Chapter 1: Theory of Consumer Behavior & Demand

1.1.1. Theory of Demand: Consumers Demand

Definition: Demand is the quantity/amount of goods and services that
consumers are willing to buy at a particular price, Ceteris Paribus
(other thing remaining unchanged/constant).
or it is simply a statement of a buyer’s plans, or intentions,
wrt to the purchase of a product.
The question however is that,
 How a consumer decide how much of a commodity to buy at a
particular price?
 Why a consumer will buy more of a commodity at lower price ?
Both questions have addressed in the demand’s definition:
 The definition involves willingness & ability to buy because
willingness alone without the necessary MONEY/birr will be a
nominal (not real or not actual) demand.
 Willingness to buy must be backed by the ability to acquire the
good.
Thus, demand will be effective if and only if the buyer has both the
willingness and ability to possess an item.
An individual's demand for a good is the
quantities of it that the consumer is willing
and able to buy
 at each specific price,
 over some given period of time,
 other things remaining the same.

 The price of goods & services influence the

consumer’s demand in that high price
discourages consumption and,
in contrast, low price encourages additional
purchases.
Demand Schedule, Demand Curve & Function
these terminologies are important in demand theory:

Demand Schedule: is a table showing the

r/ship b/n the price of a good and the
quantity demanded per period of time, other
things remained constant.

Example: Individual Demand Schedule for wheat

Price per kg of Wheat (in Birr) Quantity demanded in kg per
month
15 80
10 90
5 100
 Demand Curve: is a diagram showing the r/ship b/n
the price of goods & the quantity demanded per period of
time.
 Or it is simply the graphical representation of demand schedule.
Example: Individual Demand Curve for Wheat
It evinces; as consumers
, Br per kg

Demand curve for wheat demand more of a good,

the lower its price, holding
constant all other factors.

15
10
5

0
80 90 100 Qd, wheat In kg
 Demand Equation
 Demand can also be mathematically
represented by a demand equation.
Qd = a - bP
Where Qd stand for Quantity demanded
and P Price; and ‘a’ and ‘b’ are constants.
Using, the demand schedule above we can
determine its demand equation:
the demand equation for wheat is:
Qwheat = 110-2P
On the other hand, using the demand equation, the
demand schedule can also be determined.
 Law of Demand
As we can clearly observe there is an inverse r/ship b/n
price of a commodity and the quantity demanded. i.e.,
as price increases people will buy less and vise versa.
This condition is known as the law of demand.
The Law of Demand: States that when price of a
commodity goes up the quantity demanded falls or people
will buy less of it, other things being kept constant.
Alternatively the Law of Demand can be stated as;
 there is an inverse r/ship b/n price of a commodity &
the quantity demanded.
 all else constant (ceteris paribus), as price falls, the
quantity demanded rises, and as price rises, the
corresponding quantity demanded falls.
 I.e., consumers will buy more of a commodity at lower
price and vice versa
 Why do we observe Law of Demand?
Two fundamental reasons explain why the quantity demanded of a
commodity is inversely related to its price.
1. Substitution Effect: In real life we are all able to substitute one product
for another to satisfy our need (demand).
 This is commonly called the principle of substitution.
 If the relative price of one particular good goes up, we most likely shift in favor of
the lower priced good; against the higher priced good.
For example, the price of Coca-Cola and Pepsi-Cola is most of the time the same why?
What will happen if the price of Coca-Cola goes up while the price of Pepsi-
Cola remains the same, other things unchanged ?,
people most likely buy Pepsi-Cola rather than Coca-Cola.
 Because of this price change Pepsi-Coca is now relatively cheaper.
 People will substitute Pepsi-Cola for Coca-Cola as a result demands for Coca falls as
its price increase.
2. Income Effect: - If the price of one commodity goes down while our
income & prices of other goods stay the same, our ability to purchase goods
in general goes up.
 In other words with the same amount of money income we can buy more of
that commodity.
 Generally, the price fall of one good will increase our purchasing power and
we feel wealthier, thus, we buy more of that good.
 Individual vs. Market
Demand
 up to now what we have seen is individual demand.

 What important is market demand b/c price is

determined by market demand, not by individual demand.
 We use the analysis of individual demand to derive the
market demand.

Market Demand: is the demand of all consumers in the

market place for a particular good or services.

