constant Thus, supply being given, a decrease in demand reduces both the equilibrium P and Q and vice versa. i i. W h e n s u ppl y c h a n ge s a n d de m a n d re m a i n s constant Thus, give the demand, an increase in supply reduces the equilibrium P and increases the equilibrium Q, and vice versa. III) Effects of combined changes in demand and supply When both demand and supply increase, the quantity of the product will increase def initely. But it is not certain whether the price will rise or fall. Three Scenarios: 1) If an increase in demand is more than an increase in supply, then the price goes up. 2) if an increase in supply is more than an increase in demand, the price falls. 3) If the increase in demand and supply is same, then the price remains the same. Besides, when demand and supply decline, the quantity decreases. But the will depend upon the relative fall in demand and supply. change in price In this case too, there will be three Scenarios: 1) When the fall in demand is more than the fall in supply, the price will decrease. 2) When the fall in supply is more than the fall in demand, the price will rise. 3) If both demand and supply decline in the same ratio, there is no change in the equilibrium price, but the quantity decreases. Therefore, when both supply and demand change, the effect on the e q ui l i b ri um p ri c e d e p e nd s on the p rop or ti on of change(relative change) in demand and change in supply. END!