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Microeconomics Unit 2: Supply and demand

Supply and demand set market prices; elasticity measures responsiveness, and government interventions create surpluses, shortages and deadweight loss.

Covers: Demand and its determinants, supply and its determinants, elasticity, market equilibrium and changes, consumer and producer surplus, price controls, taxes and subsidies, trade

Study guide

The law of demand says that as price rises, quantity demanded falls, ceteris paribus, because of the substitution and income effects. A change in price causes a movement along the demand curve; a change in a determinant shifts the whole curve. Demand shifters include tastes, the number of buyers, income (normal goods rise with income, inferior goods fall), prices of related goods (substitutes and complements) and expectations. The law of supply says that higher prices increase quantity supplied; supply shifters include input prices, technology, the number of sellers, taxes and subsidies, and expectations.

Equilibrium is where quantity demanded equals quantity supplied. Above it there's a surplus, pushing prices down; below it there's a shortage, pushing prices up. When demand increases, price and quantity rise; when supply increases, price falls and quantity rises. If both shift, one variable's direction is indeterminate. Price elasticity of demand measures how much quantity responds to price: %ΔQd ÷ %ΔP. Demand is elastic (greater than 1) when there are many substitutes or the good is a luxury, and inelastic (less than 1) for necessities. The total revenue test says that if price rises and total revenue falls, demand is elastic. Income elasticity identifies normal and inferior goods, and cross-price elasticity identifies substitutes (positive) and complements (negative).

Consumer surplus is the difference between what buyers are willing to pay and the price; producer surplus is the difference between the price and sellers' costs. Free-market equilibrium maximizes total surplus. A binding price ceiling (below equilibrium, like rent control) causes a shortage; a binding price floor (above equilibrium, like a minimum wage) causes a surplus. Both create deadweight loss. Taxes raise prices for buyers and lower what sellers receive; the incidence falls more on the less elastic side. Subsidies do the opposite. With trade, world prices below domestic prices lead to imports, and tariffs and quotas protect domestic producers but create deadweight loss.

If total revenue stays the same when price changes, demand is unit elastic (elasticity = 1). Perfectly inelastic demand is a vertical line (elasticity of 0), and perfectly elastic demand is horizontal (infinite elasticity). Demand is also more elastic over longer time periods and for goods that take a large share of income. Elasticity is usually calculated with the midpoint formula, which uses average price and quantity as the base. On a linear supply-and-demand graph, consumer surplus is the triangle between the demand curve and the price line, and producer surplus is the triangle between the price line and the supply curve. Each equals ½ × base (quantity) × height (price difference). Deadweight loss is the triangle of lost surplus between the efficient quantity and the actual quantity.

If the world price is above the domestic equilibrium price, domestic producers supply more than domestic consumers buy, and the difference is exported. Domestic consumer surplus falls, producer surplus rises, and total domestic surplus rises. When a good's price falls, the substitution effect makes it cheaper relative to other goods, and the income effect raises buyers' purchasing power. For a normal good, both effects raise quantity demanded.

A per-unit tax shifts supply up (left) by the tax amount, and tax revenue is the tax per unit times the new quantity, a rectangle between the buyer and seller prices. A per-unit subsidy shifts supply down (right). The government's cost is the subsidy per unit times the new quantity, a rectangle that is larger than the gain in surplus, so the difference is deadweight loss.

Key ideas

• A change in price moves along a curve; a change in a determinant shifts it.
• Shortages push prices up and surpluses push them down toward equilibrium.
• Elasticity measures how strongly quantity responds to price.
• Binding price ceilings cause shortages; binding floors cause surpluses.
• Taxes and price controls create deadweight loss.

Formulas and rules

Common mistakes

• Saying a price change shifts the demand curve; it moves along it.
• Thinking a price ceiling sits above equilibrium; to bind, it must be below.

Words to know

Law of demand

As price rises, quantity demanded falls.

Change in quantity demanded

A movement along the demand curve caused by price.

Change in demand

A shift of the whole demand curve.

Normal good

Demand rises as income rises.

Inferior good

Demand falls as income rises.

Substitutes

Goods used in place of each other; one's price rising raises demand for the other.

Complements

Goods used together; one's price rising lowers demand for the other.

Law of supply

As price rises, quantity supplied rises.

Equilibrium

The price where quantity demanded equals quantity supplied.

Shortage

Quantity demanded exceeds quantity supplied.

Surplus

Quantity supplied exceeds quantity demanded.

Price elasticity of demand

Responsiveness of quantity demanded to price.

Total revenue test

If P rises and TR falls, demand is elastic.

Income elasticity

Responsiveness of demand to income.

Consumer surplus

Willingness to pay minus price paid.

Producer surplus

Price received minus the seller's cost.

Deadweight loss

Lost total surplus from an inefficient quantity.

Price ceiling

A legal maximum price; binding below equilibrium.

Price floor

A legal minimum price; binding above equilibrium.

Tax incidence

Who actually bears the burden of a tax.

Tariff

A tax on imports.

Quota

A limit on the quantity of imports.

Sample practice questions

23 more questions like these, from level 1 to 5, are in the practice set.