 The market demand for a particular good is the sum

of all individual consumers' demand for it.
 Mathematically, the market demand can be derived
from individual demand equation as well.
Market Demand Schedules & Market Demand Curve:
Assuming there are only two households in the market,
market demand schedules & market demand curve is as follows
Price per Household Household Market Market Demand
Schedules:
unit A demand B demand demand
The quantity demanded
3 Br 4 units 6 units 10 Units in a market is the sum
4Br 3 units 4 units 7units of the quantities
demanded by all the
buyers.
Market Demand Curve: - Is the horizontal
summation of all individual demand curves.
Mathematically, suppose the market is composed of only two
consumers whose demand equation is given by:

 Since the market demand is a summation of all individual

demands in the market, to obtain the market demand
equation, we simply add individual demand functions of the
two consumers. Thus,
Where MD is Market Demand.
If there are n number of identical consumers ( i.e. with same
demands) in the market, then we multiply it by the number
of identical consumers in the market to find the market
demand for a product.
Example: - Suppose the demand of a typical consumer is
Qd = 20 -3P and that there are 200 identical consumers in the
market. What is the market demand?
 Determinants of Demand
Demand for a commodity can be affected by several factors:
 These factors; that may affect demand (called determinants
of demand) can be grouped into two groups:
Price factor & Non-price factors
I. Price Factor: - The price of commodity X (Own price factor (Px)):
 Price affects demand negatively as stated by the law of demand.
 Price change leads to a change in quantity demanded.
 Thus any change caused by price is called change in quantity
demand.

In figure, change in demand is shown P1

by a movement from point A to
P2
point B;
which is an increase in
quantity demanded followed by
price fall from P1 to P2.
II. Non-Price Factor: These factors are also known as demand
shifters.
 Any change caused by these factors is called Change in Demand
(Shift in the Curve).
 Change in demand is graphically represented by a shift in the entire
demand curve.
 Diagram, panel a and b shows change in demand: i.e. increase and
decrease in demand respectively.
 Increase in demand panel (a), which implies with the same price more is
demanded.
 Panel (b) shows decrease in demand implying that with the same price
less quantity is purchased.
Some of the non-price factors (Non-Price determinant of
demands) which causes change/shift in demand are:-

a. Income of the consumer (M),

 Dd For normal good (+)
 Dd For inferior good (-)
b. Prices of related goods (Pr)
 The price of substitute goods (+), Qdd
 Price of complementary goods (-), Qdd
C. Taste & preference of the consumer (T),
 change in consumers' taste in favor of a good (+), Qdd
 change in consumers' taste against a good (-), Qdd
d. Number of buyers (population) in the market (POP),
 An increase in population in the economy (+), Qdd
e. Consumers' expectation (E):
 Future expectations of prices, income, and availability of
the commodity may inspire them to buy more or less of a
particular good without a change in its current price.
 Demand Function
Demand Function: is a function(equation) that
specifies the r/ship b/n the quantity demanded of a
commodity (Qd) that he/she is willing & able to buy &
the price level & other determinants of demand.
• In mathematical form, we can express a demand for a
commodity, X, as:
Qd = f { Px, M, Pr, Pc, T, POP, E,...}
 If the r/ship b/n price & quantity demanded of a product
is to be established, the effects of other determinant
factors should remain constant. This is what we mean by
ceteris paribus.
 In this case Demand can represented an equation such as:
Qd = f(Px) = a - bP
Where: Qd & Px stand for Quantity demanded and Price of
commodity, X, respectively while ‘a’ & ‘b’ are constants.
 Movements Vs Shift of the Demand Curve
A change in Quantity demanded
 it designates the movement from one point to another point, along the
same demand curve – from one price quantity combination to another.
 It is caused by a change in price of the good (an increase or decrease in the
own price).
Change in Demand: A change in the demand schedule, or graphically, a shift in
the location of the demand curve.
 Out ward shift → increase in demand
 Inward shift → decrease in demand.
 A change Caused by changes in one or more of the determinants of
demand i.e., non own price determinants of demand.
Fig b: Change in Demand
Fig a:
= shift of the DC
Change
in Quantity
demanded
=
Movement
along the
DC
Summary of factors affecting
demand and their Effect
 1.1.2. Theory of Supply
Definition, Schedule & Curve
In a market economy, while buyers of a product constitute the demand
side of the market, sellers of that product make supply side of the
market.
Definition: By supply we mean the quantity of goods that firms
(producers) are willing to produce and offer for sale at a particular
price and at a given period of time, other thing held constant.
 Supply may be defined as a schedule, which shows the various
amounts of a product,
 which a producer is willing and
 able to produce and make available for sale in the market over
specific timer period,
 at a given price, Ceteris Paribus (other things held constant).

