Supply and Demand — How Markets Set Prices

The Law of Demand

Law of Demand

• Price ↑ → Quantity demanded ↓ (inverse relationship)
• Price ↓ → Quantity demanded ↑

Demand curve: downward sloping

Change in Quantity Demanded vs. Change in Demand

• Change in quantity demanded: caused by a price change → movement along the curve
• Change in demand: caused by a non-price factor → shift of the entire curve

Demand Shifters

Demand Increases (rightward shift)

• Income rises (for normal goods)
• Price of a substitute rises
• Price of a complement falls
• Consumer preferences increase
• Expected future price rises

Demand Decreases (leftward shift)

• Reverse of the above

Inferior Good

Income rises → demand decreases

• Examples: generic store brands, bus rides when consumers can now afford a car

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The Law of Supply

Law of Supply — Price ↑ → Quantity supplied ↑ (positive relationship)

• Supply curve: upward sloping

Supply Shifters

Supply Increases (rightward shift):

• Input costs fall (wages, raw materials)
• Technology improves
• Number of sellers increases
• Taxes decrease / subsidies increase

Supply Decreases (leftward shift):

• Reverse of the above

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Equilibrium Price and Quantity

Equilibrium: Quantity demanded = Quantity supplied

Shortage (Demand > Supply)

• Upward price pressure → equilibrium restored

Surplus (Supply > Demand)

• Downward price pressure → equilibrium restored

Equilibrium Shift Examples

• Demand increases → P↑, Q↑
• Supply decreases → P↑, Q↓
• Demand and supply both increase → Q↑, P indeterminate (depends on magnitude)

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Price Elasticity

Price Elasticity of Demand (PED)

$$\text{PED} = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}} = \frac{\Delta Q / Q}{\Delta P / P}$$

Classification

• |PED| > 1: Elastic (luxuries, many substitutes)
• |PED| < 1: Inelastic (necessities, few substitutes)
• |PED| = 1: Unit elastic
• |PED| = 0: Perfectly inelastic (vertical curve)
• |PED| = ∞: Perfectly elastic (horizontal curve)

Determinants of Elasticity

• Number of substitutes: more → more elastic
• Necessity vs. luxury: necessity → less elastic
• Share of budget: larger → more elastic
• Time horizon: longer → more elastic

Elasticity and Total Revenue

Total Revenue (TR) = P × Q

Elastic demand

• Price ↑ → large drop in Q → TR falls
• Price ↓ → large rise in Q → TR rises

Inelastic demand

• Price ↑ → small drop in Q → TR rises
• Price ↓ → small rise in Q → TR falls

Unit elastic

• Price change → no change in TR

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Consumer and Producer Surplus

• Consumer Surplus: willingness to pay − price paid
• Producer Surplus: price received − minimum acceptable price

Total Social Surplus = Consumer Surplus + Producer Surplus → Maximized at free-market equilibrium (allocatively efficient outcome)

Price controls → reduce total surplus → deadweight loss (e.g., rent ceilings, minimum-wage floors)

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Key Concept Cards

Quantity Change vs. Demand Shift ★★★★★ : Price change → quantity demanded changes (movement along curve). Non-price factor → demand shifts (entire curve moves). Memory hook: price = slide along the curve; anything else = shift the curve

Elasticity and Total Revenue ★★★★★ : Elastic → cut price to grow TR. Inelastic → raise price to grow TR. Memory hook: elastic = discounts work; inelastic = price hikes work

Determinants of Demand Elasticity ★★★★☆ : Many substitutes, luxury good, large budget share, long time horizon → elastic. Necessity, short run → inelastic. Memory hook: more substitutes = more elastic

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Practice Questions

Q. Why does the quantity of gasoline demanded fall only slightly when gas prices rise sharply? Explain using elasticity.

Gasoline is a necessity with few close substitutes in the short run. Its price elasticity of demand is inelastic (|PED| < 1). A large price increase produces only a small decrease in quantity demanded.

Q. If a product has a price elasticity of demand of 2, and its price is cut by 10%, by how much does quantity demanded change?

% change in quantity demanded = PED × % change in price = 2 × 10% = 20% increase.