The document outlines theories of demand and supply, focusing on learning objectives like evaluating factors influencing demand, consumer behavior, and government modifications of prices. Demand is described as the willingness and ability to purchase goods at specified prices, influenced by factors such as income and preferences, while supply comprises the quantities producers are willing to sell at varying prices, also affected by related goods, production costs, and technology. The concepts of elasticity, including price and income elasticity, are introduced to explain market responses to changes in prices and income.

1. LESSON 2
Theories of demand and supply
2.1. Learning Objectives:
By the end of the lesson you should be able to:
1. Evaluate the factors that affect individual and market demand and supply.
2. Evaluate consumer behaviour through the concept of utility.
3. Explain market price and quantity determination in the market.
4. Explain the various reasons for and methods of government modification of
the price system and equilibrium prices.
5. Illustrate demand and supply curves and the shifts and such curves.
2.2. Demand and Supply Market Participants
The three critical economic groups/players in a market are households, firms and
central authorities. Household decisions are assumed to be consistent, aimed at
maximizing utility and they are the principal owners of the factors of production. Firms
use factors of production (land, labour, capital and enterprise) to produce commodities
that are then supplied to households, other firms, individuals or central authorities. Central
authorities include all public agencies, government bodies and other organisations
belonging to or under the direct control of the government. They exert some control over
individual decisions taken and over markets.
2.2.1. Demand Analysis
Demand is the quantity of goods which consumers (households) are willing and able to
buy in the market at specified prices and specified time when other things held constant.
Economists record demand on a demand schedule and plot it on a graph as a demand curve
that is usually downward sloping.
The downward slope reflects the negative or inverse relationship between price and
quantity demanded: as price decreases, quantity demanded increases. In principle, each
consumer has a demand curve for any product that he or she is willing and able to buy,
and the consumer’s demand curve is equal to the marginal utility (benefit) curve.
When the demand curves of all consumers are added up horizontally, the result is the
market demand curve for that product which also indicates a negative or inverse

2. relationship between the price and quantity demanded. If there are no externalities, the
market demand curve is also equal to the social utility (benefit) curve.
Accordingly, the quantities and prices in the demand schedule can be plotted on a graph.
Such a graph after the individual demand schedule is called the individual demand curve
and is downward sloping. An individual demand curve is the graph relating prices to
quantities demanded at those prices by an individual consumer of a given commodity
A market demand curve is the horizontal summation of the individual demand curves i.e.
by taking the sum of the quantities consumed by individual consumers at each price.
Consider a market consisting of two consumers whose demand curves are DI and DII
Consumer 1 demands q1, consumer II demands quantity q2, and total market de-
mand at that price is (q1+q2). At price p2, consumer 1 demands q’1, and consumer
demands quantity q’2 and total market demand at that price is (q’1+q’2). DD is the total
market demand curve.
2.3. Determinants of Demand for a Commodity
The factors that influence demand for a product are broadly divided into factors
determining household/Individual demand and factors affecting market demand. The
factors affecting household demand include:
• The taste of the household
• The income of the household
• The necessity of the commodity, and its alternatives if any
• The price of other goods

3. The factors that affect market demand on the other hand include:
1. The price of the product: this is the most important determinant of demand.
Ceteris paribus, there is an inverse relationship between price and quantity
demanded. The law of demand indicates that the higher the price of a commodity,
the lower the quantity that would be demanded of that commodity, all other factors
remaining equal. This is what provides a downward sloping demand curve.
Though this is generally the case, there are usually some exceptions to the law of
demand (downward sloping demand curves). These are:
– Inferior goods: these are goods whose demand decreases as consumer income
increases. Cheap necessary foodstuffs provide one of the best examples of
exceptional demand. Inferiority, in this sense, is an observable fact relating to
affordability rather than a statement about the quality of the good.
– Giffen goods: Some special varieties of inferior goods are termed as Giffen
goods i.e. extremely inferior goods. Robert Giffen first observed that people
used to spend more their income on inferior goods like potato and less of their
income on meat. But potatoes constitute their staple food. When the price of
potato increased, after purchasing potato they did not have much surplus to buy
meat. So the rise in price of potato compelled people to buy more potato and
thus raised the demand for potato.
– Conspicuous Consumption: these are also called Veblen goods. A few goods
like diamonds etc are purchased by the rich and wealthy sections of the society.
The prices of these goods are so high that they are be-yond the reach of the
common man. The higher the price of the diamond the higher the prestige value
of it. So when price of these goods falls, the consumers think that the prestige
value of these goods comes down. So quantity demanded of these goods falls
with fall in their price. So the law of demand does not hold good here.
Conspicuous necessities: Certain things become the necessities of modern life.
So we have to purchase them despite their high price. The demand for T.V.
sets, auto-mobiles and refrigerators etc. has not gone down in spite of the
increase in their price. These things have become the symbol of status. So they
are purchased despite their rising price. These can be termed as “U” sector
goods.
– Ignorance: A consumer’s ignorance is another factor that at times in-duces
him to purchase more of the commodity at a higher price. This is especially so