Supply Schedule
Price per unit (in $ 1 2 3 4
Quantity supplied (in tones) 10 20 30 40
 Supply Curve
The graphical representation of supply schedule is called
Supply Curve.
 When we plot each pair of values from the supply schedule in table
above on a graph and join the resulting points we get the
producer's supply curve as shown in figure.

Supply Curve

Supply equation is a mathematical model, which shows the r/ship

b/n quantity supplied & factors affecting it.
Qs = c + dP
where: Qs = Quantity supplied and P = Price of product
 The law of supply
The law of supply states that all other things being
constant, the quantity supplied of goods & services
varies directly with their prices.
 Or it states that when producers get higher price for their
product than the current one, they will supply more of it.
 Thus, there is a direct r/ship b/n price and quantity supplied.
 As price rises, the corresponding quantity supplied rises; as
price falls, the quantity supplied falls.

Individual Supply vs. Market Supply

Individual Supply is the supply of a single firm/producer in
the market place for a particular goods or services.
Market Supply is a summation of all individual supplies in
the market place.
 It is the supply of all firms in the market place for
a particular goods or services.
 Determinants of Supply
What determines a market supply; like in the case of
demand, determinants of supply can also be grouped into
price factor & non-price factors (determinants).
a. Own price Factor (Px): Own of a commodity price affects
supply positively as stated in the law of supply.
 Any change caused by own price of a good is called Change in
Quantity Supplied.
 i.e., the movement along the supply curve.
b. Non-Price Determinants of Supply:-These factors are
also known as supply shifters.
 Any change caused by one of these factors is called change in
supply.
 Change in supply is graphically shown by the movement/shift of the
entire supply curve either to the right (up) or to the left (down).
 The supply curve shifts (up) to the right when supply
increases and
 it shifts to the left (down) when supply decreases.
Some of the non price factors which causes
change in supply are:-

i. Price of related goods (Pr)

ii. Price of factors of production (Pf)
iii. State of production technology(T)
iv. Number of suppliers serving the market (N)
v. Taxes and Subsidies (TS),
vi. Producers expectation about future prices (E)
vii. Weather (W); etc.
 Supply function
Supply equation (function): is a functional form in which
we can express the r/ship b/n quantity of the
commodity that a producer is willing (& able) to supply
and its dominant factors.
 It is a mathematical model, which shows the r/ship b/n
quantity supplied & factors affecting it given as:
Qs = f (Px, Pr, Pf, N,T ,Ts, E, W …)
 However, if we want to formulate a r/ship b/n the
price of the commodity & its quantity supplied, we
make the ceteris paribus assumption;
 so that the functional r/ship would look
Qs = f(Px) = c + dP
where: Qs = Quantity supplied and P = Price of product
Example:
 Qs1= 7P1 - 4; Qs2= -100 + 75P2; Qs3 = 500P3 – 4500, etc
A Firm’s Supply Curve Vs a Market Supply Curve
A firm’s supply curve is a supply curve for that particular firm
 A market supply curve is the sum of all firms’ supply curves
 market supply is the horizontal summation of individual
firms’ supply curves.

