Ch2. 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

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

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)

Price Elasticity

Price Elasticity of Demand (PED)

PED = % Change in Quantity Demanded
      ÷ % Change in Price
    = (ΔQ/Q) / (ΔP/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

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)

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

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.