4. when the consumer is haunted by the phobia that a high-priced commodity is
better in quality than a low-priced one.
– Emergencies: Emergencies like war, famine etc. negate the operation of the
law of demand. At such times, households behave in an abnormal way.
Households accentuate scarcities and induce further price rises by making
increased purchases even at higher prices during such periods. During
depression, on the other hand, no fall in price is a sufficient inducement for
consumers to demand more.
– Future changes in prices: Households also act speculators. When the prices
are rising households tend to purchase large quantities of the commodity out of
the apprehension that prices may still go up. When prices are expected to fall
further, they wait to buy goods in future at still lower prices. So quantity
demanded falls when prices are falling.
– Change in fashion: A change in fashion and tastes affects the market for a
commodity. When a broad toe shoe replaces a narrow toe, no amount of
reduction in the price of the latter is sufficient to clear the stocks. Broad toe on
the other hand, will have more customers even though its price may be going
up. The law of demand becomes ineffective.
2. Prices of other related commodities: related commodities can be compliments
or substitutes. Complements of a commodity are those used or consumed with it
e.g. cars and petrol. As the demand for a commodity increases, so does that of its
complementaries. Substitutes are those that can be used or consumed in the place
of another commodity e.g. consumption of coffee instead of tea. As the price of a
commodity increases, its demand falls, but that of its substitutes increases, ceteris
paribus.
3.The Aggregate National Income and its distribution among the population:
Demand for normal goods increases as incomes go up. However, there are certain
goods whose demand shall increase with income up to a certain point, then remain
constant. In such a case the good is called a necessity e.g. salt. Also, there are some
goods whose demand shall increase with income up to a certain point then fall as
the income continues to increase. In such a case the good is called an inferior good.
4. Taste and preferences: there is a direct relationship between quantity de-manded
and taste. For instance, if consumers’ taste and preferences change in favour of a

5. commodity, demand will increase. On the other hand, if taste and preferences
change against the commodity e.g. due to changes in fashion, demand will fall.
5. Expectation of future price changes: If it is believed that the price of a
commodity is likely to be higher in the future than at present, then even though
the price has already risen, more of the commodity may be bought at the higher
price.
6. Climatic/seasonal factors: Seasonal variations affect the demand of certain
commodities such as cold drinks like sodas and heavy clothing.
7. The demographic characteristics: Changes in population overtime affect the
demand for a commodity. Also, as population increases, the population structure
changes in such a way that an increasing proportion of the population consists of
young age group. This will lead to a relatively higher demand for those goods and
services consumed mostly by young age group e.g. fashions, films, nightclubs,
schools, toys, etc.
8. Government influences: Such aspects as legislation requiring the wearing of
seatbelts would increase the demand for those items and vice versa.
9. Advertising: They persuade consumers to purchase more and therefore in-crease
the quantity demanded of a good, all other factors remaining equal.
2.4. Movement along and Shifts in the demand curve.
Movement along the demand curve are brought by changes in own price of the
commodity. When price falls from P1 to P2, quantity demanded increases from q2 to qI2
and movement along the demand curve is from A to B
Shifts in the demand curve are brought about by the changes in other factors that in-
fluence demand other than price e.g. like taste, prices of other related commodities,
income etc other than the price of the commodity. These lead to a shift in demand curve.
If the changes boost demand, the shift in demand curve is to the right while if it leads to
a decline in demand; the shift in demand curve is to the left. For in-stance increases in
income, other factors remaining equal may make initial demand to shift from curve DD
to curve D2D2.

6. Elasticity of Demand
Measures the extent to which the quantity demanded of a good responds to changes
in one of the factors affecting demand i.e. the responsiveness of demand to a change
in a factor that influences such demand e.g. prices, incomes, etc. There are various
types of elasticities of demand. These are discussed as:
Price Elasticity of Demand: is the responsiveness of the quantity demanded to
changes in price; its co-efficient is

7. This can be point elasticity or arc elasticity. Point elasticity measures elasticity at a
particular point and is only valid or based on small movements. Arc elasticity is the
average elasticity between two given points on the curve. Because of the negative
relationship between price and quantity demanded, price elasticity of demand is
negative. We there take the absolute magnitude of the number. Price elasticity
determines the shape of the demand curve.
There are various types of price elasticities of demand. These include:
• Perfectly inelastic demand (Ed = 0): arises when changes in price have no
effect the quantity demanded so that the demand is infinitely price inelastic.
This is the case of an absolute necessity i.e. one which a consumer cannot do
without and must have in fixed amount e.g. analysis, insulin etc.
• Inelastic demand (Ed < 1): changes in price bring about changes in quantity
demanded in less proportion so that elasticity is less than one. This is the case
of a necessity or a habit-forming commodity e.g. drinks or cigarettes.
• Unit Elasticity of demand (Ed = 1): changes in price bring about changes
in quantity demanded in the same proportion and the elasticity of demand is
equal to one or unity.
• Elastic demand (Ed > 1): changes in price being about changes in quantity
demanded in greater proportion so that elasticity is greater than one. This is