 Parts (SA), (SB) & (SC) show the supply curves for firms
A, B, and C, respectively.
 The market supply curve (S), is the sum of the
firms’ supply curves.
Examples: 1 . Suppose there are 120 sellers of sweet
potatoes in a market & the sellers have similar supply
function of the form Qs = 20p - 5.
 What is the market supply and the quantity supplied in the
market when price is Br.4?
E.g.2: What is the market supply of 100 identical suppliers if
the supply function of a typical suppliers is Qs = 3p - 2 ?
E.g.3: If the supply function of a representative supplier in
a market of 50 similar suppliers of jeans is P= 0.1Qs + 0.5,
then
 What is the market supply function & the quantity supplied in
the market if the price is Br 100?
Solution: 1. Qm = Qs x 120 = 120 (20p - 5)
Qm = 1440p – 600 and Qm (p=4)
= 1440 (4) – 600 = 5760 – 600 = 5160 units
Ans. 2: Qm = 300p – 200 and 3: Qs = 500p – 250 = 25,000
 Movement vs shift of the Supply Curve
A change in quantity supplied: as price of a good increases the quantity supplied
increases. We call this kind of movement along the supply curve "change in
quantity supplied.”
 This movement along the (same) supply curve is caused by a change in the
price of the good, while other things being constant.
 For example, movement from A to B, C to D to A, etc in fig. below.
Change in supply: This kind of change refers to a shift in the position of the
supply curve caused by a change in other factors.
 Change in any factor that contributes towards an increase in the cost of
production will shift the supply curve. The price of the factors, increase in
sales tax, decline in the number of supplies, etc will increase the cost of
production & hence shift the supply curve to the left.
Change in supply
change in quantity supplied
 1.1.3. Market Equilibrium
Supply & Demand become especially significant when they are put
together.
 Sellers offer product for sale when they anticipate demand or
willingness to pay.
 Buyers on the other hand can convert their want in to demand only
if there is supply.
 The two interact to determine (create) the market price.
 Let us put the supply schedule and demand schedule side by side
and see how the market force determine market price.
The market price or equilibrium occur at the price level; where quantity
demanded equal quantity supplied.
At price above 3units sellers will offer more quantity than consumers will
buy
 This results in surplus of some quantity of products.
 Surplus means wastage of limited resources.
 Surplus: a situation in which Qss > Qdd
So sellers have a choice of:
 Cutting back their product,
 Stopping producing that product for a while, or
 Cutting the price level
 These all put pressure on price to fall.
At the price below 3, consumers want more products than the producer
offer the sale.
 Some who wants more of this product will not be able to buy them
even if they are willing to pay more. i.e., there is a shortage, b/se
the quantity demanded exceeds,
Shortage: a situation in which Qdd > Qss
 This shortages of products put pressure on price to rise.
Only at price of 3 the number of product offered for sale and the
number of quantity that buyer are willing to buy are equal each
other.
 Thus, the actions of buyers and sellers naturally move markets toward
the equilibrium of supply and demand.
 Meaning supply and demand equal each other, the market is said to be
at equilibrium.
Definition: An equilibrium is the market condition that exists when
quantity supplied and quantity demanded are equal.
 And the price at this point is called Equilibrium Price or Market Clearing
Price.
 At equilibrium, there is no tendency for the market price to change.

At the market equilibrium price, the corresponding quantity is called

the equilibrium quantity.
 The equilibrium price is called the market-clearing price b/c, at
this price,
 everyone in the market has been satisfied:
 neither there is shortage or surplus of the good.
 Buyers have bought all they want to buy, & sellers have sold all they
want to sell.
 Markets in Equilibrium: At the equilibrium price,
the quantity of the good that buyers are willing & able to buy exactly
balances the quantity that sellers are willing and able to sell.
The equilibrium is found where the supply & demand curves intersect.
 At this price level there will be no surplus and shortage of goods in
the market that is why market is said to be at equilibrium.

Price

Quantity
Markets not in Equilibrium:
The situation at which a price is not at Market Clearing Price. Here
prices are above or below an equilibrium price.
 At this price levels there will be surplus/shortage of goods in the
market that is why market is said to be not at equilibrium or imbalance
In panel (a) below,there is a surplus. B/se the market price (P1)
is above the equilibrium price, the quantity supplied exceeds the
quantity demanded.
 Suppliers try to increase sales by cutting the price of a cone, &
this moves the price toward its equilibrium level.
In panel (b),there is a shortage. B/se the market price (P2) is
below the equilibrium price, the quantity demanded exceeds the
quantity supplied.
 With too many buyers chasing too few goods, suppliers can take
advantage of the shortage by raising the price.
Hence, in both cases, the price adjustment moves the market
toward the equilibrium of supply and demand.
Panel (a) Panel (b)

P1
E
PE E
P2
It is possible to derive the market clearing price & quantity
using mathematical approach
Example 1. If the market demand & supply functions are
given as Qd = 80 – 3P and Qs = 9P - 40 respectively.
Where, P = Price of a good.
 Then, what is the market clearing price & the
corresponding quantity?
Soln:
Equate Qd = Qs to get the equilibrium price
80 – 3p = 9p-40 substitute for Qd and Qs
 120 = 12p rearrange p* = 10 birr
To get the equilibrium quantity (Q*), substitute this price in to
either of the functions.
Qd = 80 – 3 (10) & Q* = 50 units
 Therefore, the market clears when price is Br. 10 and both
the quantity demanded and supplied are 50 units.
Example. 2: If the inverse demand and supply functions for
the market of ball point pen is given as follows:
P = 2 – 0.1 Qd & P = 1/5 Qs – 1. Then,
a. Find the equilibrium price of a unit of ball point pen.
b. How many ball point pens will be sold and bought at
equilibrium?
Example 3: The market demand and supply for soap is
estimated to be as given below.

