Ch1. Introduction to Microeconomics — The Law of Supply & Demand and How Markets Work
What Is Economics?
Economics is the study of how scarce resources are allocated.
The central concept is scarcity: human wants are unlimited, but resources (time, money, land) are finite. This imbalance is the starting point for every economic problem.
Microeconomics analyzes the decisions of individual households, firms, and markets. Unlike macroeconomics (which studies the economy as a whole), microeconomics asks questions like “Why does the price of a specific good rise?” and “How do firms maximize profit?”
Demand
Demand is the quantity of a good or service that consumers are willing and able to purchase at a given price level.
The Law of Demand
When price rises, quantity demanded falls; when price falls, quantity demanded rises.
On a graph this produces a downward-sloping (↙) demand curve.
Change in Quantity Demanded vs. Shift in Demand
| Type | Cause | Graph Change |
|---|---|---|
| Change in quantity demanded | Change in the good’s own price | Movement along the curve |
| Shift in demand | Change in a non-price factor | Entire curve shifts |
Factors that shift demand:
- Changes in consumer income
- Changes in the price of substitutes (butter price rises → margarine demand increases)
- Changes in the price of complements (coffee price rises → sugar demand falls)
- Changes in consumer expectations and preferences
- Changes in the number of consumers
Supply
Supply is the quantity of a good or service that producers are willing and able to sell at a given price level.
The Law of Supply
When price rises, quantity supplied increases; when price falls, quantity supplied decreases.
On a graph this produces an upward-sloping (↗) supply curve because higher prices make production more profitable.
Factors That Shift Supply
- Changes in the cost of inputs (raw materials, labor)
- Technological innovation (productivity gains → supply increases)
- Changes in the number of producers
- Taxes and subsidies
- Expectations about future prices
Equilibrium: Where Markets Clear
Market equilibrium is the price-quantity combination at which quantity demanded equals quantity supplied.
- Excess demand (shortage): price is below equilibrium → upward price pressure
- Excess supply (surplus): price is above equilibrium → downward price pressure
Equilibrium is self-restoring — in a free market, prices move toward the point where supply and demand balance.
Shifts in equilibrium:
- Demand increases → equilibrium price ↑, equilibrium quantity ↑
- Supply decreases → equilibrium price ↑, equilibrium quantity ↓
Elasticity
Elasticity measures how sensitively one variable responds to a change in another.
Price Elasticity of Demand (PED)
PED = % Change in Quantity Demanded / % Change in Price
| PED Value | Meaning |
|---|---|
| |PED| > 1 | Elastic: demand responds strongly to price changes |
| |PED| < 1 | Inelastic: demand responds weakly to price changes |
| |PED| = 1 | Unit elastic |
Inelastic demand examples: necessities (gasoline, prescription drugs, utilities) — consumers buy them even when prices rise.
Elastic demand examples: luxury goods, goods with many substitutes — consumers switch to alternatives when prices rise.
Firm revenue and elasticity:
- Inelastic: price increase → revenue increases
- Elastic: price increase → revenue decreases (demand falls too much)
Income Elasticity of Demand (YED)
YED = % Change in Quantity Demanded / % Change in Income
- YED > 0: Normal good — demand rises as income rises (most goods)
- YED < 0: Inferior good — demand falls as income rises (generic food brands, budget transit)
- YED > 1: Luxury good — demand grows faster than income
Cross-Price Elasticity of Demand (XED)
XED = % Change in Demand for Good A / % Change in Price of Good B
- XED > 0: Substitutes (butter price ↑ → margarine demand ↑)
- XED < 0: Complements (car price ↑ → gasoline demand ↓)
Consumer Surplus and Producer Surplus
Consumer Surplus
The difference between the maximum price a consumer is willing to pay and the price actually paid. It represents the net benefit the market provides to consumers.
Producer Surplus
The difference between the price a producer receives and the minimum price they would accept. It represents the net benefit the market provides to producers.
Market efficiency: In a competitive free market, the sum of consumer surplus and producer surplus (= total surplus, social welfare) is maximized. This is called Pareto optimality.
Market Failure and Government Intervention
Free markets do not always produce efficient outcomes.
Main Causes of Market Failure
Public Goods: Non-rival and non-excludable (national defense, street lighting). The free-rider problem leads to under-provision by the market.
Externalities: Effects on third parties not involved in the transaction.
- Negative externalities: factory pollution → government uses taxes (Pigouvian tax) or regulation to reduce output
- Positive externalities: vaccinations → government subsidizes production/consumption
Information Asymmetry: Information gaps between parties → adverse selection, moral hazard.
Natural Monopoly: Industries where economies of scale make single-firm dominance efficient (electricity, water). Government regulation or public ownership.
Government Intervention Tools
| Tool | Example |
|---|---|
| Taxes | Internalize negative externalities (carbon tax) |
| Subsidies | Encourage positive externalities (renewable energy) |
| Price controls | Price ceiling (rent control), price floor (minimum wage) |
| Direct regulation | Environmental standards, safety standards |
Learning Checklist
- Explain the law of demand and the law of supply
- Distinguish between a change in quantity demanded and a shift in demand
- Explain how equilibrium price is determined
- Calculate and interpret PED, YED, and XED
- Explain the four causes of market failure and the tools of government intervention
Key Concept Cards
Law of Demand ★★★★★ : Price rises → quantity demanded falls; price falls → quantity demanded rises. Inverse relationship. Memory tip: Price ↑ → Quantity demanded ↓ (inverse)
Demand vs. Change in Quantity Demanded ★★★★★ : Change in quantity demanded: own price changes → movement along the same demand curve. Shift in demand: non-price factors (income, expectations, preferences, related-good prices) → the entire demand curve shifts. Memory tip: Movement along curve = change in quantity demanded / Curve shift = change in demand
Law of Supply ★★★★ : Price rises → quantity supplied increases; price falls → quantity supplied decreases. Direct relationship.
Equilibrium Price and Quantity ★★★★★ : The point where quantity demanded = quantity supplied. Excess demand → price ↑; excess supply → price ↓.
Price Ceiling vs. Price Floor ★★★★★ : Price ceiling: maximum price set below equilibrium → shortage (e.g., rent control). Price floor: minimum price set above equilibrium → surplus (e.g., minimum wage). Memory tip: Ceiling = cap (shortage), Floor = bottom (surplus)
Substitutes vs. Complements ★★★★ : Substitutes: can be consumed instead of each other. One good’s price ↑ → substitute’s demand ↑ (e.g., butter/margarine). Complements: consumed together. One good’s price ↑ → complement’s demand ↓ (e.g., coffee/creamer).
Practice Quiz
Q. For a price ceiling to be effective, where must it be set?
Below the equilibrium price. Setting it above equilibrium has no effect.
Q. What type of good experiences falling demand when income rises?
An inferior good. Examples: store-brand instant noodles, second-hand goods. Normal goods see demand rise when income rises.
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