8. the case of a luxury, i.e. one that can be done without or a commodity with
close substitutes.
• Perfectly Elastic demand (Ed = ¥): Demand is perfectly elastic when con-
sumers are prepared to buy all they can obtain at some price and none at an
even slightly higher price.

9. Price elasticity of demand is affected by several factors:
• Ease of substitution.
• Nature of the commodity i.e. whether it is a necessity of life, luxury or
addictive.
• Consumers, income.
• The number of uses to which the good can be put.
• Time factor.
• The prices of other products.
• Advertisements especially the persuasive ones.
• Whether the use for the good can be postponed.
• Human and economic constraints.
Income elasticity of demand: is the degree of responsiveness of the quantity de-
manded of a product to changes in income. Its co-efficient is as follows:

10. Just like price elasticity, there are different types of income elasticity of demand.
These include:
• Negative Income Elasticity of demand: this is where the demand
decreases as income rises and rises when income falls. This is the case of
inferior goods.
• Zero Income Elastic Demand: In this case, the demand does not change as
income rises or falls. In this case it is said to be zero income, elasticity. This
is the case of a necessity.
• Income Inelastic Demand: This is where demand rises by a smaller
proportion than income or falls by a smaller proportion than income.
• Unit Income Elasticity: This is where demand rises or falls by exactly the
same proportion as income.
• Income Elastic: Demand rises or falls by a greater proportion than income.
Since income elasticity of demand can be either positive or negative, it is
therefore very important to include the sign (+ or -) when stating the value of
the co-efficient.
Suppose that the initial income of a person is Rs.2000 and quantity demanded for the
commodity by him is 20 units. When his income increases to Rs.3000, quantity demanded
by him also increases to 40 units. Find out the income elasticity of demand.
Solution:
Here, q = 100 units
∆q = (40-20) units = 20 units
y = Rs.2000
∆y =Rs. (3000-2000) =Rs.1000
Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a rise of 2% in quantity
demanded.

11. Cross Elasticity of Demand: Cross elasticity of demand measures the degree of
responsiveness of the quantity demanded of one good (B) to changes in the price
of another good (A). It is measured as follows:
2.5. Supply Analysis
Supply is the quantity of goods/services which suppliers are willing and able to put on the
market for sale at alternative prices at defined periods of time, if all other conditions are
held constant. Supply can be viewed from an individual producer’s point of view or from
the market point of view.
The table that shows the various quantities that can be supplied at specified prices is called
a supply schedule. When these are plotted on a graph, they provide an upward sloping
curve called a supply curve. This for an individual firm shows the quantities of a
commodity the firm is prepared to supply at various prices.
The market supply curve is obtained by horizontal summation of the individual firm
supply curves i.e. taking the sum of the quantities supplied by the different firms at each
price.
Consider, for the sake of exposition, an industry consisting of two firms. At price P1, firm
I (diagram below) supplies quantity q1, firm II supplies quantity q2, and the total market
supply is q1+q2
At price P2, firm I supplies q’1, firm II supplies quantity q’2, and the total market supply
is q’1+q’2,. SS is the total market supply curve.

12. There are various factors that influence supply behaviour of firms. These are
described as:
• Price of a commodity: the higher the price, the more commodities suppliers are
willing to avail to the market all factors being held equal. This relates to the law of
supply that the higher the prices, the greater the quantities supplied at specified at
periods ceteris paribus. This provides the upward sloping supply curve from left to
right. This is usually because as price goes up, less and less efficient firms are
brought into the industry.
Example . The following supply schedule shows the quantity of a commodity a firm
is willing to avail to the market at various prices. Use it to graph a supply curve.

13. • Prices of other related goods: related goods can be substitutes or complementary
goods. If X and Y are substitutes, then if the price X increases, the quantity demanded
of X falls. This will lead to increased demand for Y, and this way eventually lead to
increased supply of Y. If two commodities, say A and B are used jointly, then an
increase in the price of A shall lead to a fall in the demand for A, which will cause the
demand for B to fall too.
• Prices of the factors of production: As the prices of those factors of pro-duction used
intensively by a firm producer rise, so do the firms’ costs. This cause supply to fall as
some firms reduce output and other, less efficient firms make losses and eventually
leave the industry.
• Objectives of the firm: How much is produced by a firm depends on its objectives. A
firm which aims to maximise its sales revenue, for example, will generally supply a
greater quantity than a firm aiming to maximise profits.