a. Determine equilibrium price & equilibrium quantity of

soap
b. If the price of soap is 3 birr, will there be shortage
or surplus of soap in the market? By how much ?
Solution: Exercise
 Change in Market Equilibrium:
Change in Equilibrium Price & Quantity
The Market Equilibrium might change when
change in demand or supply; or change in
both takes place.
 Corresponding to the change in market
forces, three possibilities can be considered.
a. Change in Demand Only or
b. Change in Supply Only or
c. Change in both Supply and Demand.
 a. Change in Demand Only:
Changes in any one of the non-price determinants of
demand discussed above; will result either in
increase or decrease in market demand.
 Hence, holding supply conditions
constant, demand will vary
with changing determining
factors.
For example; Demand increases with a
fall in interest rates; &
demand falls as interest rates
rise.
 When market demand increases
without any change in market
supply, both equilibrium price
and quantity increases.
 Where as a decrease in demand
curve result fall in both
equilibrium price and quantity.
 b. Change in Supply Only:
Similarly as we have seen; changes in any non-price
determinants of supply; will cause the market supply
to increase or decrease.
 Holding demand conditions
constant, supply will vary with
changing determining factor.
For example; supply falls with a
rise in interest rates; supply rises
as interest rates decline.

 Given the demand curve,

increase in supply will result fall
in equilibrium price but increase
in equilibrium quantity.

 Where as a decrease in supply

curve will result increase in
equilibrium price but fall in in
equilibrium quantity.
c. Change in both Supply & Demand
There are three possible cases of simultaneous
change in supply and demand.
In the case; there are three possibilities to
occur.
i. Increase in both demand and supply or
ii. Decrease in both Demand and Supply or
iii. Supply and Demand Change in Different
Direction.
a. Increases in both Demand and Supply
When both market demand and supply increases
simultaneously equilibrium quantity increases.
 But the change in equilibrium price depends upon the
magnitude of change in supply and demand.
D  S  Q P
 i.e. when supply and demand both increases, equilibrium
quantity increases, but price may go up or down.
But
 If market demand increases more than supply
increase equilibrium price will increase otherwise
equilibrium price falls.
 i.e. it depends on the Relative Magnitudes of Change

 If both are increased by the same magnitude, there

will be no change in equilibrium price.
 Relative Magnitudes of Change:
 When supply & demand both increase, quantity will
increase, but price may go up or down; depending
relative magnitudes of change.

 Higher supply leads to lower  Higher demand leads to higher

equilibrium price and higher equilibrium price and higher
equilibrium quantity. equilibrium quantity.
 b. Decreases in Demand and Supply:
 When both market demand and supply decreased
simultaneously, equilibrium quantity decreases as well,
but the change in price again depends upon the magnitude
of change in demand and supply.

D  S  Q P
 i.e. when supply and demand both decrease, quantity
will decrease, but price may go up or down.
i.e. it depends on the Relative Magnitudes of Change
 If demand changes more than supply, equilibrium
price will fall.
 But supply decrease more than demand decrease,
equilibrium price will increase.

 If both are decreased by the same magnitude, there

will be no change in equilibrium price.
 Relative Magnitudes of Change:
S’

P1
S D > S
P0
 P,Q
 Lower demand D
D’
leads to lower
price & lower
quantity
exchanged. S’  Lower supply
leads to higher
price & lower
P1 S quantity
exchanged.
P0
D S >D
D’

P,Q
Supply & Demand Change in Different
Direction
When supply & demand both change in different direction;
 The relative magnitudes of change in supply & demand
determine the outcome of market equilibrium.

i.e.
Whether equilibrium quantity increases or decreases as a
result of these changes depends upon the relative
changes of market demand and supply.
1. If supply increases & demand decreases, equilibrium
price falls, but by a greater amount than when the two
changes are considered in isolation.
 but equilibrium quantity may increase or decrease
depending on the magnitude of
S  D  P Q
change in demand & supply.
2. The other alternative is that supply decreases &
demand increases.
These change have a price increasing effect,
 but equilibrium quantity may increase or decrease
depending on the magnitude of change in demand &
supply.
S  D  P Q
 If fall in supply is greater than the increase in
demand, equilibrium quantity decreases.
S > D  P, Q
 But decrease in supply is less than increase in
demand, equilibrium quantity rather increase.

S < D P, Q

The summary of the effect of change in demand
and supply on market equilibrium.