14. • State of technology: There is a direct relationship between supply and technology.
Improved technology results in more supply as with technology there is mechanisation.
• Natural events: Natural events like weather affect particularly the supply of
agricultural products.
• Time: In the long run (with time), the supply of most products will increase with capital
accumulation, technical progress and population growth so long as the last one takes
place in step with the first two. This reflects economic growth.
• Supply of Inputs: Changes in supply of inputs will affect the quantity supplied; if this
falls, less shall be supplied and vice versa.
• Taxes and subsidies: Taxes increase the cost of production while subsidies have the
opposite effect.
2.5.1. Movements along and Shifts and Supply Curve
While changes in price result in movement along the supply curve, changes in other
relevant factors cause a shift in supply, that is, a shift of the supply curve to the left or
right. Such a shift results in a change in quantity supplied for a given price level. If the
change causes an increase in the quantity supplied at each price, the supply curve would
shift to the right.

15. Reasons for rightward shift of supply curve
a) Improvement in technology
b) Decrease in tax
c) Decrease in cost of factor of production
d) Favourable weather conditions.
e) Seller’s expectation of fall in price in future
Reasons for leftward shift of supply curve
a) Use of old or outdated technology
b) Increase in tax
c) Increase in cost of factor of production
d) Unfavourable weather conditions.
e) Seller’s expectation of rise in price in future
Elasticity of Supply.
This is the responsiveness of quantity of goods supplied to the market to a change in one
of the factors influencing supply.
The most common of these supply elasticities include:
Price elasticity of supply: measures the degree of responsiveness of quantity supplied to
changes in price. The co-efficient of the elasticity of supply may be stated as:

16. For a straight-line supply curve, the gradient is constant along the whole length of the
curve, but elasticity is not necessarily constant. Steeply sloped supply curves are usually
associated with inelastic supply and non-steeply sloped supply curves are usually
associated with elastic supply. The various types of price elasticities of supply are:
• Perfectly Inelastic (Zero Elastic) Supply: Supply is said to be perfectly in-elastic if
the quantity supplied is constant at all prices.
• Inelastic Supply: arises when changes in price bring about changes in quantity supplied
in less proportion. The supply curve is steeply sloped and the elasticity of supply is less
than one.
• Unit Elasticity of Supply: arises when changes in price bring about changes in
quantity supplied in the same proportion.
• Elastic Supply: arises when changes in price bring about changes in quantity supplied
in greater proportion. Thus, when price increases, quantity supplied increases in greater
proportion.
• Perfectly Elastic Supply: arises when the price is fixed at all levels of supply. If the
supply is perfectly elastic, the supply curve is a horizontal straight line and the elasticity
of supply is equal to infinity.
Market Equilibrium
The fundamental principle of economics states that the actual quantity of an item
demanded and supplied is determined by the intersection of the supply and demand
curves. The price at which the supply and demand curves intersect is known as the
equilibrium price as shown in the figure below. At this price, the market is said to be in a
state of equilibrium (i.e. in balance). Any changes in the non-price factors influencing
supply or demand will disturb the equilibrium by shifting the supply or demand curve
either up or down.

17. When this occurs, market forces quickly bring supply and demand back into
balance and a new equilibrium point is established. An increase in supply will lead
to a fall in price (as supply exceeds demand). Whilst, an increase in demand will
lead to a rise in price (as demand exceeds supply). The change in supply or demand
causes an imbalance which is reflected as a change in a stock’s price. This change
creates a trading or investment opportunity from a technical analysis perspective.
In summary, what we have briefly explored here is the interaction of supply,
demand, and price. This is a concept that every investor (and trader) should strive
to com-prehend. It is a concept that is revisited day-in and day-out in the stock
market. It is the underlying principle behind identifying a profitable, future trade or
investment. A Twin force is therefore always at work to achieve only one price
where there is neither upward nor downward pressure on price. This is termed the
equilibrium or market price: The equilibrium price is the market condition which
once achieved tends to persist or at which the wishes of buyers and sellers coincide.
Any other price anywhere is called DISEQUILIBRIUM PRICE. As the price falls
the quantity demanded increases, but the quantity offered by suppliers is reduced,
since the least efficient suppliers cannot offer the goods at the lower prices. This
illustrates the third “law” of demand and supply that “Price adjusts to that level
which equates demand and supply”.
An equilibrium is said to be stable equilibrium when economic forces tend to push
the market towards it. In other words, any divergence from the equilibrium position
sets up forces, which tend to restore the equilibrium.

18. REVISION QUESTIONS
EXERCISE 4. Explain market price and quantity determination in the market.
EXERCISE 5. Explain the various reasons for and methods of government
modification of the price system and equilibrium prices.
EXERCISE 6. Illustrate demand and supply curves and the shifts and such curves.